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Learning Objectives
• Analyze the impact that joint costs have on decision making.
Question: When two or more products are produced from a single input, these products are called joint products14. The cost of this single input and the related manufacturing process costs are called joint costs15. For example, lumber companies often must deal with joint products (different types of lumber) resulting from one input (a log). How do the concepts of joint products and joint costs help a lumber company establish a cost for each of its products?
Answer
Suppose Oregon Lumber Company takes a log (the single input) and mills it into two types of products: high quality Grade A lumber, and lower quality Grade B lumber. Grade A lumber and Grade B lumber are examples of joint products, and the cost of the logs and related manufacturing process costs are examples of joint costs.
Figure 7.17 presents the information for Oregon Lumber for the month of June. Joint costs for the month total $250,000. Notice that the split-off point16 is the point at which identifiable products emerge from the production process. The issue is how to allocate joint costs—the$250,000 in production costs incurred prior to the split-off point—to the resulting joint products.
Two methods are commonly used to allocate these joint costs to the joint products: the physical quantities method and the sales value method. We discuss each of these methods next.
The Physical Quantities Method
Question: The physical quantities method17 allocates joint costs based on a physical measure of output. Assume Oregon Lumber produces 600,000 board feet of Grade A lumber and 200,000 board feet of Grade B lumber during June. How would Oregon Lumber use this information to allocate $250,000 in joint production costs to each grade of lumber? Answer Oregon Lumber would allocate 75 percent of the joint costs to Grade A lumber (75 percent = 600,000 Grade A board feet ÷ 800,000 total board feet), and 25 percent of the joint costs to Grade B lumber. Grade A allocation: $\ 187,500\; \text{allocation} = \ 250,000\; \text{joint costs} \times (600,000\; \text{Grade A board feet} \div 800,000\; \text{total board feet})$ Grade B allocation: $\ 62,500\; \text{allocation} = \ 250,000\; \text{joint costs} \times (200,000\; \text{Grade B board feet} \div 800,000\; \text{total board feet})$ Figure 7.18 presents the profitability of each joint product for the month using the physical quantities method assuming Grade A lumber sells for$0.40 per board foot and Grade B lumber sells for $0.30 per board foot. a$240,000 = $0.40 per board foot × 600,000 Grade A board feet. b$60,000 = $0.30 per board foot × 200,000 Grade B board feet. c$187,500 = $250,000 joint costs × (600,000 Grade A board feet ÷ 800,000 total board feet). d$62,500 = $250,000 joint costs × (200,000 Grade B board feet ÷ 800,000 total board feet). Although Grade B lumber appears to be unprofitable, elimination of Grade B lumber sales would not increase overall profit for Oregon Lumber. Grade B lumber contributes$60,000 to covering joint costs. Thus elimination of Grade B lumber sales would result in a decrease in overall profit of $60,000. The$62,500 in joint cost allocated to Grade B lumber would simply be reallocated to Grade A lumber.
The Sales Value Method
Question: A different approach to allocating joint costs to joint products is the sales value method18, which allocates joint costs based on the relative sales value of each product at the split-off point. How would Oregon Lumber allocate joint production costs using this method?
Answer
Because sales revenue totals $240,000 for Grade A lumber and$60,000 for Grade B lumber, 80 percent of the joint costs are allocated to Grade A lumber (80 percent = $240,000 Grade A revenue ÷$300,000 total revenue), and 20 percent of the joint costs are allocated to Grade B lumber:
Grade A allocation:
$\ 200,000\; \text{allocation} = \ 250,000\; \text{joint costs} \times (\ 240,000\; \text{Grade A sales value} \div \ 300,000\; \text{total sales value})$
Grade B allocation:
$\ 50,000\; \text{allocation} = \ 250,000\; \text{joint costs} \times (\ 60,000\; \text{Grade B sales value} \div \ 300,000\; \text{total sales value})$
Figure 7.19 presents the profitability of each joint product for the month using the sales value method, again assuming Grade A lumber sells for $0.40 per board foot, and Grade B lumber sells for$0.30 per board foot.
a $240,000 =$0.40 per board foot × 600,000 Grade A board feet.
b $60,000 =$0.30 per board foot × 200,000 Grade B board feet.
c $200,000 =$250,000 joint costs × ($240,000 Grade A sales value ÷$300,000 total sales value).
d $50,000 =$250,000 joint costs × ($60,000 Grade B sales value ÷$300,000 total sales value).
The sales value method assumes that profit as a percent of sales will remain the same across all products. For example, Figure 7.19 shows that Grade A lumber has a profit margin ratio of 16.67 percent (= $40,000 profit ÷$240,000 sales), as does Grade B lumber (= $10,000 profit ÷$60,000 sales). This method also ensures that joint costs allocated to each product will not exceed sales revenue for each product (unless total joint costs are higher than total revenue).
As you review Figure 7.18 and Figure 7.19, notice that the total column for both methods of joint cost allocation is the same. The issue is not with the overall results. The issue is how to allocate joint costs to each joint product.
Deciding Whether to Process Further
Question: Assume Oregon Lumber Company has the option of processing Grade B lumber further into a finished product by sanding the lumber and painting it with primer. This option is presented in Figure 7.20. The sanded and painted Grade B lumber sells for $0.45 per board foot rather than$0.30 for the unfinished Grade B lumber. The additional cost to sand and paint the Grade B lumber is $0.05 per board foot. Should Oregon Lumber process Grade B lumber further into finished lumber? Answer The answer depends on whether the additional revenue exceeds the additional cost of processing Grade B lumber further. Since the additional revenue of$0.15 per board foot (= $0.45 finished price −$0.30 unfinished price) is greater than the additional $0.05 per board foot processing cost, Oregon Lumber should process the Grade B lumber further into finished lumber. Profit increases$0.10 per board foot as a result of processing further (= $0.15 additional revenue −$0.05 additional cost).
Oregon Lumber will decide whether or not to process Grade B lumber further regardless of how joint costs are allocated to Grade A and Grade B lumber. In a sense, joint costs are sunk costs with respect to this decision, and will not influence future processing decisions. Thus joint costs incurred prior to the split-off point are irrelevant to the decision whether to process further after the split-off point.
Key Takeaway
Two or more products made from a single input are called joint products. The costs of the single input and related manufacturing process costs must be allocated to each of the joint products. The physical quantities method allocates joint costs based on a physical measure of output (e.g., pounds or yards of material). The sales value method allocates joint costs based on the relative sales value for each of the joint products. Regardless of the allocation method used, total joint costs and total profit remain the same. Companies must often decide whether to process a joint product further. If as a result of processing the product further, additional sales revenue exceeds additional costs, the wise decision is to process further.
REVIEW PROBLEM 7.10
Fresh Veggies, Inc., purchased 10,000 pounds of fresh apples from a local grower for $4,000. The apples were separated into high-quality Grade A apples (3,000 pounds) and lower-quality Grade B apples (7,000 pounds). Fresh Veggies sells Grade A apples for$0.80 per pound and Grade B apples for $0.50 per pound. 1. Allocate joint costs to each product using the physical quantities method (pounds), and calculate the profit or loss for each product. 2. Allocate joint costs to each product using the relative sales value method, and calculate the profit or loss for each product. 3. Assume Grade B apples can be processed further into dried apple slices for an additional$0.20 per pound. Customers are willing to pay $0.65 per pound for dried apple slices. Should Fresh Veggies, Inc., process the Grade B apples further? Answer 1.$2,400 = $0.80 per pound × 3,000 pounds of Grade A apples. 2.$3,500 = $0.50 per pound × 7,000 pounds of Grade B apples. 3.$1,200 = $4,000 joint costs × (3,000 pounds of Grade A apples ÷ 10,000 total pounds). 4.$2,800 = $4,000 joint costs × (7,000 pounds of Grade B apples ÷ 10,000 total pounds). 1.$2,400 = $0.80 per pound × 3,000 pounds of Grade A apples. 2.$3,500 = $0.50 per pound × 7,000 pounds of Grade B apples. 3.$1,627 (rounded) = $4,000 joint costs × ($2,400 Grade A sales value ÷ $5,900 total sales value). 4.$2,373 (rounded) = $4,000 joint costs × ($3,500 Grade B sales value ÷ $5,900 total sales value). 1. Because the additional revenue of$0.15 per pound (= $0.65 price with further processing −$0.50 without further processing) is less than the additional $0.20 per pound processing cost, Fresh Veggies should not process the Grade B apples further into dried apples. Profit decreases$0.05 per pound (= $0.20 additional cost −$0.15 additional revenue) as a result of processing further.
Definition
1. Two or more products produced from a single input.
2. The cost of inputs required to produce joint products.
3. The point at which identifiable joint products emerge from the production process.
4. A method that allocates joint costs based on a physical measure of output.
5. A method that allocates joint costs based on the relative sales value of each product at the split-off point. | textbooks/biz/Accounting/Managerial_Accounting/07%3A_How_Are_Relevant_Revenues_and_Costs_Used_to_Make_Decisions/7.11%3A_Appendix-_Making_Decisions_Involving_Joint_Costs.txt |
Questions
1. What are differential revenues and costs?
2. What is differential analysis?
3. Define what is meant by a “make-or-buy” decision. Describe how differential analysis can be used to assist in making this type of decision.
4. Figure 7.2 and Figure 7.3 provide two different formats for presenting the same analysis. Describe the similarities and differences in these two formats.
5. What is an avoidable cost?
6. Review Note 7.8 "Business in Action 7.1" Why did Salt Lake City choose to outsource the concrete panels to a company in Mexico City even though the library was being constructed in Salt Lake City?
7. How is differential analysis used in deciding whether to keep or drop product lines?
8. Why are direct fixed costs typically differential costs?
9. Why are allocated fixed costs typically not differential costs?
10. What is an opportunity cost? Why is an opportunity cost a differential cost?
11. Review Note 7.17 "Business in Action 7.2" What did Kmart do with 24 of its stores? Why might Kmart have taken this action?
12. How is differential analysis similar for customer decisions and product line decisions?
13. Review Note 7.21 "Business in Action 7.3" Why did ABCO Automation, Inc., fire its biggest client even though the client provided close to 60 percent of ABCO’s annual revenue?
14. What two important assumptions must be considered when evaluating special order scenarios?
15. What is cost-plus pricing?
16. Describe the four steps of target costing.
17. Describe the five steps used to manage constraints according to the theory of constraints.
18. What is a qualitative advantage of keeping unprofitable customers?
19. What are joint products and joint costs?
20. Describe the two methods of allocating joint costs.
Brief Exercises
1. Cutting Costs at Best Boards, Inc. Refer to the dialogue at Best Boards, Inc., presented at the beginning of the chapter. How does the vice president of operations, Jim Muller, expect to reduce costs and earn his bonus? What was the flaw in his plan?
2. Make-or-Buy Decision. Coffee Mugs, Inc., currently manufactures ceramic coffee mugs. Management is interested in outsourcing production to a reputable manufacturing company that can supply the cups for \$2 per unit. Coffee Mugs produces 100,000 mugs each year. Variable production costs are \$0.80 and annual fixed costs are \$150,000. If production is outsourced, all variable costs and 40 percent of annual fixed costs will be eliminated.
Perform differential analysis using the format presented in Figure 7.2 and explain which alternative is best, Alternative 1 (producing internally) or Alternative 2 (outsourcing).
3. Product Line Decision. The following segmented annual income statement is for Flash Drive, Inc.:
For items A, B, and C, assign allocated fixed costs to each product line based on sales revenue for each product line as a proportion of total sales revenue. For example, the 1 Gig product will be assigned 10 percent of allocated fixed costs (= \$1,000,000 in 1 Gig sales revenue ÷ \$10,000,000 total sales revenue), or \$110,000 (=\$1,100,000 total allocated fixed costs × 10 percent). For items D, E, and F, calculate the profit or loss for each product line.
4. Customer Decision. Consulting Group LLC has two customers. Customer One generates \$150,000 in income after direct fixed costs are deducted, and Customer Two generates \$200,000 in income after direct fixed costs are deducted. Allocated fixed costs total \$300,000 and are assigned 30 percent to Customer One and 70 percent to Customer Two based on several different cost drivers. Total allocated fixed costs remain the same regardless of how these costs are assigned to customers.
Calculate the amount of allocated fixed costs to be assigned to each customer, and determine the profit or loss for each customer. Should Consulting Group drop Customer Two? Explain.
5. Special Order Decision: Operating with Idle Capacity. Jerseys, Inc., currently produces 10,000 jerseys a year for its regular customers and charges \$10 per jersey. Jerseys, Inc., has capacity to produce an additional 5,000 jerseys if sales grow in the future. Variable costs total \$6 per jersey and annual fixed costs total \$15,000. The city of Rockville recently approached the company and proposed a one-time purchase of 3,000 jerseys for \$8 each. Should Jerseys, Inc., accept the proposal? Explain.
6. Cost-Plus Pricing. KJ Home Builders is bidding on a custom home for a potential customer. The company typically charges 15 percent above cost and estimates the home will cost \$500,000 to build. Calculate the price bid by KJ Home Builders.
7. Constrained Resources. Deal, Inc., produces two types of computers: Vortex and Zoom. The computers are produced in separate departments and sent to the quality testing department before being packaged and shipped. A labor-hour bottleneck has been identified in the quality testing department due to the high skill requirements of the job. Deal, Inc., would like to optimize its use of labor hours by producing the most profitable computer. Based on the information shown, calculate the contribution margin per quality testing labor hour for each product:
Quality Testing Labor Hours Contribution Margin
Vortex 0.50 \$600
Zoom 0.40 \$500
8. Evaluating Qualitative Factors. Assume your company is considering whether to outsource production. What qualitative factors should be considered before making this decision?
9. Allocating Joint Costs (Appendix). Charlotte Company produces two joint chemical products, product A and B. Prior to the split-off point, the company incurred \$100,000 in joint costs. Production totaled 12,000 gallons for product A and 8,000 gallons for product B. Allocate joint costs to each product using the physical quantities method (gallons).
Exercises: Set A
1. Make-or-Buy Decision. Wheels, Inc., currently manufactures its own custom rims for automobiles. Management is interested in outsourcing production of these rims to a reputable manufacturing company that can supply the rims for \$80 per unit. Wheels, Inc., incurs the following annual production costs to produce 10,000 rims internally.
If production is outsourced, all variable production costs, factory building and equipment lease costs, and factory insurance costs will be eliminated. The production supervisor’s salary cost will remain regardless of the decision to outsource or to produce internally because the supervisor recently signed a long-term contract with Wheels, Inc.
Required:
1. Perform differential analysis using the format presented in Figure 7.2. Assume making the rims internally is Alternative 1, and buying the rims from an outside manufacturer is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of outsourcing production using the format presented in Figure 7.3.
4. Compare the format used in requirement a with that of requirement c.
1. Product Line Decision. The following monthly segmented income statement is for Durango Company.
Management is concerned about the losses associated with product line A and is considering dropping this product line. Allocated fixed costs are assigned to product lines based on sales. If product line A is eliminated, total allocated fixed costs are assigned to the remaining product lines, and all variable and direct fixed costs for product line A will be eliminated.
Required:
1. Perform differential analysis using the format presented in Figure 7.6. Assume keeping all product lines is Alternative 1, and dropping product line A is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of dropping product line A using the format presented in Figure 7.7.
4. Explain why the loss shown for product line A in the segmented income statement might be misleading to management.
1. Customer Decision. The following customer segmented quarterly income statement is for Accounting Associates.
Management is concerned about the significant losses associated with the Nguyen account and would like to drop this customer. Allocated fixed costs are assigned to customers based on sales revenue. If Nguyen is dropped, total allocated fixed costs are assigned to the remaining customers, and all variable and direct fixed costs for the Nguyen account will be eliminated.
Required:
1. Perform differential analysis using the format presented in Figure 7.10. Assume keeping all customers is Alternative 1, and dropping the Nguyen account is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of dropping the Nguyen account using the format presented in Figure 7.12.
4. Explain what happened to the profitability of the other two customers as a result of dropping the Nguyen account.
1. Special Order Decision: Operating with Idle Capacity. The following monthly financial data are for RadioCom, Inc., a maker of handheld VHF radios. RadioCom produces and sells 5,000 radios each month to regular customers.
RadioCom received an offer from the Coast Guard Auxiliary to purchase 1,000 radios next month for \$75 per unit. RadioCom can produce up to 7,000 radios a month, so the special order would not affect regular customer sales. Variable costs per radio will remain at \$60. This special order will have no effect on monthly fixed costs.
Required:
1. Using the differential analysis format presented in Figure 7.13, determine whether RadioCom would be better off rejecting the special order (Alternative 1) or accepting the special order (Alternative 2).
2. Summarize the result of accepting the special order using the format presented in Figure 7.14.
1. Special Order Decision: Operating at Full Capacity. The following monthly financial data are for RadioCom, Inc., a maker of handheld VHF radios. RadioCom produces and sells 5,000 radios each month to regular customers.
RadioCom received an offer from the Coast Guard Auxiliary to purchase 1,000 radios next month for \$75 per unit. RadioCom can only produce up to 5,000 radios a month, so the special order would result in reduced sales to regular customers. Variable costs per radio will remain at \$60. This special order will have no effect on monthly fixed costs.
Required:
1. Using the differential analysis format presented in Figure 7.13, determine whether RadioCom would be better off rejecting (Alternative 1) or accepting (Alternative 2) the offer received from the Coast Guard Auxiliary.
2. Summarize the result of accepting the special order using the format presented in Figure 7.14.
1. Target Costing. Quality Sounds, Inc., makes speakers and headphones for high-end sound systems. The marketing department has identified a market for a specific type of headphones that Quality Sounds does not currently produce, and expects to be able to sell each pair for \$150. Management requires a profit of 45 percent of the selling price.
Required:
Determine the highest cost (target cost) management would be willing to accept to produce this product.
1. Constrained Resources. Cycle, Inc., produces three types of bicycles: racer, cruiser, and climber. The bikes are produced in separate departments and sent to the quality testing department before being packaged and shipped. A labor-hour bottleneck has been identified in the quality testing department due to the high skill requirements of the job. Cycle, Inc., would like to optimize its use of labor hours by producing the two most profitable bikes. Information for each bike follows.
Quality Testing Labor Hours Price Variable Cost
Racer 1.25 \$1,000 \$400
Cruiser 1.00 \$500 \$300
Climber 1.00 \$800 \$450
Required:
1. Calculate the contribution margin per unit of constrained resource for each product.
2. Which two products would Cycle, Inc., prefer to produce and sell to optimize the use of labor hours in the quality testing department?
1. Qualitative Factors. For each of the following independent scenarios, identify at least one qualitative factor that should be considered before making the decision.
1. A company sells three types of computers (laptops, desktops, and palmtops), all of which are profitable. The company faces a machine-hour bottleneck and plans to eliminate the palmtop product because it has the lowest contribution margin per machine hour.
2. A company plans to drop an unprofitable customer.
3. A maker of high-end stereo equipment would like to shut down its manufacturing facility and outsource production.
2. Allocating Joint Costs (Appendix). Clemson Products produces two joint products, product Y and Z. Prior to the split-off point, the company incurred \$60,000 in joint costs. Clemson Products produced 10,000 yards of product Y and 30,000 yards of product Z produced. Product Y sells for \$4 per yard and product Z sells for \$2 per yard.
Required:
1. Allocate joint costs to each product using the physical quantities method (yards), and calculate the profit or loss for each product.
2. Allocate joint costs to each product using the relative sales value method, and calculate the profit or loss for each product. | textbooks/biz/Accounting/Managerial_Accounting/07%3A_How_Are_Relevant_Revenues_and_Costs_Used_to_Make_Decisions/7.E%3A_Exercises_%28Part_1%29.txt |
Exercises: Set B
1. Make-or-Buy Decision. Quality Glass currently manufactures windshields for automobiles. Management is interested in outsourcing production of these windshields to a reputable manufacturing company that can supply the windshields for \$45 per unit. Quality Glass incurs the following annual production costs to produce 15,000 windshields internally.
If production is outsourced, all variable production costs will be eliminated, and 80 percent of fixed production costs will be eliminated. Regardless of the decision to outsource or to produce internally, 20 percent of fixed production costs will remain .
Required:
1. Perform differential analysis using the format presented in Figure 7.2. Assume making windshields internally is Alternative 1, and buying windshields from an outside manufacturer is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of outsourcing production using the format presented in Figure 7.3.
4. Why might some managers prefer the format presented in requirement c?
1. Product Line Decision. The following segmented annual income statement is for Office Express.
Management is concerned about the significant losses associated with the computers product line and would like to drop this product line. Allocated fixed costs are assigned to product lines based on sales. If the computers product line is eliminated, total allocated fixed costs are assigned to the remaining product lines, and all variable and direct fixed costs for the computers product line will be eliminated.
Required:
1. Perform differential analysis using the format presented in Figure 7.6. Assume keeping all product lines is Alternative 1, and dropping the computers product line is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of dropping the computer product line using the format presented in Figure 7.7.
4. Explain what happened to the profitability of the furniture product line as a result of dropping the computers product line.
1. Customer Decision. The following customer segmented annual income statement is for Management Consulting, Inc.
Management is concerned about the losses associated with the Apple LLP account and would like to drop this customer. Allocated fixed costs are assigned to customers based on sales revenue. If Apple LLP is dropped, total allocated fixed costs are assigned to the remaining customers, and all variable and direct fixed costs for the Apple LLP account will be eliminated.
Required:
1. Perform differential analysis using the format presented in Figure 7.10. Assume keeping all customers is Alternative 1, and dropping the Apple LLP account is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of dropping the Apple LLP account using the format presented in Figure 7.12.
4. Explain why the loss shown for the Apple LLP account in the segmented income statement might be misleading to management.
1. Special Order Decision: Operating with Idle Capacity. The following monthly financial data are for Sport Socks, Inc., a maker of socks for runners. Sport Socks makes and sells 40,000 pairs each month to regular customers.
Sport Socks received an offer from a large sporting goods store to purchase 15,000 socks next month for \$0.90 per pair. Sport Socks can produce up to 60,000 pairs of socks a month, so the special order would not affect regular customer sales. Variable costs per pair will remain at \$0.70. This special order will cause fixed costs to increase by \$6,000 for next month.
Required:
1. Using the differential analysis format presented in Figure 7.13, determine whether Sport Socks would be better off rejecting the special order (Alternative 1) or accepting the special order (Alternative 2).
2. Summarize the result of accepting the special order using the format presented in Figure 7.14.
1. Special Order Decision: Operating at Full Capacity. The following monthly financial data are for Sport Socks, Inc., a maker of socks for runners. Sport Socks makes and sells 40,000 pairs each month to regular customers.
Sport Socks received an offer from a large sporting goods store to purchase 15,000 socks next month for \$0.90 per pair. Assume Sport Socks can only produce up to 40,000 pairs of socks each month. Thus any special orders would result in reduced sales to regular customers. However, fixed costs will not change as a result of the special order.
Required:
1. Using the differential analysis format presented in Figure 7.13, determine whether Sport Socks would be better off rejecting the special order (Alternative 1) or accepting the special order (Alternative 2).
2. Summarize the result of accepting the special order using the format presented in Figure 7.14.
1. Target Costing. Nature Wood, Inc., makes wood tables for commercial use. The marketing department has identified a market for a specific table that the company does not currently produce, and it expects that each table could be sold for \$1,000. Management requires a profit of 30 percent of the selling price.
Required:
Determine the highest cost (target cost) management would be willing to accept to produce this product.
1. Constrained Resources. Ratcliff Enterprises produces three types of computers; laptop, desktop, and palmtop. A machinehour bottleneck has been identified in the production department. Ratcliff would like to optimize its use of machine hours by producing the two most profitable computers. Information for each computer follows.
Production Machine Hours Price Variable Cost
Laptop 2.00 \$1,200 \$900
Desktop 1.00 \$800 \$700
Palmtop 1.25 \$300 \$180
Required:
1. Calculate the contribution margin per unit of constrained resource for each product.
2. Which two products would Ratcliff Enterprises prefer to produce and sell to optimize the use of machine hours in the production department?
1. Qualitative Factors. For each of the following independent scenarios, identify at least one qualitative factor that should be considered before making the decision.
1. A company sells three types of chainsaws (light duty, medium duty, and heavy duty), all of which are profitable. The company faces a labor-hour bottleneck and plans to eliminate the light duty product because it has the lowest contribution margin per labor hour.
2. A company plans to drop an unprofitable customer.
3. A maker of farm equipment would like to shut down its manufacturing facility and outsource production.
2. Allocating Joint Costs and Evaluating Overall Company Profit (Appendix). Elexor, Inc., produces two joint products, product A and product B. Prior to the split-off point, the company incurred \$10,000 in joint costs. Production of product A totaled 400 pounds, and product B totaled 600 pounds. Product A sells for \$60 per pound and product B sells for \$10 per pound.
Required:
1. Allocate joint costs to each product using the physical quantities method (pounds), and calculate the profit or loss for each product.
2. Allocate joint costs to each product using the relative sales value method, and calculate the profit or loss for each product.
3. Using your answer to requirement a, describe what will happen to overall company profit if the least profitable product is eliminated.
Problems
1. Make-or-Buy Decision. Vail Door Company currently manufactures doors used in the production of custom homes. Management is interested in outsourcing production of the doors to a reputable manufacturing company that can supply the doors for \$90 per unit. Vail incurs the following annual production costs to produce 3,000 doors internally.
If production is outsourced, all variable production costs, equipment lease costs, and factory insurance costs will be eliminated. The production supervisor’s salary cost will remain regardless of the decision to outsource or to produce internally because the supervisor recently signed a long-term contract with the company. The factory lease has five years remaining and cannot be terminated before then.
Required:
1. Perform differential analysis using the format presented in Figure 7.2. Assume making the product internally is Alternative 1, and buying the product from an outside manufacturer is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of outsourcing production using the format presented in Figure 7.3.
4. Assume Vail Door Company can lease the space it currently uses to produce doors for \$30,000 per year if production of doors is outsourced. Because the company subleasing this space would also pay for insurance, Vail would not be required to pay for factory insurance. Use the format presented in Figure 7.3 to determine if Vail would be better off outsourcing production. (Hint: \$30,000 will appear in the analysis as an opportunity cost similar to Figure 7.8.)
1. Make-or-Buy Decision and Qualitative Factors. Soda Bottling, Inc., currently bottles its own soda drinks. Management is interested in outsourcing the production of bottles to a reputable manufacturing company that can supply the bottles for \$0.04 each. Soda Bottling incurs the following monthly production costs to produce 1,000,000 bottles internally.
If production is outsourced, all variable production costs and 70 percent of fixed production costs will be eliminated.
Required:
1. Perform differential analysis using the format presented in Figure 7.2. Assume making the product internally is Alternative 1, and buying the product from an outside manufacturer is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of outsourcing production using the format presented in Figure 7.3.
4. Assume all the facts of this problem remain the same. However, management of Soda Bottling has an opportunity to lease the space it currently uses to produce bottles for \$6,000 per month if production of bottles is outsourced. Use the format presented in Figure 7.3 to determine if Soda Bottling would be better off outsourcing production. (Hint: \$6,000 will appear in the analysis as an opportunity cost similar to Figure 7.8.)
5. Identify at least one qualitative factor that should be considered before management decides to outsource production.
1. Product Line Decision. The following monthly segmented income statement is for Hal’s Hardware.
Management is concerned about the low profit associated with the tools product line and is considering dropping this product line. Allocated fixed costs are assigned to product lines based on floor space used by each product line (measured in square feet), resulting in the following percentages for garden supplies, tools, and paint, respectively: 20 percent, 50 percent, and 30 percent. If the tools product line is eliminated, total allocated fixed costs will be assigned as follows: 62.5 percent to garden supplies, and 37.5 percent to paint. All variable and direct fixed costs for the tools product line will be eliminated.
Required:
1. Perform differential analysis using the format presented in Figure 7.6. Assume keeping all product lines is Alternative 1, and dropping the tools product line is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of dropping the tools product line using the format presented in Figure 7.7.
4. Assume the space available from dropping the tools product line can be used by the paint product line, resulting in increased revenues for paint of \$12,000 and increased variable costs for paint of \$4,000. No additional direct fixed costs would be incurred, and 80 percent of allocated fixed costs would be assigned to paint and 20 percent assigned to garden supplies. Should Hal’s Hardware drop the tools product line and use the freed-up space to expand the paint product line? (Hint: Prepare a differential analysis using the format presented in Figure 7.6 to find the answer. Alternative 1 assumes all product lines are kept, and Alternative 2 assumes the tools product line is dropped with a corresponding expansion of the paint product line.)
1. Product Line Decision and Qualitative Factors. The following annual segmented income statement is for Wax, Inc., a maker of wax for cars, boats, and floors.
Management is concerned about the loss associated with the floors product line and is considering dropping this product line. Allocated fixed costs are assigned to product lines based on direct labor hours associated with each product line, resulting in the following percentages for cars, boats, and floors, respectively: 30 percent, 25 percent, and 45 percent. If the floors product line is eliminated, total allocated fixed costs will be assigned to the remaining products as follows: 55 percent to cars, and 45 percent to boats. All variable and direct fixed costs for the floors product line will be eliminated.
Required:
1. Perform differential analysis using the format presented in Figure 7.6. Assume keeping all product lines is Alternative 1, and dropping the floors product line is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of dropping the floors product line using the format presented in Figure 7.7.
4. Assume the space available from dropping the floors product line can be used by the boats product line, resulting in increased revenues for boats of \$200,000 and increased variable costs for boats of \$110,000. An additional \$10,000 in direct fixed costs would be incurred for the boats product line. Allocated fixed costs would be assigned as follows: 40 percent to cars, and 60 percent to boats. Should Wax, Inc., drop the floors product line and use the freed-up space to expand the boats product line? (Hint: Prepare a differential analysis using the format presented in Figure 7.6 to find the answer. Alternative 1 assumes all product lines are kept, and Alternative 2 assumes the floors product line is dropped with a corresponding expansion of the boats product line.)
5. Identify at least one qualitative factor that should be considered before management decides to drop a product line.
1. Customer Decision. The following customer segmented quarterly income statement is for Ciena and Associates, a firm that performs legal services.
Management is concerned about the significant losses associated with the Davis account and would like to drop this customer. Allocated fixed costs are assigned to customers based on sales revenue. If Davis is dropped, total allocated fixed costs are assigned to the remaining customers, and all variable and direct fixed costs for the Davis account will be eliminated.
Required:
1. Perform differential analysis using the format presented in Figure 7.10. Assume keeping all customers is Alternative 1, and dropping the Davis account is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of dropping the Davis account using the format presented in Figure 7.12.
4. Explain what happened to the profitability of the other two customers as a result of dropping the Davis account.
5. Assume all the facts of this problem remain the same with one exception. As a result of dropping the Davis account, Ciena and Associates is only able to reduce the direct fixed costs associated with the Davis account by 90 percent. The remaining 10 percent will not be eliminated for several more years. Does this change Ciena’s decision as to whether to drop the Davis customer? Explain. (Hint: Modify one line item in your answer to requirement c.)
1. Customer Decision and Qualitative Factors. The following customer segmented monthly income statement is for Quality Web, Inc., a firm that provides Web site maintenance services.
Management is concerned about the losses associated with the Murray account and would like to drop this customer. Allocated fixed costs are assigned to customers based on sales revenue. If Murray is dropped, total allocated fixed costs are assigned to the remaining customers, and all variable and direct fixed costs for the Murray account will be eliminated.
Required:
1. Perform differential analysis using the format presented in Figure 7.10. Assume keeping all customers is Alternative 1, and dropping the Murray account is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of dropping the Murray account using the format presented in Figure 7.12.
4. Explain what happened to the profitability of the other two customers as a result of dropping the Murray account.
5. Assume all the facts of this problem remain the same with one exception. As a result of dropping the Murray account, Quality Web, Inc., is able to reduce total allocated fixed costs by 20 percent. The remaining 80 percent will be allocated to the other two products based on sales revenue. Does this change Quality Web’s decision as to whether to drop the Murray customer? Explain. (Hint: Add one line item in the requirement c analysis to reflect allocated fixed cost savings.)
6. Identify at least one qualitative factor that should be considered before deciding whether to drop the Murray account.
1. Special Order Decision with Idle Capacity and at Full Capacity. The following quarterly financial data are for Pneumatic, Inc., a maker of compressors. On average, Pneumatic makes 20,000 compressors each quarter.
Pneumatic received an offer from a one-time customer to purchase 5,000 compressors this coming quarter for \$275 per unit. Pneumatic can produce up to 30,000 units a quarter, so the special order would not affect regular customer sales. Variable costs per unit will remain at \$100. This special order will have no effect on fixed costs.
Required:
1. Using the differential analysis format presented in Figure 7.13, determine whether Pneumatic would be better off rejecting the special order (Alternative 1) or accepting the special order (Alternative 2).
2. Summarize the result of accepting the special order using the format presented in Figure 7.14.
3. Assume Pneumatic is approached with the same special offer, but has limited capacity, and can only produce up to 20,000 units per quarter. Thus any special orders will result in reduced sales to regular customers. Using the differential analysis format presented in Figure 7.13, determine whether Pneumatic would be better off rejecting (Alternative 1) or accepting (Alternative 2) the special order.
4. Summarize the result of accepting the special order in requirement c using the format presented in Figure 7.14.
1. Special Order Decision at Full Capacity. The following monthly financial data are for Green Mowers, Inc., a maker of electric lawn mowers. On average, Green Mowers makes 5,000 mowers each month.
Green Mowers received an offer from a one-time customer to purchase 1,000 mowers this coming month for \$180 per unit. Green Mowers can produce up to 5,000 units a month, so the special order would reduce regular customer sales. Variable costs per unit will remain at \$150. This special order will have no effect on fixed costs.
Required:
1. Using the differential analysis format presented in Figure 7.13, determine whether Green Mowers would be better off rejecting the special order (Alternative 1) or accepting the special order (Alternative 2).
2. Summarize the result of accepting the special order using the format presented in Figure 7.14.
3. Assume Green Mowers can increase capacity to accommodate the special order by paying an additional \$20 in variable costs per unit (for overtime pay) for the additional 1,000 units. With this increased capacity, the special order would not affect regular customer sales. Using the differential analysis format presented in Figure 7.13, determine whether Green Mowers would be better off rejecting (Alternative 1) or accepting (Alternative 2) the special order.
4. Summarize the result of accepting the special order in requirement c using the format presented in Figure 7.14.
1. Target Costing. Toolmakers, Inc., produces table saws. The marketing department has identified a market for a specific type of table saw that Toolmakers does not currently produce, and expects to be able to sell each saw for \$800. Management requires a profit of 60 percent of the selling price.
Required:
1. Determine the highest cost (target cost) management would be willing to accept to produce this product.
2. Describe the four steps of target costing, and identify what Toolmakers would do next if it cannot make the product at or below the target cost.
1. Constrained Resources. Instrumental Strings, Inc., produces three types of string instruments: violin, cello, and bass. The instruments are produced in separate departments and sent to the quality testing department before being packaged and shipped. A labor-hour bottleneck has been identified in the quality testing department due to the high skill requirements of the job. Instrumental Strings would like to optimize its use of labor hours by producing the two most profitable instruments. Information for each product follows.
Required:
1. Calculate the contribution margin per unit of constrained resource for each product.
2. Which two products would Instrumental Strings prefer to produce and sell to optimize the use of labor hours in the quality testing department?
3. Assume additional employees are hired and trained for the quality testing department thereby alleviating this constraint. A labor-hour bottleneck has now been identified in the packaging department, which is recognized by management as a crucial department given the fine craftsmanship of each instrument. Of the three instruments produced by the company, identify which two products Instrumental Strings would prefer to produce and sell to optimize the use of labor hours in the packaging department. Assume the following labor hours are required to package each instrument:
Violin: 4.00 hours
Cello: 4.00 hours
Bass: 6.00 hours
1. Allocating Joint Costs and Product Profitability (Appendix). Fresh Catch, Inc., has a fleet of fishing boats. The most recent outing cost \$90,000 and yielded 24,000 pounds of salmon and 8,000 pounds of halibut. Fresh Catch can sell salmon for \$3 per pound and halibut for \$6 per pound.
Required:
1. Allocate joint costs to each product using the physical quantities method, and calculate the profit or loss for each product.
2. Allocate joint costs to each product using the relative sales value method, and calculate the profit or loss for each product.
3. Explain what happened to the profitability of each product as the allocation method was changed from requirement a to requirement b. Why might management make bad decisions using the information from requirement a?
4. Assume salmon can be processed further into smoked salmon for an additional \$2.50 per pound. Customers are willing to pay \$7 per pound for smoked salmon. Should Fresh Catch process the salmon further? Explain.
1. Allocating Joint Costs (Appendix). Fruit Tree Nursery (FTN) grows peach and apple trees in containers for its customers. This past year, FTN grew 3,000 peach trees and 7,000 apple trees at a cost of \$100,000. FTN can sell peach trees for \$20 each and apple trees for \$11 each.
Required:
1. Allocate joint costs to each product using the physical quantities method, and calculate the profit or loss for each product.
2. Allocate joint costs to each product using the relative sales value method, and calculate the profit or loss for each product.
3. Assume peach trees can be processed further by allowing them to grow for another few months. The additional processing cost is \$4 per tree, and customers are willing to pay \$23 for the larger trees. Should FTN process the peach trees further? Explain.
One Step Further: Skill-Building Cases
1. Outsourcing Building Materials. Review Note 7.8 "Business in Action 7.1" What qualitative factors did the manager of the library’s construction likely consider in deciding to have Pretecsa produce the concrete panels?
2. Internet Project: Outsourcing. Accenture LLP is a global management consulting, technology services, and outsourcing company with more than \$17 billion in annual revenues. Go to Accenture’s Web site (www.accenture.com) and select outsourcing, or type outsourcing in Accenture’s search feature. Review the information provided about outsourcing, select a specific outsourcing topic, and write a one-page report summarizing your findings.
3. Sale of Stores at Kmart. Refer to Note 7.17 "Business in Action 7.2" What qualitative factors were likely considered by the company’s management in considering whether to keep the stores?
4. Group Activity: Qualitative Factors. Each of the following scenarios is being considered at three separate companies.
1. A company sells three types of bicycles (racers, cruisers, and climbers), all of which are profitable. The company faces a labor-hour bottleneck and plans to eliminate the cruiser product because it has the lowest contribution margin per labor hour.
2. A company plans to accept a special order at a reduced price from a one-time customer.
3. A maker of car batteries plans to eliminate one of its unprofitable product lines.
Required:
Form groups of two to four students and assign one of the three independent scenarios listed previously to each group. Each group must perform the following requirements:
1. Identify at least two qualitative factors that should be considered before making the decision.
2. Discuss each option, based on the findings of your group, with the class.
1. Special Order Decision Using Excel. The following monthly financial data are for Green Mowers, Inc., a maker of electric lawn mowers. Green Mowers makes and sells 5,000 mowers each month.
Green Mowers received an offer from a one-time customer to purchase 1,000 mowers this coming month for \$180 per unit. Green Mowers can only produce up to 5,000 units a month, so the special order would reduce regular customer sales. Variable costs per unit will remain at \$150. This special order will have no effect on fixed costs.
Required:
Prepare an Excel spreadsheet, similar to the one shown in the Computer Application box, to determine whether Green Mowers would be better off rejecting the special order (Alternative 1) or accepting the special order (Alternative 2). Make a recommendation as to which alternative should be accepted and explain the reasoning for your recommendation.
1. Ethics: Cost-Plus Pricing. JR Engineering recently negotiated a cost-plus contract with Pineville City to provide engineering services at a rate equal to direct labor costs plus 30 percent. On a separate note, the partners at JR Engineering discovered that one of its customers filed for bankruptcy last month and will not be able to pay the \$200,000 owed to the firm.
The two partners at JR Engineering, Julie and Ron, decided to include some of the direct labor costs incurred working on the bankrupt company with the direct labor costs associated with Pineville City. As Ron stated, “After all, customers fail from time to time, and it’s only fair that our other customers shoulder some of the burden. This enables us to provide the high-quality service we know is so important to our customers.”
Are JR Engineering’s actions ethical? What are the long-term implications of JR’s actions? Explain.
Comprehensive Cases
1. Make-or-Buy Decision. Keyboard, Inc., a manufacturer of pianos, typically sells each of its pianos for \$1,480. The cost of manufacturing and marketing one piano at the company’s usual monthly volume of 6,000 units is shown.
Required:
1. Keyboard, Inc., received a proposal from an independent piano manufacturer that will produce and ship 2,000 pianos each month directly to Keyboard’s customers as requested by Keyboard’s salespeople, at a cost of \$900 each. This will have the effect of reducing total fixed marketing and administrative costs by 5 percent. As a result of reducing production capacity, Keyboard’s total fixed manufacturing costs will decrease 30 percent. Total variable manufacturing costs will decrease since only 4,000 pianos will be produced rather than 6,000. Total variable marketing and administrative costs will remain unchanged.
Perform differential analysis using the format presented in Figure 7.2 to determine if Keyboard should accept the proposal from the outside supplier. Assume making all 6,000 pianos internally is Alternative 1, and outsourcing the production of 2,000 pianos and producing 4,000 pianos internally is Alternative 2. Explain which alternative is best.
2. Assume the same facts as in requirement a, with one additional point. If production of 2,000 pianos is outsourced and 4,000 pianos are produced internally, Keyboard can use the idle capacity to produce an additional 1,400 beginner pianos that can be sold for \$1,100 each. Fixed marketing and administrative costs would be unchanged (the 5 percent reduction described in requirement a no longer applies). Fixed manufacturing costs would decrease by 10 percent (rather than the 30 percent described in requirement a). Per unit variable cost information for the beginner pianos would be as follows:
Variable manufacturing costs \$400
Variable marketing and administrative costs \$80
Perform differential analysis using the format presented in Figure 7.2 to determine if Keyboard should accept the proposal from the independent supplier. Assume making all 6,000 pianos internally is Alternative 1. Alternative 2 consists of outsourcing the production of 2,000 pianos and producing 5,400 pianos internally (= 4,000 regular pianos + 1,400 beginner pianos). Explain which alternative is best. (Hint: Include a line item for sales revenue in your analysis to determine the best alternative.)
1. Product Line Decision. The following monthly segmented income statement is for Thirst Quench, a maker of soda, sports drink, and lemonade.
Management is concerned about the losses associated with the sports drink and lemonade product lines and is considering dropping all product lines except soda. Allocated fixed costs are assigned to product lines based on direct labor hours associated with each product line resulting in the following percentages for soda, sports drink, and lemonade, respectively: 25 percent, 20 percent, and 55 percent. If the sports drink and lemonade product lines are eliminated, total allocated fixed costs will decrease by \$40,000, and variable costs and direct fixed costs for these two product lines will be eliminated. (No allocated fixed cost savings occur if only one product line is dropped.)
Required:
1. Perform differential analysis using the format presented in Figure 7.6. Assume keeping all product lines is Alternative 1, and keeping only the soda product line is Alternative 2.
2. Which alternative is best? Explain.
3. Summarize the result of keeping only the soda product line using the format presented in Figure 7.7.
4. Management has asked you to look at the numbers for each product line and make a recommendation on how to increase overall company profit. What course of action would you recommend? Based on your recommendation, describe the qualitative factors that should be considered. | textbooks/biz/Accounting/Managerial_Accounting/07%3A_How_Are_Relevant_Revenues_and_Costs_Used_to_Make_Decisions/7.E%3A_Exercises_%28Part_2%29.txt |
Julie Jackson is the president and owner of Jackson’s Quality Copies, a store that makes photocopies for its customers and that has several copy machines.
© Thinkstock
Julie has the following discussion with Mike Haley, the company’s accountant:
Julie: Mike, I think it’s time to buy a new copy machine. Our volume of copies has increased dramatically over the last year, and we need a copier that does a better job of handling the big jobs.
Mike: Do you have any idea how much the new machine will cost?
Julie: We can purchase a new copier for \$50,000, maintenance costs will total \$1,000 a year, and the copier is expected to last 7 years. Since the new machine is quicker and will require less attention by our employees, we should save about \$11,000 a year in labor costs.
Mike: Will it have any salvage value at the end of seven years?
Julie: Yes. The salvage value should be about \$5,000.
Mike: How soon do you want to do this?
Julie: As soon as possible. From what I can tell, this is a winning proposition. The cash inflows of \$82,000 that we will get from the labor cost savings and the salvage value exceed the cash outflows of \$57,000 that we expect to spend on the machine and annual maintenance costs. What do you think?
Mike: Let me take a look at the numbers before we jump into this. We have to consider more than just total cash inflows and outflows. I’ll get back to you by the end of the week.
Julie: Okay, thanks for your help!
Jackson’s Quality Copies is facing a decision common to many organizations: whether to invest in equipment that will last for many years or to continue with existing equipment. This type of decision differs from the decisions covered in the previous chapter because long-term investment decisions affect organizations for several years. We will return to Julie’s plan to purchase a new copier after we provide background information on long-term investment decisions.
8.02: Capital Budgeting and Decision Making
Learning Objectives
• Apply the concept of the time value of money to capital budgeting decisions.
Question: What is the difference between management decisions made in Chapter 7 and management decisions made in this chapter?
Answer
The types of decisions covered in this chapter and Chapter 7 are similar in that they require an analysis of differential revenues and costs. However, Chapter 7 involves short-run operating decisions (e.g., special orders from customers), while this chapter focuses on long-run capacity decisions (e.g., purchasing long-lived assets to increase capacity for many years).
Organizations make a variety of long-run investment decisions. The San Francisco Symphony invests in stage risers for its orchestra members. McDonald’s invests in new restaurants. Honda Motor Co. invests in new manufacturing facilities. Bank of America invests in new branches. These examples have one common feature: all of these companies are investing in assets that will affect the organization for several years.
Question: The process of analyzing and deciding which long-term investments to make is called a capital budgeting decision1, also known as a capital expenditure decision. Capital budgeting decisions involve using company funds (capital) to invest in long-term assets. How does the evaluation of these types of capital budgeting decisions differ from short-term operating decisions discussed in Chapter 7?
Answer
When looking at capital budgeting decisions that affect future years, we must consider the time value of money. The time value of money concept is the premise that a dollar received today is worth more than a dollar received in the future. To clarify this point, suppose a friend owes you $100. Would you prefer to receive$100 today or 3 years from today? The money is worth more to you if you receive it today because you can invest the $100 for 3 years. For capital budgeting decisions, the issue is how to value future cash flows in today’s dollars. The term cash flow2 refers to the amount of cash received or paid at a specific point in time. The term present value3 describes the value of future cash flows (both in and out) in today’s dollars. Business in Action 8.1 Capital Budgeting Decisions at JCPenney and Kohl’s JCPenney Company has over 1,000 department stores in the United States, and Kohl’s Corporation has over 800. Both companies cater to a “middle market.” In October 2006, Kohl’s announced plans to open 65 new stores. At about the same time, JCPenney announced plans to open 20 new stores, 17 of which would be stand-alone stores. This was a departure from JCPenney’s typical approach of serving as an anchor store for regional shopping malls. © Thinkstock The decision to open new stores is an example of a capital budgeting decision because management must analyze the cash flows associated with the new stores over the long term. Source: James Covert, “Chasing Mr. and Mrs. Middle Market: J.C. Penney, Kohl’s Open 85 New Stores,” The Wall Street Journal, October 6, 2006. When managers evaluate investments in long-term assets, they want to know how much cash would be spent on the investment and how much cash would be received as a result of the investment. The investment proposal is likely rejected if cash inflows do not exceed cash outflows. (Think about a personal investment. If you would receive only$700 in the future from an investment of $1,000 today, you undoubtedly would not make the investment because you would lose$300!) If cash inflows are expected to exceed cash outflows, managers must consider when the cash inflows and outflows occur before taking on the investment. (Again, consider an investment of $1,000 today. If you expect to receive$1,050 in 20 years rather than at the end of 1 year, you would probably think twice before investing because it would take 20 years to make $50!) Question: We use two methods to evaluate long-term investments, both of which consider the time value of money. What are these two methods? Answer The first is called the net present value (NPV) method, and the second is called the internal rate of return method. Before presenting these two methods, let’s discuss the time value of money (present value) concepts. The Present Value Formula Question: Suppose you invest$1,000 for 1 year at an interest rate of 5 percent per year, as shown in the following timeline. How much will you have at the end of 1 year (or what is the future value of the investment)?
Answer
You will have $1,050: $\ 1,050 = \ 1,000 \times (1 + 0.05)$ Question: Let’s change course and find the present value of the same future cash flow. If you receive$1,050 in 1 year, how much is that worth in today’s dollars assuming an annual interest rate of 5 percent?
Answer
The present value is $1,000, calculated as follows: $\ 1,000 = \frac{\ 1,050}{(1 + 0.05)}$ Question: Let’s go back to finding a future value. Assume you invest$1,000 today at an annual rate of 5 percent for 2 years. How much will you have at the end of 2 years?
Answer
At the end of 1 year, you will have $1,050 (=$1,000 × [1 + .05]). At the end of the second year, you will have $1,102.50, which is$1,050 × (1 + .05). The equation is
$\ 1,102.50 = \ 1,000 \times (1 + 0.05) \times (1 + 0.05)$
or
$\ 1,102.50 = \ 1,000 \times (1 \ 0.05)^{2}$
Question: Again, let’s change course and find the present value of the same future cash flow. If you receive $1,102.50 in 2 years, how much is that worth in today’s dollars assuming an annual interest rate of 5 percent? Answer The present value is$1,000, calculated as follows:
$\ 1,000 = \frac{\ 1,102.50}{(1 + 0.05)^{2}}$
These examples show that one equation can be used to find the present value of a future cash flow. The equation is
$P = \frac{F_{n}}{(1 + r)^{n}}$
where
$\text{P = Present value of an amount}$
$F_{n} = \text{Amount received n years in the future}$
$\text{r = Annual interest rate}$
$\text{n = Number of years}$
Question: Let’s use this formula to solve for the following: Assume $500 will be received 4 years from today, and the annual interest rate is 10 percent. What is the present value of this cash flow? Answer The present value is$341.51, calculated as follows:
$\begin{split} P &= \frac{F_{n}}{(1 + r)^{n}} \ &= \frac{\ 500}{(1 + 0.10)^{4}} \ &= \frac{\ 500}{(1 + 0.10)^{4}} \ &= \frac{\ 500}{1.4641} \ &= \ 341.51 \end{split}$
Present Value Tables
Question: Although most managers use spreadsheets, such as Excel, to perform present value calculations (discussed later in this chapter), you can also use the present value tables in the appendix to this chapter, labeled Figure 8.9 and Figure 8.10, for these calculations. Figure 8.9 simply provides the present value of $1 (i.e., F =$1) given the number of years (n) and the interest rate (r). How are these tables used to calculate present value amounts?
Answer
Let’s look at an example to see how these tables work. Assume $1 will be received 4 years from today (n = 4), and the interest rate is 10 percent (r = 10 percent). What is the present value of this cash flow? Look at Figure 8.9 in the appendix. Find the column labeled 10 percent and the row labeled 4. The present value is$0.6830, or $0.68 rounded. The table amount given is often called a factor. The factor in this example is 0.6830 (note that the formula to find this factor is shown at the top of Figure 8.9). Now assume all the same facts, except that$500 rather than $1 will be received in 4 years. To find the present value, simply multiply the factor found in Figure 8.9 by$500, as follows:
$\begin{split} \text{Present value} &= \text{Amount received in the future × Present value factor} \ &= \ 500 \times 0.6830 \ &= \ 341.50 \end{split}$
Notice that this present value is the same as the one we calculated using the formula P = Fn ÷ (1 + r)n, with the exception of a small difference due to rounding the factor in Figure 8.9. Next, we use present value concepts to evaluate projects with the NPV method.
Key Takeaway
Present value calculations tell us the value of future cash flows in today’s dollars. The present value of a cash flow can be calculated by using the formula P = Fn ÷ (1 + r)n. It can also be calculated by using the tables in the appendix of this chapter. Simply find the factor in Figure 8.9 given the number of years (n) and annual interest rate (r). Then multiply the factor by the future cash flow, as follows:
$\text{Present value = Amount received in the future × Present value factor}$
REVIEW PROBLEM 8.1
For each of the following independent scenarios, calculate the present value of the cash flow described. Round to the nearest dollar.
1. You will receive $5,000, 5 years from today, and the interest rate is 8 percent. 2. You will receive$80,000, 9 years from today, and the interest rate is 10 percent.
3. You will receive $400,000, 20 years from today, and the interest rate is 20 percent. 4. You will receive$250,000, 10 years from today, and the interest rate is 15 percent.
Answer
Two approaches can be used to find the present value of a cash flow. The first requires using the formula P = Fn ÷ (1 + r)n. The second requires using Figure 8.9 in the appendix to find the present value factor and inserting it in the following formula:
$\text{Present value = Amount received in the future × Present value factor}$
(from Figure 8.9)
We show both approaches in the following solutions.
1. Using the formula P = Fn ÷ (1 + r)n, we get $\ 3,403 = \ 5,000 \div (1 + 0.08)^{5}$Using Figure 8.9, we get $\begin{split} \text{Present value} &= \text{Future value × Present value factor} \ \ 3,403 &= \ 5,000 \times 0.6806 \end{split}$
2. Using the formula P = Fn ÷ (1 + r)n, we get $\ 33,928 = \ 80,000 \div (1 + 0.10)^{9}$Using Figure 8.9, we get $\begin{split} \text{Present value} &= \text{Future value × Present value factor} \ \ 33,928 &= \ 80,000 \times 0.4241 \end{split}$
3. The small difference between the two approaches is due to rounding the factor in Figure 8.9. Using the formula P = Fn ÷ (1 + r)n, we get $\10,434 = \ 400,000 \div (1 + 0.20)^{20}$Using Figure 8.9, we get $\begin{split} \text{Present value} &= \text{Future value × Present value factor} \ \ 10,440 &= \ 400,000 \times 0.0261 \end{split}$
4. The small difference between the two approaches is due to rounding the factor Figure 8.9. Using the formula P = Fn ÷ (1 + r)n, we get $\ 61,796 = \ 250,000 \div (1 + 0.15)^{10}$Using Figure 8.9, we get $\begin{split} \text{Present value} &= \text{Future value × Present value factor} \ \ 61,800 &= \ 250,000 \times 0.2472 \end{split}$
Definition
1. The process of analyzing and deciding which long-term investments (or capital expenditure decision) to make.
2. The amount of cash received or paid at a specific point in time.
3. The term used to describe future cash flows (both in and out) in today’s dollars. | textbooks/biz/Accounting/Managerial_Accounting/08%3A_How_Is_Capital_Budgeting_Used_to_Make_Decisions/8.01%3A_Introduction.txt |
Learning Objectives
• Evaluate investments using the net present value (NPV) approach.
Question: Now that we have the tools to calculate the present value of future cash flows, we can use this information to make decisions about long-term investment opportunities. How does this information help companies to evaluate long-term investments?
Answer
The net present value (NPV)4 method of evaluating investments adds the present value of all cash inflows and subtracts the present value of all cash outflows. The term discounted cash flows is also used to describe the NPV method. In the previous section, we described how to find the present value of a cash flow. The term net in net present value means to combine the present value of all cash flows related to an investment (both positive and negative).
Recall the problem facing Jackson’s Quality Copies at the beginning of the chapter. The company’s president and owner, Julie Jackson, would like to purchase a new copy machine. Julie feels the investment is worthwhile because the cash inflows over the copier’s life total \$82,000, and the cash outflows total \$57,000, resulting in net cash inflows of \$25,000 (= \$82,000 – \$57,000). However, this approach ignores the timing of the cash flows. We know from the previous section that the further into the future the cash flows occur, the lower the value in today’s dollars.
Question: How do managers adjust for the timing differences related to future cash flows?
Answer
Most managers use the NPV approach. This approach requires three steps to evaluate an investment:
Step 2. Establish an appropriate interest rate to be used for evaluating the investment, typically called the required rate of return5.
(This rate is also called the discount rate or hurdle rate.)
Step 3. Calculate and evaluate the NPV of the investment.
Let’s use Jackson’s Quality Copies as an example to see how this process works.
Step 1. Identify the amount and timing of the cash flows required over the life of the investment.
Question: What are the cash flows associated with the copy machine that Jackson’s Quality Copies would like to buy?
Answer
Jackson’s Quality Copies will pay \$50,000 for the new copier, which is expected to last 7 years. Annual maintenance costs will total \$1,000 a year, labor cost savings will total \$11,000 a year, and the company will sell the copier for \$5,000 at the end of 7 years. Figure 8.1 summarizes the cash flows related to this investment. Amounts in parentheses are cash outflows. All other amounts are cash inflows.
Question: How do managers establish the interest rate to be used for evaluating an investment?
Answer
Although managers often estimate the interest rate, this estimate is typically based on the organization’s cost of capital. The cost of capital6 is the weighted average costs associated with debt and equity used to fund long-term investments. The cost of debt is simply the interest rate associated with the debt (e.g., interest for bank loans or bonds issued). The cost of equity is more difficult to determine and represents the return required by owners of the organization. The weighted average of these two sources of capital represents the cost of capital (finance textbooks address the complexities of this calculation in more detail).
The general rule is the higher the risk of the investment, the higher the required rate of return (assume required rate of return is synonymous with interest rate for the purpose of calculating the NPV). A firm evaluating a long-term investment with risk similar to the firm’s average risk will typically use the cost of capital. However, if a long-term investment carries higher than average risk for the firm, the firm will use a required rate of return higher than the cost of capital.
The accountant at Jackson’s Quality Copies, Mike Haley, has established the cost of capital for the firm at 10 percent. Since the proposed purchase of a copy machine is of average risk to the company, Mike will use 10 percent as the required rate of return.
Step 3. Calculate and evaluate the NPV of the investment.
Question: How do managers calculate the NPV of an investment?
Answer
Figure 8.2 shows the NPV calculation for Jackson’s Quality Copies. Examine this table carefully. The cash flows come from Figure 8.1. The present value factors come from Figure 8.9 in the appendix (r = 10 percent; n = year). The bottom row, labeled present value is calculated by multiplying the total cash in (out) × present value factor, and it represents total cash flows for each time period in today’s dollars. The bottom right of Figure 8.2 shows the NPV for the investment, which is the sum of the bottom row labeled present value.
The NPV is \$1,250. Because NPV is > 0, accept the investment. (The investment provides a return greater than 10 percent.)
The NPV Rule
Question: Once the NPV is calculated, how do managers use this information to evaluate a long-term investment?
Answer
Managers apply the following rule to decide whether to proceed with the investment:
NPV Rule: If the NPV is greater than or equal to zero, accept the investment; otherwise, reject the investment.
As summarized in Figure 8.3, if the NPV is greater than zero, the rate of return from the investment is higher than the required rate of return. If the NPV is zero, the rate of return from the investment equals the required rate of return. If the NPV is less than zero, the rate of return from the investment is less than the required rate of return. Since the NPV is greater than zero for Jackson’s Quality Copies, the investment is generating a return greater than the company’s required rate of return of 10 percent.
Note that the present value calculations in Figure 8.3 assume that the cash flows for years 1 through 7 occur at the end of each year. In reality, these cash flows occur throughout each year. The impact of this assumption on the NPV calculation is typically negligible.
Cost of Capital by Industry
Cost of capital can be estimated for a single company or for entire industries. New York University’s Stern School of Business maintains cost of capital figures by industry. Almost 7,000 firms were included in accumulating this information. The following sampling of industries compares the cost of capital across industries. Notice that high-risk industries (e.g., computer, e-commerce, Internet, and semiconductor) have relatively high costs of capital.
Air transportation 11.48 percent
Auto and truck 11.04 percent
Auto parts 9.56 percent
Beverage (soft drinks) 8.16 percent
Computer 14.49 percent
E-commerce 15.65 percent
Grocery 9.79 percent
Internet 15.98 percent
Retail store 9.30 percent
Semiconductor 19.03 percent
Source: New York University’s Stern Business School, “Home Page,” http://pages.stern.nyu.edu.
Annuity Tables
Question: Notice in Figure 8.1 that the rows labeled maintenance cost and labor savings have identical cash flows from one year to the next. Identical cash flows that occur in regular intervals, such as these at Jackson’s Quality Copies, are called an annuity7. How can we use annuities in an alternate format to calculate the NPV?
Answer
In Figure 8.4, we demonstrate an alternative approach to calculating the NPV.
*Because this is not an annuity, use Figure 8.9 in the appendix.
**Because this is an annuity, use Figure 8.10 in the appendix. The number of years (n) equals seven since identical cash flows occur each year for seven years.
Note: the NPV of \$1,250 is the same as the NPV in Figure 8.2.
The purchase price and salvage value rows in Figure 8.4 represent one-time cash flows, and thus we use Figure 8.9 in the appendix to find the present value factor for these items (these are not annuities). The annual maintenance costs and annual labor savings rows represent cash flows that occur each year for seven years (these are annuities). We use Figure 8.10 in the appendix to find the present value factor for these items (note that the number of years, n, equals seven since the cash flows occur each year for seven years). Simply multiply the cash flow shown in column (A) by the present value factor shown in column (B) to find the present value for each line item. Then sum the present value column to find the NPV. This alternative approach results in the same NPV shown in Figure 8.2.
Winning the Lottery
© Thinkstock
Like many other states, California pays out lottery winnings in installments over several years. For example, a \$1,000,000 lottery winner in California will receive \$50,000 each year for 20 years.
Does this mean that the State of California must have \$1,000,000 on the day the winner claims the prize? No. In fact, California has approximately \$550,000 in cash to pay \$1,000,000 over 20 years. This \$550,000 in cash represents the present value of a \$50,000 annuity lasting 20 years, and the state invests it so that it can provide \$1,000,000 to the winner over 20 years.
Source: California State Lottery, “California State Lottery Home Page,” http://www.calottery.com.
Key Takeaway
Present value calculations tell us the value of cash flows in today’s dollars. The NPV method adds the present value of all cash inflows and subtracts the present value of all cash outflows related to a long-term investment. If the NPV is greater than or equal to zero, accept the investment; otherwise, reject the investment.
REVIEW PROBLEM 8.2
The management of Chip Manufacturing, Inc., would like to purchase a specialized production machine for \$700,000. The machine is expected to have a life of 4 years, and a salvage value of \$100,000. Annual maintenance costs will total \$30,000. Annual labor and material savings are predicted to be \$250,000. The company’s required rate of return is 15 percent.
1. Ignoring the time value of money, calculate the net cash inflow or outflow resulting from this investment opportunity.
2. Find the NPV of this investment using the format presented in Figure 8.2.
3. Find the NPV of this investment using the format presented in Figure 8.4.
4. Should Chip Manufacturing, Inc., purchase the specialized production machine? Explain.
Answer
1. The net cash inflow, ignoring the time value of money, is \$280,000, calculated as follows:
2. The NPV is \$(14,720), calculated as follows:
3. The alternative format used for calculating the NPV is shown as follows. Note that the NPV here is identical to the NPV calculated previously in part 2.
*Because this is not an annuity, use Figure 8.9 in the appendix.
**Because this is an annuity, use Figure 8.10 in the appendix. The number of years (n) equals four since identical cash flows occur each year for four years.
4. Because the NPV is less than 0, the return generated by this investment is less than the company’s required rate of return of 15 percent. Thus Chip Manufacturing, Inc., should not purchase the specialized production machine.
Definitions
1. A method used to evaluate long-term investments. It is calculated by adding the present value of all cash inflows and subtracting the present value of all cash outflows.
2. The interest rate used for evaluating long-term investments; it represents the company’s minimum acceptable return (or discount rate; also called hurdle rate).
3. The weighted average costs associated with debt and equity used to fund long-term investments.
4. A term used to describe identical cash flows that occur in regular intervals. | textbooks/biz/Accounting/Managerial_Accounting/08%3A_How_Is_Capital_Budgeting_Used_to_Make_Decisions/8.03%3A_Net_Present_Value.txt |
Learning Objectives
• Evaluate investments using the internal rate of return (IRR) approach.
Question: Using the internal rate of return (IRR) to evaluate investments is similar to using the net present value (NPV) in that both methods consider the time value of money. However, the IRR provides additional information that helps companies evaluate long-term investments. What is the IRR, and how does it help managers make decisions related to longterm investments?
Answer
The internal rate of return (IRR)8 is the rate required (r) to get an NPV of zero for a series of cash flows. The IRR represents the time-adjusted rate of return for the investment being considered. The IRR decision rule states that if the IRR is greater than or equal to the company’s required rate of return (recall that this is often called the hurdle rate), the investment is accepted; otherwise, the investment is rejected.
Most managers use a spreadsheet, such as Excel, to calculate the IRR for an investment (we discuss this later in the chapter). However, we can also use trial and error to approximate the IRR. The goal is simply to find the rate that generates an NPV of zero. Let’s go back to the Jackson’s Quality Copies example. Figure 8.4 provides the projected cash flows for a new copy machine and the NPV calculation using a rate of 10 percent. Recall that the NPV was \$1,250, indicating the investment generates a return greater than the company’s required rate of return of 10 percent.
Although it is useful to know that the investment’s return is greater than the company’s required rate of return, managers often want to know the exact return generated by the investment. (It is often not enough to state that the exact return is something higher than 10 percent!) Managers also like to rank investment opportunities by the return each investment is expected to generate. Our goal now is to determine the exact return—that is, to determine the IRR. We know from Figure 8.4 that the copy machine investment generates a return greater than 10 percent. Figure 8.5 summarizes this calculation with the 2 columns under the 10 percent heading.
The far right side of Figure 8.5 shows that the NPV is \$(2,100) if the rate is increased to 12 percent (recall our goal is to find the rate that yields an NPV of 0). Thus the IRR is between 10 and 12 percent. Next, we try 11 percent. As shown in the middle of Figure 8.5, 11 percent provides an NPV of \$(469). Thus the IRR is between 10 and 11 percent; it is closer to 11 percent because \$(469) is closer to 0 than \$1,250. (Note that as the rate increases, the NPV decreases, and as the rate decreases, the NPV increases.)
*Because this is not an annuity, use Figure 8.9 in the appendix.
**Because this is an annuity, use Figure 8.10 in the appendix. The number of years (n) equals seven since identical cash flows occur each year for seven years.
Note: the NPV of \$(469) is closest to 0. Thus the IRR is close to 11 percent.
This trial and error approach allows us to approximate the IRR. As stated earlier, if the IRR is greater than or equal to the company’s required rate of return, the investment is accepted; otherwise, the investment is rejected. For Jackson’s Quality Copies, the IRR of approximately 11 percent is greater than the company’s required rate of return of 10 percent. Thus the investment should be accepted.
Using Excel to Calculate NPV and IRR
Let’s use the Jackson’s Quality Copies example presented at the beginning of the chapter to illustrate how Excel can be used to calculate the NPV and IRR. Two steps are required to calculate the NPV and IRR using Excel. All cell references are to the following spreadsheet shown.
Step 1. Enter the data in the spreadsheet.
Rows 1 through 7 in the spreadsheet show the cash flows associated with the proposal to purchase a new copy machine at Jackson’s Quality Copies (first presented in Figure 8.1).
Step 2. Input the functions to calculate NPV and IRR.
We selected cell H16 to calculate the NPV, so this is where the NPV function is input. Cell E16 shows the function in detail with dialogue boxes provided for clarification. Notice that the resulting NPV of \$1,250 shown in cell H16 is the same as the NPV calculated in Figure 8.2 and Figure 8.4.
We selected cell H28 to calculate the IRR, so this is where the IRR function is input. Cell E28 shows the function in detail. Notice that the resulting IRR of 10.72 percent shown in cell H28 is very close to our approximation of slightly less than 11 percent shown in Figure 8.5.
As an alternative to entering a function directly into the spreadsheet, the NPV function under the Formulas menu in Excel can be used. Simply select the cell in the spreadsheet where you would like the answer to appear (H16 in this case), and go to the Formulas menu. Click on the fx symbol or Insert Function on the formula bar. Search for the function by typing in NPV, select NPV where it appears in the box, then select OK. When asked for the Rate, enter the cell where the rate appears (B10). Then under Value 1 enter the cells containing the series of cash flows, starting with year 1 (shown as C7:I7, which means C7 through I7). Select OK. Now go back and add the cash flow at time 0 (B7) to the end of the NPV function. The resulting formula will look like the formula shown in E16, and the answer will appear in the cell where the function is entered (H16).
The IRR function can be inserted into a cell using the same process presented previously. Select the cell in the spreadsheet where you would like the answer to appear (H28), and go to the Formulas menu. Click on the fx symbol or Insert Function on the formula bar. Search for the function by typing in IRR, select IRR where it appears in the box below, then select OK. When asked for Values, enter the cells containing the series of cash flows, starting with time 0 (shown as B7:I7, which means B7 through I7). When asked for a Guess, enter your best guess as to what the IRR might be (this provides the system with a starting point), then select OK. The resulting formula will look like the formula shown in E28, and the answer will appear in the cell where the function is entered (H28).
Key Takeaway
The IRR is the rate required (r) to get an NPV of zero for a series of cash flows and represents the time-adjusted rate of return for an investment. If the IRR is greater than or equal to the company’s required rate of return (often called the hurdle rate), the investment is accepted; otherwise, the investment is rejected.
REVIEW PROBLEM 8.3
This review problem is a continuation of Note 8.17 "Review Problem 8.2", and uses the same information. The management of Chip Manufacturing, Inc., would like to purchase a specialized production machine for \$700,000. The machine is expected to have a life of 4 years, and a salvage value of \$100,000. Annual maintenance costs will total \$30,000. Annual labor and material savings are predicted to be \$250,000. The company’s required rate of return is 15 percent.
1. Based on your answer to Note 8.17 "Review Problem 8.2", use trial and error to approximate the IRR for this investment proposal.
2. Should Chip Manufacturing, Inc., purchase the specialized production machine? Explain.
Answer
1. In Note 8.17 "Review Problem 8.2", the NPV was calculated using 15 percent (the company’s required rate of return). Knowing that 15 percent results in an NPV of \$(14,720), and therefore seeing the return is less than 15 percent, we decreased the rate to 13 percent. As shown in the following figure, this resulted in an NPV of \$15,720, which indicates the return is higher than 13 percent. Using a rate of 14 percent results in an NPV very close to 0 at \$224. Thus the IRR is close to 14 percent.
*Because this is not an annuity, use Figure 8.9 in the appendix.
**Because this is an annuity, use Figure 8.10 in the appendix. The number of years (n) equals four since identical cash flows occur each year for four years.
2. Because the IRR of 14 percent is less than the company’s required rate of return of 15 percent, Chip Manufacturing, Inc., should not purchase the specialized production machine.
Definition
1. A method used to evaluate long-term investments. It is defined as the rate required to get a net present value of zero for a series of cash flows. | textbooks/biz/Accounting/Managerial_Accounting/08%3A_How_Is_Capital_Budgeting_Used_to_Make_Decisions/8.04%3A_The_Internal_Rate_of_Return.txt |
Learning Objectives
• Understand the impact of cash flows, qualitative factors, and ethical issues on long-term investment decisions.
Question: We have described the net present value (NPV) and internal rate of return (IRR) approaches to evaluating long-term investments. With both of these approaches, there are several important issues that must be considered. What are these important issues?
Answer
These issues include focusing on cash flows, factoring in inflation, assessing qualitative factors, and ethical considerations. All are described next.
Focusing on Cash Flows
Question: Which basis of accounting is used to calculate the NPV and IRR for long-term investments, cash or accrual?
Answer
Both methods of evaluating long-term investments, NPV and IRR, focus on the amount of cash flows and when the cash flows occur. Note that the timing of revenues and costs in financial accounting using the accrual basis is often not the same as when the cash inflows and outflows occur. A sale can be recorded in one period, and the cash be collected in a future period. Costs can occur in one period, and the cash be paid in a future period. For the purpose of making NPV and IRR calculations, managers typically use the time period when the cash flow occurs.
When a company invests in a long-term asset, such as a production building, the cash outflow for the asset is included in the NPV and IRR analyses. The depreciation taken on the asset in future periods is not a cash flow and is not included in the NPV and IRR calculations. However, there is a cash benefit related to depreciation (often called a depreciation tax shield) since income taxes paid are reduced as a result of recording depreciation expense. We explore the impact of income taxes on NPV and IRR calculations later in the chapter.
Factoring in Inflation
Question: Is inflation included in cash flow projections when calculating the NPV and IRR?
Answer
Most managers make cash flow projections that include an adjustment for inflation. When this is done, a rate must be used that also factors in inflation over the life of the investment. As discussed earlier in the chapter, the required rate of return used for NPV calculations is based on the firm’s cost of capital, which is the weighted average cost of debt and equity. Since the cost of debt and equity already includes the effect of inflation, no inflation adjustment is necessary when establishing the required rate of return.
The important point here is that cash flow projections must include adjustments for inflation to match the required rate of return, which already factors in inflation. If cash flows are not adjusted for inflation, managers are likely underestimating future cash flows and therefore underestimating the NPV of the investment opportunity. This is particularly pronounced for economies that have relatively high rates of inflation.
For the purposes of this chapter, assume all cash flows and required rates of return are adjusted for inflation.
Be Aware of Qualitative Factors
Question: So far, this chapter has focused on using cash flow projections and the time value of money to evaluate long-term investments. Using these quantitative factors to make decisions allows managers to support decisions with measurable data. For example, the investment opportunity at Jackson’s Quality Copies presented at the beginning of the chapter was accepted because the NPV of \$1,250 was greater than 0, and the IRR of 11 percent was greater than the company’s required rate of return of 10 percent. Why do most companies also consider nonfinancial factors, often called qualitative factors, when making a long-term investment decision?
Answer
Although using quantitative factors for decision making is important, qualitative factors may outweigh the quantitative factors in making a decision. For example, a large manufacturer of medical devices recently invested several million dollars in a small start-up medical device firm. When asked about the NPV analysis, the manager responsible for the investment indicated, “My staff did a quick and dirty NPV analysis, which indicated we should not invest in the company. However, the technology they were using for their device was of such strategic importance to us, we could not pass up the investment.” This is an example of qualitative factors (strategic importance to the company) outweighing quantitative factors (negative NPV).
Similar situations often arise when companies must invest in long-term assets even though NPV and IRR analyses indicate otherwise. Here are a few examples:
• Investing in new production facilities may be essential to maintaining a reputation as the industry leader in innovation, even though the quantitative analysis (NPV and IRR) points to rejecting the investment. (It is difficult to quantify the benefits of being the “industry leader in innovation.”)
• Investing in pollution control devices for an oil refinery may provide social benefits even though the quantitative analysis (NPV and IRR) points to rejecting the investment. (Although a reduction in fines and legal costs may be quantifiable and included in the analyses, it is difficult to quantify the social benefits.)
• Investing in a new product line of entry-level automobiles may increase foot traffic at the showroom, resulting in increased sales of other products, even though the quantitative analysis (NPV and IRR) points to rejecting the investment. (It is difficult to quantify the impact of the new product line on sales of existing product lines.)
Clearly, managers must look at the financial information and analysis when considering whether to invest in long-term assets. However, the analysis does not stop with financial information. Managers and decision makers must also consider qualitative factors.
Ethical Issues
Question: Our discussion of NPV and IRR methods implies that managers can easily make capital budgeting decisions once NPV and IRR analyses are completed and qualitative factors have been considered. However, managers sometimes make decisions that are not in the best interest of the company. Why might managers make decisions that are not in the best interest of the company?
Answer
Several examples are provided next.
Short-Term Incentives Affect Long-Term Decisions
Managers are often evaluated and compensated based on annual financial results. The financial results are typically measured using financial accounting data prepared on an accrual basis.
Suppose you are a manager considering an investment opportunity to start a new product line that has a positive NPV. Because the NPV is positive, you should accept the investment proposal. However, revenues and related cash inflows are not significant until after the second year. In the first two years, revenues are low and depreciation charges are high, resulting in significantly lower overall company net income than if the project were rejected. Assuming you are evaluated and compensated based on annual net income, you may be inclined to reject the new product line regardless of the NPV analysis.
Many companies are aware of this conflict between the manager’s incentive to improve short-term results and the company’s goal to improve long-term results. To mitigate this conflict, some companies offer managers part ownership in the company (e.g., through stock options), creating an incentive to increase the value of the company over the long run.
Modifying Cash Flow Estimates to Get Approval
Managers often have a vested interest in getting proposals approved regardless of NPV and IRR results. For example, assume a manager spent several years developing a plan to construct a new production facility. Because of the significant work involved, and the projected benefits of building a new facility, the manager wants to see the proposal approved. However, the NPV analysis indicates the production facility proposal does not meet the company’s minimum required rate of return. As a result, the manager decides to inflate projected cash inflows to get a positive NPV, and the project is approved.
Clearly, a conflict exists between the company’s desire to accept projects that meet or exceed the required rate of return and the manager’s desire to get approval for a “pet” project regardless of its profitability. Again, having part ownership in a company provides an incentive for managers to reject proposals that will not increase the value of the company.
Another way to mitigate this conflict is to conduct a postaudit9, which compares the original capital budget with the actual results. Managers who provide misleading capital budget analyses are identified through this process. Postaudits provide an incentive for managers to provide accurate estimates.
Key Takeaway
Although accountants are responsible for providing relevant and objective financial information to help managers make decisions, several important factors play a significant role in the decisionmaking process as described here:
• NPV and IRR analyses use cash flows to evaluate long-term investments rather than the accrual basis of accounting.
• Cash flow projections must include adjustments for inflation to match the required rate of return, which already factor in inflation.
• Using quantitative factors to make decisions allows managers to support decisions with measurable data. However, nonfinancial factors (often called qualitative factors) must be considered as well.
• Circumstances sometimes exist that cause managers to make decisions that are not in the best interest of the company. For example, managers may be evaluated on short-term financial results even though it is in the best interest of the company to invest in projects that are profitable in the long term. Thus projects that reduce short-term profitability in lieu of significant long-term profits may be rejected.
REVIEW PROBLEM 8.4
1. Why must cash flow projections include adjustments for inflation?
2. Why is it important for organizations to consider qualitative factors when making capital budgeting decisions?
3. Assume the manager of Best Electronics earns an annual bonus based on meeting a certain level of net income. The company is currently considering expanding by adding a second retail store. The second store is expected to become profitable three years after opening. The manager is responsible for making the final decision as to whether the second store should be opened and would be in charge of both stores.
1. Why might the manager refuse to invest in the new store even though the investment is projected to achieve a return greater than the company’s required rate of return?
2. What can the company do to mitigate the conflict between the manager’s interest of achieving the bonus and the company’s desire to accept investments that exceed the required rate of return?
Answer
1. Projected cash flows must include an adjustment for inflation to match the required rate of return. The required rate of return is based on the company’s weighted average cost of debt and equity. The cost of debt and equity already factors in inflation. Thus the cash flows must also factor in inflation to be consistent with the required rate of return.
2. Although managers prefer to make capital budgeting decisions based on quantifiable data (e.g., using NPV or IRR), nonfinancial factors may outweigh financial factors. For example, maintaining a reputation as the industry leader may require investing in long-term assets, even though the investment does not meet the minimum required rate of return. The management believes the qualitative factor of being the industry leader is critical to the company’s future success and decides to make the investment.
3. Best Electronics is considering opening a second store.
1. The manager’s bonus is based on achieving a certain level of net income each year, and the new store will likely cause net income to decrease in the first two years. Thus the manager may not be able to achieve the net income necessary to qualify for the bonus if the company invests in the new store.
2. To mitigate this conflict, Best Electronics can offer the manager part ownership in the company (perhaps through stock options). This would provide an incentive for the manager to increase profit—and therefore company value—over many years. The company may also adjust the net income required to earn a bonus to account for the losses expected in the new store for the first two years.
Definition
1. Compares the original capital budget with the actual results. | textbooks/biz/Accounting/Managerial_Accounting/08%3A_How_Is_Capital_Budgeting_Used_to_Make_Decisions/8.05%3A_Other_Factors_Affecting_NPV_and_IRR_Analysis.txt |
Learning Objectives
• Evaluate investments using the payback method.
Question: Although the net present value (NPV) and internal rate of return (IRR) methods are the most commonly used approaches to evaluating investments, some managers also use the payback method. What is the payback method, and how does it help managers make decisions related to long-term investments?
Answer
The payback method10 evaluates how long it will take to “pay back” or recover the initial investment. The payback period11, typically stated in years, is the time it takes to generate enough cash receipts from an investment to cover the cash outflows for the investment.
Managers who are concerned about cash flow want to know how long it will take to recover the initial investment. The payback method provides this information. Managers may also require a payback period equal to or less than some specified time period. For example, Julie Jackson, the owner of Jackson’s Quality Copies, may require a payback period of no more than five years, regardless of the NPV or IRR.
Note that the payback method has two significant weaknesses. First, it does not consider the time value of money. Second, it only considers the cash inflows until the investment cash outflows are recovered; cash inflows after the payback period are not part of the analysis. Both of these weaknesses require that managers use care when applying the payback method.
Payback Method Example
Question: What is the payback period for the proposed purchase of a copy machine at Jackson’s Quality Copies?
Answer
The payback period is five years. Here’s how we calculate it. Figure 8.6 repeats the cash flow estimates for Julie Jackson’s planned purchase of a copy machine for Jackson’s Quality Copies, the example presented at the beginning of the chapter.
The payback method answers the question “how long will it take to recover my initial \$50,000 investment?” With annual cash inflows of \$10,000 starting in year 1, the payback period for this investment is 5 years (= \$50,000 initial investment ÷ \$10,000 annual cash receipts). This calculation is relatively simple when one investment is made at the beginning, and annual cash inflows are identical. However, some investments require cash outflows at different points throughout the life of the asset, and cash inflows can vary from one year to the next. Table 8.1 provides a format to help calculate the payback period for these more complex investments. Note that the review problem at the end of this segment provides an example of how to calculate the payback period to the nearest month when uneven cash flows are expected.
Table 8.1 - Calculating the Payback Period for Jackson’s Quality Copies
Investment (Cash Outflow) Cash Inflow Unrecovered Investment Balance
Year 0 \$(50,000) \$(50,000)a
Year 1 \$10,000 \$(40,000)b
Year 2 \$10,000 \$(30,000)c
Year 3 \$10,000 \$(20,000)
Year 4 \$10,000 \$(10,000)
Year 5 \$10,000 \$0
Year 6 \$10,000 \$0
Year 7 \$10,000 \$0
a \$(50,000) = \$(50,000) initial investment.
b \$(40,000) = \$(50,000) unrecovered investment balance + \$10,000 year 1 cash inflow.
c \$(30,000) = \$(40,000) unrecovered investment balance at end of year 1 + \$10,000 year 2 cash inflow.
Weaknesses of the Payback Method
Question: Why is it a problem to ignore the time value of money when calculating the payback period?
Answer
Suppose you have 2 investments of \$10,000 to choose from. The first investment generates cash inflows of \$8,000 in year 1, \$2,000 in year 2, and \$1,000 in year 3. The second investment generates cash inflows of \$2,000 in year 1, \$8,000 in year 2, and \$1,000 in year 3. The two investments are summarized here:
Investment I Investment II
Year 0 \$(10,000) \$(10,000)
Year 1 \$8,000 \$2,000
Year 2 \$2,000 \$8,000
Year 3 \$1,000 \$1,000
Both investments have a payback period of two years. Does this mean both investments are of equal value? No because the first investment generates far more cash in year 1 than the second investment. In fact, it would be preferable to calculate the IRR to compare these two investments. The IRR for the first investment is 6 percent, and the IRR for the second investment is 5 percent.
Question: Why is it a problem to ignore the cash flows after the payback period?
Answer
Suppose \$50,000 can be invested in 2 separate investments with the following cash flows:
Investment I Investment II
Year 0 \$(50,000) \$(50,000)
Year 1 \$25,000 \$2,000
Year 2 \$25,000 \$2,000
Year 3 \$25,000 \$46,000
Year 4 \$1,000 \$35,000
The first investment has a payback period of two years, and the second investment has a payback period of three years. If the company requires a payback period of two years or less, the first investment is preferable. However, the first investment generates only \$3,000 in cash after its payback period while the second investment generates \$35,000 after its payback period. The payback method ignores both of these amounts even though the second investment generates significant cash inflows after year 3. Again, it would be preferable to calculate the IRR to compare these two investments. The IRR for the first investment is 4 percent, and the IRR for the second investment is 18 percent.
Although the payback method is useful in certain situations where companies are concerned about recovering investments as quickly as possible (e.g., companies on the verge of bankruptcy), it is not a measure of profitability. The NPV and IRR methods compare the profitability of each investment by considering the time value of money for all cash flows related to the investment.
Wrap-Up of Chapter Example
In the Jackson’s Quality Copies example featured throughout this chapter, the company is considering whether to purchase a new copy machine for \$50,000. A week has passed since Mike Haley, accountant, discussed this investment with Julie Jackson, president and owner. Refer to Figure 8.2, Figure 8.4, and Figure 8.5, and Table 8.1 as you learn what Mike’s findings are.
Julie: Hi Mike, any news on the copy machine proposal?
Mike: I ran the numbers for the new copy machine, and I think you’ll like the results. It’s not as simple as looking at the difference between cash outflows of \$57,000 and cash inflows of \$82,000 over the life of the asset. We also have to see when the cash flows occur and convert them into today’s dollars.
Julie: OK. What did you find?
Mike: The NPV is \$1,250 using a required rate of return of 10 percent. This means the investment will generate a return of more than 10 percent after converting the cash flows into today’s dollars.
Julie: Great! I realize the return is expected to be above 10 percent. Do you have a sense of how far above 10 percent?
Mike: Yes. The IRR is about 11 percent. I also calculated the payback period to give you an idea of how long it will take to recover our initial \$50,000 investment.
Julie: Good idea. My hope is that we won’t be waiting too long to recover the original investment.
Mike: It will take 5 years to fully recover the \$50,000 investment.
Julie: Wow! That seems like a long time.
Mike: It is. But realize we bring in an additional \$25,000 after the payback period. Also, the payback method does not measure the profitability of the investment, it simply tells us how long before the initial investment is recovered. Unless we anticipate cash flow problems, I wouldn’t place too much importance on the payback period. The NPV and IRR calculations are the best for evaluating this investment.
Julie: Good point. We don’t expect to have cash flow problems. We have plenty of capital, and the business has generated positive cash flow for the past 10 years. Let’s order the new machine!
Capital Budgeting at Fortune 1000 Companies
Studies completed over the past 40 years have indicated that managers prefer to use IRR and payback methods over NPV when evaluating long-term investments. However, a recent survey of Fortune 1000 chief financial officers indicates that NPV is now the most preferred method. According to this survey, the percentage of firms that always or often use each method is as follows:
NPV 85 percent
IRR 77 percent
Payback 53 percent
This survey also shows that companies with capital budgets exceeding \$500,000,000 are more likely to use these methods than are companies with smaller capital budgets. This is probably because larger companies have more specialized personnel in their finance and accounting departments, which enables them to use more sophisticated approaches in evaluating long-term investments.
Source: Patricia A. Ryan and Glenn P. Ryan, “Capital Budgeting Practices of the Fortune 1000: How Have Things Changed?” Journal of Business and Management 8, no. 4 (2002).
Key Takeaway
The payback method evaluates how long it will take to “pay back” or recover the initial investment. The payback period, typically stated in years, is the time it takes to generate enough cash receipts from an investment to cover the cash outflow(s) for the investment. Although this method is useful for managers concerned about cash flow, the major weaknesses of this method are that it ignores the time value of money, and it ignores cash flows after the payback period.
REVIEW PROBLEM 8.5
This review problem is a continuation of Note 8.22 "Review Problem 8.3" and Note 8.26 "Review Problem 8.4" and uses the same information. The management of Chip Manufacturing, Inc., would like to purchase a specialized production machine for \$700,000. The machine is expected to have a life of 4 years and a salvage value of \$100,000. Annual maintenance costs will total \$30,000. Annual labor and material savings are predicted to be \$250,000.
1. Use the format in Table 8.1 to calculate the payback period. Clearly state your conclusion.
2. Describe the two major weaknesses of the payback method.
Answer
1. The payback period is slightly more than three years since only \$40,000 is left to be recovered after three years, as shown in the following table.
Investment (Cash Outflow) Cash Inflow Unrecovered Investment Balance
Year 0 \$(700,000) \$700,000
Year 1 \$220,000a \$480,000
Year 2 \$220,000a \$260,000
Year 3 \$220,000a \$(40,000)
Year 4 \$320,000a \$0
a \$220,000 = \$250,000 annual savings – \$30,000 annual costs.
b \$320,000 = \$250,000 annual savings – \$30,000 annual costs + \$100,000 salvage value.
A more precise calculation can be performed assuming the \$220,000 cash inflow for year 4 occurs evenly throughout the year and the \$100,000 salvage value cash inflow occurs at the end of year 4. With these assumptions, we simply need to calculate how many months are required in year 4 to recover the remaining \$40,000. \$40,000 divided by \$220,000 equals 0.18 (rounded). Thus 0.18 of a year, or approximately 2 months (= 0.18 × 12 months), is required to recover the remaining \$40,000. This more precise calculation results in a payback period of three years and two months. Note that the salvage value is ignored as this cash inflow occurs at the end of year 4 when the machine is sold.
1. First, the payback method does not consider the time value of money (no present value or IRR calculations are performed). Second, it only considers the cash inflows until the investment cash outflows are recovered; cash inflows after the payback period are not part of the analysis. For Chip Manufacturing, Inc., the payback period is three years and two months. However, significant cash inflows totaling \$280,000 occur after the payback period and therefore are ignored (\$280,000 = \$320,000 year 4 cash inflows – \$40,000 remaining investment recovered in the first 2 months of year 4).
Definitions
1. Evaluates how long it will take to recover the initial investment.
2. The time it takes to generate enough cash receipts from an investment to cover the cash outflows for the investment. | textbooks/biz/Accounting/Managerial_Accounting/08%3A_How_Is_Capital_Budgeting_Used_to_Make_Decisions/8.06%3A_The_Payback_Method.txt |
Learning Objectives
• Evaluate investments with multiple investment and working capital cash flows.
Question: The examples in this chapter are intended to help you learn the basics of evaluating investments using the net present value (NPV), internal rate of return (IRR), and payback methods. However, there are two additional items related to estimating cash flows that must be considered: investment cash outflows and working capital. How do these two items impact long-term investment decisions?
Answer
These items impact the analysis of long-term investments as described next.
Investment Cash Outflows
The examples thus far have assumed that cash outflows for the investment occur only at the beginning of the investment. However, some investments require cash outflows at varying points throughout the life of the project. For example, suppose the JCPenney Company plans to open a new store, which requires a \$10,000,000 investment at the beginning of the project for construction of the building. However, the building will be expanded at the end of year 4, at a cost of \$2,000,000, to meet an expected increase in demand. The \$2,000,000 cash outflow must be included in the cash flows of the project for year 4 when calculating the NPV, IRR, and payback period.
Working Capital
Working capital12 is defined as current assets (cash, accounts receivable, inventory, and the like) minus current liabilities (accounts payable, wages payable, and accrued liabilities, for instance). Many long-term investments require working capital. For example, JCPenney will need cash in its registers when it opens the new store. Working capital is also required to fund inventory and accounts receivable.
Working capital necessary for long-term investments should be included as a cash outflow, typically at the beginning of the project.
Some long-term investments have an expected life, at the end of which working capital is returned to the company for investment elsewhere. When this happens, the working capital is included in the cash flow analysis as a cash outflow at the beginning of the project and a cash inflow at the end of the project.
Key Takeaway
Investment proposals often include investment cash outflows at varying points throughout the life of the project. These cash flows must be included when evaluating investment proposals using NPV, IRR, and payback period methods. Many investments include working capital cash flows required to fund items such as inventory and accounts receivable. Working capital is included as a cash outflow, typically at the beginning of the project, and is often returned back to the company as a cash inflow later in the project.
REVIEW PROBLEM 8.6
The management of Environmental Engineering, Inc. (EEI), would like to open an office for 6 years in a high-growth area of Las Vegas. The initial investment required to purchase an office building is \$250,000, and EEI needs \$50,000 in working capital for the new office. Working capital will be returned to EEI at the end of 6 years. EEI expects to remodel the office at the end of 3 years at a cost of \$200,000. Annual net cash receipts from daily operations (cash receipts minus cash payments) are expected to be as follows:
Year 1 \$ 60,000
Year 2 \$ 80,000
Year 3 \$120,000
Year 4 \$150,000
Year 5 \$160,000
Year 6 \$110,000
Although the company’s cost of capital is 8 percent, management set a required rate of return of 12 percent due to the high risk associated with this project.
1. Find the NPV of this investment using the format presented in Figure 8.2.
2. Use trial and error to approximate the IRR for this investment proposal.
3. Based on your answers to 1 and 2, should EEI open the new office? Explain.
4. Use the format in Table 8.1 to calculate the payback period.
Answer
1. The NPV is \$27,571, as shown in the following figure.
Note: The NPV is \$27,571. Because NPV is > 0, accept the investment. (The investment provides a return greater than 12 percent.)
1. The IRR is between 14 and 15 percent (approximately 14.5 percent). The IRR is the rate that generates a NPV of zero. Because the NPV is positive at 12 percent, the return is higher than 12 percent. The NPV is calculated as follows using a rate of 14 percent, NPV = \$5,007, and 15 percent, NPV = \$(5,446). Thus the IRR is between 14 and 15 percent.
NPV at 14 percent is
NPV at 15 percent is
2. Yes. The NPV is positive at \$27,571, and the IRR of 14.5 percent is higher than the company’s required rate of return of 12 percent. Thus EEI should open the office in Las Vegas.
3. The payback period is approximately 4.5 years. This approximation assumes the \$90,000 unrecovered investment at the end of year 4 will be recovered about halfway through year 5.
Investment (Cash Outflow Cash Inflow Unrecovered Investment Balance
Year 0 \$(300,000) \$(300,000)
Year 1 \$60,000 \$(240,000)a
Year 2 \$80,000 \$(160,000)b
Year 3 \$(200,000) \$120,000 \$(240,000)c
Year 4 \$150,000 \$(90,000)
Year 5 \$160,000 \$0
Year 6 \$160,000 \$0
a \$(240,000) = \$(300,000) unrecovered investment + \$60,000 year 1 cash inflow.
b \$(160,000) = \$(240,000) unrecovered investment at end of year 1 + \$80,000 year 2 cash inflow.
c \$(240,000) = \$(160,000) unrecovered investment at end of year 2 – \$200,000 year 3 investment + \$120,000 year 3 cash inflow.
A more precise calculation can be performed assuming the \$160,000 cash inflow for year 5 occurs evenly throughout the year. Simply calculate how many months are required in year 5 to recover the remaining \$90,000. \$90,000 divided by \$160,000 equals 0.56 (rounded). Thus 0.56 of a year, or approximately 7 months (= 0.56 × 12 months), is required to recover the remaining \$90,000. This more precise calculation results in a payback period of four years and seven months.
Definition
1. Current assets minus current liabilities. | textbooks/biz/Accounting/Managerial_Accounting/08%3A_How_Is_Capital_Budgeting_Used_to_Make_Decisions/8.07%3A_Additional_Complexities_of_Estimating_Cash_Flows.txt |
Learning Objectives
• Understand the impact that income taxes have on capital budgeting decisions.
Question: Throughout the chapter, we assumed no income taxes were involved. This is a reasonable assumption for not-for-profit entities and governmental agencies. However, firms that pay income taxes must consider the impact income taxes have on cash flows for long-term investments. How do for-profit organizations include income taxes in their analysis when making long-term investment decisions?
Answer
Let’s look at an example to help explain how this works. The management of Scientific Products, Inc. (SPI), is considering a five-year contract to build scientific instruments for a large school district. The initial investment required to purchase production equipment is $400,000 (to be depreciated over 5 years using the straight-line method, with no salvage value). An additional$50,000 in working capital is required for the contract. Working capital will be returned to SPI at the end of five years. Annual net cash receipts from daily operations (cash receipts minus cash payments) are shown as follows. Since depreciation expense is not a cash outflow, it is not included in these amounts.
Year 1 $50,000 Year 2$60,000
Year 3 $120,000 Year 4$200,000
Year 5 $130,000 Management established a required rate of return of 10 percent for this proposal. The company’s tax rate is 40 percent. (The complexities of government tax codes have a significant impact on the tax rate used. For simplicity, we use a tax rate of 40 percent for this example.) When taxes are involved, it is important to understand which cash flows are affected by the tax rate and which are not. We look at this by addressing the following capital budgeting items: • Investment cash outflows • Working capital cash outflows and inflows • Revenue cash inflows and expense cash outflows • Depreciation Figure 8.7 provides a detailed example of how companies adjust for income taxes when evaluating long-term investments. Examine Figure 8.7 carefully, including the footnotes, as we explain each of these items. Note: the NPV is$(56,146).
Since NPV is < 0, reject the investment. (The investment provides a return less than 10 percent.)
a Initial investment purchase price and working capital do not directly affect net income and therefore are not adjusted for income taxes.
b Amount equals net cash receipts before taxes × (1 – tax rate). For year 1, $30,000 =$50,000 × (1 – 0.40); for year 2, $36,000 =$60,000 × (1 – 0.40); and so forth.
c Depreciation tax savings = Depreciation expense × Tax rate. Depreciation expense is $80,000 (=$400,000 cost ÷ 5 year useful life). Thus annual depreciation tax savings is $32,000 (=$80,000 depreciation expense × 0.40 tax rate).
1. Investment Cash Outflows. The initial investment in production equipment of $400,000 is not adjusted for income taxes because it does not directly affect net income. Thus this amount is included in full in Figure 8.7. 2. Working Capital Cash Outflows and Inflows. Working capital of$50,000 is not adjusted for income taxes since it does not affect net income. Thus this amount is included in full as a cash outflow at the beginning of the project and again in full when returned to the company at the end of the project, as shown in Figure 8.7.
3. Revenues and Expenses. When a company must pay income taxes, all revenue cash inflows and expense cash outflows affect net income and therefore affect income taxes paid. The goal is to determine the after-tax cash flow. This is calculated in the equation that follows.
The tax rate for Scientific Products, Inc., is 40 percent. Thus net cash receipts (revenue cash inflows minus expense cash outflows) are multiplied by 0.60 (= 1 – 0.40). This results in an after-tax cash flow, as shown in Figure 8.7. $\text{After-tax revenue cash inflow = Before-tax cash inflow × (1 – tax rate)}$$\text{After-tax expense cash outflow = Before-tax cash outflow × (1 – tax rate)}$
4. Depreciation. Although depreciation expense is not a cash outflow, it does reduce taxable income and thereby reduces taxes that are paid (recall that the entry to record depreciation for financial accounting purposes does not affect cash; debit depreciation expense and credit accumulated depreciation). The term used to describe this tax savings is depreciation tax shield13. The tax savings resulting from depreciation are calculated as follows: $\text{Depreciation tax savings cash inflow = Depreciation expense × Tax rate}$The production equipment, which has a purchase price of $400,000, has a useful life of 5 years and no salvage value. SPI uses the straight-line method, which depreciates the original cost evenly over the useful life of the asset. Thus depreciation expense is$80,000 (= $400,000 ÷ 5 years). This is multiplied by the tax rate of 40 percent to get the annual tax savings of$32,000 (= $80,000 × 0.40), as shown in Figure 8.7. Question: Based on the information presented in Figure 8.7, should SPI accept the investment proposal? Answer As you can see in Figure 8.7, the NPV is negative ($[56,146]), so SPI’s management should reject the investment proposal. Figure 8.8 provides a summary of how income taxes influence cash flows for long-term investments. (Note that this section is intended to give you a general overview of how income taxes effect capital budgeting decisions. Finance textbooks provide more detail regarding how to adjust cash flows for income taxes in more complex situations.)
Key Takeaway
Companies that pay income taxes must consider the impact income taxes have on cash flows for long-term investments, and make the necessary adjustments. Investment and working capital cash flows are not adjusted because these cash flows do not affect taxable income. Revenue cash inflows and expense cash outflows are adjusted by multiplying the cash flow by (1 – tax rate). Although depreciation expense is not a cash outflow, it provides tax savings. The tax savings is calculated by multiplying depreciation expense by the tax rate. Once these adjustments are made, we can calculate the NPV and IRR.
REVIEW PROBLEM 8.7
Car Repair, Inc., would like to purchase a new machine for $400,000. The machine will have a life of 4 years with no salvage value, and is expected to generate annual cash revenue of$180,000. Annual cash expenses, excluding depreciation, will total $20,000. The company uses the straight-line depreciation method, has a tax rate of 30 percent, and requires a 10 percent rate of return. 1. Find the NPV of this investment using the format presented in Figure 8.7. 2. Should the company purchase the machine? Explain. Answer 1. The NPV is$50,112 as shown in the following figure.
1. Initial investment purchase price does not directly affect net income and therefore is not adjusted for income taxes.
2. Amount equals cash revenue before taxes × (1 – tax rate); $126,000 =$180,000 × (1 – 0.30).
3. Amount equals cash expense before taxes × (1 – tax rate); $14,000 =$20,000 × (1 – 0.30).
4. Depreciation tax savings = Depreciation expense × Tax rate. Depreciation expense is $100,000 (=$400,000 cost ÷ 4 year useful life). Thus annual depreciation tax savings is $30,000 (=$100,000 depreciation expense × 0.30 tax rate).
2. Yes, the company should purchase the machine. The positive NPV of \$50,112 shows the return of this proposal is above the company’s required rate of return of 10 percent.
Definition
1. The tax savings that result from depreciation expense. | textbooks/biz/Accounting/Managerial_Accounting/08%3A_How_Is_Capital_Budgeting_Used_to_Make_Decisions/8.08%3A_The_Effect_of_Income_Taxes_on_Capital_Budgeting_Decisions.txt |
Per-iods Rate per Period
5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% 18% 20% 25% 30%
0 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
1 .9524 .9434 .9346 .9259 .9174 .9091 .9009 .8929 .8850 .8772 .8696 .8475 .8333 .8000 .7692
2 .9070 .8900 .8734 .8573 .8417 .8264 .8116 .7972 .7831 .7695 .7561 .7182 .6944 .6400 .5917
3 .8638 .8396 .8163 .7938 .7722 .7513 .7312 .7118 .6931 .6750 .6575 .6086 .5787 .5120 .4552
4 .8227 .7921 .7629 .7350 .7084 .6830 .6587 .6355 .6133 .5921 .5718 .5158 .4823 .4086 .3501
5 .7835 .7473 .7130 .6806 .6499 .6209 .5935 .5674 .5428 .5194 .4972 .4371 .4019 .3277 .2693
6 .7462 .7050 .6663 .6302 .5963 .5645 .5346 .5066 .4803 .4556 .4323 .3704 .3349 .2621 .2072
7 .7107 .6651 .6227 .5835 .5470 .5132 .4817 .4523 .4251 .3996 .3759 .3139 .2791 .2097 .1594
8 .6768 .6274 .5820 .5403 .5019 .4665 .4339 .4039 .3762 .3506 .3269 .2660 .2326 .1678 .1226
9 .6446 .5919 .5439 .5002 .4604 .4241 .3909 .3606 .3329 .3075 .2843 .2255 .1938 .1342 .0943
10 .6139 .5584 .5083 .4632 .4224 .3855 .3522 .3220 .2946 .2697 .2472 .1991 .1615 .1074 .0725
11 .5847 .5268 .4751 .4289 .3875 .3555 .3173 .2875 .2607 .2366 .2149 .1619 .1346 .0859 .0558
12 .5568 .4970 .4440 .3971 .3555 .3186 .2858 .2567 .2307 .2076 .1869 .1372 .1122 .0687 .0429
13 .5303 .4688 .4150 .3677 .3262 .2897 .2575 .2292 .2042 .1821 .1625 .1163 .0935 .0550 .0330
14 .5051 .4423 .3878 .3405 .2992 .2633 .2320 .2046 .1807 .1597 .1413 .0985 .0779 .0440 .0254
15 .4810 .4173 .3624 .3152 .2745 .2394 .2090 .1827 .1599 .1401 .1229 .0835 .0649 .0352 .0195
16 .4581 .3936 .3387 .2919 .2519 .2176 .1883 .1631 .1415 .1229 .1069 .0708 .0541 .0281 .0150
17 .4363 .3714 .3166 .2703 .2311 .1978 .1696 .1456 .1252 .1078 .0929 .0600 .0451 .0225 .0116
18 .4155 .3503 .2959 .2502 .2120 .1799 .1528 .1300 .1108 .0946 .0808 .0508 .0376 .0180 .0089
19 .3957 .3305 .2765 .2317 .1945 .1635 .1377 .1161 .0981 .0829 .0703 .0431 .0313 .0144 .0068
20 .3769 .3118 .2584 .2145 .1784 .1486 .1240 .1037 .0868 .0728 .0611 .0365 .0261 .0115 .0053
21 .3589 .2942 .2415 .1987 .1637 .1351 .1117 .0926 .0768 .0638 .0531 .0309 .0217 .0092 .0040
22 .3418 .2775 .2257 .1839 .1502 .1128 .1007 .0826 .0680 .0560 .0462 .0262 .0181 .0074 .0031
23 .3256 .2618 .2109 .1703 .1378 .1117 .0907 .0738 .0601 .0491 .0402 .0222 .0151 .0059 .0024
24 .3101 .2470 .1971 .1577 .1264 .1015 .0817 .0659 .0532 .0431 .0349 .0188 .0126 .0047 .0018
25 .2953 .2330 .1842 .1460 01160 .0923 .0736 .0588 .0471 .0378 .0304 .0160 .0105 .0038 .0014
26 .2812 .2198 .1722 1352 .1064 .0839 .0663 .0525 .0417 .0331 .0264 .0135 .0087 .0030 .0011
27 .2678 .2074 .1609 .1252 .0976 .0763 .0597 .0469 .0369 .0291 .0230 .0115 .0073 .0024 .0008
28 .2551 .1956 .1504 .1159 .0895 .0693 .0538 .0419 .0326 .0255 .0200 .0097 .0061 .0019 .0006
29 .2429 .1846 .1406 .1073 .0822 .0630 .0485 .0374 .0289 .0224 .0174 .0082 .0051 .0015 .0005
30 .2314 .1741 .1314 .0994 .0754 .0573 .0437 .0334 .0256 .0196 .0151 .0070 .0042 .0012 .0004
Note
$\text{Factor} = \frac{1-(1+r)^{-n}}{r}$ | textbooks/biz/Accounting/Managerial_Accounting/08%3A_How_Is_Capital_Budgeting_Used_to_Make_Decisions/8.09%3A_Appendix-_Present_Value_Tables.txt |
Questions
1. What is the difference between capital budgeting decisions covered in this chapter and management decisions covered in Chapter 7?
2. What concept must be considered when looking at cash flows over several years for a long-term investment? Explain.
3. What is meant by the term present value?
4. What is the formula used to calculate the present value of a future cash flow? Describe each component.
5. Describe the three steps required to evaluate investments using the net present value method.
6. How do most firms establish the required rate of return used to calculate the net present value?
7. What is meant by the term internal rate of return? Explain the IRR decision rule?
8. For the purpose of calculating net present value and internal rate of return, do companies use the accrual basis of accounting? Explain.
9. Why might a firm choose to accept a long-term investment even if the net present value is below zero?
10. What might cause a manager to reject a long-term investment even though the net present value is positive?
11. Describe the two steps required to calculate net present value and internal rate of return when using Excel.
12. What is the payback method, and why do managers use this method?
13. What are the two weaknesses associated with the payback method?
14. Refer to Note 8.30 "Business in Action 8.4" What method of evaluating long-term investments is most popular? Why do you think the payback method is the least-used method?
15. What does the term working capital refer to, and how does working capital affect the evaluation of long-term investments?
16. Assume a company pays income taxes. How are revenue and expense cash flows adjusted for income taxes when calculating the net present value?
17. Assume a company pays income taxes. How does depreciation expense affect cash flows even though it is a noncash expense?
Brief Exercises
1. Investment Decision at Jackson’s Quality Copies. Refer to the dialogue at Jackson’s Quality Copies presented at the beginning of the chapter. What is Julie Jackson proposing? What information did Mike, the accountant, get from Julie to evaluate the proposal?
2. Present Value Calculations. For each of the following independent scenarios, use Figure 8.9 in the appendix to calculate the present value of the cash flow described.
1. \$10,000 will be received 4 years from today. The rate is 10 percent.
2. \$10,000 will be received 4 years from today. The rate is 20 percent.
3. \$50,000 will be received 15 years from today. The rate is 12 percent.
4. \$50,000 will be received 15 years from today. The rate is 6 percent.
3. Present Value Calculations (Annuities). For each of the following independent scenarios, use Figure 8.10 in the appendix to calculate the present value of the cash flow described. Round to the nearest dollar.
1. \$1,000 will be received at the end of each year for 6 years. The rate is 12 percent.
2. \$1,000 will be received at the end of each year for 6 years. The rate is 15 percent.
3. \$10,000 will be received at the end of each year for 6 years. The rate is 7 percent.
4. \$250,000 will be received at the end of each year for 4 years. The rate is 10 percent.
4. Net Present Value Calculations. Freefall, Inc., has two independent investment opportunities, each requiring an initial investment of \$65,000. The company’s required rate of return is 8 percent. The cash inflows for each investment are provided as follows.
Required:
1. Without resorting to calculations, which investment will have the highest net present value? Explain.
2. Calculate the net present value for each investment (remember to include the initial investment cash outflow in your calculation). Should the company invest in either investment? Round to the nearest dollar.
1. Internal Rate of Return Calculation. An investment costing \$50,000 today will result in cash savings of \$5,000 per year for 15 years. Use trial and error to approximate the internal rate of return for this investment proposal.
2. Evaluating Qualitative Factors. Chem, Inc., produces chemical products. The company recently decided to invest in expensive pollution control devices even though the negative net present value pointed toward rejecting this investment. What qualitative factor likely led the company to make the investment in spite of the negative net present value?
3. Ethical Issues in Making a Capital Budgeting Decision. Assume the manager of a store earns an annual bonus based on meeting a certain level of net income, which has been achieved consistently over the past five years. The company is currently considering the addition of a second store, which is expected to become profitable after two years. The manager is responsible for making the final decision whether the second store should be opened and would receive an annual bonus only if a certain level of net income were achieved for both stores combined.
Why might the manager refuse to invest in the new store even though the investment is projected to achieve a return greater than the company’s required rate of return?
4. Net Present Value Calculation Using Excel. An investment costing \$200,000 today will result in cash savings of \$85,000 per year for 3 years. The company’s required rate of return is 11 percent. Use Excel to calculate the net present value of this investment in a format similar to the one in the Computer Application box in the chapter.
5. Payback Period Calculation. Textile Services, Inc., plans to invest \$80,000 in a new machine. Annual cash inflows from this investment will be \$25,000, and annual cash outflows will be \$5,000. Determine the payback period for this investment.
6. Net Present Value Analysis with Multiple Investments. A project requiring an investment of \$20,000 today and \$10,000 one year from today, will result in cash savings of \$4,000 per year for 15 years. Find the net present value of this investment using a rate of 10 percent. Round to the nearest dollar.
7. Net Present Value Calculation with Taxes. An investment costing \$200,000 today will result in cash savings of \$85,000 per year for 3 years. The company has a tax rate of 40 percent, and requires an 11 percent rate of return. Find the net present value of this investment using the format shown in Figure 8.7. Round to the nearest dollar.
Exercises: Set A
1. Net Present Value Analysis. Architect Services, Inc., would like to purchase a blueprint machine for \$50,000. The machine is expected to have a life of 4 years, and a salvage value of \$10,000. Annual maintenance costs will total \$14,000. Annual savings are predicted to be \$30,000. The company’s required rate of return is 11 percent.
Required:
1. Ignoring the time value of money, calculate the net cash inflow or outflow resulting from this investment opportunity.
2. Find the net present value of this investment using the format presented in Figure 8.2.
3. Should the company purchase the blueprint machine? Explain.
1. Internal Rate of Return Analysis. Architect Services, Inc., would like to purchase a blueprint machine for \$50,000. The machine is expected to have a life of 4 years, and a salvage value of \$10,000. Annual maintenance costs will total \$14,000. Annual savings are predicted to be \$30,000. The company’s required rate of return is 11 percent (this is the same data as the previous exercise).
Required:
1. Use trial and error to approximate the internal rate of return for this investment proposal. Round to the nearest dollar.
2. Should the company purchase the blueprint machine? Explain.
1. Payback Period Calculation. Architect Services, Inc., would like to purchase a blueprint machine for \$50,000. The machine is expected to have a life of 4 years, and a salvage value of \$10,000. Annual maintenance costs will total \$14,000. Annual savings are predicted to be \$30,000 (this is the same data as the previous exercise). Determine the payback period for this investment using the format shown in Table 8.1.
2. Net Present Value Analysis with Multiple Investments, Alternative Format. Conway Construction Corporation would like to purchase a fleet of trucks at a cost of \$260,000. Additional equipment needed to maintain the fleet of trucks will be purchased at the end of year 2 for \$40,000. The trucks are expected to have a life of 8 years, and a salvage value of \$20,000. Annual costs for maintenance, insurance, and other cash expenses will total \$42,000. Annual net cash receipts resulting from this purchase are predicted to be \$135,000. The company’s required rate of return is 14 percent.
Required:
1. Find the net present value of this investment using the format presented in Figure 8.4.
2. Should the company purchase the new fleet of trucks? Explain.
1. Calculating NPV and IRR Using Excel. Wood Products Company would like to purchase a computerized wood lathe for \$100,000. The machine is expected to have a life of 5 years, and a salvage value of \$5,000. Annual maintenance costs will total \$20,000. Annual net cash receipts resulting from this machine are predicted to be \$45,000. The company’s required rate of return is 15 percent.
Required:
1. Use Excel to calculate the net present value and internal rate of return in a format similar to the Computer Application spreadsheet shown in the chapter.
2. Should the company purchase the wood lathe? Explain.
1. Net Present Value Analysis with Taxes. Timberline Company would like to purchase a new machine for \$100,000. The machine will have a life of 5 years with no salvage value, and is expected to generate annual cash revenue of \$50,000. Annual cash expenses, excluding depreciation, will total \$24,000. The company uses the straight-line depreciation method, has a tax rate of 40 percent, and requires a 12 percent rate of return.
Required:
1. Find the net present value of this investment using the format presented in Figure 8.7. Round to the nearest dollar.
2. Should the company purchase the machine? Explain.
Exercises: Set B
1. Net Present Value Analysis. Wood Products Company would like to purchase a computerized wood lathe for \$100,000. The machine is expected to have a life of 5 years, and a salvage value of \$5,000. Annual maintenance costs will total \$20,000. Annual net cash receipts resulting from this machine are predicted to be \$45,000. The company’s required rate of return is 15 percent.
Required:
1. Ignoring the time value of money, calculate the net cash inflow or outflow resulting from this investment opportunity.
2. Find the net present value of this investment using the format presented in Figure 8.2. Round to the nearest dollar.
3. Should the company purchase the wood lathe? Explain.
1. Internal Rate of Return Analysis. Wood Products Company would like to purchase a computerized wood lathe for \$100,000. The machine is expected to have a life of 5 years, and a salvage value of \$5,000. Annual maintenance costs will total \$20,000. Annual net cash receipts resulting from this machine are predicted to be \$45,000. The company’s required rate of return is 15 percent (this is the same data as the previous exercise).
Required:
1. Use trial and error to approximate the internal rate of return for this investment proposal.
2. Should the company purchase the wood lathe? Explain.
1. Payback Period Calculation. Wood Products Company would like to purchase a computerized wood lathe for \$100,000. The machine is expected to have a life of 5 years, and a salvage value of \$5,000. Annual maintenance costs will total \$20,000. Annual net cash receipts resulting from this machine are predicted to be \$45,000. The company’s required rate of return is 15 percent (this is the same data as the previous exercise). Determine the payback period for this investment using the format shown in Table 8.1.
2. Net Present Value Analysis and Qualitative Factors, Alternative Format. Pete’s Plumbing Supplies would like to expand into a new warehouse at a cost of \$500,000. The warehouse is expected to have a life of 20 years, and a salvage value of \$100,000. Annual costs for maintenance, insurance, and other cash expenses will total \$60,000. Annual net cash receipts resulting from this expansion are predicted to be \$115,000. The company’s required rate of return is 12 percent.
Required:
1. Find the net present value of this investment using the format presented in Figure 8.4. Round to the nearest dollar.
2. Should the company purchase the new warehouse? Explain.
3. Provide one qualitative factor that might cause the company to reach a different conclusion than the one reached in requirement b.
1. Calculating NPV and IRR Using Excel. Pete’s Plumbing Supplies would like to expand into a new warehouse at a cost of \$500,000. The warehouse is expected to have a life of 20 years, and a salvage value of \$100,000. Annual costs for maintenance, insurance, and other cash expenses will total \$60,000. Annual net cash receipts resulting from this expansion are predicted to be \$115,000. The company’s required rate of return is 12 percent.
Required:
1. Use Excel to calculate the net present value and internal rate of return in a format similar to the Computer Application spreadsheet shown in the chapter.
2. Should the company purchase the warehouse? Explain.
1. Net Present Value Analysis with Taxes. Quality Chocolate, Inc., would like to purchase a new machine for \$200,000. The machine will have a life of 4 years with no salvage value, and is expected to generate annual cash revenue of \$90,000. Annual cash expenses, excluding depreciation, will total \$10,000. The company uses the straight-line depreciation method, has a tax rate of 30 percent, and requires a 14 percent rate of return.
Required:
1. Find the net present value of this investment using the format presented in Figure 8.7. Round to the nearest dollar.
2. Should the company purchase the machine? Explain.
1. Evaluating Alternative Investments. Washington Brewery has two independent investment opportunities to purchase brewing equipment so the company can meet growing customer demand. The first option (equipment A) requires an initial investment of \$230,000 for equipment with an expected life of 5 years and a salvage value of \$20,000. The second option (equipment B) requires an initial investment of \$120,000 for equipment with an expected life of 4 years and a salvage value of \$15,000. The company’s required rate of return is 10 percent. Additional cash flow information for each investment is provided as follows.
Year 1 Year 2 Year 3 Year 4 Year 5
Equipment A
Utility savings \$ 12,000 \$ 14,000 \$ 15,000 \$ 16,000 \$ 17,000
Additional revenue \$ 45,000 \$ 48,000 \$ 50,000 \$ 55,000 \$ 60,000
Maintenance costs \$(5,000) \$(8,000) \$(10,000) \$(13,000) \$(16,000)
Equipment B
Utility savings \$ 8,000 \$ 9,000 \$ 9,000 \$ 10,000
Additional revenue \$ 35,000 \$ 36,000 \$ 38,000 \$ 42,000
Maintenance costs \$(6,000) \$(8,000) \$(9,000) \$(11,000)
Required:
1. Calculate the net present value for each investment using the format presented in Figure 8.2. (Remember to include the initial investment cash outflow and salvage value in your calculation.) Round to the nearest dollar.
2. Which, if any, investment is preferable? Explain.
1. Net Present Value, Internal Rate of Return, and Payback Period Analyses. Sherwin Moore Paint Company would like to further automate its production process by purchasing production equipment for \$660,000. The equipment is expected to have a useful life of 8 years, and will be sold at the end of 8 years for \$40,000. The equipment requires significant maintenance work at an annual cost of \$75,000. Labor and material cost savings, shown in the table, are also expected to be significant.
Year 1 \$160,000
Year 2 \$190,000
Year 3 \$200,000
Year 4 \$240,000
Year 5 \$280,000
Year 6 \$220,000
Year 7 \$180,000
Year 8 \$155,000
The company’s required rate of return is 11 percent. Assume the company requires all investments to be recovered within five years.
Required:
1. Find the net present value of this investment using the format presented in Figure 8.2. Round to the nearest dollar.
2. Use trial and error to approximate the internal rate of return for this investment proposal.
3. Determine the payback period for this investment using the format shown in Table 8.1.
4. Based on your findings in requirements a, b, and c, should the company purchase the production equipment? Explain.
1. Calculating NPV and IRR Using Excel. Sherwin Moore Paint Company would like to further automate its production process by purchasing production equipment for \$660,000. The equipment is expected to have a useful life of 8 years, and will be sold at the end of 8 years for \$40,000. The equipment requires significant maintenance work at an annual cost of \$75,000. Labor and material cost savings, shown in the table, are also expected to be significant.
Year 1 \$160,000
Year 2 \$190,000
Year 3 \$200,000
Year 4 \$240,000
Year 5 \$280,000
Year 6 \$220,000
Year 7 \$180,000
Year 8 \$155,000
The company’s required rate of return is 11 percent.
Required:
1. Use Excel to calculate the net present value and internal rate of return in a format similar to the Computer Application spreadsheet shown in the chapter.
2. Should the company purchase the production equipment? Explain.
1. Net Present Value Analysis, Multiple Investments, and Qualitative Factors. Oil Production, Inc., would like to drill oil from land the company already owns. The equipment is expected to cost \$4,000,000, has a useful life of 5 years, and will be sold at the end of 5 years for \$400,000. Annual costs for maintenance and other cash expenses will total \$550,000. Annual net cash receipts resulting from the sale of oil are predicted to be \$1,900,000. Working capital of \$270,000 is required at the beginning of the project and will be returned at the end of 5 years. The equipment will require refurbishing at the end of year 3 at a cost of \$300,000. Although the company’s cost of capital is 15 percent, management established a required rate of return of 20 percent due to the high risk associated with this project.
Required:
1. Find the net present value of this investment using the format presented in Figure 8.4. Round to the nearest dollar.
2. Use trial and error to approximate the internal rate of return for this investment proposal.
3. Should the company accept the proposal? Explain.
4. What qualitative factors might improve management’s view of this proposal?
1. Calculating NPV and IRR Using Excel. Oil Production, Inc., would like to drill oil from land the company already owns. The equipment is expected to cost \$4,000,000, has a useful life of 5 years, and will be sold at the end of 5 years for \$400,000. Annual costs for maintenance and other cash expenses will total \$550,000. Annual net cash receipts resulting from the sale of oil are predicted to be \$1,900,000. Working capital of \$270,000 is required at the beginning of the project and will be returned at the end of 5 years. The equipment will require refurbishing at the end of year 3 at a cost of \$300,000. Although the company’s cost of capital is 15 percent, management established a required rate of return of 20 percent due to the high risk associated with this project.
Required:
1. Use Excel to calculate the net present value and internal rate of return in a format similar to the Computer Application spreadsheet shown in the chapter.
2. Should the company accept the proposal? Explain.
1. Net Present Value, Internal Rate of Return, and Payback Period Analyses; Ethical Issues. Tower CD Stores would like to open a retail store in Houston. The initial investment to purchase the building is \$420,000, and an additional \$50,000 in working capital is required. Since this store will be operating for many years, the working capital will not be returned in the near future. Tower expects to remodel the store at the end of 3 years at a cost of \$100,000. Annual net cash receipts from daily operations (cash receipts minus cash payments) are expected to be as follows.
Year 1 \$ 80,000
Year 2 \$115,000
Year 3 \$118,000
Year 4 \$140,000
Year 5 \$155,000
Year 6 \$167,000
Year 7 \$175,000
The company’s required rate of return is 13 percent. Assume management decided to limit the analysis to 7 years.
Required:
1. Find the net present value of this investment using the format presented in Figure 8.2. Round to the nearest dollar.
2. Use trial and error to approximate the internal rate of return for this investment proposal.
3. Based on your answer to requirements a and b, should Tower open the new store? Explain.
4. Use the format presented in Table 8.1 to calculate the payback period (include working capital in the initial investment). Assuming management requires all investments to be recovered within three years, should Tower CD Store open the new store?
5. What is the weakness of using the payback period method to evaluate long-term investments?
6. Assume the manager of the company wanted to live in Houston and intentionally inflated the projected annual cash receipts so that the proposal would be accepted. The proposal would otherwise have been rejected. Explain how the company’s use of a postaudit would help to prevent this type of unethical behavior.
1. Net Present Value with Taxes. Refer to the Tower CD Stores information presented in the previous problem. Assume the costs associated with the purchase of the building are depreciated over 20 years using the straight-line method, with no salvage value. Costs associated with the building remodel are depreciated over 10 years with no salvage value, starting with year 4. The company’s tax rate is 40 percent. Again, management will limit the analysis to seven years.
Required:
1. Find the net present value of this investment using the format presented in Figure 8.7. Round to the nearest dollar.
2. Should Tower open the new store? Explain.
3. How did income taxes affect the decision being made by Tower CD Stores?
One Step Further: Skill-Building Cases
1. Opening New Retail Stores. Refer to Note 8.5 "Business in Action 8.1" Provide two examples of cash outflows and one example of cash inflows resulting from the decision to open a new store.
2. Determining the Cost of Capital by Industry. Refer to the Note 8.13 "Business in Action 8.2" Why do you think the cost of capital in the beverage industry is low relative to the cost of capital in other industries?
3. The California Lottery and Present Value Concepts. Refer to the Note 8.15 "Business in Action 8.3" Why does the State of California need only \$550,000 to pay a \$1,000,000 lottery winner?
4. Internet Project: Capital Expenditures at Intel. Go to Intel’s Web site (http://www.intel.com) and enter “annual report” or “10K report” in the search feature. Find the most recent annual report or 10K report and review the Consolidated Statements of Cash Flows portion of the company’s financial statements. Find the Additions to property, plant and equipment line item in the Investing Activities section of the statement, and answer the following questions. Be sure to submit a printed copy of the consolidated statements of cash flows with your answers.
1. How much cash did Intel spend on additions to property, plant, and equipment in the most current year? How does this amount compare with amounts spent in the previous two years?
2. Describe two capital budgeting decision techniques that were likely used by Intel to make long-term investment decisions.
5. Group Activity: Qualitative Factors. Each of the following scenarios is being considered at three separate companies.
1. A large regional energy company uses coal to produce electricity that is sold to local power companies. Although government regulations will not require a cleaner process for at least five years, the company is considering spending millions of dollars on equipment that will reduce pollutants from its production process. However, the net present value analysis indicates this proposal should be rejected.
2. A producer of mountain bikes known for its expensive, high-quality bikes would like to introduce a less expensive entry-level line of mountain bikes. However, the projected internal rate of return for this proposal is lower than the company’s minimum required rate of return.
3. A maker of computer chips with a reputation of staying on the cutting edge of technology would like to invest in a new production facility. However, the net present value analysis indicates this proposal should be rejected.
Required:
Your instructor will divide the class into groups of two to four students, and assign one of the three independent scenarios listed previously to each group. Each group must perform the requirements listed here:
1. Identify at least two qualitative factors that may lead to accepting the proposal.
2. Discuss each option, based on the findings of your group, with the class.
Comprehensive Cases
1. Ethical Issues in Capital Budgeting. Loomis Nursery grows a variety of plants for wholesale distribution. The company would like to expand its operations and is considering a move to one of two locations. The first location, Wyatville, is one hour from the ocean and therefore attractive for employees who like to travel on weekends. The second location, Kenton, is not as close to the ocean, and much further from desirable vacation destinations.
The company’s controller, Lisa Lennox, created a net present value analysis for each location. The Kenton location had a positive net present value, and the Wyatville location had a negative net present value. Upon providing this information to the chief financial officer of the company, Max Madden, Lisa was asked to “review the numbers carefully and make sure all the benefits of moving to Wyatville were included in the analysis.” Lisa knew that Max preferred vacationing near the ocean and had a strong desire to move operations to Wyatville. However, she was unable to find any errors in her analysis and could not identify any additional benefits.
Lisa approached Max with this information. Max responded, “There is no way Kenton should have a higher net present value than Wyatville. Redo your analysis to show that Wyatville has the highest net present value, and have it on my desk by the end of the week.”
Required:
1. Is Max Madden’s request ethical? Explain.
2. How should Lisa handle this situation? (It may be helpful to review the presentation of ethics in Chapter 1.)
1. Ethical Issues in Capital Budgeting. Toyonda Motor Company produces a variety of products including motorcycles, all-terrain vehicles, marine engines, automobiles, light trucks, and heavyduty trucks. Each division manager at Toyonda Motor Company is paid a base salary and is given an annual cash bonus if the division achieves profits of at least 10 percent of the value of assets invested in the division (this is called return on investment).
Peggy Parkins, manager of the Light Truck Division, is considering investing in new production equipment. The net present value of the proposal is positive, and Peggy is convinced the new equipment will provide a competitive edge in future years. However, because of the significant up-front cost and related depreciation, short-term profits will be negatively affected by this investment. In fact, the new equipment will reduce return on investment below the 10 percent threshold for at least 3 years, which will prevent Peggy from receiving her annual bonuses for at least 3 years. However, profits are expected to increase significantly after the three-year period. Peggy is planning to retire in two years and therefore would prefer to reject the proposal to invest in new production equipment.
Required:
1. Describe the ethical conflict facing Peggy Parkins.
2. What type of employee compensation system might prevent this type of conflict? | textbooks/biz/Accounting/Managerial_Accounting/08%3A_How_Is_Capital_Budgeting_Used_to_Make_Decisions/8.E%3A_Exercises.txt |
Jerry Feltz is the president and owner of Jerry’s Ice Cream, a producer of high-quality ice cream sold to specialty grocery stores. Jerry is holding a meeting with the company’s managers to discuss plans for this coming year. Managers at the meeting are Tom Benson, the sales manager; Lynn Young, the production manager; and Michelle Hopkins, the treasurer and controller.
Jerry: It looks as if we are having another great year. Customers love our ice cream, and sales are up. It’s time to begin the budgeting process for next year. Tom, do you have any thoughts on what our sales will look like for next year?
Tom: I think we will continue to see significant sales growth. But it’s difficult to predict exactly how much growth. On the low end, I would expect about 10 percent; on the high end, perhaps 25 percent.
Lynn: Wow! I knew sales were going well, but I had no idea we were expecting to grow 10 percent to 25 percent next year. It will take some serious planning to produce enough ice cream to handle this growth.
Michelle: I agree. We need to make sure production has enough capacity to handle the growth, and cash flow planning will be critical to ensure we don’t run out of cash in the process of ramping up production.
Jerry: Tom, talk with our salespeople and industry contacts so we can get a solid estimate of quarterly sales for next year. If sales really are expected to grow as you say, we will face a huge challenge!
Tom: I’ll have something for you by the end of next week.
Michelle: I’ll start the budgeting process once we have the sales information from Tom.
Lynn: The sooner we start the budgeting process, the better, particularly if I have to hire more employees and find more production space.
Jerry: Let’s meet in two weeks to discuss the results of Tom’s research and to set up a plan to handle the growth. Thanks for your help!
Many companies encounter the same issue of growing sales that is facing Jerry’s Ice Cream. Those that plan for growth have a better chance of succeeding than those that sit idle and hope it all works out. Operating budgets are used to (1) plan operations and (2) control operations. We describe both of these objectives next and then devote the remainder of this chapter to the planning phase by creating an operating budget for Jerry’s Ice Cream. We cover the control phase in Chapter 10.
9.02: Planning and Controlling Operations
Learning Objectives
• Understand how operating budgets are used for planning and control.
Question: If you have established a personal budget, you know the importance of planning to achieve your goals. Assume one of your goals is to purchase a new car. It is not enough to simply state, “I want to buy a new car next year.” If you do not plan ahead for a big expense like this, you may find that you don’t have enough money for a reasonable down payment or that you have very large monthly payments. If you plan ahead, you may see that working some additional hours, cutting back on entertainment, or a combination of both, allows you to buy the car and avoid these problems. Organizations are no different, except their needs tend to be more involved. How do organizations formally plan for the future?
Answer
Let’s look at Jerry’s Ice Cream to answer this question. The company wants to increase sales next year, but will have difficulty doing this without some type of plan, often called a budget. A budget1 is a plan of the resources needed to achieve the organization’s goals. An operating budget2 is a short-term budget (typically one year) that focuses on the daily operations of the organization. Before presenting the detailed schedules of an operating budget, we first discuss how organizations use budgets to plan and control their activities.
The Planning Phase
Question: How are budgets used to help organizations plan future activities?
Answer
Budgets are established in advance to help organizations communicate their plans to employees and to help employees coordinate activities across the entire organization. Imagine Jerry’s Ice Cream operating without a budget. If production has no forewarning of an increase in customer demand, Lynn Young, production manager, has no opportunity to plan for an increase in production. Inefficiencies will occur as Lynn struggles to keep pace with demand (e.g., employees working overtime or materials purchased at the last minute at a premium). Cash flow may suffer as spending initially outpaces cash receipts, which would force the company to borrow money quickly at a high interest rate. In the worst case, the company would run out of product, miss out on sales, and perhaps run out of cash.
Turn the example around and assume Jerry’s Ice Cream does have a budget in place for the coming year. The budget communicates the organization’s plans to Lynn, production manager, and Michelle, treasurer and controller, showing that sales are expected to increase. Lynn can then plan accordingly by hiring additional employees, arranging for the purchase of additional materials, and finding more space for production. Michelle can also plan accordingly by arranging for a shortterm loan at a reasonable interest rate to meet short-term cash needs. As described here, the planning phase uses the budget to communicate plans to employees and to help employees coordinate activities across the organization.
The Control Phase
Question: How do organizations use budgets to control operations?
Answer
Organizations use budgets to evaluate performance. By comparing the budget with actual results, companies can determine whether employees, and the company as a whole, have performed as expected.
For example, assume Jerry’s Ice Cream estimates sales for the first quarter of next year will be 40,000 units at \$6 per unit. Actual sales turn out to be 38,000 units at \$6.20 per unit. The company can evaluate sales manager Tom Benson’s performance by comparing the budget to actual results. For unit sales, Tom did not perform as well as expected (38,000 units actually sold versus 40,000 in budgeted unit sales). However, Tom exceeded expectations for sales price (\$6.20 per unit actual sales price versus budgeted sales price of \$6).
The next chapter covers the control phase of budgeting in depth. We now turn to the process of creating an operating budget to plan a company’s operations for the coming year. Creating an operating budget is an essential part of business. Depending on the type of product offered and the size of the company, operating budgets vary widely in complexity. International companies in particular face difficult hurdles when it comes to budgeting, as described in Note 9.4 "Business in Action 9.1".
Challenges of Budgeting for International Operations
Companies with operations in several different countries, called multinational companies, face numerous challenges in establishing operating budgets. Most experts agree that foreign exchange rates have the biggest impact on budgeting for multinationals. Specific exchange rates are used when the budget is established. However, these rates can fluctuate significantly and are likely to differ when companies compare actual results with the initial budget. This makes the budget control process difficult because exchange rate variations might cause the differences between actual results and the budget.
Exchange rate fluctuations, along with other market characteristics—such as economic uncertainty and unpredictable government activities—make budgeting for multinational companies a challenging task.
Source: Ken Milani and Juan Rivera, “The Rigorous Business of Budgeting for International Operations,” Management Accounting Quarterly 5, no. 2 (2004): 38–50.
Key Takeaway
Organizations establish budgets to communicate their plans to employees and to coordinate the activities of employees across the entire organization. Budgets are often compared with actual results to evaluate employee and organizational performance.
REVIEW PROBLEM 9.1
Why do most organizations prepare an operating budget?
Answer
Most organizations prepare an operating budget for two reasons. First, budgets help managers communicate plans to employees, which in turn helps employees coordinate activities across the entire organization. Second, budgets are often compared to actual results to evaluate employee and organizational performance.
Definitions
1. A plan of the resources needed to achieve the organization’s goals.
2. A short-term budget (typically one year) that focuses on the daily operations of the organization. | textbooks/biz/Accounting/Managerial_Accounting/09%3A_How_Are_Operating_Budgets_Created/9.01%3A_Introduction.txt |
Learning Objectives
• Understand the process used to establish budgets.
Question: Some companies prefer to take a “top-down” approach to budgeting, in which upper management establishes the budget with little input from other employees. These budgets are imposed on the organization and do little to motivate employees or to gain acceptance by employees. What method of budgeting is more effective than the top-down approach?
Answer
Successful companies approach budgeting from the bottom up. This requires the involvement of various employees within the organization, not just upper management. Lower-level employees often know more about their functional areas than upper management, and they can be an excellent source of information for budgeting purposes. Although getting input from employees throughout the organization can be time consuming, this approach tends to increase employee motivation and acceptance of the budget.
Most organizations have a budget committee that supervises the budgeting process. A budget committee3 is a group within the organization responsible for overseeing and approving the master budget. A master budget4 is a series of budget schedules outlining the organization’s plans for the upcoming period (typically for a year and presented in monthly or quarterly time periods). The master budget can take many different forms but often includes schedules that provide planning for sales, production, selling and administrative expenses, and capital expenditures. These schedules lead to the budgeted income statement, cash flows, and balance sheet (also part of the master budget).
Figure 9.1 shows the components of the master budget with references to the figure in which we present each component for Jerry’s Ice Cream.
a See Figure 9.3 for the sales budget.
b See Figure 9.8 for the selling and administrative budget.
c See Figure 9.4 for the production budget.
d See Figure 9.5 for the direct materials purchases budget.
e See Figure 9.6 for the direct labor budget.
f See Figure 9.7 for the manufacturing overhead budget.
g See Figure 9.10 for the capital expenditures budget.
h See Figure 9.9 for the budgeted income statement.
i See Figure 9.11 for the cash budget.
j See Figure 9.12 for the budgeted balance sheet.
Key Takeaway
Some companies take a top-down approach to budgeting (upper management establishes the budget with little input from others), while other companies take a bottom-up approach (lower level employees are involved in the budgeting process). The bottom-up approach tends to be more effective as employees are more inclined to accept the budget. Regardless of the approach used, the budget committee (made up of a group within the organization) is responsible for overseeing and approving the master budget.
REVIEW PROBLEM 9.2
1. What is a master budget?
2. Why do successful companies tend to use the bottom-up approach to establish a master budget?
Answer
1. A master budget is a series of budget schedules outlining the organization’s plans for the upcoming period, typically prepared monthly, quarterly, or annually. The master budget includes budgets for sales, production, operating expenses, and capital expenditures. Managers use this information to create budgeted financial statements (income statement, cash flows, and balance sheet).
2. The bottom-up approach requires involvement of employees throughout the organization, not just upper management, to create the operating budget. Successful companies use this approach because lower-level employees tend to know more about their functional areas than upper management, providing for more accurate budget information. Also, employee involvement in the budget process increases the likelihood employees will accept the budget.
Definitions
1. A group within the organization responsible for overseeing and approving the master budget.
2. A series of budget schedules outlining the organization’s plans for the upcoming period. | textbooks/biz/Accounting/Managerial_Accounting/09%3A_How_Are_Operating_Budgets_Created/9.03%3A_The_Budgeting_Process.txt |
Learning Objectives
• Develop the components of a master budget.
Question: Developing a master budget is a lengthy process. Where do companies start when preparing a master budget?
Answer
Study Figure 9.1 carefully, as it serves as the road map for the master budget presented throughout this chapter for Jerry’s Ice Cream. Notice that the budgeting process starts with the sales budget. Also, note that the budgets described next are for a manufacturing company. Manufacturing companies tend to have more budget schedules than other types of organizations because their operations are more complex. Once you understand budgeting in a manufacturing environment, you can easily modify the process to perform budgeting in other organizations, as discussed later in the chapter. As we work through the master budget for Jerry’s Ice Cream, assume the company prepares quarterly budgets.
Sales Budget
Question: The sales budget is the starting point for the master budget, as shown in Figure 9.1. What is a sales budget, and how is it prepared?
Answer
The sales budget5 is an estimate of units of product the organization expects to sell times the expected sales price per unit. This is perhaps the most important budget as it drives most of the other budgets. For example, the production budget and related materials, labor, and overhead budgets are based on expected sales.
Forecasting sales often involves extensive research and numerous sources. Companies, such as Jerry’s Ice Cream, typically start with their sales staff since salespeople have daily contact with customers and direct information about customer demand. Some companies pay for market trend data to learn about industry and product trends. Many organizations hire market research consultants to obtain and review industry data and ultimately to predict customer demand. Larger companies sometimes employ economists to develop sophisticated models used to project sales. Smaller, less sophisticated organizations simply base their estimates on past trends. Figure 9.2 shows how companies obtain sales information from sales people, market research consultants, and economists.
Tom Benson, sales manager at Jerry’s Ice Cream, talked with his salespeople and reviewed market trends for ice cream using data obtained from a market research firm. His estimate, shown in Figure 9.3, assumes the company will increase sales 15 percent this coming year. Thus, to get projected sales for quarter 1, Tom simply multiplied last year’s first quarter sales by 1.15. The average price per unit last year was $6 (1 unit = 1 gallon), and Tom does not expect any change in this price. The sales budget is presented in Figure 9.3. Production Budget Question: The production budget is developed next and is based on sales budget projections. What is a production budget, and how is it prepared? Answer If the organization uses a just-in-time production system, where production occurs just in time to ship the products to the customer, units produced each quarter would be exactly the same as projected sales. However, most companies, including Jerry’s Ice Cream, maintain a certain level of finished goods inventory. Thus production is typically not the same as projected sales. The production budget6 is an estimate of units to be produced and is based on sales projections plus an estimate of desired ending finished goods inventory less beginning finished goods inventory, as summarized in the following: $\text{Units to be produced = Expected sales in units + Desired units of ending inventory - Units in beginning inventory}$ Jerry’s Ice Cream plans to sell 40,000 units in the first quarter, as shown in Figure 9.3. For the sake of simplicity, assume work-in-process inventory is insignificant, and therefore beginning and ending work-in-process inventory is zero. (We assume beginning and ending work-in-process inventory is zero throughout this chapter.) The management prefers to maintain 10 percent of next quarter’s sales in ending inventory. Thus 4,800 units will be in inventory at the end of the first quarter (= 48,000 unit sales in second quarter × 10 percent). Units needed for the first quarter total 44,800 (= 40,000 unit sales + 4,800 units desired ending inventory). However, Jerry’s will not produce 44,800 units because inventory will be left over from the fourth quarter of last year. This beginning inventory will be 4,000 units (= 40,000 unit sales in first quarter × 10 percent). Thus actual production will total 40,800 units: $\begin{split} \text{Units to be produced} &= \text{Expected sales in units + Desired units of ending inventory - Units in beginning inventory} \ 40,800 &= 40,000 + 4,800 - 4,000 \end{split}$ Figure 9.4 presents the production budget for each of the 4 quarters of the coming year. Examine this figure carefully, particularly the last line labeled units to be produced. Lynn Young, the production manager, will be concerned about the spike in production during the third quarter of 59,200 units. The third quarter, from July 1 through September 30, is the peak sales season for ice cream. It will be difficult for Lynn to plan for this increase in production from the first and second quarters to the third quarter. However, this is exactly why companies prepare budgets—to plan for the future! *Information from Figure 9.3. **Desired ending inventory = 10 percent × Next quarter sales; for the first quarter, 4,800 = 0.10 × 48,000. Fourth quarter desired ending inventory of 4,400 units is based on an estimate of sales in the first quarter of next year. ***Beginning inventory = Inventory at end of previous quarter; for example, second quarter beginning inventory = First quarter ending inventory. Once Jerry’s Ice Cream knows how many units it must produce each quarter, budgets are established for the individual components of production: direct materials, direct labor, and manufacturing overhead. We present these budgets next. REVIEW PROBLEM 9.3 Carol’s Cookies produces cookies for resale at grocery stores throughout North America. The company is currently in the process of establishing a master budget on a quarterly basis for this coming fiscal year, which ends December 31. Prior year quarterly sales were as follows (1 unit = 1 batch): First quarter 64,000 units Second quarter 76,800 units Third quarter 96,000 units Fourth quarter 83,200 units Unit sales are expected to increase 25 percent, and each unit is expected to sell for$8. The management prefers to maintain ending finished goods inventory equal to 10 percent of next quarter’s sales. Assume finished goods inventory at the end of the fourth quarter budget period is estimated to be 9,000 units.
1. Prepare a sales budget for Carol’s Cookies using a format similar to Figure 9.3. (Hint: be sure to increase last year’s unit sales by 25 percent.)
2. Prepare a production budget for Carol’s Cookies using the format shown in Figure 9.4.
Answer
1. The following is a sales budget:
2. The following is a production budget:
*Desired ending inventory = 10 percent × Next quarter sales; for the first quarter, 9,600 = 0.10 × 96,000. Fourth quarter desired ending inventory of 9,000 units is given.
**Beginning inventory = Inventory at end of previous quarter; for example, Second quarter beginning inventory = First quarter ending inventory.
Direct Materials Purchases Budget
Question: The number of units of finished goods to be produced each quarter from the production budget is the starting point for the direct materials purchases budget. What is a direct materials purchases budget, and how is it prepared?
Answer
The direct materials purchases budget7 is an estimate of raw materials needed to achieve a desired level of production. Figure 9.4, the production budget, shows that 40,800 finished units will be produced in the first quarter. We will now establish a direct materials purchases budget that answers the questions: how many pounds of material must be purchased during the first quarter to achieve this production, and what is the cost of these materials?
Assume two pounds of material are required to produce one unit of product. Thus the amount of materials required to produce 40,800 units of ice cream is 81,600 pounds (= 40,800 units × 2 pounds per unit). This amount is labeled as materials needed in production in the direct materials purchases budget shown in Figure 9.5. (To simplify this example, assume sugar is the only material used. However, other materials, such as cream and vanilla, are typically required to produce ice cream.)
*Information from Figure 9.4.
**Desired ending inventory = 20 percent × Next quarter production needs; for the first quarter, 19,680 = 0.20 × 98,400. Fourth quarter desired ending inventory of 20,000 pounds is based on an estimate of materials needed in production first quarter of next year.
***Beginning inventory = Inventory at end of previous quarter; for example, Second quarter beginning inventory = First quarter ending inventory.
****$2 direct materials cost per unit = 2 pounds of materials required per unit ×$1 per pound.
Will the company buy 81,600 pounds of material in the first quarter? Probably not. Jerry’s will have materials in beginning raw materials inventory and prefers to maintain a certain level of ending raw materials inventory. Thus direct materials purchased is based on materials needed in production plus an estimate of desired ending raw materials inventory less beginning raw materials inventory. We summarize this in the following equation. Notice the similarity of this equation to the inventory equation presented earlier for the production budget.
$\text{Materials to be purchased = Materials needed in production + Desired materials in ending inventory - Materials in beginning inventory}$
Assume the management prefers to maintain raw materials ending inventory equal to 20 percent of next quarter’s materials needed in production. Thus 19,680 pounds of material will be in inventory at the end of the first quarter (= 98,400 pounds of materials needed in production in second quarter × 20 percent). Materials needed in inventory total 101,280 pounds (= 81,600 pounds of materials needed in production + 19,680 pounds of material in desired ending inventory). However, Jerry’s will not purchase 101,280 pounds of materials because inventory will be left over from the fourth quarter of last year. This beginning inventory will be 16,320 pounds (= 81,600 pounds of material needed in production in first quarter × 20 percent). Thus direct materials purchased in the first quarter will total 84,960 pounds:
$\begin{split} \text{Materials} &= \text{Materials needed in production + Desired materials in ending inventory - Materials in beginning inventory} \ 84,960 &= 81,600 + 19,680 - 16,320 \end{split}$
To estimate the cost of purchasing 84,960 pounds of material, multiply the number of pounds to be purchased by the cost per pound. Assume the cost per pound of material for Jerry’s is $1. This results in a cost of$84,960 for materials to be purchased during the first quarter, as shown at the bottom of Figure 9.5 (= 84,960 pounds to be purchased × $1 per pound). Review the direct materials purchases budget shown in Figure 9.5 carefully, particularly the line labeled direct materials to be purchased. The purchasing manager at Jerry’s Ice Cream uses this information, along with the price per pound, to negotiate the purchase of materials with suppliers. Direct Labor Budget Question: The direct materials purchases budget is the first of three supporting budgets for production. The second is the direct labor budget. What is the direct labor budget, and how is it prepared? Answer The direct labor budget8 is an estimate of direct labor hours, and related costs, necessary to achieve a desired level of production. Knowing Jerry’s Ice Cream plans to produce 40,800 units of ice cream during the first quarter, this budget answers the questions: how many direct labor hours will be necessary to achieve this production, and what will this labor cost? Assume it takes 0.10 direct labor hours (or 6 minutes) to produce 1 unit of product. Thus 4,080 hours of direct labor will be required to produce 40,800 units of product (= 40,800 finished units produced × 0.10 direct labor hours per unit). Given an average hourly rate of$13, the direct labor cost for the first quarter totals $53,040 (= 4,080 hours ×$13 per hour). This information is shown in the direct labor budget presented in Figure 9.6.
*From Figure 9.4.
**$1.30 direct labor cost per unit = 0.10 direct labor hours per unit ×$13 per hour.
Carefully review the direct labor budget shown in Figure 9.6. The production manager at Jerry’s Ice Cream, Lynn Young, uses this information to ensure the appropriate number of employees is available to meet production goals. Notice that the number of direct labor hours needed in production for the third quarter is significantly higher than each of the two previous quarters. Again, this is why organizations prepare budgets: to plan for these types of events. Lynn will have to start planning for this spike in direct labor hours, either by asking employees to work overtime or by hiring additional employees.
Manufacturing Overhead Budget
Question: The manufacturing overhead budget is the third of three supporting production budgets. What is a manufacturing overhead budget, and how is it prepared?
Answer
The manufacturing overhead budget9 is an estimate of all production costs, other than direct materials and direct labor, necessary to achieve a desired level of production. This budget is presented in Figure 9.7. Notice that overhead costs are separated into variable and fixed components.
*From Figure 9.4.
**$1.20 =$240,480 total overhead cost ÷ 200,400 units to be produced for the year.
^Deduct depreciation to get the actual cash payment for overhead. This information is needed for the cash budget presented in Figure 9.11.
By definition, total variable overhead costs change with changes in production and are calculated by multiplying units to be produced by the cost per unit. For example, indirect materials cost for the first quarter of $6,120 is calculated by taking 40,800 units to be produced ×$0.15 cost per unit. Fixed costs generally do not change with changes in production and therefore remain the same each quarter. (Note: In some situations, fixed overhead costs can change from one quarter to the next. For example, hiring additional salaried personnel during the year would increase fixed overhead costs, and purchasing equipment during the year would increase depreciation costs. In this example, we assume fixed overhead costs do not change during the year.)
Depreciation is deducted at the bottom of the manufacturing overhead budget to determine cash payments for overhead because depreciation is not a cash transaction. We use this information later in the chapter for the cash budget.
REVIEW PROBLEM 9.4
Carol’s Cookies, the company featured in the last review problem and in the next three, is now preparing the budget for direct materials purchases, direct labor, and manufacturing overhead.
Direct Materials Purchases Budget Information
Each unit of product requires 1.5 pounds of direct materials per unit, and the cost of direct materials is $2 per pound. Management prefers to maintain ending raw materials inventory equal to 30 percent of next quarter’s materials needed in production. Assume raw materials inventory at the end of the fourth quarter budget period is estimated to be 41,000 pounds. Direct Labor Budget Information Each unit of product requires 0.20 direct labor hours at a cost of$12 per hour.
Manufacturing Overhead Budget Information
Variable overhead costs are:
Indirect materials $0.20 per unit Indirect labor$0.15 per unit
Other $0.35 per unit Fixed overhead costs each quarter are: Salaries$28,000
Rent $22,000 Depreciation$16,165
1. Prepare a direct materials purchases budget for Carol’s Cookies using the format shown in Figure 9.5.
2. Prepare a direct labor budget for Carol’s Cookies using the format shown in Figure 9.6.
3. Prepare a manufacturing overhead budget for Carol’s Cookies using the format shown in Figure 9.7.
Answer
1.
*Desired ending inventory = 30 percent × Next quarter production needs; for the first quarter, 44,280 = 0.30 × 147,600 pounds. Fourth quarter desired ending inventory of 41,000 pounds is given.
**Beginning inventory = Inventory at end of previous quarter; for example, Second quarter beginning inventory = First quarter ending inventory.
***$3 direct materials cost per unit = 1.5 pounds of materials required per unit ×$2 per pound.
2. *$2.40 direct labor cost per unit = 0.20 direct labor hours per unit ×$12 per hour.
3. *$1.36 =$545,360 total overhead cost ÷ 401,000 units to be produced for the year.
^Deduct depreciation to get the actual cash payment for overhead. This information is needed for the cash budget prepared later.
Definitions
1. An estimate of units of product the organization expects to sell times the expected sales price per unit.
2. An estimate of units to be produced, and it is based on sales projections plus an estimate of desired ending finished goods inventory less beginning finished goods inventory.
3. An estimate of raw materials needed to achieve a desired level of production.
4. An estimate of direct labor hours, and related cost, necessary to achieve a desired level of production.
5. An estimate of all production costs, other than direct materials and direct labor, necessary to achieve a desired level of production. | textbooks/biz/Accounting/Managerial_Accounting/09%3A_How_Are_Operating_Budgets_Created/9.04%3A_The_Master_Budget_%28Part_1%29.txt |
Selling and Administrative Budget
Question: Now that the sales and production-related budgets are complete, it is time to estimate selling and administrative costs. What is a selling and administrative budget, and how is it prepared?
Answer
The selling and administrative budget10 is an estimate of all operating costs other than production. This budget is presented in Figure 9.8.
Although many organizations may have variable and fixed costs in this budget, Jerry’s Ice Cream treats all selling and administrative costs as fixed costs. Once again, depreciation is deducted at the bottom of this budget to determine cash payments for selling and administrative costs, which we use later in the chapter for the cash budget.
*Deduct depreciation to get the actual cash payment for selling and administrative costs.
**This information is needed for the cash budget presented in Figure 9.11 "Cash Budget for Jerry’s Ice Cream".
Budgeted Income Statement
Question: Budgets completed to this point include sales (Figure 9.3), production (Figure 9.4), direct materials (Figure 9.5), direct labor (Figure 9.6), manufacturing overhead (Figure 9.7), and selling and administrative (Figure 9.8). Jerry’s Ice Cream now has enough information to prepare the budgeted income statement. What is a budgeted income statement, and how is it prepared?
Answer
The budgeted income statement11 is an estimate of the organization’s profit for a given budget period. Most organizations, including Jerry’s Ice Cream, prepare the budgeted income statement using the accrual basis of accounting: revenues are recorded when earned and expenses are recorded when incurred. The budgeted income statement for Jerry’s Ice Cream is presented in Figure 9.9. The cash budget we prepare later in the chapter will show when cash is received and paid.
*Cost of goods sold = Per unit cost of \$4.50 (see above) × Units sold (from Figure 9.3); for the first quarter, \$180,000 cost of goods sold = \$4.50 unit cost × 40,000 units.
The first line in the budgeted income statement, sales, comes from the sales budget in Figure 9.3. The next line, cost of goods sold, is calculated by multiplying unit sales from Figure 9.3 by the cost per unit. The cost per unit calculation is shown at the bottom of Figure 9.9. Carefully review this calculation. Since Jerry’s Ice Cream uses full-absorption costing, all manufacturing costs related to goods sold are included (or fully absorbed) in cost of goods sold. Figure 9.5, Figure 9.6, and Figure 9.7 provide this information on a per unit basis for direct materials, direct labor, and manufacturing overhead, respectively.
The third line, gross margin, is simply sales minus cost of goods sold. The fourth line, selling and administrative costs, comes from the selling and administrative budget in Figure 9.8. The bottom line of the budgeted income statement, net income, is gross margin minus selling and administrative costs. Income tax expense is not included in this example for the sake of simplicity. However, income taxes can significantly reduce projected net income and cash flows.
Question: How do companies use the budgeted income statement to improve operations?
Answer
The budgeted income statement is perhaps the most carefully scrutinized component of the master budget. The management and employees throughout the organization use this information for planning purposes and to evaluate company performance. The board of directors and budget committee are responsible for approving the budget and often review periodic reports comparing actual net income to budgeted net income to determine if profit goals are being achieved. Lenders and owners often review the budget to ensure the organization is on track to meet its goals. The budgeted income statement answers the question: what profits does the organization expect to achieve?
After completing the budgeted income statement, only three budgets remain: the capital expenditures budget, the cash budget, and the budgeted balance sheet. We discuss the capital expenditures budget next.
REVIEW PROBLEM 9.5
Carol’s Cookies estimates that all selling and administrative costs are fixed. Quarterly selling and administrative cost estimates for the coming year are
Salaries \$60,000
Rent \$ 7,000
Advertising \$10,000
Depreciation \$ 8,000
Other \$ 1,000
1. Prepare a selling and administrative budget for Carol’s Cookies using the format shown in Figure 9.8.
2. Prepare a budgeted income statement for Carol’s Cookies using the format shown in Figure 9.9.
Answer
1. *Deduct depreciation to get the actual cash payment for selling and administrative costs.
**This information is needed for the cash budget prepared later.
2. *Cost of goods sold = Per unit cost of \$6.76 (see above) × Units sold (from sales budget); for first quarter, \$540,800 cost of goods sold = \$6.76 unit cost × 80,000 units.
**From selling and administrative budget.
Capital Expenditures Budget
Question: What is a capital expenditures budget, and how is it prepared?
Answer
The capital expenditures budget12 is an estimate of the long-term assets to be purchased during the budget period. This includes purchases of tangible longterm assets such as property, plant, and equipment, and intangible assets, such as patents, copyrights, and trademarks. This budget can have a significant impact on cash flow and requires careful planning and analysis (Chapter 8 presents a detailed discussion of capital budgeting). As shown in Figure 9.10, Jerry’s Ice Cream plans to purchase computers and production equipment at the end of the fourth quarter.
Note: These acquisitions will have no effect on depreciation expense in the fourth quarter. Items will be purchased at the end of the year. Thus depreciation begins the following year.
Because long-term asset purchases occur at the end of the year, depreciation will begin the following year. Thus depreciation shown in the manufacturing overhead and selling and administrative budgets will not be affected until the following year. The cash outlay required to make these purchases is reflected in the cash budget presented next.
Cash Budget
Question: What is a cash budget, and how is it prepared?
Answer
The cash budget13 is an estimate of the amount and timing of cash inflows and outflows for the budget period. Although the budgeted income statement provides an estimate of profitability, it stops short of providing cash flow information. For example, some of the \$240,000 in first quarter sales revenue will be collected during the first quarter and some will be collected the following quarter. A section of the cash budget will show when cash from sales will be received.
The cash budget has the following sections, each of which is described after Figure 9.11:
• Cash collections from sales
• Cash payments for purchases of materials
• Other cash collections and payments
Figure 9.11 shows the cash budget for Jerry’s Ice Cream. Amounts shown in parentheses represent cash outflows; amounts without parentheses represent cash inflows.
*Based on sales budget shown in Figure 9.3. All sales are on credit: 60 percent collected in the quarter of sale and 40 percent collected the following quarter.
**Based on purchases budget shown in Figure 9.5. All purchases are on credit: 70 percent paid in the quarter of purchase and 30 percent paid the following quarter.
***Does not include depreciation since depreciation expense does not involve a cash payment. See related figures for calculations.
^Excess of collections over payments = Cash collections from sales – Cash payments for materials purchases – Other cash payments.
^^ Beginning cash balance = Cash balance at end of previous period. Balance for first quarter is given.
^^^ Ending cash balance = Excess of collections over payments for the quarter + Beginning cash balance.
Cash Collections from Sales
Question: Assume all sales at Jerry’s Ice Cream are on credit. How long does it take, on average, for Jerry’s to collect on credit sales?
Answer
On average, 60 percent of credit sales are collected in the quarter sold and the remaining 40 percent is collected the following quarter. These percentage estimates are based on previous experience and take into consideration credit terms offered to customers. Since Jerry’s Ice Cream only sells to customers with an excellent credit record, it anticipates no bad debts.
As you examine the cash collections from sales section of Jerry’s cash budget, notice that \$180,000 in cash will be collected in the first quarter related to credit sales made in the previous quarter (this amount is given). Next, you will see \$144,000 in cash collected in the first quarter related to first quarter sales (= 60 percent collected in quarter of sale × \$240,000 first quarter sales). The remaining \$96,000 will be collected in the second quarter, as shown in Figure 9.11 (= 40 percent × \$240,000 first quarter sales).
Cash Payments for Purchases of Materials
Question: Assume all purchases at Jerry’s Ice Cream are on credit. How long does it take, on average, for Jerry’s to pay for these credit purchases?
Answer
On average, 70 percent of purchases are paid in the quarter purchased and the remaining 30 percent is paid the following quarter. These percentage estimates are based on previous experience and take into account credit terms offered by suppliers.
As you look at the cash payments for purchases of materials section of Jerry’s cash budget, notice that \$30,000 in cash will be paid in the first quarter related to purchases made in the previous quarter (this amount is given). Next, you will see \$59,472 in cash paid in the first quarter related to first quarter purchases (= 70 percent paid in quarter purchased × \$84,960 first quarter purchases). The remaining \$25,488 will be paid in the second quarter, as shown in Figure 9.11 (= 30 percent × \$84,960 first quarter purchases). Figure 9.5 shows how cash flows into the company for customer sales and out of the company for purchases of materials.
Other Cash Collections and Payments
Question: What other cash collections and cash payments must be considered at Jerry’s Ice Cream?
Answer
Assume Jerry’s Ice Cream has other cash payments but no other cash collections. Direct labor cash payments are from Figure 9.6. Manufacturing overhead cash payments are from Figure 9.7. Recall that depreciation was subtracted from total overhead costs in Figure 9.7 to calculate the cash payments for overhead. Selling and administrative cash payments are from Figure 9.8, where a similar depreciation adjustment was made. Capital expenditure cash payments are from Figure 9.10.
The other cash collections and payments section is also where organizations include financing activities such as cash collections from the sale of bonds or cash payments for the repayment of bank loans. Jerry’s Ice Cream does not have any of these financing activities.
The bottom section of the cash budget is where the ending cash balance is calculated for each budget period. The manager responsible for cash planning, typically the treasurer, scrutinizes this section carefully. Some organizations must borrow cash to fund the timing difference between when cash is used for production and when cash is received from sales. The cash budget will signal when short-term borrowing is necessary and allows time for the treasurer to arrange for financing. The cash budget presented in Figure 9.11 shows that Jerry’s will not need to borrow cash in any of the four quarters. In fact, Jerry’s Ice Cream will have a hefty reserve of cash totaling \$155,576 at the end of the fourth quarter.
REVIEW PROBLEM 9.6
Carol’s Cookies has the following information pertaining to the capital expenditures and cash budgets.
Capital Expenditures
The company plans to purchase selling and administrative equipment totaling \$20,000 and production equipment totaling \$28,000. Both will be purchased at the end of the fourth quarter and will not affect depreciation expense for the coming year.
Cash Budget
All sales are on credit. The company expects to collect 70 percent of sales in the quarter of sale, 25 percent of sales in the quarter following the sale, and 5 percent will not be collected (bad debt). Accounts receivable at the end of last year totaled \$200,000, all of which will be collected in the first quarter of this coming year.
All direct materials purchases are on credit. The company expects to pay 80 percent of purchases in the quarter of purchase and 20 percent the following quarter. Accounts payable at the end of last year totaled \$50,000, all of which will be paid in the first quarter of this coming year.
The cash balance at the end of last year totaled \$20,000.
1. Prepare a capital expenditures budget for Carol’s Cookies using the format shown in Figure 9.10.
2. Prepare a cash budget for Carol’s Cookies using the format shown in Figure 9.11.
Answer
1. Note: These acquisitions will have no effect on depreciation expense in the fourth quarter. Items will be purchased at the end of the year. Thus depreciation begins the following year.
2. *Based on sales budget. All sales are on credit: 70 percent collected in the quarter of sale, 25 percent collected the following quarter, and 5 percent bad debt.
**Based on purchases budget. All purchases are on credit: 80 percent paid in the quarter of purchase and 20 percent paid the following quarter.
***From manufacturing overhead budget. Amount does not include depreciation.
****From selling and administrative budget. Amount does not include depreciation.
*****From capital expenditures budget.
^Excess of collections over payments = Cash collections from sales – Cash payments for materials purchases – other cash payments.
^^ Beginning cash balance = Cash balance at end of previous period. Balance for first quarter is given.
^^^ Ending cash balance = Excess of collections over payments for the quarter + Beginning cash balance.
Budgeted Balance Sheet
Question: The budgeted balance sheet is the last piece of the budget process. What is the budgeted balance sheet, and how is it prepared?
Answer
The budgeted balance sheet14 is an estimate of the ending balances for all balance sheet accounts. Managers use this to assess the impact that budgeted sales and costs will have on the financial condition of the organization. We present the budgeted balance sheet for Jerry’s Ice Cream in Figure 9.12.
Information needed to prepare the budgeted balance sheet for Jerry’s Ice Cream is shown throughout the chapter and is referenced in Figure 9.12. Additional information is provided here:
• Plant and equipment (net) expected at the end of the budget period (December 31) is \$530,000.
• Common stock issued and outstanding at the end of the budget period (December 31) is expected to be \$650,000.
• Actual retained earnings at the end of last year totaled \$101,600, and no cash dividends will be paid during the current budget period ending December 31.
*\$124,800 = \$312,000 in fourth quarter sales (Figure 9.3) × 40 percent to be collected next quarter (Figure 9.11).
**\$20,000 = 20,000 pounds (Figure 9.5) × \$1 per pound (Figure 9.5).
***\$19,800 = 4,400 units (Figure 9.4) × \$4.50 (Figure 9.9).
^Given. ^^ \$30,576 = \$101,920 in fourth quarter purchases (Figure 9.5) × 30 percent to be paid next quarter (Figure 9.11).
^^^\$169,600 = \$101,600 in retained earnings at end of last year (given) + \$68,000 budgeted net income for the year (Figure 9.9).
Using Excel to Develop an Operating Budget
Managers often use spreadsheets to develop operating budgets. Spreadsheets help managers perform what-if analysis by linking the components of the master budget and automatically making changes to budget schedules when certain estimates are revised. For example, if managers at Jerry’s Ice Cream wanted to see what would happen if sales in units were decreased by 10 percent from the initial projection shown in Figure 9.3, they would simply reduce sales by 10 percent, and all budget schedules affected by this change would automatically be updated in the spreadsheet. An example of how to use Excel to develop an operating budget for Jerry’s Ice Cream follows. Notice the tabs at the bottom of the spreadsheet.
The first tab is for the sales budget worksheet, the second tab is for the production budget worksheet, the next tab is for the direct materials purchases budget worksheet, and so on. All these worksheets are linked so changes to certain estimates are reflected in the appropriate budget schedules.
Spreadsheet programs are not the only way managers use technology to facilitate the budgeting process. As indicated in Note 9.30 "Business in Action 9.2" the Web is also a useful tool when it comes to efficient budgeting.
Moving from Spreadsheets to Intranet Budgeting
The Pacific Northwest National Laboratory (PNNL) is one of nine multiprogram national laboratories of the U.S. Department of Energy. PNNL is operated by Battelle Science and Technology International, a global science and technology enterprise that conducts \$3,000,000,000 worth of research and development annually.
The Facilities & Operations (F&O) Business Office at PNNL has over 130 budget activities, each of which requires an annual budget. The total annual budget is \$70,000,000. Prior to 2000, activity managers were required to use Excel to process budget information. The F&O Business Office then uploaded this information to formulate the division’s budget.
As the F&O Business Office began the budget process for 2001, management decided to build a Web-based, or intranet, budget and planning system. The new system allowed managers to use the Web to input budget information directly, thus eliminating the need to upload initial budgets and subsequent budget changes.
Moving to intranet budgeting benefited PNNL’s F&O Business Office in several ways. Activity managers no longer had to use Excel to enter budget information, which saved 450 hours. The F&O Business Office saved 60 hours by no longer having to upload Excel budget information. Budget reports are easy to create, and the system provides real-time reports for analysis and project management.
Many organizations are adopting intranet budgeting as the primary source of planning and control. As the financial specialist at PNNL stated, intranet budgeting provides “a tool that is easy to use, accurate, and simple and will continue to save us time and money.”
Sources: Mary F. Astley, “Intranet Budgeting,” Strategic Finance, May 2003; Pacific Northwest National Laboratory, “Home Page,” http://www.pnl.gov.
REVIEW PROBLEM 9.7
Assume Carol’s Cookies will collect 25 percent of fourth quarter budgeted sales in full next year (this represents accounts receivable at the end of the fourth quarter). The following account balances are expected at the end of the fourth quarter:
• Property, plant, and equipment (net): \$320,000
• Common stock: \$450,000
Retained earnings at the end of last year totaled \$56,180, and no cash dividends are anticipated for the budget period ending December 31.
Prepare a budgeted balance sheet for Carol’s Cookies using the format shown in Figure 9.12.
Answer
*\$208,000 = \$832,000 in fourth quarter sales (from sales budget) × 25 percent to be collected next quarter (given).
**\$82,000 = 41,000 pounds × \$2 per pound (from direct materials budget).
***\$60,840 = 9,000 units (from production budget) × \$6.76 cost per unit (from budgeted income statement).
^Given.
^^ \$59,492 = \$297,460 in fourth quarter purchases (from direct materials budget) × 20 percent to be paid next quarter (given).
^^^ \$208,180 = \$56,180 in retained earnings end of last year (given) + \$152,000 budgeted net income (from budgeted income statement).
Wrap-Up of Chapter Example
The management group at Jerry’s Ice Cream is reconvening to discuss sales growth anticipated for the next budget period.
Jerry: Tom, I recall you saying we should expect growth between 10 percent and 25 percent next year. Have you been able to narrow this down a bit?
Tom: Yes, I’ve talked with our salespeople and industry contacts. We also obtained trend data from a market research firm. Based on this information, sales should increase about 15 percent this coming year. Most agree this growth is a result of our high-quality product and our ability to quickly adjust flavors to accommodate consumer tastes
Jerry: This is great news. It looks like our ice cream is really catching on
Michelle: I received Tom’s projection a few days ago and already have a preliminary budget for next year. Lynn, you will have to do some serious planning to guarantee we have enough materials and employees for the third quarter spike in sales.
Lynn: Yes, I realize we have some work to do to ensure we have enough resources to meet budgeted production levels.
Jerry: Can’t we just hire a few more employees and let our suppliers know we will need more materials?
Lynn: The problem is that we have a spike in production during the third quarter. Production goes from 49,200 units in the second quarter to 59,200 units in the third quarter and back down to 51,200 units in the fourth quarter. I don’t think materials will be an issue—our supplier has already assured me this will not be a problem. But I can’t just hire new employees in the third quarter and fire them in the fourth quarter.
Jerry: Perhaps our existing employees can work overtime, or we can hire temporary employees.
Lynn: Hiring temporary employees would be my preference, particularly since college students are looking for part-time work during the summer months. Working overtime would really cause problems with our budgeted hourly rate of \$13.
Jerry: Michelle, do we have any cash flow problems with the anticipated growth?
Michelle: Fortunately not. If all goes as planned, we should have more than \$90,000 in the bank at the end of each quarter.
Jerry: Excellent! Let’s do our best to stay on track. Michelle, I’d like an update at the end of the first quarter to see if actual profit meets or exceeds budgeted profit.
Michelle: No problem. I’ll have it for you as soon as the books are closed for the first quarter.
Jerry Now that we all have some idea of what to expect this coming year, we can make sure the resources are in place to make it happen. This should be an exciting and challenging year for us. Let’s meet again next month to discuss our progress in preparing for next year.
This narrative provides an example of how the master budget is used for planning purposes. It is much more efficient to plan in advance for significant increases in sales and production than to wait and deal with production issues as they occur. The master budget can also be used for control purposes by evaluating company performance. We discuss the control phase of budgeting further in Chapter 10.
Key Takeaway
The master budget for a manufacturing company includes budget schedules for sales, production, direct materials, direct labor, manufacturing overhead, selling and administrative, the income statement, capital expenditures, cash, and the balance sheet. The sales budget is most important because sales projections drive the other budgets.
Definitions
1. An estimate of all operating costs other than production.
2. An estimate of the organization’s profit for a given budget period.
3. An estimate of the long-term assets to be purchased during the budget period.
4. An estimate of the amount and timing of cash inflows and outflows for the budget period.
5. An estimate of the ending balances for all balance sheet accounts. | textbooks/biz/Accounting/Managerial_Accounting/09%3A_How_Are_Operating_Budgets_Created/9.05%3A_The_Master_Budget_%28Part_2%29.txt |
Learning Objectives
• Describe operating budgets for merchandising, service, and not-forprofit organizations.
The examples used thus far to describe a master budget have been limited to manufacturing companies. Manufacturing companies tend to have comprehensive operating budgets and therefore serve as a good starting point in learning how to develop a master budget. However, all types of organizations use operating budgets.
Merchandising Organizations
Question: What do operating budgets look like for merchandising organizations?
Answer
Merchandising organizations typically purchase finished goods and sell them to retail or wholesale customers. Because merchandisers do not produce goods, they do not use production or production-related budgets.
Figure 9.13 provides an overview of the master budget schedules for a merchandising organization. If you compare this diagram with Figure 9.1 (master budget schedules for a manufacturing company), you will notice that production and production-related budgets are not applicable to merchandising organizations. Direct materials are not needed, and all labor and overhead costs are included in the selling and administrative budget.
The most important aspect of budgeting for merchandising organizations is the merchandise purchases budget. The merchandise purchases budget15 estimates the units of merchandise to be purchased and the cost per unit. Much like the production budget for a manufacturing company, the merchandise purchases budget estimates units to be purchased (instead of units to be produced) and is based on sales projections, as well as an estimate of desired ending merchandise inventory less beginning merchandise inventory.
Service Organizations
Question: What do operating budgets look like for service organizations?
Answer
Service organizations, such as architectural and accounting firms, provide services rather than tangible goods. These organizations do not have raw materials, finished goods, or merchandise inventories, and therefore they do not have production or merchandise purchases budgets. Instead, the focus is on projected sales revenue from services provided and the labor necessary to achieve sales revenue projections. Service organizations must constantly estimate services to be provided and make sure labor force resources are available to meet customer demand.
Not-for-Profit Organizations
Question: Not-for-profit organizations, such as school districts and charitable organizations, also use budgets for planning and control purposes. The budgeting process in most not-forprofit organizations is critical because the approved budget often serves as the legal authority for expenditures. What do operating budgets look like for not-for-profit organizations?
Answer
Because not-for-profit organizations are very diverse in nature—for example, some provide a service, while others collect money to help victims of natural disasters or to promote medical research—it is difficult to generalize about which master budget components apply and which do not. However, with an understanding of the budget components used by manufacturing, merchandising, and service organizations, one can establish a budgeting process for virtually any not-for-profit organization. For an example of how one not-for-profit organization goes about the budgeting process, read Note 9.35 "Business in Action 9.3".
Budgeting at a Not-for-Profit Organization
Yearly, a small not-for-profit symphony in California establishes an operating budget with revenues totaling \$200,000. The symphony’s treasurer oversees the budget committee, which is made up of three board members. The budget committee is responsible for creating, approving, and monitoring the budget.
The budget committee begins the budgeting process by reviewing information from the year before. All board members and office staff are given spreadsheets showing last year’s results and are asked to provide input for the next budget period. For example, the committee responsible for ticket sales estimates sales revenue based on expected ticket sales times the average sales price. Anticipated increases in sales price are considered in the sales budget.
Expenses are also budgeted based on last year’s actual results. Those requesting increases in budgeted expenditures must justify them. Once revenues and expenses are established for the next budget period, the bookkeeper enters the information using QuickBooks software and prints a preliminary budget report, which the budget committee reviews. Once the budget committee has balanced the budget, reviewed it for reasonableness, and approved it, it goes to the board of directors for approval.
The control phase of the budgeting process requires that all expenditures be in accordance with the budget. Any expenditure exceeding the budget by more than \$25 must be approved by the board of directors. A financial report comparing actual revenues and expenditures with budgeted revenues and expenditures (produced using QuickBooks software) is submitted to the board of directors monthly.
Key Takeaway
Merchandising organizations do not produce goods, and therefore do not have production or production-related budgets. Instead, merchandisers prepare a merchandise purchases budget. Service companies do not have production or merchandise purchases budgets. Instead, service organizations focus on projected sales and labor costs. Not-for-profit organizations also use budgets for planning and control purposes. The format depends on the service being provided.
REVIEW PROBLEM 9.8
Patel and Company performs accounting services for its customers. The company had the following net income for the most recent year:
The following information was gathered to help prepare next year’s budgeted income statement:
• Service revenue will increase 10 percent (e.g., first quarter service revenue for next year will be 10 percent higher than the first quarter shown previously).
• Manager and staff salaries will increase 5 percent, and a new staff accountant will be hired at the beginning of the second quarter at a quarterly salary of \$12,000.
• Administrative staff wages will increase 10 percent.
• Supplies and rent will remain the same.
• Utilities will increase 5 percent.
• Insurance will increase 25 percent.
• Miscellaneous expenses will decrease 10 percent.
Prepare a quarterly budgeted income statement for Patel and Company; include a column summarizing the year.
Answer
*First quarter budget of \$148,500 = \$135,000 in last year’s first quarter revenue × (1 + .10).
**Quarterly budget of \$63,000 = \$60,000 in last year’s quarterly salaries × (1 + .05).
***First quarter budget of \$26,250 = \$25,000 in last year’s first quarter salaries × (1 + .05). Second, third, and fourth quarter budgets include newly hired staff at \$12,000 a quarter.
^Quarterly budget of \$11,000 = \$10,000 in last year’s quarterly budget × (1 + .10).
^^ No change from last year.
^^^ Quarterly budget of \$2,100 = \$2,000 in last year’s quarterly budget × (1 + .05).
@ Quarterly budget of \$17,500 = \$14,000 in last year’s quarterly budget × (1 + .25).
@@ Quarterly budget of \$5,850 = \$6,500 in last year’s quarterly budget × (1 – .10).
Definition
1. An estimate of the units of merchandise to be purchased and the cost per unit. | textbooks/biz/Accounting/Managerial_Accounting/09%3A_How_Are_Operating_Budgets_Created/9.06%3A_Budgeting_in_Nonmanufacturing_Organizations.txt |
Learning Objectives
• Understand ethical issues associated with budgeting.
Question: Although bottom-up budgeting, in which management elicits input from employees throughout the company, is effective in actively engaging those who have to achieve the budgeted goals, this type of budgeting is not free from problems. Ethical issues often arise in the budgeting process, particularly when employees and managers are evaluated by comparing their actual results to the budget. How might ethical issues arise in the budgeting process?
Answer
To demonstrate how ethical dilemmas might arise, assume you are a manager and you help upper management establish the master budget (this is the planning phase). Furthermore, you are evaluated based on achieving budgeted profit on a quarterly basis (this is the control phase). In fact, you will receive a \$10,000 quarterly bonus, in addition to your base salary, if you meet or exceed budgeted profit. There is an inherent conflict between the planning and control phases of this process. You are helping the company plan, but you also want to be sure budgeted profit is as low as possible so you can get the \$10,000 bonus.
Establishing a sales and profit budget that is considerably lower than what will likely happen causes problems for the entire organization. Production may be short of materials and labor, causing inefficiencies in the production process. Selling and administrative support may be lacking due to underestimating sales. Customers will not be satisfied if they must wait for the product. The dilemma you face as a manager in this situation is whether to do what is best for you (set a low profit estimate to earn the bonus) or do what is best for the company (estimate accurately so the budget reflects true sales and production needs).
Organizations must recognize this conflict and have processes in place to ensure both the interests of individual employees and the interests of the organization as a whole are served. For example, employees can be rewarded not just for meeting goals but also for providing accurate estimates. Perhaps a long-term stock option incentive system would provide motivation to do what is best for the organization, thereby increasing shareholder value. Whatever incentive system is implemented, organizations must promote honest employee input and beware of fraudulent reporting to achieve financial targets.
Key Takeaway
An inherent conflict often exists between the planning and control phases of budgeting. During the planning phase, organizations are most concerned about getting accurate estimates that lead to positive results. The control phase requires evaluating performance of employees by comparing actual results to the operating budget. Employees often must decide between doing what is best for the individual employee and what is best for the organization.
REVIEW PROBLEM 9.9
Assume you are the manager of the computer division of High Tech Retail, Inc. You are asked to help the company prepare a budgeted income statement for the computer division before the start of each fiscal year. At the completion of each fiscal year, division managers receive a bonus equal to 10 percent of actual net income in excess of budgeted net income.
Describe the ethical conflict facing you as division manager when asked to help create the budgeted income statement for your division.
Answer
Employees who are evaluated in the control phase by comparing actual results to budgeted information have an incentive to create a budget that is easy to achieve, and perhaps unrealistic. This can create problems for the organization as a whole since inventory purchases are made based on budgeted sales. If each of the division managers submits a sales budget that significantly underestimates sales, the company will likely have a shortage of inventory and lose out on sales as customers go elsewhere to find the product. Although the managers will have an easier time achieving sales and profit goals, the company as a whole will suffer. The ethical dilemma of choosing between doing what is best for the division manager and what is best for the organization can ultimately lead to lower sales and dissatisfied customers. | textbooks/biz/Accounting/Managerial_Accounting/09%3A_How_Are_Operating_Budgets_Created/9.07%3A_Ethical_Issues_in_Creating_Operating_Budgets.txt |
Questions
1. Describe the planning phase of budgeting.
2. Describe the control phase of budgeting.
3. Refer to Note 9.4 "Business in Action 9.1" Describe two characteristics that make budgeting difficult for multinational companies.
4. Why do successful companies tend to use the bottom-up approach to budgeting?
5. Briefly describe the components of a master budget for a manufacturing organization.
6. Why is the sales budget the most important component of the master budget?
7. Describe the information used by companies to estimate sales.
8. Describe how units to be produced is calculated in the production budget.
9. How does a production budget help the production manager plan for the future?
10. Why is depreciation deducted at the bottom of the manufacturing overhead budget?
11. Why do companies that prepare a budgeted income statement also prepare a cash budget?
12. Refer to Business in Action 9.2 titled “Moving from Spreadsheets to Intranet Budgeting.” What are the advantages of using intranet budgeting? What are some possible disadvantages?
13. How does the master budget for a merchandising organization differ from the master budget for a manufacturing organization?
14. Describe the difference between service organization budgets and manufacturing organization budgets.
15. Refer to Note 9.35 "Business in Action 9.3" Describe the two procedures that the symphony uses in the control phase of budgeting.
16. Describe the ethical conflict that can occur between the planning and control phases of the budgeting process.
17. Why might a sales budget that intentionally underestimates sales have a negative impact on the organization?
Brief Exercises
1. Budgeting at Jerry’s Ice Cream. Refer to the dialogue for Jerry’s Ice Cream presented at the beginning of the chapter and the follow-up dialogue after Note 9.31 "Review Problem 9.7".
Required:
1. In the opening dialogue, why is Jerry Feltz concerned about the sales growth expected for the coming year?
2. In the follow-up dialogue, why is the company’s treasurer and controller concerned about the third quarter?
1. Budget Sequence. Indicate the order in which the following budget schedules are prepared.
1. Direct materials purchases
2. Manufacturing overhead
3. Income statement
4. Direct labor
5. Selling and administrative
6. Cash
7. Production
8. Balance sheet
9. Sales
10. Capital expenditures
2. Sales Budget. Schwartz and Company expects to sell 100 units in the first quarter, 90 units in the second quarter, 150 units in the third quarter, and 160 units in the fourth quarter. The average sales price per unit is expected to be \$3,000. Prepare a sales budget for each quarter and include a column for the year ending December 31.
3. Production Budget. Schwartz and Company expects to sell 100 units in the first quarter and 90 units in the second quarter. Assuming the company prefers to maintain finished goods inventory equal to 10 percent of the next quarter’s sales, prepare a production budget for the first quarter using Figure 9.4 as a guide. (Hint: you are preparing a production budget for the first quarter only.)
4. Direct Materials Purchases Budget. The production budget for Kaminski Products shows the company expects to produce 500 units in the first quarter and 600 units in the second quarter. Each unit requires 10 pounds of direct materials at a cost of \$2 per pound. The company prefers to maintain raw materials inventory equal to 20 percent of next quarter’s materials needed in production. Prepare a direct materials purchases budget using Figure 9.5 as a guide. (Hint: you are preparing a direct materials purchases budget for the first quarter only.)
5. Direct Labor Budget. The production budget for Kaminski Products shows the company expects to produce 500 units in the first quarter. Assuming each unit of product requires 3 direct labor hours at a cost of \$13 per hour, prepare a direct labor budget for the first quarter using Figure 9.6 as a guide. (Hint: you are preparing a direct labor budget for the first quarter only.)
6. Manufacturing Overhead Budget. The production budget for Kaminski Products shows the company expects to produce 500 units in the first quarter. Assume variable overhead cost per unit is \$5 for indirect materials, \$8 for indirect labor, and \$3 for other items. Fixed overhead cost per quarter is \$30,000 for salaries, \$20,000 for rent, and \$8,000 for depreciation. Prepare a manufacturing overhead budget for the first quarter using Figure 9.7 as a guide (Hint: you are preparing a manufacturing overhead budget for the first quarter only.)
7. Sales Cash Collections Budget. All sales for Malik and Associates are on credit. Accounts receivable at the end of last quarter totaled \$100,000. Credit sales for the first quarter of the upcoming period are expected to be \$300,000. The company expects to collect 70 percent of sales in the quarter of the sale, and 30 percent the quarter following the sale. Prepare a sales cash collections budget for the first quarter of the upcoming period using the top of Figure 9.11 as a guide. (Hint: you are preparing a sales cash collections budget for the first quarter only.)
8. Purchases Cash Payments Budget. All direct material purchases made by Keen and Company are on credit. Accounts payable at the end of last quarter totaled \$50,000. Purchases for the first quarter of the upcoming period are expected to be \$200,000. The company expects to pay 40 percent of purchases in the quarter of purchase and 60 percent the quarter following the purchase. Prepare a purchases cash payments budget for the first quarter of the upcoming period using the middle of Figure 9.11 as a guide. (Hint: you are preparing a purchases cash payments budget for the first quarter only.)
9. Sales Budget for Service Organization; Ethical Issues. Rami and Associates is an accounting firm that estimates revenues based on billable hours. The company expects to charge 8,000 hours to clients in the first quarter, 9,000 hours in the second quarter, 7,000 hours in the third quarter and 8,500 hours in the fourth quarter. The average hourly billing rate is expected to be \$100.
Required:
1. Prepare a services revenue budget for each quarter and include a column for the year ending December 31. (Hint: this is similar to a sales budget except sales are measured in labor hours rather than in units, and revenue is measured as an average hourly billing rate rather than a sales price per unit.)
2. Since the manager of the company is given a bonus if actual billable hours exceed budgeted billable hours, the manager intentionally underestimated the number of expected billable hours for each quarter. How might this underestimate affect the company?
Exercises: Set A
1. Sales and Production Budgets. Templeton Corporation produces windows used in residential construction. Unit sales last year, ending December 31, are as follow:
First quarter 40,000
Second quarter 50,000
Third quarter 52,000
Fourth quarter 48,000
Unit sales are expected to increase 10 percent this coming year over the same quarter last year. Average sales price per window will remain at \$200.
Assume finished goods inventory is maintained at a level equal to 5 percent of the next quarter’s sales. Finished goods inventory at the end of the fourth quarter budget period is estimated to be 2,300 units.
Required:
1. Prepare a sales budget for Templeton Corporation using a format similar to Figure 9.3. (Hint: be sure to increase last year’s unit sales by 10 percent.)
2. Prepare a production budget for Templeton Corporation using a format similar to Figure 9.4.
1. Direct Materials Purchases and Direct Labor Budgets. Templeton Corporation produces windows used in residential construction. The company expects to produce 44,550 units in the first quarter, 55,110 units in the second quarter, 56,980 units in the third quarter, and 52,460 units in the fourth quarter. (This information is derived from the previous exercise for Templeton Corporation.)
With regards to direct materials, each unit of product requires 12 square feet of glass at a cost of \$1.50 per square foot. Management prefers to maintain ending raw materials inventory equal to 10 percent of next quarter’s materials needed in production. Raw materials inventory at the end of the fourth quarter budget period is estimated to be 65,000 square feet.
With regards to direct labor, each unit of product requires 2 labor hours at a cost of \$15 per hour.
Required:
1. Prepare a direct materials purchases budget for Templeton Corporation using a format similar to Figure 9.5.
2. Prepare a direct labor budget for Templeton Corporation using a format similar to Figure 9.6.
1. Manufacturing Overhead Budget. Templeton Corporation produces windows used in residential construction. The company expects to produce 44,550 units in the first quarter, 55,110 units in the second quarter, 56,980 units in the third quarter, and 52,460 units in the fourth quarter. (This information is the same as in the previous exercise for Templeton Corporation.) The following information relates to the manufacturing overhead budget.
Variable Overhead Costs
Indirect materials \$2.50 per unit
Indirect labor \$3.20 per unit
Other \$1.70 per unit
Fixed Overhead Costs per Quarter
Salaries \$50,000
Rent \$60,000
Depreciation \$36,370
Required:
Prepare a manufacturing overhead budget for Templeton Corporation using a format similar to Figure 9.7.
1. Budgets for Cash Collections from Sales and Cash Payments for Purchases. Templeton Corporation produces windows used in residential construction. The dollar amount of the company’s quarterly sales and direct materials purchases are projected to be as follows (this information is derived from the previous exercises for Templeton Corporation):
1st 2nd 3rd 4th
Sales \$8,800,000 \$11,000,000 \$11,440,000 \$10,560,000
Direct materials purchases \$ 820,908 \$ 995,346 \$ 1,017,504 \$ 947,352
Assume all sales are made on credit. The company expects to collect 60 percent of sales in the quarter of sale and 40 percent the quarter following the sale. Accounts receivable at the end of last year totaled \$3,000,000, all of which will be collected in the first quarter of the coming year.
Assume all direct materials purchases are on credit. The company expects to pay 70 percent of purchases in the quarter of purchase and 30 percent the following quarter. Accounts payable at the end of last year totaled \$325,000, all of which will be paid in the first quarter of this coming year.
Required:
1. Prepare a budget for cash collections from sales. Use a format similar to the top section of Figure 9.11.
2. Prepare a budget for cash payments for purchases of materials. Use a format similar to the middle section of Figure 9.11. Round to the nearest dollar.
1. Service Company Budgeted Income Statement and Ethical Issues. Lawn Care, Inc., has two owners who maintain lawns for residential customers. The company had the following net income for the most current year.
The following information was gathered from the owners to help prepare this coming year’s budgeted income statement:
• Service revenue will increase 15 percent (e.g., first quarter service revenue for this coming year will be 15 percent higher than the first quarter shown previously).
• Owner salaries will increase 8 percent.
• Crew wages will increase 12 percent.
• Administrative staff wages will increase 5 percent, and a new staff member will be hired at the beginning of the third quarter at a quarterly rate of \$7,000.
• Supplies will increase 9 percent.
• Office rent, utilities, and miscellaneous expenses will remain the same.
• Insurance will increase 18 percent.
• The tax rate will remain at 30 percent.
Required:
1. Prepare a quarterly budgeted income statement for Lawn Care, Inc., and include a column summarizing the year.
2. The owners of Lawn Care, Inc., have decided to expand and are in need of additional cash to expand operations. Unknown to the owners, the company’s accountant intentionally inflated the revenue projections for this coming year to make the company look better when applying for a loan. Is this behavior ethical? Explain. (It may be helpful to review the presentation of ethics in Chapter 1.) | textbooks/biz/Accounting/Managerial_Accounting/09%3A_How_Are_Operating_Budgets_Created/9.E%3A_Exercises_%28Part_1%29.txt |
Exercises: Set B
1. Sales and Production Budgets. Catalina, Inc., produces tents used for camping. Unit sales last year, ending December 31, follow.
First quarter 6,000
Second quarter 10,000
Third quarter 12,000
Fourth quarter 8,000
Unit sales are expected to increase 30 percent this coming year over the same quarter last year. Average sales price per tent will remain at \$300.
Assume finished goods inventory is maintained at a level equal to 10 percent of the next quarter’s sales. Finished goods inventory at the end of the fourth quarter budget period is estimated to be 1,900 units.
Required:
1. Prepare a sales budget for Catalina, Inc., using a format similar to Figure 9.3. (Hint: be sure to increase last year’s unit sales by 30 percent.)
2. Prepare a production budget for Catalina, Inc., using a format similar to Figure 9.4.
1. Direct Materials Purchases and Direct Labor Budgets. Catalina, Inc., produces tents used for camping. The company expects to produce 8,320 units in the first quarter, 13,260 units in the second quarter, 15,080 units in the third quarter, and 11,260 units in the fourth quarter (this information is derived from the previous exercise for Catalina, Inc.).
With regards to direct materials, each unit of product requires 8 yards of material, at a cost of \$4 per yard. Management prefers to maintain ending raw materials inventory equal to 15 percent of next quarter’s materials needed in production. Raw materials inventory at the end of the fourth quarter budget period is estimated to be 14,000 yards.
With regards to direct labor, each unit of product requires 3 labor hours at a cost of \$16 per hour.
Required:
1. Prepare a direct materials purchases budget for Catalina, Inc., using a format similar to Figure 9.5.
2. Prepare a direct labor budget for Catalina, Inc., using a format similar to Figure 9.6.
1. Manufacturing Overhead Budget. Catalina, Inc., produces tents used for camping. The company expects to produce 8,320 units in the first quarter, 13,260 units in the second quarter, 15,080 units in the third quarter, and 11,260 units in the fourth quarter. (This information is the same as in the previous exercise for Catalina, Inc.) The following information relates to the manufacturing overhead budget.
Variable Overhead Costs
Indirect materials \$0.20 per unit
Indirect labor \$4.20 per unit
Other \$2.70 per unit
Fixed Overhead Costs per Quarter
Salaries \$100,000
Rent \$ 30,000
Depreciation \$ 44,908
Required:
Prepare a manufacturing overhead budget for Catalina, Inc., using a format similar to Figure 9.7.
1. Budgets for Cash Collections from Sales and Cash Payments for Purchases. Catalina, Inc., produces tents used for camping. The dollar amount of the company’s quarterly sales and direct materials purchases are projected to be as follows (this information is derived from the previous exercises for Catalina, Inc.):
1st 2nd 3rd 4th
Sales \$2,340,000 \$3,900,000 \$4,680,000 \$3,120,000
Direct materials purchases \$ 289,952 \$ 289,952 \$ 464,224 \$ 362,272
Assume all sales are made on credit. The company expects to collect 80 percent of sales in the quarter of sale and 20 percent the quarter following the sale. Accounts receivable at the end of last year totaled \$400,000, all of which will be collected in the first quarter of the coming year.
Assume all direct materials purchases are on credit. The company expects to pay 90 percent of purchases in the quarter of purchase and 10 percent the following quarter. Accounts payable at the end of last year totaled \$30,000, all of which will be paid in the first quarter of this coming year.
Required:
1. Prepare a budget for cash collections from sales. Use a format similar to the top section of Figure 9.11.
2. Prepare a budget for cash payments for purchases of materials. Use a format similar to the middle section of Figure 9.11. Round to the nearest dollar.
1. Service Company Budgeted Income Statement. Civil Engineers, LLC, has five engineers who design and maintain wetlands. The company had the following net income for the most current year.
The following information was gathered from management to help prepare this coming year’s budgeted income statement:
• Service revenue will increase 3 percent (e.g., first quarter service revenue for this coming year will be 3 percent higher than the first quarter shown previously).
• Existing engineer and biologist salaries will increase 5 percent, and a new biologist will be hired at the beginning of the second quarter at a quarterly salary of \$10,000.
• Administrative staff wages will increase 15 percent.
• Supplies and rent will remain the same.
• Utilities will increase 8 percent.
• Insurance will increase 20 percent.
• Miscellaneous expenses will decrease 5 percent.
Required:
Prepare a quarterly budgeted income statement for Civil Engineers, LLC, and include a column summarizing the year.
Problems
1. Budgeting for Sales, Production, Direct Materials, Direct Labor, and Manufacturing Overhead; Ethical Issues. Sanders Swimwear, Inc., produces swimsuits. The following information is to be used for the operating budget this coming year.
• Average sales price for each swimsuit is estimated to be \$50. Unit sales for this coming year ending December 31 are expected to be as follows:
First quarter 3,000
Second quarter 5,000
Third quarter 20,000
Fourth quarter 6,000
• Finished goods inventory is maintained at a level equal to 10 percent of the next quarter’s sales. Finished goods inventory at the end of the fourth quarter budget period is estimated to be 400 units.
• Each unit of product requires 3 yards of direct materials, at a cost of \$4 per yard. Management prefers to maintain ending raw materials inventory equal to 20 percent of next quarter’s materials needed in production. Raw materials inventory at the end of the fourth quarter budget period is estimated to be 9,500 yards.
• Each unit of product requires 0.5 direct labor hours at a cost of \$12 per hour.
• Variable manufacturing overhead costs are
Indirect materials \$0.60 per unit
Indirect labor \$3.50 per unit
Other \$2.80 per unit
• Fixed manufacturing overhead costs per quarter are
Salaries \$30,000
Other \$ 5,000
Depreciation \$ 9,330
Required:
1. Prepare a sales budget using the format shown in Figure 9.3.
2. Prepare a production budget using the format shown in Figure 9.4.
3. Prepare a direct materials purchases budget using the format shown in Figure 9.5.
4. Prepare a direct labor budget using the format shown in Figure 9.6.
5. Prepare a manufacturing overhead budget using the format shown in Figure 9.7.
6. As the production manager, what concerns, if any, do you have about production requirements for each of the four quarters?
7. Assume the sales budget was developed based on input provided by the company’s vice president of sales. The vice president is paid a base salary plus a bonus if actual sales exceed budgeted sales. How might this influence the vice president’s estimate of quarterly sales? What effect might this have on the company?
1. Budgeting for Sales, Production, Direct Materials, Direct Labor, and Manufacturing Overhead. Hershel’s Chocolate produces chocolate bars and sells them by the case (1 unit = 1 case). Information to be used for the operating budget this coming year follows:
• Average sales price for each case is estimated to be \$25. Unit sales for this coming year, ending December 31, are expected to be as follows:
First quarter 80,000
Second quarter 84,000
Third quarter 88,000
Fourth quarter r 97,000
• Finished goods inventory is maintained at a level equal to 15 percent of the next quarter’s sales. Finished goods inventory at the end of the fourth quarter budget period is estimated to be 13,000 units.
• Each unit of product requires 5 pounds of cocoa beans for direct materials, at a cost of \$3 per pound. Management prefers to maintain ending raw materials inventory equal to 10 percent of next quarter’s materials needed in production. Raw materials inventory at the end of the fourth quarter budget period is estimated to be 43,000 pounds.
• Each unit of product requires 0.10 direct labor hours at a cost of \$14 per hour.
• Variable manufacturing overhead costs are
Indirect materials \$0.20 per unit
Indirect labor \$0.15 per unit
Other \$0.10 per unit
• Fixed manufacturing overhead costs per quarter are
Salaries \$80,000
Other \$70,000
Depreciation \$55,625
Required:
1. Prepare a sales budget using the format shown in Figure 9.3.
2. Prepare a production budget using the format shown in Figure 9.4.
3. Prepare a direct materials purchases budget using the format shown in Figure 9.5.
4. Prepare a direct labor budget using the format shown in Figure 9.6.
5. Prepare a manufacturing overhead budget using the format shown in Figure 9.7. Round to the nearest dollar.
6. As the production manager, what concerns, if any, do you have about production requirements for each of the four quarters?
1. Selling and Administrative Budget and Budgeted Income Statement. (The previous problem must be completed before working this problem.) Hershel’s Chocolate produces chocolate bars. Management estimates all selling and administrative costs are fixed. Quarterly selling and administrative cost estimates for the coming year follow.
Salaries \$170,000
Rent \$ 65,000
Advertising \$120,000
Depreciation \$ 75,000
Other \$ 36,000
Required:
1. Use the information presented previously to prepare a selling and administrative budget. Refer to the format shown in Figure 9.8.
2. Use the information from the previous problem and from requirement a of this problem to prepare a budgeted income statement. Refer to the format shown in Figure 9.9.
3. How will management use the information presented in the budgeted income statement?
1. Budgeting for Cash Collections and Cash Payments. Hershel’s Chocolate produces chocolate bars. The treasurer at Hershel’s Chocolate is preparing the cash budget and would like to know when cash collections from sales and cash payments for materials will occur. The dollar amount of the company’s quarterly sales and direct materials purchases are projected to be as follows (this information is the result of working the previous problems for Hershel’s Chocolate):
1st 2nd 3rd 4th
Sales \$2,000,000 \$2,100,000 \$2,200,000 \$2,425,000
Direct materials purchases \$1,215,000 \$1,276,125 \$1,349,400 \$1,417,575
• All sales are made on credit. The company expects to collect 60 percent of sales in the quarter of sale and 40 percent the quarter following the sale. Accounts receivable at the end of last year totaled \$770,000, all of which will be collected during the first quarter of this coming year.
• All direct materials purchases are on credit. The company expects to pay 80 percent of purchases in the quarter of purchase and 20 percent the following quarter. Accounts payable at the end of last year totaled \$257,000, all of which will be paid during the first quarter of this coming year.
Required:
1. Prepare a budget for cash collections from sales. Refer to the format shown at the top of Figure 9.11.
2. Prepare a budget for cash payments for purchases of materials. Refer to the format shown in the middle section of Figure 9.11.
3. How will the treasurer use this information?
1. Services Revenue and Direct Labor Budgets for Service Organization; Ethical Issues. Engineering, Inc., provides structural engineering services for its clients. Billable hours for each month of the first quarter of this coming budget period are expected to be as follows:
January 2,000
February 2,200
March 3,000
The average hourly billing rate is estimated to be \$150.
Required:
1. Prepare a services revenue budget for Engineering, Inc., for each month of the first quarter and include a total column for the quarter. (Hint: this is similar to a sales budget except sales are measured in labor hours rather than in units, and revenue is measured as an average hourly billing rate rather than a sales price per unit.)
2. The average cost for each hour of direct labor is expected to be \$50. Assume total direct labor hours are expected to be 20 percent higher than billable direct labor hours presented previously. This is caused by employees working on projects that are not billable to clients (e.g., recruiting and community work). Prepare a direct labor budget for each month of the first quarter and include a total column for the quarter. (Hint: this budget will have three lines: projected direct labor hours, labor rate per hour, and total direct labor cost.)
3. Assume the manager of the company is given a monthly bonus if actual billable hours exceed budgeted billable hours. How might this influence the manager’s estimate of monthly billable hours for budgeting purposes? What effect might this have on the company?
1. Merchandising Company Master Budget. Big Apple Sporting Goods is a retail store that sells a variety of sports equipment. The company’s fiscal year ends on December 31. Information to be used for the operating budget this coming year follows.
Sales and Merchandise Purchases Budget Information
• Sales for this coming year ending December 31 are expected to be as follows:
First quarter \$600,000
Second quarter \$650,000
Third quarter \$660,000
Fourth quarter \$800,000
• Cost of goods sold is 40 percent of sales (this is the first line of the merchandise purchases budget). Merchandise inventory is maintained at a level equal to 20 percent of the next quarter’s cost of goods sold. Merchandise inventory at the end of the fourth quarter budget period is estimated to be \$55,000.
Selling and Administrative Budget Information
• Management estimates all selling and administrative costs are fixed.
• Quarterly selling and administrative cost estimates for the coming year are
Salaries \$150,000
Rent \$ 25,000
Advertising \$ 40,000
Depreciation \$ 18,000
Other \$ 12,000
Capital Expenditure and Cash Budget Information
• The company plans to pay cash for property, plant, and equipment totaling \$35,000 at the end of the fourth quarter. This purchase will not affect depreciation expense for the coming year.
• The company expects to collect 70 percent of sales in the quarter of sale and 30 percent the quarter following the sale. Accounts receivable at the end of last year totaled \$200,000, all of which will be collected during the first quarter of this coming year.
• All inventory purchases are on credit. The company expects to pay 80 percent of inventory purchases in the quarter of purchase and 20 percent the following quarter. Accounts payable at the end of last year totaled \$68,000, all of which will be paid during the first quarter of this coming year.
• The cash balance at the beginning of this coming year is expected to be \$90,000.
Budgeted Balance Sheet Information
• Assume 30 percent of fourth quarter budgeted sales will be collected in full the following year (this represents accounts receivable at the end of the fourth quarter).
• Expected account balances at the end of the fourth quarter are
Property, plant, and equipment (net) \$120,000
Common stock \$175,000
• Actual retained earnings at the end of the last year totaled \$252,000, and no cash dividends will be paid during the current budget period ending December 31.
Required:
1. Prepare a quarterly sales budget. (Hint: this budget will not have any units of product, only total sales revenue.)
2. Prepare a quarterly merchandise purchases budget using the following format. All amounts are in dollars.
3. Prepare a quarterly selling and administrative budget using the format shown in Figure 9.8.
4. Prepare a quarterly budgeted income statement using the format shown in Figure 9.9. (Hint: cost of goods sold will be based on a percent of sales rather than a cost per unit.)
5. Prepare a quarterly capital expenditure budget using the format shown in Figure 9.10.
6. Prepare a quarterly cash budget using the format shown in Figure 9.11. (Hint: Merchandising companies have merchandise purchases rather than direct materials purchases. Merchandising companies do not have direct labor or manufacturing overhead.)
7. Prepare a budgeted balance sheet at December 31 using the format shown in Figure 9.12. (Hint: merchandising companies have merchandise inventory rather than raw materials inventory or finished goods inventory.) | textbooks/biz/Accounting/Managerial_Accounting/09%3A_How_Are_Operating_Budgets_Created/9.E%3A_Exercises_%28Part_2%29.txt |
One Step Further: Skill-Building Cases
1. Ethics in Budgeting. SportsMax sells sporting goods equipment at 100 stores throughout North America. Robert Manning is the manager of one SportsMax retail store in Chicago. The company is in the planning phase of establishing its operating budget for this coming year and has asked that all store managers submit their estimates of sales revenue, costs, and resulting profit. During the control phase, each store manager is evaluated by comparing budgeted profit with actual profit. Store managers who exceed budgeted profit are given a bonus equal to 10 percent of actual profit in excess of budgeted profit.
Required:
1. Describe the ethical conflict that Robert Manning is facing.
2. As the president and CEO of SportsMax, how might you motivate Robert Manning to provide an accurate operating budget?
1. Group Activity: Creating a Budget. Form groups of two to four students. Each group is to complete the following requirements.
Required:
1. Assume you are a full-time student living in an apartment near your college campus. Create a personal budget that includes the typical monthly expenses you would expect to incur.
2. Explain how the control phase of budgeting would be implemented for the personal budget created in requirement a.
3. Discuss the findings of your group with the class. (Optional: your instructor may ask you to submit your findings in writing.)
1. Creating a Sales Budget and Production Budget Using Excel. Review the information for Templeton Corporation in Exercise 28. Prepare an Excel spreadsheet similar to Figure 9.3 and Figure 9.4 showing Templeton’s sales budget and production budget.
2. Internet Project: Budgeting. Go to The New York Times’ Web site (http://www.nytimes.com), or a similar reputable Internet source, and find an article about budgeting. Summarize the article in a one-page report, and indicate how the budget described in the article is used for planning purposes. Submit a printed copy of the article with your report.
Comprehensive Cases
1. Comprehensive Master Budget. Creative Shirts, Inc., produces T-shirts. The company’s fiscal year ends on December 31. Information to be used for the operating budget this coming year follows.
Sales and Production-Related Budget Information
• Average sales price for each T-shirt is estimated to be \$15. Unit sales for this coming year, ending December 31, are expected to be as follows:
First quarter 20,000
Second quarter 24,000
Third quarter 28,000
Fourth quarter 18,000
• Finished goods inventory is maintained at a level equal to 10 percent of the next quarter’s sales. Finished goods inventory at the end of the fourth quarter budget period is estimated to be 2,000 units.
• Each unit of product requires 3 yards of direct materials, at a cost of \$2 per yard. Management prefers to maintain ending raw materials inventory equal to 20 percent of next quarter’s materials needed in production. Raw materials inventory at the end of the fourth quarter budget period is estimated to be 12,200 yards.
• Each unit of product requires 0.1 direct labor hours at a cost of \$14 per hour.
• Variable manufacturing overhead costs are
Indirect materials \$0.70 per unit
Indirect labor \$0.90 per unit
Other \$0.50 per unit
• Fixed manufacturing overhead costs per quarter are
Salaries \$18,000
Other \$20,000
Depreciation \$11,950
Selling and Administrative Budget Information
• Management estimates all selling and administrative costs are fixed.
• Quarterly selling and administrative cost estimates for the coming year are
Salaries \$15,000
Rent \$ 5,000
Advertising \$ 4,000
Depreciation \$ 9,000
Other \$10,000
Capital Expenditures and Cash Budget Information
• The company plans to pay cash for selling and administrative equipment totaling \$15,000 and production equipment totaling \$9,000. Both will be purchased at the end of the fourth quarter and will not affect depreciation expense for the coming year.
• All sales are made on credit. The company expects to collect 70 percent of sales in the quarter of sale and 30 percent the quarter following the sale. Accounts receivable at the end of last year totaled \$80,000, all of which will be collected during the first quarter of this coming year.
• All direct materials purchases are on credit. The company expects to pay 80 percent of purchases in the quarter of purchase and 20 percent the following quarter. Accounts payable at the end of last year totaled \$25,000, all of which will be paid during the first quarter of this coming year.
• The cash balance at the beginning of this coming year is expected to be \$30,000.
Budgeted Balance Sheet Information
• Assume 30 percent of fourth quarter budgeted sales will be collected in full the following year (this represents accounts receivable at the end of the fourth quarter).
• Expected account balances at the end of the fourth quarter are
Property, plant, and equipment (net) \$100,000
Common stock \$250,000
• Actual retained earnings at the end of last year totaled \$42,720, and no cash dividends will be paid during the current budget period ending December 31.
Required:
1. Prepare the quarterly sales and production-related budgets using the figure formats referenced here:
1. Sales budget (Figure 9.3)
2. Production budget (Figure 9.4)
3. Direct materials purchases budget (Figure 9.5)
4. Direct labor budget (Figure 9.6)
5. Manufacturing overhead budget (Figure 9.7)
2. Prepare a quarterly selling and administrative budget using the format shown in Figure 9.8.
3. Prepare a quarterly budgeted income statement using the format shown in Figure 9.9.
4. Prepare a quarterly capital expenditures budget using the format shown in Figure 9.10.
5. Prepare a quarterly cash budget using the format shown in Figure 9.11.
6. Prepare a budgeted balance sheet at December 31 using the format shown in Figure 9.12.
7. Why does management at Creative Shirts, Inc., prepare a master budget? Explain.
1. Comprehensive Master Budget with Cash Flow Issues. Air Boats, Inc., produces small inflatable boats. The company’s fiscal year ends on December 31. Information to be used for the operating budget this coming year follows.
Sales and Production-Related Budget Information
• Average sales price for each boat is estimated to be \$150. Unit sales for this coming year, ending December 31, are expected to be as follows:
First quarter 100,000
Second quarter 110,000
Third quarter 125,000
Fourth quarter 90,000
• Finished goods inventory is maintained at a level equal to 15 percent of the next quarter’s sales. Finished goods inventory at the end of the fourth quarter budget period is estimated to be 13,000 units.
• Each unit of product requires 4 pounds of direct materials, at a cost of \$5 per pound. The management prefers to maintain ending raw materials inventory equal to 8 percent of next quarter’s materials needed in production. Raw materials inventory at the end of the fourth quarter budget period is estimated to be 30,000 pounds.
• Each unit of product requires 0.5 direct labor hours at a cost of \$15 per hour.
• Variable manufacturing overhead costs are
Indirect materials \$2.10 per unit
Indirect labor \$1.10 per unit
Other \$1.70 per unit
• Fixed manufacturing overhead costs per quarter are
Salaries \$250,000
Other \$300,000
Depreciation \$613,250
Selling and Administrative Budget Information
• Management estimates all selling and administrative costs are fixed.
• Quarterly selling and administrative cost estimates for the coming year are
Salaries \$3,000,000
Rent \$1,000,000
Advertising \$ 900,000
Depreciation \$1,200,000
Other \$1,600,000
Capital Expenditures and Cash Budget Information
• The company plans to pay cash for selling and administrative equipment totaling \$5,000,000 and production equipment totaling \$20,000,000 (management plans to fully automate production with new machinery). Both will be purchased at the end of the fourth quarter and will not affect depreciation expense for the coming year.
• All sales are made on credit. The company expects to collect 90 percent of sales in the quarter of sale and 10 percent the quarter following the sale. Accounts receivable at the end of last year totaled \$1,400,000, all of which will be collected during the first quarter of this coming year.
• All direct materials purchases are on credit. The company expects to pay 80 percent of purchases in the quarter of purchase and 20 percent the following quarter. Accounts payable at the end of last year totaled \$400,000, all of which will be paid during the first quarter of this coming year.
• The cash balance at the beginning of this coming year is expected to be \$75,000.
Budgeted Balance Sheet Information
• Assume 10 percent of fourth quarter budgeted sales will be collected in full the following year (this represents accounts receivable at the end of the fourth quarter).
• Expected account balances at the end of the fourth quarter are
Property, plant, and equipment (net) \$32,000,000
Common stock \$13,500,000
• Actual retained earnings at the end of last year totaled \$2,641,400, and no cash dividends will be paid during the current budget period ending December 31.
Required:
1. Prepare the quarterly sales and production-related budgets using the figure formats referenced here:
1. Sales budget (Figure 9.3)
2. Production budget (Figure 9.4)
3. Direct materials purchases budget (Figure 9.5)
4. Direct labor budget (Figure 9.6)
5. Manufacturing overhead budget (Figure 9.7)
2. Prepare a quarterly selling and administrative budget using the format shown in Figure 9.8.
3. Prepare a quarterly budgeted income statement using the format shown in Figure 9.9.
4. Prepare a quarterly capital expenditures budget using the format shown in Figure 9.10.
5. Prepare a quarterly cash budget using the format shown in Figure 9.11.
6. Prepare a budgeted balance sheet at December 31 using the format shown in Figure 9.12. (Hint: cash will have a negative balance.)
7. Review the cash budget for Air Boats, Inc. What issue is facing the treasurer, and how might this issue be resolved?
1. Ethics in Budgeting. Carol Chadwick is the manager of the toys division at Matteler, Inc. Carol is in the process of establishing the budgeted income statement for this coming year, which will be submitted to the company president for approval. The division’s current year actual results were slightly higher than the 5 percent growth Carol had anticipated. These results are shown as follows.
Division managers receive a 20 percent bonus for actual net income in excess of budgeted net income. Carol believes growth in sales this year will be approximately 12 percent. She is considering submitting a budget showing an increase of 5 percent, which will increase her chances of receiving a significant bonus at the end of this coming year. Assume cost of goods sold are variable costs and will increase in proportion with sales revenue. That is, cost of goods sold will always be 60 percent of sales revenue. Assume selling and administrative expenses are fixed costs.
Required:
1. Prepare a budgeted income statement for the toys division assuming sales revenue will increase 5 percent.
2. Prepare a budgeted income statement for the toys division assuming sales revenue will increase 12 percent.
3. How much will Carol potentially have to gain in bonus compensation by submitting a budget showing a 5 percent increase in sales revenue if actual growth turns out to be 12 percent?
4. As the president and CEO of Matteler, how might you motivate Carol Chadwick to provide an accurate budgeted income statement? | textbooks/biz/Accounting/Managerial_Accounting/09%3A_How_Are_Operating_Budgets_Created/9.E%3A_Exercises_%28Part_3%29.txt |
© Thinkstock
Jerry Feltz, president and owner of Jerry’s Ice Cream, is discussing the results of operations for the year with the company’s management group: Tom, the sales manager; Lynn, the production manager; and Michelle, the treasurer and controller.
Jerry: Good work, everyone! It looks as if our sales this past year exceeded the budget! We were expecting to sell 200,000 gallons of ice cream, but it turns out we sold 210,000 gallons. Credit goes to our sales staff for their hard work!
Tom: Thanks, Jerry. We have a great group of salespeople and a terrific product.
Jerry: I agree. I am concerned, however, about our direct labor and direct materials costs. We expected a 5 percent increase in these costs over the original budget since sales were 5 percent higher than anticipated. However, our cost overruns far exceeded the 5 percent increase. We’ve got to get a handle on both of these costs.
Lynn: This doesn’t sound right. My production crew used fewer materials than was budgeted, and the average time it took to make each unit was also less than expected. This should cause materials and labor costs to be lower than expected, not higher.
Jerry: Michelle, are you sure we have the right information here?
Michelle: Absolutely. Total costs for direct labor and direct materials were higher than budgeted, even after considering the increase in sales.
Jerry: Can you give me more detail as to how this happened? I want to know what caused the increase in costs and how to prevent this from taking place in the future.
Michelle: Can I have a week to pull the information together?
Jerry: You’ve got it.
Jerry is evaluating the performance of his company by comparing actual costs to budgeted costs. This is the control phase of budgeting. We covered the planning phase of budgeting in Chapter 9 by showing how Jerry’s Ice Cream prepared a master budget. The focus of this chapter is on the control phase and how to calculate and analyze cost variances.
10.02: Flexible Budgets
Learning Objectives
• Understand how flexible budgets are used to evaluate performance.
Question: The master budget in Chapter 9 was prepared for only one level of activity (activity was measured by the number of units sold, which was budgeted at 200,000 units). Although this works well in the planning phase of budgeting, it is not appropriate for the control phase. Actual sales rarely match budgeted sales. When actual sales differ from budgeted sales, it is inappropriate and perhaps unfair to evaluate employee performance by comparing actual results to the master budget. If actual sales volume is higher than the master budget, variable costs should be higher than the master budget. The opposite is true as well. How do organizations modify the master budget to adjust for actual sales?
Answer
Organizations use a modified budget called a flexible budget. A flexible budget1 is simply a revised master budget based on the actual activity level. It represents what costs should be given a certain level of activity. The master budget at Jerry’s Ice Cream was based on sales of 200,000 units and production of 200,400 units. Because actual sales totaled 210,000 units, the flexible budget should be based on 210,000 units of activity. (It should be noted that in Chapter 9, we presented an example with budgeted sales of 200,000 units and budgeted production of 200,400 units resulting from differing beginning and ending finished goods inventory amounts. In this chapter, we assume beginning and ending finished goods inventory are the same, and therefore units produced and sold will be the same. Thus we assume actual sales and actual production total 210,000 units.)
Question: Imagine being the production manager at Jerry’s Ice Cream, and you are evaluated based on the quantity of direct materials used in production. Would it be fair to compare the materials used to produce 210,000 units with the master budget showing the materials that should have been used to produce 200,400 units?
Answer
Probably not. The budget should be adjusted upward to reflect the actual number of units produced before a comparison is made, thus the term flexible budget. As we develop the process of cost variance analysis, we will use flexible budget information. That is, we will revise the master budget for direct materials, direct labor, and variable manufacturing overhead to reflect actual sales volume of 210,000 units. However, we must first describe the concept of standard cost.
Key Takeaway
A flexible budget is a revised master budget that represents expected costs given actual sales. Costs in the flexible budget are compared to actual costs to evaluate performance.
REVIEW PROBLEM 10.1
What is a flexible budget, and why do companies use a flexible budget to evaluate production managers?
Answer
A flexible budget is a revised master budget based on the actual activity level achieved for a period. The master budget is established before the period begins for planning purposes, and the flexible budget is established after the period ends for control and evaluation purposes. Production managers are evaluated using the flexible budget because the usage of direct materials, direct labor, and manufacturing overhead will depend on the actual number of units produced.
Definition
1. A revised master budget based on the actual activity level. | textbooks/biz/Accounting/Managerial_Accounting/10%3A_How_Do_Managers_Evaluate_Performance_Using_Cost_Variance_Analysis/10.01%3A_Introduction.txt |
Learning Objectives
• Explain how standard costs are established.
Question: Companies often use standard costs for planning and control purposes. What are standard costs?
Answer
Standard costs2 are costs that management expects to incur to provide a good or service. They serve as the “standard” by which performance will be evaluated. For example, fast-food restaurants have a standard for the length of time it should take to serve a drive-through-window customer. Phone directory operators have a standard length of time it should take to provide a phone number to a customer. Manufacturing companies have a standard quantity of direct materials to be used to produce one unit of product.
The Difference between Standard Costs and Budgeted Costs
Question: What is the difference between standard costs and budgeted costs?
Answer
The term standard cost refers to a specific cost per unit. Budgeted cost refers to costs in total given a certain level of activity. Standard variable production costs at Jerry’s Ice Cream are shown in Figure 10.1.
*Direct materials standards come from the direct materials purchases budget presented in Chapter 9.
**Direct labor standards come from the direct labor budget presented in Chapter 9.
† Variable overhead costs are applied to products based on direct labor hours. Variable overhead cost per direct labor hour is calculated by dividing total variable overhead costs of $100,200 (from the manufacturing overhead budget in Chapter 9) by 20,040 total direct labor hours (from the direct labor budget in Chapter 9), which results in a standard variable overhead rate of$5 per direct labor hour.
These standard costs can then be used to establish a flexible budget based on a given level of activity. For example, let’s use Jerry’s actual sales of 210,000 units. The variable production costs expected to produce these units are shown in the flexible budget in Figure 10.2.
The standard cost presented in Figure 10.1 shows the variable production costs expected to produce one unit. The flexible budget in Figure 10.2 uses the standard cost information to show the variable production costs expected in total given a certain level of activity (210,000 units in this example). Later in the chapter, we compare the flexible budget presented in Figure 10.3 to actual results and analyze the difference. The flexible budget graph presented in Figure 10.3 shows that direct materials have the highest variable production cost at $420,000, followed by direct labor at$273,000 and variable overhead at $105,000. Establishing Standard Cost Question: What are the components needed to establish a standard cost for direct materials, direct labor, and variable manufacturing overhead? Answer Notice in Figure 10.1 that direct materials has two separate standards necessary to calculate the standard cost: standard quantity to produce 1 unit of product (2 pounds) and standard price ($1 per pound). Direct labor has two separate standards as well: standard hours to produce 1 unit of product (0.10 hours) and standard rate ($13 per hour). Variable manufacturing overhead also has 2 separate standards: standard hours to produce 1 unit of product (0.10 direct labor hours) and standard rate ($5 per hour). Thus there are two separate standards necessary to establish each standard cost or six standards in total to establish a standard cost for direct materials, direct labor, and variable manufacturing overhead.
As we explain next, there are many approaches to establishing these six standards for direct materials, direct labor, and variable manufacturing overhead (we discuss fixed manufacturing overhead at the end of this chapter).
Direct Materials Standard Quantity and Standard Price
Question: How do organizations determine the standard quantity and standard price for direct materials?
Answer
The standard quantity for direct materials3 represents the materials required to complete one good unit of product (i.e., a product with no defects), and it includes an allowance for waste and spoilage. For Jerry’s Ice Cream, the standard quantity of materials needed for each gallon of product is given in the recipe. Jerry’s adds a certain amount to the recipe quantity for waste and spoilage. Similar to this approach, companies might find the standard quantity in the product specifications outlined by product engineers. Some companies review historical production information to determine quantities used in the past and use this information to set standard quantities for the future.
The standard price4 for direct materials represents the final delivered cost of the materials and includes items such as shipping and insurance. The standard price for materials at Jerry’s comes from the purchase contract negotiated with the company’s supplier. As an alternative to this approach, companies might use historical data or look at price trends in the marketplace.
As shown in Figure 10.1, for Jerry’s Ice Cream, the standard quantity of direct materials is 2 pounds per unit, and the standard price is $1 per pound. Thus the standard cost per unit for direct materials is$2, calculated as follows:
$\text{\ 2 standard cost per unit = 2 pounds per unit × \ 1 per pound}$
Direct Labor Standard Hours and Standard Rate
Question: How do organizations determine the standard hours and standard rate for direct labor?
Answer
The standard hours5 for direct labor represents the direct labor time required to complete one good unit of product and includes an allowance for breaks and production inefficiencies such as machine downtime. Jerry’s Ice Cream established this standard using historical information. In addition to this approach, companies might use time and motion studies performed by engineers who observe production workers and analyze the time required to perform production activities.
The standard rate for direct labor6 represents the average cost of wages and benefits for each hour of direct labor work performed. Jerry’s Ice Cream looked at past payroll records to determine this standard. Companies also review labor contracts to estimate the costs associated with direct labor.
As shown in Figure 10.1, for Jerry’s Ice Cream, the standard hours for direct labor is 0.10, and the standard rate is $13 per hour. Thus the standard cost per unit for direct labor is$1.30, calculated as follows:
$\text{\ 1.30 standard cost per unit = 0.10 direct labor hours per unit × \ 13 per hour}$
Variable Manufacturing Overhead Standard Quantity and Standard Rate
Question: How do organizations determine the standard quantity and standard rate for variable manufacturing overhead?
Answer
The standard quantity for variable manufacturing overhead7 represents the time required to complete one unit of product. This time is often measured in direct labor hours or machine hours, depending on how the company chooses to allocate overhead (recall that we covered the choice of allocation base at length in Chapter 2). Jerry’s Ice Cream uses direct labor hours to allocate variable manufacturing overhead, so we apply the same standard quantity used for direct labor.
The standard rate for variable manufacturing overhead8 represents the variable portion of the predetermined overhead rate used to allocate overhead costs to products (see Chapter 2 for further discussion of predetermined overhead rates).
As shown in Figure 10.1, for Jerry’s Ice Cream, the standard quantity of direct labor hours is 0.10, and the standard rate (predetermined overhead rate) is $5 per direct labor hour. Thus the standard cost per unit for variable manufacturing overhead is$0.50, calculated as follows:
$\text{\ 0.50 standard cost per unit = 0.10 direct labor hours per unit × \ 5 per hour}$
Ideal Standards and Attainable Standards
Question: In the process of establishing standards, managers must decide between using ideal standards or attainable standards. What is the difference between these two standards?
Answer
Ideal standards9 are set assuming production conditions are perfect. For example, ideal standards assume machines never break down, employees are never ill, and materials are never wasted. Although ideal standards may provide motivation for workers to strive for excellence, these standards can also have a negative impact because they may be impossible to achieve.
As an alternative to ideal standards, most managers use attainable standards. Attainable standards10 take into consideration the likelihood of encountering problems in production such as machine downtime, electricity outages, materials waste, and employee illnesses. Most managers feel attainable standards have a positive behavioral impact on workers because the standards are reasonable and attainable under normal production conditions. We assume the use of attainable standards throughout this chapter.
Controlling Operations through Standards
Question: How are standards used to control operations?
Answer
Companies typically use standards to analyze the difference between budgeted costs and actual costs. The process of analyzing differences between standard costs and actual costs is called variance analysis11. Managerial accountants perform variance analysis for costs including direct materials, direct labor, and manufacturing overhead.
Standard costs are also used to determine product costs. Companies using standard costing systems are able to estimate product costs without having to wait for actual product cost data, and they often record transactions using standard cost information. The appendix shows how this process works using journal entries.
Controlling Costs in the NBA
Source: Photo courtesy of Keith Allison, www.flickr.com/photos/keithallison/2310444991/.
The National Basketball Association (NBA) imposes a “salary cap” that dictates a maximum dollar amount each team can pay its players collectively in one season. The salary cap is based on a percentage of basketball-related income and was set at $57,700,000 per team for the 2009–10 season. This serves as the cost budget for player payroll. However, “salary exceptions” allow many teams to exceed the salary cap. Annual salaries for some of the highest paid players for the 2009–10 season are shown as follows: Annual salaries for some of the highest paid players for the 2009–10 season are shown as follows: • Kevin Garnett, Boston:$24,800,000
• Jason Kidd, Dallas: $21,400,000 • Kobe Bryant, Los Angeles:$21,300,000
• Shaquille O’Neal, Phoenix: $21,000,000 • Tim Duncan, San Antonio:$20,600,000
• Ray Allen, Boston: $18,400,000 Imagine being the manager of the Boston Celtics and having to pay one player almost half of your entire budget! Clearly, controlling costs in this type of business environment is a challenge, and budgeting is a crucial element in achieving financial success. Source: InsideHoops.com, “Home Page,” http://www.insidehoops.com. Key Takeaway Standard costs are costs management expects to incur to provide a good or service. Manufacturing companies often establish standard costs for direct labor, direct materials, and manufacturing overhead. Standard cost information comes from a number of sources such as historical data, product specifications outlined by product engineers, contracts with suppliers, and labor union contracts. REVIEW PROBLEM 10.2 Recall from the review problems in Chapter 9 that Carol’s Cookies produces cookies for resale at grocery stores throughout North America. We established a master budget indicating Carol expects to use 1.5 pounds of direct materials for each unit produced at a cost of$2 per pound (1 unit = 1 batch of cookies). Each unit produced will require 0.20 direct labor hours at a cost of $12 per hour. Variable manufacturing overhead is applied based on direct labor hours at a rate of$3.50 per hour. Last year’s sales were expected to total 400,000 units.
Carol just received last year’s actual results showing sales of 390,000 units.
1. Calculate the standard cost per unit for direct materials, direct labor, and variable manufacturing overhead using the format shown in Figure 10.1.
2. Prepare a flexible budget based on actual sales for direct materials, direct labor, and variable manufacturing overhead using the format shown in Figure 10.2.
Answer
Definitions
1. Costs that management expects to incur to provide a good or service and are typically stated as a cost per unit. Standard cost is based on the combination of a price (or rate) standard and quantity (or hours) standard.
2. The quantity of materials required to complete one good unit of product.
3. The final delivered cost of materials per unit of measure (e.g., measured in yards or pounds).
4. The direct labor time required to complete one good unit of product.
5. The average cost of wages and benefits for each hour of direct labor work performed.
6. The time, typically measured in direct labor hours or machine hours depending on the allocation base, required to complete one good unit of product.
7. The variable portion of the predetermined overhead rate used to allocate overhead cost to products.
8. Standards set assuming production conditions are perfect with no inefficiencies.
9. Standards that are more realistic than ideal standards by taking into consideration the likelihood of encountering problems in production such as machine downtime, materials waste, and employee illness.
10. Using standards to analyze the difference between budgeted costs and actual costs. | textbooks/biz/Accounting/Managerial_Accounting/10%3A_How_Do_Managers_Evaluate_Performance_Using_Cost_Variance_Analysis/10.03%3A_Standard_Costs.txt |
Learning Objectives
• Calculate and analyze direct materials variances.
Question: In the dialogue at the beginning of the chapter, the president of Jerry’s Ice Cream was concerned about significant cost overruns for direct materials. We cannot simply explain these costs by saying that “we paid too much for materials” or “too many materials were used in production.” Variances must be calculated to identify the exact cause of the cost overrun. What variances are used to analyze the difference between actual direct material costs and standard direct material costs?
Answer
The difference between actual costs and standard (or budgeted) costs is typically explained by two separate variances: the materials price variance and materials quantity variance. The materials price variance12 is the difference between actual costs for materials purchased and budgeted costs based on the standards. The materials quantity variance13 is the difference between the actual quantity of materials used in production and budgeted materials that should have been used in production based on the standards.
To this point, we have provided the data for Jerry’s Ice Cream necessary to calculate standard costs. However, you must also have the actual materials cost and materials quantity data to calculate the variances described previously. The actual data for the year are as follows:
Sales volume 210,000 units
Direct materials purchased 440,000 pounds
Cost of direct materials purchased $1.20 per pound Direct materials used in production 399,000 pounds Recall from Figure 10.1 that the direct materials standard price for Jerry’s is$1 per pound, and the standard quantity of direct materials is 2 pounds per unit. Figure 10.4 shows how to calculate the materials price and quantity variances given the actual results and standards information. Review this figure carefully before moving on to the next section where these calculations are explained in detail.
Note: AQP = Actual quantity of materials purchased. AP = Actual price of materials. AQU = Actual quantity of materials used in production. SP = Standard price of materials. SQ = Standard quantity of materials for actual level of activity.
*Standard quantity of 420,000 pounds = Standard of 2 pounds per unit × 210,000 actual units produced and sold.
**$420,000 standard direct materials cost matches the flexible budget presented in Note 10.18 "Review Problem 10.2". †$88,000 unfavorable materials price variance = $528,000 –$440,000. Variance is unfavorable because the actual price of $1.20 is higher than the expected (budgeted) price of$1.
‡ $(21,000) favorable materials quantity variance =$399,000 – $420,000. Variance is favorable because the actual quantity of materials used in production of 399,000 pounds is lower than the expected (budgeted) quantity of 420,000 pounds. Direct Materials Price Variance Calculation Question: The materials price variance answers the question, did we spend more or less on direct materials than expected? If the variance is unfavorable, we spent more than expected. If the variance is favorable, we spent less than expected. How is the materials price variance calculated? Answer As shown in Figure 10.4, the materials price variance is the difference between the actual quantity of materials purchased at the actual price and the actual quantity of materials purchased at the standard price: $\text{Materials price variance} = (AQ^{P} \times AP) - (AQ^{P} \times SP)$ $\begin{split} \text{Materials price variance} &= (AQ^{P} \times AP) - (AQ^{P} \times SP) \ &= (440,000 \times \ 1.20) - (440,000 \times \ 1.00) \ &= \ 88,000\; \text{unfavorable} \end{split}$ Alternative Calculation. Since we are holding the actual quantity constant and evaluating the difference between actual price and standard price, the materials price variance calculation can be simplified as follows: $\text{Materials price variance} = (AP - SP) \times AQ^{P}$ $\begin{split} \text{Materials price variance} &= (AP - SP) \times AQ^{P} \ &= (\ 1.20 - \ 1.00) \times 440,000 \ &= \ 88,000\; \text{unfavorable} \end{split}$ Note that both approaches—the direct materials price variance calculation and the alternative calculation—yield the same result. When labeling the variances calculated in this chapter, notice that all positive variances are unfavorable and all negative variances are favorable (i.e., unfavorable cost variances increase expected costs and favorable cost variances decrease expected costs). As you calculate variances, you should think through the variance to confirm whether it is favorable or unfavorable. For example, the materials price variance calculation presented previously shows the actual price paid for materials was$1.20 per pound and the standard price was $1. Clearly, this is unfavorable because the actual price was higher than the expected (budgeted) price. Direct Materials Quantity Variance Calculation Question: The materials quantity variance answers the question, did we use more or fewer direct materials in production than expected? If the variance is unfavorable, we used more than expected. If the variance is favorable, we used fewer than expected. How is the materials quantity variance calculated? Answer As shown in Figure 10.4, the materials quantity variance is the difference between the actual quantity of materials used in production at the standard price and the standard quantity of materials allowed at the standard price: $\text{Materials quantity variance} = (AQ^{U} \times SP) - (SQ \times SP)$ $\begin{split} \text{Materials quantity variance} &= (AQ^{U} \times SP) - (SQ \times SP) \ &= (399,000 \times \ 1.00) - (420,000 \times \ 1.00) \ &= (\ 21,000)\; \text{favorable} \end{split}$ The standard quantity of 420,000 pounds is the quantity of materials allowed given actual production. For Jerry’s Ice Cream, the standard quantity of materials per unit of production is 2 pounds per unit. Thus the standard quantity (SQ) of 420,000 pounds is 2 pounds per unit × 210,000 units produced and sold. Alternative Calculation. Since we are holding the standard price constant and evaluating the difference between actual quantity used and standard quantity, the materials quantity variance calculation can be simplified as follows: $\text{Materials quantity variance} = (AQ^{U} \times SQ) - (SQ \times SP)$ $\begin{split} \text{Materials quantity variance} &= (AQ^{U} \times SQ) - (SQ \times SP) \ &= (399,00 - 420,000) \times \ 1.00 \ &= (\ 21,000)\; \text{favorable} \end{split}$ Note that both approaches—the direct materials quantity variance calculation and the alternative calculation—yield the same result. The materials quantity variance calculation presented previously shows the actual quantity used in production of 399,000 pounds is lower than the expected (budgeted) quantity of 420,000 pounds. Clearly, this is favorable because the actual quantity used was lower than the expected (budgeted) quantity. Possible Causes of Direct Materials Variances Question: The managerial accountant at Jerry’s Ice Cream will likely investigate the cause of the unfavorable materials price variance of$88,000. This will lead to discussions with the purchasing department. What might have caused the $88,000 unfavorable materials price variance? Answer The left panel of Figure 10.5 contains some possible explanations for this variance. Whatever the cause of this unfavorable variance, Jerry’s Ice Cream will likely take action to improve the cost problem identified in the materials price variance analysis. This is why we use the term control phase of budgeting to describe variance analysis. Through variance analysis, companies are able to identify problem areas (material costs for Jerry’s) and consider alternatives to controlling costs in the future. Question: Jerry’s Ice Cream might also choose to investigate the$21,000 favorable materials quantity variance. Although this could be viewed as good news for the company, management may want to know why this favorable variance occurred. What might have caused the $21,000 favorable materials quantity variance? Answer The right panel of Figure 10.5 contains some possible explanations for this variance. Notice how the cause of one variance might influence another variance. For example, the unfavorable price variance at Jerry’s Ice Cream might have been a result of purchasing high-quality materials, which in turn led to less waste in production and a favorable quantity variance. This also might have a positive impact on direct labor, as less time will be spent dealing with materials waste. Note 10.26 "Business in Action 10.2" illustrates just how important it is to track direct materials variances accurately. Business in Action 10.2 The Effect of Rising Materials Costs on Auto Suppliers In the first six months of 2004, steel prices increased 76 percent, from$350 a ton to $617 a ton. For auto suppliers that use hundreds of tons of steel each year, this had the unexpected effect of increasing expenses and reducing profits. For example, a major producer of automotive wheels had to reduce its annual earnings forecast by$10,000,000 to $15,000,000 as a result of the increase in steel prices. Most auto part suppliers operate with very small margins. GR Spring and Stamping, Inc., a supplier of stampings to automotive companies, was generating pretax profit margins of about 3 percent prior to the increase in steel prices. Profit margins have been cut in half since steel prices began rising. These thin margins are the reason auto suppliers examine direct materials variances so carefully. Any unexpected increase in steel prices will likely cause significant unfavorable materials price variances, which will lead to lower profits. Auto part suppliers that rely on steel will continue to scrutinize materials price variances and materials quantity variances to control costs, particularly in a period of rising steel prices. Source: Brett Clanton, “Steel Costs Slam Auto Suppliers,” The Detroit News, June 29, 2004, http://www.detnews.com. Clarification of Favorable Versus Unfavorable Question: Why are variances labeled favorable or unfavorable? Answer The terms favorable and unfavorable relate to the impact the variance has on budgeted operating profit. A favorable variance14 has a positive impact on operating profit. An unfavorable variance15 has a negative impact on operating profit. Companies using a standard cost system ultimately credit favorable variances and debit unfavorable variances to income statement accounts. The appendix to this chapter describes this process in further detail. Key Takeaway Standard costs are used to establish the flexible budget for direct materials. The flexible budget is compared to actual costs, and the difference is shown in the form of two variances. The materials price variance focuses on the price paid for materials, and it is defined as the difference between the actual quantity of materials purchased at the actual price and the actual quantity of materials purchased at the standard price. The materials quantity variance focuses on the quantity of materials used in production. It is defined as the difference between the actual quantity of materials used in production and budgeted materials that should have been used in production based on the standards. REVIEW PROBLEM 10.3 Carol’s Cookies expected to use 1.5 pounds of direct materials to produce 1 unit (batch) of product at a cost of$2 per pound. Actual results are in for last year, which indicates 390,000 batches of cookies were sold. The company purchased 640,000 pounds of materials at $1.80 per pound and used 624,000 pounds in production. 1. Calculate the materials price and quantity variances using the format shown in Figure 10.4. 2. Use the alternative approach to calculating the materials price and quantity variances, and compare the result to the result in part 1. (Hint: the variances should match.) 3. Suggest several possible reasons for the materials price and quantity variances. Answer 1. As shown in the following, the materials price variance is$(128,000) favorable, and the materials quantity variance is $78,000 unfavorable. Note: AQP = Actual quantity of materials purchased. AP = Actual price of materials. AQU = Actual quantity of materials used in production. SP = Standard price of materials. SQ = Standard quantity of materials for actual level of activity. *Standard quantity of 585,000 pounds = Standard of 1.5 pounds per unit × 390,000 actual units produced and sold. **$1,170,000 standard direct materials cost matches the flexible budget presented in Note 10.18 "Review Problem 10.2", part 2.
† $(128,000) favorable materials price variance =$1,152,000 – $1,280,000. Variance is favorable because the actual price of$1.80 is lower than the expected (budgeted) price of $2 ‡$78,000 unfavorable materials quantity variance = $1,248,000 –$1,170,000. Variance is unfavorable because the actual quantity of materials used in production of 624,000 pounds is higher than the expected (budgeted) quantity of 585,000 pounds.
2. Alternative direct materials variance calculations: $\begin{split} \text{Materials price variance} &= (AP - SP) \times AQ^{P} \ &= (\ 1.80 - \ 2.00) \times 640,000 \ &= (\ 128,000)\; \text{favorable (same as part 1)} \end{split}$$\begin{split} \text{Materials quantity variance} &= (AQ^{U} - SQ) \times SP \ &= (624,000 - 585,000) \times \ 2.00 \ &= \ 78,000\; \text{unfavorable (same as part 1)} \end{split}$
3. Possible causes of favorable materials price variance are
1. The supplier had excess materials on hand and lowered prices to sell off inventory;
2. New suppliers entered the market, which resulted in an excess supply of materials and lower prices;
3. Carol’s Cookies’ purchasing agent is a strong negotiator and was able to negotiate lower prices than anticipated;
4. Lower-quality materials were purchased at a lower price.
Possible causes of unfavorable materials quantity variance are
1. Lower-quality materials resulted in more waste and spoilage;
2. New, inexperienced employees were hired, resulting in more waste;
3. Old equipment breaking down caused an increased amount of waste.
Definitions
1. The difference between actual costs for materials purchased and budgeted costs based on the standards.
2. The difference between the actual quantity of materials used in production and budgeted materials that should have been used in production based on the standards.
3. A variance that has a positive impact on operating profit.
4. A variance that has a negative impact on operating profit. | textbooks/biz/Accounting/Managerial_Accounting/10%3A_How_Do_Managers_Evaluate_Performance_Using_Cost_Variance_Analysis/10.04%3A_Direct_Materials_Variance_Analysis.txt |
Learning Objectives
• Calculate and analyze direct labor variances.
Question: In addition to investigating the causes of cost overruns for direct materials, the president of Jerry’s Ice Cream wants to know why there were cost overruns for direct labor. What variances are used to analyze these types of direct labor cost overruns?
Answer
Similar to direct materials variances, direct labor variance analysis involves two separate variances: the labor rate variance and labor efficiency variance. The labor rate variance16 is the difference between actual costs for direct labor and budgeted costs based on the standards. The labor efficiency variance17 is the difference between the actual number of direct labor hours worked and budgeted direct labor hours that should have been worked based on the standards.
At Jerry’s Ice Cream, the actual data for the year are as follows:
Sales volume 210,000 units
Direct labor hours worked 18,900 hours
Cost of direct labor $15 per hour Recall from Figure 10.1 that the standard rate for Jerry’s is$13 per direct labor hour and the standard direct labor hours is 0.10 per unit. Figure 10.6 shows how to calculate the labor rate and efficiency variances given the actual results and standards information. Review this figure carefully before moving on to the next section where these calculations are explained in detail.
Note: AH = Actual hours of direct labor. AR = Actual rate incurred for direct labor. SR = Standard rate for direct labor. SH = Standard hours of direct labor for actual level of activity.
*Standard hours of 21,000 = Standard of 0.10 hours per unit × 210,000 actual units produced and sold.
**$273,000 standard direct labor cost matches the flexible budget presented in Figure 10.2. †$37,800 unfavorable labor rate variance = $283,500 –$245,700. Variance is unfavorable because the actual rate of $15 is higher than the expected (budgeted) rate of$13.
‡ $(27,300) favorable labor efficiency variance =$245,700 – $273,000. Variance is favorable because the actual hours of 18,900 are lower than the expected (budgeted) hours of 21,000. Direct Labor Rate Variance Calculation Question: The direct labor rate variance answers the question, did we spend more or less on direct labor than expected? If the variance is unfavorable, we spent more than expected. If the variance is favorable, we spent less than expected. How is the labor rate variance calculated? Answer As shown in Figure 10.6, the labor rate variance is the difference between the actual hours worked at the actual rate and the actual hours worked at the standard rate: $\text{Labor rate variance = (AH × AR) − (AH × SR)}$ $\begin{split} \text{Labor rate variance} &= \text{(AH × AR) − (AH × SR)} \ &= (18,900 \times \ 15) - (18,900 \times \ 13) \ &= \ 37,800\; unfavorable \end{split}$ Alternative Calculation. Because we are holding the actual hours constant and evaluating the difference between actual rate and standard rate, the labor rate variance calculation can be simplified as follows: $\text{Labor rate variance = (AR − SR) × AH}$ $\begin{split} \text{Labor rate variance} &= \text{(AR − SR) × AH} \ &= (\ 15 - \ 13) \times 18,900 \ &= \ 37,800\; unfavorable \end{split}$ Note that both approaches—direct labor rate variance calculation and the alternative calculation—yield the same result. As with direct materials variances, all positive variances are unfavorable, and all negative variances are favorable. The labor rate variance calculation presented previously shows the actual rate paid for labor was$15 per hour and the standard rate was $13. This results in an unfavorable variance since the actual rate was higher than the expected (budgeted) rate. Direct Labor Efficiency Variance Calculation Question: The direct labor efficiency variance answers the question, did we use more or less direct labor hours in production than expected? If the variance is unfavorable, we used more than expected. If the variance is favorable, we used less than expected. How is the labor efficiency variance calculated? Answer As shown in Figure 10.6, the labor efficiency variance is the difference between the actual hours worked at the standard rate and the standard hours at the standard rate: $\text{Labor efficiency variance = (AH × SR) − (SH × SR)}$ $\begin{split} \text{Labor efficiency variance} &= \text{(AH × SR) − (SH × SR)} \ &= (18,900 \times \ 13) - (21,00 \times \ 13) \ &= (\ 27,300)\; favorable \end{split}$ The 21,000 standard hours are the hours allowed given actual production. For Jerry’s Ice Cream, the standard allows for 0.10 labor hours per unit of production. Thus the 21,000 standard hours (SH) is 0.10 hours per unit × 210,000 units produced. Alternative Calculation. Because we are holding the standard rate constant and evaluating the difference between actual hours worked and standard hours, the labor efficiency variance calculation can be simplified as follows: $\text{Labor efficiency variance = (AH − SH) × SR}$ $\begin{split} \text{Labor efficiency variance} &= \text{(AH − SH) × SR} \ &= (18,900 - 21,000) \times \ 13 \ &= (\ 27,300)\; favorable \end{split}$ Note that both approaches—the direct labor efficiency variance calculation and the alternative calculation—yield the same result. The labor efficiency variance calculation presented previously shows that 18,900 in actual hours worked is lower than the 21,000 budgeted hours. Clearly, this is favorable since the actual hours worked was lower than the expected (budgeted) hours. Possible Causes of Direct Labor Variances Question: The managerial accountant at Jerry’s Ice Cream is interested in finding the cause of the unfavorable labor rate variance of$37,800. Jerry’s Ice Cream might also choose to investigate the $27,300 favorable labor efficiency variance. Although this could be viewed as good news for the company, management may want to know why this favorable variance occurred. What might have caused the$37,800 unfavorable labor rate variance and $27,300 favorable labor efficiency variance? Answer Figure 10.7 contains some possible explanations for the labor rate variance (left panel) and labor efficiency variance (right panel). As mentioned earlier, the cause of one variance might influence another variance. For example, many of the explanations shown in Figure 10.7 might also apply to the favorable materials quantity variance. We have demonstrated how important it is for managers to be aware not only of the cost of labor, but also of the differences between budgeted labor costs and actual labor costs. This awareness helps managers make decisions that protect the financial health of their companies. Business in Action 10.3: Labor Costs in the Airline Industry United Airlines asked a bankruptcy court to allow a one-time 4 percent pay cut for pilots, flight attendants, mechanics, flight controllers, and ticket agents. The pay cut was proposed to last as long as the company remained in bankruptcy and was expected to provide savings of approximately$620,000,000. How would this unforeseen pay cut affect United’s direct labor rate variance? The direct labor rate variance would likely be favorable, perhaps totaling close to $620,000,000, depending on how much of these savings management anticipated when the budget was first established. © Thinkstock After filing for Chapter 11 bankruptcy in December 2002, United cut close to$5,000,000,000 in annual expenditures. As a result of these cost cuts, United was able to emerge from bankruptcy in 2006.
Source: Associated Press, “United May Seek End to Union Contracts,” USA Today, November 25, 2004.
Follow-Up Meeting at Jerry’s Ice Cream
Jerry (president and owner), Tom (sales manager), Lynn (production manager), and Michelle (treasurer and controller) were at the meeting described at the opening of this chapter. Michelle was asked to find out why direct labor and direct materials costs were higher than budgeted, even after factoring in the 5 percent increase in sales over the initial budget. Lynn was surprised to learn that direct labor and direct materials costs were so high, particularly since actual materials used and actual direct labor hours worked were below budget.
The group met again a week later to discuss the issue.
Jerry: Michelle, what do you have for us?
Michelle: My staff has been working hard to identify why direct materials and direct labor costs were higher than expected. First, I would like to confirm that these costs were indeed higher than anticipated.
Lynn: I still don’t see how this can be. My production crew was as efficient with their time and materials as they’ve ever been.
Michelle: You’re right, Lynn. Our variance analysis shows a favorable direct materials quantity variance, which relates directly to the amount of materials used, and a favorable direct labor efficiency variance, which relates directly to the efficiency of our production workers. Both variances are good news.
Jerry: Then why are our direct labor and direct materials costs so high?
Michelle: The answer relates directly to the price we paid for materials, and the hourly rates we paid for labor. Both were higher than expected. We expected to pay $1 per pound for direct materials, but actually paid$1.20 per pound. In addition, we expected to pay $13 an hour for direct labor when in fact we actually paid$15 an hour. This means we paid 20 percent more than expected for direct materials, which is $0.20 divided by$1, and 15 percent more than expected for direct labor, which is $2 divided by$13.
Lynn: I do recall Tony over in purchasing telling me he obtained some premium materials for our ice cream, and I know we hired some relatively experienced workers who were paid a bit more than the normal starting rate.
Tom: This might explain why our customers were thrilled about our product. The materials were high quality and the production workers really knew their stuff
Jerry: While I like the end result of a higher-quality product and increased sales, we must do a better job of controlling costs. Perhaps Tony can negotiate a better price for materials. I don’t mind paying our employees a higher wage based on their experience, but let’s make sure we get some efficiency savings in the process to help offset the higher wages. Michelle, can we continue to monitor material and labor costs?
Michelle: Yes. I’ll have my staff analyze material and labor variances monthly, and I’ll have a report ready at the end of each month for you and Lynn.
Jerry: Excellent! Lynn, let our production crew know they are doing a fine job, and continue to encourage them to find ways to improve the efficiency of production. I’ll talk with Tony about the possibility of getting a better deal on materials.
As stated earlier, variance analysis is the control phase of budgeting. Using variance analysis for direct materials and direct labor, Jerry’s Ice Cream was able to identify strong points in its operations (quantity of materials used and efficiency of direct labor workforce), and perhaps more important, Jerry’s was able to identify problem areas (price paid for materials and wages paid to employees). This information gives the management a way to monitor and control production costs. Next, we calculate and analyze variable manufacturing overhead cost variances.
Key Takeaway
Standard costs are used to establish the flexible budget for direct labor. The flexible budget is compared to actual costs, and the difference is shown in the form of two variances. The labor rate variance focuses on the wages paid for labor and is defined as the difference between actual costs for direct labor and budgeted costs based on the standards. The labor efficiency variance focuses on the quantity of labor hours used in production. It is defined as the difference between the actual number of direct labor hours worked and budgeted direct labor hours that should have been worked based on the standards.
REVIEW PROBLEM 10.4
Carol’s Cookies expected to use 0.20 direct labor hours to produce 1 unit (batch) of product at a cost of $12 per hour. Actual results are in for last year, which indicates 390,000 batches of cookies were sold. The company’s direct labor workforce worked 97,500 hours at$11 per hour.
1. Calculate the labor rate and efficiency variances using the format shown in Figure 10.6.
2. Use the alternative approach to calculating the labor rate and efficiency variances, and compare the result to the result in part 1. (Hint: the variances should match.)
3. Suggest several possible reasons for the labor rate and efficiency variances.
Answer
1. As shown in the following, the labor rate variance is $(97,500) favorable, and the labor efficiency variance is$234,000 unfavorable.
Note: AH = Actual hours of direct labor. AR = Actual rate incurred for direct labor. SR = Standard rate for direct labor. SH = Standard hours of direct labor for actual level of activity.
*Standard hours of 78,000 = Standard of 0.20 hours per unit × 390,000 actual units produced and sold.
**$936,000 standard direct labor cost matches the flexible budget presented in Note 10.18 "Review Problem 10.2", part 2. †$(97,500) favorable labor rate variance = $1,072,500 –$1,170,000. Variance is favorable because the actual rate of $11 is lower than the expected (budgeted) rate of$12.
‡ $234,000 unfavorable labor efficiency variance =$1,170,000 – \$936,000. Variance is unfavorable because the actual hours of 97,500 are higher than the expected (budgeted) hours of 78,000.
2. The following are alternative direct labor variance calculations: $\begin{split} \text{Labor rate variance} &= \text{(AR − SR) × AH} \ &= (\ 11 - \ 12) \times 97,500 \ &= (\ 97,500)\; \text{favorable (same as part 1)} \end{split}$$\begin{split} \text{Labor efficiency variance} &= \text{(AH − SH) × SR} \ &= (97,500 - 78,000) \times \ 12 \ &= \ 2324,000\; \text{unfavorable (same as part 1)} \end{split}$
3. Possible causes of favorable labor rate variance are
1. A higher mix of newly hired and unskilled workers caused hourly rates to be lower than anticipated;
2. Product demand was lower than expected, thereby reducing the amount of overtime initially anticipated;
3. A new labor contract was negotiated at lower pay rates than anticipated.
Possible causes of unfavorable labor efficiency variance are
1. A higher mix of unskilled workers than anticipated caused inefficiencies;
2. Cutbacks in training reduced the expected efficiency of direct labor workers;
3. Old equipment breaking down caused workers to waste time waiting for repairs.
Definitions
1. The difference between actual costs for direct labor and budgeted costs based on the standards.
2. The difference between the actual number of direct labor hours worked and budgeted direct labor hours that should have been worked based on the standards. | textbooks/biz/Accounting/Managerial_Accounting/10%3A_How_Do_Managers_Evaluate_Performance_Using_Cost_Variance_Analysis/10.05%3A_Direct_Labor_Variance_Analysis.txt |
Learning Objectives
• Calculate and analyze variable manufacturing overhead variances.
Question: Similar to direct materials and direct labor variances, variable manufacturing overhead variance analysis involves two separate variances. What are the two variances used to analyze the difference between actual variable overhead costs and standard variable overhead costs?
Answer
The two variances used to analyze this difference are the spending variance and efficiency variance. The variable overhead spending variance18 is the difference between actual costs for variable overhead and budgeted costs based on the standards. For a company that allocates variable manufacturing overhead to products based on direct labor hours, the variable overhead efficiency variance19 is the difference between the number of direct labor hours actually worked and what should have been worked based on the standards.
At Jerry’s Ice Cream, the actual data for the year are as follows:
Sales volume 210,000 units
Direct labor hours worked 18,900 hours
Total cost of variable overhead $100,000 Recall from Figure 10.1 that the variable overhead standard rate for Jerry’s is$5 per direct labor hour and the standard direct labor hours is 0.10 per unit. Figure 10.8 shows how to calculate the variable overhead spending and efficiency variances given the actual results and standards information. Review this figure carefully before moving on to the next section where these calculations are explained in detail.
Note: AH = Actual hours of direct labor. (This measure will depend on the allocation base that the company uses. Jerry’s uses direct labor hours to allocate variable manufacturing overhead, so AH refers to actual direct labor hours.) SR = Standard variable manufacturing overhead rate per direct labor hour. SH = Standard hours of direct labor for actual level of activity.
*Since variable overhead is not purchased per direct labor hour, the actual rate (AR) is not used in this calculation. Simply use the total cost of variable manufacturing overhead instead.
**Standard hours of 21,000 = Standard of 0.10 hours per unit × 210,000 actual units produced and sold.
† $105,000 standard variable overhead costs matches the flexible budget presented in Figure 10.2. ‡$5,500 unfavorable variable overhead spending variance = $100,000 –$94,500. Variance is unfavorable because the actual variable overhead costs are higher than the expected costs given actual hours of 18,900.
§ $(10,500) favorable variable overhead efficiency variance =$94,500 – $105,000. Variance is favorable because the actual hours of 18,900 are lower than the expected (budgeted) hours of 21,000. Variable Overhead Spending Variance Calculation Question: How is the variable overhead spending variance calculated? Answer As shown in Figure 10.8, the variable overhead spending variance is the difference between what is actually paid for variable overhead and what should have been paid according to the standards: $\text{Variable overhead spending variance = Actual costs − (AH × SR)}$ $\begin{split} \text{Variable overhead spending variance} &= \text{Actual costs − (AH × SR)} \ &= \ 100,000 - (18,900 \times \ 5) \ &= \ 5,500\; unfavorable \end{split}$ As with direct materials and direct labor variances, all positive variances are unfavorable, and all negative variances are favorable. Note that there is no alternative calculation for the variable overhead spending variance because variable overhead costs are not purchased per direct labor hour. Thus actual rate (AR) is not used for this variance. This variance is unfavorable for Jerry’s Ice Cream because actual costs of$100,000 are higher than expected costs of $94,500. Variable Overhead Efficiency Variance Calculation Question: How is the variable overhead efficiency variance calculated? Answer As shown in Figure 10.8, the variable overhead efficiency variance is the difference between the actual hours worked at the standard rate and the standard hours at the standard rate: $\text{Variable overhead efficiency variance = (AH × SR) − (SH × SR)}$ $\begin{split} \text{Variable overhead efficiency variance} &= \text{(AH × SR) − (SH × SR)} \ &= (18,900 \times \ 5) − (21,000 \times \ 5) \ &= (\ 10,500)\; favorable \end{split}$ The 21,000 standard hours are the hours allowed given actual production (= 0.10 standard hours allowed per unit × 210,000 units produced). Since actual direct labor hours worked total 18,900, the variable manufacturing overhead costs should be lower than initially anticipated at 21,000 standard hours. (This assumes variable overhead costs are truly driven by direct labor hours!) This results in a favorable variable overhead efficiency variance. Alternative Calculation. Since we are holding the standard rate constant and evaluating the difference between actual hours worked and standard hours, the variable overhead efficiency variance calculation can be simplified as follows: $\text{Variable overhead efficiency variance = (AH − SH) × SR}$ $\begin{split} \text{Variable overhead efficiency variance} &= \text{(AH − SH) × SR} \ &= (18,900 - 21,00) \times \ 5 \ &= (\ 10,500)\; favorable \end{split}$ Note that both approaches—the variable overhead efficiency variance calculation and the alternative calculation—yield the same result. The variable overhead efficiency variance calculation presented previously shows that 18,900 in actual hours worked is lower than the 21,000 budgeted hours. Again, this variance is favorable because working fewer hours than expected should result in lower variable manufacturing overhead costs. Possible Causes of Variable Manufacturing Overhead Variances Question: The managerial accountant at Jerry’s Ice Cream is interested in finding the cause of the unfavorable variable overhead spending variance of$5,500. The spending variance can result from variances in the cost of variable overhead items and the usage of these items. What might have caused the $5,500 unfavorable variable overhead spending variance? Answer The left panel of Figure 10.9 contains some possible explanations for Jerry’s unfavorable overhead spending variance. Question: Jerry’s Ice Cream might also choose to investigate the$10,500 favorable variable overhead efficiency variance. What might have caused the $10,500 favorable variable overhead efficiency variance? Answer The focus here is on the activity base used to allocate overhead. Since Jerry’s uses direct labor hours as the activity base, the possible explanations for this variance are linked to efficiencies or inefficiencies in the use of direct labor. The right panel of Figure 10.9 contains some possible explanations for this variance. Again, this analysis is appropriate assuming direct labor hours truly drives the use of variable overhead activities. That is, we assume that an increase in direct labor hours will increase variable overhead costs and that a decrease in direct labor hours will decrease variable overhead costs. Business in Action 10.4 Hiding Fraud in Overhead Accounts The controller of a small, closely held manufacturing company embezzled close to$1,000,000 over a 3-year period. With annual revenues of $30,000,000 and less than 100 employees, the company certainly felt the impact of losing$1,000,000.
The forensic accountant who investigated the fraud identified several suspicious transactions, all of which were charged to the manufacturing overhead account. To prevent this type of fraud in the future, the forensic accountant recommended that “significant manufacturing overhead variances be analyzed both within and across time periods to identify anomalies.” Apparently, the company was not closely monitoring manufacturing overhead variances when the fraud occurred.
Source: John B. MacArthur, Bobby E. Waldrup, and Gary R. Fane, “Caution: Fraud Overhead,” Strategic Finance, October 2004, 28–32.
Key Takeaway
Standard costs are used to establish the flexible budget for variable manufacturing overhead. The flexible budget is compared to actual costs, and the difference is shown in the form of two variances. The variable overhead spending variance represents the difference between actual costs for variable overhead and budgeted costs based on the standards. The variable overhead efficiency variance is the difference between the actual activity level in the allocation base (often direct labor hours or machine hours) and the budgeted activity level in the allocation base according to the standards.
REVIEW PROBLEM 10.5
Carol’s Cookies expected to use 0.20 direct labor hours to produce 1 unit (batch) of product, and the variable overhead rate is $3.50 per hour. Actual results are in for last year, which indicates 390,000 batches of cookies were produced and sold. The company’s direct labor workforce worked 97,500 hours, and variable overhead costs totaled$360,000.
1. Calculate the variable overhead spending and efficiency variances using the format shown in Figure 10.8.
2. Suggest several possible reasons for the variable overhead spending and efficiency variances.
Answer
1. As shown in the following, the variable overhead spending variance is $18,750 unfavorable, and the variable overhead efficiency variance is$68,250 unfavorable.
AH = Actual hours of direct labor. SR = Standard variable manufacturing overhead rate per direct labor hour. SH = Standard hours of direct labor for actual level of activity.
*Since variable overhead is not purchased per direct labor hour, the actual rate (AR) is not used in this calculation. Simply use the total cost of variable manufacturing overhead instead.
**Standard hours of 78,000 = Standard of 0.20 hours per unit × 390,000 actual units produced and sold.
† $273,000 standard variable overhead costs match the flexible budget presented in Note 10.18 "Review Problem 10.2", part 2. ‡$18,750 unfavorable variable overhead spending variance = $360,000 –$341,250. Variance is unfavorable because the actual variable overhead costs are higher than the expected costs given actual hours of 97,500.
§ $68,250 unfavorable variable overhead efficiency variance =$341,250 – \$273,000. Variance is unfavorable because the actual hours of 97,500 are higher than the expected (budgeted) hours of 78,000.
2. Possible causes of unfavorable variable overhead spending variance are
1. A higher mix of skilled indirect labor workers caused hourly rates to be higher than anticipated;
2. Utility costs to run the machines were higher than anticipated due to a nationwide increase in energy costs;
3. A shortage in available indirect materials caused costs to increase unexpectedly.
Possible causes of unfavorable variable overhead efficiency variance are
1. A higher mix of unskilled workers than anticipated caused inefficiencies;
2. Cutbacks in training reduced the expected efficiency of direct labor workers;
3. Old equipment breaking down caused workers to waste time waiting for repairs.
Definitions
1. The difference between actual costs for variable overhead and budgeted costs based on the standards.
2. The difference between the actual activity level in the allocation base (often direct labor hours or machine hours) and the budgeted activity level in the allocation base according to the standards. | textbooks/biz/Accounting/Managerial_Accounting/10%3A_How_Do_Managers_Evaluate_Performance_Using_Cost_Variance_Analysis/10.06%3A_Variable_Manufacturing_Overhead_Variance_Analysis.txt |
Learning Objectives
• Determine which variances to investigate.
Question: Companies rarely investigate all variances because there is a cost associated with identifying the causes of variances. This cost involves employees who spend time talking with personnel from areas including purchasing and production to determine why variances occurred and how to control costs in the future. What can managers do to reduce the cost of investigating variances?
Answer
Managers typically establish criteria to determine which variances to focus on rather than simply investigating all variances. This is called management by exception. Management by exception20 describes managers who focus solely on variances that are significant.
Question: Figure 10.14 summarizes the cost variances calculated for Jerry’s Ice Cream. If you were in charge of investigating variances at Jerry’s Ice Cream, how would you determine which variances to focus on and which to ignore?
*From Figure 10.4.
**From Figure 10.6.
† From Figure 10.8.
Answer
Some managers might review all unfavorable variances. However, the variable overhead spending variance of \$5,500 is not very significant relative to the other variances and may not be worth investigating. Also, by focusing solely on unfavorable variances, managers might overlook problems that may result from favorable variances.
Another approach might be to investigate all favorable and unfavorable variances above a certain minimum level, calculated as a percent of the flexible budget amount. For example, management could establish a policy to investigate all variances at or above 10 percent of the flexible budget amount for each cost. At Jerry’s Ice Cream, this would mean investigating all variances at or above \$42,000 for direct materials (= 10 percent × \$420,000), \$27,300 for direct labor (= 10 percent × \$273,000), and \$10,500 for variable overhead (= 10 percent × \$105,000). Based on this policy, the following variances would be investigated:
• Unfavorable direct materials price variance of \$88,000 (≥ \$42,000 minimum)
• Unfavorable direct labor rate variance of \$37,800 (≥ \$27,300 minimum)
• Favorable direct labor efficiency variance of \$(27,300) (≥ \$27,300 minimum)
• Favorable variable overhead efficiency variance of \$(10,500) (≥ \$10,500 minimum)
Many companies calculate and investigate variances weekly, monthly, or quarterly and focus on trends. In this case, they may only investigate variances that are unfavorable and increasing over time.
Whatever the approach, managers understand that investigating variances requires resources. Thus managers must establish an efficient and cost-effective approach to analyzing variances by weighing the benefits derived from investigating variances against the costs incurred to perform the analysis.
© Thinkstock
Using Cost Variances to Detect Fraud
Variance analysis is not only an effective way to control costs; some companies, including The Dow Chemical Company, have found that investigating variances can also help them detect fraudulent activities. Dow, which provides chemical, plastic, and agricultural products to customers in 180 countries, has annual sales of \$33,000,000,000 and approximately 46,000 employees. In 1998, the company created a department called Fraud Investigative Services (FIS) whose mission is to “deter and prevent incidents of fraud and financial abuse through detection, investigation, and education.”
The most common types of fraud allegations reviewed by Dow’s FIS include expense report fraud, kickback schemes, and embezzlement. Paul Zikmund, the director of FIS, states that “unexplainable cost variances between budget and actual amounts” are among the warning signs he looks for in identifying fraud.
For example, suppose the actual cost for direct materials is significantly higher than the budgeted cost. The cost accountant at Dow would begin investigating the cause of the variance by talking with the company’s purchasing agent. The purchasing agent might be unable (or unwilling) to explain why actual costs are Chapter 10 How Do Managers Evaluate Performance Using Cost Variance Analysis? 10.6 Determining Which Cost Variances to Investigate 789 so high. Further investigation might indicate that the purchasing agent was intentionally overbilling the vendor and receiving a kickback from the vendor.
Zikmund states that for every \$1 that Dow spends on investigating fraud, the company recovers nearly \$4. He also notes that Dow’s loss per employee is far below the industry average of \$9 per employee per day. For a company with 46,000 employees, every dollar in savings per employee adds up to a significant amount.
Sources: Paul Zikmund, “Ferreting out Fraud,” Strategic Finance, April 2003, 1–4; Dow Chemical Company, “Home Page,” http://www.dow.com.
Key Takeaway
Companies often establish criteria to use in determining which variances to investigate. Some might investigate all variances above a certain dollar amount. Others might investigate variances that are above a certain percentage of the flexible budget. Or management might combine the two and investigate variances above a certain dollar amount and above a certain percentage of the flexible budget.
REVIEW PROBLEM 10.6
Use the solutions to Note 10.30 "Review Problem 10.3", Note 10.40 "Review Problem 10.4", and Note 10.49 "Review Problem 10.5" to complete the following:
1. Calculate the total variable production cost variance for Carol’s Cookies using the format shown in Figure 10.10.
2. Assume management investigates all variances at or above 15 percent of the flexible budget amount (e.g., all direct materials variances at or above 15 percent of the direct materials flexible budget are investigated). Identify which of the six variances calculated for direct materials, direct labor, and variable manufacturing overhead management should investigate.
Answer
1. See the following figure.
*From Note 10.30 "Review Problem 10.3".
**From Note 10.40 "Review Problem 10.4".
† From Note 10.49 "Review Problem 10.5".
2. Based on this policy, the following variances would be investigated:
1. Direct Materials. Neither variance would be investigated as both variances fall below \$175,500 (= 15 percent of \$1,170,000 standard cost).
2. Direct Labor. The unfavorable direct labor efficiency variance of \$234,000 would be investigated because it falls above \$140,400 (= 15 percent of \$936,000 standard cost).
3. Variable Overhead. The unfavorable variable overhead efficiency variance of \$68,250 would be investigated because it falls above \$40,950 (= 15 percent of \$273,000 standard cost).
Definitions
1. A term used to describe managers who focus solely on variances showing actual results that are significantly different than expected results. | textbooks/biz/Accounting/Managerial_Accounting/10%3A_How_Do_Managers_Evaluate_Performance_Using_Cost_Variance_Analysis/10.07%3A_Determining_Which_Cost_Variances_to_Investigate.txt |
Learning Objectives
• Explain how to use cost variance analysis with activity-based costing.
Question: As discussed in Chapter 3, activity-based costing focuses on identifying activities required to make a product, forming cost pools for each activity, and allocating overhead costs to products based on the products’ use of each activity. Rather than establishing one standard variable overhead rate and standard quantity based on one cost driver, activity-based costing establishes several standard variable overhead rates and quantities, each having its own cost driver. How would variance analysis be implemented for a company that uses activity-based costing?
Answer
Regardless of whether a company uses the traditional costing approach or an activity-based costing approach, the process of performing variance analysis is the same. Similar to the traditional costing approach, the variable overhead spending variance for activity-based costing is calculated for each activity as follows:
$\text{Variable overhead spending variance}\; = \text{Actual cost} - (\text{AQ} \times \times {SR})$
The variable overhead efficiency variance is calculated for each activity using activitybased costing as follows:
$\text{Variable overhead efficiency variance}\; = (\text{AQ} \times \times {SR}) - (\text{SQ} \times \text{SR})$
Instead of using AH and SH to represent actual hours and standard hours as we did earlier in the chapter, we use AQ and SQ to represent actual quantity and standard quantity for various activities used in activity-based costing.
Let’s work through an example of variance analysis using activity-based costing. Suppose Jerry’s Ice Cream identified three significant activities and established three standard rates to allocate variable manufacturing overhead instead of one rate based on direct labor hours. Information for the three activities for last year is:
Activity Standard Rate Standard Quantity per Unit Produced Actual Costs Actual Quantity
Purchase orders $25 per purchase order 0.01 orders per unit$42,000 1,600 purchase orders
Product testing $0.20 per test minute 1 minute per unit$31,000 180,000 test minutes
Energy $0.05 per minute of machine time 2 minutes per unit$27,000 575,000 minutes of machine time
Recall that Jerry’s produced 210,000 units for the year. Figure 10.11 shows the resulting variable overhead variance analysis. Notice that the format for Figure 10.11 is the same as for Figure 10.8. The variance calculations are also the same except variances are calculated for three activities rather than one. Note that total actual variable overhead costs remain at $100,000, but they are simply broken out into 3 activities ($100,000 = $42,000 for purchase orders +$31,000 for product testing + $27,000 for energy costs). Also, the flexible budget presented in Figure 10.11, totaling$115,500, differs from the flexible budget presented earlier since Jerry’s is using a different cost system in this example, which often results in different budgeted amounts ($115,500 =$52,500 purchase orders + $42,000 product testing +$21,000 energy).
Note: AQ = Actual quantity of activity. SR = Standard variable manufacturing overhead rate per unit of activity. SQ = Standard quantity of activity given actual production of 210,000 units.
*Standard quantity of 2,100 purchase orders = Standard of 0.01 purchase orders per unit × 210,000 actual units produced.
**$2,000 unfavorable variable overhead spending variance =$42,000 −$40,000. Variance is unfavorable because the actual variable overhead cost is higher than the expected cost given actual quantity of 1,600 purchase orders. †$(12,500) favorable variable overhead efficiency variance = $40,000 –$52,500. Variance is favorable because the 1,600 actual purchase orders are lower than the 2,100 expected (budgeted) purchase orders.
This type of costing system and resulting variance analysis provides management with further information regarding variable overhead costs and variances. As discussed earlier, management often establishes criteria to decide which variances to investigate. Assume that management of Jerry’s Ice Cream chooses to investigate the $7,750 unfavorable efficiency variance associated with energy. The management would like to know why 575,000 minutes of actual machine time were used instead of the expected 420,000 minutes. Perhaps the machines were operating poorly due to cutbacks in maintenance, or maybe new employees were not as efficient using the machines. Whatever the cause, Jerry’s has identified the issue by integrating its activity-based costing system with the cost variance analysis concepts discussed in this chapter. Key Takeaway Using cost variance analysis with activity-based costing is much like using cost variance analysis with traditional costing. Both utilize a spending variance and an efficiency variance. However, activity-based costing requires calculating a spending and efficiency variance for each activity rather than only one activity base typically used in traditional costing. REVIEW PROBLEM 10.7 Assume Carol’s Cookies uses activity-based costing to allocate variable manufacturing overhead costs instead of one rate based on direct labor hours. Carol identified three activities with the following information for last year. Activity Standard Rate Standard Quantity per Unit Produced Actual Costs Actual Quantity Indirect materials$0.60 per pound 0.5 pounds per unit $130,000 220,000 pounds Product testing$0.10 per test minute 2 minutes per unit $60,000 750,000 test minutes Energy$0.12 per minute of machine time 4 minutes per unit $170,000 1,400,000 minutes of machine time Recall that Carol’s Cookies produced and sold 390,000 units for the year. Prepare a variance analysis for Carol’s Cookies using the format shown in Figure 10.11. Answer Note: AQ = Actual quantity of activity. SR = Standard variable manufacturing overhead rate per unit of activity. SQ = Standard quantity of activity given actual production of 210,000 units. *Standard quantity of 195,000 pounds = Standard of 0.5 pounds per unit × 390,000 actual units produced. **$(2,000) favorable variable overhead spending variance = $130,000 –$132,000. Variance is favorable because the actual variable overhead cost is lower than the expected cost given actual quantity of 220,000 pounds.
† $15,000 unfavorable variable overhead efficiency variance =$132,000 – \$117,000. Variance is unfavorable because the 220,000 actual pounds is higher than the 195,000 expected (budgeted) pounds. | textbooks/biz/Accounting/Managerial_Accounting/10%3A_How_Do_Managers_Evaluate_Performance_Using_Cost_Variance_Analysis/10.08%3A_Using_Variance_Analysis_with_Activity-Based_Costing.txt |
Learning Objectives
• Calculate and analyze fixed manufacturing overhead variances.
Question: Many organizations also analyze fixed manufacturing overhead variances. Recall from earlier chapters that manufacturing companies are required to assign fixed manufacturing overhead costs to products for financial reporting purposes (this is called absorption costing). It is common for companies such as Jerry’s Ice Cream to apply fixed manufacturing overhead costs to products based on direct labor hours, machine hours, or some other activity. Companies using a standard costing system apply fixed overhead based on a standard dollar amount per unit produced (this calculation is shown in the footnote to Figure 10.12). Assume Jerry’s uses direct labor hours to assign fixed overhead costs to products shown in Figure 10.12. How is this information used to perform fixed overhead cost variance analysis?
Answer
It is important to start by noting that fixed overhead in the master budget is the same as fixed overhead in the flexible budget because, by definition, fixed costs do not change with changes in units produced. Thus budgeted fixed overhead costs of $140,280 shown in Figure 10.12 will remain the same even though Jerry’s actually produced 210,000 units instead of the master budget expectation of 200,400 units. Fixed manufacturing overhead variance analysis involves two separate variances: the spending variance and the production volume variance. We show both variances in Figure 10.13, and provide further detail following the figure. *From Chapter 9, the direct labor budget is 20,040 budgeted direct labor hours = 200,400 units budgeted to be produced × 0.10 direct labor hours per unit. **Standard hours of 21,000 = 210,000 actual units produced and sold × Standard of 0.10 hours per unit. †$140,280 is the original budget presented in the manufacturing overhead budget shown in Chapter 9. The flexible budget amount for fixed overhead does not change with changes in production, so this amount remains the same regardless of actual production.
‡ $(4,280) favorable fixed overhead spending variance =$136,000 – $140,280. Variance is favorable because the actual fixed overhead costs are lower than the budgeted costs. §$(6,720) favorable fixed overhead volume variance = $140,280 –$147,000. Variance is favorable because the volume of goods produced and sold was higher than expected.
Fixed Overhead Spending Variance Calculation
Question: How is the fixed overhead spending variance calculated?
Answer
The fixed overhead spending variance21 is the difference between actual and budgeted fixed overhead costs. As shown in Figure 10.13, Jerry’s Ice Cream incurred $136,000 in fixed overhead costs for the year. Budgeted fixed overhead costs totaled$140,280. Thus the spending variance is calculated as follows:
$\text{Fixed overhead spending variance}\; = \text{Actual costs} - \text{Budgeted costs}$
$\begin{split} \text{Fixed overhead spending variance} &= \text{Actual costs} - \text{Budgeted costs} \ &= \136,000 - 140,280 \ &= (\ 4,280)\quad \text{favorable} \end{split}$
Because fixed overhead costs are not typically driven by activity, Jerry’s cannot attribute any part of this variance to the efficient (or inefficient) use of labor. In fact, there is no efficiency variance for fixed overhead. Instead, Jerry’s must review the detail of actual and budgeted costs to determine why the favorable variance occurred. For example, factory rent, supervisor salaries, or factory insurance may have been lower than anticipated. Further investigation of detailed costs is necessary to determine the exact cause of the fixed overhead spending variance.
Fixed Overhead Production Volume Variance Calculation
Question: How is the fixed overhead production volume variance calculated?
Answer
Before discussing the production volume variance, a word of caution: do not equate the fixed overhead production volume variance with the variable overhead efficiency variance. There is no efficiency variance for fixed manufacturing overhead because, by definition, fixed costs do not change with changes in the activity base. The fixed overhead volume variance is solely a result of the difference in budgeted production and actual production. The fixed overhead production volume variance22 is the difference between the budgeted and applied fixed overhead costs. As shown in Figure 10.13, Jerry’s Ice Cream budgeted $140,280 in fixed overhead costs for the year. Fixed overhead costs applied totaled$147,000. Thus the production volume variance is calculated as follows:
$\text{Fixed overhead production volume variance}\; = \text{Budgeted costs} - \text{Applied costs}$
$\begin{split} \text{Fixed overhead production volume variance}\; &= \text{Budgeted costs} - \text{Applied costs} \ &= \ 140,280 - \ 147,000 \ &= (\ 6,720)\quad \text{favorable} \end{split}$
The fixed overhead production volume variance is a direct result of the difference in volume (units) between budgeted production and actual production. All other variables are held constant including standard direct labor hours per unit (0.10) and standard rate per direct labor hour ($7). Thus an alternative approach to this calculation can be used assuming the standard fixed overhead cost per unit is$0.70 (= 0.10 direct labor hours per unit × $7 per direct labor hour): $\text{Fixed overhead production volume variance}\; = \text{Standard fixed overhead cost per unit} \times \text{Budgeted units produced}$ $\begin{split} \text{Fixed overhead production volume variance}\; &= \text{Standard fixed overhead cost per unit} \times \text{Budgeted units produced} \ (\ 6,720)\quad \text{favorable} &= \ 0.70 \times 200,400\; \text{budgeted units} \end{split}$ The fixed overhead production volume variance is favorable because the company produced and sold more units than anticipated. Comparison of Fixed and Variable Overhead Variances Question: What are the similarities and differences between the fixed and variable overhead variances? Answer Figure 10.14 summarizes the similarities and differences between variable and fixed overhead variances. Notice that the efficiency variance is not applicable to the fixed overhead variance analysis. *Information is from Figure 10.8. **For variable manufacturing overhead, the flexible budget is the same as variable overhead applied to production. † Information is from Figure 10.13 Note Two variances are calculated and analyzed when evaluating fixed manufacturing overhead. The fixed overhead spending variance is the difference between actual and budgeted fixed overhead costs. The fixed overhead production volume variance is the difference between budgeted and applied fixed overhead costs. There is no efficiency variance for fixed manufacturing overhead. REVIEW PROBLEM 10.8 This review problem is based on the budget information presented in Chapter 9 review problems and variance analysis information presented in Chapter 10 review problems. The following information is for Carol’s Cookies: Answer *Standard hours of 78,000 = 390,000 actual units produced and sold x standard of 0.20 hours per unit. **$5,340 unfavorable fixed overhead spending variance = $270,000 –$264,660. Variance is unfavorable because the actual fixed overhead costs are higher than the budgeted costs.
† $7,260 unfavorable fixed overhead volume variance =$264,660 – \$257,400. Variance is unfavorable because the volume of goods produced and sold was lower than expected.
Definitions
1. The difference between actual and budgeted fixed overhead costs.
2. The difference between the budgeted and applied fixed overhead costs. | textbooks/biz/Accounting/Managerial_Accounting/10%3A_How_Do_Managers_Evaluate_Performance_Using_Cost_Variance_Analysis/10.09%3A_Fixed_Manufacturing_Overhead_Variance_Analysis.txt |
Learning Objectives
• Explain how to record standard costs and variances using journal entries.
This chapter has focused on performing variance analysis to evaluate and control operations. Standard costing systems assist in this process and often involve recording transactions using standard cost information. When accountants use a standard costing system to record transactions, companies are able to quickly identify variances. In addition, inventory and related cost of goods sold are valued using standard cost information, which simplifies the bookkeeping process.
Recording Direct Materials Transactions
Question: In Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream", we calculated two variances for direct materials at Jerry’s Ice Cream: materials price variance and materials quantity variance. How are these variances recorded for transactions related to direct materials?
Answer
Two journal entries are needed to record direct materials transactions that include these variances. An example of each is shown next. (Typically, many more journal entries would be made throughout the year for direct materials. For the purposes of this example, we will make one journal entry for each variance to summarize the activity for the year.)
• Materials Price Variance
The entry to record the purchase of direct materials and related price variance shown in Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream" is
Notice that the raw materials inventory account contains the actual quantity of direct materials purchased at the standard price. Accounts payable reflects the actual cost, and the materials price variance account shows the unfavorable variance. Unfavorable variances are recorded as debits and favorable variances are recorded as credits. Variance accounts are temporary accounts that are closed out at the end of the financial reporting period. We show the process of closing out variance accounts at the end of this appendix.
• Materials Quantity Variance
The entry to record the use of direct materials in production and related quantity variance shown in Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream" is
Work-in-process inventory reflects the standard quantity of direct materials allowed at the standard price. The reduction in raw materials inventory reflects the actual quantity used at the standard price, and the materials quantity variance account shows the favorable variance.
• Recording Direct Labor Transactions
Question: In Figure 10.6 "Direct Labor Variance Analysis for Jerry’s Ice Cream", we calculated two variances for direct labor at Jerry’s Ice Cream: labor rate variance and labor efficiency variance. How are these variances recorded for transactions related to direct labor?
Answer
Because labor is not inventoried for later use like materials, only one journal entry is needed to record direct labor transactions that include these variances. (Again, many more journal entries would typically be made throughout the year for direct labor. For the purposes of this example, we will make one journal entry to summarize the activity for the year.)
• Labor Rate and Efficiency Variances
The entry to record the cost of direct labor and related variances shown in Figure 10.6 "Direct Labor Variance Analysis for Jerry’s Ice Cream" is
Work-in-process inventory reflects the standard hours of direct labor allowed at the standard rate. The labor rate and efficiency variances represent the difference between work-in-process inventory (at the standard cost) and actual costs recorded in wages payable.
• Recording Manufacturing Overhead Transactions
Question: As discussed in Chapter 2 "How Is Job Costing Used to Track Production Costs?", the manufacturing overhead account is debited for all actual overhead expenditures and credited when overhead is applied to products. At the end of the period, the balance in manufacturing overhead, representing overapplied or underapplied overhead, is closed out to cost of goods sold. This overapplied or underapplied balance can be explained by combining the four overhead variances summarized in this chapter in Figure 10.14 "Comparison of Variable and Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". How are these variances recorded for transactions related to manufacturing overhead?
Answer
• Based on the information at the left side of Figure 10.14 "Comparison of Variable and Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream", the entry to record actual overhead expenditures is
The credit goes to several different accounts depending on the nature of the expenditure. For example, if the expenditure is for indirect materials, the credit goes to accounts payable. If the expenditure is for indirect labor, the credit goes to wages payable.
The next entry reflects overhead applied to products. This information comes from the right side of Figure 10.14 "Comparison of Variable and Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream".
At this point, manufacturing overhead has a \$16,000 credit balance, which represents overapplied overhead (\$16,000 = \$252,000 applied overhead – \$236,000 actual overhead). The following summary of fixed and variable overhead variances shown in Figure 10.14 "Comparison of Variable and Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream" explains the overapplied amount of \$16,000:
• Recording Finished Goods Transactions
Question: Review all the debits to work-in-process inventory throughout this appendix and you will see the following costs (all recorded at standard cost):
How are these costs transferred from work-in-process inventory to finished good inventory when the goods are completed?
Answer
When the 210,000 units are completed, the following entry is made to transfer the costs out of work-in-process inventory and into finished goods inventory.
Note that the standard cost per unit was established at \$4.50, which includes variable manufacturing costs of \$3.80 (see Figure 10.1 "Standard Costs at Jerry’s Ice Cream") and fixed manufacturing costs of \$0.70 (see footnote to Figure 10.12 "Fixed Manufacturing Overhead Information for Jerry’s Ice Cream"). Total production of 210,000 units × Standard cost of \$4.50 per unit equals \$945,000; the same amount you see in the entry presented previously.
Recording Cost of Goods Sold Transactions
Question: How do we record the costs associated with products that are sold?
Answer
When finished product is sold, the following entry is made:
Note that the entry shown previously uses standard costs, which means cost of goods sold is stated at standard cost until the next entry is made.
Closing Manufacturing Overhead and Variance Accounts
Question: At the end of the period, Jerry’s Ice Cream has balances remaining in manufacturing overhead along with all the variance accounts. These accounts must be closed out at the end of the period. How is this accomplished?
Answer
These accounts are closed out to cost of goods sold, after which point cost of goods sold will reflect actual manufacturing costs for the products sold during the period. The following entry is made to accomplish this goal:
*\$61,500 = \$88,000 + \$37,800 – \$21,000 – \$27,300 – \$16,000.
Key Takeaway
In a standard costing system, all inventory accounts reflect standard cost information. The difference between standard and actual data are recorded in the variance accounts and the manufacturing overhead account, which are ultimately closed out to cost of goods sold at the end of the period.
REVIEW PROBLEM 10.9
1. Using the solution to Note 10.30 "Review Problem 10.3", prepare a journal entry to record the purchase of raw materials.
2. Using the solution to Note 10.30 "Review Problem 10.3", prepare a journal entry to record the use of raw materials.
3. Using the solution to Note 10.40 "Review Problem 10.4", prepare a journal entry to record direct labor costs.
4. Using the solutions to Note 10.49 "Review Problem 10.5" and Note 10.67 "Review Problem 10.8", prepare a journal entry to record actual variable and fixed manufacturing overhead expenditures.
5. Using the solutions to Note 10.49 "Review Problem 10.5" and Note 10.67 "Review Problem 10.8", prepare a journal entry to record variable and fixed manufacturing overhead applied to products.
6. Based on the entries shown in items 1 through 5, prepare a journal entry to transfer all work-in-process inventory costs to finished goods inventory.
7. Assume all finished goods are sold during the period. Prepare a journal entry to transfer all finished goods inventory costs to cost of goods sold.
8. Based on the entries shown in items 1 through 7, close manufacturing overhead and all variance accounts to cost of goods sold.
Answer
1. The following is a journal entry to record purchase of raw materials:
2. The following is a journal entry to record usage of raw materials:
3. The following is a journal entry to record direct labor costs:
4. The following is a journal entry to record actual overhead expenditures:
5. The following is a journal entry to record overhead applied to production:
6. The product cost data recorded in work-in-process inventory for the period is as follows:
Thus the journal entry to transfer these production costs from work in process to finished goods is:
7. The following is a journal entry to record transfer of finished goods to cost of goods sold:
8. The following is a journal entry to close out manufacturing overhead and all variance accounts:
*\$186,100 = \$78,000 + \$234,000 + \$99,600 – \$128,000 – \$97,500.
**\$99,600 underapplied overhead = \$630,000 actual overhead costs – \$530,400 applied overhead. Because this represents a debit balance in manufacturing overhead, the account must be credited to close it. To further prove this is accurate, the sum of all overhead variances must equal \$99,600 unfavorable as shown in the following:
Variable overhead spending variance \$18,750 unfavorable (from Note 10.49 "Review Problem 10.5")
Variable overhead efficiency variance \$68,250 unfavorable (from Note 10.49 "Review Problem 10.5")
Fixed overhead spending variance \$5,340 unfavorable (from Note 10.67 "Review Problem 10.8")
Fixed overhead production volume variance \$7,260 unfavorable (from Note 10.67 "Review Problem 10.8")
Total manufacturing overhead variance \$99,600 unfavorable | textbooks/biz/Accounting/Managerial_Accounting/10%3A_How_Do_Managers_Evaluate_Performance_Using_Cost_Variance_Analysis/10.10%3A_Appendix-_Recording_Standard_Costs_and_Variances.txt |
1. Explain how a flexible budget differs from a master budget.
2. Assume you are the production manager for a manufacturing company that anticipated selling 40,000 units of product for the master budget and actually sold 50,000 units. Why would you prefer to be evaluated using a flexible budget for direct labor rather than the master budget?
3. What is a standard cost, and how does it differ from a budgeted cost?
4. How are standards established for direct materials, direct labor, and variable manufacturing overhead?
5. Explain what management is trying to evaluate in reviewing the materials price variance and materials quantity variance. Be sure to include the formula for each variance in your explanation.
6. Explain what management is trying to evaluate in reviewing the labor rate variance and labor efficiency variance. Be sure to include the formula for each variance in your explanation.
7. Explain how an unfavorable labor rate variance might cause a favorable labor efficiency variance and favorable materials quantity variance.
8. The production manager just received a report indicating an unfavorable labor rate variance. Further investigation reveals that the sales department accepted a large rush order. Who should be held responsible for the unfavorable variance? Explain.
9. Refer to Note 10.38 "Business in Action 10.3" Why is direct labor variance analysis particularly important for United Airlines?
10. Are favorable variances always a result of good management decisions? Explain.
11. Do most companies investigate all variances? Explain.
12. How is variable overhead variance analysis similar for companies using activity-based costing and companies using traditional costing?
13. What causes the fixed overhead production volume variance?
14. (Appendix). Why are direct materials and direct labor variance accounts needed in a standard costing system? What happens to these accounts at the end of the period?
Brief Exercises
1. Analyzing Costs at Jerry’s Ice Cream. Refer to the dialogue at Jerry’s Ice Cream presented at the beginning of the chapter. What happened with direct labor and direct materials costs at Jerry’s Ice Cream? What did Jerry, the owner, ask Michelle to do?
2. Direct Materials Standard Cost and Flexible Budget. Manhattan Company produces high-quality chairs. Each chair requires a standard quantity of 10 board feet of wood at \$5 per board foot. Production for July totaled 3,000 units. Calculate (a) standard cost per unit for direct materials and (b) flexible budget amount for direct materials for the month of July.
3. Direct Labor Standard Cost and Flexible Budget. Manhattan Company produces high-quality chairs. Each chair requires a standard quantity of 8 direct labor hours at \$15 per hour. Production for July totaled 3,000 units. Calculate (a) standard cost per unit for direct labor and (b) flexible budget amount for direct labor for the month of July.
4. Variable Overhead Standard Cost and Flexible Budget. Manhattan Company produces high-quality chairs. Variable manufacturing overhead is applied at a standard rate of \$10 per machine hour. Each chair requires a standard quantity of three machine hours. Production for July totaled 3,000 units. Calculate (a) standard cost per unit for variable overhead and (b) flexible budget amount for variable overhead for the month of July.
5. Materials Price Variance. Sweets Company produces boxes of chocolate. The company expects to pay \$5 a pound for chocolate. Sweets purchased 4,000 pounds of chocolate during the month of April for \$4.80 per pound. Calculate the materials price variance for the month of April.
6. Materials Quantity Variance. Sweets Company produces boxes of chocolate. A standard of 2 pounds of material is expected to be used for each box produced, at a cost of \$5 per pound. Sweets produced 1,000 boxes of chocolate during the month of April and used 2,200 pounds of chocolate. Calculate the materials quantity variance for the month of April.
7. Labor Rate Variance. Tech Company produces computer servers. The company’s standards show an expected direct labor rate of \$20 per hour. Tech’s direct labor workforce worked 3,200 hours to produce 300 units during the month of August and was paid \$22 per direct labor hour. Calculate the labor rate variance for the month of August.
8. Labor Efficiency Variance. Tech Company produces computer servers. The company’s standards show that each server will require 10 hours of direct labor at \$20 per hour. Tech produced 300 units during the month of August and direct labor hours totaled 3,200 for the month. Calculate the labor efficiency variance for the month of August.
9. Variable Overhead Spending Variance. Tech Company produces computer servers. Variable overhead is allocated to each server based on a standard of \$100 per machine hour. A total of 850 machine hours were used during the month of August and variable overhead costs totaled \$96,000. Calculate the variable overhead spending variance for the month of August.
10. Variable Overhead Efficiency Variance. Tech Company produces computer servers. Variable overhead is allocated to each server based on a standard of \$100 per machine hour and 3 machine hours per server. A total of 850 machine hours were used during the month of August to produce 300 servers. Calculate the variable overhead efficiency variance for the month of August.
11. Investigating Variances. Fiber Optic, Inc., investigates all variances above 10 percent of the flexible budget. The flexible budget for direct materials is \$50,000. The direct materials price variance is \$4,000 unfavorable and the direct materials quantity variance is \$(6,000) favorable. Which variances should be investigated according to company policy? Show calculations to support your answer.
12. Spending Variance Using Activity-Based Costing. Albany, Inc., uses activity-based costing to allocate variable manufacturing overhead costs to products. One of the activities used to allocate these costs is product testing. The standard rate is \$15 per test hour. The cost for this activity during June totaled \$2,000, and actual test time during June totaled 120 hours. Calculate the spending variance for this activity for the month of June, and clearly label whether the variance is favorable or unfavorable.
13. Fixed Overhead Spending Variance. Sampson Company applies fixed manufacturing overhead costs to products based on direct labor hours. Budgeted direct labor hours for the month of January totaled 30,000 hours, with a standard cost per direct labor hour of \$12. Actual fixed overhead costs totaled \$350,000 for January. Calculate the fixed overhead spending variance for January, and clearly label whether the variance is favorable or unfavorable.
14. (Appendix) Journalizing the Purchase of Raw Materials. Mill Company purchased 40,000 pounds of raw materials on account for \$3.40 per pound. The standard price is \$3 per pound. Prepare a journal entry to record this transaction assuming the company uses a standard costing system.
Exercises: Set A
1. Standard Cost and Flexible Budget. Hal’s Heating produces furnaces for commercial buildings. The company’s master budget shows the following standards information.
Expected production for January 300 furnaces
Direct materials 3 heating elements at \$40 per element
Direct labor 35 hours per furnace at \$18 per hour
Variable manufacturing overhead 35 direct labor hours per furnace at \$15 per hour
Required:
1. Calculate the standard cost per unit for direct materials, direct labor, and variable manufacturing overhead using the format shown in Figure 10.1.
2. Assume Hal’s Heating produced 320 furnaces during January. Prepare a flexible budget for direct materials, direct labor, and variable manufacturing overhead using the format shown in Figure 10.2 "Flexible Budget for Variable Production Costs at Jerry’s Ice Cream".
2. Materials and Labor Variances. Hal’s Heating produces furnaces for commercial buildings. (This is the same company as the previous exercise. This exercise can be assigned independently.)
For direct materials, the standard price for a heating element part is \$40. A standard quantity of 3 heating elements is expected to be used in each furnace produced. During January, Hal’s Heating purchased 1,000 heating elements for \$38,000 and used 980 heating elements to produce 320 furnaces.
For direct labor, Hal’s Heating established a standard number of direct labor hours at 35 hours per furnace. The standard rate is \$18 per hour. A total of 10,000 direct labor hours were worked during January, at a cost of \$190,000, to produce 320 furnaces.
Required:
1. Calculate the materials price variance and materials quantity variance using the format shown in Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
2. Calculate the labor rate variance and labor efficiency variance using the format shown in Figure 10.6 "Direct Labor Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
3. Variable Overhead Variances. Hal’s Heating produces furnaces for commercial buildings. (This is the same company as the previous exercises. This exercise can be assigned independently.) The company applies variable manufacturing overhead at a standard rate of \$15 per direct labor hour. The standard quantity of direct labor is 35 hours per unit. Variable overhead costs totaled \$190,000 for the month of January. A total of 10,000 direct labor hours were worked during January to produce 320 furnaces.
Required:
Calculate the variable overhead spending variance and variable overhead efficiency variance using the format shown in Figure 10.8 "Variable Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
4. Fixed Overhead Variance Analysis. Hal’s Heating produces furnaces for commercial buildings. (This is the same company as the previous exercises. This exercise can be assigned independently.) The company applies fixed manufacturing overhead costs to products based on direct labor hours. Information for the month of January appears as follows. Hal’s expected to produce and sell 300 units for the month.
Required:
Calculate the fixed overhead spending variance and production volume variance using the format shown in Figure 10.13 "Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
5. Journalizing Direct Materials and Direct Labor Transactions (Appendix). Hal’s Heating produces furnaces for commercial buildings. (This is the same company as the previous exercises. This exercise can be assigned independently.)
Direct materials and direct labor variances for the month of January are shown as follows.
Materials price variance \$(2,000) favorable
Materials quantity variance \$ 800 unfavorable
Labor rate variance \$ 10,000 unfavorable
Labor efficiency variance \$(21,600) favorable
Required:
1. The company purchased 1,000 elements during the month for \$38 each. Assuming a standard price of \$40 per element, prepare a journal entry to record the purchase of raw materials for the month.
2. The company used 980 elements in production for the month, and the flexible budget shows the company expected to use 960 elements. Assuming a standard price of \$40 per element, prepare a journal entry to record the usage of raw materials in production for the month.
3. The company used 10,000 direct labor hours during the month with an actual rate of \$19 per hour. The flexible budget shows the company expected to use 11,200 direct labor hours at a standard rate of \$18 per hour. Prepare a journal entry to record direct labor costs for the month.
6. Investigating Variances. Quality Tables, Inc., produces high-end coffee tables. Standard cost information for each table is presented as follows.
Quality Tables produced and sold 2,000 tables for the year and encountered the following production variances:
Required:
Company policy is to investigate all unfavorable variances above 10 percent of the flexible budget amount for direct materials, direct labor, and variable overhead.
1. Identify the variances that should be investigated according to company policy. Show calculations to support your answer.
2. What potential weakness exists in the company’s current policy?
7. Variance Analysis with Activity-Based Costing. Assume Mammoth Company uses activity-based costing to allocate variable manufacturing overhead costs to products. The company identified three activities with the following information for last quarter.
Activity Standard Rate Standard Quantity per Unit Produced Actual Costs Actual Quantity
Indirect materials \$2.40 per yard 7 yards per unit \$691,650 265,000 yards
Product testing \$1.50 per test minute 5 minutes per unit \$301,000 215,000 test minutes
Indirect labor \$4.50 per direct labor hour 4 hours per unit \$930,000 180,000 direct labor hours
Required:
Assume Mammoth Company produced 40,000 units last quarter. Prepare a variance analysis using the format shown in Figure 10.11 "Variable Overhead Variance Analysis for Jerry’s Ice Cream Using Activity-Based Costing". Clearly label each variance as favorable or unfavorable.
8. Closing Variance and Overhead Accounts (Appendix). Gonzaga Products had the following balances at the end of its fiscal year.
Debit Credit
Materials price variance \$10,000
Materials quantity variance \$8,000
Labor rate variance 6,000
Labor efficiency variance 5,000
Manufacturing overhead 14,000
Required:
1. Prepare a journal entry to close the variance and manufacturing overhead accounts. Assume the balances are not significant and thus are closed to cost of goods sold.
2. Assume all products were sold and the company has no ending inventories. After making the entry in requirement a, does the balance of cost of goods sold on the income statement reflect standard costs or actual costs? Explain. | textbooks/biz/Accounting/Managerial_Accounting/10%3A_How_Do_Managers_Evaluate_Performance_Using_Cost_Variance_Analysis/10.E%3A_Exercises_%28part_1%29.txt |
1. Standard Cost and Flexible Budget. Outdoor Products, Inc., produces extreme-weather sleeping bags. The company’s master budget shows the following standards information.
Expected production for September 5,000 units
Direct materials 8 yards per unit at \$5 per yard
Direct labor 3 hours per unit at \$16 per hour
Variable manufacturing overhead 3 direct labor hours per unit at \$2 per hour
Required:
1. Calculate the standard cost per unit for direct materials, direct labor, and variable manufacturing overhead using the format shown in Figure 10.1.
2. Assume Outdoor Products produced 5,100 sleeping bags during the month of September. Prepare a flexible budget for direct materials, direct labor, and variable manufacturing overhead using the format shown in Figure 10.2 "Flexible Budget for Variable Production Costs at Jerry’s Ice Cream".
2. Materials and Labor Variances. Outdoor Products, Inc., produces extreme-weather sleeping bags. (This is the same company as the previous exercise. This exercise can be assigned independently.)
For direct materials, the standard price for 1 yard of material is \$5 per yard. A standard quantity of 8 yards of material is expected to be used for each sleeping bag produced. During September, Outdoor Products, Inc., purchased 45,000 yards of material for \$238,500 and used 39,000 yards to produce 5,100 sleeping bags.
For direct labor, Outdoor Products, Inc., established a standard number of direct labor hours at three hours per sleeping bag. The standard rate is \$16 per hour. A total of 14,700 direct labor hours were worked during September, at a cost of \$238,140, to produce 5,100 sleeping bags.
Required:
1. Calculate the materials price variance and materials quantity variance using the format shown in Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
2. Calculate the labor rate variance and labor efficiency variance using the format shown in Figure 10.6 "Direct Labor Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
3. Variable Overhead Variances. Outdoor Products, Inc., produces extreme-weather sleeping bags. (This is the same company as the previous exercises. This exercise can be assigned independently.) The company applies variable manufacturing overhead at a standard rate of \$2 per direct labor hour. The standard quantity of direct labor is three hours per unit. Variable overhead costs totaled \$32,000 for the month of September. A total of 14,700 direct labor hours were worked during September to produce 5,100 sleeping bags.
Required:
Calculate the variable overhead spending variance and variable overhead efficiency variance using the format shown in Figure 10.8 "Variable Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
4. Fixed Overhead Variance Analysis. Outdoor Products, Inc., produces extreme-weather sleeping bags. (This is the same company as the previous exercises. This exercise can be assigned independently.) The company applies fixed manufacturing overhead costs to products based on direct labor hours. Information for the month of September appears as follows. Outdoor Products expected to produce and sell 5,000 units for the month.
Required:
Calculate the fixed overhead spending variance and production volume variance using the format shown in Figure 10.13 "Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
5. Journalizing Direct Materials and Direct Labor Transactions (Appendix). Outdoor Products, Inc., produces extreme-weather sleeping bags. (This is the same company as the previous exercises. This exercise can be assigned independently.)
Direct materials and direct labor variances for the month of September are shown as follows.
Materials price variance \$13,500 unfavorable
Materials quantity variance \$(9,000) favorable
Labor rate variance \$ 2,940 unfavorable
Labor efficiency variance \$(9,600) favorable
Required:
1. The company purchased 45,000 yards of material during the month for \$5.30 per yard. Assuming a standard price of \$5 per yard, prepare a journal entry to record the purchase of raw materials for the month.
2. The company used 39,000 yards of material in production for the month, and the flexible budget shows the company expected to use 40,800 yards. Assuming a standard price of \$5 per yard, prepare a journal entry to record the usage of raw materials in production for the month.
3. The company used 14,700 direct labor hours during the month with an actual rate of \$16.20 per hour. The flexible budget shows the company expected to use 15,300 direct labor hours at a standard rate of \$16 per hour. Prepare a journal entry to record direct labor costs for the month.
6. Investigating Variances. Tool Box, Inc., produces tool boxes sold at a variety of retail stores throughout the world. Standard cost information for each toolbox is presented as follows.
Tool Box produced and sold 100,000 toolboxes for the year and encountered the following production variances:
Required:
Company policy is to investigate all unfavorable variances above 5 percent of the flexible budget amount for direct materials, direct labor, and variable overhead.
1. Identify the variances that should be investigated according to company policy. Show calculations to support your answer.
2. What recommendations would you make for the company’s current policy?
7. Variance Analysis with Activity-Based Costing. Assume Hillside Hats, LLC, uses activity-based costing to allocate variable manufacturing overhead costs to products. The company identified three activities with the following information for last month.
Activity Standard Rate Standard Quantity per Unit Produced Actual Costs Actual Quantity
Purchase orders \$50 per order 0.10 order per unit \$65,000 1,600 orders
Product testing \$2 per test minute 0.50 minutes per unit \$17,000 8,000 test minutes
Indirect labor \$3 per direct labor hour 1 hour per unit \$43,000 13,000 direct labor hours
Required:
Assume Hillside Hats produced 15,000 units last month. Prepare a variance analysis using the format shown in Figure 10.11 "Variable Overhead Variance Analysis for Jerry’s Ice Cream Using Activity-Based Costing". Clearly label each variance as favorable or unfavorable.
8. Closing Variance and Overhead Accounts (Appendix). Shasta Company had the following balances at the end of its fiscal year.
Debit Credit
Materials price variance \$8,000
Materials quantity variance 2,000
Labor rate variance \$12,000
Labor efficiency variance 5,000
Manufacturing overhead 4,000
Required:
1. Prepare a journal entry to close the variance and manufacturing overhead accounts. Assume the balances are not significant and thus are closed to cost of goods sold.
2. Assume all products were sold and the company has no ending inventories. After making the entry in requirement a, does the balance of cost of goods sold on the income statement reflect standard costs or actual costs? Explain.
Problems
1. Variance Analysis for Direct Materials, Direct Labor, and Variable Overhead. Rain Gear, Inc., produces rain jackets. The master budget shows the following standards information and indicates the company expected to produce and sell 28,000 units for the year.
Direct materials 4 yards per unit at \$3 per yard
Direct labor 2 hours per unit at \$10 per hour
Variable manufacturing overhead 2 direct labor hours per unit at \$4 per hour
Rain Gear actually produced and sold 30,000 units for the year. During the year, the company purchased 130,000 yards of material for \$429,000 and used 118,000 yards in production. A total of 65,000 labor hours were worked during the year at a cost of \$637,000. Variable overhead costs totaled \$231,000 for the year.
Required:
1. Calculate the materials price variance and materials quantity variance using the format shown in Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
2. Calculate the labor rate variance and labor efficiency variance using the format shown in Figure 10.6 "Direct Labor Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
3. Calculate the variable overhead spending variance and variable overhead efficiency variance using the format shown in Figure 10.8 "Variable Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
4. Company policy is to investigate all variances greater than 10 percent of the flexible budget amount for each of the three variable production costs: direct materials, direct labor, and variable overhead. Identify which of the six variances calculated in requirements a through c should be investigated.
5. Provide two possible explanations for each variance identified in requirement d.
2. Fixed Overhead Variance Analysis. (This problem is a continuation of the previous problem but can also be worked independently.) Rain Gear, Inc., produces rain jackets and applies fixed manufacturing overhead costs to products based on direct labor hours. Information for the year appears as follows. Rain Gear expected to produce and sell 28,000 units for the year.
Required:
1. Calculate the fixed overhead spending variance and production volume variance using the format shown in Figure 10.13 "Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
2. Company policy is to investigate all variances greater than 5 percent of the flexible budget amount. Identify whether either of the two fixed overhead variances calculated in requirement a should be investigated.
3. Provide one possible explanation for variance(s) identified in requirement b.
3. Journalizing Direct Materials, Direct Labor, and Overhead Transactions (Appendix). Complete the following requirements for Rain Gear, Inc., using your solutions to the previous two problems.
Required:
1. Prepare a journal entry to record the purchase of raw materials.
2. Prepare a journal entry to record the use of raw materials.
3. Prepare a journal entry to record direct labor costs.
4. Prepare a journal entry to record actual variable and fixed manufacturing overhead expenditures.
5. Prepare a journal entry to record variable and fixed manufacturing overhead applied to products.
6. Based on the entries shown in requirements a through e, prepare a journal entry to transfer all work-in-process inventory costs to finished goods inventory.
7. Assume all finished goods are sold during the period. Prepare a journal entry to transfer all finished goods inventory costs to cost of goods sold.
8. Based on the entries shown in requirements a through g, close manufacturing overhead and all variance accounts to cost of goods sold.
4. Variance Analysis for Direct Materials, Direct Labor, and Variable Overhead; Journalizing Direct Materials and Direct Labor Transactions (Includes Appendix). Prefab Pools Company produces large prefabricated in-ground swimming pools made of a specialized plastic material. The master budget shows the following standards information and indicates the company expected to produce and sell 600 units for the month of April.
Direct materials 500 pounds per unit at \$7 per pound
Direct labor 46 hours per unit at \$12 per hour
Variable manufacturing overhead 46 direct labor hours per unit at \$30 per hour
Prefab Pools actually produced and sold 580 units for the month. During the month, the company purchased 330,000 pounds of material for \$2,277,000 and used 295,800 pounds in production. A total of 25,520 labor hours were worked during the month at a cost of \$313,896. Variable overhead costs totaled \$790,000 for the month.
Required:
1. Calculate the materials price variance and materials quantity variance using the format shown in Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
2. Calculate the labor rate variance and labor efficiency variance using the format shown in Figure 10.6 "Direct Labor Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
3. Calculate the variable overhead spending variance and variable overhead efficiency variance using the format shown in Figure 10.8 "Variable Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
4. Company policy is to investigate all variances at or above 2 percent of the flexible budget for direct materials and 4 percent for direct labor and variable overhead. Identify which of the six variances calculated in requirements a through c should be investigated.
5. Provide two possible explanations for each variance identified in requirement d.
6. Based on your answer to requirement a, prepare a journal entry to record the purchase of raw materials.
7. Based on your answer to requirement a, prepare a journal entry to record the usage of raw materials.
8. Based on your answer to requirement b, prepare a journal entry to record direct labor costs.
5. Fixed Overhead Variance Analysis. (This problem is a continuation of the previous problem but can be worked independently.) Prefab Pools Company produces prefabricated in-ground swimming pools and applies fixed manufacturing overhead costs to products based on direct labor hours. Information for the month of April appears as follows. Prefab Pools expected to produce and sell 600 units for the month.
Required:
1. Calculate the fixed overhead spending variance and production volume variance using the format shown in Figure 10.13 "Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
2. Company management has asked you to investigate the cause of the fixed overhead spending variance calculated in requirement a. Provide one possible explanation for this variance.
6. Variance Analysis for Direct Materials, Direct Labor, Variable Overhead, and Fixed Overhead. Equipment Products, Inc., produces large ladders made of a specialized metal material. The master budget shows the following standards information and indicates the company expected to produce and sell 4,000 units for the month of May.
Direct materials 60 pounds per unit at \$3 per pound
Direct labor 8 hours per unit at \$14 per hour
Variable manufacturing overhead 8 direct labor hours per unit at \$6 per hour
Equipment Products actually produced and sold 4,400 units for the month. During the month, the company purchased 300,000 pounds of material for \$960,000 and used 286,000 pounds in production. A total of 30,800 labor hours were worked during the month at a cost of \$462,000. Variable overhead costs totaled \$195,000 for the month.
With regards to fixed manufacturing overhead, the company also applies these overhead costs to products based on direct labor hours. Fixed manufacturing overhead information for the month of May appears as follows.
Required:
1. Calculate the materials price variance and materials quantity variance using the format shown in Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
2. Calculate the labor rate variance and labor efficiency variance using the format shown in Figure 10.6 "Direct Labor Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
3. Calculate the variable overhead spending variance and variable overhead efficiency variance using the format shown in Figure 10.8 "Variable Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
4. Company policy is to investigate all variances greater than 10 percent of the flexible budget amount for each of the 3 variable production costs: direct materials, direct labor, and variable overhead. Identify which of the six variances calculated in requirements a through c should be investigated.
5. Provide two possible explanations for each variance identified in requirement d.
6. Calculate the fixed overhead spending variance and production volume variance using the format shown in Figure 10.13 "Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
7. Journalizing Direct Labor and Overhead Transactions (Appendix). Complete the following requirements for Equipment Products, Inc., using your solutions to the previous problem.
Required:
1. Prepare a journal entry to record direct labor costs.
2. Prepare a journal entry to record actual variable and fixed manufacturing overhead expenditures.
3. Prepare a journal entry to record variable and fixed manufacturing overhead applied to products.
8. Variance Analysis with Activity-Based Costing. Assume Spindle Company uses activity-based costing to allocate variable manufacturing overhead costs to products. The company identified three activities with the following information for last quarter.
Activity Standard Rate Standard Quantity per Unit Produced Actual Costs Actual Quantity
Indirect materials \$5 per yard 14 yards per unit \$4,850,000 990,000 yards
Product testing \$3 per test minute 10 minutes per unit \$2,000,000 650,000 test minutes
Indirect labor \$9 per direct labor hour 6 hours per unit \$3,800,000 410,000 direct labor hours
Required:
1. Assume Spindle Company produced 70,000 units last quarter. Prepare a variance analysis using the format shown in Figure 10.11 "Variable Overhead Variance Analysis for Jerry’s Ice Cream Using Activity-Based Costing". Clearly label each variance as favorable or unfavorable.
2. Company policy is to investigate all variances above 5 percent of the flexible budget amount for each activity. Identify the variances that should be investigated according to company policy. Show calculations to support your answer.
One Step Further: Skill-Building Cases
1. Variance Analysis and Fraud. Refer to Note 10.47 "Business in Action 10.4" and to Note 10.52 "Business in Action 10.5" Explain how cost variance analysis might help detect fraud.
2. Group Activity: Setting Standards. Form groups of two to four students. Each group is to complete the following requirements.
Required:
1. Define and discuss the differences between ideal standards and attainable standards.
2. Assume your group works for a company that produces wood desks and you are in the process of creating attainable direct material and direct labor standards. Provide specific examples of the items that might be included in (1) the standard quantity and standard price for direct materials and (2) the standard hours and standard rate for direct labor. Explain where this information might be obtained, and identify specific production inefficiencies your group included in creating these standards that would not be included in ideal standards.
3. Discuss the findings of your group with the class. (Optional: your instructor may ask you to submit your findings in writing.)
3. Internet Project: Standard Costs and Cost Variances. Systems Applications and Products (SAP) is the world’s largest business software company with 38,000 customers worldwide. Go to the SAP Web site at http://www.sap.com and find the search feature. Type in “standard costing” or “cost variance” and find an article that discusses standard costs and/or cost variances (there are several articles to choose from). Summarize the article in a one-page report, and submit a printed copy of the article with your report.
4. Ethics and Setting Standards. Wilkes Golf, Inc., produces golf carts that are sold throughout the world. The company’s management is in the process of establishing the standard hours of direct labor required to complete one golf cart. Assume you are the production supervisor, and you receive a bonus for each quarter that shows a favorable labor efficiency variance. That is, you receive a bonus for each quarter showing actual direct labor hours that are fewer than budgeted direct labor hours.
The management has asked for your input in establishing the standard number of direct labor hours required to complete one golf cart.
Required:
1. As the production supervisor, describe the ethical conflict you face when asked to help with establishing direct labor hour standards.
2. How might the management of Wilkes Golf, Inc., avoid this conflict and still achieve the goal of obtaining reliable direct labor hour information?
5. Using Excel to Perform Budget Versus Actual Analysis. The management of Home Products, Inc., prepared the following budgeted income statement for the year ending December 31, 2012.
At the end of 2012, the company prepared the following income statement showing actual results:
Required:
Prepare an Excel spreadsheet comparing the actual results to budgeted amounts using the format shown as follows, and comment on the results.
Comprehensive Cases
1. Variable Production Cost Variance Analysis. Iron Products, Inc., produces prefabricated iron fencing used in commercial construction. Variable overhead is applied to products based on direct labor hours. The company uses a just-in-time production system and thus has insignificant inventory levels at the end of each month. The income statement for the month of November comparing actual results with the flexible budget based on actual sales of 2,000 units is shown as follows.
Iron Products is disappointed with the actual results and has hired you as a consultant to provide further information as to why the company has been struggling to meet budgeted net profit. Your review of the previously presented budget versus actual analysis identifies variable cost of goods sold as the main culprit. The unfavorable variance for this line item is \$67,400.
After further research, you are able to track down the following standard cost information for variable production costs:
Actual production information related to variable cost of goods sold for the month of November is as follows:
• 2,000 units were produced and sold.
• 110,000 pounds of material were purchased and used at a total cost of \$528,000.
• 5,600 direct labor hours were used during the month at a total cost of \$134,400.
• Variable overhead costs totaled \$205,000.
Required:
1. Calculate the materials price variance and materials quantity variance using the format shown in Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
2. Calculate the labor rate variance and labor efficiency variance using the format shown in Figure 10.6 "Direct Labor Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
3. Calculate the variable overhead spending variance and variable overhead efficiency variance using the format shown in Figure 10.8 "Variable Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
4. List each of the six variances calculated in requirements a, b, and c, and total the variances to show one net variance. Clearly label the net variance as favorable or unfavorable. Explain how this net variance relates to variable cost of goods sold on the income statement.
5. Identify the highest favorable variance and highest unfavorable variance from the six listed in requirement d, and provide one possible cause of each variance.
2. Variable Production Cost Variance Analysis and Performance Evaluation. Fast Sleds, Inc., produces snow sleds used for winter recreation. Variable overhead is applied to products based on machine hours. The company uses a just-in-time production system, and thus has insignificant inventory levels at the end of each month. The income statement for the month of January comparing actual results with the flexible budget is shown in the following based on actual sales of 10,000 units.
Fast Sleds is disappointed with the actual results and has hired you as a consultant to provide further information as to why the company has been struggling to meet budgeted net income. Your review of the budget presented previously versus actual analysis identifies variable cost of goods sold as the main culprit. The unfavorable variance for this line item is \$8,700.
After further research, you are able to track down the standard cost information for variable production costs:
Actual production information related to variable cost of goods sold for the month of January is as follows:
• 10,000 units were produced and sold.
• 150,000 pounds of material was purchased and used at a total cost of \$67,500.
• 1,900 direct labor hours were used during the month at a total cost of \$30,400.
• 1,200 machine hours were used during the month.
• Variable overhead costs totaled \$10,800.
Required:
1. Calculate the materials price variance and materials quantity variance using the format shown in Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
2. Calculate the labor rate variance and labor efficiency variance using the format shown in Figure 10.6 "Direct Labor Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
3. Calculate the variable overhead spending variance and variable overhead efficiency variance using the format shown in Figure 10.8 "Variable Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". Clearly label each variance as favorable or unfavorable.
4. List each of the six variances calculated in requirements a, b, and c, and total the variances to show one net variance. Clearly label the net variance as favorable or unfavorable. Explain how this net variance relates to variable cost of goods sold on the income statement.
5. Identify the highest favorable variance and highest unfavorable variance from the six listed in requirement d, and provide one possible cause of each variance.
6. Sue Mays, the manager at Fast Sleds, Inc., reviewed the company’s variance analysis report for the month of January. The materials price variance of \$(7,500) was the most significant favorable variance for the month, and the materials quantity variance of \$15,000 was the most significant unfavorable variance. Sue would like to reward the company’s purchasing agent for achieving such substantial savings by giving him a \$2,000 bonus while not providing any bonus for the production manager.
1. Do you agree with Sue’s approach to awarding bonuses? Explain.
2. What circumstances might lead to the conclusion that the purchasing agent should not receive a bonus for the month of January? | textbooks/biz/Accounting/Managerial_Accounting/10%3A_How_Do_Managers_Evaluate_Performance_Using_Cost_Variance_Analysis/10.E%3A_Exercises_%28part_2%29.txt |
Mandy Dwyer is the president and CEO of Game Products, Inc., a producer of games and sporting goods sold to a variety of retail stores. Game Products, Inc., has three divisions: Sporting Goods, Board Games, and Computer Games. Each division is relatively autonomous with a separate manager, who independently oversees each division. Mandy Dwyer is reviewing the results of the most recent fiscal year with Larry Meske, the company’s CFO:
Mandy: In reviewing our segmented income statement, it looks like the Board Games division had a terrific year. Profits increased substantially over last year, more than either of the other two divisions, and overall profit for this division is well above the other two. Carla Klesko, the Board Games division manager, is to be commended for her fine work! We should consider revising her compensation plan to increase her annual bonus based on these results.
Larry: Not so quick, Mandy. I agree that the Board Games division has successfully increased profits, but we must consider more than just the bottom line (profits) in determining how substantial the increase is in comparison to the other divisions.
Mandy: What do you have in mind?
Larry: For starters, we should consider what resources were invested in the Board Games division, and determine the return produced from these resources. As you recall, Carla made a significant investment in her division, whereas the other division managers did not. So naturally, we would expect Board Games division profits to increase by more than the other divisions.
Mandy: I’ve always focused on the bottom line for each division. What performance measures do you propose we use?
Larry: We have several options. Return on investment (ROI), residual income (RI), and economic value added (EVA) are three commonly used measures. Perhaps we can discuss this further next month once I’ve had a chance to pull some information together.
Mandy: Excellent idea. I look forward to getting your ideas on this issue next month.
Mandy and Larry are looking for ways to evaluate the performance of the company’s three division managers. Since each division is responsible for more than just the cost of production, as was the case in Chapter 10, top management must evaluate how productively each division manager is using assets to produce profits. The focus of this chapter is on how to evaluate the performance of division managers within a decentralized organization.
11.02: Using Decentralized Organizations to Control Operations
Learning Objectives
• Define the term decentralized organization and explain advantages and disadvantages of decentralizing.
Question: Many types of organizations decentralize operations to better manage each segment of the organization. What does it mean to decentralize operations?
Answer
The term used to describe this type of organizational structure is decentralized organizations. Decentralized organizations delegate decision-making and operational responsibilities to the managers of each segment of the organization. (Segments are often called divisions or subunits.) For example, universities are often segmented by discipline with one manager, or dean, responsible for each discipline (physical education, social sciences, business, etc.). Retail companies are often segmented by region, with one manager responsible for each region. Service companies are often segmented by service category, with one manager responsible for each category (e.g., an accounting firm divided into audit and tax). Decentralization is not limited to a particular type of organization, and most organizations that have grown in size and complexity decentralize to some extent.
Reasons to Decentralize
Question: Why do organizations decentralize operations?
Answer
Organizations often decentralize out of necessity as they expand. The responsibility of one manager, or group of managers, to run the entire organization can become overwhelming as the number of products offered increases.
For example, Game Products, Inc., began by selling two board games to several retail stores in the northeast United States. The company did not need to decentralize at that point because it offered only two products and the geographic region in which it sold those products was limited.
A few years later, Game Products expanded sales to Canada and the southeast Unites States, while also venturing into the computer games industry by purchasing a small maker of computer games. Although operations were not decentralized at this time—all decisions were still made at headquarters—top management was beginning to feel the strain of trying to manage two segments of the company. The decision-making process was cumbersome and slow, and the company began to miss market opportunities that would have increased sales and profits.
Two years later, Game Products decided to enter the sporting goods market, and top management and the board of directors agreed that decentralization was critical to the future success of the company. As a result, they assigned a manager to run each division. This change allowed top management to concentrate on high-level issues. such as long-range strategic planning, and it placed the decision making in the hands of managers who were intimately familiar with the operations of their individual divisions.
Figure 11.1. Decentralized Versus Centralized Organizations
Advantages of Decentralizing Operations
Question: What are the advantages of decentralizing operations for companies like Game Products, Inc.?
Answer
Organizations like Game Products tend to decentralize as their operations grow and become more complex. The advantages of decentralizing are as follows:
Increased Expertise. Rather than having one manager, or a group of managers, trying to make decisions for a wide range of products, decentralized organizations delegate decision-making authority to local managers who have expertise in specific products.
Quicker Decisions. By having increased expertise and decision-making authority, local managers are able to make decisions quickly without having to wait for the approval of the organization’s top management.
Refocus of Top Management Responsibilities. With local managers focusing on issues important to the specific segment, top management is able to delegate the day-to-day decision-making responsibilities and focus on broader companywide issues, such as long-range strategic planning.
Motivation of Local Managers. Managers who are given more responsibility, and the control necessary to manage their responsibility, tend to be more motivated than those who simply follow the orders issued by top management. In addition, a decentralized structure provides a means to train local managers for promotion to the next level of management.
Advantages of Decentralizing at a Community College
Sierra College is located in one of the fastest growing counties in California. Student enrollment has increased from 5 percent to 10 percent per year over the last decade. Prior to this rapid growth, the college held each division dean responsible for most administrative duties. For example, the dean of business and technology was responsible for administrative duties, such as hiring faculty members and developing the schedule of classes to be offered each semester.
As student enrollment increased, course offerings expanded, and faculty headcount grew into the hundreds, the administrative duties became overwhelming for each division dean. As a result, management decided to decentralize further by creating department chair positions to help with the administrative duties related directly to each department. This change gave each department (business, music, computer science, etc.) more control over day-to-day activities, and it allowed the deans to focus on larger college issues, such as strategic planning and community relations. It also allowed for quicker responses to issues, such as faculty teaching assignments and classroom space utilization.
Source: Based on the author’s experience.
Disadvantages of Decentralizing Operations
Question: What are the disadvantages of decentralizing operations for organizations, such as Game Products?
Answer
The results of decentralizing operations are not always positive. Three disadvantages of decentralizing are as follows:
Duplication of Services. Organizations that decentralize often duplicate administrative services, such as accounting and computer support. That is, each segment may have its own accounting department and computer support department when these services might be provided more efficiently through one companywide department.
Conflict of Interest. Managers who are evaluated solely with respect to their divisions have no incentive to make a decision that benefits the organization as a whole at the expense of the manager’s division. For example, a local manager may decide to purchase raw materials from an outside supplier even though another division within the company can produce the same materials at a lower cost. (To make matters worse, the other division’s manager may refuse to sell the materials at a reduced price because she is evaluated based on her division’s profits!) The appendix to this chapter discusses this issue in greater detail.
Loss of Control. Perhaps one of the most difficult decisions facing small, fast-growing organizations is whether to continue to expand and decentralize or to limit growth and remain highly centralized. Decentralization will lead to a loss of control at top management levels, which can have negative consequences for the organization’s reputation if local managers struggle to maintain the level of quality that customers expect. Decentralized organizations are only as good as the local managers who are given decision-making authority.
Disadvantage of Decentralizing an Accounting Firm
Arthur Andersen was a large, decentralized accounting firm with offices located throughout the world. One or more partners operated each office independently. In 2002, Arthur Andersen had 85,000 employees worldwide. The firm was indicted in March 2002, and later found guilty, for obstructing justice by shredding tons of documents related to its audit work for Enron Corporation. As a result, Arthur Andersen agreed to cease its accounting practice in the United States in August 2002. By 2005, only 200 employees remained at Arthur Andersen to wrap up the dissolution of the firm.
Although the entire firm was indicted and found guilty of obstruction of justice, the decision to shred documents was made at the Houston office, where the bulk of the shredding took place. This serves as an extreme example of the disadvantage of decentralizing an organization. Decisions left to the division managers (“partners” in this case) can have a negative effect on the entire organization.
Note that the U.S. Supreme Court overturned the guilty verdict of the U.S. District Court in June 2005, but the damage was done and the firm did not survive.
Source: Charles Lane, “Justices Overturn Andersen Conviction,” Washington Post, June 1, 2005, www.washingtonpost.com.
Key Takeaway
Decentralized organizations delegate decision-making and operational responsibilities to the managers of each segment, or division, of the organization. Advantages of decentralized organizations include increased expertise at each division, quicker decisions, better use of time at top management levels, and increased motivation of division managers. Disadvantages include duplication of services, such as accounting and computer support; potential increase in conflicts between division manager goals and companywide goals; and loss of control at the top management level.
REVIEW PROBLEM 11.2
Landscaping Services, Inc., founded and operated by Ed Barnes, has seen revenues double each year for the past three years. Although Ed has hired several laborers to ease the workload, he is still working seven days a week, 10 hours a day. Ed would like to hire a manager to assist in managing landscaping projects and has asked for your advice.
1. What concerns might you have about Ed’s plan to decentralize operations?
2. How might decentralizing operations benefit Landscaping Services, Inc.?
Answer
There are several potential disadvantages to decentralizing. Two examples follow:
1. For a relatively small company, such as Landscaping Services, Inc., the biggest concern is losing control over quality. Presumably Ed is successful because he provides excellent service. He must instill the importance of maintaining quality to the new manager.
2. Ed must establish a compensation system that encourages the new manager to make decisions in the best interest of the organization. For example, if the new manager encounters an opportunity to pick up a new customer, there must be an incentive to pursue this opportunity. If the new manager is simply given a monthly salary, there is no incentive to increase the workload! One approach is to offer part ownership in the company and therefore rights to a percentage of the company’s profits.
There are several potential advantages to decentralizing. A few examples follow:
• Ed can hire a manager with expertise in an area outside of Ed’s expertise, which can lead to additional business and a higher level of quality.
• Clients will no longer have to wait for Ed to arrive before a decision is made on how to proceed with the work.
• Ed can put more time into obtaining new customers. | textbooks/biz/Accounting/Managerial_Accounting/11%3A_How_Do_Managers_Evaluate_Performance_in_Decentralized_Organizations/11.01%3A_Introduction.txt |
Learning Objectives
• Define three types of responsibility centers.
Question: To evaluate performance, organizations often divide operations into segments. Segments responsible for revenues, costs, and investments in assets are called responsibility centers. Responsibility centers can be based on such attributes as sales regions, product lines, or services offered. Why do organizations establish responsibility centers?
Answer
The purpose of establishing responsibility centers within organizations is to hold managers responsible for only the assets, revenues, and costs they can control. For example, a factory manager typically has control over production costs, but not sales. This manager’s responsibility center would only include production costs. A retail store manager typically has control over sales prices and costs. This manager’s responsibility center would only include revenues and costs. The level of control a manager has over a segment’s assets, revenues, and costs will help determine the type of responsibility center used for each manager.
Figure 11.2. "Three Types of Responsibility Centers" illustrates the three types of responsibility centers commonly used to evaluate segments: cost centers, profit centers, and investment centers. Each type is described in the following sections.
Cost Center
Question: What is a cost center, and what measures are used to evaluate this type of responsibility center?
Answer
A cost center is an organizational segment that is responsible for costs, but not revenue or investments in assets. Service departments, such as accounting, marketing, computer support, and human resources, are cost centers. Managers of these departments are evaluated based on providing a certain level of services for the company at a reasonable cost.
Production departments within a manufacturing firm are also treated as cost centers. Production managers are evaluated based on meeting cost budgets for producing a certain level of goods. Chapter 10 describes the use of cost variance analysis to evaluate cost centers within a manufacturing firm.
Profit Center
Question: What is a profit center, and what measures are used to evaluate this type of responsibility center?
Answer
A profit center is an organizational segment that is responsible for costs and revenues (and therefore, profit), but not investments in assets. Retail stores for companies, such as Macy’s or Kmart, are treated as profit centers. Individual fast food restaurants for McDonald’s or Kentucky Fried Chicken are also examples of profit centers. Managers of profit centers are responsible for revenues, costs, and resulting profits. (Some individual retail stores and fast food restaurants may be considered investment centers if the store manager is also responsible for large investment decisions, such as enlarging the building and purchasing more equipment to accommodate additional customers. Profit center determination must be made on a case-by-case basis, and it depends on the level of responsibility assigned to the store manager.)
Methods of performance evaluation for profit centers vary. Some organizations compare actual profit to budgeted profit. Others compare one profit center to another. Also, some organizations use segmented income statement ratios, such as gross margin or operating profit, to compare current profit center performance to prior periods and to other profit centers. Chapter 13 explains how companies can use financial ratios to evaluate profit center performance.
Investment Center
Question: What is an investment center, and what measures are used to evaluate this type of responsibility center?
Answer
An investment center is an organizational segment that is responsible for costs, revenues, and investments in assets. Investment center managers have control over asset investment decisions. In many cases, investment centers are treated as stand-alone businesses. Examples of investment centers include the Chevrolet division of General Motors and the printer division of Hewlett Packard.
Several measures can be used to evaluate the performance of investment center managers, including segmented net income, ROI, RI, and economic value added (EVA). The remainder of this chapter will focus on these measures using Game Products, Inc., as the example company. Before turning to these topics, however, look at Note 11.12 "Business in Action 11.3" which indicates the challenges that accountants and managers at Hewlett-Packard face when preparing the company’s annual report.
Note: Business in Action 11.3
Segment Reporting at Hewlett-Packard Company
Hewlett-Packard Company provides financial information for seven segments in its annual report. Examples of segments and related revenues (in millions) include HP Services (\$15,617), Personal Systems Group (\$29,166), and Imaging and Printing Group (\$26,786). These segments are likely treated as investment centers where segment managers are responsible for costs, revenues, and investments in assets.
Source: Hewlett-Packard Company, “2006 Annual Report,” http://www.hp.com.
Key Takeaway
Responsibility centers are categorized depending on the level of control over revenues, costs, or investments. A segment responsible only for costs is called a cost center. A segment responsible for costs and revenues is called a profit center. A segment responsible for costs, revenues, and investment in assets is called an investment center. Performance measures used to evaluate managers depend on the type of responsibility center being managed.
REVIEW PROBLEM 11.3
For each of the organizational segments listed, determine whether it is a cost center, profit center, or investment center. Explain your answer.
1. Individual retail store at Home Depot
2. Accounting department at Ford Motor Company
3. Saturn division of General Motors
4. Human resources department at IBM
5. Production department at Sony
6. Jet engine division of General Electric
7. Computer support department at Nike
Answer
1. Profit center. The manager is responsible for costs and revenues, but not investments in assets. (A case might be made that if the manager has control over significant purchases of assets for the store, this would be an investment center.)
2. Cost center. The manager is responsible for costs only, not revenues or investments in assets.
3. Investment center. The manager is responsible for costs, revenues, and investment decisions.
4 Cost center. The manager is responsible for costs only, not revenues or investments in assets.
5 Cost center. The manager is responsible for costs only, not revenues or investments in assets.
6. Investment center. The manager is responsible for costs, revenues, and investment decisions.
7.Cost center. The manager is responsible for costs only, not revenues or investments in assets. | textbooks/biz/Accounting/Managerial_Accounting/11%3A_How_Do_Managers_Evaluate_Performance_in_Decentralized_Organizations/11.03%3A_Maintaining_Control_over_Decentralized_Organizations.txt |
Learning Objectives
• Calculate and interpret segmented net income to evaluate performance.
Question: Now that we know an investment center is an organizational segment responsible for costs, revenues, and investments in assets, where do we start in trying to evaluate the performance of investment centers?
Answer
Answer: The starting point for evaluating investment centers is typically with reviewing segmented income for each investment center (or division). Segmented income is segment revenues minus segment expenses. Top management is interested in the level of profit that each division generates, and segmented income gives them this information.
Revisiting Game Products, Inc.
Question: In the dialogue at the beginning of the chapter, Mandy Dwyer, president and CEO, said she would like to increase the annual bonus for Carla Klesko, manager of the Board Games division, based on the division’s level of profit relative to the other divisions. How does the Board Games division profits compare with the other divisions?
Answer
Profit for the Board Games division is higher than either of the other two, as shown in Figure \(1\).
Although this income statement looks much like a financial accounting income statement prepared for outside users, it is for internal use and therefore, need not comply with U.S. Generally Accepted Accounting Principles (U.S. GAAP). In fact, organizations can define income or profit many different ways when evaluating performance. For example, some might only look at operating income, others might exclude allocated overhead from operating income. Another alternative is to focus on gross margin. The point is that managerial accountants must be flexible in designing reports that best meet the needs of managers.
The president of Game Products, Inc., referred to net income when she indicated that the Board Games division performed very well for the year. Solely based on this measure, Mandy’s statement is accurate as the Board Games division has net income of \$3,466,000 versus \$2,306,000 for the Sporting Goods division and \$1,577,000 for the Computer Games division.
Limitations of Using Segmented Income to Measure Performance
Question: Although using net income for each division as a performance measure is relatively simple, there are two significant weaknesses. What are these weaknesses?
Answer
First, not all divisions are of equal size. Naturally, larger divisions should produce larger profits. It is unfair to compare net income for a smaller division with net income for a larger division for the purpose of evaluating division manager performance. With \$34,000,000 in sales, the Board Games division should be expected to have higher net income than the other divisions, each of which has sales of less than \$30,000,000.
One solution is to compare profit margin ratios for each division (net income ÷ sales). As shown at the bottom of Figure 11.3, the Sporting Goods division has the highest profit margin ratio at 11.53 percent, compared to 10.19 percent for Board Games, and 5.44 percent for Computer Games. (Chapter 13 presents several additional financial ratios used to evaluate performance.)
Because each division manager has control over revenues, costs, and investments in assets, each division is considered an investment center. Thus a second weakness in using segmented net income information to evaluate division manager performance is that net income as the sole measure of performance ignores the assets used to produce net income.
For example, suppose the Sporting Goods division only invested approximately \$29,000,000 in assets to produce \$2,306,000 in income, while the Board Games division invested \$55,000,000 in assets to produce \$3,466,000 in income. Which division had the best performance? We need a measure to evaluate how well each division performed relative to the investments made. We discuss three such measures next.
Key Takeaway
Investment center managers are often evaluated using segment net income, which is segment revenues minus segment expenses. However, two weaknesses are that this measure does not consider the revenues required to produce segment net income, and this measure ignores the assets used to produce segment net income.
REVIEW PROBLEM 11.4
Kitchen Appliances has two divisions—a Southern division and a Northern division. The following segmented financial information is for the most recent fiscal year ended December 31 (dollar amounts are in thousands).
Southern Division Northern Division
Sales \$5,000 \$30,000
Cost of goods sold 1,500 13,000
Allocated overhead 286 1,714
Selling and administrative expenses 2,100 12,000
Assume the tax rate is 30 percent.
1. Prepare a segmented income statement using the format presented in Figure 11.3.
2. Using net income as the measure, which division is most profitable? Explain why this conclusion might be misleading.
3. Calculate the profit margin ratio and explain why organizations often use this ratio rather than simply using net income?
Answer
1. The segmented income statements are shown as follows.
2. The Northern division is most profitable with net income of \$2,300,000 versus net income of \$780,000 in the Southern division. Using net income to evaluate which division is most profitable can be misleading because it does not consider the amount of assets needed to produce income. For example, the Northern division may have invested considerably less in assets to produce net income of \$780,000.
Another reason this may be misleading is no consideration is given to the dollar amount of sales required to produce the net income for each division. Clearly the Northern division has significantly higher sales (\$30,000,000 versus \$5,000,000 for the Southern division) and therefore should have significantly higher net income.
3. The profit margin ratio for the Southern division is 15.60 percent (= \$780,000 net income ÷ \$5,000,000 sales), and the profit margin ratio for the Northern division is 7.67 percent (= \$2,300,000 net income ÷ \$30,000,000). This shows that each dollar in sales at the Southern division generates more net income (15.60 cents) than at the Northern division (7.67 cents).
Organizations prefer to use the profit margin ratio when comparing segments because it serves as an equalizer in comparing divisions with significantly different levels of sales revenue. | textbooks/biz/Accounting/Managerial_Accounting/11%3A_How_Do_Managers_Evaluate_Performance_in_Decentralized_Organizations/11.04%3A_Comparing_Segmented_Income_for_Investment_Centers.txt |
Learning Objectives
• Calculate and interpret return on investment (ROI) to evaluate performance.
Question: Perhaps the most common measure of performance for managers responsible for investment centers is return on investment (ROI). What is ROI, and how is it used to evaluate investment centers?
Answer
ROI is defined as operating income divided by average operating assets:
Key Equation
Note that different organizations use different measures to calculate ROI. Our goal in this discussion is to introduce one common approach, but keep in mind that organizations often make adjustments to this formula to better suit their needs.
The advantage of ROI as a performance measure is that it includes the use of assets. For example, assume 2 divisions have \$10,000 in operating income. Both divisions appear to have performed equally well based on operating income. However, further review shows that Division 1 invested \$200,000 in average operating assets to produce this income while Division 2 invested \$400,000. Clearly, the division that invested half the amount in assets to produce the same amount of income had the best performance of the two. Comparing the ROI for each division proves this:
Let’s take a closer look at the components of the ROI calculation, operating income and average operating assets.
Revisiting Game Products, Inc.
Question: What is operating income, and how does it differ from net income?
Answer
Operating income is the income produced by the division from its daily activities. It excludes items used in the calculation of net income, such as income tax expense, interest income, interest expense, and any unusual gains or losses. The focus is on how well the division performed relative to its core business operations, which does not include one-time gains or losses from the sale of property, plant, and equipment for example.
Question: What are average operating assets, and how is this amount calculated?
Answer
Average operating assets are the assets that the division has in place to run the daily operations of the business, and this value is calculated by adding beginning period balances and ending period balances and dividing by two. Examples of operating assets include cash, accounts receivable, prepaid assets, buildings, and equipment. As long as the division uses the assets to produce operating income, they are included in the operating assets category. Examples of nonoperating assets—assets not included in this calculation—include land held for investment purposes and office buildings leased to other companies.
An average of operating assets is taken over the period being evaluated for two reasons. First, operating assets are often purchased and sold during an accounting period, and simply taking the ending balance might produce distorted, if not inaccurate, results. Second, operating income represents information for a period of time (income statements always present information for a period of time), while operating assets are presented at a point in time (balance sheets always present information for a point in time). If both of these items are to be included in one ratio (ROI), it is best to use average balance information for balance sheet items. In fact, if the information is readily available, it would be best to take an average of daily operating asset balances for the period being evaluated.
Computing ROI at Game Products, Inc.
Question: Using ROI as the measure, how do the divisions at Game Products, Inc., compare with each other?
Answer
Figure 11.3 shows segmented income statement information for each of Game Products’ three divisions. The operating income line of this income statement provides information needed for the numerator of the ROI calculation. Figure 11.4 presents the segmented balance sheets for each division needed to calculate average operating assets.
Figure 11.4. Segmented Balance Sheets (Game Products, Inc.)
Let’s see how each division ranks using ROI. Assume all assets at Game Products, Inc., are operating assets. We use the information in Figure 11.3 and Figure 11.4 to calculate the ROI for each division in Figure 11.5.
Figure 11.5. ROI Calculations (Game Products, Inc.)
*Operating income amount is from segmented income statements presented in Figure 11.3.
**Average operating assets are calculated using the balance sheet information in Figure 11.4. Since all assets at Game Products, Inc., are operating assets, total asset amounts are used in this calculation. The calculation of average operating assets for each division is (Beginning balance of total assets + Ending balance of total assets) ÷ 2. Average operating assets for the Sporting Goods division is \$29,350 (= [\$30,500 + \$28,200] ÷ 2).
^ROI = Operating income ÷ Average operating assets. For Sporting Goods division, 11.23 percent = \$3,295 ÷ \$29,350.
The ROI measures presented in Figure 11.5 show that although the Board Games division has the highest operating income, its ROI ranks in the middle of the three divisions. The Sporting Goods division has the highest ROI at 11.23 percent, Board Games is second at 8.93 percent, and Computer Games is the lowest at 6.75 percent. Since managers of each division are responsible for maximizing profit based on investments they make in assets, ROI is a reasonable approach to evaluating each manager. The Sporting Goods division manager appears to be outperforming the other two managers based on this measure.
Issues with ROI as a Performance Measure
Like most financial measures of performance, ROI can be calculated in several different ways. The components of this calculation often vary from one organization to the next. These variations are discussed next.
Operating Income Calculation—A Closer Look
Question: For the purposes of the Game Products, Inc., example, we use the same definition of operating income that is used for financial reporting purposes in accordance with U.S. GAAP. However, organizations often create their own unique calculation of operating income for internal evaluation purposes. How might the internal calculation of operating income vary from U.S. GAAP?
Answer
There are several variations that organizations use when calculating operating income. Two of the more common variations are discussed next.
Excluding Allocated Overhead
The segmented income statements for Game Products, Inc., are presented again in Figure 11.6 (these are the same segmented income statements as in Figure 11.3). Notice the expense line item labeled allocated overhead (from corporate). Although we include this expense in calculating operating income, many organizations do not, particularly if division managers have no control over allocated overhead. Excluding allocated overhead has the effect of increasing ROI for each division manager and holds each division manager responsible only for expense amounts that are controllable.
Figure 11.6. Segmented Income Statements (Game Products, Inc.)
Including Income Tax Expense
Review Figure 11.6 and notice the line item labeled income tax expense. Although we do not include income tax expense in the operating income calculation, some organizations prefer to include this item. Including after-tax expense reduces ROI for each division manager (assuming each division is profitable).
The point here is that the needs of management determine how to define operating income. We will use the U.S. GAAP definition, presented as operating income in Figure 11.6, throughout this chapter unless indicated otherwise.
Average Operating Assets Calculation—A Closer Look
Question: For Game Products, Inc., we assume all assets are operating assets. That is, all assets are used in the daily operations of the business. As discussed earlier, assets that are not used in the daily operations of the business, such as land held for investment or buildings sublet to other companies, are not included in this calculation. The average is found by taking the beginning balance plus ending balance and dividing by two. The issue in this calculation focuses on long-term assets that are depreciated over time. What options exist in valuing long-term assets for the purpose of calculating ROI?
Answer
There are two common approaches to valuing long-term assets when calculating ROI. Each approach is discussed next.
Using Net Book Value to Calculate ROI
In the Game Products, Inc., example, we use the net book value of long-term assets to calculate operating assets. That is, accumulated depreciation is subtracted from the original cost on the segmented balance sheet in accordance with U.S. GAAP. The balance sheet presented in Figure \(2\) shows this in the line item labeled property, plant, and equipment, net. The advantage of using net book value is that the information is easily obtained from the financial records.
The problem with this approach is division managers with older assets that have been substantially depreciated have an advantage over division managers with newer assets that have not been significantly depreciated. Older assets have a lower net book value (cost – accumulated depreciation) than newer assets, which reduces average operating assets in the denominator and increases ROI.
For example, assume two divisions have identical operating income for the year and identical assets. However, Division 1 has been in operation for many more years than Division 2 and thus has far more accumulated depreciation on long-term assets. This results in a lower net book value on long-term assets for Division 1 as shown in the following:
Assuming all other assets are identical, and both divisions have identical operating income, Division 1 will have a higher ROI simply because long-term assets are older and have more accumulated depreciation, thereby reducing average operating assets in the denominator. (Reducing the denominator increases the ratio.)
An additional weakness in using net book value to calculate average operating assets is the disincentive it creates for division managers to replace old and inefficient long-term assets, such as equipment and machinery. Although new equipment purchases may be needed to improve efficiency and to remain competitive, the short-term impact is to reduce ROI. (Older equipment will have a lower net book value than identical newer equipment. Thus replacing old equipment will decrease ROI.)
If division managers are evaluated based on ROI, using net book value tends to discourage investments in long-term assets, often at the expense of the organization’s long-term profitability.
Using Gross Book Value to Calculate ROI
An alternative approach in calculating ROI is to use gross book value in the average operating assets calculation. Gross book value simply refers to the original cost of long-term assets and ignores accumulated depreciation.
In our example of two divisions with identical assets and identical operating income, the same original cost amount is used in calculating average operating assets. Division 2 is not penalized in the denominator for having newer assets and less accumulated depreciation.
Although both net book value and gross book value are used in practice, we will use net book value throughout this chapter unless indicated otherwise. “Key Equation: Variations of ROI Calculation” summarizes the issues surrounding the calculation of ROI.
Key Equation: Variations of ROI Calculation
*The U.S. GAAP definition of operating income is used for the numerator. However, organizations often calculate operating income differently. Some exclude allocated overhead while others may include income tax expense to get after-tax operating income.
**Average operating assets includes only those assets used in the daily operations of the business. Long-term assets are valued at net book value. However, valuation of long-term assets varies from one organization to the next. Some use gross book value rather than net book value.
Note: Business in Action 11.4
Source: Photo courtesy of Rod Ramsey, http://www.flickr.com/photos/rdrcollection/2078536386/
Internal Performance Measures at General Electric
General Electric Company provides financial information for six segments in its annual report. Segments include Infrastructure, Commercial Finance, GE Money, Healthcare, NBC Universal, and Industrial. The company’s annual report indicates that “segment profit is determined based on internal performance measures used by the Chief Executive Officer to assess the performance of each business in a given period. Segment profit excludes or includes interest and other financial charges and segment income taxes according to how a particular segment’s management is measured.”
This statement reaffirms the point that companies tailor performance measures to meet the needs of each individual segment. For example, General Electric excludes interest and other financial charges in measuring segment net income for some segments, such as Healthcare, NBC Universal, and Industrial, while including interest and financial charges for other segments, such as Commercial Finance and GE Money.
Source: General Electric, “2006 Annual Report,” http://www.ge.com.
REVIEW PROBLEM 11.5
This is a continuation of Note 11.18 "Review Problem 11.3" for Kitchen Appliances. Recall that Kitchen Appliances has two divisions broken out by region—a Southern division and a Northern division. The following segmented income statement is for the most recent fiscal year ended December 31 (you were asked to prepare this income statement in Note 11.18 "Review Problem 11.3").
Segmented balance sheets for Kitchen Appliances appear as follows.
1. Calculate average operating assets for each division. (Hint: land held for sale is not an operating asset.)
2. Calculate ROI for each division.
3. What does the ROI tell you about each division at Kitchen Appliances?
Answer
(All dollar amounts are in thousands.)
Average operating assets are calculated in the following. Note that land held for sale is not an operating asset and thus must be deducted from total assets to find operating assets.
*\$9,600 = (\$9,400 ending balance + \$9,800 beginning balance) ÷ 2.
**\$41,600 = (\$40,600 ending balance + \$42,600 beginning balance) ÷ 2.
ROI is calculated as follows:
*Operating income is provided in the segmented income statement.
**Average operating assets is calculated in requirement 1.
^ROI = Operating income ÷ Average operating assets. For Southern division, 11.60 percent = \$1,114 ÷ \$9,600.
The Southern division of Kitchen Appliances has the highest ROI at 11.60 percent. The Northern division’s ROI is 7.90 percent. This measure indicates the Southern division is making more profitable use of its assets than the Northern division.
Further Analysis of ROI
Question: How does breaking ROI down into two separate measures help division managers improve their division’s ROI?
Answer
Many companies break ROI down into two ratios; operating profit margin and asset turnover. Each of these measures can be used to evaluate strengths and weaknesses of ROI within each division.
Key Equation
Operating profit margin is the ratio of operating income to sales. It provides information about how much operating profit is being produced for each dollar of sales. Asset turnover is the ratio of sales to average operating assets. It provides information about how much revenue each dollar invested in average operating assets produces.
These two ratios can be multiplied by each other to find the ROI as follows:
Key Equation
Breaking out ROI into these two ratios provides information that helps division managers identify areas for improvement. ROI can be improved by increasing the operating profit margin, which focuses solely on income statement information. ROI can also be improved by increasing asset turnover, which focuses on the division’s use of operating assets to produce sales.
Question: How are these ratios used to evaluate the three divisions at Game Products, Inc.?
Answer
Operating profit margin, asset turnover, and ROI calculations for Game Products, Inc., are shown in Figure 11.7. Notice the resulting ROI for each division is the same as the ROI shown in Figure 11.5 except for slight differences attributed to rounding.
Figure 11.7. Operating Profit Margin, Asset Turnover, and ROI for Game Products, Inc.
*From Figure 11.3.
**From Figure 11.5.
Figure 11.7 shows that Sporting Goods has the highest operating profit margin at 16.48 percent compared to Board Games (14.56 percent) and Computer Games (7.77 percent). However, Computer Games has the highest asset turnover at 0.87 compared to Sporting Goods (0.68) and Board Games (0.61).
This information helps each division manager identify strengths and weaknesses. For example, the Computer Games division has excellent asset turnover relative to other divisions, but has a very low profit margin. The manager of this division must look for ways to improve the profit margin for its products (e.g., increase prices, reduce operating expenses, or both).
Another example is the Sporting Goods division, which has an excellent profit margin, but relatively low asset turnover. The manager of this division must look at ways to improve the utilization of assets to increase turnover.
Key Takeaway
ROI is defined as operating income divided by average operating assets as shown in the following equation:
This measure provides an assessment of how effectively each division is using operating assets to produce operating income. ROI can also be broken into two separate ratios, operating profit margin and asset turnover, which are multiplied together to get ROI as follows:
Many variations of the ROI calculation are used in practice depending on the nature of the organization.
REVIEW PROBLEM 11.5
Use the information in Note 11.26 "Review Problem 11.4" for Kitchen Appliances to complete the following requirements.
1. Calculate the operating profit margin, asset turnover, and ROI.
2. Which division has the highest ROI? Explain how the two ratios—operating profit margin and asset turnover—influenced the ROI for each division.
Answer
(All dollar amounts are in thousands.)
*From Note 11.26 "Review Problem 11.4" data.
**From Note 11.26 "Review Problem 11.4" solutions, part 1.
^Due to rounding, ROI percent is slightly different than when computed in Note 11.26 "Review Problem 11.4".
The Southern division has the highest ROI (11.59 percent versus 7.88 percent at the Northern division), largely attributed to the high operating profit margin (22.28 percent versus 10.95 percent at the Northern division). However, the Southern division has the lowest asset turnover at 0.52 compared to 0.72 at the Northern division. The manager of the Northern division must look for ways to improve the profit margin for its products (e.g., increasing prices and/or reducing operating expenses). Conversely, the manager of the Southern division must look at ways to improve the utilization of assets to increase turnover. | textbooks/biz/Accounting/Managerial_Accounting/11%3A_How_Do_Managers_Evaluate_Performance_in_Decentralized_Organizations/11.05%3A_Using_Return_on_Investment_%28ROI%29_to_Evaluate_Performance.txt |
Learning Objectives
• Calculate and interpret residual income (RI) to evaluate performance.
Question: Although ROI is commonly used as a divisional performance measure, some division managers dislike this measure. Why do some division managers prefer not to use ROI as a performance measure?
Answer
Some managers dislike ROI because it can lead to decisions that benefit the division but hurt the organization as a whole. Division managers have an incentive to turn down investments that exceed the company’s minimum required rate of return but are below the division’s current ROI, mainly because ROI trends are often used to evaluate managers. For example, assume the manager of a division is evaluated based on ROI, and the division currently has an ROI of 20 percent:
The company’s minimum required rate of return is 10 percent, and the division manager is presented with an investment opportunity expected to yield an ROI of 15 percent. This investment totals \$70,000 and annual operating profit will be \$10,500 (15 percent ROI = \$10,500 ÷ \$70,000). Although this investment is well above the company’s minimum required rate of return, the division manager will likely not make the investment since the division’s overall ROI will decline from 20 percent to 17.9 percent:
If evaluated solely based on ROI, the division manager would prefer to invest only in projects that increase the division’s ROI above 20 percent. In fact, the division manager has an incentive to shed all investments yielding less than 20 percent, even if the investments are producing a return above the company’s minimum requirement of 10 percent. An alternative measure to ROI, called residual income (RI), helps to mitigate this apparent conflict.
Calculating RI
Question: What is RI, and how does it help to prevent the conflict associated with ROI?
Answer
RI is the dollar amount of division operating profit in excess of the division’s cost of acquiring capital to purchase operating assets. The calculation is as follows:
Key Equation
Rather than using a ratio to evaluate performance, RI uses a dollar amount. As long as an investment yields operating profit higher than the division’s cost of acquiring capital, managers evaluated with RI have an incentive to accept the investment. The manager’s goal is to increase RI from one period to the next.
Notice that operating income and average operating assets used here to calculate RI are the same measures used in the ROI calculation presented earlier. The one new item, percent cost of capital, is the company’s percentage cost to obtain investment funds (often called capital). For example, a company that raises funds by issuing bonds would use the interest rate associated with the bonds in establishing its percent cost of capital. We will always provide the percent cost of capital in this chapter, leaving detailed discussions of its calculation to more advanced courses. Note that several sources provide cost of capital information by industry. One source is the Leonard N. Stern School of Business at New York University (http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.htm).
Let’s take another look at the division that rejected an investment yielding an ROI higher than the company’s minimum required rate of return of 10 percent but lower than the division’s current ROI of 20 percent. Assume the company’s percent cost of capital is the same as its minimum required rate of return of 10 percent. Three RI calculations are provided as follows, (1) RI before the new investment, (2) RI from the new investment, and (3) RI after the new investment. (Note that some organizations make adjustments to the cost of capital to determine the minimum required rate of return. Throughout this chapter, assume percent cost of capital is the same as minimum required rate of return unless stated otherwise.)
Since the manager’s goal is to continually increase RI, the proposed investment would be accepted resulting in an increase of \$3,500 in RI (= \$13,500 − \$10,000). As shown in this example, using RI as a performance measure is an effective way to minimize the conflict between company goals and division goals that arise using ROI. Rather than maximizing ROI, division managers focus on increasing RI. Managers are more likely to accept investment proposals that have a return greater than the company’s minimum required rate of return, regardless of the impact on the division’s ROI.
Limitation of RI
Question: Although RI resolves some of the problems of using ROI as a performance measure, it does not provide an efficient means for comparing divisions. What is the problem with using RI to compare divisions?
Answer
Similar to the problem encountered with using segmented net income to compare divisions, RI is stated in dollars (or some other currency) rather than as a ratio. One division may have high RI simply because it has a larger asset base, which produces higher revenues. Thus division managers should be evaluated based on how effectively they increase RI from one period to the next, perhaps in percentage growth, and not on how their RI compares to other divisions.
Most organizations that use RI also use ROI. Using both measures has the benefit of comparing one division to another by using ROI and minimizes the conflict between company goals and division goals by using RI.
Computing RI at Game Products, Inc.
Answer
Figure 11.8 shows the RI calculation for each division at Game Products, Inc., assuming a cost of capital of 8 percent. Notice that Sporting Goods and Board Games have positive RI, which indicates both divisions are producing operating income above and beyond the minimum required rate of return. Since the Computer Games division has negative RI, this division is not producing enough operating income to achieve the minimum required rate of return.
Having positive RI is reasonable for Sporting Goods and Board Games since both divisions have an ROI above the 8 percent minimum required rate of return (as shown back in Figure 11.7). It is also reasonable that Computer Games has negative RI since the division’s ROI is less than 8 percent.
Figure 11.8. RI Calculations (Game Products, Inc.)
*From Figure 11.3.
**From Figure 11.5.
Key Takeaway
RI is the dollar amount of division operating profit in excess of the division’s cost of acquiring capital to purchase its operating assets. The calculation is as follows:
Operating income and average operating assets used to calculate ROI are also used here to calculate RI. The percent cost of capital is new and represents the company’s percentage cost to obtain investment funds. The goal is for each division manager to increase RI over time.
REVIEW PROBLEM \(1\)
This is a continuation of the Kitchen Appliances example presented in Note 11.18 "Review Problem 11.3", Note 11.26 "Review Problem 11.4", and Note 11.33 "Review Problem 11.5". Financial information for Kitchen Appliances is provided again as follows. Assume the cost of capital rate is 6 percent.
1. Calculate RI for each division.
2. How should this information be used to evaluate each division manager?
Answer
1. All dollar amounts are in thousands.
*From Note 11.26 "Review Problem 11.4" data.
**From Note 11.26 "Review Problem 11.4" solutions, part 1.
2. Although the Northern division has higher RI (\$790,000) than the Southern division (\$538,000), it is not enough to simply conclude that the Northern division manager is performing better than the Southern division manager. The goal for each manager is to continually increase RI over time. Thus Kitchen Appliances should compare RI for each division to prior periods and reward division managers for significant increases from one period to the next. | textbooks/biz/Accounting/Managerial_Accounting/11%3A_How_Do_Managers_Evaluate_Performance_in_Decentralized_Organizations/11.06%3A_Using_Residual_Income_%28RI%29_to_Evaluate_Performance.txt |
Learning Objectives
• Calculate and interpret economic value added (EVA) to evaluate performance.
Question: Another measure of performance similar to residual income (RI) is called economic value added. What is economic value added, and how is it used to evaluate divisions?
Answer
Economic value added (EVA) was created and trademarked by Stern Stewart & Company, a management consulting firm, and is defined as follows (additional information can be found at Stern Stewart & Company’s Web site: http://www.sternstewart.com).
Key Equation
Although the calculation is similar to RI, adjustments are made to the financial information to better reflect the economic results of the division. Stern Stewart & Company created EVA to provide financial information without the “anomalies” that result from following U.S. GAAP. One example of an anomaly is the expensing of research and development (R&D) costs even though R&D breakthroughs often benefit companies in future years.
There are two distinct differences in calculating EVA compared to RI. First, operating profit is calculated net of income taxes. Finding operating income after taxes simply requires deducting income taxes from operating income. Second, adjustments are made to operating income and average operating assets. Although more than 150 possible adjustments can be made, most firms limit adjustments to 15 or less.
Three examples of adjustments to be considered when using EVA are related to research and development (R&D), advertising, and noninterest bearing current liabilities.
Research and development. U.S. GAAP requires that R&D costs be expensed as incurred. However, R&D work typically benefits the company in future periods. EVA capitalizes R&D costs (that is, records these costs as a long-term asset) and amortizes these costs over the estimated useful life of R&D activities. Advertising. U.S. GAAP also requires that advertising costs be expensed as incurred. Since marketing efforts typically benefit the company in future periods, EVA capitalizes these costs and amortizes them over a period of time.
These three items are provided as examples of adjustments proposed by EVA advocates. However, the adjustments made depend on the organization since EVA calculations are modified to fit the needs of the organization.
• Noninterest bearing current liabilities. EVA requires deducting noninterest bearing current liabilities from average operating assets. This is because current liabilities that do not require an interest payment are a free source of capital. For example, a company purchasing large amounts of inventory (an asset) on account has a free source of capital, which is presented as a noninterest bearing current liability on the balance sheet.
These three items are provided as examples of adjustments proposed by EVA advocates. However, the adjustments made depend on the organization since EVA calculations are modified to fit the needs of the organization.
Computing EVA for Game Products, Inc.
Question: How is EVA calculated for the divisions at Game Products, Inc.?
Answer
Figure 11.9 provides the segmented income statements and segmented balance sheet information for each division. These amounts were used earlier in the chapter to calculate segmented net income, ROI, and RI. Notice that research and development costs are now shown as a separate line item on the income statement, and average balances are shown on the balance sheet rather than beginning and ending balances. (Average balances are simply beginning balances plus ending balances divided by two.)
To simplify our analysis, we make only two adjustments—one for research and development and one for noninterest bearing current liabilities. The management believes research and development activities benefit future periods and would like to capitalize R&D costs and amortize these costs over several years. In addition, all current liabilities are noninterest bearing liabilities and as such will be deducted from average operating assets.
The impact of these two adjustments that must be made to the financial information presented in Figure 11.9, described as follows, is shown in Figure 11.10.
Adjustment 1. On the balance sheet, capitalized R&D costs will increase average operating assets by the unamortized amount of \$400,000 for Sporting Goods, \$1,200,000 for Board Games, and \$2,400,000 for Computer Games. On the income statement, R&D expense for the year shown in Figure 11.9 is added back to operating income; R&D amortization expense for one year will be deducted as an expense. R&D amortization expense for the year is \$100,000 for Sporting Goods, \$300,000 for Board Games, and \$600,000 for Computer Games. (Note for the purposes of this chapter, amortization expense amounts will be given. Detailed calculations are left to more advanced cost accounting textbooks.)
Since net operating profit after taxes (NOPAT) is used in the EVA calculation, we must remember to calculate NOPAT after making the R&D adjustments. Also, assume this is the first year calculating EVA. Thus Game Products has decided not to make any adjustments related to previous years’ R&D expenditures.
Adjustment 2. All current liabilities are noninterest bearing and thus are deducted from average operating assets. (Recall that all assets are considered operating assets at Game Products, Inc.)
Figure 11.9. Income Statement and Balance Sheet Information (Game Products, Inc.)
Figure 11.10 shows the adjustments, and the resulting EVA calculation for each division. Assume the company’s cost of capital rate is 8 percent. This is the same rate that was used for calculating RI.
Figure 11.10. EVA Calculations (Game Products, Inc.)
*From Figure 11.9.
Question: How did each of the three divisions perform using EVA as the measure?
Answer
As shown at the bottom of Figure 11.10, all three divisions have positive EVA amounts, which indicates all three have NOPAT (adjusted) in excess of each division’s cost of investment funds (adjusted).
Recall from the example in Figure 11.8 that Computer Games was the only division with negative RI. This negative amount turns to a positive amount using EVA mainly because research and development costs are capitalized and amortized over future years rather than expensed as incurred. Because the Computer Games division had significant research and development costs, and these costs were backed out and recorded as an asset using EVA, NOPAT (adjusted) increased significantly. This caused the EVA amount for Computer Games to become positive.
Weaknesses with EVA
Question: While EVA is no doubt a popular method for evaluating investment centers, and companies as a whole, there are weaknesses in its approach. What are these weaknesses?
Answer
As stated earlier, EVA is similar to RI except adjustments are made to operating income and average operating assets to offset accounting anomalies created by U.S. GAAP. Critics of EVA argue that U.S. GAAP was established for a variety of reasons, one of which was to provide a set of reasonable and objective accounting rules to be followed when recording economic events. Modifying U.S. GAAP to calculate EVA strays from the objectivity provided by U.S. GAAP.
For example, U.S. GAAP requires R&D and advertising costs to be expensed in the period incurred because it is very difficult and subjective to estimate the future benefit these activities may provide. EVA adjustments described earlier for R&D and advertising costs depart from U.S. GAAP. EVA recommends that these costs be capitalized and amortized over the useful life of the activity. This leads to different interpretations of what the useful life should be. Managers now have an incentive to stretch useful lives out as far as possible to minimize amortization expense taken each period.
As with any performance measure, EVA has advantages and disadvantages. The key is to develop a measure that promotes behavior desired by top management and to provide consistency in evaluating managers.
Key Takeaway
EVA is simply an extension of RI. Adjustments are made to operating income and average operating assets. EVA is calculated as follows:
REVIEW PROBLEM \(1\)
This is a continuation of the Kitchen Appliances example used in previous review problems. Top management of Kitchen Appliances has decided to use EVA as a performance measure for its division managers. The cost of capital rate is 6 percent.
Assume management will make three adjustments to calculate EVA as follows:
• Adjustment 1. Marketing costs will be capitalized and amortized over several years. On the balance sheet, average operating assets will increase by the unamortized amount of \$70,000 for the Southern division and \$2,800,000 for the Northern division. On the income statement, marketing expense for the year will be added back to operating income; marketing amortization expense for one year will be deducted. Assume marketing amortization expense for the year is \$30,000 for the Southern division and \$1,200,000 for the Northern division. No adjustments will be made for previous years’ marketing expenditures.
• Adjustment 2. Land held for sale is not an operating asset and thus is deducted from average operating assets.
• Adjustment 3. All current liabilities are noninterest bearing and thus are deducted from average operating assets.
Segmented income statements and balance sheet average amounts are presented next.
1. Calculate EVA for each division.
2. What does the EVA show for each division?
Answer
1. The EVA calculation is as follows:
2.Both divisions have positive EVA amounts, indicating both have NOPAT (adjusted) above and beyond the cost of investment funds (adjusted). It is interesting to note that when compared to RI amounts calculated in Note 11.39 "Review Problem 11.6", EVA results in a significantly higher amount for the Northern division. This can be attributed to the large amount of marketing expenditures at the Northern division that were expensed using RI, but capitalized and amortized using EVA. Deferring significant amounts of marketing expenses to future years has the impact of increasing NOPAT in the year of the expenditure, thereby increasing EVA. | textbooks/biz/Accounting/Managerial_Accounting/11%3A_How_Do_Managers_Evaluate_Performance_in_Decentralized_Organizations/11.07%3A_Using_Economic_Value_Added_%28EVA%29_to_Evaluate_Performance.txt |
Question: At the meeting described at the beginning of the chapter between Mandy Dwyer (president and CEO) and Larry Meske (CFO), Mandy wanted to revise the compensation plan for the manager of the Board Games division to increase her bonus because profits had increased significantly compared to prior years. Larry suggested using measures other than segmented net income to evaluate each division and asked for time to gather additional information. What information did Larry gather, and how does this additional information help Mandy evaluate each division?
Answer
Larry assembled the information using the five methods of evaluating investment centers presented in this chapter: (1) segmented net income, (2) profit margin ratio, (3) return on investment (ROI), (4) residual income (RI), and (5) economic value added (EVA). These five measures have been calculated for each division of Game Products, Inc., and are summarized in Figure 11.11.
Figure 11.11. Five Performance Measures at Game Products, Inc.
Figure 11.12 shows a comparison of the three divisions for segmented income, RI, and economic value added. Figure 11.13 shows a comparison of the three divisions for the profit margin ratio and ROI.
Figure 11.12. Comparison of Income Performance Measures for Each Division at Game Products, Inc.
Figure 11.13. Comparison of Profit Margin Ratio and Return Investment for Each Division at Game Products, Inc.
When Mandy and Larry meet again a month later, Larry has the difficult task of explaining the information to Mandy and recommending a course of action.
Mandy (president and CEO): Larry, let’s begin where we left off at our last meeting. What do you have for me with regard to performance evaluation measures we might use for our division managers?
Larry (CFO): Here is a summary of five measures I think can be useful if used correctly (see Figure 11.11). As you suggested, Mandy, the starting point is segmented net income, which is shown on line one. The Board Games division has the highest net income and looks to be a strong performer in this regard.
Mandy: What is the ratio shown on line two?
Larry: This is the profit margin ratio. It is a much better measure to evaluate the profitability of each division relative to sales. This measure shows the Sporting Goods division produced the highest profit for each dollar in sales with a ratio of 11.53 percent. Board Games is second at 10.19 percent and Computer Games is last at 5.44 percent.
Mandy: I see. What about the use of assets? Each division is responsible for investments in assets and we would like to know how effective each division is in producing income with these assets. Is this where ROI comes in?
Larry: Yes. As shown on line three, the Sporting Goods division is making the best use of its operating assets with an ROI of 11.23 percent. Board Games is second at 8.93 percent, and Computer Games is last at 6.75 percent.
Mandy: So you’re telling me Sporting Goods is doing better than the other two divisions, even though Board Games has the highest net income?
Larry: Yes, Sporting Goods is the most effective at using assets to produce profit.
Mandy: What are the last two measures you show here?
Larry: Both of these last two measures also consider asset use in the calculation. As shown on line four, Sporting Goods had the best performance by producing \$947,000 in RI compared to \$516,000 at Board Games and \$(419,000) at Computer Games.
Mandy: Computer Games has negative RI?
Larry: Yes. However, you will notice that EVA shown on line five presents a different picture.
Mandy: Why?
Larry: Computer Games has high research and development costs each year—it’s the nature of the industry. U.S. GAAP requires these costs to be expensed when incurred. EVA suggests recording R&D costs as an asset and amortizing the costs over the useful life of R&D activities. Since Computer Games has much higher R&D costs than the other divisions, the numbers changed dramatically relative to the other divisions. Also, after-tax income is used rather than operating income, and average assets are adjusted as well.
Mandy: Seems as if there is an awful lot of subjectivity in using EVA.
Larry: Yes, there is. If we choose to use EVA as one of our measures, management must meet to discuss and agree upon the adjustments to be made.
Mandy: Larry, thanks for your analysis. I’m beginning to understand the importance of including asset use in our performance measures. Where do we go from here?
Larry: I like the first three measures—net income, profit margin ratio, and ROI. They are widely used in industry, and managers tend to understand the nature of these measures. The last two measures are also useful and should not be overlooked. My recommendation is to meet with the division managers to develop a comprehensive incentive compensation plan. The key is to develop a plan that motivates our managers to achieve company goals.
Mandy: I like the idea! Let’s meet next week. | textbooks/biz/Accounting/Managerial_Accounting/11%3A_How_Do_Managers_Evaluate_Performance_in_Decentralized_Organizations/11.08%3A_Wrap-Up_of_Game_Products_Inc..txt |
Learning Objectives
• Explain how transfer pricing can affect performance evaluation measures.
Question: Many companies have independent divisions that transfer goods or services from one division to another. If division managers are evaluated based only on division results using measures, such as segmented net income, profit margin ratio, or return on investment (ROI), conflicts can arise causing managers to take a course of action that benefits the division but hurts the company as a whole. For example, a division manager may decide to purchase raw materials from an outside supplier even though the same materials can be produced at a lower cost by another division within the company (the other division’s manager refuses to sell the materials at a reduced price because she is evaluated based on her division’s profits!). How should a company establish transfer pricing to avoid this kind of conflict?
Answer
The price used to value the transfer of goods or services between divisions within the same company is called a transfer price. Several different approaches can be used to establish transfer prices between divisions. The goal is to establish a transfer pricing policy that encourages managers to do what is in the best interest of the company while also doing what is in the best interest of the division manager (this is called goal congruence). Several common approaches are presented next.
Using the General Economic Transfer Pricing Rule
Question: How does the general economic transfer pricing rule help organizations to establish an appropriate transfer price?
Answer
The general economic transfer pricing rule attempts to establish guidelines for divisions to maximize overall company profit. This rule states the transfer price should be set at differential cost to the selling division (normally variable cost), plus the opportunity cost of making the sale internally (none if the seller has idle capacity or selling price minus differential cost if the seller is at capacity). This rule is summarized in “Key Equation: Economic Transfer Pricing Rule.”
Key Equation
Economic Transfer Pricing Rule
Let’s look at an example illustrating how to establish a reasonable transfer price using the economic transfer pricing rule. Umbrellas, Inc., has two divisions—Assembly and Marketing. In the past, all transfers of umbrellas from Assembly to Marketing were valued at the variable cost of \$6 each. However, the Assembly division manager would like to raise the price to \$9 per unit.
Which transfer price should be used to maximize company profit, \$6 or \$9? The answer depends on whether the selling division (Assembly) is below capacity or at capacity.
Transfer Pricing When Selling Division Is below Capacity
Question: Assume Assembly is below capacity. This means there is no opportunity cost of selling internally since no outside sales are forgone as a result of the transaction. What is the appropriate transfer price in this scenario?
Answer
Given this set of circumstances, the Assembly division should set the transfer price at its variable cost of \$6 per unit as shown in “Key Equation: Transfer Pricing When below Capacity (Umbrellas, Inc.).” This ensures Marketing does not purchase the umbrellas from another supplier at an amount greater than Umbrella, Inc.’s variable cost.
Key Equation
Transfer Pricing When below Capacity (Umbrellas, Inc.)
*This is the variable cost for Assembly to produce each umbrella.
**Opportunity cost is zero since no outside sales are forgone as a result of making this internal sale.
If Assembly sets the transfer price higher than \$6 per unit (\$9 for example), thereby violating the economic transfer pricing rule, the risk is that Marketing might find another company willing to provide the umbrellas for an amount less than \$9 and higher than \$6. If Marketing chooses to buy umbrellas from an outside supplier for \$7, for example, profit declines at Umbrella, Inc., because the company paid \$1 more than necessary for each umbrella (\$1 = \$7 outside supplier price − \$6 Umbrella, Inc.’s variable cost). Although Marketing looks better as an investment center buying from the outside for \$7 because the cost is \$2 less than the internal transfer price, the overall company is worse off because the \$7 cost is \$1 higher than if the umbrellas were produced internally.
Transfer Pricing When Selling Division Is at Capacity
Question: Now assume Assembly is at capacity. This creates an opportunity cost of selling internally, since outside sales must be forgone as a result of the transaction. What is the appropriate transfer price in this scenario?
Answer
Given this new set of circumstances for Umbrellas, Inc., the Assembly division should set the transfer price at its variable cost of \$6 per unit plus the opportunity cost of selling internally. Assume the Assembly division sells the umbrellas to outside customers for \$10 each. The opportunity cost of selling internally is \$4 (= \$10 market price − \$6 variable cost). Thus the transfer price that maximizes company profit is \$10 as shown in “Key Equation: Transfer Pricing When at Capacity (Umbrellas, Inc.).” Assembly is indifferent whether it sells internally for \$10 or to outside customers for \$10.
Key Equation
Transfer Pricing When at Capacity (Umbrellas, Inc.)
*This is the variable cost for Assembly to produce each umbrella.
**Opportunity cost is the revenue forgone of \$4 by selling internally. Revenue forgone of \$4 = \$10 market price – \$6 variable cost.
The economic transfer pricing rule works well when outside market prices are available (see Note 11.50 "Business in Action 11.5"). However, not all goods or services transferred from one division to another have a readily available outside market price. Thus other methods of establishing transfer pricing must be considered.
Business in Action 11.5
Transfer Pricing at General Electric
A review of the notes to General Electric’s annual report reveals the amount of “intersegment revenues” recorded for each of the company’s six segments. This is referring to revenue derived from transferring goods and services between divisions. The note also states that “sales from one component (segment) to another generally are priced at equivalent commercial selling prices.” It appears from this note that General Electric uses market price to establish transfer prices.
Source: General Electric, “2006 Annual Report,” http://www.ge.com.
Using Cost to Set Transfer Price
Question: Another approach to establishing a transfer price is to use the cost of the goods or services being transferred. How are these costs determined?
Answer
Transfer prices can be based on variable cost, full absorption cost, or cost-plus. Each approach is described next.
Variable Cost
Some companies simply use the selling division’s variable cost as the transfer price. However, the weakness in this approach is the selling division will not be able to mark up its products or services, and as a result, will not be able to generate a profit. This is not a problem for selling divisions treated as cost centers, but profit center and investment center managers will not be satisfied with such an approach.
Full Absorption Cost
Companies sometimes set the transfer price at the selling division’s full absorption cost. The selling division manager prefers to cover all costs rather than only variable costs, and using full-absorption cost accomplishes this goal. However, the company’s concern is the buying division might choose to purchase from an outside provider at a higher price than the differential cost plus opportunity cost but lower than the selling division’s full absorption cost. The result is a decision that does not maximize company profit.
Cost-Plus
Companies often add a markup to the selling division’s variable cost or full absorption cost to set the transfer price. This enables the selling division to earn a profit on internal transfers. Again, the risk is that the buying division might buy from an outside supplier at a higher price than differential cost plus opportunity cost, resulting in lower company profit.
Negotiating Transfer Prices
Question: If the general economic transfer pricing rule is not used, and the cost approach is not used, another alternative is to simply negotiate the transfer price. What are the potential weaknesses in negotiating a transfer price?
Answer
Investment center division managers are often expected to act independent of each other. In fact, many companies treat investment centers as separate businesses. To promote the autonomy of each division manager, companies often require the buying and selling divisions to negotiate a transfer price. This sounds reasonable in concept, but the same weakness exists here as with using costs to set a transfer price. The buying division may choose to purchase the goods or services from an outside supplier if negotiations break down, which may lead to a suboptimal decision for the company as a whole.
An additional weakness is the time required to negotiate a transfer price. Managers can spend significant amounts of time in negotiations when the time might be better spent more productively elsewhere in the division.
Choosing the Best Approach to Establish a Transfer Price
Question: Which transfer pricing approach is best?
Answer
There is no one “best” approach to establishing transfer prices. No two companies are identical, and the choice of a transfer pricing policy depends largely on the nature of the company. The most common approaches used in industry are presented in this appendix. The goal is to establish a transfer pricing policy that encourages managers to do what is in the best interest of the company while also serving the best interest of the division manager.
Key Takeaway
The price used to value the transfer of goods or services between divisions within the same company is called a transfer price. Although there are different approaches for establishing a transfer price, the general economic transfer pricing rule states the transfer price should be set at differential cost to the selling division (normally variable cost) plus the opportunity cost of making the sale internally (none if the seller has idle capacity or selling price minus variable cost if the seller is at capacity). The goal is to establish a transfer pricing policy that encourages managers to do what is in the best interest of the company while also doing what is in the best interest of the division manager.
REVIEW PROBLEM 11.9
Maine Products, LLP, has two divisions—Chocolate and Mint. The Chocolate division typically sells its chocolate to the Mint division for \$3 per pound, which covers variable costs. The Chocolate division sells to outside customers for \$5 per pound. Use the general economic transfer pricing rule to address the following requirements:
1. Calculate the optimal transfer price assuming the Chocolate division is below capacity.
2. Calculate the optimal transfer price assuming the Chocolate division is at capacity.
Answer
1. Because the Chocolate division is below capacity, no outside customer sales are forgone as a result of selling internally. Thus the opportunity cost of selling internally is zero. The optimal transfer price is \$3, calculated as follows:
*This is the variable cost per pound.
**Opportunity cost is zero since no outside sales are forgone as a result of selling internally.
2. Since the Chocolate division is at capacity, outside customer sales are forgone as a result of selling internally. Thus there is an opportunity cost of selling internally. The optimal transfer price is \$5, calculated as follows:
*This is the variable cost per pound.
**Opportunity cost is the revenue forgone of \$2 by selling internally (= \$5 market price − \$3 variable cost). | textbooks/biz/Accounting/Managerial_Accounting/11%3A_How_Do_Managers_Evaluate_Performance_in_Decentralized_Organizations/11.09%3A_Appendix-_Transfer_Prices_between_Divisions.txt |
Questions
1. What is meant by the term decentralized organization?
2. What are the advantages and disadvantages of decentralizing operations?
3. Refer to Note 11.3 "Business in Action 11.1" Why would a growing college, such as Sierra College, decentralize operations?
4. Refer to Note 11.4 "Business in Action 11.2" How did decentralization at Arthur Andersen contribute to the company’s downfall?
5. Describe the three types of responsibility centers presented in the chapter.
6. Describe at least three measures used to evaluate performance of investment center division managers.
7. What are the two weaknesses of using segmented net income to evaluate managers of investment centers? What performance measures would you use to overcome these weaknesses?
8. What is the primary advantage of using ROI rather than segmented net income or profit margin ratio to evaluate investment center managers?
9. Describe operating profit margin and asset turnover, and explain how each of these ratios can be used to help division managers improve ROI.
10. Describe the potential conflict that can occur between division manager goals and overall company goals when evaluating divisions using ROI.
11. Refer to Note 11.25 "Business in Action 11.4" How did General Electric modify net income to evaluate each segment?
12. Describe residual income (RI), and explain how RI can resolve the conflict between division manager goals and company goals often created by using ROI.
13. Explain the difference between RI and economic value added.
14. Refer to the Game Products, Inc., performance measures presented in Figure 11.11. Identify which measures you would recommend to the CEO of Game Products, and explain the reasoning behind your recommendation.
15. Appendix. Describe the general economic transfer pricing rule.
Brief Exercises
1. Evaluating Division Managers at Game Products, Inc. Refer to the dialogue at Game Products, Inc., presented at the beginning of the chapter. Why does the president want to give Carla Klesko, the Board Games division manager, a bonus? Does the CFO agree that Carla deserves a larger bonus than the other division managers? What performance measures would the CFO like to consider before awarding Carla a larger bonus?
2. Decentralizing Operations. Burton Electronics produces radios, computers, and navigation systems. Although all high level decisions are made at company headquarters by top management, rapid expansion and increasingly specialized products have caused the company to consider decentralizing into three divisions. Each division manager would be responsible for costs, revenues, and investments in assets.
Required:
1. How should the company classify each division, as a cost center, profit center, or investment center? Explain.
2. What are the potential advantages of decentralizing?
3. What are the potential disadvantages of decentralizing?
3. Responsibility Centers. Aviation Products, Inc., operates primarily in the United States and has several segments:
1. Accounting and finance: responsible for recording financial information and preparing financial reports.
2. Human resources: responsible for hiring employees and maintaining personnel records.
3. Retail stores: responsible for sales prices and all costs within each store.
4. Advertising: responsible for promotional materials.
5. Production: responsible for manufacturing company products.
6. International operations: acts as an independent segment responsible for all facets of the business outside of the United States.
Required:
For each of the preceding segments, identify whether it is a cost center, profit center, or investment center. Explain your answer.
4. Segmented Net Income. Franklin Bikes has two divisions—Road Bikes and Mountain Bikes. Using the segmented income statements presented in the following, determine the profit margin ratio for each division.
5. Return on Investment (ROI). The segmented income statements presented as follows are for the two divisions of Franklin Bikes. (This is the same company as the previous exercise. This exercise can be assigned independently.) Assume the Road Bikes division had average operating assets totaling \$4,500,000 for the year, and the Mountain Bikes division had average operating assets of \$800,000. Calculate ROI for each division.
6. Residual Income (RI). The segmented income statements presented as follows are for the two divisions of Franklin Bikes. (This is the same company as the previous exercises. This exercise can be assigned independently.) Assume the Road Bikes division had average operating assets totaling \$4,500,000 for the year, and the Mountain Bikes division had average operating assets of \$800,000. The company’s cost of capital rate is 8 percent. Calculate RI for each division.
7. Economic Value Added (EVA). Computer Tech Company has two divisions—Hardware and Software. Adjustments have already been made to net operating profit after taxes (NOPAT) and average operating assets for the purposes of calculating EVA for each division. This adjusted information is shown as follows. Assume the company’s cost of capital is 12 percent. Calculate EVA for each division.
Hardware Division Software Division
NOPAT—adjusted \$ 810,000 \$ 980,000
Average operating assets—adjusted 3,500,000 3,200,000
8. (Appendix). What is the primary goal for an organization establishing a transfer pricing policy?
Exercises: Set A
1. Segmented Net Income. Pool Accessories, Inc., has two divisions—Furniture and Supplies. The following segmented financial information is for the most recent fiscal year ended December 31.
Furniture Division Supplies Division
Sales \$3,000,000 \$1,000,000
Cost of goods sold 1,600,000 430,000
Allocated overhead 375,000 125,000
Selling and administrative expenses 250,000 200,000
Assume the tax rate is 30 percent.
Required:
1. Prepare a segmented income statement using the format presented in Figure 11.3. Include the profit margin ratio for each division at the bottom of the segmented income statement.
2. Using net income as the measure, which division is most profitable? Explain why this conclusion might be misleading.
3. What does the profit margin ratio tell us about each division? Why do organizations often use profit margin ratio to evaluate division performance rather than simply using net income?
2. ROI. Pool Accessories, Inc., has two divisions—Furniture and Supplies. (This is the same company as the previous exercise. This exercise can be assigned independently.) Segmented income statement information for the most recent fiscal year ended December 31 is shown as follows. Assume the Furniture division had average operating assets totaling \$6,500,000 for the year, and the Supplies division had average operating assets of \$1,750,000.
Required:
1. Calculate ROI for each division.
2. What does ROI tell us about each division? Indicate why this measure is useful in evaluating investment centers.
3. ROI Using Operating Profit Margin and Asset Turnover. Pool Accessories, Inc., has two divisions—Furniture and Supplies. (This is the same company as the previous exercises. This exercise can be assigned independently.) Segmented income statement information for the most recent fiscal year ended December 31 is shown as follows. Assume the Furniture division had average operating assets totaling \$6,500,000 for the year, and the Supplies division had average operating assets of \$1,750,000.
Required:
1. For each division, calculate operating profit margin, asset turnover, and resulting ROI.
2. Which division has the highest ROI? For the division that has the lowest ROI, what can be done to improve this ratio?
4. RI. Pool Accessories, Inc., has two divisions—Furniture and Supplies. (This is the same company as the previous exercises. This exercise can be assigned independently.) Segmented income statement information for the most recent fiscal year ended December 31 is shown as follows. Assume the Furniture division had average operating assets totaling \$6,500,000 for the year, and the Supplies division had average operating assets of \$1,750,000. Assume the cost of capital rate is 10 percent.
Required:
1. Calculate RI for each division.
2. What does RI tell us about each division?
5. Solving Unknowns for ROI. The following information is for two divisions at Kayak Company.
Lake Division Ocean Division
Sales ? \$900,000
Operating income ? \$108,000
Operating profit margin 8.0 percent ?
Average operating assets \$150,000 \$600,000
Asset turnover 1.7 ?
ROI ? ?
Required:
Find the missing information for each division.
6. EVA. Links Company produces golf clubs and other sporting goods accessories. The following information is for each division at Links for the most recent fiscal year.
To calculate EVA, the management requires adjustments for R&D and noninterest bearing current liabilities as outlined in the following.
Research and development will be capitalized and amortized over several years resulting in an increase to average operating assets of \$400,000 for the Golf division and \$650,000 for the Sporting Goods division. On the income statement, R&D expense for the year will be added back to operating income; then R&D amortization expense for one year will be deducted. The current year amortization expense will total \$100,000 for the Golf division and \$150,000 for the Sporting Goods division.
Noninterest bearing liabilities will be deducted from average operating assets.
Required:
Calculate EVA for each division and comment on your results.
7. (Appendix) Transfer Pricing. Creative Colors, Inc., a producer of paint, has two divisions—Paint division and Can division. Each division manager is evaluated based on profit produced by each division.
The Can division sells its cans to the Paint division for \$2 per case to cover variable costs. The Can division also sells to outside customers for \$3 per case.
Required:
1. Using the general economic transfer pricing rule, calculate the optimal transfer price assuming the Can division is below capacity.
2. Using the general economic transfer pricing rule, calculate the optimal transfer price assuming the Can division is at capacity. | textbooks/biz/Accounting/Managerial_Accounting/11%3A_How_Do_Managers_Evaluate_Performance_in_Decentralized_Organizations/11.E%3A_Exercises_%28part_1%29.txt |
1. Segmented Net Income. Photo Products, Inc., has three divisions—Digital, Film, and Video. The following segmented financial information is for the most recent fiscal year ended December 31.
Digital Division Film Division Video Division
Sales \$22,000,000 \$8,000,000 \$18,000,000
Cost of goods sold 10,000,000 2,000,000 7,000,000
Allocated overhead 4,125,000 1,500,000 3,375,000
Selling and administrative expenses 5,000,000 3,200,000 5,000,000
Assume the tax rate is 35 percent.
Required:
1. Prepare a segmented income statement using the format presented in Figure 11.3. Include the profit margin ratio for each division at the bottom of the segmented income statement.
2. Using net income as the measure, which division is most profitable? Explain why this conclusion might be misleading.
3. What does the profit margin ratio tell us about each division? Why do organizations often use profit margin ratio to evaluate division performance rather than simply using net income?
2. ROI. Photo Products, Inc., has three divisions—Digital, Film, and Video. (This is the same company as the previous exercise. This exercise can be assigned independently.) Segmented income statement information for the most recent fiscal year ended December 31 is shown as follows. Assume average operating assets totaled \$15,000,000 for the Digital division, \$6,500,000 for the Film division, and \$17,500,000 for the Video division.
Required:
1. Calculate ROI for each division.
2. What does ROI tell us about each division? Indicate why this measure is useful in evaluating investment centers.
3. ROI Using Operating Profit Margin and Asset Turnover. Photo Products, Inc., has three divisions—Digital, Film, and Video. (This is the same company as the previous exercises. This exercise can be assigned independently.) Segmented income statement information for the most recent fiscal year ended December 31 is shown as follows. Assume average operating assets totaled \$15,000,000 for the Digital division, \$6,500,000 for the Film division, and \$17,500,000 for the Video division.
Required:
1. For each division, calculate operating profit margin, asset turnover, and resulting ROI.
2. Which division has the highest ROI? For the division that has the lowest ROI, what can be done to improve this ratio?
4. RI. Photo Products, Inc., has three divisions—Digital, Film, and Video. (This is the same company as the previous exercises. This exercise can be assigned independently.) Segmented income statement information for the most recent fiscal year ended December 31 is shown as follows. Assume average operating assets totaled \$15,000,000 for the Digital division, \$6,500,000 for the Film division, and \$17,500,000 for the Video division. Assume the cost of capital rate is 16 percent.
Required:
1. Calculate RI for each division.
2. What does RI tell us about each division?
5. Solving Unknowns for ROI. The following information is for two divisions at Arrowhead, Inc.
North Division South Division
Sales \$1,200,000 \$400,000
Operating income \$ 132,000 \$ 40,000
Operating profit margin ? ?
Average operating assets \$1,000,000 ?
Asset turnover ? ?
ROI ? 8.0 percent
Required:
Find the missing information for each division.
6. EVA. Sailboats, Inc., sells sailboat parts and accessories and provides rigging services. The following information is for each division at Sailboats, Inc., for the most recent fiscal year.
To calculate EVA, management requires adjustments for marketing and noninterest bearing current liabilities as outlined in the following.
Marketing will be capitalized and amortized over several years resulting in an increase to average operating assets of \$100,000 for the Sales division and \$65,000 for the Services division. On the income statement, marketing expense for the year will be added back to operating income; marketing amortization expense for one year will be deducted. The current year amortization expense will total \$30,000 for the Sales division and \$15,000 for the Services division.
Noninterest bearing liabilities will be deducted from average operating assets.
Required:
Calculate EVA for each division and comment on your results.
7. (Appendix) Transfer Pricing. Gail’s Gardening has two divisions—Retail and Nursery. The Retail division sells plants and supplies. The Nursery division takes tree seedlings and grows them to healthy young plants before selling the trees internally to the Retail division and to outside customers. Each division manager is evaluated based on profit produced by each division.
The Nursery division sells its trees to the Retail division for \$4 per tree to cover its variable costs. The Nursery division also sells to outside customers for \$6 per tree.
Required:
1. Using the general economic transfer pricing rule, calculate the optimal transfer price assuming the Nursery division is below capacity.
2. Using the general economic transfer pricing rule, calculate the optimal transfer price assuming the Nursery division is at capacity.
Problems
1. Segmented Net Income, ROI, and RI. Custom Auto Company has two divisions—East and West. The following segmented financial information is for the most recent fiscal year:
East Division West Division
Sales \$2,000,000 \$4,000,000
Cost of goods sold 800,000 2,040,000
Allocated overhead 600,000 1,200,000
Selling and administrative expenses 360,000 380,000
The East division had average operating assets totaling \$1,800,000 for the year, and the West division had average operating assets of \$2,600,000. Assume the cost of capital rate is 8 percent, and the company’s tax rate is 30 percent. Division managers are responsible for sales, costs, and investments in assets.
Required:
1. What type of responsibility center is each division at Custom Auto Company? Explain.
2. Prepare a segmented income statement using the format presented in Figure 11.3. Include the profit margin ratio for each division at the bottom of the segmented income statement.
3. Calculate ROI for each division.
4. Calculate RI for each division.
5. Summarize the answers to parts a, b, and c using the format presented in Figure 11.11. What does this information tell us about each division?
2. Investment Decisions Using ROI and RI. (Note: the previous problem must be completed before working this problem.) Assume each division of Custom Auto Company is considering separate investment opportunities expected to yield a return of 10 percent, well above the company’s minimum required rate of return of 8 percent. Each investment opportunity will require \$1,000,000 in average operating assets and yield operating income of \$100,000.
Required:
1. Using the information presented in the previous problem, and the new investment proposal information presented previously, calculate each division’s overall ROI assuming the new investment is accepted.
2. Compare your results in part a to each division’s ROI prior to the new investment (calculated in the previous problem). Which division(s) will likely accept the proposal and which will likely reject the proposal using ROI as the measure? Explain.
3. Using the information presented in the previous problem, and the new investment proposal information presented previously, calculate each division’s overall RI assuming the new investment is accepted.
4. Compare your results in part c to each division’s RI prior to the new investment (calculated in the previous problem). Which division(s) will likely accept the proposal and which will likely reject the proposal using RI as the measure? Explain.
5. Assume the goal is to maximize company profit. Which measure do you think is best in deciding whether to accept a new investment proposal, ROI or RI? Explain.
3. Segmented Net Income, ROI, and RI; Making Investment Decisions. Quality Cycles, Inc., has two divisions—Cruisers and Racers. The following segmented financial information is for the most recent fiscal year:
Cruisers Division Racers Division
Sales \$6,000,000 \$10,000,000
Cost of goods sold 2,500,000 4,000,000
Allocated overhead 375,000 625,000
Selling and administrative expenses 2,100,000 3,950,000
The Cruisers division had average operating assets totaling \$5,700,000 for the year, and the Racers division had average operating assets of \$9,600,000. Assume the cost of capital rate is 10 percent, and the company’s tax rate is 30 percent.
Required:
1. Prepare a segmented income statement using the format presented in Figure 11.3. Include the profit margin ratio for each division at the bottom of the segmented income statement.
2. Calculate ROI for each division.
3. Calculate RI for each division.
4. Summarize the answers to parts a, b, and c using the format presented in Figure 11.11. What does this information tell us about each division?
5. Assume each division of Quality Cycles, Inc., is considering separate investment opportunities expected to yield a return of 16 percent, well above the company’s minimum required rate of return of 10 percent. Each investment opportunity will require \$4,000,000 in average operating assets and yield operating income of \$640,000.
1. Using the information presented at the beginning of this problem, and the new investment proposal information presented previously, calculate each division’s overall ROI assuming the new investment is accepted.
2. Compare your results in requirement e.1 to each division’s ROI prior to the new investment (calculated in requirement b). Which division(s) will likely accept the proposal and which will likely reject the proposal using ROI as the measure? Explain.
3. Using the information presented at the beginning of this problem, and the new investment proposal information presented previously, calculate each division’s overall RI assuming the new investment is accepted.
4. Compare your results in requirement e.3 to each division’s RI prior to the new investment (calculated in requirement c). Which division(s) will likely accept the proposal and which will likely reject the proposal using RI as the measure? Explain.
5. Assume the goal is to maximize company profit. Which measure do you think is best in deciding whether to accept a new investment proposal, ROI or RI? Explain.
4. Operating Profit Margin, Asset Turnover, and ROI. Financial information for Computer Systems, Inc., for the most recent fiscal year appears as follows. All dollar amounts are in thousands.
Required:
1. Calculate average operating assets for each division. (Hint: land held for sale is not an operating asset.)
2. Calculate operating profit margin, asset turnover, and ROI for each division.
3. What does this information tell us about each division?
5. Operating Profit Margin, Asset Turnover, ROI, and RI. Financial information for Web Design, LLP, for the most recent fiscal year appears as follows. All dollar amounts are in thousands.
Required:
1. Calculate average operating assets for each division. (Hint: land held for sale and investments in Global, Inc., are not operating assets.)
2. Calculate operating profit margin, asset turnover, and ROI for each division.
3. Calculate RI for each division assuming a cost of capital rate of 12 percent.
4. What does the information from requirements b and c tell us about each division?
6. EVA. Conner, Inc., produces brass and woodwind music instruments. The following information is for each division at Conner for the most recent fiscal year.
To calculate EVA, management requires adjustments for R&D expenses, marketing expenses, and noninterest bearing current liabilities as outlined in the following.
Research and development will be capitalized and amortized over several years resulting in an increase to average operating assets of \$40,000 for the Brass division and \$80,000 for the Woodwind division. On the income statement, R&D expenses for the year will be added back to operating income; R&D amortization expense for one year will be deducted. The current year amortization expense will total \$20,000 for the Brass division and \$30,000 for the Woodwind division.
Marketing will be capitalized and amortized over several years resulting in an increase to average operating assets of \$30,000 for the Brass division and \$38,000 for the Woodwind division. On the income statement, marketing expenses for the year will be added back to operating income; marketing amortization expense for one year will be deducted. The current year amortization expense will total \$10,000 for the Brass division and \$12,000 for the Woodwind division.
Noninterest bearing current liabilities will be deducted from average operating assets.
Required:
1. Calculate EVA for each division. What do the results show us for each division?
2. Why does EVA typically require adjustments to operating income and average operating assets?
7. (Appendix) Transfer Pricing, Service Company. Kathy Kraven is the CEO and president of Legal Solutions, Inc. She oversees the company’s two divisions—Human Resources and Litigation. The Human Resources division provides legal services to personnel departments at various clients who need help creating personnel policies and manuals. The Litigation division provides legal services to support clients in litigation. Litigation often asks for help from Human Resources when faced with issues surrounding personnel policies but also has the option of seeking help outside the firm. Currently, Human Resources is below capacity and uses variable cost as its price for providing services to Litigation.
Since each division is evaluated by how much profit it generates, Human Resources would like to increase the price charged to Litigation. Litigation is steadfast against any such change. Kathy Kraven has stepped in and established the following policy: effective immediately, Human Resources will charge Litigation variable costs plus 20 percent for any services rendered internally.
Required:
1. Why is the Human Resources division manager concerned about the price it charges to Litigation?
2. Why is the Litigation division manager concerned about an increase in price charged by the Human Resources division?
3. Do you think Kathy’s plan is effective? Explain.
4. What other options are available for establishing transfer pricing?
8. (Appendix) Transfer Pricing, Retail Company. Fred’s Fishing Supplies has two divisions, Lake and Deep Sea. Each division manager is evaluated based on profit produced by each division. The Lake division often sells a certain graphite fishing rod internally to the Deep Sea division for \$50 per rod to cover variable costs. The Lake division also sells the same graphite rod to outside customers for \$60 per rod. The Deep Sea division manager has the option of purchasing a similar rod from an outside supplier for \$56.
Required:
1. Using the general economic transfer pricing rule, calculate the optimal transfer price assuming the Lake division is below capacity.
2. Using the general economic transfer pricing rule, calculate the optimal transfer price assuming the Lake division is at capacity.
3. The company’s CEO recently established the following policy: all internal transfers will be made at variable cost plus 20 percent. Assume the Lake division is operating below capacity. As the Deep Sea division manager, what would you do: purchase internally or purchase from an outside supplier? Why? How will your decision impact overall company profit?
One Step Further: Skill-Building Cases
1. Segments at Hewlett-Packard. Refer to Note 11.12 "Business in Action 11.3" Why do you think Hewlett-Packard separates its operations into seven segments?
2. Transfer Pricing at General Electric (Appendix). Refer to Note 11.50 "Business in Action 11.5" How does General Electric establish transfer prices? What does this approach imply with regards to the products and services being provided?
3. Group Activity—Decentralizing Operations. Each of the following scenarios is being considered at two separate companies.
1. Walker Wood Products manufactures custom garage doors and custom furniture. The company recently experienced significant growth and top management would like to separate the company into two divisions—Garage and Furniture.
2. Iron Manufacturing produces iron fencing for residential and commercial properties. The company recently experienced significant growth and top management would like to separate the company into two divisions—Residential and Commercial.
Required:
Form groups of two to four students. Each group is to perform the following requirements for the scenario assigned:
1. Identify the potential advantages and disadvantages of decentralizing into two divisions and allowing the manager of each division to have complete control over operations.
2. Discuss the findings of your group with the class.
4. Internet Project—Economic Value Added. Stern Stewart & Company is a global consulting firm that pioneered the development of the EVA concept. Go to the Stern Stewart & Company Web site at http://www.sternstewart.com. Review the information provided at this Web site and write a one-page report summarizing the information you found to be most interesting. Also submit a printed copy of the information from the Web site with your report.
5. Creating a Segmented Income Statement Using Excel. Pool Accessories, Inc., has two divisions—Furniture and Supplies. The following segmented financial information is for the most recent fiscal year ended December 31.
Furniture Division Supplies Division
Sales \$3,000,000 \$1,000,000
Cost of goods sold 1,600,000 430,000
Allocated overhead 375,000 125,000
Selling and administrative expenses 250,000 200,000
Assume the tax rate is 30 percent.
Required:
1. Prepare an Excel spreadsheet similar to Figure 11.3 showing Pool Accessories’ segmented income statement and profit margin ratio for each division.
Comprehensive Case
1. Ethics and ROI. Computer chip makers incur significant costs for research and development. Some research and development projects result in technologies used in new computer chips. Other research and development projects do not result in a useable technology. Because of the unpredictable nature of R&D activities, U.S. GAAP require that R&D costs be expensed in the period incurred.
Integrated Circuits, Inc. (ICI), produces computer chips and invests heavily in R&D. The firm has been struggling in recent years, and as a result, the board of directors hired a new top management group with the clear purpose of improving profitability. The board proposed a compensation package providing top managers with an annual bonus if the company’s operating income this coming year (year 2) increases 10 percent compared to year 1 and ROI remains above the 11 percent level achieved in year 1.
The new top management group is willing to accept this proposal, but only if costs related to successful R&D activities are capitalized and amortized over five years for internal reporting purposes. Their argument is most R&D activities benefit future years, and U.S. GAAP unfairly requires all R&D costs to be expensed in the period incurred, regardless of whether the activities are successful. This treatment by U.S. GAAP provides a disincentive for managers to invest in R&D projects that are vital to the company’s future survival. The board of directors agrees with this assertion and grants the new management group their request to capitalize costs for successful R&D activities over five years.
One year has passed with the new management group in place, and their financial results are presented as follows (for year two), along with last year’s information (year one). The entire \$10,000,000 spent on R&D in year 2 was for unsuccessful projects since management decided to go a different direction with the company’s technology at the end of year 2. Nevertheless, top management capitalized the entire \$10,000,000 and amortized these costs over 5 years as reflected in the year 2 financial results. (Note: of this amount, \$2,000,000 is included in depreciation and amortization expense for year 2, and \$8,000,000 is included in average operating assets for year 2.)
Required:
1. Based on the financial data presented, calculate ROI for each year and the percent change in operating income from year 1 to year 2. Does the new management group qualify for the bonus?
2. Prepare revised financial information in the same format as presented previously assuming none of the \$10,000,000 in year 2 R&D costs are capitalized and amortized. (Hint: Amounts for year 1 will remain the same. Income statement and balance sheet amounts for year 2 will change.) Calculate the revised ROI for year two, and the revised percent change in operating income from year one to year two. Based on your results, would the new management group qualify for the bonus?
3. Is the new management group’s treatment of R&D costs for year 2 ethical?
4. How should the board of directors respond to the new management group’s assertion that \$10,000,000 in R&D costs should be capitalized in year 2?
2. Performance Evaluation Methods. Casey Fashions, Inc., sells clothing throughout North America. The company’s compensation committee, made up of five members from the board of directors, is meeting to discuss the CEO’s contract, which expires next month. The committee is currently reviewing financial information for the three most recent fiscal years: year 3 (most recent), year 2, and year 1 (shown as follows).
The income statement indicates sales increased 30 percent from year 1 to year 2 and 35 percent from year 2 to year 3. Net income increased 14 percent from year 1 to year 2, and 18 percent from year 2 to year 3. One member on the committee, Chris Carson, would like to offer the CEO a multiyear extension with a significant bump in salary and thousands of shares of stock options. When questioned why, Chris pointed to the positive results reflected on the income statement.
Another committee member, Mary Nichols, agrees with Chris that income statement trends look great, but she would like to review other measures of performance as well. Mary has asked you to come up with two measures of performance that go beyond simply looking at the income statement.
Required:
1. Calculate ROI for each of the three years. Note that balance sheet amounts presented for each year are already average balances (i.e., no need to calculate average balances). Assume land held for sale is not an operating asset.
2. Calculate RI for each of the 3 years assuming the company’s cost of capital rate is 12 percent.
3. Prepare a written report to the compensation committee summarizing and explaining your findings in part a and b. | textbooks/biz/Accounting/Managerial_Accounting/11%3A_How_Do_Managers_Evaluate_Performance_in_Decentralized_Organizations/11.E%3A_Exercises_%28part_2%29.txt |
How Is the Statement of Cash Flows Prepared and Used?
John Huston, CEO and founder of Home Store, Inc., has reviewed the company’s income statement and balance sheet for the most recent fiscal year ended December 31, 2012. Home Store has grown rapidly this past year, with sales and net income showing significant gains compared to 2011. Although John is satisfied with the increase in profitability, he notices a significant decline in cash. John decides to pursue this with Linda Nash (CFO) and Steve Bauer (treasurer) in their weekly meeting:
John: I just received the income statement and balance sheet for 2012. Profits look great, but our cash position seems to have deteriorated. We had \$130,000 in cash to start the year and ended with only \$32,000. I noticed cash was declining throughout the year when I reviewed our monthly financial statements, but I’m concerned about how far our cash balance has dropped.
Steve: You’re right, John. We encountered cash flow problems several times throughout the year in spite of increased sales and profits. On several occasions, I had to delay payments to creditors because of cash flow issues.
John: Seems to me we shouldn’t have this problem. Where is our cash going?
Linda: Good question. Let me round up our cash flow information for the year. I’ll have something for you by next week.
John: Great! I’d like to start next week’s meeting by discussing how much cash we generated in 2012 from our daily operations. I realize net income is shown on an accrual basis, but I’d like to know how much net income was received in the form of cash.
Linda: No problem. I’ll have it for you next week.
Home Store, Inc., has cash flow problems that are common to many fast growing companies. Although the income statement and balance sheet provide important information concerning financial performance and financial condition, neither statement provides information regarding cash activity for a period of time. The focus of this chapter is on preparing a statement that provides cash flow information. This statement is appropriately called the statement of cash flows.
12.02: Purpose of the Statement of Cash Flows
Learning Objectives
• Define the purpose of the statement of cash flows.
Question: Most organizations prepare four financial statements for external reporting purposes: income statement, balance sheet, statement of owners’ equity, and statement of cash flows. Financial accounting courses cover the first three statements in detail and often provide an overview of the statement of cash flows. This chapter will focus on preparing the statement of cash flows and on using the resulting cash flow information for analytical purposes. What information is provided in the statement of cash flows?
Answer
The statement of cash flows provides cash receipt and cash payment information and reconciles the change in cash for a period of time. Cash receipts and cash payments are summarized and categorized as operating, investing, or financing activities. Simply put, the statement of cash flows indicates where cash came from and where cash went for a period of time.
Assume you keep track of your individual cash transactions for an entire year in a check register (e.g., checks written and paycheck deposits) and suppose you have hundreds of transactions for the year. Rather than showing every single transaction in a formal report, the statement of cash flows summarizes these transactions. For example, all cash receipts from paychecks are added together and shown as one line item, all cash payments for rent are added together and shown as one line item, all cash payments for food are added together and shown as one line item, and so on. The goal is to start with the beginning of the year cash balance, add all cash receipts for the year, subtract all cash payments for the year, and find the resulting end-of-year cash balance. Although the formal statement of cash flows is not quite this simple, the concept is the same.
Question: Why did the Financial Accounting Standards Board (FASB) create the statement of cash flows in 1987?
Answer
The statement of cash flows was created due to a lack of cash flow information on the income statement, balance sheet, and statement of owners’ equity. The income statement shows revenues and expenses using the accrual basis of accounting, but it does not indicate how much cash was received for revenues or paid for expenses. The balance sheet shows assets, liabilities, and owners’ equity at a point in time, but it does not show how much cash was received or paid for these items. The only cash information provided on these statements is the change in cash from the end of last period to the end of the current period derived from the cash line item on the balance sheet (often called cash and cash equivalents).
Owners, creditors, and managers wanted more cash flow information. They often asked such questions as: Why did cash go down? How much cash was received related to net income? How much cash was paid for the purchase of equipment? How much cash was received from issuing bonds? As a result of the demand for more cash flow information, the FASB formally created the statement of cash flows in 1987 (Statement of Financial Accounting Standard No. 95, which can be found at http://www.fasb.org). Most companies are now required to prepare the statement of cash flows along with the other three statements. We begin the process of explaining how to prepare this statement in the next section.
Note: Business in Action 12.1
Cash Flows at Southwest Airlines
Southwest Airlines was in the enviable position of generating \$1,600,000,000 in cash from operating activities for the year ended December 31, 2010. However, cash on the balance sheet only increased \$147,000,000 for the same period. Why did total cash go up by such a small amount compared to the \$1,600,000,000 increase in cash from operating activities? The statement of cash flows provides the information necessary to answer this question. Southwest spent \$493,000,000 on property and equipment (planes, parts, etc.) and \$155,000,000 to pay off long-term debt. Southwest also purchased \$772,000,000 in short-term investments.
Key Takeaway
The statement of cash flows provides cash receipt and cash payment information and reconciles the change in cash for a period of time. The primary purpose of the statement is to show what caused the change in cash from the beginning of the period to the end of the period.
REVIEW PROBLEM 12.2
1. Describe the purpose of the statement of cash flows.
2. Why did the FASB create the statement of cash flows?
Answer
1. The purpose of the statement of cash flows is to provide a summary of cash receipt and cash payment information for a period of time and to reconcile the difference between beginning and ending cash balances shown on the balance sheet. The statement of cash flows clarifies how cash was generated and how cash was used for a period of time.
2. The FASB created the statement of cash flows because owners, creditors, managers, and other stakeholders wanted more information regarding cash receipts and cash expenditures. Although the balance sheet shows cash balances at the end of each period, no further information is provided on the balance sheet, income statement, or statement of owners’ equity regarding cash flow activities. The statement of cash flows takes care of this problem. | textbooks/biz/Accounting/Managerial_Accounting/12%3A_How_Is_the_Statement_of_Cash_Flows_Prepared_and_Used/12.01%3A_Introduction.txt |
Learning Objectives
• Describe the three categories of cash flows.
Question: What are the three types of cash flows presented on the statement of cash flows?
Answer
Cash flows are classified as operating, investing, or financing activities on the statement of cash flows, depending on the nature of the transaction. Each of these three classifications is defined as follows.
Operating activities include cash activities related to net income. For example, cash generated from the sale of goods (revenue) and cash paid for merchandise (expense) are operating activities because revenues and expenses are included in net income. Investing activities include cash activities related to noncurrent assets. Noncurrent assets include (1) long-term investments; (2) property, plant, and equipment; and (3) the principal amount of loans made to other entities. For example, cash generated from the sale of land and cash paid for an investment in another company are included in this category. (Note that interest received from loans is included in operating activities.) Financing activities include cash activities related to noncurrent liabilities and owners’ equity. Noncurrent liabilities and owners’ equity items include (1) the principal amount of long-term debt, (2) stock sales and repurchases, and (3) dividend payments. (Note that interest paid on long-term debt is included in operating activities.)
Figure 12.1 shows examples of cash flow activities that generate cash or require cash outflows within a period. Figure 12.2 presents a more comprehensive list of examples of items typically included in operating, investing, and financing sections of the statement of cash flows.
Figure 12.2 Examples of Cash Flow Activity by Category
*Receipts of cash for dividends from investments and for interest on loans made to other entities are included in operating activities since both items relate to net income. Likewise, payments of cash for interest on loans with a bank or on bonds issued are also included in operating activities because these items also relate to net income.
Question: Which section of the statement of cash flows is regarded by most financial experts to be most important?
Answer
The operating activities section of the statement of cash flows is generally regarded as the most important section since it provides cash flow information related to the daily operations of the business. This section answers the question, “how much cash did we generate from the daily activities of our core business?” Owners, creditors, and managers are most interested in cash flow generated from daily activities rather than from a one-time issuance of stock or a one-time sale of land. The operating activities section allows stakeholders to assess the ongoing viability of the company. We discuss how to use cash flow information to evaluate organizations later in the chapter.
Note: Business in Action 12.2
Cash Activity at Home Depot and Lowe’s
The Home Depot. Inc., and Lowe’s Companies, Inc., are large home improvement retail companies with stores throughout North America. A review of the statements of cash flows for both companies reveals the following cash activity. Positive amounts are cash inflows, and negative amounts are cash outflows.
Amounts are in millions.
This information shows both companies generated significant amounts of cash from daily operating activities; \$4,600,000,000 for The Home Depot and \$3,900,000,000 for Lowe’s. It is interesting to note both companies spent significant amounts of cash to acquire property and equipment and long-term investments as reflected in the negative investing activities amounts. For both companies, a significant amount of cash outflows from financing activities were for the repurchase of common stock. Apparently, both companies chose to return cash to owners by repurchasing stock.
Key Takeaway
The three categories of cash flows are operating activities, investing activities, and financing activities. Operating activities include cash activities related to net income. Investing activities include cash activities related to noncurrent assets. Financing activities include cash activities related to noncurrent liabilities and owners’ equity.
REVIEW PROBLEM 12.2
Identify whether each of the following items would appear in the operating, investing, or financing activities section of the statement of cash flows. Explain your answer for each item.
1. Cash payments for purchases of merchandise
2. Cash receipts from sale of common stock
3. Cash payments for equipment
4. Cash receipts from sales of goods
5. Cash dividends paid to shareholders
6. Cash payments to employees
7. Cash payments to lenders for interest on loans
8. Cash receipts from collection of principal for loans made to other entities
9. Cash receipts from issuance of bonds
10. Cash receipts from collection of interest on loans made to other entities
Answer
1. It would appear as operating activity because merchandise activity impacts net income as an expense (merchandise costs ultimately flow through cost of goods sold on the income statement).
2. It would appear as financing activity because sale of common stock impacts owners’ equity.
3. It would appear as investing activity because purchase of equipment impacts noncurrent assets.
4. It would appear as operating activity because sales activity impacts net income as revenue.
5. It would appear as financing activity because dividend payments impact owners’ equity.
6. It would appear as operating activity because employee payroll activity impacts net income as an expense.
7. It would appear as operating activity because interest payments impact net income as an expense.
8. It would appear as investing activity because principal collections impact noncurrent assets.
9. It would appear as financing activity because bond issuance activity impacts noncurrent liabilities.
10. It would appear as operating activity because interest received impacts net income as revenue. | textbooks/biz/Accounting/Managerial_Accounting/12%3A_How_Is_the_Statement_of_Cash_Flows_Prepared_and_Used/12.03%3A_Three_Types_of_Cash_Flow_Activities.txt |
Learning Objectives
• Describe the four steps used to prepare the statement of cash flows.
Question: Recall from your financial accounting course that the accrual basis of accounting recognizes revenue when earned and expenses when incurred, regardless of when cash is exchanged. Conversely, the cash basis of accounting recognizes revenue when cash is received and expenses when cash is paid, regardless of when goods or services are exchanged. The income statement, balance sheet, and statement of owners’ equity are all created using the accrual basis of accounting. However, the statement of cash flows is based on cash flows only, and thus adjustments must be made to convert accrual basis information to a cash basis. What information is necessary to make these adjustments?
Answer
Several pieces of information are required to make these adjustments in preparing the statement of cash flows:
• Balance sheets for the end of last year and end of the current year are needed to calculate the amount of change in each balance sheet account. These changes in balance sheet accounts are needed to prepare certain parts of the statement of cash flows.
• Income statement information for the current year is needed as the starting point for converting net income from an accrual basis to a cash basis, which is shown in the operating activities section of the statement of cash flows.
• Other information is needed to complete the statement of cash flows, such as cash dividends paid and the original cost of long-term investments sold.
Question: With this information in hand, four steps are required to prepare the statement of cash flows. What are these four steps?
Answer
The four steps required to prepare the statement of cash flows are described as follows:
Step 1. Prepare the operating activities section by converting net income from an accrual basis to a cash basis.
This step can be done using one of two methods—the direct method or the indirect method. Because more than 98 percent of companies surveyed use the indirect method (see Note 12.15 "Business in Action 12.3"), we will use the indirect method throughout this chapter. The appendix describes the direct method.
The indirect method begins with net income from the income statement and makes several adjustments related to changes in current assets, current liabilities, and other items to arrive at cash provided by operating activities (or used by operating activities if the result is a cash outflow). Cash provided by operating activities represents net income on a cash basis. It tells the reader how much cash was received from the daily operations of the business.
Step 2. Prepare the investing activities section by presenting cash activity for noncurrent assets.
This step focuses on the effect changes in noncurrent assets have on cash. Noncurrent asset balances found on the balance sheet, coupled with other information (e.g., cash proceeds from sale of equipment) are used to perform this step.
Step 3. Prepare the financing activities section by presenting cash activity for noncurrent liabilities and owners’ equity.
This step focuses on the effect changes in noncurrent liabilities and owners’ equity have on cash. Noncurrent liabilities and owners’ equity balances found on the balance sheet, coupled with other information (e.g., cash dividends paid) are used to perform this step.
Step 4. Reconcile the change in cash.
Each section of the statement of cash flows described in steps 1, 2, and 3, will show the total cash provided by (increase) or used by (decrease) the activity. Step 4 simply confirms that the net of these changes equates to the change in cash on the balance sheet.
For example, assume the balance sheet shows cash totaled \$100 at the end of last year and \$140 at the end of the current year. Thus cash increased \$40 over the course of the current year. Step 4 reconciles this change with the changes shown in the three sections of the statement of cash flows. Suppose operating activities provided cash of \$170, investing activities used cash of \$160, and financing activities provided cash of \$30. These 3 amounts netted together reconcile to the \$40 increase in cash shown on the balance sheet (= \$170 − \$160 + \$30).
Note: Business in Action 12.4
Indirect Method Is Most Popular
Most companies prefer to use the indirect method to prepare the operating activities section of the statement of cash flows. A survey taken in 2001 showed more than 98 percent of the 600 companies surveyed used the indirect method. Reasons for this preference vary, but several possibilities are as follows:
• The indirect method links net income to cash flows from operating activities by reconciling the two amounts.
• Accounting systems do not easily generate information needed to use the direct method.
• Those using the direct method are also required to provide a supplemental schedule using the indirect method. It is less costly to simply prepare the statement using the indirect method.
Key Takeaway
• The four steps required to prepare the statement of cash flows are described as follows:
Step 1. Prepare the operating activities section by converting net income from an accrual basis to a cash basis.
Step 2. Prepare the investing activities section by presenting cash activities for noncurrent assets.
Step 3. Prepare the financing activities section by presenting cash activities for noncurrent liabilities and owners’ equity.
Step 4. Reconcile the change in cash from the beginning of the period to the end of the period.
REVIEW PROBLEM 12.3
Describe the four steps necessary to prepare the statement of cash flows.
Answer
The four steps required to prepare the statement of cash flows are as follows:
Step 1. Prepare the operating activities section by converting net income from an accrual basis to a cash basis.
This step starts with net income on an accrual basis (from the income statement) and makes adjustments related to changes in current assets, current liabilities, and other items to find net income on a cash basis. The resulting cash basis net income is called cash provided by operating activities.
Step 2. Prepare the investing activities section by presenting cash activity for noncurrent assets.
This step focuses on the effect changes in noncurrent assets have on cash.
Step 3. Prepare the financing activities section by presenting cash activity for noncurrent liabilities and owners’ equity.
This step focuses on the effect changes in noncurrent liabilities and owners’ equity have on cash.
Step 4. Reconcile the change in cash.
Each section of the statement of cash flows described in steps 1, 2, and 3 will show the total cash provided by or used by each activity. Step 4 confirms that the net of these changes equates to the change in cash derived from the balance sheet. | textbooks/biz/Accounting/Managerial_Accounting/12%3A_How_Is_the_Statement_of_Cash_Flows_Prepared_and_Used/12.04%3A_Four_Key_Steps_to_Preparing_the_Statement_of_Cash_Flows.txt |
LEARNING OBJECTIVE
1. Prepare a statement of cash flows using the indirect method.
Question: Now that you are familiar with the four key steps, let’s take a look at the statement of cash flows for Home Store, Inc. Where do we start in preparing Home Store, Inc.’s statement of cash flows?
Answer: As stated earlier, the information needed to prepare the statement of cash flows includes the balance sheet, income statement, and other selected data. This information is presented in Figure 12.3. Other pertinent data for 2012 are as follows:
• Sold equipment with a book value of \$11,000 (= \$21,000 cost − \$10,000 accumulated depreciation) for \$5,000 cash
• Purchased equipment for \$67,000 cash
• Long-term investments were purchased for \$12,000 cash. There were no sales of long-term investments
• Bonds were paid with a principal amount of \$18,000
• Issued common stock for \$4,000 cash
• Declared and paid \$32,000 in cash dividends
With these data and the information provided in Figure 12.3, we can start preparing the statement of cash flows. It is important to note that all positive amounts shown in the statement of cash flows denote an increase in cash, and all negative amounts denote a decrease in cash.
Figure 12.3 Balance Sheet and Income Statement for Home Store, Inc.
Step 1: Prepare the Operating Activities Section
Question: We will be using the indirect method to prepare the operating activities section. (The direct method is covered in the appendix.) The starting point using the indirect method is net income. Home Store, Inc., had net income of \$124,000 in 2012. This amount comes from the income statement, which was prepared using the accrual basis of accounting. How do we convert this amount to a cash basis?
Answer: Several adjustments are necessary to convert this amount to a cash basis and to provide an amount related only to daily operating activities of the business. If the resulting adjusted amount is a cash inflow, it is called cash provided by operating activities; if it is a cash outflow, it is called cash used by operating activities.
Three general types of adjustments are necessary to convert net income to cash provided by operating activities. These three types of adjustments are shown in Figure 12.4, which also displays the format used for the operating activities section of the statement of cash flows. Examine this figure carefully.
Figure 12.4 Operating Activities Format and Adjustments
Adjustment One: Adding Back Noncash Expenses
Question: What is the first type of adjustment necessary to convert net income to a cash basis?
Answer: The first adjustment to net income involves adding back expenses that do not affect cash (often called noncash expenses). For example, the accrual basis of accounting deducts depreciation expense in calculating net income, even though depreciation expense does not involve cash. (Recall the financial accounting entry to record depreciation expense: debit depreciation expense and credit accumulated depreciation. Notice cash is not involved.) Thus to convert net income to a cash basis, depreciation expense is added back to net income. In effect, we are reversing depreciation expense because it is not an expense using the cash basis of accounting. The end result is as though depreciation expense was never deducted as an expense.
Next, we show how the first adjustment to net income appears in the operating activities section of the statement of cash flows for Home Store, Inc. (net income and depreciation expense come from the income statement shown in Figure 12.3):
The income statement for Home Store, Inc., shows \$24,000 in depreciation expense for the year. As shown previously, this amount is added back to the net income of \$124,000.
Adjustment Two: Adding Back Losses and Deducting Gains Related to Investing Activities
Question: What is the second type of adjustment necessary to convert net income to a cash basis?
Answer: The second adjustment to net income involves adding back losses and deducting gains related to investing activities. For example, Home Store, Inc., realized a \$6,000 loss on the sale of equipment. This loss is shown on the income statement as a deduction in calculating net income (see Figure 12.3). However, this loss is not related to the daily operations of the business. That is, Home Store, Inc., is not in the business of buying and selling equipment daily. Remember, we are trying to find the cash provided by operating activities in this section of the statement of cash flows.
Since equipment is a noncurrent asset, cash activity related to the disposal of equipment should be included in the investment activities section of the statement of cash flows. Thus the \$6,000 loss shown as a deduction on the income statement is added back to net income, and it will be included later in the investing activities section as part of the proceeds from the sale of equipment. In effect, we are reversing the \$6,000 loss because it is not an operating expense.
Here’s how the second adjustment to net income appears in the operating activities section of the statement of cash flows for Home Store, Inc.:
Adjustment Three: Adding and Subtracting Changes in Current Assets and Current Liabilities
Question: What is the third type of adjustment necessary to convert net income to a cash basis?
Answer: The third type of adjustment to net income involves analyzing the changes in all current assets (except cash) and current liabilities from the beginning of the period to the end of the period. These changes are already shown in the far right column of the balance sheet portion of Figure 12.3. Two important rules must be followed to determine how the change is reflected as an adjustment to net income. Study these two rules carefully:
1. Current assets. Increases in current assets are deducted from net income; decreases in current assets are added to net income. (There is an inverse relationship between the change in a current asset account and how it is shown as an adjustment.)
2. Current liabilities. Increases in current liabilities are added to net income; decreases in current liabilities are deducted from net income. (There is a direct relationship between the change in a current liability account and how it is shown as an adjustment.)
Now let’s work through each current asset and current liability line item shown in the balance sheet (Figure 12.3) and use these rules to determine how each item fits into the operating activities section as an adjustment to net income.
The first current asset line item, cash, shows the change in cash from the beginning of the year to the end of year. Cash decreased by \$98,000. The goal of the statement of cash flows is to show what caused this \$98,000 decrease. This amount will appear in step 4 when we reconcile the beginning cash balance to the ending cash balance. The next line item is accounts receivable.
Accounts receivable (current asset) increased by \$60,000. The current asset rule states that increases in current assets are deducted from net income. Thus \$60,000 is deducted from net income in the operating activities section of the statement of cash flows. Here’s why.
Assume all Home Store’s sales shown on the income statement are credit sales (each sale required a debit to accounts receivable and a credit to sales). The beginning accounts receivable balance of \$25,000 is increased by \$900,000 for credit sales made during the year, resulting in \$925,000 in total receivables to be collected. Since \$85,000 in accounts receivable remains at the end of the year, \$840,000 in cash was collected (= \$925,000 − \$85,000). On a cash basis, Home Store, Inc., should show \$840,000 in revenue rather than \$900,000. Thus net income must be reduced by \$60,000 (= \$900,000 revenue using accrual basis − \$840,000 revenue using cash basis). The accounts receivable T-account shown in the following provides further clarification.
Here’s how the accounts receivable adjustment to net income appears in the operating activities section of the statement of cash flows for Home Store, Inc.:
Merchandise inventory (current asset) increased by \$66,000. Because the current asset rule states that increases in current assets are deducted from net income, \$66,000 is deducted from net income in the operating activities section of the statement of cash flows. To explain why, let’s assume Home Store, Inc., pays cash for all purchases of merchandise inventory. If the merchandise inventory account increases over time, more goods are purchased than are sold. Because merchandise inventory at Home Store, Inc., increased \$66,000 and cost of goods sold totaled \$546,000 (as shown in Figure 12.3), the company must have purchased inventory with a cost of \$612,000 during the period (= \$66,000 + \$546,000). Thus more cash was paid for merchandise (\$612,000) than was reflected on the income statement as cost of goods sold (\$546,000). If expenses are higher using a cash basis, the adjustment must decrease net income. Therefore \$66,000 is deducted from net income in the operating activities section of the statement of cash flows. This information is summarized in the merchandise inventory T-account in the following.
Prepaid expenses (current asset) decreased by \$2,000. Because the current asset rule states that decreases in current assets are added to net income, \$2,000 is added to net income in the operating activities section of the statement of cash flows. This is because cash paid for these expenses was lower than the expenses recognized on the income statement using the accrual basis. Since expenses are \$2,000 lower using the cash basis, net income must be increased by \$2,000.
Key Point
Important Current Asset Rule
When preparing the operating activities section of the statement of cash flows, increases in current assets are deducted from net income; decreases in current assets are added to net income.
Question: Now that we know how to handle the change in current assets when preparing the operating activities section of the statement of cash flows, what do we do with current liabilities?
Answer: The current liability rule is a bit different than the current asset rule as described next.
Accounts payable (current liability) increased by \$1,000. Because the current liability rule states that increases in current liabilities are added to net income, \$1,000 is added to net income in the operating activities section of the statement of cash flows. An increase in accounts payable signifies that Home Store, Inc., recorded more as an expense on the income statement (accrual basis) than the company paid in cash (cash basis). Since expenses are lower using the cash basis, net income must be increased by \$1,000.
Income tax payable (current liability) decreased by \$9,000. Because the current liability rule states that decreases in current liabilities are deducted from net income, \$9,000 is deducted from net income in the operating activities section of the statement of cash flows. A decrease in income tax payable signifies that Home Store, Inc., paid more for income taxes (cash basis) than the company recorded as an expense on the income statement (accrual basis). Since expenses are higher using the cash basis, net income must be decreased by \$9,000.
Key Point
Important Current Liability Rule
When preparing the operating activities section of the statement of cash flows, increases in current liabilities are added to net income; decreases in current liabilities are deducted from net income.
Question: What does the operating activities section of the statement of cash flows look like for Home Store, Inc.?
Answer: Figure 12.5 shows the completed operating activities section of the statement of cash flows for Home Store. Inc. The most important line is at the bottom, which shows cash of \$22,000 was generated during the year from daily operations of the business. Notice this amount is significantly lower than the net income amount of \$124,000 reported on the income statement. Study Figure 12.5 carefully noting the three types of adjustments made to net income.
Figure 12.5 Operating Activities Section of Statement of Cash Flows (Home Store, Inc.)
REVIEW PROBLEM 12.4
Note 12.21 "Review Problem 12.4" through Note 12.25 "Review Problem 12.7" will use the data presented as follows for Phantom Books. Each review problem corresponds to the four steps required to prepare a statement of cash flows.
Phantom Books is a retail store that sells new and used books. Phantom’s most recent balance sheet, income statement, and other important information for 2012 are presented in the following.
Additional data for 2012 include the following:
• Sold equipment with a book value of \$8,000 (= \$30,000 cost − \$22,000 accumulated depreciation) for \$12,000 cash
• Purchased equipment for \$27,000 cash
• Sold long-term investments with an original cost of \$11,000 for \$3,000 cash
• Purchased long-term investments for \$25,000 cash
• Signed a note with the bank for \$5,000 cash. No principal amounts were paid during the year
• Repurchased common stock (treasury stock) for \$16,000 cash. No new common stock was issued
• Declared and paid \$13,000 in cash dividends
1. Prepare the operating activities section of the statement of cash flows for Phantom Books using the indirect method. Follow the format presented in Figure 12.5.
2. How much cash did Phantom Books generate from operating activities for the year?
Solution to Review Problem 12.4
1. Start with net income from the income statement; make the appropriate adjustments for (1) noncash expenses, such as depreciation and amortization; (2) gains and losses related to investing activities; and (3) changes in current assets other than cash and current liabilities. The operating activities section of the statement of cash flows for Phantom Books appears as follows.
2. Cash totaling \$82,000 was generated from the company’s operating activities during the year.
Before moving on to step 2, note that investing and financing activities sections always use the same format whether the operating activities section is presented using the direct method or indirect method.
Step 2: Prepare the Investing Activities Section
Question: Now that we have completed the operating activities section for Home Store, Inc., the next step is to prepare the investing activities section. What information is used for this section, and how is it prepared?
Answer: The investing activities section of the statement of cash flows focuses on cash activities related to noncurrent assets. Review the noncurrent asset section of Home Store, Inc.’s balance sheet presented in Figure 12.3. Three noncurrent asset line items must be analyzed to determine how to present cash flow information in the investing activities section.
Property, plant, and equipment increased by \$46,000. The additional information provided for 2012 indicates two types of transactions caused this increase. First, the company purchased equipment for \$67,000 cash. Home Store, Inc., made the following journal entry for this transaction:
Second, the company sold equipment for \$5,000 cash (often called a disposal of equipment). This equipment was on the books at an original cost of \$21,000 with accumulated depreciation of \$10,000. Home Store, Inc., made the following journal entry for this transaction:
Notice the two entries to property, plant, and equipment shown previously. The net effect of these 2 entries is an increase of \$46,000 (= \$67,000 − \$21,000). This is summarized in the following T-account:
Question: How is this property, plant, and equipment information used in the investing activities section of the statement of cash flows for Home Store, Inc.?
Answer: First, the purchase of equipment for \$67,000 cash is shown as a decrease in cash. Second, the sale of equipment for \$5,000 is shown as an increase in cash. It is not enough to simply show a cash outflow of \$62,000 in the investing activities section of the statement of cash flows (= \$67,000 − \$5,000). Instead, Home Store, Inc., must show the components of this cash outflow as separate line items in the statement of cash flows as required by U.S. GAAP. The formal presentation of this information in the investing activities section is shown later in Figure 12.6.
Accumulated depreciation decreased noncurrent assets by \$14,000. This contra asset account is not typical of the other asset accounts shown on Home Store, Inc.’s balance sheet since contra asset accounts have the effect of reducing assets. Thus as this accumulated depreciation account increases, it further reduces overall assets. Terminology can get confusing, so here is a simple way to look at it. The higher the account goes; the more it reduces assets. This is why the change column shows this account as decreasing assets.
Two items caused the change in the accumulated depreciation account. First, the sale of equipment during the year caused the company to take \$10,000 in accumulated depreciation off the books. Second, \$24,000 in depreciation expense was recorded during the year (with a corresponding entry to accumulated depreciation). This information is summarized in the following T-account:
Question: How is accumulated depreciation information used in the statement of cash flows for Home Store, Inc.?
Answer: This information is already reflected in two places (the work has already been done!). First, depreciation expense is a noncash expense and is added back to net income in the operating activities section of the statement of cash flows (see Figure 12.5). Second, \$10,000 of accumulated depreciation related to disposals is included as part of the \$5,000 proceeds from the sale of equipment in the investing activities section of the statement of cash flows (see Figure 12.6). Here are the components of the equipment sale that support the \$5,000 in cash proceeds shown in the investing activities section:
Long-term investments increased by \$12,000. The additional information provided for 2012 indicates there were no sales of long-term investments during the year. The increase of \$12,000 is solely from purchasing long-term investments with cash. Thus the purchase of long-term investments for \$12,000 is shown as a decrease in cash in the investing activities section.
Figure 12.6 shows the three investing activities described previously: (1) a \$67,000 decrease in cash from the purchase of equipment, (2) a \$5,000 increase in cash from the sale of equipment, and (3) a \$12,000 decrease in cash from the purchase of long-term investments. Examine Figure 12.6 carefully noting the impact these three items have on cash and the resulting cash used by investing activities of \$74,000.
Figure 12.6 Investing Activities Section of Statement of Cash Flows (Home Store, Inc.)
REVIEW PROBLEM 12.5
Using the information presented in Note 12.21 "Review Problem 12.4":
1. Prepare the investing activities section of the statement of cash flows for Phantom Books. Follow the format presented in Figure 12.6.
2. How much cash did Phantom Books use for investing activities during the year?
Solution to Review Problem 12.5
1. Start by analyzing changes in noncurrent assets on the balance sheet. Then prepare the investing activities section of the statement of cash flows. The cash flows related to each noncurrent asset account are underlined as follows.
Property, plant, and equipment decreased by \$3,000. Additional data provided indicate 2 items caused this change: (1) equipment was purchased for \$27,000 cash, causing a \$27,000 increase in the account; and (2) equipment with an original cost of \$30,000 was sold for \$12,000 cash, causing a \$30,000 decrease in the account. The net effect of these 2 items on the property, plant, and equipment account is a decrease of \$3,000 (= \$27,000 purchase − \$30,000 original cost of equipment sold). The impact these items have on cash is reflected in the investing activities section of the statement of cash flows by showing a \$27,000 cash outflow for the purchase of equipment and a \$12,000 cash inflow from the sale of equipment.
Accumulated depreciation decreased assets by \$7,000. Two items caused this change: (1) the sale of equipment caused the company to take \$22,000 in accumulated depreciation off the books—this was the accumulated depreciation on the books for the equipment sold, and (2) \$29,000 in depreciation expense was recorded during the year, with a corresponding entry to accumulated depreciation. Neither of these entries to accumulated depreciation impacts the investing activities section. However, \$29,000 in depreciation expense is a noncash expense and is added back to net income in the operating activities section (see solution to Note 12.21 "Review Problem 12.4").
Long-term investments increased by \$14,000. Additional data provided indicate 2 items caused this change: (1) long-term investments with an original cost of \$11,000 were sold for \$3,000 cash, and (2) long-term investments were purchased for \$25,000 cash. The net effect of these 2 items on the long-term investments account is an increase of \$14,000 (= \$25,000 purchase − \$11,000 original cost of investments sold). The impact these items have on cash is reflected in the investing activities section of the statement of cash flows by showing a \$25,000 cash outflow for the purchase of investments, and a \$3,000 cash inflow from the sale of investments.
The investing activities section of the statement of cash flows for Phantom Books is shown as follows:
2. Cash totaling \$37,000 was used for investing activities during the year.
Step 3: Prepare the Financing Activities Section
Question: Now that we have completed the operating and investing activities sections for Home Store, Inc., the next step is to prepare the financing activities section. What information is used for this section, and how is it prepared?
Answer: The financing activities section of the statement of cash flows focuses on cash activities related to noncurrent liabilities and owners’ equity (i.e., cash activities related to long-term company financing). Review the noncurrent liability and owners’ equity sections of Home Store, Inc.’s balance sheet presented in Figure 12.3. One noncurrent liability item (bonds payable) and two owners’ equity items (common stock and retained earnings) must be analyzed to determine how to present cash flow information in the financing activities section. The formal presentation of this information in the financing activities section is shown later in Figure 12.7.
Bonds payable decreased by \$18,000. The additional information provided for 2012 indicates Home Store, Inc., paid off bonds during the year with a principal amount of \$18,000. This is reflected in the financing activities section of the statement of cash flows as an \$18,000 decrease in cash.
Common stock increased by \$4,000. The additional information provided for 2012 indicates the company issued common stock for \$4,000 cash. This is reflected in the financing activities section of the statement of cash flows as \$4,000 increase in cash.
Retained earnings increased by \$92,000. Two items caused this increase: (1) net income of \$124,000 increased retained earnings, and (2) cash dividends paid totaling \$32,000 decreased retained earnings. The net effect of these two entries is an increase of \$92,000 (= \$124,000 net income − \$32,000 cash dividends).
Question: How is this information used in the statement of cash flows?
Answer: Net income is already included at the top of the operating activities section as shown in Figure 12.5. Cash dividends are included in the financing activities section as a \$32,000 decrease in cash.
Figure 12.7 shows the three financing activities described previously: (1) an \$18,000 decrease in cash from paying off the principal amount of bonds, (2) a \$4,000 increase in cash from the issuance of common stock, and (3) a \$32,000 decrease in cash from the payment of cash dividends. Examine Figure 12.7 carefully noting the impact these three items have on cash and the resulting cash used by financing activities of \$46,000.
Figure 12.7 Financing Activities Section of Statement of Cash Flows (Home Store, Inc.)
Business in Action 12.4
Source: Photo courtesy of Rob Enslin, http://www.flickr.com/photos/doos/6086236471/.
Dividend Payments at Microsoft Corporation
By fiscal year ended June 30, 2004, Microsoft was sitting on more than \$60,000,000,000 in cash and short-term investments. After reviewing its options, the company chose to give much of this cash back to shareholders in the form of cash dividends. A one-time increase in cash dividends resulted in \$33,500,000,000 paid to the owners of the company during the second quarter of fiscal year 2005 (three months ended December 31, 2004). This information is found in the financing activities section of Microsoft’s statement of cash flows.
Source: Microsoft Corporation, “2004 Annual Report,” http://www.microsoft.com; Microsoft Corporation, “2005 Second Quarter Statement of Cash Flows,” http://www.microsoft.com.
Significant Noncash Investing and Financing Activities
Question: Some organizations have noncash activities involving the exchange of one noncurrent or owners’ equity balance sheet item for another (e.g., the issuance of common stock for a building; or the issuance of common stock in exchange for bonds held by creditors). Do these types of transactions appear in the statement of cash flows?
Answer: These exchanges do not involve cash and thus do not appear directly on the statement of cash flows. However, if the amount is significant, this type of exchange must be disclosed as a separate note below the statement of cash flows or in the notes to the financial statements.
REVIEW PROBLEM 12.6
Using the information presented in Note 12.21 "Review Problem 12.4" do the following:
1. Prepare the financing activities section of the statement of cash flows for Phantom Books. Follow the format presented in Figure 12.7.
2. How much cash did Phantom Books use for financing activities during the year?
Solution to Review Problem 12.6
1. Start by analyzing changes in noncurrent liabilities and owners’ equity on the balance sheet. Then prepare the financing activities section of the statement of cash flows. The cash flows related to each noncurrent liability and owners’ equity account are underlined as follows.
Note payable increased by \$5,000. Additional data provided indicate the company signed a note with the bank and received \$5,000 cash. This is reflected in the financing activities section as a \$5,000 cash inflow.
Common stock decreased by \$16,000. Additional data provided indicate the company repurchased common stock for \$16,000 cash. This is reflected in the financing activities section as a \$16,000 cash outflow.
Retained earnings increased by \$38,000. Two items caused this increase: (1) net income of \$51,000 increased retained earnings and (2) cash dividends paid totaling \$13,000 (provided as additional data) decreased retained earnings. The net effect of these 2 items is an increase of \$38,000 (= \$51,000 net income − \$13,000 cash dividends). Net income is already included at the top of the operating activities section as shown in the solution to Note 12.21 "Review Problem 12.4". Cash dividends are included in the financing activities section as a \$13,000 cash outflow.
The financing activities section of the statement of cash flows for Phantom Books is shown as follows:
2. Cash totaling \$24,000 was used for financing activities during the year.
Step 4: Reconcile the Change in Cash
Question: We’re almost done with Home Store, Inc.’s statement of cash flows. What is the fourth and final step needed to complete the statement of cash flows?
Answer: The final step is to show that the change in cash on the statement of cash flows agrees with the change in cash on the balance sheet. As shown at the bottom of the completed statement of cash flows for Home Store, Inc., in Figure 12.8, the net decrease in cash of \$98,000 shown on this statement (= \$22,000 increase from operating activities − \$74,000 decrease from investing activities − \$46,000 decrease from financing activities) agrees with the change in cash shown on the balance sheet (= \$32,000 ending cash balance − \$130,000 beginning balance).
Figure 12.8 Statement of Cash Flows (Home Store, Inc.)
b From Figure 12.6.
c From Figure 12.7.
d From Figure 12.3.
Figure 12.9 provides a summary of cash flows for operating activities, investing activities, and financing activities for Home Store, Inc., along with the resulting total decrease in cash of \$98,000.
Figure 12.9 Cash Flows at Home Store, Inc.
REVIEW PROBLEM 12.7
Using the information presented in Note 12.21 "Review Problem 12.4" and the solutions to Note 12.21 "Review Problem 12.4", Note 12.22 "Review Problem 12.5", and Note 12.24 "Review Problem 12.6", prepare a complete statement of cash flows for Phantom Books. Follow the format presented in Figure 12.8.
Solution to Review Problem 12.7
a From Note 12.21 "Review Problem 12.4".
b From Note 12.22 "Review Problem 12.5".
c From Note 12.24 "Review Problem 12.6".
Home Store, Inc., Update
Recall the dialogue at Home Store, Inc., between John (CEO), Steve (treasurer), and Linda (CFO). John was concerned about the company’s drop in cash from \$130,000 at the beginning of the year to \$32,000 at the end of the year. He asked Linda to investigate and wanted to know how much cash was generated from daily operations during the year. The group reconvened the following week. As you read the dialogue that follows, refer to Figure 12.8; it is the statement of cash flows that Linda prepared for the meeting.
John (CEO): Welcome, everyone. Linda, what information do you have for us regarding the company’s cash flow?
Linda (CFO): I’ve completed a statement of cash flows for the year—here are copies for your review (see Figure 12.8). This statement tells us about the company’s cash activities during the year and ultimately explains why cash decreased by \$98,000.
John: How much cash did we generate from ongoing operations for the year?
Linda: That can be found in the top portion of the statement under “cash flows from operating activities.” We generated \$22,000 from operating activities.
Steve (Treasurer): You’re kidding! We had net income totaling \$124,000 but only generated \$22,000 in cash?
John: That does seem like a huge disparity. Linda, are you sure this is correct?
Linda: Yes! The reason cash from operating activities is so much lower than net income is that accounts receivable and merchandise inventory increased significantly from the beginning of the year to the end of the year. In fact, both accounts more than doubled.
Steve: The cash tied up in these two areas is definitely hurting our cash flow. We really struggled to meet our cash budgets for accounts receivable collections and inventory purchases.
John: Clearly, we’ve got to get a handle on receivables and inventory. But even with this huge difference between net income and cash flows from operating activities, we generated \$22,000 in cash. This does not explain why cash decreased by \$98,000.
Linda: You’re right, John. Operating activities produced positive cash flow in spite of these receivables and inventory issues. Let’s look further down the statement. Notice we spent \$67,000 on equipment and purchased \$12,000 in long-term investments.
Steve: Yes, I recall purchasing a new forklift—the old one was a safety hazard—and purchasing long-term investments at the beginning of the year when our cash balance was on the high side.
Linda: Once we factor in the cash proceeds from the old equipment, you can see we spent \$74,000 in cash for equipment and investments.
John: Looking back, we probably should have financed the equipment rather than having paid for it all at once. What else can you tell us, Linda?
Linda: Bonds totaling \$18,000 came due during the year, as shown toward the bottom of the statement, and we paid \$32,000 in dividends.
Steve: I realize the board felt cash levels were high enough during 2011 to warrant a large dividend payment in 2012, but we need to cut way back on these dividends in the future.
Linda: I agree. To answer your question, John, the \$98,000 decrease in cash came primarily from the purchase of equipment and long-term investments and payments for bonds and cash dividends.
John: Thank you, Linda. This provides the information we need to improve cash flow going forward.
As you can see from this dialogue, the statement of cash flows is not only a reporting requirement for most companies, it is also a useful tool for analytical and planning purposes. Next, we will discuss how to use cash flow information to assess performance and help in planning for the future.
Key Takeaway
• The statement of cash flows is prepared using the four steps described in the previous segment. In step 1, the indirect method starts with net income in the operating activities section and makes three types of adjustments to convert net income to a cash basis. The first adjustment is adding back expenses that do not affect cash, such as depreciation. The second adjustment is adding back losses and deducting gains related to investing activities. The third adjustment is adding and subtracting changes in current assets (except cash) and current liabilities using the adjustment rules. Steps 2 and 3 are done by analyzing and presenting cash activities associated with noncurrent assets (investing activities) and noncurrent liabilities and owners’ equity (financing activities). Step 4 shows that the change in cash on the statement of cash flows agrees with the change in cash on the balance sheet. | textbooks/biz/Accounting/Managerial_Accounting/12%3A_How_Is_the_Statement_of_Cash_Flows_Prepared_and_Used/12.05%3A_Using_the_Indirect_Method_to_Prepare_the_Statement_of_Cash_Flows.txt |
LEARNING OBJECTIVE
1. Analyze cash flow information.
Question: Companies and analysts tend to use income statement and balance sheet information to evaluate financial performance. In fact, financial results presented to the investing public typically focus on earnings per share (Chapter 13 discusses earnings per share in detail). However, analysis of cash flow information is becoming increasingly important to managers, auditors, and outside analysts. What measures are commonly used to evaluate performance related to cash flows?
Answer: Three common cash flow measures used to evaluate organizations are (1) operating cash flow ratio, (2) capital expenditure ratio, and (3) free cash flow. (Further coverage of these measures can be found in the following article: John R. Mills and Jeanne H. Yamamura, “The Power of Cash Flow Ratios,” Journal of Accountancy, October 1998.) We will use two large home improvement retail companies, The Home Depot, Inc., and Lowe’s Companies, Inc., to illustrate these measures.
Operating Cash Flow Ratio
Question: The operating cash flow ratio is cash provided by operating activities divided by current liabilities. What does this ratio tell us, and how is it calculated?
Answer: This ratio measures the company’s ability to generate enough cash from daily operations over the course of a year to cover current obligations. Although similar to the commonly used current ratio, this ratio replaces current assets in the numerator with cash provided by operating activities. The operating cash flow ratio is as follows:
Key Equation
The numerator, cash provided by operating activities, comes from the bottom of the operating activities section of the statement of cash flows. The denominator, current liabilities, comes from the liabilities section of the balance sheet. (Note that if current liabilities vary significantly from one period to the next, some analysts prefer to use average current liabilities. We will use ending current liabilities unless noted otherwise.)
As with most financial measures, the resulting ratio must be compared to similar companies in the industry to determine whether the ratio is reasonable. Some industries have a large operating cash flow relative to current liabilities (e.g., mature computer chip makers, such as Intel Corporation), while others do not (e.g., startup medical device companies).
The operating cash flow ratio is calculated for Home Depot and Lowe’s in the following using information from each company’s balance sheet and statement of cash flows.
Home Depot and Lowe’s are in the same industry and have comparable ratios, which is what we would expect for similar companies.
Capital Expenditure Ratio
Question: The capital expenditure ratio is cash provided by operating activities divided by capital expenditures. What does this ratio tell us, and how is it calculated?
Answer: This ratio measures the company’s ability to generate enough cash from daily operations to cover capital expenditures. A ratio in excess of 1.0, for example, indicates the company was able to generate enough operating cash to cover investments in property, plant, and equipment. The capital expenditure ratio is as follows:
Key Equation
The numerator, cash provided by operating activities, comes from the bottom of the operating activities section of the statement of cash flows. The denominator, capital expenditures, comes from information within the investing activities section of the statement of cash flows.
The capital expenditure ratio is calculated for Home Depot and Lowe’s in the following using information from each company’s statement of cash flows.
Since the capital expenditure ratio for each company is above 1.0, both companies were able to generate enough cash from operating activities to cover investments in property, plant, and equipment (also called fixed assets).
Free Cash Flow
Question: Another measure used to evaluate organizations, called free cash flow, is simply a variation of the capital expenditure ratio described previously. What does this measure tell us, and how is it calculated?
Answer: Rather than using a ratio to determine whether the company generates enough cash from daily operations to cover capital expenditures, free cash flow is measured in dollars. Free cash flow is cash provided by operating activities minus capital expenditures. The idea is that companies must continue to invest in fixed assets to remain competitive. Free cash flow provides information regarding how much cash generated from daily operations is left over after investing in fixed assets. Many organizations, such as Amazon.com, consider this measure to be one of the most important in evaluating financial performance (see Note 12.34 "Business in Action 12.5"). The free cash flow formula is as follows:
Key Equation
Free cash flow = Cash provided by operating activities − Capital expenditures
The cash provided by operating activities comes from the bottom of the operating activities section of the statement of cash flows. The capital expenditures amount comes from information within the investing activities section of the statement of cash flows.
The free cash flow amount is calculated for Home Depot and Lowe’s as follows using information from each company’s statement of cash flows.
Because free cash flow for each company is above zero, both companies were able to generate enough cash from operating activities to cover investments in fixed assets and have some left over to invest elsewhere. This conclusion is consistent with the capital expenditure ratio analysis, which uses the same information to assess the company’s ability to cover fixed asset expenditures.
Formulas for the cash flow performance measures presented in this chapter are summarized in Table 12.1.
Table 12.1 Summary of Cash Flow Performance Measures
Business in Action 12.5
Source: Photo courtesy of James Duncan Davidson, http://www.flickr.com/photos/oreilly/6629275/
Free Cash Flow at Amazon.com
Amazon.com is an online retailer that began selling books in 1996 and has since expanded into other areas of retail sales. The founder and CEO (Jeff Bezos) believes free cash flow is so important, the annual report included a letter from Mr. Bezos to the shareholders, which began with this statement, “Our ultimate financial measure, and the one we want to drive over the long-term, is free cash flow per share.”
The company justifies this focus on free cash flow by making the point that earnings presented on the income statement do not translate into cash flows, and shares are valued based on the present value of future cash flows. This implies shareholders should be most interested in free cash flow per share rather than earnings per share. Mr. Bezos goes on to state, “Cash flow statements often don’t receive as much attention as they deserve. Discerning investors don’t stop with the income statement.”
Amazon.com’s free cash flow for 2010 totaled \$2,164,000,000, compared to \$2,880,000,000 in 2009. Net income for 2010 totaled \$1,152,000,000, compared to \$902,000,000 in 2009. It is interesting to note that free cash flow is significantly higher than net income for 2010 and 2009.
Source: Amazon.com, Inc., “2010 Annual Report,” www.amazon.com.
Key Takeaway
• Three measures are often used to evaluate cash flow. The operating cash flow ratio measures the company’s ability to generate enough cash from daily operations over the course of a year to cover current obligations. The formula is as follows:
The capital expenditure ratio measures the company’s ability to generate enough cash from daily operations to cover capital expenditures. The formula is as follows:
Free cash flow measures the company’s ability to generate enough cash from daily operations to cover capital expenditures and determines how much cash is remaining to invest elsewhere in the company. The formula is as follows:
Free cash flow = Cash provided by operating activities − Capital expenditures
REVIEW PROBLEM 12.8
The following financial information is for PepsiCo Inc. and Coca-Cola Company for fiscal year 2010.
For PepsiCo and Coca-Cola, calculate the following measures and comment on your results:
1. Operating cash flow ratio
2. Capital expenditure ratio (Hint: fixed asset expenditures are the same as capital expenditures.)
3. Free cash flow
Solution to Review Problem 12.8
All dollar amounts are in millions.
1. The formula for calculating the operating cash flow ratio is as follows:
PepsiCo generated slightly more cash from operating activities to cover current liabilities than Coca-Cola.
2. The formula for calculating the capital expenditure ratio is as follows:
Both companies generated more than enough cash from operating activities to cover capital expenditures.
3. The formula to calculate free cash flow is as follows: Free cash flow = Cash provided by operating activities − Capital expenditures
The conclusion reached in requirement two is confirmed here. Both companies generated more than enough cash from operating activities to cover capital expenditures. In fact, PepsiCo had \$5,195,000,000 remaining from operating activities after investing in fixed assets, and Coca-Cola had \$7,317,000,000 remaining. | textbooks/biz/Accounting/Managerial_Accounting/12%3A_How_Is_the_Statement_of_Cash_Flows_Prepared_and_Used/12.06%3A_Analyzing_Cash_Flow_Information.txt |
Learning Objectives
• Prepare a statement of cash flows using the direct method.
Question: The same four steps apply to preparing a statement of cash flows using the direct method as with the indirect method. The only difference is how the operating activities section is presented in step 1; all other steps are the same as presented in the chapter. Although presentation of the operating activities section using the direct method differs from the indirect method, the end result is exactly the same. How does step 1 differ using the direct method?
Answer
Rather than adjusting net income from an accrual basis to a cash basis using the indirect method, the direct method simply presents the income statement on a cash basis. The format of the operating activities section using the direct method is presented in Figure 12.10.
Figure 12.10. Operating Activities Format Using the Direct Method
The first item shown in Figure 12.10, cash receipts from customers, is revenue (or sales) on a cash basis. The second item, cash payments to suppliers, is cost of goods sold on a cash basis. The third item, cash payments for operating expenses (also called selling and administrative expenses), is operating expenses on a cash basis. The fourth item, cash payments for interest expense, is interest expense on a cash basis. And the fifth item, cash payments for income taxes, is income tax expense on a cash basis. Cash receipts minus cash payments results in cash provided by operating activities.
Adjustments must be made to each income statement item to convert income statement information from an accrual basis to a cash basis. These adjustments will be described next using the same information for Home Store, Inc., presented earlier in the chapter. The income statement and balance sheet for Home Store, Inc., are presented again in Figure 12.11. We will start at the top of the income statement with sales and work our way down item-by-item making adjustments to convert each item to a cash basis.
Figure 12.11. Income Statement and Balance Sheet (Home Store, Inc.)
• Converting Sales to Cash Receipts
Question: How are sales on an accrual basis converted to sales on a cash basis?
Answer
• Sales of \$900,000 shown on the income statement do not represent cash collected from sales. The adjustment rule used to convert sales to cash receipts from customers is as follows: increases in accounts receivable are deducted from sales revenue, and conversely, decreases in accounts receivable are added to sales revenue. Since accounts receivable for Home Store, Inc., increased \$60,000, a deduction of \$60,000 from sales revenue must be taken to find cash receipts from customers. Thus cash receipts from customers totaled \$840,000 (= \$900,000 sales − \$60,000 increase in accounts receivable). The accounts receivable T-account shown in the following further clarifies this concept.
Here’s how sales revenue on a cash basis appears in the operating activities section of the statement of cash flows for Home Store, Inc.:
• Converting Cost of Goods Sold to a Cash Basis
Question: How is cost of goods sold on an accrual basis converted to cost of goods sold on a cash basis?
Answer
• Two adjustments must be made to cost of goods sold to calculate cash paid to suppliers. First, increases in inventory are added to cost of goods sold, and conversely, decreases in inventory are deducted from cost of goods sold. Since inventory for Home Store, Inc., increased \$66,000, cost of goods sold is increased \$66,000. Second, increases in accounts payable are deducted from cost of goods sold, and conversely, decreases in accounts payable are added to cost of goods sold. Since accounts payable increased \$1,000, cost of goods sold is decreased \$1,000. These 2 adjustments result in cash paid to suppliers of \$611,000 (= \$546,000 cost of goods sold + \$66,000 increase in inventory − \$1,000 increase in accounts payable).
Here’s how cost of goods sold on a cash basis appears in the operating activities section of the statement of cash flows for Home Store, Inc.:
• Converting Operating Expenses to a Cash Basis
Question: How are operating expenses on an accrual basis converted to operating expenses on a cash basis?
Answer
• Two adjustments must be made to operating expenses (also called selling and administrative expenses) to calculate cash payments for operating expenses. First, increases in prepaid expenses are added to operating expenses, and conversely, decreases in prepaid expenses are deducted from operating expenses. Since prepaid expenses for Home Store, Inc., decreased \$2,000, operating expenses are decreased \$2,000. Second, increases in accrued liabilities are deducted from operating expenses, and conversely, decreases in accrued liabilities are added to operating expenses. Home Store, Inc., does not have any accrued liabilities and, therefore, no adjustment is necessary for accrued liabilities. The 1 adjustment to operating expenses at Home Store, Inc., results in cash payments for operating expenses of \$118,000 (= \$120,000 selling and administrative expenses − \$2,000 decrease in prepaid expenses).
Here’s how operating expenses on a cash basis appears in the operating activities section of the statement of cash flows for Home Store, Inc.:
• Depreciation Expense
Question: How is depreciation expense handled when using the direct method?
Answer
Since depreciation is a noncash expense, it is not included in the statement of cash flows using the direct method.
Converting Interest Expense to a Cash Basis
Question: How is interest expense on an accrual basis converted to interest expense on a cash basis?
Answer
• Interest expense of \$15,000 shown on the income statement does not necessarily represent cash paid for interest expense. The adjustment rule used to convert interest expense to cash payments for interest expense is as follows: increases in interest payable are deducted from interest expense, and conversely, decreases in interest payable are added to interest expense. Since Home Store, Inc., had no interest payable this year or last year, no adjustment to interest expense is necessary.
Here’s how interest expense on a cash basis appears in the operating activities section of the statement of cash flows for Home Store, Inc.:
• Loss on Sale of Equipment
Question: How is the loss on sale of equipment handled when using the direct method?
Answer
Because the loss on sale of equipment is included as part of the proceeds from the sale of equipment in the investing activities section, this item is not included in the operating activities section. This holds true for both the direct and indirect methods.
Converting Income Tax Expense to a Cash Basis
Question: How is income tax expense on an accrual basis converted to income tax expense on a cash basis?
Answer
Income tax expense of \$65,000 shown on the income statement does not represent cash paid for income taxes. The adjustment rule used to convert income tax expense to cash payments for income taxes is: Increases in income taxes payable are deducted from income tax expense, and conversely, decreases in income taxes payable are added to income tax expense. (The same rules apply to companies that have deferred income taxes.) Since income taxes payable decreased \$9,000, income tax expense is increased \$9,000. Thus cash payments for income taxes totaled \$74,000 (= \$65,000 income tax expense + \$9,000 decrease in income taxes payable).
Here’s how income tax expense on a cash basis appears in the operating activities section of the statement of cash flows for Home Store, Inc.:
Question: What does the completed operating activities section for Home Store, Inc., look like using the direct method?
Answer
The operating activities section for Home Store, Inc., is shown in Figure 12.12. Notice that cash provided by operating activities of \$22,000 in Figure 12.12 (using the direct method) matches cash provided by operating activities in Figure 12.5 (using the indirect method). The direct and indirect methods of presenting the operating activities section of the statement of cash flows yield the exact same results. Also note that the investing and financing activities do not change using the direct method.
Figure 12.12. Operating Activities Section Using the Direct Method (Home Store, Inc.)
*As shown in Figure 12.5.
Figure 12.13 summarizes the rules used to convert income statement line items to a cash basis. Review these rules carefully before working Note 12.40 "Review Problem 12.9".
Figure 12.13. Adjustment Rules for the Direct Method
Key Takeaway
The same four steps apply to preparing the statement of cash flows using the direct method as with the indirect method. The difference is in the operating activities section of step 1. In step 1, the indirect method starts with net income and makes adjustments to convert net income to a cash basis. The direct method makes adjustments directly to each income statement revenue and expense line item, thereby converting each line item to a cash basis. The resulting cash provided by (used by) operating activities is identical in both approaches.
REVIEW PROBLEM 12.9
Using the information presented for Phantom Books in Note 12.21 "Review Problem 12.4", prepare the operating activities section of the statement of cash flows using the direct method. Follow the format presented in Figure 12.12, and refer to the adjustment rules in Figure 12.13.
Answer
The operating activities section of the statement of cash flows for Phantom Books using the direct method is presented as follows. Notice that cash provided by operating activities of \$82,000 shown here using the direct method is identical to cash provided by operating activities using the indirect method (shown in the solution to Note 12.21 "Review Problem 12.4").
a \$756,000 = \$750,000 sales revenue + \$6,000 decrease in accounts receivable.
b \$560,000 = \$546,000 cost of goods sold + \$13,000 increase in inventory + \$1,000 decrease in accounts payable.
c \$75,000 = \$79,000 operating expenses − \$4,000 decrease in prepaid expenses.
d Since no interest payable balances exist this year or last year, the interest expense of \$11,000 is the same as cash payments for interest expense.
e \$28,000 = \$30,000 income tax expense − \$2,000 increase in income tax payable. | textbooks/biz/Accounting/Managerial_Accounting/12%3A_How_Is_the_Statement_of_Cash_Flows_Prepared_and_Used/12.07%3A_Appendix-_Using_the_Direct_Method_to_Prepare_the_Statement_of_Cash_Flows.txt |
1. Why was the statement of cash flows created by the Financial Accounting Standards Board (FASB)?
2. Describe the three classifications of cash flows, and provide examples of activities that would appear in each classification.
3. Which section of the statement of cash flows is widely regarded as the most important? Why?
4. Briefly describe the four steps required to prepare the statement of cash flows using the indirect method.
5. Refer to the Note 12.15 "Business in Action 12.3" Why is the indirect method used by most companies?
6. Describe the three adjustments necessary to convert net income to a cash basis using the indirect method. Provide an example for each adjustment.
7. Why is depreciation expense added back to net income using the indirect method of preparing the statement of cash flows?
8. Assume you are using the indirect method to prepare the operating activities section of the statement of cash flows. Describe the adjustment rules for current assets and current liabilities, and provide one example for each rule.
9. You have just completed the statement of cash flows for a company, and the bottom of the statement shows a net increase in cash of \$250,000. Describe where this increase should be shown elsewhere in the financial statements.
10. Provide an example of a noncash investing or financing activity. Describe how these transactions are disclosed in the financial statements.
11. How is the operating cash flow ratio calculated, and what does it tell the user?
12. How is the capital expenditure ratio calculated, and what does it tell the user?
13. How is free cash flow calculated, and what does it tell the user?
14. Appendix. Describe how the indirect method differs from the direct method.
15. Appendix. Assume you are using the direct method to prepare the operating activities section of the statement of cash flows. Describe the adjustment rule used to convert sales revenue to cash receipts from customers.
16. Appendix. Assume you are using the direct method to prepare the operating activities section of the statement of cash flows. Describe the adjustment rules used to convert cost of goods sold to cash payments to suppliers.
Brief Exercises
1. Evaluating Cash Flows at Home Store, Inc. Refer to the dialogue at Home Store, Inc., presented at the beginning of the chapter and the follow-up dialogue after Note 12.25 "Review Problem 12.7".
Required:
1. Why was the CEO concerned about the company’s cash flow?
2. Why did the CEO state, “We probably should have financed the equipment rather than having paid for it all at once”?
2. Classifying Cash Flows. Identify whether each of the following items would appear in the operating, investing, or financing activities section of the statement of cash flows. Briefly explain your answer for each item.
1. Cash receipts from the sale of common stock
2. Cash receipts from the sale of a building
3. Cash payments for income taxes
4. Cash receipts from issuance of bonds
5. Cash payments for the purchase of equipment
3. Operating Activities Section Using the Indirect Method. The following income statement and current sections of the balance sheet are for Donzi, Inc.
Required:
Using the indirect method, prepare the operating activities section of the statement of cash flows for Donzi, Inc., for the year ended December 31, 2012. Use the format presented in Figure 12.5.
4. (Appendix) Operating Activities Section Using the Direct Method. The following income statement and current sections of the balance sheet are for Donzi, Inc. (this is the same information as the previous brief exercise).
Required:
Using the direct method, prepare the operating activities section of the statement of cash flows for Donzi, Inc., for the year ended December 31, 2012. Use the format presented in Figure 12.12.
5. Investing Activities Section. The following information is from the noncurrent asset portion of Santana, Inc.’s balance sheet.
The following activities occurred during 2012:
• Sold equipment with a book value of \$3,000 (= \$13,000 cost − \$10,000 accumulated depreciation) for \$4,000 cash and depreciation expense for the year totaled \$26,000
• Purchased property for \$43,000 cash
• Purchased long-term investments for \$15,000 cash
Required:
Prepare the investing activities section of the statement of cash flows for Santana, Inc., for the year ended December 31, 2012. Use the format presented in Figure 12.6.
6. Financing Activities Section. The following information is from the noncurrent liabilities and owners’ equity portions of Canton Company’s balance sheet.
The following activities occurred during 2012:
• Issued bonds for \$80,000 cash
• Issued common stock for \$100,000 cash
• Earned net income totaling \$60,000
• Paid cash dividends totaling \$15,000
Required:
Prepare the financing activities section of the statement of cash flows for Canton Company for the year ended December 31, 2012. Use the format presented in Figure 12.7.
7. Cash Flow Measures. The selected information in the following is from Diaz Company’s financial records for the most recent fiscal year.
Current assets \$600,000
Current liabilities \$250,000
Cash provided by operating activities \$700,000
Net income \$300,000
Capital expenditures \$550,000
Required:
Calculate Diaz Company’s
1. Operating cash flow ratio;
2. Capital expenditure ratio; and
3. Free cash flow.
Exercises: Set A
1. Classifying Cash Flows. Identify whether each of the following items would appear in the operating, investing, or financing activities section of the statement of cash flows. Briefly explain your answer for each item.
1. Cash payments for the repurchase of common stock
2. Cash payments for the purchases of merchandise
3. Cash receipts from the collection of interest on loans made to other entities
4. Cash receipts from the collection of principal on loans made to other entities
5. Cash payments to shareholders for dividends
6. Cash payments for the purchase of equipment
2. Operating Activities Section Using the Indirect Method. The following income statement and current sections of the balance sheet are for Capstone, Inc.
Required:
1. Using the indirect method, prepare the operating activities section of the statement of cash flows for Capstone, Inc., for the year ended December 31, 2012. Use the format presented in Figure 12.5.
2. How much cash was provided by (used by) operating activities? Briefly describe what this amount tells us about the company.
3. (Appendix) Operating Activities Section Using the Direct Method. The following income statement and current sections of the balance sheet are for Capstone, Inc. (this is the same information as the previous exercise).
Required:
1. Using the direct method, prepare the operating activities section of the statement of cash flows for Capstone, Inc., for the year ended December 31, 2012. Use the format presented in Figure 12.12.
2. How much cash was provided by (used by) operating activities? Briefly describe what this amount tells us about the company.
4. Investing Activities Section. The following information is from the noncurrent asset portion of Caldera, Inc.’s balance sheet.
The following activities occurred during 2012:
• Sold equipment with a book value of \$46,000 (= \$170,000 cost − \$124,000 accumulated depreciation) for \$37,000 cash and depreciation expense for the year totaled \$159,000
• Purchased equipment for \$310,000 cash
• No additional loans to other entities were made during the year (Hint: Solve for the principal amount on loans collected during the year.)
• Sold long-term investments with an original cost of \$27,000 for \$33,000 cash
Required:
1. Prepare the investing activities section of the statement of cash flows for Caldera, Inc., for the year ended December 31, 2012. Use the format presented in Figure 12.6.
2. How much cash was provided by (used by) investing activities? Briefly describe what this amount tells us about the company.
5. Financing Activities Section. The following information is from the noncurrent liabilities and owners’ equity portions of Flash, Inc.’s balance sheet.
The following activities occurred during 2012:
• Paid principal amount of \$20,000 for long-term notes payable
• Received \$110,000 for long-term notes payable
• Paid principal amount on bonds totaling \$33,000
• Repurchased common stock for \$60,000 cash
• Earned net income totaling \$200,000
• Paid cash dividends totaling \$40,000
Required:
1. Prepare the financing activities section of the statement of cash flows for Flash, Inc., for the year ended December 31, 2012. Use the format presented in Figure 12.7.
2. How much cash was provided by (used by) financing activities? Briefly describe what this amount tells us about the company.
6. Operating Activities Section Using the Indirect Method and Cash Ratios. The following data are for Cycle Company.
Required:
1. Using the indirect method, prepare the operating activities section of the statement of cash flows for Cycle Company for the year ended December 31, 2012. Use the format presented in Figure 12.5.
2. Calculate the following cash measures:
1. Operating cash flow ratio
2. Capital expenditure ratio
3. Free cash flow | textbooks/biz/Accounting/Managerial_Accounting/12%3A_How_Is_the_Statement_of_Cash_Flows_Prepared_and_Used/12.E%3A_Exercises_%28Part_1%29.txt |
1. Classifying Cash Flows. Identify whether each of the following items would appear in the operating, investing, or financing activities section of the statement of cash flows. Briefly explain your answer for each item.
1. Cash receipts from the sale of goods
2. Cash payments for the purchases of merchandise
3. Cash receipts from the issuance of bonds
4. Cash payments to shareholders for dividends
5. Cash payments to employees
6. Cash receipts from the sale of equipment
2. Operating Activities Section Using the Indirect Method. The following income statement and current sections of the balance sheet are for Manor Company.
Required:
1. Using the indirect method, prepare the operating activities section of the statement of cash flows for Manor Company for the year ended December 31, 2012. Use the format presented in Figure 12.5.
2. How much cash was provided by (used by) operating activities? Briefly describe what this amount tells us about the company.
3. (Appendix) Operating Activities Section Using the Direct Method. The following income statement and current sections of the balance sheet are for Manor Company (this is the same information as the previous exercise).
Required:
1. Using the direct method, prepare the operating activities section of the statement of cash flows for Manor Company for the year ended December 31, 2012. Use the format presented in Figure 12.12.
2. How much cash was provided by (used by) operating activities? Briefly describe what this amount tells us about the company.
4. Investing Activities Section. The following information is from the noncurrent asset portion of Gebhardt Company’s balance sheet.
The following activities occurred during 2012:
• Sold equipment with a book value of \$4,000 (= \$90,000 cost − \$86,000 accumulated depreciation) for \$9,000 cash and depreciation expense for the year totaled \$71,000
• Purchased equipment for \$50,000 cash
• Loans totaling \$62,000 were made to other entities during the year (Hint: Solve for the principal amount on loans collected during the year.)
• Purchased long-term investments for \$16,000 cash
Required:
1. Prepare the investing activities section of the statement of cash flows for Gebhardt, Inc., for the year ended December 31, 2012. Use the format presented in Figure 12.6.
2. How much cash was provided by (used by) investing activities? Briefly describe what this amount tells us about the company.
5. Financing Activities Section. The following information is from the noncurrent liabilities and owners’ equity portions of System, Inc.’s balance sheet.
The following activities occurred during 2012:
• Paid principal amount of \$70,000 for long-term notes payable
• Received \$40,000 for long-term notes payable
• Paid principal amount on bonds totaling \$15,000 (Hint: Solve for the proceeds received from the issuance of bonds.)
• Issued common stock for \$100,000 cash (Hint: Solve for the amount paid for the repurchase of stock.)
• Earned net income totaling \$170,000
• Paid cash dividends totaling \$20,000
Required:
1. Prepare the financing activities section of the statement of cash flows for System, Inc., for the year ended December 31, 2012. Use the format presented in Figure 12.7.
2. How much cash was provided by (used by) financing activities? Briefly describe what this amount tells us about the company.
6. Operating Activities Section Using the Indirect Method and Cash Ratios. The following data are for Mills Company.
Required:
1. Using the indirect method, prepare the operating activities section of the statement of cash flows for Mills Company for the year ended December 31, 2012. Use the format presented in Figure 12.5.
2. Calculate the following cash measures:
1. Operating cash flow ratio
2. Capital expenditure ratio
3. Free cash flow
Problems
1. Classifying Cash Flows. Big Sky, Inc., had the following transactions during 2012:
1. Issued common stock for \$150,000 cash
2. Paid \$25,000 in principal on previously issued bonds
3. Paid \$300,000 in salaries and wages to employees
4. Sold property for \$45,000 cash
5. Paid \$3,000 in cash dividends
6. Received \$600,000 from customers for cash sales
7. Paid \$350,000 cash for merchandise
8. Converted bonds into common stock
9. Purchased a building for \$850,000 cash
10. Paid \$310,000 for operating expenses
11. Received \$200,000 cash for the sale of long-term investments
12. Issued bonds for \$87,000 cash
13. Repurchased common stock for \$35,000 cash
14. Issued common stock to purchase land valued at \$450,000
15. Paid \$10,000 cash for interest on notes payable
Required:
Classify each transaction as one of the following: operating activity, investing activity, financing activity, or noncash transaction. Briefly explain your answer for each item.
2. Prepare a Statement of Cash Flows, Indirect Method. Glenbrook Company’s most recent balance sheet, income statement, and other important information for 2012 are presented as follows.
Additional data for 2012 are as follows:
• Sold equipment with a book value of \$30,000 (= \$40,000 cost − \$10,000 accumulated depreciation) for \$28,000 cash
• Purchased equipment for \$96,000 cash
• There were no sales of long-term investments (Hint: Solve for the purchase of long-term investments.)
• Issued bonds for \$16,000 cash
• Repurchased common stock (treasury shares) for \$45,000 cash
• Declared and paid \$12,000 in cash dividends
Required:
1. Use the four steps described in the chapter to prepare a statement of cash flows for the year ended December 31, 2012, using the indirect method. Refer to the format presented in Figure 12.8.
2. Briefly describe the major changes in cash identified in the statement of cash flows.
3. (Appendix) Prepare a Statement of Cash Flows, Direct Method. Refer to the information for Glenbrook Company presented in the previous problem.
Required:
1. Use the four steps described in the chapter, including the appendix, to prepare a statement of cash flows for the year ended December 31, 2012, using the direct method. Refer to the operating activities section format using the direct method presented in Figure 12.12 and the adjustment rules for the direct method presented in Figure 12.13.
2. Briefly describe the major changes in cash identified in the statement of cash flows.
4. Prepare and Analyze a Statement of Cash Flows, Indirect Method. Travel Supply, Inc.’s most recent balance sheet, income statement, and other important information for 2012 are presented as follows.
Additional data for 2012 are as follows:
• Sold equipment with a book value of \$3,000 (= \$23,000 cost − \$20,000 accumulated depreciation) for \$8,000 cash
• Purchased equipment for \$47,000 cash
• Sold long-term investments for \$9,000 cash and these investments had an original cost of \$13,000
• Paid \$16,000 cash for principal amount on notes payable
• Issued common stock for \$8,000 cash
• Declared and paid \$22,000 in cash dividends
Required:
1. Use the four steps described in the chapter to prepare a statement of cash flows for the year ended December 31, 2012, using the indirect method. Refer to the format presented in Figure 12.8.
2. The owner of Travel Supply, Inc., wants to know why cash only increased \$51,000 even though the company had net income of \$103,000, issued common stock for \$8,000, and sold long-term investments for \$9,000. Use the information in the statement of cash flows to briefly explain why cash only increased \$51,000.
5. Prepare a Statement of Cash Flows, Indirect Method; Analyze Using Cash Ratios. Nolan Company’s most recent balance sheet, income statement, and other important information for 2012 are presented as follows.
Additional data for 2012 are as follows:
• Sold equipment with a book value of \$13,000 (= \$27,000 cost − \$14,000 accumulated depreciation) for \$21,000 cash
• Purchased equipment for \$10,000 cash
• Sold long-term investments for \$6,000 cash and these investments had an original cost of \$8,000
• Received \$19,000 cash related to notes payable
• Issued common stock for \$35,000 cash
• Declared and paid \$4,000 in cash dividends
Required:
1. Use the four steps described in the chapter to prepare a statement of cash flows for the year ended December 31, 2012, using the indirect method. Refer to the format presented in Figure 12.8.
2. The owner of Nolan Company wants to know how cash more than doubled, from \$82,000 to \$165,000, given the company’s modest net income of \$9,000. Use the information in the statement of cash flows to briefly explain why cash more than doubled.
3. Calculate the following cash measures:
1. Operating cash flow ratio
2. Capital expenditure ratio (Hint: Capital expenditures can be found in the investing activities section of the statement of cash flows prepared in part a.)
3. Free cash flow
6. (Appendix) Prepare a Statement of Cash Flows (Direct Method); Analyze Using Cash Ratios. Refer to the information for Nolan Company presented in the previous problem.
Required:
1. Use the four steps described in the chapter, including the appendix, to prepare a statement of cash flows for the year ended December 31, 2012, using the direct method. Refer to the operating activities section format using the direct method presented in Figure 12.12, and the adjustment rules for the direct method presented in Figure 12.13.
2. Briefly describe the major changes in cash identified in the statement of cash flows.
3. Calculate the following cash measures:
1. Operating cash flow ratio
2. Capital expenditure ratio (Hint: Capital expenditures can be found in the investing activities section of the statement of cash flows prepared in part a.)
3. Free cash flow
7. Prepare and Analyze a Statement of Cash Flows, Indirect Method and Direct Method. Ritz Company’s most recent balance sheet, income statement, and other important information for 2012 are presented as follows.
Additional data for 2012 are as follows:
• Sold equipment with a book value of \$15,000 (= \$100,000 cost − \$85,000 accumulated depreciation) for \$32,000 cash
• Purchased equipment for \$140,000 cash
• Sold long-term investments for \$23,000 cash and these investments had an original cost of \$24,000
• Purchased long-term investments for \$5,000 cash
• Issued bonds for \$105,000 cash
• Issued common stock for \$7,000 cash
• Declared and paid \$11,000 in cash dividends
Required:
1. Use the four steps described in the chapter to prepare a statement of cash flows for the year ended December 31, 2012, using the indirect method. Refer to the format presented in Figure 12.8.
2. The owner of Ritz Company wants to know why cash decreased from \$350,000 to \$278,000 given the company’s net income of \$18,000. Use the information in the statement of cash flows to briefly explain why cash decreased.
3. Use the four steps described in the chapter, as well as in the appendix, to prepare a statement of cash flows for the year ended December 31, 2012, using the direct method. Refer to the operating activities section format using the direct method presented in Figure 12.12 and the adjustment rules for the direct method presented in Figure 12.13.
One Step Further: Skill-Building Cases
1. Southwest Airlines Statement of Cash Flows. Refer to the Note 12.3 "Business in Action 12.1" How could Southwest’s cash balance increase by \$147,000,000 even though the company generated \$1,600,000,000 in cash from operating activities?
2. Home Depot and Lowe’s Statement of Cash Flows. Refer to the Note 12.10 "Business in Action 12.2" How much cash was generated from daily activities for each company? Where was the bulk of this cash spent for each company?
3. Internet Project: Statement of Cash Flows. Using the Internet, find the most recent annual report for a company of your choice. Print the statement of cash flows and include it with your response to the following requirements.
Required:
1. How much cash was provided by (used by) operating activities? Compare this amount to net income (often called net earnings) and explain why the two are different.
2. What method did the company use to prepare the operating activities section, direct or indirect? Explain.
3. How much cash was provided by (used by) investing activities? Which activity in this section had the biggest impact on investing cash flows?
4. How much cash was provided by (used by) financing activities? Which activity in this section had the biggest impact on financing cash flows?
5. Calculate free cash flow. Did the company generate enough cash from operating activities to cover capital expenditures? Explain.
4. Dividend Cash Flow at Microsoft. Refer to the Note 12.23 "Business in Action 12.4" How much did Microsoft pay in dividends during the second quarter of 2005? Why did Microsoft pay such a large dividend to shareholders?
5. Cash Flows at Amazon.com. Refer to the Note 12.34 "Business in Action 12.5" Why does Amazon.com prefer to use free cash flow per share rather than earnings per share to evaluate the company?
6. Group Activity: Analyzing General Motors Statement of Cash Flows.The following information is from the consolidated statement of cash flows for General Motors (GM) for the year ended December 31, 2005 (in millions).
Required:
An investment advisor recently reviewed GM’s statement of cash flows and balance sheet and stated: “GM is doing great! They are sitting on cash of more than \$30,000,000,000. There is no cash flow problem with this company!” In groups of two to four students, decide whether you agree with this statement. Support your conclusion with an analysis of GM’s cash flows.
Comprehensive Case
1. Ethics: Manipulating Data to Reach Target Cash Flow. Country Market, Inc., sells food and beverage products at its five retail stores. The company’s fiscal year ends on December 31. The company’s president and CEO, Jean Williams, just received a draft of the statement of cash flows from the controller, Stan Walker. Jean is very interested in the results since a significant part of her annual bonus depends on generating at least \$400,000 in cash from operating activities. A summary of the statement is provided in the following:
Becky Swanson, the chief financial officer (CFO) for Country Market, is approached by Jean:
Jean: Becky, have you seen the statement of cash flows?
Becky: No, not yet. Last I heard Stan was just about done with it.
Jean: He just dropped off a copy for my review.
Becky: Excellent. How does it look?
Jean: Overall it looks fine, but something must be wrong with the operating activities number. I assumed it would be well above \$400,000. Can you take a look at it and make sure we exceed \$400,000?
Becky: I’ll do what I can.
Jean: Great. I knew I could depend on you.
Shortly after this discussion, Becky returned with revised numbers:
Becky: Jean, here is the corrected statement of cash flows (see as follows). I was able to reclassify a portion of cash received from the sale of long-term investments to the operating activities section to get to \$403,000.
Jean: Excellent! Thanks, Becky, I knew you could do it!
Required:
1. What impact did the reclassification of cash flows have on the total net increase in cash? Explain.
2. Are Becky’s actions ethical? Explain.
3. If you were the CFO, how would you handle Jean’s request? (If necessary, review the presentation of ethics in Chapter 1 for additional information.) | textbooks/biz/Accounting/Managerial_Accounting/12%3A_How_Is_the_Statement_of_Cash_Flows_Prepared_and_Used/12.E%3A_Exercises_%28Part_2%29.txt |
Source: Photo courtesy of Jon Seidman, http://www.flickr.com/photos/jonseidman1988/4481833335/.
Sandy Masako is the CEO of a fast-food restaurant called Chicken Deluxe. The company operates hundreds of restaurants throughout North America and is choosing between two suppliers of soft drinks: Deep Fizz Company and Extreme Fizz, Inc. Consumer surveys indicate no significant preference between the two. Sandy is meeting with Dave Roberts, the CFO, and Karen Kraft, the purchasing manager, to discuss the company’s options.
Sandy (CEO): We have a big decision to make. Our soft drink contract is up at the end of this year, and we need to decide on a supplier for next year.
Karen (Purchasing Manager): I’ve had preliminary discussions with both Deep Fizz and Extreme Fizz, and the costs of their products are about the same.
Dave (CFO): Based on extensive surveys with our customers, they are not particularly concerned about which supplier we choose, as long as it’s either Deep Fizz or Extreme Fizz.
Karen: Both companies would like our business. This is a big contract for either of them!
Sandy: OK, so we have two companies offering the same terms, and customers who would be satisfied with either company’s products. Are there any other criteria we should consider?
Dave: We must have a supplier that is on solid financial ground. If our supplier were to have financial difficulties that jeopardized product quality or timing of deliveries, we would be in a bind.
Karen: I agree. We need to determine whether these companies are in good financial shape.
Dave: I suggest we have our accounting staff evaluate their financial information by analyzing and comparing certain key financial measures.
Sandy: What do you have in mind?
Dave: My staff can look at financial trends and calculate several different ratios to evaluate the strength of each company’s income statement and balance sheet. We can compare these ratios for both companies and also compare them to industry standards. This analysis should give us a better idea about the financial stability of each company.
Sandy: Excellent! We have a few months to make our decision. How much time do you need?
Dave: We can have it ready within a few weeks.
Sandy: Great, let’s plan on reviewing your analysis next month.
Chicken Deluxe is facing a supplier decision common to many companies. Financial stability is an important factor in deciding on a supplier, along with the quality of product and reliability of service. Chicken Deluxe must analyze financial information for Deep Fizz and Extreme Fizz to determine the financial condition of each company.
The analysis of a company’s financial information typically follows a three-pronged approach. First, trends within a company’s own financial information are analyzed, such as sales and earnings from one year to the next, using two methods—trend analysis and common-size analysis. Second, financial measures are compared between competitors. Finally, financial ratios are compared to industry averages. We discuss these three approaches next using Coca-Cola as an example. We will revisit the decision facing Chicken Deluxe later in the chapter.
13.02: Trend Analysis of Financial Statements
Learning Objectives
• Perform trend analysis to evaluate financial statement information.
Question: How is trend analysis used to evaluate the financial health of an organization?
Answer: Trend analysis evaluates an organization’s financial information over a period of time. Periods may be measured in months, quarters, or years, depending on the circumstances. The goal is to calculate and analyze the amount change and percent change from one period to the next.
For example, in fiscal years 2010 and 2009, Coca-Cola had the operating income shown as follows. (Amounts are in millions. To convert to the actual amount, simply multiply the amount given times one million. For example, \$8,449 × 1,000,000 = \$8,449,000,000. Thus Coca-Cola had operating income of \$8,449,000,000 in 2010.)
Amount 2010 Amount 2009 Amount Change Percent Change
Operating income \$8,449 \$8,231 ? ?
Although readers of the financial information can see that operating income increased from 2009 to 2010, the exact dollar amount of the change and the percent change is more helpful in evaluating the company’s performance. The dollar amount of change is calculated as follows:
Key Equation
Amount of change = Current year amount – Base year amount
Question: As you can see, operating income increased by \$218,000,000 from 2009 to 2010. Is this a significant increase for Coca-Cola?
Answer: Most of us consider \$218,000,000 to be a huge amount, but the only way to gauge the true significance of this amount for Coca-Cola is to calculate the percent change from 2009 to 2010. The percent change is calculated as the current year amount minus the base year amount, divided by the base year amount.
Key Equation
Percent change = (Current year amount – Base year amount) ÷ Base year amount
The calculation that follows shows operating income increased 2.6 percent from 2009 to 2010. Although not an extraordinarily significant increase, this does represent positive results for Coca-Cola.
Trend Analysis for the Income Statement and Balance Sheet
Question: Trend analysis is often used to evaluate each line item on the income statement and balance sheet. How is this analysis prepared?
Answer: Figure 13.1 shows Coca-Cola’s income statement trend analysis, and Figure 13.2 shows Coca-Cola’s balance sheet trend analysis. Carefully examine each of these figures, including the comments.
Figure 13.1 Income Statement Trend Analysis for Coca-Cola
Note: Percent change for each line item is found by dividing the increase (decrease) amount by the 2009 amount. For example, net sales 13.3 percent increase equals \$4,129 ÷ \$30,990.
Figure 13.1 shows that net sales increased by \$4,129,000,000, or 13.3 percent. Cost of goods sold had a corresponding increase of \$1,605,000,000, or 14.5 percent. The increase in net sales and related increase in cost of goods sold resulted in an increase in gross margin of \$2,524,000,000, or 12.7 percent. The increase in selling and administrative expenses of \$1,800,000,000, or 15.8 percent, outpaced the increase in net sales, resulting in a relatively small increase in operating income of \$218,000,000, or 2.6 percent. The significant increase in other income (expenses), net of 555.6 percent relates to a one-time gain of \$4,978,000,000 resulting from Coca-Cola’s acquisition of Coca-Cola Enterprises, Inc., in 2010 (this information comes from the notes to the financial statements). This one-time gain caused an unusually large increase in net income for 2010. This is important as we continue our analysis of Coca-Cola Company throughout the chapter. Net income will appear to have an unusually large increase as we cover various measures of performance, but keep in mind that the one-time gain in 2010 of \$4,978,000,000 caused most of the increase from 2009 to 2010.
Figure 13.2 Balance Sheet Trend Analysis for Coca-Cola
Note: Percent change for each line item is found by dividing the increase (decrease) amount by the 2009 amount. For example, cash and cash equivalents 22.4 percent increase equals \$2,048 ÷ \$9,151.
Current Assets and Current Liabilities
Question: What does the balance sheet trend analysis in Figure 13.2 tell us about current assets and current liabilities for Coca-Cola?
Answer: Figure 13.2 shows that cash and cash equivalents increased by \$2,048,000,000, or 22.4 percent. Coca-Cola’s statement of cash flows would provide detailed information regarding this increase. (Chapter 12 covers the statement of cash flows.) Marketable securities increased 122.6 percent, accounts receivable increased 17.9 percent, and merchandise inventory increased 12.6 percent. Other current assets increased 42.0 percent.
Moving to current liabilities, accounts payable and accrued liabilities increased by 33.1 percent, loans and notes payable increased 20.0 percent, and other current liabilities decreased 391.7 percent (mostly attributable to a significant increase in the current portion of long-term debt).
Noncurrent Assets and Noncurrent Liabilities
Question: What does the balance sheet trend analysis in Figure 13.2 tell us about noncurrent assets and noncurrent liabilities for Coca-Cola?
Answer: Figure 13.2 shows that long-term investments increased 11.2 percent. Property, plant, and equipment increased 54.0 percent, and intangible assets increased by a significant 109.8 percent. Both items appearing under noncurrent liabilities increased, with a 177.5 percent increase in long-term debt and a 99.2 percent increase in other liabilities and deferred taxes.
Shareholders’ Equity
Question: What does the balance sheet trend analysis in Figure 13.2 tell us about shareholders’ equity for Coca-Cola?
Answer: Common stock increased 16.1 percent, and retained earnings increased 17.8 percent. Accumulated other income (loss) went further into negative territory by 91.5 percent, and treasury stock increased 9.3 percent.
Big Picture Balance Sheet Trend Analysis
Question: What are some of the key big picture items identified in the balance sheet trend analysis shown in Figure 13.2?
Answer: Overall, total assets increased by \$24,250,000,000, or 49.8 percent. Of course, total liabilities and shareholders’ equity also increased by the same amount. The increases identified in almost every asset, liability, and shareholders’ equity line item are significant. From reading the notes to the financial statements, the authors were able to identify the main source of these increases. In 2010, Coca-Cola acquired the remaining 67 percent of Coca-Cola Enterprises, Inc.’s (CCE) North America business that Coca-Cola did not already own. This resulted in significant increases in noncurrent assets and noncurrent liabilities, which were acquired as part of this transaction. It also resulted in the reporting of a one-time gain on the income statement of \$4,978,000,000, which came from Coca-Cola remeasuring its equity interest in CCE to fair value upon close of the transaction in 2010.
This analysis points to the reason we perform trend analysis—to identify the increases and decreases in dollar amounts from one year to the next and to take a close look at unusual trends.
Trend Analysis over Several Years
Question: The trend analysis just described works well when comparing financial data for two years. However, many prefer to review trends over more than two years. How might a trend analysis for several years be prepared?
Answer: A common approach is to establish the oldest year as the base year and compute future years as a percentage of the base year. For example, Coca-Cola had the following net sales and operating income for each of the past five years (in millions):
2010 2009 2008 2007 2006
Net sales \$35,119 \$30,990 \$31,944 \$28,857 \$24,088
Operating income \$ 8,449 \$ 8,231 \$ 8,446 \$ 7,252 \$ 6,308
Assuming 2006 is the base year, the trend percentage is calculated for each year using the following formula:
Key Equation
Trend percentage = Current year ÷ Base year
Figure 13.3 shows Coca-Cola’s trend percentages for net sales and operating income. Most analysts would expand this analysis to include most, if not all, of the income statement line items.
Figure 13.3 Percentage Trend Analysis for Coca-Cola
Note: Trend percentages are calculated as the current year divided by the base year (2006). For example, the net sales 2010 trend percentage of 146 percent equals \$35,119 (net sales for 2010) divided by \$24,088 (net sales for the base year 2006).
All percentages shown in Figure 13.3 are relative to the base year, which is fiscal year 2006. Notice that the increase in operating income of 34 percent (= 134 percent – 100 percent) from 2006 to 2010 was less than the increase in net sales of 46 percent for the same period. This signals that the increase in Coca-Cola’s operating expenses outpaced the increase in net sales during this period. Figure 13.4 shows the trend percentages in Coca-Cola’s operating income from 2006 to 2010.
Figure 13.4 Five-Year Percentage Trend in Operating Income for Coca-Cola
Key Takeaways
• Trend analysis provides a means to analyze company data over a period of time by focusing on the change in specific line items within the income statement and balance sheet. Changes are typically measured in dollars and percentages. Trends over several years can be evaluated by calculating the trend percentage as the current year divided by the base year.
Business in Action 13.1
Trends Presented in Annual Reports
Most public companies present trend information in their annual reports. For example, Intel shows net revenues, gross margin, research and development costs, operating income, and net income for the past five years. Nike and PepsiCo both show the percent change in selected income statement line items for the past two years. Costco Wholesale Corporation presents selected income statement information for the past five years. The fact that these financial data are provided in the annual report confirms the importance of presenting trend information to shareholders.
Sources: Intel, “Annual Report, 2010,” http://www.intel.com; Nike, “Annual Report, 2010,” http://www.nike.com; PepsiCo, “Annual Report, 2010,” http://www.pepsico.com; Costco Wholesale Corporation, “Annual Report, 2010,” www.costco.com.
REVIEW PROBLEM 13.1
The following income statements and balance sheets are for PepsiCo, Inc. We use this information in review problems throughout the chapter.
1. Prepare a trend analysis for PepsiCo‘s income statement using the format shown in Figure 13.1.
2. Prepare a trend analysis for PepsiCo’s balance sheet using the format shown in Figure 13.2.
3. Compare PepsiCo’s increase in net income from 2009 to 2010 to Coca-Cola’s increase shown in Figure 13.1. Which company has the highest percentage growth in net income?
4. Compare PepsiCo’s increase in total assets from 2009 to 2010 to Coca-Cola’s increase shown in Figure 13.2. Which company has the highest percentage growth in total assets?
Solution to Review Problem 13.1
1. Note: Percent change for each line item is found by dividing the increase (decrease) amount by the 2009 amount. For example, net sales 33.8 percent increase equals \$14,606 ÷ \$43,232.
2. Note: Percent change for each line item is found by dividing the increase (decrease) amount by the 2009 amount. For example, cash and cash equivalents 50.7 percent increase equals \$2,000 ÷ \$3,943.
3. Net income at PepsiCo increased \$374,000,000, or 6.3 percent, while net income at Coca-Cola increased \$4,985,000,000, or 73.1 percent (as shown in Figure 13.1). Thus Coca-Cola’s growth in net income far exceeded that of PepsiCo. As mentioned earlier, this huge increase in Coca-Cola’s net income is largely attributable to a one-time gain in 2010 of \$4,978,000,000.
4. Total assets at PepsiCo increased \$28,305,000,000, or 71.0 percent, while total assets at Coca-Cola increased \$24,250,000,000, or 49.8 percent (as shown in Figure 13.2). Thus PepsiCo’s growth in total assets far exceeded that of Coca-Cola. | textbooks/biz/Accounting/Managerial_Accounting/13%3A_How_Do_Managers_Use_Financial_and_Nonfinancial_Performance_Measures/13.01%3A_Introduction.txt |
Learning Objectives
• Perform common-size analysis to evaluate financial statement information.
Question: How is common-size analysis used to evaluate the financial health of an organization?
Answer: Common-size analysis (also called vertical analysis) converts each line of financial statement data to an easily comparable, or common-size, amount measured as a percent. This is done by stating income statement items as a percent of net sales and balance sheet items as a percent of total assets (or total liabilities and shareholders’ equity). For example, Coca-Cola had net income of \$11,809,000,000 and net sales of \$35,119,000,000 for 2010. The common-size percent is simply net income divided by net sales, or 33.6 percent (= \$11,809 ÷ \$35,119).
There are two reasons to use common-size analysis: (1) to evaluate information from one period to the next within a company and (2) to evaluate a company relative to its competitors. Common-size analysis answers such questions as “how do our current assets as a percent of total assets compare with last year?” and “how does our net income as a percent of net sales compare with that of our competitors?”
Using Common-Size Analysis to Evaluate Trends within a Company
Question: How is a formal common-size analysis prepared, and what does it tell us for Coca-Cola?
Answer: Figure 13.5 presents the common-size analysis for Coca-Cola’s income statement, and Figure 13.6 shows the common-size analysis for Coca-Cola’s balance sheet. As you look at these figures, notice that net sales are used as the base for the income statement, and total assets (or total liabilities and shareholders’ equity) are used as the base for the balance sheet. That is, for the income statement, each item is measured as a percent of net sales, and for the balance sheet, each item is measured as a percent of total assets (or total liabilities and shareholders’ equity).
Figure 13.5 Common-Size Income Statement Analysis for Coca-Cola
Note: All percentages use net sales as the base. For example, 2010 cost of goods sold percent of 36.1 percent equals \$12,693 cost of goods sold ÷ \$35,119 net sales. Note that rounding issues sometimes cause subtotals in the percent column to be off by a small amount.
In general, managers prefer expenses as a percent of net sales to decrease over time, and profit figures as a percent of net sales to increase over time. As you can see in Figure 13.5, Coca-Cola’s gross margin as a percent of net sales decreased from 2009 to 2010 (64.2 percent versus 63.9 percent). Operating income declined as well (26.6 percent versus 24.1 percent). Income before taxes increased significantly from 28.6 percent in 2009 to 40.4 percent in 2010, again mainly due to a one-time gain of \$4,978,000,000 in 2010. This caused net income to increase as well, from 22.0 percent in 2009 to 33.6 percent in 2010. In the expense category, cost of goods sold as a percent of net sales increased, as did other operating expenses, interest expense, and income tax expense. Selling and administrative expenses increased from 36.7 percent in 2009 to 37.5 percent in 2010.
Figure 13.6 Common-Size Balance Sheet Analysis for Coca-Cola
As you can see from Figure 13.6, the composition of assets, liabilities, and shareholders’ equity accounts changed from 2009 to 2010. Notable changes occurred for intangible assets (26.4 percent in 2009 versus 36.9 percent in 2010), long-term debt (10.4 percent in 2009 versus 19.3 percent in 2010), retained earnings (86.5 percent in 2009 versus 68.0 percent in 2010), and treasury stock (52.2 percent in 2009 versus 38.1 percent in 2010).
Using Common-Size Analysis to Evaluate Competitors
Question: To this point, we have used common-size analysis to evaluate just one company, Coca-Cola. Common-size analysis is, however, also an effective way of comparing two companies with different levels of revenues and assets. For example, suppose one company has operating income of \$100,000, and a competing company has operating income of \$2,000,000. If both companies have similar levels of net sales and total assets, it is reasonable to assume that the more profitable company is the better performer. However, most companies are not the same size. How do we compare companies of different sizes?
Answer: This is where common-size analysis can help. Figure 13.7 shows an income statement comparison for Coca-Cola and PepsiCo using common-size analysis. (The information for Coca-Cola comes from Figure 13.5, and the information for PepsiCo comes from the solution to part 1 of Note 13.15 "Review Problem 13.2" at the end of this segment.)
Figure 13.7 Common-Size Income Statement Analysis for Coca-Cola and PepsiCo
Note that rounding issues sometimes cause subtotals in the percent column to be off by a small amount.
Notice that PepsiCo has the highest net sales at \$57,838,000,000 versus Coca-Cola at \$35,119,000,000. Once converted to common-size percentages, however, we see that Coca-Cola outperforms PepsiCo in virtually every income statement category. Coca-Cola’s cost of goods sold is 36.1 percent of net sales compared to 45.9 percent at PepsiCo. Coca-Cola’s gross margin is 63.9 percent of net sales compared to 54.1 percent at PepsiCo. Coca-Cola’s operating income is 24.1 percent of sales compared to 14.4 percent at PepsiCo. Figure 13.8 compares common-size gross margin and operating income for Coca-Cola and PepsiCo.
Figure 13.8 Comparison of Common-Size Gross Margin and Operating Income for Coca-Cola and PepsiCo
Common-size analysis enables us to compare companies on equal ground, and as this analysis shows, Coca-Cola is outperforming PepsiCo in terms of income statement information. However, as you will learn in this chapter, there are many other measures to consider before concluding that Coca-Cola is winning the financial performance battle.
Common-size analysis is obviously crucial to comparative analysis. In fact, some sources of industry data present the information exclusively in a common-size format, and most of the accounting software available today has been engineered to facilitate this type of analysis.
Business in Action 13.2
Common-Size Analysis Using Accounting Software
Most accounting computer programs, including QuickBooks, Peachtree, and MAS 90, provide common-size analysis reports. You simply select the appropriate report format and financial statement date, and the system prints the report. Thus accountants using this type of software can focus more on analyzing common-size information than on preparing it.
Key Takeaway
• Common-size analysis converts each line of financial statement data to an easily comparable amount measured as a percent. Income statement items are stated as a percent of net sales and balance sheet items are stated as a percent of total assets (or total liabilities and shareholders’ equity). Common-size analysis allows for the evaluation of information from one period to the next within a company and between competing companies.
REVIEW PROBLEM 13.2
Refer to the information presented in Note 13.10 "Review Problem 13.1" for PepsiCo, and perform the following:
1. Prepare a common-size analysis for PepsiCo’s income statement using the format shown in Figure 13.5.
2. Prepare a common-size analysis for PepsiCo’s balance sheet using the format shown in Figure 13.6.
3. Briefly describe any significant changes from 2009 to 2010 identified in parts 1 and 2.
Solution to Review Problem 13.2
1. Note: All percentages use net sales as the base. For example, 2010 cost of goods sold percent of 45.9 percent equals \$26,575 cost of goods sold ÷ \$57,838 net sales. Note that rounding issues sometimes cause subtotals in the percent column to be off by a small amount.
2. Note: All percentages use total assets or total liabilities and shareholders’ equity as the base. For example, 2010 cash and cash equivalents percent of 8.7 percent equals \$5,943 ÷ \$68,153. Note that rounding issues sometimes cause subtotals in the percent column to be off by a small amount.
3. The composition of PepsiCo’s income statement remained relatively consistent from 2009 to 2010. The most notable change occurred with selling and administrative expenses, which increased from 34.8 percent of sales in 2009 to 39.4 percent of sales in 2010. This in turn drove down operating income from 18.6 percent in 2009 to 14.4 percent in 2010. This also likely caused the decrease in income before taxes, income tax expense, and net income.
The composition of PepsiCo’s balance sheet had some significant changes from 2009 to 2010. The most notable changes occurred with intangible assets (23.0 percent in 2009 versus 41.8 percent in 2010), other assets (13.7 percent in 2009 versus 4.5 percent in 2010), short-term obligations (1.2 percent in 2009 versus 7.2 percent in 2010), long-term debt (18.6 percent in 2009 versus 29.3 percent in 2010), common stock (0.7 percent in 2009 versus 6.7 percent in 2010), and retained earnings (86.4 percent in 2009 versus 54.9 percent in 2010). | textbooks/biz/Accounting/Managerial_Accounting/13%3A_How_Do_Managers_Use_Financial_and_Nonfinancial_Performance_Measures/13.03%3A_Common-Size_Analysis_of_Financial_Statements.txt |
Learning Objectives
• Use ratio analysis to measure profitability, short-term liquidity, long-term solvency, and market valuation.
Question: Although reviewing trends and using common-size analysis provides an excellent starting point for analyzing financial information, managers, investors, and other stakeholders also use various ratios to assess the financial performance and financial condition of organizations. What are the four categories of ratios used to evaluate the financial health of an organization?
Answer: The four categories of ratios presented in this chapter are as follows (in order of presentation):
1. Ratios used to measure profitability (focus is on the income statement)
2. Ratios used to measure short-term liquidity (focus is on short-term liabilities)
3. Ratios used to measure long-term solvency (focus is on long-term liabilities)
4. Ratios used to measure market valuation (focus is on market value of the company)
For each ratio, we (1) explain the meaning, (2) provide the formula, (3) calculate the ratio for Coca-Cola for two years, and (4) compare the ratio for Coca-Cola to PepsiCo’s ratio and industry averages. (Note: All industry averages throughout this chapter were obtained from http://moneycentral.msn.com. Some averages are not available or not applicable and will be noted as such.)
Table 13.1 summarizes the formulas for all the ratios presented in this section, and Table 13.2 shows the ratio results for Coca-Cola, PepsiCo, and the industry averages that will be covered throughout this section.
Table 13.1 Financial Ratio Formulas
Profitability Measures
1. Indicates the gross margin generated for each dollar in net sales.
2. Indicates the profit generated for each dollar in net sales.
3. Indicates how much net income was generated from each dollar in average assets invested.
4. Indicates how much net income was generated from each dollar of common shareholders’ equity.
5. Indicates how much net income was earned for each share of common stock outstanding.
Short-Term Liquidity Measures
1. Indicates whether a company has sufficient current assets to cover current liabilities.
2. Indicates whether a company has sufficient quick assets to cover current liabilities.
3. Indicates how many times receivables are collected in a given period.
4. Indicates how many days it takes on average to collect on credit sales.
5. Indicates how many times inventory is sold and restocked in a given period.
6. Indicates how many days it takes on average to sell the company’s inventory.
Long-Term Solvency Measures
1. Indicates the percentage of assets funded by creditors.
2. Indicates the amount of debt incurred for each dollar that owners provide.
3. Indicates the company’s ability to cover its interest expense related to long-term debt with current period earnings.
Market Valuation Measures
1. Indicates the value of a company at a point in time.
2. Indicates the premium investors are willing to pay for shares of stock relative to the company’s earnings.
Table 13.2 Summary of Financial Ratios for Coca-Cola, PepsiCo, and the Industry Average
Coca-Cola 2010 PepsiCo 2010 Industry Average 2010
Profitability Measures
1. Gross margin ratio 63.9 percent 54.1 percent 56.1 percent
2. Profit margin ratio 33.6 percent 10.9 percent 19.2 percent
3. Return on assets 19.4 percent 11.7 percent 14.2 percent
4. Return on common shareholders’ equity 41.7 percent 32.3 percent 34.7 percent
5. Earnings per share \$5.12 \$3.97 Not applicable
Short-Term Liquidity Measures
6. Current ratio 1.17 to 1 1.11 to 1 1.20 to 1
7. Quick ratio 0.85 to 1 0.80 to 1 1.10 to 1
8. Receivables turnover ratio 8.58 times 10.57 times 9.70 times
9. Average collection period 42.54 days 34.53 days 37.63 days
10. Inventory turnover ratio 5.07 times 8.87 times 7.50 times
11. Average sale period 71.99 days 41.15 days 48.67 days
Long-Term Solvency Measures
12. Debt to assets 0.57 to 1 0.68 to 1 0.48 to 1
13. Debt to equity 1.33 to 1 2.17 to 1 0.94 to 1
14. Times interest earned 20.36 times 10.10 times 10.70 times
Market Valuation Measures
15. Market capitalization \$146,500,000,000 \$100,700,000,000 \$87,500,000,000
16. Price-earnings ratio 12.48 times 16.04 times 14.60 times
Before we discuss the various ratios, it is important to note that different terms are often used in financial statements to describe the same item. For example, some companies use the term net revenues instead of net sales, and the income statement is often called the statement of earnings, or consolidated statement of earnings. Also be sure to review the income statement and balance sheet information for Coca-Cola shown in Figure 13.5 and Figure 13.6. We refer to these figures throughout this section. (All the dollar amounts given for Coca-Cola are in millions unless stated otherwise.)
Profitability Ratios
Question: Analysts, shareholders, suppliers, and other stakeholders often want to evaluate profit trends within a company and compare a company’s profits with competitors’ profits. What are the five common ratios used to evaluate company profitability?
Answer: The five ratios used to evaluate profitability are as follows:
1. Gross margin ratio
2. Profit margin ratio
3. Return on assets
4. Return on common shareholders’ equity
5. Earnings per share
Gross Margin Ratio
Question: How is the gross margin ratio calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: The gross margin ratio indicates the gross margin generated for each dollar in net sales and is calculated as gross margin (which is net sales minus cost of goods sold) divided by net sales:
Key Equation
The gross margin ratio for Coca-Cola using 2010 information is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Gross margin ratio 63.9 percent 64.2 percent 54.1 percent 56.1 percent
The gross margin ratio indicates Coca-Cola generated 63.9 cents in gross margin for every dollar in net sales. This ratio decreased slightly from 2009 to 2010 and is substantially higher than PepsiCo’s 54.1 percent. Coca-Cola is also higher than the industry average of 56.1 percent. (Alternative terms: Gross margin is often called gross profit, net sales is often called net revenues, and cost of goods sold is often called cost of sales.)
Profit Margin Ratio
Question: How is the profit margin ratio calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: The profit margin ratio shows the profit generated for each dollar in net sales. It is calculated as net income divided by net sales:
Key Equation
The profit margin ratio for Coca-Cola using 2010 information is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Profit margin ratio 33.6 percent 22.0 percent 10.9 percent 19.2 percent
The profit margin ratio indicates Coca-Cola generated 33.6 cents in net income for every dollar in net sales. This ratio increased significantly from 2009 to 2010 and is substantially higher than PepsiCo’s 10.9 percent. Coca-Cola is also higher than the industry average of 19.2 percent. (Alternative term: Net income is often called net earnings.)
Return on Assets
Question: The gross margin ratio and profit margin ratio focus solely on income statement information. Analysts also want to know what size asset base generated the net income. For example, a company with assets of \$100,000 and net income of \$15,000 is likely performing better than a company with assets of \$300,000 and identical net income of \$15,000. A measure that considers the assets required to generate net income is called return on assets. How is return on assets calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: The return on assets ratio is used to evaluate how much net income was generated from each dollar in average assets invested. Return on assets is net income divided by average total assets:
Key Equation
The average total assets amount is found by adding together total assets at the end of the current year and previous year (2010 and 2009 for this example) and dividing by two. The return on assets ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Return on assets 19.4 percent 15.3 percent 11.7 percent 14.2 percent
The return on assets ratio indicates Coca-Cola generated 19.4 cents in net income for every dollar in average assets. This ratio increased from 2009 to 2010 and is higher than PepsiCo’s 11.7 percent. Coca-Cola exceeded the industry average of 14.2 percent.
(Note: There are several variations on the return on assets calculation. Some prefer to use average operating assets in the denominator. Others adjust net income in the numerator by adding back interest expense net of the interest expense tax benefit. We leave these variations to advanced cost and intermediate accounting textbooks.)
Return on Common Shareholders’ Equity
Question: How is the return on common shareholders’ equity ratio calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: Common shareholders are interested in the return on common shareholders’ equity ratio because this ratio tells them how much net income was generated from each dollar of common shareholders’ equity. The return on common shareholders’ equity ratio is calculated as follows:
Key Equation
Note that preferred dividends are deducted from net income in the numerator. If the company does not have any outstanding preferred stock, as is the case with Coca-Cola, the preferred dividends amount is zero.
Average common shareholders’ equity in the denominator is found by adding together all items in the shareholders’ equity section of the balance sheet at the end of the current year and previous year (2010 and 2009 for this example), except preferred stock items, and dividing by two.
Because Coca-Cola does not have preferred stock, an average of all items in the shareholders’ equity section is in the denominator. The return on common shareholders’ equity ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Return on common shareholders’ equity 41.7 percent 29.5 percent 32.3 percent 34.7 percent
The return on common shareholders’ equity ratio indicates Coca-Cola generated 41.7 cents in net income for every dollar in average common shareholders’ equity. This ratio increased significantly from 2009 to 2010 and is higher than PepsiCo’s 32.3 percent. Coca-Cola exceeded the industry average of 34.7 percent.
Coca-Cola’s return on common shareholders’ equity of 41.7 percent is higher than its return on assets of 19.4 percent, indicating that the company has positive financial leverage. Financial leverage describes a company’s ability to leverage common shareholders’ equity by taking on debt at an interest rate lower than the company’s return on assets. For example, assume a company has equity of \$10,000 earning 10 percent. The company can leverage this equity by borrowing \$8,000 with a 6 percent interest rate. Assuming the company uses this \$8,000 to purchase assets that earn 10 percent, the company has created positive financial leverage since the cost of borrowing is lower than the return on assets. This results in a return on equity that is higher than the return on assets. (Note: For a one-year period, the return on assets is \$1,800 [= \$18,000 × 10 percent] less the cost of debt of \$480 [= 6 percent × \$8,000], or \$1,320. This results in a return on assets of 7.3 percent [= \$1,320 ÷ \$18,000]. Positive financial leverage causes the return on equity to be much higher at 13.2 percent [= \$1,320 ÷ \$10,000 equity].)
Although some level of financial leverage is generally regarded as healthy, companies that are highly leveraged tend to be riskier than similar companies with less leverage. Analysts and shareholders should avoid drawing quick conclusions that increases in return on common shareholders’ equity are always better than decreases without thoroughly reviewing the rest of the data.
Figure 13.9 shows the return on assets and return on equity for Coca-Cola, PepsiCo, and the industry average.
Figure 13.9 Return on Assets and Return on Equity for Coca-Cola, PepsiCo, and the Industry Average
Earnings per Share
Question: How is earnings per share calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: Earnings per share indicates how much net income was earned for each share of common stock outstanding. The earnings per share ratio states net income on a per share basis and is calculated as the following:
Key Equation
Note that preferred dividends are deducted from net income in the numerator. If the company does not have any outstanding preferred stock, as is the case with Coca-Cola, the preferred dividends amount is zero. The weighted average common shares outstanding amount used in the denominator is typically provided in the financial statements, either on the income statement or in the notes to the financial statements. (More advanced intermediate accounting textbooks discuss this calculation in detail. Throughout this chapter, we provide the number of weighted average common shares outstanding.)
Earnings per share for Coca-Cola using 2010 information is calculated as follows, with PepsiCo and industry average information following it (dollar amount and shares are in millions, except per share amount):
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Earnings per share \$5.12 \$2.95 \$3.97 Not applicable
The earnings per share amount at Coca-Cola indicates the company earned \$5.12 for each share of common stock outstanding. This ratio increased from 2009 to 2010. Although earnings per share is useful for looking at trends over time within a company, it cannot be compared in any meaningful way from one company to another because different companies have different numbers of shares outstanding.
For example, assume two identical companies earn \$10,000 for the year. One company has one share of common stock outstanding, and the other has two shares outstanding. Thus one company has earnings per share of \$10,000 (= \$10,000 ÷ 1 share) and the other company has earnings per share of \$5,000 (= \$10,000 ÷ 2 shares). The second company is not performing any worse; it simply has more shares outstanding. This is why you should not compare earnings per share across companies. (Alternative terms: Earnings per share are often called EPS or income per share.)
Business in Action 13.3
Source: Photo courtesy of DangApricot, http://commons.wikimedia.org/wiki/File:AnnTaylorLoftSign.JPG.
The Importance of Earnings per Share
The business press often uses earnings per share to announce a company’s earnings. For example, the Associated Press addressed earnings at AnnTaylor Stores Corporation, a retailer of women’s clothing, as follows: “Quarterly income fell to \$7,100,000, or 10 cents per share, from \$30,100,000, or 41 cents, the year before. Setting aside relocation costs, adjusted earnings were 18 cents per share, a penny higher than the average estimate from analysts polled by Thomson Financial.”
This quote demonstrates not only that earnings per share data are important when announcing a company’s earnings but also that analysts use these data when making predictions about a company’s performance. A quick perusal of any business publication, such as The Wall Street Journal, or a review of online business press releases at sites like finance.yahoo.com will confirm that earnings per share data are commonly used to announce a company’s financial results.
Source: Associated Press, “AnnTaylor’s 2Q Profit Plummets on Charge,” August 19, 2005.
REVIEW PROBLEM 13.3
Refer to the information presented in Note 13.10 "Review Problem 13.1" for PepsiCo, and perform the following for 2010:
1. Calculate the gross margin ratio, and briefly describe what it means for PepsiCo.
2. Calculate the profit margin ratio, and briefly describe what it means for PepsiCo.
3. Calculate return on assets, and briefly describe what it means for PepsiCo.
4. Calculate return on common shareholders’ equity, and briefly describe what it means for PepsiCo. Assume PepsiCo recorded preferred dividends of \$6,000,000 in 2010.
5. Calculate earnings per share, and briefly describe what it means for PepsiCo. Assume weighted average common shares outstanding totaled 1,590,000,000 shares.
Solutions to Review Problem 13.3
1. For every dollar in net sales, PepsiCo generated 54.1 cents in gross margin.
2. For every dollar in net sales, PepsiCo generated 10.9 cents in net income.
3. For every dollar in average assets, PepsiCo generated 11.7 cents in net income.
4. For every dollar in average common shareholders’ equity, PepsiCo generated 32.3 cents in net income (after deducting preferred dividends).
5. For each common share outstanding, PepsiCo generated \$3.97 in net income (after deducting preferred dividends).
Short-Term Liquidity Ratios
Question: Suppliers and other short-term lenders often want to evaluate whether companies can meet short-term obligations. What are the four common ratios used to evaluate short-term liquidity?
Answer: The four ratios used to evaluate short-term liquidity are as follows:
1. Current ratio
2. Quick ratio
3. Receivables turnover ratio (often converted to average collection period)
4. Inventory turnover ratio (often converted to average sale period)
Current Ratio
Question: How is the current ratio calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: The current ratio indicates whether a company has sufficient current assets to cover current liabilities. It is found by dividing current assets by current liabilities:
Key Equation
The current ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Current ratio 1.17 to 1 1.28 to 1 1.11 to 1 1.20 to 1
The current ratio indicates Coca-Cola had \$1.17 in current assets for every dollar in current liabilities. This ratio decreased from 2009 to 2010 and is slightly higher than PepsiCo’s 1.11 to 1 ratio. Coca-Cola is close to the industry average of 1.20 to 1. In general, a current ratio above 1 to 1 is preferable, which indicates the company has sufficient current assets to cover current liabilities. However, finding the ideal minimum current ratio is dependent on many factors, such as the industry, the overall financial condition of the company, and the composition of the company’s current assets and current liabilities. Because of variations in these factors from one company to the next, a more stringent measure of short-term liquidity is often used. We present this measure, called the quick ratio, next.
Quick Ratio
Question: How is the quick ratio calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: The quick ratio (also called acid-test ratio) indicates whether a company has sufficient quick, or highly liquid, assets to cover current liabilities. The quick ratio is quick assets divided by current liabilities:
Key Equation
Notice the numerator excludes current assets that are not easily and quickly converted to cash. Although inventory is typically excluded from the numerator, further analysis is needed to evaluate whether inventory should be included. For example, grocery stores turn inventory over very quickly, typically within a couple of weeks, and should consider including inventory in the quick ratio. Producers of wine, on the other hand, turn inventory over very slowly, and should consider excluding inventory in the numerator of the quick ratio. For the sake of consistency, you should exclude inventory from the numerator in this chapter, unless told otherwise. (Note: Many companies provide two quick ratio calculations, one that includes inventory in the numerator and one that excludes inventory in the numerator. If two ratios are presented, it is important to label each ratio to indicate whether inventory has been included or excluded.)
It is helpful when reviewing a company’s balance sheet to remember that current assets are presented in order of liquidity, with the most liquid current asset appearing first and the least liquid appearing last. This helps in determining whether a particular current asset should be included or excluded in the numerator of the quick ratio. The quick ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Quick ratio 0.85 to 1 0.95 to 1 0.80 to 1 1.10 to 1
The quick ratio indicates Coca-Cola had \$0.85 in quick assets for every dollar in current liabilities. This ratio decreased from 2009 to 2010 and is slightly higher than PepsiCo’s 0.80 to 1 ratio. Coca-Cola is below the industry average of 1.10 to 1.
Receivables Turnover Ratio
Question: How is the receivables turnover ratio calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: The receivables turnover ratio indicates how many times receivables are collected in a given period and is found by dividing credit sales by average accounts receivable:
Key Equation
Assume all net sales presented on the income statement are on account, and therefore will be used in the numerator. The average accounts receivable amount in the denominator is found by adding together accounts receivable at the end of the current year and previous year (2010 and 2009 for this example) and dividing by two. The receivables turnover ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Receivables turnover ratio 8.58 times 9.05 times 10.57 times 9.70 times
The receivables turnover ratio indicates Coca-Cola collected receivables 8.58 times during 2010. This ratio decreased from 2009 to 2010 and is lower than PepsiCo’s 10.57 times. Coca-Cola is below the industry average of 9.70 times.
Question: How is the receivables turnover ratio converted to average collection period?
Answer: The receivables turnover ratio can be converted to the average collection period, which indicates how many days it takes on average to collect on credit sales, as follows:
Key Equation
This ratio is typically compared to the company’s credit terms to evaluate how effectively receivables are being collected. The average collection period for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Average collection period 42.54 days 40.33 days 34.53 days 37.63 days
The average collection period indicates Coca-Cola collected credit sales in 42.54 days, on average. The number of days increased slightly from 2009 to 2010 and is higher than PepsiCo’s 34.53 days. Coca-Cola is also above the industry average of 37.63 days and therefore is slower at collecting accounts receivable than the industry as a whole.
Inventory Turnover Ratio
Question: How is the inventory turnover ratio calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: The inventory turnover ratio indicates how many times inventory is sold and restocked in a given period. It is calculated as cost of goods sold divided by average inventory:
Key Equation
The average inventory amount in the denominator is found by adding together inventory at the end of the current year and previous year (2010 and 2009 for this example) and dividing by two. The inventory turnover ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Inventory turnover ratio 5.07 times 4.88 times 8.87 times 7.50 times
The inventory turnover ratio indicates Coca-Cola sold and restocked inventory 5.07 times during 2010. This ratio increased slightly from 2009 to 2010 and is substantially lower than PepsiCo’s 8.87 times. Coca-Cola is well below the industry average of 7.50 times.
Question: How is the inventory turnover ratio converted to average sale period?
Answer: The inventory turnover ratio can be converted to the average sale period, which indicates how many days it takes on average to sell the company’s inventory, as follows:
Key Equation
The average sale period for Coca-Cola for 2009 is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Average sale period 71.99 days 74.80 days 41.15 days 48.67 days
The average sale period indicates Coca-Cola sold its inventory in 71.99 days, on average. The number of days decreased from 2009 to 2010 and is substantially higher than PepsiCo’s 41.15 days. Coca-Cola is also above the industry average of 48.67 days and therefore is slower at selling inventory than the industry as a whole.
Business in Action 13.4
© Thinkstock
Industry Variations in Inventory and Receivable Turnover
Retail grocery stores turn inventory over every 22 days, meaning that shelves are emptied and restocked about every three weeks. In addition to extremely fast inventory turnover, retail grocery stores collect credit sales in seven days. Thus it takes 29 days, on average, to convert freshly stocked inventory to cash. Very few industries are able to convert inventory to cash as quickly. Examples of inventory and receivable turnover for several industries are shown in the following.
Receivables Turnover Inventory Turnover
Auto manufacturers 39 days 41 days
Chemical manufacturing 51 days 61 days
Forestry and wood products 46 days 53 days
Computer systems 78 days 18 days
Source: Industry averages found at MSN Money, Home Page,” http://moneycentral.msn.com.
REVIEW PROBLEM 13.4
Refer to the information presented in Note 13.10 "Review Problem 13.1" for PepsiCo, and perform the following requirements for 2010:
1. Calculate the current ratio, and briefly describe what it means for PepsiCo.
2. Calculate the quick ratio, and briefly describe what it means for PepsiCo.
3. Calculate the receivables turnover ratio and average collection period, and briefly describe what these measures mean for PepsiCo. Assume all sales are on account.
4. Calculate the inventory turnover ratio and average sale period, and briefly describe what these measures mean for PepsiCo.
Solution to Review Problem 13.4
1. For every dollar in current liabilities, PepsiCo had \$1.11 in current assets.
2. For every dollar in current liabilities, PepsiCo had \$0.80 in quick assets.
3. PepsiCo collected receivables 10.57 times during 2010.
PepsiCo collected credit sales in 34.53 days, on average.
4. PepsiCo sold and restocked inventory 8.87 times during 2010.
PepsiCo sold its inventory in 41.15 days, on average.
Long-Term Solvency Ratios
Question: Banks, bondholders, and other long-term lenders often want to evaluate whether companies can meet long-term obligations. What are the three common ratios used to evaluate long-term solvency?
Answer: The three ratios used to evaluate long-term solvency are as follows:
1. Debt to assets
2. Debt to equity
3. Times interest earned
Debt to Assets
Question: How is the debt to assets ratio calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: The debt to assets ratio indicates the percentage of assets funded by creditors and is used to evaluate the financial leverage of a company. Debt to assets is found by dividing total liabilities by total assets:
Key Equation
The higher the percentage, the higher the financial leverage. The debt to assets ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Debt to assets 0.57 to 1 0.48 to 1 0.68 to 1 0.48 to 1
The debt to assets ratio indicates that creditors funded 57 percent of Coca-Cola’s assets at the end of 2010. This ratio increased from 2009 to 2010 and is lower than PepsiCo’s 0.68 to 1. Coca-Cola is higher than the industry average of 0.48 to 1.
A review of the basic balance sheet equation shows that the complement of the debt to assets ratio provides the percentage of assets funded by shareholders. Thus for every dollar Coca-Cola has in assets, creditors fund \$0.57 and shareholders fund \$0.43 (= \$1 – \$0.57):
The debt to assets ratio reveals Coca-Cola (0.57 to 1) and PepsiCo (0.68 to 1) are more highly leveraged than the industry average of 0.48 to 1.
Debt to Equity
Question: How is the debt to assets ratio calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: A variation of the debt to assets ratio is the debt to equity ratio, which measures the balance of liabilities and shareholders’ equity used to fund assets. The debt to equity ratio is total liabilities divided by total shareholders’ equity:
Key Equation
This ratio indicates the amount of debt incurred for each dollar that owners provide. The debt to equity ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Debt to equity 1.33 to 1 0.92 to 1 2.17 to 1 0.94 to 1
The debt to equity ratio indicates that Coca-Cola had \$1.33 in liabilities for each dollar in shareholders’ equity. This ratio increased from 2009 to 2010 and is substantially lower than PepsiCo’s 2.17 to 1. However, Coca-Cola is higher than the industry average of 0.94 to 1.
Business in Action 13.5
Source: Photo courtesy of spechtenhauser, http://www.flickr.com/photos/usinside/2931437356/.
Financial Leverage at General Motors and Toyota
Prior to the company’s bankruptcy filing in 2009, General Motors (GM) was the largest manufacturer of automobiles and trucks in the world (ranked by revenues). However, GM took on substantial amounts of debt over several years. With an average debt to equity ratio of 2.5 to 1, the automobile industry is relatively highly leveraged, but GM’s ratio was substantially higher at 11.3 to 1. This means that GM had \$11.30 in debt for every \$1 in shareholders’ equity.
Toyota Motor Corporation, on the other hand, was not highly leveraged; it had a debt to equity ratio of 1 to 1. Thus Toyota had \$1 in debt for every \$1 in shareholders’ equity. It is important to review other financial ratios before concluding that Toyota was in better financial shape than GM, but the fact that GM was much more highly leveraged than Toyota likely played a big role in GM’s downfall!
Source: Industry averages found at MSN Money, Home Page,” http://moneycentral.msn.com and Yahoo! Finance, “Home Page,” biz.yahoo.com.
Times Interest Earned
Question: How is times interest earned calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: The times interest earned ratio (also called interest coverage ratio) measures the company’s ability to cover its interest expense related to long-term debt with current period earnings. The times interest earned ratio is net income before income tax expense and interest expense divided by interest expense:
Key Equation
Notice that income tax expense and interest expense are added back in the numerator to find net income available to cover interest expense. The times interest earned ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average information following it:
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Times interest earned 20.36 times 25.97 times 10.10 times 10.70 times
The times interest earned ratio indicates Coca-Cola had earnings to cover interest expense 20.36 times. This ratio decreased from 2009 to 2010 and is much higher than PepsiCo’s 10.10 times. Coca-Cola is also higher than the industry average of 10.70 times. It appears that Coca-Cola has plenty of earnings to cover interest expense.
REVIEW PROBLEM 13.5
Refer to the information presented in Note 13.10 "Review Problem 13.1" for PepsiCo, and perform the following requirements for 2010:
1. Calculate the debt to assets ratio, and briefly describe what it means for PepsiCo.
2. Calculate the debt to equity ratio, and briefly describe what it means for PepsiCo.
3. Calculate the times interest earned ratio, and briefly describe what it means for PepsiCo.
Solution to Review Problem 13.5
1. Creditors funded 68 percent of PepsiCo’s assets. Owners funded the remaining 32 percent.
2. For every dollar in shareholders’ equity, PepsiCo had \$2.17 in liabilities.
3. PepsiCo had earnings to cover interest expense 10.10 times.
Market Valuation Measures
Question: Existing and potential shareholders are often interested in a company’s market value. What are the two common measures used to evaluate market value?
Answer: The two measures used to determine and evaluate the market value of a company are as follows:
1. Market capitalization
2. Price-earnings ratio
Market Capitalization
Question: How is market capitalization calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: Market capitalization (also called market cap) measures the value of a company at a point in time. It is determined by multiplying market price per share times the number of shares outstanding:
Key Equation
Market capitalization = Market price per share × Number of shares outstanding
Coca-Cola’s market capitalization for 2010 is calculated as follows, with PepsiCo information following it. The number of shares outstanding at Coca-Cola’s fiscal year ended December 31, 2010, totaled 2,292,000,000 (= 3,520,000,000 shares issued – 1,228,000,000 treasury shares). The market price per share at that time was \$63.92.
Market capitalization = \$63.92 per share × 2,292,000,000 shares = \$146,500,000,000
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Market capitalization \$146,500,000,000 \$123,200,000,000 \$100,700,000,000 \$87,500,000,000
Coca-Cola’s market capitalization indicates that the company’s shares outstanding had a market value totaling \$146,500,000,000 at the end of 2010. This amount increased significantly from 2009 to 2010 and is higher than PepsiCo’s \$100,700,000,000. Both Coca-Cola and PepsiCo are above the industry average of \$87,500,000.
(Note that the number of shares outstanding is typically found in the shareholders’ equity section of the balance sheet or in the notes to the financial statements. We provide the number of shares outstanding throughout this chapter, unless noted otherwise. This number is different than the weighted average shares outstanding used to calculate earnings per share earlier in the chapter. Also note that the price per share amount is from Yahoo’s finance Web site at finance.yahoo.com. We provide this information throughout the chapter, unless noted otherwise.)
Looking at a company’s market capitalization is a quick way of gauging its aggregate value. But what does a number like Coca-Cola’s \$146,500,000,000 market capitalization really tell us about how a company compares to others? Note 13.54 "Business in Action 13.6" has the answer.
Business in Action 13.6
Three Categories of Market Capitalization
Most investors refer to market capitalization as market cap. Companies are typically classified into one of three market cap categories: small-cap, midcap, and large-cap. In general, small-cap companies have a market value of less than \$1,000,000,000, midcap companies have a market value between \$1,000,000,000 and \$12,000,000,000, and large-cap companies have a market value greater than \$12,000,000,000.
Thus small-cap mutual funds are stock funds that invest in companies with a market value of less than \$1,000,000,000. Midcap mutual funds are stock funds that invest in companies with a market value between \$1,000,000,000 and \$12,000,000,000, and so on. These categories are important to investors because the stocks of small-cap companies tend to be more volatile than those of mid- or large-cap companies.
Source: Definitions are from the Web site of Vanguard, one of the world’s largest investment management firms (http://www.vanguard.com).
Price-Earnings Ratio
Question: How is the price-earnings ratio calculated, and what does it tell us about Coca-Cola relative to PepsiCo and the industry average?
Answer: The price-earnings ratio (also called P/E ratio) measures the premium investors are willing to pay for shares of stock relative to the company’s earnings. The price-earnings ratio is found by dividing market price per share by earnings per share:
Key Equation
In general, a relatively high price-earnings ratio indicates investors expect favorable future earnings, whereas a relatively low price-earnings ratio indicates investors expect moderate future earnings. The price-earnings ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average information following it. The market price information was given in the market capitalization example, and we calculated earnings per share earlier in the chapter.
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010
Price-earnings ratio 12.48 times 18.21 times 16.04 times 14.60 times
The price-earnings ratio indicates investors were willing to pay 12.48 times the earnings for Coca-Cola’s stock. This ratio decreased from 2009 to 2010 and is lower than PepsiCo’s 16.04 times. Coca-Cola is also lower than the industry average of 14.60 times.
Key Takeaway
• Shareholders, creditors, and analysts often evaluate a company’s profitability. Five ratios used to evaluate profitability are the gross margin ratio, the profit margin ratio, return on assets, return on common shareholders’ equity, and earnings per share. Suppliers and other short-term creditors often evaluate whether a company can meet short-term obligations. Four ratios used to evaluate short-term liquidity are the current ratio, the quick ratio, the receivables turnover ratio (often converted to average collection period), and the inventory turnover ratio (often converted to average sale period). Banks, bondholders, and other long-term lenders often evaluate whether companies can meet long-term obligations. Three ratios used to evaluate long-term solvency are debt to assets, debt to equity, and times interest earned. Shareholders are particularly interested in a company’s market value. Two measures used to determine and evaluate the market value of a company are market capitalization and the price-earnings ratio.
REVIEW PROBLEM 13.6
Perform the following requirements for PepsiCo for 2010:
1. Calculate the market capitalization, and briefly describe what it means for PepsiCo. Assume PepsiCo had 1,581,000,000 shares outstanding at the end of 2010, and the market price per share was \$63.68.
2. Calculate the price-earnings ratio, and briefly describe what it means for PepsiCo. (Hint: Earnings per share was calculated for PepsiCo in Note 13.29 "Review Problem 13.3".)
Solution to Review Problem 13.6
1. PepsiCo’s shares outstanding had a market value of \$100,700,000,000 at the end of 2010.
2. Investors were willing to pay 16.04 times earnings for PepsiCo’s stock. | textbooks/biz/Accounting/Managerial_Accounting/13%3A_How_Do_Managers_Use_Financial_and_Nonfinancial_Performance_Measures/13.04%3A_Ratio_Analysis_of_Financial_Information.txt |
Recall the dialogue at Chicken Deluxe between Sandy Masako, the CEO; Dave Roberts, the CFO; and Karen Kraft, the purchasing manager. Chicken Deluxe must choose between Deep Fizz Company and Extreme Fizz, Inc., as the supplier of the company’s beverages. Dave was asked to evaluate the financial condition of each company and report back to the group. The group reconvenes the following month, where Dave presents the financial measures for each company. As you read the dialogue, refer to Table 13.3; it is the summary of financial measures that Dave provides to the group.
Table 13.3 Summary of Financial Ratios for Deep Fizz Company; Extreme Fizz, Inc.; and the Industry Average
Deep Fizz Extreme Fizz Industry Average
Profitability Measures
1. Gross margin ratio 63.1 percent 54.1 percent 53.1 percent
2. Profit margin ratio 22.1 percent 23.2 percent 19.2 percent
3. Return on assets 15.1 percent 17.3 percent 14.2 percent
4. Return on common shareholders’ equity 36.5 percent 34.9 percent 34.7 percent
5. Earnings per share \$2.01 \$3.76 Not applicable
Short-Term Liquidity Measures
6. Current ratio 0.85 to 1 1.25 to 1 1.20 to 1
7. Quick ratio 0.62 to 1 0.87 to 1 1.10 to 1
8. Receivables turnover ratio 9.10 times 10.18 times 9.70 times
9. Average collection period 40.11 days 35.85 days 37.63 days
10. Inventory turnover ratio 5.12 times 7.86 times 7.50 times
11. Average sale period 72.29 days 46.44 days 48.67 days
Long-Term Solvency Measures
12. Debt to assets 0.34 to 1 0.38 to 1 0.48 to 1
13. Debt to equity 0.67 to 1 0.86 to 1 0.94 to 1
14. Times interest earned 31.60 times 38.93 times 10.70 times
Market Valuation Measures
15. Market capitalization \$91,800,000,000 \$86,500,000,000 \$87,500,000,000
16. Price-earnings ratio 19.34 times 20.31 times 14.60 times
Sandy: Let’s get started! Dave, what do you have for us?
Dave: I used several different financial ratios to evaluate profitability, short-term liquidity, long-term solvency, and market valuation for Deep Fizz Company and Extreme Fizz, Inc., Here is a summary of the results. Items 1 through 4 show that both companies are doing very well with regard to profitability, and exceed the industry average in all four categories. Earnings per share are not relevant for comparative purposes because different companies have different amounts of shares outstanding.
Sandy: The profitability measures look good for both companies. What about the balance sheet?
Dave: For the most part, Extreme Fizz has the edge on short-term liquidity, with top marks for all short-term liquidity measures. However, Deep Fizz is not far behind. Based on items 6 through 11, I consider both companies to have strong short-term liquidity. The only concern is with Deep Fizz’s slow inventory turnover, which is well below Extreme Fizz and the industry average.
Sandy: What about long-term solvency? Given both companies have strong profitability and excellent short-term liquidity, my biggest concern is whether these companies are able to meet long-term obligations.
Dave: The short answer is both companies will be able to meet long-term obligations as indicated in the debt to assets, debt to equity, and times interest earned ratios. Also notice that both companies have large market capitalizations, and price-earnings ratios are strong across the board!
Sandy: So what do we get from all this information?
Dave: Both companies are solid. We shouldn’t have to worry about either company having financial difficulties in the near future.
Karen: Looks like we’ll have to review other factors in deciding which company to use as our supplier.
Sandy: I agree. Thanks, Dave, for your analysis. If nothing else, this puts my mind at ease about whichever company we ultimately select as our supplier.
As you can see from the Chicken Deluxe example, analysts use many different financial measures to evaluate financial performance. In the case of Deep Fizz and Extreme Fizz, both companies appear to be strong performers. Armed with this information, management can confidently choose either company knowing the winner will be on solid financial ground for years to come. | textbooks/biz/Accounting/Managerial_Accounting/13%3A_How_Do_Managers_Use_Financial_and_Nonfinancial_Performance_Measures/13.05%3A_Wrap-Up_of_Chapter_Example.txt |
LEARNING OBJECTIVE
1. Develop and analyze nonfinancial performance measures using a balanced scorecard.
Question: Although financial measures are important for evaluation purposes, many organizations use a mix of financial and nonfinancial measures to evaluate performance. For example, airlines track on-time arrival percentages carefully, and delivery companies like Federal Express (FedEx) and United Parcel Service (UPS) monitor percentages of on-time deliveries. The balanced scorecard uses several alternative measures to evaluate performance. What is a balanced scorecard and how does it help companies to evaluate performance?
Answer: The balanced scorecard is a balanced set of measures that organizations use to motivate employees and evaluate performance. These measures are typically separated into four perspectives outlined in the following. (Dr. Robert S. Kaplan and Dr. David P. Norton created the balanced scorecard, and it is actively promoted through their company, Balanced Scorecard Collaborative. More information can be found at the company’s Web site at www.bscol.com.)
1. Financial. Measures that shareholders, creditors, and other stakeholders use to evaluate financial performance.
2. Internal business process. Measures that management uses to evaluate efficiency of existing business processes.
3. Learning and growth. Measures that management uses to evaluate effectiveness of employee training.
4. Customer. Measures that management uses to evaluate whether the organization is meeting customer expectations.
The goal is to link these four perspectives to the company’s strategies and goals. For example, a high percentage of on-time arrivals is likely an important goal from the perspective of the customer of an airline. A high percentage of defect-free computer chips is likely an important goal from the internal business process perspective of a computer chip maker. A high number of continuing education hours is likely an important goal from the learning and growth perspective for tax personnel at an accounting firm. Measures from a financial perspective were covered earlier in this chapter.
Companies that use the balanced scorecard typically establish several measures for each perspective. Table 13.4 lists several examples of these measures.
Table 13.4 Balanced Scorecard Measures
Financial Internal Business Process Learning and Growth Customer
Gross margin ratio Defect-free rate Hours of employee training Customer satisfaction (survey)
Return on assets Customer response time Employee satisfaction (survey) Number of customer complaints
Receivables turnover Capacity utilization Employee turnover Market share
Inventory turnover New product development time Number of employee accidents Number of returned products
Measures established across the four perspectives of the balanced scorecard are linked in a way that motivates employees to achieve company goals. For example, if the company wants to increase the defect-free rate and reduce product returns, effective employee training and low employee turnover will help in achieving this goal. The idea is to establish company goals first, then create measures that motivate employees to reach company goals.
Key Takeaway
• Most organizations use a mix of financial and nonfinancial measures to evaluate performance. The balanced scorecard approach uses a balanced set of measures separated into four perspectives—financial, internal business process, learning and growth, and customer. The last three perspectives tend to include nonfinancial measures, such as hours of employee training or number of customer complaints, to evaluate performance. The goal is to link financial and nonfinancial measures to the company’s strategies and goals.
REVIEW PROBLEM 13.7
Assume Chicken Deluxe, the fast-food restaurant franchise featured in this chapter, uses a balanced scorecard. Provide at least two examples of measures that Chicken Deluxe might use for each of the following perspectives of the balanced scorecard:
1. Financial
2. Internal business process
3. Learning and growth
4. Customer
Solution to Review Problem 13.7
1. Answers will vary. Several examples of financial measures are as follows:
• Gross margin ratio
• Profit margin ratio
• Return on assets
• Receivables turnover
• Inventory turnover
2. Answers will vary. Several examples of internal business process measures are as follows:
• Capacity utilization
• Amount of food spoilage
• Order response time
3. Answers will vary. Several examples of learning and growth measures are as follows:
• Hours of employee training
• Employee satisfaction
• Employee turnover
• Number of employee accidents
4. Answers will vary. Several examples of customer perspective measures are as follows:
• Customer satisfaction
• Number of customer complaints
• Market share
• Amount of food returned
END-OF-CHAPTER EXERCISES
Questions
1. What is trend analysis? Explain how the percent change from one period to the next is calculated.
2. What is common-size analysis? How is common-size analysis information used?
3. Explain the difference between trend analysis and common-size analysis.
4. Name the ratios used to evaluate profitability. Explain what the statement “evaluate profitability” means.
5. Coca-Cola’s return on assets was 19.4 percent, and return on common shareholders’ equity was 41.7 percent. Briefly explain why these two percentages are different.
6. Coca-Cola had earnings per share of \$5.12, and PepsiCo had earnings per share of \$3.97. Is it accurate to conclude PepsiCo was more profitable? Explain your reasoning.
7. Name the ratios used to evaluate short-term liquidity. Explain what the statement “evaluate short-term liquidity” means.
8. Explain the difference between the current ratio and the quick ratio.
9. Coca-Cola had an inventory turnover ratio of 5.07 times (every 71.99 days), and PepsiCo had an inventory turnover ratio of 8.87 times (every 41.15 days). Which company had the best inventory turnover? Explain your reasoning.
10. Name the ratios used to evaluate long-term solvency. Explain what the term “long-term solvency” means.
11. Name the measures used to determine and evaluate the market value of a company. Briefly describe the meaning of each measure.
12. What is the balanced scorecard? Briefly describe the four perspectives of the balanced scorecard.
Brief Exercises
1. Evaluating Suppliers at Chicken Deluxe. Refer to the dialogue at Chicken Deluxe presented at the beginning of the chapter and the follow-up dialogue immediately following Note 13.58 "Review Problem 13.6".
Required:
1. What is the big decision that Chicken Deluxe is facing?
2. Briefly describe the results of Dave’s analysis of the two suppliers.
2. Required:
3. Common-Size Analysis. Refer to the condensed income statement for Apple, Inc., in Brief Exercise 14.
Required:
Prepare a common-size analysis of the income statements for 2010 and 2011. Use the format shown in Figure 13.5 as a guide. (Round percent computations to one decimal place.)
4. Gross Margin and Profit Margin Ratios. Refer to the condensed income statement for Apple, Inc., in Brief Exercise 14.
Required:
Compute the following profitability ratios for 2011, and provide a brief explanation after each ratio (round computations to one decimal place):
1. Gross margin ratio
2. Profit margin ratio
5. Current and Quick Ratios. A condensed balance sheet for Apple, Inc., appears in the following.
Required:
Compute the following short-term liquidity ratios for 2011, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Current ratio
2. Quick ratio
6. Long-Term Solvency Ratios. Refer to the condensed balance sheet for Apple, Inc., in Brief Exercise 17.
Required:
Compute the following long-term solvency ratios for 2011, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Debt to assets
2. Debt to equity
7. Market Capitalization. On September 24, 2011, Apple, Inc., had 929,277,000 shares of common stock issued and outstanding, and the market price per share on that date was \$403.33.
Required:
Compute Apple’s market capitalization at September 24, 2011, and provide a brief explanation of what this measures represents (state the answer in billions).
8. Balanced Scorecard. Provide two nonfinancial measures likely used by delivery companies like FedEx and UPS.
Exercises: Set A
1. Trend Analysis. The following condensed income statement is for CarMax, Inc., a large retailer of used vehicles.
Required:
1. Prepare a trend analysis of the income statements from 2010 to 2011. Use the format shown in Figure 13.1 as a guide. (Round computations to one decimal place.)
2. What does the trend analysis prepared in requirement a tell you about the company?
2. Common-Size Analysis. Refer to the condensed income statement for CarMax, Inc., in Exercise 21.
Required:
1. Prepare a common-size analysis of the income statements for 2011 and 2010. Use the format shown in Figure 13.5 as a guide. (Round computations to one decimal place.)
2. What does the common-size analysis in requirement a tell you about the company?
3. Profitability Ratios. Refer to the condensed income statement for CarMax, Inc., in Exercise 21 and to the company’s balance sheet shown as follows.
Required:
Compute the following profitability ratios for 2011, and provide a brief explanation after each ratio (round percentage computations to one decimal place and earnings per share to two decimal places):
1. Gross margin ratio
2. Profit margin ratio
3. Return on assets
4. Return on common shareholders’ equity
5. Earnings per share (assume weighted average shares outstanding totaled 223,449,000 shares)
4. Short-Term Liquidity Ratios. Refer to the condensed income statement for CarMax, Inc., in Exercise 21 and to the company’s balance sheet in Exercise 23.
Required:
Compute the following short-term liquidity ratios for 2011, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Current ratio
2. Quick ratio
3. Receivables turnover ratio and average collection period (assume all sales are on account)
4. Inventory turnover ratio and average sale period
5. Long-Term Solvency Ratios. Refer to the condensed income statement for CarMax, Inc., in Exercise 21 and to the company’s balance sheet in Exercise 23.
Required:
Compute the following long-term solvency ratios for 2011, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Debt to assets
2. Debt to equity
3. Times interest earned
6. Market Valuation Measures. The following requirements are for CarMax, Inc., as of February 28, 2011.
Required:
1. Compute the following market valuation measures for 2011, and provide a brief explanation after each measure (state market capitalization in billions, and round price-earnings ratio to two decimal places):
1. Market capitalization (assume 225,885,693 shares were issued and outstanding at February 28, 2011, and the market price was \$35.37 per share)
2. Price-earnings ratio (assume earnings per share was \$1.71)
2. Refer to Note 13.54 "Business in Action 13.6" In which category does CarMax belong? Explain.
7. Balanced Scorecard Customer Measures. Tech University has more than 10,000 students enrolling in courses each term. The management would like to develop a balanced scorecard to assess performance.
Required:
Provide at least three customer measures Tech University can use on its balanced scorecard. Assume students are the customers.
Exercises: Set B
1. Trend Analysis. The following condensed income statement is for Colgate-Palmolive Company, a large retailer of personal and home care products.
Required:
1. Prepare a trend analysis of the income statements from 2009 to 2010. Use the format shown in Figure 13.1 as a guide. (Round computations to one decimal place.)
2. What does the trend analysis prepared in requirement a tell you about the company?
2. Common-Size Analysis. Refer to the condensed income statement for Colgate-Palmolive Company in Exercise 28.
Required:
1. Prepare a common-size analysis of the income statements for 2010 and 2009. Use the format shown in Figure 13.5 as a guide. (Round computations to one decimal place.)
2. What does the common-size analysis in requirement a tell you about the company?
3. Profitability Ratios. Refer to the condensed income statement for Colgate-Palmolive Company in Exercise 28. Assume the company paid preferred dividends totaling \$34,000,000 during 2010. (The company had preferred stock outstanding during 2010, but eliminated all preferred stock by the end of 2010. This is why preferred stock has a zero balance as of December 31, 2010.)
Required:
Compute the following profitability ratios for 2010, and provide a brief explanation after each ratio (round percentage computations to one decimal place and earnings per share to two decimal places):
1. Gross margin ratio
2. Profit margin ratio
3. Return on assets
4. Return on common shareholders’ equity
5. Earnings per share (assume weighted average shares outstanding totaled 487,800,000 shares)
4. Short-Term Liquidity Ratios. Refer to the condensed income statement for Colgate-Palmolive Company in Exercise 28 and to the company’s balance sheet in Exercise 30.
Required:
Compute the following short-term liquidity ratios for 2010, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Current ratio
2. Quick ratio
3. Receivables turnover ratio and average collection period (assume all sales are on account)
4. Inventory turnover ratio and average sale period
5. Long-Term Solvency Ratios. Refer to the condensed income statement for Colgate-Palmolive Company in Exercise 28 and to the company’s balance sheet in Exercise 30.
Required:
Compute the following long-term solvency ratios for 2010, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Debt to assets
2. Debt to equity
3. Times interest earned
6. Market Valuation Measures. The following requirements are for Colgate-Palmolive Company as of December 31, 2010.
Required:
1. Compute the following market valuation measures for 2010, and provide a brief explanation after each measure (state market capitalization in billions, and round price-earnings ratio to two decimal places):
1. Market capitalization (assume 494,850,467 shares were issued and outstanding at December 31, 2010, and the market price was \$77.74 per share)
2. Price-earnings ratio (assume earnings per share was \$4.45)
2. Refer to Note 13.54 "Business in Action 13.6" In which category does Colgate-Palmolive belong? Explain.
7. Balanced Scorecard Internal Business Process Measures. Tony’s Pizzeria serves pizzas at its restaurants and provides delivery services to customers. The management would like to develop a balanced scorecard to assess performance.
Required:
Provide at least three internal business process measures Tony’s Pizzeria can use on its balanced scorecard.
Problems
1. Trend Analysis and Common-Size Analysis. The following condensed income statement and balance sheet are for Nordstrom, Inc., a large retailer of apparel. (Note that Nordstrom’s 2010 fiscal year ends on January 29, 2011. This is called the 2010 fiscal year because only one month is in 2011, the other 11 months of the fiscal year are in 2010, and the company has chosen to refer to this as the 2010 fiscal year. This same concept applies to fiscal year 2009.)
Required:
1. Prepare a trend analysis of the income statements from 2009 to 2010. Use the format shown in Figure 13.1 as a guide. (Round computations to one decimal place.)
2. Prepare a trend analysis of the balance sheets from 2009 to 2010. Use the format shown in Figure 13.2 as a guide. (Round computations to one decimal place.)
3. Identify all items that changed by more than 20 percent in the trend analyses prepared in requirements a and b, and briefly comment on the results.
4. Prepare a common-size analysis of the income statements for 2010 and 2009. Use the format shown in Figure 13.5 as a guide. (Round computations to one decimal place.)
5. Prepare a common-size analysis of the balance sheets for 2010 and 2009. Use the format shown in Figure 13.6 as a guide. (Round computations to one decimal place.)
6. What does the common-size analysis prepared in requirements d and e tell you about the company?
2. Profitability and Short-Term Liquidity Ratios. Refer to the information presented in Problem 35 for Nordstrom.
Required:
1. Compute the following profitability ratios for 2010, and provide a brief explanation after each ratio (round percentage computations to one decimal place and earnings per share to two decimal places):
1. Gross margin ratio
2. Profit margin ratio
3. Return on assets
4. Return on common shareholders’ equity
5. Earnings per share (weighted average shares outstanding totaled 218,800,000 shares)
2. Compute the following short-term liquidity ratios for 2010, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Current ratio
2. Quick ratio
3. Receivables turnover ratio and average collection period (assume all sales are on account)
4. Inventory turnover ratio and average sale period
3. Long-Term Solvency Ratios and Market Valuation Measures. Refer to the information presented in Problem 35 for Nordstrom.
Required:
1. Compute the following long-term solvency ratios for 2010, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Debt to assets
2. Debt to equity
3. Times interest earned
2. Compute the following market valuation measures for 2010, and provide a brief explanation after each measure (state market capitalization in billions, and round price-earnings ratio to two decimal places):
1. Market capitalization (assume 218,000,000 shares were issued and outstanding at January 29, 2011, and the market price was \$40.08 per share)
2. Price-earnings ratio (assume the earnings per share amount was \$2.80)
4. Income Statement Trend, Common-Size, and Profitability Analysis. The following condensed income statement and balance sheet are for Starbucks Corporation, a large retailer of specialty coffee with stores throughout the world.
Required:
1. Prepare a trend analysis of the income statements from 2010 to 2011. Use the format shown in Figure 13.1 as a guide. (Round computations to one decimal place.)
2. Identify all items that changed by more than 20 percent in the trend analysis prepared in requirement a, and briefly comment on the results.
3. Prepare a common-size analysis of the income statements for 2011 and 2010. Use the format shown in Figure 13.5 as a guide. (Round computations to one decimal place.)
4. What does the common-size analysis prepared in requirement c tell you about the company?
5. Compute the following profitability ratios for 2011, and provide a brief explanation after each ratio (round percentage computations to one decimal place and earnings per share to two decimal places):
1. Gross margin ratio
2. Profit margin ratio
3. Return on assets
4. Return on common shareholders’ equity
5. Earnings per share (assume weighted average shares outstanding totaled 748,300,000 shares)
5. Short-Term Liquidity, Long-Term Solvency, and Market Valuation. Refer to the information presented in Problem 38 for Starbucks.
Required:
1. Compute the following short-term liquidity ratios for 2011, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Current ratio
2. Quick ratio
3. Receivables turnover ratio and average collection period (assume all sales are on account)
4. Inventory turnover ratio and average sale period
2. Compute the following long-term solvency ratios for 2011, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Debt to assets
2. Debt to equity
3. Times interest earned
3. Compute the following market valuation measures for 2011, and provide a brief explanation after each measure (state market capitalization in billions, and round price-earnings ratio to two decimal places):
1. Market capitalization (assume 744,800,000 shares were issued and outstanding at October 2, 2011, and the market price was \$37.14 per share)
2. Price-earnings ratio (assume the earnings per share amount was \$1.66)
6. Balance Sheet Trend and Common-Size Analysis. The following condensed income statement and balance sheet are for Wal-Mart Stores, Inc. (note that Wal-Mart’s 2010 fiscal year ends on January 31, 2011. This is called the 2010 fiscal year because only one month is in 2011, the other 11 months of the fiscal year are in 2010, and the company has chosen to refer to this as the 2010 fiscal year. This same concept applies to fiscal year 2009.)
Required:
1. Prepare a trend analysis of the balance sheets from 2009 to 2010. Use the format shown in Figure 13.2 as a guide. (Round computations to one decimal place.)
2. Prepare a common-size analysis of the balance sheets for 2010 and 2009. Use the format shown in Figure 13.6 as a guide. (Round computations to one decimal place.)
3. What does the balance sheet common-size analysis prepared in requirement b tell you about the company?
7. Income Statement Trend and Common-Size Analysis; Profitability Ratios. Refer to the information presented in Problem 40 for Wal-Mart.
Required:
1. Prepare a trend analysis of the income statements from 2009 to 2010. Use the format shown in Figure 13.1 as a guide. (Round computations to one decimal place.)
2. Based on the income statement trend analysis prepared in requirement a, describe what caused the increase in operating income from 2009 to 2010.
3. Prepare a common-size analysis of the income statements for 2010 and 2009. Use the format shown in Figure 13.5 as a guide. (Round computations to one decimal place.)
4. What does the income statement common-size analysis prepared in requirement c tell you about the company?
5. Compute the following profitability ratios for 2010, and provide a brief explanation after each ratio (round percentage computations to one decimal place and earnings per share to two decimal places):
1. Gross margin ratio
2. Profit margin ratio
3. Return on assets
4. Return on common shareholders’ equity
5. Earnings per share (assume weighted average shares outstanding totaled 3,656,000,000 shares)
8. Short-Term Liquidity, Long-Term Solvency, Market Valuation, and Balanced Scorecard. Refer to the information presented in Problem 40 for Wal-Mart.
Required:
1. Compute the following short-term liquidity ratios for 2010, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Current ratio
2. Quick ratio
3. Receivables turnover ratio and average collection period (assume all sales are on account)
4. Inventory turnover ratio and average sale period
2. Compute the following long-term solvency ratios for 2010, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Debt to assets
2. Debt to equity
3. Times interest earned
3. Compute the following market valuation measures for 2010, and provide a brief explanation after each measure (state market capitalization in billions, and round price-earnings ratio to two decimal places):
1. Market capitalization (assume 3,516,000,000 shares were issued and outstanding at January 31, 2011, and the market price was \$54.58 per share)
2. Price-earnings ratio (assume the earnings per share amount was \$4.48)
4. Assume Wal-Mart uses a balanced scorecard to assess performance. Provide at least two learning and growth measures the company can use on its balanced scorecard.
One Step Further: Skill-Building Cases
1. Trend Information in Annual Reports. Refer to Note 13.9 "Business in Action 13.1" Why is trend information important to shareholders?
2. Earnings per Share. Refer to Note 13.28 "Business in Action 13.3" Was AnnTaylor Stores’ earnings per share higher or lower than analysts expected? Explain whether you would expect the company’s stock price to increase or decrease as a result of the press release.
3. Inventory Turnover in the Computer Industry. Refer to Note 13.42 "Business in Action 13.4" Why do you think inventory turnover for the computer hardware industry is so quick?
4. Financial Leverage in the Auto Industry. Refer to Note 13.48 "Business in Action 13.5" Why do most investors consider GM to be highly leveraged?
5. Market Capitalization Categories. Refer to Note 13.54 "Business in Action 13.6" Define what is meant by small-cap, midcap, and large-cap. In which category does Coca-Cola belong? Explain.
6. Internet Project: Financial Statement Analysis. Using the Internet, find the most recent annual report (or form 10K) for a manufacturing or retail company of your choice. Most companies have links to the information at their Web sites under titles, such as investor relations or financial reports. Print the income statement and balance sheet for the company selected and include these documents with your response to the following requirements.
Required:
1. Compute the following profitability ratios for the most current year, and provide a brief explanation after each ratio (round percentage computations to one decimal place):
1. Gross margin ratio
2. Profit margin ratio
3. Return on assets
4. Return on common shareholders’ equity
2. Compute the following short-term liquidity ratios for the most current year, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Current ratio
2. Quick ratio
3. Receivables turnover ratio and average collection period (assume all sales are on account)
4. Inventory turnover ratio and average sale period
3. Compute the following long-term solvency ratios for the most current year, and provide a brief explanation after each ratio (round computations to two decimal places):
1. Debt to assets
2. Debt to equity
4. Provide a one-page written report summarizing your results in requirements a, b, and c. Identify any areas of concern as well as areas of strength for the company.
7. Group Activity: Analyzing Lowe’s Companies, Inc. The condensed income statement and balance sheet information provided as follows is for Lowe’s Companies, Inc., a large retail company that sells building materials and supplies. Lowe’s had 1,354,000,000 shares issued and outstanding at January 28, 2011, and the market price per share on that date was \$24.83. (Note that Lowe’s 2010 fiscal year ends on January 28, 2011. This is called the 2010 fiscal year because only one month is in 2011, the other 11 months of the fiscal year are in 2010, and the company has chosen to refer to this as the 2010 fiscal year. This same concept applies to fiscal year 2009.)
Form groups of two to four students. Each group is to be assigned one of the following three categories of financial measures:
1. Profitability measures
• Gross margin ratio
• Profit margin ratio
• Return on assets
• Return on common shareholders’ equity
2. Short-term liquidity measures
• Current ratio
• Quick ratio
• Inventory turnover ratio and average sales period
3. Long-term solvency and market valuation measures
• Debt to assets
• Debt to equity
• Market capitalization
Required:
1. Calculate the financial measures assigned to your group. Round all computations to two decimal places, except the market capitalization measure, which can be rounded to the nearest billion dollars.
2. Provide a brief explanation of each measure your group calculated in requirement a.
3. Discuss the results of your group with the class.
8. Performing Income Statement Trend Analysis Using Excel. Review the information for Apple, Inc., in Brief Exercise 14.
Required:
Perform income statement trend analysis for Apple, Inc., using an Excel spreadsheet. The format should be similar to the one in Figure 13.1. Round percent computations to one decimal place.
Comprehensive Cases
1. Financial Statement Analysis and Industry Standards; Manufacturing Company. Susan Hartford is the president and CEO of Computer Makers, Inc. The company is in the process of looking for a supplier of computer chips, and Susan has asked her staff to review the financial stability of Intel Corporation, the world’s largest maker of computer chips. Susan’s staff began by collecting industry average information, which is shown as follows, and would like your help in calculating and evaluating these measures for Intel.
Measure Industry Average Intel
Gross margin 57.7 percent ?
Profit margin 21.9 percent ?
Return on assets 17.7 percent ?
Return on common shareholders’ equity 21.5 percent ?
Current ratio 2.3 to 1 ?
Quick ratio 1.9 to 1 ?
Receivables turnover 12.8 times ?
Inventory turnover 4.8 times ?
Debt to assets 0.21 to 1 ?
Debt to equity 0.26 to 1 ?
Market capitalization \$80,000,000,000 ?
Intel’s income statement and balance sheet are provided as follows. The price for 1 share of common stock at December 25, 2010, the end of Intel’s fiscal year, was \$20.13. The number of shares issued and outstanding at December 25, 2010, totaled 5,581,000,000. Assume all sales were on account.
Required:
1. Using the industry average measures provided, compute the same measures for Intel for its fiscal year ended December 25, 2010. (State your results in the same format used for industry averages.)
2. Summarize your results in requirement a by completing a table using the following headings:
Measure Industry Average Intel Corporation
Immediately following each measure, indicate whether Intel’s financial condition is better or worse than the industry average.
3. Using your answers to requirements a and b to support your position, determine whether Intel is financially stable.
2. Ethics: Manipulating Data to Meet Loan Requirements. Custom Tech, Inc., designs and produces computers for a variety of customers. The company has encountered a cash shortage resulting from collection problems with several customers. If Custom Tech is unable to collect a significant portion of its receivables relatively soon, the company will not be able to pay suppliers and employees next quarter. As a result, Custom Tech’s president, Don Lardner, began discussions with a local bank about obtaining a short-term loan. Don did not mention the cause of the cash flow shortage other than to say, “This happens the same time every year due to the cyclical nature of our business.”
In a meeting with the bank’s loan officer, Jan Johnson, Don was told the loan should not be a problem as long as Custom Tech maintains a profit margin ratio above 10 percent, quick ratio above 1.0 to 1, and debt to equity ratio below 1.4 to 1. Don indicated this was in line with his company’s performance and agreed to provide financial statements for the most recent year at their next meeting.
The financial statements shown as follows are for Custom Tech’s most recent year ended December 31. This information has not yet been provided to the bank.
Required:
1. Calculate the ratios required by the bank and determine whether Custom Tech will qualify for the loan.
2. Assume you are the CFO for Custom Tech. Don Lardner asks you to reclassify \$30,000 in current liabilities to common stock. Don states, “We owe it to our shareholders and employees to do whatever it takes to get this loan! Without it, we may have to file for bankruptcy and let our employees go. Once we get this loan and collect our outstanding receivables we’ll be in good shape.” Prepare a revised balance sheet after making the \$30,000 reclassification, recalculate the ratios required by the bank, and determine whether Custom Tech will qualify for the loan with the revised numbers.
3. Are the president’s actions ethical? If you were the CFO, how would you handle the president’s request? (To answer these questions, you may want to review the presentation of ethics in Chapter 1.) | textbooks/biz/Accounting/Managerial_Accounting/13%3A_How_Do_Managers_Use_Financial_and_Nonfinancial_Performance_Measures/13.06%3A_Nonfinancial_Performance_Measures-_The_Balanced_Scorecard.txt |
Learning Objectives
By the end of this section, the students should be able to
• Compare and contrast financial vs. managerial accounting.
• Apply accounting procedures for manufacturing businesses.
After you complete the required assignments you will be able to:
• Compare/Contrast Financial vs. Managerial Accounting.
• Define product and period costs
• Compute cost of goods sold for a manufacturer
• Prepare a manufacturing statement
01: Nature of Managerial Accounting and Costs
Knowledge Targets
I can define the following terms as they relate to our unit:
Direct Cost Indirect Cost Prime Cost
Conversion Cost
Product Cost Period Cost Direct Material
Direct Labor
Overhead Raw Materials Indirect Materials
Indirect Labor
Cost of Goods Sold Variable Cost Fixed Cost
Cost of Goods Manufactured
Financial Accounting Managerial Accounting Goods in Process
Finished Goods
Reasoning Targets
• I can identify differences between financial and managerial accounting.
• I can classify costs as direct or indirect, fixed or variable, prime or conversion, and product or period.
• I can identify product costs as direct materials, direct labor or overhead.
• I can understand the flow of goods from raw materials inventory to goods in process inventory to finished goods inventory.
• I can understand the difference between cost of goods manufactured and cost of goods sold in a manufacturing environment.
• I can prepare a manufacturing statement with cost of goods manufactured calculated.
Skill Targets
• I can calculate direct materials used from raw materials inventory data.
• I can calculate cost of goods manufactured for a manufacturer.
• I can calculate cost of goods sold for a merchandiser and a manufacturer.
• I can prepare a manufacturing statement with cost of goods manufactured calculated.
Click Chapter 1 Plan for a printable copy.
1.02: The Role of Accounting in the Basic Management Process
Managerial accounting helps managers make good decisions. Managerial accounting provides information about the cost of goods and services, whether a product is profitable, whether to invest in a new business venture, and how to budget. It compares actual performance to planned performance and facilitates many other important decisions critical to the success of organizations.
The remaining chapters in this book focus on managerial accounting. This chapter provides an overview of managerial accounting and shows how to determine the cost of a particular type of product known as a job.
A YouTube element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/llmanagerialaccounting/?p=28
Compare managerial accounting with financial accounting
Whereas financial accounting provides financial information primarily for external use, managerial accounting information is for internal use. By reporting on the financial activities of the organization, financial accounting provides information needed by investors and creditors.
Most managerial decisions require more detailed information than that provided by external financial reports. For instance, in their external financial statements, large corporations such as General Electric Company show single amounts on their balance sheets for inventory. However, managers need more detailed information about the cost of each of several hundred products.
We show the fundamental differences between managerial and financial accounting in the chart and video.
Financial accounting Managerial accounting
Users External users of information – usually shareholders, financial analysts, and creditors Internal users of information – usually managers.
GAAP Must comply with generally accepted accounting principles. NO generally accepted accounting principle requirements
Time Period Uses historical (or past) data. May use estimates of the future for budgeting and decision making.
Detail presented Presents summary data, costs, revenues, and profits. More detailed data are presented about product.
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Accountants currently face a big challenge: designing information systems that provide information for multiple purposes. Some people at lower levels in the organization need detailed information, but not the big picture provided by a company’s income statement. However, managers at top levels need to see the big picture.
All of you will use accounting information in your careers. Therefore, you need to know enough about accounting to get the information you need for decision making.
Managerial accountants face many choices involving ethics. For example, managers are responsible for achieving financial targets such as net income. Managers who fail to achieve these targets may lose their jobs. If a division or company is having trouble achieving financial performance targets, managers may be tempted to manipulate the accounting numbers.
In its Standards of Ethical Conduct for Management Accountants, the Institute of Management Accountants (IMA) states that management accountants have an obligation to maintain the highest levels of ethical conduct by maintaining professional competency, refraining from disclosing confidential information, and maintaining integrity and objectivity in their work.[1]
The standards recommend that people faced with ethical conflicts follow the company’s established policies that deal with such conflicts. If the policies do not resolve the conflict, accountants should consider discussing the matter with their superiors, potentially going as high as the audit committee of the board of directors. In extreme cases, the accountants may have no alternative but to resign.
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Financial reporting by manufacturing companies
Many of you will work in manufacturing companies or provide services for them. Others will work in retail or service organizations that do business with manufacturers. This section will help you understand how manufacturing companies work and how to read both their internal and external financial statements.
Assume you own a bicycle store and purchase bicycles and accessories to sell to customers. To determine your profitability, you would subtract the cost of bicycles and accessories from your gross sales as cost of goods sold. However, if you owned the manufacturing company that made the bicycles, you would base your cost of goods sold on the cost of manufacturing those bicycles. Accounting for manufacturing costs is more complex than accounting for costs of merchandise purchased that is ready for sale.
Perhaps the most important accounting difference between merchandisers and manufacturers relates to the differences in the nature of their activities. A merchandiser purchases finished goods ready to be sold. On the other hand, a manufacturer must purchase raw materials and use production equipment and employee labor to transform the raw materials into finished products.
Thus, while a merchandiser has only one type of inventory—merchandise available for sale—a manufacturer has three types—unprocessed materials, partially complete work in process, and ready-for-sale finished goods. Instead of one inventory account, three different inventory accounts are necessary to show the cost of inventory in various stages of production. Looking at Exhibit 2, you can see how the inventory cost flows differ between manufacturing and merchandising companies.
We compare a manufacturer’s cost of goods sold section of the income statement to that same section of the merchandiser’s income statement in the chart below. There are two major differences in these cost of goods sold sections: (1) goods ready to be sold are referred to as merchandise inventory by a merchandiser and finished goods inventory by a manufacturer, and (2) the net cost of purchases for a merchandiser is equivalent to the cost of goods manufactured by a manufacturer.
Merchandiser Manufacturer
Cost of goods sold: Cost of goods sold:
Merchandise inventory, Beginning \$ 25,000 Finished goods inventory, Beginning \$ 50,000
Net cost of purchases 165,000 Cost of goods manufactured
1,100,000
Cost of goods available for sale \$ 190,000 Cost of goods available for sale \$1,150,000
Merchandise inventory, Ending 30,000 Finished goods inventory, Ending 60,000
Cost of goods sold \$ 160,000 Cost of goods sold \$1,090,000
Unlike a merchandiser’s balance sheet that reports a single inventory amount, the balance sheet for a manufacturer typically shows materials, work in process, and finished goods inventories separately. The video and chart will explain these concepts further.
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Account Account Type Description
Raw Materials Inventory Current Asset all materials to be used in production (including direct and indirect materials)
Work in Process Inventory Current Asset Direct Material + Direct Labor + Overhead applied to items started but not completed
Finished Goods Inventory Current Asset Direct Material + Direct Labor + Overhead applied to items completed BUT not sold
Cost of goods sold Expense Direct Material + Direct Labor + Overhead applied to items completed AND sold
The next section will explain the different cost types of direct materials, direct labor and overhead.
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Merchandiser and manufacturer accounting: Differences in cost concepts
Cost is a financial measure of the resources used or given up to achieve a stated purpose. Product costs are the costs a company assigns to units produced. Product costs are the costs of making a product, such as an automobile; the cost of making and serving a meal in a restaurant; or the cost of teaching a class in a university.
Manufacturing companies use the most complex product costing methods. To ensure that you understand how and why product costing is done in manufacturing companies, we use many manufacturing company examples. However, since many of you could have careers in service or merchandising companies, we also use nonmanufacturing examples.
In manufacturing companies, a product’s cost is made up of three cost elements: direct material costs, direct labor costs, and manufacturing overhead costs.
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Direct materials
Materials are unprocessed items used in the manufacturing process. Direct materials are those materials used only in making the product and are clearly and easily traceable to a particular product. For example, iron ore is a direct material to a steel company because the iron ore is clearly traceable to the finished product, steel. In turn, steel becomes a direct material to an automobile manufacturer.
Some materials (such as glue and thread used in manufacturing furniture) may become part of the finished product, but tracing those materials to a particular product would require more effort than is sensible. Such materials, called indirect materials or supplies, are included in manufacturing overhead. Indirect materials are materials used in the manufacture of a product that cannot, or will not for practical reasons, be traced directly to the product being manufactured. Indirect materials are part of overhead, which we will discuss later.
Direct labor
Direct labor costs include the labor costs of all employees actually working on materials to convert them into finished goods. As with direct material costs, direct labor costs of a product include only those labor costs clearly traceable to, or readily identifiable with, the finished product. The wages paid to a construction worker, a pizza delivery driver, and an assembler in an electronics company are examples of direct labor.
Many employees receive fringe benefits—employers pay for payroll taxes, pension costs, and paid vacations. These fringe benefit costs can significantly increase the direct labor hourly wage rate. Some companies treat fringe benefit costs as direct labor. Other companies include fringe benefit costs in overhead if they can be traced to the product only with great difficulty and effort.
Firms account for some labor costs (for example, wages of materials handlers, custodial workers, and supervisors) as indirect labor because the expense of tracing these costs to products would be too great. These indirect labor costs are part of overhead. Indirect labor consists of the cost of labor that cannot, or will not for practical reasons, be traced to the products being manufactured.
Overhead
In a manufacturing company, overhead is generally called manufacturing overhead. (You may also see other names for manufacturing overhead, such as factory overhead, factory indirect costs, or factory burden.) Service companies use service overhead, and construction companies use construction overhead. Any of these companies may just use the term overhead rather than specifying it as manufacturing overhead, service overhead, or construction overhead. Some people confuse overhead with selling and administrative costs. Overhead is part of making the good or providing the service, whereas selling costs result from sales activity and administrative costs result from running the business.
In general, overhead refers to all costs of making the product or providing the service except those classified as direct materials or direct labor. (Some service organizations have direct labor but not direct materials.) In manufacturing companies, manufacturing overhead includes all manufacturing costs except those accounted for as direct materials and direct labor. Manufacturing overhead costs are manufacturing costs that must be incurred but that cannot or will not be traced directly to specific units produced. In addition to indirect materials and indirect labor, manufacturing overhead includes depreciation and maintenance on machines and factory utility costs. Look at the following for more examples of manufacturing overhead costs.
Indirect labor including: Repairs and maintenance on factory buildings and equipment
Janitors in factory buildings Payroll taxes and fringe benefits for manufacturing employees
Supervisors in factory buildings Depreciation on factory buildings and equipment
Materials storeroom personnel Insurance and taxes on factory property and inventories
Cost accountant salary Utilities for factory buildings
Indirect materials including:
Oil
Nails
Selling expenses
Selling expenses are costs incurred to obtain customer orders and get the finished product in the customers’ possession. Advertising, market research, sales salaries and commissions, and delivery and storage of finished goods are selling costs. The costs of delivery and storage of finished goods are selling costs because they are incurred after production has been completed. Therefore, the costs of storing materials are part of manufacturing overhead, whereas the costs of storing finished goods are a part of selling costs. Remember that retailers, wholesalers, manufacturers, and service organizations all have selling costs.
Administrative expenses
Administrative expenses are nonmanufacturing costs that include the costs of top administrative functions and various staff departments such as accounting, data processing, and personnel. Executive salaries, clerical salaries, office expenses, office rent, donations, research and development costs, and legal costs are administrative costs. As with selling costs, all organizations have administrative costs.
Product Costs vs Period Expenses
Companies also classify costs as product costs and period costs. Product costs are the costs incurred in making products. These costs include the costs of direct materials, direct labor, and manufacturing overhead.
Period expenses are closely related to periods of time rather than units of products. For this reason, firms expense (deduct from revenues) period costs in the period in which they are incurred. Accountants treat all selling and administrative expenses as period costs for external financial reporting.
To illustrate, assume a company pays its sales manager a fixed salary. Even though the manager may be working on projects to benefit the company in future accounting periods, it expenses the sales manager’s salary in the period incurred because the expense cannot be traced to the production of a specific product.
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In summary, product costs (direct materials, direct labor and overhead) are not expensed until the item is sold when the product costs are recorded as cost of goods sold. Period costs are selling and administrative expenses, not related to creating a product, that are shown in the income statement along with cost of goods sold.
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• In this course, we will cover many cost classifications useful for planning and control. We will introduce the basic concepts behind these classifications but you will use them (and get in greater depth) in other chapters.
Fixed vs Variable Costs
A fixed cost remains the same in total but changes per unit. Fixed costs examples include your monthly rent, salaried employees, straight-line depreciation as these amounts do not change based on volume. A variable cost remains the same per unit but changes in total. Variable cost examples include sales commissions, hourly workers, units-of-production method depreciation as these amounts will change based on total volume but the amount charged per unit does not change.
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Direct vs Indirect Costs
A direct cost is an amount that can be traced to a specific department, process or job. Direct costs can be product costs like direct materials or direct labor or they can be period costs like an accountant’s salary would be traced to the accounting department. Indirect costs is an amount that cannot be traced to a specific department, process or job. These costs are typically allocated (or estimated) to the departments, processes or jobs using those items. Indirect costs can be product costs like overhead or period costs like an IT employee’s salary to the sales department. The sales department needs the services provided by IT and the IT employee’s time would be an indirect expense to the sales department.
Here is a video that provides a real world example of the differences between direct and indirect costs (focus on the first 2 minutes of the video):
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Controllable vs Non-controllable Costs
When evaluating the performance of an executive or manager under managerial accounting, it is helpful to recognize that some costs and expenses may be out of the control of that manager or executive. One example is the the manager’s salary. The manager has no control over his own salary and has no power to change or stay within the budget for the salary. Controllable costs are things the executive, manager, or department even can control or change. If the executive, manager or department cannot change or control the cost, it is an uncontrollable cost. An example of an uncontrollable cost would be an allocation of administrative expenses to each job or department.
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Differential Costs including Sunk and Opportunity Costs
Differential Costs represent the difference between two alternatives. We will analyze what is relevant to our decision making including any opportunity costs. Opportunity costs are what you give up by choosing one alternative over another (think about what you are giving up by taking this course — what else could you be doing?). Sunk costs are not relevant for decision making as the cost cannot be recovered at a later date. Watch this video to get a better idea of these concepts.
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• The statement of cost of goods manufactured supports the cost of goods sold figure on the income statement. The two most important numbers on this statement are the total manufacturing cost and the cost of goods manufactured. Be careful not to confuse the terms total manufacturing cost and cost of goods manufactured with each other or with the cost of goods sold.
Total Manufacturing Cost includes the costs of all resources put into production during the period (meaning, the direct materials, direct labor and overhead applied). Cost of goods manufactured consists of the cost of all goods completed during the period. It includes total manufacturing costs plus the beginning work in process inventory minus the ending work in process inventory. Cost of goods sold are the costs of all goods SOLD during the period and includes the cost of goods manufactured plus the beginning finished goods inventory minus the ending finished goods inventory. Cost of goods sold is reported as an expense on the income statements and is the only time product costs are expensed. This chart will summarize the formulas you will need:
Direct Materials Used Beginning Raw Materials Inventory + Raw Material Purchases – Ending Raw Materials Inventory – Indirect Materials Used
Total Manufacturing Cost Direct Materials + Direct Labor + Overhead applied
Cost of Goods Manufactured Total Manufacturing Cost (Direct Materials + Direct Labor + Overhead applied) + Beginning Work In Process Inventory – Ending Work in Process Inventory
Cost of Goods Sold Beginning Finished Goods Inventory + Cost of Goods Manufactured – Ending Finished Goods Inventory
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• NoteLook at the following example. Farside Manufacturing makes calendars and books. The schedule (or statement) of cost of goods manufactured follows:
Farside Manufacturing Company
Statement of cost of goods manufactured
For the year ended December 31
Direct Materials Used:
Raw Materials inventory, January 1 \$40,000
Raw Materials purchases 480,000
Less: Raw Materials inventory, December 31 30,000
Raw Materials used \$490,000
Less: Indirect Materials Used \$0
Direct Materials Used \$490,000
Direct labor 380,000
Manufacturing overhead:
Indirect labor \$120,000
Maintenance and repairs expense 60,000
Factory utilities expense 10,000
Depreciation expense – factory building 20,000
Depreciation expense – factory equipment 30,000
Other expense – factory 20,000
Total manufacturing overhead 260,000
Total Manufacturing Cost \$1,130,000
Add: Work in process inventory, January 1 30,000
Less: Work in process inventory, December 31 -60,000
Cost of goods manufactured \$1,100,000
Note how the statement shows the costs incurred for direct materials, direct labor, and manufacturing overhead. The statement totals these three costs for total manufacturing cost during the period. When adding beginning work in process inventory and deducting ending work in process inventory from the total manufacturing cost, we obtain cost of goods manufactured or completed. Cost of goods sold does not appear on the cost of goods manufactured statement but on the income statement.
To make the manufacturer’s income statement more understandable to readers of the financial statements, accountants do not show all of the details that appear in the cost of goods manufactured statement. Next, we show the income statement for Farside Manufacturing Company. Notice the relationship of the statement of cost of goods manufactured to the income statement.
The cost of goods manufactured appears in the cost of goods sold section of the income statement. The cost of goods manufactured is in the same place that purchases would be presented on a merchandiser’s income statement. We add cost of goods manufactured to beginning finished goods inventory to derive cost of goods available for sale. This is similar to the merchandiser who presents purchases added to beginning merchandise to derive goods available for sale.
Farside Manufacturing Company
Income statement
For the year ended December 31
Sales \$1,800,000
Cost of goods sold:
Finished goods inventory, January 1 \$50,000
Cost of goods manufactured 1,100,000
Cost of goods available for sale \$1,150,000
Less: Finished goods inventory, December 31 60,000
Cost of goods sold 1,090,000
Gross margin (Sales – Cost of goods sold) \$710,000
Operating expenses:
Selling expenses \$300,000
Administrative expenses 200,000
Total operating expenses 500,000
Income from operations \$210,000
Note: Cost of goods available for sale represents all items completed and read to sell during the period. It is calculated as beginning finished goods inventory + cost of goods manufactured from the statement of cost of goods manufactured. Income from operations is calculated as Gross Margin (also called Gross Profit) – total operating expenses.
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Chapter 1 Takeaway
These are the key points you should know for Chapter 1
1. Managerial accounting is designed for decision making within the company. Managerial accounting uses more projections and estimates than seen in financial accounting. The focus is within the company and is often applied to specific jobs, process, products or departments.
1. Manufacturing Costs include:
• Direct Materials — materials can be directly traced to a product or job
• Direct Labor — labor can be directly traced to a product or job
• Overhead — materials, labor, or other costs related to a product or job BUT cannot be directly traced to a specific product or job (hint: look for keywords like Indirect, Factory, or Manufacturing within the costs)
1. Prime Costs are all DIRECT manufacturing costs and include direct material and direct labor.
1. Conversion Costs are defined as any cost used to convert a raw material to a finished good and include direct labor and overhead
NOTE: Direct labor is considered BOTH a prime and a conversion cost
1. Direct Materials Used can be calculated using Raw Materials Inventory:
Beg. Raw Materials Inventory
+ Raw Material Purchases
– End. Raw Materials Inventory
= Raw Materials Used
– Indirect Materials (typically given in problems)
= DIRECT MATERIALS USED
1. Cost of Goods Manufactured is the cost of jobs, processes, or products that are finished. We need to transfer this cost to finished goods inventory and OUT of work in process inventory. We will use Direct Materials USED in this calculation which is different from material purchases (see above formula for getting direct materials used) .
Cost of Goods Manufactured is calculated as:
Direct Materials Used
+ Direct Labor
+ Overhead Applied
=Total Manufacturing Costs
+ Beg. Work in Process Inventory
– End. Work in Process Inventory
= COST OF GOODS MANUFACTURED
1. Cost of Goods Sold represents the TOTAL COST of a finished product, job, or process and is recorded as an expense ONLY when it is sold. Cost of goods sold is calculated as:
Beg. Finished Goods Inventory
+ Cost of Goods Manufactured
– End. Finished Goods Inventory
= COST OF GOODS SOLD
1. Gross Profit (or Gross Margin) is calculated as Sales – Cost of Goods Sold and does not include any selling, general or administrative costs. Net Income includes ALL expenses and is calculated as Sales – cost of goods sold, selling, general and administrative costs.
Click Chapter 1 Key points for a printable copy.
1.08: Glossary
GLOSSARY
Administrative costs Costs of managing the organization, including the costs of top administrative functions and various staff departments such as accounting, data processing, and personnel.
Cost A financial measure of the resources used or given up to achieve a stated purpose.
Cost driver Activity or transaction that causes costs to be incurred. Machine-hours can be a cost driver for costs of energy to run machines, for example.
Cost of goods manufactured Consists of the total costs of all goods completed during the period; includes cost to manufacture plus beginning work in process inventory minus ending work in process inventory
Cost of goods sold Cost of goods manufactured plus the beginning finished goods inventory minus the ending finished goods inventory.
Cost to manufacture (or manufacturing costs) Includes the direct materials, direct labor, and manufacturing overhead incurred during the period.
Direct labor Labor costs of all employees actually working on materials to convert them to finished goods. Direct labor costs are directly traced to particular products in contrast to indirect labor costs.
Direct materials Materials that are used only in making the product and are clearly and easily traceable to a particular product.
Finished goods Completed manufactured products ready to be sold. Finished Goods Inventory is the title of an inventory account maintained for such products.
Indirect labor The cost of labor that cannot, or will not for practical reasons, be traced to the goods being produced or the services being provided.
Indirect materials Materials used in making a product that cannot, or will not for practical reasons, be traced directly to particular products.
Managerial accounting Managerial accounting information is intended for internal use. The purpose is to generate information managers can use to make good decisions.
Manufacturing overhead All manufacturing costs except for those costs accounted for as direct materials and direct labor.
Materials Unprocessed items used in the manufacturing process typically stored in Raw Materials Inventory.
Overhead All costs of making goods or providing services except for those costs classified as direct materials and direct labor. See manufacturing overhead for overhead in manufacturing companies.
Period costs Costs related more closely to periods of time than to products produced. Period costs cannot be traced directly to the manufacture of a specific product; they are expensed in the period in which they are incurred.
Predetermined overhead rate Calculated by dividing estimated total overhead costs for a period by the expected level of activity, such as total expected machine-hours or total expected direct labor-hours for the period.
Product costs Costs a company assigns to units produced. In manufacturing companies, these costs are direct materials, direct labor, and manufacturing overhead. In service companies that have no materials, these costs are direct labor and overhead.
Selling costs Costs incurred to obtain customer orders and distribute the finished product to the customer.
Statement of cost of goods manufactured An accounting report showing the cost to manufacture and the cost of goods manufactured.
Work in process Partially manufactured products; a Work in Process Inventory account is maintained for such products. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/01%3A_Nature_of_Managerial_Accounting_and_Costs/1.07%3A_Chapter_1_Key_Points.txt |
SHORT Answer QUESTIONS, EXERCISES AND PROBLEMS
Questions
➢ What are the major differences between managerial and financial accounting?
➢ Identify the three elements of cost incurred in manufacturing a product and indicate the distinguishing characteristics of each.
➢ Why might a company claim that the total cost of employing a person is \$15.30 per hour when the employee’s wage rate is \$10.50 per hour? How should this difference be classified and why?
➢ Why are certain costs referred to as period costs? What are the major types of period costs incurred by a manufacturer?
➢ Explain why the income statement of a manufacturing company differs from the income statement of a merchandising company.
➢ What is the general content of a statement of cost of goods manufactured? What is its relationship to the income statement?
Real world question Assume Domino’s Pizza is considering offering a new product—a 6-inch (15.24 cm) pizza. Why would it matter if Domino’s Pizza knows how much it costs to produce and deliver this 6-inch (15.24 cm) pizza?
Real world question Why is it becoming more important that the managers of hospitals understand their product costs?
Exercises
Exercise A The following costs are incurred by an electrical appliance manufacturer. Classify these costs as direct materials, direct labor, manufacturing overhead, selling, or administrative.
1. President’s salary.
2. Cost of electrical wire used in making appliances.
3. Cost of janitorial supplies (the janitors work in the factory).
4. Wages of assembly-line workers.
5. Cost of promotional displays.
6. Assembly-line supervisor’s salary.
7. Cost accountant’s salary (the accountant works in the factory).
8. Cost of cleaner used to clean appliances when they are completed.
9. Cost of aluminum used for toasters.
10. Cost of market research survey.
Exercise B Classify the costs listed in the previous exercise as either product costs or period costs.
Exercise C Gore Company makes products for sporting events. The following data are for the year ended December 31:
Materials inventory, January 1 \$ 45,000
Materials inventory, December 31 65,000
Materials purchases 175,000
Direct labor 225,000
Work in process inventory, January 1 30,000
Work in process inventory, December 31 40,000
Manufacturing overhead 130,000
Finished goods inventory, January 1 80,000
Finished goods inventory, December 31 140,000
Prepare a Cost of Goods Manufactured Statement and compute the cost of goods sold.
Problem A Total Block, Inc., is considering a new sunscreen packet that contains a skin wipe with sunscreen on it. These would be particularly useful for people who do not want to carry a bottle of sunscreen, according to Sunspot’s marketing manager. Classify the following costs of this new product as direct materials, direct labor, manufacturing overhead, selling, or administrative.
1. President’s salary.
2. Packages used to hold the skin wipes.
3. Cleaning materials used to clean the skin wipe packages.
4. Wages of workers who package the product.
5. Cost of advertising the product.
6. The salary of the supervisor of the workers who package the product.
7. Cost accountant’s salary (the accountant works in the factory).
8. Cost of a market research survey.
9. Sales commissions paid as a percent of sales.
10. Depreciation of administrative office building.
Problem B Classify the costs listed in the previous problem as either product costs or period costs.
Problem C Good Vibrations, Inc., produces videotapes of musical performances. A newly hired executive of the company has asked you to sort through the records and prepare a statement of the company’s cost of goods manufactured. You find the following data from records prepared by Good Vibrations, Inc., for the year ended December 31:
Inventories:
Beginning direct materials inventory, January 1 \$ 6,000
Ending direct materials inventory, December 31 10,500
Beginning work in process inventory, January 1 10,000
Ending work in process inventory, December 31 9,500
Materials purchases 50,000
Direct labor 40,000
Indirect labor 15,000
Factory utilities expense 7,000
Factory supplies expense 5,000
Depreciation expense – factory building 14,000
Depreciation expense – Factory Equipment 10,500
Other manufacturing overhead 25,000
You also learn that beginning Finished Goods Inventory on January 1, was \$20,000 and ending Finished Goods Inventory on December 31, was \$5,000. Sales for the year were \$400,000. Selling expenses were \$50,000 and administrative expenses were \$75,000.
1. Prepare a statement of cost of goods manufactured for Good Vibrations, Inc., for the year ended December 31.
2. Prepare an income statement for Good Vibrations, Inc., for the year ended December 31.
Alternate problems
Alternate problem A Pocket Umbrella, Inc., is considering producing a new type of umbrella. This new pocket-sized umbrella would fit into a coat pocket or purse. Classify the following costs of this new product as direct materials, direct labor, manufacturing overhead, selling, or administrative.
1. Cost of advertising the product.
2. Fabric used to make the umbrellas.
3. Maintenance of cutting machines used to cut the umbrella fabric so it will fit the umbrella frame.
4. Wages of workers who assemble the product.
5. President’s salary.
6. The salary of the supervisor of the people who assemble the product.
7. Wages of the product tester who stands in a shower to make sure the umbrellas do not leak.
8. Cost of market research survey.
9. Salary of the company’s sales managers.
10. Depreciation of administrative office building.
Alternate problem B Classify the costs listed in Alternate problem A as either product costs or period costs.
Alternate problem C Presley Manufacturing Company is a producer of music compact discs (CDs) and tapes. The following account balances are for the year ended December 31
Administrative expenses \$ 60,000
Depreciation expense – Manufacturing equipment 50,000
Direct labor 468,000
Manufacturing supplies expense 40,000
Indirect labor 36,000
Beginning inventories, January 1:
Direct materials 14,000
Work in process 20,000
Finished goods 128,000
Ending inventories, December 31
Direct materials 44,000
Work in process 56,000
Finished goods 92,000
Direct materials purchases 216,000
Rent expense – Factory 28,000
Sales 1,400,000
Selling expense 72,000
Other manufacturing overhead 126,000
1. Prepare a statement of cost of goods manufactured for Presley Manufacturing Company for the year.
2. Prepare an income statement for the year ended December 31.
Beyond the numbers—Critical thinking
Business decision case A Companies often do work on a cost-reimbursement basis. That is, Company B reimburses Company A for the cost of doing work for Company B. Suppose your company has a contract that calls for reimbursement of direct materials and direct labor, but not overhead. Following are costs that various organizations incur; they fall into three categories: direct materials (DM), direct labor (DL), or overhead (OH).
Glue used to attach labels to bottles containing a patented medicine.
Compressed air used in operating paint sprayers for Student Painters, a company that paints houses and apartments.
Insurance on a factory building and equipment.
A production department supervisor’s salary.
Rent on factory machinery.
Iron ore in a steel mill.
Oil, gasoline, and grease for forklift trucks in a manufacturing company’s warehouse.
Services of painters in building construction.
Cutting oils used in machining operations.
Cost of paper towels in a factory employees’ washroom.
Payroll taxes and fringe benefits related to direct labor.
The plant electricians’ salaries.
Crude oil to an oil refinery.
Copy editor’s salary in a book publishing company.
1. Classify each of these items as direct materials, direct labor, or overhead.
2. Assume your classifications could be challenged in a court case. Indicate to your attorneys which of your answers for part a might be successfully disputed by the opposing attorneys. In which answers are you completely confident?
Writing assignment B Refer to Presley Manufacturing company, Alt Problem C. Assume the newly hired executive is a whiz at marketing, but a person whose eyes glaze over at the sight of a number. The executive wants you to explain the financial results for the year in words. Essentially, assume the executive has not seen the financial statements prepared. What would you say to convey the message in the financial statements? Keep it short—less than 100 words.Using the Internet—A view of the real world
Visit the website for a high technology company, such as HP, Intel Corporation, or IBM, and locate its annual report. Review the annual report to gain a general understanding of the company’s primary business segments and products. Write a report addressing the following questions based on your research. What products or services are provided by the company? How does the financial information provided in the annual report (focus on the income statement) differ from financial information used for managerial accounting purposes? As a manager making business decisions within the company, what additional information would you need? (Remember that the income statement may be referred to using different terminology such as statement of earnings or statement of operations.)
Company Website
Hewlett Packard Http://www.hp.com
Intel Corporation Http://www.intel.com
IBM Http://www.ibm.com
Visit the following website for Wells Fargo (a financial institution) and locate its annual report:
http://www.wellsfargo.com
Review the annual report to gain a general understanding of the company’s primary business segments and products. Write a report addressing the following questions based on your research. What products or services are provided by the company? How does the financial information provided in the annual report (focus on the income statement) differ from financial information used for managerial accounting purposes? As a manager making business decisions within the company, what additional information would you need? (Remember that the income statement may be referred to using different terminology such as statement of earnings or statement of operations.)
Visit the following website for Home Depot (a retail organization) and locate its annual report:
http://www.homedepot.com
Review the annual report to gain a general understanding of the company’s primary business segments and products. Write a report addressing the following questions based on your research. What products or services are provided by the company? How does the financial information provided in the annual report (focus on the income statement) differ from financial information used for managerial accounting purposes? As a manager making business decisions within the company, what additional information would you need? (Remember that the income statement may be referred to using different terminology such as statement of earnings or statement of operations.)
1. [1]See Standards of Ethical Conduct for Management Accountants (Montvale, N.J.: Institute of Management Accountants, June 1, 1983.)
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Study Plan: Job Costing
Knowledge Targets
I can define the following terms as they relate to our unit:
Applied Overhead Goods (or work) in process
Finished Goods Job Costing
Allocation Base Cost driver Cost of goods sold
Under-applied Overhead
Predetermined overhead rate Cost of Goods Sold Cost of Goods Manufactured
Over-applied Overhead
Gross Margin (or Profit) Direct materials Direct Labor Actual Overhead
Reasoning Targets
• I can identify job costs as direct materials, direct labor and overhead.
• I can track job costs from raw materials to goods in process to finished goods and cost of goods sold.
• I can identify accounts to use in recording the flow of job costs.
• I can identify the allocation base used in calculating predetermined overhead rate.
• I can identify the difference between actual overhead and applied overhead.
• I can determine under- or over-applied overhead.
• I can understand a manufacturing statement with cost of goods manufactured calculated.
Skill Targets
• I can prepare and post journal entries for job costing from raw materials to cost of goods sold.
• I can calculate the predetermined overhead rate for a company.
• I can calculate the amount of appliedoverhead using the predetermined overhead rate.
• I can calculate the amount of under- or over-applied overhead using applied overhead and actual overhead.
• I can compute the total cost of a job and determine the job’s gross margin.
• I can prepare a manufacturing statement, schedule of cost of goods sold, and income statement for job costing.
Click Job Cost Study Plan for a printable copy.
2.02: Characteristics of Job Order Costing
The general cost accumulation model
In general, companies match the flow of costs to the physical flow of products through the production process. They place materials received from suppliers in the materials storeroom and record the cost of those materials when purchasing them to raw materials inventory. As they are needed for production, the materials move from the materials storeroom (raw materials inventory) to the production departments with their cost as shown below.
During production, the materials processed by workers and machines become partially manufactured products. At any time during production, these partially manufactured products are collectively known as work in process (or goods in process). For example, if accountants compute the inventory when the company has partially finished products at the end of the year, this inventory is work in process inventory.
Completed products are finished goods. When the products are completed and transferred to the finished goods storeroom, the company removes their costs from Work in Process Inventory and assigns them to Finished Goods Inventory. As the goods are sold, the company transfers related costs from Finished Goods Inventory to Cost of Goods Sold.
The accounting flow of costs follows the physical flow of the manufacturing process in most companies. In this chapter and the next, we assume costs follow the physical flow of products.In discussing product costing, we described how accountants and managers assign costs to products. Recall that products can be either goods or services, so this discussion applies to service and merchandising companies as well as to manufacturing companies.
This video explains what job order costing is in the context of managerial accounting. An example is provided to illustrate how a job cost sheet is completed to account for the cost of a job under the job order costing method.
What kinds of companies would use job costing? The chart below shows how various companies choose different accounting systems, depending on their products. First, companies producing individual, unique products known as jobs use job costing (also called job order costing). Companies such as construction companies and consulting firms, produce jobs and use job costing.
Type of production Accounting system Type of product
Job shop Job costing Customized
Hospital, custom home builder, consulting firm
Batch production Mostly job costing Several different products
Furniture manufacturer, winery
Repetitive manufacturing Mostly process costing (operations) Few new products
Computer manufacturer, bicycle manufacturer
Continuous flow processing Process costing Standardized
Oil refinery, paint manufacturer
Second, some companies, like furniture manufacturers, produce batches of products. They produce all of the components of a single product (e.g. coffee tables) in one batch. They would then produce the components of another product (e.g. dining room sets) in a new batch. (Some university food service companies prepare meals this way.) Companies such as these use job costing methods to accumulate the cost of each batch.
The last two types of production in use process costing methods described in another chapter, so we give just a brief overview here. Repetitive manufacturing lends itself to the use of automated equipment that minimizes the amount of manual material handling. Automobile assembly plants, bicycle assembly plants, and computer assembly plants use repetitive manufacturing.
Continuous flow processing is the opposite of job shops. Companies using this process continuously mass-produce a single, homogeneous product. Companies might use process cost systems in manufacturing paint, grinding flour, and refining oil.
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2.03: Subsidiary Ledgers Needed for Job Order Costing
• If you remember from your financial accounting class, a subsidiary ledger is a secondary ledger that provides the details of a control account. A control account is a summarized account balance to make viewing financial statements easier. Accounts Receivable is an example of a control account. We show the amount owed to use by customers in total on the balance sheet and do not list an accounts receivable for each customer on the balance sheet (could you imagine the length of that report?). We have a subsidiary ledger for each customer so we can determine who owes us money and who has paid. The total of the items in the subsidiary ledger must match the balance reported in the control account.
This concept relates to job costing because we have 3 main inventory accounts control accounts: Raw Materials Inventory, Work in Process Inventory, and Finished Goods Inventory. Raw Materials inventory is used to store the costs of materials purchased but not yet used in production. The subsidiary ledger would contain details of the individual raw material components.
Work in Process Inventory is used when we have started but not completed a job and include all job costs including any costs from the previous period and costs added this period include direct materials, direct labor and applied overhead. The subsidiary ledger consists of the job cost sheet (remember the video from the previous page?) showing all the direct materials, direct labor, and overhead costs applied to a job. The total of all jobs still in process will equal the balance of Work in Process Inventory.
Finished Goods Inventory is used when we finish a job and before we sell it. We move the total job cost of the job from Work in Process Inventory to Finished Goods Inventory. The subsidiary ledger will the be for each job showing its full job cost until the item is sold. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/02%3A_Job_Order_Cost_System/2.01%3A_Chapter_2_Study_Plan.txt |
Job costing
A job cost system (job costing) accumulates costs incurred according to the individual jobs. Companies generally use job cost systems when they can identify separate products or when they produce goods to meet a customer’s particular needs.
Who uses job costing? Examples include home builders who design specific houses for each customer and accumulate the costs separately for each job, and caterers who accumulate the costs of each banquet separately. Consulting, law, and public accounting firms use job costing to measure the costs of serving each client. Motion pictures, printing, and other industries where unique jobs are produced use job costing. Hospitals also use job costing to determine the cost of each patient’s care.
We will use the following flow chart to help us record the transactions in job costing (click job cost flow for a printable version complete with journal entry examples):
In a journal entry, we will do entries for each letter labeled in the chart — where the arrow is pointing TO is our debit and where the arrow is coming FROM is our credit. Here is a video discussion of job cost journal entries and then we will do an example.
A YouTube element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/llmanagerialaccounting/?p=52
Example
Assume Creative Printers is a company run by a group of students who use desktop publishing to produce specialty books and instruction manuals. Creative Printers uses job costing. Creative Printers keeps track of the time and materials (mostly paper) used on each job.
The company compares the cost of each job with the revenue received to be sure the jobs are profitable. Sometimes the company learns that certain jobs are too costly considering the prices they can charge. For example, Creative Printers recently learned that cookbooks were not profitable. On the other hand, printing instruction manuals was quite profitable, so the company has focused more on the instruction manual market. To illustrate a job costing system, this section describes the transactions for the month of July for Creative Printers.
On July 1, Creative Printers had these beginning inventories:
Materials inventory (or Raw Materials Inventory) \$20,000
Work in process inventory
(Job No. 106: direct materials, \$4,200;direct labor, \$5,000; and overhead, \$4,000)
13,200
Finished goods inventory (Job No. 105) 5,500
Creative Printing had completed Job No. 105, a set of gardening books, but had not shipped them to the customer as of June 30. Additional information regarding July transactions follows:
a. During July, Creative Printers purchased \$ 25,000 of materials on account. This purchase included both direct materials, such as paper, and indirect materials, such as printing supplies and computer supplies. The journal entry required would be:
Debit Credit
a. Raw Materials Inventory \$ 25,000
Accounts Payable 25,000
Purchased materials on account
b. During July, Creative Printers sent direct materials from the materials storeroom to jobs as follows: \$ 9,000 to Job No. 106, and \$ 14,000 to Job No. 107. The company also sent indirect materials of \$ 1,000 to jobs. We want to move the cost of the direct materials FROM raw materials inventory TO work in process inventory. It charged indirect materials to overhead, not to each job, because the company does not keep track of how much indirect materials it uses on each job. (Manufacturing companies often use Manufacturing (or Factory) Overhead for the Overhead account. We generally use the Overhead account for both manufacturing and non-manufacturing companies in this chapter.) The entries would be:
Debit Credit
b. Work In Process Inventory 23,000
Raw Materials Inventory 23,000
Record direct materials used (\$9,000+ 14,000)
Overhead 1,000
Raw Materials Inventory 1,000
Record indirect materials used
c. Production workers keep track of the time spent on each job at Creative Printers. Based on that information, the company assigned production-related labor costs to jobs (direct labor) and to Overhead as follows: \$4,000 to Job No. 106, \$ 16,000 to Job No. 107, and indirect labor of \$ 2,000 to Overhead. The entry to record payroll incurred during the accounting period (not shown) includes a debit to Payroll Summary (or Factory Payroll) and a credit to cash or a liability accounts depending if it has been paid. In these entries, we will distribute the payroll summary (Factory Payroll) to the jobs and overhead. For direct labor, we want to take the cost of labor FROM the payroll summary account TO work in process inventory. For indirect labor, we will charge this to overhead instead of to a specific job in work in process inventory.
Debit Credit
c. Work In Process Inventory 20,000
Factory Payroll 20,000
Record direct labor used (\$4,000+ 16,000)
Overhead 2,000
Factory Payroll 2,000
Record indirect labor used
d. The company assigns overhead to each job on the basis of the machine-hours each job uses. Overhead is assigned to a job at the rate of \$ 2 per machine-hour used on the job. Job 16 had 875 machine-hours so we would charge overhead of \$1,750 (850 machine-hours x \$2 per machine-hour). Job 17 had 4,050 machine-hours so overhead would be \$8,100 (4,050 machine-hours x \$2). The journal entry to apply or assign overhead to the jobs would be to move the cost FROM overhead TO work in process inventory.
Debit Credit
d. Work In Process Inventory 9,850
Overhead 9,850
Record overhead applied (\$1,750+ 8,100)
The complete job cost sheets for Jobs 106 and 107 would appear as below:
Job: 106 107
Beginning Work in Process \$13,200 0
Added this period:
Direct Materials 9,000 14,000
Direct Labor 4,000 16,000
Overhead applied 1,750 8,100
Total Job Costs \$ 27,950 \$ 38,100
e. Job No. 106 was completed. The total job cost of Job 106 is \$27,950 for the total work done on the job, including costs in beginning Work in Process Inventory on July 1 and costs added during July. This entry records the completion of Job 106 by moving the total cost FROM work in process inventory TO finished goods inventory.
Debit Credit
e. Finished Goods Inventory 27,950
Work In Process Inventory 27,950
Record completion of Job 16
(Beg. WIP \$13,200 + DM 9,000 + DL 4,000 + OH 1,750)
f. Job No. 105 was sold on account in July for \$ 9,000. This transaction would require 2 entries: one for the sales and customer side and one for the company’s actual cost (remember, you do not want these to be the same amount. You want to charge customers MORE than it cost you to make a profit). Since this was sold on account, we know that means accounts receivable. The cost of Job 105 can be found in the beginning inventory for finished goods inventory.
Debit Credit
f. Accounts Receivable 9,000
Sales 9,000
Record sale of Job 105 for \$9,000 on account
Cost of goods sold 5,500
Finished Goods Inventory 5,500
Record total cost of Job 105 now sold
g. The company applied overhead to the jobs in entry (d) based on a predetermined overhead rate. Many of the actual overhead costs are not known until the end of the month or later. For example, the company would not receive its utility bill for July until sometime in August. In addition to the indirect materials and indirect labor recorded in entries (b) and (c), Creative Printers incurred these other overhead costs for July:
Machinery repairs and maintenance \$1,500
Utilities, including energy costs to run machines 1,000
Depreciation of building and machines 2,500
Other overhead 1,800
Total overhead incurred in July, other than indirect materials and indirect labor \$6,800
To prepare the journal entry, we debit the Overhead account for the actual costs. Then we credit Accounts Payable for the machinery repairs and maintenance, utilities, and other overhead. (We assume an outside contractor does the maintenance and repairs.) The amount is \$ 4,300 (\$ 3,500 + \$ 1,000 + \$ 1,800). And, finally we credit Accumulated Depreciation for \$ 2,500. Here is the journal entry to record the actual overhead:
Debit Credit
g. Overhead 6,800
Accounts Payable 4,300
Accum. Depreciation 2,500
Record actual overhead costs incurred
If we posted each of these journal entries, you will find the ending balances of the inventory accounts to be:
Raw Materials Inventory \$21,000
(20,000 + 25,000 – 23,000 – 1,000)
Work in Process Inventory \$38,100
(Total costs of Job 17)
Finished Goods Inventory \$27,950
(Total cost of Job 16)
Notice, Job 105 has been moved from Finished Goods Inventory since it was sold and is now reported as an expense called Cost of Goods Sold. Also, did you notice that actual overhead came to \$9,800 (\$1,000 indirect materials + \$2,000 indirect labor + \$6,800 other overhead from transaction g) but we applied \$9,850 in overhead to the jobs in transaction d? Whenever we use an estimate instead of actual numbers, it should be expected that an adjustment is needed. We will discuss the difference between actual and applied overhead and how we handle the differences in the next sections.
Managers would use the preceding cost information for several purposes: First, they would compare the actual costs of the job with expected costs, both as the work is being done and after the job has been completed. Later chapters discuss the role of managerial accounting in performance evaluation.
Second, managers would assess the profitability of jobs. For example, Job 105 had revenue of USD 9,000 and costs of USD 5,500.Third, managers would compare actual overhead on the left side of the Overhead account, with the overhead applied to jobs on the right side. If the actual overhead exceeds the applied overhead, they may wish to learn why the actual overhead is so high. Also, they may ask the accountants to increase the overhead applied to jobs to give them a better idea of the cost of jobs. If the actual is less than the applied overhead, they may ask the accountants to reduce the overhead applied to jobs.
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• By definition, overhead cannot be traced directly to jobs. Most company use a predetermined overhead rate (or estimated rate) instead of actual overhead for the following reasons:
•A company usually does not incur overhead costs uniformly throughout the year. For example, heating costs are greater during winter months. However, allocating more overhead costs to a job produced in the winter compared to one produced in the summer may serve no useful purpose.
•Some overhead costs, like factory building depreciation, are fixed costs. If the volume of goods produced varies from month to month, the actual rate varies from month to month, even though the total cost is constant from month to month. The predetermined rate, on the other hand, is constant from month to month.
•Predetermined rates make it possible for companies to estimate job costs sooner. Using a predetermined rate, companies can assign overhead costs to production when they assign direct materials and direct labor costs. Without a predetermined rate, companies do not know the costs of production until the end of the month or even later when bills arrive. For example, the electric bill for July will probably not arrive until August. If Creative Printers had used actual overhead, the company would not have determined the costs of its July work until August. It is better to have a good estimate of costs when doing the work instead of waiting a long time for only a slightly more accurate number.
Predetermined overhead rates
Predetermined overhead rates are used to apply overhead to jobs until we have all the actual costs available. To create the rate, we use cost drivers to assign overhead to jobs. A cost driver is a measure of activities, such as machine-hours, that is the cause of costs. To assign overhead to jobs, the cost driver should be the cause of the overhead costs, or at least be reasonably associated with the overhead costs. Just as automobile mileage is a good cost driver for measuring the cause of gasoline consumption, machine-hours is a measure of what causes energy costs. By assigning energy costs to jobs based on the number of machine-minutes or hours the job uses, we have a pretty good idea of the energy costs required to produce the job.
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Most manufacturing and service organizations use predetermined rates.
To calculate a predetermined overhead rate, a company divides the estimated total overhead costs for a period by an estimated base (or expected level of activity). This activity could be total expected machine-hours, total expected direct labor-hours, or total expected direct labor cost for the period. Companies set predetermined overhead rates at the beginning of the year in which they will use them. This formula computes a predetermined rate:
Predetermined Overhead Rate (POHR) = Estimated Overhead
Estimated Base
Notice how the predetermined rate is based on ESTIMATED overhead and the ESTIMATED base or level of activity. To apply overhead, we will use the actual amount of the base or level of activity x the predetermined overhead rate. Again, to apply overhead use this formula:
Applied Overhead = Actual amount of base x POHR
To demonstrate, assume the accountants at Creative Printers estimated overhead related to machine usage to be \$ 120,000 for the year and estimated the machine usage for the year to be 60,000 machine-hours. Thus, the predetermined overhead rate would be calculated as follows:
Predetermined Overhead Rate (POHR) = Estimated Overhead = \$120,000 = \$2 per machine hour
Estimated Base 60,000 machine hours
If we want to apply overhead to jobs. Job 106 had 875 machine hours and Job 107 had 4,050 machine hours. The calculation for actual overhead for each job would be:
Job ACTUAL machine hours POHR Overhead applied
106 875 x \$2 \$ 1,750
107 4050 x \$2 8,100
Total Overhead applied \$ 9,850
Actual Overhead
Actual Overhead costs are the true costs incurred and typically include things like indirect materials, indirect labor, factory supplies used, factory insurance, factory depreciation, factory maintenance and repairs, factory taxes, etc. Actual overhead costs are any indirect costs related to completing the job or making a product. Next, we look at how we correct our records when the actual and our applied (or estimated) overhead do not match (which they almost never match!). | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/02%3A_Job_Order_Cost_System/2.05%3A_Actual_Vs._Applied_Factory_Overhead.txt |
• Since we will be using the concept of the predetermined overhead rate many times during the semester, lets review what it means again.
youtu.be/orjRQjE_ZqE
We know overhead is applied using estimated or budgeted overhead and a base. Actual overhead costs may be different and we will not have all of those costs until late in the year. Estimated may be close but is rarely accurate with what really happens, so the result is Over-applied or Under-applied Overhead. At the end of the year, we will compare the applied overhead to the actual overhead and if applied overhead is GREATER than actual overhead, overhead is over-applied. If applied overhead is less than actual overhead, overhead is under-applied. But how do we correct it?
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Example – Creative Printers
We learned, in the previous pages, that Creative Printers had applied overhead to Jobs 106 and 107 for a total amount of \$9,850. Actual overhead was \$9,800 from indirect materials \$1,000, indirect labor of \$2,000 and other overhead of \$6,800. If we compare applied overhead \$9,850 and actual overhead \$9,000, we see a difference of \$50 over-applied since the applied amount is greater than the actual overhead. Companies generally transfer the balance of the Overhead account to Cost of Goods Sold at the end of the accounting period. Some companies do this monthly; others do it quarterly or annually. The journal entry to transfer Creative Printers’ overhead balance to Cost of Goods Sold for the month of July is as follows:
Debit Credit
Overhead 50
Cost of goods sold 50
To record over-applied overhead.
Why does the previous entry reduce the Cost of Goods Sold by \$50? The overhead cost applied to the jobs was too high—it was overapplied. Thus, the cost of jobs was overstated or we charged to much cost to jobs. Although those jobs are still in Work in Process or Finished Goods Inventory, companies usually adjust the Cost of Goods Sold account instead of each inventory account. Adjusting each inventory account for a small overhead adjustment is usually not a good use of managerial and accounting time and effort. All jobs appear in Cost of Goods Sold sooner or later, so companies simply adjust Cost of Goods Sold instead of the inventory accounts.
If applied overhead was less than actual overhead, we have under-applied overhead or not charged enough cost. The entry to correct under-applied overhead, using cost of goods sold, would be (XX represents the amount of under-applied overheard or the difference between applied and actual overhead):
Debit Credit
Cost of goods sold XX
Overhead XX
To record under-applied overhead.
In this book, we assume companies transfer overhead balances to Cost of Goods Sold. We leave the more complicated procedure of allocating overhead balances to inventory accounts to textbooks on cost accounting.
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Would a Pizza Studio franchisee need to use job-costing or process costing for its made-to-order pizzas?
Pizza Studio is a relatively new pizza chain that takes the made-to-order model used by Chipotle and Subway and applies it to pizzas. At a counter, customers order their pizzas with exactly the crust, sauce, cheese, and toppings they want – and then watch as the pizza travels through a conveyor-belt oven, being blasted with 150 degree heat, and then see it emerge two minutes later, hot and bubbling.
Pizza Studio has many choices for pizzas. In addition to traditional, crust choices include whole grain & flax seed, rosemary herb, and firecracker. Sauces include tomato blend, basil pesto, tangy BBQ, spicy buffalo, and others. Cheese selections include mozzarella, feta and goat cheese. Pizza Studio offers a wide variety of unlimited toppings: minced garlic, artichoke hearts, Kalamata olives, zucchini, Jamaican jerk seasoning, and caramelized onions are a sampling of the toppings available. Describe Pizza Studio process here.
The price of each pizza is \$7.99.
Pizza Studio was founded in 2012 and has nearly 25 locations, with additional locations planned to be added throughout 2015. It has several franchise operators; most of Pizza Studio’s growth is projected to be through the opening of new franchise locations.
Questions
1. Does an individual Pizza Studio franchise operator need to decide whether to use a job-costing system or a process costing system for the pizzas it sells? Why or why not?
2. Assume that Pizza Studio pizzas are extremely popular and Pizza Studio decides to expand into local grocery stores with frozen Pizza Studio pizzas. Do you think Pizza Studios would use more of a job-costing system or a process-costing system for the pizzas it produces for grocery stores? Explain.
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2.08: Chapter 2 Key Points
Job Costing Key Points
Here is some basic information you need to know about these accounts:
Account Account Type Financial Statement Increases with Decreases with
Raw Materials Inventory Asset Balance Sheet Debit Credit
Work in Process (or goods in process) Inventory Asset Balance Sheet Debit Credit
Finished Goods Inventory Asset Balance Sheet Debit Credit
Cost of Goods Sold Expense Income Statement Debit Credit
Sales Revenue Income Statement Credit Debit
Factory Payroll and Factory Overhead are temporary accounts that act like assets/expenses meaning Debit will increase and Credit will decrease. Both accounts are zeroed out at the end of the period so they will not appear on a financial statement.
Job costs include the TOTAL costs incurred for direct materials, direct labor and overhead. Direct materials can be traced to a specific job. Direct labor hours and dollars can be traced to a specific job. Overhead are indirect costs that cannot be traced to a specific job and include things like indirect materials, indirect labor, factory utilities, factory depreciation, factory rent, etc.
When a job is started, the costs (direct materials, direct labor, and applied overhead) go into Work in Process or Goods in Process Inventory. When the job is finished, the job cost gets transferred to Finished Goods Inventory and is removed from Work in process inventory.
A predetermined overhead rate can be established to budget overhead expenses to jobs. The predetermined overhead rate is used to APPLY overhead costs to jobs in Work in Process Inventory. The predetermined overhead rate (POHR) can be based on anything the company chooses – direct labor dollars, direct labor hours, machine hours, jobs finished, etc. The most common we will see is direct labor.
The formula for calculating the predetermined overhead rate is:
ESTIMATED OVERHEAD
ESTIMATED BASE
with the base being whatever is decided upon (again, examples include direct labor, machine hours, etc.).
Actual overhead costs are recorded in the Factory overhead account. Applied overhead uses the Predetermined Overhead Rate and applies the overhead to jobs in Work in Process Inventory by taking the ACTUAL amount of the BASE x the Predetermined Overhead Rate. At the end of the period, the actual overhead costs (debits to factory overhead) are compared to the applied overhead costs (credits to factory overhead) to make sure they agree – which they won’t since applied is an estimate. You will need to do an adjusting entry to Cost of Goods Sold to make the Factory Overhead account zero. If applied overhead (credits) are more than the actual overhead (debits), overhead is OVER-applied. If applied overhead is less than actual overhead, overhead is UNDER-applied.
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GLOSSARY
Actual overhead rate Total actual manufacturingoverhead divided by total actual manufacturing activity.
Cost A financial measure of the resources used or given up to achieve a stated purpose.
Cost driver Activity or transaction that causes costs to be incurred. Machine-hours can be a cost driver for costs of energy to run machines, for example.
Cost of goods manufactured Consists of the total costs of all goods completed during the period; includes cost to manufacture plus beginning work in process inventory minus ending work in process inventory
Cost of goods sold Cost of goods manufactured plus the beginning finished goods inventory minus the ending finished goods inventory.
Cost to manufacture (or total manufacturing cost) Includes the direct materials, direct labor, and manufacturing overhead incurred during the period.
Direct labor Labor costs of all employees actually working on materials to convert them to finished goods. Direct labor costs are directly traced to particular products in contrast to indirect labor costs.
Direct materials Materials that are used only in making the product and are clearly and easily traceable to a particular product.
Finished goods Completed manufactured products ready to be sold. Finished Goods Inventory is the title of an inventory account maintained for such products.
Indirect labor The cost of labor that cannot, or will not for practical reasons, be traced to the goods being produced or the services being provided.
Indirect materials Materials used in making a product that cannot, or will not for practical reasons, be traced directly to particular products.
Job cost system (job costing) A manufacturing cost system that accumulates costs incurred to produce a product according to individual jobs, such as a building, a consulting job, or a batch of 100 computer desks.
Manufacturing overhead All manufacturing costs except for those costs accounted for as direct materials and direct labor.
Materials Unprocessed items used in the manufacturing process.
Overapplied (overabsorbed) overhead The amount by which the overhead applied to production exceeds the actual overhead costs incurred in that same period.
Overhead All costs of making goods or providing services except for those costs classified as direct materials and direct labor. See manufacturing overhead for overhead in manufacturing companies.
Period costs Costs related more closely to periods of time than to products produced. Period costs cannot be traced directly to the manufacture of a specific product; they are expensed in the period in which they are incurred.
Predetermined overhead rate Calculated by dividing estimated total overhead costs for a period by the expected level of activity, such as total expected machine-hours or total expected direct labor-hours for the period.
Product costs Costs a company assigns to units produced. In manufacturing companies, these costs are direct materials, direct labor, and manufacturing overhead. In service companies that have no materials, these costs are direct labor and overhead.
Statement of cost of goods manufactured An accounting report showing the cost to manufacture and the cost of goods manufactured.
Underapplied (underabsorbed) overhead The amount by which actual overhead costs incurred in a period exceed the overhead applied to production in that period.
Work in process Partially manufactured products; a Work in Process Inventory account is maintained for such products.
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SHORT Answer QUESTIONS, EXERCISES AND PROBLEMS
Questions
➢ What are the major differences between managerial and financial accounting?
➢ Identify the three elements of cost incurred in manufacturing a product and indicate the distinguishing characteristics of each.
➢ Why might a company claim that the total cost of employing a person is \$15.30 per hour when the employee’s wage rate is \$10.50 per hour? How should this difference be classified and why?
➢ Why are certain costs referred to as period costs? What are the major types of period costs incurred by a manufacturer?
➢ Explain why the income statement of a manufacturing company differs from the income statement of a merchandising company.
➢ What is the general content of a statement of cost of goods manufactured? What is its relationship to the income statement?
➢ What is the relationship between cost flows in the accounts and the flow of physical products through a factory?
➢ Define a job cost system and give an example of a situation in which it can be used.
➢ What are the major reasons for using predetermined manufacturing overhead rates?
➢ What is the formula for computing a predetermined overhead rate? If the expected level of activity in a production center is 50,000 machine-hours and the estimated overhead costs are \$750,000, what is the predetermined overhead rate? Show the calculation.
➢ What is underapplied and overapplied overhead? What type of balance does each have in the Overhead account?
➢ Direct materials were issued to the following jobs: Material A was issued to Job No. 101, \$2,000; Job No. 102, \$1,000; and Job No. 103, \$5,000. Material B was issued to Job No. 101, \$5,000; Job No. 102, \$2,000; and Job No. 103, \$3,000. A total of \$3,000 in indirect materials was issued to all jobs.
➢ Record the direct and indirect materials issued in journal entry form.
Real world question Assume Domino’s Pizza is considering offering a new product—a 6-inch (15.24 cm) pizza. Why would it matter if Domino’s Pizza knows how much it costs to produce and deliver this 6-inch (15.24 cm) pizza?
Real world question Why is it becoming more important that the managers of hospitals understand their product costs?
Real world question Besides law firms and public accounting firms, name three service organizations that produce individual jobs and would use job costing.
Exercises
Exercise A The following costs are incurred by an electrical appliance manufacturer. Classify these costs as direct materials, direct labor, manufacturing overhead, selling, or administrative.
1. President’s salary.
2. Cost of electrical wire used in making appliances.
3. Cost of janitorial supplies (the janitors work in the factory).
4. Wages of assembly-line workers.
5. Cost of promotional displays.
6. Assembly-line supervisor’s salary.
7. Cost accountant’s salary (the accountant works in the factory).
8. Cost of cleaner used to clean appliances when they are completed.
9. Cost of aluminum used for toasters.
10. Cost of market research survey.
Exercise B Classify the costs listed in the previous exercise as either product costs or period costs.
Exercise C Gore Company makes products for sporting events. The following data are for the year ended 2010 December 31:
Materials inventory, 2010 January 1 \$ 45,000
Materials inventory, 2010 December 31 65,000
Materials purchases 175,000
Direct labor 225,000
Work in process inventory, 2010 January 1 30,000
Work in process inventory, 2010 December 31 40,000
Manufacturing overhead 130,000
Finished goods inventory, 2010 January 1 80,000
Finished goods inventory, 2010 December 31 140,000
Prepare a Cost of Goods Manufactured Statement and compute the cost of goods sold.
Exercise D In June, Sierra Company worked only on Job No. 100 and completed it on June 30. There were no prior costs accumulated on Job No. 100 before June 1. During the month, the company purchased and used \$10,800 of direct materials, used 2,000 machine-hours, and incurred \$19,200 of direct labor costs. Assuming manufacturing overhead is applied at the rate of \$12 per machine-hour, what is the total cost of Job No. 100? Prepare journal entries to assign the materials, labor, and manufacturing overhead costs to production and to record the transfer of Job No. 100 to Finished Goods Inventory.
Exercise E At the end of the second week in March, Job No. 710 has an accumulated total cost of \$37,800. In the third week, \$9,000 of direct materials were used on Job 710, 300 hours of direct labor were charged to the job at \$40 per hour, and manufacturing overhead was applied on the basis of \$40 per machine-hour for overhead. Job No. 710 was the only job worked on in the third week. It was also completed in the third week. Job No. 710 used 160 machine-hours during the third week in March. Compute the cost of Job No. 710, and give the journal entry required to record its completion and transfer to Finished Goods Inventory.
Exercise F Different companies use different bases in computing their predetermined overhead rates. From the following estimated data, compute the predetermined rate to be used by each company:
Company
Paper Rock Scissors
Machine-hours 100,000 210,000 125,000
Direct labor-hours 50,000 48,000 39,000
Direct labor cost \$800,000 \$735,000 \$410,000
Manufacturing overhead cost \$400,000 \$432,000 \$375,000
Basis for determining predetermined overhead rate:
Company Basis
Paper Direct labor cost
Rock Direct labor-hours
Scissors Machine-hours
Exercise G Refer to the previous exercise. Assume the actual hours and cost data were:
Actual Paper Rock Scissors
Manufacturing overhead \$450,000 \$400,000 \$375,000
Direct labor cost \$850,000 \$700,000 \$400,000
Direct labor-hours 45,000 46,000 38,000
Machine-hours 105,000 200,000 130,000
1. Compute overapplied or underapplied overhead for each company.
2. Prepare journal entries to transfer overapplied or underapplied overhead to Cost of Goods Sold for each company.
Exercise H Ernest Peat Consultants uses a job cost system and had the following activity during December:
There were no jobs in beginning Work in Process or Finished Goods Inventory.
Three jobs were started: No. 222, 223, and 224. Job No. 222 was completed and the customer was billed for \$10,000 on account. Job No. 223 was completed and in Finished Goods Inventory awaiting billing to the client at the end of the month. Job No. 224 was still in process at month-end.
Direct labor costs incurred for:
Job No. 222 200 hours @ \$21/hour
Job No. 223 300 hours @ \$18/hour
Job No. 224 120 hours @ \$17/hour
Assume overhead is applied at the rate of \$10 per labor-hour.
Actual overhead was \$6,400. (The credit part of the journal entry is to Accounts Payable.
Prepare journal entries to record the preceding data, as well as the transfer of underapplied or overapplied overhead to Cost of Goods Sold.
Problem A Total Block, Inc., is considering a new sunscreen packet that contains a skin wipe with sunscreen on it. These would be particularly useful for people who do not want to carry a bottle of sunscreen, according to Sunspot’s marketing manager. Classify the following costs of this new product as direct materials, direct labor, manufacturing overhead, selling, or administrative.
1. President’s salary.
2. Packages used to hold the skin wipes.
3. Cleaning materials used to clean the skin wipe packages.
4. Wages of workers who package the product.
5. Cost of advertising the product.
6. The salary of the supervisor of the workers who package the product.
7. Cost accountant’s salary (the accountant works in the factory).
8. Cost of a market research survey.
9. Sales commissions paid as a percent of sales.
10. Depreciation of administrative office building.
Problem B Classify the costs listed in the previous problem as either product costs or period costs.
Problem C Good Vibrations, Inc., produces videotapes of musical performances. A newly hired executive of the company has asked you to sort through the records and prepare a statement of the company’s cost of goods manufactured. You find the following data from records prepared by Good Vibrations, Inc., for the year ended 2009 December 31:
Inventories:
Beginning direct materials inventory, 2009 January 1 \$ 6,000
Ending direct materials inventory, 2009 December 31 10,500
Beginning work in process inventory, 2009 January 1 10,000
Ending work in process inventory, 2009 December 31 9,500
Materials purchases 50,000
Direct labor 40,000
Indirect labor 15,000
Factory utilities expense 7,000
Factory supplies expense 5,000
Depreciation expense – factory building 14,000
Depreciation expense – Factory Equipment 10,500
Other manufacturing overhead 25,000
You also learn that beginning Finished Goods Inventory on 2009 January 1, was \$20,000 and ending Finished Goods Inventory on 2009 December 31, was \$5,000. Sales for the year were \$400,000. Selling expenses were \$50,000 and administrative expenses were \$75,000.
1. Prepare a statement of cost of goods manufactured for Good Vibrations, Inc., for the year ended 2009 December 31.
2. Prepare an income statement for Good Vibrations, Inc., for the year ended 2009 December 31.
Problem D Log Cabin Homes, Inc., uses a job cost system to account for its jobs, which are prefabricated houses. As of January 1, its records showed inventories as follows:
Materials and supplies \$100,000
Work in process (Job Nos. 22 and 23) 180,000
Finished goods (Job No. 21) 140,000
The work in process inventory consisted of two jobs:
Job No.
Direct
materials
Direct
labor
Manufacturing
overhead
Total
22 \$36,000 \$40,000 \$20,000 \$ 96,000
23 40,000 28,000 16,000 84,000
\$180,000
Cost and sales data:
a. Materials purchased on account, \$400,000.
b. Direct materials used: Job No. 22, \$60,000; Job No. 23, \$120,000; Job No. 24, \$180,000.
c. Indirect materials used, \$10,000.
d. Direct labor costs: Job No. 22, \$100,000; Job No. 23, \$200,000; and Job No. 24, \$80,000.
e. Indirect labor costs, \$80,000.
f. Overhead is assigned to jobs at \$100 per machine-hour. Job No. 22 used 500 machine-hours, Job No. 23 used 1,000 machine-hours, and Job No. 24 used 300 machine-hours in January.
g. Job No. 22 and 23 were completed and transferred to Finished Goods Inventory.
h. Job No. 21 and 22 were sold on account for \$1,200,000, total.
i. Manufacturing overhead costs incurred, other than indirect materials and indirect labor, were depreciation, \$60,000, and heat, light, power, miscellaneous, \$30,000 (to be paid next month).
Required:
1. Calculate the Job Cost for each job.
2. Prepare journal entries to assign each cost for each cost and sales data item.
3. Calculate the ending balance in Raw Materials Inventory, Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold.
4. Assuming selling and administrative expenses were \$100,000, prepare a multi-step income statement.
Problem E Green Thumb Landscaping Company uses a job cost system. As of January 1, its records showed the following inventory balances:
Materials (shrubs, trees, etc.) \$ 13,500
Work in process 25,800
Finished goods (Job No. 211) 30,000
The work in process inventory consisted of two jobs:
Job No.
Direct
Materials
Direct
Labor
Manufacturing
Overhead
Total
212 10 Downing St. \$4,500 \$ 6,000 \$2,400 \$12,900
213 1010 Wilshire Blvd. 5,100 4,800 3,000 12,900
\$9,600 \$10,800 \$5,400 \$25,800
Here are data for the company for January:
Materials purchased, \$48,000.
Landscaping direct labor costs: direct labor to Job No. 212, \$12,000; to Job No. 213, \$24,000; and to Job No. 214, \$36,000. Indirect labor, \$30,000.
Direct materials used: direct materials for Job No. 212, \$7,800; for Job No. 213, \$14,400; and for Job No. 214, \$24,000. Supplies (indirect materials) used amounted to \$1,200.
Overhead is assigned to jobs at \$3 per labor-hour, with 8,000 labor-hours to Job 212 and 2,000 labor-hours each to Jobs 213 and 214.
Jobs 212 and 213 were completed and in Finished Goods Inventory at the end of January.
Sales revenues for January were \$45,000; cost of goods sold was \$30,000 for Job No. 211 that was in Finished Goods Inventory on 2010 January 1.
Overhead costs incurred other than indirect labor and indirect materials were depreciation, \$3,000, and utilities, fuel, and miscellaneous, \$3,000.
1. Prepare journal entries to record the preceding transactions, including the transfer of underapplied or overapplied overhead to Cost of Goods Sold.
2. Assuming selling and administrative expenses were \$10,000, prepare an income statement for January.
Problem F Speedy Delivery, Inc., transports computer equipment for various computer manufacturers. Speedy applies overhead to jobs using a predetermined overhead rate based on truck miles. Estimated data for 2010 are:
Estimated truck miles 20 million
Estimated overhead for hauling operations
(equivalent to manufacturing overhead)
\$12 million
1. Compute the predetermined overhead rate per mile.
2. Assume that in 2010, actual manufacturing overhead for hauling operations amounted to \$15 million, and 24 million truck miles were driven. Compute the amount of underapplied or overapplied manufacturing overhead for 2010.
3. Prepare the journal entry to transfer underapplied or overapplied overhead to Cost of Goods Sold.
Alternate problemsAlternate problem A Pocket Umbrella, Inc., is considering producing a new type of umbrella. This new pocket-sized umbrella would fit into a coat pocket or purse. Classify the following costs of this new product as direct materials, direct labor, manufacturing overhead, selling, or administrative.
1. Cost of advertising the product.
2. Fabric used to make the umbrellas.
3. Maintenance of cutting machines used to cut the umbrella fabric so it will fit the umbrella frame.
4. Wages of workers who assemble the product.
5. President’s salary.
6. The salary of the supervisor of the people who assemble the product.
7. Wages of the product tester who stands in a shower to make sure the umbrellas do not leak.
8. Cost of market research survey.
9. Salary of the company’s sales managers.
10. Depreciation of administrative office building.
Alternate problem B Classify the costs listed in Alternate problem A as either product costs or period costs.
Alternate problem C Presley Manufacturing Company is a producer of music compact discs (CDs) and tapes. The following account balances are for the year ended 2009 December 31
Administrative expenses \$ 60,000
Depreciation expense – Manufacturing equipment 50,000
Direct labor 468,000
Manufacturing supplies expense 40,000
Indirect labor 36,000
Beginning inventories, 2009 January 1:
Direct materials 14,000
Work in process 20,000
Finished goods 128,000
Ending inventories, 2009 December 31
Direct materials 44,000
Work in process 56,000
Finished goods 92,000
Direct materials purchases 216,000
Rent expense – Factory 28,000
Sales 1,400,000
Selling expense 72,000
Other manufacturing overhead 126,000
1. Prepare a statement of cost of goods manufactured for Presley Manufacturing Company for 2009.
2. Prepare an income statement for the year ended 2009 December 31.
Alternate problem D Cathy’s Catering Company uses a job cost system. Its activities in November 2010, the first month of operations, were as follows:
Job
First-rate
University
Active life
home
Precocious
School
Direct materials cost (food) \$54,000 \$36,000 \$81,000
Direct labor cost \$45,000 \$40,500 \$54,000
Labor-hours 2,900 3,500 3,800
The company applies overhead at a rate of \$16 per labor-hour. It completed all jobs in November. The total revenue for the three jobs was \$400,000. The actual overhead for the month was \$160,000, of which \$120,000 should be credited to Accounts Payable and \$40,000 should be credited to Accumulated Depreciation.
Prepare journal entries to record the costs of jobs and to record the transfer of completed jobs to Finished Goods Inventory and to Cost of Goods Sold. Transfer any underapplied or overapplied overhead to Cost of Goods Sold. The company had no beginning or ending inventories.
Alternate problem E Sullivan Company applied overhead to production using a predetermined overhead rate based on machine-hours. Budgeted data for 2010 are:
Budgeted machine-hours 75,000
Budgeted manufacturing overhead \$870,000
1. Compute the predetermined overhead rate.
2. Assume that in 2010, actual manufacturing overhead amounted to \$997,500, and 86,000 machine-hours were used. Compute the amount of underapplied or overapplied manufacturing overhead for 2010.
3. Prepare the journal entry to transfer underapplied or overapplied overhead to Cost of Goods Sold.
Beyond the numbers—Critical thinking
Business decision case A Companies often do work on a cost-reimbursement basis. That is, Company B reimburses Company A for the cost of doing work for Company B. Suppose your company has a contract that calls for reimbursement of direct materials and direct labor, but not overhead. Following are costs that various organizations incur; they fall into three categories: direct materials (DM), direct labor (DL), or overhead (OH).
Glue used to attach labels to bottles containing a patented medicine.
Compressed air used in operating paint sprayers for Student Painters, a company that paints houses and apartments.
Insurance on a factory building and equipment.
A production department supervisor’s salary.
Rent on factory machinery.
Iron ore in a steel mill.
Oil, gasoline, and grease for forklift trucks in a manufacturing company’s warehouse.
Services of painters in building construction.
Cutting oils used in machining operations.
Cost of paper towels in a factory employees’ washroom.
Payroll taxes and fringe benefits related to direct labor.
The plant electricians’ salaries.
Crude oil to an oil refinery.
Copy editor’s salary in a book publishing company.
1. Classify each of these items as direct materials, direct labor, or overhead.
2. Assume your classifications could be challenged in a court case. Indicate to your attorneys which of your answers for part a might be successfully disputed by the opposing attorneys. In which answers are you completely confident?
Business decision case B Quality Painters, Inc., uses a job cost system. As of 2010 January 1, its records showed the following inventory balances:
Materials \$ 7,000
Work in process 50,000
Finished goods 0
The work in process inventory consisted of two jobs:
Job No.
Direct
Materials
Direct
Labor
Overhead Total
100 Community housing \$ 9,000 \$12,000 \$ 4,000 \$25,000
101 Regal apartments 10,000 9,000 6,000 25,000
\$19,000 \$21,000 \$10,00 \$50,000
Here are data for the company for January:
Materials purchased, \$90,000.
Direct labor costs: direct labor to Job No. 100, \$20,000; to Job No. 101, \$48,000; and to Job No. 102 (a new job), \$50,000. Indirect labor, \$10,000.
Direct materials used: direct materials for Job No. 100, \$15,600; for Job No. 101, \$28,800; and for Job No. 102, \$48,000. Supplies (indirect materials) used amounted to \$4,000.
Overhead is assigned to jobs at \$5 per labor-hour, with 1,000 labor-hours to Job 100 and 2,000 labor-hours each to Jobs 101 and 102.
All three jobs were completed in January.
Sales revenues for January were \$350,000 for the three jobs.
Overhead costs incurred other than indirect labor and indirect materials were depreciation, \$6,000, and utilities, fuel, and miscellaneous, \$6,000.
Management is concerned about the relationship between costs incurred on jobs and the costs expected to be incurred, and has asked for your help. Here are the expected total costs (direct materials, direct labor, and overhead) for the three jobs:
Job 100 \$ 60,000
Job 101 120,000
Job 102 130,000
These cost estimates cover the entire job, including both costs in beginning Work in Process Inventory and costs incurred during January.
1. Compare the costs incurred on each job, including the costs in beginning Work in Process Inventory and costs incurred during January with the expected costs. Is the company keeping its costs below the expected costs for each job?
2. Prepare an income statement for January 2010 assuming selling and administrative expenses for January were \$50,000. Don’t forget to transfer any underapplied or overapplied overhead balance to Cost of Goods Sold.
3. Is the company profitable (that is, showing net income greater than zero)? What suggestions can you make for management to help increase the company’s net income?
Ethics case Suzie Garcia, an accountant for a consulting firm, had just received the monthly cost reports for the two jobs she supervises: one for Arrow Space, Inc., and one for the US government. She immediately called her boss after reading the figures for the Arrow Space job.
“We are going to be way over budget on the Arrow Space contract,” she informed her boss. “The job is only about three-fourths complete, but we have spent all the money that we had budgeted for the entire job.”
“You had better watch these job costs more carefully in the future,” her boss advised. “Meanwhile, charge the rest of the costs needed to complete the Arrow Space job to your US government job. The government will not notice the extra costs. Besides, we get reimbursed for costs on the government job, so we will not lose any money on this problem you have with the Arrow Space contract.”
What should Suzie do? Does it matter that Suzie’s company is reimbursed for costs on the US government contract? Explain.
Group project A In teams of two or three students, interview in person or by speakerphone, a businessperson in your community who uses job costing (for example, businesses that produce custom products such as homes, signs, or landscape design, or business consultants). Ask how this person assigns costs to products and how this information affects business decisions. Keep in mind that many businesspeople use terms other than job costing and manufacturing overhead. Be flexible with your use of accounting terminology in this interview. Each team should write a memorandum to the instructor summarizing the results of the interview. Information contained in the memo should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, date of the interview, examples of the use of accounting information for decision making, and any other pertinent information.
Group project B In teams of two or three students, interview the manager of a campus print shop or a print shop in the area about how the company bids on prospective jobs. Does it use cost information from former jobs that are similar to prospective ones, for example? Does it have a specialist in cost estimation who estimates the costs of prospective jobs? Each team should write a memorandum to the instructor summarizing the results of the interview. Information contained in the memo should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, date of the interview, and information responding to the questions above.
Using the Internet—A view of the real world
Visit the website for a high technology company, such as HP, Intel Corporation, or IBM, and locate its annual report. Review the annual report to gain a general understanding of the company’s primary business segments and products. Write a report addressing the following questions based on your research. What products or services are provided by the company? How does the financial information provided in the annual report (focus on the income statement) differ from financial information used for managerial accounting purposes? As a manager making business decisions within the company, what additional information would you need? (Remember that the income statement may be referred to using different terminology such as statement of earnings or statement of operations.)
Company Website
Hewlett Packard Http://www.hp.com
Intel Corporation Http://www.intel.com
IBM Http://www.ibm.com
Visit the following website for Wells Fargo (a financial institution) and locate its annual report:
http://www.wellsfargo.com
Review the annual report to gain a general understanding of the company’s primary business segments and products. Write a report addressing the following questions based on your research. What products or services are provided by the company? How does the financial information provided in the annual report (focus on the income statement) differ from financial information used for managerial accounting purposes? As a manager making business decisions within the company, what additional information would you need? (Remember that the income statement may be referred to using different terminology such as statement of earnings or statement of operations.)
Visit the following website for Home Depot (a retail organization) and locate its annual report:
http://www.homedepot.com
Review the annual report to gain a general understanding of the company’s primary business segments and products. Write a report addressing the following questions based on your research. What products or services are provided by the company? How does the financial information provided in the annual report (focus on the income statement) differ from financial information used for managerial accounting purposes? As a manager making business decisions within the company, what additional information would you need? (Remember that the income statement may be referred to using different terminology such as statement of earnings or statement of operations.)
1. [1]See Standards of Ethical Conduct for Management Accountants (Montvale, N.J.: Institute of Management Accountants, June 1, 1983.)
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• Accounting Principles: A Business Perspective. Authored by: James Don Edwards, University of Georgia & Roger H. Hermanson, Georgia State University. Provided by: Endeavour International Corporation. Project: The Global Text Project. License: CC BY: Attribution | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/02%3A_Job_Order_Cost_System/2.10%3A_Chapter_2-_Exercises.txt |
Study Plan: Process Costing
Knowledge Targets
I can define the following terms as they relate to our unit:
Process Costing
Equivalent Units
Conversion Cost
Predetermined overhead rate
Weighted Average method Cost of Goods Manufactured
Cost per Equivalent Unit
Goods completed and transferred out
Ending goods (or work) in process Process cost summary Percent Complete Goods started
Reasoning Targets
• I can identify the difference between process costing and job costing.
• I can identify costs in process costing as direct materials, direct labor, and overhead.
• I can understand the difference between beginning and ending balances in work inprocess inventory.
• I can track process costs from raw materials to goods in process to finished goods and cost of goods sold.
• I can identify accounts to use in recording the flow of process costing.
• I can determine the percent complete for direct materials and conversion costs.
• I can understand equivalent units of production and how it is used in process costing.
• I can determine the ending balance in goods in process inventory.
• I can understand a process cost summary report.
Skill Targets
• I can prepare and post journal entries for process costing from raw materials to cost of goods sold.
• I can calculate the equivalent units for direct materials, direct labor and overhead using the weighted average method.
• I can calculate the cost per equivalent unit using the weighted average method.
• I can calculate the amount of cost to assign to goods completed and transferred out (also known as cost of goods manufactured) using equivalent units and cost per equivalent unit.
• I can calculate the amount of cost to assign to ending goods in process inventory using equivalent units and cost per equivalent unit.
• I can prepare a process cost summary report under the weighted average method.
Click Process Cost Study Plan for a printable copy.
3.02: Process Costing Vs. Job Order Costing
• Nature of a process cost system
Many businesses produce large quantities of a single product or similar products. Pepsi-Cola makes soft drinks, Exxon Mobil produces oil, and Kellogg Company produces breakfast cereals on a continuous basis over long periods. For these kinds of products, companies do not have separate jobs. Instead, production is an ongoing process.
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Job costing and process costing have important similarities:
• Both job and process cost systems have the same goal: to determine the cost of products.
• Both job and process cost systems have the same cost flows. Accountants record production in separate accounts for materials inventory, labor, and overhead. Then, they transfer the costs to a Work in Process Inventory account.
• Both job and process cost systems use predetermined overhead rates to apply overhead.
Job costing and process costing systems also have their significant differences:
• Types of products produced. Companies that use job costing work on many different jobs with different production requirements during each period. Companies that use process costing produce a single product, either on a continuous basis or for long periods. All the products that the company produces under process costing are the same.
• Cost accumulation procedures. Job costing accumulates costs by individual jobs. Process costing accumulates costs by process or department.
• Work in Process Inventory accounts. Job cost systems have one Work in Process Inventory account for each job. Process cost systems have a Work in Process Inventory account for each department or process.
Aprocess cost system (process costing) accumulates costs incurred to produce a product according to the processes or departments a product goes through on its way to completion. Companies making paint, gasoline, steel, rubber, plastic, and similar products using process costing. In these types of operations, accountants must accumulate costs for each process or department involved in making the product. As an example, view this How’s It Made video.
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Can you imagine having to determine the cost of making just ONE lego when we can make 1.7 million legos per hour? Cost accountants have to do this. They will use process costing! Accountants compute the cost per unit by first accumulating costs for the entire period (usually a month) for each process or department. Second, they divide the accumulated costs by the number of units produced (tons, pounds, gallons, or feet) in that process or department.
The next picture shows the cost flows in a process cost system that processes the products in a specified sequential order. That is, the production and processing of products begin in Department A. From Department A, products go to Department B. Department B inputs direct materials and further processes the products. Then Department B transfers the products to Finished Goods Inventory.
There are two methods for using process costs: Weighted Average and FIFO (First In First Out). Each method uses equivalent units and cost per equivalent units but calculates them just a little differently.
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• Essentially, the concept of equivalent units involves expressing a given number of partially completed units as a smaller number of fully completed units. We do this because it is easier to account for whole units then parts of a unit. We are adding together partially completed units to make a whole unit. For example, if we have 3 units 1/3 of the way complete, we can add them together to make 1 equivalent unit (1/3 + 1/3 + 1/3). We can make this calculation easier by multiplying the units by a percentage of complete.
For example, if we bring 1,000 units to a 40 % state of completion, this is equivalent to 400 units (1,000 x 40%) that are 100% complete. Accountants base this concept on the supposition that a company must incur approximately the same amount of costs to bring 1,000 units to a 40% level of completion as it would to complete 400 units.
Here is a diagram of the concept of equivalent units. As you examine the diagram, think of the amount of water in the glasses as costs that the company has already incurred.
• Now, watch the video for another example.
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Units in Beg. Work in Process Units Completed and Transferred
+ Units Started this period + Units in End. Work in Process
= Total Units = Total Units
The total units in each column must agree with one another. This formula explains how many units we had to work with (including units in beginning work in process + units started this period) and what happened to those units (units completed or units remain in work in process inventory since there are not complete).
Under the weighted average method, equivalent units are calculated based on 2 things: units completed and transferred out and units in ending work in process inventory.
Units completed and transferred are finished units and will always be 100% complete for equivalent unit calculations for direct materials, direct labor and overhead. For units in ending work in process, we would take the units unfinished x a percent complete. The percent complete can be different for direct materials, direct labor or overhead.
Example – Jax Company
Assume that Jax Company manufactures and sells a chemical product used to clean kitchen counters and sinks. The company processes the product in two departments. Department A crushes powders and blends the basic materials. Department B packages the product and transfers it to finished goods. We will look at equivalent units for Department B. The June production data for Department B is:
Department B
Beginning work in process -0-
Units started this period 11,000
Units completed and transferred 9,000
Ending work in process units 2,000
Direct materials \$ 1,100
Direct labor \$ 2,880
Applied overhead \$ 8,880
The physical flow of units shows:
Units in Beg. WIP -0- Units Completed and Transferred 9,000
Units Started this period 11,000 Units in End. WIP 2,000
Total Units 11,000 = Total Units 11,000
The beginning step in computing Department B’s equivalent units for Jax Company is determining the stage of completion of the 2,000 unfinished units (remember units completed and transferred are always 100% complete). In Department B, the ending units may be in different stages of completion regarding the materials, labor, and overhead costs. Assume that Department B adds all materials at the beginning of the production process. Then ending inventory would be 100% complete as to materials since we received all materials at the beginning of the process.
Accountants often assume that units are at the same stage of completion for both labor and overhead. Accountants call the combined labor and overhead costs conversion costs. Conversion costs are those costs incurred to convert raw materials into the final product (meaning, direct labor and overhead).
Let us assume that, on average, the 2,000 units in ending inventory are 40% complete as to conversion costs. This means that Department B transferred out 9,000 units fully completed and brought 2,000 units to a 40% completion state. Department B now has an equivalent of 800 fully completed units remaining in inventory (800 = 2,000 X 40 per cent).
The equivalent units for materials, labor and overhead would be calculated as:
Materials Conversion Costs
Units Completed and Transferred 9,000 9,000
(9,000 x 100% complete)
Units in Ending WIP
Materials (2,000 x 100% complete) 2,000
Conversion Cost (2,000 x 40% complete) 800
Total Equivalent Units 11,000 9,800
Total equivalent units for each cost element (materials, conversion cost) is calculated as:
Equivalent units = Units completed + (Units in ending inventory X percent complete)
The key to equivalent units is determining the percent complete, especially for materials can be confusing. Common terms you will see when determine ending work in process percent complete:
Description % Complete
Materials added at the beginning of the process 100% complete for materials
Materials added evenly through out the process Use % complete for ending WIP
Materials added at the end of the process 0% complete for materials
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• Process Costing consists of the following steps:
1. Physical flow of units
2. Equivalent Units of Production
3. Cost per Equivalent Unit
4. Assign Costs to Units completed and Ending work in process inventory
5. Reconcile Costs
Keep in mind, there are no Generally Accepted Accounting Principles (GAAP) that mandate how we must do a process cost report. We will focus on the calculations involved and show you an example of a process cost summary report but know there are several ways to present the information, but the calculations are all the same.
In the previous page, we discussed the physical flow of units (step 1) and how to calculate equivalent units of production (step 2) under the weighted average method. We will continue the discussion under the weighted average method and calculate a cost per equivalent unit.
Step 3: Cost per Equivalent Unit
The formula we will use is notice we are primarily using the dollar costs and not units for this section (except we will use TOTAL equivalent units we calculated in the previous section):
Beg. Work in Process Costs
+ Costs added this period
= Total Costs
÷ Total Equivalent Units
= Cost per Equivalent Units
We will calculate a cost per equivalent unit for each cost element (direct materials and conversion costs (or direct labor and overhead).
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Example – Jax Company
To continue with our previous example, we were given the following information:
• The June production and cost data for Jax Company are:
Department B
Beginning work in process -0-
Units started this period 11,000
Units completed and transferred 9,000
Ending work in process units 2,000
Direct materials cost \$ 1,100
Direct labor cost \$ 2,880
Applied overhead cost \$ 8,880
We calculated total equivalent units of 11,000 units for materials and 9,800 for conversion.
• To calculate cost per equivalent unit by taking the total costs (both beginning work in process and costs added this period) and divide by the total equivalent units.
• Materials Conversion
Beg. Work in Process Costs -0- -0-
+ Costs added this period \$ 1,100 \$ 11,760
(Conv. Cost = DL \$2,880 + OH \$8,880)
= Total Costs \$ 1,100 \$ 11,760
÷ Total Equivalent Units 11,000 9,800
= Cost per Equivalent Units \$ 0.10 \$ 1.20
In this example, beginning work in process is zero. This will not always be the case. The problem will provide the information related to beginning work in process inventory costs and units.
Step 4: Assign Costs
In this next section, we will combine the equivalent units (from step 2) and the cost per equivalent units (step 3) to assign costs to units completed and transferred out (also called cost of goods manufactured) and costs of units remaining ending work in process inventory. The basic formula to assign costs is:
Equivalent Units per cost element
(direct materials, conversion)
x cost per equivalent unit for cost element
(direct materials, conversion)
Using the example company, Jax Company, we have the following information:
Materials Conversion Costs
Units Completed and Transferred 9,000 9,000
Units in Ending WIP 2,000 800
Total Equivalent Units 11,000 9,800
Cost per Equivalent Units \$ 0.10 \$ 1.20
We would assign costs as follows:
Cost assigned to units completed and transferred
Direct Materials (9,000 equiv units x \$0.10) \$ 900
Conversion (9,000 equiv units x \$1.20) 10,800
Total cost assigned to units completed \$ 11,700
Cost assigned to ending work in process
Direct Materials (2,000 equiv units x \$0.10) 200
Conversion (800 equiv units x \$1.20) 960
Total cost assigned to ending work in process inventory \$ 1,160
For costs of units completed and transferred, we take the equivalent units for units completed x cost per equivalent unit. We do the same of ending work in process but using the equivalent units for ending work in process.
Step 5: Cost Reconciliation
Finally, we can check our work. We want to make sure that we have assigned all the costs from beginning work in process and costs incurred or added this period to units completed and transferred and ending work in process inventory.
First, we need to know our total costs for the period (or total costs to account for) by adding beginning work in process costs to the costs incurred or added this period. Then, we compare the total to the cost assignment in step 4 for units completed and transferred and ending work in process to get total units accounted for. Both totals should agree.
For Jax Company, the cost reconciliation would be:
Beg. Work in Process Cost -0-
+ Costs added this period \$ 12,860
(\$1,100 DM + \$2,880 DL + \$8,880 OH)
= Total costs to account for \$ 12,860
Cost assigned to units completed and transferred (from step 4 above) \$ 11,700
+ Cost assigned to ending work in process inventory (from step 4 above) 1,160
= Total costs accounted for \$ 12,860
The full process cost report can be found by clicking Jax_process cost).
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3.05: Journal Entries For the Flow of Production Costs
• The journal entries for the flow of production costs are the same with process and job costing. The cost flow is as follows:
The corresponding journal entries to the letters in the flow chart are:
Journal Entries by account flow (see referenced letter)
Ref Account / Description Debit Credit
a Raw Materials Inventory X
Cash or Accounts Payable X
Purchased raw materials inventory
b Factory Payroll X
Wages Payable X
Record wages earned but unpaid
c These are examples of some of the entries you may record:
Manufacturing Overhead X
Accumulated Depreciation X
Record depreciation on factory equipment
Manufacturing Overhead X
Cash X
Record factory rent paid with cash
Manufacturing Overhead X
Accounts Payable X
Record factory supplies purchased on credit
d Work in Process Inventory X
Raw Materials Inventory X
Record Direct Materials Used
e Manufacturing Overhead X
Raw Materials Inventory X
Record INDIRECT materials used
f Work in Process Inventory X
Factory Payroll X
Record Direct Labor
g Manufacturing Overhead X
Factory Payroll X
Record INDIRECT labor
h Work in Process Inventory X
Manufacturing Overhead X
Record Overhead APPLIED to production
i Finished Goods Inventory X
Work in Process Inventory X
Record jobs or goods completed (cost of goods manufactured)
j Cost of goods sold X
Finished Goods Inventory X
Record cost of jobs or goods completed AND sold
For a printable view click job cost flow. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/03%3A_Process_Cost_System/3.04%3A_Process_Costing_%28Weighted_Average%29.txt |
Another acceptable method for determining unit cost under process costing is the first-in, first-out (FIFO) cost method. Under the FIFO method, we assume any units that were not completed last period (beginning work in process) are finished before anything else is started. The following table shows the differences between the weighted average method and the FIFO cost method:
Weighted Average FIFO
Units Completed and transferred out: Total units completed this period Total units finished from beginning work in process + units started and completed this period
Equivalent Units based on: Units completed this period + Units in Ending Work in Process Units from Beg. Work in Process completed + units started and completed + units in Ending Work in Process
Cost per Equivalent Unit based on: Beg. Work in Process Costs + Costs added this period Costs added this period only
Assign costs using: Equivalent Units x Cost per Equivalent Units for Units completed and units in ending Work in Process Beg. Work in Process Costs + Equivalent Units x cost per equivalent unit for units finished from Beg. Work In Process, Units started and completed and units in End. Work In Process
We will look at each item individually as we discuss the steps of process costing. Under either method, weighted average or FIFO, process costing consists of 5 steps:
1. Physical Flow of Units
2. Equivalent Units
3. Cost per Equivalent Unit
4. Assign Costs to Units Completed and Ending Work in Process Inventory
5. Reconcile Costs
Physical Flow of Units
The physical flow of units is as follows under the weighted average method:
Units in Beg. WIP Units Completed and Transferred
+ Units Started this period + Units in End. WIP
= Total Units = Total Units
This is altered just slightly under the FIFO method as we must separate the items in units completed into Units Completed from beginning work in process and Units started and completed this period since under FIFO, we must finish anything from beginning work in process before we start something new. Under the FIFO, we the physical flow of units would be documented as:
Units in Beg. WIP Units Completed and Transferred:
+ Units Started this period Beg. Work in Process Units Completed
= Total Units + Units started and Completed this period
= Units completed and transferred
+ Units in End. WIP
= Total Units
Just as in the weighted average method, the 2 Total Units figures must agree!
Equivalent Units of Production
Under the FIFO method, we will calculate equivalent units for 3 things: Units completed from beginning work in process, units started and completed this period and units remaining in ending work in process. This video will discuss the differences between the Weighted Average and FIFO methods for equivalent units (if you are comfortable with the weighted average method, skip to minute 4:06 to begin the discussion on the FIFO method).
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Equivalent units for the period will be calculated as follows under FIFO (keep in mind, you may have different percent complete for materials, labor and overhead):
1. Units from beginning work in process: you want to complete this units, so how much MORE effort will be needed to finish these units. You will calculate this as beginning work in process units x (100% – given % complete) to calculate the amount of additional work necessary to make the unit 100% complete.
2. Units started and completed this period: take the units x 100% complete since they were started and completed they have received all of their materials, labor and overhead and will not receive any more since they are finished.
3. Units in Ending work in process: just like with the weighted average method, we will take the ending work in process units x a given % complete.
To illustrate the computation of equivalent units under the FIFO method, assume the following facts (for simplicity we are using just one percent complete for materials, labor and overhead):
Beginning work in process inventory 3,000 units, 40% complete
Units started this period 10,000 units
Ending work in process inventory 5,000 units, 20% complete
The physical flow of units would be (calculate units started and completed as units started 10,000 – units in ending work in process 5,000):
Units in Beg. WIP 3,000 Units Completed and Transferred:
Units Started this period 10,000 Units from Beg. WIP 3,000
Total Units 13,000 Units started and completed 5,000 (10,000 – 5,000)
Total Units completed and txfr 8,000
Units in End. WIP 5,000
Total Units 13,000
The equivalent production for the period would be:
Units from beginning WIP [3,000 units x (100% – 40% complete)] 1,800
Units started and completed 5,000 units x 100% complete 5,000
Units in ending WIP 5,000 units x 20% complete 1,000
Total Equivalent Units 7,800
Cost per Equivalent Unit
Under the weighted average method, we use beginning work in process costs AND costs added this period. Under the FIFO method, we will only use the costs added this period. This video will explain the differences between the two approaches.
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The formula we will use for calculating cost per equivalent unit under the FIFO Method is:
Current Costs added this period
÷ Total Equivalent Units
= Cost per Equivalent Units
Assign Costs
When we assign costs to units completed and transferred and units remaining in ending work in process under the FIFO method, we need the following items:
1. Costs from beginning work in process: these were the costs we started the period with or the unfinished items from the previous period (no calculation required — just bring over the costs from beginning work in process). Remember, under FIFO, these are finished first so their costs must be passed along to completed units.
2. Costs to complete beginning work in process: you will take the Equivalent units calculated for completing beginning work in process x the cost per equivalent unit. You will do this for materials, labor and overhead (or for conversion costs which is the both direct labor and overhead).
3. Costs of units started and completed: you will take the equivalent units calculated for units started and completed x the cost per equivalent unit for materials, labor and overhead (or conversion).
4. The sum of these 3 will be the cost of units completed and transferred which is also known as cost of goods manufactured. This amount is transferred to the next department or to finished goods and out of work in process for the units completed this period.
5. Cost of units remaining in ending work in process: you will take the ending work in process equivalent units x the cost per equivalent unit for materials, labor and overhead (or conversion) just as we did under the weighed average method. This amount rolls over to be the next period’s beginning work in process inventory.
This video will provide a demonstration of cost assignment under the FIFO method.
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Reconcile Costs
Finally, something is the same under FIFO and Weighted Average.
We want to make sure that we have assigned all the costs from beginning work in process and costs incurred or added this period to units completed and transferred and ending work in process inventory.
First, we need to know our total costs for the period (or total costs to account for) by adding beginning work in process costs to the costs incurred or added this period. Then, we compare the total to the cost assignment in step 4 for units completed and transferred and ending work in process to get total units accounted for. Both totals should agree.
The cost reconciliation would be:
Beg. Work in Process Cost
+ Costs added this period
= Total costs to account for
Cost assigned to units completed and transferred
+ Cost assigned to ending work in process inventory
= Total costs accounted for
In the next page, we will do a demonstration problem of the FIFO method for process costing.
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To illustrate more completely the operation of the FIFO process cost method, we use an example of the month of June production costs for a company’s Department B. Department B adds materials only at the beginning of processing. The May 31 inventory in Department B (June’s beginning work in process) consists of 2,000 units that are fully complete as to materials and 60% complete as to conversion. Beginning work in process inventory has accumulated costs of \$6,180.
The following costs were added in June: Direct materials issued \$ 1,300; direct labor \$ 7,200; and manufacturing overhead applied \$ 6,000. The units for the period were:
Beginning work in process inventory 2,000 units
Units started this period 10,000 units
Ending work in process inventory 3,000 units
Ending work in process inventory was 1/3 complete as to conversion costs.
Step 1: Physical Flow of Units
For the physical flow of units, we calculate units started AND completed this period as Units started 10,000 – units remaining in ending work in process 3,000 = 7,000 units.
Units in Beg. WIP 2,000 Units Completed and Transferred:
Units Started this period 10,000 Units from Beg. WIP 2,000
Total Units 12,000 Units started and completed 7,000 (10,000 – 3,000)
Total Units completed and txfr 9,000
Units in End. WIP 3,000
Total Units 12,000
Step 2: Equivalent Units of Production
We are concerned with the right side of our physical flow of units. We must first FINISH beginning work in process, add units started and completed and units remaining in ending work in process. Beginning work in process is fully complete for materials (or 100% complete) and 60% complete for conversion so to complete these units we will need NO (or 0%) materials and 40% of conversion (100% – 60%). Units started and completed are always 100% complete for materials, labor and overhead! Ending work in process is 1/3 complete for conversion costs, but what about materials? The problem information reads “Department B adds materials only at the beginning of processing” which means we receive all (or 100%) of the materials at the beginning of the process and ending work in process will be fully complete for materials.
Materials Conversion Costs
Units from beginning WIP 0 800
[ 2,000 units x (100% – 100% complete)] [ 2,000 units x (100% – 60% complete)]
Units started and completed 7,000 7,000
(7,000 units x 100% complete)
Units in ending WIP 3,000 1,000
(3,000 units x 100% complete) (3,000 units x 1/3 complete)
Total Equivalent Units 10,000 8,800
Step 3: Cost per Equivalent Units
Under FIFO, we are only interested in the current period costs which is June for this example. Conversion costs are direct labor \$7,200 + overhead \$6,000.
Materials Conversion Costs
Current Costs added this period \$ 1,300 \$ 13,200 (7,200 + 6,000)
÷ Total Equivalent Units 10,000 8,800
= Cost per Equivalent Unit \$ 0.13 \$ 1.50
Step 4: Assign Costs to Units Completed and Ending Work in Process Inventory
Under FIFO, remember to bring over the costs of beginning work in process first, then multiply the individual equivalent units calculated in step 2 (not the total equivalent units) by the cost per equivalent unit from step 3.
Cost assigned to units completed and transferred out:
Cost of beginning work in process inventory \$6,180
Cost to complete beginning work in process inventory
Materials (0 equivalent units) \$0
Conversion (800 equiv units x \$1.50) \$1,200
\$1,200
Cost of units started and completed
Materials (7,000 equiv units x \$0.13) \$910
Conversion (7,000 equiv units x \$1.50) \$10,500
\$11,410
Total cost of units completed and transferred \$18,790
Cost assigned to ending work in process inventory:
Materials (3,000 equiv units x \$0.13) \$390
Conversion (1,000 equiv units x \$1.50) \$1,500
Total cost of units remaining in ending work in process inventory \$1,890
Step 5: Reconcile Costs
Here is our chance to check our work. Total costs to account for should always equal what was assigned in total costs accounted for.
Cost of beginning work in process \$6,180
Costs added in June \$14,500 (1,300 DM + 7,200 DL + 6,000 OH)
Total costs to account for \$20,680
Costs assigned to units completed \$18,790 (from step 4 above)
Costs assigned to ending work in process \$1,890 (from step 4 above)
Total costs accounted for \$20,680
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Would job order costing or process costing be used by the Smarties Candy Company?
Smarties come in six flavors: white (orange crème), yellow (pineapple), pink (cherry), green (strawberry), purple (grape), and orange (orange). Smarties are gluten free and vegan and have 25 calories per roll of 15 candies. The main ingredient in Smarties is dextrose, a form of sugar.The Smarties Candy Company, founded in 1949, makes its Smarties candy in a New Jersey plant. Its founder bought gunpowder pellet machines after World War I and repurposed them to make the tablet-shaped candies. Smarties are made by color in large batches and then dumped together to be sorted by machines into rolls and packs.
Three granddaughters of the original founder of Smarties now run the company and have been working to improve efficiency. Their chief mechanic designed a faster candy press and a new wrapper machine. Previously, 125 Smarties rolls could be wrapped per minute; now 200 rolls can be wrapped per minute.
Smarties are produced 24 hours a day. (You can see a short video clip about Smarties and the production process at http://www.fyi.tv/shows/food-factory-usa/videos/these-women-have-business-smarties .)
The Smarties Candy Company has its one main product that is likely to account for most of its sales, but recently it has introduced Smarties ‘n creme, which are tablets that are about the size of a quarter and have a flavor burst that is half fruit (strawberry, blueberry, raspberry, peach, or orange) and half cream (dairy-free.)
Questions
1. Give an example of each of the following types of costs at the Smarties Candy Company:
• Direct material
• Direct labor
• Manufacturing overhead
• Selling and administrative expense
2. Assume that only Smarties candies are made in the New Jersey plant. Do you think the Smarties Candy Company is likely to use job order costing or process costing? Explain.
3. If the New Jersey plant begins to produce Smarties ‘n creme in addition to Smarties candy rolls, would this change be likely to whether the company uses job order costing or process costing? Why or why not?
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3.09: Chapter 3 Key Points
Process Costing Key Points
Process costing is used for mass production – high volumes of standardized product. This makes costing difficult due to the sheer volume of product we are producing and the fact that each product uses a small amount of materials, labor and overhead. Process costing is done in a 5-step Process.
Step 1: Cost accumulation
This section lists all dollar costs in Beginning work in process and adds the costs added during the period to get your Total Costs to Account For.
Step 2: Physical Flow of Units
In this section, we document how many units we had to work on and then disclose what happened to those units – were they finished or not. The calculation is:
Beginning work in process units + units started this period = Units completed and transferred + Ending work in process units
Step 3: Equivalent Units – Weighted Average
Equivalent units is the process of adding partially completed units together to make whole units since it is easier to calculate with whole numbers. Under the weighted average method, we use only the Units completed and transferred and Ending work in process units from Step 2. You will calculated equivalent units for direct materials, direct labor and overhead. The calculation for equivalent units is:
Units completed and transferred x 100% percent complete
Plus Ending work in process units x percent complete
= Total Equivalent Units
Note: Ending work in process percent complete can be different for direct materials, direct labor, or overhead. Materials added at the beginning means 100% complete since it has received all its materials. Materials or conversion costs added evenly means use the percent complete given. Remember, conversion costs means direct labor and overhead.
Step 4: Cost per Equivalent Unit – Weighted Average
We add the total costs incurred during the process including beginning work in process and divide by the Total Equivalent Units calculated in Step 3. The formula is applied to direct materials, direct labor and overhead individually (or sometimes just direct materials and conversion costs). The calculation is:
Cost of Beginning work in process inventory + costs added this period
Total Equivalent Units
Step 5: Assign and Reconcile Costs
In this section, you will use the equivalent units calculated in Step 3 and multiply by the cost per equivalent unit calculated in Step 4. You will do this beginning with units completed and transferred and apply the costs to direct material first, then conversion costs. The result of this step is Cost of Goods Manufactured. The calculations look like this:
Cost assigned to units completed
Direct Materials (equivalent units for direct materials units completed in step 3 x direct material cost per equivalent unit in step 4)
+ Conversion Costs (equivalent units for conversion cost units completed in step 3 x conversion cost per equivalent unit in step 4).
= Total Costs transferred out (or Cost of Goods Manufactured)
Now, repeat the process using your equivalent units calculated based on Ending Work in Process.
Cost assigned to ending work in process
Direct Materials (equivalent units for direct materials for ending work in process in step 3 x direct material cost per equivalent unit in step 4)
+ Conversion Costs (equivalent units for conversion cost for ending work in process in step 3 x conversion cost per equivalent unit in step 4).
= Total Costs assigned to Ending Work in Process
Finally, you complete the reconciliation by adding your Total Costs Transferred Out and Total costs assigned to Ending Work in Process to get your Total Costs Accounted For. This should match the cost totals in Step 1.
Click Process Costing Key Points for a printable copy.
3.10: Glossary
GLOSSARY
Average cost (or weighted average) method A method of computing equivalent units where the number of equivalent units for each cost element equals the number of units transferred out plus the number of equivalent units of that cost element in the ending inventory.
Conversion costs Costs of converting raw materials into the final product. Direct labor plus overhead.
Equivalent units A method of expressing a given number of partially completed units as a smaller number of fully completed units; for example, bringing 1,000 units to a 75 per cent level of completion is the equivalent of bringing 750 units to a 100 per cent level of completion.
First-in, first-out (FIFO) method A method of determining unit cost. This method computes equivalent units by adding equivalent units of work needed to complete the units in beginning inventory, work done on units started and completed during the period, and work done on partially completed units in ending inventory.
Job cost system (job costing) A manufacturing cost system that accumulates costs incurred to produce a product according to individual jobs.
Process cost system (process costing) A manufacturing cost system that accumulates costs incurred to produce a product according to the processes or departments a product goes through on its way to completion.
Production cost report A report that shows both the flow of units and the flow of costs through a processing center. It also shows how accountants divide these costs between the cost of units completed and transferred out and the cost of units still in the processing center’s ending inventory.
Transferred-in costs Costs associated with physical units that were accumulated in previous processing centers.
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Short Answer Questions, Exercises, and Problems
Short-Answer Questions
➢ Define process costing and describe the types of companies that use process costing.
➢ How does a process cost system differ from a job costing system?
➢ Would a lumber mill use process or job costing?➢ What is meant by the term equivalent units? Of what use is the computation of the numbers of equivalent units of production?
➢ Distinguish between the number of units completed and transferred during a period and the equivalent units for the same period.➢ Under what circumstances would the number of equivalent units of materials differ from the number of equivalent units of labor and overhead in the same department in the same period? Under what circumstances would they be the same?➢ When transferring goods from one department to another, which accounts require journal entries?➢ Units are usually assumed to be at the same stage of completion for both labor and overhead. What is the reason for this assumption?
➢ What is the basic information conveyed by a production cost report?
➢ What are the four steps in preparing a production cost report?
➢ What is meant by average cost procedure? What other two cost flow assumptions could be used?
➢ Would an automobile plant that makes specialty race cars use job costing or process costing? Would an automobile plant that makes all terrain vehicles use job costing or process costing? Explain your answer.
➢ Show the differences between computing equivalent units of production using the average cost method and FIFO cost method (Appendix 19A).
Real world question Does The Coca-Cola Company use a process cost system or a job costing system in its bottling plants? Why?
Real world question Name five companies that probably use process costing.
Exercises
Exercise A Using the average cost method, compute the equivalent units of production in each of the following cases:
1. Units started in production during the month, 72,000; units completed and transferred, 52,800; and units in process at the end of the month (100% complete as to materials; 60% complete as to conversion), 19,200. (There was no beginning inventory.)
2. Units in process at the beginning of the month (100% complete as to materials; 30% complete as to conversion), 12,000; units started during the month, 48,000; and units in process at the end of the month (100% complete as to materials; 40% complete as to conversion), 24,000.
Exercise B In Department C, materials are added at the beginning of the process. There were 1,000 units in beginning inventory, 10,000 units were started during the month, and 7,000 units were completed and transferred to finished goods inventory. The ending inventory in Department C in June was 40% complete as to conversion costs. Under the average cost method, what are the equivalent units of production for materials and conversion?
Exercise C In Department D, materials are added uniformly throughout processing. The beginning inventory was considered 80% complete, as was the ending inventory. Assume that there were 6,000 units in the beginning inventory and 20,000 in the ending inventory, and that 80,000 units were completed and transferred out of Department D. What are the equivalent units for the period using the average cost method?
Exercise D If in the previous exercise the total costs charged to the department amounted to \$960,000, including the \$48,000 cost of the beginning inventory, what is the cost of the units completed and transferred out?
Exercise E The following data relate to Work in Process—Department C, in which all materials are added at the start of processing:
Work in process – Department C: Inventory, March 1:
Materials cost (1,200 pounds; 100% complete) \$7,020
Conversion cost (20% complete) 1,804
Costs incurred this period:
Direct materials used (9,000 pounds) \$36,330
Direct labor 10,880
Overhead 17,820
Inventory, March 31
Materials cost (1,800 pounds, 100% complete) ?
Conversion cost (1,800 pounds, 80% complete) ?
Pounds of product transferred out: 8,400
Using these data, compute:
1. The unit cost per equivalent unit for materials and conversion (use the average cost method).
2. The cost of the product transferred out.
Problems
Problem A The following data refer to a production center of Sipp-Fizz, a soft drink bottler:
Work in process inventory, August 1, 4,000 units (units equal 12-bottle cases):
Direct materials \$12,000
Direct labor 6,120
Manufacturing overhead applied 8,000
\$26,120
Units started in August 12,000
Costs incurred in August:
Direct materials \$36,000
Direct labor 48,000
Manufacturing overhead applied 60,000
The beginning inventory was 100% complete for materials and 50% complete for conversion costs.
The ending inventory on August 31 consisted of 6,000 units (100% complete for materials, 70% complete for conversion costs).
Compute the following:
1. Number of units completed and transferred to finished goods inventory.
2. The equivalent units of production for materials and conversion costs using the average cost method.
3. Cost per equivalent unit for materials and conversion costs.
4. Cost of units completed and transferred.
5. Cost of ending inventory.
Problem B The following information relates to Aromatic Company for its line of perfume products for the month ended March 31:
Units in beginning inventory (units equal cases of product) 2,700
Cost of units in beginning inventory:
Materials \$40,500
Conversion \$ 18,900
Units placed in production 54,000
Cost incurred during current period:
Materials \$239,598
Conversion \$215,310
Units remaining in ending inventory
(100% complete as to materials, 60% complete as to conversion)
3,000
Prepare a production cost report for the month ended March 31, using the average cost method.
Problem C Shine Company uses a process cost system to account for the costs incurred in making its single product, a hair conditioner. This product is processed in Department A and then in Department B. Materials are added in both departments. Production for May was as follows:
Department A Department B
Units started or transferred in 200,000 160,000
Units completed and transferred out 160,000 120,000
Stage of completion of May 31 inventory:
Materials 100% 80%
Conversion 50% 40%
Costs incurred this month:
Direct materials costs \$200,000 \$304,000
Conversion costs \$540,000 \$272,000
There was no May 1 inventory in either department.
1. Prepare a production cost report for Department A in May.
2. Prepare a production cost report for Department B in May.
Problem D A bottling company bottles soft drinks using a process cost system. Following are cost and production data for the mixing department for June:
Units Materials
costs
Conversion
costs
Inventory, June 1 56,000 \$11,620 \$16,240
Placed in production in June 133,000 29,960 41,720
Inventory, June 30 63,000 ? ?
The June 30 inventory was 100% complete as to materials and 30% complete as to conversion.
Prepare a production cost report for the month ended June 30 using the average cost method.
Problem E Refer to the facts given in the previous problem. Assume the beginning inventory on June 1 was 100% complete as to materials and 25% complete as to conversion.
1. Prepare a production cost report for the month ended June 30, using FIFO. Round unit costs to the nearest cent.
2. Why are ending inventory amounts different than those for the previous problem?
Alternate problems
Alternate problem A Pure Aqua Company is a producer of flavored mineral water. These data are for its March production:
Work in process inventory, March 1, 3,000 (units equal cases):
Direct materials \$12,600
Direct labor 6,000
Manufacturing overhead (1,500 machine-hours at \$6 per machine-hours) 9,000
\$27,600
Units started in March 9,000
Costs incurred in March:
Direct materials \$36,360
Direct labor 55,200
Manufacturing overhead applied (13,800 machine-hours) ?
The ending inventory consisted of 4,500 units (100% complete as to materials, 60% complete as to conversion).
Compute the following:
1. Number of units completed and transferred to finished goods inventory.
2. The equivalent units of production for materials and conversion costs using the average cost method.
3. Cost per equivalent unit for materials and conversion costs.
4. Cost of units completed and transferred.
5. Cost of ending inventory.
Alternate problem B The following data pertain to a production center of Sunbelt Company, a maker of sunscreen products:
Units Materials
costs
Conversion
costs
Inventory, October 1 70,000 \$12,000 \$16,000
Placed in production in October 200,000 20,400 18,200
Inventory, October 31 100,000 ? ?
The October 31 inventory was 100% complete as to materials and 20% complete as to conversion costs.
Prepare a production cost report for the month ended October 31, using the average cost method.
Alternate problem C Healthbar Company produces a health food and determines product costs using a process cost system. The product is moved through two departments, mixing and bottling. Production and cost data for the bottling department in August follow.
Work in process, August 1 (30,000 pints):
Costs transferred in \$30,000
Materials costs 15,000
Conversion costs 9,000
Costs incurred in August:
Transferred in (100,000 pints) \$100,000
Materials costs 50,000
Conversion costs 39,300
All materials are added at the beginning of the bottling process. Ending inventory consists of 25,000 pints, 100% complete as to materials and 40% complete as to conversion.
Prepare a production cost report for August using the average cost method.
Beyond the numbers—Critical thinking
Business decision case A Bicycles Plus, Inc., produces bicycles. While the company has developed a per unit cost, it has not been able to break down its costs in each of its three departments: frames, assembling, and finishing. Karol Ring, the production manager, has been concerned with cost overruns during July in the frames department, which produces the bicycle frames.
On July 1, the frames department had 6,000 units in its work in process inventory. These units were 100% complete as to materials and 40% complete as to conversion. The department had incurred \$12,000 in materials costs and \$90,000 in conversion costs in processing these 6,000 units.
The department handled 30,000 units during the month, including the 6,000 units in beginning inventory on July 1. At the end of the month, the department’s work in process included 3,600 units that were 100% complete as to materials and 30% complete as to conversion. The month’s costs were allocated on the number of units processed during the month as follows:
Materials Conversion
Costs \$60,000 \$300,216
Units handled during month 30,000 30,000
Cost per unit \$ 2 \$ 10
The \$12 per unit cost was assigned in a way that resulted in the following costs:
Beginning work
in process
Work started
and completed
Ending work
in process
Cost per unit incurred during the month:
Units 6,000 20,400 3,600
Cost per unit \$12 \$12 \$12
Ring realized that this per unit cost is incorrect and asks you to develop a better method of computing these costs for the month ended July 31.
1. How would you recommend that July’s costs be assigned to the units produced?How would this differ from the present method?
2. To justify your recommendation, recalculate July’s costs using your recommendation. Present your analysis in a production cost report.
Ethics case – Writing experience B Steve Yung works in the inventory control group at a company that produces stone-washed jeans. A good friend manages the Stitching Department at the same company. At the end of a recent month, Yung reviewed the Stitching Department’s production cost report and found the department had no beginning Work in Process Inventory, had started 27,000 pairs of jeans, and had produced only 24,000 pairs. That leaves 3,000 pairs in ending inventory, Yung thought, that is a lot of jeans they did not finish.
Later, Yung visited his friend who managed the Stitching Department. “Why all the ending inventory?” he asked.
“One of the new workers set several machines wrong, and the stitching was bad on 2,400 pairs,” the manager replied. “We set those aside, and we will fix them when we have some free time. The other 600 pairs are complete now, and have been transferred out. Our entire operation was slower because of the machine problem.”
“Company policy is to send all defective products to the Rework Department. They can fix the jeans. That is their job,” Yung said.
“No way!” exclaimed the Stitching Department manager. “We would all be in trouble if plant management finds out. The worker who messed up would probably be fired. I do not want that. This is our little problem, and we will take care of it.”
1. What should Yung do?
2. Would your answer change if Yung learned that the Stitching Department had fixed the jeans and sent them on to the next department?
Financial analysis C Suppose a bottling company made an error in estimating the stage of completion of its work in process inventory. Suppose the costs in beginning inventory and the costs transferred in were correct, but the company overstated the stage of completion for both materials and conversion costs in ending Work in Process Inventory causing ending Work in Process Inventory to be \$100,000 too high. The beginning and ending Finished Goods Inventory amounts are correct. What effect would this error have on the company’s last year’s financial statements?
Group project D In groups of 3 or 4 students, write a paper on the topic, “How scientific is the allocation of joint costs to products?” Prepare the paper on a computer and prepare and edit several drafts before turning in the final paper. Use examples to demonstrate your points.
Group project E In teams of two or three students, interview the manager of a grocery store. What is the cost of spoilage in the vegetable and fruit section as a percentage of the total cost of goods sold? Does the manager differentiate between normal and abnormal spoilage? If so, provide some examples. Each team should write a memorandum to the instructor summarizing the results of the interview. Information contained in the memo should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, and information responding to the questions above.
Group project F In teams of two or three students, interview the manager of a fast food restaurant such as McDonald’s. What is the cost of spoilage as a percentage of the total cost of goods sold? Does the manager differentiate between normal and abnormal spoilage? If so, provide some examples. Each team should write a memorandum to the instructor summarizing the results of the interview. Information contained in the memo should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, and information responding to the questions above.
Using the Internet—A view of the real world
Using the Internet as a research tool, describe the conversion activities (or processes) involved in producing oil or oil-related products. Your description should include examples of raw materials used as inputs, production activities required to convert inputs into products, and resulting outputs (finished goods). Write your report in the form of a memorandum. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter. Be sure to attach your research materials obtained from the Internet to the memorandum.
Using the Internet as a research tool, describe the conversion activities (or processes) involved in producing milk or milk-related products. Your description should include examples of raw materials used as inputs, production activities required to convert inputs into products, and resulting outputs (finished goods). Write your report in the form of a memorandum. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter. Be sure to attach your research materials obtained from the Internet to the memorandum.
Comprehensive review problem
The Compack Company assembles personal computers. Personal computers go through several departments where sub assemblies are unpacked and checked, the circuit board is attached, the product is tested and repaired if defective, and the computers are packed carefully for shipping. Each order is treated as a job, and the entire job is shipped at once. The company keeps track of costs by job and calculates the equivalent stage of completion for each job based on machine-hours.
Although the company has grown rapidly, it has yet to show a profit. You have been called in as a consultant. Management believes some jobs are profitable and others are not, but it is not clear which are profitable. The accounting system is almost nonexistent; however, you piece together the following information for April:
• Production:
1. Completed Job No. 101.
2. Started and completed Job No. 102.
3. Started Job No. 103.
• Inventory values:
1. Work in process inventory:
March 31: Job No. 101
Direct materials \$60,000
Direct labor 9,600
Overhead 14,400
April 30: Job No. 103
Direct materials \$45,000
Direct labor 10,400
Overhead 15,600
1. Job No. 101 was exactly one-half finished in direct labor-hours and machine-hours at the beginning of April, and Job No. 103 was exactly one-half complete in direct labor-hours and machine-hours at the end of April. However, all of the direct materials necessary to do the entire job were charged to each job as soon as the job was started.
2. There were no direct materials inventories or finished goods inventories at either March 31 or April 30.
• Manufacturing overhead is applied at \$30 per machine-hour. The company used 1,600 machine-hours during April, 480 machine-hours on Job 101 and 600 machine-hours on Job 102. The actual overhead for the month of April was \$50,000.
• Cost of goods sold (before adjustment for over applied or under applied overhead):
Job No. 101:
Materials \$60,000
Labor ?
Overhead ?
Total ?
Job No. 102:
Materials ?
Labor ?
Overhead ?
Total ?
• Overhead was applied to jobs using the predetermined rate of \$30 per machine-hour. The same rate had been used since the company began operations. Over- or under applied overhead is debited or credited to Cost of Goods Sold.
• All direct materials were purchased on account. Direct materials purchased in April amounted to \$150,000.
• Direct labor costs charged to jobs in April were \$32,000. All labor costs were the same rate per hour for April for all laborers.
1. Compute the cost of each job, whether in inventory or sold.
2. Show the transactions in journal entry form. Use a separate Work in Process Inventory account for each job.
3. Prepare an income statement for April assuming revenue was \$250,000 and selling and administrative expenses were \$60,000.
4. [1]For example, a survey of oil refineries indicated that seven of the nine companies did not allocate joint costs. See K. Slater and C. Wooton, A Study of Joint and By-Product Costing in the U.K. (Reprint, London: Chartered Institute of Management Accountants, 1988), p. 110.
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Activity-based costing and management
Suppose you go to a movie theater that has five screens showing five different movies. Jerome Justin works for the movie theater selling tickets for all five movies. Suppose management wants to know the cost of selling tickets per movie and asks you to assign Justin’s wages to each of the five movies. How would you assign his wages?
You could simply divide Justin’s wages by the number of movies and allocate 20% (1/5 = 20%) of his salary to each movie. Or you could figure out how many tickets he sold to each movie, and allocate his wages on the basis of ticket sales. For example, if 50% of the ticket sales were for Avatar, you might allocate 50% of Justin’s wages to Avatar. You probably also could think of additional ways to allocate Justin’s wages. No matter how we allocate Justin’s wages, his wages would not be directly traceable to one of the movies if he sold tickets for all five movies. In short, the allocation of Justin’s wages to a particular movie is at least somewhat arbitrary because alternative methods could allocate different amounts of Justin’s wages to each movie. Justin’s wages would be indirect costs to the different movies because his wages could not be directly assigned to any one of the movies.
By definition, the allocation of indirect costs is at least somewhat arbitrary. Nevertheless, accountants have discovered that they can improve the ways costs are assigned, such as to movies in this case, by using activity-based costing.
Activity-based costing is a costing method that assigns indirect costs to activities and to the products based on each product’s use of activities. Activity-based costing is based on the premise: Products consume activities; activities consume resources.
Activity-based costing identifies the activities generating costs and assigns costs to those activities. Take the earlier Justin example. By focusing on Justin’s activities, management could learn what caused costs and find ways to improve Justin’s efficiency. Suppose that by studying Justin’s activities, management learns he spends 40% of his time answering questions about movies, 40% of his time selling tickets, and 20% doing nothing. Based on this information, management could think about better ways to use Justin’s time. By improving their signs and posting information about the movies, management could reassign Justin to other tasks.
Closely related to activity-based costing is the notion of activity-based management (ABM). Using activity-based management, managers identify which activities consume resources. The focus is then to effectively manage costly activities with the goal of reducing costs and improving quality. Consider Justin and the movie theater again. Using activity-based management, managers would identify what Justin did with his time and perhaps find ways to help him become more efficient.
Let’s look at a company that makes clothing. The product does not cost less under one system or another. Our problem is that no cost system measures costs perfectly. We are able to trace some costs directly to the product. For example, we are pretty accurate in measuring the cost of denim, which is a direct material, in each of our shirts, pants, jackets, and so forth.
Activity-based costing and management
Suppose you go to a movie theater that has five screens showing five different movies. Jerome Justin works for the movie theater selling tickets for all five movies. Suppose management wants to know the cost of selling tickets per movie and asks you to assign Justin’s wages to each of the five movies. How would you assign his wages?
You could simply divide Justin’s wages by the number of movies and allocate 20 per cent of his salary to each movie. Or you could figure out how many tickets he sold to each movie, and allocate his wages on the basis of ticket sales. For example, if 50 per cent ofthe ticket sales were for Avatar, you might allocate 50 per cent of Justin’s wages to Avatar. You probably also could think of additional ways to allocate Justin’s wages. No matter how we allocate Justin’s wages, his wages would not be directly traceable to one of the movies if he sold tickets for all five movies. In short, the allocation of Justin’s wages to a particular movie is at least somewhat arbitrary because alternative methods could allocate different amounts of Justin’s wages to each movie. Justin’s wages would be indirect costs to the different movies because his wages could not be directly assigned to any one of the movies.
By definition, the allocation of indirect costs is at least somewhat arbitrary. Nevertheless, accountants have discovered that they can improve the ways costs are assigned, such as to movies in this case, by using activity-based costing.
Activity-based costing is a costing method that assigns indirect costs to activities and to the products based on each product’s use of activities. Activity-based costing is based on the premise: Products consume activities; activities consume resources.
Numerous companies, such as HP, Caterpillar, and IBM, have implemented activity-based costing. Activity-based costing (ABC) has revealed startling information in these companies. For example, after installing new costing methods, one well-known company found that one of its products, a printed circuit board, was generating negative margins of 46 per cent.
Activity-based costing identifies the activities generating costs and assigns costs to those activities. Take the earlier Justin example. By focusing on Justin’s activities, management could learn what caused costs and find ways to improve Justin’s efficiency. Suppose that by studying Justin’s activities, management learns he spends 40 per cent of his time answering questions about movies, 40 per cent of his time selling tickets, and 20 per cent doing nothing. Based on this information, management could think about better ways to use Justin’s time. By improving their signs and posting information about the movies, management could reassign Justin to other tasks.
Closely related to activity-based costing is the notion of activity-based management (ABM). Using activity-based management, managers identify which activities consume resources. The focus is then to effectively manage costly activities with the goal of reducing costs and improving quality. Consider Justin and the movie theater again. Using activity-based management, managers would identify what Justin did with his time and perhaps find ways to help him become more efficient.
Let’s illustrate by looking at a textile company that makes jeans. We will use this company as a basis to demonstrates important issues about the difficulty with traditional cost allocation methods and the advantages of activity-based costing.
The product does not cost less under one system or another. Our problem is that no cost system measures costs perfectly. We are able to trace some costs directly to the product. For example, we are pretty accurate in measuring the cost of denim, which is a direct material, in each of our shirts, pants, jackets, and so forth.
Overhead costs are another matter. Overhead includes costs like electricity to run machines and salaries of product designers and inspectors. All these costs are allocated to products. We know quality control inspectors cost money, but we do not know how much of that cost is caused by a particular jacket or pair of pants. So we make some assumptions about the relation between products and overhead costs. For example, we typically allocate overhead based on machine-hours required to stitch and fasten snaps. While that is probably a reasonable way to allocate the costs of electricity to run machines, its not a desirable way to allocate the cost of quality control inspectors.
overhead allocation is somewhat arbitrary (it is based on an estimate only), how will activity-based costing help?
Activity-based costing provides more accurate information because we can identify which activities cause costs, and we can determine the cost of the activity. Activity-based costing identifies and measures the costs of performing the activities that go into a product much better than traditional cost methods. For example, if a particular jacket requires 10 inspections for a production run of 1,000 jackets, we figure out the cost of those inspections and assign that cost to the production run for this particular jacket.
But exactly how would activity-based costing help us cut production costs?
Once we identify activities that cause costs, we can eliminate or modify costly activities. For example, if we find that a jacket requires too many costly inspections, we could redesign the jacket to reduce the need for inspections. Our current cost system allocates all overhead costs, including inspection costs, to products based on machine-hours. We really do not know how much it costs to make an inspection and how much inspection cost is required by each product.
Because activity-based costing provides more information, it takes more time than traditional cost systems. New accounting methods sound great in theory, but there must be enough benefit from improved management decisions to justify the additional work required to provide numbers.
Key points about activity-based costing:
1. The allocation of indirect costs is at least somewhat arbitrary, even using sophisticated accounting methods.
2. Activity-based costing provides more detailed measures of costs than traditional allocation methods.
3. Activity-based costing can help marketing people by providing more accurate product cost numbers for decisions about pricing and which unprofitable products the company should eliminate.
4. Production also benefits because activity-based costing provides better information about the cost of each activity. In practice, ABC helps managers identify cost-causing activities. To manage costs, production managers learn to manage the activities that cause costs.
5. Activity-based costing provides more information about product costs than traditional methods but requires more record-keeping. Managers must decide whether the benefits or improved decisions justify the additional record-keeping cost.
6. Installing activity-based costing requires teamwork among accountants, production managers, marketing managers, and other nonaccounting people.
Next, we discuss the methods used for activity-based costing and illustrate them with an example.
4.02: Chapter 4 Study Plan
Study Plan: Activity Based Costing
Knowledge Targets
I can define the following terms as they relate to our unit:
Cost Driver
Cost Pool
Product Margin
Activity Based Costing
Customer Margin Activity Rate
Plantwide rate
Departmental rate
Allocation Base Cost per Unit
Reasoning Targets
• I can explain the use of cost pools in activity based costing.
• I can analyze the product margin of a product when using activity based costing and plantwide allocation.
• I can understand the difference between plantwide rate, departmental rate, and activity based costing activity rate.
• I can analyze the customer margin of a product using activity based costing.
Skill Targets
• I can calculate activity rates for activity cost pools.
• I can calculate the product margin using a traditional costing system and activity based costing.
• I can allocate overhead using activity based costing activity rates.
• I can allocate overhead using plantwide rates and departmental rates.
• I can calculate the total cost of a department, job, product, or process using activity based costing.
Click ABC Costing study plan for a printable copy. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/04%3A_Activity-Based_Costing/4.01%3A_Activity-Based_Costing_and_Management.txt |
Traditional Costing method
In a traditional costing method, we calculate one plantwide allocation rate or we could calculate an overhead allocation rate for each department. We have a three step process:
Step 1: Determine the basis for allocating overhead or indirect costs. These can be anything a company decides but most common are direct labor cost, direct labor hours, direct material usage or machine hours.
Step 2: Calculated a predetermined overhead rate using estimates. This is typically calculated at the end of the year to be used during the following year. The formula we use for this is:
Predetermined Overhead Rate (POHR) = Estimated Overhead
Estimated Base (or cost driver)
Step 3: Apply overhead throughout the period using the actual amount of our base and the predetermined overhead rate (POHR) calculated in step 2. We calculate this as:
Applied Overhead = Actual amount of base x POHR
This video will discuss the differences between the traditional costing method and activity based costing.
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Traditional costing method example
Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product.
High Challenge Company allocated manufacturing overhead costs to the two products for the month of January. Department A had estimated overhead of \$2,000,000 and used 20,000 machine hours. High Challenge has decided to allocate overhead on the basis of machine hours.
• The predetermined overhead rate of \$100 per machine hour is calculated as:
Predetermined Overhead Rate (POHR) = Estimated Overhead \$2,000,000
Estimated Base (or cost driver) 20,000 machine hours
• At the end of January, High Challenge had used 1,500 machine hours for the Touring bicycle product line and 500 machine hours for the Mountain bicycle product line. Overhead would be allocated to each product as follows (use the POHR calculated above at \$100 per machine hour):
Touring Bicycle Mountain Bicycle
\$150,000 \$50,000
(1,500 machine hours x \$100 per hour) (500 machine hours x \$100 per hour)
Methods used for activity-based costing
Activity-based costing requires accountants to use the following four steps:
1. Identify the activities that consume resources and assign costs to those activities. Purchasing materials would be an activity, for example.
2. Identify the cost drivers associated with each activity. A cost driver is an activity or transaction that causes costs to be incurred. For the purchasing materials activity, the cost drivers could be the number of orders placed or the number of items ordered. Each activity could have multiple cost drivers.
3. Compute a cost rate per cost driver unit. The cost driver rate could be the cost per purchase order, for example.
4. Assign costs to products by multiplying the cost driver rate times the volume of cost driver units consumed by the product. For example, the cost per purchase order times the number of orders required for Product A for the month of December would measure the cost of the purchasing activity for Product A for December.
The next section describes these four steps.
Step 1 is often the most interesting and challenging part of the exercise. This step requires people to understand all of the activities required to make the product. Imagine the activities involved in making a simple product like a pizza—ordering, receiving and inspecting materials, making the dough, putting on the ingredients, baking, and so forth. Or imagine the activities involved in making a complex product such as an automobile or computer.
One of the lessons of activity-based costing has been that the more complex the business, the higher the indirect costs. Imagine that each month you produce 100,000 gallons of vanilla ice cream and your friend produces 100,000 gallons of 39 different flavors of ice cream. Further, assume your ice cream is sold only in one liter containers, while your friend sells ice cream in various containers. Your friend has more complicated ordering, storage, product testing (one of the more desirable jobs, nevertheless), and packing in containers. Your friend has more machine setups, too. Presumably, you can set the machinery to one setting to obtain the desired product quality and taste. Your friend has to set the machines each time a new flavor is produced. Although both of you produce the same total volume of ice cream, it is not hard to imagine that your friend’s overhead costs would be considerably higher.
In Step 2, we identify the cost drivers. In the table below, we present several examples of the cost drivers companies use. Most cost drivers are related to either the volume of production or to the complexity of the production or marketing process.
Cost driver Cost of assigned cost driver
Miles driven Automobile costs
Machine-hours Electricity to run machines
Customers served Overhead in a bank
Flight hours Airplane maintenance costs
Number of customers Selling costs
In deciding which cost drivers to use, managers consider these three factors:
• Causal relation. Choosing a cost driver that causes the cost is ideal. For example, suppose students in biology classes are messier than students in history classes. As a result, the university does more maintenance per square foot in biology classrooms and labs than in history classrooms. Further, it is possible to keep track of the time maintenance people spend cleaning classrooms and labs. The university could assign maintenance costs based on the time spent in history classrooms and in biology classrooms and labs, respectively, to the history and biology departments.
• Benefits received. Choose a cost driver so costs are assigned in proportion to benefits received. For example, if the physics department in a university benefits more from the university’s supercomputer than the German department does, the university should select a cost driver that recognizes such differences in benefits. The cost driver could be the number of faculty and/or students in each department who use the computer.
• Reasonableness. Some costs that cannot be linked to products based on causality or benefits received are assigned on the basis of reasonableness.
For step 3, we need to calculate the activity rates. These are calculated using the same formula for predetermined overhead rate (POHR) that we used for traditional costing. In general, predetermined rates for allocating indirect costs to products are computed as follows:
Predetermined Overhead Rate (POHR) = Estimated Overhead
Estimated Base (or cost driver)
This formula applies to all indirect costs, whether manufacturing overhead, administrative costs, distribution costs, selling costs, or any other indirect cost.
In Step 4, we first define the notion of an activity center. An activity center is a unit of the organization that performs some activity. For example, the costs of setting up machines would be assigned to the activity center that sets up machines. This means that each activity has associated costs. When the cost driver is the number of inspections, for example, the company must keep track of the cost of inspections.
Workers and machines perform activities on each product as it is produced. Accountants allocate costs to products by multiplying each activity’s indirect cost rate by the volume of activity used in making the product. The formula we will use for each activity is:
Applied Overhead = Actual amount of activity cost driver x activity POHR
Activity-based costing example
Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product.
In using activity-based costing, the company identified four activities that were important cost drivers and a cost driver used to allocate overhead. These activities were (1) purchasing materials, (2) setting up machines when a new product was started, (3) inspecting products, and (4) operating machines.
Accountants estimated the overhead and the volume of events for each activity. For example, management estimated the company would purchase 100,000 pieces of materials that would require overhead costs of \$200,000 for the year. These overhead costs included salaries of people to purchase, inspect, and store materials. Setting up machines for a new product would need 400 setups and overhead of \$800,000. The company would have 4,000 inspections and overhead of \$400,000. Finally, running machines would cost \$600,000 for 20,000 machine hours.
These estimates were made last year and will be used during all of the current year. In practice, companies most frequently set rates for the entire year, although some set rates for shorter periods, such as a quarter.
Look at the overhead rates computed for the four activities in the table below. Note that the total overhead for current year is \$2,000,000 using activity-based costing, just as it was using a traditional costing method. The total amount of overhead should be the same whether using activity-based costing or traditional methods of cost allocation to products. The primary difference between activity-based costing and the traditional allocation methods is the amount of detail; particularly, the number of activities used to assign overhead costs to products. Traditional allocation uses just one activity, such as machine-hours. Activity-based costing used four activities in this case. In practice, companies using activity-based costing generally use more than four activities because more than four activities are important. We used four to keep the illustration as simple as possible.
The activity cost rates (predetermined overhead rates) are calculated as follows:
Activity Cost Driver (activity) Overhead Cost Estimated Units Rate
Purchasing Materials Pieces of materials \$ 200,000 100,000 pieces \$ 2 per piece
Machine Setups Machine setups 800,000 400 setups 2,000 per setup
Inspections Inspection hours 400,000 4,000 inspect. hours 100 per inspect. hour
Running Machine Machine hours 600,000 20,000 mach. Hours 30 per machine hour
Total Overhead \$ 2,000,000
For January, the High Challenge Company has the following information about the actual number of cost driver units for each of the two products:
Touring Mountain
Purchasing Materials 6,000 pieces 4,000 pieces
Machine Setups 10 setups 30 setups
Inspections 200 hours 200 hours
Running Machine 1,500 hours 1,500 hours
Multiplying the actual activity events for each product times the predetermined rates computed earlier resulted in the overhead allocated to the two products:
Touring Mountain
Purchasing Materials \$ 12,000 (6,000 pieces x \$2 per piece) \$ 8,000 (4,000 pieces x \$2 per piece)
Machine Setups 20,000 (10 setups x \$2,000 per setup) 60,000 (30 setups x \$2,000 per setup)
Inspections 20,000 (200 hours x \$100 per hour) 20,000 (200 hours x \$100 per hour)
Running Machine 45,000 (1,500 hours x \$30 per hour) 15,000 (500 hours x \$30 per hour)
Total Overhead \$ 97,000 \$ 103,000
Now we can compare the overhead allocated to the two product lines using the traditional method and activity-based costing, as follows:
Touring bicycles Mountain bicycles
Traditional method \$150,000 \$50,000
Activity-based costing 97,000 103,000
Notice how the total overhead for the month of January is the same at \$200,000 but the amount allocated to each product is different.
Analysis More overhead is allocated to the lower volume mountain bicycles using activity-based costing. The mountain bicycles are allocated more overhead per unit primarily because activity-based costing recognizes the need for more setups for mountain bicycles and for as many inspection hours for the more specialized mountain bicycles as for the higher volume touring bicycles. By failing to assign costs to all of the activities, touring bicycles were subsidizing mountain bicycles. Many companies have found themselves in similar situations. Activity-based costing has revealed that low-volume, specialized products have been the cause of greater costs than managers had realized.
Here is a video example of activity based costing:
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All rights reserved content
• Activity Based Costing vs. Traditional Costing. Authored by: Education Unlocked. Located at: youtu.be/aDycx2hJ6tg. License: All Rights Reserved. License Terms: Standard YouTube License
• Activity Based Costing Systems for Overhead (Managerial Accounting Tutorial #28) . Authored by: Note Pirate. Located at: youtu.be/0m0Ob81nd9g. License: All Rights Reserved. License Terms: Standard YouTube License | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/04%3A_Activity-Based_Costing/4.03%3A_Activity_Based-Costing_Method.txt |
What are potential cost drivers for an ABC system at Virgin America?
The following table contains selected financial and other data for Virgin America for 2012.
Virgin America
Selected financial data
For Twelve Months Ended December 31, 2012
Partial income statement: (000s omitted)
Operating revenues \$ 1,332,837
Other expenses:
Aircraft fuel 537,501
Aircraft rent 221,275
Wages and salaries 176,216
Aircraft maintenance 74,459
Landing fees 110,165
Sales and marketing 107,136
Guest services 50,448
Depreciation 11,260
Other 76,110
Total operating expenses \$ 1,364,570
Operating income/loss \$ (31,733)
Selected data:
Available seat miles (millions) 12,545
Departures 56,362
Aircraft in service 51
Guests (thousands) 6,219
Load factor (% of seats filled)
79.0%
Fuel gallons consumed (thousands) 161,404
Financial data source here.
Questions
1. For each of the expenses listed in the income statement, select a cost driver from the drivers listed under “Selected data.” Provide rationale for your choice of each of the drivers.
2. Are there any expenses you would group together into a single pool? Why or why not?
3. How could Virgin America use these cost pools and activity-based costing information internally?
CC licensed content, Specific attribution
4.05: Chapter 4 Key Points
Activity-Based Costing Takeaways
In this chapter we reviewed/learned 3 ways of allocating overhead. We will use the formula for Predetermined Overhead Rate (POHR) you have already learned.
Plantwide Overhead
Plantwide Overhead allocation means the company uses just one allocation rate (POHR) for the entire company. The rate is calculated as:
Total Overhead for company
Total Base for company
The base is typically direct labor but it doesn’t have to be – it can be anything the company decides. To apply overhead, you will take the ACTUAL amount of whatever base was selected for a department, product, job, etc. and multiply by the Plantwide POHR.
Departmental Overhead
Departmental Overhead allocation means the each department selects a different BASE to be used to allocate overhead. The rate is calculated as:
Total Departmental Overhead
Total Departmental Base chosen by Department
The base can be anything the department decides but it will use the DEPARTMENT costs only and not total costs. You can have different rates for every department you choose.
To apply overhead, you will take the ACTUAL amount of whatever base was selected for a department and multiply by the Department POHR for that department.
Activity Based Overhead
In Activity-Based Overhead allocation, the company’s overhead is divided into cost activities. These costs have a cost driver which is the object that causes the cost to increase or decrease. A cost pool is where costs that have the same cost drivers are added together to make on activity. Each activity will have its own overhead allocation rate (POHR). The rate is calculated as:
TOTAL Overhead for the cost pool or activity
TOTAL cost driver quantity (or base)
The base or cost driver can be anything but the rate is based on TOTAL amounts for that activity. You will have different rates for every activity or cost pool.
To apply overhead, you will take the ACTUAL amount of whatever base or cost driver for the job, product or department you are assigning overhead to (not TOTAL here just the specific amount for the overhead you are applying) and multiply by the Activity–based POHR for that activity.
Click ABC Takeways for a printable copy.
4.06: Glossary
GLOSSARY
Activity-based costing A costing method that first assigns costs to activities, then assigns costs to products based on their consumption of activities.
Activity center An activity center is a unit of the organization that performs some activity.
Cost driver A cost driver is an activity or transaction that causes costs to be incurred. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/04%3A_Activity-Based_Costing/4.04%3A_Accounting_in_the_Headlines.txt |
Questions
➢ A company’s performance measure is the number of customer complaints. Why would the company measure the number of customer complaints?
➢ A company’s performance measure is the percentage of time that machines are not working. Why would the company measure the percentage of time that the machines are not working?
➢ What is the difference between activity-based costing and activity-based management?
➢ Activity-based costing methods use four steps in computing a product’s cost. What are these steps?
➢ “Activity-based costing is great for manufacturing plants, but does not really address the needs of the service sector.” Do you agree with this statement? Explain.
➢ What is a cost driver? Give three examples.
➢ The vice president of marketing wonders how products can cost less under one cost system than under another. How would you respond to her question “Are not costs cut-and-dried?”
➢ A drawback to activity-based costing is that it requires more record-keeping and extensive teamwork between all departments. What are the potential benefits of a more detailed product cost system?
➢ Give three criteria for choosing cost drivers for allocating costs to products.
➢ “Activity-based costing is for accountants and production managers. I plan to be a marketing specialist so ABC will not help me.” Do you agree with this statement? Explain.
➢ Observe the workings of a food service or coffee house. What activities are being performed? Give examples of some cost drivers that cause the cost of those activities. (For example, cooking food is an activity; the number of meals could be a cost driver for the cooking activity.)
➢ Observe the workings of a bank, credit union, or savings and loan institution. What activities are being performed? Give examples of some cost drivers that cause the cost of those activities. (For example, opening checking accounts is an activity; the number of accounts opened could be a cost driver for the opening accounts activity.)
➢ Activity-based costing assigns costs to activities that consume resources and to the products based on each product’s use of activities. What is a benefit of this approach compared to a traditional approach that allocates costs to products based on the machine-hours used to produce the product?
Exercises
Exercise A Quality Sound Corporation produces two types of compact discs (CDs), one is to install on touring bicycles and the other is a high-grade product for home and car use. The touring bicycles’ CDs are designed for durability rather than accurate sound reproduction. The company only recently began producing the high-grade disc. Management believes the accounting system may not be accurately allocating costs to products.
Management asked you to investigate the cost allocation problem. You found that manufacturing overhead is currently assigned based on the direct labor costs in the products. For your investigation, you are using data from last year. Last year’s manufacturing overhead was \$440,000 based on production of 320,000 touring bicycle CDs and 100,000 high-grade CDs. Direct labor and direct materials costs were as follows:
Touring
bicycle
High
grade
Total
Direct labor \$180,000 \$60,000 \$240,000
Materials 120,000 112,000 232,000
Management believes three activities cause overhead costs. The cost drivers and related costs for your analysis are as follows:
Activity Level
Cost drivers Cost assigned
Touring
bicycle
High
grade
Total
Number of production runs \$200,000 40 10 50
Quality tests performed 180,000 12 18 30
Shipping orders processed 60,000 100 50 150
Total overhead \$440,000
1. How much of the overhead would be assigned to each product if the three cost drivers are used to allocate overhead? What would be the cost per unit (including materials, labor, and overhead) for each product if overhead is assigned to products using the three cost drivers?
2. How much of the overhead would be assigned to each product if direct labor costs had been used as the basis for allocating overhead to each product? What would be the cost per unit (including materials, labor, and overhead) for each product if overhead is allocated to products using direct labor cost as the allocation base?
Exercise E Landscape, Inc., is a lawn and garden service. The company originally specialized in serving small residential clients; recently it has started contracting for work on larger office building grounds.
Employees worked a total of 10,000 hours last year, 6,500 on residential jobs and 3,500 on commercial jobs. Wages amounted to \$10 per hour for all work done. Materials used are included in overhead and called supplies. All overhead is allocated on the basis of labor-hours worked, which is also the basis for customer charges. Landscape, Inc., can charge \$30 per hour for residential work but, because of greater competition for commercial accounts, only \$20 per hour for commercial work.
1. Using labor-hours as the basis for allocating overhead, what was the gross margin (revenues minus labor and overhead expense) for (1) commercial and (2) residential service? Assume overhead was \$50,000.
2. Overhead consists of transportation, lawn mowing and landscaping equipment costs, depreciation on equipment, supplies, fuels, and maintenance. These costs can be traced to the following activities:
Activity Level
Activity Cost driver Cost Commercial Residential
Transportation Clients served \$10,000 15 45
Equipment costs:
Fuel, maintenance,
depreciation
Equipment hours 25,000 3,000 2,000
Supplies Square yards serviced per year 15,000 100,000 50,000
Total overhead \$50,000
Recalculate gross margin for commercial and residential services based on these cost driver bases.
1. Would you advise Landscape, Inc., to drop either the residential or commercial service based on your analysis? Explain.
Problems
Problem A C & W Corporation manufactures travel clocks and watches. Overhead costs are currently allocated using direct labor-hours, but the controller has recommended using an activity-based costing system based on the following data:
Activity Level
Activity Cost driver Cost Travel clocks Watches
Production setup Setups \$100,000 20 30
Material handling and requisition Parts 30,000 24 36
Packaging and shipping Units shipped 60,000 80,000 120,000
Total overhead \$190,000
1. Compute the amount of total overhead allocated to each of the products under activity-based costing.
2. Compute the amount of total overhead allocated to each product using labor-hours as the allocation base. Assume labor-hours required to assemble each unit are .5 per travel clock and 1.0 per watch, and that 80,000 travel clocks and 120,000 watches were produced.
3. Should the company follow the controller’s recommendations?
Problem B Sunshield Company makes three types of sunglasses: Nerds, Stars, and Fashions. Sunshield presently allocates overhead to products using a rate based on direct labor-hours. A consultant recommended that Sunshield switch to activity-based costing. Management decided to give ABC a try and identified the following activities, cost drivers, and costs for a typical year for each activity center. Use this information to compute the overhead rates for each cost driver.
Activity
Recommended
cost driver
Costs
Cost driver
units
Production setup Production runs \$ 30,000 100
Order processing Orders 50,000 200
Materials handling
Pounds of
materials used
20,000 8,000
Equipment depreciation
and maintenance
Machine-hours 60,000 10,000
Quality management Inspections 50,000 40
Packing and shipping Units shipped 40,000 20,000
Total overhead \$250,000
In addition, there are 2,500 direct labor-hours in a typical year.
Assume the following activities occurred in February of 2011:
Nerds Stars Fashions
Units produced 1,000 500 400
Direct materials costs \$4,000 \$2,500 \$2,000
Direct labor-hours 100 100 89
Orders 8 8 4
Production runs 2 4 8
Pounds of material 400 200 200
Machine-hours 500 300 300
Inspections 2 2 2
Units shipped 1,000 500 300
Direct labor costs are \$15 per hour.
1. Compute an overhead allocation rate (1) for each of the cost drivers recommended by the consultant and (2) for direct labor.
2. Management wants to compare the product costs using ABC and the traditional method for the month of February. Compute the production costs for each product for February using direct labor-hours as the allocation base. (Note: Production costs are direct materials, direct labor, and overhead.)
3. To derive product costs under ABC, compute the production costs for each product for February using the cost drivers recommended by the consultant.
4. Management has seen your numbers and wants to know how you account for the discrepancy between the product costs using direct labor-hours as the allocation base and using activity-based costing. Write a brief response to management.
Problem C Filmworks Photography offers two types of services, student portraits and family portraits. Last year, Filmworks had the following costs and revenues:
FilmworksPhotography
Income statement
Deluxe Family Total
Revenue \$180,000 \$200,000 \$380,000
Direct materials 25,000 25,000 50,000
Direct labor 90,000 60,000 150,000
Indirect costs:
Administration ——- ———- 25,000
Production setup ——- ———- 50,000
Quality control ——- ———- 25,000
Marketing ——- ———- 20,000
Operating profit \$60,000
Filmworks Photography currently uses labor costs to allocate all overhead, but management is considering implementing an activity-based costing system. After interviewing the sales and production staff, management decides to allocate administrative costs on the basis of direct labor costs and to use the following bases to allocate the remaining overhead:
Cost driver Units
Activity Cost driver Student Family
Production setup Photo sessions 150 250
Quality control Customer inspections 300 200
Marketing Advertisements 60 40
1. Complete the income statement using these activity bases.
2. Write a report describing how management might use activity-based costing to reduce costs.
3. Restate the income statement for Filmworks Photography using direct labor costs as the only overhead allocation base.
4. Write a report to management stating why product line profits differ using activity-based costing compared to the traditional approach. Indicate whether the activity-based costing method provides more accurate information and why (if you believe it does provide more accurate information). Indicate in your report how the use of labor-based overhead allocation could result in Filmworks Photography management making suboptimal decisions.
Alternate problems
Alternate problem A The manager of Rafting Excursions uses activity-based costing to compute the costs of her raft trips. Each raft holds six paying customers and a guide. She offers two types of raft trips, a three-day float trip for beginners, and a three-day white-water trip for seasoned rafters. The breakdown of costs is as follows:
Activities (with cost drivers) Costs per float trip Costs per white-water trip
Advertising (trips) \$430 \$430
Permit to use the river (trips) 60 100
Equipment use (trips, people) 40 + 10 per person 80 + \$16 per person
Insurance (trips) 150 300
Paying guide (trips, guides) 600 per guide 800 per guide
Food (people) 120 per person 120 per person
1. Compute the cost of a 28-person (including guides) float trip with four rafts and four guides.
2. Compute the cost of a 28-person (including guides) white-water trip with four rafts and four guides.
3. How much should the manager charge each customer if she wants to cover her costs?
Alternate problem B Shoe Express, Inc., manufactures two types of shoes, B-Ball and Marathon. The B-Ball shoe has a complex design that uses gel-filled compartments to provide support. The Marathon shoe is simpler to manufacture and uses conventional foam padding. Last year, Shoe Express had the following revenues and costs:
Shoe Express, Inc.
Income Statement
B-Ball Marathon Total
Revenue \$390,000 \$368,000 \$758,000
Direct materials 110,000 100,000 210,000
Direct labor 80,000 40,000 120,000
Indirect costs:
Administration ——– ——— 40,000
Production setup ——— ——— 90,000
——— ———
Quality control ——— ——— 60,000
Advertising ———- ——— 120,000
Net income before taxes \$118,000
Shoe Express currently uses labor costs to allocate all overhead, but management is considering implementing an activity-based costing system. After interviewing the sales and production staff, management decides to allocate administrative costs on the basis of direct labor costs, but to use the following bases to allocate the remaining overhead:
Activity Level
Activity Cost drivers B-ball Marathon
Production setup Production runs 20 20
Quality control Inspections 40 20
Advertising Advertisements 12 48
1. Complete the income statement using these activity bases.
2. Write a brief report indicating how management could use activity-based costing to reduce costs.
3. Restate the income statement for Shoe Express, Inc., using direct labor costs as the only overhead allocation base.
4. Write a report to management stating why product line profits differ using activity-based costing compared to the traditional approach. Indicate whether the activity-based costing method provides more accurate information and why (if you believe it does provide more accurate information). Indicate in your report how the use of labor-based overhead allocation could result in Shoe Express management making suboptimal decisions.
Beyond the numbers—Critical thinking
Business decision case A Many companies recognize that their cost systems are inadequate for today’s global market. Managers in companies selling multiple products are making important product decisions based on distorted cost information.
Write a short paper describing the benefits management should expect from implementing activity-based costing.
Business decision case B A company that makes Halloween costumes is considering using just-in-time purchasing and production methods. Write a short paper describing the problems this company might face in using just-in-time.
Business decision case C Managers at Texas Instruments developed these four cost-of-quality categories: prevention costs, appraisal costs, internal failure costs, and external failure costs. Give an example of a cost for each of these four categories. Would minimizing the sum of these four costs assure high-quality products? Why or why not? Write a short paper summarizing your analysis.
Group project D The chapter listed the following six important points to remember about activity-based costing. Following each point are the comments of a cynic in italics. After forming six groups, discuss one of these points in each group. How would you respond to the cynic’s comments? (It is okay to agree; even cynics have good points to make.) Choose one group member to report your group’s response to the class.
• The allocation of indirect costs is at least somewhat arbitrary, even using sophisticated accounting methods. (“This means no method gives you a true cost; all are arbitrary. So why go to the trouble of implementing ABC?”)
• Activity-based costing provides more detailed measures of costs than traditional allocation methods. (“Who needs more detail? Life is already too complicated“.)
• Activity-based costing can help marketing people by providing more accurate product cost numbers for decisions about pricing and which unprofitable products the company should eliminate. (“Why should accountants want to help marketing people?”)
• Production also benefits because activity-based costing provides better information about the cost of each activity. In practice, ABC helps managers identify cost causing activities. To manage costs, production managers learn to manage the activities that cause costs. (“If production people know their jobs, they do not need help from accountants“.)
• Activity-based costing provides more information about product costs than traditional methods but requires more record-keeping. Managers must decide whether the benefits of improved decisions justify the additional record-keeping cost. (“ABC sounds like a lot of work. Why bother?“)
• Installing activity-based costing requires teamwork among accountants, production managers, marketing managers, and other nonaccounting people. (“You will never get these people to work together. Accountants and marketing people? You have got to be kidding!”)
Group project E Form a group of three or four students and assume you are hired as business consultants for each of the cases below. Respond to each of the comments made in case 1 and case 2. Your response should assume you are talking directly to the CEO. State whether you agree or disagree with the statement and justify your response. (Hint: Consider the potential costs and benefits associated with each case.)
Case 1 Your group is meeting with the CEO of a relatively small company that produces one model of bicycles. After lengthy discussion regarding the company’s costing system, the CEO makes the following statement: “From what I have seen at other companies lately, activity-based costing is the wave of the future. Everyone, including us, should drop existing cost systems and adopt ABC!”
Case 2 Your group is meeting with the CEO of a relatively large company that produces hundreds of expensive custom computers. After lengthy discussion regarding the company’s costing system, the CEO makes the following statement: “From what I have seen at other companies lately, activity-based costing is the wave of the future. Everyone, including us, should drop existing cost systems and adopt ABC!”
Group project F In teams of two or three, interview the manager of a retail (or wholesale) store such as a music store, an automobile parts store, or the parts department of an appliance dealership. Ask the manager how items are ordered to replace those sold. For example, does he or she order based on observing inventory levels or place an order each time a customer buys an item? Does he or she appear to use just-in-time inventory? Write a memorandum to the instructor summarizing the results of the interview. Information contained in the memo should include:
Date:
To:
From:
Subject:
Content of the memo must include the name and title of the person interviewed, name of the company, date of the interview, and the results of the interview.
Group project G In teams of two or three, observe an organization of your choice—wholesale, retail, or service. Give examples of warning and diagnostic signals the organization uses. How could it use control charts, Pareto charts, and cause-and-effect analysis?
Using the Internet—A view of the real world
The Malcolm Baldrige National Quality Award is awarded to companies meeting certain quality standards and criteria. This award is issued annually by the National Institute of Standards and Technology (NIST). Visit the following website:
http://www.baldrige.nist.gov
Click on “Criteria and their Impact”. What criteria are used as a basis for making awards to applicants? Click on “Winners Showcase”. Who were the most recent winners of the Baldrige Award? What products or services do these companies provide?
Based on the results of the previous Internet project, perform an Internet search to find at least one recent Baldrige Award winning company. Does the company provide information on the Internet about being the recipient of the award? If so, write a report summarizing this information. If not, search for a recent award winner that does provide this information, and write a report summarizing the information provided.
1. [1]“Texas Instruments: Cost of Quality (A)” (Boston: Harvard Business School, Case 9-189-029).
1. [2]Based on R. S. Kaplan and D. P. Norton, “Using the Balanced Scorecard as a Strategic Management System,” Harvard Business Review, January-February 1996. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/04%3A_Activity-Based_Costing/4.07%3A_Chapter_4-_Exercises.txt |
Study Plan: Cost-Volume-Profit (CVP) Analysis
Knowledge Targets
I can define the following terms as they relate to our unit:
Contribution margin Fixed Costs Variable Costs Profit
Break even point Margin of safety Targeted Income
Contribution margin ratio
Reasoning Targets
• I can identify costs as fixed or variable.
• I can explain how changes in volume affect contribution margin.
• I can explain the significance of margin of safety.
• I can explain the importance of calculating break even point.
Skill Targets
• I can calculate contribution margin and contribution margin ratio.
• I can determine the break even point in units and dollars.
• I can calculate the level of sales necessary to achieve a targeted income or profit.
Click CVP Study Plan for a printable copy.
5.02: Cost Behavior Vs. Cost Estimation
Cost behavior patterns
There are four basic cost behavior patterns: fixed, variable, mixed (semivariable), and step which graphically would appear as below.
The relevant range is the range of production or sales volume over which the assumptions about cost behavior are valid. Often, we describe them as time-related costs.
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A graph depicting the relevant range would look like this:
Fixed costs remain constant (in total) over some relevant range of output. Depreciation, insurance, property taxes, and administrative salaries are examples of fixed costs. Recall that so-called fixed costs are fixed in the short run but not necessarily in the long run.
For example, a local high-tech company did not lay off employees during a recent decrease in business volume because the management did not want to hire and train new people when business picked up again. Management treated direct labor as a fixed cost in this situation. Although volume decreased, direct labor costs remained fixed.
In contrast to fixed costs, variable costs vary (in total) directly with changes in volume of production or sales. In particular, total variable costs change as total volume changes. If pizza production increases from 100 10-inch pizzas to 200 10-inch pizzas per day, the amount of dough required per day to make 10-inch pizzas would double. The dough is a variable cost of pizza production. Direct materials and sales commissions are variable costs.
Direct labor is a variable cost in many cases. If the total direct labor cost increases as the volume of output increases and decreases as volume decreases, direct labor is a variable cost. Piecework pay is an excellent example of direct labor as a variable cost. In addition, direct labor is frequently a variable cost for workers paid on an hourly basis, as the volume of output increases, more workers are hired. However, sometimes the nature of the work or management policy does not allow direct labor to change as volume changes and direct labor can be a fixed cost.
Mixed costs have both fixed and variable characteristics. A mixed cost contains a fixed portion of cost incurred even when the facility is idle, and a variable portion that increases directly with volume. Electricity is an example of a mixed cost. A company must incur a certain cost for basic electrical service. As the company increases its volume of activity, it runs more machines and runs them longer. The firm also may extend its hours of operation. As activity increases, so does the cost of electricity.
Managers usually separate mixed costs into their fixed and variable components for decision-making purposes. They include the fixed portion of mixed costs with other fixed costs, while assuming the variable part changes with volume. We will look at ways to separate fixed and variable components of a mixed cost later in the chapter.
A step cost remains constant at a certain fixed amount over a range of output (or sales). Then, at certain points, the step costs increase to higher amounts. Visually, step costs appear like stair steps.
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Supervisors’ salaries are an example of a step cost when companies hire additional supervisors as production increases. For instance, the local McDonald’s restaurant has one supervisor until sales exceed 100 meals during the lunch hour. If sales regularly exceed 100 meals during that hour, the company adds a second supervisor. The supervisor costs will remain the same for between 0 – 100 meals served that hour. When meals served are between 101 – 200, the supervisor cost goes up to reflect 2 supervisors. Step costs will increase by the same amount for each new cost or step. Step costs are sometimes labeled as step variable costs (many small steps) or step fixed costs (only a few large steps). In graph form, a step cost would appear as:
Although we have described four different cost patterns (fixed, variable, mixed, and step), we simplify our discussions in this chapter by assuming managers can separate mixed and step costs into fixed and variable components using cost estimation techniques.
Many costs do not vary in a strictly linear relationship with volume. Rather, costs may vary in a curvilinear pattern—a 10% increase in volume may yield an 8% change in total variable costs at lower output levels and an 11% change in total variable costs at higher output levels. We show a curvilinear cost pattern below.
One way to deal with a curvilinear cost pattern is to assume a linear relationship between costs and volume within some relevant range. Within that relevant range, the total cost varies linearly with volume, at least approximately. Outside of the relevant range, we presume the assumptions about cost behavior may be invalid.
Costs rarely behave in the simple way that would make life easy for decision makers. Even within the relevant range, the assumed cost behavior is usually only approximately linear. As decision makers, we have to live with the fact that cost estimates are not as precise as physical or engineering measurements.
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• Fixed Costs
Fixed costs remain in TOTAL but change per unit based on the actual amount of production. Here is a video to discuss these concepts.
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Examples of fixed costs include monthly rent, mortgage or car payments, employee salary, depreciation calculated under straight-line method, and insurance.
Variable Costs
Variable Costs remain the same PER UNIT but CHANGE in total. Watch this video for another explanation:
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Variable costs for a manufacturer would include things like direct labor of hourly workers, other wage employees, direct materials, applied overhead, sales commissions, and depreciation under units of production method.
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5.04: Mixed Costs
Mixed costs are costs that contain a portion of both fixed and variable costs. Common examples include utilities and even your cell phone! You may be charged a fixed amount each month for data usage or text messages allowed but when you exceed your limit, you are charged a set amount (variable cost) based on each text message or gigabyte of data you use over your limit.
youtu.be/mRi01CYooDA
A mixed cost would look like this in a graph:
Next, we will look at how we can estimate the fixed and variable portions of a mixed cost for accounting analysis.
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5.05: Accounting in the Headlines- Costs
Are the costs of owning a car fixed, variable, or mixed?
According to a recent news article in the Wall Street Journal (“Mercedes or Ford, It Costs a Lot More Than You Think,” Wall Street Journal, Sunday Journal, March 15, 2014), the average consumer spends more than \$760 a month on his/her vehicle and related expenses.
• Purchase price of the car
• Finance charges on car loan
• Gas
• Oil changes
• Routine maintenance
• Tires
• Insurance
• License plate/registration
• SiriusXM Radio subscription cost
• Car washes
• Garage/parking
• Parking tickets
• Speeding tickets
• Value of car owner’s time spent commuting
Questions
1. Which of the costs above would most likely be variable with respect to the number of miles the car owner drives?
2. Which of the costs above would most likely be fixed with respect to the number of miles the car owner drives?
3. Which of the costs above would most likely be mixed with respect to the number of miles the car owner drives?
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5.06: Cost-Volume-Profit Analysis In Planning
• Cost-volume-profit (CVP) analysis
Companies use cost-volume-profit (CVP) analysis (also called break-even analysis) to determine what affects changes in their selling prices, costs, and/or volume will have on profits in the short run. A careful and accurate cost-volume-profit (CVP) analysis requires knowledge of costs and their fixed or variable behavior as volume changes.
A cost-volume-profit chart is a graph that shows the relationships among sales, costs, volume, and profit. Look at illustration below. The illustration shows a cost-volume-profit chart for Video Productions, a company that produces DVDs. Each DVD sells for \$20. The variable cost per DVD is \$12, and the fixed costs per month are \$ 40,000.
The total cost line represents the fixed costs of \$40,000 plus \$12 per unit. Thus, if Video Productions produces and sells 6,000 DVDs, the company’s total costs are \$112,000, made up of \$40,000 fixed costs and \$ 72,000 total variable costs (\$ 72,000 = \$ 12 per unit X 6,000 units produced and sold).
The total revenue line shows how revenue increases as volume increases. Total revenue is \$ 120,000 for sales of 6,000 tapes (\$ 20 per unit X 6,000 units sold). In the chart, we demonstrate the effect of volume on revenue, costs, and net income, for a particular price, variable cost per unit, and fixed cost per period.
At each volume, one can estimate the company’s profit or loss. For example, at a volume of 6,000 units, the profit is \$8,000. We can find the net income either by constructing an income statement or using the profit equation. The contribution margin income statement gives the following results for a volume of 6,000 units:
Revenue \$120,000
Less: variable costs 72,000
Contribution margin \$ 48,000
Less: Fixed costs 40,000
Net income \$ 8,000
We have introduced a new term in this income statement—the contribution margin. The contribution margin is the amount by which revenue exceeds the variable costs of producing that revenue. We can calculate it on a per unit or total sales volume basis. On a per unit basis, the contribution margin for Video Productions is \$8 (the selling price of \$20 minus the variable cost per unit of \$ 12).
Contribution Margin = Sales – Variable Cost
The contribution margin indicates the amount of money remaining after the company covers its variable costs. This remainder contributes to the coverage of fixed costs and to net income. In Video Production’s income statement, the \$ 48,000 contribution margin covers the \$ 40,000 fixed costs and leaves \$ 8,000 in net income.
You can also calculate a contribution margin ratio by using the following formula:
Contribution Margin RATIO = Sales – Variable Cost
Sales
Watch this video to see more about contribution margin and how it can be used in business.
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• Profit equation The profit equation is just like the income statement, except it presents the analysis in a slightly different form. According to the profit equation:
Net income = Revenue – Total variable costs – Fixed costs
For Video Productions, the profit equation looks like this:
Net income = \$ 120,000 − \$ 72,000 − \$ 40,000
Net income = \$ 8,000
The CVP chart above shows cost data for Video Productions in a relevant range of output from 500 to 10,000 units. Recall the relevant range is the range of production or sales volume over which the basic cost behavior assumptions hold true. For volumes outside these ranges, costs behave differently and alter the assumed relationships. For example, if Video Productions produced and sold more than 10,000 units per month, it might be necessary to increase plant capacity (thus incurring additional fixed costs) or to work extra shifts (thus incurring overtime charges and other inefficiencies). In either case, the assumed cost relationships would no longer be valid.
The contribution margin income statement is used quite frequently since it separates fixed and variable costs to allow a company to see what it can directly change and what it cannot change. This video will give you an example of the why and how to do a contribution margin income statement.
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• Finding the break-even point
A company breaks even for a given period when sales revenue and costs charged to that period are equal. Thus, the break-even point is that level of operations at which a company realizes no net income or loss.
A company may express a break-even point in dollars of sales revenue or number of units produced or sold. No matter how a company expresses its break-even point, it is still the point of zero income or loss. To illustrate the calculation of a break-even point watch the following video and then we will work with the previous company, Video Productions.
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Before we can begin, we need two things from the previous page: Contribution Margin per unit and Contribution Margin RATIO. These formulas are:
Contribution Margin per unit = Sales Price – Variable Cost per Unit
• Contribution Margin Ratio = Contribution margin (Sales – Variable Cost)
Sales
• Break-even in units
Recall that Video Productions produces DVDs selling for \$20 per unit. Fixed costs per period total \$40,000, while variable cost is \$12 per unit. We compute the break-even point in units as:
BE Units =
Fixed Costs
Contribution Margin per unit
Video Productions contribution margin per unit is \$ 8 (\$ 20 selling price per unit – \$ 12 variable cost per unit). The break even point in units would be calculated as:
BE Units = Fixed Costs \$40,000 = 5,000 units
Contribution Margin per unit \$8
The result tells us that Video Productions breaks even at a volume of 5,000 units per month. We can prove that to be true by computing the revenue and total costs at a volume of 5,000 units. Revenue = (5,000 units X \$20 sales price per unit) \$100,000. Total costs = \$100,000 (\$40,000 fixed costs + \$60,000 variable costs calculated as \$12 per unit X 5,000 units).
Look at the cost-volume-profit chart and note that the revenue and total cost lines cross at 5,000 units—the break-even point. Video Productions has net income at volumes greater than 5,000, but it has losses at volumes less than 5,000 units.
Break-even in sales dollars Companies frequently think of volume in sales dollars instead of units. For a company such as GM that makes Cadillacs and certain small components, it makes no sense to think of a break-even point in units. GM breaks even in sales dollars.
The formula to compute the break-even point in sales dollars looks a lot like the formula to compute the break-even in units, except we divide fixed costs by the contribution margin ratio instead of the contribution margin per unit.
The contribution margin ratio expresses the contribution margin as a percentage of sales. To calculate this ratio, divide the contribution margin per unit by the selling price per unit, or total contribution margin by total revenues. Video Production’s contribution margin ratio is:
Contribution Margin Ratio = Contribution margin \$8 = 0.4 or 40%
Sales \$20
Or, referring to the income statement in which Video Productions had a total contribution margin of \$48,000 on revenues of \$ 120,000, we compute the contribution margin ratio as contribution margin \$48,000 / Revenues \$120,000 = 0.40 or 40%.
That is, for each dollar of sales, there is a \$ 0.40 left over after variable costs to contribute to covering fixed costs and generating net income.
Using this contribution margin ratio, we calculate Video Production’s break-even point in sales dollars as:
BE in Sales Dollars = Fixed Costs \$40,000 = \$100,000
Contribution Margin RATIO 0.40
The break-even volume of sales is \$ 100,000 (can also be calculated as break even point in units 5,000 units x sales price \$ 20 per unit). At this level of sales, fixed costs plus variable costs equal sales revenue, as shown here:
Revenue \$ 100,000 (5,000 units x \$20 per unit)
Less: variable costs 60,000 (5,000 units x \$12 per unit)
Contribution margin 40,000 (100,000 – 60,000)
Less: Fixed costs 40,000
Net Income \$ 0
Margin of Safety
If a company’s current sales are more than its break-even point, it has a margin of safety equal to current sales minus break-even sales. The margin of safety is the amount by which sales can decrease before the company incurs a loss. For example, assume Video Productions currently has sales of \$120,000 and its break-even sales are \$ 100,000. The margin of safety is \$ 20,000, computed as follows:
Margin of safety = Current sales – Break even sales
Margin of safety = \$ 120,000 – \$ 100,000 = \$ 20,000
Sometimes people express the margin of safety as a percentage, called the margin of safety rate or just margin of safety percentage. The margin of safety rate is equal to
Margin of Safety Percent = Current Sales – Break even Sales
Current Sales
Using the data just presented, we compute the margin of safety rate is \$20,000 / 120,000 = 16.67 %
This means that sales volume could drop by 16.67 percent before the company would incur a loss.
Targeted Profit or Income
You can also use this same type of analysis to determine how many sales units or sales dollars you would need to make a specific profit (very helpful!). The good news is you have already learned the basic formula, we are just changing it slightly. The formulas we will need are:
• Units at Target Profit = Fixed Costs + Target Income
Contribution Margin per unit
Sales Dollars for Target Profit = Fixed Costs + Target Income
Contribution Margin RATIO
These look familiar (or they should!). These are the same formulas we used for break even analysis but this time we have added target income. If you think about it, it IS the same formula because at break even our target income is ZERO.
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Let’s look at another example. The management of a major airline wishes to know how many seats must be sold on Flight 529 to make \$8,000 in profit. To solve this problem, management must identify and separate costs into fixed and variable categories.
The fixed costs of Flight 529 are the same regardless of the number of seats filled. Fixed costs include the fuel required to fly the plane and crew (with no passengers) to its destination; depreciation on the plane used on the flight; and salaries of required crew members, gate attendants, and maintenance and refueling personnel. Fixed costs are \$12,000.
The variable costs vary directly with the number of passengers. Variable costs include snacks and beverages provided to passengers, baggage handling costs, and the cost of the additional fuel required to fly the plane with passengers to its destination. Management would express each variable cost on a per passenger basis. Variable costs are \$25 per passenger.
Tickets are sold for \$125 each. The contribution margin is \$100 (\$125 sales – \$25 variable) and the contribution margin ratio is 80% (\$100 contribution margin /\$125 sales). We can calculate the units and sales dollar required to make \$8,000 in profit by:
Units at Target Profit = Fixed Costs + Target Income = 12,000 + 8,000 = \$20,000 = 200 tickets
Contribution Margin per unit \$100 \$100
The sales dollars required could be calculated as break even units of 200 tickets x \$125 sales price per ticket = \$25,000 or by using the following formula:
Sales Dollars for Target Profit = Fixed Costs + Target Income =
12,000 + 8,000 =
\$20,000 = \$25,000
Contribution Margin RATIO 0.80 0.80
Management can also use its knowledge of cost-volume-profit relationships to determine whether to increase sales promotion costs in an effort to increase sales volume or to accept an order at a lower-than-usual price. In general, the careful study of cost behavior helps management plan future courses of action.
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• Cost Volume Profit Analysis (CVP): calculating the Break Even Point . Authored by: Education Unlocked. Located at: youtu.be/Nw2IioaF6Lc. License: All Rights Reserved. License Terms: Standard YouTube License
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• Although you are likely to use cost-volume-profit analysis for a single product, you will more frequently use it in multi-product situations. The easiest way to use cost-volume-profit analysis for a multi-product company is to use dollars of sales as the volume measure. For CVP purposes, a multi-product company must assume a given product mix or sales mix. Product (or sales) mix refers to the proportion of the company’s total sales for each type of product sold.
To illustrate the computation of the break-even point for Wonderfood, a multi-product company that makes three types of cereal, assume the following historical data (percent is a percentage of sale, for each product, take the amount / sales and multiply by 100 to get the percentage):
• Product 1 Product 2 Product 3 Total
Amount Percent Amount Percent Amount Percent Amount Percent
Sales 60,000 100% 30,000 100% 10,000 100% 100,000 100%
Less: variable costs 40,000 67% 16,000 53% 4,000 40% 60,000 60%
Contribution margin 20,000 33% 14,000 47% 6,000 60% 40,000 40%
• We use the data in the total columns to compute the break-even point. The contribution margin ratio is 40% (total contribution margin \$40,000/total sales \$ 100,000). Assuming the product mix remains constant and fixed costs for the company are \$50,000, break-even sales are \$125,000, computed as follows:
BE in Sales Dollars = Fixed Costs \$50,000
= \$ 125,000
Contribution Margin RATIO 0.40
[To check our answer: (\$ 125,000 break even sales X 0.40 contribution margin ratio) – \$ 50,000 fixed costs = \$ 0 net income.]
Here is a video example:
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Since what we found in our example for Wonderfood is a total, we need to determine how much sales would be needed by each product to break even. To find the three product sales totals, we multiply total sales dollars by the percent of product (or sales) mix for each of the three products. The product mix for products 1, 2, and 3 is 60:30:10, respectively. That is, out of the \$ 100,000 total sales, there were sales of \$ 60,000 for product 1, \$ 30,000 for product 2, and \$ 10,000 for product 3. An easy way to calculate product or sales mix is to divide each product’s sales by total sales like in the following table:
Sales Sales Mix
Product 1 60,000 60% (60,000 / 100,000)
Product 2 30,000 30% (30,000 / 100,000)
Product 3 10,000 10% (10,000 / 100,000)
Total Sales 100,000 100%
We can calculate the amount each product needs to sell by multiplying the total break even sales required x the sales mix for each product. This is calculated as:
Sales Mix Sales at Break even
Product 1 60% \$ 75,000 (125,000 x 60%)
Product 2 30% 37,500 (125,000 x 30%)
Product 3 10% 12,500 (125,000 x 10%)
Total Sales 100% 125,000
Be aware! Predicting sales mix can be extremely different. If we know we need \$125,000 in sales to break even but the sales mix is different from what we budgeted, the numbers will appear quite different (as you should have noticed in the video). If the sales mix is different from our estimate, the break even point will not be the same.
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• Assumptions made in cost-volume-profit analysis
To summarize, the most important assumptions underlying CVP analysis are:
•Selling price, variable cost per unit, and total fixed costs remain constant through the relevant range. This means that a company can sell more or fewer units at the same price and that the company has no change in technical efficiency as volume changes.
•In multi-product situations, the product mix is known in advance.
•Costs can be accurately classified into their fixed and variable portions.
Critics may call these assumptions unrealistic in many situations, but they greatly simplify the analysis.
CVP Graph
This video review the components of the CVP Chart or graph.
youtu.be/Ei8SFrqZiag
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• Lesson FA-20-050 - Clip 12 - CVP Graph - Part 2 - Breakeven, Profits, Losses, and MoS - 3:10 . Authored by: evideolearner. Located at: youtu.be/Ei8SFrqZiag. License: All Rights Reserved. License Terms: Standard YouTube License
5.10: Accounting in the Headlines- Breakeven
What happens to the breakeven point when Sports Illustrated lays off all six staff photographers and uses freelancers instead?
Questions
1. What type of cost would staff photographers be for Sports Illustrated (fixed, variable, or mixed)?
2. What type of cost would the freelance photographers be for Sports Illustrated?
3. What is likely to happen to the breakeven point for Sports Illustrated due to the switch to using freelance photographers?
4. What are some disadvantages to Sports Illustrated’s decision to outsource its photography?
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5.11: Chapter 5 Key Points
CVP Key Takeaways
Fixed Cost stays the same in total but varies per unit.
Variable Costs stay the same per unit but vary in total.
To calculate cost per unit (this works for any type of cost per unit):
Cost (make sure to use the correct cost)
Units produced
Contribution Margin is Sales – Variable Cost (contribution margin per unit is Sales price per unit – Variable cost per unit).
Contribution Margin RATIO is: Contribution Margin per unit / Sales Price per unit
You can find the breakeven point IN UNITS or the units necessary at any income level using the same formula:
Fixed Costs + Target Income
Contribution Margin per unit
Note: At breakeven, your target income is ZERO.
You can calculate breakeven point in SALES DOLLARS or Sales necessary to achieve a specific amount of income in 2 ways:
1. Fixed Costs + Target Income
Contribution Margin RATIO
Note: At breakeven, your target income is ZERO.
1. OR, an alternative method is to take your breakeven point in UNITS x sales price per unit.
Contribution Margin Income Statement assumes all costs can be classified as either Fixed or Variable Costs. The basic structure is:
Sales
– Variable Costs
= Contribution Margin (Sales – Variable Costs)
– Fixed Costs
=Net Income (Contribution Margin – Fixed Costs)
Click CVP Key Takeaways for a printable copy.
5.12: Glossary
GLOSSARY
Break-even point That level of operations at which revenues for a period are equal to the costs assigned to that period so there is no net income or loss.
Contribution margin The amount by which revenue exceeds the variable costs of producing that revenue. The contribution margin per unit is the selling price minus the variable cost per unit.
Contribution margin ratio Contribution margin per unit divided by selling price per unit, or total contribution margin divided by total revenues.
Cost-volume-profit (CVP) analysis An analysis of the effect that any changes in a company’s selling prices, costs, and/or volume will have on income (profits) in the short run. Also called break-even analysis.
Cost-volume-profit (CVP) chart A graph that shows the relationships among sales, volume, costs, and net income or loss.
Fixed costs Costs that remain constant (in total) over some relevant range of output.
High-low method A method used in dividing mixed costs into their fixed and variable portions. The high plot and low plot of actual costs are used to draw a line representing a total mixed cost.
Margin of safety Amount by which sales can decrease before a loss is incurred.
Margin of safety rate Margin of safety expressed as a percentage, which equals (Current sales – Break-even sales)/Current sales.
Mixed cost Contains a fixed portion of cost incurred even when the plant is completely idle and a variable portion that increases directly with production volume.
Product mix The proportion of the company’s total sales attributable to each type of product sold.
Profit equation The equation is Net income = Revenue – Total variable costs – Fixed costs.
Relevant range The range of production or sales volume over which the assumptions about cost behavior are valid.
Scatter diagram A diagram that shows plots of actual costs incurred for various levels of activity; it is used in dividing mixed costs into their fixed and variable portions.
Short run The time during which a company’s management cannot change the effects of certain past decisions; often determined to be one year or less. In the short run, many costs are assumed to be fixed and unchangeable.
Step cost A cost that remains constant at a certain fixed amount over a range of output (or sales) but then keeps increasing to a higher amount at certain points.
Variable costs Costs that vary (in total) directly with changes in the volume of production or sales.
*Some terms listed in earlier chapters are repeated here for your convenience.
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Short-Answer Questions, Exercises, and Problems
Short-Answer Questions
➢ Name and describe four cost behavior patterns.
➢ Describe two methods of determining the fixed and variable components of mixed costs.
➢ What is meant by the term break-even point?
➢ What are two ways in which the break-even point can be expressed?
➢ What is the relevant range?
➢ What is the formula for calculating the break-even point in sales revenue?
➢ What formula is used to solve for the break-even point in units?
➢ How can the break-even formula be altered to calculate the number of units that must be sold to achieve a desired level of income?
➢ Why might a business wish to lower its break-even point? How would it go about lowering the break-even point?
➢ What effect would you expect the mechanization and automation of production processes to have on the break-even point?
Real world question Assume your college is considering hiring a lecturer to teach a special class in communication skills. Identify at least two costs that college administrators might consider in deciding whether to hire the lecturer and add the class.
Real world question Two enterprising students are considering renting space and opening a class video recording service. They would hire camera operators to record large introductory classes. The students taking the classes would be charged a fee to rent and view the video on their laptops or smart phones. Identify as many costs of this business as you can and indicate which would be variable and which would be fixed.
Exercises
Exercise A Name and match the types of cost behavior with the appropriate diagram below:Exercise B Research Inc., performs laboratory tests. Use the high-low method to determine the fixed and variable components of a mixed cost, given the following observations:
Volume (number of tests) Total cost
4,800 \$6,000
19,200 9,600
Exercise C Compute the break-even point in sales dollars if fixed costs are \$200,000 and the total contribution margin is 20% of revenue.
Exercise D Barney Company makes and sells stuffed animals. One product, Michael Bears, sells for \$28 per bear. Michael Bears have fixed costs of \$100,000 per month and a variable cost of \$12 per bear. How many Michael Bears must be produced and sold each month to break even?
Exercise E Peter Garcia Meza is considering buying a company if it will break even or earn net income on revenues of \$80,000 per month. The company that Peter is considering sells each unit it produces for \$5. Use the following cost data to compute the variable cost per unit and the fixed cost for the period. Calculate the break-even point in sales dollars. Should Peter buy this company?
Volume (units) Cost
8,000 \$70,000
68,000 190,000
Exercise F Never Late Delivery currently delivers packages for \$9 each. The variable cost is \$3 per package, and fixed costs are \$60,000 per month. Compute the break-even point in both sales dollars and units under each of the following independent assumptions. Comment on why the break-even points are different.
1. The costs and selling price are as just given.
2. Fixed costs are increased to \$75,000.
3. Selling price is increased by 10%. (Fixed costs are \$60,000.)
4. Variable cost is increased to \$4.50 per unit. (Fixed costs are \$60,000 and selling price is \$9.)
Exercise G Best Eastern Motel is a regional motel chain. Its rooms rent for \$100 per night, on average. The variable cost is \$40 a room per night. Fixed costs are \$5,000,000 per year. The company currently rents 200,000 units per year, with each unit defined as one room for one night. Should this company undertake an advertising campaign resulting in a \$500,000 increase in fixed costs per year, no change in variable cost per unit, and a 10% increase in revenue (resulting from an increase in the number of rooms rented)? What is the margin of safety before and after the campaign?
Exercise H Fall-For-Fun Company sells three products. Last year’s sales were \$600,000 for parachutes, \$800,000 for hang gliders, and \$200,000 for bungee jumping harnesses. Variable costs were: parachutes, \$400,000; hang gliders, \$700,000; and bungee jumping harnesses, \$100,000. Fixed costs were \$240,000. Find (a) the break-even point in sales dollars and (b) the margin of safety.
Exercise I Early Horizons Day Care Center has fixed costs of \$300,000 per year and variable costs of \$10 per child per day. If it charges \$25 a child per day, what will be its break-even point expressed in dollars of revenue? How much revenue would be required for Early Horizons Day Care to earn \$100,000 net income per year?
Problems
Problem A Assume the local franchise of Togorio Sandwich Company assigns you the task of estimating total maintenance cost on its delivery vehicles. This cost is a mixed cost. You receive the following data from past months:
Month Units Costs
March 8,000 \$14,000
April 10,000 14,960
May 9,000 15,200
June 11,000 15,920
July 10,000 15,920
August 13,000 16,880
September 14,000 18,080
October 18,000 19,280
November 20,000 21,200
1. Using the high-low method, determine the total amount of fixed costs and the amount of variable cost per unit. Draw the cost line.
2. Prepare a scatter diagram, plot the actual costs, and visually fit a linear cost line to the points. Estimate the amount of total fixed costs and the amount of variable cost per unit.
Problem B
1. Using the preceding graph, label the relevant range, total costs, fixed costs, break-even point, and profit and loss areas.
2. At 8,000 units, what are the variable costs, fixed costs, sales, and contribution margin amounts in dollars?
3. At 8,000 units, is there net income or loss? How much?
Problem C The management of Bootleg Company wants to know the break-even point for its new line hiking boots under each of the following independent assumptions. The selling price is \$50 pair of boots unless otherwise stated. (Each pair of boots is one unit.)
1. Fixed costs are \$300,000; variable cost is \$30 per unit.
2. Fixed costs are \$300,000; variable cost is \$20 per unit.
3. Fixed costs are \$250,000; variable cost is \$20 per unit.
4. Fixed costs are \$250,000; selling price is \$40; and variable cost is \$30 per unit.
Compute the break-even point in units and sales dollars for each of the four independent case.
Problem D Refer to the previous problem. Bootleg Company’s sales are \$1,100,000. Determine the margin (safety in dollars for cases (a) through (d).
Problem E Using the data in the Bootleg Company problem (a through d), determine the level of sales dollars required achieve a net income of \$125,000.
Problem F Bikes Unlimited, Inc., sells three types of bicycles. It has fixed costs of \$258,000 per month. The sales and variable costs of these products for April follow:
Bikes
Racing Mountain Touring
Sales \$1,00,000 \$1,500,000 \$2,500,000
Variable costs 700,000 900,000 1,250,000
Compute the break-even point in sales dollars.
Problem G a. Assume that fixed costs of Celtics Company are \$180,000 per year, variable cost is \$12 per unit, and selling price is \$30 per unit. Determine the break-even point in sales dollars.
1. Hawks Corporation breaks even when its sales amount to \$89,600,000. In 2010, its sales were \$14,400,000, and its variable costs amounted to \$5,760,000. Determine the amount of its fixed costs.
2. The sales of Niners Corporation last year amounted to \$20,000,000, its variable costs were \$6,000,000, and its fixed costs were \$4,000,000. At what level of sales dollars would the Niners Corporation break even?
3. What would have been the net income of the Niners Corporation in part (c), if sales volume had been 10% higher but selling prices had remained unchanged?
4. What would have been the net income of the Niners Corporation in part (c), if variable costs had been 10% lower?
5. What would have been the net income of the Niners Corporation in part (c), if fixed costs had been 10% lower?
6. Determine the break-even point in sales dollars for the Niners Corporation on the basis of the data given in (e) and then in (f).
Answer each of the preceding questions.
Problem H After graduating from college, M. J. Orth started a company that produced cookbooks. After three years, Orth decided to analyze how well the company was doing. He discovered the company has fixed costs of \$1,200,000 per year, variable cost of \$14.40 per cookbook (on average), and a selling price of \$26.90 per cookbook (on average).
How many units (that is, cookbooks) must be sold to break even? How many units will the company have to sell to earn \$48,000?
Problem I The operating results for two companies follow:
Sierra Olympias
Sales (20,000) units \$1,920,000 \$1,920,000
Variable costs 480,000 1,056,000
Contribution margin 1,440,000 864,000
Fixed costs 960,000 384,00
Net income 480,000 480,000
1. Prepare a cost-volume-profit chart for Sierra Company, indicating the break-even point, the contribution margin, and the areas of income and losses.
2. Compute the break-even point of both companies in sales dollars and units.
3. Assume that without changes in selling price, the sales of each company decline by 10%. Prepare income statements similar to the preceding statements for both companies.
Problem J Soundoff, Inc., a leading manufacturer of electronic equipment, decided to analyze the profitability of its new portable compact disc (CD) players. On the CD player line, the company incurred \$2,520,000 of fixed costs per month while selling 20,000 units at \$600 each. Variable cost was \$240 per unit.
Recently, a new machine used in the production of CD players has become available; it is more efficient than the machine currently being used. The new machine would reduce the company’s variable costs by 20%, and leasing it would increase fixed costs by \$96,000 per year.
1. Compute the break-even point in units assuming use of the old machine.
2. Compute the break-even point in units assuming use of the new machine.
3. Assuming that total sales remain at \$12,000,000 and that the new machine is leased, compute the expected net income.
4. Should the new machine be leased? Why?
Problem K Surething CD Company reports sales of \$720,000, variable costs of \$432,000, and fixed costs of \$108,000. If the company spends \$72,000 on a sales promotion campaign, it estimates that sales will be increased by \$270,000.
Determine whether the sales promotion campaign should be undertaken. Provide calculations.
Alternate problems
Alternate problem A Hear Right Company has identified certain variable and fixed costs in its production of hearing aids. Management wants you to divide one of its mixed costs into its fixed and variable portions. Here are the data for this cost:
Month Units Costs
January 20,800 \$57,600
February 20,000 54,000
March 22,000 58,500
April 25,600 57,600
May 28,400 58,500
June 30,000 62,100
July 32,800 63,900
August 35,600 68,400
September 37,600 72,000
October 40,000 77,400
1. Using the high-low method, determine the total amount of fixed costs and the amount of variable cost per unit. Draw the cost line.
2. Prepare a scatter diagram, plot the actual costs, and visually fit a linear cost line to the points. Estimate the amount of total fixed costs and the variable cost per unit.
Alternate problem B
1. Using the preceding graph, label the relevant range, total costs, fixed costs, break-even point, and profit and loss areas.
2. At 18,000 units, what would sales revenue, total costs, fixed and variable costs be?
3. At 18,000 units, would there be a profit or loss? How much?
Alternate problem C Jefferson Company has a plant capacity of 100,000 units, at which level variable costs are \$720,000. Fixed costs are expected to be \$432,000. Each unit of product sells for \$12.
1. Determine the company’s break-even point in sales dollars and units.
2. At what level of sales dollars would the company earn net income of \$144,000?
3. If the selling price were raised to \$14.40 per unit, at what level of sales dollars would the company earn \$144,000?
Alternate problem D a. Determine the break-even point in sales dollars and units for Cowboys Company that has fixed costs of \$63,000, variable cost of \$24.50 per unit, and a selling price of \$35.00 per unit.
1. Wildcats Company breaks even when sales are \$280,000. In March, sales were \$670,000, and variable costs were \$536,000. Compute the amount of fixed costs.
2. Hoosiers Company had sales in June of \$84,000; variable costs of \$46,200; and fixed costs of \$50,400. At what level of sales, in dollars, would the company break even?
3. What would the break-even point in sales dollars have been in (c) if variable costs had been 10% higher?
4. What would the break-even point in sales dollars have been in (c) if fixed costs had been 10% higher?
5. Compute the break-even point in sales dollars for Hoosiers Company in (c) under the assumptions of (d) and (e) together.
Answer each of the preceding questions.
Alternate problem E See Right Company makes contact lenses. The company has a plant capacity of 200,000 units. Variable costs are \$4,000,000 at 100% capacity. Fixed costs are \$2,000,000 per year, but this is true only between 50,000 and 200,000 units.
1. Prepare a cost-volume-profit chart for See Right Company assuming it sells its product for \$40 each. Indicate on the chart the relevant range, break-even point, and the areas of net income and losses.
2. Compute the break-even point in units.
3. How many units would have to be sold to earn \$200,000 per year?
Alternate problem F Mr Feelds Cookies has fixed costs of \$360,000 per year. It sells three types of cookies. The cost and revenue data for these products follow:
Cookies
Cream cake Goo fill Sweet tooth
Sales \$64,000 \$95,0000 \$131,000
Variable costs 38,400 55,100 66,000
Compute the break-even point in sales dollars.
Beyond the numbers—Critical thinking
Business decision case A Quality Furniture Company is operating at almost 100% of capacity. The company expects sales to increase by 25% in 2011. To satisfy the demand for its product, the company is considering two alternatives: The first alternative would increase fixed costs by 15% but not affect variable costs. The second alternative would not affect fixed costs but increase variable costs to 60% of the selling price of the company’s product.
This is Quality Furniture Company’s condensed income statement for 2010:
Sales \$3,600,000
Costs:
Variable \$1,620,000
Fixed 330,000 1,950,000
Income before taxes \$1,650,000
1. Determine the break-even point in sales dollars for 2011 under each of the alternatives.
2. Determine projected income for 2011 under each of the alternatives.
3. Which alternative would you recommend? Why?
Business decision case B When the Weidkamp Company’s plant is completely idle, fixed costs amount to \$720,000. When the plant operates at levels of 50% of capacity or less, its fixed costs are \$840,000; at levels more than 50% of capacity, its fixed costs are \$1,200,000. The company’s variable costs at full capacity (100,000 units) amount to \$1,800,000.
1. Assuming that the company’s product sells for \$60 per unit, what is the company’s break-even point in sales dollars?
2. Using only the data given, at what level of sales would it be more economical to close the factory than to operate it? In other words, at what level would operating losses approximate the losses incurred if the factory closed down completely?
3. Assume that Weidkamp Company is operating at 50% of its capacity and decides to reduce the selling price from \$60 per unit to \$36 per unit to increase sales. At what percentage of capacity must the company operate to break even at the reduced sales price?
Business decision case C Monroe Company has recently been awarded a contract to sell 25,000 units of its product to the federal government. Monroe manufactures the components of the product rather than purchasing them. When the news of the contract was released to the public, President Mary Monroe, received a call from the president of the McLean Corporation, Carl Cahn. Cahn offered to sell Monroe 25,000 units of a needed component, Part J, for \$15.00 each. After receiving the offer, Monroe calls you into her office and asks you to recommend whether to accept or reject Cahn’s offer.
You go to the company’s records and obtain the following information concerning the production of Part J.
Costs at current production
level (200,000 units)
Direct labor \$1,248,000
Direct materials 576,000
Manufacturing overhead 600,000
Total cost \$2,424,000
You calculate the unit cost of Part J to be \$12.12 or (\$2,424,000/200,000). But you suspect that this unit cost may not hold true at all production levels. To find out, you consult the production manager. She tells you that to meet the increased production needs, equipment would have to be rented and the production workers would work some overtime. She estimates the machine rental to be \$60,000 and the total overtime premiums to be \$108,000. She provides you with the following information:
Costs at current production
level (225,000 units)
Direct labor \$1,404,000
Direct materials 648,000
Manufacturing overhead
(including equipmental rental and overtime premiums)
828,000
Total cost \$2,880,000
The production manager advises you to reject Cahn’s offer, since the unit cost of Part J would be only \$12.80 or (\$2,880,000/225,000 units) with the additional costs of equipment rental and overtime premiums. This amount still is less than the \$15.00 that Cahn would charge. Undecided, you return to your office to consider the matter further.
1. Using the high-low method, compute the variable cost portion of manufacturing overhead. (Remember that the costs of equipment rental and overtime premiums are included in manufacturing overhead. Subtract these amounts before performing the calculation).
2. Compute the total costs to manufacture the additional units of Part J. (Note: include overtime premiums as a part of direct labor.)
3. Compute the unit cost to manufacture the additional units of Part J.
4. Write a report recommending that Monroe accept or reject Cahn’s offer.
Business decision case D Refer to the “A broader perspective: Major television networks are finding it harder to break even” discussion of cost-volume-profit analysis for television networks. Write a memo to your instructor describing how the networks can reduce their break-even points.
Group project E In teams of two or three students, develop a cost-volume-profit equation for a new business that you might start. Examples of such businesses are a portable espresso bar, a pizza stand, a campus movie theater, a package delivery service, a campus-to-airport limousine service, and a T-shirt printing business.
Your equation should be in the form: Profits = (Price per unit X Volume) – (Variable cost per unit X Volume) – Fixed costs per period. Pick a period of time, say one month, and project the unit price, volume, unit variable cost, and fixed costs for the period. From this information, you will be able to estimate the profits—or losses—for the period. Select one spokesperson for your team to tell the class about your proposed business and its profits or losses. Good luck, and have fun.
Group project F Refer to “A broader perspective: Even colleges use CVP” discussion of how cost-volume-profit analysis is used by colleges. In teams of two or three students, write a memo to your instructor defining step costs and explain why the step costs identified in the case are classified as such. Also include in your memo how the school might lower its break-even point.
Group project G In teams of two or three students, address the following questions:
• Why would a company consider increasing automation and decreasing the use of labor if the result would be an increase in the break-even point?
• Would an increase in automation increase fixed costs over the short-run, long-run, or both?
Write a memo to your instructor that addresses both questions. Be sure to explain your answers.
Using the Internet—A view of the real world
Visit the website for Intel Corporation, a high technology manufacturing company.
http://www.intel.com
Go to the company’s most recent financial statements and review the consolidated statement of income. What additional information, if any, would you need to perform cost-volume-profit analysis? Why is this information excluded from Intel’s income statement?
Visit the website for Wal-Mart Corporation, a retail company.
www.walmart.com
Go to the company’s most recent financial statements and review the statement of income. What additional information, if any, would you need to perform cost-volume-profit analysis? Why is this information excluded from Wal-Mart Corporation’s income statement?
level (225,000 units)Direct labor\$1,404,000Direct materials648,000
Manufacturing overhead
(including equipmental rental and overtime premiums)
828,000Total cost\$2,880,000
The production manager advises you to reject Cahn’s offer, since the unit cost of Part J would be only \$12.80 or (\$2,880,000/225,000 units) with the additional costs of equipment rental and overtime premiums. This amount still is less than the \$15.00 that Cahn would charge. Undecided, you return to your office to consider the matter further.
1. Using the high-low method, compute the variable cost portion of manufacturing overhead. (Remember that the costs of equipment rental and overtime premiums are included in manufacturing overhead. Subtract these amounts before performing the calculation).
2. Compute the total costs to manufacture the additional units of Part J. (Note: include overtime premiums as a part of direct labor.)
3. Compute the unit cost to manufacture the additional units of Part J.
4. Write a report recommending that Monroe accept or reject Cahn’s offer.
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Absorption costing, also called full costing, is what you are used to under Generally Accepted Accounting Principles. Under absorption costing, companies treat all manufacturing costs, including both fixed and variable manufacturing costs, as product costs. Remember, total variable costs change proportionately with changes in total activity, while fixed costs do not change as activity levels change. These variable manufacturing costs are usually made up of direct materials, variable manufacturing overhead, and direct labor. The product costs (or cost of goods sold) would include direct materials, direct labor and overhead. The period costs would include selling, general and administrative costs.
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The following diagram explains the cost flow for product and period costs.
The product cost, under absorption costing, would be calculated as:
Direct Materials
+ Direct Labor
+ Variable Overhead
+ Fixed Overhead
= Total Product Cost
You can calculate a cost per unit by taking the total product costs / total units PRODUCED. Yes, you will calculate a fixed overhead cost per unit as well even though we know fixed costs do not change in total but they do change per unit. We will assign a cost per unit for accounting reasons. When we prepare the income statement, we will use the multi-step income statement format.
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We will not get as complicated in our multi-step income statement as the video example but it should have provided a refresher from what you should have learning in financial accounting. For our purpose, the absorption income statement will contain:
Sales
– Cost of Goods Sold
= Gross Profit
Operating Expenses:
Selling Expenses
+ General and Admin. Expenses
= Total Expenses
= Net Operating Income
Gross Profit is also referred to as gross margin. Net operating income is Gross Profit – Total Operating Expenses and is also called Income before taxes. Let’s look at an example:
Bradley Company had the following information for May:
• Direct materials \$13,000
• Direct labor \$15,000
• Variable overhead \$5,000
• Fixed overhead \$6,000
• Fixed selling expenses \$15,000
• Variable selling expenses \$0.20 per unit
• Administrative expenses \$12,000
• 10,000 units produced
• 9,000 units sold (1,000 remain in ending finished goods inventory)
• Sales price \$8 per unit
First, we need to calculate the absorption product cost per unit:
Direct Materials \$ 13,000
+ Direct Labor \$ 15,000
+ Variable Overhead \$ 5,000
+ Fixed Overhead \$ 6,000
= Total Product Cost \$39,000
÷ Total Units Produced ÷ 10,000
= Product cost per unit \$ 3.90
Next, we can use the product cost per unit to create the absorption income statement. We will use the UNITS SOLD on the income statement (and not units produced) to determine sales, cost of goods sold and any other variable period costs.
Bradley Company
Income Statement (absorption)
For Month Ended May
Sales (9,000 x \$8 per unit) \$ 72,000
– Cost of Goods Sold (9,000 x \$3.90 per unit) 35,100
= Gross Profit 36,900
Operating Expenses:
Selling Expenses (15,000 fixed + variable 0.20 x 9,000 units sold) 16,800
+ General and Admin. Expenses 12,000
= Total Expenses 28,800
= Net Operating Income \$8,100
Remember the following under absorption costing:
• Typically used for financial reporting (GAAP)
• ALL manufacturing costs are included in the cost (direct materials, direct labor, fixed and variable overhead)
• Can be misleading as some costs are not affected by products
• Fixed manufacturing overhead costs are applied to units PRODUCED and not just unit sold
• Income statement shows Sales – Cost of Goods sold = Gross Margin (or Gross Profit) – Operating Expenses = Net Income and is based on the number of units SOLD.
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Study Plan: Variable Costing & Performance Reporting
Knowledge Targets
I can define the following terms as they relate to our unit:
Absorption costing
Variable costing
Fixed Costs Variable Costs
Segment Segment Margin Segmented Income Statement
Contribution Margin Income Statement
Traceable Cost Common cost Cost per unit Net Income
Reasoning Targets
• I can identify costs as fixed or variable.
• I can explain the difference between variable costing and absorption costing.
• I can analyze and explain the difference in net income under variable costing and absorption costing.
• I can determine the profitability of each segment in a segmented income statement.
Skill Targets
• I can calculate cost per unit under variable costing.
• I can calculate cost per unit under absorption costing.
• I can prepare income statements using variable costing and absorption costing.
• I can prepare a segmented income statement.
Click Variable Costing for a printable copy.
6.03: Variable Costing
Variable costing (also known as direct costing) treats all fixed manufacturing costs as period costs to be charged to expense in the period received. Under variable costing, companies treat only variable manufacturing costs as product costs. The logic behind this expensing of fixed manufacturing costs is that the company would incur such costs whether a plant was in production or idle. Therefore, these fixed costs do not specifically relate to the manufacture of products. The following video explains the concepts in variable costing:
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Product costs, under variable costing, includes the VARIABLE costs only like direct materials, direct labor and variable overhead. Fixed overhead would not be included as a product cost! We calculate product cost per unit as:
Direct Materials
+ Direct Labor
+ Variable Overhead
= Total Product Cost
÷ Total Units Produced
= Product cost per unit
The income statement we will use in not Generally Accepted Accounting Principles so is not typically included in published financial statements outside the company. This contribution margin income statement would be used for internal purposes only. You should remember, the contribution margin income statement separates variable costs and fixed costs (whether product or period does not matter) and calculates a contribution margin (this is sales – variable costs). Now, let’s continue with our example Bradley Company.
Bradley Company had the following information for May:
• Direct materials \$13,000
• Direct labor \$15,000
• Variable overhead \$5,000
• Fixed overhead \$6,000
• Fixed selling expenses \$15,000
• Variable selling expenses \$0.20 per unit
• Administrative expenses \$12,000
• 10,000 units produced
• 9,000 units sold (1,000 remain in ending finished goods inventory)
• Sales price \$8 per unit
First, we will calculate the variable cost product cost per unit:
Direct Materials \$ 13,000
+ Direct Labor \$ 15,000
+ Variable Overhead \$ 5,000
= Total Product Cost \$ 33,000
÷ Total Units Produced ÷ 10,000
= Product cost per unit \$ 3.30
Next, we calculate the contribution margin format income statement under variable costing:
Bradley Company
Income Statement (variable)
For Month Ended May
Sales (9,000 x \$8 per unit) \$ 72,000
Variable Costs:
Cost of goods sold (9,000 x \$3.30 per unit) 29,700
Selling expenses (9,000 x \$0.20 per unit) 1,800
Total variable costs 31,500
Contribution Margin 40,500
Fixed Costs:
Fixed overhead (fixed portion only) 6,000
Selling expenses (fixed portion only) 15,000
Administrative expenses 12,000
Total Fixed expenses 33,000
Net Operating Income \$ 7,500
In variable costing, it is important to remember:
• ONLY includes variable costs meaning costs that increase with volume
• Does not include FIXED costs as volume levels do not change these costs (fixed costs treated as period costs not product costs)
• Can provide more accurate information for decision makers as costs are better tied to production levels
• Can be applied to ALL costs and not just product costs.
• Uses Contribution Margin Income Statement showing Sales – VARIABLE expenses = Contribution Margin – Fixed Expenses = Net Income and is based on the number of units SOLD.
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In comparing the two income statements for Bradley, we notice that the cost of goods sold under absorption is \$3.90 per unit and \$3.30 per unit under variable costing. The income reported under each statement is off by \$600 because of this difference (\$8,100 under absorption and \$7,500 under variable). Let’s review how these costs were calculated:
Absorption Variable
Direct Materials \$13,000 \$13,000
+ Direct Labor \$15,000 \$15,000
+ Variable Overhead \$5,000 \$5,000
+ Fixed Overhead \$6,000 do not include
= Total Product Cost \$39,000 \$33,000
÷ Total Units Produced ÷ 10,000 ÷ 10,000
= Product cost per unit \$3.90 \$3.30
Since fixed overhead cost is given to each unit produced under the absorption costing method, the 1,000 units remaining in inventory carry forward some of May’s fixed costs into the next period. The variable costing method treats the fixed overhead as relating to May only and not to any specific units. Ending inventory would be calculated as:
Absorption Variable
\$3,900 (1,000 units x \$3.90 cost) \$3,300 (1,000 units x \$3.30 cost)
These differences are due to the treatment of fixed manufacturing costs. Under absorption costing, each unit in ending inventory carries \$0.60 of fixed overhead cost as part of product cost. At the end of the month, Bradley has 1,000 units in inventory. Therefore, ending inventory under absorption costing includes \$600 of fixed manufacturing overhead costs (\$0.60 X 1,000 units) and is valued at \$600 more than under variable costing.
Under variable costing, companies charge off, or expense, all the fixed manufacturing costs during the period rather than deferring their expense and carrying them forward to the next period as part of inventory cost. Therefore, \$6,000 of fixed manufacturing costs appear on the variable costing income statement as an expense, rather than \$5,400 (\$6,000 fixed overhead costs – \$600 fixed manufacturing included in inventory) under absorption costing. Consequently, income before income taxes under variable costing is \$600 less than under absorption costing because more costs are expensed during the period.
Finally, remember that the difference between the absorption costing and variable costing methods is solely in the treatment of fixed manufacturing overhead costs and income statement presentation. Both methods treat selling and administrative expenses as period costs. Regarding selling and administrative expenses, the only difference is their placement on the income statement and the segregation of variable and fixed selling and administrative expenses. Variable selling and administrative expenses are not part of product cost under either method.
As a general rule, relate the difference in net income under absorption costing and variable costing to the change in inventories. Assuming a relatively constant level of production, if inventories increase during the year, production exceeded sales and reported income before federal income taxes is less under variable costing than under absorption costing. Conversely, if inventories decreased, then sales exceeded production, and income before income taxes is larger under variable costing than under absorption costing.
Variable costing is not currently acceptable for income measurement or inventory valuation in external financial statements that must comply with generally accepted accounting principles (GAAP) in the United States. However, managers often use variable costing for internal company reports. Here is a video comparing the two methods:
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SUMMARY
1. Product costs are calculated differently under each method:
Absorption Variable
Direct Materials Include Include
Direct Labor Include Include
Overhead:
Variable Overhead Include Include
Fixed Overhead Include DO NOT include
Total Product Costs Sum sum
÷ Total Units Produced ÷ Total Units Produced ÷ Total Units Produced
Product Cost per Unit = Cost per unit = Cost per unit
2. Income statement formats are different under each method (both use units sold for variable expenses):
• Absorption uses standard GAAP income statement of Sales – Cost of Goods Sold = Gross Profit – Operating Expenses = Net Operating Income
• Variable uses a contribution margin income statement of Sales – Variable Costs = Contribution Margin – Fixed Expenses = Net Operating Income
3. Net income on the two reports can be different if units produced do not equal units sold.
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Absorption vs. Variable Costing
Product cost includes Direct Materials, direct labor and overhead. Period costs are selling, general and administrative costs.
Contribution Margin is Sales – Variable Costs.
Absorption Costing (or full costing):
• Typically used for financial reporting (GAAP)
• ALL manufacturing costs are included in the cost (direct materials, direct labor, fixed and variable overhead)
• Can be misleading as some costs are not affected by products
• Fixed manufacturing overhead costs are applied to units PRODUCED and not just unit sold
• Fixed manufacturing overhead per unit calculated as Fixed manufacturing costs divided by units PRODUCED.
• Cost of goods sold = units sold x absorption cost per unit (including direct materials, direct labor, fixed and variable overhead)
Variable Costing:
• ONLY includes product variable costs meaning costs that increase with volume (DM, DL & Variable OH)
• Does not include FIXED costs as volume levels do not change these costs (fixed costs treated as period costs not product costs)
• Can provide more accurate information for decision makers as costs are better tied to production levels
• Can be applied to ALL costs and not just product costs.
Comparing Absorption and Variable Cost per unit:
Absorption Variable
Direct Materials Include Include
Direct Labor Include Include
Overhead:
Variable Overhead Include Include
Fixed Overhead Include DO NOT include
Total Product Costs Sum sum
÷ Total Units ÷ Total Units ÷ Total Units
Product Cost per Unit = Cost per unit = Cost per unit
Note: Same formula can be applied for each product cost (Cost ÷ Units produced) to get direct material cost per unit, direct labor per unit, etc.
Income Statement Formats:
• Absorption Costing – this is your standard income statement showing Sales – Cost of Goods sold = Gross Margin (or Gross Profit) – Operating Expenses = Net Income and cost of goods sold is based on the number of units SOLD x absorption cost per unit.
• Variable Costing – this is a Contribution Margin Income Statement showing Sales – VARIABLE expenses = Contribution Margin – Fixed Expenses = Net Income and variable expenses are based on number of units sold x variable cost per unit.
• Net income on the two reports can be different if units produced do not equal units sold.
Click Absorption Variable Key Takeaway for a printable copy.
6.06: Chapter 6- Exercises
Questions
➢ Explain the absorption costing method.
➢ Explain the variable costing method.
➢ Discuss the differences between variable and absorption costing.
➢ When is it appropriate to use variable or absorption costing in financial reporting?
➢ Under what specific circumstances would you expect net income to be larger under variable costing than under absorption costing? What is the reason for this difference?
Exercise I The following data relate to Socks Company for the year ended 2013 December 31:
Cost of production:
Direct materials (variable) \$360,000
Direct labor (variable) 504,000
Manufacturing overhead:
Variable 180,000
Fixed 360,000
Sales commissions (variable) 108,000
Sales salaries (fixed) 72,000
Administrative expenses (fixed) 144,000
Units produced 150,000
Units sold (at \$18 each) 120,000
Beginning inventory, 2013 January 1 -0
There were no beginning inventories. Assume direct materials and direct labor are variable costs. Prepare two income statements—a variable costing income statement and an absorption costing income statement.
Problem G Costner Company uses an absorption costing system in accounting for the single product it manufactures. The following selected data are for the year
The company produced 12,000 units and sold 10,000 units. Direct materials and direct labor are variable costs. One unit of direct material goes into each unit of finished goods. Overhead rates are based on a volume of 12,000 units and are \$1.08 and \$1.44 per unit for variable and fixed overhead, respectively. The ending inventory is the 2,000 units of finished goods on hand at the end of 2013. There was no inventory at the beginning of 2013.
1. Calculate production cost per unit under variable and absorption costing.
2. Prepare an income statement for 2013 under variable costing.
3. Prepare an income statement for 2013 under absorption costing.
4. Explain the reason for the difference in net income between b and c.
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• Flexible Budget A flexible budget is a budget prepared using the ACTUAL level of production instead of the budgeted activity. The difference between actual costs incurred and the flexible budget amount for that same level of operations is called a budget variance. Budget variances can indicate a department’s or company’s degree of efficiency, since they emerge from a comparison of what was with what should have been. The performance report shows the budget variance for each line item.
A flexible budget allows volume differences to be removed from the analysis since we are using the same actual level of activity for both budget and actual. How can we do this? We will need to determine the budgeted variable cost per unit for each variable cost. Budgeted fixed costs would remain the same because they do not change based on volume.
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To illustrate the computation of budget variances, assume that Leed’s management prepared an overhead budget based on an expected volume of 100% capacity, or 25,000 units. At this level of production, the budgeted amount for supplies is a variable cost at \$0.08 per unit for a total of \$2,000 (25,000 units x \$0.08). By the end of the period, Leed has used \$1,900 of supplies. Our first impression is that a favorable variance of \$100 exists (\$1,900 actual amount is less than the \$2,000 budget amount).
However, if Leed’s actual production for the period was only 22,500 units (90% of capacity), the company would have an unfavorable variance of \$100. Why? Because at 90% capacity of 22,500 units, the flexible operating budget for supplies would be \$1,800 (22,500 units x \$0.08). The \$1900 actual supplies used is \$100 more than the flexible budget amount of \$1,800. Consequently, it appears that Leed used supplies inefficiently.
To give another example using the data in Exhibit 6, Leed’s management may have budgeted maintenance at USD 5,600 for a given period assuming the company planned to produce 20,000 units (80 per cent of operating capacity). However, Leed’s actual maintenance costs may have been USD 6,200 for the period. This result does not necessarily mean that Leed had an unfavorable variance of USD 600. The variance depends on actual production volume.
Assume once again that Leed actually produced 22,500 units during the period. The company had budgeted maintenance costs at USD 6,300 for that level of production. Therefore, there would actually be a favorable variance of USD 100 (USD 6,300 – USD 6,200).
Flexible budgets often show budgeted amounts for every 10 per cent change in the level of operations, such as at the 70 per cent, 80 per cent, 90 per cent, and 100 per cent levels of capacity. However, actual production may fall between the levels shown in the flexible budget. If so, the company can find the budgeted amounts at that level of operations using the following formula:
Budgeted amount = Budgeted fixed portion of costs + [Budgeted variable portion of cost per unit X Actual units of output]
Flexible operating budget and budget variances illustrated As stated earlier, a flexible operating budget provides detailed information about budgeted expenses at various levels of activity. The main advantage of using a flexible operating budget along with a planned operating budget is that management can appraise performance on two levels. First, management can compare the actual results with the planned operating budget, which enables management to analyze the deviation of actual output from expected output. Second, given the actual level of operations, management can compare actual costs at actual volume with budgeted costs at actual volume. The use of flexible operating budgets gives a valid basis for comparison when actual production or sales volume differs from expectations.
Using the data from Exhibit 3, Exhibit 7 and Exhibit 8, present Leed’s detailed planned operating budget and flexible operating budget for the quarter ended 2010 March 31. The planned operating budget was based on a sales forecast of 20,000 units and a production forecast of 25,000 units. Exhibit 7 and Exhibit 8 show actual sales of 19,000 units and actual production of 25,000 units. (As is typically the case, the budgeted and actual amounts are not equal.) The actual selling price was USD 20 per unit, the same price that management had forecasted.
Leed Company
Comparison of planned operating budget and actual results
For quarter ended 2010 March 31
Planned budget Actual
Sales (budgeted 20,000 units, actual 19,000 units) \$400,000 \$380,000
Cost of goods sold:
Beginning finished goods inventory \$130,000 \$130,000
Cost of goods manufactured (25,000 units):
Direct materials \$ 50,000 \$ 62,500
Direct labor 150,000 143,750
Variable manufacturing overhead 25,000 31,250
Fixed manufacturing overhead 75,000 75,000
Cost of goods manufactured \$300,000 \$312,500
Cost of goods available for sale \$430,000 \$442,500
Ending finished goods inventory 180,000 200,000
Cost of goods sold \$250,000 \$242,500
Gross margin \$150,000 \$137,500
Selling and administrative expenses:
Variable \$ 40,000 \$ 28,500
Fixed 100,000 95,000
Total selling and administrative expenses \$ 140,000 \$123,500
Income before income taxes \$ 10,000 \$ 14,000
Deduct: Estimated income taxes (40%) 4,000 5,600
Net income \$ 6,000 \$ 8,400
Exhibit 7: Leed Company: Comparison of planned operating budget and actual results
In Exhibit 7 we compare the actual results with the planned operating budget. Comparison of actual results with the planned operating budget yields some useful information because it shows where actual performance deviated from planned performance. For example, sales were 1,000 units lower than expected, sales revenue was USD 20,000 less than expected, gross margin was USD 12,500 less than expected, and net income was USD 2,400 more than expected.
The comparison of actual results with the planned operating budget does not provide a basis for evaluating whether or not management performed efficiently at the actual level of operations. For example, in Exhibit 7, the cost of goods sold was USD 7,500 less than expected. The meaning of this difference is not clear, however, because the actual cost of goods sold relates to the 19,000 units actually sold, while the planned cost of goods sold relates to the 20,000 units expected.
A company makes a valid analysis of expense controls by comparing actual results with a flexible operating budget based on the levels of sales and production that actually occurred. Exhibit 8 shows the comparison of Leed’s flexible operating budget with the actual results. Note that the flexible budget in Exhibit 8 is made up of several pieces. The flexible budget amounts for sales revenue and selling and administrative expenses come from a flexible sales budget (not shown) for 19,000 units of sales.
LeedCompany
Comparison of flexible operating budget and actual results
For quarter ended 2010 March 31
Flexible budget Actual Budget variance over (under)
Sales (19,000 units) \$ 380,000 \$ 380,000 \$ -0-
Cost of goods sold:
Beginning finished goods inventory \$ 130,000 \$ 130,000 \$ -0-
Cost of goods manufactured (25,000 units):
Direct materials \$ 50,000 \$ 62,500 \$ (12,500)
Direct labor 150,000 143,750 (6,250)
Variable manufacturing overhead 25,000 31,250 6,250
Fixed manufacturing overhead 75,000 75,000 -0-
Cost of goods manufactured) \$300,000 \$312,500 \$ 12,500
Cost of goods available for sale \$430,000 \$442,500 \$ 12,500
Ending finished goods inventory 192,000 200,000 8,000
Cost of goods sold (19,000 units) \$238,000 \$242,500 \$ 4,500
Gross margin \$ 142,000 \$ 137,500 \$ (4,500)
Selling and administrative expenses:
Variable \$ 38,000 \$ 28,500 \$ (9,500)
Fixed 100,000 95,000 (5,000)
Total selling and administrative expenses \$138,000 \$123,500 \$ (14,500)
Income before income taxes \$ 4,000 \$ 14,000 \$ 10,000
Deduct: estimated taxes (40%) 1,600 5,600 4,000
Net income \$ 2,400 \$ 8,400 \$ 6,000
Exhibit 8: Leed Company: Comparison of flexible operating budget and actual results
In comparisons such as these, if the number of units produced is equal to the number sold, many companies do not show their beginning and ending inventories in their flexible operating budgets. Instead, the flexible operating budget may show the number of units actually sold multiplied by the budgeted unit cost of direct materials, direct labor, and manufacturing overhead. This budget also shows actual costs for direct materials, direct labor, and manufacturing overhead for the number of units sold.
The comparison of the actual results with the flexible operating budget (Exhibit 8) reveals some inefficiencies for items in the cost of goods manufactured section. For instance, direct materials and variable overhead costs were considerably higher than expected. Direct labor costs, on the other hand, were somewhat lower than expected. Both variable and fixed selling and administrative expenses were lower than expected. Net income was USD 6,000 more than expected at a sales level of 19,000 units.
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7.02: Chapter 7 Study Plan
Knowledge Targets
I can define the following terms as they relate to our unit:
Budget Planning Budget Flexible Budget Cash Budget
Master Budget Activity Variance Revenue Variance Spending Variance
Fixed Cost Variable Cost Standard Cost Standard Hours
Standard Price Variance Quantity Variance Efficiency Variance
Rate Variance Price Variance Materials Labor
Variable Overhead Fixed Overhead Selling expense Administrative expense
Reasoning Targets
• I can understand the difference between a planning budget and a flexible budget.
• I can identify costs as fixed cost or variable cost.
• I can understand the purpose of using a budget for businesses.
• I can analyze differences between budget and actual and explain possible reasons for the variances.
• I can analyze and explain laborrate and efficiency variances.
• I can analyze and explain material price and quantity variances.
• I can understand the use of standards (including cost, hours or price) for budgeting and analysis.
Skill Targets
• I can prepare a sales and production budget (or purchases budget for merchandiser).
• I can prepare a selling and administrative expense budget.
• I can prepare a cash budget including schedules of receivables and payables.
• I can prepare a budgeted income statement and budgeted balance sheet.
• I can prepare a master budget including budgets for sales, purchases, selling and administrative expenses, cash, income statement and balance sheet.
• I can prepare a flexible budget based on the actual level of production.
• I can prepare a flexible budget performance report analyzing difference between budget and actual.
• I can calculate variances for materials and labor.
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• The budget—For planning and control
Time and money are scarce resources to all individuals and organizations; the efficient and effective use of these resources requires planning. Planning alone, however, is insufficient. Control is also necessary to ensure that plans actually are carried out. A budget is a tool that managers use to plan and control the use of scarce resources. A budget is a plan showing the company’s objectives and how management intends to acquire and use resources to attain those objectives.
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Companies, nonprofit organizations, and governmental units use many different types of budgets. Responsibility budgets are designed to judge the performance of an individual segment or manager. Capital budgets evaluate long-term capital projects such as the addition of equipment or the relocation of a plant. This chapter examines the master budget, which consists of a planned operating budget and a financial budget. The planned operating budget helps to plan future earnings and results in a projected income statement. The financial budget helps management plan the financing of assets and results in a projected balance sheet.
The budgeting process involves planning for future profitability because earning a reasonable return on resources used is a primary company objective. A company must devise some method to deal with the uncertainty of the future. A company that does no planning whatsoever chooses to deal with the future by default and can react to events only as they occur. Most businesses, however, devise a blueprint for the actions they will take given the foreseeable events that may occur.
A budget: (1) shows management’s operating plans for the coming periods; (2) formalizes management’s plans in quantitative terms; (3) forces all levels of management to think ahead, anticipate results, and take action to remedy possible poor results; and (4) may motivate individuals to strive to achieve stated goals.
Companies can use budget-to-actual comparisons to evaluate individual performance. For instance, the standard variable cost of producing a personal computer at IBM is a budget figure. This figure can be compared with the actual cost of producing personal computers to help evaluate the performance of the personal computer production managers and employees who produce personal computers. We will do this type of comparison in a later chapter.
Many other benefits result from the preparation and use of budgets. For example: (1) businesses can better coordinate their activities; (2) managers become aware of other managers’ plans; (3) employees become more cost conscious and try to conserve resources; (4) the company reviews its organization plan and changes it when necessary; and (5) managers foster a vision that otherwise might not be developed.
The planning process that results in a formal budget provides an opportunity for various levels of management to think through and commit future plans to writing. In addition, a properly prepared budget allows management to follow the management-by-exception principle by devoting attention to results that deviate significantly from planned levels. For all these reasons, a budget must clearly reflect the expected results.
Failing to budget because of the uncertainty of the future is a poor excuse for not budgeting. In fact, the less stable the conditions, the more necessary and desirable is budgeting, although the process becomes more difficult. Obviously, stable operating conditions permit greater reliance on past experience as a basis for budgeting. Remember, however, that budgets involve more than a company’s past results. Budgets also consider a company’s future plans and express expected activities. As a result, budgeted performance is more useful than past performance as a basis for judging actual results.
A budget should describe management’s assumptions relating to: (1) the state of the economy over the planning horizon; (2) plans for adding, deleting, or changing product lines; (3) the nature of the industry’s competition; and (4) the effects of existing or possible government regulations. If these assumptions change during the budget period, management should analyze the effects of the changes and include this in an evaluation of performance based on actual results.
Budgets are quantitative plans for the future. However, they are based mainly on past experience adjusted for future expectations. Thus, accounting data related to the past play an important part in budget preparation. The accounting system and the budget are closely related. The details of the budget must agree with the company’s ledger accounts. In turn, the accounts must be designed to provide the appropriate information for preparing the budget, financial statements, and interim financial reports to facilitate operational control.
Management should frequently compare accounting data with budgeted projections during the budget period and investigate any differences. Budgeting, however, is not a substitute for good management. Instead, the budget is an important tool of managerial control. Managers make decisions in budget preparation that serve as a plan of action.
The period covered by a budget varies according to the nature of the specific activity involved. Cash budgets may cover a week or a month; sales and production budgets may cover a month, a quarter, or a year; and the general operating budget may cover a quarter or a year.
Budgeting involves the coordination of financial and nonfinancial planning to satisfy organizational goals and objectives. No foolproof method exists for preparing an effective budget. However, budget makers should carefully consider the conditions that follow:
• Top management support All management levels must be aware of the budget’s importance to the company and must know that the budget has top management’s support. Top management, then, must clearly state long-range goals and broad objectives. These goals and objectives must be communicated throughout the organization. Long-range goals include the expected quality of products or services, growth rates in sales and earnings, and percentage-of-market targets. Overemphasis on the mechanics of the budgeting process should be avoided.
• Participation in goal setting Management uses budgets to show how it intends to acquire and use resources to achieve the company’s long-range goals. Employees are more likely to strive toward organizational goals if they participate in setting them and in preparing budgets. Often, employees have significant information that could help in preparing a meaningful budget. Also, employees may be motivated to perform their own functions within budget constraints if they are committed to achieving organizational goals.
• Communicating results People should be promptly and clearly informed of their progress. Effective communication implies (1) timeliness, (2) reasonable accuracy, and (3) improved understanding. Managers should effectively communicate results so employees can make any necessary adjustments in their performance.
• Flexibility If significant basic assumptions underlying the budget change during the year, the planned operating budget should be restated. For control purposes, after the actual level of operations is known, the actual revenues and expenses can be compared to expected performance at that level of operations.
• Follow-up Budget follow-up and data feedback are part of the control aspect of budgetary control. Since the budgets are dealing with projections and estimates for future operating results and financial positions, managers must continuously check their budgets and correct them if necessary. Often management uses performance reports as a follow-up tool to compare actual results with budgeted results.
The term budget has negative connotations for many employees. Often in the past, management has imposed a budget from the top without considering the opinions and feelings of the personnel affected. Such a dictatorial process may result in resistance to the budget. A number of reasons may underlie such resistance, including lack of understanding of the process, concern for status, and an expectation of increased pressure to perform. Employees may believe that the performance evaluation method is unfair or that the goals are unrealistic and unattainable. They may lack confidence in the way accounting figures are generated or may prefer a less formal communication and evaluation system. Often these fears are completely unfounded, but if employees believe these problems exist, it is difficult to accomplish the objectives of budgeting.
Problems encountered with such imposed budgets have led accountants and management to adopt participatory budgeting. Participatory budgeting means that all levels of management responsible for actual performance actively participate in setting operating goals for the coming period. Managers and other employees are more likely to understand, accept, and pursue goals when they are involved in formulating them.
Within a participatory budgeting process, accountants should be compilers or coordinators of the budget, not preparers. They should be on hand during the preparation process to present and explain significant financial data. Accountants must identify the relevant cost data that enables management’s objectives to be quantified in dollars. Accountants are responsible for designing meaningful budget reports. Also, accountants must continually strive to make the accounting system more responsive to managerial needs. That responsiveness, in turn, increases confidence in the accounting system.
Although many companies have used participatory budgeting successfully, it does not always work. Studies have shown that in many organizations, participation in the budget formulation failed to make employees more motivated to achieve budgeted goals. Whether or not participation works depends on management’s leadership style, the attitudes of employees, and the organization’s size and structure. Participation is not the answer to all the problems of budget preparation. However, it is one way to achieve better results in organizations that are receptive to the philosophy of participation.
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7.04: Master Budgets
• A master budget consists of a projected income statement (planned operating budget) and a projected balance sheet (financial budget) showing the organization’s objectives and proposed ways of attaining them. In diagram below, we depict a flowchart of the financial planning process that you can use as an overview of the elements in a master budget. The remainder of this chapter describes how a company prepares a master budget. We emphasize the master budget because of its prime importance to financial planning and control in a business entity.
• The budgeting process starts with management’s plans and objectives for the next period. These plans take into consideration various policy decisions concerning selling price, distribution network, advertising expenditures, and environmental influences from which the company forecasts its sales for the period (in units by product or product line). Managers arrive at the sales budget in dollars by multiplying sales units times sales price per unit. They use expected production, sales volume, and inventory policy to project cost of goods sold. Next, managers project operating expenses such as selling and administrative expenses.
This chapter cannot cover all areas of budgeting in detail—entire books have been written on budgeting. However, the following video provides an overview of a budgeting procedure that many successful companies have used.
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We begin the budget process by discussing the planned operating budget or projected income statement.
The projected balance sheet, or financial budget, depends on many items in the projected income statement. Thus, the logical starting point in preparing a master budget is the projected income statement, or planned operating budget. However, since the planned operating budget shows the net effect of many interrelated activities, management must prepare several supporting budgets (sales, production, and purchases, to name a few) before preparing the planned operating budget. The process begins with the sales budget.
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In this Operating Budget section, we will discuss the following budgets:
1. Sales Budget
2. Production Budget
3. Cost of Goods Sold Budget
4. Selling and Administrative Expense Budget
5. Income Statement
Sales budget The cornerstone of the budgeting process is the sales budget because the usefulness of the entire operating budget depends on it. The sales budget involves estimating or forecasting how much demand exists for a company’s goods and then determining if a realistic, attainable profit can be achieved based on this demand. Sales forecasting can involve either formal or informal techniques, or both. The video below illustrates a sales budget (watch the first 4 minutes of the video only for the sales budget).
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Formal sales forecasting techniques often involve the use of statistical tools. For example, to predict sales for the coming period, management may use economic indicators (or variables) such as the gross national product or gross national personal income, and other variables such as population growth, per capita income, new construction, and population migration.
To use economic indicators to forecast sales, a relationship must exist between the indicators (called independent variables) and the sales that are being forecast (called the dependent variable). Then management can use statistical techniques to predict sales based on the economic indicators.
Management often supplements formal techniques with informal sales forecasting techniques such as intuition or judgment. In some instances, management modifies sales projections using formal techniques based on other changes in the environment. Examples include the effect on sales of any changes in the expected level of advertising expenditures, the entry of new competitors, and/or the addition or elimination of products or sales territories. In other instances, companies do not use any formal techniques. Instead, sales managers and salespersons estimate how much they can sell. Managers then add up the estimates to arrive at total estimated sales for the period.
Usually, the sales manager is responsible for the sales budget and prepares it in units and then in dollars by multiplying the units by their selling price. The sales budget in units is the basis of the remaining budgets that support the operating budget.
We will be illustrating the step-by-step preparation of a master budget for Leed Company, which manufactures low-priced running shoes. Most companies develop the sales budget in units and sales dollars because the remaining budgets will use both sales units and sales dollars.
To illustrate this step, assume that Leed’s management forecasts sales for the year at 100,000 units (each pair of shoes is one unit). Quarterly sales are expected to be 15,000, 40,000, 20,000, and 25,000 units, reflecting higher demand for shoes in the late spring and again around Christmas. The selling price for each pair of shoes forecasted at \$40. Leed’s sales budget would be prepared as by showing the sales unit for each quarter x budgeted sales price to get the sales in dollars. The totals for the year are added from each quarter.
Leed Company
Sales Budget
Qtr 1 Qtr 2 Qtr 3 Qtr 4 YEAR
Sales in Units 15,000 40,000 20,000 25,000 100,000
Budgeted price x \$40 x \$40 x \$40 x \$40
Sales in Dollars \$600,000 \$1,600,000 \$800,000 \$1,000,000 \$4,000,000
Production budget The production budget considers the units in the sales budget and the company’s inventory policy. Managers develop the production budget in units and then in dollars. Determining production volume is an important task. Companies should schedule production carefully to maintain certain minimum quantities of inventory while avoiding excessive inventory accumulation. The principal objective of the production budget is to coordinate the production and sale of goods in terms of time and quantity.
Companies using a just-in-time inventory system need to closely coordinate purchasing, sales, and production. In general, maintaining high inventory levels allows for more flexibility in coordinating purchases, sales, and production. However, businesses must compare the convenience of carrying inventory with the cost of carrying inventory; for example, they must consider storage costs and the opportunity cost of funds tied up in inventory. Watch this video for an example of how to create a production budget.
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Firms often subdivide the production budget into budgets for materials, labor, and manufacturing overhead, which we will discuss in the manufacturing budgets. Usually materials, labor, and some elements of manufacturing overhead vary directly with production within a given relevant range of production. Fixed manufacturing overhead costs do not vary directly with production but are constant in total within a relevant range of production. To determine fixed manufacturing overhead costs accurately, management must determine the relevant range for the expected level of operations.
For our example company, Leed Company, we assume the company’s policy is to maintain 40% of next quarters sales in ending inventory. Finished goods inventory on January 1 is 10,000 units (Note: You should be given this information but if you do not have the beginning inventory, you can assume the company followed the same ending inventory policy. This means, you can calculate beginning finished goods inventory as Quarter 1 sales x 40% since we can assume the company followed this policy and the ending inventory of 4th quarter last year is the beginning inventory of this year). We anticipate the December 31 ending inventory to be 6,000 units. From these data, we can prepare the schedule of planned production using the Sales budget as our starting place.
Leed Company
Production Budget
Qtr 1 Qtr 2 Qtr 3 Qtr 4 YEAR
Sales in Units 15,000 40,000 20,000 25,000 100,000
Add: Desired Ending Inventory 16,000 8,000 10,000 6,000 6,000
(Next Qtr Sales x 40%) (40,000 x 40%) (20,000 x 40%) (25,000 x 40%) (given)
Total Units Needed 31,000 48,000 30,000 31,000 106,000
Less: Beginning Inventory 10,000 16,000 8,000 10,000 10,000
Units to be Produced 21,000 32,000 22,000 21,000 96,000
Important things to note:
1. Desired ending inventory is calculated as next quarter sales units x 40% in Leed’s case since the company policy is to maintain 40% of next quarters sales in ending inventory.
2. Quarter 4 ending inventory is the same number used for ending inventory for the year.
3. Quarter 1 beginning inventory is the same number used for beginning inventory for the year.
4. Quarter 2 beginning inventory is quarter 1’s ending inventory since the balance rolls over the to next period. This means, quarter 3 beginning inventory is quarter 2’s ending inventory and quarter 4 beginning inventory is quarter 3’s ending inventory.
5. Inventory refers to Finished Goods Inventory for a manufacturer.
For a merchandiser, this budget would be called a Purchases Budget and would show how many units we would need to purchase for each quarter. The inventory in this case would refer to merchandise inventory. You can see an example of a purchases budget in the Budgets for a Merchandiser section later in this chapter.
Cost of Goods Sold budget The cost of goods sold budget establishes the forecast for the inventory expense and is usually on of the largest expenses on an income statement. A cost of goods sold budget would not be necessary for a service company since they do not sell a product. Management must now prepare a schedule to forecast cost of goods sold, the next major amount in the planned operating budget. We need to understand the costs for making the product. Leed Company has the following costs:
Direct Materials \$ 10 per unit
Direct Labor \$ 6 per unit
Variable Overhead \$ 0.75 per unit
Fixed Overhead \$75,000 per quarter
The cost of goods sold budget would use the sales budget in units. We will take each of our variable costs (direct materials, direct labor and variable overhead) x budgeted sales units. The cost of goods sold budget would look like:
Leed Company
Cost of Goods Sold Budget
Qtr 1 Qtr 2 Qtr 3 Qtr 4 YEAR
Sales in Units 15,000 40,000 20,000 25,000 100,000
Direct Materials (\$10 per unit) \$150,000 \$400,000 \$200,000 \$250,000 \$1,000,000
Direct Labor (\$6 per unit) 90,000 240,000 120,000 150,000 600,000
Variable Overhead (\$0.75 per unit) 11,250 30,000 15,000 18,750 75,000
Fixed Overhead 75,000 75,000 75,000 75,000 300,000
Cost of Goods Sold \$326,250 \$745,000 \$410,000 \$493,740 \$1,975,000
After managers forecast cost of goods sold, they prepare a separate budget for all selling and administrative expenses.
Selling and administrative expense budget The costs of selling a product are closely related to the sales forecast. Generally, the higher the forecast, the higher the selling expenses. Administrative expenses are likely to be less dependent on the sales forecast because many of the items are fixed costs (e.g. salaries of administrative personnel and depreciation of administrative buildings and office equipment). Managers must also estimate other expenses such as interest expense, income tax expense, and research and development expenses.
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For Leed Company, we need to know the following information:
• Selling expenses are \$2 per unit sold
• Administrative expenses are \$100,000 per quarter
We can calculate Leed Company’s Selling and Administrative Expense Budget using the information above and the sales budget. For selling expenses, we will take the sales in units x \$2 variable selling expense per unit. Administrative expenses are fixed so they will not change based on volume. Fixed expenses include depreciation on the office building of \$20,000 per quarter.
Leed Company
Selling and Administrative Budget
Qtr 1 Qtr 2 Qtr 3 Qtr 4 YEAR
Selling Expenses 30,000 80,000 40,000 50,000 200,000
(Current qtr units sold x \$2 per unit) (15,000 units x \$2) (40,000 units x \$2) (20,000 units x \$2) (25,000 units x \$2)
Administrative Expenses 100,000 100,000 100,000 100,000 400,000
Total Selling and Admin Expenses \$130,000 \$180,000 \$140,000 \$150,000 \$600,000
Less: Office Bldg Depreciation (20,000) (20,000) (20,000) (20,000) (80,000)
Total Cash payments for selling and admin. expenses \$110,000 \$160,000 \$120,000 \$130,000 \$520,000
Notice, depreciation is subtracted from the total budget to get total cash payments — why? Because, depreciation is a non-cash expense and is not paid with cash so we will remove it from the other cash payments to use in the cash budget. The next step is to prepare the budgeted income statement.
Budgeted Income Statement
We will use a standard multi-step income statement showing sales minus gross profit is gross profit (or gross margin). Gross profit minus operating expenses is the income from operations. We will need the Sales budget, Cost of goods sold budget, and the Selling and Administrative expense budgets.
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We will use the information from the sales budget, cost of goods sold budget, and selling and administrative expense budget. Note: Remember, to use the full budget amount for selling and administrative expenses and not the cash payments amount. Leed Company pays a 40% income tax rate (multiply income from operations x 40% for each quarter).
Leed Company
Budgeted Income Statement
Qtr 1 Qtr 2 Qtr 3 Qtr 4 YEAR
Sales (in dollars) \$600,000 1,600,000 800,000 1,000,000 4,000,000 from Sales budget
Less: Cost of goods sold 326,250 745,000 410,000 493,750 1,975,000 from Cost of Goods Sold budget
Gross Profit 273,750 855,000 390,000 506,250 2,025,000 (Sales – Cost of good sold)
Operating Expenses:
Selling Expenses 30,000 80,000 40,000 50,000 200,000 from Selling and Admin budget
Administrative Expenses 100,000 100,000 100,000 100,000 400,000
Income from operations \$143,750 675,000 250,000 356,250 \$1,425,000 (Gross Profit – Selling and Admin expense)
Less: Income tax expense (40%) 57,500 270,000 100,000 142,500 570,000
Net Income \$86,250 \$405,000 \$150,000 \$213,750 \$855,000
We look look at the manufacturing budgets and cash budget next.
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In a manufacturing company, you will have a budget for all of your manufacturing costs including Direct Materials, Direct Labor and Overhead. Each cost will have their own budget. You will need the information from the Sales and Production budgets to complete these 3 budgets.
Materials Budget
The materials budget (or materials purchases budget) is used to plan how much raw materials we need to have available to meet budgeted production. This budget is prepare similarly to the production budget as the company must decide how much raw materials inventory they want to have on hand at the end of each quarter. This is typically determined as a percent of next quarter’s material needs. In a materials budget, we will deal with units first and then add the budgeted cost near the end. We also need to know how many direct materials are needed for each unit.
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For Leed Company, our budgeted cost is \$2 per pound. We need 5 pounds of materials for each unit. We want to maintain 25% of next quarter’s production needs in ending inventory. Beginning raw materials inventory was 20,000 pounds (at \$2 per pound) and we are expecting ending raw materials inventory to be 30,000 pounds.
Leed Company
Materials Purchases Budget
Qtr 1 Qtr 2 Qtr 3 Qtr 4 YEAR
Units to be produced (from production budget) 21,000 32,000 22,000 21,000 96,000
x lbs. of materials required per unit x 5 lb. x 5 lb. x 5 lb. x 5 lb
Pounds of materials required for production 105,000 160,000 110,000 105,000 480,000
Add: Desired Ending Inventory 40,000 27,500 26,250 30,000 30,000
Total Material Needed 145,000 187,500 136,250 135,000 510,000
Less: Beginning Inventory (20,000) (40,000) (27,500) (26,250) (20,000)
Material to be Purchased (in lbs) 125,000 147,500 108,750 108,750 460,000
x \$2 cost per pound x \$ 2 x \$ 2 x \$ 2 x \$ 2
Total Material to be Purchased (in \$) \$250,000 \$295,000 \$217,500 \$217,500 \$980,000
Just like with the production budget, please note the following items:
• Ending inventory is calculated as NEXT quarter’s production needs x 25% for all but quarter 4.
• Quarter 4 ending inventory is the same as the ending inventory for the year and was given in the example.
• Beginning inventory refers to the previous quarters ending inventory for all quarters except quarter 1. For quarter 1, beginning raw materials was given in the problem and should also be the beginning inventory for the YEAR. If beginning inventory is not provided, assume the company followed the same inventory policy last year and multiply Quarter 1 pounds of materials needed x percent provided for ending inventory.
• Quarter 2 beginning is quarter 1 ending inventory. Quarter 3 beginning is quarter 2 ending inventory and quarter 4 beginning is quarter 3 ending inventory.
The total material to be purchased will be used later in the cash disbursement section of the CASH budget.
Direct Labor Budget
The direct labor budget is a very easy one. We need to know the units required from the production budget. Next, we need to know how many direct labor hours it takes to complete one unit and the cost per labor hour. Using this information, we can determine how many direct labor hours are required to meet the budgeted level of production. We will take the production units x direct labor per unit to get the number of direct labor hours. Finally, we will take the direct labor hours x the rate per hour.
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For Leed Company, each unit requires 0.5 hours of direct labor and the hourly rate is \$12 per hour. The direct labor budget would be:
Leed Company
Direct Labor Budget
Qtr 1 Qtr 2 Qtr 3 Qtr 4 YEAR
Units to be produced 21,000 32,000 22,000 21,000 96,000
x 0.5 DL hour per unit x 0.5 hr x 0.5 hr x 0.5 hr x 0.5 hr
Direct Labor Hours Required 10,500 16,000 11,000 10,500 48,000
x \$12 per hour x \$12 x \$12 x \$12 x \$12
Budgeted direct labor dollars \$126,000 \$192,000 \$132,000 \$126,000 \$576,000
The budgeted direct labor dollar amount will be used later in the cash disbursement section of the CASH budget.
Manufacturing Overhead Budget
The final budget for manufacturing is the manufacturing overhead budget. The manufacturing overhead budget is prepare depending on how the company allocates overhead. The company can choose to allocate overhead using one predetermined overhead rate, departmental rates or using activity-based costing. Further, the company can choose to separate the fixed and variable overhead costs and assign costs to overhead using only the variable overhead.
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Leed Company has decided to allocate variable overhead on the basis of \$1.50 per direct labor hour and fixed overhead is \$75,000 per quarter. Depreciation on the factory machinery of \$10,000 per quarter is included in the fixed overhead.
Leed Company
Mfg. Overhead Budget
Qtr 1 Qtr 2 Qtr 3 Qtr 4 YEAR
Budgeted direct labor hours (from direct labor budget) 10,500 16,000 11,000 10,500 48,000
x Variable OH per unit x \$1.50 x \$1.50 x \$1.50 x \$1.50
Variable Overhead Cost \$15,750 \$24,000 \$16,500 \$15,750 \$72,000
Fixed Overhead Cost 75,000 75,000 75,000 75,000 300,000
Total Overhead Cost \$90,750 \$99,000 \$91,500 \$90,750 \$372,000
Less: Depreciation on Factory Machinery (10,000) (10,000) (10,000) (10,000) (40,000)
Total Cash payments for mfg overhead \$80,750 \$89,000 \$81,500 \$80,750 \$332,000
We will use the information from the overhead budget in the cash disbursement section of the cash budget.
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Cash budget After the preceding analyses have been prepared, sufficient information is available to prepare the cash budget and compute the balance in the Cash account for each quarter. Preparing a cash budget requires information about cash receipts and cash disbursements from all the other operating budget schedules.
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Cash receipts We can prepare the cash receipts schedule based on how the company expects to collect on sales. We know, from past experience, how much of our sales are cash sales and how much are credit sales. We also can analyze past accounts receivable to determine when credit sales are typically paid.
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Leed Company has determined that all sales are on credit and they do not have any cash sales. For the credit sales, experience tells Leed they will collect 60% of sales in the quarter of the sale and the remaining 40% is collected the quarter after the sale (yes, we understand collecting 100% is unlikely but Leed chooses to budget for 100% collection). Accounts Receivable at the beginning of the year is \$200,000 and is expected to be collected in the 1st Quarter. Leed Company prepares the following schedule of planned cash receipts:
Leed Company
Schedule of Cash Receipts
Qtr 1 Qtr 2 Qtr 3 Qtr 4
Budgeted Sales \$600,000 \$1,600,000 \$800,000 \$1,000,000
Cash receipts, current quarter (60% x quarter sales) 360,000 960,000 480,000 600,000
(600,000 x 60%) (1,600,000 x 60%) (800,000 x 60%) (1,000,000 x 60%)
Cash receipts, from previous qtr (40% x previous quarter sales) 200,000** 240,000 640,000 320,000
(600,000 x 40%) (1.600,000 x 40%) (800,000 x 40%)
Total Cash Collections from Sales \$560,000 \$1,200,000 \$1,120,000 \$920,000
** Cash receipts from previous quarter for Quarter 1 comes from the beginning balance in Accounts Receivable.
We can calculate the ENDING balance of Accounts Receivable for the budgeted balance sheet by taking the 4th Quarter sales \$1,000,000 x 40% to be received in 1st Quarter of the next year as \$400,000. In addition to cash receipts, we also need to understand how we plan to make our cash payments or disbursements.
Cash disbursements Companies need cash to pay for purchases, wages, rent, interest, income taxes, cash dividends, and most other expenses. We can obtain the amount of each cash disbursement from other budgets or schedules.
This video discusses the purchases budget for a merchandiser but if you begin at minute 9 it will pick up with the cash disbursement schedule example.
Leed Company is a manufacturing company and will need to use the information from the materials purchases budget first. Leed Company makes all material purchases on credit. Leed Company will pay for material purchases 80% in the quarter of purchase and 20% in the quarter after the purchase. Accounts Payable at the beginning of the year is \$80,000 and will be paid in the 1st Quarter. We will calculate cash payments for material purchases as shown in the following table.
Qtr 1 Qtr 2 Qtr 3 Qtr 4
Budgeted Material Purchases \$250,000 \$295,000 \$217,500 \$217,500
Cash payments, current quarter (80%) \$200,000 \$236,000 \$174,000 \$174,000
(250,000 x 80%) (295,000 x 80%) (217,500 x 80%) (217,500 x 80%)
Cash payments, from previous qtr (20%) 80,000** 50,000 59,000 43,500
(250,000 x 20%) (295,000 x 20%) (217,500 x 20%)
Total Cash Pmts for Material Purchases \$280,000 \$286,000 \$233,000 \$217,500
** Cash payments from previous quarter for Quarter 1 comes from the beginning balance in Accounts Payable.
We can calculate the ENDING balance of Accounts Payable for the budgeted balance sheet by taking the 4th Quarter merchandise purchases of \$217,500 x 20% to be paid during 1st Quarter of the next year as \$43,500. In addition to these cash payments for merchandise, we also need the cash disbursements from the direct labor budget, manufacturing overhead budget, and selling and administrative budget. Remember, we want the CASH PAYMENT amounts only and not the total budget amount (depreciation is a non-cash expense and is excluded from cash payments).
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Using our example, Leed Company, we need the information from the cash payments of merchandise we just calculated, cash payments for direct labor (all direct labor paid in the quarter it was incurred), cash payments for manufacturing overhead and cash payments for selling and administrative expenses. But, we also need information on dividends payments, and income taxes.
Income taxes are assumed to be 40% of budgeted income before income taxes and are paid in the next quarter. *Income taxes payable on January 1 were \$100,000. We assume that \$40,000 of dividends will be paid in the second quarter and \$80,000 in the third quarter. Also, Leed plans to expand operations into a new building that will cost \$650,000 in Quarter 4. Leed plans to pay cash for the new building.
The complete schedule of cash payments would look like this:
Leed Company
Schedule of Cash Payments
Qtr 1 Qtr 2 Qtr 3 Qtr 4
Total Cash Pmts for Material Purchases 280,000 286,000 233,000 217,500 from schedule above
Budgeted direct labor dollars 126,000 192,000 132,000 156,000 from direct labor budget
Cash payments for mfg overhead 80,750 89,000 81,500 80,750 from mfg overhead budget
Cash payments for selling and admin 110,000 160,000 120,000 130,000 from selling and admin budget
Cash payments for Income Taxes 100,000* 57,500 270,000 100,000 from budgeted income stmt
Cash payments for dividends 40,000 80,000 given in information above
Cash payment for new building 650,000 given in information above
Total Cash Payments \$696,750 \$824,500 \$916,500 \$1,304,250
Now let’s put it all together in the complete cash budget. The cash budget is a plan indicating expected inflows and outflows of cash. At the simplest form, a Cash budget is:
Beginning Cash Balance
Add: Cash Receipts
Cash Available
Subtract: Cash Payments
Budgeted Ending Cash Balance
We can make it a little more complicated by adding financing considerations. The cash budget helps management to decide whether enough cash will be available for short-term needs. If a company’s cash budget indicates a cash shortage at a certain date, the company may need to borrow money on a short-term basis. If the company’s cash budget indicates a cash excess, the company may wish to invest the extra funds for short periods to earn interest rather than leave the cash idle. Knowing in advance that a possible cash shortage or excess may occur allows management sufficient time to plan for such occurrences and avoid a cash crisis.
youtu.be/9j48YgH2VfA
To illustrate, we will complete the cash budget for Leed Company. On January 1, Leed Company’s cash balance was \$130,000. We will calculate the cash budget for each quarter using the information from the schedules on this page. We will get our cash receipts from the Schedule of Cash Receipts and the cash disbursements (or payments) from the Schedule of Cash Payments.
Important: The ending cash balance of one quarter is the beginning cash balance of the next quarter!
Leed Company
Cash Budget
Qtr 1 Qtr 2 Qtr 3 Qtr 4
Beginning Cash Balance \$130,000 \$21,250 \$408,750 \$612,250
Add: Cash Receipts (see Schedule of Cash Receipts) \$560,000 \$1,200,000 \$1,120,000 \$920,000
Cash Available \$690,000 \$1,266,250 \$1,573,750 \$1,577,250
Less: Cash Payments (see Schedule of Cash Payments) \$696,750 \$824,500 \$916,500 \$1304,250
Budgeted Ending Cash Balance -\$6,750 \$368,750 \$572,250 \$188,000
Leed Company appears to have a little bit of a problem. There is plenty of cash for the year but when we look each quarter, we see we are not planning enough cash to cover the 1st Quarter. We recover in the 2nd quarter and have sufficient cash for the remaining quarters. But what can we do about 1st quarter? We can review the budgets and see if there is anything we can cut or modify. Or, Leed can arrange short term financing with the bank. Leed Company like to keep at a minimum of \$10,000 as their ending cash balance each quarter. Leed has arranged a credit line with the bank to access funds on a short term basis. Leed will pay off any loan amount at the next possible quarter and the bank will charge 12% interest per year (3% interest per quarter). How will this change the cash budget if no changes are made to the previous budgets?
Leed Company
Cash Budget
Qtr 1 Qtr 2 Qtr 3 Qtr 4
Beginning Cash Balance \$130,000 \$5,000 \$368,397 \$571,897
Add: Cash Receipts (see Schedule of Cash Receipts) \$560,000 \$1,200,000 \$1,120,000 \$920,000
Cash Available \$690,000 \$1,205,000 \$1,488,397 \$1,491,897
Less: Cash Payments (see Schedule of Cash Payments) \$696,750 \$824,500 \$916,500 \$1,304,250
Projected Ending Cash Balance (\$6,750) \$380,500 \$571,897 \$187,647
Add: Short Term Financing Received \$11,750
Less: Short Term Financing Payment (\$11,750)
Less: Short Term Financing Interest (\$353)
Budgeted Ending Cash Balance \$5,000 \$368,397 \$571,897 \$187,647
Notice how Leed borrowed \$11,750 in the 1st Quarter to cover the \$6,750 shortage + \$5,000 minimum we want on hand. Leed plans to pay the loan off during the 2nd quarter by paying the full amount of \$11,750 plus interest for 1 quarter (11,750 x 3% per quarter).
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Preparing a projected balance sheet, or financial budget, involves analyzing every balance sheet account. The beginning balance for each account is the amount on the balance sheet prepared at the end of the preceding period. Then, managers consider the effects of any planned activities on each account. Many accounts are affected by items appearing in the operating budget and by either cash inflows or outflows. Cash inflows and outflows usually appear in a cash budget discussed later in the chapter.
The complexities encountered in preparing the financial budget often require the preparation of detailed schedules. These schedules analyze such things as planned accounts receivable collections and balances, planned material purchases, planned inventories, changes in all accounts affected by operating costs, and the amount of federal income taxes payable. Dividend policy, inventory policy, financing policy and constraints, credit policy, and planned capital expenditures also affect the amounts in the financial budget. This video will give you an overview of the budgeted balance sheet process (the first 3 minutes reviews the entire master budget process).
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Now that Leed’s management has prepared the operating budget (or projected income statement), it can prepare its financial budget. Remember that the financial budget is a projected balance sheet.
To prepare a projected balance sheet, Leed’s management must analyze each balance sheet account. Managers take the beginning balance from the balance sheet at the end of the preceding period (remember, ending balances of one period are the beginning balances of the next period). Look at Leed Company’s balance sheet as of December 31 last year. Management must consider the effects of planned activities on these balances. Many accounts are affected by items in the planned operating budget, by cash inflows and outflows, and by policy decisions. Management uses the planned operating budgets and cash budget to prepare the project balance sheet for this year.
Leed Company
Balance sheet
December 31 (last year)
Assets
Current assets:
Cash \$130,000
Accounts receivable 200,000
Inventories:
Materials \$40,000
Finished goods 130,000 170,000
Total current assets \$500,000
Property, plant, and equipment:
Land \$60,000
Buildings \$1,000,000
Less: accumulated depreciation 400,000 600,000
Factory Equipment \$600,000
Less: accumulated depreciation 180,000 420,000
Total property, plant, and equipment \$1,080,000
Total assets \$1,580,000
Liabilities and stockholders‘ equity
Current liabilities:
Accounts payable \$80,000
Income taxes payable 100,000
Total current liabilities \$180,000
Stockholders’ equity:
Common stock (100,000 shares of \$10 par value) \$1,000,000
Retained earnings 400,000
Total stockholders’ equity \$1,400,000
Total liabilities and stockholders’ equity \$1,580,000
We will look at each account and determine the new budgeted balances based on the previous schedules.
Cash
We can get the ending cash balance from the Ending Cash balance in the cash budget. The ending cash balance is \$188,000.
Accounts Receivable
The balance in Accounts Receivable represents credit sales that have not been collected during the year. This would be 40% of Quarter 4 sales of \$1,000,000 or \$400,000 to be collected during the 1st quarter of the next year.
Inventory
For a manufacturer like Leed Company, there are two inventory accounts: Raw Materials inventory and Finished Goods inventory. Raw Materials inventory will come from the materials purchases budget using desired ending inventory for quarter 4 or the year x cost per material. For Leed Company, there were 30,000 lbs of materials for ending inventory x \$2 per lb of material = \$60,000. For Finished Goods inventory, we will use the desired ending inventory units from the production budget x production cost per unit. For Leed Company, the production cost is \$20.50 per unit including direct materials, direct labor, variable and fixed overhead. The ending balance in finished goods inventory is calculate as 6,000 units x \$20.50 per unit or \$123,000.
For a merchandising company, you would use the quarter 4 or year Ending merchandise inventory units x the cost per unit.
Property, Plant and Equipment
This section will look at the balances from the previous year and add any depreciation and additional purchases for the year. Property, Plant and Equipment (also called Fixed Assets) refer to long term assets used in the business including land, equipment, machinery, buildings, etc. Depreciation is applied to all of these items except for land, which is not depreciated.
For Leed Company, there were no changes to the Land account so the balance will remain at \$60,000. Leed purchased a new building for \$650,000 in the 4th quarter so the new building balance is \$1,650,000 (\$1,000,000 last year + 650,000 new building). According to the selling and administration expense budget, we had depreciation on the office building of \$80,000 so we will add this to the existing balance from the previous year to get a new balance of \$480,000 (\$400,000 prior year + \$80,000 current year depreciation). We are not planning on buying any new equipment this year. The equipment balance will remain the same at \$600,000. According to the manufacturing overhead budget, we planned \$40,000 of factory equipment depreciation this year. The new balance for equipment accumulated depreciation is \$220,000 (\$180,000 prior year + \$40,000 current year depreciation).
Current Liabilities
Current Liabilities are liabilities we expect to pay in the next year. Accounts Payable is determined using the purchases budget (material purchases for a manufacturer or inventory purchase budget for a merchandiser) and the schedule of cash payments.
Leed Company budgets purchase payments as 80% in the quarter of purchase and 20% in the quarter after the purchase. We can calculate Leed’s ending accounts payable by looking at the Quarter 4 material purchases of \$217,500 x 20% to be paid in the first quarter of next year for \$43,500.
Income taxes are typically paid in the quarter after they were calculated or during the first quarter of the next year. For Leed Company, income taxes are paid in the quarter after they were calculated. We can determine the budgeted income tax amount from the budgeted income statement. In quarter 4, Leed Company plans income taxes of \$142,500 to be paid in the first quarter of the following year making this the ending balance for Income Taxes Payable.
Stockholder’s Equity
Stockholder’s Equity is comprised of common stock and retained earnings. Common stock represents ownership in the company. Retained Earnings is the earnings of the company over time minus any dividends paid.
Leed Company did not have any new issues of common stock so the ending common stock balance will remain the same as \$1,000,000. For retained earnings, we will need to calculate the ending balance using the following formula:
Beginning Retained Earnings + Net Income – Dividends = Ending Retained Earnings
Beginning retained earnings comes from the balance of last year’s balance sheet of \$400,000. Net Income comes from the budgeted income statement for the year of \$855,000. Dividends can be determined from the schedule of cash payments which shows \$120,000 paid this year. Ending Retained Earnings is \$1,135,000 (\$400,000 + 855,000 – 120,000).
The full budgeted balance sheet will look like this:
Leed Company
Budgeted Balance sheet
December 31
Assets
Current assets:
Cash 188,000
Accounts receivable 400,000
Inventories:
Materials 60,000
Finished goods 123,000 183,000
Total current assets 771,000
Property, plant, and equipment:
Land 60,000
Buildings 1,650,000
Less: accumulated depreciation 480,000 1,170,000
Factory Equipment 600,000
Less: accumulated depreciation 220,000 380,000
Total property, plant, and equipment 1,550,000
Total assets 2,321,000
Liabilities and stockholdersequity
Current liabilities:
Accounts payable 43,500
Income taxes payable 142,500
Total current liabilities 186,000
Stockholders’ equity:
Common stock (100,000 shares of \$10 par value) 1,000,000
Retained earnings 1,135,000
Total stockholders’ equity 2,135,000
Total liabilities and stockholders’ equity 2,321,000
The preparation of Leed’s financial budgeted balance sheet completes the master budget. Management now has information to help appraise the policies it has adopted before implementing them. If the master budget shows the results of these policies to be unsatisfactory, the company can change its policies before serious problems arise. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/07%3A_Budgeting/7.08%3A_Budgeted_Balance_Sheet.txt |
Budgeting in merchandising companies
Budget preparation for merchandising companies and service companies is similar to budgeting for manufacturing companies. A service or merchandising company will not have a production budget or direct material budget and may not have a direct labor or overhead budget. The largest difference is since we do not have a production or materials purchase budget, we still need to know how much inventory we need to buy for a merchandiser. The merchandise purchases budget is similar to the production budget. The purchases budget can be done in units or in total dollars. Typically, the purchases budget is done in dollars and will use a cost of goods sold percentage to determine the cost of inventory sales. Remember, cost of goods sold is literally the cost of the inventory we are now selling and should be less than what we can sell it. This section discusses budgeting in merchandising companies.
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Throughout this chapter, we have focused on budgeting in a manufacturing company. Suppose managers in a retail merchandising business, such as a dress shop or a furniture store, prepare a budget. In this case, the company prepares a purchases budget instead of a production budget. To compute the purchases for each quarter, management must estimate the cost of the goods to be sold during the quarter and the inventory required at the end of the quarter.
Suppose Strobel Furniture Company prepared a sales budget showing sales of \$30,000 in the first quarter, \$80,000 in the second quarter, \$50,000 in the third quarter and \$40,000 in the fourth quarter. Assume the company maintains sufficient inventory to cover one-half of the next quarter’s sales. Cost of goods sold is 55% of sales. The ending merchandise inventory this year is expected to be \$11,000. The purchases budget can now be prepared. We need the following information:
• Sales, from the Sales budget
• Cost of goods sold percentage (can also be shown as gross margin or gross profit percent which would be subtracted from 100 to get the cost of goods sold percent)
• Desired ending inventory policy
• Beginning inventory balance (if not provided, you can follow the same ending inventory policy and apply to first quarter sales.) Remember, beginning inventory of one quarter is the ending inventory of the previous quarter.
Strobel’s merchandise inventory budget would look like:
Strobel Furniture Company
Merchandise Purchases Budget
Qtr 1 Qtr 2 Qtr 3 Qtr 4
SALES (in dollars)
\$30,000 \$80,000 \$50,000 \$90,000
Cost of goods sold (Sales x 55%) \$16,500 \$44,000 \$27,500 \$49,500
Add: Desired ending inventory (1/2 of next quarter’s cost of goods sold) \$22,000 \$13,750 \$24,750 \$11,000
Total inventory needs \$38,500 \$57,750 \$52,250 \$60,500
Less: Beginning merchandise inventory (\$8,250) (\$22,000) (\$13,750) (\$24,750)
Budgeted Purchases (in dollars)
\$30,250 \$35,750 \$38,500 \$35,750
Important items to now:
• Sales is used in the calculation for cost of goods sold but is not part of the budget itself.
• Cost of goods sold takes the Sales dollars x 55% cost of goods sold percentage.
• Desired ending inventory is next quarter’s cost of goods sold x 50% or divided by 2. For fourth quarter, the information is given in the example problem.
• Beginning inventory equals the ending inventory of the previous quarter for all except for first quarter. For first quarter, we assume the same rules were followed for ending inventory in the previous year so we can calculate as first quarter cost of goods sold \$16,500 / 2.
Strobel can now use the information in its purchases budget to prepare the cost of goods sold section of the budgeted income statement, to prepare cash disbursements schedules, and to prepare the inventory and accounts payable amounts in the financial budget.
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• Purchases Budget with Example Calculations - Accounting video. Authored by: Brian Routh TheAccountingDr. Located at: youtu.be/7xs1BPfpRk4. License: All Rights Reserved. License Terms: Standard YouTube License | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/07%3A_Budgeting/7.09%3A_Budgeting_in_a_Merchandising_Company.txt |
Budgeting in service companies
The concepts discussed in this chapter are equally applicable to service companies. Service firms have service revenues and operating expenses that must be budgeted. Projected income statements and balance sheets can be prepared for service companies and are typically based on past performance.
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To illustrate, assume Windy Weather Company wants to make the following changes this year to last year’s results:
1. Sales will increase 5%
2. Sales commissions will remain the same at 10% of sales
3. Sales and administrative salaries will increase 3%
4. Supplies, rent and miscellaneous expenses will remain the same.
5. Income taxes will be 30% of net income.
The budgeted income statement for this year would be:
Windy Weather Company
Budgeted Income Statement
Last Year
BUDGET
Calculation
Sales \$450,000 \$472,500 450,000 + (450,000 x 5%)
Less Expenses: heading only – no entry
Sales Commissions \$45,000 \$49,500 472,500 x 10%
Sales Salaries \$50,000 \$51,500 \$50,000 + (50,000 x 3%)
Administrative Salaries \$75,000 \$77,250 \$75,000 + (75,000 x 3%)
Supplies Expense \$5,000 \$5,000 no change
Rent Expense \$120,000 \$120,000 no change
Miscellaneous Expense \$15,000 \$15,000 no change
Total Expenses \$310,000 \$318,250 sum of all expenses
Income from operations \$140,000 \$154,250 Sales 450,000 – Expenses 318,250
Less: Income Tax (30%) (\$42,000) (\$46,275) Inc. from operations x 30%
Net Income \$98,000 \$107,975 Inc. from operations – income tax
Zero-Based Budgeting
An alternative to the traditional budget is zero-based budgeting.
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Zero-base budgeting became popular in the 1970s, particularly when President Jimmy Carter supported it for state and federal governmental units. It has received less attention since then.
Under zero-base budgeting, managers in a company start each year with zero budget levels and must justify every dollar that appears in the budget. Managers do not assume any costs incurred in previous years should be incurred this year. Each manager prepares decision packages that describe the nature and cost of tasks that can be performed by that unit and the consequences of not performing each task. Top organization officials rank the decision packages and approve those that they believe are most worthy. A major drawback to the use of this concept is the massive amounts of paperwork and time needed to prepare and rank decision packages, especially in large organizations.
Why is Campbell Soup Company using zero-based budgeting?
In addition to expanding its healthier and more natural product lines, Campbell’s has also announced it will be implementing zero-based budgeting. It expects to save \$200 million off its expected annual costs of close to \$7 billion.
Questions
1. What is “zero-based budgeting”?
2. How does Campbell’s expect that it will save \$200 million by using zero-based budgeting?
3. What are some potential drawbacks to Campbell’s from its use of zero-based budgeting?
Final Thoughts
For the final thoughts on budgeting, it might be helpful to rethink about how we create budgets, who creates them and what motivation the person might have for the budget figures. This video discusses the difference between participating and traditional budgeting.
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CC licensed content, Specific attribution
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• What is Zero-Based Budgeting (ZBB)?. Authored by: Stroud International. Located at: youtu.be/t0KLvsvShsk. License: All Rights Reserved. License Terms: Standard YouTube License
• Participative Budgeting vs. Traditional Budgeting . Authored by: Education Unlocked. Located at: youtu.be/m-uWeIy-whQ. License: All Rights Reserved. License Terms: Standard YouTube License
• How to Build a Basic Financial Projection - Business Finance . Authored by: Gateway CFO Solutions. Located at: youtu.be/IuL0dWfd7Jk. License: All Rights Reserved. License Terms: Standard YouTube License | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/07%3A_Budgeting/7.10%3A_Other_Budgeting_Methods.txt |
Early in the chapter, you learned that a budget should be adjusted for changes in assumptions or variations in the level of operations. Managers use a technique known as flexible budgeting to deal with budgetary adjustments. A flexible operating budget is a special kind of budget that provides detailed information about budgeted expenses (and revenues) at various levels of output.
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Leed Company’s manufacturing overhead cost budget at 70% capacity is shown below. Leed can produce 25,000 units in a 3 month period or a quarter, which represents 100% of capacity.
Leed Company
Manufacturing Overhead Cost
3-month Budget
Supplies \$1,400
Power 7,000
Insurance 4,200
Maintenance 4,900
Depreciation 18,000
Supervision 57,000
Total Overhead Costs \$92,500
Units Produced (70% capacity) 17,500
To keep the example simple, we assume that the first four costs are strictly variable and we will calculate a budget per unit for these costs. On the other hand, the last two costs, depreciation and supervision, are fixed costs and are assumed to be constant over the entire relevant range of activity meaning they do not change based on volume. The table below shows the calculations for units produced at 70% capacity and calculates the variable cost per unit for all variable costs.
Variable Fixed Calculation
Units produced 17,500 units (25,00 units x 70% capacity)
Supplies \$1,400 \$0.08 (\$1,400 / 17,500 units)
Power 7,000 \$0.40 (\$7,000 / 17,500 units)
Insurance 4,200 \$0.24 (\$4,200 / 17,500 units)
Maintenance 4,900 \$0.28 (\$4,900 / 17,500 units)
Depreciation 18,000 \$18,000 No calculation – fixed cost
Supervision 57,000 \$57,000 No calculation – fixed cost
Now that we know the variable costs per unit. we can calculate the flexible budget for any level of activity using these figures. Leed Company prepares a flexible budget for 70%, 80%, 90% and 100% capacity. Notice how the variable costs change with volume but the fixed costs remain the same.
Leed Company
Flexible Budget for Mfg Overhead
70% capacity 80% capacity 90% capacity 100% capacity
Volume (in units) (25,000 units x capacity %) 17,500 20,000 22,250 25,000
Variable
Fixed
Supplies \$0.08 \$1,400 \$1,600 \$1,780 \$2,000
(17,500 units x \$0.08) (20,000 units x \$0.08) (22,250 units x \$0.08) (25,000 units x \$0.08)
Power \$0.40 7,000 8,000 8,900 10,000
(17,500 units x \$0.40) (20,000 units x \$0.40) (22,250 units x \$0.40) (25,000 units x \$0.40)
Insurance \$0.24 4,200 4,800 5,340 6,000
(17,500 units x \$0.24) (20,000 units x \$0.24) (22,250 units x \$0.24) (25,000 units x \$0.24)
Maintenance \$0.28 4,900 5,600 6,230 7,000
(17,500 units x \$0.24) (20,000 units x \$0.24) (22,250 units x \$0.24) (25,000 units x \$0.24)
Depreciation \$18,000 18,000 18,000 18,000 18,000
Supervision \$57,000 57,000 57,000 57,000 57,000
Total Mfg Overhead \$92,500 \$95,000 \$97,250 \$100,000
A flexible budget can be prepared for any level of activity. The advantage to a flexible budget is we can create a budget based on the ACTUAL level of production to give us a clearer picture of our results by comparing the flexible budget to actual results. This analysis would compare the actual level of activity so volume variances are not a factor and management can focus on the cost variances only. We will discuss this analysis next in the performance report.
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7.12: Glossary
GLOSSARY
Budget A plan showing a company’s objectives and proposed ways of attaining the objectives. Major types of budgets are (1) master budget, (2) responsibility budget, and (3) capital budget.
Budgeting The coordination of financial and nonfinancial planning to satisfy an organization’s goals.
Budget variance The difference between an actual cost incurred (or revenue earned) at a certain level of operations and the budgeted amount for the same level of operations.
Cash budget A plan indicating expected inflows (receipts) and outflows (disbursements) of cash; it helps management decide whether enough cash will be available for short-term needs.
Financial budget The projected balance sheet portion of a master budget.
Fixed costs Costs that are unaffected in total by the relative level of production or sales.
Flexible operating budget A special budget that provides detailed information about budgeted expenses (and revenues) at various levels of output.
Just-in-time inventory system Provides that goods are produced and delivered just in time to be sold.
Master budget The projected income statement (planned operating budget) and projected balance sheet (financial budget) showing the organization’s objectives and proposed ways of attaining them; includes supporting budgets for various items in the master budget; also called master profit plan. The master budget is the overall plan of the enterprise and ideally consists of all of the various segmental budgets.
Participatory budgeting A method of preparing the budget that includes the participation of all levels of management responsible for actual performance.
Planned operating budget The projected income statement portion of a master budget.
Production budget A budget that takes into account the units in the sales budget and the company’s inventory policy.
Variable costs Costs that vary in total directly with production or sales and are a constant dollar amount per unit of output over different levels of output or sales.
Zero-base budgeting Managers in a company start each year with zero budget levels and must justify every dollar that will appear in the budget. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/07%3A_Budgeting/7.11%3A_Flexible_Budgets.txt |
Short-Answer Questions, Problems, and Exercises
Short-Answer Questions
➢ What are three purposes of budgeting?
➢ What are the purposes of a master, planned operating, and financial budget?
➢ How does the management by exception concept relate to budgeting?
➢ What are five basic principles which, if followed, should improve the probability of preparing a meaningful budget? Why is each important?
➢ What is the difference between an imposed budget and a participatory budget?
➢ Define and explain a budget variance.
➢ What are the two major budgets in the master budget? Which should be prepared first? Why?
➢ Distinguish between a master budget and a responsibility budget.
➢ The budget established at the beginning of a given period carried an item for supplies expense in the amount of \$40,000. At the end of the period, the supplies used amounted to \$44,000. Can it be concluded from these data that there was an inefficient use of supplies or that care was not exercised in purchasing the supplies?
➢ Management must make certain assumptions about the business environment when preparing a budget. What areas should be considered?
➢ Why is budgeted performance better than past performance as a basis for judging actual results?
➢ Describe the concepts of just-in-time inventory systems and zero-base budgeting.
Real world question Refer to the financial statements for a publicly traded company. An industry analyst has asked you to forecast sales for each of the next five years (after the current year). Assume sales increase each year by the same percentage. That is, the percentage increase for next year is expected to be the same as it was last year. What is your estimate of sales in each of the next five years?
Real world question Refer to your forecasts of sales for the company in the previous question. Evaluate the simple forecasting method you were asked to use in that question. What additional factors should be used in forecasting sales?
Real world question Do you think the sales for a particular grocery store in your neighborhood will go up, go down, or stay the same next year compared to this year? Give your answer in sales volume, then give it in sales dollars.
Real world question The text refers to the benefits of participation in budgeting. Assume your college bookstore is preparing a budget for next year and wants to include employees in the budgeting process. Give examples of the people who should be included and state what information they could provide.
Exercises
Exercise A Hike n’ Run Company has decided to produce 288,000 pairs of socks at a uniform rate throughout 2010. The sales department of Hike n’ Run has estimated sales for 2010 according to the following schedule:
Sales of pairs of socks
First quarter 76,800
Second quarter 62,400
Third quarter 72,000
Fourth quarter 100,800
Total for 2007 312,000
Assume the 2009 December 31, inventory is estimated to be 38,400 pairs of socks. Prepare a schedule of planned sales and production for the first two quarters of 2010.
Exercise B DePaul Company projects sales of 25,000 units during May at \$6 per unit. Production costs are \$1.80 per unit. Variable selling and administrative expenses are \$0.60 per unit; fixed selling and administrative expenses are \$60,000. Compute the budgeted income before income taxes.
Exercise C Skaters Plus Company plans to sell 90,000 skateboards next quarter at a price of \$36 per unit. Production costs are \$14.40 per unit. Selling and administrative expenses are: variable, \$7.20 per unit; and fixed, \$604,800 per quarter. What are the budgeted earnings for next quarter? (Do not consider federal income taxes.)
Exercise D Duke Corporation considers materials and labor to be completely variable costs. Expected production for the year is 50,000 units. At that level of production, direct materials cost is budgeted at \$198,000, and direct labor cost is budgeted at \$450,000. Prepare a flexible budget for materials and labor for possible production levels of 52,500, 60,000, and 67,500 units of product.
Exercise E Assume that in the previous exercise the actual production was 60,000 units, materials cost was \$247,000, and labor cost was \$510,000. What are the budget variances?
Exercise F Fixed production costs for Alexia Company are budgeted at \$576,000, assuming 40,000 units of production. Actual sales for the period were 35,000 units, while actual production was 40,000 units. Actual fixed costs used in computing cost of goods sold amounted to \$504,000. What is the budget variance?
Exercise G The shoe department of Noardstone’s Department Store has prepared a sales budget for April calling for a sales volume of \$75,000. The department expects to begin in April with a \$50,000 inventory and to end the month with an \$42,500 inventory. Its cost of goods sold averages 70% of sales.
Prepare a purchases budget for the department showing the amount of goods to be purchased during April.
Problems
Problem A Joyce Corporation prepares monthly operating and financial budgets. The operating budgets for June and July are based on the following data:
Units produced Units sold
June 400,000 360,000
July 360,000 400,000
All sales are at \$30 per unit. Direct materials, direct labor, and variable manufacturing overhead are estimated at \$3, \$6, and \$3 per unit, respectively. Total fixed manufacturing overhead is budgeted at \$1,080,000 per month. Selling and administrative expenses are budgeted at \$1,200,000 plus 10% of sales, while federal income taxes are budgeted at 40% of income before federal income taxes. The inventory at June 1 consists of 200,000 units with a cost of \$17.10 each.
1. Prepare monthly budget estimates of cost of goods sold assuming that FIFO inventory procedure is used.
2. Prepare planned operating budgets for June and July.
Problem B The computation of operating income for Frisco Company for 2008 follows:
Sales \$1,800,000
Cost of goods manufactured and sold:
Direct materials \$360,000
Direct labor 240,000
Variable manufacturing overhead 120,000
Fixed manufacturing overhead 240,000 960,000
Gross margin \$ 840,000
Selling expenses:
Variable \$132,000
Fixed 168,000 300,000
Administrative expenses:
Variable \$156,000
Fixed 192,000 348,000
Net operating income \$ 192,000
An operating budget is prepared for 2009 with sales forecasted at a 25% increase in volume. Direct materials, direct labor, and all costs labeled as variable are completely variable. Fixed costs are expected to continue except for a \$24,000 increase in fixed administrative costs. Actual operating data for 2009 are:
Sales \$2,160,000
Direct materials 444,000
Direct labor 288,000
Variable manufacturing overhead 148,800
Fixed manufacturing overhead 246,000
Variable selling expenses 186,000
Fixed selling expenses 157,200
Variable administrative expenses 198,000
Fixed administrative expenses 218,200
1. Prepare a budget report comparing the 2009 planned operating budget with actual 2009 data.
2. Prepare a budget report that would be useful in appraising the performance of the various persons charged with responsibility to provide satisfactory income. (Hint: Prepare budget data on a flexible basis and use the percentage by which sales were actually experienced.)
3. Comment on the differences revealed by the two reports.
Problem C Use the following data to prepare a planned operating budget for Hi-Lo Company for the year ending 2009 December 31:
Plant capacity 100,000 units
Expected sales volume 90,000 units
Expected production 90,000 units
Actual production 90,000 units
Forecasted selling price \$ 12,00 per unit
Actual selling price \$ 13,50 per unit
Manufacturing costs:
Variable (per unit):
Direct materials \$3.60
Direct labor \$1.50
Manufacturing overhead \$2.25
Fixed manufacturing overhead \$108,000
Selling and administrative expenses:
Variable (per unit) \$1.20
Fixed \$60,000
Assume no beginning or ending inventory. Federal income taxes are budgeted at 40% of income before federal income taxes.
The actual operating data for the year ending 2009 December 31, follow:
Sales \$1,080,000
Cost of goods sold:
Direct materials \$337,500
Direct labor 135,000
Variable manufacturing overhead 202,500
Fixed manufacturing overhead 108,000
Total \$783,000
Less: Ending inventory (\$783,000 x 10/90) 87,000 696,000
Gross margin \$384,000
Selling expenses:
Variable 102,000
Fixed 72,000 174,000
Income before federal income taxes \$210,000
Deduct: Federal income taxes at 40% 84,000
Net income \$126,000
1. Prepare a planned operating budget for the year ended 2009 December 31, for part (1).
2. Using a flexible operating budget, analyze the efficiency of operations and comment on the company’s sales policy for part (2).
Problem D Kim Company wants you to prepare a flexible budget for selling and administrative expenses. The general manager and the sales manager have met with all the department heads, who provided the following information regarding selling and administrative expenses:
The company presently employs 30 full-time salespersons with a base of \$3,600 each per month plus commissions and 10 full-time salespersons with a salary of \$6,000 each per month plus commissions. In addition, the company employs nine regional sales managers with a salary of \$21,600 per month, none of whom is entitled to any commissions.
If sales volume exceeds \$80 million per year, the company must hire four more salespersons, each at a salary of \$3,600 per month plus commissions.
Sales commissions are either 10% or 5% of the selling price, depending on the product sold. Typically, a 10% commission applies on 60% of sales, and a 5% commission applies on the remaining 40% of sales.
Salespersons’ travel allowances average \$1,500 per month per salesperson (excluding managers).
Advertising expenses average \$150,000 per month plus 3% of sales.
Selling supplies expense is estimated at 1% of sales.
Administrative salaries are \$300,000 per month.
Other administrative expenses include the following:
Rent—\$48,000 per month
Office supplies—2% of sales
Other administrative expenses (telephone, etc.)—\$12,000 per month
Prepare a flexible budget for selling and administrative expenses for sales volume of \$36 million, \$48 million, and \$60 million per year.
Problem E Galaxy Lighting Company manufactures and sells lighting fixtures. Estimated sales for the next three months are:
September \$350,000
October 500,000
November 400,000
Sales for August were \$400,000. All sales are on account. Galaxy Lighting Company estimates that 60% of the accounts receivable are collected in the month of sale with the remaining 40% collected the following month. The units sell for \$30 each. The cash balance for September 1 is \$100,000.
Generally, 60% of purchases are due and payable in the month of purchase with the remainder due the following month. Purchase cost per unit for materials is \$18. The company maintains an end-of-the-month inventory of 1,000 units plus 10% of next month’s unit sales.
Prepare a cash receipts schedule for September and October and a purchases budget for August, September, and October.
Problem F Refer to the previous problem. In addition to the information given, selling and administrative expenses paid in cash are \$120,000 per month.
Prepare a monthly cash budget for September and October for Galaxy Lighting Company.
Alternate problems
Alternate problem A Cougars Company prepares monthly operating and financial budgets. Estimates of sales in units are made for each month. Production is scheduled at a level high enough to take care of current needs and to carry into each month one-half of the next month’s unit sales. Direct materials, direct labor, and variable manufacturing overhead are estimated at \$12, \$6, and \$4 per unit, respectively. Total fixed manufacturing overhead is budgeted at \$480,000 per month. Sales for April, May, June, and July 2009 are estimated at 100,000, 120,000, 160,000, and 120,000 units. The inventory at 2009 April 1, consists of 50,000 units with a cost of \$28.80 per unit.
1. Prepare a schedule showing the budgeted production in units for April, May, and June 2009.
2. Prepare a schedule showing the budgeted cost of goods sold for the same three months assuming that the FIFO method is used for inventories.
Alternate problem B Following is a summary of operating data of Bugs Company for the year 2008:
Sales \$ 7,00,000
Cost of goods manufactured and sold:
Direct materials \$1,200,000
Direct labor 1,100,000
Variable manufacturing overhead 300,000
Fixed manufacturing overhead 800,000 3,400,000
Gross margin \$ 3,600,000
Selling expenses:
Variable \$ 300,000
Fixed 400,000 700,000
2,900,000
General and administrative expenses:
Variable \$ 100,000
Fixed 1,200,000 1,300,000
Net operating income \$ 1,600,000
Sales volume for 2009 is budgeted at 90% of 2008 sales volume. Prices are not expected to change. The 2009 budget amounts for the various other costs and expenses differ from those reported in 2008 only for the expected volume change in the variable items. Actual operating data for 2009 follow:
Sales \$5,800,000
Direct materials 1,300,000
Direct labor 1,100,000
Variable manufacturing overhead 300,000
Fixed manufacturing overhead 780,000
Variable selling expenses 270,000
Fixed selling expenses 290,000
Variable administrative expenses 110,000
Fixed administrative expenses 1,100,000
1. Prepare a budget report comparing the planned operating budget for 2009 with the actual results for that year.
2. Prepare a budget report that would be useful in pinpointing responsibility for the poor showing in 2009. (Hint: Prepare a flexible operating budget.)
Alternate problem C Use the following data for Andrea Company in preparing its 2009 planned operating budget:
Plant capacity 500,000 units
Expected sales volume 450,000 units
Expected production 500,000 units
Forecasted selling price \$72 per unit
Variable manufacturing costs per unit:
Direct materials \$ 27.00
Direct labor 9.00
Manufacturing overhead 6.00
Fixed manufacturing overhead per period \$900,000
Selling and administrative expenses:
Variable (per unit) \$ 3.00
Fixed (per period) \$ 750,000
Assume no beginning inventory. Federal income taxes are budgeted at 40% of income before income taxes.
The actual results for Andrea Company for the year ended 2009 December 31, follow. (Note: The actual sales price was \$80 per unit. Actual unit production was equal to actual unit sales.)
Sales (500,000 units @ \$80 per unit) \$40,000,000
Cost of goods sold:
Direct materials \$12,000,000
Direct labor 4,400,000
Variable manufacturing overhead 4,000,000
Fixed manufacturing overhead 1,000,000 21,400,000
Gross margin \$18,600,000
Selling and administrative expenses:
Variable \$ 1,400,000
Fixed 800,000 2,200,000
Income before federal income taxes \$16,400,000
Deduct: Federal income taxes 6,560,000
Net income \$ 9,840,000
1. Prepare a planned operating budget for the year ended 2009 December 31, for (1).
2. Using a flexible operating budget, analyze the efficiency of operations. Comment on the results of 2009 and on the company’s sales policy in (2).
Alternate problem D Rocklin Company gathered the following budget information for the quarter ending 2009 September 30:
Sales \$540,000
Purchases 450,000
Salaries and wages 194,000
Rent 10,000
Supplies 8,000
Insurance 2,000
Other cash expenses 12,000
A cash balance of \$36,000 is planned for July 1. Accounts receivable are expected to be \$60,000 on July 1. All but one-half of 1% of the July 1 Accounts Receivable balance will be collected in the quarter ending September 30. The company’s sales collection pattern is 95% in the quarter of sale and 5% in the quarter after sale. Accounts payable will be \$30,000 on July 1 and will be paid during the coming quarter. The company’s purchases payment pattern is 75% in the quarter of purchase and 25% in the quarter after purchase. Expenses are paid in the quarter in which they are incurred.
Prepare a cash budget for the quarter ending 2009 September 30.
Beyond the numbers—Critical thinking
Business decision case A Golden State Company has applied at a local bank for a short-term loan of \$150,000 starting on 2009 October 1. The bank’s loan officer has requested a cash budget from the company for the quarter ending 2009 December 31. The following information is needed to prepare the cash budget:
Sales \$600,000
Purchases 350,000
Salaries and wages to be paid 125,000
Rent payments 7,000
Supplies (payments for) 4,500
Insurance payments 1,500
Other cash payments 22,000
A cash balance of \$24,000 is planned for October 1. Accounts receivable are expected to be \$48,000 on October 1. All of these accounts will be collected in the quarter ending December 31. In general, sales are collected as follows: 90% in the quarter of sale, and 10% in the quarter after sale. Accounts payable will be \$480,000 on October 1 and will be paid during the quarter ending December 31. All purchases are paid in the quarter after purchase.
1. Prepare a cash budget for the quarter ending 2009 December 31. Assume that the \$150,000 loan will be made on October 1 and will be repaid with interest at 10% on December 31.
2. Will the company be able to repay the loan on December 31? If the company desires a minimum cash balance of \$18,000, will the company be able to repay the loan as planned?
Ethics case B The state of California, USA faced large budget deficits. Meanwhile, officials in a particular community college district were looking for ways to spend the money that had been budgeted for the district. The community college was entering the last three months of the fiscal year with excess funds because the area had experienced a mild winter resulting in lower than usual utilities and maintenance costs.
At a budget meeting, one official commented, “You know what will happen if we do not spend all of our budget. The state will claim we do not need as much money next year. What happens if we have a hard winter next year? We will need every cent we can get!”
The community college’s accounting manager commented, “We are legally entitled to spend all of the money this year that has been budgeted to us. I am concerned about the memorandum that we received requesting that we cut expenditures wherever possible to help reduce the state’s deficit.”
The first official responded, “That deficit is the state’s problem, not ours. We would not have a deficit in the first place if the state administrators were able to estimate taxes and do a better job of budgeting. Let us deal with our problems and let them deal with theirs!”
Write a response from the point of view of the taxpayers of the state of California. Should the community college spend all of the money that had been budgeted for it?
Broader perspective C Refer to the Broader perspective, “Planning in a changing environment”. Describe and evaluate Verizon Communications, Inc.’s new approach to planning. How would you advise company management to communicate the company’s values and plans to employees?
Group project D In groups of three, develop a budget for an organization that publishes financial statements, such as The Coca-Cola Company or Maytag Corporation. Your budget should include three different types of projected income statements for the coming month, quarter, or year. These three income statements should be for optimistic, pessimistic, and expected scenarios. Collect or develop as much information as possible to prepare the budget. For example, to prepare a budgeted income statement for a publicly traded company such as Coca-Cola, look at previous annual reports and collect whatever additional information you can from news reports. Be sure to state the assumptions used in preparing the budget in a memorandum you write as a team. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter. Do not forget to include the three different projected income statements.
Group project E The chief executive officer (CEO) of Rigid Plastics Corporation remarked to a colleague, “I do not understand why other companies waste so much time in the budgeting process. I set our company goals, and everyone strives to meet them. What is wrong with that approach?” In groups of two or three students, write a memorandum to your instructor stating whether you agree with this comment or not and explain why. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.
Group project F Multigoal Corporation has established a bonus plan for its employees. An employee receives a bonus if his or her department meets or is below the cost levels specified in the annual budget plan. If the department’s costs exceed the budget, its employees earn no bonus. In groups of two or three students, write a memorandum to your instructor stating the problems that might arise with this bonus plan. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.
Using the Internet—A view of the real world
Visit the website for a high technology company that provides recent annual reports. Examples include Intel Corporation, IBM, and Dell. Develop a budgeted income statement (operating budget) for the coming year and include three categories for optimistic, pessimistic, and expected scenarios. Collect or develop as much information as possible to prepare the budget. For example, look at previous annual reports and collect whatever additional information you can from news reports. Be sure to state the assumptions used in preparing the budget in a memorandum. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter. Do not forget to include the three different projected income statements.
Visit the website for a retail company that provides recent annual reports. Develop a budgeted income statement (operating budget) for the coming year and include three categories for optimistic, pessimistic, and expected scenarios. Collect or develop as much information as possible to prepare the budget. For example, look at previous annual reports and collect whatever additional information you can from news reports. Be sure to state the assumptions used in preparing the budget in a memorandum. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter. Do not forget to include the three different projected income statements.
Comprehensive problems
Wimerick Corporation prepares annual budgets by quarters. The company’s post-closing trial balance as of 2010 December 31, is as follows:
Debits Credits
Cash \$138,000
Accounts receivable 360,000
Allowance for uncollectible accounts \$ 12,000
Inventories 156,000
Prepaid expenses 12,000
Furniture and equipment 180,000
Accumulated depreciation – Furniture and equipment 12,000
Accounts payable 120,000
Accrued liabilities payable 36,000
Notes payable, 5% (due 2008) 480,000
Capital stock 300,000
Retained earnings (deficit) 114,000
\$960,000 \$960,000
All of the capital stock of the company was recently acquired by Juan Jackson. After the purchase, Jackson loaned substantial sums of money to the corporation, which still owes him \$480,000 on a 5% note. There are no accrued federal income taxes payable, but future earnings will be subject to income taxation.
Jackson is anxious to withdraw \$120,000 from the corporation (as a payment on the note payable to him) but will not do so if it reduces the corporation’s cash balance below \$120,000. Thus, he is quite interested in the budgets for the quarter ending 2011 March 31.
Sales for the coming quarter ending 2011 March 31, are forecasted at \$1,200,000; for the following quarter they are forecasted at \$1,500,000. All sales are priced to yield a gross margin of 40%. Inventory is to be maintained on hand at the end of any quarter in an amount equal to 20% of the goods to be sold in the next quarter. All sales are on account, and 95% of the 2010 December 31, receivables plus 70% of the current quarter’s sales will be collected during the quarter ending 2011 March 31.
Selling expenses are budgeted at \$48,000 plus 6% of sales; \$24,000 will be incurred on account, \$66,000 accrued, \$27,000 from expiration of prepaid rent and prepaid insurance, and \$3,000 from allocated depreciation.
Purchasing expenses are budgeted at \$34,800 plus 5% of purchases for the quarter; \$9,000 will be incurred on account, \$48,000 accrued, \$13,800 from expired prepaid expenses, and \$1,200 from allocated depreciation.
Administrative expenses are budgeted at \$42,000 plus 2% of sales; \$3,000 will be incurred on account, \$36,000 accrued, \$13,200 from expired prepayments, and \$1,800 from allocated depreciation. Uncollectible accounts are estimated at 1% of sales.
Interest accrues at 5% annually on the notes payable and is credited to Accrued Liabilities Payable.
All of the beginning balances in Accounts Payable and Accrued Liabilities Payable, plus 80% of the current credits to Accounts Payable, and all but \$30,000 of the current accrued liabilities will be paid during the quarter. An \$18,000 insurance premium is to be paid prior to March 31, and a full year’s rent of \$144,000 is due on January 2.
Federal income taxes are budgeted at 40% of the income before federal income taxes. The taxes should be accrued, and no payments are due in the first quarter.
1. Prepare a planned operating budget for the quarter ending 2011 March 31, including supporting schedules for planned purchases and operating expenses.
2. Prepare a financial budget for 2011 March 31. Supporting schedules should be included that (1) analyze accounts credited for purchases and operating expenses, (2) show planned accounts receivable collections and balance, and (3) show planned cash flows and cash balance.
3. Will Jackson be able to collect the \$120,000 on his note?
Davis Corporation is a rapidly expanding company. The company’s post-closing balance as of 2010 December 31, is as follows:
Davis corporation
Post-closing trial balance
2010 December 31
Debits Credits
Cash \$240,000
Accounts receivable 480,000
Allowance for uncollectible accounts \$ 36,000
Inventories 600,000
Prepaid expenses 72,000
Land 600,000
Buildings and equipment 1,800,000
Accumulated depreciation – Buildings and equipment 240,000
Accounts payable 360,000
Accrued liabilities payable (including income taxes) 240,000
Capital stock 2,400,000
Retained earnings 516,000
\$3,792,000 \$3,792,000
Sales in the last quarter of 2010 amounted to \$2,400,000 and are projected at \$3,000,000 and \$4,800,000 for the first two quarters of 2011. This expansion has created a need for cash. Management is especially concerned about the probable cash balance of 2011 March 31, since a payment of \$360,000 for some new equipment must be made on delivery on April 2. The current cash balance of \$240,000 is considered to be the minimum workable balance.
Purchases, all on account, are to be scheduled so that the inventory at the end of any quarter is equal to one-third of the goods expected to be sold in the coming quarter. Cost of goods sold averages 60% of sales.
Selling expenses are budgeted at \$120,000 plus 8% of sales; \$24,000 is expected to be incurred on account, \$288,000 accrued, \$33,600 from expired prepayments, and \$14,400 from allocated depreciation.
Purchasing expenses are budgeted at \$84,000 plus 5% of purchases; \$12,000 will be incurred on account, \$156,000 accrued, \$13,200 from expired prepayments, and \$10,800 from allocated depreciation.
Administrative expenses are budgeted at \$150,000 plus 3% of sales; \$24,000 will be incurred on account, \$132,000 accrued, \$13,200 from expired prepayments, and \$10,800 from allocated depreciation.
Federal income taxes are budgeted at 40% of income before federal income taxes and are recorded as accrued liabilities. Payments on these taxes are included in the payments on accrued liabilities discussed in item 6.
All 2010 December 31, accounts payable plus 80% of current credits to this account will be paid in the first quarter. All of the 2010 December 31, accrued liabilities payable (except for \$72,000) will be paid in the first quarter. Of the current quarter’s accrued liabilities, all but \$288,000 will be paid during the first quarter.
Cash outlays for various expenses normally prepaid will amount to \$96,000 during the quarter.
All sales are made on account; 80% of the sales are collected in the quarter in which made, and all of the remaining sales are collected in the following quarter, except for 2% which is never collected. The Allowance for Uncollectible Accounts account shows the estimated amount of accounts receivable at 2010 December 31, arising from 2010 sales that will not be collected.
1. Prepare an operating budget for the quarter ending 2011 March 31. Supporting schedules for planned purchases and operating expenses should be included.
2. Prepare a financial budget for 2011 March 31. Include supporting schedules that (1) analyze accounts credited for purchases and expenses, (2) show planned cash flows and cash balance, and (3) show planned collections of accounts receivable and the accounts receivable balance.
3. Will sufficient cash be on hand April 2 to pay for the new equipment? | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/07%3A_Budgeting/7.13%3A_Chapter_7-_Exercises.txt |
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