Cost Accounting. Charles T. Horngren Stanford University. Srikant M. Datar Harvard University. Madhav V. Rajan Stanford University

Cost Accounting A Managerial Emphasis Fourteenth Edition

Charles T. Horngren

Stanford University

Srikant M. Datar

Harvard University

Madhav V. Rajan

Stanford University

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ISBN-13: 978-0-13-210917-8 ISBN-10: 0-13-210917-4

An Introduction to Cost Terms and Purposes

What does the word cost mean to you?

Learning Objectives

Is it the price you pay for something of value? A cash outflow? Something that affects profitability? There are many different types of costs, and at different times organizations put more or less emphasis on them. When times are good companies often focus on selling as much as they can, with costs taking a backseat. But when times get tough, the emphasis usually shifts to costs and cutting them, as General Motors tried to do. Unfortunately, when times became really bad GM was unable to cut costs fast enough leading to Chapter 11 bankruptcy.

1. Define and illustrate a cost object 2. Distinguish between direct costs and indirect costs 3. Explain variable costs and fixed costs 4. Interpret unit costs cautiously 5. Distinguish inventoriable costs from period costs 6. Explain why product costs are computed in different ways for different purposes 7. Describe a framework for cost accounting and cost management

GM Collapses Under the Weight of its Fixed Costs1 After nearly 80 years as the world’s largest automaker, General Motors (GM) was forced to file for bankruptcy protection in 2009. Declining sales and the rise of Japanese competitors, such as Toyota and Honda, affected GM’s viability given its high fixed costs—costs that did not decrease as the number of cars that GM made and sold declined. A decade of belt-tightening brought GM’s variable costs—costs such as material costs that vary with the number of cars that GM makes—in line with those of the Japanese. Unfortunately for GM, a large percentage of its operating costs were fixed because union contracts made it difficult for the company to close its factories or reduce pensions and health benefits owed to retired workers. To cover its high fixed costs, GM needed to sell a lot of cars. Starting in 2001, it began offering sales incentives and rebates, which for a few years were somewhat successful. GM also expanded aggressively into China and Europe. But in 2005, growth efforts slowed, and GM lost $10.4 billion. As a result, GM embarked on a reorganization plan that closed more than a dozen plants, eliminated tens of thousands of jobs, slashed retirement plan benefits for its 40,000-plus salaried employees, and froze its pension program. Despite these cuts, GM could not reduce its costs fast enough to keep up with the steadily declining market for new cars and trucks. In the United States, as gas prices rose above $4 a gallon, GM’s product 1

Sources: Loomis, Carol. 2006. The tragedy of General Motors. Fortune, February 6; New York Times. 2009. Times topics: Automotive industry crisis. December 6. http://topics.nytimes.com/top/reference/timestopics/ subjects/c/credit_crisis/auto_industry/index.html; Taylor, III, Alex. 2005. GM hits the skids. Fortune, April 4; Vlasic, Bill and Nick Bunkley. 2008. G.M. says U.S. cash is its best hope. New York Times, November 8.

mix was too heavily weighted toward gas-guzzling trucks, pickup trucks, and sport utility vehicles, all of which were experiencing sharp decreases in sales. In late 2008, as the economic crisis worsened, GM announced plans to cut $15 billion in costs and raise $5 billion through the sale of assets, like its Hummer brand of offroad vehicles. “We’re cutting to the bone,” said Fritz Henderson, GM’s president. “But given the situation, we think that’s appropriate.” It was appropriate, but it wasn’t enough. By November 2008, GM had lost more than $18 billion for the year, and the government loaned the company $20 billion to continue operations. Ultimately, its restructuring efforts fell short, and the weight of GM’s fixed costs drove the company into bankruptcy. In court papers, the company claimed $82.3 billion in assets and $172.8 billion in debt. When it emerges from bankruptcy, GM will be a much smaller company with only four brands of cars (down from eight), more than 20,000 fewer hourly union workers, and as many as 20 additional shuttered factories. As the story of General Motors illustrates, managers must understand costs in order to interpret and act on accounting information. Organizations as varied as as the United Way, the Mayo Clinic, and Sony generate reports containing a variety of cost concepts and terms that managers need to run their businesses. Managers must understand these concepts and terms to effectively use the information provided. This chapter discusses cost concepts and terms that are the basis of accounting information used for internal and external reporting.

Costs and Cost Terminology Accountants define cost as a resource sacrificed or forgone to achieve a specific objective. A cost (such as direct materials or advertising) is usually measured as the monetary amount that must be paid to acquire goods or services. An actual cost is the cost incurred (a historical or past cost), as distinguished from a budgeted cost, which is a predicted or forecasted cost (a future cost). When you think of cost, you invariably think of it in the context of finding the cost of a particular thing. We call this thing a cost object, which is anything for which a measurement of costs is desired. Suppose that you were a manager at BMW’s Spartanburg, South Carolina, plant. BMW makes several different types of cars and sport activity vehicles (SAVs) at this plant. What cost objects can you think of? Now look at Exhibit 2-1. You will see that BMW managers not only want to know the cost of various products, such as the BMW X5, but they also want to know the costs of things such as projects,

Learning Objective

Define and illustrate a cost object . . . examples of cost objects are products, services, activities, processes, and customers

28 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

Exhibit 2-1 Examples of Cost Objects at BMW

Cost Object Product Service Project Customer Activity Department

Illustration A BMW X5 sports activity vehicle Telephone hotline providing information and assistance to BMW dealers R&D project on enhancing the DVD system in BMW cars Herb Chambers Motors, the BMW dealer that purchases a broad range of BMW vehicles Setting up machines for production or maintaining production equipment Environmental, health, and safety department

services, and departments. Managers use their knowledge of these costs to guide decisions about, for example, product innovation, quality, and customer service. Now think about whether a manager at BMW might want to know the budgeted cost of a cost object, or the actual cost. Managers almost always need to know both types of costs when making decisions. For example, comparing budgeted costs to actual costs helps managers evaluate how well they did and learn about how they can do better in the future. How does a cost system determine the costs of various cost objects? Typically in two basic stages: accumulation, followed by assignment. Cost accumulation is the collection of cost data in some organized way by means of an accounting system. For example, at its Spartanburg plant, BMW collects (accumulates) costs in various categories such as different types of materials, different classifications of labor, and costs incurred for supervision. Managers and management accountants then assign these accumulated costs to designated cost objects, such as the different models of cars that BMW manufactures at the plant. BMW managers use this cost information in two main ways: 1. when making decisions, for instance, on how to price different models of cars or how much to invest in R&D and marketing and 2. for implementing decisions, by influencing and motivating employees to act and learn, for example, by rewarding employees for reducing costs. Decision Point What is a cost object?

Now that we know why it is useful to assign costs, we turn our attention to some concepts that will help us do it. Again, think of the different types of costs that we just discussed—materials, labor, and supervision. You are probably thinking that some costs, such as costs of materials, are easier to assign to a cost object than others, such as costs of supervision. As you will see, this is indeed the case.

Direct Costs and Indirect Costs Learning Objective

We now describe how costs are classified as direct and indirect costs and the methods used to assign these costs to cost objects. #

Distinguish between direct costs . . . costs that are traced to the cost object and indirect costs . . . costs that are allocated to the cost object #

Direct costs of a cost object are related to the particular cost object and can be traced to it in an economically feasible (cost-effective) way. For example, the cost of steel or tires is a direct cost of BMW X5s. The cost of the steel or tires can be easily traced to or identified with the BMW X5. The workers on the BMW X5 line request materials from the warehouse and the material requisition document identifies the cost of the materials supplied to the X5. In a similar vein, individual workers record the time spent working on the X5 on time sheets. The cost of this labor can easily be traced to the X5 and is another example of a direct cost. The term cost tracing is used to describe the assignment of direct costs to a particular cost object. Indirect costs of a cost object are related to the particular cost object but cannot be traced to it in an economically feasible (cost-effective) way. For example, the salaries of plant administrators (including the plant manager) who oversee production of the many different types of cars produced at the Spartanburg plant are an indirect cost of the X5s. Plant administration costs are related to the cost object (X5s) because plant administration is necessary for managing the production of X5s. Plant administration costs are indirect costs because plant administrators also oversee the production of other

DIRECT COSTS AND INDIRECT COSTS " 29 TYPE OF COST Direct Costs Example: Cost of steel and tires for the BMW X5

COST ASSIGNMENT

COST OBJECT

Cost Assignment to a Cost Object

Cost Tracing based on material requisition document Example: BMW X5

Indirect Costs Example: Lease cost for Spartanburg plant where BMW makes the X5 and other models of cars

Cost Allocation no requisition document

products, such as the Z4 Roadster. Unlike the cost of steel or tires, there is no requisition of plant administration services and it is virtually impossible to trace plant administration costs to the X5 line. The term cost allocation is used to describe the assignment of indirect costs to a particular cost object. Cost assignment is a general term that encompasses both (1) tracing direct costs to a cost object and (2) allocating indirect costs to a cost object. Exhibit 2-2 depicts direct costs and indirect costs and both forms of cost assignment—cost tracing and cost allocation—using the example of the BMW X5.

Challenges in Cost Allocation Consider the cost to lease the Spartanburg plant. This cost is an indirect cost of the X5— there is no separate lease agreement for the area of the plant where the X5 is made. But BMW allocates to the X5 a part of the lease cost of the building—for example, on the basis of an estimate of the percentage of the building’s floor space occupied for the production of the X5 relative to the total floor space used to produce all models of cars. Managers want to assign costs accurately to cost objects. Inaccurate product costs will mislead managers about the profitability of different products and could cause managers to unknowingly promote unprofitable products while deemphasizing profitable products. Generally, managers are more confident about the accuracy of direct costs of cost objects, such as the cost of steel and tires of the X5. Identifying indirect costs of cost objects, on the other hand, can be more challenging. Consider the lease. An intuitive method is to allocate lease costs on the basis of the total floor space occupied by each car model. This approach measures the building resources used by each car model reasonably and accurately. The more floor space that a car model occupies, the greater the lease costs assigned to it. Accurately allocating other indirect costs, such as plant administration to the X5, however, is more difficult. For example, should these costs be allocated on the basis of the number of workers working on each car model or the number of cars produced of each model? How to measure the share of plant administration used by each car model is not clear-cut.

Factors Affecting Direct/Indirect Cost Classifications Several factors affect the classification of a cost as direct or indirect: #

Exhibit 2-2

The materiality of the cost in question. The smaller the amount of a cost—that is, the more immaterial the cost is—the less likely that it is economically feasible to trace that cost to a particular cost object. Consider a mail-order catalog company such as Lands’ End. It would be economically feasible to trace the courier charge for delivering a package to an individual customer as a direct cost. In contrast, the cost of the invoice paper included in the package would be classified as an indirect cost. Why? Although the cost of the paper can be traced to each customer, it is not cost-effective to do so. The benefits of knowing that, say, exactly 0.5¢ worth of paper is included in each package do not exceed the data processing and administrative costs of tracing the cost to each package. The time of the sales administrator, who earns a salary of $45,000 a year, is better spent organizing customer information to assist in focused marketing efforts than on tracking the cost of paper.

30 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES #

Decision Point How do managers decide whether a cost is a direct or indirect cost?

Available information-gathering technology. Improvements in information-gathering technology make it possible to consider more and more costs as direct costs. Bar codes, for example, allow manufacturing plants to treat certain low-cost materials such as clips and screws, which were previously classified as indirect costs, as direct costs of products. At Dell, component parts such as the computer chip and the CD-ROM drive display a bar code that can be scanned at every point in the production process. Bar codes can be read into a manufacturing cost file by waving a “wand” in the same quick and efficient way supermarket checkout clerks enter the cost of each item purchased by a customer. Design of operations. Classifying a cost as direct is easier if a company’s facility (or some part of it) is used exclusively for a specific cost object, such as a specific product or a particular customer. For example, the cost of the General Chemicals facility dedicated to manufacturing soda ash is a direct cost of soda ash.

Be aware that a specific cost may be both a direct cost of one cost object and an indirect cost of another cost object. That is, the direct/indirect classification depends on the choice of the cost object. For example, the salary of an assembly department supervisor at BMW is a direct cost if the cost object is the assembly department, but it is an indirect cost if the cost object is a product such as the BMW X5 SAV, because the assembly department assembles many different models. A useful rule to remember is that the broader the definition of the cost object—the assembly department rather than the X5 SAV—the higher the proportion of total costs that are direct costs and the more confidence a manager has in the accuracy of the resulting cost amounts.

Cost-Behavior Patterns: Variable Costs and Fixed Costs Learning Objective

Explain variable costs and fixed costs . . . the two basic ways in which costs behave

Costing systems record the cost of resources acquired, such as materials, labor, and equipment, and track how those resources are used to produce and sell products or services. Recording the costs of resources acquired and used allows managers to see how costs behave. Consider two basic types of cost-behavior patterns found in many accounting systems. A variable cost changes in total in proportion to changes in the related level of total activity or volume. A fixed cost remains unchanged in total for a given time period, despite wide changes in the related level of total activity or volume. Costs are defined as variable or fixed with respect to a specific activity and for a given time period. Surveys of practice repeatedly show that identifying a cost as variable or fixed provides valuable information for making many management decisions and is an important input when evaluating performance. To illustrate these two basic types of costs, again consider costs at the Spartanburg, South Carolina, plant of BMW. 1. Variable Costs: If BMW buys a steering wheel at $60 for each of its BMW X5 vehicles, then the total cost of steering wheels is $60 times the number of vehicles produced, as the following table illustrates.

Number of X5s Produced (1) 1 1,000 3,000

Variable Cost per Steering Wheel (2) $60 60 60

Total Variable Cost of Steering Wheels (3) = (1) ! (2) $ 60 60,000 180,000

The steering wheel cost is an example of a variable cost because total cost changes in proportion to changes in the number of vehicles produced. The cost per unit of a variable cost is constant. It is precisely because the variable cost per steering wheel in column 2 is the same for each steering wheel that the total variable cost of steering wheels in column 3 changes proportionately with the number of X5s produced in column 1. When considering how variable costs behave, always focus on total costs.

COST-BEHAVIOR PATTERNS: VARIABLE COSTS AND FIXED COSTS " 31 PANEL B: Supervision Costs for the BMW X5 assembly line (in millions)

$200,000 $150,000 $100,000 $50,000 $0

1,000 2,000 3,000 4,000 Number of X5s Assembled

20,000 40,000 60,000 Number of X5s Assembled

Exhibit 2-3, Panel A, graphically illustrates the total variable cost of steering wheels. The cost is represented by a straight line that climbs from left to right. The phrases “strictly variable” and “proportionately variable” are sometimes used to describe the variable cost in Panel A. Consider an example of a variable cost with respect to a different activity—the $20 hourly wage paid to each worker to set up machines at the Spartanburg plant. Setup labor cost is a variable cost with respect to setup hours because setup cost changes in total in proportion to the number of setup hours used. 2. Fixed Costs: Suppose BMW incurs a total cost of $2,000,000 per year for supervisors who work exclusively on the X5 line. These costs are unchanged in total over a designated range of the number of vehicles produced during a given time span (see Exhibit 2-3, Panel B). Fixed costs become smaller and smaller on a per unit basis as the number of vehicles assembled increases, as the following table shows. Annual Total Fixed Supervision Costs for BMW X5 Assembly Line (1) $2,000,000 $2,000,000 $2,000,000

Exhibit 2-3 Graphs of Variable and Fixed Costs

$3 Total Supervision Costs

Total Cost of Steering Wheels

PANEL A: Variable Cost of Steering Wheels at $60 per BMW X5 Assembled

Number of X5s Produced (2) 10,000 25,000 50,000

Fixed Supervision Cost per X5 (3) = (1) ÷ (2) $200 80 40

It is precisely because total line supervision costs are fixed at $2,000,000 that fixed supervision cost per X5 decreases as the number of X5s produced increases; the same fixed cost is spread over a larger number of X5s. Do not be misled by the change in fixed cost per unit. Just as in the case of variable costs, when considering fixed costs, always focus on total costs. Costs are fixed when total costs remain unchanged despite significant changes in the level of total activity or volume. Why are some costs variable and other costs fixed? Recall that a cost is usually measured as the amount of money that must be paid to acquire goods and services. Total cost of steering wheels is a variable cost because BMW buys the steering wheels only when they are needed. As more X5s are produced, proportionately more steering wheels are acquired and proportionately more costs are incurred. Contrast the description of variable costs with the $2,000,000 of fixed costs per year incurred by BMW for supervision of the X5 assembly line. This level of supervision is acquired and put in place well before BMW uses it to produce X5s and before BMW even knows how many X5s it will produce. Suppose that BMW puts in place supervisors capable of supervising the production of 60,000 X5s each year. If the demand is for only 55,000 X5s, there will be idle capacity. Supervisors on the X5 line could have supervised the production of 60,000 X5s but will supervise only 55,000 X5s because of the lower demand. However, BMW must pay for the unused line supervision capacity because the cost of supervision cannot be reduced in the short run. If demand is even lower—say only 50,000 X5s—line supervision costs will still be the same $2,000,000, and idle capacity will increase.

32 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

Decision Point How do managers decide whether a cost is a variable or a fixed cost?

Unlike variable costs, fixed costs of resources (such as for line supervision) cannot be quickly and easily changed to match the resources needed or used. Over time, however, managers can take actions to reduce fixed costs. For example, if the X5 line needs to be run for fewer hours because of low demand for X5s, BMW may lay off supervisors or move them to another production line. Unlike variable costs that go away automatically if the resources are not used, reducing fixed costs requires active intervention on the part of managers. Do not assume that individual cost items are inherently variable or fixed. Consider labor costs. Labor costs can be purely variable with respect to units produced when workers are paid on a piece-unit (piece-rate) basis. For example, some garment workers are paid on a per-shirt-sewed basis. In contrast, labor costs at a plant in the coming year are sometimes appropriately classified as fixed. For instance, a labor union agreement might set annual salaries and conditions, contain a no-layoff clause, and severely restrict a company’s flexibility to assign workers to any other plant that has demand for labor. Japanese companies have for a long time had a policy of lifetime employment for their workers. Although such a policy entails higher fixed labor costs, the benefits are increased loyalty and dedication to the company and higher productivity. As the General Motors example in the chapter opener (p. 26) illustrated, such a policy increases the risk of losses during economic downturns as revenues decrease, while fixed costs remain unchanged. The recent global economic crisis has made companies very wary of locking-in fixed costs. The Concepts in Action box on page 33 describes how a car-sharing service offers companies the opportunity to convert the fixed costs of owning corporate cars into variable costs by renting cars on an as-needed basis. A particular cost item could be variable with respect to one level of activity and fixed with respect to another. Consider annual registration and license costs for a fleet of planes owned by an airline company. Registration and license costs would be a variable cost with respect to the number of planes owned. But registration and license costs for a particular plane are fixed with respect to the miles flown by that plane during a year. To focus on key concepts, we have classified the behavior of costs as variable or fixed. Some costs have both fixed and variable elements and are called mixed or semivariable costs. For example, a company’s telephone costs may have a fixed monthly payment and a charge per phone-minute used. We discuss mixed costs and techniques to separate out their fixed and variable components in Chapter 10.

Cost Drivers A cost driver is a variable, such as the level of activity or volume that causally affects costs over a given time span. An activity is an event, task, or unit of work with a specified purpose—for example, designing products, setting up machines, or testing products. The level of activity or volume is a cost driver if there is a cause-and-effect relationship between a change in the level of activity or volume and a change in the level of total costs. For example, if product-design costs change with the number of parts in a product, the number of parts is a cost driver of product-design costs. Similarly, miles driven is often a cost driver of distribution costs. The cost driver of a variable cost is the level of activity or volume whose change causes proportionate changes in the variable cost. For example, the number of vehicles assembled is the cost driver of the total cost of steering wheels. If setup workers are paid an hourly wage, the number of setup hours is the cost driver of total (variable) setup costs. Costs that are fixed in the short run have no cost driver in the short run but may have a cost driver in the long run. Consider the costs of testing, say, 0.1% of the color printers produced at a Hewlett-Packard plant. These costs consist of equipment and staff costs of the testing department that are difficult to change and, hence, are fixed in the short run with respect to changes in the volume of production. In this case, volume of production is not a cost driver of testing costs in the short run. In the long run, however, HewlettPackard will increase or decrease the testing department’s equipment and staff to the levels needed to support future production volumes. In the long run, volume of production is a cost driver of testing costs. Costing systems that identify the cost of each activity such as testing, design, or set up are called activity-based costing systems.

COST-BEHAVIOR PATTERNS: VARIABLE COSTS AND FIXED COSTS " 33

Concepts in Action

How Zipcar Helps Reduce Twitter’s Transportation Costs

Soaring gas prices, high insurance costs, and hefty parking fees have forced many businesses to reexamine whether owning corporate cars is economical. In some cities, Zipcar has emerged as an attractive alternative. Zipcar provides an “on demand” option for urban individuals and businesses to rent a car by the week, the day, or even the hour. Zipcar members make a reservation by phone or Internet, go to the parking lot where the car is located (usually by walking or public transportation), use an electronic card or iPhone application that unlocks the car door via a wireless sensor, and then simply climb in and drive away. Rental fees begin around $7 per hour and $66 per day, and include gas, insurance, and some mileage (usually around 180 miles per day). Currently, business customers account for 15% of Zipcar’s revenues, but that number is expected to double in the coming years. Let’s think about what Zipcar means for companies. Many small businesses own a company car or two for getting to meetings, making deliveries, and running errands. Similarly, many large companies own a fleet of cars to shuttle visiting executives and clients back and forth from appointments, business lunches, and the airport. Traditionally, owning these cars has involved very high fixed costs, including buying the asset (car), costs of the maintenance department, and insurance for multiple drivers. Unfortunately, businesses had no other options. Now, however, companies like Twitter can use Zipcar for on-demand mobility while reducing their transportation and overhead costs. Based in downtown San Francisco, Twitter managers use Zipcar’s fleet of Mini Coopers and Toyota Priuses to meet venture capitalists and partners in Silicon Valley. “We would get in a Zipcar to drive down to San Jose to pitch investors or go across the city,” says Jack Dorsey, the micro-blogging service’s co-founder. “Taxis are hard to find and unreliable here.” Twitter also uses Zipcar when traveling far away from its headquarters, like when visiting advertisers in New York and technology vendors in Boston, forgoing the traditional black sedans and long taxi rides from the airport. From a business perspective, Zipcar allows companies to convert the fixed costs of owning a company car to variable costs. If business slows, or a car isn’t required to visit a client, Zipcar customers are not saddled with the fixed costs of car ownership. Of course, if companies use Zipcar too frequently, they can end up paying more overall than they would have paid if they purchased and maintained the car themselves. Along with cutting corporate spending, car sharing services like Zipcar reduce congestion on the road and promote environmental sustainability. Users report reducing their vehicle miles traveled by 44%, and surveys show CO2 emissions are being cut by up to 50% per user. Beyond that, each shared car takes up to 20 cars off the road as members sell their cars or decide not to buy new ones—challenging the whole principle of owning a car. “The future of transportation will be a blend of things like Zipcar, public transportation, and private car ownership,” says Bill Ford, Ford’s executive chairman. But the automaker isn’t worried. “Not only do I not fear that, but I think it’s a great opportunity for us to participate in the changing nature of car ownership.” Sources: Keegan, Paul. 2009. Zipcar – the best new idea in business. Fortune, August 27. http://money.cnn.com/2009/08/26/news/companies/zipcar_car_ rentals.fortune/; Olsen, Elizabeth. 2009. Car sharing reinvents the company wheels. New York Times, May 7. http://www.nytimes.com/2009/05/07/business/ businessspecial/07CAR.html; Zipcar, Inc. Zipcar for business case studies. http://www.zipcar.com/business/is-it/case-studies (accessed October 8, 2009)

Relevant Range Relevant range is the band of normal activity level or volume in which there is a specific relationship between the level of activity or volume and the cost in question. For example, a fixed cost is fixed only in relation to a given wide range of total activity or volume (at which the company is expected to operate) and only for a given time span (usually a particular budget period). Suppose that BMW contracts with Thomas Transport Company (TTC) to transport X5s to BMW dealers. TTC rents two trucks, and each truck has annual fixed rental costs of $40,000. The maximum annual usage of each truck is 120,000 miles. In the current year (2011), the predicted combined total hauling of the two trucks is 170,000 miles. Exhibit 2-4 shows how annual fixed costs behave at different levels of miles of hauling. Up to 120,000 miles, TTC can operate with one truck; from 120,001 to 240,000 miles, it operates with two trucks; from 240,001 to 360,000 miles, it operates with three trucks. This

34 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES $160,000

Fixed-Cost Behavior at Thomas Transport Company

$120,000

Total Fixed Costs

Exhibit 2-4

$80,000 $40,000

Relevant Range in 2011

$0 120,000 240,000 Miles of Hauling

360,000

pattern will continue as TTC adds trucks to its fleet to provide more miles of hauling. Given the predicted 170,000-mile usage for 2011, the range from 120,001 to 240,000 miles hauled is the range in which TTC expects to operate, resulting in fixed rental costs of $80,000. Within this relevant range, changes in miles hauled will not affect the annual fixed costs. Fixed costs may change from one year to the next. For example, if the total rental fee of the two trucks is increased by $2,000 for 2012, the total level of fixed costs will increase to $82,000 (all else remaining the same). If that increase occurs, total rental costs will be fixed at this new level of $82,000 for 2012 for miles hauled in the 120,001 to 240,000 range. The basic assumption of the relevant range also applies to variable costs. That is, outside the relevant range, variable costs, such as direct materials, may not change proportionately with changes in production volume. For example, above a certain volume, direct material costs may increase at a lower rate because of price discounts on purchases greater than a certain quantity.

Relationships of Types of Costs We have introduced two major classifications of costs: direct/indirect and variable/fixed. Costs may simultaneously be as follows: # # # #

Direct and variable Direct and fixed Indirect and variable Indirect and fixed

Exhibit 2-5 shows examples of costs in each of these four cost classifications for the BMW X5. Assignment of Costs to Cost Object

Exhibit 2-5 Examples of Costs in Combinations of the Direct/Indirect and Variable/Fixed Cost Classifications for a Car Manufacturer

Direct Costs

Variable Costs

CostBehavior Pattern

Fixed Costs

Indirect Costs

• Cost object: BMW X5s produced Example: Tires used in assembly of automobile

• Cost object: BMW X5s produced Example: Power costs at Spartanburg plant. Power usage is metered only to the plant, where multiple products are assembled.

• Cost object: BMW X5s produced Example: Salary of supervisor on BMW X5 assembly line

• Cost object: BMW X5s produced Example: Annual lease costs at Spartanburg plant. Lease is for whole plant, where multiple products are produced.

TOTAL COSTS AND UNIT COSTS " 35

Total Costs and Unit Costs The preceding section concentrated on the behavior patterns of total costs in relation to activity or volume levels. We now consider unit costs.

Unit Costs Generally, the decision maker should think in terms of total costs rather than unit costs. In many decision contexts, however, calculating a unit cost is essential. Consider the booking agent who has to make the decision to book Paul McCartney to play at Shea Stadium. She estimates the cost of the event to be $4,000,000. This knowledge is helpful for the decision, but it is not enough. Before a decision can be reached, the booking agent also must predict the number of people who will attend. Without knowledge of both total cost and number of attendees, she cannot make an informed decision on a possible admission price to recover the cost of the event or even on whether to have the event at all. So she computes the unit cost of the event by dividing the total cost ($4,000,000) by the expected number of people who will attend. If 50,000 people attend, the unit cost is $80 ($4,000,000 ÷ 50,000) per person; if 20,000 attend, the unit cost increases to $200 ($4,000,000 ÷ 20,000). Unless the total cost is “unitized” (that is, averaged with respect to the level of activity or volume), the $4,000,000 cost is difficult to interpret. The unit cost combines the total cost and the number of people in a handy, communicative way. Accounting systems typically report both total-cost amounts and average-cost-perunit amounts. A unit cost, also called an average cost, is calculated by dividing total cost by the related number of units. The units might be expressed in various ways. Examples are automobiles assembled, packages delivered, or hours worked. Suppose that, in 2011, its first year of operations, $40,000,000 of manufacturing costs are incurred to produce 500,000 speaker systems at the Memphis plant of Tennessee Products. Then the unit cost is $80: Total manufacturing costs $40,000,000 = = $80 per unit Number of units manufactured 500,000 units

If 480,000 units are sold and 20,000 units remain in ending inventory, the unit-cost concept helps in the determination of total costs in the income statement and balance sheet and, hence, the financial results reported by Tennessee Products to shareholders, banks, and the government. Cost of goods sold in the income statement, 480,000 units * $80 per unit Ending inventory in the balance sheet, 20,000 units * $80 per unit Total manufacturing costs of 500,000 units

$38,400,000 ƒƒ1,600,000 $40,000,000

Unit costs are found in all areas of the value chain—for example, unit cost of product design, of sales visits, and of customer-service calls. By summing unit costs throughout the value chain, managers calculate the unit cost of the different products or services they deliver and determine the profitability of each product or service. Managers use this information, for example, to decide the products in which they should invest more resources, such as R&D and marketing, and the prices they should charge.

Use Unit Costs Cautiously Although unit costs are regularly used in financial reports and for making product mix and pricing decisions, managers should think in terms of total costs rather than unit costs for many decisions. Consider the manager of the Memphis plant of Tennessee Products. Assume the $40,000,000 in costs in 2011 consist of $10,000,000 of fixed costs and $30,000,000 of variable costs (at $60 variable cost per speaker system produced). Suppose the total fixed cost and the variable cost per speaker system in 2012 are expected to be unchanged from 2011. The budgeted costs for 2012 at different

Learning Objective

Interpret unit costs cautiously . . . for many decisions, managers should use total costs, not unit costs

36 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

production levels, calculated on the basis of total variable costs, total fixed costs, and total costs, are as follows:

Units Produced (1) 100,000 200,000 500,000 800,000 1,000,000

Decision Point How should costs be estimated?

Variable Cost per Unit (2) $60 $60 $60 $60 $60

Total Variable Costs (3) = (1) ! (2) $ 6,000,000 $12,000,000 $30,000,000 $48,000,000 $60,000,000

Total Fixed Costs (4) $10,000,000 $10,000,000 $10,000,000 $10,000,000 $10,000,000

Total Costs (5) = (3) + (4) $16,000,000 $22,000,000 $40,000,000 $58,000,000 $70,000,000

Unit Cost (6) = (5) ÷ (1) $160.00 $110.00 $ 80.00 $ 72.50 $ 70.00

A plant manager who uses the 2011 unit cost of $80 per unit will underestimate actual total costs if 2012 output is below the 2011 level of 500,000 units. If actual volume is 200,000 units due to, say, the presence of a new competitor, actual costs would be $22,000,000. The unit cost of $80 times 200,000 units equals $16,000,000, which underestimates the actual total costs by $6,000,000 ($22,000,000 – $16,000,000). The unit cost of $80 applies only when 500,000 units are produced. An overreliance on unit cost in this situation could lead to insufficient cash being available to pay costs if volume declines to 200,000 units. As the table indicates, for making this decision, managers should think in terms of total variable costs, total fixed costs, and total costs rather than unit cost. As a general rule, first calculate total costs, then compute a unit cost, if it is needed for a particular decision.

Business Sectors, Types of Inventory, Inventoriable Costs, and Period Costs Learning Objective

Distinguish inventoriable costs . . . assets when incurred, then cost of goods sold from period costs . . . expenses of the period when incurred

In this section, we describe the different sectors of the economy, the different types of inventory that companies hold, and some commonly used classifications of manufacturing costs.

Manufacturing-, Merchandising-, and Service-Sector Companies We define three sectors of the economy and provide examples of companies in each sector. 1. Manufacturing-sector companies purchase materials and components and convert them into various finished goods. Examples are automotive companies such as Jaguar, cellular phone producers such as Nokia, food-processing companies such as Heinz, and computer companies such as Toshiba. 2. Merchandising-sector companies purchase and then sell tangible products without changing their basic form. This sector includes companies engaged in retailing (for example, bookstores such as Barnes and Noble or department stores such as Target), distribution (for example, a supplier of hospital products, such as Owens and Minor), or wholesaling (for example, a supplier of electronic components, such as Arrow Electronics). 3. Service-sector companies provide services (intangible products)—for example, legal advice or audits—to their customers. Examples are law firms such as Wachtell, Lipton, Rosen & Katz, accounting firms such as Ernst and Young, banks such as Barclays, mutual fund companies such as Fidelity, insurance companies such as Aetna, transportation companies such as Singapore Airlines, advertising agencies such as Saatchi & Saatchi, television stations such as Turner Broadcasting, Internet service providers such as Comcast, travel agencies such as American Express, and brokerage firms such as Merrill Lynch.

BUSINESS SECTORS, TYPES OF INVENTORY, INVENTORIABLE COSTS, AND PERIOD COSTS " 37

Types of Inventory Manufacturing-sector companies purchase materials and components and convert them into various finished goods. These companies typically have one or more of the following three types of inventory: 1. Direct materials inventory. Direct materials in stock and awaiting use in the manufacturing process (for example, computer chips and components needed to manufacture cellular phones). 2. Work-in-process inventory. Goods partially worked on but not yet completed (for example, cellular phones at various stages of completion in the manufacturing process). This is also called work in progress. 3. Finished goods inventory. Goods (for example, cellular phones) completed but not yet sold. Merchandising-sector companies purchase tangible products and then sell them without changing their basic form. They hold only one type of inventory, which is products in their original purchased form, called merchandise inventory. Service-sector companies provide only services or intangible products and so do not hold inventories of tangible products.

Commonly Used Classifications of Manufacturing Costs Three terms commonly used when describing manufacturing costs are direct material costs, direct manufacturing labor costs, and indirect manufacturing costs. These terms build on the direct versus indirect cost distinction we had described earlier, in the context of manufacturing costs. 1. Direct material costs are the acquisition costs of all materials that eventually become part of the cost object (work in process and then finished goods) and can be traced to the cost object in an economically feasible way. Acquisition costs of direct materials include freight-in (inward delivery) charges, sales taxes, and custom duties. Examples of direct material costs are the steel and tires used to make the BMW X5, and the computer chips used to make cellular phones. 2. Direct manufacturing labor costs include the compensation of all manufacturing labor that can be traced to the cost object (work in process and then finished goods) in an economically feasible way. Examples include wages and fringe benefits paid to machine operators and assembly-line workers who convert direct materials purchased to finished goods. 3. Indirect manufacturing costs are all manufacturing costs that are related to the cost object (work in process and then finished goods) but cannot be traced to that cost object in an economically feasible way. Examples include supplies, indirect materials such as lubricants, indirect manufacturing labor such as plant maintenance and cleaning labor, plant rent, plant insurance, property taxes on the plant, plant depreciation, and the compensation of plant managers. This cost category is also referred to as manufacturing overhead costs or factory overhead costs. We use indirect manufacturing costs and manufacturing overhead costs interchangeably in this book. We now describe the distinction between inventoriable costs and period costs.

Inventoriable Costs Inventoriable costs are all costs of a product that are considered as assets in the balance sheet when they are incurred and that become cost of goods sold only when the product is sold. For manufacturing-sector companies, all manufacturing costs are inventoriable costs. Consider Cellular Products, a manufacturer of cellular phones. Costs of direct materials, such as computer chips, issued to production (from direct material inventory), direct manufacturing labor costs, and manufacturing overhead costs create new assets, starting as work in process and becoming finished goods (the cellular phones). Hence,

38 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

manufacturing costs are included in work-in-process inventory and in finished goods inventory (they are “inventoried”) to accumulate the costs of creating these assets. When the cellular phones are sold, the cost of manufacturing them is matched against revenues, which are inflows of assets (usually cash or accounts receivable) received for products or services provided to customers. The cost of goods sold includes all manufacturing costs (direct materials, direct manufacturing labor, and manufacturing overhead costs) incurred to produce them. The cellular phones may be sold during a different accounting period than the period in which they were manufactured. Thus, inventorying manufacturing costs in the balance sheet during the accounting period when goods are manufactured and expensing the manufacturing costs in a later income statement when the goods are sold matches revenues and expenses. For merchandising-sector companies such as Wal-Mart, inventoriable costs are the costs of purchasing the goods that are resold in their same form. These costs comprise the costs of the goods themselves plus any incoming freight, insurance, and handling costs for those goods. Service-sector companies provide only services or intangible products. The absence of inventories of tangible products for sale means there are no inventoriable costs.

Period Costs Period costs are all costs in the income statement other than cost of goods sold. Period costs, such as marketing, distribution and customer service costs, are treated as expenses of the accounting period in which they are incurred because they are expected to benefit revenues in that period and are not expected to benefit revenues in future periods. Some costs such as R&D costs are treated as period costs because, although these costs may benefit revenues in a future period if the R&D efforts are successful, it is highly uncertain if and when these benefits will occur. Expensing period costs as they are incurred best matches expenses to revenues. For manufacturing-sector companies, period costs in the income statement are all nonmanufacturing costs (for example, design costs and costs of shipping products to customers). For merchandising-sector companies, period costs in the income statement are all costs not related to the cost of goods purchased for resale. Examples of these period costs are labor costs of sales floor personnel and advertising costs. Because there are no inventoriable costs for service-sector companies, all costs in the income statement are period costs. Exhibit 2-5 showed examples of inventoriable costs in direct/indirect and variable/fixed cost classifications for a car manufacturer. Exhibit 2-6 shows examples of period costs in direct/indirect and variable/fixed cost classifications at a bank. Assignment of Costs to Cost Object

Exhibit 2-6 Examples of Period Costs in Combinations of the Direct/Indirect and Variable/Fixed Cost Classifications at a Bank

Direct Costs

Variable Costs

CostBehavior Pattern

Fixed Costs

Indirect Costs

• Cost object: Number of • Cost object: Number of mortgage loans mortgage Example: Fees paid to loans property appraisal Example: Postage paid to company for each deliver mortgagemortgage loan loan documents to lawyers/ homeowners • Cost object: Number of mortgage loans Example: Salary paid to executives in mortgage loan department to develop new mortgage-loan products

• Cost object: Number of mortgage loans Example: Cost to the bank of sponsoring annual golf tournament

ILLUSTRATING THE FLOW OF INVENTORIABLE COSTS AND PERIOD COSTS " 39

Illustrating the Flow of Inventoriable Costs and Period Costs We illustrate the flow of inventoriable costs and period costs through the income statement of a manufacturing company, for which the distinction between inventoriable costs and period costs is most detailed.

Manufacturing-Sector Example Follow the flow of costs for Cellular Products in Exhibit 2-7 and Exhibit 2-8. Exhibit 2-7 visually highlights the differences in the flow of inventoriable and period costs for a manufacturing-sector company. Note how, as described in the previous section, inventoriable costs go through the balance sheet accounts of work-in-process inventory and finished goods inventory before entering cost of goods sold in the income statement. Period costs are expensed directly in the income statement. Exhibit 2-8 takes the visual presentation in Exhibit 2-7 and shows how inventoriable costs and period expenses would appear in the income statement and schedule of cost of goods manufactured of a manufacturing company. We start by tracking the flow of direct materials shown on the left of Exhibit 2-7 and in Panel B of Exhibit 2-8. Step 1: Cost of direct materials used in 2011. Note how the arrows in Exhibit 2-7 for beginning inventory, $11,000 (all numbers in thousands), and direct material purchases, $73,000, “fill up” the direct material inventory box and how direct material used, $76,000 “empties out” direct material inventory leaving an ending inventory of direct materials of $8,000 that becomes the beginning inventory for the next year. The cost of direct materials used is calculated in Exhibit 2-8, Panel B (light blue shaded area) as follows: Beginning inventory of direct materials, January 1, 2011 + Purchases of direct materials in 2011 – Ending inventory of direct materials, December 31, 2011 = Direct materials used in 2011 Exhibit 2-7

$11,000 73,000 ƒƒ8,000 $76,000

Flow of Revenue and Costs for a Manufacturing-Sector Company, Cellular Products (in thousands) INCOME STATEMENT

BALANCE SHEET Beg. inv., $11,000

STEP 1: Direct Material Purchases $73,000

Inventoriable Costs

Direct Material Inventory

Direct Material Used $76,000 Beg. inv., $6,000

End. inv., $8,000 Direct Manufacturing Labor, $9,000 Manufacturing Overhead costs $20,000

Work-inProcess Inventory

Revenues $210,000 STEP 3: Cost of Goods Manufactured $104,000

Beg. inv., $22,000

Finished Goods Inventory

STEP 2: Total Manufacturing Costs Incurred in 2011 $105,000

End. inv., $7,000

End. inv., $18,000

deduct when sales occur

STEP 4: Cost of Goods Sold (an expense) $108,000 Equals Gross Margin $102,000 deduct

R & D Costs Design Costs Marketing Costs Distribution Costs Customer-Service Costs Equals Operating Income $32,000

Period Costs $70,000

40 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

Exhibit 2-8

Income Statement and Schedule of Cost of Goods Manufactured of a Manufacturing-Sector Company, Cellular Products

1 PANEL A: INCOME STATEMENT

Cellular Products Income Statement For the Year Ended December 31, 2011 (in thousands)

2 3 4 5 6 7

STEP 4

8 9 10 11 12 13 14 15 16

Revenues Cost of goods sold: Beginning finished goods inventory, January 1, 2009 Cost of goods manufactured (see Panel B) Cost of goods available for sale Ending finished goods inventory, December 31, 2009 Cost of goods sold Gross margin (or gross profit) Operating costs: R&D, design, mktg., dist., and cust.-service cost Total operating costs Operating income

$210,000 $ 22,000 104,000 126,000 18,000 108,000 102,000 70,000 70,000 $ 32,000

PANEL B: COST OF GOODS MANUFACTURED Cellular Products 19 Schedule of Cost of Goods Manufactureda 20 For the Year Ended December 31, 2009 (in thousands) 21 18

22 23

STEP 1

24 25 26 27 28 29 30 31

STEP 2

32 33 34 35 36 37 38

STEP 3

39 40 41

Direct materials: Beginning inventory, January 1, 2009 Purchases of direct materials Cost of direct materials available for use Ending inventory, December 31, 2009 Direct materials used Direct manufacturing labor Manufacturing overhead costs: Indirect manufacturing labor Supplies Heat, light, and power Depreciation—plant building Depreciation—plant equipment Miscellaneous Total manufacturing overhead costs Manufacturing costs incurred during 2009 Beginning work-in-process inventory, January 1, 2009 Total manufacturing costs to account for Ending work-in-process inventory, December 31, 2009 Cost of goods manufactured (to income statement) a

$11,000 73,000 84,000 8,000 $ 76,000 9,000 $ 7,000 2,000 5,000 2,000 3,000 1,000 20,000

$104,000

105,000 6,000 111,000 7,000 $104,000

Note that this schedule can become a schedule of cost of goods manufactured and sold simply by including the beginning and ending finished goods inventory figures in the supporting schedule rather than in the body of the income statement.

ILLUSTRATING THE FLOW OF INVENTORIABLE COSTS AND PERIOD COSTS " 41

Step 2: Total manufacturing costs incurred in 2011. Total manufacturing costs refers to all direct manufacturing costs and manufacturing overhead costs incurred during 2011 for all goods worked on during the year. Cellular Products classifies its manufacturing costs into the three categories described earlier. (i) Direct materials used in 2011 (shaded light blue in Exhibit 2-8, Panel B) (ii) Direct manufacturing labor in 2011 (shaded blue in Exhibit 2-8, Panel B) (iii) Manufacturing overhead costs in 2011 (shaded dark blue in Exhibit 2-8, Panel B) Total manufacturing costs incurred in 2011

$ 76,000 9,000 ƒƒ20,000 $105,000

Note how in Exhibit 2-7, these costs increase work-in-process inventory. Step 3: Cost of goods manufactured in 2011. Cost of goods manufactured refers to the cost of goods brought to completion, whether they were started before or during the current accounting period. Note how the work-in-process inventory box in Exhibit 2-7 has a very similar structure to the direct material inventory box described in Step 1. Beginning work-in-process inventory of $6,000 and total manufacturing costs incurred in 2011 of $105,000 “fill-up” the work-in-process inventory box. Some of the manufacturing costs incurred during 2011 are held back as the cost of the ending work-in-process inventory. The ending workin-process inventory of $7,000 becomes the beginning inventory for the next year, and the cost of goods manufactured during 2011 of $104,000 “empties out” the work-in-process inventory while “filling up” the finished goods inventory box. The cost of goods manufactured in 2011 (shaded green) is calculated in Exhibit 2-8, Panel B as follows: Beginning work-in-process inventory, January 1, 2011 + Total manufacturing costs incurred in 2011 = Total manufacturing costs to account for – Ending work-in-process inventory, December 31, 2011 = Cost of goods manufactured in 2011

$ 6,000 ƒ105,000 111,000 ƒƒƒ7,000 $104,000

Step 4: Cost of goods sold in 2011. The cost of goods sold is the cost of finished goods inventory sold to customers during the current accounting period. Looking at the finished goods inventory box in Exhibit 2-7, we see that the beginning inventory of finished goods of $22,000 and cost of goods manufactured in 2011 of $104,000 “fill up” the finished goods inventory box. The ending inventory of finished goods of $18,000 becomes the beginning inventory for the next year, and the cost of goods sold during 2011 of $108,000 “empties out” the finished goods inventory. This cost of goods sold is an expense that is matched against revenues. The cost of goods sold for Cellular Products (shaded brown) is computed in Exhibit 2-8, Panel A, as follows: Beginning inventory of finished goods, January 1, 2011 + Cost of goods manufactured in 2011 – Ending inventory of finished goods, December 31, 2011 = Cost of goods sold in 2011

$ 22,000 104,000 ƒƒ18,000 $108,000

Exhibit 2-9 shows related general ledger T-accounts for Cellular Products’ manufacturing cost flow. Note how the cost of goods manufactured ($104,000) is the cost of all goods completed during the accounting period. These costs are all inventoriable costs. Goods completed during the period are transferred to finished goods inventory. These costs become cost of goods sold in the accounting period when the goods are sold. Also note that the direct materials, direct manufacturing labor, and manufacturing overhead costs of the units in work-in-process inventory ($7,000) and finished goods inventory ($18,000) as of December 31, 2011, will appear as an asset in the balance sheet. These costs will become expenses next year when these units are sold.

42 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

Exhibit 2-9

General Ledger T-Accounts for Cellular Products’ Manufacturing Cost Flow (in thousands)

Work-in-Process Inventory Bal. Jan. 1, 2011 Direct materials used

6,000 Cost of goods 76,000 manufactured

Direct manuf. labor

9,000

Indirect manuf. costs

20,000

Bal. Dec. 31, 2011

Cost of Goods Sold

Finished Goods Inventory Bal. Jan. 1, 2011 104,000 Bal. Dec. 31, 2011

22,000 Cost of 104,000 goods sold

108,000 108,000

18,000

7,000

We are now in a position to prepare Cellular Products’ income statement for 2011. The income statement of Cellular Products is shown on the right-hand side of Exhibit 2-7 and in Exhibit 2-8, Panel A. Revenues of Cellular Products are (in thousands) $210,000. Inventoriable costs expensed during 2011 equal cost of goods sold of $108,000. Gross margin = Revenues - Cost of goods sold = $210,000 - $108,000 = $102,000.

The $70,000 of operating costs comprising R&D, design, marketing, distribution, and customer-service costs are period costs of Cellular Products. These period costs include, for example, salaries of salespersons, depreciation on computers and other equipment used in marketing, and the cost of leasing warehouse space for distribution. Operating income equals total revenues from operations minus cost of goods sold and operating (period) costs (excluding interest expense and income taxes) or equivalently, gross margin minus period costs. The operating income of Cellular Products is $32,000 (gross margin, $102,000 – period costs, $70,000). Those of you familiar with financial accounting will note that period costs are typically called selling, general, and administrative expenses in the income statement Newcomers to cost accounting frequently assume that indirect costs such as rent, telephone, and depreciation are always costs of the period in which they are incurred and are not associated with inventories. When these costs are incurred in marketing or in corporate headquarters, they are period costs. However, when these costs are incurred in manufacturing, they are manufacturing overhead costs and are inventoriable.

Recap of Inventoriable Costs and Period Costs

Decision Point What are the differences in the accounting for inventoriable versus period costs?

Exhibit 2-7 highlights the differences between inventoriable costs and period costs for a manufacturing company. The manufacturing costs of finished goods include direct materials, other direct manufacturing costs such as direct manufacturing labor, and manufacturing overhead costs such as supervision, production control, and machine maintenance. All these costs are inventoriable: They are assigned to work-in-process inventory until the goods are completed and then to finished goods inventory until the goods are sold. All nonmanufacturing costs, such as R&D, design, and distribution costs, are period costs. Inventoriable costs and period costs flow through the income statement at a merchandising company similar to the way costs flow at a manufacturing company. At a merchandising company, however, the flow of costs is much simpler to understand and track. Exhibit 2-10 shows the inventoriable costs and period costs for a retailer or wholesaler who buys goods for resale. The only inventoriable cost is the cost of merchandise. (This corresponds to the cost of finished goods manufactured for a manufacturing company.) Purchased goods are held as merchandise inventory, the cost of which is shown as an asset in the balance sheet. As the goods are sold, their costs are shown in the income statement as cost of goods sold. A retailer or wholesaler also has a variety of marketing, distribution, and customer-service costs, which are period costs. In the income statement, period costs are deducted from revenues without ever having been included as part of inventory.

ILLUSTRATING THE FLOW OF INVENTORIABLE COSTS AND PERIOD COSTS " 43 BALANCE SHEET

INCOME STATEMENT Revenues

Beginning Inventory

Inventoriable Costs

Merchandise Purchases

Merchandise Inventory

when sales occur

deduct

Exhibit 2-10 Flow of Revenues and Costs for a Merchandising Company (Retailer or Wholesaler)

Cost of Goods Sold (an expense) Equals Gross Margin

Ending Inventory

deduct Design Costs Purchasing Dept. Costs Marketing Costs Distribution Costs Customer-Service Costs Equals Operating Income

Prime Costs and Conversion Costs Two terms used to describe cost classifications in manufacturing costing systems are prime costs and conversion costs. Prime costs are all direct manufacturing costs. For Cellular Products, Prime costs = Direct material costs + Direct manufacturing labor costs = $76,000 + $9,000 = $85,000

As we have already discussed, the greater the proportion of prime costs in a company’s cost structure, the more confident managers can be about the accuracy of the costs of products. As information-gathering technology improves, companies can add more and more direct-cost categories. For example, power costs might be metered in specific areas of a plant and identified as a direct cost of specific products. Furthermore, if a production line were dedicated to the manufacture of a specific product, the depreciation on the production equipment would be a direct manufacturing cost and would be included in prime costs. Computer software companies often have a “purchased technology” direct manufacturing cost item. This item, which represents payments to suppliers who develop software algorithms for a product, is also included in prime costs. Conversion costs are all manufacturing costs other than direct material costs. Conversion costs represent all manufacturing costs incurred to convert direct materials into finished goods. For Cellular Products, Conversion costs =

Direct manufacturing Manufacturing + = $9,000 + $20,000 = $29,000 labor costs overhead costs

Note that direct manufacturing labor costs are a part of both prime costs and conversion costs. Some manufacturing operations, such as computer-integrated manufacturing (CIM) plants, have very few workers. The workers’ roles are to monitor the manufacturing process and to maintain the equipment that produces multiple products. Costing systems in CIM plants do not have a direct manufacturing labor cost category because direct manufacturing labor cost is relatively small and because it is difficult to trace this cost to products. In CIM plants, the only prime cost is direct material costs, and conversion costs consist only of manufacturing overhead costs.

Period Costs

44 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

Measuring Costs Requires Judgment Measuring costs requires judgment. That’s because there are alternative ways in which costs can be defined and classified. Different companies or sometimes even different subunits within the same company may define and classify costs differently. Be careful to define and understand the ways costs are measured in a company or situation. We first illustrate this point with respect to labor cost measurement.

Measuring Labor Costs Consider labor costs for software programming at companies such as Apple where programmers work on different software applications for products like the iMac, the iPod, and the iPhone. Although labor cost classifications vary among companies, many companies use multiple labor cost categories: # #

Direct programming labor costs that can be traced to individual products Overhead (examples of prominent labor components of overhead follow): • Indirect labor compensation for Office staff Office security Rework labor (time spent by direct laborers correcting software errors) Overtime premium paid to software programmers (explained next) Idle time (explained next) • Managers’, department heads’, and supervisors’ salaries • Payroll fringe costs, for example, health care premiums and pension costs (explained later)

Note how indirect labor costs are commonly divided into many subclassifications, for example, office staff and idle time, to retain information on different categories of indirect labor. Note also that managers’ salaries usually are not classified as indirect labor costs. Instead, the compensation of supervisors, department heads, and all others who are regarded as management is placed in a separate classification of labor-related overhead.

Overtime Premium and Idle Time The purpose of classifying costs in detail is to associate an individual cost with a specific cause or reason for why it was incurred. Two classes of indirect labor—overtime premium and idle time—need special mention. Overtime premium is the wage rate paid to workers (for both direct labor and indirect labor) in excess of their straight-time wage rates. Overtime premium is usually considered to be a part of indirect costs or overhead. Consider the example of George Flexner, a junior software programmer who writes software for multiple products. He is paid $20 per hour for straight-time and $30 per hour (time and a half) for overtime. His overtime premium is $10 per overtime hour. If he works 44 hours, including 4 overtime hours, in one week, his gross compensation would be classified as follows: Direct programming labor: 44 hours * $20 per hour Overtime premium: 4 hours * $10 per hour Total compensation for 44 hours

$880 ƒƒ40 $920

In this example, why is the overtime premium of direct programming labor usually considered an overhead cost rather than a direct cost? After all, it can be traced to specific products that George worked on while working overtime. Overtime premium is generally not considered a direct cost because the particular job that George worked on during the overtime hours is a matter of chance. For example, assume that George worked on two products for 5 hours each on a specific workday of 10 hours, including 2 overtime hours. Should the product George worked on during hours 9 and 10 be assigned the overtime premium? Or should the premium be prorated over both products? Prorating the overtime premium does not “penalize”—add to the cost of—a particular product solely because it happened to be worked on during the overtime hours. Instead, the overtime premium is considered to be attributable to the heavy overall volume of work. Its cost is regarded as part of overhead, which is borne by both products.

MEASURING COSTS REQUIRES JUDGMENT " 45

Sometimes overtime is not random. For example, a launch deadline for a particular product may clearly be the sole source of overtime. In such instances, the overtime premium is regarded as a direct cost of that product. Another subclassification of indirect labor is the idle time of both direct and indirect labor. Idle time is wages paid for unproductive time caused by lack of orders, machine or computer breakdowns, work delays, poor scheduling, and the like. For example, if George had no work for 3 hours during that week while waiting to receive code from another colleague, George’s earnings would be classified as follows: Direct programming labor: 41 hours * $20/hour Idle time (overhead): 3 hours * $20/hour Overtime premium (overhead): 4 hours * $10/hour Total earnings for 44 hours

$820 60 ƒƒ40 $920

Clearly, the idle time is not related to a particular product, nor, as we have already discussed, is the overtime premium. Both overtime premium and idle time are considered overhead costs.

Benefits of Defining Accounting Terms Managers, accountants, suppliers, and others will avoid many problems if they thoroughly understand and agree on the classifications and meanings of the cost terms introduced in this chapter and later in this book. Consider the classification of programming labor payroll fringe costs (for example, employer payments for employee benefits such as Social Security, life insurance, health insurance, and pensions). Consider, for example, a software programmer, who is paid a wage of $20 an hour with fringe benefits totaling, say, $5 per hour. Some companies classify the $20 as a direct programming labor cost of the product for which the software is being written and the $5 as overhead cost. Other companies classify the entire $25 as direct programming labor cost. The latter approach is preferable because the stated wage and the fringe benefit costs together are a fundamental part of acquiring direct software programming labor services. Caution: In every situation, pinpoint clearly what direct labor includes and what direct labor excludes. Achieving clarity may prevent disputes regarding cost-reimbursement contracts, income tax payments, and labor union matters. Consider that some countries such as Costa Rica and Mauritius offer substantial income tax savings to foreign companies that generate employment within their borders. In some cases, to qualify for the tax benefits, the direct labor costs must at least equal a specified percentage of the total costs. When direct labor costs are not precisely defined, disputes have arisen as to whether payroll fringe costs should be included as part of direct labor costs when calculating the direct labor percentage for qualifying for such tax benefits. Companies have sought to classify payroll fringe costs as part of direct labor costs to make direct labor costs a higher percentage of total costs. Tax authorities have argued that payroll fringe costs are part of overhead. In addition to fringe benefits, other debated items are compensation for training time, idle time, vacations, sick leave, and overtime premium. To prevent disputes, contracts and laws should be as specific as possible regarding definitions and measurements.

Different Meanings of Product Costs Many cost terms found in practice have ambiguous meanings. Consider the term product cost. A product cost is the sum of the costs assigned to a product for a specific purpose. Different purposes can result in different measures of product cost, as the brackets on the value chain in Exhibit 2-11 illustrate: #

Pricing and product-mix decisions. For the purposes of making decisions about pricing and which products provide the most profits, the manager is interested in the overall (total) profitability of different products and, consequently, assigns costs incurred in all business functions of the value chain to the different products. Contracting with government agencies. Government contracts often reimburse contractors on the basis of the “cost of a product” plus a prespecified margin of profit. Because of the cost-plus profit margin nature of the contract, government agencies provide detailed guidelines on the cost items they will allow and disallow

Learning Objective

Explain why product costs are computed in different ways for different purposes . . . examples are pricing and product-mix decisions, government contracts, and financial statements

46 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

Exhibit 2-11

Research and Development Costs

Different Product Costs for Different Purposes

Design Costs

Production Costs

Marketing Costs

Distribution Costs

CustomerService Costs

Product Cost for Financial Statements (inventoriable costs) Product Cost for Reimbursement Under Government Contracts Product Cost for Pricing and Product-Mix Decisions

Decision Point Why do managers assign different costs to the same cost object?

when calculating the cost of a product. For example, some government agencies explicitly exclude marketing, distribution, and customer-service costs from the product costs that qualify for reimbursement, and they may only partially reimburse R&D costs. These agencies want to reimburse contractors for only those costs most closely related to delivering products under the contract. The second bracket in Exhibit 2-11 shows how the product-cost calculations for a specific contract may allow for all design and production costs but only part of R&D costs. Preparing financial statements for external reporting under generally accepted accounting principles (GAAP). Under GAAP, only manufacturing costs can be assigned to inventories in the financial statements. For purposes of calculating inventory costs, product costs include only inventoriable (manufacturing) costs.

As Exhibit 2-11 illustrates, product-cost measures range from a narrow set of costs for financial statements—a set that includes only inventoriable costs—to a broader set of costs for reimbursement under a government contract to a still broader set of costs for pricing and product-mix decisions. This section focused on how different purposes result in the inclusion of different cost items of the value chain of business functions when product costs are calculated. The same caution about the need to be clear and precise about cost concepts and their measurement applies to each cost classification introduced in this chapter. Exhibit 2-12 summarizes the key cost classifications. Using the five-step process described in Chapter 1, think about how these different classifications of costs are helpful to managers when making decisions and evaluating performance. 1. Identify the problem and uncertainties. Consider a decision about how much to price a product. This decision often depends on how much it costs to make the product. 2. Obtain information. Managers identify direct and indirect costs of a product in each business function. Managers also gather other information about customers, competitors, and prices of substitute products.

Exhibit 2-12 Alternative Classifications of Costs

1. Business function a. Research and development b. Design of products and processes c. Production d. Marketing e. Distribution f. Customer service 2. Assignment to a cost object a. Direct cost b. Indirect cost

3. Behavior pattern in relation to the level of activity or volume a. Variable cost b. Fixed cost 4. Aggregate or average a. Total cost b. Unit cost 5. Assets or expenses a. Inventoriable cost b Period cost

A FRAMEWORK FOR COST ACCOUNTING AND COST MANAGEMENT " 47

3. Make predictions about the future. Managers estimate what it will cost to make the product in the future. This requires predictions about the quantity of product that managers expect to sell and an understanding of fixed and variable costs. 4. Make decisions by choosing among alternatives. Managers choose a price to charge based on a thorough understanding of costs and other information. 5. Implement the decision, evaluate performance, and learn. Managers control costs and learn by comparing actual total and unit costs against predicted amounts. The next section describes how the basic concepts introduced in this chapter lead to a framework for understanding cost accounting and cost management that can then be applied to the study of many topics, such as strategy evaluation, quality, and investment decisions.

A Framework for Cost Accounting and Cost Management Three features of cost accounting and cost management across a wide range of applications are as follows: 1. Calculating the cost of products, services, and other cost objects 2. Obtaining information for planning and control and performance evaluation 3. Analyzing the relevant information for making decisions We develop these ideas in Chapters 3 through 12. The ideas also form the foundation for the study of various topics later in the book.

Calculating the Cost of Products, Services, and Other Cost Objects We have already seen the different purposes and measures of product costs. Whatever the purpose, the costing system traces direct costs and allocates indirect costs to products. Chapters 4 and 5 describe systems, such as activity-based costing systems, used to calculate total costs and unit costs of products and services. The chapters also discuss how managers use this information to formulate strategy and make pricing, productmix, and cost-management decisions.

Obtaining Information for Planning and Control and Performance Evaluation Budgeting is the most commonly used tool for planning and control. A budget forces managers to look ahead, to translate strategy into plans, to coordinate and communicate within the organization, and to provide a benchmark for evaluating performance. Budgeting often plays a major role in affecting behavior and decisions because managers strive to meet budget targets. Chapter 6 describes budgeting systems. At the end of a reporting period, managers compare actual results to planned performance. The manager’s tasks are to understand why differences (called variances) between actual and planned performances arise and to use the information provided by these variances as feedback to promote learning and future improvement. Managers also use variances as well as nonfinancial measures, such as defect rates and customer satisfaction ratings, to control and evaluate the performance of various departments, divisions, and managers. Chapters 7 and 8 discuss variance analysis. Chapter 9 describes planning, control, and inventory-costing issues relating to capacity. Chapters 6, 7, 8, and 9 focus on the management accountant’s role in implementing strategy.

Analyzing the Relevant Information for Making Decisions When making decisions about strategy design and strategy implementation, managers must understand which revenues and costs to consider and which ones to ignore. Management accountants help managers identify what information is relevant and what information is

Learning Objective

Describe a framework for cost accounting and cost management . . . three features that help managers make decisions

48 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

Decision Point What are the three key features of cost accounting and cost management?

irrelevant. Consider a decision about whether to buy a product from an outside vendor or to make it in-house. The costing system indicates that it costs $25 per unit to make the product in-house. A vendor offers the product for $22 per unit. At first glance, it seems it will cost less for the company to buy the product rather than make it. Suppose, however, that of the $25 to make the product in-house, $5 consists of plant lease costs that the company has already paid under the lease contract. Furthermore, if the product is bought, the plant will remain idle. That is, there is no opportunity to profit by putting the plant to some alternative use. Under these conditions, it will cost less to make the product than to buy it. That’s because making the product costs only an additional $20 per unit ($25 – $5), compared with an additional $22 per unit if it is bought. The $5 per unit of lease cost is irrelevant to the decision because it is a past (or sunk) cost that has already been incurred regardless of whether the product is made or bought. Analyzing relevant information is a key aspect of making decisions. When making strategic decisions about which products and how much to produce, managers must know how revenues and costs vary with changes in output levels. For this purpose, managers need to distinguish fixed costs from variable costs. Chapter 3 analyzes how operating income changes with changes in units sold and how managers use this information to make decisions such as how much to spend on advertising. Chapter 10 describes methods to estimate the fixed and variable components of costs. Chapter 11 applies the concept of relevance to decision making in many different situations and describes methods managers use to maximize income given the resource constraints they face. Chapter 12 describes how management accountants help managers determine prices and manage costs across the value chain and over a product’s life cycle. Later chapters in the book discuss topics such as strategy evaluation, customer profitability, quality, just-in-time systems, investment decisions, transfer pricing, and performance evaluation. Each of these topics invariably has product costing, planning and control, and decision-making perspectives. A command of the first 12 chapters will help you master these topics. For example, Chapter 13 on strategy describes the balanced scorecard, a set of financial and nonfinancial measures used to implement strategy that builds on the planning and control functions. The section on strategic analysis of operating income builds on ideas of product costing and variance analysis. The section on downsizing and managing capacity builds on ideas of relevant revenues and relevant costs.

Problem for Self-Study Foxwood Company is a metal- and woodcutting manufacturer, selling products to the home construction market. Consider the following data for 2011: Sandpaper Materials-handling costs Lubricants and coolants Miscellaneous indirect manufacturing labor Direct manufacturing labor Direct materials inventory Jan. 1, 2011 Direct materials inventory Dec. 31, 2011 Finished goods inventory Jan. 1, 2011 Finished goods inventory Dec. 31, 2011 Work-in-process inventory Jan. 1, 2011 Work-in-process inventory Dec. 31, 2011 Plant-leasing costs Depreciation—plant equipment Property taxes on plant equipment Fire insurance on plant equipment Direct materials purchased Revenues Marketing promotions Marketing salaries Distribution costs Customer-service costs

2,000 70,000 5,000 40,000 300,000 40,000 50,000 100,000 150,000 10,000 14,000 54,000 36,000 4,000 3,000 460,000 1,360,000 60,000 100,000 70,000 100,000

PROBLEM FOR SELF-STUDY " 49

1. Prepare an income statement with a separate supporting schedule of cost of goods manufactured. For all manufacturing items, classify costs as direct costs or indirect costs and indicate by V or F whether each is basically a variable cost or a fixed cost (when the cost object is a product unit). If in doubt, decide on the basis of whether the total cost will change substantially over a wide range of units produced. 2. Suppose that both the direct material costs and the plant-leasing costs are for the production of 900,000 units. What is the direct material cost of each unit produced? What is the plant-leasing cost per unit? Assume that the plant-leasing cost is a fixed cost. 3. Suppose Foxwood Company manufactures 1,000,000 units next year. Repeat the computation in requirement 2 for direct materials and plant-leasing costs. Assume the implied cost-behavior patterns persist. 4. As a management consultant, explain concisely to the company president why the unit cost for direct materials did not change in requirements 2 and 3 but the unit cost for plant-leasing costs did change.

Solution 1.

Foxwood Company Income Statement For the Year Ended December 31, 2011 Revenues Cost of goods sold Beginning finished goods inventory January 1, 2011 Cost of goods manufactured (see the following schedule) Cost of goods available for sale Deduct ending finished goods inventory December 31, 2011 Gross margin (or gross profit) Operating costs Marketing promotions Marketing salaries Distribution costs Customer-service costs Operating income

$1,360,000 $ 100,000 ƒƒ960,000 1,060,000 ƒƒ150,000

60,000 100,000 70,000 ƒƒ100,000

ƒƒƒ910,000 450,000

ƒƒƒ330,000 $ƒƒ120,000

Foxwood Company Schedule of Cost of Goods Manufactured For the Year Ended December 31, 2011 Direct materials Beginning inventory, January 1, 2011 Purchases of direct materials Cost of direct materials available for use Ending inventory, December 31, 2011 Direct materials used Direct manufacturing labor Indirect manufacturing costs Sandpaper Materials-handling costs Lubricants and coolants Miscellaneous indirect manufacturing labor Plant-leasing costs Depreciation—plant equipment Property taxes on plant equipment Fire insurance on plant equipment Manufacturing costs incurred during 2011 Beginning work-in-process inventory, January 1, 2011 Total manufacturing costs to account for Ending work-in-process inventory, December 31, 2011 Cost of goods manufactured (to income statement)

$ 40,000 ƒƒƒ460,000 500,000 ƒƒƒƒ50,000 450,000 (V) 300,000 (V) $

2,000 (V) 70,000 (V) 5,000 (V) 40,000 (V) 54,000 (F) 36,000 (F) 4,000 (F) ƒƒƒƒƒ3,000 (F)

ƒƒƒ214,000 964,000 ƒƒƒƒ10,000 974,000 ƒƒƒƒ14,000 $ƒƒ960,000

Required

50 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

2. Direct material unit cost = Direct materials used ÷ Units produced = $450,000 ÷ 900,000 units = $0.50 per unit Plant-leasing unit cost = Plant-leasing costs ÷ Units produced = $54,000 ÷ 900,000 units = $0.06 per unit 3. The direct material costs are variable, so they would increase in total from $450,000 to $500,000 (1,000,000 units ! $0.50 per unit). However, their unit cost would be unaffected: $500,000 ÷ 1,000,000 units = $0.50 per unit. In contrast, the plant-leasing costs of $54,000 are fixed, so they would not increase in total. However, the plant-leasing cost per unit would decline from $0.060 to $0.054: $54,000 ÷ 1,000,000 units = $0.054 per unit. 4. The explanation would begin with the answer to requirement 3. As a consultant, you should stress that the unitizing (averaging) of costs that have different behavior patterns can be misleading. A common error is to assume that a total unit cost, which is often a sum of variable unit cost and fixed unit cost, is an indicator that total costs change in proportion to changes in production levels. The next chapter demonstrates the necessity for distinguishing between cost-behavior patterns. You must be wary, especially about average fixed cost per unit. Too often, unit fixed cost is erroneously regarded as being indistinguishable from unit variable cost.

Decision Points The following question-and-answer format summarizes the chapter’s learning objectives. Each decision presents a key question related to a learning objective. The guidelines are the answer to that question. Decision

Guidelines

1. What is a cost object?

A cost object is anything for which a separate measurement of cost is needed. Examples include a product, a service, a project, a customer, a brand category, an activity, and a department.

2. How do managers decide whether a cost is a direct or an indirect cost?

A direct cost is any cost that is related to a particular cost object and can be traced to that cost object in an economically feasible way. Indirect costs are related to the particular cost object but cannot be traced to it in an economically feasible way. The same cost can be direct for one cost object and indirect for another cost object. This book uses cost tracing to describe the assignment of direct costs to a cost object and cost allocation to describe the assignment of indirect costs to a cost object.

3. How do managers decide whether a cost is a variable or a fixed cost?

A variable cost changes in total in proportion to changes in the related level of total activity or volume. A fixed cost remains unchanged in total for a given time period despite wide changes in the related level of total activity or volume.

4. How should costs be estimated?

In general, focus on total costs, not unit costs. When making total cost estimates, think of variable costs as an amount per unit and fixed costs as a total amount. The unit cost of a cost object should be interpreted cautiously when it includes a fixed-cost component.

5. What are the differences in the accounting for inventoriable versus period costs?

Inventoriable costs are all costs of a product that are regarded as an asset in the accounting period when they are incurred and become cost of goods sold in the accounting period when the product is sold. Period costs are expensed in the accounting period in which they are incurred and are all of the costs in an income statement other than cost of goods sold.

ASSIGNMENT MATERIAL " 51

6. Why do managers assign different costs to the same cost objects?

Managers can assign different costs to the same cost object depending on the purpose. For example, for the external reporting purpose in a manufacturing company, the inventoriable cost of a product includes only manufacturing costs. In contrast, costs from all business functions of the value chain often are assigned to a product for pricing and product-mix decisions.

7. What are the three key features of cost accounting and cost management?

Three features of cost accounting and cost management are (1) calculating the cost of products, services, and other cost objects; (2) obtaining information for planning and control and performance evaluation; and (3) analyzing relevant information for making decisions.

Terms to Learn This chapter contains more basic terms than any other in this book. Do not proceed before you check your understanding of the following terms. Both the chapter and the Glossary at the end of the book contain definitions. actual cost (p. 27) average cost (p. 35) budgeted cost (p. 27) conversion costs (p. 43) cost (p. 27) cost accumulation (p. 28) cost allocation (p. 29) cost assignment (p. 29) cost driver (p. 32) cost object (p. 27) cost of goods manufactured (p. 41) cost tracing (p. 28) direct costs of a cost object (p. 28)

direct manufacturing labor costs (p. 37) direct material costs (p. 37) direct materials inventory (p. 37) factory overhead costs (p. 37) finished goods inventory (p. 37) fixed cost (p. 30) idle time (p. 45) indirect costs of a cost object (p. 28) indirect manufacturing costs (p. 37) inventoriable costs (p. 37) manufacturing overhead costs (p. 37) manufacturing-sector companies (p. 36)

merchandising-sector companies (p. 36) operating income (p. 42) overtime premium (p. 44) period costs (p. 38) prime costs (p. 43) product cost (p. 45) relevant range (p. 33) revenues (p. 38) service-sector companies (p. 36) unit cost (p. 35) variable cost (p. 30) work-in-process inventory (p. 37) work in progress (p. 37)

Assignment Material Questions 2-1 2-2 2-3 2-4 2-5 2-6 2-7 2-8 2-9 2-10 2-11 2-12 2-13 2-14 2-15

Define cost object and give three examples. Define direct costs and indirect costs. Why do managers consider direct costs to be more accurate than indirect costs? Name three factors that will affect the classification of a cost as direct or indirect. Define variable cost and fixed cost. Give an example of each. What is a cost driver? Give one example. What is the relevant range? What role does the relevant-range concept play in explaining how costs behave? Explain why unit costs must often be interpreted with caution. Describe how manufacturing-, merchandising-, and service-sector companies differ from each other. What are three different types of inventory that manufacturing companies hold? Distinguish between inventoriable costs and period costs. Define the following: direct material costs, direct manufacturing-labor costs, manufacturing overhead costs, prime costs, and conversion costs. Describe the overtime-premium and idle-time categories of indirect labor. Define product cost. Describe three different purposes for computing product costs. What are three common features of cost accounting and cost management?

52 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

Exercises 2-16 Computing and interpreting manufacturing unit costs. Minnesota Office Products (MOP) produces three different paper products at its Vaasa lumber plant: Supreme, Deluxe, and Regular. Each product has its own dedicated production line at the plant. It currently uses the following three-part classification for its manufacturing costs: direct materials, direct manufacturing labor, and manufacturing overhead costs. Total manufacturing overhead costs of the plant in July 2011 are $150 million ($15 million of which are fixed). This total amount is allocated to each product line on the basis of the direct manufacturing labor costs of each line. Summary data (in millions) for July 2011 are as follows:

Direct material costs Direct manufacturing labor costs Manufacturing overhead costs Units produced

Required

Supreme

Deluxe

Regular

$ 89 $ 16 $ 48 125

$ 57 $ 26 $ 78 150

$ 60 $ 8 $ 24 140

1. Compute the manufacturing cost per unit for each product produced in July 2011. 2. Suppose that in August 2011, production was 150 million units of Supreme, 190 million units of Deluxe, and 220 million units of Regular. Why might the July 2011 information on manufacturing cost per unit be misleading when predicting total manufacturing costs in August 2011?

2-17 Direct, indirect, fixed, and variable costs. Best Breads manufactures two types of bread, which

are sold as wholesale products to various specialty retail bakeries. Each loaf of bread requires a threestep process. The first step is mixing. The mixing department combines all of the necessary ingredients to create the dough and processes it through high speed mixers. The dough is then left to rise before baking. The second step is baking, which is an entirely automated process. The baking department molds the dough into its final shape and bakes each loaf of bread in a high temperature oven. The final step is finishing, which is an entirely manual process. The finishing department coats each loaf of bread with a special glaze, allows the bread to cool, and then carefully packages each loaf in a specialty carton for sale in retail bakeries.

Required

1. Costs involved in the process are listed next. For each cost, indicate whether it is a direct variable, direct fixed, indirect variable, or indirect fixed cost, assuming “units of production of each kind of bread” is the cost object.

Costs: Yeast Flour Packaging materials Depreciation on ovens Depreciation on mixing machines Rent on factory building Fire insurance on factory building Factory utilities Finishing department hourly laborers

Mixing department manager Materials handlers in each department Custodian in factory Night guard in factory Machinist (running the mixing machine) Machine maintenance personnel in each department Maintenance supplies for factory Cleaning supplies for factory

2. If the cost object were the “mixing department” rather than units of production of each kind of bread, which preceding costs would now be direct instead of indirect costs?

2-18 Classification of costs, service sector. Consumer Focus is a marketing research firm that organizes

focus groups for consumer-product companies. Each focus group has eight individuals who are paid $50 per session to provide comments on new products. These focus groups meet in hotels and are led by a trained, independent, marketing specialist hired by Consumer Focus. Each specialist is paid a fixed retainer to conduct a minimum number of sessions and a per session fee of $2,000. A Consumer Focus staff member attends each session to ensure that all the logistical aspects run smoothly.

ASSIGNMENT MATERIAL " 53

Classify each cost item (A–H) as follows:

Required

a. Direct or indirect (D or I) costs with respect to each individual focus group. b. Variable or fixed (V or F) costs with respect to how the total costs of Consumer Focus change as the number of focus groups conducted changes. (If in doubt, select on the basis of whether the total costs will change substantially if there is a large change in the number of groups conducted.) You will have two answers (D or I; V or F) for each of the following items:

Cost Item A. Payment to individuals in each focus group to provide comments on new products B. Annual subscription of Consumer Focus to Consumer Reports magazine C. Phone calls made by Consumer Focus staff member to confirm individuals will attend a focus group session (Records of individual calls are not kept.) D. Retainer paid to focus group leader to conduct 20 focus groups per year on new medical products E. Meals provided to participants in each focus group F. Lease payment by Consumer Focus for corporate office G. Cost of tapes used to record comments made by individuals in a focus group session (These tapes are sent to the company whose products are being tested.) H. Gasoline costs of Consumer Focus staff for company-owned vehicles (Staff members submit monthly bills with no mileage breakdowns.)

D or I V or F

2-19 Classification of costs, merchandising sector. Home Entertainment Center (HEC) operates a large

store in San Francisco. The store has both a video section and a music (compact disks and tapes) section. HEC reports revenues for the video section separately from the music section. Classify each cost item (A–H) as follows:

Required

a. Direct or indirect (D or I) costs with respect to the total number of videos sold. b. Variable or fixed (V or F) costs with respect to how the total costs of the video section change as the total number of videos sold changes. (If in doubt, select on the basis of whether the total costs will change substantially if there is a large change in the total number of videos sold.) You will have two answers (D or I; V or F) for each of the following items:

Cost Item A. Annual retainer paid to a video distributor B. Electricity costs of the HEC store (single bill covers entire store) C. Costs of videos purchased for sale to customers D. Subscription to Video Trends magazine E. Leasing of computer software used for financial budgeting at the HEC store F. Cost of popcorn provided free to all customers of the HEC store G. Earthquake insurance policy for the HEC store H. Freight-in costs of videos purchased by HEC

D or I V or F

2-20 Classification of costs, manufacturing sector. The Fremont, California, plant of New United Motor Manufacturing, Inc. (NUMMI), a joint venture of General Motors and Toyota, assembles two types of cars (Corollas and Geo Prisms). Separate assembly lines are used for each type of car. Classify each cost item (A–H) as follows:

a. Direct or indirect (D or I) costs with respect to the total number of cars of each type assembled (Corolla or Geo Prism). b. Variable or fixed (V or F) costs with respect to how the total costs of the plant change as the total number of cars of each type assembled changes. (If in doubt, select on the basis of whether the total costs will change substantially if there is a large change in the total number of cars of each type assembled.)

Required

54 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

You will have two answers (D or I; V or F) for each of the following items: Cost Item D or I V or F A. Cost of tires used on Geo Prisms B. Salary of public relations manager for NUMMI plant C. Annual awards dinner for Corolla suppliers D. Salary of engineer who monitors design changes on Geo Prism E. Freight costs of Corolla engines shipped from Toyota City, Japan, to Fremont, California F. Electricity costs for NUMMI plant (single bill covers entire plant) G. Wages paid to temporary assembly-line workers hired in periods of high production (paid on hourly basis) H. Annual fire-insurance policy cost for NUMMI plant

2-21 Variable costs, fixed costs, total costs. Bridget Ashton is getting ready to open a small restaurant. She is on a tight budget and must choose between the following long-distance phone plans:

Plan A: Pay 10 cents per minute of long-distance calling. Plan B: Pay a fixed monthly fee of $15 for up to 240 long-distance minutes, and 8 cents per minute thereafter (if she uses fewer than 240 minutes in any month, she still pays $15 for the month). Plan C: Pay a fixed monthly fee of $22 for up to 510 long-distance minutes and 5 cents per minute thereafter (if she uses fewer than 510 minutes, she still pays $22 for the month). Required

1. Draw a graph of the total monthly costs of the three plans for different levels of monthly long-distance calling. 2. Which plan should Ashton choose if she expects to make 100 minutes of long-distance calls? 240 minutes? 540 minutes?

2-22 Variable costs and fixed costs. Consolidated Minerals (CM) owns the rights to extract minerals from beach sands on Fraser Island. CM has costs in three areas:

a. Payment to a mining subcontractor who charges $80 per ton of beach sand mined and returned to the beach (after being processed on the mainland to extract three minerals: ilmenite, rutile, and zircon). b. Payment of a government mining and environmental tax of $50 per ton of beach sand mined. c. Payment to a barge operator. This operator charges $150,000 per month to transport each batch of beach sand—up to 100 tons per batch per day—to the mainland and then return to Fraser Island (that is, 0 to 100 tons per day = $150,000 per month; 101 to 200 tons per day = $300,000 per month, and so on). Each barge operates 25 days per month. The $150,000 monthly charge must be paid even if fewer than 100 tons are transported on any day and even if CM requires fewer than 25 days of barge transportation in that month. CM is currently mining 180 tons of beach sands per day for 25 days per month. Required

1. What is the variable cost per ton of beach sand mined? What is the fixed cost to CM per month? 2. Plot a graph of the variable costs and another graph of the fixed costs of CM. Your graphs should be similar to Exhibit 2-3, Panel A (p. 31), and Exhibit 2-4 (p. 34). Is the concept of relevant range applicable to your graphs? Explain. 3. What is the unit cost per ton of beach sand mined (a) if 180 tons are mined each day and (b) if 220 tons are mined each day? Explain the difference in the unit-cost figures.

2-23 Variable costs, fixed costs, relevant range. Sweetum Candies manufactures jaw-breaker candies

in a fully automated process. The machine that produces candies was purchased recently and can make 4,100 per month. The machine costs $9,000 and is depreciated using straight line depreciation over 10 years assuming zero residual value. Rent for the factory space and warehouse, and other fixed manufacturing overhead costs total $1,200 per month. Sweetum currently makes and sells 3,800 jaw-breakers per month. Sweetum buys just enough materials each month to make the jaw-breakers it needs to sell. Materials cost 30 cents per jawbreaker. Next year Sweetum expects demand to increase by 100%. At this volume of materials purchased, it will get a 10% discount on price. Rent and other fixed manufacturing overhead costs will remain the same.

Required

1. What is Sweetum’s current annual relevant range of output? 2. What is Sweetum’s current annual fixed manufacturing cost within the relevant range? What is the annual variable manufacturing cost? 3. What will Sweetum’s relevant range of output be next year? How if at all, will total annual fixed and variable manufacturing costs change next year? Assume that if it needs to Sweetum could buy an identical machine at the same cost as the one it already has.

ASSIGNMENT MATERIAL " 55

2-24 Cost drivers and value chain. Helner Cell Phones (HCP) is developing a new touch screen smart-

phone to compete in the cellular phone industry. The phones will be sold at wholesale prices to cell phone companies, which will in turn sell them in retail stores to the final customer. HCP has undertaken the following activities in its value chain to bring its product to market: Identify customer needs (What do smartphone users want?) Perform market research on competing brands Design a prototype of the HCP smartphone Market the new design to cell phone companies Manufacture the HCP smartphone Process orders from cell phone companies Package the HCP smartphones Deliver the HCP smartphones to the cell phone companies Provide online assistance to cell phone users for use of the HCP smartphone Make design changes to the smartphone based on customer feedback During the process of product development, production, marketing, distribution, and customer service, HCP has kept track of the following cost drivers: Number of smartphones shipped by HCP Number of design changes Number of deliveries made to cell phone companies Engineering hours spent on initial product design Hours spent researching competing market brands Customer-service hours Number of smartphone orders processed Number of cell phone companies purchasing the HCP smartphone Machine hours required to run the production equipment Number of surveys returned and processed from competing smartphone users 1. Identify each value chain activity listed at the beginning of the exercise with one of the following valuechain categories: a. Design of products and processes b. Production c. Marketing d. Distribution e. Customer Service

Required

2. Use the list of preceding cost drivers to find one or more reasonable cost drivers for each of the activities in HCP’s value chain.

2-25 Cost drivers and functions. The list of representative cost drivers in the right column of this table are randomized with respect to the list of functions in the left column. That is, they do not match. Function 1. Accounting 2. Human resources 3. Data processing 4. Research and development 5. Purchasing 6. Distribution 7. Billing

Representative Cost Driver A. Number of invoices sent B. Number of purchase orders C. Number of research scientists D. Hours of computer processing unit (CPU) E. Number of employees F. Number of transactions processed G. Number of deliveries made

1. Match each function with its representative cost driver. 2. Give a second example of a cost driver for each function.

Required

2-26 Total costs and unit costs. A student association has hired a band and a caterer for a graduation party. The band will charge a fixed fee of $1,000 for an evening of music, and the caterer will charge a fixed fee of $600 for the party setup and an additional $9 per person who attends. Snacks and soft drinks will be provided by the caterer for the duration of the party. Students attending the party will pay $5 each at the door. 1. Draw a graph depicting the fixed cost, the variable cost, and the total cost to the student association for different attendance levels. 2. Suppose 100 people attend the party. What is the total cost to the student association? What is the cost per person?

Required

56 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

3. Suppose 500 people attend the party. What is the total cost to the student association and the cost per attendee? 4. Draw a graph depicting the cost per attendee for different attendance levels. As president of the student association, you want to request a grant to cover some of the party costs. Will you use the per attendee cost numbers to make your case? Why or why not?

2-27 Total and unit cost, decision making. Gayle’s Glassworks makes glass flanges for scientific use. Materials cost $1 per flange, and the glass blowers are paid a wage rate of $28 per hour. A glass blower blows 10 flanges per hour. Fixed manufacturing costs for flanges are $28,000 per period. Period (nonmanufacturing) costs associated with flanges are $10,000 per period, and are fixed. Required

1. Graph the fixed, variable, and total manufacturing cost for flanges, using units (number of flanges) on the x-axis. 2. Assume Gayle’s Glassworks manufactures and sells 5,000 flanges this period. Its competitor, Flora’s Flasks, sells flanges for $10 each. Can Gayle sell below Flora’s price and still make a profit on the flanges? 3. How would your answer to requirement 2 differ if Gayle’s Glassworks made and sold 10,000 flanges this period? Why? What does this indicate about the use of unit cost in decision making?

2-28 Inventoriable costs versus period costs. Each of the following cost items pertains to one of these companies: General Electric (a manufacturing-sector company), Safeway (a merchandising-sector company), and Google (a service-sector company): a. Perrier mineral water purchased by Safeway for sale to its customers b. Electricity used to provide lighting for assembly-line workers at a General Electric refrigeratorassembly plant c. Depreciation on Google’s computer equipment used to update directories of Web sites d. Electricity used to provide lighting for Safeway’s store aisles e. Depreciation on General Electric’s computer equipment used for quality testing of refrigerator components during the assembly process f. Salaries of Safeway’s marketing personnel planning local-newspaper advertising campaigns g. Perrier mineral water purchased by Google for consumption by its software engineers h. Salaries of Google’s marketing personnel selling banner advertising Required

1. Distinguish between manufacturing-, merchandising-, and service-sector companies. 2. Distinguish between inventoriable costs and period costs. 3. Classify each of the cost items (a–h) as an inventoriable cost or a period cost. Explain your answers.

Problems 2-29 Computing cost of goods purchased and cost of goods sold. The following data are for Marvin Department Store. The account balances (in thousands) are for 2011. Marketing, distribution, and customer-service costs Merchandise inventory, January 1, 2011 Utilities General and administrative costs Merchandise inventory, December 31, 2011 Purchases Miscellaneous costs Transportation-in Purchase returns and allowances Purchase discounts Revenues Required

$ 37,000 27,000 17,000 43,000 34,000 155,000 4,000 7,000 4,000 6,000 280,000

1. Compute (a) the cost of goods purchased and (b) the cost of goods sold. 2. Prepare the income statement for 2011.

2-30 Cost of goods purchased, cost of goods sold, and income statement. The following data are for Montgomery Retail Outlet Stores. The account balances (in thousands) are for 2011. Marketing and advertising costs Merchandise inventory, January 1, 2011 Shipping of merchandise to customers

$ 24,000 45,000 2,000

ASSIGNMENT MATERIAL " 57

Building depreciation Purchases General and administrative costs Merchandise inventory, December 31, 2011 Merchandise freight-in Purchase returns and allowances Purchase discounts Revenues

$ 4,200 260,000 32,000 52,000 10,000 11,000 9,000 320,000

1. Compute (a) the cost of goods purchased and (b) the cost of goods sold. 2. Prepare the income statement for 2011.

Required

2-31 Flow of Inventoriable Costs. Renka’s Heaters selected data for October 2011 are presented here (in millions): Direct materials inventory 10/1/2011 Direct materials purchased Direct materials used Total manufacturing overhead costs Variable manufacturing overhead costs Total manufacturing costs incurred during October 2011 Work-in-process inventory 10/1/2011 Cost of goods manufactured Finished goods inventory 10/1/2011 Cost of goods sold

$ 105 365 385 450 265 1,610 230 1,660 130 1,770

Calculate the following costs: 1. 2. 3. 4. 5. 6.

Required

Direct materials inventory 10/31/2011 Fixed manufacturing overhead costs for October 2011 Direct manufacturing labor costs for October 2011 Work-in-process inventory 10/31/2011 Cost of finished goods available for sale in October 2011 Finished goods inventory 10/31/2011

2-32 Cost of finished goods manufactured, income statement, manufacturing company. Consider the following account balances (in thousands) for the Canseco Company:

A 1 Canseco Company 2 3 4 5 6 7 8 9 10 11 12 13

Direct materials inventory Work-in-process inventory Finished goods inventory Purchases of direct materials Direct manufacturing labor Indirect manufacturing labor Plant insurance Depreciation—plant, building, and equipment Repairs and maintenance—plant Marketing, distribution, and customer-service costs General and administrative costs

1. Prepare a schedule for the cost of goods manufactured for 2011. 2. Revenues for 2011 were $300 million. Prepare the income statement for 2011.

Beginning of 2011

End of 2011

$22,000 21,000 18,000

$26,000 20,000 23,000 75,000 25,000 15,000 9,000 11,000 4,000 93,000 29,000

Required

58 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

2-33 Cost of goods manufactured, income statement, manufacturing company. Consider the following account balances (in thousands) for the Piedmont Corporation:

Piedmont Corporation Direct materials inventory Work-in-process inventory Finished goods inventory Purchases of direct materials Direct manufacturing labor Indirect manufacturing labor Indirect materials Plant insurance Depreciation—plant, building, and equipment Plant utilities Repairs and maintenance—plant Equipment leasing costs Marketing, distribution, and customer-service costs General and administrative costs Required

Beginning of 2011

End of 2011

65,000 83,000 123,000

34,000 72,000 102,000 128,000 106,000 48,000 14,000 2,000 21,000 12,000 8,000 32,000 62,000 34,000

1. Prepare a schedule for the cost of goods manufactured for 2011. 2. Revenues for 2011 were $600 million. Prepare the income statement for 2011.

2-34 Income statement and schedule of cost of goods manufactured. The Howell Corporation has the following account balances (in millions): For Specific Date Direct materials inventory, Jan. 1, 2011 $15 Work-in-process inventory, Jan. 1, 2011 10 Finished goods inventory, Jan. 1, 2011 70 Direct materials inventory, Dec. 31, 2011 20 Work-in-process inventory, Dec. 31, 2011 5 Finished goods inventory, Dec. 31, 2011 55

Required

For Year 2011 Purchases of direct materials $325 Direct manufacturing labor 100 Depreciation—plant and equipment 80 Plant supervisory salaries 5 Miscellaneous plant overhead 35 Revenues 950 Marketing, distribution, and customer-service costs 240 Plant supplies used 10 Plant utilities 30 Indirect manufacturing labor 60

Prepare an income statement and a supporting schedule of cost of goods manufactured for the year ended December 31, 2011. (For additional questions regarding these facts, see the next problem.)

2-35 Interpretation of statements (continuation of 2-34). Required

1. How would the answer to Problem 2-34 be modified if you were asked for a schedule of cost of goods manufactured and sold instead of a schedule of cost of goods manufactured? Be specific. 2. Would the sales manager’s salary (included in marketing, distribution, and customer-service costs) be accounted for any differently if the Howell Corporation were a merchandising-sector company instead of a manufacturing-sector company? Using the flow of manufacturing costs outlined in Exhibit 2-9 (p. 42), describe how the wages of an assembler in the plant would be accounted for in this manufacturing company. 3. Plant supervisory salaries are usually regarded as manufacturing overhead costs. When might some of these costs be regarded as direct manufacturing costs? Give an example. 4. Suppose that both the direct materials used and the plant and equipment depreciation are related to the manufacture of 1 million units of product. What is the unit cost for the direct materials assigned to those units? What is the unit cost for plant and equipment depreciation? Assume that yearly plant and equipment depreciation is computed on a straight-line basis. 5. Assume that the implied cost-behavior patterns in requirement 4 persist. That is, direct material costs behave as a variable cost, and plant and equipment depreciation behaves as a fixed cost. Repeat the

ASSIGNMENT MATERIAL " 59

computations in requirement 4, assuming that the costs are being predicted for the manufacture of 1.2 million units of product. How would the total costs be affected? 6. As a management accountant, explain concisely to the president why the unit costs differed in requirements 4 and 5.

2-36 Income statement and schedule of cost of goods manufactured. The following items (in millions) pertain to Calendar Corporation:

For Specific Date Work-in-process inventory, Jan. 1, 2011 Direct materials inventory, Dec. 31, 2011 Finished goods inventory, Dec. 31, 2011 Accounts payable, Dec. 31, 2011 Accounts receivable, Jan. 1, 2011 Work-in-process inventory, Dec. 31, 2011 Finished goods inventory, Jan 1, 2011 Accounts receivable, Dec. 31, 2011 Accounts payable, Jan. 1, 2011 Direct materials inventory, Jan. 1, 2011

$18 8 11 24 52 3 47 38 49 32

For Year 2011 Plant utilities $ 9 Indirect manufacturing labor 27 Depreciation—plant and equipment 6 Revenues 355 Miscellaneous manufacturing overhead 15 Marketing, distribution, and customer-service costs 94 Direct materials purchased 84 Direct manufacturing labor 42 Plant supplies used 4 Property taxes on plant 2

Calendar’s manufacturing costing system uses a three-part classification of direct materials, direct manufacturing labor, and manufacturing overhead costs. Prepare an income statement and a supporting schedule of cost of goods manufactured. (For additional questions regarding these facts, see the next problem.)

2-37 Terminology, interpretation of statements (continuation of 2-36). 1. Calculate total prime costs and total conversion costs. 2. Calculate total inventoriable costs and period costs. 3. Design costs and R&D costs are not considered product costs for financial statement purposes. When might some of these costs be regarded as product costs? Give an example. 4. Suppose that both the direct materials used and the depreciation on plant and equipment are related to the manufacture of 2 million units of product. Determine the unit cost for the direct materials assigned to those units and the unit cost for depreciation on plant and equipment. Assume that yearly depreciation is computed on a straight-line basis. 5. Assume that the implied cost-behavior patterns in requirement 4 persist. That is, direct material costs behave as a variable cost and depreciation on plant and equipment behaves as a fixed cost. Repeat the computations in requirement 4, assuming that the costs are being predicted for the manufacture of 3 million units of product. Determine the effect on total costs. 6. Assume that depreciation on the equipment (but not the plant) is computed based on the number of units produced because the equipment deteriorates with units produced. The depreciation rate on equipment is $1 per unit. Calculate the depreciation on equipment assuming (a) 2 million units of product are produced and (b) 3 million units of product are produced.

2-38 Labor cost, overtime, and idle time. Jim Anderson works in the production department of Midwest

Steelworks as a machine operator. Jim, a long-time employee of Midwest, is paid on an hourly basis at a rate of $20 per hour. Jim works five 8-hour shifts per week Monday–Friday (40 hours). Any time Jim works over and above these 40 hours is considered overtime for which he is paid at a rate of time and a half ($30 per hour). If the overtime falls on weekends, Jim is paid at a rate of double time ($40 per hour). Jim is also paid an additional $20 per hour for any holidays worked, even if it is part of his regular 40 hours. Jim is paid his regular wages even if the machines are down (not operating) due to regular machine maintenance, slow order periods, or unexpected mechanical problems. These hours are considered “idle time.” During December Jim worked the following hours:

Week 1 Week 2 Week 3 Week 4

Hours worked including machine downtime Machine downtime 44 3.5 43 6.4 48 5.8 46 2

Required

60 " CHAPTER 2 AN INTRODUCTION TO COST TERMS AND PURPOSES

Included in the total hours worked are two company holidays (Christmas Eve and Christmas Day) during Week 4. All overtime worked by Jim was Monday–Friday, except for the hours worked in Week 3. All of the Week 3 overtime hours were worked on a Saturday. Required

1. Calculate (a) direct manufacturing labor, (b) idle time, (c) overtime and holiday premium, and (d) total earnings for Jim in December. 2. Is idle time and overtime premium a direct or indirect cost of the products that Jim worked on in December? Explain.

2-39 Missing records, computing inventory costs. Ron Williams recently took over as the controller of Johnson Brothers Manufacturing. Last month, the previous controller left the company with little notice and left the accounting records in disarray. Ron needs the ending inventory balances to report first quarter numbers. For the previous month (March 2011) Ron was able to piece together the following information: Direct materials purchased Work-in-process inventory, 3/1/2011 Direct materials inventory, 3/1/2011 Finished goods inventory, 3/1/2011 Conversion Costs Total manufacturing costs added during the period Cost of goods manufactured Gross margin as a percentage of revenues Revenues Required

$ 240,000 $ 70,000 $ 25,000 $ 320,000 $ 660,000 $ 840,000 4 times direct materials used 20% $1,037,500

Calculate the cost of: 1. Finished goods inventory, 3/31/2011 2. Work-in-process inventory, 3/31/2011 3. Direct materials inventory, 3/31/2011

2-40 Comprehensive problem on unit costs, product costs. Denver Office Equipment manufactures and sells metal shelving. It began operations on January 1, 2011. Costs incurred for 2011 are as follows (V stands for variable; F stands for fixed): Direct materials used Direct manufacturing labor costs Plant energy costs Indirect manufacturing labor costs Indirect manufacturing labor costs Other indirect manufacturing costs Other indirect manufacturing costs Marketing, distribution, and customer-service costs Marketing, distribution, and customer-service costs Administrative costs

$147,600 V 38,400 V 2,000 V 14,000 V 19,000 F 11,000 V 14,000 F 128,000 V 48,000 F 56,000 F

Variable manufacturing costs are variable with respect to units produced. Variable marketing, distribution, and customer-service costs are variable with respect to units sold. Inventory data are as follows:

Direct materials Work in process Finished goods

Beginning: January 1, 2011 0 lb 0 units 0 units

Ending: December 31, 2011 2,400 lbs 0 units ? units

Production in 2011 was 123,000 units. Two pounds of direct materials are used to make one unit of finished product. Revenues in 2011 were $594,000. The selling price per unit and the purchase price per pound of direct materials were stable throughout the year. The company’s ending inventory of finished goods is carried at the average unit manufacturing cost for 2011. Finished-goods inventory at December 31, 2011, was $26,000.

ASSIGNMENT MATERIAL " 61

1. 2. 3. 4.

Calculate direct materials inventory, total cost, December 31, 2011. Calculate finished-goods inventory, total units, December 31, 2011. Calculate selling price in 2011. Calculate operating income for 2011.

Required

2-41 Cost Classification; Ethics. Scott Hewitt, the new Plant Manager of Old World Manufacturing Plant

Number 7, has just reviewed a draft of his year-end financial statements. Hewitt receives a year-end bonus of 10% of the plant’s operating income before tax. The year-end income statement provided by the plant’s controller was disappointing to say the least. After reviewing the numbers, Hewitt demanded that his controller go back and “work the numbers” again. Hewitt insisted that if he didn’t see a better operating income number the next time around he would be forced to look for a new controller. Old World Manufacturing classifies all costs directly related to the manufacturing of its product as product costs. These costs are inventoried and later expensed as costs of goods sold when the product is sold. All other expenses, including finished goods warehousing costs of $3,250,000 are classified as period expenses. Hewitt had suggested that warehousing costs be included as product costs because they are “definitely related to our product.” The company produced 200,000 units during the period and sold 180,000 units. As the controller reworked the numbers he discovered that if he included warehousing costs as product costs, he could improve operating income by $325,000. He was also sure these new numbers would make Hewitt happy. 1. Show numerically how operating income would improve by $325,000 just by classifying the preceding costs as product costs instead of period expenses? 2. Is Hewitt correct in his justification that these costs “are definitely related to our product.” 3. By how much will Hewitt profit personally if the controller makes the adjustments in requirement 1. 4. What should the plant controller do?

Collaborative Learning Problem 2-42 Finding unknown amounts. An auditor for the Internal Revenue Service is trying to reconstruct some partially destroyed records of two taxpayers. For each of the cases in the accompanying list, find the unknowns designated by the letters A through D. Case 1

Case 2 (in thousands)

Accounts receivable, 12/31 Cost of goods sold Accounts payable, 1/1 Accounts payable, 12/31 Finished goods inventory, 12/31 Gross margin Work-in-process inventory, 1/1 Work-in-process inventory, 12/31 Finished goods inventory, 1/1 Direct materials used Direct manufacturing labor Manufacturing overhead costs Purchases of direct materials Revenues Accounts receivable, 1/1

$ 6,000 A 3,000 1,800 B 11,300 0 0 4,000 8,000 3,000 7,000 9,000 32,000 2,000

$ 2,100 20,000 1,700 1,500 5,300 C 800 3,000 4,000 12,000 5,000 D 7,000 31,800 1,400

Required

Cost-Volume-Profit Analysis

All managers want to know how profits will change as the units sold of a product or service change.

Learning Objectives

1. Explain the features of cost-volumeprofit (CVP) analysis

Home Depot managers, for example, might wonder how many units of a new product must be sold to break even or make a certain amount of profit. Procter & Gamble managers might ask themselves how expanding their business into a particular foreign market would affect costs, selling price, and profits. These questions have a common “what-if” theme. Examining the results of these what-if possibilities and alternatives helps managers make better decisions. Managers must also decide how to price their products and understand the effect of their pricing decisions on revenues and profits. The following article explains how the Irish rock band U2 recently decided whether it should decrease the prices on some of its tickets during its recent world tour. Does lowering ticket price sound like a wise strategy to you?

2. Determine the breakeven point and output level needed to achieve a target operating income 3. Understand how income taxes affect CVP analysis 4. Explain how managers use CVP analysis in decision making 5. Explain how sensitivity analysis helps managers cope with uncertainty 6. Use CVP analysis to plan variable and fixed costs 7. Apply CVP analysis to a company producing multiple products

How the “The Biggest Rock Show Ever” Turned a Big Profit1 When U2 embarked on its recent world tour, Rolling Stone magazine called it “the biggest rock show ever.” Visiting large stadiums across the United States and Europe, the Irish quartet performed on an imposing 164-foot high stage that resembled a spaceship, complete with a massive video screen and footbridges leading to ringed catwalks. With an ambitious 48-date trek planned, U2 actually had three separate stages leapfrogging its global itinerary—each one costing nearly $40 million dollars. As a result, the tour’s success was dependent not only on each night’s concert, but also recouping its tremendous fixed costs—costs that do not change with the number of fans in the audience. To cover its high fixed costs and make a profit, U2 needed to sell a lot of tickets. To maximize revenue, the tour employed a unique in-theround stage configuration, which boosted stadium capacity by roughly 20%, and sold tickets for as little as $30, far less than most large outdoor concerts. The band’s plan worked—despite a broader music industry slump and global recession, U2 shattered attendance records in most of the venues it played. By the end of the tour, the band played to over 1

Source: Gundersen, Edna. 2009. U2 turns 360 stadium into attendance-shattering sellouts. USA Today, October 4. www.usatoday.com/life/music/news/2009-10-04-u2-stadium-tour_N.htm

3 million fans, racking up almost $300 million in ticket and merchandise sales and turning a profit. As you read this chapter, you will begin to understand how and why U2 made the decision to lower prices. Many capital intensive companies, such as US Airways and United Airlines in the airlines industry and Global Crossing and WorldCom in the telecommunications industry, have high fixed costs. They must generate sufficient revenues to cover these costs and turn a profit. When revenues declined at these companies during 2001 and 2002 and fixed costs remained high, these companies declared bankruptcy. The methods of CVP analysis described in this chapter help managers minimize such risks.

Essentials of CVP Analysis In Chapter 2, we discussed total revenues, total costs, and income. Cost-volume-profit (CVP) analysis studies the behavior and relationship among these elements as changes occur in the units sold, the selling price, the variable cost per unit, or the fixed costs of a product. Let’s consider an example to illustrate CVP analysis. Example: Emma Frost is considering selling GMAT Success, a test prep book and software package for the business school admission test, at a college fair in Chicago. Emma knows she can purchase this package from a wholesaler at $120 per package, with the privilege of returning all unsold packages and receiving a full $120 refund per package. She also knows that she must pay $2,000 to the organizers for the booth rental at the fair. She will incur no other costs. She must decide whether she should rent a booth. Emma, like most managers who face such a situation, works through a series of steps. 1. Identify the problem and uncertainties. The decision to rent the booth hinges critically on how Emma resolves two important uncertainties—the price she can charge and the number of packages she can sell at that price. Every decision deals with selecting a course of action. Emma must decide knowing that the outcome of the chosen action is uncertain and will only be known in the future. The more confident Emma is about selling a large number of packages at a good price, the more willing she will be to rent the booth. 2. Obtain information. When faced with uncertainty, managers obtain information that might help them understand the uncertainties better. For example, Emma gathers information about the type of individuals likely to attend the fair and other test-prep packages that might be sold at the fair. She also gathers data on her past experiences selling GMAT Success at fairs very much like the Chicago fair.

Learning Objective

Explain the features of cost-volume-profit (CVP) analysis . . . how operating income changes with changes in output level, selling prices, variable costs, or fixed costs

64 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

3. Make predictions about the future. Using all the information available to them, managers make predictions. Emma predicts that she can charge a price of $200 for GMAT Success. At that price she is reasonably confident that she will be able to sell at least 30 packages and possibly as many as 60. In making these predictions, Emma like most managers, must be realistic and exercise careful judgment. If her predictions are excessively optimistic, Emma will rent the booth when she should not. If they are unduly pessimistic, Emma will not rent the booth when she should. Emma’s predictions rest on the belief that her experience at the Chicago fair will be similar to her experience at the Boston fair four months earlier. Yet, Emma is uncertain about several aspects of her prediction. Is the comparison between Boston and Chicago appropriate? Have conditions and circumstances changed over the last four months? Are there any biases creeping into her thinking? She is keen on selling at the Chicago fair because sales in the last couple of months have been lower than expected. Is this experience making her predictions overly optimistic? Has she ignored some of the competitive risks? Will the other test prep vendors at the fair reduce their prices? Emma reviews her thinking. She retests her assumptions. She also explores these questions with John Mills, a close friend, who has extensive experience selling testprep packages like GMAT Success. In the end, she feels quite confident that her predictions are reasonable, accurate, and carefully thought through. 4. Make decisions by choosing among alternatives. Emma uses the CVP analysis that follows, and decides to rent the booth at the Chicago fair. 5. Implement the decision, evaluate performance, and learn. Thoughtful managers never stop learning. They compare their actual performance to predicted performance to understand why things worked out the way they did and what they might learn. At the end of the Chicago fair, for example, Emma would want to evaluate whether her predictions about price and the number of packages she could sell were correct. Such feedback would be very helpful to Emma as she makes decisions about renting booths at subsequent fairs. How does Emma use CVP analysis in Step 4 to make her decision? Emma begins by identifying which costs are fixed and which costs are variable and then calculates contribution margin.

Contribution Margins The booth-rental cost of $2,000 is a fixed cost because it will not change no matter how many packages Emma sells. The cost of the package itself is a variable cost because it increases in proportion to the number of packages sold. Emma will incur a cost of $120 for each package that she sells. To get an idea of how operating income will change as a result of selling different quantities of packages, Emma calculates operating income if sales are 5 packages and if sales are 40 packages.

Revenues Variable purchase costs Fixed costs Operating income

5 packages sold 40 packages sold $ 1,000 ($200 per package * 5 packages) $8,000 ($200 per package * 40 packages) 600 ($120 per package * 5 packages) 4,800 ($120 per package * 40 packages) ƒƒƒ2,000 ƒ2,000 $(1,600) $1,200

The only numbers that change from selling different quantities of packages are total revenues and total variable costs. The difference between total revenues and total variable costs is called contribution margin. That is, Contribution margin = Total revenues - Total variable costs

Contribution margin indicates why operating income changes as the number of units sold changes. The contribution margin when Emma sells 5 packages is $400 ($1,000 in total revenues minus $600 in total variable costs); the contribution margin when Emma sells

ESSENTIALS OF CVP ANALYSIS " 65

40 packages is $3,200 ($8,000 in total revenues minus $4,800 in total variable costs). When calculating the contribution margin, be sure to subtract all variable costs. For example, if Emma had variable selling costs because she paid a commission to salespeople for each package they sold at the fair, variable costs would include the cost of each package plus the sales commission. Contribution margin per unit is a useful tool for calculating contribution margin and operating income. It is defined as, Contribution margin per unit = Selling price - Variable cost per unit

In the GMAT Success example, contribution margin per package, or per unit, is $200 - $120 = $80. Contribution margin per unit recognizes the tight coupling of selling price and variable cost per unit. Unlike fixed costs, Emma will only incur the variable cost per unit of $120 when she sells a unit of GMAT Success for $200. Contribution margin per unit provides a second way to calculate contribution margin: Contribution margin = Contribution margin per unit * Number of units sold

For example, when 40 packages are sold, contribution margin = $80 per unit * 40 units = $3,200. Even before she gets to the fair, Emma incurs $2,000 in fixed costs. Because the contribution margin per unit is $80, Emma will recover $80 for each package that she sells at the fair. Emma hopes to sell enough packages to fully recover the $2,000 she spent for renting the booth and to then start making a profit. Exhibit 3-1 presents contribution margins for different quantities of packages sold. The income statement in Exhibit 3-1 is called a contribution income statement because it groups costs into variable costs and fixed costs to highlight contribution margin. Each additional package sold from 0 to 1 to 5 increases contribution margin by $80 per package, recovering more of the fixed costs and reducing the operating loss. If Emma sells 25 packages, contribution margin equals $2,000 ($80 per package * 25 packages), exactly recovering fixed costs and resulting in $0 operating income. If Emma sells 40 packages, contribution margin increases by another $1,200 ($3,200 - $2,000), all of which becomes operating income. As you look across Exhibit 3-1 from left to right, you see that the increase in contribution margin exactly equals the increase in operating income (or the decrease in operating loss). Instead of expressing contribution margin as a dollar amount per unit, we can express it as a percentage called contribution margin percentage (or contribution margin ratio): Contribution margin percentage (or contribution margin ratio) =

Contribution margin per unit Selling price

In our example, Contribution margin percentage =

$80 = 0.40, or 40% $200

Contribution margin percentage is the contribution margin per dollar of revenue. Emma earns 40% of each dollar of revenue (equal to 40 cents). Exhibit 3-1 A

1 2

Revenues Variable costs Contribution margin Fixed costs

Operating income

3 4 5

$ 200 per package $ 120 per package $ 80 per package $ 2 ,0 0 0

Number of Packages Sold 0 1 5 25 40 $ 0 $ 200 $ 1,000 $ 5,000 $ 8,000 0 120 6 0 0 3 ,0 0 0 4 ,8 0 0 0 2 ,0 0 0

80 2 ,0 0 0

400 2 ,0 0 0

$(2,000) $(1,920) $(1,600) $

2,000 2 ,0 0 0

3 ,2 00 2 ,0 0 0

0 $ 1 ,2 0 0

Contribution Income Statement for Different Quantities of GMAT Success Packages Sold

66 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

Most companies have multiple products. As we shall see later in this chapter, calculating contribution margin per unit when there are multiple products is more cumbersome. In practice, companies routinely use contribution margin percentage as a handy way to calculate contribution margin for different dollar amounts of revenue: Contribution margin = Contribution margin percentage * Revenues (in dollars)

For example, in Exhibit 3-1, if Emma sells 40 packages, revenues will be $8,000 and contribution margin will equal 40% of $8,000, or 0.40 * $8,000 = $3,200. Emma earns operating income of $1,200 ($3,200 - Fixed costs, $2,000) by selling 40 packages for $8,000.

Expressing CVP Relationships How was the Excel spreadsheet in Exhibit 3-1 constructed? Underlying the Exhibit are some equations that express the CVP relationships. To make good decisions using CVP analysis, we must understand these relationships and the structure of the contribution income statement in Exhibit 3-1. There are three related ways (we will call them methods) to think more deeply about and model CVP relationships: 1. The equation method 2. The contribution margin method 3. The graph method The equation method and the contribution margin method are most useful when managers want to determine operating income at few specific levels of sales (for example 5, 15, 25, and 40 units sold). The graph method helps managers visualize the relationship between units sold and operating income over a wide range of quantities of units sold. As we shall see later in the chapter, different methods are useful for different decisions. Equation Method Each column in Exhibit 3-1 is expressed as an equation. Revenues - Variable costs - Fixed costs = Operating income

How are revenues in each column calculated? Revenues = Selling price (SP) * Quantity of units sold (Q)

How are variable costs in each column calculated? Variable costs = Variable cost per unit (VCU) * Quantity of units sold (Q)

So, ca

Selling Quantity of Variable cost Quantity of Fixed Operating * b - a * bd = price units sold per unit units sold costs income

(Equation 1)

Equation 1 becomes the basis for calculating operating income for different quantities of units sold. For example, if you go to cell F7 in Exhibit 3-1, the calculation of operating income when Emma sells 5 packages is ($200 * 5) - ($120 * 5) - $2,000 = $1,000 - $600 - $2,000 = - $1,600

Contribution Margin Method Rearranging equation 1, ca

Selling Variable cost Quantity of Fixed Operating b * a bd = price per unit units sold costs income a

Contribution margin Quantity of Fixed Operating * b = per unit units sold costs income

(Equation 2)

ESSENTIALS OF CVP ANALYSIS " 67

In our GMAT Success example, contribution margin per unit is $80 ($200 - $120), so when Emma sells 5 packages, Operating income = ($80 * 5) - $2,000 = - $1,600

Equation 2 expresses the basic idea we described earlier—each unit sold helps Emma recover $80 (in contribution margin) of the $2,000 in fixed costs. Graph Method In the graph method, we represent total costs and total revenues graphically. Each is shown as a line on a graph. Exhibit 3-2 illustrates the graph method for GMAT Success. Because we have assumed that total costs and total revenues behave in a linear fashion, we need only two points to plot the line representing each of them. 1. Total costs line. The total costs line is the sum of fixed costs and variable costs. Fixed costs are $2,000 for all quantities of units sold within the relevant range. To plot the total costs line, use as one point the $2,000 fixed costs at zero units sold (point A) because variable costs are $0 when no units are sold. Select a second point by choosing any other convenient output level (say, 40 units sold) and determine the corresponding total costs. Total variable costs at this output level are $4,800 (40 units * $120 per unit). Remember, fixed costs are $2,000 at all quantities of units sold within the relevant range, so total costs at 40 units sold equal $6,800 ($2,000 + $4,800), which is point B in Exhibit 3-2. The total costs line is the straight line from point A through point B. 2. Total revenues line. One convenient starting point is $0 revenues at 0 units sold, which is point C in Exhibit 3-2. Select a second point by choosing any other convenient output level and determining the corresponding total revenues. At 40 units sold, total revenues are $8,000 ($200 per unit * 40 units), which is point D in Exhibit 3-2. The total revenues line is the straight line from point C through point D. Profit or loss at any sales level can be determined by the vertical distance between the two lines at that level in Exhibit 3-2. For quantities fewer than 25 units sold, total costs exceed total revenues, and the purple area indicates operating losses. For quantities greater than 25 units sold, total revenues exceed total costs, and the blue-green area indicates operating incomes. At 25 units sold, total revenues equal total costs. Emma will break even by selling 25 packages. y

$10,000

Dollars

$8,000

Operating income area

$6,000

Operating income

B Variable costs

Total costs line*

$4,000

Breakeven point ! 25 units

$2,000 A

How can CVP analysis assist managers?

Exhibit 3-2 Total revenues line**

$5,000

Decision Point

Fixed costs

Operating loss area x 10

Units Sold *Slope of the total costs line is the variable cost per unit ! $120 **Slope of the total revenues line is the selling price ! $200

Cost-Volume Graph for GMAT Success

68 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

Cost-Volume-Profit Assumptions Now that you have seen how CVP analysis works, think about the following assumptions we made during the analysis: 1. Changes in the levels of revenues and costs arise only because of changes in the number of product (or service) units sold. The number of units sold is the only revenue driver and the only cost driver. Just as a cost driver is any factor that affects costs, a revenue driver is a variable, such as volume, that causally affects revenues. 2. Total costs can be separated into two components: a fixed component that does not vary with units sold and a variable component that changes with respect to units sold. 3. When represented graphically, the behaviors of total revenues and total costs are linear (meaning they can be represented as a straight line) in relation to units sold within a relevant range (and time period). 4. Selling price, variable cost per unit, and total fixed costs (within a relevant range and time period) are known and constant. As the CVP assumptions make clear, an important feature of CVP analysis is distinguishing fixed from variable costs. Always keep in mind, however, that whether a cost is variable or fixed depends on the time period for a decision. The shorter the time horizon, the higher the percentage of total costs considered fixed. For example, suppose an American Airlines plane will depart from its gate in the next hour and currently has 20 seats unsold. A potential passenger arrives with a transferable ticket from a competing airline. The variable costs (such as one more meal) to American of placing one more passenger in an otherwise empty seat is negligible At the time of this decision, with only an hour to go before the flight departs, virtually all costs (such as crew costs and baggage-handling costs) are fixed. Alternatively, suppose American Airlines must decide whether to keep this flight in its flight schedule. This decision will have a one-year planning horizon. If American Airlines decides to cancel this flight because very few passengers during the last year have taken this flight, many more costs, including crew costs, baggage-handling costs, and airport fees, would be considered variable. That’s because over this longer horizon, these costs would not have to be incurred if the flight were no longer operating. Always consider the relevant range, the length of the time horizon, and the specific decision situation when classifying costs as variable or fixed.

Breakeven Point and Target Operating Income Learning Objective

Determine the breakeven point and output level needed to achieve a target operating income . . . compare contribution margin and fixed costs

Managers and entrepreneurs like Emma always want to know how much they must sell to earn a given amount of income. Equally important, they want to know how much they must sell to avoid a loss.

Breakeven Point The breakeven point (BEP) is that quantity of output sold at which total revenues equal total costs—that is, the quantity of output sold that results in $0 of operating income. We have already seen how to use the graph method to calculate the breakeven point. Recall from Exhibit 3-1 that operating income was $0 when Emma sold 25 units, the breakeven point. But by understanding the equations underlying the calculations in Exhibit 3-1, we can calculate the breakeven point directly for GMAT Success rather than trying out different quantities and checking when operating income equals $0. Recall the equation method (equation 1): a

Selling Quantity of Variable cost Quantity of Fixed Operating * b - a * b = price units sold per unit units sold costs income

BREAKEVEN POINT AND TARGET OPERATING INCOME " 69

Setting operating income equal to $0 and denoting quantity of output units that must be sold by Q, ($200 * Q) - ($120 * Q) - $2,000 = $0 $80 * Q = $2,000 Q = $2,000 , $80 per unit = 25 units

If Emma sells fewer than 25 units, she will incur a loss; if she sells 25 units, she will break even; and if she sells more than 25 units, she will make a profit. While this breakeven point is expressed in units, it can also be expressed in revenues: 25 units * $200 selling price = $5,000. Recall the contribution margin method (equation 2): a

Contribution Quantity of * b - Fixed costs = Operating income margin per unit units sold

At the breakeven point, operating income is by definition $0 and so,

Contribution margin per unit * Breakeven number of units = Fixed cost

(Equation 3)

Rearranging equation 3 and entering the data, Breakeven Fixed costs $2,000 = 25 units = = number of units Contribution margin per unit $80 per unit Breakeven revenues = Breakeven number of units * Selling price = 25 units * $200 per unit = $5,000

In practice (because they have multiple products), companies usually calculate breakeven point directly in terms of revenues using contribution margin percentages. Recall that in the GMAT Success example, Contribution margin per unit $80 Contribution margin = 0.40, or 40% = = Selling price percentage $200

That is, 40% of each dollar of revenue, or 40 cents, is contribution margin. To break even, contribution margin must equal fixed costs of $2,000. To earn $2,000 of contribution margin, when $1 of revenue earns $0.40 of contribution margin, revenues must equal $2,000 , 0.40 = $5,000. Breakeven Fixed costs $2,000 = = = $5,000 revenues Contribution margin % 0.40

While the breakeven point tells managers how much they must sell to avoid a loss, managers are equally interested in how they will achieve the operating income targets underlying their strategies and plans. In our example, selling 25 units at a price of $200 assures Emma that she will not lose money if she rents the booth. This news is comforting, but we next describe how Emma determines how much she needs to sell to achieve a targeted amount of operating income.

Target Operating Income We illustrate target operating income calculations by asking the following question: How many units must Emma sell to earn an operating income of $1,200? One approach is to keep plugging in different quantities into Exhibit 3-1 and check when operating income equals $1,200. Exhibit 3-1 shows that operating income is $1,200 when 40 packages are sold. A more convenient approach is to use equation 1 from page 66. ca

Selling Quantity of Variable cost Quantity of Fixed Operating * b - a * bd = price units sold per unit units sold costs income

(Equation 1)

We denote by Q the unknown quantity of units Emma must sell to earn an operating income of $1,200. Selling price is $200, variable cost per package is $120, fixed costs are

70 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

$2,000, and target operating income is $1,200. Substituting these values into equation 1, we have ($200 * Q) - ($120 * Q) - $2,000 = $1,200 $80 * Q = $2,000 + $1,200 = $3,200 Q = $3,200 , $80 per unit = 40 units

Alternatively, we could use equation 2, a

Contribution margin Quantity of Fixed Operating * b = per unit units sold costs income

(Equation 2)

Given a target operating income ($1,200 in this case), we can rearrange terms to get equation 4. Fixed costs + Target operating income Quantity of units = Contribution margin per unit required to be sold

(Equation 4)

Quantity of units $2,000 + $1,200 = 40 units = required to be sold $80 per unit Proof:

Revenues, $200 per unit * 40 units Variable costs, $120 per unit * 40 units Contribution margin, $80 per unit * 40 units Fixed costs Operating income

$8,000 ƒ4,800 3,200 ƒ2,000 $1,200

The revenues needed to earn an operating income of $1,200 can also be calculated directly by recognizing (1) that $3,200 of contribution margin must be earned (fixed costs of $2,000 plus operating income of $1,200) and (2) that $1 of revenue earns $0.40 (40 cents) of contribution margin. To earn $3,200 of contribution margin, revenues must equal $3,200 , 0.40 = $8,000. Revenues needed to earn operating income of $1,200 =

Decision Point How can managers determine the breakeven point or the output needed to achieve a target operating income?

Learning Objective

Understand how income taxes affect CVP analysis . . . focus on net income

$3,200 $2,000 + $1,200 = = $8,000 0.40 0.40

The graph in Exhibit 3-2 is very difficult to use to answer the question: How many units must Emma sell to earn an operating income of $1,200? Why? Because it is not easy to determine from the graph the precise point at which the difference between the total revenues line and the total costs line equals $1,200. However, recasting Exhibit 3-2 in the form of a profit-volume (PV) graph makes it easier to answer this question. A PV graph shows how changes in the quantity of units sold affect operating income. Exhibit 3-3 is the PV graph for GMAT Success (fixed costs, $2,000; selling price, $200; and variable cost per unit, $120). The PV line can be drawn using two points. One convenient point (M) is the operating loss at 0 units sold, which is equal to the fixed costs of $2,000, shown at –$2,000 on the vertical axis. A second convenient point (N) is the breakeven point, which is 25 units in our example (see p. 69). The PV line is the straight line from point M through point N. To find the number of units Emma must sell to earn an operating income of $1,200, draw a horizontal line parallel to the x-axis corresponding to $1,200 on the vertical axis (that’s the y-axis). At the point where this line intersects the PV line, draw a vertical line down to the horizontal axis (that’s the x-axis). The vertical line intersects the x-axis at 40 units, indicating that by selling 40 units Emma will earn an operating income of $1,200.

Target Net Income and Income Taxes Net income is operating income plus nonoperating revenues (such as interest revenue) minus nonoperating costs (such as interest cost) minus income taxes. For simplicity, throughout this chapter we assume nonoperating revenues and nonoperating costs are zero. Thus, Net income = Operating income - Income taxes

Until now, we have ignored the effect of income taxes in our CVP analysis. In many companies, the income targets for managers in their strategic plans are expressed in terms of

TARGET NET INCOME AND INCOME TAXES " 71 $4,000

Exhibit 3-3

$3,000

Operating Income

Profit-Volume Graph for GMAT Success

Profit-volume line

$2,000 $1,600

Operating income area

$1,200 $1,000

0 20 . 30

10 "$1,000

40 45 50 60 70 Units Sold

100

BEP ! 25 units

- Operating loss area

"$2,000

BEP ! Breakeven point

net income. That’s because top management wants subordinate managers to take into account the effects their decisions have on operating income after income taxes. Some decisions may not result in large operating incomes, but they may have favorable tax consequences, making them attractive on a net income basis—the measure that drives shareholders’ dividends and returns. To make net income evaluations, CVP calculations for target income must be stated in terms of target net income instead of target operating income. For example, Emma may be interested in knowing the quantity of units she must sell to earn a net income of $960, assuming an income tax rate of 40%. Target net income = a

Target Target b - a * Tax rateb operating income operating income

Target net income = (Target operating income) * (1 - Tax rate) Target operating income =

Target net income $960 = = $1,600 1 - Tax rate 1 - 0.40

In other words, to earn a target net income of $960, Emma’s target operating income is $1,600. Proof:

Target operating income Tax at 40% (0.40 * $1,600) Target net income

$1,600 ƒƒƒ640 $ƒƒ960

The key step is to take the target net income number and convert it into the corresponding target operating income number. We can then use equation 1 for target operating income and substitute numbers from our GMAT Success example. ca

Selling Quantity of Variable cost Quantity of Fixed Operating * b - a * bd = price units sold per unit units sold costs income

(Equation 1)

($200 * Q) - ($120 * Q) - $2,000 = $1,600 $80 * Q = $3,600

Q = $3,600 , $80 per unit = 45 units

Alternatively we can calculate the number of units Emma must sell by using the contribution margin method and equation 4: Fixed costs + Target operating income Quantity of units = Contribution margin per unit required to be sold =

$2,000 + $1,600 = 45 units $80 per unit

(Equation 4)

72 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

Proof:

Decision Point How can managers incorporate income taxes into CVP analysis?

Learning Objective

Explain how managers use CVP analysis in decision making . . . choose the alternative that maximizes operating income

Revenues, $200 per unit * 45 units Variable costs, $120 per unit * 45 units Contribution margin Fixed costs Operating income Income taxes, $1,600 * 0.40 Net income

$9,000 ƒ5,400 3,600 ƒ2,000 1,600 ƒƒƒ640 $ƒƒ960

Emma can also use the PV graph in Exhibit 3-3. To earn target operating income of $1,600, Emma needs to sell 45 units. Focusing the analysis on target net income instead of target operating income will not change the breakeven point. That’s because, by definition, operating income at the breakeven point is $0, and no income taxes are paid when there is no operating income.

Using CVP Analysis for Decision Making We have seen how CVP analysis is useful for calculating the units that need to be sold to break even, or to achieve a target operating income or target net income. Managers also use CVP analysis to guide other decisions, many of them strategic decisions. Consider a decision about choosing additional features for an existing product. Different choices can affect selling prices, variable cost per unit, fixed costs, units sold, and operating income. CVP analysis helps managers make product decisions by estimating the expected profitability of these choices. Strategic decisions invariably entail risk. CVP analysis can be used to evaluate how operating income will be affected if the original predicted data are not achieved—say, if sales are 10% lower than estimated. Evaluating this risk affects other strategic decisions a company might make. For example, if the probability of a decline in sales seems high, a manager may take actions to change the cost structure to have more variable costs and fewer fixed costs. We return to our GMAT Success example to illustrate how CVP analysis can be used for strategic decisions concerning advertising and selling price.

Decision to Advertise Suppose Emma anticipates selling 40 units at the fair. Exhibit 3-3 indicates that Emma’s operating income will be $1,200. Emma is considering placing an advertisement describing the product and its features in the fair brochure. The advertisement will be a fixed cost of $500. Emma thinks that advertising will increase sales by 10% to 44 packages. Should Emma advertise? The following table presents the CVP analysis.

Revenues ($200 * 40; $200 * 44) Variable costs ($120 * 40; $120 * 44) Contribution margin ($80 * 40; $80 * 44) Fixed costs Operating income

40 Packages Sold with No Advertising (1) $8,000 ƒ4,800 3,200 ƒ2,000 $1,200

44 Packages Sold with Advertising (2) $8,800 ƒ5,280 3,520 ƒ2,500 $1,020

Difference (3) = (2) - (1) $ 800 ƒƒ480 320 ƒƒ500 $(180)

Operating income will decrease from $1,200 to $1,020, so Emma should not advertise. Note that Emma could focus only on the difference column and come to the same conclusion: If Emma advertises, contribution margin will increase by $320 (revenues, $800 - variable costs, $480), and fixed costs will increase by $500, resulting in a $180 decrease in operating income. As you become more familiar with CVP analysis, try evaluating decisions based on differences rather than mechanically working through the contribution income statement. Analyzing differences gets to the heart of CVP analysis and sharpens intuition by focusing only on the revenues and costs that will change as a result of a decision.

SENSITIVITY ANALYSIS AND MARGIN OF SAFETY " 73

Decision to Reduce Selling Price Having decided not to advertise, Emma is contemplating whether to reduce the selling price to $175. At this price, she thinks she will sell 50 units. At this quantity, the testprep package wholesaler who supplies GMAT Success will sell the packages to Emma for $115 per unit instead of $120. Should Emma reduce the selling price? Contribution margin from lowering price to $175: ($175 - $115) per unit * 50 units Contribution margin from maintaining price at $200: ($200 - $120) per unit * 40 units Change in contribution margin from lowering price

$3,000 ƒƒ3,200 $ƒ(200)

Decreasing the price will reduce contribution margin by $200 and, because the fixed costs of $2,000 will not change, it will also reduce operating income by $200. Emma should not reduce the selling price. Determining Target Prices Emma could also ask “At what price can I sell 50 units (purchased at $115 per unit) and continue to earn an operating income of $1,200?” The answer is $179, as the following calculations show. Target operating income Add fixed costs Target contribution margin Divided by number of units sold Target contribution margin per unit Add variable cost per unit Target selling price Proof:

Revenues, $179 per unit * 50 units Variable costs, $115 per unit * 50 units Contribution margin Fixed costs Operating income

$1,200 ƒ2,000 $3,200 !50 units $ 64 ƒƒƒ115 $ƒƒ179 $8,950 ƒ5,750 3,200 ƒ2,000 $1,200

Emma should also examine the effects of other decisions, such as simultaneously increasing advertising costs and lowering prices. In each case, Emma will compare the changes in contribution margin (through the effects on selling prices, variable costs, and quantities of units sold) to the changes in fixed costs, and she will choose the alternative that provides the highest operating income.

Decision Point How do managers use CVP analysis to make decisions?

Sensitivity Analysis and Margin of Safety Before choosing strategies and plans about how to implement strategies, managers frequently analyze the sensitivity of their decisions to changes in underlying assumptions. Sensitivity analysis is a “what-if” technique that managers use to examine how an outcome will change if the original predicted data are not achieved or if an underlying assumption changes. In the context of CVP analysis, sensitivity analysis answers questions such as, “What will operating income be if the quantity of units sold decreases by 5% from the original prediction?” and “What will operating income be if variable cost per unit increases by 10%?” Sensitivity analysis broadens managers’ perspectives to possible outcomes that might occur before costs are committed. Electronic spreadsheets, such as Excel, enable managers to conduct CVP-based sensitivity analyses in a systematic and efficient way. Using spreadsheets, managers can conduct sensitivity analysis to examine the effect and interaction of changes in selling price, variable cost per unit, fixed costs, and target operating income. Exhibit 3-4 displays a spreadsheet for the GMAT Success example. Using the spreadsheet, Emma can immediately see how many units she needs to sell to achieve particular operating-income levels, given alternative levels of fixed costs and variable cost per unit that she may face. For example, 32 units must be sold to earn an

Learning Objective

Explain how sensitivity analysis helps managers cope with uncertainty . . . determine the effect on operating income of different assumptions

74 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

Exhibit 3-4 Spreadsheet Analysis of CVP Relationships for GMAT Success

D5 A 1 2 3 4 5 6 7 8 9 10 11 12 13

=($A5+D$3)/($F$1-$B5) C

Number of units required to be sold at $200 Selling Price to Earn Target Operating Income of Variable Costs $0 $1,200 $1,600 $2,000 Fixed Costs per Unit (Breakeven point) 32a $2,000 $100 20 36 40 $2,000 $120 25 40 45 50 $2,000 $150 40 64 72 80 $2,400 $100 24 36 40 44 $2,400 $120 30 45 50 55 $2,400 $150 48 72 80 88 $2,800 $100 28 40 44 48 $2,800 $120 35 50 55 60 $2,800 $150 56 80 88 96

14 15 16

Number of units Fixed costs + Target operating income $2,000 + $1,200 = = = 32 Contribution margin per unit $200 – $100 required to be sold a

operating income of $1,200 if fixed costs are $2,000 and variable cost per unit is $100. Emma can also use Exhibit 3-4 to determine that she needs to sell 56 units to break even if fixed cost of the booth rental at the Chicago fair is raised to $2,800 and if the variable cost per unit charged by the test-prep package supplier increases to $150. Emma can use information about costs and sensitivity analysis, together with realistic predictions about how much she can sell to decide if she should rent a booth at the fair. Another aspect of sensitivity analysis is margin of safety: Margin of safety = Budgeted (or actual) revenues - Breakeven revenues Margin of safety (in units) = Budgeted (or actual) sales quantity - Breakeven quantity

The margin of safety answers the “what-if” question: If budgeted revenues are above breakeven and drop, how far can they fall below budget before the breakeven point is reached? Sales might decrease as a result of a competitor introducing a better product, or poorly executed marketing programs, and so on. Assume that Emma has fixed costs of $2,000, a selling price of $200, and variable cost per unit of $120. From Exhibit 3-1, if Emma sells 40 units, budgeted revenues are $8,000 and budgeted operating income is $1,200. The breakeven point is 25 units or $5,000 in total revenues. Budgeted Breakeven = $8,000 - $5,000 = $3,000 revenues revenues Margin of Budgeted Breakeven = = 40 - 25 = 15 units safety (in units) sales (units) sales (units)

Margin of safety =

Sometimes margin of safety is expressed as a percentage: Margin of safety percentage =

Margin of safety in dollars Budgeted (or actual) revenues

In our example, margin of safety percentage =

$3,000 = 37.5% $8,000

This result means that revenues would have to decrease substantially, by 37.5%, to reach breakeven revenues. The high margin of safety gives Emma confidence that she is unlikely to suffer a loss.

COST PLANNING AND CVP " 75

If, however, Emma expects to sell only 30 units, budgeted revenues would be $6,000 ($200 per unit * 30 units) and the margin of safety would equal: Budgeted revenues - Breakeven revenues = $6,000 - $5,000 = $1,000 Margin of safety in dollars $1,000 Margin of = = 16.67% = Budgeted (or actual) revenues safety percentage $6,000

The analysis implies that if revenues decrease by more than 16.67%, Emma would suffer a loss. A low margin of safety increases the risk of a loss. If Emma does not have the tolerance for this level of risk, she will prefer not to rent a booth at the fair. Sensitivity analysis is a simple approach to recognizing uncertainty, which is the possibility that an actual amount will deviate from an expected amount. Sensitivity analysis gives managers a good feel for the risks involved. A more comprehensive approach to recognizing uncertainty is to compute expected values using probability distributions. This approach is illustrated in the appendix to this chapter.

Decision Point What can managers do to cope with uncertainty or changes in underlying assumptions?

Cost Planning and CVP Managers have the ability to choose the levels of fixed and variable costs in their cost structures. This is a strategic decision. In this section, we describe various factors that managers and management accountants consider as they make this decision.

Alternative Fixed-Cost/Variable-Cost Structures CVP-based sensitivity analysis highlights the risks and returns as fixed costs are substituted for variable costs in a company’s cost structure. In Exhibit 3-4, compare line 6 and line 11.

Line 6 Line 11

Fixed Cost $2,000 $2,800

Variable Cost $120 $100

Number of units required to be sold at $200 selling price to earn target operating income of $0 (Breakeven point) $2,000 25 50 28 48

Compared to line 6, line 11, with higher fixed costs, has more risk of loss (has a higher breakeven point) but requires fewer units to be sold (48 versus 50) to earn operating income of $2,000. CVP analysis can help managers evaluate various fixed-cost/variable-cost structures. We next consider the effects of these choices in more detail. Suppose the Chicago college fair organizers offer Emma three rental alternatives: Option 1: $2,000 fixed fee Option 2: $800 fixed fee plus 15% of GMAT Success revenues Option 3: 25% of GMAT Success revenues with no fixed fee Emma’s variable cost per unit is $120. Emma is interested in how her choice of a rental agreement will affect the income she earns and the risks she faces. Exhibit 3-5 graphically depicts the profit-volume relationship for each option. The line representing the relationship between units sold and operating income for Option 1 is the same as the line in the PV graph shown in Exhibit 3-3 (fixed costs of $2,000 and contribution margin per unit of $80). The line representing Option 2 shows fixed costs of $800 and a contribution margin per unit of $50 [selling price, $200, minus variable cost per unit, $120, minus variable rental fees per unit, $30, (0.15 * $200)]. The line representing Option 3 has fixed costs of $0 and a contribution margin per unit of $30 [$200 - $120 - $50 (0.25 * $200)]. Option 3 has the lowest breakeven point (0 units), and Option 1 has the highest breakeven point (25 units). Option 1 has the highest risk of loss if sales are low, but it also has the highest contribution margin per unit ($80) and hence the highest operating income when sales are high (greater than 40 units). The choice among Options 1, 2, and 3 is a strategic decision that Emma faces. As in most strategic decisions, what she decides now will significantly affect her operating

Learning Objective

Use CVP analysis to plan variable and fixed costs . . . compare risk of losses versus higher returns

76 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS y

Exhibit 3-5 Profit-Volume Graph for Alternative Rental Options for GMAT Success

$4,000

Operating income area

Option 1 ($2,000 fixed fee) Option 2 ($800 fixed fee # 15% of revenues)

$2,800 Option 3 (no fixed fee # 25% of revenues)

Operating Income

$2,200 $1,800 $1,200

BEP ! 0 units

$0 10

20 . 30

"$800

"$2,000

60 70 80 Units Sold BEP ! 25 units BEP ! 16 units

100

Operating loss area

BEP ! Breakeven point

income (or loss), depending on the demand for GMAT Success. Faced with this uncertainty, Emma’s choice will be influenced by her confidence in the level of demand for GMAT Success and her willingness to risk losses if demand is low. For example, if Emma’s tolerance for risk is high, she will choose Option 1 with its high potential rewards. If, however, Emma is averse to taking risk, she will prefer Option 3, where the rewards are smaller if sales are high but where she never suffers a loss if sales are low.

Operating Leverage The risk-return trade-off across alternative cost structures can be measured as operating leverage. Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold and contribution margin. Organizations with a high proportion of fixed costs in their cost structures, as is the case under Option 1, have high operating leverage. The line representing Option 1 in Exhibit 3-5 is the steepest of the three lines. Small increases in sales lead to large increases in operating income. Small decreases in sales result in relatively large decreases in operating income, leading to a greater risk of operating losses. At any given level of sales, Contribution margin Degree of = operating leverage Operating income

The following table shows the degree of operating leverage at sales of 40 units for the three rental options.

1. Contribution margin per unit (p. 75) 2. Contribution margin (row 1 * 40 units) 3. Operating income (from Exhibit 3-5) 4. Degree of operating leverage (row 2 , row 3)

Option 1 $ 80 $3,200 $1,200 $3,200 = 2.67 $1,200

Option 2 $ 50 $2,000 $1,200 $2,000 = 1.67 $1,200

Option 3 $ 30 $1,200 $1,200 $1,200 = 1.00 $1,200

These results indicate that, when sales are 40 units, a percentage change in sales and contribution margin will result in 2.67 times that percentage change in operating income for Option 1, but the same percentage change (1.00) in operating income for Option 3. Consider, for example, a sales increase of 50% from 40 to 60 units. Contribution margin will increase by 50% under each option. Operating income, however, will increase by 2.67 * 50% = 133% from $1,200 to $2,800 in Option 1, but it will increase by

EFFECTS OF SALES MIX ON INCOME " 77

only 1.00 * 50% = 50% from $1,200 to $1,800 in Option 3 (see Exhibit 3-5). The degree of operating leverage at a given level of sales helps managers calculate the effect of sales fluctuations on operating income. Keep in mind that, in the presence of fixed costs, the degree of operating leverage is different at different levels of sales. For example, at sales of 60 units, the degree of operating leverage under each of the three options is as follows:

1. Contribution margin per unit (p. 75) 2. Contribution margin (row 1 * 60 units) 3. Operating income (from Exhibit 3-5) 4. Degree of operating leverage (row 2 , row 3)

Option 1 $ 80 $4,800 $2,800 $4,800 = 1.71 $2,800

Option 2 $ 50 $3,000 $2,200 $3,000 = 1.36 $2,200

Option 3 $ 30 $1,800 $1,800 $1,800 = 1.00 $1,800

The degree of operating leverage decreases from 2.67 (at sales of 40 units) to 1.71 (at sales of 60 units) under Option 1 and from 1.67 to 1.36 under Option 2. In general, whenever there are fixed costs, the degree of operating leverage decreases as the level of sales increases beyond the breakeven point. If fixed costs are $0 as in Option 3, contribution margin equals operating income, and the degree of operating leverage equals 1.00 at all sales levels. But why must managers monitor operating leverage carefully? Again, consider companies such as General Motors, Global Crossing, US Airways, United Airlines, and WorldCom. Their high operating leverage was a major reason for their financial problems. Anticipating high demand for their services, these companies borrowed money to acquire assets, resulting in high fixed costs. As sales declined, these companies suffered losses and could not generate sufficient cash to service their interest and debt, causing them to seek bankruptcy protection. Managers and management accountants should always evaluate how the level of fixed costs and variable costs they choose will affect the risk-return trade-off. See Concepts in Action, page 78, for another example of the risks of high fixed costs. What actions are managers taking to reduce their fixed costs? Many companies are moving their manufacturing facilities from the United States to lower-cost countries, such as Mexico and China. To substitute high fixed costs with lower variable costs, companies are purchasing products from lower-cost suppliers instead of manufacturing products themselves. These actions reduce both costs and operating leverage. More recently, General Electric and Hewlett-Packard began outsourcing service functions, such as post-sales customer service, by shifting their customer call centers to countries, such as India, where costs are lower. These decisions by companies are not without controversy. Some economists argue that outsourcing helps to keep costs, and therefore prices, low and enables U.S. companies to remain globally competitive. Others argue that outsourcing reduces job opportunities in the United States and hurts working-class families.

Decision Point How should managers choose among different variable-cost/ fixed-cost structures?

Effects of Sales Mix on Income Sales mix is the quantities (or proportion) of various products (or services) that constitute total unit sales of a company. Suppose Emma is now budgeting for a subsequent college fair in New York. She plans to sell two different test-prep packages—GMAT Success and GRE Guarantee—and budgets the following:

Expected sales Revenues, $200 and $100 per unit Variable costs, $120 and $70 per unit Contribution margin, $80 and $30 per unit Fixed costs Operating income

GMAT Success ƒƒƒƒƒ60 $12,000 ƒƒ7,200 $ƒ4,800

GRE Guarantee ƒƒƒƒ40 $4,000 ƒ2,800 $1,200

Total ƒƒƒƒ100 $16,000 ƒ10,000 6,000 ƒƒ4,500 $ƒ1,500

Learning Objective

Apply CVP analysis to a company producing multiple products . . . assume sales mix of products remains constant as total units sold changes

78 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

Concepts in Action

Fixed Costs, Variable Costs, and the Future of Radio

Building up too much fixed costs can be hazardous to a company’s health. Because fixed costs, unlike variable costs, do not automatically decrease as volume declines, companies with too much fixed costs can lose a considerable amount of money during lean times. Sirius XM, the satellite radio broadcaster, learned this lesson the hard way. To begin broadcasting in 2001, both Sirius Satellite Radio and XM Satellite Radio—the two companies now comprising Sirius XM—spent billions of dollars on broadcasting licenses, space satellites, and other technology infrastructure. Once operational, the companies also spent billions on other fixed items such as programming and content (including Howard Stern and Major League Baseball), satellite transmission, and R&D. In contrast, variable costs were minimal, consisting mainly of artist-royalty fees and customer service and billing. In effect, this created a business model with a high operating leverage—that is, the companies’ cost structure had a very significant proportion of fixed costs. As such, profitability could only be achieved by amassing millions of paid subscribers and selling advertising. The competitive disadvantage of this highly-leveraged business model was nearly disastrous. Despite amassing more than 14 million subscribers, over the years Sirius and XM rang up $3 billion in debt and tallied cumulative operating losses in excess of $10 billion. Operating leverage, and the threat of bankruptcy, forced the merger of Sirius and XM in 2007, and since then the combined entity has struggled to cut costs, refinance its sizable debt, and reap the profits from over 18 million monthly subscribers. While satellite radio has struggled under the weight of too much fixed cost, Internet radio had the opposite problem—too much variable costs. But “How?” you ask. Don’t variable costs only increase as revenues increase? Yes, but if the revenue earned is less than the variable cost, an increase in revenue can lead to bankruptcy. This is almost what happened to Pandora, the Internet radio service. Pandora launched in 2005 with only $9.3 million in venture capital. Available free over the Internet, Pandora earned revenue in three ways: advertising on its Web site, subscription fees from users who wanted to opt-out of advertising, and affiliate fees from iTunes and Amazon.com. Pandora had low fixed costs but high variable costs for streaming and performance royalties. Over time, as Pandora’s popular service attracted millions of loyal listeners, its costs for performance royalties––set by the Copyright Royalty Board on a per song basis––far exceeded its revenues from advertising and subscriptions. As a result, even though royalty rates were only a fraction of a cent, Pandora lost more and more money each time it played another song! In 2009, Pandora avoided bankruptcy by renegotiating a lower per-song royalty rate in exchange for at least 25% of its U.S. revenue annually. Further, Pandora began charging its most frequent users a small fee and also started increasing its advertising revenue. Sources: Birger, Jon. 2009. Mel Karmazian fights to rescue Sirius. Fortune, March 16; Clifford, Stephanie. 2007. Pandora’s long strange trip. Inc., October 1; Pandora: Royalties kill the web radio star? (A). Harvard Business School Case No. 9-310-026; Satellite radio: An industry case study. Kellogg School of Management, Northwestern University. Case No. 5-206-255; XM satellite radio (A). Harvard Business School Case No. 9-504-009.

What is the breakeven point? In contrast to the single-product (or service) situation, the total number of units that must be sold to break even in a multiproduct company depends on the sales mix—the combination of the number of units of GMAT Success sold and the number of units of GRE Guarantee sold. We assume that the budgeted sales mix (60 units of GMAT Success sold for every 40 units of GRE Guarantee sold, that is, a ratio of 3:2) will not change at different levels of total unit sales. That is, we think of Emma selling a bundle of 3 units of GMAT Success and 2 units of GRE Guarantee. (Note that this does not mean that Emma physically bundles the two products together into one big package.)

EFFECTS OF SALES MIX ON INCOME " 79

Each bundle yields a contribution margin of $300 calculated as follows:

GMAT Success GRE Guarantee Total

Number of Units of GMAT Success and GRE Guarantee in Each Bundle

Contribution Margin per Unit for GMAT Success and GRE Guarantee

3 2

$80 30

Contribution Margin of the Bundle $240 ƒƒ60 $300

To compute the breakeven point, we calculate the number of bundles Emma needs to sell. Breakeven Fixed costs $4,500 = 15 bundles point in = = Contribution margin per bundle $300 per bundle bundles

Breakeven point in units of GMAT Success and GRE Guarantee is as follows: GMAT Success: 15 bundles * 3 units of GMAT Success per bundle GRE Guarantee: 15 bundles * 2 units of GRE Guarantee per bundle Total number of units to break even

45 units 30 units 75 units

Breakeven point in dollars for GMAT Success and GRE Guarantee is as follows: GMAT Success: 45 units * $200 per unit GRE Guarantee: 30 units * $100 per unit Breakeven revenues

$ 9,000 ƒƒ3,000 $12,000

When there are multiple products, it is often convenient to use contribution margin percentage. Under this approach, Emma first calculates the revenues from selling a bundle of 3 units of GMAT Success and 2 units of GRE Guarantee: Number of Units of GMAT Success and GRE Guarantee in Each Bundle GMAT Success GRE Guarantee Total

3 2

Selling Price for GMAT Success and GRE Guarantee

Revenue of the Bundle

$200 100

$600 ƒ200 $800

Contribution Contribution margin of the bundle margin $300 = = = 0.375 or 37.5% percentage for Revenue of the bundle $800 the bundle $4,500 Breakeven Fixed costs = = $12,000 = Contribution margin % for the bundle 0.375 revenues Number of bundles $12,000 Breakeven revenues = required to be sold = = 15 bundles Revenue per bundle $800 per bundle to break even

The breakeven point in units and dollars for GMAT Success and GRE Guarantee are as follows: GMAT Success: 15 bundles * 3 units of GMAT Success per bundle = 45 units * $200 per unit = $9,000 GRE Guarantee: 15 bundles * 2 units of GRE Guarantee per bundle = 30 units * $100 per unit = $3,000

Recall that in all our calculations we have assumed that the budgeted sales mix (3 units of GMAT Success for every 2 units of GRE Guarantee) will not change at different levels of total unit sales.

80 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

Of course, there are many different sales mixes (in units) that result in a contribution margin of $4,500 and cause Emma to break even, as the following table shows: Sales Mix (Units) GMAT Success GRE Guarantee (1) (2) 48 22 36 54 30 70

Decision Point How can CVP analysis be applied to a company producing multiple products?

Contribution Margin from GMAT Success GRE Guarantee (3) ! $80 : (1) (4) ! $30 : (2) $3,840 $ 660 2,880 1,620 2,400 2,100

Total Contribution Margin (5) ! (3) " (4) $4,500 4,500 4,500

If for example, the sales mix changes to 3 units of GMAT Success for every 7 units of GRE Guarantee, the breakeven point increases from 75 units to 100 units, comprising 30 units of GMAT Success and 70 units of GRE Guarantee. The breakeven quantity increases because the sales mix has shifted toward the lower-contribution-margin product, GRE Guarantee ($30 per unit compared to GMAT Success’s $80 per unit). In general, for any given total quantity of units sold, as the sales mix shifts toward units with lower contribution margins (more units of GRE Guarantee compared to GMAT Success), operating income will be lower. How do companies choose their sales mix? They adjust their mix to respond to demand changes. For example, as gasoline prices increase and customers want smaller cars, auto companies shift their production mix to produce smaller cars. The multi-product case has two cost drivers, GMAT Success and GRE Guarantee. It shows how CVP and breakeven analysis can be adapted to the case of multiple cost drivers. The key point is that many different combinations of cost drivers can result in a given contribution margin.

CVP Analysis in Service and Nonprofit Organizations Thus far, our CVP analysis has focused on a merchandising company. CVP can also be applied to decisions by manufacturing companies like BMW, service companies like Bank of America, and nonprofit organizations like the United Way. To apply CVP analysis in service and nonprofit organizations, we need to focus on measuring their output, which is different from the tangible units sold by manufacturing and merchandising companies. Examples of output measures in various service and nonprofit industries are as follows: Industry Airlines Hotels/motels Hospitals Universities

Measure of Output Passenger miles Room-nights occupied Patient days Student credit-hours

Consider an agency of the Massachusetts Department of Social Welfare with a $900,000 budget appropriation (its revenues) for 2011. This nonprofit agency’s purpose is to assist handicapped people seeking employment. On average, the agency supplements each person’s income by $5,000 annually. The agency’s only other costs are fixed costs of rent and administrative salaries equal to $270,000. The agency manager wants to know how many people could be assisted in 2011. We can use CVP analysis here by setting operating income to $0. Let Q be the number of handicapped people to be assisted: Revenues - Variable costs - Fixed costs $900,000 - $5,000 Q - $270,000 $5,000 Q = $900,000 - $270,000 Q = $630,000 , $5,000 per person

= = = =

0 0 $630,000 126 people

Suppose the manager is concerned that the total budget appropriation for 2012 will be reduced by 15% to $900,000 * (1 - 0.15) = $765,000. The manager wants to know

CONTRIBUTION MARGIN VERSUS GROSS MARGIN " 81

how many handicapped people could be assisted with this reduced budget. Assume the same amount of monetary assistance per person: $765,000 - $5,000 Q - $270,000 = 0 $5,000Q = $765,000 - $270,000 = $495,000 Q = $495,000 , $5,000 per person = 99 people

Note the following two characteristics of the CVP relationships in this nonprofit situation: 1. The percentage drop in the number of people assisted, (126 - 99) , 126, or 21.4%, is greater than the 15% reduction in the budget appropriation. It is greater because the $270,000 in fixed costs still must be paid, leaving a proportionately lower budget to assist people. The percentage drop in service exceeds the percentage drop in budget appropriation. 2. Given the reduced budget appropriation (revenues) of $765,000, the manager can adjust operations to stay within this appropriation in one or more of three basic ways: (a) reduce the number of people assisted from the current 126, (b) reduce the variable cost (the extent of assistance per person) from the current $5,000 per person, or (c) reduce the total fixed costs from the current $270,000.

Contribution Margin Versus Gross Margin In the following equations, we clearly distinguish contribution margin, which provides information for CVP analysis, from gross margin, a measure of competitiveness, as defined in Chapter 2. Gross margin = Revenues - Cost of goods sold Contribution margin = Revenues - All variable costs

Gross margin measures how much a company can charge for its products over and above the cost of acquiring or producing them. Companies, such as branded pharmaceuticals, have high gross margins because their products provide unique and distinctive benefits to consumers. Products such as televisions that operate in competitive markets have low gross margins. Contribution margin indicates how much of a company’s revenues are available to cover fixed costs. It helps in assessing risk of loss. Risk of loss is low (high) if, when sales are low, contribution margin exceeds (is less than) fixed costs. Gross margin and contribution margin are related but give different insights. For example, a company operating in a competitive market with a low gross margin will have a low risk of loss if its fixed costs are small. Consider the distinction between gross margin and contribution margin in the context of manufacturing companies. In the manufacturing sector, contribution margin and gross margin differ in two respects: fixed manufacturing costs and variable nonmanufacturing costs. The following example (figures assumed) illustrates this difference: Contribution Income Statement Emphasizing Contribution Margin (in 000s) Revenues

$1,000

Variable manufacturing costs

$250

Variable nonmanufacturing costs

ƒ270

Contribution margin Fixed manufacturing costs Fixed nonmanufacturing costs Operating income

Revenues

$1,000

Cost of goods sold (variable manufacturing costs, $250 + fixed manufacturing costs, $160) ƒƒƒ410 ƒƒƒ520 480

160 ƒ138

Financial Accounting Income Statement Emphasizing Gross Margin (in 000s)

Gross margin

590

ƒƒƒ298

Nonmanufacturing costs (variable, $270 + fixed $138)

ƒƒƒ408

$ƒƒ182

Operating income

$ƒƒ182

Fixed manufacturing costs of $160,000 are not deducted from revenues when computing contribution margin but are deducted when computing gross margin. Cost of goods sold in a manufacturing company includes all variable manufacturing costs and

82 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

all fixed manufacturing costs ($250,000 + $160,000). Variable nonmanufacturing costs (such as commissions paid to salespersons) of $270,000 are deducted from revenues when computing contribution margin but are not deducted when computing gross margin. Like contribution margin, gross margin can be expressed as a total, as an amount per unit, or as a percentage. For example, the gross margin percentage is the gross margin divided by revenues—59% ($590 , $1,000) in our manufacturing-sector example. One reason why gross margin and contribution margin are confused with each other is that the two are identical in the case of merchandising companies. That’s because cost of goods sold equals the variable cost of goods purchased (and subsequently sold).

Problem for Self-Study Wembley Travel Agency specializes in flights between Los Angeles and London. It books passengers on United Airlines at $900 per round-trip ticket. Until last month, United paid Wembley a commission of 10% of the ticket price paid by each passenger. This commission was Wembley’s only source of revenues. Wembley’s fixed costs are $14,000 per month (for salaries, rent, and so on), and its variable costs are $20 per ticket purchased for a passenger. This $20 includes a $15 per ticket delivery fee paid to Federal Express. (To keep the analysis simple, we assume each round-trip ticket purchased is delivered in a separate package. Thus, the $15 delivery fee applies to each ticket.) United Airlines has just announced a revised payment schedule for all travel agents. It will now pay travel agents a 10% commission per ticket up to a maximum of $50. Any ticket costing more than $500 generates only a $50 commission, regardless of the ticket price. Required

1. Under the old 10% commission structure, how many round-trip tickets must Wembley sell each month (a) to break even and (b) to earn an operating income of $7,000? 2. How does United’s revised payment schedule affect your answers to (a) and (b) in requirement 1?

Solution 1. Wembley receives a 10% commission on each ticket: 10% * $900 = $90. Thus, Selling price = $90 per ticket Variable cost per unit = $20 per ticket Contribution margin per unit = $90 - $20 = $70 per ticket Fixed costs = $14,000 per month

Breakeven number Fixed costs $14,000 = 200 tickets = = of tickets Contribution margin per unit $70 per ticket

b. When target operating income = $7,000 per month, Fixed costs + Target operating income Quantity of tickets = required to be sold Contribution margin per unit $21,000 $14,000 + $7,000 = = 300 tickets = $70 per ticket $70 per ticket

2. Under the new system, Wembley would receive only $50 on the $900 ticket. Thus, Selling price = $50 per ticket Variable cost per unit = $20 per ticket Contribution margin per unit = $50 - $20 = $30 per ticket Fixed costs = $14,000 per month

Breakeven number $14,000 = = 467 tickets (rounded up) of tickets $30 per ticket

DECISION POINTS " 83

Quantity of tickets $21,000 = 700 tickets = required to be sold $30 per ticket

The $50 cap on the commission paid per ticket causes the breakeven point to more than double (from 200 to 467 tickets) and the tickets required to be sold to earn $7,000 per month to also more than double (from 300 to 700 tickets). As would be expected, travel agents reacted very negatively to the United Airlines announcement to change commission payments. Unfortunately for travel agents, other airlines also changed their commission structure in similar ways.

Guidelines

1. How can CVP analysis assist managers?

CVP analysis assists managers in understanding the behavior of a product’s or service’s total costs, total revenues, and operating income as changes occur in the output level, selling price, variable costs, or fixed costs.

2. How can managers determine the breakeven point or the output needed to achieve a target operating income?

The breakeven point is the quantity of output at which total revenues equal total costs. The three methods for computing the breakeven point and the quantity of output to achieve target operating income are the equation method, the contribution margin method, and the graph method. Each method is merely a restatement of the others. Managers often select the method they find easiest to use in the specific decision situation.

3. How can managers incorporate income taxes into CVP analysis?

Income taxes can be incorporated into CVP analysis by using target net income to calculate the corresponding target operating income. The breakeven point is unaffected by income taxes because no income taxes are paid when operating income equals zero.

4. How do managers use CVP analysis to make decisions?

Managers compare how revenues, costs, and contribution margins change across various alternatives. They then choose the alternative that maximizes operating income.

5. What can managers do to cope with uncertainty or changes in underlying assumptions?

Sensitivity analysis, a “what-if” technique, examines how an outcome will change if the original predicted data are not achieved or if an underlying assumption changes. When making decisions, managers use CVP analysis to compare contribution margins and fixed costs under different assumptions. Managers also calculate the margin of safety equal to budgeted revenues minus breakeven revenues.

6. How should managers choose between different variable-cost/fixed-cost structures?

Choosing the variable-cost/fixed-cost structure is a strategic decision for companies. CVP analysis highlights the risk of losses when revenues are low and the upside profits when revenues are high for different proportions of variable and fixed costs in a company’s cost structure.

7. How can CVP analysis be applied to a company producing multiple products?

CVP analysis can be applied to a company producing multiple products by assuming the sales mix of products sold remains constant as the total quantity of units sold changes.

84 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

Appendix Decision Models and Uncertainty This appendix explores the characteristics of uncertainty, describes an approach managers can use to make decisions in a world of uncertainty, and illustrates the insights gained when uncertainty is recognized in CVP analysis.

Coping with Uncertainty2 In the face of uncertainty, managers rely on decision models to help them make the right choices.

Role of a Decision Model Uncertainty is the possibility that an actual amount will deviate from an expected amount. In the GMAT Success example, Emma might forecast sales at 42 units, but actual sales might turn out to be 30 units or 60 units. A decision model helps managers deal with such uncertainty. It is a formal method for making a choice, commonly involving both quantitative and qualitative analyses. The quantitative analysis usually includes the following steps: Step 1: Identify a choice criterion. A choice criterion is an objective that can be quantified such as maximize income or minimize costs. Managers use the choice criterion to choose the best alternative action. Emma’s choice criterion is to maximize expected operating income at the Chicago college fair. Step 2: Identify the set of alternative actions that can be taken. We use the letter a with subscripts 1, 2, and 3 to distinguish each of Emma’s three possible actions: a1 = Pay $2,000 fixed fee a2 = Pay $800 fixed fee plus 15% of GMAT Success revenues a3 = Pay 25% of GMAT Success revenues with no fixed fee

Step 3: Identify the set of events that can occur. An event is a possible relevant occurrence, such as the actual number of GMAT Success packages Emma might sell at the fair. The set of events should be mutually exclusive and collectively exhaustive. Events are mutually exclusive if they cannot occur at the same time. Events are collectively exhaustive if, taken together, they make up the entire set of possible relevant occurrences (no other event can occur). Examples of mutually exclusive and collectively exhaustive events are growth, decline, or no change in industry demand, and increase, decrease, or no change in interest rates. Only one event out of the entire set of mutually exclusive and collectively exhaustive events will actually occur. Suppose Emma’s only uncertainty is the number of units of GMAT Success that she can sell. For simplicity, suppose Emma estimates that sales will be either 30 or 60 units. This set of events is mutually exclusive because clearly sales of 30 units and 60 units cannot both occur at the same time. It is collectively exhaustive because under our assumptions, sales cannot be anything other than 30 or 60 units. We use the letter x with subscripts 1 and 2 to distinguish the set of mutually exclusive and collectively exhaustive events: x1 = 30 units x2 = 60 units

Step 4: Assign a probability to each event that can occur. A probability is the likelihood or chance that an event will occur. The decision model approach to coping with uncertainty assigns probabilities to events. A probability distribution describes the likelihood, or the probability, that each of the mutually exclusive and collectively exhaustive set of events will occur. In some cases, there will be much evidence to guide the assignment of probabilities. For example, the probability of obtaining heads in the toss of a coin is 1/2 and that of drawing a particular playing card from a standard, wellshuffled deck is 1/52. In business, the probability of having a specified percentage of defective units may be assigned with great confidence on the basis of production experience with thousands of units. In other cases, there will be little evidence supporting estimated probabilities—for example, expected sales of a new pharmaceutical product next year. Suppose that Emma, on the basis of past experience, assesses a 60% chance, or a 6/10 probability, that she will sell 30 units and a 40% chance, or a 4/10 probability, that she will sell 60 units. Using P(x) as the notation for the probability of an event, the probabilities are as follows: P(x1) = 6/10 = 0.60 P(x2) = 4/10 = 0.40

The sum of these probabilities must equal 1.00 because these events are mutually exclusive and collectively exhaustive. 2

The presentation here draws (in part) from teaching notes prepared by R. Williamson.

APPENDIX " 85

Decision Table for GMAT Success

Exhibit 3-6

2 3

Fixed

Actions

F ee

Percentage of Fair Revenues

Event X1 : Units Sold = 30 Probability(X 1 ) = 0.60

Event X 2 : Units Sold = 60 Probability(X 2 ) = 0.40

$2,800m

a1: Pay $2,000 fixed fee

$2,000

$400

a2: Pay $800 fixed fee plus 15% of revenues

$ 800

15%

$700

$2,200

$900

$1,800r

a3: Pay 25% of revenues with no fixed fee

Operating Income Under Each Possible Event

Selling price = $200 Package cost = $120

25%

9 10 11 12 13 14 15

Operating income = ($200 – $120)(30) – $2,000 Operating income = ($200 – $120)(60) – $2,000 n Operating income = ($200 – $120 – 15% × $200)(30) – $800 p Operating income = ($200 – $120 – 15% × $200)(60) – $800 q Operating income = ($200 – $120 – 25% × $200)(30) r Operating income = ($200 – $120 – 25% × $200)(60)

= = = = = =

$ 400 $2,800 $ 700 $2,200 $ 900 $1,800

Step 5: Identify the set of possible outcomes. Outcomes specify, in terms of the choice criterion, the predicted economic results of the various possible combinations of actions and events. In the GMAT Success example, the outcomes are the six possible operating incomes displayed in the decision table in Exhibit 3-6. A decision table is a summary of the alternative actions, events, outcomes, and probabilities of events. Distinguish among actions, events, and outcomes. Actions are decision choices available to managers—for example, the particular rental alternatives that Emma can choose. Events are the set of all relevant occurrences that can happen—for example, the different quantities of GMAT Success packages that may be sold at the fair. The outcome is operating income, which depends both on the action the manager selects (rental alternative chosen) and the event that occurs (the quantity of packages sold). Exhibit 3-7 presents an overview of relationships among a decision model, the implementation of a chosen action, its outcome, and a subsequent performance evaluation. Thoughtful managers step back and evaluate what happened and learn from their experiences. This learning serves as feedback for adapting the decision model for future actions.

Expected Value An expected value is the weighted average of the outcomes, with the probability of each outcome serving as the weight. When the outcomes are measured in monetary terms, expected value is often called expected monetary value. Using information in Exhibit 3-6, the expected monetary value of each booth-rental alternative denoted by E(a1), E(a2), and E(a3) is as follows: Pay $2,000 fixed fee: Pay $800 fixed fee plus 15% of revenues: Pay 25% of revenues with no fixed fee:

Exhibit 3-7 Decision Model 1. Choice criterion 2. Set of alternative actions 3. Set of relevant events 4. Set of probabilities 5. Set of possible outcomes

E(a1) = (0.60 * $400) + (0.40 * $2,800) = $1,360 E(a2) = (0.60 * $700) + (0.40 * $2,200) = $1,300 E(a3) = (0.60 * $900) + (0.40 * $1,800) = $1,260

A Decision Model and Its Link to Performance Evaluation

Implementation of Chosen Action

Uncertainty Resolved*

Feedback *Uncertainty resolved means the event becomes known.

Outcome of Chosen Action

Performance Evaluation

86 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

To maximize expected operating income, Emma should select action a1—pay the fair organizers a $2,000 fixed fee. To interpret the expected value of selecting action a1, imagine that Emma attends many fairs, each with the probability distribution of operating incomes given in Exhibit 3-6. For a specific fair, Emma will earn operating income of either $400, if she sells 30 units, or $2,800, if she sells 60 units. But if Emma attends 100 fairs, she will expect to earn $400 operating income 60% of the time (at 60 fairs), and $2,800 operating income 40% of the time (at 40 fairs), for a total operating income of $136,000 ($400 * 60 + $2,800 * 40). The expected value of $1,360 is the operating income per fair that Emma will earn when averaged across all fairs ($136,000 , 100). Of course, in many real-world situations, managers must make one-time decisions under uncertainty. Even in these cases, expected value is a useful tool for choosing among alternatives. Consider the effect of uncertainty on the preferred action choice. If Emma were certain she would sell only 30 units (that is, P(x1) = 1), she would prefer alternative a3—pay 25% of revenues with no fixed fee. To follow this reasoning, examine Exhibit 3-6. When 30 units are sold, alternative a3 yields the maximum operating income of $900. Because fixed costs are $0, booth-rental costs are lower, equal to $1,500 (25% of revenues = 0.25 * $200 per unit * 30 units), when sales are low. However, if Emma were certain she would sell 60 packages (that is, P(x2) = 1), she would prefer alternative a1— pay a $2,000 fixed fee. Exhibit 3-6 indicates that when 60 units are sold, alternative a1 yields the maximum operating income of $2,800. Rental payments under a2 and a3 increase with units sold but are fixed under a1. Despite the high probability of selling only 30 units, Emma still prefers to take action a1, which is to pay a fixed fee of $2,000. That’s because the high risk of low operating income (the 60% probability of selling only 30 units) is more than offset by the high return from selling 60 units, which has a 40% probability. If Emma were more averse to risk (measured in our example by the difference between operating incomes when 30 versus 60 units are sold), she might have preferred action a2 or a3. For example, action a2 ensures an operating income of at least $700, greater than the operating income of $400 that she would earn under action a1 if only 30 units were sold. Of course, choosing a2 limits the upside potential to $2,200 relative to $2,800 under a1, if 60 units are sold. If Emma is very concerned about downside risk, however, she may be willing to forgo some upside benefits to protect against a $400 outcome by choosing a2.3

Good Decisions and Good Outcomes Always distinguish between a good decision and a good outcome. One can exist without the other. Suppose you are offered a one-time-only gamble tossing a coin. You will win $20 if the event is heads, but you will lose $1 if the event is tails. As a decision maker, you proceed through the logical phases: gathering information, assessing outcomes, and making a choice. You accept the bet. Why? Because the expected value is $9.50 [0.5($20) + 0.5( - $1)]. The coin is tossed and the event is tails. You lose. From your viewpoint, this was a good decision but a bad outcome. A decision can be made only on the basis of information that is available at the time of evaluating and making the decision. By definition, uncertainty rules out guaranteeing that the best outcome will always be obtained. As in our example, it is possible that bad luck will produce bad outcomes even when good decisions have been made. A bad outcome does not mean a bad decision was made. The best protection against a bad outcome is a good decision.

Terms to Learn This chapter and the Glossary at the end of the book contain definitions of the following important terms: breakeven point (BEP) (p. 68) choice criterion (p. 84) contribution income statement (p. 65) contribution margin (p. 64) contribution margin per unit (p. 65) contribution margin percentage (p. 65) contribution margin ratio (p. 65) cost-volume-profit (CVP) analysis (p. 63) decision table (p. 85)

degree of operating leverage (p. 76) event (p. 84) expected monetary value (p. 85) expected value (p. 85) gross margin percentage (p. 82) margin of safety (p. 74) net income (p. 70) operating leverage (p. 76) outcomes (p. 85)

For more formal approaches, refer to Moore, J. and L. Weatherford. 2001. Decision modeling with Microsoft Excel, 6th ed. Upper Saddle River, NJ: Prentice Hall.

probability (p. 84) probability distribution (p. 84) PV graph (p. 70) revenue driver (p. 68) sales mix (p. 77) sensitivity analysis (p. 73) uncertainty (p. 75)

ASSIGNMENT MATERIAL " 87

Assignment Material Note: To underscore the basic CVP relationships, the assignment material ignores income taxes unless stated otherwise. Questions 3-1 3-2 3-3 3-4 3-5 3-6 3-7 3-8 3-9 3-10 3-11 3-12 3-13 3-14 3-15

Define cost-volume-profit analysis. Describe the assumptions underlying CVP analysis. Distinguish between operating income and net income. Define contribution margin, contribution margin per unit, and contribution margin percentage. Describe three methods that can be used to express CVP relationships. Why is it more accurate to describe the subject matter of this chapter as CVP analysis rather than as breakeven analysis? “CVP analysis is both simple and simplistic. If you want realistic analysis to underpin your decisions, look beyond CVP analysis.” Do you agree? Explain. How does an increase in the income tax rate affect the breakeven point? Describe sensitivity analysis. How has the advent of the electronic spreadsheet affected the use of sensitivity analysis? Give an example of how a manager can decrease variable costs while increasing fixed costs. Give an example of how a manager can increase variable costs while decreasing fixed costs. What is operating leverage? How is knowing the degree of operating leverage helpful to managers? “There is no such thing as a fixed cost. All costs can be ‘unfixed’ given sufficient time.” Do you agree? What is the implication of your answer for CVP analysis? How can a company with multiple products compute its breakeven point? “In CVP analysis, gross margin is a less-useful concept than contribution margin.” Do you agree? Explain briefly.

Exercises 3-16 CVP computations. Fill in the blanks for each of the following independent cases.

Case a. b. c. d.

Revenues $2,000 $1,000 $1,500

Variable Costs $500 $700

Fixed Costs $300 $300

Total Costs $ 800 $1,000

Operating Income $1,200 $ 200

Contribution Margin Percentage

40%

3-17 CVP computations. Garrett Manufacturing sold 410,000 units of its product for $68 per unit in 2011. Variable cost per unit is $60 and total fixed costs are $1,640,000.

1. Calculate (a) contribution margin and (b) operating income. 2. Garrett’s current manufacturing process is labor intensive. Kate Schoenen, Garrett’s production manager, has proposed investing in state-of-the-art manufacturing equipment, which will increase the annual fixed costs to $5,330,000. The variable costs are expected to decrease to $54 per unit. Garrett expects to maintain the same sales volume and selling price next year. How would acceptance of Schoenen’s proposal affect your answers to (a) and (b) in requirement 1? 3. Should Garrett accept Schoenen’s proposal? Explain.

3-18 CVP analysis, changing revenues and costs. Sunny Spot Travel Agency specializes in flights between Toronto and Jamaica. It books passengers on Canadian Air. Sunny Spot’s fixed costs are $23,500 per month. Canadian Air charges passengers $1,500 per round-trip ticket. Calculate the number of tickets Sunny Spot must sell each month to (a) break even and (b) make a target operating income of $17,000 per month in each of the following independent cases. 1. Sunny Spot’s variable costs are $43 per ticket. Canadian Air pays Sunny Spot 6% commission on ticket price. 2. Sunny Spot’s variable costs are $40 per ticket. Canadian Air pays Sunny Spot 6% commission on ticket price. 3. Sunny Spot’s variable costs are $40 per ticket. Canadian Air pays $60 fixed commission per ticket to Sunny Spot. Comment on the results. 4. Sunny Spot’s variable costs are $40 per ticket. It receives $60 commission per ticket from Canadian Air. It charges its customers a delivery fee of $5 per ticket. Comment on the results.

Required

88 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

3-19 CVP exercises. The Super Donut owns and operates six doughnut outlets in and round Kansas City. You are given the following corporate budget data for next year: Revenues Fixed costs Variable costs Required

Variable costs change with respect to the number of doughnuts sold. Compute the budgeted operating income for each of the following deviations from the original budget data. (Consider each case independently.) 1. 2. 3. 4. 5. 6. 7. 8.

Required

$10,000,000 $ 1,800,000 $ 8,000,000

A 10% increase in contribution margin, holding revenues constant A 10% decrease in contribution margin, holding revenues constant A 5% increase in fixed costs A 5% decrease in fixed costs An 8% increase in units sold An 8% decrease in units sold A 10% increase in fixed costs and a 10% increase in units sold A 5% increase in fixed costs and a 5% decrease in variable costs

3-20 CVP exercises. The Doral Company manufactures and sells pens. Currently, 5,000,000 units are sold per year at $0.50 per unit. Fixed costs are $900,000 per year. Variable costs are $0.30 per unit. Consider each case separately: 1a. What is the current annual operating income? b. What is the present breakeven point in revenues? Compute the new operating income for each of the following changes: 2. A $0.04 per unit increase in variable costs 3. A 10% increase in fixed costs and a 10% increase in units sold 4. A 20% decrease in fixed costs, a 20% decrease in selling price, a 10% decrease in variable cost per unit, and a 40% increase in units sold Compute the new breakeven point in units for each of the following changes: 5. A 10% increase in fixed costs 6. A 10% increase in selling price and a $20,000 increase in fixed costs 3-21 CVP analysis, income taxes. Brooke Motors is a small car dealership. On average, it sells a car for $27,000, which it purchases from the manufacturer for $23,000. Each month, Brooke Motors pays $48,200 in rent and utilities and $68,000 for salespeople’s salaries. In addition to their salaries, salespeople are paid a commission of $600 for each car they sell. Brooke Motors also spends $13,000 each month for local advertisements. Its tax rate is 40%.

Required

1. How many cars must Brooke Motors sell each month to break even? 2. Brooke Motors has a target monthly net income of $51,000. What is its target monthly operating income? How many cars must be sold each month to reach the target monthly net income of $51,000?

3-22 CVP analysis, income taxes. The Express Banquet has two restaurants that are open 24-hours a day. Fixed costs for the two restaurants together total $459,000 per year. Service varies from a cup of coffee to full meals. The average sales check per customer is $8.50. The average cost of food and other variable costs for each customer is $3.40. The income tax rate is 30%. Target net income is $107,100.

Required

1. Compute the revenues needed to earn the target net income. 2. How many customers are needed to break even? To earn net income of $107,100? 3. Compute net income if the number of customers is 170,000.

3-23 CVP analysis, sensitivity analysis. Hoot Washington is the newly elected leader of the Republican

Party. Media Publishers is negotiating to publish Hoot’s Manifesto, a new book that promises to be an instant best-seller. The fixed costs of producing and marketing the book will be $500,000. The variable costs of producing and marketing will be $4.00 per copy sold. These costs are before any payments to Hoot. Hoot negotiates an up-front payment of $3 million, plus a 15% royalty rate on the net sales price of each book. The net sales price is the listed bookstore price of $30, minus the margin paid to the bookstore to sell the book. The normal bookstore margin of 30% of the listed bookstore price is expected to apply.

Required

1. Prepare a PV graph for Media Publishers. 2. How many copies must Media Publishers sell to (a) break even and (b) earn a target operating income of $2 million? 3. Examine the sensitivity of the breakeven point to the following changes: a. Decreasing the normal bookstore margin to 20% of the listed bookstore price of $30 b. Increasing the listed bookstore price to $40 while keeping the bookstore margin at 30% c. Comment on the results

ASSIGNMENT MATERIAL " 89

3-24 CVP analysis, margin of safety. Suppose Doral Corp.’s breakeven point is revenues of $1,100,000. Fixed costs are $660,000. 1. Compute the contribution margin percentage. 2. Compute the selling price if variable costs are $16 per unit. 3. Suppose 95,000 units are sold. Compute the margin of safety in units and dollars.

Required

3-25 Operating leverage. Color Rugs is holding a two-week carpet sale at Jerry’s Club, a local warehouse store. Color Rugs plans to sell carpets for $500 each. The company will purchase the carpets from a local distributor for $350 each, with the privilege of returning any unsold units for a full refund. Jerry’s Club has offered Color Rugs two payment alternatives for the use of space. #

Option 1: A fixed payment of $5,000 for the sale period

Option 2: 10% of total revenues earned during the sale period

Assume Color Rugs will incur no other costs. 1. Calculate the breakeven point in units for (a) option 1 and (b) option 2. 2. At what level of revenues will Color Rugs earn the same operating income under either option? a. For what range of unit sales will Color Rugs prefer option 1? b. For what range of unit sales will Color Rugs prefer option 2?

Required

3. Calculate the degree of operating leverage at sales of 100 units for the two rental options. 4. Briefly explain and interpret your answer to requirement 3.

3-26 CVP analysis, international cost structure differences. Global Textiles, Inc., is considering three possible countries for the sole manufacturing site of its newest area rug: Singapore, Brazil, and the United States. All area rugs are to be sold to retail outlets in the United States for $250 per unit. These retail outlets add their own markup when selling to final customers. Fixed costs and variable cost per unit (area rug) differ in the three countries.

Country Singapore Brazil United States

Sales Price to Retail Outlets $250.00 250.00 250.00

Variable Manufacturing Cost per Area Rug $75.00 60.00 82.50

Annual Fixed Costs $ 9,000,000 8,400,000 12,400,000

Variable Marketing & Distribution Cost per Area Rug $25.00 15.00 12.50

1. Compute the breakeven point for Global Textiles, Inc., in each country in (a) units sold and (b) revenues. 2. If Global Textiles, Inc., plans to produce and sell 75,000 rugs in 2011, what is the budgeted operating income for each of the three manufacturing locations? Comment on the results.

Required

3-27 Sales mix, new and upgrade customers. Data 1-2-3 is a top-selling electronic spreadsheet product. Data is about to release version 5.0. It divides its customers into two groups: new customers and upgrade customers (those who previously purchased Data 1-2-3, 4.0 or earlier versions). Although the same physical product is provided to each customer group, sizable differences exist in selling prices and variable marketing costs:

Selling price Variable costs Manufacturing Marketing Contribution margin

New Customers $275 $35 ƒ65

ƒ100 $175

Upgrade Customers $100 $35 ƒ15

ƒƒ50 $ƒ50

The fixed costs of Data 1-2-3, 5.0 are $15,000,000. The planned sales mix in units is 60% new customers and 40% upgrade customers. 1. What is the Data 1-2-3, 5.0 breakeven point in units, assuming that the planned 60%:40% sales mix is attained? 2. If the sales mix is attained, what is the operating income when 220,000 total units are sold? 3. Show how the breakeven point in units changes with the following customer mixes: a. New 40% and Upgrade 60% b. New 80% and Upgrade 20% c. Comment on the results

Required

90 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

3-28 Sales mix, three products. Bobbie’s Bagel Shop sells only coffee and bagels. Bobbie estimates that every time she sells one bagel, she sells four cups of coffee. The budgeted cost information for Bobbie’s products for 2011 follows: Selling Price Product ingredients Hourly sales staff (cost per unit) Packaging Fixed Costs Rent on store and equipment Marketing and advertising cost Required

Coffee $2.50 $0.25 $0.50 $0.50

Bagels $3.75 $0.50 $1.00 $0.25 $5,000 $2,000

1. How many cups of coffee and how many bagels must Bobbie sell in order to break even assuming the sales mix of four cups of coffee to one bagel, given previously? 2. If the sales mix is four cups of coffee to one bagel, how many units of each product does Bobbie need to sell to earn operating income before tax of $28,000? 3. Assume that Bobbie decides to add the sale of muffins to her product mix. The selling price for muffins is $3.00 and the related variable costs are $0.75. Assuming a sales mix of three cups of coffee to two bagels to one muffin, how many units of each product does Bobbie need to sell in order to break even? Comment on the results.

3-29 CVP, Not for profit. Monroe Classical Music Society is a not-for-profit organization that brings guest

artists to the community’s greater metropolitan area. The Music Society just bought a small concert hall in the center of town to house its performances. The mortgage payments on the concert hall are expected to be $2,000 per month. The organization pays its guest performers $1,000 per concert and anticipates corresponding ticket sales to be $2,500 per event. The Music Society also incurs costs of approximately $500 per concert for marketing and advertising. The organization pays its artistic director $50,000 per year and expects to receive $40,000 in donations in addition to its ticket sales.

Required

1. If the Monroe Classical Music Society just breaks even, how many concerts does it hold? 2. In addition to the organization’s artistic director, the Music Society would like to hire a marketing director for $40,000 per year. What is the breakeven point? The Music Society anticipates that the addition of a marketing director would allow the organization to increase the number of concerts to 60 per year. What is the Music Society’s operating income/(loss) if it hires the new marketing director? 3. The Music Society expects to receive a grant that would provide the organization with an additional $20,000 toward the payment of the marketing director’s salary. What is the breakeven point if the Music Society hires the marketing director and receives the grant?

3-30 Contribution margin, decision making. Lurvey Men’s Clothing’s revenues and cost data for 2011 are as follows: Revenues Cost of goods sold Gross margin Operating costs: Salaries fixed Sales commissions (10% of sales) Depreciation of equipment and fixtures Store rent ($4,500 per month) Other operating costs Operating income (loss)

$600,000 ƒ300,000 300,000 $170,000 60,000 20,000 54,000 ƒƒ45,000

ƒ349,000 $ƒ(49,000)

Mr. Lurvey, the owner of the store, is unhappy with the operating results. An analysis of other operating costs reveals that it includes $30,000 variable costs, which vary with sales volume, and $15,000 (fixed) costs. Required

1. Compute the contribution margin of Lurvey Men’s Clothing. 2. Compute the contribution margin percentage. 3. Mr. Lurvey estimates that he can increase revenues by 15% by incurring additional advertising costs of $13,000. Calculate the impact of the additional advertising costs on operating income.

3-31 Contribution margin, gross margin, and margin of safety. Mirabella Cosmetics manufactures and sells a face cream to small ethnic stores in the greater New York area. It presents the monthly operating income statement shown here to George Lopez, a potential investor in the business. Help Mr. Lopez understand Mirabella’s cost structure.

ASSIGNMENT MATERIAL " 91

Mirabella Cosmetics Operating Income Statement, June 2011

1 2

Units sold 4 Revenues 5 Cost of goods sold Variable manufacturing costs 6

10,000 $100,000

Fixed manufacturing costs

7 8 9 10 11 12

Total Gross margin Operating costs Variable marketing costs Fixed marketing & administration costs

$55,000 20,000 75,000 25,000 $ 5,000 10,000

Total operating costs 14 Operating income

15,000 $ 10,000

1. Recast the income statement to emphasize contribution margin. 2. Calculate the contribution margin percentage and breakeven point in units and revenues for June 2011. 3. What is the margin of safety (in units) for June 2011? 4. If sales in June were only 8,000 units and Mirabella’s tax rate is 30%, calculate its net income.

Required

3-32 Uncertainty and expected costs. Foodmart Corp, an international retail giant, is considering imple-

menting a new business to business (B2B) information system for processing purchase orders. The current system costs Foodmart $2,500,000 per month and $50 per order. Foodmart has two options, a partially automated B2B and a fully automated B2B system. The partially automated B2B system will have a fixed cost of $10,000,000 per month and a variable cost of $40 per order. The fully automated B2B system has a fixed cost of $20,000,000 per month and $25 per order. Based on data from the last two years, Foodmart has determined the following distribution on monthly orders: Monthly Number of Orders

Probability

350,000

0.15

450,000

0.20

550,000

0.35

650,000

0.20

750,000

0.10

1. Prepare a table showing the cost of each plan for each quantity of monthly orders. 2. What is the expected cost of each plan? 3. In addition to the information systems costs, what other factors should Foodmart consider before deciding to implement a new B2B system?

Problems 3-33 CVP analysis, service firm. Lifetime Escapes generates average revenue of $5,000 per person on its five-day package tours to wildlife parks in Kenya. The variable costs per person are as follows: Airfare Hotel accommodations Meals Ground transportation Park tickets and other costs Total

$1,400 1,100 300 100 ƒƒƒ800 $3,700

Required

92 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

Annual fixed costs total $520,000. Required

1. Calculate the number of package tours that must be sold to break even. 2. Calculate the revenue needed to earn a target operating income of $91,000. 3. If fixed costs increase by $32,000, what decrease in variable cost per person must be achieved to maintain the breakeven point calculated in requirement 1?

3-34 CVP, target operating income, service firm. Snow Leopard Daycare provides daycare for children Mondays through Fridays. Its monthly variable costs per child are as follows: Lunch and snacks Educational supplies Other supplies (paper products, toiletries, etc.) Total

$150 60 ƒƒ20 $230

Monthly fixed costs consist of the following: Rent Utilities Insurance Salaries Miscellaneous Total

$2,150 200 250 2,350 ƒƒƒ650 $5,600

Snow Leopard charges each parent $580 per child. Required

1. Calculate the breakeven point. 2. Snow Leopard’s target operating income is $10,500 per month. Compute the number of children who must be enrolled to achieve the target operating income. 3. Snow Leopard lost its lease and had to move to another building. Monthly rent for the new building is $3,150. At the suggestion of parents, Snow Leopard plans to take children on field trips. Monthly costs of the field trips are $1,300. By how much should Snow Leopard increase fees per child to meet the target operating income of $10,500 per month, assuming the same number of children as in requirement 2?

3-35 CVP analysis, margin of safety. (CMA, adapted) Technology Solutions sells a ready-to-use software product for small businesses. The current selling price is $300. Projected operating income for 2011 is $490,000 based on a sales volume of 10,000 units. Variable costs of producing the software are $120 per unit sold plus an additional cost of $5 per unit for shipping and handling. Technology Solutions annual fixed costs are $1,260,000. Required

1. Calculate Technology Solutions breakeven point and margin of safety in units. 2. Calculate the company’s operating income for 2011 if there is a 10% increase in unit sales. 3. For 2012, management expects that the per unit production cost of the software will increase by 30%, but the shipping and handling costs per unit will decrease by 20%. Calculate the sales revenue Technology Solutions must generate for 2012 to maintain the current year’s operating income if the selling price remains unchanged, assuming all other data as in the original problem.

3-36 CVP analysis, income taxes. (CMA, adapted) R. A. Ro and Company, a manufacturer of quality

handmade walnut bowls, has had a steady growth in sales for the past five years. However, increased competition has led Mr. Ro, the president, to believe that an aggressive marketing campaign will be necessary next year to maintain the company’s present growth. To prepare for next year’s marketing campaign, the company’s controller has prepared and presented Mr. Ro with the following data for the current year, 2011: Variable cost (per bowl) Direct materials Direct manufacturing labor Variable overhead (manufacturing, marketing, distribution, and customer service) Total variable cost per bowl Fixed costs Manufacturing Marketing, distribution, and customer service Total fixed costs Selling price Expected sales, 20,000 units Income tax rate

3.25 8.00 ƒƒƒƒ2.50 $ƒƒ13.75 $ 25,000 ƒ110,000 $135,000 25.00 $500,000 40%

ASSIGNMENT MATERIAL " 93

1. What is the projected net income for 2011? 2. What is the breakeven point in units for 2011? 3. Mr. Ro has set the revenue target for 2012 at a level of $550,000 (or 22,000 bowls). He believes an additional marketing cost of $11,250 for advertising in 2012, with all other costs remaining constant, will be necessary to attain the revenue target. What is the net income for 2012 if the additional $11,250 is spent and the revenue target is met? 4. What is the breakeven point in revenues for 2012 if the additional $11,250 is spent for advertising? 5. If the additional $11,250 is spent, what are the required 2012 revenues for 2012 net income to equal 2011 net income? 6. At a sales level of 22,000 units, what maximum amount can be spent on advertising if a 2012 net income of $60,000 is desired?

Required

3-37 CVP, sensitivity analysis. The Brown Shoe Company produces its famous shoe, the Divine Loafer that sells for $60 per pair. Operating income for 2011 is as follows: Sales revenue ($60 per pair) Variable cost ($25 per pair) Contribution margin Fixed cost Operating income

$300,000 ƒ125,000 175,000 ƒ100,000 $ƒ75,000

Brown Shoe Company would like to increase its profitability over the next year by at least 25%. To do so, the company is considering the following options: 1. Replace a portion of its variable labor with an automated machining process. This would result in a 20% decrease in variable cost per unit, but a 15% increase in fixed costs. Sales would remain the same. 2. Spend $30,000 on a new advertising campaign, which would increase sales by 20%. 3. Increase both selling price by $10 per unit and variable costs by $7 per unit by using a higher quality leather material in the production of its shoes. The higher priced shoe would cause demand to drop by approximately 10%. 4. Add a second manufacturing facility which would double Brown’s fixed costs, but would increase sales by 60%. Evaluate each of the alternatives considered by Brown Shoes. Do any of the options meet or exceed Brown’s targeted increase in income of 25%? What should Brown do?

Required

3-38 CVP analysis, shoe stores. The WalkRite Shoe Company operates a chain of shoe stores that sell 10 different styles of inexpensive men’s shoes with identical unit costs and selling prices. A unit is defined as a pair of shoes. Each store has a store manager who is paid a fixed salary. Individual salespeople receive a fixed salary and a sales commission. WalkRite is considering opening another store that is expected to have the revenue and cost relationships shown here:

A 1 2

Unit Variable Data (per pair of shoes) Selling price

Cost of shoes 4 Sales commission 5 Variable cost per unit 3

Annual Fixed Costs

$30.00

Rent

$19.50 1.50 $21.00

Salaries Advertising

$ 60,000 200,000 80,000

Other fixed costs

20,000

Total fixed costs

$360,000

Consider each question independently: 1. What is the annual breakeven point in (a) units sold and (b) revenues? 2. If 35,000 units are sold, what will be the store’s operating income (loss)? 3. If sales commissions are discontinued and fixed salaries are raised by a total of $81,000, what would be the annual breakeven point in (a) units sold and (b) revenues? 4. Refer to the original data. If, in addition to his fixed salary, the store manager is paid a commission of $0.30 per unit sold, what would be the annual breakeven point in (a) units sold and (b) revenues? 5. Refer to the original data. If, in addition to his fixed salary, the store manager is paid a commission of $0.30 per unit in excess of the breakeven point, what would be the store’s operating income if 50,000 units were sold?

Required

94 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

3-39 CVP analysis, shoe stores (continuation of 3-38). Refer to requirement 3 of Problem 3-38. In this problem, assume the role of the owner of WalkRite. Required

1. Calculate the number of units sold at which the owner of WalkRite would be indifferent between the original salary-plus-commissions plan for salespeople and the higher fixed-salaries-only plan. 2. As owner, which sales compensation plan would you choose if forecasted annual sales of the new store were at least 55,000 units? What do you think of the motivational aspect of your chosen compensation plan? 3. Suppose the target operating income is $168,000. How many units must be sold to reach the target operating income under (a) the original salary-plus-commissions plan and (b) the higher-fixed-salaries-only plan? 4. You open the new store on January 1, 2011, with the original salary-plus-commission compensation plan in place. Because you expect the cost of the shoes to rise due to inflation, you place a firm bulk order for 50,000 shoes and lock in the $19.50 price per unit. But, toward the end of the year, only 48,000 shoes are sold, and you authorize a markdown of the remaining inventory to $18 per unit. Finally, all units are sold. Salespeople, as usual, get paid a commission of 5% of revenues. What is the annual operating income for the store?

3-40 Alternate cost structures, uncertainty, and sensitivity analysis. Stylewise Printing Company currently leases its only copy machine for $1,000 a month. The company is considering replacing this leasing agreement with a new contract that is entirely commission based. Under the new agreement Stylewise would pay a commission for its printing at a rate of $10 for every 500 pages printed. The company currently charges $0.15 per page to its customers. The paper used in printing costs the company $.03 per page and other variable costs, including hourly labor amount to $.04 per page. Required

1. What is the company’s breakeven point under the current leasing agreement? What is it under the new commission based agreement? 2. For what range of sales levels will Stylewise prefer (a) the fixed lease agreement (b) the commission agreement? 3. Do this question only if you have covered the chapter appendix in your class. Stylewise estimates that the company is equally likely to sell 20,000; 40,000; 60,000; 80,000; or 100,000 pages of print. Using information from the original problem, prepare a table that shows the expected profit at each sales level under the fixed leasing agreement and under the commission based agreement. What is the expected value of each agreement? Which agreement should Stylewise choose?

3-41 CVP, alternative cost structures. PC Planet has just opened its doors. The new retail store sells refurbished computers at a significant discount from market prices. The computers cost PC Planet $100 to purchase and require 10 hours of labor at $15 per hour. Additional variable costs, including wages for sales personnel, are $50 per computer. The newly refurbished computers are resold to customers for $500. Rent on the retail store costs the company $4,000 per month. Required

1. How many computers does PC Planet have to sell each month to break even? 2. If PC Planet wants to earn $5,000 per month after all expenses, how many computers does the company need to sell? 3. PC Planet can purchase already refurbished computers for $200. This would mean that all labor required to refurbish the computers could be eliminated. What would PC Planet’s new breakeven point be if it decided to purchase the computers already refurbished? 4. Instead of paying the monthly rental fee for the retail space, PC Planet has the option of paying its landlord a 20% commission on sales. Assuming the original facts in the problem, at what sales level would PC Planet be indifferent between paying a fixed amount of monthly rent and paying a 20% commission on sales?

3-42 CVP analysis, income taxes, sensitivity. (CMA, adapted) Agro Engine Company manufactures and sells diesel engines for use in small farming equipment. For its 2012 budget, Agro Engine Company estimates the following: Selling price Variable cost per engine Annual fixed costs Net income Income tax rate

$ 3,000 $ 500 $3,000,000 $1,500,000 25%

The first quarter income statement, as of March 31, reported that sales were not meeting expectations. During the first quarter, only 300 units had been sold at the current price of $3,000. The income statement showed that variable and fixed costs were as planned, which meant that the 2012 annual net income

ASSIGNMENT MATERIAL " 95

projection would not be met unless management took action. A management committee was formed and presented the following mutually exclusive alternatives to the president: a. Reduce the selling price by 20%. The sales organization forecasts that at this significantly reduced price, 2,000 units can be sold during the remainder of the year. Total fixed costs and variable cost per unit will stay as budgeted. b. Lower variable cost per unit by $50 through the use of less-expensive direct materials. The selling price will also be reduced by $250, and sales of 1,800 units are expected for the remainder of the year. c. Reduce fixed costs by 20% and lower the selling price by 10%. Variable cost per unit will be unchanged. Sales of 1,700 units are expected for the remainder of the year. 1. If no changes are made to the selling price or cost structure, determine the number of units that Agro Engine Company must sell (a) to break even and (b) to achieve its net income objective. 2. Determine which alternative Agro Engine should select to achieve its net income objective. Show your calculations.

Required

3-43 Choosing between compensation plans, operating leverage. (CMA, adapted) Marston Corporation manufactures pharmaceutical products that are sold through a network of external sales agents. The agents are paid a commission of 18% of revenues. Marston is considering replacing the sales agents with its own salespeople, who would be paid a commission of 10% of revenues and total salaries of $2,080,000. The income statement for the year ending December 31, 2011, under the two scenarios is shown here.

A 1 2 3 4 5 Revenues

Marston Corporation Income Statement For theYear Ended December 31, 2011 Using Sales Agents Using Own Sales Force $26,000,000 $26,000,000

6 Cost of goods sold 7 8 9 10 11 12 13

Variable Fixed Gross margin Marketing costs Commissions Fixed costs Operating income

$11,700,000 2,870,000

$ 4,680,000 3,420,000

14,570,000 11,430,000

8,100,000 $ 3,330,000

$11,700,000 2,870,000

$ 2,600,000 5,500,000

14,570,000 11,430,000

8,100,000 $ 3,330,000

1. Calculate Marston’s 2011 contribution margin percentage, breakeven revenues, and degree of operating leverage under the two scenarios. 2. Describe the advantages and disadvantages of each type of sales alternative. 3. In 2012, Marston uses its own salespeople, who demand a 15% commission. If all other cost behavior patterns are unchanged, how much revenue must the salespeople generate in order to earn the same operating income as in 2011?

Required

3-44 Sales mix, three products. The Ronowski Company has three product lines of belts—A, B, and C— with contribution margins of $3, $2, and $1, respectively. The president foresees sales of 200,000 units in the coming period, consisting of 20,000 units of A, 100,000 units of B, and 80,000 units of C. The company’s fixed costs for the period are $255,000. 1. What is the company’s breakeven point in units, assuming that the given sales mix is maintained? 2. If the sales mix is maintained, what is the total contribution margin when 200,000 units are sold? What is the operating income? 3. What would operating income be if 20,000 units of A, 80,000 units of B, and 100,000 units of C were sold? What is the new breakeven point in units if these relationships persist in the next period?

Required

96 " CHAPTER 3 COST-VOLUME-PROFIT ANALYSIS

3-45 Multiproduct CVP and decision making. Pure Water Products produces two types of water filters. One attaches to the faucet and cleans all water that passes through the faucet. The other is a pitcher-cum-filter that only purifies water meant for drinking. The unit that attaches to the faucet is sold for $80 and has variable costs of $20. The pitcher-cum-filter sells for $90 and has variable costs of $25. Pure Water sells two faucet models for every three pitchers sold. Fixed costs equal $945,000. Required

1. What is the breakeven point in unit sales and dollars for each type of filter at the current sales mix? 2. Pure Water is considering buying new production equipment. The new equipment will increase fixed cost by $181,400 per year and will decrease the variable cost of the faucet and the pitcher units by $5 and $9 respectively. Assuming the same sales mix, how many of each type of filter does Pure Water need to sell to break even? 3. Assuming the same sales mix, at what total sales level would Pure Water be indifferent between using the old equipment and buying the new production equipment? If total sales are expected to be 30,000 units, should Pure Water buy the new production equipment?

3-46 Sales mix, two products. The Stackpole Company retails two products: a standard and a deluxe version of a luggage carrier. The budgeted income statement for next period is as follows: Standard Carrier

Required

Deluxe Carrier

Total

Units sold

ƒƒƒ187,500

ƒƒƒƒ62,500

ƒƒƒ250,000

Revenues at $28 and $50 per unit

$5,250,000

$3,125,000

$8,375,000

Variable costs at $18 and $30 per unit

ƒƒ3,375,000

ƒ1,875,000

ƒ5,250,000

Contribution margins at $10 and $20 per unit

$1,875,000

$1,250,000

3,125,000

Fixed costs

ƒ2,250,000

Operating income

$ƒƒ875,000

1. Compute the breakeven point in units, assuming that the planned sales mix is attained. 2. Compute the breakeven point in units (a) if only standard carriers are sold and (b) if only deluxe carriers are sold. 3. Suppose 250,000 units are sold but only 50,000 of them are deluxe. Compute the operating income. Compute the breakeven point in units. Compare your answer with the answer to requirement 1. What is the major lesson of this problem?

3-47 Gross margin and contribution margin. The Museum of America is preparing for its annual appreciation dinner for contributing members. Last year, 525 members attended the dinner. Tickets for the dinner were $24 per attendee. The profit report for last year’s dinner follows. Ticket sales Cost of dinner Gross margin Invitations and paperwork Profit (loss)

$12,600 ƒ15,300 (2,700) ƒƒ2,500 $(5,200)

This year the dinner committee does not want to lose money on the dinner. To help achieve its goal, the committee analyzed last year’s costs. Of the $15,300 cost of the dinner, $9,000 were fixed costs and $6,300 were variable costs. Of the $2,500 cost of invitations and paperwork, $1,975 were fixed and $525 were variable. Required

1. Prepare last year’s profit report using the contribution margin format. 2. The committee is considering expanding this year’s dinner invitation list to include volunteer members (in addition to contributing members). If the committee expands the dinner invitation list, it expects attendance to double. Calculate the effect this will have on the profitability of the dinner assuming fixed costs will be the same as last year.

3-48 Ethics, CVP analysis. Allen Corporation produces a molded plastic casing, LX201, for desktop computers. Summary data from its 2011 income statement are as follows: Revenues Variable costs Fixed costs Operating income

$5,000,000 3,000,000 ƒ2,160,000 $ƒƒ(160,000)

ASSIGNMENT MATERIAL " 97

Jane Woodall, Allen’s president, is very concerned about Allen Corporation’s poor profitability. She asks Max Lemond, production manager, and Lester Bush, controller, to see if there are ways to reduce costs. After two weeks, Max returns with a proposal to reduce variable costs to 52% of revenues by reducing the costs Allen currently incurs for safe disposal of wasted plastic. Lester is concerned that this would expose the company to potential environmental liabilities. He tells Max, “We would need to estimate some of these potential environmental costs and include them in our analysis.” “You can’t do that,” Max replies. “We are not violating any laws. There is some possibility that we may have to incur environmental costs in the future, but if we bring it up now, this proposal will not go through because our senior management always assumes these costs to be larger than they turn out to be. The market is very tough, and we are in danger of shutting down the company and costing all of us our jobs. The only reason our competitors are making money is because they are doing exactly what I am proposing.” 1. 2. 3. 4.

Calculate Allen Corporation’s breakeven revenues for 2011. Calculate Allen Corporation’s breakeven revenues if variable costs are 52% of revenues. Calculate Allen Corporation’s operating income for 2011 if variable costs had been 52% of revenues. Given Max Lemond’s comments, what should Lester Bush do?

Required

Collaborative Learning Problem 3-49 Deciding where to produce. (CMA, adapted) The Domestic Engines Co. produces the same power generators in two Illinois plants, a new plant in Peoria and an older plant in Moline. The following data are available for the two plants:

A 1 2 3 4 5 6 7 8 9 10 11

Peoria Selling price Variable manufacturing cost per unit Fixed manufacturing cost per unit Variable marketing and distribution cost per unit Fixed marketing and distribution cost per unit Total cost per unit Operating income per unit Production rate per day Normal annual capacity usage Maximum annual capacity

Moline

$150.00 $72.00 30.00 14.00 19.00 135.00 $ 15.00 400 units 240 days 300 days

$150.00 $88.00 15.00 14.00 14.50 131.50 $ 18.50 320 units 240 days 300 days

All fixed costs per unit are calculated based on a normal capacity usage consisting of 240 working days. When the number of working days exceeds 240, overtime charges raise the variable manufacturing costs of additional units by $3.00 per unit in Peoria and $8.00 per unit in Moline. Domestic Engines Co. is expected to produce and sell 192,000 power generators during the coming year. Wanting to take advantage of the higher operating income per unit at Moline, the company’s production manager has decided to manufacture 96,000 units at each plant, resulting in a plan in which Moline operates at capacity (320 units per day * 300 days) and Peoria operates at its normal volume (400 units per day * 240 days). 1. Calculate the breakeven point in units for the Peoria plant and for the Moline plant. 2. Calculate the operating income that would result from the production manager’s plan to produce 96,000 units at each plant. 3. Determine how the production of 192,000 units should be allocated between the Peoria and Moline plants to maximize operating income for Domestic Engines. Show your calculations.

Required

Job Costing

It’s fair to say that no one likes to lose money.

Learning Objectives

Whether a company is a new startup venture providing marketing consulting services or an established manufacturer of custom-built motorcycles, knowing how to job cost—how much it costs to produce an individual product—is critical if a profit is to be generated. As the following article shows, Nexamp, a clean-energy company, knows this all too well.

1. Describe the building-block concepts of costing systems 2. Distinguish job costing from process costing 3. Describe the approaches to evaluating and implementing jobcosting systems 4. Outline the seven-step approach to normal costing 5. Distinguish actual costing from normal costing 6. Track the flow of costs in a jobcosting system 7. Dispose of under- or overallocated manufacturing overhead costs at the end of the fiscal year using alternative methods 8. Apply variations from normal costing

Job Costing and Nexamp’s Next Generation Energy and Carbon Solutions1 Making a profit on a project depends on pricing it correctly. At Nexamp, a leading renewable-energy systems provider in Massachusetts, a team of managers and employees is responsible for the costing and pricing of its solar, geothermal, wind, and biomass installation jobs for homeowners and businesses. For each project, account managers carefully examine and verify job costs as part of a competitive bidding process. Using a computer model developed from previous projects, a company executive double-checks all the numbers, watching for costs that could wreak havoc with the net profit on the job. Projects of a certain size, such as a recent $20 million government stimulus contract to install solar panels, require the approval of a company vice president or other high-ranking officer. This type of approval ensures that Nexamp does not approve jobs that could lose money. Nexamp holds a weekly project management meeting where managers report on the status of each job approved and scheduled. Once a project is underway, on-site project managers provide weekly reports on the progress of each phase of installation. Nexamp project managers are also responsible for identifying any potential problems with each project and determining any alterations necessary to ensure high quality, on-time delivery within the original project budget. At Nexamp, job costing includes three key elements: direct costs of a job, indirect costs of a job, and general administrative costs. Direct costs are costs traceable to a specific job such as costs of solar panels, electricity converters, mounting systems, and 1

Sources: Conversations with Nexamp management. June 4, 2010. Noblett, Jackie. 2010. Nexamp lands $20M stimulus contract. Boston Business Journal, February 5.

subcontractor payments. All materials are purchased through a formal procurement process, which helps Nexamp carefully manage and control material costs. Another key element of direct costs is direct labor. Besides the actual wages paid to employees, direct labor costs include costs of workers’ compensation insurance, health insurance, vacations and holidays, sick days, and paid days off. Indirect costs of a job are allocated to each project. These include cost of supervisory labor, company-owned equipment, construction supplies, and safety equipment. Finally, Nexamp allocates general and administrative costs, such as office rent, utilities, and general insurance to each job. Just like at Nexamp, managers at Nissan need to know how much it costs to manufacture its new Leaf electric car, and managers at Ernst & Young need to know what it costs to audit Whole Foods, the organic grocer. Knowing the costs and profitability of jobs helps managers pursue their business strategies, develop pricing plans, and meet external reporting requirements. Of course, when making decisions, managers combine cost information with noncost information, such as personal observations of operations, and nonfinancial performance measures, such as quality and customer satisfaction.

Building-Block Concepts of Costing Systems Before we begin our discussion of costing systems, let’s review Chapter 2’s cost-related terms and introduce the new terms that we will need for our primary discussion. 1. Cost object—anything for which a measurement of costs is desired—for example, a product, such as an iMac computer, or a service, such as the cost of repairing an iMac computer. 2. Direct costs of a cost object—costs related to a particular cost object that can be traced to that cost object in an economically feasible (cost-effective) way—for example the cost of purchasing the main computer board or the cost of parts used to make an iMac computer. 3. Indirect costs of a cost object—costs related to a particular cost object that cannot be traced to that cost object in an economically feasible (cost-effective) way—for example, the costs of supervisors who oversee multiple products, one of which is the iMac, or the rent paid for the repair facility that repairs many different Apple computer products besides the iMac. Indirect costs are allocated to the cost object using a costallocation method. Recall that cost assignment is a general term for assigning costs, whether direct or indirect, to a cost object. Cost tracing is a specific term for assigning direct costs; cost allocation

Learning Objective

Describe the buildingblock concepts of costing systems . . . the building blocks are cost object, direct costs, indirect costs, cost pools, and costallocation bases

100 " CHAPTER 4 JOB COSTING

refers to assigning indirect costs. The relationship among these three concepts can be graphically represented as Cost Assignment Direct Costs

Cost Tracing Cost Object

Indirect Costs

Cost Allocation

Throughout this chapter, the costs assigned to a cost object, for example, a product such as a Mini Cooper or a service such as an audit of MTV, include both variable costs and costs that are fixed in the short run. Managers cost products and services to guide long-run strategic decisions (for example, what mix of products and services to produce and sell and what prices to charge for them). In the long run, managers want revenues to exceed total costs. We also need to introduce and explain two more terms before discussing costing systems:

Decision Point What are the building block concepts of a costing system?

4. Cost pool. A cost pool is a grouping of individual indirect cost items. Cost pools can range from broad, such as all manufacturing-plant costs, to narrow, such as the costs of operating metal-cutting machines. Cost pools are often organized in conjunction with cost-allocation bases. 5. Cost-allocation base. How should a company allocate costs to operate metal-cutting machines among different products? One way to allocate costs is based on the number of machine-hours used to produce different products. The cost-allocation base (number of machine-hours) is a systematic way to link an indirect cost or group of indirect costs (operating costs of all metal-cutting machines) to cost objects (different products). For example, if indirect costs of operating metal-cutting machines is $500,000 based on running these machines for 10,000 hours, the cost allocation rate is $500,000 ÷ 10,000 hours = $50 per machine-hour, where machine-hours is the cost allocation base. If a product uses 800 machine-hours, it will be allocated $40,000, $50 per machine-hour ! 800 machine-hours. The ideal cost-allocation base is the cost driver of the indirect costs, because there is a cause-and-effect relationship between the cost allocation base and the indirect costs. A cost-allocation base can be either financial (such as direct labor costs) or nonfinancial (such as the number of machine-hours). When the cost object is a job, product, or customer, the cost-allocation base is also called a cost-application base. The concepts represented by these five terms constitute the building blocks that we will use to design the costing systems described in this chapter.

Job-Costing and Process-Costing Systems Learning Objective

Distinguish job costing . . . job costing is used to cost a distinct product from process costing . . . process costing is used to cost masses of identical or similar units

Management accountants use two basic types of costing systems to assign costs to products or services: 1. Job-costing system. In this system, the cost object is a unit or multiple units of a distinct product or service called a job. Each job generally uses different amounts of resources. The product or service is often a single unit, such as a specialized machine made at Hitachi, a construction project managed by Bechtel Corporation, a repair job done at an Audi Service Center, or an advertising campaign produced by Saatchi & Saatchi. Each special machine made by Hitachi is unique and distinct. An advertising campaign for one client at Saatchi and Saatchi is unique and distinct from advertising campaigns for other clients. Job costing is also used by companies such as Ethan Allen

JOB-COSTING AND PROCESS-COSTING SYSTEMS " 101

to cost multiple identical units of distinct furniture products. Because the products and services are distinct, job-costing systems accumulate costs separately for each product or service. 2. Process-costing system. In this system, the cost object is masses of identical or similar units of a product or service. For example, Citibank provides the same service to all its customers when processing customer deposits. Intel provides the same product (say, a Pentium 4 chip) to each of its customers. All Minute Maid consumers receive the same frozen orange juice product. In each period, process-costing systems divide the total costs of producing an identical or similar product or service by the total number of units produced to obtain a per-unit cost. This per-unit cost is the average unit cost that applies to each of the identical or similar units produced in that period. Exhibit 4-1 presents examples of job costing and process costing in the service, merchandising, and manufacturing sectors. These two types of costing systems are best considered as opposite ends of a continuum; in between, one type of system can blur into the other to some degree.

Job-costing system

Process-costing system

Distinct units of a product or service

Masses of identical or similar units of a product or service

Many companies have costing systems that are neither pure job costing nor pure process costing but have elements of both. Costing systems need to be tailored to the underlying operations. For example, Kellogg Corporation uses job costing to calculate the total cost to manufacture each of its different and distinct types of products—such as Corn Flakes, Crispix, and Froot Loops—and process costing to calculate the per-unit cost of producing each identical box of Corn Flakes. In this chapter, we focus on jobcosting systems. Chapters 17 and 18 discuss process-costing systems.

Service Sector

Merchandising Sector

Manufacturing Sector

• L. L. Bean sending individual items by mail order • Special promotion of new products by Wal-Mart

• Assembly of individual aircrafts at Boeing • Construction of ships at Litton Industries

Job Costing Used

• Audit engagements done by Price Waterhouse Coopers • Consulting engagements done by McKinsey & Co. • Advertising-agency campaigns run by Ogilvy & Mather • Individual legal cases argued by Hale & Dorr • Computer-repair jobs done by CompUSA • Movies produced by Universal Studios

Process Costing Used

• Bank-check clearing at Bank of America • Postal delivery (standard items) by U.S. Postal Service

• Grain dealing by Arthur Daniel Midlands • Lumber dealing by Weyerhauser

• Oil refining by Shell Oil • Beverage production by PepsiCo

Decision Point How do you distinguish job costing from process costing?

Exhibit 4-1 Examples of Job Costing and Process Costing in the Service, Merchandising, and Manufacturing Sectors

102 " CHAPTER 4 JOB COSTING

Job Costing: Evaluation and Implementation Learning Objective

Describe the approaches to evaluating and implementing jobcosting systems . . . to determine costs of jobs in a timely manner

We illustrate job costing using the example of Robinson Company, a company that manufactures and installs specialized machinery for the paper-making industry. In early 2011, Robinson receives a request to bid for the manufacturing and installation of a new paper-making machine for the Western Pulp and Paper Company (WPP). Robinson had never made a machine quite like this one, and its managers wonder what to bid for the job. Robinson’s management team works through the five-step decision-making process. 1. Identify the problems and uncertainties. The decision of whether and how much to bid for the WPP job depends on how management resolves two critical uncertainties: what it will cost to complete the job and the prices that its competitors are likely to bid. 2. Obtain information. Robinson’s managers first evaluate whether doing the WPP job is consistent with the company’s strategy. Do they want to do more of these kinds of jobs? Is this an attractive segment of the market? Will Robinson be able to develop a competitive advantage over its competitors and satisfy customers? Robinson’s managers conclude that the WPP job fits well with the company’s strategy. Robinson’s managers study the drawings and engineering specifications provided by WPP and decide on technical details of the machine. They compare the specifications of this machine to similar machines they have made in the past, identify competitors who might bid on the job, and gather information on what these bids might be. 3. Make predictions about the future. Robinson’s managers estimate the cost of direct materials, direct manufacturing labor, and overhead for the WPP job. They also consider qualitative factors and risk factors and think through any biases they might have. For example, do engineers and employees working on the WPP job have the necessary skills and technical competence? Would they find the experience valuable and challenging? How accurate are the cost estimates, and what is the likelihood of cost overruns? What biases do Robinson’s managers have to be careful about? Remember, Robinson has not made a machine quite like this one. Robinson’s managers need to be careful not to draw inappropriate analogies and to seek the most relevant information when making their judgments. 4. Make decisions by choosing among alternatives. Robinson bids $15,000 for the WPP job. This bid is based on a manufacturing cost estimate of $10,000 and a markup of 50% over manufacturing cost. The $15,000 price takes into account likely bids by competitors, the technical and business risks, and qualitative factors. Robinson’s managers are very confident that they have obtained the best possible information in reaching their decision. 5. Implement the decision, evaluate performance, and learn. Robinson wins the bid for the WPP job. As Robinson works on the WPP job, it keeps careful track of all the costs it has incurred (which are detailed later in this chapter). Ultimately, Robinson’s managers compare the predicted amounts against actual costs to evaluate how well they did on the WPP job. In its job-costing system, Robinson accumulates costs incurred on a job in different parts of the value chain, such as manufacturing, marketing, and customer service. We focus here on Robinson’s manufacturing function (which also includes product installation). To make a machine, Robinson purchases some components from outside suppliers and makes others itself. Each of Robinson’s jobs also has a service element: installing a machine at a customer’s site, integrating it with the customer’s other machines and processes, and ensuring the machine meets customer expectations. One form of a job-costing system that Robinson can use is actual costing. Actual costing is a costing system that traces direct costs to a cost object by using the actual directcost rates times the actual quantities of the direct-cost inputs. It allocates indirect costs based on the actual indirect-cost rates times the actual quantities of the cost-allocation bases. The actual indirect-cost rate is calculated by dividing actual total indirect costs by the actual total quantity of the cost-allocation base. As its name suggests, actual costing

JOB COSTING: EVALUATION AND IMPLEMENTATION " 103

systems calculate the actual costs of jobs. Yet, actual costing systems are not commonly found in practice because actual costs cannot be computed in a timely manner. The problem is not with computing direct-cost rates for direct materials and direct manufacturing labor. For example, Robinson records the actual prices paid for materials. As it uses these materials, the prices paid serve as actual direct-cost rates for charging material costs to jobs. As we discuss next, calculating actual indirect-cost rates on a timely basis each week or each month is, however, a problem. Robinson can only calculate actual indirect-cost rates at the end of the fiscal year and Robinson’s managers are unwilling to wait that long to learn the costs of various jobs.

Time Period Used to Compute Indirect-Cost Rates There are two reasons for using longer periods, such as a year, to calculate indirectcost rates. 1. The numerator reason (indirect-cost pool). The shorter the period, the greater the influence of seasonal patterns on the amount of costs. For example, if indirect-cost rates were calculated each month, costs of heating (included in the numerator) would be charged to production only during the winter months. An annual period incorporates the effects of all four seasons into a single, annual indirect-cost rate. Levels of total indirect costs are also affected by nonseasonal erratic costs. Examples of nonseasonal erratic costs include costs incurred in a particular month that benefit operations during future months, such as costs of repairs and maintenance of equipment, and costs of vacation and holiday pay. If monthly indirect-cost rates were calculated, jobs done in a month with high, nonseasonal erratic costs would be charged with these costs. Pooling all indirect costs together over the course of a full year and calculating a single annual indirect-cost rate helps smooth some of the erratic bumps in costs associated with shorter periods. 2. The denominator reason (quantity of the cost-allocation base). Another reason for longer periods is to avoid spreading monthly fixed indirect costs over fluctuating levels of monthly output and fluctuating quantities of the cost-allocation base. Consider the following example. Reardon and Pane are tax accountants whose work follows a highly seasonal pattern with very busy months during tax season and less busy months at other times. Assume the following mix of variable indirect costs (such as supplies, food, power, and indirect support labor) that vary with the quantity of the cost-allocation base (direct professional labor-hours) and fixed indirect costs (depreciation and general administrative support) that do not vary with short-run fluctuations in the quantity of the cost-allocation base:

High-output month Low-output month

Indirect Costs Direct Allocation Rate per Direct Variable Fixed Total Professional Labor-Hours Professional Labor-Hour (1) (2) (3) (4) (5) = (3) ÷ (4) $40,000 $60,000 $100,000 3,200 $31.25 10,000 60,000 70,000 800 87.50

You can see that variable indirect costs change in proportion to changes in direct professional labor-hours. Therefore, the variable indirect-cost rate is the same in both the highoutput months and the low-output months ($40,000 ÷ 3,200 labor-hours = $12.50 per labor-hour; $10,000 ÷ 800 labor-hours = $12.50 per labor-hour). Sometimes overtime payments can cause the variable indirect-cost rate to be higher in high-output months. In such cases, variable indirect costs will be allocated at a higher rate to production in highoutput months relative to production in low-output months. Consider now the fixed costs of $60,000. The fixed costs cause monthly total indirect-cost rates to vary considerably—from $31.25 per hour to $87.50 per hour. Few managers believe that identical jobs done in different months should be allocated indirect-cost charges per hour that differ so significantly ($87.50 ÷ $31.25 = 2.80, or 280%) because of fixed costs. Furthermore, if fees for preparing tax returns are based on costs, fees would be high in low-output months leading to lost business, when in

104 " CHAPTER 4 JOB COSTING

Decision Point What is the main challenge in implementing jobcosting systems?

fact management wants to accept more bids to utilize idle capacity. Reardon and Pane chose a specific level of capacity based on a time horizon far beyond a mere month. An average, annualized rate based on the relationship of total annual indirect costs to the total annual level of output smoothes the effect of monthly variations in output levels and is more representative of the total costs and total output that management considered when choosing the level of capacity and, hence, fixed costs. Another denominator reason for using annual overhead rates is that the calculation of monthly indirect-cost rates is affected by the number of Monday-to-Friday workdays in a month. The number of workdays per month varies from 20 to 23 during a year. If separate rates are computed each month, jobs in February would bear a greater share of indirect costs (such as depreciation and property taxes) than jobs in other months, because February has the fewest workdays (and consequently labor-hours) in a month. Many managers believe such results to be an unrepresentative and unreasonable way to assign indirect costs to jobs. An annual period reduces the effect that the number of working days per month has on unit costs.

Normal Costing The difficulty of calculating actual indirect-cost rates on a weekly or monthly basis means managers cannot calculate the actual costs of jobs as they are completed. However, managers, including those at Robinson, want a close approximation of the costs of various jobs regularly during the year, not just at the end of the fiscal year. Managers want to know manufacturing costs (and other costs, such as marketing costs) for ongoing uses, including pricing jobs, monitoring and managing costs, evaluating the success of the job, learning about what worked and what didn’t, bidding on new jobs, and preparing interim financial statements. Because of the need for immediate access to job costs, few companies wait to allocate overhead costs until year-end when the actual manufacturing overhead is finally known. Instead, a predetermined or budgeted indirect-cost rate is calculated for each cost pool at the beginning of a fiscal year, and overhead costs are allocated to jobs as work progresses. For the numerator and denominator reasons already described, the budgeted indirect-cost rate for each cost pool is computed as follows: Budgeted annual indirect costs Budgeted indirect = cost rate Budgeted annual quantity of the cost-allocation base

Using budgeted indirect-cost rates gives rise to normal costing. Normal costing is a costing system that (1) traces direct costs to a cost object by using the actual direct-cost rates times the actual quantities of the direct-cost inputs and (2) allocates indirect costs based on the budgeted indirect-cost rates times the actual quantities of the cost-allocation bases. We illustrate normal costing for the Robinson Company example using the following seven steps to assign costs to an individual job. This approach is commonly used by companies in the manufacturing, merchandising, and service sectors.

General Approach to Job Costing Learning Objective

Outline the seven-step approach to normal costing . . . the seven-step approach is used to compute direct and indirect costs of a job

Step 1: Identify the Job That Is the Chosen Cost Object. The cost object in the Robinson Company example is Job WPP 298, manufacturing a paper-making machine for Western Pulp and Paper (WPP) in 2011. Robinson’s managers and management accountants gather information to cost jobs through source documents. A source document is an original record (such as a labor time card on which an employee’s work hours are recorded) that supports journal entries in an accounting system. The main source document for Job WPP 298 is a job-cost record. A job-cost record, also called a job-cost sheet, records and accumulates all the costs assigned to a specific job, starting when work begins. Exhibit 4-2 shows the job-cost record for the paper-making machine ordered by WPP. Follow the various steps in costing Job WPP 298 on the job-cost record in Exhibit 4-2.

NORMAL COSTING " 105

Exhibit 4-2

Source Documents at Robinson Company: Job-Cost Record

JOB-COST RECORD CUSTOMER: Date Completed

JOB NO: 3 Date Started: 2

WPP 298 Feb. 7, 2011

Western Pulp and Paper Feb. 28, 2011

4 5 6 7 8 9 10

DIRECT MATERIALS Materials Date Received Requisition No. Feb. 7, 2011 2011: 198 Feb. 7, 2011 2011: 199

Part No. MB 468-A TB 267-F

Quantity Used 8 12

Unit Cost $14 63

Total Costs $ 112 756

11 12 13

Total

$ 4,606

DIRECT MANUFACTURING LABOR Period Labor Time Covered Record No. 17 LT 232 18 Feb. 7-13, 2011 19 Feb. 7-13, 2011 LT 247 15

Employee No. 551-87-3076 287-31-4671

Hours Used 25 5

Hourly Rate $18 19

Total Costs $ 450 95

20 21 22

Total

$ 1,579

MANUFACTURING OVERHEAD* Cost Pool 26 Date Category 27 Dec. 31, 2011 Manufacturing 24 25

Allocation Base Direct Manufacturing Labor-Hours

Allocation Base Quantity Used 88 hours

AllocationBase Rate $40

Total Costs $ 3,520

29 30 31 32 33

Total TOTAL MANUFACTURING COST OF JOB

$ 3,520 $ 9,705

*The Robinson Company uses a single manufacturing-overhead cost pool. The use of multiple overhead cost pools 35 would mean multiple entries in the “Manufacturing Overhead” section of the job-cost record. 34 36

Step 2: Identify the Direct Costs of the Job. Robinson identifies two direct-manufacturing cost categories: direct materials and direct manufacturing labor. #

Direct materials: On the basis of the engineering specifications and drawings provided by WPP, a manufacturing engineer orders materials from the storeroom. The order is placed using a basic source document called a materials-requisition record, which contains information about the cost of direct materials used on a specific job and in a specific department. Exhibit 4-3, Panel A, shows a materials-requisition record for the Robinson Company. See how the record specifies the job for which the material is requested (WPP 298), the description of the material (Part Number MB 468-A, metal brackets), the actual quantity (8), the actual unit cost ($14), and the actual total cost ($112). The $112 actual total cost also appears on the job-cost record in Exhibit 4-2. If we add the cost of all material requisitions, the total actual

106 " CHAPTER 4 JOB COSTING

direct material cost is $4,606, which is shown in the Direct Materials panel of the jobcost record in Exhibit 4-2. # Direct manufacturing labor: The accounting for direct manufacturing labor is similar to the accounting described for direct materials. The source document for direct manufacturing labor is a labor-time sheet, which contains information about the amount of labor time used for a specific job in a specific department. Exhibit 4-3, Panel B, shows a typical weekly labor-time sheet for a particular employee (G. L. Cook). Each day Cook records the time spent on individual jobs (in this case WPP 298 and JL 256), as well as the time spent on other tasks, such as maintenance of machines or cleaning, that are not related to a specific job. The 25 hours that Cook spent on Job WPP 298 appears on the job-cost record in Exhibit 4-2 at a cost of $450 (25 hours ! $18 per hour). Similarly, the job-cost record for Job JL 256 will carry a cost of $216 (12 hours ! $18 per hour). The three hours of time spent on maintenance and cleaning at $18 per hour equals $54. This cost is part of indirect manufacturing costs because it is not traceable to any particular job. This indirect cost is included as part of the manufacturing-overhead cost pool allocated to jobs. The total direct manufacturing labor costs of $1,579 for the papermaking machine that appears in the Direct Manufacturing Labor panel of the job-cost record in Exhibit 4-2 is the sum of all the direct manufacturing labor costs charged to this job by different employees. All costs other than direct materials and direct manufacturing labor are classified as indirect costs. Step 3: Select the Cost-Allocation Bases to Use for Allocating Indirect Costs to the Job. Indirect manufacturing costs are costs that are necessary to do a job but that cannot be traced to a specific job. It would be impossible to complete a job without incurring indirect costs such as supervision, manufacturing engineering, utilities, and repairs. Because these costs cannot be traced to a specific job, they must be allocated to all jobs in a systematic way. Different jobs require different quantities of indirect resources. The objective is to allocate the costs of indirect resources in a systematic way to their related jobs. Companies often use multiple cost-allocation bases to allocate indirect costs because different indirect costs have different cost drivers. For example, some indirect costs such as depreciation and repairs of machines are more closely related to machine-hours. Other indirect costs such as supervision and production support are more closely related to direct manufacturing labor-hours. Robinson, however, chooses direct manufacturing labor-hours as the sole allocation base for linking all indirect manufacturing costs to jobs. That’s because, in its labor-intensive environment, Robinson believes that the number of direct manufacturing labor-hours drives the manufacturing overhead resources (such as salaries paid to supervisors, engineers, production support staff, and quality management staff) required by individual jobs. (We will see in Chapter 5 that, in many manufacturing Exhibit 4-3

Source Documents at Robinson Company: Materials Requisition Record and Labor-Time Sheet

PANEL A:

PANEL B:

MATERIALS-REQUISITION RECORD Materials-Requisition Record No. 2011: 198 Job No. WPP 298 Date: FEB. 7, 2011 Part Part Unit Total No. Description Quantity Cost Cost Metal MB 468-A Brackets 8 $14 $112 Issued By: B. Clyde Received By: L. Daley

Date: Date:

Feb. 7, 2011 Feb. 7, 2011

LABOR-TIME SHEET Labor-Time Record No: LT 232 Employee Name: G. L. Cook Employee No: 551-87-3076 Employee Classification Code: Grade 3 Machinist Hourly Rate: $18 Week Start: Feb. 7, 2011 Week End: Feb. 13, 2011 Job. No. WPP 298 JL 256 Maintenance Total Supervisor: R. Stuart

M T W Th F S Su Total 4 8 3 6 4 0 0 25 3 0 4 2 3 0 0 12 1 0 1 0 1 0 0 3 8 8 8 8 8 0 0 40 Date: Feb. 13, 2011

NORMAL COSTING " 107

environments, we need to broaden the set of cost drivers.) In 2011, Robinson budgets 28,000 direct manufacturing labor-hours. Step 4: Identify the Indirect Costs Associated with Each Cost-Allocation Base. Because Robinson believes that a single cost-allocation base—direct manufacturing labor-hours— can be used to allocate indirect manufacturing costs to jobs, Robinson creates a single cost pool called manufacturing overhead costs. This pool represents all indirect costs of the Manufacturing Department that are difficult to trace directly to individual jobs. In 2011, budgeted manufacturing overhead costs total $1,120,000. As we saw in Steps 3 and 4, managers first identify cost-allocation bases and then identify the costs related to each cost-allocation base, not the other way around. They choose this order because managers must first understand the cost driver, the reasons why costs are being incurred (for example, setting up machines, moving materials, or designing jobs), before they can determine the costs associated with each cost driver. Otherwise, there is nothing to guide the creation of cost pools. Of course, Steps 3 and 4 are often done almost simultaneously. Step 5: Compute the Rate per Unit of Each Cost-Allocation Base Used to Allocate Indirect Costs to the Job. For each cost pool, the budgeted indirect-cost rate is calculated by dividing budgeted total indirect costs in the pool (determined in Step 4) by the budgeted total quantity of the cost-allocation base (determined in Step 3). Robinson calculates the allocation rate for its single manufacturing overhead cost pool as follows: Budgeted manufacturing overhead rate = =

Budgeted manufacturing overhead costs Budgeted total quantity of cost-allocation base $1,120,000 28,000 direct manufacturing labor-hours

= $40 per direct manufacturing labor-hour

Step 6: Compute the Indirect Costs Allocated to the Job. The indirect costs of a job are calculated by multiplying the actual quantity of each different allocation base (one allocation base for each cost pool) associated with the job by the budgeted indirect cost rate of each allocation base (computed in Step 5). Recall that Robinson’s managers selected direct manufacturing labor-hours as the only cost-allocation base. Robinson uses 88 direct manufacturing labor-hours on the WPP 298 job. Manufacturing overhead costs allocated to WPP 298 equal $3,520 ($40 per direct manufacturing labor-hour ! 88 hours) and appear in the Manufacturing Overhead panel of the WPP 298 job-cost record in Exhibit 4-2. Step 7: Compute the Total Cost of the Job by Adding All Direct and Indirect Costs Assigned to the Job. Exhibit 4-2 shows that the total manufacturing costs of the WPP job are $9,705. Direct manufacturing costs Direct materials Direct manufacturing labor Manufacturing overhead costs ($40 per direct manufacturing labor-hour * 88 hours) Total manufacturing costs of job WPP 298

$4,606 ƒ1,579

$ 6,185 ƒ3,520 $9,705

Recall that Robinson bid a price of $15,000 for the job. At that revenue, the normalcosting system shows a gross margin of $5,295 ($15,000 – $9,705) and a gross-margin percentage of 35.3% ($5,295 ÷ $15,000 = 0.353). Robinson’s manufacturing managers and sales managers can use the gross margin and gross-margin percentage calculations to compare the profitability of different jobs to try to understand the reasons why some jobs show low profitability. Have direct materials been wasted? Was direct manufacturing labor too high? Were there ways to improve the efficiency of these jobs? Were these jobs simply underpriced? Job-cost analysis provides the information needed for judging the performance of manufacturing and sales managers and for making future improvements (see Concepts in Action on p. 108).

108 " CHAPTER 4 JOB COSTING

Concepts in Action

Job Costing on Cowboys Stadium

Over the years, fans of the National Football League have identified the Dallas Cowboys as “America’s Team.” Since 2009, however, the team known for winning five Super Bowls has become just as recognized for its futuristic new home, Cowboys Stadium in Arlington, Texas. When the Cowboys take the field, understanding each week’s game plan is critical for success. But for Manhattan Construction, the company that managed the development of the $1.2 billion Cowboys Stadium project, understanding costs is just as critical for making successful pricing decisions, winning contracts, and ensuring that each project is profitable. Each job is estimated individually because the unique end-products, whether a new stadium or an office building, demand different quantities of Manhattan Construction’s resources. In 2006, the Dallas Cowboys selected Manhattan Construction to lead the construction of its 73,000 seat, 3 millionsquare-foot stadium. To be completed in three years, the stadium design featured two monumental arches spanning about a quarter-mile in length over the dome, a retractable roof, the largest retractable glass doors in the world (in each end zone), canted glass exterior walls, 325 private suites, and a 600-ton JumboTron hovering 90 feet above the field. With only 7% of football fans ever setting foot in a professional stadium, “Our main competition is the home media center,” Cowboys owner Jerry Jones said in unveiling the stadium design in 2006. “We wanted to offer a real experience that you can’t have at home, but to see it with the technology that you do have at home.” Generally speaking, the Cowboys Stadium project had five stages: (1) conceptualization, (2) design and planning, (3) preconstruction, (4) construction, and (5) finalization and delivery. During this 40-month process, Manhattan Construction hired architects and subcontractors, created blueprints, purchased and cleared land, developed the stadium—ranging from excavation to materials testing to construction—built out and finished interiors, and completed last-minute changes before the stadium’s grand opening in mid-2009. While most construction projects have distinct stages, compressed timeframes and scope changes required diligent management by Manhattan Construction. Before the first game was played, Manhattan Construction successfully navigated nearly 3,000 change requests and a constantly evolving budget. To ensure proper allocation and accounting of resources, Manhattan Construction project managers used a jobcosting system. The system first calculated the budgeted cost of more than 500 line items of direct materials and labor costs. It then allocated estimated overhead costs (supervisor salaries, rent, materials handling, and so on) to the job using direct material costs and direct labor-hours as allocation bases. Manhattan Construction’s job-costing system allowed managers to track project variances on a weekly basis. Manhattan Construction continually estimated the profitability of the Cowboys Stadium project based on the percentage of work completed, insight gleaned from previous stadium projects, and revenue earned. Managers used the job-costing system to actively manage costs, while the Dallas Cowboys had access to clear, concise, and transparent costing data. Just like quarterback Tony Romo navigating opposing defenses, Manhattan Construction was able to leverage its job-costing system to ensure the successful construction of a stadium as iconic as the blue star on the Cowboys’ helmets. Sources: Dillon, David. 2009. New Cowboys Stadium has grand design, but discipline isn’t compromised The Dallas Morning News, June 3. http://www.dallasnews.com/sharedcontent/dws/ent/stories/DN-stadiumarchitecture_03gd.ART.State.Edition2.5125e7c.html; Knudson, Brooke. 2008. Profile: Dallas Cowboys Stadium. Construction Today, December 22. http://www.construction-today.com/cms1/content/view/1175/139/1/0/; Lacayo, Richard. 2009. Inside the new Dallas Cowboys stadium. Time, September 21. http://www.time.com/time/nation/article/0,8599,1924535,00.html; Penny, Mark, Project Manager, Manhattan Construction Co. 2010. Interview. January 12.

Exhibit 4-4 is an overview of Robinson Company’s job-costing system. This exhibit represents the concepts comprising the five building blocks—cost object, direct costs of a cost object, indirect (overhead) costs of a cost object, indirect-cost pool, and costallocation base—of job-costing systems that were first introduced at the beginning of this chapter. Costing-system overviews such as Exhibit 4-4 are important learning tools. We urge you to sketch one when you need to understand a costing system in manufacturing, merchandising, or service companies. (The symbols in Exhibit 4-4 are used consistently in the costing-system overviews presented in this book. A triangle always identifies a direct

NORMAL COSTING " 109

INDIRECT-COST POOL

All Manufacturing Overhead Costs $1,120,000

Exhibit 4-4 Job-Costing Overview for Determining Manufacturing Costs of Jobs at Robinson Company

28,000 Direct Manufacturing Labor-Hours

COST-ALLOCATION BASE

$40 per direct manufacturing labor-hour

COST OBJECT: SPECIALIZED MACHINERY

Allocated Manufacturing Overhead Costs Direct Costs

DIRECT COSTS Direct Materials

Direct Manufacturing Labor

cost, a rectangle represents the indirect-cost pool, and an octagon describes the costallocation base.) Note the parallel between the overview diagram and the cost of the WPP 298 job described in Step 7. Exhibit 4-4 shows two direct-cost categories (direct materials and direct manufacturing labor) and one indirect-cost category (manufacturing overhead) used to allocate indirect costs. The costs in Step 7 also have three dollar amounts, each corresponding respectively to the two direct-cost and one indirect-cost categories.

The Role of Technology To improve the efficiency of their operations, managers use costing information about products and jobs to control materials, labor, and overhead costs. Modern information technology provides managers with quick and accurate product-cost information, making it easier to manage and control jobs. For example, in many costing systems, source documents exist only in the form of computer records. Bar coding and other forms of online information recording reduce human intervention and improve the accuracy of materials and labor time records for individual jobs. Consider, for example, direct materials charged to jobs for product-costing purposes. Managers control these costs as materials are purchased and used. Using Electronic Data Interchange (EDI) technology, companies like Robinson order materials from their suppliers by clicking a few keys on a computer keyboard. EDI, an electronic computer link between a company and its suppliers, ensures that the order is transmitted quickly and accurately with minimum paperwork and costs. A bar code scanner records the receipt of incoming materials. The computer matches the receipt with the order, prints out a check to the supplier, and records the material received. When an operator on the production floor transmits a request for materials via a computer terminal, the computer prepares a materials-requisition record, instantly recording the issue of materials in the materials and job-cost records. Each day, the computer sums the materials-requisition records charged to a particular job or manufacturing department. A performance report is then prepared

Decision Point How do you implement a normalcosting system?

110 " CHAPTER 4 JOB COSTING

monitoring actual costs of direct materials. Direct material usage can be reported hourly— if the benefits exceed the cost of such frequent reporting. Similarly, information about direct manufacturing labor is obtained as employees log into computer terminals and key in the job numbers, their employee numbers, and start and end times of their work on different jobs. The computer automatically prints the labor time record and, using hourly rates stored for each employee, calculates the direct manufacturing labor costs of individual jobs. Information technology also provides managers with instantaneous feedback to help control manufacturing overhead costs, jobs in process, jobs completed, and jobs shipped and installed at customer sites.

Actual Costing Learning Objective

Distinguish actual costing . . . actual costing uses actual indirect-cost rates

How would the cost of Job WPP 298 change if Robinson had used actual costing rather than normal costing? Both actual costing and normal costing trace direct costs to jobs in the same way because source documents identify the actual quantities and actual rates of direct materials and direct manufacturing labor for a job as the work is being done. The only difference between costing a job with normal costing and actual costing is that normal costing uses budgeted indirect-cost rates, whereas actual costing uses actual indirect-cost rates calculated annually at the end of the year. Exhibit 4-5 distinguishes actual costing from normal costing. The following actual data for 2011 are for Robinson’s manufacturing operations:

from normal costing . . . normal costing uses budgeted indirect-cost rates

Total manufacturing overhead costs Total direct manufacturing labor-hours

Actual $1,215,000 27,000

Steps 1 and 2 are exactly as before: Step 1 identifies WPP 298 as the cost object; Step 2 calculates actual direct material costs of $4,606, and actual direct manufacturing labor costs of $1,579. Recall from Step 3 that Robinson uses a single cost-allocation base, direct manufacturing labor-hours, to allocate all manufacturing overhead costs to jobs. The actual quantity of direct manufacturing labor-hours for 2011 is 27,000 hours. In Step 4, Robinson groups all actual indirect manufacturing costs of $1,215,000 into a single manufacturing overhead cost pool. In Step 5, the actual indirect-cost rate is calculated by dividing actual total indirect costs in the pool (determined in Step 4) by the actual total quantity of the cost-allocation base (determined in Step 3). Robinson calculates the actual manufacturing overhead rate in 2011 for its single manufacturing overhead cost pool as follows: Actual annual manufacturing overhead costs Actual manufacturing = overhead rate Actual annual quantity of the cost-allocation base $1,215,000 = 27,000 direct manufacturing labor-hours = $45 per direct manufacturing labor-hour

In Step 6, under an actual-costing system, Manufacturing overhead costs Actual manufacturing Actual quantity of direct = * allocated to WPP 298 overhead rate manufacturing labor-hours $45 per direct manuf. 88 direct manufacturing = * labor-hour labor-hours = $3,960 Exhibit 4-5 Actual Costing and Normal Costing Methods

Actual Costing

Normal Costing

Actual direct-cost rates ! Actual direct-cost rates ! actual quantities of direct-cost inputs actual quantities of direct-cost inputs Indirect Costs Actual indirect-cost rates ! Budgeted indirect-cost rates ! actual quantities of cost-allocation bases actual quantities of cost-allocation bases Direct Costs

A NORMAL JOB-COSTING SYSTEM IN MANUFACTURING " 111

In Step 7, the cost of the job under actual costing is $10,145, calculated as follows: Direct manufacturing costs Direct materials Direct manufacturing labor Manufacturing overhead costs ($45 per direct manufacturing labor-hour * 88 actual direct manufacturing labor-hours) Total manufacturing costs of job

$4,606 ƒ1,579

$ 6,185

ƒƒ3,960 $10,145

The manufacturing cost of the WPP 298 job is higher by $440 under actual costing ($10,145) than it is under normal costing ($9,705) because the actual indirect-cost rate is $45 per hour, whereas the budgeted indirect-cost rate is $40 per hour. That is, ($45 – $40) ! 88 actual direct manufacturing labor-hours = $440. As we discussed previously, manufacturing costs of a job are available much earlier under a normal-costing system. Consequently, Robinson’s manufacturing and sales managers can evaluate the profitability of different jobs, the efficiency with which the jobs are done, and the pricing of different jobs as soon as the jobs are completed, while the experience is still fresh in everyone’s mind. Another advantage of normal costing is that corrective actions can be implemented much sooner. At the end of the year, though, costs allocated using normal costing will not, in general, equal actual costs incurred. If material, adjustments will need to be made so that the cost of jobs and the costs in various inventory accounts are based on actual rather that normal costing. We describe these adjustments later in the chapter.

Decision Point How do you distinguish actual costing from normal costing?

A Normal Job-Costing System in Manufacturing We now explain how a normal job-costing system operates in manufacturing. Continuing with the Robinson Company example, the following illustration considers events that occurred in February 2011. Before getting into details, study Exhibit 4-6, which provides a broad framework for understanding the flow of costs in job costing. The upper part of Exhibit 4-6 shows the flow of inventoriable costs from the purchase of materials and other manufacturing inputs, to their conversion into work-in-process and finished goods, to the sale of finished goods. Direct materials used and direct manufacturing labor can be easily traced to jobs. They become part of work-in-process inventory on the balance sheet because direct manufacturing labor transforms direct materials into another asset, work-in-process inventory. Robinson also incurs manufacturing overhead costs (including indirect materials and indirect manufacturing labor) to convert direct materials into work-in-process inventory. The overhead (indirect) costs, however, cannot be easily traced to individual jobs. Exhibit 4-6

Purchases of Direct Materials Direct Manufacturing Labor Manufacturing Overhead Including Indirect Materials and Indirect Manufacturing Labor

Period Costs:

Track the flow of costs in a job-costing system . . . from purchase of materials to sale of finished goods

Flow of Costs in Job Costing

BALANCE SHEET

Inventoriable Costs:

Learning Objective

Traced

Conversion into Work-in-Process Allocated Inventory to

INCOME STATEMENT Revenues

Conversion into Finished Goods Inventory

When sales occur

Cost of Goods Sold

Marketing Expense Customer-Service Expense

112 " CHAPTER 4 JOB COSTING

Manufacturing overhead costs, therefore, are first accumulated in a manufacturing overhead account and later allocated to individual jobs. As manufacturing overhead costs are allocated, they become part of work-in-process inventory. As individual jobs are completed, work-in-process inventory becomes another balance sheet asset, finished goods inventory. Only when finished goods are sold is an expense, cost of goods sold, recognized in the income statement and matched against revenues earned. The lower part of Exhibit 4-6 shows the period costs—marketing and customerservice costs. These costs do not create any assets on the balance sheet because they are not incurred to transform materials into a finished product. Instead, they are expensed in the income statement, as they are incurred, to best match revenues. We next describe the entries made in the general ledger.

General Ledger You know by this point that a job-costing system has a separate job-cost record for each job. A summary of the job-cost record is typically found in a subsidiary ledger. The general ledger account Work-in-Process Control presents the total of these separate job-cost records pertaining to all unfinished jobs. The job-cost records and Work-in-Process Control account track job costs from when jobs start until they are complete. Exhibit 4-7 shows T-account relationships for Robinson Company’s general ledger. The general ledger gives a “bird’s-eye view” of the costing system. The amounts shown in Exhibit 4-7

Manufacturing Job-Costing System Using Normal Costing: Diagram of General Ledger Relationships for February 2011

GENERAL LEDGER 1

Purchase of direct and indirect materials, $89,000 Usage of direct materials, $81,000, and indirect materials, $4,000

Cash paid for direct manufacturing labor, $39,000, and indirect manufacturing labor, $15,000

Incurrence of other manufacturing dept. overhead, $75,000 Allocation of manufacturing overhead, $80,000

GENERAL LEDGER

MATERIALS CONTROL 1 89,000 2 85,000

CASH CONTROL 3 54,000 4 57,000 8 60,000 ACCOUNTS PAYABLE CONTROL 1 89,000

MANUFACTURING OVERHEAD CONTROL 2 4,000 3 15,000 4 75,000

MANUFACTURING OVERHEAD ALLOCATED 5 80,000 ACCUMULATED DEPRECIATION CONTROL 4 18,000

Completion and transfer to finished goods, $188,800 Cost of goods sold, $180,000

WORK-IN-PROCESS CONTROL 2 81,000 6 188,800 3 39,000 5 80,000 Bal. 11,200 FINISHED GOODS CONTROL 6 188,800 7 180,000 Bal. 8,800 ACCOUNTS RECEIVABLE CONTROL 9 270,000

Incurrence of marketing and customer-service costs, $60,000 Sales, $270,000

REVENUES 9 270,000

COST OF GOODS SOLD 7 180,000

MARKETING EXPENSES 8 45,000 CUSTOMER-SERVICE EXPENSES 8 15,000

The debit balance of $11,200 in the Work-in-Process Control account represents the total cost of all jobs that have not been completed as of the end of February 2011. There were no incomplete jobs as of the beginning of February 2011. The debit balance of $8,800 in the Finished Goods Control account represents the cost of all jobs that have been completed but not sold as of the end of February 2011. There were no jobs completed but not sold as of the beginning of February 2011.

A NORMAL JOB-COSTING SYSTEM IN MANUFACTURING " 113

Exhibit 4-7 are based on the transactions and journal entries that follow. As you go through each journal entry, use Exhibit 4-7 to see how the various entries being made come together. General ledger accounts with “Control” in the titles (for example, Materials Control and Accounts Payable Control) have underlying subsidiary ledgers that contain additional details, such as each type of material in inventory and individual suppliers that Robinson must pay. Some companies simultaneously make entries in the general ledger and subsidiary ledger accounts. Others, such as Robinson, make entries in the subsidiary ledger when transactions occur and entries in the general ledger less frequently, on a monthly basis. A general ledger should be viewed as only one of many tools that assist management in planning and control. To control operations, managers rely on not only the source documents used to record amounts in the subsidiary ledgers, but also on nonfinancial information such as the percentage of jobs requiring rework.

Explanations of Transactions We next look at a summary of Robinson Company’s transactions for February 2011 and the corresponding journal entries for those transactions. 1. Purchases of materials (direct and indirect) on credit, $89,000 Materials Control Accounts Payable Control

89,000 89,000

2. Usage of direct materials, $81,000, and indirect materials, $4,000 Work-in-Process Control Manufacturing Overhead Control Materials Control

81,000 4,000 85,000

3. Manufacturing payroll for February: direct labor, $39,000, and indirect labor, $15,000, paid in cash Work-in-Process Control Manufacturing Overhead Control Cash Control

39,000 15,000 54,000

4. Other manufacturing overhead costs incurred during February, $75,000, consisting of supervision and engineering salaries, $44,000 (paid in cash); plant utilities, repairs, and insurance, $13,000 (paid in cash); and plant depreciation, $18,000 Manufacturing Overhead Control Cash Control Accumulated Depreciation Control

75,000 57,000 18,000

5. Allocation of manufacturing overhead to jobs, $80,000 Work-in-Process Control Manufacturing Overhead Allocated

80,000 80,000

Under normal costing, manufacturing overhead allocated—also called manufacturing overhead applied—is the amount of manufacturing overhead costs allocated to individual jobs based on the budgeted rate multiplied by actual quantity used of the allocation base. Keep in mind the distinct difference between transactions 4 and 5. In transaction 4, all actual overhead costs incurred throughout the month are added (debited) to the Manufacturing Overhead Control account. These costs are not debited to Work-in-Process Control because, unlike direct costs, they cannot be traced to individual jobs. Manufacturing overhead costs are added (debited) to individual jobs and to Work-in-Process Control only when manufacturing overhead costs are allocated in Transaction 5. At the time these costs are allocated, Manufacturing Overhead Control is, in effect, decreased (credited) via its contra account, Manufacturing Overhead Allocated. Recall that under normal costing, the budgeted manufacturing overhead rate of $40 per direct manufacturing labor-hour is calculated

114 " CHAPTER 4 JOB COSTING

at the beginning of the year on the basis of predictions of annual manufacturing overhead costs and the annual quantity of the cost-allocation base. Almost certainly, the overhead allocated will differ from the actual overhead incurred. In a later section, we discuss what to do with this difference. 6. Completion and transfer of individual jobs to finished goods, $188,800 Finished Goods Control Work-in-Process Control

188,800 188,800

7. Cost of goods sold, $180,000 Cost of Goods Sold Finished Goods Control

180,000 180,000

8. Marketing costs for February, $45,000, and customer service costs for February, $15,000, paid in cash Marketing Expenses Customer Service Expenses Cash Control

45,000 15,000 60,000

9. Sales revenues, all on credit, $270,000 Accounts Receivable Control Revenues

270,000 270,000

Subsidiary Ledgers Exhibits 4-8 and 4-9 present subsidiary ledgers that contain the underlying details— the “worm’s-eye view” that helps Robinson’s managers keep track of the WPP 298 job, as opposed to the “bird’s-eye view” of the general ledger. The sum of all entries in Exhibit 4-8

Subsidiary Ledger for Materials, Labor, and Manufacturing Department Overhead1

PANEL A: Materials Records by Type of Materials

PANEL B: Labor Records by Employee

Metal Brackets Part No. MB 468-A Received Issued Balance

G. L. Cook Empl. No. 551-87-3076

PANEL C: Manufacturing Department Overhead Records by Month

Req. Date No. Qty. Rate Amt. 2-7 2011: 8 $14 $112 198 2

Week Hours Endg. Job No. Worked Rate 2-13 WPP 25 298 $18 12 JL 256 18 3 Mntnce. 18 2-20

Copies of invoices or receiving reports

Copies of materialsrequisition records

Amt.

February 2011 Indir. Indir. Supervn. Plant Matr. Manuf. & Ins. & Plant Issued Labor Eng. Utilities Deprn. 2

$450 216 54 $720

Copies of labor-time sheets

Manuf. labor-time record or payroll analysis

Payroll analysis, invoices, special authorizations

Copies of materials requisitions

$4,000 $15,000 $44,000 $13,000 $18,000 Total cost of all types of materials received in February, $89,000 1The

Total cost of all types of materials issued in February, $85,000

Total cost of all direct and indirect manufacturing labor incurred in February, $54,000 ($39,000 " $15,000)

Other manufacturing overhead costs incurred in February, $75,000

arrows show how the supporting documentation (for example, copies of materials requisition records) results in the journal entry number shown in circles (for example, journal entry number 2) that corresponds to the entries in Exhibit 4-7.

A NORMAL JOB-COSTING SYSTEM IN MANUFACTURING " 115

Exhibit 4-9

Subsidiary Ledger for Individual Jobs1

PANEL A: Work-in-Process Inventory Records by Jobs

Direct Date Materials 2-7 $ 112 2-13 • 2-28 $4,606 2

Job No. WPP 298 In-Process Completed Balance Direct Allocated Manuf. Manuf. Total Total Total Labor Overhead Cost Date Cost Date Cost $ 112 $ 450 $ 450 • • $1,579 $9,705 2-28 $9,705 2-28 $3,520 $0 3

Copies of Copies of Budgeted materials- laborrate ! requisition time actual direct records sheets manuf. labor-hours Total cost of direct materials issued to all jobs in Feb., $81,000

Total cost Total of direct manuf. manuf. overhead labor allocated to used on all jobs in Feb., all jobs in Feb., $80,000 $39,000

PANEL B: Finished Goods Inventory Records by Job Received

Job No. WPP 298 Issued Balance

Date Amt. Date Amt. Date 2-28 $9,705 2-28 $9,705 2-28 6

Completed job-cost record

Costed sales invoice

Total cost of all jobs transferred to finished goods in Feb., $188,800

Total cost of all jobs sold and invoiced in Feb., $180,000

Amt. $0

Completed job-cost record

Total cost of all jobs completed and transferred to finished goods in Feb., $188,800

1The

underlying subsidiary ledgers equals the total amount in the corresponding general ledger control accounts. Material Records by Type of Materials The subsidiary ledger for materials at Robinson Company—called Materials Records—keeps a continuous record of quantity received, quantity issued to jobs, and inventory balances for each type of material. Panel A of Exhibit 4-8 shows the Materials Record for Metal Brackets (Part No. MB 468-A). In many companies, the source documents supporting the receipt and issue of materials (the material requisition record in Exhibit 4-3, Panel A, p. 106) are scanned into a computer. Software programs then automatically update the Materials Records and make all the necessary accounting entries in the subsidiary and general ledgers. The cost of materials received across all types of direct and indirect material records for February 2011 is $89,000 (Exhibit 4-8, Panel A). The cost of materials issued across all types of direct and indirect material records for February 2011 is $85,000 (Exhibit 4-8, Panel A). As direct materials are used, they are recorded as issued in the Materials Records (see Exhibit 4-8, Panel A, for a record of the Metal Brackets issued for the WPP machine job). Direct materials are also charged to Work-in-Process Inventory Records for Jobs, which are the subsidiary ledger accounts for the Work-in-Process Control account in the general ledger. For example, the metal brackets used in the WPP machine job appear as direct material costs of $112 in the subsidiary ledger under the work-in-process inventory record for WPP 298 (Exhibit 4-9, Panel A, based on the job-cost record source document in Exhibit 4-2, p. 105.). The cost of direct materials used across all job-cost records for February 2011 is $81,000 (Exhibit 4-9, Panel A). As indirect materials (for example, lubricants) are used, they are charged to the Manufacturing Department overhead records (Exhibit 4-8, Panel C), which comprise the

116 " CHAPTER 4 JOB COSTING

subsidiary ledger for Manufacturing Overhead Control. The Manufacturing Department overhead records accumulate actual costs in individual overhead categories by each indirect-cost-pool account in the general ledger. Recall that Robinson has only one indirect-cost pool: Manufacturing Overhead. The cost of indirect materials used is not added directly to individual job records. Instead, the cost of these indirect materials is allocated to individual job records as a part of manufacturing overhead. Labor Records by Employee Labor records by employee (see Exhibit 4-8, Panel B for G. L. Cook) are used to trace direct manufacturing labor to individual jobs and to accumulate the indirect manufacturing labor in Manufacturing Department overhead records (Exhibit 4-8, Panel C). The labor records are based on the labor-time sheet source documents (see Exhibit 4-3, Panel B, p. 106). The subsidiary ledger for employee labor records shows the different jobs that G. L. Cook, Employee No. 551-87-3076 worked on and the $720 of wages owed to Cook, for the week ending February 13. The sum of total wages owed to all employees for February 2011 is $54,000. The job-cost record for WPP 298 shows direct manufacturing labor costs of $450 for the time Cook spent on the WPP machine job (Exhibit 4-9, Panel A). Total direct manufacturing labor costs recorded in all job-cost records (the subsidiary ledger for Work-in-Process Control) for February 2011 is $39,000. G. L. Cook’s employee record shows $54 for maintenance, which is an indirect manufacturing labor cost. The total indirect manufacturing labor costs of $15,000 for February 2011 appear in the Manufacturing Department overhead records in the subsidiary ledger (Exhibit 4-8, Panel C). These costs, by definition, cannot be traced to an individual job. Instead, they are allocated to individual jobs as a part of manufacturing overhead. Manufacturing Department Overhead Records by Month The Manufacturing Department overhead records (see Exhibit 4-8, Panel C) that make up the subsidiary ledger for Manufacturing Overhead Control show details of different categories of overhead costs such as indirect materials, indirect manufacturing labor, supervision and engineering, plant insurance and utilities, and plant depreciation. The source documents for these entries include invoices (for example, a utility bill) and special schedules (for example, a depreciation schedule) from the responsible accounting officer. Manufacturing department overhead for February 2011 is indirect materials, $4,000; indirect manufacturing labor, $15,000; and other manufacturing overhead, $75,000 (Exhibit 4-8, Panel C). Work-in-Process Inventory Records by Jobs As we have already discussed, the job-cost record for each individual job in the subsidiary ledger is debited by the actual cost of direct materials and direct manufacturing labor used by individual jobs. In Robinson’s normal-costing system, the job-cost record for each individual job in the subsidiary ledger is also debited for manufacturing overhead allocated based on the budgeted manufacturing overhead rate times the actual direct manufacturing labor-hours used in that job. For example, the job-cost record for Job WPP 298 (Exhibit 4-9, Panel A) shows Manufacturing Overhead Allocated of $3,520 (budgeted rate of $40 per labor-hour ! 88 actual direct manufacturing labor-hours used). For the 2,000 actual direct manufacturing labor-hours used for all jobs in February 2011, total manufacturing overhead allocated equals $40 per labor-hour ! 2,000 direct manufacturing labor-hours = $80,000. Finished Goods Inventory Records by Jobs Exhibit 4-9, Panel A, shows that Job WPP 298 was completed at a cost of $9,705. Job WPP 298 also simultaneously appears in the finished goods records of the subsidiary ledger. The total cost of all jobs completed and transferred to finished goods in February 2011 is $188,800 (Exhibit 4-9, Panels A and B). Exhibit 4-9, Panel B, indicates that Job WPP 298 was sold and delivered to the customer on February 28, 2011, at which time $9,705 was transferred from finished goods to cost of goods sold. The total cost of all jobs sold and invoiced in February 2011 is $180,000 (Exhibit 4-9, Panel B).

BUDGETED INDIRECT COSTS AND END-OF-ACCOUNTING-YEAR ADJUSTMENTS " 117

Revenues Cost of goods sold ($180,000 + $14,0001) Gross margin Operating costs Marketing costs Customer-service costs Total operating costs Operating income

$270,000 194,000 76,000 $45,000 15,000

Exhibit 4-10 Robinson Company Income Statement for the Month Ending February 2011

60,000 $ 16,000

1Cost of goods sold has been increased by $14,000, the difference between the Manufacturing overhead control account ($94,000) and the Manufacturing overhead allocated ($80,000). In a later section of this chapter, we discuss this adjustment, which represents the amount by which actual manufacturing overhead cost exceeds the manufacturing overhead allocated to jobs during February 2011.

Other Subsidiary Records Just as in manufacturing payroll, Robinson maintains employee labor records in subsidiary ledgers for marketing and customer service payroll as well as records for different types of advertising costs (print, television, and radio). An accounts receivable subsidiary ledger is also used to record the February 2011 amounts due from each customer, including the $15,000 due from the sale of Job WPP 298. At this point, pause and review the nine entries in this illustration. Exhibit 4-7 is a handy summary of all nine general-ledger entries presented in T-account form. Be sure to trace each journal entry, step-by-step, to T-accounts in the general ledger presented in Exhibit 4-7. Exhibit 4-10 provides Robinson’s income statement for February 2011 using information from entries 7, 8, and 9. If desired, the cost of goods sold calculations can be further subdivided and presented in the format of Exhibit 2-8, page 40. Nonmanufacturing Costs and Job Costing Chapter 2 (pp. 45–47) pointed out that companies use product costs for different purposes. The product costs reported as inventoriable costs to shareholders may differ from product costs reported for government contracting and may also differ from product costs reported to managers for guiding pricing and product-mix decisions. We emphasize that even though marketing and customer-service costs are expensed when incurred for financial accounting purposes, companies often trace or allocate these costs to individual jobs for pricing, product-mix, and cost-management decisions. To identify marketing and customer-service costs of individual jobs, Robinson can use the same approach to job costing described earlier in this chapter in the context of manufacturing. Robinson can trace the direct marketing costs and customer-service costs to jobs. Assume marketing and customer-service costs have the same cost-allocation base, revenues, and are included in a single cost pool. Robinson can then calculate a budgeted indirect-cost rate by dividing budgeted indirect marketing costs plus budgeted indirect customer-service costs by budgeted revenues. Robinson can use this rate to allocate these indirect costs to jobs. For example, if this rate were 15% of revenues, Robinson would allocate $2,250 to Job WPP 298 (0.15 ! $15,000, the revenue from the job). By assigning both manufacturing costs and nonmanufacturing costs to jobs, Robinson can compare all costs against the revenues that different jobs generate.

Budgeted Indirect Costs and End-ofAccounting-Year Adjustments Using budgeted indirect-cost rates and normal costing instead of actual costing has the advantage that indirect costs can be assigned to individual jobs on an ongoing and timely basis, rather than only at the end of the fiscal year when actual costs are known. However, budgeted rates are unlikely to equal actual rates because they are based on

Decision Point How are transactions recorded in a manufacturing jobcosting system?

118 " CHAPTER 4 JOB COSTING

Learning Objective

Dispose of under- or overallocated manufacturing overhead costs at the end of the fiscal year using alternative methods . . . for example, writing off this amount to the Cost of Goods Sold account

estimates made up to 12 months before actual costs are incurred. We now consider adjustments that are needed when, at the end of the fiscal year, indirect costs allocated differ from actual indirect costs incurred. Recall that for the numerator and denominator reasons discussed earlier (pp. 103–104), we do not expect actual overhead costs incurred each month to equal overhead costs allocated each month.

Underallocated and Overallocated Direct Costs Underallocated indirect costs occur when the allocated amount of indirect costs in an accounting period is less than the actual (incurred) amount. Overallocated indirect costs occur when the allocated amount of indirect costs in an accounting period is greater than the actual (incurred) amount. Underallocated (overallocated) indirect costs = Actual indirect costs incurred - Indirect costs allocated

Underallocated (overallocated) indirect costs are also called underapplied (overapplied) indirect costs and underabsorbed (overabsorbed) indirect costs. Consider the manufacturing overhead cost pool at Robinson Company. There are two indirect-cost accounts in the general ledger that have to do with manufacturing overhead: 1. Manufacturing Overhead Control, the record of the actual costs in all the individual overhead categories (such as indirect materials, indirect manufacturing labor, supervision, engineering, utilities, and plant depreciation) 2. Manufacturing Overhead Allocated, the record of the manufacturing overhead allocated to individual jobs on the basis of the budgeted rate multiplied by actual direct manufacturing labor-hours At the end of the year, the overhead accounts show the following amounts. Manufacturing Overhead Control Bal. Dec. 31, 2011 1,215,000

Manufacturing Overhead Allocated Bal. Dec. 31, 2011 1,080,000

The $1,080,000 credit balance in Manufacturing Overhead Allocated results from multiplying the 27,000 actual direct manufacturing labor-hours worked on all jobs in 2011 by the budgeted rate of $40 per direct manufacturing labor-hour. The $135,000 ($1,215,000 – $1,080,000) difference (a net debit) is an underallocated amount because actual manufacturing overhead costs are greater than the allocated amount. This difference arises from two reasons related to the computation of the $40 budgeted hourly rate: 1. Numerator reason (indirect-cost pool). Actual manufacturing overhead costs of $1,215,000 are greater than the budgeted amount of $1,120,000. 2. Denominator reason (quantity of allocation base). Actual direct manufacturing laborhours of 27,000 are fewer than the budgeted 28,000 hours. There are three main approaches to accounting for the $135,000 underallocated manufacturing overhead caused by Robinson underestimating manufacturing overhead costs and overestimating the quantity of the cost-allocation base: (1) adjusted allocation-rate approach, (2) proration approach, and (3) write-off to cost of goods sold approach.

Adjusted Allocation-Rate Approach The adjusted allocation-rate approach restates all overhead entries in the general ledger and subsidiary ledgers using actual cost rates rather than budgeted cost rates. First, the actual manufacturing overhead rate is computed at the end of the fiscal year. Then, the manufacturing overhead costs allocated to every job during the year are recomputed using the actual manufacturing overhead rate (rather than the budgeted manufacturing overhead rate). Finally, end-of-year closing entries are made. The result is that at year-end, every job-cost record and finished goods record—as well as

BUDGETED INDIRECT COSTS AND END-OF-ACCOUNTING-YEAR ADJUSTMENTS " 119

the ending Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold accounts—represent actual manufacturing overhead costs incurred. The widespread adoption of computerized accounting systems has greatly reduced the cost of using the adjusted allocation-rate approach. In our Robinson example, the actual manufacturing overhead ($1,215,000) exceeds the manufacturing overhead allocated ($1,080,000) by 12.5% [($1,215,000 – $1,080,000) ÷ $1,080,000]. At year-end, Robinson could increase the manufacturing overhead allocated to each job in 2011 by 12.5% using a single software command. The command would adjust both the subsidiary ledgers and the general ledger. Consider the Western Pulp and Paper machine job, WPP 298. Under normal costing, the manufacturing overhead allocated to the job is $3,520 (the budgeted rate of $40 per direct manufacturing labor-hour ! 88 hours). Increasing the manufacturing overhead allocated by 12.5%, or $440 ($3,520 ! 0.125), means the adjusted amount of manufacturing overhead allocated to Job WPP 298 equals $3,960 ($3,520 + $440). Note from page 110 that using actual costing, manufacturing overhead allocated to this job is $3,960 (the actual rate of $45 per direct manufacturing labor-hour ! 88 hours). Making this adjustment under normal costing for each job in the subsidiary ledgers ensures that all $1,215,000 of manufacturing overhead is allocated to jobs. The adjusted allocation-rate approach yields the benefits of both the timeliness and convenience of normal costing during the year and the allocation of actual manufacturing overhead costs at year-end. Each individual job-cost record and the end-of-year account balances for inventories and cost of goods sold are adjusted to actual costs. After-the-fact analysis of actual profitability of individual jobs provides managers with accurate and useful insights for future decisions about job pricing, which jobs to emphasize, and ways to manage job costs.

Proration Approach Proration spreads underallocated overhead or overallocated overhead among ending work-in-process inventory, finished goods inventory, and cost of goods sold. Materials inventory is not included in this proration, because no manufacturing overhead costs have been allocated to it. In our Robinson example, end-of-year proration is made to the ending balances in Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold. Assume the following actual results for Robinson Company in 2011:

Account

Work-in-process control Finished goods control 4 Cost of goods sold 2 3 5

Allocated Manufacturing Overhead Included in Each Account Balance Account Balance (Before Proration) (Before Proration)

50,000 75,000 2,375,000 $2,500,000

16,200 31,320 1,032,480 $1,080,000

How should Robinson prorate the underallocated $135,000 of manufacturing overhead at the end of 2011? Robinson prorates underallocated or overallocated amounts on the basis of the total amount of manufacturing overhead allocated in 2011 (before proration) in the ending balances of Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold. The $135,000 underallocated overhead is prorated over the three affected accounts in

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proportion to the total amount of manufacturing overhead allocated (before proration) in column 2 of the following table, resulting in the ending balances (after proration) in column 5 at actual costs.

Account Work-in-process control 13 Finished goods control 11 12 14 15

Allocated Allocated Manufacturing Manufacturing Overhead Included Overhead Included in Each in Each Account Balance as a Account Balance Account Balance (Before Proration) (Before Proration) Percent of Total

Cost of goods sold Total

(1) 50,000 75,000

2,375,000 $2,500,000

(2) 16,200 31,320

1,032,480 $1,080,000

Account Proration of $135,000 of Balance Underallocated Manufacturing Overhead (After Proration) (3) = (2) / $1,080,000 (4) = (3) x $135,000 (5) = (1) + (4) $ 52,025 1.5% 0.015 x $135,000 = $ 2,025 2.9% 0.029 x 135,000 = 3,915 78,915 95.6% 100.0%

0.956 x 135,000 =

129,060 $135,000

2,504,060 $2,635,000

Prorating on the basis of the manufacturing overhead allocated (before proration) results in allocating manufacturing overhead based on actual manufacturing overhead costs. Recall that the actual manufacturing overhead ($1,215,000) in 2011 exceeds the manufacturing overhead allocated ($1,080,000) in 2011 by 12.5%. The proration amounts in column 4 can also be derived by multiplying the balances in column 2 by 0.125. For example, the $3,915 proration to Finished Goods is 0.125 ! $31,320. Adding these amounts effectively means allocating manufacturing overhead at 112.5% of what had been allocated before. The journal entry to record this proration is as follows: Work-in-Process Control Finished Goods Control Cost of Goods Sold Manufacturing Overhead Allocated Manufacturing Overhead Control

2,025 3,915 129,060 1,080,000 1,215,000

If manufacturing overhead had been overallocated, the Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold accounts would be decreased (credited) instead of increased (debited). This journal entry closes (brings to zero) the manufacturing overhead-related accounts and restates the 2011 ending balances for Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold to what they would have been if actual manufacturing overhead rates had been used rather than budgeted manufacturing overhead rates. This method reports the same 2011 ending balances in the general ledger as the adjusted allocation-rate approach. However, unlike the adjusted allocation-rate approach, the sum of the amounts shown in the subsidiary ledgers will not match the amounts shown in the general ledger after proration. That’s because the amounts in the subsidiary ledgers will still show allocated overhead based on budgeted manufacturing overhead rates. The proration approach only adjusts the general ledger and not the subsidiary ledgers to actual manufacturing overhead rates. Some companies use the proration approach but base it on the ending balances of Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold before proration (column 1 of the preceding table). The following table shows that prorations based on ending account balances are not the same as the more accurate prorations calculated earlier based on the amount of manufacturing overhead allocated to the accounts because the proportions of manufacturing overhead costs to total costs in these accounts are not the same.

BUDGETED INDIRECT COSTS AND END-OF-ACCOUNTING-YEAR ADJUSTMENTS " 121

3 4 5 6

Account Balance Account Balance as a (Before Proration) Percent of Total

1 2

Account Work-in-process control

(1) 50,000

Finished goods control Cost of goods sold Total

75,000 2,375,000 $2,500,000

(2) = (1) / $2,500,000 2.0% 3.0% 95.0% 100.0%

Proration of $135,000 of Underallocated Manufacturing Overhead (3) = (2) x $135,000 0.02 x $135,000 = $ 2,700 0.03 x 135,000 = 0.95 x 135,000 =

4,050 128,250 $135,000

Account Balance (After Proration) (4) = (1) + (3) $ 52,700 79,050 2,503,250 $2,635,000

However, proration based on ending balances is frequently justified as being an expedient way of approximating the more accurate results from using manufacturing overhead costs allocated.

Write-Off to Cost of Goods Sold Approach Under this approach, the total under- or overallocated manufacturing overhead is included in this year’s Cost of Goods Sold. For Robinson, the journal entry would be as follows: Cost of Goods Sold Manufacturing Overhead Allocated Manufacturing Overhead Control

135,000 1,080,000 1,215,000

Robinson’s two Manufacturing Overhead accounts are closed with the difference between them included in cost of goods sold. The Cost of Goods Sold account after the write-off equals $2,510,000, the balance before the write-off of $2,375,000 plus the underallocated manufacturing overhead amount of $135,000.

Choice Among Approaches Which of these three approaches is the best one to use? In making this decision, managers should be guided by the causes for underallocation or overallocation and the purpose of the adjustment. The most common purpose is to state the balance sheet and income statement amounts based on actual rather than budgeted manufacturing overhead rates. Many management accountants, industrial engineers, and managers argue that to the extent that the under- or overallocated overhead cost measures inefficiency during the period, it should be written off to Cost of Goods Sold instead of being prorated. This line of reasoning argues for applying a combination of the write-off and proration methods. For example, the portion of the underallocated overhead cost that is due to inefficiency (say, because of excessive spending) and that could have been avoided should be written off to Cost of Goods Sold, whereas the portion that is unavoidable should be prorated. Unlike full proration, this approach avoids carrying the costs of inefficiency as part of inventory assets. Proration should be based on the manufacturing overhead allocated component in the ending balances of Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold. Prorating to each individual job (as in the adjusted allocation-rate approach) is only done if the goal is to develop the most accurate record of individual job costs for profitability analysis purposes. For balance sheet and income statement reporting purposes, the write-off to Cost of Goods Sold is the simplest approach for dealing with under- or overallocated overhead. If the amount of under- or overallocated overhead is small—in comparison with total operating income or some other measure of materiality—the write-off to Cost of Goods Sold approach yields a good approximation to more accurate, but more complex, approaches. Companies are also becoming increasingly conscious of inventory control, and quantities of inventories are lower than they were in earlier years. As a result, cost of goods sold tends to be higher in relation to the dollar amount of work-in-process and finished goods inventories. Also, the inventory balances of job-costing companies are usually small

Decision Point How should managers dispose of under- or overallocated manufacturing overhead costs at the end of the fiscal year?

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because goods are often made in response to customer orders. Consequently, as is true in our Robinson example, writing off, instead of prorating, under- or overallocated overhead is unlikely to result in significant distortions in financial statements. The Robinson Company illustration assumed that a single manufacturing overhead cost pool with direct manufacturing labor-hours as the cost-allocation base was appropriate for allocating all manufacturing overhead costs to jobs. Had Robinson used multiple costallocation bases, such as direct manufacturing labor-hours and machine-hours, it would have created two cost pools and calculated two budgeted overhead rates: one based on direct manufacturing labor-hours and the other based on machine-hours to allocate overhead costs to jobs. The general ledger would contain Manufacturing Overhead Control and Manufacturing Overhead Allocated amounts for each cost pool. End-of-year adjustments for under- or overallocated overhead costs would then be made separately for each cost pool.

Variations from Normal Costing: A Service-Sector Example Learning Objective

Apply variations from normal costing . . . variations from normal costing use budgeted directcost rates

Job costing is also very useful in service industries such as accounting and consulting firms, advertising agencies, auto repair shops, and hospitals. In an accounting firm, each audit is a job. The costs of each audit are accumulated in a job-cost record, much like the document used by Robinson Company, based on the seven-step approach described earlier. On the basis of labor-time sheets, direct labor costs of the professional staff—audit partners, audit managers, and audit staff—are traced to individual jobs. Other direct costs, such as travel, out-of-town meals and lodging, phone, fax, and copying, are also traced to jobs. The costs of secretarial support, office staff, rent, and depreciation of furniture and equipment are indirect costs because these costs cannot be traced to jobs in an economically feasible way. Indirect costs are allocated to jobs, for example, using a costallocation base such as number of professional labor-hours. In some service organizations, a variation from normal costing is helpful because actual direct-labor costs—the largest component of total costs—can be difficult to trace to jobs as they are completed. For example, in our audit illustration, the actual direct-labor costs may include bonuses that become known only at the end of the year (a numerator reason). Also, the hours worked each period might vary significantly depending on the number of working days each month and the demand from clients (a denominator reason). In situations like these, a company needing timely information during the progress of an audit (and not wanting to wait until the end of the fiscal year) will use budgeted rates for some direct costs and budgeted rates for indirect costs. All budgeted rates are calculated at the start of the fiscal year. In contrast, normal costing uses actual cost rates for all direct costs and budgeted cost rates only for indirect costs. The mechanics of using budgeted rates for direct costs are similar to the methods employed when using budgeted rates for indirect costs in normal costing. We illustrate this for Donahue and Associates, a public accounting firm. For 2011, Donahue budgets total direct-labor costs of $14,400,000, total indirect costs of $12,960,000, and total direct (professional) labor-hours of 288,000. In this case, Budgeted total direct-labor costs Budgeted direct-labor = cost rate Budgeted total direct-labor hours $14,400,000 = $50 per direct labor-hour = 288,000 direct labor-hours

Assuming only one indirect-cost pool and total direct-labor costs as the cost-allocation base, Budgeted total costs in indirect cost pool Budgeted indirect = cost rate Budgeted total quantity of cost-allocation base (direct-labor costs) $12,960,000 = = 0.90, or 90% of direct-labor costs $14,400,000

Suppose that in March 2011, an audit of Hanley Transport, a client of Donahue, uses 800 direct labor-hours. Donahue calculates the direct-labor costs of the Hanley Transport audit by multiplying the budgeted direct-labor cost rate, $50 per direct labor-hour, by

PROBLEM FOR SELF-STUDY " 123

800, the actual quantity of direct labor-hours. The indirect costs allocated to the Hanley Transport audit are determined by multiplying the budgeted indirect-cost rate (90%) by the direct-labor costs assigned to the job ($40,000). Assuming no other direct costs for travel and the like, the cost of the Hanley Transport audit is as follows: Direct-labor costs, $50 * 800 Indirect costs allocated, 90% * $40,000 Total

$40,000 ƒ36,000 $76,000

At the end of the fiscal year, the direct costs traced to jobs using budgeted rates will generally not equal actual direct costs because the actual rate and the budgeted rate are developed at different times using different information. End-of-year adjustments for under- or overallocated direct costs would need to be made in the same way that adjustments are made for under- or overallocated indirect costs. The Donahue and Associates example illustrates that all costing systems do not exactly match either the actual-costing system or the normal-costing system described earlier in the chapter. As another example, engineering consulting firms often have some actual direct costs (cost of making blueprints or fees paid to outside experts), other direct costs (professional labor costs) assigned to jobs using a budgeted rate, and indirect costs (engineering and office-support costs) allocated to jobs using a budgeted rate. Therefore, users of costing systems should be aware of the different systems that they may encounter.

Problem for Self-Study You are asked to bring the following incomplete accounts of Endeavor Printing, Inc., up-to-date through January 31, 2012. Consider the data that appear in the T-accounts as well as the following information in items (a) through (j). Endeavor’s normal-costing system has two direct-cost categories (direct material costs and direct manufacturing labor costs) and one indirect-cost pool (manufacturing overhead costs, which are allocated using direct manufacturing labor costs). Materials Control 12-31-2011 Bal. 15,000 Work-in-Process Control Finished Goods Control 12-31-2011 Bal. 20,000

Wages Payable Control 1-31-2012 Bal.

3,000

Manufacturing Overhead Control 1-31-2012 Bal. 57,000 Costs of Goods Sold

Additional information follows: a. Manufacturing overhead is allocated using a budgeted rate that is set every December. Management forecasts next year’s manufacturing overhead costs and next year’s direct manufacturing labor costs. The budget for 2012 is $600,000 for manufacturing overhead costs and $400,000 for direct manufacturing labor costs. b. The only job unfinished on January 31, 2012, is No. 419, on which direct manufacturing labor costs are $2,000 (125 direct manufacturing labor-hours) and direct material costs are $8,000. c. Total direct materials issued to production during January 2012 are $90,000. d. Cost of goods completed during January is $180,000. e. Materials inventory as of January 31, 2012, is $20,000. f. Finished goods inventory as of January 31, 2012, is $15,000. g. All plant workers earn the same wage rate. Direct manufacturing labor-hours used for January total 2,500 hours. Other labor costs total $10,000. h. The gross plant payroll paid in January equals $52,000. Ignore withholdings. i. All “actual” manufacturing overhead incurred during January has already been posted. j. All materials are direct materials.

Decision Point What are some variations from normal costing?

124 " CHAPTER 4 JOB COSTING

Required

Calculate the following: 1. 2. 3. 4. 5. 6. 7. 8.

Materials purchased during January Cost of Goods Sold during January Direct manufacturing labor costs incurred during January Manufacturing Overhead Allocated during January Balance, Wages Payable Control, December 31, 2011 Balance, Work-in-Process Control, January 31, 2012 Balance, Work-in-Process Control, December 31, 2011 Manufacturing Overhead Underallocated or Overallocated for January 2012

Solution Amounts from the T-accounts are labeled “(T).” 1. From Materials Control T-account, Materials purchased: $90,000 (c) + $20,000 (e) – $15,000 (T) = $95,000 2. From Finished Goods Control T-account, Cost of Goods Sold: $20,000 (T) + $180,000 (d) – $15,000 (f) = $185,000 3. Direct manufacturing wage rate: $2,000 (b) ÷ 125 direct manufacturing labor-hours (b) = $16 per direct manufacturing labor-hour Direct manufacturing labor costs: 2,500 direct manufacturing labor-hours (g) ! $16 per hour = $40,000 4. Manufacturing overhead rate: $600,000 (a) ÷ $400,000 (a) = 150% Manufacturing Overhead Allocated: 150% of $40,000 = 1.50 ! $40,000 (see 3) = $60,000 5. From Wages Payable Control T-account, Wages Payable Control, December 31, 2011: $52,000 (h) + $3,000 (T) – $40,000 (see 3) – $10,000 (g) = $5,000 6. Work-in-Process Control, January 31, 2012: $8,000 (b) + $2,000 (b) + 150% of $2,000 (b) = $13,000 (This answer is used in item 7.) 7. From Work-in-Process Control T-account, Work-in-Process Control, December 31, 2011: $180,000 (d) + $13,000 (see 6) – $90,000 (c) – $40,000 (see 3) – $60,000 (see 4) = $3,000 8. Manufacturing overhead overallocated: $60,000 (see 4) – $57,000 (T) = $3,000. Letters alongside entries in T-accounts correspond to letters in the preceding additional information. Numbers alongside entries in T-accounts correspond to numbers in the preceding requirements.

December 31, 2011, Bal. January 31, 2012, Bal.

December 31, 2011, Bal. Direct materials Direct manufacturing labor Manufacturing overhead allocated January 31, 2012, Bal.

December 31, 2011, Bal. January 31, 2012, Bal.

(given) (1) (e)

(7) (c) (b) (g) (3) (3) (a) (4) (b) (6)

(given) (d) (f)

Materials Control 15,000 95,000* 20,000 Work-in-Process Control 3,000 90,000 40,000 60,000

(c)

90,000

(d)

180,000

(2)

185,000

13,000 Finished Goods Control 20,000 180,000 15,000

*Can be computed only after all other postings in the account have been made.

DECISION POINTS " 125

(h)

Wages Payable Control 52,000 December 31, 2011, Bal.

January 31, 2012

Total January charges

(5) (g) (3) (g) (given)

5,000 40,000 10,000 3,000

(3) (a) (4)

60,000

Manufacturing Overhead Control (given) 57,000 Manufacturing Overhead Allocated

(d) (f) (2)

Cost of Goods Sold 185,000

Guidelines

1. What are the building-block concepts of a costing system?

The building-block concepts of a costing system are cost object, direct costs of a cost object, indirect costs of a cost object, cost pool, and cost-allocation base. Costing-system overview diagrams represent these concepts in a systematic way. Costing systems aim to report cost numbers that reflect the way chosen cost objects (such as products or services) use the resources of an organization.

2. How do you distinguish job costing from process costing?

Job-costing systems assign costs to distinct units of a product or service. Process-costing systems assign costs to masses of identical or similar units and compute unit costs on an average basis. These two costing systems represent opposite ends of a continuum. The costing systems of many companies combine some elements of both job costing and process costing.

3. What is the main challenge of implementing job-costing systems?

The main challenge of implementing job-costing systems is estimating actual costs of jobs in a timely manner.

4. How do you implement a normal-costing system?

A general seven-step approach to normal costing requires identifying (1) the job, (2) the actual direct costs, (3) the budgeted cost-allocation bases, (4) the budgeted indirect cost pools, (5) the budgeted cost-allocation rates, (6) the allocated indirect costs (budgeted rate times actual quantity), and (7) the total direct and indirect costs of a job.

5. How do you distinguish actual costing from normal costing?

Actual costing and normal costing differ in the type of indirect-cost rates used: Direct-cost rates Indirect-cost rates

Actual Costing Actual rates Actual rates

Normal Costing Actual rates Budgeted rates

Both systems use actual quantities of inputs for tracing direct costs and actual quantities of the allocation bases for allocating indirect costs.

126 " CHAPTER 4 JOB COSTING

6. How are transactions recorded in a manufacturing job-costing system?

A job-costing system in manufacturing records the flow of inventoriable costs in the general and subsidiary ledgers for (a) acquisition of materials and other manufacturing inputs, (b) their conversion into work in process, (c) their conversion into finished goods, and (d) the sale of finished goods. The job costing system also expenses period costs, such as marketing costs, as they are incurred.

7. How should managers dispose of under- or overallocated manufacturing overhead costs at the end of the fiscal year?

The two theoretically correct approaches to disposing of under- or overallocated manufacturing overhead costs at the end of the fiscal year for correctly stating balance sheet and income statement amounts are (1) to adjust the allocation rate and (2) to prorate on the basis of the total amount of the allocated manufacturing overhead cost in the ending balances of Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold. Many companies, however, simply write off amounts of under- or overallocated manufacturing overhead to Cost of Goods Sold when amounts are immaterial.

8. What are some variations from normal costing?

In some variations from normal costing, organizations use budgeted rates to assign direct costs, as well as indirect costs, to jobs.

Terms to Learn This chapter and the Glossary at the end of the book contain definitions of the following important terms: actual costing (p. 102) actual indirect-cost rate (p. 110) adjusted allocation-rate approach (p. 118) budgeted indirect-cost rate (p. 104) cost-allocation base (p. 100) cost-application base (p. 100) cost pool (p. 100) job (p. 100) job-cost record (p. 104)

job-cost sheet (p. 104) job-costing system (p. 100) labor-time sheet (p. 106) manufacturing overhead allocated (p. 113) manufacturing overhead applied (p. 113) materials-requisition record (p. 105) normal costing (p. 104)

overabsorbed indirect costs (p. 118) overallocated indirect costs (p. 118) overapplied indirect costs (p. 118) process-costing system (p. 101) proration (p. 119) source document (p. 104) underabsorbed indirect costs (p. 118) underallocated indirect costs (p. 118) underapplied indirect costs (p. 118)

Assignment Material Questions 4-1 Define cost pool, cost tracing, cost allocation, and cost-allocation base. 4-2 How does a job-costing system differ from a process-costing system? 4-3 Why might an advertising agency use job costing for an advertising campaign by Pepsi, whereas 4-4 4-5 4-6 4-7 4-8 4-9 4-10 4-11 4-12 4-13 4-14 4-15

a bank might use process costing to determine the cost of checking account deposits? Describe the seven steps in job costing. Give examples of two cost objects in companies using job costing? Describe three major source documents used in job-costing systems. What is the advantage of using computerized source documents to prepare job-cost records? Give two reasons why most organizations use an annual period rather than a weekly or monthly period to compute budgeted indirect-cost rates. Distinguish between actual costing and normal costing. Describe two ways in which a house construction company may use job-cost information. Comment on the following statement: “In a normal-costing system, the amounts in the Manufacturing Overhead Control account will always equal the amounts in the Manufacturing Overhead Allocated account.” Describe three different debit entries to the Work-in-Process Control T-account under normal costing. Describe three alternative ways to dispose of under- or overallocated overhead costs. When might a company use budgeted costs rather than actual costs to compute direct-labor rates? Describe briefly why Electronic Data Interchange (EDI) is helpful to managers.

ASSIGNMENT MATERIAL " 127

Exercises 4-16 Job costing, process costing. In each of the following situations, determine whether job costing or process costing would be more appropriate. a. A CPA firm b. An oil refinery c. A custom furniture manufacturer d. A tire manufacturer e. A textbook publisher f. A pharmaceutical company g. An advertising agency h. An apparel manufacturing plant i. A flour mill j. A paint manufacturer k. A medical care facility

l. m. n. o. p. q. r. s. t. u.

A landscaping company A cola-drink-concentrate producer A movie studio A law firm A commercial aircraft manufacturer A management consulting firm A breakfast-cereal company A catering service A paper mill An auto repair shop

4-17 Actual costing, normal costing, accounting for manufacturing overhead. Destin Products uses a job-costing system with two direct-cost categories (direct materials and direct manufacturing labor) and one manufacturing overhead cost pool. Destin allocates manufacturing overhead costs using direct manufacturing labor costs. Destin provides the following information: Direct material costs Direct manufacturing labor costs Manufacturing overhead costs

Budget for 2011 $2,000,000 1,500,000 2,700,000

Actual Results for 2011 $1,900,000 1,450,000 2,755,000

1. Compute the actual and budgeted manufacturing overhead rates for 2011. 2. During March, the job-cost record for Job 626 contained the following information: Direct materials used Direct manufacturing labor costs

Required

$40,000 $30,000

Compute the cost of Job 626 using (a) actual costing and (b) normal costing. 3. At the end of 2011, compute the under- or overallocated manufacturing overhead under normal costing. Why is there no under- or overallocated overhead under actual costing?

4-18 Job costing, normal and actual costing. Amesbury Construction assembles residential houses. It uses

a job-costing system with two direct-cost categories (direct materials and direct labor) and one indirect-cost pool (assembly support). Direct labor-hours is the allocation base for assembly support costs. In December 2010, Amesbury budgets 2011 assembly-support costs to be $8,300,000 and 2011 direct labor-hours to be 166,000. At the end of 2011, Amesbury is comparing the costs of several jobs that were started and completed in 2011.

Construction period Direct material costs Direct labor costs Direct labor-hours

Laguna Model Feb–June 2011 $106,760 $ 36,950 960

Mission Model May–Oct 2011 $127,550 $ 41,320 1,050

Direct materials and direct labor are paid for on a contract basis. The costs of each are known when direct materials are used or when direct labor-hours are worked. The 2011 actual assembly-support costs were $6,520,000, and the actual direct labor-hours were 163,000. 1. Compute the (a) budgeted indirect-cost rate and (b) actual indirect-cost rate. Why do they differ? 2. What are the job costs of the Laguna Model and the Mission Model using (a) normal costing and (b) actual costing? 3. Why might Amesbury Construction prefer normal costing over actual costing?

4-19 Budgeted manufacturing overhead rate, allocated manufacturing overhead. Gammaro Company

uses normal costing. It allocates manufacturing overhead costs using a budgeted rate per machine-hour. The following data are available for 2011: Budgeted manufacturing overhead costs Budgeted machine-hours Actual manufacturing overhead costs Actual machine-hours

$4,200,000 175,000 $4,050,000 170,000

Required

128 " CHAPTER 4 JOB COSTING

Required

1. Calculate the budgeted manufacturing overhead rate. 2. Calculate the manufacturing overhead allocated during 2011. 3. Calculate the amount of under- or overallocated manufacturing overhead.

4-20 Job costing, accounting for manufacturing overhead, budgeted rates. The Lynn Company uses a

normal job-costing system at its Minneapolis plant. The plant has a machining department and an assembly department. Its job-costing system has two direct-cost categories (direct materials and direct manufacturing labor) and two manufacturing overhead cost pools (the machining department overhead, allocated to jobs based on actual machine-hours, and the assembly department overhead, allocated to jobs based on actual direct manufacturing labor costs). The 2011 budget for the plant is as follows:

Manufacturing overhead Direct manufacturing labor costs Direct manufacturing labor-hours Machine-hours Required

Machining Department $1,800,000 $1,400,000 100,000 50,000

Assembly Department $3,600,000 $2,000,000 200,000 200,000

1. Present an overview diagram of Lynn’s job-costing system. Compute the budgeted manufacturing overhead rate for each department. 2. During February, the job-cost record for Job 494 contained the following:

Direct materials used Direct manufacturing labor costs Direct manufacturing labor-hours Machine-hours

Machining Department $45,000 $14,000 1,000 2,000

Assembly Department $70,000 $15,000 1,500 1,000

Compute the total manufacturing overhead costs allocated to Job 494. 3. At the end of 2011, the actual manufacturing overhead costs were $2,100,000 in machining and $3,700,000 in assembly. Assume that 55,000 actual machine-hours were used in machining and that actual direct manufacturing labor costs in assembly were $2,200,000. Compute the over- or underallocated manufacturing overhead for each department.

4-21 Job costing, consulting firm. Turner & Associates, a consulting firm, has the following condensed budget for 2011: Revenues Total costs: Direct costs Professional Labor Indirect costs Client support Operating income

$21,250,000

$ 5,312,500 ƒ13,600,000

ƒ18,912,500 $ƒ2,337,500

Turner has a single direct-cost category (professional labor) and a single indirect-cost pool (client support). Indirect costs are allocated to jobs on the basis of professional labor costs. Required

1. Prepare an overview diagram of the job-costing system. Calculate the 2011 budgeted indirect-cost rate for Turner & Associates. 2. The markup rate for pricing jobs is intended to produce operating income equal to 11% of revenues. Calculate the markup rate as a percentage of professional labor costs. 3. Turner is bidding on a consulting job for Tasty Chicken, a fast-food chain specializing in poultry meats. The budgeted breakdown of professional labor on the job is as follows: Professional Labor Category Director Partner Associate Assistant

Budgeted Rate per Hour $198 101 49 36

Budgeted Hours 4 17 42 153

Calculate the budgeted cost of the Tasty Chicken job. How much will Turner bid for the job if it is to earn its target operating income of 11% of revenues?

ASSIGNMENT MATERIAL " 129

4-22 Time period used to compute indirect cost rates. Splash Manufacturing produces outdoor wading and

slide pools. The company uses a normal-costing system and allocates manufacturing overhead on the basis of direct manufacturing labor-hours. Most of the company’s production and sales occur in the first and second quarters of the year. The company is in danger of losing one of its larger customers, Sotco Wholesale, due to large fluctuations in price. The owner of Splash has requested an analysis of the manufacturing cost per unit in the second and third quarters. You have been provided the following budgeted information for the coming year:

Pools manufactured and sold

Quarter 1 2 3 4 700 500 150 150

It takes 0.5 direct manufacturing labor-hour to make each pool. The actual direct material cost is $7.50 per pool. The actual direct manufacturing labor rate is $16 per hour. The budgeted variable manufacturing overhead rate is $12 per direct manufacturing labor-hour. Budgeted fixed manufacturing overhead costs are $10,500 each quarter. 1. Calculate the total manufacturing cost per unit for the second and third quarter assuming the company allocates manufacturing overhead costs based on the budgeted manufacturing overhead rate determined for each quarter. 2. Calculate the total manufacturing cost per unit for the second and third quarter assuming the company allocates manufacturing overhead costs based on an annual budgeted manufacturing overhead rate. 3. Splash Manufacturing prices its pools at manufacturing cost plus 30%. Why might Sotco Wholesale be seeing large fluctuations in the prices of pools? Which of the methods described in requirements 1 and 2 would you recommend Splash use? Explain.

Required

4-23 Accounting for manufacturing overhead. Consider the following selected cost data for the Pittsburgh Forging Company for 2011. Budgeted manufacturing overhead costs Budgeted machine-hours Actual manufacturing overhead costs Actual machine-hours

$7,500,000 250,000 $7,300,000 245,000

The company uses normal costing. Its job-costing system has a single manufacturing overhead cost pool. Costs are allocated to jobs using a budgeted machine-hour rate. Any amount of under- or overallocation is written off to Cost of Goods Sold. 1. Compute the budgeted manufacturing overhead rate. 2. Prepare the journal entries to record the allocation of manufacturing overhead. 3. Compute the amount of under- or overallocation of manufacturing overhead. Is the amount material? Prepare a journal entry to dispose of this amount.

4-24 Job costing, journal entries. The University of Chicago Press is wholly owned by the university. It performs the bulk of its work for other university departments, which pay as though the press were an outside business enterprise. The press also publishes and maintains a stock of books for general sale. The press uses normal costing to cost each job. Its job-costing system has two direct-cost categories (direct materials and direct manufacturing labor) and one indirect-cost pool (manufacturing overhead, allocated on the basis of direct manufacturing labor costs). The following data (in thousands) pertain to 2011: Direct materials and supplies purchased on credit Direct materials used Indirect materials issued to various production departments Direct manufacturing labor Indirect manufacturing labor incurred by various production departments Depreciation on building and manufacturing equipment Miscellaneous manufacturing overhead* incurred by various production departments (ordinarily would be detailed as repairs, photocopying, utilities, etc.) Manufacturing overhead allocated at 160% of direct manufacturing labor costs Cost of goods manufactured Revenues Cost of goods sold (before adjustment for under- or overallocated manufacturing overhead) Inventories, December 31, 2010 (not 2011):

$ 800 710 100 1,300 900 400 550 ? 4,120 8,000 4,020

* The term manufacturing overhead is not used uniformly. Other terms that are often encountered in printing companies include job overhead and shop overhead.

Required

130 " CHAPTER 4 JOB COSTING

Materials Control Work-in-Process Control Finished Goods Control Required

100 60 500

1. Prepare an overview diagram of the job-costing system at the University of Chicago Press. 2. Prepare journal entries to summarize the 2011 transactions. As your final entry, dispose of the year-end under- or overallocated manufacturing overhead as a write-off to Cost of Goods Sold. Number your entries. Explanations for each entry may be omitted. 3. Show posted T-accounts for all inventories, Cost of Goods Sold, Manufacturing Overhead Control, and Manufacturing Overhead Allocated.

4-25 Journal entries, T-accounts, and source documents. Production Company produces gadgets for the coveted small appliance market. The following data reflect activity for the year 2011: Costs incurred: Purchases of direct materials (net) on credit Direct manufacturing labor cost Indirect labor Depreciation, factory equipment Depreciation, office equipment Maintenance, factory equipment Miscellaneous factory overhead Rent, factory building Advertising expense Sales commissions Inventories: Direct materials Work in process Finished goods

January 1, 2011 $ 9,000 6,000 69,000

$124,000 80,000 54,500 30,000 7,000 20,000 9,500 70,000 90,000 30,000

December 31, 2011 $11,000 21,000 24,000

Production Co. uses a normal costing system and allocates overhead to work in process at a rate of $2.50 per direct manufacturing labor dollar. Indirect materials are insignificant so there is no inventory account for indirect materials. Required

1. Prepare journal entries to record the transactions for 2011 including an entry to close out over- or underallocated overhead to cost of goods sold. For each journal entry indicate the source document that would be used to authorize each entry. Also note which subsidiary ledger, if any, should be referenced as backup for the entry. 2. Post the journal entries to T-accounts for all of the inventories, Cost of Goods Sold, the Manufacturing Overhead Control Account, and the Manufacturing Overhead Allocated Account.

4-26 Job costing, journal entries. Donnell Transport assembles prestige manufactured homes. Its job costing system has two direct-cost categories (direct materials and direct manufacturing labor) and one indirect-cost pool (manufacturing overhead allocated at a budgeted $30 per machine-hour in 2011). The following data (in millions) pertain to operations for 2011: Materials Control, beginning balance, January 1, 2011 Work-in-Process Control, beginning balance, January 1, 2011 Finished Goods Control, beginning balance, January 1, 2011 Materials and supplies purchased on credit Direct materials used Indirect materials (supplies) issued to various production departments Direct manufacturing labor Indirect manufacturing labor incurred by various production departments Depreciation on plant and manufacturing equipment Miscellaneous manufacturing overhead incurred (ordinarily would be detailed as repairs, utilities, etc., with a corresponding credit to various liability accounts) Manufacturing overhead allocated, 2,100,000 actual machine-hours Cost of goods manufactured Revenues Cost of goods sold

$ 12 2 6 150 145 10 90 30 19 9 ? 294 400 292

ASSIGNMENT MATERIAL " 131

1. Prepare an overview diagram of Donnell Transport’s job-costing system. 2. Prepare journal entries. Number your entries. Explanations for each entry may be omitted. Post to T-accounts. What is the ending balance of Work-in-Process Control? 3. Show the journal entry for disposing of under- or overallocated manufacturing overhead directly as a year-end write-off to Cost of Goods Sold. Post the entry to T-accounts.

Required

4-27 Job costing, unit cost, ending work in process. Rafael Company produces pipes for concert-

quality organs. Each job is unique. In April 2011, it completed all outstanding orders, and then, in May 2011, it worked on only two jobs, M1 and M2:

1 2 3

Rafael Company, May 2011

Job M1

Job M2

$ 78,000 273,000

$ 51,000 208,000

Direct materials Direct manufacturing labor

Direct manufacturing labor is paid at the rate of $26 per hour. Manufacturing overhead costs are allocated at a budgeted rate of $20 per direct manufacturing labor-hour. Only Job M1 was completed in May. 1. 2. 3. 4.

Calculate the total cost for Job M1. 1,100 pipes were produced for Job M1. Calculate the cost per pipe. Prepare the journal entry transferring Job M1 to finished goods. What is the ending balance in the Work-in-Process Control account?

Required

4-28 Job costing; actual, normal, and variation from normal costing. Chico & Partners, a Quebec-based public accounting partnership, specializes in audit services. Its job-costing system has a single direct-cost category (professional labor) and a single indirect-cost pool (audit support, which contains all costs of the Audit Support Department). Audit support costs are allocated to individual jobs using actual professional labor-hours. Chico & Partners employs 10 professionals to perform audit services. Budgeted and actual amounts for 2011 are as follows:

A 1 2 3 4 5

Chico & Partners

Budget for 2011 Professional labor compensation $990,000 $774,000 Audit support department costs Professional labor-hours billed to clients 18,000 hours

Actual results for 2011 $735,000 8 Audit support department costs 17,500 9 Professional labor-hours billed to clients $ 59 per hour 10 Actual professional labor cost rate 7

1. Compute the direct-cost rate and the indirect-cost rate per professional labor-hour for 2011 under (a) actual costing, (b) normal costing, and (c) the variation from normal costing that uses budgeted rates for direct costs. 2. Chico’s 2011 audit of Pierre & Co. was budgeted to take 150 hours of professional labor time. The actual professional labor time spent on the audit was 160 hours. Compute the cost of the Pierre & Co. audit using (a) actual costing, (b) normal costing, and (c) the variation from normal costing that uses budgeted rates for direct costs. Explain any differences in the job cost.

4-29 Job costing; actual, normal, and variation from normal costing. Braden Brothers, Inc., is an architecture firm specializing in high-rise buildings. Its job-costing system has a single direct-cost category (architectural labor) and a single indirect-cost pool, which contains all costs of supporting the office. Support costs are allocated to individual jobs using architect labor-hours. Braden Brothers employs 15 architects.

Required

132 " CHAPTER 4 JOB COSTING

Budgeted and actual amounts for 2010 are as follows:

Required

Braden Brothers, Inc. Budget for 2010 Architect labor cost Office support costs Architect labor-hours billed to clients

$2,880,000 $1,728,000 32,000 hours

Actual results for 2010 Office support costs Architect labor-hours billed to clients Actual architect labor cost rate

$1,729,500 34,590 hours $ 92 per hour

1. Compute the direct-cost rate and the indirect-cost rate per architectural labor-hour for 2010 under (a) actual costing, (b) normal costing, and (c) the variation from normal costing that uses budgeted rates for direct costs. 2. Braden Brother’s architectural sketches for Champ Tower in Houston was budgeted to take 275 hours of architectural labor time. The actual architectural labor time spent on the job was 250 hours. Compute the cost of the Champ Tower sketches using (a) actual costing, (b) normal costing, and (c) the variation from normal costing that uses budgeted rates for direct costs.

4-30 Proration of overhead. The Ride-On-Wave Company (ROW) produces a line of non-motorized boats. ROW uses a normal-costing system and allocates manufacturing overhead using direct manufacturing labor cost. The following data are for 2011: Budgeted manufacturing overhead cost Budgeted direct manufacturing labor cost Actual manufacturing overhead cost Actual direct manufacturing labor cost

$125,000 $250,000 $117,000 $228,000

Inventory balances on December 31, 2011, were as follows:

Account Work in process Finished goods Cost of goods sold Required

Ending balance $ 50,700 245,050 549,250

2011 direct manufacturing labor cost in ending balance $ 20,520 59,280 148,200

1. Calculate the manufacturing overhead allocation rate. 2. Compute the amount of under- or overallocated manufacturing overhead. 3. Calculate the ending balances in work in process, finished goods, and cost of goods sold if underoverallocated manufacturing overhead is as follows: a. Written off to cost of goods sold b. Prorated based on ending balances (before proration) in each of the three accounts c. Prorated based on the overhead allocated in 2011 in the ending balances (before proration) in each of the three accounts 4. Which method makes the most sense? Justify your answer.

Problems 4-31 Job costing, accounting for manufacturing overhead, budgeted rates. The Fasano Company uses a

job-costing system at its Dover, Delaware, plant. The plant has a machining department and a finishing department. Fasano uses normal costing with two direct-cost categories (direct materials and direct manufacturing labor) and two manufacturing overhead cost pools (the machining department with machinehours as the allocation base, and the finishing department with direct manufacturing labor costs as the allocation base). The 2011 budget for the plant is as follows:

Manufacturing overhead costs Direct manufacturing labor costs Direct manufacturing labor-hours Machine-hours

Machining Department $10,660,000 $ 940,000 36,000 205,000

Finishing Department $7,372,000 $3,800,000 145,000 32,000

ASSIGNMENT MATERIAL " 133

1. Prepare an overview diagram of Fasano’s job-costing system. 2. What is the budgeted manufacturing overhead rate in the machining department? In the finishing department? 3. During the month of January, the job-cost record for Job 431 shows the following: Machining Department $15,500 $ 400 50 130

Direct materials used Direct manufacturing labor costs Direct manufacturing labor-hours Machine-hours

Required

Finishing Department $ 5,000 $1,1,00 50 20

Compute the total manufacturing overhead cost allocated to Job 431. 4. Assuming that Job 431 consisted of 400 units of product, what is the cost per unit? 5. Amounts at the end of 2011 are as follows:

Manufacturing overhead incurred Direct manufacturing labor costs Machine-hours

Machining Department $11,070,000 $ 1,000,000 210,000

Finishing Department $8,236,000 $4,400,000 31,000

Compute the under- or overallocated manufacturing overhead for each department and for the Dover plant as a whole. 6. Why might Fasano use two different manufacturing overhead cost pools in its job-costing system?

4-32 Service industry, job costing, law firm. Keating & Associates is a law firm specializing in labor rela-

tions and employee-related work. It employs 25 professionals (5 partners and 20 associates) who work directly with its clients. The average budgeted total compensation per professional for 2011 is $104,000. Each professional is budgeted to have 1,600 billable hours to clients in 2011. All professionals work for clients to their maximum 1,600 billable hours available. All professional labor costs are included in a single direct-cost category and are traced to jobs on a per-hour basis. All costs of Keating & Associates other than professional labor costs are included in a single indirect-cost pool (legal support) and are allocated to jobs using professional labor-hours as the allocation base. The budgeted level of indirect costs in 2011 is $2,200,000. 1. 2. 3. 4.

Prepare an overview diagram of Keating’s job-costing system. Compute the 2011 budgeted direct-cost rate per hour of professional labor. Compute the 2011 budgeted indirect-cost rate per hour of professional labor. Keating & Associates is considering bidding on two jobs: a. Litigation work for Richardson, Inc., which requires 100 budgeted hours of professional labor b. Labor contract work for Punch, Inc., which requires 150 budgeted hours of professional labor Prepare a cost estimate for each job.

Required

4-33 Service industry, job costing, two direct- and two indirect-cost categories, law firm (continuation

of 4-32). Keating has just completed a review of its job-costing system. This review included a detailed analysis of how past jobs used the firm’s resources and interviews with personnel about what factors drive the level of indirect costs. Management concluded that a system with two direct-cost categories (professional partner labor and professional associate labor) and two indirect-cost categories (general support and secretarial support) would yield more accurate job costs. Budgeted information for 2011 related to the two direct-cost categories is as follows:

Number of professionals Hours of billable time per professional Total compensation (average per professional)

Professional Partner Labor Professional Associate Labor 5 20 1,600 per year 1,600 per year $200,000 $80,000

Budgeted information for 2011 relating to the two indirect-cost categories is as follows:

Total costs Cost-allocation base

General Support $1,800,000 Professional labor-hours

Secretarial Support $400,000 Partner labor-hours

1. Compute the 2011 budgeted direct-cost rates for (a) professional partners and (b) professional associates. 2. Compute the 2011 budgeted indirect-cost rates for (a) general support and (b) secretarial support.

Required

134 " CHAPTER 4 JOB COSTING

3. Compute the budgeted costs for the Richardson and Punch jobs, given the following information:

Professional partners Professional associates

Richardson, Inc. 60 hours 40 hours

Punch, Inc. 30 hours 120 hours

4. Comment on the results in requirement 3. Why are the job costs different from those computed in Problem 4-32?

4-34 Proration of overhead. (Z. Iqbal, adapted) The Zaf Radiator Company uses a normal-costing system with a single manufacturing overhead cost pool and machine-hours as the cost-allocation base. The following data are for 2011: Budgeted manufacturing overhead costs Overhead allocation base Budgeted machine-hours Manufacturing overhead costs incurred Actual machine-hours

$4,800,000 Machine-hours 80,000 $4,900,000 75,000

Machine-hours data and the ending balances (before proration of under- or overallocated overhead) are as follows:

Cost of Goods Sold Finished Goods Control Work-in-Process Control Required

Actual Machine-Hours 60,000 11,000 4,000

2011 End-of-Year Balance $8,000,000 1,250,000 750,000

1. Compute the budgeted manufacturing overhead rate for 2011. 2. Compute the under- or overallocated manufacturing overhead of Zaf Radiator in 2011. Dispose of this amount using the following: a. Write-off to Cost of Goods Sold b. Proration based on ending balances (before proration) in Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold c. Proration based on the overhead allocated in 2011 (before proration) in the ending balances of Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold 3. Which method do you prefer in requirement 2? Explain.

4-35 Normal costing, overhead allocation, working backward. Gibson Manufacturing uses normal costing for its job-costing system, which has two direct-cost categories (direct materials and direct manufacturing labor) and one indirect-cost category (manufacturing overhead). The following information is obtained for 2011:

Required

Total manufacturing costs, $8,000,000

Manufacturing overhead allocated, $3,600,000 (allocated at a rate of 200% of direct manufacturing labor costs)

Work-in-process inventory on January 1, 2011, $320,000

Cost of finished goods manufactured, $7,920,000

1. Use information in the first two bullet points to calculate (a) direct manufacturing labor costs in 2011 and (b) cost of direct materials used in 2011. 2. Calculate the ending work-in-process inventory on December 31, 2011.

4-36 Proration of overhead with two indirect cost pools. New Rise, Inc., produces porcelain figurines. The production is semi-automated where the figurine is molded almost entirely by operator-less machines and then individually hand-painted. The overhead in the molding department is allocated based on machinehours and the overhead in the painting department is allocated based on direct manufacturing labor-hours. New Rise, Inc., uses a normal-costing system and reported actual overhead for the month of May of $17,248 and $31,485 for the molding and painting departments, respectively. The company reported the following information related to its inventory accounts and cost of goods sold for the month of May:

Balance before proration Molding Department Overhead Allocated Painting Department Overhead Allocated

Work in Process $27,720 $ 4,602 $ 2,306

Finished Goods Cost of Goods Sold $15,523.20 $115,156.80 $ 957.00 $ 12,489.00 $ 1,897.00 $ 24,982.00

ASSIGNMENT MATERIAL " 135

1. Calculate the over- or underallocated overhead for each of the Molding and Painting departments for May. 2. Calculate the ending balances in work in process, finished goods, and cost of goods sold if the underor overallocated overhead amounts in each department are as follows: a. Written off to cost of goods sold b. Prorated based on the ending balance (before proration) in each of the three accounts c. Prorated based on the overhead allocated in May (before proration) in the ending balances in each of the three accounts 3. Which method would you choose? Explain.

Required

4-37 General ledger relationships, under- and overallocation. (S. Sridhar, adapted) Needham Company uses normal costing in its job-costing system. Partially completed T-accounts and additional information for Needham for 2011 are as follows:

Direct Materials Control 1-1-2011 30,000 380,000 400,000

Work-in-Process Control 1-1-2011 20,000 Dir. manuf. labor 360,000

Finished Goods Control 1-1-2011 10,000 900,000 940,000

Manufacturing Overhead Control Manufacturing Overhead Allocated Cost of Goods Sold 540,000 Additional information follows: a. Direct manufacturing labor wage rate was $15 per hour. b. Manufacturing overhead was allocated at $20 per direct manufacturing labor-hour. c. During the year, sales revenues were $1,090,000, and marketing and distribution costs were $140,000. What was the amount of direct materials issued to production during 2011? What was the amount of manufacturing overhead allocated to jobs during 2011? What was the total cost of jobs completed during 2011? What was the balance of work-in-process inventory on December 31, 2011? What was the cost of goods sold before proration of under- or overallocated overhead? What was the under- or overallocated manufacturing overhead in 2011? Dispose of the under- or overallocated manufacturing overhead using the following: a. Write-off to Cost of Goods Sold b. Proration based on ending balances (before proration) in Work-in-Process Control, Finished Goods Control, and Cost of Goods Sold 8. Using each of the approaches in requirement 7, calculate Needham’s operating income for 2011. 9. Which approach in requirement 7 do you recommend Needham use? Explain your answer briefly. 1. 2. 3. 4. 5. 6. 7.

4-38 Overview of general ledger relationships. Brady Company uses normal costing in its job-costing

system. The company produces custom bikes for toddlers. The beginning balances (December 1) and ending balances (as of December 30) in their inventory accounts are as follows:

Materials Control Work-in-Process Control Manufacturing Department Overhead Control Finished Goods Control

Beginning Balance 12/1 $1,200 5,800 — 3,500

Ending Balance 12/30 $ 7,600 8,100 94,070 18,500

Additional information follows: Direct materials purchased during December were $65,400. Cost of goods manufactured for December was $225,000. No direct materials were returned to suppliers. No units were started or completed on December 31. The manufacturing labor costs for the December 31 working day: direct manufacturing labor, $3,850, and indirect manufacturing labor, $950. f. Manufacturing overhead has been allocated at 120% of direct manufacturing labor costs through December 30.

a. b. c. d. e.

Required

136 " CHAPTER 4 JOB COSTING

Required

1. Prepare journal entries for the December 31 payroll. 2. Use T-accounts to compute the following: a. The total amount of materials requisitioned into work in process during December b. The total amount of direct manufacturing labor recorded in work in process during December (Hint: You have to solve requirements 2b and 2c simultaneously) c. The total amount of manufacturing overhead recorded in work in process during December d. Ending balance in work in process, December 31 e. Cost of goods sold for December before adjustments for under- or overallocated manufacturing overhead 3. Prepare closing journal entries related to manufacturing overhead. Assume that all under- or overallocated manufacturing overhead is closed directly to Cost of Goods Sold.

4-39 Allocation and proration of overhead. Tamden, Inc., prints custom marketing materials. The business was started January 1, 2010. The company uses a normal-costing system. It has two direct cost pools, materials and labor and one indirect cost pool, overhead. Overhead is charged to printing jobs on the basis of direct labor cost. The following information is available for 2010. Budgeted direct labor costs Budgeted overhead costs Costs of actual material used Actual direct labor costs Actual overhead costs

$150,000 $180,000 $126,500 $148,750 $176,000

There were two jobs in process on December 31, 2010: Job 11 and Job 12. Costs added to each job as of December 31 are as follows:

Job 11 Job 12

Direct materials $3,620 $6,830

Direct labor $4,500 $7,250

Tamden, Inc., has no finished goods inventories because all printing jobs are transferred to cost of goods sold when completed. Required

1. Compute the overhead allocation rate. 2. Calculate the balance in ending work in process and cost of goods sold before any adjustments for under- or overallocated overhead. 3. Calculate under- or overallocated overhead. 4. Calculate the ending balances in work in process and cost of goods sold if the under- or overallocated overhead amount is as follows: a. Written off to cost of goods sold b. Prorated using the ending balance (before proration) in cost of goods sold and work-in-process control accounts 5. Which of the methods in requirement 4 would you choose? Explain.

4-40 Job costing, contracting, ethics. Kingston Company manufactures modular homes. The company

has two main products that it sells commercially: a 1,000 square foot, one-bedroom model and a 1,500 square foot, two-bedroom model. The company recently began providing emergency housing (huts) to FEMA. The emergency housing is similar to the 1,000 square foot model. FEMA has requested Kingston to create a bid for 150 emergency huts to be sent for flood victims in the south. Your boss has asked that you prepare this bid. In preparing the bid, you find a recent invoice to FEMA for 200 huts provided after hurricane Katrina. You also have a standard cost sheet for the 1,000 square foot model sold commercially. Both are provided as follows: Standard cost sheet: 1,000 sq. ft. one-bedroom model Direct materials Direct manufacturing labor 30 hours Manufacturing overhead* $3 per direct labor dollar Total cost Retail markup on total cost Retail price

$ 8,000 600 ƒƒ1,800 $10,400 20% $12,480

*Overhead cost pool includes inspection labor ($15 per hour), setup labor ($12 per hour), and other indirect costs associated with production.

ASSIGNMENT MATERIAL " 137

INVOICE: DATE: September 15, 2005 BILL TO: FEMA FOR: 200 Emergency Huts SHIP TO: New Orleans, Louisiana Direct materials Direct manufacturing labor** Manufacturing overhead Total cost Government contract markup on total cost Total due

$1,840,000 138,400 ƒƒƒ415,200 ƒ2,393,600 15% $2,752,640

**Direct manufacturing labor includes 28 production hours per unit, 4 inspection hours per unit, and 6 setup hours per unit

1. Calculate the total bid if you base your calculations on the standard cost sheet assuming a cost plus 15% government contract. 2. Calculate the total bid if you base your calculations on the September 15, 2005, invoice assuming a cost plus 15% government contract. 3. What are the main discrepancies between the bids you calculated in #1 and #2? 4. What bid should you present to your boss? What principles from the IMA Standards of Ethical Conduct for Practitioners of Management Accounting and Financial Management should guide your decision?

Required

Collaborative Learning Problem 4-41 Job costing—service industry. Cam Cody schedules book signings for science fiction authors and creates e-books and books on CD to sell at each signing. Cody uses a normal-costing system with two direct cost pools, labor and materials, and one indirect cost pool, general overhead. General overhead is allocated to each signing based on 80% of labor cost. Actual overhead equaled allocated overhead in March 2010. Actual overhead in April was $1,980. All costs incurred during the planning stage for a signing and during the signing are gathered in a balance sheet account called “Signings in Progress (SIP).” When a signing is completed, the costs are transferred to an income statement account called “Cost of Completed Signings (CCS).” Following is cost information for April 2010:

Author N. Asher T. Bucknell S. Brown S. King D. Sherman

From Beginning SIP Materials Labor $425 $750 710 575 200 550 — — — —

Incurred in April Materials Labor $ 90 $225 150 75 320 450 650 400 150 200

The following information relates to April 2010. As of April 1, there were three signings in progress, N. Asher, T. Bucknell, and S. Brown. Signings for S. King and D. Sherman were started during April. The signings for T. Bucknell and S. King were completed during April. Calculate SIP at the end of April. Calculate CCS for April. Calculate under/overallocated overhead at the end of April. Calculate the ending balances in SIP and CCS if the under/overallocated overhead amount is as follows: a. Written off to CCS b. Prorated based on the ending balances (before proration) in SIP and CCS c. Prorated based on the overhead allocated in April in the ending balances of SIP and CCS (before proration) 5. Which of the methods in requirement 4 would you choose?

1. 2. 3. 4.

Required

Activity-Based Costing and ActivityBased Management

A good mystery never fails to capture the imagination.

Learning Objectives

Money is stolen or lost, property disappears, or someone meets with foul play. On the surface, what appears unremarkable to the untrained eye can turn out to be quite a revelation once the facts and details are uncovered. Getting to the bottom of the case, understanding what happened and why, and taking action can make the difference between a solved case and an unsolved one. Business and organizations are much the same. Their costing systems are often mysteries with unresolved questions: Why are we bleeding red ink? Are we pricing our products accurately? Activitybased costing can help unravel the mystery and result in improved operations, as LG Electronics discovers in the following article.

1. Explain how broad averaging undercosts and overcosts products or services 2. Present three guidelines for refining a costing system 3. Distinguish between simple and activity-based costing systems 4. Describe a four-part cost hierarchy 5. Cost products or services using activity-based costing 6. Evaluate the costs and benefits of implementing activity-based costing systems 7. Explain how activity-based costing systems are used in activity-based management 8. Compare activity-based costing systems and department costing systems

LG Electronics Reduces Costs and Inefficiencies Through Activity-Based Costing1 LG Electronics is one of the world’s largest manufacturers of flatscreen televisions and mobile phones. In 2009, the Seoul, South Korea-based company sold 16 million liquid crystal display televisions and 117 million mobile phones worldwide. To make so many electronic devices, LG Electronics spends nearly $40 billion annually on the procurement of semiconductors, metals, connectors, and other materials. Costs for many of these components have soared in recent years. Until 2008, however, LG Electronics did not have a centralized procurement system to leverage its scale and to control supply costs. Instead, the company had a decentralized system riddled with wasteful spending and inefficiencies. To respond to these challenges, LG Electronics hired its first chief procurement officer who turned to activity-based costing (“ABC”) for answers. ABC analysis of the company’s procurement system revealed that most company resources were applied to administrative and not strategic tasks. Furthermore, the administrative tasks were done manually and at a very high cost. The ABC analysis led LG Electronics to change many of its procurement practices and processes, improve efficiency and focus 1

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Sources: Carbone, James. 2009. LG Electronics centralizes purchasing to save. Purchasing, April. http://www.purchasing.com/article/217108-LG_Electronics_centralizes_purchasing_to_save.php; Linton’s goals. 2009. Supply Management, May 12. http://www.supplymanagement.com/analysis/features/ 2009/lintons-goals/; Yoou-chul, Kim. 2009. CPO expects to save $1 billion in procurement. The Korea Times, April 1. http://www.koreatimes.co.kr/www/news/biz/2009/04/123_42360.html

on the highest-value tasks such as managing costs of commodity products and negotiating with suppliers. Furthermore, the company developed a global procurement strategy for its televisions, mobile phones, computers, and home theatre systems by implementing competitive bidding among suppliers, standardizing parts across product lines, and developing additional buying capacity in China. The results so far have been staggering. In 2008 alone, LG Electronics reduced its materials costs by 16%, and expects to further reduce costs by $5 billion by the end of 2011. Most companies—such as Dell, Oracle, JP Morgan Chase, and Honda—offer more than one product (or service). Dell Computer, for example, produces desktops, laptops, and servers. The three basic activities for manufacturing computers are (a) designing computers, (b) ordering component parts, and (c) assembly. The different products, however, require different quantities of the three activities. For example, a server has a more complex design, many more parts, and a more complex assembly than a desktop. To measure the cost of producing each product, Dell separately tracks activity costs for each product. In this chapter, we describe activity-based costing systems and how they help companies make better decisions about pricing and product mix. And, just as in the case of LG Electronics, we show how ABC systems assist in cost management decisions by improving product designs, processes, and efficiency.

Broad Averaging and Its Consequences Historically, companies (such as television and automobile manufacturers) produced a limited variety of products. Indirect (or overhead) costs were a relatively small percentage of total costs. Using simple costing systems to allocate costs broadly was easy, inexpensive, and reasonably accurate. However, as product diversity and indirect costs have increased, broad averaging has resulted in greater inaccuracy of product costs. For example, the use of a single, plant-wide manufacturing overhead rate to allocate costs to products often produces unreliable cost data. The term peanut-butter costing (yes, that’s what it’s called) describes a particular costing approach that uses broad averages for assigning (or spreading, as in spreading peanut butter) the cost of resources uniformly to cost

Learning Objective

Explain how broad averaging undercosts and overcosts products or services . . . this problem arises when reported costs of products do not equal their actual costs

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objects (such as products or services) when the individual products or services, may in fact, use those resources in nonuniform ways.

Undercosting and Overcosting The following example illustrates how averaging can result in inaccurate and misleading cost data. Consider the cost of a restaurant bill for four colleagues who meet monthly to discuss business developments. Each diner orders separate entrees, desserts, and drinks. The restaurant bill for the most recent meeting is as follows:

Entree Dessert Drinks Total

Emma $11 0 ƒƒ4 $15

James $20 8 ƒ14 $42

Jessica $15 4 ƒƒ8 $27

Matthew $14 4 ƒƒ6 $24

Total $ 60 16 ƒƒ32 $108

Average $15 4 ƒƒ8 $27

If the $108 total restaurant bill is divided evenly, $27 is the average cost per diner. This cost-averaging approach treats each diner the same. Emma would probably object to paying $27 because her actual cost is only $15; she ordered the lowest-cost entree, had no dessert, and had the lowest-cost drink. When costs are averaged across all four diners, both Emma and Matthew are overcosted, James is undercosted, and Jessica is (by coincidence) accurately costed. Broad averaging can lead to undercosting or overcosting of products or services: #

Product undercosting—a product consumes a high level of resources but is reported to have a low cost per unit (James’s dinner). Product overcosting—a product consumes a low level of resources but is reported to have a high cost per unit (Emma’s dinner).

What are the strategic consequences of product undercosting and overcosting? Think of a company that uses cost information about its products to guide pricing decisions. Undercosted products will be underpriced and may even lead to sales that actually result in losses—sales bring in less revenue than the cost of resources they use. Overcosted products lead to overpricing, causing these products to lose market share to competitors producing similar products. Worse still, product undercosting and overcosting causes managers to focus on the wrong products, drawing attention to overcosted products whose costs may in fact be perfectly reasonable and ignoring undercosted products that in fact consume large amounts of resources.

Product-Cost Cross-Subsidization Product-cost cross-subsidization means that if a company undercosts one of its products, it will overcost at least one of its other products. Similarly, if a company overcosts one of its products, it will undercost at least one of its other products. Product-cost cross-subsidization is very common in situations in which a cost is uniformly spread— meaning it is broadly averaged—across multiple products without recognizing the amount of resources consumed by each product. In the restaurant-bill example, the amount of cost cross-subsidization of each diner can be readily computed because all cost items can be traced as direct costs to each diner. If all diners pay $27, Emma is paying $12 more than her actual cost of $15. She is crosssubsidizing James who is paying $15 less than his actual cost of $42. Calculating the amount of cost cross-subsidization takes more work when there are indirect costs to be considered. Why? Because when the resources represented by indirect costs are used by two or more diners, we need to find a way to allocate costs to each diner. Consider, for example, a $40 bottle of wine whose cost is shared equally. Each diner would pay $10 ($40 ÷ 4). Suppose Matthew drinks 2 glasses of wine while Emma, James, and Jessica drink one glass each for a total of 5 glasses. Allocating the cost of the bottle of wine on the basis of the glasses of wine that each diner drinks would result in Matthew paying $16 ($40 * 2/5) and

SIMPLE COSTING SYSTEM AT PLASTIM CORPORATION " 141

each of the others $8 ($40 * 1/5). In this case, by sharing the cost equally, Emma, James, and Jessica are each paying $2 ($10 – $8) more and are cross-subsidizing Matthew who is paying $6 ($16 – $10) less for the wine he consumes. To see the effects of broad averaging on direct and indirect costs, we consider Plastim Corporation’s costing system.

Simple Costing System at Plastim Corporation Plastim Corporation manufactures lenses for the rear taillights of automobiles. A lens, made from black, red, orange, or white plastic, is the part of the lamp visible on the automobile’s exterior. Lenses are made by injecting molten plastic into a mold to give the lamp its desired shape. The mold is cooled to allow the molten plastic to solidify, and the lens is removed. Under its contract with Giovanni Motors, a major automobile manufacturer, Plastim makes two types of lenses: a complex lens, CL5, and a simple lens, S3. The complex lens is a large lens with special features, such as multicolor molding (when more than one color is injected into the mold) and a complex shape that wraps around the corner of the car. Manufacturing CL5 lenses is more complex because various parts in the mold must align and fit precisely. The S3 lens is simpler to make because it has a single color and few special features.

Design, Manufacturing, and Distribution Processes The sequence of steps to design, produce, and distribute lenses, whether simple or complex, is as follows: #

# #

Design products and processes. Each year Giovanni Motors specifies some modifications to the simple and complex lenses. Plastim’s design department designs the molds from which the lenses will be made and specifies the processes needed (that is, details of the manufacturing operations). Manufacture lenses. The lenses are molded, finished, cleaned, and inspected. Distribute lenses. Finished lenses are packed and sent to Giovanni Motors.

Plastim is operating at capacity and incurs very low marketing costs. Because of its highquality products, Plastim has minimal customer-service costs. Plastim’s business environment is very competitive with respect to simple lenses. At a recent meeting, Giovanni’s purchasing manager indicated that a new supplier, Bandix, which makes only simple lenses, is offering to supply the S3 lens to Giovanni at a price of $53, well below the $63 price that Plastim is currently projecting and budgeting for 2011. Unless Plastim can lower its selling price, it will lose the Giovanni business for the simple lens for the upcoming model year. Fortunately, the same competitive pressures do not exist for the complex lens, which Plastim currently sells to Giovanni at $137 per lens. Plastim’s management has two primary options: #

Plastim can give up the Giovanni business in simple lenses if selling simple lenses is unprofitable. Bandix makes only simple lenses and perhaps, therefore, uses simpler technology and processes than Plastim. The simpler operations may give Bandix a cost advantage that Plastim cannot match. If so, it is better for Plastim to not supply the S3 lens to Giovanni. Plastim can reduce the price of the simple lens and either accept a lower margin or aggressively seek to reduce costs.

To make these long-run strategic decisions, management needs to first understand the costs to design, make, and distribute the S3 and CL5 lenses. While Bandix makes only simple lenses and can fairly accurately calculate the cost of a lens by dividing total costs by units produced, Plastim’s costing environment is more challenging. The processes to make both simple and complex lenses are more complicated than the processes required to make only simple lenses. Plastim needs to find a way to allocate costs to each type of lens.

Decision Point When does product undercosting or overcosting occur?

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In computing costs, Plastim assigns both variable costs and costs that are fixed in the short run to the S3 and CL5 lenses. Managers cost products and services to guide longrun strategic decisions (for example, what mix of products and services to produce and sell and what prices to charge for them). In the long-run, managers want revenues to exceed total costs (variable and fixed) to design, make, and distribute the lenses. To guide their pricing and cost-management decisions, Plastim’s managers assign all costs, both manufacturing and nonmanufacturing, to the S3 and CL5 lenses. If managers had wanted to calculate the cost of inventory, Plastim’s management accountants would have assigned only manufacturing costs to the lenses, as required by generally accepted accounting principles. Surveys of company practice across the globe overwhelmingly indicate that the vast majority of companies use costing systems not just for inventory costing but also for strategic purposes such as pricing and product-mix decisions and decisions about cost reduction, process improvement, design, and planning and budgeting. As a result, even merchandising-sector companies (for whom inventory costing is straightforward) and service-sector companies (who have no inventory) expend considerable resources in designing and operating their costing systems. In this chapter, we take this more strategic focus and allocate costs in all functions of the value chain to the S3 and CL5 lenses.

Simple Costing System Using a Single Indirect-Cost Pool Plastim has historically had a simple costing system that allocates indirect costs using a single indirect-cost rate, the type of system described in Chapter 4. We calculate budgeted costs for each type of lens in 2011 using Plastim’s simple costing system and later contrast it with activity-based costing. (Note that instead of jobs, as in Chapter 4, we now have products as the cost objects.) Exhibit 5-1 shows an overview of Plastim’s simple costing system. Use this exhibit as a guide as you study the following steps, each of which is marked in Exhibit 5-1. Exhibit 5-1 Overview of Plastim’s Simple Costing System

STEP 4:

All Indirect Costs $2,385,000

INDIRECT– COST POOL

39,750 Direct Manufacturing Labor-Hours

STEP 3:

COST-ALLOCATION BASE

STEP 5:

$60 per Direct Manufacturing Labor-Hour STEP 1:

COST OBJECT: S3 AND CL5 LENSES

STEP 6: Indirect Costs

Direct Costs

STEP 7

STEP 2:

DIRECT COSTS

Direct Materials

Direct Manufacturing Labor

SIMPLE COSTING SYSTEM AT PLASTIM CORPORATION " 143

Step 1: Identify the Products That Are the Chosen Cost Objects. The cost objects are the 60,000 simple S3 lenses and the 15,000 complex CL5 lenses that Plastim will produce in 2011. Plastim’s goal is to first calculate the total costs and then the unit cost of designing, manufacturing, and distributing these lenses. Step 2: Identify the Direct Costs of the Products. Plastim identifies the direct costs— direct materials and direct manufacturing labor—of the lenses. Exhibit 5-2 shows the direct and indirect costs for the S3 and the CL5 lenses using the simple costing system. The direct cost calculations appear on lines 5, 6, and 7 of Exhibit 5-2. Plastim classifies all other costs as indirect costs. Step 3: Select the Cost-Allocation Bases to Use for Allocating Indirect (or Overhead) Costs to the Products. A majority of the indirect costs consist of salaries paid to supervisors, engineers, manufacturing support, and maintenance staff, all supporting direct manufacturing labor. Plastim uses direct manufacturing labor-hours as the only allocation base to allocate all manufacturing and nonmanufacturing indirect costs to S3 and CL5. In 2011, Plastim plans to use 39,750 direct manufacturing labor-hours. Step 4: Identify the Indirect Costs Associated with Each Cost-Allocation Base. Because Plastim uses only a single cost-allocation base, Plastim groups all budgeted indirect costs of $2,385,000 for 2011 into a single overhead cost pool. Step 5: Compute the Rate per Unit of Each Cost-Allocation Base. Budgeted indirect-cost rate = =

Budgeted total costs in indirect-cost pool Budgeted total quantity of cost-allocation base $2,385,000 39,750 direct manufacturing labor-hours

= $60 per direct manufacturing labor-hour

Step 6: Compute the Indirect Costs Allocated to the Products. Plastim expects to use 30,000 total direct manufacturing labor-hours to make the 60,000 S3 lenses and 9,750 total direct manufacturing labor-hours to make the 15,000 CL5 lenses. Exhibit 5-2 shows indirect costs of $1,800,000 ($60 per direct manufacturing labor-hour * 30,000 direct manufacturing labor-hours) allocated to the simple lens and $585,000 ($60 per direct manufacturing labor-hour * 9,750 direct manufacturing labor-hours) allocated to the complex lens. Step 7: Compute the Total Cost of the Products by Adding All Direct and Indirect Costs Assigned to the Products. Exhibit 5-2 presents the product costs for the simple and complex lenses. The direct costs are calculated in Step 2 and the indirect costs in Step 6. Be sure you see the parallel between the simple costing system overview diagram (Exhibit 5-1) Exhibit 5-2

Plastim’s Product Costs Using the Simple Costing System

Direct materials Direct manufacturing labor Total direct costs (Step 2) Indirect costs allocated (Step 6) Total costs (Step 7)

60,000 Simple Lenses (S3) Total per Unit (1) (2) = (1) ÷ 60,000 $1,125,000 $18.75 10.00 600,000

(

)

15,000 Complex Lenses (CL5) Total per Unit (3) (4) = (3) ÷ 15,000 $45.00 $ 675,000 195,000 13.00

Total (5) = (1) + (3) $1,800,000 795,000

1,725,000 1,800,000

28.75 30.00

870,000 585,000

58.00 39.00

2,595,000 2,385,000

$3,525,000

$58.75

$1,455,000

$97.00

$4,980,000

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and the costs calculated in Step 7. Exhibit 5-1 shows two direct-cost categories and one indirect-cost category. Hence, the budgeted cost of each type of lens in Step 7 (Exhibit 5-2) has three line items: two for direct costs and one for allocated indirect costs. The budgeted cost per S3 lens is $58.75, well above the $53 selling price quoted by Bandix. The budgeted cost per CL5 lens is $97.

Applying the Five-Step Decision-Making Process at Plastim To decide how it should respond to the threat that Bandix poses to its S3 lens business, Plastim’s management works through the five-step decision-making process introduced in Chapter 1. Step 1: Identify the problem and uncertainties. The problem is clear: If Plastim wants to retain the Giovanni business for S3 lenses and make a profit, it must find a way to reduce the price and costs of the S3 lens. The two major uncertainties Plastim faces are (1) whether Plastim’s technology and processes for the S3 lens are competitive with Bandix’s and (2) whether the S3 lens is overcosted by the simple costing system. Step 2: Obtain information. Management asks a team of its design and process engineers to analyze and evaluate the design, manufacturing, and distribution operations for the S3 lens. The team is very confident that the technology and processes for the S3 lens are not inferior to those of Bandix and other competitors because Plastim has many years of experience in manufacturing and distributing the S3 with a history and culture of continuous process improvements. If anything, the team is less certain about Plastim’s capabilities in manufacturing and distributing complex lenses, because it only recently started making this type of lens. Given these doubts, management is happy that Giovanni Motors considers the price of the CL5 lens to be competitive. It is somewhat of a puzzle, though, how at the currently budgeted prices, Plastim is expected to earn a very large profit margin percentage (operating income ÷ revenues) on the CL5 lenses and a small profit margin on the S3 lenses:

Revenues Total costs Operating income Profit margin percentage

60,000 Simple Lenses (S3) 15,000 Complex Lenses (CL5) Total per Unit Total per Unit (1) (2) = (1) ÷ 60,000 (3) (4) = (3) ÷ 15,000 $3,780,000 $63.00 $2,055,000 $137.00 ƒ3,525,000 ƒ58.75 ƒƒ1,455,000 ƒƒ97.00 $ƒƒ255,000 $ƒ4.25 $ƒƒ600,000 $ƒ40.00 ƒƒ6.75% ƒƒ29.20%

Total (5) = (1) + (3) $5,835,000 ƒ4,980,000 $ƒƒ855,000

As it continues to gather information, Plastim’s management begins to ponder why the profit margins (and process) are under so much pressure for the S3 lens, where the company has strong capabilities, but high on the newer, less-established CL5 lens. Plastim is not deliberately charging a low price for S3, so management starts to believe that perhaps the problem lies with its costing system. Plastim’s simple costing system may be overcosting the simple S3 lens (assigning too much cost to it) and undercosting the complex CL5 lens (assigning too little cost to it). Step 3: Make predictions about the future. Plastim’s key challenge is to get a better estimate of what it will cost to design, make, and distribute the S3 and CL5 lenses. Management is fairly confident about the direct material and direct manufacturing labor costs of each lens because these costs are easily traced to the lenses. But management is quite concerned about how accurately the simple costing system measures the indirect resources used by each type of lens. It believes it can do much better. At the same time, management wants to ensure that no biases enter its thinking. In particular, it wants to be careful that the desire to be competitive on the S3 lens should not lead to assumptions that bias in favor of lowering costs of the S3 lens.

REFINING A COSTING SYSTEM " 145

Step 4: Make decisions by choosing among alternatives. On the basis of predicted costs, and taking into account how Bandix might respond, Plastim’s managers must decide whether they should bid for Giovanni Motors’ S3 lens business and if they do bid, what price they should offer. Step 5: Implement the decision, evaluate performance, and learn. If Plastim bids and wins Giovanni’s S3 lens business, it must compare actual costs, as it makes and ships S3 lenses, to predicted costs and learn why actual costs deviate from predicted costs. Such evaluation and learning form the basis for future improvements. The next few sections focus on Steps 3, 4, and 5—how Plastim improves the allocation of indirect costs to the S3 and CL5 lenses, how it uses these predictions to bid for the S3 lens business, and how it makes product design and process improvements.

Refining a Costing System A refined costing system reduces the use of broad averages for assigning the cost of resources to cost objects (such as jobs, products, and services) and provides better measurement of the costs of indirect resources used by different cost objects—no matter how differently various cost objects use indirect resources.

Reasons for Refining a Costing System There are three principal reasons that have accelerated the demand for such refinements. 1. Increase in product diversity. The growing demand for customized products has led companies to increase the variety of products and services they offer. Kanthal, the Swedish manufacturer of heating elements, for example, produces more than 10,000 different types of electrical heating wires and thermostats. Banks, such as the Cooperative Bank in the United Kingdom, offer many different types of accounts and services: special passbook accounts, ATMs, credit cards, and electronic banking. These products differ in the demands they place on the resources needed to produce them, because of differences in volume, process, and complexity. The use of broad averages is likely to lead to distorted and inaccurate cost information. 2. Increase in indirect costs. The use of product and process technology such as computer-integrated manufacturing (CIM) and flexible manufacturing systems (FMS), has led to an increase in indirect costs and a decrease in direct costs, particularly direct manufacturing labor costs. In CIM and FMS, computers on the manufacturing floor give instructions to set up and run equipment quickly and automatically. The computers accurately measure hundreds of production parameters and directly control the manufacturing processes to achieve high-quality output. Managing more complex technology and producing very diverse products also requires committing an increasing amount of resources for various support functions, such as production scheduling, product and process design, and engineering. Because direct manufacturing labor is not a cost driver of these costs, allocating indirect costs on the basis of direct manufacturing labor (which was the common practice) does not accurately measure how resources are being used by different products. 3. Competition in product markets. As markets have become more competitive, managers have felt the need to obtain more accurate cost information to help them make important strategic decisions, such as how to price products and which products to sell. Making correct pricing and product mix decisions is critical in competitive markets because competitors quickly capitalize on a company’s mistakes. Whereas the preceding factors point to reasons for the increase in demand for refined cost systems, advances in information technology have enabled companies to implement these refinements. Costing system refinements require more data gathering and more analysis, and improvements in information technology have drastically reduced the costs to gather, validate, store, and analyze vast quantities of data.

Learning Objective

Present three guidelines for refining a costing system . . . classify more costs as direct costs, expand the number of indirectcost pools, and identify cost drivers

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Guidelines for Refining a Costing System There are three main guidelines for refining a costing system. In the following sections, we delve more deeply into each in the context of the Plastim example. 1. Direct-cost tracing. Identify as many direct costs as is economically feasible. This guideline aims to reduce the amount of costs classified as indirect, thereby minimizing the extent to which costs have to be allocated, rather than traced. 2. Indirect-cost pools. Expand the number of indirect-cost pools until each pool is more homogeneous. All costs in a homogeneous cost pool have the same or a similar causeand-effect (or benefits-received) relationship with a single cost driver that is used as the cost-allocation base. Consider, for example, a single indirect-cost pool containing both indirect machining costs and indirect distribution costs that are allocated to products using machine-hours. This pool is not homogeneous because machine-hours are a cost driver of machining costs but not of distribution costs, which has a different cost driver, number of shipments. If, instead, machining costs and distribution costs are separated into two indirect-cost pools (with machine-hours as the cost-allocation base for the machining cost pool and number of shipments as the cost-allocation base for the distribution cost pool), each indirect-cost pool would become homogeneous. 3. Cost-allocation bases. As we describe later in the chapter, whenever possible, use the cost driver (the cause of indirect costs) as the cost-allocation base for each homogenous indirect-cost pool (the effect).

Decision Point How do managers refine a costing system?

Learning Objective

Distinguish between simple and activitybased costing systems . . . unlike simple systems, ABC systems calculate costs of individual activities to cost products

Activity-Based Costing Systems One of the best tools for refining a costing system is activity-based costing. Activity-based costing (ABC) refines a costing system by identifying individual activities as the fundamental cost objects. An activity is an event, task, or unit of work with a specified purpose—for example, designing products, setting up machines, operating machines, and distributing products. More informally, activities are verbs; they are things that a firm does. To help make strategic decisions, ABC systems identify activities in all functions of the value chain, calculate costs of individual activities, and assign costs to cost objects such as products and services on the basis of the mix of activities needed to produce each product or service.2 Assignment to Other Cost Objects

Fundamental Cost Objects Activities

Costs of Activities

Costs of • Products • Services • Customers

Plastim’s ABC System After reviewing its simple costing system and the potential miscosting of product costs, Plastim decides to implement an ABC system. Direct material costs and direct manufacturing labor costs can be traced to products easily, so the ABC system focuses on refining the assignment of indirect costs to departments, processes, products, or other cost objects. Plastim’s ABC system identifies various activities that help explain why Plastim incurs the costs it currently classifies as indirect in its simple costing system. In other words, it breaks up the current indirect cost pool into finer pools of costs related to various activities. To identify these activities, Plastim organizes a team comprised of managers from design, manufacturing, distribution, accounting, and administration. 2

For more details on ABC systems, see R. Cooper and R. S. Kaplan, The Design of Cost Management Systems (Upper Saddle River, NJ: Prentice Hall, 1999); G. Cokins, Activity-Based Cost Management: An Executive’s Guide (Hoboken, NJ: John Wiley & Sons, 2001); and R. S. Kaplan and S. Anderson, Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits (Boston: Harvard Business School Press, 2007).

ACTIVITY-BASED COSTING SYSTEMS " 147

Defining activities is not a simple matter. The team evaluates hundreds of tasks performed at Plastim before choosing the activities that form the basis of its ABC system. For example, it decides if maintenance of molding machines, operations of molding machines, and process control should each be regarded as a separate activity or should be combined into a single activity. An activity-based costing system with many activities becomes overly detailed and unwieldy to operate. An activity-based costing system with too few activities may not be refined enough to measure cause-and-effect relationships between cost drivers and various indirect costs. Plastim’s team focuses on activities that account for a sizable fraction of indirect costs and combines activities that have the same cost driver into a single activity. For example, the team decides to combine maintenance of molding machines, operations of molding machines, and process control into a single activity—molding machine operations—because all these activities have the same cost driver: molding machine-hours. The team identifies the following seven activities by developing a flowchart of all the steps and processes needed to design, manufacture, and distribute S3 and CL5 lenses. a. Design products and processes b. Set up molding machines to ensure that the molds are properly held in place and parts are properly aligned before manufacturing starts c. Operate molding machines to manufacture lenses d. Clean and maintain the molds after lenses are manufactured e. Prepare batches of finished lenses for shipment f. Distribute lenses to customers g. Administer and manage all processes at Plastim These activity descriptions form the basis of the activity-based costing system—sometimes called an activity list or activity dictionary. Compiling the list of tasks, however, is only the first step in implementing activity-based costing systems. Plastim must also identify the cost of each activity and the related cost driver. To do so, Plastim uses the three guidelines for refining a costing system described on page 146. 1. Direct-cost tracing. Plastim’s ABC system subdivides the single indirect cost pool into seven smaller cost pools related to the different activities. The costs in the cleaning and maintenance activity cost pool (item d) consist of salaries and wages paid to workers who clean the mold. These costs are direct costs, because they can be economically traced to a specific mold and lens. 2. Indirect-cost pools. The remaining six activity cost pools are indirect cost pools. Unlike the single indirect cost pool of Plastim’s simple costing system, each of the activity-related cost pools is homogeneous. That is, each activity cost pool includes only those narrow and focused set of costs that have the same cost driver. For example, the distribution cost pool includes only those costs (such as wages of truck drivers) that, over time, increase as the cost driver of distribution costs, cubic feet of packages delivered, increases. In the simple costing system, all indirect costs were lumped together and the cost-allocation base, direct manufacturing labor-hours, was not a cost driver of the indirect costs. Determining costs of activity pools requires assigning and reassigning costs accumulated in support departments, such as human resources and information systems, to each of the activity cost pools on the basis of how various activities use support department resources. This is commonly referred to as first-stage allocation, a topic which we discuss in detail in Chapters 14 and 15. We focus here on the second-stage allocation, the allocation of costs of activity cost pools to products. 3. Cost-allocation bases. For each activity cost pool, the cost driver is used (whenever possible) as the cost-allocation base. To identify cost drivers, Plastim’s managers consider various alternatives and use their knowledge of operations to choose among them. For example, Plastim’s managers choose setup-hours rather than the number of setups as the cost driver of setup costs, because Plastim’s managers believe that more complex setups take more time and are more costly. Over time, Plastim’s managers can use data to test their beliefs. (Chapter 10 discusses several methods to estimate the relationship between a cost driver and costs.)

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The logic of ABC systems is twofold. First, structuring activity cost pools more finely with cost drivers for each activity cost pool as the cost-allocation base leads to more accurate costing of activities. Second, allocating these costs to products by measuring the cost-allocation bases of different activities used by different products leads to more accurate product costs. We illustrate this logic by focusing on the setup activity at Plastim. Setting up molding machines frequently entails trial runs, fine-tuning, and adjustments. Improper setups cause quality problems such as scratches on the surface of the lens. The resources needed for each setup depend on the complexity of the manufacturing operation. Complex lenses require more setup resources (setup-hours) per setup than simple lenses. Furthermore, complex lenses can be produced only in small batches because the molds for complex lenses need to be cleaned more often than molds for simple lenses. Thus, relative to simple lenses, complex lenses not only use more setup-hours per setup, but they also require more frequent setups. Setup data for the simple S3 lens and the complex CL5 lens are as follows:

1 2 3 = (1) ÷ (2) 4 5 = (3) * (4)

Quantity of lenses produced Number of lenses produced per batch Number of batches Setup time per batch Total setup-hours

Simple S3 Lens 60,000 240 250 2 hours 500 hours

Complex CL5 Lens Total 15,000 50 300 5 hours 1,500 hours 2,000 hours

Of the $2,385,000 in the total indirect-cost pool, Plastim identifies the total costs of setups (consisting mainly of depreciation on setup equipment and allocated costs of process engineers, quality engineers, and supervisors) to be $300,000. Recall that in its simple costing system, Plastim uses direct manufacturing labor-hours to allocate all indirect costs to products. The following table compares how setup costs allocated to simple and complex lenses will be different if Plastim allocates setup costs to lenses based on setup-hours rather than direct manufacturing labor-hours. Of the $60 total rate per direct manufacturing labor-hour (p. 143), the setup cost per direct manufacturing labor-hour amounts to $7.54717 ($300,000 ÷ 39,750 total direct manufacturing labor-hours). The setup cost per setup-hour equals $150 ($300,000 ÷ 2,000 total setup-hours).

Setup cost allocated using direct manufacturing labor-hours: $7.54717 * 30,000; $7.54717 * 9,750 Setup cost allocated using setup-hours: $150 * 500; $150 * 1,500

Decision Point What is the difference between the design of a simple costing system and an activity-based costing (ABC) system?

Simple S3 Lens

Complex CL5 Lens

Total

$226,415

$ 73,585

$300,000

$ 75,000

$225,000

$300,000

As we have already discussed when presenting guidelines 2 and 3, setup-hours, not direct manufacturing labor-hours, are the cost driver of setup costs.. The CL5 lens uses substantially more setup-hours than the S3 lens (1,500 hours ÷ 2,000 hours = 75% of the total setup-hours) because the CL5 requires a greater number of setups (batches) and each setup is more challenging and requires more setup-hours. The ABC system therefore allocates substantially more setup costs to CL5 than to S3. When direct manufacturing labor-hours rather than setup-hours are used to allocate setup costs in the simple costing system, it is the S3 lens that is allocated a very large share of the setup costs because the S3 lens uses a larger proportion of direct manufacturing labor-hours (30,000 ÷ 39,750 = 75.47%). As a result, the simple costing system overcosts the S3 lens with regard to setup costs. Note that setup-hours are related to batches (or groups) of lenses made, not the number of individual lenses. Activity-based costing attempts to identify the most relevant cause-andeffect relationship for each activity pool, without restricting the cost driver to only units of output or variables related to units of output (such as direct manufacturing labor-hours). As our discussion of setups illustrates, limiting cost-allocation bases in this manner weakens the cause-and-effect relationship between the cost-allocation base and the costs in a cost pool.

ACTIVITY-BASED COSTING SYSTEMS " 149

Cost Hierarchies A cost hierarchy categorizes various activity cost pools on the basis of the different types of cost drivers, or cost-allocation bases, or different degrees of difficulty in determining cause-and-effect (or benefits-received) relationships. ABC systems commonly use a cost hierarchy with four levels—output unit-level costs, batch-level costs, product-sustaining costs, and facility-sustaining costs—to identify cost-allocation bases that are cost drivers of the activity cost pools. Output unit-level costs are the costs of activities performed on each individual unit of a product or service. Machine operations costs (such as the cost of energy, machine depreciation, and repair) related to the activity of running the automated molding machines are output unit-level costs. They are output unit-level costs because, over time, the cost of this activity increases with additional units of output produced (or machine-hours used). Plastim’s ABC system uses molding machine-hours—an output-unit level cost-allocation base—to allocate machine operations costs to products. Batch-level costs are the costs of activities related to a group of units of a product or service rather than each individual unit of product or service. In the Plastim example, setup costs are batch-level costs because, over time, the cost of this setup activity increases with setup-hours needed to produce batches (groups) of lenses. As described in the table on page 148, the S3 lens requires 500 setup-hours (2 setup-hours per batch * 250 batches). The CL5 lens requires 1,500 setup-hours (5 setup-hours per batch * 300 batches). The total setup costs allocated to S3 and CL5 depend on the total setup-hours required by each type of lens, not on the number of units of S3 and CL5 produced. (Setup costs being a batch-level cost cannot be avoided by producing one less unit of S3 or CL5.) Plastim’s ABC system uses setup-hours—a batch-level cost-allocation base—to allocate setup costs to products. Other examples of batch-level costs are material-handling and quality-inspection costs associated with batches (not the quantities) of products produced, and costs of placing purchase orders, receiving materials, and paying invoices related to the number of purchase orders placed rather than the quantity or value of materials purchased. Product-sustaining costs (service-sustaining costs) are the costs of activities undertaken to support individual products or services regardless of the number of units or batches in which the units are produced. In the Plastim example, design costs are product-sustaining costs. Over time, design costs depend largely on the time designers spend on designing and modifying the product, the mold, and the process. These design costs are a function of the complexity of the mold, measured by the number of parts in the mold multiplied by the area (in square feet) over which the molten plastic must flow (12 parts * 2.5 square feet, or 30 parts-square feet for the S3 lens, and 14 parts * 5 square feet, or 70 parts-square feet for the CL5 lens). As a result, the total design costs allocated to S3 and CL5 depend on the complexity of the mold, regardless of the number of units or batches of production. Design costs cannot be avoided by producing fewer units or running fewer batches. Plastim’s ABC system uses parts-square feet—a product-sustaining cost-allocation base—to allocate design costs to products. Other examples of product-sustaining costs are product research and development costs, costs of making engineering changes, and marketing costs to launch new products. Facility-sustaining costs are the costs of activities that cannot be traced to individual products or services but that support the organization as a whole. In the Plastim example, the general administration costs (including top management compensation, rent, and building security) are facility-sustaining costs. It is usually difficult to find a good causeand-effect relationship between these costs and the cost-allocation base. This lack of a cause-and-effect relationship causes some companies not to allocate these costs to products and instead to deduct them as a separate lump-sum amount from operating income. Other companies, such as Plastim, allocate facility-sustaining costs to products on some basis—for example, direct manufacturing labor-hours—because management believes all costs should be allocated to products. Allocating all costs to products or services becomes important when management wants to set selling prices on the basis of an amount of cost that includes all costs.

Learning Objective

Describe a four-part cost hierarchy . . . a four-part cost hierarchy is used to categorize costs based on different types of cost drivers—for example, costs that vary with each unit of a product versus costs that vary with each batch of products

Decision Point What is a cost hierarchy?

150 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

Implementing Activity-Based Costing Learning Objective

Cost products or services using activitybased costing . . . use cost rates for different activities to compute indirect costs of a product

Now that you understand the basic concepts of ABC, let’s use it to refine Plastim’s simple costing system, compare it to alternative costing systems, and examine what managers look for when deciding whether or not to develop ABC systems.

Implementing ABC at Plastim In order to apply ABC to Plastim’s costing system, we follow the seven-step approach to costing and the three guidelines for refining costing systems (increasing direct-cost tracing, creating homogeneous indirect-cost pools, and identifying cost-allocation bases that have cause-and-effect relationships with costs in the cost pool). Exhibit 5-3 shows an overview of Plastim’s ABC system. Use this exhibit as a guide as you study the following steps, each of which is marked in Exhibit 5-3. Step 1: Identify the Products That Are the Chosen Cost Objects. The cost objects are the 60,000 S3 and the 15,000 CL5 lenses that Plastim will produce in 2011. Plastim’s goal is to first calculate the total costs and then the per-unit cost of designing, manufacturing, and distributing these lenses. Step 2: Identify the Direct Costs of the Products. Plastim identifies as direct costs of the lenses: direct material costs, direct manufacturing labor costs, and mold cleaning and maintenance costs because these costs can be economically traced to a specific lens or mold. Exhibit 5-5 shows the direct and indirect costs for the S3 and CL5 lenses using the ABC system. The direct costs calculations appear on lines 6, 7, 8, and 9 of Exhibit 5-5. Plastim classifies all other costs as indirect costs, as we will see in Exhibit 5-4. Step 3: Select the Activities and Cost-Allocation Bases to Use for Allocating Indirect Costs to the Products. Following guidelines 2 and 3 for refining a costing system, Plastim identifies six activities—(a) design, (b) molding machine setups, (c) machine operations, (d) shipment setup, (e) distribution, and (f) administration—for allocating indirect costs to products. Exhibit 5-4, column 2, shows the cost hierarchy category, and column 4

Exhibit 5-3

Overview of Plastim’s Activity-Based Costing System

Design Activity $450,000

Molding Machine Setup Activity $300,000

Molding Machine Operations Activity $637,500

Shipment Setup Activity $81,000

Distribution Activity $391,500

Administration Activity $255,000

100 PartsSquare feet

2,000 Setup-Hours

12,750 Molding Machine-Hours

200 Shipments

67,500 Cubic Feet Delivered

39,750 Direct Manufacturing Labor-Hours

$4,500 per partsquare foot

$150 per setup-hour

$50 per molding machine-hour

$405 per shipment

$5.80 per cubic foot delivered

$6.4151 per direct manufacturing labor-hour

STEP 4:

INDIRECT– COST POOL

STEP 3:

COST-ALLOCATION BASE

STEP 1:

COST OBJECT: S3 AND CL5 LENSES

S T E P 7

STEP 6: Indirect Costs

Direct Costs

STEP 2:

DIRECT COSTS

Direct Materials

Direct Manufacturing Labor

S T E P 5

Mold Cleaning and Maintenance

IMPLEMENTING ACTIVITY-BASED COSTING " 151

Exhibit 5-4

Activity-Cost Rates for Indirect-Cost Pools

Activity (1)

Design

Cost Hierarchy Category (2) Productsustaining

(Step 4) Total Budgeted Indirect Costs (3) $ 450,000

(

)

(Step 3)

Budgeted Quantity of Cost-Allocation Base (4) 100 parts-square feet

Setup molding machines

Batch-level

$ 300,000

2,000 setup-hours

Machine operations

Output unitlevel

$ 637,500

Shipment setup

Batch-level

$ 81,000

200 shipments

Distribution

Output-unitlevel

$ 391,500

150 per setup-hour Indirect setup costs increase with setup-hours. 50 per molding Indirect costs of operating molding machine-hour machines increases with molding machine-hours.

405 per shipment

Shipping costs incurred to prepare batches for shipment increase with the number of shipments.

67,500 cubic feet delivered

$ 5.80 per cubic foot delivered

Distribution costs increase with the cubic feet of packages delivered.

Administration

Facility sustaining

$ 255,000

39,750 direct manuf. labor-hours

$6.4151 per direct manuf. laborhour

The demand for administrative resources increases with direct manufacturing labor-hours.

12,750 molding machinehours

Cause-and-Effect Relationship Between Allocation Base and Budgeted Indirect Activity Cost Cost Rate ( 6) (5) = (3) ÷ (4) $ 4,500 per part-square Design Department indirect costs foot increase with more complex molds (more parts, larger surface area).

(Step 5)

shows the cost-allocation base and the budgeted quantity of the cost-allocation base for each activity described in column 1. Identifying the cost-allocation bases defines the number of activity pools into which costs must be grouped in an ABC system. For example, rather than define the design activities of product design, process design, and prototyping as separate activities, Plastim defines these three activities together as a combined “design” activity and forms a homogeneous design cost pool. Why? Because the same cost driver, the complexity of the mold, drives costs of each design activity. A second consideration for choosing a cost-allocation base is the availability of reliable data and measures. For example, in its ABC system, Plastim measures mold complexity in terms of the number of parts in the mold and the surface area of the mold (parts-square feet). If these data are difficult to obtain or measure, Plastim may be forced to use some other measure of complexity, such as the amount of material flowing through the mold that may only be weakly related to the cost of the design activity. Step 4: Identify the Indirect Costs Associated with Each Cost-Allocation Base. In this step, Plastim assigns budgeted indirect costs for 2011 to activities (see Exhibit 5-4, column 3), to the extent possible, on the basis of a cause-and-effect relationship between the cost-allocation base for an activity and the cost. For example, all costs that have a cause-and-effect relationship to cubic feet of packages moved are assigned to the distribution cost pool. Of course, the strength of the cause-and-effect relationship between the cost-allocation base and the cost of an activity varies across cost pools. For example, the cause-and-effect relationship between direct manufacturing labor-hours and administration activity costs is not as strong as the relationship between setup-hours and setup activity costs. Some costs can be directly identified with a particular activity. For example, cost of materials used when designing products, salaries paid to design engineers, and depreciation of equipment used in the design department are directly identified with the design activity. Other costs need to be allocated across activities. For example, on the basis of interviews or time records, manufacturing engineers and supervisors estimate the time they will spend on design, molding machine setup, and machine operations. The time to be spent on these activities serves as a basis for allocating each manufacturing engineer’s and supervisor’s salary

152 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

Exhibit 5-5

Plastim’s Product Costs Using Activity-Based Costing System

Cost Description Direct costs Direct materials Direct manufacturing labor Direct mold cleaning and maintenance costs Total direct costs (Step 2) Indirect Costs of Activities Design S3, 30 parts-sq.ft. × $4,500 CL5, 70 parts-sq.ft. × $4,500 Setup of molding machines S3, 500 setup-hours × $150 CL5, 1,500 setup-hours × $150 Machine operations S3, 9,000 molding machine-hours × $50 CL5, 3,750 molding machine-hours × $50 Shipment setup S3, 100 shipments × $405 CL5, 100 shipments × $405 Distribution S3, 45,000 cubic feet delivered × $5.80 CL5, 22,500 cubic feet delivered × $5.80 Administration S3, 30,000 dir. manuf. labor-hours × $6.4151

60,000 Simple Lenses (S3) Total per Unit (1) (2) = (1) ÷ 60,000

(

)

15,000 Complex Lenses (CL5) Total per Unit Total (3) (4) = (3) ÷ 15,000 (5) = (1) + (3)

$1,125,000 600,000 120,000

$18.75 10.00 2.00

$ 675,000 195,000 150,000

$ 45.00 13.00 10.00

$1,800,000 795,000 270,000

1,845,000

30.75

1,020,000

68.00

2,865,000

135,000

2.25 315,000

21.00

}

450,000

225,000

15.00

}

300,000

187,500

12.50

}

637,500

40,500

2.70

}

81,000

130,500

8.70

}

391,500

62,547

4.17

}

255,000

961,047 $1,981,047

64.07 $132.07

75,000

450,000

40,500

261,000

192,453

1.25

7.50

0.67

4.35

3.21

CL5, 9,750 dir. manuf. labor-hours × $6.4151 Total indirect costs allocated (Step 6) Total Costs (Step 7)

1,153,953 $2,998,953

19.23 $ 49.98

2,115,000 $ 4,980,000

costs to various activities. Still other costs are allocated to activity-cost pools using allocation bases that measure how these costs support different activities. For example, rent costs are allocated to activity cost pools on the basis of square-feet area used by different activities. The point here is that all costs do not fit neatly into activity categories. Often, costs may first need to be allocated to activities (Stage 1 of the 2-stage cost-allocation model) before the costs of the activities can be allocated to products (Stage 2). Step 5: Compute the Rate per Unit of Each Cost-Allocation Base. Exhibit 5-4, column 5, summarizes the calculation of the budgeted indirect cost rates using the budgeted quantity of the cost-allocation base from Step 3 and the total budgeted indirect costs of each activity from Step 4. Step 6: Compute the Indirect Costs Allocated to the Products. Exhibit 5-5 shows total budgeted indirect costs of $1,153,953 allocated to the simple lens and $961,047 allocated to the complex lens. Follow the budgeted indirect cost calculations for each lens in Exhibit 5-5. For each activity, Plastim’s operations personnel indicate the total quantity of the cost-allocation base that will be used by each type of lens (recall that Plastim operates at capacity). For example, lines 15 and 16 of Exhibit 5-5 show that of the 2,000 total

IMPLEMENTING ACTIVITY-BASED COSTING " 153

setup-hours, the S3 lens is budgeted to use 500 hours and the CL5 lens 1,500 hours. The budgeted indirect cost rate is $150 per setup-hour (Exhibit 5-4, column 5, line 5). Therefore, the total budgeted cost of the setup activity allocated to the S3 lens is $75,000 (500 setup-hours * $150 per setup-hour) and to the CL5 lens is $225,000 (1,500 setuphours * $150 per setup-hour). Budgeted setup cost per unit equals $1.25 ($75,000 ÷ 60,000 units) for the S3 lens and $15 ($225,000 ÷ 15,000 units) for the CL5 lens. Step 7: Compute the Total Cost of the Products by Adding All Direct and Indirect Costs Assigned to the Products. Exhibit 5-5 presents the product costs for the simple and complex lenses. The direct costs are calculated in Step 2, and the indirect costs are calculated in Step 6. The ABC system overview in Exhibit 5-3 shows three direct-cost categories and six indirect-cost categories. The budgeted cost of each lens type in Exhibit 5-5 has nine line items, three for direct costs and six for indirect costs. The differences between the ABC product costs of S3 and CL5 calculated in Exhibit 5-5 highlight how each of these products uses different amounts of direct and indirect costs in each activity area. We emphasize two features of ABC systems. First, these systems identify all costs used by products, whether the costs are variable or fixed in the short run. When making long-run strategic decisions using ABC information, managers want revenues to exceed total costs. Second, recognizing the hierarchy of costs is critical when allocating costs to products. It is easiest to use the cost hierarchy to first calculate the total costs of each product. The per-unit costs can then be derived by dividing total costs by the number of units produced.

Comparing Alternative Costing Systems

Decision Point How do managers cost products or services using ABC systems?

Exhibit 5-6 compares the simple costing system using a single indirect-cost pool (Exhibit 5-1 and Exhibit 5-2) Plastim had been using and the ABC system (Exhibit 5-3 and Exhibit 5-5). Note three points in Exhibit 5-6, consistent with the guidelines for Exhibit 5-6

Simple Costing System Using a Single Indirect-Cost Pool (1) Direct-cost categories

2 Direct materials Direct manufacturing labor

Total direct costs Indirect-cost pools

$2,595,000 1 Single indirect-cost pool allocated using direct manufacturing labor-hours

Total indirect costs Total costs assigned to simple (S3) lens Cost per unit of simple (S3) lens Total costs assigned to complex (CL5) lens Cost per unit of complex (CL5) lens

$2,385,000

ABC System (2)

Difference (3) ! (2) " (1)

3 1 Direct materials Direct manufacturing labor Direct mold cleaning and maintenance labor $2,865,000 $270,000 6 5 Design (parts-square feet)1 Molding machine setup (setup-hours) Machine operations (molding machine-hours) Shipment setup (number of shipments) Distribution (cubic feet delivered) Administration (direct manufacturing labor-hours) $2,115,000 ($270,000)

$3,525,000

$2,998,953

($526,047)

$58.75

$49.98

($8.77)

$1,455,000

$1,981,047

$526,047

$97.00

$132.07

$35.07

1Cost drivers for the various indirect-cost pools are shown in parentheses.

Comparing Alternative Costing Systems

154 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

refining a costing system: (1) ABC systems trace more costs as direct costs; (2) ABC systems create homogeneous cost pools linked to different activities; and (3) for each activity-cost pool, ABC systems seek a cost-allocation base that has a cause-and-effect relationship with costs in the cost pool. The homogeneous cost pools and the choice of cost-allocation bases, tied to the cost hierarchy, give Plastim’s managers greater confidence in the activity and product cost numbers from the ABC system. The bottom part of Exhibit 5-6 shows that allocating costs to lenses using only an output unit-level allocation base—direct manufacturing labor-hours, as in the single indirect-cost pool system used prior to ABC—overcosts the simple S3 lens by $8.77 per unit and undercosts the complex CL5 lens by $35.07 per unit. The CL5 lens uses a disproportionately larger amount of output unit-level, batchlevel, and product-sustaining costs than is represented by the direct manufacturing labor-hour cost-allocation base. The S3 lens uses a disproportionately smaller amount of these costs. The benefit of an ABC system is that it provides information to make better decisions. But this benefit must be weighed against the measurement and implementation costs of an ABC system.

Considerations in Implementing Activity-Based-Costing Systems Learning Objective

Evaluate the costs and benefits of implementing activitybased costing systems . . . measurement difficulties versus more accurate costs that aid in decision making

Managers choose the level of detail to use in a costing system by evaluating the expected costs of the system against the expected benefits that result from better decisions. There are telltale signs of when an ABC system is likely to provide the most benefits. Here are some of these signs: # #

Significant amounts of indirect costs are allocated using only one or two cost pools. All or most indirect costs are identified as output unit-level costs (few indirect costs are described as batch-level costs, product-sustaining costs, or facility-sustaining costs). Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity. Products that a company is well-suited to make and sell show small profits; whereas products that a company is less suited to produce and sell show large profits. Operations staff has substantial disagreement with the reported costs of manufacturing and marketing products and services.

When a company decides to implement ABC, it must make important choices about the level of detail to use. Should it choose many finely specified activities, cost drivers, and cost pools, or would a few suffice? For example, Plastim could identify a different molding machine-hour rate for each different type of molding machine. In making such choices, managers weigh the benefits against the costs and limitations of implementing a more detailed costing system. The main costs and limitations of an ABC system are the measurements necessary to implement it. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers for these pools to serve as cost-allocation bases. Even basic ABC systems require many calculations to determine costs of products and services. These measurements are costly. Activity cost rates also need to be updated regularly. As ABC systems get very detailed and more cost pools are created, more allocations are necessary to calculate activity costs for each cost pool. This increases the chances of misidentifying the costs of different activity cost pools. For example, supervisors are more prone to incorrectly identify the time they spent on different activities if they have to allocate their time over five activities rather than only two activities. At times, companies are also forced to use allocation bases for which data are readily available rather than allocation bases they would have liked to use. For example, a company might be forced to use the number of loads moved, instead of the degree of difficulty and distance of different loads moved, as the allocation base for

IMPLEMENTING ACTIVITY-BASED COSTING " 155

Concepts in Action

Successfully Championing ABC

Successfully implementing ABC systems requires more than an understanding of the technical details. ABC implementation often represents a significant change in the costing system and, as the chapter indicates, it requires a manager to make major choices with respect to the definition of activities and the level of detail. What then are some of the behavioral issues that the management accountant must be sensitive to? 1. Gaining support of top management and creating a sense of urgency for the ABC effort. This requires management accountants to lay out the vision for the ABC project and to clearly communicate its strategic benefits (for example, the resulting improvements in product and process design). It also requires selling the idea to end users and working with members of other departments as business partners of the managers in the various areas affected by the ABC project. For example, at USAA Federal Savings Bank, project managers demonstrated how the information gained from ABC would provide insights into the efficiency of bank operations, which was previously unavailable. Now the finance area communicates regularly with operations about new reports and proposed changes to the financial reporting package that managers receive. 2. Creating a guiding coalition of managers throughout the value chain for the ABC effort. ABC systems measure how the resources of an organization are used. Managers responsible for these resources have the best knowledge about activities and cost drivers. Getting managers to cooperate and take the initiative for implementing ABC is essential for gaining the required expertise, the proper credibility, and the necessary leadership. Gaining wider participation among managers has other benefits. Managers who feel more involved in the process are likely to commit more time to and be less skeptical of the ABC effort. Engaging managers throughout the value chain also creates greater opportunities for coordination and cooperation across the different functions, for example, design and manufacturing. 3. Educating and training employees in ABC as a basis for employee empowerment. Disseminating information about ABC throughout an organization allows workers in all areas of a business to use their knowledge of ABC to make improvements. For example, WS Industries, an Indian manufacturer of insulators, not only shared ABC information with its workers but also established an incentive plan that gave employees a percentage of the cost savings. The results were dramatic because employees were empowered and motivated to implement numerous cost-saving projects. 4. Seeking small short-run successes as proof that the ABC implementation is yielding results. Too often, managers and management accountants seek big results and major changes far too quickly. In many situations, achieving a significant change overnight is difficult. However, showing how ABC information has helped improve a process and save costs, even if only in small ways, motivates the team to stay on course and build momentum. The credibility gained from small victories leads to additional and bigger improvements involving larger numbers of people and different parts of the organization. Eventually ABC and ABM become rooted in the culture of the organization. Sharing shortterm successes may also help motivate employees to be innovative. At USAA Federal Savings Bank, managers created a “process improvement” mailbox in Microsoft Outlook to facilitate the sharing of process improvement ideas. 5. Recognizing that ABC information is not perfect because it balances the need for better information against the costs of creating a complex system that few managers and employees can understand. The management accountant must help managers recognize both the value and the limitations of ABC and not oversell it. Open and honest communication about ABC ensures that managers use ABC thoughtfully to make good decisions. Critical judgments can then be made without being adversarial, and tough questions can be asked to help drive better decisions about the system.

material-handling costs, because data on degree of difficulty and distance of moves are difficult to obtain. When erroneous cost-allocation bases are used, activity-cost information can be misleading. For example, if the cost per load moved decreases, a company may conclude that it has become more efficient in its materials-handling operations. In fact, the lower cost per load move may have resulted solely from moving many lighter loads over shorter distances. Many companies, such as Kanthal, the Swedish manufacturer of heating elements, have found the strategic and operational benefits of a less-detailed ABC system to be good enough to not warrant incurring the costs and challenges of operating a more-detailed system. Other organizations, such as Hewlett-Packard, implement ABC in chosen divisions or functions. As improvements in information technology and accompanying

156 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

Decision Point What should managers consider when deciding to implement ABC systems?

declines in measurement costs continue, more-detailed ABC systems have become a practical alternative in many companies. As such trends persist, more detailed ABC systems will be better able to pass the cost–benefit test. Global surveys of company practice suggest that ABC implementation varies among companies. Nevertheless, its framework and ideas provide a standard for judging whether any simple costing system is good enough for a particular management’s purposes. Any contemplated changes in a simple costing system will inevitably be improved by ABC thinking. The Concepts in Action box on page 155 describes some of the behavioral issues that management accountants must be sensitive to as they seek to immerse an organization in ABC thinking.

Using ABC Systems for Improving Cost Management and Profitability Learning Objective

Explain how activitybased costing systems are used in activitybased management . . . such as pricing decisions, product-mix decisions, and cost reduction

The emphasis of this chapter so far has been on the role of ABC systems in obtaining better product costs. However, Plastim’s managers must now use this information to make decisions (Step 4 of the 5-step decision process, p. 145) and to implement the decision, evaluate performance, and learn (Step 5, p. 145). Activity-based management (ABM) is a method of management decision making that uses activity-based costing information to improve customer satisfaction and profitability. We define ABM broadly to include decisions about pricing and product mix, cost reduction, process improvement, and product and process design.

Pricing and Product-Mix Decisions An ABC system gives managers information about the costs of making and selling diverse products. With this information, managers can make pricing and product-mix decisions. For example, the ABC system indicates that Plastim can match its competitor’s price of $53 for the S3 lens and still make a profit because the ABC cost of S3 is $49.98 (see Exhibit 5-5). Plastim’s managers offer Giovanni Motors a price of $52 for the S3 lens. Plastim’s managers are confident that they can use the deeper understanding of costs that the ABC system provides to improve efficiency and further reduce the cost of the S3 lens. Without information from the ABC system, Plastim managers might have erroneously concluded that they would incur an operating loss on the S3 lens at a price of $53. This incorrect conclusion would have probably caused Plastim to reduce its business in simple lenses and focus instead on complex lenses, where its single indirect-cost-pool system indicated it is very profitable. Focusing on complex lenses would have been a mistake. The ABC system indicates that the cost of making the complex lens is much higher—$132.07 versus $97 indicated by the direct manufacturing labor-hour-based costing system Plastim had been using. As Plastim’s operations staff had thought all along, Plastim has no competitive advantage in making CL5 lenses. At a price of $137 per lens for CL5, the profit margin is very small ($137.00 – $132.07 = $4.93). As Plastim reduces its prices on simple lenses, it would need to negotiate a higher price for complex lenses with Giovanni Motors.

Cost Reduction and Process Improvement Decisions Manufacturing and distribution personnel use ABC systems to focus on how and where to reduce costs. Managers set cost reduction targets in terms of reducing the cost per unit of the cost-allocation base in different activity areas. For example, the supervisor of the distribution activity area at Plastim could have a performance target of decreasing distribution cost per cubic foot of products delivered from $5.80 to $5.40 by reducing distribution labor and warehouse rental costs. The goal is to reduce these costs by improving the way work is done without compromising customer service or the actual or perceived value (usefulness) customers obtain from the product or service. That is, Plastim will

USING ABC SYSTEMS FOR IMPROVING COST MANAGEMENT AND PROFITABILITY " 157

attempt to take out only those costs that are nonvalue added. Controlling physical cost drivers, such as setup-hours or cubic feet delivered, is another fundamental way that operating personnel manage costs. For example, Plastim can decrease distribution costs by packing the lenses in a way that reduces the bulkiness of the packages delivered. The following table shows the reduction in distribution costs of the S3 and CL5 lenses as a result of actions that lower cost per cubic foot delivered (from $5.80 to $5.40) and total cubic feet of deliveries (from 45,000 to 40,000 for S3 and 22,500 to 20,000 for CL5). 60,000 (S3) Lenses Total per Unit (1) (2) = (1) ÷ 60,000 Distribution costs (from Exhibit 5-5) S3, 45,000 cubic feet * $5.80/cubic foot $261,000 CL5, 22,500 cubic feet * $5.80/cubic foot Distribution costs as a result of process improvements S3, 40,000 cubic feet * $5.40/cubic foot 216,000 CL5, 20,000 cubic feet * $5.40/cubic foot ƒƒƒƒƒƒƒƒ Savings in distribution costs from process improvements $ƒ45,000

15,000 (CL5) Lenses Total per Unit (3) (4) = (3) ÷ 15,000

$4.35

3.60 ƒƒƒƒƒ $0.75

$130,500

$8.70

ƒ108,000 $ƒ22,500

ƒ7.20 $1.50

In the long run, total distribution costs will decrease from $391,500 ($261,000 + $130,500) to $324,000 ($216,000 + $108,000). In the short run, however, distribution costs may be fixed and may not decrease. Suppose all $391,500 of distribution costs are fixed costs in the short run. The efficiency improvements (using less distribution labor and space) mean that the same $391,500 of distribution costs can now be used to distribute $391,500 72,500 a b cubic feet of lenses. In this case, how should costs be $5.40 per cubic feet allocated to the S3 and CL5 lenses? ABC systems distinguish costs incurred from resources used to design, manufacture, and deliver products and services. For the distribution activity, after process improvements, Costs incurred = $391,500 Resources used = $216,000 (for S3 lens) + $108,000 (for CL5 lens) = $324,000

On the basis of the resources used by each product, Plastim’s ABC system allocates $216,000 to S3 and $108,000 to CL5 for a total of $324,000. The difference of $67,500 ($391,500 – $324,000) is shown as costs of unused but available distribution capacity. Plastim’s ABC system does not allocate the costs of unused capacity to products so as not to burden the product costs of S3 and CL5 with the cost of resources not used by these products. Instead, the system highlights the amount of unused capacity as a separate line item to signal to managers the need to reduce these costs, such as by redeploying labor to other uses or laying off workers. Chapter 9 discusses issues related to unused capacity in more detail.

Design Decisions Management can evaluate how its current product and process designs affect activities and costs as a way of identifying new designs to reduce costs. For example, design decisions that decrease complexity of the mold reduce costs of design, materials, labor, machine setups, machine operations, and mold cleaning and maintenance. Plastim’s customers may be willing to give up some features of the lens in exchange for a lower price. Note that Plastim’s previous costing system, which used direct manufacturing laborhours as the cost-allocation base for all indirect costs, would have mistakenly signaled that Plastim choose those designs that most reduce direct manufacturing labor-hours when, in fact, there is a weak cause-and-effect relationship between direct manufacturing labor-hours and indirect costs.

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Planning and Managing Activities

Decision Point How can ABC systems be used to manage better?

Many companies implementing ABC systems for the first time analyze actual costs to identify activity-cost pools and activity-cost rates. To be useful for planning, making decisions, and managing activities, companies calculate a budgeted cost rate for each activity and use these budgeted cost rates to cost products as we saw in the Plastim example. At year-end, budgeted costs and actual costs are compared to provide feedback on how well activities were managed and to make adjustments for underallocated or overallocated indirect costs for each activity using methods described in Chapter 4. As activities and processes are changed, new activity-cost rates are calculated. We will return to activity-based management in later chapters. Management decisions that use activity-based costing information are described in Chapter 6, in which we discuss activity-based budgeting; Chapter 11, in which we discuss outsourcing and adding or dropping business segments; in Chapter 12, in which we evaluate alternative design choices to improve efficiency and reduce nonvalue-added costs; in Chapter 13, in which we cover reengineering and downsizing; in Chapter 14, in which we explore managing customer profitability; in Chapter 19, in which we explain quality improvements; and in Chapter 20, in which we describe how to evaluate suppliers.

Activity-Based Costing and Department Costing Systems Learning Objective

Compare activity-based costing systems and department costing systems . . . activity-based costing systems are a refinement of department costing systems into morefocused and homogenous cost pools

Companies often use costing systems that have features of ABC systems—such as multiple cost pools and multiple cost-allocation bases—but that do not emphasize individual activities. Many companies have evolved their costing systems from using a single indirect cost rate system to using separate indirect cost rates for each department (such as design, manufacturing, distribution, and so on) or each subdepartment (such as machining and assembly departments within manufacturing) that can be thought of as representing broad tasks. ABC systems, with its focus on specific activities, are a further refinement of department costing systems. In this section, we compare ABC systems and department costing systems. Plastim uses the design department indirect cost rate to cost its design activity. Plastim calculates the design activity rate by dividing total design department costs by total parts-square feet, a measure of the complexity of the mold and the driver of design department costs. Plastim does not find it worthwhile to calculate separate activity rates within the design department for the different design activities, such as designing products, making temporary molds, and designing processes. Why? Because complexity of a mold is an appropriate cost-allocation base for costs incurred in each design activity. Design department costs are homogeneous with respect to this costallocation base. In contrast, the manufacturing department identifies two activity cost pools—a setup cost pool and a machine operations cost pool—instead of a single manufacturing department overhead cost pool. It identifies these activity cost pools for two reasons. First, each of these activities within manufacturing incurs significant costs and has a different cost driver, setup-hours for the setup cost pool and machine-hours for the machine operations cost pool. Second, the S3 and CL5 lenses do not use resources from these two activity areas in the same proportion. For example, CL5 uses 75% (1,500 ÷ 2,000) of the setuphours but only 29.4% (3,750 ÷ 12,750) of the machine-hours. Using only machine-hours, say, to allocate all manufacturing department costs at Plastim would result in CL5 being undercosted because it would not be charged for the significant amounts of setup resources it actually uses. Based on what we just explained, using department indirect cost rates to allocate costs to products results in similar information as activity cost rates if (1) a single activity accounts for a sizable proportion of the department’s costs; or (2) significant costs are incurred on different activities within a department, but each activity has the same cost driver and hence cost-allocation base (as was the case in Plastim’s design department). From a purely product costing standpoint, department and activity indirect cost rates

ABC IN SERVICE AND MERCHANDISING COMPANIES " 159

will also result in the same product costs if (1) significant costs are incurred for different activities with different cost-allocation bases within a department but (2) different products use resources from the different activity areas in the same proportions (for example, if CL5 had used 65%, say, of the setup-hours and 65% of the machine-hours). In this case, though, not identifying activities and cost drivers within departments conceals activity cost information that would be valuable for cost management and design and process improvements. We close this section with a note of caution. Do not assume that because department costing systems require the creation of multiple indirect cost pools that they properly recognize the drivers of costs within departments as well as how resources are used by products. As we have indicated, in many situations, department costing systems can be refined using ABC. Emphasizing activities leads to more-focused and homogeneous cost pools, aids in identifying cost-allocation bases for activities that have a better cause-andeffect relationship with the costs in activity cost pools, and leads to better design and process decisions. But these benefits of an ABC system would need to be balanced against its costs and limitations.

ABC in Service and Merchandising Companies Although many of the early examples of ABC originated in manufacturing, ABC has many applications in service and merchandising companies. In addition to manufacturing activities, the Plastim example includes the application of ABC to a service activity—design— and to a merchandising activity—distribution. Companies such as the Cooperative Bank, Braintree Hospital, BCTel in the telecommunications industry, and Union Pacific in the railroad industry have implemented some form of ABC system to identify profitable product mixes, improve efficiency, and satisfy customers. Similarly, many retail and wholesale companies—for example, Supervalu, a retailer and distributor of grocery store products, and Owens and Minor, a medical supplies distributor—have used ABC systems. Finally, as we describe in Chapter 14, a large number of financial services companies (as well as other companies) employ variations of ABC systems to analyze and improve the profitability of their customer interactions. The widespread use of ABC systems in service and merchandising companies reinforces the idea that ABC systems are used by managers for strategic decisions rather than for inventory valuation. (Inventory valuation is fairly straightforward in merchandising companies and not needed in service companies.) Service companies, in particular, find great value from ABC because a vast majority of their cost structure comprises indirect costs. After all, there are few direct costs when a bank makes a loan, or when a representative answers a phone call at a call center. As we have seen, a major benefit of ABC is its ability to assign indirect costs to cost objects by identifying activities and cost drivers. As a result, ABC systems provide greater insight than traditional systems into the management of these indirect costs. The general approach to ABC in service and merchandising companies is similar to the ABC approach in manufacturing. The Cooperative Bank followed the approach described in this chapter when it implemented ABC in its retail banking operations. It calculated the costs of various activities, such as performing ATM transactions, opening and closing accounts, administering mortgages, and processing Visa transactions. It then used the activity cost rates to calculate costs of various products, such as checking accounts, mortgages, and Visa cards and the costs of supporting different customers. ABC information helped the Cooperative Bank to improve its processes and to identify profitable products and customer segments. The Concepts in Action feature on page 160 describes how Charles Schwab has similarly benefited from using ABC analysis. Activity-based costing raises some interesting issues when it is applied to a public service institution such as the U.S. Postal Service. The costs of delivering mail to remote locations are far greater than the costs of delivering mail within urban areas. However, for fairness and community-building reasons, the Postal Service cannot charge higher prices to customers in remote areas. In this case, activity-based costing is valuable for understanding, managing, and reducing costs but not for pricing decisions.

Decision Point When can department costing systems be used instead of ABC systems?

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Concepts in Action

Time-Driven Activity-Based Costing at Charles Schwab

Time-driven activity-based costing (“TDABC”) helps Charles Schwab, the leading stock brokerage, with strategic-analysis, measurement, and management of its stock trading activity across multiple channels such as branches, call centers, and the Internet. Because the costs for each channel are different, TDABC helps answer questions such as the following: What are the total costs of branch transactions versus online transactions? Which channels help reduce overall costs? How can Charles Schwab price its services to drive changes in customer behavior? TDABC assigns all of the company’s resource costs to cost objects using a framework that requires two sets of estimates. TDABC first calculates the cost of supplying resource capacity, such as broker time. The total cost of resources including personnel, management, occupancy, technology, and supplies is divided by the available capacity—the time available for brokers to do the work—to obtain the capacity cost rate. Next, TDABC uses the capacity cost rate to drive resource costs to cost objects, such as stock trades executed through brokers at a branch, by estimating the demand for resource capacity (time) that the cost object requires. Realizing that trades executed online cost much less than trades completed through brokers, Charles Schwab developed a fee structure for trading of mutual funds to stimulate the use of cheaper channels. Charles Schwab also used TDABC information to lower process costs by several hundred million dollars annually and to better align product pricing and account management to the company’s diverse client segments. The company is working on other opportunities, including priority-call routing and email marketing, to further reduce costs while maintaining or enhancing Charles Schwab’s already top-rated customer service. Sources: Kaplan, R. S. and S. R., Anderson. 2007. The innovation of time-driven activity-based costing. Cost Management, March–April: 5–15; Kaplan R. S. and S.R. Anderson. 2007. Time-driven activity-based costing. Boston, MA: Harvard Business School Press; Martinez-Jerez, F. Asis. 2007. Understanding customer profitability at Charles Schwab. Harvard Business School Case Study No. 9-106-102, January.

Problem for Self-Study Family Supermarkets (FS) has decided to increase the size of its Memphis store. It wants information about the profitability of individual product lines: soft drinks, fresh produce, and packaged food. FS provides the following data for 2011 for each product line:

Revenues Cost of goods sold Cost of bottles returned Number of purchase orders placed Number of deliveries received Hours of shelf-stocking time Items sold

Soft Drinks $317,400 $240,000 $ 4,800 144 120 216 50,400

Fresh Produce $840,240 $600,000 $ 0 336 876 2,160 441,600

Packaged Food $483,960 $360,000 $ 0 144 264 1,080 122,400

PROBLEM FOR SELF-STUDY " 161

FS also provides the following information for 2011:

Activity (1) 1. Bottle returns

Description of Activity (2) Returning of empty bottles to store

2. Ordering 3. Delivery

Placing of orders for purchases Physical delivery and receipt of merchandise Stocking of merchandise on store shelves and ongoing restocking Assistance provided to customers, including checkout and bagging

4. Shelf-stocking 5. Customer support Total

Total Support Costs Cost-Allocation Base (3) (4) $ 4,800 Direct tracing to softdrink line $ 62,400 624 purchase orders $100,800 1,260 deliveries $ 69,120 $122,880

3,456 hours of shelfstocking time 614,400 items sold

$360,000

1. Family Supermarkets currently allocates store support costs (all costs other than cost of goods sold) to product lines on the basis of cost of goods sold of each product line. Calculate the operating income and operating income as a percentage of revenues for each product line. 2. If Family Supermarkets allocates store support costs (all costs other than cost of goods sold) to product lines using an ABC system, calculate the operating income and operating income as a percentage of revenues for each product line. 3. Comment on your answers in requirements 1 and 2.

Solution 1. The following table shows the operating income and operating income as a percentage of revenues for each product line. All store support costs (all costs other than cost of goods sold) are allocated to product lines using cost of goods sold of each product line as the cost-allocation base. Total store support costs equal $360,000 (cost of bottles returned, $4,800 + cost of purchase orders, $62,400 + cost of deliveries, $100,800 + cost of shelf-stocking, $69,120 + cost of customer support, $122,880). The allocation rate for store support costs = $360,000 ÷ $1,200,000 (soft drinks $240,000 + fresh produce $600,000 + packaged food, $360,000) = 30% of cost of goods sold. To allocate support costs to each product line, FS multiplies the cost of goods sold of each product line by 0.30.

Revenues Cost of goods sold Store support cost ($240,000; $600,000; $360,000) * 0.30 Total costs Operating income Operating income ÷ Revenues

Soft Drinks

Fresh Produce

Packaged Food

Total

$317,400 240,000

$840,240 600,000

$483,960 360,000

$1,641,600 1,200,000

ƒƒ72,000 ƒ312,000 $ƒƒ5,400 1.70%

ƒ180,000 ƒ780,000 $ƒ60,240 7.17%

ƒ108,000 ƒ468,000 $ƒ15,960 3.30%

ƒƒƒ360,000 ƒ1,560,000 $ƒƒƒ81,600 4.97%

Required

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2. Under an ABC system, FS identifies bottle-return costs as a direct cost because these costs can be traced to the soft drink product line. FS then calculates cost-allocation rates for each activity area (as in Step 5 of the seven-step costing system, described in the chapter, p. 152). The activity rates are as follows:

Activity (1) Ordering Delivery Shelf-stocking Customer support

Cost Hierarchy (2) Batch-level Batch-level Output unit-level Output unit-level

Total Costs (3) $ 62,400 $100,800 $ 69,120 $122,880

Quantity of Cost-Allocation Base Overhead Allocation Rate (4) (5) = (3) ÷ (4) 624 purchase orders $100 per purchase order 1,260 deliveries $80 per delivery 3,456 shelf-stocking-hours $20 per stocking-hour 614,400 items sold $0.20 per item sold

Store support costs for each product line by activity are obtained by multiplying the total quantity of the cost-allocation base for each product line by the activity cost rate. Operating income and operating income as a percentage of revenues for each product line are as follows:

Revenues Cost of goods sold Bottle-return costs Ordering costs (144; 336; 144) purchase orders * $100 Delivery costs (120; 876; 264) deliveries * $80 Shelf-stocking costs (216; 2,160; 1,080) stocking-hours * $20 Customer-support costs (50,400; 441,600; 122,400) items sold * $0.20 Total costs Operating income Operating income ÷ Revenues

Soft Drinks $317,400 240,000 4,800

Fresh Produce $840,240 600,000 0

Packaged Food Total $483,960 $1,641,600 360,000 1,200,000 0 4,800

14,400

33,600

14,400

62,400

9,600

70,080

21,120

100,800

4,320

43,200

21,600

69,120

ƒƒ10,080 ƒ283,200 $ƒ34,200 10.78%

ƒƒ88,320 ƒ835,200 $ƒƒ5,040 0.60%

ƒƒ24,480 ƒ441,600 $ƒ42,360 8.75%

122,880 ƒ1,560,000 $ƒƒƒ81,600 4.97%

3. Managers believe the ABC system is more credible than the simple costing system. The ABC system distinguishes the different types of activities at FS more precisely. It also tracks more accurately how individual product lines use resources. Rankings of relative profitability—operating income as a percentage of revenues—of the three product lines under the simple costing system and under the ABC system are as follows: Simple Costing System 1. Fresh produce 7.17% 2. Packaged food 3.30% 3. Soft drinks 1.70%

ABC System 1. Soft drinks 10.78% 2. Packaged food 8.75% 3. Fresh produce 0.60%

The percentage of revenues, cost of goods sold, and activity costs for each product line are as follows: Revenues Cost of goods sold Bottle returns Activity areas: Ordering Delivery Shelf-stocking Customer-support

Soft Drinks 19.34% 20.00 100.00 23.08 9.53 6.25 8.20

Fresh Produce 51.18% 50.00 0 53.84 69.52 62.50 71.88

Packaged Food 29.48% 30.00 0 23.08 20.95 31.25 19.92

DECISION POINTS " 163

Soft drinks have fewer deliveries and require less shelf-stocking time and customer support than either fresh produce or packaged food. Most major soft-drink suppliers deliver merchandise to the store shelves and stock the shelves themselves. In contrast, the fresh produce area has the most deliveries and consumes a large percentage of shelf-stocking time. It also has the highest number of individual sales items and so requires the most customer support. The simple costing system assumed that each product line used the resources in each activity area in the same ratio as their respective individual cost of goods sold to total cost of goods sold. Clearly, this assumption is incorrect. Relative to cost of goods sold, soft drinks and packaged food use fewer resources while fresh produce uses more resources. As a result, the ABC system reduces the costs assigned to soft drinks and packaged food and increases the costs assigned to fresh produce. The simple costing system is an example of averaging that is too broad. FS managers can use the ABC information to guide decisions such as how to allocate a planned increase in floor space. An increase in the percentage of space allocated to soft drinks is warranted. Note, however, that ABC information should be but one input into decisions about shelf-space allocation. FS may have minimum limits on the shelf space allocated to fresh produce because of shoppers’ expectations that supermarkets will carry products from this product line. In many situations, companies cannot make product decisions in isolation but must consider the effect that dropping or deemphasizing a product might have on customer demand for other products. Pricing decisions can also be made in a more informed way with ABC information. For example, suppose a competitor announces a 5% reduction in soft-drink prices. Given the 10.78% margin FS currently earns on its soft-drink product line, it has flexibility to reduce prices and still make a profit on this product line. In contrast, the simple costing system erroneously implied that soft drinks only had a 1.70% margin, leaving little room to counter a competitor’s pricing initiatives.

Guidelines

1. When does product undercosting or overcosting occur?

Product undercosting (overcosting) occurs when a product or service consumes a high (low) level of resources but is reported to have a low (high) cost. Broad averaging, or peanut-butter costing, a common cause of undercosting or overcosting, is the result of using broad averages that uniformly assign, or spread, the cost of resources to products when the individual products use those resources in a nonuniform way. Product-cost cross-subsidization exists when one undercosted (overcosted) product results in at least one other product being overcosted (undercosted).

2. How do managers refine a costing system?

Refining a costing system means making changes that result in cost numbers that better measure the way different cost objects, such as products, use different amounts of resources of the company. These changes can require additional direct-cost tracing, the choice of more-homogeneous indirect cost pools, or the use of cost drivers as cost-allocation bases.

3. What is the difference between the design of a simple costing system and an activity-based costing (ABC) system?

The ABC system differs from the simple system by its fundamental focus on activities. The ABC system typically has more-homogeneous indirect-cost pools than the simple system, and more cost drivers are used as cost-allocation bases.

164 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

4. What is a cost hierarchy?

A cost hierarchy categorizes costs into different cost pools on the basis of the different types of cost-allocation bases or different degrees of difficulty in determining cause-and-effect (or benefits-received) relationships. A four-part hierarchy to cost products consists of output unit-level costs, batch-level costs, product-sustaining or service-sustaining costs, and facility-sustaining costs.

5. How do managers cost products or services using ABC systems?

In ABC, costs of activities are used to assign costs to other cost objects such as products or services based on the activities the products or services consume.

6. What should managers consider when deciding to implement ABC systems?

ABC systems are likely to yield the most decision-making benefits when indirect costs are a high percentage of total costs or when products and services make diverse demands on indirect resources. The main costs of ABC systems are the difficulties of the measurements necessary to implement and update the systems.

7. How can ABC systems be used to manage better?

Activity-based management (ABM) is a management method of decision making that uses ABC information to satisfy customers and improve profits. ABC systems are used for such management decisions as pricing, product-mix, cost reduction, process improvement, product and process redesign, and planning and managing activities.

8. When can department costing systems be used instead of ABC systems?

Activity-based costing systems are a refinement of department costing systems into more-focused and homogeneous cost pools. Cost information in department costing systems approximates cost information in ABC systems only when each department has a single activity (or a single activity accounts for a significant proportion of department costs), a single cost driver for different activities, or when different products use the different activities of the department in the same proportions.

Terms to Learn This chapter and the Glossary at the end of this book contain definitions of the following important terms: activity (p. 146) activity-based costing (ABC) (p. 146) activity-based management (ABM) (p. 156) batch-level costs (p. 149)

cost hierarchy (p. 149) facility-sustaining costs (p. 149) output unit-level costs (p. 149) product-cost cross-subsidization (p. 140)

product overcosting (p. 140) product-sustaining costs (p. 149) product undercosting (p. 140) refined costing system (p. 145) service-sustaining costs (p. 149)

Assignment Material Questions 5-1 5-2 5-3 5-4 5-5 5-6 5-7

What is broad averaging and what consequences can it have on costs? Why should managers worry about product overcosting or undercosting? What is costing system refinement? Describe three guidelines for refinement. What is an activity-based approach to designing a costing system? Describe four levels of a cost hierarchy. Why is it important to classify costs into a cost hierarchy? What are the key reasons for product cost differences between simple costing systems and ABC systems? 5-8 Describe four decisions for which ABC information is useful. 5-9 “Department indirect-cost rates are never activity-cost rates.” Do you agree? Explain. 5-10 Describe four signs that help indicate when ABC systems are likely to provide the most benefits.

ASSIGNMENT MATERIAL " 165

5-11 What are the main costs and limitations of implementing ABC systems? 5-12 “ABC systems only apply to manufacturing companies.” Do you agree? Explain. 5-13 “Activity-based costing is the wave of the present and the future. All companies should adopt it.” Do you agree? Explain.

5-14 “Increasing the number of indirect-cost pools is guaranteed to sizably increase the accuracy of product or service costs.” Do you agree? Why?

5-15 The controller of a retail company has just had a $50,000 request to implement an ABC system quickly turned down. A senior vice president, in rejecting the request, noted, “Given a choice, I will always prefer a $50,000 investment in improving things a customer sees or experiences, such as our shelves or our store layout. How does a customer benefit by our spending $50,000 on a supposedly better accounting system?” How should the controller respond?

Exercises 5-16 Cost hierarchy. Hamilton, Inc., manufactures boom boxes (music systems with radio, cassette, and compact disc players) for several well-known companies. The boom boxes differ significantly in their complexity and their manufacturing batch sizes. The following costs were incurred in 2011: a. Indirect manufacturing labor costs such as supervision that supports direct manufacturing labor, $1,450,000 b. Procurement costs of placing purchase orders, receiving materials, and paying suppliers related to the number of purchase orders placed, $850,000 c. Cost of indirect materials, $275,000 d. Costs incurred to set up machines each time a different product needs to be manufactured, $630,000 e. Designing processes, drawing process charts, making engineering process changes for products, $775,000 f. Machine-related overhead costs such as depreciation, maintenance, production engineering, $1,500,000 (These resources relate to the activity of running the machines.) g. Plant management, plant rent, and plant insurance, $925,000 1. Classify each of the preceding costs as output unit-level, batch-level, product-sustaining, or facilitysustaining. Explain each answer. 2. Consider two types of boom boxes made by Hamilton, Inc. One boom box is complex to make and is produced in many batches. The other boom box is simple to make and is produced in few batches. Suppose that Hamilton needs the same number of machine-hours to make each type of boom box and that Hamilton allocates all overhead costs using machine-hours as the only allocation base. How, if at all, would the boom boxes be miscosted? Briefly explain why. 3. How is the cost hierarchy helpful to Hamilton in managing its business?

Required

5-17 ABC, cost hierarchy, service. (CMA, adapted) Vineyard Test Laboratories does heat testing (HT) and stress testing (ST) on materials and operates at capacity. Under its current simple costing system, Vineyard aggregates all operating costs of $1,190,000 into a single overhead cost pool. Vineyard calculates a rate per test-hour of $17 ($1,190,000 ÷ 70,000 total test-hours). HT uses 40,000 test-hours, and ST uses 30,000 test-hours. Gary Celeste, Vineyard’s controller, believes that there is enough variation in test procedures and cost structures to establish separate costing and billing rates for HT and ST. The market for test services is becoming competitive. Without this information, any miscosting and mispricing of its services could cause Vineyard to lose business. Celeste divides Vineyard’s costs into four activity-cost categories. a. Direct-labor costs, $146,000. These costs can be directly traced to HT, $100,000, and ST, $46,000. b. Equipment-related costs (rent, maintenance, energy, and so on), $350,000. These costs are allocated to HT and ST on the basis of test-hours. c. Setup costs, $430,000. These costs are allocated to HT and ST on the basis of the number of setuphours required. HT requires 13,600 setup-hours, and ST requires 3,600 setup-hours. d. Costs of designing tests, $264,000. These costs are allocated to HT and ST on the basis of the time required for designing the tests. HT requires 3,000 hours, and ST requires 1,400 hours. 1. Classify each activity cost as output unit-level, batch-level, product- or service-sustaining, or facilitysustaining. Explain each answer. 2. Calculate the cost per test-hour for HT and ST. Explain briefly the reasons why these numbers differ from the $17 per test-hour that Vineyard calculated using its simple costing system. 3. Explain the accuracy of the product costs calculated using the simple costing system and the ABC system. How might Vineyard’s management use the cost hierarchy and ABC information to better manage its business?

Required

166 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

5-18 Alternative allocation bases for a professional services firm. The Walliston Group (WG) provides tax advice to multinational firms. WG charges clients for (a) direct professional time (at an hourly rate) and (b) support services (at 30% of the direct professional costs billed). The three professionals in WG and their rates per professional hour are as follows: Professional Max Walliston Alexa Boutin Jacob Abbington

Billing Rate per Hour $640 220 100

WG has just prepared the May 2011 bills for two clients. The hours of professional time spent on each client are as follows:

Professional Walliston Boutin Abbington Total Required

Hours per Client San Antonio Dominion Amsterdam Enterprises 26 4 5 14 39 52 70 70

1. What amounts did WG bill to San Antonio Dominion and Amsterdam Enterprises for May 2011? 2. Suppose support services were billed at $75 per professional labor-hour (instead of 30% of professional labor costs). How would this change affect the amounts WG billed to the two clients for May 2011? Comment on the differences between the amounts billed in requirements 1 and 2. 3. How would you determine whether professional labor costs or professional labor-hours is the more appropriate allocation base for WG’s support services?

5-19 Plant-wide, department, and ABC indirect cost rates. Automotive Products (AP) designs and produces automotive parts. In 2011, actual variable manufacturing overhead is $308,600. AP’s simple costing system allocates variable manufacturing overhead to its three customers based on machine-hours and prices its contracts based on full costs. One of its customers has regularly complained of being charged noncompetitive prices, so AP’s controller Devon Smith realizes that it is time to examine the consumption of overhead resources more closely. He knows that there are three main departments that consume overhead resources: design, production, and engineering. Interviews with the department personnel and examination of time records yield the following detailed information:

Department Design Production Engineering Total

Required

Cost Driver CAD-design-hours Engineering-hours Machine-hours

Variable Manufacturing Overhead in 2011 $ 39,000 29,600 240,000 $308,600

(

)

Usage of Cost Drivers by Customer Contract United Holden Leland Motors Motors Vehicle 110 70 120

200 60 2,800

80 240 1,080

1. Compute the variable manufacturing overhead allocated to each customer in 2011 using the simple costing system that uses machine-hours as the allocation base. 2. Compute the variable manufacturing overhead allocated to each customer in 2011 using departmentbased variable manufacturing overhead rates. 3. Comment on your answers in requirements 1 and 2. Which customer do you think was complaining about being overcharged in the simple system? If the new department-based rates are used to price contracts, which customer(s) will be unhappy? How would you respond to these concerns?

ASSIGNMENT MATERIAL " 167

4. How else might AP use the information available from its department-by-department analysis of variable manufacturing overhead costs? 5. AP’s managers are wondering if they should further refine the department-by-department costing system into an ABC system by identifying different activities within each department. Under what conditions would it not be worthwhile to further refine the department costing system into an ABC system?

5-20 Plant-wide, department, and activity-cost rates. Tarquin’s Trophies makes trophies and plaques and operates at capacity. Tarquin does large custom orders, such as the participant trophies for the Mishawaka Little League. The controller has asked you to compare plant-wide, department, and activitybased cost allocation. Tarquin’s Trophies Budgeted Information For the Year Ended November 30, 2011 Forming Department Trophies Plaques Direct materials $13,000 $11,250 Direct labor 15,600 9,000 Overhead Costs Setup Supervision Assembly Department Direct materials Direct labor Overhead costs Setup Supervision

Trophies $ 2,600 7,800

Plaques $ 9,375 10,500

Total $24,250 24,600 12,000 10,386 Total $11,975 18,300 23,000 10,960

Other information follows: Setup costs vary with the number of batches processed in each department. The budgeted number of batches for each product line in each department is as follows:

Forming department Assembly department

Trophies 40 43

Plaques 116 103

Supervision costs vary with direct labor costs in each department. 1. Calculate the budgeted cost of trophies and plaques based on a single plant-wide overhead rate, if total overhead is allocated based on total direct costs. 2. Calculate the budgeted cost of trophies and plaques based on departmental overhead rates, where forming department overhead costs are allocated based on direct labor costs of the forming department, and assembly department overhead costs are allocated based on total direct costs of the assembly department. 3. Calculate the budgeted cost of trophies and plaques if Tarquin allocates overhead costs in each department using activity-based costing. 4. Explain how the disaggregation of information could improve or reduce decision quality.

5-21 ABC, process costing. Parker Company produces mathematical and financial calculators and operates at capacity. Data related to the two products are presented here:

Annual production in units Direct material costs Direct manufacturing labor costs Direct manufacturing labor-hours Machine-hours Number of production runs Inspection hours

Mathematical 50,000 $150,000 $ 50,000 2,500 25,000 50 1,000

Financial 100,000 $300,000 $100,000 5,000 50,000 50 500

Required

168 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

Total manufacturing overhead costs are as follows:

Machining costs Setup costs Inspection costs

Total $375,000 120,000 105,000

1. Choose a cost driver for each overhead cost pool and calculate the manufacturing overhead cost per unit for each product.

Required

2. Compute the manufacturing cost per unit for each product.

5-22 Activity-based costing, service company. Quikprint Corporation owns a small printing press that

prints leaflets, brochures, and advertising materials. Quikprint classifies its various printing jobs as standard jobs or special jobs. Quikprint’s simple job-costing system has two direct-cost categories (direct materials and direct labor) and a single indirect-cost pool. Quikprint operates at capacity and allocates all indirect costs using printing machine-hours as the allocation base. Quikprint is concerned about the accuracy of the costs assigned to standard and special jobs and therefore is planning to implement an activity-based costing system. Quickprint’s ABC system would have the same direct-cost categories as its simple costing system. However, instead of a single indirect-cost pool there would now be six categories for assigning indirect costs: design, purchasing, setup, printing machine operations, marketing, and administration. To see how activity-based costing would affect the costs of standard and special jobs, Quikprint collects the following information for the fiscal year 2011 that just ended.

Number of printing jobs Price per job Cost of supplies per job Direct labor costs per job Printing machine-hours per job Cost of printing machine operations

Standard Job Special Job 400 200 $ 1,500 $1,200 $ 250 $ 200 $ 200 $ 180 10 10

Setup-hours per job Setup costs Total number of purchase orders Purchase order costs

400

500

Design costs

$8,000

$32,000

Marketing costs as a percentage of revenues Administration costs

Required

$ 90,000 Indirect setup costs increase with setup hours

)

$150,000 Indirect costs of operating printing machines increase with printing machine hours

Total

(

Cause-and-Effect Relationship Between Allocation Base and Activity Cost

$ 36,000 Indirect purchase order costs increase with number of purchase orders $ 40,000 Design costs are allocated to standard and special jobs based on a special study of the design department $ 39,000 $ 48,000 Demand for administrative resources increases with direct labor costs

1. Calculate the cost of a standard job and a special job under the simple costing system. 2. Calculate the cost of a standard job and a special job under the activity-based costing system. 3. Compare the costs of a standard job and a special job in requirements 1 and 2. Why do the simple and activity-based costing systems differ in the cost of a standard job and a special job? 4. How might Quikprint use the new cost information from its activity-based costing system to better manage its business?

5-23 Activity-based costing, manufacturing. Open Doors, Inc., produces two types of doors, interior and exterior. The company’s simple costing system has two direct cost categories (materials and labor) and one indirect cost pool. The simple costing system allocates indirect costs on the basis of machinehours. Recently, the owners of Open Doors have been concerned about a decline in the market share for

ASSIGNMENT MATERIAL " 169

their interior doors, usually their biggest seller. Information related to Open Doors production for the most recent year follows:

Units sold Selling price Direct material cost per unit Direct manufacturing labor cost per hour Direct manufacturing labor-hours per unit Production runs Material moves Machine setups Machine-hours Number of inspections

Interior 3,200 $ 125 $ 30 $ 16 1.50 40 72 45 5,500 250

Exterior 1,800 $ 200 $ 45 $ 16 2.25 85 168 155 4,500 150

The owners have heard of other companies in the industry that are now using an activity-based costing system and are curious how an ABC system would affect their product costing decisions. After analyzing the indirect cost pool for Open Doors, six activities were identified as generating indirect costs: production scheduling, material handling, machine setup, assembly, inspection, and marketing. Open Doors collected the following data related to the indirect cost activities: Activity Production scheduling Material handling Machine setup Assembly Inspection

Activity Cost $95,000 $45,000 $25,000 $60,000 $ 8,000

Activity Cost Driver Production runs Material moves Machine setups Machine-hours Number of inspections

Marketing costs were determined to be 3% of the sales revenue for each type of door. 1. Calculate the cost of an interior door and an exterior door under the existing simple costing system. 2. Calculate the cost of an interior door and an exterior door under an activity-based costing system. 3. Compare the costs of the doors in requirements 1 and 2. Why do the simple and activity-based costing systems differ in the cost of an interior and exterior door? 4. How might Open Door, Inc., use the new cost information from its activity-based costing system to address the declining market share for interior doors?

5-24 ABC, retail product-line profitability. Family Supermarkets (FS) operates at capacity and decides to apply ABC analysis to three product lines: baked goods, milk and fruit juice, and frozen foods. It identifies four activities and their activity cost rates as follows: Ordering Delivery and receipt of merchandise Shelf-stocking Customer support and assistance

$100 per purchase order $ 80 per delivery $ 20 per hour $ 0.20 per item sold

The revenues, cost of goods sold, store support costs, the activities that account for the store support costs, and activity-area usage of the three product lines are as follows:

Financial data Revenues Cost of goods sold Store support Activity-area usage (cost-allocation base) Ordering (purchase orders) Delivery (deliveries) Shelf-stocking (hours) Customer support (items sold)

Baked Goods

Milk and Fruit Juice

Frozen Products

$57,000 $38,000 $11,400

$63,000 $47,000 $14,100

$52,000 $35,000 $10,500

30 98 183 15,500

25 36 166 20,500

13 28 24 7,900

Required

170 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

Under its simple costing system, FS allocated support costs to products at the rate of 30% of cost of goods sold. Required

1. Use the simple costing system to prepare a product-line profitability report for FS. 2. Use the ABC system to prepare a product-line profitability report for FS. 3. What new insights does the ABC system in requirement 2 provide to FS managers?

5-25 ABC, wholesale, customer profitability. Ramirez Wholesalers operates at capacity and sells furni-

ture items to four department-store chains (customers). Mr. Ramirez commented, “We apply ABC to determine product-line profitability. The same ideas apply to customer profitability, and we should find out our customer profitability as well.” Ramirez Wholesalers sends catalogs to corporate purchasing departments on a monthly basis. The customers are entitled to return unsold merchandise within a six-month period from the purchase date and receive a full purchase price refund. The following data were collected from last year’s operations:

Gross sales Sales returns: Number of items Amount Number of orders: Regular Rush

1 $55,000

Chain 2 3 $25,000 $100,000

4 $75,000

101 $11,000

25 $ 3,500

65 $ 7,000

35 $ 6,500

45 11

175 48

52 11

75 32

Ramirez has calculated the following activity rates: Activity Regular order processing Rush order processing Returned items processing Catalogs and customer support

Cost-Driver Rate $25 per regular order $125 per rush order $15 per item $1,100 per customer

Customers pay the transportation costs. The cost of goods sold averages 70% of sales. Required

Determine the contribution to profit from each chain last year. Comment on your solution.

5-26 ABC, activity area cost-driver rates, product cross-subsidization. Idaho Potatoes (IP) operates at

capacity and processes potatoes into potato cuts at its highly automated Pocatello plant. It sells potatoes to the retail consumer market and to the institutional market, which includes hospitals, cafeterias, and university dormitories. IP’s simple costing system, which does not distinguish between potato cuts processed for retail and institutional markets, has a single direct-cost category (direct materials, i.e. raw potatoes) and a single indirect-cost pool (production support). Support costs, which include packaging materials, are allocated on the basis of pounds of potato cuts processed. The company uses 1,200,000 pounds of raw potatoes to process 1,000,000 pounds of potato cuts. At the end of 2011, IP unsuccessfully bid for a large institutional contract. Its bid was reported to be 30% above the winning bid. This feedback came as a shock because IP included only a minimum profit margin on its bid and the Pocatello plant was acknowledged as the most efficient in the industry. As a result of its review process of the lost contract bid, IP decided to explore ways to refine its costing system. The company determined that 90% of the direct materials (raw potatoes) related to the retail market and 10% to the institutional market. In addition, the company identified that packaging materials could be directly traced to individual jobs ($180,000 for retail and $8,000 for institutional). Also, the company used ABC to identify three main activity areas that generated support costs: cleaning, cutting, and packaging. #

Cleaning Activity Area—The cost-allocation base is pounds of raw potatoes cleaned.

Cutting Activity Area—The production line produces (a) 250 pounds of retail potato cuts per cuttinghour and (b) 400 pounds of institutional potato cuts per cutting-hour. The cost-allocation base is cuttinghours on the production line.

Packaging Activity Area—The packaging line packages (a) 25 pounds of retail potato cuts per packaginghour and (b) 100 pounds of institutional potato cuts per packaging-hour. The cost-allocation base is packaging-hours on the production line.

ASSIGNMENT MATERIAL " 171

The following table summarizes the actual costs for 2011 before and after the preceding cost analysis: After the cost analysis Before the cost analysis Direct materials used Potatoes Packaging Production support Cleaning Cutting Packaging Total

Production Support

$ 150,000

Retail

Institutional

Total

$135,000 180,000

$15,000 8,000

$ 150,000 188,000

$23,000

120,000 231,000 ƒƒƒ444,000 $1,133,000

983,000

$1,133,000

$120,000 231,000 ƒ444,000 $795,000

$315,000

1. Using the simple costing system, what is the cost per pound of potato cuts produced by IP? 2. Calculate the cost rate per unit of the cost driver in the (a) cleaning, (b) cutting, and (c) packaging activity areas. 3. Suppose IP uses information from its activity cost rates to calculate costs incurred on retail potato cuts and institutional potato cuts. Using the ABC system, what is the cost per pound of (a) retail potato cuts and (b) institutional potato cuts? 4. Comment on the cost differences between the two costing systems in requirements 1 and 3. How might IP use the information in requirement 3 to make better decisions?

5-27 Activity-based costing. The job costing system at Smith’s Custom Framing has five indirect cost

pools (purchasing, material handling, machine maintenance, product inspection, and packaging). The company is in the process of bidding on two jobs; Job 215, an order of 15 intricate personalized frames, and Job 325, an order of 6 standard personalized frames. The controller wants you to compare overhead allocated under the current simple job-costing system and a newly-designed activity-based job-costing system. Total budgeted costs in each indirect cost pool and the budgeted quantity of activity driver are as follows:

Purchasing Material handling Machine maintenance Product inspection Packaging

Budgeted Overhead $ 70,000 87,500 237,300 18,900 ƒƒ39,900 $453,600

Activity Driver Purchase orders processed Material moves Machine-hours Inspections Units produced

Budgeted Quantity of Activity Driver 2,000 5,000 10,500 1,200 3,800

Information related to Job 215 and Job 325 follows. Job 215 incurs more batch-level costs because it uses more types of materials that need to be purchased, moved, and inspected relative to Job 325.

Number of purchase orders Number of material moves Machine-hours Number of inspections Units produced

Job 215 25 10 40 9 15

Job 325 8 4 60 3 6

1. Compute the total overhead allocated to each job under a simple costing system, where overhead is allocated based on machine-hours. 2. Compute the total overhead allocated to each job under an activity-based costing system using the appropriate activity drivers. 3. Explain why Smith’s Custom Framing might favor the ABC job-costing system over the simple jobcosting system, especially in its bidding process.

5-28 ABC, product costing at banks, cross-subsidization. National Savings Bank (NSB) is examining the profitability of its Premier Account, a combined savings and checking account. Depositors receive a 7% annual interest rate on their average deposit. NSB earns an interest rate spread of 3% (the difference

Required

172 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

between the rate at which it lends money and the rate it pays depositors) by lending money for home loan purposes at 10%. Thus, NSB would gain $60 on the interest spread if a depositor had an average Premier Account balance of $2,000 in 2011 ($2,000 * 3% = $60). The Premier Account allows depositors unlimited use of services such as deposits, withdrawals, checking accounts, and foreign currency drafts. Depositors with Premier Account balances of $1,000 or more receive unlimited free use of services. Depositors with minimum balances of less than $1,000 pay a $22-a-month service fee for their Premier Account. NSB recently conducted an activity-based costing study of its services. It assessed the following costs for six individual services. The use of these services in 2011 by three customers is as follows: Account Usage Activity-Based Cost Turner Graham per “Transaction” Holt Deposit/withdrawal with teller $ 2.30 42 48 5 Deposit/withdrawal with automatic teller machine (ATM) 0.70 7 19 17 Deposit/withdrawal on prearranged monthly basis 0.40 0 13 62 Bank checks written 8.40 11 1 3 Foreign currency drafts 12.40 4 2 6 Inquiries about account balance 1.40 12 20 9 Average Premier Account balance for 2011 $1,100 $700 $24,600 Assume Holt and Graham always maintain a balance above $1,000, whereas Turner always has a balance below $1,000. Required

1. Compute the 2011 profitability of the Holt, Turner, and Graham Premier Accounts at NSB. 2. Why might NSB worry about the profitability of individual customers if the Premier Account product offering is profitable as a whole? 3. What changes would you recommend for NSB’s Premier Account?

Problems 5-29 Job costing with single direct-cost category, single indirect-cost pool, law firm. Wigan Associates is a recently formed law partnership. Ellery Hanley, the managing partner of Wigan Associates, has just finished a tense phone call with Martin Offiah, president of Widnes Coal. Offiah strongly complained about the price Wigan charged for some legal work done for Widnes Coal. Hanley also received a phone call from its only other client (St. Helen’s Glass), which was very pleased with both the quality of the work and the price charged on its most recent job. Wigan Associates operates at capacity and uses a cost-based approach to pricing (billing) each job. Currently it uses a simple costing system with a single direct-cost category (professional labor-hours) and a single indirect-cost pool (general support). Indirect costs are allocated to cases on the basis of professional labor-hours per case. The job files show the following:

Professional labor

Widnes Coal 104 hours

St. Helen’s Glass 96 hours

Professional labor costs at Wigan Associates are $70 an hour. Indirect costs are allocated to cases at $105 an hour. Total indirect costs in the most recent period were $21,000. Required

1. Why is it important for Wigan Associates to understand the costs associated with individual jobs? 2. Compute the costs of the Widnes Coal and St. Helen’s Glass jobs using Wigan’s simple costing system.

5-30 Job costing with multiple direct-cost categories, single indirect-cost pool, law firm (continuation of 5-29). Hanley asks his assistant to collect details on those costs included in the $21,000 indirect-cost pool that can be traced to each individual job. After analysis, Wigan is able to reclassify $14,000 of the $21,000 as direct costs: Other Direct Costs Research support labor Computer time Travel and allowances Telephones/faxes Photocopying Total

Widnes Coal $1,600 500 600 200 ƒƒƒ250 $3,150

St. Helen’s Glass $ 3,400 1,300 4,400 1,000 ƒƒƒƒ750 $10,850

ASSIGNMENT MATERIAL " 173

Hanley decides to calculate the costs of each job as if Wigan had used six direct cost-pools and a single indirect-cost pool. The single indirect-cost pool would have $7,000 of costs and would be allocated to each case using the professional labor-hours base. 1. What is the revised indirect-cost allocation rate per professional labor-hour for Wigan Associates when total indirect costs are $7,000? 2. Compute the costs of the Widnes and St. Helen’s jobs if Wigan Associates had used its refined costing system with multiple direct-cost categories and one indirect-cost pool. 3. Compare the costs of Widnes and St. Helen’s jobs in requirement 2 with those in requirement 2 of Problem 5-29. Comment on the results.

Required

5-31 Job costing with multiple direct-cost categories, multiple indirect-cost pools, law firm

(continuation of 5-29 and 5-30). Wigan has two classifications of professional staff: partners and associates. Hanley asks his assistant to examine the relative use of partners and associates on the recent Widnes Coal and St. Helen’s jobs. The Widnes job used 24 partner-hours and 80 associate-hours. The St. Helen’s job used 56 partner-hours and 40 associate-hours. Therefore, totals of the two jobs together were 80 partner-hours and 120 associate-hours. Hanley decides to examine how using separate direct-cost rates for partners and associates and using separate indirect-cost pools for partners and associates would have affected the costs of the Widnes and St. Helen’s jobs. Indirect costs in each indirect-cost pool would be allocated on the basis of total hours of that category of professional labor. From the total indirect cost-pool of $7,000, $4,600 is attributable to the activities of partners, and $2,400 is attributable to the activities of associates. The rates per category of professional labor are as follows: Category of Professional Labor Partner Associate

Direct Cost per Hour $100.00 50.00

Indirect Cost per Hour $4,600 ÷ 80 hours = $57.50 $2,400 ÷ 120 hours = $20.00

1. Compute the costs of the Widnes and St. Helen’s cases using Wigan’s further refined system, with multiple direct-cost categories and multiple indirect-cost pools. 2. For what decisions might Wigan Associates find it more useful to use this job-costing approach rather than the approaches in Problem 5-29 or 5-30?

5-32 Plant-wide, department, and activity-cost rates. Allen’s Aero Toys makes two models of toy airplanes, fighter jets, and cargo planes. The fighter jets are more detailed and require smaller batch sizes. The controller has asked you to compare plant-wide, department, and activity-based cost allocations. Allen’s Aero Toys Budgeted Information per unit For the Year Ended 30 November 2010 Assembly Department Fighters Cargo Direct materials $2.50 $3.75 Direct manufacturing labor ƒ3.50 ƒ2.00 Total direct cost per unit $6.00 $5.75

Total $ 6.25 ƒƒ5.50 $11.75

Painting Department Direct materials Direct manufacturing labor Total direct cost per unit

$ 1.50 ƒƒ3.75 $ƒ5.25

Fighters $0.50 ƒ2.25 $2.75

Number of units produced

800

Cargo $1.00 ƒ1.50 $2.50 740

The budgeted overhead cost for each department is as follows:

Materials handling Quality inspection Utilities

Assembly Department $1,700 2,750 ƒ2,580 $7,030

Painting Department $ 900 1,150 ƒ2,100 $4,150

Total $ 2,600 3,900 ƒƒ4,680 $11,180

Required

174 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

Other information follows: Materials handling and quality inspection costs vary with the number of batches processed in each department. The budgeted number of batches for each product line in each department is as follows:

Assembly department Painting department Total

Fighters 150 100 250

Cargo 48 32 80

Total 198 132 330

Utilities costs vary with direct manufacturing labor cost in each department. Required

1. Calculate the budgeted cost per unit for fighter jets and cargo planes based on a single plant-wide overhead rate, if total overhead is allocated based on total direct costs. 2. Calculate the budgeted cost per unit for fighter jets and cargo planes based on departmental overhead rates, where assembly department overhead costs are allocated based on direct manufacturing labor costs of the assembly department and painting department overhead costs are allocated based on total direct costs of the painting department. 3. Calculate the budgeted cost per unit for fighter jets and cargo planes if Allen’s Aero Toys allocates overhead costs using activity-based costing. 4. Explain how activity-based costing could improve or reduce decision quality.

5-33 Department and activity-cost rates, service sector. Roxbury’s Radiology Center (RRC) performs

X-rays, ultrasounds, CT scans, and MRIs. RRC has developed a reputation as a top Radiology Center in the state. RRC has achieved this status because it constantly reexamines its processes and procedures. RRC has been using a single, facility-wide overhead allocation rate. The VP of Finance believes that RRC can make better process improvements if it uses more disaggregated cost information. She says, “We have state of the art medical imaging technology. Can’t we have state of the art accounting technology?”

Technician labor Depreciation Materials Administration Maintenance Sanitation Utilities

Roxbury’s Radiology Center Budgeted Information For the Year Ended May 30, 2011 X-rays Ultrasound $ 64,000 $104,000 136,800 231,000 22,400 16,500

Number of procedures Minutes to clean after each procedure Minutes for each procedure

ƒƒƒƒƒƒƒƒ $223,200 2,555 10 5

ƒƒƒƒƒƒƒƒ $351,500 4,760 10 20

CT scan $119,000 400,200 23,900

ƒƒƒƒƒƒƒƒ $543,100 3,290 20 15

MRI Total $106,000 $ 393,000 792,000 1560,000 30,800 93,600 19,000 260,000 267,900 ƒƒƒƒƒƒƒƒ ƒƒƒ121,200 $928,800 $2,714,700 2,695 40 40

RRC operates at capacity. The proposed allocation bases for overhead are as follows: Administration Maintenance (including parts) Sanitation Utilities Required

Number of procedures Capital cost of the equipment (use Depreciation) Total cleaning minutes Total procedure minutes

1. Calculate the budgeted cost per service for X-rays, Ultrasounds, CT scans, and MRIs using direct technician labor costs as the allocation basis. 2. Calculate the budgeted cost per service of X-rays, Ultrasounds, CT scans, and MRIs if RRC allocated overhead costs using activity-based costing. 3. Explain how the disaggregation of information could be helpful to RRC’s intention to continuously improve its services.

ASSIGNMENT MATERIAL " 175

5-34 Choosing cost drivers, activity-based costing, activity-based management. Annie Warbucks runs a dance studio with childcare and adult fitness classes. Annie’s budget for the upcoming year is as follows: Annie Warbuck’s Dance Studio Budgeted Costs and Activities For the Year Ended June 30, 2010 Dance teacher salaries $62,100 Child care teacher salaries 24,300 Fitness instructor salaries ƒ39,060 Total salaries Supplies (art, dance accessories, fitness) Rent, maintenance, and utilities Administration salaries Marketing expenses Total

$125,460 21,984 97,511 50,075 ƒƒ21,000 $316,030

Other budget information follows:

Square footage Number of participants Teachers per hour Number of advertisements

Dance

Childcare

Fitness

Total

6,000 1,485 3 26

3,150 450 3 24

2,500 270 1 20

11,650 2,205 7 70

1. Determine which costs are direct costs and which costs are indirect costs of different programs. 2. Choose a cost driver for the indirect costs and calculate the budgeted cost per unit of the cost driver. Explain briefly your choice of cost driver. 3. Calculate the budgeted costs of each program. 4. How can Annie use this information for pricing? What other factors should she consider?

Required

5-35 Activity-based costing, merchandising. Pharmacare, Inc., a distributor of special pharmaceutical products, operates at capacity and has three main market segments: a. General supermarket chains b. Drugstore chains c. Mom-and-Pop single-store pharmacies Rick Flair, the new controller of Pharmacare, reported the following data for 2011:

General Supermarket Chains $3,708,000 3,600,000 $ 108,000

Drugstore Chains $3,150,000 3,000,000 $ 150,000

Mom-and-Pop Single Stores $1,980,000 1,800,000 $ 180,000

(

Pharmacare, 2011

Revenues Cost of goods sold Gross margin Other operating costs Operating income

Pharmacare $8,838,000 8,400,000 438,000 301,080 $ 136,920

176 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

For many years, Pharmacare has used gross margin percentage [(Revenue – Cost of goods sold) ÷ Revenue] to evaluate the relative profitability of its market segments. But, Flair recently attended a seminar on activity-based costing and is considering using it at Pharmacare to analyze and allocate “other operating costs.” He meets with all the key managers and several of his operations and sales staff and they agree that there are five key activities that drive other operating costs at Pharmacare:

Activity Area Order processing Line-item processing Delivering to stores Cartons shipped to store Stocking of customer store shelves

Cost Driver Number of customer purchase orders Number of line items ordered by customers Number of store deliveries Number of cartons shipped Hours of shelf-stocking

Each customer order consists of one or more line items. A line item represents a single product (such as Extra-Strength Tylenol Tablets). Each product line item is delivered in one or more separate cartons. Each store delivery entails the delivery of one or more cartons of products to a customer. Pharmacare’s staff stacks cartons directly onto display shelves in customers’ stores. Currently, there is no additional charge to the customer for shelf-stocking and not all customers use Pharmacare for this activity. The level of each activity in the three market segments and the total cost incurred for each activity in 2011 is as follows:

Activity-based Cost Data Pharmacare 2011

Activity Orders processed (number) Line-items ordered (number) Store deliveries made (number) Cartons shipped to stores (number) Shelf stocking (hours)

Required

(

Mom-and-Pop Single Stores 1,500 15,000 1,000 16,000 100

Total Cost of Activity in 2011 $ 80,000 63,840 71,000 76,000 10,240 $301,080

Activity Level General Supermarket Chains 140 1,960 120 36,000 360

Drugstore Chains 360 4,320 360 24,000 180

1. Compute the 2011 gross-margin percentage for each of Pharmacare’s three market segments. 2. Compute the cost driver rates for each of the five activity areas. 3. Use the activity-based costing information to allocate the $301,080 of “other operating costs” to each of the market segments. Compute the operating income for each market segment. 4. Comment on the results. What new insights are available with the activity-based costing information?

5-36 Choosing cost drivers, activity-based costing, activity-based management. Pumpkin Bags (PB) is a designer of high quality backpacks and purses. Each design is made in small batches. Each spring, PB comes out with new designs for the backpack and for the purse. The company uses these designs for a year, and then moves on to the next trend. The bags are all made on the same fabrication equipment that is expected to operate at capacity. The equipment must be switched over to a new design and set up

ASSIGNMENT MATERIAL " 177

to prepare for the production of each new batch of products. When completed, each batch of products is immediately shipped to a wholesaler. Shipping costs vary with the number of shipments. Budgeted information for the year is as follows:

Pumpkin Bags Budget for costs and Activities For the Year Ended February 28, 2011 Direct materials—purses Direct materials—backpacks Direct manufacturing labor—purses Direct manufacturing labor—backpacks Setup Shipping Design Plant utilities and administration Total

$ 379,290 412,920 98,000 120,000 65,930 73,910 166,000 ƒƒƒ243,000 $1,559,050

Other budget information follows:

Number of bags Hours of production Number of batches Number of designs

1. 2. 3. 4. 5.

Backpacks

Purses

Total

6,050 1,450 130 2

3,350 2,600 60 2

9,400 4,050 190 4

Identify the cost hierarchy level for each cost category. Identify the most appropriate cost driver for each cost category. Explain briefly your choice of cost driver. Calculate the budgeted cost per unit of cost driver for each cost category. Calculate the budgeted total costs and cost per unit for each product line. Explain how you could use the information in requirement 4 to reduce costs.

5-37 ABC, health care. Uppervale Health Center runs two programs: drug addict rehabilitation and aftercare (counseling and support of patients after release from a mental hospital). The center’s budget for 2010 follows:

Professional salaries: 4 physicians * $150,000 12 psychologists * $75,000 16 nurses * $30,000 Medical supplies Rent and clinic maintenance Administrative costs to manage patient charts, food, laundry Laboratory services Total

$600,000 900,000 ƒ480,000

$1,980,000 220,000 126,000 440,000 ƒƒƒƒ84,000 $2,850,000

Required

178 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

Muriel Clayton, the director of the center, is keen on determining the cost of each program. Clayton compiled the following data describing employee allocations to individual programs:

Physicians Psychologists Nurses

Drug 4 4 6

Aftercare 8 10

Total Employees 4 12 16

Clayton has recently become aware of activity-based costing as a method to refine costing systems. She asks her accountant, Huey Deluth, how she should apply this technique. Deluth obtains the following budgeted information for 2010:

Square feet of space occupied by each program Patient-years of service Number of laboratory tests Required

Drug 9,000 50 1,400

Aftercare 12,000 60 700

Total 21,000 110 2,100

1. a. Selecting cost-allocation bases that you believe are the most appropriate for allocating indirect costs to programs, calculate the budgeted indirect cost rates for medical supplies; rent and clinic maintenance; administrative costs for patient charts, food, and laundry; and laboratory services. b. Using an activity-based costing approach to cost analysis, calculate the budgeted cost of each program and the budgeted cost per patient-year of the drug program. c. What benefits can Uppervale Health Center obtain by implementing the ABC system? 2. What factors, other than cost, do you think Uppervale Health Center should consider in allocating resources to its programs?

5-38 Unused capacity, activity-based costing, activity-based management. Nivag’s Netballs is a manu-

facturer of high quality basketballs and volleyballs. Setup costs are driven by the number of batches. Equipment and maintenance costs increase with the number of machine-hours, and lease rent is paid per square foot. Capacity of the facility is 12,000 square feet and Nivag is using only 70% of this capacity. Nivag records the cost of unused capacity as a separate line item, and not as a product cost. The following is the budgeted information for Nivag: Nivag’s Netballs Budgeted Costs and Activities For the Year Ended August 31, 2012 Direct materials—basketballs Direct materials—volleyballs Direct manufacturing labor—basketballs Direct manufacturing labor—volleyballs Setup Equipment and maintenance costs Lease rent Total

$ 209,750 358,290 107,333 102,969 143,500 109,900 ƒƒƒ216,000 $1,247,742

Other budget information follows:

Number of balls Machine-hours Number of batches Square footage of production space used Required

Basketballs 66,000 11,000 300 3,360

Volleyballs 100,000 12,500 400 5,040

1. Calculate the budgeted cost per unit of cost driver for each indirect cost pool. 2. What is the budgeted cost of unused capacity? 3. What is the budgeted total cost and the cost per unit of resources used to produce (a) basketballs and (b) volleyballs? 4. What factors should Nivag consider if it has the opportunity to manufacture a new line of footballs?

ASSIGNMENT MATERIAL " 179

5-39 Activity-based job costing, unit-cost comparisons. The Tracy Corporation has a machining facility specializing in jobs for the aircraft-components market. Tracy’s previous simple job-costing system had two direct-cost categories (direct materials and direct manufacturing labor) and a single indirect-cost pool (manufacturing overhead, allocated using direct manufacturing labor-hours). The indirect cost-allocation rate of the simple system for 2010 would have been $115 per direct manufacturing labor-hour. Recently a team with members from product design, manufacturing, and accounting used an ABC approach to refine its job-costing system. The two direct-cost categories were retained. The team decided to replace the single indirect-cost pool with five indirect-cost pools. The cost pools represent five activity areas at the plant, each with its own supervisor and budget responsibility. Pertinent data are as follows: Activity Area Materials handling Lathe work Milling Grinding Testing

Cost-Allocation Base Parts Lathe turns Machine-hours Parts Units tested

Cost-Allocation Rate $ 0.40 0.20 20.00 0.80 15.00

Information-gathering technology has advanced to the point at which the data necessary for budgeting in these five activity areas are collected automatically. Two representative jobs processed under the ABC system at the plant in the most recent period had the following characteristics:

Direct material cost per job Direct manufacturing labor cost per job Number of direct manufacturing labor-hours per job Parts per job Lathe turns per job Machine-hours per job Units per job (all units are tested)

Job 410 $ 9,700 $750 25 500 20,000 150 10

Job 411 $59,900 $11,250 375 2,000 59,250 1,050 200

1. Compute the manufacturing cost per unit for each job under the previous simple job-costing system. 2. Compute the manufacturing cost per unit for each job under the activity-based costing system. 3. Compare the per-unit cost figures for Jobs 410 and 411 computed in requirements 1 and 2. Why do the simple and the activity-based costing systems differ in the manufacturing cost per unit for each job? Why might these differences be important to Tracy Corporation? 4. How might Tracy Corporation use information from its ABC system to better manage its business?

5-40 ABC, implementation, ethics. (CMA, adapted) Applewood Electronics, a division of Elgin

Corporation, manufactures two large-screen television models: the Monarch, which has been produced since 2006 and sells for $900, and the Regal, a newer model introduced in early 2009 that sells for $1,140. Based on the following income statement for the year ended November 30, 2010, senior management at Elgin have decided to concentrate Applewood’s marketing resources on the Regal model and to begin to phase out the Monarch model because Regal generates a much bigger operating income per unit. Applewood Electronics Income Statement For the Fiscal Year Ended November 30, 2010 Monarch Regal Revenues $19,800,000 $4,560,000 Cost of goods sold ƒ12,540,000 ƒ3,192,000 Gross margin 7,260,000 1,368,000 Selling and administrative expense ƒƒ5,830,000 ƒƒƒ978,000 Operating income $ƒ1,430,000 $ƒƒ390,000 Units produced and sold 22,000 4,000 Operating income per unit sold $65.00 $97.50

Total $24,360,000 ƒ15,732,000 8,628,000 ƒƒ6,808,000 $ƒ1,820,000

Required

180 " CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

Details for cost of goods sold for Monarch and Regal are as follows:

Direct materials Direct manufacturing labora Machine costsb Total direct costs Manufacturing overhead costsc Total cost of goods sold a b c

Monarch Total Per unit $ 4,576,000 $208 396,000 18 ƒƒ3,168,000 ƒ144 $ 8,140,000 $370 $ƒ4,400,000 $200 $12,540,000 $570

Regal Total $2,336,000 168,000 ƒƒƒ288,000 $2,792,000 $ƒƒ400,000 $3,192,000

Per unit $584 42 ƒƒ72 $698 $100 $798

Monarch requires 1.5 hours per unit and Regal requires 3.5 hours per unit. The direct manufacturing labor cost is $12 per hour. Machine costs include lease costs of the machine, repairs, and maintenance. Monarch requires 8 machine-hours per unit and Regal requires 4 machine-hours per unit. The machine hour rate is $18 per hour. Manufacturing overhead costs are allocated to products based on machine-hours at the rate of $25 per hour.

Applewood’s controller, Susan Benzo, is advocating the use of activity-based costing and activity-based management and has gathered the following information about the company’s manufacturing overhead costs for the year ended November 30, 2010.

Activity Center (Cost-Allocation Base) Soldering (number of solder points) Shipments (number of shipments) Quality control (number of inspections) Purchase orders (number of orders) Machine power (machine-hours) Machine setups (number of setups) Total manufacturing overhead

Total Activity Costs $ 942,000 860,000 1,240,000 950,400 57,600 ƒƒƒ750,000 $4,800,000

Units of the Cost-Allocation Base Monarch Regal Total 1,185,000 385,000 1,570,000 16,200 3,800 20,000 56,200 21,300 77,500 80,100 109,980 190,080 176,000 16,000 192,000 16,000 14,000 30,000

After completing her analysis, Benzo shows the results to Fred Duval, the Applewood division president. Duval does not like what he sees. “If you show headquarters this analysis, they are going to ask us to phase out the Regal line, which we have just introduced. This whole costing stuff has been a major problem for us. First Monarch was not profitable and now Regal.” “Looking at the ABC analysis, I see two problems. First, we do many more activities than the ones you have listed. If you had included all activities, maybe your conclusions would be different. Second, you used number of setups and number of inspections as allocation bases. The numbers would be different had you used setup-hours and inspection-hours instead. I know that measurement problems precluded you from using these other cost-allocation bases, but I believe you ought to make some adjustments to our current numbers to compensate for these issues. I know you can do better. We can’t afford to phase out either product.” Benzo knows that her numbers are fairly accurate. As a quick check, she calculates the profitability of Regal and Monarch using more and different allocation bases. The set of activities and activity rates she had used results in numbers that closely approximate those based on more detailed analyses. She is confident that headquarters, knowing that Regal was introduced only recently, will not ask Applewood to phase it out. She is also aware that a sizable portion of Duval’s bonus is based on division revenues. Phasing out either product would adversely affect his bonus. Still, she feels some pressure from Duval to do something. Required

1. Using activity-based costing, calculate the gross margin per unit of the Regal and Monarch models. 2. Explain briefly why these numbers differ from the gross margin per unit of the Regal and Monarch models calculated using Applewood’s existing simple costing system. 3. Comment on Duval’s concerns about the accuracy and limitations of ABC. 4. How might Applewood find the ABC information helpful in managing its business? 5. What should Susan Benzo do in response to Duval’s comments?

ASSIGNMENT MATERIAL " 181

Collaborative Learning Problem 5-41 Activity-based costing, activity-based management, merchandising. Super Bookstore (SB) is a large city bookstore that sells books and music CDs, and has a café. SB operates at capacity and allocates selling, general, and administration (S, G & A) costs to each product line using the cost of merchandise of each product line. SB wants to optimize the pricing and cost management of each product line. SB is wondering if its accounting system is providing it with the best information for making such decisions.

Super Bookstore Product Line Information For the Year Ended December 31, 2010 Books CDs Revenues $3,720,480 $2,315,360 Cost of merchandise $2,656,727 $1,722,311 Cost of café cleaning — — Number of purchase orders placed 2,800 2,500 Number of deliveries received 1,400 1,700 Hours of shelf stocking time 15,000 14,000 Items sold 124,016 115,768

Café $736,216 $556,685 $ 18,250 2,000 1,600 10,000 368,108

Super Bookstore incurs the following selling, general, and administration costs:

Super Bookstore Selling, General, & Administration (S, G & A) Costs For the Year Ended December 31, 2010 Purchasing department expenses Receiving department expenses Shelf stocking labor expense Customer support expense (cashiers and floor employees)

$ 474,500 432,400 487,500 ƒƒƒƒ91,184 $1,485,584

1. Suppose Super Bookstore uses cost of merchandise to allocate all S, G & A costs. Prepare product line and total company income statements. 2. Identify an improved method for allocating costs to the three product lines. Explain. Use the method for allocating S, G & A costs that you propose to prepare new product line and total company income statements. Compare your results to the results in requirement 1. 3. Write a memo to Super Bookstore’s management describing how the improved system might be useful for managing Super Bookstore.

Required

Master Budget and Responsibility Accounting

Learning Objectives

1. Describe the master budget and explain its benefits 2. Describe the advantages of budgets 3. Prepare the operating budget and its supporting schedules 4. Use computer-based financial planning models for sensitivity analysis 5. Describe responsibility centers and responsibility accounting 6. Recognize the human aspects of budgeting 7. Appreciate the special challenges of budgeting in multinational companies

Amid the recent recession, one of the hottest innovations was the growth of Web sites that enable users to get an aggregate picture of their financial data and to set up budgets to manage their spending and other financial decisions online. (Mint.com, a pioneer in this market, was acquired by Intuit for $170 million in September 2009.) Budgets play a similar crucial role in businesses. Without budgets, it’s difficult for managers and their employees to know whether they’re on target for their growth and spending goals. You might think a budget is only for companies that are in financial difficulty (such as Citigroup) or whose profit margins are slim—Wal-Mart, for example. As the following article shows, even companies that sell high-dollar value goods and services adhere to budgets.

“Scrimping” at the Ritz: Master Budgets “Ladies and gentlemen serving ladies and gentlemen.” That’s the motto of the Ritz-Carlton. With locations ranging from South Beach (Miami) to South Korea, the grand hotel chain is known for its indulgent luxury and sumptuous surroundings. However, the aura of the chain’s old-world elegance stands in contrast to its rather heavy emphasis— behind the scenes, of course—on cost control and budgets. It is this very approach, however, that makes it possible for the Ritz to offer the legendary grandeur its guests expect during their stay. A Ritz hotel’s performance is the responsibility of its general manager and controller at each location worldwide. Local forecasts and budgets are prepared annually and are the basis of subsequent performance evaluations for the hotel and people who work there. The preparation of a hotel’s budget begins with the hotel’s sales director, who is responsible for all hotel revenues. Sources of revenue include hotel rooms, conventions, weddings, meeting facilities, merchandise, and food and beverage. The controller then seeks input about costs. Standard costs, based on cost per occupied room, are used to build the budget for guest room stays. Other standard costs are used to calculate costs for meeting rooms and food and beverages. The completed sales budget and annual operating budget are sent to corporate headquarters. From there, the hotel’s actual monthly performance is monitored against the

182

approved budget.

Determining How Costs Behave

What is the value of looking at the past?

Learning Objectives

Perhaps it is to recall fond memories you’ve had or help you understand historical events. Maybe your return to the past enables you to better understand and predict the future. When an organization looks at the past, it typically does so to analyze its results, so that the best decisions can be made for the company’s future. This activity requires gathering information about costs and how they behave so that managers can predict what they will be “down the road.” Gaining a deeper understanding of cost behavior can also spur a firm to reorganize its operations in innovative ways and tackle important challenges, as the following article shows.

1. Describe linear cost functions and three common ways in which they behave 2. Explain the importance of causality in estimating cost functions 3. Understand various methods of cost estimation 4. Outline six steps in estimating a cost function using quantitative analysis 5. Describe three criteria used to evaluate and choose cost drivers 6. Explain nonlinear cost functions, in particular those arising from learning curve effects 7. Be aware of data problems encountered in estimating cost functions

Management Accountants at Cisco Embrace Opportunities, Enhance Sustainability1 Understanding how costs behave is a valuable technical skill. Managers look to management accountants to help them identify cost drivers, estimate cost relationships, and determine the fixed and variable components of costs. To be effective, management accountants must have a clear understanding of the business’s strategy and operations to identify new opportunities to reduce costs and increase profitability. At Cisco Systems, management accountants’ in-depth understanding of the company’s costs and operations led to reduced costs, while also helping the environment. Cisco, makers of computer networking equipment including routers and wireless switches, traditionally regarded the used equipment it received back from its business customers as scrap and recycled it at a cost of about $8 million a year. As managers looked at the accumulated costs and realized that they may literally be “throwing away money,” they decided to reassess their treatment of scrap material. In 2005, managers at Cisco began trying to find uses for the equipment, mainly because 80% of the returns were in working condition. A value recovery team at Cisco identified groups within the company that could use the returned equipment. These included its customer service group, which supports warranty claims and service

340

Source: Nidumolu, R., C. Prahalad, and M. Rangaswami. 2009. Why sustainability is now the key driver of innovation. Harvard Business Review, September 2009; Cisco Systems, Inc. 2009. 2009 corporate social responsibility report. San Jose, CA: Cisco Systems, Inc.

contracts, and the labs that provide technical support, training, and product demonstrations. Based on the initial success of the value recovery team, in 2005, Cisco designated its recycling group as a company business unit, set clear objectives for it, and assigned the group its own income statement. As a result, the reuse of equipment rose from 5% in 2004 to 45% in 2008, and Cisco’s recycling costs fell by 40%. The unit has become a profit center that contributed $153 million to Cisco’s bottom line in 2008. With product returns reducing corporate profitability by an average of about 4% a year, companies like Cisco can leverage management accountants’ insight to reduce the cost of these returns while decreasing its environmental footprint. Not only can this turn a cost center into a profitable business, but sustainability efforts like these signals that the company is concerned about preventing environmental damage by reducing waste. As the Cisco example illustrates, managers must understand how costs behave to make strategic and operating decisions that have a positive environmental impact. Consider several other examples. Managers at FedEx decided to replace old planes with new Boeing 757s that reduced fuel consumption by 36%, while increasing capacity by 20%. At Clorox, managers decided to create a new line of nonsynthetic cleaning products that were better for the environment and helped create a new category of ‘green’ cleaning products worth about $200 million annually. In each situation, knowledge of cost behavior was needed to answer key questions. This chapter will focus on how managers determine costbehavior patterns—that is, how costs change in relation to changes in activity levels, in the quantity of products produced, and so on.

Basic Assumptions and Examples of Cost Functions Managers are able to understand cost behavior through cost functions. A cost function is a mathematical description of how a cost changes with changes in the level of an activity relating to that cost. Cost functions can be plotted on a graph by measuring the level of an activity, such as number of batches produced or number of machinehours used, on the horizontal axis (called the x-axis) and the amount of total costs corresponding to—or, preferably, dependent on—the levels of that activity on the vertical axis (called the y-axis).

Learning Objective

Describe linear cost functions . . . graph of cost function is a straight line and three common ways in which they behave . . . variable, fixed, and mixed

342 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Basic Assumptions Managers often estimate cost functions based on two assumptions: 1. Variations in the level of a single activity (the cost driver) explain the variations in the related total costs. 2. Cost behavior is approximated by a linear cost function within the relevant range. Recall that a relevant range is the range of the activity in which there is a relationship between total cost and the level of activity. For a linear cost function represented graphically, total cost versus the level of a single activity related to that cost is a straight line within the relevant range. We use these two assumptions throughout most, but not all, of this chapter. Not all cost functions are linear and can be explained by a single activity. Later sections will discuss cost functions that do not rely on these assumptions.

Linear Cost Functions To understand three basic types of linear cost functions and to see the role of cost functions in business decisions, consider the negotiations between Cannon Services and World Wide Communications (WWC) for exclusive use of a videoconferencing line between New York and Paris. #

Alternative 1: $5 per minute used. Total cost to Cannon changes in proportion to the number of minutes used. The number of minutes used is the only factor whose change causes a change in total cost. Panel A in Exhibit 10-1 presents this variable cost for Cannon Services. Under alternative 1, there is no fixed cost. We write the cost function in Panel A of Exhibit 10-1 as y = $5X

where X measures the number of minutes used (on the x-axis), and y measures the total cost of the minutes used (on the y-axis) calculated using the cost function. Panel A illustrates the $5 slope coefficient, the amount by which total cost changes when a one-unit change occurs in the level of activity (one minute of usage in the Cannon example). Throughout the chapter, uppercase letters, such as X, refer to the actual observations, and lowercase letters, such as y, represent estimates or calculations made using a cost function. Alternative 2: Total cost will be fixed at $10,000 per month, regardless of the number of minutes used. (We use the same activity measure, number of minutes used, to compare cost-behavior patterns under the three alternatives.) Panel B in Exhibit 10-1 presents this fixed cost for Cannon Services. We write the cost function in Panel B as y = $10,000

Exhibit 10-1

Examples of Linear Cost Functions

PANEL A: Variable Cost

PANEL B: Fixed Cost

4,000

8,000

Minutes Used (X)

$10,000

$20,000 Total Cost (Y)

Total Cost (Y)

Slope coefficient ! variable cost of $5 per minute used

Total Cost (Y)

$20,000

$10,000

PANEL C: Mixed Cost

$10,000

Constant or intercept of $10,000 4,000

Slope coefficient ! variable cost of $2 per minute used

8,000

Minutes Used (X)

$3,000

Constant or intercept of $3,000 4,000

8,000

Minutes Used (X)

BASIC ASSUMPTIONS AND EXAMPLES OF COST FUNCTIONS " 343

The fixed cost of $10,000 is called a constant; it is the component of total cost that does not vary with changes in the level of the activity. Under alternative 2, the constant accounts for all the cost because there is no variable cost. Graphically, the slope coefficient of the cost function is zero; this cost function intersects the y-axis at the constant value, and therefore the constant is also called the intercept. Alternative 3: $3,000 per month plus $2 per minute used. This is an example of a mixed cost. A mixed cost—also called a semivariable cost—is a cost that has both fixed and variable elements.

Panel C in Exhibit 10-1 presents this mixed cost for Cannon Services. We write the cost function in Panel C of Exhibit 10-1 as y = $3,000 + $2X

Unlike the graphs for alternatives 1 and 2, Panel C has both a constant, or intercept, value of $3,000 and a slope coefficient of $2. In the case of a mixed cost, total cost in the relevant range increases as the number of minutes used increases. Note that total cost does not vary strictly in proportion to the number of minutes used within the relevant range. For example, with 4,000 minutes of usage, the total cost equals $11,000 [$3,000 + ($2 per minute * 4,000 minutes)], but when 8,000 minutes are used, total cost equals $19,000 [$3,000 + ($2 per minute * 8,000 minutes)]. Although the usage in terms of minutes has doubled, total cost has increased by only about 73% [($19,000 – $11,000) ÷ $11,000]. Cannon’s managers must understand the cost-behavior patterns in the three alternatives to choose the best deal with WWC. Suppose Cannon expects to do at least 4,000 minutes of videoconferencing per month. Its cost for 4,000 minutes under the three alternatives would be as follows: # # #

Alternative 1: $20,000 ($5 per minute * 4,000 minutes) Alternative 2: $10,000 Alternative 3: $11,000 [$3,000 + ($2 per minute * 4,000 minutes)]

Alternative 2 is the least costly. Moreover, if Cannon were to use more than 4,000 minutes, as is likely to be the case, alternatives 1 and 3 would be even more costly. Cannon’s managers, therefore, should choose alternative 2. Note that the graphs in Exhibit 10-1 are linear. That is, they appear as straight lines. We simply need to know the constant, or intercept, amount (commonly designated a) and the slope coefficient (commonly designated b). For any linear cost function based on a single activity (recall our two assumptions discussed at the start of the chapter), knowing a and b is sufficient to describe and graphically plot all the values within the relevant range of number of minutes used. We write a general form of this linear cost function as y ! a " bX

Under alternative 1, a = $0 and b = $5 per minute used; under alternative 2, a = $10,000 and b = $0 per minute used; and under alternative 3, a = $3,000 and b = $2 per minute used. To plot the mixed-cost function in Panel C, we draw a line starting from the point marked $3,000 on the y-axis and increasing at a rate of $2 per minute used, so that at 1,000 minutes, total costs increase by $2,000 ($2 per minute * 1,000 minutes) to $5,000 ($3,000 + $2,000) and at 2,000 minutes, total costs increase by $4,000 ($2 per minute * 2,000 minutes) to $7,000 ($3,000 + $4,000) and so on.

Review of Cost Classification Before we discuss issues related to the estimation of cost functions, we briefly review the three criteria laid out in Chapter 2 for classifying a cost into its variable and fixed components. Choice of Cost Object A particular cost item could be variable with respect to one cost object and fixed with respect to another cost object. Consider Super Shuttle, an airport transportation company. If the fleet of vans it owns is the cost object, then the annual van registration and

344 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

license costs would be variable costs with respect to the number of vans owned. But if a particular van is the cost object, then the registration and license costs for that van are fixed costs with respect to the miles driven during a year. Time Horizon Whether a cost is variable or fixed with respect to a particular activity depends on the time horizon being considered in the decision situation. The longer the time horizon, all other things being equal, the more likely that the cost will be variable. For example, inspection costs at Boeing Company are typically fixed in the short run with respect to inspection-hours used because inspectors earn a fixed salary in a given year regardless of the number of inspection-hours of work done. But, in the long run, Boeing’s total inspection costs will vary with the inspection-hours required: More inspectors will be hired if more inspection-hours are needed, and some inspectors will be reassigned to other tasks or laid off if fewer inspection-hours are needed. Relevant Range Decision Point What is a linear cost function and what types of cost behavior can it represent?

Managers should never forget that variable and fixed cost-behavior patterns are valid for linear cost functions only within a given relevant range. Outside the relevant range, variable and fixed cost-behavior patterns change, causing costs to become nonlinear (nonlinear means the plot of the relationship on a graph is not a straight line). For example, Exhibit 10-2 plots the relationship (over several years) between total direct manufacturing labor costs and the number of snowboards produced each year by Ski Authority at its Vermont plant. In this case, the nonlinearities outside the relevant range occur because of labor and other inefficiencies (first because workers are learning to produce snowboards and later because capacity limits are being stretched). Knowing the relevant range is essential to properly classify costs.

Identifying Cost Drivers

. . . only a cause-andeffect relationship establishes an economically plausible relationship between an activity and its costs

Exhibit 10-2 Linearity Within Relevant Range for Ski Authority, Inc.

$350,000 $300,000 $250,000 $200,000 $150,000 $100,000 $50,000

Relevant Range

00 40 ,0 00 60 ,0 00 80 ,0 00

Explain the importance of causality in estimating cost functions

20 ,0

The Cannon Services/WWC example illustrates variable-, fixed-, and mixed-cost functions using information about future cost structures proposed to Cannon by WWC. Often, however, cost functions are estimated from past cost data. Managers use cost estimation to measure a relationship based on data from past costs and the related level of an activity. For example, marketing managers at Volkswagen could use cost estimation to understand what causes their marketing costs to change from year to year (for example, the number of new car models introduced or a competitor’s sudden recall) and the fixed and variable components of these costs. Managers are interested in estimating past cost-behavior functions primarily because these estimates can help them make more-accurate cost predictions, or forecasts, of future costs. Better cost predictions help managers make more-informed planning and control decisions, such as preparing next year’s marketing budget. But better management decisions, cost predictions, and estimation of cost functions can be achieved only if managers correctly identify the factors that affect costs.

Total Direct Manufacturing Labor Costs (Y)

Learning Objective

Snowboards Produced (X)

IDENTIFYING COST DRIVERS " 345

The Cause-and-Effect Criterion The most important issue in estimating a cost function is determining whether a causeand-effect relationship exists between the level of an activity and the costs related to that level of activity. Without a cause-and-effect relationship, managers will be less confident about their ability to estimate or predict costs. Recall from Chapter 2 that when a causeand-effect relationship exists between a change in the level of an activity and a change in the level of total costs, we refer to the activity measure as a cost driver. We use the terms level of activity and level of cost driver interchangeably when estimating cost functions. Understanding the drivers of costs is crucially important for managing costs. The causeand-effect relationship might arise as a result of the following: #

A physical relationship between the level of activity and costs. An example is when units of production are used as the activity that affects direct material costs. Producing more units requires more direct materials, which results in higher total direct material costs. A contractual arrangement. In alternative 1 of the Cannon Services example described earlier, number of minutes used is specified in the contract as the level of activity that affects the telephone line costs. Knowledge of operations. An example is when number of parts is used as the activity measure of ordering costs. A product with many parts will incur higher ordering costs than a product with few parts.

Managers must be careful not to interpret a high correlation, or connection, in the relationship between two variables to mean that either variable causes the other. Consider direct material costs and labor costs. For a given product mix, producing more units generally results in higher material costs and higher labor costs. Material costs and labor costs are highly correlated, but neither causes the other. Using labor costs to predict material costs is problematic. Some products require more labor costs relative to material costs, while other products require more material costs relative to labor costs. If the product mix changes toward more labor-intensive products, then labor costs will increase while material costs will decrease. Labor costs are a poor predictor of material costs. By contrast, factors that drive material costs such as product mix, product designs, and manufacturing processes, would have more accurately predicted the changes in material costs. Only a cause-and-effect relationship—not merely correlation—establishes an economically plausible relationship between the level of an activity and its costs. Economic plausibility is critical because it gives analysts and managers confidence that the estimated relationship will appear again and again in other sets of data from the same situation. Identifying cost drivers also gives managers insights into ways to reduce costs and the confidence that reducing the quantity of the cost drivers will lead to a decrease in costs. To identify cost drivers on the basis of data gathered over time, always use a long time horizon. Why? Because costs may be fixed in the short run (during which time they have no cost driver), but they are usually variable and have a cost driver in the long run.

Cost Drivers and the Decision-Making Process Consider Elegant Rugs, which uses state-of-the-art automated weaving machines to produce carpets for homes and offices. Management has made many changes in manufacturing processes and wants to introduce new styles of carpets. It would like to evaluate how these changes have affected costs and what styles of carpets it should introduce. It follows the five-step decision-making process outlined in Chapter 1. Step 1: Identify the problem and uncertainties. The changes in the manufacturing process were specifically targeted at reducing indirect manufacturing labor costs, and management wants to know whether costs such as supervision, maintenance, and quality control did, in fact, decrease. One option is to simply compare indirect manufacturing labor costs before and after the process change. The problem with this approach is that the volume of activity before and after the process change was very different so costs need to be compared after taking into account the change in activity volume.

346 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Decision Point What is the most important issue in estimating a cost function?

Managers were fairly confident about the direct material and direct manufacturing labor costs of the new styles of carpets. They were less certain about the impact that the choice of different styles would have on indirect manufacturing costs. Step 2: Obtain information. Managers gathered information about potential cost drivers—factors such as machine-hours or direct manufacturing labor-hours that cause indirect manufacturing labor costs to be incurred. They also began considering different techniques (discussed in the next section) such as the industrial engineering method, the conference method, the account analysis method, the high-low method, and the regression method for estimating the magnitude of the effect of the cost driver on indirect manufacturing labor costs. Their goal was to identify the best possible single cost driver. Step 3: Make predictions about the future. Managers used past data to estimate the relationship between cost drivers and costs and used this relationship to predict future costs. Step 4: Make decisions by choosing among alternatives. As we will describe later (pp. 353–355), Elegant Rugs chose machine-hours as the cost driver of indirect manufacturing labor costs. Using the regression analysis estimate of indirect manufacturing labor cost per machine-hour, managers estimated the costs of alternative styles of carpets and chose to introduce the most profitable styles. Step 5: Implement the decision, evaluate performance, and learn. After the managers at Elegant Rugs introduced the new carpet styles, they focused on evaluating the results of their decision. Comparing predicted to actual costs helped managers to learn how accurate the estimates were, to set targets for continuous improvement, and to constantly seek ways to improve efficiency and effectiveness.

Cost Estimation Methods Learning Objective

Understand various methods of cost estimation . . . for example, the regression analysis method determines the line that best fits past data

As we mentioned in Step 2, four methods of cost estimation are the industrial engineering method, the conference method, the account analysis method, and the quantitative analysis method (which takes different forms). These methods differ with respect to how expensive they are to implement, the assumptions they make, and the information they provide about the accuracy of the estimated cost function. They are not mutually exclusive, and many organizations use a combination of these methods.

Industrial Engineering Method The industrial engineering method, also called the work-measurement method, estimates cost functions by analyzing the relationship between inputs and outputs in physical terms. Consider Elegant Rugs. It uses inputs of cotton, wool, dyes, direct manufacturing labor, machine time, and power. Production output is square yards of carpet. Time-and-motion studies analyze the time required to perform the various operations to produce the carpet. For example, a time-and-motion study may conclude that to produce 10 square yards of carpet requires one hour of direct manufacturing labor. Standards and budgets transform these physical input measures into costs. The result is an estimated cost function relating direct manufacturing labor costs to the cost driver, square yards of carpet produced. The industrial engineering method is a very thorough and detailed way to estimate a cost function when there is a physical relationship between inputs and outputs, but it can be very time consuming. Some government contracts mandate its use. Many organizations, such as Bose and Nokia, use it to estimate direct manufacturing costs but find it too costly or impractical for analyzing their entire cost structure. For example, physical relationships between inputs and outputs are difficult to specify for some items, such as indirect manufacturing costs, R&D costs, and advertising costs.

Conference Method The conference method estimates cost functions on the basis of analysis and opinions about costs and their drivers gathered from various departments of a company (purchasing, process engineering, manufacturing, employee relations, etc.). The Cooperative Bank

COST ESTIMATION METHODS " 347

in the United Kingdom has a cost-estimating department that develops cost functions for its retail banking products (checking accounts, VISA cards, mortgages, and so on) based on the consensus of estimates from personnel of the particular departments. Elegant Rugs gathers opinions from supervisors and production engineers about how indirect manufacturing labor costs vary with machine-hours and direct manufacturing labor-hours. The conference method encourages interdepartmental cooperation. The pooling of expert knowledge from different business functions of the value chain gives the conference method credibility. Because the conference method does not require detailed analysis of data, cost functions and cost estimates can be developed quickly. However, the emphasis on opinions rather than systematic estimation means that the accuracy of the cost estimates depends largely on the care and skill of the people providing the inputs.

Account Analysis Method The account analysis method estimates cost functions by classifying various cost accounts as variable, fixed, or mixed with respect to the identified level of activity. Typically, managers use qualitative rather than quantitative analysis when making these cost-classification decisions. The account analysis approach is widely used because it is reasonably accurate, cost-effective, and easy to use. Consider indirect manufacturing labor costs for a small production area (or cell) at Elegant Rugs. Indirect manufacturing labor costs include wages paid for supervision, maintenance, quality control, and setups. During the most recent 12-week period, Elegant Rugs ran the machines in the cell for a total of 862 hours and incurred total indirect manufacturing labor costs of $12,501. Using qualitative analysis, the manager and the cost analyst determine that over this 12-week period indirect manufacturing labor costs are mixed costs with only one cost driver—machine-hours. As machine-hours vary, one component of the cost (such as supervision cost) is fixed, whereas another component (such as maintenance cost) is variable. The goal is to use account analysis to estimate a linear cost function for indirect manufacturing labor costs with number of machine-hours as the cost driver. The cost analyst uses experience and judgment to separate total indirect manufacturing labor costs ($12,501) into costs that are fixed ($2,157, based on 950 hours of machine capacity for the cell over a 12-week period) and costs that are variable ($10,344) with respect to the number of machine-hours used. Variable cost per machine-hour is $10,344 ÷ 862 machine-hours = $12 per machine-hour. The linear cost equation, y = a + bX, in this example is as follows: Indirect manufacturing labor costs = $2,157 + ($12 per machine-hour * Number of machine-hours)

Management at Elegant Rugs can use the cost function to estimate the indirect manufacturing labor costs of using, say, 950 machine-hours to produce carpet in the next 12-week period. Estimated costs equal $2,157 + (950 machine-hours * $12 per machine-hour) = $13,557. To obtain reliable estimates of the fixed and variable components of cost, organizations must take care to ensure that individuals thoroughly knowledgeable about the operations make the cost-classification decisions. Supplementing the account analysis method with the conference method improves credibility.

Quantitative Analysis Method Quantitative analysis uses a formal mathematical method to fit cost functions to past data observations. Excel is a useful tool for performing quantitative analysis. Columns B and C of Exhibit 10-3 show the breakdown of Elegant Rugs’ total machine-hours (862) and total indirect manufacturing labor costs ($12,501) into weekly data for the most recent 12-week period. Note that the data are paired; for each week, there is data for the number of machine-hours and corresponding indirect manufacturing labor costs. For example, week 12 shows 48 machine-hours and indirect manufacturing labor costs of $963. The next section uses the data in Exhibit 10-3 to illustrate how to estimate a cost

Decision Point What are the different methods that can be used to estimate a cost function?

348 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Exhibit 10-3 Weekly Indirect Manufacturing Labor Costs and MachineHours for Elegant Rugs

Week

1 2 3 4 5 6 7 8 9 10 11 12

Total

3 4 5 6 7 8 9 10 11 12 13

Indirect Cost Driver: Manufacturing Machine-Hours Labor Costs (X ) (Y ) 68 $ 1,190 1,211 88 62 1,004 917 72 770 60 1,456 96 78 1,180 46 710 82 1,316 94 1,032 68 752 963 48 862

$12,501

function using quantitative analysis. We examine two techniques—the relatively simple high-low method as well as the more common quantitative tool used to examine and understand data, regression analysis.

Steps in Estimating a Cost Function Using Quantitative Analysis Learning Objective

Outline six steps in estimating a cost function using quantitative analysis . . . the end result (Step 6) is to evaluate the cost driver of the estimated cost function

There are six steps in estimating a cost function using quantitative analysis of a past cost relationship. We illustrate the steps as follows using the Elegant Rugs example. Step 1: Choose the dependent variable. Choice of the dependent variable (the cost to be predicted and managed) will depend on the cost function being estimated. In the Elegant Rugs example, the dependent variable is indirect manufacturing labor costs. Step 2: Identify the independent variable, or cost driver. The independent variable (level of activity or cost driver) is the factor used to predict the dependent variable (costs). When the cost is an indirect cost, as it is with Elegant Rugs, the independent variable is also called a cost-allocation base. Although these terms are sometimes used interchangeably, we use the term cost driver to describe the independent variable. Frequently, the cost analyst, working with the management team, will cycle through the six steps several times, trying alternative economically plausible cost drivers to identify a cost driver that best fits the data. A cost driver should be measurable and have an economically plausible relationship with the dependent variable. Economic plausibility means that the relationship (describing how changes in the cost driver lead to changes in the costs being considered) is based on a physical relationship, a contract, or knowledge of operations and makes economic sense to the operating manager and the management accountant. As we saw in Chapter 5, all the individual items of costs included in the dependent variable should have the same cost driver, that is, the cost pool should be homogenous. When all items of costs in the dependent variable do not have the same cost driver, the cost analyst should investigate the possibility of creating homogenous cost pools and estimating more than one cost function, one for each cost item/cost driver pair.

STEPS IN ESTIMATING A COST FUNCTION USING QUANTITATIVE ANALYSIS " 349

As an example, consider several types of fringe benefits paid to employees and the cost drivers of the benefits: Fringe Benefit Health benefits Cafeteria meals Pension benefits Life insurance

Cost Driver Number of employees Number of employees Salaries of employees Salaries of employees

The costs of health benefits and cafeteria meals can be combined into one homogenous cost pool because they have the same cost driver—the number of employees. Pension benefits and life insurance costs have a different cost driver—the salaries of employees—and, therefore, should not be combined with health benefits and cafeteria meals. Instead, pension benefits and life insurance costs should be combined into a separate homogenous cost pool. The cost pool comprising pension benefits and life insurance costs can be estimated using salaries of employees receiving these benefits as the cost driver. Step 3: Collect data on the dependent variable and the cost driver. This is usually the most difficult step in cost analysis. Cost analysts obtain data from company documents, from interviews with managers, and through special studies. These data may be timeseries data or cross-sectional data. Time-series data pertain to the same entity (organization, plant, activity, and so on) over successive past periods. Weekly observations of indirect manufacturing labor costs and number of machine-hours at Elegant Rugs are examples of time-series data. The ideal time-series database would contain numerous observations for a company whose operations have not been affected by economic or technological change. A stable economy and technology ensure that data collected during the estimation period represent the same underlying relationship between the cost driver and the dependent variable. Moreover, the periods used to measure the dependent variable and the cost driver should be consistent throughout the observations. Cross-sectional data pertain to different entities during the same period. For example, studies of loans processed and the related personnel costs at 50 individual, yet similar, branches of a bank during March 2012 would produce cross-sectional data for that month. The cross-sectional data should be drawn from entities that, within each entity, have a similar relationship between the cost driver and costs. Later in this chapter, we describe the problems that arise in data collection. Step 4: Plot the data. The general relationship between the cost driver and costs can be readily observed in a graphical representation of the data, which is commonly called a plot of the data. The plot provides insight into the relevant range of the cost function, and reveals whether the relationship between the driver and costs is approximately linear. Moreover, the plot highlights extreme observations (observations outside the general pattern) that analysts should check. Was there an error in recording the data or an unusual event, such as a work stoppage, that makes these observations unrepresentative of the normal relationship between the cost driver and the costs? Exhibit 10-4 is a plot of the weekly data from columns B and C of the Excel spreadsheet in Exhibit 10-3. This graph provides strong visual evidence of a positive linear relationship between number of machine-hours and indirect manufacturing labor costs (that is, when machine-hours go up, so do indirect manufacturing labor costs). There do not appear to be any extreme observations in Exhibit 10-4. The relevant range is from 46 to 96 machine-hours per week (weeks 8 and 6, respectively). Step 5: Estimate the cost function. We will show two ways to estimate the cost function for our Elegant Rugs data. One uses the high-low method, and the other uses regression analysis, the two most frequently described forms of quantitative analysis. The widespread availability of computer packages such as Excel makes regression analysis much more easy to use. Still, we describe the high-low method to provide some basic intuition for the idea of drawing a line to “fit” a number of data points. We present these methods after Step 6.

Exhibit 10-4 Plot of Weekly Indirect Manufacturing Labor Costs and MachineHours for Elegant Rugs

Indirect Manufacturing Labor Costs (Y)

350 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE $1,600 1,400

1,200

1,000 8

600

800

4 5

400 200 20

100

Cost Driver: Machine-Hours (X)

Step 6: Evaluate the cost driver of the estimated cost function. In this step, we describe criteria for evaluating the cost driver of the estimated cost function. We do this after illustrating the high-low method and regression analysis.

High-Low Method The simplest form of quantitative analysis to “fit” a line to data points is the high-low method. It uses only the highest and lowest observed values of the cost driver within the relevant range and their respective costs to estimate the slope coefficient and the constant of the cost function. It provides a first cut at understanding the relationship between a cost driver and costs. We illustrate the high-low method using data from Exhibit 10-3.

Highest observation of cost driver (week 6) Lowest observation of cost driver (week 8) Difference

Cost Driver: Machine-Hours (X ) 96 46 50

Indirect Manufacturing Labor Costs (Y ) $1,456 ƒƒƒ710 $ƒƒ746

The slope coefficient, b, is calculated as follows: Difference between costs associated with highest and lowest observations of the cost driver Slope coefficient = Difference between highest and lowest observations of the cost driver = $746 , 50 machine-hours = $14.92 per machine-hour

To compute the constant, we can use either the highest or the lowest observation of the cost driver. Both calculations yield the same answer because the solution technique solves two linear equations with two unknowns, the slope coefficient and the constant. Because y = a + bX a = y - bX

At the highest observation of the cost driver, the constant, a, is calculated as follows: Constant = $1,456 - ($14.92 per machine-hour * 96 machine-hours) = $23.68

And at the lowest observation of the cost driver, Constant = $710 - ($14.92 per machine-hour * 46 machine-hours) = $23.68

Thus, the high-low estimate of the cost function is as follows: y = a + bX y = $23.68 + ($14.92 per machine-hour * Number of machine-hours)

STEPS IN ESTIMATING A COST FUNCTION USING QUANTITATIVE ANALYSIS " 351

Indirect Manufacturing Labor Costs (Y)

The purple line in Exhibit 10-5 shows the estimated cost function using the highlow method (based on the data in Exhibit 10-3). The estimated cost function is a straight line joining the observations with the highest and lowest values of the cost driver (number of machine-hours). Note how this simple high-low line falls “in-between” the data points with three observations on the line, four above it and five below it. The intercept (a = $23.68), the point where the dashed extension of the purple line meets the y-axis, is the constant component of the equation that provides the best linear approximation of how a cost behaves within the relevant range of 46 to 96 machine-hours. The intercept should not be interpreted as an estimate of the fixed costs of Elegant Rugs if no machines were run. That’s because running no machines and shutting down the plant—that is, using zero machine-hours—is outside the relevant range. Suppose indirect manufacturing labor costs in week 6 were $1,280, instead of $1,456, while 96 machine-hours were used. In this case, the highest observation of the cost driver (96 machine-hours in week 6) will not coincide with the newer highest observation of the costs ($1,316 in week 9). How would this change affect our high-low calculation? Given that the cause-and-effect relationship runs from the cost driver to the costs in a cost function, we choose the highest and lowest observations of the cost driver (the factor that causes the costs to change). The high-low method would still estimate the new cost function using data from weeks 6 (high) and 8 (low). There is a danger of relying on only two observations to estimate a cost function. Suppose that because a labor contract guarantees certain minimum payments in week 8, indirect manufacturing labor costs in week 8 were $1,000, instead of $710, when only 46 machine-hours were used. The blue line in Exhibit 10-5 shows the cost function that would be estimated by the high-low method using this revised cost. Other than the two points used to draw the line, all other data lie on or below the line! In this case, choosing the highest and lowest observations for machine-hours would result in an estimated cost function that poorly describes the underlying linear cost relationship between number of machine-hours and indirect manufacturing labor costs. In such situations, the high-low method can be modified so that the two observations chosen to estimate the cost function are a representative high and a representative low. By using this adjustment, managers can avoid having extreme observations, which arise from abnormal events, influence the estimate of the cost function. The modification allows managers to estimate a cost function that is representative of the relationship between the cost driver and costs and, therefore, is more useful for making decisions (such as pricing and performance evaluation). The advantage of the high-low method is that it is simple to compute and easy to understand; it gives a quick, initial insight into how the cost driver—number of machinehours—affects indirect manufacturing labor costs. The disadvantage is that it ignores information from all but two observations when estimating the cost function. We next describe the regression analysis method of quantitative analysis that uses all available data to estimate the cost function. Relevant Range

Exhibit 10-5

$1,600 1,400 1,200 1,000

High-low line using revised costs for week 8

1 7

3 12

800

600 400 200 20

4 5

9 2 10

High-low line using data in Exhibit 10-3 60

Cost Driver: Machine-Hours (X)

100

High-Low Method for Weekly Indirect Manufacturing Labor Costs and MachineHours for Elegant Rugs

352 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Regression Analysis Method Regression analysis is a statistical method that measures the average amount of change in the dependent variable associated with a unit change in one or more independent variables. In the Elegant Rugs example, the dependent variable is total indirect manufacturing labor costs. The independent variable, or cost driver, is number of machine-hours. Simple regression analysis estimates the relationship between the dependent variable and one independent variable. Multiple regression analysis estimates the relationship between the dependent variable and two or more independent variables. Multiple regression analysis for Elegant Rugs might use as the independent variables, or cost drivers, number of machine-hours and number of batches. The appendix to this chapter will explore simple regression and multiple regression in more detail. In later sections, we will illustrate how Excel performs the calculations associated with regression analysis. The following discussion emphasizes how managers interpret and use the output from Excel to make critical strategic decisions. Exhibit 10-6 shows the line developed using regression analysis that best fits the data in columns B and C of Exhibit 10-3. Excel estimates the cost function to be y = $300.98 + $10.31X

The regression line in Exhibit 10-6 is derived using the least-squares technique. The leastsquares technique determines the regression line by minimizing the sum of the squared vertical differences from the data points (the various points in the graph) to the regression line. The vertical difference, called the residual term, measures the distance between actual cost and estimated cost for each observation of the cost driver. Exhibit 10-6 shows the residual term for the week 1 data. The line from the observation to the regression line is drawn perpendicular to the horizontal axis, or x-axis. The smaller the residual terms, the better the fit between actual cost observations and estimated costs. Goodness of fit indicates the strength of the relationship between the cost driver and costs. The regression line in Exhibit 10-6 rises from left to right. The positive slope of this line and small residual terms indicate that, on average, indirect manufacturing labor costs increase as the number of machine-hours increases. The vertical dashed lines in Exhibit 10-6 indicate the relevant range, the range within which the cost function applies. Instructors and students who want to explore the technical details of estimating the least-squares regression line, can go to the appendix, pages 367–371 and return to this point without any loss of continuity. The estimate of the slope coefficient, b, indicates that indirect manufacturing labor costs vary at the average amount of $10.31 for every machine-hour used within the relevant range. Management can use the regression equation when budgeting for future indirect manufacturing labor costs. For instance, if 90 machine-hours are budgeted for the upcoming week, the predicted indirect manufacturing labor costs would be

Exhibit 10-6 Regression Model for Weekly Indirect Manufacturing Labor Costs and MachineHours for Elegant Rugs

Indirect Manufacturing Labor Costs (Y)

y = $300.98 + ($10.31 per machine-hour * 90 machine-hours) = $1,228.88 Relevant Range $1,600

Residual term 1

1,400 1,200

1,000

600 400

2 10

800

Regression line y ! $300.98 " $10.31X

200 20

Cost Driver: Machine-Hours (X)

100

110

EVALUATING COST DRIVERS OF THE ESTIMATED COST FUNCTION " 353

As we have already mentioned, the regression method is more accurate than the high-low method because the regression equation estimates costs using information from all observations, whereas the high-low equation uses information from only two observations. The inaccuracies of the high-low method can mislead managers. Consider the high-low method equation in the preceding section, y = $23.68 + $14.92 per machine-hour * Number of machine-hours. For 90 machine-hours, the predicted weekly cost based on the high-low method equation is $23.68 + ($14.92 per machinehour * 90 machine-hours) = $1,366.48. Suppose that for 7 weeks over the next 12-week period, Elegant Rugs runs its machines for 90 hours each week. Assume average indirect manufacturing labor costs for those 7 weeks are $1,300. Based on the highlow method prediction of $1,366.48, Elegant Rugs would conclude it has performed well because actual costs are less than predicted costs. But comparing the $1,300 performance with the more-accurate $1,228.88 prediction of the regression model tells a much different story and would probably prompt Elegant Rugs to search for ways to improve its cost performance. Accurate cost estimation helps managers predict future costs and evaluate the success of cost-reduction initiatives. Suppose the manager at Elegant Rugs is interested in evaluating whether recent strategic decisions that led to changes in the production process and resulted in the data in Exhibit 10-3 have reduced indirect manufacturing labor costs, such as supervision, maintenance, and quality control. Using data on number of machinehours used and indirect manufacturing labor costs of the previous process (not shown here), the manager estimates the regression equation, y = $546.26 + ($15.86 per machine-hour * Number of machine-hours)

The constant ($300.98 versus $545.26) and the slope coefficient ($10.31 versus $15.86) are both smaller for the new process relative to the old process. It appears that the new process has decreased indirect manufacturing labor costs.

Evaluating Cost Drivers of the Estimated Cost Function How does a company determine the best cost driver when estimating a cost function? In many cases, the choice of a cost driver is aided substantially by understanding both operations and cost accounting. To see why the understanding of operations is needed, consider the costs to maintain and repair metal-cutting machines at Helix Corporation, a manufacturer of treadmills. Helix schedules repairs and maintenance at a time when production is at a low level to avoid having to take machines out of service when they are needed most. An analysis of the monthly data will then show high repair costs in months of low production and low repair costs in months of high production. Someone unfamiliar with operations might conclude that there is an inverse relationship between production and repair costs. The engineering link between units produced and repair costs, however, is usually clear-cut. Over time, there is a cause-and-effect relationship: the higher the level of production, the higher the repair costs. To estimate the relationship correctly, operating managers and analysts will recognize that repair costs will tend to lag behind periods of high production, and hence, they will use production of prior periods as the cost driver. In other cases, choosing a cost driver is more subtle and difficult. Consider again indirect manufacturing labor costs at Elegant Rugs. Management believes that both the number of machine-hours and the number of direct manufacturing labor-hours are plausible cost drivers of indirect manufacturing labor costs. However, management is not sure which is the better cost driver. Exhibit 10-7 presents weekly data (in Excel) on indirect manufacturing labor costs and number of machine-hours for the most recent 12-week period from Exhibit 10-3, together with data on the number of direct manufacturing labor-hours for the same period.

Decision Point What are the steps to estimate a cost function using quantitative analysis?

Learning Objective

Describe three criteria used to evaluate and choose cost drivers . . . economically plausible relationships, goodness of fit, and significant effect of the cost driver on costs

354 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Exhibit 10-7 Weekly Indirect Manufacturing Labor Costs, Machine-Hours, and Direct Manufacturing LaborHours for Elegant Rugs

Week 1 2 3 4 5 6 7 8 9 10 11 12

Original Cost Driver: Machine-Hours 68 88 62 72 60 96 78 46 82 94 68 48

Total

862

1 2 3 4 5 6 7 8 9 10 11 12

Alternate Cost Driver: Indirect Direct Manufacturing Manufacturing Labor Costs Labor-Hours (Y) (X) $ 1,190 30 1,211 35 1,004 36 917 20 770 47 1,456 45 1,180 44 710 38 1,316 70 1,032 30 752 29 963 38 462

$ 12,501

Choosing Among Cost Drivers What guidance do the different cost-estimation methods provide for choosing among cost drivers? The industrial engineering method relies on analyzing physical relationships between cost drivers and costs, relationships that are difficult to specify in this case. The conference method and the account analysis method use subjective assessments to choose a cost driver and to estimate the fixed and variable components of the cost function. In these cases, managers must rely on their best judgment. Managers cannot use these methods to test and try alternative cost drivers. The major advantages of quantitative methods are that they are objective—a given data set and estimation method result in a unique estimated cost function—and managers can use them to evaluate different cost drivers. We use the regression analysis approach to illustrate how to evaluate different cost drivers. First, the cost analyst at Elegant Rugs enters data in columns C and D of Exhibit 10-7 in Excel and estimates the following regression equation of indirect manufacturing labor costs based on number of direct manufacturing labor-hours: y = $744.67 + $7.72X

Exhibit 10-8 shows the plot of the data points for number of direct manufacturing laborhours and indirect manufacturing labor costs, and the regression line that best fits the data. Recall that Exhibit 10-6 shows the corresponding graph when number of machine-hours is the cost driver. To decide which of the two cost drivers Elegant Rugs should choose, the analyst compares the machine-hour regression equation and the direct manufacturing laborhour regression equation. There are three criteria used to make this evaluation. 1. Economic plausibility. Both cost drivers are economically plausible. However, in the state-of-the-art, highly automated production environment at Elegant Rugs, managers familiar with the operations believe that costs such as machine maintenance are likely to be more closely related to number of machine-hours used than to number of direct manufacturing labor-hours used. 2. Goodness of fit. Compare Exhibits 10-6 and 10-8. The vertical differences between actual costs and predicted costs are much smaller for the machine-hours regression than for the direct manufacturing labor-hours regression. Number of machine-hours used, therefore, has a stronger relationship—or goodness of fit—with indirect manufacturing labor costs.

Indirect Manufacturing Labor Costs (Y)

EVALUATING COST DRIVERS OF THE ESTIMATED COST FUNCTION " 355 Relevant Range $1,600

Exhibit 10-8

1,400

1,200 4

1,000

800 11

600

Regression Model for Weekly Indirect Manufacturing Labor Costs and Direct Manufacturing LaborHours for Elegant Rugs

12 5

400

Regression line y ! $744.67 " $7.72X

200 10

Cost Driver: Direct Manufacturing Labor-Hours (X)

3. Significance of independent variable. Again compare Exhibits 10-6 and 10-8 (both of which have been drawn to roughly the same scale). The machine-hours regression line has a steep slope relative to the slope of the direct manufacturing labor-hours regression line. For the same (or more) scatter of observations about the line (goodness of fit), a flat, or slightly sloped regression line indicates a weak relationship between the cost driver and costs. In our example, changes in direct manufacturing labor-hours appear to have a small influence or effect on indirect manufacturing labor costs. Based on this evaluation, managers at Elegant Rugs select number of machine-hours as the cost driver and use the cost function y = $300.98 + ($10.31 per machine-hour * Number of machine-hours) to predict future indirect manufacturing labor costs. Instructors and students who want to explore how regression analysis techniques can be used to choose among different cost drivers can go to the appendix, pages 371–374 and return to this point without any loss of continuity. Why is choosing the correct cost driver to estimate indirect manufacturing labor costs important? Because identifying the wrong drivers or misestimating cost functions can lead management to incorrect (and costly) decisions along a variety of dimensions. Consider the following strategic decision that management at Elegant Rugs must make. The company is thinking of introducing a new style of carpet that, from a manufacturing standpoint, is similar to the carpets it has manufactured in the past. Prices are set by the market and sales of 650 square yards of this carpet are expected each week. Management estimates 72 machine-hours and 21 direct manufacturing labor-hours would be required per week to produce the 650 square yards of carpet needed. Using the machine-hour regression equation, Elegant Rugs would predict indirect manufacturing labor costs of y = $300.98 + ($10.31 per machine-hour * 72 machine-hours) = $1,043.30. If it used direct manufacturing labor-hours as the cost driver, it would incorrectly predict costs of $744.67 + ($7.72 per labor-hour * 21 labor-hours) = $906.79. If Elegant Rugs chose similarly incorrect cost drivers for other indirect costs as well and systematically underestimated costs, it would conclude that the costs of manufacturing the new style of carpet would be low and basically fixed (fixed because the regression line is nearly flat). But the actual costs driven by number of machine-hours used and other correct cost drivers would be higher. By failing to identify the proper cost drivers, management would be misled into believing the new style of carpet would be more profitable than it actually is. It might decide to introduce the new style of carpet, whereas if Elegant identifies the correct cost driver it might decide not to introduce the new carpet. Incorrectly estimating the cost function would also have repercussions for cost management and cost control. Suppose number of direct manufacturing labor-hours were used as the cost driver, and actual indirect manufacturing labor costs for the new carpet were $970. Actual costs would then be higher than the predicted costs of $906.79. Management would feel compelled to find ways to cut costs. In fact, on the basis of the preferred machine-hour cost driver, the plant would have actual costs lower than the $1,043.30 predicted costs—a performance that management should seek to replicate, not change!

356 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Concepts in Action

Activity-Based Costing: Identifying Cost and Revenue Drivers

Many cost estimation methods presented in this chapter are essential to service, manufacturing, and retail-sector implementations of activity-based costing across the globe. To determine the cost of an activity in the banking industry, ABC systems often rely on expert analyses and opinions gathered from operating personnel (the conference method). For example, the loan department staff at the Co-operative Bank in the United Kingdom subjectively estimate the costs of the loan processing activity and the quantity of the related cost driver—the number of loans processed, a batch-level cost driver, as distinguished from the amount of the loans, an output unit-level cost driver—to derive the cost of processing a loan. Elsewhere in the United Kingdom, the City of London police force uses input-output relationships (the industrial engineering method) to identify cost drivers and the cost of an activity. Using a surveying methodology, officials can determine the total costs associated with responding to house robberies, dealing with burglaries, and filling out police reports. In the United States, the Boeing Commercial Airplane Group’s Wichita Division used detailed analyses of its commercial airplanemanufacturing methods to support make/buy decisions for complex parts required in airplane assembly. The industrial engineering method is also used by U.S. government agencies such as the U.S. Postal Service to determine the cost of each post office transaction and the U.S. Patent and Trademark Office to identify the costs of each patent examination. Regression analysis is another helpful tool for determining the cost drivers of activities. Consider how fuel service retailers (that is, gas stations with convenience stores) identify the principal cost driver for labor within their operations. Two possible cost drivers are gasoline sales and convenience store sales. Gasoline sales are batch-level activities because payment transactions occur only once for each gasoline purchase, regardless of the volume of gasoline purchased; whereas convenience store sales are output unit-level activities that vary based on the amount of food, drink, and other products sold. Fuel service retailers generally use convenience store sales as the basis for assigning labor costs because multiple regression analyses confirm that convenience store sales, not gasoline sales, are the major cost driver of labor within their operations. While popular, these are not the only methods used to evaluate cost drivers. If you recall from chapter five, Charles Schwab is one of the growing number of companies using time-driven activity based costing, which uses time as the cost driver. At Citigroup, the company’s internal technology infrastructure group uses time to better manage the labor capacity required to provide reliable, secure, and cost effective technology services to about 60 Citigroup business units around the world. The trend of using activity-based costing to identify cost and revenue drivers also extends into emerging areas. For example, the U.S. government allocated $19 billion in 2009 to support the adoption of electronic health records. Using the input-output method, many health clinics and doctor’s offices are leveraging activity-based costing to identify the cost of adopting this new health information technology tool. Sources: Barton, T., and J. MacArthur. 2003. Activity-based costing and predatory pricing: The case of the retail industry. Management Accounting Quarterly (Spring); Carter, T., A. Sedaghat, and T. Williams. 1998. How ABC changed the post office. Management Accounting, (February); The Cooperative Bank. Harvard Business School. Case No. N9-195-196; Federowicz, M., M. Grossman, B. Hayes, and J. Riggs. 2010. A tutorial on activity-based costing of electronic health records. Quality Management in Health Care (January–March); Kaplan, Robert, and Steven Anderson. 2008. Time-driven activity-based costing: A simpler and more powerful path to higher profits. Boston: Harvard Business School Publishing; Leapman, B. 2006. Police spend £500m filling in forms. The Daily Telegraph, January 22; Paduano, Rocco, and Joel Cutcher-Gershenfeld. 2001. Boeing Commercial Airplane Group Wichita Division (Boeing Co.). MIT Labor Aerospace Research Agenda Case Study. Cambridge, MA: MIT; Peckenpaugh, J. 2002. Teaching the ABCs. Government Executive, April 1; The United Kingdom Home Office. 2007. The police service national ABC model: Manual of guidance. London: Her Majesty’s Stationary Office.

Cost Drivers and Activity-Based Costing Activity-based costing (ABC) systems focus on individual activities—such as product design, machine setup, materials handling, distribution, and customer service—as the fundamental cost objects. To implement ABC systems, managers must identify a cost driver for each activity. For example, using methods described in this chapter, the manager must decide whether the number of loads moved or the weight of loads moved is the cost driver of materials-handling costs.

NONLINEAR COST FUNCTIONS " 357

To choose the cost driver and use it to estimate the cost function in our materialshandling example, the manager collects data on materials-handling costs and the quantities of the two competing cost drivers over a reasonably long period. Why a long period? Because in the short run, materials-handling costs may be fixed and, therefore, will not vary with changes in the level of the cost driver. In the long run, however, there is a clear cause-and-effect relationship between materials-handling costs and the cost driver. Suppose number of loads moved is the cost driver of materials-handling costs. Increases in the number of loads moved will require more materials-handling labor and equipment; decreases will result in equipment being sold and labor being reassigned to other tasks. ABC systems have a great number and variety of cost drivers and cost pools. That means ABC systems require many cost relationships to be estimated. In estimating the cost function for each cost pool, the manager must pay careful attention to the cost hierarchy. For example, if a cost is a batch-level cost such as setup cost, the manager must only consider batch-level cost drivers like number of setup-hours. In some cases, the costs in a cost pool may have more than one cost driver from different levels of the cost hierarchy. In the Elegant Rugs example, the cost drivers for indirect manufacturing labor costs could be machine-hours and number of production batches of carpet manufactured. Furthermore, it may be difficult to subdivide the indirect manufacturing labor costs into two cost pools and to measure the costs associated with each cost driver. In these cases, companies use multiple regression to estimate costs based on more than one independent variable. The appendix to this chapter discusses multiple regression in more detail. As the Concepts in Action feature (p. 356) illustrates, managers implementing ABC systems use a variety of methods—industrial engineering, conference, and regression analysis—to estimate slope coefficients. In making these choices, managers trade off level of detail, accuracy, feasibility, and costs of estimating cost functions.

Decision Point How should a company evaluate and choose cost drivers?

Nonlinear Cost Functions In practice, cost functions are not always linear. A nonlinear cost function is a cost function for which the graph of total costs (based on the level of a single activity) is not a straight line within the relevant range. To see what a nonlinear cost function looks like, return to Exhibit 10-2 (p. 344). The relevant range is currently set at 20,000 to 65,000 snowboards. But if we extend the relevant range to encompass the region from 0 to 80,000 snowboards produced, it is evident that the cost function over this expanded range is graphically represented by a line that is not straight. Consider another example. Economies of scale in advertising may enable an advertising agency to produce double the number of advertisements for less than double the costs. Even direct material costs are not always linear variable costs because of quantity discounts on direct material purchases. As shown in Exhibit 10-9 (p. 358), Panel A, total direct material costs rise as the units of direct materials purchased increase. But, because of quantity discounts, these costs rise more slowly (as indicated by the slope coefficient) as the units of direct materials purchased increase. This cost function has b = $25 per unit for 1–1,000 units purchased, b = $15 per unit for 1,001 –2,000 units purchased, and b = $10 per unit for 2,001–3,000 units purchased. The direct material cost per unit falls at each price break—that is, the cost per unit decreases with larger purchase orders. If managers are interested in understanding cost behavior over the relevant range from 1 to 3,000 units, the cost function is nonlinear—not a straight line. If, however, managers are only interested in understanding cost behavior over a more narrow relevant range (for example, from 1 to 1,000 units), the cost function is linear. Step cost functions are also examples of nonlinear cost functions. A step cost function is a cost function in which the cost remains the same over various ranges of the level of activity, but the cost increases by discrete amounts—that is, increases in steps—as the level of activity increases from one range to the next. Panel B in Exhibit 10-9 shows a step variable-cost function, a step cost function in which cost remains the same over narrow ranges of the level of activity in each relevant range. Panel B presents the relationship between units of production and setup costs. The pattern is a step cost function because, as we described in Chapter 5 on activity-based costing, setup costs are

Learning Objective

Explain nonlinear cost functions . . . graph of cost function is not a straight line, for example, because of quantity discounts or costs changing in steps in particular those arising from learning curve effects . . . either cumulative average-time learning, where cumulative average time per unit declines by a constant percentage, as units produced double . . . or incremental unittime learning, in which incremental time to produce last unit declines by constant percentage, as units produced double

358 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Examples of Nonlinear Cost Functions

$50,000 $40,000

Slope coefficient b ! $15 per unit

$20,000 $10,000

$7,500

Slope coefficient b ! $10 per unit

$30,000

Slope coefficient b ! $25 per unit 1,000

2,000

PANEL C: Step Fixed-Cost Function

PANEL B: Step Variable-Cost Function

Setup Costs (Y)

Total Direct Material Costs (Y)

PANEL A: Effects of Quantity Discounts on Slope Coefficient of Direct Material Cost Function

Actual cost behavior $5,000

$2,500

3,000

Units of Direct Materials Purchased (X)

Linear approximation of cost behavior 2,000

4,000

Units of Production (X)

6,000

Furnace Costs (in thousands) (Y)

Exhibit 10-9

Actual cost behavior $900 $600 $300

Linear approximation of cost behavior 7,500

15,000

22,500

Relevant range Hours of Furnace Time (X)

related to each production batch started. If the relevant range is considered to be from 0 to 6,000 production units, the cost function is nonlinear. However, as shown by the blue line in Panel B, managers often approximate step variable costs with a continuouslyvariable cost function. This type of step cost pattern also occurs when production inputs such as materials-handling labor, supervision, and process engineering labor are acquired in discrete quantities but used in fractional quantities. Panel C in Exhibit 10-9 shows a step fixed-cost function for Crofton Steel, a company that operates large heat-treatment furnaces to harden steel parts. Looking at Panel C and Panel B, you can see that the main difference between a step variable-cost function and a step fixed-cost function is that the cost in a step fixed-cost function remains the same over wide ranges of the activity in each relevant range. The ranges indicate the number of furnaces being used (each furnace costs $300,000). The cost increases from one range to the next higher range when the hours of furnace time needed require the use of another furnace. The relevant range of 7,500 to 15,000 hours of furnace time indicates that the company expects to operate with two furnaces at a cost of $600,000. Management considers the cost of operating furnaces as a fixed cost within this relevant range of operation. However, if the relevant range is considered to be from 0 to 22,500 hours, the cost function is nonlinear: The graph in Panel C is not a single straight line; it is three broken lines.

Learning Curves Nonlinear cost functions also result from learning curves. A learning curve is a function that measures how labor-hours per unit decline as units of production increase because workers are learning and becoming better at their jobs. Managers use learning curves to predict how labor-hours, or labor costs, will increase as more units are produced. The aircraft-assembly industry first documented the effect that learning has on efficiency. In general, as workers become more familiar with their tasks, their efficiency improves. Managers learn how to improve the scheduling of work shifts and how to operate the plant more efficiently. As a result of improved efficiency, unit costs decrease as productivity increases, and the unit-cost function behaves nonlinearly. These nonlinearities must be considered when estimating and predicting unit costs. Managers have extended the learning-curve notion to other business functions in the value chain, such as marketing, distribution, and customer service, and to costs other than labor costs. The term experience curve describes this broader application of the learning curve. An experience curve is a function that measures the decline in cost per unit in various

NONLINEAR COST FUNCTIONS " 359

business functions of the value chain—marketing, distribution, and so on—as the amount of these activities increases. For companies such as Dell Computer, Wal-Mart, and McDonald’s, learning curves and experience curves are key elements of their strategies. These companies use learning curves and experience curves to reduce costs and increase customer satisfaction, market share, and profitability. We now describe two learning-curve models: the cumulative average-time learning model and the incremental unit-time learning model.

Cumulative Average-Time Learning Model In the cumulative average-time learning model, cumulative average time per unit declines by a constant percentage each time the cumulative quantity of units produced doubles. Consider Rayburn Corporation, a radar systems manufacturer. Rayburn has an 80% learning curve. The 80% means that when the quantity of units produced is doubled from X to 2X, cumulative average time per unit for 2X units is 80% of cumulative average time per unit for X units. Average time per unit has dropped by 20% (100% – 80%). Exhibit 10-10 is an Excel spreadsheet showing the calculations for the cumulative average-time learning model for Rayburn Corporation. Note that as the number of units produced doubles from 1 to 2 in column A, cumulative average time per unit declines from 100 hours to 80% of 100 hours (0.80 * 100 hours = 80 hours) in column B. As the number of units doubles from 2 to 4, cumulative average time per unit declines to 80% of 80 hours = 64 hours, and so on. To obtain the cumulative total time in column D, multiply cumulative average time per unit by the cumulative number of units produced. For example, to produce 4 cumulative units would require 256 labor-hours (4 units * 64 cumulative average labor-hours per unit). Exhibit 10-10

Cumulative Average-Time Learning Model for Rayburn Corporation

1 2

80% Learning Curve

3 4 5 6 7

Cumulative Number of Units (X )

Cumulative Average Time per Unit (y )*: Labor-Hours

Cumulative Total Time: Labor-Hours

Individual Unit Time for X th Unit: Labor-Hours

D = Col A × Col B

E13 = D13 – D12 = 210.63 – 160.00

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

100.00 80.00 70.21 64.00 59.56 56.17 53.45 51.20 49.29 47.65 46.21 44.93 43.79 42.76 41.82 40.96

= (100 × 0.8) = (80 × 0.8)

= (64 × 0.8)

= (51.2 × 0.8)

100.00 160.00 210.63 256.00 297.82 337.0 1 374.14 409.60 443.65 476.51 508.32 539.22 569.29 598.63 627.30 655.36

100.00 60.00 50.63 45.37 41.82 39.19 37.13 35.46 34.05 32.86 31.81 30.89 30.07 29.34 28.67 28.06

*The mathematical relationship underlying the cumulative average-time learning model is as follows: y = aXb where y = Cumulative average time (labor-hours) per unit X = Cumulative number of units produced a = Time (labor-hours) required to produce the first unit b = Factor used to calculate cumulative average time to produce units The value of b is calculated as

ln (learning-curve % in decimal form) ln2

For an 80% learning curve, b = ln 0.8/ln 2 = –0.2231/0.6931 = –0.3219 For example, when X = 3, a = 100, b = –0.3219, –0.3219

y = 100 × 3

= 70.21 labor-hours

The cumulative total time when X = 3 is 70.21 × 3 = 210.63 labor-hours. Numbers in table may not be exact because of rounding.

360 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Incremental Unit-Time Learning Model In the incremental unit-time learning model, incremental time needed to produce the last unit declines by a constant percentage each time the cumulative quantity of units produced doubles. Again, consider Rayburn Corporation and an 80% learning curve. The 80% here means that when the quantity of units produced is doubled from X to 2X, the time needed to produce the last unit when 2X total units are produced is 80% of the time needed to produce the last unit when X total units are produced. Exhibit 10-11 is an Excel spreadsheet showing the calculations for the incremental unit-time learning model for Rayburn Corporation based on an 80% learning curve. Note how when units produced double from 2 to 4 in column A, the time to produce unit 4 (the last unit when 4 units are produced) is 64 hours in column B, which is 80% of the 80 hours needed to produce unit 2 (the last unit when 2 units are produced). We obtain the cumulative total time in column D by summing individual unit times in column B. For example, to produce 4 cumulative units would require 314.21 labor-hours (100.00 + 80.00 + 70.21 + 64.00). Exhibit 10-12 presents graphs using Excel for the cumulative average-time learning model (using data from Exhibit 10-10) and the incremental unit-time learning model (using data from Exhibit 10-11). Panel A graphically illustrates cumulative average time per unit as a function of cumulative units produced for each model (column A in Exhibit 10-10 or 10-11). The curve for the cumulative average-time learning model is plotted using the data from Exhibit 10-10, column B, while the curve for the incremental unit-time learning model is plotted using the data from Exhibit 10-11, column E. Panel B graphically illustrates cumulative total labor-hours, again as a function of cumulative units produced for each model. The curve for the cumulative average-time learning model is plotted using the data from Exhibit 10-10, column D, while that for the incremental unit-time learning model is plotted using the data from Exhibit 10-11, column D. Exhibit 10-11

A 1

Incremental Unit-Time Learning Model for Rayburn Corporation

80% Learning Curve

3 4 5 6 7

C u mu l at i ve Number of Units (X )

Individual Unit Time for Xth Unit (y )*: Labor-Hours

C u mu l at i ve Total Time: Labor-Hours

C u mu l at i ve Average Time per Unit: Labor-Hours

E = Col D ÷ Col A

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

100.00 80.00 70 . 21 64.00 59.56 56.17 53.45 51.20 49.29 47.65 46.21 44.93 43.79 42.76 41.82 40.96

= (100 × 0.8) = (80 × 0.8)

= (64 × 0.8)

= (51.2 × 0.8)

100.00 180.00 250.21 314.21 373.77 429.94 483.39 534.59 583.89 631.54 677.75 722.68 766.47 809.23 851.05 892.01

100.00 90.00 83.40 78.55 74.75 71 .66 69.06 66.82 64.88 63.15 61.61 60.22 58.96 57.80 56.74 55.75

D14 = D13 + B14 = 180.00 + 70.21 *The mathematical relationship underlying the incremental unit-time learning model is as follows: y = aXb

where y = Time (labor-hours) taken to produce the last single unit X = Cumulative number of units produced a = Time (labor-hours) required to produce the first unit b = Factor used to calculate incremental unit time to produce units ln (learning-curve % in decimal form) = ln2 For an 80% learning curve, b = ln 0.8 ÷ ln 2 = –0.2231 ÷ 0.6931 = –0.3219 For example, when X = 3, a = 100, b = –0.3219, –0.3219

y = 100 × 3 = 70.21 labor-hours The cumulative total time when X = 3 is 100 + 80 + 70.21 = 250.21 labor-hours. Numbers in the table may not be exact because of rounding.

NONLINEAR COST FUNCTIONS " 361

Exhibit 10-12

15 16 17 18

120 Incremental Unit-Time Learning Model

100 80

Cumulative Average-Time Learning Model

60 40 20 0 0

112

5000 4000

Cumulative Average-Time Learning Model

Incremental Unit-Time Learning Model

3000 2000 1000 0 0

128

Cumulative Number of Units (X)

The incremental unit-time learning model predicts a higher cumulative total time to produce 2 or more units than the cumulative average-time learning model, assuming the same learning rate for both models. That is, in Exhibit 10-12, Panel B, the graph for the 80% incremental unit-time learning model lies above the graph for the 80% cumulative averagetime learning model. If we compare the results in Exhibit 10-10 (column D) with the results in Exhibit 10-11 (column D), to produce 4 cumulative units, the 80% incremental unit-time learning model predicts 314.21 labor-hours versus 256.00 labor-hours predicted by the 80% cumulative average-time learning model. That’s because under the cumulative average-time learning model average labor-hours needed to produce all 4 units is 64 hours; the labor-hour amount needed to produce unit 4 is much less than 64 hours—it is 45.37 hours (see Exhibit 10-10). Under the incremental unit-time learning model, the labor-hour amount needed to produce unit 4 is 64 hours, and the labor-hours needed to produce the first 3 units are more than 64 hours, so average time needed to produce all 4 units is more than 64 hours. How do managers choose which model and what percent learning curve to use? It is important to recognize that managers make their choices on a case-by-case basis. For example, if the behavior of manufacturing labor-hour usage as production levels increase follows a pattern like the one predicted by the 80% learning curve cumulative average-time learning model, then the 80% learning curve cumulative average-time learning model should be used. Engineers, plant managers, and workers are good sources of information on the amount and type of learning actually occurring as production increases. Plotting this information and estimating the model that best fits the data is helpful in selecting the appropriate model.2

Incorporating Learning-Curve Effects into Prices and Standards How do companies use learning curves? Consider the data in Exhibit 10-10 for the cumulative average-time learning model at Rayburn Corporation. Suppose variable costs subject to learning effects consist of direct manufacturing labor, at $20 per hour, and related overhead, at $30 per direct manufacturing labor-hour. Managers should predict the costs shown in Exhibit 10-13. These data show that the effects of the learning curve could have a major influence on decisions. For example, managers at Rayburn Corporation might set an extremely low selling price on its radar systems to generate high demand. As its production increases to meet this growing demand, cost per unit drops. Rayburn “rides the product down the 2

Panel B: Cumulative Total Labor-Hours (80% Learning Curve; First Unit Takes 100 Labor-Hours) Cumulative Total Labor-Hours (Y)

Panel A: Cumulative Average Time per Unit (80% Learning Curve; First Unit Takes 100 Labor-Hours) Cumulative Average Time per Unit (Labor-Hours) (Y)

1 2 3 4 5 6 7 8 9 10 11 12 13

Plots for Cumulative Average-Time Learning Model and Incremental Unit-Time Learning Model for Rayburn Corporation

For details, see C. Bailey, “Learning Curve Estimation of Production Costs and Labor-Hours Using a Free Excel Add-In,” Management Accounting Quarterly, (Summer 2000: 25–31). Free software for estimating learning curves is available at Dr. Bailey’s Web site, www.profbailey.com.

112

128

362 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Exhibit 10-13 Predicting Costs Using Learning Curves at Rayburn Corporation

A 1

Cumulative Number of Units 1 2 4 8 16

2 3 4 5 6 7 8 9

Cumulative Average Time Cumulative Total Time: per Unit: Labor-Hoursa Labor-Hoursa 100.00 100.00 80.00 160.00 64.00 256.00 51.20 409.60 40.96 655.36

Cumulative Costs at $50 per Labor-Hour $ 5,000 (100.00 × $50) 8,000 (160.00 × $50) 12,800 (256.00 × $50) 20,480 (409.60 × $50) 32,768 (655.36 × $50)

Additions to Cumulative Costs $ 5,000 3,000 4,800 7,680 12,288

10 11 12

Decision Point What is a nonlinear cost function and in what ways do learning curves give rise to nonlinearities?

Based on the cumulative average-time learning model. See Exhibit 10-10 for the computations of these amounts.

learning curve” as it establishes a larger market share. Although it may have earned little operating income on its first unit sold—it may actually have lost money on that unit— Rayburn earns more operating income per unit as output increases. Alternatively, subject to legal and other considerations, Rayburn’s managers might set a low price on just the final 8 units. After all, the total labor and related overhead costs per unit for these final 8 units are predicted to be only $12,288 ($32,768 – $20,480). On these final 8 units, the $1,536 cost per unit ($12,288 ÷ 8 units) is much lower than the $5,000 cost per unit of the first unit produced. Many companies, such as Pizza Hut and Home Depot, incorporate learning-curve effects when evaluating performance. The Nissan Motor Company expects its workers to learn and improve on the job and evaluates performance accordingly. It sets assemblylabor efficiency standards for new models of cars after taking into account the learning that will occur as more units are produced. The learning-curve models examined in Exhibits 10-10 to 10-13 assume that learning is driven by a single variable (production output). Other models of learning have been developed (by companies such as Analog Devices and Hewlett-Packard) that focus on how quality— rather than manufacturing labor-hours—will change over time, regardless of whether more units are produced. Studies indicate that factors other than production output, such as job rotation and organizing workers into teams, contribute to learning that improves quality.

Data Collection and Adjustment Issues Learning Objective

Be aware of data problems encountered in estimating cost functions . . . for example, unreliable data and poor record keeping, extreme observations, treating fixed costs as if they are variable, and a changing relationship between a cost driver and cost

The ideal database for estimating cost functions quantitatively has two characteristics: 1. The database should contain numerous reliably measured observations of the cost driver (the independent variable) and the related costs (the dependent variable). Errors in measuring the costs and the cost driver are serious. They result in inaccurate estimates of the effect of the cost driver on costs. 2. The database should consider many values spanning a wide range for the cost driver. Using only a few values of the cost driver that are grouped closely considers too small a segment of the relevant range and reduces the confidence in the estimates obtained. Unfortunately, cost analysts typically do not have the advantage of working with a database having both characteristics. This section outlines some frequently encountered data problems and steps the cost analyst can take to overcome these problems. 1. The time period for measuring the dependent variable (for example, machine-lubricant costs) does not properly match the period for measuring the cost driver. This problem often arises when accounting records are not kept on the accrual basis. Consider a cost function with machine-lubricant costs as the dependent variable and number of machine-hours as the cost driver. Assume that the lubricant is purchased sporadically

DATA COLLECTION AND ADJUSTMENT ISSUES " 363

and stored for later use. Records maintained on the basis of lubricants purchased will indicate little lubricant costs in many months and large lubricant costs in other months. These records present an obviously inaccurate picture of what is actually taking place. The analyst should use accrual accounting to measure cost of lubricants consumed to better match costs with the machine-hours cost driver in this example. Fixed costs are allocated as if they are variable. For example, costs such as depreciation, insurance, or rent may be allocated to products to calculate cost per unit of output. The danger is to regard these costs as variable rather than as fixed. They seem to be variable because of the allocation methods used. To avoid this problem, the analyst should carefully distinguish fixed costs from variable costs and not treat allocated fixed cost per unit as a variable cost. Data are either not available for all observations or are not uniformly reliable. Missing cost observations often arise from a failure to record a cost or from classifying a cost incorrectly. For example, marketing costs may be understated because costs of sales visits to customers may be incorrectly recorded as customer-service costs. Recording data manually rather than electronically tends to result in a higher percentage of missing observations and erroneously entered observations. Errors also arise when data on cost drivers originate outside the internal accounting system. For example, the accounting department may obtain data on testing-hours for medical instruments from the company’s manufacturing department and data on number of items shipped to customers from the distribution department. One or both of these departments might not keep accurate records. To minimize these problems, the cost analyst should design data collection reports that regularly and routinely obtain the required data and should follow up immediately whenever data are missing. Extreme values of observations occur from errors in recording costs (for example, a misplaced decimal point), from nonrepresentative periods (for example, from a period in which a major machine breakdown occurred or from a period in which a delay in delivery of materials from an international supplier curtailed production), or from observations outside the relevant range. Analysts should adjust or eliminate unusual observations before estimating a cost relationship. There is no homogeneous relationship between the cost driver and the individual cost items in the dependent variable-cost pool. A homogeneous relationship exists when each activity whose costs are included in the dependent variable has the same cost driver. In this case, a single cost function can be estimated. As discussed in Step 2 for estimating a cost function using quantitative analysis (p. 348), when the cost driver for each activity is different, separate cost functions (each with its own cost driver) should be estimated for each activity. Alternatively, as discussed on pages 372–374, the cost function should be estimated with more than one independent variable using multiple regression. The relationship between the cost driver and the cost is not stationary. That is, the underlying process that generated the observations has not remained stable over time. For example, the relationship between number of machine-hours and manufacturing overhead costs is unlikely to be stationary when the data cover a period in which new technology was introduced. One way to see if the relationship is stationary is to split the sample into two parts and estimate separate cost relationships—one for the period before the technology was introduced and one for the period after the technology was introduced. Then, if the estimated coefficients for the two periods are similar, the analyst can pool the data to estimate a single cost relationship. When feasible, pooling data provides a larger data set for the estimation, which increases confidence in the cost predictions being made. Inflation has affected costs, the cost driver, or both. For example, inflation may cause costs to change even when there is no change in the level of the cost driver. To study the underlying cause-and-effect relationship between the level of the cost driver and costs, the analyst should remove purely inflationary price effects from the data by dividing each cost by the price index on the date the cost was incurred.

In many cases, a cost analyst must expend considerable effort to reduce the effect of these problems before estimating a cost function on the basis of past data.

Decision Point What are the common data problems a company must watch for when estimating costs?

364 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Problem for Self-Study The Helicopter Division of GLD, Inc., is examining helicopter assembly costs at its Indiana plant. It has received an initial order for eight of its new land-surveying helicopters. GLD can adopt one of two methods of assembling the helicopters:

1 2 3 4 5 6 7

Direct material cost per helicopter Direct-assembly labor time for first helicopter Learning curve for assembly labor time per helicopter Direct-assembly labor cost Equipment-related indirect manufacturing cost Material-handling-related indirect manufacturing cost

Labor-Intensive Assembly Method $ 40,000 2,000 labor-hours 85% cumulative average time* 30 per hour $ $ 12 per direct-assembly labor-hour 50% of direct material cost

Machine-Intensive Assembly Method $ 36 , 0 0 0 800 labor-hours 90% incremental unit time** $ 30 per hour $ 45 per direct-assembly labor-hour 50% of direct material cost

8 9 10

*Using the formula (p. 359), for an 85% learning curve, b =

ln 0.85 ln 2

–0.162519 0.693147

= –0.234465

12 13 14 15

**Using the formula (p. 360), for a 90% learning curve, b =

ln 0.90 ln 2

–0.105361 0.693147

= –0.152004

Required

1. How many direct-assembly labor-hours are required to assemble the first eight helicopters under (a) the labor-intensive method and (b) the machine-intensive method? 2. What is the total cost of assembling the first eight helicopters under (a) the laborintensive method and (b) the machine-intensive method?

Solution 1. a. The following calculations show the labor-intensive assembly method based on an 85% cumulative average-time learning model (using Excel):

G 1 2 3

Cumulative Number of Units

Cumulative Average Time per Unit (y): Labor-Hours

5 6 7 8 9 10 11 12 13 14

1 2 3 4 5 6 7 8

2,000 1,700 1,546 1,445 1,371 1,314 1,267 1,228.25

(2,000 × 0.85) (1,700 × 0.85)

(1,445 × 0.85)

Cumulative Total Time: Labor-Hours

Individual time for Xth unit: Labor-Hours

Col J = Col G × Col H 2,000 3,400 4,637 5,780 6,857 7,884 8,871 9,826

2,000 1,400 1,237 1,143 1,077 1,027 987 955

PROBLEM FOR SELF-STUDY " 365

Cumulative average-time per unit for the Xth unit in column H is calculated as y = aXb; see Exhibit 10-10 (p. 359). For example, when X = 3, y = 2,000 * 3–0.234465 = 1,546 labor-hours. b. The following calculations show the machine-intensive assembly method based on a 90% incremental unit-time learning model:

G 1 2 3

Cumulative Number of Units

Individual Unit Time for Xth Unit (y): Labor-Hours

Cumulative Total Time: Labor-Hours

Cumulative Average Time Per Unit: Labor-Hours Col K = Col J ÷ Col G 800 760 73 2 711 694 680 668 657

5 6 7 8 9 10 11 12 13

1 2 3 4 5 6 7 8

800 720 677 648 626 609 595 583

(800 × 0.9) (720 × 0.9)

(648 × 0.9)

800 1,520 2,197 2,845 3,471 4,081 4,676 5,258

Individual unit time for the Xth unit in column H is calculated as y = aXb; see Exhibit 10-11 (p. 360). For example, when X = 3, y = 800 * 3–0.152004 = 677 labor-hours. 2. Total costs of assembling the first eight helicopters are as follows:

O 1 2 3 4 5 6 7 8 9 10 11 12 13

Direct materials: 8 helicopters × $40,000; $36,000 per helicopter Direct-assembly labor: 9,826 hrs.; 5,258 hrs. × $30/hr. Indirect manufacturing costs Equipment related 9,826 hrs. × $12/hr.; 5,258 hrs. × $45/hr. Materials-handling related 0.50 × $320,000; $288,000 Total assembly costs

Labor-Intensive Assembly Method (using data from part 1a)

Machine-Intensive Assembly Method (using data from part 1b)

$320,000

$288,000

294,780

157,740

117,912

236,610

160,000 $892,692

144,000 $826,350

The machine-intensive method’s assembly costs are $66,342 lower than the laborintensive method ($892,692 – $826,350).

366 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Guidelines

1. What is a linear cost function and what types of cost behavior can it represent?

A linear cost function is a cost function in which, within the relevant range, the graph of total costs based on the level of a single activity is a straight line. Linear cost functions can be described by a constant, a, which represents the estimate of the total cost component that, within the relevant range, does not vary with changes in the level of the activity; and a slope coefficient, b, which represents the estimate of the amount by which total costs change for each unit change in the level of the activity within the relevant range. Three types of linear cost functions are variable, fixed, and mixed (or semivariable).

2. What is the most important issue in estimating a cost function?

The most important issue in estimating a cost function is determining whether a cause-and-effect relationship exists between the level of an activity and the costs related to that level of activity. Only a cause-and-effect relationship—not merely correlation—establishes an economically plausible relationship between the level of an activity and its costs.

3. What are the different methods that can be used to estimate a cost function?

Four methods for estimating cost functions are the industrial engineering method, the conference method, the account analysis method, and the quantitative analysis method (which includes the high-low method and the regression analysis method). If possible, the cost analyst should apply more than one method. Each method is a check on the others.

4. What are the steps to estimate a cost function using quantitative analysis?

There are six steps to estimate a cost function using quantitative analysis: (a) Choose the dependent variable; (b) identify the cost driver; (c) collect data on the dependent variable and the cost driver; (d) plot the data; (e) estimate the cost function; and (f) evaluate the cost driver of the estimated cost function. In most situations, working closely with operations managers, the cost analyst will cycle through these steps several times before identifying an acceptable cost function.

5. How should a company evaluate and choose cost drivers?

Three criteria for evaluating and choosing cost drivers are (a) economic plausibility, (b) goodness of fit, and (c) significance of independent variable.

6. What is a nonlinear cost function and in what ways do learning curves give rise to nonlinearities?

A nonlinear cost function is one in which the graph of total costs based on the level of a single activity is not a straight line within the relevant range. Nonlinear costs can arise because of quantity discounts, step cost functions, and learning-curve effects. With learning curves, labor-hours per unit decline as units of production increase. In the cumulative average-time learning model, cumulative average-time per unit declines by a constant percentage each time the cumulative quantity of units produced doubles. In the incremental unit-time learning model, the time needed to produce the last unit declines by a constant percentage each time the cumulative quantity of units produced doubles.

7. What are the common data problems a company must watch for when estimating costs?

The most difficult task in cost estimation is collecting high-quality, reliably measured data on the costs and the cost driver. Common problems include missing data, extreme values of observations, changes in technology, and distortions resulting from inflation.

APPENDIX " 367

Appendix Regression Analysis This appendix describes estimation of the regression equation, several commonly used regression statistics, and how to choose among cost functions that have been estimated by regression analysis. We use the data for Elegant Rugs presented in Exhibit 10-3 (p. 348) and displayed here again for easy reference. Week 1 2 3 4 5 6 7 8 9 10 11 12 Total

Cost Driver: Machine-Hours (X) 68 88 62 72 60 96 78 46 82 94 68 ƒ48 862

Indirect Manufacturing Labor Costs (Y) $ 1,190 1,211 1,004 917 770 1,456 1,180 710 1,316 1,032 752 ƒƒƒƒ963 $12,501

Estimating the Regression Line The least-squares technique for estimating the regression line minimizes the sum of the squares of the vertical deviations from the data points to the estimated regression line (also called residual term in Exhibit 10-6, p. 352). The objective is to find the values of a and b in the linear cost function y = a + bX, where y is the predicted cost value as distinguished from the observed cost value, which we denote by Y. We wish to find the numerical values of a and b that minimize © (Y – y)2, the sum of the squares of the vertical deviations between Y and y. Generally, these computations are done using software packages such as Excel. For the data in our example,3 a = $300.98 and b = $10.31, so that the equation of the regression line is y = $300.98 + $10.31X.

Goodness of Fit Goodness of fit measures how well the predicted values, y, based on the cost driver, X, match actual cost observations, Y. The regression analysis method computes a measure of goodness of fit, called the coefficient of determination. The coefficient of determination (r2) measures the percentage of variation in Y explained by X (the independent variable). 3

The formulae for a and b are as follows: a =

(©Y ) (©X 2) - (©X ) (©XY ) n(©X 2) - (©X ) (©X )

and b =

n(©XY ) - (©X ) (©Y ) n(©X 2) - (©X ) (©X )

where for the Elegant Rugs data in Exhibit 10-3,

n = = = = =

©X ©X 2 ©Y ©XY

a = b =

number of data points = 12 sum of the given X values = 68 + 88 + ... + 48 = 862 sum of squares of the X values = (68)2 + (88)2 + ... + (48)2 + 4,624 + 7,744 + ... + 2,304 = 64,900 sum of given Y values = 1,190 + 1,211 + ... + 963 = 12,501 sum of the amounts obtained by multiplying each of the given X values by the associated observed Y value = (68) (1,190) + (88) (1,211) + ... + (48) (963) = 80,920 + 106,568 + ... + 46,224 = 928,716 (12,501) (64,900) - (862) (928,716) 12(64,900) - (862) (862) 12(928,716) - (862) (12,501) 12(64,900) - (862) (862)

= $300.98

= $10.31

368 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

It is more convenient to express the coefficient of determination as 1 minus the proportion of total variance that is not explained by the independent variable—that is, 1 minus the ratio of unexplained variation to total variation. The unexplained variance arises because of differences between the actual values, Y, and the predicted values, y, which in the Elegant Rugs example is given by4 r2 = 1 -

©(Y - y )2 Unexplained variation 290,824 = 1 = 0.52 = 1 2 Total variation 607,699 ©(Y - Y )

The calculations indicate that r2 increases as the predicted values, y, more closely approximate the actual observations, Y. The range of r2 is from 0 (implying no explanatory power) to 1 (implying perfect explanatory power). Generally, an r2 of 0.30 or higher passes the goodness-of-fit test. However, do not rely exclusively on goodness of fit. It can lead to the indiscriminate inclusion of independent variables that increase r2 but have no economic plausibility as cost drivers. Goodness of fit has meaning only if the relationship between the cost drivers and costs is economically plausible. An alternative and related way to evaluate goodness of fit is to calculate the standard error of the regression. The standard error of the regression is the variance of the residuals. It is equal to S =

©(Y - y)2 ©(Y - y)2 290,824 = = = $170.54 D Degrees of freedom D n - 2 A 12 - 2

Degrees of freedom equal the number of observations, 12, minus the number of coefficients estimated in the regression (in this case two, a and b). On average, actual Y and the predicted value, y, differ by $170.54. For comparison, Y, the average value of Y, is $1,041.75. The smaller the standard error of the regression, the better the fit and the better the predictions for different values of X.

Significance of Independent Variables Do changes in the economically plausible independent variable result in significant changes in the dependent variable? Or alternatively stated, is the slope coefficient, b = $10.31, of the regression line statistically significant (that is, different from $0)? Recall, for example, that in the regression of number of machine-hours and indirect manufacturing labor costs in the Elegant Rugs illustration, b is estimated from a sample of 12 weekly observations. The estimate, b, is subject to random factors, as are all sample statistics. That is, a different sample of 12 data points would undoubtedly give a different estimate of b. The standard error of the estimated coefficient indicates how much the estimated value, b, is likely to be affected by random factors. The t-value of the b coefficient measures how large the value of the estimated coefficient is relative to its standard error. The cutoff t-value for making inferences about the b coefficient is a function of the number of degrees of freedom, the significance level, and whether it is a one-sided or two-sided test. A 5% level of significance indicates that there is less than a 5% probability that random factors could have affected the coefficient b. A two-sided test assumes that random factors could have caused the coefficient to be either greater than $10.31 or less than $10.31 with equal probability. At a 5% level of significance, this means that there is less than a 2.5% (5% ÷ 2) probability that random factors could have caused the coefficient to be greater than $10.31 and less than 2.5% probability that random factors could have caused the coefficient to be less than $10.31. Under the expectation that the coefficient of b is positive, a one-sided test at the 5% level of significance assumes that there is less than 5% probability that random factors would have caused the coefficient to be less than $10.31. The cutoff t-value at the 5% significance level and 10 degrees of freedom for a two-sided test is 2.228. If there were more observations and 60 degrees of freedom, the cutoff t-value would be 2.00 at a 5% significance level for a two-sided test. The t-value (called t Stat in the Excel output) for the slope coefficient b is the value of the estimated coefficient, $10.31 ÷ the standard error of the estimated coefficient $3.12 = 3.30, which exceeds the cutoff t-value of 2.228. In other words, a relationship exists between the independent variable, machine-hours, and the dependent variable that cannot be attributed to random chance alone. Exhibit 10-14 shows a convenient format (in Excel) for summarizing the regression results for number of machine-hours and indirect manufacturing labor costs. 4

From footnote 3, ©Y = 12,501 and Y = 12,501 , 12 = 1,041.75 ©(Y - Y )2 = (1,190 - 1,041.75)2 + (1,211 - 1,041.75)2 + ... + (963 - 1,041.75)2 = 607,699

Each value of X generates a predicted value of y. For example, in week 1, y = $300.98 + ($10.31 * 68) = $1002.06; in week 2, y = $300.98 + ($10.31 * 88) = $1,208.26; and in week 12, y = $300.98 + ($10.31 * 48) = $795.86. Comparing the predicted and actual values, ©(Y - y)2 = (1,190 - 1,002.06)2 + (1,211 - 1208.26)2 + ... + (963 - 795.86)2 = 290,824.

APPENDIX " 369

Exhibit 10-14

A 1 2

Intercept Independent Variable: 4 Machine-Hours (X ) 3

Simple Regression Results with Indirect Manufacturing Labor Costs as Dependent Variable and Machine-Hours as Independent Variable (Cost Driver) for Elegant Rugs

Coefficients (1) $300.98

Standard Error (2) $229.75

t Stat (3) = (1) ÷ (2) 1.31

$ 10.31

$ 3.12

3.30

= Coefficient/Standard Error = B3/C3 = 300.98/229.75

Regression Statistics R Square 0.52 Durbin-Watson Statistic 2.05 8 6 7

An alternative way to test that the coefficient b is significantly different from zero is in terms of a confidence interval: There is less than a 5% chance that the true value of the machine-hours coefficient lies outside the range $10.31 # (2.228 * $3.12), or $10.31 # $6.95, or from $3.36 to $17.26. Because 0 does not appear in the confidence interval, we can conclude that changes in the number of machine-hours do affect indirect manufacturing labor costs. Similarly, using data from Exhibit 10-14, the t-value for the constant term a is $300.98 ÷ $229.75 = 1.31, which is less than 2.228. This t-value indicates that, within the relevant range, the constant term is not significantly different from zero. The Durbin-Watson statistic in Exhibit 10-14 will be discussed in the following section.

Specification Analysis of Estimation Assumptions Specification analysis is the testing of the assumptions of regression analysis. If the assumptions of (1) linearity within the relevant range, (2) constant variance of residuals, (3) independence of residuals, and (4) normality of residuals all hold, then the simple regression procedures give reliable estimates of coefficient values. This section provides a brief overview of specification analysis. When these assumptions are not satisfied, more-complex regression procedures are necessary to obtain the best estimates.5 1. Linearity within the relevant range. A common assumption—and one that appears to be reasonable in many business applications—is that a linear relationship exists between the independent variable X and the dependent variable Y within the relevant range. If a linear regression model is used to estimate a nonlinear relationship, however, the coefficient estimates obtained will be inaccurate. When there is only one independent variable, the easiest way to check for linearity is to study the data plotted in a scatter diagram, a step that often is unwisely skipped. Exhibit 10-6 (p. 352) presents a scatter diagram for the indirect manufacturing labor costs and machine-hours variables of Elegant Rugs shown in Exhibit 10-3 (p. 348). The scatter diagram reveals that linearity appears to be a reasonable assumption for these data. The learning-curve models discussed in this chapter (pp. 358–361) are examples of nonlinear cost functions. Costs increase when the level of production increases, but by lesser amounts than would occur with a linear cost function. In this case, the analyst should estimate a nonlinear cost function that incorporates learning effects. 2. Constant variance of residuals. The vertical deviation of the observed value Y from the regression line estimate y is called the residual term, disturbance term, or error term, u = Y – y. The assumption of constant variance implies that the residual terms are unaffected by the level of the cost driver. The assumption also implies that there is a uniform scatter, or dispersion, of the data points about the regression line as in Exhibit 10-15, Panel A. This assumption is likely to be violated, for example, in cross-sectional estimation of costs in operations of different sizes. For example, suppose Elegant Rugs has production areas of varying sizes. The company collects data from these different production areas to estimate the relationship between machine-hours and indirect manufacturing labor costs. It is very possible that the residual terms in this regression will be larger for the larger production 5

For details see, for example, W. H. Greene, Econometric Analysis, 6th ed. (Upper Saddle River, NJ: Prentice Hall, 2007).

370 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Exhibit 10-15

Constant Variance of Residuals Assumption PANEL B: Nonconstant Variance (Higher Outputs Have Larger Residuals)

$4,000

Indirect Manufacturing Labor Costs (Y)

PANEL A: Constant Variance (Uniform Scatter of Data Points Around Regression Line)

$3,000 $2,000 $1,000

100

150

200

$4,000 $3,000 $2,000 $1,000

250

Machine-Hours (X)

100

150

200

250

Machine-Hours (X)

areas that have higher machine-hours and higher indirect manufacturing labor costs. There would not be a uniform scatter of data points about the regression line (see Exhibit 10-15, Panel B). Constant variance is also known as homoscedasticity. Violation of this assumption is called heteroscedasticity. Heteroscedasticity does not affect the accuracy of the regression estimates a and b. It does, however, reduce the reliability of the estimates of the standard errors and thus affects the precision with which inferences about the population parameters can be drawn from the regression estimates. 3. Independence of residuals. The assumption of independence of residuals is that the residual term for any one observation is not related to the residual term for any other observation. The problem of serial correlation (also called autocorrelation) in the residuals arises when there is a systematic pattern in the sequence of residuals such that the residual in observation n conveys information about the residuals in observations n + 1, n + 2, and so on. Consider another production cell at Elegant Rugs that has, over a 20-week period, seen an increase in production and hence machine-hours. Exhibit 10-16 Panel B is a scatter diagram of machine-hours and indirect manufacturing labor costs. Observe the systematic pattern of the residuals in Panel B—positive residuals for extreme (high and low) quantities of machine-hours and negative residuals for moderate quantities of machine-hours. One reason for this observed pattern at low values of the cost driver is the “stickiness” of costs. When machine-hours are below 50 hours, indirect manufacturing labor costs do not decline. When machine-hours increase over time as production is ramped up, indirect manufacturing labor costs increase more as managers at Elegant Rugs struggle

Exhibit 10-16

Independence of Residuals Assumption PANEL B: Serial Correlation in Residuals (A Pattern of Positive Residuals for Extreme Machine-Hours Used; Negative Residuals for Moderate Machine-Hours Used)

$3000

Indirect Manufacturing Labor Costs (Y)

PANEL A: Independence of Residuals (No Pattern in Residuals)

$2500 $2000 $1500 $1000 $500 50

100

150

200

Machine-Hours (X)

250

$3000 $2500 $2000 $1500 $1000 $500 50

100

150

200

Machine-Hours (X)

250

APPENDIX " 371

to manage the higher volume. How would the plot of residuals look if there were no auto-correlation? Like the plot in Exhibit 10-16, Panel A that shows no pattern in the residuals. Like nonconstant variance of residuals, serial correlation does not affect the accuracy of the regression estimates a and b. It does, however, affect the standard errors of the coefficients, which in turn affect the precision with which inferences about the population parameters can be drawn from the regression estimates. The Durbin-Watson statistic is one measure of serial correlation in the estimated residuals. For samples of 10 to 20 observations, a Durbin-Watson statistic in the 1.10–2.90 range indicates that the residuals are independent. The Durbin-Watson statistic for the regression results of Elegant Rugs in Exhibit 10-14 is 2.05. Therefore, an assumption of independence in the estimated residuals is reasonable for this regression model. 4. Normality of residuals. The normality of residuals assumption means that the residuals are distributed normally around the regression line. The normality of residuals assumption is frequently satisfied when using regression analysis on real cost data. Even when the assumption does not hold, accountants can still generate accurate estimates based on the regression equation, but the resulting confidence interval around these estimates is likely to be inaccurate.

Using Regression Output to Choose Cost Drivers of Cost Functions Consider the two choices of cost drivers we described earlier in this chapter for indirect manufacturing labor costs (y): y = a + (b * Number of machine-hours) y = a + (b * Number of direct manufacturing labor-hours)

Exhibits 10-6 and 10-8 show plots of the data for the two regressions. Exhibit 10-14 reports regression results for the cost function using number of machine-hours as the independent variable. Exhibit 10-17 presents comparable regression results (in Excel) for the cost function using number of direct manufacturing labor-hours as the independent variable. On the basis of the material presented in this appendix, which regression is better? Exhibit 10-18 compares these two cost functions in a systematic way. For several criteria, the cost function based on machine-hours is preferable to the cost function based on direct manufacturing labor-hours. The economic plausibility criterion is especially important. Do not always assume that any one cost function will perfectly satisfy all the criteria in Exhibit 10-18. A cost analyst must often make a choice among “imperfect” cost functions, in the sense that the data of any particular cost function will not perfectly meet one or more of the assumptions underlying regression analysis. For example, both of the cost functions in Exhibit 10-18 are imperfect because, as stated in the section on specification analysis of estimation assumptions, inferences drawn from only 12 observations are not reliable.

Exhibit 10-17

A 1 2 3

Intercept

Independent Variable: Direct Manufacturing 4 Labor-Hours (X )

Simple Regression Results with Indirect Manufacturing Labor Costs as Dependent Variable and Direct Manufacturing Labor-Hours as Independent Variable (Cost Driver) for Elegant Rugs

Coefficients (1) $744.67

Standard Error (2) $ 217.61

t Stat (3) = (1) ÷ (2) 3.42

$ 7.72

Regression Statistics R Square 0.17 7 2.26 8 Durbin-Watson Statistic 6

$ 5.40

1.43

= Coefficient/Standard Error = B4/C4 = 7.72/5.40

372 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Exhibit 10-18

Criterion

Comparison of Alternative Cost Functions for Indirect Manufacturing Labor Costs Estimated with Simple Regression for Elegant Rugs Cost Function 2: Direct Manufacturing Labor-Hours as Independent Variable

Cost Function 1: Machine-Hours as Independent Variable

Economic plausibility

A positive relationship between indirect manufacturing labor costs (technical support labor) and machine-hours is economically plausible in Elegant Rugs’ highly automated plant

A positive relationship between indirect manufacturing labor costs and direct manufacturing laborhours is economically plausible, but less so than machine-hours in Elegant Rugs’ highly automated plant on a week-to-week basis.

Goodness of fita

r 2 = 0.52; standard error of regression = $170.50. Excellent goodness of fit.

r 2 = 0.17; standard error of regression = $224.60. Poor goodness of fit.

Significance of independent variable(s)

The t-value of 3.30 is significant at the 0.05 level.

The t-value of 1.43 is not significant at the 0.05 level.

Specification analysis of estimation assumptions

Plot of the data indicates that assumptions of linearity, constant variance, independence of residuals (Durbin-Watson statistic = 2.05), and normality of residuals hold, but inferences drawn from only 12 observations are not reliable.

Plot of the data indicates that assumptions of linearity, constant variance, independence of residuals (Durbin-Watson statistic = 2.26), and normality of residuals hold, but inferences drawn from only 12 observations are not reliable.

aIf the number of observations available to estimate the machine-hours regression differs from the number of observations available to estimate the direct manufacturing labor-hours regression, an adjusted r 2 can be calculated to take this difference (in degrees of freedom) into account. Programs such as Excel calculate and present adjusted r 2.

Multiple Regression and Cost Hierarchies In some cases, a satisfactory estimation of a cost function may be based on only one independent variable, such as number of machine-hours. In many cases, however, basing the estimation on more than one independent variable (that is, multiple regression) is more economically plausible and improves accuracy. The most widely used equations to express relationships between two or more independent variables and a dependent variable are linear in the form y = a + b1X1 + b2X2 + ... + u

where, y = Cost to be predicted X1,X2, ... = Independent variables on which the prediction is to be based a, b1, b2,... = Estimated coefficients of the regression model u = Residual term that includes the net effect of other factors not in the model as well as measurement errors in the dependent and independent variables

Example: Consider the Elegant Rugs data in Exhibit 10-19. The company’s ABC analysis indicates that indirect manufacturing labor costs include large amounts incurred for setup and changeover costs when a new batch of carpets is started. Management believes that in addition to number of machine-hours (an output unit-level cost driver), indirect manufacturing labor costs are also affected by the number of batches of carpet produced during each week (a batchlevel driver). Elegant Rugs estimates the relationship between two independent variables, number of machine-hours and number of production batches of carpet manufactured during the week, and indirect manufacturing labor costs.

APPENDIX " 373

Exhibit 10-19 A

Week 1 2 3 4 5 6 7 8 9 10 11 12

MachineHours (X1) 68 88 62 72 60 96 78 46 82 94 68 48

Number of Production Batches (X2) 12 15 13 11 10 12 17 7 14 12 7 14

Direct Manufacturing Labor-Hours 30 35 36 20 47 45 44 38 70 30 29 38

Indirect Manufacturing Labor Costs (Y ) $ 1,190 1,211 1,004 917 770 1,456 1,180 710 1,316 1,032 752 963

Total

1 2 3 4 5 6 7 8 9 10 11 12

862

$12,501

462

144

Weekly Indirect Manufacturing Labor Costs, Machine-Hours, Direct Manufacturing Labor-Hours, and Number of Production Batches for Elegant Rugs

Exhibit 10-20 presents results (in Excel) for the following multiple regression model, using data in columns B, C, and E of Exhibit 10-19: y = $42.58 + $7.60X1 + $37.77X2

where X1 is the number of machine-hours and X2 is the number of production batches. It is economically plausible that both number of machine-hours and number of production batches would help explain variations in indirect manufacturing labor costs at Elegant Rugs. The r2 of 0.52 for the simple regression using number of machine-hours (Exhibit 10-14) increases to 0.72 with the multiple regression in Exhibit 10-20. The t-values suggest that the independent variable coefficients of both number of machine-hours ($7.60) and number of production batches ($37.77) are significantly different from zero (t = 2.74 is the t-value for number of machine-hours, and t = 2.48 is the t-value for number of production batches compared to the cut-off t-value of 2.26). The multiple regression model in Exhibit 10-20 satisfies both economic plausibility and statistical criteria, and it explains much greater variation (that Exhibit 10-20

Multiple Regression Results with Indirect Manufacturing Labor Costs and Two Independent Variables of Cost Drivers (Machine-Hours and Production Batches) for Elegant Rugs

A 1 2

Intercept Independent Variable 1: Machine4 Hours (X1) Independent Variable 2: Number of 5 Production Batches (X2) 3

Coefficients (1) $ 42.58

Standard Error (2) $ 213.91

t Stat (3) = (1) ÷ (2) 0.20

$ 7.60

$ 2.77

2.74

$ 37.77

$ 15.25

2.48

6 7 8 9

Regression Statistics R Square Durbin-Watson Statistic

0.72 2.49

= Coefficient/Standard Error = B4/C4 = 7.60/2.77

374 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

is, r2 of 0.72 versus r2 of 0.52) in indirect manufacturing labor costs than the simple regression model using only number of machine-hours as the independent variable.6 The standard error of the regression equation that includes number of batches as an independent variable is ©(Y - y)2 170,156 = = $137.50 D n - 3 A 9

which is lower than the standard error of the regression with only machine-hours as the independent variable, $170.50. That is, even though adding a variable reduces the degrees of freedom in the denominator, it substantially improves fit so that the numerator, ©(Y - y)2, decreases even more. Number of machine-hours and number of production batches are both important cost drivers of indirect manufacturing labor costs at Elegant Rugs. In Exhibit 10-20, the slope coefficients—$7.60 for number of machine-hours and $37.77 for number of production batches—measure the change in indirect manufacturing labor costs associated with a unit change in an independent variable (assuming that the other independent variable is held constant). For example, indirect manufacturing labor costs increase by $37.77 when one more production batch is added, assuming that the number of machinehours is held constant. An alternative approach would create two separate cost pools for indirect manufacturing labor costs: one for costs related to number of machine-hours and another for costs related to number of production batches. Elegant Rugs would then estimate the relationship between the cost driver and the costs in each cost pool. The difficult task under this approach is to properly subdivide the indirect manufacturing labor costs into the two cost pools.

Multicollinearity A major concern that arises with multiple regression is multicollinearity. Multicollinearity exists when two or more independent variables are highly correlated with each other. Generally, users of regression analysis believe that a coefficient of correlation between independent variables greater than 0.70 indicates multicollinearity. Multicollinearity increases the standard errors of the coefficients of the individual variables. That is, variables that are economically and statistically significant will appear not to be significantly different from zero. The matrix of correlation coefficients of the different variables described in Exhibit 10-19 are as follows:

Indirect manufacturing labor costs Machine-hours Number of production batches Direct manufacturing labor-hours

Indirect Manufacturing Labor Costs 1 0.72 0.69 0.41

Machine-Hours

Number of Production Batches

Direct Manufacturing Labor-Hours

1 0.4 0.12

1 0.31

These results indicate that multiple regressions using any pair of the independent variables in Exhibit 10-19 are not likely to encounter multicollinearity problems. When multicollinearity exists, try to obtain new data that do not suffer from multicollinearity problems. Do not drop an independent variable (cost driver) that should be included in a model because it is correlated with another independent variable. Omitting such a variable will cause the estimated coefficient of the independent variable included in the model to be biased away from its true value.

Adding another variable always increases r 2. The question is whether adding another variable increases r 2 sufficiently. One way to get insight into this question is to calculate an adjusted r 2 as follows: n - 1 Adjusted r 2 = 1 - (1 - r2) , where n is the number of observations and p is the number of coefficients estimated. n - p - 1 12 - 1 In the model with only machine-hours as the independent variable, adjusted r 2 = 1 - (1 - 0.52) = 0.41. 12 - 2 - 1 In the model with both machine-hours and number of batches as independent variables, adjusted 12 - 1 = 0.62. Adjusted r 2 does not have the same interpretation as r 2 but the increase in adjusted r 2 = 1 - (1 - 0.72) 12 - 3 - 1 r 2 when number of batches is added as an independent variable suggests that adding this variable significantly improves the fit of the model in a way that more than compensates for the degree of freedom lost by estimating another coefficient.

ASSIGNMENT MATERIAL " 375

Terms to Learn This chapter and the Glossary at the end of this book contain definitions of the following important terms: account analysis method (p. 347) coefficient of determination (r 2 ) (p. 367) conference method (p. 346) constant (p. 343) cost estimation (p. 344) cost function (p. 341) cost predictions (p. 344) cumulative average-time learning model (p. 359) dependent variable (p. 348) experience curve (p. 358) high-low method (p. 350)

incremental unit-time learning model (p. 360) independent variable (p. 348) industrial engineering method (p. 346) intercept (p. 343) learning curve (p. 358) linear cost function (p. 342) mixed cost (p. 343) multicollinearity (p. 374) multiple regression (p. 352) nonlinear cost function (p. 357) regression analysis (p. 352)

residual term (p. 352) semivariable cost (p. 343) simple regression (p. 352) slope coefficient (p. 342) specification analysis (p. 369) standard error of the estimated coefficient (p. 368) standard error of the regression (p. 368) step cost function (p. 357) work-measurement method (p. 346)

Assignment Material Questions 10-1 What two assumptions are frequently made when estimating a cost function? 10-2 Describe three alternative linear cost functions. 10-3 What is the difference between a linear and a nonlinear cost function? Give an example of each type of cost function.

10-4 “High correlation between two variables means that one is the cause and the other is the effect.” Do you agree? Explain.

10-5 Name four approaches to estimating a cost function. 10-6 Describe the conference method for estimating a cost function. What are two advantages of this method?

10-7 Describe the account analysis method for estimating a cost function. 10-8 List the six steps in estimating a cost function on the basis of an analysis of a past cost relationship. Which step is typically the most difficult for the cost analyst?

10-9 When using the high-low method, should you base the high and low observations on the dependent variable or on the cost driver?

10-10 Describe three criteria for evaluating cost functions and choosing cost drivers. 10-11 Define learning curve. Outline two models that can be used when incorporating learning into the estimation of cost functions.

10-12 Discuss four frequently encountered problems when collecting cost data on variables included in a cost function.

10-13 What are the four key assumptions examined in specification analysis in the case of simple regression?

10-14 “All the independent variables in a cost function estimated with regression analysis are cost drivers.” Do you agree? Explain.

10-15 “Multicollinearity exists when the dependent variable and the independent variable are highly correlated.” Do you agree? Explain.

Exercises 10-16 Estimating a cost function. The controller of the Ijiri Company wants you to estimate a cost function from the following two observations in a general ledger account called Maintenance:

Month January February

Machine-Hours 6,000 10,000

Maintenance Costs Incurred $4,000 5,400

376 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Required

1. Estimate the cost function for maintenance. 2. Can the constant in the cost function be used as an estimate of fixed maintenance cost per month? Explain.

10-17 Identifying variable-, fixed-, and mixed-cost functions. The Pacific Corporation operates car rental agencies at more than 20 airports. Customers can choose from one of three contracts for car rentals of one day or less:

Required

Contract 1: $50 for the day

Contract 2: $30 for the day plus $0.20 per mile traveled

Contract 3: $1 per mile traveled

1. Plot separate graphs for each of the three contracts, with costs on the vertical axis and miles traveled on the horizontal axis. 2. Express each contract as a linear cost function of the form y = a + bX. 3. Identify each contract as a variable-, fixed-, or mixed-cost function.

10-18 Various cost-behavior patterns. (CPA, adapted) Select the graph that matches the numbered manufacturing cost data (requirements 1–9). Indicate by letter which graph best fits the situation or item described.

The vertical axes of the graphs represent total cost, and the horizontal axes represent units produced during a calendar year. In each case, the zero point of dollars and production is at the intersection of the two axes. The graphs may be used more than once. Required

1. Annual depreciation of equipment, where the amount of depreciation charged is computed by the machine-hours method. 2. Electricity bill—a flat fixed charge, plus a variable cost after a certain number of kilowatt-hours are used, in which the quantity of kilowatt-hours used varies proportionately with quantity of units produced. 3. City water bill, which is computed as follows: First 1,000,000 gallons or less Next 10,000 gallons Next 10,000 gallons Next 10,000 gallons and so on

$1,000 flat fee $0.003 per gallon used $0.006 per gallon used $0.009 per gallon used and so on

The gallons of water used vary proportionately with the quantity of production output. 4. Cost of direct materials, where direct material cost per unit produced decreases with each pound of material used (for example, if 1 pound is used, the cost is $10; if 2 pounds are used, the cost is $19.98; if 3 pounds are used, the cost is $29.94), with a minimum cost per unit of $9.20.

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5. Annual depreciation of equipment, where the amount is computed by the straight-line method. When the depreciation schedule was prepared, it was anticipated that the obsolescence factor would be greater than the wear-and-tear factor. 6. Rent on a manufacturing plant donated by the city, where the agreement calls for a fixed-fee payment unless 200,000 labor-hours are worked, in which case no rent is paid. 7. Salaries of repair personnel, where one person is needed for every 1,000 machine-hours or less (that is, 0 to 1,000 hours requires one person, 1,001 to 2,000 hours requires two people, and so on). 8. Cost of direct materials used (assume no quantity discounts). 9. Rent on a manufacturing plant donated by the county, where the agreement calls for rent of $100,000 to be reduced by $1 for each direct manufacturing labor-hour worked in excess of 200,000 hours, but a minimum rental fee of $20,000 must be paid.

10-19 Matching graphs with descriptions of cost and revenue behavior. (D. Green, adapted) Given here are a number of graphs.

The horizontal axis represents the units produced over the year and the vertical axis represents total cost or revenues. Indicate by number which graph best fits the situation or item described (a–h). Some graphs may be used more than once; some may not apply to any of the situations. a. b. c. d. e. f. g. h.

Direct material costs Supervisors’ salaries for one shift and two shifts A cost-volume-profit graph Mixed costs—for example, car rental fixed charge plus a rate per mile driven Depreciation of plant, computed on a straight-line basis Data supporting the use of a variable-cost rate, such as manufacturing labor cost of $14 per unit produced Incentive bonus plan that pays managers $0.10 for every unit produced above some level of production Interest expense on $2 million borrowed at a fixed rate of interest

10-20 Account analysis method. Lorenzo operates a car wash. Incoming cars are put on an automatic conveyor belt. Cars are washed as the conveyor belt carries them from the start station to the finish station. After a car moves off the conveyor belt, it is dried manually. Workers then clean and vacuum the inside of the car. Lorenzo serviced 80,000 cars in 2012. Lorenzo reports the following costs for 2012: Account Description Car wash labor Soap, cloth, and supplies Water Electric power to move conveyor belt Depreciation Salaries

Costs $260,000 42,000 38,000 72,000 64,000 46,000

378 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Required

1. Classify each account as variable or fixed with respect to the number of cars washed. Explain. 2. Suppose Lorenzo washed 90,000 cars in 2012. Use the cost classification you developed in requirement 1 to estimate Lorenzo’s total costs in 2012. Depreciation is computed on a straightline basis.

10-21 Account analysis, high-low. Java Joe Coffees wants to find an equation to estimate monthly utility costs. Java Joe’s has been in business for one year and has collected the following cost data for utilities: Month January February March April May June July August September October November December Required

1. 2. 3. 4.

Electricity Bill $360 $420 $549 $405 $588 $624 $522 $597 $630 $615 $594 $633

Kilowatt Hours Used 1,200 1,400 1,830 1,350 1,960 2,080 1,740 1,990 2,100 2,050 1,980 2,110

Telephone Bill $92.00 $91.20 $94.80 $89.60 $98.00 $98.80 $93.40 $96.20 $95.60 $93.80 $91.00 $97.00

Telephone Minutes Used 1,100 1,060 1,240 980 1,400 1,440 1,170 1,310 1,280 1,190 1,050 1,350

Water Bill $60 $60 $60 $60 $60 $60 $60 $60 $60 $60 $60 $60

Gallons of Water Used 30,560 26,800 31,450 29,965 30,568 25,540 32,690 31,222 33,540 31,970 28,600 34,100

Which of the preceding costs is variable? Fixed? Mixed? Explain. Using the high-low method, determine the cost function for each cost. Combine the preceding information to get a monthly utility cost function for Java Joe’s. Next month, Java Joe’s expects to use 2,200 kilowatt hours of electricity, make 1,500 minutes of telephone calls, and use 32,000 gallons of water. Estimate total cost of utilities for the month.

10-22 Account analysis method. Gower, Inc., a manufacturer of plastic products, reports the following manufacturing costs and account analysis classification for the year ended December 31, 2012. Account Direct materials Direct manufacturing labor Power Supervision labor Materials-handling labor Maintenance labor Depreciation Rent, property taxes, and administration

Classification All variable All variable All variable 20% variable 50% variable 40% variable 0% variable 0% variable

Amount $300,000 225,000 37,500 56,250 60,000 75,000 95,000 100,000

Gower, Inc., produced 75,000 units of product in 2012. Gower’s management is estimating costs for 2013 on the basis of 2012 numbers. The following additional information is available for 2013. a. Direct materials prices in 2013 are expected to increase by 5% compared with 2012. b. Under the terms of the labor contract, direct manufacturing labor wage rates are expected to increase by 10% in 2013 compared with 2012. c. Power rates and wage rates for supervision, materials handling, and maintenance are not expected to change from 2012 to 2013. d. Depreciation costs are expected to increase by 5%, and rent, property taxes, and administration costs are expected to increase by 7%. e. Gower expects to manufacture and sell 80,000 units in 2013. Required

1. Prepare a schedule of variable, fixed, and total manufacturing costs for each account category in 2013. Estimate total manufacturing costs for 2013. 2. Calculate Gower’s total manufacturing cost per unit in 2012, and estimate total manufacturing cost per unit in 2013. 3. How can you obtain better estimates of fixed and variable costs? Why would these better estimates be useful to Gower?

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10-23 Estimating a cost function, high-low method. Reisen Travel offers helicopter service from suburban

towns to John F. Kennedy International Airport in New York City. Each of its 10 helicopters makes between 1,000 and 2,000 round-trips per year. The records indicate that a helicopter that has made 1,000 round-trips in the year incurs an average operating cost of $350 per round-trip, and one that has made 2,000 round-trips in the year incurs an average operating cost of $300 per round-trip. 1. Using the high-low method, estimate the linear relationship y = a + bX, where y is the total annual operating cost of a helicopter and X is the number of round-trips it makes to JFK airport during the year. 2. Give examples of costs that would be included in a and in b. 3. If Reisen Travel expects each helicopter to make, on average, 1,200 round-trips in the coming year, what should its estimated operating budget for the helicopter fleet be?

Required

10-24 Estimating a cost function, high-low method. Laurie Daley is examining customer-service costs in the southern region of Capitol Products. Capitol Products has more than 200 separate electrical products that are sold with a six-month guarantee of full repair or replacement with a new product. When a product is returned by a customer, a service report is prepared. This service report includes details of the problem and the time and cost of resolving the problem. Weekly data for the most recent 8-week period are as follows: Week 1 2 3 4 5 6 7 8

Customer-Service Department Costs $13,700 20,900 13,000 18,800 14,000 21,500 16,900 21,000

Number of Service Reports 190 275 115 395 265 455 340 305

1. Plot the relationship between customer-service costs and number of service reports. Is the relationship economically plausible? 2. Use the high-low method to compute the cost function, relating customer-service costs to the number of service reports. 3. What variables, in addition to number of service reports, might be cost drivers of weekly customerservice costs of Capitol Products?

Required

10-25 Linear cost approximation. Terry Lawler, managing director of the Chicago Reviewers Group, is examining how overhead costs behave with changes in monthly professional labor-hours billed to clients. Assume the following historical data: Total Overhead Costs $335,000 400,000 430,000 472,000 533,000 582,000

Professional Labor-Hours Billed to Clients 2,000 3,000 4,000 5,000 6,500 7,500

1. Compute the linear cost function, relating total overhead costs to professional labor-hours, using the representative observations of 3,000 and 6,500 hours. Plot the linear cost function. Does the constant component of the cost function represent the fixed overhead costs of the Chicago Reviewers Group? Why? 2. What would be the predicted total overhead costs for (a) 4,000 hours and (b) 7,500 hours using the cost function estimated in requirement 1? Plot the predicted costs and actual costs for 4,000 and 7,500 hours. 3. Lawler had a chance to accept a special job that would have boosted professional labor-hours from 3,000 to 4,000 hours. Suppose Lawler, guided by the linear cost function, rejected this job because it would have brought a total increase in contribution margin of $35,000, before deducting the predicted increase in total overhead cost, $38,000. What is the total contribution margin actually forgone?

Required

380 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Required

10-26 Cost-volume-profit and regression analysis. Goldstein Corporation manufactures a children’s bicycle, model CT8. Goldstein currently manufactures the bicycle frame. During 2012, Goldstein made 32,000 frames at a total cost of $1,056,000. Ryan Corporation has offered to supply as many frames as Goldstein wants at a cost of $32.50 per frame. Goldstein anticipates needing 35,000 frames each year for the next few years. 1. a. What is the average cost of manufacturing a bicycle frame in 2012? How does it compare to Ryan’s offer? b. Can Goldstein use the answer in requirement 1a to determine the cost of manufacturing 35,000 bicycle frames? Explain. 2. Goldstein’s cost analyst uses annual data from past years to estimate the following regression equation with total manufacturing costs of the bicycle frame as the dependent variable and bicycle frames produced as the independent variable: y = $435,000 + $19X During the years used to estimate the regression equation, the production of bicycle frames varied from 31,000 to 35,000. Using this equation, estimate how much it would cost Goldstein to manufacture 35,000 bicycle frames. How much more or less costly is it to manufacture the frames rather than to acquire them from Ryan? 3. What other information would you need to be confident that the equation in requirement 2 accurately predicts the cost of manufacturing bicycle frames?

10-27 Regression analysis, service company. (CMA, adapted) Bob Jones owns a catering company that prepares food and beverages for banquets and parties. For a standard party the cost on a per-person basis is as follows: Food and beverages Labor (0.5 hour * $10 per hour) Overhead (0.5 hour * $14 per hour) Total cost per person

$15 5 ƒƒ7 $27

Jones is quite certain about his estimates of the food, beverages, and labor costs but is not as comfortable with the overhead estimate. The overhead estimate was based on the actual data for the past 12 months, which are presented here. These data indicate that overhead costs vary with the direct labor-hours used. The $14 estimate was determined by dividing total overhead costs for the 12 months by total labor-hours. Month January February March April May June July August September October November December Total

Labor-Hours 2,500 2,700 3,000 4,200 7,500 5,500 6,500 4,500 7,000 4,500 3,100 ƒ6,500 57,500

Overhead Costs $ 55,000 59,000 60,000 64,000 77,000 71,000 74,000 67,000 75,000 68,000 62,000 ƒƒ73,000 $805,000

Jones has recently become aware of regression analysis. He estimated the following regression equation with overhead costs as the dependent variable and labor-hours as the independent variable: y = $48,271 + $3.93X Required

1. Plot the relationship between overhead costs and labor-hours. Draw the regression line and evaluate it using the criteria of economic plausibility, goodness of fit, and slope of the regression line. 2. Using data from the regression analysis, what is the variable cost per person for a standard party? 3. Bob Jones has been asked to prepare a bid for a 200-person standard party to be given next month. Determine the minimum bid price that Jones would be willing to submit to recoup variable costs.

ASSIGNMENT MATERIAL " 381

10-28 High-low, regression. Melissa Crupp is the new manager of the materials storeroom for

Canton Manufacturing. Melissa has been asked to estimate future monthly purchase costs for part #4599, used in two of Canton’s products. Melissa has purchase cost and quantity data for the past nine months as follows: Month January February March April May June July August September

Cost of Purchase $10,390 10,550 14,400 13,180 10,970 11,580 12,690 8,560 12,450

Quantity Purchased 2,250 parts 2,350 3,390 3,120 2,490 2,680 3,030 1,930 2,960

Estimated monthly purchases for this part based on expected demand of the two products for the rest of the year are as follows: Month October November December

Purchase Quantity Expected 2,800 parts 3,100 2,500

1. The computer in Melissa’s office is down and Melissa has been asked to immediately provide an equation to estimate the future purchase cost for part # 4599. Melissa grabs a calculator and uses the highlow method to estimate a cost equation. What equation does she get? 2. Using the equation from requirement 1, calculate the future expected purchase costs for each of the last three months of the year. 3. After a few hours Melissa’s computer is fixed. Melissa uses the first nine months of data and regression analysis to estimate the relationship between the quantity purchased and purchase costs of part #4599. The regression line Melissa obtains is as follows:

Required

y = $1,779.6 + 3.67X Evaluate the regression line using the criteria of economic plausibility, goodness of fit, and significance of the independent variable. Compare the regression equation to the equation based on the high-low method. Which is a better fit? Why? 4. Use the regression results to calculate the expected purchase costs for October, November, and December. Compare the expected purchase costs to the expected purchase costs calculated using the high-low method in requirement 2. Comment on your results.

10-29 Learning curve, cumulative average-time learning model. Global Defense manufactures radar systems. It has just completed the manufacture of its first newly designed system, RS-32. Manufacturing data for the RS-32 follow:

A 1 2 3 4 5

Direct material cost Direct manufacturing labor time for first unit Learning curve for manufacturing labor time per radar system Direct manufacturing labor cost Variable manufacturing overhead cost

$160,000 6,000 85% $ 30 $ 20

per unit of RS-32 direct manufacturing labor-hours cumulative average timea per direct manufacturing labor-hour per direct manufacturing labor-hour

6 ln 0.85 –0.162519 a 7 Using the formula (p. 359), for a 85% learning curve, b = ln 2 = 0.693147 = –0.234465 8

382 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Required

Calculate the total variable costs of producing 2, 4, and 8 units.

10-30 Learning curve, incremental unit-time learning model. Assume the same information for Global Defense as in Exercise 10-29, except that Global Defense uses an 85% incremental unit-time learning model as a basis for predicting direct manufacturing labor-hours. (An 85% learning curve means b = –0.234465.) Required

1. Calculate the total variable costs of producing 2, 3, and 4 units. 2. If you solved Exercise 10-29, compare your cost predictions in the two exercises for 2 and 4 units. Why are the predictions different? How should Global Defense decide which model it should use?

Problems 10-31 High-low method. Ken Howard, financial analyst at KMW Corporation, is examining the behavior

of quarterly maintenance costs for budgeting purposes. Howard collects the following data on machinehours worked and maintenance costs for the past 12 quarters: Quarter 1 2 3 4 5 6 7 8 9 10 11 12

Required

Machine-Hours 100,000 120,000 110,000 130,000 95,000 115,000 105,000 125,000 105,000 125,000 115,000 140,000

Maintenance Costs $205,000 240,000 220,000 260,000 190,000 235,000 215,000 255,000 210,000 245,000 200,000 280,000

1. Estimate the cost function for the quarterly data using the high-low method. 2. Plot and comment on the estimated cost function. 3. Howard anticipates that KMW will operate machines for 100,000 hours in quarter 13. Calculate the predicted maintenance costs in quarter 13 using the cost function estimated in requirement 1.

10-32 High-low method and regression analysis. Local Harvest, a cooperative of organic familyowned farms outside of Columbus, Ohio, has recently started a fresh produce club to provide support to the group’s member farms, and to promote the benefits of eating organic, locally-produced food to the nearby suburban community. Families pay a seasonal membership fee of $50, and place their orders a week in advance for a price of $40 per week. In turn, Local Harvest delivers fresh-picked seasonal local produce to several neighborhood distribution points. Eight hundred families joined the club for the first season, but the number of orders varied from week to week. Harvey Hendricks has run the produce club for the first 10-week season. Before becoming a farmer, Harvey had been a business major in college, and he remembers a few things about cost analysis. In planning for next year, he wants to know how many orders will be needed each week for the club to break even, but first he must estimate the club’s fixed and variable costs. He has collected the following data over the club’s first 10 weeks of operation: Week 1 2 3 4 5 6 7 8 9 10

Number of Orders per Week 351 385 410 453 425 486 455 467 525 510

Weekly Total Costs $18,795 21,597 22,800 22,600 21,900 24,600 23,900 22,900 25,305 24,500

ASSIGNMENT MATERIAL " 383

1. Plot the relationship between number of orders per week and weekly total costs. 2. Estimate the cost equation using the high-low method, and draw this line on your graph. 3. Harvey uses his computer to calculate the following regression formula:

Required

Total weekly costs = $8,631 + ($31.92 * Number of weekly orders) Draw the regression line on your graph. Use your graph to evaluate the regression line using the criteria of economic plausibility, goodness of fit, and significance of the independent variable. Is the cost function estimated using the high-low method a close approximation of the cost function estimated using the regression method? Explain briefly. 4. Did Fresh Harvest break even this season? Remember that each of the families paid a seasonal membership fee of $50. 5. Assume that 900 families join the club next year, and that prices and costs do not change. How many orders, on average, must Fresh Harvest receive each week to break even?

10-33 High-low method; regression analysis. (CIMA, adapted) Anna Martinez, the financial manager at the Casa Real restaurant, is checking to see if there is any relationship between newspaper advertising and sales revenues at the restaurant. She obtains the following data for the past 10 months: Month March April May June July August September October November December

Revenues $50,000 70,000 55,000 65,000 55,000 65,000 45,000 80,000 55,000 60,000

Advertising Costs $2,000 3,000 1,500 3,500 1,000 2,000 1,500 4,000 2,500 2,500

She estimates the following regression equation: Monthly revenues = $39,502 + ($8.723 * Advertising costs) 1. Plot the relationship between advertising costs and revenues. 2. Draw the regression line and evaluate it using the criteria of economic plausibility, goodness of fit, and slope of the regression line. 3. Use the high-low method to compute the function, relating advertising costs and revenues. 4. Using (a) the regression equation and (b) the high-low equation, what is the increase in revenues for each $1,000 spent on advertising within the relevant range? Which method should Martinez use to predict the effect of advertising costs on revenues? Explain briefly.

10-34 Regression, activity-based costing, choosing cost drivers. Fitzgerald Manufacturing has been

using activity-based costing to determine the cost of product X-678. One of the activities, “Inspection,” occurs just before the product is finished. Fitzgerald inspects every 10th unit, and has been using “number of units inspected” as the cost driver for inspection costs. A significant component of inspection costs is the cost of the test-kit used in each inspection. Neela McFeen, the line manager, is wondering if inspection labor-hours might be a better cost driver for inspection costs. Neela gathers information for weekly inspection costs, units inspected, and inspection labor-hours as follows: Week 1 2 3 4 5 6 7

Units Inspected 1,400 400 1,700 2,400 2,100 700 900

Inspection Labor-Hours 190 70 230 240 210 90 110

Inspection Costs $3,700 1,800 4,500 5,900 5,300 2,400 2,900

Required

384 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Neela runs regressions on each of the possible cost drivers and estimates these cost functions: Inspection Costs = $977 + ($2.05 * Number of units inspected) Inspection Costs = $478 + ($20.31 * Inspection labor-hours) Required

1. Explain why number of units inspected and inspection labor-hours are plausible cost drivers of inspection costs. 2. Plot the data and regression line for units inspected and inspection costs. Plot the data and regression line for inspection labor-hours and inspection costs. Which cost driver of inspection costs would you choose? Explain. 3. Neela expects inspectors to work 140 hours next period and to inspect 1,100 units. Using the cost driver you chose in requirement 2, what amount of inspection costs should Neela budget? Explain any implications of Neela choosing the cost driver you did not choose in requirement 2 to budget inspection costs.

10-35 Interpreting regression results, matching time periods. Brickman Apparel produces equipment for the extreme-sports market. It has four peak periods, each lasting two months, for manufacturing the merchandise suited for spring, summer, fall, and winter. In the off-peak periods, Brickman schedules equipment maintenance. Brickman’s controller, Sascha Green, wants to understand the drivers of equipment maintenance costs. The data collected is shown in the table as follows: Month January February March April May June July August September October November December

Machine-Hours 5,000 5,600 1,500 6,500 5,820 1,730 7,230 5,990 2,040 6,170 5,900 1,500

Maintenance Costs $ 1,300 2,200 12,850 1,665 2,770 15,250 1,880 2,740 15,350 1,620 2,770 14,700

A regression analysis of one year of monthly data yields the following relationships: Maintenance costs = $18,552 - ($2.683 * Number of machine-hours) Upon examining the results, Green comments, “So, all I have to do to reduce maintenance costs is run my machines longer?! This is hard to believe, but numbers don’t lie! I would have guessed just the opposite.” Required

1. Explain why Green made this comment. What is wrong with her analysis? 2. Upon further reflection, Sascha Green reanalyzes the data, this time comparing quarterly machinehours with quarterly maintenance expenditures. This time, the results are very different. The regression yields the following formula: Maintenance costs = $2,622.80 + ($1.175 * Number of machine-hours) What caused the formula to change, in light of the fact that the data was the same?

10-36 Cost estimation, cumulative average-time learning curve. The Nautilus Company, which is under contract to the U.S. Navy, assembles troop deployment boats. As part of its research program, it completes the assembly of the first of a new model (PT109) of deployment boats. The Navy is impressed with the PT109. It requests that Nautilus submit a proposal on the cost of producing another six PT109s. Nautilus reports the following cost information for the first PT109 assembled and uses a 90% cumulative average-time learning model as a basis for forecasting direct manufacturing labor-hours for the next six PT109s. (A 90% learning curve means b = –0.152004.)

ASSIGNMENT MATERIAL " 385

A 1 2 3 4 5 6 7 8 9 10

Direct material Direct manufacturing labor time for first boat Direct manufacturing labor rate Variable manufacturing overhead cost Other manufacturing overhead Tooling costsa Learning curve for manufacturing labor time per boat a

$ 200,000 15,000 labor-hours $ 40 per direct manufacturing labor-hour $ 25 per direct manufacturing labor-hour 20% of direct manufacturing labor costs $280,000 b 90% cumulative average time

Tooling can be reused at no extra cost because all of its cost has been assigned to the first deployment boat.

ln 0.9 –0.105361 11 bUsing the formula (p. 359), for a 90% learning curve, b = ln 2 = 0.693147 = –0.152004 12

1. Calculate predicted total costs of producing the six PT109s for the Navy. (Nautilus will keep the first deployment boat assembled, costed at $1,575,000, as a demonstration model for potential customers.) 2. What is the dollar amount of the difference between (a) the predicted total costs for producing the six PT109s in requirement 1, and (b) the predicted total costs for producing the six PT109s, assuming that there is no learning curve for direct manufacturing labor? That is, for (b) assume a linear function for units produced and direct manufacturing labor-hours.

Required

10-37 Cost estimation, incremental unit-time learning model. Assume the same information for the Nautilus Company as in Problem 10-36 with one exception. This exception is that Nautilus uses a 90% incremental unit-time learning model as a basis for predicting direct manufacturing labor-hours in its assembling operations. (A 90% learning curve means b = –0.152004.) 1. Prepare a prediction of the total costs for producing the six PT109s for the Navy. 2. If you solved requirement 1 of Problem 10-36, compare your cost prediction there with the one you made here. Why are the predictions different? How should Nautilus decide which model it should use?

10-38 Regression; choosing among models. Tilbert Toys (TT) makes the popular Floppin’ Freddy Frog and Jumpin’ Jill Junebug dolls in batches. TT has recently adopted activity-based costing. TT incurs setup costs for each batch of dolls that it produces. TT uses “number of setups” as the cost driver for setup costs. TT has just hired Bebe Williams, an accountant. Bebe thinks that “number of setup-hours” might be a better cost driver because the setup time for each product is different. Bebe collects the following data.

1 2 3 4 5 6 7 8 9 10

Month 1 2 3 4 5 6 7 8 9

Number of Setups 300 410 150 480 310 460 420 300 270

Number of Setup Hours 1,840 2,680 1,160 3,800 3,680 3,900 2,980 1,200 3,280

Setup Costs $104,600 126,700 57,480 236,840 178,880 213,760 209,620 90,080 221,040

Required

386 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

Required

1. Estimate the regression equation for (a) setup costs and number of setups and (b) setup costs and number of setup-hours. You should obtain the following results: Regression 1: Setup costs = a + (b * Number of setups) Variable Constant Independent variable 1: No. of setups

Coefficient $12,890 $ 426.77

Standard Error $ 61,365 $ 171

t-Value 0.21 2.49

r 2 = 0.47; Durbin-Watson statistic = 1.65 Regression 2: Setup costs = a + (b * Number of setup-hours) Variable Constant Independent variable 1: No. of setup-hours

Coefficient $6,573 $ 56.27

Standard Error $ 25,908 $ 8.90

t-Value 0.25 6.32

r 2 = 0.85; Durbin-Watson statistic = 1.50 2. On two different graphs plot the data and the regression lines for each of the following cost functions: a. Setup costs = a + (b * Number of setups) b. Setup costs = a + (b * Number of setup-hours) 3. Evaluate the regression models for “Number of setups” and “Number of setup-hours” as the cost driver according to the format of Exhibit 10-18 (p. 372). 4. Based on your analysis, which cost driver should Tilbert Toys use for setup costs, and why?

10-39 Multiple regression (continuation of 10-38). Bebe Williams wonders if she should run a multiple regression with both number of setups and number of setup-hours, as cost drivers. Required

1. Run a multiple regression to estimate the regression equation for setup costs using both number of setups and number of setup-hours as independent variables. You should obtain the following result: Regression 3: Setup costs = a (b1 * No. of setups) + (b2 * No. of setup-hours) Variable Constant Independent variable 1: No. of setups Independent variable 2: No. of setup-hours r 2 = 0.86; Durbin-Watson statistic = 1.38

Coefficient –$2,807 $ 58.62 $ 52.31

Standard Error $ 34,850 $ 133.42 $ 13.08

t-Value –0.08 0.44 4.00

2. Evaluate the multiple regression output using the criteria of economic plausibility goodness of fit, significance of independent variables, and specification of estimation assumptions. (Assume linearity, constant variance, and normality of residuals.) 3. What difficulties do not arise in simple regression analysis that may arise in multiple regression analysis? Is there evidence of such difficulties in the multiple regression presented in this problem? Explain. 4. Which of the regression models from Problems 10-38 and 10-39 would you recommend Bebe Williams use? Explain.

10-40 Purchasing department cost drivers, activity-based costing, simple regression analysis. Fashion Bling operates a chain of 10 retail department stores. Each department store makes its own purchasing decisions. Barry Lee, assistant to the president of Fashion Bling, is interested in better understanding the drivers of purchasing department costs. For many years, Fashion Bling has allocated purchasing department costs to products on the basis of the dollar value of merchandise purchased. A $100 item is allocated 10 times as many overhead costs associated with the purchasing department as a $10 item. Lee recently attended a seminar titled “Cost Drivers in the Retail Industry.” In a presentation at the seminar, Couture Fabrics, a leading competitor that has implemented activity-based costing, reported number of purchase orders and number of suppliers to be the two most important cost drivers of purchasing department costs. The dollar value of merchandise purchased in each purchase order was not found to be a significant cost driver. Lee interviewed several members of the purchasing department at the Fashion Bling store in Miami. They believed that Couture Fabrics’ conclusions also applied to their purchasing department.

ASSIGNMENT MATERIAL " 387

Lee collects the following data for the most recent year for Fashion Bling’s 10 retail department stores:

Purchasing Department Costs (PDC) $1,522,000 1,095,000 542,000 2,053,000 1,068,000 517,000 1,544,000 1,761,000 1,605,000 1,263,000

Dollar Value of Merchandise Purchased (MP$) $ 68,307,000 33,463,000 121,800,000 119,450,000 33,575,000 29,836,000 102,840,000 38,725,000 139,300,000 130,110,000

Number of Purchase Orders (No. of POs) 4,345 2,548 1,420 5,935 2,786 1,334 7,581 3,623 1,712 4,736

Number of Suppliers (No. of Ss) 125 230 8 188 21 29 101 127 202 196

1 2 3 4 5 6 7 8 9 10 11

Department Store Baltimore Chicago Los Angeles Miami New York Phoenix Seattle St. Louis Toronto Vancouver

Lee decides to use simple regression analysis to examine whether one or more of three variables (the last three columns in the table) are cost drivers of purchasing department costs. Summary results for these regressions are as follows: Regression 1: PDC = a + (b * MP$) Variable Constant Independent variable 1: MP$ r 2 = 0.08; Durbin-Watson statistic = 2.41

Standard Error $346,709 0.0038

t-Value 3.00 0.83

Coefficient $ 722,538 $ 159.48

Standard Error $ 265,835 $ 64.84

t-Value 2.72 2.46

Coefficient $ 828,814 $ 3,816

Standard Error $246,570 $ 1,698

t-Value 3.36 2.25

Coefficient $1,041,421 0.0031

Regression 2: PDC = a (b * No. of POs) Variable Constant Independent variable 1: No. of POs r 2 = 0.43; Durbin-Watson statistic = 1.97

Regression 3: PDC = a + (b * No. of Ss) Variable Constant Independent variable 1: No. of Ss

r 2 = 0.39; Durbin-Watson statistic = 2.01 1. Compare and evaluate the three simple regression models estimated by Lee. Graph each one. Also, use the format employed in Exhibit 10-18 (p. 372) to evaluate the information. 2. Do the regression results support the Couture Fabrics’ presentation about the purchasing department’s cost drivers? Which of these cost drivers would you recommend in designing an ABC system? 3. How might Lee gain additional evidence on drivers of purchasing department costs at each of Fashion Bling’s stores?

Required

388 " CHAPTER 10 DETERMINING HOW COSTS BEHAVE

10-41 Purchasing department cost drivers, multiple regression analysis (continuation of 10-40). Barry Lee decides that the simple regression analysis used in Problem 10-40 could be extended to a multiple regression analysis. He finds the following results for two multiple regression analyses: Regression 4: PDC = a + (b1 * No. of POs) + (b2 * No. of Ss) Variable Constant Independent variable 1: No. of POs Independent variable 2: No. of Ss r 2 = 0.64; Durbin-Watson statistic = 1.91

Coefficient $ 484,522 $ 126.66 $ 2,903

Standard Error $256,684 $ 57.80 $ 1,459

t-Value 1.89 2.19 1.99

Regression 5: PDC = a + (b1 * No. of POs) + (b2 * No. of Ss) + (b3 * MP$) Variable Constant Independent variable 1: No. of POs Independent variable 2: No. of Ss Independent variable 3: MP$ r 2 = 0.64; Durbin-Watson statistic = 1.91

Coefficient $483,560 $ 126.58 $ 2,901 0.00002

Standard Error $312,554 $ 63.75 $ 1,622 0.0029

t-Value 1.55 1.99 1.79 0.01

The coefficients of correlation between combinations of pairs of the variables are as follows:

MP$ No. of POs No. of Ss Required

PDC 0.28 0.66 0.62

MP$

No. of POs

0.27 0.30

0.29

1. Evaluate regression 4 using the criteria of economic plausibility, goodness of fit, significance of independent variables and specification analysis. Compare regression 4 with regressions 2 and 3 in Problem 10-40. Which one of these models would you recommend that Lee use? Why? 2. Compare regression 5 with regression 4. Which one of these models would you recommend that Lee use? Why? 3. Lee estimates the following data for the Baltimore store for next year: dollar value of merchandise purchased, $78,000,000; number of purchase orders, 4,000; number of suppliers, 95. How much should Lee budget for purchasing department costs for the Baltimore store for next year? 4. What difficulties do not arise in simple regression analysis that may arise in multiple regression analysis? Is there evidence of such difficulties in either of the multiple regressions presented in this problem? Explain. 5. Give two examples of decisions in which the regression results reported here (and in Problem 10-40) could be informative.

Collaborative Learning Problem 10-42 Interpreting regression results, matching time periods, ethics. Jayne Barbour is working as a summer intern at Mode, a trendy store specializing in clothing for twenty-somethings. Jayne has been working closely with her cousin, Gail Hubbard, who plans promotions for Mode. The store has only been in business for 10 months, and Valerie Parker, the store’s owner, has been unsure of the effectiveness of the store’s advertising. Wanting to impress Valerie with the regression analysis skills she acquired in a cost accounting course the previous semester, Jayne decides to prepare an analysis of the effect of advertising on revenues. She collects the following data:

ASSIGNMENT MATERIAL " 389

1 2 3 4 5 6 7 8 9 10 11

Month October November December January February March April May June July

Advertising Expense 4,560 3,285 1,200 4,099 3,452 1,075 4,768 4,775 1,845 1,430

Revenue $35,400 44,255 56,300 28,764 49,532 43,200 30,600 52,137 49,640 29,542

Jayne performs a regression analysis, comparing each month’s advertising expense with that month’s revenue, and obtains the following formula: Revenue = $47,801 – (1.92 * Advertising expense) Variable Constant Independent variable: Advertising expense r 2 = 0.43; Standard error = 10,340.18

Coefficient $47,801.72 –1.92

Standard Error 7,628.39 2.26

t-Value 6.27 –0.85

1. Plot the preceding data on a graph and draw the regression line. What does the cost formula indicate about the relationship between monthly advertising expense and monthly revenues? Is the relationship economically plausible? 2. Jayne worries that if she makes her presentation to the owner as planned, it will reflect poorly on her cousin Gail’s performance. Is she ethically obligated to make the presentation? 3. Jayne thinks further about her analysis, and discovers a significant flaw in her approach. She realizes that advertising done in a given month should be expected to influence the following month’s sales, not necessarily the current month’s. She modifies her analysis by comparing, for example, October advertising expense with November sales revenue. The modified regression yields the following: Revenue = $23,538 + (5.92 * Advertising expense) Variable Constant Independent variable: Previous month’s advertising expense r 2 = 0.71; Standard error = 6,015.67

Coefficient $23,538.45 5.92

Standard Error 4,996.60 1.42

t-Value 4.71 4.18

What does the revised cost formula indicate? Plot the revised data on a graph. (You will need to discard October revenue and July advertising expense from the data set.) Is this relationship economically plausible? 4. Can Jayne conclude that there is a cause and effect relationship between advertising expense and sales revenue? Why or why not?

Required

Allocation of Support-Department Costs, Common Costs, and Revenues

How a company allocates its overhead and internal support costs—costs related to marketing, advertising, and other internal services—among its various production departments or projects, can have a big impact on how profitable those departments or projects are.

Learning Objectives

1. Distinguish the single-rate method from the dual-rate method 2. Understand how divisional incentives are affected by the choice between allocation based on budgeted and actual rates, and budgeted and actual usage

While the allocation won’t affect the firm’s profit as a whole, if the allocation isn’t done properly, it can make some departments and projects (and their managers) look better or worse than they should profit-wise. As the following article shows, the method of allocating costs for a project affects not just the firm but also the consumer. Based on the method used, consumers may spend more, or less, for the same service.

3. Allocate multiple supportdepartment costs using the direct method, the step-down method, and the reciprocal method 4. Allocate common costs using the stand-alone method and the incremental method 5. Explain the importance of explicit agreement between contracting parties when the reimbursement amount is based on costs incurred 6. Understand how bundling of products gives rise to revenue allocation issues and the methods for doing so

Cost Allocation and the Future of “Smart Grid” Energy Infrastructure1 Across the globe, countries are adopting alternative methods of generating and distributing energy. In the United States, government leaders and companies ranging from GE to Google are advocating the movement towards a “Smart Grid”—that is, making transmission and power lines operate and communicate in a more effective and efficient manner using technology, computers, and software. This proposed system would also integrate with emerging clean energy sources, such as solar farms and geothermal systems, to help create a more sustainable electricity supply that reduces carbon emissions. According to the Electric Power Resource Institute, the cost of developing the “Smart Grid” is $165 billion over the next two decades. These costs include new infrastructure and technology improvements—mostly to power lines—as well as traditional indirect costs for the organizations upgrading the power system, which include traditional support-department costs and common costs. Private utilities and the U.S. government will pay for the upfront costs of “Smart Grid” development, but those costs will be recouped over time by charging energy consumers. But one question remains: How should those costs be allocated for reimbursement? A controversy has emerged as two cost allocation methods are being debated by the U.S. government. One method is 1

542

Sources: Garthwaite, Josie. 2009. The $160B question: Who should foot the bill for transmission buildout?” Salon.com, March 12; Jaffe, Mark. 2010. Cost of Smart-Grid projects shocks consumer advocates. The Denver Post, February 14.

interconnection-wide cost allocation. Under this system, everybody in the region where a new technology is deployed would have to help pay for it. For example, if new power lines and “smart” energy meters are deployed in Denver, everybody in Colorado would help pay for them. Supporters argue that this method would help lessen the costs consumers would be charged by utilities for the significant investments in new technology. Another competing proposal would only allocate costs to utility ratepayers that actually benefit from the new “Smart Grid” system. Using the previous example, only utility customers in Denver would be charged for the new power lines and energy meters (likely through additional monthly utility costs). Supporters of this method believe that customers with new “Smart Grid” systems should not be subsidized by those not receiving any of the benefits. Regardless of the method selected, cost allocation is going to play a key role in the future of the U.S. energy generation and distribution system. The same allocation dilemmas apply to the costs of corporate support departments and the apportionment of revenues when products are sold in bundles. These concerns are common to managers at manufacturing companies such as Nestle, service companies such as Comcast, merchandising companies such as Trader Joe’s, and academic institutions such as Auburn University. This chapter focuses on several challenges that arise with regard to cost and revenue allocations.

Allocating Support Department Costs Using the Single-Rate and Dual-Rate Methods Companies distinguish operating departments (and operating divisions) from support departments. An operating department, also called a production department, directly adds value to a product or service. A support department, also called a service department, provides the services that assist other internal departments (operating departments and other support departments) in the company. Examples of support departments are information systems and plant maintenance. Managers face two questions when allocating the costs of a support department to operating departments or divisions: (1) Should fixed costs of support departments be allocated to operating divisions? (2) If fixed costs are allocated, should variable and fixed costs be allocated in the same way? With regard to the first question, most companies believe that fixed costs of support departments should be allocated because the support department needs to incur fixed costs to provide

Learning Objective

Distinguish the singlerate method . . . one rate for allocating costs in a cost pool from the dual-rate method . . . two rates for allocating costs in a cost pool—one for variable costs and one for fixed costs

544 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

operating divisions with the services they require. Depending on the answer to the second question, there are two approaches to allocating support-department costs: the single-rate cost-allocation method and the dual-rate cost-allocation method.

Single-Rate and Dual-Rate Methods The single-rate method makes no distinction between fixed and variable costs. It allocates costs in each cost pool (support department in this section) to cost objects (operating divisions in this section) using the same rate per unit of a single allocation base. By contrast, the dual-rate method partitions the cost of each support department into two pools, a variablecost pool and a fixed-cost pool, and allocates each pool using a different cost-allocation base. When using either the single-rate method or the dual-rate method, managers can allocate support-department costs to operating divisions based on either a budgeted rate or the eventual actual cost rate. The latter approach is neither conceptually preferred nor widely used in practice (we explain why in the next section). Accordingly, we illustrate the singlerate and dual-rate methods next based on the use of budgeted rates. Consider the central computer department of Sand Hill Company (SHC). This support department has two users, both operating divisions: the microcomputer division and the peripheral equipment division. The following data relate to the 2012 budget: Practical capacity Fixed costs of operating the computer facility in the 6,000-hour to 18,750-hour relevant range Budgeted long-run usage (quantity) in hours: Microcomputer division Peripheral equipment division Total Budgeted variable cost per hour in the 6,000-hour to 18,750-hour relevant range Actual usage in 2012 in hours: Microcomputer division Peripheral equipment division Total

18,750 hours $3,000,000

8,000 hours ƒ4,000 hours 12,000 hours $200 per hour used

9,000 hours ƒ3,000 hours 12,000 hours

The budgeted rates for central computer department costs can be computed based on either the demand for computer services or the supply of computer services. We consider the allocation of central computer department costs based first on the demand for (or usage of) computer services and then on the supply of computer services.

Allocation Based on the Demand for (or Usage of) Computer Services We present the single-rate method followed by the dual-rate method. Single-Rate Method In this method, a combined budgeted rate is used for fixed and variable costs. The rate is calculated as follows: Budgeted usage Budgeted total cost pool: $3,000,000 + (12,000 hours * $200/hour) Budgeted total rate per hour: $5,400,000 ÷ 12,000 hours Allocation rate for microcomputer division Allocation rate for peripheral equipment division

12,000 hours $5,400,000 $450 per hour used $450 per hour used $450 per hour used

Note that the budgeted rate of $450 per hour is substantially higher than the $200 budgeted variable cost per hour. That’s because the $450 rate includes an allocated amount of $250 per hour (budgeted fixed costs, $3,000,000, ÷ budgeted usage, 12,000 hours) for the fixed costs of operating the facility. Under the single-rate method, divisions are charged the budgeted rate for each hour of actual use of the central facility. Applying this to our example, SHC allocates central

ALLOCATING SUPPORT DEPARTMENT COSTS USING THE SINGLE-RATE AND DUAL-RATE METHODS " 545

computer department costs based on the $450 per hour budgeted rate and actual hours used by the operating divisions. The support costs allocated to the two divisions under this method are as follows: Microcomputer division: 9,000 hours * $450 per hour Peripheral equipment division: 3,000 hours * $450 per hour

$4,050,000 $1,350,000

Dual-Rate Method When the dual-rate method is used, allocation bases must be chosen for both the variable and fixed cost pools of the central computer department. As in the single-rate method, variable costs are assigned based on the budgeted variable cost per hour of $200 for actual hours used by each division. However, fixed costs are assigned based on budgeted fixed costs per hour and the budgeted number of hours for each division. Given the budgeted usage of 8,000 hours for the microcomputer division and 4,000 hours for the peripheral equipment division, the budgeted fixed-cost rate is $250 per hour ($3,000,000 ÷ 12,000 hours), as before. Since this rate is charged on the basis of the budgeted usage, however, the fixed costs are effectively allocated in advance as a lump-sum based on the relative proportions of the central computing facilities expected to be used by the operating divisions. The costs allocated to the microcomputer division in 2012 under the dual-rate method would be as follows: Fixed costs: $250 per hour * 8,000 (budgeted) hours Variable costs: $200 per hour * 9,000 (actual) hours Total costs

$2,000,000 ƒ1,800,000 $3,800,000

The costs allocated to the peripheral equipment division in 2012 would be as follows: Fixed costs: $250 per hour * 4,000 (budgeted) hours Variable costs: $200 per hour * 3,000 (actual) hours Total costs

$1,000,000 ƒƒƒ600,000 $1,600,000

Note that each operating division is charged the same amount for variable costs under the single-rate and dual-rate methods ($200 per hour multiplied by the actual hours of use). However, the overall assignment of costs differs under the two methods because the single-rate method allocates fixed costs of the support department based on actual usage of computer resources by the operating divisions, whereas the dual-rate method allocates fixed costs based on budgeted usage. We next consider the alternative approach of allocating central computer department costs based on the capacity of computer services supplied.

Allocation Based on the Supply of Capacity We illustrate this approach using the 18,750 hours of practical capacity of the central computer department. The budgeted rate is then determined as follows: Budgeted fixed-cost rate per hour, $3,000,000 ÷ 18,750 hours Budgeted variable-cost rate per hour Budgeted total-cost rate per hour

$160 per hour ƒ200 per hour $360 per hour

Using the same procedures for the single-rate and dual-rate methods as in the previous section, the support cost allocations to the operating divisions are as follows: Single-Rate Method Microcomputer division: $360 per hour * 9,000 (actual) hours Peripheral equipment division: $360 per hour * 3,000 (actual) hours Fixed costs of unused computer capacity: $160 per hour * 6,750 hoursa a6,750

$3,240,000 1,080,000 1,080,000

hours = Practical capacity of 18,750 – (9,000 hours used by microcomputer division + 3,000 hours used by peripheral equipment division).

546 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

Dual-Rate Method Microcomputer division Fixed costs: $160 per hour * 8,000 (budgeted) hours Variable costs: $200 per hour * 9,000 (actual) hours Total costs

$1,280,000 ƒ1,800,000 $3,080,000

Peripheral equipment division Fixed costs: $160 per hour * 4,000 (budgeted) hours Variable costs: $200 per hour * 3,000 (actual) hours Total costs

$ 640,000 ƒƒƒ600,000 $1,240,000

Fixed costs of unused computer capacity: $160 per hour * 6,750 hoursb

$1,080,000

b6,750

hours = Practical capacity of 18,750 hours – (8,000 hours budgeted to be used by microcomputer division + 4,000 hours budgeted to be used by peripheral equipment division).

When practical capacity is used to allocate costs, the single-rate method allocates only the actual fixed-cost resources used by the microcomputer and peripheral equipment divisions, while the dual-rate method allocates the budgeted fixed-cost resources to be used by the operating divisions. Unused central computer department resources are highlighted but usually not allocated to the divisions.2 The advantage of using practical capacity to allocate costs is that it focuses management’s attention on managing unused capacity (described in Chapter 9, pp. 317–318, and Chapter 13, pp. 486–487). Using practical capacity also avoids burdening the user divisions with the cost of unused capacity of the central computer department. In contrast, when costs are allocated on the basis of the demand for computer services, all $3,000,000 of budgeted fixed costs, including the cost of unused capacity, are allocated to user divisions. If costs are used as a basis for pricing, then charging user divisions for unused capacity could result in the downward demand spiral (see p. 316).

Single-Rate Versus Dual-Rate Method There are benefits and costs of both the single-rate and dual-rate methods. One benefit of the single-rate method is the low cost to implement it. The single-rate method avoids the often-expensive analysis necessary to classify the individual cost items of a department into fixed and variable categories. Also, by conditioning the final allocations on the actual usage of central facilities, rather than basing them solely on uncertain forecasts of expected demand, it offers the user divisions some operational control over the charges they bear. A problem with the single-rate method is that it makes the allocated fixed costs of the support department appear as variable costs to the operating divisions. Consequently, the single-rate method may lead division managers to make outsourcing decisions that are in their own best interest but that may be inefficient from the standpoint of the organization as a whole. Consider the setting where allocations are made on the basis of the demand for computer services. In this case, each user division is charged $450 per hour under the single-rate method (recall that $250 of this charge relates to the allocated fixed costs of the central computer department). Suppose an external vendor offers the microcomputer division computer services at a rate of $340 per hour, at a time when the central computer department has unused capacity. The microcomputer division’s managers would be tempted to use this vendor because it would lower the division’s costs ($340 per hour instead of the $450 per hour internal charge for computer services). In the short run, however, the fixed costs of the central computer department remain unchanged in the relevant range (between 6,000 hours of usage and the practical capacity of 18,750 hours). SHC will therefore incur an additional cost of $140 per hour if the managers were to take this offer—the difference between the $340 external purchase price and the true internal variable cost of $200 of using the central computer department. 2

In our example, the cost of unused capacity under the single-rate and the dual-rate methods coincide (each equals $1,080,000). This occurs because the total actual usage of the facility matches the total expected usage of 12,000 hours. The budgeted cost of unused capacity (in the dual-rate method) can be either greater or lower than the actual cost (in the singlerate method), depending on whether the total actual usage is lower or higher than the budgeted usage.

BUDGETED VERSUS ACTUAL COSTS, AND THE CHOICE OF ALLOCATON BASE " 547

The divergence created under the single-rate method between SHC’s interests and those of its division managers is lessened when allocation is done on the basis of practical capacity. The variable cost per hour perceived by the operating division managers is now $360 (rather than the $450 rate when allocation is based on budgeted usage). However, any external offer above $200 (SHC’s true variable cost) and below $360 (the single-rate charge per hour) will still result in the user manager preferring to outsource the service at the expense of SHC’s overall profits. A benefit of the dual-rate method is that it signals to division managers how variable costs and fixed costs behave differently. This information guides division managers to make decisions that benefit the organization as a whole, as well as each division. For example, using a third-party computer provider that charges more than $200 per hour would result in SHC’s being worse off than if its own central computer department were used, because the latter has a variable cost of $200 per hour. Under the dual-rate method, neither division manager has an incentive to pay more than $200 per hour for an external provider because the internal charge for computer services is precisely that amount. By charging the fixed costs of resources budgeted to be used by the divisions as a lump-sum, the dual-rate method succeeds in removing fixed costs from the division managers’ consideration when making marginal decisions regarding the outsourcing of services. It thus avoids the potential conflict of interest that can arise under the single-rate method. Recently, the dual-rate method has been receiving more attention. Resource Consumption Accounting (RCA), an emerging management accounting system, employs an allocation procedure akin to a dual-rate system. For each cost/resource pool, cost assignment rates for fixed costs are based on practical capacity supplied, while rates for proportional costs (i.e., costs that vary with regard to the output of the resource pool) are based on planned quantities.3

Budgeted Versus Actual Costs, and the Choice of Allocaton Base The allocation methods previously outlined follow specific procedures in terms of the support department costs that are considered as well as the manner in which costs are assigned to the operating departments. In this section, we examine these choices in greater detail and consider the impact of alternative approaches. We show that the decision whether to use actual or budgeted costs, as well as the choice between actual and budgeted usage as allocation base, has a significant impact on the cost allocated to each division and the incentives of the division managers.

Budgeted Versus Actual Rates In both the single-rate and dual-rate methods, we use budgeted rates to assign support department costs (fixed as well as variable costs). An alternative approach would involve using the actual rates based on the support costs realized during the period. This method is much less common because of the level of uncertainty it imposes on user divisions. When allocations are made using budgeted rates, managers of divisions to which costs are allocated know with certainty the rates to be used in that budget period. Users can then determine the amount of the service to request and—if company policy allows— whether to use the internal source or an external vendor. In contrast, when actual rates are used for cost allocation, user divisions are kept unaware of their charges until the end of the budget period. Budgeted rates also help motivate the manager of the support (or supplier) department (for example, the central computer department) to improve efficiency. During the 3

Other salient features of Resource Consumption Accounting (RCA) include the selective use of activity-based costing, the nonassignment of fixed costs when causal relationships cannot be established, and the depreciation of assets based on their replacement cost. RCA has its roots in the nearly fifty-year-old German cost accounting system called Grenzplankostenrechnung (GPK), which is used by organizations such as Mercedes-Benz, Porsche, and Stihl. For further details, as well as illustrations of the use of RCA and GPK in organizations, see S. Webber and B. Clinton, “Resource Consumption Accounting Applied: The Clopay Case,” Management Accounting Quarterly (Fall 2004) and B. Mackie, “Merging GPK and ABC on the Road to RCA,” Strategic Finance (November 2006).

Decision Point When should managers use the dual-rate method over the single-rate method?

Learning Objective

Understand how divisional incentives are affected by the choice between allocation based on budgeted and actual rates, . . . budgeted rates provide certainty to users about charges and motivate the support division to engage in cost control and budgeted and actual usage . . . budgeted usage helps in planning and efficient utilization of fixed resources, actual usage controls consumption of variable resources

548 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

budget period, the support department, not the user divisions, bears the risk of any unfavorable cost variances. That’s because user divisions do not pay for any costs or inefficiencies of the supplier department that cause actual rates to exceed budgeted rates. The manager of the supplier department would likely view the budgeted rates negatively if unfavorable cost variances occur due to price increases outside of his or her control. Some organizations try to identify these uncontrollable factors and relieve the support department manager of responsibility for these variances. In other organizations, the supplier department and the user division agree to share the risk (through an explicit formula) of a large, uncontrollable increase in the prices of inputs used by the supplier department. This procedure avoids imposing the risk completely on either the supplier department (as when budgeted rates are used) or the user division (as in the case of actual rates). For the rest of this chapter, we will continue to consider only allocation methods that are based on the budgeted cost of support services.

Budgeted Versus Actual Usage In both the single-rate and dual-rate methods, the variable costs are assigned on the basis of budgeted rates and actual usage. Since the variable costs are directly and causally linked to usage, charging them as a function of the actual usage is appropriate. Moreover, allocating variable costs on the basis of budgeted usage would provide the user departments with no incentive to control their consumption of support services. What about the fixed costs? Consider the budget of $3,000,000 fixed costs at the central computer department of SHC. Recall that budgeted usage is 8,000 hours for the microcomputer division and 4,000 hours for the peripheral equipment division. Assume that actual usage by the microcomputer division is always equal to budgeted usage. We consider three cases: when actual usage by the peripheral equipment division equals (Case 1), is greater than (Case 2), and is less than (Case 3) budgeted usage. Fixed Cost Allocation Based on Budgeted Rates and Budgeted Usage This is the dual-rate procedure outlined in the previous section. When budgeted usage is the allocation base, regardless of the actual usage of facilities (i.e., whether Case 1, 2, or 3 occurs), user divisions receive a preset lump-sum fixed cost charge. If rates are based on expected demand ($250 per hour), the microcomputer division is assigned $2,000,000 and the peripheral equipment division, $1,000,000. If rates are set using practical capacity ($160 per hour), the microcomputer division is charged $1,280,000, the peripheral equipment division is allocated $640,000, and the remaining $1,080,000 is the unallocated cost of excess capacity. The advantage of knowing the allocations in advance is that it helps the user divisions with both short-run and long-run planning. Companies commit to infrastructure costs (such as the fixed costs of a support department) on the basis of a long-run planning horizon; budgeted usage measures the long-run demands of the user divisions for supportdepartment services. Allocating fixed costs on the basis of budgeted long-run usage may tempt some managers to underestimate their planned usage. Underestimating will result in their divisions bearing a lower percentage of fixed costs (assuming all other managers do not similarly underestimate their usage). To discourage such underestimates, some companies offer bonuses or other rewards—the “carrot” approach—to managers who make accurate forecasts of long-run usage. Other companies impose cost penalties—the “stick” approach—for underestimating long-run usage. For instance, a higher cost rate is charged after a division exceeds its budgeted usage. Fixed Cost Allocation Based on Budgeted Rates and Actual Usage Column 2 of Exhibit 15-1 provides the allocations when the budgeted rate is based on expected demand ($250 per hour), while column 3 shows the allocations when practical capacity is used to derive the rate ($160 per hour). Note that each operating division’s

BUDGETED VERSUS ACTUAL COSTS, AND THE CHOICE OF ALLOCATON BASE " 549

Exhibit 15-1

Effect of Variations in Actual Usage on Fixed Cost Allocation to Operating Divisions (1)

(2) Budgeted Rate Based on Expected Demanda

Actual Usage Case 1 2 3

Micro. Div. 8,000 hours 8,000 hours 8,000 hours

Periph. Div. 4,000 hours 7,000 hours 2,000 hours

Micro. Div. $2,000,000 $2,000,000 $2,000,000

Periph. Div. $1,000,000 $1,750,000 $ 500,000

(3) Budgeted Rate Based on Practical Capacityb Micro. Div. $1,280,000 $1,280,000 $1,280,000

(4) Allocation of Budgeted Total Fixed Cost

Periph. Div.

Micro. Div.

Periph. Div.

$ 640,000 $1,120,000 $ 320,000

$2,000,000c

$1,000,000d $1,400,000f $ 600,000h

$1,600,000e

$2,400,000g

$3,000,000 = $250 per hour (8, 000 + 4,000) hours

$3,000,000 = $160 per hour 18,750 hours

8, 000 × $3,000,000 (8, 000 + 4, 000)

4, 000 × $3,000,000 (8, 000 + 4, 000)

8, 000 × $3,000,000 (8, 000 + 7,000)

7, 000 × $3,000,000 (8, 000 + 7, 000)

8, 000 × $3,000,000 (8, 000 + 2, 000)

2, 000 × $3,000,000 (8, 000 + 2, 000)

fixed cost allocation varies based on its actual usage of support facilities. However, variations in actual usage in one division do not affect the costs allocated to the other division. The microcomputer division is allocated either $2,000,000 or $1,280,000, depending on the budgeted rate chosen, independent of the peripheral equipment division’s actual usage. Therefore, combining actual usage as the allocation base with budgeted rates provides user divisions with advanced knowledge of rates, as well as control over the costs charged to them.4 Note, however, that this allocation procedure for fixed costs is exactly the same as that under the single-rate method. As such, the procedure shares the disadvantages of the single-rate method discussed in the previous section, such as charging excessively high costs, including the cost of unused capacity, when rates are based on expected usage. Moreover, even when rates are based on practical capacity, recall that allocating fixed cost rates based on actual usage induces conflicts of interest between the user divisions and the firm when evaluating outsourcing possibilities. Allocating Budgeted Fixed Costs Based on Actual Usage Finally, consider the impact of having actual usage as the allocation base when the firm assigns total budgeted fixed costs to operating divisions (rather than specifying budgeted fixed cost rates, as we have thus far). If the budgeted fixed costs of $3,000,000 are allocated using budgeted usage, we are back in the familiar dual-rate setting. On the other hand, if the actual usage of the facility is the basis for allocation, the charges would equal the amounts in Exhibit 15-1, column 4. In Case 1, the fixed-cost allocation equals the budgeted amount (which is also the same as the charge under the dual-rate method). In Case 2, the fixed-cost allocation is $400,000 less to the microcomputer division than the amount based on budgeted usage ($1,600,000 versus $2,000,000). In Case 3, the fixed-cost allocation is $400,000 more to the microcomputer division than the amount based on budgeted usage ($2,400,000 versus $2,000,000). Why does the microcomputer division receive $400,000 more in costs in Case 3, even though its actual usage equals its budgeted usage? Because the total fixed costs of $3,000,000 are now spread over 2,000 fewer hours of actual total usage. In other words, the lower usage by the peripheral equipment division leads to an increase in the fixed costs allocated to the microcomputer division. When budgeted fixed costs are allocated based on actual usage, user divisions will not know their fixed cost allocations until the end of the budget period. This method therefore shares the same flaw as those that rely on the use of actual cost realizations rather than budgeted cost rates. To summarize, there are excellent economic and motivational reasons to justify the precise forms of the single-rate and dual-rate methods considered in the previous section, and in particular, to recommend the dual-rate allocation procedure. 4

The total amount of fixed costs allocated to divisions will in general not equal the actual realized costs. Adjustments for overallocations and underallocations would then be made using the methods discussed previously in chapters 4, 7 and 8.

Decision Point What factors should managers consider when deciding between allocation based on budgeted and actual rates, and budgeted and actual usage?

550 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

Allocating Costs of Multiple Support Departments Learning Objective

We just examined general issues that arise when allocating costs from one support department to operating divisions. In this section, we examine the special cost-allocation problems that arise when two or more of the support departments whose costs are being allocated provide reciprocal support to each other as well as to operating departments. An example of reciprocal support is a firm’s human resource department providing recruiting, training, and performance management services to all employees of a firm, including those who work in the legal department, while also utilizing the services of the legal department for compliance activities, drafting of contracts, checking stock option plan documents, etc. More accurate support-department cost allocations result in more accurate product, service, and customer costs. Consider Castleford Engineering, which operates at practical capacity to manufacture engines used in electric-power generating plants. Castleford has two support departments and two operating departments in its manufacturing facility:

Allocate multiple support-department costs using the direct method, . . . allocates supportdepartment costs directly to operating departments the step-down method, . . . partially allocates support-department costs to other support departments

Support Departments Plant (and equipment) maintenance Information systems

and the reciprocal method

Operating Departments Machining Assembly

The two support departments at Castleford provide reciprocal support to each other as well as support to the two operating departments. Costs are accumulated in each department for planning and control purposes. Exhibit 15-2 displays the data for this example. To understand the percentages in this exhibit, consider the plant maintenance department. This support department provides a total of 20,000 hours of support work: 20% (4,000 ÷ 20,000 = 0.20) for the information systems department, 30% (6,000 ÷ 20,000 = 0.30) for the machining department, and 50% (10,000 ÷ 20,000 = 0.50) for the assembly department. We now examine three methods of allocating the costs of reciprocal support departments: direct, step-down, and reciprocal. To simplify the explanation and to focus on concepts, we use the single-rate method to allocate the costs of each support department using budgeted rates and budgeted hours used by the other departments. (The Problem for SelfStudy illustrates the dual-rate method for allocating reciprocal support-department costs.)

. . . fully allocates support-department costs to other support departments

Direct Method The direct method allocates each support department’s costs to operating departments only. The direct method does not allocate support-department costs to other support departments. Exhibit 15-3 illustrates this method using the data in Exhibit 15-2. The Exhibit 15-2

Data for Allocating Support-Department Costs at Castleford Engineering for 2012

SUPPORT DEPARTMENTS Plant Information Systems Maintenance

1 2

OPERATING DEPARTMENTS Machining

Assembly

Total

3 Budgeted overhead costs 4

before any interdepartment cost allocations

$6,300,000

$1,452,150

$4,000,000

$2,000,000

$13,752,150

— —

4,000 20%

6,000 30%

10,000 50%

20,000 100%

500 10%

— —

4,000 80%

500 10%

5,000 100%

5 Support work furnished: 6 7 8 9 10 11

By plant maintenance Budgeted labor-hours Percentage By information systems Budgeted computer hours Percentage

ALLOCATING COSTS OF MULTIPLE SUPPORT DEPARTMENTS " 551 SUPPORT DEPARTMENTS Plant Maintenance $6,300,000

OPERATING DEPARTMENTS $2,362,500

Exhibit 15-3

Machining Department

Direct Method of Allocating SupportDepartment Costs at Castleford Engineering for 2012

$3,937,500 $1,290,800 Information Systems $1,452,150

Assembly Department

$161,350

SUPPORT DEPARTMENTS Plant Information Maintenance Systems

1 2

OPERATING DEPARTMENTS Machining

Assembly

Total

$1,452,150

$4,000,000

$2,000,000

$13,752,150

(1,452,150)

2,362,500 1,290,800

3,937,500 161,350

$7,653,300

$6,098,850

3 Budgeted overhead costs

before any interdepartment cost allocations a 5 Allocation of plant maintenance (3/8, 5/8) b 6 Allocation of information systems (8/9, 1/9) 4

7 8 Total budgeted overhead of operating departments

$6,300,000 (6,300,000)

9 10

Base is (6,000 + 10,000), or 16,000 hours; 6,000 ÷ 16,000 = 3/8; 10,000 ÷ 16,000 = 5/8.

Base is (4,000 + 500), or 4,500 hours; 4,000 ÷ 4,500 = 8/9; 500 ÷ 4,500 = 1/9.

base used to allocate plant maintenance costs to the operating departments is the budgeted total maintenance labor-hours worked in the operating departments: 6,000 + 10,000 = 16,000 hours. This amount excludes the 4,000 hours of budgeted support time provided by plant maintenance to information systems. Similarly, the base used for allocation of information systems costs to the operating departments is 4,000 + 500 = 4,500 budgeted hours of computer time, which excludes the 500 hours of budgeted support time provided by information systems to plant maintenance. An equivalent approach to implementing the direct method involves calculating a budgeted rate for each support department’s costs. For example, the rate for plant maintenance department costs is $6,300,000 ÷ 16,000 hours, or $393.75 per hour. The machining department is then allocated $2,362,500 ($393.75 per hour * 6,000 hours) while the assembly department is assigned $3,937,500 ($393.75 per hour * 10,000 hours). For ease of explanation throughout this section, we will use the fraction of the support-department services used by other departments, rather than calculate budgeted rates, to allocate support-department costs. The direct method is widely practiced because of its ease of use. The benefit of the direct method is simplicity. There is no need to predict the usage of support-department services by other support departments. A disadvantage of the direct method is that it ignores information about reciprocal services provided among support departments and can therefore lead to inaccurate estimates of the cost of operating departments. We now examine a second approach, which partially recognizes the services provided among support departments.

Step-Down Method Some organizations use the step-down method, also called the sequential allocation method, which allocates support-department costs to other support departments and to operating departments in a sequential manner that partially recognizes the mutual services provided among all support departments. Exhibit 15-4 shows the step-down method. The plant maintenance costs of $6,300,000 are allocated first. Exhibit 15-2 shows that plant maintenance provides 20% of its services

$13,752,150

552 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

Exhibit 15-4

SUPPORT DEPARTMENTS

Step-Down Method of Allocating SupportDepartment Costs at Castleford Engineering for 2012

Plant Maintenance $6,300,000

OPERATING DEPARTMENTS

$3,150,000

$1,260,000

$2,410,800

Information Systems $1,260,000 + $1,452,150 = $2,712,150

$301,350

SUPPORT DEPARTMENTS Plant Information Maintenance Systems

Machining Department

$1,890,000

Assembly Department

OPERATING DEPARTMENTS Machining

Assembly

Total

$1,452,150 1,260,000 2,712,150 (2,712,150)

$4,000,000 1,890,000

$2,000,000 3,150,000

$13,752,150

2,410,800

301,350

$8,300,800

$5,451,350

3 Budgeted overhead costs before any

interdepartment cost allocations a 5 Allocation of plant maintenance (2/10, 3/10, 5/10) 4

$6,300,000 (6,300,000)

6 b

7 Allocation of information systems (8/9, 1/9) 8

9 Total budgeted overhead of operating departments

$13,752,150

10 11

Base is (4,000 + 6,000 + 10,000), or 20,000 hours; 4,000 ÷ 20,000 = 2/10; 6,000 ÷ 20,000 = 3/10; 10,000 ÷ 20,000 = 5/10.

Base is (4,000 + 500), or 4,500 hours; 4,000 ÷ 4,500 = 8/9; 500 ÷ 4,500 = 1/9.

to information systems, 30% to machining, and 50% to assembly. Therefore, $1,260,000 is allocated to information systems (20% of $6,300,000), $1,890,000 to machining (30% of $6,300,000), and $3,150,000 to assembly (50% of $6,300,000). The information systems costs now total $2,712,150: budgeted costs of the information systems department before any interdepartmental cost allocations, $1,452,150, plus $1,260,000 from the allocation of plant maintenance costs to the information systems department. The $2,712,150 is then only allocated between the two operating departments based on the proportion of the information systems department services provided to machining and assembly. From Exhibit 15-2, the information systems department provides 80% of its services to machining and 10% to assembly, so $2,410,800 (8/9 * $2,712,150) is allocated to machining and $301,350 (1/9 * $2,712,150) is allocated to assembly. Note that this method requires the support departments to be ranked (sequenced) in the order that the step-down allocation is to proceed. In our example, the costs of the plant maintenance department were allocated first to all other departments, including the information systems department. The costs of the information systems support department were allocated second, but only to the two operating departments. If the information systems department costs had been allocated first and the plant maintenance department costs second, the resulting allocations of support-department costs to operating departments would have been different. A popular step-down sequence begins with the support department that renders the highest percentage of its total services to other support departments. The sequence continues with the department that renders the next-highest percentage, and so on, ending with the support department that renders the lowest percentage.5 In our example, costs of the plant maintenance department were allocated first because it provides 20% of its services to the information systems department, whereas the information systems department provides only 10% of its services to the plant maintenance department (see Exhibit 15-2). 5

An alternative approach to selecting the sequence of allocations is to begin with the support department that renders the highest dollar amount of services to other support departments. The sequence ends with the allocation of the costs of the department that renders the lowest dollar amount of services to other support departments.

ALLOCATING COSTS OF MULTIPLE SUPPORT DEPARTMENTS " 553

Under the step-down method, once a support department’s costs have been allocated, no subsequent support-department costs are allocated back to it. Once the plant maintenance department costs are allocated, it receives no further allocation from other (lowerranked) support departments. The result is that the step-down method does not recognize the total services that support departments provide to one another. The reciprocal method fully recognizes all such services, as you will see next.

Reciprocal Method The reciprocal method allocates support-department costs to operating departments by fully recognizing the mutual services provided among all support departments. For example, the plant maintenance department maintains all the computer equipment in the information systems department. Similarly, information systems provide database support for plant maintenance. The reciprocal method fully incorporates interdepartmental relationships into the support-department cost allocations. One way to understand the reciprocal method is as an extension of the step-down method. This approach is illustrated in Exhibit 15-5. As in the step-down procedure, plant maintenance costs are first allocated to all other departments, including the information systems support department: information systems, 20%; machining, 30%; assembly, 50%. The costs in the information systems department then total $2,712,150 ($1,452,150 + $1,260,000 from the first-round allocation), as in Exhibit 15-4. Under the step-down method, these costs are allocated directly to the operating departments alone. But the reciprocal method recognizes that a portion of the information systems department costs arises Exhibit 15-5

Reciprocal Method of Allocating Support-Department Costs Using Repeated Iterations at Castleford Engineering for 2012

SUPPORT DEPARTMENTS Information Plant Maintenance Systems

1 2

OPERATING DEPARTMENTS Machining

Assembly

Total $13,752,150

3 Budgeted overhead costs before any

interdepartment cost allocations a 5 First allocation of plant maintenance (2/10, 3/10, 5/10) 4

$6,300,000 (6,300,000)

$1,452,150 1,260,000 2,712,150

$4,000,000 1,890,000

$2,000,000 3,150,000

271,215

(2,712,150)

2,169,720

271,215

(271,215)

54,243

81,364

135,608

6 b

7 First allocation of information systems (1/10, 8/10, 1/10)

8 Second allocation of plant maintenance (2/10, 3/10, 5/10)

9 Second allocation of information systems (1/10, 8/10, 1/10) 10 Third allocation of plant maintenance (2/10, 3/10, 5/10)

5,424

(54,243)

43,395

5,424

(5,424)

1,085

1,627

2,712

109

(1,085)

867

109

(109)

(22)

(2)

$8,187,025

$5,565,125

11 Third allocation of information systems (1/10, 8/10, 1/10) 12 Fourth allocation of plant maintenance (2/10, 3/10, 5/10)

13 Fourth allocation of information systems (1/10, 8/10, 1/10) a

14 Fourth allocation of plant maintenance (2/10, 3/10, 5/10) 15 16 Total budgeted overhead of operating departments

17 18 Total support department amounts allocated and reallocated (the numbers in parentheses in the first two columns):

Plant Maintenance: $6,300,000 + $271,215 + $5,424 + $109 + $2 = $6,576,750 Information Systems: $2,712,150 + $54,243 + $1,085 + $22 = $2,767,500

19 20 21 22

Base is (4,000 + 6,000 + 10,000), or 20,000 hours; 4,000 ÷ 20,000 = 2/10; 6,000 ÷ 20,000 = 3/10; 10,000 ÷ 20,000 = 5/10.

Base is (500 + 4,000 + 500), or 5,000 hours; 500 ÷ 5,000 = 1/10; 4,000 ÷ 5,000 = 8/10; 500 ÷ 5,000 = 1/10.

$13,752,150

554 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

because of the support it provides to plant maintenance. Accordingly, the $2,712,150 is allocated to all departments supported by the information systems department, including the plant maintenance department: plant maintenance, 10%; machining, 80%; and assembly, 10% (see Exhibit 15-2). The plant maintenance costs that had been brought down to $0 now have $271,215 from the information systems department allocation. In the next step, these costs are again reallocated to all other departments, including information systems, in the same ratio that the plant maintenance costs were previously assigned. Now the information systems department costs that had been brought down to $0 have $54,243 from the plant maintenance department allocations. These costs are again allocated in the same ratio that the information systems department costs were previously assigned. Successive rounds result in smaller and smaller amounts being allocated to and reallocated from the support departments until eventually all support-department costs are allocated to the operating departments. The final budgeted overhead costs for the operating departments under the reciprocal method are given by the amounts in line 16 of Exhibit 15-5. An alternative way to implement the reciprocal method is to formulate and solve linear equations. This process requires three steps. Step 1: Express Support Department Costs and Reciprocal Relationships in the Form of Linear Equations. We will use the term complete reciprocated costs or artificial costs to mean the support department’s own costs plus any interdepartmental cost allocations. Let PM be the complete reciprocated costs of plant maintenance and IS be the complete reciprocated costs of information systems. We can then express the data in Exhibit 15-2 as follows: PM = $6,300,000 + 0.1IS IS = $1,452,150 + 0.2PM

(1) (2)

The 0.1IS term in equation 1 is the percentage of the information systems services used by plant maintenance. The 0.2PM term in equation 2 is the percentage of plant maintenance services used by information systems. Step 2: Solve the Set of Linear Equations to Obtain the Complete Reciprocated Costs of Each Support Department. Substituting equation 1 into 2, IS = $1,452,150 + [0.2($6,300,000 + 0.1IS)] IS = $1,452,150 + $1,260,000 + 0.02IS 0.98IS = $2,712,150 IS = $2,767,500

Substituting this into equation 1, PM = $6,300,000 + 0.1($2,767,500) PM = $6,300,000 + $276,750 = $6,576,750

The complete reciprocated costs or artificial costs for plant maintenance and information systems are $6,576,750 and $2,767,500, respectively. Note that these are the same amounts that appear at the bottom of Exhibit 15-5 (lines 19 and 20) as the total support department costs allocated and reallocated during the iterative process. By setting up the system of simultaneous equations, we are able to solve for these amounts directly. When there are more than two support departments with reciprocal relationships, software such as Excel or Matlab is required to compute the complete reciprocated costs of each support department. Since the calculations involve finding the inverse of a matrix, the reciprocal method is also sometimes referred to as the matrix method.6 Step 3: Allocate the Complete Reciprocated Costs of Each Support Department to All Other Departments (Both Support Departments and Operating Departments) on the Basis of the Usage Percentages (Based on Total Units of Service Provided to All Departments). 6

If there are n support departments, then Step 1 will yield n linear equations. Solving the equations to calculate the complete reciprocated costs then requires finding the inverse of an n-by-n matrix.

ALLOCATING COSTS OF MULTIPLE SUPPORT DEPARTMENTS " 555

Consider the information systems department. The complete reciprocated costs of $2,767,500 are allocated as follows: To plant maintenance (1/10) * $2,767,500 To machining (8/10) * $2,767,500 To assembly (1/10) * $2,767,500 Total

= $ 276,750 = 2,214,000 = ƒƒƒ276,750 $2,767,500

Exhibit 15-6 presents summary data pertaining to the reciprocal method. Castleford’s $9,344,250 complete reciprocated costs of the support departments exceed the budgeted amount of $7,752,150. Support Department Plant maintenance Information systems Total

Complete Reciprocated Costs $6,576,750 ƒ2,767,500 $9,344,250

Budgeted Costs $6,300,000 ƒ1,452,150 $7,752,150

Difference $ 276,750 ƒ1,315,350 $1,592,100

Each support department’s complete reciprocated cost is greater than the budgeted amount to take into account that the support costs will be allocated to all departments using its services and not just to operating departments. This step ensures that the reciprocal method fully recognizes all interrelationships among support departments, as well as relationships between support and operating departments. The difference between complete Exhibit 15-6

Reciprocal Method of Allocating Support-Department Costs Using Linear Equations at Castleford Engineering for 2012

SUPPORT DEPARTMENTS

OPERATING DEPARTMENTS

Plant Maintenance ($276,750 +$6,300,000 = $6,576,750)

$1,973,025

Machining Department

$276,750

Assembly Department

$3,288,375 $276,750

$1,315,350 $2,214,000 Information Systems ($1,315,350 +$1,452,150 = $2,767,500)

SUPPORT DEPARTMENTS Plant Information Maintenance Systems

1 2

OPERATING DEPARTMENTS Machining

Assembly

Total

$2,000,000 $13,752,150

3 Budgeted overhead costs before any

interdepartment cost allocations Allocation of plant maintenance (2/10, 3/10, 5/10) a 5 b 6 Allocation of information systems (1/10, 8/10, 1/10) 4

7 8 Total budgeted overhead of operating departments

$6,300,000

$1,452,150

$4,000,000

(6,576,750) 276,750

1,315,350 (2,767,500)

1,973,025 2,214,000

$8,187,025

3,288,375 276,750 $5,565,125 $13,752,150

9 10

Base is (4,000 + 6,000 + 10,000), or 20,000 hours; 4,000 ÷ 20,000 = 2/10; 6,000 ÷ 20,000 = 3/10; 10,000 ÷ 20,000 = 5/10.

Base is (500 + 4,000 + 500), or 5,000 hours; 500 ÷ 5,000 = 1/10; 4,000 ÷ 5,000 = 8/10; 500 ÷ 5,000 = 1/10.

556 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

reciprocated costs and budgeted costs for each support department reflects the costs allocated among support departments. The total costs allocated to the operating departments under the reciprocal method are still only $7,752,150.

Overview of Methods Assume that Castleford reallocates the total budgeted overhead costs of each operating department in Exhibits 15-3 through 15-6 to individual products on the basis of budgeted machine-hours for the machining department (18,000 hours) and budgeted direct laborhours for the assembly department (25,000 hours). The budgeted overhead allocation rates (to the nearest dollar) for each operating department by allocation method are as follows: Total Budgeted Overhead Costs After Allocation of All Support-Department Costs Support Department Cost-Allocation Method Direct Step-down Reciprocal

Machining $7,653,300 8,300,800 8,187,025

Assembly $6,098,850 5,451,350 5,565,125

Budgeted Overhead Rate per Hour for ProductCosting Purposes Machining Assembly (18,000 machine-hours) (25,000 labor-hours) $425 $244 461 218 455 223

These differences in budgeted overhead rates under the three support-department costallocation methods can, for example, affect the amount of costs Castleford is reimbursed for engines it manufactures under cost-reimbursement contracts. Consider a cost-reimbursement contract for a project that uses 200 machine-hours in the machining department and 50 direct labor-hours in the assembly department. The overhead costs allocated to this contract under the three methods would be as follows: Direct: Step-down: Reciprocal:

$97,200 ($425 per hour * 200 hours + $244 per hour * 50 hours) 103,100 ($461 per hour * 200 hours + $218 per hour * 50 hours) 102,150 ($455 per hour * 200 hours + $223 per hour * 50 hours)

The amount of cost reimbursed to Castleford will differ depending on the method used to allocate support-department costs to the contract. Differences among the three methods’ allocations increase (1) as the magnitude of the reciprocal allocations increases and (2) as the differences across operating departments’ usage of each support department’s services increase. Note that while the final allocations under the reciprocal method are in between those under the direct and step-down methods in our example, this is not true in general. To avoid disputes in cost-reimbursement contracts that require allocation of supportdepartment costs, managers should always clarify the method to be used for allocation. For example, Medicare reimbursements and federal contracts with universities that pay for the recovery of indirect costs typically mandate use of the step-down method, with explicit requirements about the costs that can be included in the indirect cost pools. The reciprocal method is conceptually the most precise method because it considers the mutual services provided among all support departments. The advantage of the direct and step-down methods is that they are simple to compute and understand relative to the reciprocal method. However, as computing power to perform repeated iterations (as in Exhibit 15-5) or to solve sets of simultaneous equations (as on pp. 554–555) increases, more companies find the reciprocal method easier to implement. Another advantage of the reciprocal method is that it highlights the complete reciprocated costs of support departments and how these costs differ from budgeted or actual costs of the departments. Knowing the complete reciprocated costs of a support department is a key input for decisions about whether to outsource all the services that the support department provides. Suppose all of Castleford’s support-department costs are variable over the period of a possible outsourcing contract. Consider a third party’s bid to provide, say, all the information systems services currently provided by Castleford’s information systems department. Do not compare the bid to the $1,452,150 costs reported for the information systems department. The complete reciprocated costs of the information systems

ALLOCATING COMMON COSTS " 557

department, which include the services the plant maintenance department provides the information systems department, are $2,767,500 to deliver 5,000 hours of computer time to all other departments at Castleford. The complete reciprocated costs for computer time are $553.50 per hour ($2,767,500 ÷ 5,000 hours). Other things being equal, a third party’s bid to provide the same information services as Castleford’s internal department at less than $2,767,500, or $553.50 per hour (even if much greater than $1,452,150) would improve Castleford’s operating income. To see this point, note that the relevant savings from shutting down the information systems department are $1,452,150 of information systems department costs plus $1,315,350 of plant maintenance department costs. By closing down the information systems department, Castleford will no longer incur the 20% of reciprocated plant maintenance department costs (equal to $1,315,350) that were incurred to support the information systems department. Therefore, the total cost savings are $2,767,500 ($1,452,150 + $1,315,350).7 Neither the direct nor the step-down methods can provide this relevant information for outsourcing decisions. We now consider common costs, another special class of costs for which management accountants have developed specific allocation methods.

Decision Point What methods can managers use to allocate costs of multiple support departments to operating departments?

Allocating Common Costs A common cost is a cost of operating a facility, activity, or like cost object that is shared by two or more users. Common costs exist because each user obtains a lower cost by sharing than the separate cost that would result if such a user were an independent entity. The goal is to allocate common costs to each user in a reasonable way. Consider Jason Stevens, a graduating senior in Seattle who has been invited to a job interview with an employer in Albany. The round-trip Seattle–Albany airfare costs $1,200. A week later, Stevens is also invited to an interview with an employer in Chicago. The Seattle–Chicago round-trip airfare costs $800. Stevens decides to combine the two recruiting trips into a Seattle–Albany–Chicago–Seattle trip that will cost $1,500 in airfare. The $1,500 is a common cost that benefits both prospective employers. Two methods of allocating this common cost between the two prospective employers are the stand-alone method and the incremental method.

Stand-Alone Cost-Allocation Method The stand-alone cost-allocation method determines the weights for cost allocation by considering each user of the cost as a separate entity. For the common-cost airfare of $1,500, information about the separate (stand-alone) round-trip airfares ($1,200 and $800) is used to determine the allocation weights: Albany employer:

$1,200 * $1,500 = 0.60 * $1,500 = $900 $1,200 + $800

Chicago employer:

$800 * $1,500 = 0.40 * $1,500 = $600 $800 + $1,200

Advocates of this method often emphasize the fairness or equity criterion described in Exhibit 14-2 (p. 504). The method is viewed as reasonable because each employer bears a proportionate share of total costs in relation to the individual stand-alone costs.

Incremental Cost-Allocation Method The incremental cost-allocation method ranks the individual users of a cost object in the order of users most responsible for the common cost and then uses this ranking to allocate cost among those users. The first-ranked user of the cost object is the primary user (also called the primary party) and is allocated costs up to the costs of the primary user as a standalone user. The second-ranked user is the first-incremental user (first-incremental party) and 7

Technical issues when using the reciprocal method in outsourcing decisions are discussed in R. S. Kaplan and A. A. Atkinson, Advanced Management Accounting, 3rd ed. (Upper Saddle River, NJ: Prentice Hall, 1998), 73–81.

Learning Objective

Allocate common costs using the stand-alone method . . . uses cost information of each user as a separate entity to allocate common costs and the incremental method . . . allocates common costs primarily to one user and the remainder to other users

558 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

is allocated the additional cost that arises from two users instead of only the primary user. The third-ranked user is the second-incremental user (second-incremental party) and is allocated the additional cost that arises from three users instead of two users, and so on. To see how this method works, consider again Jason Stevens and his $1,500 airfare cost. Assume the Albany employer is viewed as the primary party. Stevens’ rationale is that he had already committed to go to Albany before accepting the invitation to interview in Chicago. The cost allocations would be as follows: Party Albany (primary) Chicago (incremental) Total

Decision Point What methods can managers use to allocate common costs to two or more users?

Learning Objective

Explain the importance of explicit agreement between contracting parties when the reimbursement amount is based on costs incurred . . . to avoid disputes regarding allowable cost items and how indirect costs should be allocated

Costs Allocated $1,200 ƒƒƒ300 ($1,500 – $1,200) $1,500

Cumulative Costs Allocated $1,200 $1,500

The Albany employer is allocated the full Seattle–Albany airfare. The unallocated part of the total airfare is then allocated to the Chicago employer. If the Chicago employer had been chosen as the primary party, the cost allocations would have been Chicago $800 (the stand-alone round-trip Seattle–Chicago airfare) and Albany $700 ($1,500 – $800). When there are more than two parties, this method requires them to be ranked from first to last (such as by the date on which each employer invited the candidate to interview). Under the incremental method, the primary party typically receives the highest allocation of the common costs. If the incremental users are newly formed companies or subunits, such as a new product line or a new sales territory, the incremental method may enhance their chances for short-run survival by assigning them a low allocation of the common costs. The difficulty with the method is that, particularly if a large common cost is involved, every user would prefer to be viewed as the incremental party! One approach to sidestep disputes in such situations is to use the stand-alone costallocation method. Another approach is to use the Shapley value, which considers each party as first the primary party and then the incremental party. From the calculations shown earlier, the Albany employer is allocated $1,200 as the primary party and $700 as the incremental party, for an average of $950 [($1,200 + $700) ÷ 2]. The Chicago employer is allocated $800 as the primary party and $300 as the incremental party, for an average of $550 [($800 + 300) ÷ 2]. The Shapley value method allocates, to each employer, the average of the costs allocated as the primary party and as the incremental party: $950 to the Albany employer and $550 to the Chicago employer.8 As our discussion suggests, allocating common costs is not clear-cut and can generate disputes. Whenever feasible, the rules for such allocations should be agreed on in advance. If this is not done, then, rather than blindly follow one method or another, managers should exercise judgment when allocating common costs. For instance, Stevens must choose an allocation method for his airfare cost that is acceptable to each prospective employer. He cannot, for example, exceed the maximum reimbursable amount of airfare for either firm. The next section discusses the role of cost data in various types of contracts, another area where disputes about cost allocation frequently arise.

Cost Allocations and Contract Disputes Many commercial contracts include clauses based on cost accounting information. Examples include the following: #

A contract between the Department of Defense and a company designing and assembling a new fighter plane specifies that the price paid for the plane is to be based on the contractor’s direct and overhead costs plus a fixed fee. A contract between an energy-consulting firm and a hospital specifies that the consulting firm receive a fixed fee plus a share of the energy-cost savings that arise from implementing the consulting firm’s recommendations.

For further discussion of the Shapley value, see J. Demski, “Cost Allocation Games,” in Joint Cost Allocations, ed. S. Moriarity (University of Oklahoma Center for Economic and Management Research, 1981); L. Kruz and P. Bronisz, “Cooperative Game Solution Concepts to a Cost Allocation Problem,” European Journal of Operations Research 122 (2000): 258–271.

COST ALLOCATIONS AND CONTRACT DISPUTES " 559

Contract disputes often arise with respect to cost allocation. The areas of dispute between the contracting parties can be reduced by making the “rules of the game” explicit and in writing at the time the contract is signed. Such rules of the game include the definition of allowable cost items; the definitions of terms used, such as what constitutes direct labor; the permissible cost-allocation bases; and how to account for differences between budgeted and actual costs.

Contracting with the U.S. Government The U.S. government reimburses most contractors in one of two main ways: 1. The contractor is paid a set price without analysis of actual contract cost data. This approach is used, for example, when there is competitive bidding, when there is adequate price competition, or when there is an established catalog with prices quoted for items sold in substantial quantities to the general public. 2. The contractor is paid after analysis of actual contract cost data. In some cases, the contract will explicitly state that the reimbursement amount is based on actual allowable costs plus a fixed fee.9 This arrangement is called a cost-plus contract. All contracts with U.S. government agencies must comply with cost accounting standards issued by the Cost Accounting Standards Board (CASB). For government contracts, the CASB has the exclusive authority to make, put into effect, amend, and rescind cost accounting standards and interpretations. The standards are designed to achieve uniformity and consistency in regard to measurement, assignment, and allocation of costs to government contracts within the United States.10 In government contracting, there is a complex interplay of political considerations and accounting principles. Terms such as “fairness” and “equity,” as well as cause and effect and benefits received, are often used in government contracts.

Fairness of Pricing In many defense contracts, there is great uncertainty about the final cost to produce a new weapon or equipment. Such contracts are rarely subject to competitive bidding. The reason is that no contractor is willing to assume all the risk of receiving a fixed price for the contract and subsequently incurring high costs to fulfill it. Hence, setting a market-based fixed price for the contract fails to attract contractors, or requires a contract price that is too high from the government’s standpoint. To address this issue, the government typically assumes a major share of the risk of the potentially high costs of completing the contract. Rather than relying on selling prices as ordinarily set by suppliers in the marketplace, the government negotiates contracts on the basis of costs plus a fixed fee. In costs-plus-fixed-fee contracts, which often involve billions of dollars, the allocation of a specific cost may be difficult to defend on the basis of any cause-and-effect reasoning. Nonetheless, the contracting parties may still view it as a “reasonable” or “fair” means to help establish a contract amount. Some costs are “allowable;” others are “unallowable.” An allowable cost is a cost that the contract parties agree to include in the costs to be reimbursed. Some contracts specify how allowable costs are to be determined. For example, only economy-class airfares are allowable in many U.S. government contracts. Other contracts identify cost categories that are unallowable. For example, the costs of lobbying activities and alcoholic beverages are not allowable costs in U.S. government contracts. However, the set of allowable costs is not always clear-cut. Contract disputes and allegations about overcharging the government arise from time to time (see Concepts in Action, p. 560). 9

The Federal Acquisition Regulation (FAR), issued in March 2005 (see https://www.acquisition.gov/far/current/pdf/FAR.pdf) includes the following definition of “allocability” (in FAR 31.201-4): “A cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship. Subject to the foregoing, a cost is allocable to a Government contract if it: (a) Is incurred specifically for the contract; (b) Benefits both the contract and other work, and can be distributed to them in reasonable proportion to the benefits received; or (c) Is necessary to the overall operation of the business, although a direct relationship to any particular cost objective cannot be shown.” 10 Details on the Cost Accounting Standards Board are available at www.whitehouse.gov/omb/procurement/casb.html. The CASB is part of the Office of Federal Procurement Policy, U.S. Office of Management and Budget.

Decision Point How can contract disputes over reimbursement amounts based on costs be reduced?

560 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

Concepts in Action

Contract Disputes over Reimbursable Costs for the U.S. Department of Defense For 2011, United States combat activities in Afghanistan are budgeted to cost $159 billion. As in prior years, a portion of this money is allocated to private companies to carry out specific contracted services for the U.S. Department of Defense. In recent years, the U.S. government has pursued cases against several contractors for overcharging for services provided in the combat zone. The following four examples are from cases pursued by the U.S. Department of Justice’s Civil Division, who did so on behalf of the federal government. These recent examples illustrate several types of cost disputes that arise in practice.

1. Eagle Global Logistics agreed to pay $4 million to settle allegations of allegedly inflating invoices for military cargo shipments to Iraq. The complaint alleged that a company executive added an extra 50 cents per kilogram “war risk surcharge” to invoices for flights between Dubai and Iraq. This bogus surcharge, which was not part of Eagle’s U.S. Department of Defense contract, was applied 379 times between 2003 and 2004. 2. In another shipping case, APL Limited paid the federal government $26.3 million to resolve claims of knowingly overcharging and double-billing the U.S. Department of Defense to transport thousands of containers to destinations in Afghanistan and Iraq. APL was accused of inflating invoices in several ways: marking up electricity costs for containers with perishable cargo, billing in excess of the contractual rate to maintain the operation of refrigerated containers in the port of Karachi, Pakistan, and billing for non-reimbursable services performed by an APL subcontractor at a Kuwaiti port. 3. L-3 communications, a leading defense contractor, paid $4 million to settle a complaint that it overbilled for hours worked by the firm’s employees on a contract supporting military operations by the United States in Iraq. The company allegedly submitted false time records and inflated claims for personnel hours as part of an ongoing contract with the U.S. Army to provide helicopter maintenance services at Camp Taji, Iraq. 4. In late 2009, Public Warehousing Company—a principal food supplier for the U.S. military in Iraq, Kuwait, and Jordan since 2003—was sued by the U.S. government for presenting false claims for payment under the company’s multibillion dollar contract with the Defense Logistics Agency. The complaint alleged that the company overcharged the U.S. for locally available fresh fruits and vegetables and failed to disclose pass through rebates and discounts it obtained from U.S.-based suppliers, as required by its contracts. Source: Press releases from the United States Department of Justice, Civil Division (2006–2009).

Learning Objective

Understand how bundling of products . . . two or more products sold for a single-price gives rise to revenue allocation issues . . . allocating revenues to each product in the bundle to evaluate managers of individual products and the methods for doing so . . . using the standalone method or the incremental method

Bundled Products and Revenue Allocation Methods Allocation issues can also arise when revenues from multiple products (for example, different software programs or cable and internet packages) are bundled together and sold at a single price. The methods for revenue allocation parallel those described for common-cost allocations.

Bundling and Revenue Allocation Revenues are inflows of assets (almost always cash or accounts receivable) received for products or services provided to customers. Similar to cost allocation, revenue allocation occurs when revenues are related to a particular revenue object but cannot be traced to it in an economically feasible (cost-effective) way. A revenue object is anything for which a separate measurement of revenue is desired. Examples of revenue objects include products, customers, and divisions. We illustrate revenue-allocation issues for Dynamic Software Corporation, which develops, sells, and supports three software programs: 1. WordMaster, a word-processing program, released 36 months ago 2. DataMaster, a spreadsheet program, released 18 months ago 3. FinanceMaster, a budgeting and cash-management program, released six months ago with a lot of favorable media attention

BUNDLED PRODUCTS AND REVENUE ALLOCATION METHODS " 561

Dynamic Software sells these three products individually as well as together as bundled products. A bundled product is a package of two or more products (or services) that is sold for a single price but whose individual components may be sold as separate items at their own “stand-alone” prices. The price of a bundled product is typically less than the sum of the prices of the individual products sold separately. For example, banks often provide individual customers with a bundle of services from different departments (checking, safety-deposit box, and investment advisory) for a single fee. A resort hotel may offer, for a single amount per customer, a weekend package that includes services from its lodging (the room), food (the restaurant), and recreational (golf and tennis) departments. When department managers have revenue or profit responsibilities for individual products, the bundled revenue must be allocated among the individual products in the bundle. Dynamic Software allocates revenues from its bundled product sales (called “suite sales”) to individual products. Individual-product profitability is used to compensate software engineers, outside developers, and product managers responsible for developing and managing each product. How should Dynamic Software allocate suite revenues to individual products? Consider information pertaining to the three “stand-alone” and “suite” products in 2012:

Stand-alone WordMaster DataMaster FinanceMaster Suite Word + Data Word + Finance Finance + Data Word + Finance + Data

Selling Price

Manufacturing Cost per Unit

$125 150 225

$18 20 25

$220 280 305 380

Just as we saw in the section on common-cost allocations, the two main revenue-allocation methods are the stand-alone method and the incremental method.

Stand-Alone Revenue-Allocation Method The stand-alone revenue-allocation method uses product-specific information on the products in the bundle as weights for allocating the bundled revenues to the individual products. The term stand-alone refers to the product as a separate (nonsuite) item. Consider the Word + Finance suite, which sells for $280. Three types of weights for the stand-alone method are as follows: 1. Selling prices. Using the individual selling prices of $125 for WordMaster and $225 for FinanceMaster, the weights for allocating the $280 suite revenues between the products are as follows: WordMaster:

$125 * $280 = 0.357 * $280 = $100 $125 + $225

FinanceMaster:

$225 * $280 = 0.643 * $280 = $180 $125 + $225

2. Unit costs. This method uses the costs of the individual products (in this case, manufacturing cost per unit) to determine the weights for the revenue allocations. WordMaster:

$18 * $280 = 0.419 * $280 = $117 $18 + $25

FinanceMaster:

$25 * $280 = 0.581 * $280 = $163 $18 + $25

562 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

3. Physical units. This method gives each product unit in the suite the same weight when allocating suite revenue to individual products. Therefore, with two products in the Word + Finance suite, each product is allocated 50% of the suite revenues. WordMaster:

1 * $280 = 0.50 * $280 = $140 1 + 1

FinanceMaster:

1 * $280 = 0.50 * $280 = $140 1 + 1

These three approaches to determining weights for the stand-alone method result in very different revenue allocations to the individual products: Revenue-Allocation Weights Selling prices Unit costs Physical units

WordMaster $100 117 140

FinanceMaster $180 163 140

Which method is preferred? The selling prices method is best, because the weights explicitly consider the prices customers are willing to pay for the individual products. Weighting approaches that use revenue information better capture “benefits received” by customers than unit costs or physical units.11 The physical-units revenue-allocation method is used when any of the other methods cannot be used (such as when selling prices are unstable or unit costs are difficult to calculate for individual products).

Incremental Revenue-Allocation Method The incremental revenue-allocation method ranks individual products in a bundle according to criteria determined by management—such as the product in the bundle with the most sales—and then uses this ranking to allocate bundled revenues to individual products. The first-ranked product is the primary product in the bundle. The secondranked product is the first-incremental product, the third-ranked product is the second-incremental product, and so on. How do companies decide on product rankings under the incremental revenueallocation method? Some organizations survey customers about the importance of each of the individual products to their purchase decision. Others use data on the recent stand-alone sales performance of the individual products in the bundle. A third approach is for top managers to use their knowledge or intuition to decide the rankings. Consider again the Word + Finance suite. Assume WordMaster is designated as the primary product. If the suite selling price exceeds the stand-alone price of the primary product, the primary product is allocated 100% of its stand-alone revenue. Because the suite price of $280 exceeds the stand-alone price of $125 for WordMaster, WordMaster is allocated revenues of $125, with the remaining revenue of $155 ($280 – $125) allocated to FinanceMaster: Product WordMaster FinanceMaster Total

Revenue Allocated $125 ƒ155 ($280 – $125) $280

Cumulative Revenue Allocated $125 $280

If the suite price is less than or equal to the stand-alone price of the primary product, the primary product is allocated 100% of the suite revenue. All other products in the suite receive no allocation of revenue. 11 Revenue-allocation

issues also arise in external reporting. The AICPA’s Statement of Position 97-2 (Software Revenue Recognition) states that with bundled products, revenue allocation “based on vendor-specific objective evidence (VSOE) of fair value” is required. The “price charged when the element is sold separately” is said to be “objective evidence of fair value” (see “Statement of Position 97-2,” Jersey City, NJ: AICPA, 1998). In September 2009, the FASB ratified Emerging Issues Task Force (EITF) Issue 08-1, specifying that with no VSOE or third-party evidence of selling price for all units of accounting in an arrangement, the consideration received for the arrangement should be allocated to the separate units based upon their relative selling prices.

BUNDLED PRODUCTS AND REVENUE ALLOCATION METHODS " 563

Now suppose FinanceMaster is designated as the primary product and WordMaster as the first-incremental product. Then, the incremental revenue-allocation method allocates revenues of the Word + Finance suite as follows: Product FinanceMaster WordMaster Total

Revenue Allocated $225 ƒƒ55 ($280 – $225) $280

Cumulative Revenue Allocated $225 $280

If Dynamic Software sells equal quantities of WordMaster and FinanceMaster, then the Shapley value method allocates to each product the average of the revenues allocated as the primary and first-incremental products: WordMaster: FinanceMaster: Total

($125 + $ 55) ÷ 2 = $180 ÷ 2 = $ 90 ($225 + $155) ÷ 2 = $380 ÷ 2 = ƒ190 $280

But what if, in the most recent quarter, the firm sells 80,000 units of WordMaster and 20,000 units of FinanceMaster. Because Dynamic Software sells four times as many units of WordMaster, its managers believe that the sales of the Word + Finance suite are four times more likely to be driven by WordMaster as the primary product. The weighted Shapley value method takes this fact into account. It assigns four times as much weight to the revenue allocations when WordMaster is the primary product as when FinanceMaster is the primary product, resulting in the following allocations: WordMaster: FinanceMaster: Total

($125 * 4 + $ 55 * 1) ÷ (4 + 1) = $555 ÷ 5 = $111 ($225 * 1 + $155 * 4) ÷ (4 + 1) = $845 ÷ 5 = ƒ169 $280

When there are more than two products in the suite, the incremental revenue-allocation method allocates suite revenues sequentially. Assume WordMaster is the primary product in Dynamic Software’s three-product suite (Word + Finance + Data). FinanceMaster is the first-incremental product, and DataMaster is the second-incremental product. This suite sells for $380. The allocation of the $380 suite revenues proceeds as follows: Product WordMaster FinanceMaster DataMaster Total

Revenue Allocated $125 155 ($280 – $125) ƒ100 ($380 – $280) $380

Cumulative Revenue Allocated $125 $280 (price of Word + Finance suite) $380 (price of Word + Finance + Data suite)

Now suppose WordMaster is the primary product, DataMaster is the first-incremental product, and FinanceMaster is the second-incremental product. Product WordMaster DataMaster FinanceMaster Total

Revenue Allocated $125 95 ($220 – $125) ƒ160 ($380 – $220) $380

Cumulative Revenue Allocated $125 $220 (price of Word + Data suite) $380 (price of Word + Data + Finance suite)

The ranking of the individual products in the suite determines the revenues allocated to them. Product managers at Dynamic Software likely would differ on how they believe their individual products contribute to sales of the suite products. In fact, each product manager would claim to be responsible for the primary product in the Word + Finance + Data suite!12 12 Calculating

the Shapley value mitigates this problem because each product is considered as a primary, first-incremental, and second-incremental product. Assuming equal weights on all products, the revenue allocated to each product is an average of the revenues calculated for the product under these different assumptions. In the preceding example, the interested reader can verify that this will result in the following revenue assignments: FinanceMaster, $180; WordMaster, $87.50; and DataMaster, $112.50.

Decision Point What is product bundling and how can managers allocate revenues of a bundled product to individual products in the package?

564 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

Because the stand-alone revenue-allocation method does not require rankings of individual products in the suite, this method is less likely to cause debates among product managers.

Problem for Self-Study This problem illustrates how costs of two corporate support departments are allocated to operating divisions using the dual-rate method. Fixed costs are allocated using budgeted costs and budgeted hours used by other departments. Variable costs are allocated using actual costs and actual hours used by other departments. Computer Horizons budgets the following amounts for its two central corporate support departments (legal and personnel) in supporting each other and the two manufacturing divisions, the laptop division (LTD) and the work station division (WSD):

2 3 4 5 6 7

SUPPORT Legal Personnel Department Department

BUDGETED USAGE Legal (hours) (Percentages) Personnel (hours) (Percentages)

OPERATING LTD

WSD

Total

— — 2,500 5%

250 10% — —

1,500 60% 22,500 45%

750 30% 25,000 50%

2,500 100% 50,000 100%

— — 2,000 5%

400 2 0% — —

400 20% 26,600 66.50%

1,200 60% 11,400 28.5%

2,000 100% 40,000 100%

$360,000

$475,000

—

$835,000

$200,000

$600,000

—

$800,000

8 9 10 11 12 13 14 15 16 17

ACTUAL USAGE Legal (hours) (Percentages) Personnel (hours) (Percentages) Budgeted fixed overhead costs before any interdepartment cost allocations Actual variable overhead costs before any interdepartment cost allocations

Required

What amount of support-department costs for legal and personnel will be allocated to LTD and WSD using (a) the direct method, (b) the step-down method (allocating the legal department costs first), and (c) the reciprocal method using linear equations?

Solution Exhibit 15-7 presents the computations for allocating the fixed and variable supportdepartment costs. A summary of these costs follows: (a) Direct Method Fixed costs Variable costs (b) Step-Down Method Fixed costs Variable costs (c) Reciprocal Method Fixed costs Variable costs

Laptop Division (LTD)

Work Station Division (WSD)

$465,000 ƒ470,000 $935,000

$370,000 ƒ330,000 $700,000

$458,053 ƒ488,000 $946,053

$376,947 ƒ312,000 $688,947

$462,513 ƒ476,364 $938,877

$372,487 ƒ323,636 $696,123

PROBLEM FOR SELF-STUDY " 565

Exhibit 15-7

Alternative Methods of Allocating Corporate Support-Department Costs to Operating Divisions of Computer Horizons: Dual-Rate Method

CORPORATE SUPPORT DEPARTMENTS Legal Personnel Department Department

20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51

52 53 54 55 56 57

Allocation Method A. DIRECT METHOD Fixed costs Legal (1,500 ÷ 2,250; 750 ÷ 2,250) Personnel (22,500 ÷ 47,500; 25,000 ÷ 47,500) Fixed support dept. cost allocated to operating divisions Variable costs Legal (400 ÷ 1,600; 1,200 ÷ 1,600) Personnel (26,600 ÷ 38,000; 11,400 ÷ 38,000) Variable support dept. cost allocated to operating divisions B. STEP-DOWN METHOD (Legal department first) Fixed costs Legal (250 ÷ 2,500; 1,500 ÷ 2,500; 750 ÷ 2,500) Personnel (22,500 ÷ 47,500; 25,000 ÷ 47,500) Fixed support dept. cost allocated to operating divisions Variable costs Legal (400 ÷ 2,000; 400 ÷ 2,000; 1,200 ÷ 2,000) Personnel (26,600 ÷ 38,000; 11,400 ÷ 38,000) Variable support dept. cost allocated to operating divisions C. RECIPROCAL METHOD Fixed costs Legal (250 ÷ 2,500; 1,500 ÷ 2,500; 750 ÷ 2,500 ) Personnel (2,500 ÷ 50,000; 22,500 ÷ 50,000; 25,000 ÷ 50,000) Fixed support dept. cost allocated to operating divisions Variable costs Legal (400 ÷ 2,000; 400 ÷ 2,000; 1,200 ÷ 2,000) Personnel (2,000 ÷ 40,000; 26,600 ÷ 40,000; 11,400 ÷ 40,000) Variable support dept. cost allocated to operating divisions a

FIXED COSTS Letting LF = Legal department fixed costs, and PF = Personnel department fixed costs, the simultaneous equations for the reciprocal method for fixed costs are LF = $360,000 + 0.05 PF PF = $475,000 + 0.10 LF LF = $360,000 + 0.05 ($475,000 + 0.10 LF) LF = $385,678 PF = $475,000 + 0.10 ($385,678) = $513,568

$360,000 (360,000) 0 $ $200,000 (200,000) $

$360,000 (360,000) $ 0 $200,000 (200,000) $

$360,000 (385,678)a 25,678 $ 0 $200,000 (232,323)b 32,323 0 $ b

OPERATING DIVISIONS LTD

WSD

Total

$240,000 225,000 $465,000

$120,000 250,000 $370,000

$835,000

$ 50,000 420,000 $470,000

$150,000 180,000 $330,000

$800,000

$216,000 242,053 $458,053

$108,000 268,947 $376,947

$835,000

$ 40,000 448,000 $488,000

$120,000 192,000 $312,000

$800,000

$231,407 231,106 $462,513

$115,703 256,784 $372,487

$835,000

$ 46,465 429,899 $476,364

$139,393 184,243 $323,636

$800,000

$475,000 (475,000) 0 $600,000 (600,000) 0

$475,000 36,000 (511,000) 0 $600,000 40,000 (640,000) 0 $475,000 38,568 (513,568)a $ 0 $600,000 46,465 (646,465)b 0 $

VARIABLE COSTS Letting LF = Legal department variable costs, and PV = Personnel department variable costs, the simultaneous equations for the reciprocal method for variable costs are LV = $200,000 + 0.05 PV PV = $600,000 + 0.20 LV LV = $200,000 + 0.05 ($600,000 + 0.20 LV ) LV = $232,323 PV = $600,000 + 0.20 ($232,323) = $646,465

566 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

Guidelines

1. When should managers use the dual-rate method over the single-rate method?

The single-rate method aggregates fixed and variable costs and allocates them to objects using a single allocation base and rate. Under the dual-rate method, costs are grouped into separate variable cost and fixed cost pools; each pool uses a different cost-allocation base and rate. If costs can be easily separated into variable and fixed costs, the dual-rate method should be used because it provides better information for making decisions.

2. What factors should managers consider when deciding between allocation based on budgeted and actual rates, and budgeted and actual usage?

The use of budgeted rates enables managers of user departments to have certainty about the costs allocated to them, and insulates users from inefficiencies in the supplier department. Charging budgeted variable cost rates to users based on actual usage is causally appropriate and promotes control of resource consumption. Charging fixed cost rates on the basis of budgeted usage helps user divisions with planning, and leads to goal congruence when considering outsourcing decisions.

3. What methods can managers use to allocate costs of multiple support departments to operating departments?

The three methods managers can use are the direct, the step-down, and the reciprocal methods. The direct method allocates each support department’s costs to operating departments without allocating a support department’s costs to other support departments. The step-down method allocates support-department costs to other support departments and to operating departments in a sequential manner that partially recognizes the mutual services provided among all support departments. The reciprocal method fully recognizes mutual services provided among all support departments.

4. What methods can managers use to allocate common costs to two or more users?

Common costs are the costs of a cost object (such as operating a facility or performing an activity) that are shared by two or more users. The stand-alone costallocation method uses information pertaining to each user of the cost object to determine cost-allocation weights. The incremental cost-allocation method ranks individual users of the cost object and allocates common costs first to the primary user and then to the other incremental users. The Shapley value method considers each user, in turn, as the primary and the incremental user.

5. How can contract disputes over reimbursement amounts based on costs be reduced?

Disputes can be reduced by making the cost-allocation rules as explicit as possible and in writing at the time the contract is signed. These rules should include details such as the allowable cost items, the acceptable cost-allocation bases, and how differences between budgeted and actual costs are to be accounted for.

6. What is product bundling and how can managers allocate revenues of a bundled product to individual products in the package?

Bundling occurs when a package of two or more products (or services) is sold for a single price. Revenue allocation of the bundled price is required when managers of the individual products in the bundle are evaluated on product revenue or product operating income. Revenues can be allocated for a bundled product using the stand-alone method, the incremental method, or the Shapley value method.

Terms to Learn This chapter and the Glossary at the end of the book contain definitions of the following important terms: allowable cost (p. 559) artificial costs (p. 554) bundled product (p. 561)

common cost (p. 557) complete reciprocated costs (p. 554)

Cost Accounting Standards Board (CASB) (p. 559) direct method (p. 550)

ASSIGNMENT MATERIAL " 567

dual-rate method (p. 544) incremental cost-allocation method (p. 557) incremental revenue-allocation method (p. 562) matrix method (p. 554) operating department (p. 543)

production department (p. 543) reciprocal method (p. 553) revenue allocation (p. 561) revenue object (p. 561) service department (p. 543) single-rate method (p. 544) sequential allocation method (p. 552)

stand-alone cost-allocation method (p. 557) stand-alone revenue-allocation method (p. 561) step-down method (p. 552) support department (p. 543)

Assignment Material Questions 15-1 15-2 15-3 15-4 15-5 15-6 15-7 15-8 15-9 15-10 15-11 15-12 15-13 15-14 15-15

Distinguish between the single-rate and the dual-rate methods. Describe how the dual-rate method is useful to division managers in decision making. How do budgeted cost rates motivate the support-department manager to improve efficiency? Give examples of allocation bases used to allocate support-department cost pools to operating departments. Why might a manager prefer that budgeted rather than actual cost-allocation rates be used for costs being allocated to his or her department from another department? “To ensure unbiased cost allocations, fixed costs should be allocated on the basis of estimated long-run use by user-department managers.” Do you agree? Why? Distinguish among the three methods of allocating the costs of support departments to operating departments. What is conceptually the most defensible method for allocating support-department costs? Why? Distinguish between two methods of allocating common costs. What role does the Cost Accounting Standards Board play when companies contract with the U.S. government? What is one key way to reduce cost-allocation disputes that arise with government contracts? Describe how companies are increasingly facing revenue-allocation decisions. Distinguish between the stand-alone and the incremental revenue-allocation methods. Identify and discuss arguments that individual product managers may put forward to support their preferred revenue-allocation method. How might a dispute over the allocation of revenues of a bundled product be resolved?

Exercises 15-16 Single-rate versus dual-rate methods, support department. The Chicago power plant that services all manufacturing departments of MidWest Engineering has a budget for the coming year. This budget has been expressed in the following monthly terms: Manufacturing Department Rockford Peoria Hammond Kankakee Total

Needed at Practical Capacity Production Level (Kilowatt-Hours) 10,000 20,000 12,000 ƒ8,000 50,000

Average Expected Monthly Usage (Kilowatt-Hours) 8,000 9,000 7,000 ƒ6,000 30,000

The expected monthly costs for operating the power plant during the budget year are $15,000: $6,000 variable and $9,000 fixed. 1. Assume that a single cost pool is used for the power plant costs. What budgeted amounts will be allocated to each manufacturing department if (a) the rate is calculated based on practical capacity and costs are allocated based on practical capacity, and (b) the rate is calculated based on expected monthly usage and costs are allocated based on expected monthly usage? 2. Assume the dual-rate method is used with separate cost pools for the variable and fixed costs. Variable costs are allocated on the basis of expected monthly usage. Fixed costs are allocated on the basis of practical capacity. What budgeted amounts will be allocated to each manufacturing department? Why might you prefer the dual-rate method?

Required

568 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

15-17 Single-rate method, budgeted versus actual costs and quantities. Chocolat Inc. is a producer of premium chocolate based in Palo Alto. The company has a separate division for each of its two products: dark chocolate and milk chocolate. Chocolat purchases ingredients from Wisconsin for its dark chocolate division and from Louisiana for its milk chocolate division. Both locations are the same distance from Chocolat’s Palo Alto plant. Chocolat Inc. operates a fleet of trucks as a cost center that charges the divisions for variable costs (drivers and fuel) and fixed costs (vehicle depreciation, insurance, and registration fees) of operating the fleet. Each division is evaluated on the basis of its operating income. For 2012, the trucking fleet had a practical capacity of 50 round-trips between the Palo Alto plant and the two suppliers. It recorded the following information:

Costs of truck fleet Number of round-trips for dark chocolate 3 division (Palo Alto plant—Wisconsin) Number of round-trips for milk chocolate 4 division (Palo Alto plant—Louisiana) 2

Required

Budgeted $115,000

Actual $96,750

1. Using the single-rate method, allocate costs to the dark chocolate division and the milk chocolate division in these three ways. a. Calculate the budgeted rate per round-trip and allocate costs based on round-trips budgeted for each division. b. Calculate the budgeted rate per round-trip and allocate costs based on actual round-trips used by each division. c. Calculate the actual rate per round-trip and allocate costs based on actual round-trips used by each division. 2. Describe the advantages and disadvantages of using each of the three methods in requirement 1. Would you encourage Chocolat Inc. to use one of these methods? Explain and indicate any assumptions you made.

15-18 Dual-rate method, budgeted versus actual costs and quantities (continuation of 15-17). Chocolat Inc. decides to examine the effect of using the dual-rate method for allocating truck costs to each roundtrip. At the start of 2012, the budgeted costs were as follows: Variable cost per round-trip Fixed costs

$ 1,350 $47,500

The actual results for the 45 round-trips made in 2012 were as follows: Variable costs Fixed costs

$58,500 ƒ38,250 $96,750

Assume all other information to be the same as in Exercise 15-17. Required

1. Using the dual-rate method, what are the costs allocated to the dark chocolate division and the milk chocolate division when (a) variable costs are allocated using the budgeted rate per round-trip and actual round-trips used by each division and when (b) fixed costs are allocated based on the budgeted rate per round-trip and round-trips budgeted for each division? 2. From the viewpoint of the dark chocolate division, what are the effects of using the dual-rate method rather than the single-rate methods?

15-19 Support-department cost allocation; direct and step-down methods. Phoenix Partners provides management consulting services to government and corporate clients. Phoenix has two support departments—administrative services (AS) and information systems (IS)—and two operating departments— government consulting (GOVT) and corporate consulting (CORP). For the first quarter of 2012, Phoenix’s cost records indicate the following:

ASSIGNMENT MATERIAL " 569

SUPPORT AS IS

1 2

OPERATING GOVT CORP

Total

3 Budgeted overhead costs before any

interdepartment cost allocations Support work supplied by AS 5 (budgeted head count) Support work supplied by IS 6 (budgeted computer time) 4

$600,000

$2,400,000

$8,756,000

$12,452,000

$24,208,000

—

25%

40%

35%

100%

10%

—

30%

60%

100%

1. Allocate the two support departments’ costs to the two operating departments using the following methods: a. Direct method b. Step-down method (allocate AS first) c. Step-down method (allocate IS first) 2. Compare and explain differences in the support-department costs allocated to each operating department. 3. What approaches might be used to decide the sequence in which to allocate support departments when using the step-down method?

Required

15-20 Support-department cost allocation, reciprocal method (continuation of 15-19). Refer to the data given in Exercise 15-19. 1. Allocate the two support departments’ costs to the two operating departments using the reciprocal method. Use (a) linear equations and (b) repeated iterations. 2. Compare and explain differences in requirement 1 with those in requirement 1 of Exercise 15-19. Which method do you prefer? Why?

Required

15-21 Direct and step-down allocation. E-books, an online book retailer, has two operating departments— corporate sales and consumer sales—and two support departments—human resources and information systems. Each sales department conducts merchandising and marketing operations independently. E-books uses number of employees to allocate human resources costs and processing time to allocate information systems costs. The following data are available for September 2012:

2 4 5 6 7 8

SUPPORT DEPARTMENTS Human Information Resources Systems

Budgeted costs incurred before any interdepartment cost allocations Support work supplied by human resources department Budgeted number of employees Support work supplied by information systems department Budgeted processing time (in minutes)

OPERATING DEPARTMENTS Corporate Consumer Sales Sales

$72,700

$234,400

$998,270

$489,860

—

320

—

1,920

1,600

1. Allocate the support departments’ costs to the operating departments using the direct method. 2. Rank the support departments based on the percentage of their services provided to other support departments. Use this ranking to allocate the support departments’ costs to the operating departments based on the step-down method. 3. How could you have ranked the support departments differently?

15-22 Reciprocal cost allocation (continuation of 15-21). Consider E-books again. The controller of E-books reads a widely used textbook that states that “the reciprocal method is conceptually the most defensible.” He seeks your assistance.

Required

570 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

Required

1. Describe the key features of the reciprocal method. 2. Allocate the support departments’ costs (human resources and information systems) to the two operating departments using the reciprocal method. 3. In the case presented in this exercise, which method (direct, step-down, or reciprocal) would you recommend? Why?

15-23 Allocation of common costs. Ben and Gary are students at Berkeley College. They share an apartment that is owned by Gary. Gary is considering subscribing to an Internet provider that has the following packages available: Package A. Internet access B. Phone services C. Internet access + phone services

Per Month $60 15 65

Ben spends most of his time on the Internet (“everything can be found online now”). Gary prefers to spend his time talking on the phone rather than using the Internet (“going online is a waste of time”). They agree that the purchase of the $65 total package is a “win–win” situation. Required

1. Allocate the $65 between Ben and Gary using (a) the stand-alone cost-allocation method, (b) the incremental cost-allocation method, and (c) the Shapley value method. 2. Which method would you recommend they use and why?

15-24 Allocation of common costs. Sunny Gunn, a self-employed consultant near Sacramento, received an invitation to visit a prospective client in Baltimore. A few days later, she received an invitation to make a presentation to a prospective client in Chicago. She decided to combine her visits, traveling from Sacramento to Baltimore, Baltimore to Chicago, and Chicago to Sacramento. Gunn received offers for her consulting services from both companies. Upon her return, she decided to accept the engagement in Chicago. She is puzzled over how to allocate her travel costs between the two clients. She has collected the following data for regular round-trip fares with no stopovers: Sacramento to Baltimore Sacramento to Chicago

$1,200 $ 800

Gunn paid $1,600 for her three-leg flight (Sacramento–Baltimore, Baltimore–Chicago, Chicago–Sacramento). In addition, she paid $40 each way for limousines from her home to Sacramento Airport and back when she returned. Required

1. How should Gunn allocate the $1,600 airfare between the clients in Baltimore and Chicago using (a) the stand-alone cost-allocation method, (b) the incremental cost-allocation method, and (c) the Shapley value method? 2. Which method would you recommend Gunn use and why? 3. How should Gunn allocate the $80 limousine charges between the clients in Baltimore and Chicago?

15-25 Revenue allocation, bundled products. Yves Parfum Company blends and sells designer fragrances. It has a Men’s Fragrances Division and a Women’s Fragrances Division, each with different sales strategies, distribution channels, and product offerings. Yves is now considering the sale of a bundled product consisting of a men’s cologne and a women’s perfume. For the most recent year, Yves reported the following:

Product 2 Monaco (men’s cologne) 3 Innocence (women’s perfume) 4 L’Amour (Monaco + Innocence) 1

Required

Retail Price $ 48 112 130

1. Allocate revenue from the sale of each unit of L’Amour to Monaco and Innocence using the following: a. The stand-alone revenue-allocation method based on selling price of each product b. The incremental revenue-allocation method, with Monaco ranked as the primary product c. The incremental revenue-allocation method, with Innocence ranked as the primary product d. The Shapley value method, assuming equal unit sales of Monaco and Innocence 2. Of the four methods in requirement 1, which one would you recommend for allocating L’Amour’s revenues to Monaco and Innocence? Explain.

ASSIGNMENT MATERIAL " 571

15-26 Allocation of common costs. Jim Dandy Auto Sales uses all types of media to advertise its products (television, radio, newspaper, etc.). At the end of 2011, the company president, Jim Dandridge, decided that all advertising costs would be incurred by corporate headquarters and allocated to each of the company’s three sales locations based on number of vehicles sold. Jim was confident that his corporate purchasing manager could negotiate better advertising contracts on a corporate-wide basis than each of the sales managers could on their own. Dandridge budgeted total advertising cost for 2012 to be $1.8 million. He introduced the new plan to his sales managers just before the New Year. The manager of the east sales location, Tony Snider, was not happy. He complained that the new allocation method was unfair and would increase his advertising costs significantly over the prior year. The east location sold high volumes of low-priced used cars and most of the corporate advertising budget was related to new car sales. Following Tony’s complaint, Jim decided to take another hard look at what each of the divisions were paying for advertising before the new allocation plan. The results were as follows: Sales Location East West North South

Actual Number of Cars Sold in 2011 3,150 1,080 2,250 2,520 9,000

Actual Advertising Cost Incurred in 2011 $ 324,000 432,000 648,000 ƒƒƒ756,000 $2,160,000

1. Using 2011 data as the cost bases, show the amount of the 2012 advertising cost ($1,800,000) that would be allocated to each of the divisions under the following criteria: a. Dandridge’s allocation method based on number of cars sold b. The stand-alone method c. The incremental-allocation method, with divisions ranked on the basis of dollars spent on advertising in 2011 2. Which method do you think is most equitable to the divisional sales managers? What other options might President Jim Dandridge have for allocating the advertising costs?

Required

Problems 15-27 Single-rate, dual-rate, and practical capacity allocation. Perfection Department Store has a

new promotional program that offers a free gift-wrapping service for its customers. Perfection’s customerservice department has practical capacity to wrap 7,000 gifts at a budgeted fixed cost of $6,650 each month. The budgeted variable cost to gift wrap an item is $0.40. Although the service is free to customers, a gift-wrapping service cost allocation is made to the department where the item was purchased. The customer-service department reported the following for the most recent month:

1 2 3 4 5 6 7

Department Women’s face wash Men’s face wash Fragrances Body wash Hair products Total

Actual Number of Gifts Wrapped 2,020 730 1,560 545 1,495 6,350

Budgeted Number of Gifts to Be Wrapped 2,470 825 1,805 430 1,120 6,650

Practical Capacity Available for Gift-Wrapping 2,640 945 1,970 650 795 7,000

1. Using the single-rate method, allocate gift-wrapping costs to different departments in these three ways. a. Calculate the budgeted rate based on the budgeted number of gifts to be wrapped and allocate costs based on the budgeted use (of gift-wrapping services). b. Calculate the budgeted rate based on the budgeted number of gifts to be wrapped and allocate costs based on actual usage. c. Calculate the budgeted rate based on the practical gift-wrapping capacity available and allocate costs based on actual usage.

Required

572 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

2. Using the dual-rate method, compute the amount allocated to each department when (a) the fixed-cost rate is calculated using budgeted costs and the practical gift-wrapping capacity, (b) fixed costs are allocated based on budgeted usage of gift-wrapping services, and (c) variable costs are allocated using the budgeted variable-cost rate and actual usage. 3. Comment on your results in requirements 1 and 2. Discuss the advantages of the dual-rate method.

15-28 Revenue allocation. Lee Shu-yu Inc. produces and sells DVDs to business people and students who are planning extended stays in China. It has been very successful with two DVDs: Beginning Mandarin and Conversational Mandarin. It is introducing a third DVD, Reading Chinese Characters. It has decided to market its new DVD in two different packages grouping the Reading Chinese Characters DVD with each of the other two language DVDs. Information about the separate DVDs and the packages follow. DVD Beginning Mandarin (BegM) Conversational Mandarin (ConM) Reading Chinese Characters (RCC) BegM + RCC ConM + RCC Required

Selling Price $ 50 $ 90 $ 30 $ 60 $100

1. Using the selling prices, allocate revenues from the BegM + RCC package to each DVD in that package using (a) the stand-alone method; (b) the incremental method, in either order; and (c) the Shapley value method. 2. Using the selling prices, allocate revenues from the ConM + RCC package to each DVD in that package using (a) the stand-alone method; (b) the incremental method, in either order; and (c) the Shapley value method. 3. Which method is most appropriate for allocating revenues among the DVDs? Why?

15-29 Fixed cost allocation. State University completed construction of its newest administrative building at

the end of 2011. The University’s first employees moved into the building on January 1, 2012. The building consists of office space, common meeting rooms (including a conference center), a cafeteria and even a workout room for its exercise enthusiasts. The total 2012 building space of 125,000 square feet was utilized as follows: Usage of Space Office space (occupied) Vacant office space Common meeting space Workout room Cafeteria

% of Total Building Space 52% 8% 25% 5% 10%

The new building cost the university $30 million and was depreciated using the straight-line method over 20 years. At the end of 2012 three departments occupied the building: executive offices of the president, accounting, and human resources. Each department’s usage of its assigned space was as follows:

Department Executive Accounting Human resources Required

Actual Office Space Used (sq. ft.) 16,250 26,000 22,750

Planned Office Space Used (sq. ft.) 12,400 26,040 23,560

Practical Capacity Office Space (sq. ft.) 18,000 33,000 24,000

1. How much of the total building cost will be allocated in 2012 to each of the departments, if allocated on the basis of the following? a. Actual usage b. Planned usage c. Practical capacity 2. Assume that State University allocates the total annual building cost in the following manner: a. All vacant office space is absorbed by the university and is not allocated to the departments. b. All occupied office space costs are allocated on the basis of actual square footage used. c. All common costs are allocated on the basis of a department’s practical capacity. Calculate the cost allocated to each department in 2012 under this plan. Do you think the allocation method used here is appropriate? Explain.

ASSIGNMENT MATERIAL " 573

15-30 Allocating costs of support departments; step-down and direct methods. The Central Valley Company has prepared department overhead budgets for budgeted-volume levels before allocations as follows: Support departments: Building and grounds Personnel General plant administration Cafeteria: operating loss Storeroom Operating departments: Machining Assembly Total for support and operating departments

$10,000 1,000 26,090 1,640 ƒƒ2,670 $34,700 ƒ48,900

$ 41,400

ƒƒ83,600 $125,000

Management has decided that the most appropriate inventory costs are achieved by using individualdepartment overhead rates. These rates are developed after support-department costs are allocated to operating departments. Bases for allocation are to be selected from the following: Direct Square Feet of Manufacturing Number of Floor Space Manufacturing Number of Labor-Hours Employees Occupied Labor-Hours Requisitions Department Building and grounds 0 0 0 0 0 Personnela 0 0 2,000 0 0 General plant administration 0 35 7,000 0 0 Cafeteria: operating loss 0 10 4,000 1,000 0 Storeroom 0 5 7,000 1,000 0 Machining 5,000 50 30,000 8,000 2,000 Assembly 15,000 100 ƒ50,000 17,000 1,000 Total 20,000 200 100,000 27,000 3,000 aBasis

used is number of employees.

1. Using the step-down method, allocate support-department costs. Develop overhead rates per direct manufacturing labor-hour for machining and assembly. Allocate the costs of the support departments in the order given in this problem. Use the allocation base for each support department you think is most appropriate. 2. Using the direct method, rework requirement 1. 3. Based on the following information about two jobs, determine the total overhead costs for each job by using rates developed in (a) requirement 1 and (b) requirement 2. Direct Manufacturing Labor-Hours Machining Assembly Job 88 18 2 Job 89 3 17 4. The company evaluates the performance of the operating department managers on the basis of how well they managed their total costs, including allocated costs. As the manager of the machining department, which allocation method would you prefer from the results obtained in requirements 1 and 2? Explain.

15-31 Support-department cost allocations; single-department cost pools; direct, step-down, and reciprocal methods. The Manes Company has two products. Product 1 is manufactured entirely in department X. Product 2 is manufactured entirely in department Y. To produce these two products, the Manes Company has two support departments: A (a materials-handling department) and B (a power-generating department). An analysis of the work done by departments A and B in a typical period follows:

Supplied By A B

A — 500

Used By B X 100 250 — 100

Y 150 400

Required

574 " CHAPTER 15 ALLOCATION OF SUPPORT-DEPARTMENT COSTS, COMMON COSTS, AND REVENUES

The work done in department A is measured by the direct labor-hours of materials-handling time. The work done in department B is measured by the kilowatt-hours of power. The budgeted costs of the support departments for the coming year are as follows:

Variable indirect labor and indirect materials costs Supervision Depreciation

Department A (Materials Handling)

Department B (Power Generation)

$ 70,000 10,000 ƒƒ20,000 $100,000 +Power costs

$10,000 10,000 ƒ20,000 $40,000 +Materials-handling costs

The budgeted costs of the operating departments for the coming year are $1,500,000 for department X and $800,000 for department Y. Supervision costs are salary costs. Depreciation in department B is the straight-line depreciation of power-generation equipment in its 19th year of an estimated 25-year useful life; it is old, but wellmaintained, equipment. Required

1. What are the allocations of costs of support departments A and B to operating departments X and Y using (a) the direct method, (b) the step-down method (allocate department A first), (c) the step-down method (allocate department B first), and (d) the reciprocal method? 2. An outside company has offered to supply all the power needed by the Manes Company and to provide all the services of the present power department. The cost of this service will be $40 per kilowatt-hour of power. Should Manes accept? Explain.

15-32 Common costs. Wright Inc. and Brown Inc. are two small clothing companies that are considering leasing a dyeing machine together. The companies estimated that in order to meet production, Wright needs the machine for 800 hours and Brown needs it for 200 hours. If each company rents the machine on its own, the fee will be $50 per hour of usage. If they rent the machine together, the fee will decrease to $42 per hour of usage. Required

1. Calculate Wright’s and Brown’s respective share of fees under the stand-alone cost-allocation method. 2. Calculate Wright’s and Brown’s respective share of fees using the incremental cost-allocation method. Assume Wright to be the primary party. 3. Calculate Wright’s and Brown’s respective share of fees using the Shapley value method. 4. Which method would you recommend Wright and Brown use to share the fees?

15-33 Stand-alone revenue allocation. MaxSystems, Inc., sells computer hardware to end consumers. Its most popular model, the CX30 is sold as a “bundle,” which includes three hardware products: a personal computer (PC) tower, a 23-inch monitor, and a color laser printer. Each of these products is made in a separate manufacturing division of MaxSystems and can be purchased individually, as well as in a bundle. The individual selling prices and per unit costs are as follows: Computer Component PC tower Monitor Color laser printer Computer bundle purchase price Required

Individual Selling Price per Unit $ 840 $ 280 $ 480 $1,200

Cost per Unit $300 $180 $270

1. Allocate the revenue from the computer bundle purchase to each of the hardware products using the stand-alone method based on the individual selling price per unit. 2. Allocate the revenue from the computer bundle purchase to each of the hardware products using the stand-alone method based on cost per unit. 3. Allocate the revenue from the computer bundle purchase to each of the hardware products using the standalone method based on physical units (that is, the number of individual units of product sold per bundle). 4. Which basis of allocation makes the most sense in this situation? Explain your answer.

15-34 Support-department cost allocations; single-department cost pools; direct, step-down, and reciprocal methods. Spirit Training, Inc., manufactures athletic shoes and athletic clothing for both amateur and professional athletes. The company has two product lines (clothing and shoes), which are produced in separate manufacturing facilities; however, both manufacturing facilities share the same support services for information technology and human resources. The following shows total costs for each manufacturing facility and for each support department.

ASSIGNMENT MATERIAL " 575

Information technology (IT) Human resources (HR) Clothing Shoes Total costs

Variable Costs $ 500 $ 100 $3,000 $2,500 $7,100

Fixed Costs $ 1,500 $ 900 $ 7,000 $ƒ5,500 $16,900

Total Costs by Department (in thousands) $ 2,000 $ 1,000 $10,000 $ƒ8,000 $24,000

The total costs of the support departments (IT and HR) are allocated to the production departments (clothing and shoes) using a single rate based on the following: Information technology: Human resources:

Number of IT labor hours worked by department Number of employees supported by department

Data on the bases, by department, are given as follows: Department Clothing Shoes Information technology Human resources

IT Hours Used 5,000 3,000 2,000

Number of Employees 120 40 40 -

1. What are the total costs of the production departments (clothing and shoes) after the support department costs of information technology and human resources have been allocated using (a) the direct method, (b) the step-down method (allocate information technology first), (c) the step-down method (allocate human resources first), and (d) the reciprocal method? 2. Assume that all of the work of the IT department could be outsourced to an independent company for $97.50 per hour. If Spirit Training no longer operated its own IT department, 30% of the fixed costs of the IT department could be eliminated. Should Spirit outsource its IT services?

Required

Collaborative Learning Problem 15-35 Revenue allocation, bundled products. Exclusive Resorts (ER) operates a five-star hotel with a championship golf course. ER has a decentralized management structure, with three divisions: # # #

Lodging (rooms, conference facilities) Food (restaurants and in-room service) Recreation (golf course, tennis courts, swimming pool, etc.)

Starting next month, ER will offer a two-day, two-person “getaway package” for $1,000. This deal includes the following:

Two nights’ stay for two in an ocean-view room Two rounds of golf (can be used by either guest) Candlelight dinner for two at ER’s finest restaurant Total package value

As Priced Separately $ 800 ($400 per night) $ 375 ($187.50 per round) $ƒƒ200 ($100 per person) $1,375

Jenny Lee, president of the recreation division, recently asked the CEO of ER how her division would share in the $1,000 revenue from the getaway package. The golf course was operating at 100% capacity. Currently, anyone booking the package was guaranteed access to the golf course. Lee noted that every “getaway” booking would displace $375 of other golf bookings not related to the package. She emphasized that the high demand reflected the devotion of her team to keeping the golf course rated one of the “Best 10 Courses in the World” by Golf Monthly. As an aside, she also noted that the lodging and food divisions had to turn away customers during only “peak-season events such as the New Year’s period.” 1. Using selling prices, allocate the $1,000 getaway-package revenue to the three divisions using: a. The stand-alone revenue-allocation method b. The incremental revenue-allocation method (with recreation first, then lodging, and then food) 2. What are the pros and cons of the two methods in requirement 1? 3. Because the recreation division is able to book the golf course at 100% capacity, the company CEO has decided to revise the getaway package to only include the lodging and food offerings shown previously. The new package will sell for $900. Allocate the revenue to the lodging and food divisions using the following: a. The Shapley value method. b. The weighted Shapley value method, assuming that lodging is three times as likely to sell as the food.

Required

Inventory Management, Just-in-Time, and Simplified Costing Methods

Suppose you could receive a large quantity discount for a product that you regularly use, but the discount requires you to buy a year’s supply and necessitates a large up-front expenditure.

Learning Objectives

1. Identify six categories of costs associated with goods for sale

Would you take the quantity discount? Companies face similar decisions because firms pay a price for tying up money in inventory sitting on their shelves or elsewhere. Money tied up in inventory is a particularly serious problem when times are tough. When faced with these circumstances, companies like Costco work very hard to better manage their inventories.

2. Balance ordering costs with carrying costs using the economic-orderquantity (EOQ) decision model 3. Identify the effect of errors that can arise when using the EOQ decision model and ways to reduce conflicts between the EOQ model and models used for performance evaluation 4. Describe why companies are using just-in-time purchasing 5. Distinguish materials requirements planning (MRP) systems from just-in-time (JIT) systems for manufacturing 6. Identify the features and benefits of a just-in-time production system 7. Describe different ways backflush costing can simplify traditional inventory-costing systems 8. Understand the principles of lean accounting

Costco Aggressively Manages Inventory to Thrive in Tough Times1 When consumers reduced their spending in 2008, traditional stalwarts like Circuit City and Linens ‘n Things wilted under the weight of their own massive inventories. They could not turn their inventories quickly enough to pay suppliers and were forced to close their doors when cash ran out. At the same time, Costco continued to thrive! How? By intentionally stocking fewer items than its competitors—and employing inventory management practices that successfully reduced costs throughout its operations. While the average grocery store carries around 40,000 items, Costco limits its offerings to about 4,000 products, or 90% less! Limiting the number of products on its shelves reduces Costco’s costs of carrying inventory. Costco also employs a just-in-time inventory management system, which includes sharing data directly with many of its largest suppliers. Companies like Kimberly-Clark calculate re-order points in real time and send new inventory, as needed, to replenish store shelves. Costco also works to redesign product packaging to squeeze more bulky goods onto trucks and shelves, reducing the number of orders Costco needs to place with suppliers. Occasionally, the company leverages its 75 million square feet of warehouse space to reduce purchasing costs. For example, when Procter & Gamble recently announced a 6% price increase for its paper goods, Costco bought 258 truckloads of paper towels at the old rate and stored them using available capacity in its distribution centers and warehouses.

702

Source: McGregor, Jena. 2008. Costco’s artful discounts. BusinessWeek, October 20.

These inventory management techniques have allowed Costco to succeed in tough times while others have failed. Costco turns its inventory nearly 12 times a year, far more often than other retailers. With many suppliers agreeing to be paid 30 days after delivery, Costco often sells many of its goods before it even has to pay for them! Inventory management is important because materials costs often account for more than 40% of total costs of manufacturing companies and more than 70% of total costs in merchandising companies. In this chapter, we describe the components of inventory costs, relevant costs for different inventory-related decisions, and planning and control systems for managing inventory.

Inventory Management in Retail Organizations Inventory management includes planning, coordinating, and controlling activities related to the flow of inventory into, through, and out of an organization. Consider this breakdown of operations for three major retailers for which cost of goods sold constitutes their largest cost item.

Revenues Deduct costs: Cost of goods sold Selling and administration costs Other costs, interest, and taxes Total costs Net income

Kroger 100.0%

Costco 100.0%

Wal-Mart 100.0%

76.8% 21.7% ƒ1.4% 99.9% ƒ0.1%

87.2% 10.2% ƒ1.1% 98.5% ƒ1.5%

74.7% 19.5% ƒ2.3% 96.5% ƒ3.5%

The low percentages of net income to revenues mean that improving the purchase and management of goods for sale can cause dramatic percentage increases in net income.

Costs Associated with Goods for Sale Managing inventories to increase net income requires companies to effectively manage costs that fall into the following six categories: 1. Purchasing costs are the cost of goods acquired from suppliers, including incoming freight costs. These costs usually make up the largest cost category of goods for sale. Discounts for various purchase-order sizes and supplier payment terms affect purchasing costs.

Learning Objective

Identify six categories of costs associated with goods for sale . . . purchasing, ordering, carrying, stockout, quality, and shrinkage

704 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

2. Ordering costs arise in preparing and issuing purchase orders, receiving and inspecting the items included in the orders, and matching invoices received, purchase orders, and delivery records to make payments. Ordering costs include the cost of obtaining purchase approvals, as well as other special processing costs. 3. Carrying costs arise while holding an inventory of goods for sale. Carrying costs include the opportunity cost of the investment tied up in inventory (see Chapter 11, pp. 403–405) and the costs associated with storage, such as space rental, insurance, obsolescence, and spoilage. 4. Stockout costs arise when a company runs out of a particular item for which there is customer demand, a stockout. The company must act quickly to replenish inventory to meet that demand or suffer the costs of not meeting it. A company may respond to a stockout by expediting an order from a supplier, which can be expensive because of additional ordering costs plus any associated transportation costs. Or the company may lose sales due to the stockout. In this case, the opportunity cost of the stockout includes lost contribution margin on the sale not made plus any contribution margin lost on future sales due to customer ill will. 5. Costs of quality result when features and characteristics of a product or service are not in conformance with customer specifications. There are four categories of quality costs (prevention costs, appraisal costs, internal failure costs, and external failure costs), as described in Chapter 19. 6. Shrinkage costs result from theft by outsiders, embezzlement by employees, misclassifications, and clerical errors. Shrinkage is measured by the difference between (a) the cost of the inventory recorded on the books in the absence of theft and other incidents just mentioned, and (b) the cost of inventory when physically counted. Shrinkage can often be an important measure of management performance. Consider, for example, the grocery business, where operating income percentages hover around 2%. With such small margins, it is easy to see why one of a store manager’s prime responsibilities is controlling inventory shrinkage. A $1,000 increase in shrinkage will erase the operating income from sales of $50,000 (2% * $50,000 = $1,000).

Decision Point What are the six categories of costs associated with goods for sale?

Note that not all inventory costs are available in financial accounting systems. For example, opportunity costs are not recorded in these systems and are a significant component in several of these cost categories. Information-gathering technology increases the reliability and timeliness of inventory information and reduces costs in the six cost categories. For example, barcoding technology allows a scanner to record purchases and sales of individual units. As soon as a unit is scanned, an instantaneous record of inventory movements is created that helps in the management of purchasing, carrying, and stockout costs. In the next several sections, we consider how relevant costs are computed for different inventory-related decisions in merchandising companies.

Economic-Order-Quantity Decision Model Learning Objective

Balance ordering costs with carrying costs using the economicorder-quantity (EOQ) decision model . . . choose the inventory quantity per order to minimize these costs

The first decision in managing goods for sale is how much to order of a given product. The economic order quantity (EOQ) is a decision model that, under a given set of assumptions, calculates the optimal quantity of inventory to order. #

# #

The simplest version of an EOQ model assumes there are only ordering and carrying costs. The same quantity is ordered at each reorder point. Demand, ordering costs, and carrying costs are known with certainty. The purchase-order lead time, the time between placing an order and its delivery, is also known with certainty. Purchasing cost per unit is unaffected by the order quantity. This assumption makes purchasing costs irrelevant to determining EOQ, because the purchase price is the same, whatever the order size.

INVENTORY MANAGEMENT IN RETAIL ORGANIZATIONS " 705 #

No stockouts occur. The basis for this assumption is that the costs of stockouts are so high that managers maintain adequate inventory to prevent them. In deciding on the size of a purchase order, managers consider costs of quality and shrinkage costs only to the extent that these costs affect ordering or carrying costs.

Given these assumptions, EOQ analysis ignores purchasing costs, stockout costs, costs of quality, and shrinkage costs. EOQ is the order quantity that minimizes the relevant ordering and carrying costs (that is, the ordering and carrying costs affected by the quantity of inventory ordered): Relevant total costs = Relevant ordering costs + Relevant carrying costs

We use the following notations: D = Demand in units for a specified period (one year in this example) Q = Size of each order (order quantity) Number of purchase orders per period (one year) =

Demand in units for a period (one year) D = Size of each order (order quantity) Q

Q , because each time the inventory goes down to 0, an order 2 0 + Q for Q units is received. The inventory varies from Q to 0 so the average inventory is . 2 Average inventory in units =

P = Relevant ordering cost per purchase order C = Relevant carrying cost of one unit in stock for the time period used for D (one year)

For any order quantity, Q, Annual relevant ordering costs =

Annual relevant carrying costs =

Number of Relevant ordering D purchase orders * cost per = a * Pb Q Q P per year purchase order

Annual Average inventory Q * relevant carrying = a * Cb in units Q 2 P cost per unit

Annual Annual D Q Annual relevant total costs = relevant ordering + relevant carrying = a * Pb + a * Cb Q 2 costs costs

The order quantity that minimizes annual relevant total costs is EOQ =

2DP A C

The EOQ model is solved using calculus but the key intuition is that relevant total costs are minimized when relevant ordering costs equal relevant carrying costs. If carrying costs are less (greater) than ordering costs, total costs can be reduced by increasing (decreasing) the order quantity. To solve for EOQ, we set a

D Q * Cb = a * Pb 2 Q

Multiplying both sides by Q =

2Q 2DP , we get Q 2 = C C

2DP A C

The formula indicates that EOQ increases with higher demand and/or higher ordering costs and decreases with higher carrying costs. Let’s consider an example to see how EOQ analysis works. CD World is an independent electronics store that sells blank compact disks. CD World purchases the CDs from

706 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

Sontek at $14 a package (each package contains 20 disks). Sontek pays for all incoming freight. No inspection is necessary at CD World because Sontek supplies quality merchandise. CD World’s annual demand is 13,000 packages, at a rate of 250 packages per week. CD World requires a 15% annual rate of return on investment. The purchase-order lead time is two weeks. Relevant ordering cost per purchase order is $200. Relevant carrying cost per package per year is as follows: Required annual return on investment, 0.15 * $14 Relevant costs of insurance, materials handling, breakage, shrinkage, and so on, per year Total

$2.10 ƒ3.10 $5.20

What is the EOQ of packages of disks? Substituting D = 13,000 packages per year, P = $200 per order, and C = $5.20 per package per year, in the EOQ formula, we get, EOQ =

2 * 13,000 * $200 = 21,000,000 = 1,000 packages $5.20

Purchasing 1,000 packages per order minimizes total relevant ordering and carrying costs. Therefore, the number of deliveries each period (one year in this example) is as follows: 13,000 D = = 13 deliveries EOQ 1,000 D

Recall the annual relevant total costs (RTC) = a * Pb + a * C b Q 2 For Q = 1,000 units, RTC =

13,000 * $200 1,000 * $5.20 + 1,000 2

= $2,600 + $2,600 = $5,200

Exhibit 20-1 graphs the annual relevant total costs of ordering (DP/Q) and carrying inventory (QC/2) under various order sizes (Q), and it illustrates the trade-off between these two types of costs. The larger the order quantity, the lower the annual relevant ordering costs, but the higher the annual relevant carrying costs. Annual relevant total costs are at a minimum at the EOQ at which the relevant ordering and carrying costs are equal. Exhibit 20-1

Graphic Analysis of Ordering Costs and Carrying Costs for Compact Disks at CD World

10,000

Relevant Total Costs (Dollars)

Annual relevant total costs 8,000

Annual relevant ordering costs (DP/Q)

6,000 5,200 4,000 Annual relevant carrying costs (QC/2)

2,000

0 0

650

EOQ ! 1,000

1,300

1,950

Order Quantity (Q) in Units

2,600

INVENTORY MANAGEMENT IN RETAIL ORGANIZATIONS " 707

When to Order, Assuming Certainty The second decision in managing goods for sale is when to order a given product. The reorder point is the quantity level of inventory on hand that triggers a new purchase order. The reorder point is simplest to compute when both demand and purchase-order lead time are known with certainty: Reorder point =

Number of units sold Purchase-order * per time period lead time

In our CD World example, we choose one week as the time period in the reorder-point formula: Economic order quantity Number of units sold per week Purchase-order lead time

1,000 packages 250 packages per week (13,000 packages , 52 weeks) 2 weeks

Reorder point = 250 packages per week * 2 weeks = 500 packages

CD World will order 1,000 packages each time inventory stock falls to 500 packages.2 The graph in Exhibit 20-2 shows the behavior of the inventory level of compact disk packages, assuming demand occurs uniformly during each week. If purchase-order lead time is two weeks, a new order will be placed when the inventory level falls to 500 packages, so the 1,000 packages ordered will be received at the precise time that inventory reaches zero.

Safety Stock We have assumed that demand and purchase-order lead time are known with certainty. Retailers who are uncertain about demand, lead time, or the quantity that suppliers can provide, hold safety stock. Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model. Safety stock is used as a buffer against unexpected increases in demand, uncertainty about lead time, and unavailability of stock from suppliers. Suppose that in the CD World example, the only uncertainty is about demand. CD World’s managers will have some notion (usually based on experience) of the range of weekly demand. CD World’s managers expect demand to be 250 packages per week, but they feel that a maximum demand of 400 packages per week Exhibit 20-2

Inventory in Units

1,000

Inventory Level of Compact Disks at CD Worlda Reorder point

Reorder point 500

0 Weeks

3 Lead time

2 weeks

7 Lead time

2 weeks

a This exhibit assumes that demand and purchase-order lead time are certain: Demand ! 250 CD packages per week Purchase-order lead time ! 2 weeks

This handy but special formula does not apply when receipt of the order fails to increase inventory to the reorder-point quantity (for example, when lead time is three weeks and the order is a one-week supply). In these cases, orders will overlap.

708 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

may occur. If stockout costs are very high, CD World will hold a safety stock of 300 packages and incur higher carrying costs. The 300 packages equal the maximum excess demand of 150 (400 - 250) packages per week times the two weeks of purchaseorder lead time. If stockout costs are minimal, CD World will hold no safety stocks and avoid incurring the additional carrying costs. A frequency distribution based on prior daily or weekly levels of demand forms the basis for computing safety-stock levels. Assume that one of the following levels of demand will occur over the two-week purchase-order lead time at CD World. Total Demand for 2 Weeks Probability (sums to 1.00)

200 Units 300 Units 400 Units 500 Units 600 Units 700 Units 800 Units 0.06 0.09 0.20 0.30 0.20 0.09 0.06

We see that 500 units is the most likely level of demand for two weeks because it has the highest probability of occurrence. We see also a 0.35 probability that demand will be 600, 700, or 800 packages (0.20 + 0.09 + 0.06 = 0.35). If a customer wants to buy compact disks and the store has none in stock, CD World can “rush” them to the customer at an additional cost to CD World of $4 per package. The relevant stockout costs in this case are $4 per package. The optimal safety-stock level is the quantity of safety stock that minimizes the sum of annual relevant stockout and carrying costs. Note that CD World will place 13 orders per year and will incur the same ordering costs whatever level of safety stock it chooses. Therefore, ordering costs are irrelevant for the safety-stock decision. Recall that the relevant carrying cost for CD World is $5.20 per package per year. Exhibit 20-3 tabulates annual relevant total stockout and carrying costs when the reorder point is 500 units. Over the two-week purchase-order lead time, stockouts can occur if demand is 600, 700, or 800 units because these levels of demand exceed the 500 units in stock at the time CD World places the purchase orders. Consequently, CD World only evaluates safety stock levels of 0, 100, 200, and 300 units. If safety stock is 0 units, CD World will Exhibit 20-3

Safety Stock Level in Units (1) 0

1 2 3 4 5 6 7 8

Computation of Safety Stock for CD World When Reorder Point Is 500 Units

Demand Levels Stockout Probability Resulting a in Units of Stockout in Stockouts (2) (3) = (2) – 500 – (1) (4) 600 100 0.20 700 200 0.09 800 300 0.06

Relevant Stockout b Costs (5) = (3) × $4 $ 400 800 1,200

Number of Orders c per Year (6) 13 13 13

9 10

100

700 800

100 200

0.09 0.06

400 800

13 13

200 300

800 -

100 -

0.06 -

400 -

13 -

11 12 13 14 15 16 17 18 19 20 21 22

Expected Relevant Relevant Stockout Total Carrying d e Costs Costs Costs (7) = (4) × (5) × (6) (8) = (1) × $5.20 (9) = (7) + (8) $1,040 936 936 $2,912 $ 0 $2,912 $ 468 624 $1,092 $ 520 $1,612 $ 312 $1,040 $1,352 $ 0f $1,560 $1,560

Demand level resulting in stockouts – Inventory available during lead time (excluding safety stock), 500 units – Safety stock. Stockout in units × Relevant stockout costs of $4.00 per unit. c Annual demand, 13,000 ÷ 1,000 EOQ = 13 orders per year. d Probability of stockout × Relevant stockout costs × Number of orders per year. e Safety stock × Annual relevant carrying costs of $5.20 per unit (assumes that safety stock is on hand at all times and that there is no overstocking caused by decreases in expected usage). f At a safety stock level of 300 units, no stockout will occur and, hence, expected stockout costs = $0. b

ESTIMATING INVENTORY-RELATED RELEVANT COSTS AND THEIR EFFECTS " 709

incur stockout costs if demand is 600, 700, or 800 units but will have no additional carrying costs. At the other extreme, if safety stock is 300 units, CD World will never incur stockout costs but will have higher carrying costs. As Exhibit 20-3 shows, annual relevant total stockout and carrying costs would be the lowest ($1,352) when a safety stock of 200 packages is maintained. Therefore, 200 units is the optimal safety-stock level. Consider the 200 units of safety stock as extra stock that CD World maintains. For example, CD World’s total inventory of compact disks at the time of reordering its EOQ of 1,000 units would be 700 units (the reorder point of 500 units plus safety stock of 200 units).

Decision Point What does the EOQ decision model help managers do and how do managers decide on the level of safety stocks?

Estimating Inventory-Related Relevant Costs and Their Effects Just as we did in earlier chapters, we need to determine which costs are relevant when making and evaluating inventory management decisions. We next describe the estimates that need to be made to calculate the annual relevant carrying costs of inventory, stockout costs, and ordering costs.

Considerations in Obtaining Estimates of Relevant Costs Relevant inventory carrying costs consist of the relevant incremental costs plus the relevant opportunity cost of capital. What are the relevant incremental costs of carrying inventory? Only those costs of the purchasing company, such as warehouse rent, warehouse workers’ salaries, costs of obsolescence, costs of shrinkage, and costs of breakage, that change with the quantity of inventory held. Salaries paid to clerks, stock keepers, and materials handlers are irrelevant if they are unaffected by changes in inventory levels. Suppose, however, that as inventories increase (decrease), total salary costs increase (decrease) as clerks, stock keepers, and materials handlers are added (transferred to other activities or laid off). In this case, salaries paid are relevant costs of carrying inventory. Similarly, costs of storage space owned that cannot be used for other profitable purposes when inventories decrease are irrelevant. But if the space has other profitable uses, or if total rental cost is tied to the amount of space occupied, storage costs are relevant costs of carrying inventory. What is the relevant opportunity cost of capital? It is the return forgone by investing capital in inventory rather than elsewhere. It is calculated as the required rate of return multiplied by the per-unit costs such as the purchase price of units, incoming freight, and incoming inspection. Opportunity costs are not computed on investments (say, in buildings) if these investments are unaffected by changes in inventory levels. In the case of stockouts, the relevant incremental cost is the cost of expediting an order from a supplier. The relevant opportunity cost is (1) the lost contribution margin on sales forgone because of the stockout and (2) lost contribution margin on future sales forgone as a result of customer ill will. Relevant ordering costs are only those ordering costs that change with the number of orders placed (for example, costs of preparing and issuing purchase orders and receiving and inspecting materials).

Cost of a Prediction Error Predicting relevant costs is difficult and seldom flawless, which raises the question, “What is the cost when actual relevant costs differ from the estimated relevant costs used for decision making?” Let’s revisit the CD World example. Suppose relevant ordering costs per purchase order are $100, while the manager predicts them to be $200 at the time of calculating the order quantity. We can calculate the cost of this “prediction” error using a threestep approach. Step 1: Compute the Monetary Outcome from the Best Action That Could Be Taken, Given the Actual Amount of the Cost Input (Cost per Purchase Order). This is the benchmark, the decision the manager would have made if the manager had known the correct

Learning Objective

Identify the effect of errors that can arise when using the EOQ decision model . . . errors in predicting parameters have a small effect on costs and ways to reduce conflicts between the EOQ model and models used for performance evaluation . . . by making the two models congruent

710 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

ordering cost against which actual performance can be measured. Using D = 13,000 packages per year, P = $100, and C = $5.20 per package per year, EOQ = =

2DP A C

2 * 13,000 * $100 = 2500,000 A $5.20

= 707 packages (rounded)

Annual relevant total costs when EOQ = 707 packages are as follows: RTC = =

QC DP + Q 2 707 * $5.20 13,000 * $100 + 707 2

= $1,839 + $1,838 = $3,677

Step 2: Compute the Monetary Outcome from the Best Action Based on the Incorrect Predicted Amount of the Cost Input (Cost per Purchase Order). In this step, the manager calculates the order quantity based on the prediction (that later proves to be wrong) that the ordering cost is $200. If the relevant ordering cost per purchase order is predicted to be $200, the best action is to purchase 1,000 packages in each order (p. 706). The actual cost of the purchase order turns out to be $100 so the actual annual relevant total costs when D = 13,000 packages per year, Q = 1,000 packages, P = $100, and C = $5.20 per package per year are as follows: RTC =

13,000 * $100 1,000 * $5.20 + 1,000 2

= $1,300 + $2,600 = $3,900

Step 3: Compute the Difference Between the Monetary Outcomes from Step 1 and Step 2.

Step 1 Step 2 Difference

Monetary Outcome $3,677 ƒ3,900 $ƒ(223)

The cost of the prediction error, $223, is less than 7% of the relevant total costs of $3,677. Note that the annual relevant-total-costs curve in Exhibit 20-1 is somewhat flat over the range of order quantities from 650 to 1,300 units. The square root in the EOQ model dampens the effect of errors in predicting parameters because taking square roots results in the incorrect numbers becoming smaller. In the next section, we consider a planning-and-control and performance-evaluation issue that frequently arises when managing inventory. Decision Point What is the effect on costs of errors in predicting parameters of the EOQ model? How can companies reduce the conflict between the EOQ decision model and models used for performance evaluation?

Conflict Between the EOQ Decision Model and Managers’ Performance Evaluation What happens if the order quantity calculated based on the EOQ decision model differs from the order quantity that managers making inventory management decisions would choose to make their own performance look best? For example, because there are no opportunity costs recorded in financial accounting systems, conflicts may arise between the EOQ model’s optimal order quantity and the order quantity that purchasing managers (who are evaluated on financial accounting numbers) will regard as optimal. As a result of ignoring some carrying costs (the opportunity costs), managers will be inclined to purchase larger lot sizes of materials than the lot sizes calculated according to the EOQ model. To achieve congruence between the EOQ decision model and managers’ performance evaluations, companies such as Wal-Mart design performance-evaluation

JUST-IN-TIME PURCHASING " 711

models that charge managers responsible for managing inventory levels with carrying costs that include a required return on investment.

Just-in-Time Purchasing Just-in-time (JIT) purchasing is the purchase of materials (or goods) so that they are delivered just as needed for production (or sales). Consider JIT purchasing for HewlettPackard’s (HP’s) manufacture of computer printers. HP has long-term agreements with suppliers for the major components of its printers. Each supplier is required to make frequent deliveries of small orders directly to the production floor, based on the production schedule that HP gives its suppliers. Suppliers work hard to keep their commitments because failure to deliver components on time, or to meet agreed-upon quality standards, can cause an HP assembly plant not to meet its own scheduled deliveries for printers.

JIT Purchasing and EOQ Model Parameters

Learning Objective

Describe why companies are using just-in-time purchasing . . . high carrying costs, low ordering costs, highquality suppliers, and reliable supply chains

Companies moving toward JIT purchasing to reduce their costs of carrying inventories (parameter C in the EOQ model) say that, in the past, carrying costs have actually been much greater than estimated because costs of warehousing, handling, shrinkage, and investment have not been fully identified. At the same time, the cost of placing a purchase order (parameter P in the EOQ model) is decreasing because of the following: #

Companies are establishing long-term purchasing agreements that define price and quality terms over an extended period. Individual purchase orders covered by those agreements require no additional negotiation regarding price or quality. Companies are using electronic links to place purchase orders at a cost that is estimated to be a small fraction of the cost of placing orders by telephone or by mail. Companies are using purchase-order cards (similar to consumer credit cards such as VISA and MasterCard). As long as purchasing personnel stay within preset total and individual-transaction dollar limits, traditional labor-intensive procurement-approval procedures are not required.

Exhibit 20-4 tabulates the sensitivity of CD World’s EOQ (p. 705) to changes in carrying and ordering costs. Exhibit 20-4 supports JIT purchasing because, as relevant carrying costs increase and relevant ordering costs per purchase order decrease, EOQ decreases and ordering frequency increases.

Relevant Costs of JIT Purchasing JIT purchasing is not guided solely by the EOQ model. The EOQ model is designed only to emphasize the trade-off between relevant carrying and ordering costs. However, inventory management also includes purchasing costs, stockout costs, costs of quality, and shrinkage costs. We next present the calculation of relevant costs in a JIT purchasing decision. Exhibit 20-4 A

Economic Order Quantity in Units At Different Ordering and Carrying Costs

1 2 3

Annual Demand (D) =

13,000 units

4 5 6 7 8 9 10

Relevant Carrying Costs Per Package per Year (C) $ 5.20 7.00 10.00 15.00

Relevant Ordering Costs per Purchase Order (P) $ 200 $150 $100 $ 30 1,000 866 707 387 862 746 609 334 721 624 510 279 589 510 416 228

Sensitivity of EOQ to Variations in Relevant Ordering and Carrying Costs for CD World

712 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

Exhibit 20-5

Annual Relevant Costs of Current Purchasing Policy and JIT Purchasing Policy for CD World

Quantity Per Year

Total Costs

(6) 13,0 00 130 c 50

(7) = (5) × (6) $182,260 260 105

Relevant Costs Under

JIT Purchasing Policy

Current Purchasing Policy

Relevant Items

(1 ) 5 Purchasing costs 6 Ordering costs Opportunity carrying costs 4

Relevant Cost Per Unit (2) $14.00 per unit 2.00 per order a 2.10 per unit of average inventory per year

Other carrying costs (insurance, materials handling, and so on)

3.10 per unit of average inventory per year

Stockout costs

4.00 per unit

Quantity Per Year

Total Costs

(3) 13,000 13 b 500

(4) = (2) × (3) $182,000 26 1,050

500

Relevant Cost Per Unit (5) $14.02 per unit 2.00 per order a 2.10 per unit of average inventory per year

1,550

3.10 per unit of average inventory per year

4.00 per unit

$184,626

10 Total annual relevant costs

155

150

600 $183,380

$1,246

Annual difference in favor of JIT 11 purchasing 12 a

Purchasing cost per unit × 0.15 per year Order quantity ÷ 2 = 1,000 ÷ 2 = 500 units c 15 Order quantity ÷ 2 = 100 ÷ 2 = 50 units

CD World has recently established an Internet business-to-business purchase-order link with Sontek. CD World triggers a purchase order for compact disks by a single computer entry. Payments are made electronically for batches of deliveries, rather than for each individual delivery. These changes reduce the ordering cost from $200 to only $2 per purchase order! CD World will use the Internet purchase-order link whether or not it shifts to JIT purchasing. CD World is negotiating to have Sontek deliver 100 packages of disks 130 times per year (5 times every 2 weeks), instead of delivering 1,000 packages 13 times per year, as shown in Exhibit 20-1. Sontek is willing to make these frequent deliveries, but it would add $0.02 to the price per package. As before, CD World’s required rate of return on investment is 15% and the annual relevant carrying cost of insurance, materials handling, shrinkage, breakage, and the like is $3.10 per package per year. Also assume that CD World incurs no stockout costs under its current purchasing policy, because demand and purchase-order lead times during each four-week period are known with certainty. CD World is concerned that lower inventory levels from implementing JIT purchasing will lead to more stockouts, because demand variations and delays in supplying disks are more likely in the short time intervals between orders delivered under JIT purchasing. Sontek has flexible manufacturing processes that enable it to respond rapidly to changing demand patterns. Nevertheless, CD World expects to incur stockout costs on 150 compact disk packages per year under the JIT purchasing policy. When a stockout occurs, CD World must rush-order compact disk packages from another supplier at an additional cost of $4 per package. Should CD World implement the JIT purchasing option of 130 deliveries per year? Exhibit 20-5 compares CD World’s relevant total costs under the current purchasing policy and the JIT policy, and it shows net cost savings of $1,246 per year by shifting to a JIT purchasing policy.

Supplier Evaluation and Relevant Costs of Quality and Timely Deliveries Companies that implement JIT purchasing choose their suppliers carefully and develop long-term supplier relationships. Some suppliers are better positioned than others to support JIT purchasing. For example, Frito-Lay, a supplier of potato chips and other snack foods, has a corporate strategy that emphasizes service, consistency, freshness, and quality of the delivered products. As a result, the company makes deliveries to retail outlets more frequently than many of its competitors.

JUST-IN-TIME PURCHASING " 713

Exhibit 20-6

Annual Relevant Costs of Purchasing from Sontek and Denton

Sontek

Relevant Items

(1) 5 Purchasing costs 6 Ordering costs 7 Inspection costs 4

Relevant Cost Per Unit (2) $14.02 per unit 2.00 per order 0.05 per unit a

Opportunity carrying costs

Total Costs

(3) 13,000 130 0

(4) = (2) × (3) $182,260 260 0

Total Costs

(6) 13,0 00 130 13,0 00

(7) = (5) × (6) $179,400 260 650

155

3.00 per unit of average inventory per year

0 150

0 600

3.10 per unit of average inventory per year

10 Customer return costs

10.00 per unit returned 4.00 per unit

12 Total annual relevant costs 13 Annual difference in favor of Sontek

(5) $13.80 per unit 2.00 per order 0.05 per unit 2.07 per unit of average inventory per year

Other carrying costs (insurance, 9 materials handling, and so on)

10.00 per unit returned 4.00 per unit

$183,380 $1,873

14 15

Purchasing cost per unit × 0.15 per year Order quantity ÷ 2 = 100 ÷ 2 = 50 units c 17 2.5% of units returned × 13,000 units

What are the relevant total costs when choosing suppliers? Consider again CD World. Denton Corporation, another supplier of disks, offers to supply all of CD World’s compact disk needs at a price of $13.80 per package, less than Sontek’s price of $14.02, under the same JIT delivery terms that Sontek offers. Denton proposes an Internet purchase-order link identical to Sontek’s link, making CD World’s ordering cost $2 per purchase order. CD World’s relevant cost of insurance, materials handling, breakage, and the like would be $3.00 per package per year if it purchases from Denton, versus $3.10 if it purchases from Sontek. Should CD World buy from Denton? To answer this, we need to consider the relevant costs of quality and delivery performance. CD World has used Sontek in the past and knows that Sontek will deliver quality disks on time. In fact, CD World does not even inspect the compact disk packages that Sontek supplies and therefore incurs zero inspection costs. Denton, however, does not enjoy such a sterling reputation for quality. CD World anticipates the following negative aspects of using Denton:

Quantity Per Year

105

11 Stockout costs

Relevant Cost Per Unit

Denton Quantity Per Year

2.10 per unit of average inventory per year

Relevant Cost of Purchasing From

Inspection cost of $0.05 per package. Average stockouts of 360 packages per year requiring rush orders at an additional cost of $4 per package. Product returns of 2.5% of all packages sold due to poor compact disk quality. CD World estimates an additional cost of $10 to handle each returned package.

Exhibit 20-6 shows the relevant total costs of purchasing from Sontek and Denton. Even though Denton is offering a lower price per package, there is a net cost savings of $1,873 per year by purchasing disks from Sontek. Selling Sontek’s high-quality compact disks also enhances CD World’s reputation and increases customer goodwill, which could lead to higher sales and profitability in the future.

JIT Purchasing, Planning and Control, and Supply-Chain Analysis The levels of inventories held by retailers are influenced by the demand patterns of their customers and supply relationships with their distributors and manufacturers, the suppliers to their manufacturers, and so on. The supply chain describes the flow of goods,

325 360

103

150

3,250 1,440 $185,253

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Decision Point Why are companies using just-in-time purchasing?

services, and information from the initial sources of materials and services to the delivery of products to consumers, regardless of whether those activities occur in the same company or in other companies. Retailers can purchase inventories on a JIT basis only if activities throughout the supply chain are properly planned, coordinated, and controlled. Procter and Gamble’s (P&G’s) experience with its Pampers product illustrates the gains from supply-chain coordination. Retailers selling Pampers encountered variability in weekly demand because families purchased disposable diapers randomly. Anticipating even more demand variability and lacking information about available inventory with P&G, retailers’ orders to P&G became more variable that, in turn, increased variability of orders at P&G’s suppliers, resulting in high levels of inventory at all stages in the supply chain. How did P&G respond to these problems? By sharing information and planning and coordinating activities throughout the supply chain among retailers, P&G, and P&G’s suppliers. Sharing sales information reduced the level of uncertainty that P&G and its suppliers had about retail demand for Pampers and led to (1) fewer stockouts at the retail level, (2) reduced manufacture of Pampers not immediately needed by retailers, (3) fewer manufacturing orders that had to be “rushed” or “expedited,” and (4) lower inventories held by each company in the supply chain. The benefits of supply chain coordination at P&G have been so great that retailers such as Wal-Mart have contracted with P&G to manage Wal-Mart’s retail inventories on a just-in-time basis. This practice is called supplier- or vendor-managed inventory. Supply-chain management, however, has challenges in sharing accurate, timely, and relevant information about sales, inventory, and sales forecasts caused by problems of communication, trust, incompatible information systems, and limited people and financial resources.

Inventory Management, MRP and JIT Production Learning Objective

Distinguish materials requirements planning (MRP) systems . . . manufacturing products based on demand forecasts from just-in-time (JIT) systems for manufacturing . . . manufacturing products only upon receiving customer orders

We now turn our attention away from purchasing to managing production inventories in manufacturing companies. Managers at manufacturing companies have developed numerous systems to plan and implement inventory activities within their plants. We consider two widely used types of systems: materials requirements planning (MRP) and just-in-time (JIT) production.

Materials Requirements Planning Materials requirements planning (MRP) is a “push-through” system that manufactures finished goods for inventory on the basis of demand forecasts. To determine outputs at each stage of production, MRP uses (1) demand forecasts for final products; (2) a bill of materials detailing the materials, components, and subassemblies for each final product; and (3) available inventories of materials, components, and products. Taking into account the lead time required to purchase materials and to manufacture components and finished products, a master production schedule specifies the quantity and timing of each item to be produced. Once production starts as scheduled, the output of each department is pushed through the production line. This “push through” can sometimes result in an accumulation of inventory when workstations receive work they are not yet ready to process. Maintaining accurate inventory records and costs is critical in an MRP system. For example, after becoming aware of the full costs of carrying finished goods inventory in its MRP system, National Semiconductor contracted with Federal Express to airfreight its microchips from a central location in Singapore to customer sites worldwide, instead of storing products at geographically dispersed warehouses. This change enabled National to move products from plant to customer in 4 days rather than 45 days and to reduce distribution costs from 2.6% to 1.9% of revenues. These benefits subsequently led National to outsource all its shipping activities to Federal Express. MRP is a push-through approach. We now consider JIT production, a “demand-pull” approach, which is used by companies such as Toyota in the automobile industry, Dell in the computer industry, and Braun in the appliance industry.

INVENTORY MANAGEMENT, MRP AND JIT PRODUCTION " 715

JIT Production Just-in-time (JIT) production, which is also called lean production, is a “demand-pull” manufacturing system that manufactures each component in a production line as soon as, and only when, needed by the next step in the production line. In a JIT production line, manufacturing activity at any particular workstation is prompted by the need for that workstation’s output at the following workstation. Demand triggers each step of the production process, starting with customer demand for a finished product at the end of the process and working all the way back to the demand for direct materials at the beginning of the process. In this way, demand pulls an order through the production line. The demand-pull feature of JIT production systems achieves close coordination among workstations. It smooths the flow of goods, despite low quantities of inventory. JIT production systems aim to simultaneously (1) meet customer demand in a timely manner (2) with high-quality products and (3) at the lowest possible total cost.

Decision Point How do materials requirements planning (MRP) systems differ from just-in-time (JIT) production systems?

Features of JIT Production Systems A JIT production system has these features: #

Production is organized in manufacturing cells, groupings of all the different types of equipment used to make a given product. Materials move from one machine to another, and various operations are performed in sequence, minimizing materials-handling costs. Workers are hired and trained to be multiskilled and capable of performing a variety of operations and tasks, including minor repairs and routine equipment maintenance. Defects are aggressively eliminated. Because of the tight links between workstations in the production line and the minimal inventories at each workstation, defects arising at one workstation quickly affect other workstations in the line. JIT creates an urgency for solving problems immediately and eliminating the root causes of defects as quickly as possible. Low levels of inventories allow workers to trace problems to and solve problems at earlier workstations in the production process, where the problems likely originated. Setup time, the time required to get equipment, tools, and materials ready to start the production of a component or product, and manufacturing cycle time, the time from when an order is received by manufacturing until it becomes a finished good, are reduced. Setup costs correspond to the ordering costs P in the EOQ model. Reducing setup time and costs makes production in smaller batches economical, which in turn reduces inventory levels. Reducing manufacturing cycle time enables a company to respond faster to changes in customer demand (see also Concepts in Action, p. 717). Suppliers are selected on the basis of their ability to deliver quality materials in a timely manner. Most companies implementing JIT production also implement JIT purchasing. JIT plants expect JIT suppliers to make timely deliveries of high-quality goods directly to the production floor.

We next present a relevant-cost analysis for deciding whether to implement a JIT production system.

Financial Benefits of JIT and Relevant Costs Early advocates saw the benefit of JIT production as lower carrying costs of inventory. But there are other benefits of lower inventories: heightened emphasis on improving quality by eliminating the specific causes of rework, scrap, and waste, and lower manufacturing cycle times. In computing the relevant benefits and costs of reducing inventories in JIT production systems, the cost analyst should take into account all benefits and all costs. Consider Hudson Corporation, a manufacturer of brass fittings. Hudson is considering implementing a JIT production system. To implement JIT production, Hudson must incur $100,000 in annual tooling costs to reduce setup times. Hudson expects that JIT will reduce average inventory by $500,000 and that relevant costs of insurance, storage, materials handling, and setup will decline by $30,000 per year. The company’s required rate of return on

Learning Objective

Identify the features and benefits of a just-in-time production system . . . for example, organizing work in manufacturing cells, improving quality, and reducing manufacturing lead time to reduce costs and earn higher margins

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inventory investments is 10% per year. Should Hudson implement a JIT production system? On the basis of the information provided, we would be tempted to say “no,” because annual relevant total cost savings amount to $80,000 [(10% of $500,000) + $30,000)], which is less than the additional annual tooling costs of $100,000. Our analysis, however, is incomplete. We have not considered the other benefits of lower inventories in JIT production. Hudson estimates that implementing JIT will improve quality and reduce rework on 500 units each year, resulting in savings of $50 per unit. Also, better quality and faster delivery will allow Hudson to charge $2 more per unit on the 20,000 units that it sells each year. The annual relevant benefits and costs from implementing JIT equal the following: Incremental savings in insurance, storage, materials handling, and set up Incremental savings in inventory carrying costs (10% * $500,000) Incremental savings from reduced rework ($50 per unit * 500 units) Additional contribution margin from better quality and faster delivery ($2 per unit * 20,000 units) Incremental annual tooling costs Net incremental benefit

$ 30,000 50,000 25,000 40,000 (100,000) $ƒƒ45,000

Therefore, Hudson should implement a JIT production system.

JIT in Service Industries JIT purchasing and production methods can be applied in service industries as well. For example, inventories and supplies, and the associated labor costs to manage them, represent more than a third of the costs in most hospitals. By implementing a JIT purchasing and distribution system, Eisenhower Memorial Hospital in Palm Springs, California, reduced its inventories and supplies by 90% in 18 months. McDonald’s has adapted JIT production practices to making hamburgers.3 Before, McDonald’s precooked a batch of hamburgers that were placed under heat lamps to stay warm until ordered. If the hamburgers didn’t sell within a specified period of time, they were discarded resulting in high inventory holding costs and spoilage costs. Moreover, the quality of hamburgers deteriorated the longer they sat under the heat lamps. Finally, customers placing a special order for a hamburger (such as a hamburger with no cheese) had to wait for the hamburger to be cooked. Today, the use of new technology (including an innovative bun toaster) and JIT production practices allow McDonald’s to cook hamburgers only when they are ordered, significantly reducing inventory holding and spoilage costs. More importantly, JIT has improved customer satisfaction by increasing the quality of hamburgers and reducing the time needed for special orders. We next turn our attention to planning and control in JIT production systems.

Enterprise Resource Planning (ERP) Systems4 The success of a JIT production system hinges on the speed of information flows from customers to manufacturers to suppliers. Information flows are a problem for large companies that have fragmented information systems spread over dozens of unlinked computer systems. Enterprise Resource Planning (ERP) systems improve these information flows. An ERP system is an integrated set of software modules covering accounting, distribution, manufacturing, purchasing, human resources, and other functions. ERP uses a single database to collect and feed data into all software applications, allowing integrated, real-time information sharing and providing visibility to the company’s business processes as a whole. For example, using an ERP system, a salesperson can 3 4

Charles Atkinson, “McDonald’s, A Guide to the Benefits of JIT,” Inventory Management Review, www.inventorymanagementreview.org/2005/11/mcdonalds_a_gui.html (accessed May 2, 2007). For an excellent discussion, see T. H. Davenport, “Putting the Enterprise into the Enterprise System,” Harvard Business Review, (July–August 1998); also see A. Cagilo, “Enterprise Resource Planning Systems and Accountants: Towards Hybridization?” European Accounting Review, (May 2003).

INVENTORY MANAGEMENT, MRP AND JIT PRODUCTION " 717

Concepts in Action

After the Encore: Just-in-Time Live Concert Recordings

Each year, millions of music fans flock to concerts to see artists ranging from Lady Gaga to rock-band O.A.R. Although many of them stop by the merchandise stand to pick up a t-shirt or poster after the show ends, they increasingly have another option: buying a professional recording of the concert they just saw! Just-in-time production, enabled by recent advances in audio and computer technology, now allows fans to relive the live concert experience just a few minutes after the final chord is played. Live concert recordings have long been hampered by production and distribution difficulties. Traditionally, fans could only hear these recordings via unofficial “bootleg” cassettes or CDs. Occasionally, artists would release official live albums between studio releases. Further, live albums typically sold few copies, and retail outlets that profit from volume-driven merchandise turnover, like Best Buy, were somewhat reluctant to carry them. Enter instant concert recordings. Organizations such as Adreea, Concert Live, and Live Nation employ microphones, recording and audio mixing hardware and software, and an army of high-speed computers to produce concert recordings during the show. As soon as each song is complete, engineers burn that track onto hundreds of CDs or USB drives. At the end of the show, they have to burn only one last song. Once completed, the CDs or USB drives are packaged and rushed to merchandise stands throughout the venue for instant sale. There are, of course, some limitations to this technology. With such a quick turnaround time, engineers cannot edit or remaster any aspect of the show. Also, although just-in-time live recordings work successfully in smaller venues, the logistics for arenas, amphitheatres, and stadiums are much more difficult. Despite these concerns, the benefits of this new technology include sound-quality assurance, near-immediate production turnaround, and low finished-goods carrying costs. These recordings can also be distributed through Apple’s iTunes platform and artist Web sites, making live recordings more accessible than ever. With such opportunities, it’s no wonder that bands like O.A.R. augment their existing CD sales with just-in-time recordings. Sources: Buskirk, Eliot Van. 2009. Apple unveils ‘live music’ in iTunes. Wired. “Epicenter,” blog November 24. www.wired.com/epicenter/2009/11/ apple-unveils-live-music-in-itunes/ Chartrand, Sabra. 2004. How to take the concert home. New York Times, May 3. www.nytimes.com/2004/05/03/ technology/03patent.html Daily Telegraph. 2009. Online exclusive: How Concert Live co-founders overcame barriers. February 3. www.telegraph.co.uk/ sponsored/business/businesstruth/diary_of_a/4448290/Online-Exclusive-How-Concert-Live-co-founders-overcame-barriers.html Humphries, Stephen. 2003. Get your official ‘bootleg’ here. Christian Science Monitor, November 21. www.csmonitor.com/2003/1121/p16s01-almp.html Websites: Live O.A.R. http://liveoar.com/store/first_index.php Aderra. www.aderra.net/ Concert Live. www.concertlive.co.uk/

generate a contract for a customer in Germany, verify the customer’s credit limits, and place a production order. The system then uses this same information to schedule manufacturing in, say, Brazil, requisition materials from inventory, order components from suppliers, and schedule shipments. At the same time, it credits sales commissions to the salesperson and records all the costing and financial accounting information. ERP systems give lower-level managers, workers, customers, and suppliers access to detailed and timely operating information. This benefit, coupled with tight coordination across business functions of the value chain, enables ERP systems to shift manufacturing and distribution plans rapidly in response to changes in supply and demand. Companies believe that an ERP system is essential to support JIT initiatives because of the effect it has on lead times. Using an ERP system, Autodesk, a maker of computer-aided design software, reduced order lead time from two weeks to one day; and Fujitsu reduced lead time from 18 days to 1.5 days. ERP systems are large and unwieldy. Because of its complexity, suppliers of ERP systems such as SAP and Oracle provide software packages that are standard but that can be customized, although at considerable cost. Without some customization, unique and distinctive features that confer strategic advantage will not be available. The challenge when implementing ERP systems is to strike the proper balance between the lower cost of standardized systems and the strategic benefits that accrue from customization.

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Performance Measures and Control in JIT Production In addition to personal observation, managers use financial and nonfinancial measures to evaluate and control JIT production. We describe these measures and indicate the effect that JIT systems are expected to have on these measures. 1. Financial performance measures, such as inventory turnover ratio (Cost of goods sold , Average inventory), which is expected to increase 2. Nonfinancial performance measures of inventory, quality, and time such as the following: # Number of days of inventory on hand, expected to decrease # Units produced per hour, expected to increase #

Number of units scrapped or requiring rework , expected to decrease Total number of units started and completed

Manufacturing cycle time, expected to decrease

Total setup time for machines , expected to decrease Total manufacturing time

Personal observation and nonfinancial performance measures provide the most timely, intuitive, and easy to understand measures of manufacturing performance. Rapid, meaningful feedback is critical because the lack of inventories in a demand-pull system makes it urgent to detect and solve problems quickly. JIT measures can also be incorporated into the four perspectives of the balanced scorecard (financial, customer, internal business process, and learning and growth). The logic is as follows: Multiskilled, and well-trained employees (learning and growth measures) improve internal business processes measured by the preceding inventory, quality, and time measures. As operational performance improves, customer satisfaction also increases because of greater flexibility, responsiveness, and quality resulting in better financial performance from lower purchasing, inventory holding, and quality costs, and higher revenues.

Effect of JIT Systems on Product Costing Decision Point What are the features and benefits of a JIT production system?

By reducing materials handling, warehousing, and inspection, JIT systems reduce overhead costs. JIT systems also aid in direct tracing of some costs usually classified as indirect. For example, the use of manufacturing cells makes it cost-effective to trace materials handling and machine operating costs to specific products or product families made in these cells. These costs then become direct costs of those products. Also, the use of multiskilled workers in these cells allows the costs of setup, maintenance, and quality inspection to be traced as direct costs. These changes have prompted some companies using JIT to adopt simplified product costing methods that dovetail with JIT production and that are less costly to operate than the traditional costing systems described in Chapters 4, 7, 8, and 17. We examine two of these methods next: backflush costing and lean accounting.

Backflush Costing Learning Objective

Describe different ways backflush costing can simplify traditional inventory-costing systems . . . for example, by not recording journal entries for work in process, purchase of materials, or production of finished goods

Organizing manufacturing in cells, reducing defects and manufacturing cycle time, and ensuring timely delivery of materials enables purchasing, production, and sales to occur in quick succession with minimal inventories. The absence of inventories makes choices about cost-flow assumptions (such as weighted average or first-in, first-out) or inventory-costing methods (such as absorption or variable costing) unimportant: All manufacturing costs of the accounting period flow directly into cost of goods sold. The rapid conversion of direct materials into finished goods that are immediately sold greatly simplifies the costing system.

Simplified Normal or Standard Costing Systems Traditional normal or standard-costing systems (Chapters 4, 7, 8, and 17) use sequential tracking, which is a costing system in which recording of the journal entries occurs in the same order as actual purchases and progress in production. Costs are tracked sequentially as products pass through each of the following four stages:

BACKFLUSH COSTING " 719 Stage A

Stage B

Stage C

Stage D

Purchase of Direct Materials and Incurring of Conversion Costs

Production Resulting in Work in Process

Completion of Good Finished Units of Product

Sale of Finished Goods

Dr: Work-in-Process Control Cr: Materials Inventory Cr: Conversion Costs Allocated

Dr: Finished Goods Control Cr: Work-in-Process Control

Dr: Cost of Goods Sold Cr: Finished Goods Control

Dr: Materials Inventory Cr: Accounts Payable Control Dr: Conversion Costs Control Cr: Various Accounts (such as Wages Payable)

Dr or Cr: Cost of Goods Sold Dr: Conversion Costs Allocated Cr: Conversion Costs Control

A sequential-tracking costing system has four trigger points, corresponding to Stages A, B, C, and D. A trigger point is a stage in the cycle, from purchase of direct materials and incurring of conversion costs (Stage A) to sale of finished goods (Stage D), at which journal entries are made in the accounting system. The journal entries (with Dr. representing debits and Cr. representing credits) for each stage are displayed below the box for that stage (as described in Chapter 4). An alternative approach to sequential tracking is backflush costing. Backflush costing is a costing system that omits recording some of the journal entries relating to the stages from purchase of direct materials to the sale of finished goods. When journal entries for one or more stages are omitted, the journal entries for a subsequent stage use normal or standard costs to work backward to “flush out” the costs in the cycle for which journal entries were not made. When inventories are minimal, as in JIT production systems, backflush costing simplifies costing systems without losing much information. Consider the following data for the month of April for Silicon Valley Computer (SVC), which produces keyboards for personal computers. #

There are no beginning inventories of direct materials and no beginning or ending work-in-process inventories. SVC has only one direct manufacturing cost category (direct materials) and one indirect manufacturing cost category (conversion costs). All manufacturing labor costs are included in conversion costs. From its bill of materials and an operations list (description of operations to be undergone), SVC determines that the standard direct material cost per keyboard unit is $19 and the standard conversion cost is $12. SVC purchases $1,950,000 of direct materials. To focus on the basic concepts, we assume SVC has no direct materials variances. Actual conversion costs equal $1,260,000. SVC produces 100,000 good keyboard units and sells 99,000 units. Any underallocated or overallocated conversion costs are written off to cost of goods sold at the end of April.

We use three examples to illustrate backflush costing. They differ in the number and placement of trigger points. Example 1: The three trigger points for journal entries are Purchase of direct materials and incurring of conversion costs (Stage A), Completion of good finished units of product (Stage C), and Sale of finished goods (Stage D). Note that there is no journal entry for Production resulting in work in process (Stage B) because JIT production has minimal work in process. SVC records two inventory accounts: Type Combined materials inventory and materials in work in process Finished goods

Account Title Materials and In-Process Inventory Control Finished Goods Control

Exhibit 20-7, Panel A, summarizes the journal entries for Example 1 with three trigger points: Purchase of direct materials and incurring of conversion costs, Completion of good

720 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

Exhibit 20-7

Journal Entries and General Ledger Overview for Backflush Costing and Journal Entries for Sequential Tracking with Three Trigger Points: Purchase of Direct Materials and Incurring of Conversion Costs, Completion of Good Finished Units of Product, and Sale of Finished Goods

PANEL A: Journal Entries

Backflush Costing

Sequential Tracking

Stage A: Record Purchase of Direct Materials and Incurring of Conversion Costs 1. Record Direct Materials Purchased. Entry (A1) Materials and In-Process Inventory Control Accounts Payable Control 2. Record Conversion Costs Incurred. Entry (A2) Conversion Costs Control Various accounts (such as Wages Payable Control)

1,950,000

Materials Inventory Control Accounts Payable Control

1,950,000

1,260,000

Conversion Costs Control Various accounts (such as Wages Payable Control)

Work-in-Process Control Materials Inventory Control Conversion Costs Allocated

3,100,000

Finished Goods Control Work-in-Process Control

3,100,000

1,260,000

1,950,000

1,260,000

Stage B: Record Production Resulting in Work in Process. Entry (B1)

No Entry Recorded

1,900,000 1,200,000

Stage C: Record Cost of Good Finished Units Completed. Entry (C1)

Finished Goods Control 3,100,000 Materials and In-Process Inventory Control 1,900,000 Conversion Costs Allocated 1,200,000

3,100,000

Stage D: Record Cost of Finished Goods Sold (and Under- or Overallocated Conversion Costs). 1. Record Cost of Finished Goods Sold. Entry (D1) Cost of Goods Sold Finished Goods Control

3,069,000 3,069,000

2. Record Underallocated or Overallocated Conversion Costs. Entry (D2) Conversion Costs Allocated 1,200,000 Cost of Goods Sold 60,000 Conversion Costs Control 1,260,000

Cost of Goods Sold Finished Goods Control

3,069,000

Conversion Costs Allocated Cost of Goods Sold Conversion Costs Control

1,200,000 60,000

3,069,000

1,260,000

PANEL B: General Ledger Overview for Backflush Costing

Direct Materials

Materials and In-Process Inventory Control

Finished Goods Control

(A1) 1,950,000 (C1) 1,900,000

(C1) 3,100,000 (D1) 3,069,000

Bal. 50,000

Bal.

Cost of Goods Sold (D1) 3,069,000

31,000

Conversion Costs Allocated (D2) 1,200,000 (C1) 1,200,000 Conversion Costs

(D2) Conversion Costs Control

60,000 3,129,000

(A2) 1,260,000 (D2) 1,260,000

The coding that appears in parentheses for each entry indicates the stage in the production process that the entry relates to as presented in the text.

BACKFLUSH COSTING " 721

finished units of product, and Sale of finished goods (and recognizing under- or overallocated costs). For each stage, the backflush costing entries for SVC are shown on the left. The comparable entries under sequential tracking (costing) are shown on the right. Consider first the entries for purchase of direct materials and incurring of conversion costs (Stage A). As described earlier, the inventory account under backflush costing combines direct materials and work in process. When materials are purchased, these costs increase (are debited to) Materials and In-Process Inventory Control. Under the sequential tracking approach, the direct materials and work in process accounts are separate, so the purchase of direct materials is debited to Materials Inventory Control. Actual conversion costs are recorded as incurred under backflush costing, just as in sequential tracking, and they increase (are debited to) Conversion Costs Control. Next consider the entries for production resulting in work in process (Stage B). Recall that 100,000 units were started into production in April and that the standard cost for the units produced is $31 ($19 direct materials + $12 conversion costs) per unit. Under backflush costing, no entry is recorded in Stage B because work-in-process inventory is minimal and all units are quickly converted to finished goods. Under sequential tracking, work-in-process inventory is increased as manufacturing occurs and later decreased as manufacturing is completed and the product becomes a finished good. The entries to record completion of good finished units of product (Stage C) gives backflush costing its name. Costs have not been recorded sequentially with the flow of product along its production route through work in process and finished goods. Instead, the output trigger point reaches back and pulls (“flushes”) the standard direct material costs from Materials and In-Process Inventory Control and the standard conversion costs for manufacturing the finished goods. Under the sequential tracking approach, Finished Goods Control is debited (increased) and Work-in-Process Control is credited (decreased) as manufacturing is completed and finished goods are produced. The net effect of Stages B and C under sequential tracking is the same as the effect under backflush costing (except for the name of the inventory account). Finally consider entries to record the sale of finished goods (and under- or overallocated conversion costs) (Stage D). The standard cost of 99,000 units sold in April equals $3,069,000 (99,000 units * $31 per unit). The entries to record the cost of finished goods sold are exactly the same under backflush costing and sequential tracking. Actual conversion costs may be underallocated or overallocated in an accounting period. Chapter 4 (pp. 117–122) discussed various ways to dispose of underallocated or overallocated manufacturing overhead costs. Companies that use backflush costing typically have low inventories, so proration of underallocated or overallocated conversion costs between work in process, finished goods, and cost of goods sold is seldom necessary. Many companies write off underallocated or overallocated conversion costs to cost of goods sold only at the end of the fiscal year. Other companies, like SVC, record the write-off monthly. The journal entry to dispose of the difference between actual conversion costs incurred and standard conversion costs allocated is exactly the same under backflush costing and sequential tracking. The April 30 ending inventory balances under backflush costing are as follows: Materials and In-Process Inventory Control ($1,950,000 - $1,900,000) Finished Goods Control, 1,000 units * $31/unit ($3,100,000 - $3,069,000) Total

$50,000 ƒ31,000 $81,000

The April 30 ending inventory balances under sequential tracking would be exactly the same except that the inventory account would be Materials Inventory Control. Exhibit 20-7, Panel B (p. 720), provides a general-ledger overview of this version of backflush costing. The elimination of the typical Work-in-Process Control account reduces the amount of detail in the accounting system. Units on the production line may still be tracked in physical terms, but there is “no assignment of costs” to specific work orders while they are in the production cycle. In fact, there are no work orders or labor-time records in the accounting system. The three trigger points to make journal entries in Example 1 will lead SVC’s backflush costing system to report costs that are similar to the costs reported under sequential tracking when SVC has minimal work-in-process inventory. In Example 1, any inventories of direct materials or finished goods are recognized in SVC’s backflush costing system when they first

722 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

appear (as would be done in a costing system using sequential tracking). International Paper Company uses a method similar to Example 1 in its specialty papers plant. Accounting for Variances Accounting for variances between actual and standard costs is

basically the same under all standard-costing systems. The procedures are described in Chapters 7 and 8. Suppose that in Example 1, SVC had an unfavorable direct materials price variance of $42,000. Then the journal entry would be as follows: Materials and In-Process Inventory Control Direct Materials Price Variance Accounts Payable Control

1,950,000 42,000 1,992,000

Direct material costs are often a large proportion of total manufacturing costs, sometimes well over 60%. Consequently, many companies will at least measure the direct materials efficiency variance in total by physically comparing what remains in direct materials inventory against what should remain based on the output of finished goods for the accounting period. In our example, suppose that such a comparison showed an unfavorable materials efficiency variance of $30,000. The journal entry would be as follows: Direct Materials Efficiency Variance Materials and In-Process Inventory Control

30,000 30,000

The underallocated or overallocated conversion costs are split into various overhead variances (spending variance, efficiency variance, and production-volume variance), as explained in Chapter 8. Each variance is closed to cost of goods sold, if it is immaterial in amount. Example 2: The two trigger points are Purchase of direct materials and incurring of conversion costs (Stage A) and Sale of finished goods (Stage D). This example uses the SVC data to illustrate a backflush costing that differs more from sequential tracking than the backflush costing in Example 1. This example and Example 1 have the same first trigger point, purchase of direct materials and incurring of conversion costs. But the second trigger point in Example 2 is the sale, not the completion, of finished goods. Note that in this example, there is no journal entry for Production resulting in work in progress (Stage B) and Completion of good finished units of product (Stage C) because there are minimal work in process and finished goods inventories. In this example, there is only one inventory account: direct materials, whether they are in storerooms, in process, or in finished goods. Type Combines direct materials inventory and any direct materials in work-in-process and finished goods inventories

Account Title Inventory Control

Exhibit 20-8, Panel A, summarizes the journal entries for Example 2 with two trigger points: Purchase of direct materials and incurring of conversion costs, and Sale of finished goods (and recognizing under- or overallocated costs). As in Example 1, for each stage, the backflush costing entries for SVC are shown on the left. The comparable entries under sequential tracking are shown on the right. The entries for direct materials purchased and conversion costs incurred (Stage A) are the same as in Example 1, except that the inventory account is called Inventory Control. As in Example 1, no entry is made to record production of work-in-process inventory (Stage B) because work-in-process inventory is minimal. When finished goods are completed (Stage C), no entry is recorded because the completed units are expected to be sold quickly and finished goods inventory is expected to be minimal. As finished goods are sold (Stage D), the cost of goods sold is calculated as 99,000 units sold * $31 per unit = $3,069,000, which is composed of direct material costs (99,000 units * $19 per unit = $1,881,000) and conversion costs allocated (99,000 units * $12 per unit = $1,188,000). This is the same Cost of Goods Sold calculated under sequential tracking as described in Example 1.

BACKFLUSH COSTING " 723

Exhibit 20-8

Journal Entries and General Ledger Overview for Backflush Costing and Journal Entries for Sequential Tracking with Two Trigger Points: Purchase of Direct Materials and Incurring of Conversion Costs and Sale of Finished Goods

PANEL A: Journal Entries

Backflush Costing

Sequential Tracking

Stage A: Record Purchase of Direct Materials and Incurring of Conversion Costs 1. Record Direct Materials Purchased. Entry (A1) Inventory: Control Accounts Payable Control

1,950,000

2. Record Conversion Costs Incurred. Entry (A2) Conversion Costs Control Various accounts (such as Wages Payable Control)

Materials Inventory Control Accounts Payable Control

1,950,000

1,260,000

Conversion Costs Control Various accounts (such as Wages Payable Control)

Work-in-Process Control Materials Inventory Control Conversion Costs Allocated

3,100,000

Finished Goods Control Work-in-Process Control

3,100,000

1,260,000

1,950,000

1,260,000

Stage B: Record Production Resulting in Work in Process. Entry (B1)

No Entry Recorded

1,900,000 1,200,000

Stage C: Record Cost of Good Finished Units Completed. Entry (C1)

No Entry Recorded

3,100,000

Stage D: Record Cost of Finished Goods Sold (and Under- or Overallocated Conversion Costs). 1. Record Cost of Finished Goods Sold. Entry (D1) Cost of Goods Sold Inventory Control Conversion Costs Allocated

3,069,000 1,881,000 1,188,000

2. Record Underallocated or Overallocated Conversion Costs. Entry (D2) Conversion Costs Allocated 1,188,000 Cost of Goods Sold 72,000 Conversion Costs Control 1,260,000

Cost of Goods Sold Finished Goods Control

3,069,000

Conversion Costs Allocated Cost of Goods Sold Conversion Costs Control

1,200,000 60,000

3,069,000

PANEL B: General Ledger Overview for Backflush Costing

Inventory Control Direct Materials

(A1) 1,950,000 (D1) 1,881,000

Cost of Goods Sold (D1) 3,069,000

Bal. 69,000 Conversion Costs Allocated (D2) 1,188,000 (D1) 1,188,000

Conversion Costs

(D2) Conversion Costs Control

72,000 3,141,000

(A2) 1,260,000 (D2) 1,260,000

The coding that appears in parentheses for each entry indicates the stage in the production process that the entry relates to as presented in the text.

1,260,000

724 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

Under this method of backflush costing, conversion costs are not inventoried because no entries are recorded when finished goods are produced in Stage C. That is, compared with sequential tracking, Example 2 does not assign $12,000 ($12 per unit * 1,000 units) of conversion costs to finished goods inventory produced but not sold. Of the $1,260,000 in conversion costs, $1,188,000 is allocated at standard cost to the units sold. The remaining $72,000 ($1,260,000 - $1,188,000) of conversion costs is underallocated. Entry (D2) presents the journal entry if SVC, like many companies, writes off these underallocated costs monthly as additions to cost of goods sold. The April 30 ending balance of Inventory Control is $69,000 ($1,950,000 $1,881,000). This balance represents the $50,000 direct materials still on hand + $19,000 direct materials embodied in the 1,000 good finished units manufactured but not sold during the period. Exhibit 20-8, Panel B, provides a general-ledger overview of Example 2. The approach described in Example 2 closely approximates the costs computed using sequential tracking when a company holds minimal work-in-process and finished goods inventories. Toyota’s cost accounting system at its Kentucky plant is similar to this example. Two advantages of this system are (1) it removes the incentive for managers to produce for inventory because conversion costs are recorded as period costs instead of inventoriable costs and (2) it focuses managers on sales. Example 3: The two trigger points are Completion of good finished units of product (Stage C) and Sale of finished goods (Stage D). This example has two trigger points. In contrast to Example 2, the first trigger point in Example 3 is delayed until Stage C, SVC’s completion of good finished units of product. Note that in this example, there are no journal entries for Purchase of direct materials and incurring of conversion costs (Stage A) and Production resulting in work in process (Stage B) because there are minimal direct materials and work-in-process inventories. Exhibit 20-9, Panel A, summarizes the journal entries for Example 3 with two trigger points: Completion of good finished units of product and Sale of finished goods (and recognizing under- or overallocated costs). As in Examples 1 and 2, for each stage, the backflush costing entries for SVC are shown on the left. The comparable entries under sequential tracking are shown on the right. No entry is made for direct materials purchases of $1,950,000 (Stage A) because the acquisition of direct materials is not a trigger point in this form of backflush costing. As in Examples 1 and 2, actual conversion costs are recorded as incurred and no entry is made to record production resulting in work-in-process inventory (Stage B). The cost of 100,000 good finished units completed (Stage C) is recorded at standard cost of $31 ($19 direct materials + $12 conversion costs) per unit as in Example 1 except that Accounts Payable Control is credited (instead of Materials and In-Process Inventory Control) because no entry had been made when direct materials were purchased in Stage A. Note that at the end of April, $50,000 of direct materials purchased have not yet been placed into production ($1,950,000 - $1,900,000 = $50,000), nor have the cost of those direct materials been entered into the inventory-costing system. The Example 3 version of backflush costing is suitable for a JIT production system in which both direct materials inventory and work-inprocess inventory are minimal. As finished goods are sold (Stage D), the cost of goods sold is calculated as 99,000 units sold * $31 per unit = $3,069,000. This is the same Cost of Goods sold calculated under sequential tracking. Finished Goods Control has a balance of $31,000 under both this form of backflush costing and sequential tracking. The journal entry to dispose of the difference between actual conversion costs incurred and standard conversion costs allocated is the same under backflush costing and sequential tracking. The only difference between this form of backflush costing and sequential tracking is that direct materials inventory of $50,000 (and the corresponding Accounts Payable Control) is not recorded, which is no problem if direct materials inventories are minimal. Exhibit 20-9, Panel B, provides a general-ledger overview of Example 3.

BACKFLUSH COSTING " 725

Exhibit 20-9

Journal Entries and General Ledger Overview for Backflush Costing and Journal Entries for Sequential Tracking with Two Trigger Points: Completion of Good Finished Units of Product and Sale of Finished Goods

PANEL A: Journal Entries

Backflush Costing

Sequential Tracking

Stage A: Record Purchase of Direct Materials and Incurring of Conversion Costs. 1. Record Direct Materials Purchased. Entry (A1) No Entry Recorded 2. Record Conversion Costs Incurred. Entry (A2) Conversion Costs Control Various accounts (such as Wages Payable Control)

1,260,000 1,260,000

Materials Inventory Control Accounts Payable Control

1,950,000

Conversion Costs Control Various accounts (such as Wages Payable Control)

1,260,000

Work-in-Process Control Materials Inventory Control Conversion Costs Allocated

3,100,000

Finished Goods Control Work-in-Process Control

3,100,000

1,950,000

1,260,000

Stage B: Record Production Resulting in Work in Process. Entry (B1)

No Entry Recorded

1,900,000 1,200,000

Stage C: Record Cost of Good Finished Units Completed. Entry (C1)

Finished Goods Control Accounts Payable Control Conversion Costs Allocated

3,100,000 1,900,000 1,200,000

3,100,000

Stage D: Record Cost of Finished Goods Sold (and Under- or Overallocated Conversion Costs). 1. Record Cost of Finished Goods Sold. Entry (D1) Cost of Goods Sold Finished Goods Control

3,069,000 3,069,000

2. Record Underallocated or Overallocated Conversion Costs. Entry (D2) Conversion Costs Allocated 1,200,000 Cost of Goods Sold 60,000 Conversion Costs Control 1,260,000

Cost of Goods Sold Finished Goods Control

3,069,000

Conversion Costs Allocated Cost of Goods Sold Conversion Costs Control

1,200,000 60,000

3,069,000

1,260,000

PANEL B: General Ledger Overview for Backflush Costing

Finished Goods Control Direct Materials

(C1) 3,100,000 (D1) 3,069,000 Bal.

Cost of Goods Sold (D1) 3,069,000

31,000

Conversion Costs Allocated (D2) 1,200,000 Conversion Costs

(C1) 1,200,000 (D2)

Conversion Costs Control (A2) 1,260,000

60,000 3,129,000

(D2) 1,260,000

The coding that appears in parentheses for each entry indicates the stage in the production process that the entry relates to as presented in the text.

726 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

Extending Example 3, backflush costing systems could use the sale of finished goods as the only trigger point. This version of backflush costing is most suitable for a JIT production system with minimal direct materials, work-in-process, and finished goods inventories. That’s because this backflush costing system maintains no inventory accounts.

Special Considerations in Backflush Costing The accounting procedures illustrated in Examples 1, 2, and 3 do not strictly adhere to generally accepted accounting principles (GAAP). For example, work in process inventory, which is an asset, exists although it is not recognized in the financial accounting system. Advocates of backflush costing, however, cite the generally accepted accounting principle of materiality in support of the various versions of backflush costing. As the three examples illustrate, backflush costing can approximate the costs that would be reported under sequential tracking by varying the number of trigger points and where they are located. If significant amounts of direct materials inventory or finished goods inventory exist, adjusting entries can be incorporated into backflush costing (as explained next). Suppose there are material differences in operating income and inventories based on a backflush costing system and a conventional standard-costing system. A journal entry can be recorded to adjust the backflush number to satisfy GAAP. For example, the backflush entries in Example 2 would result in expensing all conversion costs to Cost of Goods Sold ($1,188,000 at standard costs + $72,000 write-off of underallocated conversion costs = $1,260,000). But suppose conversion costs were regarded as sufficiently material in amount to be included in Inventory Control. Then entry (D2) in Example 2, closing the Conversion Costs accounts, would change as follows: Original entry (D2) Conversion Costs Allocated Cost of Goods Sold Conversion Costs Control Revised entry (D2) Conversion Costs Allocated Inventory Control (1,000 units * $12) Cost of Goods Sold Conversion Costs Control

Decision Point How does backflush costing simplify traditional inventory costing?

1,188,000 72,000 1,260,000 1,188,000 12,000 60,000 1,260,000

Critics say backflush costing leaves no audit trails—the ability of the accounting system to pinpoint the uses of resources at each step of the production process. However, the absence of sizable amounts of materials inventory, work-in-process inventory, and finished goods inventory means managers can keep track of operations by personal observations, computer monitoring, and nonfinancial measures. What are the implications of JIT and backflush costing systems for activity-based costing (ABC) systems? Simplifying the production process, as in a JIT system, makes more of the costs direct and reduces the extent of overhead cost allocations. Simple ABC systems are often adequate for companies implementing JIT. These simple ABC systems work well with backflush costing. Costs from ABC systems yield more-accurate budgeted conversion cost per unit for different products in the backflush costing system. The activity-based cost information is also useful for product costing, decision making, and cost management.

Lean Accounting Learning Objective

Understand the principles of lean accounting . . . focus on costing value streams rather than products, and limit arbitrary allocations

Another approach for simplified product costing in JIT (or lean production) systems is lean accounting. Successful JIT production requires companies to focus on the entire value chain of business functions (from suppliers to manufacturing to customers) in order to reduce inventories, lead times, and waste. The emphasis on improvements throughout the value chain has led some JIT companies to develop organization structures and costing systems that focus on value streams, which are all the value-added activities needed to design, manufacture, and deliver a given product or product line to customers. For example, a value stream can include the activities needed to develop and engineer products, advertise and market those products, process orders, purchase and receive materials, manufacture and ship orders, bill customers, and collect payments. The focus on value streams is aided by the use of manufacturing cells in JIT systems that group together the operations needed to make a given product or product line.

LEAN ACCOUNTING " 727

Lean accounting is a costing method that supports creating value for customers by costing the value streams, as distinguished from individual products or departments, thereby eliminating waste in the accounting process.5 If multiple, related products are made in a single value stream, product costs for the individual products are not computed. Actual costs are directly traced to the value stream and standard costs and variances are not computed. Tracing direct costs to value streams is simple because companies using lean accounting dedicate resources to individual value streams. Consider the following product costs for Allston Company that makes two models of designer purses in one manufacturing cell and two models of designer wallets in another manufacturing cell.

Revenues Direct materials Direct manufacturing labor Manufacturing overhead costs (e.g., equipment lease, supervision, and unused facility costs) Rework costs Design costs Marketing and sales costs Total costs Operating income Direct materials purchased Unused facility costs

Purses Model A Model B $600,000 $700,000 340,000 400,000 70,000 78,000 112,000 15,000 20,000 ƒƒ30,000 ƒ587,000 $ƒ13,000 $350,000 $ 22,000

Wallets Model C Model D $800,000 $550,000 410,000 270,000 105,000 82,000

130,000 17,000 21,000 ƒƒ33,000 ƒ679,000 $ƒ21,000 $420,000 $ 38,000

128,000 14,000 24,000 ƒƒ40,000 ƒ721,000 $ƒ79,000 $430,000 $ 18,000

103,000 10,000 18,000 ƒƒ28,000 ƒ511,000 $ƒ39,000 $285,000 $ 15,000

Using lean accounting principles, Allston calculates value-stream operating costs and operating income for purses and wallets, not individual models, as follows:

Revenues ($600,000 + $700,000; $800,000 + $550,000) Direct material purchases ($350,000 + $420,000; $430,000 + $285,000) Direct manufacturing labor (70,000 + $78,000; $105,000 + $82,000) Manufacturing overhead (after deducting unused facility costs) ($112,000 – $22,000) + ($130,000 – $38,000); ($128,000 – $18,000) + $103,000 – $15,000) Design costs ($20,000 + $21,000; $24,000 + $18,000) Marketing and sales costs ($30,000 + $33,000; $40,000 + $28,000) Total value stream operating costs Value stream operating income

Purses

Wallets

$1,300,000

$1,350,000

770,000

715,000

148,000

187,000

182,000

198,000

41,000

42,000

ƒƒƒƒ63,000 ƒ1,204,000 $ƒƒƒ96,000

ƒƒƒƒ68,000 ƒ1,210,000 $ƒƒ140,000

Allston Company, like many lean accounting systems, expenses the costs of all purchased materials in the period in which they are bought to signal that direct material and work-in-process inventory need to be reduced. In our example, the cost of direct material purchases under lean accounting exceeds the cost of direct materials used in the operating income statement. Facility costs (such as depreciation, property taxes, and leases) are allocated to value streams based on the square footage used by each value stream to encourage managers to use less space for holding and moving inventory. Note that unused facility costs are subtracted when calculating manufacturing overhead costs of value streams. These costs are instead treated as plant or business unit expenses. Excluding unused facility costs from value stream costs means that only those costs that add value are included in value-stream costs. 5

See B. Baggaley, “Costing by Value Stream,” Journal of Cost Management (May–June 2003).

728 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

Decision Point How is lean accounting different from traditional costing systems?

Moreover, increasing the visibility of unused capacity costs creates incentives to reduce these costs or to find alternative uses for capacity. Allston Company excludes rework costs when calculating value-stream costs and operating income because these costs are nonvalue-added costs. Companies also exclude from value stream costs common costs such as corporate or support department costs that cannot reasonably be assigned to value streams. The analysis indicates that while total cost for purses is $1,266,000 ($587,000 + $679,000), the value stream cost using lean accounting is $1,204,000 (95.1% of $1,266,000), indicating significant opportunities for improving profitability by reducing unused facility and rework costs, and by purchasing direct materials only as needed for production. Wallets portray a different picture. Total cost for wallets is $1,232,000 ($721,000 + $511,000) while the value-stream cost using lean accounting is $1,210,000 (98.2% of $1,232,000). The wallets value stream has low unused facility and rework costs and is more efficient. Lean accounting is much simpler than traditional product costing. Why? Because calculating actual product costs by value streams requires less overhead allocation. Compared to traditional product costing methods, the focus on value streams and costs is consistent with the emphasis of JIT and lean production on improvements in the value chain from suppliers to customers. Moreover, the practices that lean accounting encourages (such as reducing direct material and work-in-process inventories, improving quality, using less space, and eliminating unused capacity) reflect the goals of JIT production. A potential limitation of lean accounting is that it does not compute costs for individual products. Critics charge that this limits its usefulness for decision making. Proponents of lean accounting argue that the lack of individual product costs is not a problem because most decisions are made at the product line level rather than the individual product level, and that pricing decisions are based on the value created for the customer (market prices) and not product costs. Another criticism is that lean accounting excludes certain support costs and unused capacity costs. As a result, the decisions based on only value stream costs will look profitable because they do not consider all costs. Supporters argue that lean accounting overcomes this problem by adding a larger markup on value stream costs to compensate for some of these excluded costs. Moreover, in a competitive market, prices will eventually settle at a level that represents a reasonable markup above value stream costs because customers will be unwilling to pay for nonvalue-added costs. The goal must therefore be to eliminate nonvalue-added costs. A final criticism is that lean accounting, like backflush costing, does not correctly account for inventories under generally accepted accounting principles (GAAP). However, proponents are quick to point out that in lean accounting environments, work in process and finished goods inventories are immaterial from an accounting perspective.

Problems for Self-Study Problem 1 Lee Company has a Singapore plant that manufactures MP3 players. One component is an XT chip. Expected demand is for 5,200 of these chips in March 2011. Lee estimates the ordering cost per purchase order to be $250. The monthly carrying cost for one unit of XT in stock is $5. Required

1. Compute the EOQ for the XT chip. 2. Compute the number of deliveries of XT in March 2011.

Solution EOQ =

2 * 5,200 * $250 $5

= 721 chips (rounded) Number of deliveries =

5,200 721

= 8 (rounded)

DECISION POINTS " 729

Problem 2 Littlefield Company uses a backflush costing system with three trigger points: # # #

Purchase of direct materials Completion of good finished units of product Sale of finished goods

There are no beginning inventories. Information for April 2011 is as follows: Direct materials purchased Direct materials used Conversion costs incurred

$880,000 $850,000 $422,000

Conversion costs allocated Costs transferred to finished goods Cost of goods sold

$ 400,000 $1,250,000 $1,190,000

1. Prepare journal entries for April (without disposing of underallocated or overallocated conversion costs). Assume there are no direct materials variances. 2. Under an ideal JIT production system, how would the amounts in your journal entries differ from the journal entries in requirement 1?

Required

Solution 1. Journal entries for April are as follows: Entry (A1) Materials and In-Process Inventory Control Accounts Payable Control (direct materials purchased) Entry (A2) Conversion Costs Control Various accounts (such as Wages Payable Control) (conversion costs incurred) Entry (C1) Finished Goods Control Materials and In-Process Inventory Control Conversion Costs Allocated (standard cost of finished goods completed) Entry (D1) Cost of Goods Sold Finished Goods Control (standard costs of finished goods sold)

880,000 880,000 422,000 422,000 1,250,000 850,000 400,000 1,190,000 1,190,000

2. Under an ideal JIT production system, if the manufacturing lead time per unit is very short, there would be zero inventories at the end of each day. Entry (C1) would be $1,190,000 finished goods production [to match finished goods sold in entry (D1)], not $1,250,000. If the marketing department could only sell goods costing $1,190,000, the JIT production system would call for direct materials purchases and conversion costs of lower than $880,000 and $422,000, respectively, in entries (A1) and (A2).

Guidelines The six categories are purchasing costs (costs of goods acquired from suppliers), ordering costs (costs of preparing a purchase order and receiving goods), carrying costs (costs of holding inventory of goods for sale), stockout costs (costs arising when a customer demands a unit of product and that unit is not on hand), costs of quality (prevention, appraisal, internal failure, and external failure costs), and shrinkage costs (the costs resulting from theft by outsiders, embezzlement by employees, misclassifications, and clerical errors).

730 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

2. What does the EOQ decision model help managers do and how do managers decide on the level of safety stocks?

The economic-order-quantity (EOQ) decision model helps managers to calculate the optimal quantity of inventory to order by balancing ordering costs and carrying costs. The larger the order quantity, the higher the annual carrying costs and the lower the annual ordering costs. The EOQ model includes costs recorded in the financial accounting system as well as opportunity costs not recorded in the financial accounting system. Managers choose a level of safety stocks to minimize stock out costs and carrying costs of holding more inventory.

3. What is the effect on costs of errors in predicting parameters of the EOQ model? How can companies reduce the conflict between the EOQ decision model and models used for performance evaluation?

The cost of prediction errors when using the EOQ model is small. To reduce the conflict between the EOQ decision model and the performance evaluation model, companies should include the opportunity cost of investment when evaluating managers. The opportunity cost of investment tied up in inventory is a key input in the EOQ decision model that is often ignored in the performanceevaluation model.

4. Why are companies using just-in-time purchasing?

Just-in-time (JIT) purchasing is making purchases in small order quantities just as needed for production (or sales). JIT purchasing is a response to high carrying costs and low ordering costs. JIT purchasing increases the focus of companies and suppliers on quality and timely deliveries. Companies coordinate their activities and reduce inventories throughout the supply chain, from the initial sources of materials and services to the delivery of products to consumers.

5. How do materials requirements planning (MRP) systems differ from just-in-time (JIT) production systems?

Materials requirements planning (MRP) systems use a “push-through” approach that manufactures finished goods for inventory on the basis of demand forecasts. Just-in-time (JIT) production systems use a “demand-pull” approach in which goods are manufactured only to satisfy customer orders.

6. What are the features and benefits of a JIT production system?

JIT production systems (a) organize production in manufacturing cells, (b) hire and train multiskilled workers, (c) emphasize total quality management, (d) reduce manufacturing lead time and setup time, and (e) build strong supplier relationships. The benefits of JIT production include lower costs and higher margins from better flow of information, higher quality, and faster delivery.

7. How does backflush costing simplify traditional inventory costing?

Traditional inventory-costing systems use sequential tracking, in which recording of the journal entries occurs in the same order as actual purchases and progress in production. Most backflush costing systems do not record journal entries for the work-in-process stage of production. Some backflush costing systems also do not record entries for either the purchase of direct materials or the completion of finished goods.

8. How is lean accounting different from traditional costing systems?

Lean accounting costs value streams rather than products. Nonvalue-added costs, unused capacity costs and costs that cannot be easily traced to value streams are not allocated but instead expensed.

Terms to Learn This chapter and the Glossary at the end of the book contain definitions of the following important terms: backflush costing (p. 719) carrying costs (p. 704) economic order quantity (EOQ) (p. 704) inventory management (p. 703) just-in-time (JIT) production (p. 715) just-in-time (JIT) purchasing (p. 711) lean accounting (p. 727)

lean production (p. 715) manufacturing cells (p. 715) materials requirements planning (MRP) (p. 714) ordering costs (p. 704) purchase-order lead time (p. 704) purchasing costs (p. 703)

reorder point (p. 707) safety stock (p. 707) sequential tracking (p. 718) shrinkage costs (p. 704) stockout costs (p. 704) trigger point (p. 719) value streams (p. 726)

ASSIGNMENT MATERIAL " 731

Assignment Material Questions 20-1 Why do better decisions regarding the purchasing and managing of goods for sale frequently cause dramatic percentage increases in net income?

20-2 Name six cost categories that are important in managing goods for sale in a retail company. 20-3 What assumptions are made when using the simplest version of the economic-order-quantity (EOQ) decision model?

20-4 Give examples of costs included in annual carrying costs of inventory when using the EOQ decision model.

20-5 Give three examples of opportunity costs that typically are not recorded in accounting systems, although they are relevant when using the EOQ model in the presence of demand uncertainty.

20-6 What are the steps in computing the cost of a prediction error when using the EOQ decision model? 20-7 Why might goal-congruence issues arise when an EOQ model is used to guide decisions on how 20-8 20-9 20-10 20-11 20-12 20-13 20-14 20-15

much to order? Describe JIT purchasing and its benefits. What are three factors causing reductions in the cost to place purchase orders for materials? “You should always choose the supplier who offers the lowest price per unit.” Do you agree? Explain. What is supply-chain analysis, and how can it benefit manufacturers and retailers? What are the main features of JIT production? Distinguish inventory-costing systems using sequential tracking from those using backflush costing. Describe three different versions of backflush costing. Discuss the differences between lean accounting and traditional cost accounting.

Exercises 20-16 Economic order quantity for retailer. Fan Base (FB) operates a megastore featuring sports merchandise. It uses an EOQ decision model to make inventory decisions. It is now considering inventory decisions for its Los Angeles Galaxy soccer jerseys product line. This is a highly popular item. Data for 2011 are as follows: Expected annual demand for Galaxy jerseys Ordering cost per purchase order Carrying cost per year

10,000 $200 $7 per jersey

Each jersey costs FB $40 and sells for $80. The $7 carrying cost per jersey per year comprises the required return on investment of $4.80 (12% * $40 purchase price) plus $2.20 in relevant insurance, handling, and theft-related costs. The purchasing lead time is 7 days. FB is open 365 days a year. 1. Calculate the EOQ. 2. Calculate the number of orders that will be placed each year. 3. Calculate the reorder point.

Required

20-17 Economic order quantity, effect of parameter changes (continuation of 20-16). Athletic Textiles (AT) manufactures the Galaxy jerseys that Fan Base (FB) sells to its customers. AT has recently installed computer software that enables its customers to conduct “one-stop” purchasing using state-of-the-art Web site technology. FB’s ordering cost per purchase order will be $30 using this new technology. 1. Calculate the EOQ for the Galaxy jerseys using the revised ordering cost of $30 per purchase order. Assume all other data from Exercise 20-16 are the same. Comment on the result. 2. Suppose AT proposes to “assist” FB. AT will allow FB customers to order directly from the AT Web site. AT would ship directly to these customers. AT would pay $10 to FB for every Galaxy jersey purchased by one of FB’s customers. Comment qualitatively on how this offer would affect inventory management at FB. What factors should FB consider in deciding whether to accept AT’s proposal?

20-18 EOQ for a retailer. The Denim World sells fabrics to a wide range of industrial and consumer users. One of the products it carries is denim cloth, used in the manufacture of jeans and carrying bags. The supplier for the denim cloth pays all incoming freight. No incoming inspection of the denim is necessary because the supplier has a track record of delivering high-quality merchandise. The purchasing officer of the Denim World has collected the following information: Annual demand for denim cloth Ordering cost per purchase order Carrying cost per year Safety-stock requirements Cost of denim cloth

26,400 yards $165 20% of purchase costs None $9 per yard

Required

732 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

The purchasing lead time is 2 weeks. The Denim World is open 250 days a year (50 weeks for 5 days a week). Required

1. Calculate the EOQ for denim cloth. 2. Calculate the number of orders that will be placed each year. 3. Calculate the reorder point for denim cloth.

20-19 EOQ for manufacturer. Lakeland Company produces lawn mowers and purchases 18,000 units of a

rotor blade part each year at a cost of $60 per unit. Lakeland requires a 15% annual rate of return on investment. In addition, the relevant carrying cost (for insurance, materials handling, breakage, and so on) is $6 per unit per year. The relevant ordering cost per purchase order is $150.

Required

1. 2. 3. 4.

Calculate Lakeland’s EOQ for the rotor blade part. Calculate Lakeland’s annual relevant ordering costs for the EOQ calculated in requirement 1. Calculate Lakeland’s annual relevant carrying costs for the EOQ calculated in requirement 1. Assume that demand is uniform throughout the year and known with certainty so that there is no need for safety stocks. The purchase-order lead time is half a month. Calculate Lakeland’s reorder point for the rotor blade part.

20-20 Sensitivity of EOQ to changes in relevant ordering and carrying costs, cost of prediction error. Alpha Company’s annual demand for its only product, XT-590, is 10,000 units. Alpha is currently analyzing possible combinations of relevant carrying cost per unit per year and relevant ordering cost per purchase order, depending on the company’s choice of supplier and average levels of inventory. This table presents three possible combinations of carrying and ordering costs. Relevant Carrying Cost per Unit per Year $10 $20 $40 Required

Relevant Ordering Cost per Purchase Order $400 $200 $100

1. For each of the relevant ordering and carrying-cost alternatives, determine (a) EOQ and (b) annual relevant total costs. 2. How does your answer to requirement 1 give insight into the impact of changes in relevant ordering and carrying costs on EOQ and annual relevant total costs? Explain briefly. 3. Suppose the relevant carrying cost per unit per year was $20 and the relevant ordering cost per purchase order was $200. Suppose further that Alpha calculates EOQ after incorrectly estimating relevant carrying cost per unit per year to be $10 and relevant ordering cost per purchase order to be $400. Calculate the actual annual relevant total costs of Alpha’s EOQ decision. Compare this cost to the annual relevant total costs that Alpha would have incurred if it had correctly estimated the relevant carrying cost per unit per year of $20 and the relevant ordering cost per purchase order of $200 that you have already calculated in requirement 1. Calculate and comment on the cost of the prediction error.

20-21 Inventory management and the balanced scorecard. Devin Sports Cars (DSC) has implemented a balanced scorecard to measure and support its just-in-time production system. In the learning and growth category, DSC measures the percentage of employees who are cross-trained to perform a wide variety of production tasks. Internal business process measures are inventory turns and on-time delivery. The customer perspective is measured using a customer satisfaction measure and financial performance using operating income. DSC estimates that if it can increase the percentage of cross-trained employees by 5%, the resulting increase in labor productivity will reduce inventory-related costs by $100,000 per year and shorten delivery times by 10%. The 10% reduction in delivery times, in turn, is expected to increase customer satisfaction by 5%, and each 1% increase in customer satisfaction is expected to increase revenues by 2% due to higher prices. Required

1. Assume that budgeted revenues in the coming year are $5,000,000. Ignoring the costs of training, what is the expected increase in operating income in the coming year if the number of cross-trained employees is increased by 5%? 2. What is the most DSC would be willing to pay to increase the percentage of cross-trained employees if it is only interested in maximizing operating income in the coming year? 3. What factors other than short-term profits should DSC consider when assessing the benefits from employee cross-training?

20-22 JIT production, relevant benefits, relevant costs. The Champion Hardware Company manufactures specialty brass door handles at its Lynchburg plant. Champion is considering implementing a JIT production system. The following are the estimated costs and benefits of JIT production: a. Annual additional tooling costs would be $100,000. b. Average inventory would decline by 80% from the current level of $1,000,000.

ASSIGNMENT MATERIAL " 733

c. Insurance, space, materials-handling, and setup costs, which currently total $300,000 annually, would decline by 25%. d. The emphasis on quality inherent in JIT production would reduce rework costs by 30%. Champion currently incurs $200,000 in annual rework costs. e. Improved product quality under JIT production would enable Champion to raise the price of its product by $4 per unit. Champion sells 40,000 units each year. Champion’s required rate of return on inventory investment is 15% per year. 1. Calculate the net benefit or cost to Champion if it adopts JIT production at the Lynchburg plant. 2. What nonfinancial and qualitative factors should Champion consider when making the decision to adopt JIT production? 3. Suppose Champion implements JIT production at its Lynchburg plant. Give examples of performance measures Champion could use to evaluate and control JIT production. What would be the benefit of Champion implementing an enterprise resource planning (ERP) system?

Required

20-23 Backflush costing and JIT production. Road Warrior Corporation assembles handheld computers that have scaled-down capabilities of laptop computers. Each handheld computer takes six hours to assemble. Road Warrior uses a JIT production system and a backflush costing system with three trigger points: # # #

Purchase of direct materials and incurring of conversion costs Completion of good finished units of product Sale of finished goods

There are no beginning inventories of materials or finished goods and no beginning or ending work-inprocess inventories. The following data are for August 2011: Direct materials purchased Direct materials used

$2,754,000 $2,733,600

Conversion costs incurred Conversion costs allocated

$723,600 $750,400

Road Warrior records direct materials purchased and conversion costs incurred at actual costs. It has no direct materials variances. When finished goods are sold, the backflush costing system “pulls through” standard direct material cost ($102 per unit) and standard conversion cost ($28 per unit). Road Warrior produced 26,800 finished units in August 2011 and sold 26,400 units. The actual direct material cost per unit in August 2011 was $102, and the actual conversion cost per unit was $27. 1. Prepare summary journal entries for August 2011 (without disposing of under- or overallocated conversion costs). 2. Post the entries in requirement 1 to T-accounts for applicable Materials and In-Process Inventory Control, Finished Goods Control, Conversion Costs Control, Conversion Costs Allocated, and Cost of Goods Sold. 3. Under an ideal JIT production system, how would the amounts in your journal entries differ from those in requirement 1?

Required

20-24 Backflush costing, two trigger points, materials purchase and sale (continuation of 20-23). Assume the same facts as in Exercise 20-23, except that Road Warrior now uses a backflush costing system with the following two trigger points: # #

Purchase of direct materials and incurring of conversion costs Sale of finished goods

The Inventory Control account will include direct materials purchased but not yet in production, materials in work in process, and materials in finished goods but not sold. No conversion costs are inventoried. Any under- or overallocated conversion costs are written off monthly to Cost of Goods Sold. 1. Prepare summary journal entries for August, including the disposition of under- or overallocated conversion costs. 2. Post the entries in requirement 1 to T-accounts for Inventory Control, Conversion Costs Control, Conversion Costs Allocated, and Cost of Goods Sold.

Required

20-25 Backflush costing, two trigger points, completion of production and sale (continuation of 20-23). Assume the same facts as in Exercise 20-23, except now Road Warrior uses only two trigger points, Completion of good finished units of product and Sale of finished goods. Any under- or overallocated conversion costs are written off monthly to Cost of Goods Sold. 1. Prepare summary journal entries for August, including the disposition of under- or overallocated conversion costs. 2. Post the entries in requirement 1 to T-accounts for Finished Goods Control, Conversion Costs Control, Conversion Costs Allocated, and Cost of Goods Sold.

Required

734 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

Problems 20-26 Effect of different order quantities on ordering costs and carrying costs, EOQ. Soothing Meadow, a retailer of bed and bath linen, sells 380,000 packages of Mona Lisa designer sheets each year. Soothing Meadow incurs an ordering cost of $57 per purchase order placed with Mona Lisa Enterprises and an annual carrying cost of $12.00 per package. Liv Carrol, purchasing manager at Soothing Meadow, seeks your help: She wants to understand how ordering and carrying costs vary with order quantity. Scenario

Annual demand (packages) Cost per purchase order Carrying cost per package per year Quantity (packages) per purchase order Number of purchase orders per year Annual relevant ordering costs Annual relevant carrying costs Annual relevant total costs of ordering and carrying inventory Required

380,000 $ 57 $ 12.00 760

380,000 $ 57 $ 12.00 1,000

380,000 $ 57 $ 12.00 1,900

380,000 $ 57 $ 12.00 3,800

380,000 $ 57 $ 12.00 4,750

1. Complete the table for Liv Carrol. What is the EOQ? Comment on your results. 2. Mona Lisa is about to introduce a Web-based ordering system for its customers. Liv Carrol estimates that Soothing Meadow’s ordering costs will reduce to $30 per purchase order. Calculate the new EOQ and the new annual relevant costs of ordering and carrying inventory. 3. Liv Carrol estimates that Soothing Meadow will incur a cost of $2,150 to train its two purchasing assistants to use the new Mona Lisa system. Will Soothing Meadow recoup its training costs within the first year of adoption?

20-27 EOQ, uncertainty, safety stock, reorder point. Chadwick Shoe Co. produces and sells an excellent quality walking shoe. After production, the shoes are distributed to 20 warehouses around the country. Each warehouse services approximately 100 stores in its region. Chadwick uses an EOQ model to determine the number of pairs of shoes to order for each warehouse from the factory. Annual demand for Warehouse OR2 is approximately 120,000 pairs of shoes. The ordering cost is $250 per order. The annual carrying cost of a pair of shoes is $2.40 per pair. Required

1. Use the EOQ model to determine the optimal number of pairs of shoes per order. 2. Assume each month consists of approximately 4 weeks. If it takes 1 week to receive an order, at what point should warehouse OR2 reorder shoes? 3. Although OR2’s average weekly demand is 2,500 pairs of shoes (120,000 , 12 months , 4 weeks), demand each week may vary with the following probability distribution: Total demand for 1 week Probability (sums to 1.00)

2,000 pairs 0.04

2,250 pairs 0.20

2,500 pairs 0.52

2,750 pairs 0.20

3,000 pairs 0.04

If a store wants shoes and OR2 has none in stock, OR2 can “rush” them to the store at an additional cost of $2 per pair. How much safety stock should Warehouse OR2 hold? How will this affect the reorder point and reorder quantity?

20-28 MRP, EOQ, and JIT. Global Tunes Corp. produces J-Pods, music players that can download thou-

sands of songs. Global Tunes forecasts that demand in 2011 will be 48,000 J-Pods. The variable production cost of each J-Pod is $54. Due to the large $10,000 cost per setup, Global Tunes plans to produce J-Pods once a month in batches of 4,000 each. The carrying cost of a unit in inventory is $17 per year.

Required

1. Using an MRP system, what is the annual cost of producing and carrying J-Pods in inventory? (Assume that, on average, half of the units produced in a month are in inventory.) 2. A new manager at Global Tunes has suggested that the company use the EOQ model to determine the optimal batch size to produce. (To use the EOQ model, Global Tunes needs to treat the setup cost in the same way it would treat ordering cost in a traditional EOQ model.) Determine the optimal batch size and number of batches. Round up the number of batches to the nearest whole number. What would be the annual cost of producing and carrying J-Pods in inventory if it uses the optimal batch size? Compare this cost to the cost calculated in requirement 1. Comment briefly. 3. Global Tunes is also considering switching from an MRP system to a JIT system. This will result in producing J-Pods in batch sizes of 600 J-Pods and will reduce obsolescence, improve quality, and result in a higher selling price. The frequency of production batches will force Global Tunes to reduce setup

ASSIGNMENT MATERIAL " 735

time and will result in a reduction in setup cost. The new setup cost will be $500 per setup. What is the annual cost of producing and carrying J-Pods in inventory under the JIT system? 4. Compare the models analyzed in the previous parts of the problem. What are the advantages and disadvantages of each?

20-29 Effect of management evaluation criteria on EOQ model. Computers 4 U purchases one model of computer at a wholesale cost of $200 per unit and resells it to end consumers. The annual demand for the company’s product is 500,000 units. Ordering costs are $800 per order and carrying costs are $50 per computer, including $20 in the opportunity cost of holding inventory. 1. Compute the optimal order quantity using the EOQ model. 2. Compute a) the number of orders per year and b) the annual relevant total cost of ordering and carrying inventory. 3. Assume that when evaluating the manager, the company excludes the opportunity cost of carrying inventory. If the manager makes the EOQ decision excluding the opportunity cost of carrying inventory, the relevant carrying cost would be $30 not $50. How would this affect the EOQ amount and the actual annual relevant cost of ordering and carrying inventory? 4. What is the cost impact on the company of excluding the opportunity cost of carrying inventory when making EOQ decisions? Why do you think the company currently excludes the opportunity costs of carrying inventory when evaluating the manager’s performance? What could the company do to encourage the manager to make decisions more congruent with the goal of reducing total inventory costs?

Required

20-30 JIT purchasing, relevant benefits, relevant costs. (CMA, adapted) The Margro Corporation is an automotive supplier that uses automatic turning machines to manufacture precision parts from steel bars. Margro’s inventory of raw steel averages $600,000. John Oates, president of Margro, and Helen Gorman, Margro’s controller, are concerned about the costs of carrying inventory. The steel supplier is willing to supply steel in smaller lots at no additional charge. Gorman identifies the following effects of adopting a JIT inventory program to virtually eliminate steel inventory: #

Without scheduling any overtime, lost sales due to stockouts would increase by 35,000 units per year. However, by incurring overtime premiums of $40,000 per year, the increase in lost sales could be reduced to 20,000 units per year. This would be the maximum amount of overtime that would be feasible for Margro. Two warehouses currently used for steel bar storage would no longer be needed. Margro rents one warehouse from another company under a cancelable leasing arrangement at an annual cost of $60,000. The other warehouse is owned by Margro and contains 12,000 square feet. Three-fourths of the space in the owned warehouse could be rented for $1.50 per square foot per year. Insurance and property tax costs totaling $14,000 per year would be eliminated.

Margro’s required rate of return on investment is 20% per year. Margro’s budgeted income statement for the year ending December 31, 2011 (in thousands) is as follows: Revenues (900,000 units) Cost of goods sold Variable costs Fixed costs Total costs of goods sold Gross margin Marketing and distribution costs Variable costs Fixed costs Total marketing and distribution costs Operating income

$10,800 $4,050 ƒ1,450 ƒƒ5,500 5,300 $ 900 ƒ1,500 ƒƒ2,400 $ƒ2,900

1. Calculate the estimated dollar savings (loss) for the Margro Corporation that would result in 2011 from the adoption of JIT purchasing. 2. Identify and explain other factors that Margro should consider before deciding whether to adopt JIT purchasing.

20-31 Supply chain effects on total relevant inventory cost. Cow Spot Computer Co. outsources the production of motherboards for its computers. It is currently deciding which of two suppliers to use: Maji or Induk. Due to differences in the product failure rates across the two companies, 5% of motherboards purchased from Maji will be inspected and 25% of motherboards purchased from Induk will be inspected. The following data refers to costs associated with Maji and Induk.

Required

736 " CHAPTER 20 INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING METHODS

Number of orders per year Annual motherboards demanded Price per motherboard Ordering cost per order Inspection cost per unit Average inventory level Expected number of stockouts Stockout cost (cost of rush order) per stockout Units returned by customers for replacing motherboards Cost of replacing each motherboard Required annual return on investment Other carrying cost per unit per year Required

Maji 50 10,000 $93 $10 $5 100 units 100 $5 50 $25 10% $2.50

Induk 50 10,000 $90 $8 $5 100 units 300 $8 500 $25 10% $2.50

1. What is the relevant cost of purchasing from Maji and Induk? 2. What factors other than cost should Cow Spot consider?

20-32 Backflush costing and JIT production. The Rippel Corporation manufactures electrical meters. For August, there were no beginning inventories of direct materials and no beginning or ending work in process. Rippel uses a JIT production system and backflush costing with three trigger points for making entries in the accounting system: # # #

Purchase of direct materials and incurring of conversion costs Completion of good finished units of product Sale of finished goods

Rippel’s August standard cost per meter is direct material, $26, and conversion cost, $19. Rippel has no direct materials variances. The following data apply to August manufacturing: Direct materials purchased Conversion costs incurred Required

$546,000 $399,000

Number of finished units manufactured Number of finished units sold

20,000 19,000

1. Prepare summary journal entries for August (without disposing of under- or overallocated conversion costs). Assume no direct materials variances. 2. Post the entries in requirement 1 to T-accounts for Materials and In-Process Inventory Control, Finished Goods Control, Conversion Costs Control, Conversion Costs Allocated, and Cost of Goods Sold.

20-33 Backflush, two trigger points, materials purchase and sale (continuation of 20-32). Assume that the second trigger point for Rippel Corporation is the sale—rather than the completion—of finished goods. Also, the inventory account is confined solely to direct materials, whether these materials are in a storeroom, in work in process, or in finished goods. No conversion costs are inventoried. They are allocated to the units sold at standard costs. Any under- or overallocated conversion costs are written off monthly to Cost of Goods Sold. Required

1. Prepare summary journal entries for August, including the disposition of under- or overallocated conversion costs. Assume no direct materials variances. 2. Post the entries in requirement 1 to T-accounts for Inventory Control, Conversion Costs Control, Conversion Costs Allocated, and Cost of Goods Sold.

20-34 Backflush, two trigger points, completion of production and sale (continuation of 20-32). Assume the same facts as in Problem 20-32 except now there are only two trigger points: Completion of good finished units of product and Sale of finished goods. Required

1. Prepare summary journal entries for August, including the disposition of under- or overallocated conversion costs. Assume no direct materials variances. 2. Post the entries in requirement 1 to T-accounts for Finished Goods Control, Conversion Costs Control, Conversion Costs Allocated, and Cost of Goods Sold.

20-35 Lean Accounting. Flexible Security Devices (FSD) has introduced a just-in-time production process and is considering the adoption of lean accounting principles to support its new production philosophy. The company has two product lines: Mechanical Devices and Electronic Devices. Two individual products are made in each line. Product-line manufacturing overhead costs are traced directly to product lines, and then allocated to the two individual products in each line. The company’s traditional cost accounting system allocates all plantlevel facility costs and some corporate overhead costs to individual products. The latest accounting report using traditional cost accounting methods included the following information (in thousands of dollars).

ASSIGNMENT MATERIAL " 737

Sales Direct material (based on quantity used) Direct manufacturing labor Manufacturing overhead (equipment lease, supervision, production control) Allocated plant-level facility costs Design and marketing costs Allocated corporate overhead costs Operating income

Mechanical Devices Product A Product B $700 $500 200 100 150 75 90 50 95 ƒƒ15 $100

120 40 50 ƒƒ10 $105

Electronic Devices Product C Product D $900 $450 250 75 200 60 200 80 105 ƒƒ20 $ƒ45

95 30 42 ƒƒƒ8 $140

FSD has determined that each of the two product lines represents a distinct value stream. It has also determined that out of the $200,000 ($50,000 + $40,000 + $80,000 + $30,000) plant-level facility costs, product A occupies 22% of the plant’s square footage, product B occupies 18%, product C occupies 36%, and product D occupies 14%. The remaining 10% of square footage is not being used. Finally, FSD has decided that direct material should be expensed in the period it is purchased, rather than when the material is used. According to purchasing records, direct material purchase costs during the period were as follows:

Direct material (purchases)

Mechanical Devices Product A Product B $210 $120

Electronic Devices Product C Product D $250 $90

1. What are the cost objects in FSD’s lean accounting system? 2. Compute operating income for the cost objects identified in requirement 1 using lean accounting principles. Why does operating income differ from the operating income computed using traditional cost accounting methods? Comment on your results.

Required

Collaborative Learning Problem 20-36 JIT production, relevant benefits, relevant costs, ethics. Parson Container Corporation is consider-

ing implementing a JIT production system. The new system would reduce current average inventory levels of $2,000,000 by 75%, but would require a much greater dependency on the company’s core suppliers for on-time deliveries and high quality inputs. The company’s operations manager, Jim Ingram, is opposed to the idea of a new JIT system. He is concerned that the new system will be too costly to manage; will result in too many stockouts; and will lead to the layoff of his employees, several of whom are currently managing inventory. He believes that these layoffs will affect the morale of his entire production department. The plant controller, Sue Winston is in favor of the new system, due to the likely cost savings. Jim wants Sue to rework the numbers because he is concerned that top management will give more weight to financial factors and not give due consideration to nonfinancial factors such as employee morale. In addition to the reduction in inventory described previously, Sue has gathered the following information for the upcoming year regarding the JIT system: # # # #

Annual insurance and warehousing costs for inventory would be reduced by 60% of current budgeted level of $350,000. Payroll expenses for current inventory management staff would be reduced by 15% of the budgeted total of $600,000. Additional annual costs for JIT system implementation and management, including personnel costs, would equal $220,000. The additional number of stockouts under the new JIT system is estimated to be 5% of the total number of shipments annually. 10,000 shipments are budgeted for the upcoming year. Each stockout would result in an average additional cost of $250. Parson’s required rate of return on inventory investment is 10% per year.

1. From a financial perspective should Parson adopt the new JIT system? 2. Should Sue Winston rework the numbers? 3. How should she manage Jim Ingram’s concerns?

Required

Cost Accounting. Charles T. Horngren Stanford University. Srikant M. Datar Harvard University. Madhav V. Rajan Stanford University - KIPDF.COM (2025)