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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.
Click Budgeting Study Plan for a printable copy.
8.02: The Role of Standard Costs in Management
• Uses of standard costs
Whenever you have set goals that you have sought to achieve, these goals could have been called standards. Periodically, you might measure your actual performance against these standards and analyze the differences to see how close you are to your goal. Similarly, management sets goals, such as standard costs, and compares actual costs with these goals to identify possible problems.
This section begins with a discussion of the nature of standard costs. Next, we explain how managers use standard costs to establish budgets. Then we describe how management uses the concept of management by exception to investigate variances from standards. We also explain setting standards and how management decides whether to use ideal or practical standards. The section closes with a discussion of the other uses of standard costs.
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Nature of standard costs
A standard cost is a carefully predetermined measure of what a cost should be under stated conditions. Standard costs are not only estimates of what costs will be but also goals to be achieved. When standards are properly set, their achievement represents a reasonably efficient level of performance.
Usually, effective standards are the result of engineering studies and of time and motion studies undertaken to determine the amounts of materials, labor, and other services required to produce a product. Also considered in setting standards are general economic conditions because these conditions affect the cost of materials and other services that must be purchased by a manufacturing company.
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Manufacturing companies determine the standard cost of each unit of product by establishing the standard cost of direct materials, direct labor, and manufacturing overhead necessary to produce that unit. Determining the standard cost of direct materials and direct labor is less complicated than determining the standard cost of manufacturing overhead.
The standard direct materials cost per unit of a product consists of the standard amount of material required to produce the unit multiplied by the standard price of the material. You must distinguish between the terms standard price and standard cost. Standard price usually refers to the price per unit of inputs into the production process, such as the price per pound of raw materials.
Standard cost, however, is the standard quantity of an input required per unit of output times the standard price per unit of that input. For example, if the standard price of cloth is \$ 3 per yard and the standard quantity of material required to produce a dress is 3 yards, the standard direct materials cost of the dress is 3 yards x \$ 3 per yard = \$ 9. Similarly, a company computes the standard direct labor cost per unit for a product as the standard number of hours needed to produce one unit multiplied by the standard labor or wage rate per hour.
Standard manufacturing overhead cost To find the standard manufacturing overhead cost of a unit, use the following steps. First, determine the expected level of output for the year. This level of output is called the standard level of output. Second, determine the total budgeted manufacturing overhead cost at the standard level of output. The total budgeted overhead cost includes both fixed and variable components. Total fixed cost is the same at every level of output within a relevant range. Total variable overhead varies in direct proportion to the number of units produced. Third, compute the standard manufacturing overhead cost per unit by dividing the total budgeted manufacturing overhead cost at the standard level of output by the standard level of output. The result is standard overhead cost (or rate) per unit of output.
The formula to compute the standard overhead cost per unit is:
Total Budgeted Manufacturing OH at standard level / standard level of output
Sometimes accountants find the standard overhead rate per unit of input, such as direct labor-hour instead of per unit. To find the standard overhead cost per unit, multiply the direct labor-hours per unit times the standard overhead cost per direct labor-hour. For instance, if the standard overhead costs per direct labor-hour is \$ 5 and the standard number of direct labor-hours is two hours per unit, the standard overhead cost per unit is \$ 5 x 2 hours = \$ 10.
As discussed in the previously, budgets are formal written plans that represent management’s planned actions in the future and the impacts of these actions on the business. As a business incurs actual expenses and revenues, management compares them with the budgeted amounts. To control operations, management investigates any differences between the actual and budgeted amounts and takes corrective action.
When management compares actual expenses and revenues with budgeted expenses and revenues, differences—called variances—are likely to occur. The responsibility of management is to investigate significant variances. Obviously, management must determine when a variance is significant. This process of focusing on only the most significant variances is known as management by exception. The process of management by exception enables management to concentrate its efforts on those variances that could have a big effect on the company, ignoring those variances that are not significant.
In developing standards, management must consider the assumed conditions under which these standards can be met. Standards generally fall into two groups—ideal and practical.
A company attains ideal standards under the best circumstances—with no machinery problems or worker problems. The company can attain these unrealistic standards only when it has highly efficient, skilled workers who are working at their best effort throughout the entire period needed to complete the job.
Practical standards are strict but attainable standards that have allowances made for machinery problems and rest periods for workers. Companies can meet these standards if average workers are efficient at their work. These standards are generally used in planning.
Generally, management does not use ideal standards because ideal standards do not allow for normal repairs to machinery or rest periods for workers. A company rarely runs its operations under ideal conditions. Since planning under ideal standards is unrealistic, managers rarely use ideal standards in budgeting. Instead, management uses practical standards in planning because these standards are more realistic, allowing for machinery repairs and rest periods for workers. Any variances that result when practical standards are used indicate abnormal or unusual problems.
In addition to developing budgets, companies use standard costs in evaluating management’s performance, evaluating workers’ performance, and setting appropriate selling prices.
Firms evaluate management’s and workers’ performances through the use of a budget. When management compares actual results with budgeted amounts, it can see how well it is performing its own duties and managing its employees. Management also can evaluate workers based on how well they performed relative to the budgeted amounts pertaining to the activities they performed.
Standard costs are useful in setting selling prices. The budget shows the expected expenses incurred by the business. By considering these expenses, management can determine how much to charge for a product so that it can produce the desired net income. As the business actually incurs these expenses, management determines if the selling prices set are still reasonable and, when necessary, considers some price adjustments after taking competition into account.
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• Computing variances
As stated earlier, standard costs represent goals. Standard cost is the amount a cost should be under a given set of circumstances. The accounting records also contain information about actual costs.
The amount by which actual cost differs from standard cost is called a variance. When actual costs are less than the standard cost, a cost variance is favorable. When actual costs exceed the standard costs, a cost variance is unfavorable. Do not automatically equate favorable and unfavorable variances with good and bad. You must base such an appraisal on the causes of the variance.
The following section explains how to compute the dollar amount of variances, a process called isolating variances, using data for Beta Company. Beta manufactures and sells a single product, each unit of which has the following standard costs:
Materials – 5 sheets at \$6 \$30
Direct labor – 2 hours at \$10 20
Manufacturing overhead – 2 direct labor hours at \$5 10
Total standard cost per unit \$60
We present additional data regarding the production activities of the company as needed.
The standard materials cost of any product is simply the standard quantity of materials that should be used multiplied by the standard price that should be paid for those materials. Actual costs may differ from standard costs for materials because the price paid for the materials and/or the quantity of materials used varied from the standard amounts management had set. These two factors are accounted for by isolating two variances for materials—a price variance and a usage variance.
Accountants isolate these two materials variances for three reasons. First, different individuals may be responsible for each variance—a purchasing agent for the price variance and a production manager for the usage variance. Second, materials might not be purchased and used in the same period. The variance associated with the purchase should be isolated in the period of purchase, and the variance associated with usage should be isolated in the period of use. As a general rule, the sooner a variance can be isolated, the greater its value in cost control. Third, it is unlikely that a single materials variance—the difference between the standard cost and the actual cost of the materials used—would be of any real value to management for effective cost control. A single variance would not show management what caused the difference, or one variance might simply offset another and make the total difference appear to be immaterial.
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Materials price variance In a manufacturing company, the purchasing and accounting departments usually set a standard price for materials meeting certain engineering specifications. They consider factors such as market conditions, vendors’ quoted prices, and the optimum size of a purchase order when setting a standard price. A materials price variance (MPV) occurs when a company pays a higher or lower price than the standard price set for materials. Materials price variance is the difference between actual price paid (AP) and standard price allowed (SP) multiplied by the actual quantity of materials purchased (AQ). In equation form, the materials price variance can be done in two ways:
Materials price variance = (Actual price – Standard price) x Actual quantity purchased
OR
Materials price variance = (Actual price x Actual quantity purchased) – (Standard price x Actual quantity purchased)
To illustrate, assume that a new supplier entered the market enabling Beta Company to purchase 60,000 sheets of material at a price of \$ 5.90 each. Since the standard price set by management is \$ 6 per sheet, the materials price variance is computed as:
Materials price variance= (Actual price – Standard price) x Actual quantity purchased
= (\$5.90 – \$6.00) x 60,000 sheets of material
= (-0.10) x 60,000 sheets = -6,000 which means \$6,000 favorable
OR
Materials price variance = (Actual price x Actual quantity purchased) – (Standard price x Actual quantity purchased)
= (\$5.90 x 60,000) – (\$6.00 x 60,000 sheets of material)
= \$345,000 – \$360,000 = -6,000 which means \$6,000 favorable
The materials price variance of \$ 6,000 is considered favorable since the materials were acquired for a price less than the standard price. If the actual price had exceeded the standard price, the variance would be unfavorable because the costs incurred would have exceeded the standard price. We do not show variances with a negative or positive but at the absolute value with favorable or unfavorable specified.
Materials usage variance Because the standard quantity of materials used in making a product is largely a matter of physical requirements or product specifications, usually the engineering department sets it. But if the quality of materials used varies with price, the accounting and purchasing departments may perform special studies to find the right quality.
The materials usage variance occurs when more or less than the standard amount of materials is used to produce a product or complete a process. The variance shows only differences from the standard quantity caused by the quantity of materials used; it does not include any effect of variances in price. Thus, the materials usage variance is :
Materials usage variance = (Actual qty – Standard qty allowed) x Standard price
OR
Materials price variance = (Actual Qty x Standard price) – (Standard Qty x Standard price)
To illustrate, assume that Beta Company used 55,500 sheets of material to produce 11,000 units of a product for which the standard quantity allowed is 55,000 sheets (5 sheets per unit allowed x 11,000 units actually produced). Since the standard price of the material is \$ 6 per sheet, the materials usage variance of \$ 3,000 would be computed as follows:
Materials usage variance = (Actual qty Standard qty allowed) x Standard price
= (55,500 actual sheets – 55,000 allowed sheets) x \$6 per sheet
= 500 sheets x \$6 per sheet
= \$ 3,000 which means \$3,000 unfavorable variance
OR
Materials price variance = (Actual Qty x Standard price) – (Standard Qty x Standard price)
= (55,500 actual sheets x \$6) – (55,000 allowed sheets x \$6 per sheet)
= \$333,000 – 330,000
= \$ 3,000 which means \$3,000 unfavorable variance
The variance is unfavorable because more materials were used than the standard quantity allowed to complete the job. If the standard quantity allowed had exceeded the quantity actually used, the materials usage variance would have been favorable.
Determine whether a variance is favorable or unfavorable by reliance on reason or logic. If more materials were used than the standard quantity, or if a price greater than the standard price was paid, the variance is unfavorable. If the reverse is true, the variance is favorable.
The standard labor cost of any product is equal to the standard quantity of labor time allowed multiplied by the wage rate that should be paid for this time. Here again, it follows that the actual labor cost may differ from standard labor cost because of the wages paid for labor, the quantity of labor used, or both. Thus, two labor variances exist—a rate variance and an efficiency variance.
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Labor rate variance The labor rate variance occurs when the average rate of pay is higher or lower than the standard cost to produce a product or complete a process. The labor rate variance is similar to the materials price variance.
To compute the labor rate variance, we use the actual direct labor-hour rate paid (AR), the standard direct labor-hour rate allowed (SR) and the actual hours of direct labor services worked (AH). It can also be calculated in either of the following ways:
Labor rate variance= (Actual rate – Standard rate) x Actual hours worked
OR
Labor rate variance = (Actual rate x actual hours worked) – (Standard rate x actual hours worked)
To continue the Beta example, assume that the direct labor payroll of the company consisted of 22,200 hours at a total cost of \$ 233,100 (an average actual hourly rate of \$ 10.50). Because management has set a standard direct labor-hour rate of \$ 10 per hour, the labor rate variance is:
Labor rate variance = (Actual rate – Standard rate) x Actual hours worked
= (\$10.50 actual rate – \$10 per hour standard) x 22,200 actual hours
= \$ 0.50 x 22,200
= \$ 11,100 or \$11,100 unfavorable variance
OR
Labor rate variance = (Actual rate x actual hours worked) – (Standard rate x actual hours worked)
= (\$10.50 actual rate x 22,200 hours) – (\$10 per hour standard x 22,200 actual hours)
= \$ 233,100 – \$ 222,000
= \$ 11,100 or \$11,100 unfavorable variance
The variance is positive and unfavorable because the actual rate paid exceeded the standard rate allowed. If the reverse were true, the variance would be favorable.
Labor efficiency variance Usually, the company’s engineering department sets the standard amount of direct labor-hours needed to complete a product. Engineers may base the direct labor-hours standard on time and motion studies or on bargaining with the employees’ union. The labor efficiency variance occurs when employees use more or less than the standard amount of direct labor-hours to produce a product or complete a process. The labor efficiency variance is similar to the materials usage variance.
To compute the labor efficiency variance, we will use the actual direct labor-hours worked (AH), the standard direct labor-hours allowed (SH), and the standard direct labor-hour rate per hour (SR) in either of the following ways:
Labor efficiency variance= (Actual DL hours – Standard DL hours) x Standard DL rate per hour
OR
Labor efficiency variance = (Actual DL hours x Std Rate) – (Std DL hours x Std Rate)
To illustrate, assume that the 22,200 hours of direct labor-hours worked by Beta Company employees resulted in 11,000 units of production. Assume these units have a standard direct labor-hours of 22,000 hours (11,000 units at 2 hour unit). Since the standard direct labor rate is \$ 10 per hour, the labor efficiency variance is \$ 2,000, computed as follows:
Labor efficiency variance= (Actual hours worked – Standard hours allowed) x Standard rate
= (22,200 actual DL hours x 22,000 standard DL hours) x \$10 per hour
= 200 hours x \$10
= \$ 2,000 unfavorable variance
OR
Labor efficiency variance= (Actual DL hours x Std Rate) – (Std DL hours x Std Rate)
= (22,200 actual DL hours x \$10 per hour) – x (22,000 standard DL hours x \$10 per hour)
= \$222,000 – 220,000
= \$ 2,000 unfavorable variance
The variance is unfavorable since more hours than the standard number of hours were required to complete the period’s production. If the reverse were true, the variance would be favorable.
The unfavorable labor rate variance is not necessarily caused by paying employees more wages than they are entitled to receive. More probable reasons are either that more highly skilled employees with higher wage rates worked on production than originally anticipated, or that employee wage rates increased after the standard was developed and the standard was not revised. Favorable rate variances, on the other hand, could be caused by using less-skilled, cheaper labor in the production process. Typically, the hours of labor employed are more likely to be under management’s control than the rates that are paid. For this reason, labor efficiency variances are generally watched more closely than labor rate variances.
Summary of labor variances The accuracy of the two labor variances can be checked by comparing their sum with the difference between actual and standard labor cost for a period. In the Beta Company illustration, this difference was:
Actual labor cost incurred (22,200 hours x \$10.50) \$233,100
Standard labor cost allowed (22,000 hours x \$10) 220,000
Total labor variance (unfavorable) \$ 13,100
This \$13,100 unfavorable variance is made up of two labor variances:
Labor rate variance (22,200 x \$0.50) \$11,100 unfavorable
Labor efficiency variance (200 x \$10) 2,000 unfavorable
Total labor variance (11,100 U + 2,000 U) \$ 13,100 Unfavorable
Since both the rate and efficiency variances are unfavorable, we would add them together to get the TOTAL labor variance. If we had one favorable and one unfavorable variance, we would subtract the numbers.
Still unsure about material and labor variances, watch this Note Pirate video to help.
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• In a standard cost system, accountants apply the manufacturing overhead to the goods produced using a standard overhead rate. They set the rate prior to the start of the period by dividing the budgeted manufacturing overhead cost by a standard level of output or activity. Total budgeted manufacturing overhead varies at different levels of standard output, but since some overhead costs are fixed, total budgeted manufacturing overhead does not vary in direct proportion with output.
Managers use a flexible budget to isolate overhead variances and to set the standard overhead rate. Flexible budgets show the budgeted amount of manufacturing overhead for various levels of output.
Look at Beta Company’s flexible budget below. Note that Beta’s flexible budget shows the variable and fixed manufacturing overhead costs expected to be incurred at three levels of activity: 9,000 units, 10,000 units, and 11,000 units. For product costing purposes, Beta must estimate the expected level of activity in advance and set a rate based on that level. The level chosen is called the standard volume of output. This standard volume of output (or activity) may be expressed in terms of any of the activity bases used in setting standard overhead rates. These activity bases include percentage of capacity, units of output machine-hours, and direct labor-hours, among others. Machine-hours are budgeted at 2 machine-hours per product. In our example, standard volume is assumed to be 10,000 units produced. Management expects to use 20,000 machine-hours of services. These will be used as our budgeted amounts.
BetaCompany
Flexible manuf. overhead budget
Machine-hours 18,000 20,000 22,000
Units of output 9,000 10,000 11,000
Variable overhead:
Indirect materials \$7,200 \$8,000 \$8,800
Power 9,000 10,000 11,000
Royalties 1,800 2,000 2,200
Other 18,000 20,000 22,000
Total variable overhead \$36,000 \$40,000 \$44,000
Fixed overhead:
Insurance \$4,000 \$4,000 \$4,000
Property taxes 6,000 6,000 6,000
Depreciation 20,000 20,000 20,000
Other 30,000 30,000 30,000
Total fixed overhead \$60,000 \$60,000 \$60,000
Total Overhead (variable + fixed ) \$96,000 \$100,000 \$104,000
Standard overhead rate (\$100,000/20,000 hours) \$5
Assume that Beta applies manufacturing overhead using a rate based on machine-hours. According to the flexible manufacturing overhead budget, the expected manufacturing overhead cost at the standard volume (20,000 machine-hours) is \$ 100,000, so the standard overhead rate is \$ 5 per machine-hour (\$100,000/20,000 machine-hours).
Knowing the separate rates for variable and fixed overhead is useful for decision making. We will be using the company’s expected volume of 10,000 units. The variable overhead rate is \$ 2 per machine hour (\$ 40,000 variable OH/20,000 hours), and the fixed overhead rate is \$ 3 per hour (\$ 60,000/20,000 hours). If the expected volume had been 18,000 machine-hours, the standard overhead rate would have been \$ 5.33 (\$96,000/18,000 hours). If the standard volume had been 22,000 machine-hours, the standard overhead rate would have been \$ 4.73 (\$104,000/22,000 hours).
Note that the difference in rates is due solely to dividing fixed overhead by a different number of machine-hours. That is, the variable overhead cost per unit stays constant (\$ 2 per machine-hour) regardless of the number of units expected to be produced, and only the fixed overhead cost per unit changes. Since fixed overhead does not change per unit, we will separate the fixed and variable overhead for variance analysis.
Continuing with the Beta Company illustration, assume that the company incurred \$ 108,000 of actual manufacturing overhead costs (\$46,000 in variable OH and \$62,000 in fixed OH) in a period during which 11,000 units of product were produced. The actual costs would be debited to Manufacturing Overhead and credited to a variety of accounts such as Accounts Payable, Accumulated Depreciation, Prepaid Insurance, Property Taxes Payable, and so on. According to the flexible budget, the standard number of machine-hours allowed for 11,000 units of production is 22,000 hours. Therefore, \$ 110,000 of manufacturing overhead is applied to production (\$ 5 per machine-hour times 22,000 hours) by debiting Work in Process Inventory and crediting Manufacturing Overhead for \$ 110,000.
These show that manufacturing overhead has been overapplied to production by the \$ 2,000 (\$110,000 applied OH – \$108,000 actual OH). Because of its fixed component, manufacturing overhead tends to be over applied when actual production is greater than standard production. Now, we will separate the variable and fixed components for analysis.
Variable Overhead Variances
Although various complex computations can be made for overhead variances, we use a simple approach in this text. In this approach, known as the two-variance approach to variable overhead variances, we calculate only two variances—a variable overhead spending variance and a variable overhead efficiency variance.
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Variable Overhead Spending Variance The variable overhead spending variance shows in one amount how economically overhead services were purchased and how efficiently they were used. This overhead spending variance is similar to a price variance for materials or labor. We compare the Variable OH rate for budget and actual using the actual amount of our variable overhead base (machine-hours, direct labor dollars, direct labor hours, etc.)
Variable OH Spending Variance = (Actual Variable OH per base – Std Variable OH per base) x Actual OH base
OR
Variable OH Spending Variance = (Actual OH base x Actual Variable OH per base) – (Actual OH base x Std Variable OH per base)
For Beta Company, overhead is applied based on machine hours. The Variable OH rate per machine hour is \$2 (calculated above) and actual variable overhead was \$46,000 for 22,000 actual machine hours giving an actual rate of \$2.0909 rounded (\$46,000 / 22,000 actual machine hours). We can calculate the variable OH spending variance using either of these two methods below:
Variable OH Spending Variance = (Actual Variable OH per base – Std Variable OH per base) x Actual OH base
= (\$2.0909 per machine hour – \$2.00 per machine hour) x 22,000 actual machine hours
= \$0.0909 x 22,000 machine hours
= \$2,000 (rounded) Unfavorable
OR
Variable OH Spending Variance = (Actual OH base x Actual Variable OH per base) – (Actual OH base x Std Variable OH per base)
= \$46,000 actual variable OH – (22,000 actual machine hours x \$2 standard OH per machine hour)
= \$46,000 – 44,000
= \$2,000 unfavorable
The variance is unfavorable because actual variable overhead costs were \$46,000, while according to the flexible budget for 11,000 units, they should have been \$44,000 meaning Beta spent more on variable overhead than they had planned.Variable Overhead Efficiency Variance The variable efficiency overhead variance is caused by producing at a level other than that used in setting the standard overhead application rate. The variable OH efficiency variance shows whether plant assets produced more or fewer units than expected.
Variable OH Efficiency Variance = (Actual OH base – Std OH base) x Standard Variable OH per base
OR
Variable OH Efficiency Variance = (Actual OH base x Std Variable OH per base) – (Std OH base x Std Variable OH per base)
For Beta Company, the Variable OH rate per machine hour is \$2 (calculated above) and actual variable overhead was \$46,000 for 22,000 actual machine hours. Management expected to use 20,000 hours for 10,000 units produced. We can calculate the variable OH spending variance using either of these two methods below:
Variable OH Efficiency Variance = (Actual OH base – Std OH base) x Standard Variable OH per base
= (22,000 actual machine hours – 20,000 standard machine hours ) x \$2 per machine hour
= 2,000 machine hours x \$2 per machine hour
= \$4,000 unfavorable
OR
Variable OH Efficiency Variance = (Actual OH base x Std Variable OH per base) – (Std OH base x Std Variable OH per base)
= (22,000 actual hours x \$2 per machine hour) – (20,000 standard hours x \$2 per machine hour)
= \$44,000 – 40,000
= \$4,000 unfavorable
The efficiency variance is unfavorable because we used more machine hours than we had budgeted. Of course, this is because we produced 11,000 units when the budget planned for 10,000 units.
Fixed Overhead Variance
Because fixed overhead is not constant on a per unit basis, any deviation from planned production causes the overhead application rate to be incorrect. We can calculate a fixed overhead variance by comparing:
Fixed Overhead variance = Actual fixed overhead – Budgeted fixed overhead
In the Beta Company illustration, the budgeted fixed overhead was \$60,000 (notice the level of production does not matter since fixed costs remain the same regardless of volume) and the actual fixed costs were \$62,000.
Fixed Overhead variance = Actual fixed overhead – Budgeted fixed overhead
= \$62,000 actual fixed – \$60,000 budgeted fixed
= \$2,000 unfavorable variance
This variance is unfavorable since we spent more on fixed costs than we had planned.
Summary of overhead variances To easily determine the accuracy of the overhead variances, Beta would compare the sum of the variances with the difference between the costs of actual manufacturing overhead and budgeted manufacturing overhead. For Beta Company, the difference between actual and budgeted overhead (budget is based on the expected level of volume of 10,000 units) was:
Actual manufacturing overhead incurred \$ 108,000
Budgeted overhead (at 10,000 units) 100,000
Total overhead variance (unfavorable) \$ 8,000
This difference is made up of the following overhead variances:
Variable OH Spending Variance \$ 2,000 U
Variable OH Efficiency Variance \$ 4,000 U
Fixed OH Variance \$ 2,000 U
Total overhead variance (2,000 U + 4,000 U + 2,000 U) \$8,000 Unfavorable
The unfavorable spending variance is because we had more variable cost per unit than budgeted. The efficiency variance is unfavorable because we spent more machine hours than budgeted because we produced more units. We spent more on fixed costs than we had anticipated.
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Advantages and disadvantages of using standard costs
Five of the benefits that result from a business using a standard cost system are:
• Improved cost control.
• More useful information for managerial planning and decision making.
• More reasonable and easier inventory measurements.
• Cost savings in record-keeping.
• Possible reductions in production costs.
Improved cost control Companies can gain greater cost control by setting standards for each type of cost incurred and then highlighting exceptions or variances—instances where things did not go as planned. Variances provide a starting point for judging the effectiveness of managers in controlling the costs for which they are held responsible.
Assume, for example, that in a production center, actual direct materials costs of \$ 52,015 exceeded standard costs by \$ 6,015. Knowing that actual direct materials costs exceeded standard costs by \$ 6,015 is more useful than merely knowing the actual direct materials costs amounted to \$ 52,015. Now the firm can investigate the cause of the excess of actual costs over standard costs and take action.
Further investigation should reveal whether the exception or variance was caused by the inefficient use of materials or resulted from higher prices due to inflation or inefficient purchasing. In either case, the standard cost system acts as an early warning system by highlighting a potential hazard for management.
More useful information for managerial planning and decision making When management develops appropriate cost standards and succeeds in controlling production costs, future actual costs should be close to the standard. As a result, management can use standard costs in preparing more accurate budgets and in estimating costs for bidding on jobs. A standard cost system can be valuable for top management in planning and decision making.
More reasonable and easier inventory measurements A standard cost system provides easier inventory valuation than an actual cost system. Under an actual cost system, unit costs for batches of identical products may differ widely. For example, this variation can occur because of a machine malfunction during the production of a given batch that increases the labor and overhead charged to that batch. Under a standard cost system, the company would not include such unusual costs in inventory. Rather, it would charge these excess costs to variance accounts after comparing actual costs to standard costs.
Thus, in a standard cost system, a company assumes that all units of a given product produced during a particular time period have the same unit cost. Logically, identical physical units produced in a given time period should be recorded at the same cost.
Cost savings in record-keeping Although a standard cost system may seem to require more detailed record-keeping during the accounting period than an actual cost system, the reverse is true. For example, a system that accumulates only actual costs shows cost flows between inventory accounts and eventually into cost of goods sold. It records these varying amounts of actual unit costs that must be calculated during the period. In a standard cost system, a company shows the cost flows between inventory accounts and into cost of goods sold at consistent standard amounts during the period. It needs no special calculations to determine actual unit costs during the period. Instead, companies may print standard cost sheets in advance showing standard quantities and standard unit costs for the materials, labor, and overhead needed to produce a certain product.
Possible reductions in production costs A standard cost system may lead to cost savings. The use of standard costs may cause employees to become more cost conscious and to seek improved methods of completing their tasks. Only when employees become active in reducing costs can companies really become successful in cost control.
Three of the disadvantages that result from a business using standard costs are:
• Controversial materiality limits for variances.
• Nonreporting of certain variances.
• Low morale for some workers.
Controversial materiality limits for variances Determining the materiality limits of the variances may be controversial. The management of each business has the responsibility for determining what constitutes a material or unusual variance. Because materiality involves individual judgment, many problems or conflicts may arise in setting materiality limits.
Nonreporting of certain variances Workers do not always report all exceptions or variances. If management only investigates unusual variances, workers may not report negative exceptions to the budget or may try to minimize these exceptions to conceal inefficiency. Workers who succeed in hiding variances diminish the effectiveness of budgeting.
Low morale for some workers The management by exception approach focuses on the unusual variances. Management often focuses on unfavorable variances while ignoring favorable variances. Workers might believe that poor performance gets attention while good performance is ignored. As a result, the morale of these workers may suffer.
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See below for a summary of the six variances from standard discussed in this chapter.
Materials price variance =
(Actual price – Standard price) x Actual quantity purchased OR
(Actual Price x Actual Qty purch) – (Standard Price x Actual Quantity purchased)
Materials usage variance =
(Actual quantity used – Standard quantity allowed) x Standard price OR
(Actual qty used x Standard price) – (Standard Qty allowed x Standard price)
Labor rate variance =
(Actual rate – standard rate) x Actual hours worked OR
(Actual rate x Actual hours worked) – (Standard rate x Actual hours worked)
Labor efficiency variance =
(Actual hours worked – standard hours allowed) x Standard rate OR
(Actual hours worked x Standard Rate) – (Standard hours allowed x Standard Rate)
Variable OH Spending variance =
(Actual variable OH rate – standard variable OH rate) x Actual OH base OR
(Actual variable OH rate x Actual OH base) – (Std variable OH rate x Actual OH base)
Variable OH Efficiency variance =
(Actual OH base – standard OH base) x Standard variable OH rate OR
(Actual OH base x Standard variable OH rate) – (Std OH base x Std variable OH rate)
Fixed OH variance = Actual fixed overhead – Budgeted fixed overhead
Remember, variances are expressed at the absolute values meaning we do not show negative or positive numbers. We express variances in terms of FAVORABLE or UNFAVORABLE and negative is not always bad or unfavorable and positive is not always good or favorable.
Keep these in mind:
• When actual materials are more than standard (or budgeted), we have an UNFAVORABLE variance.
• When actual materials are less than the standard, we have a FAVORABLE variance.
• Same rule applies for direct labor. If actual direct labor (either hours or dollars) is more than the standard, we have an UNFAVORABLE variance. A FAVORABLE variance occurs when actual direct labor is less than the standard.
Accounting in the Headlines
How will the increasing cost of chocolate impact Hershey’s variances?
Although the demand for all chocolate has been increasing, consumer tastes have been gradually shifting towards dark chocolate because of its purported health benefits. Dark chocolate uses more cocoa beans per ounce than milk chocolate.
So what does the predicted price increase mean for companies that use chocolate and/or cocoa beans?
Questions
1. The Hershey Company produces several products that use chocolate and/or cocoa beans. Which of the following variances for Hershey’s chocolate products are likely to be impacted by the projected price increase in the cost of chocolate? Explain your answer.
• a. Direct material price variance
• b. Direct material quantity variance
• c. Direct labor rate variance
• d. Direct labor efficiency variance
2. Hershey’s Special Dark Mildly Sweet Chocolate Bar and Hershey’s Milk Chocolate with Almonds Bar both weigh 1.45 ounces. Which bar’s variances are more likely to be impacted by the increase in the cost of chocolate? Explain your reasoning.
3. Since The Hershey Company’s management knows that the price of chocolate is likely to increase, it might revise one or more of its standards. Which standard(s) would be impacted? What would be the benefit of revising the standard(s) before the end of the reporting period?
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8.07: Accounting in the Headlines
How will cost standards be impacted at PEZ Candy Inc. by the rising cost of sugar and labor?
In the United States, PEZ candies are produced in a factory in Connecticut since 1973. The PEZ candies are made from about 95% sugar, which makes the PEZ product cost particularly sensitive to changes in the cost of sugar. The cost of sugar in the United States has been significantly increasing over the past year, due in least at part, to preliminary tariffs imposed by the U.S. government on Mexican sugar. In addition, the cost of labor has been increasing due to increases in the minimum wage in the U.S. For these reasons, PEZ expects to raise its prices in 2015.
Questions
1. What cost standards will most likely be adjusted at PEZ for the rising costs? When do you think these standard adjustments will be made?
2. If the related cost standard is not adjusted, what variance(s) will be impacted by the rising cost of sugar? What department would typically be responsible for explaining this variance(s)?
3. If the related cost standard is not adjusted, what variance(s) will be impacted by the rising cost of labor? What department would typically be responsible for explaining this variance(s)?
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GLOSSARY
Budgets Formal written plans that represent management’s planned actions in the future and the impacts of these actions on the business.
Flexible budget A budget that shows the budgeted amount of manufacturing overhead for various levels of output; used in isolating overhead variances and setting standard overhead rates.
Ideal standards Standards that can be attained under the best circumstances—that is, with no machinery problems or worker problems. These unrealistic standards can only be met when the company has highly efficient, skilled workers who are working at their best effort throughout the entire period needed to complete the job.
Fixed overhead variance A variance from standard caused by using more or less than the standard amount of fixed overhead costs to produce a product or complete a process; computed as Actual fixed overhead – Budgeted fixed overhead.
Labor efficiency variance (LEV) A variance from standard caused by using more or less than the standard amount of direct labor-hours to produce a product or complete a process; computed as (Actual hours worked – Standard hours allowed) x Standard rate per hour.
Labor rate variance (LRV) A variance from standard caused by paying a higher or lower average rate of pay than the standard cost to produce a product or complete a process; computed as (Actual rate -Standard rate) x Actual hours worked.
Management by exception The process where management only investigates those variances that are unusually favorable or unfavorable or that have a material effect on the company.
Materials price variance (MPV) A variance from standard caused by paying a higher or lower price than the standard for materials purchased; computed as (Actual price – Standard price) x Actual quantity purchased.
Materials usage variance (MUV) A variance from standard caused by using more or less than the standard amount of materials to produce a product or complete a process; computed as (Actual quantity used – Standard quantity allowed) x Standard price.
Overhead Base The overhead base is how overhead is applied to a product and is typically based on direct labor hours, direct labor dollars or machine hours.
Practical standards Standards that are strict but attainable. Allowances are made for machinery problems and rest periods for workers. These standards are generally used in planning.
Standard cost A carefully predetermined measure of what a cost should be under stated conditions.
Standard level of output A carefully predetermined measure of what the expected level of output should be for a specified period of time, usually one year.
Variance A deviation of actual costs from standard costs; may be favorable or unfavorable. That is, actual costs may be less than or more than standard costs. Variances may relate to materials, labor, or manufacturing overhead.
Variable Overhead Spending variance (VOHSV) A variance from standard caused by incurring more actual variable overhead than the standard variable overhead cost to produce a product or complete a process; computed as (Actual variable OH rate -Standard variable OH rate) x Actual amount of base.
Variable Overhead Efficiency variance (VOHEV) A variance from standard caused by using more or less than the standard amount of overhead application base to produce a product or complete a process; computed as (Actual OH base – Standard OH base) x Standard variable OH rate per base.
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Short-Answer Questions
➢ Is a standard cost an estimated cost? What is the primary objective of employing standard costs in a cost system?
➢ What is a budget?
➢ What is the difference between ideal and practical standards? Which standard generally is used in planning?
➢ What is meant by the term management by exception?
➢ What are some advantages of using standard costs? What are some disadvantages?
➢ Describe how the materials price and usage variances would be computed from the following data:
➢ Standard—1 unit of material at \$20 per unit. Purchased—1,200 units of material at \$20.30; used—990 units. Production—1,000 units of finished goods.
➢ When might a given company have a substantial favorable materials price variance and a substantial unfavorable materials usage variance?
➢ What is the usual cause of a favorable or unfavorable labor rate variance? What other labor variance is isolated in a standard cost system? Of the two variances, which is more likely to be under the control of management? Explain.
➢ Identify the type of variance indicated by each of the following situations and indicate whether it is favorable or unfavorable:
• The cutting department of a company during the week ending July 15 cut 12 size-S cogged wheels out of three sheets of 12-inch high-tempered steel. Usually three wheels of such size are cut out of each sheet.
• A company purchased and installed an expensive new cutting machine to handle expanding orders. This purchase and the related depreciation had not been anticipated when the overhead was budgeted.
• Edwards, the band saw operator, was on vacation last week. Lands took her place for the normal 40-hour week. Edwards’ wage rate is \$12 per hour, while Lands’ is \$10 per hour. Production was at capacity last week and the week before.
➢ Theoretically, how would an accountant dispose of variances from standard? How does an accountant typically dispose of variances?
➢ Why are variances typically isolated as soon as possible?
➢ Is it correct to consider favorable variances as always being desirable? Explain.
➢ How does the use of standard costs permit the application of the principle of management by exception?
➢ How do standards help in controlling production costs?
Real world question Imagine you are making and selling pizzas for Domino’s Pizza. How would you set standards for one pizza to be made and delivered?
Exercises
Exercise A During July, the cutting department completed 8,000 units of a product that had a standard materials cost of 2 square feet per unit at \$2.40 per square foot. The actual materials purchased consisted of 16,400 square feet at \$2.20 per square foot, for a total cost of \$36,080. The actual material used this period was 16,160 square feet. Compute the materials price and usage variances. Indicate whether each is favorable or unfavorable.
Direct materials – 4 pounds at \$5 per pound \$20
Direct labor – 3 hours at \$6 per hour 18
Manufacturing overhead – 150% of direct labor 27
\$65
Exercise B Whitewater’s purchasing agent took advantage of a special offer from one of its suppliers to purchase 44,000 pounds of material at \$4.10 per pound. Assume 5,500 units were produced and 34,100 pounds of material were used. Compute the variances for materials. Comment on the purchasing agent’s decision to take the special offer.
Exercise C Compute the labor variances in the following situation:
Actual direct labor payroll (51,600 hours at \$18) \$928,800
Standard direct labor allowed per unit, 4.20 hours at \$19.20 80.64
Production for month (in units) 10,000
Exercise D Blackman Company manufactures a product that has a standard direct labor cost of four hours per unit at \$24 per hour. In producing 6,000 units, the foreman used a different crew than usual, which resulted in a total labor cost of \$26 per hour for 22,000 hours. Compute the labor variances and comment on the foreman’s decision to use a different crew.
Exercise E The following data relates to the manufacturing activities of Strauss Company for the first quarter of the current year:
Standard activity (in units) 30,000
Actual production (units) 24,000
Budgeted fixed manufacturing overhead \$36,000
Variable overhead rate (per unit) \$ 4.00
Actual fixed manufacturing overhead \$37,200
Actual variable manufacturing overhead \$88,800
Compute the variable overhead spending variance, variable overhead efficiency variance and the fixed overhead variance. (Assume overhead is applied based on units produced.)
Exercise F Assume that the actual production in the previous exercise was 26,000 units rather than 24,000. What was the variable overhead efficiency variance?
Problems
Problem A A product has a standard materials usage and cost of 4 pounds per unit at \$7.00 per pound. During the month, 2,400 pounds of materials were purchased at \$7.30 per pound. Production for the month totaled 550 units requiring 2,100 pounds of materials.
Compute the materials variances.
Problem B During December, a department completed 2,500 units of a product that has a standard materials usage and cost of 1.2 square feet per unit at \$0.48 per square foot. The actual material used consisted of 3,050 square feet at an actual cost of \$2,664.48. The actual purchase of this material amounted to 4,500 square feet at a total cost of \$3,931.20.
Prepare journal entries (a) for the purchase of the materials and (b) for the issuance of materials to production.
Problem C Martin Company makes plastic garbage bags. One box of bags requires one hour of direct labor at an hourly rate of \$6. The company produced 200,000 boxes of bags using 208,000 hours of direct labor at a total cost of \$1,144,000.
Compute the labor variances.
Problem D The finishing department of Mozart Company produced 25,000 units during November. The standard number of direct labor-hours per unit is two hours. The standard rate per hour is \$37.80. During the month, 51,250 direct labor-hours were worked at a cost of \$1,742,500.
Compute labor variances.
Problem E The standard amount of output for the Chicago plant of Worldworth Company is 50,000 units per month. Overhead is applied based on units produced. The flexible budget of the month for manufacturing overhead allows \$180,000 for fixed overhead and \$4.80 per unit of output for variable overhead. Actual overhead for the month consisted of \$181,440 of fixed overhead; the actual variable overhead follows.
Compute the overhead variances variance assuming the following actual production in units and actual variable overhead in dollars:
1. 37,500 and \$182,400.
2. 55,000 and \$270,480.
Problem F Based on a standard volume of output of 96,000 units per month, the standard cost of the product manufactured by Tahoe Company consists of:
Direct materials (0.25 pounds x \$8 per pound) \$2.00
Direct labor (0.5 hours x \$7.60 per hour) 3.80
Variable manufacturing overhead 2.50
Fixed manufacturing overhead (\$144,000 in total) 1.50
Total \$9.80
A total of 25,200 pounds of materials was purchased at \$8.40 per pound. During May, 98,400 units were produced with the following costs:
Direct materials used (24,000 pounds at \$8.40) \$201,600
Direct labor (50,000 hours at \$7.80) 390,000
Variable manufacturing overhead 249,000
Fixed manufacturing overhead 145,000
Compute the materials price and usage variances, the labor rate and efficiency variances, and the overhead budget and volume variances. (Overhead is applied based on units produced.)
Alternate problems
Alternate problem A The following data apply to Roseanne Company for August, when 2,500 units were produced:
Materials used: 16,000 pounds
standard materials per unit: 6 pounds at 5 per pound
Materials purchased: 24,000 pounds at\$4.80 per pound
Direct labor: 5,800 hours at a total cost of \$69,600
Standard labor per unit: 2 hours at \$11 per hour.
1. Compute the materials and labor variances.
2. Prepare journal entries to record the transactions involving these variances.
Alternate problem B During April, Shakespeare Company produced 15,000 units of a product called Creative. Creative has a standard materials cost of two pieces per unit at \$8 per piece. The actual materials used consisted of 30,000 pieces at a cost of \$230,000. Actual purchases of the materials amounted to 40,000 pieces at a cost of \$300,000.
Compute the two materials variances.
Alternate problem C Some of the records of Gonzaga Company’s repair and maintenance division were accidentally shredded. Salvaged records indicate that actual direct labor-hours for the period were 2,000 hours. The total labor variance was \$6,000, favorable. The standard labor rate was \$7 per direct labor-hour, and the labor rate variance was \$2,000, unfavorable.
Compute the actual direct labor rate per hour and prepare the journal entry to record the labor rate and the labor efficiency variances.
Alternate problem D All Fixed Overhead Company computes its overhead rate based on a standard level of output of 20,000 units. Fixed manufacturing overhead for the current year is budgeted at \$30,000. Actual fixed manufacturing overhead for the current year was \$31,000. Overhead is applied based on units produced.
Compute the amount of overhead volume variance for the year under each of the following assumptions regarding actual output:
1. 12,500 units.
2. 22,500 units.
Beyond the numbers—Critical thinking
Business decision case A Turn to the Sun City Company exercise in this chapter. For each of the variances listed, give a possible reason for its existence.
Business decision case B Diane La Hoya, the president of the Rebokk Company, has a problem that does not involve substantial dollar amounts but does involve the important question of responsibility for variances from standard costs. She has just received the following report:
Standard materials at standard price for the actual production in May \$9,000
Unfavorable materials price variance
(\$3.60 – \$3.00) x 3,450 pounds 2,070
Unfavorable materials usage variance
(3,450 – 3,000 pounds) x \$3 1,350
Total actual materials cost for the month of May
(3,450 pounds at \$3.60 per pound) \$12,420
La Hoya has discussed the unfavorable price variance with Jim Montel, the purchasing officer. Montel agrees that under the circumstances he should be held responsible for most of the materials price variance. But he objects to the inclusion of \$270 (450 pounds of excess materials used at \$0.60 per pound). This, he argues, is the responsibility of the production department. If the production department had not been so inefficient in the use of materials, he would not have had to purchase the extra 450 pounds.
On the other hand, Ken Kechum, the production manager, agrees that he is basically responsible for the excess quantity of materials used. But, he does not agree that the materials usage variance should be revised to include the \$270 of unfavorable price variance on the excess materials used. “That is Jim’s responsibility,” he says.
La Hoya now turns to you for help. Specifically, she wants you to tell her:
1. Who is responsible for the \$270 in dispute?
2. If responsibility cannot be clearly assigned, how should the accounting department categorize the variance (price or usage)? Why?
3. Are there likely to be other circumstances where materials variances cannot be considered the responsibility of the manager most closely involved with them? Explain.
Prepare written answers to the three questions La Hoya asked.
A broader perspective C Refer to “A broader perspective: Quality management and Balridge award”. The Baldrige Award has been criticized for fostering a winner-versus-loser mentality, instead of encouraging every organization to improve its quality. Further, the award has been criticized for grading on the curve by awarding companies that are the best in US industry but still do not compete well against foreign competition.
Write a response to each of these criticisms of the Baldrige Award.
Group project D Many workers hate standards. Some people claim standards reduce morale and productivity. Others believe standards are necessary to motivate people. Based on your own experience in school or on a job, what do you think?
In groups of three, choose an organization or business to use as an example. List all the possible standards you could set for this organization or business. Then decide whether your group favors setting standards. If the group does, decide who should set each of the standards on your list. If the group does not favor standards, discuss your reasons. Choose one member to report for your group to the class.
Group project E The chief executive officer (CEO) of Tax Preparation Services, Incorporated, remarked to a colleague, “Establishing standard costs and performing variance analysis is only useful for companies with inventories. As a service organization, how could we possibly benefit from implementing such a system?” 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 The controller of Plastics Manufacturing, Incorporated, states: “Let us figure the materials price variances when the materials are used rather than at the time of purchase. This way we can prepare the price and usage variances at the same time and directly link the price variance to production.” In groups of two or three students, write a memorandum to your instructor stating whether you agree with this suggestion 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.
Using the Internet—A view of the real world
Using any Internet search engine enter “standard costs” (be sure to include the quotation marks). Select an article that directly discusses standard costs and print a copy of the article. You are encouraged (but not required) to find an article that answers some of the following questions: When is the use of standard costing appropriate? How do certain industries use standard costing? How are standard costs established? How do standard costs help management in production?
Write a memorandum to your instructor summarizing the key points of the article. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter. Be sure to include a copy of the article used for this assignment.
Using any Internet search engine select one of the new terms at the end of the chapter and perform a key word search. Be sure to include quotation marks (for example: “Management by exception”). Select an article that directly discusses the new term used and print a copy of the article. Write a memorandum to your instructor summarizing the key points of the article. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter. Be sure to include a copy of the article used for this assignment.
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Study Plan: Performance Measurement
Knowledge Targets
I can define the following terms as they relate to our unit:
Decentralized
Profit Center
Cost Center Investment Center
Return on Investment Operating Assets Margin
Balanced Scorecard
Turnover
Residual Income Rate of Return Operating Income
Wait Time
Value-added Throughput Time Economic Value Added
Non-value added
Delivery Cycle Time Manufacturing Cycle Time
Reasoning Targets
• I can understand the difference between profit center, cost center and investment centers.
• I can understand the meaning of delivery cycle time, throughput time and manufacturing cycle efficiency.
• I can understand how to use a balanced scorecard.
• I can analyze projects or departments using return on investment and residual income.
Skill Targets
• I can calculate return on investment, margin and turnover for a company.
• I can calculate residual income for a company.
• I can compute delivery cycle time, throughput time and manufacturing cycle efficiency.
• I can construct a balanced scorecard.
9.02: Types of Costs
Product vs. Period Cost
A product cost is any cost related to creating a product and can be a direct or indirect cost. The key word is CREATING a product. Product costs are typically direct materials, direct labor and manufacturing overhead. These costs are not expensed until the product is actually sold, then it is reported as cost of goods sold on the income statement.
A period cost is NOT related to creating the product. These are costs necessary for the product to be sold or accounted for but not for actually making the product. A period cost is typically selling, general and administrative costs expensed on the income statement when it is incurred.
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Direct vs. Indirect Cost
A direct cost is a cost that can be directly tied or traced to a specific unit, department or process. Examples of a direct cost include direct materials, direct labor, sales salaries to the sales department, accounting dept salaries to the accounting department, etc.
An indirect cost is a cost that cannot be directly traced to a specific unit, department or process. Examples include manufacturing overhead, executive staff salaries, and even the Information Technology department salaries to all other departments.
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9.03: Responsibility Accounting in Management
Responsibility accounting
The term responsibility accounting refers to an accounting system that collects, summarizes, and reports accounting data relating to the responsibilities of individual managers. A responsibility accounting system provides information to evaluate each manager on the revenue and expense items over which that manager has primary control (authority to influence).
A responsibility accounting report contains those items controllable by the responsible manager. When both controllable and uncontrollable items are included in the report, accountants should clearly separate the categories. The identification of controllable items is a fundamental task in responsibility accounting and reporting.
To implement responsibility accounting in a company, the business entity must be organized so that responsibility is assignable to individual managers. The various company managers and their lines of authority (and the resulting levels of responsibility) should be fully defined. The organization chart below demonstrates lines of authority and responsibility that could be used as a basis for responsibility reporting.
To identify the items over which each manager has control, the lines of authority should follow a specified path. For example, in the picture above we show that a department supervisor may report to a store manager, who reports to the vice president of operations, who reports to the president. The president is ultimately responsible to stockholders or their elected representatives, the board of directors. In a sense, the president is responsible for all revenue and expense items of the company, since at the presidential level all items are controllable over some period. The president often carries the title, Chief Executive Officer (CEO) and usually delegates authority to lower level managers since one person cannot keep fully informed of the day-to-day operating details of all areas of the business.
The manager’s level in the organization also affects those items over which that manager has control. The president is usually considered a first-level manager. Managers (usually vice presidents) who report directly to the president are second-level managers. Notice on the organization chart that individuals at a specific management level are on a horizontal line across the chart. Not all managers at that level, however, necessarily have equal authority and responsibility. The degree of a manager’s authority varies from company to company.
While the president may delegate much decision-making power, some revenue and expense items remain exclusively under the president’s control. For example, in some companies, large capital (plant and equipment) expenditures may be approved only by the president. Therefore, depreciation, property taxes, and other related expenses should not be designated as a store manager’s responsibility since these costs are not primarily under that manager’s control.
The controllability criterion is crucial to the content of performance reports for each manager. For example, at the department supervisor level, perhaps only direct materials and direct labor cost control are appropriate for measuring performance. A plant manager, however, has the authority to make decisions regarding many other costs not controllable at the supervisory level, such as the salaries of department supervisors. These other costs would be included in the performance evaluation of the store manager, not the supervisor.
Watch this short video to further explain the concept of responsibility accounting and to give you a preview of the rest of the chapter.
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Decentralization is the dispersion of decision-making authority among individuals at lower levels of the organization. In other words, the extent of decentralization refers to the degree of control that segment managers have over the revenues, expenses, and assets of their segments. When a segment manager has control over these elements, the investment center concept can be applied to the segment. Thus, the more decentralized the decision making is in an organization, the more applicable is the investment center concept to the segments of the company. The more centralized the decision making is, the more likely responsibility centers are to be established as expense centers.
Some advantages of decentralized decision making are:
• Managing segments trains managers for high-level positions in the company. The added authority and responsibility also represent job enlargement and often increase job satisfaction and motivation.
• Top management can be more removed from day-to-day decision making at lower levels of the company and can manage by exception. When top management is not involved with routine problem solving, it can devote more time to long-range planning and to the company’s most significant problem areas.
• Decisions can be made at the point where problems arise. It is often difficult for top managers to make appropriate decisions on a timely basis when they are not intimately involved with the problem they are trying to solve.
• Since decentralization permits the use of the investment center concept, performance evaluation criteria such as ROI and residual income (to be explained later) can be used.
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Responsibility reports
Responsibility accounting provides reports to different levels of management. The amount of detail varies depending on the manager’s level in the organization. A performance report to a department manager of a retail store would include actual and budgeted dollar amounts of all revenue and expense items under that supervisor’s control. The report issued to the store manager would show only totals from all the department supervisors’ performance reports and any additional items under the store manager’s control, such as the store’s administrative expenses. The report to the company’s president includes summary totals of all the stores’ performance levels plus any additional items under the president’s control. In effect, the president’s report should include all revenue and expense items in summary form because the president is responsible for controlling the profitability of the entire company.
Management by exception is the principle that upper level management does not need to examine operating details at lower levels unless there appears to be a problem. As businesses become increasingly complex, accountants have found it necessary to filter and condense accounting data so that these data may be analyzed quickly. Most executives do not have time to study detailed accounting reports and search for problem areas. Reporting only summary totals highlights any areas needing attention and makes the most efficient use of the executive’s time.
The condensation of data in successive levels of management reports is justified on the basis that the appropriate manager will take the necessary corrective action. Thus, specific performance details need not be reported to superiors.
For example, if sales personnel costs have been excessively high in a particular department, that departmental manager should find and correct the cause of the problem. When the store manager questions the unfavorable budget variance of the department, the departmental supervisor can inform the store manager that corrective action was taken. Hence, it is not necessary to report to any higher authority that a particular department within one of the stores is not operating satisfactorily because the matter has already been resolved. Alternatively, if a manager’s entire store has been performing poorly, summary totals reported to the vice president of operations discloses this situation, and an investigation of the store manager’s problems may be indicated.
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In preparing responsibility accounting reports, companies use two basic methods to handle revenue or expense items. In the first approach, only those items over which a manager has direct control are included in the responsibility report for that management level. Any revenue and expense items that cannot be directly controlled are not included. The second approach is to include all revenue and expense items that can be traced directly or allocated indirectly to a particular manager, whether or not they are controllable. This second method represents a full-cost approach, which means all costs of a given area are disclosed in a single report. When this approach is used, care must be taken to separate controllable from noncontrollable items to differentiate those items for which a manager can and should be held responsible.
For accounting reports to be of maximum benefit, they must be timely. That is, accountants should prepare reports as soon as possible after the end of the performance measurement period. Timely reporting allows prompt corrective action to be taken. When reports are delayed excessively, they lose their effectiveness as control devices. For example, a report on the previous month’s operations that is not received until the end of the current month is virtually useless for analyzing poor performance areas and taking corrective action.
Companies also should issue reports regularly so that managers can spot trends. Then, appropriate management action can be initiated before major problems occur. Regular reporting allows managers to rely on reports and become familiar with their contents.
Firms should make the format of their responsibility reports relatively simple and easy to read. Confusing terminology should be avoided. Where appropriate, expressing results in physical units may be more familiar and understandable to some managers. To assist management in quickly spotting budget variances, companies can report both budgeted (expected) and actual amounts. A budget variance is the difference between the budgeted and actual amounts of an item. Because variances highlight problem areas (exceptions), they are helpful in applying the management-by-exception principle. To help management evaluate performance to date, responsibility reports often include both a current period and year-to-date analysis.
Responsibility reports—An illustration
Assume Macy’s has four management levels—the president, vice president of operations, store manager, and department manager. In this section, we show that a responsibility report would be prepared for each management level. We will begin with the lowest level, the Men’s department manager and work our way up to the president. We start at the lowest level because the totals from each level will be reported in the next highest level.
Only the individual manager’s controllable expenses are contained in these reports. For example, the store manager’s report includes only totals from the Men’s Clothing Department manager’s report. In turn, the report to the vice president includes only totals from the store manager’s report, and so on. Detailed data from the lower levels are summarized or condensed and reported at the next higher level.
Macy’s Corporation
Manger, Men’s Clothing Department
Responsibility Report
Actual Amount Budget Amount Over or (Under) Budget
Controllable Expenses This Month Year to Date This Month Year to Date This Month Year to Date
Inventory losses \$2,000 \$10,000 \$1,900 \$9,600 \$100 \$400
Supplies 1,800 8,500 \$1,000 \$7,550 800 950
Salaries 11,000 53,000 \$11,100 \$52,190 (100) 810
Overtime 2,000 14,500 \$1,200 \$14,360 800 140
Totals \$16,800 \$86,000 \$15,200 \$83,700 \$1,600 \$2,300
Macy’s Corporation
Store Manager
Responsibility Report
Actual Amount Budget Amount Over or (Under) Budget
Controllable Expenses This Month Year to Date This Month Year to Date This Month Year to Date
Children’s Clothing Department \$23,500 \$150,450 \$24,000 \$151,000 (\$500) (\$550)
Women’s Clothing Department \$31,000 \$157,700 \$32,500 \$158,000 (\$1,500) (\$300)
Men’s Clothing Department \$16,800 \$86,000 \$15,200 \$83,700 \$1,600 \$2,300
Shoe Department \$11,750 \$64,350 \$9,600 \$62,000 \$2,150 \$2,350
Accessories Department \$5,750 \$31,500 \$5,000 \$30,300 \$750 \$1,200
Totals 88,800 490,000 \$86,300 \$485,000 2,500 5,000
You can see that at each level, more and more costs become controllable. Also, the company introduces controllable costs not included on lower level reports into the reports for levels 3, 2, and 1. The only store cost not included at the store manager’s level is the store manager’s salary because it is noncontrollable by that store manager. It is, however, controllable by the store manager’s supervisor, the vice president of operations.
Macy’s Corporation
Vice President of Operations Responsibility Report
Actual Amount Budget Amount Over or (Under) Budget
Controllable Expenses This Month Year to Date This Month Year to Date This Month Year to Date
Vice president’s office expense \$2,840 \$9,500 \$3,340 \$17,500 (\$500) (\$8,000)
Store manager 88,800 490,000 \$86,300 \$485,000 2,500 5,000
Purchasing 5,300 32,500 \$4,300 \$30,500 1,000 2,000
Receiving 4,700 33,000 \$1,700 \$24,000 3,000 9,000
Salaries of store managers and heads of purchasing and receiving 27,000 135,000 \$27,000 \$135,000 -0- -0-
Totals \$128,640 \$700,000 \$122,640 \$692,000 \$6,000 \$8,000
Macy’s Corporation
President’s Responsibility Report
Actual Amount Budget Amount Over or (Under) Budget
Controllable Expenses This Month Year to Date This Month Year to Date This Month Year to Date
President’s office expense \$11,000 \$55,000 \$10,000 \$53,000 \$1,000 \$2,000
Vice president of operations 128,640 700,000 122,640 692,000 6,000 8,000
Vice president of marketing 18,700 119,000 \$14,700 \$111,000 4,000 8,000
Vice president of finance 14,000 115,000 \$6,000 \$106,000 8,000 9,000
Vice presidents’ salaries 29,000 145,000 \$29,000 \$145,000 -0- -0-
Totals \$201,340 \$1,134,000 \$182,340 \$1,107,000 \$19,000 \$27,000
Based on an analysis of these reports, the Men’s Clothing Department manager probably would take immediate action to see why supplies and overtime were significantly over budget this month. The store manager may ask the department manager what the problems were and whether they are now under control. The vice president may ask the same question of the store manager. The president may ask each vice president why the budget was exceeded this month and what corrective action has been taken.
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• A segment is a fairly autonomous unit or division of a company defined according to function or product line. Traditionally, owners have organized their companies along functional lines. The segments or departments organized along functional lines perform a specified function such as marketing, finance, purchasing, production, or shipping. Recently, large companies have tended to organize segments according to product lines such as an electrical products division, shoe department, or food division.
A responsibility center is a segment of an organization for which a particular executive is responsible. There are three types of responsibility centers—expense (or cost) centers, profit centers, and investment centers. In designing a responsibility accounting system, management must examine the characteristics of each segment and the extent of the responsible manager’s authority. Care must be taken to ensure that the basis for evaluating the performance of an expense center, profit center, or investment center matches the characteristics of the segment and the authority of the segment’s manager. The following sections of the chapter discuss the characteristics of each of these centers and the appropriate bases for evaluating the performance of each type.
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An expense center is a responsibility center incurring only expense items and producing no direct revenue from the sale of goods or services. Examples of expense centers are service centers (e.g. the maintenance department or accounting department) or intermediate production facilities that produce parts for assembly into a finished product. Managers of expense centers are held responsible only for specified expense items.
The appropriate goal of an expense center is the long-run minimization of expenses. Short-run minimization of expenses may not be appropriate. For example, a production supervisor could eliminate maintenance costs for a short time, but in the long run, total costs might be higher due to more frequent machine breakdowns.
Aprofit center is a responsibility center having both revenues and expenses. Because segmental earnings equal segmental revenues minus related expenses, the manager must be able to control both of these categories. The manager must have the authority to control selling price, sales volume, and all reported expense items. To properly evaluate performance, the manager must have authority over all of these measured items. Controllable profits of a segment result from deducting the expenses under a manager’s control from revenues under that manager’s control.
Closely related to the profit center concept is an investment center. An investment center is a responsibility center having revenues, expenses, and an appropriate investment base. When a firm evaluates an investment center, it looks at the rate of return it can earn on its investment base.
Typical investment centers are large, autonomous segments of large companies. The centers are often separated from one another by location, types of products, functions, and/or necessary management skills. Segments such as these often seem to be separate companies to an outside observer. But the investment center concept can be applied even in relatively small companies in which the segment managers have control over the revenues, expenses, and assets of their segments.
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• Two evaluation bases that include the concept of investment base in the analysis are ROI (return on investment) and RI (residual income).
Return on Investment (ROI)
A segment that has a large amount of assets usually earns more in an absolute sense than a segment that has a small amount of assets. Therefore, a firm cannot use absolute amounts of segmental income to compare the performance of different segments. To measure the relative effectiveness of segments, a company might use return on investment (ROI), which calculates the return (income) as a percentage of the assets employed (investment). The formula for ROI is:
ROI = Segment Income
Investment Base
For example, a segment that earns \$500,000 on an investment base of \$5,000,000 has an ROI of 10% (\$500,000 /\$5,000,000). Return on investment is reported as a percentage. The return on investments means how much income do we generate for every dollar of investment. In this example, ROI was 10% which means the company earns 10 cents on every \$1 of investment. To illustrate the difference between using absolute amounts and using percentages in evaluating a segment’s performance, consider the data in the table below for a company with three segments.
When using absolute dollars of income to evaluate performance, Segment B appears to be doing twice as well as Segment C. However, using ROI to evaluate the segments indicates that Segment C is really performing the best (25%), Segment B is next (20%), and Segment A is performing the worst (10%). Therefore, ROI is a more useful indicator of the relative performance of segments than absolute income.
This video will summarize the return on investment concept. Focus on the first 3 steps listed in the video.
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Determining the investment base to be used in the ROI calculation is a tricky matter. Normally, the assets available for use by the division make up its investment base. But accountants disagree on whether depreciable assets should be included in the ROI calculation at original cost, original cost less accumulated depreciation, or current replacement cost. Original cost is the price paid to acquire the assets. Original cost less accumulated depreciation is the book value of the assets—the amount paid less total depreciation taken. Current replacement cost is the cost of replacing the present assets with similar assets in the same condition as those now in use. A different rate of return results from each of these measures. Therefore, management must select and agree on an appropriate measure of investment base prior to making ROI calculations or interdivision comparisons.
Each of the valuation bases has merits and drawbacks, as we discuss next. First, cost less accumulated depreciation is probably the most widely used valuation base and is easily determined. Because of the many types of depreciation methods, comparisons between segments or companies may be difficult. Also, as book value decreases, a constant income results in a steadily increasing ROI even though the segment’s performance is unchanged. Second, the use of original cost eliminates the problem of decreasing book value but has its own drawback. The cost of old assets is much less than an investment in new assets, so a segment with old assets can earn less than a segment with new assets and realize a higher ROI. Third, current replacement cost is difficult to use because replacement cost figures often are not available, but this base does eliminate some of the problems caused by the other two methods. Whichever valuation basis is adopted, all ROI calculations that are to be used for comparative purposes should be made consistently.
Although ROI appears to be a quite simple and straightforward computation, there are several alternative methods for making the calculation. These alternatives focus on what is meant by income and investment. The table below shows various definitions and applicable situations for each type of computation.
Situation
Definition of Income
Definition of Investment
1. Evaluation of the earning power of the company. Do not use for segments or segment managers due to inclusion of non controllable expenses. Net income of the company.* Total assets of the company.†
2. Evaluation of rate of income contribution of segment. Do not use for segment managers due to inclusion of non controllable expenses. Contribution to indirect expenses. Assets directly used by and identified with the segment.
3. Evaluation of income performance of segment manager.
Controllable income. Begin with contribution to indirect expenses and eliminate any revenues and direct expenses not under the control of the segment manager.
Assets under the control of the segment manager.
* Often net operating income is used; this term is defined as income before interest and taxes.
Operating assets are often used in the calculation. This definition excludes assets not used in normal operations.
Even after the investment base is defined, problems may still remain because many segment managers have limited control over some of the items included in the investment base of their segment. For instance, top-level management often makes capital expenditure decisions for major store assets rather than allowing the segment managers to do so. Therefore, the segment manager may have little control over the store assets used by the segment. Another problem area may be the company’s centralized credit and collection department. The segment manager may have little or no control over the amount of accounts receivable included as segment assets because the manager cannot change the credit-granting or collection policies of the company.
Usually these problems are overcome when managers realize that if all segments are treated in the same manner, the inclusion of noncontrollable items in the investment base may have negligible effects. Then, comparisons of the ROI for all segments are based on a consistent treatment of items. To avoid adverse reactions or decreased motivation, segment managers must agree to this treatment.
Expanded form of ROI computation
The ROI formula breaks into two component parts:
ROI = Income x Sales
Sales Turnover
The first part of the formula, Income/Sales, is called margin or return on sales. The margin refers to the percentage relationship of income or profits to sales. This percentage shows the number of cents of profit generated by each dollar of sales. The second part of the formula, Sales/Investment, is called turnover. Turnover shows the number of dollars of sales generated by each dollar of investment. Turnover measures how effectively each dollar of assets was used.
A manager can increase ROI in the following three ways.
1. By concentrating on increasing the profit margin while holding turnover constant: Pursuing this strategy means keeping selling prices constant and making every effort to increase efficiency and thereby reduce expenses.
2. By concentrating on increasing turnover by reducing the investment in assets while holding income and sales constant: For example, working capital could be decreased, thereby reducing the investment in assets.
3. By taking actions that affect both margin and turnover: For example, disposing of nonproductive depreciable assets would decrease investment while also increasing income (through the reduction of depreciation expense). Thus, both margin and turnover would increase. An advertising campaign would probably increase sales and income. Turnover would increase, and margin might increase or decrease depending on the relative amounts of the increases in income and sales.
Residual Income
When a company uses ROI to evaluate performance, managers have incentives to focus on the average returns from their segments’ assets. However, the company’s best interest is served if managers also focus on the marginal returns.
Residual income (RI) is defined as the amount of income a segment has in excess of the segment’s investment base times its cost of capital percentage. Each company based on debt costs establishes its cost of capital coverage and desired returns to stockholders. The formula for residual income (RI) is:
RI = Income − (Investment x Cost of capital percentage)
When a company uses RI to evaluate performance, the segment rated as the best is the segment with the greatest amount of RI rather than the one with the highest ROI.
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Critics of the RI method complain that larger segments are likely to have the highest RI. In a given situation, it may be advisable to look at both ROI and RI in assessing performance or to scale RI for size.
A manager tends to make choices that improve the segment’s performance. The challenge is to select evaluation bases for segments that result in managers making choices that benefit the entire company. When performance is evaluated using RI, choices that improve a segment’s performance are more likely also to improve the entire company’s performance.
When calculating RI for a segment, the income and investment definitions are contribution to indirect expenses and assets directly used by and identified with the segment. When calculating RI for a manager of a segment, the income and investment definitions should be income controllable by the manager and assets under the control of the segment manager.
In evaluating the performance of a segment or a segment manager, comparisons should be made with (1) the current budget, (2) other segments or managers within the company, (3) past performance of that segment or manager, and (4) similar segments or managers in other companies. Consideration must be given to factors such as general economic conditions and market conditions for the product being produced. A superior segment in Company A may be considered superior because it is earning a return of 12%, which is above similar segments in other companies but below other segments in Company A. However, segments in Company A may be more profitable because of market conditions and the nature of the company’s products rather than because of the performance of the segment managers. Top management must use careful judgment whenever performance is evaluated.
To illustrate, assume the manager of Segment 3 below has an opportunity to take on a project involving an investment of \$100,000 that is estimated to return \$22,000, or 22%, on the investment with an income of \$22,000. Since the segment’s ROI is currently 25%, or \$250,000/\$1,000,000, the manager may decide to reject the project because accepting the project will cause the segment’s ROI to decline. Suppose however, from the company’s point of view, all projects earning greater than a 10%return should be accepted, even if they are lower than a particular segment’s ROI.
Before acceptance of the project by Segment 3, the amounts are as follows:
Segment A Segment B Segment C Total
(a) Income \$250,000 \$1,000,000 \$500,000 \$1,750,000
(b) Investment 2,500,000 5,000,000 2,000,000 9,500,000
Return on investment (a) ÷ (b) 10% 20% 25% 18.42%
Segment 1 Segment 2 Segment 3
a. Income \$ 100,000 \$ 500,000 \$ 250,000
b. Investment 1,000,000 2,500,000 1,000,000
c. Cost of capital 10% 10% 10%
d. Desired minimum income (b) x (c) \$ 100,000 \$ 250,000 \$ 100,000
e. Residual Income (RI) [a – d] -0- 250,000 150,000
If Segment 3 accepts the new project, the Residual Income (RI) would be calculated as:
Segment 3
a. Income \$272,000
b. Investment 1,100,000
c. Cost of capital x 10%
d. Desired minimum income (b) x (c) \$ 110,000
e. Residual Income (RI) [a – d] 162,000
The project opportunity for Segment 3 could earn in excess of the desired minimum ROI of 10%. In fact, the project generates RI of \$12,000 more for the segment. If RI were applied as the basis for evaluating segmental performance, the manager of Segment 3 would accept the project because doing so would improve the segment’s performance. That choice would also be beneficial to the entire company.
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Concepts used in segmental analysis
To understand segmental analysis, you need to know about the concepts of variable cost, fixed cost, direct cost, indirect cost, net income of a segment, and contribution to indirect expenses. Next, we describe each concept.
Costs may be either directly or indirectly related to a particular cost object. A cost object is a segment, product, or other item for which costs may be accumulated. In other words, a cost is not direct or indirect in and of itself. It is only direct or indirect in relation to a given cost object.
A direct cost (expense) is specifically traceable to a given cost object. An indirect cost (expense) is not traceable to a given cost object but has been allocated to it. Accountants can designate a particular cost (expense) as direct or indirect by reference to a given cost object. Thus, a cost that is direct to one cost object may be indirect to another. For instance, the salary of a segment manager may be a direct cost of a given manufacturing segment but an indirect cost of one of the products manufactured by that segment. In this example, the segment and the product are two distinct cost objects.
Because a direct cost is traceable to a cost object, the cost is likely to be eliminated if the cost object is eliminated. For instance, if the plastics segment of a business closes down, the salary of the manager of that segment probably is eliminated. Sometimes a direct cost would remain even if the cost object were eliminated, but this is the exception rather than the rule.
An indirect cost is not traceable to a particular cost object; therefore, it only becomes an expense of the cost object through an allocation process. For example, consider the depreciation expense on the company headquarters building that is allocated to each segment of the company. The depreciation expense is a direct cost for the company headquarters, but it is an indirect cost to each segment. If a segment of the company is eliminated, the indirect cost for depreciation assigned to that segment does not disappear; the cost is simply allocated among the remaining segments. In a given situation, it may be possible to identify an indirect cost that would be eliminated if the cost object were eliminated, but this would be the exception to the general rule.
Because the direct costs of a segment are clearly identified with that segment, these costs are often controllable by the segment manager. In contrast, indirect costs become segment costs only through allocation; therefore, most indirect costs are noncontrollable by the segment manager. Be careful, however, not to equate direct costs with controllable costs. For example, the salary of a segment manager may be direct to that segment and yet is noncontrollable by that manager because managers cannot specify their own salaries.
When preparing internal reports on the performance of segments of a company, management often finds it is important to classify expenses as fixed or variable and as direct or indirect to the segment. These classifications may be more useful to management than the traditional classifications of cost of goods sold, operating expenses, and nonoperating expenses that are used for external reporting in the company’s financial statements. As a result, many companies prepare an income statement for internal use with the format shown below.
Indirect Expenses not allocated to Segments
Segment A Segment B Total
Sales \$2,500,000 \$1,500,000 \$4,000,000
Less: Variable expenses 700,000 650,000 1,350,000
Contribution margin \$1,800,000 \$850,000 \$2,650,000
Less: Direct fixed expenses 450,000 550,000 1,000,000
Contribution to indirect expenses \$1,350,000 \$300,000 \$1,650,000
Less: Indirect fixed expenses 600,000
Net income \$1,050,000
This format is called the contribution margin format for an income statement because it shows the contribution margin. Contribution margin is defined as sales revenue less variable expenses. Notice that all variable expenses are direct expenses of the segment. The second subtotal in the contribution margin format income statement is the segment’s contribution to indirect expenses. Contribution to indirect expenses is defined as sales revenue less all direct expenses of the segment (both variable direct expenses and fixed direct expenses). The final total in the income statement is segmental net income, defined as segmental revenues less all expenses (direct expenses and allocated indirect expenses).
Earlier we stated that the performance of a profit center is evaluated on the basis of the segment’s profits. It is tempting to use segmental net income to make this evaluation since total net income is used to evaluate the performance of the entire company. The problem with using segmental net income to evaluate performance is that segmental net income includes certain indirect expenses that have been allocated to the segment but are not directly related to it or its operations. Because segmental contribution to indirect expenses includes only revenues and expenses directly related to the segment, this amount is often more appropriate for evaluation purposes.
To stress the importance of a segment’s contribution to indirect expenses, many companies prefer the contribution margin income statement format. Notice how the indirect fixed costs are not allocated to individual segments. Indirect fixed expenses appear only in the total column for the computation of net income for the entire company. The computation for each segment stops with the segment’s contribution to indirect expenses; this is the appropriate figure to use for evaluating the earnings performance of a segment. Only for the company as a whole is net income (revenues minus all expenses) computed; this is, of course, the appropriate figure to use for evaluating the company as a whole.
Arbitrary allocations of indirect fixed expenses As stated earlier, indirect fixed expenses, such as depreciation on the corporate administration building or on the computer facility maintained at company headquarters, can only be allocated to segments on some arbitrary basis. The two basic guidelines for allocating indirect fixed expenses are by the benefit received and by the responsibility for the incurrence of the expense.
Accountants can make an allocation on the basis of benefit received for certain indirect expenses. For instance, assume the entire company used a corporate computer for a total of 10,000 hours. If it used 4,000 hours, Segment K could be charged (allocated) with 40 per cent of the computer’s depreciation for the period because it received 40 per cent of the total benefits for the period.
For certain other indirect expenses, accountants base allocation on responsibility for incurrence. For instance, assume that Segment M contracts with a magazine to run an advertisement benefiting Segment M and various other segments of the company. Some companies would allocate the entire cost of the advertisement to Segment M because it was responsible for incurring the advertising expense.
To further illustrate the allocation of indirect expenses based on a measure of benefit or responsibility for incurrence, assume that Daily Company operates two segments, X and Y. It allocates the following indirect expenses to its two segments using the designated allocation bases:
Expense Allocation Base
Administrative office building occupancy expense, \$ 50,000 Net sales
Insurance expense, \$ 35,000 Cost of segmental plant assets
General administrative expenses, \$ 40,000 Number of employees
The following additional data are provided:
Segment X Segment Y Total
Net sales \$400,000 \$500,000 \$900,000
Segmental plant assets \$250,000 \$400,000 \$650,000
Number of employees 50 80 130
The following expense allocation schedule shows the allocation of indirect expenses:
Segment X Segment Y Total
Administrative office building occupancy expense \$22,222 \$27,778 \$50,000
[(400,000 / 900,000) x \$50,000 ] [(500,000 / 900,000) x \$50,000]
Insurance expense 13,462 21,538 35,000
[(250,000/650,000) x \$35,000] [(400,000 / 650,000) x \$35,000]
General administrative expenses 15,385 24,615 40,000
[(50 / 130) x \$40,000] [(80 / 130) x \$40,000]
When it uses neither benefit nor responsibility to allocate indirect fixed expenses, a company must find some other reasonable, but arbitrary, basis. Often, for lack of a better approach, a firm may allocate indirect expenses based on net sales. For instance, if Segment X’s net sales were 60% of total company sales, then 60% of the indirect expenses would be allocated to Segment X. Allocating expenses based on sales is not recommended because it reduces the incentive of a segment manager to increase sales because this would result in more indirect expenses being allocated to that segment. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/09%3A_Responsibility_Accounting_for_Cost_Profit_and_Investment_Centers/9.07%3A_Segmented_Income_Statements.txt |
How should the cost of national advertising by Whole Foods impact the performance report (and segment margin) for each store?
In October 2014, Whole Foods rolled out its first national advertising campaign in the United States. This advertising campaign is centered on the slogan “Values matter,” and is estimated to have a cost of \$20 million. The advertising will be on TV, in print, and online.
Questions
1. Would each of Whole Foods’ stores be considered to be a cost center, a revenue center, a profit center, or an investment center?
2. Assume that Whole Foods prepares performance reports for each of its stores. Would you expect to see a portion of the national advertising campaign cost in each store’s segment margin? Why or why not?
3. Assume now that the advertising campaign turns out to be quite successful because it increases Whole Foods’ visibility and results in increased sales across all stores in the U.S. Should the U.S. store managers be evaluated on the variance between the budgeted national advertising costs and the actual national advertising costs? Why or why not?
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9.09: Transfer Pricing
Transfer prices
Profit centers and investment centers inside companies often exchange products with each other. The Pontiac, Buick, and other divisions of General Motors buy and sell automobile parts from each other, for example. No market exchange takes place, so the company sets transfer prices that represent revenue to the selling division and costs to the buying division.
A transfer price is an artificial price used when goods or services are transferred from one segment to another segment within the same company. Accountants record the transfer price as a revenue of the producing segment and as a cost, or expense, of the receiving segment. Usually no cash actually changes hands between the segments. Instead, the transfer price is an internal accounting transaction.
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Segments are generally evaluated based on some measure of profitability. The transfer price is important because it affects the profitability of the buying and selling segments. The higher the transfer price, the better for the seller. The lower the transfer price, the better for the buyer.
Ideally, a transfer price provides incentives for segment managers to make decisions not only in their best interests but also in the interests of the entire company. For example, if the selling segment can sell everything it produces for \$100 per unit, the buying segment should pay the market price of \$100 per unit. A seller with excess capacity, however, should be willing to transfer a product to the buying segment for any price at or above the differential cost of producing and transferring the product to the buying segment (typically all variable costs).
In practice, companies mostly base transfer prices on (1) the market price of the product, (2) the cost of the product, or (3) some amount negotiated by the buying and selling segment managers.
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The balanced scorecard is a set of performance targets and results that show an organization’s performance in meeting its objectives to its stakeholders. It is a management tool that recognizes organizational responsibility to different stakeholder groups, such as employees, suppliers, customers, business partners, the community, and shareholders. Often different stakeholders have different needs or desires that the managers of the organization must balance. The concept of a balanced scorecard is to measure how well the organization is doing in view of those competing stakeholder concerns.
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An example of a balanced scorecard is shown in below. As you can see, the focus is to balance the efforts of the organization between the financial, customer, process, and innovative responsibilities.
Traditionally, business organizations have focused on financial results, which mainly have reflected the shareholders’ interests. In recent years, organizations have shifted attention to customer issues, such as quality and service, to employees, and to the community. For example, Ben & Jerry’s Ice Cream measures its social performance along with financial performance and presents a social audit in its annual report next to its financial audit (click SEAR to see the 2014 report). Johnson & Johnson’s code of conduct (click CODE to see it) makes it clear that the company has a responsibility to several competing stakeholders.
The balanced scorecard has been developed and used in many companies. It primarily has been used at the top management level to support the organization’s development of strategies. For example, Kaplan and Norton describe the development of the balanced scorecard at an insurance company as follows:
• Step 1: Ten of the company’s top executives formed a team to clarify the company’s strategy and objectives to meet responsibilities.
• Step 2: The top three layers of the company’s management (100 people) were brought together to discuss the new strategy and to develop performance measures for each part of the company. These performance measures became the scorecards for each part of the business and reflected the company’s desired balance in satisfying different stakeholders.
• Step 3: Managers began eliminating programs that were not contributing to the company’s objectives.
• Step 4: Top management reviewed the scorecards for each part of the organization.
**Based on R. S. Kaplan and D. P. Norton, “Using the Balanced Scorecard as a Strategic Management System,” Harvard Business Review, January-February 1996.
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9.11: Chapter 9 Key Points
Key Takeaways – Performance Measurement
• Managers and Department heads should be evaluated based on CONTROLLABLE costs or things that they can alter.
• Indirect costs from other departments can be allocated using whatever base the company had decided upon. The basic formula is Indirect Department Cost / Total Base to get our allocation rate. Then take the number of actual base used by the current department x allocation rate.
• Direct costs are costs that can be directly traced to a segment, department or product and can be either fixed or variable.
• Contribution to Indirect expenses by a segment is used to determine the amount of money the segments gives towards indirect (and often uncontrollable) expenses. It is calculated as Contribution Margin (Sales – Variable expenses) – direct fixed expenses.
• Return on Investment is calculated as Income / Investment Base. Return on investment tells you how many cents are earned in income for every dollar of investment base.
• Return on Investment can also be calculated as Margin (Income / Sales) x Turnover (Sales / Investment)
9.12: Glossary
GLOSSARY
Budget variance The difference between the budgeted and actual amounts of an item.
Contribution margin Sales revenues less variable expenses.
Contribution margin format An income statement format that shows the contribution margin (Sales$-$Variable expenses) for a segment.
Contribution to indirect expenses Sales revenue less all direct expenses of the segment.
Controllable profits of a segment Profit of a segment when expenses under a manager’s control are deducted from revenues under that manager’s control.
Cost object A segment, product, or other item for which costs may be accumulated.
Current replacement cost The cost of replacing the present assets with similar assets in the same condition as those now in use.
Decentralization The dispersion of decision-making authority among individuals at lower levels of the organization.
Direct cost (expense) A cost that is specifically traceable to a given cost object.
Expense center A responsibility center incurring only expense items and producing no direct revenue from the sale of goods or services. Examples include the accounting department and the maintenance department.
Indirect cost (expense) A cost that is not traceable to a given cost object but has been allocated to it.
Investment center A responsibility center having revenues, expenses, and an appropriate investment base.
Management by exception The principle that upper level management does not need to examine operating details at lower levels unless there appears to be a problem (an exception).
Margin (as used in ROI) The percentage relationship of income (or profits) to sales.
$\text{Margin}=\frac{\text{Income}}{\text{Sales}}\$
Original cost The price paid to acquire an asset.
Original cost less accumulated depreciation The book value of an asset—the amount paid less total depreciation taken.
Profit center A responsibility center having both revenues and expenses.
Residual income (RI), Economic Value Added The amount of income a segment has in excess of the investment base times the cost of capital percentage. Residual income is equal to $\text{Income}-(\text{Investment}\times\text{Cost of capital percentage})\$.
Responsibility accounting Refers to an accounting system that collects, summarizes, and reports accounting data relating to the responsibility of the individual managers. A responsibility accounting system provides information to evaluate each manager on revenue and expense items over which that manager has primary control.
Responsibility center A segment of an organization for which a particular executive is responsible.
Return on investment (ROI) Calculates the return (income) as a percentage of the assets employed (investment).
$\text{Return on investment}=\frac{\text{Income}}{\text{Investment}}\text{or}\frac{\text{Income}}{\text{Sales}}\times\frac{\text{Sales}}{\text{Investment}}\$
Segment A fairly autonomous unit or division of a company defined according to function or product line.
Segmental net income The final total in the income statement; segmental revenues less all expenses (direct expenses and allocated indirect expenses).
Transfer price An artificial price used when goods or services are transferred from one segment to another segment within the same company.
Turnover (as used in ROI) The number of dollars of sales generated by each dollar of investment.
$\text{Turnover}=\frac{\text{Sales}}{\text{Investment}}\$ | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/09%3A_Responsibility_Accounting_for_Cost_Profit_and_Investment_Centers/9.10%3A_Balanced_Scorecard.txt |
Short-Answer Questions, Exercises, and Problems
Short-Answer Questions
• What is the fundamental principle of responsibility accounting?
• List five important factors that should be considered in designing reports for a responsibility accounting system.
• How soon should accounting reports be prepared after the end of the performance measurement period? Explain.
• Name and describe three types of responsibility centers.
• Describe a segment of a business enterprise that is best treated as an expense center. List four indirect expenses that may be allocated to such an expense center.
• Compare and contrast an expense center and an investment center.
• What purpose is served by setting transfer prices?
• What is the advantage of using investment centers as a basis for performance evaluation?
• Which categories of items must a segment manager have control over for the investment center concept to be applicable?
• What is the connection between the extent of decentralization and the investment center concept?
• Give some of the advantages of decentralization.
• Differentiate between a direct cost and an indirect cost of a segment. What happens to these categories if the segment to which they are related is eliminated?
• Is it possible for a cost to be direct to one cost object and indirect to another cost object? Explain.
• Describe some of the methods by which indirect expenses are allocated to a segment.
• Give the general formula for return on investment (ROI). What are its two components?
• Give the three sets of definitions for income and investment that can be used in ROI calculations, and explain when each set is applicable.
• Give the various valuation bases that can be used for plant assets in investment center calculations. Discuss some of the advantages and disadvantages of these methods.
• In what way is the use of the residual income (RI) concept superior to the use of ROI?
• How is residual income (RI) determined?
• If the RI for segment manager A is \$50,000 while the RI for segment manager B is \$100,000, does this necessarily mean that B is a better manager than A? Explain.
• Real world question Refer to the annual report of a publicly traded company. Which of the company’s geographic regions performed better? Explain.
• (Based on Appendix) Briefly discuss the two methods of allocating service department costs.
Exercises
Exercise A The following information refers to the inspection department of a chemical packaging plant for September:
Amount
Over or (Under) Budget
Supplies
\$ 54,000
\$ (10,800)
Repairs and maintenance
270,000
21,600
Overtime paid to inspectors
108,000
10,800
Salary of inspection department manager
32,400
(5,400)
Salary of plant manager
43,200
-0-
Allocation of company accounting costs
32,400
10,800
Allocation of building depreciation to the inspection department
21,600
(5,400)
Using this information, prepare a responsibility report for the manager of the inspection department for September. Include those items for which you think the inspection department manager would be held responsible.
Exercise B Present the following information for the Hardware Division of ABC Computer Company,
Sales
\$ 1,400,000
Variable selling and administrative expenses
100,000
Fixed direct manufacturing expenses
35,000
Fixed indirect manufacturing expenses
56,000
Variable manufacturing expenses
400,000
Fixed direct selling and administrative expenses
175,000
Fixed indirect selling and administrative expenses
28,000
Exercise C Given the following data, prepare a schedule that shows contribution margin, contribution to indirect expenses, and net income of the Sharks Division of Hockey, Inc.:
Direct fixed expenses
\$ 324,000
Indirect fixed expenses
259,200
Sales
2,100,000
Variable expenses
1,500,000
What would be the effect on the company income if the segment were eliminated?
Exercise D Three segments (A, B, and C) of Trump Enterprises have net sales of \$300,000, \$150,000, and \$50,000, respectively. A decision is made to allocate the pool of \$25,000 of administrative overhead expenses of the home office to the segments, using net sales as the basis for allocation.
a. How much of the \$25,000 should be allocated to each segment?
b. If Segment C is eliminated, how much of the \$25,000 will be allocated to A and B?
Exercise E Two segments (Mountain Bike and Road Bike) showed the following data for the most recent year:
Mountain bike
Road bike
Contribution to indirect expenses
\$ 840,000
\$ 504,000
Assets directly used by and identified with the segment
2,520,000
2,184,000
Sales
3,360,000
6,720,000
a. Calculate return on investment for each segment in the most direct manner.
b. Calculate return on investment using the margin and turnover components.
Exercise F Calculate the new margin, turnover, and return on investment of the Mountain Bike segment for each of the following changes. Consider each change independently of the others.
a. Direct variable expenses were reduced by \$33,600. Sales and assets were unaffected.
b. Assets used by the segment were reduced by \$540,000, while income and sales were unaffected.
c. An advertising campaign increased sales by \$336,000 and income by \$50,000. Assets directly used by the segment were unaffected.
Exercise G The following data are available for Segment A of ABC Company:
Net income of the segment
\$ 50,000
Contribution to indirect expenses
40,000
Controllable income by manager
48,000
Assets directly used by the manager
360,000
Assets under the control of the segment manager
240,000
Determine the return on investment for evaluating (a) the income performance of the manager of Segment A and (b) the rate of income contribution of the segment.
Exercise H Travel Company has three segments: Air, Land, and Sea. Data concerning income and investment follow:
Air
Land
Sea
Contribution to indirect expenses
\$ 43,200
\$ 86,400
\$ 115,200
Assets directly used by and identified with the segment
288,000
576,000
1,296,000
Assuming that the cost of capital on investment is 12%, calculate the residual income of each of the segments. Do the results indicate that any of the segments should be eliminated?
Problems
Problem A You are given the following information for Farflung Company for the year ended 2009 December 31. The company is organized according to functions:
Plant Manager
Vice President Of Manufacturing
President
Controllable expenses
Budget
Actual
Budget
Actual
Budget
Actual
Office expense
\$ 7,200
\$ 9,600
\$ 12,000
\$ 16,800
\$ 24,000
\$ 16,800
Printing
19,200
16,800
Paging
2,400
2,160
Binding
4,800
4,800
Purchasing
24,000
26,400
Receiving
12,000
14,400
Inspection
19,200
16,800
Vice president of marketing
192,000
168,000
Controller
144,000
120,000
Treasurer
96,000
72,000
Vice president of personnel
48,000
72,000
Prepare the responsibility accounting reports for the three levels of management—plant manager, vice president of manufacturing, and president.
Problem B Joey Bauer Corporation has production plants in Sacramento, Dallas, and Seattle. Following is a summary of the results for past year:
Plant
Revenues
Expenses
Investment base (gross assets)
Sacramento
\$ 450,000
\$ 225,000
\$ 4,500,000
Dallas
450,000
180,000
3,375,000
Seattle
675,000
247,500
7,200,000
a. If the plants are treated as profit centers, which plant manager appears to have done the best job?
b. If the plants are treated as investment centers, which plant manager appears to have done the best job? (Assume the plant managers are evaluated by return on investment on gross assets.)
c. Do the results of profit center analysis and investment center analysis give different findings? If so, why?
Problem C Quinn Company allocates all of its home office expenses to its two segments, A and B. Allocations are based on the following selected expense account balances and additional data:
Expenses (allocation bases)
Home office building expense (net sales)
\$ 76,800
Buying expense (net purchases)
67,200
Uncollectible accounts (net sales)
8,000
Depreciation of home office equipment (net sales)
21,120
Advertising expense (indirect, allocated on basis of relative amounts of direct advertising)
86,400
Insurance expense (relative amounts of equipment plus average inventory in department)
23,040
Segment A
Segment B
Total
Purchases (net)
\$ 243,200
\$ 76,800
\$ 320,000
Sales (net)
512,000
128,000
640,000
Equipment (cost)
96,000
64,000
160,000
Advertising (cost)
25,600
12,800
38,400
Average inventory
160,000
64,000
224,000
a. Prepare a schedule showing the amounts of each type of expense allocable to Segments X and Y using these data and bases of allocation.
b. Evaluate and criticize these allocation bases.
Problem D Allentown, Inc., is a company with two segments, X and Y. Its revenues and expenses for 2009 follow:
Segment X
Segment Y
Total
Net sales
\$ 96,000
\$ 144,000
\$ 240,000
Direct expenses:*
Cost of goods sold
45,000
99,000
144,000
Selling
13,680
7,200
20,880
Administrative:
Uncollectible accounts
3,000
1,800
4,800
Insurance
2,400
1,200
3,600
Interest
480
240
720
Indirect expenses (all fixed):
Selling
18,000
Administrative
25,200
* All the direct expenses are variable except insurance and interest, which are fixed.
a. Prepare a schedule showing the contribution margin, the contribution to indirect expenses of each segment, and net income for the company as a whole. Do not allocate indirect expenses to the segments.
b. Assume that indirect selling expenses are to be allocated on the basis of net sales and that indirect administrative expenses are to be allocated on the basis of direct administrative expenses. Prepare a statement (starting with the contribution to indirect expenses) that shows the net income of each segment.
c. Comment on the appropriateness of the income amounts shown in parts (a) and (b) for determining the income contribution of the segments.
Problem E The following data pertain to the operating revenues and expenses for Golden State Company for 2009:
Los Angeles
(LA) Segment
San Francisco
(SF) Segment
Total
Sales
\$ 180,000
\$ 360,000
\$ 540,000
Variable expenses
96,000
240,000
336,000
Direct fixed expenses
24,000
30,000
54,000
Indirect fixed expenses
72,000
Regarding the company’s total operating assets of \$900,000, the following facts exist:
Los Angeles
Segment
San Francisco
Segment
Assets directly used by and identified with the segment
\$ 180,000
\$ 360,000
a. Prepare a statement showing the contribution margin of each segment, the contribution to indirect expenses of each segment, and the total income of Golden State Company.
b. Determine the return on investment for evaluating (1) the earning power of the entire company and (2) the performance of each segment.
c. Comment on the results of part (b).
Problem F Shaq Company operates with three segments, Louisiana, Orlando, and LA. Data regarding these segments follow:
Louisiana
segment
Orlando
segment
LA
segment
Contribution to indirect expenses
\$ 324,000
\$ 180,000
\$ 144,000
Assets directly used and identified with the segment
1,800,000
1,440,000
720,000
a. Calculate the return on investment for each segment. Rank them from highest to lowest.
b. Assume the cost of capital is 12% for a segment. Calculate residual income for each segment. Rank them from highest to lowest.
c. Repeat (b), but assume the cost of capital is 17% for a segment. Rank them from highest to lowest.
d. Comment on the rankings achieved.
Problem G The manager of the Winston Company faced the following data for the year 2009:
Contribution to indirect expenses
\$ 1,800,000
Assets directly used by and identified with the segment
22,500,000
Sales
36,000,000
a. Determine the margin, turnover, and return on investment for the segment in 2009.
b. Determine the effect on margin, turnover, and return on investment of the segment in 2010 if each of the following changes were to occur. Consider each change separately and assume that any items not specifically mentioned remain the same as in 2009:
A campaign to control costs resulted in \$180,000 of reduced expenses.
Certain nonproductive assets were eliminated. As a result, investment decreased by \$900,000, and expenses decreased by \$72,000.
An advertising campaign resulted in increasing sales by \$3,600,000, cost of goods sold by \$2,700,000, and advertising expense by \$540,000.
An investment was made in productive assets costing \$900,000. As a result, sales increased by \$360,000, and expenses increased by \$54,000.
Problem H For the year ended 2009 December 31, Fore Company reported the following information for the company as a whole and for the sports segment of Fore Corporation:
Sports Segment
Fore
company
Woods
Project
Irons
Project
Total
Sales
\$12,000,000
\$1,350,000
\$600,000
\$1,950,000
Income
1,125,000
300,000
37,500
337,500
Investment
4,500,000
900,000
105,000
1,005,000
Fore Company anticipates that these relationships (return on investment, margin, and turnover) will hold true for the upcoming year. The sports segment is faced with the possibility of adding a new project in 2010, with the following projected data:
Putters
Project
Sales
\$450,000
Income
52,500
Investment
187,500
a. Determine the return on investment for Fore Company, for the sports segment, and for the Woods and Irons projects separately for the year ended 2009 December 31.
b. Using this information, determine the effect of adding the Putters project on the sports segment’s return on investment. What problem may be encountered?
Using the data provided in the previous problem, determine the residual income (1) for all three projects and (2) for the sports segment with and without the Putters project, if the cost of capital is 25%. What is the effect on the sport segment’s residual income if the Putter project is added? How does this result compare with your answer to the previous problem?
Alternate problems
Alternate problem A Swiss Corporation has three production plants (X, Y, and Z). Following is a summary of the results for January 2009:
Plant
Revenues
Expenses
Investment
Base
(gross assets)
X
\$ 720,000
\$ 300,000
\$ 1,440,000
Y
960,000
180,000
1,920,000
Z
5,040,000
1,920,000
13,200,000
a. If the plants are treated as profit centers, which plant manager appears to have done the best job?
b. If the plants are treated as investment centers, which plant manager appears to have done the best job? (Assume the plant managers are evaluated by return on investment.)
c. Do the results of profit center analysis and investment center analysis give different findings? If so, why?
Alternate problem B Easy Loans, Inc., allocates expenses and revenues to the two segments that it operates. Easy Loans extends credit to customers under a revolving charge plan whereby all account balances not paid within 30 days are charged interest at the rate of 11/2% per month.
Following are selected revenue and expense accounts and some additional data needed to complete the allocation of the one revenue amount and the expenses.
Revenue and Expenses (allocation bases)
Revolving charge service revenue (net sales)
\$600,000
Home office building occupancy expense (net sales)
45,000
Buying expenses (net purchases)
150,000
General administrative expenses (number of employees in
department)
75,000
Insurance expense (relative average inventory plus cost
of equipment and fixtures in each department)
18,000
Depreciation expense on home office equipment (net sales)
30,000
High Risk
Segment
Low Risk
Segment
Total
Number of employees
3
7
10
Net sales
\$ 300,000
\$ 600,000
\$ 900,000
Net purchases
240,000
360,000
600,000
Averaging inventory
60,000
120,000
180,000
Cost of equipment fixtures
90,000
180,000
270,000
a. Prepare a schedule showing allocation of these items to the High and Low Risk segments.
b. Do you think these are good allocation bases? Why or why not?
Alternate problem C Student Painters, Inc., operates two segments, interior and exterior. The revenue and expense data for 2009 follow:
Interior
Exterior
Total
Net sales
\$ 335,700
553,800
\$ 889,500
Direct expenses:*
Cost of goods sold
186,000
282,000
468,000
Selling
31,800
27,000
58,800
Administrative
9,000
6,000
15,000
Uncollectible accounts
2,400
6,600
9,000
Indirect expenses (all fixed):
Selling
126,000
Administrative
156,000
*All the direct expenses are variable except administrative expense, which is fixed.
a. Prepare a schedule showing the contribution margin, the contribution to indirect expenses of each segment, and net income for the company as a whole. Do not allocate indirect expenses to the segments.
b. Assume that indirect selling expenses are to be allocated to segments on the basis of net sales (round to the nearest%) and that indirect administrative expenses are to be allocated on the basis of direct administrative expenses. Prepare a statement (starting with the contribution to indirect expenses) which shows the net income of each segment.
c. Comment on the appropriateness of the income amounts shown in parts (a) and (b) for determining the income contribution of the segments.
Alternate problem D Elliott Corporation has three segments. Following are the results of operations for 2009:
Segment A
Segment B
Segment C
Total
Sales
\$36,000,000
\$ 21,600,000
\$ 14,400,000
\$ 72,000,000
Variable expenses
25,920,000
12,240,000
9,720,000
47,880,000
Fixed expenses:
Direct
5,040,000
1,800,000
720,000
7,560,000
Indirect
3,600,000
For the company’s total operating assets of \$100,800,000, the following facts exist:
Segment A
Segment B
Segment C
Assets directly used by and
identified with the segment
\$ 50,400,000
\$ 28,800,000
\$ 14,400,000
a. Prepare a statement (in thousands of dollars) showing the contribution margin, the contribution to indirect expenses for each segment, and the total income of the Elliott Corporation.
b. Determine the return on investment for evaluating (1) the performance of the entire company and (2) performance of each segment.
c. Comment on the results of part (a).
Alternative problem E Goodwin Company has three segments, 1,2, and 3. Data regarding these segments follow:
Segment 1
Segment 2
Segment 3
Contribution to indirect expenses
\$ 432,000
\$ 208,800
\$ 72,000
Assets directly used by and identified
with the segment
3,600,000
1,440,000
360,000
a. Calculate the return on investment for each segment. Rank them from highest to lowest.
b. Assume the cost of capital is 10% for a segment. Calculate the residual income for each segment. Rank them from highest to lowest.
c. Repeat (b), but assume the desired cost of capital is 14%. Rank the segments from highest to lowest.
d. Comment on the rankings achieved.
Beyond the numbers—Critical thinking
Business decision case A Texas Company manufactures skateboards. Because the company’s business is seasonal, between August and December skilled manufacturing employees are laid off. To improve morale, the financial vice president suggested that 10 employees not be laid off in the future. Instead, she suggested that they work in general labor from August to December but still be paid their manufacturing wages of \$10 per hour. General labor personnel earn \$6.60 per hour. What are the implications of this plan for the assignment of costs to the various segments of the business?
Business decision case B Piero Company builds new homes. Sarah Richards is in charge of the construction department. Among other responsibilities, Sarah hires and supervises the carpenters and other workers who build the homes. Piero Company does not do its own foundation work. The construction of foundations is done by subcontractors hired by Leslie Larue of the procurement department.
To start the development of a 500-home community, Larue hired Dire Company to build the foundations for the homes. On the day construction was to begin, Dire Company went out of business. Consequently, construction was delayed six weeks while Larue hired a new subcontractor. Which department should be charged with the cost of the delay in construction? Why?
Business decision case C Ken Silva is the supervisor of Department 103 of Laguna Company. The annual budget for Silva’s department is as follows:
Annual budget for Department 103
Small tools
\$ 6,750
Set up
7,500
Direct labor
8,250
Direct materials
15,000
Supplies
3,750
Supervision
22,500
Property taxes
3,750
Property insurance
750
Depreciation, machinery
1,500
Depreciation, building
1,500
Total
\$ 71,250
Silva’s salary of \$15,000 is included in supervision. The remaining \$7,500 in supervision is the salary of the assistant supervisor directly responsible to Silva. Identify the budget items that Silva controls.
Broader perspective – Writing experience D Refer to “A broader perspective: Employee buyouts”. Write a brief report explaining the effects of employee buyouts on employee motivation.
Group project E Macrofast Software, Inc., faces stiff competition in selling its products. Macrofast’s top management feels considerable pressure from the company’s stockholders to increase earnings.
Mac Washington, the vice president of marketing at the company’s Production Software Division, received a memorandum from top management that said, in effect, “Increase your division’s earnings or look for a new job”.
Washington could think of only one way to increase earnings by the end of the year. The Production Software Division had several installations that should be completed early the following year, probably in February or March. For each of those jobs, he asked the customers to sign a Completed Installation document stating the job was completed to the customer’s satisfaction. He did this because Macrofast’s accounting department would record the revenue from the job when it received the Completed Installation document.
Several customers signed Completed Installation documents even though the jobs were not complete because Washington gave them a personally signed letter stating the Completion Installation document was not legally binding.
The scheme initially worked. Revenues were prematurely recorded for these jobs, sales and earnings for the year were up, Macrofast’s top management was delighted with the results, and Washington was rewarded with a large bonus and a promotion to a vice presidency at corporate headquarters.
The following June, a staff accountant discovered the scheme when a customer called to complain that he was being billed for a job that was not yet completed. When the accountant produced the customer’s Completed Installation document, the customer produced Washington’s letter saying the document was not binding. The accountant did some detective work and unearthed the scheme. When she presented the results to her supervisor, the supervisor said, “This practice is unfortunate and is against company policy. But what is done is done. Do not worry about last year’s financial statements. Just be sure it does not happen again.”
a. In teams of four, discuss what the staff accountant should do.
b. Then, decide how your solution would change if all jobs had been completed to the customers’ satisfaction.
c. As a team, write a memorandum to your instructor describing your solutions. The heading of the memo should contain the date, to whom it is written, from whom, and the subject matter.
Group project F Bleak Prospects, Inc., found that its market share was slipping. Division managers were encouraged to maximize ROI and made decisions consistent with that goal. Nonetheless, there were frequent customer complaints, with resulting loss of business. Moreover, Bleak depended on an established product line and was unable to find new products for expansion while its competitors seemed to be able to generate new products almost yearly. What would you suggest Bleak Prospects’ management do to improve the situation? In groups of two or three students, write a memorandum to your instructor addressing this question. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.
Group project G Management of Division A is evaluated based on residual income measures. The division can either rent or buy a certain asset. Will the performance evaluation technique have an impact on the rent-or-buy decision? Why or why not? In groups or three students, write a memorandum to your instructor addressing this question. 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 PepsiCo, Incorporated.
http://www.pepsico.com
Go to the company’s most recent annual report. Compare the performance of PepsiCo’s three business segments: (1) beverages, (2) snack foods, and (3) restaurants. (You will find business segment information in the notes to the financial statements.) Which business segment had the most operating profits? Which business performed better using ROI, profit margin, and asset turnover as the performance measures? Use end-of-year “identifiable assets” to measure investment, “operating profits” to measure income, and “net sales” to measure sales. Be sure to submit a copy of PepsiCo’s business segment information from the annual report.
Visit the website for PepsiCo, Incorporated.
http://www.pepsico.com
Go to the company’s most recent annual report. Using financial information for the most recent year, which of the company’s geographic areas had the highest ROI? (You will find business segment information in the notes to the financial statements, including geographic segments.) Use end-of-year “identifiable assets” to measure investment, “operating profits” to measure income, and “net sales” to measure sales. Be sure to submit a copy of PepsiCo’s business segment information from the annual report. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/09%3A_Responsibility_Accounting_for_Cost_Profit_and_Investment_Centers/9.13%3A_Chapter_9-_Exercises.txt |
Study Plan: Relevant Costing for Managers
Knowledge Targets
I can define the following terms as they relate to our unit:
Avoidable Cost Constraint Make or Buy Differential Cost
Differential Revenue Joint Product Joint Cost Opportunity Cost
Sunk Cost Relevant Benefit Relevant Cost Sells or Process further
Special Order Split Off Point Constrained Resource
Reasoning Targets
• I can identify costs as relevant, avoidable, opportunity or sunk cost.
• I can classify costs as relevant or not relevant.
• I can determine value and use of a constrained resource.
Skill Targets
• I can prepare an analysis showing if a product line or business segment should be dropped or added.
• I can prepare make or buy analysis.
• I can prepare analysis showing whether a special order should be accepted or rejected.
• I can prepare an analysis showing whether a joint product should be sold at the split off point or processed further.
Click Relevant Costs for a printable copy.
10.02: Differential Analysis
• Differential analysis
Differential analysis involves analyzing the different costs and benefits that would arise from alternative solutions to a particular problem. Relevant revenues or costs in a given situation are future revenues or costs that differ depending on the alternative course of action selected. Differential revenue is the difference in revenues between two alternatives. Differential cost or expense is the difference between the amounts of relevant costs for two alternatives.[1]
Future costs that do not differ between alternatives are irrelevant and may be ignored since they affect both alternatives similarly. Past costs, also known as sunk costs, are not relevant in decision making because they have already been incurred; therefore, these costs cannot be changed no matter which alternative is selected.
For certain decisions, revenues do not differ between alternatives. Under those circumstances, management should select the alternative with the least cost. In other situations, costs do not differ between alternatives. Accordingly, management should select the alternative that results in the largest revenue. Many times both future costs and revenues differ between alternatives. In these situations, the management should select the alternative that results in the greatest positive difference between future revenues and expenses (costs).
To illustrate relevant, differential, and sunk costs, assume that Joanna Bennett invested \$400 in a tiller so she could till gardens to earn \$1,500 during the summer. Not long afterward, Bennett was offered a job at a horse stable feeding horses and cleaning stalls for \$1,200 for the summer. The costs that she would incur in tilling are \$100 for transportation and \$150 for supplies. The costs she would incur at the horse stable are \$100 for transportation and \$50 for supplies. If Bennett works at the stable, she would still have the tiller, which she could loan to her parents and friends at no charge.
The tiller cost of \$400 is not relevant to the decision because it is a sunk cost. The transportation cost of \$100 is also not relevant because it is the same for both alternatives. These costs and revenues are relevant (note: differential means difference):
Performing tilling service Working at horse stable Differential
Revenues \$1,500 \$1,200 \$300
Costs 150 50 100
Net benefit in favor of tilling service \$200
Based on this differential analysis, Joanna Bennett should perform her tilling service rather than work at the stable. Of course, this analysis considers only cash flows; nonmonetary considerations, such as her love for horses, could sway the decision.
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In many situations, total variable costs differ between alternatives while total fixed costs do not. For example, suppose you are deciding between taking the bus to work or driving your car on a particular day. The differential costs of driving a car to work or taking the bus would involve only the variable costs of driving the car versus the variable costs of taking the bus.
Suppose the decision is whether to drive your car to work every day for a year versus taking the bus for a year. If you bought a second car for commuting, certain costs such as insurance and an auto license that are fixed costs of owning a car would be differential costs for this particular decision.
Before studying the applications of differential analysis, you must realize that opportunity costs are also relevant in choosing between alternatives. An opportunity cost is the potential benefit that is forgone by not following the next best alternative course of action. For example, assume that the two best uses of a plot of land are as a mobile home park (annual income of \$100,000) and as a golf driving range (annual income of \$60,000). The opportunity cost of using the land as a mobile home park is \$60,000, while the opportunity cost of using the land as a driving range is \$100,000.
Companies do not record opportunity costs in the accounting records because they are the costs of not following a certain alternative. Thus, opportunity costs are not transactions that occurred but that did not occur. However, opportunity cost is a relevant cost in many decisions because it represents a real sacrifice when one alternative is chosen instead of another.
In the next section, we will look at examples of differential analysis.
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• Differential Analysis - Concepts. Authored by: Christy Lynch Chauvin. Located at: youtu.be/ZtATVI1Oeyo. License: All Rights Reserved. License Terms: Standard YouTube License | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/10%3A_Differential_Analysis_(or_Relevant_Costs)/10.01%3A_Chapter_10_Study_Plan.txt |
Applications of differential analysis
To illustrate the application of differential analysis to specific decision problems, we consider five decisions:
1. setting prices of products;
2. accepting or rejecting special orders;
3. adding or eliminating products, segments, or customers;
4. processing or selling joint products; and
5. deciding whether to make products or buy them.
Although these five decisions are not the only applications of differential analysis, they represent typical short-term business decisions using differential analysis. Our discussion ignores income taxes.
Pricing Decisions
When applying differential analysis to pricing decisions, each possible price for a given product represents an alternative course of action. The sales revenues for each alternative and the costs that differ between alternatives are the relevant amounts in these decisions. Total fixed costs often remain the same between pricing alternatives and, if so, may be ignored. In selecting a price for a product, the goal is to select the price at which total future revenues exceed total future costs by the greatest amount, thus maximizing income.
A high price is not necessarily the price that maximizes income. The product may have many substitutes. If a company sets a high price, the number of units sold may decline substantially as customers switch to lower-priced competitive products. Thus, in the maximization of income, the expected volume of sales at each price is as important as the contribution margin per unit of product sold. In making any pricing decision, management should seek the combination of price and volume that produces the largest total contribution margin. This combination is often difficult to identify in an actual situation because management may have to estimate the number of units that can be sold at each price.
For example, assume that a company selling fried chicken in the New York market estimates product demand for its large bucket of chicken for a particular period to be:
Choice Demand
1 15,000 units at \$6 per unit
2 12,000 units at \$7 per unit
3 10,000 units at \$8 per unit
4 7,000 units at \$9 per unit
The company’s fixed costs of \$20,000 per year are not affected by the different volume alternatives. Variable costs are \$5 per unit. What price should be set for the product? Based on the calculations shown in the table below, the company should select a price of \$8 per unit because choice (3) results in the greatest total contribution margin and net income. In the short run, maximizing total contribution margin maximizes profits.
Choice Sales Price – Var. Cost =
Contribution
margin per unit x
Number
of units =
Total
margin
Fixed
costs
Net
income (loss)
1 \$6 \$5 \$1 15,000 \$15,000 \$20,000 \$(5,000)
2 \$7 \$5 2 12,000 24,000 20,000 4,000
3 \$8 \$5 3 10,000 30,000 20,000 10,000
4 \$9 \$5 4 7,000 28,000 20,000 8,000
Accept or Reject Special Orders
Sometimes management has an opportunity to sell its product in two or more markets at two or more different prices. Movie theaters, for example, sell tickets at discount prices to particular groups of people—children, students, and senior citizens. Differential analysis can determine whether companies should sell their products at prices below regular levels.
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Good business management requires keeping the cost of idleness at a minimum. When operating at less than full capacity, management should seek additional business. Management may decide to accept such additional business at prices lower than average unit costs if the differential revenues from the additional business exceed the differential costs. By accepting special orders at a discount, businesses can keep people employed that they would otherwise lay off.
To illustrate, assume Rios Company produces and sells a single product with a variable cost of \$8 per unit. Annual capacity is 10,000 units, and annual fixed costs total \$48,000. The selling price is \$20 per unit and production and sales are budgeted at 5,000 units. Thus, budgeted income before income taxes is \$12,000, as shown below.
Rios company
Income statement
For the period ending May 31
Revenue (5,000 units at \$20) \$100,000
Variable costs:
Direct materials cost (\$4 per unit) \$20,000
Labor (\$1 per unit) 5,000
Overhead (\$2 per unit) 10,000
Marketing and administrative costs (\$1 per unit) 5,000
Total variable costs (\$8 per unit) \$40,000
Fixed costs:
Overhead \$28,000
Marketing and administrative costs 20,000
Total fixed costs 48,000
Total costs (\$17.60 per unit) 88,000
Net income \$12,000
Assume the company receives an order from a foreign distributor for 3,000 units at \$10 per unit. This \$10 price is not only half of the regular selling price per unit, but also less than the \$17.60 average cost per unit (\$88,000/5,000 units). However, the \$10 price offered exceeds the variable cost per unit by \$2. If the company accepts the order, net income increases to \$18,000.
Revenue would increase to \$130,000 with the special order. Each of the variable costs increases in total by 60% because total volume increases by 60% (3,000 units in the special order/5,000 units regularly produced). The revised income statement would appear as follows:
Rios company
Income statement (with Special Order)
For the period ending May 31
Revenue (5,000 units at \$20 + 3,000 units at \$10) \$130,000
Variable costs:
Direct materials cost (\$4) \$32,000
Labor (\$1) 8,000
Overhead (\$2) 16,000
Marketing and administrative costs (\$1) 8,000
Total variable costs (\$8 per unit) \$64,000
Fixed costs:
Manufacturing overhead \$28,000
Marketing and administrative costs 20,000
Total fixed costs 48,000
Total costs (\$14 per unit) 112,000
Net income \$18,000
Note that the fixed costs do not increase with the special order. Because the special order does not increase the fixed costs, the special order’s revenues need only cover its variable costs.
If Rios Company continues to operate at 50% capacity (producing 5,000 units without the special order) it would generate income of only \$12,000. By accepting the special order, net income increases by \$6,000 (\$18,000 net income with special order – \$12,000 net income without special order).
Differential analysis would provide the following calculations:
Accept
order
Reject
order
Differential
Revenues \$130,000 \$100,000 \$30,000
Costs 112,000 88,000 24,000
Net benefit of accepting order \$6,000
Variable costs set a floor for the selling price in special-order situations. Even if the price exceeds variable costs only slightly, the additional business increases net income, assuming fixed costs do not change. However, pricing just above variable costs of special-order business often brings only short-term increases in net income. In the long run, companies must cover all of their costs, not just the variable costs.
Adding or Eliminating
Periodically, management has to decide whether to add or eliminate certain products, segments, or customers. If you have watched a store or a plant open or close in your area, you have seen the results of these decisions. Differential analysis is useful in this decision making because a company’s income statement does not automatically associate costs with certain products, segments, or customers. Thus, companies must reclassify costs as those that the action would change and those that it would not change.
youtu.be/w7Ve8__NtPY
If companies add or eliminate products, they usually increase or decrease variable costs. The fixed costs may change, but not in many cases. Management bases decisions to add or eliminate products only on the differential items; that is, the costs and revenues that change.
To illustrate, assume that the Campus Bookstore is considering eliminating its art supplies department. If the bookstore dropped the art supplies department, it would lose revenues of \$100,000 annually. The bookstore’s management assigns costs of \$110,000 (\$80,000 variable and \$30,000 fixed) to the art supplies department. Therefore, art supplies has an apparent annual loss of \$10,000 (\$100,000 revenue minus \$110,000 costs). But careful cost analysis reveals that if the art supplies department were dropped, the reduction in costs would be only \$80,000 variable costs directly related to the art supplies department and the \$30,000 fixed costs are general bookstore fixed costs allocated to the art supplies department. These fixed costs would continue to be incurred and would not be saved by closing the art supplies department. Look at the differential analysis below.
Art Supplies Department
Keep Close Differential
Revenues \$100,000 \$-0- \$100,000
Variable costs 80,000 -0- 80,000
Fixed costs 30,000 30,000 -0-
Net benefit of keeping art supplies department \$ 20,000
Note that the art supplies department has been contributing \$20,000 (\$100,000 revenues – \$80,000 variable costs) annually toward covering the fixed costs of the business. Consequently, its elimination could be a costly mistake unless there is a more profitable use for the vacated facilities.
If the company has a profitable alternative use for the vacated facilities, the potential income from that alternative represents an opportunity cost of retaining the product, segment, or customer. Assume, for example, that the bookstore could use the facilities currently occupied by the art supplies department to open a new department to display and sell personal computers, printers, and software. This new department would contribute \$35,000 to the bookstore’s income.
The relevant costs in the decision to retain the art supplies department are \$115,000 (\$80,000 of variable manufacturing costs and \$35,000 of opportunity cost of not opening a new department), while the relevant revenues are still \$100,000. Therefore, the bookstore has a net disadvantage in keeping the art supplies department because it loses \$15,000 compared to the computer department.
Art Supplies PCs Differential
Revenues \$100,000
Variable costs -80,000
Additional Income \$20,000 35,000 \$15,000
Sell or Process Further
Sometimes two or more products result from a common raw material or production process; these products are called joint products. Companies can process these products further or sell them in their current condition. For instance, when Chevron refines crude oil, it produces a wide variety of fuels, solvents, lubricants, and residual petrochemicals.
Management can use differential analysis to decide whether to process a joint product further or to sell it in its present condition. Joint costs are those costs incurred up to the point where the joint products split off from each other. These costs are sunk costs and are not considered when deciding whether to process a joint product further before selling it or to sell it in its condition at the split-off point.
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The following example illustrates the issue of whether to process or sell joint products. Assume that Pacific Paper, Inc., produces two paper products, A and B, from a common manufacturing process. Each of the products could either be sold in its present form or processed further and sold at a higher price. Data for both products follow:
Product Selling price per unit at split-off point Cost per unit of further processing Selling price per unit after further processing
A \$10 \$6 \$21
B 12 7 18
The differential revenues and costs of further processing of the two products are as follows:
Product Different revenue of further processing Differential cost of further processing Net advantage (disadvantage) of further processing
A \$11 \$6 \$5
B 6 7 (1)
Based on this analysis, Pacific Paper should process product A further to increase income by \$5 per unit sold. The company should not process product B further because that would decrease income by \$1 per unit sold.
Companies use this same form of differential analysis to decide whether they should discard their by-products or process them further. By-products are additional products resulting from the production of a main product and generally have a small market value compared to the main product. Sometimes companies consider by-products to be waste materials. For example, the bark from trees cut into lumber is a by-product of lumber production. Although a by-product, companies convert this bark into fuel or landscaping material. When the differential revenue of further processing exceeds the differential cost, firms should do further processing. As concerns increase about the effects of waste on the environment, companies find more and more waste materials that can be converted into by-products.
Make or Buy
Managers also apply differential analysis to make-or-buy decisions. A make-or-buy decision occurs when management must decide whether to make or purchase a part or material used in manufacturing another product. Management must compare the price paid for a part with the additional costs incurred to manufacture the part. When most of the manufacturing costs are fixed and would exist in any case, it is likely to be more economical to make the part rather than buy it.
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To illustrate the application of differential analysis to make-or-buy decisions, assume that Small Motor Company manufactures a part costing \$6 for use in its toy automobile engines. Cost components are: materials, \$3.00; labor, \$1.50; fixed overhead costs, \$1.05; and variable overhead costs, \$0.45. Small could purchase the part for \$5.25. Fixed overhead would presumably continue even if the part were purchased. The added costs (variable costs only) of manufacturing amount to \$4.95 (\$3.00 DM + \$1.50 DL + \$0.45 Variable OH). This amount is 30 cents per unit less than the purchase price of the part. Therefore, manufacturing the part should be continued as shown in the following analysis:
Make Buy Differential
Variable Costs \$4.95 \$5.25 \$0.30
Net advantage of making \$0.30
In make-or-buy decisions, management also should consider the opportunity cost of not utilizing the space for some other purpose. In the previous example, if the opportunity costs of not using this space in its best alternative use is more than 30 cents per unit times the number of units produced, the part should be purchased.
In some manufacturing situations, firms avoid a portion of fixed costs by buying from an outside source. For example, suppose eliminating a part would reduce production so that a supervisor’s salary could be saved. In such a situation, firms should treat these fixed costs the same as variable costs in the analysis because they would be relevant costs.
Sometimes the cost to manufacture may be only slightly less than the cost of purchasing the part or material. Then management should place considerable weight on other factors such as the competency of existing personnel to undertake manufacturing the part or material, the availability of working capital, and the cost of any loans that may be necessary.
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Applying differential analysis to quality
High quality is essential to success in a competitive environment. Therefore, companies use differential analysis to make decisions about the quality of their products.
Assume Erie Waters produces bottled water. The variable cost of a case (12 one-liter bottles) is as follows:
Water and bottles \$2.00
Inspection and rework costs 1.00
All other variable costs 3.00
Total variable cost per case \$6.00
In addition, the company has \$150,000 of fixed costs per year.
The company inspects the product at various stages. When inspectors find the water is below standard or the bottles have defects, production workers replace the water and/or the bottles. The cost of inspecting the product and replacing water and/or bottles averages \$1.00 per case, and is shown as inspection and rework costs.
Management of Erie Waters is concerned about product quality. Despite the inspection just noted, management has learned that dissatisfied customers are switching to competitive products. Management is considering purchasing a high-quality water product. This product would increase water and bottle costs to \$2.50 per case while decreasing inspection and rework costs to \$0.40 per case. All other variable costs would remain at \$3.00 per case. Erie Waters would sell this water for \$8.00 per case.
If the high-quality water is purchased, Erie Waters expects to sell 100,000 cases of water this year at \$8.00 per case. If Erie continues to use the current low-quality water, the company expects to sell 90,000 cases of water this year at \$8.00 per case. Fixed costs are \$150,000 per year whether the company buys high-quality water or low-quality water. Should Erie Waters buy the high-quality water? We compare the two alternatives below.
Low-quality water (90,000 cases)
High-quality water
(100,000 cases)
Revenue at \$8.00 per case \$ 720,000 \$ 800,000
Water and bottles at \$2.00 per case for
low quality and \$2.50 per case for
high quality
(180,000)
[90,000 cases x \$2.00]
(250,000)
[100,000 cases x \$2.50]
Inspection and rework at \$1.00 per case
for low quality and \$0.40 per case for high
quality
(90,000)
[90,000 cases x \$1.00]
(40,000)
[100,000 cases x \$0.40]
All other variable costs at \$3.00 per case
(270,000)
[90,000 cases x \$3]
(300,000)
[100,000 cases x \$3]
Fixed costs (150,000) (150,000)
Net income \$ 30,000 \$ 60,000
Erie Waters should purchase the high-quality water because it increases net income from \$30,000 to \$60,000 per year. In addition, a high-quality product improves the company’s prospects for maintaining or even increasing its market share in years to come. Many companies have learned the hard way that letting quality slip creates a bad reputation that is hard to overcome.
10.05: Accounting in the Headlines
Should Apple Country Orchards sell Granny Smith apples or make cider from those apples?
Apple Country Orchards in Idalou, Texas, has 6,000 apple trees and offers 30 varieties of apples. The orchard is 29 years old and allows customers to pick their own apples or to purchase pre-picked apples. In addition to apples and apple picking, the orchard offers hayrides, lunch, pumpkins, and a variety of other items.
Apple Country Orchards makes cider from several different apple varieties. One of the varieties used to make cider is the Granny Smith apple, which is known for its ability to be easily preserved in storage for up to a year and for its high antioxidant activity.
Assume that Apple Country Orchards sells Granny Smith apples for \$0.90 per pound. One gallon of fresh-pressed cider at Apple Country Orchards sells for \$8. (On average, ten pounds of Granny Smith apples yield one gallon of fresh-pressed cider.)
Questions
1. Do you need to know the cost per pound that Apple Country Orchards uses for its Granny Smith apples to be able to decide if the Granny Smith apples should be sold as is (as raw apples) or processed further into cider, pie, turnovers, or any other apple product? Why or why not?
2. From a purely quantitative standpoint, should Apple Country Orchards sell raw Granny Smith apples or process those apples further into apple cider? Support your answer with calculations.
3. Assume that it is financially advantageous to sell raw apples rather than process them further into cider. What qualitative factors might influence Apple Country Orchards’ decision to offer fresh-pressed cider?
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10.06: Glossary
GLOSSARY
By-products Additional products resulting from the production of a main product. By-products generally have a small market value compared to the main product.
Committed fixed costs Costs relating to the basic facilities and organizational structure that a company must have to continue operations.
Differential analysis An analysis of the different costs and benefits that would arise from alternative solutions to a particular problem.
Differential cost or expense The difference between the amounts of relevant costs for two alternatives.
Differential revenue The difference between the amounts of relevant revenues for two alternatives.
Discretionary fixed costs Fixed costs subject to management control from year to year; an example is advertising expense.
Joint costs Those production costs incurred up to the point where the joint products split off from each other.
Joint products Two or more products resulting from a common raw material or production process.
Make-or-buy decision A decision concerning whether to manufacture or purchase a part or material used in manufacturing another product.
Opportunity cost The potential benefit that is forgone from not following the next best alternative course of action.
Relevant revenues or costs Revenues or costs that will differ in the future depending on which alternative course of action is selected.
Sunk costs Past costs that are not relevant in decision making because they have already been incurred. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/10%3A_Differential_Analysis_(or_Relevant_Costs)/10.04%3A_Applying_Differential_Analysis_to_Quality_Decisions.txt |
Short-Answer Questions, Exercises, and Problems
Questions
➢ Identify types of decisions that can be made using differential analysis.
➢ What is a committed fixed cost? Give some examples.
➢ What is a discretionary fixed cost? Give some examples.
➢ Give an example of a fixed cost that might be considered committed for one company and discretionary for another.
➢ What is the disadvantage of a company having all committed fixed costs? Explain.
➢ What is an opportunity cost? Give some examples.
➢ What essential feature distinguishes the contribution margin income statement from the traditional income statement?
Real world question Give an example of a make-or-buy decision that you have made or someone you know has made.
Real world question Give an example in which your campus bookstore replaces one of its departments with another it currently does not have. (For example, it stops selling magazines and starts selling cameras.) What revenues and costs would be differential?
Real world question Assume that McDonald’s, of McDonald’s fast-food restaurants, currently buys its french fries from agricultural growers and food processors. In doing so, McDonald’s has decided to buy the materials for its french fries instead of “make” them. (Assume that making french fries includes growing the potatoes.) What factors would go into McDonald’s decision to buy instead of make french fries?➢ Real world question Suppose that Wal-Mart, one of the fastest growing companies in the world, were to close one of its stores. Which differential revenues and costs would be affected by that decision?ExercisesExercise A The following data are for Paso Robles Company for the year ended 2009 December 31:
Costs:
Direct material \$ 90,000
Direct labor 130,000
Manufacturing overhead:
Variable 45,000
Fixed 90,000
Sales commissions (variable) 25,000
Sales salaries (fixed) 20,000
Administrative expenses (fixed) 35,000
Selling price per unit \$ 10
Units produced and sold 60,000
Assume direct materials and direct labor are variable costs. Prepare a contribution margin income statement and a traditional income statement.
Exercise B Assume you had invested \$1,000 in a lawn mower to set up a lawn mowing business for the summer. During the first week, you could choose either to mow the grounds at a housing development for \$1,400 or to help paint a garage for \$1,360. Each job would take one week. You cannot do both. You would incur additional costs of \$160 for lawn mowing and \$80 for garage painting. These costs include \$60 under each alternative for transportation to the job. Prepare a schedule showing the net benefit or advantage of selecting one alternative over the other.
Exercise C The marketing department of Specialty Coffees estimates the following monthly demand for espresso in these four price-quantity relationships:
Demand
1 9,000 cups at \$1.00 per cup
2 8,000 cups at \$1.25 per cup
3 6,000 cups at \$1.50 per cup
4 4,000 cups at \$1.75 per cup
The fixed costs of \$3,000 per month are not affected by the different price-volume alternatives. Variable costs are \$0.25 per cup. What price should Specialty Coffees set for espresso?
Exercise D Viking Corporation is operating at 80% of capacity, which means it produces 8,000 units. Variable cost is \$100 per unit. Wholesaler Y offers to buy 2,000 additional units at \$120 per unit. Wholesaler Z proposes to buy 1,500 additional units at \$140 per unit. Which offer, if either, should Viking Corporation accept? Fixed costs are not affected by accepting either offer.
Exercise E Analysis of Hair Care Company’s citrus hair conditioner reveals that it is losing \$5,000 annually. The company sells 5,000 units of citrus hair conditioner each year at \$10 per unit. Variable costs are \$6 per unit. None of the company’s fixed costs would be saved if the citrus hair conditioner were eliminated. What would be the increase or decrease in company net income if citrus hair condition were eliminated?
Exercise F The luggage department of Sampson Company has revenues of \$1,000,000; variable expenses of \$250,000; direct fixed costs of \$500,000; and allocated, indirect fixed costs of \$300,000 in an average year. If the company eliminates this department, what would be the effect on net income?
Exercise G Raiders Company manufactures two joint products. At the split-off point, they have sales values of:
Product 1 \$18 per unit
Product 2 12 per unit
After further processing, the company can sell them for \$36 and \$16, respectively. Product 1 costs \$12 per unit to process further and Product 2 costs \$8 to process further. Should further processing be done on either or both of these products? Why or why not?
Exercise H Gopherit Corporation currently is manufacturing 40,000 units per year of a part used in its final product. The cost of producing this part is \$50 per unit. The variable portion of this cost consists of direct materials of \$25, direct labor of \$15, and variable manufacturing overhead of \$3. The company could earn \$100,000 per year from the space now used to manufacture this part. Assuming equal quality and availability, what is the maximum price per unit that Gopherit Corporation should pay to buy the part rather than make it? (The total fixed costs would not be affected by this decision.)
Exercise I Ortez Company buys strawberries and produces strawberry jam. The variable cost of a case of strawberry jam is as follows:
Materials (strawberries and jars) \$10.00
Inspection and rework costs 4.00
All other variable costs 8.00
Total variable cost per case \$22.00
In addition, the company has \$1,000,000 of fixed costs per year.
The company inspects the product at various stages. The cost of inspecting the product and replacing jam and/or jars averages \$4.00 per case, shown as in the inspection and rework costs.
Management is considering purchasing high-quality strawberries. This would increase materials costs to \$12.00 per case, while decreasing inspection and rework costs to \$2.00 per case. All other costs would remain at \$8.00 per case for variable costs and \$1,000,000 for fixed costs whether or not the high-quality strawberries were purchased. Ortez’s jam sells for \$40 per case. If the high-quality strawberries were purchased, the company could sell 100,000 cases of jam this year at \$40 per case. If the company continued to use the current low-quality berries, it could sell 80,000 cases of jam this year at \$40 per case.
Should Ortez purchase the high-quality strawberries?
Problems
Problem A Montonya Company has the following selected data for the current year:
Sales (10,000 units) \$90,000
Direct materials 30,000
Direct labor costs 10,000
Variable manufacturing overhead 3,500
Fixed manufacturing overhead 7,500
Variable selling and administrative expenses 2,500
Fixed selling and administrative expenses 15,000
The company produced and sold 10,000 units. Direct materials and direct labor are variable costs.
1. Prepare an income statement for the current year using the contribution margin format.
2. Prepare an income statement for the current year using the traditional format.
3. What additional information do you learn from the contribution margin format?
Problem B Pick-Me-Up Company is introducing a new coffee in its stores and must decide what price to set for the coffee beans. An estimated demand schedule for the product follows:
Price One-pound units demanded
\$ 5 80,000
6 72,000
7 56,000
8 48,000
9 36,000
10 30,000
Estimated costs follow:
Variable manufacturing costs \$2 per unit
Fixed manufacturing costs \$40,000 per year
Variable selling and administrative costs \$1 per unit
Fixed selling and administrative costs \$20,000 per year
1. Prepare a schedule showing management the total revenue, total cost, and total profit or loss for each selling price.
2. Which price do you recommend to the management of Pick-Me-Up? Explain your answer.
Problem C Ocean View Company operates tour boats. Its predicted operations for the year are as follows:
Sales (1,000 tours per year) \$400,000
Costs:
Variable \$250 per tour
Fixed \$100,000 per year
The company has received a request to offer 100 tours for \$300 each. Ocean View has plenty of capacity to do these tours in addition to its regular business. Doing these tours would not affect the company’s regular sales or its fixed costs.
1. Should the company do the special tours for \$300 per tour?
2. What is the effect of the decision on the company’s operating profit?
Problem D Following are sales and other operating data for the three products made and sold by Ranger Company:
Product
A B C Total
Sales \$ 600,000 \$ 300,000 \$ 200,000 \$ 1,100,000
Manufacturing costs:
Fixed \$ 60,000 \$ 20,000 \$ 60,000 \$ 140,000
Variable 280,000 220,000 100,000 600,000
Selling and administrative expenses:
Fixed 20,000 20,000 12,000 52,000
Variable 40,000 20,000 30,000 90,000
Total costs \$ 400,000 \$ 280,000 \$ 202,000 \$ 882,000
Net income \$ 200,000 \$ 20,000 \$ (2,000) \$ 218,000
In view of the net loss for Product C, Ranger’s management is considering dropping that product. All variable costs are direct costs and would be eliminated if Product C were dropped. Fixed costs are indirect costs; no fixed costs would be eliminated. Assume that the space used to produce Product C would be left idle.
Would you recommend the elimination of Product C? Give supporting computations.
Problem E Sierra Lumber Company produces lumber. The company has two grades of lumber at the split-off point, A and B. Grade A sells for \$4 per board foot and Grade B sells for \$2 per board foot. This lumber is suitable for framing and most exterior work but not for the interior of buildings. Either grade can be further processed to make it suitable for interior work at a cost of \$1.20 per board foot. After this further processing, the firm can sell Grade A lumber for \$5.50 per board foot and Grade B for \$3.00 per board foot.
Would you recommend the company sell the lumber at the split-off point or process it further to make it suitable for interior work? Explain and give supporting computations.
Problem F Skate-Right Company, a skateboard manufacturer, is currently operating at 60% capacity and producing about 8,000 units a year. To use more capacity, the manager has been considering the research and development department’s suggestion that the company manufacture its own wheels.
Currently the company purchases wheels from a supplier at a unit price of \$20. (Each unit is a set of wheels for a skateboard.) Estimates show the company can manufacture its own wheels at \$10 for direct materials costs and \$4 for direct labor cost per unit. The variable factory overhead is \$1 per unit. The company’s accountants would probably allocate another \$6 per unit to the wheels.
1. Should Skate-Right make or buy the wheels?
2. Suppose Skate-Right could rent out the factory space needed to make the wheels for \$30,000 a month. How would this affect your decision in (a), if at all?
Problem G Quality Calc, Inc., purchases calculator components and assembles them into handheld calculators. The variable cost of one Model A-25 is as follows:
Materials \$10
Inspection and rework costs 2
All other variable costs 5
Total variable cost per case \$17
In addition, this product incurs \$5,000,000 of fixed costs per year.
The company inspects the product at various stages. The cost of inspecting the product and replacing components averages \$2 per calculator, shown as the inspection and rework costs.
Management is considering purchasing better components that would both increase quality and expand the calculator’s capacity. These new components would increase materials costs to \$12.50 per calculator, but would decrease inspection and rework costs to \$1.50 per calculator. All other variables cost would remain at \$5 per calculator. Fixed costs would remain at \$5,000,000 per year.
Quality Calc currently sells each A-25 calculator for \$25 at a volume of 1 million calculators per year. Management believes it can increase the price of the calculator (which would now be called the A-25 STAR) to \$30 per calculator because of its increased capability. Sales volume would remain at 1 million calculators per year for the improved A-25 STAR. Should Quality Calc purchase the better components?
Alternate problems
Alternate problem A The following data are for Nets Company for the current year:
Sales (20,000 units) \$750,000
Direct materials 270,000
Direct labor cost 90,000
Variable manufacturing overhead 27,000
Fixed manufacturing overhead 36,000
Variable selling and administrative expenses 45,000
Fixed selling and administrative expenses 150,000
The company produced and sold 20,000 units.
1. Prepare an income statement for the current year using the contribution margin format.
2. Prepare an income statement for the current year using the traditional format.
3. What additional information does the contribution margin format provide compared to the traditional format?
Alternate problem B The Havana Company is introducing a new product and must decide its price. An estimated demand schedule for the product is as follows:
Price Units demanded
\$ 5 20,000
6 18,000
7 14,000
8 12,000
9 9,000
10 8,000
Estimated costs are as follows:
Variable manufacturing costs \$2.20 per unit
Fixed manufacturing costs \$20,000 per year
Variable selling and administrative costs \$1.00 per unit
Fixed selling and administrative costs \$5,000 per year
1. Prepare a schedule showing the total revenue, total cost, and total profit or loss for each selling price.
2. Which price should Havana select? Explain.
Alternate problem C Following are sales and other operating data for the three products made and sold by Marine Enterprises:
Product
A B C Total
Sales \$150,000 \$90,000 \$240,000 \$480,000
Manufacturing costs:
Fixed \$ 15,000 \$25,000 \$ 30,000 \$ 70,000
Variable 120,000 35,000 134,000 289,000
Selling and administrative expenses:
Fixed 5,000 30,000 10,000 45,000
Variable 2,500 5,000 6,000 13,500
Total costs \$142,500 \$95,000 \$180,000 \$417,500
Net income (loss) \$ 7,500 \$(5,000) \$ 60,000 \$ 62,500
In view of the net loss shown for Product B, company management is considering dropping that product. All variable costs are direct costs and would be eliminated if Product B were dropped; all fixed costs are indirect costs and would not be eliminated. Assume that the space used to produce Product B would be left idle.
Would you recommend the elimination of Product B? Give supporting computations.
Alternate problem D Sailboard Enterprises, a wind sailing board manufacturer, is currently operating at 70% capacity and producing about 20,000 units a year. To use more capacity, the manager has been considering the research and development department’s suggestion that Sailboard manufacture its own sails. Currently Sailboard purchases sails from a supplier at a unit price of \$100. Estimates show that Sailboard can manufacture its own sails for a \$40 direct materials cost and a \$32 direct labor cost per unit. The variable factory overhead is \$8 per sail. The company’s accountants would allocate fixed manufacturing overhead of \$30 per sail to the sail production.
1. Should Sailboard Enterprises make or buy the sails?
2. Suppose that Sailboard Enterprises could rent out the part of the factory that would otherwise be used for sail manufacturing for \$8,000 a month. How would this affect the decision in (a)?
Alternate problem E Cool-Snacks Company produces and sells ice cream for ice cream shops. Management is considering purchasing better ingredients. The variable cost of producing a gallon of ice cream is as follows:
Materials (cream, containers, etc.) \$1.40
Inspection and replacement costs .40
All other variable costs .70
Total variable cost per gallon \$2.50
In addition, the company has \$1,000,000 of fixed costs per year.
The company inspects the product at various stages. The cost of inspecting the product and replacing ice cream averages \$0.40 per gallon, shown as the inspection and replacement costs.
Management is considering purchasing high-quality ingredients, in particular, high-quality dairy products. These high-quality ingredients would increase materials costs to \$1.80 per gallon, but would decrease inspection and replacement costs to \$0.30 per gallon. All other costs would remain at \$0.70 per gallon for variable costs and \$1,000,000 for fixed costs whether or not the high-quality ingredients are purchased. If the high-quality ingredients are purchased, the company expects to sell 1,200,000 gallons of ice cream this year at \$4 per gallon. If the company continues to use the current low-quality ingredients, the company expects to sell 1,000,000 gallons of ice cream at \$3.50 per gallon. Should Cool-Snacks Company buy the high-quality ingredients for its ice cream?
Beyond the numbers—Critical thinking
Business decision case A Prior to 2011, Starks Wholesalers Company had not kept department income statements. To achieve better management control, the company decided to install department-by-department accounts. At the end of 2011, the new accounts showed that although as a whole the business was profitable, the dry goods department had a substantial loss. The following income statement for the dry goods department reports on operations for 2011:
Starks wholesalers company
Dry goods department
Partial income statement for 2011
Sales \$1,200,000
Cost of goods sold 800,000
Gross margin \$ 400,000
Costs:
Payroll, direct labor, and supervision \$120,000
Commissions of sales staff a 60,000
Rent b 40,000
Insurance on inventory 20,000
Depreciation c 80,000
Administration and general office d 80,000
Interest for inventory carrying costs e 10,000
Total costs 410,000
Net income (loss) \$ (10,000)
A All sales staff are compensated on straight commission on sales.
B Rent charged to departments on a square-foot basis. The company rents an entire building, and the dry goods department occupies 15% of the building.
C Depreciation is 8.5% of the cost of the departmental equipment.
D Allocated on basis of departmental sales as a fraction of total company sales.
D Based on average inventory quantity multiplied by the company’s borrowing rate for three-month loans.
Analysis of these results has led management to suggest closing the dry goods department. Members of the management team agree that keeping the dry goods department is not essential to maintaining good customer relations and supporting the rest of the company’s business. In other words, eliminating the dry goods department is expected to have no effect on the amount of business done by the other departments.
Prepare a written report recommending whether or not Starks should close the dry goods department. Explain why. State your assumptions.
Business decision case B After working for a software company for several years, Chris and Terry quit their jobs and set up their own consulting firm called C & T Software, Inc. Major customers include corporate, professional, and government organizations that are setting up information networks.
The cost per billable hour of service at the company’s normal volume of 3,000 billable hours per month follows. (A billable hour is one hour billed to a client.)
Average cost per hour billed to client:
Variable labor – consultants \$50
Variable overhead, including supplies and clerical support 20
Fixed overhead, including allowance for unbilled hours 80
\$150
Marketing and administrative costs per billable hour (all fixed) 40
Total hourly cost \$190
Treat each of the following questions independently. Unless given otherwise, the regular fee per hour is \$200.
1. How many hours must the firm bill per month to break even? (You may need to refer to Chapter 21 to answer this question.)
2. Market research estimates that a fee increase to \$250 per hour would decrease monthly volume to 2,000 hours. The accounting department estimates that fixed overhead costs would be \$120 per hour, while variable cost per hour would remain unchanged. What effect would a fee increase have on profits?
3. Assume C & T Software is operating at its normal volume of 3,000 hours per month. It has received a special request from one of its long-time customers to provide services on a special-order basis. Because of the long-term nature of the contract (four months) and the magnitude (1,000 hours per month), the customer believes a fee reduction is in order. C & T Software has a capacity limitation of 4,000 hours per month. Fixed costs would not change if the firm accepts the special order. What is the lowest fee C & T Software would be willing to charge?
Business decision case C Refer to “A broader perspective: Differential analysis in sports”. In a memorandum to your instructor identify which costs and revenues you think would be differential for a sports team acquiring a major star like Bonds. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.
Group project D In teams of two or three students, visit a local department store and imagine the types of costs that it would save if it closed a significant department (for example, the housewares department). List the types of costs that would be saved, but do not attempt to assign numbers to those costs. For example, would rent be saved? Would security be saved? What about taxes on inventories? Consider the effects of closing the department on the people who work there. As a team, write a memorandum describing the costs saved and the effects of closing a department in a local department store. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.
Group project E A manager in your organization just received a special order at a price that is “below cost”. The manager points to the document and says, “These are the kinds of orders that will get you in trouble. Every sale must bear its share of the full costs of running the business. If we sell below our full cost, we will be out of business in no time.” 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 Form a group of two or three students. Assume you are considering driving to a weekend resort for a quick break from school. What are the differential costs of operating your car for the drive? Write a memorandum to your instructor addressing this question. 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 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. Looking at the most recent year on the statement of income, assume 70% of the cost of sales are variable costs and the remaining 30% are fixed costs. Furthermore, assume all other costs and expenses (research and development, marketing, general and administrative, interest, taxes, etc.) are 60% variable and 40% fixed. Prepare an income statement using the contribution margin format. Be sure to submit a copy of Intel’s consolidated statement of income with the contribution margin income statement.
Visit the following website for Wal-Mart, a retail company.
http:/www.walmart.com
Go to the company’s most recent financial statements and review the statement of income. Looking at the most recent year on the statement of income, assume 45% of the cost of sales are variable costs and the remaining 55% are fixed costs. Furthermore, assume all other costs and expenses (research and development, marketing, general and administrative, interest, taxes, etc.) are 30% variable and 70% fixed. Prepare an income statement using the contribution margin format. Be sure to submit acopy of Wal-Mart’s income statement with the contribution margin income statement. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/10%3A_Differential_Analysis_(or_Relevant_Costs)/10.07%3A_Chapter_10-_Exercises.txt |
• Capital budgeting
Capital budgeting is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds, within the framework of company goals and objectives. A capital project is any available alternative to purchase, build, lease, or renovate buildings, equipment, or other long-range major items of property. The alternative selected usually involves large sums of money and brings about a large increase in fixed costs for a number of years in the future. Once a company builds a plant or undertakes some other capital expenditure, its future plans are less flexible.
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Poor capital-budgeting decisions can be costly because of the large sums of money and relatively long periods involved. If a poor capital budgeting decision is implemented, the company can lose all or part of the funds originally invested in the project and not realize the expected benefits. In addition, other actions taken within the company regarding the project, such as finding suppliers of raw materials, are wasted if the capital-budgeting decision must be revoked. Poor capital-budgeting decisions may also harm the company’s competitive position because the company does not have the most efficient productive assets needed to compete in world markets.
Investment of funds in a poor alternative can create other problems as well. Workers hired for the project might be laid off if the project fails, creating morale and unemployment problems. Many of the fixed costs still remain even if a plant is closed or not producing. For instance, advertising efforts would be wasted, and stock prices could be affected by the decline in income.
On the other hand, failure to invest enough funds in a good project also can be costly. Ford’s Mustang is an excellent example of this problem. At the time of the original capital-budgeting decision, if Ford had correctly estimated the Mustang’s popularity, the company would have expended more funds on the project. Because of an undercommitment of funds, Ford found itself short on production capacity, which caused lost and postponed sales of the automobile.
Finally, the amount of funds available for investment is limited. Thus, once a company makes a capital investment decision, alternative investment opportunities are normally lost. The benefits or returns lost by rejecting the best alternative investment are the opportunity cost of a given project.
For all these reasons, companies must be very careful in their analysis of capital projects. Capital expenditures do not occur as often as ordinary expenditures such as payroll or inventory purchases but involve substantial sums of money that are then committed for a long period. Therefore, the means by which companies evaluate capital expenditure decisions should be much more formal and detailed than would be necessary for ordinary purchase decisions.
Project selection: A general view
Making capital-budgeting decisions involves analyzing cash inflows and outflows. This section shows you how to calculate the benefits and costs used in capital-budgeting decisions. Because money has a time value, these benefits and costs are adjusted for time under the last two methods covered in the chapter.
Money received today is worth more than the same amount of money received at a future date, such as a year from now. This principle is known as the time value of money. Money has time value because of investment opportunities, not because of inflation. For example, \$100 today is worth more than \$100 to be received one year from today because the \$100 received today, once invested, grows to some amount greater than \$100 in one year. Future value and present value concepts are extremely important in assessing the desirability of long-term investments (capital budgeting).
The net cash inflow (as used in capital budgeting) is the net cash benefit expected from a project in a period. The net cash inflow is the difference between the periodic cash inflows and the periodic cash outflows for a proposed project.
Asset acquisition Assume, for example, that a company is considering the purchase of new equipment for \$120,000. The equipment is expected (1) to have a useful life of 15 years and no salvage value, and (2) to produce cash inflows (revenue) of \$75,000 per year and cash outflows (costs) of \$50,000 per year. Ignoring depreciation and taxes, the annual net cash inflow is computed as follows:
Cash inflows \$75,000
Cash outflows 50,000
Net cash inflow \$ 25,000
Depreciation and taxes The computation of the net income usually includes the effects of depreciation and taxes. Although depreciation does not involve a cash outflow, it is deductible in arriving at federal taxable income. Therefore depreciation is subtracted to get net income but is not included in the cash flow since it does not involve cash. Income tax expense is based on net income and not net cash flow. To calculate income taxes, we use the following formula:
Income before taxes x tax rate = income tax expense
Keep in mind, you will use the income tax expense amount calculated under both the net income and net cash flow since income tax is a cash expense.
Using the data in the previous example and assuming straight-line depreciation of \$8,000 per year and a 40% tax rate. Now, considering taxes and depreciation, we compute the annual net income and net cash inflow from the \$120,000 of equipment as follows:
Change in net income Change in cash flow
Cash inflows \$ 75,000 \$75,000
Cash outflows 50,000 50,000
Net cash inflow before taxes \$25,000 \$25,000
Depreciation 8,000
Income before income taxes \$17,000
Deduct: Income tax(17,000 x 40%) -6,800 -6,800
Net income after taxes \$10,200
Net cash inflow (after taxes) \$18,200
Notice how depreciation of \$8,000 is NOT included in the net cash inflow because it is a non-cash expense. Also note, the income taxes expense calculated under net income is the same amount reported under the net cash inflow since we have to pay income tax based on net income in cash.
Asset replacement Sometimes a company must decide whether or not it should replace existing plant assets. Such replacement decisions often occur when faster and more efficient machinery and equipment appear on the market.
The computation of the net cash inflow is more complex for a replacement decision than for an acquisition decision because cash inflows and outflows for two items (the asset being replaced and the new asset) must be considered. To illustrate, assume that a company operates two machines purchased four years ago at a cost of \$18,000 each. The estimated useful life of each machine is 12 years (with no salvage value). Each machine will produce 40,000 units of product per year. The annual cash operating expenses (labor, repairs, etc.) for the two machines together total \$14,000. After the old machines have been used for four years, a new machine becomes available. The new machine can be acquired for \$28,000 and has an estimated useful life of eight years (with no salvage value). The new machine produces 60,000 units annually and entails annual cash operating expenses of \$10,000. The \$4,000 reduction in operating expenses (\$14,000 for old machines – \$10,000 for the new machine) is a \$4,000 increase in net cash inflow (savings) before taxes.
The firm would pay \$28,000 in the first year to acquire the new machine. In addition to this initial outlay, the annual net cash inflow from replacement is computed as follows:
Using these data, the following display shows how you can use this formula to find the net cash flow after taxes:
Change in Annual Cash Expenses: Net Cash Flow
Old Machines 14,000
New Machine 10,000
Annual net cash savings before taxes 4,000
x 40% income tax EXPENSE – 1,600
(4,000 x 40%)
Annual net cash inflow after tax 2,400 2,400
Annual Depreciation:
Old Machines 3,000
New Machine 3,500
Additional Annual Depreciation Expense 500
x 40% income tax expense SAVED + 200 + 200
(500 x 40%)
Annual net cash inflow after tax 2,600
(2,400 annual net cash inflow + 200 tax savings from depreciation)
Remember, depreciation is a non-cash expense so it will not change net cash BUT it will change income tax expense as it is reported for net income.
Notice that these figures concentrated only on the differences in costs for each of the two alternatives. Two other items also are relevant to the decision. First, the purchase of the new machine creates a \$28,000 cash outflow immediately after acquisition. Second, the two old machines can probably be sold, and the selling price or salvage value of the old machines creates a cash inflow in the period of disposal. Also, the previous example used straight-line depreciation.
Out-of-pocket and sunk costs A distinction between out-of-pocket costs and sunk costs needs to be made for capital budgeting decisions. An out-of-pocket cost is a cost requiring a future outlay of resources, usually cash. Out-of-pocket costs can be avoided or changed in amount. Future labor and repair costs are examples of out-of-pocket costs.
Sunk costs are costs already incurred. Nothing can be done about sunk costs at the present time; they cannot be avoided or changed in amount. The price paid for a machine becomes a sunk cost the minute the purchase has been made (before that moment it was an out-of-pocket cost). The amount of that past outlay cannot be changed, regardless of whether the machine is scrapped or used. Thus, depreciation is a sunk cost because it represents a past cash outlay. Depletion and amortization of assets, such as ore deposits and patents, are also sunk costs.
A sunk cost is a past cost, while an out-of-pocket cost is a future cost. Only the out-of-pocket costs (the future cash outlays) are relevant to capital budgeting decisions. Sunk costs are not relevant, except for any effect they have on the cash outflow for taxes.
Initial cost and salvage value Any cash outflows necessary to acquire an asset and place it in a position and condition for its intended use are part of the initial cost of the asset. If an investment has a salvage value, that value is a cash inflow in the year of the asset’s disposal.
The cost of capital The cost of capital is important in project selection. Certainly, any acceptable proposal should offer a return that exceeds the cost of the funds used to finance it. Cost of capital, usually expressed as a rate, is the cost of all sources of capital (debt and equity) employed by a company. For convenience, most current liabilities, such as accounts payable and federal income taxes payable, are treated as being without cost. Every other item on the right (equity) side of the balance sheet has a cost. The subject of determining the cost of capital is a controversial topic in the literature of accounting and finance and is not discussed here. We give the assumed rates for the cost of capital in this book. Next, we describe several techniques for deciding whether to invest in capital projects.
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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
All rights reserved content
• What is Capital Budgeting: Introduction - Managerial Accounting video . Authored by: Brian Routh The Accounting Dr. Located at: youtu.be/kFyZkXHit_A. License: All Rights Reserved. License Terms: Standard YouTube License | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/11%3A_Capital_Investment_Analysis/11.01%3A_Capital_Investment_Analysis.txt |
Knowledge Targets
I can define the following terms as they relate to our unit:
Payback period
Investment Cash Flows Net Cash Flow
Capital Budgeting Cost of Capital Rate of return Time value of money
Reasoning Targets
• I can determine the payback period for an investment.
• I can rank investment projects in order of preference using payback period and rate of return.
• I can understand the time value of money.
Skill Targets
• I can calculate the payback period for an investment.
• I can evaluate investments using payback period and rate of return.
• I can compute the rate of return for an investment.
• I can evaluate investment projects with uncertain cash flows.
Click Capital Budget for a printable copy.
11.03: Short Term Business Decisions
• Project selection: Payback period
The payback period is the time it takes for the cumulative sum of the annual net cash inflows from a project to equal the initial net cash outlay. In effect, the payback period answers the question: How long will it take the capital project to recover, or pay back, the initial investment?
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If the net cash inflows each year are a constant amount, the formula for the payback period is:
Payback period = Initial cash outlay
Annual net cash inflow (benefit)
For the two assets discussed in the previous section, you can compute the payback period as follows. The purchase of the \$120,000 equipment creates an annual net cash inflow after taxes of \$18,200, so the payback period is 6.6 years, computed as follows:
Payback period = Initial cash outlay = 120,000 = 6.6 years (rounded)
Annual net cash inflow (benefit) 18,200
The payback period for the replacement machine with a \$28,000 cash outflow in the first year and an annual net cash inflow of \$2,600, is 10.8 years, computed as follows:
Payback period = Initial cash outlay = 28,000 = 10.8 years (rounded)
Annual net cash inflow (benefit) 2,600
Remember that the payback period indicates how long it will take the machine to pay for itself. The replacement machine being considered has a payback period of 10.8 years but a useful life of only 8 years. Therefore, because the investment cannot pay for itself within its useful life, the company should not purchase a new machine to replace the two old machines.
In each of the previous examples, the projected net cash inflow per year was uniform. When the annual returns are uneven, companies use a cumulative calculation to determine the payback period, as shown in the following situation.
Neil Company is considering a capital investment project that costs \$40,000 and is expected to last 10 years. The projected annual net cash inflows are:
Year Investment Annual net cash inflow Cumulative net cash inflows
0 \$ 40,000 —–
1 \$ 8,00 \$ 8,000
2 6,000 14,000
3 7,000 21,000
4 —- 5,000 26,000
5 8,000 34,000
6 6,000 40,000
7 3,000 43,000
8 2,000 45,000
10 1,000 49,000
The payback period in this example is six years, the time it takes to recover the \$40,000 original investment as show in the cumulative net cash inflows of year 6.
When using payback period analysis to evaluate investment proposals, management may choose one of these rules to decide on project selection:
• Select the investments with the shortest payback periods.
• Select only those investments that have a payback period of less than a specified number of years.
Both decision rules focus on the rapid return of invested capital. If capital can be recovered rapidly, a firm can invest it in other projects, thereby generating more cash inflows or profits.
Some managers use payback period analysis in capital budgeting decisions due to its simplicity. However, this type of analysis has two important limitations:
• Payback period analysis ignores the time period beyond the payback period. For example, assume Allen Company is considering two alternative investments; each requires an initial outlay of \$30,000. Proposal Y returns \$6,000 per year for five years, while proposal Z returns \$5,000 per year for eight years. The payback period for Y is five years (\$30,000/\$6,000) and for Z is six years (\$30,000/\$5,000). But, if the goal is to maximize income, proposal Z should be selected rather than proposal Y, even though Z has a longer payback period. This is because Z returns a total of \$40,000 (\$5,000 per year x 8 years), while Y simply recovers the initial \$30,000 (\$6,000 per year for 5 years) outlay.
• Payback analysis also ignores the time value of money. For example, assume the following net cash inflows are expected in the first three years from two capital projects:
Net Cash Inflows
Project A Project B
First year \$ 15,000 \$ 9,000
Second year 12,000 12,000
Third year 9,000 15,000
Total \$ 36,000 \$ 36,000
Assume that both projects have the same net cash inflow each year beyond the third year. If the cost of each project is \$36,000, each has a payback period of three years. But common sense indicates that the projects are not equal because money has time value and can be reinvested to increase income. Because larger amounts of cash are received earlier under Project A, it is the preferable project.
Project selection: Unadjusted rate of return or Accounting rate of return
Another method of evaluating investment projects that you are likely to encounter in practice is the accounting (or unadjusted) rate of return method. To compute the accounting rate of return, you will need to know 2 things:
1. Annual income after taxes; and
2. Average amount of the investment in the project. The average investment is the (Beginning balance + Ending balance)/2. If the ending balance is zero (as we assume), the average investment equals the original cash investment divided by 2.
The formula for the unadjusted (or Accounting) rate of return is:
Rate of Return = Average annual income after taxes
Average amount of investment
Notice that this calculation uses annual income rather than net cash inflow.[1]
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To illustrate the use of the unadjusted rate of return, assume Thomas Company is considering two capital project proposals, each having a useful life of three years. The company does not have enough funds to undertake both projects. Information relating to the projects follows:
Average annual Before-tax Average
Proposal Initial cost Salvage Value Net cash inflow Annual depreciation
1 \$ 76,000 \$ 4,000 \$ 45,000 \$ 24,000
2 95,000 5,000 55,000 30,000
Assuming a 40% tax rate, Thomas Company can determine the unadjusted rate of return for each project as follows:
Proposal 1 Proposal 2
Average investment: (original outlay + Salvage value)/2 (1) \$ 40,000 \$ 50,000
(76,000 + 4,000) / 2 (95,000 + 5,000) / 2
Annual net cash inflow (before income taxes) \$ 45,000 \$ 55,000
Less: Annual depreciation – 24,000 – 30,000
Annual income (before income taxes) \$ 21,000 \$ 25,000
Deduct: Income taxes at 40% – 8,400 – 10,000
Average annual net income from investment (2) \$ 12,600 \$ 15,000
Rate of return (2)/(1) 31.5% 30%
(12,600 / 40,000) (15,000 / 50,000)
From these calculations, if Thomas Company makes an investment decision solely on the basis of the unadjusted rate of return, it would select Proposal 1 since it has a higher rate.
Sometimes companies receive information on the average annual after-tax net cash inflow. Average annual after-tax net cash inflow is equal to annual before-tax cash inflow minus taxes. Given this information, the firms could deduct the depreciation to arrive at average net income. For instance, for Proposal 2, Thomas Company would compute average net income as follows:
After-tax net cash inflow (\$55,000-\$10,000) \$ 45,000
Less: Depreciation – 30,000
Average net income \$ 15,000
The unadjusted rate of return, like payback period analysis, has several limitations:
• The length of time over which the return is earned is not considered.
• The rate allows a sunk cost, depreciation, to enter into the calculation. Since depreciation can be calculated in so many different ways, the rate of return can be manipulated by simply changing the method of depreciation used for the project.
• The timing of cash flows is not considered. Thus, the time value of money is ignored.
Unlike the two project selection methods just illustrated, the remaining two methods—net present value and time-adjusted rate of return—take into account the time value of money in the analysis. In both of these methods, we assume that all net cash inflows occur at the end of the year. Often used in capital budgeting analysis, this assumption makes the calculation of present values less complicated than if we assume the cash flows occurred at some other time.
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Should you rent a cable modem from Time Warner Cable or buy one?
Questions
1. What is the payback period (in months) if you decide to purchase the Motorola Surfboard SB6121 cable modem?
2. What are the advantages to renting a cable modem from Time Warner?
3. What are the advantages to buying a cable model from Time Warner?
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11.05: The Capital Rationing Process
• Investments in working capital
An investment in a capital asset usually must be supported by an investment in working capital, such as accounts receivable and inventory. For example, companies often invest in a capital project expecting to increase sales. Increased sales usually bring about an increase in accounts receivable from customers and an increase in inventory to support the higher sales level. The increases in current assets—accounts receivable and inventory—are investments in working capital that usually are recovered in full at the end of a capital project’s life. Such working capital investments should be considered in capital-budgeting decisions.
To illustrate, assume that a company is considering a capital project involving a \$50,000 investment in machinery and a \$40,000 investment in working capital. The machine, which will produce a new product, has an estimated useful life of eight years and no salvage value. The annual cash inflows (before taxes) are estimated at \$25,000, with annual cash outflows (before taxes) of \$5,000. The annual net cash inflow from the project is computed as follows (assuming straight-line depreciation and a 40% tax rate):
Cash inflows \$ 25,000
Cash outflows 5,000
Net cash inflow before taxes \$ 20,000
Less: 40% Income Tax Expense (20,000 x 40%) – 8,000
Net cash inflow after taxes (ignoring depreciation) (1) \$ 12,000
Depreciation expense (\$ 50,000/8 years) \$ 6,250
Income tax rate x 40%
Depreciation tax savings (2) \$ 2,500
Annual net cash inflow, years 1-8 (1) + (2) \$ 14,500
The annual net cash inflow from the machine is \$14,500 each year for eight years. However, the working capital investment must be considered. The investment of \$40,000 in working capital at the start of the project is an additional outlay that must be made when the project is started. The \$40,000 would be tied up every year until the project is finished, or in this case, until the end of the life of the machine. At that point, the working capital would be released, and the \$40,000 could be used for other investments. Therefore, the \$40,000 is a cash outlay at the start of the project and a cash inflow at the end of the project.
The net present value of the project is computed as follows (assuming a 14% minimum desired rate of return):
Net cash inflow, years 1-8 (\$14,500 x 4.63886) \$67,263
Recovery of investment in working capital (\$40,000 x 0.35056) 14,022
Present value of net cash inflows \$81,285
Initial cash outlay (\$50,000 + \$40,000) 90,000
Net present value \$(8,715)
The discount factor for the cash inflows, 4.63886, comes from Table 2 in the Appendix at the end of the book, because the cash inflows in this example are a series of equal payments—an annuity. The recovery of the investment in working capital is assumed to represent a single lump sum received at the end of the project’s life. As such, it is discounted using a factor (0.35056) that comes from Table 1 in the Appendix.
The investment is not acceptable because it has a negative net present value. If the working capital investment had been ignored, the proposal would have had a rather large positive net present value of \$17,263 (\$67,263 net cash inflow – \$50,000 initial cost). Thus, it should be obvious that investments in working capital must be considered if correct capital-budgeting decisions are to be made.
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During the budget process, a company should prepare a capital expenditures budget. This budget may affect the cash budget, the budgeted income statement and the budgeted balance sheet so it should be prepared before these final budgets are prepared.
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The capital expenditure budget should not if the capital projects will be paid with cash or with a liability. We will need this information to budget for depreciation on the capital projects as well as the cash payments in the cash budget.
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11.08: Glossary
GLOSSARY
Annuity A series of equal cash inflows.
Capital budgeting The process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds, within the framework of company goals and objectives.
Capital project Any available alternative to purchase, build, lease, or renovate equipment, buildings, property, or other long-term assets.
Cost of capital The cost of all sources of capital (debt and equity) employed by a company.
Initial cost of an asset Any cash outflows necessary to acquire an asset and place it in a position and condition for its intended use.
Net cash inflow The periodic cash inflows from a project less the periodic cash outflows related to the project.
Net present value A project selection technique that discounts all expected after-tax cash inflows and outflows from the proposed investment to their present values using the company’s minimum rate of return as a discount rate. If the amount obtained by this process exceeds or equals the investment amount, the proposal is considered acceptable for further consideration.
Opportunity cost The benefits or returns lost by rejecting the best alternative investment.
Out-of-pocket cost A cost requiring a future outlay of resources, usually cash.
Payback period The period of time it takes for the cumulative sum of the annual net cash inflows from a project to equal the initial net cash outlay.
Profitability index The ratio of the present value of the expected net cash inflows (after taxes) divided by the initial cash outlay (or present value of cash outlays if future outlays are required).
Sunk costs Costs that have already been incurred. Nothing can be done about sunk costs at the present time; they cannot be avoided or changed in amount.
Time-adjusted rate of return A project selection technique that finds a rate of return that will equate the present value of future expected net cash inflows (after taxes) from an investment with the cost of the investment; also called internal rate of return.
Unadjusted (or accounting) rate of return The rate of return computed by dividing average annual income after taxes from a project by the average amount of the investment. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/11%3A_Capital_Investment_Analysis/11.06%3A_Controlling_Capital_Investment_Expenditures.txt |
Short-Answer Questions, Exercises, and Problems
Short-Answer Questions
• How do capital expenditures differ from ordinary expenditures?
• What effects can capital-budgeting decisions have on a company?
• What effect does depreciation have on cash flow?
• Give an example of an out-of-pocket cost and a sunk cost by describing a situation in which both are encountered.
• A machine is being considered for purchase. The salesperson attempting to sell the machine says that it will pay for itself in five years. What is meant by this statement?
• Discuss the limitations of the payback period method.
• What is the profitability index, and of what value is it?
• What is the time-adjusted rate of return on a capital investment?
• What role does the cost of capital play in the time-adjusted rate of return method and in the net present value method?
• What is the purpose of a postaudit? When should a postaudit be performed?
• A friend who knows nothing about the concepts in this chapter is considering purchasing a house for rental to students. In just a few words, what would you tell your friend to think about in making this decision?
Exercises
Exercise A Diane Manufacturing Company is considering investing \$600,000 in new equipment with an estimated useful life of 10 years and no salvage value. The equipment is expected to produce \$240,000 in cash inflows and \$160,000 in cash outflows annually. The company uses straight-line depreciation, and has a 40% tax rate. Determine the annual estimated net income and net cash inflow.
Exercise B Zen Manufacturing Company is considering replacing a four-year-old machine with a new, advanced model. The old machine was purchased for \$60,000, has an estimated useful life of 10 years with no salvage value, and has annual maintenance costs of \$15,000. The new machine would cost \$45,000, but annual maintenance costs would be only \$6,000. The new machine would have an estimated useful life of 10 years with no salvage value. Using straight-line depreciation and an assumed 40% tax rate, compute the additional annual cash inflow if the old machine is replaced.
Exercise C Given the following annual costs, compute the payback period for the new machine if its initial cost is \$420,000.
Old machine
New machine
Depreciation
\$ 18,000
\$ 42,000
Labor
72,000
63,000
Repairs
21,000
4,500
Other costs
12,000
3,600
\$ 123,000
\$ 113,100
Exercise D Jefferson Company is considering investing \$33,000 in a new machine. The machine is expected to last five years and to have a salvage value of \$8,000. Annual before-tax net cash inflow from the machine is expected to be \$7,000. Calculate the unadjusted rate of return. The income tax rate is 40%.
Exercise E Compute the profitability index for each of the following two proposals assuming the desired minimum rate of return is 20%. Based on the profitability indexes, which proposal is better?
Proposal 1
Proposal 2
Initial cash outlay
\$ 16,000
\$ 10,300
Net cash inflow (after taxes):
First year
10,000
6,000
Second year
9,000
6,000
Third year
6,000
4,000
Fourth year
-0-
2,500
Exercise F Ross Company is considering three alternative investment proposals. Using the following information, rank the proposals in order of desirability using the payback period method.
Proposal
A
B
C
Initial outlay
\$ 360,000
\$ 360,000
\$ 360,000
Net cash inflow (after taxes):
First year
\$ -0-
\$ 90,000
\$ 90,000
Second year
180,000
270,000
180,000
Third year
180,000
90,000
270,000
Fourth year
90,000
180,000
450,000
\$ 450,000
\$ 630,000
\$ 990,000
Exercise G Simone Company is considering the purchase of a new machine costing \$50,000. It is expected to save \$9,000 cash per year for 10 years, has an estimated useful life of 10 years, and no salvage value. Management will not make any investment unless at least an 18% rate of return can be earned. Using the net present value method, determine if the proposal is acceptable. Assume all tax effects are included in these numbers.
Exercise H Refer to the data in previous exercise. Calculate the time-adjusted rate of return.
Exercise I Rank the following investments for Renate Company in order of their desirability using the (a) payback period method, (b) net present value method, and (c) time-adjusted rate of return method. Management requires a minimum rate of return of 14%.
Initial
Expected after-tax net cash
Expected life of proposal
Investment
Cash outlay
Inflow per year
(years)
A
\$ 120,000
\$ 15,000
8
B
150,000
26,000
20
C
240,000
48,000
10
Problems
Problem A Hamlet Company is considering the purchase of a new machine that would cost \$300,000 and would have an estimated useful life of 10 years with no salvage value. The new machine is expected to have annual before-tax cash inflows of \$100,000 and annual before-tax cash outflows of \$40,000. The company will depreciate the machine using straight-line depreciation, and the assumed tax rate is 40%.
a. Determine the net after-tax cash inflow for the new machine.
b. Determine the payback period for the new machine.
Problem B Graham Company currently uses four machines to produce 400,000 units annually. The machines were bought three years ago for \$50,000 each and have an expected useful life of 10 years with no salvage value. These machines cost a total of \$30,000 per year to repair and maintain.
The company is considering replacing the four machines with one technologically superior machine capable of producing 400,000 units annually by itself. The machine would cost \$140,000 and have an estimated useful life of seven years with no salvage value. Annual repair and maintenance costs are estimated at \$14,000.
Assuming straight-line depreciation and a 40% tax rate, determine the annual additional after-tax net cash inflow if the new machine is acquired.
Problem C Macro Company owns five machines that it uses in its manufacturing operations. Each of the machines was purchased four years ago at a cost of \$120,000. Each machine has an estimated life of 10 years with no expected salvage value. A new machine has become available. One new machine has the same productive capacity as the five old machines combined; it can produce 800,000 units each year. The new machine will cost \$648,000, is estimated to last six years, and will have a salvage value of \$72,000. A trade-in allowance of \$24,000 is available for each of the old machines. These are the operating costs per unit:
Five old Machines
New Machines
Repairs
\$ 0.6796
\$ 0.0856
Depreciation
0.1500
0.2400
Power
0.1890
0.1036
Other operating costs
0.1620
0.0496
\$ 1.1806
\$ 0.4788
Ignore federal income taxes. Use the payback period method for (a) and (b).
a. Do you recommend replacing the old machines? Support your answer with computations. Disregard all factors except those reflected in the data just given.
b. If the old machines were already fully depreciated, would your answer be different? Why?
c. Using the net present value method with a discount rate of 20%, present a schedule showing whether or not the new machine should be acquired.
Problem D Span Fruit Company has used a particular canning machine for several years. The machine has a zero salvage value. The company is considering buying a technologically improved machine at a cost of \$232,000. The new machine will save \$50,000 per year after taxes in cash operating costs. If the company decides not to buy the new machine, it can use the old machine for an indefinite time by incurring heavy repair costs. The new machine would have an estimated useful life of eight years.
a. Compute the time-adjusted rate of return for the new machine.
b. Management thinks the estimated useful life of the new machine may be more or less than eight years. Compute the time-adjusted rate of return for the new machine if its useful life is (1) 5 years and (2) 12 years, instead of 8 years.
c. Suppose the new machine’s useful life is eight years, but the annual after-tax cost savings are only \$45,000. Compute the time-adjusted rate of return.
d. Assume the annual after-tax cost savings from the new machine will be \$35,000 and its useful life will be 10 years. Compute the time-adjusted rate of return.
Problem E Merryll, Inc., is considering three different investments involving depreciable assets with no salvage value. The following data relate to these investments:
Initial cash
Expected before-tax net
Expected after-tax net
Life of proposal
Investment
Outlay
Cash inflow per year
Cash inflow per year
(years)
1
\$ 140,000
\$ 37,333
\$ 28,000
10
2
240,000
72,000
48,000
20
3
360,000
89,333
68,000
10
The income tax rate is 40%. Management requires a minimum return on investment of 12%.
Rank these proposals using the following selection techniques:
a. Payback period.
b. Unadjusted rate of return.
c. Profitability index.
d. Time-adjusted rate of return.
Problem F Slow to Change Company has decided to computerize its accounting system. The company has two alternatives—it can lease a computer under a three-year contract or purchase a computer outright.
If the computer is leased, the lease payment will be \$5,000 each year. The first lease payment will be due on the day the lease contract is signed. The other two payments will be due at the end of the first and second years. The lessor will provide all repairs and maintenance.
If the company purchases the computer outright, it will incur the following costs:
Acquisition cost
\$ 10,500
Repairs and maintenance:
First year
300
Second year
250
Third year
350
The computer is expected to have only a three-year useful life because of obsolescence and technological advancements. The computer will have no salvage value and be depreciated on a double-declining-balance basis. Slow to Change Company’s cost of capital is 16%.
a. Calculate the net present value of out-of-pocket costs for the lease alternative.
b. Calculate the net present value of out-of-pocket costs for the purchase alternative.
c. Do you recommend that the company purchase or lease the machine?
Problem G Van Gogh Sports Company is trying to decide whether to add tennis equipment to its existing line of football, baseball, and basketball equipment. Market research studies and cost analyses have provided the following information:
Van Gogh will need additional machinery and equipment to manufacture the tennis equipment. The machines and equipment will cost \$450,000, have an estimated 10-year useful life, and have a \$10,000 salvage value.
Sales of tennis equipment for the next 10 years have been projected as follows:
Years
Sales in dollars
1
\$ 75,000
2
112,500
3
168,750
4
187,500
5
206,250
6 – 10 (each year)
225,000
Variable costs are 60% of selling price, and fixed costs (including straight-line depreciation) will total \$88,500 per year.
The company must advertise its new product line to gain rapid entry into the market. Its advertising campaign costs will be:
Years
Annual advertising cost
1 – 3
\$ 75,000
4 – 10
37,500
The company requires a 14% minimum rate of return on investments.
Using the net present value method, decide whether or not Van Gogh Sports Company should add the tennis equipment to its line of products. (Ignore federal income taxes.) Round to the nearest dollar.
Problem H Jordan Company is considering purchasing new equipment costing \$2,400,000. Jordan estimates that the useful life of the equipment will be five years and that it will have a salvage value of \$600,000. The company uses straight-line depreciation. The new equipment is expected to have a net cash inflow (before taxes) of \$258,000 annually. Assume that the tax rate is 40% and that management requires a minimum return of 14%.
Using the net present value method, determine whether the equipment is an acceptable investment.
Problem I Penny Company has an opportunity to sell some equipment for \$40,000. Such a sale will result in a tax-deductible loss of \$4,000. If the equipment is not sold, it is expected to produce net cash inflows after taxes of \$8,000 for the next 10 years. After 10 years, the equipment can be sold for its book value of \$4,000. Assume a 40% federal income tax rate.
Management currently has other opportunities that will yield 18%. Using the net present value method, show whether the company should sell the equipment. Prepare a schedule to support your conclusion.
Alternate problems
Alternate problem A Mark’s Manufacturing Company is currently using three machines that it bought seven years ago to manufacture its product. Each machine produces 10,000 units annually. Each machine originally cost \$25,500 and has an estimated useful life of 17 years with no salvage value.
The new assistant manager of Mark’s Manufacturing Company suggests that the company replace the three old machines with two technically superior machines for \$22,500 each. Each new machine would produce 15,000 units annually and would have an estimated useful life of 10 years with no salvage value.
The new assistant manager points out that the cost of maintaining the new machines would be much lower. Each old machine costs \$2,500 per year to maintain; each new machine would cost only \$1,500 a year to maintain.
Compute the increase in after-tax annual net cash inflow that would result from replacing the old machines; use straight-line depreciation and an assumed tax rate of 40%.
Alternate problem B Fed Extra Company is considering replacing 10 of its delivery vans that originally cost \$30,000 each; depreciation of \$18,750 has already been taken on each van. The vans were originally estimated to have useful lives of eight years and no salvage value. Each van travels an average of 150,000 miles per year. The 10 new vans, if purchased, will cost \$36,000 each. Each van will be driven 150,000 miles per year and will have no salvage value at the end of its three-year estimated useful life. A trade-in allowance of \$3,000 is available for each of the old vans. Following is a comparison of costs of operation per mile:
Old vans
New vans
Fuel, lubricants, etc.
\$ 0.152
\$ 0.119
Tires
0.067
0.067
Repairs
0.110
0.087
Depreciation
0.025
0.080
Other operating costs
0.051
0.043
Operating costs per mile
\$ 0.405
\$ 0.396
Use the payback period method for (a) and (b).
a. Do you recommend replacing the old vans? Support your answer with computations and disregard all factors not related to the preceding data.
b. If the old vans were already fully depreciated, would your answer be different? Why?
c. Assume that all cost flows for operating costs fall at the end of each year and that 18% is an appropriate rate for discounting purposes. Using the net present value method, present a schedule showing whether or not the new vans should be acquired.
Alternate problem C Mesa Company has been using an old-fashioned computer for many years. The computer has no salvage value. The company is considering buying a computer system at a cost of \$35,000. The new computer system will save \$7,000 per year after taxes in cash (including tax effects of depreciation). If the company decides not to buy the new computer system, it can use the old one for an indefinite time. The new computer system will have an estimated useful life of 10 years.
a. Compute the time-adjusted rate of return for the new computer system.
b. The company is uncertain about the new computer system’s 10-year useful life. Compute the time-adjusted rate of return for the new computer system if its useful life is (1) 6 years and (2) 15 years, instead of 10 years.
c. Suppose the computer system has a useful life of 10 years, but the annual after-tax cost savings are only \$4,500. Compute the time-adjusted rate of return.
d. Assume the annual after-tax cost savings will be \$7,500 and the useful life will be eight years. Compute the time-adjusted rate of return.
Alternate problem D Ott’s Fresh Produce Company has always purchased its trucks outright and sold them after three years. The company is ready to sell its present fleet of trucks and is trying to decide whether it should continue to purchase trucks or whether it should lease trucks. If the trucks are purchased, the company will incur the following costs:
Costs per fleet
Acquisition cost
\$ 312,000
Repairs:
First year
3,600
Second year
6,600
Third year
9,000
Other annual costs
9,600
At the end of three years, the trucks could be sold for a total of \$96,000. Another fleet of trucks would then be purchased. The costs just listed, including the same acquisition cost, also would be incurred with respect to the second fleet of trucks. The second fleet also could be sold for \$96,000 at the end of three years.
If the company leases the trucks, the lease contract will run for six years. One fleet of trucks will be provided immediately, and a second fleet of trucks will be provided at the end of three years. The company will pay \$126,000 per year under the lease contract. The first lease payment will be due on the day the lease contract is signed. The lessor bears the cost of all repairs.
Using the net present value method, determine if the company should buy or lease the trucks. Assume the company’s cost of capital is 18%. (Ignore federal income taxes.)
Beyond the numbers—Critical thinking
Business decision case A Lloyd’s Company wishes to invest \$750,000 in capital projects that have a minimum expected rate of return of 14%. The company is evaluating five proposals. Acceptance of one proposal does not preclude acceptance of any of the other proposals. The company’s criterion is to select proposals that meet its 14% minimum required rate of return. The relevant information related to the five proposals is as follows:
Initial cash
Expected after-tax net
Expected life of
Investment
Outlay
Cash inflow per year
Proposal (years)
A
\$ 150,000
\$ 45,000
5
B
300,000
60,000
8
C
375,000
82,500
10
D
450,000
78,000
12
E
150,000
31,500
10
a. Compute the net present value of each of the five proposals.
b. Which projects should be undertaken? Why? Rank them in order of desirability.
Business decision case B Slick Company is considering a capital project involving a \$225,000 investment in machinery and a \$45,000 investment in working capital. The machine has an expected useful life of 10 years and no salvage value. The annual cash inflows (before taxes) are estimated at \$90,000 with annual cash outflows (before taxes) of \$30,000. The company uses straight-line depreciation. Assume the federal income tax rate is 40%.
The company’s new accountant computed the net present value of the project using a minimum required rate of return of 16% (the company’s cost of capital). The accountant’s computations follow:
Cash inflows
\$ 90,000
Cash outflows
30,000
Net cash inflow
\$ 60,000
Present value of net cash at 16%
X 4.833
Present value of net cash inflow
\$283,980
Initial cash outlay
225,000
Net present value
\$ 64,980
a. Are the accountant’s computations correct? If not, compute the correct net present value.
b. Is this capital project acceptable to the company? Why or why not?
An accounting perspective – Writing experience C Refer to “An accounting perspective: Business insight”. Write a brief paper explaining why managers in Japan might use lower measures of the cost of capital than US managers.
Ethics case – Writing experience D Rebecca Peters just learned that First Bank’s investment review committee rejected her pet project, a new computerized method of storing data that would enable customers to have instant access to their bank records. Peters’ software consulting firm specializes in working with financial institutions. This project for First Bank was her first as project manager.
Following up, Peters learned that First Bank’s investment review committee liked the idea but were not convinced that the new software’s financial benefits would justify the cost of the software. When she told a colleague about the rejection at First Bank, the colleague said, “Why not tell the committee this software will increase the bank’s profits? After we installed the software in the bank in Indianapolis, Indiana, USA their profits increased substantially. We even have data from that bank that you could present.”
Peters thought about the suggestion. She knew First Bank would be pleased with the software if they installed it, and she wanted to make the sale. She also knew that the situation in Indianapolis, Indiana, USA was different; profits there had increased primarily because of other software that had reduced the bank’s operating costs.
What should Rebecca Peters do? Write her a letter telling what you would do.
Group assignment E For summer employment, a friend is considering investing in a coffee stand on a busy street near office buildings. Being unfamiliar with the concepts in this chapter, your friend does not know how to make the decision. In teams of four, help your friend get started by providing a framework and questions that your friend should answer. (For example, how much will the investment be? How much are the estimated cash flows from sales?) Prepare a memorandum from the group to your instructor; list your questions and suggestions for your friend. In the heading, include the date, to whom it is written, from whom, and the subject matter.
Group project F You have the option of choosing between two projects with equal total cash flows over five years but different annual cash flows. In groups of two or three students, determine which project should be selected for investment. Write a memorandum to your instructor addressing this issue. Be sure to provide examples to reinforce your answer. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter.
Group project G A manager comments to her superior, “There is no need to perform a postaudit. The project was justified based on our initial projections and we were given the green light to proceed. It has been a year since we started the project, a postaudit would be a waste of time.” In groups of two or three students, respond to this comment. Do you agree? Do you disagree? If this manager is right, why bother with a postaudit? Write a memorandum to your instructor addressing these questions. 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
Using any Internet search engine enter “budgeting” . Select an article that directly discusses budgeting in an organization or industry and print a copy of the article. You are encouraged (but not required) to find an article that answers some of the following questions: What is the purpose of budgeting? How are budgets developed? How is budgeting used to motivate employees? How might budgeting create ethical dilemmas?
Write a memorandum to your instructor summarizing the key points of the article. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter. Be sure to include a copy of the article used for this assignment.
Using any Internet search engine select one of the new terms at the end of the chapter and perform a key word search. Be sure to include quotation marks (for example: “Payback period”). Select an article that directly discusses the new term used, and print a copy of the article. Write a memorandum to your instructor summarizing the key points of the article. The heading of the memorandum should contain the date, to whom it is written, from whom, and the subject matter. Be sure to include a copy of the article used for this assignment. | textbooks/biz/Accounting/Managerial_Accounting_(Lumen)/11%3A_Capital_Investment_Analysis/11.09%3A_Chapter_11-_Exercises.txt |
This chapter discusses several common methods of analyzing and relating the data in financial statements and, as a result, gaining a clear picture of the solvency and profitability of a company. Internally, management analyzes a company’s financial statements as do external investors, creditors, and regulatory agencies. Although these users have different immediate goals, their overall objective in financial statement analysis is the same—to make predictions about an organization as an aid in decision making.
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Objectives of financial statement analysis
Management’s analysis of financial statements primarily relates to parts of the company. Using this approach, management can plan, evaluate, and control operations within the company. Management obtains any information it wants about the company’s operations by requesting special-purpose reports. It uses this information to make difficult decisions, such as which employees to lay off and when to expand operations. Our primary focus in this chapter, however, is not on the special reports accountants prepare for management. Rather, it is on the information needs of persons outside the firm.
Investors, creditors, and regulatory agencies generally focus their analysis of financial statements on the company as a whole. Since they cannot request special-purpose reports, external users must rely on the general-purpose financial statements that companies publish. These statements include a balance sheet, an income statement, a statement of stockholders’ equity, a statement of cash flows, and the explanatory notes that accompany the financial statements.
Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information. This information reveals significant relationships between data and trends in those data that assess the company’s past performance and current financial position. The information shows the results or consequences of prior management decisions. In addition, analysts use the information to make predictions that may have a direct effect on decisions made by users of financial statements.
Comparative financial statements present the same company’s financial statements for one or two successive periods in side-by-side columns. The calculation of dollar changes or percentage changes in the statement items or totals is horizontal analysis. This analysis detects changes in a company’s performance and highlights trends.
The good news is you have already been performing the first part of horizontal analysis without realizing it when you were preparing the statement of cash flows. Horizontal analysis consists of 2 things:
• Dollar amount of change (calculated as Current Year amount – Previous Year amount)
• Percentage of change (calculated as Dollar amount of change / previous year amount)
Horizontal analysis is called horizontal because we look at one account at a time across time. We can perform this type of analysis on the balance sheet or the income statement. Let’s look at this video followed by another example.
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The comparative financial statements of Synotech, Inc., will serve as a basis for an example of horizontal analysis and vertical analysis of a balance sheet and a statement of income and retained earnings. Recall that horizontal analysis calculates changes in comparative statement items or totals. Here is an example of Synotech, Inc. current asset section (in millions) of the balance sheet with horizontal analysis performed:
2015 2014 Increase (or Decrease) Percent of Change
Current assets:
Cash \$ 298.00 \$ 250.50 \$ 47.50 19.0%
Marketable securities 71.30 57.50 \$ 13.80 24.0%
Receivables, net 1,277.30 1,340.30 \$ (63.00) -4.7%
Inventories 924.80 929.80 \$ (5.00) -0.5%
Other current assets 275.30 254.30 \$ 21.00 8.3%
Total current assets \$ 2,846.70 \$ 2,832.40 \$ 14.30 0.5%
What does this tell us? Notice total current assets have increased \$ 14.3 million, consisting largely of increases in cash, marketable securities, and other current assets despite a \$63.0 million decrease in net receivables.
Next, study Column (4), which expresses as a percentage the dollar change in Column (3). Frequently, these percentage increases are more informative than absolute amounts, as illustrated by the current asset changes. The percentages reveal that current assets increased .5% which if we compared this to current liabilities would give us an idea if the company could pay their debt in the future.
Studying the percentages on the balance sheet could lead to several other observations. For instance, if there was a 6.9% decrease in long-term debt indicates that interest charges will be lower in the future, having a positive effect on future net income. An increase in retained earnings could be a sign of increased dividends in the future; in addition, the increase in cash of 19% could support this conclusion.
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• What is Financial Statement Analysis? - Accounting Video. Authored by: Brian Routh TheAccountingDr. Located at: youtu.be/8DmChanpSmw. License: All Rights Reserved. License Terms: Standard YouTube License
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Study Plan: Financial Statement Analysis
Knowledge Targets
I can define the following terms as they relate to our unit:
Net Income Retained Earnings Horizontal Analysis
Vertical Analysis Ratio Analysis Trend Percents
Current Assets Current Liabilities Average Inventory
Average Accounts Receivable Percent of change Dollar amount of change
Reasoning Targets
• I can understand the use of horizontal analysis, vertical analysis and ratio analysis
to evaluate company performance.
• I can analyze and explain the trends of a company using horizontal analysis.
• I can analyze and explain a company’s financial statements using vertical analysis.
• I can analyze and explain a company’s financial performance using ratio analysis.
Skill Targets
• I can calculate dollar amount of change and percentage of change for accounts on the financial statements using horizontal analysis.
• I can calculate trend percentages for horizontal analysis.
• I can calculate the common-size percentages using vertical analysis.
• I can calculate ratios used in ratio analysis.
Click Fin Stmt Analysis for a printable copy.
12.03: Calculating Trend Percentages
Trend percentages are similar to horizontal analysis except that comparisons are made to a selected base year or period. Trend percentages are useful for comparing financial statements over several years because they disclose changes and trends occurring through time.
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Trend percentages, also referred to as index numbers, help you to compare financial information over time to a base year or period. You can calculate trend percentages by:
• Selecting a base year or period.
• Assigning a weight of 100% to the amounts appearing on the base-year financial statements.
• Expressing the corresponding amounts on the other years’ financial statements as a percentage of base-year or period amounts. Compute the percentages by Analysis year amount / base year amount and then multiplying the result by 100 to get a percentage.
The following information for Synotech illustrates the calculation of trend percentages:
(USD millions) 20Y3 20Y4 20Y5
Net sales \$9,105.50 \$10,029.80 \$10,498.80
Cost of goods sold 4,696.00 5,223.70 5,341.30
Gross profit \$4,409.50 \$4,806.10 \$5,157.50
Operating expenses 3,353.60 4,369.90 4,012.00
Income before income taxes \$1,055.90 \$436.20 \$1,145.50
We will calculate the trend percentages using 2ox3 as the base year and everything in 20Y3 will be 100%. For Net Sales in 20×4, take \$10,029.80 from 20Y4 / 9,105.50 from base year 20Y3 and multiply by 100 to get 119.6%. For Net Sales in 20Y5, take \$10,498.80 from 20Y5 / 9,105.50 from base year 20Y3 and multiply by 100 to get 115.3%. The same process continues for each account using the amount for each account in the base year 20Y3. The trend analysis would look like this (calculations added beside each column):
20Y3 20Y4 20Y5
Net sales 100.00% 119.20% (\$10,029.80 115.30% (\$10,498.80
\$9,105.50) \$9,105.50)
Cost of goods sold 100 111.2 (5,223.70 113.7 (5,341.30
4,696.00) 4,696.00)
Gross profit 100 109 (\$4,806.10 117 (\$5,157.50
\$4,409.50) \$4,409.50)
Operating expenses 100 130.3 (4,369.90 119.6 (4,012.00
3,353.60) 3,353.60)
Income before income taxes 100 41.3 (\$436.20 108.5 (\$1,145.50
\$1,055.90) \$1,055.90)
These trend percentages indicate the changes taking place in the organization and highlight the direction of these changes. For instance, the percentage of sales is increasing each year compared to the base year. Cost of goods sold increased at a lower rate than net sales in 20Y3 and 20Y5, causing gross profit to increase at a higher rate than net sales. Operating expenses in 20Y4 increased due to the provision for restructured operations, causing a significant decrease in income before income taxes. Percentages provide clues to an analyst about which items need further investigation or analysis. In reviewing trend percentages, a financial statement user should pay close attention to the trends in related items, such as the cost of goods sold in relation to sales. Trend analysis that shows a constantly declining gross margin (profit) rate may be a signal that future net income will decrease.
As useful as trend percentages are, they have one drawback. Expressing changes as percentages is usually straightforward as long as the amount in the base year or period is positive—that is, not zero or negative. Analysts cannot express a \$30,000 increase in notes receivable as a percentage if the increase is from zero last year to \$30,000 this year (remember, you cannot divide by zero). Nor can they express an increase from a loss last year of – \$10,000 to income this year of \$20,000 in a realistic percentage term.
Proper analysis does not stop with the calculation of increases and decreases in amounts or percentages over several years. Such changes generally indicate areas worthy of further investigation and are merely clues that may lead to significant findings. Accurate predictions depend on many factors, including economic and political conditions; management’s plans regarding new products, plant expansion, and promotional outlays; and the expected activities of competitors. Considering these factors along with horizontal analysis, vertical analysis, and trend analysis should provide a reasonable basis for predicting future performance.
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Analysts also use vertical analysis of a single financial statement, such as an income statement. Vertical analysis consists of the study of a single financial statement in which each item is expressed as a percentage of a significant total. Vertical analysis is especially helpful in analyzing income statement data such as the percentage of cost of goods sold to sales. Where horizontal analysis looked at one account at a time, vertical analysis will look at one YEAR at a time.
Financial statements that show only percentages and no absolute dollar amounts are common-size statements. All percentage figures in a common-size balance sheet are percentages of total assets while all the items in a common-size income statement are percentages of net sales. The use of common-size statements facilitates vertical analysis of a company’s financial statements.
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The calculation for common-size percentages is: (Amount / Base amount) and multiply by 100 to get a percentage. Remember, on the balance sheet the base is total assets and on the income statement the base is net sales. The video showed an example using the balance sheet so we will look at Synotech, Inc.’s income statement with common-size percentages (calculations provided in last column).
Synotech, Inc.
Income Statement
For year ended December 31
Net Sales \$10,498.8 100.0% ( 10,498.8
10,498.8 )
Cost of goods sold 5,341.3 50.9% ( 5,341.3
10,498.8 )
Gross profit 5,157.5 49.1% ( 5,157.5
10,498.8 )
Selling, general and admin expenses 3,662.5 34.9% ( 3,662.5
10,498.8 )
Other expense, net 112.6 1.1% ( 112.6
10,498.8 )
Interest expense 236.9 2.3% ( 236.9
10,498.8 )
Income before taxes 1145.5 10.9% ( 1,145.5
10,498.8 )
Income tax expense 383.5 3.7% ( 383.5
10,498.8 )
Net Income 762 7.3% ( 762
10,498.8 )
What does this common-size percentage tell you about the company? Since we use net sales as the base on the income statement, it tells us how every dollar of net sales is spent by the company. For Synotech, Inc., approximately 51 cents of every sales dollar is used by cost of goods sold and 49 cents of every sales dollar is left in gross profit to cover remaining expenses. Of the 49 cents remaining, almost 35 cents is used by operating expenses (selling, general and administrative), 1 cent by other and 2 cents in interest. We earn almost 11 cents of net income before taxes and over 7 cents in net income after taxes on every sales dollar. This is a little easier to understand than the larger numbers showing Synotech earned \$762 million dollars.
The same process would apply on the balance sheet but the base is total assets. The common-size percentages on the balance sheet explain how our assets are allocated OR how much of every dollar in assets we owe to others (liabilities) and to owners (equity). Many computerized accounting systems automatically calculate common-size percentages on financial statements.
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12.05: Accounting in the Headlines
How can a common-size income statement help analysis of Pandora’s results of operations in 2015 compared to 2014?
Pandora Internet Radio by Pandora Media (P) is a streaming music service. Its free advertising-supported radio service was first launched in 2005. Pandora users streamed 20.03 billion hours of internet radio during 2014. In December 2014, there were 81.5 million active users of Pandora, making it the largest streaming music service currently. Pandora has a database of over 1,000,000 songs from over 125,000 artists.
Pandora offers its streaming music through two services:
1. Free Service: This option allows the listener access to the music by including advertisements.
2. Pandora One: This option is a paid subscription model without any advertisements; it also allows users to have more daily skips and longer listening times.
While Pandora currently has plenty of cash from its investors, it has yet to generate a profit since its inception. Pandora is facing increasing competition from sources such as Apple Music (approximately 6.5 million subscribers in 2015), Spotify (approximately 20 million paid subscribers in 2015), and other streaming services. In addition, Pandora’s costs in some areas are increasing.
Pandora recently released its earnings for the third quarter of 2015. Earnings were less than expected by investors and Pandora’s stock price fell sharply. At the end of this posting, excerpts from Pandora’s statement of operations is provided, both in dollars and in common-size formats. Use those excerpts to answer the questions.
Questions
1. Using the statement of operations excerpt in dollars, what can you say about how Pandora is doing in the third quarter of 2015 compared to the third quarter of 2014? What can you say about how Pandora is doing for the nine months ended September 2015 compared to September 2014? Can you tell if the rate of increase is greater for revenues or expenses from 2014 to 2015? Why or why not?
2. Using the statement of operations excerpt in dollars again, why is the loss from operations larger in 2015 than in 2014?
3. Using the common-size statement of operations excerpt, what can you say about how Pandora is doing in the third quarter of 2015 compared to the third quarter of 2014? What can you say about how Pandora is doing for the nine months ended September 2015 compared to September 2014? Is the rate of increase is greater for revenues or expenses from 2014 to 2015?
4. Using the common-size statement of operations excerpt again, why is the loss from operations larger in 2015 than in 2014? Also, what can you say about the mix of advertising revenue versus subscription revenue?
5. Which statement (dollars versus common-size) is more useful for analyzing the financial performance of Pandora in this case? Explain.
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Ratios are expressions of logical relationships between items in the financial statements of a single period. Analysts can compute many ratios from the same set of financial statements. A ratio can show a relationship between two items on the same financial statement or between two items on different financial statements (e.g. balance sheet and income statement). The only limiting factor in choosing ratios is the requirement that the items used to construct a ratio have a logical relationship to one another.
Ratio analysis
Logical relationships exist between certain accounts or items in a company’s financial statements. These accounts may appear on the same statement or on two different statements. We set up the dollar amounts of the related accounts or items in fraction form called ratios. These ratios include: (1) liquidity ratios; (2) equity, or long-term solvency, ratios; (3) profitability tests; and (4) market tests.
Liquidity ratios indicate a company’s short-term debt-paying ability. Thus, these ratios show interested parties the company’s capacity to meet maturing current liabilities.
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Current (or working capital) ratio Working capital is the excess of current assets over current liabilities. The ratio that relates current assets to current liabilities is the current (or working capital) ratio. The current ratio indicates the ability of a company to pay its current liabilities from current assets and, thus, shows the strength of the company’s working capital position. You calculate the current ratio by:
Current Assets
Current Liabilities
The ratio is usually stated as a number of dollars of current assets available to pay every dollar of current liabilities (although the dollar signs usually are omitted). Thus, for Synotech, when current assets totaled \$2,846.7 million and current liabilities totaled \$2,285.2 million, the ratio is 1.25:1 (or 1.25 to 1), meaning that the company has \$1.25 of current assets available to pay every \$1.00 of current liabilities.
Short-term creditors are particularly interested in the current ratio since the conversion of inventories and accounts receivable into cash is the primary source from which the company obtains the cash to pay short-term creditors. Long-term creditors are also interested in the current ratio because a company that is unable to pay short-term debts may be forced into bankruptcy. For this reason, many bond indentures, or contracts, contain a provision requiring that the borrower maintain at least a certain minimum current ratio. A company can increase its current ratio by issuing long-term debt or capital stock or by selling noncurrent assets.
A company must guard against a current ratio that is too high, especially if caused by idle cash, slow-paying customers, and/or slow-moving inventory. Decreased net income can result when too much capital that could be used profitably elsewhere is tied up in current assets.
Acid-test (quick) ratio The current ratio is not the only measure of a company’s short-term debt-paying ability. Another measure, called the acid-test (quick) ratio, is the ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities. Analysts exclude inventories and prepaid expenses from current assets to compute quick assets because they might not be readily convertible into cash. The formula for the acid-test ratio is:
Cash + Short-term investments + net current receivables
Current Liabilities
Short-term creditors are particularly interested in this ratio, which relates the pool of cash and immediate cash inflows to immediate cash outflows. In deciding whether the acid-test ratio is satisfactory, investors consider the quality of the marketable securities and receivables. An accumulation of poor-quality marketable securities or receivables, or both, could cause an acid-test ratio to appear deceptively favorable. When referring to marketable securities, poor quality means securities likely to generate losses when sold. Poor-quality receivables may be uncollectible or not collectible until long past due.
Since inventory and accounts receivable are a large part of a company’s current assets, it is important to understand the company’s ability to collect from their customers and the company’s efficiency in buying and selling inventory.
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Accounts receivable turnoverTurnover is the relationship between the amount of an asset and some measure of its use. Accounts receivable turnover is the number of times per year that the average amount of receivables is collected. To calculate this ratio:
Net Sales
AVERAGE Accounts receivable, net
Net accounts receivable is accounts receivable after deducting the allowance for uncollectible accounts. Calculate average accounts receivable by taking the beginning balance in accounts receivable (or ending amount from the previous year) + the ending balance of the current year and divide by 2.
The accounts receivable turnover ratio provides an indication of how quickly the company collects receivables. For Synotech, Inc., we have the following information:
Net Sales \$ 10,498.80
Accounts Receivable, Net
January 1 \$ 1,340.30
December 31 1,277.30
We first need to calculate average accounts receivable. Jan 1 accounts receivable \$1,340.30 + Dec 31 Accounts receivable \$1,277.30 = \$2,617.60 / 2 gives us average accounts receivable of \$1,308.80. We calculate the AR Turnover of 8.02 times:
Net Sales \$10,498.80
Avg. Accts Receivable = \$1,308.80
The accounts receivable turnover ratio indicates Synotech collected, or turned over, its accounts receivable slightly more than eight times. The ratio is better understood and more easily compared with a company’s credit terms if we convert it into a number of days, as is illustrated in the next ratio.
Number of days’ sales in accounts receivable The number of days’ sales in accounts receivable ratio is also called the average collection period for accounts receivable. Calculate it as follows:
Avg Accounts Receivable x 365 days
Net Sales
We use a 365 days in a year for this calculation. Notice we are using Average accounts receivable here as well, but it can also be calculated with ending accounts receivable instead. Still using Synotech, Inc.’s information from above, we calculate 45.5 or 46 days from:
Avg. Accts Receivable = \$1,308.80 x 365 Days
Net Sales \$10,498.80
It can also be calculated as (365 days / AR Turnover). This ratio tells us it takes 46 days to collect on accounts receivable. Standard credit terms are 30 days but 46 days is not too bad.
What about how a company handles inventory? We can prepare similar ratios for inventory turnover and number of days’ sales in inventory.
Inventory turnover A company’s inventory turnover ratio shows the number of times its average inventory is sold during a period. You can calculateinventory turnover as follows:
Cost of Goods Sold
Average Inventory
When comparing an income statement item and a balance sheet item, measure both in comparable dollars. Notice that we measure the numerator and denominator in cost rather than sales dollars. (Earlier, when calculating accounts receivable turnover, we measured both numerator and denominator in sales dollars.) We will calculate average inventory by taking the beginning inventory + ending inventory and divide by 2. Let’s look at the following information for Synotech, Inc.:
Cost of goods sold \$ 5,341.30
Inventory
January 1 \$ 929.80
December 31 924.80
We first calculate average inventory as Jan 1 inventory \$929.80 + Dec 31 inventory \$924.80 = total inventory of \$1,854.60 and divide by 2 for average inventory of \$927.30. Next, we calculate inventory turnover:
Cost of Goods Sold = \$5,341.30
Average Inventory \$927.30
Synotech was able to sell average inventory 5.76 times during the year. This ratio can better be understood by looking at the number of days’ sales in inventory. Calculated as 365 days / inventory turnover or by this formula:
Average Inventory x 365 days
Cost of goods sold
We will calculate Synotech’s number of days in inventory using average inventory (but can also be calculated using ending inventory) of 63.4 or just 63 days as follows:
Average Inventory \$1,854.60 x 365 Days
Cost of Goods Sold \$5,341.30
This means it takes 63 days to sell our inventory. This is a very useful ratio to determine how quickly a company’s inventory moves through the company.
Other things being equal, a manager who maintains the highest inventory turnover ratio (and lowest number of days) is the most efficient. Yet, other things are not always equal. For example, a company that achieves a high inventory turnover ratio by keeping extremely small inventories on hand may incur larger ordering costs, lose quantity discounts, and lose sales due to lack of adequate inventory. In attempting to earn satisfactory income, management must balance the costs of inventory storage and obsolescence and the cost of tying up funds in inventory against possible losses of sales and other costs associated with keeping too little inventory on hand.
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12.07: Ratios That Analyze a Companys Long-Term Debt Paying Ability
Creditors are interested to know if a company can pay its long-term debts. There are several ratios we use for this as demonstrated in the video:
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Debt ratio The debt ratio measures how much we owe in total liabilities for every dollar in total assets we have. This is a good overall ratio to tell creditors or investors if we have enough assets to cover our debt. The ratio is calculated as:
Total Liabilities
Total Assets
Total Liabilities \$7,041.00
Total Assets \$9,481.80
Times interest earned ratio Creditors, especially long-term creditors, want to know whether a borrower can meet its required interest payments when these payments come due. The times interest earned ratio, or interest coverage ratio, is an indication of such an ability. It is computed as follows:
Income from operations (IBIT)
Interest expense
The ratio is a rough comparison of cash inflows from operations with cash outflows for interest expense. Income before interest and taxes (IBIT) is the numerator because there would be no income taxes if interest expense is equal to or greater than IBIT. (To find income before interest and taxes, take net income from continuing operations and add back the net interest expense and taxes.) Analysts disagree on whether the denominator should be (1) only interest expense on long-term debt, (2) total interest expense, or (3) net interest expense. We will use net interest expense in the Synotech illustration.
For Synotech, the net interest expense is \$236.9 million. With an IBIT of \$1,382.4 million, the times interest earned ratio is 5.84, calculated as:
Income from operations \$1,382.40
Interest expense \$236.90
The company earned enough during the period to pay its interest expense almost 6 times over.
Low or negative interest coverage ratios suggest that the borrower could default on required interest payments. A company is not likely to continue interest payments over many periods if it fails to earn enough income to cover them. On the other hand, interest coverage of 5 to 10 times or more suggests that the company is not likely to default on interest payments.
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Equity, or long-term solvency, ratios show the relationship between debt and equity financing in a company.
Equity (stockholders’ equity) ratio The two basic sources of assets in a business are owners (stockholders) and creditors; the combined interests of the two groups are total equities. In ratio analysis, however, the term equity generally refers only to stockholders’ equity. Thus, the equity (stockholders’ equity) ratio indicates the proportion of total assets (or total liabilities and equity) provided by stockholders (owners) on any given date. The formula for the equity ratio is:
Total Stockholder’s Equity
Total Assets (or Total Liabilities & Equity)
Notice how we can use either Total Assests or Total Liabilities and Equity as the denominator, why? Because of the accounting equation — Assets = Liabilities + Equity. This calculation should look familiar as this is the same calculation we would have done in a vertical analysis (common-size percentages). Synotech’s liabilities and stockholders’ equity follow. The company’s equity ratio increased from 22.0% in 20Y4 to 25.7% in 20Y5. The information below shows that stockholders increased their proportionate equity in the company’s assets due largely to the retention of earnings (which increases retained earnings).
20Y5 December 31 20Y4 December 31
(USD millions) Amount % Amount %
Current liabilities \$2,285.2 24.1% \$2,103.8 22.9%
Long-term liabilities 4,755.8 50.2 5,051.3 55.1
Total liabilities \$7,041.0 74.3 \$7,155.1 78.0
Total stockholders’ equity 2,440.8 25.7 2,015.7 22.0
Total liabilities & equity (equal to total assets) \$9,481.8 100% \$9,170.8 100.0%
The equity ratio must be interpreted carefully. From a creditor’s point of view, a high proportion of stockholders’ equity is desirable. A high equity ratio indicates the existence of a large protective buffer for creditors in the event a company suffers a loss. However, from an owner’s point of view, a high proportion of stockholders’ equity may or may not be desirable. If the business can use borrowed funds to generate income in excess of the net after-tax cost of the interest on such funds, a lower percentage of stockholders’ equity may be desirable.
We should point out, however, that too low a percentage of stockholders’ equity (too much debt) has its dangers. Financial leverage magnifies losses per share as well as Earnings Per Share (EPS) since there are fewer shares of stock over which to spread the losses. A period of business recession may result in operating losses and shrinkage in the value of assets, such as receivables and inventory, which in turn may lead to an inability to meet fixed payments for interest and principal on the debt. As a result, the company may be forced into liquidation, and the stockholders could lose their entire investments.
Stockholders’ equity to debt (debt to equity) ratio Analysts express the relative equities of owners and creditors in several ways. To say that creditors held a 74.3% interest in the assets of Synotech (remember the debt ratio from the previous section?) on 20Y5 December 31, is equivalent to saying stockholders held a 25.7% interest. Another way of expressing this relationship is the stockholders’ equity to debt ratio:
Total Stockholder’s Equity
Total Liabilities
Such a ratio for Synotech would be 0.28:1 (or \$2,015.7 million/\$7,155.1 million) on 20Y4 December 31, and 0.35:1 (or \$2,440.8 million/\$7,041.0 million) on 20Y5 December 31. This ratio is often inverted and called the debt to equity ratio. Some analysts use only long-term debt rather than total debt in calculating these ratios. These analysts do not consider short-term debt to be part of the capital structure since it is paid within one year.
Profitability is an important measure of a company’s operating success. Generally, we are concerned with two areas when judging profitability: (1) relationships on the income statement that indicate a company’s ability to recover costs and expenses, and (2) relationships of income to various balance sheet measures that indicate the company’s relative ability to earn income on assets employed. Each of the following ratios utilizes one of these relationships.
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Return on average common stockholders’ equity From the stockholders’ point of view, an important measure of the income-producing ability of a company is the relationship of return on average common stockholders’ equity, also called rate of return on average common stockholders’ equity, or simply the return on equity (ROE). Although stockholders are interested in the ratio of operating income to operating assets as a measure of management’s efficient use of assets, they are even more interested in the return the company earns on each dollar of stockholders’ equity. The formula for return on average common stockholders’ equity if no preferred stock is outstanding is:
Net Income – preferred dividends
AVERAGE common stockholder’s equity
When a company has preferred stock outstanding, the numerator of this ratio becomes net income minus the annual preferred dividends. Synotech has preferred stock outstanding. The ratios for the company follow. Total common stockholders’ equity on January 1 was \$ 1,531.5 million and on December 31 \$1,969.6. Net income for the year was \$762 million and preferred dividends were \$25.7 million. NOTE: Common stockholder’s equity is Total stockholder’s equity – par value of preferred stock. We calculate average common stockholders equity by taking Jan 1 \$1,531.50 + Dec 31 \$1,969.60 and dividing by 2 to get \$1,750.55 million. The return on average stockholder’s equity calculation would be:
Net Income – preferred dividends = \$ 762 – \$25.7
AVERAGE common stockholder’s equity \$1,750.55
The ratio would be 42.06% which indicates that for each dollar of capital invested by a common stockholder, the company earned approximately 42 cents.
Earnings per share of common stock Probably the measure used most widely to appraise a company’s operations is earnings per share (EPS) of common stock. The formula for EPS is:
Earnings available to common stockholders
weighted average common shares outstanding
The financial press regularly publishes actual and forecasted EPS amounts for publicly traded corporations, together with period-to-period comparisons. The Accounting Principles Board noted the significance attached to EPS by requiring that such amounts be reported on the face of the income statement.[2] (Unit 14 illustrated how earnings per share should be presented on the income statement.)
The calculation of EPS may be fairly simple or highly complex depending on a corporation’s capital structure. A company has a simple capital structure if it has no outstanding securities (e.g. convertible bonds, convertible preferred stocks, warrants, or options) that can be exchanged for common stock. If a company has such securities outstanding, it has a complex capital structure. Discussion of EPS for a corporation with a complex capital structure is beyond the scope of this text.
The amount of earnings available to common stockholders is equal to net income minus the current year’s preferred dividends, whether such dividends have been declared or not.
Determining the weighted-average number of common shares The denominator in the EPS fraction is the weighted-average number of common shares outstanding for the period. If the number of common shares outstanding did not change during the period, the weighted-average number of common shares outstanding would, of course, be the number of common shares outstanding at the end of the period.
To illustrate, the balance in the Common Stock account of Synotech is \$219.9 million on December 31. The common stock had a \$1.20 par value. Assuming no common shares were issued or redeemed during the year, the weighted-average number of common shares outstanding would be 183.2 million (or \$219.9 million common stock account balance /\$1.20 par value per share). (Normally, common treasury stock reacquired and reissued are also included in the calculation of the weighted-average number of common shares outstanding. We ignore treasury stock transactions to simplify the illustrations.) The EPS in this example would be \$4.02 per share calculated as:
Earnings available to common stockholders = Net Income – preferred dividends = \$762 – \$25.7 = 736.3
weighted average common shares outstanding Common stock account balance / par value \$219.9 / \$1.20 183.25 shares
If the number of common shares changed during the period, such a change increases or decreases the capital invested in the company and should affect earnings available to stockholders. To compute the weighted-average number of common shares outstanding, we weight the change in the number of common shares by the portion of the year that those shares were outstanding. Shares are outstanding only during those periods that the related capital investment is available to produce income.
To illustrate, assume that during Synotech’s began the year with 171.5 million shares outstanding. Assume that the company issued 9.5 million shares on April 1, and 2.2 million shares on October 1. The computation of the weighted-average number of common shares outstanding would be:
171.5 million shares x 1 year 171.500 million
9.5 million shares x ¾ year (April – December or 9/12) 7.125 million
2.2 million shares x ¼ year (October – December or 3/12) 0.550
Weighted-average number of common shares outstanding 179.175 million
The EPS in this example would be \$4.11 per share calculated as:
Earnings available to common stockholders = Net Income – preferred dividends = \$ 762 – \$25.7 = 736.3
weighted average common shares outstanding 171.5 + 7.125 + 0.55 179.175 shares 179.18
EPS and stock dividends or splits Increases in shares outstanding as a result of a stock dividend or stock split do not require weighting for fractional periods. Such shares do not increase the capital invested in the business and, therefore, do not affect income. All that is required is to restate all prior calculations of EPS using the increased number of shares. For example, assume a company reported EPS for the year as \$1.20 (or \$120,000/100,000 shares) and earned \$120,000 of net income during the year. The only change in common stock was a two-for-one stock split on December 1, which doubled the shares outstanding to 200,000. The firm would restate EPS as \$0.60 (or \$120,000/200,000 shares).
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Price-earnings ratio The price-earnings ratiomeasures the value of the stock in relation to its selling or market price typically on the New York Stock Exchange. The formula to compute the price-earnings ratio is:
Market price per common share
Earnings per share
Assume Synotech has common stock with an EPS of \$5.03 and that the quoted market price of the stock on the New York Stock Exchange is \$110.70. Investors would say that this stock is selling at 22 times earnings, or at a multiple of 22 calculated as:
Market price per common share = \$110.70
Earnings per share \$5.03
These investors might have a specific multiple in mind that indicates whether the stock is underpriced or overpriced. Different investors have different estimates of the proper price-earnings ratio for a given stock and also different estimates of the future earnings prospects of the company. These different estimates may cause one investor to sell stock at a particular price and another investor to buy at that price.
Dividend yield on common stock The dividend paid per share of common stock is also of much interest to common stockholders. The dividend yield on common stockis calculated as:
Annual cash dividend per share
Market price per share
For example, Synotech’s December 31 common stock market price was \$110.70 per share. Synotech paid cash dividends per share of \$1.80. The company’s dividend yield on common stock is 1.6% calculated as:
Annual cash dividend per share = \$1.80
Market price per share \$110.70
The dividend yield tells investors the company pays 1.6% of the market price in cash dividends. Through the use of dividend yield rates, we can compare different stocks having different annual dividends and different market prices.
Final considerations in financial statement analysis
Standing alone, a single financial ratio may not be informative. Investors gain greater insight by computing and analyzing several related ratios for a company. Financial analysis relies heavily on informed judgment. As guides to aid comparison, percentages and ratios are useful in uncovering potential strengths and weaknesses. However, the financial analyst should seek the basic causes behind changes and established trends.
Analysts must be sure that their comparisons are valid—especially when the comparisons are of items for different periods or different companies. They must follow consistent accounting practices if valid interperiod comparisons are to be made. Comparable intercompany comparisons are more difficult to secure. Accountants cannot do much more than disclose the fact that one company is using FIFO and another is using LIFO for inventory and cost of goods sold computations. Such a disclosure alerts analysts that intercompany comparisons of inventory turnover ratios, for example, may not be comparable.
Also, when comparing a company’s ratios to industry averages provided by an external source such as Dun & Bradstreet, the analyst should calculate the company’s ratios in the same manner as the reporting service. Thus, if Dun & Bradstreet uses net sales (rather than cost of goods sold) to compute inventory turnover, so should the analyst. Net sales is sometimes preferable because all companies do not compute and report cost of goods sold amounts in the same manner.
Facts and conditions not disclosed by the financial statements may, however, affect their interpretation. A single important event may have been largely responsible for a given relationship. For example, competitors may put a new product on the market, making it necessary for the company under study to reduce the selling price of a product suddenly rendered obsolete. Such an event would severely affect the percentage of gross margin to net sales. Yet there may be little chance that such an event will happen again.
Analysts must consider general business conditions within the industry of the company under study. A corporation’s downward trend in earnings, for example, is less alarming if the industry trend or the general economic trend is also downward.
Investors also need to consider the seasonal nature of some businesses. If the balance sheet date represents the seasonal peak in the volume of business, for example, the ratio of current assets to current liabilities may be much lower than if the balance sheet date is in a season of low activity.
Potential investors should consider the market risk associated with the prospective investment. They can determine market risk by comparing the changes in the price of a stock in relation to the changes in the average price of all stocks.
Potential investors should realize that acquiring the ability to make informed judgments is a long process and does not occur overnight. Using ratios and percentages without considering the underlying causes may lead to incorrect conclusions.
Relationships between financial statement items also become more meaningful when standards are available for comparison. Comparisons with standards provide a starting point for the analyst’s thinking and lead to further investigation and, ultimately, to conclusions and business decisions. Such standards consist of (1) those in the analyst’s own mind as a result of experience and observations, (2) those provided by the records of past performance and financial position of the business under study, and (3) those provided about other enterprises. Examples of the third standard are data available through trade associations, universities, research organizations (such as Dun & Bradstreet and Robert Morris Associates), and governmental units (such as the Federal Trade Commission).
In financial statement analysis, remember that standards for comparison vary by industry, and financial analysis must be carried out with knowledge of specific industry characteristics. For example, a wholesale grocery company would have large inventories available to be shipped to retailers and a relatively small investment in property, plant, and equipment, while an electric utility company would have no merchandise inventory (except for repair parts) and a large investment in property, plant, and equipment.
Even within an industry, variations may exist. Acceptable current ratios, gross margin percentages, debt to equity ratios, and other relationships vary widely depending on unique conditions within an industry. Therefore, it is important to know the industry to make comparisons that have real meaning.
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Type Ratio Formula Significance
Liquidity Ratios
Working Capital Current Assets – Current Liabilities Amount of current assets left over after paying liabilities
Current ratio
Current Assets
Current Liabilities
Test of debt-paying ability – how much do we have available for every \$1 of liabilities.
Acid-test (quick) Ratio
Quick Assets (Cash + Marketable Securities + net receivables)
Current Liabilities
Test of immediate debt-paying ability – how much cash do we have available immediately to pay debt
Cash flow liquidity ratio
(Cash + Marketable securities + Cash flow from operating activities)
Current Liabilities
Test of short-term, debt paying ability
Accounts Receivable Turnover
Net credit sales (or net sales)
Average Accounts Receivable
**Avg Accounts Receivable is calculated as (beg. or last year’s accounts receivable + current year end Accounts receivable) / 2
Test of quality of accounts receivable – how many times have we collected avg accts receivable
Days Sales Uncollected
Accts Receivable, Net x 365 days
Net Sales
**Accts Receivable, Net means Accounts Receivable – Allowance for doubtful or uncollectible accounts.
How many days it takes to collect on accounts receivable
Inventory Turnover
Cost of Goods Sold
Average Inventory
**Avg Inventory is calculated as (beg. or last year’s inventory + current year end inventory) / 2
Test of management efficiency – how many times we have sold avg. inventory
Days Sales in Inventory
Ending Inventory x 365 days
Cost of Goods Sold
How many days it takes to sell inventory
Total Asset Turnover
Net Sales
Average Total Assets
**Avg Total Assets is calculated as (beg. or last year’s total assets + current year end total assets) / 2
How many times we have been able to sell the amount equal to avg total assets. Tests whether the volume of business is adequate.
Equity (or Solvency) Ratios
Debt Ratio
Total Liabilities
Total Assets
How much we owe in liabilities for every \$1 in assets.
Equity (or Stockholder’s Equity) Ratio
Total Equity
Total Assets
How much equity we have for every \$1 in assets.
Debt to Equity Ratio
Total Liabilities
Total Equity
How much we owe in liabilities for every \$1 of equity.
Stockholder’s Equity to Debt Ratio
Total Equity
Total Liabilities
How much equity we have to cover \$1 in liabilities.
Profitability Ratios
Profit Margin Ratio
Net Income
Net Sales
How much NET income we generate from every dollar of sales.
Gross Margin Ratio
Net sales – Cost of goods sold
Net Sales
How much gross profit is earned on every dollar of sales (also known as markup)
Return on total assets
Net Income
Average Total Assets
**Avg Total Assets is calculated as (beg. or last year’s total assets + current year end total assets) / 2
How many times we have earned back average total assets from net income.
Return on common stockholder’s equity
Net Income – Preferred dividends
Average common stockholder’s equity
How much net income was generated from every dollar of common stock invested.
Basic Earnings per Share (EPS)
Net Income – Preferred Dividends
Weighted Avg common shares outstanding
How much net income generate on every share of common stock
Market Prospects
Price-earnings ratio
Market price per common share
Earnings per share
How much the market price is for every dollar of earnings per share
Dividend yield
Annual cash dividends per share
Market price per share
How much dividends you receive based on every dollar of market price per share.
Click ratio summary for a printable copy.
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QUESTIONS, EXERCISES AND PROBLEMS
Questions
➢ What are the major sources of financial information for publicly owned corporations?
➢ The higher the accounts receivable turnover rate, the better off the company is. Do you agree? Why?
➢ Can you think of a situation where the current ratio is very misleading as an indicator of short-term, debt-paying ability? Does the acid-test ratio offer a remedy to the situation you have described? Describe a situation where the acid-test ratio does not suffice either.
➢ Before the Marvin Company issued \$20,000 of long-term notes (due more than a year from the date of issue) in exchange for a like amount of accounts payable, its current ratio was 2:1 and its acid-test ratio was 1:1. Will this transaction increase, decrease, or have no effect on the current ratio and acid-test ratio? What would be the effect on the equity ratio?➢ Through the use of turnover rates, explain why a firm might seek to increase the volume of its sales even though such an increase can be secured only at reduced prices.➢ Indicate which of the relationships illustrated in the chapter would be best to judge:
• The short-term debt-paying ability of the firm.
• The overall efficiency of the firm without regard to the sources of assets.
• The return to owners (stockholders) of a corporation.
• The safety of long-term creditors’ interest.
• The safety of preferred stockholders’ dividends.
➢ Indicate how each of the following ratios or measures is calculated:
• Payout ratio.
• Earnings per share of common stock.
• Price-earnings ratio.
• Earnings yield on common stock.
• Dividend yield on preferred stock.
• Times interest earned.
• Times preferred dividends earned.
• Return on average common stockholders’ equity.
• Cash flow margin.
➢ How is the rate of return on operating assets determined? Is it possible for two companies with operating margins of 5 per cent and 1 per cent, respectively, to both have a rate of return of 20 per cent on operating assets? How?
➢ Cite some of the possible deficiencies in accounting information, especially regarding its use in analyzing a particular company over a 10-year period.
Exercises
Exercise A Income statement data for Boston Company for 2009 and 2010 follow:
2009 2010
Net sales \$2,610,000 \$1,936,000
Cost of goods sold 1,829,600 1,256,400
Selling expenses 396,800 350,000
Administrative expenses 234,800 198,400
Federal income taxes 57,600 54,000
Prepare a horizontal and vertical analysis of the income data in a form similar to Exhibit 2. Comment on the results of this analysis.
Exercise B A company engaged in the following three independent transactions:
• Merchandise purchased on account, \$2,400,000.
• Machinery purchased for cash, \$2,400,000.
• Capital stock issued for cash, \$2,400,000.
1. Compute the current ratio after each of these transactions assuming current assets were \$3,200,000 and the current ratio was 1:1 before the transactions occurred.
2. Repeat part (a) assuming the current ratio was 2:1.
3. Repeat part (a) assuming the current ratio was 1:2.
Exercise C A company has sales of \$3,680,000 per year. Its average net accounts receivable balance is \$920,000.
1. What is the average number of days accounts receivable are outstanding?
2. By how much would the capital invested in accounts receivable be reduced if the turnover could be increased to 6 without a loss of sales?
Exercise D Columbia Corporation had the following selected financial data for 2009 December 31: Net cash provided by operating activities
Net sales \$1,800,000
Cost of goods sold 1,080,000
Operating expenses 315,000
Net income 195,000
Total assets 1,000,000
Net cash provided by operating activities 25,000
Compute the cash flow margin.
Exercise E From the following partial income statement, calculate the inventory turnover for the period.
\$2,028,000 1,294,800 \$ 733,200 327,600 \$ 405,600
Net sales
Cost of goods sold:
Beginning inventory \$ 234,000
Purchases 1,236,000
Cost of goods available for sale \$1,560,000
Less: Ending inventory 265,200
Cost of goods sold
Gross margin
Operating expenses
Net operating income
Exercise F Eastern, Inc., had net sales of \$3,520,000, gross margin of \$1,496,000, and operating expenses of \$904,000. Total assets (all operating) were \$3,080,000. Compute Eastern’s rate of return on operating assets.
Exercise G Nelson Company began the year 2010 with total stockholders’ equity of \$2,400,000. Its net income for 2010 was \$640,000, and \$106,800 of dividends were declared. Compute the rate of return on average stockholders’ equity for 2010. No preferred stock was outstanding.
Exercise H Rogers Company had 60,000 shares of common stock outstanding on 2010 January 1. On 2010 April 1, it issued 20,000 additional shares for cash. The amount of earnings available for common stockholders for 2010 was \$600,000. What amount of EPS of common stock should the company report?
Exercise I Smith Company started 2011 with 800,000 shares of common stock outstanding. On March 31, it issued 96,000 shares for cash, and on September 30, it purchased 80,000 shares of its own stock for cash. Compute the weighted-average number of common shares outstanding for the year.
Exercise J A company reported EPS of \$2 (or ) for 2009, ending the year with 1,200,000 shares outstanding. In 2010, the company earned net income of \$7,680,000, issued 320,000 shares of common stock for cash on September 30, and distributed a 100 per cent stock dividend on 2010 December 31. Compute EPS for 2010, and compute the adjusted earnings per share for 2009 that would be shown in the 2010 annual report.
Exercise K A company paid interest of \$32,000, incurred federal income taxes of \$88,000, and had net income (after taxes) of \$112,000. How many times was interest earned?
Exercise L John Company had 20,000 shares of \$600 par value, 8 per cent preferred stock outstanding. Net income after taxes was \$5,760,000. The market price per share was \$720.
1. How many times were the preferred dividends earned?
2. What was the dividend yield on the preferred stock assuming the regular preferred dividends were declared and paid?
Exercise M A company had 80,000 weighted-average number of shares of \$320 par value common stock outstanding. The amount of earnings available to common stockholders was \$800,000. Current market price per share is \$720. Compute the EPS and the price-earnings ratio.
Problems
Problem A Loom’s comparative statements of income and retained earnings for 2010 and 2009 are given below.
Loom
Consolidated statement of earnings
For the years ended 2010 December 31, and 2009
(\$thousands, except per data share)
December 31
(1) (2)
2010 2009
Net sales \$ 2,403,100 \$ 2,297,800
Cost of sales 1,885,700 1,651,300
Gross earnings \$ 517,400 \$ 646,500
Selling, general and administrative expenses 429,700 376,300
Goodwill amortization 37,300 35,200
Impairment write down of goodwill 158,500 0
Operating earnings (loss) \$ (108,100) \$235,000
Interest expense (116,900) (95,400)
Other expense-net (21,700) (6,100)
Earnings (loss) before income tax (benefit) expense, extraordinary item and cumulative effect of change in accounting principles \$ (246,700) \$133,500
Income tax (benefit) expense (19,400) 73,200
Earnings (loss) before cumulative effect of change in account principles \$ (227,300) \$60,300
Cumulative effect of change in accounting principles:
Pre-operating costs (5,200) 0
Net earnings (loss) \$ (232,500) \$60,300
Retained earnings, January 1 680,600 620,300
\$ 448,100 \$680,600
Dividends 0 0
Retained earnings, December 31 \$ 448,100 \$680,600
Loom
consolidated balance sheet
As of 2010 December 31, and 2009
(\$thousands)
December 31
(1) (2)
2010 2009
Assets
Current assets
Cash and cash equivalents \$ 26,500 \$ 49,400
Notes and accounts receivable (less allowance for possible losses of \$26,600,000 and \$20,700,000, respectively) 261,000 295,600
Inventories
Finished goods 522,300 496,200
Work in process 132,400 141,500
Materials and supplies 44,800 39,100
Other 72,800 54,800
Total current assets \$ 1,059,800 \$ 1,076,600
Property, plant, and equipment
Land \$ 20,100 \$ 19,300
Buildings, structures and improvements 486,400 435,600
Machinery and equipment 1,076,600 1,041,300
Construction in progress 24,200 35,200
Total property, plant and equipment \$ 1,607,300 \$ 1,531,400
Less accumulated depreciation 578,900 473,200
Net property, plant and equipment \$ 1,028,400 \$ 1,058,200
Other assets
Goodwill (less accumulated amortization of \$257,800,000 and \$242,400,000, respectively). \$ 771,100 \$ 965,800
Other 60,200 62,900
Total other assets \$831,300 \$ 1,028,700
Total assets \$ 2,919,500 \$ 3,163,500
Liabilities and stockholders’ equity
Current liabilities
Current maturities of long-term debt \$ 14,600 \$ 23,100
Trade accounts payable 60,100 113,300
Accrued insurance obligations 38,800 23,600
Accrued advertising and promotion 23,800 23,400
Interest payable 16,000 18,300
Accrued payroll and vacation pay 15,300 33,100
Accrued pension 11,300 19,800
Other accounts payable and accrued expenses 123,900 77,200
Total current liabilities \$ 303,800 \$ 331,800
Noncurrent liabilities
Long-term debt 1,427,200 1,440,200
Net deferred income taxes 0 43,400
Other 292,900 222,300
Total noncurrent liabilities \$ 1,720,000 \$ 1,705,900
Total liabilities \$ 2,023,900 \$ 2,037,700
Common stockholders’ equity
Common stock and capital in excess of par value, \$.01 par value; authorized, Class A, 200,000,000 shares, Class B, 30,000,000 shares; issued and outstanding:
Class A Common Stock, 69,268,701 and 69,160,349 shares, respectively \$ 465,600 \$ 463,700
Class B Common Stock, 6,690,976 shares 4,400 4,400
Retained earnings 448,100 680,600
Currency translation and minimum pension liability adjustments (22,500) (22,900)
Total common stockholders’ equity \$ 895,600 \$ 1,125,800
Total liabilities and stockholders’ equity \$ 2,919,500 \$ 3,163,500
Perform a horizontal and vertical analysis of Loom’s financial statements in a manner similar to those illustrated in this chapter. Comment on the results of the analysis in (a).
Problem B Deere & Company manufactures, distributes, and finances a full range of agricultural equipment; a broad range of industrial equipment for construction, forestry, and public works; and a variety of lawn and grounds care equipment. The company also provides credit, health care, and insurance products for businesses and the general public. Consider the following information from the Deere & Company 2000 Annual Report:
(in millions) 1997 1998 1999 2000
Sales \$12,791 \$13,822 \$11,751 \$13,137
Cost of goods sold 8,481 9,234 8,178 8,936
Gross margin 4,310 4,588 3,573 4,201
Operating expenses 2,694 2,841 3,021 3,236
Net operating income \$ 1,616 \$ 1,747 \$ 552 \$ 965
1. Prepare a statement showing the trend percentages for each item using 1997 as the base year.
2. Comment on the trends noted in part (a).
Problem C The following data are for Toy Company:
December 31
2011 2010
Allowance for uncollectible accounts \$72,000 \$57,000
Prepaid expenses 34,500 45,000
Accrued liabilities 210,000 186,000
Cash in Bank A 1,095,000 975,000
Wages payable -0- 37,500
Accounts payable 714,000 585,000
Merchandise inventory 1,342,500 1,437,000
Bonds payable, due in 2005 615,000 594,000
Marketable securities 217,500 147,000
Notes payable (due in six months) 300,000 195,000
Accounts receivable 907,500 870,000
Cash flow from operating activities 192,000 180,000
1. Compute the amount of working capital at both year-end dates.
2. Compute the current ratio at both year-end dates.
3. Compute the acid-test ratio at both year-end dates.
4. Compute the cash flow liquidity ratio at both year-end dates.
5. Comment briefly on the company’s short-term financial position.
Problem D On 2011 December 31, Energy Company’s current ratio was 3:1 before the following transactions were completed:
• Purchased merchandise on account.
• Paid a cash dividend declared on 2011 November 15.
• Sold equipment for cash.
• Temporarily invested cash in trading securities.
• Sold obsolete merchandise for cash (at a loss).
• Issued 10-year bonds for cash.
• Wrote off goodwill to retained earnings.
• Paid cash for inventory.
• Purchased land for cash.
• Returned merchandise that had not been paid for.
• Wrote off an account receivable as uncollectible. Uncollectible amount is less than the balance in the Allowance for Uncollectible Accounts.
• Accepted a 90-day note from a customer in settlement of customer’s account receivable.
• Declared a stock dividend on common stock.
Consider each transaction independently of all the others.
1. Indicate whether the amount of working capital will increase, decrease, or be unaffected by each of the transactions.
2. Indicate whether the current ratio will increase, decrease, or be unaffected by each of the transactions.
Problem E Digital Company has net operating income of \$500,000 and operating assets of \$2,000,000.
Its net sales are \$4,000,000.
The accountant for the company computes the rate of return on operating assets after computing the operating margin and the turnover of operating assets.
1. Show the computations the accountant made.
2. Indicate whether the operating margin and turnover increase or decrease after each of the following changes. Then determine what the actual rate of return on operating assets would be. The events are not interrelated; consider each separately, starting from the original earning power position. No other changes occurred.
(a)Sales increased by \$160,000. There was no change in the amount of operating income and no change in operating assets.
(b)Management found some cost savings in the manufacturing process. The amount of reduction in operating expenses was \$40,000. The savings resulted from the use of less materials to manufacture the same quantity of goods. As a result, average inventory was \$16,000 lower than it otherwise would have been. Operating income was not affected by the reduction in inventory.
(c) The company invested \$80,000 of cash (received on accounts receivable) in a plot of land it plans to use in the future (a nonoperating asset); income was not affected.
(d)The federal income tax rate increased and caused income tax expense to increase by \$20,000. The taxes have not yet been paid.
(e)The company issued bonds and used the proceeds to buy \$400,000 of machinery to be used in the business. Interest payments are \$20,000 per year. Net operating income increased by \$100,000 (net sales did not change).
Problem F Polaroid Corporation designs, manufactures, and markets worldwide instant photographic cameras and films, electronic imaging recording devices, conventional films, and light polarizing filters and lenses. The following information is for Polaroid:
(in millions) 2000 1999
Net sales \$13,994 \$14,089
Income before interest and taxes 2,310 2,251
Net income 1,407 1,392
Interest expense 178 142
Stockholders’ equity (on 1998 December 31, \$3,988) 3,428 3,912
Common stock, par value \$1, December 31 978 978
Compute the following for both 2000 and 1999. Then compare and comment.
1. EPS of common stock.
2. Net income to net sales.
3. Net income to average common stockholders’ equity.
4. Times interest earned ratio.
Problem G The Walt Disney Company operates several ranges of products from theme parks and resorts to broadcasting and other creative content. The following balance sheet and supplementary data are for The Walt Disney Company for 2000.
The Walt Disney Company
Consolidated balance sheet
For 2000 September 30
(\$millions)
\$ 842 3,599 702 1,162 1,258 \$7,563 5,339 2,270 1,995 597 16,117 1,428 \$25,027 \$ 5,161 2,502 739 \$ 8,402 6,959 2,833 2,377 356 \$45,027
Assets
Cash and cash equivalents
Receivables
Inventories
Film and television costs
Other
Total current costs
Film and television costs
Investments
Theme parks, resorts, and other property, at cost
Attractions, buildings, and equipment \$16,160
Accumulated depreciation (6,892)
9,718
Project in process
Land
Intangibles assets, net
Other assets
Total assets
Liabilities and stockholders’ equity
Accounts payable and accrued liabilities
Current portion of borrowing
Unearned royalties
Total current liabilities
Borrowings
Deferred income taxes
Other long-term liabilities
Minority interest
Common shareholders’ equity
Common shares (\$.01 par value) \$12,101
Retained earnings 12,767
Cumulative translation and other adjustments (28)
Treasury shares (740) 24,100
Total liabilities and stockholders’ equity
• Net income, \$920.
• Income before interest and taxes, \$3,231.
• Cost of goods sold, \$21,321.
• Net sales, \$25,402.
• Inventory on 1999 September 30, \$796.
• Total interest expense for the year, \$598.
Calculate the following ratios and show your computations. For calculations normally involving averages, such as average stockholders’ equity, use year-end amounts unless the necessary information is provided.
1. Current ratio.
2. Net income to average common stockholders’ equity.
3. Inventory turnover.
4. Number of days’ sales in accounts receivable (assume 365 days in 2000).
5. EPS of common stock (ignore treasury stock).
6. Times interest earned ratio.
7. Equity ratio.
8. Net income to net sales.
9. Total assets turnover.
10. Acid-test ratio.
Problem H Cooper Company currently uses the FIFO method to account for its inventory but is considering a switch to LIFO before the books are closed for the year. Selected data for the year are:
Merchandise inventory, January 1 \$1,430,000
Current assets 3,603,600
Total assets (operating) 5,720,000
Cost of goods sold (FIFO) 2,230,800
Merchandise inventory, December 31 (LIFO) 1,544,400
Merchandise inventory, December 31 (FIFO) 1,887,600
Current liabilities 1,144,000
Net sales 3,832,400
Operating expenses 915,200
1. Compute the current ratio, inventory turnover ratio, and rate of return on operating assets assuming the company continues using FIFO.
2. Repeat part (a) assuming the company adjusts its accounts to the LIFO inventory method.
Alternate problems
Alternate problem A Steel Corporation’s comparative statements of income and retained earnings and consolidated balance sheet for 2010 and 2009 follow:
Steel Corporation
Consolidated statement of Earnings
For the years ended 2010 December 31, 2009
(USDthousands)
December 31
(1) (2)
2010 2009
Net sales \$4,876.5 \$4,819.4
Costs and expenses:
Cost of sales \$4,202.8 \$4,287.3
Depreciation 284.0 261.1
Estimated restructuring losses 111.8 137.4
Total costs \$4,598.6 \$4,685.8
Income from operations \$268.9 \$ 133.6
Financing income (expense):
Interest and other income 7.7 7.1
Interest and other financing costs (60.0) (46.2)
Loss before income taxes and cumulative effect of changes in accounting \$ 216.6 \$ 94.5
Benefit (provision) for income taxes (37.0) (14.0)
Net earning (loss) \$ 179.6 \$ 80.5
Retained earnings, January 1 (859.4) (939.9)
\$ (679.8) \$ (859.4)
Dividends 0.0 0.0
Retained earnings, December 31 \$ (679.8) (859.4)
Steel Corporation
Consolidated balance sheet
As of 2010 December 31, and 2009
December 31
(1) (2)
2010 2009
Assets
Current Assets
Cash and cash equivalents \$ 180.0 \$ 159.5
Receivables 374.6 519.5
Total \$ 554.6 \$ 679.0
Inventories
Raw materials and supplies \$ 335.5 \$ 331.9
Finished and semifinished products 604.9 534.9
Contract work in process less billings of \$10.9 and \$2.3 17.8 16.1
Total inventories \$ 958.2 \$ 882.9
Other current assets \$ 13.0 \$ 7.2
Total current assets \$ 1,525.8 \$ 1,569.1
Property, plant and equipment less accumulated depreciation of \$4329.5 and \$4167.8 \$ 2,714.2 \$ 2,759.3
Investments and miscellaneous assets 112.3 124.2
Deferred income tax asset – net 885.0 903.2
Intangible asset – Pensions 463.0 426.6
Total assets \$ 5,700.3 \$ 5,782.4
Liabilities and stockholders’ equity
Current liabilities
Accounts payable \$ 381.4 \$ 387.0
Accrued employment costs 208.0 165.8
Postretirement benefits other than pensions 150.0 138.0
Accrued taxes 72.4 67.6
Debt and capital lease obligations 91.5 88.9
Other current liabilities 146.3 163.9
Total current liabilities \$ 1,049.6 \$ 1,011.2
Pension liability \$ 1,115.0 \$ 1,117.1
Postretirement benefits other than pensions 1,415.0 1,441.4
Long-term debt and capital lease obligations 546.8 668.4
Other 335.6 388.5
Total noncurrent liabilities \$ 3,412.4 # 3,615.4
Total liabilities \$ 4,462.0 \$ 4,626.6
Common stockholders’ equity
Preferred stock – at \$1 per share par value (aggregate liquidation preference of \$481.2); Authorized 20,000,000 shares \$ 11.6 \$ 11.6
Preference stock – at \$1 per share par value (aggregate liquidation preference of \$88.2); Authorized 20,000,000 shares 2.6 2.6
Common stock – at \$1 per share par value/Authorized 250,000,000 and 150,000,000 shares; Issued 112,699,869 and 111,882,276 shares 112.7 111.9
Held in treasury, 1,992,189 and 1,996,715 shares at cost (59.4) (59.5)
Additional paid-in capital 1,850.6 1,948.6
Accumulated deficit (679.8) (859.4)
Total common stockholders’ equity \$ 1,238.3 \$ 1,155.8
Total liabilities and stockholders’ equity \$ 5,700.3 \$ 5,782.4
1. Perform a horizontal and vertical analysis of Steel’s financial statements in a manner similar to Exhibit 1 and Exhibit 2.
2. Comment on the results obtained in part (a).
Alternate problem B Ford Motor Company is the world’s second-largest producer of cars and trucks and ranks among the largest providers of financial services in the United States. The following information pertains to Ford: (in millions)
(in millions) 1998 1999 2000
Sales \$118.017 \$135,073 \$141,230
Cost of goods sold 104,616 118,985 126,120
Gross margin \$ 13,401 \$ 16,088 \$ 15,110
Operating expenses 7,834 8,874 9,884
Net operating income \$ 5,567 \$ 7,214 \$ 5,226
1. Prepare a statement showing the trend percentages for each item, using 1998 as the base year.
2. Comment on the trends noted in part (a).
Alternate problem C The following data are for Clock Company: Allowance for uncollectible accounts
December 31
2011 2010
Notes payable (due in 90 days) \$75,200 \$60,000
Merchandise inventory 240,000 208,000
Cash 100,000 128,000
Marketable securities 49,600 30,000
Accrued liabilities 19,200 22,000
Accounts receivable 188,000 184,000
Accounts payable 112,000 72,000
Allowance for uncollectible accounts 24,000 15,200
Bonds payable, due 2008 156,000 160,000
Prepaid expenses 6,400 7,360
Cash flow from operating activities 60,000 40,000
1. Compute the amount of working capital at both year-end dates.
2. Compute the current ratio at both year-end dates.
3. Compute the acid-test ratio at both year-end dates.
4. Compute the cash flow liquidity ratio at both year-end dates.
5. Comment briefly on the company’s short-term financial position.
Alternate problem D Tulip Products, Inc., has a current ratio on 2010 December 31, of 2:1 before the following transactions were completed:
• Sold a building for cash.
• Exchanged old equipment for new equipment. (No cash was involved.)
• Declared a cash dividend on preferred stock.
• Sold merchandise on account (at a profit).
• Retired mortgage notes that would have matured in 2011.
• Issued a stock dividend to common stockholders.
• Paid cash for a patent.
• Temporarily invested cash in government bonds.
• Purchased inventory for cash.
• Wrote off an account receivable as uncollectible. Uncollectible amount is less than the balance of the Allowance for Uncollectible Accounts.
• Paid the cash dividend on preferred stock that was declared earlier.
• Purchased a computer and gave a two-year promissory note.
• Collected accounts receivable.
• Borrowed from the bank on a 120-day promissory note.
• Discounted a customer’s note. Interest expense was involved.
Consider each transaction independently of all the others.
1. Indicate whether the amount of working capital will increase, decrease, or be unaffected by each of the transactions.
2. Indicate whether the current ratio will increase, decrease, or be unaffected by each of the transactions.
Alternate problem E The following selected data are for three companies:
Operating
Assets
Net Operating
Income
Net
Sales
Company 1 \$ 1,404,000 \$ 187,200 \$ 2,059,200
Company 2 8,424,000 608,400 18,720,000
Company 3 37,440,000 4,914,000 35,100,000
1. Determine the operating margin, turnover of operating assets, and rate of return on operating assets for each company.
2. In the subsequent year, the following changes took place (no other changes occurred):
Company 1 bought some new machinery at a cost of \$156,000. Net operating income increased by \$12,480 as a result of an increase in sales of \$249,600.
Company 2 sold some equipment it was using that was relatively unproductive. The book value of the equipment sold was \$624,000. As a result of the sale of the equipment, sales declined by \$312,000, and operating income declined by \$6,240.
Company 3 purchased some new retail outlets at a cost of \$6,240,000. As a result, sales increased by \$9,360,000, and operating income increased by \$499,200.
• Which company has the largest absolute change in:
1. Operating margin ratio?
2. Turnover of operating assets?
3. Rate of return on operating assets?
• Which one realized the largest dollar change in operating income? Explain this change in relation to the changes in the rate of return on operating assets.
Alternate problem F One of the largest spice companies in the world, McCormick & Company, Inc., produces a diverse array of specialty foods. The following information is for McCormick & Company, Inc.:
2000 1999
(\$thousands)
Net sales \$2,123,500 \$2,006,900
Income before interest and taxes 225,700 174,700
Net income 137,500 98,500
Interest expense 39,700 32,400
Stockholders’ equity 359,300 382,400
Common stock, no par value, November 30 175,300 173,800
Assume average common shares outstanding for 2000 and 1999 are 69,600 and 72,000 (in thousands), respectively.
Compute the following for both 2000 and 1999. Then compare and comment. Assume stockholders’ equity for 1998 was \$388,100.
1. EPS of common stock.
2. Net income to net sales.
3. Return on average common stockholders’ equity.
4. Times interest earned ratio.
Alternate problem G Parametric Technology Corporation is in the CAD/CAM/CAE industry and is the top supplier of software tools used to automate a manufacturing company. The following consolidated balance sheet and supplementary data are for Parametric for 2003:
Parametric Technology Corporation
Consolidated balance sheet
For 2003 September 30 (in thousands)
Assets
Current assets
Cash and cash equivalents \$ 325,872
Short-term investments 22,969
Accounts receivable, net of allowances for doubtful account of \$6,270 183,804
Other current assets 95,788
Total current assets \$ 628,433
Marketable investments 26,300
Property and equipment, net 66,879
Other assets 203,271
Total assets \$ 924,883
Liabilities and stockholdersequity
Current liabilities
Accounts payable and accrued expenses \$ 77,144
Accrued compensation 52,112
Deferred revenue 231,495
Income taxes 1,601
Total currents liabilities \$ 362,352
Other liabilities 33,989
Stockholders’ equity
Preferred stock, \$.01 par value; 5,000 shares authorized; none issued
Common stock, \$.01 par value; 500,000 shares authorized; 276,053 (2000) and 272,277 (1999) shares issued 2,761
Additional paid-in capital 1,641,513
Foreign currency translation adjustment (12,629)
Accumulated deficit (1,036,456)
Treasury stock, at cost, 6,456 (2000) and 2,113 (1999) shares (66,647)
Total liabilities and stockholders’ equity \$ 924,883
• Net loss, (\$3,980).
• Loss before interest and taxes, (\$4,700).
• Cost of goods sold, \$244,984.
• Net sales, \$928,414.
• Total interest expense for the year, \$367.
• Weighted-average number of shares outstanding, 273,081.
Calculate the following ratios and show your computations. For calculations normally involving averages, such as average accounts receivable or average stockholders’ equity, use year-end amounts if the information is not available to use averages.
1. Current ratio.
2. Net income to average common stockholders’ equity.
3. Number of days’ sales in accounts receivable (assume 365 days in 2003).
4. EPS of common stock.
5. Times interest earned ratio.
6. Equity ratio.
7. Net income to net sales.
8. Total assets turnover.
9. Acid-test ratio.
Alternate problem H Paper Company is considering switching from the FIFO method to the LIFO method of accounting for its inventory before it closes its books for the year. The January 1 merchandise inventory was \$864,000. Following are data compiled from the adjusted trial balance at the end of the year:
Merchandise inventory, December 31 (FIFO) \$1,008,000
Current liabilities 720,000
Net sales 2,520,000
Operating expenses 774,000
Current assets 1,890,000
Total assets (operating) 2,880,000
Cost of goods sold 1,458,000
If the switch to LIFO takes place, the December 31 merchandise inventory would be \$900,000.
1. Compute the current ratio, inventory turnover ratio, and rate of return on operating assets assuming the company continues using FIFO.
2. Repeat (a) assuming the company adjusts its accounts to the LIFO inventory method.
Beyond the numbers – Critical thinking
Business decision case A The comparative balance sheets of the Darling Corporation for 2011 December 31, and 2010 follow:
Darling Corporation
Comparative balance sheets
2011 December 31, and 2010
(\$millions)
2011 2010
Assets
Cash \$ 480,000 \$ 96,000
Accounts receivable, net 86,400 115,200
Merchandise inventory 384,000 403,200
Plant and equipment, net 268,800 288,000
Total assets \$ 1,219,200 \$902,400
Liabilities and stockholders’ equity
Accounts payable \$ 96,000 \$ 96,000
Common stock 672,000 672,000
Retained earnings 451,200 134,400
Total liabilities and stockholders’ equity \$1,219,200 \$902,400
Based on your review of the comparative balance sheets, determine the following:
1. What was the net income for 2011 assuming there were no dividend payments?
2. What was the primary source of the large increase in the cash balance from 2010 to 2011?
3. What are the two main sources of assets for Darling Corporation?
4. What other comparisons and procedures would you use to complete the analysis of the balance sheet?
Business decision case B As Miller Manufacturing Company’s internal auditor, you are reviewing the company’s credit policy. The following information is from Miller’s annual reports for 2008, 2009, 2010, and 2011:
2008 2009 2010 2011
Nets accounts receivable \$ 1,080,000 \$ 2,160,000 \$ 2,700,000 \$ 3,600,000
Net sales 10,800,000 13,950,000 17,100,000 19,800,000
Management has asked you to calculate and analyze the following in your report:
1. If cash sales account for 30 per cent of all sales and credit terms are always 1/10, n/60, determine all turnover ratios possible and the number of days’ sales in accounts receivable at all possible dates. (The number of days’ sales in accounts receivable should be based on year-end accounts receivable and net credit sales.)
2. How effective is the company’s credit policy?
Business decision case C Wendy Prince has consulted you about the possibility of investing in one of three companies (Apple, Inc., Baker Company, or Cookie Corp.) by buying its common stock. The companies’ investment shares are selling at about the same price. The long-term capital structures of the companies alternatives are as follows:
\$2,400,000 \$2,400,000
Apple,
Inc.
Baker
Company
Cookie
Corp.
Bonds with a 10% interest rate
Preferred stock with an 8% dividend rate
Common stock, \$10 par value \$4,800,000 2,400,000 2,400,000
Retained earnings 384,000 384,000 384,000
Total long-term equity \$5,184,000 \$5,184,000 \$5,184,000
Number of common shares outstanding 480,000 240,000 240,000
Prince has already consulted two investment advisers. One adviser believes that each of the companies will earn \$300,000 per year before interest and taxes. The other adviser believes that each company will earn about \$960,000 per year before interest and taxes. Prince has asked you to write a report covering these points:
1. Compute each of the following, using the estimates made by the first and second advisers.
(a)Earnings available for common stockholders assuming a 40 per cent tax rate.
(b)EPS of common stock.
(c) Rate of return on total stockholders’ equity.
1. Which stock should Prince select if she believes the first adviser?
2. Are the stockholders as a group (common and preferred) better off with or without the use of long-term debt in the companies?
Annual Report analysis D The following selected financial data excerpted from the annual report of Appliance Corporation represents the summary information which management presented for interested parties to review:
Appliance Corporation
Selected Financial Data
(\$thousands except per share data)
2010 2009 2008 2007 2006
Net sales \$3,049,524 \$3,372,515 \$2,987,054 \$3,041,223 \$2,970,626
Cost of sales 2,250,616 2,496,065 2,262,942 2,339,406 2,254,221
Income taxes 74,800 90,200 38,600 15,900 44,400
Income (loss) from continuing operations (14,996) 151,137 51,270 (8,254) 79,017
Per cent of income (loss) from continuing operations to net sales (0.5%) 4.5% 1.7% (0.3%) 2.7%
Income (loss) from continuing operations per share \$ (0.14) 1.42 0.48 (0.08) \$ 0.75
Dividends paid per share 0.515 0.50 0.50 0.50 0.50
Average shares outstanding (in thousands) 107,062 106,795 106,252 106,077 105,761
Working capital \$ 543,431 \$ 595,703 \$ 406,181 \$452,626 \$ 509,025
Depreciation of property, plant and equipment 102,572 110,044 102,459 94,032 83,352
Additions to property, plant and equipment 152,912 84,136 99,300 129,891 143,372
Total assets 2,125,066 2,504,327 2,469,498 2,501,490 2,535,068
Long-term debt 536,579 663,205 724,65 789,232 809,480
Total debt to capitalization 45.9% 50.7% 60.0% 58.7% 45.9%
Shareowners’ equity per share of common stock \$ 6.05 \$ 6.82 \$ 5.50 \$ 9.50
1. As a creditor, what do you believe management’s objectives should be? Which of the preceding items of information would assist a creditor in judging management’s performance?
2. As an investor, what do you believe management’s objectives should be? Which of the preceding items of information would assist an investor in judging management’s performance?
3. What other information might be considered useful?
Group project E Choose a company the class wants to know more about and obtain its annual report. In groups of two or three students, calculate either the liquidity, equity, profitability, or market test ratios. Each group should select a spokesperson to tell the rest of the class the results of the group’s calculations. Finally, the class should decide whether or not to invest in the corporation based on the ratios they calculated.
Group project F In a group of two or three students, go to the library and attempt to locate Dun & Bradstreet’s Industry Norms and Key Business Ratios. You may have to ask the reference librarian for assistance to see if this item is available at your institution. If it is not available at your institution, ask if it is available through an interlibrary loan. (Obviously, if you cannot obtain this item, you cannot do this project.) Then select and obtain the latest annual report of a company of your choice. Determine the company’s SIC Code (a code that indicates the industry in which that company operates). SIC Codes for specific companies are available on COMPACT DISCLOSURE, an electronic source that may be available at your library. As an alternative, you could call the company’s home office to inquire about its SIC Code. The annual report often contains the company’s phone number. From the annual report, determine various ratios for the company, such as the current ratio, debt to equity ratio, and net income to net sales. Then compare these ratios to the industry norms for the company’s SIC Code as given in the Dun & Bradstreet source. Write a report to your instructor summarizing the results of your investigation.
Group project G In a group of two or three students, obtain the annual report of a company of your choice Identify the major sections of the annual report and the order in which they appear. Would you recommend the order be changed to emphasize the most useful and important information? If so, how? Then describe some specific useful information in each section. Comment on your perceptions of the credibility that a reader of the annual report could reasonably assign to each section of the report. For instance, if such a discussion appears in the annual report you select, would you assign high credibility to everything that appears in the Letter to Stockholders regarding the company’s future prospects? Write a report to your instructor summarizing the results of your investigation.
Using the Internet—A view of the real world
Visit the following website for Eastman Kodak Company:
http://www.kodak.com
By following choices on the screen, locate the income statements and balance sheets for the latest two years. Calculate all of the ratios illustrated in the chapter for which the data are available. Compare the ratios to those shown for Synotech as presented in the chapter. Write a report to your instructor showing your calculations and comment on the results of your comparison of the two companies.
Visit the following website for General Electric Company:
http://www.ge.com
By following choices on the screen, locate the income statements and balance sheets for the latest two years. Calculate all of the ratios illustrated in the chapter for which the data are available. Compare the ratios to those shown for Synotech as presented in the chapter. Write a report to your instructor showing your calculations and comment on the results of your comparison of the two companies.
Answers to self-test
True-false
True. Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information.
False. Horizontal analysis provides useful information about the changes in a company’s performance over several periods by analyzing comparative financial statements of the same company for two or more successive periods.
False. Common-size statements show only percentage figures, such as percentages of total assets and percentages of net sales.
True. Liquidity ratios such as the current ratio and acid-test ratio indicate a company’s short-term debt-paying ability.
True. The accrual net income shown on the income statement is not cash basis income and does not indicate cash flows.
True. Analysts must use comparable data when making comparisons of items for different periods or different companies.
Multiple-choice
1. b. Current assets: \$136,000 + \$64,000 + \$184,000 + \$244,000 + \$12,000 = \$640,000
Current liabilities: \$256,000 + \$64,000 = \$320,000
Current ratio:
1. c. Quick assets:
\$136,000 + \$64,000 + \$184,000 = \$384,000
Current liabilities:
256,000 + \$64,000 = \$320,000
Acid-test ratio:
1. Net sales:
\$4,620,000
Average accounts receivable:
Accounts receivable turnover:
1. Cost of goods sold:
\$3,360,000
Average inventory:
Inventory turnover:
1. Income before interest and taxes, \$720,000
Interest on bonds, 192,000
Times interest earned ratio: \$720,000/\$192,000 = 3.75 times
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Throughout this text, we have emphasized cost allocations only in the operating departments of a company. These operating departments perform the primary purpose of the company—to produce goods and services for consumers. Examples of operating departments are the assembly departments of manufacturing firms and the departments in hotels that take and confirm reservations.
The costs of service departments are allocated to the operating departments because they exist to support the operating departments. Examples of service departments are maintenance, administration, cafeterias, laundries, and receiving. Service departments aid multiple production departments at the same time, and accountants must allocate and account for all of these costs. It is crucial that these service department costs be allocated to the operating departments so that the costs of conducting business in the operating departments are clearly and accurately reflected.
Accountants allocate service department costs using some type of base. When the companies’ managers choose bases to use, they consider such criteria as the types of services provided, the benefits received, and the fairness of the allocation method. Examples of bases used to allocate service department costs are number of employees, machine-hours, direct labor-hours, square footage, and electricity usage.
There are three methods for allocating service department costs:
• The first method, the direct method, is the simplest of the three. The direct method allocates costs of each of the service departments to each operating department based on each department’s share of the allocation base. Services used by other service departments are ignored.
• The second method of allocating service department costs is the step method. This method allocates service costs to the operating departments and other service departments in a sequential process. The sequence of allocation generally starts with the service department that has incurred the greatest costs. After this department’s costs have been allocated, the service department with the next
highest costs has its costs allocated, and so forth until the service department with the lowest costs has had its costs allocated. Costs are not allocated back to a department that has already had all of its costs allocated.
• The third method is the most complicated but also the most accurate. The reciprocal method allocates services department costs to operating departments and other service departments. Under the reciprocal cost, the relationship between service departments is recognized and cost is allocated to and from each service department for services provided.
Next, we will look at each method.
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13.02: Direct Method of Allocation
The direct method allocates costs of each of the service departments to each operating department based on each department’s share of the allocation base. Services used by other service departments are ignored. This means the direct method does not recognize service performed by other service departments. For example, if Service Department A uses some of Service Department B’s services, these services would be ignored in the cost allocation process. Because these services are not allocated to other service departments, some accountants
believe the direct method is not accurate.
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Let’s look at another example. A company has 2 service departments, Maintenance and Administration, and 2 operating departments (Department 1 and 2 for simplicity). The costs of the maintenance department are allocated based on the machine-hours used. For the
administration department, the cost allocation is based on the number of employees. The following information is provided:
Service Dept Operating Dept
Maintenance Administration 1 2
Costs \$8,000 \$4,000 \$32,000 \$36,000
Machine-hours used 1,000 2,000 1,500 2,500
Number of Employees 100 200 250 150
Remember how we calculate predetermined overhead rates? We will need that same formula again. The formula to calculate the allocation rate will be slightly modified for service department cost but will be:
Service Dept Cost
TOTAL Cost Driver (operating depts only)
Notice, we use the operating department cost drivers only since we are allocating the service department cost to operating departments only and not to another service department. Maintenance uses machine-hours as the cost driver or basis and Administration uses number of employees. We can calculate the service department allocation rates as follows:
Maintenance Dept Cost = \$8,000
=\$8,000 = \$2 per machine hour
TOTAL Machine Hours (operating depts only) (1,500 + 2,500) 4,000
Administration Dept Cost = \$4,000 =\$4,000 = \$10 per employee
TOTAL Employees (operating depts only) (250 + 150) 400
To allocate the service department costs to each operating department, we will take the amount of the cost driver (machine hours for maintenance and employees for administration) x the allocation rate we just calculated.
Operating Dept 1 Operating Dept 2
Maintenance \$3,000 \$5,000
(1,500 mach hour x \$2 per mach hr) (2,500 mach hour x \$2 per mach hr)
Administration \$2,500 \$1,500
(250 employees x \$10 per employee) (150 employees x \$10 per employee)
Notice how the total maintenance amount allocated to the two departments (3,000 + 5,000) equals the maintenance department cost of \$8,000. The same applies to administration as the total cost is \$4,000 and we allocated a total of \$4,000 (2,500 + 1,500). We can summarize the changes to the costs of each department:
Service Dept Operating Dept
Maintenance Administration 1 2
Costs \$8,000 \$4,000 \$32,000 \$36,000
Allocation of maintenance (\$8,000) 3,000 5,000
Allocation of administration (\$4,000) 2,500 1,500
Total Costs \$0 \$0 \$37,500 \$42,500
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The second method of allocating service department costs is the step method. This method allocates service costs to the operating departments and other service departments in a sequential process. The sequence of allocation generally starts with the service department that has incurred the greatest costs. After this department’s costs have been allocated, the service department with the next highest costs has its costs allocated, and so forth until the service department with the lowest costs has had its costs allocated. Costs are not allocated back to a department that has already had all of its costs allocated.
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For this example, we will use the same data as before which was:
Service Dept Operating Dept
Maintenance Administration 1 2
Costs \$8,000 \$4,000 \$32,000 \$36,000
Machine-hours used 1,000 2,000 1,500 2,500
Number of Employees 100 200 250 150
In the step method, we typically begin with the highest service cost first. We will start with Maintenance and allocate the cost to all remaining operating AND service departments (administration, operating dept 1 and operating dept 2). When calculating the allocation rate, we never use the service department cost driver itself (so do not use the maintenance machine hours used).
Maintenance Cost = \$8,000 =\$8,000 = \$1.3333 per machine hour
Machine Hours (all but maintenance) (2,000 + 1,500 + 2,500) 6,000
We would allocate maintenance to Administration, Operating Departments 1 and 2 using the machine hours for each department x the maintenance rate per machine hour (round final answer to nearest dollar).
Admin Oper. Dept 1 Oper. Dept 2
Maintenance 2,667 2,000 3,333
(2,000 MH x 1.333) (1,500 MH x 1.3333) (2,500 MH x 1.3333)
Next, we would allocate the administration department. The total administration cost has changed since we have the original department costs of \$4,000 + maintenance cost allocated above of \$2,667 making the new administration cost \$6,667. Administration will be allocated based on number of employees. We will use the operating departments only since we have already allocate all of maintenance costs and there are no other service departments.
Administration Cost = \$6,667 =\$6,667 = \$16.6675 per employee
Employees (operating depts only) (250 + 150) 400
We would allocate administration to the operating departments only by taking each department number of employees x the administration rate per employee (round final answer to nearest dollar).
Oper. Dept 1 Oper. Dept 2
Administration 4,167 2,500
(250 employees x 16.6675) (150 employees x 16.6675)
The final cost allocation would appear as follows:
Service Dept Operating Dept
Maintenance Administration 1 2
Costs \$8,000 \$4,000 \$32,000 \$36,000
Maintenance cost allocated (\$8,000) 2,667 2,000 3,333
Administration cost allocated (\$6,667) 4,167 2,500
Total Costs \$0 \$0 \$38,167 \$41,833
Remember, the step method recognizes a one-way relationship between service departments and once the service department cost has been allocated out to other departments, we do not go back and give additional costs to that department.
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The final method, is the reciprocal method. Although it is the most accurate, it is also the most complicated. In the reciprocal method, the relationship between the service departments is recognized. This means service department costs are allocated to and from the other service departments.
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We can break the process up into 3 steps so we can make sense of the process. To demonstrate, we will use the same basic data:
Service Dept Operating Dept
Maintenance Administration 1 2
Costs \$8,000 \$4,000 \$32,000 \$36,000
Machine-hours used 1,000 2,000 1,500 2,500
Number of Employees 100 200 250 150
Step 1: Determine allocation bases
Just like you would for direct or step,we need to calculate the allocation base EXCEPT the only thing you are excluding is the department cost you are trying to allocate — ALL other departments are included. We can calculate the allocation base amount for each service department as follows:
Maintenance Dept Administration Dept
Mach Hrs % of Total Employees % of Total
Maintenance 100 20.00% (100/500)
Administration 2,000 2/6** (2,000/6,000)
Dept 1 1,500 25% (1,500/6,000) 250 50.00% (250/500)
Dept 2 2,500 2.5/6** (2,500/6,000) 150 30.00% (150/500)
Total 6,000 100% 500 100.00%
**since these numbers do not come out evenly, we keep them in the fraction form and only round the final answer to the nearest dollar.
Step 2: Setup the formulas.
Since maintenance costs are allocated to administration and administration cost is allocated to maintenance — things get interesting. You will need to determine the TOTAL cost being allocated to both the Administration and Maintenance Departments first.
(a) Total Maintenance cost = Maintenance department cost + cost allocated to maintenance from administration.
(b) Total Administration cost = Administration department cost + cost allocated to administration from maintenance.
We will work with the administration cost formula in (b) first:
Total Administration cost = Administration department cost + cost allocated to administration from maintenance. From step 1, we know the cost allocation to administration from maintenance is (2/6 x total maintenance cost). We still do not know what total maintenance cost but we can plug in this new formula.
Total Administration cost = \$ 4,000 administration department cost + (2/6 x total maintenance cost)
We can insert the formula from (a) for total maintenance cost into the total administration cost formula (b) as follows:
Total Administration cost = \$4,000 admin department cost + [2/6 x (Maintenance department cost + cost allocated to maintenance from administration) ]
We can see from step 1 that administration cost is allocated to maintenance as total administration cost x 20%. Adding this to our formula, we now have:
Total Administration cost = \$4,000 admin department cost + [2/6 x (\$8,000 Maintenance department cost + (total admin cost x 20%) ) ]
Using algebra, we can assign Total Administration Cost a variable of A giving the formula:
A = 4,000 + [ 2/6 x (\$8,000 + 0.20)A]
A = 4,000 + (2/6 x 8,000) + (2/6 x 0.20A)
A = 4,000 + 2,666.67 + 0.067A — rounded
A = 6,666.67 + 0.067A
1.0A – 0.067A = 6,666.67
0.933A = 6,666.67
A or total administration cost = \$7,145 rounded
Total maintenance cost can be calculated as \$8,000 department cost + \$1,429 (7,145 x 20%) allocated from administration for a total of \$9,429.
Step 3: Show cost allocations
Now that you have the TOTAL Cost of Maintenance and Personnel, it is time to allocate it using the Total Cost amounts from Step 2 and the percents from Step 1.
Service Dept Operating Dept
Maintenance Administration 1 2
Costs \$8,000 \$4,000 \$32,000 \$36,000
Maintenance costs allocated -9,429 3,143 2,357 3,929
(9,429 x 2/6) (9,429 x 25%) (,9429 x 2.5/6)
Administration costs allocated 1,429 -7,145 3,572.50 2,143.50
(7,145 x 20%) (7,145 x 50%) (7,145 x 30%)
Total costs \$0 (\$2)** \$37,930 \$42,073
** difference due to rounding in calculations.
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01: Accounting as a Tool for Managers
You have been elected as the coordinator of committees for your school’s business honor society. In essence, this makes you the manager of all the committees. This is a new position that was created because the committees have never been evaluated for their effectiveness within the organization. Your job in this position is to ensure that the committees—such as recruiting, fundraising, community service, professional activities, and regional and national conference presentations—are operating within the goals put forth in the society’s mission statements, as well as to assess the effectiveness and efficiency of each committee in meeting the organization’s goals. Your starting point is to understand the overriding mission—the strategic direction and purpose—of the society. Next, you want to understand how each committee fits into the strategic goal of the society and then identify the separate goals of each committee. Once you understand the purpose and goal of each committee, it will be necessary to know how each committee is going about meeting its goals. Last, you will evaluate each committee to see if the goals are being met.
Notice that in performing your role as the coordinator of committees, you will need financial information, such as budgets and financial statements, along with other nonfinancial information, for example, the society’s mission statement, each committee’s strategy statement, and records of their activities and meetings. To help assess how well the honor society and its committees are meeting their goals, you need more information than can be obtained from simply looking at the various financial documents assembled by each committee within the organization. The same is true in any business organization. Managers and other internal decision makers need more information than is available in the basic financial statements: they need information generated by the managerial accounting system.
1.02: Define Managerial Accounting and Identify the Three Primary Responsibilities of Management
Financial accounting process provides a useful level of detail for external users, such as investors and creditors, but it does not provide enough detailed information for the types of decisions made in the day-to-day operation of the business or for the types of decisions that guide the company long term. Managerial accounting is the process that allows decision makers to set and evaluate business goals by determining what information they need to make a particular decision and how to analyze and communicate this information. Let’s explore the role of managerial accounting in several different organizations and at different levels of the organization, and then examine the primary responsibilities of management.
Three friends who are recent graduates from business school, Alex, Hana, and Gillian, have each just begun their first postgraduation jobs. They meet for lunch and discuss what each of their jobs entails. Alex has taken a position as a market analyst for a Fortune 500 company that operates in the shipping industry. Her first assignment is to suggest and evaluate ways the company can increase the revenue from shipping contracts by $10$ percent for the year. Before tackling this project, she has a number of questions. What is the purpose of this analysis? What type of information does she need? Where would she find this information? Can she get it from a basic income statement and balance sheet? How will she know if her suggestions for pricing are creating more shipping contracts and helping to meet the company’s goal? She begins with an analysis of the company’s top fifty customers, including the prices they pay, discounts offered, discounts applied, frequency of shipments, and so on, to determine if there are price adjustments that need to be made to attract those customers to use the company’s shipping services more frequently.
Hana has a position in the human resources department of a pharmaceutical company and is asked to research and analyze a new trend in compensation in which employers are forgoing raises to employees and are instead giving large bonuses for meeting certain goals. Her task is to ascertain if this new idea would be appropriate for her company. Her questions are similar to Alex’s. What information does she need? Where would she find this information? How would she determine the impact of this type of change on the business? If implemented, what information would she need to assess the success of the plan?
Gillian is working in the supply chain area of a major manufacturer that produces the various mirrors found on cars and trucks. Her first assignment is to determine whether it is more cost effective and efficient for her company to make or purchase a bracket used in the assembly of the mirrors. Her questions are also similar to her friends’ questions. Why is the company considering this decision? What information does she need? Where would she find this information? Would choosing the option with the lowest cost be the correct choice?
The women are surprised by how similar their questions are despite how different their jobs are. They each are assigned tasks that require them to use various forms of information from many different sources to answer an important question for their respective companies. Table $1$ provides possible answers to each of the questions posed in these scenarios.
Table $1$: Managerial Accounting and Various Business Roles
Questions Possible Answers
Alex, Marketing Analyst
What is the purpose of this analysis? To determine a better way to price their services
What type of information does she need? Financial and nonfinancial information, such as the number of contracts per client
Where would she find this information? Financial statements, customer contracts, competitor information, and customer surveys
Can she get it from a basic income statement and balance sheet? No, she would need to use many other sources of information
How will she know if her suggestions for pricing are creating more shipping contracts and helping to meet the company’s goal? By using a means to evaluate the success, such as by comparing the number of contracts received from each company before the new pricing structure with the number received after the pricing change of contracts
Hana, Human Resources
What information does she need? Financial and nonfinancial information, such as how other companies have implemented this idea, including the amount of the bonus and the types of measures on which the bonus was measured
Where would she find this information? Mostly from internal company sources, such as employee performance records, but also from industry and competitor sources
How would she determine the impact of this type of change on the business? Perform surveys to determine the effect of the bonus method on employee morale and employee turnover; she could determine the effect on gross revenue of annual bonuses versus annual raises
If implemented, what information would she need to assess the success of the plan? Measuring employee turnover; evaluating employee satisfaction after the change; assessing whether the performance measures being used to determine the bonus were measures that truly impacted the company in a positive manner
Gillian, Supply Chain
Why is the company considering this decision? Management likely wants to minimize costs, and this particular part is one they believe may be more cost effective to buy than to make
What information does she need? She needs the cost to buy the part as well as all the costs that would be incurred to make the part; whether her company has the ability (capacity) to make the part; the quality of the part if they buy it compared to if they make it; the ability of a supplier of the part to deliver on time
Where would she find this information? She would find the information from internal records about production costs, from cost details provided by the external producer, and from industry reports on the quality of production from the external supplier
Would choosing the option with the lowest cost be the correct choice? The lowest-cost option may not be the best choice if the quality is subpar, if the part is not delivered in a timely manner and thus throws off or slows production, or if the use of a purchased part will affect the relationship between the company and the car manufacturer to whom the mirror is ultimately sold
The questions the women have and the answers they require show that there are many types of information that a company needs to make business decisions. Although none of these individuals is given the title of manager, they need information to help provide management with the information necessary to make decisions to move the company forward with its strategic plan. The scenarios of the three women are not unique. These types of questions occur every day in businesses across the world.
Some decisions will be more clearly appropriate for higher-level management. For example, Lynx Boating Company produces three different lines of boats (sport boats, pontoon boats, and large cruisers). All three boat lines are profitable, but the pontoon boat line seems to be less profitable than the other two types of boats. Management may want to consider abandoning the pontoon line and using that additional capacity to produce one of the other more profitable lines. They would need detailed financial information in order to make such a decision.
LINK TO LEARNING
This short video goes inside a manufacturing process to show you how machines, people, planning, implementation, efficiency, and costs interact to arrive at a finished product.
Service organizations also face decisions that require more detailed information than is available in financial accounting statements. A company’s financial statements aggregate information for the company as a whole, but for most managerial decisions, information must be gathered in a timely manner at a product, customer, or division level. For example, the management of City Hospital is considering the purchase of four new magnetic resonance imaging (MRI) machines that scan three times faster than their current machines and thus would allow the hospital’s imaging department to evaluate eight additional patients each day. Each machine costs $\425,000$ and will last five years before needing to be replaced. Would this be a wise investment for City Hospital? Hospital management would need the appropriate information to assess the alternatives in order to make this decision. Throughout your study of managerial accounting, you will learn about the types of information needed to make these decisions, as well as techniques for analyzing this information. First, it is important to understand the various roles managers play in the organization in order to understand the types of information and the level of detail that are needed. Most of the job responsibilities of a manager fit into one of three categories: planning, controlling, or evaluating.
The model in Figure $1$ sums up the three primary responsibilities of management and the managerial accountant’s role in the process. As you can see from the model, the function of accomplishing an entity’s mission statement is a circular, ongoing process.
Planning
One of the first items on a new company’s agenda is the creation of a mission statement. A mission statement is a short statement of a company’s purpose and focus. This statement should be broad enough that it will encompass future growth and changes of the company. Table $2$ contains the mission statement of three different types of companies: a manufacturer, an e-commerce company, and a service company.
Table $2$: Sample Mission Statements
Company Mission Statement
Dow Chemical “To passionately create innovation for our stakeholders at the intersection of chemistry, biology, and physics.”1
Starbucks “To inspire and nurture the human spirit—one person, one cup, and one neighborhood at a time.”2
Google “Our mission is to organize the world’s information and make it universally accessible and useful.”3
Once the mission of the company has been determined, the company can begin the process of setting goals, or what the company expects to accomplish over time, and objectives, or the targets that need to be met in order to meet the company’s goals. This is known as planning. Planning occurs at all levels of an organization and can cover various periods of time. One type of planning, called strategic planning, involves setting priorities and determining how to allocate corporate resources to help an organization accomplish both short-term and long-term goals. For example, one hotel may want to be the low-price, no-frills, clean alternative, while another may decide to be the superior quality, high-price luxury hotel with many amenities. Obviously, to be successful, either of these businesses must determine the goals necessary to meet their particular strategy.
Typically, a strategic plan will span any number of years an organization chooses (three, five, seven, or even ten years), and often companies will have multiple strategic plans, such as one for three years, one for five years, and one for ten years. Given the time length involved in many plans, the organization also needs to factor in the potential effects of changes in their senior executive leadership and the composition of the board of directors.
What types of objectives are part of a strategic plan? Strategic objectives should be diverse and will vary from company to company and from industry to industry, but some general goals can include maximizing market share, increasing short-term profits, increasing innovation, offering the best value for the cost, maintaining commitment to community programs, and exceeding environmental protection mandates.
From a managerial accounting perspective, planning involves determining steps or actions to meet the strategic or other goals of the company. For example, Daryn’s Dairy, a major producer of organic dairy products in the Midwest, has made increasing the market share of its products one of its strategic goals. However, to be truly effective, the goals need to be defined specifically. For example, the goals might be stated in terms of percentage growth, both annually and in terms of the number of markets addressed in their growth projections.
Also, Daryn’s planning process would include the steps the company plans to use to implement to increase market share. These plans may include current-year plans, five-year plans, and ten-year plans.
The current-year plan may be to sell the company’s products in $10$ percent more stores in the states in which it currently operates. The five-year plan may be to sell the products internationally in three countries, and the ten-year plan may be to acquire their chief competitor and, thus, their customers. Each of these plans will require outlining specific steps to reach these goals and communicating those steps to the employees who will carry out or have an impact on reaching these goals and implementing these plans.
Planning can involve financial and nonfinancial processes and measures. One planning tool discussed in Budgeting is the budgeting process, which requires management to assess the resources—for example, time, money, and number and type of employees needed—to meet current-year objectives. Budgeting often includes both financial data, such as worker pay rates, and nonfinancial data, such as the number of customers an employee can serve in a given time period.
A retail company can plan for the expected sales volume, a hospital can plan for the number of x-rays they expect to administer, a law firm can plan the hours expected for the various types of legal services they perform, a manufacturing firm can plan for the level of quality expected in each item produced, and a utility company can plan for the level of air pollutants that are acceptable. Notice that in each of these examples, the aspect of the business that is being planned and evaluated is a qualitative (nonfinancial) factor or characteristic. In your study of managerial accounting, you will learn about many situations in which both financial and nonfinancial data or information are equally relevant. However, the qualitative aspects are typically not quantified in dollars but evaluated using some other standards, such as customers served or students advised.
While these functions are initially stated in qualitative terms, most of these items would at some point be translated into a dollar value or dollar effect. In each of these examples, the managerial accounting function would help to determine the variables that would help appropriately measure the desired goal as well as plan how to quantify these measures. However, measures are only useful if tracked and used to determine their effectiveness. This is known as the control function of management.
Controlling
To measure whether plans are meeting objectives or goals, management must put in place ways to assess success or lack of success. Controlling involves the monitoring of the planning objectives that were put into place. For example, if you have a retail store and you have a plan to minimize shoplifting, you can implement a control, such as antitheft tags that trigger an alarm when someone removes them from the store. You could also install in the ceilings cameras that provide a different view of customers shopping and therefore may catch a thief more easily or clearly. The antitheft tags and cameras serve as your controls against shoplifting.
Managerial accounting is a useful tool in the management control function. Managerial accounting helps determine the appropriate controls for measuring the success of a plan. There are many types of controls that a company can use. Some controls can be in the form of financial measures, such as the ratio for inventory turnover, which is a measure of inventory control and is defined as $\text{Cost of Goods Sold} ÷ \text{Average Inventory}$, or in the form of a performance measure, such as decreasing production costs by $10$ percent to help guide or control the decisions made by managers. Other controls can be physical controls, such as fingerprint identification or password protection. Essentially, the controlling function in management involves helping to coordinate the day-to-day activities of a business so that these activities lead to meeting corporate goals.
Without controls, it is very unlikely a plan would be successful, and it would be difficult to know if your plan was a success. Consider the plan by Daryn’s Dairy to increase market share. The plan for the first year was to increase market share by selling the company’s products in $10$ percent more stores in the states in which the company already operates. How will the company implement this plan? The implementation, or carrying out, of the plan will require the company to put controls in place to measure which new stores are successfully selling the company’s products, which products are being sold the most, what the sales volume and dollar value of the new stores are, and whether the sales in these new stores are affecting the volume of sales in current stores. Without this information, the company would not know if the plan is reaching the desired result of increased market share.
The control function helps to determine the courses of action that are taken in the implementation of a plan by helping to define and administer the steps of the plan. Essentially, the control function facilitates coordination of the plan within the organization. It is through the system of controls that the actual results of decisions made in implementing a plan can be identified and measured. Managerial accounting not only helps to determine and design control measures, it also assists by providing performance reports and control reports that focus on variances between the planned objective performance and the actual performance. Control is achieved through effective feedback, or information that is used to assess a process. Feedback allows management to evaluate the results, determine whether progress is being made, or determine whether corrective measures need to be taken. This evaluation is in the next management function.
Evaluating
Managers must ultimately determine whether the company has met the goals set in the planning phase. Evaluating, also called assessing or analyzing, involves comparing actual results against expected results, and it can occur at the product, department, division, and company levels. When there are deviations from the stated objectives, managers must decide what modifications are needed.
The controls that were put into place to coordinate the implementation of a particular company plan must be evaluated so that success can be measured, or corrective action can be taken. Consider Daryn’s Dairy’s one-year plan to increase market share by selling products in $10$ percent more stores in the states in which the company currently operates. Suppose one of the controls put into place is to measure the sales in the current stores to determine if selling the company’s products in new stores is adding new sales or merely moving sales from existing stores. This control measure, same-store sales, must be evaluated to determine the effect of the decision to expand the selling of products within the state. This control measure will be evaluated by comparing sales in the current year in those stores to sales from the prior year in those same stores. The results of this evaluation will help guide management in their decision to move forward with their plan, to modify the plan, or to scrap the plan.
As discussed previously, not all evaluations will involve quantitative or financial measures. In expanding market share, the company wants to maintain or improve its reputation with customers and does not want the planned increased availability or easier access to their products to decrease customer perceptions of the products or the company. They could use customer surveys to evaluate the perceived effect on the company’s reputation as a result of implementing this one-year plan. However, there are many ways that companies can evaluate various controls. In addition to the financial gauges, organizations are now measuring efficiencies, customer development, employee retention, and sustainability.
Managers spend their time in various stages of planning, controlling, and evaluating. Generally, higher-level managers spend more time on planning, whereas lower-level managers spend more time on evaluating. At any level, managers work closely with the managerial accounting team to help in each of these stages. Managerial accountants help determine whether plans are measurable, what controls should be implemented to carry out a plan, and what are the proper means of evaluation of those controls. This would include the type of feedback necessary for management to assess the results of their plans and actions. Management accountants generate the reports and information needed to assess the results of the various evaluations, and they help interpret the results.
To put this in context, think about how you will spend your weekend. First, you are the manager of your own time. You must plan based on your workload and on how much time you will spend studying, exercising, sleeping, and meeting with friends. You then control how your plan is implemented by setting self-imposed or possibly group meeting–imposed deadlines, and last, you evaluate how well you carried out your plan by gathering more data—such as grades on assignments, personal fulfillment, and number of hours of sleep—to determine if you met your plans (goals). Not planning, controlling, and evaluating often results in less-than-desirable outcomes, such as late assignments, too little sleep, or bad grades. In this scenario, you did not need a separate managerial accountant to help you with these functions, because you could manage planning, controlling, and evaluating on your own. However, in the business world, most businesses will have both managers and managerial accountants. Table $3$ illustrates some examples.
Table $3$: Relating Managerial Accounting Functions to Various Business Majors
Sales Human Resources Logistics
Planning What are our expected sales for each product in each geographic region?
How much should be budgeted for salaries and commissions for our salespeople?
How much should we budget for salary and wage increases for the year?
How much should we plan to spend on safety and training for the year?
Should we invest in radio-frequency identification (RFID) processors to enable computer tracking of inventory?
How much raw material should be ordered and delivered to ensure timely delivery of our finished products to our customers?
Controlling Are we meeting expected sales growth in each region?
Are each of the salespeople meeting their sales projections?
Is our projected budget for wages and salaries sufficient?
Are we meeting our safety and training goals?
Are our products being delivered to our customers in a timely manner, and at what cost?
Are we dealing with stock-outs in inventory? If so, what is that costing us?
Evaluating How do our actual sales compare to our forecasted or budgeted sales?
What sales promotions are our competitors offering, and what effect is it having on our market share?
Would it be cheaper to hire temporary employees to get through our “busy” season or to pay our current employees for overtime? What are the cost differences in starting our own delivery service versus continuing to use other carriers?
Should we outsource the manufacturing of a component part or continue to make it ourselves? What are the price differences?
Example $1$: Evaluating On-Campus versus Off-Campus Living
The principal purpose of managerial accounting is to deliver information useful for management decision-making. Many of the techniques used in managerial accounting are useful for decisions in your everyday life. In choosing whether to live on campus or off campus, how might you use planning, controlling, and evaluating in your decision-making process? What types of financial and nonfinancial information might you need?
Solution
Planning:
• Creating a list of financial and nonfinancial goals to be accomplished in your next year in college
• Determining how much each alternative will cost, including utilities, food, and transportation, and creating a budget
Controlling:
• Using an expense recording app to monitor your expenses
• Monitoring the effectiveness of your study time as reflected in your grades
• Monitoring your physical health to measure if your living arrangements are conducive to staying healthy
Evaluating:
• Assessing the effectiveness of your living arrangements by measuring your grades, bank account, and general happiness
Financial:
• Cost of staying in dorm versus the cost of an apartment or house
• Estimate of differences in other costs, such as utilities, food, and additional transportation
Nonfinancial:
• Convenience of location of dorm versus apartment or house
• Quality of living experience including number of roommates, ability to have own room, study environment differences
• Length of rental term of dorm versus apartment or house
• Where you plan to live in the summer, what you plan to do during that time
THINK IT THROUGH: US Small Business Administration
Many students who study managerial accounting will work for a small business, and some may even own a small business. In order to operate a small business, you need an understanding of managerial accounting, among other skills. The US Small Business Administration is an agency within the federal government that has the sole purpose of supporting small businesses. You can find a plethora of information on their website, https://www.sba.gov/.
1. What are some of the steps in creating a small business?
2. What are the top ten reasons given for a business failure?
3. How could an understanding of managerial accounting help a small business owner?
Footnotes
1. “Mission and Vision.” DOW. https://www.dow.com/en-us/about-dow/...ion-and-vision
2. “Our Starbucks Mission Statement.” Starbucks. https://www.starbucks.com/about-us/c...sion-statement
3. “About.” Google. https://www.google.com/about/ | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/01%3A_Accounting_as_a_Tool_for_Managers/1.01%3A_Prelude_to_Accounting_as_a_Tool_for_Managers.txt |
Now that you have a basic understanding of managerial accounting, consider how it is similar to and different from financial accounting. After completing a financial accounting class, many students do not look forward to another semester of debits, credits, and journal entries. Thankfully, managerial accounting is much different from financial accounting. Also known as management accounting or cost accounting, managerial accounting provides information to managers and other users within the company in order to make more informed decisions. The overriding roles of managers (planning, controlling, and evaluating) lead to the distinction between financial and managerial accounting. The main objective of management accounting is to provide useful information to managers to assist them in the planning, controlling, and evaluating roles.
Unlike managerial accounting, financial accounting is governed by rules set out by the Financial Accounting Standards Board (FASB), an independent board made up of accounting professionals who determine and publicize the standards of financial accounting and reporting in the United States. Larger, publicly traded companies are also governed by the US Securities and Exchange Commission (SEC), in the form of the generally accepted accounting principles (GAAP), the common set of rules, standards, and procedures that publicly traded companies must follow when they are composing their financial statements.
Financial accounting provides information to enable stockholders, creditors, and other stakeholders to make informed decisions. This information can be used to evaluate and make decisions for an individual company or to compare two or more companies. However, the information provided by financial accounting is primarily historical and therefore is not sufficient and is often synthesized too late to be overly useful to management. Managerial accounting has a more specific focus, and the information is more detailed and timelier. Managerial accounting is not governed by GAAP, so there is unending flexibility in the types of reports and information gathered. Managerial accountants regularly calculate and manage “what-if” scenarios to help managers make decisions and plan for future business needs. Thus, managerial accounting focuses more on the future, while financial accounting focuses on reporting what has already happened. In addition, managerial accounting uses nonfinancial data, whereas financial accounting relies solely on financial data.
For example, Daryn’s Dairy makes many different organic dairy products. Daryn’s managers need to track their costs for certain jobs. One of the company’s top-selling ice creams is their seasonal variety; a new flavor is introduced every three months and sold for only a six-month period. The cost of these specialty ice creams is different from the cost of the standard flavors for reasons such as the unique or expensive ingredients and the specialty packaging. Daryn wants to compare the costs involved in making the specialty ice cream and those involved in making the standard flavors of ice cream. This analysis will require that Daryn track not only the cost of materials that go into the product, but also the labor hours and cost of the labor, plus other costs, known as overhead costs (rent, electricity, insurance, etc.), that are incurred in producing the various ice creams. Once the total costs for both the specialty ice cream and the standard flavored ice cream are known, the cost per unit can be determined for each type. These types of analyses help a company evaluate how to set pricing, evaluate the need for new or substitute ingredients, manage product additions and deletions, and make many other decisions. Figure \(1\) shows an example of a materials cost analysis by Daryn’s Dairy used to compare the materials cost for producing \(500\) gallons of their best-selling standard flavor—vanilla—with one of their specialty ice creams—Very Berry Biscotti.
Financial and Managerial Accounting Comparative
Managerial and financial accounting are used by every business, and there are important differences in their reporting functions. Those differences are detailed in Figure \(2\).
Users of Reports
The information generated from the reports of financial accountants tends to be used primarily by external users, including the creditors, tax authorities and regulators, investors, customers, competitors, and others outside the company, who rely on the financial statements and annual reports to access information about a company in order to make more informed decisions. Since these external people do not have access to the documents and records used to produce the financial statements, they depend on Generally Applied Accounting Principles (GAAP). These outside users also depend greatly on the preparation of audits that are done by public accounting firms, under the guidelines and standards of either the American Institute of Certified Public Accountants (AICPA), the US Securities and Exchange Commission (SEC), or the Public Company Accounting Oversight Board (PCAOB).
Managerial accounting information is gathered and reported for a more specific purpose for internal users, those inside the company or organization who are responsible for managing the company’s business interests and executing decisions. These internal users may include management at all levels in all departments, owners, and other employees. For example, in the budget development process, a company such as Tesla may want to project the costs of producing a new line of automobiles. The managerial accountants could create a budget to estimate the costs, such as parts and labor, and after the manufacturing process has begun, they can measure the actual costs, thus determining if they are over or under their budgeted amounts. Although outside parties might be interested in this information, companies like Tesla, Microsoft, and Boeing spend significant amounts of time and money to keep their proprietary information secret. Therefore, these internal budget reports are only available to the appropriate users. While you can find a cost of goods sold schedule in the financial statements of publicly traded companies, it is difficult for outside parties to break it down in order to identify the individual costs of products and services.
LINK TO LEARNING
Investopedia is considered to be the largest Internet financial education resource in the world. There are many short, helpful videos that explain various concepts of managerial accounting. Watch this video explaining managerial accounting and how useful it can be to many different types of managers to learn more.
Types of Reports
Financial accounting information is communicated through reporting, such as the financial statements. The financial statements typically include a balance sheet, income statement, cash flow statement, retained earnings statement, and footnotes. Managerial accounting information is communicated through reporting as well. However, the reports are more detailed and more specific and can be customized. One example of a managerial accounting report is a budget analysis (variance report) as shown in Figure \(3\). Other reports can include cost of goods manufactured, job order cost sheets, and production reports. Since managerial accounting is not governed by GAAP or other constraints, it is important for the creator of the reports to disclose all assumptions used to make the report. Since the reports are used internally, and not typically released to the general public, the presentation of any assumptions does not have to follow any industry-wide guidelines. Each organization is free to structure its reports in the format that organizes its information in the best way for it.
This type of analysis helps management to evaluate how effective they were at carrying out the plans and meeting the goals of the corporation. You will see many examples of reports and analyses that can be used as tools to help management make decisions.
Think it Through: Projection Error
You are working as the accountant in the special projects and budgets area of Sturm, Ruger & Company, a law firm that currently specializes in bankruptcy law. In order to serve their customers better and more efficiently, the company is trying to decide whether or not to expand its services and offer credit counseling, credit monitoring, credit rebuilding, and identity protection services. The president comes to you and asks for some sales and revenue projections. He would like the projections in three days’ time so that he can present the results to the board at the annual meeting.
You work tirelessly for two straight days compiling projections of sales and revenues to prepare the reports. The report is provided to the president just before the board is to arrive.
When you return to your office, you start clearing away some of the materials that you used in your report, and you discover an error that makes all of your projections significantly overstated. You ask the president’s administrative assistant if the president has presented the report to the board, and you find that he had mentioned it but not given the full report as of yet.
What would you do?
• What are the ethical concerns in this matter?
• What would be the results of telling the president of your error?
• What would be the results of not telling the president of your error?
Frequency of Reports
The financial statements are typically generated quarterly and annually, although some entities also require monthly statements. Much work is involved in creating the financial statements, and any adjustments to accounts must be made before the statements can be produced. A physical count inventory must be done to adjust the inventory and cost of goods sold accounts, depreciation must be calculated and entered, all prepaid asset accounts must be reviewed for adjustments, and so forth. The annual reports are not finalized for several weeks after the year-end, because they are based on historical data; for a company that is traded on one of the major or regional stock exchanges, it must have an audit of the financial statements conducted by an independent certified public accountant. This audit cannot be completed until after the end of the company’s fiscal year, because the auditors need access to all of the information for the company for that year. For companies that are privately held, an audit is not normally required. However, potential lenders might require an independent audit.
Conversely, managers can quickly attain managerial accounting information. No external, independent auditors are needed, and it is not necessary to wait until the year-end. Projections and estimates are adequate. Managers should understand that in order to obtain information quickly, they must accept less precision in the reporting. While there are several reports that are created on a regular basis (e.g., budgets and variance reports), many management reports are produced on an as-needed basis.
Purpose of Reports
The general purpose of financial statement reporting is to provide information about the results of operations, financial position, and cash flows of an organization. This data is useful to a wide range of users in order to make economic decisions. The purpose of the reporting done by management accountants is more specific to internal users. Management accountants make available the information that could assist companies in increasing their performance and profitability. Unlike financial reports, management reporting centers on components of the business. By dividing the business into smaller sections, a company is able to get into the details and analyze the smallest segments of the business.
An understanding of managerial accounting will assist anyone in the business world in determining and understanding product costs, analyzing break-even points, and budgeting for expenses and future growth (which will be covered in other parts of this course). As a manager, chief executive officer, or owner, you need to have information available at hand to answer these types of questions:
• Are my profits higher this quarter over last quarter?
• Do I have enough cash flow to pay my employees?
• Are my jobs priced correctly?
• Are my products priced correctly in order for me to make the profit I need to make?
• Who are my most productive and least productive employees?
In the world of business, information is power; stated simply, the more you know, typically, the better your decisions can be. Managerial accounting delivers data-driven feedback for these decisions that can assist in improving decision-making over the long term. Business managers can leverage this powerful tool in order to make their businesses more successful, because management accounting adds value to common business decision-making. All of this readily available information can lead to great improvements for any business.
Focus of Reports
Because financial accounting typically focuses on the company as a whole, external users of this information choose to invest or loan money to the entire company, not to a department or division within the company. Therefore, the global focus of financial accounting is understandable.
However, the focus of management accounting is typically different. Managerial reporting is more focused on divisions, departments, or any component of a business, down to individuals. The mid-level and lower-level managers are typically responsible for smaller subsets within the company.
Managers need accounting reports that deal specifically with their division and their specific activities. For instance, production managers are responsible for their specific area and the results within their division. Accordingly, these production managers need information about results achieved in their division, as well as individual results of departments within the division. The company can be broken into segments based on what managers need—for example, geographic location, product line, customer demographics (e.g., gender, age, race), or any of a variety of other divisions.
Nature of Reports
Both financial reports and managerial reports use monetary accounting information, or information relating to money or currency. Financial reports use data from the accounting system that is gathered from the reporting of transactions in the form of journal entries and then aggregated into financial statements. This information is monetary in nature. Managerial accounting uses some of the same financial information as financial accounting, but much of that information will be broken down to a more detailed level. For example, in financial reporting, net sales are needed for the income statement. In managerial accounting, the quantity and dollar value of the sales of each product are likely more useful. In addition, managerial accounting uses a significant amount of nonmonetary accounting information, such as quantity of material, number of employees, number of hours worked, and so forth, which does not relate to money or currency.
Verification of Reports
Financial reports rely on structure. They are generated using accepted principles that are enforced through a vast set of rules and guidelines, also known as GAAP. As mentioned previously, companies that are publicly traded are required to have their financial statements audited on an annual basis, and companies that are not publicly traded also may be required to have their financial statements audited by their creditors. The information generated by the management accountants is intended for internal use by the company’s divisions, departments, or both. There are no rules, guidelines, or principles to follow. Managerial accounting is much more flexible, so the design of the managerial accounting system is difficult to standardize, and standardization is unnecessary. It depends on the nature of the industry. Different companies (even different managers within the same company) require different information. The most important issue is whether the reporting is useful for the planning, controlling, and evaluation purposes.
Example \(1\): Daryn’s Dairy
Suppose you have been hired by Daryn’s Dairy as a market analyst. Your first assignment is to evaluate the sales of various standard and specialty ice creams within the Midwest region where Daryn’s Dairy operates. You also need to determine the best-selling flavors of ice cream in other regions of the United States as well as the selling patterns of the flavors. For example, do some flavors sell better than others at different times of the year, or are some top sellers sold as limited-edition flavors? Remember that one of the strategic goals of the company is to increase market share, and the first step in meeting this goal is to sell their product in 10 percent more stores within their current market, so your research will help upper-level management carry out the company’s goals. Where would you gather the information? What type of information would you need? Where would you find this information? How would the company determine the impact of this type of change on the business? If implemented, what information would you need to assess the success of the plan?
Solution
Answers will vary. Sample answer:
Where would you gather the information? Where would you find this information?
• Current company sales information would be obtained from internal company reports and records that detail the sale of each type of ice cream including volume, cost, price, and profit per flavor.
• Sales of ice cream from other companies may be more difficult to obtain, but the footnotes and supplemental information to the annual reports of those companies being analyzed, as well as industry trade journals, would likely be good sources of information.
What types of information would you need?
• Some of the types of information that would be needed would be the volume of sales of each flavor (number of gallons), how long each flavor has been sold, whether seasonal or limited-edition flavors are produced and sold only once or are on a rotating basis, the size of the market being examined (number of households), whether the other companies sell similar products (organic, all natural, etc.), the median income of consumers or other information to assess the consumers’ willingness to pay for organic products, and so forth.
How would Daryn’s Dairy determine the impact of this type of change on the business?
• Management would evaluate the cost to expand into new stores in their current market compared to the potential revenues from selling their products in those stores in order to assess the ability of the potential expansion to generate a profit for the company.
If implemented, what information would Daryn’s Dairy need to assess the success of the plan?
• Management would measure the profitability of selling any new products, expanding into new stores in their current market, or both to determine if the implementation of the plan was a success. If the plan is a success and the company is generating profits, the company will continue to figure out ways to improve efficiency and profitability. If the plan is not a success, the company will determine the reasons (cost to produce too high, sales price too high, volume too low, etc.) and make a new plan. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/01%3A_Accounting_as_a_Tool_for_Managers/1.03%3A_Distinguish_between_Financial_and_Managerial_Accounting.txt |
It is clear that management accountants must have a solid foundation in accounting, in both financial and managerial accounting, but other than accounting skills, what makes good managerial accountants?
• They must have knowledge of the business in which they are working. Commercial awareness is knowing how a business is run and how it is influenced by the external environment and knowing and understanding the overall industry within which the business is operating.
• Collaboration, which involves working in cross-functional teams and earning the trust and respect of colleagues in order to complete a task, is vital to improving managerial accounting talents. They should be “team players.”
• Management accountants should have effective communication skills that allow them to convey accounting information in both written and oral forms in a way that the intended audience can understand. Being able to gather the data quickly and accurately is important, but the data is meaningless if it is not presented in an intuitive style that the audience can understand.
• Strong technology skills are also essential. These skills include not only accounting and reporting software but also other programs that would assist in automating processes, improving efficiencies, and adding value to the company. For many companies, additional software and accompanying technology are often needed for both their financial and managerial accounting functions. For example, enterprise resource planning (ERP) systems often play a major role in the creation of comprehensive accounting systems. This additional support is often provided by outside suppliers such as Hyperion, Cognos, Sage, SAP, PeopleSoft, and Oracle.
• Managerial accountants must possess extensive analytical skills. They must regularly work with financial analysts and management personnel to find ways to reduce expenses and analyze budgets. These skills include the ability to envision, verbalize, conceptualize, or solve both multifaceted and simplistic problems by making choices that make sense with the given information.
• Managerial accountants must have ethics and values. They should be an example to others and encourage them to follow internal control practices and procedures. Ethics is discussed in more detail in Describe the role of the Institute of Management Accountants and the use of ethical standards.
Managers at all levels make many different types of decisions every day, but to make most decisions, they need specific information. Some information is easily obtainable, and some is not. Managers do not always know what information they need or what is available, and they need to know if the decisions they make are having the desired outcome and meeting specific goals.
To this point, we’ve described managerial accounting as a process. The following definition considers it a profession. Management accountants are the individuals who help management with this information. The Institute of Management Accountants (IMA) defines management accounting as “a profession that involves partnering in management decision making, devising planning and performance management systems, and providing expertise in financial reporting and control to assist management in the formulation and implementation of an organization’s strategy.”1
The IMA also reports that nearly \(75\) percent of financial professionals work in business as management accountants in positions such as financial analysts, accounting managers, controllers, and chief financial officers.2 These professionals have a significant impact on businesses through influencing the decision-making process and business strategy.
Management accountants work at various levels of the organization, from the project level to the division level to the controller and chief financial officer. Often, management accountants work where they are needed and not necessarily at corporate headquarters. They tend to be hands-on in the decision-making process. They need many types of information to inform the many decisions they must make.
Continuing Application
Who Uses Managerial Accounting?
When most people think of an accounting job, they think of someone who does taxes or who puts together financial statements. However, almost all jobs use accounting information, particularly managerial accounting information. Table \(1\) shows how certain professions might use managerial accounting information. Can you think of other examples?
Table \(1\): Use of Managerial Accounting Information
Profession How They Use Managerial Accounting in Their Industry
Engineer Properly track and report the use of resources involved in an engineering project; measure and communicate costs of a project and its outcomes
Mayor Put together a budget, a planning and control mechanism that plays an important role in every government
Nurse Track operating or service costing per patient, or per unit
Mechanic Use job costing to figure total costs and overall profitability on each job
Retail store manager Forecast inventory needs, review profit margins, and track sales margins on individual products as well as entire stores
Restaurant owner Calculate the cost of serving a single table by estimating the cost of the food plus time of server, keep food costs under control through inventory tracking
Architect Track direct and indirect costs for each job; track profitability per job
Farmer Calculate yields per field, analyze fertilizer and seeding rates, and control waste
Organizational Structure
Most companies have an organizational chart that displays the configuration and the delegation of authority in the decision-making processes (Figure \(1\)). The structure helps define roles and responsibilities. The organizational charts provide guidance to employees and other stakeholders by outlining the official reporting affiliations that direct the workflow within the organization. If the company is particularly efficient, it also will include contact information within the chart. This is a convenient directory to circulate among employees. It helps them find a particular person in a certain position, or determine whom to speak to about certain areas within the company, or even identify a specific person’s supervisor to report positive or negative work behavior.
Stockholders of a company are the owners; however, they elect a board of directors to manage that company for them. The board selects the officers who will implement the policies and strategic goals that the board has set in place. The chief executive officer (CEO) is the corporation officer who has the overall responsibility for the management of the company. The person overseeing all of the accounting and finance concerns is the chief financial officer (CFO). This individual is in charge of the financial planning and record-keeping of the organization and reports to the CEO. The controller is responsible for the accounting side of the business (accounting records, financial statements, tax returns, and internal reports) and reports to the CFO. Also reporting to the CFO is the treasurer, who is in control of the finance side of the business (cash position, corporation funds). An additional area that sometimes falls under the control of the CFO is the internal audit staff. Internal auditors supply independent assurance that a company’s internal control processes are effective. However, there is strong support for keeping the internal audit staff outside of the CFO, because of a possible conflict of interest.
Think it Through: Managing Cash Flow
Assume you are the managerial accountant at Anchor Head Brewery, a Midwest craft brewery that distributes nationwide. Its year-end is December 31. Because of poor cash flow management, the CFO has some concerns about having enough cash to be able to pay the tax bill that is expected. In early December, the purchasing department bought excess hops, barley, malt, oats, and yeast in anticipation of brewing more beer for the holiday and Super Bowl seasons. In order to decrease the company’s net income, thereby reducing their taxable income, the CFO tells you to enter the purchase of this inventory as part of the “Supplies Expense” in the current year.
1. In which account should these materials be recorded?
2. How should you reply to this request?
3. Should you bring this matter to another executive officer?
Careers
The field of managerial accounting, or corporate accounting, is composed of the financial and accounting responsibilities required to operate any type of business. Managerial accountants are employed within organizations to monitor costs, sales, budgets, and spending; conduct audits; predict future requirements; and aid the executive leaders of the organization with financial decision-making.
Figure \(2\) lists approximate salaries for several financial and managerial accounting employment positions. In reviewing the salary information, be aware that there are often major variances in salaries based on geographical locations. For example, a cost accountant manager in San Francisco, California, would typically be paid significantly more than an accountant in a similar position in Fayetteville, Arkansas. However, the cost of living, especially housing costs, in San Francisco is also significantly higher than the cost of living in Fayetteville.
Managerial accountants find employment opportunities in a wide variety of settings and industries. Professionals in this discipline are in high demand from public and private companies, government agencies, and not-for-profit entities (NFPs). Some areas of management accounting are versatile to any sector (corporate, government, or NFP).
• A financial analyst assists in preparing budgets, tracking actual costs, examining task performance, scrutinizing different types of variances, and supporting other management personnel in organizing forecasts and projections.
• A budget analyst arranges and manages the master budget and compares master budget projections to actual results. This individual must be vastly aware of all operations in the budget and work closely with the rest of the accounting staff as well as management personnel.
• An internal auditor typically reports to high-level executives within the company. An internal auditor is often called on to investigate budget variances, industrial sabotage, poor work quality, fraud, and theft. He or she also safeguards the internal controls and confirms they are working and effective.
• A cash-management accountant has responsibilities that include transferring monies between accounts, monitoring deposits and payments, reconciling cash balances, creating and tracking cash forecasts, and performing all other cash-related financial processes.
Other areas of managerial accounting are specific to the sector in which accountants work. For example, the area of cost accounting is more specific to the corporate or manufacturing sector. These cost accountants amass large sums of data, checking for accuracy and then formulating the cost of raw materials, work in process, finished goods, labor, overhead, and other associated manufacturing costs.
Governmental entities also use accounting to communicate with their constituents. Government agencies include all levels of government, federal, state, county, and city, including military, law enforcement, airports, and school systems. Government accountants deal with budgets, auditing, and payroll, the same as all other managerial accountants. However, they must follow a different set of accounting rules called the Governmental Accounting Standards Board (GASB).
Nonprofit (not-for-profit) organizations are tax-exempt organizations that serve their communities in a variety of areas, such as religion, education, social services, health care, and the arts. Managerial accountants in this area are most often focused on budgets. The biggest difference between a corporate budget analyst and a nonprofit budget analyst is that the nonprofit analyst works the budget backward, compared to the corporate analyst. For example, if a corporation was selling widgets, its budget would start with a sales forecast of how many widgets the company thinks it can sell. This gives the company a forecast of how much it can spend on expenses and fixed assets. The nonprofit budget analysts often start with the expenses. They forecast how much the expenses will be in order to continue to offer their service to the community. From there, they then adjust how much they will need to obtain through fundraising, donations, grants, or other sources to meet their expenses.
Example \(1\): Career Planning
All companies need to plan ahead in order to continuously move forward. Their top management must take into consideration where they want the company to be in the next three to five years. Just like a company, you also need to consider where you want to be in three to five years, and you need to start taking strides now to accomplish what it is you need to in order to get there (Figure \(3\)).
Answer the following:
1. What job would you like to be doing in three to five years? What is your plan for getting there? Identify five to ten steps needed.
2. Do you have a specific company you would like to be working for in the next three to five years? What are the reasons you want to work for them?
3. In order to acquire the position you want, at the company you want, you need a résumé. Your résumé is like the company report of “you.” It needs to offer reliable information about your experiences and achievements. What are the basic elements of a résumé, and how will you provide reassurance that the information on your résumé is trustworthy?
Solution
Answers will vary. Sample answer:
1. I would like to own my own home remodeling company. Steps to get there include the following:
1. complete double major in business and building construction
2. in the summers before graduation, work for a local handyman franchise
3. after graduation, work for a home builder as a project manager
4. while working, save money for five years to be used to start my own company
5. put together a business plan
6. start my own business six years after graduation
2. I would like to work for a national home builder such as Pulte or Toll Brothers. Ideally, I would have an internship with one of them during college. I would like to work for a national builder or a large regional builder because they already have a good business model and I could learn how that works.
3. My résumé needs to contain my education information such as the degree and my majors as well as classes that are pertinent to my career. It should also indicate all of my work experience and any particular skills or certifications I have achieved, such as Eagle Scout. An example of how this information may be presented on a résumé can be seen in Figure \(4\).
Certifications
There are many distinct accounting certifications that accountants can earn in order to improve their careers, attain promotions, and acquire raises in their pay. The certifications are somewhat different from each other and focused toward different career paths. Many accountants have more than one of these credentials to diversify their paths.
The Certified Public Accountant (CPA) is considered the top tier in accounting certifications. Many companies or positions require CPA certification. For example, most employees at accounting firms earn a CPA certificate within the first few of years of graduation. Some positions, such as controller or CFO, often require CPA certification. In the United States, each state has different educational and experience requirements in order to obtain the CPA. The certification requires passing the four-part CPA exam as well. This is administered by the American Institute of Certified Public Accountants (AICPA). There are four parts to the exam: Financial Accounting and Reporting (FAR), Auditing and Attestation (AUD), Regulation (REG), and Business Environment and Concepts (BEC). Each part is graded on a \(100\)-point scale. A score of seventy-five or greater must be achieved in order to pass each section. The exams can be intimidating, as it is a difficult process to go through. As of 2017, the AICPA reported a pass rate of less than \(50\) percent, which may contribute to its high regard around the world. After passing the CPA exam, candidates must work for one year under the supervision of a licensed CPA before their own license is approved by a state regulatory agency. Those certified in public accounting work in all areas of accounting. However, do not assume that being a CPA is the only way to secure an excellent position in accounting.
The Certified Management Accountant (CMA) is another top-tiered certification for accountants. The CMA title identifies the individual as a specialist in corporate accounting management. The CMA has some overlap with the CPA, but the CPA is focused more on compliance, tax, and controls. CMAs favor financial analytics, budgeting, and strategic assessment. This certification requires the minimum of a bachelor’s degree from an accredited college or university, two years of work experience, and successfully passing both parts of the exam. Part one of the exam covers financial reporting, planning, performance, and controls. Part two focuses on financial decision-making. The exam is administered by the IMA and has a \(50\) percent passing rate globally.
Not as popular in the United States as the CPA, the Certified Financial Analyst (CFA) certification is more in demand throughout Europe and Asia. This certification prepares accountants for a career in the finance and investment domains. Requirements of this credential include a bachelor’s degree or four years’ worth of experience, plus passing all three sections of the exam. The exam is administered by the CFA Institute. There are three separate exams, each one taking up to six hours to complete. The exams must be completed in succession. This credential is considered one of the more rigorous ones to obtain, with a passing rate of less than \(45\) percent.
The Enrolled Agent (EA) credential focuses on a career in taxation, whether it is working in tax preparation for the public, internally for a corporation, or for the government at the Internal Revenue Service (IRS). The EA certification was created by the IRS to signify significant knowledge of the US tax code and the ability to apply the concepts of that code. Enrolled agents have the privilege of being able to sign tax returns as paid preparers, and they are able to represent their clients in front of the IRS. The EA certification can be obtained by passing a three-part exam covering all types of individual and business tax returns. Once the certification is obtained, enrolled agents must follow strict ethical standards and complete \(72\) hours of continuing education courses every three years.
The Certified Internal Auditor (CIA) is a credential offered by the Institute of Internal Auditors (IIA) and is one of the only certifications that is accepted worldwide. CIAs tend to be employed in auditing areas within government agencies, banking, finance, or corporations. They examine financial documents to investigate deficiencies in internal controls. Requirements for this certification include a bachelor’s degree, two years of work experience in a related field, and passing the three sections of the examination. Also required are providing character references, following a code of ethics, and continuing education.
The Certified Fraud Examiner (CFE) certification signifies proven proficiency in fraud prevention, detection, and deterrence. CFEs are instructed in how to identify the red flags that may indicate fraudulent actions. The designation is awarded by the Association of Certified Fraud Examiners (ACFE) after applicants have met the following requirements: bachelor’s degree, two years of work-related experience, moral character references, and the passing of four separate exams.
The Certified Government Auditing Professional (CGAP) designation is exclusively for auditors employed throughout the public sector (federal, state, local) and is offered by the IIA. Requirements for this credential are the same as for the CIA. The exam has \(115\) multiple-choice questions and covers four areas focusing on proficiency in generally accepted government auditing standards (GAGAS).
These certifications lead to different job responsibilities and different career paths. As indicated, each of the certifications requires varying degrees of education and has exams that are unique to that particular certification. All of these certifications also require a certain number of hours of continuing education in order to keep the certification active. This ensures that the certificate holder is up to date on changes in the field. There are always many opportunities throughout the year to obtain continuing education credits through seminars, webinars, symposiums, and online and in-person classes.
LINK TO LEARNING
Accounting.com has an application that will help to acquaint you with the different opportunities available, skill sets that may be required, and different salaries for accounting careers. See the Careers in Accounting report for more information.
Footnotes
1. “Management Accounting Careers.” Institute of Management Accountants. https://www.imanet.org/students/mana...areers?ssopc=1
2. “Management Accounting Careers.” Institute of Management Accountants. https://www.imanet.org/students/mana...areers?ssopc=1 | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/01%3A_Accounting_as_a_Tool_for_Managers/1.04%3A_Explain_the_Primary_Roles_and_Skills_Required_of_Managerial_Accountants.txt |
As you’ve learned, unlike the specific rules set forth by GAAP and the SEC that govern financial accounting, managerial accounting does not have specific rules and is considered flexible, as the reporting stays internal and does not need to follow external rules. Managers of a business need detailed information in a timely manner. This means that a managerial accountant needs to understand many detailed aspects of how the company operates in addition to financial accounting methods, because the framework of typical management reports often comes from the financial statements. However, the reports can be individualized and customized to the information the manager is seeking. Each company has different strategies, timing, and needs for information.
The Institute of Management Accountants (IMA), the professional organization for management accountants, provides research, education, a means of knowledge sharing, and practice development to its members. The IMA also issues the Certified Management Accountant (CMA) certification to those accountants who meet the educational requirements, pass the rigorous two-part exam, and maintain continuing professional education requirements. The CMA exam covers essential managerial accounting topics as well as topics on economics and finance. Many accountants hold both CMA and CPA certifications.
Business Ethics
The IMA also develops standards and principles to help management accountants deal with ethical challenges. Trust is an important cornerstone of business interactions, both internal and external. When there is a lack of trust, it changes how decisions are made. Trust develops when there are good ethics: when people know right from wrong. Consider these three questions as put forth by the Institute of Business Ethics:
1. Do I mind others knowing what I have done?
2. Who does my decision affect or hurt?
3. Would my decision be considered fair to those affected?
These questions can help evaluate the ethics of a decision.
Ethics is more than simply obeying laws; it involves doing the right thing as well as the legal thing. Many companies have a code of conduct to help guide their employees. For example, Google has a code of ethics that they expect all of their employees and board members to follow. Failing to do so can cause termination of employment. The preface of the code includes “Don’t be evil.” They use that to show all employees and other shareholders within Google that they are serious about ethics—that trust and respect are essential in providing a great service to their customers.
The IMA has its own Statement of Ethical Professional Practice for its members. Managerial accountants should never commit acts that violate the standards of ethics, and they should never ignore such deeds by others within their companies. Many other professional organizations, across many different professions, have codes of ethics. For example, there are codes of ethics for the AICPA, ACFE, Financial Executives International, American Marketing Association, National Society of Professional Engineers, and the American Nurses Association.
ETHICAL CONSIDERATIONS: Institute of Management Accountants (IMA) Ethical Standards
Four standards of ethical conduct in management accountants’ professional activities were developed by the Institute of Management Accountants. The four standards are competence, confidentiality, integrity, and credibility. Credibility is a key standard that is based on an accountant communicating information with fairness and objectivity, disclosing all information that is relevant to the intended users understanding, and disclosing “delays or deficiencies in information, timeliness, processing, or internal controls in conformance with organization policy and/or applicable law.”1
Often, when we think of unethical behavior, we imagine large-scale scenarios involving tens of thousands of dollars or more, but ethical issues are more likely faced on a small scale. For example, suppose you work for an organization that makes and sells virtual reality headsets. Because of competition, your company has decreased their forecasted sales for next year by \(20\) percent over the current year. In a meeting, the CEO expressed concern over the effect of the decreased sales on the bonuses of upper-level executives, since their bonus is tied to meeting income projections. The vice president of marketing suggested in the meeting that if the company simply continued to produce the same number of headsets as they had in the previous year, income levels may still be achieved in order for the bonuses to be awarded. This would involve the company producing excess inventory with hopes of selling them, in order to achieve income levels sufficiently adequate to be able to pay bonuses to executives. While a conflict of interest might not be intuitively obvious, the company (and thus its managerial accountants) has an obligation to many stakeholders such as investors, creditors, employees and the community. The obligation of a corporation to these stakeholders depends somewhat on the stakeholder. For example, the primary obligation to a creditor may be to make timely payments, the obligation to the community may be to minimize negative environmental impact. Most stakeholders to not have access to internal information or decisions and thus rely on management to be ethical in their decision-making. The company may indeed be able to sell all that it produces, but given the forecasted drop in sales, producing the same number of units as during the current year will likely lead to unsellable inventory, the need to sell the units at a significant discount in order to dispose of them, or both. Following the recommendation to produce more than forecasted sales might hurt the value of the company’s stock, which could hurt many categories of stakeholders who depend on the accountants and financial analysts to protect their financial interests.
In addition to managing production and inventory, a budget and the entire budget process have an impact on managerial decision-making. Suppose you are the manager of the research department of a pharmaceutical company. Your budget includes the costs for various types of training for your staff. Because of the amount of time spent in development of a highly promising medication to treat diabetes, your staff has not had time to complete as much training during the current year as you had allowed for in the budget. You are concerned that if you do not use the training money, your training budget will be decreased in the next budget cycle. To prevent this from happening, you arrange for several online training sessions for your staff. These training sessions are on the basics of laboratory safety. All of your staff is very experienced and current on this topic and can likely go straight to the course completion quiz and complete it in a matter of minutes without actually watching any of the ten modules. What would encourage a manager to schedule and spend money on training that is not useful for the employees? While it is expected to stay within the budget, many managers will spend any “excess” amounts remaining in the budget at the end of the fiscal year. This practice is known as “use it or lose it.” Managers do this to avoid having their budgets cut in the next fiscal year. Stated simply, management spends everything in their budget regardless of the value added or the necessity. This is not ethical behavior and is usually the result of a budgetary process that needs to be modified so that the possibility of being able to pad the budget is removed or at least minimized.
All employees within a company are expected to act ethically within their business actions. This can sometimes be difficult when the company itself almost promotes the idea of unethical actions. For example, Wells Fargo started offering incentives to their employees who succeeded in selling to current customers other services and products that the bank had to offer. This incentive created an unethical culture. Employees manufactured fake accounts, credit cards, and other services in order to qualify for the bonuses. In the end, \(5,300\) employees lost their jobs, and everyone learned a lesson on creating proper incentives. Executives who aspire to run an ethical company can do so, if they change reward systems from “pay for performance” to more holistic values. Examples of proper incentives include attendance rewards, merit rewards, team bonuses, overall profit sharing, and stock options.
LINK TO LEARNING
Most, if not all, major corporations have a code of ethics or a code of conduct. Read Google’s Code of Conduct and consider the following questions:
• What is the basic foundation for their code of conduct? What do you think it means?
• After reading their document, has it changed your opinion of the company?
• Do you think having a code of ethics or a code of conduct really matters?
Ethics Legislation
In response to several corporate scandals, the United States Congress passed the Sarbanes-Oxley Act of 2002 (SOX), also known as the “public company accounting reform.” It is a federal law (http://www.soxlaw.com/) that was a far-reaching reform of business practices. Its focus is primarily on public accounting firms that act as auditors of publicly traded corporations. The act intended to protect investors by enhancing the accuracy and reliability of corporate financial statements and disclosures. Thousands of corporations now must confirm that their accounting processes comply with SOX. The act itself is fairly detailed, but the most significant issues for compliance are as follows:
• Section 302. The CEO and CFO must review all financial reports and sign the report.
• Section 404. All financial reports must be audited on an annual basis and must be accompanied by an internal control audit.
• Section 806. Whistleblowers, or those who provide evidence of fraud, are afforded special protections.
• Section 906. The criminal penalties for a fraudulent financial report are increased from pre-SOX. Penalties can be up to \(\$5\) million in fines and up to \(25\) years in prison.
LINK TO LEARNING
The Sarbanes-Oxley Act has been in place for many years now and has its champions and its critics. Read this 2017 article from Accounting Today on the benefits and negative impacts of the act to learn more. This article from ConnectUSdiscusses the benefits and negative impacts as well.
Individuals who work throughout the accounting profession have a significant responsibility to the general public. Financial accountants deliver information about companies that the public uses to make major financial decisions. There must be a level of trust and confidence in the ethical behavior of these accountants. Just like others in the business world, accountants are confronted endlessly with ethical dilemmas. A high standard of ethical behavior is expected of those employed in a profession. While ethical codes are helpful guidelines, the rationale to act ethically must originate from within oneself, from personal morals and values. There are steps that can provide an outline for examining ethical issues:
1. Recognize the ethical issue at hand and those involved (employees, creditors, vendors, and community).
2. Establish the facts of the situation (who, what, where, when, and how).
3. Recognize the competing values related to the issue (confidentiality and conflict of interest).
4. Determine alternative courses of action (do not limit yourself).
5. Evaluate each course of action and how each relates to the values in step 3.
6. Recognize the possible consequences of each course of action and how each affects those involved in step 1.
7. Make a decision, and take a course of action.
8. Evaluate the decision. (Is the issue solved? Did it create other issues?)
ETHICAL CONSIDERATIONS: Ethical Dilemma
You are about to sign a new client to a very large contract worth over \(\$900,000\). Your supervisor is under a lot of pressure to increase sales. He calls you into his office and tells you his future with the company is in jeopardy, and he asks you to include the revenue for the new contract in the sales figures for the quarter that ends today. You know the contract is a certainty, but the client is out of town and cannot possibly sign for at least a week. Use the eight steps in examining an ethical situation to determine how you would react to this situation.
One of the issues with ethics is that what one person, community, or even country considers unethical or wrong may not be problematic for another person, community, or country, who see it as a way of doing business. For example, bribery in the world of business happens when an organization or representative of an organization gives money or other financial benefits to another individual, business, or official in order to gain favor or to manipulate a business decision. Bribery in the United States is illegal. However, in Russia or China, a bribe is sometimes one cost of doing business, so it is part of their culture and completely ordinary.
The Foreign Corrupt Practices Act (FCPA) was implemented in 1977 in the aftermath of disclosures of bribery of foreign bureaucrats by more than \(400\) US corporations. The law is broken down into two parts: the antibribery section and the accounting section. The antibribery section specifically prohibits payments to foreign government officials to aid in attaining or retaining business. This provision applies to all US persons and foreign firms acting within the United States. It also requires corporations that are listed in the United States to converge their accounting records with certain accounting provisions. These include making and keeping records that fairly represent the transactions of the company and maintaining an acceptable system of internal controls. Companies doing business outside the United States are obligated to follow this law and dedicate resources to its compliance.
The accounting section of the FCPA requires a company to have good internal controls so a slush fund to pay bribes cannot be created and maintained. A slush fund is a cash account that is often created for illegal activities or payments that are not typically recorded on the books.
More details on the SOX and the FCPA are covered in such courses as auditing, intermediate accounting, cost accounting, and business law.
Example \(1\): Logistics Analyst
As a corporate accountant, it is very important to understand both financial and managerial aspects of the company and industry in which you are working. In order to assist management in their roles of planning, controlling, and evaluating, an accountant needs to be aware not only of GAAP but also of the products or services offered by the company, the processes by which those products or services are produced, and pertinent facts about suppliers, customers, and competitors. Not having this knowledge not only makes it more difficult for the corporate or managerial accountant to perform any assigned duties, but there is also an ethical responsibility to be knowledgeable in order to offer assistance, analysis, or recommendations to management or customers.
Assume you have been hired by Triumph Motorcycles as a new logistics analyst. In this position, you will carry out such tasks as obtaining and analyzing information about your company’s goods or services; monitoring the production, service, and information processes and flow; and looking for ways to improve efficiency of operations.
How would you go about obtaining the knowledge and understanding you will need to work for this company? How would financial and managerial accounting concepts help you in understanding the company and the industry as a whole?
Solution
Answers will vary. Sample answer:
Ways to learn about the company and industry include the company website, press or news releases, industry trade journals, company internal documents such as procedure manuals and job descriptions, and conversations or interviews with fellow employees at various levels of the organization. The more knowledge you have regarding financial and managerial accounting, the better you can link the operations of the organizations to financial results and the more easily you can ascertain both efficiencies and inefficiencies in the organization.
Footnotes
1. Institute of Management Accountants. “Standards of Ethical Conduct for Management Accountants.” AccountingVerse. https://www.accountingverse.com/mana...of-ethics.html | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/01%3A_Accounting_as_a_Tool_for_Managers/1.05%3A_Describe_the_Role_of_the_Institute_of_Management_Accountants_and_the_Use_of_Ethical_Standards.txt |
The business environment never rests. Regulations are always changing, global competition continues to increase, and technology provides continual disruption. Management accounting is always evolving due to changes in the business environment. The types of information needed and obtainable have changed significantly over time.
Many areas of employment are impacting businesses and the managerial accounting function today. For example, more than \(60\) percent of workers in the United States are employed within service industries, such as government agencies, marketing firms, accounting firms, and airlines. The health-care and social service industries have doubled in size. However, as the number of service jobs has increased, the number of manufacturing jobs, as a percentage of all jobs, has been decreasing.1 One of the primary reasons for the decline in manufacturing jobs is automation and other technological changes.
How are service industries different from manufacturing organizations? The fundamental difference is the product they sell. The service company, such as a marketing, legal, or consulting firm, produces intangible goods, meaning that the product has no physical substance. Manufacturing companies produce tangible goods, which customers can handle and see. This leads to another significant difference between manufacturing companies and service firms: inventory. Service firms, unlike manufacturing, do not have large inventories, because there is no tangible product. Manufacturing will have inventories of raw materials, of goods that are in the process of being produced and goods that have been completed but not yet sold. Managerial accountants must track all of this information for manufacturing companies. However, managerial accountants are still needed within service-based firms to track time, materials, and overhead. For example, Boeing Company is a manufacturer of airplanes. Their accountants must track several different types of inventory categories, direct labor, and overhead costs, among other things. One of Boeing’s customers, Delta Air Lines, is a service-based company. The managerial accountants for the airline also are responsible for following costs, but their reports are targeted toward industry-specific measures such as operating margins, revenue from passenger miles, load factors, and passenger yield, among others.
Much of managerial accounting focuses on manufacturing. However, the techniques used for cost accounting for manufacturing companies also can be applied to service-based organizations. The former would develop a cost of goods manufactured schedule, and the latter would need a cost of service schedule. The structure of the reports is principally the same, but section headings would reflect the type of organization.
Technology
Business entities always look for ways to leverage technology. Any type of technology that can increase production, reduce costs, or increase safety will attract attention from the business world. There are many areas of technology that businesses have used already, but to continue reaping those benefits, these companies need to adjust quickly with the ever-advancing business technology.
Companies have the ability to integrate many of their business processes through enterprise resource planning (ERP) systems, which help companies streamline their operations and help management respond quickly to change. Although they are expensive, these systems help alleviate the complications that arise from business systems that do not coordinate with one another. For example, a company may have many different individual systems for each function: human resources may have a system to track employees’ insurance benefits, training, and retirement programs, while payroll may have a program that tracks employees’ earnings, taxes, deductions, and direct deposit information. Much of the information human resources and payroll collect is the same. Having one system with different silos is much more efficient than having two separate systems. Management must be aware of and adapt to whichever type of system that the business has—either one ERP or several independent systems that may not coordinate information (Figure \(1\)).
Businesses have been on the forefront of advancing technology. As computer systems developed throughout the twentieth century, they brought with them the potential for many benefits, but the business world needed to adapt and transform their infrastructure. Over the last forty years, tangible assets (buildings, machinery, and vehicles) have declined from 80 percent of a company’s value to \(15\) percent, while intangible assets (trademarks, patents, and competencies) are now at an average of \(85\) percent of a company’s value. It can be difficult to put a value on some of the intangible assets, but it is not hard to realize they do have worth. JetBlue has the number one brand loyalty of all North American airlines. Apple has built a kingdom around brand loyalty. Intangible assets can give a company a competitive edge, entice consumers, and protect the organization’s brain trust.
Technological advances can directly affect managerial accounting reports, through estimates of overhead costs. Historically, overhead was typically calculated on the basis of relatively straightforward relationships, such as direct labor costs or direct labor hours. With the advancements through automation, in many instances, direct labor costs are much lower and no longer relevant in computing overhead costs. Automation is a method of using systems such as computers or robots to operate different processes and machinery to improve efficiencies and lower direct labor costs. Companies use automation to remove the complex, superfluous stages from a process in order to streamline the practice. In essence, labor is being traded for machine production. Such industries as auto production are excellent examples. This exchange of direct labor for greater costs in overhead for such factors as machinery depreciation will be addressed in Job Order Costing and Process Costing on calculating production costs.
LINK TO LEARNING
Automation has changed the production of automobiles over the last \(100\) years. This 100-second video from Ford Motor Company on automation demonstrates this concept.
With the growth of the Internet and the speed by which information is shared, businesses can now communicate with employees from around the world within seconds. This has made outsourcing common in certain sectors. Outsourcing is hiring workers outside of the company who perform their tasks inside or outside of the country. Most of the exported jobs have gone to less-developed countries, where there are lower labor costs. Outsourcing saves the company money on labor and overhead costs and has become a major trend over the past several years. More and more organizations, both large and small, are now using outsourcing as a way of growing their entities without adding additional labor and overhead costs. Outsourcing allows a company to focus on its own competencies and hire those outside sources to handle other duties.
Another technology that is quickly becoming widespread is radio-frequency identification (RFID). This technology uses electromagnetic fields to routinely identify and trace inventory tags that have been attached to objects. The tags contain information that has been stored by electronic means. The RFID tags can made into many shapes and sizes and enclosed in many different materials. These tiny devices have advantages over the common bar code. They do not need to be positioned precisely over the scanner and cannot be manipulated like barcodes. This technology has been used for many years in identifying and tracking lost pets, but it was considered too expensive for more extensive use in industry. With the advancements over the last several years, RFID devices are now seen as “throwaway” control devices. One company recently signed a contract to sell \(500\) million RFID tags at a cost of about ten cents per device. Other current uses include antitheft tags attached to merchandise, credit card chips, and heavy-duty transponders used in shipping containers. New uses being investigated include RFID chips in passports, food, and people.
THINK IT THROUGH: Outsourcing
With the increase in global businesses and competition, there has been an increased focus on outsourcing in order to reduce costs. As you’ve learned, outsourcing involves hiring an outside company to provide services or products rather than having them produced internally.
For example, you are the vice president of operations for a manufacturing firm. Other firms similar to yours have outsourced some of the product assembly. You estimate that you could save a significant amount of money on wages and benefits, as you would let go approximately ten workers if you outsource. Would you outsource? Why or why not?
Lean Practices
All companies want to be successful. This requires continuously trying to improve the function of the organization. A lean business model is one in which a company strives to eliminate waste in its products, services, and processes, while still fulfilling the company’s mission. This type of model was originally implemented by the Japanese automaker, Toyota Motor Corporation, soon after the end of World War II. The implications of an organization adopting a lean business model can be overall business improvement, but a lean business model can be difficult to implement because it often requires all systems and procedures that an organization follows to be readjusted and coordinated. Managerial accounting plays a vital role in the success and implementation of a lean business model by providing accurate cost and performance evaluation information. Entities must comprehend the nature and sources of costs and develop systems that encapsulate costs accurately. The better an organization is at controlling costs, the more it can improve its overall financial performance. Continuous improvement is the manufacturing process that rejects the ideas of “good enough.” It is an ongoing effort to improve processes, products, services, and practices. This philosophy has led organizations to adopt practices such as total quality management, just-in-time manufacturing, and Lean Six Sigma. The fundamental ideas of all of these involve continuous improvement; they differ only in focus.
Total quality management (TQM) concentrates on quality improvement and applies this benchmark to all aspects of business activities. In TQM, management and employees look to reveal waste and errors, streamline the supply chain, improve customer relations, and confirm that employees are informed and properly trained. The objective of TQM is continuous improvement by concentrating on systematic problem-solving and customer service. Scientific methods are used to study what succeeds and what does not, and then the best practices are implemented throughout the organization.
However, the pursuit of total quality will cost the company money. With the help of management accountants, companies can track these costs and forecast whether or not the improvements will eventually save the organization money down the road.
Just-in-time (JIT) manufacturing is an inventory system that companies use to increase efficiency and decrease waste by receiving goods only as they are needed within the production process, thereby reducing warehousing costs. This method requires accurate forecasting. Managerial accountants work together with purchasing and production schedulers in keeping the flow of materials accurate and efficient.
This method was initiated by Toyota Motor Corporation, and it has expanded to many other manufacturing organizations throughout the world. Toyota set the example by controlling their inventory levels by relying on their supply chain to deliver the raw materials it needed to build their cars. The parts arrived just as they were needed, not before or after.
One major advantage of JIT manufacturing is reducing costs by eradicating warehouse storage needs. Organizations, in turn, tend to spend less money on raw materials because of a reduction in spoilage and waste. Another advantage is that companies can easily move from the assembly of one product to the assembly of another.
Disadvantages of JIT manufacturing start with its complexity. In moving from a traditional manufacturing approach to a JIT approach, management must reconfigure the entire flow of the production process, from the initial use of the raw materials to the output of the final finished good. Another disadvantage of JIT manufacturing is that it makes organizations more susceptible to disruptions in the supply chain. If a supplier of raw materials has a labor strike, weather problems, a breakdown of machinery, or some other catastrophe and cannot deliver the materials on time, that one supplier can shut down an entire production process and delay delivery of finished goods. An example of this occurred in 2011 after a tsunami and earthquake hit Japan and disrupted production at a critical supplier of auto parts. General Motors (GM) facilities in the United States announced they would have to shut down assembly plants where they could not continue production without the parts from Japan.
Lean Six Sigma (LSS) is a quality control program that depends on a combined effort of many team members to enhance performance by analytically removing waste and diminishing variations between products. The lean component of LSS is the concept that anything that is not needed in a product or service, or any unnecessary steps that exist, add cost to the product or service and therefore should be considered waste and eliminated. The Six Sigma component of LSS has to do with the elimination of defects. Essentially, as a company becomes leaner, it should also be able to reduce defects in manufacturing or in providing a service. Fewer defects add to cost savings through the need for fewer reworked products, fewer repeat service calls, and therefore, more satisfied customers. It was developed by Motorola in 1986 and emphasized cycle-time improvement and the reduction of defects. This process has shown to be a powerful way of improving business efficiency and effectiveness. As organizations continue to modify and update their processes for optimal productivity, they must be flexible. As of 2017, LSS had developed into a business management way of thinking that focused on customer needs, customer retention, and improvement of business products and services. There are many establishments, including Motorola, that now do LSS training. There are certifications including white belt, yellow belt, green belt, black belt, and master black belt. The belts signify an employee’s knowledge regarding LSS. For example, a white belt understands the terminology, structure, and idea of LSS and reports issues to green or black belts. A green belt typically manages LSS projects, and a master black belt works with upper-level management to find the areas in the business where LSS needs to be implemented, leads several LSS teams, and oversees implementation of those projects.
Kaizen (Japanese for change for the better) is another process that is often linked to Six Sigma (Figure \(2\)). The two concepts are often used together for process improvements, as they both are designed for continuous improvement by eliminating waste and increasing efficiencies. The concept of kaizen comes from an ancient Japanese philosophy that involves continuously working toward perfection in all areas of one’s life. It was adopted in the business world after World War II in an effort to rebuild Japan. It centers on making small, day-to-day changes that develop into major improvements over time. The key behind the success of kaizen comes from requiring all employees—from the CEO at the top, all the way down to the shop-floor janitors—to participate by making recommendations to improve the organization. From the start of the process, it must be well defined that all recommendations are appreciated and that there will be no adverse results for participating. Workers, instead, should be rewarded for any modifications that advance the workplace. Employees become more self-assured and invested when they help improve the company.
Another lean practice, the theory of constraints (TOC), involves recognizing and removing bottlenecks within the value chain that may be limiting an organization’s profitability. This philosophy, developed by Dr. Eliyahu M. Goldratt, is a valuable instrument for improving the flaws in processes. The main goal of this methodology is to remove obstructions, or constraints, which are referred to as “bottlenecks.” There are several types of bottlenecks that organizations must deal with endlessly. One example occurs at the grocery store when it is crowded and there are only three checkout lanes open but ten people in each line. Obviously, the bottleneck is created by having too few checkout lanes open. The bottleneck can be mitigated by opening more checkout lanes. Other examples are listed in Table \(1\).
Table \(1\): Examples of Constraints
Bottleneck Examples
Physical Employee resources, limited space, equipment resources
Policy Procedures, regulations, contracts
Culture “It’s the way we’ve always done it”
Market Size of the market, demand for product, nature of competition
There are five steps in the cycle of continuous improvement under TOC:
1. Identify the system constraint.
2. Decide how best to exploit the constraint and make quick changes using existing resources.
3. Subordinate everything else to the process to ensure alignment with and support of the needs of the constraint.
4. Elevate the system’s constraint, and determine if the constraint has shifted to another area in the process.
5. Repeat the process.
This is a continuous cycle; therefore, once a bottleneck is solved, the next bottleneck should be addressed immediately (Figure \(3\)).
Balanced Scorecard
The balanced scorecard (BSC) approach uses both financial and nonfinancial measures in evaluating all attributes of the organization’s procedures. This approach differs from the traditional approach of only using financial measures to evaluate a company. While financial measures are essential, they are only a portion of what needs to be evaluated. The balanced scorecard focuses on both high-level and low-level measures, using the company’s own strategic plan. This method assesses the organization in four separate perspectives:
• Financial. The financial measures are the major focus of the BSC—but not the only measures. This perspective asks questions like whether the organization is making money or whether the stockholders are pleased.
• Customer. The BSC also evaluates how the organization is perceived, from the customer’s perspective. This measures customer satisfaction, new customer growth, and market share.
• Internal process. The internal procedures and processes perspective observes how smoothly things are running. This perspective will examine quality, efficiency, and waste as they relate directly to the products or services.
• Learning and growth/capacity. This area evaluates the entity and its performance from the standpoint of human capital, infrastructure, culture, technology, and other areas. Are employees collaborating and sharing information? Does everyone have access to the latest trends in training and continuing education in their areas?
The main advantage of this approach is that it offers organizations a way to see the cause-and-effect in the objectives. For example, if an organization would like to make more money in order to pay higher dividends to its stockholders, the organization will need to increase market share, improve customer satisfaction, or grow its customer base. In order to make customers happier or gain new customers, the organization could try to reduce defects and increase overall quality of the products; to accomplish that, the organization could retrain or offer new training to its employees.
Globalization
The development of business through international influence or extending social and cultural aspects around the world is known as globalization. It has expanded our competitive borders, giving customers more alternatives. Customers can order an item from another country with the click of a button and have that item delivered in a few days or less. How has globalization affected companies? Not only must they choose between ordering goods or components globally, but they must decide in which countries to sell their goods, and in which companies they may be able to establish factories.
Globalization affects management accountants in several ways. Companies need real-time, accurate information to make good decisions, so more timely and accurate information is needed. As companies expand globally, managers need to know the cost of operating internationally, as well as the laws, rules, and customs. Globalization also can expose companies to improvements in running a business.
Debates continue as to the positive and negative consequences of globalization in all of its contexts. The advantages of globalization include helping developing countries in creating jobs, developing industries, differentiating and expanding their markets, and bettering their standard of living for their citizens. Some believe the expansion of pop culture around the globe to be an advantage of cultural globalization. It has multiplied the interchange of ideas, music, art, language, and cultural ideals. On the other side of the debate, one common criticism of globalization is that it has enhanced wealth disparity and, further, that organizations of the Western world have benefited much more than those anywhere else. There is also the argument that globalization is improving standards of living worldwide as industrialization is expanding, but it is causing global warming and climate change, due to the greenhouse gases the factories emit. Additionally, in some areas it has led to the abuse and misuse of natural resources and caused other detrimental consequences.
How do these various globalization debates affect businesses? A successful company must be profitable to stay in business, but profitability is not the single key to success. A successful company must also consider the environment in which it operates—culturally, socially, environmentally, and economically—which requires companies to evolve and adjust as each of these environments changes. This evolution means that companies must continually evaluate themselves and their impact on all of their stakeholders, which include investors, creditors, management, employees, customers, governments, and, either directly or indirectly, the world. What companies used as measures of success forty years ago are different from the measures used twenty years ago, and those are different from those that are used today and still different from what will be needed in the future. Management accounting is the area in which many of these changing measures are either generated or evaluated. Such measures not only evaluate the cost effectiveness of products or services, but determine the best way to evaluate and reward employees and evaluate the cost-benefit of environmental protections, the impact of automation versus outsourcing, and the cost of training and educating employees.
ETHICAL CONSIDERATIONS: Global Ethics
In an article in Business 2 Community, Kate Gerasimova draws on her experience within the Russian and American business environments to discuss the role of ethics in global business endeavors. Ethics are the principles, and the values that underlie them, that allow us to determine what is right and wrong. According to Gerasimova, ethics fall into three categories: “code and compliance, destiny and values, and social outreach.”2 In the global business context, she also emphasizes the importance of respecting differences in values held by coworkers, communicating honestly in business dealings, and building trust. To assist in the application of the organization’s ethical approach to doing business in a different culture, it needs to develop a set of “core values as the basis for global policies and decision-making.” 3 Gerasimova notes that organizations also need to consider that “clients and coworkers may have a different perspective on ethics and proper behavior than those to which you are accustomed.” To address the different perspectives, an organization should train its employees to be culturally sensitive while balancing the need for rules and policies with the ability for employees to be flexible and to use their imagination.
Social Responsibility and Sustainability
What is sustainability, and what does it have to do with businesses? The United Nations definition is “the ability to meet the needs of the present without compromising the ability of future generations to meet their own needs.” 4 Usually, sustainability is viewed as having three components: economic, social, and environmental. Obviously, a business cannot continue into the future unless it is economically sound; however, if it maintains its economic status by depleting too many natural resources or paying illegal wages, then that company is not practicing good social responsibility.
Corporate social responsibility (CSR) is an organization’s programs that evaluate and take responsibility for the organization’s effects on environmental and social welfare. There are many aspects of corporate social responsibility, including the types, locations, and wages of the labor employed; the ways in which renewable and nonrenewable resources are utilized; how charitable organizations or local areas in which the company operates are helped; and setting corporate employee policies such as maternity and paternity leave that promote family well-being. Although the causes and cures of climate change are open to discussion, most will agree that everyone, including corporations, should do their part to avoid further damage and improve any negative impact on the environment.
CONCEPTS IN PRACTICE: Corporate Social Responsibility at New Belgium Brewing
As New Belgium Brewing Company states on their website: “We’re New Belgium and we pollute. There. We said it. We are not perfect and we know it.” But New Belgium Brewing has become a leader in sustainability. They preach it in every aspect of the company: production, marketing, employees, and customers. The company makes the point that being energy efficient is not only being environmentally responsible, it is being financially responsible through their “internal energy efficiency tax.” The company uses many different metrics to track and improve its impact on the environment. For example, the company measures its energy usage and taxes itself on energy consumption and then saves those internal tax dollars to implement further energy savings by installing new processes and techniques. They divert 99.9 percent of the waste from their brewery away from landfills. The company makes enough in recycling revenues to pay four salaries. These are just a few ways in which New Belgium Brewing faces the challenges of social responsibility. Read more at http://www.newbelgium.com/Sustainabi...mental-Metrics.
In late 2016, the Paris Agreement (Paris Accord) brought together nations for the common cause of combatting climate change. There were \(197\) nations in attendance, and until recently, all \(197\) ratified or agreed to the effort. It requires all partners to pursue specific endeavors to keep the global temperature rise to \(2\) degrees Celsius above that of preindustrial levels. This would be accomplished by voluntarily reducing greenhouse gas emissions. In early 2017, US President Donald Trump announced that the United States would withdraw from the agreement. At that time, only Syria and Nicaragua were holdouts. Since then, both have signed the agreement, leaving the United States now as the lone holdout, although it will take several years for the formal withdrawal. In spite of the president’s announcement, there have been representatives from cities, states, corporations, and universities around the United States that have pledged to continue with the agreement and meet the greenhouse gas emission targets as set out in the Paris Accord. Many of the corporations who have promised to move forward with reducing greenhouse gases have expressed that the Paris Accord expands markets for groundbreaking clean technologies and that it creates employment opportunities alongside economic growth.
In terms of managerial accounting, sustainable business practices create many issues. Organizations need to decide what elements will be measured. For example, minimizing electricity consumption, maximizing employee safety, or reducing greenhouse gases may be the biggest issue of concern for a company. Then, the company needs to determine ways of measurement that make sense regarding those items. Companies are becoming more aware of their impact on the world, and many are creating social responsibility reports in addition to their annual reports. This type of reporting requires different types of information and analysis than the typical financial measures gathered by companies. This is sometimes referred to as the triple bottom line, as it assesses an organization’s performance not only relating to the profit, but also relating to the world and its people, and will be covered in Sustainability Reporting.
Example \(1\): Zaley’s Machining Division
Zaley is an aerospace manufacturing firm in the southwest United States. They manufacture several products used in the aviation and aerospace industry. The company has been steadily growing over the past ten years in both sales and personnel. The engineering and design team uses computerized aided drafting (CAD) to design the various products that are produced by the machining division.
The machining division recently implemented significant technological improvements by installing an advanced technique using hard-metal and aluminum high-speed machining. The following managers are involved with the machining division:
• Alex Freedman, technical specialist (supervises all computer programs)
• Emma Vlovski, sales manager (supervises all sales agents)
• Kayla McClaughley, cost accounting director (supervises all cost accountants)
• Mwangi Kori, lead test engineer (oversees all new-product testing and design)
• Torek Sanchez, production director (supervises all manufacturing employees)
Each of these managers needs information to make decisions needed to carry out the respective jobs.
Think about what might be involved in the job of each of these managers and the types of decisions they may be required to make in order to meet the goals of the company. What information would be needed by each of the managers?
Solution
Answers will vary. Sample answer:
• Alex Freeman, technical specialist (supervises all computer programs), needs information on the hours and type of usage possibly by department or by individual to ascertain if the equipment is being used effectively or if the programs used by the company are appropriate or additions or deletions need to be made. In addition, this information is needed to address how much and what type of staffing he needs in his department.
• Emma Vlovski, sales manager (supervises all sales agents), would want information about the level and type of sales for the company as a whole as well as for the individual sales agents. She would want to know which products are selling well, which ones are not, which sales agents are being the most successful, and why they are more successful than the others. Emma would also want information on how the agents are compensated, as this may be tied to the sales agent’s efforts to meet sales goals.
• Kayla McClaughley, cost accounting director (supervises all cost accountants), would want to know what tasks the cost accountants perform, how much time they spend on these tasks, and whether there are any redundancies in workload so that improvements in efficiency can be made. If any of the accountants has certifications such as CPA or CMA, she would want to know if they are keeping their certifications current through continuing professional education.
• Mwangi Kori, lead test engineer (oversees all new-product testing and design), would need information on the efficiency and effectiveness of each of the products tested, including success and failure rates. She would want information on how well the policies and procedures for design changes are being followed and if those policies and procedures need updating or rewriting.
• Thomas Sanchez, production director (supervises all manufacturing employees), would want information on hours worked, pay rates, and training (past and ongoing) for the manufacturing employees. She would also want information on how each individual employee performs his or her role in the manufacturing environment. For example, are there particular employees who have fewer defects or down time in their part of the process than others?
Footnotes
1. Dr. Patricia Buckley. “Geographic Trends in Manufacturing Job Creation: Something Old, Something New.” Deloitte Insight. September 25, 2017. https://www2.deloitte.com/insights/u...-creation.html
2. Kate Gerasimova. “The Critical Role of Ethics and Culture in Business Globalization.” Business to Community. September 29, 2016. https://www.business2community.com/s...ation-01667737
3. Kate Gerasimova. “The Critical Role of Ethics and Culture in Business Globalization.” Business to Community. September 29, 2016. https://www.business2community.com/s...ation-01667737
4. “Sustainable Development.” General Assembly of the United Nations. www.un.org/en/ga/president/65.../sustdev.shtml | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/01%3A_Accounting_as_a_Tool_for_Managers/1.06%3A_Describe_Trends_in_Todays_Business_Environment_and_Analyze_Their_Impact_on_Accounting.txt |
Section Summaries
1.1 Define Managerial Accounting and Identify the Three Primary Responsibilities of Management
• The purpose of managerial accounting is to supply financial and nonfinancial information to the organization’s management and other internal decision makers.
• Most of the job responsibilities of a manager fit into one of three categories: planning, controlling, and evaluating.
• Planning involves setting goals and forming the plans to achieve those goals.
• Controlling involves the day-to-day activities. Its purpose is to help in planning functions and to facilitate coordination within the organization.
• Evaluation determines whether plans are being followed and whether progress is being made as planned toward the fulfillment of organizational goals and objectives. It also involves taking corrective measures in case of deviations identified in the course of action.
1.2 Distinguish between Financial and Managerial Accounting
• Managerial accounting provides information to managers and other users within the company. It has a specific focus, and the information is detailed and timely.
• Financial accounting follows the guidelines of the GAAP, set in place by the FASB and, in many cases, by the SEC. Managerial accounting is much more flexible and does not have to follow specific rules or guidelines.
• There are seven key differences between managerial accounting and financial accounting: users, types of reports produced, frequency of producing the reports, purpose of the information produced, focus of the reporting information, nature of the original information used to produce the reports, and verification of the data used to create the reports.
1.3 Explain the Primary Roles and Skills Required of Managerial Accountants
• Essential skills for managerial accountants include commercial awareness, collaboration, effective communication skills, strong technology talents, extensive analytical abilities, and elevated ethical values.
• Management accountants work with individuals at all levels of an organization from the CEO to the shop floor workers.
• There are many different career paths management accountants can take to work in corporations, government entities, service firms, or nonprofit organizations.
• There are numerous certifications that accountants can earn to improve their careers and set themselves apart from their peers.
1.4 Describe the Role of the Institute of Management Accountants and the Use of Ethical Standards
• Many professional organizations share resources, such as education, research, and practice development, with their members. They also enforce a code of ethics for their members.
• All employees within a company are expected to act ethically within their business actions. This can sometimes be difficult when the company almost promotes the idea of unethical actions.
• In response to several corporate scandals, the United States Congress passed the Sarbanes-Oxley Act of 2002 (SOX).
• Ethical codes can be helpful guidelines, but the rationale to act ethically must originate from within oneself, from personal morals and values. There are steps that provide an outline for examining ethical issues.
• One of the issues with ethics is that what one person, community, or even country considers unethical or wrong, another person, community, or country may have no problem with and see it as just a way of doing business.
• The Foreign Corrupt Practices Act of 1977 specifically prohibits payments to foreign government officials to aid in attaining or retaining business. This provision applies to all US persons and foreign firms acting within the United States.
1.5 Describe Trends in Today’s Business Environment and Analyze Their Impact on Accounting
• Business regulations are always being altered, global competition continues to increase, and technology provides continual disruption. Management accounting must keep up with the changes in the business environment.
• The fundamental difference between manufacturing organizations and service-based firms is whether the organizations produce a tangible product.
• Business entities have been in the lead for using technology, but they must continue to adjust quickly with the ever-advancing business technology.
• ERP systems help companies streamline their operations and help management respond quickly to change.
• Lean manufacturing, which was started in Japan by automakers, is now a widely used practice that attempts to increase productivity and eliminate waste.
• The philosophy of continuous improvement has led organizations to adopt practices such as TQM, JIT manufacturing, and LSS.
• The balanced scorecard approach uses both financial and nonfinancial measures in evaluating all attributes of the organization’s procedures.
• Globalization has expanded competitive borders, giving customers and companies more alternatives.
• Many companies have started to assess their corporation not only on financial profits, but also on their corporate social responsibility.
Key Terms
automation
method of using systems such as computers or robots to operate different processes, and machinery to improve efficiencies and lower direct labor costs
balanced scorecard
tool used to evaluate performance using qualitative and nonqualitative measures
board of directors
group of individuals elected by the shareholders of a company with the role of placing management, supervising management, and making key decisions on major issues of the company
bribery
when an organization or representative of an organization gives money or other financial benefits to another individual, business, or official in order to gain favor or to manipulate a business decision
budget analyst
someone who arranges and manages the master budget and compares master budget projections to actual results
cash-management accountant
someone with responsibilities that include transferring monies between accounts, monitoring deposits and payments, reconciling cash balances, creating and tracking cash forecasts, and performing all other cash-related financial processes
Certified Financial Analyst (CFA)
certification for a career in the finance and investment domains; requirements include a bachelor’s degree or four years’ experience and passing all three sections of the exam
Certified Fraud Examiner (CFE)
signifies proven proficiency in fraud prevention, detection, and deterrence; requirements include bachelor’s degree, two years of work-related experience, moral character references, and passing of four separate exams
Certified Government Auditing Professional (CGAP)
designation exclusively for auditors employed throughout the public sector (federal, state, local); requirements are the same as for the CIA, but with a different exam
Certified Internal Auditor (CIA)
credential offered by the Institute of Internal Auditors (IIA) and one of the only certifications accepted worldwide; requirements include a bachelor’s degree, two years of work experience in a related field, and passing the three sections of the examination
Certified Management Accountant (CMA)
certification for a specialist in corporate accounting management, including financial analytics, budgeting, and strategic assessment; requires a bachelor’s degree, two years of work experience, and successfully passing both parts of the exam
Certified Public Accountant (CPA)
top tier in accounting certifications; in the United States, each state has different educational and experience requirements, and certification requires passing the four-part CPA administered by the American Institute of Certified Public Accountants (AICPA)
chief executive officer (CEO)
executive within a company with the highest ranking title who has the overall responsibility for the management of a company; reports to the board of directors
chief financial officer (CFO)
corporation officer who reports to the CEO and oversees all of the accounting and finance concerns of a company
collaboration
working in cross-functional teams and earning the trust and respect of colleagues in order to complete a task
commercial awareness
knowing how a business is run and how it is influenced by the external environment, and knowing and understanding the overall industry within which the business is operating
continuous improvement
ongoing effort to improve processes, products, services, and practices
controller
financial officer of a corporation reporting to the CFO who is responsible for an organization’s accounting records, financial statements, tax returns, and internal reporting
controlling
monitoring of the planning objectives that were put into place
corporate social responsibility (CSR)
actions that firms take to assume responsibility for their impact on the environment and social well-being
cost accountant
employee who amasses large sums of data, checking for accuracy and then formulating the cost of raw materials, work in process, finished goods, labor, overhead, and other associated manufacturing costs
effective communication
conveying information in both written and oral forms in a way that the intended audience can understand
Enrolled Agent (EA)
credential focusing on a career in taxation; created by the IRS to signify significant knowledge of the US tax code and the ability to apply the concepts of that code
enterprise resource planning (ERP)
system that helps a company streamline its operations and helps management respond quickly to change
evaluating
comparing actual results against the planned results
external user
someone who relies on the financial statements and annual reports to access information about a company in order to make more informed decisions (e.g., creditor, tax authority and regulator, investor, customer, competitor, and others)
Financial Accounting Standards Board (FASB)
independent, nonprofit organization that sets financial accounting and reporting standards for both public and private sector businesses in the United States that use Generally Accepted Accounting Principles (GAAP)
financial analyst
someone who assists in preparing budgets and tracking actual costs, and performs other tasks that support other management personnel in organizing forecasts and projections
Foreign Corrupt Practices Act (FCPA)
law that specifically prohibits payments to foreign government officials to aid in attaining or retaining business and requires a company to have good internal controls so a slush fund to pay bribes cannot be created and maintained
generally accepted accounting principles (GAAP)
common set of rules, standards, and procedures that publicly traded companies must follow when composing their financial statements
globalization
development of business through international influence, or extending social and cultural aspects around the world
goal
what a company expects to accomplish over time
government agency
found at all levels of government: federal, state, county, city, and so on; includes military, law enforcement, airports, and school systems
Institute of Management Accountants (IMA)
professional organization for management accountants that provides research, education, a means of knowledge sharing, and practice development to its members
intangible good
good with financial value but no physical presence; examples include copyrights, patents, goodwill, and trademarks
internal auditor
employee of an organization whose job is to provide an independent and objective evaluation of the company's accounting and operational activities
internal user
someone inside the company or organization who is responsible for managing the company’s business interests and executing decisions (e.g., all levels of management, owner, and other employees)
just-in-time (JIT) manufacturing
inventory system that companies use to increase efficiency and decrease waste by receiving goods only as they are needed within the production process, thereby reducing warehousing costs
kaizen
another process that is often linked to Six Sigma and is designed for continuous improvement by eliminating waste and increasing efficiencies; a Japanese word meaning change for the better
lean business model
one in which a company strives to eliminate waste in its products, services, and processes, while still fulfilling the company’s mission
Lean Six Sigma (LSS)
quality control program that depends on a combined effort of many team members to enhance performance by analytically removing waste and diminishing variations between products
managerial accounting
process that allows decision makers to set and evaluate business goals by determining what information they need to make a particular decision and how to analyze and communicate this information
mission statement
short statement of a company’s purpose and focus
monetary accounting information
relating to money or currency
nonmonetary accounting information
not relating to money or currency, such as the quantity of materials, number of employees, number of hours worked, and so forth
nonprofit (not-for-profit) organization
tax-exempt organization that serves its community in a variety of areas
objective
target that needs to be met in order to meet company goals
outsourcing
act of using another company to provide goods or services that your company requires
planning
process of setting goals and objectives
radio-frequency identification (RFID)
technology that uses electromagnetic fields to routinely identify and trace inventory tags that have been attached to objects
Sarbanes-Oxley Act (SOX)
federal law that regulates business practices; intended to protect investors by enhancing the accuracy and reliability of corporate financial statements and disclosures through governance guidelines including sanctions for criminal conduct
strategic planning
setting priorities and determining how to allocate corporate resources to help an organization accomplish short-term and long-term goals
sustainability
meeting the needs of the present generation without compromising the ability of future generations to meet their own needs by being aware of current economic, social, and environmental impacts
tangible good
physical good that customers can handle and see
theory of constraints (TOC)
process of recognizing and removing bottlenecks within the value chain that may be limiting an organization’s profitability
total quality management (TQM)
process in which management and employees look to reveal waste and errors, streamline the supply chain, improve customer relations, and confirm that employees are informed and properly trained
treasurer
financial officer of a corporation reporting to the CFO who is in control of the finance side of the business (cash position, corporation funds)
whistleblower
someone who provides evidence of fraud | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/01%3A_Accounting_as_a_Tool_for_Managers/1.07%3A_Summary_and_Key_Terms.txt |
Multiple Choice
1. The managers of an organization are responsible for performing several broad functions. They are ________.
1. planning, controlling, and selling
2. directing, controlling, and evaluating
3. planning, evaluating, and manufacturing
4. planning, controlling, and evaluating
Answer:
d
1. Management accountants help the management of an organization in their planning function through ________.
1. monitoring anti-theft systems
2. strategic planning
3. evaluating costs
4. analyzing profits
2. Which of the following is a primary aspect of the evaluating function within an organization?
1. comparing actual results against expected results for products, departments, divisions, or the company as a whole
2. reviewing only the quantitative or financial results of the company
3. setting goals
4. putting controls in place for the upcoming year
Answer:
a
1. During the control function, the measurements taken of the performance must be accurate enough to see ________.
1. only positive results
2. deviations and variances
3. the primary focus
4. only the negative results
2. Which of the following is false regarding strategic planning?
1. It is the sole responsibility of supervisors.
2. It will span many years.
3. It should include both short-term and long-term goals.
4. Strategic objectives will be diverse and vary from company to company.
Answer:
a
1. Managerial accounting produces information:
1. to meet the needs of external users
2. that is often focused on the future
3. to meet the needs of investors
4. that follows the rules of GAAP
2. Management accounting:
1. emphasizes special-purpose information
2. relates to the company as a whole
3. is limited to strictly cost figures
4. is controlled by GAAP
Answer:
a
1. Internal users of accounting information would not include ________.
1. managers
2. employees
3. creditors
4. officers
2. External users of accounting information would include ________.
1. employees
2. managers
3. investors
4. supervisors
Answer:
c
1. Which of the following statements is incorrect?
1. The practice of management accounting is fairly flexible.
2. The information gathered from management accounting is not required by law.
3. Management accounting focuses mainly on the internal user.
4. Reports produced using management accounting must follow GAAP.
2. The stockholders of a company are:
1. the owners
2. policy setters
3. responsible and liable for the financial well-being of the company
4. operating within the company as independent shareholders
Answer:
a
1. The controller of a corporation:
1. reports to the CFO and is in charge of the finance side of the business
2. reports to the CFO and is in charge of the accounting side of the business
3. reports to the CEO and implements all cash policies
4. reports to the board of directors
2. The Certified Financial Analyst (CFA) certification:
1. only requires a high school diploma
2. is administered by the AICPA
3. consists of three separate exams that must be taken in succession
4. is the most popular certification among accountants in the United States
Answer:
c
1. The Certified Management Accountant (CMA) certification:
1. signifies someone specializing in tax accounting
2. requires an associate’s degree and four years of work experience
3. includes a two-part exam, education requirements, and a work experience requirement
4. is offered to managers who take special courses in accounting
2. Which of the following terms means the ability to work in cross-functional teams in order to complete a task?
1. supervisory skills
2. conceptualization
3. collaboration
4. resource planning
Answer:
c
1. Which of the following terms means knowing how a business is run and how it is influenced by external forces, and knowing and understanding the overall industry?
1. commercial awareness
2. conceptualization
3. collaboration
4. imagination
2. What is the law that protects investors from fraudulent financial accounting activity?
1. FASB
2. SACS
3. SOX
4. CPAS
Answer:
c
1. What year was the Sarbanes-Oxley Act enacted?
1. 2007
2. 1992
3. 1997
4. 2002
2. When a representative of an organization gives money to another business official in order to gain favor and/or manipulate a business decision, this is known as ________.
1. whistleblowing
2. bribery
3. buyer debits
4. face value
Answer:
b
1. The law that specifically prohibits payments to foreign officials in order to attain business is known as ________.
1. FCPA
2. AICPA
3. SOX
4. IFRS
2. Which of the following is not a step in the outline for examining ethical issues?
1. Establish the facts of the situation.
2. Evaluate each course of action.
3. Make a decision.
4. Confirm decision with FASB.
Answer:
d
1. Which of the following is not an objective used in the balanced scorecard approach?
1. Customer
2. Financial
3. Vendor
4. Learning and growth
2. Which of the following is not true regarding continuous improvement?
1. It applies to both service and manufacturing companies.
2. It is used to reduce performance costs.
3. It rejects the idea of “good enough.”
4. It can be applied only to improve processes and products but not services and practices.
Answer:
d
1. A company’s attempts to utilize sustainable business practices with regard to its employees, the environment, and society are known as ________.
1. a balanced scorecard
2. corporate social responsibility
3. total quality management
4. value chain
2. A process that is often linked to Six Sigma and is designed toward continuous improvement by eliminating waste is ________.
1. kamikaze
2. value chain
3. total quality management
4. kaizen
Answer:
d
1. An inventory system that organizations use to increase efficiency and decrease waste is ________.
1. corporate social responsibility
2. just-in-time manufacturing
3. total quality management
4. Lean Six Sigma
2. A quality control program that depends on multiple team members for removing waste and diminishing defects within products is ________.
1. kaizen
2. total quality management
3. Lean Six Sigma
4. a balanced scorecard
Answer:
c
Questions
1. Carlita believes an important part of the planning process for managers is being sure to position the company to achieve its goals. She thinks that positioning is an extensive concept and can depend on the right information and that managerial accountants assist in positioning the company. Is she correct? Explain.
Answer:
Answers will vary but should include that cost analysis, branding, pricing, and competition all fall under positioning, and this information comes from the managerial accounting staff. It is used to plan for future processes.
1. What are some activities and tasks a manager might perform when engaging in the controlling function of management responsibilities?
2. If there are deviations from the stated goals and objectives, what steps can managers take to get back on track? Provide at least two specific examples.
Answer:
Answers will vary but should include the following: Managers must determine what modifications and changes need to be made to operations to get back on track to meet the stated goals and objectives. Managers need to decide if stated goals and objectives should continue to be pursued as they are, or if they should be modified or completely scrapped. Examples may include revising inventory controls to include antitheft tags that trigger an alarm when inventory is moved from an approved location in order to reduce inventory losses; installing more cameras in more strategic locations to further reduce theft from shoplifting; revising the financial metrics such as ratios or other performance measurements to provide more meaningful and timely insight to help determine how to get back on track; investigating why market share has not changed as expected by talking to the sales force and analyzing market data; evaluating same-store sales to understand how to expand sales in accordance with goals and objectives; and investigating why a production process has experienced a bottleneck and how to relieve the pressure in that specific area, such as making sure appropriate raw materials are available in a timely manner to avoid machine shutdowns waiting on materials to arrive.
1. Explain how managerial accountants help managers plan, control, and evaluate.
2. How do the subject matter of reports and the verification of reports differ between financial accounting and managerial accounting?
Answer:
Reports generated from financial accounting are a compilation of a company’s various transactions and contain aggregated information for the entire company in the form of financial statements. For publicly traded companies, these reports follow the rules set forth by the Financial Accounting Standards Board (FASB). In addition, the financial statements are verified by external auditors. Reports generated by managerial accounting are varied in nature because they are driven by the questions that need to be addressed by management. Different companies and different questions require different reports. Managerial accounting reports are therefore on a more detailed level, such as on a product or division level. There are no specific rules guiding the creation of these reports, and they are usually unaudited.
1. What is the purpose of management accounting?
2. Who are the primary users of the information gathered by managerial accountants?
Answer:
The primary users of information gathered by managerial accountants are internal users, including management, employees, and officers.
1. What are the key differences between financial accounting and managerial accounting?
2. Other than accounting skills, what six qualities must be prevalent in a managerial accountant?
Answer:
Six qualities a managerial accountant should exhibit are commercial awareness, collaboration, effective communication, strong technology skills, analytical skills, and ethics.
1. Explain how having more than one of the accounting credentials would be beneficial to an accounting career.
2. Briefly discuss the chain of command for someone being hired into an organization as a staff managerial accountant.
Answer:
The chain of command for someone being hired into an organization as a staff managerial accounting is: Management accounting supervisor → Controller → CFO → CEO → Board of Directors
1. According to the information available at http://www.accounting.com/careers/, what are six different areas of accounting on which you can focus your career?
2. According to the information on management accounting available at http://www.accounting.com/careers/, what are some areas of specialization?
Answer:
Specialization areas for management accountants includes budget analyst, financial analyst, accounting manager, controller, chief financial officer.
1. Go to http://www.accounting.com/careers/ and look up your state to find projected job growth and projected salaries.
2. What other professional business organizations have a code of ethics?
Answer:
Professional business organizations that have a code of ethics include the American Institute of Public Accountants, the Association of Certified Fraud Examiners, the Financial Executives Institute, the American Marketing Association, and National Society of Professional Engineers
1. How can having a bonus system based purely on sales goals create an environment that encourages unethical behavior?
2. What led to the United States Congress passing the public accounting reform act called Sarbanes-Oxley?
Answer:
Several accounting scandals involving publicly traded companies (Enron, WorldCom, and Arthur Andersen) led to the act. It was aimed particularly at public accounting organizations that performed audits of publicly traded corporations.
1. What is an enterprise resource planning (ERP) system? What are the principal benefits of such a system?
2. Describe what is meant by the term “balanced” in the term balanced scorecard method.
3. What is corporate social responsibility, and who are the stakeholders?
Exercise Set A
1. Indicate whether each statement describes financial accounting or managerial accounting.
1. The information is directed at external users who are making decisions pertaining to investing, extending credit, and other decisions.
2. The principal users are the organization’s managers.
3. The key focus is on the entity as a whole.
4. The rules and principles are very flexible.
5. The information gathered is usually available after an independent audit has been completed.
2. Identify the following as True or False:
1. Managerial accounting reports must comply with the rules set in place by the FASB.
2. Financial accounting reports are typically general-purpose reports.
3. Financial accounting reports pertain to the entity as a whole, whereas managerial accounting focuses more on subunits of the organization.
4. The main users of the financial accounting information are the internal users.
5. Managerial reports are prepared on an as-needed basis.
6. Financial accounting reports often must be audited at least annually by an independent auditor.
3. Define each of these users of accounting information as an internal user of external user:
1. Management
2. Employees
3. Investors
4. Creditors
5. Customers
6. Tax authorities
4. Discuss what information would be most useful for these users of accounting information:
1. Management
2. Employees
3. Investors
4. Creditors
5. Customers
6. Tax authorities
5. Taylor Speedy has prepared the following list of statements about managerial accounting, financial accounting, and the functions of management. Identify each statement as true or false.
1. Financial accounting centers on providing information to internal users.
2. Staff positions are directly involved in the company’s primary revenue-generating activities.
3. Preparation of budgets is part of financial accounting.
4. Managerial accounting applies only to merchandising and manufacturing companies.
5. Both managerial accounting and financial accounting deal with many of the same economic events.
6. Match the term with the description:
1. Certified Public Accountant
1. Specialist in corporate accounting management; favors financial analytics, budgeting, and strategic domains
1. Certified Financial Analyst
1. Considered the top tier in accounting certifications; must pass a four-part exam, with education and work experience requirements
1. Certified Management Accountant
1. Designation that is exclusively for auditors of the public sector
1. Certified Internal Auditor
1. Credential for auditors who work within organizations and is one of a few that is accepted worldwide
1. Certified Fraud Examiner
1. Certification for those with a career in finance and investment areas
1. Certified Government Auditing Professional
1. Designation that proves proficiency in fraud prevention, detection, and deterrence
1. After the passage of the Sarbanes-Oxley Act in 2002, many new responsibilities were put into place for organizations and their management. What are the four significant issues that were addressed by the act and its provisions as presented in this chapter? How does the act and its various requirements help deter fraudulent activity?
2. Indicate whether each of the following statements is true or false.
1. Bribery in the world of business typically happens when an organization or representative of an organization gives financial benefits to an official to gain favor or manipulate a business decision.
2. The Foreign Corrupt Practices Act was implemented in the aftermath of disclosures that businesses were violating the IMA Code of Ethics.
3. Managers are required to follow specific rules issued by the IMA for internal financial reporting.
4. Ethics is more than obeying laws.
5. The Sarbanes-Oxley Act addressed public company accounting reform.
3. Match each lean business method to the best description:
1. Just-in-time manufacturing
1. The focus is on quality throughout the entire process.
1. Continuous improvements
1. Inventory is attained or produced only as needed.
1. Total quality management
1. A combined effort of team members is used to eliminate waste and defects.
1. Lean Six Sigma
1. All managers and employees are always looking for ways to improve operations.
1. For each of the activities listed, choose the manufacturing concept that applies: (i) just-in-time inventory, (ii) continuous improvement, or (iii) total quality management.
1. A company receives inventory daily based on customer orders.
2. Manufacturing factories have been arranged in such a fashion to reduce inefficiencies.
3. Companies organize customer focus groups in order to look at customer needs and expectations.
4. The entire production process is standardized and written down with procedures.
5. Each customer receives a survey of satisfaction with their product.
6. All orders are complete and shipped within three business days.
2. Look up the definitions for the following terms:
1. Budget
2. Capital budget
3. Balanced scorecard
4. Break-Even point
Provide examples of how each of these terms is used in your own life and how using these practices is useful.
Exercise Set B
1. Indicate whether the statement describes reporting by the financial accounting function or the managerial accounting function of an organization.
1. The users of the report are managers who need a daily summary of work done each shift.
2. The report is a job cost sheet for jobs completed in a 24-hour period.
3. The annual report is released each year on the company’s website.
4. The report is audited by the company’s certified public accountant firm.
5. The report is prepared every day because the customer service manager needs information about inventory ready to be shipped to customers.
2. Identify the following as true or false:
1. Financial accounting reports are not released to external users.
2. Managerial accounting reports are not used by employees inside the organization.
3. Managerial accounting reports include only monetary information.
4. Financial accounting reports are monetary in nature.
5. If a result of a company’s operations is nonmonetary in nature, it must be converted to monetary units for managerial reporting.
6. Tax authorities and government regulatory agencies are external users of financial information.
3. Companies need to report both monetary and nonmonetary data and information.
1. Define these two terms and provide examples of each.
2. Discuss what sources are available that provide companies with both types of data and information.
4. Marvin has been thinking about the fields of managerial and financial accounting and the functions of management within an organization. He has the following list of statements to understand. Identify them as true or false.
1. Managerial accounting reports are prepared only quarterly and annually.
2. Financial accounting reports are general-purpose reports.
3. Managerial accounting reports pertain to subunits of the business.
4. Managerial accounting reports must comply with GAAP.
5. The company treasurer reports directly to the vice president of operations.
5. Match the term with the description.
1. Chief Executive Officer
1. has responsibilities that include transferring monies between accounts and monitoring deposits
1. Chief Financial Officer
1. the corporation officer who has the overall responsibility of the management of a company
1. Enrolled Agent
1. a corporate officer who reports to the chief executive officer and oversees all of the accounting and finance concerns of a company
1. Cash Management Accountant
1. the financial officer of a corporation reporting to the chief financial officer who is responsible for the accounting records and financial statements
1. Controller
1. credential focusing on a career in taxation created by the IRS to signify significant knowledge of the US tax code
1. Financial Analyst
1. Someone who assists in preparing budgets, tracking actual costs and performs other tasks that support other management personnel in organizing forecasts and projections
1. The Foreign Corrupt Practices Act (FCPA) was implemented in 1977. Why was it enacted, and what are its major provisions?
2. Indicate whether each of the following statements is true or false.
1. Section 302 of Sarbanes-Oxley requires the CEO and CFO to review all financial reports and sign the reports.
2. One of the three questions put forth by the Institute of Business Ethics is “Do I mind others knowing what I have done?”
3. Ethical issues may be faced on a small scale, such as making a business decision to produce excess inventory for the sole purpose of trying to influence managers’
4. bonuses.
5. A manager who spends excess budgeted funds remaining at the end of a fiscal year on unnecessary expenditures thinking that it is better to “use it than lose it” is acting
6. ethically.
7. The Foreign Corrupt Practices Act was implemented in 2001 to protect investors by enhancing the accuracy and reliability of corporate financial statements and disclosures.
Thought Provokers
1. Table 1.1.3 shows how different areas within the business world use the information from managerial accountants. Think of the ways that the events coordinator for the United Way (a nonprofit charitable organization) would use each area (planning, controlling, and evaluation).
2. There are individuals who are under the impression that managerial accounting provides services mainly for manufacturing organizations. Are they correct? Explain.
3. Think about the organization chart in Figure 1.3.1. Describe ways in which each of the accounting and managerial functions might overlap and complement each other.
4. Controversy tends to surround the topic of whistleblowers. For example, should they be considered heroes or traitors? Many pro-whistleblowing policies have been enacted by the federal government to allow these individuals to reap significant monetary rewards for coming forward and giving information about behaviors and actions such as corporate fraud and unethical deeds. Many corporate whistleblowers face negative consequences of their actions, such as reassignment, revenge, and hate crimes, and are seen as traitors (e.g., Edward Snowden and Gina Gray). Yet Sherron Watkins and Cynthia Cooper were celebrated as heroes. Look up the stories of Sherron Watkins and Cynthia Cooper. Why do you think that some whistleblowers are vilified and others made to be heroes? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/01%3A_Accounting_as_a_Tool_for_Managers/1.0E%3A_1.E%3A_Accounting_as_a_Tool_for_Managers_%28Exercises%29.txt |
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02: Building Blocks of Managerial Accounting
Many 16-year-olds in the United States eagerly anticipate having a car of their own and the freedom that comes from having their own means of transportation. For many, this means not having to bum a ride from a friend, take a bus, hire Uber or Lyft, or worse, borrow the parents’ car. However, as appealing as having one’s own set of wheels sounds, it comes with an array of costs that many young drivers do not anticipate. Some of the costs associated with buying and owning a car are fixed, and some vary with the level of activity. For example, a driver pays car payments and insurance premiums every month whether or not the car is driven, but the cost of maintenance and gas can be controlled by driving less. A driver cannot control the price of gasoline or the mechanic’s hourly wage but can control how much of each is used each month.
Just as car owners incur a variety of costs—fixed, variable, controllable, and uncontrollable—businesses incur these types of costs as well. The goal of managerial accountants is to use this cost information to assist management in both long- and short-term decision-making. Managerial accounting follows standards and best practices for reporting cost data that are less formal than those used for financial accounting. This means management often has the discretion to determine how costs are used internally.
Since businesses collect and analyze cost data for internal use, there may be distinct differences among businesses in how they estimate and treat certain costs. What does not change, regardless of how cost data is used, are generally agreed upon cost classifications managers use for decision-making. In short, most businesses incur the same type of costs, but how each firm classifies and manages these costs can vary widely.
2.02: Distinguish between Merchandising Manufacturing and Service Organizations
Most businesses can be classified into one or more of these three categories: manufacturing, merchandising, or service. Stated in broad terms, manufacturing firms typically produce a product that is then sold to a merchandising entity (a retailer). For example, Proctor and Gamble produces a variety of shampoos that it sells to retailers, such as Walmart, Target, or Walgreens. A service entity provides a service such as accounting or legal services or cable television and internet connections.
Some companies combine aspects of two or all three of these categories within a single business. If it chooses, the same company can both produce and market its products directly to consumers. For example, Nike produces products that it directly sells to consumers and products that it sells to retailers. An example of a company that fits all three categories is Apple, which produces phones, sells them directly to consumers, and also provides services, such as extended warranties.
Regardless of whether a business is a manufacturer of products, a retailer selling to the customer, a service provider, or some combination, all businesses set goals and have strategic plans that guide their operations. Strategic plans look very different from one company to another. For example, a retailer such as Walmart may have a strategic plan that focuses on increasing same store sales. Facebook’s strategic plan may focus on increasing subscribers and attracting new advertisers. An accounting firm may have long-term goals to open offices in neighboring cities in order to serve more clients. Although the goals differ, the process all companies use to achieve their goals is the same. First, they must develop a plan for how they will achieve the goal, and then management will gather, analyze, and use information regarding costs to make decisions, implement plans, and achieve goals.
Table \(1\) lists examples of these costs. Some of these are similar across different types of businesses; others are unique to a particular business.
Table \(1\): Some Costs Incurred by a Business
Type of Business Costs Incurred
Manufacturing Business
• Direct labor
• Plant and equipment
• Manufacturing overhead
• Raw materials
Merchandising Business
• Lease on retail space
• Merchandise inventory
• Retail sales staff
Service Business
• Billing and collections
• Computer network equipment
• Professional staff
Some costs, such as raw materials, are unique to a particular type of business. Other costs, such as billing and collections, are common to most businesses, regardless of the type.Knowing the basic characteristics of each cost category is important to understanding how businesses measure, classify, and control costs.
Merchandising Organizations
A merchandising firm is one of the most common types of businesses. A merchandising firm is a business that purchases finished products and resells them to consumers. Consider your local grocery store or retail clothing store. Both of these are merchandising firms. Often, merchandising firms are referred to as resellers or retailers since they are in the business of reselling a product to the consumer at a profit.
Think about purchasing toothpaste from your local drug store. The drug store purchases tens of thousands of tubes of toothpaste from a wholesale distributor or manufacturer in order to get a better per-tube cost. Then, they add their mark-up (or profit margin) to the toothpaste and offer it for sale to you. The drug store did not manufacture the toothpaste; instead, they are reselling a toothpaste that they purchased. Virtually all of your daily purchases are made from merchandising firms such as Walmart, Target, Macy’s, Walgreens, and AutoZone.
Merchandising firms account for their costs in a different way from other types of business organizations. To understand merchandising costs, Figure \(1\) shows a simplified income statement for a merchandising firm:
This simplified income statement demonstrates how merchandising firms account for their sales cycle or process. Sales revenue is the income generated from the sale of finished goods to consumers rather than from the manufacture of goods or provision of services. Since a merchandising firm has to purchase goods for resale, they account for this cost as cost of goods sold—what it cost them to acquire the goods that are then sold to the customer. The difference between what the drug store paid for the toothpaste and the revenue generated by selling the toothpaste to consumers is their gross profit. However, in order to generate sales revenue, merchandising firms incur expenses related to the process of operating their business and selling the merchandise. These costs are called operating expenses, and the business must deduct them from the gross profit to determine the operating profit. (Note that while the terms “operating profit” and “operating income” are often used interchangeably, in real-world interactions you should confirm exactly what the user means in using those terms.) Operating expenses incurred by a merchandising firm include insurance, marketing, administrative salaries, and rent.
CONCEPTS IN PRACTICE: Balancing Revenue and Expenses
Plum Crazy is a small boutique selling the latest in fashion trends. They purchase clothing and fashion accessories from several distributors and manufacturers for resale. In 2017, they reported these revenue and expenses:
Before examining the income statement, let’s look at Cost of Goods Sold in more detail. Merchandising companies have to account for inventory, a topic covered in Inventory. As you recall, merchandising companies carry inventory from one period to another. When they prepare their income statement, a crucial step is identifying the actual cost of goods that were sold for the period. For Plum Crazy, their Cost of Goods Sold was calculated as shown in Figure \(4\).
Once the calculation of the Cost of Goods Sold has been completed, Plum Crazy can now construct their income statement, which would appear as shown in Figure \(5\).
Since merchandising firms must pass the cost of goods on to the consumer to earn a profit, they are extremely cost sensitive. Large merchandising businesses like Walmart, Target, and Best Buy manage costs by buying in bulk and negotiating with manufacturers and suppliers to drive the per-unit cost.
CONTINUING APPLICATION: Introduction to the Gearhead Outfitters Story
Gearhead Outfitters, founded by Ted Herget in 1997 in Jonesboro, AR, is a retail chain which sells outdoor gear for men, women, and children. The company’s inventory includes clothing, footwear for hiking and running, camping gear, backpacks, and accessories, by brands such as The North Face, Birkenstock, Wolverine, Yeti, Altra, Mizuno, and Patagonia. Ted fell in love with the outdoor lifestyle while working as a ski instructor in Colorado and wanted to bring that feeling back home to Arkansas. And so, Gearhead was born in a small downtown location in Jonesboro. The company has had great success over the years, expanding to numerous locations in Ted’s home state, as well as Louisiana, Oklahoma, and Missouri.
While Ted knew his industry when starting Gearhead, like many entrepreneurs he faced regulatory and financial issues which were new to him. Several of these issues were related to accounting and the wealth of decision-making information which accounting systems provide.
For example, measuring revenue and expenses, providing information about cash flow to potential lenders, analyzing whether profit and positive cash flow is sustainable to allow for expansion, and managing inventory levels. Accounting, or the preparation of financial statements (balance sheet, income statement, and statement of cash flows), provides the mechanism for business owners such as Ted to make fundamentally sound business decisions.
link to learning
Walmart is inarguably a retail giant, but how did the company become so successful? Read the article about how low costs have allowed Walmart to keep prices low while still making a large profit to learn more.
Manufacturing Organizations
A manufacturing organization is a business that uses parts, components, or raw materials to produce finished goods (Figure \(6\)). These finished goods are sold either directly to the consumer or to other manufacturing firms that use them as a component part to produce a finished product. For example, Diehard manufactures automobile batteries that are sold directly to consumers by retail outlets such as AutoZone, Costco, and Advance Auto. However, these batteries are also sold to automobile manufacturers such as Ford, Chevrolet, or Toyota to be installed in cars during the manufacturing process. Regardless of who the final consumer of the final product is, Diehard must control its costs so that the sale of batteries generates revenue sufficient to keep the organization profitable.
Manufacturing firms are more complex organizations than merchandising firms and therefore have a larger variety of costs to control. For example, a merchandising firm may purchase furniture to sell to consumers, whereas a manufacturing firm must acquire raw materials such as lumber, paint, hardware, glue, and varnish that they transform into furniture. The manufacturer incurs additional costs, such as direct labor, to convert the raw materials into furniture. Operating a physical plant where the production process takes place also generates costs. Some of these costs are tied directly to production, while others are general expenses necessary to operate the business. Because the manufacturing process can be highly complex, manufacturing firms constantly evaluate their production processes to determine where cost savings are possible.
CONCEPTS IN PRACTICE: Cost Control
Controlling costs is an integral function of all managers, but companies often hire personnel to specifically oversee cost control. As you’ve learned, controlling costs is vital in all industries, but at Hilton Hotels, they translate this into the position of Cost Controller. Here is an excerpt from one of Hilton’s recent job postings.
Position Title: Cost Controller
Job Description: “A Cost Controller will work with all Heads of Departments to effectively control all products that enter and exit the hotel.”1
Job Requirements:
“As Cost Controller, you will work with all Heads of Departments to effectively control all products that enter and exit the hotel. Specifically, you will be responsible for performing the following tasks to the highest standards:
• Review the daily intake of products into the hotel and ensure accurate pricing and quantity of goods received
• Control the stores by ensuring accuracy of inventory and stock control and the pricing of goods received
• Alert relevant parties of slow-moving goods and goods nearing expiry dates to reduce waste and alter product purchasing to accommodate
• Manage cost reporting on a weekly basis
• Attend finance meetings, as required
• Maintain good communication and working relationships with all hotel areas
• Act in accordance with fire, health and safety regulations and follow the correct procedures when required”2
As you can see, the individual in this position will interact with others across the organization to find ways to control costs for the benefit of the company. Some of the benefits of cost control include:
• Lowering overall company expenses, thereby increasing net income.
• Freeing up financial resources for investment in research & development of new or improved products, goods, or services
• Providing funding for employee development and training, benefits, and bonuses
• Allowing corporate earnings to be used to support humanitarian and charitable causes
Manufacturing organizations account for costs in a way that is similar to that of merchandising firms. However, as you will learn, there is a significant difference in the calculation of cost of goods sold. Figure \(7\) shows a simplification of the income statement for a manufacturing firm:
At first it appears that there is no difference between the income statements of the merchandising firm and the manufacturing firm. However, the difference is in how these two types of firms account for the cost of goods sold. Merchandising firms determine their cost of goods sold by accounting for both existing inventory and new purchases, as shown in the Plum Crazy example. It is typically easy for merchandising firms to calculate their costs because they know exactly what they paid for their merchandise.
Unlike merchandising firms, manufacturing firms must calculate their cost of goods sold based on how much they manufacture and how much it costs them to manufacture those goods. This requires manufacturing firms to prepare an additional statement before they can prepare their income statement. This additional statement is the Cost of Goods Manufactured statement. Once the cost of goods manufactured is calculated, the cost is then incorporated into the manufacturing firm’s income statement to calculate its cost of goods sold.
One thing manufacturing firms must consider in their cost of goods manufactured is that, at any given time, they have products at varying levels of production: some are finished and others are still process. The cost of goods manufactured statement measures the cost of the goods actually finished during the period, whether or not they were started during that period.
Before examining the typical manufacturing firm’s process to track cost of goods manufactured, you need basic definitions of three terms in the schedule of Costs of Goods Manufactured: direct materials, direct labor, and manufacturing overhead. Direct materials are the components used in the production process whose costs can be identified on a per item-produced basis. For example, if you are producing cars, the engine would be a direct material item. The direct material cost would be the cost of one engine. Direct labor represents production labor costs that can be identified on a per item-produced basis. Referring to the car production example, assume that the engines are placed in the car by individuals rather than by an automated process. The direct labor cost would be the amount of labor in hours multiplied by the hourly labor cost. Manufacturing overhead generally includes those costs incurred in the production process that are not economically feasible to measure as direct material or direct labor costs. Examples include the department manager’s salary, the production factory’s utilities, or glue used to attach rubber molding in the auto production process. Since there are so many possible costs that can be classified as manufacturing overhead, they tend to be grouped and then allocated in a predetermined manner to the production process.
Figure \(8\) is an example of the calculation of the Cost of Goods Manufactured for Koeller Manufacturing. It demonstrates the relationship between cost of goods manufactured and cost of goods in progress and includes the three main types of manufacturing costs.
As you can see, the manufacturing firm takes into account its work-in-process (WIP) inventory as well as the costs incurred during the current period to finish not only the units that were in the beginning WIP inventory, but also a portion of any production that was started but not finished during the month. Notice that the current manufacturing costs, or the additional costs incurred during the month, include direct materials, direct labor, and manufacturing overhead. Direct materials are calculated as
All of these costs are carefully tracked and classified because the cost of manufacturing is a vital component of the schedule of cost of goods sold. To continue with the example, Koeller Manufacturing calculated that the cost of goods sold was \(\$95,000\), which is carried through to the Schedule of Cost of Goods Sold (Figure \(10\)).
So, even though the income statements for the merchandising firm and the manufacturing firm appear very similar at first glance, there are many more costs to be captured by the manufacturing firm. Figure \(12\) compares and contrasts the methods merchandising and manufacturing firms use to calculate the cost of goods sold in their income statement.
CONCEPTS IN PRACTICE: Calculating Cost of Goods Sold in Manufacturing
Just Desserts is a bakery that produces and sells cakes and pies to grocery stores for resale. Although they are a small manufacturer, they incur many of the costs of a much larger organization. In 2017, they reported these revenue and expenses:
Their income statement is shown in Figure \(14\).
You’ll learn more about the flow of manufacturing costs in Identify and Apply Basic Cost Behavior Patterns. For now, recognize that, unlike a merchandising firm, calculating cost of goods sold in manufacturing firms can be a complex task for management.
Service Organizations
A service organization is a business that earns revenue by providing intangible products, those that have no physical substance. The service industry is a vital sector of the U.S. economy, providing \(65\%\) of the U.S. private-sector gross domestic product and more than \(79\%\) of U.S. private-sector jobs.3 If tangible products, physical goods that customers can handle and see, are provided by a service organization, they are considered ancillary sources of revenue. Large service organizations such as airlines, insurance companies, and hospitals incur a variety of costs in the provision of their services. Costs such as labor, supplies, equipment, advertising, and facility maintenance can quickly spiral out of control if management is not careful. Therefore, although their cost drivers are sometimes not as complex as those of other types of firms, cost identification and control are every bit as important in the service industry.
For example, consider the services that a law firm provides its clients. What clients pay for are services such as representation in legal proceedings, contract negotiations, and preparation of wills. Although the true value of these services is not contained in their physical form, they are of value to the client and the source of revenue to the firm. The managing partners in the firm must be as cost conscious as their counterparts in merchandising and manufacturing firms. Accounting for costs in service firms differs from merchandising and manufacturing firms in that they do not purchase or produce goods. For example, consider a medical practice. Although some services provided are tangible products, such as medications or medical devices, the primary benefits the physicians provide their patients are the intangible services that are comprised of his or her knowledge, experience, and expertise.
Service providers have some costs (or revenue) derived from tangible goods that must be taken into account when pricing their services, but their largest cost categories are more likely to be administrative and personnel costs rather than product costs.
For example, Whichard & Klein, LLP, is a full-service accounting firm with their primary offices in Baltimore, Maryland. With two senior partners and a small staff of accountants and payroll specialists, the majority of the costs they incur are related to personnel. The value of the accounting and payroll services they provide to their clients is intangible in comparison to goods sold by a merchandiser or produced by a manufacturer but has value and is the primary source of revenue for the firm. At the end of 2019, Whichard and Klein reported the following revenue and expenses:
Their Income Statement for the period is shown in Figure \(17\).
The bulk of the expenses incurred by Whichard & Klein are in personnel and administrative/office costs, which are very common among businesses that have services as their primary source of revenue.
CONCEPTS IN PRACTICE: Revenue and Expenses for a Law Office
The revenue and expenses for a law firm illustrate how the income statement for a service firm differs from that of a merchandising or manufacturing firm.
Welch & Graham is a well-established law firm that provides legal services in the areas of criminal law, real estate transactions, and personal injury. The firm employs several attorneys, paralegals, and office support staff. In 2017, they reported the following revenue and expenses:
Their income statement is shown in Figure \(19\).
As you can see, the majority of the costs incurred by the law firm are personnel related. They may also incur costs from equipment and materials such computer networks, phone and switchboard equipment, rent, insurance, and law library materials necessary to support the practice, but these costs represent a much smaller percentage of total cost than the administrative and personnel costs.
THINK IT THROUGH: Expanding a Business
Margo is the owner of a small retail business that sells gifts and home decorating accessories. Her business is well established, and she is now considering taking over additional retail space to expand her business to include gourmet foods and gift baskets. Based on customer feedback, she is confident that there is a demand for these items, but she is unsure how large that demand really is. Expanding her business this way will require that she incur not only new costs but also increases in existing costs.
Margo has asked for your help in identifying the impact of her decision to expand in terms of her costs. When discussing these cost increases, be sure to specifically identify those costs that are directly tied to her products and that would be considered overhead expenses.
Footnotes
1. Hilton. “Cost Controller: Job Description.” Hosco. https://www.hosco.com/en/job/hilton-...ost-controller
2. Hilton. “Cost Controller: Job Description.” Hosco. https://www.hosco.com/en/job/hilton-...ost-controller
3. John Ward. “The Services Sector: How Best to Measure It?” International Trade Administration. Oct. 2010. 2016.trade.gov/publications/...measure-it.asp. “United States GDP from Private Services Producing Industries.” Trading Economics / U.S. Bureau of Economic Analysis. July 2018. https://tradingeconomics.com/united-...-from-services. “Employment in Services (% of Total Employment) (Modeled ILO Estimate).” International Labour Organization, ILOSTAT database. The World Bank. Sept. 2018. https://data.worldbank.org/indicator/SL.SRV.EMPL.ZS. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/02%3A_Building_Blocks_of_Managerial_Accounting/2.01%3A_Prelude_to_Building_Blocks_of_Managerial_Accounting.txt |
Now that we have identified the three key types of businesses, let’s identify cost behaviors and apply them to the business environment. In managerial accounting, different companies use the term cost in different ways depending on how they will use the cost information. Different decisions require different costs classified in different ways. For instance, a manager may need cost information to plan for the coming year or to make decisions about expanding or discontinuing a product or service. In practice, the classification of costs changes as the use of the cost data changes. In fact, a single cost, such as rent, may be classified by one company as a fixed cost, by another company as a committed cost, and by even another company as a period cost. Understanding different cost classifications and how certain costs can be used in different ways is critical to managerial accounting.
ethical considerations: Institute of Management Accountants and Certified Management Accountant Certification
Managerial accountants provide businesses with clear and direct insight into the monetary effects of any particular operational action under consideration. They are expected to report financial information in a transparent and ethical fashion. The Institute of Management Accountants (IMA) offers the Certified Management Accountant (CMA) certification. IMA members and CMAs agree to uphold a set of ethical principles that includes honesty, fairness, objectivity, and responsibility. Any managerial accountant, even if not an IMA member or certified CMA, should act in accordance with these principles and encourage coworkers to follow ethical principles for reporting financial results and monetary effects of financial decisions related to their organization. The IMA Committee on Ethics encourages organizations and individuals to adopt, promote, and execute business practices consistent with high ethical standards.1
Major Cost Behavior Patterns
Any discussion of costs begins with the understanding that most costs will be classified in one of three ways: fixed costs, variable costs, or mixed costs. The costs that don’t fall into one of these three categories are hybrid costs, which are examined only briefly because they are addressed in more advanced accounting courses. Because fixed and variable costs are the foundation of all other cost classifications, understanding whether a cost is a fixed cost or a variable cost is very important.
Fixed versus Variable Costs
A fixed cost is an unavoidable operating expense that does not change in total over the short term, even if a business experiences variation in its level of activity. Table $1$ illustrates the types of fixed costs for merchandising, service, and manufacturing organizations.
Table $1$: Examples of Fixed Costs
Type of Business Fixed Cost
Merchandising Rent, insurance, managers’ salaries
Manufacturing Property taxes, insurance, equipment leases
Service Rent, straight-line depreciation, administrative salaries, and insurance
We have established that fixed costs do not change in total as the level of activity changes, but what about fixed costs on a per-unit basis? Let’s examine Tony’s screen-printing company to illustrate how costs can remain fixed in total but change on a per-unit basis.
Tony operates a screen-printing company, specializing in custom T-shirts. One of his fixed costs is his monthly rent of $\1,000$. Regardless of whether he produces and sells any T-shirts, he is obligated under his lease to pay $\1,000$ per month. However, he can consider this fixed cost on a per-unit basis, as shown in Figure $1$.
Tony’s information illustrates that, despite the unchanging fixed cost of rent, as the level of activity increases, the per-unit fixed cost falls. In other words, fixed costs remain fixed in total but can increase or decrease on a per-unit basis.
Two specialized types of fixed costs are committed fixed costs and discretionary fixed costs. These classifications are generally used for long-range planning purposes and are covered in upper-level managerial accounting courses, so they are only briefly described here.
Committed fixed costs are fixed costs that typically cannot be eliminated if the company is going to continue to function. An example would be the lease of factory equipment for a production company.
Discretionary fixed costs generally are fixed costs that can be incurred during some periods and postponed during other periods but which cannot normally be eliminated permanently. Examples could include advertising campaigns and employee training. Both of these costs could potentially be postponed temporarily, but the company would probably incur negative effects if the costs were permanently eliminated. These classifications are generally used for long-range planning purposes.
In addition to understanding fixed costs, it is critical to understand variable costs, the second fundamental cost classification. A variable cost is one that varies in direct proportion to the level of activity within the business. Typical costs that are classified as variable costs are the cost of raw materials used to produce a product, labor applied directly to the production of the product, and overhead expenses that change based upon activity. For each variable cost, there is some activity that drives the variable cost up or down. A cost driver is defined as any activity that causes the organization to incur a variable cost. Examples of cost drivers are direct labor hours, machine hours, units produced, and units sold. Table $2$ provides examples of variable costs and their associated cost drivers.
Table $2$: Variable Costs and Associated Cost Drivers
Variable Cost Cost Driver
Merchandising Total monthly hourly wages for sales staff Hours business is open during month
Manufacturing Direct materials used to produce one unit of product Number of units produced
Service Cost of laundering linens and towels Number of hotel rooms occupied
Unlike fixed costs that remain fixed in total but change on a per-unit basis, variable costs remain the same per unit, but change in total relative to the level of activity in the business. Revisiting Tony’s T-Shirts, Figure $2$ shows how the variable cost of ink behaves as the level of activity changes.
Figure $2$ shows, the variable cost per unit (per T-shirt) does not change as the number of T-shirts produced increases or decreases. However, the variable costs change in total as the number of units produced increases or decreases. In short, total variable costs rise and fall as the level of activity (the cost driver) rises and falls.
Distinguishing between fixed and variable costs is critical because the total cost is the sum of all fixed costs (the total fixed costs) and all variable costs (the total variable costs). For every unit produced, every customer served, or every hotel room rented, for example, managers can determine their total costs both per unit of activity and in total by combining their fixed and variable costs together. The graphic in Figure $3$ illustrates the concept of total costs.
Remember that the reason that organizations take the time and effort to classify costs as either fixed or variable is to be able to control costs. When they classify costs properly, managers can use cost data to make decisions and plan for the future of the business.
2
If you’ve ever flown on an airplane, there’s a good chance you know Boeing. The Boeing Company generates around $\90$ billion each year from selling thousands of airplanes to commercial and military customers around the world. It employs around $200,000$ people, and it’s indirectly responsible for more than a million jobs through its suppliers, contractors, regulators, and others. Its main assembly line in Everett, WA, is housed in the largest building in the world, a colossal facility that covers nearly a half-trillion cubic feet. Boeing is, simply put, a massive enterprise.
And yet, Boeing’s managers know the exact cost of everything the company uses to produce its airplanes: every propeller, flap, seat belt, welder, computer programmer, and so forth. Moreover, they know how those costs would change if they produced more airplanes or fewer. They also know the price at which they sold each plane and the profit the company made on each sale. Boeing’s executives expect their managers to know this information, in real time, if the company is to remain profitable.
Table $3$: Link between Business Decision and Cost Information Utilized
Decision Cost Information
Discontinue a product line Variable costs, overhead directly tied to product, potential reduction in fixed costs
Add second production shift Labor costs, cost of fringe benefits, potential overhead increases (utilities, security personnel)
Open additional retail outlets Fixed costs, variable operating costs, potential increases in administrative expenses at corporate headquarters
Average Fixed Costs versus Average Variable Costs
Another way management may want to consider their costs is as average costs. Under this approach, managers can calculate both average fixed and average variable costs. Average fixed cost (AFC) is the total fixed costs divided by the total number of units produced, which results in a per-unit cost. The formula is:
$\text { Average Fixed cost (A F C)}=\dfrac{\text { Total Fixed costs }}{\text { Total Number of Units Produced }}$
To show how a company would use AFC to make business decisions, consider Carolina Yachts, a company that manufactures sportfishing boats that are sold to consumers through a network of marinas and boat dealerships. Carolina Yachts produces $625$ boats per year, and their total annual fixed costs are $\1,560,000$. If they want to determine an average fixed cost per unit, they will find it using the formula for AFC:
$\mathrm{AFC}=\dfrac{\ 1,560,000}{625}=\ 2,496$ per boat
When they produce $625$ boats, Carolina Yachts has an AFC of $\2,496$ per boat. What happens to the AFC if they increase or decrease the number of boats produced? Figure $4$ shows the AFC for different numbers of boats.
We see that total fixed costs remain unchanged, but the average fixed cost per unit goes up and down with the number of boats produced. As more units are produced, the fixed costs are spread out over more units, making the fixed cost per unit fall. Likewise, as fewer boats are manufactured, the average fixed costs per unit rises. We can use a similar approach with variable costs.
Average variable cost (AVC) is the total variable costs divided by the total number of units produced, which results in a per-unit cost. Like ATC, we can use this formula:
$\text { Average Variable cost }(\mathrm{AVC})=\dfrac{\text { Total Variable Costs }}{\text { Total Number of Units Produced }}$
To demonstrate AVC, let’s return to Carolina Yachts, which incurs total variable costs of $\6,875,000$ when they produce $625$ boats per year. They can express this as an average variable cost per unit:
$\mathrm{AVC}=\dfrac{\ 6,875,000}{625}=\ 11,000$ per boat
Because average variable costs are the average of all costs that change with production levels on a per-unit basis and include both direct materials and direct labor, managers often use AVC to determine if production should continue or not in the short run. As long as the price Carolina Yachts receives for their boats is greater than the per-unit AVC, they know that they are not only covering the variable cost of production, but each boat is making a contribution toward covering fixed costs. If, at any point, the average variable cost per boat rises to the point that the price no longer covers the AVC, Carolina Yachts may consider halting production until the variable costs fall again.
These changes in variable costs per unit could be caused by circumstances beyond their control, such as a shortage of raw materials or an increase in shipping costs due to high gas prices. In any case, average variable cost can be useful for managers to get a big picture look at their variable costs per unit.
LINK TO LEARNING
Watch the video from Khan Academy that uses the scenario of computer programming to teach fixed, variable, and marginal cost to learn more.
Mixed Costs and Stepped Costs
Not all costs can be classified as purely fixed or purely variable. Mixed costs are those that have both a fixed and variable component. It is important, however, to be able to separate mixed costs into their fixed and variable components because, typically, in the short run, we can only change variable costs but not most fixed costs. To examine how these mixed costs actually work, consider the Ocean Breeze hotel.
The Ocean Breeze is located in a resort area where the county assesses an occupancy tax that has both a fixed and a variable component. Ocean Breeze pays $\2,000$ per month, regardless of the number of rooms rented. Even if it does not rent a single room during the month, Ocean Breeze still must remit this tax to the county. The hotel treats this $\2,000$ as a fixed cost. However, for every night that a room is rented, Ocean Breeze must remit an additional tax amount of $\5.00$ per room per night. As a result, the occupancy tax is a mixed cost. Figure $5$ further illustrates how this mixed cost behaves.
Notice that Ocean Breeze cannot control the fixed portion of this cost and that it remains fixed in total, regardless of the activity level. On the other hand, the variable component is fixed per unit, but changes in total based upon the level of activity. The fixed portion of this cost plus the variable portion of this cost combine to make the total cost. As a result, the formula for total cost looks like this:
$Y=a+b x$
where $Y$ is the total mixed cost, $a$ is the fixed cost, $b$ is the variable cost per unit, and $x$ is the level of activity.
Graphically, mixed costs can be explained as shown in Figure $6$.
The graph shows that mixed costs are typically both fixed and linear in nature. In other words, they will often have an initial cost, in Ocean Breeze’s case, the $\2,000$ fixed component of the occupancy tax, and a variable component, the $\5$ per night occupancy tax. Note that the Ocean Breeze mixed cost graph starts at an initial $\2,000$ for the fixed component and then increases by $\5$ for each night their rooms are occupied.
Some costs behave less linearly. A cost that changes with the level of activity but is not linear is classified as a stepped cost. Step costs remain constant at a fixed amount over a range of activity. The range over which these costs remain unchanged (fixed) is referred to as the relevant range, which is defined as a specific activity level that is bounded by a minimum and maximum amount. Within this relevant range, managers can predict revenue or cost levels. Then, at certain points, the step costs increase to a higher amount. Both fixed and variable costs can take on this stair-step behavior. For instance, wages often act as a stepped variable cost when employees are paid a flat salary and a commission or when the company pays overtime. Further, when additional machinery or equipment is placed into service, businesses will see their fixed costs stepped up. The “trigger” for a cost to step up is the relevant range. Graphically, step costs appear like stair steps (Figure $7$).
For example, suppose a quality inspector can inspect a maximum of $80$ units in a regular $8$-hour shift and his salary is a fixed cost. Then the relevant range for QA inspection is from $0–80$ units per shift. If demand for these units increases and more than $80$ inspections are needed per shift, the relevant range has been exceeded and the business will have one of two choices:
1. Pay the quality inspector overtime in order to have the additional units inspected. This overtime will “step up” the variable cost per unit. The advantage to handling the increased cost in this way is that when demand falls, the cost can quickly be “stepped down” again. Because these types of step costs can be adjusted quickly and often, they are often still treated as variable costs for planning purposes.
2. “Step up” fixed costs. If the company hires a second quality inspector, they would be stepping up their fixed costs. In effect, they will double the relevant range to allow for a maximum of $160$ inspections per shift, assuming the second QA inspector can inspect an additional 80 units per shift. The down side to this approach is that once the new QA inspector is hired, if demand falls again, the company will be incurring fixed costs that are unnecessary. For this reason, adding salaried personnel to address a short-term increase in demand is not a decision most businesses make.
Step costs are best explained in the context of a business experiencing increases in activity beyond the relevant range. As an example, let’s return to Tony’s T-Shirts.
Tony’s cost of operations and the associated relevant ranges are shown in Table $4$.
Table $4$: Tony’s T-Shirts Cost Options
Cost Type of Cost Relevant Range
Lease on Screen-Printing Machine $2,000 per month Fixed 0–2,000 T-shirts per month Employee$10 per hour Variable 20 shirts per hour
Tony’s Salary $2,500 per month Fixed N/A Screen-Printing Ink$0.25 per shirt Variable N/A
Building Rent \$1,500 per month Fixed 2 screen-printing machines and 2 employees
As you can see, Tony has both fixed and variable costs associated with his business. His one screen-printing machine can only produce $2,000$ T-shirts per month and his current employee can produce $20$ shirts per hour ($160$ per $8$-hour work day). The space that Tony leases is large enough that he could add an additional screen-printing machine and 1 additional employee. If he expands beyond that, he will need to lease a larger space, and presumably his rent would increase at that point. It is easy for Tony to predict his costs as long as he operates within the relevant ranges by applying the total cost equation $Y = a + bx$. So, for Tony, as long as he produces $2,000$ or fewer T-shirts, his total cost will be found by $Y = \6,000 + \0.75x$, where the variable cost of $\0.75$ is the $\0.25$ cost of the ink per shirt and $\0.50$ per shirt for labor ($\10$ per hour wage/$20$ shirts per hour). As soon as his production passes the $2,000$ T-shirts that his one employee and one machine can handle, he will have to add a second employee and lease a second screen-printing machine. In other words, his fixed costs will rise from $\6,000$ to $\8,000$, and his variable cost per T-shirt will rise from $\0.75$ to $\1.25$ (ink plus $2$ workers). Thus, his new cost equation is $Y = \8,000 + \1.25x$ until he “steps up” again and adds a third machine and moves to a new location with a presumably higher rent. Let’s take a look at this in chart form to better illustrate the “step” in cost Tony will experience as he steps past $2,000$ T-shirts.
Tony’s cost information is shown in the chart for volume between $500$ and $4,000$ shirts.
When presented graphically, notice what happens when Tony steps outside of his original relevant range and has to add a second employee and a second screen-printing machine:
It is important to remember that even though Tony’s costs stepped up when he exceeded his original capacity (relevant range), the behavior of the costs did not change. His fixed costs still remained fixed in total and his total variable cost rose as the number of T-shirts he produced rose. Table $5$ summarizes how costs behave within their relevant ranges.
Table $5$: Summary of Fixed and Variable Cost Behaviors
Cost In Total Per Unit
Variable Cost Changes in response to the level of activity Remains fixed per unit regardless of the level of activity
Fixed Cost Does not change with the level of activity, within the relevant range, but does change when the relevant range changes Changes based upon activity within the relevant range: increased activity decreases per-unit cost; decreased activity increases per-unit cost
Product versus Period Costs
Many businesses can make decisions by dividing their costs into fixed and variable costs, but there are some business decisions that require grouping costs differently. Sometimes companies need to consider how those costs are reported in the financial statements. At other times, companies group costs based on functions within the business. For example, a business would group administrative and selling expenses by the period (monthly or quarterly) so that they can be reported on an Income Statement. However, a manufacturing firm may carry product costs such as materials from one period to the other in order to have the costs “travel” with the units being produced. It is possible that both the selling and administrative costs and materials costs have both fixed and variable components. As a result, it may be necessary to analyze some fixed costs together with some variable costs. Ultimately, businesses strategically group costs in order to make them more useful for decision-making and planning. Two of the broadest and most common grouping of costs are product costs and period costs.
Product costs are all those associated with the acquisition or production of goods and products. When products are purchased for resale, the cost of goods is recorded as an asset on the company’s balance sheet. It is not until the products are sold that they become an expense on the income statement. By moving product costs to the expense account for the cost of goods sold, they are easily matched to the sales revenue income account. For example, Bert’s Bikes is a bicycle retailer who purchases bikes from several wholesale distributors and manufacturers. When Bert purchases bicycles for resale, he places the cost of the bikes into his inventory account, because that is what those bikes are—his inventory available for sale. It is not until someone purchases a bike that it creates sales revenue, and in order to fulfill the requirements of double-entry accounting, he must match that income with an expense: the cost of goods sold (Figure $10$).
Some product costs have both a fixed and variable component. For example, Bert purchases $10$ bikes for $\100$ each. The distributor charges $\10$ per bike for shipping for $1$ to $10$ bikes but $\8$ per bike for $11$ to $20$ bikes. This shipping cost is fixed per unit but varies in total. If Bert wants to save money and control his cost of goods sold, he can order an $11^{th}$ bike and drop his shipping cost by $\2$ per bike. It is important for Bert to know what is fixed and what is variable so that he can control his costs as much as possible.
What about the costs Bert incurs that are not product costs? Period costs are simply all of the expenses that are not product costs, such as all selling and administrative expenses. It is important to remember that period costs are treated as expenses in the period in which they occur. In other words, they follow the rules of accrual accounting practice by recognizing the cost (expense) in the period in which they occur regardless of when the cash changes hands. For example, Bert pays his business insurance in January of each year. Bert’s annual insurance premium is $\10,800$, which is $\900$ per month. Each month, Bert will recognize $1/12$ of this insurance cost as an expense in the period in which it is incurred (Figure $11$).
Why is it so important for Bert to know which costs are product costs and which are period costs? Bert may have little control over his product costs, but he maintains a great deal of control over many of his period costs. For this reason, it is important that Bert be able to identify his period costs and then determine which of them are fixed and which are variable. Remember that fixed costs are fixed over the relevant range, but variable costs change with the level of activity. If Bert wants to control his costs to make his bike business more profitable, he must be able to differentiate between the costs he can and cannot control.
Just like a merchandising business such as Bert’s Bikes, manufacturers also classify their costs as either product costs or period costs. For a manufacturing business, product costs are the costs associated with making the product, and period costs are all other costs. For the purposes of external reporting, separating costs into period and product costs is not all that is necessary. However, for management decision-making activities, refinement of the types of product costs is helpful.
In a manufacturing firm, the need for management to be aware of the types of costs that make up the cost of a product is of paramount importance. Let’s look at Carolina Yachts again and examine how they can classify the product costs associated with building their sportfishing boats. Just like automobiles, every year, Carolina Yachts makes changes to their boats, introducing new models to their product line. When the engineers begin to redesign boats for the next year, they must be careful not to make changes that would drive the selling price of their boats too high, making them less attractive to the customer. The engineers need to know exactly what the addition of another feature will do to the cost of production. It is not enough for them to get total product cost data; instead, they need specific information about the three classes of product costs: materials, labor, and overhead.
As you’ve learned, direct materials are the raw materials and component parts that are directly economically traceable to a unit of production.
Table $6$ provides some examples of direct materials.
Table $6$: Examples of Direct Materials
Manufacturing Business Product Direct Materials
Bakery Birthday cakes Flour, sugar, eggs, milk
Automobile manufacturer Cars Glass, steel, tires, carpet
Furniture manufacturer Recliners Wood, fabric, cotton batting
In each of the examples, managers are able to trace the cost of the materials directly to a specific unit (cake, car, or chair) produced. Since the amount of direct materials required will change based on the number of units produced, direct materials are almost always classified as a variable cost. They remain fixed per unit of production but change in total based on the level of activity within the business.
It takes more than materials for Carolina Yachts to build a boat. It requires the application of labor to the raw materials and component parts. You’ve also learned that direct labor is the work of the employees who are directly involved in the production of goods or services. In fact, for many industries, the largest cost incurred in the production process is labor. For Carolina Yachts, their direct labor would include the wages paid to the carpenters, painters, electricians, and welders who build the boats. Like direct materials, direct labor is typically treated as a variable cost because it varies with the level of activity. However, there are some companies that pay a flat weekly or monthly salary for production workers, and for these employees, their compensation could be classified as a fixed cost. For example, many auto mechanics are now paid a flat weekly or monthly salary.
While in the example Carolina Yachts is dependent upon direct labor, the production process for companies in many industries is moving from human labor to a more automated production process. For these companies, direct labor in these industries is becoming less significant. For an example, you can research the current production process for the automobile industry.
The third major classification of product costs for a manufacturing business is overhead. Manufacturing overhead (sometimes referred to as factory overhead) includes all of the costs that a manufacturing business incurs, other than the variable costs of direct materials and direct labor required to build products. These overhead costs are not directly attributable to a specific unit of production, but they are incurred to support the production of goods. Some of the items included in manufacturing overhead include supervisor salaries, depreciation on the factory, maintenance, insurance, and utilities. It is important to note that manufacturing overhead does not include any of the selling or administrative functions of a business. For Carolina Yachts, costs like the sales, marketing, CEO, and clerical staff salaries will not be included in the calculation of manufacturing overhead costs but will instead be allocated to selling and administrative expenses.
As you have learned, much of the power of managerial accounting is its ability to break costs down into the smallest possible trackable unit. This also applies to manufacturing overhead. In many cases, businesses have a need to further refine their overhead costs and will track indirect labor and indirect materials.
When labor costs are incurred but are not directly involved in the active conversion of materials into finished products, they are classified as indirect labor costs. For example, Carolina Yachts has production supervisors who oversee the manufacturing process but do not actively participate in the construction of the boats. Their wages generally support the production process but cannot be traced back to a single unit. For this reason, the production supervisors’ salary would be classified as indirect labor. Similar to direct labor, on a product or department basis, indirect labor, such as the supervisor’s salary, is often treated as a fixed cost, assuming that it does not vary with the level of activity or number of units produced. However, if you are considering the supervisor’s salary cost on a per unit of production basis, then it could be considered a variable cost.
Similarly, not all materials used in the production process can be traced back to a specific unit of production. When this is the case, they are classified as indirect material costs. Although needed to produce the product, these indirect material costs are not traceable to a specific unit of production. For Carolina Yachts, their indirect materials include supplies like tools, glue, wax, and cleaning supplies. These materials are required to build a boat, but management cannot easily track how much of a bottle of glue they use or how often they use a particular drill to build a specific boat. These indirect materials and their associated cost represent a small fraction of the total materials needed to complete a unit of production. Like direct materials, indirect materials are classified as a variable cost since they vary with the level of production. Table $7$ provides some examples of manufacturing costs and their classifications.
Table $7$: Examples of Classifications of Manufacturing Costs
Cost Classification Fixed or Variable
Production supervisor salary Indirect labor Fixed
Raw materials used in production Direct materials Variable
Wages of production employees Direct labor Variable
Straight-line depreciation on factory equipment General manufacturing overhead Fixed
Glue and adhesives Indirect materials Variable
Prime Costs versus Conversion Costs
In certain production environments, once a business has separated the costs of the product into direct materials, direct labor, and overhead, the costs can then be gathered into two broader categories: prime costs and conversion costs. Prime costs are the direct material expenses and direct labor costs, while conversion costs are direct labor and general factory overhead combined. Please note that these two categories of costs are examples of cost categories where a particular cost can be included in both. In this case, direct labor is included in both prime costs and conversion costs.
These cost classifications are common in businesses that produce large quantities of an item that is then packaged into smaller, sellable quantities such as soft drinks or cereal. In these types of production environments, it easier to lump the costs of direct labor and overhead into one category, since these costs are what are needed to convert raw materials into a finished product. This method of costing is termed process costing and is covered in Process Costing.
Although it seems as if there are many classifications or labels associated with costs, remember that the purpose of cost classification is to assist managers in the decision-making process. Since this type of data is not used for external reporting purposes, it is important to understand that (1) a single cost can have many different labels; (2) the terms are used independently, not simultaneously; and (3) each classification is important to understand in order to make business decisions. Figure $12$ uses some example costs to demonstrate these principles.
Effects of Changes in Activity Level on Unit Costs and Total Costs
We have spent considerable time identifying and describing the various ways that businesses categorize costs. However, categorization itself is not enough. It is important not only to understand the categorization of costs but to understand the relationships between changes in activity levels and the changes in costs in total. It is worth repeating that when a cost is considered to be fixed, that cost is only fixed for the relevant range. Once the boundary of the relevant range has been reached or moved beyond, fixed costs will change and then remain fixed for the new relevant range. Remember that, within a relevant range of activity, where the relevant range refers to a specific activity level that is bounded by a minimum and maximum amount, total fixed costs are constant, but costs change on a per-unit basis. Let’s examine an example that demonstrates how changes in activity can affect costs.
ETHICAL CONSIDERATIONS: Cost Accounting Helps Reduce Fraud and Promotes Ethical Behavior
Managerial and related cost accounting systems assist managers in making ethical and sound business decisions. Managerial accountants implement accounting reporting systems to minimize or prevent fraud and promote ethical decision-making. For example, tracking changes in costing activity and ensuring that activity remains in a relevant range, helps ensure that an organization’s business activity is properly bounded within a reasonable range of expense. If the minimum or maximum expense range is exceeded, this can indicate that management is acting without authority or is pursuing unauthorized activities. Excessive costs may even be a red flag that possible fraud is occurring. Cost accounting helps ensure that financial costs are within an acceptable range and helps an organization make reliable forward-looking financial decisions.
Comprehensive Example of the Effect on Changes in Activity Level on Costs
Pat is planning a three-day ski trip on his spring break after he works on a Habitat for Humanity project in Dallas. The costs for the trip are as follows:
He is considering his costs for the trip if he goes alone, or if he takes one, two, three, or four friends. However, before he can begin his analysis, he needs to consider the characteristics of the costs. Some of the costs will stay the same no matter how many people go, and some of the costs will fluctuate, based on the number of participants.
Those costs that do not change are the fixed costs. Once you incur a fixed cost, it does not change within a given range. For example, Pat can take up to five people in one car, so the cost of the car is fixed for up to five people. However, if he took more friends, then he would need more cars. The condo rental and the gasoline expenses would also be considered fixed costs, because they are not going to change in the reference range.
The costs that do change as the number of participants change are the variable costs. The food and lift ticket expenses are examples of variable costs, since they fluctuate based upon the number of participants and the number of days of activities.
In analyzing the costs, Pat also needs to consider the total costs and average costs. The analysis will calculate the average fixed costs, the total fixed costs, the average variable costs, and the total variable costs.
In the analysis of total costs versus average costs, both total and average fixed costs will stay the same and total and average variable costs will change. Here are the total fixed costs:
The total fixed costs for the trip will be $\720.00$, no matter whether Pat goes alone or takes up to $4$ friends. However, the average fixed costs will be the total fixed costs divided by the number of participants. The average fixed cost could range from $\720 (720/1)$ to $\144 (720/5)$.
Here are the variable costs:
The average variable cost will be $\70.00$ per person per day, no matter how many people go on the trip. However, the total variable costs will range from $\70.00$, if Pat goes alone, to $\350.00$, if five people go. Figure $16$ shows the relationships of the various costs, based on the number of participants.
Looking at this analysis, it is clear that, if there is an activity that you think that you cannot afford, it can become less expensive if you are creative in your cost-sharing techniques.
Example $1$: Spring Break Trip Planning
Margo is planning an $8$-day spring break trip from Atlanta, Georgia, to Tampa, Florida, leaving on Sunday and returning the following Sunday. She has located a condominium on the beach and has put a deposit down on the unit. The rental company has a maximum occupancy for the condominium of seven adults. There is an amusement park that she plans to visit. She is going to use her parents’ car, an SUV that can carry up to six people and their luggage. The SUV can travel an average of $20$ miles per gallon, the total distance is approximately $1,250$ miles ($550$ miles each way plus driving around Tampa every day), and the average price of gas is $\3$ per gallon. A season pass for an amusement park she wants to visit is $\168$ per person. Margo estimates spending $\40$ per day per person for food. She estimates the costs for the trip as follows:
Now that she has cost estimates, she is trying to decide how many of her friends she wants to invite. Since the car can only seat six people, Marg made a list of five other girls to invite. Use her data to answer the following questions and fill out the cost table:
1. What are the total variable costs for the trip?
2. What are the average variable costs for the trip?
3. What are the total fixed costs for the trip?
4. What are the average fixed costs for the trip?
5. What are the average costs per person for the trip?
6. What would the trip cost Margo if she were to go alone?
7. What additional costs would be incurred if a seventh girl was invited on the trip? Would this be a wise decision (from a cost perspective)? Why or why not?
8. Which cost will not be affected if a seventh girl was invited on the trip?
Solution
Answers will vary. All responses should recognize that there is no room in the car for the seventh girl and her luggage, although the condominium will accommodate the extra person. This means they will have to either find a larger vehicle and incur higher gas expenses or take a second car, which will at least double the fixed gas cost.
Footnotes
1. “Ethics Center.” Institute of Management Accountants. https://www.imanet.org/career-resour...center?ssopc=1
2. Attribution: Modification of work by Sharon Kioko and Justin Marlowe. “Cost Analysis.” Financial Strategy for Public Managers. CC BY 4.0. https://press.rebus.community/financ...cost-analysis/
3. Attribution: Modification of work by Roger Hermanson, James Edwards, and Michael Maher. Accounting Principles: A Business Perspective. 2011, CC BY. Source: Available at https://open.umn.edu/opentextbooks/textbooks/383.
4. Attribution: Modification of work by Roger Hermanson, James Edwards, and Michael Maher. Accounting Principles: A Business Perspective. 2011, CC BY. Source: Available at https://open.umn.edu/opentextbooks/textbooks/383. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/02%3A_Building_Blocks_of_Managerial_Accounting/2.03%3A_Identify_and_Apply_Basic_Cost_Behavior_Patterns.txt |
Sometimes, a business will need to use cost estimation techniques, particularly in the case of mixed costs, so that they can separate the fixed and variable components, since only the variable components change in the short run. Estimation is also useful for using current data to predict the effects of future changes in production on total costs. Three estimation techniques that can be used include the scatter graph, the high-low method, and regression analysis. Here we will demonstrate the scatter graph and the high-low methods (you will learn the regression analysis technique in advanced managerial accounting courses.
Functions of Cost Equations
The cost equation is a linear equation that takes into consideration total fixed costs, the fixed component of mixed costs, and variable cost per unit. Cost equations can use past data to determine patterns of past costs that can then project future costs, or they can use estimated or expected future data to estimate future costs. Recall the mixed cost equation:
$y=a+b x$
where $Y$ is the total mixed cost, $a$ is the fixed cost, $b$ is the variable cost per unit, and $x$ is the level of activity.
Let’s take a more in-depth look at the cost equation by examining the costs incurred by Eagle Electronics in the manufacture of home security systems, as shown in Table $1$.
Table $1$: Cost Information for Eagle Electronics
Cost Incurred Fixed or Variable Cost
Lease on manufacturing equipment Fixed $50,000 per year Supervisor salary Fixed$75,000 per year
Direct materials Variable $50 per unit Direct labor Variable$20 per unit
By applying the cost equation, Eagle Electronics can predict its costs at any level of activity ($x$) as follows:
1. Determine total fixed costs: $\50,000 + \75,000 = \125,000$
2. Determine variable costs per unit: $\50 + \20 = \70$
3. Complete the cost equation: $Y = \125,000 + \70x$
Using this equation, Eagle Electronics can now predict its total costs ($Y$) for any given level of activity ($x$), as in Figure $1$:
When using this approach, Eagle Electronics must be certain that it is only predicting costs for its relevant range. For example, if they must hire a second supervisor in order to produce $12,000$ units, they must go back and adjust the total fixed costs used in the equation. Likewise, if variable costs per unit change, these must also be adjusted.
This same approach can be used to predict costs for service and merchandising firms, as shown by examining the costs incurred by J&L Accounting to prepare a corporate income tax return, shown in Table $2$.
Table $2$: Cost Information for J&L Accounting
Cost Incurred Fixed or Variable Cost
Building rent Fixed $1,000 per month Direct labor (for CPAs) Variable$250 per tax return
Secretarial staff Fixed $2,000 per month Accounting clerks Variable$100 per return
J&L wants to predict their total costs if they complete $25$ corporate tax returns in the month of February.
1. Determine total fixed costs: $\1,000 + \2,000 = \3,000$
2. Determine variable costs per tax return: $\250 + \100 = \350$
3. Complete the cost equation: $Y = \3,000 + \350x$
Using this equation, J&L can now predict its total costs ($Y$) for the month of February when they anticipate preparing $25$ corporate tax returns:
$\begin{array}{l}{Y=\ 3,000+(\ 350 \times 25)} \ {Y=\ 3,000+\ 8,750} \ {Y=\ 11,750}\end{array}$
J&L can now use this predicted total cost figure of $\11,750$ to make decisions regarding how much to charge clients or how much cash they need to cover expenses. Again, J&L must be careful to try not to predict costs outside of the relevant range without adjusting the corresponding total cost components.
J&L can make predictions for their costs because they have the data they need, but what happens when a business wants to estimate total costs but has not collected data regarding per-unit costs? This is the case for the managers at the Beach Inn, a small hotel on the coast of South Carolina. They know what their costs were for June, but now they want to predict their costs for July. They have gathered the information in Figure $2$.
In June, they had an occupancy of $75$ nights. For the Beach Inn, occupancy (rooms rented) is the cost driver. Since they know what is driving their costs, they can determine their per-unit variable costs in order to forecast future costs:
$\begin{array}{l}{\dfrac{\text { Front Desk Staff }}{75\text { nights }}=\dfrac{\ 3,800}{75}=\ 50.67 \text { variable front desk staff costs per night }} \ {\dfrac{\text { Cleaning Staff }}{75\text {nights }}=\dfrac{\ 2,500}{75}=\ 33.33 \text { variable cleaning staff costs per night }} \ {\dfrac{\text { Laundry Service }}{75 \text { nights }}=\dfrac{\ 1,200}{75}=\ 16.00 \text { variable laundry service costs per night }}\end{array}$
Now, the Beach Inn can apply the cost equation in order to forecast total costs for any number of nights, within the relevant range.
1. Determine total fixed costs: $\700 + \2,500 = \3,200$
2. Determine variable costs per night of occupancy: $\50.67 + \33.33 + \16.00 = \100$
3. Complete the cost equation: $Y = \3,200 + 100x$
Using this equation, the Beach Inn can now predict its total costs ($Y$) for the month of July, when they anticipate an occupancy of $93$ nights.
$\begin{array}{l}{Y=\ 3,200+(\ 100 \times 93)} \ {Y=\ 3,200+\ 9,300} \ {Y=\ 12,500}\end{array}$
In all three examples, managers used cost data they have collected to forecast future costs at various activity levels.
Example $1$: Waymaker Furniture
Waymaker Furniture has collected cost information from its production process and now wants to predict costs for various levels of activity. They plan to use the cost equation to formulate these predictions. Information gathered from March is presented in Table $3$.
Table $3$: March Cost Information for Waymaker Furniture
Cost Incurred Fixed or Variable March Cost
Plant supervisor salary Fixed $12,000 per month Lumber (direct materials) Variable$75,000 total
Production worker wages Variable $11.00 per hour Machine maintenance Variable$5.00 per unit produced
Lease on factory Fixed $15,000 per month In March, Waymaker produced $1,000$ units and used $2,000$ hours of production labor. Using this information and the cost equation, predict Waymaker’s total costs for the levels of production in Table $4$. Table $4$: Waymaker’s Levels of Production Month Activity Level April 1,500 units May 2,000 units June 2,500 units Solution $\text {Total Fixed Cost} = \12,000 + \15,000 = \27,000$. $\text { Direct Materials per Unit }=\dfrac {\ 75,000 }{1,000} \text { Units }=\ 75 \text { per unit}$. $\text {Direct Labor per Hour} = \11.00$. $\text {Machine Maintenance} = \5.00 \text {per unit}$. $\text {Total Variable Cost per Unit} = \75 + \11 + \5 = \91 \text {per unit}$. Demonstration of the Scatter Graph Method to Calculate Future Costs at Varying Activity Levels One of the assumptions that managers must make in order to use the cost equation is that the relationship between activity and costs is linear. In other words, costs rise in direct proportion to activity. A diagnostic tool that is used to verify this assumption is a scatter graph. A scatter graph shows plots of points that represent actual costs incurred for various levels of activity. Once the scatter graph is constructed, we draw a line (often referred to as a trend line) that appears to best fit the pattern of dots. Because the trend line is somewhat subjective, the scatter graph is often used as a preliminary tool to explore the possibility that the relationship between cost and activity is generally a linear relationship. When interpreting a scatter graph, it is important to remember that different people would likely draw different lines, which would lead to different estimations of fixed and variable costs. No one person’s line and cost estimates would necessarily be right or wrong compared to another; they would just be different. After using a scatter graph to determine whether cost and activity have a linear relationship, managers often move on to more precise processes for cost estimation, such as the high-low method or least-squares regression analysis. To demonstrate how a company would use a scatter graph, let’s turn to the data for Regent Airlines, which operates a fleet of regional jets serving the northeast United States. The Federal Aviation Administration establishes guidelines for routine aircraft maintenance based upon the number of flight hours. As a result, Regent finds that its maintenance costs vary from month to month with the number of flight hours, as depicted in Figure $4$. When creating the scatter graph, each point will represent a pair of activity and cost values. Maintenance costs are plotted on the vertical axis ($Y$), while flight hours are plotted on the horizontal axis ($X$). For instance, one point will represent $21,000$ hours and $84,000$ in costs. The next point on the graph will represent $23,000$ hours and $\90,000$ in costs, and so forth, until all of the pairs of data have been plotted. Finally, a trend line is added to the chart in order to assist managers in seeing if there is a positive, negative, or zero relationship between the activity level and cost. Figure $5$ shows a scatter graph for Regent Airlines. In scatter graphs, cost is considered the dependent variable because cost depends upon the level of activity. The activity is considered the independent variable since it is the cause of the variation in costs. Regent’s scatter graph shows a positive relationship between flight hours and maintenance costs because, as flight hours increase, maintenance costs also increase. This is referred to as a positive linear relationship or a linear cost behavior. Will all cost and activity relationships be linear? Only when there is a relationship between the activity and that particular cost. What if, instead, the cost of snow removal for the runways is plotted against flight hours? Suppose the snow removal costs are as listed in Table $5$. Table $5$: Snow Removal Costs Month Activity Level: Flight Hours Snow Removal Costs January 21,000$40,000
February 23,000 50,000
March 14,000 8,000
April 17,000 0
May 10,000 0
June 19,000 0
As you can see from the scatter graph, there is really not a linear relationship between how many flight hours are flown and the costs of snow removal. This makes sense as snow removal costs are linked to the amount of snow and the number of flights taking off and landing but not to how many hours the planes fly.
Using a scatter graph to determine if this linear relationship exists is an essential first step in cost behavior analysis. If the scatter graph reveals a linear cost behavior, then managers can proceed with a more sophisticated analyses to separate mixed costs into their fixed and variable components. However, if this linear relationship is not present, then other methods of analysis are not appropriate. Let’s examine the cost data from Regent Airline using the high-low method.
Demonstration of the High-Low Method to Calculate Future Costs at Varying Activity Levels
As you’ve learned, the purpose of identifying costs is to control them, and managers regularly use past costs to predict future costs. Since we know that variable costs change with the level of activity, we can conclude that there is usually a positive relationship between cost and activity: As one rises, so does the other. Ideally, this can be confirmed on a scatter graph. One of the simplest ways to analyze costs is to use the high-low method, a technique for separating the fixed and variable cost components of mixed costs. Using the highest and lowest levels of activity and their associated costs, we are able to estimate the variable cost components of mixed costs.
Once we have established that there is linear cost behavior, we can equate variable costs with the slope of the line, expressed as the rise of the line over the run. The steeper the slope of the line, the faster costs rise in response to a change in activity. Recall from the scatter graph that costs are the dependent $Y$ variable and activity is the independent $X$ variable. By examining the change in $Y$ relative to the change in $X$, we can predict cost:
$\text { Variable cost }=\dfrac{\text { Rise of the line }}{\text { Run of the line }}=\dfrac{Y_{2}-Y_{1}}{X_{2}-X_{1}}$
where $Y_2$ is the total cost at the highest level of activity; $Y_1$ is the total cost at the lowest level of activity; $X_2$ is the number of units, labor hours, etc., at the highest level of activity; and $X_1$ is the number of units, labor hours, etc., at the lowest level of activity.
Using the maintenance cost data from Regent Airlines shown in Figure $7$, we will examine how this method works in practice.
The first step in analyzing mixed costs with the high-low method is to identify the periods with the highest and lowest levels of activity. In this case, it would be February and May, as shown in Figure $8$. We always choose the highest and lowest activity and the costs that correspond with those levels of activity, even if they are not the highest and lowest costs.
We are now able to estimate the variable costs by dividing the difference between the costs of the high and the low periods by the change in activity using this formula:
$\text { Variable cost }=\dfrac{\text { Change in cost }}{\text { Change in Activity }}=\dfrac{\text { Cost at the high activity level- cost at the low activity level }}{\text { Highest activity level -Lowest activity level }}$
For Regent Airlines, this is:
$\text { Variable Cost}=\dfrac{\ 90,000-\ 64,500}{23,000-10,000}=\ 1.96 \text { per flight hour }$
Having determined that the variable cost per flight-hour is $\1.96$, we can now determine the amount of fixed costs. We can determine these fixed costs by taking the total costs at either the high or the low level of activity and subtracting this variable component. You will recall that total cost = fixed costs + variable costs, so the fixed cost component for Regent Airlines can be isolated as shown:
$\begin{array}{l}{\text { Fixed cost }=\text { total cost-variable cost }} \ {\text { Fixed cost }=\ 90,000-(23,000 \times \ 1.96)} \ {\text { Fixed cost }=\ 44,920}\end{array}$
Notice that if we had chosen the other data point, the low cost and activity, we would still get the same fixed cost of $\44,920 = [\64,500 – (10,000 × \1.96)]$.
Now that we have isolated both the fixed and the variable components, we can express Regent Airlines’ cost of maintenance using the total cost equation:
$Y=\ 44,920+\ 1.96 x$
where $Y$ is total cost and $x$ is flight hours.
Because we confirmed that the relationship between cost and activity at Regent exhibits linear cost behavior on the scatter graph, this equation allows managers at Regent Airlines to conclude that for every one unit increase in activity, there will be a corresponding rise in variable cost of $\1.96$. When put into practice, the managers at Regent Airlines can now predict their total costs at any level of activity, as shown in Figure $9$.
Although managers frequently use this method, it is not the most accurate approach to predicting future costs because it is based on only two pieces of cost data: the highest and the lowest levels of activity. Actual costs can vary significantly from these estimates, especially when the high or low activity levels are not representative of the usual level of activity within the business. For a more accurate model, the least-squares regression method would be used to separate mixed costs into their fixed and variable components. The least-squares regression method is a statistical technique that may be used to estimate the total cost at the given level of activity based on past cost data. Least-squares regression minimizes the errors of trying to fit a line between the data points and thus fits the line more closely to all the data points.
Understanding the various labels used for costs is the first step toward using costs to evaluate business decisions. You will learn more about these various labels and how they are applied in decision-making processes as you continue your study of managerial accounting in this course. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/02%3A_Building_Blocks_of_Managerial_Accounting/2.04%3A_Estimate_a_Variable_and_Fixed_Cost_Equation_and_Predict_Future_Costs.txt |
Section Summaries
2.1 Distinguish between Merchandising, Manufacturing, and Service Organizations
• Merchandising, manufacturing, and service organizations differ in what they provide to consumers; however, all three types of firms must control costs in order to remain profitable. The type of costs they incur is primarily determined by the product/good, or service they provide.
• As the type of organization differs, so does the way they account for costs. Some of these differences are reflected in the income statement.
2.2 Identify and Apply Basic Cost Behavior Patterns
• Costs can be broadly classified as either fixed or variable costs. However, in order for managers to manage effectively, these two cost classifications are often further expanded to include mixed, step, prime, and conversion costs.
• For manufacturing firms, it is essential that they differentiate among direct materials, direct labor, and manufacturing overhead in order to identify and manage their total product costs.
• For planning purposes, managers must be careful to consider the relevant range because it is only within this relevant range that total fixed costs remain constant.
2.3 Estimate a Variable and Fixed Cost Equation and Predict Future Costs
• In order to make business decisions, managers can utilize past cost data to predict future costs employing three methods: scatter graphs, the high-low method, and least-squares regression analysis.
• Scatter graphs are used as a diagnostic tool to determine if the relationship between activity and cost is a linear relationship.
• Both the high-low method and the least-squares regression method separate mixed costs into their fixed and variable components to allow managers to predict future costs from historical costs.
Key Terms
average fixed cost (AFC)
total fixed costs divided by the total number of units produced, which results in a per-unit cost
average variable cost (AVC)
total variable costs divided by the total number of units produced, which results in a per-unit cost
conversion costs
total of labor and overhead for a product; the costs that “convert” the direct material into the finished product
cost driver
activity that is the reason for the increase or decrease of another cost; examples include labor hours incurred, labor costs paid, amounts of materials used in production, units produced, or any other activity that has a cause-and-effect relationship with incurred costs
direct labor
labor directly related to the manufacturing of the product or the production of a service
direct materials
materials used in the manufacturing process that can be traced directly to the product
fixed cost
unavoidable operating expense that does not change in total, regardless of the level of activity
high-low method
technique for separating the fixed and variable cost components of mixed costs
indirect labor
labor not directly involved in the active conversion of materials into finished products or the provision of services
indirect materials
materials used in production but not efficiently traceable to a specific unit of production
intangible good
good with financial value but no physical presence; examples include copyrights, patents, goodwill, and trademarks
manufacturing organization
business that uses parts, components, or raw materials to produce finished goods
manufacturing overhead
costs incurred in the production process that are not economically feasible to measure as direct material or direct labor costs; examples include indirect material, indirect labor, utilities, and depreciation
merchandising firm
business that purchases finished products and resells them to consumers
mixed costs
expenses that have a fixed component and a variable component
period costs
typically related to a particular time period instead of attached to the production of an asset; treated as an expense in the period incurred (examples include many sales and administrative expenses)
prime costs
direct material expenses and direct labor costs
product costs
all expenses required to manufacture the product: direct materials, direct labor, and manufacturing overhead
relevant range
quantitative range of units that can be produced based on the company’s current productive assets; for example, if a company has sufficient fixed assets to produce up to 10,000 units of product, the relevant range would be between 0 and 10,000 units
scatter graph
plot of pairs of numerical data that represents actual costs incurred for various levels of activity, with one variable on each axis, used to determine whether there is a relationship between them
service organization
business that earns revenue primarily by providing an intangible product
stepped cost
one that changes with the level of activity but will remain constant within a relevant range
tangible good
physical good that customers can handle and see
total cost
sum of all fixed and all variable costs
total fixed costs
sum of all fixed costs
total variable costs
sum of all variable costs
variable cost
one that varies in direct proportion to the level of activity within the business | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/02%3A_Building_Blocks_of_Managerial_Accounting/2.05%3A_Summary_and_Key_Terms.txt |
Multiple Choice
1. Which of the following is the primary source of revenue for a service business?
1. the production of products from raw materials
2. the purchase and resale of finished products
3. providing intangible goods and services
4. the sale of raw materials to manufacturing firms
Answer:
c
1. Which of the following is the primary source of revenue for a merchandising business?
1. the production of products from raw materials
2. the purchase and resale of finished products
3. the provision of intangible goods and services
4. the sale of raw materials to manufacturing firms
2. Which of the following is the primary source of revenue for a manufacturing business?
1. the production of products from raw materials
2. the purchase and resale of finished products
3. the provision of intangible goods and services
4. both the provision of services and the sale of finished goods
Answer:
a
1. Which of the following represents the components of the income statement for a service business?
1. Sales Revenue – Cost of Goods Sold = gross profit
2. Service Revenue – Operating Expenses = operating income
3. Sales Revenue – Cost of Goods Manufactured = gross profit
4. Service Revenue – Cost of Goods Purchased = gross profit
2. Which of the following represents the components of the income statement for a manufacturing business?
1. Sales Revenue – Cost of Goods Sold = gross profit
2. Service Revenue – Operating Expenses = gross profit
3. Service Revenue – Cost of Goods Manufactured = gross profit
4. Sales Revenue – Cost of Goods Manufactured = gross profit
Answer:
a
1. Which of the following represents the components of the income statement for a merchandising business?
1. Sales Revenue – Cost of Goods Sold = gross profit
2. Service Revenue – Operating Expenses = gross profit
3. Sales Revenue – Cost of Goods Manufactured = gross profit
4. Service Revenue – Cost of Goods Purchased = gross profit
2. Conversion costs include all of the following except:
1. wages of production workers
2. depreciation on factory equipment
3. factory utilities
4. direct materials purchased
Answer:
d
1. Which of the following is not considered a product cost?
1. direct materials
2. direct labor
3. indirect materials
4. selling expense
2. Fixed costs are expenses that ________.
1. vary in response to changes in activity level
2. remain constant on a per-unit basis
3. increase on a per-unit basis as activity increases
4. remain constant as activity changes
Answer:
d
1. Variable costs are expenses that ________.
1. remain constant on a per-unit basis but change in total based on activity level
2. remain constant on a per-unit basis and remain constant in total regardless of activity level
3. decrease on a per-unit basis as activity level increases
4. remain constant in total regardless of activity level within a relevant range
2. Total costs for ABC Distributing are \(\$250,000\) when the activity level is \(10,000\) units. If variable costs are \(\$5\) per unit, what are their fixed costs?
1. \(\$240,000\)
2. \(\$200,000\)
3. \(\$260,000\)
4. Their fixed costs cannot be determined from the information presented.
Answer:
b
1. Which of the following would not be classified as manufacturing overhead?
1. indirect materials
2. indirect labor
3. direct labor
4. property taxes on factory
2. Which of the following are prime costs?
1. indirect materials, indirect labor, and direct labor
2. direct labor, indirect materials, and indirect labor
3. direct labor and indirect labor
4. direct labor and direct materials
Answer:
d
1. Which of the following statements is true regarding average fixed costs?
1. Average fixed costs per unit remain fixed regardless of level of activity.
2. Average fixed costs per unit rise as the level of activity rises.
3. Average fixed costs per unit fall as the level of activity rises.
4. Average fixed costs per unit cannot be determined.
2. The high-low method and least-squares regression are used by managers to ________.
1. decide whether to make or buy a component part
2. minimize corporate tax liability
3. maximize output
4. estimate costs
Answer:
d
1. Which of the following methods of cost estimation relies on only two data points?
1. the high-low method
2. account analysis
3. least-squares regression
4. SWOT analysis.
2. In the cost equation \(Y = a + bx\), \(Y\) represents which of the following?
1. fixed costs
2. variable costs
3. total costs
4. units of production
Answer:
c
1. A scatter graph is used to test the assumption that the relationship between cost and activity level is ________.
1. curvilinear
2. cyclical
3. unpredictable
4. linear
Questions
1. Identify the three primary classifications of businesses and explain the differences among the three.
Answer:
Answers will vary but should include merchandising, service, and manufacturing businesses.
1. Explain how the income statement of a manufacturing company differs from the income statement of a merchandising company.
2. Walsh & Coggins, a professional accounting firm, collects cost information about the services they provide to their clients. Describe the types of cost data they would collect and explain the importance of analyzing this cost data.
Answer:
Answers will vary but should include a discussion of operating costs such as salaries and wages, advertising, rent, and office expenses.
1. Lizzy’s is a retail clothing store, specializing in formal wear for weddings. They purchase their clothing for resale from specialty distributors and manufacturers. Recently the owners of Lizzy’s have noted an increased interest in costume jewelry and fashion accessories among their clientele. If the owners of Lizzy’s decide to expand their business to include these products, what cost data would they need to collect and analyze prior to expanding the business?
2. Identify and describe the three types of product costs in a manufacturing firm.
Answer:
Answers will vary but must include direct materials, direct labor, and manufacturing overhead.
1. Explain the difference between a period cost and a product cost.
2. Explain the concept of relevant range and how it affects total fixed costs.
Answer:
Answers will vary but should include that fixed costs remain fixed in total across the relevant range, bounded by a minimum and maximum activity level.
1. Explain the differences among fixed costs, variable costs, and mixed costs.
2. Explain the difference between prime costs and conversion costs.
Answer:
Answers will vary but should include that prime costs are the direct material and direct labor costs, and conversion costs are direct labor and general factory overhead combined.
1. Explain how a scatter graph is used to identify and measure cost behavior.
2. Explain the components of the total cost equation and describe how each of the components can be used by management for decision-making.
Answer:
Answers will vary.
1. Explain how the high-low method is used for cost estimation. What, if any, are the limitations of this approach to cost estimation?
Exercise Set A
1. Magio Company manufactures kitchen equipment used in hospitals. They distribute their products directly to the customer and, for the year ending 2019, they reported the following revenues and expenses. Use this information to construct an income statement for the year 2019.
1. Park and West, LLC, provides consulting services to retail merchandisers in the Midwest. In 2019, they generated \(\$720,000\) in service revenue. Their total cost (fixed and variable) per client was \(\$2,500\) and they served \(115\) clients during the year. If operating expenses for the year were \(\$302,000\) what was their net income?
2. Canine Couture is a specialty dog clothing boutique that sells clothing and clothing accessories for dogs. In 2019, they had gross revenue from sales totaling \(\$86,500\). Their operating expenses for this same period were \(\$27,500\). If their Cost of Goods Sold (COGS) was \(24\%\) of gross revenue, what was their net operating income for the year?
3. Hicks Contracting collects and analyzes cost data in order to track the cost of installing decks on new home construction jobs. The following are some of the costs that they incur. Classify these costs as fixed or variable costs and as product or period costs.
1. Lumber used to construct decks (\(\$12.00\) per square foot)
2. Carpenter labor used to construct decks (\(\$10\) per hour)
3. Construction supervisor salary (\(\$45,000\) per year)
4. Depreciation on tools and equipment (\(\$6,000\) per year)
5. Selling and administrative expenses (\(\$35,000\) per year)
6. Rent on corporate office space (\(\$34,000\) per year)
7. Nails, glue, and other materials required to construct deck (varies per job)
4. Rose Company has a relevant range of production between \(10,000\) and \(25,000\) units. The following cost data represents average cost per unit for \(15,000\) units of production.
Using the cost data from Rose Company, answer the following questions:
1. If \(10,000\) units are produced, what is the variable cost per unit?
2. If \(18,000\) units are produced, what is the variable cost per unit?
3. If \(21,000\) units are produced, what are the total variable costs?
4. If \(11,000\) units are produced, what are the total variable costs?
5. If \(19,000\) units are produced, what are the total manufacturing overhead costs incurred?
6. If \(23,000\) units are produced, what are the total manufacturing overhead costs incurred?
7. If \(19,000\) units are produced, what are the per unit manufacturing overhead costs incurred?
8. If \(25,000\) units are produced, what are the per unit manufacturing overhead costs incurred?
1. Carr Company provides human resource consulting services to small- and medium-sized companies. Last year, Carr provided services to \(700\) clients. Total fixed costs were \(\$159,000\) with total variable costs of \(\$87,500\). Based on this information, complete this chart:
1. Western Trucking operates a fleet of delivery trucks. The fixed expenses to operate the fleet are \(\$79,900\) in March and rose to \(\$93,120\) in April. It costs Western Trucking \(\$0.15\) per mile in variable costs. In March, the delivery trucks were driven a total of \(85,000\) miles, and in April, they were driven a total of \(96,000\) miles. Using this information, answer the following:
1. What were the total costs to operate the fleet in March and April, respectively?
2. What were the cost per mile to operate the fleet in March and April, respectively?
2. Suppose that a company has fixed costs of \(\$18\) per unit and variable costs \(\$9\) per unit when \(15,000\) units are produced. What are the fixed costs per unit when \(12,000\) units are produced?
3. The cost data for Evencoat Paint for the year 2019 is as follows:
1. Using the high-low method, express the company’s maintenance costs as an equation where \(x\) represents the gallons of paint produced. Then estimate the fixed and variable costs.
2. Predict the maintenance costs if \(90,000\) gallons of paint are produced.
3. Predict the maintenance costs if \(81,000\) gallons of paint are produced.
4. Using Excel, create a scatter graph of the cost data and explain the relationship between gallons of paint produced and equipment maintenance expenses
1. This cost data from Hickory Furniture is for the year 2017.
1. Using the high-low method, express the company’s utility costs as an equation where X represents number of tables produced.
2. Predict the utility costs if \(800\) tables are produced.
3. Predict the utility costs if \(600\) tables are produced.
4. Using Excel, create a scatter graph of the cost data and explain the relationship between number of tables produced and utility expenses.
1. Markson and Sons leases a copy machine with terms that include a fixed fee each month plus a charge for each copy made. Markson made \(9,000\) copies and paid a total of \(\$480\) in January. In April, they paid \(\$320\) for \(5,000\) copies. What is the variable cost per copy if Markson uses the high-low method to analyze costs?
2. Markson and Sons leases a copy machine with terms that include a fixed fee each month of \(\$500\) plus a charge for each copy made. The company uses the high-low method to analyze costs. If Markson paid \(\$360\) for \(5,000\) copies and \(\$280\) for \(3,000\) copies, how much would Markson pay if it made \(7,500\) copies?
Exercise Set B
1. Winterfell Products manufactures electrical switches for the aerospace industry. For the year ending 2019, they reported these revenues and expenses. Use this information to construct an income statement for the year 2019.
1. CPK & Associates is a mid-size legal firm, specializing in closings and real estate law in the south. In 2019, they generated \(\$945,000\) in sales revenue. Their expenses related to this year’s revenue are shown:
Based on the information provided for the year, what was their net operating income?
1. Flip or Flop is a retail shop selling a wide variety of sandals and beach footwear. In 2019, they had gross revenue from sales totaling \(\$93,200\). Their operating expenses for this same period were \(\$34,000\). If their Cost of Goods Sold (COGS) was \(21\%\) of gross revenue, what was their net operating income for the year?
2. Roper Furniture manufactures office furniture and tracks cost data across their process. The following are some of the costs that they incur. Classify these costs as fixed or variable costs, and as product costs or period costs.
1. Wood used to produce desks (\(\$125.00\) per desk)
2. Production labor used to produce desks (\(\$15\) per hour)
3. Production supervisor salary (\(\$45,000\) per year)
4. Depreciation on factory equipment (\(\$60,000\) per year)
5. Selling and administrative expenses (\(\$45,000\) per year)
6. Rent on corporate office (\(\$44,000\) per year)
7. Nails, glue, and other materials required to produce desks (varies per desk)
8. Utilities expenses for production facility
9. Sales staff commission (\(5\%\) of gross sales)
3. Baxter Company has a relevant range of production between \(15,000\) and \(30,000\) units. The following cost data represents average variable costs per unit for \(25,000\) units of production.
Using the costs data from Rose Company, answer the following questions:
1. If \(15,000\) units are produced, what is the variable cost per unit?
2. If \(28,000\) units are produced, what is the variable cost per unit?
3. If \(21,000\) units are produced, what are the total variable costs?
4. If \(29,000\) units are produced, what are the total variable costs?
5. If \(17,000\) units are produced, what are the total manufacturing overhead costs incurred?
6. If \(23,000\) units are produced, what are the total manufacturing overhead costs incurred?
7. If \(30,000\) units are produced, what are the per unit manufacturing overhead costs incurred?
8. If \(15,000\) units are produced, what are the per unit manufacturing overhead costs incurred?
1. Sanchez & Vukmin, LLP, is a full-service accounting firm located near Chicago, Illinois. Last year, Sanchez provided tax preparation services to \(500\) clients. Total fixed costs were \(\$265,000\) with total variable costs of \(\$180,000\). Based on this information, complete this chart.
1. Case Airlines provides charter airline services. The fixed expenses to operate the company’s aircraft are \(\$377,300\) in January and \(\$378,880\) in February. It costs Case Airlines \(\$0.45\) per mile in variable costs. In January, Case aircraft flew a total of \(385,000\) miles, and in February, Case aircraft flew a total of \(296,000\) miles. Using this information, answer the following:
1. What were the total costs to operate the aircraft in January and February, respectively?
2. What were the total costs per mile to operate the fleet in January and February, respectively?
2. Suppose that a company has fixed costs of \(\$11\) per unit and variable costs \(\$6\) per unit when \(11,000\) units are produced. What are the fixed costs per unit when \(20,000\) units are produced?
3. The cost data for BC Billing Solutions for the year 2020 is as follows:
1. Using the high-low method, express the company’s overtime wages as an equation where \(x\) represents number of invoices processed. Assume BC has monthly fixed costs of \(\$3,800\).
2. Predict the overtime wages if \(9,000\) invoices are processed.
3. Predict the overtime wages if \(6,500\) invoices are processed.
4. Using Excel, create a scatter graph of the cost data and explain the relationship between the number of invoices processed and overtime wage expense.
1. This cost data from Hickory Furniture is for the year 2017.
1. Using Excel, create a scatter graph of the cost data and explain the relationship between number of chairs processed and utility expenses.
1. Able Transport operates a tour bus that they lease with terms that involve a fixed fee each month plus a charge for each mile driven. Able Transport drove the tour bus \(4,000\) miles and paid a total of \(\$1,250\) in March. In April, they paid \(\$970\) for \(3,000\) miles. What is the variable cost per mile if Able Transport uses the high-low method to analyze costs?
2. Able Transport operates a tour bus that they lease with terms that involve a fixed fee each month plus a charge for each mile driven. Able Transport drove the bus \(7,000\) miles and paid a total of \(\$1,360\) in June. In October, Able Transport paid \(\$1,280\) for the \(5,000\) miles driven. If Able Transport uses the high-low method to analyze costs, how much would Able Transport pay in December, if they drove \(6,000\) miles?
Problem Set A
1. Ballentine Manufacturing produces and sells lawnmowers through a national dealership network. They purchase raw materials from a variety of suppliers, and all manufacturing and assembly work is performed at their plant outside of Kansas City, Missouri. They recorded these costs for the year ending December 31, 2017. Construct an income statement for Ballentine Manufacturing to reflect their net income for 2017.
1. Tom West is a land surveyor who operates a small surveying company, performing surveys for both residential and commercial clients. He has a staff of surveyors and engineers who are employed by the firm. For the year ending December 31, 2017, he reported these income and expenses. Using this information, construct an income statement to reflect his net income for 2017.
1. Just Beachy is a retail business located on the coast of Florida where it sells a variety of beach apparel, T-shirts, and beach-related souvenir items. They purchase all of their inventory from wholesalers and distributors. For the year ending December 31, 2017, they reported these revenues and expenses. Using this information, prepare an income statement for Just Beachy for 2017.
1. Listed as follows are various costs found in businesses. Classify each cost as a fixed or variable cost, and as a product and/or period cost.
1. Wages of administrative staff
2. Shipping costs on merchandise sold
3. Wages of workers assembling computers
4. Cost of lease on factory equipment
5. Insurance on factory
6. Direct materials used in production of lamps
7. Supervisor salary, factory
8. Advertising costs
9. Property taxes, factory
10. Health insurance cost for company executives
11. Rent on factory
2. Wachowski Company reported these cost data for the year 2017.
Use the data to complete the following table.
Total prime costs
Total manufacturing overhead costs
Total conversion costs
Total product costs
Total period costs
1. Carolina Yachts builds custom yachts in its production factory in South Carolina. Once complete, these yachts must be shipped to the dealership. They have collected this shipping cost data:
1. Prepare a scatter graph of the shipping data. Plot cost on the vertical axis and yachts shipped on the horizontal axis. Is the relationship between shipping costs and unit shipped approximately linear? Draw a straight line through the scatter graph.
2. Using the high-low method, create the cost formula for Carolina Yachts’ shipping costs.
3. The least-squares regression method was used and the analysis resulted in this cost equation: \(Y = 4,000 + 1,275x\). Comment on the accuracy of your high-low method estimation.
4. What would you estimate shipping costs to be if Carolina Yachts shipped \(10\) yachts in a single month? Use the cost formula you obtained in part B. Comment on how accurately this is reflected by the scatter graph you constructed.
5. What factors other than number of yachts shipped do you think could affect Carolina Yachts’ shipping expense? Explain.
Problem Set B
1. Hicks Products produces and sells patio furniture through a national dealership network. They purchase raw materials from a variety of suppliers and all manufacturing, and assembly work is performed at their plant outside of Cleveland, Ohio. They recorded these costs for the year ending December 31, 2017. Construct an income statement for Hicks Products, to reflect their net income for 2017.
1. Conner & Scheer, Attorneys at Law, provide a wide range of legal services for their clients. They employ several paralegal and administrative support staff in order to provide high-quality legal services at competitive prices. For the year ending December 31, 2017, the firm reported these income and expenses. Using this information, construct an income statement to reflect the firm’s net income for 2017.
1. Puzzles, Pranks & Games is a retail business selling children’s toys and games as well as a wide selection of jigsaw puzzles and accessories. They purchase their inventory from local and national wholesale suppliers. For the year ending December 31, 2017, they reported these revenues and expenses. Using this information, prepare an income statement for Puzzles, Pranks & Games for 2017.
1. 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, or selling and 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
2. Using the costs listed in the previous problem, classify the costs as either product costs or period costs.
3. Gadell Farms produces venison sausage that is distributed to grocery stores throughout the Southeast. They have collected this shipping cost data:
1. Prepare a scatter graph of the shipping data. Plot cost on the vertical axis and tons produced on the horizontal axis. Is the relationship between packaging costs and tons produced approximately linear? Draw a straight line through the scatter graph.
2. Using the high-low method, estimate the cost formula for Gadell Farms’ packaging costs.
3. The least-squares regression method was used and the analysis resulted in this cost equation: \(Y = 1650 + 78.57x\). Comment on the accuracy of your high-low method estimation.
4. What would you estimate packaging costs to be if Gadell Farms shipped \(10\) tons in a single month? Use the cost formula you obtained in part B. Comment on how accurately this is reflected by the scatter graph you constructed.
5. What factors other than number of tons produced do you think could affect Gadell Farm’s packaging expense? Explain.
Thought Provokers
1. In a team of two or three students, interview the manager/owner of a local business. In this interview, ask the manager/owner the following questions:
1. Does the business collect and use cost information to make decisions?
2. Does it have a specialist in cost estimation who works with this cost data? If not, who is responsible for the collection of cost information? Be as specific as possible.
3. What type of cost information does the business collect and how is each type of information used?
4. How important does the owner/manager believe cost information is to the success of the business?
Then, write a report to the instructor summarizing the results of the interview.
Content of the memo must include
• date of the interview,
• the name and title of the person interviewed,
• name and location of the business,
• type of business (service, merchandising, manufacturing) and brief description of the goods/services provided by the business, and
• responses to questions A–D.
1. This list contains costs that various organizations incur; they fall into three categories: direct materials (DM), direct labor (DL), or overhead (OH).
1. Classify each of these items as direct materials, direct labor, or overhead.
1. Glue used to attach labels to bottles containing a patented medicine.
2. Compressed air used in operating paint sprayers for Student Painters, a company that paints houses and apartments.
3. Insurance on a factory building and equipment.
4. A production department supervisor’s salary.
5. Rent on factory machinery.
6. Iron ore in a steel mill.
7. Oil, gasoline, and grease for forklift trucks in a manufacturing company’s warehouse.
8. Services of painters in building construction.
9. Cutting oils used in machining operations.
10. Cost of paper towels in a factory employees’ washroom.
11. Payroll taxes and fringe benefits related to direct labor.
12. The plant electricians’ salaries.
13. Crude oil to an oil refinery.
14. Copy editor’s salary in a book publishing company.
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 and why. In which answers are you completely confident? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/02%3A_Building_Blocks_of_Managerial_Accounting/2.0E%3A_2.E%3A_Building_Blocks_of_Managerial_Accounting_%28Exercises%29.txt |
In this chapter, we will explore how managers can use cost-volume-profit analysis to make a wide range of decisions about their business operations.
Thumbnail: pixabay.com/photos/calculato...rance-1044173/
03: Cost-Volume-Profit Analysis
As president of the Accounting Club, you are working on a fundraiser selling T-shirts on campus. You have gotten quotes from several suppliers ranging from $\8$ to $\10$ per shirt and now have to select a vendor. The prices vary based on whether the T-shirts have pockets, have long sleeves or short sleeves, and are printed on one side or both. You are confident that you can sell them for $\15$ each. However, the college charges clubs a $\100$ “student sale” fee, and your T-shirt sales must cover this cost and still net the club enough money to pay for your spring trip
In addition, several of the vendors will give volume discounts—the more shirts you purchase, the less each shirt costs. In short, you need to know exactly which style of T-shirt, vendor, and quantity will allow you to reach your desired net income and cover your fixed expense of $\100$. You decide on a short-sleeve shirt with a pocket that costs $\10$ each and that you can sell for $\15$.
This $\5$ per shirt “gross profit” will first go toward covering the $\100$ student sale fee. That means you will have to sell $20$ shirts to pay the fee $\left (\frac {\ 100}{ \ 5}=20 \text{ shirts} \right )$. After selling the first $20$ shirts, the $\5$ profit will be available to start paying for the cost of the trip. Your faculty advisor has calculated that the trip will cost $\125$ per student, and you have $6$ people signed up for the trip. This means the sale will need to generate an additional $\750$ from the sale ($6$ students $\times \ 125$). At $\5$ per shirt you will need to sell $150$ shirts to cover the student costs $\left (\frac {\750}{\5} \right )$. So, you will need to sell a total of $170$ shirts: $20$ to cover your fixed cost of $\100$ and an additional $150$ to cover the student’s cost of the trip ($\750$). What you have just completed is a cost-volume-profit analysis. In this chapter, we will explore how managers can use this type of analysis to make a wide range of decisions about their business operations.
3.02: Explain Contribution Margin and Calculate Contribution Margin per Unit Contribution Margin Ratio and Total Contribution Margin
Before examining contribution margins, let’s review some key concepts: fixed costs, relevant range, variable costs, and contribution margin. Fixed costs are those costs that will not change within a given range of production. For example, in the current case, the fixed costs will be the student sales fee of \(\$100\). No matter how many shirts the club produces within the relevant range, the fee will be locked in at \(\$100\). The relevant range is the anticipated production activity level. Fixed costs remain constant within a relevant range. If production levels exceed expectations, then additional fixed costs will be required.
For example, assume that the students are going to lease vans from their university’s motor pool to drive to their conference. A university van will hold eight passengers, at a cost of \(\$200\) per van. If they send one to eight participants, the fixed cost for the van would be \(\$200\). If they send nine to sixteen students, the fixed cost would be \(\$400\) because they will need two vans. We would consider the relevant range to be between one and eight passengers, and the fixed cost in this range would be \(\$200\). If they exceed the initial relevant range, the fixed costs would increase to \(\$400\) for nine to sixteen passengers.
Variable costs are those costs that vary per unit of production. Direct materials are often typical variable costs, because you normally use more direct materials when you produce more items. In our example, if the students sold \(100\) shirts, assuming an individual variable cost per shirt of \(\$10\), the total variable costs would be \(\$1,000\) (\(100 × \$10\)). If they sold \(250\) shirts, again assuming an individual variable cost per shirt of \(\$10\), then the total variable costs would \(\$2,500 (250 × \$10)\).
Contribution margin is the amount by which a product’s selling price exceeds its total variable cost per unit. This difference between the sales price and the per unit variable cost is called the contribution margin because it is the per unit contribution toward covering the fixed costs. It typically is calculated by comparing the sales revenue generated by the sale of one item versus the variable cost of the item:
In our example, the sales revenue from one shirt is \(\$15\) and the variable cost of one shirt is \(\$10\), so the individual contribution margin is \(\$5\). This \(\$5\) contribution margin is assumed to first cover fixed costs first and then realized as profit.
As you will see, it is not just small operations, such as the accounting club scenario provided in Prelude, that benefit from cost-volume-profit (CVP) analysis. At some point, all businesses find themselves asking the same basic questions: How many units must be sold in order to reach a desired income level? How much will each unit cost? How much of the sales price from each unit will help cover our fixed costs? For example, Starbucks faces these same questions every day, only on a larger scale. When they introduce new menu items, such as seasonal specialty drinks, they must determine the fixed and variable costs associated with each item. Adding menu items may not only increase their fixed costs in the short run (via advertising and promotions) but will bring new variable costs. Starbucks needs to price these drinks in a way that covers the variable costs per unit and additional fixed costs and contributes to overall net income. Regardless of how large or small the enterprise, understanding how fixed costs, variable costs, and volume are related to income is vital for sound decision-making.
Understanding how to use fixed costs, variable costs, and sales in CVP analyses requires an understanding of the term margin. You may have heard that restaurants and grocery stores have very low margins, while jewelry stores and furniture stores have very high margins. What does “margin” mean? In the broadest terms, margin is the difference between a product or service's selling price and its cost of production. Recall the accounting club’s T-shirt sale. The difference between the sales price per T-shirt and the purchase price of the T-shirts was the accounting club’s margin:
Recall that Building Blocks of Managerial Accounting explained the characteristics of fixed and variable costs and introduced the basics of cost behavior. Let’s now apply these behaviors to the concept of contribution margin. The company will use this “margin” to cover fixed expenses and hopefully to provide a profit. Let’s begin by examining contribution margin on a per unit basis.
Unit Contribution Margin
When the contribution margin is calculated on a per unit basis, it is referred to as the contribution margin per unit or unit contribution margin. You can find the contribution margin per unit using the equation shown in Figure \(4\).
It is important to note that this unit contribution margin can be calculated either in dollars or as a percentage. To demonstrate this principle, let’s consider the costs and revenues of Hicks Manufacturing, a small company that manufactures and sells birdbaths to specialty retailers.
Hicks Manufacturing sells its Blue Jay Model for \(\$1100\) and incurs variable costs of \(\$20\) per unit. In order to calculate their per unit contribution margin, we use the formula in Figure \(4\) to determine that on a per unit basis, their contribution margin is:
This means that for every Blue Jay model they sell, they will have \(\$80\) to contribute toward covering fixed costs, such as rent, insurance, and manager salaries. But Hicks Manufacturing manufactures and sells more than one model of birdbath. They also sell a Cardinal Model for \(\$75\), and these birdbaths incur variable costs of \(\$15\) per unit. For the Cardinal Model, their contribution margin on a per unit basis is the \(\$75\) sales price less the \(\$15\) per unit variable costs is as follows:
This demonstrates that, for every Cardinal model they sell, they will have \(\$60\) to contribute toward covering fixed costs and, if there is any left, toward profit. Every product that a company manufactures or every service a company provides will have a unique contribution margin per unit. In these examples, the contribution margin per unit was calculated in dollars per unit, but another way to calculate contribution margin is as a ratio (percentage).
Contribution Margin Ratio
The contribution margin ratio is the percentage of a unit’s selling price that exceeds total unit variable costs. In other words, contribution margin is expressed as a percentage of sales price and is calculated using this formula:
For Hicks Manufacturing and their Blue Jay Model, the contribution margin ratio will be
At a contribution margin ratio of \(80\%\), approximately \(\$0.80\) of each sales dollar generated by the sale of a Blue Jay Model is available to cover fixed expenses and contribute to profit. The contribution margin ratio for the birdbath implies that, for every \(\$1\) generated by the sale of a Blue Jay Model, they have \(\$0.80\) that contributes to fixed costs and profit. Thus, \(20\%\) of each sales dollar represents the variable cost of the item and \(80\%\) of the sales dollar is margin. Just as each product or service has its own contribution margin on a per unit basis, each has a unique contribution margin ratio. Although this process is extremely useful for analyzing the profitability of a single product, good, or service, managers also need to see the “big picture” and will examine contribution margin in total across all products, goods, or services.
Example \(1\): Margin at the Kiosk
You rent a kiosk in the mall for \(\$300\) a month and use it to sell T-shirts with college logos from colleges and universities all over the world. You sell each T-shirt for \(\$25\), and your cost for each shirt is \(\$15\). You also pay your sales person a commission of \(\$0.50\) per T-shirt sold in addition to a salary of \(\$400\) per month. Construct a contribution margin income statement for two different months: in one month, assume \(100\) T-shirts are sold, and in the other, assume \(200\) T-shirts are sold.
Total Contribution Margin
This “big picture” is gained by calculating total contribution margin—the total amount by which total sales exceed total variable costs. We calculate total contribution margin by multiplying per unit contribution margin by sales volume or number of units sold. This approach allows managers to determine how much profit a company is making before paying its fixed expenses. For Hicks Manufacturing, if the managers want to determine how much their Blue Jay Model contributes to the overall profitability of the company, they can calculate total contribution margin as follows:
For the month of April, sales from the Blue Jay Model contributed \(\$36,000\) toward fixed costs. Looking at contribution margin in total allows managers to evaluate whether a particular product is profitable and how the sales revenue from that product contributes to the overall profitability of the company. In fact, we can create a specialized income statement called a contribution margin income statement to determine how changes in sales volume impact the bottom line.
To illustrate how this form of income statement can be used, contribution margin income statements for Hicks Manufacturing are shown for the months of April and May.
In April, Hicks sold \(500\) Blue Jay Models at \(\$100\) per unit, which resulted in the operating income shown on the contribution margin income statement:
In May, \(750\) of the Blue Jay models were sold as shown on the contribution margin income statement. When comparing the two statements, take note of what changed and what remained the same from April to May.
Using this contribution margin format makes it easy to see the impact of changing sales volume on operating income. Fixed costs remained unchanged; however, as more units are produced and sold, more of the per-unit sales price is available to contribute to the company’s net income.
Before going further, let’s note several key points about CVP and the contribution margin income statement. First, the contribution margin income statement is used for internal purposes and is not shared with external stakeholders. Secondly, in this specialized income statement, when “operating income” is shown, it actually refers to “net operating income” without regard to income taxes. Companies can also consider taxes when performing a CVP analysis to project both net operating income and net income. (The preparation of contribution margin income statements with regard to taxes is covered in advanced accounting courses; here, we will consider net income as net operating income without regard to taxes.)
Regardless of whether contribution margin is calculated on a per-unit basis, calculated as a ratio, or incorporated into an income statement, all three express how much sales revenue is available to cover fixed expenses and contribute to profit. Let’s examine how all three approaches convey the same financial performance, although represented somewhat differently.
You will recall that the per-unit contribution margin was \(\$80\) for a Hicks Blue Jay birdbath. When Hicks sold \(500\) units, each unit contributed \(\$80\) to fixed expenses and profit, which can be verified from April’s income statement:
Now, let’s use May’s Contribution Margin Income Statement as previously calculated to verify the contribution margin based on the contribution margin ratio previously calculated, which was \(80\%\), by applying this formula:
Regardless of how contribution margin is expressed, it provides critical information for managers. Understanding how each product, good, or service contributes to the organization’s profitability allows managers to make decisions such as which product lines they should expand or which might be discontinued. When allocating scarce resources, the contribution margin will help them focus on those products or services with the highest margin, thereby maximizing profits.
The Evolution of Cost-Volume-Profit Relationships
The CVP relationships of many organizations have become more complex recently because many labor-intensive jobs have been replaced by or supplemented with technology, changing both fixed and variable costs. For those organizations that are still labor-intensive, the labor costs tend to be variable costs, since at higher levels of activity there will be a demand for more labor usage. For example, assuming one worker is needed for every \(50\) customers per hour, we might need two workers for an average sales season, but during the Thanksgiving and Christmas season, the store might experience \(250\) customers per hour and thus would need five workers.
However, the growing trend in many segments of the economy is to convert labor-intensive enterprises (primarily variable costs) to operations heavily dependent on equipment or technology (primarily fixed costs). For example, in retail, many functions that were previously performed by people are now performed by machines or software, such as the self-checkout counters in stores such as Walmart, Costco, and Lowe’s. Since machine and software costs are often depreciated or amortized, these costs tend to be the same or fixed, no matter the level of activity within a given relevant range.
In China, completely unmanned grocery stores have been created that use facial recognition for accessing the store. Patrons will shop, bag the purchased items, leave the store, and be billed based on what they put in their bags. Along with managing the purchasing process, inventory is maintained by sensors that let managers know when they need to restock an item.
In the United States, similar labor-saving processes have been developed, such as the ability to order groceries or fast food online and have it ready when the customer arrives. Another major innovation affecting labor costs is the development of driverless cars and trucks (primarily fixed costs), which will have a major impact on the number of taxi and truck drivers in the future (primarily variable costs). Do these labor-saving processes change the cost structure for the company? Are variable costs decreased? What about fixed costs? Let’s look at this in more detail.
When ordering food through an app, there is no need to have an employee take the order, but someone still needs to prepare the food and package it for the customer. The variable costs associated with the wages of order takers will likely decrease, but the fixed costs associated with additional technology to allow for online ordering will likely increase. When grocery customers place their orders online, this not only requires increased fixed costs for the new technology, but it can also increase variable labor costs, as employees are needed to fill customers’ online orders. Many stores may move cashier positions to online order fulfillment rather than hiring additional employees. Other stores may have employees fill online grocery orders during slow or downtimes.
Using driverless cars and trucks decreases the variable costs tied to the wages of the drivers but requires a major investment in fixed-cost assets—the autonomous vehicles—and companies would need to charge prices that allowed them to recoup their expensive investments in the technology as well as make a profit. Alternatively, companies that rely on shipping and delivery companies that use driverless technology may be faced with an increase in transportation or shipping costs (variable costs). These costs may be higher because technology is often more expensive when it is new than it will be in the future, when it is easier and more cost effective to produce and also more accessible. A good example of the change in cost of a new technological innovation over time is the personal computer, which was very expensive when it was first developed but has decreased in cost significantly since that time. The same will likely happen over time with the cost of creating and using driverless transportation.
You might wonder why a company would trade variable costs for fixed costs. One reason might be to meet company goals, such as gaining market share. Other reasons include being a leader in the use of innovation and improving efficiencies. If a company uses the latest technology, such as online ordering and delivery, this may help the company attract a new type of customer or create loyalty with longstanding customers. In addition, although fixed costs are riskier because they exist regardless of the sales level, once those fixed costs are met, profits grow. All of these new trends result in changes in the composition of fixed and variable costs for a company and it is this composition that helps determine a company’s profit.
As you will learn in future chapters, in order for businesses to remain profitable, it is important for managers to understand how to measure and manage fixed and variable costs for decision-making. In this chapter, we begin examining the relationship among sales volume, fixed costs, variable costs, and profit in decision-making. We will discuss how to use the concepts of fixed and variable costs and their relationship to profit to determine the sales needed to break even or to reach a desired profit. You will also learn how to plan for changes in selling price or costs, whether a single product, multiple products, or services are involved.
Deciding Between Orders
You are evaluating orders from two new customers, but you will only be able to accept one of the orders without increasing your fixed costs. Management has directed you to choose the one that is most profitable for the company. Customer A is ordering \(500\) units and is willing to pay \(\$200\) per unit, and these units have a contribution margin of \(\$60\) per unit. Customer B is ordering \(1,000\) units and is willing to pay \(\$140\) per unit, and these units have a contribution margin ratio of \(40\%\). Which order do you select and why?
LINK TO LEARNING
Watch this video from Investopedia reviewing the concept of contribution margin to learn more. Keep in mind that contribution margin per sale first contributes to meeting fixed costs and then to profit. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/03%3A_Cost-Volume-Profit_Analysis/3.01%3A_Prelude_to_Cost-Volume-Profit_Analysis.txt |
In Building Blocks of Managerial Accounting, you learned how to determine and recognize the fixed and variable components of costs, and now you have learned about contribution margin. Those concepts can be used together to conduct cost-volume-profit (CVP) analysis, which is a method used by companies to determine what will occur financially if selling prices change, costs (either fixed or variable) change, or sales/production volume changes.
It is important, first, to make several assumptions about operations in order to understand CVP analysis and the associated contribution margin income statement. However, while the following assumptions are typical in CVP analysis, there can be exceptions. For example, while we typically assume that the sales price will remain the same, there might be exceptions where a quantity discount might be allowed. Our CVP analysis will be based on these assumptions:
• Costs are linear and can clearly be designated as either fixed or variable. In other words, fixed costs remain fixed in total over the relevant range and variable costs remain fixed on a per-unit basis. For example, if a company has the capability of producing up to $1,000$ units a month of a product given its current resources, the relevant range would be $0$ to $1,000$. If they decided that they wanted to produce $1,800$ units a month, they would have to secure additional production capacity. While they might be able to add an extra production shift and then produce $1,800$ units a month without buying an additional machine that would increase production capacity to $2,000$ units a month, companies often have to buy additional production equipment to increase their relevant range. In this example, the production capacity between $1,800$ and $2,000$ would be an expense that currently would not provide additional contribution toward fixed costs.
• Selling price per unit remains constant and does not increase or decrease based on volume (i.e., customers are not given discounts based on quantity purchased).
• In the case of manufacturing businesses, inventory does not change because we make the assumption that all units produced are sold.
• In the case of a company that sells multiple products, the sales mix remains constant. For example, if we are a beverage supplier, we might assume that our beverage sales are $3$ units of coffee pods and two units of tea bags.
Using these assumptions, we can begin our discussion of CVP analysis with the break-even point.
Basics of the Break-Even Point
The break-even point is the dollar amount (total sales dollars) or production level (total units produced) at which the company has recovered all variable and fixed costs. In other words, no profit or loss occurs at break-even because Total Cost = Total Revenue. Figure $1$ illustrates the components of the break-even point:
The basic theory illustrated in Figure $1$ is that, because of the existence of fixed costs in most production processes, in the first stages of production and subsequent sale of the products, the company will realize a loss. For example, assume that in an extreme case the company has fixed costs of $\20,000$, a sales price of $\400$ per unit and variable costs of $\250$ per unit, and it sells no units. It would realize a loss of $\20,000$ (the fixed costs) since it recognized no revenue or variable costs. This loss explains why the company’s cost graph recognized costs (in this example, $\20,000$) even though there were no sales. If it subsequently sells units, the loss would be reduced by $\150$ (the contribution margin) for each unit sold. This relationship will be continued until we reach the break-even point, where total revenue equals total costs. Once we reach the break-even point for each unit sold the company will realize an increase in profits of $\150$.
For each additional unit sold, the loss typically is lessened until it reaches the break-even point. At this stage, the company is theoretically realizing neither a profit nor a loss. After the next sale beyond the break-even point, the company will begin to make a profit, and the profit will continue to increase as more units are sold. While there are exceptions and complications that could be incorporated, these are the general guidelines for break-even analysis.
As you can imagine, the concept of the break-even point applies to every business endeavor—manufacturing, retail, and service. Because of its universal applicability, it is a critical concept to managers, business owners, and accountants. When a company first starts out, it is important for the owners to know when their sales will be sufficient to cover all of their fixed costs and begin to generate a profit for the business. Larger companies may look at the break-even point when investing in new machinery, plants, or equipment in order to predict how long it will take for their sales volume to cover new or additional fixed costs. Since the break-even point represents that point where the company is neither losing nor making money, managers need to make decisions that will help the company reach and exceed this point as quickly as possible. No business can operate for very long below break-even. Eventually the company will suffer losses so great that they are forced to close their doors.
ETHICAL CONSIDERATIONS: Break-Even Analysis and Profitability
The first step in determining the viability of the business decision to sell a product or provide a service is analyzing the true cost of the product or service and the timeline of payment for the product or service. Ethical managers need an estimate of a product or service's cost and related revenue streams to evaluate the chance of reaching the break-even point.
Determining an accurate price for a product or service requires a detailed analysis of both the cost and how the cost changes as the volume increases. This analysis includes the timing of both costs and receipts for payment, as well as how these costs will be financed. An example is an IT service contract for a corporation where the costs will be frontloaded. When costs or activities are frontloaded, a greater proportion of the costs or activities occur in an earlier stage of the project. An IT service contract is typically employee cost intensive and requires an estimate of at least $120$ days of employee costs before a payment will be received for the costs incurred. An IT service contract for $\100,000$ in monthly services with a $30\%$ profit margin will require $4$ months of upfront financing of $\280,000$ balanced over the four months before a single payment is received.
The overall profit at a specific point in time requires a careful determination of all of the costs associated with creating and selling the product or providing the service. An ethical managerial accountant will provide a realistic cost estimate, regardless of management's desire to sell a product or provide a service. What might be a lucrative product on its face needs additional analysis provided by the managerial accountant.
To illustrate the concept of break-even, we will return to Hicks Manufacturing and look at the Blue Jay birdbath they manufacture and sell.
LINK TO LEARNING
Watch this video of an example of performing the first steps of cost-volume-profit analysis to learn more.
Sales Where Operating Income Is $\0$
Hicks Manufacturing is interested in finding out the point at which they break even selling their Blue Jay Model birdbath. They will break even when the operating income is $\0$. The operating income is determined by subtracting the total variable and fixed costs from the sales revenue generated by an enterprise. In other words, the managers at Hicks want to know how many Blue Jay birdbaths they will need to sell in order to cover their fixed expenses and break even. Information on this product is:
In order to find their break-even point, we will use the contribution margin for the Blue Jay and determine how many contribution margins we need in order to cover the fixed expenses, as shown below.
$\text { Break-Even Point in Units: } \dfrac{\text { Total Fixed Costs }}{\text { Contribution Margin per Unit }}$
Applying this to Hicks calculates as:
$\dfrac{18,000}{80}=225\ \text { units} \nonumber$
What this tells us is that Hicks must sell $225$ Blue Jay Model birdbaths in order to cover their fixed expenses. In other words, they will not begin to show a profit until they sell the $226^{th}$ unit. This is illustrated in their contribution margin income statement.
The break-even point for Hicks Manufacturing at a sales volume of $\22,500$ ($225$ units) is shown graphically in Figure $4$.
As you can see, when Hicks sells $225$ Blue Jay Model birdbaths, they will make no profit, but will not suffer a loss because all of their fixed expenses are covered. However, what happens when they do not sell $225$ units? If that happens, their operating income is negative.
Sales Where Operating Income Is Negative
In a recent month, local flooding caused Hicks to close for several days, reducing the number of units they could ship and sell from $225$ units to $175$ units. The information in Figure $5$ reflects this drop in sales.
At $175$ units ($\17,500$ in sales), Hicks does not generate enough sales revenue to cover their fixed expenses and they suffer a loss of $\4,000$. They did not reach the break-even point of $225$ units.
Sales Where Operating Income Is Positive
What happens when Hicks has a busy month and sells $300$ Blue Jay birdbaths? We have already established that the contribution margin from $225$ units will put them at break-even. When sales exceed the break-even point the unit contribution margin from the additional units will go toward profit. This is reflected on their income statement.
Again, looking at the graph for break-even (Figure $8$), you will see that their sales have moved them beyond the point where total revenue is equal to total cost and into the profit area of the graph.
Hicks Manufacturing can use the information from these different scenarios to inform many of their decisions about operations, such as sales goals.
However, using the contribution margin per unit is not the only way to determine a break-even point. Recall that we were able to determine a contribution margin expressed in dollars by finding the contribution margin ratio. We can apply that contribution margin ratio to the break-even analysis to determine the break-even point in dollars. For example, we know that Hicks had $\18,000$ in fixed costs and a contribution margin ratio of $80\%$ for the Blue Jay model. We will use this ratio (Figure $9$) to calculate the break-even point in dollars.
$\text { Break-Even Point in Dollars }=\dfrac{\text { Fixed Costs }}{\text { Contribution Margin Ratio }} \label{eq1}$
Applying Equation \ref{eq1} to Hicks gives this calculation:
$\dfrac{\ 18,000}{0.80}=\ 22,500 \nonumber$
Hicks Manufacturing will have to generate $\22,500$ in monthly sales in order to cover all of their fixed costs. In order for us to verify that Hicks’ break-even point is $\22,500$ (or $225$ units) we will look again at the contribution margin income statement at break-even:
By knowing at what level sales are sufficient to cover fixed expenses is critical, but companies want to be able to make a profit and can use this break-even analysis to help them.
THINK IT THROUGH: The Cost of a Haircut
You are the manager of a hair salon and want to know how many ladies’ haircuts your salon needs to sell in a month in order to cover the fixed costs of running the salon. You have determined that, at the current price of $\35$ per haircut, you have $\20$ in variable costs associated with each cut. These variable costs include stylist wages, hair product, and shop supplies. Your fixed costs are $\3,000$ per month. You perform a break-even analysis on a per-unit basis and discover the following:
You have $4$ stylists plus yourself working in the salon and are open 6 days per week. Considering the break-even point and the number of available stylists, will the salon ever break even? If it does, what will need to happen? What can be done to achieve the break-even point?
Examples of the Effects of Variable and Fixed Costs in Determining the Break-Even Point
Companies typically do not want to simply break even, as they are in business to make a profit. Break-even analysis also can help companies determine the level of sales (in dollars or in units) that is needed to make a desired profit. The process for factoring a desired level of profit into a break-even analysis is to add the desired level of profit to the fixed costs and then calculate a new break-even point. We know that Hicks Manufacturing breaks even at $225$ Blue Jay birdbaths, but what if they have a target profit for the month of July? They can simply add that target to their fixed costs. By calculating a target profit, they will produce and (hopefully) sell enough bird baths to cover both fixed costs and the target profit.
If Hicks wants to earn $\16,000$ in profit in the month of May, we can calculate their new break-even point as follows:
$\text { Target Profit }=\dfrac{\text { Fixed costs }+\text { desired profit }}{\text { Contribution margin per unit }}=\dfrac{\ 18,000+\ 16,000}{\ 80}=425 \text { units } \nonumber$
We have already established that the $\18,000$ in fixed costs is covered at the $225$ units mark, so an additional $200$ units will cover the desired profit ($200$ units $× \80$ per unit contribution margin $= \16,000$). Alternatively, we can calculate this in terms of dollars by using the contribution margin ratio.
$\text { Target Profit }=\dfrac{\text { Fixed costs }+\text { desired profit }}{\text { Contribution margin ratio }}=\dfrac{\ 18,000+\ 16,000}{0.80}=\ 42,500 \nonumber$
As done previously, we can confirm this calculation using the contribution margin income statement:
Note that the example calculations ignored income taxes, which implies we were finding target operating income. However, companies may want to determine what level of sales would generate a desired after-tax profit. To find the break-even point at a desired after-tax profit, we simply need to convert the desired after-tax profit to the desired pre-tax profit, also referred to as operating income, and then follow through as in the example. Suppose Hicks wants to earn $\24,000$ after-taxes, what level of sales (units and dollars) would be needed to meet that goal? First, the after-tax profit needs to be converted to a pre-tax desired profit:
$\text { Pre-tax desired profit }=\dfrac{\text { After-tax profit }}{(1-\text { tax rate })} \nonumber$
If the tax rate for Hicks is $40\%$, then the $\24,000$ after-tax profit is equal to a pre-tax profit of $\40,000$:
$\ 40,000=\dfrac{\ 24,000}{(1-0.40)} \nonumber$
The tax rate indicates the amount of tax expense that will result from any profits and $1-\text {tax rate}$ indicates the amount remaining after taking out tax expense. The concept is similar to buying an item on sale. If an item costs $\80$ and is on sale for $40\%$ off, then the amount being paid for the item is $60\%$ of the sale price, or $\ 48(\ 80 \times 60 \%)$. Another way to find this involves two steps. First find the discount ($\80 × 40\% = \32$) and then subtract the discount from the sales price ($\80 – \32 = \48$).
Taxes and profit work in a similar fashion. If we know the profit before tax is $\100,000$ and the tax rate is $30\%$, then tax expenses are $\100,000 × 30\% = \30,000$. This means the after-tax income is $\100,000 – \30,000 = \70,000$. However, in most break-even situations, as well as other decision-making areas, the desired after-tax profit is known, and the pre-tax profit must be determined by dividing the after-tax profit by $1-\text {tax rate}$.
To demonstrate the combination of both a profit and the after-tax effects and subsequent calculations, let’s return to the Hicks Manufacturing example. Let’s assume that we want to calculate the target volume in units and revenue that Hicks must sell to generate an after-tax return of $\24,000$, assuming the same fixed costs of $\18,000$.
Since we earlier determined $\24,000$ after-tax equals $\40,000$ before-tax if the tax rate is $40\%$, we simply use the break-even at a desired profit formula to determine the target sales.
$\text { Target sales }=\dfrac{\text { (Fixed costs }+\text { Desired profit) }}{\text { Contribution margin per unit }}=\dfrac{(\ 18,000+\ 40,000)}{\ 80}=725 \text { units } \nonumber$
This calculation demonstrates that Hicks would need to sell $725$ units at $\100$ a unit to generate $\72,500$ in sales to earn $\24,000$ in after-tax profits.
Alternatively, target sales in sales dollars could have been calculated using the contribution margin ratio:
$\text { Target sales }=\dfrac{\text { (Fixed costs + Desired profit) }}{\text { Contribution margin per unit }}=\dfrac{(\ 18,000+\ 40,000)}{0.80}=\ 72,500 \nonumber$
Once again, the contribution margin income statement proves the sales and profit relationships.
Thus, to calculate break-even point at a particular after-tax income, the only additional step is to convert after-tax income to pre-tax income prior to utilizing the break-even formula. It is good to understand the impact of taxes on break-even analysis as companies will often want to plan based on the after-tax effects of a decision as the after-tax portion of income is the only part of income that will be available for future use.
Application of Break-Even Concepts for a Service Organization
Because break-even analysis is applicable to any business enterprise, we can apply these same principles to a service organization. For example, Marshall & Hirito is a mid-sized accounting firm that provides a wide range of accounting services to its clients but relies heavily on personal income tax preparation for much of its revenue. They have analyzed the cost to the firm associated with preparing these returns. They have determined the following cost structure for the preparation of a standard 1040A Individual Income Tax Return:
They have fixed costs of $\14,000$ per month associated with the salaries of the accountants who are responsible for preparing the Form 1040A. In order to determine their break-even point, they first determine the contribution margin for the Form 1040A as shown:
Now they can calculate their break-even point:
$\text { Break-Even Point in Units }=\dfrac{\text { Total fixed costs }}{\text { Contribution margin per unit }}=\dfrac{\ 14,000}{\ 250}=56 \text { returns } \nonumber$
Remember, this is the break-even point in units (the number of tax returns) but they can also find a break-even point expressed in dollars by using the contribution margin ratio. First, they find the contribution margin ratio. Then, they use the ratio to calculate the break-even point in dollars:
$\text { Break-Even Point in Dollars }=\dfrac{\text { Fixed costs }}{\text { Contribution margin ratio }}=\dfrac{\ 14,000}{0.625}=\ 22,400 \nonumber$
We can confirm these figures by preparing a contribution margin income statement:
Therefore, as long as Marshall & Hirito prepares $56$ Form 1040 income tax returns, they will earn no profit but also incur no loss. What if Marshall & Hirito has a target monthly profit of $\10,000$? They can use the break-even analysis process to determine how many returns they will need to prepare in order to cover their fixed expenses and reach their target profit:
$\text { Target Profit }=\dfrac{\text { Fixed costs }+\text { desired profit }}{\text { Contribution margin per unit }}=\dfrac{\ 14,000+\ 10,000}{\ 250}=96 \text { returns } \nonumber$
They will need to prepare $96$ returns during the month in order to realize a $\10,000$ profit. Expressing this in dollars instead of units requires that we use the contribution margin ratio as shown:
$\text { Target Profit }=\dfrac{\text { Fixed costs }+\text { desired profit }}{\text { Contribution margin per unit }}=\dfrac{\ 14,000+\ 10,000}{0.625}=\ 38,400 \nonumber$
Marshall & Hirito now knows that, in order to cover the fixed costs associated with this service, they must generate $\38,400$ in revenue. Once again, let’s verify this by constructing a contribution margin income statement:
As you can see, the $\38,400$ in revenue will not only cover the $\14,000$ in fixed costs, but will supply Marshall & Hirito with the $\10,000$ in profit (net income) they desire.
As you’ve learned, break-even can be calculated using either contribution margin per unit or the contribution margin ratio. Now that you have seen this process, let’s look at an example of these two concepts presented together to illustrate how either method will provide the same financial results.
Suppose that Channing’s Chairs designs, builds, and sells unique ergonomic desk chairs for home and business. Their bestselling chair is the Spine Saver. Figure $18$ illustrates how Channing could determine the break-even point in sales dollars using either the contribution margin per unit or the contribution margin ratio.
Note that in either scenario, the break-even point is the same in dollars and units, regardless of approach. Thus, you can always find the break-even point (or a desired profit) in units and then convert it to sales by multiplying by the selling price per unit. Alternatively, you can find the break-even point in sales dollars and then find the number of units by dividing by the selling price per unit.
Example $1$: College Creations
College Creations, Inc (CC), builds a loft that is easily adaptable to most dorm rooms or apartments and can be assembled into a variety of configurations. Each loft is sold for $\500$, and the cost to produce one loft is $\300$, including all parts and labor. CC has fixed costs of $\100,000$.
1. What happens if CC produces nothing?
2. Now, assume CC produces and sells one unit (loft). What are their financial results?
3. Now, what do you think would happen if they produced and sold 501 units?
4. How many units would CC need to sell in order to break even?
5. How many units would CC need to sell if they wanted to have a pretax profit of $\50,000$?
Solution
1. If they produce nothing, they will still incur fixed costs of $\100,000$. They will suffer a net loss of $\100,000$.
2. If they sell one unit, they will have a net loss of $\99,800$.
1. If they produce $501$ units, they will have operating income of $\200$ as shown:
1. Break-even can be determined by FC/CM per unit: $\ 100,000 \div \ 200=500$. Five hundred lofts must be sold to break even.
2. The desired profit can be treated like a fixed cost, and the target profit would be (FC + Desired Profit)/CM or ($\100,000 + \50,000) ÷ \200 = 750$. Seven hundred fifty lofts need to be sold to reach a desired income of $\50,000$. Another way to have found this is to know that, after fixed costs are met, the $\200$ per unit contribution margin will go toward profit. The desired profit of $\50,000 ÷ \200 \text { per unit contribution margin } = 250$. This means that $250$ additional units must be sold. To break even requires $500$ units to be sold, and to reach the desired profit of $\50,000$ requires an additional $250$ units, for a total of $750$ units. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/03%3A_Cost-Volume-Profit_Analysis/3.03%3A_Calculate_a_Break-Even_Point_in_Units_and_Dollars.txt |
Finding the break-even point or the sales necessary to meet a desired profit is very useful to a business, but cost-volume-profit analysis also can be used to conduct a sensitivity analysis, which shows what will happen if the sales price, units sold, variable cost per unit, or fixed costs change. Companies use this type of analysis to consider possible scenarios that assist them in planning.
The Effects on Break-Even under Changing Business Conditions
Circumstances often change within a company, within an industry, or even within the economy that impact the decision-making of an organization. Sometimes, these effects are sudden and unexpected, for example, if a hurricane destroyed the factory of a company’s major supplier; other times, they occur more slowly, such as when union negotiations affect your labor costs. In either of these situations, costs to the company will be affected. Using CVP analysis, the company can predict how these changes will affect profits.
Changing a Single Variable
To demonstrate the effects of changing any one of these variables, consider Back Door Café, a small coffee shop that roasts its own beans to make espresso drinks and gourmet coffee. They also sell a variety of baked goods and T-shirts with their logo on them. They track their costs carefully and use CVP analysis to make sure that their sales cover their fixed costs and provide a reasonable level of profit for the owners.
Change in Sales Price
The owner of Back Door has one of her employees conduct a survey of the other coffee shops in the area and finds that they are charging \(\$0.75\) more for espresso drinks. As a result, the owner wants to determine what would happen to operating income if she increased her price by just \(\$0.50\) and sales remained constant, so she performs the following analysis:
The only variable that has changed is the \(\$0.50\) increase in the price of their espresso drinks, but the net operating income will increase by \(\$750\). Another way to think of this increase in income is that, if the sales price increases by \(\$0.50\) per espresso drink and the estimated sales are \(1,500\) units, then this will result in an increase in overall contribution margin of \(\$750\). Moreover, since all of the fixed costs were met by the lower sales price, all of this \(\$750\) goes to profit. Again, this is assuming the higher sales price does not decrease the number of units sold. Since the other coffee shops will still be priced higher than Back Door, the owner believes that there will not be a decrease in sales volume.
When making this adjustment to their sales price, Back Door Café is engaging in target pricing, a process in which a company uses market analysis and production information to determine the maximum price customers are willing to pay for a good or service in addition to the markup percentage. If the good can be produced at a cost that allows both the desired profit percentage as well as deliver the good at a price acceptable to the customer, then the company should proceed with the product; otherwise, the company will not achieve its desired profit goals.
Change in Variable Cost
In March, the owner of Back Door receives a letter from her cups supplier informing her that there is a \(\$0.05\) price increase due to higher material prices. Assume that the example uses the original \(\$3.75\) per unit sales price. The owner wants to know what would happen to net operating income if she absorbs the cost increase, so she performs the following analysis:
She is surprised to see that just a \(\$0.05\) increase in variable costs (cups) will reduce her net income by \(\$75\). The owner may decide that she is fine with the lower income, but if she wants to maintain her income, she will need to find a new cup supplier, reduce other costs, or pass the price increase on to her customers. Because the increase in the cost of the cups was a variable cost, the impact on net income can be seen by taking the increase in cost per unit, \(\$0.05\), and multiplying that by the units expected to be sold, \(1,500\), to see the impact on the contribution margin, which in this case would be a decrease of \(\$75\). This also means a decrease in net income of \(\$75\).
Change in Fixed Cost
Back Door Café’s lease is coming up for renewal. The owner calls the landlord to indicate that she wants to renew her lease for another \(5\) years. The landlord is happy to hear she will continue renting from him but informs her that the rent will increase \(\$225\) per month. She is not certain that she can afford an additional \(\$225\) per month and tells him she needs to look at her numbers and will call him back. She pulls out her CVP spreadsheet and adjusts her monthly fixed costs upwards by \(\$225\). Assume that the example uses the original \(\$3.75\) per unit sales price. The results of her analysis of the impact of the rent increase on her annual net income are:
Because the rent increase is a change in a fixed cost, the contribution margin per unit remains the same. However, the break-even point in both units and dollars increase because more units of contribution are needed to cover the \(\$225\) monthly increase in fixed costs. If the owner of the Back Door agrees to the increase in rent for the new lease, she will likely look for ways to increase the contribution margin per unit to offset this increase in fixed costs.
In each of the prior examples, only one variable was changed—sales volume, variable costs, or fixed costs. There are some generalizations that can be made regarding how a change in any one of these variables affects the break-even point. These generalizations are summarized in Table \(1\).
Table \(1\): Generalizations Regarding Changes in Break-Even Point from a Change in One Variable
Condition Result
Sales Price Increases Break-Even Point Decreases (Contribution Margin is Higher, Need Fewer Sales to Break Even)
Sales Price Decreases Break-Even Point Increases (Contribution Margin is Lower, Need More Sales to Break Even)
Variable Costs Increase Break-Even Point Increases (Contribution Margin is Lower, Need More Sales to Break Even)
Variable Costs Decrease Break-Even Point Decreases (Contribution Margin is Higher, Need Fewer Sales to Break Even)
Fixed Costs Increase Break-Even Point Increases (Contribution Margin Does Not Change, but Need More Sales to Meet Fixed Costs)
Fixed Costs Decrease Break-Even Point Decreases (Contribution Margin Does Not Change, but Need Fewer Sales to Meet Fixed Costs)
Changing Multiple Variables
We have analyzed situations in which one variable changes, but often, more than one change will occur at a time. For example, a company may need to lower its selling price to compete, but they may also be able to lower certain variable costs by switching suppliers.
Suppose Back Door Café has the opportunity to purchase a new espresso machine that will reduce the amount of coffee beans required for an espresso drink by putting the beans under higher pressure. The new machine will cost \(\$15,000\), but it will decrease the variable cost per cup by \(\$0.05\). The owner wants to see what the effect will be on the net operating income and break-even point if she purchases the new machine. She has arranged financing for the new machine and the monthly payment will increase her fixed costs by \(\$400\) per month. When she conducts this analysis, she gets the following results:
Looking at the “what-if” analysis, we see that the contribution margin per unit increases because of the \(\$0.05\) reduction in variable cost per unit. As a result, she has a higher total contribution margin available to cover fixed expenses. This is good, because the monthly payment on the espresso machine represents an increased fixed cost. Even though the contribution margin ratio increases, it is not enough to totally offset the increase in fixed costs, and her monthly break-even point has risen from \(\$4,125.00\) to \(\$4,687.50\). If the new break-even point in units is a realistic number (within the relevant range), then she would decide to purchase the new machine because, once it has been paid for, her break-even point will fall and her net income will rise. Performing this analysis is an effective way for managers and business owners to look into the future, so to speak, and see what impact business decisions will have on their financial position.
Let’s look at another option the owner of the Back Door Café has to consider when making the decision about this new machine. What would happen if she purchased the new machine to realize the variable cost savings and also raised her price by just \(\$0.20\)? She feels confident that such a small price increase will go virtually unnoticed by her customers but may help her offset the increase in fixed costs. She runs the analysis as follows:
The analysis shows the expected result: an increase in the per-unit contribution margin, a decrease in the break-even point, and an increase in the net operating income. She has changed three variables in her costs—sales price, variable cost, and fixed cost. In fact, the small price increase almost gets her back to the net operating income she realized before the purchase of the new expresso machine.
By now, you should begin to understand why CVP analysis is such a powerful tool. The owner of Back Door Café can run an unlimited number of these what-if scenarios until she meets the financial goals for her company. There are very few tools in managerial accounting as powerful and meaningful as a cost-volume-profit analysis.
CONCEPTS IN PRACTICE: Value Menus
In January 2018, McDonald’s brought back its \(\$1\) value menu. After discontinuing its popular Dollar Menu six years previously, the new version has a list of items priced not only at \(\$1\), but at \(\$2\) and \(\$3\) as well. How can McDonald’s afford to offer menu items at this discounted price? Volume! Although the margin on each unit is very small, the food chain hopes to make up the difference in quantity. They also hope that consumers will add higher priced (and higher margin) items to their orders.1 The strategy is not without its risks, however, as rising food or labor costs could put franchisees in a position where the value pricing does not cover their product costs. Rivals Taco Bell and Dunkin’ Donuts have aggressively marketed their value menus, making it almost impossible for McDonald’s to ignore the growing trend among consumers for “value pricing.” Watch this video to see what McDonald’s is offering consumers. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/03%3A_Cost-Volume-Profit_Analysis/3.04%3A_Perform_Break-Even_Sensitivity_Analysis_for_a_Single_Product_Under_Changing_Business_Situations.txt |
Up to this point in our CVP analysis, we have assumed that a company only sells one product, but we know that, realistically, this is not the case. Most companies operate in a multi-product environment, in which they sell different products, manufacture different products, or offer different types of services. Companies price each one of their products or services differently, and the costs associated with each of those products or services vary as well. In addition, companies have limited resources, such as time and labor, and must decide which products to sell or produce and in what quantities, or which services to offer in order to be the most profitable. These profitability considerations are often what contributes substance to a sales mix decision
The Basics of Break-Even Analysis in a Multi-Product Environment
In order to perform a break-even analysis for a company that sells multiple products or provides multiple services, it is important to understand the concept of a sales mix. A sales mix represents the relative proportions of the products that a company sells—in other words, the percentage of the company’s total revenue that comes from product A, product B, product C, and so forth. Sales mix is important to business owners and managers because they seek to have a mix that maximizes profit, since not all products have the same profit margin. Companies can maximize their profits if they are able to achieve a sales mix that is heavy with high-margin products, goods, or services. If a company focuses on a sales mix heavy with low-margin items, overall company profitability will often suffer.
Performing a break-even analysis for these multi-product businesses is more complex because each product has a different selling price, a different variable cost, and, ultimately, a different contribution margin. We must also proceed under the assumption that the sales mix remains constant; if it does change, the CVP analysis must be revised to reflect the change in sales mix. For the sake of clarity, we will also assume that all costs are companywide costs, and each product contributes toward covering these companywide costs.
THINK IT THROUGH: Selling Subs
You are the manager of a sub shop located near a college campus. The college has recently added a fast-food style café to the student center, which has reduced the number of students eating at your restaurant. Your highest margin items are drinks (a contribution margin of approximately $90\%$) and vegetarian subs (a contribution margin of approximately $75\%$). How can you use CVP analysis to help you compete with the college’s café? What would you suggest as possible ways to increase business while maintaining target income levels?
Calculating Break-Even Analysis in a Multi-Product Environment
When a company sells more than one product or provides more than one service, break-even analysis is more complex because not all of the products sell for the same price or have the same costs associated with them: Each product has its own margin. Consequently, the break-even point in a multi-product environment depends on the mix of products sold. Further, when the mix of products changes, so does the break-even point. If demand shifts and customers purchase more low-margin products, then the break-even point rises. Conversely, if customers purchase more high-margin products, the break-even point falls. In fact, even if total sales dollars remain unchanged, the break-even point can change based on the sales mix. Let’s look at an example of how break-even analysis works in a multi-product environment.
In multi-product CVP analysis, the company’s sales mix is viewed as a composite unit, a selection of discrete products associated together in proportion to the sales mix. The composite unit is not sold to customers but is a concept used to calculate a combined contribution margin, which is then used to estimate the break-even point. Think of a composite unit as a virtual basket of fruit that contains the proportion of individual fruits equal to the company’s sales mix. If we purchased these items individually to make the fruit basket, each one would have a separate price and a different contribution margin. This is how a composite unit works in CVP analysis. We calculate the contribution margins of all of the component parts of the composite unit and then use the total to calculate the break-even point. It is important to note that fixed costs are allocated among the various components (products) that make up this composite unit. Should a product be eliminated from the composite unit or sales mix, the fixed costs must be re-allocated among the remaining products.
If we use the fruit basket as an example, we can look at the individual fruits that make up the basket: apples, oranges, bananas, and pears. We see that each individual fruit has a selling price and a cost. Each fruit has its own contribution margin. But how would we determine the contribution margin for a composite of fruit, or in other words, for our basket of fruit?
For our particular baskets, we will use $5$ apples, $3$ oranges, $2$ bananas, and $1$ pear. This means that our product mix is $5:3:2:1$, as shown in Figure $1$.
Notice that the composite contribution margin is based on the number of units of each item that is included in the composite item. If we change the composition of the basket, then the composite contribution margin would change even though contribution margin of the individual items would not change. For example, if we only include $4$ apples, the contribution margin of a single apple is still $\0.35$, but the contribution margin of the apples in the basket is $\1.40$, not $\1.75$ as it is when $5$ apples are included in the basket. Let’s look at an additional example and see how we find the break-even point for a composite good.
We will consider West Brothers for an example of a multi-product break-even analysis. West Brothers manufactures and sells $3$ types of house siding: restoration vinyl, architectural vinyl, and builder grade vinyl, each with its own sales price, variable cost, and contribution margin, as shown:
The sales mix for West Brothers is $5 \mathrm{ft}^{2}$ of builder grade to $3 \mathrm{ft}^{2}$ of architectural grade to $2 \mathrm{ft}^{2}$ of restoration grade vinyl (a ratio of $5:3:2$). This sales mix represents one composite unit, and the selling price of one composite unit is:
West Brothers’ fixed costs are $\145,000$ per year, and the variable costs for one composite unit are:
We will calculate the contribution margin of a composite unit for West Brothers using the same formula as before:
$\text {Selling Price per Composite Unit} - \text { Variable cost per Composite Unit} = \text {Contribution Margin per Composite Unit}$
Applying the formula, we determine that $\73 – \42.25 = 30.75$. We then use the contribution margin per composite unit to determine West Brothers’ break-even point:
$\text { Break-Even Point per Composite Unit }=\dfrac{\text { Total fixed costs }}{\text { Contribution margosite unit }}=\dfrac{\ 145,000}{\ 30.75}=4,715.45 \text { composite unit } \nonumber$
West Brothers will break even when it sells $4,715.45$ (or $4,716$ since it can’t sell a partial unit) composite units. To determine how many of each product West Brothers needs to sell, we apply their sales mix ratio ($5:3:2$) to the break-even quantity as follows:
Using a forecasted or estimated contribution margin income statement, we can verify that the quantities listed will place West Brothers at break-even.
West Brothers can use this CVP analysis for a wide range of business decisions and for planning purposes. Remember, however, that if the sales mix changes from its current ratio, then the break-even point will change. For planning purposes, West Brothers can change the sales mix, sales price, or variable cost of one or more of the products in the composite unit and perform a “what-if” analysis.
Example $1$: Margins in the Sales Mix
The sales mix of a company selling two products, A and B, is $3:1$. The per-unit variable costs is $\4$ for Product A and $\5$ for Product B. Product A sells for $\10$ and product B sells for $\9$. Fixed costs for the company are $\220,000$.
1. What is the contribution margin per composite unit?
2. What is the break-even point in composite units?
3. How many units of product A and product B will the company sell at the break-even point?
Solution
$\text {Break-even per composite unit } = 15,385$. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/03%3A_Cost-Volume-Profit_Analysis/3.05%3A_Perform_Break-Even_Sensitivity_Analysis_for_a_Multi-Product_Environment_Under_Changing_Business_Situations.txt |
Our discussion of CVP analysis has focused on the sales necessary to break even or to reach a desired profit, but two other concepts are useful regarding our break-even sales. Those concepts are margin of safety and operating leverage.
Margin of Safety
A company’s margin of safety is the difference between its current sales and its break-even sales. The margin of safety tells the company how much they could lose in sales before the company begins to lose money, or, in other words, before the company falls below the break-even point. The higher the margin of safety is, the lower the risk is of not breaking even or incurring a loss. In order to calculate margin of safety, we use the following formula:
$\text { Margin of Safety in Dollars }=\text { Total Budgeted (or actual sales) - Break-Even Sales }$
Let’s look at Manteo Machine, a company that machines parts that are then sold and used in the manufacture of farm equipment. For their core product, the break-even analysis is as follows:
Interpreting this information tells Manteo Machine that, when sales equal $\153,000$, they will be at the break-even point. However, as soon as sales fall below this figure, they will have negative net operating income. They have decided that they want a margin of safety of $\10,000$. They can add this as if it were a fixed cost (very much the same way we added target profit earlier) and then find a new break-even point that includes a $\10,000$ margin of safety. If they approached it from this perspective, their new break-even would appear as follows:
As shown in Figure $2$, the margin of safety of $1,900$ units is found from ($\text { (FC + Margin of Safety)/CM per unit }=\ 95,000 / \ 50$). Thus, $1,900$ units must be sold in order to meet fixed cost and have a $\10,000$ margin of safety. Another way to see this is to realize the $\10,000$ margin of safety will be met in $\50$ increments based on the current contribution margin. This means the company will need to sell an additional $200$ units, which is an additional $\18,000$ in sales to have the desired margin of safety. The true break-even, where only fixed costs were met, was $1,700$ units, or $\153,000$ in sales. The point at which the company would have a $\10,000$ margin of safety is $1,900$ units, or $\171,000$ in sales. Note that the new level of units is the break-even units of $1,700$ plus the $200$ units for the margin of safety. The same can be seen for the sales dollar. The new level of desired sales dollars is the break-even sales of $\153,000$ plus the additional $\18,000$ in sales for the margin of safety.
The margin of safety can also be determined when a company knows its sales volume. For example, Manteo Machine sold $2,500$ units in March and wants to know its margin of safety at that sales volume:
From this analysis, Manteo Machine knows that sales will have to decrease by $\72,000$ from their current level before they revert to break-even operations and are at risk to suffer a loss.
Ethical Considerations: The Importance of Relevant Range Analysis
Ethical managerial decision-making requires that information be communicated fairly and objectively. The failure to include the demand for individual products in the company's mixture of products may be misleading. Providing misleading or inaccurate managerial accounting information can lead to a company becoming unprofitable. Ignoring relevant range(s) in setting assumptions about cost behavior and ignoring the actual demand for the product in the company's market also distorts the information provided to management and may cause the management of the company to produce products that cannot be sold.
Many companies prefer to consider the margin of safety as a percentage of sales, rather than as a dollar amount. In order to express margin of safety as a percentage, we divide the margin of safety (in dollars) by the total budgeted or actual sales volume. The formula to express margin of safety as a percentage is:
$\text { Margin of Safety Percentage }=\dfrac{\text { Margin of Safety (dollars) }}{\text { Total Budget (or Actual) Sales (dollars) }}$
Previously, we calculated Manteo Machine’s margin of safety as $\72,000$. As a percentage, it would be
$\dfrac{\ 72,000}{\ 225,000}=0.32 \text { or } 32 \% \nonumber$
This tells management that as long as sales do not decrease by more than $32\%$, they will not be operating at or near the break-even point, where they would run a higher risk of suffering a loss. Often, the margin of safety is determined when sales budgets and forecasts are made at the start of the fiscal year and also are regularly revisited during periods of operational and strategic planning.
Operating Leverage
In much the same way that managers control the risk of incurring a net loss by watching their margin of safety, being aware of the company’s operating leverage is critical to the financial well-being of the firm. Operating leverage is a measurement of how sensitive net operating income is to a percentage change in sales dollars. Typically, the higher the level of fixed costs, the higher the level of risk. However, as sales volumes increase, the payoff is typically greater with higher fixed costs than with higher variable costs. In other words, the higher the risk the greater the payoff.
First, let’s look at this from a general example to understand payoff. Suppose you had $\10,000$ to invest and you were debating between putting that money in low risk bonds earning $3\%$ or taking a chance and buying stock in a new company that currently is not profitable but has an innovative product that many analysts predict will take off and be the next “big thing.” Obviously, there is more risk with buying the stock than with buying the bonds. If the company remains unprofitable, or fails, you stand to lose all or a portion of your investment, whereas the bonds are less risky and will continue to pay $3\%$ interest. However, the risk associated with the stock investment could result in a much higher payoff if the company is successful.
So how does this relate to fixed costs and companies? Companies have many types of fixed costs including salaries, insurance, and depreciation. These costs are present regardless of our production or sales levels. This makes fixed costs riskier than variable costs, which only occur if we produce and sell items or services. As we sell items, we have learned that the contribution margin first goes to meeting fixed costs and then to profits. Here is an example of how changes in fixed costs affects profitability.
Gray Co. has the following income statement:
What is the effect of switching $\10,000$ of fixed costs to variable costs? What is the effect of switching $\10,000$ of variable costs to fixed costs?
Notice that in this instance, the company’s net income stayed the same. Now, look at the effect on net income of changing fixed to variable costs or variable costs to fixed costs as sales volume increases. Assume sales volume increase by $10\%$.
As you can see from this example, moving variable costs to fixed costs, such as making hourly employees salaried, is riskier in that fixed costs are higher. However, the payoff, or resulting net income, is higher as sales volume increases.
This is why companies are so concerned with managing their fixed and variable costs and will sometimes move costs from one category to another to manage this risk. Some examples include, as previously mentioned, moving hourly employees (variable) to salaried employees (fixed), or replacing an employee (variable) with a machine (fixed). Keep in mind that managing this type of risk not only affects operating leverage but can have an effect on morale and corporate climate as well.
Concepts In Practice: Fluctuating Operating Leverage - Why Do Stores Add Self-Service Checkout Lanes?
Operating leverage fluctuations result from changes in a company’s cost structure. While any change in either variable or fixed costs will change operating leverage, the fluctuations most often result from management’s decision to shift costs from one category to another. As the next example shows, the advantage can be great when there is economic growth (increasing sales); however, the disadvantage can be just as great when there is economic decline (decreasing sales). This is the risk that must be managed when deciding how and when to cause operating leverage to fluctuate.
Consider the impact of reducing variable costs (fewer employee staffed checkout lanes) and increasing fixed costs (more self-service checkout lanes). A store with $\125,000,000$ per year in sales installs some self-service checkout lanes. This increases its fixed costs by $10\%$ but reduces its variable costs by $5\%$. As Figure $7$ shows, at the current sales level, this could produce a whopping $35\%$ increase in net operating income. And, if the change results in higher sales, the increase in net operating income would be even more dramatic. Do the math and you will see that each $1\%$ increase in sales would produce a $6\%$ increase in net operating income: well worth the change, indeed.
(in $000$s) Without Selfservice Checkout Lanes, With Selfservice Checkout Lanes (respectively): Sales $\125,000$, $125,000$; Variable Costs $93,750$, $89,063$; Contribution Margin $31,250$, $35,938$; Fixed Costs $25,000$, $27,500$; Net Operating Income $6,250 8,438$; Percent Increase in Income $35$ percent.
The company in this example also faces a downside risk, however. If customers disliked the change enough that sales decreased by more than $6\%$, net operating income would drop below the original level of $\6,250$ and could even become a loss.
Operating leverage has a multiplier effect. A multiplier effect is one in which a change in an input (such as variable cost per unit) by a certain percentage has a greater effect (a higher percentage effect) on the output (such as net income). To explain the concept of a multiplier effect, think of having to open a very large, heavy wooden crate. You could pull and pull with your hands all day and still not exert enough force to get it open. But, what if you used a lever in the form of a pry bar to multiply your effort and strength? For every additional amount of force you apply to the pry bar, a much larger amount of force is applied to the crate. Before you know it, you have the crate open. Operating leverage works much like that pry bar: if operating leverage is high, then a very small increase in sales can result in a large increase in net operating income.
How does a company increase its operating leverage? Operating leverage is a function of cost structure, and companies that have a high proportion of fixed costs in their cost structure have higher operating leverage. There is, however, a cautionary side to operating leverage. Since high operating leverage is the result of high fixed costs, if the market for the company’s products, goods, or services shrinks, or if demand for the company’s products, goods, or services declines, the company may find itself obligated to pay for fixed costs with little or no sales revenue to spare. Managers who have made the decision to chase large increases in net operating income through the use of operating leverage have found that, when market demand falls, their only recourse is to close their doors. In fact, many large companies are making the decision to shift costs away from fixed costs to protect them from this very problem.
Link to Learning
During periods of sales downturns, there are many examples of companies working to shift costs away from fixed costs. This Yahoo Finance article reports that many airlines are changing their cost structure to move away from fixed costs and toward variable costs such as Delta Airlines. Although they are decreasing their operating leverage, the decreased risk of insolvency more than makes up for it.
In order to calculate the degree of operating leverage at a given level of sales, we will apply the following formula:
$\text { Degree of Operating Leverage }=\dfrac{\text { Contribution Margin }}{\text { Net Operating Income }}$
To explain further the concept of operating leverage, we will look at two companies and their operating leverage positions:
Both companies have the same net income of $\85,000$, but company B has a higher degree of operating leverage because its fixed costs are higher than that of company A. If we want to see how operating leverage impacts net operating income, then we can apply the following formula:
$\text {Degree of percentage Operating Leverage } \times \text { Percentage Change in Sales } = \text { Net Operating Income}$
Let’s assume that both company A and company B are anticipating a 10% increase in sales. Based on their respective degrees of operating leverage, what will their percentage change in net operating income be?
$\begin{array}{l}{\text { Company } \mathrm{A}: 1.71 \times 10 \%=17.4 \%} \ {\text { Company } \mathrm{B}: 2.47 \times 10 \%=24.7 \%}\end{array} \nonumber$
For company A, for every $10\%$ increase in sales, net operating income will increase $17.4\%$. But company B has a much higher degree of operating leverage, and a $10\%$ increase in sales will result in a $24.7\%$ increase in net operating income. These examples clearly show why, during periods of growth, companies have been willing to risk incurring higher fixed costs in exchange for large percentage gains in net operating income. But what happens in periods where income declines?
We will return to Company A and Company B, only this time, the data shows that there has been a $20\%$ decrease in sales. Note that the degree of operating leverage changes for each company. The reduced income resulted in a higher operating leverage, meaning a higher level of risk.
It is equally important to realize the percentage decrease in income for both companies. The decrease in sales by $20\%$ resulted in a $31.9\%$ decrease in net income for Company A. For Company B, the $20\%$ decrease in sales resulted in a $46.9\%$ decrease in net income. This also could have been found by taking the initial operating leverage times the $20\%$ decrease:
$\begin{array}{l}{\text { Company } A: 20 \% \text { decreases } \times 1.74 \text { operating leverage }=34.8 \% \text { decrease in net income }} \ {\text { Company } B: 20 \% \text { decreases } \times 2.47 \text { operating leverage }=49.4 \% \text { decrease in net income }}\end{array} \nonumber$
This example also shows why, during periods of decline, companies look for ways to reduce their fixed costs to avoid large percentage reductions in net operating income.
Think It Through: Moving Costs
You are the managerial accountant for a large manufacturing firm. The company has sales that are well above its break-even point, but they have historically carried most of their costs as fixed costs. The outlook for the industry you are in is not positive. How could you move more costs away from fixed costs to put the company in a better financial position if the industry does, in fact, take a downturn?
Continuing Application: Viking Grocery Stores
You might wonder why the grocery industry is not comparable to other big-box retailers such as hardware or large sporting goods stores. Just like other big-box retailers, the grocery industry has a similar product mix, carrying a vast of number of name brands as well as house brands. The main difference, then, is that the profit margin per dollar of sales (i.e., profitability) is smaller than the typical big-box retailer. Also, the inventory turnover and degree of product spoilage is greater for grocery stores. Overall, while the fixed and variable costs are similar to other big-box retailers, a grocery store must sell vast quantities in order to create enough revenue to cover those costs.
This is reflected in the business plan. Unlike a manufacturer, a grocery store will have hundreds of products at one time with various levels of margin, all of which will be taken into account in the development of their break-even analysis. Review a business plan developed by Viking Grocery Stores in consideration of opening a new site in Springfield, Missouri to see how a grocery store develops a business plan and break-even based upon multiple products. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/03%3A_Cost-Volume-Profit_Analysis/3.06%3A_Calculate_and_Interpret_a_Companys_Margin_of_Safety_and_Operating_Leverage.txt |
Section Summaries
3.1 Explain Contribution Margin and Calculate Contribution Margin per Unit, Contribution Margin Ratio, and Total Contribution Margin
• Contribution margin can be used to calculate how much of every dollar in sales is available to cover fixed expenses and contribute to profit.
• Contribution margin can be expressed on a per-unit basis, as a ratio, or in total.
• A specialized income statement, the Contribution Margin Income Statement, can be useful in looking at total sales and total contribution margin at varying levels of activity.
3.2 Calculate a Break-Even Point in Units and Dollars
• Break-even analysis is a tool that almost any business can use for planning and evaluation purposes. It helps identify a level of activity that is necessary before an organization starts to generate a profit.
• A break-even point can be found on a per-unit basis or as a dollar amount, depending upon whether a per-unit contribution margin or a contribution margin ratio is applied.
3.3 Perform Break-Even Sensitivity Analysis for a Single Product Under Changing Business Situations
• Cost-volume-profit analysis can be used to conduct a sensitivity analysis that shows what will happen if there are changes in any of the variables: sales price, units sold, variable cost per unit, or fixed costs.
• The break-even point may or may not be impacted by changes in costs depending on the type of cost affected.
3.4 Perform Break-Even Sensitivity Analysis for a Multi-Product Environment Under Changing Business Situations
• Companies provide multiple products, goods, and services to the consumer and, as result, need to calculate their break-even point based on the mix of the products, goods, and services.
• In a multi-product environment, calculating the break-even point is more complex and is usually calculated using a composite unit, which represents the sales mix of the business.
• If the sales mix of a company changes, then the break-even point changes, regardless of whether total sales dollars change or not.
3.5 Calculate and Interpret a Company’s Margin of Safety and Operating Leverage
• Businesses determine a margin of safety (sales dollars beyond the break-even point). The higher the margin of safety is, the lower the risk is of not breaking even and incurring a loss.
• Operating leverage is a measurement of how sensitive net operating income is to a percentage change in sales dollars. A high degree of operating leverage results from a cost structure that is heavily weighted in fixed costs.
Key Terms
break-even point
dollar amount (total sales dollars) or production level (total units produced) at which the company has recovered all variable and fixed costs; it can also be expressed as that point where Total Cost (TC) = Total Revenue (TR)
composite unit
selection of discrete products associated together in relation or proportion to their sales mix
contribution margin
amount by which a product’s selling price exceeds its total variable cost per unit
contribution margin ratio
percentage of a unit’s selling price that exceeds total unit variable costs
margin of safety
difference between current sales and break-even sales
multi-product environment
business environment in which a company sells different products, manufactures different products, or offers different types of services
multiplier effect
when the change in an input by a certain percentage has a greater effect (a higher percentage effect) on the output
operating leverage
measurement of how sensitive net operating income is to a percentage change in sales dollars
relevant range
quantitative range of units that can be produced based on the company’s current productive assets; for example, if a company has sufficient fixed assets to produce up to \(10,000\) units of product, the relevant range would be between \(0\) and \(10,000\) units
sales mix
relative proportions of the products that a company sells
sensitivity analysis
what will happen if sales price, units sold, variable cost per unit, or fixed costs change
target pricing
process in which a company uses market analysis and production information to determine the maximum price customers are willing to pay for a good or service in addition to the markup percentage
total contribution margin
amount by which total sales exceed total variable costs | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/03%3A_Cost-Volume-Profit_Analysis/3.07%3A_Summary_and_Key_Terms.txt |
Multiple Choice
1. The amount of a unit’s sales price that helps to cover fixed expenses is its ________.
1. contribution margin
2. profit
3. variable cost
4. stepped cost
Answer:
a
1. A company’s product sells for \(\$150\) and has variable costs of \(\$60\) associated with the product. What is its contribution margin per unit?
1. \(\$40\)
2. \(\$60\)
3. \(\$90\)
4. \(\$150\)
2. A company’s product sells for \(\$150\) and has variable costs of \(\$60\) associated with the product. What is its contribution margin ratio?
1. \(10\%\)
2. \(40\%\)
3. \(60\%\)
4. \(90\%\)
Answer:
c
1. A company’s contribution margin per unit is \(\$25\). If the company increases its activity level from \(200\) units to \(350\) units, how much will its total contribution margin increase?
1. \(\$1,250\)
2. \(\$3,750\)
3. \(\$5,000\)
4. \(\$8,750\)
2. A company sells its products for \(\$80\) per unit and has per-unit variable costs of \(\$30\). What is the contribution margin per unit?
1. \(\$30\)
2. \(\$50\)
3. \(\$80\)
4. \(\$110\)
Answer:
b
1. If a company has fixed costs of \(\$6,000\) per month and their product that sells for \(\$200\) has a contribution margin ratio of \(30\%\), how many units must they sell in order to break even?
1. \(100\)
2. \(180\)
3. \(200\)
4. \(2,000\)
2. Company A wants to earn \(\$5,000\) profit in the month of January. If their fixed costs are \(\$10,000\) and their product has a per-unit contribution margin of \(\$250\), how many units must they sell to reach their target income?
1. \(20\)
2. \(40\)
3. \(60\)
4. \(120\)
Answer:
c
1. A company wants to earn an income of \(\$60,000\) after-taxes. If the tax rate is \(32\%\), what must be the company’s pre-tax income in order to have \(\$60,000\) after-taxes?
1. \(\$88,235\)
2. \(\$19,200\)
3. \(\$79,200\)
4. \(\$143,000\)
2. A company has pre-tax or operating income of \(\$120,000\). If the tax rate is \(40\%\), what is the company’s after-tax income?
1. \(\$300,000\)
2. \(\$240,000\)
3. \(\$48,000\)
4. \(\$72,000\)
Answer:
d
1. When sales price increases and all other variables are held constant, the break-even point will ________.
1. remain unchanged
2. increase
3. decrease
4. produce a lower contribution margin
2. When sales price decreases and all other variables are held constant, the break-even point will ________.
1. remain unchanged
2. increase
3. decrease
4. produce a higher contribution margin
Answer:
b
1. When variable costs increase and all other variables remain unchanged, the break-even point will ________.
1. remain unchanged
2. increase
3. decrease
4. produce a lower contribution margin
2. When fixed costs decrease and all other variables remain unchanged, the break-even point will ________.
1. remain unchanged
2. increase
3. decrease
4. produce a lower contribution margin
Answer:
c
1. When fixed costs increase and all other variables remain unchanged, the contribution margin will ________.
1. remain unchanged
2. increase
3. decrease
4. increase variable costs per unit
2. If the sales mix in a multi-product environment shifts to a higher volume in low contribution margin products, the break-even point will ________.
1. remain unchanged because all products are included in the calculation of break-even
2. increase because the low contribution margin products have little effect on break-even
3. increase because the per composite unit contribution margin will decrease
4. decrease because the per composite unit contribution margin will increase
Answer:
c
1. Break-even for a multiple product firm ________.
1. can be calculated by dividing total fixed costs by the contribution margin of a composite unit
2. can be calculated by multiplying fixed costs by the contribution margin ratio of a composite unit
3. can only be calculated when the proportion of products sold is the same for all products
4. can be calculated by multiplying fixed costs by the contribution margin ratio of the most common product in the sales mix
2. Waskowski Company sells three products (A, B, and C) with a sales mix of \(3:2:1\). Unit sales price are shown. What is the sales price per composite unit?
1. \(\$17.00\)
2. \(\$25.00\)
3. \(\$35.00\)
4. \(\$20.00\)
Answer:
c
1. Beaucheau Farms sells three products (E, F, and G) with a sale mix ratio of \(3:1:2\). Unit sales price are shown. What is the sales price per composite unit?
1. \(\$28.00\)
2. \(\$20.00\)
3. \(\$59.00\)
4. \(\$41.00\)
1. A company sells two products, Model 101 and Model 202. For every one unit of Model 101, they sell they sell two units of Model 202. Sales and cost information for the two products is shown. What is the contribution margin for a composite unit based on the sales mix?
1. \$14
2. \$21
3. \$35
4. \$56
Answer:
d
1. Wallace Industries has total contribution margin of \(\$58,560\) and net income of \(\$24,400\) for the month of April. Wallace expects sales volume to increase by \(5\%\) in May. What are the degree of operating leverage and the expected percent change in income for Wallace Industries?
1. \(0.42\) and \(2.2\%\)
2. \(0.42\) and \(5\%\)
3. \(2.4\) and \(12\%\)
4. \(2.5\) and \(13\%\)
2. Macom Manufacturing has total contribution margin of \(\$61,250\) and net income of \(\$24,500\) for the month of June. Marcus expects sales volume to increase by \(10\%\) in July. What are the degree of operating leverage and the expected percent change in income for Macom Manufacturing?
1. \(0.4\) and \(10\%\)
2. \(2.5\) and \(10\%\)
3. \(2.5\) and \(25\%\)
4. \(5.0\) and \(50\%\)
Answer:
c
1. If a firm has a contribution margin of \(\$59,690\) and a net income of \(\$12,700\) for the current month, what is their degree of operating leverage?
1. \(0.18\)
2. \(1.18\)
3. \(2.4\)
4. \(4.7\)
2. If a firm has a contribution margin of \(\$78,090\) and a net income of \(\$13,700\) for the current month, what is their degree of operating leverage?
1. \(0.21\)
2. \(1.21\)
3. \(2.4\)
4. \(5.7\)
Answer:
d
Questions
1. Define and explain contribution margin on a per unit basis.
Answer:
Answers will vary. Responses should include that per-unit contribution margin is the amount by which a product’s selling price exceeds it total variable cost per unit.
1. Define and explain contribution margin ratio.
2. Explain how a contribution margin income statement can be used to determine profitability.
Answer:
Answers will vary. Responses should include that contribution income statements express total contribution margin for a given level of activity and can be useful in making decisions about product pricing and optimal levels of activity.
1. In a cost-volume-profit analysis, explain what happens at the break-even point and why companies do not want to remain at the break-even point.What is meant by a product’s contribution margin ratio and how is this ratio useful in planning business operations?
2. Explain how a manager can use CVP analysis to make decisions regarding changes in operations or pricing structure.
Answer:
Answers will vary. Responses should include the fact that the contribution margin ratio represents the percentage of every sales dollar available to cover fixed expenses. Businesses can use this ratio when projecting profit at various levels of sales revenue.
1. After conducting a CVP analysis, most businesses will then recreate a revised or projected income statement incorporating the results of the CVP analysis. What is the benefit of taking this extra step in the analysis?
2. Explain how it is possible for costs to change without changing the break-even point.
Answer:
Answers will vary. Responses should include a description of how the CVP analysis information can be brought into a projected income statement that takes into account additional revenues and expenses of the business to create a “big picture” of what happens as a result of a change in cost, volume, and profit.
1. Explain what a sales mix is and how changes in the sales mix affect the break-even point.
2. Explain how break-even analysis for a multi-product company differs from a company selling a single product.
Answer:
Answers will vary. Responses should include the definition of sales mix as the relative proportions in which a company’s products are sold as well as a description of how products within the sales mix have unique sales prices, variable costs, and contribution margins.
1. Explain margin of safety and why it is an important measurement for managers.
2. Define operating leverage and explain its importance to a company and how it relates to risk.
Answer:
Answers will vary. Responses should include an explanation of how margin of safety allows the business to operate at a level where the risk of falling to or below the break-even point is low. There should also be some mention of the usefulness of the margin safety as an “alarm” for companies, such that when sales fall to the margin of safety level, action may be warranted.
Exercise Set A
1. Calculate the per-unit contribution margin of a product that has a sale price of \(\$200\) if the variable costs per unit are \(\$65\).
2. Calculate the per-unit contribution margin of a product that has a sale price of \(\$400\) if the variable costs per unit are \(\$165\).
3. A product has a sales price of \(\$150\) and a per-unit contribution margin of \(\$50\). What is the contribution margin ratio?
4. A product has a sales price of \(\$250\) and a per-unit contribution margin of \(\$75\). What is the contribution margin ratio?
5. Maple Enterprises sells a single product with a selling price of \(\$75\) and variable costs per unit of \(\$30\). The company’s monthly fixed expenses are \(\$22,500\).
1. What is the company’s break-even point in units?
2. What is the company’s break-even point in dollars?
3. Construct a contribution margin income statement for the month of September when they will sell \(900\) units.
4. How many units will Maple need to sell in order to reach a target profit of \(\$45,000\)?
5. What dollar sales will Maple need in order to reach a target profit of \(\$45,000\)?
6. Construct a contribution margin income statement for Maple that reflects \(\$150,000\) in sales volume.
6. Marlin Motors sells a single product with a selling price of \(\$400\) with variable costs per unit of \(\$160\). The company’s monthly fixed expenses are \(\$36,000\).
1. What is the company’s break-even point in units?
2. What is the company’s break-even point in dollars?
3. Prepare a contribution margin income statement for the month of November when they will sell \(130\) units.
4. How many units will Marlin need to sell in order to realize a target profit of \(\$48,000\)?
5. What dollar sales will Marlin need to generate in order to realize a target profit of \(\$48,000\)?
6. Construct a contribution margin income statement for the month of February that reflects \(\$200,000\) in sales revenue for Marlin Motors.
7. Flanders Manufacturing is considering purchasing a new machine that will reduce variable costs per part produced by \(\$0.15\). The machine will increase fixed costs by \(\$18,250\) per year. The information they will use to consider these changes is shown here.
1. Marchete Company produces a single product. They have recently received the results of a market survey that indicates that they can increase the retail price of their product by \(8\%\) without losing customers or market share. All other costs will remain unchanged. Their most recent CVP analysis is shown. If they enact the \(8\%\) price increase, what will be their new break-even point in units and dollars?
1. Brahma Industries sells vinyl replacement windows to home improvement retailers nationwide. The national sales manager believes that if they invest an additional \(\$25,000\) in advertising, they would increase sales volume by \(10,000\) units. Prepare a forecasted contribution margin income statement for Brahma if they incur the additional advertising costs, using this information:
1. Salvador Manufacturing builds and sells snowboards, skis and poles. The sales price and variable cost for each are shown:
Their sales mix is reflected in the ratio \(7:3:2\). What is the overall unit contribution margin for Salvador with their current product mix?
1. Salvador Manufacturing builds and sells snowboards, skis and poles. The sales price and variable cost for each follows:
Their sales mix is reflected in the ratio \(7:3:2\). If annual fixed costs shared by the three products are \(\$196,200\), how many units of each product will need to be sold in order for Salvador to break even?
1. Use the information from the previous exercises involving Salvador Manufacturing to determine their break-even point in sales dollars.
2. Company A has current sales of \(\$10,000,000\) and a \(45\%\) contribution margin. Its fixed costs are \(\$3,000,000\). Company B is a service firm with current service revenue of \(\$5,000,000\) and a \(20\%\) contribution margin. Company B’s fixed costs are \(\$500,000\). Compute the degree of operating leverage for both companies. Which company will benefit most from a \(25\%\) increase in sales? Explain why.
3. Marshall & Company produces a single product and recently calculated their break-even point as shown.
What would Marshall’s target margin of safety be in units and dollars if they required a \(\$14,000\) margin of safety?
Exercise Set B
1. Calculate the per-unit contribution margin of a product that has a sale price of \(\$150\) if the variable costs per unit are \(\$40\).
2. Calculate the per-unit contribution margin of a product that has a sale price of \(\$350\) if the variable costs per unit are \(\$95\).
3. A product has a sales price of \(\$175\) and a per-unit contribution margin of \(\$75\). What is the contribution margin ratio?
4. A product has a sales price of \(\$90\) and a per-unit contribution margin of \(\$30\). What is the contribution margin ratio?
5. Cadre, Inc., sells a single product with a selling price of \(\$120\) and variable costs per unit of \(\$90\). The company’s monthly fixed expenses are \(\$180,000\).
1. What is the company’s break-even point in units?
2. What is the company’s break-even point in dollars?
3. Prepare a contribution margin income statement for the month of October when they will sell \(10,000\) units.
4. How many units will Cadre need to sell in order to realize a target profit of \(\$300,000\)?
5. What dollar sales will Cadre need to generate in order to realize a target profit of \(\$300,000\)?
6. Construct a contribution margin income statement for the month of August that reflects \(\$2,400,000\) in sales revenue for Cadre, Inc.
6. Kerr Manufacturing sells a single product with a selling price of \(\$600\) with variable costs per unit of \(\$360\). The company’s monthly fixed expenses are \(\$72,000\).
1. What is the company’s break-even point in units?
2. What is the company’s break-even point in dollars?
3. Prepare a contribution margin income statement for the month of January when they will sell \(500\) units.
4. How many units will Kerr need to sell in order to realize a target profit of \(\$120,000\)?
5. What dollar sales will Kerr need to generate in order to realize a target profit of \(\$120,000\)?
6. Construct a contribution margin income statement for the month of June that reflects \(\$600,000\) in sales revenue for Kerr Manufacturing.
7. Delta Co. sells a product for \(\$150\) per unit. The variable cost per unit is \(\$90\) and fixed costs are \(\$15,250\). Delta Co.’s tax rate is \(36\%\) and the company wants to earn \(\$44,000\) after taxes.
1. What would be Delta’s desired pre-tax income?
2. What would be break-even point in units to reach the income goal of \(\$44,000\) after taxes?
3. What would be break-even point in sales dollars to reach the income goal of \(\$44,000\) after taxes?
4. Create a contribution margin income statement to show that the break-even point calculated in B, generates the desired after-tax income.
8. Shonda & Shonda is a company that does land surveys and engineering consulting. They have an opportunity to purchase new computer equipment that will allow them to render their drawings and surveys much more quickly. The new equipment will cost them an additional \(\$1,200\) per month, but they will be able to increase their sales by \(10\%\) per year. Their current annual cost and break-even figures are as follows:
1. What will be the impact on the break-even point if Shonda & Shonda purchases the new computer?
2. What will be the impact on net operating income if Shonda & Shonda purchases the new computer?
3. What would be your recommendation to Shonda & Shonda regarding this purchase?
1. Baghdad Company produces a single product. They have recently received the result of a market survey that indicates that they can increase the retail price of their product by \(10\%\) without losing customers or market share. All other costs will remain unchanged. If they enact the \(10\%\) price increase, what will be their new break-even point in units and dollars? Their most recent CVP analysis is:
1. Keleher Industries manufactures pet doors and sells them directly to the consumer via their web site. The marketing manager believes that if the company invests in new software, they will increase their sales by \(10\%\). The new software will increase fixed costs by \(\$400\) per month. Prepare a forecasted contribution margin income statement for Keleher Industries reflecting the new software cost and associated increase in sales. The previous annual statement is as follows:
1. JJ Manufacturing builds and sells switch harnesses for glove boxes. The sales price and variable cost for each follows:
Their sales mix is reflected in the ratio \(4:4:1\). What is the overall unit contribution margin for JJ Manufacturing with their current product mix?
1. JJ Manufacturing builds and sells switch harnesses for glove boxes. The sales price and variable cost for each follow:
Their sales mix is reflected in the ratio \(4:4:1\). If annual fixed costs shared by the three products are \(\$18,840\) how many units of each product will need to be sold in order for JJ to break even?
1. Use the information from the previous exercises involving JJ Manufacturing to determine their break-even point in sales dollars.
2. Company A has current sales of \(\$4,000,000\) and a \(45\%\) contribution margin. Its fixed costs are \(\$600,000\). Company B is a service firm with current service revenue of \(\$2,800,000\) and a \(15\%\) contribution margin. Company B’s fixed costs are \(\$375,000\). Compute the degree of operating leverage for both companies. Which company will benefit most from a \(15\%\) increase in sales? Explain why.
3. Best Wholesale recently calculated their break-even point for their Midwest operations. The national sales manager has asked them to include a \(\$10,500\) margin of safety in their calculations. Using the following information, recalculate Best Wholesale’s break-even point in units and dollars with the \(\$10,500\) margin of safety included.
Problem Set A
1. A company sells small motors as a component part to automobiles. The Model 101 motor sells for \(\$850\) and has per-unit variable costs of \(\$400\) associated with its production. The company has fixed expenses of \(\$90,000\) per month. In August, the company sold \(425\) of the Model 101 motors.
1. Calculate the contribution margin per unit for the Model 101.
2. Calculate the contribution margin ratio of the Model 101.
3. Prepare a contribution margin income statement for the month of August.
2. A company manufactures and sells racing bicycles to specialty retailers. The Bomber model sells for \(\$450\) and has per-unit variable costs of \(\$200\) associated with its production. The company has fixed expenses of \(\$40,000\) per month. In May, the company sold \(225\) of the Bomber model bikes.
1. Calculate the contribution margin per unit for the Bomber.
2. Calculate the contribution margin ratio of the Bomber.
3. Prepare a contribution margin income statement for the month of May.
3. Fill in the missing amounts for the four companies. Each case is independent of the others. Assume that only one product is being sold by each company.
1. Markham Farms reports the following contribution margin income statement for the month of August. The company has the opportunity to purchase new machinery that will reduce its variable cost per unit by \(\$2\) but will increase fixed costs by \(15\%\). Prepare a projected contribution margin income statement for Markham Farms assuming it purchases the new equipment. Assume sales level remains unchanged.
1. Kylie’s Cookies is considering the purchase of a larger oven that will cost \(\$2,200\) and will increase her fixed costs by \(\$59\). What would happen if she purchased the new oven to realize the variable cost savings of \(\$0.10\) per cookie, and what would happen if she raised her price by just \(\$0.20\)? She feels confident that such a small price increase will decrease the sales by only \(25\) units and may help her offset the increase in fixed costs. Given the following current prices how would the break-even in units and dollars change if she doesn’t increase the selling price and if she does increase the selling price? Complete the monthly contribution margin income statement for each of these cases.
1. Morris Industries manufactures and sells three products (AA, BB, and CC). The sales price and unit variable cost for the three products are as follows:
Their sales mix is reflected as a ratio of \(5:3:2\). Annual fixed costs shared by the three products are \(\$258,000\) per year.
1. What are total variable costs for Morris with their current product mix?
2. Calculate the number of units of each product that will need to be sold in order for Morris to break even.
3. What is their break-even point in sales dollars?
4. Using an income statement format, prove that this is the break-even point.
1. Manatoah Manufacturing produces 3 models of window air conditioners: model 101, model 201, and model 301. The sales price and variable costs for these three models are as follows:
The current product mix is \(4:3:2\). The three models share total fixed costs of \(\$430,000\).
1. Calculate the sales price per composite unit.
2. What is the contribution margin per composite unit?
3. Calculate Manatoah’s break-even point in both dollars and units.
4. Using an income statement format, prove that this is the break-even point.
1. Jakarta Company is a service firm with current service revenue of \(\$400,000\) and a \(40\%\) contribution margin. Its fixed costs are \(\$80,000\). Maldives Company has current sales of \(\$6,610,000\) and a \(45\%\) contribution margin. Its fixed costs are \(\$1,800,000\).
1. What is the margin of safety for Jakarta and Maldives?
2. Compare the margin of safety in dollars between the two companies. Which is stronger?
3. Compare the margin of safety in percentage between the two companies. Now, which one is stronger?
4. Compute the degree of operating leverage for both companies. Which company will benefit most from a \(15\%\) increase in sales? Explain why. Illustrate your findings in an Income Statement that is increased by \(15\%\).
Problem Set B
1. A company sells mulch by the cubic yard. Grade A much sells for \(\$150\) per cubic yard and has variable costs of \(\$65\) per cubic yard. The company has fixed expenses of \(\$15,000\) per month. In August, the company sold \(240\) cubic yards of Grade A mulch.
1. Calculate the contribution margin per unit for Grade A mulch.
2. Calculate the contribution margin ratio of the Grade A mulch.
3. Prepare a contribution margin income statement for the month of August.
2. A company manufactures and sells blades that are used in riding lawnmowers. The \(18\)-inch blade sells for \(\$15\) and has per-unit variable costs of \(\$4\) associated with its production. The company has fixed expenses of \(\$85,000\) per month. In January, the company sold \(12,000\) of the \(18\)-inch blades.
1. Calculate the contribution margin per unit for the \(18\)-inch blade.
2. Calculate the contribution margin ratio of the \(18\)-inch blade.
3. Prepare a contribution margin income statement for the month of January.
3. Fill in the missing amounts for the four companies. Each case is independent of the others. Assume that only one product is being sold by each company.
1. West Island distributes a single product. The company’s sales and expenses for the month of June are shown.
Using the information presented, answer these questions:
1. What is the break-even point in units sold and dollar sales?
2. What is the total contribution margin at the break-even point?
3. If West Island wants to earn a profit of \(\$21,000\), how many units would they have to sell?
4. Prepare a contribution margin income statement that reflects sales necessary to achieve the target profit.
1. Wellington, Inc., reports the following contribution margin income statement for the month of May. The company has the opportunity to purchase new machinery that will reduce its variable cost per unit by \(\$10\) but will increase fixed costs by \(20\%\). Prepare a projected contribution margin income statement for Wellington, Inc., assuming it purchases the new equipment. Assume sales level remains unchanged.
1. Karen’s Quilts is considering the purchase of a new Long-arm Quilt Machine that will cost \(\$17,500\) and will increase her fixed costs by \(\$119\). What would happen if she purchased the new quilt machine to realize the variable cost savings of \(\$5.00\) per quilt, and what would happen if she raised her price by just \(\$5.00\)? She feels confident that such a small price increase will not decrease the sales in units that will help her offset the increase in fixed costs. Given the following current prices how would the break-even in units and dollars change? Complete the monthly contribution margin income statement for each of these cases.
1. Abilene Industries manufactures and sells three products (XX, YY, and ZZ). The sales price and unit variable cost for the three products are as follows:
Their sales mix is reflected as a ratio of \(4:2:1\). Annual fixed costs shared by the three products are \(\$345,000\) per year.
1. What are total variable costs for Abilene with their current product mix?
2. Calculate the number of units of each product that will need to be sold in order for Abilene to break even.
3. What is their break-even point in sales dollars?
4. Using an income statement format, prove that this is the break-even point.
1. Tim-Buck-II rents jet skis at a beach resort. There are three models available to rent: Junior, Adult, and Expert. The rental price and variable costs for these three models are as follows:
The current product mix is \(5:4:1\). The three models share total fixed costs of \(\$114,750\).
1. Calculate the sales price per composite unit.
2. What is the contribution margin per composite unit?
3. Calculate Tim-Buck-II’s break-even point in both dollars and units.
4. Using an income statement format, prove that this is the break-even point.
1. Fire Company is a service firm with current service revenue of \(\$900,000\) and a \(40\%\) contribution margin. Its fixed costs are \(\$200,000\). Ice Company has current sales of \(\$420,000\) and a \(30\%\) contribution margin. Its fixed costs are \(\$90,000\).
1. What is the margin of safety for Fire and Ice?
2. Compare the margin of safety in dollars between the two companies. Which is stronger?
3. Compare the margin of safety in percentage between the two companies. Now which one is stronger?
4. Compute the degree of operating leverage for both companies. Which company will benefit most from a \(10\%\) increase in sales? Explain why. Illustrate your findings in an Income Statement that is increased by \(10\%\).
Thought Provokers
1. Mariana Manufacturing and Bellow Brothers compete in the same industry and in all respects their products are virtually identical. However, most of Mariana’s costs are fixed while Bellow’s costs are primarily variable. If sales increase for both companies, which will realize the greatest increase in profits? Why?
2. Roald is the sales manager for a small regional manufacturing firm you own. You have asked him to put together a plan for expanding into nearby markets. You know that Roald’s previous job had him working closely with many of your competitors in this new market, and you believe he will be able to facilitate the company expansion. He is to prepare a presentation to you and your partners outlining his strategy for taking the company into this expanded market. The day before the presentation, Roald comes to you and explains that he will not be making a presentation on market expansion but instead wants to discuss several ways he believes the company can reduce both fixed and variable costs. Why would Roald want to focus on reducing costs rather than on expanding into a new market?
3. As a manager, you have to choose between two options for new production equipment. Machine A will increase fixed costs by a substantial margin but will produce greater sales volume at the current price. Machine B will only slightly increase fixed costs but will produce considerable savings on variable cost per unit. No additional sales are anticipated if Machine B is selected. What are the relative merits of both machines, and how could you go about analyzing which machine is the better investment for the company in terms of both net operating income and break-even?
4. Couture’s Creations is considering offering Joe, an hourly employee, the opportunity to become a salaried employee. Why is this a good idea for Couture’s Creations? Is this a good idea for Joe? What if Couture’s Creations entices Joe to agree to the change by offering him a salaried position with no risk of layoff during the winter lull? What if Joe agrees and Couture’s Creations lays him off anyway six months into the agreement? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/03%3A_Cost-Volume-Profit_Analysis/3.0E%3A_3.E%3A_Cost-Volume-Profit_Analysis_%28Exercises%29.txt |
Hallie graduated from college last year and moved to Tempe, Arizona, to begin her career. Before moving, she purchased a secondhand dresser for \(\$35\) and spent \(\$25\) on refinishing materials. After two hours of work, she posted a picture of the dresser on social media, and a friend offered her \(\$100\) to refinish another dresser exactly the same way.
Fortunately, Hallie understands cost accounting and knew she needed to calculate the cost to refinish another dresser. She found a similar dresser for \(\$65\). She knows that the refinishing materials will cost \(\$25\), and thus before adding in any cost for labor she is already at a cost of \(\$90\), without considering any overhead, such as electricity to run her sander.
Hallie estimated that her labor costs should be \(\$20\) per hour. The total cost then would be \(\$130\), and accepting less would mean accepting less for her labor. For a business in this situation, agreeing to the \(\$100\) offer would be considered a loss. If Hallie accepts the \(\$100\) price before checking her costs, she would have received only \(\$10\) for her labor (the sales price of \(\$100\) less the \(\$90\) cost of the dresser and materials).
Hallie didn’t know if she would lose a potential customer by raising the price, so she found a different style dresser costing \(\$25\). A sales price of \(\$100\) would be fair with the two hours to refinish at \(\$20\) per hour and a materials cost of \(\$25\). She offered her friend the original style dresser for \(\$130\) or the alternate style dresser for \(\$100\).
As this example illustrates, it was essential for Hallie to know the cost to complete her project. It is also essential for all types and sizes of organizations to know the costs to complete their project. Manufacturing organizations need to know the costs of production, retail organizations need to know the cost to sell their products, and service organizations need to know the cost of providing their services. Management strives to eliminate unnecessary costs and needs to know the costs associated with using large pieces of equipment as well as seemingly insignificant office supplies. Cost accounting involves measuring and reporting the cost of production or service, while also providing data to determine the cost of the individual unit produced.
4.02: Distinguish between Job Order Costing and Process Costing
Pet Smart, H&R Block, Chili’s, and Marshalls are popular chains often found at the same shopping center, even though they are very different businesses. Although they have a retail store, the Pet Smart Corporation also manufactures large volumes of its own products, whereas H&R Block prepares taxes for individual customers. Chili’s prepares food, and its wait staff provides a service, whereas Marshalls sells a variety of products at retail.
The management of each business relies on knowing each cost when making decisions, such as setting the sales price, planning production and staffing schedules, and ordering materials. Although these companies share a common location, which suggests similar rental costs, all the other costs vary significantly. Because of these cost differences, each company must have a system for gathering its cost data. For example, Pet Smart manufactures Great Choice squeaker balls in large batches and collects cost data through a process costing system. A process costing system is often used to trace and determine production costs when similar products or services are provided. The concept and mechanics of a process costing system are addressed in Process Costing.
Since a typical tax return can vary significantly from one taxpayer to the next, H&R Block provides a service that they customize for each customer. Its cost data are collected via a job order cost system, which is designed to allow for individualized products or services.
Marshalls does not produce a product yet still needs a system to assign overhead costs to the products it sells. (Overhead was addressed in Building Blocks of Managerial Accounting.) And while Chili’s has the same nationwide menu, it needs a system to collect the costs for each menu item within each location.
While companies may choose different cost accounting systems, each system must be capable of accumulating the costs incurred and allocating the costs to the product. Each costing system also requires the ability to obtain and analyze the cost data, and the more detailed the information needed, the higher the cost of collecting the data. The choice of cost accumulation system depends on the variety and type of products or services sold, or the type of manufacturing processes employed. The system used should be determined by weighing the cost of collecting the data and the benefit of having that information.
Companies use different costing systems for determining the cost of custom products than they do for determining the cost of mass-produced products. When products are custom ordered, knowing the cost of the materials, labor, and overhead is critical to determining the sales price. As an easy example, think of a tailor who alters, repairs, and makes custom clothes for customers. If a customer orders a custom-made suit, the specific fabric, detail of any special features, and the time involved in sewing are all factors that will determine the total cost and, therefore, the selling price of the garment. Each component of the cost of producing the clothing will be tracked as it occurs, thus improving the accuracy of determining the price. However, in mass production, wherein one batch leads to a second batch, stopping the process to properly identify the materials, labor, and overhead costs used for each batch does not provide enough valuable data to justify determining the individual costing of each product. For example, in the case of a mass-produced clothing item, such as jeans, a company like Levi’s will track costs for a batch of jeans rather than for a pair of jeans. Levi’s had over \(\$4.9\) billion in revenue in 2017 generated from the many different styles and brands of clothing items they produce and sell. It would be difficult, and not cost effective, to track the cost of each individual clothing item; rather, it is more efficient to track the costs in each phase of the clothing-making process. Levi’s can then accumulate the costs of the phases of production to determine the total cost of production for a batch and allocate those costs over the number of pairs of jeans made. This process allows them to determine the cost of each item.
Even retail companies need to know the cost of the purchased products before the sales price is set. While it seems simple to think of the sales price as the purchase price plus a markup, determining the markup costs needs to be an accurate process in order to ensure the sale price is higher than the product cost. To properly capture the information necessary for decision-making, there are different costing systems that track costs in order to determine sales prices, and to measure profits and manufacturing efficiency.
As previously mentioned, the two traditional types of costing systems are job order costing and process costing. Each anticipates or determines unit costs of products being manufactured and/or services being provided prior to year-end. Companies may decide to use only one or a combination of methods. This chapter examines job order costing and demonstrates how it differs from process costing. Process Costing and other costing systems (Activity-Based, Variable, and Absorption Costing) are covered in other chapters.
In this chapter, you will also learn the terminology used to track costs within the job order cost system and how to segregate and aggregate these costs to determine the costs of production in a job order costing environment. You will also learn how to record these job costs and where they appear on financial statements.
Job Order Costing versus Process Costing
Job order costing is an accounting system that traces the individual costs directly to a final job or service, instead of to the production department. It is used when goods are made to order or when individual costs are easy to trace to individual jobs, assuming that the additional information provides value. In these circumstances, the individual costs are easy to trace to the individual jobs.
For example, assume that a homeowner wants to have a custom deck added to her home. Also assume that in order to fit her lot’s topography and her anticipated uses for the addition, she needs a uniquely designed deck. Her contractor will design the deck, price the necessary components (in this case, the direct materials, direct labor, and overhead), and construct it.
The final cost will be unique to this project. If another homeowner wanted the contractor to construct a deck, the contractor would go through the same design and pricing process, and you would expect that the design and costs would not be the same as those of the deck in the first example, since the decks would differ from one another.
The job order costing method also works well for companies such as movie production companies, print service providers, advertising agencies, building contractors, accounting firms, consulting entities, and repair service providers. For example, Star Wars: The Last Jedi is believed to have cost \$200 million to produce, whereas Logan only cost \$97 million. The production processes for both films differed significantly, so that the accumulated costs for each job also differed significantly. Both were made in 2017.1
In contrast, process costing is used when the manufacturing process is continuous, so it is difficult to establish how much of each material is used and exactly how much time is invested in each unit of finished product. Therefore, in process costing, costs are accounted for by the production process or production department instead of by the product or by the job. This method works well for manufacturers of products such as Titleist golf balls, Kellogg’s cereal, Turkey Hill ice cream, CITGO gasoline, Dow Chemicals, or Sherwin Williams’ paints. However, process costing is not limited to basic manufacturing activities: It can also be used in the manufacturing of more complex items, such as small engines. A process costing system assigns costs to each department as the costs are incurred, and the costs to produce one unit are calculated based on the information from the production department. Unit costs are determined after total production costs are determined.
One factor that can complicate the choice between job order costing and process costing is the growth of automation in the production process, which typically is accompanied by a reduction in direct labor. The cost of the increase in equipment (typically reflected as a depreciation expense) is allocated to overhead, while the decreased need for labor usually reduces the direct labor cost. Because of these issues, some companies choose a hybrid system, using process costing to account for mass producing a part and using job order costing to account for assembling some of those individual parts into a custom product. Table \(1\) summarizes the use of these two systems.
Table \(1\): Job Order and Process Cost Systems
Job Order Cost System Process Cost System
Product type Custom order Mass production
Examples Signs, buildings, tax returns Folding tables, toys, buffet restaurants
Cost accumulation Job lot Accumulated per process
Work in process inventory Individual job cost sheets Separate work in process inventory department
Record keeping Individual job cost sheets Production cost report
To illustrate how a company can determine whether to use job order costing or process costing, consider the cost accounting options for a local restaurant. Macs & Cheese makes specialty macaroni and cheese, and the company wants to erect a special sign on an already constructed billboard outside a stadium. It wants to use this space to target stadium customers; thus, the company wants a sign built specifically for that site. Dinosaur Vinyl is secured as the sign manufacturer and would use job order costing to account for the associated manufacturing costs because of the unique nature of the sign, including the art work involved. However, if Macs & Cheese was designing a costing system for the specialty food product they market, they typically would use a process costing approach because their product is made and marketed in homogeneous, similar batches.
LINK TO LEARNING
Dynamic Systems provides bar code-traceable software that helps companies track the costs associated with production. The company explains the difference between job order cost systems and process cost systems to their customers who often ask if their job order cost software is also the process cost software.
Organization of Flow of Goods through Production
Regardless of the costing method used (job order costing, process costing, or another method), manufacturing companies are generally similar in their organizational structure and have a similar flow of goods through production. The diagram in Figure \(1\) shows a partial organizational chart for sign manufacturer Dinosaur Vinyl. The CEO has several direct reporting units—Financing, Production, Information Technology, Marketing, Human Resources, and Maintenance—each with a director responsible for several departments.
The diagram also shows the departments that report to the production unit director and gives an indication as to the flow of goods through production. The flow of goods through production is more evident in Figure \(2\), which depicts Dinosaur Vinyl as a simple factory with three stages of production.
Raw materials are stored in the materials storeroom and delivered to the appropriate production department—cutting, painting, or assembly/finishing. The design department uses direct labor to create the design specifications, and, when completed, it sends them to the production department. The production department uses the material and design specifications and adds additional labor to create the sign. The sign is transferred to the finishing department for final materials and labor, before the sign is installed or delivered to the customer.
Manufacturing Costs
In a manufacturing environment, the manufacturing costs are also called product costs and include all expenses used to manufacture the product: direct materials, direct labor, and manufacturing overhead. To review these costs, see Building Blocks of Managerial Accounting. The total of these costs becomes the cost of ending inventory and later becomes the cost of goods sold when the product is sold. Both job order costing and process costing use categorized cost information to make decisions and evaluate the effectiveness of the cost tracking process. Because of the difference in how each of the two costing systems track costs, different terminology is used. Thus, it is important to separate product costs from period costs, and it is sometimes important to separate product costs into prime costs and conversion costs. Prime costs are costs that include the primary (or direct) product costs: direct materials and direct labor. Conversion costs are costs that include the expenses necessary to convert direct materials into a finished product: direct labor and manufacturing overhead. Their relationship is shown in Figure \(3\).
Job order costing systems assign costs directly to the product by assigning direct materials and direct labor to the work in process (WIP) inventory. As you learned in Building Blocks of Managerial Accounting, direct materials are the components that can be directly traced to the products produced, whereas direct labor is the labor cost that can be directly traced to the products produced.
Material and labor costs that cannot be traced directly to the product produced are included in the overhead costs that are allocated in the production costing process. Overhead is applied to each product based on an activity base, which will be explained in Compute a Predetermined Overhead Rate and Apply Overhead to Production.
The assignment of direct materials and direct labor to each production unit illustrates the job order costing system’s focus on prime costs, in contrast to the process costing system, which assigns costs to the department and focuses on direct materials and conversion costs, which are composed of a combination of direct labor and overhead. Process costs will be demonstrated in Process Costing.
Selling and Administrative Costs
Selling and administrative costs (S&A) are period costs, and these costs are expensed as incurred, instead of being included in the product’s costs, as they move through the relevant inventory accounts. A period cost is a cost tied to a specific time period, such as a month, quarter, or year, instead of being associated with a particular job order. For example, if a company paid an insurance company \(\$12,000\) for one year’s liability insurance coverage, the first month’s expense would be \$1,000. This expense would not be related to a particular job order, but instead would be classified as a period cost, and in this case recorded monthly as an administrative expense. Selling costs are the expenses related to the promotion and sale of the company’s products, whereas administrative costs are the expenses related to the operations of the company. The S&A costs are considered period costs because they include costs of departments not directly associated with manufacturing but necessary to operate the business. Some examples include research and development costs, marketing costs, sales commissions, administration building rent, the CEO’s salary expense, and accounting, payroll, and IT department expenses.
Example \(1\): Maria’s Market
A grocery store’s analysis of a recent customer survey finds an increasing number of customers interested in being able to custom-order meals to go. Maria sees this as an opportunity to enter a niche market for busy families or individuals who want home-cooked meals with a variety of options and combinations, but who have little time. Maria already has an expansive deli, bakery, and prepared foods section in the store and sees this opportunity as a viable option to increase sales and its customer base. With meals to go, customers can choose from an array of options and can indicate the quantity of each item and the time of pickup. The customer simply pulls up in a designated spot at Maria’s and the food is brought to their car, packaged, and ready to take home to enjoy.
What type of costing system will work best for the Maria’s Market? What sales price information, cost information, and other options are important to this decision?
Solution
A job order cost system will work well for this store. In addition to specific price and cost, these are other important considerations.
• The optimal sales price should be set to encourage customers to purchase the meals.
• The materials, labor, and overhead cost should be considered for each meal option.
• Direct material costs may include the cost of the protein, grain, and vegetable option, as well as the cost of the packing containers.
• The direct labor cost is for employees who are directly involved in preparing the meals.
• Manufacturing overhead includes the cost of gloves used when preparing the meals, the cost of employees who support but are not directly involved in preparing the meals, and the cost to operate the oven.
• The cost of the various meal options should all be less than the sales price.
• The meal options should change to take advantage of seasonal items.
• There may be a need to vary the sales price, depending on the combinations selected.
Recording Costs in Job Order Costing versus Process Costing
Both job order costing and process costing track the costs of materials, labor, and overhead as components of virtually all products. The process of production does not change because of the costing method: The costing method is chosen based on the process of production and is intended to provide the most accurate representation of the costs incurred in the production process.
Maintaining accounting records for each system has its advantages. A job order costing system uses a job cost sheet to keep track of individual jobs and the direct materials, direct labor, and overhead associated with each job. The focus of a job order costing system is tracking costs per job, since each job is unique and therefore has different costs relative to other jobs. Maintaining this information is typically more expensive than process costing, and it is often used for the production of smaller, more individualized jobs because the benefit of knowing the cost of each product outweighs the additional cost of maintaining a job order costing system.
In contrast, a process costing system does not need to maintain the cost for individual jobs because the jobs use a continual system of production, and the items are typically not significantly unique but instead are basically equivalent. The accounting emphasis is in keeping records for the individual departments, which is useful for large batches or runs. Process costing is the optimal system to use when the production process is continuous and when it is difficult to trace a particular input cost to an individual product. Process costing systems assign costs to each department as the costs are incurred. The costs to produce one unit are calculated, based on the information from the production department. Therefore, the focus of process costing systems is on measuring and assigning the conversion costs to the proper department in order to best determine the cost of individual units.
Under either costing method, accounting theory explains why it is important to understand when costs become expenses. A primary reason for separating production costs from other company expenses is the expense recognition principle, which requires costs to be expensed when they match the revenue being earned and to separate the costs of production from other costs for the proper timing of recognition of expenses. Think about measuring the profit from the sale of an item, say a TV, in a nonmanufacturing environment. It is logical to subtract the costs associated with buying the TV in order to determine the profit, before applying other costs from that sale. Suppose the TV was purchased as inventory by the store in January and sold to a customer in March. This requires that the cost of the TV not be recorded as an expense (cost of goods sold) until March, when the sale from the TV is recorded, thus matching the revenue with the expense. Until that time, the TV and its cost are considered inventory. This same idea applies to the manufacturing process.
Per the expense recognition principle, product costs—the direct materials, direct labor, and manufacturing overhead incurred to produce the job—are expensed on the income statement for the period of the sale as cost of goods sold when the completed job is sold. If the products are not sold, their costs remain in ending inventory.
Prior to the sale of the product, separating production costs and assigning them to the product results in these costs remaining with the inventory. Until they are sold, the costs incurred are reflected in an assortment of inventory accounts, such as raw materials inventory, work in process inventory, and finished goods inventory.
In contrast, period costs are not directly related to the production process and are expensed during the period in which they are incurred. This approach matches administrative and other expenses shown on the income statement in the same period in which the company earns income.
Footnotes
1. “Production Costs and Global Box Office Revenue of Star Wars Movies from 1977 to 2018 (in million U.S. dollars).” The Statistics Portal. https://www.statista.com/statistics/...ffice-revenue/. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/04%3A_Job_Order_Costing/4.01%3A_Prelude_to_Job_Order_Costing.txt |
In order to set an appropriate sales price for a product, companies need to know how much it costs to produce an item. Just as a company provides financial statement information to external stakeholders for decision-making, they must provide costing information to internal managerial decision makers. Virtually every tangible product has direct materials, direct labor, and overhead costs that can include indirect materials and indirect labor, along with other costs, such as utilities and depreciation on production equipment. To account for these and inform managers making decisions, the costs are tracked in a cost accounting system.
While the flow of costs is generally the same for all costing systems, the difference is in the details: Product costs have material, labor, and overhead costs, which may be assessed differently. In most production facilities, the raw materials are moved from the raw materials inventory into the work in process inventory. The work in process involves one or more production departments and is where labor and overhead convert the raw materials into finished goods. The movement of these costs through the work in process inventory is shown in Figure $1$.
At this stage, the completed products are transferred into the finished goods inventory account. When the product is sold, the costs move from the finished goods inventory into the cost of goods sold.
While many types of production processes could be demonstrated, let’s consider an example in which a contractor is building a home for a client. The accounting system will track direct materials, such as lumber, and direct labor, such as the wages paid to the carpenters constructing the home. Along with these direct materials and labor, the project will incur manufacturing overhead costs, such as indirect materials, indirect labor, and other miscellaneous overhead costs. Samples of these costs include indirect materials, such as nails, indirect labor, such as the supervisor’s salary, assuming that the supervisor is overseeing several projects at the same time, and miscellaneous overhead costs such as depreciation on the equipment used in the construction project.
As direct materials, direct labor, and overhead are introduced into the production process, they become part of the work in process inventory value. When the home is completed, the accumulated costs become part of the finished goods inventory value, and when the home is sold, the finished goods value of the home becomes the cost of goods sold. Figure $2$ illustrates the flow of these costs through production.
The three general categories of costs included in manufacturing processes are direct materials, direct labor, and overhead. Note that there are a few exceptions, since some service industries do not have direct material costs, and some automated manufacturing companies do not have direct labor costs. For example, a tax accountant could use a job order costing system during tax season to trace costs. The one major difference between the home builder example and this one is that the tax accountant will not have direct material costs to track. The few assets used will typically be categorized as overhead.
A benefit of knowing the production costs for each job in a job order costing system is the ability to set appropriate sales prices based on all the production costs, including direct materials, direct labor, and overhead. The unique nature of the products manufactured in a job order costing system makes setting a price even more difficult. For each job, management typically wants to set the price higher than its production cost. Even if management is willing to price the product as a loss leader, they still need to know how much money will be lost on each product. To achieve this, management needs an accounting system that can accurately assign and document the costs for each product.
If you’re not familiar with the concept of a loss leader, a simple example might help clarify the concept. A loss leader is a product that is sold at a price that is often less than the cost of producing it in order to entice you to buy accessories that are necessary for its use. For example, you might pay $\50$ or $\60$ for a printer (for which the producer probably does not make any profit) in order to then sell you extremely expensive printer cartridges that only print a few pages before they have to be replaced. However, even pricing a product as a loss leader requires analysis of the three categories of costs: direct materials, direct labor, and overhead.
Direct Materials
Direct materials are those materials that can be directly traced to the manufacturing of the product. Some examples of direct materials for different industries are shown in Table $1$. In order to respond quickly to production needs, companies need raw materials inventory on hand. While production volume might change, management does not want to stop production to wait for raw materials to be delivered. Further, a company needs raw materials on hand for future jobs as well as for the current job. The materials are sent to the production department as it is needed for production of the products.
Table $1$: Common Direct Materials by Industry
Industry Direct Materials
Automotive Iron, aluminum, glass, rubber
Cell phones Glass, various metals, plastic
Furniture Wood, leather, vinyl
Jewelry Gold, silver, diamonds, rubies
Pharmaceuticals Natural or synthetic biological ingredients
Each job begins when raw materials are put into the work in process inventory. When the materials are requested for production, a materials requisition slip is completed and shows the exact items and quantity requested, along with the associated cost. The completed form is signed by the requestor and approved by the manager responsible for the budget.
Returning to the example of Dinosaur Vinyl’s order for Macs & Cheese’s stadium sign, Figure $3$ shows the materials requisition form for Job MAC001. This form indicates the quantity and specific items to be put into the work in process. It also transfers the cost of those items to the work in process inventory and decreases the raw materials inventory by the same amount. The raw materials inventory department maintains a copy to document the change in inventory levels, and the accounting department maintains a copy to properly assign the costs to the particular job.
Dinosaur Vinyl has a beginning inventory of $\1,000$ in raw materials: vinyl, and $\300$ in each of its ink inventories: raw materials: black ink, raw materials: red ink, and raw materials: gold ink. In order to have enough inventory on hand for all of its jobs, it purchases $\10,000$ in vinyl and $\500$ in black ink. The T-accounts in Figure $4$ show the stated beginning debit balances. An additional $\10,000$ of vinyl and $\500$ of black ink were then purchased for anticipated use, providing the demonstrated final account balances. The red ink and gold ink balances did not change, since no additional quantities were purchased.
The beginning balances and purchases in each of these accounts are illustrated in Figure $4$.
Traditional billboards with the design printed on vinyl include direct materials of vinyl and printing ink, plus the framing materials, which consist of wood and grommets. The typical billboard sign is $14$ feet high by $48$ feet wide, and Dinosaur Vinyl incurs a vinyl cost of $\300$ per billboard. The price for the ink varies by color. For this job, Dinosaur Vinyl needs two units of black ink at a cost of $\50$ each, one unit of red ink and one unit of gold ink at a cost of $\60$ each, twelve grommets at a cost of $\10$ each, and forty units of wood at a cost of $\1.50$ per unit. The total cost of direct materials is $\700$, as shown in Figure $5$.
Some items are more difficult to measure per unit, such as adhesives and other materials not directly traceable to the final product. Their costs are assigned to the product as part of manufacturing overhead as indirect materials.
When Dinosaur Vinyl requests materials to complete Job MAC001, the materials are moved from raw materials inventory to work in process inventory. We will use the beginning inventory balances in the accounts that were provided earlier in the example. The requisition is recorded on the job cost sheet along with the cost of the materials transferred. The costs assigned to job MAC001 are $\300$ in vinyl, $\100$ in black ink, $\60$ in red ink, and $\60$ in gold ink. During the finishing stages, $\120$ in grommets and $\60$ in wood are requisitioned and put into work in process inventory. The costs are tracked from the materials requisition form to the work in process inventory and noted specifically as part of Job MAC001 on the preceding job order cost sheet. The movement of goods is illustrated in Figure $6$.
Each of the T-accounts traces the movement of the raw materials from inventory to work in process. The vinyl and ink were used first to print the billboard, and then the billboard went to the finishing department for the grommets and frame, which were moved to work in process after the vinyl and ink. The final T-account shows the total cost for the raw materials placed into work in process on April 2 (vinyl and ink) and on April 14 (grommets and wood). The journal entries to reflect the flow of costs from raw materials to work in process to finished goods are provided in the section describing how to Prepare Journal Entries for a Job Order Cost System.
Direct Labor
Direct labor is the total cost of wages, payroll taxes, payroll benefits, and similar expenses for the individuals who work directly on manufacturing a particular product. The direct labor costs for Dinosaur Vinyl to complete Job MAC001 occur in the production and finishing departments. In the production department, two individuals each work one hour at a rate of $\15$ per hour, including taxes and benefits. The finishing department’s direct labor involves two individuals working one hour each at a rate of $\18$ per hour. Figure $7$ shows the direct labor costs for Job MAC001.
Job MAC001 is also manufactured with the work of individuals whose contributions cannot be directly traced to the product: These indirect labor costs are assigned to the product as part of manufacturing overhead.
A company can use various methods to trace employee wages to specific jobs. For example, employees may fill out time tickets that include job numbers and time per job, or workers may scan bar codes of specific jobs when they begin a job task. Figure $8$ shows what time tickets might look like on Job MAC001. Please note that in the employee time tickets that are displayed, each employee worked on more than one job. However, we are only going to track the expenses for Job MAC001.
When the accounting department processes time tickets, the costs are assigned to the individual jobs, resulting in labor costs being recorded on the work in process inventory, as shown in Figure $9$.
Manufacturing Overhead
Recall that the costs of a manufactured item are direct materials, direct labor, and manufacturing overhead. Costs that support production but are not direct materials or direct labor are considered overhead. Manufacturing overhead has three components: indirect materials, indirect labor, and overhead.
Indirect Materials
Indirect material costs are derived from the goods not directly traced to the finished product, like the sign adhesive in the Dinosaur Vinyl example. Tracking the exact amount of adhesive used would be difficult, time consuming, and expensive, so it makes more sense to classify this cost as an indirect material.
Indirect materials are materials used in production but not traced to specific products because the net informational value from the time and effort to trace the cost to each individual product produced is impossible or inefficient. For example, a furniture factory classifies the cost of glue, stain, and nails as indirect materials. Nails are often used in furniture production; however, one chair may need $15$ nails, whereas another may need 18 nails. At a cost of less than one cent per nail, it is not worth keeping track of each nail per product. It is much more practical to track how many pounds of nails were used for the period and allocate this cost (along with other costs) to the overhead costs of the finished products.
Indirect Labor
Indirect labor represents the labor costs of those employees associated with the manufacturing process, but whose contributions are not directly traceable to the final product. These would include the costs of the factory floor supervisor, the factory housekeeping staff, and factory maintenance workers. For Dinosaur Vinyl, for example, labor costs for the technician who maintains the printers would be indirect labor. It would be too time consuming to determine how much of the technician’s time is attributable to each sign being produced. It makes much more sense to classify that labor expense as indirect labor.
It is important to understand that the allocation of costs may vary from company to company. What may be a direct labor cost for one company may be an indirect labor cost for another company or even for another department within the same company. Deciding whether the expense is direct or indirect depends on its task. If the employee’s work can be directly tied to the product, it is direct labor. If it is tied to the factory but not to the product, it is indirect labor. If it is tied to the marketing department, it is a sales and administrative expense, and not included in the cost of the product. For example, salaries of factory employees assembling parts are direct labor, salaries of factory employees performing maintenance are indirect labor, and salaries of employees in the marketing department are sales and administration expenses.
Overhead
The last category of manufacturing overhead is the overhead itself. These costs are necessary for production but not efficient to assign to individual product production. Examples of typical overhead costs are production facility electricity, warehouse rent, and depreciation of equipment.
But note that while production facility electricity costs are treated as overhead, the organization’s administrative facility electrical costs are not included as as overhead costs. Instead, they are treated as period costs, as office rent or insurance would be.
When both administrative and production activities occur in a common building, the production and period costs would be allocated in some predetermined manner. For example, if a $10,000$ square foot building were physically allocated at $4,000$ square feet for administrative purposes and $6,000$ square feet for production, a company might allocate its annual $\30,000$ property tax expense on a $40\%/60\%$ basis, or $\12,000$ as a period cost for the administrative offices and a production (overhead) cost of $\18,000$.
link to learning
Do you know of a restaurant that was doing really well until it moved into a larger space? Often this happens because the owners thought their profits could handle the costs of the increased space. Unfortunately, they were not really aware of the production costs. Keeping track of product costs is critical for pricing and cost control. Read advice from restaurant owner John Gutekanst about the importance of understanding food costs and his approach to account for these in his pizzeria.
Accounting for Manufacturing Overhead
In all costing systems, the expense recognition principle requires costs to be recorded in the period in which they are incurred. The costs are expensed when matched to the revenue with which they are associated; this is commonly referred to as having the expenses follow the revenues. This explains why raw material purchases are not assigned to the job until the materials are requested. When companies use an inventory account, the product costs are expensed when the inventory is sold. It is common to have an item produced in one year, such as 2017, and expensed as cost of goods sold in a later year, such as 2018. In addition to the previously mentioned revenue recognition treatment, this treatment is justified under GAAP’s matching principle. If the inventory has not been sold, the company has an inventory asset rather than an expense.
The expense recognition principle also applies to manufacturing overhead costs. The manufacturing overhead is an expense of production, even though the company is unable to trace the costs directly to each specific job. For example, the electricity needed to run production equipment typically is not easily traced to a particular product or job, yet it is still a cost of production. As a cost of production, the electricity—one type of manufacturing overhead—becomes a cost of the product and part of inventory costs until the product or job is sold. Fortunately, the accounting system keeps track of the manufacturing overhead, which is then applied to each individual job in the overhead allocation process.
ETHICAL CONSIDERATIONS: Ethical Job Order Costing
Job order costing requires the assignment of direct materials, direct labor, and overhead to each production unit. The primary focus on costs allows some leeway in recording amounts because the accountant assigns the costs. When jobs are billed on a cost-plus-fee basis, management may be tempted to overcharge the cost of the job. Cost-based contracts may include a guaranteed maximum, time and materials, or cost reimbursable contract. An example is the design and delivery of a corporate training program. The training company may charge for the hours worked by instructors in preparation and delivery of the course, plus a fee for the course materials.
One major issue in all of these contracts is adding too much overhead cost and fraudulent invoicing for unused materials or unperformed work by subcontractors. Management might be tempted to direct the accountant to avoid the appearance of going over the original estimate by manipulating job order costing. It is the accountant’s job to ensure that the amounts recorded in the accounting system fairly represent the economic activity of the company, and the fair and proper allocation of costs.
Managers use the information in the manufacturing overhead account to estimate the overhead for the next fiscal period. This estimated overhead needs to be as close to the actual value as possible, so that the allocation of costs to individual products can be accurate and the sales price can be properly determined.
Properly allocating overhead to the individual jobs depends on finding a cost driver that provides a fair basis for the allocation. A cost driver is a production factor that causes a company to incur costs. An example would be a bakery that produces a line of apple pies that it markets to local restaurants. To make the pies requires that the bakery incur labor costs, so it is safe to say that pie production is a cost driver. It should also be safe to assume that the more pies made, the greater the number of labor hours experienced (also assuming that direct labor has not been replaced with a greater amount of automation). We assume, in this case, that one of the marketing advantages that the bakery advertises is $100\%$ handmade pastries.
In traditional costing systems, the most common activities used as cost drivers are direct labor in dollars, direct labor in hours, or machine hours. Often in the production process, there is a correlation between an increase in the amount of direct labor used and an increase in the amount of manufacturing overhead incurred. If the company can demonstrate such a relationship, they then often allocate overhead based on a formula that reflects this relationship, such as the upcoming equation. In the case of the earlier bakery, the company could determine an overhead allocation amount based on each hour of direct labor or, in other cases, based on the ratio of anticipated total direct labor costs to total manufacturing overhead costs.
For example, assume that the company estimates total manufacturing overhead for the year to be $\400,000$ and the direct labor costs for the year to be $\200,000$. This relationship would lead to $\2.00$ of applied overhead for each $\1.00$ of direct labor incurred. The manufacturing overhead cost can be calculated and applied to each specific job, based on the direct labor costs. The formula that represents the overhead allocation relationship is shown, and it is the formula for overhead allocation:
$\dfrac{ \text { Estimated Annual Overhead costs ( }\)}{\text { Expected Annual Activity }(D L \)}=\text { Overhead Allocation Rate }$
For example, Dinosaur Vinyl determined that the direct labor cost is the appropriate driver to use when establishing an overhead rate. The estimated annual overhead cost for Dinosaur Vinyl is $\250,000$. The total direct labor cost is estimated to be $\100,000$, so the allocation rate is computed as shown:
$\dfrac{\text { Estimated Annual Overhead } \operatorname{cost} s(\ 250,000)}{\text { Expected Annual Activity }(\ 100,000)}=\ 2.50 \text { per } \ 1.00 \text { Direct Labor Expense } \nonumber$
Since the direct labor expense for MAC001 is $\66$, the overhead allocated is $\66$times the overhead application rate of $\2.50$ per direct labor dollar, or $\165$, as shown:
$\text { Overhead Allocated }=\ 66 \text { (Direct Labor) } \times \ 2.50 \text { (Overhead Application Rate) }=\ 165 \nonumber$
Figure $10$ shows the journal entry to record the overhead allocation.
THINK IT THROUGH: Franchise or Unique Venture?
You are deciding whether to purchase a pizza franchise or open your own restaurant specializing in pizza. List the expenses necessary to sell pizza and identify them as a fixed cost or variable cost; as a manufacturing cost or sales and administrative costs; and as a direct materials, direct labor, or overhead. For each overhead item, state whether it is an indirect material expense, indirect labor expense, or other. For each cost, identify its origination in a job order costing environment. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/04%3A_Job_Order_Costing/4.03%3A_Describe_and_Identify_the_Three_Major_Components_of_Product_Costs_under_Job_Order_Costing.txt |
Job order costing can be used for many different industries, and each industry maintains records for one or more inventory accounts. The manufacturing industry keeps track of the costs of each inventory account as the product is moved from raw materials inventory into work in process, through work in process, and into the finished goods inventory.
Conversely, typical companies in the merchandising industry sell products they do not manufacture and purchase their inventory in an already completed state. It is relatively easy to keep track of the inventory cost for a merchandising company through its application of first-in/first-out (FIFO), last-in/last-out (LIFO), weighted average, or specific identification inventory techniques on the unsold items. The primary difference in the four methods is the valuation of the cost of goods sold and the remaining ending inventory valuation, assuming that the company did not sell 100% of the inventory that they had available for sale during a given period. Companies are allowed to choose the method that they feel best represents their cost flows through their cost of goods sold and their ending inventory balances.
Not all service companies have inventory, and those companies do not have direct materials nor do they consider their work in process their inventory, since their final product is often an intangible asset, such as a legal document or tax return. Regardless of whether the service has inventory accounts, service companies all keep track of the direct labor and overhead costs incurred while completing each job in progress.
Inventory is an asset reported on the balance sheet, and each company needs to maintain accurate records for the cost of each type of inventory: raw materials inventory, work in process inventory, and finished goods inventory. All three costs are computed in a similar manner. You can see in Figure \(1\) that the general format is the same for maintaining all accounts, whether the company uses a job order, process, or hybrid cost system.
Each inventory account starts with a beginning balance at the start of an accounting period. During the period, if additional inventory is purchased, the new inventory amount is added to the beginning balance to calculate the total inventory available for use or sale. The ending inventory balance at the end of the accounting period can then be subtracted from the inventory available for use, and the total represents the cost of the inventory used during the period.
For example, if the beginning inventory balance were \(\$400\), and the company bought an additional \(\$1,000\), it would have \(\$1,400\) of inventory available for use. If the ending inventory balance were \(\$500\), the amount of inventory used during the period would be \(\$900 (\$400 + \$1,000 = \$1,400 – \$500 = \$900)\).
Raw Materials Inventory
Raw materials inventory is the total cost of materials that will be used in the production process. Usually, several accounts make up the raw materials inventory, and these can be actual accounts or accounts subsidiary to the general raw materials inventory account. In our example, Dinosaur Vinyl has several raw materials accounts: vinyl, red ink, black ink, gold ink, grommets, and wood.
Within the raw materials inventory account, purchases increase the inventory, whereas raw materials sent into production reduce it. It is easy to reconcile the amount of ending inventory and the cost of direct materials used in production, since the materials requisition form (Figure 4.2.3) keeps track of the inventory requested and sent into each specific job. Since the costs are transferred with production, the calculation shows the amount of materials used in production:
Work in Process Inventory
In a job order cost system, the balance in the work in process inventory account is continually updated as job costs are recorded and is the total of all unfinished jobs, as shown on the individual job cost sheets.
The production cycle is a continuous cycle that begins with raw materials being transferred to work in process, moving through production, and ending as finished goods inventory. Typically, as goods are being produced, additional jobs are being started and finished, and the work in process inventory includes unit costs of jobs still in production at the end of the accounting period. At the end of the accounting cycle, there will be jobs that remain unfinished in the production cycle, and these represent the work in process inventory. The costs on the job order cost sheet help reconcile the cost of the items transferred to the finished goods inventory and the cost of the work in process inventory.
For example, Dinosaur Vinyl has completed Job MAC001. The total cost of \(\$931\) is transferred to the finished goods inventory:
At this point, we need to examine an important component of the costing process. The cost of goods manufactured (COGM) is the costs of all of the units that a company completed and transferred to the finished goods inventory during an accounting period. Obviously, the cost of goods manufactured is not just a single number that can be pulled from one location. We have to look at all costs included in the manufacturing process to determine the cost of goods manufactured. The calculation begins with the beginning balance in the work in process inventory, incorporates the new production costs incurred during the current period (typically a year), and then subtracts the ending balance in the work in process inventory since these costs will be included in the subsequent accounting period’s cost of goods manufactured, as shown:
Finished Goods Inventory
After each job has been completed and overhead has been applied, the product is transferred to the finished goods inventory where it stays until it is sold. As each job is transferred, the costs are summarized and transferred as well, and the job cost sheet is completed to show the actual production cost of the product and the sales price of the items produced.
A job order cost system continually updates each job cost sheet as materials, labor, and overhead are added. As a result, all inventory accounts are constantly maintained. The materials inventory balance is continually updated, as materials are purchased and requisitioned for individual jobs. The work in process inventory and finished goods inventory are master accounts, and their balances are determined by adding the total of the job cost sheets. The total of the incomplete jobs becomes the total work in process inventory, and the total of the completed and unsold jobs becomes the total of the finished goods inventory.
Similar to the raw materials and work in process inventories, the cost of goods sold can be calculated as shown:
Cost of Goods Sold
The cost of goods sold is the manufacturing cost of the items sold during the period. It is calculated by adding the beginning finished goods inventory and the cost of goods manufactured to arrive at the cost of goods available for sale. The cost of goods available for sale less the ending inventory results in the cost of goods sold.
In our example, when the sale has occurred, the goods are transferred to the buyer, and the product is transferred from the finished goods inventory to the cost of goods sold. A corresponding entry is also made to record the sale. Dinosaur Vinyl’s sales price for Job MAC001 was \(\$2,000\), and its cost of goods sold was \(\$931\):
Figure \(6\) shows the flow to cost of goods sold.
Example \(1\): Tracking the Flow with Selected T-Accounts
Use the transaction letters to show the flow in and out of the T-accounts. Note: some items may be used more than once. Also, not every possible T-account entry is required in this exercise. For example, for the purchase of raw materials, the credit entry for either cash or accounts payable is not required.
1. Purchase raw materials inventory
2. Factory wage expense incurred
3. Issue raw materials inventory to Job P33
4. Factory wage allocated to Job P33
5. Factory wage allocated to overhead
6. Job P33 completed
7. Job P33 sold | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/04%3A_Job_Order_Costing/4.04%3A_Use_the_Job_Order_Costing_Method_to_Trace_the_Flow_of_Product_Costs_through_the_Inventory_Accounts.txt |
Job order cost systems maintain the actual direct materials and direct labor for each individual job. Since production consists of overhead—indirect materials, indirect labor, and other overhead—we need a methodology for applying that overhead. Unfortunately, the nature of indirect material, indirect labor, and other overhead expenses makes it impossible to determine the exact amount of overhead for each specific job. For example, how do you know the cost of electricity and heat for manufacturing one job? And, if you did, is it fair to say products manufactured in January are more expensive than the same product manufactured in March because of heat expense?
Fundamental Characteristics of the Overhead Determination Environment
Added to these issues is the nature of establishing an overhead rate, which is often completed months before being applied to specific jobs. Establishing the overhead allocation rate first requires management to identify which expenses they consider manufacturing overhead and then to estimate the manufacturing overhead for the next year. Manufacturing overhead costs include all manufacturing costs except for direct materials and direct labor. Therefore, in order to estimate manufacturing overhead, management must estimate the future purchase prices of dozens, or sometimes hundreds, of individual components, such as utilities, raw materials, contract labor, or diesel fuel. Estimating overhead costs is difficult because many costs fluctuate significantly from when the overhead allocation rate is established to when its actual application occurs during the production process. You can envision the potential problems in creating an overhead allocation rate within these circumstances.
Before demonstrating the calculation of a predetermined overhead allocation rate, let’s review the basic principles of revenue recognition and expense. In accounting, there are three ways to recognize expenses:
1. Direct relationship between the expense and the associated revenue. This method is used for many costs, and the expense is recognized when a direct relationship exists. For example, sales commission expenses can be directly traced to product sales, and a commission expense is recorded when a sale is made.
2. Systematic and rational allocation of expenses. This approach is used when costs exist and there is an expected benefit, even though the costs cannot be directly traced to the benefit. The assigning of expenses to a product or time period must be done in an objective and consistent manner. Examples of such expenses would include equipment rental for a factory or property insurance for the factory.
Both of these expenses (direct relationship and systematic and rational) are also examples of the types of expenses that compose manufacturing overhead. An example of the current revenue recognition principle is a company paying $\4,800$ a year for property insurance. Since production rates can vary month to month, most producers would allocate $\400$ each month for property insurance, and this cost would be incorporated into the total overhead costs anticipated when estimating a manufacturing overhead allocation rate.
The direct benefit is that the product will be sold and the revenue recognized. The overhead is associated but cannot be directly traced to an individual product, so the overhead expenses need to be assigned in a systematic and rational manner.
3. Immediate recognition. This method is used when expenses exist but there is no direct expected benefit. In this case, the expense is recognized immediately. For example, research and development costs are necessary expenses but cannot be traced to a specific product, so they are expensed as incurred.
The allocation of overhead to the cost of the product is also recognized in a systematic and rational manner. The expected overhead is estimated, and an allocation system is determined. The actual costs are accumulated in a manufacturing overhead account. The overhead is then applied to the cost of the product from the manufacturing overhead account. The overhead used in the allocation is an estimate due to the timing considerations already discussed.
The application rate that will be used in a coming period, such as the next year, is often estimated months before the actual overhead costs are experienced. Often, the actual overhead costs experienced in the coming period are higher or lower than those budgeted when the estimated overhead rate or rates were determined. At this point, do not be concerned about the accuracy of the future financial statements that will be created using these estimated overhead allocation rates. You will learn in Determine and Disposed of Underapplied or Overapplied Overhead how to adjust for the difference between the allocated amount and the actual amount.
Despite improvements in technology and information flow, using the actual overhead to calculate the application rate is usually not possible because the actual overhead information is available too late for management to make decisions. Also, as you will learn, the results of the actual overhead costs, if they were available, could be misleading. Therefore, most manufacturing companies use predetermined overhead rates for these reasons:
• Overhead costs are not uniform throughout the year. An example is electricity costs that vary by weather and time of day.
• Some overhead costs are fixed, and the cost per unit varies with production. For example, rent may be $\1,000$ per month. If $500$ units were made during one month, and $2,000$ units were made the next month, the cost per unit would vary from $\2$ per unit to $\0.50$ per unit.
• The total number of units produced varies and is often known sooner than the cost of overhead. For example, a company may know it will have a contract to produce $100$ custom units long before it knows the utility costs for the next year.
As previously described, a predetermined overhead rate is established prior to the beginning of the fiscal year and typically is not changed during the year. The predetermined rate is calculated as shown and is used to apply overhead costs to work in process:
$\dfrac{\text { Estimated (budgeted) Overhead cost }}{\text { Expected (budgeted) Level of Activity }}=\text { Predetermined Overhead Rate }$
CONCEPTS IN PRACTICE: Overhead in the Movie Industry
The movie industry uses job order costing, and studios need to allocate overhead to each movie. Their amount of allocated overhead is not publicly known because while publications share how much money a movie has produced in ticket sales, it is rare that the actual expenses are released to the public.
It has been speculated that Star Wars: The Force Awakens cost $\201,000,000$, with $\30,000,000$ considered overhead. Studios have estimated that the higher the movie expenses, the more studio overhead is required, and it has also been estimated that $10\%$ of the total cost is assigned to studio overhead.
Determining Estimated Overhead Cost
The estimated or budgeted overhead is the amount of overhead determined during the budgeting process and consists of manufacturing costs but, as you have learned, excludes direct materials and direct labor. Examples of manufacturing overhead costs include indirect materials, indirect labor, manufacturing utilities, and manufacturing equipment depreciation. Another way to view it is overhead costs are those production costs that are not categorized as direct materials or direct labor.
Selecting an Estimated Activity Base
As you have learned, the overhead needs to be allocated to the manufactured product in a systematic and rational manner. This allocation process depends on the use of a cost driver, which drives the production activity’s cost. Examples can include labor hours incurred, labor costs paid, amounts of materials used in production, units produced, or any other activity that has a cause-and-effect relationship with incurred costs.
Direct labor hours, direct labor dollars, or machine hours are often chosen as the allocation base because those costs are associated with each product, and as the activity increases, so does the manufacturing overhead. In other words, the products that involve more direct labor hours, direct labor dollars, or machine hours also increase utility expenses, supervisor time (and thus indirect labor), equipment usage and the related depreciation expense, and so forth.
Traditionally, direct labor hours were used as the activity base, but technology continually decreases the amount of direct labor used in production, and machine hours or units produced have become more common activity bases. Management analyzes the costs and selects the activity as the estimated activity base because it drives the overhead costs of the unit.
Computing a Predetermined Overhead Rate
Dinosaur Vinyl uses the expenses from the prior two years to estimate the overhead for the upcoming year to be $\250,000$, as shown in Figure $1$.
Dinosaur Vinyl also used its payroll records to estimate that it will spend $\100,000$ on direct labor. Using the predetermined overhead rate calculation, the overhead rate is $\2.50$ per direct labor dollar:
$\dfrac{\text { Estimated (budgeted) Overhead cost }(\ 250,000)}{\text { Expected (budgeted) Level of Activity }(\ 100,000)}=\ 2.50 \text { per Direct Labor Dollar } \nonumber$
Over the fiscal year, the actual costs are recorded as debits into the account called manufacturing overhead. When the overhead is applied to the jobs, the amount is first calculated using the application rate. If the total labor paid for the job is $\66$, the overhead applied to the job is $\2.50$ times that amount, or $\165$. The entry to record the overhead for Job MAC001 is:
That amount is added to the cost of the job, and the amount in the manufacturing overhead account is reduced by the same amount. At the end of the year, the amount of overhead estimated and applied should be close, although it is rare for the applied amount to exactly equal the actual overhead. For example, Figure $3$ shows the monthly costs, the annual actual cost, and the estimated overhead for Dinosaur Vinyl for the year. While the total amounts are close to each other, they are not exact.
Calculating Manufacturing Overhead Cost for an Individual Job
Figure $3$ shows the monthly manufacturing actual overhead recorded by Dinosaur Vinyl. As explained previously, the overhead is allocated to the individual jobs at the predetermined overhead rate of $\2.50$ per direct labor dollar when the jobs are complete. When Job MAC001 is completed, overhead is $\165$, computed as $\2.50$ times the $\66$ of direct labor, with the total job cost of $\931$, which includes $\700$ for direct materials, $\66$ for direct labor, and $\165$ for manufacturing overhead.
LINK TO LEARNING
Companies need to make certain the sales price is higher than the prime costs and the overhead costs. This can be a difficult task in industries in which overhead costs change. In some industries, the company has no control over the costs it must pay, like tire disposal fees. To ensure that the company is profitable, an additional cost is added and the price is modified as necessary. In this example, the guarantee offered by Discount Tire does not include the disposal fee in overhead and increases that fee as necessary. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/04%3A_Job_Order_Costing/4.05%3A_Compute_a_Predetermined_Overhead_Rate_and_Apply_Overhead_to_Production.txt |
To summarize the job order cost system, the cost of each job includes direct materials, direct labor, and manufacturing overhead. While the product is in production, the direct materials and direct labor costs are included in the work in process inventory. The direct materials are requested by the production department, and the direct material cost is directly attached to each individual job, as the materials are released from raw materials inventory. The cost of direct labor is recorded by the employees and assigned to each individual job. When the allocation base is known, usually when the product is completed, the overhead is allocated to the product on the basis of the predetermined overhead rate.
LINK TO LEARNING
The construction industry typically uses job order costing and accounts for its costing in a manner similar to the businesses profiled in this chapter.
Determining the Costs of an Individual Job Using Job Order Costing
When a job is completed, the costs of the job—the direct materials, direct labor, and manufacturing overhead—are totaled on the job cost sheet, and the total amount is transferred to finished goods at the same time the product is transferred, either physically or legally, such as in the case of a home built by a contractor. Finally, when the product is sold, the sale is recorded at the sale price, while the cost is transferred from finished goods inventory to the cost of goods sold expense account. Figure \(1\) shows the flow of costs from raw materials inventory to cost of goods sold.
At all points in the process, the work in process should include the cost of direct materials and direct labor. When the job is completed and overhead assigned, the overhead allocation increases the cost of the work in process inventory. The cost of each individual job is maintained on a job cost sheet, and the total of all the work in process job cost sheets equals the work in process inventory and the statement of cost of goods manufactured, as you have learned.
A job cost sheet is a subsidiary ledger that identifies the individual costs for each job. Figure \(2\) shows the job cost sheet for Job MAC001.
Sample Cost Information for Dinosaur Vinyl
Dinosaur Vinyl worked on three jobs during the month: POR143, MAC001, and TRJ441, and a fourth Job SWM505 had been finished and moved to the finished goods inventory account during the previous month.
At the beginning of the month, the company had a beginning raw materials inventory balance of \(\$2,500\), and during the month, it purchased an additional \(\$10,500\), giving it a total of \(\$13,000\) in raw materials available for use in production.
The following example will examine four different production jobs. Each of the four will be at beginning stages at either the beginning of the current month or the end of the current month.
1. Job POR 143: This job was the only work in process inventory at the beginning of the current month, and it had \(\$1,000\) in direct material costs, and \(\$0\) of direct labor costs already allocated to the work in process inventory. During the current month, additional direct materials of \(\$200\) and direct labor of \(\$150\) were added to POR143. An overhead cost of \(\$375\) was applied to POR143 at the predetermined overhead rate of \(\$2.50\) per direct labor dollar. It was finished during the month and transferred to the finished goods inventory. The sale was not finalized during the month, so it continues to be part of the finished goods inventory.
2. Job MAC 001: This job was started and completed during the month. Since the job began in and was completed in the same month, there was no beginning balance in the work in process inventory. During the month it incurred \(\$700\) in direct materials costs, \(\$66\) in direct labor, and \(\$165\) of overhead applied to the job before it was transferred to the finished goods inventory upon completion. The sale was finalized during the month at a sale price of \(\$2,000\), so the costs were transferred from finished goods inventory to cost of goods sold.
3. Job TRJ441: This job was started during the current month. Its costs consist of \(\$500\) in direct material cost, \(\$150\) in direct labor expenses, and \(\$375\) in applied overhead. The job remains in the work in process inventory awaiting assembly.
4. Job SWM505: At the beginning of the month, this job was completed and already in the finished goods inventory at a cost of \(\$1,531\). Since it was completed, it did not incur any additional costs in the current month. It was sold during the month for \(\$3,500\), and the costs were transferred from the finished goods inventory to cost of goods sold.
The cost of raw materials used is calculated as shown:
The individual job cost sheets show the \(\$1,400\) worth of materials used in production:
The cost of goods manufactured is accounted for as shown:
Notice the costs for Job TJR441 are included in the work in process inventory, whereas the costs for POR143 and MAC001 were transferred to the cost of goods manufactured. The costs of the jobs transferred are shown in the cost of goods sold and the finished goods inventory:
Mechanics of Job Order Costing for Dinosaur Vinyl
The amounts in raw materials, work in process, and finished goods inventories compose the total cost for each account, whereas the job cost sheets contain the costs for each individual job. A summary of the jobs for Dinosaur Vinyl is given in Figure \(7\).
THINK IT THROUGH: Allocating Costs
A manufacturing company has incurred these costs:
What is the cost allocated to Job A? For any costs not used, explain why they are not used. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/04%3A_Job_Order_Costing/4.06%3A_Compute_the_Cost_of_a_Job_Using_Job_Order_Costing.txt |
As you’ve learned, the actual overhead incurred during the year is rarely equal to the amount that was applied to the individual jobs. Thus, at year-end, the manufacturing overhead account often has a balance, indicating overhead was either overapplied or underapplied.
If, at the end of the term, there is a debit balance in manufacturing overhead, the overhead is considered underapplied overhead. A debit balance in manufacturing overhead shows either that not enough overhead was applied to the individual jobs or overhead was underapplied. If, at the end of the term, there is a credit balance in manufacturing overhead, more overhead was applied to jobs than was actually incurred. This shows the actual amount was overapplied overhead.
The actual overhead costs are recorded through a debit to manufacturing overhead. The same account is credited when overhead is applied to the individual jobs in production, as shown:
Since the overhead is first recorded in the manufacturing overhead account, then applied to the individual jobs, traced through finished goods inventory, and eventually transferred to cost of goods sold, the year-end balance is eliminated through an adjusting entry, offsetting the cost of goods sold. If manufacturing overhead has a debit balance, the overhead is underapplied, and the resulting amount in cost of goods sold is understated. The adjusting entry is:
If manufacturing overhead has a credit balance, the overhead is overapplied, and the resulting amount in cost of goods sold is overstated. The adjusting entry is:
Returning to our example, at the end of the year, Dinosaur Vinyl had actual overhead expenses of $\256,500$ and applied overhead expenses of $\250,000$, as shown:
Since manufacturing overhead has a debit balance, it is underapplied, as it has not been completely allocated. The adjusting journal entry is:
If the overhead was overapplied, and the actual overhead was $\248,000$ and the applied overhead was $\250,000$, the entry would be:
To adjust for overapplied or underapplied manufacturing overhead, some companies have a more complicated, three-part allocation to work in process, finished goods, and cost of goods sold. This method is typically used in the event of larger variances in their balances or in bigger companies. (You will learn more about this in future cost or advanced managerial accounting courses.)
Example $1$: Kraken Boardsports
Kraken Boardsports manufactures winches for snow and ski boarders to snow ski without a mountain or water ski without a lake (Figure $7$). End-of-year data show these overhead expenses:
Kraken Boardsports had $6,240$ direct labor hours for the year and assigns overhead to the various jobs at the rate of $\33.50$ per direct labor hour. How much overhead was overapplied or underapplied during the year? What would be the journal entry to adjust manufacturing overhead?
Solution
The total overhead incurred is the total of:
The total overhead applied is $\209,040$, which is calculated as:
$\ 33.50 \text { ldirect labor hours } \times 6,240 \text { direct labor hours} \nonumber$
The balance in manufacturing overhead is a debit balance of $\210$:
The adjusting journal entry is:
Link to Learning
Job order costing and overhead allocation are not new methods of accounting and apply to governmental units as well. See it applied in this 1992 report on Accounting for Shipyard Costs and Nuclear Waste Disposal Plans from the United States General Accounting Office. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/04%3A_Job_Order_Costing/4.07%3A_Determine_and_Dispose_of_Underapplied_or_Overapplied_Overhead.txt |
Although you have seen the job order costing system using both T-accounts and job cost sheets, it is necessary to understand how these transactions are recorded in the company’s general ledger.
Journal Entries to Move Direct Materials, Direct Labor, and Overhead into Work in Process
Dinosaur Vinyl keeps track of its inventory and orders additional inventory to have on hand when the production department requests it. This inventory is not associated with any particular job, and the purchases stay in raw materials inventory until assigned to a specific job. For example, Dinosaur Vinyl purchased an additional \(\$10,000\) of vinyl and \(\$500\) of black ink to complete Macs & Cheese’s billboard. If the purchase is made on account, the entry is as shown:
As shown in Figure 4.5.2, for the production process for job MAC001, the job supervisor submitted a materials requisition form for \(\$300\) in vinyl, \(\$100\) in black ink, \(\$60\) in red ink, and \(\$60\) in gold ink. For the finishing process for Job MAC001, \(\$120\) in grommets and \(\$60\) in finishing wood were requisitioned. The entry to reflect these actions is:
The production department employees work on the sign and send it over to the finishing/assembly department when they have completed their portion of the job.
The direct cost of factory labor includes the direct wages paid to the employees and all other payroll costs associated with that labor. Typically, this includes wages and the payroll taxes and fringe benefits directly tied to those wages. The accounting system needs to keep track of the labor and the other related expenses assigned to a particular job. These records are typically kept in a time ticket submitted by employees daily.
On April 10, the labor time sheet totaling \(\$30\) is recorded for Job MAC001 through this entry:
The assembly personnel in the finishing/assembly department complete Job MAC001 in two hours. The labor is recorded as shown:
Indirect materials also have a materials requisition form, but the costs are recorded differently. They are first transferred into manufacturing overhead and then allocated to work in process. The entry to record the indirect material is to debit manufacturing overhead and credit raw materials inventory.
Indirect labor records are also maintained through time tickets, although such work is not directly traceable to a specific job. The difference between direct labor and indirect labor is that the indirect labor records the debit to manufacturing overhead while the credit is to factory wages payable.
Dinosaur Vinyl’s time tickets indicate that \(\$4,000\) in indirect labor costs were incurred during the period. The entry is:
Dinosaur Vinyl also records the actual overhead incurred. As shown in Figure 4.4.3, manufacturing overhead costs of \(\$21,000\) were incurred. The entry to record these expenses increases the amount of overhead in the manufacturing overhead account. The entry is:
The amount of overhead applied to Job MAC001 is \(\$165\). The process of determining the manufacturing overhead calculation rate was explained and demonstrated in Accounting for Manufacturing Overhead. The journal entry to record the manufacturing overhead for Job MAC001 is:
Journal Entry to Move Work in Process Costs into Finished Goods
When each job and job order cost sheet have been completed, an entry is made to transfer the total cost from the work in process inventory to the finished goods inventory. The total cost of the product for Job MAC001 is \(\$931\) and the entry is:
Journal Entries to Move Finished Goods into Cost of Goods Sold
When the sale has occurred, the goods are transferred to the buyer. The product is transferred from the finished goods inventory to cost of goods sold. A corresponding entry is also made to record the sale. The sign for Job MAC001 had a sales price of \(\$2,000\) and a cost of \(\$931\). These are the entries to record the transfer of goods and sale to the buyer:
The resulting accounting is shown on the company’s income statement:
Think It Through: Ongoing Overapplied Overhead
At the end of each year, manufacturing overhead is analyzed, and an adjusting entry is made to dispose of the under- or overapplied overhead. How would you advise a company that has had overapplied overhead for each of the last five years? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/04%3A_Job_Order_Costing/4.08%3A_Prepare_Journal_Entries_for_a_Job_Order_Cost_System.txt |
Job order cost systems can be used beyond the manufacturing realm and are often used in the production of services. The same cost tracking and journaling techniques apply, as the outcome still consists of materials, labor, and overhead. However, the terminology changes in a nonmanufacturing environment. For example, a movie production studio and an accounting firm produce movies and financial statement audits, respectively, instead of manufacturing units.
Fundamentals of the Job Order Costing Method for Service Entities
Instead of being dependent on materials, service industries depend on labor. Since their work is labor intensive, it makes sense to use labor as an activity base with billable hours often as the best allocation base. For example, in an audit, there often will be several accountants, with differing levels of experience and expertise involved in the assignment. The accounting firms have more billable hours at the staff level and fewer billable hours at the partner level. And since the firm bills the partner’s time at a significantly higher rate than the staff, it makes sense to apply overhead at the billable hours instead of the billable costs.
In service industries, there is no manufacturing overhead because they are not manufacturing a product, but instead are providing a service. Accordingly, overhead is called operating overhead.
Another terminology difference is the inventory accounts. The jobs are considered movies or assignments in process, and are transferred to a cost of service sold account instead of to a finished goods inventory.
Concepts In Practice: Tracking Costs in Healthcare
Healthcare is one of the industries that keeps track of materials, such as medicine. In this industry, direct labor is shown to the patient as the cost of the provider, such as a physician, physician assistant, or nurse practitioner. Indirect labor includes all other personnel from front desk staff to the nurse who gathers vital signs or a technician who performs tests. Patients do not see the overhead cost on their bill, but it is built into the invoice as part of the practitioner or testing fees.
Service Entity Use of a Job Order Costing System
To understand how a service provider uses a job order cost system, let’s consider the case of IFixIT. IFixIT Systems is a Sony-authorized repair provider that fixes audiovisual equipment brought in by customers. IFixIT requires customers to pay \(\$50\) to diagnose the problem. IFixIt pays its employees \(\$25\) per hour and assigns overhead equal to its direct labor cost. The customers’ bills do not show overhead and are instead itemized as parts plus labor, where the cost for parts is the original cost plus a markup, and the labor rate is \(\$80\) per hour.
A customer brought in his TV and paid the \(\$50\) diagnostic fee. IFixIT determined a new power cord was needed. To fix it, IFixIT purchases the part from its suppliers at \(\$42\) and pays \(\$75\) in direct labor for \(3\) hours at \(\$25\) per hour. Overhead is applied equal to the direct labor cost of \(\$75\). The customer is charged \(\$310\), consisting of \(\$70\) for the part and \(3\) hours of labor at a rate of \(\$80\) per hour. IFixIT records the journal entries shown:
Ethical Considerations: Subcontractor Misrepresentation of Costs of Jobs Used to Overbill Clients
Construction is a typical industry where job order costing and related accounting misstatements can be used to commit fraud. A construction subcontractor might overstate the units of production accomplished, the units of labor, or the equipment actually used.1 This occurs most commonly with subcontractor fraud, where the subcontractor does not perform the work but bills for it anyway.
Another complicating issue is that many subcontractors are disadvantaged business enterprises that are required by law to be included in governmental construction contracts. In Chicago, for example, McHugh Construction paid \(\$12\) million in fines to settle the claims that its disadvantaged business enterprise subcontractor did not perform work.2 The subcontractor received a prison sentence, and a related party was put on probation. An accountant had to prepare the invoices that allowed this common type of scheme to operate.
Footnotes
1. Jim Schmid and Todd F. Taggart, “The Most Common Types of Construction Fraud,” Construction Business Owner, November 2, 2011, http://www.constructionbusinessowner...truction-fraud.
2. Kim Slowey, “Chicago Subcontractor Sentenced to 1-year Prison Term for DBE Fraud Scheme,” Construction Dive, March 20, 2017, https://www.constructiondive.com/new...scheme/438441/. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/04%3A_Job_Order_Costing/4.09%3A_Explain_How_a_Job_Order_Cost_System_Applies_to_a_Nonmanufacturing_Environment.txt |
Multiple Choice
1. Which of the following product situations is better suited to job order costing than to process costing?
1. Each product batch is exactly the same as the prior batch.
2. The costs are easily traced to a specific product.
3. Costs are accumulated by department.
4. The value of work in process is based on assigning standard costs.
Answer:
b
1. A job order costing system is most likely used by which of the following?
1. a pet food manufacturer
2. a paper manufacturing company
3. an accounting firm specializing in tax returns
4. a stereo manufacturing company
2. Which of the following is a prime cost?
1. indirect materials
2. direct labor
3. administrative expenses
4. factory depreciation expenses
Answer:
b
1. Which of the following is a conversion cost?
1. raw materials
2. direct materials
3. administrative expenses
4. factory depreciation expenses
2. During production, to what are the costs in job order costing applied?
1. manufacturing overhead
2. cost of goods sold
3. each individual product
4. each individual department
Answer:
c
1. Which document lists the inventory that will be removed from the raw materials inventory?
1. job cost sheet
2. purchase order
3. materials requisition form
4. receiving document
2. Which document shows the cost of direct materials, direct labor, and overhead applied for each specific job?
1. job cost sheet
2. purchase order
3. materials requisition form
4. receiving document
Answer:
a
1. Which document lists the total direct materials used in a specific job?
1. job cost sheet
2. purchase order
3. materials requisition form
4. receiving document
2. Which document lists the total direct labor used in a specific job?
1. job cost sheet
2. purchase order
3. employee time ticket
4. receiving document
Answer:
a
1. Assigning indirect costs to specific jobs is completed by which of the following?
1. applying the costs to manufacturing overhead
2. using the predetermined overhead rate
3. using the manufacturing costs incurred
4. applying the indirect labor to the work in process inventory
2. In a job order cost system, which account shows the overhead used by the company?
1. work in process inventory
2. finished goods inventory
3. cost of goods sold
4. manufacturing overhead
Answer:
d
1. In a job order cost system, raw materials purchased are debited to which account?
1. raw materials inventory
2. work in process inventory
3. finished goods inventory
4. cost of goods sold
2. In a job order cost system, overhead applied is debited to which account?
1. work in process inventory
2. finished goods inventory
3. manufacturing overhead
4. cost of goods sold
Answer:
a
1. In a job order cost system, factory wage expense is debited to which account?
1. raw materials inventory
2. work in process inventory
3. finished goods inventory
4. cost of goods sold
2. In a job order cost system, utility expense incurred is debited to which account?
1. work in process inventory
2. finished goods inventory
3. manufacturing overhead
4. cost of goods sold
Answer:
c
1. In a job order cost system, indirect labor incurred is debited to which account?
1. work in process inventory
2. finished goods inventory
3. manufacturing overhead
4. cost of goods sold
2. The activity base for service industries is most likely to be ________.
1. machine hours
2. administrative salaries
3. direct labor cost
4. direct labor hours
Answer:
d
Questions
1. A printing company manufactures notebooks of various sizes. The company manufactures \(3,000\) notebooks each day. Should the company use process costing or job order costing?
Answer:
The company should use process costing. Since there are many similar items, process costing is a better fit than job order costing.
1. Burnham Industries incurs these costs for the month:
What is the prime cost?
1. Choco’s Chocolates incurs these costs for the month:
What is the conversion cost?
Answer:
The conversion cost is \(\$72,000\): the sum of direct labor, factory depreciation expense, and utility expense.
1. How do job order costing and process costing differ with respect to recording direct materials and direct labor?
2. Why are product costs assigned to the product and period costs immediately expensed?
Answer:
The expense recognition principle requires that expenses follow the revenue. Product costs are assigned to the product because they are associated with the revenue from the sale of the product. The cost is transferred from inventory to cost of goods sold when the item is sold. This matches the revenue from the sale with the cost of the item being sold. Period costs are expensed when incurred because they are not related to a specific product but are instead related to the time period in which revenue is earned.
1. Is the cost of goods manufactured the same as the cost of goods sold?
2. From beginning to end, place these items in the order of the flow of goods.
1. cost of goods sold
2. raw materials inventory
3. finished goods inventory
4. work in process inventory
Answer:
b, d, c, a
1. How is the predetermined overhead rate determined?
2. How is the predetermined overhead rate applied?
Answer:
Management uses the activity considered to be the cost driver and multiplies that rate by the activity for each specific job. The result is the amount of overhead applied to that specific job.
1. Why are the overhead costs first accumulated in the manufacturing overhead account instead of in the work in process inventory account?
2. Why is the manufacturing overhead account debited as expenses are recognized and then credited when overhead is applied?
Answer:
Expenses normally have a debit balance, and the manufacturing overhead account is debited when expenses are incurred to recognize the incurrence. When the expenses are allocated to the asset, the work in process inventory, the expense account manufacturing overhead is credited. This is in accordance with the expense recognition principle. The timing of the expense follows the revenue, and when the costs are allocated to inventory, they become a part of the product’s cost and are recognized when the asset is sold.
1. Match the concept on the left to its correct description.
a. job order costing i. computes the overhead applied to each job
b. materials requisition sheet ii. source document indicating the number of hours an employee worked on specific jobs
c. overapplied overhead iii. source document indicating the raw materials assigned to a specific production job
d. predetermined overhead rate iv. the cost accounting system used by pet food manufacturers
e. process costing v. the cost accounting system used by law firms
f. time ticket vi. the result when the actual overhead is less than the amount assigned to each specific job
G. underapplied overhead vii. the result when the actual overhead is more than the amount assigned to each specific job
1. When compared to manufacturing companies, service industries do not generally use ________ as a component of product cost.
Answer:
direct materials
Exercise Set A
1. Little Things manufactures toys. For each item listed, identify whether it is a product cost, a period cost, or not an expense.
1. internet provider services
2. material expense
3. raw materials inventory
4. production equipment rental
5. showroom rental
6. factory employee salary
7. Human Resource Director salary
2. Table 4.E.1 shows a list of expenses involved in the production of custom, professional lacrosse sticks.
1. For each item listed, state whether the cost should be applied to manufacturing or sales and administration.
2. If the cost is a manufacturing cost, state whether it is direct materials, direct labor, or manufacturing overhead.
3. If the cost is a manufacturing overhead cost, state whether it is indirect materials, indirect labor, or another type of manufacturing overhead.
Table 4.E.1: Expenses Involved in Lacrosse Stick Production
Lacrosse Stick Production Costs Manufacturing or Sales & Administration Cost? If Manufacturing: Direct Materials, Direct Labor, or Overhead? If Overhead: Indirect Materials, Indirect Labor, or Other?
Carbon, fiberglass
Administrative building rent
Accountant salary
Factory building depreciation
Strings for the pocket
Advertising
Production supervisor salary
Paint for sticks
Research and development costs
Wages of person who strings the sticks
Cutting machine depreciation
Human resources salaries
Factory maintenance
1. Burnham Industries incurs these costs for the month:
1. What is the prime cost?
2. What is the conversion cost?
1. Marzoni’s records show raw materials inventory had a beginning balance of \(\$200\) and an ending balance of \(\$300\). If the cost of materials used during the month was \$900, what were the purchases made during the month?
2. Sterling’s records show the work in process inventory had a beginning balance of \(\$4,000\) and an ending balance of \(\$3,000\). How much direct labor was incurred if the records also show:
1. Logo Gear purchased \(\$2,250\) worth of merchandise during the month, and its monthly income statement shows cost of goods sold of \(\$2,000\). What was the beginning inventory if the ending inventory was \(\$1,000\)?
2. A company estimates its manufacturing overhead will be \(\$750,000\) for the next year. What is the predetermined overhead rate given the following independent allocation bases?
1. Budgeted direct labor hours: \(60,000\)
2. Budgeted direct labor expense: \(\$1,500,000\)
3. Estimated machine hours: \(100,000\)
3. Job order cost sheets show the following costs assigned to each job:
The company assigns overhead at \(\$1.25\) for each direct labor dollar spent. What is the total cost for each of the jobs?
1. A new company started production. Job 10 was completed, and Job 20 remains in production. Here is the information from job cost sheets from their first and only jobs so far:
Using the information provided,
1. What is the balance in work in process?
2. What is the balance in the finished goods inventory?
3. If manufacturing overhead is applied on the basis of direct labor hours, what is the predetermined overhead rate?
1. K company production was working on Job 1 and Job 2 during the month. Of the \(\$780\) in direct materials, \(\$375\) in materials was requested for Job 1. Direct labor cost, including payroll taxes, are \(\$23\) per hour, and employees worked \(18\) hours on Job 1 and \(29\) hours on Job 2. Overhead is applied at the rate of \(\$20\) per direct labor hours. Prepare job order cost sheets for each job.
2. A company has the following transactions during the week.
• Purchase of \(\$1,000\) raw materials inventory
• Assignment of \(\$500\) of raw materials inventory to Job 5
• Payroll for \(20\) hours with \(\$1,000\) assigned to Job 5
• Factory utility bills of \(\$750\)
• Overhead applied at the rate of \(\$10\) per hour
What is the cost assigned to Job 5 at the end of the week?
1. During the month, Job AB2 used specialized machinery for \(450\) hours and incurred \(\$500\) in utilities on account, \(\$300\) in factory depreciation expense, and \(\$100\) in property tax on the factory. Prepare journal entries for the following:
1. Record the expenses incurred.
2. Record the allocation of overhead at the predetermined rate of \(\$1.50\) per machine hour.
2. Job 113 was completed at a cost of \(\$5,000\), and Job 85 was completed at a cost of \(\$3,000\) and sold on account for \(\$4,500\). Prepare journal entries for the following:
1. Completion of Job 113.
2. Completion and sale of Job 85.
3. A company’s individual job sheets show these costs:
Overhead is applied at \(1.25\) times the direct labor cost. Use the data on the cost sheets to perform these tasks:
1. Apply overhead to each of the jobs.
2. Prepare an entry to record the assignment of direct materials to work in process.
3. Prepare an entry to record the assignment of direct labor to work in process.
4. Prepare an entry to record the assignment of manufacturing overhead to work in process.
1. A summary of material requisition slips and time tickets, along with the overhead allocation, show these costs:
1. Prepare an entry to record the assignment of direct material to work in process.
2. Prepare an entry to record the assignment of direct labor to work in process.
3. Prepare an entry to record the assignment of manufacturing overhead to work in process.
Exercise Set B
1. Abuah Goods manufactures clothing. For each item listed, identify whether it is a product cost, a period cost, or not an expense.
1. pins to keep materials together while garment is being manufactured
2. real estate taxes on store
3. advertising expense
4. product inspector wages
5. shirts for sale
6. Chief Financial Officer salary
7. cost of goods sold
2. Choco’s Chocolates incurs the following costs for the month:
1. What is the prime cost?
2. What is the conversion cost?
1. The table shows a list of expenses involved in the production of custom snowboard bindings.
1. For each item listed, state if the cost is manufacturing or sales and administration.
2. If the cost is a manufacturing cost, state if it is direct materials, direct labor, or manufacturing overhead.
3. If the cost is a manufacturing overhead cost, state if it is indirect materials, indirect labor, or another type of manufacturing overhead.
Table 4.E.2: Snowboard Binding Production Costs
Snowboard Bindings Production Costs Manufacturing or Sales & Administration Cost? If Manufacturing: Direct Materials, Direct Labor, or Overhead? If Overhead: Indirect Materials, Indirect Labor, or Other?
Aluminum
Factory building rent
Fiberglass framework for each pair of bindings
Accountant salary
Administration building depreciation
Straps
Advertising
Production supervisor salary
Glue
Research and development costs
Inspector wages
Metal shaping machine depreciation
Human resources salaries
Factory repair
1. Masonry’s records show the raw materials inventory had purchases of \(\$1,000\) and an ending raw materials inventory balance of \(\$200\). If the cost of materials used during the month was \(\$900\), what was the beginning inventory?
2. Steinway’s records show their work in process inventory had a beginning balance of \(\$3,000\) and an ending balance of \(\$3,500\). How much overhead was applied if the records also show the following:
1. Langston’s purchased \(\$3,100\) of merchandise during the month, and its monthly income statement shows a cost of goods sold of \(\$3,000\). What was the beginning inventory if the ending inventory was \(\$1,250\)?
2. A company estimates its manufacturing overhead will be \(\$840,000\) for the next year. What is the predetermined overhead rate given each of the following independent allocation bases?
1. Budgeted direct labor hours: \(90,615\)
2. Budgeted direct labor expense: \(\$750,000\)
3. Estimated machine hours: \(150,000\)
3. Job order cost sheets show the following costs assigned to each job:
The company assigns overhead at twice the direct labor cost. What is the total cost for each job?
1. A new company started production. Job 1 was completed, and Job 2 remains in production. Here is the information from the job cost sheets from their first and only jobs so far:
Using the information provided,
1. What is the balance in work in process?
2. What is the balance in finished goods inventory?
3. If manufacturing overhead is applied on the basis of direct labor hours, what is the predetermined overhead rate?
1. Inez has the following information relating to Job AA5. Direct material cost was \(\$200,000\), direct labor was \(\$36,550\), and overhead applied on the basis of direct labor hours was \(\$73,100\). What was the predetermined overhead rate using the labor rate of \(\$17\) per hour?
2. A company has the following information relating to its production costs:
Compute the actual and applied overhead using the company’s predetermined overhead rate of \(\$23.92\) per machine hour. Was the overhead overapplied or underapplied, and by how much?
1. A company has the following transactions during the week.
• Purchase of \(\$3,000\) raw materials inventory
• Assignment of \(\$700\) of raw materials inventory to Job 7
• Payroll for \(10\) hours and \(\$3,000\) is assigned to Job 7
• Factory depreciation of \(\$1,750\)
• Overhead applied at the rate of \(\$200\) per hour
What is the cost assigned to Job 7 at the end of the week?
1. During the month, Job Arch2 used specialized machinery for \(350\) hours and incurred \(\$700\) in utilities on account, \(\$400\) in factory depreciation expense, and \(\$200\) in property tax on the factory. Prepare journal entries for the following:
1. Record the expenses incurred.
2. Record the allocation of overhead at the predetermined rate of \(\$1.50\) per machine hour.
2. Job 113 was completed at a cost of \(\$7,500\), and Job 85 was completed at a cost of \(\$2,300\) and sold on account for \(\$4,500\). Prepare journal entries for the following:
1. Completion of Job 113.
2. Completion and sale of Job 85.
3. A company’s individual job sheets show these costs:
Overhead is applied at \(1.75\) times the direct labor cost. Use the data on the cost sheets to perform these tasks:
1. Apply overhead to each of the jobs.
2. Prepare an entry to record the assignment of direct material to work in process.
3. Prepare an entry to record the assignment of direct labor to work in process.
4. Prepare an entry to record the assignment of manufacturing overhead to work in process.
1. A summary of materials requisition slips and time tickets, along with the overhead allocation, show these costs:
1. Prepare an entry to record the assignment of direct material to work in process.
2. Prepare an entry to record the assignment of direct labor to work in process.
3. Prepare an entry to record the assignment of manufacturing overhead to work in process.
Problem Set A
1. For each item listed, state whether a job order costing system or process costing system would be best.
1. cereal
2. team uniforms
3. houses
4. beach chairs
5. plastic
6. restaurant-specific pizza boxes
7. sneakers customized with number and colors
2. York Company is a machine shop that estimated overhead will be \(\$50,000\), consisting of \(5,000\) hours of direct labor. The cost to make Job 0325 is \(\$70\) in aluminum and two hours of labor at \(\$20\) per hour. During the month, York incurs \(\$50\) in indirect material cost, \(\$150\) in administrative labor, \(\$300\) in utilities, and \(\$250\) in depreciation expense.
1. What is the predetermined overhead rate if direct labor hours are considered the cost driver?
2. What is the cost of Job 0325?
3. What is the overhead incurred during the month?
3. Pocono Cement Forms expects \(\$900,000\) in overhead during the next year. It does not know whether it should apply overhead on the basis of its anticipated direct labor hours of \(60,000\) or its expected machine hours of \(30,000\). Determine the product cost under each predetermined allocation rate if the last job incurred \(\$1,550\) in direct material cost, \(90\) direct labor hours, and \(75\) machine hours. Wages are paid at \(\$16\) per hour.
4. Job cost sheets show the following information:
What are the balances in the work in process inventory, finished goods inventory, and cost of goods sold for January, February, and March?
1. Complete the information in the cost computations shown here:
1. During the year, a company purchased raw materials of \(\$77,321\), and incurred direct labor costs of \(\$125,900\). Overhead is applied at the rate of \(75\%\) of the direct labor cost. These are the inventory balances:
Compute the cost of materials used in production, the cost of goods manufactured, and the cost of goods sold.
1. Freeman Furnishings has summarized its data as shown:
Compute the cost of goods manufactured, assuming that the overhead is allocated based on direct labor hours.
1. Coop’s Stoops estimated its annual overhead to be \(\$85,000\) and based its predetermined overhead rate on \(24,286\) direct labor hours. At the end of the year, actual overhead was \(\$90,000\) and the total direct labor hours were \(24,100\). What is the entry to dispose of the overapplied or underapplied overhead?
2. Mountain Peaks applies overhead on the basis of machine hours and reports the following information:
1. What is the predetermined overhead rate?
2. How much overhead was applied during the year?
3. Was overhead over- or underapplied, and by what amount?
4. What is the journal entry to dispose of the over- or underapplied overhead?
1. The actual overhead for a company is \(\$74,539\). Overhead was based on \(6,000\) direct labor hours and was \(\$2,539\) underapplied for the year.
1. What is the overhead application rate per direct labor hour?
2. What is the journal entry to dispose of the underapplied overhead?
2. When setting its predetermined overhead application rate, Tasty Box Meals estimated its overhead would be \(\$100,000\) and would require \(25,000\) machine hours in the next year. At the end of the year, it found that actual overhead was \(\$102,000\) and required \(26,000\) machine hours.
1. Determine the predetermined overhead rate.
2. What is the overhead applied during the year?
3. Prepare the journal entry to eliminate the underapplied or overapplied overhead.
3. The following data summarize the operations during the year. Prepare a journal entry for each transaction.
1. Purchase of raw materials on account: \(\$3,000\)
2. Raw materials used by Job 1: \(\$500\)
3. Raw materials used as indirect materials: \(\$100\)
4. Direct labor for Job 1: \(\$300\)
5. Indirect labor incurred: \(\$50\)
6. Factory utilities incurred on account: \(\$700\)
7. Adjusting entry for factory depreciation: \(\$250\)
8. Manufacturing overhead applied as percent of direct labor: \(200\%\)
9. Job 1 is transferred to finished goods
10. Job 1 is sold: \(\$3,000\)
11. Manufacturing overhead is overapplied: \(\$100\)
4. The following events occurred during March for Ajax Company. Prepare a journal entry for each transaction.
1. Materials were purchased on account for \(\$35,429\).
2. Materials were requisitioned to begin work on Job C15 in the amount of \(\$25,259\).
3. Direct labor expense for Job C15 was \(\$24,129\).
4. Actual overhead was incurred on account of \(\$32,852\).
5. Factory overhead was charged to Job C15 at the rate of \(200\%\) of direct labor.
6. Job C15 was transferred to finished goods at \(\$97,646\).
7. Job C15 was sold on account for \(\$401,000\).
5. A movie production studio incurred the following costs related to its current movie:
1. Purchased office supplies on account: \(\$33,000\)
2. Issued direct supplies: \(\$22,512\)
3. Issued indirect supplies: \(\$7,535\)
4. Time tickets showing direct labor: \(\$32,503,230\)
5. Time tickets showing indirect labor: \(\$574,326\)
6. Utilities expense on account: \(\$957,323\)
7. Overhead applied: \(10\%\) of direct labor cost
Create journal entries for the listed transactions.
Problem Set B
1. For each item listed, state whether a job order costing system or process costing system would be best.
1. television repair
2. cell phone charge cords
3. glassware with company logo
4. dog food
5. golf balls
6. hotel signs to welcome guests
7. highlighters and pens
2. Rulers Company is a neon sign company that estimated overhead will be \(\$60,000\), consisting of \(1,500\) machine hours. The cost to make Job 416 is \(\$95\) in neon, 15 hours of labor at \(\$13\) per hour, and five machine hours. During the month, it incurs \(\$95\) in indirect material cost, \(\$130\) in administrative labor, \(\$320\) in utilities, and \(\$350\) in depreciation expense.
1. What is the predetermined overhead rate if machine hours are considered the cost driver?
2. What is the cost of Job 416?
3. What is the overhead incurred during the month?
3. Event Forms expects \(\$120,000\) in overhead during the next year. It doesn’t know whether it should apply overhead on the basis of its anticipated direct labor hours of \(6,000\) or its expected machine hours of \(5,000\). What would be the product cost under each predetermined allocation rate if the last job incurred \(\$3,500\) in direct material cost, \(55\) direct labor hours, and \(55\) machine hours? Wages are paid at \(\$17\) per hour.
4. Summary information from a company’s job cost sheets shows the following information:
What are the balances in the work in process inventory, finished goods inventory, and cost of goods sold for April, May, and June?
1. Complete the information in the cost computations shown here:
1. During the year, a company purchased raw materials of \(\$77,321\) and incurred direct labor costs of \(\$125,900\). Overhead is applied at the rate of \(75\%\) of the direct labor cost. These are the inventory balances:
Compute the cost of materials used in production, the cost of goods manufactured, and the cost of goods sold.
1. Freeman Furnishings has summarized its data as shown. Direct labor hours will be used as the activity base to allocate overhead:
Compute the cost of goods manufactured.
1. Queen Bee’s Honey, Inc., estimated its annual overhead to be \(\$110,000\) and based its predetermined overhead rate on \(27,500\) direct labor hours. At the end of the year, actual overhead was \(\$106,000\) and the total direct labor hours were \(29,000\). What is the entry to dispose of the overapplied or underapplied overhead?
2. Mountain Tops applies overhead on the basis of direct labor hours and reports the following information:
1. What is the predetermined overhead rate?
2. How much overhead was applied during the year?
3. Was overhead overapplied or underapplied, and by what amount?
4. What is the journal entry to dispose of the overapplied or underapplied overhead?
1. The actual overhead for a company is \(\$73,175\). Overhead was based on \(4,500\) machine hours and was \(\$3,325\) overapplied for the year.
1. What is the overhead application rate per direct labor hour?
2. What is the journal entry to dispose of the underapplied overhead?
2. When setting its predetermined overhead application rate, Tasty Turtle estimated its overhead would be \(\$75,000\) and manufacturing would require \(25,000\) machine hours in the next year. At the end of the year, it found that actual overhead was \(\$74,000\) and manufacturing required \(24,000\) machine hours.
1. Determine the predetermined overhead rate.
2. What is the overhead applied during the year?
3. Prepare the journal entry to eliminate the under- or overapplied overhead.
3. The following data summarize the operations during the year. Prepare a journal entry for each transaction.
1. Purchase of raw materials on account: \(\$1,500\)
2. Raw materials used by Job 1: \(\$400\)
3. Raw materials used as indirect materials: \(\$50\)
4. Direct labor for Job 1: \(\$200\)
5. Indirect labor incurred for Job 1: \(\$30\)
6. Factory utilities incurred on account: \(\$500\)
7. Adjusting entry for factory depreciation: \(\$200\)
8. Manufacturing overhead applied as percent of direct labor: \(100\%\)
9. Job 1 is transferred to finished goods
10. Job 1 is sold: \(\$1,000\)
11. Manufacturing overhead is underapplied: \(\$100\)
4. The following events occurred during March for Ajax Company. Prepare a journal entry for each transaction.
1. Materials were purchased on account for \(\$5,429\).
2. Materials were requisitioned to begin work on Job C15 in the amount of \(\$2,500\).
3. Direct labor expense for Job C15 was \(\$4,250\).
4. Actual overhead was incurred on account for \(\$5,385\).
5. Factory overhead was charged to Job C15 at the rate of \(200\%\) direct labor.
6. Job C15 was transferred to finished goods at \(\$15,250\).
7. Job C15 was sold on account for \(\$28,000\).
5. A leather repair shop incurred the following expenses while repairing luggage for a major airline.
1. Time cards showing direct labor: \(\$750\)
2. Time cards showing indirect labor: \(\$100\)
3. Purchased repair supplies on account: \(\$1,500\)
4. Issued indirect supplies: \(\$350\)
5. Utilities expense on account: \(\$24,000\)
6. Overhead applied: \(100\%\) of direct labor costs
Journalize the listed transactions.
Thought Provokers
1. Can a company use both job order costing and process costing? Why or why not?
2. If a job order cost system tracks the direct materials and direct labor, why doesn’t it track the actual overhead used for a specific job?
3. What are the similarities in calculating the cost of materials used in production, the cost of goods manufactured, and the cost of goods sold?
4. If a company bases its predetermined overhead rate on \(100,000\) machine hours, and it actually has \(100,000\) machine hours, would there be an underapplied or overapplied overhead?
5. How do the job cost sheets act as a subsidiary ledger for the work in process inventory if journal entries are not made to the job cost sheets?
6. How is a job order cost system used in a service industry? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/04%3A_Job_Order_Costing/4.0E%3A_4.E%3A_Job_Order_Costing_%28Exercises%29.txt |
Section Summaries
4.1 Distinguish between Job Order Costing and Process Costing
• Job order costing (JOC) is the optimal costing method for producing custom goods or when it is easy to identify the cost directly with the product.
• A JOC system assigns costs to each individual job as the costs are incurred, so that at all points in the manufacturing process, the costs assigned to that particular job are known.
4.2 Describe and Identify the Three Major Components of Product Costs under Job Order Costing
• Direct materials are requested on a materials requisition form and recorded on the job cost sheet when transferred from raw materials inventory to the work in process inventory.
• Time tickets are used to accumulate the labor associated with particular jobs and assigned to those jobs on the job cost sheet.
• Manufacturing overhead costs are accumulated in the manufacturing overhead account and assigned to the individual jobs using the predetermined overhead rate.
4.3 Use the Job Order Costing Method to Trace the Flow of Product Costs through the Inventory Accounts
• Materials used in production include the beginning raw materials inventory and purchases, less the ending inventory. This amount is the amount added to the work in process inventory.
• The cost of goods manufactured includes the beginning work in process inventory, the materials used in production, the direct labor assigned to each job, and the manufacturing overhead costs assigned, less the costs remaining in the work in process inventory. This amount is transferred to the finished goods inventory.
• The cost of goods sold include the beginning finished goods inventory and the cost of goods manufactured during the period, less the ending inventory.
• When the job is completed, the costs are transferred from the work in process inventory to the finished goods inventory.
• When the jobs are sold, the costs are transferred from the finished goods inventory to the cost of goods sold.
4.4 Compute a Predetermined Overhead Rate and Apply Overhead to Production
• Expenses are recognized when they have a direct relationship with the associated revenue, when there is a systematic and rational method to allocate them, or immediately when there is no expected benefit.
• The estimated activity base is typically direct labor dollars or direct labor hours, and is based on an allocation base that increases or decreases as overhead increases or decreases.
• The predetermined overhead rate is the estimated overhead divided by the activity base.
4.5 Compute the Cost of a Job Using Job Order Costing
• Costs from the materials requisition sheet and time tickets are recorded on the job cost sheet.
• Overhead is allocated from the manufacturing overhead account to the individual jobs and recorded on the job cost sheet.
• Each job has its own job cost sheet, showing the materials, labor, and overhead for each job.
4.6 Determine and Dispose of Underapplied or Overapplied Overhead
• Overhead is allocated to individual jobs based on the estimated overhead costs for the year and may be overapplied or underapplied for the year.
• Overhead is underapplied when not all of the costs accumulated in the manufacturing overhead account are applied during the year.
• Overhead is overapplied when more overhead is applied to the jobs than was actually incurred.
• The amount of overhead overapplied or underapplied is adjusted into the cost of goods sold account.
4.7 Prepare Journal Entries for a Job Order Cost System
• Job cost sheets record the material, labor, and overhead costs for each job, whereas journal entries actually transfer the costs into the work in process inventory, the finished goods inventory, and cost of goods sold.
4.8 Explain How a Job Order Cost System Applies to a Nonmanufacturing Environment
• Job order costing can be used in nonmanufacturing companies and with the same techniques, even though there are not any inventory accounts.
Key Terms
conversion costs
total of labor and overhead for a product; the costs that “convert” the direct material into the finished product
cost driver
activity that is the reason for the increase or decrease of another cost; examples include labor hours incurred, labor costs paid, amounts of materials used in production, units produced, machine hours, or any other activity that has a cause-and-effect relationship with incurred costs
cost of goods manufactured
manufacturing costs incurred less the ending work in process inventory
cost of goods sold
expense account that houses all costs associated with getting a product ready for sale
direct labor
labor directly related to the manufacturing of the product or the production of a service
direct materials
materials used in the manufacturing process that can be traced directly to the product
estimated activity base
total amount of the activity for the year
expense recognition principle
(also, matching principle) matches expenses with associated revenues in the period in which the revenues were generated
indirect labor
labor not directly involved in the active conversion of materials into finished products or the provision of services
indirect materials
materials used in production but not efficiently traceable to a specific unit of production
job cost sheet
document created for each job that includes all material, labor, and overhead costs for that job
job order costing
information system that traces the individual costs directly to the final product and not to production departments
loss leader
product sold at a price that is often less than the cost of producing it in order to entice customers to buy accessories that are necessary for its use
manufacturing costs
total of all costs expended in the manufacturing process; generally consists of direct material, direct labor, and manufacturing overhead
manufacturing overhead
costs incurred in the production process that are not economically feasible to measure as direct material or direct labor costs; examples include indirect material, indirect labor, utilities, and depreciation
materials requisition form
form showing which specific raw materials and costs are transferred from raw materials inventory to work in process inventory
operating overhead
overhead account used for service industries
overapplied overhead
situation when the overhead applied to the individual jobs is greater than the actual overhead; when overhead is overapplied, the manufacturing overhead has a credit balance
period costs
typically related to a particular time period instead of attached to the production of an asset; treated as an expense in the period incurred (examples include many sales and administrative expenses)
prime costs
direct material expenses and direct labor costs
time ticket
document used to record the particular job worked on by each employee
underapplied overhead
situation when the overhead applied to the individual jobs is less than the actual overhead; when overhead is underapplied, the manufacturing overhead has a debit balance | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/04%3A_Job_Order_Costing/4.10%3A_Summary_and_Key_Terms.txt |
David and William’s family has used a secret family recipe for generations to make amazing chocolate chip cookies. While in college, they helped their grandmother, who used only locally sourced products, make and sell the cookies to a local restaurant. They helped her become more efficient, discovered how to retain the quality taste while making larger batches, and developed a plate-sized version that could be decorated similar to a birthday cake. After creating an equally successful peanut butter cookie recipe, David and William decided to expand the business and sell to high-end grocers as well as to a second restaurant. They found it was optimal in terms of cost, efficiency, and quality to produce \(100\) cookies per batch for each regular-sized cookie and \(5\) cookies per batch for the large cookies. They surveyed restaurants and grocery stores and determined that each flavor should be offered in four different package sizes. They also analyzed the marketability at various sale prices. David and William now know they need to use their information to identify the costs associated with making the cookies. They need to know the cost to produce one unit of their product in order to price their cookies correctly, determine the optimal product mix, manage efficiency and process improvement, and make other management decisions.
5.02: Compare and Contrast Job Order Costing and Process Costing
As you’ve learned, job order costing is the optimal accounting method when costs and production specifications are not identical for each product or customer but the direct material and direct labor costs can easily be traced to the final product. Job order costing is often a more complex system and is appropriate when the level of detail is necessary, as discussed in Job Order Costing. Examples of products manufactured using the job order costing method include tax returns or audits conducted by a public accounting firm, custom furniture, or, in a comprehensive example, semitrucks. At the Peterbilt factory in Denton, Texas, the company can build over \(100,000\) unique versions of their semitrucks without making the same truck twice.
Process costing is the optimal costing system when a standardized process is used to manufacture identical products and the direct material, direct labor, and manufacturing overhead cannot be easily or economically traced to a specific unit. Process costing is used most often when manufacturing a product in batches. Each department or production process or batch process tracks its direct material and direct labor costs as well as the number of units in production. The actual cost to produce each unit through a process costing system varies, but the average result is an adequate determination of the cost for each manufactured unit. Examples of items produced and accounted for using a form of the process costing method could be soft drinks, petroleum products, or even furniture such as chairs, assuming that the company makes batches of the same chair, instead of customizing final products for individual customers.
For example, small companies, such as David and William’s, and large companies, such as Nabisco, use similar cost-determination processes. In order to understand how much each product costs—for example, Oreo cookies—Nabisco uses process costing to track the direct materials, direct labor, and manufacturing overhead used in the manufacturing of its products. Oreo production has six distinct steps or departments:
1. make the cookie dough,
2. press the cookie dough into a molding machine,
3. bake the cookies,
4. make the filling and apply it to the cookies,
5. put the cookies together into a sandwich,
6. place the cookies into plastic trays and packages.
Each department keeps track of its direct materials used and direct labor incurred, and manufacturing overhead applied to facilitate determining the cost of a batch of Oreo cookies.
As previously mentioned, process costing is used when similar items are produced in large quantities. As such, many individuals immediately associate process costing with assembly line production. Process costing works best when products cannot be distinguished from each other and, in addition to obvious production line products like ice cream or paint, also works for more complex manufacturing of similar products like small engines. Conversely, products in a job order cost system are manufactured in small quantities and include custom jobs such as custom manufacturing products. They can also be legal or accounting tasks, movie production, or major projects such as construction activities.
The difference between process costing and job order costing relates to how the costs are assigned to the products. In either costing system, the ability to obtain and analyze cost data is needed. This results in the costing system selected being the one that best matches the manufacturing process.
A job order cost system is often more expensive to maintain than a basic process costing system, since there is a cost associated with assigning the individual material and labor to the product. Thus, a job order cost system is used for custom jobs when it is easy to determine the cost of materials and labor used for each job. A process cost system is often less expensive to maintain and works best when items are identical and it is difficult to trace the exact cost of materials and labor to the final product. For example, assume that your company uses three production processes to make jigsaw puzzles. The first process glues the picture on the cardboard backing, the second process cuts the puzzle into pieces, and the final process loads the pieces into the boxes and seals them. Tracing the complete costs for the batch of similar puzzles would likely entail three steps, with three separate costing system components. In this environment, it would be difficult and not economically feasible to trace the exact materials and the exact labor to each individual puzzle; rather, it would be more efficient to trace the costs per batch of puzzles.
The costing system used typically depends on whether the company can most efficiently and economically trace the costs to the job (favoring job order costing system) or to the production department or batch (favoring a process costing system).
While the costing systems are different from each other, management uses the information provided to make similar managerial decisions, such as setting the sales price. For example, in a job order cost system, each job is unique, which allows management to establish individual prices for individual projects. Management also needs to establish a sales price for a product produced with a process costing system, but this system is not designed to stop the production process and individually cost each batch of a product, so management must set a price that will work for many batches of the product.
In addition to setting the sales price, managers need to know the cost of their products in order to determine the value of inventory, plan production, determine labor needs, and make long- and short-term plans. They also need to know the costs to determine when a new product should be added or an old product removed from production.
In this chapter, you will learn when and why process costing is used. You’ll also learn the concepts of conversion costs and equivalent units of production and how to use these for calculating the unit and total cost of items produced using a process costing system.
Basic Managerial Accounting Terms Used in Job Order Costing and Process Costing
Regardless of the costing system used, manufacturing costs consist of direct material, direct labor, and manufacturing overhead. Figure \(2\) shows a partial organizational chart for Rock City Percussion, a drumstick manufacturer. In this example, two groups—administrative and manufacturing—report directly to the chief financial officer (CFO). Each group has a vice president responsible for several departments. The organizational chart also shows the departments that report to the production department, illustrating the production arrangement. The material storage unit stores the types of wood used (hickory, maple, and birch), the tips (nylon and felt), and packaging materials.
Understanding the company’s organization is an important first step in any costing system. Next is understanding the production process. The most basic drumstick is made of hickory and has a wooden tip. When the popular size 5A stick is manufactured, the hickory stored in the materials storeroom is delivered to the shaping department where the wood is cut into pieces, shaped into dowels, and shaped into the size 5A shape while under a stream of water. The sticks are dried, and then sent to the packaging department, where the sticks are embossed with the Rock City Percussion logo, inspected, paired, packaged, and shipped to retail outlets such as Guitar Center. The manufacturing process is described in Figure \(3\).
The different units within Rock City Percussion illustrate the two main cost categories of a manufacturing company: manufacturing costs and administrative costs.
LINK TO LEARNING
Understanding the full manufacturing process for a product helps with tracking costs. This video on how drumsticks are made shows the production process for drumsticks at one company, starting with the raw wood and ending with packaging.
Manufacturing Costs
Manufacturing costs or product costs include all expenses required to manufacture the product: direct materials, direct labor, and manufacturing overhead. Since process costing assigns the costs to each department, the inventory at the end of the period includes the finished goods inventory, and the work in process inventory for each manufacturing department. For example, using the departments shown in Figure \(3\), raw materials inventory is the cost paid for the materials that remain in the storeroom until requested.
While still in production, the work in process units are moved from one department to the next until they are completed, so the work in process inventory includes all of the units in the shaping and packaging departments. When the units are completed, they are transferred to finished goods inventory and become costs of goods sold when the product is sold.
When assigning costs to departments, it is important to separate the product costs from the period costs, which are those that are typically related with a particular time period, instead of attached to the production of an asset. Management often needs additional information to make decisions and needs the product costs further categorized as prime costs or conversion costs (Figure \(4\)). Prime costs are costs that include the primary (or direct) product costs: direct material and direct labor. Conversion costs are the costs necessary to convert direct materials into a finished product: direct labor and manufacturing overhead, which includes other costs that are not classified as direct materials or direct labor, such as plant insurance, utilities, or property taxes. Also, note that direct labor is considered to be a component of both prime costs and conversion costs.
Job order costing tracks prime costs to assign direct material and direct labor to individual products (jobs). Process costing also tracks prime costs to assign direct material and direct labor to each production department (batch). Manufacturing overhead is another cost of production, and it is applied to products (job order) or departments (process) based on an appropriate activity base.
1,2
According to the Federal Bureau of Investigation (FBI), “Sandy Jenkins was a shy, daydreaming accountant at the Collin Street Bakery, the world’s most famous fruitcake company. He was tired of feeling invisible, so he started stealing—and got a little carried away.” Being unethical netted the accountant ten years in federal prison, and his wife Kay was sentenced to five years’ probation and 100 hours of community service, and she was required to write a formal apology to the bakery. According to the FBI, “Jenkins spent over \(\$11\) million on a Black American Express card alone—roughly \(\$98,000\) per month over the course of the scheme—for a couple that had a legitimate income, through the Bakery, of approximately \(\$50,000\) per year.”
How did this happen? Texas Monthly reports that Sandy found a way to write unapproved checks in the accounting system. He implemented his accounting system and created checks that were “signed” by the owner of the company, Bob McNutt. McNutt was perplexed as to why his bakery was not more profitable year after year. The accountant was stealing the money while making the stolen checks appear to be paying for material costs or operating costs. According to Texas Monthly, “Once Sandy was sure that nobody had noticed the first fraudulent check, he tried it again. And again and again. Each time, Sandy would repeat the scheme, pairing his fraudulent check with one that appeared legitimate. Someone would have to closely examine the checks to see any discrepancies, and that seemed unlikely.” The multimillion dollar fraud was exposed when another accountant looked closely at the checks and noticed discrepancies.
Selling and Administrative Expenses
Selling and administrative (S&A) expenses are period costs, which means that they are recorded in the period in which they were incurred. Selling and administrative expenses typically are not directly assigned to the items produced or services provided and include costs of departments not directly associated with manufacturing but necessary to operate the business. The selling costs component of S&A expenses is related to the promotion and sale of the company’s products, while administrative expenses are related to the administration of the company. Some examples of S&A expenses include marketing costs; administration building rent; the chief executive officer’s salary expense; and the accounting, payroll, and data processing department expenses.
These general rules for S&A expenses, however, have their exceptions. For example, some items that are classified as overhead, such as plant insurance, are period costs but are classified as overhead and are attached to the items produced as product costs.
The expense recognition principle is the primary reason to separate the costs of production from the other expenses of the company. This principle requires costs to be recorded in the period in which they are incurred. The costs are expensed when matched to the revenue with which they are associated; this is commonly referred to as having the expenses follow the revenues.
Period costs are expensed during the period in which they are incurred; this allows a company to apply the administrative and other expenses shown on the income statement to the same period in which the company earns income. Under generally accepted accounting principles (GAAP), separating the production costs and assigning them to the department results in the costs of the product staying with the work in process inventory for each department. This follows the expense recognition principle because the cost of the product is expensed when revenue from the sale is recognized.
Equivalent Units
In a process cost system, costs are maintained by each department, and the method for determining the cost per individual unit is different than in a job order costing system. Rock City Percussion uses a process cost system because the drumsticks are produced in batches, and it is not economically feasible to trace the direct labor or direct material, like hickory, to a specific drumstick. Therefore, the costs are maintained by each department, rather than by job, as they are in job order costing.
How does an organization determine the cost of each unit in a process costing environment? The costs in each department are allocated to the number of units produced in a given period. This requires determination of the number of units produced, but this is not always an easy process. At the end of the accounting period, there typically are always units still in production, and these units are only partially complete. Think of it this way: At midnight on the last day of the month, all accounting numbers need to be determined in order to process the financial statements for that month, but the production process does not stop at the end of each accounting period. However, the number of units produced must be calculated at the end of the accounting period to determine the number of equivalent units, or the number of units that would have been produced if the units were produced sequentially and in their entirety in a particular time period. The number of equivalent units is different from the number of actual units and represents the number of full or whole units that could have been produced given the amount of effort applied. To illustrate, consider this analogy. You have five large pizzas that each contained eight slices. Your friends served themselves, and when they were finished eating, there were several partial pizzas left. In equivalent units, determine how many whole pizzas are left if the remaining slices are divided as shown in Figure \(5\).
• Pie 1 had one slice
• Pie 2 had two slices
• Pie 3 had two slices
• Pie 4 had three slices
• Pie 5 had eight slices
Together, there are sixteen slices left. Since there are eight slices per pizza, the leftover pizza would be considered two full equivalent units of pizzas. The equivalent unit is determined separately for direct materials and for conversion costs as part of the computation of the per-unit cost for both material and conversion costs.
Major Characteristics of Process Costing
Process costing is the optimal system for a company to use when the production process results in many similar units. It is used when production is continuous or occurs in large batches and it is difficult to trace a particular input cost to a specific individual product.
For example, before David and William found ways to make five large cookies per batch, their family always made one large cookie per batch. In order to make five cookies at a time, they had to gather the ingredients and baking materials, including five bowls and five cookie sheets. The exact amount of ingredients for one large cookie was mixed in each separate bowl and then placed on the cookie sheet. When this method was used, it was easy to establish that exactly one egg, two cups of flour, three-quarter cup of chocolate chips, three-quarter cup of sugar, one-quarter teaspoon salt, and so forth, were in each cookie. This made it easy to determine the exact cost of each cookie. But if David and William used one bowl instead of five bowls, measured the ingredients into it and then divided the dough into five large cookies, they could not know for certain that each cookie has exactly two cups of flour. One cookie may have \(1 \tfrac{7}{8}\) cups and another may have \(1 \tfrac{15}{16}\) cups, and one cookie may have a few more chocolate chips than another. It is also impossible to trace the chocolate chips from each bag to each cookie because the chips were mixed together. These variations do not affect the taste and are not important in this type of accounting. Process costing is optimal when the products are relatively homogenous or indistinguishable from one another, such as bottles of vegetable oil or boxes of cereal.
Often, process costing makes sense if the individual costs or values of each unit are not significant. For example, it would not be cost effective for a restaurant to make each cup of iced tea separately or to track the direct material and direct labor used to make each eight-ounce glass of iced tea served to a customer. In this scenario, job order costing is a less efficient accounting method because it costs more to track the costs per eight ounces of iced tea than the cost of a batch of tea. Overall, when it is difficult or not economically feasible to track the costs of a product individually, process costing is typically the best cost system to use.
Process costing can also accommodate increasingly complex business scenarios. While making drumsticks may sound simple, an immense amount of technology is involved. Rock City Percussion makes \(8,000\) hickory sticks per day, four days each week. The sticks made of maple and birch are manufactured on the fifth day of the week. It is difficult to tell the first drumstick made on Monday from the \(32,000\)th one made on Thursday, so a computer matches the sticks in pairs based on the tone produced.
Process costing measures and assigns the costs to the associated department. The basic 5A hickory stick consists only of hickory as direct material. The rest of the manufacturing process involves direct labor and manufacturing overhead, so the focus is on properly assigning those costs. Thus, process costing works well for simple production processes such as cereal, rubber, and steel, and for more complicated production processes such as the manufacturing of electronics and watches, if there is a degree of similarity in the production process.
In a process cost system, each department accumulates its costs to compute the value of work in process inventory, so there will be a work in process inventory for each manufacturing or production department as well as an inventory cost for finished goods inventory. Manufacturing departments are often organized by the various stages of the production process. For example, blending, baking, and packaging could each be categorized as manufacturing or production departments for the cookie producer, while cutting, assembly, and finishing could be manufacturing or production departments with accompanying costs for a furniture manufacturer. Each department, or process, will have its own work in process inventory account, but there will only be one finished goods inventory account.
There are two methods used to compute the values in the work in process and finished goods inventories. The first method is the weighted-average method, which includes all costs (costs incurred during the current period and costs incurred during the prior period and carried over to the current period). This method is often favored, because in the process cost production method there often is little product left at the end of the period and most has been transferred out. The second method is the first-in, first-out (FIFO) method, which calculates the unit costs based on the assumption that the first units sold come from the prior period’s work in process that was carried over into the current period and completed. After these units are sold, the newer completed units can then be sold. The theory is similar to the FIFO inventory valuation process that you learned about in Inventory. (Since the FIFO process costing method is more complicated than the weighted-average method, the FIFO method is typically covered in more advanced accounting courses.)
With processing, it is difficult to establish how much of each material, and exactly how much time is in each unit of finished product. This will require the use of the equivalent unit computation, and management selects the method (weighted average or FIFO) that best fits their information system.
Process costing can also be used by service organizations that provide homogeneous services and often do not have inventory to value, such as a hotel reservation system. Although they have no inventory, the hotel might want to know its costs per reservation for a period. They could allocate the total costs incurred by the reservation system based on the number of inquiries they served. For example, assume that in a year they incurred costs of \(\$200,000\) and served \(50,000\) potential guests. They could determine an average cost by dividing costs by number of inquiries, or \(\$200,000/50,000 = \$4.00\) per potential guest.
In the case of a not-for-profit company, the same process could be used to determine the average costs incurred by a department that performs interviews. The department’s costs would be allocated based on the number of cases processed. For example, assume a not-for-profit pet adoption organization has an annual budget of \(\$180,000\) and typically matches 900 shelter animals with new owners each year. The average cost would be \(\$200\) per match.
Similarities between Process Costing and Job Order Costing
Both process costing and job order costing maintain the costs of direct material, direct labor, and manufacturing overhead. The process of production does not change because of the costing method. The costing method is chosen based on the production process.
In job order cost production, the costs can be directly traced to the job, and the job cost sheet contains the total expenses for that job. Process costing is optimal when the costs cannot be traced directly to the job. For example, it would be impossible for David and William to trace the exact amount of eggs in each chocolate chip cookie. It is also impossible to trace the exact amount of hickory in a drumstick. Even two sticks made sequentially may have different weights because the wood varies in density. These types of manufacturing are optimal for the process cost system.
The similarities between job order cost systems and process cost systems are the product costs of materials, labor, and overhead, which are used determine the cost per unit, and the inventory values. The differences between the two systems are shown in Table \(1\).
Table \(1\): Differences between Job Order Costing and Process Costing
Job Order Costing Process Costing
Product costs are traced to the product and recorded on each job’s individual job cost sheet. Product costs are traced to departments or processes.
Each department tracks its expenses and adds them to the job cost sheet. As jobs move from one department to another, the job cost sheet moves to the next department as well. Each department tracks its expenses, the number of units started or transferred in, and the number of units transferred to the next department.
Unit costs are computed using the job cost sheet. Unit costs are computed using the departmental costs and the equivalent units produced.
Finished goods inventory includes the products completed but not sold, and all incomplete jobs are work in process inventory. Finished goods inventory is the number of units completed at the per unit cost. Work in process inventory is the cost per unit and the equivalent units remaining to be completed.
CONCEPTS IN PRACTICE: Choosing Between Process Costing and Job Order Costing
Process costing and job order costing are both acceptable methods for tracking costs and production levels. Some companies use a single method, while some companies use both, which creates a hybrid costing system. The system a company uses depends on the nature of the product the company manufactures.
Companies that mass produce a product allocate the costs to each department and use process costing. For example, General Mills uses process costing for its cereal, pasta, baking products, and pet foods. Job order systems are custom orders because the cost of the direct material and direct labor are traced directly to the job being produced. For example, Boeing uses job order costing to manufacture planes.
When a company mass produces parts but allows customization on the final product, both systems are used; this is common in auto manufacturing. Each part of the vehicle is mass produced, and its cost is calculated with process costing. However, specific cars have custom options, so each individual car costs the sum of the specific parts used.
THINK IT THROUGH: Direct or Indirect Material
Around Again is a wooden frame manufacturer. Wood and fastener metals are typically added at the beginning of the process and are easily tracked as direct material. Sometimes, after inspection, the product needs to be reworked and additional pieces are added. Because the frames have already been through each department, the additional work is typically minor and often entails simply adding an additional fastener to keep the back of the frame intact. Other times, all the frame needs is additional glue for a corner piece.
How does a company differentiate between direct and indirect material? Many direct material costs, as the wood in the frame, are easy to identify as direct costs because the material is identifiable in the final product. But not all readily identifiable material is a direct material cost.
Technology makes it easy to track costs as small as one fastener or ounce of glue. However, if each fastener had to be requisitioned and each ounce of glue recorded, the product would take longer to make and the direct labor cost would be higher. So, while it is possible to track the cost of each individual product, the additional information may not be worth the additional expense. Managerial accountants work with management to decide which products should be accounted for as direct material and tracked individually, versus which should be considered indirect material and allocated to the departments through overhead application.
Should Around Again consider the fasteners or glue added after inspection as direct material or indirect material?
Footnotes
1. Katy Vine. “Just Desserts.” Texas Monthly. October 2010. https://features.texasmonthly.com/ed...just-desserts/
2. Federal Bureau of Investigation (FBI). “Former Collin Street Bakery Executive and Wife Sentenced.” September 16, 2015. www.fbi.gov/contact-us/field...wife-sentenced | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/05%3A_Process_Costing/5.01%3A_Prelude_to_Process_Costing.txt |
In a processing environment, there are two concepts important to determining the cost of products produced. These are the concepts of equivalent units and conversion costs. As you have learned, equivalent units are the number of units that would have been produced if one unit was completed before starting a second unit. For example, four units that are one-fourth finished would equal one equivalent unit. Conversion costs are the labor and overhead expenses that “convert” raw materials into a completed unit. Each department tracks its conversion costs in order to determine the quantity and cost per unit (see TBD; we discuss this concept in more detail later). Management often uses the cost information generated to set the sales price; to set standard usage data and price for material, labor, and overhead; and to allow management to evaluate the efficiency of production and plan for the future.
Definition of Conversion Costs
Conversion costs are the total of direct labor and factory overhead costs. They are combined because it is the labor and overhead together that convert the raw material into the finished product. Remember that factory, manufacturing, or organizational overhead (you might see all three terms in practice) is composed of three sources: indirect materials, indirect labor, and all other overhead costs that are not indirect materials or indirect labor. Materials are often added in stages at discrete points of production, such as at the beginning, middle, or end of a process, but conversion is usually applied equally throughout the process. For example, in the opening example, David and William do not add direct material (ingredients) evenly throughout the cookie-making process. They are all added at the beginning of the production process, so they begin with the direct materials but add labor and overhead throughout the rest of the process.
Conversion costs can be explained through the process of making Just Born’s Peeps. Just Born makes \(5.5\) million Peeps per day using three ingredients and the following process:1
1. Use machines to add and mix the sugar, corn syrup, and gelatin into a mixture called a slurry. Send slurry through a whipper to give the marshmallow its fluffy texture.
2. Color the sugar.
3. Deposit marshmallows on sugar-coated belts in the Peep shape. Send Peeps on belts through a wind tunnel that stirs up the sugar to coat the entire shape.
4. Add eyes, and inspect.
5. Move the Peeps via belt into their appropriate tray, and wrap with cellophane.
In the Peep-making process, the direct materials of sugar, corn syrup, gelatin, color, and packaging materials are added at the beginning of steps 1, 2, and 5. While the fully automated production does not need direct labor, it does need indirect labor in each step to ensure the machines are operating properly and to perform inspections (step 4).
Mechanics of Applying Conversion Costs
Let’s return to our drumstick example to learn how to work with conversion costs. Rock City Percussion has two departments critical to manufacturing drumsticks: the shaping and packaging departments.
The shaping department uses only wood as its direct material and water as its indirect material. In the shaping department, the material is added first. Then, machines cut the wood underwater into dowels, separate them, and move them to machines that shape the dowels into drumsticks. These machines need electricity to operate and personnel to monitor and adjust the processes and to maintain the equipment. When the shaping is finished, a conveyer belt transfers the sticks to the finishing department.
Since the drumsticks are made by performing one process on one batch at a time, instead of producing one stick at a time from start to finish, it is difficult to determine the exact materials, labor, and overhead for a single pair of drumsticks. It is easier to track the materials and conversion costs for one batch and have those costs follow the batch to the next process.
Therefore, once the batch of sticks gets to the second process—the packaging department—it already has costs attached to it. In other words, the packaging department receives both the drumsticks and their related costs from the shaping department. For the basic size 5A stick, the packaging department adds material at the beginning of the process. The 5A uses only packaging sleeves as its direct material, while other types may also include nylon, felt, and/or the ingredients for the proprietary handgrip. Direct labor and manufacturing overhead are used to test, weigh, and sound-match the drumsticks into pairs.
Thus, at the end of the accounting period, there are two work in process inventories: one in the shaping department and one in the packaging department.
Direct materials are added at the beginning of shaping and packaging departments, so the work in process inventory for those departments is 100% complete with regard to materials, but it is not complete with regard to conversion costs. If they were \(100\%\) complete with regard to conversion costs, then they would have been transferred to the next department.
LINK TO LEARNING
Management needs to understand its costs in order to set prices, budget for the upcoming year, and evaluate performance. Sometimes individuals become managers due to their knowledge of the production process but not necessarily the costs. Managers can view this information on the importance of identifying prime and conversion costsfrom Investopedia, a resource for managers.
Footnotes
1. Just Born. “Marshmallow Peeps Factory Tour.” n.d. www.justborn.com/resource/cor...irtualTour.cfm | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/05%3A_Process_Costing/5.03%3A_Explain_and_Identify_Conversion_Costs.txt |
As described previously, process costing can have more than one work in process account. Determining the value of the work in process inventory accounts is challenging because each product is at varying stages of completion and the computation needs to be done for each department. Trying to determine the value of those partial stages of completion requires application of the equivalent unit computation. The equivalent unit computation determines the number of units if each is manufactured in its entirety before manufacturing the next unit. For example, forty units that are \(25\%\) complete would be ten (\(40 × 25\%\)) units that are totally complete.
Direct material is added in stages, such as the beginning, middle, or end of the process, while conversion costs are expensed evenly over the process. Often there is a different percentage of completion for materials than there is for labor. For example, if material is added at the beginning of the process, the forty units that are \(100\%\) complete with respect to material and \(25\%\) complete with respect to conversion costs would be the same as forty units of material and ten units (\(40 × 25\%\)) completed with conversion costs.
For example, during the month of July, Rock City Percussion purchased raw material inventory of \(\$25,000\) for the shaping department. Although each department tracks the direct material it uses in its own department, all material is held in the material storeroom. The inventory will be requisitioned for each department as needed.
During the month, Rock City Percussion’s shaping department requested \(\$10,179\) in direct material and started into production \(8,700\) hickory drumsticks of size 5A. There was no beginning inventory in the shaping department, and \(7,500\) drumsticks were completed in that department and transferred to the finishing department. Wood is the only direct material in the shaping department, and it is added at the beginning of the process, so the work in process (WIP) is considered to be \(100\%\) complete with respect to direct materials. At the end of the month, the drumsticks still in the shaping department were estimated to be \(35\%\) complete with respect to conversion costs. All materials are added at the beginning of the shaping process. While beginning the size 5A drumsticks, the shaping department incurred these costs in July:
These costs are then used to calculate the equivalent units and total production costs in a four-step process.
Step One: Determining the Units to Which Costs Will Be Assigned
In addition to the equivalent units, it is necessary to track the units completed as well as the units remaining in ending inventory. A similar process is used to account for the costs completed and transferred. Reconciling the number of units and the costs is part of the process costing system. The reconciliation involves the total of beginning inventory and units started into production. This total is called “units to account for,” while the total of beginning inventory costs and costs added to production is called “costs to be accounted for.” Knowing the total units or costs to account for is helpful since it also equals the units or costs transferred out plus the amount remaining in ending inventory.
When the new batch of hickory sticks was started on July 1, Rock City Percussion did not have any beginning inventory and started \(8,700\) units, so the total number of units to account for in the reconciliation is \(8,700\):
The shaping department completed \(7,500\) units and transferred them to the testing and sorting department. No units were lost to spoilage, which consists of any units that are not fit for sale due to breakage or other imperfections. Since the maximum number of units that could possibly be completed is \(8,700\), the number of units in the shaping department’s ending inventory must be \(1,200\). The total of the \(7,500\) units completed and transferred out and the \(1,200\) units in ending inventory equal the \(8,700\) possible units in the shaping department.
Step Two: Computing the Equivalent Units of Production
All of the materials have been added to the shaping department, but all of the conversion elements have not; the numbers of equivalent units for material costs and for conversion costs remaining in ending inventory are different. All of the units transferred to the next department must be \(100\%\) complete with regard to that department’s cost or they would not be transferred. So the number of units transferred is the same for material units and for conversion units. The process cost system must calculate the equivalent units of production for units completed (with respect to materials and conversion) and for ending work in process with respect to materials and conversion.
For the shaping department, the materials are \(100\%\) complete with regard to materials costs and \(35\%\) complete with regard to conversion costs. The \(7,500\) units completed and transferred out to the finishing department must be \(100\%\) complete with regard to materials and conversion, so they make up \(7,500 (7,500 × 100\%)\) units. The \(1,200\) ending work in process units are \(100\%\) complete with regard to material and have \(1,200 (1,200 × 100%)\) equivalent units for material. The \(1,200\) ending work in process units are only \(35\%\) complete with regard to conversion costs and represent \(420 (1,200 × 35\%)\) equivalent units.
Step Three: Determining the Cost per Equivalent Unit
Once the equivalent units for materials and conversion are known, the cost per equivalent unit is computed in a similar manner as the units accounted for. The costs for material and conversion need to reconcile with the total beginning inventory and the costs incurred for the department during that month.
The total materials costs for the period (including any beginning inventory costs) is computed and divided by the equivalent units for materials. The same process is then completed for the total conversion costs. The total of the cost per unit for material (\(\$1.17\)) and for conversion costs (\(\$2.80\)) is the total cost of each unit transferred to the finishing department (\(\$3.97\)).
Step Four: Allocating the Costs to the Units Transferred Out and Partially Completed in the Shaping Department
Now you can determine the cost of the units transferred out and the cost of the units still in process in the shaping department. To calculate the goods transferred out, simply take the units transferred out times the sum of the two equivalent unit costs (materials and conversion) because all items transferred to the next department are complete with respect to materials and conversion, so each unit brings all its costs. But the ending WIP value is determined by taking the product of the work in process material units and the cost per equivalent unit for materials plus the product of the work in process conversion units and the cost per equivalent unit for conversion.
This information is accumulated in a production cost report. This report shows the costs used in the preparation of a product, including the cost per unit for materials and conversion costs, and the amount of work in process and finished goods inventory. A complete production cost report for the shaping department is illustrated in Figure \(7\).
Example \(1\): Calculating Inventory Transferred and Work in Process Costs
Kyler Industries started a new batch of paint on October 1. The new batch consists of \(8,700\) cans of paint, of which \(7,500\) was completed and transferred to finished goods. During October, the manufacturing process recorded the following expenses: direct materials of \(\$10,353\); direct labor of \(\$17,970\); and applied overhead of \(\$9,000\). The inventory still in process is \(100\%\) complete with respect to materials and \(30\%\) complete with respect to conversion. What is the cost of inventory transferred out and work in process? Assume that there is no beginning work in process inventory. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/05%3A_Process_Costing/5.04%3A_Explain_and_Compute_Equivalent_Units_and_Total_Cost_of_Production_in_an_Initial_Processing_Stage.txt |
In many production departments, units are typically transferred from the initial stage to the next stage in the process. When the units are transferred, the accumulated cost per unit is transferred along with them. Since the unit being produced includes work from all of the prior departments, the transferred-in cost is the cost of the work performed in all earlier departments.
When the hickory size 5A drumsticks have completed the shaping process, they are transferred to the packaging department along with the inventory costs of \(\$29,775\). The inventory costs of \(\$29,775\) were \(\$8,775\) for materials and \(\$21,000\) for conversion costs and were calculated in Figure 5.3.7. During the month of July, Rock City Percussion purchased raw material inventory of \(\$2,000\) for the packaging department. As with the shaping department, the packaging department tracks its costs and requisitions the raw material from the material storeroom. The packaging department has computed direct material costs of \(\$2,000\), direct labor costs of \(\$13,000\), and applied overhead of \(\$9,100\), for a total of \(\$22,100\) in conversion costs. Equivalent units are computed for this department, and a new cost per unit is computed.
As with calculating the equivalent units and total cost of production in the initial processing stage, there are four steps for calculating these costs in a subsequent processing stage.
Step One: Determining the Stage 2 Units to Which Costs Will Be Assigned
In the initial manufacturing department, there is beginning inventory, and units are started in production. In subsequent stages, instead of starting new units, units are transferred in from the prior department, but the accounting process is the same. Returning to the example, Rock City Percussion had a beginning inventory of \(750\) units in the packaging department. When the \(7,500\) sticks are transferred into the packaging department from the shaping department, the total number of units to account for in the reconciliation is \(8,250\), which is the total of the beginning WIP and the units transferred in:
The reconciliation of units to account for are the same for each department. The units that were completed and transferred out plus the ending inventory equal the total units to account for. The packaging department for Rock City Percussion completed \(6,500\) units and transferred them into finished goods inventory. Since the maximum number of units to possibly be completed is \(8,250\) and no units were lost to spoilage, the number of units in the packaging department’s ending inventory must be \(1,750\). The total of the \(6,500\) units completed and transferred out and the \(1,750\) units in ending inventory equal the \(8,250\) possible units in the packaging department.
Step Two: Computing the Stage 2 Equivalent Units of Production
The only direct material added in the packaging department for the 5A sticks is packaging. The packaging materials are added at the beginning of the process, so all the materials have been added before the units are transferred out, but all of the conversion elements have not. As a result, the number of equivalent units for material costs and for conversion costs remaining in ending inventory is different for the testing and sorting department. As you’ve learned, all of the units transferred to the next department must be \(100\%\) complete with regard to that department’s cost, or they would not be transferred. The process cost system must calculate the equivalent units of production for units completed (with respect to materials and conversion) and for ending WIP with respect to materials and conversion.
For the packaging department, the materials are \(100\%\) complete with regard to materials costs and \(40\%\) complete with regard to conversion costs. The \(6,500\) units completed and transferred out to the finishing department must be \(100\%\) complete with regard to materials and conversion, so they make up \(6,500 (6,500 × 100\%)\) units. The \(1,750\) ending WIP units are \(100\%\) complete with regard to material and have \(1,750 (1,750 × 100\%)\) equivalent units for material. The \(1,750\) ending WIP units are only \(40\%\) complete with regard to conversion costs and represent \(700 (1,750 × 40\%)\) equivalent units.
Step Three: Determining the Stage 2 Cost per Equivalent Unit
Once the equivalent units for materials and conversion are known for the packaging department, the cost per equivalent unit is computed in a manner similar to the calculation for the units accounted for. The costs for material and conversion need to reconcile with the department’s beginning inventory and the costs incurred for the department during that month.
The total materials costs for the period (including any beginning inventory costs) are computed and divided by the equivalent units for materials. The same process is then completed for the total conversion costs. The total of the cost per unit for materials (\(\$1.50\)) and for conversion costs (\(\$6.90\)) is the total cost of each unit transferred to the testing and sorting department.
Step Four: Allocating the Costs to the Units in the Finishing Department
Now you can determine the cost of the units transferred out and the cost of the units still in process in the finishing department. For the goods transferred out, simply take the units transferred out times the sum of the two equivalent unit costs (materials and conversion) because all items transferred to the next department are complete with respect to materials and conversion, so each unit brings all its costs. But the ending WIP value is determined by taking the product of the work in process materials units and the cost per equivalent unit for materials plus the product of the work in process conversion units and the cost per equivalent unit for conversion.
LINK TO LEARNING
Knowing the cost to produce a unit is critical to management’s decisions. Sometimes that knowledge leads to management’s decision to stop production, but sometimes that decision isn’t as simple as it seems. The cost to produce a penny is more than one cent, and yet, the United States still makes pennies. See this article from Forbes that explains the difference among cost, worth, and value to learn more. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/05%3A_Process_Costing/5.05%3A_Explain_and_Compute_Equivalent_Units_and_Total_Cost_of_Production_in_a_Subsequent_Processing_Stage.txt |
Calculating the costs associated with the various processes within a process costing system is only a part of the accounting process. Journal entries are used to record and report the financial information relating to the transactions. The example that follows illustrates how the journal entries reflect the process costing system by recording the flow of goods and costs through the process costing environment.
Purchased Materials for Multiple Departments
Each department within Rock City Percussion has a separate work in process inventory account. Raw materials totaling $\33,500$ were ordered prior to being requisitioned by each department: $\25,000$ for the shaping department and $\8,500$ for the packaging department. The July 1 journal entry to record the purchases on account is:
Direct Materials Requisitioned by the Shaping and Packaging Departments and Indirect Material Used
During July, the shaping department requisitioned $\10,179$ in direct material. Similar to job order costing, indirect material costs are accumulated in the manufacturing overhead account. The overhead costs are applied to each department based on a predetermined overhead rate. In the example, assume that there was an indirect material cost for water of $\400$ in July that will be recorded as manufacturing overhead. The journal entry to record the requisition and usage of direct materials and overhead is:
During July, the packaging department requisitioned $\2,000$ in direct material and overhead costs for indirect material totaled $\300$ for the month of July. The journal entry to record the requisition and usage of materials is:
Direct Labor Paid by All Production Departments
During July, the shaping department incurred $\15,000$ in direct labor costs and $\600$ in indirect labor. The journal entry to record the labor costs is:
During July, the packaging department incurred $\13,000$ of direct labor costs and indirect labor of $\1,000$. The journal entry to record the labor costs is:
Applied Manufacturing Overhead to All Production Departments
Manufacturing overhead includes indirect material, indirect labor, and other types of manufacturing overhead. It is difficult, if not impossible, to trace manufacturing overhead to a specific product, and yet, the total cost per unit needs to include overhead in order to make management decisions.
Overhead costs are accumulated in a manufacturing overhead account and applied to each department on the basis of a predetermined overhead rate. Properly allocating overhead to each department depends on finding an activity that provides a fair basis for the allocation. It needs to be an activity common to each department and influential in driving the cost of manufacturing overhead. In traditional costing systems, the most common activities used are machine hours, direct labor in dollars, or direct labor in hours. If the number of machine hours can be related to the manufacturing overhead, the overhead can be applied to each department based on the machine hours. The formula for overhead allocation is:
$\text { Overhead Allocation }=\dfrac{\text { Estimated Overhead costs (\) }}{\text { Expected Annual Activity (machine hours) }}$
Rock City Percussion determined that machine hours is the appropriate base to use when allocating overhead. The estimated annual overhead cost is $\340,000$ per year. It was also estimated that the total machine hours will be $34,000$ hours, so the allocation rate is computed as:
$\dfrac{\text { Estimated Overhead } \operatorname{cost}(\ 340,000)}{\text { Expected Annual Activity }(34,000)}=\ 10 \text { per machine hour } \nonumber$
The shaping department used $700$ machine hours, and with an overhead application rate of $\10$ per direct labor hour, the journal entry to record the overhead allocation is:
The finishing department used $910$ machine hours, and with an overhead application rate of $\10$ per direct labor hour, the journal entry to record the overhead allocation is:
Transferred Costs of Finished Goods from the Shaping Department to the Packaging Department
When the units are transferred from the shaping department to the packaging department, they are transferred at $\3.97$ per unit, as calculated previously. The amount transferred from the shaping department is the same amount listed on the production cost report in Figure 5.3.7. The journal entry is:
Transferred Goods from the Packaging Department to Finished Goods
The computation of inventory for the packaging department is shown in Figure $9$.
The value of the inventory transferred to finished goods in the production cost report is the same as in the journal entry:
Recording the Cost of Goods Sold Out of the Finished Goods Inventory
Each unit is a package of two drumsticks that cost $\8.40$ to make and sells for $\24.99$. There are two transactions when recording a sale. One entry is to transfer the inventory from finished goods inventory to cost of goods sold and is at the cost of the product. The second transaction is to record the sale at the sales price. The compound entry to record both transactions for the sale of $500$ units on account is:
LINK TO LEARNING
The importance of properly recording the production process is illustrated in this report on work in process inventory from InventoryOps.com. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/05%3A_Process_Costing/5.06%3A_Prepare_Journal_Entries_for_a_Process_Costing_System.txt |
Section Summaries
5.1 Compare and Contrast Job Order Costing and Process Costing
• The three categories of costs incurred in producing an item are direct material, direct labor, and manufacturing overhead.
• Process costing is the system of accumulating costs within each department for large-volume, mass-produced units.
• Process costing often groups direct labor and manufacturing overhead as conversion costs.
• Costs under GAAP are categorized as period costs when they are not related to production and instead cover a time period.
• Selling and administrative costs are period costs related to the sales of products and management of the company and are not directly tied to a specific product.
• Process costing determines the cost per unit through the use of equivalent units, or the number of units that would have been produced if production was sequential instead of in batches.
5.2 Explain and Identify Conversion Costs
• Conversion costs are the costs of direct labor and manufacturing overhead used to convert raw materials into a finished product.
• Materials are added during various stages of the manufacturing process, such as the beginning or end, while conversion of the product from raw material into finished goods is considered to occur uniformly through the process. Thus, it is possible for a product to have all of its materials and not be complete.
• Equivalent units for direct materials can be different than the equivalent units for conversion costs because materials are added in steps through the manufacturing process, while conversion costs are incurred evenly throughout the process.
5.3 Explain and Compute Equivalent Units and Total Cost of Production in an Initial Processing Stage
• Process costing has a work in process inventory account for each department.
• Equivalent units of production for materials may differ from the equivalent units for conversion costs.
• The total units to account for is the number of units in the beginning work in process inventory plus the number of units started into production; this total also represents the sum of the number of units completed and the number of units in the ending work in process inventory.
• The cost per equivalent unit for materials is the total of the material costs for the beginning work in process inventory and the total of material costs incurred during the period.
• The cost per equivalent unit for conversion costs is the total of the conversion costs for the beginning work in process inventory and the total of conversion costs incurred during the period.
• The cost of units transferred to the next department is the number of units transferred times the total of the cost per equivalent unit of material plus the cost per equivalent unit for conversion costs.
5.4 Explain and Compute Equivalent Units and Total Cost of Production in a Subsequent Processing Stage
• The total units to account for is the number of units in the beginning work in process inventory plus the number of units transferred from the prior department; this total also represents the number of units completed plus the number of units in the ending work in process inventory.
• The cost per equivalent units for materials is the total of the material costs for the beginning work in process inventory plus the cost of material transferred in to the department plus the total of material costs incurred during the period.
• The cost per equivalent unit for conversion costs is the total of the conversion costs for the beginning work in process inventory plus the conversion costs transferred in plus the total of conversion costs incurred during the period.
5.5 Prepare Journal Entries for a Process Costing System
• Traditional journal entries show the purchase of material and the incurring of overhead costs.
• Each department records the transfer of material from the storeroom into production, its direct labor costs, the application of overhead, and the transfer of goods to the next department or finished goods.
• The value of the inventory transferred to the next department or to finished goods equals the amount listed as transferred on the production cost report.
Key Terms
conversion cost
total of labor and overhead for a product; the costs that “convert” the direct material into the finished product
equivalent units
number of units that would have been produced if the units were produced sequentially and in their entirety in a particular time period
expense recognition principle
(also, matching principle) matches expenses with associated revenues in the period in which the revenues were generated
manufacturing costs
(also, product costs) total of all costs expended in the manufacturing process; generally consists of direct material, direct labor, and manufacturing overhead
period costs
typically related to a particular time period instead of attached to the production of an asset; treated as an expense in the period incurred (examples include many sales and administrative expenses)
prime costs
direct material expenses and direct labor costs
process costing
costing system used when a standardized process is used to manufacture identical products and the direct material, direct labor, and manufacturing overhead cannot be traced to a specific unit
product costs
all expenses required to manufacture the product: direct materials, direct labor, and manufacturing overhead
production cost report
shows the costs used in the preparation of a product, including the cost per unit for materials and conversion costs and the amount of work in process and finished goods inventory
selling and administrative (S&A) expenses
period costs not directly assigned to the items produced or services provided; include costs of departments not directly associated with manufacturing but necessary to operate the business
spoilage
any units that are not fit for sale due to breakage or other imperfections | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/05%3A_Process_Costing/5.07%3A_Summary_and_Key_Terms.txt |
Multiple Choice
1. Which of the following production characteristics is better suited for process costing and not job order costing?
1. Each product batch is distinguishable from the prior batch.
2. The costs are easily traced to a specific product.
3. Costs are accumulated by department.
4. The value of work in process is the direct material used, the direct labor incurred, and the overhead applied to the job in process.
Answer:
c
1. A process costing system is most likely used by which of the following?
1. airplane manufacturing
2. a paper manufacturing company
3. an accounting firm specializing in tax returns
4. a hospital
2. Which of the following is a prime cost?
1. direct labor
2. work in process inventory
3. administrative labor
4. factory maintenance expenses
Answer:
a
1. Which of the following is a conversion cost?
1. raw materials
2. direct labor
3. sales commissions
4. direct material used
2. During production, how are the costs in process costing accumulated?
1. to cost of goods sold
2. to each individual product
3. to manufacturing overhead
4. to each individual department
Answer:
d
1. Which is not needed to compute equivalent units of production?
1. the percentage of completion for inventory still in process
2. the number of units transferred out
3. the number of units started and completed
4. the material cost per unit
2. What is the cost of direct labor if the conversion costs are \(\$330,000\) and manufacturing overhead is \(\$275,000\)?
1. \(\$55,000\)
2. \(\$275,000\)
3. \(\$330,000\)
4. \(\$605,000\)
Answer:
a
1. What is the conversion cost to manufacture insulated travel cups if the costs are: direct materials, \(\$17,000\); direct labor, \(\$33,000\); and manufacturing overhead, \(\$70,000\)?
1. \(\$16,000\)
2. \(\$50,000\)
3. \(\$103,000\)
4. \(\$120,000\)
2. Which of the following lists contains only conversion costs for an inflatable raft manufacturing corporation?
1. vinyl for raft, machine operator, electricity, insurance
2. machine operator, electricity, depreciation, plastic for air valves
3. machine operator, electricity, depreciation, insurance
4. vinyl for raft, electricity, insurance, plastic for air valves
Answer:
c
1. Direct material costs \(\$3\) per unit, direct labor costs \(\$5\) per unit, and overhead is applied at the rate of \(100\%\) of the direct labor cost. What is the value of the inventory transferred to the next department if beginning inventory was \(2,000\) units; \(9,000\) units were started; and 1,000 units were in ending inventory?
1. \(\$1,000\)
2. \(\$13,000\)
3. \(\$130,000\)
4. \(\$20,000\)
2. Beginning inventory and direct material cost added during the month total \(\$55,000\). What is the value of the ending work in process inventory if beginning inventory was \(2,000\) units; \(9,000\) units were started; and \(1,000\) units were in ending inventory?
1. \(\$1,000\)
2. \(\$5,000\)
3. \(\$50,000\)
4. \(\$55,000\)
Answer:
b
1. The initial processing department had a beginning inventory of \(750\) units and an ending inventory of \(1,350\) units, and it started \(9,500\) units into production. How many were transferred out to the next department?
1. \(750\)
2. \(1,350\)
3. \(8,900\)
4. \(10,250\)
2. There were \(1,000\) units in ending inventory after transferring \(16,000\) units to finished goods inventory. If the beginning inventory was \(2,000\) units, how many units were started in process?
1. \(1,000\)
2. \(2,000\)
3. \(15,000\)
4. \(17,000\)
Answer:
c
1. The costs to be accounted for consist of which of the following?
1. costs added during the period
2. costs of the units in ending inventory
3. costs started and transferred during the period
4. costs in the beginning inventory and costs added during the period
2. Which of the following is the step in which materials, labor, and overhead are detailed?
1. determining the units to which costs are assigned
2. determining the equivalent units of production
3. determining the cost per equivalent units
4. allocating the costs to the units transferred out and the units partially completed
Answer:
c
1. The journal entry to record the \(\$500\) of work in process ending inventory that consists of \(\$300\) of direct materials, \(\$50\) of manufacturing overhead, and \(\$150\) od direct labor is which of the following?
2. Assigning indirect costs to departments is completed by ________.
1. applying the predetermined overhead rate
2. debiting the manufacturing costs incurred
3. applying the costs to manufacturing overhead
4. applying the costs to work in process inventory
Answer:
c
1. In a process costing system, which account shows the overhead assigned to the department?
1. cost of goods sold
2. finished goods inventory
3. raw material inventory
4. work in process inventory
2. In a process cost system, factory depreciation expense incurred is debited to ________.
1. finished goods inventory
2. work in process inventory
3. manufacturing overhead
4. cost of goods sold
Answer:
c
Questions
1. Explain how process costing differs from job order costing.
Answer:
Answers will vary but should include the following:
Area Process Job Order
Types of jobs Identical Custom order
Quantity within each job Large volume Small volume
Cost accumulation In each department In each job
1. Would a pharmaceutical manufacturer use process or job order costing? Why?
2. Which costs are assigned using the weighted-average method?
Answer:
The weighted-average method assigns the beginning inventory and the costs added during the period. The weighted-average method does not differentiate between the beginning inventory and the units started in production. This is different from the FIFO method that accounts for the beginning inventory differently and separately from current period costs.
1. What is the primary purpose of process costing?
2. What is the difference between prime costs and conversion costs?
Answer:
Prime costs and conversion costs both include labor. Prime costs are the direct costs, other than equipment, used in manufacturing and therefore are direct material and direct labor. Conversion costs are the costs involved in converting the direct material into the product and therefore are direct labor and manufacturing overhead.
1. Explain conversion costs using an example.
2. Why are there conversion costs in both job order costing and process costing?
Answer:
Job order costing and process costing are the accounting systems used to record the costs expended to produce a product. Conversion costs are the direct labor and manufacturing overhead involved in the production process and exist regardless of the accounting system used.
1. What are equivalent units of production, and how are they used in process costing?
2. How can there be a different number of equivalent units for materials as compared to conversion costs?
Answer:
While conversion typically occurs evenly throughout the process, materials are not typically added evenly, so the ending work in process can be different. For example, when materials are added at the beginning of the process, materials can be 100% complete and conversion can be 50% complete. Different completion percentages result in different equivalent units.
1. Why is the number of equivalent units for materials only sometimes equal to the equivalent units for conversion?
2. What are the four steps involved in determining the cost of inventory transferred from one department to the next and the cost of work in process inventory?
Answer:
• Step 1: Determine the units to which costs are assigned.
• Step 2: Compute the equivalent units of production.
• Step 3: Determine the cost per equivalent unit.
• Step 4: Allocate the costs to the units transferred out and the units partially completed.
1. What is the weighted-average method for computing the equivalent units of production?
2. How does process costing treat the costs transferred in from another department?
Answer:
The costs transferred in are treated in the same way as direct material that is added to production at the beginning of the process.
1. Why does each department have its own work in process inventory?
2. Match each term with its description.
a. conversion costs i. total of direct material costs and direct labor costs
b. cost of goods sold ii. manufacturing costs of the items sold
c. cost of production report iii. number of units produced if each unit was produced sequentially
d. cost per equivalent unit iv. total of direct labor costs, indirect labor costs, indirect material costs, and manufacturing overhead
e. equivalent units of production v. where costs in a process cost system are reported before being applied to the product
f. manufacturing department vi. detailed listing of the total costs of the product including the value of work in process
g. prime costs vii. cost of materials or conversion for a specific department during production
h. transferred out costs viii. product of the total cost per unit and the number of units completed and transferred during the time period
Answer:
a. iv; b. ii; c. vi; d. vii; e. iii; f. v; g. i; h. viii.
1. How is manufacturing overhead handled in a process cost system?
2. How are predetermined overhead rates used in process costing?
Answer:
Prior to the new year, a company computes the estimates of the annual overhead per department divided by the estimated driver for that department. A driver is the measure that increases the cost of overhead and is commonly direct labor hours, direct labor cost, or machine hours. The result is the predetermined overhead rate. Costs are accumulated in an account called manufacturing overhead. At the end of each period, the overhead is removed from the overhead account and applied to the department.
Exercise Set A
1. How many units were started into production in a period if there were zero units of beginning work in process inventory, \(1,100\) units in ending work in process inventory, and \(21,500\) completed and transferred out units?
2. A company started a new product, and in the first month started \(100,000\) units. The ending work in process inventory was \(20,000\) units that were \(100\%\) complete with materials and \(75\%\) complete with conversion costs. There were \(100,000\) units to account for, and the equivalent units for materials was \(\$6\) per unit while the equivalent units for conversion was \(\$8\) per unit. What is the value of the inventory transferred out, using the weighted-average inventory method?
3. Given the following information, determine the equivalent units of ending work in process for materials and conversion under the weighted-average method:
• beginning inventory of \(2,500\) units is \(100\%\) complete with regard to materials and \(60\%\) complete with regard to conversion
• \(18,000\) units were started during the period
• \(17,500\) units were completed and transferred
• ending inventory is \(100\%\) complete with materials and \(65\%\) complete with conversion
4. There were \(1,700\) units in beginning inventory that were \(40\%\) complete with regard to conversion. During the month, \(8,550\) units were started and \(9,000\) were transferred to finished goods. The ending work in process was \(60\%\) complete with regard to conversion costs, and materials are added at the beginning of the process. What is the total amount of equivalent units for materials and conversion at the end of the month using the weighted-average method?
5. A company has \(1,500\) units in ending work in process that are \(30\%\) complete after transferring out \(10,000\) units. All materials are added at the beginning of the process. If the cost per unit is \(\$4\) for materials and \(\$7\) for conversion, what is the cost of units transferred out and in ending work in process inventory using the weighted-average method?
6. There were \(2,400\) units in ending work in process inventory that were \(100\%\) complete with regard to material and \(25\%\) complete with regard to conversion costs. Ending work in process inventory had a cost of \(\$9,000\) and a per-unit material cost of \(\$2\). What was the conversion cost per unit using the weighted-average method?
7. How many units must be in ending inventory if beginning inventory was \(15,000\) units, \(55,000\) units were started, and \(57,000\) units were completed and transferred out?
8. How many units must have been completed and transferred if beginning inventory was \(75,000\) units, ending inventory was \(72,000\) units, and \(290,000\) units were started?
9. Using the weighted-average method, compute the equivalent units of production if the beginning inventory consisted of \(20,000\) units; \(55,000\) units were started in production; and \(57,000\) units were completed and transferred to finished goods inventory. For this process, materials are added at the beginning of the process, and the units are \(35\%\) complete with respect to conversion.
10. Using the weighted-average method, compute the equivalent units of production for a new company that started \(85,000\) units into production and transferred \(67,000\) to the second department. Assume that beginning inventory was \(0\). Conversion is considered to occur evenly throughout the process, while materials are added at the beginning of the process. The ending inventory for Equivalent Units: Conversion is \(9,000\) units.
11. Mazomanie Farm completed \(20,000\) units during the quarter and has \(2,500\) units still in process. The units are \(100\%\) complete with regard to materials and \(55\%\) complete with regard to conversion costs. What are the equivalent units for materials and conversion?
12. What are the total costs to account for if a company’s beginning inventory had \(\$231,432\) in materials, \(\$186,450\) in conversion costs, and added direct material costs (\(\$4,231,392\)), direct labor (\(\$2,313,392\)), and manufacturing overhead (\(\$1,156,696\))?
13. A company started the month with \(8,329\) units in work in process inventory. It started \(23,142\) units and had an ending inventory of \(9,321\). The units were \(100\%\) complete to materials and \(67\%\) complete with conversion. How many units were transferred out during the period?
14. A production department within a company received materials of \(\$10,000\) and conversion costs of \(\$10,000\) from the prior department. It added material of \(\$27,200\) and conversion costs of \(\$53,000\). The equivalent units are \(20,000\) for material and \(18,000\) for conversion. What is the unit cost for materials and conversion?
15. Production data show \(35,920\) units were transferred out of a stage of production and \(6,150\) units remained in ending WIP inventory that was \(100\%\) complete to material and \(35\%\) complete to conversion. The unit material cost is \(\$5\) for material and \(\$8\) for conversion. What is the amount of inventory transferred out and remaining in ending work in process inventory?
16. Overhead is assigned to the manufacturing department at the rate of \(\$10\) per machine hour. There were \(3,500\) machine hours during October in the shaping department and \(2,500\) in the packaging department. Prepare the journal entry to apply overhead to the manufacturing departments.
17. Prepare the journal entry to record the factory wages of \(\$28,000\) incurred for a single production department assuming payment will be made in the next pay period.
18. Prepare the journal entry to record the transfer of \(3,000\) units from the packaging department to finished goods if the material cost per unit is \(\$4\) and the conversion cost per unit is \(\$5.50\).
19. Prepare the journal entry to record the sale of \(2,000\) units that cost \(\$8\) per unit and sold for \(\$15\) per unit.
Exercise Set B
1. Given the following information, determine the equivalent units of ending work in process for materials and conversion using the weighted-average method:
• Beginning inventory of \(750\) units is \(100\%\) complete with regard to materials and \(30\%\) complete with regard to conversion.
• \(9,500\) units were started during the period.
• \(8,900\) units were completed and transferred.
• Ending inventory is \(100\%\) complete with regard to materials and \(68\%\) complete with regard to conversion.
2. There were \(2,000\) units in beginning inventory that were \(70\%\) complete with regard to conversion. During the month, \(15,000\) units were started, and \(16,000\) were transferred to finished goods. The ending work in process was \(55\%\) complete with regard to conversion costs, and materials are added at the beginning of the process. What is the total amount of equivalent units for materials and conversion at the end of the month using the weighted-average method?
3. A company has \(100\) units in ending work in process that are \(40\%\) complete after transferring out \(750\) units. If the cost per unit is \(\$5\) for materials and \(\$2.50\) for conversion, what is the cost of units transferred out and in ending work in process inventory using the weighted-average method?
4. There were \(1,500\) units in ending work in process inventory that were \(100\%\) complete with regard to material and \(60\%\) complete with regard to conversion costs. Ending work in process inventory had a cost of \(\$7,200\) and a per-unit material cost of \(\$3\). What was the conversion cost per unit using the weighted-average method?
5. Using the weighted-average method, compute the equivalent units of production if the beginning inventory consisted of \(20,000\) units, \(55,000\) units were started in production, and \(57,000\) units were completed and transferred to finished goods inventory. For this process, materials are \(70\%\) complete and the units are \(30\%\) complete with respect to conversion.
6. What are the total costs to account for if a company’s beginning inventory had \(\$23,432\) in materials and \(\$18,450\) in conversion costs, and added direct material costs (\(\$41,392\)), direct labor (\(\$23,192\)), and manufacturing overhead (\(\$62,500\))?
7. A company started the month with \(4,519\) units in work in process inventory. It started \(15,295\) units and had an ending inventory of \(4,936\). The units were \(100\%\) complete to materials and \(30\%\) complete with conversion. How many units were transferred out during the period?
8. A production department within a company received materials of \(\$7,000\) and conversion costs of \(\$5,000\) from the prior department. It added material of \(\$78,400\) and conversion costs of \(\$47,000\). The equivalent units are \(5,000\) for material and \(4,000\) for conversion. What is the unit cost for materials and conversion?
9. Production data show \(15,200\) units were transferred out of a stage of production and \(3,500\) units remained in ending WIP inventory that was \(100\%\) complete to material and \(60\%\) complete to conversion. The unit material cost is \(\$9\) for material and \(\$4\) for conversion. What is the amount of inventory transferred out and remaining in ending work in process inventory?
10. Overhead is assigned to the manufacturing department at the rate of \(\$5\) per machine hour. There were \(3,000\) machine hours used in the molding department. Prepare the journal entry to apply overhead to the manufacturing department.
11. Prepare the journal entry to record the factory wages of \(\$25,000\) incurred in the processing department and \(\$15,000\) incurred in the production department assuming payment will be made in the next pay period.
12. Prepare the journal entry to record the transfer of \(3,500\) units from the separation department to the mash department if the material cost per unit is \(\$2\) and the conversion cost per unit is \(\$5\).
13. Prepare the journal entry to record the sale of \(700\) units that cost \(\$5\) per unit and sold for \(\$15\) per unit.
Problem Set A
1. The following product costs are available for Haworth Company on the production of chairs: direct materials, \(\$15,500\); direct labor, \(\$22,000\); manufacturing overhead, \(\$16,500\); selling expenses, \(\$6,900\); and administrative expenses, \(\$15,200\).
1. What are the prime costs?
2. What are the conversion costs?
3. What is the total product cost?
4. What is the total period cost?
5. If \(7,750\) equivalent units are produced, what is the equivalent material cost per unit?
6. If \(22,000\) equivalent units are produced, what is the equivalent conversion cost per unit?
2. The following product costs are available for Arrez Company on the production of DVD cases: direct materials, \(\$1,450\); direct labor, \(\$15.50\); manufacturing overhead, applied at \(150\%\) of direct labor cost; selling expenses, \(\$1,550\); and administrative expenses, \(\$950\). The direct labor hours worked for the month are \(90\) hours.
1. What are the prime costs?
2. What are the conversion costs?
3. What is the total product cost?
4. What is the total period cost?
5. If \(1,450\) equivalent units are produced, what is the equivalent material cost per unit?
6. What is the equivalent conversion cost per unit?
3. Pant Risers manufactures bands for self-dressing assistive devices for mobility-impaired individuals. Manufacturing is a one-step process where the bands are cut and sewn. This is the information related to this year’s production:
Ending inventory was \(100\%\) complete as to materials and \(70\%\) complete as to conversion, and the total materials cost is \(\$57,540\) and the total conversion cost is \(\$36,036\). Using the weighted-average method, what are the unit costs if the company transferred out \(17,000\) units? What is the value of the inventory transferred out and the value of the ending WIP inventory?
1. During March, the following costs were charged to the manufacturing department: \(\$14,886\) for materials; \(\$14,656\) for labor; and \(\$13,820\) for manufacturing overhead. The records show that \(30,680\) units were completed and transferred, while \(2,400\) remained in ending inventory. There were \(33,080\) equivalent units of material and \(31,640\) of conversion costs. Using the weighted-average method, what is the cost of inventory transferred and the balance in work in process inventory?
2. Materials are added at the beginning of a production process, and ending work in process inventory is \(30\%\) complete with respect to conversion costs. Use the information provided to complete a production cost report using the weighted-average method.
1. Narwhal Swimwear has a beginning work in process inventory of \(13,500\) units and transferred in \(130,000\) units before ending the month with \(14,000\) units that were \(100\%\) complete with regard to materials and \(30\%\) complete with regard to conversion costs. The cost per unit of material is \(\$5.80\) and the cost per unit for conversion is \(\$8.20\) per unit. Using the weighted-average method, what is the amount of material and conversion costs assigned to the department for the month?
2. The following data show the units in beginning work in process inventory, the number of units started, the number of units transferred, and the percent completion of the ending work in process for conversion. Given that materials are added at the beginning of the process, what are the equivalent units for material and conversion costs for each quarter using the weighted-average method? Assume that the quarters are independent.
1. The finishing department started the month with \(700\) units in WIP inventory. It received \(2,200\) units from the molding department and transferred out \(2,150\) units. How many units were in process at the end of the month?
2. The packaging department began the month with \(500\) units that were \(100\%\) complete with regard to material and \(85\%\) complete with regard to conversion. It received \(9,500\) units from the processing department and ended the month with \(750\) units that were \(100\%\) complete with regard to materials and \(30\%\) complete with regard to conversion. With a \(\$5\) per unit cost for conversion and a \(\$5\) per unit cost for materials, what is the cost of the units transferred out and remaining in ending inventory?
3. Production information shows these costs and units for the smoothing department in August.
All materials are added at the beginning of the period. The ending work in process is \(30\%\) complete as to conversion. What is the value of the inventory transferred to finished goods and the value of the WIP inventory at the end of the month?
1. Given the following information, prepare a production report with materials added at the beginning and ending work in process inventory being \(25\%\) complete with regard to conversion costs.
1. Complete this production cost report:
1. Selected information from Skylar Studios shows the following:
Prepare journal entries to record the following:
1. raw material purchased
2. direct labor incurred
3. depreciation expense (hint: this is part of manufacturing overhead)
4. raw materials used
5. overhead applied on the basis of \(\$0.50\) per machine hour
6. the transfer from department 1 to department 2
1. Loanstar had \(100\) units in beginning inventory before starting \(950\) units and completing \(800\) units. The beginning work in process inventory consisted of \(\$2,000\) in materials and \(\$5,000\) in conversion costs before \(\$8,500\) of materials and \(\$11,200\) of conversion costs were added during the month. The ending WIP inventory was \(100\%\) complete with regard to materials and \(40\%\) complete with regard to conversion costs. Prepare the journal entry to record the transfer of inventory from the manufacturing department to the finished goods department.
Problem Set B
1. The following product costs are available for Stellis Company on the production of erasers: direct materials, \(\$22,000\); direct labor, \(\$35,000\); manufacturing overhead, \(\$17,500\); selling expenses, \(\$17,600\); and administrative expenses; \(\$13,400\).
1. What are the prime costs?
2. What are the conversion costs?
3. What is the total product cost?
4. What is the total period cost?
5. If \(13,750\) equivalent units are produced, what is the equivalent material cost per unit?
6. If \(17,500\) equivalent units are produced, what is the equivalent conversion cost per unit?
2. The following product costs are available for Kellee Company on the production of eyeglass frames: direct materials, \(\$32,125\); direct labor, \(\$23.50\); manufacturing overhead, applied at \(225\%\) of direct labor cost; selling expenses, \(\$22,225\); and administrative expenses, \(\$31,125\). The direct labor hours worked for the month are \(3,200\) hours.
1. What are the prime costs?
2. What are the conversion costs?
3. What is the total product cost?
4. What is the total period cost?
5. If \(6,425\) equivalent units are produced, what is the equivalent material cost per unit?
6. What is the equivalent conversion cost per unit?
3. Vexar manufactures nails. Manufacturing is a one-step process where the nails are forged. This is the information related to this year’s production:
Ending inventory was \(100\%\) complete as to materials and \(70\%\) complete as to conversion, and the total materials cost is \(\$115,080\) and the total conversion cost is \(\$72,072\). Using the weighted-average method, what are the unit costs if the company transferred out \(34,000\) units? Using the weighted-average method, prepare the company’s process cost summary for the month.
1. During March, the following costs were charged to the manufacturing department: \(\$22,500\) for materials; \(\$45,625\) for labor; and \(\$50,000\) for manufacturing overhead. The records show that \(40,000\) units were completed and transferred, while \(10,000\) remained in ending inventory. There were \(45,000\) equivalent units of material and \(42,500\) units of conversion costs. Using the weighted-average method, prepare the company’s process cost summary for the month.
2. Ardt-Barger has a beginning work in process inventory of \(5,500\) units and transferred in \(25,000\) units before ending the month with \(3,000\) units that were \(100\%\) complete with regard to materials and \(80\%\) complete with regard to conversion costs. The cost per unit of material is \(\$5.45\), and the cost per unit for conversion is \(\$6.20\) per unit. Using the weighted-average method, prepare the company’s process cost summary for the month.
3. The following data show the units in beginning work in process inventory, the number of units started, the number of units transferred, and the percent completion of the ending work in process for conversion. Given that materials are added at the beginning of the process, what are the equivalent units for material and conversion costs for each quarter using the weighted-average method? Assume that the quarters are independent.
1. The following data show the units in beginning work in process inventory, the number of units started, the number of units transferred, and the percent completion of the ending work in process for conversion. Given that materials are added \(50\%\) at the beginning of the process and 50% at the end of the process, what are the equivalent units for material and conversion costs for each quarter using the weighted-average method? Assume that the quarters are independent.
1. The following data show the units in beginning work in process inventory, the number of units started, the number of units transferred, and the percent completion of the ending work in process for conversion. Given that materials are added \(50\%\) at the beginning of the process and \(50\%\) at the end of the process, what are the equivalent units for material and conversion costs for each quarter using the weighted-average method? Assume that the quarters are independent.
1. The finishing department started the month with \(600\) units in WIP inventory. It received \(1,500\) units from the molding department and ended the month with \(550\) units still in process. How many units were transferred out?
2. The packaging department began the month with \(750\) units that were \(100\%\) complete with regard to material and \(25\%\) complete with regard to conversion. It received \(9,500\) units from the processing department and ended the month with \(500\) units that were \(100\%\) complete with regard to materials and \(75\%\) complete with regard to conversion. With a \(\$7\) per unit material cost and a \(\$4\) per unit cost for conversion, what is the cost of the units transferred out and remaining in ending inventory?
3. Production information shows these costs and units for the smoothing department in August.
What is the value of the inventory transferred out to finished goods and the value of the WIP inventory at the end of the month, assuming conversion costs are \(30\%\) complete?
1. Given the following information, prepare a production report with materials added at the beginning and ending work in process inventory being \(80\%\) complete with regard to conversion costs.
1. Selected information from Hernandez Corporation shows the following:
Prepare journal entries to record the following:
1. raw material purchased
2. direct labor incurred
3. depreciation expense (hint: this is part of manufacturing overhead)
4. raw materials used
5. overhead applied on the basis of \(\$0.50\) per machine hour
6. the transfer from department 1 to department 2
1. Rexar had \(1,000\) units in beginning inventory before starting \(9,500\) units and completing \(8,000\) units. The beginning work in process inventory consisted of \(\$5,000\) in materials and \(\$8,500\) in conversion costs before \(\$16,000\) of materials and \(\$18,500\) of conversion costs were added during the month. The ending WIP inventory was \(100\%\) complete with regard to materials and \(40\%\) complete with regard to conversion costs. Prepare the journal entry to record the transfer of inventory from the manufacturing department to the finished goods department.
Thought Provokers
1. How would process costing exist in a service industry?
2. Why are labor and manufacturing overhead grouped together as conversion costs?
3. How is process costing for a single manufacturing department different from a manufacturing company with multiple departments?
4. What is different between the journal entries for process costing and that of job order costing? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/05%3A_Process_Costing/5.0E%3A_5.E%3A_Process_Costing_%28Exercises%29.txt |
Barry thinks of his education as a job and spends forty hours a week in class or studying. Barry estimates he has about eighty hours per week to allocate between school and other activities and believes everyone should follow his fifty-fifty rule of time allocation. His roommate, Kamil, disagrees with Barry and argues that allocating \(50\) percent of one’s time to class and studying is not a great formula because everyone has different activities and responsibilities. Kamil points out, for example, that he has a job tutoring other students, is involved with student activities, and plays in a band, while Barry spends some of his nonstudy time doing volunteer work and working out.
Kamil plans each week based on how many hours he will need for each activity: classes, studying and coursework, tutoring, and practicing and performing with his band. In essence, he considers the details of each week’s needs to budget his time. Kamil explains to Barry that being aware of the activities that consume his limited resources (time, in this example) helps him to better plan his week. He adds that individuals who have activities with lots of time commitments (class, work, study, exercise, family, friends, and so on) must be efficient with their time or they risk doing poorly in one or more areas. Kamil argues these individuals cannot simply assign a percentage of their time to each activity but should use each specific activity as the basis for allocating their time. Barry insists that assigning a set percentage to everything is easy and the better method. Who is correct?
6.02: Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method
Both roommates make valid points about allocating limited resources. Ultimately, each must decide which method to use to allocate time, and they can make that decision based on their own analyses. Similarly, businesses and other organizations must create an allocation system for assigning limited resources, such as overhead. Whereas Kamil and Barry are discussing the allocation of hours, the issue of allocating costs raises similar questions. For example, for a manufacturer allocating maintenance costs, which are an overhead cost, is it better to allocate to each production department equally by the number of machines that need to be maintained or by the square footage of space that needs to be maintained?
In the past, overhead costs were typically allocated based on factors such as total direct labor hours, total direct labor costs, or total machine hours. This allocation process, often called the traditional allocation method, works most effectively when direct labor is a dominant component in production. However, many industries have evolved, primarily due to changes in technology, and their production processes have become more complicated, with more steps or components. Many of these industries have significantly reduced their use of direct labor and replaced it with technology, such as robotics or other machinery. For example, a mobile phone production facility in China replaced 90 percent of its workforce with robots.1
In these situations, a direct cost (labor) has been replaced by an overhead cost (e.g., depreciation on equipment). Because of this decrease in reliance on labor and/or changes in the types of production complexity and methods, the traditional method of overhead allocation becomes less effective in certain production environments. To account for these changes in technology and production, many organizations today have adopted an overhead allocation method known as activity-based costing (ABC). This chapter will explain the transition to ABC and provide a foundation in its mechanics.
Activity-based costing is an accounting method that recognizes the relationship between product costs and a production activity, such as the number of hours of engineering or design activity, the costs of the set up or preparation for the production of different products, or the costs of packaging different products after the production process is completed. Overhead costs are then allocated to production according to the use of that activity, such as the number of machine setups needed. In contrast, the traditional allocation method commonly uses cost drivers, such as direct labor or machine hours, as the single activity.
Because of the use of multiple activities as cost drivers, ABC costing has advantages over the traditional allocation method, which assigns overhead using a single predetermined overhead rate. Those advantages come at a cost, both in resources and time, since additional information needs to be collected and analyzed. Chrysler, for instance, shifted its overhead allocation to ABC in 1991 and estimates that the benefits of cost savings, product improvement, and elimination of inefficiencies have been ten to twenty times greater than the investment in the program at some sites. It believes other sites experienced savings of fifty to one hundred times the cost to implement the system.2
As you’ve learned, understanding the cost needed to manufacture a product is critical to making many management decisions (Figure $1$). Knowing the total and component costs of the product is necessary for price setting and for measuring the efficiency and effectiveness of the organization. Remember that product costs consist of direct materials, direct labor, and manufacturing overhead. It is relatively simple to understand each product’s direct material and direct labor cost, but it is more complicated to determine the overhead component of each product’s costs because there are a number of indirect and other costs to consider. A company’s manufacturing overhead costs are all costs other than direct material, direct labor, or selling and administrative costs. Once a company has determined the overhead, it must establish how to allocate the cost. This allocation can come in the form of the traditional overhead allocation method or activity-based costing..
Component Categories under Traditional Allocation
Traditional allocation involves the allocation of factory overhead to products based on the volume of production resources consumed, such as the amount of direct labor hours consumed, direct labor cost, or machine hours used. In order to perform the traditional method, it is also important to understand each of the involved cost components: direct materials, direct labor, and manufacturing overhead. Direct materials and direct labor are cost categories that are relatively easy to trace to a product. Direct material comprises the supplies used in manufacturing that can be traced directly to the product. Direct labor is the work used in manufacturing that can be directly traced to the product. Although the processes for tracing the costs differ, both job order costing and process costing trace the material and labor through materials requisition requests and time cards or electronic mechanisms for measuring labor input. Job order costing traces the costs directly to the product, and process costing traces the costs to the manufacturing department.
ETHICAL CONSIDERATIONS: Ethical Cost Modeling
The proper use of management accounting skills to model financial and non-financial data optimizes the organization’s evaluation and use of resources and assists in the proper evaluation of costs and revenues in an organization. The IFAC provides guidance on the use of cost models and how to ethically design proper cost models: “Cost models should be designed and maintained to reflect the cause-and-effect interrelationships and the behavioral dynamics of the way the organization functions. The information needs of decision makers at all levels of an organization should be taken into account, by incorporating an organization’s business and operational models, strategy, structure, and competitive environment.”3
Estimated Total Manufacturing Overhead Costs
The more challenging product component to track is manufacturing overhead. Overhead consists of indirect materials, indirect labor, and other costs closely associated with the manufacturing process but not tied to a specific product. Examples of other overhead costs include such items as depreciation on the factory machinery and insurance on the factory building. Indirect material comprises the supplies used in production that cannot be traced to an individual product, and indirect labor is the work done by employees not directly involved in the manufacturing process, such as the supervisors’ salaries or the maintenance staff’s wages. Because these costs cannot be traced directly to the product like direct costs are, they have to be allocated among all of the products produced and added, or applied, to the production and product cost.
For example, the recipe for shea butter has easily identifiable quantities of shea nuts and other ingredients. Based on the manufacturing process, it is also easy to determine the direct labor cost. But determining the exact overhead costs is not easy, as the cost of electricity needed to dry, crush, and roast the nuts changes depending on the moisture content of the nuts upon arrival.
Until now, you have learned to apply overhead to production based on a predetermined overhead rate typically using an activity base. An activity base is considered to be a primary driver of overhead costs, and traditionally, direct labor hours or machine hours were used for it. For example, a production facility that is fairly labor intensive would likely determine that the more labor hours worked, the higher the overhead will be. As a result, management would likely view labor hours as the activity base when applying overhead costs.
A predetermined overhead rate is calculated at the start of the accounting period by dividing the estimated manufacturing overhead by the estimated activity base. The predetermined overhead rate is then applied to production to facilitate determining a standard cost for a product. This estimated overhead rate will allow a company to determine a cost for the product without having to wait, possibly several months, until all of the actual overhead costs are determined, and to help with issues such as seasonal production or variable overhead costs, such as utilities.
Calculation of Predetermined Overhead and Total Cost under Traditional Allocation
The predetermined overhead rate is set at the beginning of the year and is calculated as the estimated (budgeted) overhead costs for the year divided by the estimated (budgeted) level of activity for the year. This activity base is often direct labor hours, direct labor costs, or machine hours. Once a company determines the overhead rate, it determines the overhead rate per unit and adds the overhead per unit cost to the direct material and direct labor costs for the product to find the total cost.
$\text { Predetermined Overhead Rate }=\dfrac{\text { Estimated Overhead cost (s) }}{\text { Estimated Activity Base (units or s) }}$
To put this method into context, consider this example. Musicality Manufacturing developed a recording device similar to a microphone that allows musicians and music aficionados to record their playing or singing along with any song publicly available. There are three products that vary in features and ability: Solo, Band, and Orchestra. Musicality was started by musicians who majored in math and software engineering while in college. Their main concern was building a quality manufacturing plant, so they used the simpler traditional allocation method. They started by determining their direct costs, which are shown in Figure $2$.
Musicality determines the overhead rate based on direct labor hours. At the beginning of the year, the company estimates total overhead costs to be $\2,500,000$ and total direct labor hours to be $1,250,000$. The predetermined overhead rate is
$\dfrac{\ 2,500,000 \text { overhead }}{1,250,000 \text { labor hours }}=\ 2.00 \text { per labor hour } \nonumber$
Musicality uses this information to determine the cost of each product. For example, the total direct labor hours estimated for the solo product is $350,000$ direct labor hours. With $\2.00$ of overhead per direct hour, the Solo product is estimated to have $\700,000$ of overhead applied. When the $\700,000$ of overhead applied is divided by the estimated production of $140,000$ units of the Solo product, the estimated overhead per product for the Solo product is $\5.00$ per unit. The computation of the overhead cost per unit for all of the products is shown in Figure $3$.
The overhead cost per unit from Figure $3$ is combined with the direct material and direct labor costs as shown in Figure $2$ to compute the total cost per unit as shown in Figure $4$.
After reviewing the product cost and consulting with the marketing department, the sales prices were set. The sales price, cost of each product, and resulting gross profit are shown in Figure $5$.
Sales of each product have been strong, and the total gross profit for each product is shown in Figure $6$. Using the Solo product as an example, $150,000$ units are sold at a price of $\20$ per unit resulting in sales of $\3,000,000$. The cost of goods sold consists of direct materials of $\3.50$ per unit, direct labor of $\10$ per unit, and manufacturing overhead of $\5.00$ per unit. With $150,000$ units, the direct material cost is $\525,000$; the direct labor cost is $\1,500,000$; and the manufacturing overhead applied is $\750,000$ for a total Cost of Goods Sold of $\2,775,000$. The resulting Gross Profit is $\225,000$ or $\1.50$ per unit.
THINK IT THROUGH: Computing Actual Overhead Costs
As manufacturing technology becomes less expensive and more efficient, the mix between overhead and labor changes so that tasks are more computerized tasks and involve less direct labor; the traditional use of direct labor hours or direct labor dollars changes accordingly. If the predetermined overhead rate is based on direct labor hours and set at the beginning of the year but manufacturing technology leads to a reduction in direct labor during the year, the number of direct labor hours may be less than estimated. This reduces the amount of overhead applied so that the overhead is more likely to be underapplied at the end of the year. Why do companies not wait until the end of the period and compute an actual overhead rate based on actual manufacturing costs and actual units?
Footnotes
1. June Javelosa and Kristin Houser. “This Company Replaced 90% of Its Workforce with Machines. Here’s What Happened.” Futurism / World Economic Forum. https://www.weforum.org/agenda/2017/...ctivity-soared
2. Joseph H. Ness and Thomas G. Cucuzza. “Tapping the Full Potential of ABC.” Harvard Business Review. July-Aug. 1995. https://hbr.org/1995/07/tapping-the-...tential-of-abc
3. International Federation of Accountings (IFAC) PAIB Committee. “Evaluating and Improving Costing in Organizations.” International Good Practice Guidance. June 30, 2009. https://www.ifac.org/system/files/pu...-July-2009.pdf | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/06%3A_Activity-Based_Variable_and_Absorption_Costing/6.01%3A_Prelude_to_Activity-Based_Variable_and_Absorption_Costing.txt |
As you’ve learned, the most common bases for predetermined overhead are direct labor hours, direct labor dollars, or machine hours. Each of these costs is considered a cost driver because of the causal relationship between the base and the related costs: As the cost driver’s usage increases, the cost of overhead increases as well. Table \(1\) shows various costs and potential cost drivers.
Table \(1\): Common Manufacturing Expenses and Potential Cost Drivers
Common Expenses Potential Cost Drivers
• Customer Service
• Cleaning Equipment Costs
• Marketing Expenses
• Office Supplies
• Green Floral Tape (indirect material)
• Website Maintenance Expense
• Number of product returns from customers
• Number of square feet
• Number of customer contacts
• Number of employees
• Number of customer orders
• Number of customer online orders
The more accurately a company can determine the cost drivers for its products, the more accurate the costing information will be, which in turn allows management to make better use of the cost data in making decisions. As technology changes, however, the mix between materials, labor, and overhead changes. Often, improved technology means less waste of material and fewer direct labor hours, but possibly more overhead. For example, technology has changed the way pharmaceuticals are manufactured. Advancing technology allows for the now smaller labor force to be more productive than a larger labor force from earlier years. While the labor cost has changed, this decrease may only be temporary as a labor force with higher costs and different skills is often needed. Additionally, an increase in technology often raises overhead costs. How accurate, then, is the company’s product cost information if it has become more efficient in its production process? Should the company still be using a predetermined overhead application rate based on direct labor hours or machine hours? A detailed analysis of the cost drivers will answer these questions.
Another benefit of looking at cost drivers is that doing so allows a company to analyze all costs. A company can differentiate among costs that drive overhead and have value, those that do not drive overhead but still add value, and those that may or may not drive the overhead but do not add any value. For example, a furniture manufacturer produces and sells wooden tables in various colors. The painting process involves a white base coat, a color coat, and a clear protective top coat. The three coats are applied in a sealed room using a spraying process followed by an ultraviolet drying process. The depreciation on the spraying machines and the ultraviolet bulbs used in the painting process are overhead costs. These costs drive or increase overhead, and they add value to the product by increasing the quality. Costs associated with repainting or fixing any blemishes are overhead costs that are necessary to sell the product but would not be considered value-added costs. The goal is to eliminate as many of the non-value-added costs as possible and subsequently reduce overhead costs.
Cost Drivers and Overhead
In today’s production environment, there are many activities within the production process that can contribute to the cost of the product, but determining the cost drivers may be complicated because some of those activities may change over time. Additionally, the appropriate level of assigning cost drivers needs to be determined. In some cases, overhead costs such as inspection increase with each unit inspected, and the costs need to be allocated on a per-unit level. In other cases, the overhead costs, such as machine setup costs, are incurred each time a batch of products is manufactured and need to be allocated at the batch level.
For example, the labor hours for the staff taking, fulfilling, and inspecting orders may increase as the number of orders increases, driving up the overhead. Furthermore, the costs of taking orders or of quality inspections can vary per product and may not be captured properly. Technology improvements, including switching to automated processes for production, may decrease the labor hours of the production staff, driving the labor-related overhead downward but potentially increasing other overhead expenses. These activities—order taking, fulfillment, and quality inspections—are potential cost drivers associated with production, and they each drive the overhead at varying rates.
THINK IT THROUGH: Identifying Cost Drivers
Cost drivers vary widely among companies.
1. After costs are accumulated into cost pools, what information would help management select the appropriate cost driver?
2. Name an appropriate cost driver for each of the following cost pools:
1. Plant cleaning and maintenance
2. Factory supervision
3. Machine maintenance
4. Machine setups
Identify Cost Drivers
How does a company determine its cost drivers for indirect materials, indirect labor, and other overhead costs? To begin the determination of appropriate cost drivers, an accountant analyzes the activities in the product production process that contribute to the cost of that product. An activity is any action that consumes company resources, such as taking orders for a product, setting up machines to produce the product, inspecting the product, and providing customer support before and through the order process. For example, Musicality’s direct costs can be traced to the products, but there are indirect costs associated with using various types of material for each product. While the Orchestra product has more intricate materials and labor, it has fewer costs associated with requisitioning and conveying materials to the production line than the other products have. Additionally, examining the inspection costs indicates the Orchestra product is a simple product to inspect, so random quality inspections are sufficient. But individual inspections for both the Solo and Band products are critical, and the overhead related to inspection costs should be based on the number of inspections.
As you can imagine, the unique aspects of the production process for each product affect the overhead cost of each product. However, these costs may not be allocated to the products appropriately when overhead is applied using a predetermined rate based on one activity. While Solo, Band, and Orchestra might appear to be different only in quality, they are actually very different from each other when it comes to manufacturing overhead costs.
Whether the products produced require significantly different overhead resources or not, the company benefits from understanding what its cost drivers are. The more efficiently each product’s activities are tracked, the more actual cost drivers are discovered, and the more accurately overhead can be assigned to each product.
CONCEPTS IN PRACTICE: Cost Drivers for Small Businesses
The value of analyzing cost drivers can be used in budgeting beyond allocating overhead to products. American Express has forums designed to help small businesses be successful. Knowing the cost drivers for your business can help with budgeting. American Express states that all business activities are related to five main cost drivers:1
• Employee head count is often the driver for office supply expense.
• Salesperson head count is often the driver for auto and other employee travel expense.
• The number of leads required to reach the target sales goal is often the driver for advertising, public relations, social media, search engine optimization expense, and other expenses associated with generating leads.
• Sales and all related variable expenses are often the driver for commissions, bad debt, insurance expense, and so on.
• Fixed costs, such as postage, web hosting fees, business licenses, and banking fees, are often overlooked as cost drivers.
Footnotes
1. American Express. “5 Cost Drivers to Help You Make Accurate Expense Projections.” June 23, 2011. https://www.americanexpress.com/us/s...e-projections/ | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/06%3A_Activity-Based_Variable_and_Absorption_Costing/6.03%3A_Describe_and_Identify_Cost_Drivers.txt |
As technology changes the ratio between direct labor and overhead, more overhead costs are linked to drivers other than direct labor and machine hours. This shift in costs gives companies the opportunity to stop using the traditional single predetermined overhead rate applied to all units of production and instead use an overhead allocation approach based on the actual activities that drive overhead. Making this change allows management to obtain more accurate product cost information, which leads to more informed decisions. Activity-based costing (ABC) is the process that assigns overhead to products based on the various activities that drive overhead costs.
Historical Perspective on Determination of Manufacturing Overhead Allocation
All products consist of material, labor, and overhead, and the major cost components have historically been materials and labor. Manufacturing overhead was not a large cost of the product, so an overhead allocation method based on labor or machine hours was logical. For example, as shown in Figure 6.1.2, Musicality determined the direct costs and direct labor for their three products: Solo, Band, and Orchestra. Under the traditional method of costing, the predetermined overhead rate of \(\$2\) per direct labor hour was computed by dividing the estimated overhead by the estimated direct labor hours. Based on the number of direct labor hours and the number of units produced for each product, the overhead per product is shown in Figure 6.1.3.
As technology costs decreased and production methods became more efficient, overhead costs changed and became a much larger component of product costs. For many companies, and in many cases, overhead costs are now significantly larger than labor costs. For example, in the last few years, many industries have increased technology, and the amount of overhead has doubled.1 Technology has changed the manufacturing labor force, and therefore, the type and cost of labor associated with those jobs have changed. In addition, technology has made it easier to track the various activities and their related overhead costs.
Costs can be gathered on a unit level, batch level, product level, or factory level. The idea behind these various levels is that at each level, there are additional costs that are encountered, so a company must decide at which level or levels it is best for the company to accumulate costs. A unit-level cost is incurred each time a unit of product is produced and includes costs such as materials and labor. A batch-level cost is incurred every time a batch of items is manufactured, for example, costs associated with purchasing and receiving materials. A product-level cost is incurred each time a product is produced and includes costs such as engineering costs, testing costs, or quality control costs. A factory-level cost is incurred because products are being produced and includes costs such as the plant supervisor’s salary and rent on the factory building. By definition, indirect labor is not traced to individual products. However, it is possible to track some indirect labor to several jobs or batches. A similar amount of information can be derived for indirect material. An example of an indirect material in some manufacturing processes is cleaning solution. For example, one type of cleaning solution is used in the manufacturing of pop sockets. It is not practical to measure every ounce of cleaning solution used in the manufacture of an individual pop socket; rather, it makes sense to allocate to a particular batch of pop sockets the cost of the cleaning solution needed to make that batch. Likewise, a manufacturer of frozen french fries uses a different type of solution to clean potatoes prior to making the french fries and would allocate the cost of the solution based on how much is used to make each batch of fries.
Establishing an Activity-Based Costing System
ABC is a five-stage process that allocates overhead more precisely than traditional allocation does by applying it to the products that use those activities. ABC works best in complex processes where the expenses are not driven by a single cost driver. Instead, several cost drivers are used as the overhead costs are analyzed and grouped into activities, and each activity is allocated based on each group’s cost driver. The five stages of the ABC process are:
1. Identify the activities performed in the organization
2. Determine activity cost pools
3. Calculate activity rates for each cost pool
4. Allocate activity rates to products (or services)
5. Calculate unit product costs
The first step is to identify activities needed for production. An activity is an action or process involved in the production of inventory. There can be many activities that consume resources, and management will need to narrow down the activities to those that have the biggest impact on overhead costs. Examples of these activities include:
• Taking orders
• Setting up machines
• Purchasing material
• Assembling products
• Inspecting products
• Providing customer service
The second step is assigning overhead costs to the identified activities. In this step, overhead costs are assigned to each of the activities to become a cost pool. A cost pool is a list of costs incurred when related activities are performed. Table 6.3.1 illustrates the various cost pools along with their activities and related costs.
Table \(1\): Cost Pools and Their Activities and Related Costs
Cost Pool Activities and Related Costs
Production
• Indirect labor setting up machines
• Indirect labor cost of accepting and verifying orders
• Machine maintenance costs
• Costs to operate the machine: utilities, insurance, etc.
Purchasing material
• Preparing purchase requisitions for the material
• Cost to move material from receiving department into production
• Depreciation of equipment used to move material
Inspect products
• Inspection supervisor costs
• Cost to move product to and from the inspection area
Assemble products
• Cost of assembly machine
• Cost of label machine
• Cost of labels
Technological production
• Website maintenance
• Depreciation of computers
For example, the production cost pool consists of costs such as indirect labor for those accepting the order, verifying the customer has credit to pay for the order, maintenance and depreciation on the machines used to produce the orders, and utilities and rent for operating the machines. Figure \(1\) illustrates how the costs in each pool are allocated to each product in a different proportion.
Once the costs are grouped into similar cost pools, the activities in each pool are analyzed to determine which activity “drives” the costs in that pool, leading to the third step of ABC: identify the cost driver for each cost pool and estimate an annual level of activity for each cost driver. As you’ve learned, the cost driver is the specific activity that drives the costs in the cost pools. Table \(2\) shows some activities and cost drivers for those activities.
Table \(2\): Activities and Their Common Cost Drivers
Cost Pool Cost Driver
Customer order Number of orders
Production Machine setups
Purchasing materials Purchase requisitions
Assembling products Direct labor hours
Inspecting products Inspection hours
Customer service Number of contacts with customer
The fourth step is to compute the predetermined overhead rate for each of the cost drivers. This portion of the process is similar to finding the traditional predetermined overhead rate, where the overhead rate is divided by direct labor dollars, direct labor hours, or machine hours. Each cost driver will have its own overhead rate, which is why ABC is a more accurate method of allocating overhead.
Finally, step five is to allocate the overhead costs to each product. The predetermined overhead rate found in step four is applied to the actual level of the cost driver used by each product. As with the traditional overhead allocation method, the actual overhead costs are accumulated in an account called manufacturing overhead and then applied to each of the products in this step.
Notice that steps one through three represent the process of allocating overhead costs to activities, and steps four and five represent the process of allocating the overhead costs that have been assigned to activities to the products to which they pertain. Thus, the five steps of ABC involve two major processes: first, allocating overhead costs to the various activities to get a cost per activity, and then allocating the cost per activity to each product based on that product’s usage of the activities.
Now that the steps involved have been detailed, let’s demonstrate the calculations using the Musicality example.
Example \(1\): Comparing Estimates to Actual Costs
A company has determined that its estimated \(500,000\) machine hours is the optimal driver for its estimated \(\$1,000,000\) machine overhead cost pool. The \(\$750,000\) in the material overhead cost pool should be allocated using the estimated \(15,000\) material requisition requests. How much is over- or underapplied if there were actually \(490,000\) machine hours and \(15,500\) material requisitions that resulted in \(\$950,000\) in the machine overhead cost pool, and \(\$780,000\) in the material cost pool? What does this difference indicate?
Solution
The predetermined overhead rate is \(\$2\) per machine hour (\(\$1,000,000/500,000\) machine hours) and \(\$50\) per material requisition (\(\$750,000/15,000\) requisitions). The actual and applied overhead can then be calculated to determine whether it is over- or underapplied:
The difference is a combination of factors. There were fewer machine hours than estimated, but there was also less overhead than estimated. There were more requisitions than estimated, and there was also more overhead.
The Calculation of Product Costs Using the Activity-Based Costing Allocation Method
Musicality is considering switching to an activity-based costing approach for determining overhead and has collected data to help them decide which overhead allocation method they should use. Performing the analysis requires these steps:
1. Identify cost pools necessary to complete the product. Musicality determined its cost pools are:
• Setting up machines
• Purchasing material
• Inspecting products
• Assembling products
• Technological production
2. Assign overhead cost to the cost pools. Musicality has estimated the overhead for each cost pool to be:
1. Identify the cost driver for each activity, and estimate an annual activity for each driver. Musicality determined the driver and estimated activity for each product to be the following:
1. Compute the predetermined overhead for each cost driver. Musicality determined this predetermined overhead rate for each driver:
1. Allocate overhead costs to products. Assuming Musicality’s activities were as estimated, the amount allocated to each product is:
Now that Musicality has applied overhead to each product, they can calculate the cost per unit. Management can review its sales price and make necessary decisions regarding its products. The overhead cost per unit is the overhead for each product divided by the number of units of each product:
The overhead per unit can be added to the unit cost for direct material and direct labor to compute the total product cost per unit:
The sales price was set after management reviewed the product cost with traditional allocation along with other factors such as competition and product demand. The current sales price, cost of each product using ABC, and the resulting gross profit are shown in Figure \(4\).
The loss on each sale of the Solo product was not discovered until the company did the calculations for the ABC method, because the sales of the other products were strong enough for the company to retain a total gross profit.
Additionally, the more accurate gross profit for each product calculated using ABC is shown in Figure \(5\):
The calculations Musicality did in order to switch to ABC revealed that the Solo product was generating a loss for every unit sold. Knowing this information will allow Musicality to consider whether they should make changes to generate a profit from the Solo product, such as increase the selling price or carefully analyze the costs to identify potential cost reductions. Musicality could also decide to continue selling Solo at a loss, because the other products are generating enough profit for the company to absorb the Solo product loss and still be profitable. Why would a company continue to sell a product that is generating a loss? Sometimes these products are ones for which the company is well known or that draw customers into the store. For example, companies will sometimes offer extreme sales, such as on Black Friday, to attract customers in the hope that the customers will purchase other products. This information shows how valuable ABC can be in many situations for providing a more accurate picture than traditional allocation.
The Service Industries and Their Use of the Activity-Based Costing Allocation Method
ABC costing was developed to help management understand manufacturing costs and how they can be better managed. However, the service industry can apply the same principles to improve its cost management. Direct material and direct labor costs range from nonexistent to minimal in the service industry, which makes the overhead application even more important. The number and types of cost pools may be completely different in the service industry as compared to the manufacturing industry. For example, the health-care industry may have different overhead costs and cost drivers for the treatment of illnesses than they have for injuries. Some of the overhead related to monitoring a patient’s health status may overlap, but most of the overhead related to diagnosis and treatment differ from each other.
LINK TO LEARNING
Activity-based costing is not restricted to manufacturing. Service industries also have cost drivers and can benefit from analyzing what drives their costs. See this report on activity-based costing at UPS for an example.
Footnotes
1. Mary Ellen Biery. “A Sure-Fire Way to Boost the Bottom Line.” Forbes. January 12, 2014. https://www.forbes.com/sites/sagewor.../#47a9ea69d068 | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/06%3A_Activity-Based_Variable_and_Absorption_Costing/6.04%3A_Calculate_Activity-Based_Product_Costs.txt |
Calculating an accurate manufacturing cost for each product is a vital piece of information for a company’s decision-making. For example, knowing the cost to produce a unit of product affects not only how a business budgets to manufacture that product, but it is often the starting point in determining the sales price.
An important component in determining the total production costs of a product or job is the proper allocation of overhead. For some companies, the often less-complicated traditional method does an excellent job of allocating overhead. However, for many products, the allocation of overhead is a more complex issue, and an activity-based costing (ABC) system is more appropriate.
Another factor to consider in determining which of the two major overhead allocation methods to use is the cost associated with collecting and analyzing information. When making their decision regarding which method to use, the company must consider these costs, both in time and money. Table \(1\) compares overhead in the two systems. In many cases, the ABC method is more expensive in terms of time and other costs.
The difference between the traditional method (using one cost driver) and the ABC method (using multiple cost drivers) is more complex than simply the number of cost drivers. When direct labor is a large portion of the product cost, the overhead costs tend to be consistently driven by one cost driver, which is typically direct labor or machine hours; the traditional method appropriately allocates those costs. When technology is a large portion of the product cost, the overhead costs tend to be driven by multiple drivers, so using multiple cost drivers in the ABC method allows for a more precise allocation of overhead.
Table \(1\): Overhead in Traditional versus ABC Costing
Traditional ABC
Overhead assigned Single cost driver Multiple cost drivers
Optimal usage When direct labor is a large portion of the product cost When technology is a large portion of the product cost
Orientation Cost driven Process driven
As shown with Musicality’s products, not only are there different costs for each product when comparing traditional allocation with an activity-based costing, but ABC showed that the Solo product creates a loss for the company. Activity-based costing is a more accurate method, because it assigns overhead based on the activities that drive the overhead costs. It can be concluded, then, that the cost and subsequent gross loss for each unit’s sales provide a more accurate picture than the overall cost and gross profit under the traditional method. Figure \(1\) compares the cost per unit using the different cost systems and shows how different the costs can be depending on the method used.
Advantages and Disadvantages of the Traditional Method of Calculating Overhead
The traditional allocation system assigns manufacturing overhead based on a single cost driver, such as direct labor hours, direct labor dollars, or machine hours, and is optimal when there is a relationship between the activity base and overhead. This most often occurs when direct labor is a large part of the product cost. The theory supporting the single cost driver is that the cost driver selected increases as overhead increases, and further analysis is more costly than it is valuable. Each method has its advantages and disadvantages. These are advantages of the traditional method:
• All manufacturing costs are classified as material, labor, or overhead and assigned to products regardless of whether they drive or are driven by production.
• All manufacturing costs are considered to be part of the product cost, whereas nonmanufacturing costs are not considered to be production costs and are not assigned to products, regardless of whether the costs are based on the products. For example, the machines used to receive and process customer orders are necessary because product orders must be taken, but their costs are not allocated to particular products.
• There is only one overhead cost pool and a single measure of activity, such as direct labor hours, which makes the traditional method simple and less costly to maintain. The predetermined overhead rate is based on estimated costs at the budgeted level of activity. Therefore, the overhead rate is consistent across products, but overhead may be over- or underapplied.
Disadvantages of the traditional method include:
• The use of the single cost driver does not allocate overhead as accurately as using multiple cost drivers.
• The use of the single cost driver may overallocate overhead to one product and underallocate overhead to another product, resulting in erroneous total costs and potentially setting an incorrect sales price.
• Traditional allocation assigns costs as period or product costs, and all product costs are included in the cost of inventory, which makes this method acceptable for generally accepted accounting principles (GAAP).
THINK IT THROUGH: ABC Method and Financial Statements
There are pros and cons to both the traditional and the ABC system. One advantage of the ABC system is that it provides more accurate information on the costs to manufacture products, but it does not show up on the financial statements. Explain how this costing information has value if it does not appear on the financial statements.
Advantages and Disadvantages of Creating an Activity-Based Costing System for Allocating Overhead
While ABC systems more accurately allocate the costs based on the various resources used to make the product, they cost more to use and, therefore, are not always the best method. Management needs to consider each system and how it will work within its own organization. Some advantages of activity-based costing include:
• There are multiple overhead cost pools, and each has its own unique measure of activity. This provides more accurate rates for applying overhead, but it takes more time to implement and results in a higher cost.
• The allocation bases (i.e., measures of activity) often differ from those used in traditional allocation. Multiple cost pools allow management to group costs being influenced by similar drivers and to consider cost drivers beyond the typical labor or machine hour. This results in a more accurate overhead application rate.
• The activity rates may consider the level of activity at capacity instead of the budgeted level of activity.
• Both nonmanufacturing costs and manufacturing costs may be assigned to products. The main rationale in assigning costs is the relationship between the cost and the product. If the cost increases as the volume of the product increases, it is considered part of overhead.
There are disadvantages to using ABC costing that management needs to consider when determining which method to use. Those disadvantages include:
• Some manufacturing costs may be excluded from product costs. For example, the cost to heat the factory may be excluded as a product cost because, while it is necessary for production, it does not fit into one of the activity-driven cost pools.
• It is more expensive, as there is a cost to collect and analyze cost driver information as well as to allocate overhead on the basis of multiple cost drivers.
• An ABC system takes much more to implement and operate, as information on cost drivers must be collected in an objective manner.
The advantages and disadvantages of both methods are as previously listed, but what is the practical impact on the product cost? There are several items to consider at the product costs level:
• Adopting an ABC overhead allocation system can allow a company to shift manufacturing overhead costs between products based on their volume.
• Using an ABC method to better assign unit-level, batch-level, product-level, and factory-level costs can increase the per-unit costs of the low-volume products and decrease the per-unit costs of the high-volume products.
• The effects are not symmetrical; there is usually a larger change in the per-unit costs of the low-volume products.
• The cost of the products may include some period costs but not some of the product costs, so it is not considered GAAP compliant. The information is supplemental and very helpful to management, but the company still needs to compute the product’s cost under the traditional method for financial reporting.
LINK TO LEARNING
Changing from the traditional allocation method to ABC costing is not as simple as having management dictate that employees follow the new system. There are often challenges that begin with convincing employees that it will provide benefits and that they should buy into the new system. See this 1995 article, Tapping the Full Potential of ABC, illustrating some of Chrysler’s challenges to learn more. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/06%3A_Activity-Based_Variable_and_Absorption_Costing/6.05%3A_Compare_and_Contrast_Traditional_and_Activity-Based_Costing_Systems.txt |
ABC costing assigns a proportion of overhead costs on the basis of the activities under the presumption that the activities drive the overhead costs. As such, ABC costing converts the indirect costs into product costs. There are also cost systems with a different approach. Instead of focusing on the overhead costs incurred by the product unit, these methods focus on assigning the fixed overhead costs to inventory.
There are two major methods in manufacturing firms for valuing work in process and finished goods inventory for financial accounting purposes: variable costing and absorption costing. Variable costing, also called direct costing or marginal costing, is a method in which all variable costs (direct material, direct labor, and variable overhead) are assigned to a product and fixed overhead costs are expensed in the period incurred. Under variable costing, fixed overhead is not included in the value of inventory. In contrast, absorption costing, also called full costing, is a method that applies all direct costs, fixed overhead, and variable manufacturing overhead to the cost of the product. The value of inventory under absorption costing includes direct material, direct labor, and all overhead.
The difference in the methods is that management will prefer one method over the other for internal decision-making purposes. The other main difference is that only the absorption method is in accordance with GAAP.
Variable Costing Versus Absorption Costing Methods
The difference between the absorption and variable costing methods centers on the treatment of fixed manufacturing overhead costs. Absorption costing “absorbs” all of the costs used in manufacturing and includes fixed manufacturing overhead as product costs. Absorption costing is in accordance with GAAP, because the product cost includes fixed overhead. Variable costing considers the variable overhead costs and does not consider fixed overhead as part of a product’s cost. It is not in accordance with GAAP, because fixed overhead is treated as a period cost and is not included in the cost of the product.
CONCEPTS IN PRACTICE: Absorbing Costs through Overproduction
While companies use absorption costing for their financial statements, many also use variable costing for decision-making. The Big Three auto companies made decisions based on absorption costing, and the result was the manufacturing of more vehicles than the market demanded. Why? With absorption costing, the fixed overhead costs, such as marketing, were allocated to inventory, and the larger the inventory, the lower was the unit cost of that overhead. For example, if a fixed cost of $\1,000$ is allocated to $500$ units, the cost is $\2$ per unit. But if there are $2,000$ units, the per-unit cost is $\0.50$. While this was not the only reason for manufacturing too many cars, it kept the period costs hidden among the manufacturing costs. Using variable costing would have kept the costs separate and led to different decisions.
Deferred Costs
Absorption costing considers all fixed overhead as part of a product’s cost and assigns it to the product. This treatment means that as inventories increase and are possibly carried over from the year of production to actual sales of the units in the next year, the company allocates a portion of the fixed manufacturing overhead costs from the current period to future periods.
Carrying over inventories and overhead costs is reflected in the ending inventory balances at the end of the production period, which become the beginning inventory balances at the start of the next period. It is anticipated that the units that were carried over will be sold in the next period. If the units are not sold, the costs will continue to be included in the costs of producing the units until they are sold. Finally, at the point of sale, whenever it happens, these deferred production costs, such as fixed overhead, become part of the costs of goods sold and flow through to the income statement in the period of the sale. This treatment is based on the expense recognition principle, which is one of the cornerstones of accrual accounting and is why the absorption method follows GAAP. The principle states that expenses should be recognized in the period in which revenues are incurred. Including fixed overhead as a cost of the product ensures the fixed overhead is expensed (as part of cost of goods sold) when the sale is reported.
For example, assume a new company has fixed overhead of $\12,000$ and manufactures $10,000$ units. Direct materials cost is $\3$ per unit, direct labor is $\15$ per unit, and the variable manufacturing overhead is $\7$ per unit. Under absorption costing, the amount of fixed overhead in each unit is $\1.20$ ($\12,000/10,000$ units); variable costing does not include any fixed overhead as part of the cost of the product. Figure $1$ shows the cost to produce the $10,000$ units using absorption and variable costing.
Assume each unit is sold for $\33$ each, so sales are $\330,000$ for the year. If the entire finished goods inventory is sold, the income is the same for both the absorption and variable cost methods. The difference is that the absorption cost method includes fixed overhead as part of the cost of goods sold, while the variable cost method includes it as an administrative cost, as shown in Figure $2$. When the entire inventory is sold, the total fixed cost is expensed as the cost of goods sold under the absorption method or it is expensed as an administrative cost under the variable method; net income is the same under both methods.
Now assume that $8,000$ units are sold and $2,000$ are still in finished goods inventory at the end of the year. The cost of the fixed overhead expensed on the income statement as cost of goods sold is $\ 9,600(\ 1.20 / \text { unit } \times 8,000\text { units) }$, and the fixed overhead cost remaining in finished goods inventory is $\ 2,400(\ 1.20 / \text { unit } \times 2,000\text { units) }$. The amount of the fixed overhead paid by the company is not totally expensed, because the number of units in ending inventory has increased. Eventually, the fixed overhead cost will be expensed when the inventory is sold in the next period. Figure $3$ shows the cost to produce the $8,000$ units of inventory that became cost of goods sold and the $2,000$ units that remain in ending inventory.
If the $8,000$ units are sold for $\33$ each, the difference between absorption costing and variable costing is a timing difference. Under absorption costing, the $2,000$ units in ending inventory include the $\1.20$ per unit share, or $\2,400$ of fixed cost. That cost will be expensed when the inventory is sold and accounts for the difference in net income under absorption and variable costing, as shown in Figure $4$.
Under variable costing, the fixed overhead is not considered a product cost and would not be assigned to ending inventory. The fixed overhead would have been expensed on the income statement as a period cost.
Inventory Differences
Because absorption costing defers costs, the ending inventory figure differs from that calculated using the variable costing method. As shown in Figure $3$, the inventory figure under absorption costing considers both variable and fixed manufacturing costs, whereas under variable costing, it only includes the variable manufacturing costs.
Suitability for Cost-Volume-Profit Analysis
Using the absorption costing method on the income statement does not easily provide data for cost-volume-profit (CVP) computations. In the previous example, the fixed overhead cost per unit is $\1.20$ based on an activity of $10,000$ units. If the company estimated $12,000$ units, the fixed overhead cost per unit would decrease to $\1$ per unit. This calculation is possible, but it must be done multiple times each time the volume of activity changes in order to provide accurate data, as CVP analysis makes no distinction between variable costing and absorption costing income statements.
Example $1$: Comparing Variable and Absorption Methods
A company expects to manufacture $7,000$ units. Its direct material costs are $\10$ per unit, direct labor is $\9$ per unit, and variable overhead is $\3$ per unit. The fixed overhead is estimated at $\49,000$. How much would each unit cost under both the variable method and the absorption method?
Solution
The variable cost per unit is $\22$ (the total of direct material, direct labor, and variable overhead). The absorption cost per unit is the variable cost ($\22$) plus the per-unit cost of $\7$ ($\49,000/7,000$ units) for the fixed overhead, for a total of $\29$.
Advantages and Disadvantages of the Variable Costing Method
Variable costing only includes the product costs that vary with output, which typically include direct material, direct labor, and variable manufacturing overhead. Fixed overhead is not considered a product cost under variable costing. Fixed manufacturing overhead is still expensed on the income statement, but it is treated as a period cost charged against revenue for each period. It does not include a portion of fixed overhead costs that remains in inventory and is not expensed, as in absorption costing.
If absorption costing is the method acceptable for financial reporting under GAAP, why would management prefer variable costing? Advocates of variable costing argue that the definition of fixed costs holds, and fixed manufacturing overhead costs will be incurred regardless of whether anything is actually produced. They also argue that fixed manufacturing overhead costs are true period expenses and have no future service potential, since incurring them now has no effect on whether these costs will have to be incurred again in the future.
Advantages of the variable approach are:
• More useful for CVP analysis. Variable costing statements provide data that are immediately useful for CVP analysis because fixed and variable overhead are separate items. Computations from financial statements prepared with absorption costing need computations to break out the fixed and variable costs from the product costs.
• Income is not affected by changes in production volume. Fixed overhead is treated as a period cost and does not vary as the volume of inventory changes. This results in income increasing in proportion to sales, which may not happen under absorption costing. Under absorption costing, the fixed overhead assigned to a cost changes as the volume changes. Therefore, the reported net income changes with production, since fixed costs are spread across the changing number of units. This can distort the income picture and may even result in income moving in an opposite direction from sales.
• Understandability. Managers may find it easier to understand variable costing reports because overhead changes with the cost driver.
• Fixed costs are more visible. Variable costing emphasizes the impact fixed costs have on income. The total amount of fixed costs for the period is reported after gross profit. This emphasizes the direct impact fixed costs have on net income, whereas in absorption costing, fixed costs are included as product costs and thus are part of cost of goods sold, which is a determinant of gross profit.
• Margins are less distorted. Gross margins are not distorted by the allocation of common fixed costs. This facilitates appraisal of the profitability of products, customers, and business segments. Common fixed costs, sometimes called allocated fixed costs, are costs of the organization that are shared by the various revenue-generating components of the business, such as divisions. Examples of these costs include the chief executive officer (CEO) salary and corporate headquarter costs, such as rent and insurance. These overhead costs are typically allocated to various components of the organization, such as divisions or production facilities. This is necessary, because these costs are needed for doing business but are generated by a part of the company that does not directly generate revenues to offset these costs. The company’s revenues are generated by the goods that are produced and sold by the various divisions of the company.
• Control is facilitated. Variable costing considers only variable production costs and facilitates the use of control mechanisms such as flexible budgets that are based on differing levels of production and therefore designed around variable costs, since fixed costs do not change within a relevant range of production.
• Incremental analysis is more straightforward. Variable cost corresponds closely with the current out-of-pocket expenditure necessary to manufacture goods and can therefore be used more readily in incremental analysis.
While the variable cost method helps management make decisions, especially when the number of units in ending inventory fluctuates, there are some disadvantages:
• Financial reporting. The variable cost method is not acceptable for financial reporting under GAAP. GAAP requires expenses to be recognized in the same period as the related revenue, and the variable method expenses fixed overhead as a period cost regardless of how much inventory remains.
• Tax reporting. Tax laws in the United States and many other countries do not allow variable costing and require absorption costing.
Advantages and Disadvantages of the Absorption Costing Method
Under the absorption costing method, all costs of production, whether fixed or variable, are considered product costs. This means that absorption costing allocates a portion of fixed manufacturing overhead to each product.
Advocates of absorption costing argue that fixed manufacturing overhead costs are essential to the production process and are an actual cost of the product. They further argue that costs should be categorized by function rather than by behavior, and these costs must be included as a product cost regardless of whether the cost is fixed or variable.
The advantages of absorption costing include:
• Product cost. Absorption costing includes fixed overhead as part of the inventory cost, and it is expensed as cost of goods sold when inventory is sold. This represents a more complete list of costs involved in producing a product.
• Financial reporting. Absorption costing is the acceptable reporting method under GAAP.
• Tax reporting. Absorption costing is the method required for tax preparation in the United States and many other countries.
While financial and tax reporting are the main advantages of absorption costing, there is one distinct disadvantage:
• Difficulty in understanding. The absorption costing method does not list the incremental fixed overhead costs and is more difficult to understand and analyze as compared to variable costing.
ETHICAL CONSIDERATIONS: Cost Accounting for Ethical Business Managers
An ethical and evenhanded approach to providing clear and informative financial information regarding costing is the goal of the ethical accountant. Ethical business managers understand the benefits of using the appropriate costing systems and methods. The accountant’s entire business organization needs to understand that the costing system is created to provide efficiency in assisting in making business decisions. Determining the appropriate costing system and the type of information to be provided to management goes beyond providing just accounting information. The costing system should provide the organization’s management with factual and true financial information regarding the organization’s operations and the performance of the organization. Unethical business managers can game the costing system by unfairly or unscrupulously influencing the outcome of the costing system’s reports.
Comparing the Operating Income Statements for Both Methods Assuming No Ending Inventory in the First Year, and the Existence of Ending Inventory in the Second Year
In order to understand how to prepare income statements using both methods, consider a scenario in which a company has no ending inventory in the first year but does have ending inventory in the second year. Outdoor Nation, a manufacturer of residential, tabletop propane heaters, wants to determine whether absorption costing or variable costing is better for internal decision-making. It manufactures $5,000$ units annually and sells them for $\15$ per unit. The total of direct material, direct labor, and variable overhead is $\5$ per unit with an additional $\1$ in variable sales cost paid when the units are sold. Additionally, fixed overhead is $\15,000$ per year, and fixed sales and administrative expenses are $21,000$ per year.
Production is estimated to hold steady at $5,000$ units per year, while sales estimates are projected to be $5,000$ units in year $1$; $4,000$ units in year $2$; and $6,000$ in year $3$.
Under absorption costing, the ending inventory costs include all manufacturing costs, including overhead. If fixed overhead is $\15,000$ per year and $5,000$ units are manufactured each year, the fixed overhead per unit is $\3$:
$\dfrac{\ 15,000}{5,000 \text { units }}=\ 3 \text { per unit } \nonumber$
The projected income statement using absorption costing is shown in Figure $5$:
In variable costing, the fixed overhead is not included in the cost of goods sold even if it relates to manufacturing. As a result, the net income under variable costing differs from absorption costing by the same amount as inventory differential. The projected income under variable costing is shown in Figure $6$:
The difference between the methods is attributable to the fixed overhead. Therefore, the methods can be reconciled with each other, as shown in Figure $7$.
Each method results in different amounts for net income when the inventory amounts change. More specifically, the effects on income are:
• Sales and Production equal. When a company sells the same quantity of products produced during the period, the resulting net income will be identical whether absorption costing or variable costing is used. When sales equals production, all manufacturing costs are accounted for in net income, and none of the costs are waiting in finished goods inventory to be recognized in a future period. Remember, with absorption costing, all manufacturing costs are added to the cost of the product during the work in process phase; thus, as the goods are sold, all costs have been accounted for. With variable costing, only the variable costs or production are added to the cost of the product during the work in process phase, and the fixed costs are expensed in the period in which they are incurred. Thus, in the example where sales and production are equal, all costs have been accounted for since all of the produced inventory has moved through cost of goods sold. This means that net income under absorption costing would be the same as net income under variable costing.
• Sales less than Production. When a company produces more than it sells, net income will be less under variable costing than under absorption costing. In this scenario, there will be a buildup, or an increase, in inventory from the beginning of the period to the end of the period. Under variable costing, fixed manufacturing costs are still in the finished goods inventory account. But under absorption costing, those fixed costs have been expensed during the current production period and thus have reduced net income.
• Sales greater than Production. When a company sells more than it produces during the current period, this indicates it is selling goods produced in a prior period. This will result in net income under variable costing being greater than under absorption costing. With absorption costing, all manufacturing costs are captured in the finished goods inventory account, and as those goods are sold, those costs become expenses. Selling items that were produced in a prior period defers the recognition of the costs of those products until the future period in which they are sold. Variable costing results in all of the variable costs associated with the sold products being in the current period net income, but only the current period fixed expenses would be included in the current period net income. The fixed expenses associated with the items produced in a prior period were recognized in the period in which they were incurred, not the period in which the products are sold. This results in fewer expenses and therefore greater income with the variable cost method.
• Effect of differences in Sales and Production Long Term. The differences between net income generated under absorption costing and variable costing will be almost zero over the long run, as all costs associated with the production of goods will eventually be recognized in net income. The use of absorption versus variable costing creates more of a timing issue for the recognition of fixed expenses, and this is why net income would vary from period to period under the two methods but in the long run would not. In addition, absorption costing does allow for manipulation of income by managers through overproduction. Increasing production at year-end results in a higher net income than if the additional goods had not been produced, since increasing the number of units decreases the fixed cost per unit. Under absorption costing, these fixed costs follow the units produced and do not become a part of cost of goods sold until they are sold. Instead, a portion of the fixed costs is in the inventory accounts. Why would a manager want to manipulate income by overproducing? If the manager’s annual bonus or other compensation is linked to net income, then the manager may be motivated to overproduce in order to increase the potential for or the amount of a bonus. If the level of sales remain constant while manipulating the production level, such an action would increase the company’s expenses (including the amount of bonus) while not increasing its revenue. Barring any other justification for the increase in production, such an action by the manager would typically be considered an ethical violation, since the manager’s actions would be in the manager’s best interests, but contrary to the best interests of the company.
LINK TO LEARNING
Absorption costing is not as well understood as variable costing because of its financial statement limitations. But understanding how it can help management make decisions is very important. See the Strategic CFO forum on Absorption Cost Accounting that helps managers understand its uses to learn more. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/06%3A_Activity-Based_Variable_and_Absorption_Costing/6.06%3A_Compare_and_Contrast_Variable_and_Absorption_Costing.txt |
Section Summaries
6.1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method
• Manufacturing overhead is estimated for the upcoming period.
• An activity base is selected to allocate overhead. This is traditionally direct labor hours, direct labor cost, or machine hours.
• A predetermined overhead rate is calculated by dividing the estimated overhead by the allocation base.
• Overhead is allocated to each product based on the estimated predetermined overhead rate and the number of units in the selected activity base.
6.2 Describe and Identify Cost Drivers
• Overhead costs are analyzed and grouped based on similar activity bases. A cost driver, such as inspections, machine setups, or order taking, is selected for each cost grouping.
• Analysis of cost drivers allows for better selection of true overhead cost drivers and more appropriate allocation of overhead.
6.3 Calculate Activity-Based Product Costs
• Costs can be traced to the unit level or batch level.
• There are five steps in the ABC process:
• identify activities needed for production
• assign overhead expenses
• assign a cost driver for each expense
• determine a predetermined overhead rate
• allocate overhead to each product
6.4 Compare and Contrast Traditional and Activity-Based Costing Systems
• Traditional allocation assigns overhead based on a single overhead rate, while ABC assigns overhead based on several cost pools and the activities that drive costs.
• Traditional allocation is optimal when the manufacturing process is labor driven and overhead increases based on traditional activity bases, such as direct labor hours, direct labor dollars, or machine hours.
• ABC costing is optimal when the manufacturing process is technology driven and overhead increases based on various activities that differ for each product.
6.5 Compare and Contrast Variable and Absorption Costing
• Absorption costing assigns all manufacturing costs to products, whereas variable costing only assigns variable costs to the products.
• Income statements from both methods can be reconciled by starting with the net income or loss using variable costing and adding the amount of fixed costs included in ending inventory and subtracting the fixed costs included in beginning inventory.
• Variable costing is not considered GAAP compliant but lends itself to cost-volume-profit analysis.
Key Terms
absorption costing
(also, full costing) system of accounting where all costs are treated as product costs regardless of whether they are variable or fixed
activity base
activity that has been considered to be a primary driver of overhead costs and for which, traditionally, direct labor hours or machine hours were used
activity-based costing
process of assigning overhead to products based on the cost driver for each activity cost pool
batch-level cost
one that is incurred when a group (or batch) of items is produced
common fixed costs
expenses that are shared among all divisions or production units and include such costs as the CEO salary and corporate headquarter costs
cost driver
activity that is the reason for the increase or decrease of another cost; examples include labor hours incurred, labor costs paid, amounts of materials used in production, units produced, or any other activity that has a cause-and-effect relationship with incurred costs
cost pool
accumulation of costs that are incurred during the production of the activities included in the activity cost pool
direct labor
labor directly related to the manufacturing of the product or the production of a service
direct materials
materials used in the manufacturing process that can be traced directly to the product
expense recognition principle
(also, matching principle) matches expenses with associated revenues in the period in which the revenues were generated
factory-level cost
one that is incurred when production occurs, such as production supervisor salary
indirect labor
labor not directly involved in the active conversion of materials into finished products or the provision of services
indirect materials
materials used in production but not efficiently traceable to a specific unit of production
manufacturing overhead costs
all manufacturing costs excluding direct material and direct labor
product-level cost
one that occurs as support of the product, such as engineering
traditional allocation
allocation of factory overhead to products based on the volume of production resources consumed
unit-level cost
one that is incurred for each unit produced
variable costing
(also, direct costing or marginal costing) system of accounting where only variable costs are treated as product costs | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/06%3A_Activity-Based_Variable_and_Absorption_Costing/6.07%3A_Summary_and_Key_Terms.txt |
Multiple Choice
1. Active Frame, Inc., manufactures clear and tinted sport glasses. The manufacturing of clear glasses takes \(45,000\) direct labor hours and involves \(1,700\) parts and \(115\) inspections. The manufacturing of tinted glasses takes \(115,000\) direct labor hours and involves \(1,400\) parts and \(450\) inspections. The traditional method applies \(\$560,000\) of overhead on the basis of direct labor hours. What is the amount of overhead per direct labor hour applied to the clear glass products?
1. \(\$933.33\)
2. \(\$157,500\)
3. \(\$322.500\)
4. \(\$402,500\)
Answer:
b
1. TyeDye Lights makes two products: Party and Holiday. It takes \(80,900\) direct labor hours to manufacture the Party Line and \(93,500\) direct labor hours to manufacture the Holiday Line. Overhead consists of \(\$225,000\) in the machine setup cost pool and \(\$149,960\) in the packaging cost pool. The machine setup pool has \(\)52,000 setups for the Party product and \(98,000\) setups for the Holiday product. The packaging cost pool has \(26,000\) parts in the Party product and \(39,200\) parts for the Holiday product. Using the traditional cost method of direct labor hours, what is the predetermined overhead rate?
1. \(\$1.50\) per direct labor hour
2. \(\$2.15\) per direct labor hour
3. \(\$2.30\) per direct labor hour
4. \(\$3.80\) per direct labor hour
2. Which is not a step in analyzing the cost driver for manufacturing overhead?
1. identify the cost
2. identify non-value-added costs
3. analyze the effect on manufacturing overhead
4. identify the correlation between the potential driver and manufacturing overhead
Answer:
b
1. Overhead costs are assigned to each product based on ________.
1. the proportion of that product’s use of the cost driver
2. a predetermined overhead rate for a single cost driver
3. price of the product
4. machine hours per product
2. Which of the following is a reason a company would implement activity-based costing?
1. The cost of record keeping is high.
2. The additional data obtained through traditional allocation are not worth the cost.
3. They want to improve the data on which decisions are made.
4. A company only has one cost driver.
Answer:
c
1. Which is the correct formula for computing the overhead rate?
1. estimated use of the cost driver for production/estimated overhead for the activity
2. estimated overhead for the product/estimated use of the cost driver for the activity
3. estimated use of the cost driver for production/estimated overhead for the activity
4. estimated overhead for the activity/estimated use of the cost driver for the activity
2. A company anticipates the cost to heat the building will be \(\$21,000\). Product A takes up \(500\) square feet of space, while Product B takes up \(200\) square feet. The activity rate per product using activity-based costing would be which of the following?
1. \(\$30\)/square foot
2. \(\$4.20\)/square foot
3. \(\$11\)/square foot
4. \(\$15.20\)/square foot
Answer:
a
1. A company calculated the predetermined overhead based on an estimated overhead of \(\$70,000\), and the activity for the cost driver was estimated as \(2,500\) hours. If product A utilized \(1,350\) hours and product B utilized \(1,100\) hours, what was the total amount of overhead assigned to the products?
1. \(\$35,000\)
2. \(\$30,800\)
3. \(\$37,800\)
4. \(\$68,600\)
2. Which is not a step in activity-based costing?
1. identify the activities performed by the organization
2. identify the cost driver(s) associated with each activity
3. compute a cost rate per production
4. assign costs to products by multiplying the cost driver rate by the volume of the cost driver units consumed by the product
Answer:
c
1. What is the proper order of tasks in an ABC system?
1. identify the cost drivers, assign the costs to the products, calculate the overhead application rate for each cost pool, identify the cost pools
2. assign the costs to the products, identify the cost drivers, calculate the overhead application rate for each cost pool, identify the cost pools
3. identify the cost drivers, identify the cost pools, calculate the overhead application rate for each cost pool, assign the costs to the products
4. identify the cost pools, identify the cost drivers, calculate the overhead application rate for each cost pool, assign the costs to the products
2. Which is not a task typically associated with ABC systems?
1. calculating the overhead application rate for each cost pool
2. applying a single cost rate
3. identifying a cost driver
4. more correctly allocating overhead costs
Answer:
b
1. Which statement is correct?
1. Activity-based cost systems are less costly than traditional cost systems.
2. Activity-based cost systems are easier to implement than traditional cost systems.
3. Activity-based cost systems are more accurate than traditional cost systems.
4. Activity-based cost systems provide the same data as traditional cost systems.
2. Activity-based costing systems:
1. use a single predetermined overhead rate based on machine hours instead of on direct labor
2. frequently increase the overhead allocation to at least one product while decreasing the overhead allocation to at least one other product
3. limit the number of cost pools
4. always result in an increase of at least one product’s selling price
Answer:
b
1. Activity-based costing is preferable in a system:
1. when multiple products have similar product volumes and costs
2. with a large direct labor cost as a percentage of the total product cost
3. with multiple, diverse products
4. where management needs to support an increase in sales price
2. Absorption costing is also referred to as:
1. direct costing
2. marginal costing
3. full costing
4. variable costing
Answer:
c
1. Under variable costing, a unit of product includes which costs?
1. direct material, direct labor, and manufacturing overhead
2. direct material, direct labor, and variable manufacturing overhead
3. direct material, direct labor, and fixed manufacturing overhead
4. direct material, direct labor, and all variable manufacturing overhead
2. Under absorption costing, a unit of product includes which costs?
1. direct material, direct labor, and manufacturing overhead
2. direct material, direct labor, and variable manufacturing overhead
3. direct material, direct labor, and fixed manufacturing overhead
4. direct material, direct labor, and all variable manufacturing overhead
Answer:
a
1. A downside to absorption costing is:
1. not including fixed manufacturing overhead in the cost of the product
2. that it is not really useful for managerial decisions
3. that it is not allowable under GAAP
4. that it is not well designed for cost-volume-profit analysis
2. When the number of units in ending inventory increases through the year, which of the following is true?
1. Net income is the same for variable and absorption costing.
2. Net income is higher for variable costing than for absorption costing.
3. Net income is higher for absorption costing than for variable costing.
4. There is no relationship between net income and the costing method.
Answer:
c
1. Product costs under variable costing are typically:
1. higher than under absorption costing
2. lower than under absorption costing
3. the same as with absorption costing
4. higher than absorption costing when inventory increases
Questions
1. What is the predetermined overhead rate, and when is it typically estimated?
Answer:
The predetermined overhead rate is the amount of manufacturing overhead that is estimated to be applied to each product or department depending on the cost system used (job order costing or process costing). It typically is estimated at the beginning of each period by dividing the estimated manufacturing overhead by an activity base. While it is most commonly a year, the period can be a year, quarter, or month as determined by management. In traditional allocation systems, that base is typically direct labor hours, direct labor dollars, or machine hours. In activity-based costing systems, the activity base is one or more cost drivers.
1. When is an activity-based costing system better than a traditional allocation system?
2. What is the advantage of labeling activities as value added or nonvalue added?
Answer:
Non-value-added costs can often be eliminated since they are rarely essential, and identifying them helps managers reduce their costs.
1. What conditions are necessary to designate an activity as a cost driver?
2. For each cost pool, identify an appropriate cost driver.
1. order department
2. accounts receivable processing
3. catering
4. raw material inventory
Answer:
Answers may vary but should be similar to the following:
1. number of orders
2. number of customers
3. number of meals
4. number of material requisitions received.
1. How is the primary focus of activity-based costing different from that of traditional allocation?
2. What are the primary differences between traditional and activity-based costing?
Answer:
Activity-based costing has multiple cost drivers and focuses on the overhead-related activities performed during manufacturing. Traditional allocation has a single unit-level base for allocating overhead and focuses on the units of production.
1. How are service companies similar or different from manufacturing companies in using ABC costing?
2. How are costs allocated in an ABC system?
Answer:
Estimated overhead costs are first allocated to activity cost pools. Then, an allocation rate is determined based on the estimated usage of the cost driver for that pool. Then the costs are allocated to each product based on that product’s cost driver usage.
1. In production, what has changed to allow ABC costing to become valuable?
2. Why is it important to know the true cost for a product or service?
Answer:
The traditional method of applying overhead does not allocate overhead as precisely as with the ABC method. Management relies on the costing information when setting selling prices and bidding on service jobs. If the costing method is not accurate, some products may be considered profitable under traditional allocation, when those products are actually operating at a loss
1. What is the primary difference between variable costing and absorption costing?
2. Why would managers prefer variable costing over absorption costing?
Answer:
While variable costing is not acceptable for financial reporting purposes, some managers prefer variable costing because they believe fixed costs are period costs and do not change during the period. Variable costing separates variable and fixed manufacturing overhead, and using only variable costs allows them to make decisions based on the more reliable variations in unit costs.
1. Why is absorption costing the method allowable for GAAP?
2. Can a company gather information for both variable and absorption costing systems?
Answer:
Yes, as long as the system computes the amount of fixed manufacturing overhead per unit. The total amount can be expensed under variable costing and assigned to overhead produced during absorption costing. This will allow a portion to be included in ending inventory for absorption costing and not included for variable costing.
Exercise Set A
1. Steeler Towel Company estimates its overhead to be \(\$250,000\). It expects to have \(100,000\) direct labor hours costing \(\$2,500,000\) in labor and utilizing \(12,500\) machine hours. Calculate the predetermined overhead rate using:
1. Direct labor hours
2. Direct labor dollars
3. Machine hours
2. Crystal Pools estimates overhead will utilize \(250,000\) machine hours and cost \(\$750,000\). It takes \(2\) machine hours per unit, direct material cost of \(\$14\) per unit, and direct labor of \(\$20\) per unit. What is the cost of each unit produced?
3. A company estimated \(100,000\) direct labor hours and \(\$800,000\) in overhead. The actual overhead was \(\$805,100\), and there were \(99,900\) direct labor hours. What is the predetermined overhead rate, and how much was applied during the year?
4. Cozy, Inc., manufactures small and large blankets. It estimates \(\$350,000\) in overhead during the manufacturing of \(75,000\) small blankets and \(25,000\) large blankets. What is the predetermined overhead rate if a small blanket takes \(1\) machine hour and a large blanket takes \(2\) machine hours?
5. Identify appropriate cost drivers for these cost pools:
1. setup cost pools
2. assembly cost pool
3. supervising cost pool
4. testing cost pool
6. Match the activity with the most appropriate cost driver.
Table 6.E.1: Activities and Cost Drivers
Activity Cost Driver
Fringe benefits Square feet
Electricity Direct labor hours
Depreciation Machine hours
Machine maintenance
Heat and air conditioning
1. Rex Industries has two products. They manufactured \(12,539\) units of product A and \(8,254\) units of product B. The data are:
What is the activity rate for each cost pool?
1. Rex Industries has identified three different activities as cost drivers: machine setups, machine hours, and inspections. The overhead and estimated usage are:
Compute the overhead rate for each activity.
1. Custom’s makes two types of hats: polyester (poly) and silk. There are two cost pools: setup, with an estimated \(\$100,000\) in overhead, and inspection, with \(\$25,000\) in overhead. Poly is estimated to have \(750,000\) setups and \(170,000\) inspections, while silk has \(250,000\) setups and \(80,000\) inspections. How much overhead is applied to each product?
2. Custom’s has three cost pools and an associated cost driver to allocate the costs to the product. The cost pools, cost driver, estimated overhead, and estimated activity for the cost pool are:
What is the predetermined overhead rate for each activity?
1. Potterii sells its products to large box stores and recently added a retail line of products to sell directly to consumers. These estimates are to be used in determining the overhead allocation rate for ABC:
What would be the predetermined rate for each cost pool?
1. Assign each of the following expenses to either the machine setup cost pool or the factory cost pool:
1. indirect materials
2. factory insurance
3. machine depreciation
4. machine setup (indirect labor)
5. machine setup (indirect material)
2. Tri-bikes manufactures two different levels of bicycles: the Standard and the Extreme. The total overhead of \(\$300,000\) has traditionally been allocated by direct labor hours, with \(150,000\) hours for the Standard and \(50,000\) hours for the Extreme. After analyzing and assigning costs to two cost pools, it was determined that machine hours is estimated to have \(\$200,000\) of overhead, with \(4,000\) hours used on the Standard product and \(1,000\) hours used on the Extreme product. It was also estimated that the setup cost pool would have \(\$100,000\) of overhead, with \(1,000\) hours for the Standard and \(1,500\) hours for the Extreme. What is the overhead rate per product, under traditional and under ABC costing?
3. Cool Pool has these costs associated with production of \(20,000\) units of accessory products: direct materials, \(\$70\); direct labor, \(\$110\); variable manufacturing overhead, \(\$45\); total fixed manufacturing overhead, \(\$800,000\). What is the cost per unit under both the variable and absorption methods?
4. Using this information from Planters, Inc., what is the cost per unit under both variable and absorption costing?
Exercise Set B
1. Green Bay Cheese Company estimates its overhead to be \(\$375,000\). It expects to have \(125,000\) direct labor hours costing \(\$1,500,000\) in labor and utilizing \(15,000\) machine hours. Calculate the predetermined overhead rate using:
1. Direct labor hours
2. Direct labor dollars
3. Machine hours
2. Boarders estimates overhead will utilize \(160,000\) machine hours and cost \(\$80,000\). It takes \(4\) machine hours per unit, direct material cost of \(\$5\) per unit, and direct labor of \(\$5\) per unit. What is the cost of each unit produced?
3. A company estimated \(50,000\) direct labor hours and \(\$450,000\) in overhead. The actual overhead was \(\$445,000\), and there were \(50,500\) direct labor hours. What is the predetermined overhead rate, and how much was applied during the year?
4. Cozy, Inc., manufactures small and large blankets. It estimates \(\$950,000\) in overhead during the manufacturing of \(360,000\) small blankets and \(120,000\) large blankets. What is the predetermined overhead rate if a small blanket takes \(2\) hours of direct labor and a large blanket takes \(3\) hours of direct labor?
5. Identify appropriate cost drivers for these cost pools:
1. material cost pool
2. machine cost pool
3. painting cost pool
4. maintenance cost pool
6. Match the activity with the most appropriate cost driver.
Table 6.E.2: Activities and Cost Drivers
Activity Cost Driver
Factory maintenance Number of setups
Payroll tax Number of employees
Rent Square feet
Machine setups Direct labor hours
Factory supervision
1. Rocks Industries has two products. They manufactured \(12,539\) units of product A and \(8,254\) units of product B. The data are:
What is the activity rate for each cost pool?
1. Rocks Industries has identified three different activities as cost drivers: machine setups, machine hours, and inspections. The overhead and estimated usage are:
Compute the overhead rate for each activity.
1. Frenchy’s makes two types of scarves: polyester (poly) and silk. There are two cost pools: setup, with an estimated \(\$120,000\) in overhead, and inspection, with \(\$30,000\) in overhead. Poly is estimated to have \(800,000\) setups and \(450,000\) inspections, while silk has \(400,000\) setups and \(150,000\) inspections. How much overhead is applied to each product?
2. Frenchy’s has three cost pools and an associated cost driver to allocate the costs to the product. The cost pools, cost driver, estimated overhead, and estimated activity for the cost pool are:
What is the predetermined overhead rate for each activity?
1. Carboni recently added a carbon line in addition to its aluminum line. The following are estimates to be used in determining the overhead allocation rate for ABC.
What would be the predetermined rate for each cost pool?
1. Assign each of the following expenses to either the machine cost pool or the factory cost pool:
1. property taxes
2. heat and air-conditioning
3. electricity, machines
4. plant depreciation
5. electricity, plant
6. machine maintenance wages
2. Stacks manufactures two different levels of hockey sticks: the Standard and the Slap Shot. The total overhead of \(\$600,000\) has traditionally been allocated by direct labor hours, with \(400,000\) hours for the Standard and \(200,000\) hours for the Slap Shot. After analyzing and assigning costs to two cost pools, it was determined that machine hours is estimated to have \(\$450,000\) of overhead, with \(30,000\) hours used on the Standard product and \(15,000\) hours used on the Slap Shot product. It was also estimated that the inspection cost pool would have \(\$150,000\) of overhead, with \(25,000\) hours for the Standard and \(5,000\) hours for the Slap Shot. What is the overhead rate per product, under traditional and under ABC costing?
3. Crafts 4 All has these costs associated with production of \(12,000\) units of accessory products: direct materials, \(\$19\); direct labor, \(\$30\); variable manufacturing overhead, \(\$15\); total fixed manufacturing overhead, \(\$450,000\). What is the cost per unit under both the variable and absorption methods?
4. Using this information from Outdoor Grills, what is the cost per unit under both variable and absorption costing?
Problem Set A
1. Colonels uses a traditional cost system and estimates next year’s overhead will be \(\$480,000\), with the estimated cost driver of \(240,000\) direct labor hours. It manufactures three products and estimates these costs:
If the labor rate is \(\$25\) per hour, what is the per-unit cost of each product?
1. Five Card Draw manufactures and sells \(24,000\) units of Diamonds, which retails for \(\$180\), and \(27,000\) units of Clubs, which retails for \(\$190\). The direct materials cost is \(\$25\) per unit of Diamonds and \(\$30\) per unit of Clubs. The labor rate is \(\$25\) per hour, and Five Card Draw estimated \(180,000\) direct labor hours. It takes \(3\) direct labor hours to manufacture Diamonds and \(4\) hours for Clubs. The total estimated overhead is \(\$720,000\). Five Card Draw uses the traditional allocation method based on direct labor hours.
1. What is the gross profit per unit for Diamonds and Clubs?
2. What is the total gross profit for the year?
2. A local picnic table manufacturer has budgeted these overhead costs:
They are considering adapting ABC costing and have estimated the cost drivers for each pool as shown:
Recent success has yielded an order for \(1,000\) tables. Assume direct labor costs per hour of \(\$20\). Determine how much the job would cost given the following activities:
1. Explain how each activity in this list can be associated with the corresponding unit or batch level provided.
1. Assembling products: unit level
2. Issuing raw materials: batch level
3. Machine setup: batch level
4. Inspection: unit level
5. Loading the labeling machine: batch level
6. Equipment maintenance: batch level
7. Printing a banner: unit level
8. Moving material: batch level
9. Ordering a part: batch level
2. Medical Tape makes two products: Generic and Label. It estimates it will produce \(423,694\) units of Generic and \(652,200\) of Label, and the overhead for each of its cost pools is as follows:
It has also estimated the activities for each cost driver as follows:
How much is the overhead allocated to each unit of Generic and Label?
1. Box Springs, Inc., makes two sizes of box springs: twin and double. The direct material for the twin is \(\$25\) per unit and \(\$40\) is used in direct labor, while the direct material for the double is \(\$40\) per unit, and the labor cost is \(\$50\) per unit. Box Springs estimates it will make \(5,000\) twins and \(9,000\) doubles in the next year. It estimates the overhead for each cost pool and cost driver activities as follows:
How much does each unit cost to manufacture?
1. Please use the information from problem 6 above for these calculations. After grouping cost pools and estimating overhead and activities, Box Springs determined these rates:
It estimates there will be five orders in the next year, and those jobs will involve:
What is the total cost of the jobs?
1. A company has traditionally allocated its overhead based on machine hours but had collected this information to change to activity-based costing:
1. How much overhead would be allocated to each unit under the traditional allocation method?
2. How much overhead would be allocated to each unit under activity-based costing?
1. Carlton’s Kitchens makes two types of pasta makers: Strands and Shapes. The company expects to manufacture \(70,000\) units of Strands, which has a per-unit direct material cost of \(\$10\) and a per-unit direct labor cost of \(\$60\). It also expects to manufacture \(30,000\) units of Shapes, which has a per-unit material cost of \(\$15\) and a per-unit direct labor cost of \(\$40\). It is estimated that Strands will use \(140,000\) machine hours and Shapes will require \(60,000\) machine hours. Historically, the company has used the traditional allocation method and applied overhead at a rate of \(\$21\) per machine hour. It was determined that there were three cost pools, and the overhead for each cost pool is shown:
The cost driver for each cost pool and its expected activity is shown:
1. What is the per-unit cost for each product under the traditional allocation method?
2. What is the per-unit cost for each product under ABC costing?
3. Compared to ABC costing, was each product’s overhead under- or overapplied?
4. How much was overhead under- or overapplied for each product?
1. Carlton’s Kitchen’s three cost pools and overhead estimates are as follows:
Compare the overhead allocation using:
1. The traditional allocation method
2. The activity-based costing method
(Hint: the traditional method uses machine hours as the allocation base.)
1. Lampierre makes brass and gold frames. The company computed this information to decide whether to switch from the traditional allocation method to ABC:
The estimated overhead for the material cost pool is estimated as \(\$12,500\), and the estimate for the machine setup pool is \(\$35,000\). Calculate the allocation rate per unit of brass and per unit of gold using:
1. The traditional allocation method
2. The activity-based costing method
1. Portable Seats makes two chairs: folding and wooden. This information was obtained to review the decision to consider ABC:
Compute the overhead assigned to each product under:
1. The traditional allocation method
2. The activity-based costing method
1. Grainger Company produces only one product and sells that product for \(\$100\) per unit. Cost information for the product is:
Direct Material \$15 per Unit
Direct Labor \$25 per Unit
Variable Overhead \$5 per Unit
Fixed Overhead \$34,000
Selling expenses are \(\$4\) per unit and are all variable. Administrative expenses of \(\$20,000\) are all fixed. Grainger produced \(5,000\) units; sold \(4,000\); and had no beginning inventory.
1. Compute net income under
1. absorption costing
2. variable costing
2. Reconcile the difference between the income under absorption and variable costing.
1. Summarized data for Walrus Co. for its first year of operations are:
1. Prepare an income statement under absorption costing
2. Prepare an income statement under variable costing
1. Happy Trails has this information for its manufacturing:
Its income statement under absorption costing is:
Prepare an income statement with variable costing and a reconciliation statement between both methods.
1. Appliance Apps has the following costs associated with its production and sale of devices that allow appliances to receive commands from cell phones.
Prepare an income statement under both the absorption and variable costing methods along with a reconciliation between the two statements.
1. This information was collected for the first year of manufacturing for Appliance Apps:
Prepare an income statement under variable costing, and prepare a reconciliation to the income under the absorption method.
Problem Set B
1. Bobcat uses a traditional cost system and estimates next year’s overhead will be \(\$800,000\), as driven by the estimated \(25,000\) direct labor hours. It manufactures three products and estimates the following costs:
If the labor rate is \(\$30\) per hour, what is the per-unit cost of each product?
1. Five Card Draw manufactures and sells \(10,000\) units of Aces, which retails for \(\$200\), and \(8,000\) units of Kings, which retails for \(\$170\). The direct materials cost is \(\$20\) per unit of Aces and \(\$15\) per unit of Kings. The labor rate is \(\$30\) per hour, and Five Card Draw estimated \(64,000\) direct labor hours. It takes \(4\) direct labor hours to manufacture Aces and \(3\) hours for Kings. The total estimated overhead is \$128,000. Five Card Draw uses the traditional allocation method based on direct labor hours.
1. How much is the gross profit per unit for Aces and Kings?
2. What is the total gross profit for the year?
2. A local picnic table manufacturer has budgeted the following overhead costs:
They are considering adapting ABC costing and have estimated the cost drivers for each pool as shown:
Recent success has yielded an order for \(1,500\) tables. Determine how much the job would cost given the following activities, and assuming an hourly rate for direct labor of \(\$25\) per hour:
1. Explain how each activity in this list can be associated with the corresponding unit or batch level provided.
1. Assembling products: batch level
2. Issuing raw materials: unit level
3. Machine setup: unit level
4. Inspection: batch level
5. Loading the labeling machine: unit level
6. Equipment maintenance: unit level
7. Printing a banner: batch level
8. Moving material: unit level
9. Ordering a part: unit level
2. Wrappers Tape makes two products: Simple and Removable. It estimates it will produce \(369,991\) units of Simple and \(146,100\) of Removable, and the overhead for each of its cost pools is as follows:
It has also estimated the activities for each cost driver as follows:
How much is the overhead allocated to each unit of Simple and Removable?
1. Box Springs, Inc., makes two sizes of box springs: queen and king. The direct material for the queen is \(\$35\) per unit and \(\$55 \)is used in direct labor, while the direct material for the king is \(\$55\) per unit, and the labor cost is \(\$70\) per unit. Box Springs estimates it will make \(4,300\) queens and \(3,000\) kings in the next year. It estimates the overhead for each cost pool and cost driver activities as follows:
How much does each unit cost to manufacture?
1. Please use the information from problem 6 above for these calculations. After grouping cost pools and estimating overhead and activities, Box Springs determined these rates:
Box Springs estimates there will be four orders in the next year, and those jobs will involve:
What is the total cost of the jobs?
1. A company has traditionally allocated its overhead based on machine hours but collected this information to change to activity-based costing:
1. How much overhead would be assigned to each unit under the traditional allocation method?
2. How much overhead would be assigned to each unit under activity-based costing?
1. Casey’s Kitchens makes two types of food smokers: Gas and Electric. The company expects to manufacture \(20,000\) units of Gas smokers, which have a per-unit direct material cost of \(\$15\) and a per-unit direct labor cost of \(\$25\). It also expects to manufacture \(50,000\) units of Electric smokers, which have a per-unit material cost of \(\$20\) and a per-unit direct labor cost of \(\$45\). Historically, it has used the traditional allocation method and applied overhead at a rate of \(\$125\) per machine hour. It was determined that there were three cost pools, and the overhead for each cost pool is as follows:
The cost driver for each cost pool and its expected activity is as follows:
1. What is the per-unit cost for each product under the traditional allocation method?
2. What is the per-unit cost for each product under ABC costing?
1. Casey’s Kitchens’ three cost pools and overhead estimates are as follows:
Compare the overhead allocation using:
1. The traditional allocation method
2. The activity-based costing method
(Hint: the traditional method uses machine hours as the allocation base.)
1. Lampierre makes silver and gold candlesticks. The company computed this information to decide whether to switch from the traditional allocation method to ABC.
The estimated overhead for the material cost pool is estimated as \(\$45,000\), and the estimate for the machine setup pool is \(\$55,000\). Calculate the allocation rate per unit of silver and per unit of gold using:
1. The traditional allocation method
2. The activity-based costing method
1. Portable Seats makes two chairs: folding and wooden. This information was obtained to review the decision to consider ABC:
Compute the overhead assigned to each product under:
1. The traditional allocation method
2. The activity-based costing method
1. Submarine Company produces only one product and sells that product for \(\$150\) per unit. Cost information for the product is as follows:
Selling expenses are \(\$2\) per unit and are all variable. Administrative expenses of \(\$15,000\) are all fixed, Submarine produced \(2,000\) units and sold \(1,800\). Grainger had no beginning inventory.
1. Compute net income under
1. absorption costing
2. variable costing
2. Reconcile the difference between the income under absorption and variable costing.
1. Summarized data for Backdraft Co. for its first year of operations are as follows:
1. Prepare an income statement under absorption costing
2. Prepare an income statement under variable costing
1. Trail Outfitters has this information for its manufacturing:
Its income statement under absorption costing is as follows:
Prepare an income statement with variable costing and a reconciliation statement between both methods.
1. Wifi Apps has these costs associated with its production and sale of devices that allow visual communications between cell phones:
Prepare an income statement under both the absorption and variable costing methods along with a reconciliation between the two statements.
1. This information was collected for the first year of manufacturing for Wifi Apps:
Prepare an income statement under variable costing and prepare a reconciliation to the income under the absorption method.
Thought Provokers
1. What conditions are optimal for using traditional allocation? Is the allocation more effective when there is high-volume production?
2. College Cases sells cases for electronic devices such as phones, computers, and tablets. These cases have college logos or mascots on them and can be customized by adding such things as the customer’s name, initials, sport, or fraternity letters. The company buys the cases in various colors and then uses laser technology to do the customization of the letters and to add school names, logos, mascots, and so on. What are potential activity-based costing pools for College Cases, and what would be appropriate cost drivers?
3. How would a service industry apply activity-based costing?
4. Cape Cod Adventures makes foam noodles with sales of \(3,000,000\) units per year and retractable boat oars with sales of \(50,000\) pairs per year. What information would Cape Cod Adventures need in order to change from traditional to ABC costing? What are the limitations to activity-based costing?
5. In designing a bonus structure to reward your production managers, one of the options is to reward the managers based on reaching annual income targets. What are the differences between a reward system for a company that uses absorption costing and one for a company that uses variable costing? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/06%3A_Activity-Based_Variable_and_Absorption_Costing/6.0E%3A_6.E%3A_Activity-Based_Variable_and_Absorption_Costing_%28Exercises%29.txt |
In this chapter, you will learn the basic process companies use to create budgets and the general composition of basic budgets that are summed up in a master budget. You will also learn the importance of the flexible budget and be introduced to the idea of how budgets are used to evaluate company and management performance.
• 7.0: Prelude to Budgeting
Preparing a budget for future anticipated activities requires a company to look critically at its revenue and expenses. A good budget gives management the ability to evaluate results at the end of the budget cycle. Even well-planned budgets can have emergencies or unplanned financial disruptions, but having a budget provides a company with the information to develop an alternative budget. A good budget can be adjusted to work with changes in income and still produce similar results.
• 7.1: Describe How and Why Managers Use Budgets
Implementation of a company’s strategic plan often begins by determining management’s basic expectations about future economic, competitive, and technological conditions, and their effects on anticipated goals, both long-term and short-term. Many firms at this stage conduct a situational analysis that involves examining their strengths and weaknesses and the external opportunities available and the threats that they might face from competitors. This common analysis is often labeled as SWOT.
• 7.2: Prepare Operating Budgets
Operating budgets are a primary component of the master budget and involve examining the expectations for the primary operations of the business. Assumptions such as sales in units, sales price, manufacturing costs per unit, and direct material needed per unit involve a significant amount of time and input from various parts of the organization. It is important to obtain all of the information, however, because the more accurate the information, the more accurate the resulting budget.
• 7.3: Prepare Financial Budgets
• 7.4: Prepare Flexible Budgets
• 7.5: Explain How Budgets Are Used to Evaluate Goals
• 7.6: Summary and Key Terms
• 7.E: Budgeting (Exercises)
Thumbnail: pixabay.com/photos/calculato...rance-1044173/
07: Budgeting
Chris and Nikki are studying abroad next semester. Chris wants to spend her weekends sightseeing, but she does not have a lot of extra money. She creates a budget so she can save money to sightsee. She can reliably predict costs such as tuition, books, travel, and much of the sightseeing costs. She can also predict the amount of resources she will have to meet those costs, including scholarships, some savings, and earnings from her job.
Chris developed a budget from this information and planned for emergencies by including extra working hours and listing expenses that could be eliminated. On her trip, Chris was very careful with expenses and visited all the places she budgeted to visit.
Chris’s roommate, Nikki, on the other hand, did not plan ahead before going abroad. She did not have any travel funds for the last several weeks and lamented that she should not have purchased so many souvenirs.
Chris and Nikki are clear illustrations of why people and companies prepare budgets. Preparing a budget for future anticipated activities requires a company to look critically at its revenue and expenses. A good budget gives management the ability to evaluate results at the end of the budget cycle. Even well-planned budgets can have emergencies or unplanned financial disruptions, but having a budget provides a company with the information to develop an alternative budget. A good budget can be adjusted to work with changes in income and still produce similar results. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/07%3A_Budgeting/7.01%3A_Prelude_to_Budgeting.txt |
Implementation of a company’s strategic plan often begins by determining management’s basic expectations about future economic, competitive, and technological conditions, and their effects on anticipated goals, both long-term and short-term. Many firms at this stage conduct a situational analysis that involves examining their strengths and weaknesses and the external opportunities available and the threats that they might face from competitors. This common analysis is often labeled as SWOT.
After performing the situational analysis, the organization identifies potential strategies that could enable achievement of its goals. Finally, the company will create, initiate, and monitor both long-term and short-term plans.
An important step in the initiation of the company’s strategic plan is the creation of a budget. A good budgeting system will help a company reach its strategic goals by allowing management to plan and to control major categories of activity, such as revenue, expenses, and financing options. As detailed in Accounting as a Tool for Managers, planning involves developing future objectives, whereas controlling involves monitoring the planning objectives that have been put into place.
There are many advantages to budgeting, including:
• Communication
• Budgeting is a formal method to communicate a company’s plans to its internal stakeholders, such as executives, department managers, and others who have an interest in—or responsibility for—monitoring the company’s performance.
• Budgeting requires managers to plan for both revenues and expenses.
• Planning
• Preparing a budget requires managers to consider and evaluate
• The assumptions used to prepare the budget.
• Long-term financial goals.
• Short-term financial goals.
• The company’s position in the market.
• How each department supports the strategic plan.
• Preparing a budget requires departments to work together to
• Determine realizable sales goals.
• Compute the manufacturing or other requirements necessary to meet the sales goals.
• Solve bottlenecks that are predicted by the budget.
• Allocate resources so they can be used effectively to meet the sales and manufacturing goals.
• Compare forecasted or flexible budgets with actual results.
• Evaluation
• When compared to actual results, budgets are early alerts and they forecast:
• Cash flows for various levels of production.
• When loans may be required or when loans may be reduced.
• Budgets show which areas, departments, units, and so forth, are profitable or meet their appropriate goals. Similarly, they also show which components are unprofitable or do not reach their anticipated goals.
• Budgets set defined benchmarks that may be used for evaluating company and management performance, including raises and bonuses, as well as negative consequences, such as firing.
To understand the benefits of budgeting, consider Big Bad Bikes, a company that manufactures high-end mountain bikes. The company will begin producing and selling trainers this year. Trainers are stands that allow a rider to ride their bike indoors similar to the way bikes are used in spinning classes. Big Bad Bikes has a \(5\)-year plan and has always been successful in managing its budget. Managers participate in developing the budget and are aware that all expenses must be related to the company’s strategic plan. They know that managing their departments is much easier when the budget is developed to support the strategic plan.
The plan for Big Bad Bikes is to introduce itself to the trainer market with a sales price of \(\$70\) for the first two quarters of the year and then raise the price to \(\$75\) per unit. The marketing department estimates that sales will be \(1,000\) units for the first two quarters, \(1,500\) for the third quarter, and \(2,500\) per quarter through the second year. Management will work with each department to communicate goals and build a budget based on the sales plan. The resulting budget can be evaluated by all departments involved.
ETHICAL CONSIDERATIONS: Break-Even Analysis and Profitability
In the long run, proper budget reporting assists management in making good decisions. Management uses budgets to evaluate the performance of employees and their department. They can also use budgets to evaluate and benchmark the performance of a business unit in a large business organization or of the entire performance of a small company. They can also use budgets to evaluate separate projects. In budgeting situations, employees may feel a tension between reporting actual results and reporting results that reach the predetermined goals created by the budget. This creates a situation where managers may choose to act unethically and pressure accountants to report favorable financial results not supported by the operations.
Accountants need to be aware of this circumstance and use ethical standards when assisting the development and creation of budgets. After a proper budget has been created, the reporting of the actual results will assist in creating a realistic and honest picture of the actual operations for the managers reviewing the budget. The budget accountant needs to take steps to ensure that employees are not trying to misreport the budget results; for example, managers might be tempted to set artificially low standards to ensure that targets are hit and significantly exceeded. Such results could lead to what might be considered as excessive bonuses paid to managers.
The Basics of Budgeting
All companies—large and small—have limits on the amount of money or resources they can receive and pay out. How these resources are used to reach their goals and objectives must be planned. The quantitative plan estimating when and how much cash or other resources will be received and when and how the cash or other resources will be used is the budget. As you’ve learned, some of the benefits of budgeting include improved communication, planning, coordination, and evaluation.
All budgets are quantitative plans for the future and will be constructed based on the needs of the organization for which the budget is being created. Depending on the complexity, some budgets can take months or even years to develop. The most common time period covered by a budget is one year, although the time period may vary from strategic, long-term budgets to very detailed, short-term budgets. Generally, the closer the company is to the start of the budget’s time period, the more detailed the budget becomes.
Management begins with a vision of the future. The long-term vision sets the direction of the company. The vision develops into goals and strategies that are built into the budget and are directly or indirectly reflected on the master budget.
The master budget has two major categories: the financial budget and the operating budget. The financial budget plans the use of assets and liabilities and results in a projected balance sheet. The operating budget helps plan future revenue and expenses and results in a projected income statement. The operating budget has several subsidiary budgets that all begin with projected sales. For example, management estimates sales for the upcoming few years. It then breaks down estimated sales into quarters, months, and weeks and prepares the sales budget. The sales budget is the foundation for other operating budgets. Management uses the number of units from the sales budget and the company’s inventory policy to determine how many units need to be produced. This information in units and in dollars becomes the production budget.
The production budget is then broken up into budgets for materials, labor, and overhead, which use the standard quantity and standard price for raw materials that need to be purchased, the standard direct labor rate and the standard direct labor hours that need to be scheduled, and the standard costs for all other direct and indirect operating expenses. Companies use the historic quantities of the amount of material per unit and the hours of direct labor per unit to compute a standard used to estimate the quantity of materials and labor hours needed for the expected level of production. Current costs are used to develop standard costs for the price of materials, the direct labor rate, as well as an estimate of overhead costs.
The budget development process results in various budgets for various purposes, such as revenue, expenses, or units produced, but they all begin with a plan. To save time and eliminate unnecessary repetition, management often starts with the current year’s budget and adjusts it to meet future needs.
There are various strategies companies use in adjusting the budget amounts and planning for the future. For example, budgets can be derived from a top-down approach or from a bottom-up approach. Figure \(1\) shows the general difference between the top-down approach and the bottom-up approach. The top-down approach typically begins with senior management. The goals, assumptions, and predicted revenue and expenses information are passed from the senior manager to middle managers, who further pass the information downward. Each department must then determine how it can allocate its expenses efficiently while still meeting the company goals. The benefit of this approach is that it ties in to the strategic plan and company goals. Another benefit of passing the amount of allowed expenses downward is that the final anticipated costs are reduced by the vetting (fact checking and information gathering) process.
In the top-down approach, management must devote attention to efficiently allocating resources to ensure that expenses are not padded to create budgetary slack. The drawback to this approach to budgeting is that the budget is prepared by individuals who are not familiar with specific operations and expenses to understand each department’s nuances.
The bottom-up approach (sometimes also named a self-imposed or participative budget) begins at the lowest level of the company. After senior management has communicated the expected departmental goals, the departments then plans and predicts their sales and estimates the amount of resources needed to reach these goals. This information is communicated to the supervisor, who then passes it on to upper levels of management. The advantages of this approach are that managers feel their work is valued and that knowledgeable individuals develop the budget with realistic numbers. Therefore, the budget is more likely to be attainable. The drawback is that managers may not fully understand or may misunderstand the strategic plan.
Other approaches in addition to the top-down and bottom-up approaches are a combination approach and the zero-based budgeting approach. In the combination approach, guidelines and targets are set at the top while the managers work to develop a budget within the targeted parameters.
Zero-based budgeting begins with zero dollars and then adds to the budget only revenues and expenses that can be supported or justified. Figure \(2\) illustrates the difference between traditional budget preparation and zero-based budgeting in a bottom-up budgeting scenario. The advantage to zero-based budgeting is that unnecessary expenses are eliminated because managers cannot justify them. The drawback is that every expense needs to be justified, including obvious ones, so it takes a lot of time to complete. A compromise tactic is to use a zero-based budgeting approach for certain expenses, like travel, that can be easily justified and linked to the company goals.
Often budgets are developed so they can adjust for changes in the volume or activity and help management make decisions. Changes and challenges can affect the budget and have an impact on a company’s plans. A flexible budget adjusts the cost of goods produced for varying levels of production and is more useful than a static budget, which remains at one amount regardless of the production level. A flexible budget is created at the end of the accounting period, whereas the static budget is created before the fiscal year begins.
Additionally Figure \(3\) shows a comparison of a static budget and a flexible budget for Bingo’s Bags, a company that produces purses and backpacks. In the flexible budget, the budgeted costs are calculated with actual sales, whereas in the static budget, budgeted costs are calculated with budgeted sales. The flexible budget allows management to see what they would expect the budget to look like based on the actual sales and budgeted costs. Flexible budgets are addressed in greater detail in Prepare Flexible Budgets.
In order to handle changes that occur in the future, companies can also use a rolling budget, which is one that is continuously updated. While the company’s goals may be multi-year, the rolling budget is adjusted monthly, and a new month is added as each month passes. Rolling budgets allow management to respond to changes in estimates or actual occurrences, but it also takes management away from other duties as it requires continual updating. Figure \(4\) shows an example of how a rolling quarterly budget would work. Notice that as one month rolls off (is completed) another month is added to the budget so that four quarters of a year are always presented.
Because budgets are used to evaluate a manager’s performance as well as the company’s, managers are responsible for specific expenses within their own budget. Each manager’s performance is evaluated by how well he or she manages the revenues and expenses under his or her control. Each individual who exercises control over spending should have a budget specifying limits on that spending.
The Role of the Master Budget
Most organizations will create a master budget—whether that organization is large or small, public or private, or a merchandising, manufacturing, or service company. A master budget is one that includes two areas, operational and financial, each of which has its own sub-budgets. The operating budget spans several areas that help plan and manage day-to-day business. The financial budget depicts the expectations for cash inflows and outflows, including cash payments for planned operations, the purchase or sale of assets, the payment or financing of loans, and changes in equity. Each of the sub-budgets is made up of separate but interrelated budgets, and the number and type of separate budgets will differ depending on the type and size of the organization. For example, the sales budget predicts the sales expected for each quarter. The direct materials budget uses information from the sales budget to compute the number of units necessary for production. This information is used in other budgets, such as the direct materials budget, which plans when materials will be purchased, how much will be purchased, and how much that material should cost. You will review some specific examples of budgeting for direct materials in Prepare Operating Budgets.
Figure \(5\) shows how operating budgets and financial budgets are related within a master budget.
The Role of Operating Budgets
An operating budget consists of the sales budget, production budget, direct material budget, direct labor budget, and overhead budget. These budgets serve to assist in planning and monitoring the day-to-day activities of the organization by informing management of how many units need to be produced, how much material needs to be ordered, how many labor hours need to be scheduled, and the amount of overhead expected to be incurred. The individual pieces of the operating budget collectively lead to the creation of the budgeted income statement. For example, Big Bad Bikes estimates it will sell \(1,000\) trainers for \(\$70\) each in the first quarter and prepares a sales budget to show the sales by quarter. Management understands that it needs to have on hand the \(1,000\) trainers that it estimates will be sold. It also understands that additional inventory needs to be on hand in the event there are additional sales and to prepare for sales in the second quarter. This information is used to develop a production budget. Each trainer requires \(3.2\) pounds of material that usually costs \(\$1.25\) per pound. Knowing how many units are to be produced and how much inventory needs to be on hand is used to develop a direct materials budget.
The direct materials budget lets managers know when and how much raw materials need to be ordered. The same is true for direct labor, as management knows how many units will be manufactured and how many hours of direct labor are needed. The necessary hours of direct labor and the estimated labor rate are used to develop the direct labor budget. While the materials and labor are determined from the production budget, only the variable overhead can be determined from the production budget. Existing information regarding fixed manufacturing costs are combined with variable manufacturing costs to determine the manufacturing overhead budget. The information from the sales budget is used to determine the sales and administrative budget. Finally, the sales, direct materials, direct labor, fixed manufacturing overhead budget, and sales and administrative budgets are used to develop a pro-forma income statement.
The Role of Financial Budgets
A financial budget consists of the cash budget, the budgeted balance sheet, and the budget for capital expenses. Similar to the individual budgets that make up the operating budgets, the financial budgets serve to assist with planning and monitoring the financing requirements of the organization. Management plans its capital asset needs and states them in the capital expense budget. Management addresses its collection and payment policies to determine when it will receive cash from sales and when it will pay the material, labor, and overhead expenses. The capital expense budget and the estimated payment and collection of cash allow management to build a cash budget and determine when it will need financing or have additional funds to pay back loans. These budgets taken together will be part of the budgeted balance sheet. Figure \(5\) shows how these budgets relate.
Example \(1\): Maintaining a Cash Balance
DaQuan recently began work as a senior accountant at Mad Coffee Company. He learned he would be responsible for monitoring the cash balance because there is a bank loan requirement that a minimum balance of \(\$10,000\) be maintained with the bank at all times. DaQuan asked to see the cash budget so he could anticipate when the balance was most likely to go below \(\$10,000\). How can DaQuan determine potential cash balance issues by looking at the budget?
Solution
Budgeting helps plan for those times when cash is in short supply and bills need to be paid. Proper budgeting shows when and for how long a cash shortage may exist. DaQuan can see the months when the cash payments exceed the cash receipts and when the company is in danger of having a cash balance below the minimum requirement of \(\$10,000\). Knowing the inflow and outflow of cash will help him plan and manage the shortage through a line of credit, delay in purchasing, delay in hiring, or delay in payment of non-essential items.
LINK TO LEARNING
Budgeting is a task that should be completed by all organizations, not only those limited to manufacturing. Unfortunately, there are many individuals who want to operate a business and know nothing about budgeting. Often, professional organizations or industry trade groups offer information to help their members succeed in business. For example, the real estate profession provides information and suggestions such as this article on preparing a marketing budget to help professionals. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/07%3A_Budgeting/7.02%3A_Describe_How_and_Why_Managers_Use_Budgets.txt |
Operating budgets are a primary component of the master budget and involve examining the expectations for the primary operations of the business. Assumptions such as sales in units, sales price, manufacturing costs per unit, and direct material needed per unit involve a significant amount of time and input from various parts of the organization. It is important to obtain all of the information, however, because the more accurate the information, the more accurate the resulting budget, and the more likely management is to effectively monitor and achieve its budget goals.
Individual Operating Budgets
In order for an organization to align the budget with the strategic plan, it must budget for the day-to-day operations of the business. This means the company must understand when and how many sales will occur, as well as what expenses are required to generate those sales. In short, each component—sales, production, and other expenses—must be properly budgeted to generate the operating budget components and the resulting pro-forma budgeted income statement.
The budgeting process begins with the estimate of sales. When management has a solid estimate of sales for each quarter, month, week, or other relevant time period, they can determine how many units must be produced. From there, they determine the expenditures, such as direct materials necessary to produce the units. It is critical for the sales estimate to be accurate so that management knows how many units to produce. If the estimate is understated, the company will not have enough inventory to satisfy customers, and they will not have ordered enough material or scheduled enough direct labor to manufacture more units. Customers may then shop somewhere else to meet their needs. Likewise, if sales are overestimated, management will have purchased more material than necessary and have a larger labor force than needed. This overestimate will cause management to have spent more cash than was necessary.
Sales Budget
The sales budget details the expected sales in units and the sales price for the budget period. The information from the sales budget is carried to several places in the master budget. It is used to determine how many units must be produced as well as when and how much cash will be collected from those sales.
For example, Big Bad Bikes used information from competitor sales, its marketing department, and industry trends to estimate the number of units that will be sold in each quarter of the coming year. The number of units is multiplied by the sales price to determine the sales by quarter as shown in Figure $1$.
The sales budget leads into the production budget to determine how many units must be produced each week, month, quarter, or year. It also leads into the cash receipts budget, which will be discussed in Prepare Financial Budgets.
Production Budget
Estimating sales leads to identifying the desired quantity of inventory to meet the demand. Management wants to have enough inventory to meet production, but they do not want too much in the ending inventory to avoid paying for unnecessary storage. Management often uses a formula to estimate how much should remain in ending inventory. Management wants to be flexible with its budgeting, wants to create budgets that can grow or shrink as needed, and needs to have inventory on hand. So the amount of ending inventory often is a percentage of the next week’s, month’s, or quarter’s sales.
In creating the production budget, a major issue is how much inventory should be on hand. Having inventory on hand helps the company avoid losing a customer because the product isn’t available. However, there are storage costs associated with holding inventory as well as having a lag time between paying to manufacture a product and receiving cash from selling that product. Management must balance the two issues and determine the amount of inventory that should be available.
When determining the number of units needed to be produced, start with the estimated sales plus the desired ending inventory to derive the maximum number of units that must be available during the period. Since the number of units in beginning inventory are already produced, subtracting the beginning inventory from the goods available results in the number of units that need to be produced.
After management has estimated how many units will sell and how many units need to be in ending inventory, it develops the production budget to compute the number of units that need to be produced during each quarter. The formula is the reverse of the formula for the cost of goods sold.
$\begin{array}{c} \mathbf{Cost\;of\; Goods\; Sold} \ \quad \text {Beginning Inventory}\ \quad \quad \text{ + Purchases (or produced)}\ \hline\ \quad \quad \text {Goods available for sale}\ \quad \quad \text { - Ending Inventory}\ \hline\ \end{array} \nonumber$
$\begin{array}{c} \mathbf{Number\;of\; Units\; Produced} \ \quad \text {Goods Sold}\ \quad \quad \text{ + Ending Inventory}\ \hline\ \quad \quad \text {Goods available for sale}\ \quad \quad \text { - Beginning Inventory}\ \hline\ \end{array} \nonumber$
The number of units expected to be sold plus the desired ending inventory equals the number of units that are available. When the beginning inventory is subtracted from the number of units available, management knows how many units must be produced during that quarter to meet sales.
In a merchandising firm, retailers do not produce their inventory but purchase it. Therefore, stores such as Walmart do not have raw materials and instead substitute the number of units to be purchased in place of the number of units to be produced; the result is the merchandise inventory to be purchased.
To illustrate the steps in developing a production budget, recall that Big Bad Bikes is introducing a new product that the marketing department thinks will have strong sales. For new products, Big Bad Bikes requires a target ending inventory of $30\%$ of the next quarter’s sales. Unfortunately, they were unable to manufacture any units before the end of the current year, so the first quarter’s beginning inventory is $0$ units. As shown in Figure $1$, sales in quarter 2 are estimated at $1,000$ units; since $30\%$ is required to be in ending inventory, the ending inventory for quarter 1 needs to be $300$ units. With expected sales of $1,000$ units for quarter 2 and a required ending inventory of $30\%$, or $300$ units, Big Bad Bikes needs to have $1,300$ units available during the quarter. Since $1,300$ units needed to be available and there are zero units in beginning inventory, Big Bad Bikes needs to manufacture $1,300$ units, as shown in Figure $2$.
The ending inventory from one quarter is the beginning inventory for the next quarter and the calculations are all the same. In order to determine the ending inventory in quarter 4, Big Bad Bikes must estimate the sales for the first quarter of the next year. Big Bad Bikes’s marketing department believes sales will increase in each of the next several quarters, and they estimate sales as $3,500$ for the first quarter of the next year and $4,500$ for the second quarter of the next year. Thirty percent of $3,500$ is $1,050$, so the number of units required in the ending inventory for quarter 4 is $1,050$.
The number of units needed in production for the first quarter of the next year provides information needed for other budgets such as the direct materials budget, so Big Bad Bikes must also determine the number of units needed in production for that first quarter. The estimated sales of $3,500$ and the desired ending inventory of $1,350$ ($30\%$ of the next quarter’s estimated sales of $4,500$) determines that $4,850$ units are required during the quarter. The beginning inventory is estimated to be $1,050$, which means the number of units that need to be produced during the first quarter of year 2 is $3,800$.
The number of units needed to be produced each quarter was computed from the estimated sales and is used to determine the quantity of direct or raw material to purchase, to schedule enough direct labor to manufacture the units, and to approximate the overhead required for production. It is also necessary to estimate the sales for the first quarter of the next year. The ending inventory for the current year is based on the sales estimates for the first quarter of the following year. From this amount, the production budget and direct materials budget are calculated and flow to the operating and cash budget.
Direct Materials Budget
From the production budget, management knows how many units need to be produced in each budget period. Management is already aware of how much material it needs to produce each unit and can combine the direct material per unit with the production budget to compute the direct materials budget. This information is used to ensure the correct quantity of materials is ordered and the correct amount is budgeted for those materials.
Similar to the production budget, management wants to have an ending inventory available to ensure there are enough materials on hand. The direct materials budget illustrates how much material needs to be ordered and how much that material costs. The calculation is similar to that used in the production budget, with the addition of the cost per unit.
If Big Bad Bikes uses $3.2$ pounds of material for each trainer it manufactures and each pound of material costs $\1.25$, we can create a direct materials budget. Management’s goal is to have $20\%$ of the next quarter’s material needs on hand as the desired ending materials inventory. Therefore, the determination of each quarter’s material needs is partially dependent on the following quarter’s production requirements. The desired ending inventory of material is readily determined for quarters 1 through 3 as those needs are based on the production requirements for quarters 2 through 4. To compute the desired ending materials inventory for quarter 4, we need the production requirements for quarter 1 of year 2. Recall that the number of units to be produced during the first quarter of year 2 is $3,800$. Thus, quarter 4 materials ending inventory requirement is $20\%$ of $3,800$. That information is used to compute the direct materials budget shown in Figure $3$.
Management knows how much the materials will cost and integrates this information into the schedule of expected cash disbursements, which will be shown in Prepare Financial Budgets. This information will also be used in the budgeted income statement and on the budgeted balance sheet. With $6,000$ units estimated for sale, $3.2$ pounds of material per unit, and $\1.25$ per pound, the direct materials used represent $\24,000$ of the cost of goods sold. The remaining $\7,240$ is included in ending inventory as units completed and raw material.
Direct Labor Budget
Management uses the same information in the production budget to develop the direct labor budget. This information is used to ensure that the proper amount of staff is available for production and that there is money available to pay for the labor, including potential overtime. Typically, the number of hours is computed and then multiplied by an hourly rate, so the total direct labor cost is known.
If Big Bad Bikes knows that they need $45$ minutes or $0.75$ hours of direct labor for each unit produced, and the labor rate for this type of manufacturing is $\20$ per hour, the computation for direct labor simply begins with the number of units in the production budget. As shown in Figure $4$, the number of units produced each quarter multiplied by the number of hours per unit equals the required direct labor hours needed to be scheduled in order to meet production needs. The total number of hours is next multiplied by the direct labor rate per hour, and the labor cost can be budgeted and used in the cash disbursement budget and operating budget illustrated in Prepare Financial Budgets.
The direct labor of $\105,750$ will be apportioned to the budgeted income statement and budgeted balance sheet. With $0.75$ hours of direct labor per unit and $\20$ per direct labor hour, each unit will cost $\15$ in direct labor. Of the $7,050$ units produced, $6,000$ units will be sold, so $\90,000$ represents the labor portion of the cost of goods sold and will be shown on the income statement, while the remaining $\15,750$ will be the labor portion of ending inventory and will be shown on the balance sheet.
Manufacturing Overhead Budget
The manufacturing overhead budget includes the remainder of the production costs not covered by the direct materials and direct labor budgets. In the manufacturing overhead budgeting process, producers will typically allocate overhead costs depending upon their cost behavior production characteristics, which are generally classified as either variable or fixed. Based on this allocation process, the variable component will be treated as occurring proportionately in relation to budgeted activity, while the fixed component will be treated as remaining constant. This process is similar to the overhead allocation process you learned in studying product, process, or activity-based costing.
For Big Bad Bikes to create their manufacturing overhead budget, they first determine that the appropriate driver for assigning overhead costs to products is direct labor hours. The overhead allocation rates for the variable overhead costs are: indirect material of $\1.00$ per hour, indirect labor of $\1.25$ per hour, maintenance of $\0.25$ per hour, and utilities of $\0.50$ per hour. The fixed overhead costs per quarter are: supervisor salaries of $\15,000$, fixed maintenance salaries of $\4,000$, insurance of $\7,000$, and depreciation expenses of $\3,000$.
Given the direct labor hours for each quarter from the direct labor budget, the variable costs are the number of hours multiplied by the variable overhead application rate. The fixed costs are the same for each quarter, as shown in the manufacturing overhead budget in Figure $5$.
The total manufacturing overhead cost was $\131,863$ for $7,050$ units, or $\18.70$ per unit (rounded). Since $6,000$ units are sold, $\112,200 (6,000 \text{ units } × \18.70 /\text { unit})$ will be expensed as cost of goods sold, while the remaining $\19,663$ will be part of finished goods ending inventory.
Sales and Administrative Expenses Budget
The direct materials budget, the direct labor budget, and the manufacturing overhead budget plan for all costs related to production, while the selling and administrative expense budget contains a listing of variable and fixed expenses estimated to be incurred in all areas other than production costs. While this one budget contains all nonmanufacturing expenses, in practice, it actually comprises several small budgets created by managers in sales and administrative positions. All managers must follow the budget, but setting an appropriate budget for selling and administrative functions is complicated and is not always thoroughly understood by managers without a background in managerial accounting.
If Big Bad Bikes pays a sales commission of $\2$ per unit sold and a transportation cost of $\0.50$ per unit, they can use these costs to put together their sales and administrative budget. All other costs are fixed costs per quarter: sales salaries of $\5,000$; administrative salaries of $\5,000$; marketing expenses of $\5,000$; insurance of $\1,000$; and depreciation of $\2,000$. The sales and administrative budget is shown in Figure $6$, along with the budgeted sales used in the computation of variable sales and administrative expenses.
Only manufacturing costs are treated as a product cost and included in ending inventory, so all of the expenses in the sales and administrative budget are period expenses and included in the budgeted income statement.
Budgeted Income Statement
A budgeted income statement is formatted similarly to a traditional income statement except that it contains budgeted data. Once all of the operating budgets have been created, these costs are used to prepare a budgeted income statement and budgeted balance sheet. The manufacturing costs are allocated to the cost of goods sold and the ending inventory.
Big Bad Bikes uses the information on direct materials (Figure $3$), direct labor (Figure $4$), and manufacturing overhead (Figure $5$) to allocate the manufacturing costs between the cost of goods sold and the ending work in process inventory, as shown in (Figure $7$).
Once they perform this allocation, the budgeted income statement can be prepared. Big Bad Bikes estimates an interest of $\954$. It also estimates that $\22,000$ of its income will not be collected and will be reported as uncollectible expense. The budgeted income statement is shown in Figure $8$.
THINK IT THROUGH: Errors in a Budgeted Balance Sheet
Which error has the potential to cause more problems with the budgeted balance sheet: overstating sales or understating the cash collected? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/07%3A_Budgeting/7.03%3A_Prepare_Operating_Budgets.txt |
Now that you have developed an understanding of operating budgets, let’s turn to the other primary component of the master budget: financial budgets. Preparing financial budgets involves examining the expectations for financing the operations of the business and planning for the cash needs of the organization. The budget helps estimate the source, amount, and timing of cash collection and cash payments as well as determine if and when additional financing is needed or debt can be paid.
Individual Financial Budgets
Preparing a financial budget first requires preparing the capital asset budget, the cash budgets, and the budgeted balance sheet. The capital asset budget represents a significant investment in cash, and the amount is carried to the cash budget. Therefore, it needs to be prepared before the cash budget. If the cash will not be available, the capital asset budget can be adjusted and, again, carried to the cash budget.
When the budgets are complete, the beginning and ending balance from the cash budget, changes in financing, and changes in equity are shown on the budgeted balance sheet.
Capital Asset Budget
The capital asset budget, also called the capital expenditure budget, shows the company’s plans to invest in long-term assets. Some assets, such as computers, must be replaced every few years, while other assets, such as manufacturing equipment, are purchased very infrequently. Some assets can be purchased with cash, whereas others may require a loan. Budgeting for these types of expenditures requires long-range planning because the purchases affect cash flows in current and future periods and affect the income statement due to depreciation and interest expenses.
Cash Budget
The cash budget is the combined budget of all inflows and outflows of cash. It should be divided into the shortest time period possible, so management can be quickly made aware of potential problems resulting from fluctuations in cash flow. One goal of this budget is to anticipate the timing of cash inflows and outflows, which allows a company to try to avoid a decrease in the cash balance due to paying out more cash than it receives. In order to provide timely feedback and alert management to short-term cash needs, the cash flow budget is commonly geared toward monthly or quarterly figures. Figure \(1\) shows how the other budgets tie into the cash budget.
Cash is so important to the operations of a company that, often, companies will arrange to have an emergency cash source, such as a line of credit, to avoid defaulting on current payables due and also to protect against other unanticipated expenses, such as major repair costs on equipment. This line of credit would be similar in function to the overdraft protection offered on many checking accounts.
Because the cash budget accounts for every inflow and outflow of cash, it is broken down into smaller components. The cash collections schedule includes all of the cash inflow expected to be received from customer sales, whether those customers pay at the same rate or even if they pay at all. The cash collections schedule includes all the cash expected to be received and does not include the amount of the receivables estimated as uncollectible. The cash payments schedule plans the outflow or payments of all accounts payable, showing when cash will be used to pay for direct material purchases. Both the cash collections schedule and the cash payments schedule are included along with other cash transactions in a cash budget. The cash budget, then, combines the cash collection schedule, the cash payment schedule, and all other budgets that plan for the inflow or outflow of cash. When everything is combined into one budget, that budget shows if financing arrangements are needed to maintain balances or if excess cash is available to pay for additional liabilities or assets.
The operating budgets all begin with the sales budget. The cash collections schedule does as well. Since purchases are made at varying times during the period and cash is received from customers at varying rates, data are needed to estimate how much will be collected in the month of sale, the month after the sale, two months after the sale, and so forth. Bad debts also need to be estimated, since that is cash that will not be collected.
To illustrate, let’s return to Big Bad Bikes. They believe cash collections for the trainer sales will be similar to the collections from their bicycle sales, so they will use that pattern to budget cash collections for the trainers. In the quarter of sales, \(65\%\) of that quarter’s sales will be collected. In the quarter after the sale, \(30\%\) will be collected. This leaves \(5\%\) of the sales considered uncollectible. Figure \(3\) illustrates when each quarter’s sales will be collected. An estimate of the net realizable balance of Accounts Receivable can be reconciled by using information from the cash collections schedule:
For example, in quarter 1 of year 2, \(65\%\) of the quarter 1 sales will be collected in cash, as well as \(30\%\) of the sales from quarter 4 of the prior year. There were no sales in quarter 4 of the prior year so \(30\%\) of zero sales shows the collections are \(\$0\). Using information from Big Bad Bikes sales budget, the cash collections from the sales are shown in Figure \(4\).
When the cash collections schedule is made for sales, management must account for other potential cash collections such as cash received from the sale of equipment or the issuance of stock. These are listed individually in the cash inflows portion of the cash budget.
The cash payments schedule, on the other hand, shows when cash will be used to pay for Accounts Payable. One such example are direct material purchases, which originates from the direct materials budget. When the production budget is determined from the sales, management prepares the direct materials budget to determine when and how much material needs to be ordered. Orders for materials take place throughout the quarter, and payments for the purchases are made at different intervals from the orders. A schedule of cash payments is similar to the cash collections schedule, except that it accounts for the company’s purchases instead of the company’s sales. The information from the cash payments schedule feeds into the cash budget.
Big Bad Bikes typically pays half of its purchases in the quarter of purchase. The remaining half is paid in the following quarter, so payments in the first quarter include payments for purchases made during the first quarter as well as half of the purchases for the preceding quarter. Figure \(6\) shows when each quarter’s purchases will be paid. Additionally, the balance of purchases in Accounts Payable can be reconciled by using information from the cash payment schedule as follows:
The first quarter of the year plans cash payments from the prior quarter as well as the current quarter. Again, since the trainers are a new product, in this example, there are no purchases in the preceding quarter, and the payments are \(\$0\). Figure \(7\).
While the cash payments schedule is made for purchases of material on account, there are other outflows of cash for the company, and management must estimate all other cash payments for the year. Typically, this includes the manufacturing overhead budget, the sales and administrative budget, the capital asset budget, and any other potential payments of cash. Since depreciation is an expense not requiring cash, the cash budget includes the amount from the budgets less depreciation. Cash payments are listed on the cash budget following cash receipts. Figure \(8\) shows the major components of the cash budget.
The cash budget totals the cash receipts and adds it to the beginning cash balance to determine the available cash. From the available cash, the cash payments are subtracted to compute the net cash excess or deficiency of cash for the quarter. This amount is the potential ending cash balance. Organizations typically require a minimum cash balance. If the potential ending cash balance does not meet the minimum amount, management must plan to acquire financing to reach that amount. If the potential ending cash balance exceeds the minimum cash balance, the excess amount may be used to pay any financing loans and interest.
Big Bad Bikes has a minimum cash balance requirement of \(\$10,000\) and has a line of credit available for an interest rate of \(19\%\). They also plan to issue additional capital stock for \(\$5,000\) in the first quarter, to pay taxes of \(\$1,000\) during each quarter, and to purchase a copier for \(\$8,500\) cash in the third quarter. The beginning cash balance for Big Bad Bikes is \(\$13,000\), which can be used to create the cash budget shown in Figure \(9\).
Budgeted Balance Sheet
The cash budget shows how cash changes from the beginning of the year to the end of the year, and the ending cash balance is the amount shown on the budgeted balance sheet. The budgeted balance sheet is the estimated assets, liabilities, and equities that the company would have at the end of the year if their performance were to meet its expectations. Table \(1\) shows a list of the most common changes to the balance sheet and where the information is derived.
Table \(1\): Common Changes in the Budgeted Balance Sheet
Information Source Balance Sheet Change
Cash balance ending cash balance from the cash budget
Accounts Receivable balance uncollected receivables from the cash collections schedule
Inventory ending balance in inventory as shown from calculations to create the income statement
Machinery & Equipment ending balance in the capital asset budget
Accounts Payable unpaid purchases from the cash payments schedule
Other balance sheet changes throughout the year are reflected in the income statement and statement of cash flows. For example, the beginning cash balance of Accounts Receivable plus the sales, less the cash collected results in the ending balance of Accounts Receivable. A similar formula is used to compute the ending balance in Accounts Payable. Other budgets and information such as the capital asset budget, depreciation, and financing loans are used as well.
To explain how to use a budgeted balance sheet, let’s return to Big Bad Bikes. For simplicity, assume that they did not have accounts receivable or payable at the beginning of the year. They also incurred and paid back their financing during the year, so there is no ending debt. However, the cash budget shows cash inflows and outflows not related to sales or the purchase of materials. The company’s capital assets increased by \(\$8,500\) from the copier purchase, and their common stock increased by \(\$5,000\) from the additional issue as shown in Figure \(10\).
Though there seem to be many budgets, they all fit together like a puzzle to create an overall picture of how a company expects the upcoming business year to look. Figure \(1\) detailed the components of the master budget, and can be used to summarize the budget process. All budgets begin with the sales budget. This budget estimates the number of units that need to be manufactured and precedes the production budget. The production budget (refer to Figure 7.1.5) provides the necessary information for the budgets needed to plan how many units will be produced. Knowing how many units need to be produced from the production budget, the direct materials budget, direct labor budget, and the manufacturing overhead budget are all prepared. The sales and administrative budget is a nonmanufacturing budget that relies on the sales estimates to pay commissions and other variable expenses. The sales and expenses estimated in all of these budgets are used to develop a budgeted income statement.
The estimated sales information is used to prepare the cash collections schedule, and the direct materials budget is used to prepare the cash payment schedule. The cash receipts and cash payments budget are combined with the direct labor budget, the manufacturing overhead budget, the sales and administrative budget, and the capital assets budget to develop the cash budget. Finally, all the information is used to flow to the budgeted balance sheet.
Example \(1\): Creating a Master Budget
Molly Malone is starting her own company in which she will produce and sell Molly’s Macaroons. Molly is trying to learn about the budget process as she puts her business plan together. Help Molly by explaining the optimal order for preparing the following budgets and schedules and why this is the optimal order.
• budgeted balance sheet
• budgeted income statement
• capital asset budget
• cash budget
• cash collections schedule
• cash payments schedule
• direct materials budget
• direct labor budget
• master budget
• manufacturing overhead
• production budget
• sales budget
• selling and administrative budget
Solution
A master budget always begins with the sales budget must be prepared first as this determines the number of units that will need to be produced. The next step would be to create the production budget, which helps determine the number of units that will need to be produced each period to meet sales goals. Once Molly knows how many units she will need to produce, she will need to budget the costs associated with those units, which will require her to create the direct materials budget, the direct labor budget and the manufacturing overhead budget. But Molly will have costs other than manufacturing costs so she will need to create a selling and administrative expenses budget. Molly will need to determine what are her capital asset needs and budget for those. Now that Molly has all her revenues budgeted and her costs budgeted, she can determine her budgeted cash inflows and outflows by putting together the cash schedules that lead to the cash budget. Molly will then need to create a cash collections schedule and a cash payments schedule and that information, along with the cash inflow and outflow information from her other budgets, will allow her to create her cash budget. Once Molly has completed her cash budget she will be able to put together her budgeted income statement and budgeted balance sheet. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/07%3A_Budgeting/7.04%3A_Prepare_Financial_Budgets.txt |
A company makes a budget for the smallest time period possible so that management can find and adjust problems to minimize their impact on the business. Everything starts with the estimated sales, but what happens if the sales are more or less than expected? How does this affect the budget? What adjustments does a company have to make in order to compare the actual numbers to budgeted numbers when evaluating results? If production is higher than planned and has been increased to meet the increased sales, expenses will be over budget. But is this bad? To account for actual sales and expenses differing from budgeted sales and expenses, companies will often create flexible budgets to allow budgets to fluctuate with future demand.
Flexible Budgets
A flexible budget is one based on different volumes of sales. A flexible budget flexes the static budget for each anticipated level of production. This flexibility allows management to estimate what the budgeted numbers would look like at various levels of sales. Flexible budgets are prepared at each analysis period (usually monthly), rather than in advance, since the idea is to compare the operating income to the expenses deemed appropriate at the actual production level.
Big Bad Bikes is planning to use a flexible budget when they begin making trainers. The company knows its variable costs per unit and knows it is introducing its new product to the marketplace. Its estimations of sales and sales price will likely change as the product takes hold and customers purchase it. Big Bad Bikes developed a flexible budget that shows the change in income and expenses as the number of units changes. It also looked at the effect a change in price would have if the number of units remained the same. The expenses that do not change are the fixed expenses, as shown in Figure \(1\).
Static versus Flexible Budgets
A static budget is one that is prepared based on a single level of output for a given period. The master budget, and all the budgets included in the master budget, are examples of static budgets. Actual results are compared to the static budget numbers as one means to evaluate company performance. However, this comparison may be like comparing apples to oranges because variable costs should follow production, which should follow sales. Thus, if sales differ from what is budgeted, then comparing actual costs to budgeted costs may not provide a clear indicator of how well the company is meeting its targets. A flexible budget created each period allows for a comparison of apples to apples because it will calculate budgeted costs based on the actual sales activity.
For example, Figure \(2\) shows a static quarterly budget for \(1,500\) trainers sold by Big Bad Bikes. The budget will change if there are more or fewer units sold.
Budget with Varying Levels of Production
Companies develop a budget based on their expectations for their most likely level of sales and expenses. Often, a company can expect that their production and sales volume will vary from budget period to budget period. They can use their various expected levels of production to create a flexible budget that includes these different levels of production. Then, they can modify the flexible budget when they have their actual production volume and compare it to the flexible budget for the same production volume. A flexible budget is more complicated, requires a solid understanding of a company’s fixed and variable expenses, and allows for greater control over changes that occur throughout the year. For example, suppose a proposed sale of items does not occur because the expected client opted to go with another supplier. In a static budget situation, this would result in large variances in many accounts due to the static budget being set based on sales that included the potential large client. A flexible budget on the other hand would allow management to adjust their expectations in the budget for both changes in costs and revenue that would occur from the loss of the potential client. The changes made in the flexible budget would then be compared to what actually occurs to result in more realistic and representative variance. This ability to change the budget also makes it easier to pinpoint who is responsible if a revenue or cost target is missed.
Big Bad Bikes used the flexible budget concept to develop a budget based on its expectation that production levels will vary by quarter. By the fourth quarter, sales are expected to be strong enough to pay back the financing from earlier in the year. The budget shown in Figure \(3\) illustrates the payment of interest and contains information helpful to management when determining which items should be produced if production capacity is limited.
CONCEPTS IN PRACTICE: Flexible Budgets and Sustainability
The ability to provide flexible budgets can be critical in new or changing businesses where the accuracy of estimating sales or usage my not be strong. For example, organizations are often reporting their sustainability efforts and may have some products that require more electricity than other products. The reporting of the energy per unit of output has sometimes been in error and can mislead management into making changes that may or may not help the company. For example, based on the energy per unit reported, management may decide to change the product mix, the amount that is outsourced, and/or the amount that is produced.1 If the energy output isn’t correct, the decisions may be wrong and create an adverse impact on the budget.
LINK TO LEARNING
In theory, a flexible budget is not difficult to develop since the variable costs change with production and the fixed costs remain the same. However, planning to meet an organization’s goals can be very difficult if there are not many variable costs, if the cash inflows are relatively fixed, and if the fixed costs are high. For example, this article shows some large U.S. cities are faced with complicated budgets because of high fixed costs.
Footnotes
1. Jon Bartley, et al. “Using Flexible Budgeting to Improve Sustainability Measures.: American Institute of CPAs. Jan. 23, 2017. https://www.aicpa.org/interestareas/...ymeasures.html | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/07%3A_Budgeting/7.05%3A_Prepare_Flexible_Budgets.txt |
As you’ve learned, an advantage of budgeting is evaluating performance. Having a strong understanding of their budgets helps managers keep track of expenses and work toward the company’s goals. Companies need to understand their revenue and expense details to develop budgets as a tool for planning operations and cash flow. Part of understanding revenue and expenses is evaluating the prior year. Did the company earn the expected profit? Could it have earned a higher profit? What expenses or revenues were not on the budget? Critically evaluating the actual results versus the estimated budgetary results can help management plan for the future. Variance analysis helps the manager analyze its results. It does not necessarily find a problem, but it does indicate where a problem may exist. The same is true for favorable variances as well as unfavorable variances. A favorable variance occurs when revenue is higher than budgeted or expenses are lower than budgeted. An unfavorable variance is when revenue is lower than budgeted or expenses are higher than budgeted.
Table \(1\): Comparing Favorable to Unfavorable Variances
Favorable Unfavorable
Actual Sales > Budgeted Sales Actual Sales < Budgeted Sales
Actual Expenses < Budgeted Expenses Actual Expenses > Budgeted expenses
It is easy to understand that an unfavorable variance may be a problem. But that is not always true, as a higher labor rate may mean the company has a higher quality employee who is able to waste less material. Likewise, having a favorable variance indicates that more revenue was earned or less expenses were incurred but further analysis can indicate if costs were cut too far and better materials should have been purchased.
If a company has only a static budget, meaningful comparisons are difficult. Analyzing the sales for Bid Bad Bikes will illustrate whether there was a profit and how net income impacts the company. In the third quarter, Big Bad Bikes sold \(1,400\) trainers and had third quarter net income of \(\$15,915\) as shown in Figure \(1\).
The company earned a profit during the third quarter, but what does that mean to the company? Simply having net income instead of a net loss does not help plan for the future. The third quarter static budget was for the sale of \(1,500\) units. Comparing that budget to the actual results shows whether there is a favorable variance or an unfavorable variance. A comparison of the actual costs with the budget for the third quarter, as shown in Figure \(2\), has a favorable variance for all of the expenses and an unfavorable variance for everything associated with revenues.
How do those results advise management when evaluating the company’s performance? It is difficult to look at one variance and make a conclusion about the company or its management. However, the variances can help narrow down the areas that need addressing because they differ from the budgeted amount. For example, looking at the variance when using a static budget does not indicate the amount of the variance results because they sold 100 fewer units than budgeted. The variance for the cost of goods sold is favorable, but it should be if production was less than the budget. A static budget does not evaluate whether costs for \(1,400\) were appropriate for production of those \(1,400\) units.
Using a static budget to evaluate performance affects the bottom line as well as the individual expenses. The net income for the sale of \(1,400\) units is less than the budgeted net income for \(1,500\) units, but it does not indicate whether expenses were appropriate for \(1,400\) units. If there had been \(1,600\) units sold, the expenses would be more than the budgeted amount, but sales would be higher. Would it be fair to evaluate a manager’s control over their expenses using a static budget?
ETHICAL CONSIDERATIONS: Budget Manipulation and Ethics Training
Why is ethics training important? An organization that bases a manager’s evaluation and pay on how close to the budget the division performs may inadvertently encourage that manager to act unethically in order to get a pay raise. Many employees manipulate the budget process to enhance their earnings by garnering bonuses based upon questionably ethical behavior and improper financial reporting. Generally, this unethical behavior involves either manipulating the numbers in the budget or modifying the timing of reports to apply income to a different budget period. Kenton Walker and Gary Fleischman studied ethics in budgeting and determined that certain ethics-related structures in a business created a better operational environment.
The study found that the existence of formal ethical codes, ethics training, good management role models, and social pressure to be disclosing within an organization can be a deterrent to budget manipulation by employees. The authors recommended: “Therefore, organizations should carefully cultivate an ethical atmosphere that is sensitive to the pressures employees may feel to game the budget through actions that involve cheating and/or manipulating earnings targets to maximize bonuses.” 1 The study concluded that requiring organizational ethics training that includes role playing helps teach ethical behavior in budgeting and other areas of business. Ethics training never goes out so style.
Evaluating the expenses on a flexible budget computed for the number of units sold would provide an indication of management’s ability to control expenses. As shown in Figure \(3\), some expenses have a favorable variance, while others have an unfavorable variance. This type of variance analysis provides more information to evaluate management and help prepare the next year’s budget. For example, the direct labor in the flexible budget comparison shows an unfavorable variance, meaning the direct labor expense was more than budgeted for the production of \(1,400\) units. When comparing direct labor expense, the direct labor in the static budget mentioned earlier was even larger because it computed direct labor required to manufacture \(1,500\) units. It is not surprising that the static budget variance is favorable because \(100\) fewer units were actually produced. However, that information is not as useful as the unfavorable variance when comparing \(1,400\) units produced versus the budgeted direct labor for \(1,400\) units used.
THINK IT THROUGH: A Budget for a New Business
You are beginning your own business and developed a budget based on modest sales and expense assumptions. The actual results are very close to the budget at the end of the first and second months. During the third month, both cash collected and paid differ significantly from the budget. What could be the cause and what should you do?
LINK TO LEARNING
Budgeting is only the beginning of the process. Evaluating the results to determine if the financial goals are being met can make the difference in whether an organization or individual meets its goals or not. Forbes recognizes that budgeting is an important personal task that should start early in one’s professional career. This article provides some custom budgeting guidelines for young adults to help.
Footnotes
1. Kenton B. Walker, et al. “Toeing the Line: The Ethics of Manipulating Budgets and Earnings.” Management Accounting Quarterly 14, no. 3 (Spring 2013). https://www.imanet.org/-/media/f4869...45a0192ff.ashx | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/07%3A_Budgeting/7.06%3A_Explain_How_Budgets_Are_Used_to_Evaluate_Goals.txt |
Section Summaries
7.1 Describe How and Why Managers Use Budgets
• A good budgeting system assists management in reaching their goals through the planning and control of cash inflows through revenue and financing and outflows through payment and expenses.
• There are various budgeting strategies including bottom-up, top-down, and zero-based budgeting.
• A static budget is prepared at one level of activity, while a flexible budget allows the variable expenses to be adjusted for various levels of activity.
• A master budget includes the subcategories of operating budgets and financial budgets.
• A master budget is developed at the estimated level of activity.
7.2 Prepare Operating Budgets
• The sales budget is the first budget developed, and the estimated sales in turn guide the production budget.
• The production budget shows the quantity of goods produced for each time period and leads to computing when and how much direct material needs to be ordered, when and how much labor needs to be scheduled, and when and how much manufacturing overhead needs to be planned.
• The sales and administrative budget plans for the nonmanufacturing expenses.
• All operating budgets combine to develop the budgeted income statement.
7.3 Prepare Financial Budgets
• The financial budgets include the capital asset budget and the cash budget. The cash collections schedule and cash payments schedule are computed and combined with the other budgets to develop the cash budget.
• Information from the other budgets and the budgeted income statement are used to develop the budgeted balance sheet.
7.4 Prepare Flexible Budgets
• A master budget and related budgets are prepared as static budgets for the estimated level of activity.
• A flexible budget adjusts the budgets for various levels of activity and allows for the actual results to be evaluated at the actual volume of activity.
7.5 Explain How Budgets Are Used to Evaluate Goals
• Management’s evaluations of the actual results versus the estimated budgetary results help plan for the future.
• Favorable variances occur when sales are higher or expenses are lower than budgeted.
• Unfavorable variances occur when sales are lower or expenses are higher than budgeted.
Key Terms
budget
quantitative plan estimating when and how much cash or other resources will be received and how the cash or other resources will be used
budgeted balance sheet
estimated assets, liabilities, and equities that the company would have at the end of the year if their performance were to meet its expectations
budgeted income statement
statement similar to a traditional income statement except it contains budgeted data
capital asset budget
budget showing the organization’s plans to invest in long-term assets
cash budget
combined budget of all cash inflows and outflows of the organization
cash collections schedule
schedule showing when cash will be received from customers
cash payments schedule
schedule showing when cash will be used to pay for direct material purchases
direct labor budget
budget based on the production budget used to ensure the proper amount of staff is available for production and that there is money available to pay for the labor
direct materials budget
budget combining the production budget with the direct material per unit to ensure the proper quantity of direct materials is available when needed for production
financial budget
category of budgeting that details estimates for cash inflows and outflows through planned operations and changes capital investments of assets, liabilities, and equities
flexible budget
budget based on different levels of activity
manufacturing overhead budget
budget including the remainder of the production costs not covered by the direct materials and direct labor budgets
master budget
overall budget that includes the operating and financial budgets
operating budget
category of budgeting that helps managers plan and manage production, order materials, schedule direct labor, and monitor overhead expenses
production budget
budget showing the number of units that need to be produced for each period based on sales estimates and required inventory levels
rolling budget
budget that is continuously updated by adding an additional budget period at the end of the current budget period
sales budget
budget showing the expected sales in units and the sales price for the budget period
selling and administrative expense budget
budget showing the variable and fixed expenses estimated to be incurred in all areas other than production
static budget
budget prepared for a single level of activity for a given period
zero-based budgeting
budget that begins with zero dollars and then includes in the budget only revenue and expenses that can be supported or justified | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/07%3A_Budgeting/7.07%3A_Summary_and_Key_Terms.txt |
Multiple Choice
1. Which of the following is not a part of budgeting?
1. planning
2. finding bottlenecks
3. providing performance evaluations
4. preventing net operating losses
Answer:
d
1. Which of the following is an operating budget?
1. cash budget
2. production budget
3. tax budget
4. capital budget
2. Which of the following is a finance budget?
1. cash budget
2. production budget
3. direct materials purchasing budget
4. tax budget
Answer:
a
1. Which approach is most likely to result in employee buy-in to the budget?
1. top-down approach
2. bottom-up approach
3. total participation approach
4. basing the budget on the prior year
2. Which approach requires management to justify all its expenditures?
1. bottom-up approach
2. zero-based budgeting
3. master budgeting
4. capital allocation budgeting
Answer:
b
1. Which of the following is true in a bottom-up budgeting approach?
1. Every expense needs to be justified.
2. Supervisors tell departments their budget amount and the departments are free to work within those amounts.
3. Departments budget their needs however they see fit.
4. Departments determine their needs and relate them to the overall goals.
2. The most common budget is prepared for a ________.
1. week
2. month
3. quarter
4. year
Answer:
d
1. Which of the operating budgets is prepared first?
1. production budget
2. sales budget
3. cash received budget
4. cash payments budget
2. The direct materials budget is prepared using which budget’s information?
1. cash payments budget
2. cash receipts budget
3. production budget
4. raw materials budget
Answer:
c
1. Which of the following is not an operating budget?
1. sales budget
2. production budget
3. direct labor budget
4. cash budget
2. Which of the following statements is not correct?
1. The sales budget is computed by multiplying estimated sales by the sales price.
2. The production budget begins with the sales estimated for each period.
3. The direct materials budget begins with the sales estimated for each period.
4. The sales budget is typically the first budget prepared.
Answer:
c
1. The units required in production each period are computed by which of the following methods?
1. adding budgeted sales to the desired ending inventory and subtracting beginning inventory
2. adding beginning inventory, budgeted sales, and desired ending inventory
3. adding beginning inventory to budgeted sales and subtracting desired ending inventory
4. adding budgeted sales to the beginning inventory and subtracting the desired ending inventory.
2. The cash budget is part of which category of budgets?
1. sales budget
2. cash payments budget
3. finance budget
4. operating budget
Answer:
c
1. Which is not a section of the cash budget?
1. cash receipts
2. cash disbursements
3. allowance for uncollectible accounts
4. financing needs
2. Which budget is the starting point in preparing financial budgets?
1. the budgeted income statement
2. the budgeted balance sheet
3. the capital expense budget
4. the cash receipts budget
Answer:
a
1. Which of the following includes only financial budgets?
1. capital asset budget, budgeted income statement, sales budget
2. production budget, capital asset budget, budgeted balance sheet
3. cash budget, budgeted balance sheet, capital asset budget
4. budgeted income statement, direct material purchases budget, cash budget
2. Which budget evaluates the results of operations at the actual level of activity?
1. capital budget
2. cash budget
3. flexible budget
4. static budget
Answer:
c
1. What is the main difference between static and flexible budgets?
1. The fixed manufacturing overhead is adjusted for units sold in the flexible budget.
2. The variable manufacturing overhead is adjusted in the static budget.
3. There is no difference between the budgets.
4. The variable costs are adjusted in a flexible budget.
Questions
1. What is a budget and what are the different types of budgets?
Answer:
A budget is a written financial plan for a set period, which is typically a year. There are several different types of budgets including the master budget, operating budget, financial budget, flexible budget, and operating budget.
1. What is the difference between budgeting and long-range planning?
2. What are the advantages and disadvantages of the bottom-up budgeting approach?
Answer:
This approach begins at the lowest levels of management. These managers know the details involved with their departments. This allows for more accurate budget estimates when management understands how their department contributes to the company’s goals. Disadvantages include that this type of budgeting takes time, which leads to more labor costs, and when management doesn’t fully understand how it contributes to the company goals, the budget may support the department and not the company.
1. Why might a rolling budget require more management participation than an annual budget?
2. What information is necessary for the operating budgets?
Answer:
Operating budgets plan the primary operations of the business and need accurate information in order to provide accurate planning. Assumptions such as sales in units, sales price, desired ending inventory in units, manufacturing costs per unit, which include direct material needed per unit, desired direct materials ending inventory, amount of direct labor hours and rate, and the overhead required for production and managing the company.
1. What operating budget exists for manufacturing but not for a retail company?
2. What is the process for developing a budgeted balance sheet?
Answer:
The budgeted income statement includes the estimated revenue and expenses for the company. Using historical data on cash collections helps plan when the cash will be received and is used to develop the cash collections schedule. The company applies its payment policies on its purchases and other items requiring cash expenditures. This creates the cash payments schedule. Information from the cash collections schedule, cash payments schedule, and the capital expense budget are combined to develop the cash budget. The information from the cash budget and the ending balance sheet from the preceding year are used to develop the budgeted balance sheet.
1. Which of the financial budgets is the most important? Why?
2. A company has prepared the operating budget and the cash budget. It is now preparing the budgeted balance sheet. Identify the document that contains each of these balances.
1. cash
2. accounts receivable
3. finished goods inventory
4. accounts payable
5. equipment purchases
Answer:
1. cash budget
2. cash receipts budget
3. production budget
4. cash payments schedule
5. capital assets budge
1. Fill in the blanks: A flexible budget summarizes _______ and _______ for various volume levels by adjusting the _______ costs for the various levels of activities. The _______ costs remain the same for all levels of activities.
2. What information is included in the capital asset budget?
Answer:
This budget is the plan for the purchase and disposal of plant assets and lists the estimated dollar amounts for each
1. Why does budget planning typically begin with the sales forecast?
2. What steps should be considered if a budget is to be set and later have its results evaluated?
Answer:
Before the time period begins, the organization’s goals should be defined so the budget can be set to achieve the goals. During the time period, the results should be properly measured and reported so necessary changes can be made during the year. Then, the results of the operations can be evaluated and compared to the original budget and organization’s goals.
Exercise Set A
1. Blue Book printing is budgeting sales of \(25,000\) units and already has \(5,000\) in beginning inventory. How many units must be produced to also meet the \(7,000\) units required in ending inventory?
2. How many units are in beginning inventory if \(32,000\) units are budgeted for sales, \(35,000\) units are produced, and the desired ending inventory is \(9,000\) units?
3. Navigator sells GPS trackers for \(\$50\) each. It expects sales of \(5,000\) units in quarter 1 and a \(5\%\) increase each subsequent quarter for the next 8 quarters. Prepare a sales budget by quarter for the first year.
4. One Device makes universal remote controls and expects to sell \(500\) units in January, \(800\) in February, \(450\) in March, \(550\) in April, and \(600\) in May. The required ending inventory is \(20\%\) of the next month’s sales. Prepare a production budget for the first four months of the year.
5. Sunrise Poles manufactures hiking poles and is planning on producing \(4,000\) units in March and \(3,700\) in April. Each pole requires a half pound of material, which costs \(\$1.20\) per pound. The company’s policy is to have enough material on hand to equal \(10\%\) of the next month’s production needs and to maintain a finished goods inventory equal to \(25\%\) of the next month’s production needs. What is the budgeted cost of purchases for March?
6. Given the following information from Rowdy Enterprises’ direct materials budget, how much direct materials needs to be purchased?
1. Each unit requires direct labor of \(2.2\) hours. The labor rate is \(\$11.50\) per hour and next year’s direct labor budget totals \(\$834,900\). How many units are included in the production budget for next year?
2. How many units are estimated to be sold if Skyline, Inc., has a planned production of \(900,000\) units, a desired beginning inventory of \(160,000\) units, and a desired ending inventory of \(100,000\) units?
3. Cash collections for Wax On Candles found that \(60\%\) of sales were collected in the month of the sale, \(30\%\) was collected the month after the sale, and \(10\%\) was collected the second month after the sale. Given the sales shown, how much cash will be collected in January and February?
1. Nonna’s Re-Appliance Store collects \(55\%\) of its accounts receivable in the month of sale and \(40\%\) in the month after the sale. Given the following sales, how much cash will be collected in February?
1. Dream Big Pillow Co. pays \(65\%\) of its purchases in the month of purchase, \(30\%\) the month after the purchase, and \(5\%\) in the second month following the purchase. It made the following purchases at the end of 2017 and the beginning of 2018:
1. Desiccate purchases direct materials each month. Its payment history shows that \(70\%\) is paid in the month of purchase with the remaining balance paid the month after purchase. Prepare a cash payment schedule for March if in January through March, it purchased \(\$35,000\), \(\$37,000\), and \(\$39,000\), respectively.
2. What is the amount of budgeted cash payments if purchases are budgeted for \(\$420,000\) and the beginning and ending balances of accounts payable are \(\$95,000\) and \(\$92,000\), respectively?
3. Halifax Shoes has \(30\%\) of its sales in cash and the remainder on credit. Of the credit sales, \(65\%\) is collected in the month of sale, \(25\%\) is collected the month after the sale, and \(5\%\) is collected the second month after the sale. How much cash will be collected in August if sales are estimated as \(\$75,000\) in June, \(\$65,000\) in July, and \(\$90,000\) in August?
4. Cold X, Inc. uses this information when preparing their flexible budget: direct materials of \(\$2\) per unit, direct labor of \(\$3\) per unit, and manufacturing overhead of \(\$1\) per unit. Fixed costs are \(\$35,000\). What would be the budgeted amounts for \(20,000\) and \(25,000\) units?
5. Using the provided budgeted information for production of \(10,000\) and \(15,000\) units, prepare a flexible budget for \(17,000\) units.
1. The production cost for a waterproof phone case is \(\$7\) per unit and fixed costs are \(\$23,000\) per month. How much is the favorable or unfavorable variance if \(5,500\) units were produced for a total of \(\$61,000\)?
Exercise Set B
1. Lovely Wedding printing is budgeting sales of \(32,000\) units and already has \(4,000\) in beginning inventory. How many units must be produced to also meet the \(6,000\) units required in ending inventory?
2. How many units are in beginning inventory if \(32,000\) units are budgeted for sales, \(35,000\) units are produced, and the desired ending inventory is \(9,000\) units?
3. Barnstormer sells airplane accessories for \(\$20\) each. It expects sales of \(120,000\) units in quarter 1 and a \(7\%\) increase each subsequent quarter for the next 8 quarters. Prepare a sales budget by quarter for the first year.
4. Rehydrator makes a nutrition additive and expects to sell \(3,000\) units in January, \(2,000\) in February, \(2,500\) in March, \(2,700\) in April, and \(2,900\) in May. The required ending inventory is \(20\%\) of the next month’s sales, and the beginning inventory on January 1 was \(600\) units. Prepare a production budget for the first four months of the year.
5. Cloud Shoes manufactures recovery sandals and is planning on producing \(12,000\) units in March and \(11,500\) in April. Each sandal requires \(1.2\) yards if material, which costs \(\$3.00\) per yard. The company’s policy is to have enough material on hand to equal \(15\%\) of next month’s production needs and to maintain a finished goods inventory equal to \(20\%\) of the next month’s production needs. What is the budgeted cost of purchases for March?
6. Given the following information from Power Enterprises’ direct materials budget, how much direct materials needs to be purchased?
1. Each unit requires direct labor of \(4.1\) hours. The labor rate is \(\$13.75\) per hour and next year’s production is estimated at \(75,000\) units. What is the amount to be included in next year’s direct labor budget?
2. How many units are estimated to be sold if Kino, Inc., has planned production of \(750,000\) units, a desired beginning inventory of \(30,000\) units, and a desired ending inventory of \(45,000\) units?
3. Cash collections for Renew Lights found that \(65\%\) of sales were collected in the month of sale, \(25\%\) was collected the month after the sale, and \(10\%\) was collected the second month after the sale. Given the sales shown, how much cash will be collected in March and April?
1. My Aunt’s Closet Store collects \(60\%\) of its accounts receivable in the month of sale and \(35\%\) in the month after the sale. Given the following sales, how much cash will be collected in March?
1. Gear Up Co. pays \(65\%\) of its purchases in the month of purchase, \(30\%\) in the month after the purchase, and \(5\%\) in the second month following the purchase. What are the cash payments if it made the following purchases in 2018?
1. Drainee purchases direct materials each month. Its payment history shows that \(65\%\) is paid in the month of purchase with the remaining balance paid the month after purchase. Prepare a cash payment schedule for January using this data: in December through February, it purchased \(\$22,000\), \(\$25,000\), and \(\$23,000\) respectively.
2. What is the amount of budgeted cash payments if purchases are budgeted for \(\$190,500\) and the beginning and ending balances of accounts payable are \(\$21,000\) and \(\$25,000\), respectively?
3. Earthie’s Shoes has \(55\%\) of its sales in cash and the remainder on credit. Of the credit sales, \(70\%\) is collected in the month of sale, \(15\%\) is collected the month after the sale, and \(10\%\) is collected the second month after the sale. How much cash will be collected in June if sales are estimated as \(\$75,000\) in April, \(\$65,000\) in May, and \(\$90,000\) in June?
4. Judge’s Gavel uses this information when preparing their flexible budget: direct materials of \(\$3\) per unit, direct labor of \(\$2.50\) per unit, and manufacturing overhead of \(\$1.25\) per unit. Fixed costs are \(\$49,000\). What would be the budgeted amounts for \(33,000\) and \(35,000\) units?
5. Using the following budgeted information for production of \(5,000\) and \(12,000\) units, prepare a flexible budget for \(9,000\) units.
1. The production cost for UV protective sunglasses is \(\$5.50\) per unit and fixed costs are \(\$19,400\) per month. How much is the favorable or unfavorable variance if \(14,000\) units were produced for a total of \(\$97,000\)?
Problem Set A
1. Lens Junction sells lenses for \(\$45\) each and is estimating sales of \(15,000\) units in January and \(18,000\) in February. Each lens consists of \(2\) pounds of silicon costing \(\$2.50\) per pound, \(3\) oz of solution costing \(\$3\) per ounce, and \(30\) minutes of direct labor at a labor rate of \(\$18\) per hour. Desired inventory levels are:
Prepare a sales budget, production budget, direct materials budget for silicon and solution, and a direct labor budget.
1. The data shown were obtained from the financial records of Italian Exports, Inc., for March:
Sales are expected to increase each month by \(10\%\). Prepare a budgeted income statement.
1. Echo Amplifiers prepared the following sales budget for the first quarter of 2018:
It also has this additional information related to its expenses:
Prepare a sales and administrative expense budget for each month in the quarter ending March 31, 2018.
1. Prepare a budgeted income statement using the information shown.
1. Spree Party Lights overhead expenses are:
Prepare a manufacturing overhead budget if the number of units to produce for January, February, and March are \(2,500\), \(3,000\), and \(2,700\), respectively.
1. Relevant data from the Poster Company’s operating budgets are:
Additional data: Capital assets were sold in January for \(\$10,000\) and \(\$4,500\) in May. Dividends of \(\$4,500\) were paid in February. The beginning cash balance was \(\$60,359\) and a required minimum cash balance is \(\$59,000\). Use this information to prepare a cash budget for the first two quarters of the year.
1. Fill in the missing information from the following schedules:
1. Direct labor hours are estimated as \(2,000\) in Quarter 1; \(2,100\) in Quarter 2; \(1,900\) in Quarter 3; and \(2,300\) in Quarter 4. Prepare a manufacturing overhead budget using the information provided.
1. Fitbands’ estimated sales are:
What are the balances in accounts receivable for January, February, and March if \(65\%\) of sales is collected in the month of sale, \(25\%\) is collected the month after the sale, and \(10\%\) is second month after the sale?
1. Sports Socks has a policy of always paying within the discount period and each of its suppliers provides a discount of \(2\%\) if paid within \(10\) days of purchase. Because of the purchase policy, \(85\%\) of its payments are made in the month of purchase and \(15\%\) are made the following month. The direct materials budget provides for purchases of \(\$129,582\) in November, \(\$294,872\) in December, \(\$239,582\) in January, and \(\$234,837\) in February. What is the balance in accounts payable for January 31, and February 28?
2. Prepare a flexible budgeted income for \(120,000\) units using the following information from a static budget for \(100,000\) units:
1. Before the year began, the following static budget was developed for the estimated sales of \(100,000\). Sales are sluggish and management needs to revise its budget. Use this information to prepare a flexible budget for \(80,000\) and \(90,000\) units of sales.
1. Caribbean Hammocks currently sells \(75,000\) units at \(\$50\) per unit. Its expenses are:
Management believes it can increase sales by \(5,000\) units for every \(\$5\) decrease in sales price. It also believes the additional sales will allow a decrease in direct material of \(\$1\) for each additional \(5,000\) units. Prepare a flexible budgeted income statement for \(75,000-\), \(80,000-\), and \(85,000-\) unit sales.
1. Total Pop’s data show the following information:
New machinery will be added in April. This machine will reduce the labor required per unit and increase the labor rate for those employees qualified to operate the machinery. Finished goods inventory is required to be \(20\%\) of the next month’s requirements. Direct material requires \(2\) pounds per unit at a cost of \(\$3\) per pound. The ending inventory required for direct materials is \(15\%\) of the next month’s needs. In January, the beginning inventory is \(3,000\) units of finished goods and \(4,470\) pounds of material. Prepare a production budget, direct materials budget, and direct labor budget for the first quarter of the year.
1. Identify the document that contains the information listed in these lines from the budgeted balance sheet shown.
1. Cash
2. Accounts receivable
3. Raw materials inventory
4. Computers
5. Accounts payable
1. Titanium Blades refines titanium for use in all brands of razor blades. It prepared a static budget for the sales of \(5,000\) units. These variances were observed:
Determine the static budget and use the information to prepare a flexible budget and analysis for the \(6,000\) units actually sold.
Problem Set B
1. Lens & Shades sells sunglasses for \(\$37\) each and is estimating sales of \(21,000\) units in January and \(19,000\) in February. Each lens consists of \(2.00\) mm of plastic costing \(\$2.50\) per mm, \(1.7\) oz of dye costing \(\$2.80\) per ounce, and \(0.50\) hours direct labor at a labor rate of \(\$18\) per unit. Desired inventory levels are:
Prepare a sales budget, production budget, direct materials budget for silicon and solution, and a direct labor budget.
1. The following data were obtained from the financial records of Sonicbrush, Inc., for March:
Sales are expected to increase each month by 15%. Prepare a budgeted income statement.
1. TIB makes custom guitars and prepared the following sales budget for the second quarter
It also has this additional information related to its expenses:
Direct material per unit \(\$55\), Direct labor per hour \(20\), Variable manufacturing overhead per hour \(3.50\), Fixed manufacturing overhead per month \(3,000\), Sales commissions per unit \(20\), Sales salaries per month \(5,000\), Delivery expense per unit \(0.50\), Utilities per month \(4,000\), Administrative salaries per month \(20,000\), Marketing expenses per month \(8,000\), Insurance expense per month \(11,000\), Depreciation expense per month \(9,000\).
Prepare a sales and administrative expense budget for each month in the quarter ended June 30, 2018.
1. Prepare a budgeted income statement using the information shown.
1. Sunshine Gardens overhead expenses are:
Given production of \(10,200\); \(11,300\); \(12,900\); and \(13,200\) for each quarter of the next year, prepare a manufacturing overhead budget for each quarter.
1. Relevant data from the operating budget of The Framers are:
Other data:
• Capital assets were sold in quarter 1 and \(\$8,000\) was collected in quarter 1 and \(\$500\) collected in quarter 2.
• Dividends of \(\$500\) will be paid in May
• The beginning cash balance was \(\$50,000\) and a required minimum cash balance is \(\$10,000\).
• Prepare a cash budget for the first two quarters of the year.
1. Fill in the missing information from the following schedules:
1. Mesa Aquatics, Inc. estimated direct labor hours as \(1,900\) in quarter 1, \(2,000\) in quarter 2, \(2,200\) in quarter 3, and \(1,800\) in quarter 4. a sales and administration budget using the information provided.
1. Amusement tickets estimated sales are:
What are the balances in accounts receivable for April, May, and June if \(60\%\) of sales are collected in the month of sale, \(30\%\) are collected the month after the sale, and \(10\%\) are collected the second month after the sale?
1. All Temps has a policy of always paying within the discount period, and each of its suppliers provides a discount of \(2\%\) if paid within \(10\) days of purchase. Because of the purchase policy, \(80\%\) of its payments are made in the month of purchase and \(20\%\) are made the following month. The direct materials budget provides for purchases of \(\$23,812\) in February, \(\$23,127\) in March, \(\$21,836\) in April, and \(\$28,173\) in May. What is the balance in accounts payable for April 30, and May 31?
2. Prepare a flexible budgeted income statement for \(47,000\) units using the following information from a static budget for \(45,000\) units:
1. Before the year began, the following static budget was developed for the estimated sales of \(50,000\). Sales are higher than expected and management needs to revise its budget. Prepare a flexible budget for \(100,000\) and \(110,000\) units of sales.
1. Artic Camping Gear’s currently sells \(35,000\) units at \(\$73\) per unit. Its expenses are as follows:
Management believes it can increase sales by \(2,000\) units for every \(\$5\) decrease in sales price. It also believes the additional sales will allow a decrease in direct material of \(\$1\) for each additional \(2,000\) units. Prepare a flexible budgeted income statement for \(35,000-\), \(37,000-\), and \(39,000-\) unit sales.
1. Fruit Tea’s data show the following information:
New machinery will be added in October. This machine will reduce the labor required per unit and increase the labor rate for those employees qualified to operate the machinery. Finished goods inventory is required to be \(20\%\) of the next month’s requirements. Direct material requires \(2.5\) pounds per unit at a cost of \(\$5\) per pound. The ending inventory required for direct materials is \(20\%\) of the next month’s needs. In August, the beginning inventory is \(3,750\) units of finished goods and \(13,125\) pounds of materials. Prepare a production budget, direct materials budget, and direct labor budget for the first quarter of the year.
1. Identify the document that contains the information listed in these lines from the budgeted balance sheet shown.
1. Accounts receivable
2. Finished goods inventory
3. Machinery
4. Accumulated depreciation
5. Notes payable
6. Common stock
1. Replenish sells shampoo that removes chlorine from hair. It prepared a static budget for the sales of 10,000 units. These variances were observed:
Determine the static budget and use the information to prepare a flexible budget and analysis for the 8,000 units actually sold.
Thought Provokers
1. Why is a clear understanding of management’s goals and objectives necessary for effective budgets?
2. It is proper budgeting procedure to begin with estimated revenues, but why might some nonprofit entities begin planning their expenditures instead of their revenues?
3. How would a human resources department use information in the operating budgets?
4. How would maintenance departments use information in the budget?
5. How might service industries predict revenue?
6. The management of Hess, Inc., is developing a flexible budget for the upcoming year. It was not pleased with the small amount of net income the budget showed at all sales levels and is contemplating using a less expensive material. This action reduces direct material cost by \$1 per unit. What would be the effects on financial statements and a flexible budget if management takes this approach? Are there other factors that need to be considered?
7. When would a static budget be effective in evaluating a manager’s performance?
8. If management is being evaluated on their ability to manage a budget, what can they do to increase cash flow?
9. If management is being evaluated on their ability to manage a budget, what can they do to decrease cash outflow? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/07%3A_Budgeting/7.0E%3A_7.E%3A_Budgeting_%28Exercises%29.txt |
Thumbnail: pixabay.com/photos/calculato...urance-385506/
08: Standard Costs and Variances
Sam saw how much coffee his fellow students were drinking and decided to open a student-run coffee shop on campus. Sam knew that developing a plan for the coffee shop would help make the shop successful. He researched what types of coffee to offer, the hours the shop would be open, and the number of employees needed, by researching other coffee shops near campus. He brewed coffee to determine the cost of the coffee and the time it took to brew. He also served several friends to determine how long it would take to serve customers. He observed, in other coffee shops, how much cream and other additives are used by customers. He talked to several coffee suppliers for prices of his various materials. He looked at empty stores near campus to determine what his rent would be. Now that he has this information, he is not sure how to make it useful to him. How could he use this information to plan and control the operations of the shop? One calculation he can do is determine his standard costs.
What is the difference between a budget and a standard? A budget usually refers to a company’s projections for costs, revenues, and cash flows associated with the overall operations of the organization, or a subsection of the corporation such as a division. A standard usually refers to a company’s projected costs for a single unit of a product or service and includes the expected, or standard, cost for the various cost components of each unit, such as materials, labor, and overhead.
8.02: Explain How and Why a Standard Cost Is Developed
A syllabus is one way an instructor can communicate expectations to students. Students can use the syllabus to plan their studying to maximize their grade and to coordinate the amount and timing of studying for each course. Knowing what is expected, and when it is expected, allows for better plans and performance. When your performance does not match your expectations, a variance arises—a difference between the standard and the actual performance. You then need to determine why the difference occurred. You want to know why you did not receive the grade you expected so you can make adjustments for the next assignment to earn a better grade.
Companies operate in a similar manner. They have an expectation, or standard, for production. For example, if a company is producing tables, it might establish standards for such components as the amount of board feet of lumber expected to be used in producing each table or the number of hours of direct labor hours it expected to use in the table’s production. These standards can then be used in establishing standard costs that can be used in creating an assortment of different types of budgets.
When a variance occurs in its standards, the company investigates to determine the causes, so they can perform better in the future. For example, General Motors has standards for each item on a vehicle. It can determine the cost and selling price of a power antenna by knowing the standard material cost for the antenna and the standard labor cost of adding the antenna to the vehicle. General Motors also can add up all of the standard times for all vehicles it makes to determine if too much or too little labor was used in production.
LINK TO LEARNING
Developing standards is a complicated and costly process. Review this article on how to develop a standard cost system for more details.
Fundamentals of Standard Costs
It is important to establish standards for cost at the beginning of a period to prepare the budget; manage material, labor, and overhead costs; and create a reasonable sales price for a good. A standard cost is an expected cost that a company usually establishes at the beginning of a fiscal year for prices paid and amounts used. The standard cost is an expected amount paid for materials costs or labor rates. The standard quantity is the expected usage amount of materials or labor. A standard cost may be determined by past history or industry norms. The company can then compare the standard costs against its actual results to measure its efficiency. Sometimes when comparing standard costs against actual results, there is a difference.
This difference can be attributed to many reasons. For example, the coffee company mentioned in the opening vignette may expect to pay \(\$0.50\) per ounce for coffee grounds. After the company purchased the coffee grounds, it discovered it paid \(\$0.60\) per ounce. This variance would need to be accounted for, and possible operational changes would occur as a result. Cost accounting systems become more useful to management when they include budgeted amounts to serve as a point of comparison with actual results.
Many departments help determine standard cost. Product design, in conjunction with production, purchasing, and sales, determines what the product will look like and what materials will be used. Production works with purchasing to determine what material will work best in production and will be the most cost efficient. Sales will also help decide the material in terms of customer demand. Production will work with personnel to determine labor costs for the product, which is based on how long it will take to make the product, which departments will be involved, and what type and number of employees it will take.
Consider how many different materials can go into a product. For example, there are approximately \(14,000\) parts that comprise the average automobile. The manufacturer will set a standard price and a quantity used per automobile for each part, and it will determine the labor required to install the part. At Fiat Chrysler Automobiles’ Belvidere Assembly Plant, for example, there are approximately \(5,000\) employees assembling automobiles.1 In addition to having standard costs associated with each part, each employee has standards for the job he or she performs.
Standard costs are typically established for reasonably attainable levels of efficiency (production). They serve as a target and are useful in motivating standard performance. An ideal standard level is set assuming that everything is perfect, machines do not break down, employees show up on time, there are no defects, there is no scrap, and materials are perfect. This level of standard is not the best motivator, because employees may see this level as unattainable. For example, consider whether you would take a course if the letter grades were as follows: an \(A\) is \(99–100\%\), a \(B\) is \(98–99\%\), a \(C\) is \(97–98\%\), a \(D\) is \(96–97\%\), and below \(96\%\) is an \(F\). These standards are unreasonable and unrealistic, and they would not motivate students to do well in the course.
At the other end of the spectrum, if the standards are too easy, there is little motivation to do better, and products may not be properly built, may be built with inferior materials, or both. For example, consider how you would handle the following grading scale for your course: an \(A\) is \(50–100\%\), a \(B\) is \(35–50\%\), a \(C\) is \(10–35\%\), a \(D\) is \(2–10\%\), and below \(2\%\) is an \(F\). Would you learn anything? Would you try very hard? The same considerations come into play for employees with standards that are too easy.
Instead of these two extremes, a company would set an attainable standard, which is one that employees can reach with reasonable effort. The standards are not so high that employees will not try to reach them and not so low that they do not give any incentive for employees to achieve profitability.
In order for a company to establish its attainable standard cost for each product, it must consider the standard costs for materials, labor, and overhead. The material standard cost consists of a standard price per unit of material and a standard amount of material per unit. Returning to the opening vignette, let us say the coffee shop is trying to establish the standard materials cost for one cup of regular coffee. To keep the example simple, we are not incorporating the cost of water or the ceramic cup cost (since they are reused). Two components for the cup of coffee will need to be considered:
1. Price per ounce of coffee grounds
2. Amount of coffee grounds (materials) used per cup of coffee
To determine the standards for labor, the coffee shop would need to consider two additional components:
1. Labor rate per minute
2. Amount of time to make one cup of regular coffee
To determine the standard for overhead, the coffee shop would first need to consider the fact that it has two types of overhead as shown in Figure \(1\). Greater detail about the calculation of the variable and fixed overhead is provided in Compute and Evaluate Overhead Variances.
1. Fixed overhead (does not change in total with production)
2. Variable overhead (does change in total with production)
All of this information is entered on a standard cost card.
Once a company determines a standard cost, they can then evaluate any variances. A variance is the difference between a standard cost and actual performance. There are favorable and unfavorable variances. A favorable variance involves spending less, or using less, than the anticipated or estimated standard. An unfavorable variance involves spending more, or using more, than the anticipated or estimated standard. Before determining whether the variance is favorable or unfavorable, it is often helpful for the company to determine why the variance exists.
Example \(1\): Developing a Standard Cost Card
Use the information provided to create a standard cost card for production of one deluxe bicycle from Bicycles Unlimited.
To make one bicycle it takes four pounds of material. The material can usually be purchased for \(\$5.25\) per pound. The labor necessary to build a bicycle consists of two types. The first type of labor is assembly, which takes \(2.75\) hours. These workers are paid \(\$11.00\) per hour. The second type of labor is finishing, which takes \(4\) hours. These workers are paid \(\$15.00\) per hour. Overhead is applied using labor hours. The variable overhead rate is \(\$5.00\) per labor hour. The fixed overhead rate is \(\$3.00\) per hour.
ETHICAL CONSIDERATIONS: Ethical Variance Analysis
Variance analysis allows managers to see whether costs are different than planned. Once a difference between expected and actual costs is identified, variance analysis should delve into why the costs differ and what the magnitude of the difference means. To determine why a cost differs, it should be established if the additional cost provides a benefit or detriment to an organization’s stakeholders, the people or entities that are affected by the organization’s actions or inactions. Not all stakeholders are equal in the analysis, but an organization should recognize each stakeholder’s interest in the organization’s business and operational decisions, while ranking the importance of the stakeholder in relation to any decision made.
Ranking should look to how stakeholders are affected by costs and any decisions related to cost variance, or why the variance occurred. For example, if a cost variance is due to an additional cost to make a product eco-friendly, then an organization may determine that incurring the cost is a benefit to its stakeholders. However, if the additional cost creates an unfavorable situation for a stakeholder, the process incurring the cost should be investigated. Remember that the owners of a company, including shareholders, are also stakeholders. To determine the best course of action for an organization, cost analysis should help inform stakeholder analysis—the process of systematically gathering and analyzing all of the information related to a business decision.
Different factors may produce a variance. The company could have paid too much or too little for production. It may have purchased the wrong grade of material or hired employees with more or less experience than required. Sometimes the variances are interrelated. For example, purchasing substandard materials may lead to using more time to make the product and may produce more scrap. The substandard material may have been more difficult to work with or had more defects than the proper grade material. In such a situation, a favorable material price variance could cause an unfavorable labor efficiency variance and an unfavorable material quantity variance. Employees who do not have the expected experience level may save money in the wage rate but may require more hours to be worked and more material to be used because of their inexperience.
Another situation in which a variance may occur is when the cost of labor and/or material changes after the standard was established. Toward the end of the fiscal year, standards often become less reliable because time has passed and the environment has changed. It is not reasonable to expect the price of all materials and labor to remain constant for \(12\) months. For example, the grade of material used to establish the standard may no longer be available.
Manufacturing Cost Variances
As you’ve learned, the standard price and standard quantity are anticipated amounts. Any change from these budgeted amounts will produce a variance. There can be variances for materials, labor, and overhead. Direct materials may have a variance in price of materials or quantity of materials used. Direct labor may have a variance in the rate paid to workers or the amount of time used to make a product. Overhead may produce a variance in expected fixed or variable costs, leading to possible differences in production capacity and management’s ability to control overhead. More specifics on the formulas, processes, and interpretations of the direct materials, direct labor, and overhead variances are discussed in each of this chapter’s following sections.
2
Qualcomm Inc. is a large producer of telecommunications equipment focusing mainly on wireless products and services. As with any company, Qualcomm sets labor standards and must address any variances in labor costs to stay on budget, and control overall manufacturing costs.
In 2018, Qualcomm announced a reduction to its labor force, affecting many of its full-time and temporary workers. The reduction in labor was necessary to suppress rising expenses that could not be controlled through overhead or materials cost-cutting measures. The variances between standard labor rates and actual labor rates, and diminishing profit margins will have contributed to this decision. It is important for Qualcomm management to keep labor variances minimal in the future so that large workforce reductions are not required to control costs.
THINK IT THROUGH: Chocolate Cow Ice Cream Company
The Chocolate Cow Ice Cream Company has grown substantially recently, and management now feels the need to develop standards and compute variances. A consulting firm was hired to develop the standards and the format for the variance computation. One standard in particular that the consulting firm developed seemed too excessive to plant management. The consulting firm’s standard was production of \(100\) gallons of ice cream every \(45\) minutes. The plant’s middle level of management thought the standard should be \(100\) gallons every \(55\) minutes, while the top management of the company thought that the consulting firm’s standard would provide more motivation to the employees.
1. Why is the company establishing a standard for production?
2. What are some factors the company may need to consider before selecting one of the proposed standards?
Footnotes
1. “Belvidere Assembly Plant and Belvidere Satellite Stamping Plant.” Fiat Chrysler Automobiles. June 2018. http://media.fcanorthamerica.com/new...o?id=323&mid=1
2. Munsif Vengattil. “Qualcomm Begins Layoffs as Part of Cost Cuts.” Reuters. April 18, 2018. https://www.reuters.com/article/us-q...-idUSKBN1HP33L | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/08%3A_Standard_Costs_and_Variances/8.01%3A_Prelude_to_Standard_Costs_and_Variances.txt |
As you’ve learned, direct materials are those materials used in the production of goods that are easily traceable and are a major component of the product. The amount of materials used and the price paid for those materials may differ from the standard costs determined at the beginning of a period. A company can compute these materials variances and, from these calculations, can interpret the results and decide how to address these differences.
CONCEPTS IN PRACTICE: Buttering Popcorn
In a movie theater, management uses standards to determine if the proper amount of butter is being used on the popcorn. They train the employees to put two tablespoons of butter on each bag of popcorn, so total butter usage is based on the number of bags of popcorn sold. Therefore, if the theater sells 300 bags of popcorn with two tablespoons of butter on each, the total amount of butter that should be used is $600$ tablespoons. Management can then compare the predicted use of $600$ tablespoons of butter to the actual amount used. If the actual usage of butter was less than $600$, customers may not be happy, because they may feel that they did not get enough butter. If more than $600$ tablespoons of butter were used, management would investigate to determine why. Some reasons why more butter was used than expected (unfavorable outcome) would be because of inexperienced workers pouring too much, or the standard was set too low, producing unrealistic expectations that do not satisfy customers.
Fundamentals of Direct Materials Variances
The direct materials variances measure how efficient the company is at using materials as well as how effective it is at using materials. There are two components to a direct materials variance, the direct materials price variance and the direct materials quantity variance, which both compare the actual price or amount used to the standard amount.
Direct Materials Price Variance
The direct materials price variance compares the actual price per unit (pound or yard, for example) of the direct materials to the standard price per unit of direct materials. The formula for direct materials price variance is calculated as:
\begin{align} \begin{array}{c} \text{Direct Materials} \ \text {Price Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Quantity Used} \ \times\ \text {Actual Price Paid}\ \end{array} \right ) - \left (\begin{array}{c} \text{Actual Quantity Used} \ \times\ \text {Standard Price}\ \end{array} \right ) \end{align}
Factoring out actual quantity used from both components of the formula, it can be rewritten as:
\begin{align} \begin{array}{c} \text{Direct Materials} \ \text {Price Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Price per } \ \text {Unit of Materials}\ \end{array} - \begin{array}{c} \text{Standard Price per} \ \text {Unit of Materials}\ \end{array} \right ) \times \begin{array}{c} \text{Actual Quantity of } \ \text {Materials Used}\ \end{array} \end{align}
With either of these formulas, the actual quantity used refers to the actual amount of materials used to create one unit of product. The standard price is the expected price paid for materials per unit. The actual price paid is the actual amount paid for materials per unit. If there is no difference between the standard price and the actual price paid, the outcome will be zero, and no price variance exists.
If the actual price paid per unit of material is lower than the standard price per unit, the variance will be a favorable variance. A favorable outcome means you spent less on the purchase of materials than you anticipated. If, however, the actual price paid per unit of material is greater than the standard price per unit, the variance will be unfavorable. An unfavorable outcome means you spent more on the purchase of materials than you anticipated.
The actual price can differ from the standard or expected price because of such factors as supply and demand of the material, increased labor costs to the supplier that are passed along to the customer, or improvements in technology that make the material cheaper. The producer must be aware that the difference between what it expects to happen and what actually happens will affect all of the goods produced using these particular materials. Therefore, the sooner management is aware of a problem, the sooner they can fix it. For that reason, the material price variance is computed at the time of purchase and not when the material is used in production.
Let us consider an example. Connie’s Candy Company produces various types of candies that they sell to retailers. Connie’s Candy establishes a standard price for candy-making materials of $\7.00$ per pound. Each box of candy is expected to use $0.25$ pounds of candy-making materials. Connie’s Candy found that the actual price of materials was $\6.00$ per pound. They still actually use $0.25$ pounds of materials to make each box. The direct materials price variance computes as:
$\text { Direct Materials Price Variance }=(\ 6.00-\ 7.00) \times 0.25 \text { lb. }=\ 0.25 \text { or } \ 0.25 \text { (Favorable) } \nonumber$
In this case, the actual price per unit of materials is $\6.00$, the standard price per unit of materials is $\7.00$, and the actual quantity used is $0.25$ pounds. This computes as a favorable outcome. This is a favorable outcome because the actual price for materials was less than the standard price. As a result of this favorable outcome information, the company may consider continuing operations as they exist, or could change future budget projections to reflect higher profit margins, among other things.
Let us take the same example except now the actual price for candy-making materials is $\9.00$ per pound. The direct materials price variance computes as:
$\text { Direct Materials Price Variance }=(\ 9.00-\ 7.00) \times 0.25 \text { lbs. }=\ 0.50 \text { or } \ 0.50 \text { (Unfavorable) } \nonumber$
In this case, the actual price per unit of materials is $\9.00$, the standard price per unit of materials is $\7.00$, and the actual quantity used is $0.25$ pounds. This computes as an unfavorable outcome. This is an unfavorable outcome because the actual price for materials was more than the standard price. As a result of this unfavorable outcome information, the company may consider using cheaper materials, changing suppliers, or increasing prices to cover costs.
Another element this company and others must consider is a direct materials quantity variance.
THINK IT THROUGH: Don’t “Skirt” the Issue
You run a fabric store and order materials through a supplier. At the end of the month, you review your materials cost and discover that your direct materials price and quantity variances produced unfavorable results. What could be attributed to these unfavorable outcomes? How would these unfavorable outcomes impact the total direct materials variance?
Direct Materials Quantity Variance
The direct materials quantity variance compares the actual quantity of materials used to the standard materials that were expected to be used to make the actual units produced. The variance is calculated using this formula:
\begin{align} \begin{array}{c} \text{Direct Materials} \ \text {Quantity Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Quantity Used} \ \times\ \text {Standard Price }\ \end{array} \right ) - \left (\begin{array}{c} \text{Standard Quantity } \ \times\ \text {Standard Price}\ \end{array} \right ) \end{align}
Factoring out standard price from both components of the formula, it can be rewritten as:
\begin{align} \begin{array}{c} \text{Direct Materials} \ \text {Quantity Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Quantity of } \ \text {Materials Used}\ \text {for Units Produced} \end{array} - \begin{array}{c} \text{Standard Quantity} \ \text { of Materials Expected}\ \text {for Units Produced} \end{array} \right ) \times \begin{array}{c} \text{Standard Price} \ \end{array} \end{align}
With either of these formulas, the actual quantity used refers to the actual amount of materials used at the actual production output. The standard price is the expected price paid for materials per unit. The standard quantity is the expected amount of materials used at the actual production output. If there is no difference between the actual quantity used and the standard quantity, the outcome will be zero, and no variance exists.
If the actual quantity of materials used is less than the standard quantity used at the actual production output level, the variance will be a favorable variance. A favorable outcome means you used fewer materials than anticipated, to make the actual number of production units. If, however, the actual quantity of materials used is greater than the standard quantity used at the actual production output level, the variance will be unfavorable. An unfavorable outcome means you used more materials than anticipated to make the actual number of production units.
The actual quantity used can differ from the standard quantity because of improved efficiencies in production, carelessness or inefficiencies in production, or poor estimation when creating the standard usage.
Consider the previous example with Connie’s Candy Company. Connie’s Candy established a standard price for candy-making materials of $\7.00$ per pound. Each box of candy is expected to use $0.25$ pounds of candy-making materials. Connie’s Candy found that the actual quantity of candy-making materials used to produce one box of candy was $0.20$ per pound. The direct materials quantity variance computes as:
$\text { Direct Materials Quantity Variance }=(0.20 \mathrm{lb}-0.25 \mathrm{lb} .) \times \ 7.00=-\ 0.35 \text { or } \ 0.35 \text { (Favorable) } \nonumber$
In this case, the actual quantity of materials used is $0.20$ pounds, the standard price per unit of materials is $\7.00$, and the standard quantity used is $0.25$ pounds. This computes as a favorable outcome. This is a favorable outcome because the actual quantity of materials used was less than the standard quantity expected at the actual production output level. As a result of this favorable outcome information, the company may consider continuing operations as they exist, or could change future budget projections to reflect higher profit margins, among other things.
Let us take the same example except now the actual quantity of candy-making materials used to produce one box of candy was 0.50 per pound. The direct materials quantity variance computes as:
$\text { Direct Materials Quantity Variance }=(0.50 \text { Ib. }-0.25 \text { Ib. }) \times \ 7.00=\ 1.75 \text { or } \ 1.75 \text { (Unfavorable) } \nonumber$
In this case, the actual quantity of materials used is $0.50$ pounds, the standard price per unit of materials is $\7.00$, and the standard quantity used is $0.25$ pounds. This computes as an unfavorable outcome. This is an unfavorable outcome because the actual quantity of materials used was more than the standard quantity expected at the actual production output level. As a result of this unfavorable outcome information, the company may consider retraining workers to reduce waste or change their production process to decrease materials needs per box.
The combination of the two variances can produce one overall total direct materials cost variance.
Total Direct Materials Cost Variance
When a company makes a product and compares the actual materials cost to the standard materials cost, the result is the total direct materials cost variance.
\begin{align} \begin{array}{c} \text{Total Direct} \ \text { Materials Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Quantity } \ \times\ \text {Actual Price }\ \end{array} \right ) - \left (\begin{array}{c} \text{Standard Quantity } \ \times\ \text {Standard Price}\ \end{array} \right ) \end{align}
An unfavorable outcome means the actual costs related to materials were more than the expected (standard) costs. If the outcome is a favorable outcome, this means the actual costs related to materials are less than the expected (standard) costs.
The total direct materials cost variance is also found by combining the direct materials price variance and the direct materials quantity variance. By showing the total materials variance as the sum of the two components, management can better analyze the two variances and enhance decision-making.
Figure $1$ shows the connection between the direct materials price variance and direct materials quantity variance to total direct materials cost variance.
For example, Connie’s Candy Company expects to pay $\7.00$ per pound for candy-making materials but actually pays $\9.00$ per pound. The company expected to use $0.25$ pounds of materials per box but actually used $0.50$ per box. The total direct materials variance is computed as:
$\text { Total Direct Materials Variance }=(0.50 \mathrm{lbs} . \times \ 9.00)-(0.25 \text { lbs. } \times \ 7.00)=\ 4.50-\ 1.75=\ 2.75 \text { (Unfavorable) } \nonumber$
In this case, two elements contribute to the unfavorable outcome. Connie’s Candy paid $\2.00$ per pound more for materials than expected and used $0.25$ pounds more of materials than expected to make one box of candy.
The same calculation is shown using the outcomes of the direct materials price and quantity variances.
As with the interpretations for the materials price and quantity variances, the company would review the individual components contributing to the overall unfavorable outcome for the total direct materials variance, and possibly make changes to production elements as a result.
Example $1$: Sweet and Fresh Shampoo Materials
Biglow Company makes a hair shampoo called Sweet and Fresh. Each bottle has a standard material cost of $8$ ounces at $\0.85$ per ounce. During May, Biglow manufactured $11,000$ bottles. They bought $89,000$ ounces of material at a cost of $\74,760$. All $89,000$ ounces were used to make the $11,000$ bottles. Calculate the material price variance and the material quantity variance.
Solution
Actual price per pound: $74,760/89,000 = \0.84$
Material price variance: $89,000 × (0.84 − 0.85) = \890$ favorable
Material quantity variance: $0.85 × (89,000 – 88,000) = \850$ unfavorable | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/08%3A_Standard_Costs_and_Variances/8.03%3A_Compute_and_Evaluate_Materials_Variances.txt |
In addition to evaluating materials usage, companies must assess how efficiently and effectively they are using labor in the production of their products. Direct labor is a cost associated with workers working directly in the production process. The company must look at both the quantity of hours used and the rate of the labor and compare outcomes to standard costs. Determining efficiency and effectiveness of labor leads to individual labor variances. A company can compute these labor variances and make informed decisions about labor operations based on these differences.
Fundamentals of Direct Labor Variances
The direct labor variance measures how efficiently the company uses labor as well as how effective it is at pricing labor. There are two components to a labor variance, the direct labor rate variance and the direct labor time variance.
Direct Labor Rate Variance
The direct labor rate variance compares the actual rate per hour of direct labor to the standard rate per hour of labor for the hours worked. The direct labor rate variance is calculated using this formula:
\begin{align} \begin{array}{c} \text{Direct Labor} \ \text { Rate Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Hours Worked } \ \times\ \text {Actual Rate per Hour }\ \end{array} \right ) - \left (\begin{array}{c} \text{Actual Hours Worked } \ \times\ \text {Standard Rate per Hour}\ \end{array} \right ) \end{align}
Factoring out the actual hours worked from both components of the formula, it can be rewritten as
\begin{align} \begin{array}{c} \text{Direct Labor} \ \text {Rate Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Rate } \ \text {per Hour}\ \end{array} - \begin{array}{c} \text{Standard Rate} \ \text {per Hour}\ \end{array} \right ) \times \begin{array}{c} \text{Actual Hours } \ \text {Worked}\ \end{array} \end{align}
With either of these formulas, the actual rate per hour refers to the actual rate of pay for workers to create one unit of product. The standard rate per hour is the expected rate of pay for workers to create one unit of product. The actual hours worked are the actual number of hours worked to create one unit of product. If there is no difference between the standard rate and the actual rate, the outcome will be zero, and no variance exists.
If the actual rate of pay per hour is less than the standard rate of pay per hour, the variance will be a favorable variance. A favorable outcome means you paid workers less than anticipated. If, however, the actual rate of pay per hour is greater than the standard rate of pay per hour, the variance will be unfavorable. An unfavorable outcome means you paid workers more than anticipated.
The actual rate can differ from the standard or expected rate because of supply and demand of the workers, increased labor costs due to economic changes or union contracts, or the ability to hire employees at a different skill level. Once the manufacturer makes the products, the labor costs will follow the goods through production, so the company should evaluate how the difference between what it expected to happen and what actually happened will affect all the goods produced using these particular labor rates.
Let us again consider Connie’s Candy Company with respect to labor. Connie’s Candy establishes a standard rate per hour for labor of $\8.00$. Each box of candy is expected to require $0.10$ hours of labor ($6$ minutes). Connie’s Candy found that the actual rate of pay per hour for labor was $\7.50$. They still actually required $0.10$ hours of labor to make each box. The direct labor rate variance computes as:
$\text { Direct Labor Rate Variance }=(\ 7.50-\ 8.00) \times 0.10 \text { hours }=-\ 0.05 \text { or } \ 0.05 \text { (Favorable) } \nonumber$
In this case, the actual rate per hour is $\7.50$, the standard rate per hour is $\8.00$, and the actual hour worked is $0.10$ hours per box. This computes as a favorable outcome. This is a favorable outcome because the actual rate of pay was less than the standard rate of pay. As a result of this favorable outcome information, the company may consider continuing operations as they exist, or could change future budget projections to reflect higher profit margins, among other things.
Let us take the same example except now the actual rate of pay per hour is $\9.50$. The direct labor rate variance computes as:
$\text { Direct Labor Rate Variance }=(\ 9.50-\ 8.00) \times 0.10 \text { hours }=\ 0.15 \text { or } \ 0.15 \text { (Unfavorable) } \nonumber$
In this case, the actual rate per hour is $\9.50$, the standard rate per hour is $\8.00$, and the actual hours worked per box are $0.10$ hours. This computes as an unfavorable outcome. This is an unfavorable outcome because the actual rate per hour was more than the standard rate per hour. As a result of this unfavorable outcome information, the company may consider using cheaper labor, changing the production process to be more efficient, or increasing prices to cover labor costs.
Another element this company and others must consider is a direct labor time variance.
Direct Labor Time Variance
The direct labor time variance compares the actual labor hours used to the standard labor hours that were expected to be used to make the actual units produced. The variance is calculated using this formula:
\begin{align} \begin{array}{c} \text{Direct Labor} \ \text { Time Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Hours Worked } \ \times\ \text {Standard Rate per Hour }\ \end{array} \right ) - \left (\begin{array}{c} \text{Standard Hours } \ \times\ \text {Standard Rate per Hour}\ \end{array} \right ) \end{align}
Factoring out the standard rate per hour from both components of the formula, it can be rewritten as:
\begin{align} \begin{array}{c} \text{Direct Labor} \ \text {Time Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Hours } \ \text {Worked}\ \end{array} - \begin{array}{c} \text{Standard Hours Expected} \ \text {for the Units Produced}\ \end{array} \right ) \times \begin{array}{c} \text{Standard Rate } \ \text {per Hour}\ \end{array} \end{align}
With either of these formulas, the actual hours worked refers to the actual number of hours used at the actual production output. The standard rate per hour is the expected hourly rate paid to workers. The standard hours are the expected number of hours used at the actual production output. If there is no difference between the actual hours worked and the standard hours, the outcome will be zero, and no variance exists.
If the actual hours worked are less than the standard hours at the actual production output level, the variance will be a favorable variance. A favorable outcome means you used fewer hours than anticipated to make the actual number of production units. If, however, the actual hours worked are greater than the standard hours at the actual production output level, the variance will be unfavorable. An unfavorable outcome means you used more hours than anticipated to make the actual number of production units.
The actual hours used can differ from the standard hours because of improved efficiencies in production, carelessness or inefficiencies in production, or poor estimation when creating the standard usage.
Consider the previous example with Connie’s Candy Company. Connie’s Candy establishes a standard rate per hour for labor of $\8.00$. Each box of candy is expected to require $0.10$ hours of labor ($6$ minutes). Connie’s Candy found that the actual hours worked per box were $0.05$ hours ($3$ minutes). The actual rate per hour for labor remained at $\8.00$ to make each box. The direct labor time variance computes as:
$\text { Direct Labor Time Variance }=(0.05-0.10) \times \ 8.00 \text { per hour }=-\ 0.40 \text { or } \ 0.40 \text { (Favorable) } \nonumber$
In this case, the actual hours worked are $0.05$ per box, the standard hours are $0.10$ per box, and the standard rate per hour is $\8.00$. This computes as a favorable outcome. This is a favorable outcome because the actual hours worked were less than the standard hours expected. As a result of this favorable outcome information, the company may consider continuing operations as they exist, or could change future budget projections to reflect higher profit margins, among other things.
Let us take the same example except now the actual hours worked are $0.20$ hours per box. The direct labor time variance computes as:
$\text { Direct Labor Time Variance }=(\ 0.20-\ 0.10) \times \ 8.00 \text { per hour }=\ 0.80 \text { or } \ 0.80 \text { (Unfavorable) } \nonumber$
In this case, the actual hours worked per box are $0.20$, the standard hours per box are $0.10$, and the standard rate per hour is $\8.00$. This computes as an unfavorable outcome. This is an unfavorable outcome because the actual hours worked were more than the standard hours expected per box. As a result of this unfavorable outcome information, the company may consider retraining its workers, changing the production process to be more efficient, or increasing prices to cover labor costs.
The combination of the two variances can produce one overall total direct labor cost variance.
THINK IT THROUGH: Package Deliveries
UPS drivers are evaluated on how many miles they drive and how quickly they deliver packages. The drivers are given the route and time they are expected to take, so they are expected to complete their route in a timely and efficient manner. They also work until all packages are delivered. A GPS tracking system tracks the trucks throughout the day. The system keeps track of how much they back up and if they take any left turns because right turns are much more time efficient.1 Tracking drivers like this does not leave them very much time to deal with customers. Customer service is a major part of the driver’s job. Can the driver service the customer and drive the route in the time and distance allotted? Which is more important: customer service or driving the route in a timely and efficient manner?
Total Direct Labor Variance
When a company makes a product and compares the actual labor cost to the standard labor cost, the result is the total direct labor variance.
\begin{align} \begin{array}{c} \text{Total Direct} \ \text {Labor Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Hours } \times \text {Actual Rate } \end{array} \right ) - \left (\begin{array}{c} \text{Standard Hours } \times \text {Standard Rate }\ \end{array} \right ) \end{align}
If the outcome is unfavorable, the actual costs related to labor were more than the expected (standard) costs. If the outcome is favorable, the actual costs related to labor are less than the expected (standard) costs.
The total direct labor variance is also found by combining the direct labor rate variance and the direct labor time variance. By showing the total direct labor variance as the sum of the two components, management can better analyze the two variances and enhance decision-making.
Figure $1$ shows the connection between the direct labor rate variance and direct labor time variance to total direct labor variance.
For example, Connie’s Candy Company expects to pay a rate of $\8.00$ per hour for labor but actually pays $\9.50$ per hour. The company expected to use $0.10$ hours of labor per box but actually used $0.20$ hours per box. The total direct labor variance is computed as:
$\text { Total Direct Labor Time Variance }=(0.20 \text { hours } \times \ 9.50)-(0.10 \text { hours } \times \ 8.00)=\ 1.90-80.80=\ 1.10(\text { Unfavorable }) \nonumber$
In this case, two elements are contributing to the unfavorable outcome. Connie’s Candy paid $\1.50$ per hour more for labor than expected and used $0.10$ hours more than expected to make one box of candy. The same calculation is shown as follows using the outcomes of the direct labor rate and time variances.
As with the interpretations for the labor rate and time variances, the company would review the individual components contributing to the overall unfavorable outcome for the total direct labor variance, and possibly make changes to production elements as a result.
Example $1$: Sweet and Fresh Shampoo Labor
Biglow Company makes a hair shampoo called Sweet and Fresh. Each bottle has a standard labor cost of $1.5$ hours at $\35.00$ per hour. During May, Biglow manufactured $11,000$ bottles. They used $16,000$ hours at a cost of $\565,600$. Calculate the labor rate variance, labor time variance, and total labor variance.
CONCEPTS IN PRACTICE: Labor Costs in Service Industries
In the service industry, labor is the main cost. Doctors, for example, have a time allotment for a physical exam and base their fee on the expected time. Insurance companies pay doctors according to a set schedule, so they set the labor standard. They pay a set rate for a physical exam, no matter how long it takes. If the exam takes longer than expected, the doctor is not compensated for that extra time. This would produce an unfavorable labor variance for the doctor. Doctors know the standard and try to schedule accordingly so a variance does not exist. If anything, they try to produce a favorable variance by seeing more patients in a quicker time frame to maximize their compensation potential.
Footnotes
1. Graham Kendall. “Why UPS Drivers Don’t Turn Left and Why You Shouldn’t Either.” The Conversation. January 20, 2017. http://theconversation.com/why-ups-d...t-either-71432 | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/08%3A_Standard_Costs_and_Variances/8.04%3A_Compute_and_Evaluate_Labor_Variances.txt |
Recall that the standard cost of a product includes not only materials and labor but also variable and fixed overhead. It is likely that the amounts determined for standard overhead costs will differ from what actually occurs. This will lead to overhead variances.
Determination and Evaluation of Overhead Variance
In a standard cost system, overhead is applied to the goods based on a standard overhead rate. This is similar to the predetermined overhead rate used previously. The standard overhead rate is calculated by dividing budgeted overhead at a given level of production (known as normal capacity) by the level of activity required for that particular level of production.
$\text {Standard Overhead Rate} = \dfrac{\text {Budgeted Overhead Rate}}{\text {Level of Activity}}$
Usually, the level of activity is either direct labor hours or direct labor cost, but it could be machine hours or units of production.
Creation of Flexible Overhead Budget
To determine the overhead standard cost, companies prepare a flexible budget that gives estimated revenues and costs at varying levels of production. The standard overhead cost is usually expressed as the sum of its component parts, fixed and variable costs per unit. Note that at different levels of production, total fixed costs are the same, so the standard fixed cost per unit will change for each production level. However, the variable standard cost per unit is the same per unit for each level of production, but the total variable costs will change.
We continue to use Connie’s Candy Company to illustrate. Suppose Connie’s Candy budgets capacity of production at $100\%$ and determines expected overhead at this capacity. Connie’s Candy also wants to understand what overhead cost outcomes will be at $90\%$ capacity and $110\%$ capacity. The following information is the flexible budget Connie’s Candy prepared to show expected overhead at each capacity level.
Units of output at $100\%$ is $1,000$ candy boxes (units). The standard overhead rate is the total budgeted overhead of $\10,000$ divided by the level of activity (direct labor hours) of $2,000$ hours. Notice that fixed overhead remains constant at each of the production levels, but variable overhead changes based on unit output. If Connie’s Candy only produced at $90\%$ capacity, for example, they should expect total overhead to be $\9,600$ and a standard overhead rate of $\5.33$ (rounded). If Connie’s Candy produced $2,200$ units, they should expect total overhead to be $\10,400$ and a standard overhead rate of $\4.73$ (rounded). In addition to the total standard overhead rate, Connie’s Candy will want to know the variable overhead rates at each activity level.
Using the flexible budget, we can determine the standard variable cost per unit at each level of production by taking the total expected variable overhead divided by the level of activity, which can still be direct labor hours or machine hours.
$\text {Variable Overhead Rate} = \dfrac{\text {Budgeted Variable Overhead}}{\text {Level of Activity}}$
Looking at Connie’s Candies, the following table shows the variable overhead rate at each of the production capacity levels.
Table $1$: Connie’s Candies variable overhead rate at each of the production capacity levels
Production Capacity Variable/Unit
90% $3,600/1,800 =$2
100% $4,000/2,000 =$2
110% $4,400/2,200 =$2
Sometimes these flexible budget figures and overhead rates differ from the actual results, which produces a variance.
Determination of Variable Overhead Variances
There are two components to variable overhead rates: the overhead application rate and the activity level against which that rate was applied. If we compare the actual variable overhead to the standard variable overhead, by analyzing the difference between actual overhead costs and the standard overhead for current production, it is difficult to determine if the variance is due to application rate differences or activity level differences. Thus, there are two variable overhead variances that will better provide these answers: the variable overhead rate variance and the variable overhead efficiency variance.
Determination of Variable Overhead Rate Variance
The variable overhead rate variance, also known as the spending variance, is the difference between the actual variable manufacturing overhead and the variable overhead that was expected given the number of hours worked. The variable overhead rate variance is calculated using this formula:
\begin{align} \begin{array}{c} \text{Variable Overhead} \ \text { Rate Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Hours Worked } \ \times\ \text {Actual Variable Overhead Rate per Hour }\ \end{array} \right ) - \left (\begin{array}{c} \text{Actual Hours Worked } \ \times\ \text {Standard Variable Overhead Rate per Hour}\ \end{array} \right ) \end{align}
Factoring out actual hours worked, we can rewrite the formula as
\begin{align} \begin{array}{c} \text{Variable Overhead} \ \text {Rate Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Variable} \ \text {Overhead Rate}\ \end{array} - \begin{array}{c} \text{Standard Variable} \ \text {Overhead Rate}\ \end{array} \right ) \times \begin{array}{c} \text{Actual Hours } \ \text {Worked}\ \end{array} \end{align}
If the outcome is favorable (a negative outcome occurs in the calculation), this means the company spent less than what it had anticipated for variable overhead. If the outcome is unfavorable (a positive outcome occurs in the calculation), this means the company spent more than what it had anticipated for variable overhead.
Connie’s Candy Company wants to determine if its variable overhead spending was more or less than anticipated. Connie’s Candy had this data available in the flexible budget:
Connie’s Candy also had this actual output information:
To determine the variable overhead rate variance, the standard variable overhead rate per hour and the actual variable overhead rate per hour must be determined. The standard variable overhead rate per hour is $\2.00$ ($\4,000/2,000$ hours), taken from the flexible budget at $100\%$ capacity. The actual variable overhead rate is $\2.80$ ($\7,000/2,500$), taken from the actual results at $100\%$ capacity. Therefore,
$\text { Variable Overhead Rate Variance }=(\ 2.80-82.00) \times 2,500=\ 2,000( \text { Unfavorable) } \nonumber$
This produces an unfavorable outcome. This could be for many reasons, and the production supervisor would need to determine where the variable cost difference is occurring to make production changes.
Let us look at another example producing a favorable outcome. Connie’s Candy had this data available in the flexible budget:
Connie’s Candy also had this actual output information:
To determine the variable overhead rate variance, the standard variable overhead rate per hour and the actual variable overhead rate per hour must be determined. The standard variable overhead rate per hour is $\2.00$ ($\4,000/2,000$ hours), taken from the flexible budget at $100\%$ capacity. The actual variable overhead rate is $\1.75$ ($\3,500/2,000$), taken from the actual results at $100\%$ capacity. Therefore,
$\text { Variable Overhead Rate Variance }=(\ 1.75-\ 2.00) \times \ 2,000=-\ 500 \text { or } \ 500 \text { (Favorable) } \nonumber$
This produces a favorable outcome. This could be for many reasons, and the production supervisor would need to determine where the variable cost difference is occurring to better understand the variable overhead reduction.
Interpretation of the variable overhead rate variance is often difficult because the cost of one overhead item, such as indirect labor, could go up, but another overhead cost, such as indirect materials, could go down. Often, explanation of this variance will need clarification from the production supervisor. Another variable overhead variance to consider is the variable overhead efficiency variance.
Determination of Variable Overhead Efficiency Variance
The variable overhead efficiency variance, also known as the controllable variance, is driven by the difference between the actual hours worked and the standard hours expected for the units produced. This variance measures whether the allocation base was efficiently used. The variable overhead efficiency variance is calculated using this formula:
\begin{align} \begin{array}{c} \text{Variable Overhead} \ \text { Efficiency Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual Hours Worked } \ \times\ \text {Standard Variable Overhead Rate per Hour }\ \end{array} \right ) - \left (\begin{array}{c} \text{Standard Hours} \ \times\ \text {Standard Variable Overhead Rate per Hour}\ \end{array} \right ) \end{align}
Factoring out standard overhead rate, the formula can be written as
\begin{align} \begin{array}{c} \text{Variable Overhead} \ \text {Efficiency Variance}\ \end{array} &= \left (\begin{array}{c} \text{Actual}\ \text {Labor Hours } \ \end{array} - \begin{array}{c} \text{Standard} \ \text { Labor Hours} \ \end{array} \right ) \times \begin{array}{c} \text{Standard Overhead} \ \text {Rate}\ \end{array} \end{align}
If the outcome is favorable (a negative outcome occurs in the calculation), this means the company was more efficient than what it had anticipated for variable overhead. If the outcome is unfavorable (a positive outcome occurs in the calculation), this means the company was less efficient than what it had anticipated for variable overhead.
Connie’s Candy Company wants to determine if its variable overhead efficiency was more or less than anticipated. Connie’s Candy had the following data available in the flexible budget:
Connie’s Candy also had the following actual output information:
To determine the variable overhead efficiency variance, the actual hours worked and the standard hours worked at the production capacity of $100\%$ must be determined. Actual hours worked are $2,500$, and standard hours are $2,000$. The standard variable overhead rate per hour is $\2.00$ ($\4,000/2,000$ hours), taken from the flexible budget at $100\%$ capacity. Therefore,
$\text { Variable Overhead Efficiency Variance }=(2,500-2,000) \times \ 2.00=\ 1,000 \text { (Unfavorable) } \nonumber$
This produces an unfavorable outcome. This could be for many reasons, and the production supervisor would need to determine where the variable cost difference is occurring to make production changes.
Let us look at another example producing a favorable outcome. Connie’s Candy had the following data available in the flexible budget:
Connie’s Candy also had the following actual output information:
To determine the variable overhead efficiency variance, the actual hours worked and the standard hours worked at the production capacity of $100\%$ must be determined. Actual hours worked are $1,800$, and standard hours are $2,000$. The standard variable overhead rate per hour is $\2.00$ ($\4,000/2,000$ hours), taken from the flexible budget at $100\%$ capacity. Therefore,
$\text { Variable Overhead Efficiency Variance }=(1,800-2,000) \times \ 2.00=-\ 400 \text { or } \ 400 \text { (Favorable) } \nonumber$
This produces a favorable outcome. This could be for many reasons, and the production supervisor would need to determine where the variable cost difference is occurring to better understand the variable overhead efficiency reduction.
The total variable overhead cost variance is also found by combining the variable overhead rate variance and the variable overhead efficiency variance. By showing the total variable overhead cost variance as the sum of the two components, management can better analyze the two variances and enhance decision-making.
Figure $10$ shows the connection between the variable overhead rate variance and variable overhead efficiency variance to total variable overhead cost variance.
For example, Connie’s Candy Company had the following data available in the flexible budget:
Connie’s Candy also had the following actual output information:
The variable overhead rate variance is calculated as $(1,800 × \1.94) – (1,800 × \2.00) = –\108$, or $\108$ (favorable). The variable overhead efficiency variance is calculated as $(1,800 × \2.00) – (2,000 × \2.00) = –\400$, or $\400$ (favorable).
The total variable overhead cost variance is computed as:
$\text { Total Variable Overhead Cost Variance }=(-\ 108)+(-\ 400)=-\ 508 \text { or } \ 508 \text { (Favorable) } \nonumber$
In this case, two elements are contributing to the favorable outcome. Connie’s Candy used fewer direct labor hours and less variable overhead to produce $1,000$ candy boxes (units).
The same calculation is shown as follows in diagram format.
As with the interpretations for the variable overhead rate and efficiency variances, the company would review the individual components contributing to the overall favorable outcome for the total variable overhead cost variance, before making any decisions about production in the future. Other variances companies consider are fixed factory overhead variances.
Fundamentals of Fixed Factory Overhead Variances
The fixed factory overhead variance represents the difference between the actual fixed overhead and the applied fixed overhead. There are two fixed overhead variances. One variance determines if too much or too little was spent on fixed overhead. The other variance computes whether or not actual production was above or below the expected production level.
Example $1$: Sweet and Fresh Shampoo Overhead
Biglow Company makes a hair shampoo called Sweet and Fresh. They have the following flexible budget data:
What is the standard variable overhead rate at $90\%$, $100\%$, and $110\%$ capacity levels?
Solution
$90\% = \315,000/14,000 = \22.50$, $100\% = \346,000/16,000 = \21.63$ (rounded), $110\% = \378,000/18,000 = \21.00$.
THINK IT THROUGH: Purchasing Planes
The XYZ Firm is bidding on a contract for a new plane for the military. As the management team is going over the bid, they come to the conclusion it is too high on a per-plane basis, but they cannot find any costs they feel can be reduced. The information from the military states they will purchase between $50$ and $100$ planes, but will more likely purchase $50$ planes rather than $100$ planes. XYZ’s bid is based on $50$ planes. The controller suggests that they base their bid on $100$ planes. This would spread the fixed costs over more planes and reduce the bid price. The lower bid price will increase substantially the chances of XYZ winning the bid. Should XYZ Firm keep the bid at $50$ planes or increase its bid to $100$ planes? What are the pros and cons to keeping the bid at $50$ or increasing to $100$ planes? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/08%3A_Standard_Costs_and_Variances/8.05%3A_Compute_and_Evaluate_Overhead_Variances.txt |
Companies use variance analysis in different ways. The starting point is the determination of standards against which to compare actual results. Many companies produce variance reports, and the management responsible for the variances must explain any variances outside of a certain range. Some companies only require that unfavorable variances be explained, while many companies require both favorable and unfavorable variances to be explained.
Requiring managers to determine what caused unfavorable variances forces them to identify potential problem areas or consider if the variance was a one-time occurrence. Requiring managers to explain favorable variances allows them to assess whether the favorable variance is sustainable. Knowing what caused the favorable variance allows management to plan for it in the future, depending on whether it was a one-time variance or it will be ongoing.
Another possibility is that management may have built the favorable variance into the standards. Management may overestimate the material price, labor rate, material quantity, or labor hours per unit, for example. This method of overestimation, sometimes called budget slack, is built into the standards so management can still look good even if costs are higher than planned. In either case, managers potentially can help other managers and the company overall by noticing particular problem areas or by sharing knowledge that can improve variances.
Often, management will manage “to the variances,” meaning they will make decisions that may not be advantageous to the company’s best interests over the long run, in order to meet the variance report threshold limits. This can occur when the standards are improperly established, causing significant differences between actual and standard numbers.
ETHICAL CONSIDERATIONS: Ethical Long-Term Decisions in Variance Analysis
The proper use of variance analysis is a significant tool for an organization to reach its long-term goals. When its accounting system recognizes a variance, an organization needs to understand the significant influence of accounting not only in recording its financial results, but also in how reacting to that variance can shape management’s behavior toward reaching its goals.1 Many managers use variance analysis only to determine a short-term reaction, and do not analyze why the variance occurred from a long-term perspective. A more long-term analysis of variances allows an approach that “is responsibility accounting in which authority and accountability for tasks is delegated downward to those managers with the most influence and control over them.”2 It is important for managers to analyze the reported variances with more than just a short-term perspective.
Managers sometimes focus only on making numbers for the current period. For example, a manager might decide to make a manufacturing division’s results look profitable in the short term at the expense of reaching the organization’s long-term goals. A recognizable cost variance could be an increase in repair costs as a percentage of sales on an increasing basis. This variance could indicate that equipment is not operating efficiently and is increasing overall cost. However, the expense of implementing new, more efficient equipment might be higher than repairing the current equipment. In the short term, it might be more economical to repair the outdated equipment, but in the long term, purchasing more efficient equipment would help the organization reach its goal of eco-friendly manufacturing. If the system use for controlling costs is not aligned to reinforce management of the organization with a long-term perspective, “the manager has no organizational incentive to be concerned with important issues unrelated to anything but the immediate costs”3 related to the variance. A manager needs to be cognizant of his or her organization’s goals when making decisions based on variance analysis.
Management can use standard costs to prepare the budget for the upcoming period, using the past information to possibly make changes to production elements. Standard costs are a measurement tool and can thus be used to evaluate performance. As you’ve learned, management may manage “to the variances” and can manipulate results to meet expectations. To reduce this possibility, performance should be measured on multiple outcomes, not simply on standard cost variances.
As shown in Table $1$, standard costs have pros and cons to consider when using them in the decision-making and evaluation processes.
Table $1$: Standard Costs
Pros Cons
• Useful when developing a future budget
• Can be used as a benchmark for performance and quality expectations
• Can individually identify areas of success and areas for improvement
• Might ignore customer and employee satisfaction rates
• Information could be historical data and not useful in real-time decision-making needs
• The system to manage and develop standard costs requires a lot of resources, which could be costly and time consuming
Standard costing provides many benefits and challenges, and a thorough analysis of each variance and the possible unfavorable or favorable outcomes is required to set future expectations and adjust current production goals.
The following is a summary of all direct materials variances (Figure $1$), direct labor variances (Figure $2$), and overhead variances (Figure $3$) presented as both formulas and tree diagrams. Note that for some of the formulas, there are two presentations of the same formula, for example, there are two presentations of the direct materials price variance. While both arrive at the same answer, students usually prefer one formula structure over the other.
Example $1$: Barley, Inc. Production
Barley, Inc., produces a product and has the following as standard costs per unit for materials and labor:
For the month of October, the following information was gathered related to production:
Compute:
1. The materials price and quantity variances
2. The labor rate and efficiency variances
Provide possible explanations for each variance.
Solution
Materials price variance:
$\ 50,000 \text { unfavorable }=\left(\ 16^{*}-\ 15\right) \times 50,000 \mathrm{lb}$
$* \ 800,000 / 50,000$
An unfavorable materials price variance occurred because the actual cost of materials was greater than the expected or standard cost. This could occur if a higher-quality material was purchased or the suppliers raised their prices.
Materials quantity variance:
$\ 150,000 \text { unfavorable }=\left(50,000 \text { lb. }-40,000^{*} \mathrm{lb} \right) \times \ 15 \mathrm{lb}$
$^{\star} 4 \mathrm{lb} . \times 10,000$ units
An unfavorable materials quantity variance occurred because the pounds of materials used were greater than the pounds expected to be used. This could occur if there were inefficiencies in production or the quality of the materials was such that more needed to be used to meet safety or other standards.
Materials inputs:
Labor rate variance:
$\ 50,000 \text { favorable }=\left(\ 18^{*} \text { per hour }-\ 20 \text { per hour }\right) \times 25,000 \text { hours }$
$*\450,000/25,000$
A favorable labor rate variance occurred because the rate paid per hour was less than the rate expected to be paid (standard) per hour. This could occur because the company was able to hire workers at a lower rate, because of negotiated union contracts, or because of a poor labor rate estimate used in creating the standard.
Labor quantity variance:
$\ 100,000 \text { unfavorable }=(25,000 \text { hours }-20,000 * \text { hours }) \times \ 20 \text { per hour }$
$^{\star} 2 \text { hours } \times 10,000 \text { units }$
An unfavorable labor quantity variance occurred because the actual hours worked to make the $10,000$ units were greater than the expected hours to make that many units. This could occur because of inefficiencies of the workers, defects and errors that caused additional time reworking items, or the use of new workers who were less efficient.
Labor inputs:
THINK IT THROUGH: Explaining Differences in Expected and Actual Operational Outcomes
The manager of a plant has called operations, purchasing, and personnel into her office to discuss the results of the last month. She notes that there was more than normal scrap, and employees worked more hours than expected. She is looking for an explanation for these results. What system might she have used to determine these material and labor issues? Why might these variances have occurred? What should she do about it for future periods?
LINK TO LEARNING: Standard Costing Advantages Explained
See this article on the four major advantages of standard costing to learn more.
Footnotes
1. Jeffrey R. Cohen and Laurie W. Pant. “The Only Thing That Counts Is That Which Is Counted: A Discussion of Behavioral and Ethical Issues in Cost Accounting That Are Relevant for the OB Professor.” September 18, 2018. http://citeseerx.ist.psu.edu/viewdoc...=rep1&type=pdf
2. Jeffrey R. Cohen and Laurie W. Pant. “The Only Thing That Counts Is That Which Is Counted: A Discussion of Behavioral and Ethical Issues in Cost Accounting That Are Relevant for the OB Professor.” September 18, 2018. http://citeseerx.ist.psu.edu/viewdoc...=rep1&type=pdf
3. Jeffrey R. Cohen and Laurie W. Pant. “The Only Thing That Counts Is That Which Is Counted: A Discussion of Behavioral and Ethical Issues in Cost Accounting That Are Relevant for the OB Professor.” September 18, 2018. http://citeseerx.ist.psu.edu/viewdoc...=rep1&type=pdf | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/08%3A_Standard_Costs_and_Variances/8.06%3A_Describe_How_Companies_Use_Variance_Analysis.txt |
Section Summaries
8.1 Explain How and Why a Standard Cost Is Developed
• Standards are budgeted unit amounts for price paid and amount used.
• Variances are the difference between actual and standard amounts.
• A favorable variance is when the actual price or quantity is less than the standard amount.
• An unfavorable variance is when the actual price or amount is greater than the standard amount.
8.2 Compute and Evaluate Materials Variances
• There are two components to material variances: the direct materials price variance and the direct materials quantity variance.
• The direct materials price variance is caused by paying too much or too little for material.
• The direct materials quantity variance is caused by using too much or too little material.
8.3 Compute and Evaluate Labor Variances
• There are two labor variances: the direct labor rate variance and the direct labor time variance.
• The direct labor rate variance determines if the rate paid is greater than or less than the standard rate.
• The direct labor time variance determines if the actual hours used are greater than or less than the standards that should have been used.
8.4 Compute and Evaluate Overhead Variances
• There are two sets of overhead variances: variable and fixed.
• The variable variances are caused by the overhead application rate and the activity level against which the rate was applied.
• The variable overhead rate variance is the difference between the actual variable manufacturing overhead and the variable overhead that was expected given the number of hours worked.
• The variable overhead efficiency variance is driven by the difference between the actual hours worked and the standard hours expected for the units produced.
• There are two fixed overhead variances. One is caused by spending too much or too little on fixed overhead. The other is caused by actual production being above or below the expected production level.
8.5 Describe How Companies Use Variance Analysis
• The key to analyzing variances is to determine why the variance occurred.
• If a company cannot determine why there is a variance, it will not know if the variance is indicative of a problem or not.
• All firms—manufacturing, retail, and service—use standards and variances.
Key Terms
attainable standard
level that may be reached with reasonable effort
direct labor rate variance
difference between the actual rate paid and the standard rate that should have been paid based on the actual hours worked
direct labor time variance
difference between the actual hours worked and the standard hours that should have been worked for the actual units produced
direct labor variance
measures how efficiently the company uses labor as well as how effective it is at pricing labor
direct materials price variance
difference between the actual price paid per unit for materials and what should have been paid per the standards
direct materials quantity variance
difference between the actual quantity of materials used and the standard materials that were expected to be used to make the actual units produced
direct materials variance
difference between the actual price or amount used and the standard amount
favorable variance
difference involving spending less, or using less, than the standard amount
fixed factory overhead variance
difference between the actual fixed overhead and applied fixed overhead
flexible budget
measurement and prediction of estimated revenues and costs at varying levels of production
ideal standard
level that could be achieved if everything ran perfectly
standard
expectation for a component used in production
standard cost
cost expectation for price paid and amount (quantities) used
total direct labor variance
actual labor costs compared to standard labor costs
total direct materials cost variance
difference between actual materials cost and standard materials cost
total variable overhead cost variance
total cost variance found by combining variable overhead rate variance and variable overhead efficiency variance
unfavorable variance
difference involving spending more or using more than the standard amount
variable overhead efficiency variance
difference between the actual hours worked and the standard hours expected for the units produced
variable overhead rate variance
difference between the actual variable manufacturing overhead and the variable overhead that was expected given the number of hours worked
variance
difference between standard and actual performance | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/08%3A_Standard_Costs_and_Variances/8.07%3A_Summary_and_Key_Terms.txt |
Multiple Choice
1. Why does a company use a standard costing system?
1. to identify variances from actual cost that assist them in maintaining profits
2. to identify nonperformers in the workplace
3. to identify what vendors are unreliable
4. to identify defective materials
Answer:
a
1. This standard is set at a level that may be reached with reasonable effort.
1. ideal standard
2. attainable standard
3. unattainable standard
4. variance from standard
1. This standard is set at a level that could be achieved if everything ran perfectly.
1. ideal standard
2. attainable standard
3. unattainable standard
4. variance from standard
Answer:
a
1. This variance is the difference involving spending more or using more than the standard amount.
1. favorable variance
2. unfavorable variance
3. no variance
4. variance
2. This variance is the difference involving spending less, or using less than the standard amount.
1. favorable variance
2. unfavorable variance
3. no variance
4. variance
Answer:
a
1. What are some possible reasons for a material price variance?
1. substandard material
2. labor rate increases
3. labor rate decreases
4. labor efficiency
2. When is the material price variance unfavorable?
1. when the actual quantity used is greater than the standard quantity
2. when the actual quantity used is less than the standard quantity
3. when the actual price paid is greater than the standard price
4. when the actual price is less than the standard price
Answer:
c
1. When is the material price variance favorable?
1. when the actual quantity used is greater than the standard quantity
2. when the actual quantity used is less than the standard quantity
3. when the actual price paid is greater than the standard price
4. when the actual price is less than the standard price
2. What are some reasons for a material quantity variance?
1. building rental charges increase
2. labor rate decreases
3. more qualified workers
4. labor efficiency increases
Answer:
c
1. When is the material quantity variance favorable?
1. when the actual quantity used is greater than the standard quantity
2. when the actual quantity used is less than the standard quantity
3. when the actual price paid is greater than the standard price
4. when the actual price is less than the standard price
2. When is the material quantity unfavorable?
1. when the actual quantity used is greater than the standard quantity
2. when the actual quantity used is less than the standard quantity
3. when the actual price paid is greater than the standard price
4. when the actual price is less than the standard price
Answer:
a
1. What are some possible reasons for a labor rate variance?
1. hiring of less qualified workers
2. an excess of material usage
3. material price increase
4. utilities usage change
2. When is the labor rate variance unfavorable?
1. when the actual quantity used is greater than the standard quantity
2. when the actual quantity used is less than the standard quantity
3. when the actual price paid is greater than the standard price
4. when the actual price is less than the standard price
Answer:
c
1. When is the labor rate variance favorable?
1. when the actual quantity used is greater than the standard quantity
2. when the actual quantity used is less than the standard quantity
3. when the actual price paid is greater than the standard price
4. when the actual price is less than the standard price
2. What are some possible reasons for a direct labor time variance?
1. utility usage decrease
2. less qualified workers
3. office supplies spending
4. sales decline
Answer:
b
1. When is the direct labor time variance favorable?
1. when the actual quantity used is greater than the standard quantity
2. when the actual quantity used is less than the standard quantity
3. when the actual price paid is greater than the standard price
4. when the actual price is less than the standard price
2. When is the direct labor time variance unfavorable?
1. when the actual quantity used is greater than the standard quantity
2. when the actual quantity used is less than the standard quantity
3. when the actual price paid is greater than the standard price
4. when the actual price is less than the standard price
Answer:
a
1. A flexible budget ________.
1. predicts estimated revenues and costs at varying levels of production
2. gives actual figures for selling price
3. gives actual figures for variable and fixed overhead
4. is not used in overhead variance calculations
2. The variable overhead rate variance is caused by the sum between which of the following?
1. actual and standard allocation base
2. actual and standard overhead rates
3. actual and budgeted units
4. actual units and actual overhead rates
Answer:
b
1. The variable overhead efficiency variance is caused by the difference between which of the following?
1. actual and budgeted units
2. actual and standard allocation base
3. actual and standard overhead rates
4. actual units and actual overhead rates
2. The fixed factory overhead variance is caused by the difference between which of the following?
1. actual and standard allocation base
2. actual and budgeted units
3. actual fixed overhead and applied fixed overhead
4. actual and standard overhead rates
Answer:
c
1. Which of the following is a possible cause of an unfavorable material price variance?
1. purchasing too much material
2. purchasing higher-quality material
3. hiring substandard workers
4. buying substandard material
2. Which of the following is a possible cause of an unfavorable material quantity variance?
1. purchasing substandard material
2. hiring higher-quality workers
3. paying more than should have for workers
4. purchasing too much material
Answer:
a
1. Which of the following is a possible cause of an unfavorable labor efficiency variance?
1. hiring substandard workers
2. making too many units
3. buying higher-quality material
4. paying too much for workers
2. Which of the following is a possible cause of an unfavorable labor rate variance?
1. hiring too many workers
2. hiring higher-quality workers at a higher wage
3. making too many units
4. purchasing too much material
Answer:
b
Questions
1. What two components are needed to determine a standard for materials?
Answer:
The expected price of materials per unit and the expected quantity usage are needed to help determine a standard.
1. What two components are needed to determine a standard for labor?
2. What elements require consideration before establishing an overhead standard?
Answer:
Fixed overhead and variable overhead should be considered
1. What is a variance?
2. What causes the material price variance?
Answer:
Paying more or less than the standard price
1. What causes the material quantity variance?
2. What are some possible causes of a material price variance?
Answer:
Buying a different quality level of material; good or bad purchasing/negotiation
1. What are some possible causes of a material quantity variance?
2. What is the direct labor rate variance?
Answer:
A direct labor rate variance is the actual rate paid being different from the standard rate
1. What is the direct labor time variance?
2. What are some possible causes of a direct labor rate variance?
Answer:
Employees have a different level of experience than standards; the labor market is tighter or looser than expected; contract renegotiation.
1. What are some possible causes of a direct labor time variance?
2. How is the total direct labor variance calculated?
Answer:
$\text {Total direct labor variance} = (\text {Actual hours} × \text {Actual rate}) – (\text {Standard hours} × \text {Standard rate})$ or the total direct labor variance is also found by combining the direct labor rate variance and the direct labor time variance.
1. What causes the variable overhead rate variance?
2. What causes the variable overhead efficiency variance?
Answer:
The difference between the actual and standard amounts of the allocation base cause variable overhead efficiency variance.
1. What is the main difference between a flexible budget and a master budget?
2. What causes a favorable variance?
Answer:
It is caused by paying or using less than the standard amount
1. What causes an unfavorable variance?
2. When might a favorable variance not be a good outcome?
Answer:
It may not be a good outcome when buying substandard material or hiring substandard employees
1. When might an unfavorable variance be a good outcome?
2. Identify several causes of a favorable material price variance.
Answer:
Causes may include substandard material, quantity discount, negotiated better price, quantity discount, or price drop.
1. Identify several causes of an unfavorable material price variance.
2. Identify several causes of a favorable material quantity variance.
Answer:
Causes may include higher-quality material, better-qualified employees, or a change in manufacturing process.
1. Identify several causes of an unfavorable material quantity.
2. Identify several causes of a favorable labor rate variance.
Answer:
Causes may include less-qualified employees or a change in quality level of employees due to a change in process.
1. Identify several causes of an unfavorable labor rate variance.
2. Identify several causes of a favorable labor efficiency variance.
Answer:
Causes may include better material, higher-quality employees, or a change in process.
1. Identify several causes of an unfavorable labor efficiency variance.
Exercise Set A
1. Moisha is developing material standards for her company. The operations manager wants grade A widgets because they are the easiest to work with and are the quality the customers want. Grade B will not work because customers do not want the lower grade, and it takes more time to assemble the product than with grade A materials. Moisha calls several suppliers to get prices for the widget. All are within $\0.05$ of each other. Since they will use millions of widgets, she decides that the $\0.05$ difference is important. The supplier who has the lowest price is known for delivering late and low-quality materials. Moisha decides to use the supplier who is $\0.02$ more but delivers on time and at the right quality. This supplier charges $\0.48$ per widget. Each unit of product requires four widgets. What is the standard cost per unit for widgets?
2. Rene is working with the operations manager to determine what the standard labor cost is for a spice chest. He has watched the process from start to finish and taken detailed notes on what each employee does. The first employee selects and mills the wood, so it is smooth on all four sides. This takes the employee $1$ hour for each chest. The next employee takes the wood and cuts it to the proper size. This takes $30$ minutes. The next employee assembles and sands the chest. Assembly takes $2$ hours. The chest then goes to the finishing department. It takes $1.5$ hours to finish the chest. All employees are cross-trained so they are all paid the same amount per hour, $\17.50$.
1. What are the standard hours per chest?
2. What is the standard cost per chest for labor?
3. Fiona cleans offices. She is allowed $5$ seconds per square foot. She cleans building A, which is $3,000$ square feet, and building B, which is $2,460$ square feet. Will she finish these two buildings in an 8-hour shift? Will she have time for a break?
4. Use the information provided to create a standard cost card for production of one glove box switch. To make one switch it takes 16 feet of plastic-coated copper wire and $0.5$ pounds of plastic material. The plastic material can usually be purchased for $\20.00$ per pound, and the wire costs $\2.50$ per foot. The labor necessary to assemble a switch consists of two types. The first type of labor is assembly, which takes $3.5$ hours. These workers are paid $\27.00$ per hour. The second type of labor is finishing, which takes $2$ hours. These workers are paid $\29.00$ per hour. Overhead is applied using labor hours. The variable overhead rate is $\14.90$ per labor hour. The fixed overhead rate is $\15.60$ per hour.
5. Sitka Industries uses a cost system that carries direct materials inventory at a standard cost. The controller has established these standards for one ladder (unit):
Sitka Industries made $3,000$ ladders in July and used $8,800$ pounds of material to make these units. Smith Industries bought $15,500$ pounds of material in the current period. There was a $\250$ unfavorable direct materials price variance.
1. How much in total did Sitka pay for the $15,500$ pounds?
2. What is the direct materials quantity variance?
3. What is the total direct material cost variance?
4. What if $9,500$ pounds were used to make these ladders, what would be the direct materials quantity variance?
5. If there was a $\340$ favorable direct materials price variance, how much did Sitka pay for the $15,500$ pounds of material?
1. Use the information provided to answer the questions.
All material purchased was used in production.
1. What is the standard price paid for materials?
2. What is the direct materials quantity variance?
3. What is the total direct materials cost variance?
4. If the direct materials price variance was unfavorable, what would be the standard price?
1. Dog Bone Bakery, which bakes dog treats, makes a special biscuit for dogs. Each biscuit uses $0.75$ cup of pure semolina flour. They buy $4,000$ cups of flour at $\0.55$ per cup. They use $3,550$ cups of flour to make $4,750$ biscuits. The standard cost per cup of flour is $\0.53$.
1. What are the direct materials price variance, the direct materials quantity variances, and the total direct materials cost variance?
2. What is the standard cost per biscuit for the semolina flour?
2. Queen Industries uses a standard costing system in the manufacturing of its single product. It requires $2$ hours of labor to produce $1$ unit of final product. In February, Queen Industries produced $12,000$ units. The standard cost for labor allowed for the output was $\90,000$, and there was an unfavorable direct labor time variance of $\5,520$.
1. What was the standard cost per hour?
2. How many actual hours were worked?
3. If the workers were paid $\3.90$ per hour, what was the direct labor rate variance?
3. Penny Company manufactures only one product and uses a standard cost system. The following information is from Penny’s records for May:
During May, the company used $12.5\%$ more hours than the standard allowed.
1. What were the total standard hours allowed for the units manufactured during the month?
2. What were the actual hours worked?
3. How many actual units were produced during May?
1. ThingOne Company has the following information available for the past year. They use machine hours to allocate overhead.
What is the variable overhead efficiency variance?
1. A manufacturer planned to use $\78$ of variable overhead per unit produced, but in the most recent period, it actually used $\76$ of variable overhead per unit produced. During this same period, the company planned to produce $500$ units but actually produced $540$ units. What is the variable overhead spending variance?
2. Acme Inc. has the following information available:
1. Compute the material price and quantity, and the labor rate and efficiency variances.
2. Describe the possible causes for this combination of favorable and unfavorable variances.
1. Acme Inc. has the following information available:
1. Compute the material price and quantity, and the labor rate and efficiency variances.
2. Describe the possible causes for this combination of favorable and unfavorable variances.
1. Acme Inc. has the following information available:
1. Compute the material price and quantity, and the labor rate and efficiency variances.
2. Describe the possible causes for this combination of favorable and unfavorable variances.
Exercise Set B
1. Bristol is developing material standards for her company. The operations manager wants grade A plastic tops because they are the easiest to work with and are the quality the customers want. Grade B will not work because customers do not want the lower grade, and it takes more time to assemble the product than with grade A materials. Bristol calls several suppliers to get prices for the plastic top. All are within $\0.10$ of each other. Since the company will use millions of the plastic tops, she decides that the $\0.10$ difference is important. The supplier who has the lowest price is known for delivering late and low-quality materials. Bristol decides to use the supplier who is $\0.04$ more but delivers on time and at the right quality. This supplier charges $\0.52$ per plastic top. Each unit of product requires six plastic tops. What is the standard cost per unit for plastic tops?
2. Salley is developing material and labor standards for her company. She finds that it costs $\0.55$ per pound of material per widget. Each widget requires $6$ pounds of material per widget. Salley is also working with the operations manager to determine what the standard labor cost is for a widget. Upon observation, Salley notes that it takes $3$ hours in the assembly department and $1$ hour in the finishing department to complete one widget. All employees are paid $\10.50$ per hour.
1. What is the standard materials cost per unit for a widget?
2. What is the standard labor cost per unit for a widget?
3. Use the following information to create a standard cost card for production of one photography drone from Drone Experts.
1. To make one drone it takes $2$ pounds of plastic material. The material can usually be purchased for $\25.00$ per pound. The labor necessary to build a drone consists of two types. The first type of labor is assembly, which takes $10.5$ hours. These workers are paid $\21.00$ per hour. The second type of labor is finishing, which takes $7$ hours. These workers are paid $\25.00$ per hour. Overhead is applied using labor hours. The variable overhead rate is $\14.00$ per labor hour. The fixed overhead rate is $\16.00$ per hour.
4. Mateo makes gizmos. He would like to set up a system to help him manage his business. The gizmos are made in a standard process. There is a certain amount of material and labor that goes into each gizmo. The only difference between the gizmo is the color of the material. What information should Mateo collect, how should he format it, and what kind of reports should he prepare to help him run his business?
5. Smith Industries uses a cost system that carries direct materials inventory at a standard cost. The controller has established these standards for the cost of one basket (unit):
Smith Industries made $3,000$ baskets in July and used $15,500$ pounds of material to make these units. Smith Industries paid $\39,370$ for the $15,500$ pounds of material.
1. What was the direct materials price variance for July?
2. What was the direct materials quantity variance for July?
3. What is the total direct materials cost variance?
4. If Smith Industries used $15,750$ pounds to make the baskets, what would be the direct materials quantity variance?
1. Lizbeth, Inc., makes ice cream. The toffee coffee ice cream takes $4$ quarts of cream, $3$ cups of sugar, $2$ tablespoons of toffee flavoring, and $1.5$ tablespoons of coffee flavoring per gallon. The standard prices are $\2.00$ per quart of cream, $\0.40$ per cup of sugar, $\0.50$ per tablespoon of toffee flavoring, and $\0.75$ per tablespoon of coffee flavoring.
1. What is the standard material cost for a gallon of toffee coffee ice cream?
2. If Lizbeth makes $35$ gallons of toffee coffee ice cream, how much of each of the ingredients should she use?
3. If Lizbeth uses $105$ quarts of cream to make $25$ gallons of ice cream, what would be the cream (direct materials) quantity variance?
4. If Lizbeth uses $45$ tablespoons of toffee flavoring to make $25$ gallons of ice cream, what would be the toffee flavoring (direct materials) quantity variance?
2. Woodpecker manufactures sawmill equipment. They use a standard costing system and recognize material price variance at the time of material purchases. They use carbide to make the teeth on their band-saw blades. They received an order for $250$ band-saw blades, but they did not have any carbide in stock. They purchased $3,500$ pounds of carbide for $\14,875$ but should have spent $\16,275$. Each saw blade has a standard carbide direct materials quantity of $7.8$ pounds.
1. If they used $8$ pounds per blade, what would be the direct materials quantity variance?
2. If they used $7.5$ pounds per blade, what would be the direct materials quantity variance?
3. Compute the direct materials price variance based on $7.5$ pounds of carbide per blade actually used.
3. Case made $24,500$ units during June, using $32,000$ direct labor hours. They expected to use $31,450$ hours per the standard cost card. Their employees were paid $\15.75$ per hour for the month of June. The standard cost card uses $\15.50$ as the standard hourly rate.
1. Compute the direct labor rate and time variances for the month of June, and also calculate the total direct labor variance.
2. If the standard rate per hour was $\16.00$, what would change?
4. Eagle Inc. uses a standard cost system. During the most recent period, the company manufactured $115,000$ units. The standard cost sheet indicates that the standard direct labor cost per unit is $\1.50$. The performance report for the period includes an unfavorable direct labor rate variance of $\3,700$ and a favorable direct labor time variance of $\10,275$. What was the total actual cost of direct labor incurred during the period?
5. A manufacturer planned to use $\45$ of variable overhead per unit produced, but in the most recent period, it actually used $\47$ of variable overhead per unit produced. During this same period, the company planned to produce $200$ units but actually produced $220$ units. What is the variable overhead spending variance?
6. Fitzgerald Company manufactures sewing machines, and they produced $2,500$ this past month. The standard variable manufacturing overhead (MOH) rate used by the company is $\6.75$ per machine hour. Each sewing machine requires $13.5$ machine hours. Actual machine hours used last month were $33,500$, and the actual variable MOH rate last month was $\7.00$. Calculate the variable overhead rate variance and the variable overhead efficiency variance.
7. Acme Inc. has the following information available:
1. Compute the material price and quantity, and the labor rate and efficiency variances.
2. Describe the possible causes for this combination of favorable and unfavorable variances.
1. Acme Inc. has the following information available:
1. Compute the material price and quantity, and the labor rate and efficiency variances.
2. Describe the possible causes for this combination of favorable and unfavorable variances.
1. Acme Inc. has the following information available:
1. Compute the material price and quantity, and the labor rate and efficiency variances.
2. Describe the possible causes for this combination of favorable and unfavorable variances.
Problem Set A
1. The comptroller wants to set the standards according to a study done by a consulting firm for a company. The consulting firm used the following assumptions: The machines never break down. Workers never take a break. The material used is perfect. The material arrives on time. No one takes a day off. Workers are well trained. Workers do not make defective units. What kinds of standards are these? Will the workers be motivated to achieve these standards?
2. Stan is opening a coffee shop next to Big State University. He knows that controlling his costs will be important to the success of the shop. He will not be able to work all the hours the shop is open, so the employees will need some guidelines to perform their jobs correctly. After talking to an accounting professor, he decides he needs a standard cost system for his shop. Describe the process Stan should follow in setting his standards for materials and labor.
3. What makes a variance favorable? Give an example of a favorable variance involving materials. What makes a variance unfavorable? Give an example of an unfavorable variance involving labor.
4. April Industries employs a standard costing system in the manufacturing of its sole product, a park bench. They purchased $60,000$ feet of raw material for $\300,000$, and it takes $5$ feet of raw materials to produce one park bench. In August, the company produced $10,000$ park benches. The standard cost for material output was $\100,000$, and there was an unfavorable direct materials quantity variance of $\6,000$.
1. What is April Industries’ standard price for one unit of material?
2. What was the total number of units of material used to produce the August output?
3. What was the direct materials price variance for August?
5. Ed Co. manufactures two types of O rings, large and small. Both rings use the same material but require different amounts. Standard materials for both are shown.
Large Small
Rubber 3 feet at $0.25 per foot 1.25 feet at$0.25 per foot
Connector 1 at $0.03 1 at$0.03
At the beginning of the month, Ed Co. bought $25,000$ feet of rubber for $\6,875$. The company made $3,000$ large O rings and $4,000$ small O rings. The company used $14,500$ feet of rubber.
1. What are the direct materials price variance, the direct materials quantity variance, and the total direct materials cost variance?
2. If they bought $10,000$ connectors costing $\310$, what would the direct materials price variance be for the connectors?
3. If there was an unfavorable direct materials price variance of $\125$, how much did they pay per foot for the rubber?
1. The Whizbang Company makes a special type of toy. Each top takes $6$ ounces of a special material that costs $\3$ per ounce. Whizbang bought $4,000$ ounces of the material at a cost of $\11,300$. They used $3,400$ ounces to make $534$ toys. Compute the direct materials price variance, the direct materials quantity variance, and the total direct materials cost variance.
2. Ellis Company’s labor information for September is as follows:
1. Compute the standard direct labor rate per hour.
2. Compute the direct labor time variance.
3. Compute the standard direct labor rate if the direct labor rate variance was $\2,712.50$ (unfavorable).
1. Breakaway Company’s labor information for May is as follows:
1. What is the actual direct labor rate per hour?
2. What is the standard direct labor rate per hour?
3. What was the total standard direct labor cost for May?
4. What was the direct labor rate variance for May?
1. Power Co.’s labor information for June is as follows:
1. What was the actual labor rate per hour?
2. What was the standard labor rate per hour?
3. What was the total standard labor cost for units produced in June?
4. What was the direct labor time variance for June?
1. Prepare a flexible budget for overhead based on the following data:
1. Reddy Corporation has collected the following data for the month of June:
What is the variable overhead efficiency variance?
1. ABC Inc. spent a total of $\48,000$ on factory overhead. Of this, $\28,000$ was fixed overhead. ABC Inc. had budgeted $\27,000$ for fixed overhead. Actual machine hours were $5,000$. Standard hours for units made were $4,800$. The standard variable overhead rate was $\4.10$. What is the variable overhead rate variance?
2. Recompute the variances from the second Acme Inc. exercise using $\0.0725$ as the standard cost of the material and $\14$ as the standard labor cost per hour. How has your explanation of the variances changed?
Problem Set B
1. Sameerah is trying to determine the standard hours to make one unit. She has studied the manufacturing process and is trying to determine what portion of the employees’ time should be included in the standard time to make the product. She knows that the actual time the worker is assembling, cutting, and painting should be part of the standard hours. She is questioning whether setup, down time, rest periods, and cleanup should be part of the standard hours. Explain why you would or would not include these times.
2. Carl cleans offices. He has the following buildings to clean every day: building A, which is $12,500$ square feet; building B, which is $24,500$ square feet; building C, which is $10,500$ square feet; and building D, which is $6,700$ square feet. He is allowed $5$ seconds per square foot. Each employee is allowed one $30$-minute lunch per shift. How many employees will he need to hire?
3. Freidrich is working with the operations manager to determine what the standard material cost is for a spice chest. He has watched the process from start to finish and taken detailed notes on what material is used. The easiest material to measure is the wood. Each chest uses $5$ board feet and produces $1.5$ feet of scrap. He is not sure what to do with the scrap that is produced; the company cannot buy the boards in any other dimensions. What amount of materials should be included in the standard for material costs?
4. A company bought $45,000$ pounds of plastic pellets to make DVDs at a cost of $\9,900$. The standard cost per pound for the pellets is $20.5$ cents. Some of these pellets were used in three jobs. The first job called for $7,500$ pounds but used $7,250$ pounds. The second job called for $8,800$ pounds but used $9,000$ pounds. The third job called for $2,300$ pounds but used $2,250$ pounds. Compute the direct materials price variance and the direct materials quantity variance for each job and in total. Why would you want to calculate the direct materials quantity variance for each job?
5. Illinois Company is a medium-sized company that makes dresses. During the month of June, $8,575$ dresses were made. All material purchases were used to make the dresses. The company had this information: standard per dress of $6$ yards of material at $\6.20$ per yard. The actual quantity was $52,000$ yards at a cost of $\325,520$. Compute the direct materials price variance, the direct materials quantity variance, and the total direct materials cost variance.
6. Corolla Manufacturing has a standard cost for steel of $\20$ per pound for a product that uses $4$ pounds of steel. During September, Corolla purchased and used $4,200$ pounds of steel to make $1,040$ units. They paid $\20.75$ per pound for the steel. Compute the direct materials price variance, the direct materials quantity variance, and the total direct materials cost variance for the month of September. What would change if Corolla had made $2,200$ units?
7. Marymount Company makes one product. In the month of April, it made $3,500$ units. Workers were paid $\32$ per hour for labor, for a total of $\718,848$. The standard hours per unit are $6.4$, and the standard labor wage rate is $\38.40$ per hour.
1. What are the actual hours worked?
2. What are the standard hours for the units made?
3. What is the direct labor rate variance for April?
4. What is the direct labor time variance for April?
5. What is the total direct labor variance for April?
8. Adam Inc.’s records for May include the following information:
1. What are Adam’s standard labor hours for the units made?
2. What is Adam’s total standard labor cost for the units made?
1. Ribco’s labor cost information for making its only product for March is as follows:
1. What is the direct labor rate variance?
2. What is the direct labor time variance?
3. What is the total direct labor variance?
1. Use the following standard cost card for $1$ gallon of ice cream to answer the questions.
Actual direct costs incurred to make $50$ gallons of ice cream:
• $275$ quarts of cream at $\1.05$ per quart
• $832$ ounces of sugar at $\0.075$ per ounce
• $165$ minutes of labor at $\37$ per hour
All material used was bought during the current period.
1. Compute the material and labor variances.
2. Comment on the results and possible causes of the variances.
1. Use the following standard cost card for $1$ gallon of ice cream to answer the questions.
Actual direct costs incurred to make $50$ gallons of ice cream:
• $275$ quarts of cream at $\1.05$ per quart
• $832$ ounces of sugar at $\0.075$ per ounce
• $165$ minutes of labor at $\37$ per hour
All materials used were bought during the current period.
1. Compute the material and labor variances.
2. Comment on the results and possible causes of the variances.
Thought Provokers
1. How do you balance a firm’s need to succeed and the need for not asking the workers for perfection?
2. What type of firm would use standard costing? What type of firm would not use standard costing?
3. You started your own construction business and need to determine the cost of materials used to build one house, and how many materials you will need to do so.
1. Where would you begin to determine the standard price and quantity needs to build one house?
2. What would produce a difference between the standard cost to build a house and the actual cost? What would cause a favorable outcome? What would cause an unfavorable outcome?
3. What action might your company take if you had an unfavorable total direct materials cost variance?
4. Is labor a true variable cost?
5. Why would managers use a flexible budget? What information does it provide that a regular budget does not?
6. Fill in the blanks in the following flexible budget:
1. Before automation became more prevalent, overhead was often calculated and allocated as a function of direct labor costs or direct labor hours. Why was this the case, and has this pattern changed?
2. In your opinion, is it important that an organization set standards and measure them monthly? Why or why not? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/08%3A_Standard_Costs_and_Variances/8.0E%3A_8.E%3A_Standard_Costs_and_Variances_%28Exercises%29.txt |
In this chapter, you will learn the difference between centralized and decentralized management and how that relates to decision-making. You will learn about responsibility accounting and the type of decision-making authority that may be granted through different responsibility centers. Finally, you will learn how certain types of decisions have differing effects, depending on the type of responsibility center.
• 9.0: Prelude to Responsibility Accounting and Decentralization
After several years of research and planning, Lauren opens her food truck and finds instant success. She is so busy that she decides to recruit several others to join her in her food truck business. While this is an exciting next step, she has some questions about expanding the food truck concept. In particular, she wants to know if she can grow the business while maintaining the level of quality in her food that has led to her success.
• 9.1: Differentiate between Centralized and Decentralized Management
All businesses start with an idea. After putting the idea into action and forming the business, measuring the performance of the business is a crucial next step for the business owners. As the business begins operations, it is fairly easy for the entrepreneur to measure the performance because the owner is heavily involved in the daily activities and decisions of the business. As the business grows, it becomes more complicated to measure the performance of the organization.
• 9.2: Describe How Decision-Making Differs between Centralized and Decentralized Environments
Larger businesses use segments, uniquely identifiable components of the business. A company often creates them because of the specific activities undertaken within a particular portion of the business. Segments are often categorized within the organization based on the services provided (i.e., departments), products produced, or even by geographic region. The purpose of identifying distinguishable segments within an organization is to provide efficiency in decision-making and performance.
• 9.3: Describe the Types of Responsibility Centers
Responsibility accounting is a basic component of accounting systems for many companies as their performance measurement process becomes more complex. The process involves assigning the responsibility of accounting for particular segments of the company to a specific individual or group. These segments are often structured as responsibility centers in which designated supervisors or managers will have both the responsibility for the performance of the center and the authority to make decisions.
• 9.4: Describe the Effects of Various Decisions on Performance Evaluation of Responsibility Centers
Organizations incur various types of costs using decentralization and responsibility accounting, and they need to determine how the costs relate to particular segments of the organization within the responsibility accounting framework. One way to categorize costs is based on the level of autonomy the organization (or responsibility center manager) has over the costs. Controllable costs are costs that a company or manager can influence.
• 9.5: Summary and Key Terms
• 9.E: Responsibility Accounting and Decentralization (Exercises)
09: Responsibility Accounting and Decentralization
Lauren is a good cook who can make delicious meals quickly, and she enjoys cooking tremendously. Several friends have suggested she consider opening a food truck. She is intrigued by this idea and decides to further explore the possibility.
After several years of research and planning, Lauren opens her food truck and finds instant success. She is so busy that she decides to recruit several others to join her in her food truck business. While this is an exciting next step, she has some questions about expanding the food truck concept. In particular, she wants to know if she can grow the business while maintaining the level of quality in her food that has led to her success.
Since the concept of multiple food trucks is similar to the franchising concept, Lauren reaches out to a good friend who is the founder of a franchise that now has \(10\) regional locations. Her friend shares with her the concepts of a decentralized business and responsibility accounting. Under this approach, her friend tells her, she will be able to allow the individual food truck owners to have autonomy over their food truck while achieving the broader goals of financial success and serving quality food. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/09%3A_Responsibility_Accounting_and_Decentralization/9.01%3A_Prelude_to_Responsibility_Accounting_and_Decentralization.txt |
All businesses start with an idea. After putting the idea into action and forming the business, measuring the performance of the business is a crucial next step for the business owners. As the business begins operations, it is fairly easy for the entrepreneur to measure the performance because the owner is heavily involved in the daily activities and decisions of the business. As the business grows through increased sales volume, additional products and locations, and more employees, however, it becomes more complicated to measure the performance of the organization. Owners and managers must design organizational systems that allow for operational efficiency, performance measurement, and the achievement of organizational goals.
In this chapter, you will learn the difference between centralized and decentralized management and how that relates to decision-making. You will learn about responsibility accounting and the type of decision-making authority that may be granted through different responsibility centers. Finally, you will learn how certain types of decisions have differing effects, depending on the type of responsibility center.
Management Control System
It is important for those studying business (and accounting, in particular) to understand the concept of a management control system. A management control system is a structure within an organization that allows managers to establish, implement, and monitor progress toward the strategic goals of the organization.
Establishing strategic goals within any organization is important. Strategic goals relate to all facets of the business, including which markets to operate in, what products and services to offer to customers, and how to recruit and retain a talented workforce. It is the responsibility of the organization’s management to establish strategic goals and to ensure that all activities of the business help meet goals.
Once an organization establishes its strategic goals, it must implement them. Implementing the strategic goals of the organization requires communication and providing plans that guide the work of those in the organization.
The final factor in creating a management control system is to design mechanisms to monitor the activities of the organization to assess how well they are meeting the strategic goals. This aspect of the management control system includes the accounting system (both financial and managerial). Monitoring the performance of the organization allows management to repeat the activities that lead to good performance and to adjust activities that are not supporting the strategic goals. In addition, monitoring the activities of the organization provides feedback to management as to whether adjustments to the organization’s strategy are necessary.
Establishing a management control system is very important to an organization. Organizations must continually evaluate ways to improve and remain competitive in an ever-changing market. This requires the organization to be both forward-looking (via strategic planning) and backward-looking (by evaluating what has occurred), constantly monitoring performance and making necessary adjustments.
CONCEPTS IN PRACTICE: Double Loop Learning
In the fall of 1977, Harvard professor Chris Argyris wrote an article entitled “Double Loop Learning in Organizations.” The article describes how organizations “learn,” defined by Argyris as “a process of detecting and correcting error.”1 Argyris suggests there are two types of learning—single loop and double loop.
Single loop learning is characterized as a system that evaluates the organization from the perspective of the organization’s present policies. The result of single loop learning is binary: the organization is either meeting or not meeting the company’s objectives. There is no further evaluation or additional information fed back into the management control system.
Double loop learning, on the other hand, allows for a more comprehensive evaluation. In addition to evaluating whether or not the organization is meeting the current goals, double loop learning takes into consideration whether or not the current goals of the organization are relevant or should be adjusted in any way. That is, double loop learning requires organizations to evaluate the underlying assumptions that serves as the basis for establishing the current goals.
Argyris’s introduction of double loop learning has had a significant impact on the study of management and organizations. The concept of double loop learning also highlights how accounting systems, both financial and managerial, play a vital role in helping the organization attain its strategic goals.
Establishing effective management control systems is important for organizations of all sizes. It is important for businesses to determine how they should structure the organization to ease decision-making and subsequent evaluation. First, levels of management within an organization help the organization form a structure that establishes levels of authority and roles within the organization. Lower-level management provides basic supervision and oversight for the operations of the organization. Mid-level management supervises and provides direction to lower-level management. Mid-level management often directs the various departments or divisions within the organization. Mid-level managers receive direction and are responsible for achieving the goals established by upper management. Upper management consists of the board of directors and chief executives charged with providing strategic guidance for the organization. Upper management has the ultimate authority within the organization and is accountable to the owners of the organization.
Once a company establishes its management levels, it must determine whether the business is set up as centralized or decentralized—opposite ends of a spectrum. Many businesses fall somewhere between the two ends. Understanding the structures of both centralized and decentralized organizations provides a foundation for understanding the variations in management accounting the organizations use.
ETHICAL CONSIDERATIONS: The Ethical Bakery Accountant
Bakery accountant Keith Roberts worked at Archway & The Mother’s Cookie Company as the director of finance. According to the New York Times, Roberts found himself perplexed by some numbers: "he knew things had been bad—daily reports he had been monitoring for six months showed that cookie sales at the company had been dismal. But the financial data he was looking at showed much more robust sales." He could not figure out where the sales were coming from, and after researching the accounting records, he determined that the company was booking nonexistent sales.
Why? Roberts reasoned that sham transactions allowed Archway, which was owned by a private-equity firm, Catterton Partners, to maintain access to badly needed money from its lender, Wachovia. Roberts played a major role in alerting Archway's auditing firm of the possibility of accounting fraud. When challenged with the deceptive accounting, Roberts’s supervisor invoked a crucial period in the business as a rationale for the unorthodox accounting for sales. Roberts finally quit his job and the accounting misstatements were brought to the attention of the bank and the auditors.
Centralized Organizations
Centralization is a business structure in which one individual makes the important decisions (such as resource allocation) and provides the primary strategic direction for the company. Most small businesses are centralized in that the owner makes all decisions regarding products, services, strategic direction, and most other significant areas. However, a business does not have to be small to be centralized. Apple is an example of a business with a centralized management structure. Within Apple, much of the decision-making responsibility lies with the Chief Executive Officer (CEO) Tim Cook, who assumed the leadership role within Apple following the death of Steve Jobs. Apple has long been viewed as an organization that maintains a high level of centralized control over the company’s strategic initiatives such as new product development, markets to operate in, and company acquisitions. Many businesses in rapidly changing technological environments have a centralized form of management structure. The decisions made by the lower level management are limited in a centralized environment.
The advantages of centralized organizations include clarity in decision-making, streamlined implementation of policies and initiatives, and control over the strategic direction of the organization. The primary disadvantages of centralized organizations can include limited opportunities for employees to provide feedback and a higher risk of inflexibility.
Decentralized Organizations
Decentralization is a business structure in which the decision-making is made at various levels of the organization. Typically, decentralized businesses are divided into smaller segments or groups in order to make it easier to measure the performance of the company and the individuals within each of the sub-groups.
Advantages of Decentralized Management
Many businesses operate in markets and industries that are highly competitive. In order to be successful, a company must work hard to develop strategic competitive advantages that distinguish the company from its peers. To accomplish this, the organizational structure must allow the organization to quickly adapt and take advantage of opportunities. Therefore, many organizations adopt a decentralized management structure in order to maintain a competitive advantage.
There are numerous advantages of a decentralized management, such as:
• Quick decision and response times—it is important for decisions to be made and implemented in a timely manner. In order to remain competitive, it is important for organizations to take advantage of opportunities that fit within the organization’s strategy.
• Better ability to expand company—it is important for organizations to constantly explore new opportunities to provide goods and services to its customers.
• Skilled and/or specialized management—organizations must invest in developing highly skilled employees who are able to make sound decisions that help the organization achieve its goals.
• Increased morale of employees—the success of an organization depends on its ability to obtain, develop, and retain highly motivated employees. Empowering employees to make decisions is one way to help increase employee morale.
• Link between compensation and responsibility—promotional opportunities are often linked with a corresponding increase in compensation. In a decentralized organization, a compensation increase often corresponds to a commensurate increase in the responsibilities associated with learning new skills, increased decision-making authority, and supervision of other employees.
• Better use of lower and middle management—many tasks must be performed in order to achieve success in an organization. Decentralized organizations often rely on lower and middle management to perform many of these tasks. This allows managers to gain valuable experience and expertise in different areas.
Disadvantages of Decentralized Management
While a decentralized organizational structure can be an advantage for many organizations, there are also disadvantages to this type of structure, including:
• Coordination problems—it is important for an organization to be working toward a common goal. Because decision-making is delegated in a decentralized organization, it is often difficult to ensure that all segments of the company are working in a consistent manner to achieve the strategic goals of the organization.
• Increased administrative costs due to duplication of efforts—because similar decisions need to be made and activities undertaken across all divisions of an organization, decentralized organizations are susceptible to duplicating efforts, which results in inefficiency and increased costs.
• Incongruity in operations—when autonomy is dispersed throughout the organization, as is the case in decentralized organizations, division managers may be tempted to customize/alter the operations of the division in an effort to maximize efficiency and suit the best interest of the division. In this structure, it is important to ensure the shortcuts taken by one division of the organization do not conflict with or disrupt the operations of another division within the organization.
• Each department/division is often self-centered (its own fiefdom)—it is not uncommon for separate divisions within an organization to be measured on the performance of the division rather than of the entire company. In a decentralized organization, it is possible for division managers to prioritize divisional goal over organizational goals. Leaders of decentralized organizations should ensure the organization’s goals remain the priority for all divisions to attain.
• Significant, if not almost total, reliance on the divisional or department managers—because divisions within decentralized organizations have a high level of autonomy, the division may become operationally isolated from other divisions within the organization, focusing solely on the priorities of the division. If divisional or departmental managers do not have a wide breadth of experience or skills, the division may be at a disadvantage due to limited access to other expertise.
CONCEPTS IN PRACTICE: Johnson & Johnson
Johnson & Johnson was founded in 1886. The first factory had \(14\) employees: eight women and six men.2 Today, Johnson & Johnson, employs over 125,000 associates and operates in over 60 countries. You may recognize some of Johnson & Johnson’s products, which include Johnson’s Baby Shampoo, Neutrogena, Band-Aid, Tylenol, Listerine, and Neosporin.
William Weldon was Chief Executive Officer (CEO) of Johnson & Johnson from 2002 to 2012. Under Weldon’s leadership, Johnson & Johnson operated under a decentralized structure. This interview on successfully operating a decentralized organization shows it is clear that the key is the people within the organization. Weldon notes that to be successful, a decentralized organization must empower employees to innovate, develop expertise, and collaborate to achieve organizational goals.
Daily and Strategic Decision-Making
An underlying assumption is that businesses possess a single structure (either centralized or decentralized) at any given point. That is not necessarily the case. For example, businesses often add employees who specialize in the various needs of the organization. Over the life of an organization, it is not uncommon for businesses to demonstrate aspects of both centralization and decentralization.
New businesses, for example, are often centralized. When a business first opens, it is common for the owner(s) to be highly involved in the day-to-day operations. In addition, the small size of a new business allows the owner to have a high level of involvement in both the daily and the strategic decisions of the business. Daily decisions are ongoing, immediate decisions that must be made in order to effectively and efficiently meet the needs of the organization’s customers. Strategic decisions, on the other hand, are made fairly infrequently and involve long-term goals of the organization. Being actively involved in the business allows new business owners to gain experience in all aspects of the business so that they can get a sense of the patterns of the daily operations and the decisions that need to be made. For example, the owner can be involved in determining the number of workers needed to meet the day’s production goal. Having too many workers would be inefficient and require the company to incur unnecessary expenses. Having too few workers, on the other hand, may result in inferior quality of products, missed shipments, or lost sales.
Additionally, an owner involved in daily operations has the opportunity to evaluate and, if necessary, alter any strategic goals that may impact the daily operations. Strategic goals relate to all facets of the business, including in which markets to operate, what products and services to offer to customers, how to recruit and retain a talented workforce, and many other aspects of the business.
If an owner is involved in daily operations, an example of a potential strategic goal could be that he or she can determine whether to pursue a cost leadership perspective. When pursuing a cost leadership perspective, companies undertake activities to eliminate costs in order to produce a product or provide a service that has a cost advantage compared to competing products or services. While providing a high-quality goods or service is important to a company pursuing a cost leadership perspective, the competitive advantage of the company is eliminating wasteful activities that add unnecessary costs, entering into strategic partnerships with suppliers and other companies, and focusing on activities that allow the organization to offer the good or service at a lower price than its competitors. Being highly involved in both the daily and strategic decisions can be very beneficial as the business is established, but it is demanding on the business owner and, without adjustments, often cannot be sustained.
As the business grows, management of a centralized organization faces a choice. Remaining highly involved in the daily decisions of the business results in a low level of involvement in the strategic decisions of the organization. While this may be effective in the short-term, the risks associated with not establishing and adjusting long-term strategic goals increase. On the other hand, remaining highly involved in the strategic decisions of the business results in a low level of involvement in the daily decisions of the business. This, too, is risky because ineffectively managing daily business decisions may have long-term, negative consequences.
ETHICAL CONSIDERATIONS: Ethically Directed Strategic Management
Managers in some organizations follow legal and regulatory requirements to operate their business at the lowest level of acceptable behavior in their business environment in order to keep costs low; however, some stakeholders may expect more than the minimum level of ethics. Stakeholders of business organizations are now insisting on higher ethical standards from their organizations. Stakeholders are any group or individual who may be affected by the organization’s business decisions. Organizations providing high-quality goods and services need to consider all of their stakeholders when developing a strategic decision-making process to direct the organization’s strategic decisions.
Another alternative for growing businesses is to move toward a decentralized operating structure. The management of growing businesses with a decentralized structure has a low level of involvement in the daily decisions of the business. Instead, management in these businesses focuses on strategic decisions that impact the long-term success of the organization. The daily decisions are delegated to others, thereby allowing management to focus on developing, implementing, and monitoring the firm’s performance with respect to the strategic goals of the business.
THINK IT THROUGH: Centralized Structure at Procter & Gamble
The organizational chart shows the \(10\) product categories of Procter & Gamble.3
Review the different types of products that Procter & Gamble produces. Think of \(2–3\) instances where Procter & Gamble would adopt a centralized perspective in its operations. Why would this perspective be beneficial for Procter & Gamble? Don’t forget to consider the ingredients used to make these products and how these products are sold to consumers.
Footnotes
1. Chris Argyris “Double Loop Learning in Organizations.” Harvard Business Review 55, no. 5 (1977): 115–116.
2. “Our Story.” Johnson & Johnson. https://ourstory.jnj.com/timeline
3. “Company Strategy.” Procter & Gamble. http://www.pginvestor.com/Company-St...GenPage=208821 | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/09%3A_Responsibility_Accounting_and_Decentralization/9.02%3A_Differentiate_between_Centralized_and_Decentralized_Management.txt |
Businesses are organized with the intention of creating efficiency and effectiveness in achieving organizational goals. To aid in this, larger businesses use segments, uniquely identifiable components of the business. A company often creates them because of the specific activities undertaken within a particular portion of the business.1 Segments are often categorized within the organization based on the services provided (i.e., departments), products produced, or even by geographic region. The purpose of identifying distinguishable segments within an organization is to provide efficiency in decision-making and effectiveness in operational performance.
Organizational Charts
Many organizations use an organizational chart to graphically represent the authority for decision-making and oversight. Organizational charts are similar in appearance to flowcharts. An organizational chart for a centralized organization is shown in Figure \(1\). The middle tier represents position held by individuals or departments within the company. The lowest tier represents geographic locations in which the company operates. The lines connecting the boxes indicate the relationship among the segments and branch from the ultimate and decision-making authority. Organizational charts are typically arranged with the highest-ranking person (or group) listed at the top.
Notice the organization depicted in Figure \(1\) has segments based on departments as well as geographic regions. In addition, all lines connect directly to the president of the organization. This indicates that the president is responsible for the oversight and decision-making for the production and sales departments as well as the district (Northeast, Southwest, and Midwest) managers; essentially, the president has seven direct reports. In this centralized organizational structure, all decision-making responsibility resides with the president.
Figure \(2\) shows the same organization structured as a decentralized organization.
Notice that the organization depicted in Figure \(2\) has the same segments, which represent departments and geographic regions. There are, however, noticeable differences between the centralized and decentralized structure. Instead of seven direct reports, the president now oversees five direct reports, three of which are based on geography—the Western, Southern, and Eastern regional managers. Notice, too, each regional district manager is responsible for their respective production and sales departments. In this decentralized organization, all decision-making responsibility does not reside with the president; regional decisions are delegated to the three regional managers. Understand, however, that responsibility for achieving the organization’s goals still ultimately resides with the company president.
In a centralized environment, the major decisions are made at the top by the CEO and then are carried out by everyone below the CEO. In a decentralized environment, the CEO sets the tone for the running of the organization and provides some decision-making guidelines, but the actual decisions for the day-to-day operations are made by the managers at the various levels of the organization. In other words, the essential difference between centralized and decentralized organizations involves decision-making. While no organization can be \(100\%\) centralized or \(100\%\) decentralized, organizations generally have a well-established structure that outlines the decision-making authority within the organization.
CONTINUING APPLICATION: Centralized vs. Decentralized Management
Gearhead Outfitters was founded by Ted Herget in 1997 in a friend’s living room in Jonesboro, AR. By 2003, the business moved to its downtown location. In 2006, a second Jonesboro location was opened. Over the next several years, the company’s growth allowed for expansion to several different cities, miles and hours away. Eventually Little Rock, AR, Fayetteville, AR, Shreveport, LA, Springfield, MO, and Tulsa, OK became home to Gearhead branches.
With such growth, the company faced many management challenges. Would it be best for management to remain centralized with decision-making coming from a single location, or should the process be decentralized, allowing local management the flexibility and autonomy to run individual locations? If local management is given autonomy to make their own decisions, will those decisions be in line with company, or perhaps, individual goals? How will management be evaluated? Will inventory management be a uniform process, or will people and the process have to adapt to accommodate differences in demand at each location?
These are just some of the hurdles that Gearhead needed to address. What are some other issues which Gearheadmight have considered? Think in terms of inventory management, personnel, efficiencies, and leadership development. How could Gearhead have use decentralized management to grow and thrive? Conversely, what would the benefits of keeping all or some of the company’s management decisions more centralized be?
How Does Decision-Making Differ in a Centralized versus a Decentralized Environment?
The CEO of a centralized organization will determine the direction of the company and determine how to get the company to its goals. The steps necessary to reach these goals are then passed along to the lower-level managers who carry out these steps and report back to the CEO. The CEO would then evaluate the results and incorporate any necessary operational changes. On the other hand, the CEO of a decentralized organization will determine the goals of the company and either pass along the goals to the divisional managers for them to determine how to reach these goals or work with the managers to determine the strategic plans and how to meet the goals laid out by those plans. The divisional managers will then meet with the managers below them to determine the best way to reach these goals. The lower-level managers are responsible for carrying out the plan and reporting their results to the manager above them. The higher-level managers will combine the results of several managers and evaluate those results before sending them to the divisional manager.
THINK IT THROUGH: Determining the Best Structure
Here are some examples of decisions that every business must make:
• Facility and equipment purchases and upgrades
• Personnel decisions such as hiring and compensation
• Products and services to offer, prices to charge customers, markets in which to operate
For each decision listed, identify and explain the best structure (centralized, decentralized, or both) for each of the following types of businesses:
• Auto manufacturer with multiple production departments
• Florist shop (with three part-time employees) owned by a local couple
• Law firm with four attorneys
Footnotes
1. In Building Blocks of Managerial Accounting, you learned that generally accepted accounting principles (GAAP)—also called accounting standards—provide official guidance to the accounting profession. Under the oversight of the Securities and Exchange Commission (SEC), GAAP are created by the Financial Accounting Standards Board (FASB). The official definition of segments as provided by FASB can be reviewed in ASC 280-10-50. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/09%3A_Responsibility_Accounting_and_Decentralization/9.03%3A_Describe_How_Decision-Making_Differs_between_Centralized_and_Decentralized_Environments.txt |
You’ve learned how segments are established within a business to increase decision-making and operational effectiveness and efficiency. In other words, segments allow management to establish a structure of operational accountability.
The terminology changes slightly when we think about accountability relating to the financial performance of the segment. In a decentralized organization, the system of financial accountability for the various segments is administered through what is called responsibility accounting.
Responsibility accounting is a basic component of accounting systems for many companies as their performance measurement process becomes more complex. The process involves assigning the responsibility of accounting for particular segments of the company to a specific individual or group. These segments are often structured as responsibility centers in which designated supervisors or managers will have both the responsibility for the performance of the center and the authority to make decisions that affect the center.
Often, businesses will use the segment structure to establish the responsibility accounting framework. You might think of segments and responsibility centers as two sides of the same coin: segments establish the structure for operational accountability whereas responsibility centers establish the structure for financial accountability. Both segments and responsibility centers (which will likely be the same) attempt to accomplish the same goal: ensure all sectors of the business achieve the organization’s strategic goals.
Before learning about the five types of responsibility centers in detail, it is important to understand the essence of responsibility accounting and responsibility centers.
Fundamentals of Responsibility Accounting and Responsibility Centers
Recall the discussion of management control systems. These systems allow management to establish, implement, monitor, and adjust the activities of the organization toward attainment of strategic goals. Responsibility accounting and the responsibility centers framework focuses on monitoring and adjusting activities, based on financial performance. This framework allows management to gain valuable feedback relating to the financial performance of the organization and to identify any segment activity where adjustments are necessary.
Types of Responsibility Centers
Organizations must exercise care when establishing responsibility centers. In a responsibility accounting framework, decision-making authority is delegated to a specific manager or director of each segment. The manager or director will, in turn, be evaluated based on the financial performance of that segment or responsibility center. It is important, therefore, to establish a responsibility accounting framework that allows for an adequate and equitable evaluation of the financial performance of the responsibility center (and, by default, the manager of the responsibility center) as well as the attainment of the organization’s strategic goals.
This is not an easy task. There are several factors that organizations must consider when developing and using a responsibility accounting framework. Before discussing those factors, let’s explore the five types of responsibility centers: cost centers, discretionary cost centers, revenue centers, profit centers, and investment centers.
Cost Centers
A cost center is an organizational segment in which a manager is held responsible only for costs. In these types of responsibility centers, there is a direct link between the costs incurred and the product or services produced. This link must be recognized by managers and properly structured within the responsibility accounting framework.
An example of a cost center is the custodial department of a department store called Apparel World. On one hand, since the custodial department is structured as a cost center, the goal of the custodial department manager is to keep costs as low as possible, since this is the basis by which the manager will be evaluated by upper-level management. On the other hand, the custodial department manager, who is responsible for cleaning the store entrances, also wants to keep the store as clean as possible for the store’s customers. If the store appears unclean and disorganized, customers will not continue to shop at the store. Therefore, the custodial department manager and upper-level management must work together to establish goals of the cost center (the custodial department, in this example) that satisfy the strategic goals of the business—maintaining a clean and organized store while minimizing the costs of managing the custodial department.
Figure $1$ shows an example of what the cost center report might look like for the Apparel World custodial department.
Let’s use this report to explore how the department manager and upper-level management might review and use this information. In total, in December, the custodial department incurred $\980$ more of actual expenses than budgeted (or expected) expenses. This represents a $5.2\%$ increase in expenses than was expected.
Notice the terminology used to describe the financial information of the custodial department: the department “incurred $\980$ more of actual expenses,” rather than the department “spent $\980$ more of actual expenses.” Recall from Introduction to Financial Statements that financial statements are typically prepared using accrual accounting rather than cash accounting. Under accrual accounting, certain transactions are recorded regardless of when the cash is exchanged. Therefore, to say the custodial department “spent $\19,725$” or “spent $\980$ more for expenses” would technically be incorrect, since the cash may not have been spent.
The managers would then review each line item to determine what caused the $\980$ increase in expenses over what was expected. Keep in mind, the $\980$ represents the total overage from the budget, so it is possible that some expense accounts could have actually been below expectations. Unfortunately, that is not the case in the month of December because every line item, with the exception of department manager wages, exceeded the budgeted amount. It was no surprise to management that the department manager’s wages were exactly as expected. Even though the custodial department manager worked more hours in the month of December, the manager is a salaried employee, so the wages are the same regardless of the number of hours worked.
Upon further investigation, it was determined that in December, the town where the Apparel World store is located received an unusually high amount of snow. This had an impact on each of the expense amounts in the custodial department. Because of the need to shovel snow more often, some of the custodial staff had to work overtime to ensure customers could easily and safely enter the store. This led to an increase in custodial wages of $\500$ compared to the budgeted or expected amount, which was established based on the previous year, when snowfall in the area was closer to average.
The research conducted by management also identified that additional cleaning equipment (mop buckets, mops, and “wet floor” signs) were purchased. The increased snowfall also led to the purchase of more salt than usual for the sidewalks outside the store. Because it was important to promptly clean the snow as well as the salt that was brought into the store on customers’ shoes, additional equipment was purchased so that each entrance would have a mop and bucket. The custodial department manager decided this was the best course of action. Normally, the store uses a single mop and bucket to clean all entrances. This would have taken more time and increased the risk of an accident.
The increased application of salt partially explains the $129.2\%$ (or $\155$) overage in the cleaning supplies expense account. Management has learned that the overage in this account was also caused by an increase in purchases of mop head replacements, floor cleaner, and paper towels.
After reviewing the December information and learning the causes of the increased expenses, the company determined that no corrective action was necessary going forward. The area received an unusually high level of snowfall that year, which was not something the custodial department manager could control. In fact, the upper-level managers praised the custodial department manager for taking action that was in the best interest of the store and its customers. The managers commented that they had received numerous compliments from customers regarding how easy and safe it was to enter the store compared to other local stores. The manager noted that, despite the increased snowfall, store sales were higher than expected and attributed much of the success to the work of the custodial department.
Discretionary Cost Centers
A discretionary cost center is similar to a cost center, with one distinguishing factor. A discretionary cost center is an organizational segment in which a manager is held responsible for controllable costs when there is not a well-defined relationship between the center’s costs and its services or products. Examples include human resources and accounting departments. Human resources departments often establish policies that affect the entire organization. For instance, while a policy requiring all workers to have annual safety training for fires, injuries, and tornadoes is beneficial to the entire company, it is difficult to evaluate the human resources department manager’s performance in relation to impacting the products or services the company provides. As you might expect, reviewing the financial performance of a discretionary cost center is similar to that of the review of a cost center.
Revenue Centers
A revenue center is an organizational segment in which a manager is held accountable only for revenues. As the name implies, the goal of a revenue center is to generate revenues for the business. In order to accomplish the goal of increasing revenues, the manager of a revenue center would focus on developing specific skillsets of the revenue center’s employees. The reservations group of Southwest Airlines is an example of a segment that may be structured as a revenue center. The employees should be well-trained in providing excellent customer service, handling customer complaints, and converting customer interactions into actual sales. As the financial performance of cost centers and discretionary cost centers is similar, so is the financial performance of a revenue center and a cost center.
Profit Centers
A profit center is an organizational segment in which a manager is responsible for both revenues and costs (such as a Starbucks store location). Of the responsibility centers explored so far, a profit center structure is the most complex because a manager must be well-versed in techniques to increase revenues, decrease expenses, and thereby increase profits while also meeting the strategic goals of the organization.
Let’s return to the Apparel World department store. Figure $2$ shows an example of what the profit center report might look like for the Apparel World children’s clothing department.
Just as with the cost center, let’s walk through an analysis of the December children’s clothing department profit center report. Overall, the department’s actual profit exceeded budgeted profit by $\3,891$, or $13.5\%$, compared to budgeted (or expected) profit. This increase was driven by a total revenue increase over budget by $\29,200$ or $19.8\%$. Recall from Building Blocks of Managerial Accounting that variable costs, unlike fixed costs, change in proportion to the level of activity in a business. Therefore, it should be no surprise that the expenses in the children’s clothing department also increased. In fact, the expenses increased $\25,309$ (or $21.4\%$) versus the budgeted amount. The revenues of the department increased $\29,200$, while expenses increased $\25,309$, yielding an increase in profit of $\3,891$ over expectations.
The increase in revenue could be further analyzed. Because the store also sells accessories such as belts and socks, the children’s clothing department tracks two revenue sources (also called streams)—clothing and accessories. Management was pleased to learn that clothing revenue exceeded expectations by $\30,000$, or $20.7\%$. Given the higher-than-usual level of snowfall in the area, this is an impressive increase, and the company can attribute a portion of the successful month to the employees of the custodial department, who worked extra hard to ensure customers could easily and safely enter the store.
The overall revenue of the department increased by $\29,200$. Since the clothing department revenue increased by $\30,000$, the clothing accessories revenue stream must have experienced a decline in revenue. In fact, the accessories revenue dropped by $36.4\%$. While this is a large percentage, consider the fact that the actual value of revenue decline was relatively minor—only $\800$ lower (as indicated by the negative amount) than expected. This indicates the employees may not have encouraged customers to also get belts or socks with their clothing purchase. This is an opportunity for the department manager to remind employees to encourage customers to purchase accessories to complement the clothing purchases. Overall, the increase in revenue attained by the children’s clothing department is a highlight for the store.
A review of the department’s expenses shows increases in all expenses, except department manager wages and cost of accessories sold. When reviewing the profit center report, pay special attention to how the differences between the actual and budgeted expenses are calculated in this analysis. In the revenue section, a positive number indicates the revenue exceeded the budgeted amount, which means a favorable financial performance. In the expense section, a positive number indicates the expense exceeded the budgeted amount, which means an unfavorable financial performance.
As with the custodial department manager, the manager of the children’s clothing department is also a salaried employee, so the wages do not change each month—the wages are a fixed cost for the department. Since the clothing accessories revenue declined, the cost of accessories also declined. The accessories expenses were $\576$ lower than expected. While this appears to be good news for the department, recall that clothing accessories revenue dropped by $\800$. Therefore, the department profit margin decreased by a net amount of $\224$ versus expectations ($\800$ revenue decline and a corresponding expense decrease of $\576$).
All other actual expenses were over budget, as indicated by the positive numbers. Remember, these are expenses, and in this analysis, they indicate unfavorable financial performance. It probably comes as no surprise that all of the expense overages are a result of the increased sales. Because of the increased sales, more associates were needed to cover each shift, and they worked more hours to cover the longer store hours, which caused wages to go over budget. The substantial increase in clothing revenue also caused the cost of clothing sold to increase proportionately. Similarly, the increased sales drove an increase in equipment/fixture repairs of $\735$ (or $253.4\%$) over budget due to repairs to cash registers and clothing racks. Because the store was open longer hours during the holiday season, the utilities expenses also exceeded budget by $\275$, or $44.4\%$.
Overall, the Apparel World department store management was pleased with the December financial performance of the children’s clothing department. The department exceeded budgeted sales, which resulted in an increase in department profitability. The review also highlighted an area for improvement in the department—increasing accessory sales—which is easily corrected through additional training.
Notice that the review of the children’s clothing department profit center report discussed differences measured in both dollars and percentages. When analyzing financial information, looking only at dollar values can be misleading. Displaying information as percentages—percentage of an entire amount or percentage change—standardizes the information and facilitates an easier and more accurate comparison, especially when dealing with segments (or companies) with vastly different sizes.
Let’s look at another scenario using Apparel World. The example so far has explored the financial performance review processes for a cost center and a profit center. Now assume that store management wants to compare two different profit centers—children’s clothing and women’s clothing. Figure $3$ shows the December financial information for the children’s clothing department, and Figure $4$ shows the financial information for the women’s clothing department.
Comparing the dollar differences in the two departments, notice that the children’s clothing department is a smaller department, as measured by total revenue, than the women’s clothing department.
Now, let’s compare the differences in the two departments by looking at the percentages. The children’s clothing department financial information is shown in Figure $5$, and the women’s clothing department financial information is shown in Figure $6$.
Does the comparison change when the dollar differences are shown as percentages? Which department was more effective at strengthening the store’s financial position? Which department was more efficient with the December revenue? What other factors might the Apparel World management consider?
Adding the percentages to the financial analysis allows managers to more directly make comparisons, to separate departments in this case. Simply reviewing the dollar differences can be misleading because of size differences between the departments being compared. The Women’s Department added more value ($\61,113$) to the store’s financial position, while the Children’s Department was more efficient, converting $13.5\%$ (or $\0.135$) of every dollar of revenue to profit.
Investment Centers
It is important for managers to continually invest in the business. Managers must choose investments that improve the value of the business by improving the customer experience, increasing customer loyalty, and, ultimately, increasing the value of the organization. A limitation of the centers explored so far—cost center, discretionary cost center, revenue center, and profit center—is that these structures do not account for the investments made by the various responsibility center managers. The final responsibility center—investment centers—takes into account and evaluates the investments made by the responsibility center managers. The goal of the investment center structure is to ensure that segment managers choose investments that add value and help the organization achieve its strategic goals.
An investment center is an organizational segment (such as the northern region of Best Buy or the food trucks used in the Prelude to the chapter opening case) in which a manager is accountable for profits (revenues minus expenses) and the invested capital used by the segment.
CONCEPTS IN PRACTICE: Research and Development at Hershey’s
As you know by now, financial statements tell users what has occurred in the past—the statements provide feedback value. Responsibility accounting is no exception—it is a system that measures the financial performance of what has already occurred and provides management with a measure of past events.
Have you ever considered how companies measure the outcome of activities that have not yet occurred? As you’ve learned, many companies invest in research and development activities to determine how to improve existing products and to create entirely new products or processes.
The Hershey Chocolate Company is one company that invests heavily in research and development. Hershey’s has created an Advanced Technology & Foresight Lab, which looks for innovative ways to bring chocolate to the market.
Here are some of the innovative things that Hershey’s has developed:
• Sourcemap—an interactive, web-based tool to show consumers where the ingredients in their favorite Hershey’ssnack, such as Hershey’s Milk Chocolate with Almonds Bar comes from. There is also a video and short story for each point on the interactive map for more information.
• SmartLabel—a scanable label on each Hershey’s product that gives the user up-to-date ingredient, allergen, and other information.
• Chocolate made inside the package—Hershey’s developed this process to form a piece of chocolate inside the package.
• 3D Chocolate Printing—using a 3D printer, Hershey’s has developed an innovative way to create customized chocolate candies.1
Measuring the financial success of innovations such as these is nearly impossible in the short-run. However, in the long-run, investments in product development help companies like Hershey’s increase sales, reduce costs, gain market share, and remain competitive in the marketplace.
There are numerous methods used to evaluate the financial performance of investment centers. When discussing profit centers, we used the segment’s profit/loss stated in dollars. Another method to evaluate segment financial performance involves using the profit margin percentage.
The profit margin percentage is calculated by taking the net profit (or loss) divided by the net sales. This is a useful calculation to measure the organization’s (or segment’s) efficiency at converting revenue into profit (net income). While the dollar value of a segment’s profit/loss is important, the advantage of using a percentage is that percentages allow for more direct comparisons of different-sized segments.
Let’s return to the Apparel World example and look at the profit margin percentage for the children’s and women’s clothing departments. Figure $7$ shows the December financial information for the children’s clothing department, including the profit margin percentage.
The actual profit margin percentage achieved by the children’s clothing department was $18.5\%$, calculated by taking the department profit of $\32,647$ divided by the total revenue of $\176,400$ ($\32,647 /\ 176,400$). The actual profit margin percentage was slightly lower than the expected percentage of $19.5\%$ ($\28,756 / \147,200$). To determine why the profit margin percentage slipped slightly compared to expectations, management could compare the actual revenue and expenses with the budgeted revenue and expenses using a vertical analysis, as shown in Financial Statement Analysis. Doing so would highlight the fact that the cost of clothing sold as a percentage of clothing revenue increased significantly compared to what was expected. Management would want to explore this further, looking at factors influencing both clothing revenue (sales prices and quantity) and the cost of the clothing (which may have increased).
Figure $8$ shows the December financial information for the women’s clothing department, including the profit margin percentage.
The actual profit margin percentage of the women’s clothing department was $14.6\%$, calculated by taking the department profit of $\61,113$ divided by the total revenue of $\417,280$ ($\61,113 / \417,280$). The actual profit margin percentage was significantly lower than the expected percentage of $18.2\%$ ($\58,580 / \322,300$). As with the children’s clothing department, a vertical analysis indicates the significant decrease from budgeted profit margin percentage was a result of the cost of clothing sold. This would lead management to investigate possible causes that would have influenced the clothing revenue (sales prices and quantity), the cost of the clothing, or both.
Another method used to evaluate investment centers is called return on investment. Return on investment (ROI) is the department or segment’s profit (or loss) divided by the investment base (Net Income / Base). It is a measure of how effective the segment was at generating profit with a given level of investment. Another way to think about ROI is its use as a measure of leverage. That is, the return on investment calculation measures how much profit the segment can realize per dollar invested.
Several points are in order regarding the definition of return on investment. In practice, the numerator (segment profit or loss) may have different names, depending upon the terms used by the organization. Some organizations may call this value net income (or loss) or operating income (or loss). These terms relate to the financial performance of the segment, and each organization decides how best to identify and quantify financial performance.
Another significant point in the definition of return on investment relates to the denominator (investment base). There is no uniform definition of “investment base” within the accounting/finance profession. Some organizations define investment base as operating assets, while others define the investment base as average operating assets. Other organizations use the book value of assets, and still others use the historical or even replacement cost of assets. There are valid arguments for all of these definitions for investment base. It is important not to be confused by these variations but instead to know the definition in a particular context and to use it consistently. For our purposes, the denominator in the return on investment formula will be “investment base,” and the value will be provided.
Finally, you may recall from Long-Term Assets that accountants carefully consider where to place certain costs (either on the balance sheet as assets or on the income statement as expenses). While ROI typically deals with long-lived assets such as buildings and equipment that are charged to the balance sheet, the ROI approach also applies to certain “investments” that are expensed. For instance, advertising costs are expensed. If a segment is considering an advertising campaign, management would assess the effectiveness of the advertising campaign in a similar manner as the traditional ROI analysis using large, capitalized investments. That is, management would want to assess the additional revenue (or profit) derived from the advertising campaign (which would be the numerator in the ROI calculation) compared to the investment or cost of the advertising campaign (which would be the denominator in the ROI calculation). To illustrate, let’s say management was able to identify that an advertising campaign costing $\2,500$ brought in an additional $\500$ of profit. This would be a $20\%$ return on investment ($\500 / \2,500$).
A return on investment analysis of an investment center begins with the same information as an analysis of a profit center. To explore return on investment, let’s return to the December Apparel World profit center information analyzing the children’s and women’s clothing departments. Assume that a smaller store in another location had the following profit for December:
• Children’s clothing department: $\3,891$
• Women’s clothing department: $\2,533$
Now assume that each department had an investment base of the following amounts:
• Children’s clothing department: $\15,000$
• Women’s clothing department: $\65,000$
To calculate the return on investment (ROI) for each department, divide the segment profit by the segment investment base. The ROI for each department is:
• Children’s clothing department: $25.9\%$ ($\3,891 / \15,000$)
• Women’s clothing department: $3.9\%$ ($\2,533 / \65,000$)
The children’s clothing department contributed the most to the financial position of this Apparel World location ($\3,891$ vs. $\2,533$). In addition, the children’s clothing department was able to better leverage every dollar invested into profit. Stated differently, for every dollar invested, the children’s clothing department was able to realize $\0.259$ of profit while the women’s clothing department realized only $\0.039$ of profit for every dollar invested.
It is also significant that the children’s clothing department requires a smaller dollar value of investment. This conserves store resources (financial capital) and helps store management prioritize and efficiently allocate future resources. By investing in the children’s clothing department, store management is able to invest a smaller dollar amount while achieving a higher rate of return (profitability) on that investment.
One of the criticisms of the ROI approach is that each segment evaluates potential investments only in relation to the individual segment’s ROI. This may cause the individual segment manager to select only projects or activities that improve the individual segment’s ROI and decline projects that improve the financial position of the overall company. Most often, segment managers are primarily evaluated based on the performance of the segment they manage with only a small portion, if any, of their evaluation based on overall corporate performance. This means that the bonuses of a segment manager are largely dependent on how the segment performs, or in other words, based on the decisions made by that segment manager. A manager may choose to forgo a project or activity because it will lower the segment’s ROI even though the project would benefit the entire company. ROI and the many implications of its use are explained further and demonstrated in Balanced Scorecard and Other Performance Measures.
The final investment center evaluation method, residual income (RI), structures the investment selection process to incentivize segment managers to select projects that benefit the entire company, rather than only the specific segment.
Example $1$: Analyzing Historical Success
Companies want to be sure the investments they make are generating an acceptable return. Additonally, individual investors want to ensure they are receiving the highest financial return for the money they are investing.
This article published in the New York Times on best investments listed Microsoft as having one of the best investments since 1926 (based on a study by Hendrik Bessembinder). Based on stock market returns to investors, Microsoft ranked third, behind ExxonMobil and Apple. According to the article, “since 1986, it has had an annualized return of $25$ percent.”
Other companies in the ranking included familiar company names such as General Electric (ranked #4), Walmart(ranked #10), McDonald’s (#31), and Coca-Cola (#15).
But does historical success ensure future success? General Electric is listed in the article as the 4th highest-ranking company for creating wealth for investors. Conduct internet research to find out the condition of General Electric today. What do you think the future holds for General Electric?
As the world-wide economy changes, General Electric seems to be struggling to evolve, and this issue potentially leaves them with an uncertain future.
Residual income (RI) establishes a minimum level that all investments must attain in order to be accepted by management. This minimum acceptable level is defined as a dollar value and is applicable to all departments or segments of the business. Residual income is calculated by taking the segment income less the product of the investment value and cost of capital percentage. The formula is:
$\text {Residual Income} = \text {Income} - (\text {Investment} \times \text {Cost of Capital Percentage})$
As with the return on investment calculation, income can be defined as segment operating income (or loss) or segment profit (or loss). Some organizations may use different terms. In RI scenarios, the investment refers to a specific project the segment is considering. Investment, in RI calculations, should not be confused with the total investment base, which was used in the ROI calculation. Finally, the cost of capital, which is covered in Short-Term Decision-Making, refers to the rate at which the company raises (or earns) capital. Essentially, the cost of capital can be considered the same as the interest rate at which the company can borrow funds through a bank loan. By establishing a standard cost of capital rate used by all segments of the company, the company is establishing a minimum investment level that all investment opportunities must achieve. For example, assume a company can borrow funds from a local bank at an interest rate of $10\%$. The company, then, does not want a segment accepting an investment opportunity that earns anything less than $10\%$. Therefore, the company will establish a threshold—the cost of capital percentage—that will be used to screen potential investments. At the same time, under the residual income structure, managers of the individual segments (also called responsibility centers) will be incentivized to undertake investments that benefit not only the segment but also the entire company. Recall that the ROI of the children’s clothing department was $25.9\%$ ($\3,891$ profit / $\15,000$ investment). Under an ROI analysis, the manager of the children’s clothing department would not accept an investment that earns less than $25.9\%$ because the rate of return would be negatively impacted, even though the company may benefit. Under a residual income structure, managers would accept all investments with a positive value because the investment would exceeded the investment threshold established by the company.
Let’s look at an example. Recall that the children’s clothing department of Apparel World had an investment base of $\15,000$. Assuming the cost of capital (understood as the rate of a bank loan) to Apparel World is $10\%$. This is the rate that Apparel World will also set as the rate it expects all responsibility centers to earn. Therefore, in the example, the expected amount of residual value—the profit goal, in a sense—for the children’s clothing department is $\1,500$ ($\15,000 \text {investment base} × 10\% \text {cost of capital}$). Management is pleased with the December performance of the children’s clothing department because it earned a profit of $\3,891$, well in excess of the $\1,500$ goal.
Now let’s examine how the manager of the children’s clothing department would evaluate a potential investment opportunity. Assume in December the manager had an opportunity to invest to upgrade the store by adding a supervised children’s play area for children to use while parents shopped. The manager believes this enhancement might increase sales because parents could take their time shopping, while knowing their children are safe and having fun. The upgrade would make the customer shopping experience more enjoyable for everyone.
The children’s play area requires an investment of $\50,000$ and the expected increase in income as a result of the children’s play area is $\5,001$. Because the Apparel World store has a cost of capital requirement of $10\%$, the manager would invest in the children’s play area because the residual income on this investment would be positive. To be precise, the residual income is $\1$. Using the residual income formula, the residual income is $\5,001 – (\50,000 × 10\%) = \1$.
While this is an exaggerated and oversimplified example, it is intended to highlight the fact that, as long as resources (funds) are available to invest, a responsibility manager will (or should) accept projects that have a positive residual value. In this example, the children’s clothing department would be in a better financial position by undertaking this project than if they rejected this project. The department earned $\3,891$ of profit in December but would have earned, based on the estimates, $\3,892$ if the department added the children’s play area.
The benefit of a residual income approach is that all investments in all segments of the organization are evaluated using the same approach. Instead of having each segment select only investments that benefit only the segment, the residual income approach guides managers to select investments that benefit the entire organization.
Footnotes
1. Sue Gleiter. “Hershey Company Goes Futuristic with 3-D Printed Chocolates.” PennLive. https://www.pennlive.com/food/index....chocolate.html | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/09%3A_Responsibility_Accounting_and_Decentralization/9.04%3A_Describe_the_Types_of_Responsibility_Centers.txt |
Organizations incur various types of costs using decentralization and responsibility accounting, and they need to determine how the costs relate to particular segments of the organization within the responsibility accounting framework. One way to categorize costs is based on the level of autonomy the organization (or responsibility center manager) has over the costs. Controllable costs are costs that a company or manager can influence. Examples of controllable costs include the wages paid to employees of the company, the cost of training provided to employees, and the cost of maintaining buildings and equipment. As it relates to controllable costs, managers have a fair amount of discretion. While managers may choose to reduce controllable costs like the examples listed, the long-term implications of reducing certain controllable costs must be considered. For example, suppose a manager chooses to reduce the costs of maintaining buildings and equipment. While the manager would achieve the short-term goal of reducing expenses, it is important to also consider the long-term implications of those decisions. Often, deferring routine maintenance costs leads to a greater expense in the long-term because once the building or equipment ultimately needs repairs, the repairs will likely be more extensive, expensive, and time-consuming compared to investments in routine maintenance.
THINK IT THROUGH: The Frequency of Maintenance
If you own your own vehicle, you may have been advised (maybe all too often) to have your vehicle maintained through routine oil changes, inspections, and other safety-related checks. With advancements in technology in both car manufacturing and motor oil technology, the recommended mileage intervals between oil changes has increased significantly. If you ask some of your family members how often to change the oil in your vehicle, you might get a wide range of answers—including both time-based and mileage-based recommendations. It is not uncommon to hear that oil should be changed every three months or \(3,000\) miles. An article from the Edmunds.com website devoted to automobiles suggests automobile manufacturers are extending the recommended intervals between oil changes to up to \(15,000\) miles.
Do you know what the recommendation is for changing the oil in the vehicle you drive? Why do you think the recommendations have increased from the traditional \(3,000\) miles to longer intervals? How might a business apply these concepts to the concept of maintaining and upgrading equipment? If you were the accountant for a business, what factors would you recommend management consider when making the decisions on how frequently to maintain equipment and how big of a priority should equipment maintenance be?
The goal of responsibility center accounting is to evaluate managers only on the decisions over which they have control. While many of the costs that managers will encounter are controllable, other costs are uncontrollable and originate from within the organization. Uncontrollable costs are those costs that the organization or manager has little or no ability to influence (in the short-term, at least) and therefore should not be incorporated into the analysis of either the manager or the segment’s performance. Examples of uncontrollable costs include the cost of electricity the company uses, the cost per gallon of fuel for a company’s delivery trucks, and the amount of real estate taxes charged by the municipalities in which the company operates. While there are some long-term ways that companies can influence these costs, the examples listed are generally considered uncontrollable.
One category of uncontrollable costs is allocated costs. These are costs that are often allocated (or charged) to the segments within the organization based on some allocation formula or process, such as the costs of receiving support from corporate headquarters. These costs cannot be controlled by the responsibility center manager and thus should not be considered when that manager is being evaluated. Costs relevant to decision-making and financial performance evaluation will be further explored in Short-Term Decision-Making.
Effects of Decisions on Performance Evaluation of Responsibility Centers
Suppose, as the manager of the maintenance department of a major airline, you become aware of a training session that is available to your mechanics. The disadvantages are that the training will require the mechanics to miss an entire week of work and the associated costs (travel, lodging, training session) are high. The advantage is that, as a result of the training, the time during which the planes are grounded for repairs will significantly decrease. What factors would influence your decision regarding whether or not to send mechanics to school? Considering the fact that each mechanic would miss an entire week of work, what factors would you consider in determining how many mechanics to send? Do these factors align with or conflict with what is best for the company or you as the department manager? Is there a way to quantify the investment in the training compared to the benefit of quicker repairs for the airplanes?
Scenarios such as this are common for managers of the various responsibility centers—cost, discretionary cost, revenue, profit, and investment centers. Managers must be well-versed at using both financial and nonfinancial information to make decisions such as these in order to do what is best for the organization.
ETHICAL CONSIDERATIONS: Pro-Stakeholder Culture Opens Business Opportunities
The use of pro-stakeholder decision-making by managers in their responsibility centers allows managers to determine alternatives that are both profitable and follow stakeholders’ ethics-related demands. In an essay in Business Horizons, Michael Hitt and Jamie Collins explain that companies with a pro-stakeholder culture should better understand the multiple ethical demands of those stakeholders. They also argue that this understanding should “provide these firms with an advantage in recognizing economic opportunities associated with such concerns.”1 The identification of these opportunities can make a manager’s decisions more profitable in the long run.
Hitt and Collins go on to argue that “as products and services may be developed in response to consumers’ desires, stakeholders’ ethical expectations can, in fact, represent latent signals on emerging economic opportunities.”2 Providing managers the ability to identify alternatives based upon stakeholders’ desires and demands gives them a broader decision-making platform that allows for decisions that are in the best interest of the organization.
Often one of the most challenging decisions a manager must make relates to transfer pricing, which is the pricing process put into place when one segment of a business “sells” goods to another segment of the same business. In order to understand the significance of transfer pricing, recall that the primary goal of a responsibility center manager is to manage costs and make decisions that contribute to the success of the company. In addition, often the financial performance of the segment impacts the manager’s compensation, through bonuses and raises, which are likely tied to the financial performance of the segment. Therefore, the decisions made by the manager will affect both the manager and the company.
Application of Transfer Pricing
Transfer pricing can affect goal congruence—alignment between the goals of the segment or responsibility center, or even an individual manager, with the strategic goals of the organization. Recall what you’ve learned regarding segments of the business. Often, segments will be arranged by the type of product produced or service offered. Segments often sell products to external customers. For example, assume a soft drink company has a segment—called the blending department—dedicated to producing various types of soft drinks. The company may have an external customer to which it sells unique soft drink flavors that the customer will bottle under a different brand name (perhaps a store brand like Kroger or Meijer). The segment may also produce soft drinks for another segment within its own company—the bottling department, for example—for further processing and ultimate sale to external customers. When the internal transfer occurs between the blending segment and the bottling segment, the transaction will be structured as a sale for the blending segment and as a purchase for the bottling department. To facilitate the transaction, the company will establish a transfer price, even though the transaction is internal because each segment is responsible for its own profits and costs.
Figure \(1\) shows a graphical representation of the transfer pricing structure for the soft drink company used in the example.
Notice that the blending department has two categories of customers—external and internal. External customers purchase the soft drink mixtures and bottle the drinks under a different label, such as a store brand. Internally, the blending department “sells” the soft drink mixtures to the bottling department. Notice the “sale” by the blending department (a positive amount) and the “purchase” by the bottling department (a negative amount) net out to zero. This transaction does not impact the overall financial performance of the organization and allows the responsibility center managers to analyze the financial performance of the segment just as if these were transactions involving outside entities.
What issues might this scenario cause as it relates to goal congruence—that is, meeting the goals of the corporation as a whole as well as meeting the goals of the individual managers?
In situations where the selling division, in this case the blending division, has excess capacity—meaning they can produce more than they currently sell—and ignoring goal congruence issues, the selling division would sell its products internally for variable cost. If there is no excess capacity, though, the opportunity cost of the contribution margin given up by taking internal sales instead of external sales would need to be considered. Let’s look at each of these general situations individually.
In the case of excess capacity, the selling division has the ability to produce the goods to sell internally with only variable costs increasing. Thus, it seems logical to make transfer price the same as the variable costs—but is it? Reflecting back on the concept of responsibility centers, the idea is to allow management to have decision-making authority and to evaluate and reward management based on how well they make decisions that lead to increased profitability for their segment. These managers are often rewarded with bonuses or other forms of compensation based on how well they reach certain profitability measures. Does selling goods at variable cost increase the profitability for the selling division? The answer, of course, is no. Thus, why would a manager, who is rewarded based on profitability, sell goods at variable cost? Obviously, the manager would prefer not to sell at variable cost and would rather sell the goods at some amount above variable cost and thus contribute to the segment’s profitability. What should the transfer price be? There are various options for choosing a transfer price.
CONCEPTS IN PRACTICE: Transfer Pricing with Overseas Segments
An inherent assumption in transfer pricing is that the divisions of a company are located in the same country. While implementing a transfer pricing framework can be complex for a business located entirely in the United States, transfer pricing becomes even more complex when any of the divisions are located outside of the United States.
Companies with overseas transactions involving transfer pricing must pay particular attention to ensure compliance with the tax, foreign currency exchange rate fluctuations, and other regulations in the countries in which they operate.
This can be expensive and difficult for companies to manage. While many firms use their own employees to manage the process, the Big Four accounting firms, for example, offer expertise in transfer pricing setup and regulatory compliance. This short video from Deloitte on transfer pricing provides more information about this valuable service that accountants provide.
Available Transfer Pricing Approaches
There are three primary transfer pricing approaches: market-based prices, cost-based prices, or negotiated prices.
Market Price Approach
With the market price approach, the transfer price paid by the purchaser is the price the seller would use for an outside customer. Market-based prices are consistent with the responsibility accounting concepts of profit and investment centers, as managers of these units are evaluated based on purchasing and selling goods and services at market prices. Market-based transfer pricing is very common in a situation in which the seller is operating at full capacity.
The benefit of using a market price approach is that the company will need to stay familiar with market prices. This will likely occur naturally because the company will also have outside sales. A potential disadvantage of this approach is that conflicts might arise when there are discrepancies between the current market price and the market price the company sets for transfer prices. Firms should decide at what point and how frequently to update the transfer prices used in a market approach.
For example, assume a company adopts a market approach for transfer prices. As time goes by, the market price will likely change—it will either increase or decrease. When this occurs, the firm must decide if and when to update transfer prices. If current market prices are higher than the market price the company uses, the selling division will be happy because the price earned for intersegment (transfer) sales will increase while inputs (costs) to provide the goods or services remain the same. An increase in the transfer price will, in turn, increase the profit margins of the selling division. The opposite is true for the purchasing division. If the market transfer price increases to match the current market price, the costs (cost of goods sold, in particular) will increase. Without a corresponding increase in the prices charged to its customers or an offset through cost reductions, the profit margins of the purchasing division will decrease. This situation could cause conflict between divisions within same company, an unenviable situation for management as one manager is pleased with the transfer price situation and the other is not. Both managers desire to improve the profits of their respective divisions, but in this situation, the purchasing division may feel they are giving up profits that are then being realized by the selling division due the increase in the market price of the goods and the use of a market-based transfer price.
Cost Approach
When the transfer price uses a cost approach, the price may be based on either total variable cost, full cost, or a cost-plus scenario. In the variable cost scenario, as mentioned previously, the transfer of the goods would take place at the total of all variable costs incurred to produce the product. In a full-cost scenario, the goods would be transferred at the variable cost plus the fixed cost per unit associated with making that product. With a cost-plus transfer price, the goods would be transferred at either the variable cost or the full-cost plus a predetermined markup percentage. For example, assume the variable cost to produce a product is \(\$10\) and the full cost is \(\$12\). If the company uses a cost-plus methodology to calculate the transfer price with a \(30\%\) mark-up, the transfer price would be \(\$13 (\$10 × 130\%)\) based on just the variable cost or \(\$15.60 (\$12 × 130\%)\) based on the full cost. When using the full cost as a basis for applying markup, it is important to understand that the cost structure may include costs that are irrelevant to establishing a transfer price (for example, costs unrelated to producing the actual product to be transferred, such as the fixed cost of the plant supervisor’s salary, which will exist whether the product is transferred internally or externally), which may unnecessarily influence decisions.
The benefit of using a cost approach is that the company will invest effort into determining the actual costs involved in making a product or providing another service. The selling division should be able to justify to the purchasing division the cost that will be charged, which likely includes a profit margin, based on what the division would earn on a sale to an outside customer. At the same time, a deeper understanding of what drives the costs within a division provides an opportunity to identify activities that add unnecessary costs. Companies can, in turn, work to increase efficiency and eliminate unnecessary activity and bring down the cost. In essence, the selling division has to justify the costs it is charging the purchasing division.
Negotiated Price Approach
Somewhere in between a transfer price based on cost and one based on market is a negotiated price approach in which the company allows the buying segment and the selling segment to negotiate the transfer price. This is common in situations in which there is no external market. When an external price exists and is used as a starting point for establishing the transfer price, the organization must be aware of differences in specific costs between the source of the external price and its own organization. For example, a price from an external source may include a higher profit margin than the profit margin targeted by a company pursuing a cost leadership strategy. In this case, the external price should be reduced to account for such differences.
However, one disadvantage of using a negotiated price system is the possibility of creating a situation in which competition exists between a department and an outside vendor (as occurs when it is cheaper for a department to purchase from an outside vendor rather than another department in the organization) or, worse yet, between departments of the same organization. It is paramount that, when selecting a transfer pricing methodology, the goals of the particular departments involved align with the overall strategic goals of the organization. A transfer pricing structure is not intended to facilitate competition between departments within the same company. Rather, a transfer pricing system should be viewed as a tool to help the company remain competitive in the marketplace and improve a company’s overall profit margin.
Other Transfer Pricing Issues
The three approaches to transfer pricing assume that the selling department has excess capacity to produce additional products to sell internally. What happens if the selling department does not have excess capacity—in other words, if the selling department can sell all that it produces to external customers? If an internal department wants to purchase goods from the selling department, what would be an appropriate selling price? In this case, the transfer price must take into consideration the opportunity cost of the contribution margin that would be lost from having to forego external sales in order to meet internal sales.
Suppose in the previous example that the blending department is at full capacity but the bottling department wants to purchase some of its soft drink blends internally. Assume the variable cost to produce one unit of soft drink is \(\$10\), the fixed cost per unit is \(\$2\), and the market price for selling one unit is \(\$18\). What would be an appropriate transfer price in this situation? Since the blending department does not have the capacity to meet external sales plus internal sales, in order to accept the internal sales order, the blending department would have to lose sales to external customers. The contribution margin per unit is \(\$8 (\$18 − \$10)\). Thus, \(\$8\) per unit would be given up for each external unit that is sold internally.
Looking only at costs, the blending department would be indifferent between an external sale of \(\$18\) and an internal sale of \(\$18\) (\(\$10\) variable cost + \(\$8\) contribution margin). Obviously, there are other issues that need to be considered in these situations, such as the effect on external customers if demand cannot be met. Overall, if there is no excess capacity, the transfer price should take into consideration the opportunity cost lost from taking internal sales over external sales.
In addition to the possibility of losing opportunity costs, there are additional transfer pricing issues. Recall that decentralized organizations delegate decision-making authority throughout the organization. A well-designed transfer pricing policy can contribute not only to the segment manager’s profits but to overall corporate profits in situations where the transfer price is lower than the external price. However, when a transfer pricing system is used to facilitate transactions between departments, an ill-designed policy is likely to lead to disputes between departments. It is possible the departments view each other as competition rather than strategic partners. When this occurs, it is important for upper-level management to establish a process that allows managers to resolve disagreements in a way that aligns with organizational, rather than departmental, goals.
Transfer pricing systems become even more complicated when departments are located in different countries. The transfer price in an international setting must also account for differences in currencies and fluctuating exchange rate as well as differences in regulations such as tariffs and duties, taxes, and other regulations.
Transfer Pricing Example
Regal Paper has two divisions. The Paper Division produces copy paper, wrapping paper, and paper used on the outside of cardboard displays placed in grocery, office, and department stores. The Box Division produces cardboard boxes sold at Christmas, cardboard boxes purchased by manufacturers for packaging their goods, and cardboard displays for stores, particularly seasonal displays. Both divisions are profit centers, and each manager is evaluated and rewarded based on his division’s profitability. The Box Division has approached the Paper Division to buy paper needed to cover cardboard displays that have been ordered by several major snack food manufacturers for the upcoming Superbowl game. The Box Division has been buying the display coverings from an external seller for \(\$12.50\) per unit. Currently, the Paper Division has excess capacity and can fill the order for the \(500,000\) display coverings that the Box Division is requesting.
The cost to the Paper Division to produce one display covering is as follows:
What would be the transfer price per unit under each of the following scenarios?
1. Market-based transfer price. This transfer price is the same as the selling price to external customers, which is \(\$12\).
2. Cost-based transfer price. This transfer price is the same as the variable costs per unit, which is \(\$8\).
3. Full-cost–based transfer price. This transfer price is the same as the variable costs plus the fixed cost per unit, which is \(\$9\).
4. Cost plus assuming \(20\%\) mark-up. This marks up the cost-based transfer price by \(20\%\), which is \(\$8 × 120\%\), or \(\$9.60\).
5. Full-cost plus assuming \(20\%\) mark-up. This marks up the full-cost–based transfer price by \(20\%\), which is \(\$9 × 120\%\), or \(\$10.80\).
6. Range of negotiated transfer price. The negotiated transfer price should be between the lowest and highest possible prices: \(\$8–\$12\)
7. What if Paper had no excess capacity? If the Paper Division had no excess capacity, the transfer price would be the cost plus the contribution margin, which is \(\$8 + \$4\), or \(\$12\).
8. Which transfer price is best? If there is excess capacity, then typically a negotiated transfer price is best, as it allows the managers who are evaluated on that decision to have input into the decision and does not take away their autonomy. Table \(1\) shows the per-unit effect on income of each of the transfer pricing options on each division. Remember, the effects provided here cannot necessarily be generalized, as there are two critical factors: whether or not the selling department is at capacity and the price at which the purchasing department could buy the goods externally, which in this case is \(\$0.50\) more per unit than the market price of the paper being sold by the Paper Division.
Table \(1\): Per-Unit Effect on Division Income of Various Transfer Pricing Methodologies
Transfer Pricing Method Paper Division Box Division
Market \$4 per unit increase in income
(\$12 SP − \$8 VC)
\$0.50 per unit increase in income
(\$12.50 − \$12 SP)
Cost \$0 per unit increase in income
(\$8 SP − \$8 VC)
\$4.50 per unit increase in income
(\$12.50 − \$8)
Full-cost \$1 per unit increase in income
(\$9 SP − \$8 VC)
\$3.50 per unit increase in income
(\$12.50 − \$9)
Cost-Plus (20%) \$1.60 per unit increase in income
(\$9.60 SP − \$8 VC)
\$2.90 per unit increase in income
(\$12.50 − \$9.60)
Full-cost Plus (20%) \$2.80 per unit increase in income
(\$10.80 SP − \$8VC)
\$1.70 per unit increase in income
(\$12.50 − \$10.80)
Negotiated (\$0 − \$12) Increase to income between \$0 and \$4 per unit Increase to income between \$0.50 and \$4.50
No Excess Capacity \$4 per unit increase in income
(\$12 SP − \$8 VC)
\$0.50 per unit increase in income
(\$12.50 − \$12 SP)
SP = selling price; VC = variable cost
As you can see, the transfer price can significantly affect the profitability of the division. It is easy to see which transfer prices most benefit the seller and which most benefit the buyer. Thus, as previously mentioned, a negotiated transfer price is often the best resolution to determining a transfer price.
think it through: Comparing Transfer Pricing and Outsourcing
Assume you are the President of a manufacturing firm that has a division that transfers products to other divisions within the company. The other divisions have recently complained that the transfer price charged to the departments has increased significantly over the past several quarters. They are frustrated because performance evaluations and bonuses are linked to the profitability of their respective departments.
During a recent management meeting, a cost accountant suggests the company can solve this issue by transferring production to another supplier that has a lower cost of production due to lower labor costs. In addition to solving the conflict between departments, the company’s overall profitability will increase because of the substantial cost savings.
Evaluate this scenario and explain how you would respond as the company’s President. Consider the perspectives of various stakeholders in this situation.
Footnotes
1. Michael Hitt and Jamie Collins “Business Ethics, Strategic Decision Making, and Firm Performance.” Business Horizons 50, no. 5 (February 2007): 353–357.
2. Michael Hitt and Jamie Collins “Business Ethics, Strategic Decision Making, and Firm Performance.” Business Horizons 50, no. 5 (February 2007): 353–357. | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/09%3A_Responsibility_Accounting_and_Decentralization/9.05%3A_Describe_the_Effects_of_Various_Decisions_on_Performance_Evaluation_of_Responsibility_Centers.txt |
Section Summaries
9.1 Differentiate between Centralized and Decentralized Management
• Management control systems allow managers to develop a reporting structure to help the organization meet its strategic goals.
• In centralized organizations, primary decisions are made by the person or persons at the top of the organization.
• Decentralized organizations delegate decision-making authority throughout the organization.
• Daily decision-making involves frequent and immediate decisions.
• Strategic decision-making involves infrequent and long-term decisions.
9.2 Describe How Decision-Making Differs between Centralized and Decentralized Environments
• Segments are uniquely identifiable components of the business that facilitate the effective and efficient operation of the business.
• Organizational charts are used to graphically represent the authority structure of an organization.
• The CEO of a centralized organization will establish the strategy and make decisions that will be implemented throughout the organization.
• The CEO of a decentralized organization will establish strategic goals and empower managers to achieve the goals.
9.3 Describe the Types of Responsibility Centers
• A responsibility accounting structure helps management evaluate the financial performance of the segments in the organization.
• Responsibility centers are segments within a responsibility accounting structure.
• Five types of responsibility centers include cost centers, discretionary cost centers, revenue centers, profit centers, and investment centers.
• Cost centers are responsibility centers that focus only on expenses.
• Discretionary cost centers are responsibility centers that focus only on controllable expenses.
• Revenue centers are responsibility centers that focus on revenues.
• Profit centers are responsibility centers that focus on revenues and expenses.
• Investment centers are responsibility centers that consider the investments made by the responsibility center.
• Return on investment is a particular type of investment center structure that calculates a responsibility center’s profit percentage relative to the center’s investment.
• Residual income is a particular type of investment center structure that evaluates investments using a common cost of capital rate amongst all responsibility centers.
9.4 Describe the Effects of Various Decisions on Performance Evaluation of Responsibility Centers
• Uncontrollable costs are costs that management or an organization has little or no ability to influence.
• Controllable costs are costs that managers or an organization can influence.
• Managers in a responsibility accounting structure should only be evaluated based on controllable costs.
• Businesses with segments that provide goods to other segments within the business often use a transfer pricing structure to record the transaction.
• The general transfer pricing model considers the opportunity costs involved in selling to internal rather than external customers. This method is difficult to implement and businesses often choose other methods.
• The market price model uses market prices that would be used for external customers as the basis for internal transfers.
• The cost approach uses the company’s cost to make the product as the basis for establishing the transfer price.
• The negotiated model allows the selling and buying segments within the business to determine the transfer price.
• Transfer price arrangements are more difficult in international businesses because of complexities related to taxes, duties, and currency fluctuations.
Key Terms
allocated costs
costs that are generated by non–revenue generating portions of the business, such as corporate headquarters, that are assigned based on some formula to the revenue generating portions of the business
centralization
business structure in which one individual makes the important decisions and provides the primary strategic direction for the company
controllable costs
those that a company or manager can influence
cost approach
transfer pricing structure in which the transfer price may be based on total variable cost, full cost, or a cost-plus scenario, calculated by adding a markup to either variable cost or full cost
cost center
organizational segment in which a manager is held responsible only for costs
decentralization
business structure in which the decision-making is made at various levels of the organization
discretionary cost center
organizational segment in which a manager is held responsible only for controllable costs when there is not a well-defined relationship between the center’s costs and its services or products
goal congruence
integration of multiple goals, either within an organization or across multiple components or entities; congruence is achieved by aligning goals to achieve an anticipated mission
investment center
organizational segment in which a manager is accountable for profits (revenues minus expenses) and the invested capital used by the segment
lower-level management
level of management that provides basic supervision and oversight for the operations of the organization
management control system
structure within an organization that allows managers to establish, implement, and monitor progress toward the strategic goals of the organization
market price approach
transfer pricing structure in which the transfer price is based on the price the seller would use for an outside customer
mid-level management
level of management that receives direction from upper management and supervises and provides direction to lower-level management
negotiated price approach
transfer pricing structure in which the transfer price is based on negotiations between the buying segment and the selling segment
organizational chart
graphical representations illustrating the authority for decision-making and oversight throughout an organization
profit center
organizational segment in which a manager is responsible for and evaluted on both revenues and costs
residual income (RI)
amount of income a given division (or project) is expected to earn in excess of a firm’s minimum return goal
responsibility accounting
method of encouraging goal congruence by setting and communicating the financial performance measures by which managers will be evaluated
responsibility centers
segments in which supervisors or managers have responsibility for the performance of the center and the authority to make decisions that affect the center
return on investment (ROI)
measure of the percentage of income generated by profits that were invested in capital assets
revenue center
part of an organization in which management is evaluated based on the ability to generate revenues; the manager's primary control is only revenues
segment
portion of the business that management believes has sufficient similarities in product lines, geographic locations, or customers to warrant reporting that portion of the company as a distinct part of the entire company
transfer pricing
pricing structure used when one segment of a business “sells” goods to another segment of the same business
uncontrollable costs
those that an organization or manager has little or no ability to influence
upper management
level of management that consists of the board of directors and chief executives charged with providing strategic guidance for the organization | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/09%3A_Responsibility_Accounting_and_Decentralization/9.06%3A_Summary_and_Key_Terms.txt |
Multiple Choice
1. Which of the following is not a common goal of an organization?
1. operational efficiency
2. being acquired by another business
3. achieving strategic goals
4. measuring financial performance
Answer:
b
1. Which of the following does not describe a management control system?
1. establishes a company’s strategic goals
2. implements a company’s strategic goals
3. monitors a company’s strategic goals
4. a system that only measures profitability
2. In centralized organizations, primary decisions are made by ________.
1. an individual at the top of the organization
2. various managers throughout the organization
3. outside consultants
4. low-level management
Answer:
a
1. A key advantage of a decentralized organization is ________.
1. increased administrative costs
2. quicker decisions and response time
3. the ease of aligning segment and company goals
4. duplication of efforts
2. Strategic decisions occur ________.
1. frequently and involve immediate decisions
2. frequently and involve long-term decisions
3. infrequently and involve long-term decisions
4. infrequently and involve immediate decisions
Answer:
c
1. Segments are uniquely identifiable components of the business and can be categorized by all of the following except________.
1. products produced
2. services provided
3. geographical location
4. number of employees
2. Organizational charts ________.
1. list the salaries of all employees
2. outline the strategic goals of the organization
3. show the structure of an organization
4. help management measure financial performance
Answer:
c
1. In a centralized organization, where are goals established?
1. at the lower level of the organization and promoted upward
2. outside the organization based on best practices in the industry
3. by each segment of the organization
4. at the highest level of the organization and promoted downward
2. Managers in decentralized organizations make decisions relating to all of the following except ________.
1. the company’s stock price
2. equipment purchases
3. personnel
4. prices to charge customers
Answer:
a
1. Which of the following is not a type of responsibility center?
1. concentrated cost center
2. investment center
3. profit center
4. cost center
2. A system that establishes financial accountability for operating segments within an organization is called ________.
1. a financial statement
2. an internal control system
3. responsibility accounting
4. centralization
Answer:
c
1. A responsibility center in which managers are held accountable for both revenues and expenses is called a ________.
1. discretionary cost center
2. revenue center
3. cost center
4. profit center
2. A responsibility center structure that considers investments made by the operating segments by using a common cost of capital percentage is called ________.
1. return on investment
2. residual income
3. a profit center
4. a discretionary cost center
Answer:
b
1. An important goal of a responsibility accounting framework is to help ensure which of the following?
1. decision-making is made by the top executives.
2. investments made by each segment are minimized.
3. identification of operating segments that should be closed.
4. segment and company financial goals are congruent.
2. Costs that a company or manager can influence are called ________.
1. discretionary costs
2. fixed costs
3. variable costs
4. controllable costs
Answer:
d
1. An example of an uncontrollable cost would include all of the following except ________.
1. real estate taxes charged by the county in which the business operates
2. per-gallon cost of fuel for the company’s delivery trucks
3. hourly rate of pay for the company’s purchasing manager
4. federal income tax rate paid by the company
2. Internal costs that are charged to the segments of a business are called ________.
1. controllable costs
2. variable costs
3. fixed costs
4. allocated costs
Answer:
d
1. A transfer pricing arrangement that uses the price that would be charged to an external customer is a ________.
1. market-based approach
2. negotiated approach
3. cost approach
4. decentralized approach
2. A transfer pricing structure that considers the opportunity costs of selling to internal rather than external customers uses ________.
1. the cost approach
2. the general transfer pricing approach
3. the market-based approach
4. the opportunity cost approach
Answer:
b
Questions
1. What is a management control system? What are its components and how does the system help the business?
Answer:
A management control system allows management to establish, implement, and monitor the organization’s achievement of strategic goals. Once the goals are developed, goals must be communicated throughout the organization and activities of the organization should align to achieve the strategic goals. The control system must also provide feedback and allow for alterations, as necessary, to the organization’s strategic goals.
1. Identify and describe the levels of management, including the various types of decisions managers at each level make.
2. Discuss the difference between centralized and decentralized organizations. Does the size of the organization influence whether the organization has a centralized or decentralized structure? Explain.
Answer:
Centralized organizations reserve decision-making authority for top management. Decentralized organizations disperse decision-making throughout the organization. Companies of all sizes may exhibit tendencies for both centralized and decentralized decision-making. For example, while Apple might give its stores great latitude to meet customer needs, the company will reserve research and development activities for the highest levels of the organization.
1. Identify a company where you recently shopped. Assume the company operates with a decentralized structure. Describe how customers might benefit from the decentralized structure.
2. Discuss the difference between daily and strategic decisions. Think of a business and provide an example of a daily and strategic decision.
Answer:
Daily decisions are frequent and usually have a short-term impact. Strategic decisions are infrequent and usually have a long-term impact. Daily decisions impact the operational effectiveness and efficiency of the organization while strategic decisions address the long-term aspect of the business. For example, daily decisions for a grocery store might relate to signage, displays, and inventory levels to maintain. Strategic decisions for a grocery store might include whether or not to offer online ordering or leasing in-store space to other businesses such as a coffee shop, nail salon, or bank.
1. Access PepsiCo’s 2017 annual report. Starting at the top of the document, use the find (Ctrl + F) or search feature in the browser to search the annual report for the word “segments” to determine how many operating segments PepsiCo has. What are the segments? How are the segments categorized?
2. Another search of PepsiCo’s 2017 annual report reveals the company maintains a centralized management perspective on aspects of these items:
• Commodities (items such as sugar and high fructose corn syrup that go into many of the beverages)
• Research and development
• Insurance and benefit program
• Foreign currency transactions
• Debt, investments, and other financing activities
Explain why these activities would be centralized functions within PepsiCo as opposed to decentralized like many other activities.
Answer:
These activities represent a significant cost to the organization, require specialization, relate to strategic and quality goals, and allow for benefits related to buying power. Also, there is the possibility that without centralizing some of these costs, they might experience a significant cost overrun. For example, the company might want to finance capital improvements, and they often can do so less expensively, in terms of interest rates, by packaging bonds into one issue. Similar cost savings and improvements in operational efficiencies could probably be identified in the other examples listed.
1. Define segments and describe how identifying segments within a business might help manage the business.
2. Choose a company and describe how a specific issue, policy, or procedure (for example, granting merchandise returns, establishing sales prices) might look if the business is structured as a centralized business.
Answer:
Answers will vary. Sample answer: McDonald’s might have a policy that all stores must sell items at a price set by the company. The purpose of this is to prevent stores from competing with each other based on price and causing confusion or frustration with customers.
1. Choose a company and explain how a specific issue, policy, or procedure (for example, granting merchandise returns, establishing sales prices) might look if the business is structured as a decentralized business.
2. Assume you are the manager of a local Starbucks. What factors do you feel would be relevant to hiring workers (including pay), assuming Starbucks is a decentralized organization?
Answer:
Answers will vary. Responses should include factors relating to establishing a competitive pay rate based on the local economy, hiring experienced workers, investing in training, and other factors necessary to ensure the store’s success.
1. Assume you are the manager of a local Starbucks. What factors do you feel would be relevant to hiring workers (including pay), assuming Starbucks is a centralized organization?
2. Use Netflix’s 2017 annual report to answer the following questions. How many segments does Netflix have? What are the segments? The annual report also shows selected nonfinancial and financial information for each segment. Prepare a brief presentation listing the “Paid memberships at end of period,” “Revenues,” and “Contribution profit” (also calledoperating profit) for the three most recent years (2017, 2016, and 2015). In the presentation, include any observations you notice about the trends of each segment.
Answer:
Netflix has three segments: Domestic Streaming, International Streaming, and Domestic DVD. Responses should present the following information:
Domestic Streaming 2017 2016 2015
Paid memberships 54,750 47,905 43,401
Revenues \$6,153,025 \$5,077,307 \$4,180,339
Contribution profit/(loss) \$2,280,454 \$1,838,686 \$1,375,500
International Streaming 2017 2016 2015
Paid memberships 62,832 41,185 27,438
Revenues \$5,089,191 \$3,211,095 \$1,953,435
Contribution profit/(loss) \$226,589 (\$308,521) (\$333,386)
Domestic DVD 2017 2016 2015
Paid memberships 3,380 4,029 4,787
Revenues \$450,497 \$542,267 \$645,737
Contribution profit/(loss) \$249,972 \$279,525 \$321,829
Responses may note that Domestic Streaming memberships, revenues, and contribution profit are all increasing. International streaming is experiencing significant increases in memberships and revenues, but the contribution loss continues (the loss decreased from 2016 to 2017). The Domestic DVD segment is experiencing declining memberships, revenues, and contribution profit.
1. Reference the Kellogg Company’s 2017 annual report to answer the following question. In “Note 18: Reportable Segments,” you will find selected financial information for segments within Kellogg Company. Prepare a brief presentation listing each segment, along with the “Net Sales,” “Operating Profit,” and “Total Assets.” For Total Assets, you should ignore Corporate and Elimination entries, and you will need to combine the U.S. divisions into a North American total. Report this information for the three most recent years (2017, 2016, and 2015). In the presentation, include any observations you notice about the trends of each segment. You may want to use Microsoft Excel or another spreadsheet application for the numerical data. This information will be used in a subsequent question.
2. Lavell started out mowing lawns in the neighborhood when he was \(13\) years old. He did such good work that, without advertising, his business grew steadily each year. After college, Lavell decided to continue the business as a full-time career. One of his concerns, however, is the number of hours he is putting in. Once school lets out, he finds himself working long hours nearly every day of the week. Although he has added workers, his business now handles mowing, trimming, and landscaping for residential, corporate, and nonprofit clients. He is considering adding managers but is not quite sure how to structure the organization. Lavell wants to focus on building the business rather than doing the daily work, so he knows a decentralized structure will be best. He has asked you to develop a potential organizational chart to help him envision the best way to organize the business. Describe the advantages to this approach as well as any concerns he should have.
Answer:
Answers will vary. Responses should include an organizational chart for a decentralized structure that includes three divisions: residential, corporate, and nonprofit. Under each of these divisions would be the mowing, trimming, and landscaping activities. Alternative responses may present three divisions: mowing, trimming, and landscaping activities with the client categories (residential, corporate, and nonprofit) below each. This is less desirable due to inefficiency. The advantage of this approach is the speed of decision-making and responding to clients. Lavell would need to ensure the quality of the services remains at a high standard.
1. Describe the concept of responsibility accounting.
2. Describe the concept of a cost center and, using a specific organization, give an example of how this might be used to achieve the strategic goals of the organization.
Answer:
Answers will vary. One example is the transportation division in a school system. The goal of the transportation division is to manage costs while maintaining safety in transporting students.
1. Describe the concept of a profit center and, using a specific organization, give an example of how this might be used to achieve the strategic goals of the organization.
2. Explain the benefits of a return on investment structure within an investment center framework. It may help to think of an example using an existing company.
Answer:
Answers will vary. The benefits of an ROI structure include consideration for the segment’s investment and evaluation of management’s ability to generate profitability. In addition, this framework incentivizes management to undertake value-added investments. A disadvantage is that the segment may prioritize the segment over company financial goals.
1. Explain the benefits of a residual income structure within an investment center framework. It may help to think of an example using an existing company.
2. Discuss the concept of controllable and uncontrollable costs and how they affect the evaluation of the responsibility center’s financial performance.
Answer:
Answers will vary. Managers can influence controllable costs but have little or no ability to influence uncontrollable costs. While it is common to include uncontrollable (including allocated) costs in the financial information of the responsibility center, managers should be evaluated only on controllable costs.
1. Discuss the concept of transfer pricing.
2. Discuss the advantages and disadvantages of a market-based transfer pricing approach.
Answer:
Answers will vary. An advantage of a market-based approach is that the company remains up-to-date on current cost levels. This allows the business to compare its current cost structure to the market and to identify areas where changes are necessary. A disadvantage is this approach is that it requires a significant investment of time and resources on the part of the business.
1. Discuss the advantages and disadvantages of a cost-based transfer pricing approach.
2. Discuss the advantages and disadvantages of a negotiated transfer pricing approach.
Answer:
Answers will vary. An advantage of a negotiated approach is that the responsibility center management must be actively involved in the process of establishing the transfer price. This approach may encourage managers to remain attentive to opportunities for cost improvements. A disadvantage would include the possibility of significant disagreements between responsibility center managers.
Exercise Set A
1. Assume you have been hired by Hilton Hotels and Resorts. As part of your new role in the accounting department, you have been tasked to set up a responsibility accounting structure for the company. As your first task, your supervisor has asked you to give an example of a cost center, profit center, and an investment center within the Hilton organization. Your supervisor is a little unsure of the difference between a profit center and investment center and would like you to explain the difference.
2. Consider the national nonprofit organization the American Red Cross. Assume you are the regional director of the organization, and you just received the quarterly financial reports. Even though the organization is a nonprofit, assume it is set up as a profit center because it is helpful for the financial reports to show both donations and expenses by each region/location. One particular report shows there is one location in your region that is extremely over budget on nearly every expense item. From a management perspective, can you think of a reason(s) when going over budget might actually be a good thing? As the regional manager, how might you respond to the overages to help the particular location in the future?
3. The following information is from Bluff Run Golf Courses. The company runs three courses and the July income statement for each course is shown.
1. Find the missing value for outings revenue, wages, and operating income.
2. Comment on the financial performance of each course.
3. Identify a limitation of analyzing the information provided.
You may want to consider using Microsoft Excel or another spreadsheet application for the numerical data. This information will be used in a subsequent question.
1. The following information is from Dave’s Sporting Goods. Dave’s is a Midwest sporting goods store with three regional stores. The August income statement for all stores is shown.
1. Comment on the operating income results for each store.
2. Now assume the costs allocated from corporate is an uncontrollable cost for each store. How does this change your assessment of each store?
1. Assume you are the department B manager for Marley’s Manufacturing. Marley’s operates under a cost-based transfer structure. Assume you receive the majority of your raw materials from department A, which sells only to department B (they have no outside sales). After calculating the operating income in dollars and operating income in percentage, analyze the following financial information to determine costs that may need further investigation. (Hint: It may be helpful to perform a vertical analysis.)
1. As manager of department B in Marley’s Manufacturing, based on the costs you identified in exercise 5 for further research, how does this impact the financial performance of your department, and what might be some questions you want to ask or solutions you might propose to Marley’s management?
2. Based on your research of the market in the previous exercises, you have determined the market price for the items your department purchase is \(15\%\) below what you are being charged by department A of Marley’s Manufacturing. How would you view this as a manager? What steps could you take to solve this discrepancy? What alternatives would you consider, assuming you had control over purchasing decisions?
3. Using the information in the previous exercises about Marley's Manufacturing, determine the operating income for department B, assuming department A “sold” department B 1,000 units during the month and department A reduces the selling price to the market price.
Exercise Set B
1. Assume you have been hired by Cabela’s Sporting Goods. As part of your new role in the accounting department, you have been tasked to set up a responsibility accounting structure for the company. As your first task, your supervisor has asked you to give an example of a cost center, profit center, and an investment center within the Cabela’sorganization. Your supervisor is a little unsure of the difference between a profit center and investment center and would like you to explain the difference.
2. Assume you are the regional manager for a hotel chain. You receive the quarterly financial reports and notice one particular hotel had drastically lower revenue and a corresponding high occupancy rate. Upon further investigation, you discover the manager for the hotel provided lodging for a neighboring town that was hit by a tornado. As the manager, how do you respond to this?
3. The following information is from Dessert Dynasty. The company runs three stores and the December Income Statement for all stores is shown.
1. Find the missing values for retail revenue, ingredients, and operating income.
2. Comment on the financial performance of each store.
3. Identify a limitation of analyzing the information provided.
You may want to consider using Microsoft Excel or another spreadsheet application for the numerical data. This information will be used in a subsequent question.
1. The following information is from Good Read Books. Good Read is a regional book store with three regional stores. The May income statement for all stores is shown.
1. Comment on the operating income results for each store.
2. Now assume the costs allocated from corporate is an uncontrollable cost for each store. How does this change your assessment of each store?
1. Assume you are the warehouse manager for Vinnie’s Vinyls, a multi-location business specializing in vinyl records. Vinnies’s operates under a cost-based transfer structure and the warehouse supplies all stores with the records. The stores can purchase records only from the warehouse, and the warehouse can only sell to Vinnie’s stores. The manager of the West store has some concerns relating to the store’s financial performance and has asked for your help analyzing transfer costs. After calculating the operating income in dollars and the operating income percent, analyze the following financial information to determine costs that may need further investigation. (Hint: it may be helpful to perform a vertical analysis.)
1. As manager of the warehouse for Vinnie’s Vinyls, based on this analysis and the items you identified for further research, what is your advice to the manager of the West store? What might be some questions you want to ask or solutions you might propose to Vinnie’s management?
2. Discuss how, as warehouse manager for Vinnie’s Vinyls, you view the different rate of allocated costs the warehouse is being charged compared to the West store. Describe the implications of this. What steps could you take to solve this discrepancy? What alternatives would you consider, assuming management is willing to consider making changes in the rate?
3. Determine the operating income for Vinnie’s Vinyls’ West store, assuming the warehouse allocation is reduced to 10% of sales for the warehouse and the difference will be charged to the West store. Management has determined that the warehouse takes fewer corporate resources and the allocation to the West store was lower than it should have been.
Problem Set A
1. Use the following information to answer the questions that follow.
1. Calculate the operating income percentage for each of the courses. Comment on how your analysis has changed for each course.
2. Perform a vertical analysis for each course. Based on your analysis, what accounts would you want to investigate further? How might management utilize this information?
3. Which method of analysis (using a dollar value or percentage) is most relevant and/or useful? Explain.
1. Use Netflix’s 2017 annual report to answer the following questions.
1. Using the revenue and contribution profit information, calculate the contribution profit (loss) percentage for each of the divisions. Comment on how your analysis has changed compared to your analysis of the dollar amounts for each division.
2. Since companies typically do not publicly provide more than macro levels of asset values, let’s assume the following level of assets (investment):
Calculate the return on investment (ROI) for each division. Comment on the results.
1. Assume that Netflix uses a cost of capital of \(7\%\). Calculate the residual income (RI) for each of the divisions. Comment on the results.
1. The income statement comparison for Forklift Material Handling shows the income statement for the current and prior year.
1. Determine the operating income (loss) (dollars) for each year.
2. Determine the operating income (percentage) for each year.
3. The company made a strategic decision to invest in additional assets in the current year. These amounts are provided. Using the total assets amounts as the investment base, calculate the return on investment. Was the decision to invest additional assets in the company successful? Explain.
4. Assuming an \(8\%\) cost of capital, calculate the residual income for each year. Explain how this compares to your findings in part c.
1. Assume you are the leather department manager at the Famous Football Factory. The leather department is a cost center and you are reviewing the scrap costs for the previous year, shown here:
1. Using Microsoft Excel or another spreadsheet application, create a line chart with markers showing the leather scrap expense. Describe your observations.
2. Knowing that leather is susceptible to indoor temperature, you decide to talk with the maintenance manager and obtain the following information:
Using Microsoft Excel or another spreadsheet application, create individual line charts with markers showing the indoor temperature, spare parts inventory, and breakdowns. Describe your observations and actions you might consider.
1. Financial information for BDS Enterprises for the year-ended December 31, \(20xx\), was gathered from an accounting intern, who has asked for your guidance on how to prepare an income statement format that will be distributed to management. Subtotals and totals are included in the information, but you will need to calculate the values.
1. In the correct format, prepare the income statement using the following information:
2. Calculate the profit margin, return on investment, and residual income. Assume an investment base of \(\$100,000\) and \(6\%\) cost of capital.
3. Prepare a short response to accompany the income statement that explains why uncontrollable costs are included in the income statement.
1. Using the information from BDS Enterprises, prepare the income statement to include all costs, but separate out uncontrollable costs. Insert subtotals where appropriate (include one for operating income) before the uncontrollable costs. Income tax expense should be based on all expenses (that is, it will be the same amount as in question 1). Calculate net income, profit margin, ROI, and RI, excluding uncontrollable expenses. Prepare a short response to accompany the income statement that explains why uncontrollable costs are separated in the income statement.
2. Management of Great Springs Bottled Water Company has asked you, the controller, to develop a transfer pricing system for the company. The Transportation Department of the company sells all of its product to the Bottling Department of the company. Thus the Transportation Department’s sales become the Bottling Department’s cost of goods sold. In order to determine an optimal transfer pricing system, management would like you to demonstrate what an income statement would look like under a cost, market, and negotiated transfer pricing structure. These various transfer prices are listed as follows. Prepare an income statement for each of the transfer prices by filling in the missing numbers in the provided income statement based on each transfer price (thus four different income statements) and calculate the operating income/loss percentage. Prepare a brief summary of the results.
1. The following revenue data were taken from the December 31, 2017, Coca-Cola annual report (10-K):
For each segment and each year, calculate intersegment sales (another name for transfer sales) as a percentage of total sales. Using Microsoft Excel or another spreadsheet application, create a clustered column graph to show the 2016 and 2017 percentages for each division. Comment on your observations of this data. How might a division sales manager use this data?
Problem Set B
1. Use the following information to answer the questions that follow.
1. Calculate the operating income percentage for each of the stores. Comment on how your analysis has changed for each store.
2. Perform a vertical analysis for each store. Based on your analysis, what accounts would you want to investigate further? How might management utilize this information?
3. Which method of analysis (using a dollar value or percentage) is most relevant and/or useful? Explain.
1. Use Kellogg Company’s 2017 annual report to answer the following questions.
1. Using the information for Kellogg, calculate the operating profit percentage for each of the divisions. Comment on how your analysis has changed compared to your analysis of the dollar amounts for each division.
2. Using total assets as the investment, calculate the ROI for each division. In the total assets information you compile, you should ignore corporate and elimination entries amounts and you will also need to combine the U.S. divisions into a North American total. Comment on the results.
3. Assume that Kellogg uses a cost of capital of \(10\%\). Calculate the RI for each of the divisions (you will need to condense the U.S. divisions into a North American total). Comment on the results.
2. The income statement comparison for Rush Delivery Company shows the income statement for the current and prior year.
1. Determine the operating income (loss) (dollars) for each year.
2. Determine the operating income (percentage) for each year.
3. The company made a strategic decision to invest in additional assets in the current year. These amounts are provided. Using the total assets amounts as the investment base, calculate the ROI. Was the decision to invest additional assets in the company successful? Explain.
4. Assuming an \(8\%\) cost of capital, calculate the RI for each year. Explain how this compares to your findings in part C.
1. Assume you are the manager for the semi-trucks division at the Speedy Delivery Company. The semi-truck division is a cost center and you are reviewing the driver overtime costs for the previous year, shown here:
1. Microsoft Excel or another spreadsheet application, create a line chart with markers showing the driver overtime expense. Describe your observations.
2. Knowing that safety is important in your industry and weather plays a significant role in the safety of drivers, you decide to talk with the safety manager and obtained the following information:
Using Microsoft Excel or another spreadsheet application, create individual line charts with markers showing the average snowfall and non-company highway accidents. Describe your observations and actions you might consider.
1. Financial information for Lighthizer Trading Company for the fiscal year-ended September 30, \(20xx\), was collected. As part of a management training session, you have been asked to prepare an income statement format that will be used to distribute to management. Subtotals and totals are included in the information, but you will need to calculate the values.
1. In the correct format, prepare the income statement using this information:
2. Calculate the profit margin, return on investment, and residual income. Assume an investment base of \(\$42,000\) and \(8\%\) cost of capital.
3. Prepare a short response to accompany the income statement that explains why uncontrollable costs are included in the income statement.
1. Using the information for Lighthizer Trading Company, prepare the income statement to include all costs, but separate out uncontrollable costs. Insert subtotals where appropriate (include one for operating income) before the uncontrollable costs. Income tax expense should be based on all expenses (that is, it will be the same amount as in the previous exercise 5). Calculate net income, profit margin, ROI, and RI excluding uncontrollable expenses. Prepare a short response to accompany the income statement that explains why uncontrollable costs are separated in the income statement.
2. Management of Green Peak Tea Company has asked you, the controller, to develop a transfer pricing system for the company. The Brewing Department of the company sells all of its product to the Bottling Department of the company. Thus the Brewing Department’s sales become the Bottling Department’s cost of goods sold. In order to determine an optimal transfer pricing system, management would like you to demonstrate what an income statement would look like under a cost, market, and negotiated transfer pricing structure. These various transfer prices are listed as follows. Prepare an income statement for each of the transfer prices by filling in the missing numbers in the provided income statement based on each transfer price (thus four different income statements) and calculate the operating income/loss percentage. Prepare a brief summary of the results.
1. The following revenue data were taken from the December 31, 2017, General Electric annual report (10-K):
For each segment and each year, calculate intersegment sales (another name for transfer sales) as a percentage of total sales. Using Microsoft Excel or another spreadsheet application, create a clustered column graph to show the 2016 and 2017 percentages for each division. Comment on your observations of this data. How might a division sales manager use this data?
Thought Provokers
1. You have just been elected president of a brand-new service club on campus. The club is part of a national organization, but the organization charter gives the local organization a fair amount of flexibility in setting up the management of the club. As president, you can choose to make most of the decisions for the club and pass along your direction to the officers and members below you, or you can create specific committees, such as membership or academic, and allow each of the committees to make its own decisions and rules within the overall guidelines set out by the national charter. Consider the need to manage and evaluate the club and describe which form of organization would you set up for your club and why.
2. Consider these two companies: Apple and ExxonMobil. Write a summary of your perception of each company’s financial position. Consider the levels of revenue, profitability, and any other financial measures you feel are relevant. After completing your summary, download Apple’s September 30, 2017 annual report (10-K) and download Exxon Mobil’s December 31, 2016 annual report (10-K) for more information. Gather the following information for each company:
Table 9.E.1: Apple Data
Apple 9/30/2017 9/24/2016 9/26/2015
Net sales
Income before provision for income taxes
Net income
Table 9.E.2: Exxon Mobile Data
Exxon 2017 2016 2015
Total revenues and other income
Income before income taxes
Net income attributable to ExxonMobil
What observations do you have about the financial performance of each company? Calculate the net income \(\%\) (also called profit margin \(\%\)) of each company. What observations do you have? How do these results compare to your perception of these companies before reviewing the annual reports? | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/09%3A_Responsibility_Accounting_and_Decentralization/9.0E%3A_9.E%3A_Responsibility_Accounting_and_Decentralization_%28Exercises%29.txt |
One day, at your part-time job in a local coffee shop, you realize that the employees throw many pounds of used coffee grounds in the trash each day. From an environmental perspective, you are concerned because of the volume of trash being transferred to the landfill. From a business perspective, you wonder if discarding the used grounds is the only option. Could those coffee grounds be used in a profitable manner? After a bit of research, you discover that, if prepared in certain ways, used coffee grounds are good as fertilizer, can kill insects on some plants, can be used as a body scrub, among other options. A recent radio talk show discussed the possibility that coffee grounds could be used as an alternative fuel source, and you learned that coffee grounds are actually being used to help fuel buses in London.
You consider the options for the used coffee grounds and come up with three possibilities for your coffee shop: (1) throw away the used grounds; (2) sell the used grounds to a company that will process them into fertilizer, bio-fuel, or some other product; or (3) process and package the used grounds for resale in the coffee shop as fertilizer and bug repellant. What information would you need for your analysis? Which decision would you choose and why? Are the revenue and cost components the only components of the decision that you should consider? These and similar issues are the types of questions that the accounting analysis process can help management address when evaluating short-term decisions.
10.02: Identify Relevant Information for Decision-Making
Almost everything we do in life results from choosing between alternatives, and the choices we make result in different consequences. For example, when choosing whether or not to eat breakfast before going to class, you face two alternatives and two sets of consequences. Eating breakfast means you must get up a little earlier, have food available, and be willing to prepare the food. Not eating means sleeping in longer, not having to plan food, and being hungry during class. Just as our lives are fraught with decisions large and small, the same is true for businesses. Almost every aspect of being in business involves choosing between alternatives, and each alternative typically has one or more consequences. Understanding how businesses make decisions paves the way not only to better decision-making processes but potentially to better outcomes.
Decisions made by businesses can have short-term effects or long-term impacts, or in some situations, both. Short-term decisions often address a temporary circumstance or an immediate need while long-term decisions align more with permanent problem solving and meeting strategic goals. Because these two types of decisions require different types of analyses, we will consider short-term decision-making here and long-term decision-making in Capital Budgeting Decision. Accounting distinguishes between short-term and long-term decisions not only because of the difference in the general nature of these decisions but also because the types of analyses differ significantly between short-term and long-term decision categories. As the time horizon over which the decision will have an impact expands, more costs become relevant to the decision-making process. In addition, when a time element is considered, there will be additional factors such as interest (paid or received) that will have a greater influence on decisions. Table \(1\) provides examples of short-term and long-term business decisions.
Table \(1\): Examples of Short-Term and Long-Term Business Decisions
Short-Term Business Decisions Long-Term Business Decisions
• Accepting a special production order
• Determining the best product mix from current products
• Outsourcing a part or service
• Further processing or refining a current product
• Buying new equipment versus remodeling old equipment
• Choosing which products to manufacture
• Expanding into a new area or country
• Diversifying by buying another business
Short-term and long-term business decisions should be analyzed using different frameworks.
CONTINUING APPLICATION: Short-Term Decision-Making
Considering the business challenges facing Gearhead Outfitters, what short-term decisions might the company encounter? Remember that the retailer sells men’s, women’s and children’s outdoor clothing, footwear, and accessories. Gearhead must carry a certain level and variety of inventory to meet the demands of its customers. The company will have to maintain appropriate accounting records to make proper business decisions to promote sustainability and growth.
How might Gearhead be able to compete with larger chains and remain profitable? Will every sale result in the anticipated profit to the company? Consider what specialized short-term decision-making processes the company may use to meet its goals. Should more of an item than normal be purchased for resale to receive a larger discount from the supplier? What information about cost, volume, and profit is needed to make a sound business decision in this case? Some items may be sold at a loss (or lesser profit) to attract customers to the store. What type of information and accounting system is needed to help in this situation? The company requires relevant, consistent, and reliable data to determine the proper course of action.
Short-term decision-making is vital in any business. Consider this concept in relation to Centralized vs. Decentralized Management and how a company’s approach may affect the decision-making process. Discuss possible short-term issues and decisions, management focuses, and whether or not the centralized versus decentralized style will aid in company flexibility and success. Also, think in terms of how the decision-making process will be evaluated.
Relevant Information for Short-Term Decision-Making
Business decision-making can be outlined as a process that is applied by management with each decision that is made. The process of decision-making in a managerial business environment can be summed up in these steps.
1. Identify the objective or goal. For a business, typically the goal is to maximize revenues or minimize costs.
2. Identify alternative courses of action that can achieve the goal or address an obstacle that is hindering goal achievement.
3. Perform a comprehensive analysis of potential solutions. This includes identifying revenues, costs, benefits, and other financial and qualitative variables.
4. Decide, based upon the analysis, the best course of action.
5. Review, analyze, and evaluate the results of the decision.
The first step of the decision-making process is to identify the goal. In the decisions discussed in this course, the quantitative goal will either be to maximize revenues or to minimize costs. The second step is to identify the alternative courses of action to achieve the goal. (In the real world, steps one and two may require more thought and research that you will learn about in advanced cost accounting and management courses.). This chapter focuses on steps three and four, which involve short-term decision analysis: determining the appropriate information necessary for making a decision that will impact the company in the short term, usually \(12\) months or fewer, and using that information in a proper analysis in order to reach an informed decision among alternatives. Step five, which involves reviewing and evaluating the decision, is briefly addressed with each type of decision analyzed.
Though these same general steps could be used in long-term decision analyses, the nature of long-term decisions is different. Short-term decisions are typically operational in nature: making versus buying a component of a product, using scarce resources, selling a product as-is or processing it further into a different product. It is relatively easy to change a short-term decision with minimal impact on the company. Long-term decisions are strategic in nature and typically involve large sums of money. The effects of a long-term decision can have significant financial impact on a company for years. Examples of long-term decisions include replacing manufacturing equipment, building a new factory, or deciding to eliminate a product line. While you’ve learned how managerial accounting classifies, tracks, monitors, and controls costs, managerial accountants also closely analyze revenues, which are less controllable than costs, but are important in these decisions. As stated in the first step of the decision-making process, maximizing revenues is usually one of the goals of an organization. Therefore, making some short-term decisions requires analysis of both costs and revenues.
In carrying out step three of the managerial decision-making process, a differential analysis compares the relevant costs and revenues of potential solutions. What does this involve? First, it is important to understand that there are many types of short-term decisions that a business may face, but these decisions always involve choosing between alternatives. Examples of these types of decisions include determining whether to accept a special order; making a product or component versus buying the product or component; performing additional processing on a product; keeping versus eliminating a product or segment; or determining whether to take on a new project. In each of these situations, the business should compare the relevant costs and the relevant revenues of one alternative to the relevant costs and relevant revenues of the other alternative(s). Therefore, an important step in the differential analysis of potential solutions is to identify the relevant costs and relevant revenues of the decision.
What does it mean for something to be relevant? In the context of decision-making, something is relevant if it will influence the decision being made. For example, suppose you have two options for a summer job—either flagging traffic for a road crew or working for a landscaping company doing lawn care. For either job, you will be required to have industrial grade sound protectors (plugs or headphones) for your ears. This cost would not be relevant because it is the same under either alternative, so it will not influence your decision between the two jobs; it would be considered an irrelevant cost. You also believe your transportation costs will be the same for either job; thus this would also be an irrelevant cost.
However, if you are required to have steel-toed boots for the road work job but can wear any type of work boot for the landscaping job, you would need to consider the difference between the costs, or the differential cost, of these two types of boots. This difference in cost between the two pairs of boots would be designated as a relevant cost because it influences your decision.
The two jobs also may have differences in revenues, called a differential revenue. Because the differential revenue influences the decision, it is also a relevant revenue. If both jobs pay the same hourly wage, it would have an irrelevant revenue, but if the road crew job offers overtime for any time worked over 40 hours, then this overtime wage has the potential to be a relevant revenue if overtime is a likely occurrence. Looking only at these differences—of both costs and revenues—between the alternatives, is known as differential analysis.
In conducting these types of analyses between alternatives, the initial focus will be on each quantitative factor of the analysis—in other words, the component that can be measured numerically. Examples of quantitative factors in business include sales growth, number of defective parts produced, or number of labor hours worked. However, in decision-making, it is important also to consider each qualitative factor, which is one that cannot be measured numerically. For example, using the same summer job scenario, qualitative factors may include the environment in which you would be working (road dust and tar odors versus pollen and mower exhaust fumes), the amount of time exposed to the sun, the people with whom you will be working (working with friends versus making new friends), and weather-related issues (both jobs are outdoors, but could one job send you home for the day due to weather?). Examples of qualitative factors in business include employee morale, customer satisfaction, and company or brand image. In making short-term decisions, a business will want to analyze both qualitative and quantitative factors.
In short-term decision-making, revenues are often easier to evaluate than costs. In addition, each alternative typically only has one possible one revenue outcome even though there are many costs to consider for each alternative. How do we know if a cost will have an impact on the decision? The starting point is to understand the various labels that are attached to costs in these decision-making environments.
Avoidable versus Unavoidable Costs
Management must determine if a cost is avoidable or unavoidable because in the short run, only avoidable costs are relevant for decision-making purposes. An avoidable cost is one that can be eliminated (in whole or in part) by choosing one alternative over another. For example, assume that a bike shop offers their customers custom paint jobs for bikes that the customers already own. If they eliminate the service, the cost of the bike paint could be eliminated. Also assume that they had been employing a part-time painter to do the work. The painter’s compensation would also be an avoidable cost.
An unavoidable cost is one that does not change or go away in the short-run by choosing one alternative over another. For example, a company might sign a long-term lease on equipment or a production facility. These types of leases typically don’t allow for cancellation, so if this one does not, then their required payments are unavoidable costs for the duration of the lease.
Variable costs are avoidable costs, since variable costs do not exist if the product is no longer made, or if the portion of the business (such as a segment or division) that generated the variable costs ceases to operate. Fixed costs, on the other hand, may be unavoidable, partially unavoidable, or avoidable only in certain circumstances. Remember that fixed costs tend to remain constant for a period of time and within a relevant range of production and are not easily eliminated in the short-run. Therefore, most fixed costs also are unavoidable. If a fixed cost is specific only to one of the alternatives, then that fixed cost also may be avoidable. Avoidable costs are future costs that are relevant to decision-making. Past costs are never an avoidable cost.
Recall that we are using a short-term viewpoint to determine whether or not costs are avoidable. In the long run, virtually all costs are avoidable. For example, assume that a company has a long-term, ten-year lease on a production facility that cannot be cancelled. For the first ten years it would be noncancelable and thus unavoidable. But after ten years it would become avoidable.
Example \(1\): AlexCo’s Wagons
AlexCo produces collapsible wagons that are popular with beachgoers, shoppers, gardeners, parents, and tailgaters. Annual sales have been \(100,000\) wagons per year. The retail selling price of each wagon is \(\$67.00\). To date, AlexCo has produced each of the components used in making the wagons but has been approached by DAL, Inc. with an offer to provide the axle and wheel assembly for \(\$18.75\) per assembly. AlexCo’s costs to produce the axle and wheel assembly are \(\$9.00\) in direct materials, \(\$6.50\) in direct labor, \(\$3.57\) in variable overhead, and \(\$2.50\) in fixed overhead. Twenty-five percent of the fixed overhead is avoidable if the assembly is produced by DAL. Should AlexCo continue to make the axle and wheel assembly or should it buy the assembly from DAL, Inc.?
Solution
Ignoring qualitative factors, it would be more cost effective for AlexCo to buy the axle and wheel assembly from DAL, Inc. However, AlexCo should be certain of any qualitative issues and not solely base their decision on the quantitative analysis.
Sunk Costs
A sunk cost is one that cannot be avoided because it has already occurred. A sunk cost will not change regardless of the alternative that management chooses; therefore, sunk costs have no bearing on future events and are not relevant in decision-making. The basic premise sounds simple enough, but sunk costs are difficult to ignore due to human nature and are sometimes incorrectly included in the decision-making process. For example, suppose you have an old car, a hand-me-down from your grandmother, and last year you spent \(\$1,600\) on repairs and new tires and were just told by your mechanic that the car needs \(\$1,200\) in repairs to operate safely. Your goal is to have a safe and reliable car. Your alternatives are to get the repairs completed or trade in the car for a newer used car.
From a quantitative perspective, you have gathered the following information to help with your decision. The trade-in value of your old car will be the minimum given by the dealer, or \(\$200\). The newer used car will require you to make monthly payments of \(\$150\) for two years. In analyzing your two alternatives, what costs do you consider? Remember, the \(\$1,600\) you have already spent (note the past tense) is a sunk cost; it is a consequence of a past decision. In this example, the relevant costs for each alternative are the following: \(\$1,200\) in current repair costs to keep your current car or \(\$3,400\) (from the \(24\) payments of \(\$150\) minus \(\$200\) for the trade in) to buy a newer used car. Obviously, you also would consider qualitative factors, such as the sentimental value of your grandmother’s car or the excitement of having a newer car.
Sunk costs are most problematic for business decisions when they pertain to existing equipment. The book value of an asset (historical cost – accumulated depreciation) is a sunk cost regardless of whether a business keeps the asset or disposes of it in some manner. The cost of the asset occurred in the past and therefore is sunk and irrelevant to the decision at hand. Mangers may be reluctant to ignore sunk costs when making decisions, especially if the prior decision to purchase the asset was an unwise one. Often, when management takes a path of action that is not achieving the desired results, managers may continue the same path in the hope that the effect of prior decisions will improve the results. The use of the word prior is a key indicator that information is nonrelevant to a current decision. Holding on to old decisions or old commitments is common because letting them go forces management to admit they made a bad decision.
Future Costs That Do Not Differ
Any future cost that does not differ between the alternatives is not a relevant cost for the decision. For example, if a company is considering baking either bagels or doughnuts and both baked goods require \(\$0.30\) worth of flour, then the cost of flour would not be a relevant cost in determining which of the two had the highest production cost. As relevant information for short-term decision-making, the cost of sound protectors for your summer job would not be relevant to your decision because that cost exists in both scenarios. Another irrelevant cost would be your transportation cost, since that cost is also the same regardless of the job you choose. In another example, if a company is planning to produce either red widgets or blue wingdings and will need to hire \(10\) additional employees to produce either of the goods, the cost of those \(10\) employees is irrelevant because it does not differ between the alternatives.
ETHICAL CONSIDERATIONS: Johnson & Johnson’s 1982 Recall and Replacement of All Tylenol in the World
In 1982, Johnson & Johnson was faced with a large-scale business and ethical dilemma. During the course of several days beginning on September 29, 1982, seven deaths occurred in the Chicago area that were attributed to consuming capsules of Extra-Strength Tylenol. The painkiller was, at the time, Johnson & Johnson’s best-selling product. The company had to decide if the short-term cost of replacing the Tylenol was worth the future cost to their reputation and their customer’s health and safety. At tremendous expense, Johnson & Johnson “placed consumers first by recalling 31 million bottles of Tylenol capsules from store shelves and offering replacement product in the safer tablet form free of charge.”1
As it was later discovered, someone was lacing Tylenol capsules with cyanide and returning the pills in the original packages to store shelves. However, Johnson & Johnson’s decision to incur short-term costs by recalling all of their pills ultimately paid off, as in the long run, the company’s stock value increased and Tylenol sales recovered. One could look at the decision as an opportunity cost: Johnson & Johnson had to choose between two alternatives. The company could have chosen a short-term solution with reduced short-term losses, but by making an ethical business decision, the long-term rewards were greater than the short-term savings.
Opportunity Costs
When choosing between two alternatives, usually only one of the two choices can be selected. When this is the case, you may be faced with opportunity costs, which are the costs associated with not choosing the other alternative. For example, if you are trying to choose between going to work immediately after completing your undergraduate degree or continuing to graduate school, you will have an opportunity cost. If you choose to go to work immediately, your opportunity cost is forgoing a graduate degree and any potential job limitations or advancements that result from that decision. If you choose instead to go directly into graduate school, your opportunity cost is the income that you could have been earning by going to work immediately upon graduation.
Example \(2\): Costs and Revenue at Carolina Clusters
Carolina Clusters, Inc., a candy manufacturer in a resort town, just bought a new taffy pulling machine for \(\$27,000\) and is planning to increase the production of salt-water taffy. Due to the increased production, Carolina is deciding between hiring two part-time college students or one full-time employee. Each college student would work half days totaling \(20\) hours per week, and would earn \(\$12\) per hour. The full-time employee would work full days \(40\) hours per week and would earn \(\$12\) per hour plus the equivalent of \(\$2\) per hour in benefits. Each employee is given two t-shirts to wear as their uniform. The t-shirts cost Carolina \(\$8\) each. In addition, Carolina provides disposable hair coverings and gloves for the employees. Each employee uses, on average, six sets of gloves per eight-hour shift or four sets per four-hour shift. One hair covering per shift per person is typical. The cost of the hair covering is \(\$0.05\) per covering and the cost of a pair of gloves is \(\$0.02\) per pair. Identify any relevant costs, relevant revenues, sunk costs, and opportunity costs that Carolina Clusters needs to consider in making the decision whether to hire two part-time employees or one full-time employee.
Solution
Relevant costs:
• \(\$2\) per hour for benefits
• \(\$16\) for two t-shirts: Hiring one full-time person will result in a \(\$16\) expenditure for t-shirts. Hiring two college students would result in \(\$32\) in t-shirt expenditures, thus the relevant t-shirts costs is the \(\$16\) difference.
• \(\$0.05\) for a hair covering: Hiring one full-time person will result in \(\$0.05\) per day in hair covering costs but hiring two college students would result in \(\$0.10\) per day in hair covering costs thus the relevant hair covering cost is the \(\$0.05\) difference.
• \(\$0.04\) for a pair of gloves: Hiring one full-time person will result in \(\$0.12 (6 × \$0.02)\) per day in glove costs, but hiring two college students would result in \(\$0.16 (8 × \$0.02)\) per day in glove costs. Thus, the relevant glove cost is the \(\$0.04\) difference.
Relevant revenues: None
Sunk costs: \(\$27,000\) for the taffy machine
Opportunity costs: None
Footnotes
1. Judith Rehak. “Tylenol Made a Hero of Johnson & Johnson: The Recall That Started Them All.” New York Times. Mar. 23, 2002. https://www.nytimes.com/2002/03/23/y...t-started.html | textbooks/biz/Accounting/Managerial_Accounting_(OpenStax)/10%3A_Short-Term_Decision_Making/10.01%3A_Prelude_to_Short-Term_Decision_Making.txt |
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