“This document is attributed to Kurt Heisinge and Joe Ben

Hoyle”

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 About the Authors

Kurt Heisinger

Kurt Heisinger (CMA, CPA, MBA) teaches financial and managerial accounting full time and
holds a tenured position at Sierra College. He recently received the 2011–12 Faculty of the Year
award, which was voted on and presented by the Associated Students of Sierra College. Kurt has
also taught accounting classes at the University of California—Davis and American River
College.

Kurt began his career in public accounting with Ernst & Young and continued as a manager of a
large local accounting firm in California. He received his MBA at the University of California—
Davis and is currently a certified management accountant (CMA) and certified public accountant
(CPA). The knowledge Kurt gained from his seven years in industry and more than 15 years in
education has enabled him to write a clear and concise book filled with real world examples.

Joe Ben Hoyle

Joe Hoyle is an associate professor of accounting at the Robins School of Business at the
University of Richmond. In 2006, he was named byBusinessWeek as one of 26 favorite
undergraduate business professors in the United States. In 2007, he was selected as the Virginia
Professor of the Year by the Carnegie Foundation for the Advancement of Teaching and the
Council for the Advancement and Support of Education. In 2009, he was judged to be one of the
100 most influential members of the accounting profession by Accounting Today.

Joe has two market-leading textbooks published with McGraw-Hill—Advanced

Accounting (eleventh edition, 2012) and Essentials of Advanced Accounting (fifth edition, 2012), both
coauthored with Tom Schaefer of the University of Notre Dame and Tim Doupnik of the
University of South Carolina.

At the Robins School of Business, Joe teaches fundamentals of financial accounting,

intermediate financial accounting I, intermediate financial accounting II, and advanced financial
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 accounting. He earned his BA degree in accounting from Duke University and his MA degree in
business and economics, with a minor in education, from Appalachian State University. He has
written numerous articles and continues to make many presentations around the country on
teaching excellence. He maintains a blog on teaching at http://www.joehoyle-teaching.blogspot.com.

Joe also has three decades of experience operating his own CPA (Certified Public Accountant)
Exam review programs. In 2008, he created CPA Review for Free
(http://www.CPAreviewforFREE.com), which provides thousands of free questions to help
accountants around the world prepare for the CPA Exam.

Joe and his wife, Sarah, have four children and four grandchildren.

 
 

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 Acknowledgments

We would like to thank the following reviewers. Their insightful feedback and suggestions for
improving the material helped us make this a better text:

• William Murphy, University of Wisconsin—Stout

• Carleton Donchess, Bridgewater State University
• Jason Sharp, Ferrum College
• Todd Jensen, Sierra College
• Robert Walsh, University of Dallas
• Michael Brown, Millikin University
• Jennifer Robinson, Trident Technical College
• James Aitken, Central Michigan University
• Delvan Roehling, Ivy Tech Community College
• Carol Lawrence, Northern Kentucky University
• Curtis Crocker, Central Georgia Technical College
• Kathleen Fitzpatrick, University of Toledo
• Walt Walczykowski, Sierra College
• Annette Fisher, Glendale Community College
• Walter Austin, Mercer University
• Hubert Glover, Drexel University
• Steven LaFave, Augsburg College
• Joan Van Hise, Fairfield University
• Holly Ratwani, Bridgewater College
• Alan Shattuck, Sierra College
• Paul Fisher, Rogue Community College
• Rick Blumenfeld, Sierra College
• Paula Wilson, University of Puget Sound
• Jianing Fang, Iona College
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 • Dan Sevall, Lincoln University
• Alan Adams, Dean College
• John Stancil, Florida Southern College
• Christy Land, Catawba Valley Community College
• Birendra Mishra, University of California—Riverside

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 Dedication

Kurt Heisinger

To my parents for their continued optimism and support; to my wife and children for their
patience and encouragement; and to Michael Maher, professor of management at the University
of California—Davis, who served as my mentor and encouraged me to write this book. I could
not have done it without him.

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 Preface

Brief, Focused, Essential

Student learning styles continue to evolve as we move into the twenty-first century. Students
want to learn accounting in the most efficient way possible, balancing coursework with personal
schedules. They tend to focus on their studies in short intense segments between jobs, classes,
and family commitments. Meanwhile, the accounting industry has endured dramatic shifts since
the collapse of Enron and WorldCom, causing a renewed focus on ethical behavior in
accounting.

Core Themes

This book is aimed squarely at the new learning styles evident in today’s students and addresses
accounting industry changes as well. Accordingly, three core themes lie at the foundation of this
text:

Focused. Students want to be as efficient as possible in their learning. This book adopts a
concise, jargon-free, and easy-to-understand approach. Key concepts are provided in short
segments with bullet points and step-by-step instructions to simplify concepts. A thoughtful,
stepwise approach helps students avoid distractions and focuses attention on the big picture.

Reinforcement. Review Problems at the end of each major section offer practical opportunities
for students to apply what they have learned. These Review Problems allow students to
immediately reinforce what they have learned and are provided within the body of the chapter
along with the solutions.

Relevance. Students perform better when they can answer the “why” question. Why is
managerial accounting important? Meaningful references to companies throughout the chapters
help students tie the concepts presented in each chapter to real organizations.

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 In addition, realistic managerial scenarios present an issue that must be addressed by the
management accountant. These pique student interest and are designed to show how issues can
be resolved using the concepts presented in the chapter.

Finally, Business in Action features in this text link managerial decision making to real business
decisions.

Other Key Features

A focus on decision making. This book focuses on the essential managerial accounting concepts
used within organizations for decision-making purposes and covers these concepts in 13
straightforward and concise chapters. Knowing that the majority of students taking managerial
accounting at the introductory level are general business majors and will not become
accountants, this text was written to help students make informed business decisions using
managerial accounting concepts.

Thorough end-of-chapter coverage. The Exercises, Problems, and Cases were developed to
give student a wide range of reinforcement at different levels of complexity and to help build
critical thinking skills.

Ethics coverage. The importance of ethics is evident from the outset since the book begins with
an entire segment on ethical issues facing the accounting industry. This segment includes the
Institute of Management Accountants’ revised standards of ethical conduct and describes
professional codes of conduct provided by the American Institute of Certified Public
Accountants, Financial Executives International, and International Federation of Accountants.
Ethics questions and cases are included throughout the text.

Group projects. The accounting industry and business in general have made it clear employees
must be able to work effectively and efficiently in groups. In addition, studies show students
learn concepts more effectively when working in groups. To reinforce this idea, we have
included group projects throughout the book.

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 Spreadsheet applications. Computer Application features and End-of-Chapter Exercises
emphasize the importance of using Excel spreadsheets for analytical purposes.

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 Chapter 1

What Is Managerial Accounting?

Dana Matthews is the president of Sportswear Company, a producer of hats and jerseys for fans
of several professional sports teams. Imagine you are the accountant in charge of all accounting
functions at Sportswear. Dana just reviewed the financial statements for the most recent fiscal
year for the first time and has the following conversation with you:

I just reviewed our most recent financial statements, and I noticed we did not do
as well as we had planned. I would like to look more closely at the profitability
of each of our products to determine exactly what happened, but I don’t have
President this information in the financial statements. Is there a reason we don’t include
(Dana): this in the financial statements?

Yes, the financial statements are prepared following U.S. Generally Accepted
Accounting Principles (U.S. GAAP) and are intended for outside users, such as
owners, banks, and suppliers. U.S. GAAP does not require us to disclose
profitability by product, and we prefer not to make this information public.
Product profitability information stays in-house and is prepared by our
Accountant: managerial accountant, Dave Hicks.

That makes sense. Can you have Dave pull together product profitability
information for the past year so we can take a close look at which products are
President: doing well and which are not?

Accountant: You bet. We’ll have the information for you early next week.

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 1.1 Characteristics of Managerial Accounting

L E A R N I N G   O B J E C T I V E  

1. Compare  characteristics  of  financial  and  managerial  accounting.  

Question: The issue facing the president at Sportswear is a common one. Companies prefer not
to disclose more information than is required by U.S. GAAP, but they would like to have more
detailed information for internal decision-making and performance-evaluation purposes. This is
why it is important to distinguish between financial and managerial accounting. What is the
difference between information prepared by financial accountants and information prepared by
managerial accountants?

Answer: Financial accounting focuses on providing historical financial information to external

users. External users are those outside the company, including owners (e.g., shareholders) and
creditors (e.g., banks or bondholders). Financial accountants reporting to external users are
required to followU.S. Generally Accepted Accounting Principles (U.S. GAAP), a set of
accounting rules that requires consistency in recording and reporting financial information. This
information typically summarizes overall company results and does not provide detailed
information.

Managerial accounting focuses on internal users—executives, product managers, sales managers,

and any other personnel within the organization who use accounting information to make
important decisions. Managerial accounting information need not conform with U.S. GAAP. In
fact, conformance with U.S. GAAP may be a deterrent to getting useful information for internal
decision-making purposes. For example, when establishing an inventory cost for one or more
units of product (each jersey or hat produced at Sportswear Company), U.S. GAAP requires that
production overhead costs, such as factory rent and factory utility costs, be included. However,
for internal decision-making purposes, it might make more sense to include nonproduction costs
that are directly linked to the product, such as sales commissions or administrative costs.

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 Question: It’s clear that financial accounting focuses on reporting to outside users while
managerial accounting focuses on reporting to inside users. What specific characteristics would
we expect to see in managerial accounting information?

Answer: Managerial accounting often focuses on making future projections for segments of a
company. Suppose Sportswear Company is considering introducing a new line of coffee mugs
with team logos on each mug. Management would certainly need detailed financial projections
for sales, costs, and the resulting profits (or losses). Although historical financial accounting data
from other product lines would be useful, preparing projections for the new line of mugs would
be a managerial accounting function.

Another characteristic of managerial accounting data is its high level of detail. As noted in the
opening dialogue between the president and accountant at Sportswear Company, the financial
information in the annual report provides a general overview of the company’s financial results
but does not provide any detailed information about each product. Information, such as product
profitability, would come from the managerial accounting function.

Finally, managerial accounting information often takes the form of nonfinancial measures. For
example, Sportswear Company might measure the percentage of defective products produced or
the percentage of on-time deliveries to customers. This kind of nonfinancial information comes
from the managerial accounting function.

Table 1.1 "Comparison of Financial and Managerial Accounting" summarizes the characteristics
of both managerial and financial accounting.

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 Table 1.1 Comparison of Financial and Managerial Accounting
Managerial Accounting Financial Accounting

Users Inside the organization Outside the organization

U.S. Generally Accepted Accounting Principles

Accounting rules None (U.S. GAAP)

Time horizon Future projections (sometimes historical if in detail) Historical information

Often presents segments of an organization (e.g., Presents overall company information in

Level of detail products, divisions, departments) accordance with U.S. GAAP

Performance
measures Financial and nonfinancial Primarily financial

Follow-Up at Sportswear Company

Question: What did the president at Sportswear Company learn about product profitability from
the information provided by the managerial accountant?

Answer: The president at Sportswear, Dana Matthews, learned that the hats product line was
much more profitable than expected, accounting for 55 percent of the company’s profits even
though initial estimates were that the hat segment would account for 40 percent of company
profits. Conversely, the jerseys product line was much less profitable than expected, accounting
for 45 percent of the company’s profits.

There are many issues associated with determining product profitability, including how to
allocate costs that are not easily traced to each product and whether the product revenue and cost
information is accurate enough to make important managerial decisions. These important issues
will be addressed throughout the book.

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 K E Y   T A K E A W A Y  

• Financial  accounting  provides  historical  financial  information  for  external  users  in  accordance  with  U.S.  GAAP.  

Managerial  accounting  provides  detailed  financial  and  nonfinancial  information  for  internal  users  who  use  the  

information  for  decision  making,  planning,  and  control  purposes.  

R E V I E W   P R O B L E M   1 . 1  

1. Suppose  you  are  the  co-­‐owner  and  manager  of  a  retail  store  that  sells  and  repairs  mountain  bikes.  Provide  one  

example  of  a  financialaccounting  report  that  would  be  useful  to  you  and  your  co-­‐owner.  Provide  two  examples  

of  managerial  accounting  reports  that  would  be  useful  to  you  as  the  manager.  

2. Provide  two  examples  of  nonfinancial  measures  used  by  a  pizza  eatery  that  serves  food  in  the  restaurant  and  offers  

delivery  services.  

3. For  each  report  listed  in  the  following,  indicate  whether  it  relates  to  financial  or  managerial  accounting.  Explain  

the  reasoning  behind  your  answer  for  each  item.  

1. Projected  net  income  for  next  quarter  by  division  

2. Defective  goods  produced  as  a  percentage  of  all  goods  produced  

3. Income  statement  for  the  most  current  year,  prepared  in  accordance  with  U.S.  GAAP  

4. Monthly  sales  broken  down  by  geographic  region  

5. Production  department  budget  for  the  next  quarter  

6. Balance  sheet  at  the  end  of  the  current  year,  prepared  in  accordance  with  U.S.  GAAP  

Solution  to  Review  Problem  1.1  

1. Financial  accounting  reports  provided  to  owners  typically  include  the  income  statement,  statement  of  owners’  equity,  

balance  sheet,  and  statement  of  cash  flows.  All  are  prepared  in  accordance  with  U.S.  GAAP.  Managerial  accounting  

reports  prepared  for  managers  might  include  a  quarterly  budget  for  revenues  and  expenses  for  each  segment  of  the  

business  (e.g.,  bike  sales  and  bike  repairs),  returns  for  defective  merchandise  as  a  percent  of  total  monthly  sales,  

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 income  projections  to  be  used  in  deciding  whether  to  open  a  new  store,  and  projected  sales  for  each  bike  model.  

(There  are  many  correct  answers  to  this  problem.  Use  Table  1.1  "Comparison  of  Financial  and  Managerial  

Accounting"  as  a  guide  in  determining  the  accuracy  of  your  answer.)  

2. Examples  of  nonfinancial  measures  include  percentage  of  on-­‐time  deliveries,  percentage  of  burned  pizzas,  average  

time  required  to  prepare  pizza  for  restaurant  customers  (from  taking  a  customer’s  order  to  providing  the  pizza  at  the  

customer’s  table),  and  results  of  customer  satisfaction  surveys.  (These  are  just  a  few  examples.  There  are  many  correct  

answers  to  this  problem.)  

3. The  answers  appear  as  follows.  Be  sure  you  explained  your  answers.  

1. Managerial  accounting—information  is  for  future  projections  and  involves  segments  of  the  company  

2. Managerial  accounting—nonfinancial  detailed  measure  of  defective  products  

3. Financial  accounting—historical  information  prepared  in  accordance  with  U.S.  GAAP  

4. Managerial  accounting—detailed  information  provided  monthly  

5. Managerial  accounting—information  is  for  future  projections  and  involves  a  segment  of  the  company  

6. Financial  accounting—historical  information  prepared  in  accordance  with  U.S.  GAAP  

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 1.2 Planning and Control Functions Performed by Managers

L E A R N I N G   O B J E C T I V E  

1. Describe  the  planning  and  control  functions  performed  by  managers.  

Question: Managers of most organizations continually plan for the future, and after the plan is
implemented, managers assess whether they achieved their goals. What are the two functions
that enable management to go through the process of continually planning and evaluating?

Answer: The two important functions that enable management to continually plan for the future
and assess implementation are called planning and control. Planning is the process of
establishing goals and communicating these goals to employees of the organization.
The controlfunction is the process of evaluating whether the organization’s plans were
implemented effectively.

Planning

Question: Continually planning for the future is an important quality of many successful
organizations, such as Southwest Airlines (discussed in Note 1.11 "Business in Action 1.1"). How
do organizations formalize their strategic plans?

Answer: Organizations formalize their plans by creating a budget, which is a series of reports
used to quantify an organization’s plans for the future. For example, Ernst & Young, an
international accounting firm, plans for the future by establishing a budget indicating the labor
hours required to perform specific services for each client. The process of creating a budget for
each client enables the firm to plan for future staffing needs and communicate these needs to
employees of the company. Rather than simply hoping it all works out in the end, Ernst &
Young projects the labor hours required in the future, hires accounting staff based on these
projections, and schedules the staff required for each client.

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 A budget can take a variety of forms. A budgeted income statement indicates a profit plan for the
future. A capital budget shows the long-term investments planned for the future. A cash flow
budget outlines cash inflows and outflows for the future. We provide more information about
how budgets can be used for planning purposes in later chapters.

Business  in  Action  1.1  

Plans for the Future

Review the annual report or 10K for just about any company, and you are likely to find information regarding

plans for the future. Here are some examples:

• Southwest Airlines. A low-fare, short-haul carrier that targets business commuters as well as leisure travelers

states in its annual report, “We are focused on four big initiatives: the AirTran integration, the All-New Rapid

Rewards program, the addition of the Boeing 737–800 in 2012, and the replacement of our reservations system.”

• Sears Holdings Corporation. A multiline retailer that offers a wide array of merchandise and related services

states in its 10K report, “We will continue to invest in our online properties. By integrating our vast store network

with our online properties, we believe that Sears Holdings will succeed in the rapidly evolving retail environment.”

• Nordstrom, Inc. A fashion specialty retailer indicates in its 10K report that its “strategic growth plan includes

opening new Nordstrom full-line and Nordstrom Rack stores, with 6 announced Nordstrom full-line and 18

announced Nordstrom Rack store openings, the majority of which will occur by 2012.”

As these companies go through the process of making decisions about the future, developing plans based on

their decisions, and controlling the implementation of their plans, managerial accounting information will play

a key role in all phases of the process.

Sources: Southwest Airlines, “Annual Report, 2010,”http://www.southwest.com; Sears Holdings

Corporation, “10K Report, 2010,” http://www.searsholdings.com; Nordstrom, Inc., “10K Report,

2010,” http://www.nordstrom.com.

Control

Question: Although planning for the future is important, plans are only effective if implemented
properly. How do organizations assess the implementation of their plans?
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 Answer: The control function evaluates whether an organization’s plans were implemented
effectively and often leads to recommendations for the future. Many organizations compare
actual results with the initial plan (or budget) to evaluate performance of employees,
departments, or the entire organization.

For example, assume Ernst & Young creates a budget indicating the labor hours needed to
perform tax services for a particular client (this is theplanning function). After the work is
performed, actual labor hours used to complete the work are compared to budgeted labor hours.
This analysis is then used to evaluate whether employees were able to complete the work within
the budgeted time and often results in recommendations for the future. Recommendations might
include the need for adding more labor hours to the budget or obtaining better support documents
from the client.

Planning and controlling operations are critical functions within most organizations. In today’s
business environment, effective planning and control by managers can be the key to survival.

K E Y   T A K E A W A Y  

• Managers  continually  plan  and  control  operations  within  organizations.  Planning  involves  establishing  goals  and  

communicating  these  goals  to  employees  of  the  organization.  The  control  function  assesses  whether  goals  were  

achieved  and  is  often  used  to  evaluate  the  performance  of  employees,  departments,  and  the  organization  as  a  whole.  
R E V I E W   P R O B L E M   1 . 2  

Assume  you  are  preparing  a  personal  budget  of  all  income  and  expenses  for  next  month.  

1. Describe  the  planning  and  control  functions  of  this  process.  

2. What  benefits  might  be  derived  from  performing  the  planning  and  control  functions  for  a  personal  budget?  

Solution  to  Review  Problem  1.2  

1. The  planning  function  would  involve  establishing  income  and  expense  goals  for  next  month.  Possible  sources  

of  income  include  wages,  scholarships,  or  student  loans.  Expenses  might  include  rent,  textbooks,  tuition,  food,  

entertainment,  and  transportation.  

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 The  control  function  occurs  after  the  end  of  the  month  and  involves  comparing  actual  income  and  expenses  

with  budgeted  income  and  expenses.  This  allows  for  the  evaluation  of  whether  income  and  expense  goals  

were  achieved.  

2. There  are  several  benefits  to  using  a  planning  and  control  process.  The  planning  function  establishes  income  

and  expense  goals  and  helps  to  identify  any  deviations  from  these  goals.  For  example,  planned  expenditures  

are  clearly  outlined  in  the  budget  and  provide  guidelines  for  making  expenditure  decisions  throughout  the  

month.  Without  clear  guidelines,  money  might  be  spent  on  items  that  are  not  needed.  

The  control  function  allows  for  an  evaluation  of  how  well  you  met  the  goals  established  in  the  planning  

process.  Perhaps  some  goals  were  achieved  (e.g.,  food  expenditures  were  close  to  what  was  budgeted)  while  

other  goals  were  not  (e.g.,  transportation  expenditures  were  higher  than  what  was  budgeted).  The  control  

function  identifies  these  areas  and  leads  to  refined  goals  in  the  future.  For  example,  the  decision  might  be  

made  to  carpool  next  month  to  save  on  transportation  costs  or  to  earn  more  income  to  pay  for  transportation  

by  working  additional  hours.  

1.3  Key Finance and Accounting Personnel

L E A R N I N G   O B J E C T I V E  

1. Describe  the  functions  of  key  finance  and  accounting  personnel.  

Question: From the previous discussion, we know that planning and control functions are often
designed to evaluate the performance of employees and departments of an organization. This
often includes employees overseeing financial information. Thus it is important to understand
how most large companies organize their accounting and finance personnel. What are the
accounting and finance positions within a typical large company, and what functions do they
perform?

Answer: Let’s look at an example to answer this question. Suppose you are the president of Sportswear
Company, mentioned earlier in the chapter, which produces hats and jerseys for fans of professional sports
teams. Assume this is a large public company. (The term public company refers to a company whose shares of

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 stock are publicly traded—that is, the general investing public can purchase and sell ownership in the
company.) As president of Sportswear, you ask the following questions:

1. How much will we owe the government in income taxes for the year?
2. What was total net income for the last fiscal year?
3. Should we expand into new geographic markets?
4. If we do decide to expand into new markets, should we obtain financing by issuing
bonds, obtaining a loan from a bank, or issuing common stock?
5. How profitable is each segment of our business (hats and jerseys)?
6. How effective are our internal controls over cash?

The challenge is to determine who within Sportswear would be best suited to answer each of
these questions. An organization chart will help in finding a solution.

Organizational Structure

Figure 1.1 "A Typical Organization Chart" is a typical organization chart; it shows how accounting and
finance personnel fit within most companies. The personnel at the bottom of the chart report to
those above them. For example, the managerial accountant reports to the controller. At the top of
the chart are those who control the company, typically the board of directors (who are elected by
the owners or shareholders). Review Figure 1.1 "A Typical Organization Chart" before moving on to the
detailed discussion of each important finance and accounting position.

Figure 1.1 A Typical Organization Chart

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*Represents vice presidents of various departments outside of accounting and finance such as
production, personnel, and research and development.

**In addition to reporting to the chief financial officer, the internal auditor typically reports
independently to the board of directors and/or the audit committee (made up of select members
of the board of directors).

Chief Financial Officer

The chief financial officer (CFO) is in charge of all the organization’s finance and accounting
functions and typically reports to the chief executive officer.

Controller

The controller is responsible for managing the accounting staff that provides managerial accounting
information used for internal decision making, financial accounting information for external
reporting purposes, and tax accounting information to meet tax filing requirements. The three
accountants the controller manages are as follows:

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 • Managerial accountant. The managerial accountant reports directly to the controller and
assists in preparing information used for decision making within the organization.
Reports prepared by managerial accountants include operational budgets, cost estimates
for existing products, budgets for new product lines, and profit and loss reports by
division. (Note that some people use the term cost accountantinterchangeably
with managerial accountant. Others consider cost accounting a specific function of
managerial accounting that focuses on measuring costs. In this text, we use the
term managerial accountant and assume that cost accountants focus on measuring costs.)
• Financial accountant. The financial accountant reports directly to the controller and
assists in preparing financial information, in accordance with U.S. GAAP, for those
outside the company. Reports prepared by financial accountants include a quarterly report
filed with the Securities and Exchange Commission (SEC) that is called a 10Q and an
annual report filed with the SEC that is called a 10K.
• Tax accountant. The tax accountant reports directly to the controller and assists in
preparing tax reports for governmental agencies, including the Internal Revenue Service.

Treasurer

The treasurer reports directly to the CFO. A treasurer’s primary duties include obtaining sources of
financing for the organization (e.g., from banks and shareholders), projecting cash flow needs,
and managing cash and short-term investments.

Internal Auditor

An internal auditor reports to the CFO and is responsible for confirming that the company has
controls that ensure accurate financial data. The internal auditor often verifies the financial
information provided by the managerial, financial, and tax accountants (all of whom report to the
controller and ultimately to the CFO). If conflicts arise with the CFO, an internal auditor can
report directly to the board of directors or to the audit committee, which consists of select board
members.

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 Not All Organizations Are Alike!

Question: The organization chart in Figure 1.1 "A Typical Organization Chart" is intended to
serve as a guide. However, all organizations are not the same, particularly smaller
organizations. How might the organizational structure differ for a small organization?

Answer: Smaller organizations tend to have only one or two key finance and accounting
personnel who perform the functions described previously. For example, one accountant might
perform the financial and managerial accounting duties while another takes care of the tax work
(or the tax work might be contracted out to a tax firm). Instead of employing its own internal
auditor, an organization might hire one from an outside consulting firm. Some organizations may
not have a CFO, or they may have a CFO but not a controller. An organization’s structure
depends on many different factors, including its size and reporting requirements, as indicated in
the Note 1.23 "Business in Action 1.2".

Business  in  Action  1.2  

The Organizational Structure of a Not-for-Profit Symphony

Financial limitations prevent a small not-for-profit symphony in California from hiring full-time finance and accounting employees.

In spite of having annual revenues approaching $200,000, all financial transactions are processed and recorded by a part-time

bookkeeper hired by the symphony. The bookkeeper also inputs budget information and provides monthly financial reports to the

treasurer. The treasurer, a volunteer member of the board of directors, is responsible for establishing the annual budget and

providing monthly financial reports to the board of directors. An outside firm prepares and processes all tax filings, assembles

annual financial statements, and performs a review of the accounting operations at the end of each fiscal year.

Notice how the symphony does not have any of the formal positions identified in Figure 1.1 "A Typical Organization Chart", with the

exception of the treasurer. This illustrates how financial constraints and reporting requirements may require an organization to be

creative in establishing its organizational structure.

K E Y   T A K E A W A Y  

• It  is  important  to  understand  the  key  accounting  and  finance  positions  within  a  typical  company  and  how  each  position  fits  into  the  

organizational  structure.  The  chief  financial  officer  (CFO)  oversees  all  accounting  and  finance  personnel,  including  the  controller,  treasurer,  and  

internal  auditor.  The  controller  is  responsible  for  the  managerial,  financial,  and  tax  accounting  staff.  
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 R E V I E W   P R O B L E M   1 . 3  

For  each  of  the  six  questions  listed  at  the  beginning  of  this  section  for  Sportswear  Company,  determine  who  within  the  company  would  

be  responsible  for  providing  the  appropriate  information.  Assume  Sportswear  has  the  same  organizational  structure  as  the  one  shown  

inFigure  1.1  "A  Typical  Organization  Chart".  

Solution  to  Review  Problem  1.3  

1. The  tax  accountant  is  responsible  for  determining  the  income  taxes  to  be  paid  to  various  government  agencies.  

2. The  financial  accountant  prepares  the  annual  report,  which  includes  the  income  statement  where  net  income  can  be  found.  

3. Although  several  personnel  would  likely  be  involved,  the  managerial  accountant  is  responsible  for  providing  financial  projections.  However,  the  

financial  accountant  might  provide  historical  information  for  existing  geographic  segments,  which  would  form  the  basis  for  the  managerial  

accountant’s  estimates.  

4. The  treasurer  handles  financing  decisions.  

5. Detailed  financial  information  that  goes  beyond  what  is  required  by  U.S.  GAAP  may  be  provided  by  the  managerial  accountants.  

6. The  internal  auditors  are  responsible  for  evaluating  the  effectiveness  of  internal  controls.  

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 1.4 Ethical Issues Facing the Accounting Industry

L E A R N I N G   O B J E C T I V E  

1. Use  standards  of  ethical  conduct  to  resolve  ethical  conflicts  facing  accountants.  

Imagine you are the accountant for Drive Write, a company that produces computer disk drives,
and you are in charge of all accounting functions within the company. The president has
informed you that if the company’s profits grow by 20 percent this year, you will receive a
$20,000 bonus, and she will receive a $50,000 bonus. No bonuses will be awarded if profit
growth is less than 20 percent. Because the company’s profits have grown 20 percent annually
for the last 10 years, investors have come to expect significant growth from one year to the next.
Near the end of this fiscal year, the president and you have the following conversation:

We are awfully close to hitting our numbers and getting to the 20 percent target. With two weeks remaining,
projections show we will come in at 18 percent for the year. What can we do on the accounting side to increase
President: current year profits?

Well, I’m not sure there is anything we can do. Our accounting is squeaky clean, as confirmed by our
Accountant: independent auditors. Perhaps our sales will improve next year.

There has to be something we can do—I could sure use the bonus money, and our investors would appreciate
an increase in their investment! I know we have a large customer order to be filled the first week of next year.
President: Why not include that sale in this year’s numbers?

Accountant: I’m not comfortable recording sales in the wrong fiscal year.

We’re only talking about moving sales by a few days! I would like you to consider this carefully. If you can’t do
President: this, I may have to find an accountant who can! Let’s talk about our options later this week.

Question: The situation at Drive Write creates a serious ethical dilemma. (The Drive Write
example is based on a real company called MiniScribe Corporation, subsequently purchased by
a competitor.) Companies are constantly under pressure to meet sales and profit goals.
Employees who succeed in meeting these goals often reap huge monetary rewards; those who
fail may be penalized with lower pay or may even lose their jobs. What would you do if asked to
record information in a way that distorts the company’s financial results?

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 Answer: As the accountant for Drive Write, your response to the president’s request would likely
affect your reputation as a professional and your future as an accountant. The unethical behavior
at corporations like Xerox,Enron, and WorldCom in recent years makes it imperative that we
know both how to act ethically and how to resolve ethical conflicts.

To help guide accounting professionals through ethical dilemmas like the one at Drive Write, the
Institute of Management Accountants (IMA) has established a Statement of Ethical Professional
Practice, which appears in . The standards outlined in this statement are guidelines that can help
accountants choose an ethically acceptable course of action. As you review , notice that the IMA
specifies four core responsibilities (competence, confidentiality, integrity, and credibility) as well
as guidelines on how to resolve ethical conflicts. The “Resolution of Ethical Conflict” section
provides specific guidance on how to resolve the conflict at Drive Write.

Figure 1.2 IMA Statement of Ethical Professional Practice

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Source: Adapted from the Institute of Management Accountants,http://www.imanet.org.

Question: The IMA is just one of many professional accounting organizations.Do other
professional accounting organizations also provide guidance regarding ethics in accounting?

Answer: Yes, other professional organizations do provide ethical guidance. Several are listed as
follows:

• The American Institute for Certified Public Accountants (AICPA) has aCode of
Professional Conduct (see http://www.aicpa.org).
• Financial Executives International provides a Model Code of Ethical Conduct for
Financial Managers (seehttp://www.financialexecutives.org).

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 • The International Federation of Accountants has a Code of Ethics and Statement of
Policy Implementation & Enforcement of Ethical Requirements(see http://www.ifac.org).
• The Securities and Exchange Commission (SEC), in compliance with the Sarbanes-Oxley
Act of 2002, requires a company to disclose whether it has adopted a code of ethics
(see http://www.sec.gov).
• The Institute of Management Accountants even provides an ethics help line to give
financial professionals a resource to provide guidance in making the right decisions
(see http://www.imanet.org).
• Because of alleged wrongdoing, such as that reported in the , improving ethics is a top
priority for most businesses as shown in the . As a result, professional organizations like
those we have cited have become instrumental in providing ethical guidelines.

Business  in  Action  1.3  

Production Firm Employees Charged with Fraud

The Securities and Exchange Commission (SEC) filed three actions against Diebold, Inc., a manufacturer and

seller of automated teller machines, for improperly inflating earnings over a five-year period. Three former

employees—the CFO, controller, and director of accounting—were accused of improperly inflating revenue on

factory orders, improperly recognizing revenue on a lease transaction, manipulating reserves and accruals,

improperly capitalizing expenses, and improperly increasing the value of inventory. These actions allegedly

resulted in over 40 misstated annual, quarterly, and other reports filed with the SEC, along with numerous

inaccurate press releases.

The company agreed to pay a $25,000,000 civil penalty, and the three former employees remain in litigation.

Although the CEO was not accused of wrongdoing, he settled with the SEC and agreed to pay back cash

bonuses, stock, and stock options received during the periods when the financial fraud was committed.

Source: Securities and Exchange Commission, “SEC Charges Diebold and Former Executives with Accounting

Fraud,” news release, June 2, 2010.

Business  in  Action  1.4  
The Code of Ethics at Home Depot and Hewlett-Packard

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 Ethics policies are becoming increasingly important to organizations.Home Depot, Inc., has an ethics code

that “provides the basic principles for associates to make business decisions consistent with how Home Depot

operates” and “forms the groundwork for our ethical behavior.”

Hewlett-Packard Company has established “business ethics guided by enduring values.” The company states

it is committed to the following principles: honesty, excellence, responsibility, compassion, citizenship, fairness,

and respect.

Sources: Home Depot, “Home Page,” http://www.homedepot.com; Hewlett-Packard, “Home

Page,” http://www.hp.com.
K E Y   T A K E A W A Y  

• Should  you  encounter  ethical  conflicts  during  your  career,  use  the  resources  provided  by  internal  company  policies,  by  

professional  organizations  such  as  the  IMA  and  AICPA,  and  by  governmental  organizations  such  as  the  SEC  as  a  guide  to  

ethical  behavior  and  the  resolution  of  ethical  conflicts.  

R E V I E W   P R O B L E M   1 . 4  

1. Describe  the  four  key  standards  of  ethical  conduct  for  IMA  members  outlined  in  .  

2. What  steps  does  the  IMA  recommend  for  resolving  ethical  conflicts?  

3. Using  as  a  guide,  discuss  your  options  as  the  accountant  at  Drive  Write.  

Solution  to  Review  Problem  1.4  

1. The  four  key  standards  shown  in  are  outlined  as  follows:  

1. Competence.  Members  of  the  IMA  must  maintain  an  adequate  level  of  skill  to  perform  duties  in  an  accurate  

and  professional  manner.  

2. Confidentiality.  Members  of  the  IMA  must  not  disclose  confidential  information  for  any  reason  unless  legally  

obligated  to  do  so.  

3. Integrity.  Members  of  the  IMA  must  avoid  any  actual  or  apparent  conflict  of  interest,  including  receiving  gifts  

or  favors,  and  must  not  engage  in  any  activity  that  would  discredit  the  profession.  

4. Credibility.  Members  of  the  IMA  must  disclose  all  relevant  information  fairly  and  objectively.  

Several  options  exist  for  resolving  ethical  conflicts.  The  IMA  suggests  the  following  courses  of  action:  

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 0. Follow  the  policies  of  the  organization  involving  the  resolution  of  ethical  conflicts.  

1. If  following  the  organization’s  policies  does  not  effectively  resolve  the  conflict,  discuss  the  problem  with  your  

immediate  supervisor  unless  the  supervisor  is  involved.  

2. If  the  immediate  superior  cannot  reach  a  satisfactory  resolution,  the  problem  should  be  presented  to  the  next  

higher  managerial  level.  

3. If  all  higher  levels  of  management  do  not  reach  a  satisfactory  resolution,  an  acceptable  reviewing  authority  

may  be  a  group,  such  as  the  audit  committee,  executive  committee,  board  of  directors,  board  of  trustees,  or  

owners.  

4. Another  option  includes  consulting  an  objective  advisor  (e.g.,  IMA  ethics  counseling  service  or  an  attorney).  

Several  options  are  available.  The  IMA  suggests  first  following  the  organization’s  policies  with  regard  to  resolving  

ethical  conflicts.  If  Drive  Write  does  not  have  policies  in  place  or  if  following  the  organization’s  policies  does  not  resolve  

the  conflict,  the  next  step  is  to  discuss  the  conflict  with  the  immediate  supervisor.  However,  the  president  of  Drive  

Write  (the  immediate  supervisor)  is  involved  in  the  conflict,  so  approaching  the  president’s  superiors  would  be  best.  

This  could  be  the  audit  committee,  executive  committee,  board  of  directors,  or  owners.  If  after  pursuing  these  different  

courses  of  action  the  ethical  conflict  still  exists,  it  may  be  appropriate  to  consult  an  objective  advisor  (e.g.,  the  IMA  

helpline)  and  perhaps  consult  an  attorney  as  to  legal  obligations  and  rights  concerning  the  ethical  conflict.  (Many  would  

argue  that  regardless  of  the  outcome,  one  would  not  want  to  work  for  a  company  where  this  type  of  unethical  

behavior  occurs  at  the  top,  or  anywhere  within  the  organization,  and  that  resigning  is  the  best  course  of  action.)  

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 1.5 Computerized Accounting Systems

L E A R N I N G   O B J E C T I V E  

1. Understand  how  accounting  systems  can  help  organizations.  

Question: Many companies today are growing out of their accounting systems. In the old days,
accounting systems were designed primarily to track daily transactions and provide reports to
external users on a monthly, quarterly, or annual basis. But times have changed, and companies
now need more information internally to make good decisions. Accounting systems are currently
used for both external reporting (financial accounting) and internal reporting (managerial
accounting). Even relatively small accounting packages, such as QuickBooks and Peachtree,
provide features that are important for managerial accounting. However, most agree that no
single accounting system will meet the needs of every organization and that two important
factors must be considered when choosing a system. What are the two factors that must be
considered when deciding on an accounting system?

Answer: The two factors are (1) the size of the organization and (2) the information needs of the
organization. Each factor is discussed next.

How Big Is Your Company?

Accounting software is designed to serve different-sized companies. The size of a company is

commonly measured in sales revenue. Experts express varying opinions on what constitutes a
small, midsized, or large company. Some believe that small companies have sales up to
$10,000,000, midsized companies have sales up to $100,000,000, and large companies have
sales greater than $100,000,000. Others prefer different amounts. Regardless of the number used,
the goal is to find an accounting system that best meets the needs of the organization, and the
size of the organization plays a big part in finding the best-fitting system.

What Information Is Needed?

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 Before selecting an accounting system, an organization must determine its accounting needs.
Some organizations simply need the equivalent of a check register, which provides easy tracking
of expense codes as checks are issued and makes bank reconciliations a snap. Other
organizations require more than a check register; they may demand a system that can create
invoices, process payroll, and track inventory. More complex organizations will want the ability
to perform more advanced functions. Such organizations might need to customize reports (e.g.,
create an income statement by division or customer), modify input screens, send financial reports
via e-mail, export reports to spreadsheet software such as Excel, and create reports with graphics
(e.g., tables, pie charts, and line charts).

Enterprise Resource Planning System

Question: Clearly the size and information needs of a company will drive the selection of an
accounting system for the company. As the need for accounting data has become more complex,
accounting systems have been developed that perform a wide variety of tasks. These systems are
called enterprise resource planning systems. What is an enterprise resource planning system,
and how does this system help companies utilize accounting data?

Answer: Enterprise resource planning (ERP) systems are designed to record and share
information across functional areas (e.g., accounting, marketing, human resources, and shipping)
and across geographical areas (e.g., from a sales office in California to headquarters in Hong
Kong). ERP systems continually update information to provide real-time data to all users, and
the data can be organized in different formats to meet the needs of internal and external users.
For example, in his book Onward, Howard Schultz describes how as CEO of Starbucks he
reviews comparative financial data for Starbucks stores daily. This information comes from the
ERP system at Starbucks.

The idea behind ERP software, and a central theme in managerial accounting, is that accurate
and up-to-date financial information will help organizations make better decisions. Better
decisions typically lead to improvements in profitability, efficiency, and customer satisfaction.

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 ERP systems are expensive. Annual costs for large organizations can easily exceed $10,000,000.
However, smaller systems for midsized companies are available at a much lower cost. Most ERP
software is offered in modules for functional accounting areas, such as accounts receivable,
accounts payable, payroll, inventory, and job costing. The more modules included, the higher the
cost will be. Popular makers of ERP systems include Microsoft, Oracle, and SAP Corporation.

In deciding whether to upgrade to an ERP system, organizations must be sure that the benefits of
using the data from a new system outweigh the costs of implementing the system. If management
does not intend to use the information to improve planning and decision making, then going with
a less sophisticated accounting system may be the better approach.

Using Spreadsheet Software

Question: ERP systems commonly provide a means to download data to spreadsheets for further
analysis. How can spreadsheet software help us to analyze financial information?

Answer: Since managers make extensive use of spreadsheets to organize and analyze data, most
computerized accounting systems are designed to export data to spreadsheet software programs
such as Excel. For example, Figure 1.3 "Excel Spreadsheet for Southwest Airlines" shows how a
spreadsheet was used to import data directly from Southwest Airlines’ 2010 annual report. This
allows the user to analyze the data more easily. Notice that inFigure 1.3 "Excel Spreadsheet for
Southwest Airlines" the total operating revenue increased over the three years shown. We could
use Excel to quickly determine the exact percentage increase from 2008 to 2009 and from 2009
to 2010.

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 Figure 1.3 Excel Spreadsheet for Southwest Airlines

 
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 Question: Let’s assume you are asked to prepare an income statement showing revenue and
expense projections for next year. How might you use Excel to prepare your projections?

Answer: You could start by exporting this year’s results from the accounting system to an Excel
spreadsheet. Then you could set up a new column to show estimates for next year. You would
likely discuss different aspects of the income statement with various personnel in the
organization—making changes as you go—before finalizing your projections.

Imagine the work involved if you did not use a computer but instead had to write the information
down by hand. If there were any changes to the information, you would have to make time-
consuming calculations, and once the data were finalized, you would be faced with the manual
preparation of formal reports. With the relatively recent advances in business technology, the
days of preparing information manually are over. Most organizations require their accounting
and finance personnel to have advanced computer spreadsheet skills. Our goal is to provide you
with an opportunity to use spreadsheets in a way that mirrors the real world.

K E Y   T A K E A W A Y  

• Throughout  this  text,  you  will  learn  about  different  methods  of  recording,  sorting,  analyzing,  

and  reporting  financial  information  for  internal  users.  Before  deciding  to  implement  one  of  

these  methods,  ask  yourself  the  following  question:  Will  the  benefits  derived  from  a  new  

system,  such  as  an  ERP  system,  exceed  the  costs  of  putting  the  system  in  place?  If  the  answer  is  

“yes,”  then  go  for  it!  If  the  answer  is  “no,”  consider  other  alternatives.  
R E V I E W   P R O B L E M   1 . 5  

Assume  you  are  the  CFO  for  an  electronics  consulting  firm  with  annual  revenues  of  
$30,000,000  and  annual  profit  of  $5,000,000.  The  current  accounting  system  is  used  for  
basic  functions,  such  as  issuing  checks,  creating  invoices,  and  processing  payroll.  The  
company  is  considering  upgrading  its  accounting  system  by  purchasing  an  ERP  system.  
Describe  the  factors  to  be  considered  by  the  company  in  making  this  decision.  

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 Solutions  to  Review  Problem  1.5  

This  company  is  a  midsized  company  with  $30,000,000  in  revenues,  although  some  would  
argue  that  this  is  a  small  company.  Going  to  an  ERP  system  is  probably  not  appropriate  if  
management  is  simply  looking  for  a  few  reports  beyond  what  most  financial  accounting  
systems  can  provide.  

If  management  has  a  need  for  more  detailed  and  complex  financial  information—other  
than  processing  checks,  invoices,  and  payroll—then  a  low-­‐end  ERP  system  might  be  
appropriate.  However,  the  benefits  derived  from  such  a  system  must  outweigh  the  costs.  

1.6 Cost Terminology

L E A R N I N G   O B J E C T I V E  

1. Understand  the  terms  used  for  costing  purposes.  

Question: Much of what we discuss in this book relates to companies that manufacture products,
such as Nike and Apple, and terminology is a key component of accounting for manufacturing
companies. The challenge is in classifying costs correctly for items such as production materials,
production labor, marketing department labor, rent for production facilities, and rent for the
administrative services facilities. These costs must be classified accurately so that they appear
correctly in company financial reports. The starting point for learning how to classify costs
correctly is in understanding two broad categories of costs. What are the two broad terms used
to categorize cost information in a manufacturing setting?

Answer: The two broad categories of costs are manufacturing costs andnonmanufacturing costs.
Each category is described in detail as follows.

Manufacturing Costs

All costs related to the production of goods are called manufacturing costs; they are also referred
to as product costs. A manufacturer purchases materials, employs workers who use the materials
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 to assemble the goods, provides a building where the materials are stored and goods are
assembled, and sells the goods. We classify the costs associated with these activities into three
categories: direct materials, direct labor, and manufacturing overhead.

To help clarify which costs are included in these three categories, let’s look at a furniture
company that specializes in building custom wood tables called Custom Furniture Company.
Each table is unique and built to customer specifications for use in homes (coffee tables and
dining room tables) and offices (boardroom and meeting room tables). The sales price of each
table varies significantly, from $1,000 to more than $30,000. Figure 1.4 "Direct Materials, Direct
Labor, and Manufacturing Overhead at Custom Furniture Company" shows examples of
production activities at Custom Furniture Company for each of the three categories (we continue
using this company as an example in Chapter 2 "How Is Job Costing Used to Track Production
Costs?").

Direct Materials

Question: Raw materials used in the production process that are easily traced to the product are
called direct materials. What materials used in the production process at Custom Furniture
would be classified as direct materials?

Answer: The wood used to build tables and the hardware used to attach table legs would be
considered direct materials. Small, inexpensive items like glue, nails, and masking tape are
typically not included in direct materials because the cost of tracing these items to the product
outweighs the benefit of having accurate cost data. These minor types of materials, often
calledsupplies or indirect materials, are included in manufacturing overhead, which we define
later.

Direct Labor

Question: Workers who convert materials into a finished product and whose time is easily traced
to the product are called direct labor. Who represents direct labor at Custom Furniture?

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 Answer: Direct labor would include the workers who use the wood, hardware, glue, lacquer, and
other materials to build tables.

Manufacturing Overhead

Question: All costs associated with the production process other than direct material costs and
direct labor costs are called manufacturing overhead. Terms synonymous with manufacturing
overhead include factory overhead, factory burden, and overhead. What items are included in
manufacturing overhead?

Answer: Manufacturing overhead consists of the following:

• Indirect material costs. The cost of materials necessary to manufacture a product that
are not easily traced to the product or not worth tracing to the product.
• Indirect labor costs. The cost of workers who are involved in the production process but
whose time cannot easily be traced to the product. For example, supervisors in the
production process who oversee several different products and are responsible for hiring
employees, scheduling employees, and ordering materials are considered indirect labor.
• Other manufacturing costs. These are all other costs for items associated with the factory,
including equipment maintenance, insurance, utilities, and depreciation.

Table 1.2 "Manufacturing Costs at Custom Furniture Company" provides several examples of
manufacturing costs at Custom Furniture Company by category.

Table 1.2 Manufacturing Costs at Custom Furniture Company

Direct Materials

• Wood: cherry, maple, oak, and mahogany

• Hardware: drawer handles

Direct Labor

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 • Workers who cut, plane, and glue wood

• Workers who fill and sand tables

• Workers who stain and finish tables

Manufacturing Overhead

• Indirect materials: glue, screws, nails, sandpaper, stain, and lacquer

• Indirect labor: factory supervisors

• Other manufacturing costs: equipment maintenance, equipment depreciation, factory utilities, factory

insurance, factory building depreciation, and factory property taxes

Note 1.43 "Business in Action 1.5" details the materials, labor, and manufacturing overhead at a
company that has been producing boats since 1968.

Business  in  Action  1.5  

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Photo courtesy of Brian Miller,http://www.flickr.com/photos/13233728@N00/5155012186/

Manufacturing Costs at MasterCraft

MasterCraft produces boats for water skiers and wake boarders. Each boat produced

incurs significant manufacturing costs. MasterCraftrecords these manufacturing costs as

inventory on the balance sheet until the boats are sold, at which time the costs are
transferred to cost of goods sold on the income statement.
Examples of direct materials for each boat include the hull, engine, transmission, carpet,
gauges, seats, windshield, and swim platform. Examples of indirect materials (part of
manufacturing overhead) include glue, paint, and screws. Direct labor includes the
production workers who assemble the boats and test them before they are shipped out.
Indirect labor (part of manufacturing overhead) includes the production supervisors who
oversee production for several different boats and product lines.

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 Manufacturing overhead includes the indirect materials and indirect labor mentioned
previously. Other manufacturing overhead items are factory building rent, maintenance and
depreciation for production equipment, factory utilities, and quality control testing.
Source: MasterCraft, “Home Page,” http://www.mastercraft.com.

Nonmanufacturing Costs

Costs that are not related to the production of goods are callednonmanufacturing costs; they are
also referred to as period costs. These costs have two components—selling costs and general and
administrative costs—which are described next. Examples of nonmanufacturing costs appear
in Figure 1.5 "Examples of Nonmanufacturing Costs at Custom Furniture Company".

Selling Costs

Question: Costs incurred to obtain customer orders and provide customers with a finished
product are called selling costs. (They are also often called marketing costs or selling and
advertising costs.) What activities would be classified as selling costs at Custom Furniture?

Answer: Examples of selling costs include advertising, sales commissions, salaries for
marketing and advertising personnel, office space for marketing and advertising personnel,
finished goods storage costs, and shipping costs paid by the seller for products shipped to
customers.

General and Administrative Costs

Question: Costs related to the overall management of an organization are

calledgeneral and administrative costs. What activities would be classified as general and
administrative costs at Custom Furniture?

Answer: Examples include personnel and support staff in the following areas: accounting,
human resources, legal, executive, and information technology. Depreciation of office equipment

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 and buildings associated with these areas would also be included as general and administrative
costs. General and administrative costs are often simply called administrative costs.

Figure 1.5 Examples of Nonmanufacturing Costs at Custom Furniture Company

 
Although selling costs and general and administrative costs are considered nonmanufacturing
costs, managers often want to assign some of these costs to products for decision-making
purposes. For example, sales commissions and shipping costs for a specific product could be
assigned to the product. This does not comply with U.S. GAAP because, under U.S. GAAP, only
product costs can be assigned to products. However, as we noted earlier, managerial accounting
information is tailored to meet the needs of the users and need not follow U.S. GAAP.

Distinguishing between manufacturing and nonmanufacturing costs is not always simple. For
example, if legal staff works on an issue associated with production personnel and if human
resources staff hires assembly line workers, are the costs involved manufacturing or
nonmanufacturing costs? It is up to each organization to determine how to handle such costs for
product costing purposes. The advantage of managerial accounting over financial accounting is

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 that costs can be organized in any manner that helps managers make decisions. However, in this
chapter, to avoid ambiguity, we follow the definitions provided by U.S. GAAP.

Presentation of Manufacturing and Nonmanufacturing Costs in Financial

Statements

Question: At this point, you should be able to distinguish between manufacturing costs and
nonmanufacturing costs. Why is it important to make this distinction?

Answer: Distinguishing between the two categories is critical because the category determines
where a cost will appear in the financial statements. All manufacturing costs (direct materials,
direct labor, and manufacturing overhead) are attached to inventory as an asset on the balance
sheet until the goods are sold, at which point the costs are transferred to cost of goods sold on the
income statement as an expense. As we indicated earlier, nonmanufacturing costs are also
called period costs; that is because they are expensed on the income statement in the time period
in which they are incurred.

Table 1.3 "Manufacturing Versus Nonmanufacturing Costs" clarifies the relationship between
manufacturing and nonmanufacturing costs. It also describes the point at which these costs are
recorded as expenses on the income statement. (Remember that the terms manufacturing
cost andproduct cost are interchangeable, as are the terms nonmanufacturing costand period
cost.)

Table 1.3 Manufacturing Versus Nonmanufacturing Costs

Manufacturing Costs (Also Called Product
Costs) Nonmanufacturing Costs (Also Called Period Costs)

• Direct materials • Selling

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 Manufacturing Costs (Also Called Product
Costs) Nonmanufacturing Costs (Also Called Period Costs)

• Direct labor • General and administrative

• Manufacturing overhead

Timing of expense: Costs are expensed when Timing of expense: Costs are expensed during the time
goods are sold. period incurred.

Note 1.48 "Business in Action 1.6" provides examples of nonmanufacturing costs at PepsiCo,
Inc.

Business  in  Action  1.6  

Source: Photo courtesy of

JeffBedord,http://www.flickr.com/photos/jeffbedford/6218820224/in/photostream/.

Nonmanufacturing Costs at PepsiCo

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 PepsiCo, Inc., produces more than 500 products under several different brand names,

including Frito-Lay, Pepsi-Cola, Gatorade, Tropicana, and Quaker. Net sales for 2010
totaled $57,800,000,000, resulting in operating profits of $6,300,000,000. Cost of sales
represented the highest cost on the income statement at $26,600,000,000. The second
highest cost on the income statement—selling and general and administrative expenses—
totaled $22,800,000,000. These expenses are period costs, meaning they must be expensed
in the period in which they are incurred.
Examples of selling costs for PepsiCo include television advertising (probably the biggest
piece of the $22,800,000,000), promotional coupons, costs of shipping products to
customers, and salaries of marketing and advertising personnel.
Examples of general and administrative costs include salaries and bonuses of top executives
and the costs of administrative departments, including personnel, accounting, legal, and
information technology.
Source: PepsiCo, “PepsiCo 2010 Annual Report,”http://www.pepsico.com.
K E Y   T A K E A W A Y  

• All  manufacturing  costs  that  are  easily  traceable  to  a  product  are  classified  as  either  direct  

materials  or  direct  labor.  All  other  manufacturing  costs  are  classified  as  manufacturing  

overhead.  All  nonmanufacturing  costs  are  not  related  to  production  and  are  classified  as  either  

selling  costs  or  general  and  administrative  costs.  

R E V I E W   P R O B L E M   1 . 6  

1. The  following  manufacturing  items  are  for  a  construction  company  working  on  several  

custom  homes.  Identify  whether  each  item  should  be  categorized  as  direct  materials,  

direct  labor,  or  manufacturing  overhead.  

1. Nails  

2. Lumber  

3. Drywall  

4. Workers  building  the  house  frame  

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 5. Supervisor  responsible  for  three  homes  

6. Light  bulbs  

7. Cabinets  

8. Depreciation  of  construction  equipment  

2. Identify  whether  each  item  in  the  following  should  be  categorized  as  a  product  

(manufacturing)  cost  or  as  period  (nonmanufacturing)  cost.  Also  indicate  whether  the  

cost  should  be  recorded  as  an  expense  when  the  cost  is  incurred  or  as  an  expense  

when  the  goods  are  sold.  

1. Advertising  

2. Shipping  costs  for  raw  materials  coming  from  a  supplier  

3. Shipping  costs  for  goods  shipped  to  a  customer  

4. Chief  executive  officer’s  salary  

5. Production  supervisor’s  salary  

6. Depreciation  on  production  equipment  

7. Raw  materials  used  in  production  

8. Paper  used  by  the  accounting  staff  

9. Commissions  paid  to  salespeople  

10. Janitorial  services  provided  for  production  facility  

11. Supplies  used  by  human  resources  personnel  

12. Utility  costs  for  retail  store  

13. Insurance  costs  for  production  facility  

14. Assembly  line  workers  

15. Clerical  support  for  chief  executive  officer  

16. Maintenance  of  production  equipment  

3. Identify  whether  each  item  listed  in  item  2  should  be  categorized  as  direct  materials,  direct  

labor,  manufacturing  overhead,  selling  cost,  or  general  and  administrative  cost.  

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 Solution  to  Review  Problem  1.6  

1.    

1. Manufacturing  overhead  

2. Direct  materials  

3. Direct  materials  

4. Direct  labor  

5. Manufacturing  overhead  

6. Manufacturing  overhead  (You  might  call  this  a  direct  material,  but  the  benefit  of  

tracking  this  item  as  a  direct  material  probably  does  not  outweigh  the  cost.)  

7. Direct  materials  

8. Manufacturing  overhead  

2.    

1. Period  cost,  expensed  when  incurred  

2. Product  cost,  expensed  when  goods  are  sold  

3. Period  cost,  expensed  when  incurred  

4. Period  cost,  expensed  when  incurred  

5. Product  cost,  expensed  when  goods  are  sold  

6. Product  cost,  expensed  when  goods  are  sold  

7. Product  cost,  expensed  when  goods  are  sold  

8. Period  cost,  expensed  when  incurred  

9. Period  cost,  expensed  when  incurred  

10. Product  cost,  expensed  when  goods  are  sold  

11. Period  cost,  expensed  when  incurred  

12. Period  cost,  expensed  when  incurred  

13. Product  cost,  expensed  when  goods  are  sold  

14. Product  cost,  expensed  when  goods  are  sold  

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 15. Period  cost,  expensed  when  incurred  

16. Product  cost,  expensed  when  goods  are  sold  

3.    

1. Selling  

2. Direct  materials  or  manufacturing  overhead,  depending  on  if  the  materials  are  easily  

traced  to  the  product  (direct)  or  not  (indirect  manufacturing  overhead)  

3. Selling  

4. General  and  administrative  

5. Manufacturing  overhead  

6. Manufacturing  overhead  

7. Direct  materials  or  manufacturing  overhead,  depending  on  if  the  materials  are  easily  

traced  to  the  product  (direct)  or  not  (indirect  manufacturing  overhead)  

8. General  and  administrative  

9. Selling  

10. Manufacturing  overhead  

11. General  and  administrative  

12. Selling  

13. Manufacturing  overhead  

14. Direct  labor  

15. General  and  administrative  

16. Manufacturing  overhead  

 
1.7 How Product Costs Flow through Accounts

L E A R N I N G   O B J E C T I V E  

1. Identify  how  costs  flow  through  the  three  inventory  accounts  and  cost  of  goods  sold  account.  

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 Question: Custom Furniture Company’s direct materials include items such as wood and
hardware. Direct labor involves the employees who build the custom tables. Manufacturing
overhead includes items such as indirect materials (glue, screws, nails, sandpaper, and stain),
indirect labor (production supervisor), and other manufacturing costs, such as factory
equipment maintenance and factory utilities. What accounts are used to record the costs
associated with these items, and where do these accounts appear in the financial statements?

Answer: All the costs mentioned previously for Custom Furniture are product costs (also
called manufacturing costs). Product costs are recorded as an asset on the balance sheet until the
products are sold, at which point the costs are recorded as an expense on the income statement.
To record product costs as an asset, accountants use one of three inventory accounts: raw
materials inventory, work-in-process inventory, or finished goods inventory. The account they
use depends on the product’s level of completion. They use one expense account—cost of goods
sold—to record the product costs when the goods are sold.

Summarizes the accounts used to track product costs. Shows how product costs flow through the
balance sheet and income statement. Lastly, provides an example of how the accounts shown
in and appear in financial statements. Take time to review these items carefully. Your
understanding of them will help clarify how product costs flow through the accounts and where
product costs appear in the financial statements. The following discussion provides further
clarification.

Product Costs on the Balance Sheet

Question: What is the difference between raw materials inventory, work-in-process inventory,
and finished goods inventory?

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 Answer: Each of these accounts is used to record product costs depending on where the product
is in the production process, and each account is an asset account on the balance sheet.

Raw Materials

The raw materials inventory account records the cost of materials not yet put into production. For
Custom Furniture Company, this account includes items such as wood, brackets, screws, nails,
glue, lacquer, and sandpaper.

Work in Process

The work-in-process (WIP) inventory account records the costs of products that have not yet
been completed. Suppose Custom Furniture Company has eight tables that are still in production
at the end of the year. All manufacturing costs associated with these incomplete eight tables—
direct materials, direct labor, and manufacturing overhead—are included in the WIP inventory
account.

Once goods in WIP inventory are completed, they are transferred into finished goods inventory.
The cost of completed goods that are transferred out of WIP inventory into finished goods
inventory is called thecost of goods manufactured.

Finished Goods

The finished goods inventory account records the manufacturing costs of products that are
completed and ready to sell. Suppose Custom Furniture Company has five completed tables at
the end of the year (in addition to the eight partially completed tables in work-in-process
inventory). The manufacturing costs of these five tables—direct materials, direct labor, and
manufacturing overhead—are included in the finished goods inventory account until the tables
are sold. (For the purposes of this example, assume the tables are “sold” when delivered to the
customer.)

Product Costs on the Income Statement

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 Question: The costs of materials not yet put into production are included in raw materials
inventory. The costs associated with products that are not yet complete are included in WIP
inventory. And the costs associated with products that are completed and ready to sell are
included in finished goods inventory.What happens to the product costs in finished goods
inventory when the products are sold?

Answer: When completed goods are sold, their costs are transferred out of finished goods
inventory into the cost of goods sold account. Cost of goods sold is an expense account on the
income statement that represents the product costs of all goods sold during the period.

For example, suppose Custom Furniture Company sells one table that cost $3,000 to produce
(i.e., direct materials, direct labor, and manufacturing overhead costs incurred to produce the
table total $3,000). The $3,000 cost is in finished goods inventory until the entry is made to
record the sale, at which time finished goods inventory is reduced by $3,000 (the table is no
longer in inventory) and cost of goods sold is increased by $3,000.

Table 1.4 Accounts Used to Record Product Costs

Account Name Description Financial Statement

Raw materials inventory Cost of unused production materials Balance sheet (asset)

Work-in-process inventory Cost of incomplete products Balance sheet (asset)

Finished goods inventory Cost of completed products not yet sold Balance sheet (asset)

Cost of goods sold Cost of products sold Income statement (expense)

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 Figure 1.6 Flow of Product Costs through Balance Sheet and Income Statement Accounts

Business  in  Action  1.7  

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Source: Photo courtesy of Matthew

Rutledge,http://www.flickr.com/photos/rutlo/4252743250//.

Presentation of Product Costs at Advanced Micro Devices

Advanced Micro Devices (AMD), a producer of microprocessors and flash memory

devices for personal and networked computers, has annual revenues of $6,500,000,000. A
summarized version of AMD’sbalance sheet appears as follows (all amounts are in
millions). Notice that three inventory accounts, totaling $632,000,000, support the total
inventory amount that appears in the asset section of the balance sheet. The raw materials
inventory account ($28,000,000) is used to record the cost of materials not yet put into
production. The work-in-process inventory account ($441,000,000) is used to record costs
associated with microprocessors and flash memory devices in the production process that
are not yet complete. The finished goods inventory account ($163,000,000) is used to
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 record the product costs associated with AMD’s products that are completed and ready to
sell.

When AMD sells finished goods, the cost of these goods is transferred out of finished goods
inventory into the cost of goods sold account, which this company calls cost of sales, as many
companies do. The operating portion of AMD’s income statement follows—again, all
amounts are in millions. Notice that cost of sales appears below net sales and above all other
operating expenses.

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Source: Advanced Micro Devices, “Advanced Micro Devices 2010 Annual

Report,” http://www.amd.com.
K E Y   T A K E A W A Y  

• The  raw  materials  inventory  account  is  used  to  record  the  cost  of  materials  not  yet  put  into  

production.  The  work-­‐in-­‐process  inventory  account  is  used  to  record  the  cost  of  products  that  

are  in  production  but  that  are  not  yet  complete.  The  finished  goods  inventory  account  is  used  to  

record  the  costs  of  products  that  are  complete  and  ready  to  sell.  These  three  inventory  

accounts  are  assets  accounts  that  appear  on  the  balance  sheet.  The  costs  of  completed  goods  

that  are  sold  are  recorded  in  the  cost  of  goods  sold  account.  This  account  appears  on  the  

income  statement  as  an  expense.  

R E V I E W   P R O B L E M   1 . 7  

Match  each  of  the  following  accounts  with  the  appropriate  description  that  follows.  
• _____  Raw  materials  inventory  

• _____  Work-­‐in-­‐process  inventory  

• _____  Finished  goods  inventory  

• _____  Cost  of  goods  sold  

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 1. Used  to  record  product  costs  of  goods  that  are  completed  and  ready  to  sell  

2. Used  to  record  product  costs  of  goods  that  have  been  sold  

3. Used  to  record  product  costs  of  goods  that  are  still  in  production  

4. Used  to  record  the  cost  of  materials  not  yet  put  into  production  

Solutions  to  Review  Problem  1.7  

Raw materials inventory 4. Used to record cost of materials not yet put into production.

Work-in- 3. Used to record product costs associated with incomplete goods in the
process inventory production process.

1. Used to record product costs associated with goods that are completed and
Finished goods inventory ready to sell.

Cost of goods sold 2. Used to record product costs associated with goods that are sold.

1.8 Income Statements for Manufacturing Companies

L E A R N I N G   O B J E C T I V E  

1. Describe  how  to  prepare  an  income  statement  for  a  manufacturing  company.  

Question: Companies that provide services, such as Ernst & Young(accounting) and Accenture
LLP (consulting), do not sell goods and therefore have no inventory. The accounting process and
income statement for service companies are relatively simple. Merchandising companies (also
called retail companies) like Macy’s and Home Depot buy and sell goods but typically do not
manufacture goods. Since merchandising companies must account for the purchase and sale of
goods, their accounting systems are more complex than those of service companies.
Manufacturing companies, such as Johnson & Johnson and Honda Motor Company, produce
and sell goods. Such companies require an accounting system that goes well beyond accounting
solely for the purchase and sale of goods. Why are accounting systems more complex for
manufacturing companies?

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 Answer: Accounting systems are more complex for manufacturing companies because they need
a system that tracks manufacturing costs throughout the production process to the point at which
goods are sold. Since income statements for manufacturing companies tend to be more complex
than for service or merchandising companies, we devote this section to income statements for
manufacturing companies. Understanding income statements in a manufacturing setting begins
with the inventory cost flow equation.

Inventory Cost Flow Equation

Question: How do companies use the cost flow equation to calculate unknown balances?

Answer: We can use the basic cost flow equation to calculate unknown balances for just about
any balance sheet account (e.g., cash, accounts receivable, and inventory). The equation is as
follows:

Key  Equation  
Beginning  balance  (BB)  +  Transfers  in  (TI)  –  Ending  balance  (EB)  =  Transfers  out  (TO)  

We will apply this equation to the three inventory asset accounts discussed earlier (raw materials,
work in process, and finished goods) to calculate the cost of raw materials used in production,
cost of goods manufactured, and cost of goods sold.

Raw materials used in production shows the cost of direct and indirect materials placed into the
production process. Cost of goods manufacturedrepresents the cost of goods completed and
transferred out of work-in-process (WIP) inventory into finished goods inventory. Cost of goods
sold represents the cost of goods that are sold and transferred out of finished goods inventory
into cost of goods sold.

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 Accountants need all these amounts—raw materials placed in production, cost of goods
manufactured, and cost of goods sold—to prepare an income statement for a manufacturing
company. We describe how to calculate these amounts using three formal schedules in the
following order:

1. Schedule of raw materials placed in production

2. Schedule of cost of goods manufactured
3. Schedule of cost of goods sold

Question: The basic cost flow equation can be used in three supporting schedules to help us
determine the cost of goods sold amount on the income statement for manufacturing
companies. What information is included in these schedules, and what do they look like for
Custom Furniture Company?

Answer: Figure 1.7 "Income Statement Schedules for Custom Furniture Company" shows these
three schedules for Custom Furniture Company for the month of May. As you review these
schedules, note that each schedule provides information required for the next schedule, as
indicated by the arrows. Remember the inventory cost flow equation is used for each schedule.
This is why you see abbreviations for each element of the equation: beginning balance (BB),
transfers in (TI), ending balance (EB), and transfers out (TO).

The goal of going through the process shown in Figure 1.7 "Income Statement Schedules for
Custom Furniture Company" is to arrive at a cost of goods sold amount, which is presented on
the income statement. Custom Furniture Company’s income statement for the month ended May
31 is shown in Figure 1.8 "Income Statement for Custom Furniture Company". As you
review Figure 1.7 "Income Statement Schedules for Custom Furniture Company" and Figure 1.8
"Income Statement for Custom Furniture Company", look back at Figure 1.6 "Flow of Product
Costs through Balance Sheet and Income Statement Accounts" to see how costs flow through the
three inventory accounts and the cost of goods sold account.

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 In Chapter 2 "How Is Job Costing Used to Track Production Costs?", we provide the detailed
information necessary to prepare the schedules and income statement presented in Figure 1.7
"Income Statement Schedules for Custom Furniture Company" and Figure 1.8 "Income
Statement for Custom Furniture Company". At this point, your job is to understand how we use
the inventory cost flow equation to calculate raw materials placed in production, cost of goods
manufactured, and cost of goods sold. (Note: Companies using a perpetual inventory system do
not necessarily prepare these formal schedules because perpetual systems update records
immediately when inventory is transferred from one inventory account to another. However,
these companies take a physical count periodically to ensure the accuracy of inventory accounts
and use the cost flow equation and similar schedules to ensure their perpetual system balances
are accurate. Note 1.62 "Business in Action 1.8" shows how the cost flow equation can be used
to analyze the effects of fraud that was allegedly committed at Rite Aid.)

Figure 1.7 Income Statement Schedules for Custom Furniture Company

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a
From the company’s balance sheet at April 30 (April 30 ending balance is the same as May 1
beginning balance).
b
From the company’s balance sheet at May 31.

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 c
This is actual manufacturing overhead for the period and includes indirect materials, indirect
labor, factory rent, factory utilities, and other factory-related expenses for the month. In Chapter 2
"How Is Job Costing Used to Track Production Costs?", we look at an alternative approach to
recording manufacturing overhead called normal costing.
Figure 1.8 Income Statement for Custom Furniture Company

 
*
$135,000 comes from the schedule of cost of goods sold in Figure 1.7 "Income Statement
Schedules for Custom Furniture Company".

Business  in  Action  1.8  

Using the Cost Flow Equation to Analyze Fraud
Rite Aid Corporation operates 3,400 drug stores in the United States. In 2002, the

Securities and Exchange Commission (SEC) filed accounting fraud charges against several
former executives of Rite Aid. The SEC complaint alleged that Rite Aid had significantly
overstated income for several years.
According to the complaint, Rite Aid executives committed financial fraud in several areas,
one of which involved inventory. At the end of the company’s fiscal year, the physical
inventory count showed $9,000,000 less than Rite Aid’s inventory balance on the books,
presumably due to physical deterioration of the goods or theft. Rite Aidexecutives allegedly
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 failed to record this shrinkage, thereby overstating ending inventory on the balance sheet
and understating cost of goods sold on the income statement.
Using the cost flow equation, you can see how failing to record the $9,000,000 loss would
understate cost of goods sold.

By failing to record the inventory loss, Rite Aid overstated inventory (an asset) on the
balance sheet by $9,000,000 and understated cost of goods sold (an expense) by
$9,000,000 on the income statement. This ultimately increased profit by $9,000,000
because reported expenses were too low.
This inventory fraud was a relatively small part of the fraud allegedly committed by Rite
Aid executives. In fact, Rite Aid’s net income was restated downward by $1,600,000,000

in 2002. Several former executives pled guilty to conspiracy charges. The former chief
executive, Martin Grass, was sentenced to eight years in prison and the former chief
financial officer, Franklyn Bergonzi, was sentenced to 28 months in prison. Rite Aid’s stock
fell from a high of $50 per share to $5 per share in 2003.
Sources: Securities and Exchange Commission, “Release 2002–92,” news
release, http://www.sec.gov; AP wires dated July 10, 2003, and May 27, 2004.

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 Manufacturing Versus Merchandising Income Statements

Question: Manufacturing companies clearly have more complex accounting systems to account
for all the costs involved in producing products. However, the income statement for a
manufacturing company is not all that much different than the income statement for a
merchandising company. What are primary differences between manufacturing and
merchandising company income statements?

Answer: The primary differences are as follows:

• Merchandising companies do not calculate the raw materials placed in production or cost
of goods manufactured (shown in the top section ofFigure 1.7 "Income Statement
Schedules for Custom Furniture Company").
• Merchandisers purchase goods from suppliers instead of manufacturing goods. The cost
of these purchases from suppliers is often called net purchases in the income statement, in
contrast to cost of goods manufactured in a manufacturer’s income statement. The net
purchases line consists of purchases, purchases returns and allowances, purchases
discounts, and freight in.
• Merchandisers do not use the schedule of cost of goods manufactured (and related
schedule of raw materials placed in production).
• Merchandisers use an account called merchandise inventory, or simply inventory, instead
of finished goods inventory. This reflects that merchandisers do not produce goods.

Table 1.5 "Income Statement Terminology in Manufacturing and Merchandising

Companies" summarizes the differences in income statement terminology between
manufacturing companies and merchandising companies.

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 Table 1.5 Income Statement Terminology in Manufacturing and Merchandising Companies
The following terms are used by manufacturing and merchandising companies:sales, cost of goods
available for sale, cost of goods sold, operating expenses, selling,general and administrative,
and operating profit.

Finished goods inventory is used by manufacturing Merchandise inventory is used by merchandising

companies. companies.

Cost of goods manufactured is used by manufacturing Net purchases is used by merchandising

companies. companies.

Figure 1.9 "Merchandising Company Income Statement for Fashion, Inc."presents an income
statement for Fashion, Inc., a retail company that sells clothing. Notice that the schedule of cost
of goods manufactured (and related schedule of raw materials placed in production) is not
needed for merchandising companies, and the terms merchandise inventory and net
purchases are used instead of finished goods inventory and cost of goods manufactured. Also, the
schedule of cost of goods sold is simply included in the income statement. Many companies
prefer this approach because it means they do not have to prepare a separate schedule.

Figure 1.9 Merchandising Company Income Statement for Fashion, Inc.

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K E Y   T A K E A W A Y S  

• Three  schedules  are  necessary  to  prepare  an  income  statement  for  a  manufacturing  

company,  in  the  following  order:  

o Schedule  of  raw  materials  placed  in  production,  which  shows  cost  of  direct  materials  

added  to  work-­‐in-­‐process  inventory  and  cost  of  indirect  materials  added  to  

manufacturing  overhead  

o Schedule  of  cost  of  goods  manufactured,  which  shows  cost  of  goods  completed  and  

transferred  out  of  work-­‐in-­‐process  inventory  into  finished  goods  inventory  

o Schedule  of  cost  of  goods  sold,  which  shows  cost  of  goods  sold  and  transferred  out  of  

finished  goods  inventory  into  cost  of  goods  sold  

• The  income  statements  of  merchandising  companies  differ  from  those  of  manufacturing  

companies  in  several  areas.  Merchandising  companies  do  not  use  a  schedule  of  raw  materials  

placed  in  production  or  a  schedule  of  cost  of  goods  manufactured,  and  they  use  a  merchandise  

inventory  account  instead  of  a  finished  goods  inventory  account.  In  addition,  they  use  the  term  

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 net  purchases  instead  of  cost  of  goods  manufactured  and  often  include  the  schedule  of  cost  of  

goods  sold  in  the  income  statement  rather  than  presenting  it  separately.  
R E V I E W   P R O B L E M   1 . 8  

Fine  Cabinets,  Inc.,  produces  custom  cabinets.  The  following  inventory  balances  appeared  
on  its  balance  sheet.  (Note  that  the  most  current  financial  information  is  presented  in  the  
first  column.)  
December 31, 2012 December 31, 2011

Raw materials inventory $ 8,000 $ 10,000

Work-in-process inventory 600,000 550,000

Finished goods inventory 350,000 410,000

Fine  Cabinets  had  $1,265,000  in  sales  for  the  year  ended  December  31,  2012.  The  company  
also  had  the  following  costs  for  the  year:  
Selling $ 90,000

General and administrative $240,000

Raw materials purchases $100,000

Direct labor used in production $125,000

Manufacturing overhead $630,000

Of  the  total  raw  materials  placed  in  production  for  the  year,  $12,000  was  for  indirect  
materials  and  must  be  deducted  to  find  direct  materials  placed  in  production.  
Required:  

1. Prepare  the  schedules  listed  in  the  following  for  the  year  ended  December  31,  2012.  

Use  the  format  shown  in  Figure  1.7  "Income  Statement  Schedules  for  Custom  Furniture  

Company".  (Note  that  Figure  1.7  "Income  Statement  Schedules  for  Custom  Furniture  

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 Company"  shows  information  for  a  month  and  this  review  problem  presents  

information  for  a  year.)  

1. Schedule  of  raw  materials  placed  in  production  

2. Schedule  of  cost  of  goods  manufactured  

3. Schedule  of  cost  of  goods  sold  

2. Prepare  an  income  statement  for  the  year  ended  December  31,  2012.  Use  the  format  shown  

in  Figure  1.8  "Income  Statement  for  Custom  Furniture  Company".  

3. Assume  Fine  Cabinets,  Inc.,  is  a  merchandising  company  that  purchases  its  cabinets  from  a  

manufacturer.  Use  the  information  from  the  schedule  of  cost  of  goods  sold  prepared  in  

requirement  1and  the  income  statement  prepared  in  requirement  2  to  prepare  an  income  

statement.  Use  the  format  shown  in  Figure  1.9  "Merchandising  Company  Income  Statement  for  

Fashion,  Inc.".  

Solution  to  Review  Problem  1.8  

1.    

   

1.    

 
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 2.    

*$90,000  comes  from  the  direct  materials  placed  in  production  in  part  1a.  

3.    

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*$795,000  comes  from  the  cost  of  goods  manufactured  (TO)  in  part  1b.  

4.    

*$855,000  comes  from  the  cost  of  goods  sold  (TO)  in  part  1c.  

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 5.    

E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  
1. Describe  the  characteristics  of  managerial  accounting  and  financial  accounting.  

2. What  are  nonfinancial  measures  of  performance?  Provide  several  examples.  

3. Which  accountant  (financial  or  managerial)  would  prepare  each  of  the  following  

reports:  

1. Income  statement  for  the  Chevrolet  division  of  General  Motors  

2. Balance  sheet  for  PepsiCo  prepared  in  accordance  with  U.S.  GAAP  

3. The  Boston  Symphony  Orchestra’s  budgeted  income  statement  for  next  quarter  

4. Defect  rate  of  computer  chips  produced  by  Intel  

5. Statement  of  cash  flows  for  Hewlett-­‐Packard  prepared  in  accordance  with  U.S.  GAAP  

4. Describe  the  planning  and  control  functions  performed  by  most  managers.  

5. What  is  the  controller’s  primary  responsibility?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     70  
     
 
 6. How  do  the  treasurer’s  responsibilities  differ  from  those  of  the  controller?  

7. Explain  why  ethical  behavior  is  so  important  for  finance  and  accounting  personnel.  

8. Briefly  summarize  the  Institute  of  Management  Accountants  (IMA)Statement  of  Ethical  

Professional  Practice  shown  in  Figure  1.2  "IMA  Statement  of  Ethical  Professional  Practice".  

What  is  the  purpose  of  this  statement?  

9. Review  Note  1.27  "Business  in  Action  1.3"  Why  would  the  company’s  former  employees  

improperly  record  information  as  described  here?  

10. Review  Note  1.28  "Business  in  Action  1.4"  Why  is  improving  ethics  a  top  priority  for  businesses,  

such  as  Home  Depot  and  Hewlett-­‐Packard?  

11. What  is  an  enterprise  resource  planning  system?  

12. Why  do  manufacturing  companies  use  product  costing  systems  to  track  costs  throughout  the  

production  process?  

13. Describe  manufacturing  costs  and  nonmanufacturing  costs.  Provide  examples  of  each.  

14. Describe  the  difference  between  direct  materials  and  direct  labor  versus  indirect  materials  and  

indirect  labor.  

15. Why  are  the  terms  product  costs  and  period  costs  used  to  describe  manufacturing  costs  and  

nonmanufacturing  costs?  

16. How  does  the  timing  of  recording  expenses  differ  between  product  and  period  costs?  

17. Review  Note  1.43  "Business  in  Action  1.5"  Why  are  items  such  as  the  hull,  engine,  transmission,  

carpet,  and  seats  classified  as  direct  materials  and  items  such  as  glue,  paint,  and  screws  

classified  as  indirect  materials?  

18. Review  Note  1.48  "Business  in  Action  1.6"  Provide  two  examples  of  selling  costs  and  two  

examples  of  general  and  administrative  costs  at  PepsiCo.  

19. Describe  the  three  inventory  accounts  used  to  record  product  costs.  

20. What  are  the  three  categories  of  product  costs  that  flow  through  the  work-­‐in-­‐process  inventory  

account?  Describe  each  one.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     71  
     
 
 21. When  is  the  cost  of  goods  sold  account  (often  called  cost  of  sales)  used,  and  how  is  the  dollar  

amount  recorded  in  this  account  determined?  

22. Review  Note  1.57  "Business  in  Action  1.7"  What  are  the  names  and  dollar  amounts  of  the  

inventory  accounts  appearing  on  the  balance  sheet?  What  is  the  total  amount  of  product  costs  

recorded  as  an  expense  on  the  income  statement  for  the  year  ended  December  31,  2010?  

23. Describe  the  inventory  cost  flow  equation  and  how  it  applies  to  the  three  schedules  shown  

in  Figure  1.7  "Income  Statement  Schedules  for  Custom  Furniture  Company".  

24. How  does  a  merchandising  company  income  statement  differ  from  a  manufacturing  company  

income  statement?  

Brief  Exercises  
25. Accounting  Information  at  Sportswear  Company.  Refer  to  the  dialogue  between  the  president  

and  accountant  at  Sportswear  Company  presented  at  the  beginning  of  the  chapter.  Why  can’t  

the  president  find  information  for  each  product  line  (hats  and  jerseys)  in  the  financial  

statements?  Who  within  the  company  typically  provides  this  type  of  information?  

26. Financial  Versus  Managerial  Accounting.  Maria  is  the  loan  officer  at  a  local  bank  that  lends  

money  to  Old  Town  Market,  a  small  grocery  store.  She  requests  several  quarterly  financial  

reports  on  an  ongoing  basis  to  assess  the  store’s  ability  to  repay  the  loan.  Provide  one  example  

of  a  financial  accounting  report  and  two  examples  of  managerial  accounting  reports  that  Maria  

might  request.  

27. Planning  and  Control.  Two  college  graduates  recently  started  a  Web  page  design  firm.  The  first  

month  was  just  completed,  and  the  owners  are  in  the  process  of  comparing  budgeted  revenues  

and  expenses  with  actual  revenues  and  expenses  for  the  month.  Would  this  be  considered  part  

of  the  planning  function  or  the  control  function?  Explain.  

28. Finance  and  Accounting  Personnel.  Determine  whether  the  chief  financial  officer,  

controller,  treasurer,  internal  auditor,  managerial  accountant,  financial  accountant,  or  

tax  accountant  would  perform  the  following  tasks.  (Hint:  Some  job  titles  may  be  used  

more  than  once,  and  others  may  not  be  used  at  all.)  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     72  
     
 
 a. Prepares  annual  reports  for  shareholders  and  creditors  

b. Provides  a  quarterly  summary  of  financial  results  to  the  CEO  and  board  of  directors  

c. Provides  profit  and  loss  reports  by  product  line  

d. Calculates  estimated  quarterly  tax  payments  

e. Oversees  the  treasurer  and  internal  auditor  

f. Obtains  sources  of  financing  and  manages  short-­‐term  investments  

g. Verifies  that  annual  report  financial  information  is  accurate  

Enterprise  Resource  Planning  (ERP)  System.  Enterprise  resource  planning  (ERP)  systems  

are  designed  to  record  and  share  information  across  functional  and  geographical  areas  on  a  

real-­‐time  basis.  However,  these  systems  tend  to  be  costly  to  purchase  and  maintain.  Why  do  

organizations  continue  to  invest  millions  of  dollars  in  ERP  systems  in  spite  of  the  cost?  

Manufacturing  Cost  Terms.  Indicate  whether  each  of  the  following  costs  associated  

with  production  would  be  classified  as  direct  materials,  direct  labor,  or  manufacturing  

overhead.  

0. Salaried  supervisor  responsible  for  several  product  lines  

1. Hourly  workers  assembling  goods  

2. Grease  used  to  maintain  machines  

3. Maintenance  personnel  

4. Bike  frame  used  to  build  a  racing  bike  

5. Factory  property  taxes  

6. Glue  used  to  assemble  toys  

Manufacturing  Cost  Terms.  Indicate  whether  each  of  the  following  costs  associated  

with  production  would  be  classified  as  direct  materials,  direct  labor,  or  manufacturing  

overhead.  

0. Depreciation  on  production  equipment  

1. Paint  used  to  produce  wagons  

2. Accounting  staff  performing  tax  services  for  a  client  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     73  
     
 
 3. Nails  used  to  assemble  cabinets  

4. Fiberglass  used  to  produce  a  custom  boat  

5. Hourly  workers  assembling  goods  

6. Factory  utilities  

Manufacturing  and  Nonmanufacturing  Cost  Terms.  Burns  Company  incurred  costs  for  

the  following  items.  

0. Salary  of  chief  financial  officer  

1. Factory  insurance  

2. Salary  for  salespeople  

3. Raw  materials  used  in  production  easily  traced  to  the  product  

4. Computer  equipment  depreciation  for  accounting  department  

5. Insurance  for  headquarters  building  

6. Production  line  workers  

7. Clerical  support  for  production  supervisors  

Required:  

h. Indicate  whether  each  item  should  be  categorized  as  a  product  or  period  cost.  

i. Indicate  whether  each  item  should  be  categorized  as  direct  materials,  direct  labor,  

manufacturing  overhead,  selling,  or  general  and  administrative.  

Manufacturing  and  Nonmanufacturing  Cost  Terms.  Leighton,  Inc.,  incurred  costs  for  

the  following  items.  

0. Janitorial  services  in  the  production  facility  

1. Personnel  department  supplies  

2. Shipping  costs  for  raw  materials  purchased  from  a  supplier,  easily  traced  to  the  product  

3. Newspaper  advertisements  

4. Supervisor  of  several  production  lines  

5. Insurance  for  factory  equipment  

6. Production  line  workers  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     74  
     
 
 7. Clerical  support  for  sales  staff  

Required:  

h. Indicate  whether  each  item  should  be  categorized  as  a  product  or  period  cost.  

i. Indicate  whether  each  item  should  be  categorized  as  direct  materials,  direct  labor,  

manufacturing  overhead,  selling,  or  general  and  administrative.  

Accounts  Used  to  Record  Product  Costs.  Match  each  of  the  following  accounts  with  

the  appropriate  description  that  follows.  

o _____  Raw  materials  inventory  

o _____  Work-­‐in-­‐process  inventory  

o _____  Finished  goods  inventory  

o _____  Cost  of  goods  sold  

4. Used  to  record  product  costs  associated  with  goods  that  are  sold  

5. Used  to  record  the  cost  of  materials  not  yet  put  into  production  

6. Used  to  record  product  costs  associated  with  goods  that  are  complete  and  ready  to  sell  

7. Used  to  record  product  costs  associated  with  incomplete  goods  in  the  production  

process  

Income  Statement  Terminology:  Manufacturing  Versus  Merchandising.  Match  each  

of  the  following  terms  used  in  a  manufacturing  company’s  income  statement  with  the  

equivalent  term  used  in  a  merchandising  company’s  income  statement.  

   

Manufacturing  Company  

o _____  Cost  of  goods  manufactured  

o _____  Work-­‐in-­‐process  inventory  

o _____  Finished  goods  inventory  

o _____  Cost  of  goods  sold  

   

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     75  
     
 
 Merchandising  Company  

4. Merchandise  inventory  

5. Same  term  is  used  by  a  merchandising  company  

6. Net  purchases  

7. Not  applicable  for  a  merchandising  company.  

Exercises:  Set  A  
36. Financial  Versus  Managerial  Accounting  (Manufacturing).  The  income  statement  

from  Ford’s  annual  report  appears  as  follows  in  summary  form.  (This  information  was  

obtained  from  the  company’s  Web  site,  http://www.ford.com.)  

Required:  

a. The  financial  information  in  the  company’s  annual  report  was  prepared  

primarily  for  shareholders  and  creditors  in  accordance  with  U.S.  Generally  Accepted  

Accounting  Principles  (U.S.  GAAP).  Does  the  income  statement  provide  enough  detailed  

information  for  managers  atFord?  Explain.  

b. Provide  at  least  three  additional  detailed  pieces  of  financial  information  that  would  

help  managers  evaluate  performance  at  Ford.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     76  
     
 
 c. Provide  at  least  two  nonfinancial  measures  that  would  help  managers  evaluate  

performance  at  Ford.  

Organizational  Structure.  The  following  list  of  personnel  within  organizations  comes  

from  Figure  1.2  "IMA  Statement  of  Ethical  Professional  Practice".  

0. Board  of  directors  

1. Chief  financial  officer  

2. Controller  

3. Managerial  accountant  

4. Financial  accountant  

5. Tax  accountant  

6. Treasurer  

7. Internal  auditor  

Required:  

Match  each  previous  item  with  the  most  accurate  description  as  follows.  

h. Assists  in  preparing  information  used  for  decision  making  within  the  

organization  

i. Assists  in  preparing  tax  reports  for  governmental  agencies,  including  the  Internal  

Revenue  Service  

j. Responsible  for  confirming  that  controls  within  the  company  are  effective  in  ensuring  

accurate  financial  data,  and  serves  as  an  independent  link  with  the  board  of  directors  

k. Responsible  for  all  finance  and  accounting  functions  within  the  organization  and  

typically  reports  to  the  chief  executive  officer  

l. Elected  by  the  shareholders  of  the  company  

m. Oversees  the  managerial  accountant,  financial  accountant,  and  tax  accountant  

n. Responsible  for  obtaining  financing  for  the  organization,  projecting  cash  flow  needs,  

and  managing  cash  and  short-­‐term  investments  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     77  
     
 
 o. Assists  in  preparing  financial  information,  usually  in  accordance  with  U.S.  GAAP,  for  

those  outside  the  company  

Schedule  of  Raw  Materials  Placed  in  Production.  The  balance  in  Sedona  Company’s  

raw  materials  inventory  account  was  $110,000  at  the  beginning  of  September  and  

$135,000  at  the  end  of  September.  Raw  materials  purchased  during  the  month  totaled  

$50,000.  Sedona  used  $8,000  in  indirect  materials  for  the  month.  

Required:  

Prepare  a  schedule  of  raw  materials  placed  in  production  for  the  month  of  September.  

Schedule  of  Cost  of  Goods  Manufactured.  The  balance  in  Reid  Company’s  work-­‐in-­‐

process  inventory  account  was  $300,000  at  the  beginning  of  March  and  $320,000  at  the  

end  of  March.  Manufacturing  costs  for  the  month  follow.  

Direct materials (from the schedule of raw materials placed in production) $ 40,000

Direct labor $ 70,000

Manufacturing overhead $200,000

Required:  

Prepare  a  schedule  of  cost  of  goods  manufactured  for  the  month  of  March.  

Schedule  of  Cost  of  Goods  Sold.  The  balance  in  Blue  Oak  Company’s  finished  goods  

inventory  account  was  $25,000  at  the  beginning  of  September  and  $28,000  at  the  end  

of  September.  Cost  of  goods  manufactured  for  the  month  totaled  $17,000.  

Required:  

Prepare  a  schedule  of  cost  of  goods  sold  for  the  month  of  September.  

Income  Statement.  Auto  Products,  Inc.,  had  the  following  activity  for  the  month  of  

October.  
Sales revenue $1,100,000

Selling expenses $ 300,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     78  
     
 
 General and administrative expenses $ 230,000

Cost of goods sold $ 475,000

Required:  

Prepare  an  income  statement  for  the  month  of  October.  

Exercises:  Set  B  
42. Financial  Versus  Managerial  Accounting  (Merchandising).  Home  Depot’s  annual  

report  appears  as  follows  in  summary  form.  (This  information  was  obtained  from  the  

company’s  Web  site,http://www.homedepot.com.)  

Required:  

a. The  financial  information  in  the  company’s  annual  report  was  prepared  

primarily  for  shareholders  and  creditors  in  accordance  with  U.S.  GAAP.  Does  the  

income  statement  provide  enough  detailed  information  for  managers  atHome  Depot?  

Explain.  

b. Provide  at  least  three  additional  detailed  pieces  of  financial  information  that  would  

help  managers  evaluate  performance  at  Home  Depot.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     79  
     
 
 c. Provide  at  least  two  nonfinancial  measures  that  would  help  managers  evaluate  

performance  at  Home  Depot.  

Organizational  Structure.  The  following  list  of  personnel  within  organizations  comes  

from  Figure  1.2  "IMA  Statement  of  Ethical  Professional  Practice".  

0. Board  of  directors  

1. Chief  financial  officer  

2. Controller  

3. Managerial  accountant  

4. Financial  accountant  

5. Tax  accountant  

6. Treasurer  

7. Internal  auditor  

Required:  

Match  each  previous  item  with  the  most  accurate  description  as  follows:  

h. Responsible  for  hiring  and  overseeing  the  chief  executive  officer  

i. Assists  in  preparing  financial  information  for  those  outside  the  company,  such  as  

shareholders  and  bondholders  

j. Responsible  for  reviewing  internal  controls  within  the  company  and  ensuring  accurate  

financial  data  

k. Responsible  for  controller,  treasurer,  and  internal  auditor  functions  within  the  

organization  

l. Responsible  for  projecting  cash  flow  needs  and  managing  cash  and  short-­‐term  

investments  

m. Oversees  the  managerial  accountant,  financial  accountant,  and  tax  accountant  

n. Prepares  profit  information  by  product,  which  is  used  for  decision  making  within  the  

organization  

o. Assists  in  establishing  tax  strategies  for  the  organization  

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 Schedule  of  Raw  Materials  Placed  in  Production.  The  balance  in  Clay  Company’s  raw  

materials  inventory  account  was  $45,000  at  the  beginning  of  April  and  $38,000  at  the  

end  of  April.  Raw  materials  purchased  during  the  month  totaled  $55,000.  Clay  used  

$14,000  in  indirect  materials  for  the  month.  

Required:  

Prepare  a  schedule  of  raw  materials  placed  in  production  for  the  month  of  April.  

Schedule  of  Cost  of  Goods  Manufactured.  The  balance  in  the  work-­‐in-­‐process  

inventory  account  of  Verdi  Production,  Inc.,  was  $900,000  at  the  beginning  of  May  and  

$750,000  at  the  end  of  May.  Manufacturing  costs  for  the  month  follow.  
Direct materials (from the schedule of raw materials placed in production) $340,000

Direct labor $810,000

Manufacturing overhead $660,000

Required:  

Prepare  a  schedule  of  cost  of  goods  manufactured  for  the  month  of  May.  

Schedule  of  Cost  of  Goods  Sold.  The  balance  in  Posada  Company’s  finished  goods  

inventory  account  was  $650,000  at  the  beginning  of  March  and  $625,000  at  the  end  of  

March.  Cost  of  goods  manufactured  for  the  month  totaled  $445,000.  

Required:  

Prepare  a  schedule  of  cost  of  goods  sold  for  the  month  of  March.  

Income  Statement.  Game  Products,  Inc.,  had  the  following  activity  for  the  month  of  

June.  
Sales revenue $800,000

Selling expenses $100,000

General and administrative expenses $200,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Cost of goods sold $360,000

Required:  

Prepare  an  income  statement  for  the  month  of  June.  

Problems  
48. Financial  Versus  Managerial  Accounting  (Service).  The  income  statement  from  the  

annual  report  of  United  Parcel  Service  (UPS)appears  as  follows  in  summary  form.  (This  

information  was  obtained  from  the  company’s  Web  site,  http://www.ups.com.)  

Required:  

a. The  financial  information  in  the  company’s  annual  report  was  prepared  

primarily  for  shareholders  and  creditors  in  accordance  with  U.S.  GAAP.  Does  the  

income  statement  provide  enough  detailed  information  for  managers  atUPS?  Explain.  

b. Provide  at  least  three  additional  detailed  pieces  of  financial  information  that  would  

help  managers  evaluate  performance  at  UPS.  

c. Provide  at  least  two  nonfinancial  measures  that  would  help  managers  evaluate  

performance  at  UPS.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Income  Statement  and  Supporting  Schedules.  The  following  financial  information  is  

for  Industrial  Company.  (Note  that  the  most  current  financial  information  is  presented  

in  the  first  column.)  

December 31, 2011 December 31, 2010

Raw materials inventory $ 24,000 $ 30,000

Work-in-process inventory 1,800,000 1,650,000

Finished goods inventory 1,050,000 1,230,000

Of  the  total  raw  materials  placed  in  production  for  the  year,  $36,000  was  for  indirect  

materials.  Industrial  had  $3,795,000  in  sales  for  the  year  ended  December  31,  2011.  

The  company  also  had  the  following  costs  for  the  year:  
Selling $ 270,000

General and administrative $ 720,000

Raw materials purchases $ 300,000

Direct labor used in production $ 375,000

Manufacturing overhead $1,890,000

Required:  

 . Prepare  a  schedule  of  raw  materials  placed  in  production  for  the  year  ended  

December  31,  2011.  

a. Prepare  a  schedule  of  cost  of  goods  manufactured  for  the  year  ended  December  31,  

2011.  

b. Prepare  a  schedule  of  cost  of  goods  sold  for  the  year  ended  December  31,  2011.  

c. Prepare  an  income  statement  for  the  year  ended  December  31,  2011.  

d. Describe  the  three  types  of  costs  included  in  cost  of  goods  sold  on  the  income  

statement.  (Dollar  amounts  are  not  necessary  in  your  descriptions.)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Income  Statement  and  Supporting  Schedules.  The  following  financial  information  is  

for  Danville  Company.  (Note  that  the  most  current  financial  information  is  presented  in  

the  first  column.)  

December 31, 2011 December 31, 2010

Raw materials inventory $ 8,000 $ 10,000

Work-in-process inventory 600,000 550,000

Finished goods inventory 350,000 410,000

Of  the  total  raw  materials  placed  in  production  for  the  year,  $12,000  was  for  indirect  

materials.  Danville  had  $1,265,000  in  sales  for  the  year  ended  December  31,  2011.  The  

company  also  had  the  following  costs  for  the  year:  

Selling $ 90,000

General and administrative $240,000

Raw materials purchases $100,000

Direct labor used in production $125,000

Manufacturing overhead $630,000

Required:  

 . Prepare  a  schedule  of  raw  materials  placed  in  production  for  the  year  ended  

December  31,  2011.  

a. Prepare  a  schedule  of  cost  of  goods  manufactured  for  the  year  ended  December  31,  

2011.  

b. Prepare  a  schedule  of  cost  of  goods  sold  for  the  year  ended  December  31,  2011.  

c. Prepare  an  income  statement  for  the  year  ended  December  31,  2011.  

d. Describe  the  three  types  of  costs  included  in  cost  of  goods  manufactured.  (Dollar  

amounts  are  not  necessary  in  your  descriptions.)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Income  Statement  and  Supporting  Schedules.  The  following  information  is  for  Ciena,  

Inc.,  for  the  year  ended  December  31,  2011.  

Raw materials inventory beginning balance $ 15,000

Raw materials inventory ending balance $ 12,000

Work-in-process inventory beginning balance $ 825,000

Work-in-process inventory ending balance $ 900,000

Finished goods inventory beginning balance $ 615,000

Finished goods inventory ending balance $ 525,000

Raw material purchases $ 150,000

Direct labor used in production $ 187,500

Manufacturing overhead $ 945,000

Selling costs $ 135,000

General and administrative $ 360,000

Sales revenue $1,897,500

Of  the  total  raw  materials  placed  in  production  for  the  year,  $18,000  was  for  indirect  

materials.  

Required:  

 . Prepare  a  schedule  of  raw  materials  placed  in  production  for  the  year  ended  

December  31,  2011.  

a. Prepare  a  schedule  of  cost  of  goods  manufactured  for  the  year  ended  December  31,  

2011.  

b. Prepare  a  schedule  of  cost  of  goods  sold  for  the  year  ended  December  31,  2011.  

c. Prepare  an  income  statement  for  the  year  ending  December  31,  2011.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Income  Statement  and  Supporting  Schedules.  The  following  information  is  for  Diablo,  

Inc.,  for  the  year  ended  December  31,  2011.  

Raw materials inventory beginning balance $ 60,000

Raw materials inventory ending balance $ 48,000

Work-in-process inventory beginning balance $3,300,000

Work-in-process inventory ending balance $3,600,000

Finished goods inventory beginning balance $2,460,000

Finished goods inventory ending balance $2,100,000

Raw material purchases $ 600,000

Direct labor used in production $ 750,000

Manufacturing overhead $3,780,000

Selling costs $ 540,000

General and administrative $1,440,000

Sales revenue $7,590,000

Of  the  total  raw  materials  placed  in  production  for  the  year,  $72,000  was  for  indirect  

materials.  

Required:  

 . Prepare  a  schedule  of  raw  materials  placed  in  production  for  the  year  ended  

December  31,  2011.  

a. Prepare  a  schedule  of  cost  of  goods  manufactured  for  the  year  ended  December  31,  

2011.  

b. Prepare  a  schedule  of  cost  of  goods  sold  for  the  year  ended  December  31,  2011.  

c. Prepare  an  income  statement  for  the  year  ending  December  31,  2011.  

One  Step  Further:  Skill-­‐Building  Cases  

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 53. Ethics:  Accounting  for  Obsolete  Inventory.  High  Tech,  Inc.,  is  a  public  company  that  

produces  laser  and  ink  jet  printers.  Jorge  is  an  accounting  staff  member  who  works  for  

the  company’s  controller  and  is  involved  in  preparing  the  annual  report.  One  of  High  

Tech’s  competitors  developed  a  superior  color  laser  jet  printer  using  a  less  costly  

production  process.  Jorge  realizes  that  High  Tech’s  substantial  inventory  of  color  laser  

jet  printers  is  effectively  obsolete  and  will  have  to  be  written  down  to  its  net  realizable  

value  in  accordance  with  U.S.  GAAP.  This  means  higher  expenses  and  lower  profits.  

Jorge’s  boss,  the  controller,  is  aware  of  the  situation  but  the  chief  financial  officer  is  

not.  In  fact,  the  controller  told  the  CFO  that  High  Tech  does  not  have  any  obsolete  

inventory.  Both  Jorge’s  boss  and  the  CFO  receive  bonuses  tied  to  the  company’s  profits.  

The  outside  auditors  are  completing  the  audit  and  are  unaware  of  the  obsolete  

inventory.  

Required:  

How  should  Jorge  handle  this  situation?  Use  the  IMA’sStatement  of  Ethical  Professional  

Practice  shown  in  Figure  1.2  "IMA  Statement  of  Ethical  Professional  Practice"  as  a  guide  

to  answering  this  question.  

54. Internet  Project:  Institute  of  Management  Accountants.  Go  to  the  Web  site  of  the  Institute  of  

Management  Accountants  (http://www.imanet.org).  Review  various  parts  of  the  site  

(e.g.,  About  IMA  or  Certification)  and  write  a  one-­‐page  summary  of  your  findings.  

55. Internet  Project:  American  Institute  of  Certified  Public  Accountants.  Go  to  the  Web  site  of  the  

American  Institute  of  Certified  Public  Accountants  (AICPA;  http://www.aicpa.org).  Review  

various  parts  of  the  site  (e.g.,About  the  AICPA  or  Professional  Resources)  and  write  a  one-­‐page  

summary  of  your  findings.  

56. Internet  Project:  Sarbanes-­‐Oxley  Act  of  2002.  Go  to  the  Securities  and  Exchange  

Commission’s  Web  site  (http://www.sec.gov)  and  click  on  Laws  and  Regulations.  Click  

on  the  full  text  of  the  Sarbanes-­‐Oxley  Act  of  2002.  

Required:  
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 a. Go  to  section  302,  Corporate  Responsibility  for  Financial  Reports,  and  

summarize  the  six  requirements  in  this  section.  Assume  you  are  the  chief  financial  

officer  of  a  public  company.  What  concerns  might  you  have  about  these  requirements?  

b. Go  to  section  404,  subsection  a,  Management  Assessment  of  Internal  Controls.  Assume  

you  are  an  executive  officer  of  a  public  company.  What  two  items  are  you  required  to  

present  in  the  annual  report?  

Ethics:  Companies  Accused  of  Committing  Fraud.  Using  a  source  like  The  Wall  Street  

Journal,  BusinessWeek,  or  an  Internet  search  engine,  find  an  article  about  an  organization  

accused  of  committing  accounting  fraud.  Write  a  one-­‐page  summary  of  your  findings.  Include  a  

copy  of  the  article  with  your  summary.  

Internet  Project:  Finding  Company  with  Ethics  Policy.  Using  the  Internet,  find  a  company  

that  has  standards  for  ethical  behavior.  (Some  companies  refer  to  these  standards  as  a  “code  of  

ethics”;  others  may  use  different  terminology.)  Write  a  one-­‐page  summary  of  your  findings.  

Group  Activity:  Inventory  Accounts  for  Manufacturing  Company.  In  groups  of  two  to  four  

students,  use  the  Internet  to  find  a  manufacturing  company  that  presents  three  inventory  

accounts  on  the  balance  sheet  or  in  the  notes  to  the  financial  statements.  Include  a  printout  of  

your  findings,  and  explain  what  each  account  and  related  dollar  amount  represents.  

Comprehensive  Case  
60. Ethics:  Accounting  for  Revenues  and  Expenses.  Equipment  Group  produces  excavating  

equipment  for  contractors.  Equipment  Group  is  working  on  the  annual  financial  

statements  for  its  shareholders,  who  are  expecting  profits  of  $200,000,000  for  the  year  

ending  December  31.  The  controller  (Jeff)  and  CFO  (Kathy)  will  receive  bonuses  totaling  

50  percent  of  their  salaries  if  company  profits  exceed  $200,000,000.  Sarah  is  a  staff  

accountant  who  works  for  the  controller.  One  week  before  the  end  of  the  fiscal  year,  a  

customer  decides  to  delay  a  significant  purchase  of  equipment  until  March  of  the  next  

year.  As  a  result,  Equipment  Group’s  profits  will  decrease  by  $2,000,000  to  

$198,000,000  for  the  year.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 Jeff,  the  controller,  approaches  Sarah  and  asks  her  to  think  of  a  way  to  increase  profits  

by  $2,500,000.  He  suggests  looking  at  sales  occurring  in  early  January  and  perhaps  

moving  them  up  to  December.  He  also  hints  that  some  December  expenses  could  be  

pushed  back  and  recorded  in  January.  

Required:  

a. Is  there  a  problem  with  the  controller’s  request?  Explain  your  answer.  

b. How  should  Sarah  handle  this  situation?  There  are  many  possible  steps,  as  described  in  

the  IMA’s  Statement  of  Ethical  Professional  Practice  shown  in  Figure  1.2  "IMA  

Statement  of  Ethical  Professional  Practice".  

c. What  are  the  potential  consequences  for  Sarah  if  she  agrees  to  do  what  Jeff  suggests?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Chapter 2

How Is Job Costing Used to Track Production Costs?

Dan Stevens recently started Custom Furniture Company, a manufacturing company that
specializes in building custom wood tables for individuals and organizations. Each table is
unique and built to customer specifications for use in homes (coffee tables and dining room
tables) and offices (boardroom and meeting room tables). The sales price of each table varies
significantly, from $1,000 to more than $30,000. (Note that this is the same company as the
example in the last part of Chapter 1 "What Is Managerial Accounting?". Although not required,
you may find it helpful to refer to the Chapter 1 "What Is Managerial Accounting?" discussion of
Custom Furniture Company.)

When Dan received the company’s income statement for May, he was surprised by the lack of
profits. Because sales prices are based on a markup of estimated costs, Dan is questioning the
accuracy of his estimates. He approaches Leslie, the full-time accountant for Custom Furniture
Company, to get more information.

Leslie, last month’s income statement shows we are struggling to make a decent profit. I’m
not sure why this is happening, especially since we price our furniture 70 percent above
Dan: estimated production costs.

Basing prices on estimated costs is a good approach, but it only works if your estimates are
Leslie: accurate. Have you compared the actual cost of each table with your original estimates?

Dan: No, but I like the idea. Where do I start?

We use a job cost accounting system that tracks costs for each table you produce. I can pull
Leslie: together the information for you. How far back do you want to go?

Let’s start by looking at actual product costs for the three costliest tables produced in May. It
would be helpful to break these costs out for direct materials, direct labor, and
Dan: manufacturing overhead. I would also like to see the gross profit generated by each table.

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Leslie: No problem, I’ll have the information for you by the end of the day.

We use Custom Furniture Company as an example throughout the chapter to explain how a job
costing system works and to provide information that will address Dan’s concerns.

2.1 Differentiating Job Costing from Process Costing

L E A R N I N G   O B J E C T I V E  

1. Distinguish  between  job  costing  and  process  costing.  

Question: Financial accounting classes cover how merchandising companies, such

as Sears and Lowe’s, account for the cost of the goods that they purchase from a supplier and
later sell to a customer. These companies simply record the cost of the purchase in an inventory
account and account for any returns and allowances, discounts, and shipping costs. Once the
merchandise is sold, the related inventory costs are transferred to cost of goods sold. However,
manufacturing companies are different. How do manufacturing companies account for inventory
at different stages of production?

Answer: Manufacturing companies like Custom Furniture Company, Ford, and IBM don’t have
it quite as easy as merchandising companies. They must account for the materials, labor, and
other manufacturing costs that go into building the product. The process of accounting for
manufacturing costs depends on which costing system a company uses—job costing or process
costing.

Job Costing

Question: We define a job as an activity that produces a unique product—one that can be easily
distinguished from other products. For example, building a custom home is a job because the
home is unique and easy to distinguish from other homes. An accounting firm’s provision of tax
services to a client is another example of a job. How does a job costing system help companies
that produce unique products or jobs?

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Answer: A job costing system records revenues and costs for each job. Because each job at
Custom Furniture Company results in a unique product and has different material and labor
requirements, the company uses a job costing system.

Tracking revenues and costs for each job is important for several reasons:

• Like Dan at Custom Furniture, managers want to assess the accuracy of cost estimates.
This is particularly important when prices are based on estimated costs.
• Managers want to review actual revenues and costs for each job to see if the job is
profitable.
• Managers want to compare actual costs with estimated costs throughout a project so they
can identify unexpected changes as early in the project as possible. For example, if the
cost of mahogany wood increases by 50 percent, Custom Furniture might renegotiate the
price of a mahogany table with the customer. If it’s too late to renegotiate the price of a
current job, the cost increase could be built into the pricing of future jobs.

Process Costing

Question: Job costing may work for builders of custom furniture and tax professionals, but does
job costing make sense for a company that produces soft drinks? Imagine trying to track costs
for each can of soda produced. A job costing system would not be appropriate for this type of
company. A different costing system, called process costing, would be a better fit. Which types of
companies use this type of system?

Answer: Companies that produce identical units of product in batches using a consistent process
track costs with a process costing system. Table 2.1 "Job Costing Versus Process Costing" lists
some products and services that require the use of process costing versus job costing, and Figure
2.1 "Examples of Job Costing and Process Costing" shows an example of each. This chapter

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 focuses on job costing. We explore process costing further inChapter 4 "How Is Process Costing
Used to Track Production Costs?".

Table 2.1 Job Costing Versus Process Costing

Job Costing Process Costing

Custom homes Oil

Custom vans Chemicals

House painting services Paint

Movies Lumber

Airplanes Milk

Bridges Pencils

Legal services Paper

Figure 2.1 Examples of Job Costing and Process Costing

K E Y   T A K E A W A Y  

• Job  costing  systems  record  revenues  and  costs  for  unique  products;  ones  that  can  be  easily  distinguished  from  other  products.  Process  costing  

systems  record  revenues  and  costs  for  batches  of  identical  units  of  product.  When  deciding  whether  to  use  a  job  costing  or  process  costing  

system,  we  must  understand  a  company’s  products  and  production  processes.  

R E V I E W   P R O B L E M   2 . 1  

Identify  whether  each  company  listed  in  the  following  would  use  job  costing  or  process  costing.  

a. Coca-­‐Cola  Company  

b. Kelly  Moore  Paint  

c. Volkswagen—custom  campers  

d. Universal  Studios—movie  division  

e. Chevron  Corporation  

f. Michelin  

g. Boeing  Co.  

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 h. Ernst  &  Young—tax  division  

Solutions  to  Review  Problem  2.1  

a. Process  costing  

b. Process  costing  

c. Job  costing  

d. Job  costing  

e. Process  costing  

f. Process  costing  

g. Job  costing  

h. Job  costing  

2.2 How a Job Costing System Works

L E A R N I N G   O B J E C T I V E  

1. Understand  how  direct  materials  and  direct  labor  costs  are  assigned  to  jobs.  

Question: Now that we know a job costing system records revenues and costs for each unique
job, we can determine whether this type of system would be appropriate at Custom Furniture
Company. Recall that Custom Furniture produces high-quality custom wood tables that are sold
for between $1,000 and $30,000. A job costing system is a perfect fit for this type of
company. How would Custom Furniture Company use a job costing system to track production
costs?

Answer: We use financial information for the month of May at Custom Furniture Company to
illustrate how a job costing system works. Refer toChapter 1 "What Is Managerial Accounting?",
as needed, for a refresher on manufacturing cost terms and how the three different inventory
accounts are used by manufacturing companies. Let’s start our example with the purchase of raw
materials.

Purchasing Raw Materials

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 Question: Recall from Chapter 1 "What Is Managerial Accounting?" that raw materials are the
items necessary to build a product. For Custom Furniture Company, this includes items such as
wood, brackets, screws, nails, glue, lacquer, and sandpaper. How do we record the purchase of
raw materials?

Answer: The accountants at Custom Furniture record the cost of raw materials purchased in the
raw materials inventory account. Assume Custom Furniture Company purchased $4,500 in raw
materials on May 2. All purchases are on account. The journal entry to reflect this transaction is
as follows:

This purchase of raw materials is further illustrated in the T-accounts shown in the following.
Assume the beginning balance for raw material inventory is $25,000. Beginning balances are
only provided for inventory accounts since the focus of this chapter is on manufacturing costs
that flow through these accounts.

Introductory financial accounting texts discuss the rules for double-entry accounting in detail.
Recall that the following account categories areincreased with a debit (and are therefore
decreased with a credit): assets, dividends, and expenses. Conversely, the following account
categories areincreased with a credit (and decreased with a debit): liabilities, stockholders’
equity, and revenues. Also note that the individual transactions shown throughout this chapter

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 represent one example of many similar transactions that occurred throughout the month of May.
A summary of activity for the entire month of May is presented in Figure 2.7 "Custom Furniture
Company’s Journal Entries for May" and Figure 2.8 "Custom Furniture Company’s T-
Accounts".

Assigning Direct Material Costs to Jobs

Question: The next step is to move raw materials from the storeroom to production. How does
the company track this information, and how is this transaction recorded in the general journal?

Answer: A materials requisition form tracks materials taken out of raw materials inventory and
placed in production. This form specifies the type, quantity, and cost of materials being
requested, as well as the number of the job in which the materials will be used. Figure 2.2
"Materials Requisition Form for Custom Furniture Company" shows a materials requisition form
that Custom Furniture Company used to transfer $370 in direct materials out of raw materials
inventory into production.

Figure 2.2 Materials Requisition Form for Custom Furniture Company

The journal entry to reflect this transfer is as follows:

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This flow of direct materials from one account to another is further illustrated in the T-accounts
that follow. Assume the beginning balance for work-in-process inventory is $35,000.

Using a Job Cost Sheet

Question: The next step is to post the information shown on the materials requisition form to the
appropriate job cost sheet. Because the work-in-process (WIP) inventory account tracks
manufacturing costs in total, a separate subsidiary ledger is necessary to track manufacturing
costs for each job. The total of all WIP inventory subsidiary ledgers matches the WIP inventory
account shown on the balance sheet. What does a WIP inventory subsidiary ledger look like, and
how is it used?

Answer: The WIP inventory subsidiary ledger typically comprises many individual job cost
sheets. A job cost sheet simply accumulates manufacturing costs incurred for each job. Figure
2.3 "Job Cost Sheet for Custom Furniture Company" shows a job cost sheet for Custom
Furniture Company. Notice how the materials requisition in Figure 2.2 "Materials Requisition
Form for Custom Furniture Company" is a line item in the job cost sheet for job 50.

Figure 2.3 Job Cost Sheet for Custom Furniture Company

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*$370 comes from the total in Figure 2.2 "Materials Requisition Form for Custom Furniture Company".

Assigning Direct Labor Costs to Jobs

Question: Recall from Chapter 1 "What Is Managerial Accounting?" that direct labor is defined
as workers who convert materials into a finished product and whose time is easily traced to the
product or job. Manufacturing companies, such as Custom Furniture Company, must keep track
of the hours each worker spends on any given job. How do companies track this information, and
how is this information recorded in the general journal?

Answer: Workers use a timesheet to track the hours spent on each job. The timesheet is often
called a time card, time ticket, or job ticket. The worker is responsible for completing the
timesheet, including the date, job number, and hours worked on each job.

Figure 2.4 "Timesheet for Custom Furniture Company" provides an example of a timesheet used
at Custom Furniture Company to track direct labor costs of $120 related to jobs 50 and 51 for
Tim Wallace. The journal entry to reflect this is as follows:
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Recording these direct labor costs is further illustrated in the T-accounts that follow. Again,
beginning balances are only provided for inventory accounts since the focus of this chapter is on
manufacturing costs that flow through these accounts.

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 Figure 2.4 Timesheet for Custom Furniture Company

The next step is to post the information shown on the timesheet to the appropriate job cost sheet,
just as we did with direct materials. This is done for job 50 in Figure 2.5 "Direct Labor Costs for
Custom Furniture Company’s Job 50".

Figure 2.5 Direct Labor Costs for Custom Furniture Company’s Job 50

*Direct labor information carried over from Figure 2.4 "Timesheet for Custom Furniture Company".

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 K E Y   T A K E A W A Y  

• A  materials  requisition  form  tracks  materials  taken  out  of  raw  materials  inventory  and  placed  in  production.  It  identifies  the  job  in  which  the  

materials  will  be  used.  A  timesheet  tracks  the  hours  that  workers  spend  on  each  job.  The  information  from  both  the  materials  requisition  forms  

and  timesheets  is  recorded  on  each  job  cost  sheet.  A  job  cost  sheet  accumulates  manufacturing  costs  for  each  job  and  serves  as  a  subsidiary  

ledger  for  the  work-­‐in-­‐process  inventory  account.  

R E V I E W   P R O B L E M   2 . 2  

1. Provide  the  journal  entry  to  record  each  of  the  following  transactions:  

1. Raw  materials  totaling  $40,000  are  purchased  on  account.  

2. Direct  materials  totaling  $5,000  are  requisitioned  and  placed  into  production.  

3. Timesheets  submitted  by  employees  reflect  direct  labor  costs  of  $2,000,  to  be  paid  the  next  week.  

2. Which  of  the  previously  stated  entries  must  also  be  recorded  on  the  appropriate  job  cost  sheet?  Why?  

Solutions  to  Review  Problem  2.2  

1.    

1.    

2.    

 
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 3.    

4. Entries  b  and  c  must  be  recorded  on  the  appropriate  job  cost  sheet.  Direct  materials  (entry  b)  and  direct  labor  (entry  c)  are  by  definition  

easily  traceable  to  the  job  and  therefore  must  be  recorded  on  the  job  cost  sheet  when  the  cost  is  incurred.  

2.3 Assigning Manufacturing Overhead Costs to Jobs

L E A R N I N G   O B J E C T I V E  

1. Understand  how  manufacturing  overhead  costs  are  assigned  to  jobs.  

Question: We have discussed how to assign direct material and direct labor costs to jobs using a
materials requisition form, timesheet, and job cost sheet. The third manufacturing cost—
manufacturing overhead—requires a little more work. How do companies assign manufacturing
overhead costs, such as factory rent and factory utilities, to individual jobs?

Answer: Recall from Chapter 1 "What Is Managerial Accounting?" that manufacturing overhead
consists of all costs related to the production process other than direct materials and direct labor.
Because manufacturing overhead costs are difficult to trace to specific jobs, the amount allocated
to each job is based on an estimate. The process of creating this estimate requires the calculation
of a predetermined rate.

Using a Predetermined Overhead Rate

The goal is to allocate manufacturing overhead costs to jobs based on some common activity,
such as direct labor hours, machine hours, or direct labor costs. The activity used to allocate
manufacturing overhead costs to jobs is called an allocation base. Once the allocation base is
selected, a predetermined overhead rate can be established. Thepredetermined overhead rate is
calculated prior to the year in which it is used in allocating manufacturing overhead costs to jobs.
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 Calculating the Predetermined Overhead Rate

Question: How is the predetermined overhead rate calculated?

Answer: We calculate the predetermined overhead rate as follows, using estimates for the
coming year:

Key  Equation  
Predetermined overhead rate=Estimated overhead costs*Estimated activity in allocation base**  

*The numerator requires an estimate of all overhead costs for the year, such as indirect
materials, indirect labor, and other indirect costs associated with the factory. Custom
Furniture Company estimates annual overhead costs to be $1,140,000 based on actual
overhead costs last year.
**The denominator requires an estimate of activity in the allocation base for the year.
Custom Furniture uses direct labor hours as the allocation base and expects its direct labor
workforce to record 38,000 direct labor hours for the year.

The predetermined overhead rate calculation for Custom Furniture is as follows:

Predetermined overhead rate=$1,140,000 estimated overhead costs38,000 estimated direct labor

hours=$30 per direct labor hour

Thus each job will be assigned $30 in overhead costs for every direct labor hour charged to the
job. The assignment of overhead costs to jobs based on a predetermined overhead rate is
called overhead applied. Remember that overhead applied does not represent actual overhead
costs incurred by the job—nor does it represent direct labor or direct material costs. Instead,
overhead applied represents a portion of estimated overhead costs that is assigned to a particular
job.
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 Question: Now that we know how to calculate the predetermined overhead rate, the next step is
to use this rate to apply overhead to jobs. How do companies use the predetermined overhead
rate to apply overhead to jobs, and how is this information recorded in the general journal?

Answer: As shown on the timesheet in Figure 2.4 "Timesheet for Custom Furniture Company",
Tim Wallace charged six hours to job 50. Because manufacturing overhead is applied at a rate of
$30 per direct labor hour, $180 (= $30 × 6 hours) in overhead is applied to job 50. The journal
entry to reflect this is as follows:

 
Recording the application of overhead costs to a job is further illustrated in the T-accounts that
follow.

 
When this journal entry is recorded, we also record overhead applied on the appropriate job cost
sheet, just as we did with direct materials and direct labor. Figure 2.6 "Overhead Applied for
Custom Furniture Company’s Job 50" shows the manufacturing overhead applied based on the
six hours worked by Tim Wallace. Notice that total manufacturing costs as of May 4 for job 50
are summarized at the bottom of the job cost sheet.

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 Figure 2.6 Overhead Applied for Custom Furniture Company’s Job 50

*$180 = $30 per direct labor hour × 6 direct labor hours.

Selecting an Allocation Base

Question: Although we used direct labor hours as the allocation base for Custom Furniture
Company’s predetermined overhead rate, organizations use various other types of allocation
bases. The most common allocation bases are direct labor hours, direct labor costs, and machine
hours. What factors do companies consider when deciding on an allocation base?

Answer: Companies typically look at the following two items when determining which
allocation base to use:

1. Link to overhead costs. The goal is to find an allocation base that drives overhead costs,
often called a cost driver. For example, if a company’s production process is labor
intensive (i.e., it requires a large labor force), overhead costs are likely driven by direct
labor hours or direct labor costs. The more direct labor hours worked, the higher the

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 overhead costs incurred. Thus direct labor hours or direct labor costs would be used as
the allocation base.

If a company’s production process is highly mechanized (i.e., it relies on machinery more

than on labor), overhead costs are likely driven by machine hours. The more machine
hours used, the higher the overhead costs incurred. Thus machine hours would be used as
the allocation base.

It may make more sense to use several allocation bases and several overhead rates to
allocate overhead to jobs. This approach, calledactivity-based costing, is discussed in
depth in Chapter 3 "How Does an Organization Use Activity-Based Costing to Allocate
Overhead Costs?".

2. Ease of measurement. An allocation base should not only be linked to overhead costs; it
should also be measurable. The three most common allocation bases—direct labor hours,
direct labor costs, and machine hours—are relatively easy to measure. Direct labor hours
and direct labor costs can be measured by using a timesheet, as discussed earlier, so using
either of these as a base for allocating overhead is quite simple. Machine hours can also
be easily measured by placing an hour meter on each machine if one does not already
exist.

Why Use a Predetermined Overhead Rate?

Question: The use of a predetermined overhead rate rather than actual data to apply overhead
to jobs is called normal costing. Most companies prefer normal costing over assigning actual
overhead costs to jobs. Why do most companies prefer to use normal costing?

Answer: Companies use normal costing for several reasons:

• Actual overhead costs can fluctuate from month to month, causing high amounts of
overhead to be charged to jobs during high-cost periods. For example, utility costs might

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 be higher during cold winter months and hot summer months than in the fall and spring
seasons. Maintenance costs might be higher during slow periods. Normal costing
averages these costs out over the course of a year.
• Actual overhead cost data are typically only available at the end of the month, quarter, or
year. Managers prefer to know the cost of a job when it is completed—and in some cases
during production—rather than waiting until the end of the period.
• The price charged to customers is often negotiated based on cost. A predetermined
overhead rate is helpful when estimating costs.
• Bookkeeping is simplified by using a predetermined overhead rate. One rate is used to
record overhead costs rather than tabulating actual overhead costs at the end of the
reporting period and going back to assign the costs to jobs.

Using a Manufacturing Overhead Account

Question: Using a predetermined overhead rate to apply overhead costs to jobs requires the use
of a manufacturing overhead account. How is the manufacturing overhead account used to
record transactions?

Answer: The manufacturing overhead account tracks the following two pieces of information:

First, the manufacturing overhead account tracks actual overhead costs incurred. Recall that
manufacturing overhead costs include all production costs other than direct labor and direct
materials. The actual manufacturing overhead costs incurred in a period are recorded as debits in
the manufacturing overhead account. For example, assume Custom Furniture Company places
$4,200 in indirect materials into production on May 10. The journal entry to reflect this is as
follows:

 
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 Other examples of actual manufacturing overhead costs include factory utilities, machine
maintenance, and factory supervisor salaries. All these costs are recorded as debits in the
manufacturing overhead account when incurred.

Second, the manufacturing overhead account tracks overhead costs applied to jobs. The overhead
costs applied to jobs using a predetermined overhead rate are recorded as credits in the
manufacturing overhead account. You saw an example of this earlier when $180 in overhead was
applied to job 50 for Custom Furniture Company. We repeat the entry here.

 
The following T-account summarizes how overhead costs flow through the manufacturing
overhead account:

 
The manufacturing overhead account is classified as a clearing account. A clearing account is
used to hold financial data temporarily and is closed out at the end of the period before preparing
financial statements.

Underapplied and Overapplied Overhead

Question: Because manufacturing overhead costs are applied to jobs based on an estimated
predetermined overhead rate, overhead applied (credit side of manufacturing overhead) rarely
equals actual overhead costs incurred (debit side of manufacturing overhead). What terms are
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 used to describe the difference between actual overhead costs incurred during a period and
overhead applied during a period?

Answer: Two terms are used to describe this difference—underapplied

overhead and overapplied overhead.

Underapplied overhead occurs when actual overhead costs (debits) arehigher than overhead
applied to jobs (credits). The T-account that follows provides an example of underapplied
overhead. Note that the manufacturing overhead account has a debit balance when overhead is
underapplied because fewer costs were applied to jobs than were actually incurred.

Overapplied overhead occurs when actual overhead costs (debits) arelower than overhead

applied to jobs (credits). The T-account that follows provides an example of overapplied
overhead. Note that the manufacturing overhead account has a credit balance when
overhead is overapplied because more costs were applied to jobs than were actually
incurred.

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 Business  in  Action  2.1  

Source: Photo courtesy of

prayitno,http://www.flickr.com/photos/34128007@N04/5293183651/.
Job Costing at Boeing
Boeing Company is the world’s leading aerospace company and the largest manufacturer

of commercial jetliners and military aircraft combined. Boeing provides products and
services to customers in 150 countries and employs 165,000 people throughout the world.
Since most of Boeing’s products are unique and costly, the company likely uses job costing
to track costs associated with each product it manufactures. For example, the costly direct
materials that go into each jetliner produced are tracked using a job cost sheet. Direct labor
and manufacturing overhead costs (think huge production facilities!) are also assigned to
each jetliner. This careful tracking of production costs for each jetliner provides
management with important cost information that is used to assess production efficiency
and profitability. Management can answer questions, such as “How much did direct
materials cost?,” “How much overhead was allocated to each jetliner?,” or “What was the
total production cost for each jetliner?” This is important information when it comes time to

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 negotiate the sales price of a jetliner with a potential buyer like United
Airlines or Southwest Airlines.

Source: Boeing, “Home Page,” http://www.boeing.com.

Closing the Manufacturing Overhead Account

Question: Since the manufacturing overhead account is a clearing account, it must be closed at
the end of the period. How do we close the manufacturing overhead account?

Answer: Most companies simply close the manufacturing overhead account balance to the cost
of goods sold account. For example, if there is a $2,000 debit balance in manufacturing overhead
at the end of the period, the journal entry to close the underapplied overhead is as follows:

 
If manufacturing overhead has a $3,000 credit balance at the end of the period, the journal entry
to close the overapplied overhead is as follows:

 
Alternative Approach to Closing the Manufacturing Overhead Account

Question: Although most companies close the manufacturing overhead account to cost of goods
sold, this is typically only done when the amount is immaterial (immaterial is a common
accounting term used to describe an amount that is small relative to a company’s size). The term
material describes a relatively large amount. How do we close the manufacturing overhead
account when the amount is material?

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 Answer: If the amount is material, it should be closed to three different accounts—work-in-
process (WIP) inventory, finished goods inventory, and cost of goods sold—in proportion to the
account balances in these accounts.

For example, suppose a company has $2,000 in underapplied overhead (debit balance in
manufacturing overhead) and that the three account balances are as follows:

 
The $2,000 is closed to each of the three accounts based on their respective percentages. Thus
$1,200 is apportioned to WIP inventory (= $2,000 × 60 percent), $600 goes to finished goods
inventory (= $2,000 × 30 percent), and $200 goes to cost of goods sold (= $2,000 × 10 percent).
The journal entry to close the $2,000 underapplied overhead debit balance in manufacturing
overhead is as follows:

 
Although this approach is not as common as simply closing the manufacturing overhead account
balance to cost of goods sold, companies do this when the amount is relatively significant.

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 K E Y   T A K E A W A Y S  

• Most  companies  use  a  normal  costing  system  to  track  product  costs.  Normal  costing  

tracks  actual  direct  material  costs  and  actual  direct  labor  costs  for  each  job  and  charges  

manufacturing  overhead  to  jobs  using  a  predetermined  overhead  rate.  The  

predetermined  overhead  rate  is  calculated  as  follows:  

Predetermined overhead rate=Estimated overhead costsEstimated activity in allocation base  

• A  manufacturing  overhead  account  is  used  to  track  actual  overhead  costs  (debits)  and  applied  

overhead  (credits).  This  account  is  typically  closed  to  cost  of  goods  sold  at  the  end  of  the  period.  
R E V I E W   P R O B L E M   2 . 3  

1. Chan  Company  estimates  that  annual  manufacturing  overhead  costs  will  be  $500,000.  Chan  

allocates  overhead  to  jobs  based  on  machine  hours,  and  it  expects  that  100,000  machine  hours  

will  be  required  for  the  year.  Calculate  the  predetermined  overhead  rate.  

2. Why  might  Chan  Company  use  machine  hours  as  the  overhead  allocation  base?  

3. Chan  Company  received  a  bill  totaling  $3,700  for  machine  parts  used  in  maintaining  factory  

equipment.  The  bill  will  be  paid  next  month.  Make  the  journal  entry  to  record  this  transaction.  

4. Job  153  used  a  total  of  2,000  machine  hours.  Make  the  journal  entry  to  record  manufacturing  

overhead  applied  to  job  153.  What  other  document  will  include  this  amount?  

5. Assume  Chan  Company  incurs  actual  manufacturing  overhead  costs  of  $470,000  and  

applies  overhead  of  $510,000  for  the  year.  Account  balances  are  as  follows:  WIP  

inventory,  $25,000;  finished  goods  inventory,  $25,000;  and  cost  of  goods  sold,  $50,000.  

1. Is  overhead  overapplied  or  underapplied?  Explain  your  answer.  

2. Make  the  journal  entry  to  close  the  manufacturing  overhead  account  assuming  the  

balance  is  immaterial.  

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 3. Make  the  journal  entry  to  close  the  manufacturing  overhead  account  assuming  the  

balance  is  material.  

Solutions  to  Review  Problem  2.3  

1. The  predetermined  overhead  rate  is  calculated  as  follows:  

Predetermined overhead rate=Estimated overhead costsEstimated activity in allocation base=$500,000 estimated

overhead costs100,000 machine hours= $5 per machine hour  

2. If  Chan’s  production  process  is  highly  mechanized,  overhead  costs  are  likely  driven  by  

machine  use.  The  more  machine  hours  used,  the  higher  the  overhead  costs  incurred.  

Thus  there  is  a  link  between  machine  hours  and  overhead  costs,  and  using  machine  

hours  as  an  allocation  base  is  preferable.  

Machine  hours  are  also  easily  tracked,  making  implementation  relatively  simple.  

3.    

4. A  total  of  $10,000  (=  $5  per  machine  hour  rate  ×  2,000  machine  hours)  will  be  applied  

to  job  153  and  recorded  in  the  journal  as  follows:  

This  amount  will  also  be  recorded  on  the  job  cost  sheet  for  Job  153.  

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 5.    

1. Overhead  is  overapplied  because  actual  overhead  costs  are  lower  than  overhead  

applied  to  jobs.  Also,  the  manufacturing  overhead  account  has  a  credit  balance.  

2.    

3.    

*Amounts  are  calculated  as  follows.  Allocation  amount  =  percent  of  total  ×  the  overapplied  

balance  of  $40,000.  

2.4 Job Costing in Service Organizations

L E A R N I N G   O B J E C T I V E  

1. Apply  job  costing  methods  to  service  organizations.  

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 Question: Although this chapter has focused on job costing in a manufacturing setting, many
service organizations use job costing as well. Electricians, accountants, and auto mechanics are
examples of service providers that use job costing. Electricians track costs by project (e.g., a
new building or a kitchen remodel), accountants track costs by client (e.g., an individual or a
corporation), and auto mechanics track costs by job (e.g., replacing a drive belt on a company
truck). How does job costing work in a service company setting?

Answer: Job costing in service organizations is the same as in manufacturing organizations,

except that service organizations tend to use fewer materials. There are also minor differences in
the accounts that these types of organizations use, as shown in Table 2.2 "Accounts Used in
Service Organizations and Manufacturing Organizations".

Table 2.2 Accounts Used in Service Organizations and Manufacturing Organizations

Manufacturing Organization Account Service Organization Account
Name Name Financial Statement

Raw materials inventory Parts inventory or supplies Balance sheet (asset)

Work-in-process inventory Work in process* Balance sheet (asset)

Finished goods (Not applicable) Balance sheet (asset)

Cost of services (or other expense Income statement

Cost of goods sold accounts) (expense)

Manufacturing overhead Overhead (or service overhead) None (clearing account)

*Some service companies do not use a work-in-process account but instead simply charge costs
directly to expense accounts.

Service organizations use a job cost sheet like the one discussed earlier to track direct materials,
direct labor, and overhead.
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 Direct Materials

Question: How do service organizations track direct materials using job costing?

Answer: Many service organizations do not track direct materials for each job because the cost
of the materials is negligible. For example, accountants and attorneys use low-cost materials,
such as binders and paper. These materials, often called supplies, are included in overhead rather
than tracked by job.

Some service organizations track direct materials for each job because the cost of the materials is
significant. Consider auto mechanics, who track the parts needed to perform repairs for each job,
or electricians, who track the materials needed to wire a new building. Materials may be
requisitioned from parts inventory or supplies, similar to raw materials inventory in a
manufacturing setting, or may be purchased directly from a supplier, depending on the nature of
the business. The process of recording this information in the journal and job cost sheet is
exactly the same as for a manufacturing company (refer back to Figure 2.3 "Job Cost Sheet for
Custom Furniture Company" for an example).

Direct Labor

Question: How do service organizations track direct labor using job costing?

Answer: Direct labor tends to be the most significant cost for service organizations. The process
of tracking labor using a timesheet and recording labor costs in the journal and job cost sheet is
exactly the same as for a manufacturing company (refer back to Figure 2.4 "Timesheet for
Custom Furniture Company" and Figure 2.5 "Direct Labor Costs for Custom Furniture
Company’s Job 50" for examples).

Overhead

Question: Like manufacturing companies, service organizations often use a predetermined

overhead rate to apply overhead. What allocation bases are most commonly used by service
organizations to apply overhead costs to jobs?
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 Answer: Because overhead is typically driven by direct labor hours in a service organization,
direct labor hours or direct labor cost is the most common allocation base. Again, the process of
recording this information in the journal and job cost sheet is exactly the same as for a
manufacturing company (refer back to Figure 2.6 "Overhead Applied for Custom Furniture
Company’s Job 50" for an example).

Business  in  Action  2.2  

Job Costing at Movie Studios
Studios that produce costly movies, such as 20th Century Fox,Universal Studios,
and Warner Brothers, incur a variety of costs that are tracked using a job costing system.
For example, the production of a Harry Potter movie requires direct labor in the form of
actors, directors, editors, and the film crew. The direct materials category includes
costumes, extensive sets, and props. Overhead costs include items such as depreciation of
film production equipment, utilities in the editing studio, and executive salaries for those
overseeing the production of several films concurrently.
Determining the production costs of movies and related profitability is important for this
industry since actors, directors, and others involved in the film are often compensated based
on a percentage of profits. Disagreements sometimes arise between studios and actors
regarding the accuracy of costs for movies, particularly in the area of overhead. Some
studios have been accused of allocating too much overhead to individual films to drive down
the reported profitability of each film, thereby reducing the amount owed to those receiving
a portion of the profits.
K E Y   T A K E A W A Y  

• Job  costing  systems  in  service  organizations  are  similar  to  those  used  by  manufacturing  

companies.  However,  service  organizations  use  fewer  materials  than  manufacturing  

organizations,  the  account  names  they  use  are  slightly  different,  and  they  often  track  costs  by  

customer  rather  than  by  product.  

R E V I E W   P R O B L E M   2 . 4  
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 Describe  the  similarities  and  differences  in  how  service  companies  and  manufacturing  
companies  account  for  direct  materials,  direct  labor,  and  overhead.  

Solutions  to  Review  Problem  2.4  

The  similarities  and  differences  in  how  service  companies  and  manufacturing  companies  
account  for  direct  materials,  direct  labor,  and  overhead  are  as  follows:  
• Direct  materials.  The  cost  of  direct  materials  for  many  service  companies,  such  as  accounting  

and  law  firms,  is  insignificant.  These  companies  therefore  do  not  track  direct  materials  for  each  

job.  However,  service  companies  that  use  costly  materials,  such  as  an  auto  repair  shop,  do  track  

direct  materials  for  each  job.  Because  direct  materials  tend  to  be  costly  for  manufacturing  firms,  

these  firms  typically  track  direct  materials  for  each  job.  

• Direct  labor.  Because  direct  labor  tends  to  be  the  most  significant  cost  for  service  companies,  

these  companies  track  costs  by  job  using  a  timesheet  and  job  cost  sheet,  just  as  manufacturing  

companies  do.  

• Overhead.  Service  and  manufacturing  firms  track  overhead  costs  in  a  similar  way.  Both  often  

use  a  predetermined  overhead  rate  to  charge  overhead  costs  to  jobs.  Because  overhead  is  

typically  driven  by  direct  labor  hours  in  a  service  company,  direct  labor  hours  are  often  used  as  

the  allocation  base.  The  process  of  recording  overhead  costs  in  the  journal  and  job  cost  sheet  is  

the  same  for  both  types  of  firms.  

2.5 Chapter Wrap-Up: Summary of Cost Flows at Custom Furniture Company

L E A R N I N G   O B J E C T I V E  

1. Use  a  job  costing  system  to  track  costs  and  evaluate  profitability  for  each  job.  

Question: The goal of this section is to pull it all together for Custom Furniture Company. We
begin by looking at revenue and cost information for May, including manufacturing and
nonmanufacturing costs. Why is it important for companies like Custom Furniture Company to

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 correctly classify and record costs such as direct materials (e.g., wood used for each table),
salaries of administrative personnel, and rent on the factory?

Answer: Companies must be able to evaluate the profitability of each job and on a broader scale,
evaluate the overall profitability of the company. This requires that all manufacturing and
nonmanufacturing costs be classified and recorded correctly in the general journal. The
following information shows how to accomplish this with transactions for the month of May at
Custom Furniture Company.

Revenue  and  Cost  Information  for  Custom  Furniture  Company  

Question: How are the typical transactions for a manufacturing company recorded in the
general journal?

Answer: Figure 2.7 "Custom Furniture Company’s Journal Entries for May"shows Custom
Furniture Company’s journal entries for May. Figure 2.8 "Custom Furniture Company’s T-
Accounts" presents the same information in T-account format. (Note that each entry shows the
total dollar amount for the month rather than individual transaction amounts.) If you understand
how to make an entry summarized in total, you know how to make each individual (perhaps
daily) entry. Beginning balances for raw materials inventory ($25,000), work-in-process
inventory ($35,000), and finished goods inventory ($90,000) are shown in the T-accounts
in Figure 2.8 "Custom Furniture Company’s T-Accounts". Although it is not necessary to refer
back to Chapter 1 "What Is Managerial Accounting?" at this point, we should note that the
beginning balance and transaction amounts used here for these three inventory accounts tie back
to the three schedules presented in Chapter 1 "What Is Managerial Accounting?" (schedule of
raw materials placed in production, schedule of cost of goods manufactured, and schedule of cost
of goods sold).

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 Figure 2.7 Custom Furniture Company’s Journal Entries for May

*All debit amounts to work-in-process inventory are also recorded on the appropriate job cost sheets.
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 Figure 2.8 Custom Furniture Company’s T-Accounts

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 *Beginning and ending balances are only provided for inventory accounts since the focus of this chapter is on manufacturing costs

that flow through the inventory accounts.

Question: Now that the information for the month of May has been recorded for Custom
Furniture Company, we need to summarize this information to evaluate the profitability of the
company and the profitability of jobs. How profitable was Custom Furniture for the month of
May?

Answer: Custom Furniture Company’s income statement for the month of May, shown in Figure
2.9 "Custom Furniture Company’s Income Statement", indicates the company had operating
profit of $11,000. This information comes directly from the T-accounts shown in Figure 2.8
"Custom Furniture Company’s T-Accounts".

Figure 2.9 Custom Furniture Company’s Income Statement

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 *See entry 12 in Figure 2.7 "Custom Furniture Company’s Journal Entries for May" and Figure 2.8 "Custom Furniture Company’s

T-Accounts" for this adjustment. This represents the amount of overhead underapplied to jobs and closed out to cost of goods sold

at the end of May. An alternative presentation is to simply show the cost of goods sold amount of $135,000 directly under sales.

Analysis of Job Profitability at Custom Furniture Company

Recall from the beginning of the chapter that Dan Stevens, the owner of Custom Furniture
Company, is concerned about the company’s profitability. Although Dan prices his furniture at
70 percent above estimated production costs, the company had only $11,000 in profits for the
month of May, as shown in Figure 2.9 "Custom Furniture Company’s Income Statement". Dan
asked Leslie (the accountant) to look into the accuracy of his estimates by reviewing actual
production costs for the three costliest tables produced in May. As you read Leslie’s comments,
be sure to look at the income statement in Figure 2.9 "Custom Furniture Company’s Income
Statement" and the job cost estimates and actual results in Figure 2.10 "Job Cost Estimates
Versus Actual Results for Custom Furniture Company".

Figure 2.10 Job Cost Estimates Versus Actual Results for Custom Furniture Company

a Product costs are from the job cost sheet, and the sales price is based on the original bid.

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 b Based on 70 percent markup of estimated total production costs. For example, job 40’s sales price of $18,360 = $10,800 × 170

percent.

c Equals gross profit divided by total production costs. Company target is 70 percent.

d Rounded.
Leslie: Dan, I have the production cost information you requested.

Dan: Great! What did you find out?

Well, first I looked at the income statement for May. If you establish prices based on a 70 percent markup of production costs, then sales
Leslie: revenue should be 170 percent of cost of goods sold, and the resulting gross profit should be 70 percent of cost of goods sold.

Dan: Sounds reasonable. Are we anywhere near these numbers?

Not really. Cost of goods sold for May total $135,000, so sales should be closer to $229,500 (that would be $135,000 times 170 percent), and
gross profit should be closer to $94,500, which is $135,000 times 70 percent. As you can see on the income statement, we didn’t get very close
Leslie: to these numbers.

Dan: Do you have any idea why?

Leslie: I pulled together production cost information from our job costing system for the three highest-cost tables produced in May as you requested.

Dan: And?

I compared the job cost sheet information for each item with your original estimates, and here’s what I found. It looks as if the problem is with
direct materials. All three jobs show that direct material costs were significantly higher than you estimated. Direct labor and manufacturing
Leslie: overhead costs were pretty close.

Wow, I’m surprised that direct material costs were so high. I’ll have to check into this further. I do recall wood costs increasing over the last
Dan: couple of months, but not to this extent.

There are lots of potential causes for the increase in direct materials. Perhaps materials were wasted as a result of machine problems or
Leslie: because of inexperienced employees.

Dan: Let’s try to nail down why my estimates are so far off so I can do a better job of estimating costs in the future.

Leslie: Good idea—I’ll look into the direct materials costs and get back to you later this week.

Question: Figure 2.10 "Job Cost Estimates Versus Actual Results for Custom Furniture
Company" provides an in depth view of the costs associated with each job and the resulting
profitability. How does this information help Custom Furniture Company plan for the future?

Answer: This information helps managers assess the profitability of individual jobs. Custom
Furniture Company was able to identify areas of concern by comparing information from job
cost sheets with Dan’s estimates. Dan and Leslie will have to do more research to find the cause
of the high material costs. If changes cannot be made to the production process to reduce these
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 costs, Dan may have to consider revising his estimates and raising prices on future jobs. The goal
is to provide enough information for the company to make informed decisions about areas of
concern, such as direct materials costs, and how much to charge for future jobs.

K E Y   T A K E A W A Y S  

• Job  costing  systems  can  do  more  than  simply  track  the  costs  of  each  job.  Companies  also  use  these  systems  to  track  revenue  and  the  resulting  

profit  for  each  job.  

• A  job  costing  system  can  be  used  to  identify  areas  of  concern  by  comparing  the  cost  estimate  prepared  before  starting  the  job  with  information  

on  the  completed  job  cost  sheet.  This  type  of  analysis  often  leads  to  changes  in  the  production  process  and  revised  estimates  for  future  jobs.  
R E V I E W   P R O B L E M   2 . 5  

Farm  Equipment,  Inc.,  produces  tractors  and  other  farm  machinery.  Each  piece  of  equipment  is  built  to  customer  specifications.  During  

May,  its  first  month  of  operations,  Farm  Equipment,  Inc.,  began  working  on  three  customer  orders:  jobs  1,  2,  and  3.  The  following  

transactions  occurred  during  May:  

1. Purchased  production  materials  on  account  totaling  $450,000  

2. Processed  material  requisitions  for  the  following  items:  

3. Processed  timesheets  showing  the  following:  

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4. Applied  overhead  using  a  predetermined  rate  of  160  percent  of  direct  labor  cost  

5. Completed  job  1  and  transferred  it  to  finished  goods  

6. Delivered  job  1  to  the  customer  and  billed  her  $140,000.  (Hint:  Two  entries  are  required—one  for  the  cost  of  the  goods  and  another  for  the  

revenue.)  

Required:  

a. Calculate  the  production  costs  incurred  in  May  for  each  of  the  three  jobs.  

b. Make  the  appropriate  journal  entry  for  each  item  described  previously.  Assume  all  payments  will  be  made  next  month.  (Hint:  UseFigure  2.7  

"Custom  Furniture  Company’s  Journal  Entries  for  May"  as  a  guide.)  

c. How  much  gross  profit  did  Farm  Equipment,  Inc.,  earn  from  the  sale  of  job  1?  

d. Assuming  selling  costs  totaled  $4,000  and  general  and  administrative  costs  totaled  $11,000  in  May,  prepare  an  income  statement  for  Farm  

Equipment,  Inc.,  for  the  month.  (Assume  there  is  no  adjustment  to  cost  of  goods  sold  for  underapplied  or  overapplied  overhead.)  

Solutions  to  Review  Problem  2.5  

a.    

b.    

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*$161,200  comes  from  the  total  for  direct  materials  in  part  a.  

*$33,100  comes  from  the  total  for  direct  labor  in  part  a.  

*$52,960  comes  from  the  total  for  manufacturing  overhead  in  part  a.  

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c. Farm  Equipment,  Inc.,  made  $23,920  in  gross  profit  from  the  sale  of  job  1  ($23,920  =  $140,000  revenue  –  $116,080  cost).  

d.    

E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  

1. Describe  the  characteristics  of  companies  likely  to  use  a  job  costing  system.  Explain  how  these  characteristics  differ  from  companies  likely  to  use  

a  process  costing  system.  

2. What  information  is  included  on  the  materials  requisition  form?  

3. What  is  the  purpose  of  a  job  cost  sheet?  Describe  the  information  typically  included  on  a  job  cost  sheet.  

4. What  information  is  included  on  a  timesheet?  

5. What  is  the  purpose  of  using  a  predetermined  overhead  rate?  

6. Review  Note  2.23  "Business  in  Action  2.1"  Explain  why  Boeing  likely  uses  a  job  costing  system.  How  does  the  information  that  comes  from  a  job  

costing  system  help  Boeing  make  better  decisions?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 7. What  is  a  normal  costing  system,  and  why  do  companies  tend  to  use  a  normal  costing  system  to  apply  overhead  to  jobs  rather  than  using  actual  

overhead  costs?  

8. Describe  the  two  important  factors  in  selecting  an  overhead  allocation  base.  

9. What  cost  information  is  recorded  on  the  debit  side  of  the  manufacturing  overhead  account,  and  what  information  is  recorded  on  the  credit  

side?  

10. When  is  manufacturing  overhead  underapplied?  When  is  it  overapplied?  

11. What  two  options  are  available  when  closing  the  manufacturing  overhead  account  at  the  end  of  the  period,  depending  on  the  significance  of  the  

balance?  

12. How  might  a  job  costing  system  used  by  a  service  organization  differ  from  a  job  costing  system  used  by  a  manufacturing  organization?  

13. Review  Note  2.27  "Business  in  Action  2.2"  Why  is  it  important  for  movie  studios  to  have  accurate  costs  for  each  movie  produced?  

14. How  does  a  job  costing  system  help  a  company  evaluate  the  profitability  of  jobs?  

Brief  Exercises  

15. Product  Costs  at  Custom  Furniture  Company.  Refer  to  the  dialogue  between  Dan  and  Leslie  at  Custom  Furniture  Company  that  appears  at  the  

beginning  of  the  chapter.  What  is  Dan  concerned  about,  and  how  did  Leslie  propose  to  help?  

16. Job  Costing  Versus  Process  Costing.  Indicate  whether  each  of  the  firms  listed  in  the  following  would  use  job  costing  or  process  costing.  

1. Oil  refinery  

2. Builder  of  pools  

3. Cereal  producer  

4. Legal  firm  

5. Upholstery  repair  shop  

6. Sport  drink  producer  

7. Toner  cartridge  producer  

8. Landscape  design  firm  

17. Job  Costing  Versus  Process  Costing.  Indicate  whether  each  of  the  firms  listed  in  the  following  would  use  job  costing  or  process  costing.  

1. Custom  home  builder  

2. Dairy  farm  

3. Surgical  unit  of  hospital  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 4. Candy  bar  producer  

5. Auto  body  repair  shop  

6. Producer  of  basketballs  

7. Producer  of  T-­‐shirts  

8. Plumber  

18. Recording  Purchase  and  Transfer  of  Raw  Materials  in  T-­‐Accounts.The  following  transactions  occurred  during  the  month  of  October:  
October 5 Raw materials totaling $15,000 were purchased on account.

October 8 Direct materials totaling $6,000 were placed in production.

October 10 Indirect materials totaling $1,000 were placed in production.

19. Required:  

a. Set  up  T-­‐accounts  for  raw  materials  inventory,  work-­‐in-­‐process  inventory,  manufacturing  overhead,  and  accounts  payable.  

b. Use  the  T-­‐accounts  established  in  part  a  to  record  the  transactions  for  October.  

Calculating  Predetermined  Overhead  Rate.  Manufacturing  overhead  costs  totaling  $1,000,000  are  expected  for  this  coming  year.  The  

company  also  expects  to  use  20,000  in  direct  labor  hours.  Calculate  the  predetermined  overhead  rate  and  provide  a  one-­‐sentence  description  of  

how  the  rate  will  be  used  in  a  job  costing  system.  

Service  Organization  Accounts.  Provide  the  account  name  commonly  used  by  service  companies  for  each  of  the  following  accounts  

used  in  a  manufacturing  environment.  

0. Raw  materials  inventory  

1. Work-­‐in-­‐process  inventory  

2. Finished  goods  inventory  

3. Cost  of  goods  sold  

4. Manufacturing  overhead  

Evaluating  Profitability  of  Jobs.  Refer  to  the  job  cost  information  inFigure  2.10  "Job  Cost  Estimates  Versus  Actual  Results  for  Custom  

Furniture  Company".  Why  is  Custom  Furniture  Company  comparing  estimated  product  costs  to  actual  product  costs  for  each  of  the  three  jobs?  

Briefly  summarize  the  results  of  this  comparison.  

Exercises:  Set  A  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 22. Raw  Materials  Inventory  Journal  Entries.  The  balance  in  Sedona  Company’s  raw  materials  inventory  account  was  $110,000  at  the  

beginning  of  September.  Raw  materials  purchased  during  the  month  totaled  $50,000.  Sedona  used  $17,000  in  direct  materials  and  

$8,000  in  indirect  materials  for  the  month.  

Required:  

a. Prepare  separate  journal  entries  to  record  the  following  items:  

1. Raw  materials  purchased  for  the  month,  assuming  all  purchases  were  on  account  

2. The  transfer  of  direct  materials  into  production  

3. The  transfer  of  indirect  materials  into  production  

b. Prepare  a  T-­‐account  for  raw  materials  inventory  and  include  the  beginning  balance  for  September.  Post  the  appropriate  items  from  

the  journal  entries  in  part  a  to  this  account,  and  calculate  the  ending  balance  in  raw  materials  inventory.  

Work-­‐in-­‐Process  Inventory  Journal  Entries.  The  balance  in  Reid  Company’s  work-­‐in-­‐process  inventory  account  was  $300,000  at  the  

beginning  of  March.  Manufacturing  costs  for  the  month  are  as  follows:  
Direct materials $ 40,000

Direct labor $ 70,000

Manufacturing overhead applied $200,000

Cost of goods manufactured $290,000

Required:  

 . Prepare  separate  journal  entries  to  record  the  following  items.  (Hint:  Use  Figure  2.7  "Custom  Furniture  Company’s  

Journal  Entries  for  May"  as  a  guide.)  

1. Direct  materials  placed  in  production  for  the  month  

2. Direct  labor  used  during  the  month,  assuming  employees  will  be  paid  next  month  

3. Manufacturing  overhead  applied  for  the  month  

4. Transfer  of  cost  of  goods  manufactured  to  finished  goods  

a. Prepare  a  T-­‐account  for  Work-­‐in-­‐process  inventory  and  include  the  beginning  balance  for  March.  Post  the  appropriate  items  from  the  

journal  entries  in  part  a  to  this  account,  and  calculate  the  ending  balance  in  work-­‐in-­‐process  inventory.  

Cost  of  Goods  Sold  Journal  Entries.  The  balance  in  Blue  Oak  Company’s  finished  goods  inventory  account  was  $25,000  at  the  

beginning  of  September.  Cost  of  goods  manufactured  for  the  month  totaled  $17,000,  and  cost  of  goods  sold  totaled  $14,000.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     134  
     
 
 Required:  

 . Prepare  separate  journal  entries  to  record  the  following  items.  (Hint:  Use  Figure  2.7  "Custom  Furniture  Company’s  Journal  

Entries  for  May"  as  a  guide.)  

1. Cost  of  goods  manufactured  for  the  month  

2. Cost  of  goods  sold  for  the  month  

a. Prepare  a  T-­‐account  for  finished  goods  inventory  and  include  the  beginning  balance  for  September.  Post  the  appropriate  items  from  

the  journal  entries  in  part  a  to  this  account,  and  calculate  the  ending  balance  in  finished  goods  inventory.  

Income  Statement  (with  cost  of  goods  sold  adjustment).  Rambler  Company  had  the  following  activity  for  the  year  ended  December  

31.  
Sales revenue $2,050,000

Selling expenses $ 575,000

General and administrative expenses $ 330,000

Cost of goods sold (before adjustment) $ 700,000

Underapplied overhead $ 23,000

Required:  

Prepare  an  income  statement  for  year  ended  December  31.  

Manufacturing  Overhead  Allocation  Base  and  Calculating  the  Cost  of  Jobs.  Pyramid  Company  expects  to  incur  $3,000,000  in  

manufacturing  overhead  costs  this  year.  During  the  year,  it  expects  to  use  40,000  direct  labor  hours  at  a  cost  of  $600,000  and  80,000  

machine  hours.  

Required:  

 . Prepare  a  predetermined  overhead  rate  based  on  direct  labor  hours,  direct  labor  cost,  and  machine  hours.  

a. Why  might  Pyramid  Company  prefer  to  use  machine  hours  to  allocate  manufacturing  overhead?  

b. Using  each  of  the  predetermined  overhead  rates  calculated  in  part  a  and  the  data  that  follows  for  job  128,  determine  the  cost  of  job  

128.  
Direct materials $6,000

Direct labor $4,000 (200 hours at $15 per hour) + (100 hours at $10 per hour)

Machine time 700 hours

Exercises:  Set  B  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 27. Raw  Materials  Inventory  Journal  Entries.  The  balance  in  Clay  Company’s  raw  materials  inventory  account  was  $45,000  at  the  beginning  

of  April.  Raw  materials  purchased  during  the  month  totaled  $55,000.  Clay  used  $48,000  in  direct  materials  and  $14,000  in  indirect  

materials  for  the  month.  

Required:  

a. Prepare  separate  journal  entries  to  record  the  following  items:  

1. Raw  materials  purchased  for  the  month,  assuming  all  purchases  were  on  account  

2. The  transfer  of  direct  materials  into  production  

3. The  transfer  of  indirect  materials  into  production  

b. Prepare  a  T-­‐account  for  raw  materials  inventory  and  include  the  beginning  balance  for  April.  Post  the  appropriate  items  from  the  

journal  entries  in  part  a  to  this  account,  and  calculate  the  ending  balance  in  raw  materials  inventory.  

Work-­‐in-­‐Process  Inventory  Journal  Entries.  The  balance  in  the  work-­‐in-­‐process  inventory  account  of  Verdi  Production,  Inc.,  was  

$900,000  at  the  beginning  of  May.  Manufacturing  costs  for  the  month  are  as  follows:  
Direct materials $ 340,000

Direct labor $ 810,000

Manufacturing overhead applied $ 660,000

Cost of goods manufactured $1,960,000

Required:  

 . Prepare  separate  journal  entries  to  record  the  following  items.  (Hint:  Use  Figure  2.7  "Custom  Furniture  Company’s  Journal  

Entries  for  May"  as  a  guide.)  

1. Direct  materials  placed  in  production  for  the  month  

2. Direct  labor  used  during  the  month,  assuming  employees  will  be  paid  next  month  

3. Manufacturing  overhead  applied  for  the  month  

4. Transfer  of  cost  of  goods  manufactured  to  finished  goods  

a. Prepare  a  T-­‐account  for  work-­‐in-­‐process  inventory  and  include  the  beginning  balance  for  May.  Post  the  appropriate  items  from  the  

journal  entries  in  part  a  to  this  account,  and  calculate  the  ending  balance  in  work-­‐in-­‐process  inventory.  

Cost  of  Goods  Sold  Journal  Entries.  The  balance  in  Posada  Company’s  finished  goods  inventory  account  was  $650,000  at  the  

beginning  of  March.  Cost  of  goods  manufactured  for  the  month  totaled  $445,000,  and  cost  of  goods  sold  totaled  $470,000.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     136  
     
 
 Required:  

 . Prepare  separate  journal  entries  to  record  the  following  items.  (Hint:  Use  Figure  2.7  "Custom  Furniture  Company’s  Journal  

Entries  for  May"  as  a  guide.)  

1. Cost  of  goods  manufactured  for  the  month  

2. Cost  of  goods  sold  for  the  month  

a. Prepare  a  T-­‐account  for  finished  goods  inventory  and  include  the  beginning  balance  for  March.  Post  the  appropriate  items  from  the  

journal  entries  in  part  b  to  this  account,  and  calculate  the  ending  balance  in  finished  goods  inventory.  

Income  Statement  (with  cost  of  goods  sold  adjustment).  Statton  Company  had  the  following  activity  for  the  year  ended  December  

31.  
Sales revenue $4,000,000

Selling expenses $ 825,000

General and administrative expenses $ 470,000

Cost of goods sold (before adjustment) $1,900,000

Overapplied overhead $ 109,000

Required:  

Prepare  an  income  statement  for  year  ended  December  31.  

Manufacturing  Overhead  Allocation  Base  and  Calculating  the  Cost  of  Jobs.  Elko  Company  expects  to  incur  $800,000  in  

manufacturing  overhead  costs  this  year.  During  the  year,  it  expects  to  use  10,000  direct  labor  hours  at  a  cost  of  $200,000  and  4,000  

machine  hours.  

Required:  

 . Prepare  a  predetermined  overhead  rate  based  on  direct  labor  hours,  direct  labor  cost,  and  machine  hours.  

a. Why  might  Elko  Company  prefer  to  use  direct  labor  hours  or  direct  labor  costs,  rather  than  machine  hours,  to  allocate  manufacturing  

overhead?  

b. Using  each  of  the  predetermined  overhead  rates  for  Elko  Company  calculated  in  part  a  and  the  data  that  follows  for  job  15B,  determine  

the  cost  of  job  15B.  

Direct materials $1,750

Direct labor $860 (30 hours at $12 per hour) + (50 hours at $10 per hour)

Machine time 20 hours

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Problems  

32. Actual  and  Applied  Manufacturing  Overhead.  Marine  Products,  Inc.,  incurred  the  following  actual  overhead  costs  for  the  month  of  

June.  
Indirect materials $20,000

Indirect labor $18,000

Rent $ 3,000

Equipment depreciation $ 6,500

33. Overhead  is  applied  based  on  a  predetermined  rate  of  $12  per  machine  hour,  and  5,100  machine  hours  were  used  during  June.  

34. Required:  

a. Prepare  a  journal  entry  to  record  actual  overhead  costs  for  June.  Assume  that  labor  costs  will  be  paid  next  month  and  that  rent  was  

prepaid.  

b. Prepare  a  journal  entry  to  record  manufacturing  overhead  applied  to  jobs  during  June.  

c. Create  a  T-­‐account  for  manufacturing  overhead,  post  the  appropriate  information  from  parts  a  and  b  to  this  account,  and  calculate  the  

ending  balance.  

d. Is  manufacturing  overhead  overapplied  or  underapplied?  Using  the  balance  in  the  manufacturing  overhead  account  calculated  in  part  c,  

prepare  the  journal  entry  to  close  manufacturing  overhead  to  cost  of  goods  sold.  

Actual  and  Applied  Manufacturing  Overhead.  Quincy  Company  incurred  the  following  actual  overhead  costs  for  the  month  of  

February.  
Indirect materials $335,000

Indirect labor $275,000

Factory depreciation $ 18,000

Factory utilities $ 9,500

Overhead  is  applied  based  on  a  predetermined  rate  of  $2  per  direct  labor  dollar  (200  percent  of  direct  labor  cost),  and  direct  labor  

costs  were  $300,000  for  the  month.  

Required:  

 . Prepare  a  journal  entry  to  record  actual  overhead  costs  for  February.  Assume  indirect  labor  costs  and  utilities  will  be  paid  next  

month.  

a. Prepare  a  journal  entry  to  record  manufacturing  overhead  applied  to  jobs  during  February.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     138  
     
 
 b. Create  a  T-­‐account  for  manufacturing  overhead,  post  the  appropriate  information  from  parts  a  and  b  to  this  account,  and  calculate  the  

ending  balance.  

c. Is  manufacturing  overhead  overapplied  or  underapplied?  Using  the  balance  in  the  manufacturing  overhead  account  calculated  in  part  c,  

prepare  the  journal  entry  to  close  manufacturing  overhead  to  cost  of  goods  sold.  

Calculating  the  Cost  of  Jobs,  Making  Journal  Entries,  and  Preparing  an  Income  Statement.  Racing  Bikes,  Inc.,  produces  custom  

bicycles  for  professional  racers.  Each  bike  is  built  to  customer  specifications.  During  July,  its  first  month  of  operations,  Racing  Bikes  

began  production  of  four  customer  orders—jobs  1  through  4.  The  following  transactions  occurred  during  July.  

0. Purchased  bike  parts  totaling  $14,400  

1. Processed  material  requisitions  for  the  following  items:  

2. Processed  timesheets  showing  the  following:  

3. Applied  overhead  using  a  predetermined  rate  of  $30  per  direct  labor  hour  

4. Completed  and  transferred  to  finished  goods  jobs  1,  2,  and  3  

5. Delivered  jobs  1  and  2  to  customers,  billing  them  $6,000  for  job  1  and  $3,500  for  job  2  (Hint:  Two  entries  are  required—one  for  the  cost  

of  the  goods  and  another  for  the  revenue.)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Required:  

f. Calculate  the  production  costs  incurred  in  July  for  each  of  the  four  jobs.  

g. Make  the  appropriate  journal  entry  for  each  transaction  described  previously  (1  through  6).  Assume  all  payments  will  be  made  next  

month.  (Hint:  Use  Figure  2.7  "Custom  Furniture  Company’s  Journal  Entries  for  May"  as  a  guide.)  

h. How  much  gross  profit  did  Racing  Bikes,  Inc.,  earn  from  the  sale  of  job  2?  

i. Assume  selling  costs  totaled  $1,000  and  that  general  and  administrative  costs  totaled  $2,200.  Prepare  an  income  statement  for  Racing  

Bikes  for  the  month  of  July.  (Assume  there  is  no  adjustment  to  cost  of  goods  sold  for  underapplied  or  overapplied  overhead.)  

Calculating  the  Cost  of  Jobs,  Making  Journal  Entries,  and  Preparing  an  Income  Statement.  Classic  Boats,  Inc.,  produces  custom  

wood  boats.  Each  boat  is  built  to  customer  specifications.  During  April,  its  first  month  of  operations,  Classic  Boats  began  production  of  

three  customer  orders—jobs  1  through  3.  The  following  transactions  occurred  during  April.  

0. Purchased  production  materials  totaling  $225,000  

1. Processed  material  requisitions  for  the  following  items:  

2. Processed  timesheets  showing  the  following:  

3. Applied  overhead  using  a  predetermined  rate  of  160  percent  of  direct  labor  cost  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 4. Completed  job  1  and  transferred  it  to  finished  goods  

5. Delivered  job  1  to  the  customer  and  billed  her  $70,000.  (Hint:  Two  entries  are  required—one  for  the  cost  of  the  goods  and  another  for  

the  revenue.)  

Required:  

f. Calculate  the  production  costs  incurred  in  April  for  each  of  the  three  jobs.  

g. Make  the  appropriate  journal  entry  for  each  of  the  six  transactions  described  previously.  Assume  all  payments  will  be  made  next  month.  

(Hint:  Use  Figure  2.7  "Custom  Furniture  Company’s  Journal  Entries  for  May"  as  a  guide.)  

h. How  much  gross  profit  did  Classic  Boats  earn  from  the  sale  of  job  1?  

i. Assume  selling  costs  totaled  $2,000  and  general  and  administrative  costs  totaled  $5,500.  Prepare  an  income  statement  for  Classic  Boats  

for  the  month  of  April.  (Assume  there  is  no  adjustment  to  cost  of  goods  sold  for  underapplied  or  overapplied  overhead.)  

Calculating  the  Cost  of  Jobs  and  Making  Journal  Entries  for  a  Service  Company.  Sampson  &  Associates  provides  accounting  

services.  It  began  jobs  1  through  3  in  the  first  week  of  January.  The  following  transactions  occurred  that  week.  

0. Purchased  supplies  on  account  totaling  $1,500  

1. Used  supplies  totaling  $800  for  various  jobs  

2. Processed  timesheets  showing  the  following:  

3. Applied  overhead  using  a  predetermined  rate  of  $10  per  direct  labor  hour.  

4. Completed  job  1  and  billed  the  customer  $3,000.  (Hint:  Two  entries  are  required—one  for  the  cost  of  services  and  another  for  revenue.)  

Required:  

e. Calculate  the  costs  incurred  in  January  for  each  of  the  three  jobs.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     141  
     
 
 f. Make  the  appropriate  journal  entry  for  each  item  described  previously.  Assume  all  payments  will  be  made  next  month.  (Hint:  Use  Figure  

2.7  "Custom  Furniture  Company’s  Journal  Entries  for  May"  as  a  guide.)  

g. How  much  gross  profit  did  Sampson  &  Associates  earn  from  job  1?  

Calculating  the  Cost  of  Jobs  and  Making  Journal  Entries  for  a  Service  Company.  Management  Consulting,  Inc.,  provides  consulting  

services  and  began  operations  on  September  1.  It  began  jobs  1  through  4  during  the  first  half  of  September.  The  following  transactions  

occurred  during  that  time.  

0. Purchased  supplies  on  account  totaling  $6,000  

1. Used  supplies  totaling  $3,200  for  various  jobs  

2. Processed  timesheets  showing  the  following:  

3. Applied  overhead  using  a  predetermined  rate  of  120  percent  of  direct  labor  cost  

4. Completed  jobs  1  and  2  and  billed  the  customers  $20,000  and  $21,000,  respectively.  (Hint:  Two  entries  are  required—one  for  the  cost  of  

services  and  another  for  revenue.)  

Required:  

e. Calculate  the  costs  incurred  in  September  for  each  of  the  four  jobs.  

f. Make  the  appropriate  journal  entry  for  each  item  described  previously.  Assume  all  payments  will  be  made  next  month.  (Hint:  Use  Figure  

2.7  "Custom  Furniture  Company’s  Journal  Entries  for  May"  as  a  guide.)  

g. How  much  gross  profit  did  Management  Consulting,  Inc.,  earn  from  job  1  and  job  2?  

h. What  is  the  amount  in  work  in  process  at  the  end  of  the  first  half  of  September?  

Closing  Manufacturing  Overhead:  Two  Approaches.  Olympia  Company  incurred  actual  manufacturing  overhead  costs  of  $630,000  

during  the  year  ended  December  31,  2012.  A  total  of  $570,000  in  overhead  was  applied  to  jobs.  At  December  31,  2012,  work-­‐in-­‐process  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     142  
     
 
 inventory  totals  $200,000,  and  finished  goods  inventory  totals  $400,000.  Cost  of  goods  sold  before  adjustments  totals  $1,400,000  for  

the  year.  

Required:  

 . Is  overhead  underapplied  or  overapplied?  

a. Close  the  manufacturing  overhead  account,  assuming  the  balance  is  immaterial.  

b. Close  the  manufacturing  overhead  account,  assuming  the  amount  is  material.  

Closing  Manufacturing  Overhead:  Two  Approaches.  Placer  Company  incurred  actual  manufacturing  overhead  costs  of  $260,000  

during  the  year  ended  December  31,  2012.  A  total  of  $350,000  in  overhead  was  applied  to  jobs.  At  December  31,  2012,  work-­‐in-­‐process  

inventory  totals  $100,000,  and  finished  goods  inventory  totals  $300,000.  Cost  of  goods  sold  before  adjustments  totals  $600,000  for  the  

year.  

Required:  

 . Is  overhead  underapplied  or  overapplied?  

a. Close  the  manufacturing  overhead  account,  assuming  the  balance  is  immaterial.  

b. Close  the  manufacturing  overhead  account,  assuming  the  amount  is  material.  

One  Step  Further:  Skill-­‐Building  Cases  

40. Ethics:  Shifting  Hours  Using  Job  Costing.  Shawney  Accountancy  Corporation  provides  accounting  services.  It  uses  a  job  costing  system  to  

track  each  client’s  revenues  and  costs.  The  firm  is  currently  working  on  two  jobs.  The  first  job,  preparing  tax  returns  for  Bantem  

Corporation,  was  bid  at  $25,000  and  had  budgeted  costs  of  $18,000.  The  second  job,  performing  a  review  of  internal  controls  for  

Maxum  Company,  was  bid  at  50  percent  above  actual  costs.  The  following  conversation  took  place  between  Kelly  (a  manager)  and  Ron  

(senior  staff  working  for  Kelly).  

Ron, I just reviewed timesheets for the two jobs we’re working on, and it appears we are quickly approaching the budget of $18,000 for the Bantem
Kelly: job.

Ron: Yes, we’re having trouble completing the Bantem job in the hours budgeted.

Kelly: This is the first year on the Bantem job, and budgeting for first-year clients is always difficult.

Ron: I’m sure we can retain this job next year with a little bump in the bid—perhaps to $29,000.

That’s fine for next year, but I have to answer to my boss for this year’s results. Why don’t we take some of the pressure off by charging some time
from the Bantem job to the internal control project we have with Maxum Company? We’re under budget with the Maxum job, and they are paying us
Kelly: based on actual costs plus a 50 percent markup.

Ron: Can we do that?

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     143  
     
 
 Kelly: We don’t do it often, but in cases like this, we have to get creative.

41. Required:  

a. Why  is  there  an  incentive  to  inflate  the  hours  charged  to  the  Maxum  job?  

b. What  should  Ron  do?  (You  may  want  to  refer  to  the  IMA’s  ethical  standards  discussed  in  Chapter  1  "What  Is  Managerial  Accounting?".)  

Internet  Project:  Automation  and  Overhead  Allocation.  Over  the  past  several  decades,  manufacturing  companies  have  tended  to  

move  away  from  direct  labor  and  more  toward  automation  (i.e.,  using  machinery  rather  than  people  to  produce  products).  

Required:  

 . Use  the  Internet  to  find  several  examples  of  companies  that  have  made  the  shift  toward  an  automated  production  environment.  

Write  a  one-­‐page  summary  of  your  findings,  and  include  specific  information  indicating  what  type  of  automation  is  being  used.  

a. How  might  this  shift  to  automation  affect  the  allocation  base  used  to  allocate  overhead  to  products?  

Group  Project:  Labor  Costs  at  General  Motors  and  Toyota.  BothGeneral  Motors  (GM)  and  Toyota  have  production  facilities  in  

Texas.  GM’s  plant  was  built  in  1956  on  a  249-­‐acre  site  and  has  since  undergone  billions  of  dollars  in  renovations.  Toyota’splant  was  built  

in  2006  on  2,000  acres.  Each  plant  has  a  production  capacity  of  200,000  vehicles  per  year.  GM  averages  close  to  22  assembly  labor  hours  

per  vehicle  (no  data  on  labor  hours  per  vehicle  are  available  for  Toyota).  The  labor  cost  per  vehicle  is  $1,800  for  GM,  which  uses  a  

unionized  labor  force,  and  $800  for  Toyota,  which  uses  nonunion  labor.  (Based  on  Lee  Hawkins  Jr.  and  Norihiko  Shirouzu,  “A  Tale  of  Two  

Auto  Plants,”  Wall  Street  Journal,  May  24,  2006.)  

Required:   Form  groups  of  two  to  four  students  and  respond  to  the  following  items:  

 . Provide  at  least  two  reasons  for  the  significant  difference  in  assembly  labor  cost  per  vehicle  for  GM  and  Toyota.  

a. What  other  production  costs  should  be  considered  in  evaluating  the  efficiency  of  each  plant?  

Comprehensive  Cases  

43. Journal  Entries,  Closing  Manufacturing  Overhead,  and  Preparing  an  Income  Statement.  Benning,  Inc.,  is  a  defense  contractor  that  uses  

job  costing.  Because  the  firm  uses  a  perpetual  inventory  system,  the  three  supporting  schedules  to  the  income  statement  (the  schedule  

of  raw  materials  placed  in  production,  the  schedule  of  cost  of  goods  manufactured,  and  the  schedule  of  cost  of  goods  sold)  

are  not  necessary.  Inventory  account  beginning  balances  at  January  1,  2012,  are  listed  as  follows.  
Raw materials inventory $ 500,000

Work-in-process inventory $ 700,000

Finished goods inventory $1,800,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     144  
     
 
 44. You  will  be  recording  the  following  transactions,  which  summarize  the  activities  that  occurred  during  the  year  ended  December  31,  

2012:  

1. Raw  materials  were  purchased  for  $300,000  on  account.  

2. Raw  materials  totaling  $420,000  were  placed  in  production,  $60,000  for  indirect  materials  and  $360,000  for  direct  materials.  

3. The  raw  materials  purchased  in  transaction  1  were  paid  for.  

4. A  total  cost  of  $800,000  for  direct  labor,  shown  on  the  timesheets,  was  recorded  as  wages  payable.  

5. Production  supervisors  and  other  indirect  labor  working  in  the  factory  were  owed  $540,000,  recorded  as  wages  payable.  

6. Wages  owed,  totaling  $1,200,000,  were  paid.  (These  wages  were  previously  recorded  correctly  as  wages  payable.)  

7. The  costs  listed  in  the  following  related  to  the  factory  were  incurred  during  the  period.  (Hint:  Record  these  items  in  one  entry  

with  one  debit  to  manufacturing  overhead  and  four  separate  credits):  
Building depreciation $580,000

Insurance (prepaid during 2012, now expired) $220,000

Utilities (on account) $ 80,000

Maintenance (paid cash) $440,000

8. Manufacturing  overhead  was  applied  at  a  rate  of  $20  per  machine  hour,  and  90,000  machine  hours  were  utilized  during  the  year.  (Hint:  

No  need  to  calculate  the  predetermined  overhead  rate  since  it  is  already  given  to  you  here.)  

9. Miscellaneous  selling  costs  totaling  $430,000  were  paid.  These  costs  were  recorded  in  an  account  called  selling  expenses.  

10. Miscellaneous  general  and  administrative  costs  totaling  $265,000  were  paid.  These  costs  were  recorded  in  an  account  called  G&A  

expenses.  

11. Goods  costing  $2,030,000  (per  the  job  cost  sheets)  were  completed  and  transferred  out  of  work-­‐in-­‐process  inventory.  

12. Goods  were  sold  on  account  for  $3,800,000.  

13. The  goods  sold  in  transaction  12  had  a  cost  of  $2,570,000  (per  the  job  cost  sheets).  

14. Payments  totaling  $3,300,000  from  credit  customers  related  to  transaction  12  were  received.  

Required:  

o. Prepare  T-­‐accounts  for  raw  materials  inventory,  work-­‐in-­‐process  inventory,  finished  goods  inventory,  manufacturing  overhead,  and  

cost  of  goods  sold.  Enter  the  beginning  balances  for  the  inventory  accounts.  (Manufacturing  overhead  and  cost  of  goods  sold  are  temporary  

accounts  and  thus  do  not  have  a  beginning  balance.)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     145  
     
 
 p. Prepare  a  journal  entry  for  each  transaction  from  1through  14  in  a  format  like  the  one  in  Figure  2.7  "Custom  Furniture  Company’s  

Journal  Entries  for  May",  and  where  appropriate,  post  each  entry  to  the  T-­‐accounts  set  up  in  requirement  a.  Note  that  these  entries  

reflect  the  flow  of  costs  through  the  inventory  and  cost  of  goods  sold  accounts  for  the  year.  Label  each  entry  in  the  T-­‐accounts  by  

transaction  number,  include  a  short  description  (e.g.,  direct  materials  and  manufacturing  overhead  applied),  and  total  each  T-­‐account.  

q. Based  on  the  balance  in  the  manufacturing  overhead  account  prepared  in  requirement  b,  prepare  a  journal  entry  to  close  the  

manufacturing  overhead  account  to  cost  of  goods  sold.  

r. Prepare  an  income  statement  for  the  year  ended  December  31,  2012.  Remember  to  adjust  cost  of  goods  sold  for  any  underapplied  or  

overapplied  overhead.  

s. Why  is  cost  of  goods  sold  adjusted  upward  on  the  income  statement?  

Journal  Entries,  Closing  Manufacturing  Overhead,  and  Preparing  an  Income  Statement.  Sierra  Nursery  Company  grows  a  variety  of  

plants  and  sells  them  to  local  nurseries.  Raw  materials  consist  of  such  items  as  seeds  and  the  fertilizer  required  to  grow  plants  from  the  

seedling  stage  to  a  viable,  saleable  plant.  Sierra  Nursery  uses  a  job  costing  system  to  track  revenues  and  costs  associated  with  customer  

orders.  Because  the  firm  uses  a  perpetual  inventory  system,  the  three  supporting  schedules  to  the  income  statement  (the  schedule  of  

raw  materials  placed  in  production,  the  schedule  of  cost  of  goods  manufactured,  and  the  schedule  of  cost  of  goods  sold)  

are  not  necessary.  Inventory  account  beginning  balances  at  January  1,  2012,  are  as  follows:  
Raw materials inventory $50,000

Work-in-process inventory $60,000

Finished goods inventory $90,000

You  will  be  recording  the  following  transactions,  which  summarize  the  activities  that  occurred  during  the  year  ended  December  31,  

2012:  

0. Raw  materials  were  purchased  for  $30,000  on  account.  

1. Raw  materials  totaling  $41,000  were  placed  in  production,  $5,000  for  indirect  materials  and  $36,000  for  direct  materials.  

2. The  raw  materials  purchased  in  transaction  1  were  paid  for.  

3. A  total  cost  of  $140,000  for  9,000  hours  of  direct  labor,  shown  on  the  timesheets,  was  recorded  as  wages  payable.  

4. Production  supervisors  and  other  indirect  labor  working  in  the  nursery  were  owed  $134,000,  recorded  as  wages  payable.  

5. Wages  owed  totaling  $180,000  were  paid.  (These  wages  were  previously  recorded  correctly  as  wages  payable.)  

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 6. The  costs  listed  in  the  following  related  to  the  nursery  were  incurred  during  the  period.  (Hint:  Record  these  items  in  one  entry  

with  one  debit  to  manufacturing  overhead  and  four  separate  credits):  
Equipment depreciation $22,000

Rent (prepaid during 2012) $36,000

Utilities (on account) $33,000

Maintenance (paid cash) $19,000

7. Manufacturing  overhead  was  applied  at  a  rate  of  $30  per  direct  labor  hour.  (Hint:  No  need  to  calculate  the  predetermined  overhead  

rate  since  it  is  already  given  to  you  here.)  

8. Miscellaneous  selling  costs  totaling  $63,000  were  paid.  These  costs  were  recorded  in  an  account  called  selling  expenses.  

9. Miscellaneous  general  and  administrative  costs  totaling  $18,000  were  paid.  These  costs  were  recorded  in  an  account  called  G&A  

expenses.  

10. Goods  costing  $478,000  (per  the  job  cost  sheets)  were  completed  and  transferred  out  of  work-­‐in-­‐process  inventory.  

11. Goods  were  sold  on  account  for  $780,000.  

12. The  goods  sold  in  transaction  12  had  a  cost  of  $415,000  (per  the  job  cost  sheets).  

13. Payments  totaling  $380,000  from  credit  customers  related  to  transaction  12  were  received.  

Required:  

n. Prepare  T-­‐accounts  for  raw  materials  inventory,  work-­‐in-­‐process  inventory,  finished  goods  inventory,  manufacturing  overhead,  and  

cost  of  goods  sold.  Enter  the  beginning  balances  for  the  inventory  accounts.  (Manufacturing  overhead  and  cost  of  goods  sold  are  temporary  

accounts  and  thus  do  not  have  a  beginning  balance.)  

o. Prepare  a  journal  entry  for  each  transaction  from  1through  14  in  a  format  like  the  one  in  Figure  2.7  "Custom  Furniture  Company’s  

Journal  Entries  for  May",  and  where  appropriate,  post  each  entry  to  the  T-­‐accounts  set  up  in  requirement  a.  Note  that  these  entries  

reflect  the  flow  of  costs  through  the  inventory  and  cost  of  goods  sold  accounts  for  the  year.  Label  each  entry  in  the  T-­‐accounts  by  

transaction  number,  include  a  short  description  (e.g.,  direct  materials  and  manufacturing  overhead  applied),  and  total  each  T-­‐account.  

p. Based  on  the  balance  in  the  manufacturing  overhead  account  prepared  in  requirement  b,  prepare  a  journal  entry  to  close  the  

manufacturing  overhead  account  to  cost  of  goods  sold.  

q. Prepare  an  income  statement  for  the  year  ended  December  31,  2012.  Remember  to  adjust  cost  of  goods  sold  for  any  underapplied  or  

overapplied  overhead.  

r. Why  is  cost  of  goods  sold  adjusted  downward  on  the  income  statement?  
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 Chapter 3

How Does an Organization Use Activity-Based Costing to Allocate Overhead

Costs?

Cindy Hall is the owner and chief executive officer of SailRite Company. SailRite builds two
models of sailboats that are sold at hundreds of retail boat showrooms throughout the world. At
its inception several years ago, the company produced only the Basic model, which is 12 feet
long and designed for two sailors. Very few options are available for this model, and the
production process is relatively simple. Because many owners of the Basic model wanted to
move to a bigger, more sophisticated boat, SailRite developed the Deluxe model two years ago.
The Deluxe model is 14 feet long and designed for three sailors. Many additional features are
available for this model, and the production process is more complex than for the Basic model.
Last year, SailRite sold 5,000 units of the Basic and 1,000 units of the Deluxe.

Although sales of both models increased last year over the year before, company profits have
steadily declined. Cindy, the CEO, is concerned about this trend and discusses her concerns with
John Lester, the company’s accountant; Mary McCann, the vice president of marketing; and Bob
Schuler, the vice president of production.

Ever since we introduced the Deluxe model our profits have taken a beating. I need some input on what we
Cindy (CEO): should do to get this turned around.

I’m not sure you can blame our salespeople. We’ve asked them to push the Deluxe model because of the high
Mary (Marketing profit margins, and our sales force has really responded. Sales have steadily increased over the last couple of
Vice President): years, and customers seem to love our sailboats.

I don’t think the problem is with our products, and using our current costing system, we make $320 in profit for
each Basic model and $850 for each Deluxe model. We need to take a close look at how the cost of each boat is
determined. Overhead costs have increased significantly since we started producing the Deluxe boat—to about
45 percent of total production costs—and yet we use only one overhead rate based on direct labor hours to
Bob (Production allocate these costs. I don’t see how this can lead to an accurate cost, and I assume we set the price based on the
Vice President): cost of each boat.

We certainly considered the cost in our pricing structure. Are you telling me the cost information I have isn’t
Cindy: accurate?

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 No, the cost information you have is fine for financial reporting, but not for pricing products. When we were
producing only the Basic model, overhead allocation wasn’t an issue. All overhead costs were simply assigned to
the one product. Now that we have two products, overhead is allocated based on direct labor hours as Bob
John stated. We are required to allocate overhead for financial reporting purposes, but I wouldn’t use this cost
(Accountant): information for internal pricing purposes.

I can tell you that the production process for the Deluxe model is much more complicated than the one for the
Bob: Basic model, so I would expect to see significantly higher costs attached to the Deluxe boat.

What I’m hearing is that we need better cost information. I think it’s time we move to a more sophisticated
John: costing system called activity-based costing. Give me time to do some research. Let’s meet next week.

This dialogue between the accountant and top management emphasizes the importance of having
accurate cost information for decision-making purposes. Very few costing systems provide
“perfect” product cost information. Overhead (indirect manufacturing costs) can be allocated in a
number of different ways and result in a number of different costs for the same product. The goal
is to find a system of allocation that best approximates the amount of overhead costs caused by
each product. Sophisticated costing systems are expensive, however. Organizations like SailRite
must continually ask the question: Will the benefits of having improved cost information
outweigh the costs of obtaining the information?

Several options are available to allocate overhead costs. Before we discuss these options, it is
important to understand why overhead costs are allocated at all.

3.1 Why Allocate Overhead Costs?

L E A R N I N G   O B J E C T I V E  

1. Understand  why  organizations  allocate  overhead  costs  to  products.  

Question: Recall that costs for direct labor and direct materials are easily traced to products.
When SailRite produces a sailboat, the direct materials include items such as fiberglass to build
the hull, mast, sails, and rope. Direct labor includes the employees building the boat. Accounting
for these costs is fairly simple. Indirect manufacturing costs (also called manufacturing
overhead or overhead) include electricity to run the factory, rent for the factory building, and

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 factory maintenance. These costs are not easily traced to products and pose a much more
complicated challenge for SailRite. Accounting for indirect manufacturing costs typically
requires allocating overhead using predetermined overhead rates. Why do managers insist on
allocating overhead costs to products?

Answer: Three important reasons that managers allocate overhead costs to products are
described in the following:

Provide information for decision making. Setting prices for products is one example of a
decision that must be made by management. Prices are often established based on the cost of
products. It is not enough to simply include direct materials and direct labor. Overhead must be
considered as well.

Promote efficient use of resources. Several different activities are performed to produce a
product, such as purchasing raw materials, setting up production machinery, inspecting the final
product, and repairing defective products. All of these activities consume resources (consuming
resources is another way of stating that a cost is associated with each of these activities). If
products are charged for the use of these activities, managers will have an incentive to be
efficient in utilizing the activities.

Comply with U.S. Generally Accepted Accounting Principles (U.S. GAAP). U.S. GAAP
requires that all manufacturing costs—direct materials, direct labor, and overhead—be assigned
to products for inventory costing purposes. This requires the allocation of overhead costs to
products.

K E Y   T A K E A W A Y  

• Overhead  costs  are  allocated  to  products  to  provide  information  for  internal  decision  making,  to  promote  the  efficient  use  of  

resources,  and  to  comply  with  U.S.  Generally  Accepted  Accounting  Principles.  
R E V I E W   P R O B L E M   3 . 1  

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 For  each  scenario  listed  as  follows,  identify  which  of  the  three  important  reasons  presented  in  this  section  best  explains  why  

managers  choose  to  allocate  overhead  costs  to  products.  

a. Financial  statements  are  prepared  for  the  annual  report  that  is  provided  to  shareholders.  

b. Management  is  considering  the  addition  of  a  new  product  line.  

c. The  production  manager  decides  to  decrease  the  frequency  of  raw  materials  purchases  to  reduce  the  allocated  portion  of  the  

purchasing  department’s  costs.  

d. Profits  are  calculated  for  each  product  so  management  can  decide  which  products  to  promote.  

e. Quality  control  inspections  are  reduced  to  cut  down  on  the  allocated  portion  of  the  quality  control  department’s  costs.  

f. Financial  statements  are  prepared  for  the  company’s  bondholders.  

g. Management  asks  for  cost  information  to  assist  in  bidding  for  a  contract.  

Solutions  to  Review  Problem  3.1  

a. Comply  with  U.S.  GAAP  

b. Provide  information  for  decision  making  

c. Promote  efficient  use  of  resources  

d. Provide  information  for  decision  making  

e. Promote  efficient  use  of  resources  

f. Comply  with  U.S.  GAAP  

g. Provide  information  for  decision  making  

3.2 Approaches to Allocating Overhead Costs

L E A R N I N G   O B J E C T I V E  

1. Compare  and  contrast  allocating  overhead  costs  using  a  plantwide  rate,  department  rates,  and  activity-­‐based  costing.  

Question: Managers at companies such as Hewlett-Packard often look for better ways to figure
out the cost of their products. When Hewlett-Packardproduces printers, the company has three
possible methods that can be used to allocate overhead costs to products—plantwide allocation,
department allocation, and activity-based allocation (called activity-based costing). How do
managers decide which allocation method to use?
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 Answer: The choice of an allocation method depends on how managers decide to group
overhead costs and the desired accuracy of product cost information. Groups of overhead costs
are called cost pools. For example,Hewlett Packard’s printer production division may choose to
collect all factory overhead costs in one cost pool and allocate those costs from the cost pool to
each product using one predetermined overhead rate. Or Hewlett Packard may choose to have
several cost pools (perhaps for each department, such as assembly, packaging, and quality
control) and allocate overhead costs from each department cost pool to products using a separate
predetermined overhead rate for each department. In general, the more cost pools used, the more
accurate the allocation process.

Plantwide Allocation

Question: Let’s look at SailRite Company, which was presented at the beginning of the chapter.
The managers at SailRite like the idea of using the plantwide allocation method to allocate
overhead to the two sailboat models produced by the company. How would SailRite implement
the plantwide allocation method?

Answer: The plantwide allocation method uses one predetermined overhead rate to allocate
overhead costs. [1] One cost pool accounts for all overhead costs, and therefore one
predetermined overhead rate is used to apply overhead costs to products. You learned about this
approach inChapter 2 "How Is Job Costing Used to Track Production Costs?" where one
predetermined rate—typically based on direct labor hours, direct labor costs, or machine hours—
was used to allocate overhead costs. (Remember, the focus here is on the allocation of overhead
costs. Direct materials and direct labor are easily traced to the product and therefore are not a
part of the overhead allocation process.)

Using SailRite Company as an example, assume annual overhead costs are estimated to be
$8,000,000 and direct labor hours are used for the plantwide allocation base. Management
estimates that a total of 250,000 direct labor hours are worked annually. These estimates are
based on the previous year’s overhead costs and direct labor hours and are adjusted for expected
increases in demand the coming year. The predetermined overhead rate is $32 per direct labor
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 hour (= $8,000,000 ÷ 250,000 direct labor hours). Thus, as shown in Figure 3.1 "Using One
Plantwide Rate to Allocate SailRite Company’s Overhead", products are charged $32 in
overhead costs for each direct labor hour worked.

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 Figure 3.1 Using One Plantwide Rate to Allocate SailRite Company’s Overhead

Product Costs Using the Plantwide Allocation Approach at SailRite

Question: Assume SailRite uses one plantwide rate to allocate overhead based on direct labor
hours. What is SailRite’s product cost per unit and resulting profit using the plantwide approach
to allocate overhead?

Answer: The calculation of a product’s cost involves three components—direct materials, direct
labor, and manufacturing overhead. Assume direct materials cost $1,000 for one unit of the Basic
sailboat and $1,300 for the Deluxe. Direct labor costs are $600 for one unit of the Basic sailboat
and $750 for the Deluxe. This information, combined with the overhead cost per unit, gives us
what we need to determine the product cost per unit for each model.

Given the predetermined overhead rate of $32 per direct labor hour calculated in the previous
section, and assuming it takes 40 hours of direct labor to build one Basic sailboat and 50 hours to
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 build one Deluxe sailboat, we can calculate the manufacturing overhead cost per unit.
Manufacturing overhead cost per unit is $1,280 (= $32 × 40 direct labor hours) for the Basic boat
and $1,600 (= $32 × 50 direct labor hours) for the Deluxe boat. Combine the manufacturing
overhead with direct materials and direct labor, as shown in Figure 3.2 "SailRite Company
Product Costs Using One Plantwide Rate Based on Direct Labor Hours", and we are able to
calculate the product cost per unit.

Figure 3.2 SailRite Company Product Costs Using One Plantwide Rate Based on Direct Labor Hours

*$1,280 = 40 direct labor hours per unit × $32 rate.

**$1,600 = 50 direct labor hours per unit × $32 rate.

The average sales price is $3,200 for the Basic model and $4,500 for the Deluxe. Using the
product cost information in Figure 3.2 "SailRite Company Product Costs Using One Plantwide Rate Based on Direct
Labor Hours", the profit per unit is $320 (= $3,200 price – $2,880 cost) for the Basic model and
$850 (= $4,500 price – $3,650 cost) for the Deluxe. Recall from the opening dialogue that
SailRite’s overall profit has declined ever since it introduced the Deluxe model even though the
data shows both products are profitable.

Question: The managers at SailRite like the idea of using the plantwide allocation approach, but
they are concerned that this approach will not provide accurate product cost information.
Although the plantwide allocation method is the simplest and least expensive approach, it also

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 tends to be the least accurate.In spite of this weakness, why do some organizations prefer to use
one plantwide overhead rate to allocate overhead to products?

Answer: Organizations that use a plantwide allocation approach typically have simple
operations with a few similar products. Management may not want more accurate product cost
information or may not have the resources to implement a more complex accounting system. As
we move on to more complex costing systems, remember that these systems are more expensive
to implement. Thus the benefits of having improved cost information must outweigh the costs of
obtaining the information.

Department Allocation

Question: Assume the managers at SailRite Company prefer a more accurate approach to
allocating overhead costs to its two products. As a result, they are considering using the
department allocation approach. How would SailRite form cost pools for the department
allocation approach?

Answer: The department allocation approach is similar to the plantwide approach except that
cost pools are formed for each department rather than for the entire plant, and a separate
predetermined overhead rate is established for each department. Remember, total estimated
overhead costs will not change. Instead, they will be broken out into various department cost
pools. This approach allows for the use of different allocation bases for different departments
depending on what drives overhead costs for each department. For example, the Hull Fabrication
department at SailRite Company may find that overhead costs are driven more by the use of
machinery than by labor, and therefore decides to use machine hours as the allocation base. The
Assembly department may find that overhead costs are driven more by labor activity than by
machine use and therefore decides to use labor hours or labor costs as the allocation base.

Assume that SailRite is considering using the department approach rather than the plantwide
approach for allocating overhead. The cost pool in the Hull Fabrication department is estimated
to be $3,000,000 for the year, and the cost pool in the Assembly department is estimated at
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 $5,000,000. Note that total estimated overhead cost is still $8,000,000 (= $3,000,000 +
$5,000,000). Machine hours (estimated at 60,000 hours) will be used as the allocation base for
Hull Fabrication, and direct labor hours (estimated at 217,000 hours) will be used as the
allocation base for Assembly. Thus two rates are used to allocate overhead (rounded to the
nearest dollar) as follows:

1. Hull Fabrication department rate: $50 per machine hour (= $3,000,000 ÷ 60,000 hours)
2. Assembly department rate: $23 per direct labor hour (= $5,000,000 ÷ 217,000 hours)

As shown in Figure 3.3 "Using Department Rates to Allocate SailRite Company’s

Overhead", products going through the Hull Fabrication department are charged $50 in
overhead costs for each machine hour used. Products going through the Assembly
department are charged $23 in overhead costs for each direct labor hour used.

Figure 3.3 Using Department Rates to Allocate SailRite Company’s Overhead

 
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 The department allocation approach allows cost pools to be formed for each department and
provides for flexibility in the selection of an allocation base. Although Figure 3.3 "Using
Department Rates to Allocate SailRite Company’s Overhead" shows just two rates, many
companies have more than two departments and therefore more than two rates. Organizations
that use this approach tend to have simple operations within each department but different
activities across departments. One department may use machinery, while another department
may use labor, as is the case with SailRite’s two departments. This approach typically provides
more accurate cost information than simply using one plantwide rate but still relies on the
assumption that overhead costs are driven by direct labor hours, direct labor costs, or machine
hours. This assumption of a causal relationship is increasingly less realistic as production
processes become more complex.

The plantwide and department allocation methods are “traditional” approaches because both
typically use direct labor hours, direct labor costs, or machine hours as the allocation base, and
both were used prior to the creation of activity-based costing in the 1980s.

K E Y   T A K E A W A Y  

• Regardless  of  the  approach  used  to  allocate  overhead,  a  predetermined  overhead  rate  is  established  for  each  cost  pool.  The  

plantwide  allocation  approach  uses  one  cost  pool  to  collect  and  apply  overhead  costs  and  therefore  uses  one  predetermined  

overhead  rate  for  the  entire  company.  The  department  allocation  approach  uses  several  cost  pools  (one  for  each  department)  

and  therefore  uses  several  predetermined  overhead  rates.  

R E V I E W   P R O B L E M   3 . 2  

Kline  Company  expects  to  incur  $800,000  in  overhead  costs  this  coming  year—$200,000  in  the  Cut  and  Polish  department  and  

$600,000  in  the  Quality  Control  department.  Total  annual  direct  labor  costs  are  expected  to  be  $160,000.  The  Cut  and  Polish  

department  expects  to  use  25,000  machine  hours,  and  the  Quality  Control  department  plans  to  utilize  50,000  hours  of  direct  

labor  time  for  the  year.  

Required:  

1. Assume  Kline  Company  allocates  overhead  costs  with  the  plantwide  approach,  and  direct  labor  cost  is  the  allocation  base.  

Calculate  the  rate  used  by  the  company  to  allocate  overhead  costs.  
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 2. Assume  Kline  Company  allocates  overhead  costs  with  the  department  approach.  Calculate  the  rate  used  by  each  department  

to  allocate  overhead  costs.  

Solutions  to  Review  Problem  3.2  

1. The  plantwide  rate  is  calculated  as  follows:  

Predetermined overhead rate=Estimated overhead costsEstimated activity in allocation base=$800,000$160,000=$5 per $1 in direct labor cost (or 500 perce

nt of direct labor cost)  

2. The  department  rates  are  calculated  using  the  same  formula  as  the  plantwide  rate.  However,  overhead  costs  and  

activity  levels  are  estimated  for  each  department  rather  than  for  the  entire  company,  and  two  separate  rates  are  

calculated:  

Cut and Polish department=$200,00025,000 machine hours=$8 per machine hour  

Quality Control department=$600,00050,000 direct labor hours=$12 per direct labor hour  

[1]  Regardless  of  the  approach  used  to  allocate  overhead,  a  predetermined  overhead  rate  is  established  for  each  cost  pool.  The  
predetermined  overhead  rate  is  calculated  as  follows  (from  Chapter  2  "How  Is  Job  Costing  Used  to  Track  Production  Costs?"):  

Predetermined overhead rate=Estimated overhead costsEstimated activity in allocation base

When activity-based costing is used, the denominator can also be called estimated cost driver
activity.

3.3 Using Activity-Based Costing to Allocate Overhead Costs

L E A R N I N G   O B J E C T I V E  

1. Understand  how  to  use  the  five  steps  of  activity-­‐based  costing  to  determine  product  costs.  

Question: Suppose the managers at SailRite Company decide that the benefits of implementing
an activity-based costing system would exceed the cost, and thus the company should use

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 activity-based costing to allocate overhead. What are the five steps of activity-based costing, and
how would this method work for SailRite?

Answer: Activity-based costing (ABC) uses several cost pools, organized by activity, to allocate
overhead costs. (Remember that plantwide allocation uses one cost pool for the whole plant, and
department allocation uses one cost pool for each department.) The idea is that activities are
required to produce products—activities such as purchasing materials, setting up machinery,
assembling products, and inspecting finished products. These activities can be costly. Thus the
cost of activities should be allocated to products based on the products’ use of the activities.

ABC in Action at SailRite Company

Five steps are required to implement activity-based costing. As you work through the example
for SailRite Company, once again note that total estimated overhead costs remain at $8,000,000.
However, the total is broken out into different activities rather than departments, and an overhead
rate is established for each activity. The five steps are as follows:

Step 1. Identify costly activities required to complete products.

An activity is any process or procedure that consumes overhead resources. The goal is to
understand all the activities required to make the company’s products. This requires interviewing
and meeting with personnel throughout the organization. Companies that use activity-based
costing, such as Hewlett Packard and IBM, may identify hundreds of activities required to make
their products. The most challenging part of this step is narrowing down the activities to those
that have the biggest impact on overhead costs.

After meeting with personnel throughout the company, SailRite’s accountant identified the
following activities as having the biggest impact on overhead costs:

• Purchasing materials
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 • Setting up machines
• Running machines
• Assembling products
• Inspecting finished products

Step 2. Assign overhead costs to the activities identified in step 1.

This step requires that overhead costs associated with each activity be assigned to the activity
(i.e., a cost pool is formed for each activity). For SailRite, the cost pool for the purchasing
materials activity will include costs for items such as salaries of purchasing personnel, rent for
purchasing department office space, and depreciation of purchasing office equipment.

The accountant at SailRite developed the following allocations after careful review of all
overhead costs (remember, these are overhead costs, not direct materials or direct labor costs):

*We should note that this is not the direct labor cost. Instead, this represents overhead costs associated with assembling products,

such as supplies and the factory space being used for assembly.

At this point, we have identified the most important and costly activities required to make
products, and we have assigned overhead costs to each of these activities. The next step is to find
an allocation base that drives the cost of each activity.

Step 3. Identify the cost driver for each activity.

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 A cost driver is the action that causes (or “drives”) the costs associated with the activity.
Identifying cost drivers requires gathering information and interviewing key personnel in various
areas of the organization, such as purchasing, production, quality control, and accounting. After
careful scrutiny of the process required for each activity, SailRite established the following cost
drivers:

Activity Cost Driver Estimated Annual Cost Driver Activity

Purchasing materials Purchase requisitions 10,000 requisitions

Setting up machines Machine setups 2,000 setups

Running machines Machine hours 90,000 hours

Assembling products Direct labor hours 250,000 hours

Inspecting finished products Inspection hours 20,000 hours

Notice that this information includes an estimate of the level of activity for each cost driver,
which is needed to calculate a predetermined rate for each activity in step 4.

Step 4. Calculate a predetermined overhead rate for each activity.

This is done by dividing the estimated overhead costs (from step 2) by the estimated level of cost
driver activity (from step 3). provides the overhead rate calculations for SailRite Company based
on the information shown in the previous three steps. It shows that products will be charged $120
in overhead costs for each purchase requisition processed, $800 for each machine setup, $30 for
each machine hour used, $6 for each direct labor hour worked, and $50 for each hour of
inspection time.

Figure 3.4 Predetermined Overhead Rates for SailRite Company

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 ]  

Step 5. Allocate overhead costs to products.

Overhead costs are allocated to products by multiplying the predetermined overhead rate for
each activity (calculated in step 4) by the level of cost driver activity used by the product. The
term applied overhead is often used to describe this process.

Assume the following annual cost driver activity takes place at SailRite for the Basic and Deluxe
sailboats: [1]

Activity Basic Sailboat Deluxe Sailboat Total

Purchasing materials 7,000 requisitions 3,000 requisitions 10,000 requisitions

Setting up machines 1,100 setups 900 setups 2,000 setups

Running machines 50,000 hours 40,000 hours 90,000 machine hours

Assembling products 200,000 hours 50,000 hours 250,000 direct labor hours

Inspecting finished products 12,000 hours 8,000 hours 20,000 inspection hours

shows the allocation of overhead using the cost driver activity just presented and the overhead
rates calculated in . Notice that allocated overhead costs total $8,000,000. This is the same cost
figure used for the plantwide and department allocation methods we discussed earlier. Activity-
based costing simply provides a more refined way to allocate the same overhead costs to
products.

Figure 3.5 Allocation of Overhead Costs to Products at SailRite Company

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*Overhead allocated equals the predetermined overhead rate times the cost driver activity.

**Overhead cost per unit for the Basic model equals $5,020,000 (overhead allocated) ÷ 5,000 units produced, and for the Deluxe

model, it equals $2,980,000 ÷ 1,000 units produced.

The bottom of shows the overhead cost per unit for each product assuming SailRite produces 5,000
units of the Basic sailboat and 1,000 units of the Deluxe sailboat. This information is needed to
calculate the product cost for each unit of product, which we discuss next.

Product Costs Using the Activity-Based Costing Approach at SailRite

Question: As shown in , SailRite knows the overhead cost per unit using activity-based costing is
$1,004 for the Basic model and $2,980 for the Deluxe.Now that SailRite has the overhead cost
per unit, how will the company find the total product cost per unit and resulting profit?

Answer: Recall from our discussion earlier that the calculation of a product’s cost involves three
components—direct materials, direct labor, and manufacturing overhead. Assume direct
materials cost $1,000 for the Basic sailboat and $1,300 for the Deluxe. Direct labor costs are
$600 for the Basic sailboat and $750 for the Deluxe. This information, combined with the
overhead cost per unit calculated at the bottom of , gives us what we need to determine the
product cost per unit for each model, which is presented in . The average sales price is $3,200 for
the Basic model and $4,500 for the Deluxe. Using the product cost information in , the Basic

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 model yields a profit of $596 (= $3,200 price – $2,604 cost) per unit and the Deluxe model
yields a loss of $530 (= $4,500 price – $5,030 cost) per unit.

Figure 3.6 SailRite Company Product Costs Using Activity-Based Costing

As you can see, overhead is a significant component of total product costs. This explains the
need for a refined overhead allocation system such as activity-based costing.

Comparison of ABC to Plantwide Costing at SailRite

After going through the process of allocating overhead using activity-based costing, John Lester
(the company accountant) called a meeting with the same management group introduced at the
beginning of the chapter: Cindy Hall (CEO), Mary McCann (vice president of marketing), and
Bob Schuler (vice president of production). As you read the following dialogue, refer to , which
summarizes John’s findings.

Cindy: What do you have for us, John?

I think you’ll find the results of our most recent costing analysis very interesting. We used an approach called activity-based costing to
John: allocate overhead to products.

Bob: I recall being interviewed last week about the activities involved in the production process.

Yes, here’s what we found. The old allocation approach indicates that the Basic boat costs $2,880 to build and the Deluxe boat costs $3,650 to
build. Our average sales price for the Basic is $3,200 and $4,500 for the Deluxe. You can see why we pushed sales of the Deluxe boat—it has
John: a profit of $850 per boat.

Cindy: John, from your analysis, it looks as if we were wrong about the Deluxe boat being the most profitable.

We do have some startling results. Using activity-based costing, an approach I think is much more accurate, the Deluxe boat is not profitable
John: at all. In fact, we lose $530 for each Deluxe boat sold, and the profits from the Basic boat are much higher than we thought at $596 per unit.

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 I see direct materials and direct labor are the same no matter which costing system we use. Why is there such a large variation in overhead
Cindy: costs?

Good question! When we used our old approach of one plantwide rate based on direct labor hours, the Deluxe process consumed 20 percent
of all direct labor hours worked—that is, 50,000 Deluxe hours divided by 250,000 total hours. Therefore the Deluxe model was allocated 20
percent of all overhead costs. Using activity-based costing, we identified five key activities and assigned overhead costs based on the use of
these activities. The Deluxe process consumed more than 20 percent of the resources provided for every activity. For example, running
machines is one of the most costly activities, and the Deluxe model used about 44 percent of the resources provided by this activity. This is
John: significantly higher than the 20 percent allocated using direct labor hours under the old approach.

Bob: This certainly makes sense! Each Deluxe boat takes a whole lot more machine hours to produce than the Basic boat.

Thanks for this analysis, John. Now we know why company profits have been declining even though sales have increased. Either the Deluxe
Cindy: sales price must go up or costs must go down—or a combination of both!

Figure 3.7 Activity-Based Costing Versus Plantwide Costing at SailRite Company

*From .

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 **From .

Question: SailRite has more accurate product cost information using activity-based costing to
allocate overhead. Why is the overhead cost per unit so different using activity-based costing?

Answer: provides a more thorough look at how the Deluxe product consumes a significant share
of overhead resources—much higher than the 20 percent that was being allocated based on direct
labor hours. Let’s look at in detail:

• The ABC column represents overhead costs allocated using the activity-based costing
shown back in .
• The DLH (direct labor hours) column represents overhead costs allocated using direct
labor hours as the allocation base where 80 percent was allocated to the Basic boat (=
200,000 hours ÷ 250,000 total hours) and 20 percent allocated to the Deluxe boat (=
50,000 hours ÷ 250,000 total hours).
• The Diff. (difference) column shows the difference between one allocation method and
the other. Notice the shift in the allocation of overhead costs using activity-based costing.
A total of $1,380,000 in overhead costs shifts to the Deluxe sailboat, which amounts to
$1,380 per boat (= $1,380,000 ÷ 1,000 boats).

Figure 3.8 Detailed Analysis of Overhead Allocations at SailRite Company

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*Amounts in this column come from .

**Amounts in this column are calculated by multiplying 80 percent for the Basic boat (20 percent for the Deluxe) by the total

overhead cost for the activity. For example, the total overhead cost for purchasing materials is $1,200,000 (see ) and $1,200,000

× 80 percent = $960,000. Using the plantwide approach (one plantwide rate based on direct labor hours), $960,000 is the

amount allocated to the Basic sailboat for this activity, and $240,000 is the amount allocated to the Deluxe boat.

The primary reason that using activity-based costing shifted overhead costs to the Deluxe
sailboat is that producing each Deluxe boat requires more resources than the Basic boat. For
example, the Basic boat requires 50,000 machine hours to produce 5,000 boats, and the Deluxe
boat requires 40,000 machine hours to produce 1,000 boats. The number of machine hours
required per boat produced is as follows:

You can see from this analysis that the Deluxe boat consumes four times the machine hours of
the Basic boat. At a rate of $30 per machine hour, the Deluxe boat is assigned $1,200 per boat
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 for this activity ($30 rate × 40 machine hours) while the Basic boat is assigned $300 per boat
($30 rate × 10 machine hours).

Advantages and Disadvantages of ABC

Question: Activity-based costing undoubtedly provides better cost information than most
traditional costing methods, such as plantwide and department allocation methods. However,
ABC has its limitations. What are the advantages and disadvantages of using activity-based
costing?

Answer: The advantages and disadvantages of ABC are as follows:

Advantages

More accurate cost information leads to better decisions. The cost information provided by ABC
is generally regarded as more accurate than the information provided by most traditional costing
methods. This allows management to make better decisions in areas such as product pricing,
product line changes (adding products or eliminating products), and product mix decisions (how
much of each product to produce and sell).

Increased knowledge of production activities leads to process improvements and reduced

costs. ABC requires identifying the activities involved in the production process (step 1) and
assigning costs to these activities (step 2). This provides management with a better view of the
detailed activities involved (purchasing materials, machine setups, inspections, and so forth) and
the cost of each activity. Managers are more likely to focus on improving efficiency in the most
costly activities, thereby reducing costs.

Disadvantages

ABC systems can be costly to implement. ABC systems require teamwork across the
organization and therefore require employees to take time out from their day-to-day activities to
assist in the ABC process (e.g., to identify costly activities). Assigning costs to activities takes
time, as does identifying and tracking cost drivers. And assigning costs to products requires a
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 significant amount of time in the accounting department. Imagine having 15 cost pools
(activities), each with a predetermined overhead rate used to assign overhead costs to the
company’s 80 products—not an unrealistic example for a large company. The accounting costs
incurred to maintain such a system can be prohibitively high.

Unitizing fixed costs can be misleading. Product costing involves allocating costs from activity
centers to products and calculating a product cost per unit. The problem with this approach is
that fixed costs are often a large part of the overhead costs being allocated (e.g., building and
machinery depreciation and supervisor salaries). Recall that fixed costs are costs that do not
change in total with changes in activity.

Looking back to the SailRite example using activity-based costing, the Deluxe sailboat cost
$5,030 per unit to produce based on production of 1,000 units (as shown in ). If SailRite
produces 2,000 units of the Deluxe boat, will the unit cost remain at $5,030? Probably not. A
significant portion of overhead costs are fixed and will be spread out over more units, thereby
reducing the cost per unit. We address this issue at length in later chapters. The point here is that
managers must beware of using per unit cost information blindly for decision making,
particularly if a significant change in the level of production is anticipated.

The benefits may not outweigh the costs. Companies with one or two products that require very
little variation in production may not benefit from an ABC system. Suppose a company produces
one product. The overhead costs can be divided into as many cost pools as you like, but all
overhead costs will still be assigned to the one product. (We should mention, however, that
management would benefit from understanding the activities involved in the process and the
costs associated with each activity. It’s the allocation to the one product—steps 4 and 5 of
ABC—that would provide little useful information in this scenario.)

Companies that produce several different products may believe that the benefits of implementing
ABC will outweigh the costs. However, management must be willing to use the ABC
information to benefit the company. Companies like Chrysler Group LLC have been known to

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 try ABC, only to meet resistance from their managers. Until managers are willing to use the
ABC information to make improvements in the organization, there is no point in implementing
such a system.

Business  in  Action  3.1  

Characteristics of Companies That Use Activity-Based Costing

A survey of 130 U.S. manufacturing companies yielded some interesting results. The companies that used activity-based costing

(ABC) had higher overhead costs as a percent of total product costs than companies that used traditional costing. Those using ABC

also had a higher level of automation. The complexity of production processes and products tended to be higher for those using ABC,

and ABC companies operated at capacity more frequently.

It is important to note that the differences between companies using ABC and companies using traditional costing systems in all

these areas—overhead costs, automation, complexity of production, and frequency of capacity—were relatively small. However, users

of ABC indicated their systems were more adequate than traditional systems in providing useful information for performance

evaluation and cost reduction.

Source: Susan B. Hughes and Kathy A. Paulson Gjerde, “Do Different Cost Systems Make a Difference?” Management Accounting

Quarterly, Fall 2003.

ABC Cost Flows

Question: How are overhead costs recorded when using activity-based costing?

Answer: We presented the flow of costs for a job costing system in , including how to track
actual overhead costs and how to track overhead applied using a separate manufacturing
overhead account. The cost flows are the same for an activity-based costing system, with one
exception. Instead of using one plantwide overhead rate to allocate (or apply) overhead to
products, an ABC system uses several overhead rates to allocate overhead. The entry to record
this allocation—whether it involves one rate or multiple rates—is the same as the entry in .
Simply debit work-in-process inventory and credit manufacturing overhead for the amount of
overhead applied. (Some companies use separate work-in-process inventory and manufacturing
overhead accounts for each activity. For the sake of simplicity, we do not use separate accounts.)

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 For example, assume production of SailRite’s Basic sailboats has the following cost driver
activity for one week of operations:

*From .

The entry to record overhead applied to the Basic sailboats for the week is as follows:

Recall from that the manufacturing overhead account is closed to cost of goods sold at the end of
the period. If actual overhead costs are higher than applied overhead, the
resulting underapplied overhead is closed with a debit to cost of goods sold and a credit to
manufacturing overhead. If actual overhead costs are lower than applied overhead, the
resulting overappliedoverhead is closed with a debit to manufacturing overhead and a credit to cost
of goods sold.

Recap of Three Allocation Methods

We have discussed three different methods of allocating overhead to products—plantwide

allocation, department allocation, and activity-based costing. Remember, total overhead costs
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 will not change in the short run, but the way total overhead costs are allocated to products will
change depending on the method used.

Presents the three allocation methods, using SailRite as an example. Notice that the three pie
charts in the illustration are of equal size, representing the $8,000,000 total overhead costs
incurred by SailRite.

Figure 3.9 The Three Methods of Overhead Allocation

Overhead Rates:

1 Allocated based on direct labor hours (DLH): $8,000,000 ÷ 250,000 DLH = $32 per DLH.

2 Allocated based on direct labor hours (DLH): $5,000,000 ÷ 217,000 DLH = $23 per DLH.

3 Allocated based on machine hours (MH): $3,000,000 ÷ 60,000 MH = $50 per MH.

4 Allocated based on direct labor hours (DLH): $1,500,000 ÷ 250,000 DLH = $6 per DLH.

5 Allocated based on inspection hours (IH): $1,000,000 ÷ 20,000 IH = $50 per IH.

6 Allocated based on purchase requisitions (PR): $1,200,000 ÷ 10,000 PR = $120 per PR.

7 Allocated based on machine setups (MS): $1,600,000 ÷ 2,000 MS = $800 per MS.

8 Allocated based on machine hours (MH): $2,700,000 ÷ 90,000 MH = $30 per MH.

K E Y   T A K E A W A Y  

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 • Activity-­‐based  costing  focuses  on  identifying  the  activities  required  to  make  products,  on  forming  cost  pools  for  each  activity,  and  on  allocating  

overhead  costs  to  the  products  based  on  their  use  of  each  activity.  ABC  systems  and  traditional  systems  often  result  in  vastly  different  product  

costs.  But  even  if  the  resulting  product  costs  are  not  much  different,  ABC  provides  managers  with  a  better  understanding  of  the  production  

activities  required  for  each  activity  and  the  associated  costs,  which  often  leads  to  improved  efficiency  and  reduced  costs.  
Business  in  Action  3.2  

Using Activity-Based Costing to Argue Predatory Pricing

BuyGasCo Corporation, a privately owned chain of gas stations based in Florida, was taken to court for selling regular grade

gasoline below cost, and an injunction was issued. Florida law prohibits selling gasoline below refinery cost if doing so injures

competition. Using a plantwide approach of allocating costs to products, the plaintiff’s costing expert was able to support the

allegation of predatory pricing. The defendant’s expert witness, an accounting professor, used activity-based costing to dispute the

allegation.

Both costing experts had to allocate costs to each of the three grades of gasoline (regular, plus, and premium) to determine a total

cost per grade of fuel and a cost per gallon for each grade. Sales of regular grade fuel were significantly higher (63 percent of total

sales) than the other two grades. Using the plantwide approach, the plaintiff‘s expert allocated all costs based on gallons of gas sold.

Using the activity-based costing approach, the defendant‘s expert formed three activity cost pools—labor, kiosk, and gas dispensing.

The first two cost pools allocated costs using gallons of gas sold and therefore were allocated as they would be with the plantwide

approach (63 percent for regular grade, 20 percent for plus, and 17 percent for premium). The third cost pool (gas dispensing)

allocated costs equally to each grade of fuel (i.e., one-third of costs to each grade of fuel). The gas dispensing pool included costs for

storage tanks, all of which were the same size, as well as gas pumps and signs.

Compared with the plantwide approach, activity-based costing showed a lower cost per gallon for regular gas and a higher cost per

gallon for the other two grades of fuel. Once the ABC information was presented, the case was settled, and the initial injunction was

lifted.

Sources: Thomas L. Barton and John B. MacArthur, “Activity-Based Costing and Predatory Pricing: The Case of the Petroleum Retail

Industry,” Management Accounting, Spring 2003; All Business, “Home Page,” http://www.allbusiness.com.
R E V I E W   P R O B L E M   3 . 3  

Parker  Company  produces  an  inkjet  printer  that  sells  for  $150  and  a  laser  printer  that  sells  for  $350.  Last  year,  total  overhead  costs  of  

$1,050,000  were  allocated  based  on  direct  labor  hours.  A  total  of  15,000  direct  labor  hours  were  required  last  year  to  build  12,000  

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 inkjet  printers  (1.25  hours  per  unit),  and  10,000  direct  labor  hours  were  required  to  build  4,000  laser  printers  (2.50  hours  per  unit).  

Total  direct  labor  and  direct  materials  costs  for  the  year  were  as  follows:  
Inkjet Printer Laser Printer

Direct materials $540,000 $320,000

Direct labor $600,000 $400,000

The  management  of  Parker  Company  would  like  to  use  activity-­‐based  costing  to  allocate  overhead  rather  than  use  one  plantwide  rate  

based  on  direct  labor  hours.  The  following  estimates  are  for  the  activities  and  related  cost  drivers  identified  as  having  the  greatest  

impact  on  overhead  costs.  

Required:  

1. Calculate  the  direct  materials  cost  per  unit  and  direct  labor  cost  per  unit  for  each  product.  

2.    

1. Using  the  plantwide  allocation  method,  calculate  the  predetermined  overhead  rate  and  determine  the  overhead  cost  per  unit  for  the  

inkjet  and  laser  products.  

2. What  is  the  cost  per  unit  for  the  inkjet  and  laser  products?  

3.    

1. Using  the  activity-­‐based  costing  allocation  method,  calculate  the  predetermined  overhead  rate  for  each  activity.  (Hint:  Step  1  through  

step  3  in  the  activity-­‐based  costing  process  have  already  been  done  for  you;  this  is  step  4.)  

2. Using  the  activity-­‐based  costing  allocation  method,  allocate  overhead  to  each  product.  (Hint:  This  is  step  5  in  the  activity-­‐based  costing  

process.)  Determine  the  overhead  cost  per  unit.  Round  amounts  to  the  nearest  dollar.  
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 3. What  is  the  product  cost  per  unit  for  the  inkjet  and  laser  products?  

4. Calculate  the  per  unit  profit  for  each  product  using  the  plantwide  approach  and  the  activity-­‐based  costing  approach.  Comment  on  the  

differences  between  the  results  of  the  two  approaches.  

Solutions  to  Review  Problem  3.3  

1. The  cost  per  unit  for  direct  materials  is  as  follows:  

The  cost  per  unit  for  direct  labor  is  as  follows:  

2.    

1. The  plantwide  allocation  used  by  Parker  Company  is  based  on  direct  labor  hours.  The  predetermined  overhead  rate  is  

calculated  as  follows:  

Estimated overhead costEstimated activity in allocation base=$1,050,00025,000 hours=$42 per direct labor hour  

Because  the  inkjet  printer  requires  1.25  direct  labor  hours  to  build  and  the  laser  printer  takes  2.50  direct  labor  hours  to  build  

(both  figures  are  provided  in  the  problem  data),  $52.50  in  overhead  is  allocated  to  1  unit  of  the  inkjet  product  (=  $42  rate  ×  1.25  

hours)  and  $105  in  overhead  is  allocated  to  1  unit  of  the  laser  product  ($42  rate  ×  2.50  direct  labor  hours).  

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 2. Per  unit  product  costs  are  as  follows:  

   

Direct  materials  and  direct  labor  determined  from  Question  1.  

*$52.50  =  1.25  direct  labor  hours  per  unit  ×  $42  rate.  

**$105  =  2.50  direct  labor  hours  per  unit  ×  $42  rate.  

3.    

1. Predetermined  overhead  rates  are  calculated  for  each  activity  as  follows:  

2. Overhead  costs  are  allocated  as  follows:  

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*Overhead  allocated  equals  the  predetermined  overhead  rate  times  the  cost  driver  activity.  

**Overhead  cost  per  unit  for  the  inkjet  printer  equals  $695,000  (overhead  allocated)  ÷  12,000  units  produced,  and  for  the  laser  printer,  

$355,000  ÷  4,000  units  produced.  Amounts  are  rounded  to  the  nearest  dollar.  

3. Per  unit  product  costs  are  as  follows:  

Direct  materials  and  direct  labor  determined  from  Question  1.  Overhead  determined  from  Question  3b.  

4.    

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Although  unit  product  costs  do  not  change  significantly  for  the  inkjet  printer  when  activity-­‐based  costing  is  used  (from  $147.50  to  $153),  

the  cost  increases  enough  to  result  in  a  $3  loss  for  each  unit.  Conversely,  the  laser  printer  costs  decrease  significantly  from  $285  to  $269  

per  unit  when  using  activity-­‐based  costing,  resulting  in  a  profit  of  $81  per  unit.  

The  shift  in  overhead  costs  to  the  inkjet  printer  is  primarily  a  result  of  the  inkjet  printer  using  80  percent  of  the  production  run  resources  

and  thus  being  assigned  80  percent  of  the  overhead  costs  associated  with  production  runs.  The  plantwide  rate  approach  only  assigned  

60  percent  of  all  overhead  costs  to  the  inkjet  printer,  including  those  related  to  production  runs  (60  percent  =  15,000  inkjet  direct  labor  

hours  ÷  25,000  total  direct  labor  hours).  

[1]  Notice  that  the  total  activity  levels  presented  here  match  the  estimated  activity  levels  presented  in  step  4.  This  was  done  to  avoid  
complicating  the  example  with  overapplied  and  underapplied  overhead.  However,  a  more  realistic  scenario  would  
provide  actual  activity  levels  that  are  different  thanestimated  activity  levels,  thereby  creating  overapplied  and  underapplied  overhead  
for  each  activity.  We  described  the  disposition  of  overapplied  and  underapplied  overhead  in  .  
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 3.4 Using Activity-Based Management to Improve Operations

L E A R N I N G   O B J E C T I V E  

1. Understand  the  concept  of  activity-­‐based  management.  

Question: Activity-based costing is helpful in providing relatively accurate product cost

information. However, the value of activity-based costing information goes beyond accurate
product costing. When activity-based costing is used in conjunction with activity-based
management, organizations are often able to make dramatic improvements to operations. How
does activity-based management help an organization reduce costs and become more efficient?

Answer: Activity-based management (ABM) provides three steps for managers to use that lead
to improved efficiency and profitability of operations.

Step 1. Identify activities required to complete products.

This involves interviewing personnel throughout the company. Recall that activity-based costing
also requires the identification of key activities. However, ABM allows for a more detailed
analysis because the estimation of costs and related overhead rates are not required when using
ABM.

Step 2. Determine whether activities are value-added or non-value-added.

Activities that add to the product’s quality and performance are calledvalue-added activities.
Activities that do not add to the product’s quality and performance are called non-value-
added activities. Examples of value-added activities at SailRite include using materials and
machines to produce hulls and assembling each sailboat. Examples of non-value-added activities
include storing parts in a warehouse and letting machinery sit idle.

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 Step 3. Continuously improve the value-added activities and minimize or eliminate the non-
value-added activities.

Even if an activity is identified as value-added, ABM requires the continuous improvement of

the activity. For example, SailRite’s assembly process (a value-added activity) may require
workers to shift back and forth between Basic and Deluxe sailboats throughout the day, each of
which uses different parts and requires different tools. Perhaps the efficiency of this process
could be improved by assembling the boats in batches—one day working on Basic boats, another
day working on Deluxe boats.

Activities that are non-value-added should be minimized or eliminated. For example, storing
parts in a warehouse at SailRite (a non-value-added activity) might be minimized by moving to a
just-in-time system that requires suppliers to deliver parts immediately before they are needed
for production.

The next time you visit a fast-food restaurant, go to a clothing store, or stand in line at a college
bookstore, try to identify value-added and non-value-added activities. Think about ways the
organization can eliminate non-value-added activities and improve value-added activities.

K E Y   T A K E A W A Y  

• Activity-­‐based  management  provides  a  three  step  process  that  shows  management  how  to  use  the  cost  information  obtained  

from  an  activity-­‐based  costing  system  to  improve  the  efficiency  and  profitability  of  operations.  
Business  in  Action  3.3  
Why Use Activity-Based Costing (ABC) and Activity-Based Management (ABM)?

A survey of 296 users of activity-based costing and activity-based management showed that the top four objectives of using

ABC and ABM were as follows:

1. To provide product costing (58 percent)

2. To analyze processes (51 percent)

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 3. To evaluate performance (49 percent)

4. To assess profitability (38 percent)

All these objectives are important to most organizations and can be achieved with the help of ABC and ABM systems.

Source: Mohan Nair, “Activity-Based Costing: Who’s Using It and Why?”Management Accounting Quarterly, Spring 2000.
R E V I E W   P R O B L E M   3 . 4  

Label  each  of  the  following  activities  as  value-­‐added  or  non-­‐value-­‐added:  

a. Placing  customers  who  call  to  order  a  pizza  on  hold  

b. Assembling  desks  to  be  sold  to  customers  

c. Storing  raw  materials  to  be  used  in  production  the  next  month  

d. Designing  a  car  to  maximize  comfort  

e. Scrapping  defective  production  materials  

f. Waiting  for  a  phone  call  from  a  customer  

g. Moving  raw  materials  from  one  end  of  a  factory  to  the  other  

Solutions  to  Review  Problem  3.4  

a. Non-­‐value-­‐added  activity  

b. Value-­‐added  activity  

c. Non-­‐value-­‐added  activity  

d. Value-­‐added  activity  

e. Non-­‐value-­‐added  activity  

f. Non-­‐value-­‐added  activity  

g. Non-­‐value-­‐added  activity  

3.5 Using Activity-Based Costing (ABC) and Activity-Based Management (ABM) in

Service Organizations

L E A R N I N G   O B J E C T I V E  

1. Apply  activity-­‐based  costing  and  activity-­‐based  management  to  service  organizations.  

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 Question: To this point, we have presented ABC and ABM examples in a manufacturing setting.
However, service organizations, such as banks, hospitals, airlines, and government agencies,
also use ABC and ABM. [1]In fact, a recent survey indicates that 75 percent of companies that
use ABC are in the public sector, a service industry, or a consulting industry. [2]How can ABC
help service organizations get better product cost information?

Answer: The same five steps used in manufacturing organizations can also be used in service
organizations. To understand how ABC could be used in a service organization, let’s look at how
ABC can be used to determine the cost of loan products at a financial institution.

Service Organization Example of ABC

Imagine you are the chief financial officer of Five Star Bank. You are interested in implementing
an activity-based costing system to evaluate the cost of different loan products, such as auto
loans and home equity loans, offered by the bank. The five steps of activity-based costing we
presented earlier still apply. Let’s look at how these steps might work when evaluating the cost
of bank loans.

Step 1. Identify costly activities.

Processing loans includes activities such as meeting with customers, reviewing customer
applications, and running credit reports.

Step 2. Assign overhead costs to the activities identified in step 1.

Costs assigned to the activity of reviewing customer applications include items such as wages of
personnel reviewing applications, depreciation of computer equipment used to review online
applications, and supplies needed for the review process.

Step 3. Identify the cost driver for each activity.

Activity cost drivers are shown as follows:

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 Activity Cost Driver

Meeting with customers Hours of meeting time

Reviewing customer applications Number of applications reviewed

Running credit reports Number of credit reports run

Step 4. Calculate a predetermined overhead rate for each activity.

This is done by dividing estimated overhead costs for each activity by the estimated cost driver
activity. For the activity meeting with customers, this calculation results in a rate per hour of
meeting time. For the activityreviewing customer applications, the calculation results in a rate
per application reviewed, and for running credit reports, a rate per credit report run.

Step 5. Allocate overhead costs to products.

Overhead is allocated, or applied, to products (auto loans and home equity loans in this example)
based on the use of each activity’s cost driver. If a loan officer reviews 30 auto loan applications,
an amount equal to the rate per application reviewed times 30 applications is allocated to the auto loans
product.

Service Organization Example of ABM

Question: Managers at Five Star Bank are not only interested in product cost information; they
would also like to scrutinize the activities involved in processing loans and make the process
more efficient. How can the management of Five Star Bank use activity-based management to
become more efficient?

Answer: Managers and accountants can apply the three steps of activity-based management to
Five Star Bank as follows:

1. Identify activities required to complete the product. This involves interviewing personnel
throughout the company to capture all the activities involved in processing loans.
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 2. Determine whether activities are value-added or non-value-added. An example of a
value-added activity is the quick approval of a loan. An example of a non-value-added
activity is time spent waiting for credit reports.
3. Continuously improve the value-added activities and minimize, or eliminate, the non-
value-added activities. Five Star Bank should continually strive to improve its ability to
approve loans quickly (a value-added activity). While waiting for credit reports (a non-
value-added activity), perhaps the bank can find other value-added activities that bank
personnel can perform (e.g., responding to customer questions or processing other loan
applications).

Business  in  Action  3.4  

Activity-Based Costing at Blue Cross and Blue Shield of Florida (BCBSF)

Management at Blue Cross and Blue Shield of Florida realized it needed more sophisticated cost information to make

better decisions. Given the highly competitive nature of the health care insurance industry and the need to minimize

costs, BCBSF’s management decided to implement an activity-based costing system. Management’s primary concern was

how to allocate administrative costs totaling $588,000,000 (21 percent of revenue) to the products and services the

organization provides.

The benefits of implementing an activity-based costing and management system at BCBSF are as follows:

• Product pricing is improved as a result of having better cost information (prices are based on cost).

• Regional management is able to identify the cost of services provided by headquarters and make more efficient use of costly

services.

• Product managers use the cost information to design products in a way that is most cost-effective.

As stated by the product director and cost accounting manager atBCBSF, “The goal is to provide the right information at the

right time to the right people in a cost-efficient way.”

Source: Kenneth L. Thurston, Dennis M. Kelemen, and John B. MacArthur, “Cost for Pricing at Blue Cross and Blue Shield of

Florida,”Management Accounting Quarterly, Spring 2000.

K E Y   T A K E A W A Y  

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 • Activity-­‐based  costing  and  activity-­‐based  management  techniques  are  not  limited  to  manufacturing  companies.  Virtually  all  

organizations—including  service,  nonprofit,  retail,  and  governmental—can  benefit  from  implementing  some  form  of  ABC  and  

ABM.  
R E V I E W   P R O B L E M   3 . 5  

Menzies  and  Associates  provides  two  products  to  its  clients—tax  services  and  audit  services.  Last  year,  total  overhead  costs  of  

$1,000,000  were  allocated  based  on  direct  labor  hours.  A  total  of  10,000  direct  labor  hours  were  required  last  year  for  tax  

clients  at  a  cost  of  $350,000,  and  30,000  direct  labor  hours  were  required  for  audit  clients  at  a  cost  of  $1,200,000.  Direct  

materials  used  were  negligible  and  are  included  in  overhead  costs.  Sales  revenue  totaled  $720,000  for  tax  services  and  

$2,200,000  for  audit  services.  

Management  of  Menzies  and  Associates  would  like  to  use  activity-­‐based  costing  to  allocate  overhead  rather  than  use  one  

plantwide  rate  based  on  direct  labor  hours  (perhaps  the  term  “officewide”  rate  would  be  more  appropriate  here).  The  

following  estimates  are  for  the  activities  and  related  cost  drivers  identified  as  having  the  greatest  impact  on  overhead  costs.  

Required:  

1.    

1. Using  the  plantwide  allocation  method,  calculate  the  total  cost  for  each  product.  (Hint:  Product  costs  for  this  company  

include  overhead  and  direct  labor.)  

2. Calculate  the  profit  for  each  product  using  this  approach.  Also  calculate  profit  as  a  percent  of  sales  revenue  for  each  

product.  

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 2.    

1. Using  activity-­‐based  costing,  calculate  the  predetermined  overhead  rate  for  each  activity.  (Hint:  Step  1  through  step  3  

in  the  activity-­‐based  costing  process  have  already  been  done  for  you;  this  is  step  4.)  

2. Using  activity-­‐based  costing,  calculate  the  amount  of  overhead  assigned  to  each  product.  (Hint:  This  is  step  5  in  the  

activity-­‐based  costing  process.)  

3. Calculate  the  profit  for  each  product  using  this  approach.  Also  calculate  profit  as  a  percent  of  sales  revenue  for  each  

product.  

3. Comment  on  the  results  of  using  activity-­‐based  costing  compared  to  plantwide  allocation.  

Solutions  to  Review  Problem  3.5  

1.    

1. The  plantwide  allocation  used  by  Menzies  and  Associates  is  based  on  direct  labor  hours.  The  rate  is  calculated  

as  follows:  

Estimated overhead costEstimated activity in allocation base=$1,000,00040,000 hours= $25 per direct labor hour  

Total  product  costs  are  as  follows:  

*$250,000  =  10,000  direct  labor  hours  ×  $25  rate.  

**$750,000  =  30,000  direct  labor  hours  per  unit  ×  $25  rate.  

2.    

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2.    

1. Predetermined  overhead  rates  are  calculated  for  each  activity  as  follows:  

2. Overhead  costs  are  allocated  as  follows:  

*Overhead  allocated  equals  the  predetermined  overhead  rate  times  the  cost  driver  activity.  

3. The  profit  and  profit  as  a  percent  of  sales  revenue  are  calculated  as  follows:  

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3. Activity-­‐based  costing  results  in  a  significant  increase  of  overhead  costs  allocated  to  the  tax  product  and  a  decrease  of  

overhead  costs  allocated  to  the  audit  product.  The  plantwide  allocation  approach  allocates  overhead  based  on  direct  

labor  hours,  which  results  in  25  percent  of  all  overhead  costs  being  allocated  to  tax  (=  10,000  direct  labor  hours  in  tax  ÷  

40,000  total  direct  labor  hours)  and  75  percent  to  audit.  However,  ABC  shows  that  tax  uses  60  percent  of  scheduling  

and  data  entry  resources  (=  150  tax  clients  ÷  250  total  clients),  90  percent  of  advertising  resources  (=  45  tax  ads  ÷  50  

total  ads),  and  50  percent  of  computer  resources  (=  2,500  tax  computer  hours  ÷  5,000  total  computer  hours).  Thus  tax  

is  allocated  more  overhead  costs  using  ABC  than  using  one  plantwide  rate  based  on  direct  labor  hours.  Note  that  total  

profit  of  $370,000  is  the  same  regardless  of  the  overhead  cost  allocation  approach  used.  Using  the  plantwide  

allocation  approach,  $370,000  =  $120,000  +  $250,000.  Using  the  ABC  approach,  $370,000  =  ($210,000)  +  $580,000.  

Management  must  use  this  information  to  make  improvements  to  the  company’s  operations.  It  would  probably  be  

unwise  to  eliminate  tax  services  because  of  the  connection  they  have  with  audit  services  (i.e.,  audit  clients  may  

appreciate  the  convenience  of  also  having  tax  services  available  to  them).  However,  management  can  look  for  ways  to  

make  the  process  more  efficient  by  focusing  on  costly  activities  identified  in  the  ABC  analysis.  

Note  that  when  calculating  product  costs  for  service  organizations,  it  is  difficult,  if  not  impossible,  to  calculate  a  

product  cost  per  unit.  Most  service  organizations  do  not  have  an  easily  defined  unit  of  measure  because  services  vary  

so  much  from  one  customer  to  another.  One  alternative  is  to  calculate  total  profit  as  a  percent  of  total  sales  revenue.  

This  allows  for  a  comparison  of  profitability  between  different  types  of  services,  similar  to  comparing  the  profitability  

for  units  of  product.  

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 [1]  Some  specialists  refer  to  activity-­‐based  costing  and  activity-­‐based  management  as  activity-­‐based  costing  and  management,  

or  ABCM.  

[2]  Mohan  Nair,  “Activity-­‐Based  Costing:  Who’s  Using  It  and  Why?”  Management  Accounting  Quarterly,  Spring  2000,  29–33.  

3.6  Variations of Activity-Based Costing (ABC)

L E A R N I N G   O B J E C T I V E  

1. Expand  the  use  of  activity-­‐based  costing.  

Question: The primary focus of activity-based costing thus far has been on allocating
manufacturing overhead costs to products. Although this is important for external reporting
purposes, we can expand ABC to include costs beyond manufacturing overhead. Also, we can
organize costs in different ways to help managers evaluate performance. What different
approaches can be used to organize cost data in a way that helps managers make better
decisions?

Answer: Cost data can be organized in a number of ways to help managers make decisions. Four
common approaches are addressed in this section:

3. Expanding ABC to include nonmanufacturing costs

4. Allocating service department costs to production departments
5. Using the hierarchy of costs to organize cost information
6. Measuring the costs of controlling and failing to control quality

External Reporting and Internal Decision Making

Question: U.S. Generally Accepted Accounting Principles require the allocation of all
manufacturing costs to products for inventory costing purposes. The choice of an allocation
method is not critical to this process. Companies that use direct labor hours, machine hours,
activity-based costing, or some other method to allocate overhead costs to products are likely to
be in compliance with U.S. GAAP. Throughout this chapter, we have illustrated how ABC is used
to allocate manufacturing overhead costs. However, organizations often use ABC for purposes
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 that go beyond allocating costs solely for external reporting.How might ABC be used to help
companies in areas other than external reporting?

Answer: Commissions paid to sales people for the sale of specific products (often called selling,
general, and administrative) are included as an operating expense in financial reports prepared
for external users as required by U.S. GAAP. However, many organizations may assign
commission costs to specific products for internal decision-making purposes. This treatment is
not in compliance with U.S. GAAP, but it is perfectly acceptable for internal reporting purposes
and may be done using activity-based costing. It is important to understand that managers have
ultimate control over which costs should be allocated to products for internal reporting purposes,
and this allocation often involves going beyond overhead costs.

Table 3.1 "Examples of Costs Allocated to Products" provides examples of costs that could be
allocated to products. It also includes cost categories—product, selling, and general and
administrative (G&A)—and indicates whether the cost allocation complies with U.S. GAAP
for external reporting. As you can see in the far right column, all costs can be allocated to
products for internalreporting purposes.

Table 3.1 Examples of Costs Allocated to Products

OK to Allocate to Products for External OK to Allocate to Products for
Cost Cost Category* Reporting (U.S. GAAP)? Internal Reporting?

Direct materials Product Yes Yes

Direct labor Product Yes Yes

Manufacturing overhead** Product Yes Yes

Sales commissions Selling No Yes

Shipping products to customers Selling No Yes

Product advertising Selling No Yes

Legal costs for product lawsuit G&A No Yes

Processing payroll for production

personnel G&A No Yes

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 OK to Allocate to Products for External OK to Allocate to Products for
Cost Cost Category* Reporting (U.S. GAAP)? Internal Reporting?

Company president’s salary G&A No Yes

Costs of implementing ABC G&A No Yes

*See Chapter 2 "How Is Job Costing Used to Track Production Costs?"for information about category definitions.

**Includes all manufacturing costs other than direct labor and direct materials, such as factory related costs for

supervisors, building rent, machine maintenance, utilities, and indirect materials. See Chapter 2 "How Is Job Costing

Used to Track Production Costs?" for more detail.

Allocating Service Department Costs Using the Direct Method

Question: Most companies have departments that are classified as either service departments or
production departments. Service departments provide services to other departments within the
company and include such functions as accounting, human resources, legal, maintenance, and
computer support.Production departments are directly involved with producing goods or
providing services for customers and include such functions as ordering materials, assembling
products, and performing quality inspections. Why do companies often allocate a share of
service department costs to production departments for internal reporting purposes even though
U.S. GAAP generally does not allow it for external reporting?

Answer: Companies allocate service department costs to production departments for several
reasons:

• The services provided by departments within a company are not free, and they should be
used as efficiently as possible. Managers of production departments that use these
services thus have an incentive to minimize their use.
• To minimize costs, Hewlett Packard and other large companies often “outsource”
services like building maintenance and legal support (i.e., they have other companies
provide the services for them). This creates an incentive for the company’s service
departments to provide services at a reasonable cost.
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 • Organizations often include service department costs when determining product costs for
internal decision-making purposes, as described earlier (refer to Table 3.1 "Examples of
Costs Allocated to Products" for examples).

Question: How do companies allocate service department costs to production departments and
how might this be done at SailRite?

Answer: Several methods of allocating service department costs to production departments are
available. We introduce the simplest approach—the direct method—here (complex approaches
are presented in more advanced cost accounting texts). The direct method allocates service
department costs directly to production departments but not to other service departments.

For example, assume that SailRite Company has two service departments—Human Resources
and Computer Support. Costs associated with Human Resources and Computer Support total
$90,000 and $150,000, respectively. Recall that SailRite has two production departments—Hull
Fabrication and Assembly. The goal is to allocate service department costs to the two production
departments, as shown in Figure 3.10 "Allocating Service Department Costs to Production
Departments at SailRite Company: Direct Method (Before Allocations)".

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 Figure 3.10 Allocating Service Department Costs to Production Departments at SailRite Company: Direct Method (Before

Allocations)

SailRite would like to allocate service department costs using an allocation base that drives these
costs. Assume management decides to use the number of employees as the allocation base to allocate
Human Resources costs, and the number of computers as the allocation base to allocate Computer
Support costs. Allocation base activity for each production department is as follows:

Hull Fabrication Assembly Total

Number of employees 35 85 120

Number of computers 42 33 75

The allocation rate for human resource services is $750 per employee (= $90,000 department
costs ÷ 120 employees). The allocation rate for computer support services is $2,000 per
computer (= $150,000 ÷ 75 computers). Thus the Hull Fabrication department receives an
allocation of $26,250 in human resource costs (= 35 employees × $750 rate) and $84,000 in
computer support costs (= 42 computers × $2,000 rate). The Assembly department receives an
allocation of $63,750 in human resource costs (= 85 employees × $750 rate) and $66,000 in
computer support costs (= 33 computers × $2,000 rate).

The allocations to production departments are shown in Figure 3.11 "Allocating Service
Department Costs to SailRite’s Production Departments: Direct Method (After Allocations)". If
management chooses to allocate service department costs to production departments as described
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 here, there must be some benefit to going through the process. Should these costs be assigned to
activity cost pools for the purpose of costing products (activity-based costing)? Should
production department managers be evaluated based on the use of these services? Should actual
service department usage be compared to budgeted usage for each production department? The
answers to these questions vary from one organization to the next. However, one point is
certain—the benefits of implementing this allocation system must outweigh the costs!

Figure 3.11 Allocating Service Department Costs to SailRite’s Production Departments: Direct Method (After Allocations)

The  Hierarchy  of  Costs  

Question: Some organizations group activities into four cost categories, called the hierarchy of
costs, to help managers form cost pools for activity-based costing purposes.
The cost hierarchy [1]groups costs based on whether the activity is at the facility level, product
or customer level, batch level, or unit level. What is the difference between each of these
categories, and how does this information help managers?

Answer: Each category within the cost hierarchy is described as follows:

• Facility-level activities (or costs) are required to sustain facility operations and include
items such as building rent and management of the factory. These costs are generally
changed over long time horizons and are incurred regardless of how many product-,
batch-, or unit-level activities take place.

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 • Product-level activities (or customer-level activities) are required to develop, produce,
and sell specific types of products. This category includes items such as product
development and product advertising. These costs can be changed over a shorter time
horizon than facility-level activities and are incurred regardless of the number of batches
run or units produced.
• Batch-level activities are required to produce batches (or groups) of products and include
items such as machine setups and quality inspections. These costs can be changed over a
shorter time horizon than product- and facility-level activities and are driven by the
number of batches run rather than the number of units produced. For example, a batch
can consist of producing 5 units or 10,000 units. The costs in this category are driven by
the number of batches, not the number of units in each batch.
• Unit-level activities are required to produce individual units of product and include items
such as energy to run machines, direct labor, and direct materials. These costs can be
changed over a short time horizon based on how many units management chooses to
produce.

The cost hierarchy serves as a framework for managers to establish cost pools and determine
what drives the change in costs for each cost pool. It also provides a sense of how quickly (or
slowly) costs change based on decisions made by management. Examples of activities often
identified by companies using activity-based costing, and how these activities fit in the cost
hierarchy, appear in Table 3.2 "Cost Hierarchy Examples".

Table 3.2 Cost Hierarchy Examples

Cost Hierarchy Category Activity/Cost

Plant depreciation

Building rent

Facility-level Management of facility

New product development

Product/customer-level Product engineering

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 Cost Hierarchy Category Activity/Cost

Product marketing and advertising

Maintaining customer records

Machine setups

Processing purchase orders

Batch-level Batch quality inspections

Energy to run production machines

Direct labor

Unit-level Direct materials

Measuring the Costs of Controlling and Improving Quality

Question: The hierarchy of costs is not the only approach organizations use to group costs.
Managers are also concerned about measuring the costs associated with quality. Quality-related
costs can be organized into four categories. The first two categories—prevention and
appraisal—are costs incurred to control and improve quality. The final two categories—internal
failure and external failure—are costs incurred as a result of failing to control and improve
quality. What is the difference between these cost categories, and how does this information help
managers improve quality?

Prevention costs are costs incurred to prevent defects in products and services. Examples include
designing production processes that minimize defects, providing quality training to employees,
and inspecting raw materials before they are placed in production.

• Appraisal costs (often called detection costs) are costs incurred to detect defective
products before they are delivered to customers. The cost of finished goods inspections
falls in this category.
• Internal failure costs are the costs incurred as a result of detecting defective products
before they are delivered to customers. Examples include the reworking of defective

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 products, the scrapping of defective products, and the machine downtime resulting from
process problems that cause defects.
• External failure costs are the costs incurred as a result of delivering defective products to
customers. Examples include warranty repairs, warranty replacements, and product
liability resulting from unsafe defective products.

Companies that measure these costs of quality typically calculate the costs in each category as a
percent of total revenue. The goal is to steadily shift costs toward the prevention and appraisal
categories and away from the internal and external failure categories. As organizations
concentrate more on preventing defects, total quality costs as a percent of revenue tends to
decline and product quality improves. Table 3.3 "Summary of Quality Costs" provides a
summary of the four classifications of quality-related costs.

Table 3.3 Summary of Quality Costs

Quality Cost Category Description

Prevention cost Cost of activities that prevent defects in products, such as quality training and raw materials inspections

Cost of activities that detect defective products before they are delivered to customers, such as finished goods
Appraisal cost inspections and field inspections

Cost of activities that result from detecting defective products before they are delivered to customers, such as
Internal failure cost rework and scrap

Cost of activities that result from delivering defective products to customers, such as warranty repairs and
External failure cost warranty replacements

K E Y   T A K E A W A Y  

• Activity-­‐based  costing  is  not  simply  used  to  allocate  manufacturing  overhead  costs  to  products  for  external  reporting  purposes;  

it  is  also  often  used  to  allocate  selling,  general,  and  administrative  costs  to  products  for  internal  decision-­‐making  purposes.  A  

number  of  methods  can  be  used  to  assist  in  the  cost  allocation  process.  For  example,  the  cost  of  service  departments  can  be  

allocated  to  production  departments  using  the  direct  method.  Also  the  cost  hierarchy  can  be  used  to  help  establish  cost  pools  

and  identify  cost  drivers  used  to  allocate  costs.  Organizations  are  also  concerned  with  measuring  and  reducing  the  cost  of  

quality  by  categorizing  quality  costs  into  four  categories—prevention,  appraisal,  internal  failure,  and  external  failure.  
R E V I E W   P R O B L E M   3 . 6  
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 Fill  in  the  following  table  to  identify  if  the  cost  item  can  be  included  in  the  cost  of  products  for  external  reporting  purposes  

and/or  internal  reporting  purposes.  The  first  item  is  completed  for  you.  
OK to Allocate to Products for External Reporting OK to Allocate to Products for Internal
Cost (U.S. GAAP)? Reporting?

Direct materials Yes Yes

Salaries of sales people

Indirect materials used in production

Rent for headquarters building

Product promotions

Direct labor

Legal costs for patent applications

Processing payroll for human resource

personnel

Depreciation of factory equipment

Marketing vice president’s salary

Depreciation of administrative department

equipment

Solution  to  Review  Problem  3.6  

OK to Allocate to Products for External Reporting OK to Allocate to Products for Internal
Cost (U.S. GAAP)? Reporting?

Direct materials Yes Yes

Salaries of sales people No Yes

Indirect materials used in production Yes Yes

Rent for headquarters building No Yes

Product promotions No Yes

Direct labor Yes Yes

Legal costs for patent applications No Yes

Processing payroll for human resource

personnel No Yes

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 Depreciation of factory equipment Yes Yes

Marketing vice president’s salary No Yes

Depreciation of administrative department

equipment No Yes

E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  

1. Why  do  managers  allocate  overhead  costs  to  products?  

2. Describe  the  three  methods  of  allocating  overhead  costs.  

3. What  is  a  cost  pool,  and  how  does  it  relate  to  allocating  overhead  to  products?  

4. What  is  the  difference  between  an  activity  and  a  cost  driver?  

5. How  do  cost  flows  using  activity-­‐based  costing  differ  from  cost  flows  using  one  plantwide  rate?  

6. Describe  the  five  steps  required  to  implement  activity-­‐based  costing.  

7. What  are  some  advantages  of  using  an  activity-­‐based  costing  system?  

8. What  are  some  disadvantages  of  using  an  activity-­‐based  costing  system?  

9. Review  Note  3.14  "Business  in  Action  3.1"  What  were  the  two  common  characteristics  of  the  130  U.S.  manufacturing  

companies  that  used  activity-­‐based  costing?  

10. Explain  how  to  record  the  application  of  overhead  to  products  using  activity-­‐based  costing.  

11. Describe  the  three  steps  required  to  implement  activity-­‐based  management.  

12. How  does  activity-­‐based  management  differ  from  activity-­‐based  costing?  

13. What  is  the  difference  between  a  value-­‐added  activity  and  a  non-­‐value-­‐added  activity?  Provide  two  examples  of  non-­‐

value-­‐added  activities  for  each  of  the  following:  

1. Fast-­‐food  restaurant  

2. Clothing  store  

3. College  bookstore  

14. Review  Note  3.16  "Business  in  Action  3.2"  How  did  activity-­‐based  costing  help  BuyGasCo  Corporation  settle  its  predatory  

pricing  case?  

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 15. Review  Note  3.23  "Business  in  Action  3.3"  What  did  the  survey  of  296  users  of  ABC  and  ABM  show  were  the  top  two  objectives  

in  using  these  systems?  

16. Review  Note  3.26  "Business  in  Action  3.4"  What  was  management’s  primary  concern  in  deciding  to  implement  an  activity-­‐

based  costing  system?  

17. What  selling  costs  and  general  and  administrative  costs  might  be  allocated  to  products  using  activity-­‐based  costing?  Why  do  

some  managers  prefer  allocating  these  costs  to  products?  

18. What  are  service  departments?  Why  do  some  managers  allocate  service  department  costs  to  production  departments?  

19. Describe  the  four  categories  included  in  the  hierarchy  of  costs.  

20. What  is  the  difference  between  a  facility-­‐level  cost  and  a  unit-­‐level  cost?  

21. How  does  the  hierarchy  of  costs  help  managers  allocate  overhead  costs?  

22. Describe  the  four  categories  related  to  the  costs  of  quality.  How  might  the  allocation  of  quality  costs  to  these  four  categories  

help  managers?  

Brief  Exercises  

23. Product  Costing  at  SailRite.  Refer  to  the  dialogue  presented  at  the  beginning  of  the  chapter  and  the  follow-­‐up  dialogue  

before  Figure  3.7  "Activity-­‐Based  Costing  Versus  Plantwide  Costing  at  SailRite  Company".  

Required:  

a. In  the  opening  dialogue,  why  was  the  owner  concerned  about  the  product  costs  for  each  of  the  company’s  boats?  

b. In  the  follow-­‐up  dialogue  before  Figure  3.7  "Activity-­‐Based  Costing  Versus  Plantwide  Costing  at  SailRite  Company",  

what  did  the  company’s  accountant  discover  about  the  profitability  of  each  boat  using  activity-­‐based  costing?  (Refer  

to  Figure  3.7  "Activity-­‐Based  Costing  Versus  Plantwide  Costing  at  SailRite  Company"  as  you  prepare  your  answer.)  

Calculating  Plantwide  Predetermined  Overhead  Rate.Manufacturing  overhead  costs  totaling  $5,000,000  are  

expected  for  this  coming  year.  The  company  also  expects  to  use  50,000  direct  labor  hours  and  20,000  machine  hours.  

Required:  

 . Calculate  the  plantwide  predetermined  overhead  rate  using  direct  labor  hours  as  the  base.  Provide  a  one-­‐sentence  

description  of  how  the  rate  will  be  used  to  allocate  overhead  costs  to  products.  

a. Calculate  the  plantwide  predetermined  overhead  rate  using  machine  hours  as  the  base.  Provide  a  one-­‐sentence  

description  of  how  the  rate  will  be  used  to  allocate  overhead  costs  to  products.  
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 Calculating  Department  Predetermined  Overhead  Rates.Manufacturing  overhead  costs  totaling  $1,000,000  are  

expected  for  this  coming  year—$400,000  in  the  Assembly  department  and  $600,000  in  the  Finishing  department.  The  

Assembly  department  expects  to  use  4,000  machine  hours,  and  the  Finishing  department  expects  to  use  30,000  direct  

labor  hours.  

Required:  

 . Assume  this  company  uses  the  department  approach  for  allocating  overhead  costs.  Calculate  the  predetermined  

overhead  rate  for  each  department,  and  explain  how  these  rates  will  be  used  to  allocate  overhead  costs  to  products.  

a. Why  do  different  departments  use  different  allocation  bases  (e.g.,  direct  labor  hours  or  machine  hours)?  

Identifying  Cost  Drivers.  Ehrman  Company  identified  the  activities  listed  in  the  following  as  being  most  important  

(step  1  and  step  2  of  activity-­‐based  costing),  and  it  formed  cost  pools  for  each  activity.  

0. Purchasing  raw  materials  

1. Inspecting  raw  materials  

2. Storing  raw  materials  

3. Maintaining  production  equipment  

4. Setting  up  machines  to  produce  batches  of  product  

5. Testing  finished  products  

Required:  

Perform  step  3  of  the  activity-­‐based  costing  process  by  identifying  a  possible  cost  driver  for  each  activity.  

Identifying  Cost  Drivers:  Service  Company.  McHale  Architects,  Inc.,  designs,  engineers,  and  supervises  the  

construction  of  custom  homes.  The  following  activities  were  identified  as  being  most  important  (step  1  and  step  2  of  

activity-­‐based  costing),  and  cost  pools  were  formed  for  each  activity.  

0. Meeting  with  customers  

1. Coordinating  inspections  with  the  building  department  

2. Consulting  with  contractors  

3. Maintaining  office  equipment  

4. Processing  customer  billings  (invoices)  

Required:  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 Perform  step  3  of  the  activity-­‐based  costing  process  by  identifying  a  possible  cost  driver  for  each  activity.  

Value-­‐Added  and  Non-­‐Value-­‐Added  Activities.  Novak  Corporation  manufactures  custom-­‐made  kayaks  and  

accessories.  The  company  performs  the  following  activities.  

0. Storing  parts  and  materials  

1. Queuing  orders  before  beginning  production  

2. Assembling  kayaks  

3. Waiting  for  materials  to  arrive  to  continue  production  

4. Painting  kayaks  

5. Designing  kayaks  to  maximize  comfort  

6. Scrapping  defective  materials  

Required:  

Label  each  activity  as  value-­‐added  or  non-­‐value-­‐added.  

Allocation  Base  for  Service  Departments.  Valencia  Company  has  15  production  departments  and  produces  

hundreds  of  products.  Service  department  costs  are  allocated  to  production  departments  using  the  direct  method.  Five  

service  departments  provide  the  following  services  to  the  production  departments.  

0. The  Computer  Technology  department  provides  computer  support.  

1. The  Personnel  department  posts  job  openings,  hires  employees,  and  coordinates  employee  benefits.  

2. The  Accounting  department  processes  accounting  data,  provides  financial  reports,  and  performs  general  accounting  

duties.  

3. The  Maintenance  department  maintains  buildings  and  equipment.  

4. The  Legal  department  provides  legal  services.  

Required:  

e. For  each  service  department,  provide  a  possible  allocation  base.  Explain  why  the  base  you  chose  for  each  service  

department  is  reasonable.  

f. Does  the  direct  method  provide  for  allocations  from  one  service  department  to  another?  Explain.  

Exercises:  Set  A  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 30. Plantwide  Versus  Department  Allocations  of  Overhead.  San  Juan  Company  expects  to  incur  $600,000  in  overhead  

costs  this  coming  year—$100,000  in  the  Cutting  department,  $300,000  in  the  Assembly  department,  and  $200,000  in  

the  Finishing  department.  Direct  labor  hours  worked  in  all  departments  are  expected  to  total  40,000  (used  for  the  

plantwide  rate).  The  Cutting  department  expects  to  use  20,000  machine  hours,  the  Assembly  department  expects  to  

use  25,000  direct  labor  hours,  and  the  Finishing  department  expects  to  incur  $100,000  in  direct  labor  costs  (this  

information  will  be  used  for  department  rates).  

Required:  

a. Assume  San  Juan  Company  uses  the  plantwide  approach  for  allocating  overhead  costs  and  direct  labor  hours  as  the  

allocation  base.  Calculate  the  predetermined  overhead  rate,  and  explain  how  this  rate  will  be  used  to  allocate  

overhead  costs.  

b. Assume  San  Juan  Company  uses  the  department  approach  for  allocating  overhead  costs.  Calculate  the  predetermined  

overhead  rate  for  each  department,  and  explain  how  these  rates  will  be  used  to  allocate  overhead  costs.  

Computing  Product  Costs  Using  Activity-­‐Based  Costing.  Stillwater  Company  identified  the  following  activities,  

estimated  costs  for  each  activity,  and  identified  cost  drivers  for  each  activity  for  this  coming  year.  (These  are  the  first  

three  steps  of  activity-­‐based  costing.)  

The  company  produces  three  products,  Z1,  Z2,  and  Z3.  Information  about  these  products  for  the  month  of  January  

follows:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Actual  cost  driver  activity  levels  for  the  month  of  January  are  as  follows:  

Required:  

 . Using  the  estimates  for  the  year,  compute  the  predetermined  overhead  rate  for  each  activity  (this  is  step  4  of  the  

activity-­‐based  costing  process).  

a. Using  the  activity  rates  calculated  in  requirement  a  and  the  actual  cost  driver  activity  levels  shown  for  January,  allocate  

overhead  to  the  three  products  for  the  month  of  January  (this  is  step  5  of  the  activity-­‐based  costing  process).  

b. For  each  product,  calculate  the  overhead  cost  per  unit  for  the  month  of  January.  Round  results  to  the  nearest  cent.  

c. For  each  product,  calculate  the  product  cost  per  unit  for  the  month  of  January.  Round  results  to  the  nearest  cent.  

Journal  Entry  to  Apply  Overhead.  Caspian  Company  is  deciding  which  of  three  approaches  it  should  use  to  apply  

overhead  to  products.  Information  for  each  approach  is  provided  in  the  following.  

o One  plantwide  rate.  The  predetermined  overhead  rate  is  150  percent  of  direct  labor  cost.  

o Department  rates.  The  Machining  department  uses  a  rate  of  $55  per  machine  hour,  and  the  Assembly  department  

uses  a  rate  of  $35  per  direct  labor  hour.  

o Activity-­‐based  costing  rates.  Three  activities  were  identified  and  rates  were  calculated  for  each  activity.  
Purchase requisitions $15 per requisition processed

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     206  
     
 
 Production setup $50 per setup

Quality control $70 per inspection

o Required:  

d. Direct  labor  costs  for  the  year  totaled  $80,000.  Using  the  plantwide  method,  calculate  the  amount  of  overhead  applied  

to  products  and  make  the  appropriate  journal  entry.  

e. During  the  year,  the  Machining  department  used  1,000  machine  hours,  and  the  Assembly  department  used  1,200  

direct  labor  hours.  Using  the  department  method,  calculate  the  amount  of  overhead  applied  to  products  and  make  the  

appropriate  journal  entry.  

f. During  the  year,  900  purchase  requisitions  were  processed,  1,300  production  setups  were  performed,  and  400  

products  were  inspected.  Using  the  activity-­‐based  costing  approach,  calculate  the  amount  of  overhead  applied  to  

products,  and  make  the  appropriate  journal  entry.  

Allocating  Service  Department  Costs.  Crandall  Company  has  two  production  departments  (P1  and  P2)  and  three  

service  departments  (S1,  S2,  and  S3).  Service  department  costs  are  allocated  to  production  departments  using  the  

direct  method.  The  $400,000  costs  of  department  S1  are  allocated  based  on  the  number  of  employees  in  each  

production  department.  The  $600,000  costs  of  department  S2  are  allocated  based  on  the  square  footage  of  space  

occupied  by  each  production  department.  The  $300,000  costs  of  department  S3  are  allocated  based  on  hours  of  

computer  support  used  by  each  production  department.  Information  for  each  production  department  follows.  

Required:  

 . Calculate  the  service  department  costs  allocated  to  each  production  department.  

a. In  general,  do  U.S.  Generally  Accepted  Accounting  Principles  allow  for  the  allocation  of  service  department  costs  to  

production  departments  for  the  purpose  of  valuing  inventory?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     207  
     
 
 Cost  Hierarchy.  The  following  activities  and  costs  are  for  Tanaka  Company.  

0. Direct  materials  used  by  workers  to  assemble  products  

1. Purchase  requisitions  issued  for  raw  materials  

2. Machines  set  up  to  produce  groups  of  products  

3. New  product  research  and  development  

4. Maintenance  performed  on  the  factory  building  

5. Direct  labor  assembling  products  

6. Product  designed  for  a  specific  customer  

7. Factory  building  rent  

Required:  

h. Determine  whether  each  item  is  a  facility-­‐level,  product-­‐  or  customer-­‐level,  batch-­‐level,  or  unit-­‐level  cost.  

i. Provide  one  example  of  an  appropriate  allocation  base  for  each  item.  (For  instance,  an  appropriate  allocation  base  for  

item  1  is  the  quantity  of  direct  materials  used.)  

Exercises:  Set  B  

35. Plantwide  Versus  Department  Allocations  of  Overhead:  Service  Company.  Chan  and  Associates  provides  wetlands  

design  and  maintenance  services  for  its  customers,  most  of  whom  are  developers.  Billing  is  based  on  costs  plus  a  30  

percent  markup.  Thus  costs  are  allocated  to  customers  rather  than  to  products.  

Total  overhead  costs  this  coming  year  are  expected  to  be  $2,000,000  ($600,000  in  the  Design  department  and  

$1,400,000  in  the  Wetlands  Maintenance  department).  Direct  labor  costs  are  expected  to  total  $800,000  (used  for  the  

plantwide  rate).  The  Design  department  expects  to  incur  direct  labor  costs  of  $500,000,  and  the  Wetlands  

Maintenance  department  expects  to  work  30,000  direct  labor  hours  (this  information  is  used  for  the  department  

rates).  

Required:  

a. Assume  Chan  and  Associates  uses  the  plantwide  approach  to  allocating  overhead  costs  and  direct  labor  costs  as  the  

allocation  base.  Calculate  the  predetermined  overhead  rate,  and  explain  how  this  rate  will  be  used  to  allocate  

overhead  costs.  Round  results  to  the  nearest  cent.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     208  
     
 
 b. Assume  Chan  and  Associates  uses  the  department  approach  for  allocating  overhead  costs.  Calculate  the  

predetermined  overhead  rate  for  each  department,  and  explain  how  these  rates  will  be  used  to  allocate  overhead  

costs.  Round  results  to  the  nearest  cent.  

c. What  are  two  possible  interpretations  of  the  term  costs  in  the  following  statement?  “Customers  are  billed  based  on  

costs  plus  a  30  percent  markup.”  

Computing  Product  Costs  Using  Activity-­‐Based  Costing.  Petrov  Company  identified  the  following  activities,  

estimated  costs  for  each  activity,  and  identified  cost  drivers  for  each  activity  for  this  coming  year.  (These  are  the  first  

three  steps  of  activity-­‐based  costing.)  

The  company  produces  two  products,  MX1  and  MX2.  Information  about  these  products  for  the  month  of  March  

follows:  

Actual  cost  driver  activity  levels  for  the  month  of  March  are  as  follows:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     209  
     
 
  

Required:  

 . Using  the  estimates  for  the  year,  compute  the  predetermined  overhead  rate  for  each  activity  (this  is  step  4  of  the  

activity-­‐based  costing  process).  

a. Using  the  activity  rates  calculated  in  requirement  a  and  the  actual  cost  driver  activity  levels  shown  for  March,  allocate  

overhead  to  the  three  products  for  the  month  of  March  (this  is  step  5  of  the  activity-­‐based  costing  process).  

b. For  each  product,  calculate  the  overhead  cost  per  unit  for  the  month  of  March.  Round  results  to  the  nearest  cent.  

c. For  each  product,  calculate  the  product  cost  per  unit  for  the  month  of  March.  Round  results  to  the  nearest  cent.  

Journal  Entry  to  Apply  Overhead,  Closing  Overhead  Account.Premium  Products,  Inc.,  is  deciding  which  of  three  

approaches  it  should  use  to  apply  overhead  to  products.  Information  for  each  approach  is  provided  as  follows.  

o One  plantwide  rate.  The  predetermined  overhead  rate  is  $130  per  direct  labor  hour.  

o Department  rates.  The  Cutting  department  uses  a  rate  of  200  percent  of  direct  labor  cost,  and  the  Finishing  

department  uses  a  rate  of  $50  per  machine  hour.  

o Activity-­‐based  costing  rates.  Three  activities  were  identified,  and  rates  were  calculated  for  each  activity.  
Materials handling $8 per pound of material purchased

Production setup $60 per setup

Quality control $110 per batch inspected

o Required:  

d. Direct  labor  hours  totaled  2,000  for  the  year.  Using  the  plantwide  method,  calculate  the  amount  of  overhead  applied  

to  products,  and  make  the  appropriate  journal  entry.  

e. During  the  year,  the  Cutting  department  incurred  $80,000  in  direct  labor  costs,  and  the  Finishing  department  used  

1,800  machine  hours.  Using  the  department  method,  calculate  the  amount  of  overhead  applied  to  products,  and  make  

the  appropriate  journal  entry.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     210  
     
 
 f. During  the  year,  6,000  pounds  of  material  were  purchased,  1,600  production  setups  were  performed,  and  1,300  

batches  of  products  were  inspected.  Using  the  activity-­‐based  costing  approach,  calculate  the  amount  of  overhead  

applied  to  products,  and  make  the  appropriate  journal  entry.  

g. Premium  Products,  Inc.,  closes  overapplied  or  underapplied  overhead  to  the  cost  of  goods  sold  account  at  the  

end  of  each  year.  Prepare  the  journal  entry  to  close  the  manufacturing  overhead  account  at  the  end  of  the  

year  for  each  of  the  following  independent  scenarios  assuming  the  company  made  the  journal  entry  to  apply  

overhead  in  requirement  c.  

1. The  company  recorded  $302,500  in  actual  overhead  costs  for  the  year.  

2. The  company  recorded  $243,000  in  actual  overhead  costs  for  the  year.  

Allocating  Service  Department  Costs.  Southwest,  Inc.,  has  two  production  departments  (P1  and  P2)  and  three  

service  departments  (S1,  S2,  and  S3).  Service  department  costs  are  allocated  to  production  departments  using  the  

direct  method.  The  $800,000  costs  of  department  S1  are  allocated  based  on  the  number  of  employees  in  each  

production  department.  The  $300,000  costs  of  department  S2  are  allocated  based  on  the  square  footage  of  space  

occupied  by  each  production  department.  The  $600,000  costs  of  department  S3  are  allocated  based  on  hours  of  

computer  support  used  by  each  production  department.  Information  for  each  production  department  follows.  

Required:  

 . Calculate  the  service  department  costs  allocated  to  each  production  department.  

a. In  general,  do  U.S.  Generally  Accepted  Accounting  Principles  allow  for  the  allocation  of  service  department  costs  to  

production  departments  for  the  purpose  of  valuing  inventory?  

Cost  Hierarchy.  The  following  activities  and  costs  are  for  Rios  Corporation.  

0. Salary  of  a  supervisor  responsible  for  one  product  line  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     211  
     
 
 1. Moving  groups  of  products  to  the  finished  goods  warehouse  upon  completion  

2. New  product  design  

3. Factory  building  depreciation  

4. Direct  materials  used  by  workers  to  assemble  products  

5. Machines  set  up  to  produce  groups  of  products  

6. Product  designed  for  a  specific  customer  

7. Maintenance  performed  on  the  factory  building  

Required:  

h. Determine  whether  each  item  is  a  facility-­‐level,  product-­‐  or  customer-­‐level,  batch-­‐level,  or  unit-­‐level  cost.  

i. Provide  one  example  of  an  appropriate  allocation  base  for  each  item.  

Problems  

40. Activity-­‐Based  Costing  Versus  Traditional  Approach.  Techno  Company  produces  a  regular  computer  monitor  that  sells  

for  $175  and  a  flat  panel  computer  monitor  that  sells  for  $300.  Last  year,  total  overhead  costs  of  $3,675,000  were  

allocated  based  on  direct  labor  hours.  A  total  of  63,000  direct  labor  hours  were  required  last  year  to  build  36,000  

regular  monitors  (1.75  hours  per  unit),  and  42,000  direct  labor  hours  were  required  to  build  12,000  flat  panel  monitors  

(3.50  hours  per  unit).  Total  direct  labor  and  direct  materials  costs  for  last  year  were  as  follows:  
Regular Monitor Flat Panel Monitor

Direct materials $1,908,000 $ 900,000

Direct labor $1,728,000 $1,200,000

41. The  management  of  Techno  Company  would  like  to  use  activity-­‐based  costing  to  allocate  overhead  rather  than  one  

plantwide  rate  based  on  direct  labor  hours.  The  following  estimates  are  for  the  activities  and  related  cost  drivers  

identified  as  having  the  greatest  impact  on  overhead  costs.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     212  
     
 
 42.  

43. Required:  

a. Calculate  the  direct  materials  cost  per  unit  and  direct  labor  cost  per  unit  for  each  product.  

b.    

1. Using  the  plantwide  allocation  method,  calculate  the  predetermined  overhead  rate  and  determine  the  

overhead  cost  per  unit  allocated  to  the  regular  and  flat  panel  products.  

2. Using  the  plantwide  allocation  method,  calculate  the  product  cost  per  unit  for  the  regular  and  flat  panel  

products.  Round  results  to  the  nearest  cent.  

c.    

1. Using  the  activity-­‐based  costing  allocation  method,  calculate  the  predetermined  overhead  rate  for  each  

activity.  (Hint:  Step  1  through  step  3  in  the  activity-­‐based  costing  process  have  already  been  done  for  you;  this  

is  step  4.)  

2. Using  the  activity-­‐based  costing  allocation  method,  allocate  overhead  to  each  product.  (Hint:  This  is  step  5  in  

the  activity-­‐based  costing  process.)  Determine  the  overhead  cost  per  unit.  Round  results  to  the  nearest  cent.  

3. What  is  the  product  cost  per  unit  for  the  regular  and  flat  panel  products?  

d. Calculate  the  per  unit  profit  for  each  product  using  the  plantwide  approach  and  the  activity-­‐based  costing  approach.  

e. How  much  did  the  profit  per  unit  change  for  each  product  when  moving  from  the  plantwide  approach  to  the  activity-­‐

based  costing  approach?  What  caused  this  change?  

Activity-­‐Based  Costing  Versus  Traditional  Approach,  Activity-­‐Based  Management.  Quality  Furniture,  Inc.,  produces  

a  wood  desk  that  sells  for  $500  and  a  wood  table  that  sells  for  $900.  Last  year,  total  overhead  costs  of  $6,000,000  were  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     213  
     
 
 allocated  based  on  direct  labor  costs.  Direct  labor  costs  totaled  $2,000,000  last  year,  and  Quality  Furniture  produced  

15,000  desks  and  5,000  tables.  Total  direct  labor  and  direct  materials  costs  by  product  for  last  year  were  as  follows:  
Desk Table

Direct materials $1,575,000 $950,000

Direct labor $1,200,000 $800,000

The  management  of  Quality  Furniture  would  like  to  use  activity-­‐based  costing  to  allocate  overhead  rather  than  one  

plantwide  rate  based  on  direct  labor  costs.  The  following  estimates  are  for  the  activities  and  related  cost  drivers  

identified  as  having  the  greatest  impact  on  overhead  costs.  

Required:  

 . Calculate  the  direct  materials  cost  per  unit  and  direct  labor  cost  per  unit  for  each  product.  

a.    

1. Using  the  plantwide  allocation  method,  calculate  the  predetermined  overhead  rate  and  determine  the  

overhead  cost  per  unit  allocated  to  the  desk  and  table  products.  

2. Using  the  plantwide  allocation  method,  calculate  the  product  cost  per  unit  for  the  desk  and  table  products.  

Round  results  to  the  nearest  cent.  

b.    

1. Using  the  activity-­‐based  costing  allocation  method,  calculate  the  predetermined  overhead  rate  for  each  

activity.  (Hint:  Step  1  through  step  3  in  the  activity-­‐based  costing  process  have  already  been  done  for  you;  this  

is  step  4.)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     214  
     
 
 2. Using  the  activity-­‐based  costing  allocation  method,  allocate  overhead  to  each  product.  (Hint:  This  is  step  5  in  

the  activity-­‐based  costing  process.)  Determine  the  overhead  cost  per  unit.  Round  results  to  the  nearest  cent.  

3. What  is  the  product  cost  per  unit  for  the  desk  and  table  products?  

c. Calculate  the  per  unit  profit  for  each  product  using  the  plantwide  approach  and  the  activity-­‐based  costing  approach.  

How  much  did  the  per  unit  profit  change  when  moving  from  one  approach  to  the  other?  

d. Refer  to  the  estimated  cost  driver  activity  provided.  Calculate  the  percent  of  each  activity  consumed  by  each  product  

(e.g.,  the  desk  product  issued  900  of  the  1,000  purchase  orders  issued  in  total  and  therefore  consumes  90  percent  of  

this  activity).  These  percentages  represent  the  amount  of  overhead  costs  allocated  to  each  product  using  activity-­‐

based  costing.  Using  the  plantwide  approach,  60  percent  of  all  overhead  costs  are  allocated  to  the  desk  and  40  percent  

to  the  table.  Compare  the  activity-­‐based  costing  percentages  to  the  percentage  of  overhead  allocated  to  each  product  

using  the  plantwide  approach.  Use  this  information  to  explain  what  caused  the  shift  in  overhead  costs  to  the  desk  

product  using  activity-­‐based  costing.  

Calculating  and  Recording  Overhead  Applied.  Assume  Quality  Furniture,  Inc.,  discussed  in  Problem  41,  uses  

activity-­‐based  costing.  

Required:  

 . Using  the  data  presented  at  the  beginning  of  Problem  41,  calculate  the  predetermined  overhead  rate  for  each  

activity.  

a. The  following  activity  associated  with  the  desk  product  was  reported  for  the  month  of  March.  
Number of purchase orders processed 40

Number of machine setups 22

Number of machine hours 2,425

Number of quality inspections 890

b. Using  the  predetermined  overhead  rates  calculated  in  requirement  a,  determine  the  amount  of  

overhead  applied  to  the  desk  product  for  the  month  of  March.  

c. Make  the  journal  entry  to  record  overhead  applied  to  the  desk  product  for  the  month  of  March.  

d. Assume  you  are  the  manager  of  the  desk  product  line  and  would  like  to  reduce  the  amount  of  overhead  costs  being  

applied  to  your  products.  Which  activity  would  you  focus  on  first?  Why?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     215  
     
 
 Computing  Product  Costs  Using  Activity-­‐Based  Costing,  Service  Company.  Roseville  Community  Bank  uses  activity-­‐

based  costing  to  assign  overhead  costs  to  two  different  loan  products—student  loans  and  auto  loans.  The  bank  

identified  the  following  activities,  estimated  costs  for  each  activity,  and  identified  cost  drivers  for  each  activity  for  this  

coming  year.  (These  are  the  first  three  steps  of  activity-­‐based  costing.)  

The  following  information  for  the  two  loan  products  offered  by  Roseville  Community  Bank  is  for  the  month  of  July:  

Actual  cost  driver  activity  levels  for  the  month  of  July  are  as  follows:  

Required:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     216  
     
 
  . Using  the  estimates  for  the  year,  compute  the  predetermined  overhead  rate  for  each  activity  (this  is  step  4  of  the  

activity-­‐based  costing  process).  

a. Using  the  activity  rates  calculated  in  requirement  a  and  the  actual  cost  driver  activity  levels  shown  for  July,  allocate  

overhead  to  the  two  products  for  the  month  of  July.  

b. For  each  loan  product,  calculate  the  overhead  cost  per  loan  approved  for  the  month  of  July.  Round  results  to  the  

nearest  cent.  

c. For  each  loan  product,  calculate  the  total  cost  per  loan  approved  for  the  month  of  July.  Round  results  to  the  nearest  

cent.  

d. Assume  you  are  the  manager  of  the  auto  loans  product  line  and  would  like  to  reduce  the  amount  of  overhead  costs  

being  applied  to  your  products.  Which  activity  would  you  focus  on  first?  Why?  

Activity-­‐Based  Costing  Versus  Traditional  Approach:  Service  Company,  Activity-­‐Based  Management.  Hodges  and  

Associates  is  a  small  firm  that  provides  structural  engineering  services  for  its  clients.  The  company  performs  structural  

engineering  services  for  both  residential  and  commercial  buildings.  Last  year,  total  overhead  costs  of  $330,000  were  

allocated  based  on  direct  labor  costs.  A  total  of  $300,000  in  direct  labor  costs  were  incurred  in  the  following  areas:  

$120,000  in  the  residential  segment  and  $180,000  in  the  commercial  segment.  Direct  materials  used  were  negligible  

and  are  included  in  overhead  costs.  Sales  revenue  totaled  $450,000  for  residential  services  and  $330,000  for  

commercial  services.  

The  management  of  Hodges  and  Associates  would  like  to  use  activity-­‐based  costing  to  allocate  overhead  rather  than  a  

plantwide  rate  based  on  direct  labor  costs.  The  following  estimates  are  for  the  activities  and  related  cost  drivers  

identified  as  having  the  greatest  impact  on  overhead  costs.  

 
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     217  
     
 
 Required:  

 .    

1. Using  the  plantwide  allocation  method,  calculate  the  total  cost  for  each  product.  (Hint:  Product  costs  for  this  

company  include  overhead  and  direct  labor.)  

2. Using  the  plantwide  approach,  calculate  the  profit  for  each  product.  Also  calculate  profit  as  a  percent  of  sales  

revenue  for  each  product  (round  to  the  nearest  tenth  of  a  percent).  

a.    

1. Using  activity-­‐based  costing,  calculate  the  predetermined  overhead  rate  for  each  activity.  (Hint:  Step  1  through  

step  3  in  the  activity-­‐based  costing  process  have  already  been  done  for  you;  this  is  step  4.)  Round  results  to  the  

nearest  cent.  

2. Using  activity-­‐based  costing,  calculate  the  amount  of  overhead  assigned  to  each  product.  (Hint:  This  is  step  5  in  

the  activity-­‐based  costing  process.)  

3. Using  activity-­‐based  costing,  calculate  the  profit  for  each  product.  Also  calculate  profit  as  a  percent  of  sales  

revenue  for  each  product  (round  to  the  nearest  tenth  of  a  percent).  

b. What  caused  the  shift  of  overhead  costs  to  the  residential  product  using  activity-­‐based  costing?  How  might  

management  use  this  information  to  make  improvements  within  the  company?  

Calculating  and  Recording  Overhead  Applied:  Service  Company.Assume  Hodges  and  Associates,  discussed  in  

Problem  44,  uses  activity-­‐based  costing.  

Required:  

 . Using  the  data  presented  at  the  beginning  of  Problem  44,  calculate  the  predetermined  overhead  rate  for  each  

activity.  Round  results  to  the  nearest  cent.  

a. The  following  activity  associated  with  the  commercial  product  was  reported  for  the  month  of  

September.  
Number of direct labor hours 350

Number of computer hours 960

Number of applications 50

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     218  
     
 
 b. Using  the  predetermined  overhead  rates  calculated  in  requirement  a,  determine  the  amount  of  

overhead  applied  to  the  commercial  product  for  the  month  of  September.  

c. Make  the  journal  entry  to  record  overhead  applied  to  the  commercial  product  for  the  month  of  September.  

d. Assume  you  are  manager  of  the  commercial  product  line  and  would  like  to  reduce  the  amount  of  overhead  costs  being  

applied  to  your  products.  Which  activity  would  you  focus  on  first?  Why?  

Allocating  Service  Department  Costs.  Szabo  Industries  has  two  production  departments  (Finishing  and  Painting)  

and  three  service  departments  (Maintenance,  Computer  Support,  and  Personnel).  Service  department  costs  are  

allocated  to  production  departments  using  the  direct  method.  Maintenance  allocates  costs  totaling  $3,000,000  based  

on  the  square  footage  of  space  occupied  by  each  production  department.  Computer  Support  allocates  costs  totaling  

$4,000,000  based  on  hours  of  computer  support  used  by  each  production  department.  Personnel  allocates  costs  

totaling  $2,500,000  based  on  number  of  employees  in  each  production  department.  Information  for  each  production  

department  follows.  

Required:  

 . Calculate  the  service  department  costs  allocated  to  each  production  department.  

a. Why  do  companies  allocate  service  department  costs  to  production  departments?  

Selecting  an  Allocation  Base  for  Service  Costs.  Winstead,  Inc.,  is  looking  for  an  appropriate  allocation  base  to  

allocate  personnel  costs  totaling  $5,000,000.  Service  department  costs  are  allocated  to  three  production  departments:  

Assembly,  Sanding,  and  Finishing.  Management  is  considering  two  allocation  bases.  
Possible Allocation Base Assembly Sanding Finishing

Number of employees 30 20 50

Square feet of space occupied 25,000 15,000 10,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     219  
     
 
 Required:  

 . Calculate  the  amount  of  personnel  department  costs  allocated  to  production  departments  using  each  allocation  

base.  

a. Which  allocation  base  do  you  think  is  most  reasonable?  Why?  

One  Step  Further:  Skill-­‐Building  Cases  

48. Overhead  Allocation.  Do  you  agree  with  the  following  statement?  Explain  your  answer.  

Total  estimated  overhead  costs  will  vary  depending  on  whether  we  use  the  plantwide  method,  department  method,  or  

activity-­‐based  costing  to  allocate  overhead.  

49. Cost  Allocation  Issues.  Assume  you  rent  a  house  with  two  friends.  The  total  monthly  rent  is  $1,500.  Your  bedroom  is  

the  smallest  of  the  three  bedrooms,  and  each  of  the  others  has  a  bathroom  attached.  You  and  your  friends  are  trying  

to  decide  how  to  divide  up  the  rent.  Two  possibilities  are  being  discussed.  

1. Share  the  cost  equally  among  the  three  of  you.  

2. Determine  rent  based  on  square  feet  occupied  (the  attached  bathrooms  would  be  part  of  the  square  footage  

measurement).  

Required:  

c. Which  approach  do  you  think  is  most  fair  for  all  involved?  Why?  

d. Which  approach  is  easiest?  Why?  

e. Suggest  another  approach  to  dividing  up  the  cost  of  rent.  

Activity-­‐Based  Costing  and  Activity-­‐Based  Management.  A  colleague  states,  “We  produce  one  product,  and  our  

operations  are  relatively  simple.  Activity-­‐based  costing  and  activity-­‐based  management  would  be  a  waste  of  time  for  our  

company!”  Do  you  agree  with  this  statement?  Explain.  

Product  Costs.  The  company  president  makes  the  following  statement:  “Product  costs  are  straightforward.  Whatever  

costs  are  incurred  to  produce  a  product  are  assigned  to  that  product.”  Do  you  agree  with  this  statement?  Explain.  

Changing  Plantwide  Allocation  Rate  at  SailRite.  Recall  from  the  chapter  discussion  that  SailRite  uses  one  plantwide  

rate  based  on  direct  labor  hours  to  allocate  manufacturing  overhead  costs  to  the  company’s  two  sailboat  products—

Basic  and  Deluxe.  Management  was  concerned  about  the  inaccuracy  of  overhead  costs  being  assigned  to  each  product  

and  decided  to  calculate  product  costs  using  activity-­‐based  costing.  Product  cost  and  profit  results  are  summarized  in  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 the  following  for  the  plantwide  allocation  approach  (based  on  direct  labor  hours)  and  activity-­‐based  costing  approach.  

This  information  was  presented  in  the  chapter  in  Figure  3.7  "Activity-­‐Based  Costing  Versus  Plantwide  Costing  at  SailRite  

Company".  

*Overhead  taken  from  Figure  3.2  "SailRite  Company  Product  Costs  Using  One  Plantwide  Rate  Based  on  Direct  Labor  Hours".  

**Overhead  taken  from  Figure  3.5  "Allocation  of  Overhead  Costs  to  Products  at  SailRite  Company".  

Although  management  of  SailRite  prefers  the  accuracy  of  activity-­‐based  costing,  the  cost  of  maintaining  such  an  

accounting  system  for  the  long  term  is  prohibitive.  John,  the  accountant,  has  proposed  going  back  to  using  one  

plantwide  rate,  but  he  would  like  to  allocate  overhead  costs  using  machine  hours  rather  than  direct  labor  hours.  

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 Recall  that  overhead  costs  totaled  $8,000,000.  A  total  of  90,000  machine  hours  were  used  for  the  period:  50,000  for  

Basic  sailboats  and  40,000  for  Deluxe  sailboats.  The  company  produced  5,000  units  of  the  Basic  model  and  1,000  units  

of  the  Deluxe  model.  Thus  the  Basic  model  uses  10  machine  hours  per  unit  (=  50,000  machine  hours  ÷  5,000  units)  and  

the  Deluxe  model  uses  40  machine  hours  per  unit  (=  40,000  machine  hours  ÷  1,000  units).  

Required:  

 . Calculate  the  predetermined  overhead  rate  using  machine  hours  as  the  allocation  base,  and  determine  the  

overhead  cost  per  unit  allocated  to  the  Basic  and  Deluxe  sailboats.  Round  results  to  the  nearest  cent.  

a. For  each  product,  calculate  the  unit  product  cost  and  profit  using  the  same  format  presented  previously.  Round  results  

to  the  nearest  cent.  

b. Compare  your  results  in  requirement  b  to  the  results  using  direct  labor  hours  as  the  allocation  base  and  activity-­‐based  

costing.  

c. Provide  at  least  two  reasons  why  management  might  prefer  machine  hours  as  the  overhead  allocation  base  rather  

than  direct  labor  hours  or  activity-­‐based  costing.  

Service  Department  Cost  Allocation.  Biotech,  Inc.,  recently  began  providing  cafeteria  services  to  its  employees.  

Because  revenue  from  the  sale  of  food  at  the  cafeteria  does  not  fully  cover  cafeteria  expenses,  Biotech  must  pay  for  

the  shortfall.  These  costs  are  allocated  to  production  departments  based  on  employee  usage.  That  is,  the  company  

tracks  which  employees  use  the  cafeteria  and  allocates  costs  to  production  departments  accordingly.  

Sarah  Kolster,  manager  of  the  quality  testing  department,  is  not  happy  with  receiving  cafeteria  cost  allocations.  She  is  

evaluated  based  on  meeting  a  cost  budget  established  at  the  beginning  of  the  fiscal  year,  which  does  not  include  the  

cafeteria  allocation,  and  she  clearly  has  an  incentive  to  minimize  costs.  

When  Sarah  met  with  the  company’s  accountant,  Dan,  regarding  this  issue,  she  said,  “Dan,  I  like  the  idea  of  providing  

cafeteria  service  to  our  employees,  but  the  costs  allocated  to  my  department  are  killing  my  budget.  Last  month  alone,  I  

was  allocated  $3,000  in  costs  related  to  the  new  cafeteria.  I  have  no  choice  but  to  require  my  employees  to  go  

elsewhere  for  food.”  

Dan  responded,  “I  understand  your  concern,  Sarah.  Management’s  intent  was  to  provide  a  service  to  our  employees  

that  would  improve  productivity  and  reward  employees  for  their  hard  work.  If  you  tell  your  employees  to  stop  using  

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 the  cafeteria,  more  costs  will  be  allocated  to  other  departments,  and  the  other  departments  might  also  stop  using  the  

cafeteria.  My  belief  is  that  the  cafeteria  will  be  self-­‐sufficient  within  a  year  if  more  employees  are  encouraged  to  use  it.  

This  translates  into  no  more  cost  allocations  to  departments  within  a  year.  I’ll  discuss  your  concerns  with  top  

management  later  this  week.”  

Required:  

 . Why  does  Biotech,  Inc.,  allocate  cafeteria  costs  to  departments?  

a. What  recommendations  would  you  make  to  top  management  regarding  the  way  cafeteria  costs  are  allocated  to  

departments?  

Comprehensive  Case  

54. Activity-­‐Based  Costing,  Journal  Entries,  T-­‐Accounts,  and  Preparing  an  Income  Statement.  This  problem  is  an  

adaptation  of  the  example  presented  at  the  end  of  Chapter  2  "How  Is  Job  Costing  Used  to  Track  Production  Costs?"  for  

Custom  Furniture  Company.  The  only  difference  is  that  this  problem  uses  activity-­‐based  costing  to  allocate  overhead  

costs  rather  than  one  plantwide  rate.  Recall  that  inventory  beginning  balances  were  $25,000  for  raw  materials  

inventory,  $35,000  for  work-­‐in-­‐process  inventory,  and  $90,000  for  finished  goods  inventory.  

Management  of  Custom  Furniture  Company  would  like  to  use  activity-­‐based  costing  to  allocate  overhead  costs  totaling  

$1,140,000  rather  than  one  plantwide  rate  based  on  direct  labor  hours.  The  following  estimates  are  for  the  activities  

and  related  cost  drivers  identified  as  having  the  greatest  impact  on  overhead  costs.  

Transactions  for  the  month  of  May  are  shown  as  follows:  

1. Raw  materials  were  purchased  during  the  month  for  $15,000  on  account.  

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 2. Raw  materials  totaling  $21,000  were  placed  in  production:  $3,000  for  indirect  materials  (glue,  screws,  nails,  and  the  

like)  and  $18,000  for  direct  materials  (wood  planks,  hardware,  etc.).  

3. Timesheets  from  the  direct  labor  workforce  show  total  costs  of  $40,000,  to  be  paid  the  next  month.  

4. Production  supervisors  and  other  indirect  labor  working  in  the  factory  are  owed  wages  totaling  $27,000.  

5. The  following  costs  were  incurred  related  to  the  factory:  building  depreciation  of  $29,000,  insurance  of  $11,000  

(originally  recorded  as  prepaid  insurance),  utilities  of  $4,000  (to  be  paid  the  next  month),  and  maintenance  costs  of  

$22,000  (paid  immediately).  

6. Manufacturing  overhead  is  applied  to  products  based  on  the  following  cost  driver  activity  for  the  month:  
Number of purchase orders 75

Number of machine setups 120

Machine hours 1,850

Direct labor hours 3,240

7. The  following  selling  costs  were  incurred:  wages  of  $5,000  (to  be  paid  the  next  month),  building  rent  of  $3,000  

(originally  recorded  as  prepaid  rent),  and  advertising  totaling  $10,000  (to  be  paid  the  next  month).  

8. The  following  general  and  administrative  (G&A)  costs  were  incurred:  wages  of  $13,000  (to  be  paid  the  next  month),  

equipment  depreciation  of  $6,000,  and  building  rent  of  $7,000  (originally  recorded  as  prepaid  rent).  

9. Completed  goods  costing  $155,000  were  transferred  out  of  work-­‐in-­‐process  inventory.  

10. Sold  goods  for  $100,000  on  account  and  $90,000  cash.  

11. The  goods  sold  in  the  previous  transaction  had  a  cost  of  $129,000.  

12. Closed  the  manufacturing  overhead  account  to  cost  of  goods  sold.  

Required:  

m. Calculate  the  predetermined  overhead  rate  for  each  activity.  

n. Prepare  T-­‐accounts  for  the  following  accounts:  cash,  accounts  receivable,  prepaid  insurance,  prepaid  rent,  raw  

materials  inventory,  work-­‐in-­‐process  inventory,  finished  goods  inventory,  accumulated  depreciation  (building  and  

equipment),  accounts  payable,  wages  payable,  manufacturing  overhead,  sales,  cost  of  goods  sold,  advertising  expense  

(selling),  rent  expense  (selling),  wages  expense  (selling),  depreciation  expense  (G&A),  rent  expense  (G&A),  and  wages  

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 expense  (G&A).  Enter  beginning  balances  in  T-­‐accounts  for  the  inventory  accounts  (raw  materials,  work  in  process,  and  

finished  goods).  

o. Prepare  a  journal  entry  for  each  of  the  transactions  1through  11,  and  post  each  entry  to  the  T-­‐accounts  set  up  in  

requirement  b.  Label  each  entry  in  the  T-­‐accounts  by  transaction  number,  and  total  each  T-­‐account.  

p. Is  overhead  underapplied  or  overapplied  for  the  month  of  May?  Based  on  the  balance  in  the  manufacturing  overhead  

T-­‐account  prepared  in  requirement  c,  prepare  a  journal  entry  for  transaction  12.  

q. Prepare  an  income  statement  for  the  month  of  May.  (Hint:  Be  sure  to  include  the  adjustment  made  to  cost  of  goods  

sold  in  requirement  d.)  

[1]  Credit  for  developing  the  cost  hierarchy  is  generally  given  to  R.  Cooper  and  R.  S.  Kaplan,  “Profit  Priorities  from  Activity-­‐Based  Costing,”  Harvard  
Business  Review,  May  1991,  130–35.  

   

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 Chapter  4  
How Is Process Costing Used to Track Production Costs?

Ann Watkins owns and operates a company that mass produces wood desks used in classrooms
throughout the world. Ann’s company, Desk Products, Inc., maintains an advantage over its
competitors by producing one desk in large quantities—4,000 to 8,000 desks per month—using a
universally accepted design. This enables the company to buy materials in bulk, often leading to
volume price discounts from suppliers. Because the exact same desk is produced for all
customers, Desk Products purchases precut wood materials from suppliers. As a result, Desk
Products can limit the production process to two processing departments—Assembly and
Finishing. The Assembly department requisitions precut materials and hardware from the raw
materials storeroom, assembles each desk, and moves the assembled desks to the Finishing
department. The Finishing department sands and paints each desk and moves completed desks to
the finished goods warehouse.

A new competitor recently began producing a similar desk, and Ann is concerned about whether
Desk Products’ production costs are reasonable. In particular, Ann is concerned about the costs
in the Assembly department since this department is responsible for the majority of the
company’s production costs. Ann talks with the accountant at Desk Products, John Fuller, to
investigate.

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 John, as you know, we have a new competitor that is aggressively going after our
customers. It looks as if we will have to focus on keeping costs low to compete. The
Assembly department is my biggest concern, and it would help if I knew the cost of
Ann: each desk that goes through this department.

Although we don’t track production costs for each desk individually, we do use a
process costing system that assigns costs to each batch of desks produced. This system
enables us to calculate a cost per unit as the products move through the Assembly
John: department.

Excellent! Can you get me the cost information for the Assembly department for last
Ann: month?

John: Sure, I’ll put together a production cost report for you by the end of the week.

We return to Desk Products, Inc., throughout the chapter to explain how process costing systems
work.

4.1 Comparison of Job Costing with Process Costing

L E A R N I N G   O B J E C T I V E  

1. Compare  and  contrast  job  costing  and  process  costing.  

Question: A process costing system is used by companies that produce similar or identical units
of product in batches employing a consistent process. Examples of companies that use process
costing include Chevron Corporation(petroleum products), the Wrigley Company (chewing
gum), and Pittsburgh Paints (paint). A job costing system is used by companies that produce
unique products or jobs. Examples of companies that use job costing systems
include Boeing (airplanes), Lockheed Martin (advanced technology systems), and Deloitte &
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 Touche (accounting). What are the similarities and differences between job costing and process
costing systems?

Answer: Although these systems have marked differences, they are also similar in many ways.
(As you read through this section, refer to Chapter 1 "What Is Managerial Accounting?" for a
review of important terms if necessary.) Recall the three inventory accounts that accountants use
to track product cost information—raw materials inventory, work-in-process inventory, and
finished goods inventory. These three inventory accounts are used to record product cost
information for both process costing and job costing systems. However, several work-in-process
inventory accounts are typically used in a process costing system to track the flow of product
costs through each production department. Thus each department has its own work-in-process
inventory account. (For the purposes of this chapter, assume each department represents a
production process. This explains the term process costing because we are tracking costs by
process.) The sum of all work-in-process inventory accounts represents total work in process for
the company.

Recall the three components of product costs—direct materials, direct labor, and manufacturing
overhead. Assigning these product costs to individual products remains an important goal for
process costing, just as with job costing. However, instead of assigning product costs to
individual jobs(shown on a job cost sheet), process costing assigns these costs to departments
(shown on a departmental production cost report).

Figure 4.1 "A Comparison of Cost Flows for Job Costing and Process Costing"shows how
product costs flow through accounts for job costing and process costing systems. Table 4.1 "A
Comparison of Process Costing and Job Costing"outlines the similarities and differences
between these two costing systems. Review these illustrations carefully before moving on to the
next section.

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 Figure 4.1 A Comparison of Cost Flows for Job Costing and Process Costing

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 Table 4.1 A Comparison of Process Costing and Job Costing
Product Costs

Similarities Product costs consist of direct materials, direct labor, and manufacturing overhead.

Process Costing Job Costing

Differences Product costs are assigned to departments (or processes). Product costs are assigned to jobs.

Unit Cost Information

Similarities Unit cost information is needed by management for decision-making purposes.

Process Costing Job Costing

Unit cost information comes from the departmental production cost

Differences report. Unit cost information comes from the job cost sheet.

Inventory Accounts

Similarities Inventory accounts include raw materials inventory, work-in-process inventory, and finished goods inventory.

Process Costing Job Costing

Several different work-in-process inventory accounts are used—one for One work-in-process inventory account is used—job cost sheets
Differences each department (or process). track costs assigned to each job.

Business  in  Action  4.1  

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Source: Photo courtesy of Simon Berry,http://www.flickr.com/photos/bezznet/3105213435/.

The Production Process at Coca-Cola

The Coca-Cola Company is one of the world’s largest producers of nonalcoholic beverages. According to the company, more than

11,000 of its soft drinks are consumed every second of every day.

In the first stage of production, Coca-Cola mixes direct materials—water, refined sugar, and secret ingredients—to make the liquid

for its beverages. The second stage includes filling cleaned and sanitized bottles before placing a cap on each bottle. In the third

stage, filled bottles are inspected, labeled, and packaged.

Work in process begins with the first stage of production (mixing and blending), continues with the second stage (bottling), and ends

with the third stage (inspecting, labeling, and packaging). When products have gone through all three stages of production, they are

shipped to a warehouse, and the costs are entered into finished goods inventory. Once products are delivered to retail stores, product

costs are transferred from finished goods inventory to cost of goods sold.

Source: Coca-Cola Company, “Home Page,” http://www2.coca-cola.com/ourcompany/bottlingtoday.

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 K E Y   T A K E A W A Y  

• A  process  costing  system  is  used  by  companies  that  produce  similar  or  identical  units  of  product  in  batches  employing  a  consistent  process.  A  job  

costing  system  is  used  by  companies  that  produce  unique  products  or  jobs.  Process  costing  systems  track  costs  by  processing  department,  

whereas  job  costing  systems  track  costs  by  job.  

R E V I E W   P R O B L E M   4 . 1  

Identify  whether  each  business  listed  in  the  following  would  use  job  costing  or  process  costing.  

a. Trash  bag  manufacturer  

b. Custom  furniture  manufacturer  

c. Shampoo  manufacturer  

d. Automobile  repair  shop  

e. Sports  drink  manufacturer  

f. Antique  boat  restorer  

Solution  to  Review  Problem  4.1  

a. Process  costing  

b. Job  costing  

c. Process  costing  

d. Job  costing  

e. Process  costing  

f. Job  costing  

4.2 Product Cost Flows in a Process Costing System

L E A R N I N G   O B J E C T I V E  

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 1. Identify  how  product  costs  flow  through  accounts  using  process  costing.  

As products physically move through the production process, the product costs associated with
these products move through several important accounts as shown back in Figure 4.1 "A
Comparison of Cost Flows for Job Costing and Process Costing". In this section, we present a
detailed look at how product costs flow through accounts using a process costing system. Later
in the chapter, we explain how dollar amounts are established for product costs that flow through
the accounts. As you review each of the following cost flows for a process costing system,
remember that product costs are now tracked by department rather than by job.

Direct Materials

Question: In a process costing setting, direct materials are often used by several production
departments. How do we record direct materials costs for each production department?

Answer: When direct materials are requisitioned from the raw materials storeroom, a journal
entry is made to reduce the raw materials inventory account and increase the appropriate work-
in-process inventory account. For example, assume the Assembly department of Desk Products,
Inc., requisitions direct materials to be used in production. The journal entry to reflect this is as
follows:

The use of direct materials is not limited to one production department. Suppose the Finishing
department requisitions direct materials for production. The journal entry to reflect this is as
follows:

 
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 Notice that two different work-in-process inventory accounts are used to track production
costs—one for each department.

Direct Labor

Question: Each production department typically has a direct labor work force.How do we record
direct labor costs for each production department?

Answer: Direct labor costs are recorded directly in the production department’s work-in-process
inventory account. Assume direct labor costs are incurred by the Assembly department. The
journal entry to reflect this is as follows:

As with direct materials, the use of direct labor is not limited to one production department.
Suppose direct labor costs are incurred by the Finishing department. The journal entry to reflect
this is as follows:

Manufacturing Overhead

Question: Manufacturing overhead costs are typically assigned to products using a

predetermined overhead rate using a normal costing system as discussed in Chapter 2 "How Is
Job Costing Used to Track Production Costs?"(job costing) and Chapter 3 "How Does an
Organization Use Activity-Based Costing to Allocate Overhead Costs?" (activity-based
costing). How do we record manufacturing overhead costs for each department?

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 Answer: Assume manufacturing overhead costs (often simply calledoverhead costs) are being
applied to products going through the Assembly department. The journal entry to reflect this is as
follows:

The journal entry to reflect manufacturing overhead costs being applied to products going
through the Finishing department is as follows:

Transferred-In Costs

Question: At this point, we have discussed how to record product costs (direct materials, direct
labor, and manufacturing overhead) related to each production department. As you
review Figure 4.1 "A Comparison of Cost Flows for Job Costing and Process Costing", notice
that products often flow from one production department to the next. Transferred-in costs are the
costs associated with products moving from one department to another. How do we record
transferred-in costs for each department?

Answer: Assume the Assembly department at Desk Products, Inc., completes a batch of desks
and moves the desks to the Finishing department. The costs associated with these desks must be
transferred from the work-in-process inventory account for the Assembly department to the
work-in-process inventory account for the Finishing department. Thus these costs are
beingtransferred in to the Finishing department. The journal entry to reflect this is as follows:

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Finished Goods

Question: Goods are completed and ready to sell once they have gone through the final
production department. The final production department at Desk Products, Inc., is the Finishing
department. How do we record production costs for products moved from the final production
department to the finished goods warehouse?

Answer: When goods go through the final production department and are completed, the related
costs are moved to the finished goods inventory account. The journal entry to reflect this is as
follows:

Cost of Goods Sold

Question: How do we record production costs for goods that have been sold?

Answer: Once the completed goods are sold, the related costs are moved out of the finished
goods inventory account and into the cost of goods sold account. The journal entry to reflect this
is as follows:

Figure 4.2 "Flow of Product Costs in a Process Costing System" summarizes the flow of product
costs through T-accounts for each of the journal entries presented in this section. Note that when
goods are sold and production costs are moved from finished goods inventory to cost of goods
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 sold, an additional entry is made to record the revenue associated with this transaction. We do
not show this entry because the focus of this section is on the flow of production costs rather than
revenues.

Figure 4.2 Flow of Product Costs in a Process Costing System

Business  in  Action  4.2  

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Source: Photo courtesy of Mykl Roventine,http://www.flickr.com/photos/myklroventine/3471836813/.

The Production Process for Wrigley’s Gum

The Wrigley Company has 14 factories located in various parts of the world, including North America, Europe, Africa,

India, and the Asia/Pacific region. The gum produced by these factories is sold in 150 countries. According to Wrigley

Company, 50 percent of Americans chew gum, and on average, each person consumes 190 sticks per year. The number

drops to 130 sticks per person in the United Kingdom and to 100 sticks per person in Taiwan.

The production process at Wrigley involves six sequential stages:

1. Melting. The gum base, which comes in small round balls, is melted and purified.

2. Mixing. The melted base is poured into a mixer, to which sweeteners and flavors are added.

3. Rolling. A large “loaf” of gum is sent through a series of rollers, thereby reducing thickness to the desired size.

4. Scoring. The gum is cut into the shape of sticks or pellets.

5. Conditioning. The gum is cooled and “conditioned” to ensure the right consistency before being packaged.

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 6. Packaging. The gum is packaged and made ready for shipping.

Because Wrigley produces identical units of product in batches employing a consistent process, it likely uses a process

costing system. With such a system, Wrigley would need a separate work-in-process inventory account to track costs for

each stage of the production process.

Source: Wrigley’s, “Home Page,” http://www.wrigley.com.

K E Y   T A K E A W A Y  

• The  cost  flows  in  a  process  costing  system  are  similar  to  the  cost  flows  in  a  job  costing  system.  The  primary  difference  between  

the  two  costing  methods  is  that  a  process  costing  system  assigns  product  costs—direct  materials,  direct  labor,  and  

manufacturing  overhead—to  each  production  department  (or  process)  rather  than  to  each  job.  Each  production  department  

has  its  own  work-­‐in-­‐process  inventory  account  when  using  process  costing.  
R E V I E W   P R O B L E M   4 . 2  

Chewy  Gum  Corporation  produces  bubble  gum  in  large  batches  and  uses  a  process  costing  system.  Three  departments—

Mixing,  Rolling,  and  Packaging—are  involved  in  the  production  process.  Chewy  Gum  has  the  following  transactions:  

a. Direct  materials  totaling  $20,000—$6,000  for  the  Mixing  department,  $5,000  for  the  Rolling  department,  and  $9,000  for  

the  Packaging  department—are  requisitioned  and  placed  in  production.  

b. Each  production  department  incurs  the  following  direct  labor  costs  (wages  payable):  
Mixing $2,500

Rolling $4,600

Packaging $2,200

c. Manufacturing  overhead  costs  are  applied  to  each  department  as  follows:  
Mixing $10,000

Rolling $ 7,000

Packaging $ 7,500

d. Products  with  a  cost  of  $5,500  are  transferred  from  the  Mixing  department  to  the  Rolling  department.  

e. Products  with  a  cost  of  $6,400  are  transferred  from  the  Rolling  department  to  the  Packaging  department.  

f. Products  with  a  cost  of  $9,100  are  completed  and  transferred  from  the  Packaging  department  to  the  finished  goods  

warehouse.  

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 g. Products  with  a  cost  of  $8,300  are  sold  to  customers.  

Perform  the  following  steps  for  each  transaction:  

1. Prepare  a  journal  entry  to  record  the  transaction.  

2. Summarize  the  flow  of  costs  through  T-­‐accounts.  Use  the  format  presented  in  Figure  4.2  "Flow  of  Product  Costs  in  a  Process  

Costing  System"  (no  need  to  include  T-­‐accounts  for  raw  materials  inventory,  wages  payable,  or  manufacturing  overhead).  

Assume  there  are  no  beginning  balances  in  the  work-­‐in-­‐process  inventory,  finished  goods  inventory,  and  cost  of  goods  sold  

accounts.  

Solution  to  Review  Problem  4.2  

1.    

1.    

2.    

3.    

 
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 4.    

5.    

6.    

7.    

8.    

4.3 Determining Equivalent Units

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 L E A R N I N G   O B J E C T I V E  

1. Understand  the  concept  of  an  equivalent  unit.  

Question: The beginning of this chapter describes process costing and the flow of costs through
accounts used in a process costing system. The challenge is determining the unit cost of products
being transferred out of each departmental work-in-process inventory account. We start the
process of determining unit cost information with an important concept, the concept of
equivalent units.What are equivalent units, and how are equivalent units calculated?

Answer: Units of product in work-in-process inventory are assumed to bepartially completed;

otherwise, the units would not be in work-in-process inventory. Process costing
requires partially completed units in ending work-in-process inventory to be converted to the
equivalent completed units (called equivalent units). Equivalent units are calculated by
multiplying the number of physical (or actual) units on hand by the percentage of completion of
the units. If the physical units are 100 percent complete, equivalent units will be the same as the
physical units. However, if the physical units are not 100 percent complete, the equivalent units
will be less than the physical units.

For example, if four physical units of product are 50 percent complete at the end of the period, an
equivalent of two units has been completed (2 equivalent units = 4 physical units × 50 percent).
The formula used to calculate equivalent units is as follows:

Equivalent units = Number of physical units × Percentage of completion

Figure 4.3 "Concept of Equivalent Units" provides an example of the equivalent unit concept in
which four desks, 50 percent complete, are the equivalent of two completed desks.

Figure 4.3 Concept of Equivalent Units

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 Question: With the concept of equivalent units now in hand, we can calculate equivalent units for
the three product costs—direct materials, direct labor, and manufacturing overhead. Why do we
calculate equivalent units separately for direct materials, direct labor, and manufacturing
overhead?

Answer: Equivalent units in work in process are often different for direct materials, direct labor,
and manufacturing overhead because these three components of production may enter the
process at varying stages. For example, in the Assembly department at Desk Products, Inc.,
direct materials enter production early in the process while direct labor and overhead are used
throughout the process. (Imagine asking workers to assemble desks without materials!) Thus
equivalent units must be calculated for each of the three production costs. (Note that direct labor
and manufacturing overhead are sometimes combined in a category calledconversion costs,
which assumes both are added to the process at the same time. In this text, we keep direct labor
and manufacturing overhead separate.) The next section presents how we use the equivalent unit
concept for product costing purposes. Be sure you understand the concept of equivalent units
before moving on.

Business  in  Action  4.3  

Calculating Full-Time Equivalent Students

The concept of an equivalent unit can be applied to determine the number of full-time equivalent students (FTES) at a school. Colleges

use FTES data to plan and make decisions about course offerings, staffing, and facility needs. Although having information about the

number of students enrolled (the headcount) is helpful, headcount data do not provide an indication of whether the students are full

time or part time. Clearly, full-time students take more classes each term and generally use more resources than part-time students.

Thus administrators often prefer to convert enrollment data to FTES.

Using a simple example to explain this concept, assume 30 students attend school and each takes half a full load of classes. The

headcount is 30. However, this is the equivalent of 15 full-time students, or 15 FTES.

To apply this to the real world, let’s look at the enrollment data forSierra College, a community college located near Sacramento,

California. During a recent semester, the student headcount in a specific department at Sierra College was 8,190. Because a large

number of students in the department were part time, the full-time equivalent number of students totaled 3,240.

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 Source: Based on enrollment data from Sierra College.
K E Y   T A K E A W A Y S  

• When  units  of  work-­‐in-­‐process  (WIP)  inventory  exist  at  the  end  of  the  reporting  period,  process  costing  requires  that  these  partially  

completed  units  be  converted  to  the  equivalent  completed  units  (called  equivalent  units).  The  equation  used  to  calculate  equivalent  

completed  units  is  as  follows:  

Equivalent  units  =  Number  of  physical  units  ×  Percentage  of  completion  

• Because  direct  materials,  direct  labor,  and  manufacturing  overhead  typically  enter  the  production  process  at  different  stages,  equivalent  units  

must  be  calculated  separately  for  each  of  these  production  costs.  
R E V I E W   P R O B L E M   4 . 3  

Soap  Production  Company’s  Mixing  department  shows  the  following  information  for  the  1,000  units  of  product  remaining  in  work  in  

process  at  the  end  of  the  period.  Assume  there  was  no  beginning  inventory.  
Direct materials 90 percent complete

Direct labor 30 percent complete

Overhead 60 percent complete

Calculate  the  equivalent  units  for  each  of  the  three  product  costs—direct  materials,  direct  labor,  and  overhead.  

Solution  to  Review  Problem  4.3  

The  formula  used  to  calculate  equivalent  units  is  as  follows:  

Equivalent  units  =  Number  of  partially  completed  units  ×  Percentage  of  completion  

Materials 900 equivalent units = 1,000 partially completed units × 90 percent

Labor 300 equivalent units = 1,000 partially completed units × 30 percent

Overhead 600 equivalent units = 1,000 partially completed units × 60 percent

4.4 The Weighted Average Method

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 L E A R N I N G   O B J E C T I V E  

1. Use  four  steps  to  assign  costs  to  products  using  the  weighted  average  method.  

Most companies use either the weighted average or first-in-first-out (FIFO)method to assign
costs to inventory in a process costing environment. Theweighted average method includes costs
in beginning inventory and current period costs to establish an average cost per unit. The first-in-
first-out (FIFO) method keeps beginning inventory costs separate from current period costs and
assumes that beginning inventory units are completed and transferred out before the units started
during the current period are completed and transferred out. We focus on the weighted average
approach here and leave the discussion of the FIFO method to more advanced cost accounting
textbooks.

Question: The primary goal stated in and , and continued in this chapter, is to assign product
costs to products. In a process costing system,cost per equivalent unit is the term used to
describe the average unit cost for each product. How is the concept of cost per equivalent unit
used to assign costs to (1) completed units transferred out and (2) units still in work-in-process
(WIP) inventory at the end of the period?

Answer: Costs are assigned to completed units transferred out and units in ending WIP
inventory using a four-step process. We list the four steps in the following and then explain them
in detail. Review these steps carefully.

Step 1. Summarize the physical flow of units and compute the equivalent units for direct
materials, direct labor, and overhead.

Step 2. Summarize the costs to be accounted for (separated into direct materials, direct
labor, and overhead).

Step 3. Calculate the cost per equivalent unit.

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 Step 4. Use the cost per equivalent unit to assign costs to (1) completed units transferred
out and (2) units in ending WIP inventory.

The Four Key Steps of Assigning Costs

Recall that Desk Products, Inc., has two departments—Assembly and Finishing. Although this
chapter focuses on the Assembly department, the Finishing department would also use the four
steps to determine product costs for completed units transferred out and ending WIP
inventory.presents information for the Assembly department at Desk Products for the month of
May. Review this information carefully as it will be used to illustrate the four key steps.

Table 4.2 Production Information for Desk Products’ Assembly Department

Assembly Department—Month of May

• The company had 3,000 units in beginning WIP inventory; all were completed and transferred out during May.

• During May, 6,000 units were started. Of the 6,000 units started:

o 1,000 units were completed and transferred out to the Finishing department (100 percent complete with respect to direct materials, direct

labor, and overhead); thus 1,000 units werestarted and completed during May.

o 5,000 units were partially completed and remained in ending WIP inventory on May 31 (60 percent complete for direct materials, 30 percent

complete for direct labor, and 30 percent complete for overhead, which is applied based on direct labor hours).

• Costs in beginning WIP inventory totaled $161,000 (= $95,000 in direct materials + $40,000 in direct labor + $26,000 in overhead).

• Costs incurred during May totaled $225,000 (= $115,000 in direct materials + $70,000 in direct labor + $40,000 in overhead).

Question: Costs for the Assembly department totaled $386,000 for the month of May ($386,000
= $161,000 in beginning WIP inventory + $225,000 incurred during May). How much of the
$386,000 should be assigned to (1) completed units transferred out to the Finishing department
and (2) units remaining in the Assembly department ending WIP inventory?

Answer: Let’s use the four key steps as follows to answer this question.

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 Step 1. Summarize the physical flow of units and compute the equivalent units for direct
materials, direct labor, and overhead.

This step uses the basic cost flow equation presented in to identify the physical flow of units (the
basic cost flow equation applies to costs and tounits):

Beginning balance+Transfers in(BB)+(TI)Units to be accounted for==Transfers out + Ending balance(TO)+(EB)Units accounted for  

Question: What are the two categories used to summarized the physical flow of units?

Answer: The first category, units to be accounted for, includes the beginning balance (BB) and
transfers in (TI). The second category, units accounted for, includes the ending balance (EB) and
transfers out (TO). As you can see from the previous equation, units to be accounted for must
equal units accounted for. Here is how it looks for the Assembly department for the month of
May:

*This information is used in the physical units column of .

This step shows that 3,000 units were in WIP inventory on May 1 and 6,000 units were started
during May. Thus 9,000 units must be accounted for. These 9,000 units will end up in one of two
places, either completed and transferred out (to the Finishing department) or not completed and
therefore in ending WIP inventory. The previous schedule shows that 4,000 units were
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 completed and transferred out (3,000 from beginning WIP inventory and 1,000 from the units
started and completed during the month), and 5,000 units remain in ending WIP inventory.

Question: Based on the previous information for Desk Products, Inc., we now know that 4,000
units were completed and transferred out, and 5,000 units were in ending WIP inventory at the
end of May. How do we convert this information into equivalent units?

Answer: The units accounted for (4,000 transferred out and 5,000 in ending WIP inventory) must
be converted into equivalent units for direct materials, direct labor, and overhead, as shown in .
The 4,000 units transferred out are 100 percent complete for direct materials, direct labor, and
overhead (otherwise, they would not be transferred out), which results in equivalent units
matching the physical units. However, the 5,000 units in ending WIP inventory are at varying
levels of completion for direct materials, direct labor, and overhead, and must be converted into
equivalent units using the following formula (as described earlier in the chapter):

Equivalent  units  =  Number  of  physical  units  ×  Percentage  of  completion  

Later in step 3, we will use equivalent unit information for the Assembly department to calculate
the cost per equivalent unit.

Figure 4.4 Flow of Units and Equivalent Unit Calculations for Desk Products’ Assembly Department

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 a This column represents actual physical units accounted for before converting to equivalent units.

b Equivalent units = Number of physical units × Percentage of completion. Units completed and transferred out are 100

percent complete. Thus equivalent units are the same as the physical units. (Information is from .)

c Equivalent units = Number of physical units × Percentage of completion. For direct materials, 3,000 equivalent units =

5,000 physical units × 60 percent complete; for direct labor and overhead, 1,500 equivalent units = 5,000 physical units ×

30 percent complete. (Information is from .)

Step 2. Summarize the costs to be accounted for (separated into direct materials, direct
labor, and overhead).

Question: How do we summarize the costs that are used to calculate the cost per equivalent
unit?

Answer: The total costs to be accounted for include the costs in beginning WIP inventory and
the costs incurred during the period. shows these costs for the Assembly department. Notice that
the costs are separated into direct materials, direct labor, and overhead.

Figure 4.5 Summary of Costs to Be Accounted for in Desk Products’ Assembly Department

a Information is from .

Shows that costs totaling $386,000 must be assigned to (1) completed units transferred out and
(2) units in ending WIP inventory.

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 Step 3. Calculate the cost per equivalent unit.

Question: We now have the costs () and equivalent units () needed to determine the cost per
equivalent unit for direct materials, direct labor, and overhead.How do we use this information
to calculate the cost per equivalent unit?

Answer: The formula to calculate the cost per equivalent unit using the weighted average
method is as follows:

Key  Equation  

Cost per equivalent unit=Costs in beginning WIP + Current period costsEquivalent units completed and transferred out + Equivalent unit
s in ending WIP  

In summary, the same formula is as follows:

Cost per equivalent unit=Total costs to be accounted for*Total equivalent units accounted for**  

*From the bottom of .

**From the bottom of .

Presents the cost per equivalent unit calculation for Desk Products’ Assembly department.
Figure 4.6 Calculation of the Cost per Equivalent Unit for Desk Products’ Assembly Department

a Information is from .

b Information is from .

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 The cost per equivalent unit is calculated for direct materials, direct labor, and overhead. Simply
divide total costs to be accounted for by total equivalent units accounted for. It is important to
note that the information shown inallows managers to carefully assess the unit cost information
in the Assembly department for direct materials, direct labor, and overhead. We discuss this
further later in the chapter.

Step 4. Use the cost per equivalent unit to assign costs to (1) completed units transferred
out and (2) units in ending WIP inventory.

Question: Recall our primary goal of assigning costs to completed units transferred out and to
units in ending WIP inventory. How do we accomplish this goal?

Answer: Costs are assigned by multiplying the cost per equivalent unit (shown in ) by the
number of equivalent units (shown in ) for direct materials, direct labor, and overhead. shows
how this is done.

Figure 4.7 Assigning Costs to Products in Desk Products’ Assembly Department

a The total cost assigned to units transferred out equals the cost per equivalent unit times the number of equivalent units.

For example, the cost assigned to direct materials of $120,000 = 4,000 equivalents units () × $30 per equivalent unit ().

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 b The total cost assigned to units in ending inventory equals the cost per equivalent unit times the number of equivalent

units. For example, the cost assigned to direct materials of $90,000 = 3,000 equivalent units () × $30 per equivalent unit

().

c This must match total costs to be accounted for shown in . Although not an issue in this example, rounding the cost per

equivalent unit may cause minor differences between the two amounts.

Shows that total costs of $248,000 are assigned to units completed and transferred out and that
$138,000 in costs are assigned to ending WIP inventory.

On completion of step 4, it is important to reconcile the total costs to be accounted for shown at
the bottom of with the total costs accounted for shown at the bottom of . The two balances must
match (note that small discrepancies may exist due to rounding the cost per equivalent unit). This
reconciliation relates back to the basic cost flow equation as follows:

Beginning balance+Transfers in(BB)+(TI)Costs to be accounted for($386,000*)==Transfers out + Ending balance(TO)+(EB)Costs accounted for($386,0
00**)  

**From .

***From .

Although the examples in this chapter have been created in a way that minimizes rounding
errors, always round the cost per equivalent unit calculations in step 3 to the nearest thousandth
(e.g., if the cost per equivalent unit is $2.3739, round this to $2.374 rather than to $2). Although
rounding differences still may occur, this will minimize the size of rounding errors when
attempting to reconcile costs to be accounted for (step 2) with costs accounted for (step 4).

Journalizing Costs Assigned to Units Completed and Transferred

Question: Once the four-step process is complete, a journal entry must be made to record the
transfer of costs out of the Assembly department and into the Finishing department. How do we
record the costs associated with units completed and transferred out?

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 Answer: At Desk Products, Inc., 4,000 units were transferred from the Assembly department to
the Finishing department. Costs totaling $248,000 were assigned to these units as shown in . The
journal entry to record this at the end of May is as follows:

(Note that this was journal entry number four, presented without dollar amounts earlier in the
chapter.)

Shows the flow of costs through the work-in-process inventory T-account for the Assembly
department. Note that four key steps were performed for the Assembly department to determine
the costs assigned to (1) completed units transferred out to the Finishing department ($248,000)
and (2) units in Assembly’s WIP inventory ($138,000). Both amounts are highlighted.

Figure 4.8 Flow of Costs through the Work-in-Process Inventory T-Account of Desk Products’ Assembly Department

 
Business  in  Action  4.4  
The Production Process for Hershey’s Chocolate

Hershey Foods Corp. is best known for its chocolate products, including brands like Almond Joy, Hershey’s Kisses, and

Reese’s.Hershey’s products are sold in more than 90 countries worldwide. According to Hershey, more than 80 million

Kiss-shaped products are made every day!

Several sequential stages of production are required to produce chocolate at Hershey:

1. Fermentation. Cocoa beans are placed in large heaps for one week to allow the cocoa flavor to develop.

2. Roasting. The cocoa beans are roasted at very high temperatures.

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 3. Hulling. A hulling machine separates the shell from the inside of the bean (called the nib).

4. Milling. The nibs are ground into chocolate liquor (a liquid with a pure chocolate flavor that contains no alcohol).

5. Mixing. The chocolate liquor is mixed with cocoa butter, sugar, and milk. This mixture is dried into a brown powder,

called chocolate crumb, and processed into chocolate paste.

6. Molding. Machines are used to fill more than 1,000 molds per minute with chocolate. The chocolate is then chilled to form

solid candy.

7. Packaging. The candy is wrapped, packaged, and ready to be shipped.

Hershey likely uses a process costing system since it produces identical units of product in batches employing a consistent

process. Process costing systems require the use of work-in-process inventory accounts for each process.

Thus Hershey would track production costs using separate work-in-process inventory accounts for each stage of

production.

Source: Hershey’s, “Home Page,” http://www.hersheys.com.

K E Y   T A K E A W A Y S  

• Four  steps  are  used  to  assign  product  costs  to  (1)  completed  units  transferred  out  and  (2)  units  in  work-­‐in-­‐process  inventory  at  

the  end  of  the  period.  

• The  four-­‐step  process  must  be  performed  for  each  processing  department  and  results  in  a  journal  entry  to  record  the  costs  

assigned  to  units  transferred  out.  

R E V I E W   P R O B L E M   4 . 4  

Kelley  Paint  Company  uses  the  weighted  average  method  to  account  for  costs  of  production.  Kelley  manufactures  base  paint  in  

two  separate  departments—Mixing  and  Packaging.  The  following  information  is  for  the  Mixing  department  for  the  month  of  

March.  

• A  total  of  40,000  units  (measured  in  gallons)  were  in  beginning  WIP  inventory.  All  were  completed  and  transferred  out  during  

March.  

• A  total  of  70,000  units  were  started  during  March.  Of  the  70,000  units  started,  

o 20,000  units  were  completed  and  transferred  out  to  the  Packaging  department  (100  percent  complete  with  respect  to  

direct  materials,  direct  labor,  and  overhead),  and  

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 o 50,000  units  were  partially  completed  and  remained  in  ending  WIP  inventory  on  March  31  (90  percent  complete  for  

direct  materials,  70  percent  complete  for  direct  labor,  and  30  percent  complete  for  overhead,  which  is  applied  based  

on  machine  hours).  

• Costs  in  beginning  WIP  inventory  totaled  $229,000  (=  $98,000  in  direct  materials  +  $41,000  in  direct  labor  +  $90,000  in  

overhead).  

• Costs  incurred  during  March  totaled  $165,000  (=  $70,000  in  direct  materials  +  $35,000  in  direct  labor  +  $60,000  in  overhead).  

Required:  

a. Use  the  four  key  steps  to  assign  costs  to  units  completed  and  transferred  out  and  to  units  in  ending  WIP  inventory  for  

the  Mixing  department.  

b. Prepare  the  journal  entry  necessary  at  the  end  of  March  to  record  the  transfer  of  costs  associated  with  units  completed  and  

transferred  to  the  Packaging  department.  

Solution  to  Review  Problem  4.4  

a. The  four  steps  are  as  follows:  

Step  1.  Summarize  the  physical  flow  of  units  and  compute  the  equivalent  units  for  direct  materials,  direct  labor,  and  

overhead.  

a
 60,000  units  =  40,000  from  beginning  WIP  inventory  +  20,000  started  and  completed  in  March.  

b
 This  column  represents  actual  physical  units  accounted  for  beforeconverting  to  equivalent  units.  

c
 Equivalent  units  =  number  of  physical  units  ×  percentage  of  completion.  Units  completed  and  transferred  out  are  100  percent  

complete.  Thus  equivalent  units  are  the  same  as  the  physical  units.  
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 d
 Equivalent  units  =  number  of  physical  units  ×  percentage  of  completion.  For  direct  materials,  45,000  equivalent  units  =  50,000  physical  

units  ×  90  percent  complete;  for  direct  labor,  35,000  equivalent  units  =  50,000  physical  units  ×  70  percent  complete;  for  overhead,  

15,000  equivalent  units  =  50,000  physical  units  ×  30  percent  complete.  

Step  2.  Summarize  the  costs  to  be  accounted  for  (separated  into  direct  materials,  direct  labor,  and  overhead).  

e
 Information  is  given.  

Step  3.  Calculate  the  cost  per  equivalent  unit.  

Step  4.  Use  the  cost  per  equivalent  unit  to  assign  costs  to  (1)  completed  units  transferred  out  and  (2)  units  in  ending  

WIP  inventory.  

f
 Total  costs  assigned  to  units  transferred  out  equals  the  cost  per  equivalent  unit  times  the  number  of  equivalent  units.  For  example,  

costs  assigned  for  direct  materials  of  $96,000  =  60,000  equivalents  units  (from  step  1)  ×  $1.60  per  equivalent  unit  (from  step  3).  

g
 Total  costs  assigned  to  ending  WIP  inventory  equals  the  cost  per  equivalent  unit  times  the  number  of  equivalent  units.  For  example,  

costs  assigned  for  direct  materials  of  $72,000  =  45,000  equivalent  units  (from  step  1)  ×  $1.60  per  equivalent  unit  (from  step  3).  

h
 This  must  match  total  costs  to  be  accounted  for  in  step  2,  as  shown  in  the  following:  

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 Beginning balance + Transfers in(BB)+(TI)Costs to be accounted for(394,000 from step 2)==Transfers out + Ending balance(TO)+(EB)Costs accounted for($394,000 from step 4)  

b. As  shown  in  step  4,  $264,000  in  total  costs  are  assigned  to  units  completed  and  transferred  out.  The  entry  to  record  

this  is  as  follows:  

4.5  Preparing  a  Production  Cost  Report  

L E A R N I N G   O B J E C T I V E  

1. Prepare  a  production  cost  report  for  a  processing  department.  

Question: The results of the four key steps are typically presented in a production cost report.
The production cost report summarizes the production and cost activity within a department for a
reporting period. It is simply a formal summary of the four steps performed to assign costs to
units transferred out and units in ending work-in-process (WIP) inventory. What does the
production cost report look like for the Assembly department at Desk Products, Inc.?

Answer: The production cost report for the month of May for the Assembly department appears
in Figure 4.9 "Production Cost Report for Desk Products’ Assembly Department". Notice that
each section of this report corresponds with one of the four steps described earlier. We provide
references to the following illustrations so you can review the detail supporting calculations.

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 Figure 4.9 Production Cost Report for Desk Products’ Assembly Department

a Total costs to be accounted for (step 2) must equal total costs accounted for (step 4).

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 b Data are given.
c This section comes from Figure 4.4 "Flow of Units and Equivalent Unit Calculations for Desk

Products’ Assembly Department".

d This section comes from Figure 4.5 "Summary of Costs to Be Accounted for in Desk Products’

Assembly Department".
e This section comes from Figure 4.6 "Calculation of the Cost per Equivalent Unit for Desk

Products’ Assembly Department".

f This section comes from Figure 4.7 "Assigning Costs to Products in Desk Products’ Assembly

Department".

How Do Managers Use Production Cost Report Information?

Question: Although the production cost report provides information needed to transfer costs
from one account to another, managers also use this report for decision-making purposes. What
important questions can be answered using the production cost report?

Answer: A production cost report helps managers answer several important questions:

• How much does it cost to produce each unit of product for each department?
• Which production cost is the highest—direct materials, direct labor, or overhead?
• Where are we having difficulties in the production process? In any particular
departments?
• Are we seeing any significant changes in unit costs for direct materials, direct labor, or
overhead? If so, why?
• How many units flow through each processing department each month?
• Are improvements in the production process being reflected in the cost per unit from one
month to the next?
• Beware of Fixed Costs

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 Question: Why might the per unit cost data provided in the production cost report be
misleading?

Answer: When using information from the production cost report, managers must be careful not
to assume that all production costs are variable costs. The CEO of Desk Products, Inc., Ann
Watkins, was told that the Assembly department cost for each desk totaled $62 for the month of
May (from Figure 4.9 "Production Cost Report for Desk Products’ Assembly Department", step
3). However, if the company produces more or fewer units than were produced in May, the unit
cost will change. This is because the $62 unit cost includes both variable and fixed costs
(see Chapter 5 "How Do Organizations Identify Cost Behavior Patterns?" for a detailed
discussion of fixed and variable costs).

Assume direct materials and direct labor are variable costs. In the Assembly department, the
variable costs per unit associated with direct materials and direct labor of $50 (= $30 direct
materials + $20 direct labor) will remain the same regardless of the level of production, within
the relevant range. However, the remaining unit product cost of $12 associated with overhead
must be analyzed further to determine the amount that is variable (e.g., indirect materials) and
the amount that is fixed (e.g., factory rent). Managers must understand that fixed costs per
unit will change depending on the level of production. More specifically, Ann Watkins must
understand that the $62 unit cost in the Assembly department provided in the production cost
report will change depending on the level of production.Chapter 5 "How Do Organizations
Identify Cost Behavior Patterns?" provides a detailed presentation of how cost information can
be separated into fixed and variable components for the purpose of providing managers with
more useful information.

K E Y   T A K E A W A Y  

• The  four  key  steps  of  assigning  costs  to  units  transferred  out  and  units  in  ending  WIP  inventory  are  formally  presented  in  a  

production  cost  report.  The  production  cost  report  summarizes  the  production  and  cost  activity  within  a  processing  

department  for  a  reporting  period.  A  separate  report  is  prepared  for  each  processing  department.  Rounding  the  cost  per  

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 equivalent  unit  to  the  nearest  thousandth  will  minimize  rounding  differences  when  reconciling  costs  to  be  accounted  for  in  

step  2  with  costs  accounted  for  in  step  4.  

Computer  Application  
Using Excel to Prepare a Production Cost Report

Managers typically use computer software to prepare production cost reports. They do so for several reasons:

• Once the format is established, the template can be used from one period to the next.

• Formulas underlie all calculations, thereby minimizing the potential for math errors and speeding up the process.

• Changes can be made easily without having to redo the entire report.

• Reports can be easily combined to provide a side-by-side analysis from one period to the next.

Review Figure 4.9 "Production Cost Report for Desk Products’ Assembly Department" and then ask yourself: “How can I use

Excel to help prepare this report?” Answers will vary widely depending on your experience with Excel. However, Excel has a

few basic features that can make the job of creating a production cost report easier. For example, you can use formulas to

sum numbers in a column (note that each of the four steps presented in Figure 4.9 "Production Cost Report for Desk

Products’ Assembly Department" has column totals) and to calculate the cost per equivalent unit. Also you can establish a

separate line to double-check that

• the units to be accounted for match the units accounted for; and

• the total costs to be accounted for match the total costs accounted for.

For those who want to add more complex features, the basic data (e.g., the data in Table 4.2 "Production Information for

Desk Products’ Assembly Department") can be entered at the top of the spreadsheet and pulled down to the production cost

report where necessary.

An example of how to use Excel to prepare a production cost report follows. Notice that the basic data are at the top of the

spreadsheet, and the rest of the report is driven by formulas. Each month, the data at the top are changed to reflect the

current month’s activity, and the production cost report takes care of itself.

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R E V I E W   P R O B L E M   4 . 5  

Using  the  information  in  Note  4.24  "Review  Problem  4.4",  prepare  a  production  cost  report  for  the  Mixing  department  of  

Kelley  Paint  Company  for  the  month  ended  March  31.  (Hint:  You  have  already  completed  the  four  key  steps  in  Note  4.24  

"Review  Problem  4.4".  Simply  summarize  the  information  in  a  production  cost  report  as  shown  in  Figure  4.9  "Production  Cost  

Report  for  Desk  Products’  Assembly  Department".)  

Solution  to  Review  Problem  4.5  

(See  solutions  to  Note  4.24  "Review  Problem  4.4"  for  detailed  calculations.)  

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E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  

1. Which  types  of  companies  use  a  process  costing  system  to  account  for  product  costs?  Provide  at  least  three  examples  of  

products  that  would  require  the  use  of  a  process  costing  system.  

2. Describe  the  similarities  between  a  process  costing  system  and  a  job  costing  system.  

3. Describe  the  differences  between  a  process  costing  system  and  a  job  costing  system.  
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 4. Review  Note  4.4  "Business  in  Action  4.1"  What  are  the  three  stages  of  production  at  Coca-­‐Cola,  and  what  account  is  used  to  

track  production  costs  for  each  stage?  

5. What  are  transferred-­‐in  costs?  

6. Review  Note  4.9  "Business  in  Action  4.2"  Why  is  it  likely  that  Wrigleyuses  a  process  costing  system  rather  than  a  job  costing  

system?  

7. Explain  the  difference  between  physical  units  and  equivalent  units.  

8. Explain  the  concept  of  equivalent  units  assuming  the  weighted  average  method  is  used.  

9. Explain  why  direct  materials,  direct  labor,  and  overhead  might  be  at  different  stages  of  completion  at  the  end  of  a  reporting  

period.  

10. Review  Note  4.14  "Business  in  Action  4.3"  Why  do  colleges  convert  the  actual  number  of  students  attending  school  to  a  full-­‐

time  equivalent  number  of  students?  

11. Describe  the  four  key  steps  shown  in  a  production  cost  report  assuming  the  weighted  average  method  is  used.  

12. What  two  important  amounts  are  determined  in  step  4  of  the  production  cost  report?  

13. Describe  the  basic  cost  flow  equation  and  explain  how  it  is  used  to  reconcile  units  to  be  accounted  for  with  units  accounted  

for.  

14. Describe  the  basic  cost  flow  equation  and  explain  how  it  is  used  to  reconcile  costs  to  be  accounted  for  with  costs  accounted  

for.  

15. Review  Note  4.22  "Business  in  Action  4.4"  Describe  the  last  two  stages  of  the  production  process  at  Hershey.  

16. How  does  a  company  determine  the  number  of  production  cost  reports  to  be  prepared  for  each  reporting  period?  

17. What  is  a  production  cost  report,  and  how  is  it  used  by  management?  

18. Explain  how  the  cost  per  equivalent  unit  might  be  misleading  to  managers,  particularly  when  a  significant  change  in  production  

is  anticipated.  

Brief  Exercises  

19. Product  Costing  at  Desk  Products,  Inc.  Refer  to  the  dialogue  presented  at  the  beginning  of  the  chapter.  

Required:  

a. Why  was  the  owner  of  Desk  Products,  Inc.,  concerned  about  the  Assembly  department  product  cost  of  each  desk?  

b. What  did  the  accountant,  John  Fuller,  promise  by  the  end  of  the  week?  
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 Job  Costing  Versus  Process  Costing.  For  each  firm  listed  in  the  following,  identify  whether  it  would  use  job  costing  

or  process  costing.  

0. Chewing  gum  manufacturer  

1. Custom  automobile  restorer  

2. Facial  tissue  manufacturer  

3. Accounting  services  provider  

4. Electrical  services  provider  

5. Pool  builder  

6. Cereal  producer  

7. Architectural  design  provider  

Process  Costing  Journal  Entries.  Assume  a  company  has  two  processing  departments—Molding  and  Packaging.  

Transactions  for  the  month  are  shown  as  follows.  

0. The  Molding  department  requisitioned  direct  materials  totaling  $2,000  to  be  used  in  production.  

1. Direct  labor  costs  totaling  $3,500  were  incurred  in  the  Molding  department,  to  be  paid  the  next  month.  

2. Manufacturing  overhead  costs  applied  to  products  in  the  Molding  department  totaled  $2,500.  

3. The  cost  of  goods  transferred  from  the  Molding  department  to  the  Packaging  department  totaled  $10,000.  

4. Manufacturing  overhead  costs  applied  to  products  in  the  Packaging  department  totaled  $1,800.  

Required:  

Prepare  journal  entries  to  record  transactions  1  through  5.  

Calculating  Equivalent  Units.  Complete  the  requirements  for  each  item  in  the  following.  

0. A  university  has  500  students  enrolled  in  classes.  Each  student  attends  school  on  a  part-­‐time  basis.  On  average,  

each  student  takes  three-­‐quarters  of  a  full  load  of  classes.  Calculate  the  number  of  full-­‐time  equivalent  students  (i.e.,  

calculate  the  number  of  equivalent  units).  

1. A  total  of  10,000  units  of  product  remain  in  the  Assembly  department  at  the  end  of  the  year.  Direct  materials  are  80  

percent  complete  and  direct  labor  is  40  percent  complete.  Calculate  the  equivalent  units  in  the  Assembly  department  

for  direct  materials  and  direct  labor.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     265  
     
 
 2. A  local  hospital  has  60  nurses  working  on  a  part-­‐time  basis.  On  average,  each  nurse  works  two-­‐thirds  of  a  full  load.  

Calculate  the  number  of  full-­‐time  equivalent  nurses  (i.e.,  calculate  the  number  of  equivalent  units).  

3. A  total  of  6,000  units  of  product  remain  in  the  Quality  Testing  department  at  the  end  of  the  year.  Direct  materials  are  

75  percent  complete  and  direct  labor  is  20  percent  complete.  Calculate  the  equivalent  units  in  the  Quality  Testing  

department  for  direct  materials  and  direct  labor.  

Calculating  Cost  per  Equivalent  Unit.  The  following  information  pertains  to  the  Finishing  department  for  the  month  

of  June.  
Direct Materials Direct Labor Overhead

Total costs to be accounted for $100,000 $200,000 $300,000

Total equivalent units accounted for 10,000 units 8,000 units 8,000 units

Required:  

Calculate  the  cost  per  equivalent  unit  for  direct  materials,  direct  labor,  overhead,  and  in  total.  Show  your  

calculations.  

Assigning  Costs  to  Completed  Units  and  to  Units  in  Ending  WIP  Inventory.  The  following  information  is  for  the  

Painting  department  for  the  month  of  January.  

Direct Materials Direct Labor Overhead

Cost per equivalent unit $2.10 $1.50 $3.80

Equivalent units completed and transferred out 3,000 units 3,000 units 3,000 units

Equivalent units in ending WIP inventory 1,000 units 1,200 units 1,200 units

Required:  

 . Calculate  the  costs  assigned  to  units  completed  and  transferred  out  of  the  Painting  department  for  direct  materials,  

direct  labor,  overhead,  and  in  total.  

a. Calculate  the  costs  assigned  to  ending  WIP  inventory  for  the  Painting  department  for  direct  materials,  direct  labor,  

overhead,  and  in  total.  

Exercises:  Set  A  

25. Assigning  Costs  to  Products:  Weighted  Average  Method.  Sydney,  Inc.,  uses  the  weighted  average  method  for  its  

process  costing  system.  The  Assembly  department  at  Sydney,  Inc.,  began  April  with  6,000  units  in  work-­‐in-­‐process  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     266  
     
 
 inventory,  all  of  which  were  completed  and  transferred  out  during  April.  An  additional  8,000  units  were  started  during  

the  month,  3,000  of  which  were  completed  and  transferred  out  during  April.  A  total  of  5,000  units  remained  in  work-­‐

in-­‐process  inventory  at  the  end  of  April  and  were  at  varying  levels  of  completion,  as  shown  in  the  following.  
Direct materials 40 percent complete

Direct labor 30 percent complete

Overhead 50 percent complete

26. The  following  cost  information  is  for  the  Assembly  department  at  Sydney,  Inc.,  for  the  month  of  April.  
Direct Materials Direct Labor Overhead Total

Beginning WIP inventory $300,000 $350,000 $250,000 $900,000

Incurred during the month $180,000 $200,000 $170,000 $550,000

27. Required:  

a. Determine  the  units  to  be  accounted  for  and  units  accounted  for;  then  calculate  the  equivalent  units  for  direct  

materials,  direct  labor,  and  overhead.  (Hint:  This  requires  performing  step  1  of  the  four-­‐step  process.)  

b. Calculate  the  cost  per  equivalent  unit  for  direct  materials,  direct  labor,  and  overhead.  (Hint:  This  requires  performing  

step  2  and  step  3  of  the  four-­‐step  process.)  

c. Assign  costs  to  units  transferred  out  and  to  units  in  ending  WIP  inventory.  (Hint:  This  requires  performing  step  4  of  the  

four-­‐step  process.)  

d. Confirm  that  total  costs  to  be  accounted  for  (from  step  2)  equals  total  costs  accounted  for  (from  step  4).  Note  that  

minor  differences  may  occur  due  to  rounding  the  cost  per  equivalent  unit  in  step  3.  

e. Explain  the  meaning  of  equivalent  units.  

Production  Cost  Report:  Weighted  Average  Method.  Refer  to  Exercise  25.  Prepare  a  production  cost  report  for  Sydney,  

Inc.,  for  the  month  of  April  using  the  format  shown  in  Figure  4.9  "Production  Cost  Report  for  Desk  Products’  Assembly  

Department".  

Process  Costing  Journal  Entries.  Silva  Piping  Company  produces  PVC  piping  in  two  processing  departments—

Fabrication  and  Packaging.  Transactions  for  the  month  of  July  are  shown  as  follows.  

0. Direct  materials  totaling  $15,000  are  requisitioned  and  placed  into  production—$7,000  for  the  Fabrication  

department  and  $8,000  for  the  Packaging  department.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     267  
     
 
 1. Direct  labor  costs  (wages  payable)  are  incurred  by  each  department  as  follows:  
Fabrication $4,500

Packaging $6,700

2. Manufacturing  overhead  costs  are  applied  to  each  department  as  follows:  
Fabrication $20,000

Packaging $14,000

3. Products  with  a  cost  of  $22,000  are  transferred  from  the  Fabrication  department  to  the  Packaging  department.  

4. Products  with  a  cost  of  $35,000  are  completed  and  transferred  from  the  Packaging  department  to  the  finished  goods  

warehouse.  

5. Products  with  a  cost  of  $31,000  are  sold  to  customers.  

Required:  

1. Prepare  journal  entries  to  record  each  of  the  previous  transactions.  

2. In  general,  how  does  the  process  costing  system  used  here  differ  from  a  job  costing  system?  

Exercises:  Set  B  

28. Assigning  Costs  to  Products:  Weighted  Average  Method.  Varian  Company  uses  the  weighted  average  method  for  its  

process  costing  system.  The  Molding  department  at  Varian  began  the  month  of  January  with  80,000  units  in  work-­‐in-­‐

process  inventory,  all  of  which  were  completed  and  transferred  out  during  January.  An  additional  90,000  units  were  

started  during  the  month,  30,000  of  which  were  completed  and  transferred  out  during  January.  A  total  of  60,000  units  

remained  in  work-­‐in-­‐process  inventory  at  the  end  of  January  and  were  at  varying  levels  of  completion,  as  shown  in  the  

following.  
Direct materials 80 percent complete

Direct labor 90 percent complete

Overhead 90 percent complete

29. The  following  cost  information  is  for  the  Molding  department  at  Varian  Company  for  the  month  of  January.  
Direct Materials Direct Labor Overhead Total

Beginning WIP inventory $1,400,000 $1,100,000 $1,700,000 $4,200,000

Incurred during the month $1,210,000 $ 980,000 $1,450,000 $3,640,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     268  
     
 
 30. Required:  

a. Determine  the  units  to  be  accounted  for  and  units  accounted  for;  then  calculate  the  equivalent  units  for  direct  

materials,  direct  labor,  and  overhead.  (Hint:  This  requires  performing  step  1  of  the  four-­‐step  process.)  

b. Calculate  the  cost  per  equivalent  unit  for  direct  materials,  direct  labor,  and  overhead.  (Hint:  This  requires  performing  

step  2  and  step  3  of  the  four-­‐step  process.)  

c. Assign  costs  to  units  transferred  out  and  to  units  in  ending  WIP  inventory.  (Hint:  This  requires  performing  step  4  of  the  

four-­‐step  process.)  

d. Confirm  that  total  costs  to  be  accounted  for  (from  step  2)  equals  total  costs  accounted  for  (from  step  4).  Note  that  

minor  differences  may  occur  due  to  rounding  the  cost  per  equivalent  unit  in  step  3.  

e. Explain  the  meaning  of  equivalent  units.  

Production  Cost  Report:  Weighted  Average  Method.  Refer  to  Exercise  28.  Prepare  a  production  cost  report  for  Varian  

Company  for  the  month  of  January  using  the  format  shown  in  Figure  4.9  "Production  Cost  Report  for  Desk  Products’  Assembly  

Department".  

Process  Costing  Journal  Entries.  Westside  Chemicals  produces  paint  thinner  in  three  processing  departments—

Mixing,  Testing,  and  Packaging.  Transactions  for  the  month  of  September  are  shown  as  follows.  

0. Direct  materials  totaling  $80,000  are  requisitioned  and  placed  into  production—$60,000  for  the  Mixing  

department,  $11,000  for  the  Testing  department,  and  $9,000  for  the  Packaging  department.  

1. Direct  labor  costs  (wages  payable)  incurred  by  each  department  are  as  follows:  
Mixing $35,000

Testing $25,000

Packaging $18,000

2. Manufacturing  overhead  costs  are  applied  to  each  department  as  follows:  
Mixing $17,500

Testing $12,500

Packaging $ 6,000

3. Products  with  a  cost  of  $55,000  are  transferred  from  the  Mixing  department  to  the  Testing  department.  

4. Products  with  a  cost  of  $86,000  are  transferred  from  the  Testing  department  to  the  Packaging  department.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     269  
     
 
 5. Products  with  a  cost  of  $100,000  are  completed  and  transferred  from  the  Packaging  department  to  the  finished  goods  

warehouse.  

6. Products  with  a  cost  of  $81,000  are  sold  to  customers.  

Required:  

g. Prepare  journal  entries  to  record  each  of  the  previous  transactions.  

h. In  general,  how  does  the  process  costing  system  used  here  differ  from  a  job  costing  system?  

Problems  

31. Production  Cost  Report:  Weighted  Average  Method.  Calvin  Chemical  Company  produces  a  chemical  used  in  the  

production  of  silicon  wafers.  Calvin  Chemical  uses  the  weighted  average  method  for  its  process  costing  system.  The  

Mixing  department  at  Calvin  Chemical  began  the  month  of  June  with  5,000  units  (gallons)  in  work-­‐in-­‐process  inventory,  

all  of  which  were  completed  and  transferred  out  during  June.  An  additional  15,000  units  were  started  during  the  

month,  11,000  of  which  were  completed  and  transferred  out  during  June.  A  total  of  4,000  units  remained  in  work-­‐in-­‐

process  inventory  at  the  end  of  June  and  were  at  varying  levels  of  completion,  as  shown  in  the  following.  
Direct materials 60 percent complete

Direct labor 40 percent complete

Overhead 40 percent complete

32. The  cost  information  is  as  follows:  

33.    

34. Costs  in  beginning  work-­‐in-­‐process  inventory  

Direct materials $8,000

Direct labor $3,000

Overhead $2,800

35.    

36. Costs  incurred  during  the  month  

Direct materials $21,000

Direct labor $ 8,500

Overhead $ 7,200

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     270  
     
 
 37. Required:  

a. Prepare  a  production  cost  report  for  the  Mixing  department  at  Calvin  Chemical  Company  for  the  month  of  June.  

b. Confirm  that  total  costs  to  be  accounted  for  (from  step  2)  equals  total  costs  accounted  for  (from  step  4).  Note  that  

minor  differences  may  occur  due  to  rounding  the  cost  per  equivalent  unit  in  step  3.  

c. According  to  the  production  cost  report,  what  is  the  total  cost  per  equivalent  unit  for  the  work  performed  in  the  

Mixing  department?  Which  of  the  three  product  cost  components  is  the  highest,  and  what  percent  of  the  total  does  

this  product  cost  represent?  

Production  Cost  Report:  Weighted  Average  Method.  Quality  Confections  Company  manufactures  chocolate  bars  in  

two  processing  departments,  Mixing  and  Packaging,  and  uses  the  weighted  average  method  for  its  process  costing  

system.  The  table  that  follows  shows  information  for  the  Mixing  department  for  the  month  of  March.  
Unit Information (Measured in Pounds) Mixing

Beginning work-in-process inventory 8,000

Started or transferred in during the month 230,000

Ending work-in-process inventory: 80 percent materials, 70 percent labor, and 60 percent overhead 6,000

Cost Information

Beginning Work-in-Process Inventory

Direct materials $ 3,000

Direct labor $ 1,500

Overhead $ 2,200

Costs Incurred during the Period

Direct materials $103,000

Direct labor $ 55,000

Overhead $ 81,000

Required:  

 . Prepare  a  production  cost  report  for  the  Mixing  department  for  the  month  of  March.  

a. Confirm  that  total  costs  to  be  accounted  for  (from  step  2)  equals  total  costs  accounted  for  (from  step  4);  minor  

differences  may  occur  due  to  rounding  the  cost  per  equivalent  unit  in  step  3.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     271  
     
 
 b. According  to  the  production  cost  report,  what  is  the  total  cost  per  equivalent  unit  for  the  work  performed  in  the  

Mixing  department?  Which  of  the  three  product  cost  components  is  the  highest,  and  what  percent  of  the  total  does  

this  product  cost  represent?  

Production  Cost  Report  and  Journal  Entries:  Weighted  Average  Method.  Wood  Products,  Inc.,  manufactures  

plywood  in  two  processing  departments,  Milling  and  Sanding,  and  uses  the  weighted  average  method  for  its  process  

costing  system.  The  table  that  follows  shows  information  for  the  Milling  department  for  the  month  of  April.  
Unit Information (Measured in Feet) Milling

Beginning work-in-process inventory 24,000

Started or transferred in during the month 110,000

Ending work-in-process inventory: 80 percent materials, 70 percent labor, and 60 percent overhead 32,000

Cost Information

Beginning Work-in-Process Inventory

Direct materials $ 9,000

Direct labor $ 3,000

Overhead $ 3,200

Costs Incurred during the Period

Direct materials $45,000

Direct labor $14,000

Overhead $16,000

Required:  

 . Prepare  a  production  cost  report  for  the  Milling  department  for  the  month  of  April.  

a. Confirm  that  total  costs  to  be  accounted  for  (from  step  2)  equals  total  costs  accounted  for  (from  step  4);  minor  

differences  may  occur  due  to  rounding  the  cost  per  equivalent  unit  in  step  3.  

b. For  the  Milling  department  at  Wood  Products,  Inc.,  prepare  journal  entries  to  record:  

1. The  cost  of  direct  materials  placed  into  production  during  the  month  (from  step  2).  

2. Direct  labor  costs  incurred  during  the  month  but  not  yet  paid  (from  step  2).  

3. The  application  of  overhead  costs  during  the  month  (from  step  2).  

4. The  transfer  of  costs  from  the  Milling  department  to  the  Sanding  department  (from  step  4).  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     272  
     
 
 One  Step  Further:  Skill-­‐Building  Cases  

34. Internet  Project:  Production  Company  Plant  Tour.  Using  the  Internet,  find  a  company  that  provides  a  virtual  tour  of  its  

production  processes.  Document  your  findings  by  completing  the  following  requirements.  

Required:  

a. Summarize  each  step  in  the  production  process.  

b. Which  type  of  costing  system  (job  or  process)  would  you  expect  the  company  to  use?  Why?  

Process  Costing  at  Coca-­‐Cola.  Refer  to  Note  4.4  "Business  in  Action  4.1".  

Required:  

 . What  type  of  costing  system  does  Coca-­‐Cola  use?  Explain.  

a. What  is  the  purpose  of  preparing  a  production  cost  report?  What  information  results  from  preparing  a  production  cost  

report  for  the  mixing  and  blending  department  at  Coca-­‐Cola?  

b. Based  on  the  information  provided,  what  is  the  minimum  number  of  production  cost  reports  that  Coca-­‐Cola  prepares  

each  reporting  period?  Explain.  

Process  Costing  at  Wrigley.  Refer  to  Note  4.9  "Business  in  Action  4.2".  

Required:  

 . What  type  of  costing  system  does  Wrigley  use?  Explain.  

a. What  is  the  purpose  of  preparing  a  production  cost  report?  What  information  results  from  preparing  a  production  cost  

report  for  Wrigley’s  Packaging  department?  

b. Based  on  the  information  provided,  what  is  the  minimum  number  of  production  cost  reports  that  Wrigley  prepares  

each  reporting  period?  Explain.  

Group  Activity:  Job  or  Process  Costing?  Form  groups  of  two  to  four  students.  Each  group  should  determine  

whether  a  process  costing  or  job  costing  system  is  most  likely  used  to  calculate  product  costs  for  each  item  listed  in  the  

following  and  should  be  prepared  to  explain  its  answers.  

0. Jetliners  produced  by  Boeing  

1. Gasoline  produced  by  Shell  Oil  Company  

2. Audit  of  Intel  by  Ernst  &  Young  

3. Oreo  cookies  produced  by  Nabisco  Brands,  Inc.  

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 4. Frosted  Mini-­‐Wheats  produced  by  Kellogg  Co.  

5. Construction  of  suspension  bridge  in  Puget  Sound,  Washington,  by  Bechtel  Group,  Inc.  

6. Aluminum  foil  produced  by  Alcoa,  Inc.  

7. Potato  chips  produced  by  Frito-­‐Lay,  Inc.  

Comprehensive  Cases  

38. Ethics:  Manipulating  Percentage  of  Completion  Estimates.Computer  Tech  Corporation  produces  computer  keyboards,  

and  its  fiscal  year  ends  on  December  31.  The  weighted  average  method  is  used  for  the  company’s  process  costing  

system.  As  the  controller  of  Computer  Tech,  you  present  December’s  production  cost  report  for  the  Assembly  

department  to  the  president  of  the  company.  The  Assembly  department  is  the  last  processing  department  before  

goods  are  transferred  to  finished  goods  inventory.  All  160,000  units  completed  and  transferred  out  during  the  month  

were  sold  by  December  31.  

The  board  of  directors  at  Computer  Tech  established  a  compensation  incentive  plan  that  includes  a  substantial  bonus  

for  the  president  of  the  company  if  annual  net  income  before  taxes  exceeds  $2,000,000.  Preliminary  figures  show  

current  year  net  income  before  taxes  totaling  $1,970,000,  which  is  short  of  the  target  by  $30,000.  The  president  

approaches  you  and  asks  you  to  increase  the  percentage  of  completion  for  the  40,000  units  in  ending  WIP  inventory  to  

90  percent  for  direct  materials  and  to  95  percent  for  direct  labor  and  overhead.  Even  though  you  are  confident  in  the  

percentages  used  to  prepare  the  production  cost  report,  which  appears  as  follows,  the  president  insists  that  his  change  

is  minor  and  will  have  little  impact  on  how  investors  and  creditors  view  the  company.  

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Required:  

a. Why  is  the  president  asking  you  to  increase  the  percentage  of  completion  estimates?  

b. Prepare  another  production  cost  report  for  Computer  Tech  Company  that  includes  the  president’s  revisions.  Indicate  

what  impact  the  president’s  request  will  have  on  cost  of  goods  sold  and  on  net  income  (ignore  income  taxes  in  your  

calculations).  

c. As  the  controller  of  the  company,  how  would  you  handle  the  president’s  request?  (If  necessary,  review  the  

presentation  of  ethics  in  Chapter  1  "What  Is  Managerial  Accounting?"  for  additional  information.)  

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 Ethics:  Increasing  Production  to  Boost  Profits.  Pacific  Siding,  Inc.,  produces  synthetic  wood  siding  used  in  the  

construction  of  residential  and  commercial  buildings.  Pacific  Siding’s  fiscal  year  ends  on  March  31,  and  the  weighted  

average  method  is  used  for  the  company’s  process  costing  system.  

Financial  results  for  the  first  11  months  of  the  current  fiscal  year  (through  February  28)  are  well  below  expectations  of  

management,  owners,  and  creditors.  Halfway  through  the  month  of  March,  the  chief  executive  officer  and  chief  

financial  officer  asked  the  controller  to  estimate  the  production  results  for  the  month  of  March  in  the  form  of  a  

production  cost  report  (the  company  only  has  one  production  department).  This  report  is  shown  as  follows.  

Armed  with  the  preliminary  production  cost  report  for  March,  and  knowing  that  the  company’s  production  is  well  

below  capacity,  the  CEO  and  CFO  decide  to  produce  as  many  units  as  possible  for  the  last  half  of  March  even  though  

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 sales  are  notexpected  to  increase  any  time  soon.  The  production  manager  is  told  to  push  his  employees  to  get  as  far  as  

possible  with  production,  thereby  increasing  the  percentage  of  completion  for  ending  WIP  inventory.  However,  since  

the  production  process  takes  three  weeks  to  complete,  all  the  units  produced  in  the  last  half  of  March  will  be  in  WIP  

inventory  at  the  end  of  March.  

Required:  

 . Explain  how  the  CEO  and  CFO  expect  to  increase  profit  (net  income)  for  the  year  by  boosting  production  at  the  end  

of  March.  

a. Using  the  following  assumptions,  prepare  a  revised  estimate  of  production  results  in  the  form  of  a  production  

cost  report  for  the  month  of  March.  

Assumptions  based  on  the  CEO  and  CFO’s  request  to  boost  production  

1. Units  started  and  partially  completed  during  the  period  will  increase  to  225,000  (from  the  initial  estimate  of  

70,000).  This  is  the  projected  ending  WIP  inventory  at  March  31.  

2. Percentage  of  completion  estimates  for  units  in  ending  WIP  inventory  will  increase  to  80  percent  for  direct  

materials,  85  percent  for  direct  labor,  and  90  percent  for  overhead.  

3. Costs  incurred  during  the  period  will  increase  to  $95,000  for  direct  materials,  $102,000  for  direct  labor,  and  

$150,000  for  overhead  (most  overhead  costs  are  fixed).  

4. All  units  completed  and  transferred  out  during  March  are  sold  by  March  31.  

b. Compare  your  new  production  cost  report  with  the  one  prepared  by  the  controller.  How  much  do  you  expect  profit  

to  increase  as  a  result  of  increasing  production  during  the  last  half  of  March?  (Ignore  income  taxes  in  your  

calculations.)  

c. Is  the  request  made  by  the  CEO  and  CFO  ethical?  Explain  your  answer.  

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 Chapter  5  
How Do Organizations Identify Cost Behavior Patterns?  

Eric Mendez is the chief financial officer (CFO) of Bikes Unlimited, a company that produces
mountain bikes and sells them to retail bicycle stores. Bikes Unlimited obtains the bulk of its
parts from outside suppliers and assembles them into the mountain bikes prior to shipment. Last
month (June), Bikes Unlimited sold 5,000 mountain bikes for $100 each. Last month’s income
statement shows total revenue of $500,000 and operating profit of $50,000:

 
Susan Wesley is Bikes Unlimited’s cost accountant. Planning for July was completed during
June. Senior management is now planning for next month (August) and has asked Eric, the CFO,
to obtain some vital financial information for budgeting purposes. Eric arranged a meeting with
Susan to discuss the August budget.

As you know, we are in the middle of our planning for next month. The senior management group asked me to make some projections based on
Eric: expected changes to our sales next month.

Susan: Where do you think sales are headed?

Eric: We expect unit sales to increase 10 percent, perhaps 20 percent if all goes well.

Susan: If sales increase 10 percent, I would expect profit to increase by more than 10 percent since some costs are fixed.

Eric: Sounds reasonable. What’s the next step to get a reasonable estimate of profit?

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 First, we have to identify how costs behave with changes in sales and production—whether the costs are variable, fixed, or some other type.
Susan: Then we can set up the income statement in a contribution margin format and determine if the numbers are within the relevant range.

Eric: Perhaps you and your staff can discuss this and get me some accurate estimates.

Susan: I’ll meet with them tomorrow and should have some information for you within a few days.

5.1  Cost Behavior Patterns

L E A R N I N G   O B J E C T I V E  

1. Identify  typical  cost  behavior  patterns.  

Question: To predict what will happen to profit in the future at Bikes Unlimited, we must
understand how costs behave with changes in the number of units sold (sales volume). Some
costs will not change at all with a change in sales volume (e.g., monthly rent for the production
facility). Some costs will change with a change in sales volume (e.g., materials for the mountain
bikes). What are the three cost behavior patterns that help organizations identify which costs will
change and which will remain the same with changes in sales volume?

Answer: The three basic cost behavior patterns are known as variable, fixed, and mixed. Each of
these cost patterns is described next.

Variable Costs

Question: We know that some costs vary with changes in activity. What do we call this type of
cost behavior?

Answer: This cost behavior pattern is called a variable cost. A variable costdescribes a cost
that varies in total with changes in volume of activity. The activity in this example is the number
of bikes produced and sold. However, the activity can take many different forms depending on
the organization. The two most common variable costs are direct materials and direct labor.
Other examples include indirect materials and energy costs.

Assume the cost of direct materials (wheels, seats, frames, and so forth) for each bike at Bikes
Unlimited is $40. If Bikes Unlimited produces one bike,total variable cost for direct materials
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 amounts to $40. If Bikes Unlimited doubles its production to two bikes, total variable cost for
direct materials also doubles to $80. Variable costs typically change in proportion to changes in
volume of activity. If volume of activity doubles, total variable costs also double, while the cost
per unit remains the same. It is important to note that the term variable refers to what happens
to total costs with changes in activity, not to the cost per unit.

Taking it one step further for Bikes Unlimited, let’s consider all variable costs related to
production. Assume direct materials, direct labor, and all other variable production costs amount
to $60 per unit. Table 5.1 "Variable Cost Behavior for Bikes Unlimited" provides the total and per unit variable
costs at three different levels of production, and Figure 5.1 "Total Variable Production Costs for Bikes
Unlimited" graphs the relation of total variable costs (y-axis) to units produced (x-axis). Note that
the slope of the line represents the variable cost per unit of $60 (slope = change in variable cost ÷
change in units produced).

Table 5.1 Variable Cost Behavior for Bikes Unlimited

Units Produced Total Variable Costs Per Unit Variable Cost

1 $ 60 $60

2,000 120,000 60

4,000 240,000 60

Figure 5.1 Total Variable Production Costs for Bikes Unlimited

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Using Different Activities to Measure Variable Costs

Question: At Bikes Unlimited, it is reasonable to assume that the activity, number of units
produced, will affect total variable costs for direct materials and direct labor. However,
companies often use a different activity to estimate total variable costs. What types of activities
might be used to estimate variable costs?

Answer: The type of activity used to estimate variable costs depends on the cost. For example, a
law firm might use the number of labor hours to estimate labor costs. An airline such
as American Airlines might usehours of flying time to estimate fuel costs. A mail delivery
service such asUPS might use the number of packages processed to estimate labor costs
associated with sorting packages. A retail store such as Best Buy might usesales dollars to
estimate cost of goods sold.

Variable costs are affected by different activities depending on the organization. The goal is to
find the activity that causes the variable cost so that accurate cost estimates can be made.

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 Fixed Costs

Question: Costs that vary in total with changes in activity are called variable costs. What do we
call costs that remain the same in total with changes in activity?

Answer: This cost behavior pattern is called a fixed cost. A fixed costdescribes a cost that
is fixed (does not change) in total with changes in volume of activity. Assuming the activity is
the number of bikes produced and sold, examples of fixed costs include salaried personnel,
building rent, and insurance.

Assume Bikes Unlimited pays $8,000 per month in rent for its production facility. In addition,
insurance for the same building is $2,000 per month and salaried production personnel are paid
$6,000 per month. All other fixed production costs total $4,000. Thus Bikes Unlimited has total
fixed costs of $20,000 per month related to its production facility (= $8,000 + $2,000 + $6,000 +
$4,000). If only one bike is produced, Bikes Unlimited still must pay $20,000 per month. If
5,000 bikes are produced, Bikes Unlimited still pays $20,000 per month. The fixed costs remain
unchanged in total as the level of activity changes.

Question: What happens to fixed costs on a per unit basis as production levels change?

Answer: If Bikes Unlimited only produces one bike, the fixed cost per unitwould amount to
$20,000 (= $20,000 total fixed costs ÷ 1 bike). If Bikes Unlimited produces two bikes, the fixed
cost per unit would be $10,000 (= $20,000 ÷ 2 bikes). As activity increases, the fixed costs are
spread out over more units, which results in a lower cost per unit.

Table 5.2 "Fixed Cost Behavior for Bikes Unlimited" provides the total and per unit fixed costs
at three different levels of production, and Figure 5.2 "Total Fixed Production Costs for Bikes
Unlimited" graphs the relation of total fixed costs (y-axis) to units produced (x-axis). Note that
regardless of the activity level, total fixed costs remain the same.

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 Table 5.2 Fixed Cost Behavior for Bikes Unlimited
Units Produced Total Fixed Costs Per Unit Fixed Cost

1 $20,000 $20,000

2,000 20,000 10

4,000 20,000 5

Figure 5.2 Total Fixed Production Costs for Bikes Unlimited

 
 
Business  in  Action  5.1  

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Source: Photo courtesy of Simon_sees,http://www.flickr.com/photos/39551170@N02/3696524201/.

United Airlines Struggles to Control Costs

United Airlines is the second largest air carrier in the world. It has hubs in Chicago, Denver, Los Angeles, San Francisco,

and New York and flies to 109 destinations in 23 countries. Destinations include Tokyo, London, and Frankfurt.

Back in 2002, United filed for bankruptcy. Industry analysts reported that United had relatively high fixed costs, making it

difficult for the company to cut costs quickly in line with its reduction in revenue. A few years later, United emerged from

bankruptcy, and in 2010 merged with Continental Airlines. Although financial information was presented separately for

each company (United and Continental) in 2010, both companies are now owned by United Continental Holdings,

Inc. The following financial information for United Airlines is from the company’s income statement for the year ended

December 31, 2010 (amounts are in millions). Review this information carefully. Which costs are likely to be fixed?

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Although we cannot identify all fixed costs with certainty, several costs likely fall into this category: salaries (for union

employees, such as pilots, flight crews, and mechanics); aircraft fuel (assuming flights are not easily canceled); aircraft rent;

and depreciation. These costs total $11.1 billion, or 60 percent of total operating expenses (rounded). Fixed costs are clearly a

large component of total operating expenses, which makes it difficult for airline companies like United Airlines to make

short-term cuts in expenses when revenue declines.

Source: United Continental, Inc., form 10K for 2010.

Committed Versus Discretionary Fixed Costs

Question: Organizations often view fixed costs as either committed or discretionary. What is the
difference between these two types of fixed costs?

Answer: A committed fixed cost is a fixed cost that cannot easily be changed in the short run
without having a significant impact on the organization. For example, assume Bikes Unlimited
has a five-year lease on the company’s production facility, which costs $8,000 per month. This is
a committed fixed cost because the lease cannot easily be broken, and the company is committed

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 to using this facility for years to come. Other examples of committed fixed costs include salaried
employees with long-term contracts, depreciation on buildings, and insurance.

A discretionary fixed cost is a fixed cost that can be changed in the short run without having a
significant impact on the organization. For example, assume Bikes Unlimited contributes
$10,000 each year toward charitable organizations. Management has the option of changing this
amount in the short run without causing a significant impact on the organization. Other examples
of discretionary fixed costs include advertising, research and development, and training
programs (although an argument can be made that reducing these expenditures could have a
significant impact on the company depending on the amount of the cuts).

In general, management looks to cut discretionary fixed costs when sales and profits are
declining, since cuts in this area tend not to have as significant an impact on the organization as
cutting committed fixed costs. Difficulties arise when struggling organizations go beyond cutting
discretionary fixed costs and begin looking at cutting committed fixed costs.

Mixed Costs

Question: We have now learned about two types of cost behavior patterns—variable costs and
fixed costs. However, there is a third type of cost that behaves differently in that both total and
per unit costs change with changes in activity. What do we call this type of cost?

Answer: This cost behavior pattern is called a mixed cost. The termmixed cost describes a cost
that has a mix of fixed and variable costs. For example, assume sales personnel at Bikes
Unlimited are paid a total of $10,000 in monthly salary plus a commission of $7 for every bike
sold. This is a mixed cost because it has a fixed component of $10,000 per month and a variable
component of $7 per unit.

Table 5.3 "Mixed Cost Behavior for Bikes Unlimited" provides the total and per unit fixed costs
at three different levels of production, and Figure 5.3 "Total Mixed Sales Compensation Costs
for Bikes Unlimited" graphs the relation of total mixed costs (y-axis) to units produced (x-axis).

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 The point at which the line intersects the y-axis represents the total fixed cost ($10,000), and the
slope of the line represents the variable cost per unit ($7).

Table 5.3 Mixed Cost Behavior for Bikes Unlimited

Units Sold Total Mixed Costs Per Unit Mixed Cost

1 $10,007 $10,007.00

2,000 24,000 12.00

4,000 38,000 9.50

Figure 5.3 Total Mixed Sales Compensation Costs for Bikes Unlimited

Because this cost is depicted with a straight line, we can use the equation for a straight line to
describe a mixed cost:

Key  Equation  

Total  mixed  cost  =  Total  fixed  cost  +  (Unit  variable  cost  ×  Number  of  units)  

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 or

Y  =  f  +  vX  

where

Y  =  total  mixed  costs  (this  is  the  y-­‐axis  in  Figure  5.3  "Total  Mixed  Sales  Compensation  Costs  for  Bikes  Unlimited")f  =  total  
fixed  costsv  =  variable  cost  per  unitX  =  level  of  activity  (this  is  the  x-­‐axis  in  Figure  5.3  "Total  Mixed  Sales  Compensation  
Costs  for  Bikes  Unlimited")  

For Bikes Unlimited, the mixed cost equation is Y = $10,000 + $7X. If Bikes Unlimited sells
4,000 bikes (X) in one month, the total mixed cost (Y) for sales personnel compensation would
be $38,000 [= $10,000 + ($7 × 4,000 units)].

Short Term Versus Long Term and the Relevant Range

We now introduce two important concepts that must be considered when estimating costs: short
term versus long term, and the relevant range.

Short Term Versus Long Term

Question: When identifying cost behavior patterns, we assume that management is using the cost
information to make short-term decisions. Why is this short-term decision making assumption so
important?

Answer: Variable, fixed, and mixed cost concepts are useful for short-term decision making and
therefore apply to a specific period of time. This short-term period will vary depending on the
company’s current production capacity and the time required to change capacity. In the long
term, all cost behavior patterns will likely change.

For example, suppose Bikes Unlimited’s production capacity is 8,000 units per month, and
management plans to expand capacity in two years by renting a new production facility and
hiring additional personnel. This is a long-term decision that will change the cost behavior
patterns identified earlier. Variable production costs will no longer be $60 per unit, fixed

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 production costs will no longer be $20,000 per month, and mixed sales compensation costs will
also change. All these costs will change because the estimates are accurate only in the short term.

The Relevant Range

Question: Another important concept we use when estimating costs is called the relevant
range. What is the relevant range and why is it so important when estimating costs?

Answer: The relevant range is the range of activity for which cost behavior patterns are likely to
be accurate. The variable, fixed, and mixed costs identified for Bikes Unlimited will only be
accurate within a certain range of activity. Once the firm goes outside that range, cost estimates
are not necessarily accurate and often must be reevaluated and recalculated.

For example, assume Bikes Unlimited’s mixed sales compensation costs of $10,000 per month
plus $7 per unit is only valid up to 4,000 units per month. If unit sales increase beyond 4,000
units, management will hire additional salespeople and the total monthly base salary will
increase beyond $10,000. Thus the relevant range for this mixed cost is from zero to 4,000 units.
Once the company exceeds sales of 4,000 units per month, it is out of the relevant range, and the
mixed cost must be recalculated.

We discuss the relevant range concept in more detail later in the chapter. For now, remember that
the accuracy of cost behavior patterns is limited to a certain range of activity called the relevant
range.

Computer  Application  
Using Excel to Create Charts

Managers typically use computer applications on a daily basis to perform a variety of functions. For example, they often use

Excel to generate tables, graphs, and charts. You could use Excel to create the charts shown in Figure 5.1 "Total Variable

Production Costs for Bikes Unlimited", Figure 5.2 "Total Fixed Production Costs for Bikes Unlimited", and Figure 5.3 "Total

Mixed Sales Compensation Costs for Bikes Unlimited". Here’s how:

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 1. Enter the data. Open a new Excel document and enter the data in two columns: one column for the x-axis (horizontal

axis), and one column for the y-axis (vertical axis). Let’s suppose you want to create the chart shown in Figure 5.1 "Total

Variable Production Costs for Bikes Unlimited". In that case, the x-axis represents units produced, and the y-axis represents

total variable costs. An excerpt from your Excel document would appear as follows:

2. Create the chart. After you have entered the data, highlight the appropriate data cells (including headings and labels) and

click onInsert, Chart, Scatter. Choose Scatter with Smooth Lines and Markers. The chart that results is linked to your data

points. If you change the data, the chart changes, too. (In earlier versions of Excel, the chart wizard walks you through the

steps necessary to create the chart.)

3. Format the chart. Now that you have created the chart, select it and use Chart Tools to format it with background shading,

text inserts, font size, chart size, and other more advanced features. If you want to display the chart within some other

document (e.g., a Word document), you can copy it (highlight the chart and selectEdit, Copy from the menu bar) and paste it

into the document (selectEdit, Paste or Paste Special).

The Excel document created by following these three steps would look like the one shown in Figure 5.1 "Total Variable

Production Costs for Bikes Unlimited".

How Cost Behavior Patterns Are Used

Question: How do managers use cost behavior patterns to make better decisions?

Answer: Accurately predicting what costs will be in the future can help managers answer
several important questions. For example, managers at Bikes Unlimited might ask the following:

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 • We expect to see a 5 percent increase in unit sales next year. How will this affect
revenues and costs?
• We are applying for a loan with a bank, and bank managers think our sales estimates are
high. What happens to our revenues and costs if we lower estimates by 20 percent?
• What happens to revenues and costs if we add a racing bike to our product line?
• How will costs behave in the future if we increase automation in the production process?

The only way to accurately predict costs is to understand how costs behave given changes in
activity. To make good decisions, managers must know how costs are structured (fixed, variable,
or mixed). The next section explains how to estimate fixed and variable costs, and how to
identify the fixed and variable components of mixed costs.

Business  in  Action  5.2  

Budget Cuts at an Elementary School District

A school district outside Sacramento, California, was faced with making budget cuts because of a reduction in state funding.

To reduce costs, the school district’s administration decided to consider closing one of the smaller elementary schools in the

district. According to an initial estimate, closing this school would reduce costs by $500,000 to $1,000,000 per year.

However, further analysis identified only $100,000 to $150,000 in cost savings.

Why did the analysis yield lower savings than the initial estimate? Most of the costs were committed fixed costs (e.g.,

teachers’ salaries and benefits) and could not be eliminated in the short term. In fact, teachers and students at the school

being considered for closure were to be moved to other schools in the district, and so no savings on teachers’ salaries and

benefits would result. The only real short-term cost savings would be in not having to maintain the classrooms, computer

lab, and library (nonunion employees would be let go) and in utilities (heat and air conditioning would be turned off).

The school district ultimately decided not to close the school because of the large committed fixed costs involved, as well as a

lack of community support, and budget cuts were made in other areas throughout the district.
R E V I E W   P R O B L E M   5 . 1  
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 Sierra  Company  is  trying  to  identify  the  behavior  of  the  three  costs  shown  in  the  following  table.  The  following  cost  information  

is  provided  for  six  months.  Calculate  the  cost  per  unit,  and  then  identify  how  each  cost  behaves  (fixed,  variable,  or  mixed).  

Explain  your  answers.  

Cost 1 Cost 2 Cost 3

Month Units Produced Total Costs Cost per Unit Total Costs Cost per Unit Total Costs Cost per Unit

1 50 $100 $2.00 $100 $2.00 $100 $2.00

2 100 200 2.00 100 1.00 150 1.50

3 150 300 _____ 100 _____ 200 _____

4 200 400 _____ 100 _____ 250 _____

5 250 500 _____ 100 _____ 300 _____

6 300 600 _____ 100 _____ 350 _____

Solution  to  Review  Problem  5.1  

As  shown  in  the  following  table,  cost  1  is  a  variable  cost  because  as  the  number  of  units  produced  changes,  total  costs  change  

(in  proportion  to  changes  in  activity)  and  per  unit  cost  remains  the  same.  Cost  2  is  a  fixed  cost  because  as  the  number  of  units  

produced  changes,  total  costs  remain  the  same  and  per  unit  costs  change.  Cost  3  is  a  mixed  cost  because  as  the  number  of  

units  produced  changes,  total  cost  changes  (but  not  in  proportion  to  changes  in  activity)  and  per  unit  cost  changes.  
Cost 1 Cost 2 Cost 3

Month Units Produced Total Costs Cost per Unit Total Costs Cost per Unit* Total Costs Cost per Unit*

1 50 $100 $2.00 $100 $2.00 $100 $2.00

2 100 200 2.00 100 1.00 150 1.50

3 150 300 2.00 100 0.67 200 1.33

4 200 400 2.00 100 0.50 250 1.25

5 250 500 2.00 100 0.40 300 1.20

6 300 600 2.00 100 0.33 350 1.17

*Rounded.

5.2 Cost Estimation Methods

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 L E A R N I N G   O B J E C T I V E  

1. Estimate  costs  using  account  analysis,  the  high-­‐low  method,  the  scattergraph  method,  and  regression  analysis.  

Question: Recall the conversation that Eric (CFO) and Susan (cost accountant) had about Bikes
Unlimited’s budget for the next month, which is August. The company expects to increase sales
by 10 to 20 percent, and Susan has been asked to estimate profit for August given this expected
increase. Although examples of variable and fixed costs were provided in the previous sections,
companies typically do not know exactly how much of their costs are fixed and how much are
variable. (Financial accounting systems do not normally sort costs as fixed or variable.) Thus
organizations must estimate their fixed and variable costs. What methods do organizations use to
estimate fixed and variable costs?

Answer: Four common approaches are used to estimate fixed and variable costs:

• Account analysis
• High-low method
• Scattergraph method
• Regression analysis

All four methods are described next. The goal of each cost estimation method is to estimate fixed
and variable costs and to describe this estimate in the form of Y = f + vX. That is, Total mixed
cost = Total fixed cost + (Unit variable cost × Number of units). Note that the estimates
presented next for Bikes Unlimited may differ from the dollar amounts used previously, which
were for illustrative purposes only.

Account Analysis

Question: The account analysis approach is perhaps the most common starting point for
estimating fixed and variable costs. How is the account analysis approach used to estimate fixed
and variable costs?

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 Answer: This approach requires that an experienced employee or group of employees review the
appropriate accounts and determine whether the costs in each account are fixed or variable.
Totaling all costs identified as fixed provides the estimate of total fixed costs. To determine the
variable cost per unit, all costs identified as variable are totaled and divided by the measure of
activity (units produced is the measure of activity for Bikes Unlimited).

Let’s look at the account analysis approach using Bikes Unlimited as an example. Susan (the cost
accountant) asked the financial accounting department to provide cost information for the
production department for the month of June (July information is not yet available). Because the
financial accounting department tracks information by department, it is able to produce this
information. The production department information for June is as follows:

Susan reviewed this cost information with the production manager, Indira Bingham, who has
worked as production manager at Bikes Unlimited for several years. After careful review, Indira
and Susan came up with the following breakdown of variable and fixed costs for June:

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 Total fixed cost is estimated to be $30,000, and variable cost per unit is estimated to be $52 (=
$260,000 ÷ 5,000 units produced). Remember, the goal is to describe the mixed costs in the
equation form Y = f + vX. Thus the mixed cost equation used to estimate future production costs
is

Y  =  $30,000  +  $52X  

Now Susan can estimate monthly production costs (Y) if she knows how many units Bikes
Unlimited plans to produce (X). For example, if Bikes Unlimited plans to produce 6,000 units for
a particular month (a 20 percent increase over June) and this level of activity is within the
relevant range, total production costs should be approximately $342,000 [= $30,000 + ($52 ×
6,000 units)].

Question: Why should Susan be careful using hysterical data for one month (June) to estimate
future costs?

Answer: June may not be a typical month for Bikes Unlimited. For example, utility costs may be
low relative to those in the winter months, and production costs may be relatively high as the
company prepares for increased demand in July and August. This might result in a lower
materials cost per unit from quantity discounts offered by suppliers. To smooth out these
fluctuations, companies often use data from the past quarter or past year to estimate costs.

R E V I E W   P R O B L E M   5 . 2  

Alta  Production,  Inc.,  is  using  the  account  analysis  approach  to  identify  the  behavior  of  production  costs  for  a  month  in  which  it  

produced  350  units.  The  production  manager  was  asked  to  review  these  costs  and  provide  her  best  guess  as  to  how  they  

should  be  categorized.  She  responded  with  the  following  information:  

 
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 1. Describe  the  production  costs  in  the  equation  form  Y  =  f  +  vX.  

2. Assume  Alta  intends  to  produce  400  units  next  month.  Calculate  total  production  costs  for  the  month.  

Solution  to  Review  Problem  5.2  

1. Because  f  represents  total  fixed  costs,  and  v  represents  variable  cost  per  unit,  the  cost  equation  is:  Y  =  $7,000  +  $1,428.57X.  

(Variable  cost  per  unit  of  $1,428.57  =  $500,000  ÷  350  units.)  

2. Using  the  previous  equation,  simply  substitute  400  units  for  X,  as  follows:  

YYY=$7,000+($1,428.57×400 units)=$7,000+$571,428=$578,428  

Thus  total  production  costs  are  expected  to  be  $578,428  for  next  month.  

High-Low Method

Question: Another approach to identifying fixed and variable costs for cost estimation purposes
is the high-low method. Accountants who use this approach are looking for a quick and easy
way to estimate costs, and will follow up their analysis with other more accurate
techniques. How is the high-low method used to estimate fixed and variable costs?

Answer: The high-low method uses historical information from several reporting periods to
estimate costs. Assume Susan Wesley obtains monthly production cost information from the
financial accounting department for the last 12 months. This information appears in .

Table 5.4 Monthly Production Costs for Bikes Unlimited

Reporting Period (Month) Total Production Costs Level of Activity (Units Produced)

July $230,000 3,500

August 250,000 3,750

September 260,000 3,800

October 220,000 3,400

November 340,000 5,800

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 Reporting Period (Month) Total Production Costs Level of Activity (Units Produced)

December 330,000 5,500

January 200,000 2,900

February 210,000 3,300

March 240,000 3,600

April 380,000 5,900

May 350,000 5,600

June 290,000 5,000

All of the data points from are plotted on the graph shown in . Although a graph is not required
using the high-low method, it is a helpful visual tool. Susan then draws a straight line using the
high (April) and low (January)activity levels from these data. The goal of the high-low method is to
describe this line mathematically in the form of an equation stated as Y = f + vX, which requires
calculating both the total fixed costs amount (f) and per unit variable cost amount (v). Four steps
are required to achieve this using the high-low method:

Step 1. Identify the high and low activity levels from the data set.
Step 2. Calculate the variable cost per unit (v).
Step 3. Calculate the total fixed cost (f).
Step 4. State the results in equation form Y = f + vX.

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 Figure 5.4 Estimated Total Mixed Production Costs for Bikes Unlimited: High-Low Method

Question: How are the four steps of the high-low method used to estimate total fixed costs and
per unit variable cost?

Answer: Each of the four steps is described next.

Step 1. Identify the high and low activity levels from the data set.

The highest level of activity (level of production) occurred in the month of April (5,900 units;
$380,000 production costs), and the lowest level of activity occurred in the month of January
(2,900 units; $200,000 production costs). Note that we are identifying the high and
low activitylevels rather than the high and low dollar levels—choosing the high and low dollar
levels can result in incorrect high and low points.

Step 2. Calculate the variable cost per unit (v).

Because the slope of the line shown in represents the variable cost per unit, the goal here is to
calculate the slope of the line using the high and low points identified in step 1 (the slope

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 calculation is often referred to as “rise over run” in math courses). The calculation of the variable
cost per unit for Bikes Unlimited is shown as follows:

Unit variable cost (v)=Cost at highest level − Cost at lowest level Highest activity level − Lowest activity level =$380,000−$200,0005,90
0 units−2,900 units=$180,0003,000 units=$60  

Step 3. Calculate the total fixed cost (f).

After completing step 2, the equation to describe the line is partially complete and stated as Y
= f + $60X. The goal of step 3 is to calculate a value for total fixed cost (f). Simply select either
the high or low activity level, and fill in the data to solve for f (total fixed costs), as shown.

Using the low activity level of 2,900 units and $200,000,

Y$200,000fff=f+vX=f+($60×2,900 units)=$200,000−($60×2,900 units)=$200,000−$174,000=$26,000  

Thus total fixed costs total $26,000. (Try this using the high activity level of 5,900 units and
$380,000. You will get the same result as long as the per unit variable cost is not rounded.)

Step 4. State the results in equation form Y = f + vX.

We know from step 2 that the variable cost per unit is $60, and from step 3 that total fixed cost is
$26,000. Thus we can state the equation used to estimate total costs as

Y  =  $26,000  +  $60X  

Now it is possible to estimate total production costs given a certain level of production (X). For
example, if Bikes Unlimited expects to produce 6,000 units during August, total production costs
are estimated to be $386,000:

YYY=$26,000+($60×6,000 units)=$26,000+$360,000=$386,000  

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 Question: Although the high-low method is relatively simple, it does have a potentially
significant weakness. What is the potential weakness in using the high-low method?

Answer: In reviewing , you will notice that this approach only considers the high and low
activity levels in establishing an estimate of fixed and variable costs. The high and low data
points may not represent the data set as a whole, and using these points can result in distorted
estimates.

For example, the $380,000 in production costs incurred in April may be higher than normal
because several production machines broke down resulting in costly repairs. Or perhaps several
key employees left the company, resulting in higher than normal labor costs for the month
because the remaining employees were paid overtime. Cost accountants will often throw out the
high and low points for this reason and use the next highest and lowest points to perform this
analysis. While the high-low method is most often used as a quick and easy way to estimate
fixed and variable costs, other more sophisticated methods are most often used to refine the
estimates developed from the high-low method.

R E V I E W   P R O B L E M   5 . 3  

Alta  Production,  Inc.,  reported  the  following  production  costs  for  the  12  months  January  through  December.  (This  is  the  same  

company  featured  in  .)  

Reporting Period (Month) Total Production Costs Level of Activity (Units Produced)

January $460,000 300

February 300,000 220

March 480,000 330

April 550,000 390

May 570,000 410

June 310,000 240

July 440,000 290

August 455,000 320

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 September 530,000 380

October 250,000 150

November 700,000 450

December 490,000 350

1. Using  this  information,  perform  the  four  steps  of  the  high-­‐low  method  to  estimate  costs  and  state  your  results  in  cost  equation  

form  Y  =  f  +  vX.  

2. Assume  Alta  Production,  Inc.,  will  produce  400  units  next  month.  Calculate  total  production  costs  for  the  month.  

3. What  is  the  potential  weakness  in  using  this  approach  to  estimate  costs?  

Solution  to  Review  Problem  5.3  

1. The  four  steps  are  as  follows:  

   

Step  1.  Identify  the  high  and  low  activity  levels  from  the  data  set.  

The  highest  level  of  activity  occurred  in  November  (450  units;  $700,000  production  costs),  and  the  lowest  level  of  

activity  occurred  in  October  (150  units;  $250,000  production  costs).  

   

Step  2.  Calculate  the  variable  cost  per  unit  (v).  

Unit variable cost=Change in cost ÷ Change in activity=($700,000−$250,000)÷(450 units−150 units)=$1,500  

   

Step  3.  Calculate  the  total  fixed  cost  (f).  

After  completing  step  2,  the  equation  to  describe  the  line  is  partially  complete  and  stated  as  Y  =  f  +  $1,500X.  To  

calculate  total  fixed  costs,  simply  select  either  the  high  or  low  activity  level,  and  fill  in  the  data  to  solve  for  f  (total  fixed  

costs),  as  shown.  

Using  the  high  activity  level,  

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 Y$700,000fff=f+vX=f+($1,500×450 units)=($1,500×450 units)=$700,000−$675,000=$25,000  

Thus  total  fixed  cost  is  $25,000.  

   

Step  4.  State  the  results  in  equation  form  Y  =  f  +  vX.  

We  know  from  step  2  that  the  variable  cost  per  unit  is  $1,500,  and  from  step  3  that  total  fixed  costs  are  $25,000.  Thus  

the  equation  used  to  estimate  total  production  costs  is  

Y =$25,000+$1,500X  

2. Using  the  equation  from  part  1,  simply  substitute  400  units  for  X,  as  follows:  

YYY=$25,000+($1,500×400 units)=$25,000+$600,000=$625,000  

Thus  total  production  costs  are  expected  to  be  $625,000  for  next  month.  

3. This  approach  only  considers  the  high  and  low  activity  levels  in  establishing  an  estimate  of  fixed  and  variable  costs.  The  high  

and  low  data  points  may  not  represent  the  data  set  as  a  whole,  and  using  these  points  can  result  in  distorted  estimates.  In  

reviewing  the  set  of  data  points  for  January  through  December,  it  appears  that  October  and  November  are  relatively  extreme  

points  when  compared  to  the  other  10  months.  Because  the  cost  equation  is  based  solely  on  these  two  points,  the  resulting  

estimate  of  production  costs  for  400  units  of  production  (in  part  2)  may  not  be  accurate.  

Scattergraph Method

Question: Many organizations prefer to use the scattergraph method to estimate costs.
Accountants who use this approach are looking for an approach that does not simply use the
highest and lowest data points. How is the scattergraph method used to estimate fixed and
variable costs?

Answer: The scattergraph method considers all data points, not just the highest and lowest levels
of activity. Again, the goal is to develop an estimate of fixed and variable costs stated in equation

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 form Y = f + vX. Using the same data for Bikes Unlimited shown in , we will follow the five
steps associated with the scattergraph method:

Step 1. Plot the data points for each period on a graph.

Step 2. Visually fit a line to the data points and be sure the line touches one data point.

Step 3. Estimate the total fixed costs (f).

Step 4. Calculate the variable cost per unit (v).

Step 5. State the results in equation form Y = f + vX.

Question: How are the five steps of the scattergraph method used to estimate total fixed costs
and per unit variable cost?

Answer: Each of the five steps is described next.

Step 1. Plot the data points for each period on a graph.

This step requires that each data point be plotted on a graph. The x-axis (horizontal axis) reflects
the level of activity (units produced in this example), and the y-axis (vertical axis) reflects the
total production cost.shows a scattergraph for Bikes Unlimited using the data points for 12
months, July through June.

Figure 5.5 Scattergraph of Total Mixed Production Costs for Bikes Unlimited

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Step 2. Visually fit a line to the data points and be sure the line touches one data point.

Once the data points are plotted as described in step 1, draw a line through the points touching
one data point and extending to the y-axis. The goal here is to minimize the distance from the
data points to the line (i.e., to make the line as close to the data points as possible). shows the line
through the data points. Notice that the line hits the data point for July (3,500 units produced and
$230,000 total cost).

Figure 5.6 Estimated Total Mixed Production Costs for Bikes Unlimited: Scattergraph Method

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 Step 3. Estimate the total fixed costs (f).

The total fixed costs are simply the point at which the line drawn in step 2 meets the y-axis. This
is often called the y-intercept. Remember, the line meets the y-axis when the activity level (units
produced in this example) is zero. Fixed costs remain the same in total regardless of level of
production, and variable costs change in total with changes in levels of production. Since
variable costs are zero when no units are produced, the costs reflected on the graph at the y-
intercept must represent total fixed costs. The graph inindicates total fixed costs of
approximately $45,000. (Note that the y-intercept will always be an approximation.)

Step 4. Calculate the variable cost per unit (v).

After completing step 3, the equation to describe the line is partially complete and stated as Y =
$45,000 + vX. The goal of step 4 is to calculate a value for variable cost per unit (v). Simply use
the data point the line intersects (July: 3,500 units produced and $230,000 total cost), and fill in
the data to solve for v (variable cost per unit) as follows:

Y$230,000$230,000−$45,000$185,000vv=f+vX=$45,000+(v×3,500)=v×3,500=v×3,500=$185,000÷3,500=$52.86 (rounded)  

Thus variable cost per unit is $52.86.

Step 5. State the results in equation form Y = f + vX.

We know from step 3 that the total fixed costs are $45,000, and from step 4 that the variable cost
per unit is $52.86. Thus the equation used to estimate total costs looks like this:

Y  =  $45,000  +  $52.86X  

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 Now it is possible to estimate total production costs given a certain level of production (X). For
example, if Bikes Unlimited expects to produce 6,000 units during August, total production costs
are estimated to be $362,160:

YYY=$45,000+($52.86×6,000 units)=$45,000+$317,160=$362,160  

Question: Remember that the key weakness of the high-low method discussed previously is that it considers only two data
points in estimating fixed and variable costs. How does the scattergraph method mitigate this weakness?

Answer: The scattergraph method mitigates this weakness by considering all data points in
estimating fixed and variable costs. The scattergraph method gives us an opportunity to review
all data points in the data set when we plot these data points in a graph in step 1. If certain data
points seem unusual (statistics books often call these points outliers), we can exclude them from
the data set when drawing the best-fitting line. In fact, many organizations use a scattergraph to
identify outliers and then useregression analysis to estimate the cost equation Y = f + vX. We discuss
regression analysis in the next section.

Although the scattergraph method tends to yield more accurate results than the high-low method,
the final cost equation is still based on estimates. The line is drawn using our best judgment and
a bit of guesswork, and the resulting y-intercept (fixed cost estimate) is based on this line. This
approach is not an exact science! However, the next approach to estimating fixed and variable
costs—regression analysis—uses mathematical equations to find the best-fitting line.

R E V I E W   P R O B L E M   5 . 4  

Alta  Production,  Inc.,  reported  the  following  production  costs  for  the  12  months  January  through  December.  (These  are  the  

same  data  presented  in  .)  

Reporting Period (Month) Total Production Costs Level of Activity (Units Produced)

January $460,000 300

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 February 300,000 220

March 480,000 330

April 550,000 390

May 570,000 410

June 310,000 240

July 440,000 290

August 455,000 320

September 530,000 380

October 250,000 150

November 700,000 450

December 490,000 350

1. Using  the  information,  perform  the  five  steps  of  the  scattergraph  method  to  estimate  costs  and  state  your  results  in  cost  

equation  form  Y  =  f  +  vX.  

2. Assume  Alta  Production,  Inc.,  will  produce  400  units  next  month.  Calculate  total  production  costs  for  the  month.  

3. When  is  this  approach  likely  to  yield  more  accurate  results  than  the  high-­‐low  method?  

Solution  to  Review  Problem  5.4  

1. The  five  steps  are  as  follows:  

   
   

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 Step  1.  Plot  the  data  points  for  each  period  on  a  graph.  

   

Step  2.  Visually  fit  a  line  to  the  data  points,  and  be  sure  the  line  touches  one  data  point.  

   

Step  3.  Estimate  the  total  fixed  costs  (f).  

The  y-­‐intercept  represents  total  fixed  costs.  This  is  where  the  line  meets  the  y-­‐axis.  Total  fixed  costs  in  the  graph  

appear  to  be  approximately  $5,000.  You  will  likely  get  a  different  answer  because  the  answer  depends  on  the  line  that  

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 you  visually  fit  to  the  data  points.  Remember  you  must  draw  the  line  through  one  data  point.  The  line  intersects  the  

data  point  for  March  ($480,000  production  costs;  330  units  produced).  This  will  be  used  in  step  4.  

   

Step  4.  Calculate  the  variable  cost  per  unit  (v).  

After  completing  step  3,  the  equation  to  describe  the  line  is  partially  complete  and  stated  as  Y  =  $5,000  +  vX.  The  goal  

of  this  step  is  to  calculate  a  value  for  variable  cost  per  unit  (v).  Use  the  data  point  the  line  intersects  (for  March,  330  

units  produced  and  $480,000  total  costs),  and  fill  in  the  data  to  solve  for  v  (variable  cost  per  unit):  

Y$480,000$480,000−$5,000$475,000vv=f+vX=$5,000+(v×330)=v×330=v×330=$475,000÷330=$1,439.39 (rounded)  

   

Step  5.  State  the  results  in  equation  form  Y  =  f  +  vX.  

We  know  from  step  3  that  the  total  fixed  costs  are  $5,000,  and  from  step  4  that  variable  cost  per  unit  is  $1,439.39.  

Thus  the  equation  used  to  estimate  total  production  costs  is  stated  as:  

Y=$5,000+$1,439.39X  

It  is  evident  from  this  information  that  this  company  has  very  little  in  fixed  costs  and  relatively  high  variable  costs.  This  

is  indicative  of  a  company  that  uses  a  high  level  of  labor  and  materials  (both  variable  costs)  and  a  low  level  of  

machinery  (typically  a  fixed  cost  through  depreciation  or  lease  costs).  

2. Using  the  equation,  simply  substitute  400  units  for  X,  as  follows:  

YYY=$5,000+($1,439.39×400 units)=$5,000+$575,756=$580,756  

Thus  total  production  costs  are  expected  to  be  $580,756  for  next  month.  

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 3. This  approach  is  likely  to  yield  more  accurate  results  than  the  high-­‐low  method  when  the  high  and  low  points  are  not  

representative  of  the  entire  set  of  data.  Notice  that  fixed  costs  are  much  lower  using  the  scattergraph  method  ($5,000)  than  

the  high-­‐low  method  ($25,000).  

Regression Analysis

Question: Regression analysis is similar to the scattergraph approach in that both fit a straight
line to a set of data points to estimate fixed and variable costs.How does regression analysis
differ from the scattergraph method for estimating costs?

Answer: Regression analysis uses a series of mathematical equations to find the best possible fit
of the line to the data points and thus tends to provide more accurate results than the scattergraph
approach. Rather than running these computations by hand, most companies use computer
software, such as Excel, to perform regression analysis. Using the data for Bikes Unlimited
shown back in , regression analysis in Excel provides the following output. (This is a small
excerpt of the output; see the appendix to this chapter for an explanation of how to use Excel to
perform regression analysis.)

Coefficients

y-intercept 43,276

x variable 53.42

Thus the equation used to estimate total production costs for Bikes Unlimited looks like this:

Y  =  $43,276  +  $53.42X  

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 Now it is possible to estimate total production costs given a certain level of production (X). For
example, if Bikes Unlimited expects to produce 6,000 units during August, total production costs
are estimated to be $363,796:

YYY=$43,276+($53.42×6,000 units)=$43,276+$320,520=$363,796  

Regression analysis tends to yield the most accurate estimate of fixed and variable costs,
assuming there are no unusual data points in the data set. It is important to review the data set
first—perhaps in the form of a scattergraph—to confirm that no outliers exist.

R E V I E W   P R O B L E M   5 . 5  

Alta  Production,  Inc.,  reported  the  following  production  costs  for  the  12  months  January  through  December.  (These  are  the  

same  data  that  appear  in  and  .)  

Reporting Period (Month) Total Production Cost Level of Activity (Units Produced)

January $460,000 300

February 300,000 220

March 480,000 330

April 550,000 390

May 570,000 410

June 310,000 240

July 440,000 290

August 455,000 320

September 530,000 380

October 250,000 150

November 700,000 450

December 490,000 350

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 Regression  analysis  performed  using  Excel  resulted  in  the  following  output:  
Coefficients

y-intercept 703

x variable 1,442.97

1. Using  this  information,  create  the  cost  equation  in  the  form  Y  =  f  +  vX.  

2. Assume  Alta  Production,  Inc.,  will  produce  400  units  next  month.  Calculate  total  production  costs  for  the  month.  

Solution  to  Review  Problem  5.5  

1. The  cost  equation  using  the  data  from  regression  analysis  is:  

Y=$703+$1,442.97X  

2. Using  the  equation,  simply  substitute  400  units  for  X,  as  follows:  

YYY=$703+($1,442.97×400 units)=$703+$577,188=$577,891  

Thus  total  production  costs  are  expected  to  be  $577,891  for  next  month.  

Summary of Four Cost Estimation Methods

Question: You are now able to create the cost equation Y = f + vX to estimate costs using four
approaches. What does the cost equation look like for each approach at Bikes Unlimited?

Answer: The results of these four approaches for Bikes Unlimited are summarized as follows:

• Account analysis: Y = $30,000 + $52.00X

• High-low method: Y = $26,000 + $60.00X
• Scattergraph method: Y = $45,000 + $52.86X
• Regression analysis: Y = $43,276 + $53.42X

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 Question: We have seen that different methods yield different results, so which method should be
used?

Answer: Regression analysis tends to be most accurate because it provides a cost equation that
best fits the line to the data points. However, the goal of most companies is to get close—the
results do not need to be perfect. Some could reasonably argue that the account analysis
approach is best because it relies on the knowledge of those who are familiar with the costs
involved.

At Bikes Unlimited, Eric (CFO) and Susan (cost accountant) met several days later. After
consulting with her staff, Susan agreed that regression analysis was the best approach to use in
estimating total production costs (keep in mind nothing has been done yet with selling and
administrative expenses). Account analysis was ruled out because no one on the accounting staff
had been with the company long enough to review the accounts and determine which costs were
variable, fixed, or mixed. The high-low method was ruled out because it only uses two data
points and Eric would prefer a more accurate estimate. Susan did request that her staff prepare a
scattergraph and review it for any unusual data points before performing regression analysis.
Based on the scattergraph prepared, all agreed that the data was relatively uniform and no
outlying data points were identified.

My staff has been working hard to determine what will happen to profit if sales volume increases. So far, we’ve been able to
identify cost behavior patterns for production costs, and we’re currently working on the cost behavior patterns for selling
Susan: and administrative expenses.

Eric: What do you have for production costs?

The portion of production costs that are fixed—that won’t change with changes in production and sales—totals $43,276. The
Susan: portion of production costs that are variable—that vary with changes in production and sales—totals $53.42 per unit.

Eric: When do you expect to have further information for the selling and administrative costs?

We should have those results by the end of the day tomorrow. At that point, I’ll put together an income statement projecting
Susan: profit for August.

Eric: Sounds good. Let’s meet when you have the information ready.

K E Y   T A K E A W A Y S  
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 • Account  analysis  requires  that  a  knowledgeable  employee  (or  group  of  employees)  determine  whether  costs  are  fixed,  

variable,  or  mixed.  If  employees  do  not  have  enough  experience  to  accurately  estimate  these  costs,  another  method  should  be  

used.  

•  and  show  that  total  variable  costs  change  with  changes  in  activity,  but  per  unit  variable  cost  does  not  change  with  changes  in  

activity.and  show  that  total  fixed  costs  do  not  change  with  changes  in  activity,  but  per  unit  fixed  costs  do  change  with  changes  

in  activity.and  show  that  total  mixed  costs  change  with  changes  in  activity,  and  per  unit  mixed  cost  also  changes  with  changes  

in  activity.  

• The  high-­‐low  method  starts  with  the  highest  and  lowest  activity  levels  and  uses  four  steps  to  estimate  fixed  and  variable  costs.  

• The  scattergraph  method  has  five  steps  and  starts  with  plotting  all  points  on  a  graph  and  fitting  a  line  through  the  points.  This  

line  represents  costs  throughout  a  range  of  activity  levels  and  is  used  to  estimate  fixed  and  variable  costs.  The  scattergraph  is  

also  used  to  identify  any  outlying  or  unusual  data  points.  

• Regression  analysis  forms  a  mathematically  determined  line  that  best  fits  the  data  points.  Software  packages  like  Excel  are  

available  to  perform  regression  analysis.  As  with  the  account  analysis,  high-­‐low,  and  scattergraph  methods,  this  line  is  

described  in  the  equation  form  Y  =  f  +  vX.  This  equation  is  used  to  estimate  future  costs.  

• Four  methods  can  be  used  to  estimate  fixed  and  variable  costs.  Each  method  has  its  advantages  and  disadvantages,  and  the  

choice  of  a  method  will  depend  on  the  situation  at  hand.  Experienced  employees  may  be  able  to  effectively  estimate  fixed  and  

variable  costs  by  using  the  account  analysis  approach.  If  a  quick  estimate  is  needed,  the  high-­‐low  method  may  be  appropriate.  

The  scattergraph  method  helps  with  identifying  any  unusual  data  points,  which  can  be  thrown  out  when  estimating  costs.  

Finally,  regression  analysis  can  be  run  using  computer  software  such  as  Excel  and  generally  provides  for  more  accurate  cost  

estimates.  
R E V I E W   P R O B L E M   5 . 6  

Use  the  solutions  you  prepared  for  ,  ,  ,  and  to  do  the  following:  

1. Show  the  four  cost  equations  created  for  Alta  Production,  Inc.,  using  account  analysis  (),  the  high-­‐low  method  (),  the  

scattergraph  method  (),  and  regression  analysis  ().  

2. Using  the  four  equations  listed  in  your  answer  to  1,  calculate  total  production  costs  assuming  Alta  Production,  Inc.,  will  

produce  400  units  next  month.  Comment  on  your  results.  

Solution  to  Review  Problem  5.6  

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 1. The  cost  equations  for  each  of  the  four  methods  used  in  ,  ,  ,  and  are  shown  here.  Each  of  these  cost  equations  was  

created  using  the  same  historical  production  cost  data  for  Alta  Production,  Inc.  The  goal  for  you  as  a  student  is  to  

understand  how  to  develop  a  cost  equation  that  will  help  in  estimating  costs  for  the  future  (based  on  past  

information).  

1. Account  analysis:  Y  =  $7,000  +  $1,428.57X  

2. High-­‐low  method:  Y  =  $25,000  +  $1,500.00X  

3. Scattergraph  method:  Y  =  $5,000  +  $1,439.39X  

4. Regression  analysis:  Y  =  $703  +  $1,442.97X  

Total  production  costs  assuming  400  units  will  be  produced  are  calculated  for  each  method  given.  Note  that  the  

equations  presented  previously  are  used  for  these  calculations.  

   

Account  analysis  

YYY=$7,000+($1,428.57×400 units)=$7,000+$571,428=$578,428  

   

High-­‐low  method  

YYY=$25,000+($1,500×400 units)=$25,000+$600,000=$625,000  

   

Scattergraph  method  

YYY=$5,000+($1,439.39×400 units)=$5,000+$575,756=$580,756  

   

Regression  analysis  

YYY=$703+($1,442.97×400 units)=$703+$577,188=$577,891  

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 The  account  analysis  ($578,428),  scattergraph  method  ($580,756),  and  regression  analysis  ($577,891)  all  yield  similar  

estimated  production  costs.  The  high-­‐low  method  varies  significantly  from  the  other  three  approaches,  likely  because  

only  two  data  points  are  used  to  estimate  unit  variable  cost  and  total  fixed  costs.  

5.3 The Contribution Margin Income Statement

L E A R N I N G   O B J E C T I V E  

1. Prepare  a  contribution  margin  income  statement.  

After further work with her staff, Susan was able to break down the selling and administrative
costs into their variable and fixed components. (This process is the same as the one we discussed
earlier for production costs.) Susan then established the cost equations shown in Table 5.5.

Table 5.5 Cost Equations for Bikes Unlimited

Production costs Y = $43,276 + $53.42X

Selling and administrative costs Y = $110,000 + $9.00X

Question: The challenge now is to organize this information in a way that is helpful to
management—specifically, to Eric Mendez. The traditional income statement format used for
external financial reporting simply breaks costs down by functional area: cost of goods sold and
selling and administrative costs. It does not show fixed and variable costs. Panel A of illustrates
the traditional format. (We defer consideration of income taxes to the end of .) How can this
information be presented in an income statement that shows fixed and variable costs separately?

Answer: Another income statement format, called thecontribution margin income statement,
shows the fixed and variable components of cost information. This type of statement appears in
panel B of. Note that operating profit is the same in both statements, but the organization of data
differs. The contribution margin income statement organizes the data in a way that makes it
easier for management to assess how changes in production and sales will affect operating profit.

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 Thecontribution margin represents sales revenue left over after deducting variable costs from
sales. It is the amount remaining that will contribute to covering fixed costs and to operating
profit (hence, the name contribution margin).

Eric indicated that sales volume in August could increase by 20 percent over sales in June of
5,000 units, which would increase unit sales to 6,000 units [= 5,000 units + (5,000 × 20
percent)], and he asked Susan to come up with projected profit for August. Eric also mentioned
that the sales price would remain the same at $100 per unit. Using this information and the cost
estimate equations in , Susan prepared the contribution margin income statement in panel B of .
Assume for now that 6,000 units is just within the relevant range for Bikes Unlimited. (We will
discuss this assumption later in the chapter.)

Figure 5.7 Traditional and Contribution Margin Income Statements for Bikes Unlimited

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*From .

The contribution margin income statement shown in panel B of clearly indicates which costs are
variable and which are fixed. Recall that the variable cost per unit remains constant, and variable
costs in total change in proportion to changes in activity. Because 6,000 units are expected to be
sold in August, total variable costs are calculated by multiplying 6,000 units by the cost per unit
($53.42 per unit for cost of goods sold, and $9.00 per unit for selling and administrative costs).
Thus total variable cost of goods sold is $320,520, and total variable selling and administrative
costs are $54,000. These two amounts are combined to calculate total variable costs of $374,520,
as shown in panel B of .

The contribution margin of $225,480 represents the sales revenue left over after deducting
variable costs from sales ($225,480 = $600,000 − $374,520). It is the amount remaining that
will contribute to covering fixed costs and to operating profit.

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 Recall that total fixed costs remain constant regardless of the level of activity. Thus fixed cost of
goods sold remains at $43,276, and fixed selling and administrative costs stay at $110,000. This
holds true at both the 5,000 unit level of activity for June, and the 6,000 unit level of activity
projected for August. Total fixed costs of $153,276 (= $43,276 + $110,000) are deducted from
the contribution margin to calculate operating profit of $72,204.

Armed with this information, Susan meets with Eric the next day. Refer to panel B of as you read
Susan’s comments about the contribution margin income statement.

Eric, I have some numbers for you. My projection for August is complete, and I expect profit to be approximately $72,000 if
Susan: sales volume increases 20 percent.

Eric: Excellent! You were correct in figuring that profit would increase at a higher rate than sales because of our fixed costs.

Here’s a copy of our projected income for August. This income statement format provides the variable and fixed costs. As
you can see, our monthly fixed costs total approximately $153,000. Now that we have this information, we can easily make
Susan: projections for different scenarios.

This will be very helpful in making projections for future months. I’ll take your August projections to the management group
Eric: this afternoon. Thanks for your help!

 
Business  in  Action  5.3  

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Source:http://commons.wikimedia.org/wiki/File:LowesMeyerlandHoustonTX.jpg

Costs at Lowe’s Companies, Inc.

Lowe’s is the world’s second largest home improvement retailer with more than 1,700 stores in the United States, Canada,

and Mexico. The company has 234,000 employees. The following financial information is from Lowe’s income statement

for the year ended January 28, 2011 (amounts are in millions). Which of the company’s costs are likely to be variable?

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 Variable costs probably include cost of sales (the cost of goods sold) and a portion of selling and general and administrative

costs (e.g., the cost of hourly labor). Cost of sales alone represents 65 percent of net sales (rounded). Retail companies

like Lowe’s tend to have higher variable costs than manufacturing companies like General Motors and Boeing.

Source: Lowe’s Web site (http://www.lowes.com).

K E Y   T A K E A W A Y  

• The  contribution  margin  income  statement  shows  fixed  and  variable  components  of  cost  information.  Revenue  minus  variable  

costs  equals  the  contribution  margin.  The  contribution  margin  minus  fixed  costs  equals  operating  profit.  This  statement  

provides  a  clearer  picture  of  which  costs  change  and  which  costs  remain  the  same  with  changes  in  levels  of  activity.  
R E V I E W   P R O B L E M   5 . 7  

Last  month,  Alta  Production,  Inc.,  sold  its  product  for  $2,500  per  unit.  Fixed  production  costs  were  $3,000,  and  variable  

production  costs  amounted  to  $1,400  per  unit.  Fixed  selling  and  administrative  costs  totaled  $50,000,  and  variable  selling  and  

administrative  costs  amounted  to  $200  per  unit.  Alta  Production  produced  and  sold  400  units  last  month.  

Prepare  a  traditional  income  statement  and  a  contribution  margin  income  statement  for  Alta  Production.  Use  as  a  guide.  

Solution  to  Review  Problem  5.7  

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*Given.  

5.4 The Relevant Range and Nonlinear Costs

L E A R N I N G   O B J E C T I V E  

1. Understand  the  assumptions  used  to  estimate  costs.  

Question: Bikes Unlimited is making an important assumption in estimating fixed and variable
costs. What is this important assumption and why might it be misleading?

Answer: The assumption is that total fixed costs and per unit variable costs will always be at the
levels shown in regardless of the level of production. This will not necessarily hold true under all
circumstances.

For example, let’s say Bikes Unlimited picks up a large contract with a customer that requires
producing an additional 30,000 units per month. Do you think the cost equations in would lead to
accurate cost estimates? Probably not, because additional fixed costs would be incurred for
facilities, salaried personnel, and other areas. Variable cost per unit would likely change also
since additional direct labor would be required (either through overtime, which requires overtime
pay, or by hiring more employees who are less efficient as they learn the process), and the
volume of parts purchased from suppliers would increase, perhaps leading to reductions in per
unit costs due to volume discounts for the parts.
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 As defined earlier, the relevant range is a term used to describe the range of activity (units of
production in this example) for which cost behavior patterns are likely to be accurate. Because
the historical data used to create these equations for Bikes Unlimited ranges from a low of 2,900
units in January to a high of 5,900 units in April (see ), management would investigate costs
further when production levels fall outside of this range. The relevant range for total production
costs at Bikes Unlimited is shown in . It is up to the cost accountant to determine the relevant
range and make clear to management that estimates being made for activity outside of the
relevant range must be analyzed carefully for accuracy.

Figure 5.8 Relevant Range for Total Production Costs at Bikes Unlimited

 
Recall that Bikes Unlimited estimated costs based on projected sales of 6,000 units for the month
of August. Although this is slightly higher than the highest sales of 5,900 units in April, Susan
(cost accountant) determined that Bikes Unlimited had the production capacity to produce 6,000
units without significantly affecting total fixed costs or per unit variable costs. Thus she
determined that a sales level of 6,000 units was still within the relevant range. However, Susan
also made Eric (CFO) aware that Bikes Unlimited was quickly approaching full capacity. If sales
were expected to increase in the future, the company would have to increase capacity, and cost
estimates would have to be revised.

Question: Another important assumption being made by Bikes Unlimited is that all costs behave
in a linear manner. Variable, fixed, and mixed costs are all described and shown as a straight
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 line. However, many costs are not linear and often take on a nonlinear pattern. Why do some
costs behave in a nonlinear way?

Answer: Assume the pattern shown in is for total variable production costs. Consider this: Have
you ever worked a job where you were very slow at first but improved rapidly with experience?
If a company produces just a few units each month, workers (direct labor) do not gain the
experience needed to work efficiently and may waste time and materials. This has the effect of
driving up the per unit variable cost. Recall that the slope of the line represents the unit cost;
thus, when the unit cost increases, so does the slope. If the company produces more units each
month, workers gain experience resulting in improved efficiency, and the per unit cost decreases
(both in materials and labor). This causes the total cost line to flatten out a bit as the slope
decreases. This is fine until the company starts to reach its limit in how much it can produce
(called capacity). Now the company must hire additional inexperienced employees or pay its
current employees overtime, which once again drives up the cost per unit. Thus the slope begins
to increase.

Figure 5.9 Nonlinear Variable Costs

 
Although this is probably a more accurate description of how variable costs actually behave for
most companies, it is much simpler to describe and estimate costs if you assume they are linear.
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 As long as the relevant range is clearly identified, most companies can reasonably use the
linearity assumption to estimate costs.

K E Y   T A K E A W A Y  

• Two  important  assumptions  must  be  considered  when  estimating  costs  using  the  methods  described  in  this  chapter.  

1. When  costs  are  estimated  for  a  specific  level  of  activity,  the  assumption  is  that  the  activity  level  is  within  the  relevant  range.  

2. Costs  are  estimated  assuming  that  they  are  linear.  

Both  assumptions  are  reasonable  as  long  as  the  relevant  range  is  clearly  identified,  and  the  linearity  assumption  does  not  significantly  

distort  the  resulting  cost  estimate.  

R E V I E W   P R O B L E M   5 . 8  

1. Using  the  data  in  ,  identify  the  relevant  range.  

2. Why  is  it  important  to  determine  the  relevant  range?  

Solution  to  Review  Problem  5.8  

1. The  relevant  range,  the  range  of  activity  for  which  cost  estimates  are  more  likely  to  be  accurate,  is  from  150  units  (lowest  activity  level)  to  450  

units  of  production  (highest  activity  level).  

2. Identifying  the  relevant  range  when  estimating  costs  is  important  because  if  a  cost  estimate  is  being  made  for  activity  outside  of  the  relevant  

range,  total  fixed  costs  and  per  unit  variable  costs  may  be  different  from  those  described  in  the  cost  equation.  For  example,  if  production  is  

doubled,  additional  factory  space  may  be  needed,  resulting  in  higher  fixed  costs.  

5.5  Appendix:  Performing  Regression  Analysis  with  Excel  

L E A R N I N G   O B J E C T I V E  

1. Perform  regression  analysis  using  Excel.  

Question: Regression analysis is often performed to estimate fixed and variable costs. Many
different software packages have the capability of performing regression analysis, including
Excel. This appendix provides a basic illustration of how to use Excel to perform regression
analysis. Statistics courses cover this topic in more depth. How is regression analysis used to
estimate fixed and variable costs?

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 Answer: As noted in the chapter, regression analysis uses a series of mathematical equations to
find the best possible fit of the line to the data points. For the purposes of this chapter, the end
goal of regression analysis is to estimate fixed and variable costs, which are described in the
equation form of Y = f + vX. Recall that the following Excel output was provided earlier in the
chapter based on the data presented in for Bikes Unlimited.

Coefficients

y-intercept 43,276

x variable 53.42

The resulting equation to estimate production costs is Y = $43,276 + $53.42X. We now describe
the steps to be performed in Excel to get this equation.

Step 1. Confirm that the Data Analysis package is installed.

Go to the Data tab on the top menu bar and look for Data Analysis. If Data Analysis appears, you
are ready to perform regression analysis. If Data Analysis does not appear, go to the help button
(denoted as a question mark in the upper right-hand corner of the screen) and type Analysis
ToolPak. Look for the Load the Analysis ToolPak option and follow the instructions given.

Step 2. Enter the data in the spreadsheet.

Using a new Excel spreadsheet, enter the data points in two columns. The monthly data
in includes Total Production Costs and Units Produced. Thus use one column (column A) to
enter Total Production Costs data and another column (column B) to enter Units Produced data.

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Step 3. Run the regression analysis.

Using the same spreadsheet set up in step 2, select Data, Data Analysis, andRegression. A box
appears that requires the input of several items needed to perform regression. Input Y
Range requires that you highlight the y-axis data, including the heading (cells B1 through B13 in
the example shown in step 2). Input X Range requires that you highlight the x-axis data,
including the heading (cells C1 through C13 in the example shown in step 2). Check
the Labels box; this indicates that the top of each column has a heading (B1 and C1). Select New
Workbook; this will put the regression results in a new workbook. Lastly, check the Line Fit
Plots box, then select OK. The result is as follows (note that we made a few minor format
changes to allow for a better presentation of the data).

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Step 4. Analyze the output.

Here, we discuss key items shown in the regression output provided in step 3.

• Cost Equation: The output shows that estimated fixed costs (shown as
the Intercept coefficient in cell B17) total $43,276, and the estimated variable cost per
unit (shown as the Units Produced coefficient in B18) is $53.42. Thus the cost equation
is:

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 Y = $43,276 + $53.42XorTotal Production Costs = $43,276 + ($53.42 × Units Produced)

• Line Fit Plot and R-Squared: The plot shows that actual total production costs are very
close to predicted total production costscalculated using the cost equation. Thus the cost
equation created from the regression analysis is likely to be useful in predicting total
production costs. Another way to assess the accuracy of the regression output is to review
the R-squared statistic shown in cell B5. R-squaredmeasures the percent of the variance
in the dependent variable (total production costs, in this example) explained by the
independent variable (units produced, in this example). According to the output, 96.29
percent of the variance in total production costs is explained by the level of units
produced—further evidence that the regression results will be useful in predicting total
production costs.

The discussion of regression analysis in this chapter is meant to serve as an introduction to the topic.

To further enhance your knowledge of regression analysis and to provide for a more thorough

analysis of the data, you should pursue the topic in an introductory statistics course.
K E Y   T A K E A W A Y  

• Software  applications,  such  as  Excel,  can  use  regression  analysis  to  estimate  fixed  and  variable  costs.  

o Once  the  data  analysis  package  is  installed,  historical  data  are  entered  in  the  spreadsheet,  and  the  regression  analysis  

is  run.  

o The  resulting  data  are  used  to  determine  the  cost  equation,  which  includes  estimated  fixed  and  variable  costs.  

The  line  fit  plot  and  R-­‐squared  statistic  are  used  to  assess  the  usefulness  of  the  cost  equation  in  estimating  costs.  
R E V I E W   P R O B L E M   5 . 9  

Refer  to  the  monthly  production  cost  data  for  Alta  Production,  Inc.,  in  .  Use  the  four  steps  of  regression  analysis  described  in  

this  appendix  to  estimate  total  fixed  costs  and  variable  cost  per  unit.  State  your  results  in  the  equation  form  Y  =  f  +  vX.  

Solution  to  Review  Problem  5.9  

Regression  analysis  performed  using  Excel  results  in  the  following  output:  
Coefficients

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 y-intercept 703

x variable 1,442.97

Thus  the  total  cost  equation  is:  

Y  =  $703  +  $1,442.97X  

E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  

1. What  is  a  fixed  cost?  Provide  two  examples.  

2. What  is  the  difference  between  a  committed  fixed  cost  and  a  discretionary  fixed  cost?  Provide  examples  of  each.  

3. What  is  a  variable  cost?  Provide  two  examples.  

4. What  is  a  mixed  cost?  Provide  two  examples.  

5. Describe  the  variables  in  the  cost  equation  Y  =  f  +  vX.  

6. How  is  the  cost  equation  Y  =  f  +  vX  used  to  estimate  future  costs?  

7. Why  is  it  important  to  identify  how  costs  behave  with  changes  in  activity?  

8. Review  Why  was  the  school  district’s  administration  surprised  to  find  out  that  cost  savings  from  closing  a  school  would  be  

much  lower  than  initially  anticipated?  

9. Explain  how  account  analysis  is  used  to  estimate  costs.  

10. Describe  the  four  steps  of  the  high-­‐low  method  and  how  these  steps  are  used  to  estimate  costs.  

11. Why  might  the  high-­‐low  method  lead  to  inaccurate  results?  

12. Describe  the  five  steps  of  the  scattergraph  method  and  how  these  steps  are  used  to  estimate  costs.  

13. How  can  the  scattergraph  method  be  used  to  identify  unusual  data  points?  

14. Describe  how  regression  analysis  is  used  to  estimate  costs.  

15. How  does  the  contribution  margin  income  statement  differ  from  the  traditional  income  statement?  

16. Review  Which  costs  at  Lowe’s  are  likely  to  be  variable  costs?  

17. Describe  the  term  relevant  range.  Why  is  it  important  to  stay  within  the  relevant  range  when  estimating  costs?  

18. Explain  how  some  costs  can  behave  in  a  nonlinear  way.  

Brief  Exercises  
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 19. Planning  at  Bikes  Unlimited.  Refer  to  the  dialogue  at  Bikes  Unlimited  presented  at  the  beginning  of  the  chapter.  What  is  the  

first  step  to  be  taken  by  Susan  and  her  accounting  staff  to  help  in  estimating  profit  for  August?  

20. Identifying  Cost  Behavior.  Vasquez  Incorporated  is  trying  to  identify  the  cost  behavior  of  the  three  costs  that  follow.  

Cost  information  is  provided  for  three  months.  

Cost A Cost B Cost C

Month Units Produced Total Costs Cost per Unit Total Costs Cost per Unit Total Costs Cost per Unit

1 1,500 $1,500 _____ $4,500 _____ $3,000 _____

2 3,000 1,500 _____ 5,250 _____ 6,000 _____

3 750 1,500 _____ 3,750 _____ 1,500 _____

21. Required:  

a. Calculate  the  cost  per  unit,  and  then  identify  how  the  cost  behaves  for  each  of  the  three  costs  (fixed,  variable,  or  

mixed).  Explain  the  reasoning  for  your  answers.  

b. How  does  identifying  cost  behavior  patterns  help  managers?  

Account  Analysis.  Cordova  Company  would  like  to  estimate  production  costs  on  an  annual  basis.  Costs  incurred  for  

direct  materials  and  direct  labor  are  variable  costs.  The  accounting  records  indicate  that  the  following  production  costs  

were  incurred  last  year  for  50,000  units.  

Direct materials $100,000

Direct labor $215,000

Manufacturing overhead $300,000 (20 percent fixed; 80 percent variable)

Required:  

Use  account  analysis  to  estimate  the  fixed  costs  per  year,  and  the  variable  cost  per  unit.  

High-­‐Low  Method.  The  city  of  Rockville  reported  the  following  annual  cost  data  for  maintenance  work  performed  

on  its  fleet  of  trucks.  

Reporting Period (Year) Total Costs Level of Activity (Miles Driven)

Year 1 $ 750,000 225,000

Year 2 850,000 240,000

Year 3 1,100,000 430,000

Year 4 1,150,000 454,000

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 Year 5 1,250,000 560,000

Year 6 1,550,000 710,000

Required:  

 . Use  the  four  steps  of  the  high-­‐low  method  to  estimate  total  fixed  costs  per  year  and  the  variable  cost  per  mile.  

State  your  results  in  the  cost  equation  form  Y  =  f  +  vX.  

a. What  would  the  estimated  costs  be  if  the  trucks  drove  500,000  miles  in  year  7?  

Scattergraph  Method.  Refer  to  the  data  in  Brief  Exercise  22  for  the  city  of  Rockville.  

Required:  

 . Use  the  five  steps  of  the  scattergraph  method  to  estimate  total  fixed  costs  per  year  and  the  variable  cost  per  mile.  

State  your  results  in  the  cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

a. What  would  the  estimated  costs  be  if  the  trucks  drove  500,000  miles  in  year  7?  

Regression  Analysis.  Regression  analysis  was  run  using  the  data  in  Brief  Exercise  22  for  the  city  of  Rockville.  The  

output  is  shown  here:  

Coefficients

y-intercept 441,013

x variable 1.53

Required:  

 . Use  the  regression  output  to  develop  the  cost  equation  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

a. What  would  the  city  of  Rockville’s  estimated  costs  be  if  its  trucks  drove  500,000  miles  in  year  7?  

Contribution  Margin  Income  Statement.  Last  year  Pod  Products,  Inc.,  sold  its  product  for  $250  per  unit.  Production  

costs  totaled  $40,000  (25  percent  fixed,  75  percent  variable).  Selling  and  administrative  costs  totaled  $150,000  (10  

percent  fixed,  90  percent  variable).  Pod  Products  produced  and  sold  1,000  units  last  year.  

Required:  

Prepare  a  contribution  margin  income  statement  for  Pod  Products,  Inc.  

Relevant  Range.  Jersey  Company  produces  jerseys  for  athletic  teams,  and  typically  produces  between  1,000  and  

5,000  jerseys  annually.  The  accountant  is  asked  to  estimate  production  costs  for  this  coming  year  assuming  9,000  

jerseys  will  be  produced.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Required:  

What  is  meant  by  the  term  relevant  range,  and  why  is  the  relevant  range  important  for  estimating  production  costs  for  

this  coming  year  at  Jersey  Company?  

Exercises:  Set  A  

27. Identifying  Cost  Behavior.  Zhang  Corporation  is  trying  to  identify  the  cost  behavior  of  the  three  costs  shown.  Cost  

information  is  provided  for  six  months.  

Cost 1 Cost 2 Cost 3

Month Units Produced Total Costs Cost per Unit Total Costs Cost per Unit Total Costs Cost per Unit

1 18,000 $36,000 _____ $19,800 _____ $5,000 _____

2 16,000 32,000 _____ 19,200 _____ 5,000 _____

3 14,000 28,000 _____ 18,200 _____ 5,000 _____

4 12,000 24,000 _____ 16,800 _____ 5,000 _____

5 10,000 20,000 _____ 14,500 _____ 5,000 _____

6 8,000 16,000 _____ 12,000 _____ 5,000 _____

28. Required:  

a. Calculate  the  cost  per  unit,  and  then  identify  how  the  cost  behaves  (fixed,  variable,  or  mixed)  for  each  of  the  three  

costs.  Explain  the  reasoning  behind  your  answers.  

b. Why  is  it  important  to  identify  how  costs  behave  with  changes  in  activity?  

Account  Analysis.  Baker  Advertising  Incorporated  would  like  to  estimate  costs  associated  with  its  clients  on  an  

annual  basis.  Assume  costs  for  supplies  and  advertising  staff  are  variable  costs.  The  accounting  records  indicate  the  

following  costs  were  incurred  last  year  for  100  clients:  

Supplies $ 20,000

Advertising staff wages (hourly employees) $170,000

Manager salary $ 90,000

Building rent $ 56,000

Required:  

 . Use  account  analysis  to  estimate  total  fixed  costs  per  year,  and  the  variable  cost  per  unit.  State  your  results  in  the  

cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 a. Estimate  the  total  costs  for  this  coming  year  assuming  120  clients  will  be  served.  

High-­‐Low  Method.  Castanza  Company  produces  computer  printers.  Management  wants  to  estimate  the  cost  of  

production  equipment  used  to  produce  printers.  The  company  reported  the  following  monthly  cost  data  related  to  

production  equipment:  
Reporting Period (Month) Total Costs Machine Hours

January $ 920,000 45,000

February 600,000 25,000

March 500,000 20,000

April 1,100,000 90,000

May 1,140,000 95,000

June 620,000 30,000

July 880,000 38,000

August 910,000 48,000

September 1,060,000 78,000

October 960,000 51,000

November 1,400,000 96,000

December 980,000 54,000

Required:  

 . Use  the  four  steps  of  the  high-­‐low  method  to  estimate  total  fixed  costs  per  month  and  the  variable  cost  per  

machine  hour.  State  your  results  in  the  cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

a. What  would  Castanza  Company’s  estimated  costs  be  if  it  used  50,000  machine  hours  next  month?  

b. What  would  Castanza  Company’s  estimated  costs  be  if  it  used  15,000  machine  hours  next  month?  Why  should  you  feel  

uncomfortable  estimating  costs  for  15,000  machine  hours?  

Scattergraph  Method.  Castanza  Company  produces  computer  printers.  Management  wants  to  estimate  the  cost  of  

production  equipment  used  to  produce  printers.  The  company  reported  the  following  monthly  cost  data  related  to  

production  equipment  (this  is  the  same  data  as  the  previous  exercise):  
Reporting Period (Month) Costs Machine Hours

January $ 920,000 45,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     334  
     
 
 February 600,000 25,000

March 500,000 20,000

April 1,100,000 90,000

May 1,140,000 95,000

June 620,000 30,000

July 880,000 38,000

August 910,000 48,000

September 1,060,000 78,000

October 960,000 51,000

November 1,400,000 96,000

December 980,000 54,000

Required:  

 . Use  the  five  steps  of  the  scattergraph  method  to  estimate  total  fixed  costs  per  month  and  the  variable  cost  per  

machine  hour.  State  your  results  in  the  cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

a. What  would  Castanza  Company’s  estimated  costs  be  if  it  used  50,000  machine  hours  next  month?  

b. What  would  Castanza  Company’s  estimated  costs  be  if  it  used  15,000  machine  hours  next  month?  

Regression  Analysis.  Regression  analysis  was  run  for  Castanza  Company  resulting  in  the  following  output  (this  is  

based  on  the  same  data  as  the  previous  two  exercises):  
Coefficients

y-intercept 445,639

x variable 8.54

Required:  

 . Use  the  regression  output  given  to  develop  the  cost  equation  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  fand  v.  

a. What  would  Castanza  Company’s  estimated  costs  be  if  it  used  50,000  machine  hours  next  month?  

b. What  would  Castanza  Company’s  estimated  costs  be  if  it  used  15,000  machine  hours  next  month?  

Contribution  Margin  Income  Statement.  Last  month  Kumar  Production  Company  sold  its  product  for  $60  per  unit.  

Fixed  production  costs  were  $40,000,  and  variable  production  costs  amounted  to  $15  per  unit.  Fixed  selling  and  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     335  
     
 
 administrative  costs  totaled  $26,000,  and  variable  selling  and  administrative  costs  amounted  to  $5  per  unit.  Kumar  

Production  produced  and  sold  7,000  units  last  month.  

Required:  

 . Prepare  a  traditional  income  statement  for  Kumar  Production  Company.  

a. Prepare  a  contribution  margin  income  statement  for  Kumar  Production  Company.  

b. Why  do  companies  use  the  contribution  margin  income  statement  format?  

Regression  Analysis  Using  Excel  (Appendix).  Walleye  Company  produces  fishing  reels.  Management  wants  to  

estimate  the  cost  of  production  equipment  used  to  produce  the  reels.  The  company  reported  the  following  monthly  

cost  data  related  to  production  equipment:  

Reporting Period (Month) Total Costs Machine Hours

January $1,104,000 54,000

February 720,000 30,000

March 600,000 24,000

April 1,320,000 108,000

May 1,368,000 114,000

June 744,000 36,000

July 1,056,000 45,600

August 1,092,000 57,600

September 1,272,000 93,600

October 1,152,000 61,200

November 1,680,000 115,200

December 1,176,000 64,800

Required:  

 . Use  Excel  to  perform  regression  analysis.  Provide  a  printout  of  the  results.  

a. Use  the  regression  output  to  develop  the  cost  equation  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

b. What  would  Walleye  Company’s  estimated  costs  be  if  it  used  90,000  machine  hours  this  month?  

Exercises:  Set  B  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 34. Identifying  Cost  Behavior.  Ivanov,  Inc.,  is  trying  to  identify  the  cost  behavior  of  the  three  costs  shown.  Cost  

information  is  provided  for  six  months.  

Cost 1 Cost 2 Cost 3

Month Units Produced Total Costs Cost per Unit Total Costs Cost per Unit Total Costs Cost per Unit

1 8,000 $10,000 _____ $24,000 _____ $32,000 _____

2 10,000 10,000 _____ 29,000 _____ 40,000 _____

3 12,000 10,000 _____ 33,600 _____ 48,000 _____

4 14,000 10,000 _____ 36,400 _____ 56,000 _____

5 16,000 10,000 _____ 38,400 _____ 64,000 _____

6 18,000 10,000 _____ 39,600 _____ 72,000 _____

35. Required:  

a. Calculate  the  cost  per  unit,  and  then  identify  how  the  cost  behaves  (fixed,  variable,  or  mixed)  for  each  of  the  three  

costs.  Explain  the  reasoning  behind  your  answers.  

b. Why  is  it  important  to  identify  how  costs  behave  with  changes  in  activity?  

Account  Analysis.  Swim-­‐Safe  Company  hires  several  instructors  who  provide  weekly  one-­‐hour  private  swim  lessons  

to  individuals.  The  company  would  like  to  estimate  costs  associated  with  its  swim  lessons  on  a  weekly  basis.  Assume  

costs  for  towels,  snacks,  drinks,  and  instructor  wages  are  variable  costs.  The  accounting  records  indicate  the  following  

costs  were  incurred  last  week  for  250  customer  lessons:  

Towels, snacks, drinks $1,250

Instructor wages (hourly employees) $3,000

Manager (owner) salary $1,500

Pool rental $2,000

Required:  

 . Use  account  analysis  to  estimate  total  fixed  costs  per  week,  and  the  variable  cost  per  lesson.  State  your  results  in  

the  cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

a. Estimate  the  total  costs  for  this  coming  week  assuming  220  lessons  will  be  provided.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     337  
     
 
 High-­‐Low  Method  Quality  Tools.  Quality  Tools  Incorporated  would  like  to  estimate  costs  associated  with  its  sales  

personnel.  Salespeople  are  paid  a  salary  plus  commission.  Commission  rates  vary  among  products  and  are  based  on  

sales  dollars.  The  company  reported  the  following  monthly  cost  data  related  to  sales  personnel:  
Reporting Period (Month) Total Costs Sales Amount

January $710,000 $13,800,000

February 695,000 13,600,000

March 765,000 15,100,000

April 650,000 12,000,000

May 775,000 15,500,000

June 750,000 14,700,000

July 715,000 14,500,000

August 680,000 13,100,000

September 830,000 16,500,000

October 815,000 16,000,000

November 800,000 15,600,000

December 690,000 13,200,000

Required:  

 . Use  the  four  steps  of  the  high-­‐low  method  to  estimate  total  fixed  costs  per  month  and  the  variable  cost  per  sales  

dollar.  State  your  results  in  the  cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

a. What  would  Quality  Tools’  estimated  costs  be  if  it  had  sales  of  $12,500,000  next  month?  

b. What  would  Quality  Tools’  estimated  costs  be  if  it  had  sales  of  $20,000,000  next  month?  Why  should  you  feel  

uncomfortable  estimating  costs  for  $20,000,000  in  sales?  

Scattergraph  Method.  Quality  Tools  Incorporated  would  like  to  estimate  costs  associated  with  its  sales  personnel.  

Salespeople  are  paid  a  salary  plus  commission.  Commission  rates  vary  among  products  and  are  based  on  sales  dollars.  

The  company  reported  the  following  monthly  cost  data  related  to  sales  personnel  (this  is  the  same  data  as  the  

previous  exercise):  
Reporting Period (Month) Total Costs Sales Amount

January $710,000 $13,800,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 February 695,000 13,600,000

March 765,000 15,100,000

April 650,000 12,000,000

May 775,000 15,500,000

June 750,000 14,700,000

July 715,000 14,500,000

August 680,000 13,100,000

September 830,000 16,500,000

October 815,000 16,000,000

November 800,000 15,600,000

December 690,000 13,200,000

Required:  

 . Use  the  five  steps  of  the  scattergraph  method  to  estimate  total  fixed  costs  per  month  and  the  variable  cost  per  

sales  dollar.  State  your  results  in  the  cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

a. What  would  Quality  Tools’  estimated  costs  be  if  it  had  sales  of  $12,500,000  next  month?  

b. What  would  Quality  Tools’  estimated  costs  be  if  it  had  sales  of  $20,000,000  next  month?  

Regression  Analysis.  Regression  analysis  was  run  for  Quality  Tools  Incorporated  resulting  in  the  following  output  

(this  is  based  on  the  same  data  as  the  previous  two  exercises):  
Coefficients

y-intercept 129,188

x variable 0.04

Required:  

 . Use  the  regression  output  given  to  develop  the  cost  equation  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  fand  v.  

a. What  would  Quality  Tools’  estimated  costs  be  if  it  had  sales  of  $12,500,000  next  month?  

b. What  would  Quality  Tools’  estimated  costs  be  if  it  had  sales  of  $20,000,000  next  month?  

Contribution  Margin  Income  Statement,  Service  Company.  Last  month  Seafood  Grill  had  total  sales  of  $200,000.  

Food  preparation  and  service  costs  totaled  $90,000  (20  percent  fixed,  80  percent  variable).  Selling  and  administrative  

costs  totaled  $30,000  (70  percent  fixed,  30  percent  variable).  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     339  
     
 
 Required:  

 . Prepare  a  traditional  income  statement  for  Seafood  Grill.  

a. Prepare  a  contribution  margin  income  statement  for  Seafood  Grill.  

b. Why  do  companies  use  the  contribution  margin  income  statement  format?  

Regression  Analysis  Using  Excel  (Appendix).  Cain  Company  produces  calculators.  Management  wants  to  estimate  

the  cost  of  production  equipment  used  to  produce  the  calculators.  The  company  reported  the  following  monthly  cost  

data  related  to  production  equipment:  

Reporting Period (Month) Total Costs Machine Hours

January $1,250,000 59,000

February 990,000 33,000

March 850,000 28,000

April 1,580,000 120,000

May 1,670,000 126,000

June 1,050,000 40,000

July 1,360,000 51,000

August 1,400,000 70,000

September 1,550,000 105,000

October 1,500,000 67,000

November 1,860,000 128,000

December 1,480,000 71,000

Required:  

 . Use  Excel  to  perform  regression  analysis.  Provide  a  printout  of  the  results.  

a. Use  the  regression  output  to  develop  the  cost  equation  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

b. What  would  Cain  Company’s  estimated  costs  be  if  it  used  110,000  machine  hours  this  month?  

Problems  

41. Cost  Behavior.  Assume  you  are  a  consultant  performing  work  for  two  different  companies.  Each  company  has  asked  

you  to  help  them  identify  the  behavior  of  certain  costs.  

Required:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     340  
     
 
 a. Identify  each  of  the  following  costs  for  Hwang  Company,  a  producer  of  ski  boats,  as  variable  (V),  

fixed  (F),  or  mixed  (M):  

1. _____Salary  of  production  manager  

2. _____Materials  required  for  production  

3. _____Monthly  rent  on  factory  building  

4. _____Hourly  wages  for  assembly  workers  

5. _____Straight-­‐line  depreciation  for  factory  equipment  

6. _____Annual  insurance  on  factory  building  

7. _____Invoices  sent  to  customers  

8. _____Salaries  and  commissions  of  salespeople  

9. _____Salary  of  chief  executive  officer  

10. _____Company  cell  phones  with  first  50  hours  free,  then  10  cents  per  minute  

b. Identify  each  of  the  following  costs  for  Rainier  Camping  Products,  a  maker  of  backpacks,  as  variable  

(V),  fixed  (F),  or  mixed  (M):  

1. _____Hourly  wages  for  assembly  workers  

2. _____Fabric  required  for  production  

3. _____Straight-­‐line  depreciation  on  factory  building  

4. _____Salaries  and  commissions  of  salespeople  

5. _____Lease  payments  for  factory  equipment  

6. _____Company  cell  phones  with  first  80  hours  free,  then  8  cents  per  minute  

7. _____Invoices  sent  to  customers  

8. _____Salary  of  production  manager  

9. _____Salary  of  controller  (accounting)  

10. _____Electricity  for  factory  building  

c. How  might  the  managers  of  these  companies  use  the  cost  behavior  information  requested?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Account  Analysis  and  Contribution  Margin  Income  Statement.Madden  Company  would  like  to  estimate  costs  

associated  with  its  production  of  football  helmets  on  a  monthly  basis.  The  accounting  records  indicate  the  following  

production  costs  were  incurred  last  month  for  4,000  helmets.  

Assembly workers’ labor (hourly) $70,000

Factory rent 3,000

Plant manager’s salary 5,000

Supplies 20,000

Factory insurance 12,000

Materials required for production 20,000

Maintenance of production equipment (based on usage) 18,000

Required:  

 . Use  account  analysis  to  estimate  total  fixed  costs  per  month  and  the  variable  cost  per  unit.  State  your  results  in  the  

cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

a. Estimate  total  production  costs  assuming  5,000  helmets  will  be  produced  and  sold.  

b. Prepare  a  contribution  margin  income  statement  assuming  5,000  helmets  will  be  produced,  and  each  helmet  will  be  

sold  for  $70.  Fixed  selling  and  administrative  costs  total  $10,000.  Variable  selling  and  administrative  costs  are  $8  per  

unit.  

High-­‐Low,  Scattergraph,  and  Regression  Analysis;  Manufacturing  Company.  Woodworks,  Inc.,  produces  cabinet  

doors.  Manufacturing  overhead  costs  tend  to  fluctuate  from  one  month  to  the  next,  and  management  would  like  to  

accurately  estimate  these  costs  for  planning  and  decision-­‐making  purposes.  

The  accounting  staff  at  Woodworks  recommends  that  costs  be  broken  down  into  fixed  and  variable  components.  

Because  the  production  process  is  highly  automated,  most  of  the  manufacturing  overhead  costs  are  related  to  

machinery  and  equipment.  The  accounting  staff  believes  the  best  starting  point  is  to  review  historical  data  for  costs  

and  machine  hours:  

Reporting Period (Month) Total Costs Machine Hours

January $278,000 1,550

February 280,000 1,570

March 266,000 1,115

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 April 290,000 1,700

May 262,000 1,110

June 269,000 1,225

July 275,000 1,335

August 286,000 1,660

September 250,000 1,000

October 253,000 1,020

November 260,000 1,025

December 281,000 1,600

These  data  were  entered  into  a  computer  regression  program,  which  produced  the  following  output:  
Coefficients

y-intercept 210,766

x variable 45.31

Required:  

 . Use  the  four  steps  of  the  high-­‐low  method  to  estimate  total  fixed  costs  per  month  and  the  variable  cost  per  

machine  hour.  State  your  results  in  the  cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

a. Use  the  five  steps  of  the  scattergraph  method  to  estimate  total  fixed  costs  per  month,  and  the  variable  cost  per  

machine  hour.  State  your  results  in  the  cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

b. Use  the  regression  output  given  to  develop  the  cost  equation  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  fand  v.  

c. Use  the  results  of  the  high-­‐low  method  (a),  scattergraph  method  (b),  and  regression  analysis  (c),  to  estimate  costs  for  

1,500  machine  hours.  (You  will  have  three  different  answers—one  for  each  method.)  Which  approach  do  you  think  is  

most  accurate  and  why?  

d. Management  likes  the  regression  analysis  approach  and  asks  you  to  estimate  costs  for  5,000  machine  hours  using  this  

approach  (the  company  plans  to  expand  by  opening  another  facility  and  hiring  additional  employees).  Calculate  your  

estimate,  and  explain  why  your  estimate  might  be  misleading.  

High-­‐Low,  Scattergraph,  and  Regression  Analysis;  Service  Company.Sanchez  Accounting  Company  prepares  tax  

returns  for  individuals.  Marie  Sanchez,  the  owner,  would  like  an  accurate  estimate  of  the  company’s  costs  for  planning  

and  decision-­‐making  purposes.  When  Marie  asks  you  to  devise  a  way  to  estimate  costs  on  a  monthly  basis,  you  recall  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     343  
     
 
 the  importance  of  breaking  costs  into  fixed  and  variable  components.  Because  the  company’s  costs  are  driven  

primarily  by  the  number  of  tax  returns  prepared,  you  decide  to  use  historical  data  for  costs  and  tax  returns  prepared:  
Reporting Period (Month) Total Costs Returns Prepared

January $157,000 315

February 145,000 300

March 167,500 375

April 163,000 325

May 120,000 250

June 112,000 210

July 138,000 280

August 100,000 190

September 108,000 205

October 115,000 245

November 136,000 265

December 126,000 255

You  enter  these  data  into  a  computer  regression  program  and  get  the  following  results:  
Coefficients

y-intercept 24,626

x variable 401.86

Required:  

 . Use  the  four  steps  of  the  high-­‐low  method  to  estimate  total  fixed  costs  per  month  and  the  variable  cost  per  tax  

return  prepared.  State  your  results  in  the  cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

a. Use  the  five  steps  of  the  scattergraph  method  to  estimate  total  fixed  costs  per  month  and  the  variable  cost  per  tax  

return  prepared.  State  your  results  in  the  cost  equation  form  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

b. Use  the  regression  output  given  to  develop  the  cost  equation  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  fand  v.  

c. Use  the  results  of  the  high-­‐low  method  (a),  scattergraph  method  (b),  and  regression  analysis  (c)  to  estimate  costs  for  

290  tax  returns.  (You  will  have  three  different  answers—one  for  each  method.)  Which  approach  do  you  think  is  most  

accurate,  and  why?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     344  
     
 
 d. Marie  likes  the  regression  analysis  approach  and  asks  you  to  estimate  costs  for  800  tax  returns  using  this  approach  

(she  plans  to  expand  by  opening  another  office  and  hiring  additional  employees).  Calculate  your  estimate,  and  explain  

why  your  estimate  might  be  misleading.  

High-­‐Low,  Scattergraph,  Regression  Analysis,  and  Contribution  Margin  Income  Statement.  Eye  Care,  Inc.,  provides  

vision  correction  surgery  for  its  patients.  You  are  the  accountant  for  Eye  Care,  and  management  has  asked  you  to  

devise  a  way  of  accurately  estimating  company  costs  for  planning  and  decision-­‐making  purposes.  You  believe  that  

reviewing  historical  data  for  costs  and  number  of  surgeries  is  the  best  starting  point.  These  data  are  as  follows:  
Reporting Period (Month) Total Costs Number of Surgeries

January $208,000 54

February 205,000 52

March 217,000 55

April 200,000 50

May 232,000 62

June 230,000 60

July 226,000 57

August 235,000 63

September 252,000 71

October 250,000 70

November 245,000 66

December 244,000 65

You  enter  these  data  into  a  computer  regression  program  and  get  the  following  results:  
Coefficients

y-intercept 75,403

x variable 2,536.77

Required:  

 . Use  the  four  steps  of  the  high-­‐low  method  to  estimate  total  fixed  costs  per  month,  and  the  variable  cost  per  

surgery.  State  your  results  in  the  cost  equation  form  Y  =  f  +vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     345  
     
 
 a. Use  the  five  steps  of  the  scattergraph  method  to  estimate  total  fixed  costs  per  month,  and  the  variable  cost  per  

surgery.  State  your  results  in  the  cost  equation  form  Y  =  f  +vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

b. Use  the  regression  output  given  to  develop  the  cost  equation  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  fand  v.  

c. Use  the  results  of  the  high-­‐low  method  (a),  scattergraph  method  (b),  and  regression  analysis  (c),  to  estimate  costs  for  

70  surgeries.  (You  will  have  three  different  answers—one  for  each  method.)  Which  approach  do  you  think  is  most  

accurate  and  why?  

d. Assume  Eye  Care  charges  $4,000  for  each  surgery  performed.  Use  the  regression  analysis  cost  information  (for  70  

surgeries)  to  prepare  a  contribution  margin  income  statement.  (Hint:  You  will  only  have  one  line  item  for  variable  costs  

and  one  line  item  for  fixed  costs.)  

Regression  Analysis  Using  Excel  (Appendix).  Metal  Products,  Inc.,  produces  metal  storage  sheds.  The  company’s  

manufacturing  overhead  costs  tend  to  fluctuate  from  one  month  to  the  next,  and  management  would  like  an  accurate  

estimate  of  these  costs  for  planning  and  decision-­‐making  purposes.  

The  company’s  accounting  staff  recommends  that  costs  be  broken  down  into  fixed  and  variable  components.  Because  

the  production  process  is  highly  automated,  most  of  the  manufacturing  overhead  costs  are  related  to  machinery  and  

equipment.  The  accounting  staff  agrees  that  reviewing  historical  data  for  costs  and  machine  hours  is  the  best  starting  

point.  Data  for  the  past  18  months  follow.  

Reporting Period (Month) Total Overhead Costs Total Machine Hours

January $695,000 3,875

February 700,000 3,925

March 665,000 2,788

April 725,000 4,250

May 655,000 2,775

June 672,500 3,063

July 687,500 3,338

August 715,000 4,150

September 625,000 2,500

October 632,500 2,550

November 650,000 2,563

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     346  
     
 
 December 702,500 4,000

January 730,000 4,025

February 735,000 4,088

March 697,500 2,900

April 762,500 4,425

May 687,500 2,888

June 705,000 3,188

Required:  

 . Use  Excel  to  perform  regression  analysis.  Provide  a  printout  of  the  results.  

a. Use  the  regression  output  given  to  develop  the  cost  equation  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  fand  v.  

b. Use  the  results  of  the  regression  analysis  to  estimate  costs  for  3,750  machine  hours.  

c. Management  is  considering  plans  to  expand  by  opening  several  new  facilities  and  asks  you  to  estimate  costs  for  22,000  

machine  hours.  Calculate  your  estimate,  and  explain  why  this  estimate  may  be  misleading.  

d. What  can  be  done  to  improve  the  estimate  made  in  part  d?  

One  Step  Further:  Skill-­‐Building  Cases  

47. Internet  Project:  Variable  and  Fixed  Costs.  Using  the  Internet,  find  the  annual  report  of  one  retail  company  and  one  

manufacturing  company.  Print  out  each  company’s  income  statement.  (Hint:  The  income  statement  is  often  called  

thestatement  of  operations  or  statement  of  earnings.)  

Required:  

a. Review  each  income  statement,  and  provide  an  analysis  of  which  operating  costs  are  likely  to  be  variable  and  which  

are  likely  to  be  fixed.  Include  copies  of  both  income  statements  when  submitting  your  answer.  

b. How  would  you  expect  a  retail  company’s  mix  of  variable  and  fixed  operating  costs  to  differ  from  that  of  a  

manufacturing  company?  

c. How  might  the  managers  of  these  companies  use  cost  behavior  information?  

Group  Activity:  Identifying  Variable  and  Fixed  Costs.  To  complete  the  following  requirements,  form  groups  of  two  

to  four  students.  

Required:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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  . Each  group  should  select  a  product  that  is  easy  to  manufacture.  

a. Prepare  a  list  of  materials,  labor,  and  other  resources  needed  to  make  the  product.  

b. Using  the  list  prepared  in  requirement  b,  identify  whether  the  costs  associated  with  each  item  are  variable,  fixed,  or  

mixed.  

c. As  a  manager  for  this  company,  why  would  you  want  to  know  whether  costs  are  variable,  fixed,  or  mixed?  

Cost  Behavior  at  Best  Buy.  The  following  condensed  income  statement  is  for  Best  Buy  Co.,  Inc.,  a  large  retailer  of  

consumer  electronics.  

Required:  

Assume  that  cost  of  goods  sold  comprises  only  variable  costs,  and  selling  and  administrative  expenses  are  all  fixed  

costs.  Also  assume  that  Best  Buy  expects  sales  to  grow  by  10  percent  for  the  year  ended  March  3,  2012.  

 . Calculate  expected  operating  income  for  the  year  ended  March  3,  2012  assuming  the  company  is  still  within  the  

relevant  range  of  activity.  

a. Calculate  the  expected  percent  increase  in  operating  income  from  the  year  ended  February  26,  2011,  to  the  year  

ended  March  3,  2012.  

b. Why  is  the  percent  increase  in  operating  income  higher  than  the  percent  increase  in  sales?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     348  
     
 
 c. Is  the  assumption  that  all  selling  and  administrative  expenses  are  fixed  a  reasonable  assumption?  Explain.  

Fixed  Costs  at  United  Airlines.  Review  .  

Required:  

 . What  is  meant  by  the  term  fixed  cost?  

a. Which  costs  at  United  Airlines  were  identified  as  fixed  costs?  

b. How  might  United  Airlines  reduce  its  fixed  costs?  Be  specific.  

Comprehensive  Case  

51. Ethics:  Manipulating  Data  to  Establish  a  Budget  (Appendix).Healthy  Bar,  Inc.,  produces  energy  bars  for  sports  

enthusiasts.  The  company’s  fiscal  year  ends  on  December  31.  The  production  manager,  Jim  Wallace,  is  establishing  a  

cost  budget  for  the  production  department  for  each  month  of  this  coming  quarter  (January  through  March).  At  the  end  

of  March,  Jim  will  be  evaluated  based  on  his  ability  to  meet  the  budget  for  the  three  months  ending  March  31.  In  fact,  

Jim  will  receive  a  significant  bonus  if  actual  costs  are  below  budgeted  costs  for  the  quarter.  

The  production  budget  is  typically  established  based  on  data  from  the  last  18  months.  These  data  are  as  follows:  
Reporting Period (Month) Total Overhead Costs Total Machine Hours

July $695,000 3,410

August 700,000 3,454

September 665,000 2,453

October 725,000 3,740

November 655,000 2,442

December 672,500 2,695

January 687,500 2,937

February 715,000 3,652

March 625,000 2,200

April 632,500 2,244

May 650,000 2,255

June 702,500 3,520

July 730,000 3,542

August 735,000 3,597

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     349  
     
 
 September 697,500 2,552

October 762,500 3,894

November 687,500 2,541

December 705,000 2,805

You  are  the  accountant  who  assists  Jim  in  preparing  an  estimate  of  production  costs  for  the  next  three  months.  You  

intend  to  use  regression  analysis  to  estimate  costs,  as  was  done  in  the  past.  Jim  expects  that  3,100  machine  hours  will  

be  used  in  January,  3,650  machine  hours  in  February,  and  2,850  machine  hours  in  March.  

Jim  approaches  you  and  asks  that  you  add  $100,000  to  production  costs  for  each  of  the  past  18  months  before  running  

the  regression  analysis.  As  he  puts  it,  “After  all,  management  always  takes  my  proposed  budgets  and  reduces  them  by  

about  10  percent.  This  is  my  way  of  leveling  the  playing  field!”  

Required:  

a. Use  Excel  to  perform  regression  analysis  using  the  historical  data  provided.  

1. Submit  a  printout  of  the  results.  

2. Use  the  regression  output  to  develop  the  cost  equation  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

3. Calculate  estimated  production  costs  for  January,  February,  and  March.  Also  provide  a  total  for  the  three  

months.  

b. Use  Excel  to  perform  regression  analysis  after  adding  $100,000  to  production  costs  for  each  of  the  

past  18  months,  as  Jim  requested.  

1. Submit  a  printout  of  the  results.  

2. Use  the  regression  output  to  develop  the  cost  equation  Y  =  f  +  vX  by  filling  in  the  dollar  amounts  for  f  and  v.  

3. Calculate  estimated  production  costs  for  January,  February,  and  March.  Also  provide  a  total  for  the  three  

months.  

c. Why  did  Jim  ask  you  to  add  $100,000  to  production  costs  for  each  of  the  past  18  months?  

d. How  should  you  handle  Jim’s  request?  (If  necessary,  review  the  presentation  of  ethics  in  for  additional  information.)  

   

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 Chapter 6

How Is Cost-Volume-Profit Analysis Used for Decision Making?

Recilia Vera is vice president of sales at Snowboard Company, a manufacturer of one model of
snowboard. Lisa Donley is the company accountant. Recilia and Lisa are in their weekly
meeting.

Lisa, I’m in the process of setting up an incentive system for my sales staff, and I’d like to get a better handle on our
Recilia: financial information.

Lisa: No problem. How can I help?

I’ve reviewed our financial results for the past 12 months. It looks like we made a profit in some months, and had losses in
other months. From what I can tell, we sell each snowboard for $250, our variable cost is $150 per unit, and our fixed cost
is $75 per unit. It seems to me that if we sell just one snowboard each month, we should still show a profit of $25, and any
Recilia: additional units sold should increase total profit.

Your unit sales price of $250 and unit variable cost of $150 look accurate to me, but I’m not sure about your unit fixed cost
of $75. Fixed costs total $50,000 a month regardless of the number of units we produce. Trying to express fixed costs on a
per unit basis can be misleading because it depends on the number of units being produced and sold, which changes each
month. I can tell you that each snowboard produced and sold provides $100 toward covering fixed costs—that is, $250, the
Lisa: sales price of one snowboard, minus $150 in variable cost.

The $75 per unit for fixed costs was my estimate based on last year’s sales, but I get your point. As you know, I’d like to
avoid having losses. Is it possible to determine how many units we have to sell each month to at least cover our expenses?
Recilia: I’d also like to discuss what it will take to make a decent profit.

We can certainly calculate how many units have to be sold to cover expenses, and I’d be glad to discuss how many units
Lisa: must be sold to make a decent profit.

Recilia: Excellent! Let’s meet again next week to go through this in detail.

Answering questions regarding break-even and target profit points requires an understanding of
the relationship among costs, volume, and profit (often called CVP). This chapter discusses cost-
volume-profit analysis, which identifies how changes in key assumptions (for example,
assumptions related to cost, volume, or profit) may impact financial projections. We address
Recilia’s questions in the next section.

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 6.1 Cost-Volume-Profit Analysis for Single-Product Companies

L E A R N I N G   O B J E C T I V E  

1. Perform  cost-­‐volume-­‐profit  analysis  for  single-­‐product  companies.  

Question: The profit equation shows that profit equals total revenues minus total variable costs
and total fixed costs. This profit equation is used extensively in cost-volume-profit (CVP)
analysis, and the information in the profit equation is typically presented in the form of a
contribution margin income statement (first introduced in Chapter 5 "How Do Organizations
Identify Cost Behavior Patterns?"). What is the relationship between the profit equation and the
contribution margin income statement?

Answer: Recall that the contribution margin income statement starts with sales, deducts variable
costs to determine the contribution margin, and deducts fixed costs to arrive at profit. We use the
term “variable cost” because it describes a cost that varies in total with changes in volume of
activity. We use the term “fixed cost” because it describes a cost that is fixed (does not change)
in total with changes in volume of activity.

To allow for a mathematical approach to performing CVP analysis, the contribution margin
income statement is converted to an equation using the following variables:

Key  Equation  

S  =  Selling  price  per  unitV  =  Variable  cost  per  unitF  =  Total  fixed  costsQ  =  Quantity  of  units  produced  and  sold  

Thus

ProfitProfit=Total sales−Total variable costs−Total fixed costs=(S×Q)−(V×Q)−F  

Figure 6.1 "Comparison of Contribution Margin Income Statement with Profit

Equation" clarifies the link between the contribution margin income statement presented
in Chapter 5 "How Do Organizations Identify Cost Behavior Patterns?" and the profit equation
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 stated previously. Study this figure carefully because you will encounter these concepts
throughout the chapter.

Figure 6.1 Comparison of Contribution Margin Income Statement with Profit Equation

 
Recall that when identifying cost behavior patterns, we assume that management is using the
cost information to make short-term decisions. Variable and fixed cost concepts are useful for
short-term decision making. The short-term period varies, depending on a company’s current
production capacity and the time required to change capacity. In the long term, all cost behavior
patterns are likely to change.

Break-Even and Target Profit

Question: Companies such as Snowboard Company often want to know the sales required to
break even, which is called the break-even point. What is meant by the term break-even point?

Answer: The break-even point can be described either in units or in sales dollars. The break-
even point in units is the number of units that must be sold to achieve zero profit. The break-
even point in sales dollars is the total sales measured in dollars required to achieve zero profit. If
a company sells products or services easily measured in units (e.g., cars, computers, or mountain
bikes), then the formula for break-even point in units is used. If a company sells products or
services not easily measured in units (e.g., restaurants, law firms, or electricians), then the
formula for break-even point in sales dollars is used.

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 Break-Even Point in Units

Question: How is the break-even point in units calculated, and what is the break-even point for
Snowboard Company?

Answer: The break-even point in units is found by setting profit to zero using the profit equation.
Once profit is set to zero, fill in the appropriate information for selling price per unit (S), variable
cost per unit (V), and total fixed costs (F), and solve for the quantity of units produced and sold
(Q).

Let’s calculate the break-even point in units for Snowboard Company. Recall that each
snowboard sells for $250. Unit variable costs total $150, and total monthly fixed costs are
$50,000. To find the break-even point in units for Snowboard Company, set the profit to zero,
insert the unit sales price (S), insert the unit variable cost (V), insert the total fixed costs (F), and
solve for the quantity of units produced and sold (Q):

Profit$0$0$50,000Q=(S×Q)−(V×Q)−F=$250Q−$150Q−$50,000=$100Q−$50,000=$100Q=500 units  

Thus Snowboard Company must produce and sell 500 snowboards to break even. This answer is
confirmed in the following contribution margin income statement.

Target Profit in Units

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 Question: Although it is helpful for companies to know the break-even point, most organizations
are more interested in determining the sales required to make a targeted amount of profit. How
does finding the target profit in units help companies like Snowboard Company?

Answer: Finding a target profit in units simply means that a company would like to know how
many units of product must be sold to achieve a certain profit. At Snowboard Company, Recilia
(the vice president of sales) and Lisa (the accountant) are in their next weekly meeting.

Recilia, last week you asked how many units we have to sell to cover our expenses. This is called the break-even point. If
each unit produced and sold provides $100 toward covering fixed costs, and if total monthly fixed costs are $50,000, we
Lisa: would have to sell 500 units to break even—that is, $50,000 divided by $100.

Recilia: What happens once we sell enough units to cover all of our fixed costs for the month?

Lisa: Good question! Once all fixed costs are covered for the month, each unit sold contributes $100 toward profit.

I think I’m getting the hang of this. It will take 500 units in sales to break even, and each unit sold above 500 results in a
Recilia: $100 increase in profit. So if we sell 503 units for a month, profit will total $300?

Lisa: You’ve got it!

Recilia: So if our goal is to make a profit of $30,000 per month (target profit), how many units must be sold?

It takes 500 units to break even. We also know each unit sold above and beyond 500 units contributes $100 toward profit.
Thus we would have to sell an additional 300 units above the break-even point to earn a profit of $30,000. This means we
Lisa: would have to sell 800 units in total to make $30,000 in profit.

Wow, I’m not sure selling 800 units is realistic, but at least we have a better sense of what needs to be done to make a
Recilia: decent profit. Thanks for your help!

Profit Equation

Question: Let’s formalize this discussion by using the profit equation. How is the profit equation
used to find a target profit amount in units?

Answer: Finding the target profit in units is similar to finding the break-even point in units
except that profit is no longer set to zero. Instead, set the profit to the target profit the company
would like to achieve. Then fill in the information for selling price per unit (S), variable cost per
unit (V), and total fixed costs (F), and solve for the quantity of units produced and sold (Q):

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 Profit$30,000$30,000$80,000Q=(S×Q)−(V×Q)−F=$250Q−$150Q−$50,000=$100Q−$50,000=$100Q=800 units  

Thus Snowboard Company must produce and sell 800 snowboards to achieve $30,000 in profit.
This answer is confirmed in the following contribution margin income statement:

Shortcut Formula

Question: Although using the profit equation to solve for the break-even point or target profit in
units tends to be the easiest approach, we can also use a shortcut formula derived from this
equation. What is the shortcut formula, and how is it used to find the target profit in units for
Snowboard Company?

Answer: The shortcut formula is as follows:

Key  Equation  

Q  =  (F  +  Target  Profit)  ÷  (S  −  V)  

If you want to find the break-even point in units, set “Target Profit” in the equation to zero. If
you want to find a target profit in units, set “Target Profit” in the equation to the appropriate
amount. To confirm that this works, use the formula for Snowboard Company by finding the
number of units produced and sold to achieve a target profit of $30,000:

QQQQ=(F+Target Profit)÷(S−V)=($50,000+$30,000)÷($250−$150)=$80,000÷$100=800 units  

The result is the same as when we used the profit equation.

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 Break-Even Point in Sales Dollars

Question: Finding the break-even point in units works well for companies that have products
easily measured in units, such as snowboard or bike manufacturers, but not so well for
companies that have a variety of products not easily measured in units, such as law firms and
restaurants. How do companies find the break-even point if they cannot easily measure sales in
units?

Answer: For these types of companies, the break-even point is measured in sales dollars. That is,
we determine the total revenue (total sales dollars) required to achieve zero profit for companies
that cannot easily measure sales in units.

Finding the break-even point in sales dollars requires the introduction of two new
terms: contribution margin per unit and contribution margin ratio.

Contribution Margin per Unit

The contribution margin per unit is the amount each unit soldcontributes to (1) covering fixed
costs and (2) increasing profit. We calculate it by subtracting variable costs per unit (V) from the
selling price per unit (S).

Key  Equation  

Contribution  margin  per  unit  =  S  −  V  

For Snowboard Company the contribution margin is $100:

Contribution margin per unit$100=S−V=$250−$150  

Thus each unit sold contributes $100 to covering fixed costs and increasing profit.

Contribution Margin Ratio

The contribution margin ratio (often called contribution margin percent) is the contribution
margin as a percentage of sales. It measures the amounteach sales dollar contributes to (1)
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 covering fixed costs and (2) increasing profit. The contribution margin ratio is the contribution
margin per unit divided by the selling price per unit. (Note that the contribution margin ratio can
also be calculated using the total contribution margin and totalsales; the result is the same.)

Key  Equation  

Contribution  margin  ratio  =  (S  −  V)  ÷  S  

For Snowboard Company the contribution margin ratio is 40 percent:

Contribution margin ratio40%=(S−V)÷S=($250−$150)÷$250  

Thus each dollar in sales contributes 40 cents ($0.40) to covering fixed costs and increasing profit.

Question: With an understanding of the contribution margin and contribution margin ratio, we
can now calculate the break-even point in sales dollars. How do we calculate the break-even
point in sales dollars for Snowboard Company?

Answer: The formula to find the break-even point in sales dollars is as follows.

Key  Equation  

Break-even point in sales dollars=Total fixed costs + Target profitContribution margin ratio  

For Snowboard Company the break-even point in sales dollars is $125,000 per month:

Break-even point in sales dollars$125,000 in sales=$50,000+$00.40=$50,000+$00.40  

Thus Snowboard Company must achieve $125,000 in total sales to break even. The following
contribution margin income statement confirms this answer:

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Target Profit in Sales Dollars

Key  Equation  

Target profit in sales dollars=Total fixed costs + Target profitContribution margin ratio  

Question: Finding a target profit in sales dollars simply means that a company would like to
know total sales measured in dollars required to achieve a certain profit. Finding the target
profit in sales dollars is similar to finding the break-even point in sales dollars except that
“target profit” is no longer set to zero. Instead, target profit is set to the profit the company
would like to achieve. Recall that management of Snowboard Company asked the following
question: What is the amount of total sales dollars required to earn a target profit of $30,000?

Answer: Use the break-even formula described in the previous section. Instead of setting the
target profit to $0, set it to $30,000. This results in an answer of $200,000 in monthly sales:

Target profit in sales dollars$200,000 in sales=Total fixed costs + Target profitContribution margin ratio=$50,000+$30,0000.40  

Thus Snowboard Company must achieve $200,000 in sales to make $30,000 in monthly profit.
The following contribution margin income statement confirms this answer:

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Business  in  Action  6.1  

Measuring the Break-Even Point for Airlines

During the month of September 2001, United Airlines was losing $15 million per day. With $2.7 billion in

cash, United had six months to return to profitability before facing a significant cash shortage. Many analysts

believed United’s troubles resulted in part from a relatively high break-even point.

Airlines measure break-even points, also called load factors, in terms of the percentage of seats filled. At the end of 2001,

one firm estimated thatUnited had to fill 96 percent of its seats just to break even. This is well above the figure for other

major airlines, as you can see in the list that follows:

• American Airlines: 85 percent

• Delta Airlines: 85 percent

• Southwest Airlines: 65 percent

• Alaska Airlines:75 percent

United Airlines filed for bankruptcy at the end of 2002 and emerged from bankruptcy in 2006 after reducing costs by $7

billion a year. Other airlines continue to work on reducing their break-even points and maximizing the percentage of seats

filled.

Source: Lisa DiCarlo, “Can This Airline Be Saved?” Forbes magazine’s Web site (http://www.forbes.com), November 2001;

“United Airlines Emerges from Bankruptcy,” Reuters (http://www.foxnews.com), February 1, 2005.

CVP Graph

Question: The relationship of costs, volume, and profit can be displayed in the form of a
graph. What does this graph look like for Snowboard Company, and how does it help
management evaluate financial information related to the production of snowboards?
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 Answer: Figure 6.2 "CVP Graph for Snowboard Company" shows in graph form the
relationship between cost, volume, and profit for Snowboard Company. The vertical axis
represents dollar amounts for revenues, costs, and profits. The horizontal axis represents the
volume of activity for a period, measured as units produced and sold for Snowboard.

There are three lines in the graph:

• Total revenue
• Total cost
• Profit

The total revenue line shows total revenue based on the number of units produced and sold. For
example, if Snowboard produces and sells one unit, total revenue is $250 (= 1 × $250). If it
produces and sells 2,000 units, total revenue is $500,000 (= 2,000 × $250).

The total cost line shows total cost based on the number of units produced and sold. For
example, if Snowboard produces and sells one unit, total cost is $50,150 [= $50,000 + (1 ×
$150)]. If it produces and sells 2,000 units, total cost is $350,000 [= $50,000 + (2,000 × $150)].

The profit line shows profit or loss based on the number of units produced and sold. It is simply
the difference between the total revenue and total cost lines. For example, if Snowboard
produces and sells 2,000 units, the profit is $150,000 (= $500,000 − $350,000). If no units are
sold, a loss is incurred equal to total fixed costs of $50,000.

Figure 6.2 CVP Graph for Snowboard Company

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Margin of Safety

Question: Managers often like to know how close projected sales are to the break-even
point. How is this information calculated and used by management?

Answer: The excess of projected sales over the break-even point is called themargin of safety.
The margin of safety represents the amount by which sales can fall before the company incurs a
loss.

Key  Equation  

Margin  of  safety  (in  units)  =  Projected  sales  (in  units)  −  Break-­‐even  sales  (in  units)  

Assume Snowboard Company expects to sell 700 snowboards and that its break-even point is
500 units; the margin of safety is 200 units. The calculation is

Margin of safety (in units)200=Projected sales (in units)−Break-even sales (in units)=700−500  

Thus sales can drop by 200 units per month before the company begins to incur a loss.

The margin of safety can also be stated in sales dollars.

Key  Equation  

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 Margin  of  safety  (in  sales  $)  =  Projected  sales  (in  sales  $)  −  Break-­‐even  sales  (in  sales  $)  

For Snowboard the margin of safety in sales dollars is $50,000:

Margin of safety (in sales $)$50,000=Projected sales (in sales $)−Break-even sales (in sales $)=(700 units×$250)−(500 units×$250)  

Thus sales revenue can drop by $50,000 per month before the company begins to incur a loss.

K E Y   T A K E A W A Y  

• Cost-­‐volume-­‐profit  analysis  involves  finding  the  break-­‐even  and  target  profit  point  in  units  and  in  sales  dollars.  The  key  

formulas  for  an  organization  with  a  single  product  are  summarized  in  the  following  list.  Set  the  target  profit  to  $0  for  

break-­‐even  calculations,  or  to  the  appropriate  profit  dollar  amount  for  target  profit  calculations.  The  margin  of  safety  

formula  is  also  shown:  

o Break-­‐even  or  target  profit  point  measured  inunits:  

Total fixed costs + Target profitSelling price per unit − Variable cost per unit  

(The  denominator  is  also  called  “contribution  margin  per  unit.”)  

o Break-­‐even  or  target  profit  point  measured  in  sales  dollars:  

Total fixed costs + Target profitContribution margin ratio  

o Margin  of  safety  in  units  or  sales  dollars:  

Projected  sales  −  Break-­‐even  sales  

R E V I E W   P R O B L E M   6 . 1  

Star  Symphony  would  like  to  perform  for  a  neighboring  city.  Fixed  costs  for  the  performance  total  $5,000.  Tickets  will  sell  for  

$15  per  person,  and  an  outside  organization  responsible  for  processing  ticket  orders  charges  the  symphony  a  fee  of  $2  per  

ticket.  Star  Symphony  expects  to  sell  500  tickets.  

1. How  many  tickets  must  Star  Symphony  sell  to  break  even?  

2. How  many  tickets  must  the  symphony  sell  to  earn  a  profit  of  $7,000?  

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 3. How  much  must  Star  Symphony  have  in  sales  dollars  to  break  even?  

4. How  much  must  Star  Symphony  have  in  sales  dollars  to  earn  a  profit  of  $7,000?  

5. What  is  the  symphony’s  margin  of  safety  in  units  and  in  sales  dollars?  

Solution  to  Review  Problem  6.1  

Note:  All  solutions  are  rounded.  

1. The  symphony  must  sell  385  tickets  to  break  even:  

Total fixed costs + Target profitSelling price per unit − Variable cost per unit=$5,000+$0$15−$2=385 tickets (rounded)  

2. The  symphony  must  sell  923  tickets  to  make  a  profit  of  $7,000:  

Total fixed costs + Target profitSelling price per unit − Variable cost per unit=$5,000+$7,000$15−$2=923 tickets (rounded)  

3. The  symphony  must  make  $5,769  in  sales  to  break  even:  

Total fixed costs + Target profitContribution margin ratio=$5,000+$0$(15−$2)÷$15=$5,769 (rounded)  

4. The  symphony  must  make  $13,846  in  sales  to  earn  a  profit  of  $7,000:  

Total fixed costs + Target profitContribution margin ratio=$5,000+$7,000$(15−$2)÷$15=$13,846 (rounded)  

5. The  symphony’s  margin  of  safety  is  115  units  or  $1,725  in  sales:  

Margin of safety115 tickets$1,725 in sales=Projected sales − Break-even sales=500 tickets−385 tickets=(500×$15)−(385×$15)  

6.2 Cost-Volume-Profit Analysis for Multiple-Product and Service Companies

L E A R N I N G   O B J E C T I V E  

1. Perform  cost-­‐volume-­‐profit  analysis  for  multiple-­‐product  and  service  companies.  

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 Question: Although the previous section illustrated cost-volume-profit (CVP) analysis for
companies with a single product easily measured in units, most companies have more than one
product or perhaps offer services not easily measured in units. Suppose you are the manager of a
company called Kayaks-For-Fun that produces two kayak models, River and Sea. What
information is needed to calculate the break-even point for this company?

Answer: The following information is required to find the break-even point:

• Monthly fixed costs total $24,000.

• The River model represents 60 percent of total sales volume and the Sea model accounts
for 40 percent of total sales volume.
• The unit selling price and variable cost information for the two products follow:

 
Finding the Break-Even Point and Target Profit in Units for Multiple-Product
Companies

Question: Given the information provided for Kayaks-For-Fun, how will the company calculate
the break-even point?

Answer: First, we must expand the profit equation presented earlier to include multiple products.
The following terms are used once again. However, subscript r identifies the River model, and
subscript s identifies the Sea model (e.g., Sr stands for the River model’s selling price per unit).
CM is new to this section and represents the contribution margin.

Key  Equation  

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 S  =  Selling  price  per  unitV  =  Variable  cost  per  unitF  =  Total  fixed  costsQ  =  Quantity  of  units  produced  and  soldCM  =  Contribution  
margin  

Thus

ProfitProfit==Total sales−Total variable costs−Total fixed costs[(Sr×Qr)+(Ss×Qs)]−[(Vr×Qr)+(Vs×Qs)]−F  

Without going through a detailed derivation, this equation can be restated in a simplified manner
for Kayaks-For-Fun, as follows:

ProfitProfit=(Unit CM for River×Quantity of River)+(Unit CM for Sea×Quantity of Sea)−F=$400Qr+$150Qs−$24,000  

One manager at Kayaks-For-Fun believes the break-even point should be 60 units in total, and
another manager believes the break-even point should be 160 units in total. Which manager is
correct? The answer is both might be correct. If only the River kayak is produced and sold, 60
units is the break-even point. If only the Sea kayak is produced and sold, 160 units is the break-
even point. There actually are many different break-even points, because the profit equation has
two unknown variables, Q and Q . r s

Further evidence of multiple break-even points is provided as follows (allow for rounding to the
nearest unit), and shown graphically in :

Profit  ($0)  =  ($400  ×  30  units  of  River)  +  ($150  ×  80  units  of  Sea)  −  $24,000Profit  ($0)  =  ($400  ×  35  units  of  River)  +  ($150  
×  67  units  of  Sea)  −  $24,000Profit  ($0)  =  ($400  ×  40  units  of  River)  +  ($150  ×  53  units  of  Sea)  −  $24,000  

Figure 6.3 Multiple Break-Even Points for Kayaks-For-Fun

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Break-Even Point in Units and the Weighted Average Contribution Margin per Unit

Question: Because most companies sell multiple products that have different selling prices and
different variable costs, the break-even or target profit point depends on the sales mix. What is
the sales mix, and how is it used to calculate the break-even point?

Answer: The sales mix is the proportion of one product’s sales to total sales. In the case of
Kayaks-For-Fun, the River model accounts for 60 percent of total unit sales and the Sea model
accounts for 40 percent of total unit sales.

In calculating the break-even point for Kayaks-For-Fun, we must assume the sales mix for the
River and Sea models will remain at 60 percent and 40 percent, respectively, at all different sales
levels. The formula used to solve for the break-even point in units for multiple-product
companies is similar to the one used for a single-product company, with one change. Instead of
using the contribution margin per unit in the denominator, multiple-product companies use
a weighted average contribution margin per unit. The formula to find the break-even point in
units is as follows.

Key  Equation  
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 Total fixed costs + Target profitWeighted average contribution margin per unit  

When a company assumes a constant sales mix,

aweighted average contribution margin per unit can be calculated by multiplying each product’s
unit contribution margin by its proportion of total sales. The resulting weighted unit contribution
margins for all products are then added together.

At Kayaks-For-Fun, the weighted average contribution margin per unit of $300 is

$300  =  ($400  ×  60  percent)  +  ($150  ×  40  percent)  

We can now determine the break-even point in units by using the following formula:

Break-even point in unitsBreak-

even point in units=Total fixed costs + Target profitWeighted average contribution margin per unit=$24,000+$0$300=80 total kayaks  

Kayaks-For-Fun must sell 48 River models (= 60 percent × 80 units) and 32 Sea models (= 40
percent × 80 units) to break even. Again, this assumes the sales mix remains the same at different
levels of sales volume.

Target Profit in Units

Question: We now know how to calculate the break-even point in units for a company with
multiple products. How do we extend this process to find the target profit in units for a company
with multiple products?

Answer: Finding the target profit in units for a company with multiple products is similar to
finding the break-even point in units except that profit is no longer set to zero. Instead, profit is
set to the target profit the company would like to achieve.

Key  Equation  

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 Target profit in units=Total fixed costs + Target profitWeighted average contribution margin per unit  

For example, assume Kayaks-For-Fun would like to know how many units it must sell to make a
monthly profit of $96,000. Simply set the target profit to $96,000 and run the calculation:

Target profit in unitsTarget profit in units=Total fixed costs + Target profitWeighted average contribution margin per unit=$24,000+$96,000$300=400 tota
l kayaks  

Kayaks-For-Fun must sell 240 River models (= 60 percent × 400) and 160 Sea models (= 40
percent × 400) to make a profit of $96,000.

R E V I E W   P R O B L E M   6 . 2  

International  Printer  Machines  (IPM)  builds  three  computer  printer  models:  Inkjet,  Laser,  and  Color  Laser.  Information  for  these  three  

products  is  as  follows:  

Inkjet Laser Color Laser Total

Selling price per unit $250 $400 $1,600

Variable cost per unit $100 $150 $ 800

Expected unit sales (annual) 12,000 6,000 2,000 20,000

Sales mix 60 percent 30 percent 10 percent 100 percent

Total  annual  fixed  costs  are  $5,000,000.  Assume  the  sales  mix  remains  the  same  at  all  levels  of  sales.  

1.    

1. How  many  printers  in  total  must  be  sold  to  break  even?  

2. How  many  units  of  each  printer  must  be  sold  to  break  even?  

2.    

1. How  many  printers  in  total  must  be  sold  to  earn  an  annual  profit  of  $1,000,000?  

2. How  many  units  of  each  printer  must  be  sold  to  earn  an  annual  profit  of  $1,000,000?  

Solution  to  Review  Problem  6.2  

Note:  All  solutions  are  rounded.  

1.    

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 1. IPM  must  sell  20,408  printers  to  break  even:  

Total fixed costs + Target profitWeighted average contribution margin per unit  

$5,000,000+$0($150×0.60)+($250×0.30)+($800×0.10)=$5,000,000$245=20,408 total units  

2. As  calculated  previously,  20,408  printers  must  be  sold  to  break  even.  Using  the  sales  mix  provided,  the  following  number  of  

units  of  each  printer  must  be  sold  to  break  even:  

1. Inkjet: 12,245 units=20,408×0.60  

2. Laser: 6,122 units=20,408×0.30  

3. Color laser: 2,041 units=20,408×0.10  

   

IPM  must  sell  24,490  printers  to  earn  $1,000,000  in  profit:  

Total fixed costs + Target profitWeighted average contribution margin per unit  

$5,000,000+$1,000,000($150×0.60)+($250×0.30)+($800×0.10)=$6,000,000$245=24,490 total units  

As  calculated  previously,  24,490  printers  must  be  sold  to  earn  $1,000,000  in  profit.  Using  the  sales  mix  provided,  the  following  

number  of  units  for  each  printer  must  be  sold  to  earn  $1,000,000  in  profit:  

0. Inkjet:14,694 units=24,490×0.60  

1. Laser:7,347 units=24,490×0.30  

2. Color laser:2,449 units=24,490×0.10  

Finding the Break-Even Point and Target Profit in Sales Dollars for Multiple-
Product and Service Companies

A restaurant like Applebee’s, which serves chicken, steak, seafood, appetizers, and beverages,
would find it difficult to measure a “unit” of product. Such companies need a different approach
to finding the break-even point. illustrates this point by contrasting a company that has similar

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 products easily measured in units (kayaks) with a company that has unique products (meals at a
restaurant) not easily measured in units.

Break-Even Point in Sales Dollars and the Weighted Average Contribution Margin
Ratio

Question: For companies that have unique products not easily measured in units, how do we find
the break-even point?

Answer: Rather than measuring the break-even point in units, a more practical approach for
these types of companies is to find the break-even point in sales dollars. We can use the formula
that follows to find the break-even point in sales dollars for organizations with multiple products
or services. Note that this formula is similar to the one used to find the break-even point in sales
dollars for an organization with one product, except that the contribution margin ratio now
becomes the weighted averagecontribution margin ratio.

Key  Equation  

Break-even point in sales dollars=Total fixed costs + Target profitWeighted average contribution margin ratio  

For example, suppose Amy’s Accounting Service has three departments—tax, audit, and
consulting—that provide services to the company’s clients.shows the company’s income
statement for the year. Amy, the owner, would like to know what sales are required to break
even. Note that fixed costs are known in total, but Amy does not allocate fixed costs to each
department.

Figure 6.5 Income Statement for Amy’s Accounting Service

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The contribution margin ratio differs for each department:

Tax 70 percent (= $70,000 ÷ $100,000)

Audit 20 percent (= $30,000 ÷ $150,000)

Consulting 50 percent (= $125,000 ÷ $250,000)

Question: We have the contribution margin ratio for each department, but we need it for the
company as a whole. How do we find the contribution margin ratio for all of the departments in
the company combined?

Answer: The contribution margin ratio for the company as a whole is

theweighted average contribution margin ratio. We calculate it by dividing the total contribution
margin by total sales. For Amy’s Accounting Service, the weighted average contribution margin
ratio is 45 percent (= $225,000 ÷ $500,000). For every dollar increase in sales, the company will
generate an additional 45 cents ($0.45) in profit. This assumes that the sales mix remains the
same at all levels of sales. (The sales mix here is measured in sales dollars for each department
as a proportion of total sales dollars.)

Now that you know the weighted average contribution margin ratio for Amy’s Accounting
Service, it is possible to calculate the break-even point in sales dollars:

Break-even point in sales dollarsBreak-

even point in sales dollars=Total fixed costs + Target profitWeighted average contribution margin ratio=$120,000+$00.45=$266,667 (rounded)  

Amy’s Accounting Service must achieve $266,667 in sales to break even.[1]

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 Target Profit in Sales Dollars

Question: How do we find the target profit in sales dollars for companies with products not
easily measured in units?

Answer: Finding the target profit in sales dollars for a company with multiple products or
services is similar to finding the break-even point in sales dollars except that profit is no longer
set to zero. Instead, profit is set to the target profit the company would like to achieve.

Key  Equation  

Target profit in sales dollars=Total fixed costs + Target profitWeighted average contribution margin ratio  

For example, assume Amy’s Accounting Service would like to know sales dollars required to
make $250,000 in annual profit. Simply set the target profit to $250,000 and run the calculation:

Target profit in sales dollarsTarget profit in sales dollars=Total fixed costs + Target profitWeighted average contribution margin ratio=$120,000+$250,000
0.45=$822,222 (rounded)  

Amy’s Accounting Service must achieve $822,222 in sales to earn $250,000 in profit.

Important Assumptions

Question: Several assumptions are required to perform break-even and target profit calculations
for companies with multiple products or services. What are these important assumptions?

Answer: These assumptions are as follows:

• Costs can be separated into fixed and variable components.

• Contribution margin ratio remains constant for each product, segment, or department.
• Sales mix remains constant with changes in total sales.

These assumptions simplify the CVP model and enable accountants to perform CVP analysis
quickly and easily. However, these assumptions may not be realistic, particularly if significant
changes are made to the organization’s operations. When performing CVP analysis, it is

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 important to consider the accuracy of these simplifying assumptions. It is always possible to
design a more accurate and complex CVP model. But the benefits of obtaining more accurate
data from a complex CVP model must outweigh the costs of developing such a model.

Margin of Safety

Question: Managers often like to know how close expected sales are to the break-even point. As
defined earlier, the excess of projected sales over the break-even point is called the margin of
safety. How is the margin of safety calculated for multiple-product and service organizations?

Answer: Let’s return to Amy’s Accounting Service and assume that Amy expects annual sales
of $822,222, which results in expected profit of $250,000. Given a break-even point of $266,667,
the margin of safety in sales dollars is calculated as follows:

Margin of safety$555,555=Projected sales − Break-even sales=$822,222 − $266,667  

Thus sales revenue can drop by $555,555 per year before the company begins to incur a loss.

K E Y   T A K E A W A Y S  

• The  key  formula  used  to  calculate  the  break-­‐even  or  target  profit  point  in  units  for  a  company  with  multiple  products  is  as  follows.  

Simply  set  the  target  profit  to  $0  for  break-­‐even  calculations,  or  to  the  appropriate  profit  dollar  amount  for  target  profit  calculations.  

Total fixed costs + Target profitWeighted average contribution margin per unit  

• The  formula  used  to  find  the  break-­‐even  point  or  target  profit  in  sales  dollars  for  companies  with  multiple  products  or  service  is  as  

follows.  Simply  set  the  “Target  Profit”  to  $0  for  break-­‐even  calculations,  or  to  the  appropriate  profit  dollar  amount  for  target  profit  

calculations:  

Total fixed costs + Target profitWeighted Average contribution margin ratio  

R E V I E W   P R O B L E M   6 . 3  

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 Ott  Landscape  Incorporated  provides  landscape  maintenance  services  for  three  types  of  clients:  commercial,  residential,  and  sports  

fields.  Financial  projections  for  this  coming  year  for  the  three  segments  are  as  follows:  

Assume  the  sales  mix  remains  the  same  at  all  levels  of  sales.  

1. How  much  must  Ott  Landscape  have  in  total  sales  dollars  to  break  even?  

2. How  much  must  Ott  Landscape  have  in  total  sales  dollars  to  earn  an  annual  profit  of  $1,500,000?  

3. What  is  the  margin  of  safety,  assuming  projected  sales  are  $5,000,000  as  shown  previously?  

Solution  to  Review  Problem  6.3  

1. Sales  of  $1,000,000  are  required  to  break  even:  

Total fixed costs + Target profitWeighted average contribution margin ratio*=$200,000+$00.20=$1,000,000 in sales  

*Weighted  average  contribution  margin  ratio  =  $1,000,000  ÷  $5,000,000  =  20  percent  or  0.20.  

2. Sales  of  $8,500,000  are  required  to  make  a  profit  of  $1,500,000:  

Total fixed costs + Target profitWeighted average contribution margin ratio=$200,000+$1,500,0000.20=$8,500,000 in sales  

3. The  margin  of  safety  is  $4,000,000  in  sales:  

Margin of safety$4,000,000 in sales=Projected sales − Break-even sales=$5,000,000−$1,000,000  

[1]  The  weighted  average  contribution  margin  ratio  can  also  be  found  by  multiplying  each  department’s  contribution  margin  ratio  by  
its  proportion  of  total  sales.  The  resulting  weighted  average  contribution  margin  ratios  for  all  departments  are  then  added.  The  
calculation  for  Amy’s  Accounting  Service  is  as  follows:45  percent  weighted  average  contribution  margin  ratio  =  (tax  has  20  percent  of  

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 total  sales  ×  70  percent  contribution  margin  ratio)  +  (audit  has  30  percent  of  total  sales  ×  20  percent  contribution  margin  ratio)  +  
(consulting  has  50  percent  of  total  sales  ×  50  percent  contribution  margin  ratio)Thus  45  percent  =  14  percent  +  6  percent  +  25  percent.  

6.3 Using Cost-Volume-Profit Models for Sensitivity Analysis

L E A R N I N G   O B J E C T I V E  

1. Use  sensitivity  analysis  to  determine  how  changes  in  the  cost-­‐volume-­‐profit  equation  affect  profit.  

Question: We can use the cost-volume-profit (CVP) financial model described in this chapter for
single-product, multiple-product, and service organizations to perform sensitivity analysis, also
called what-if analysis. How is sensitivity analysis used to help managers make decisions?

Answer: Sensitivity analysis shows how the CVP model will change with changes in any of its
variables (e.g., changes in fixed costs, variable costs, sales price, or sales mix). The focus is
typically on how changes in variables will alter profit.

Sensitivity Analysis: An Example

To illustrate sensitivity analysis, let’s go back to Snowboard Company, a company that produces
one snowboard model. The assumptions for Snowboard were as follows:

Sales price per unit $ 250

Variable cost per unit 150

Fixed costs per month 50,000

Target profit 30,000

Recall from earlier calculations that the break-even point is 500 units, and Snowboard must sell
800 units to achieve a target profit of $30,000. Management believes a goal of 800 units is overly

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 optimistic and settles on a best guess of 700 units in monthly sales. This is called the “base case.”
The base case is summarized as follows in contribution margin income statement format:

Question: Although management believes the base case is reasonably accurate, it is concerned
about what will happen if certain variables change. As a result, you are asked to address the
following questions from management (you are now performing sensitivity analysis!). Each
scenario is independent of the others. Unless told otherwise, assume that the variables used in
the base case remain the same. How do you answer the following questions for management?

1. How will profit change if the sales price increases by $25 per unit (10 percent)?
2. How will profit change if sales volume decreases by 70 units (10 percent)?
3. How will profit change if fixed costs decrease by $15,000 (30 percent) and variable cost
increases $15 per unit (10 percent)?

Answer: The CVP model shown in Figure 6.6 "Sensitivity Analysis for Snowboard Company" answers these
questions. Each column represents a different scenario, with the first column showing the base
case and the remaining columns providing answers to the three questions posed by management.
The top part of Figure 6.6 "Sensitivity Analysis for Snowboard Company" shows the value of each variable based
on the scenarios presented previously, and the bottom part presents the results in contribution
margin income statement format.

Figure 6.6 Sensitivity Analysis for Snowboard Company

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a $17,500 = $37,500 $20,000.

b 87.5 percent = $17,500 ÷ $20,000.

Carefully review Figure 6.6 "Sensitivity Analysis for Snowboard Company". The column
labeled Scenario 1 shows that increasing the price by 10 percent will increase profit 87.5 percent
($17,500). Thus profit is highly sensitive to changes in sales price. Another way to look at this is
that for every one percent increase in sales price, profit will increase by 8.75 percent, or for every
one percent decrease in sales price, profit will decrease by 8.75 percent.

The column labeled Scenario 2 shows that decreasing sales volume 10 percent will decrease
profit 35 percent ($7,000). Thus profit is also highly sensitive to changes in sales volume. Stated
another way, every one percentdecrease in sales volume will decrease profit by 3.5 percent; or
every one percent increase in sales volume will increase profit by 3.5 percent.

When comparing Scenario 1 with Scenario 2, we see that Snowboard Company’s profit is more
sensitive to changes in sales price than to changes in sales volume, although changes in either
will significantly affect profit.

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 The column labeled Scenario 3 shows that decreasing fixed costs by 30 percent and increasing
variable cost by 10 percent will increase profit 22.5 percent ($4,500). (Perhaps Snowboard
Company is considering moving toward less automation and more direct labor!)

Computer  Application  

Using Excel to Perform Sensitivity Analysis

The accountants at Snowboard Company would likely use a spreadsheet program, such as Excel, to develop a CVP model for the

sensitivity analysis shown in Figure 6.6 "Sensitivity Analysis for Snowboard Company". An example of how to use Excel to prepare

the CVP model shown in Figure 6.6 "Sensitivity Analysis for Snowboard Company" is presented as follows. Notice that the basic data

are entered at the top of the spreadsheet (data entry section), and the rest of the information is driven by formulas. This allows for

quick sensitivity analysis of different scenarios.

Using the base case as an example, sales of $175,000 (cell D14) are calculated by multiplying the $250 sales price per unit (cell D5)

by 700 units (cell D8). Variable costs of $105,000 (cell D15) are calculated by multiplying the $150 variable cost per unit (cell D6) by

700 units (cell D8). Fixed costs of $50,000 come from the top section (cell D7). The contribution margin of $70,000 is calculated by

subtracting variable costs from sales, and profit of $20,000 is calculated by subtracting fixed costs from the contribution margin.

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Expanding the Use of Sensitivity Analysis

Question: Although the focus of sensitivity analysis is typically on how changes in variables will
affect profit (as shown in Figure 6.6 "Sensitivity Analysis for Snowboard Company"),
accountants also use sensitivity analysis to determine the impact of changes in variables on the
break-even point and target profit.How is sensitivity analysis used to evaluate the impact
changes in variables will have on break-even and target profit points?

Answer: Let’s look at an example for Snowboard Company. Assume the company is able to
charge $275 per unit, instead of $250 per unit. How many units must Snowboard Company sell
to break even? The following calculation is based on the shortcut formula presented earlier in the
chapter:

QQQQ=(F + Target Profit)÷(S − V)=($50,000+$0)÷($275−$150)=$50,000÷$125=400 units  

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 Thus if the sales price per unit increases from $250 to $275, the break-even point decreases from
500 units (calculated earlier) to 400 units, which is a decrease of 100 units.

How would this same increase in sales price change the required number of units sold to achieve
a profit of $30,000? We apply the same shortcut formula:

QQQQ=(F + Target Profit)÷(S − V)=($50,000+$30,000)÷($275−$150)=$80,000÷$125=640 units  

Thus if the sales price per unit increases from $250 to $275, the number of units sold to achieve a
profit of $30,000 decreases from 800 units (calculated earlier) to 640 units, which is a decrease
of 160 units.

Business  in  Action  6.2  

Performing Sensitivity Analysis for a Brewpub

Three entrepreneurs in California were looking for investors and banks to finance a new brewpub. Brewpubs focus on two segments:

food from the restaurant segment, and freshly brewed beer from the beer production segment. All parties involved in the process of

raising money—potential investors and banks, as well as the three entrepreneurs (i.e., the owners)—wanted to know what the new

business’s projected profits would be. After months of research, the owners created a financial model that provided this information.

Projected profits were slightly more than $300,000 for the first year (from sales of $1.95 million) and were expected to increase in

each of the next four years.

One of the owners asked, “What if our projected revenues are too high? What will happen to profits if sales are lower than we expect?

After all, we will have debt of well over $1 million, and I don’t want anyone coming after my personal assets if the business doesn’t

have the money to pay!” Although all three owners felt the financial model was reasonably accurate, they decided to find the break-

even point and the resulting margin of safety.

Because a brewpub does not sell “units” of a specific product, the owners found the break-even point in sales dollars. The owners

knew the contribution margin ratio and all fixed costs from the financial model. With this information, they were able to calculate

the break-even point and margin of safety. The worried owner was relieved to discover that sales could drop over 35 percent from

initial projections before the brewpub incurred an operating loss.

K E Y   T A K E A W A Y  

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 • Sensitivity  analysis  shows  how  the  cost-­‐volume-­‐profit  model  will  change  with  changes  in  any  of  its  variables.  Although  the  focus  is  typically  on  

how  changes  in  variables  affect  profit,  accountants  often  analyze  the  impact  on  the  break-­‐even  point  and  target  profit  as  well.  
R E V I E W   P R O B L E M   6 . 4  

This  problem  is  an  extension  of  Note  6.28  "Review  Problem  6.2".  Recall  that  International  Printer  Machines  (IPM)  builds  three  computer  

printer  models:  Inkjet,  Laser,  and  Color  Laser.  Base  case  information  for  these  three  products  is  as  follows:  
Inkjet Laser Color Laser Total

Selling price per unit $250 $400 $1,600

Variable cost per unit $100 $150 $ 800

Expected unit sales (annual) 12,000 6,000 2,000 20,000

Sales mix 60 percent 30 percent 10 percent 100 percent

Total  annual  fixed  costs  are  $5,000,000.  Assume  that  each  scenario  that  follows  is  independent  of  the  others.  Unless  stated  otherwise,  

the  variables  are  the  same  as  in  the  base  case.  

1. Prepare  a  contribution  margin  income  statement  for  the  base  case.  Use  the  format  shown  in  Figure  6.5  "Income  Statement  for  Amy’s  Accounting  

Service".  

2. How  will  total  profit  change  if  the  Laser  sales  price  increases  by  10  percent?  (Hint:  Use  the  format  shown  in  Figure  6.5  "Income  Statement  for  

Amy’s  Accounting  Service",  and  compare  your  result  with  requirement  1.)  

3. How  will  total  profit  change  if  the  Inkjet  sales  volume  decreases  by  4,000  units  and  the  sales  volume  of  other  products  remains  the  same?  

4. How  will  total  profit  change  if  fixed  costs  decrease  by  20  percent?  

Solution  to  Review  Problem  6.4  

1. Base  Case:  

2. Laser  sales  price  increases  10  percent:  

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Total  profit  would  increase  $240,000  (from  loss  of  $100,000  in  base  case  to  profit  of  $140,000  in  this  scenario).  

3. Inkjet  sales  volume  decreases  4,000  units:  

Total  profit  would  decrease  $600,000  (from  loss  of  $100,000  in  base  case  to  loss  of  $700,000  in  this  scenario).  

4. Fixed  costs  decrease  20  percent:  

Total  profit  would  increase  $1,000,000  (from  loss  of  $100,000  in  base  case  to  profit  of  $900,000  in  this  scenario).  

6.4 Impact of Cost Structure on Cost-Volume-Profit Analysis

L E A R N I N G   O B J E C T I V E  

1. Understand  how  cost  structure  affects  cost-­‐volume-­‐profit  sensitivity  analysis.  

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 Question: Describing an organization’s cost structure helps us to understand the amount of fixed
and variable costs within the organization. What is meant by the term cost structure?

Answer: Cost structure is the term used to describe the proportion of fixed and variable costs to
total costs. For example, if a company has $80,000 in fixed costs and $20,000 in variable costs,
the cost structure is described as 80 percent fixed costs and 20 percent variable costs.

Question: Operating leverage refers to the level of fixed costs within an organization. How do
we determine if a company has high operating leverage?

Answer: Companies with a relatively high proportion of fixed costs have high operating
leverage. For example, companies that produce computer processors, such as NEC and Intel,
tend to make large investments in production facilities and equipment and therefore have a cost
structure with high fixed costs. Businesses that rely on direct labor and direct materials, such as
auto repair shops, tend to have higher variable costs than fixed costs.

Operating leverage is an important concept because it affects how sensitive profits are to changes
in sales volume. This is best illustrated by comparing two companies with identical sales and
profits but with different cost structures, as we do in . High Operating Leverage Company
(HOLC) has relatively high fixed costs, and Low Operating Leverage Company (LOLC) has
relatively low fixed costs.

Figure 6.7 Operating Leverage Example

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One way to observe the importance of operating leverage is to compare the break-even point in
sales dollars for each company. HOLC needs sales of $375,000 to break even (= $300,000 ÷
0.80), whereas LOLC needs sales of $166,667 to break even (= $50,000 ÷ 0.30).

Question: Why don’t all companies strive for low operating leverage to lower the break-even
point?

Answer: In , LOLC looks better up to the sales point of $500,000 and profit of $100,000.
However, once sales exceed $500,000, HOLC will have higher profit than LOLC. This is
because every additional dollar in sales will provide $0.80 in profit for HOLC (80 percent
contribution margin ratio), and only $0.30 in profit for LOLC (30 percent contribution margin
ratio). If a company is relatively certain of increasing sales, then it makes sense to have higher
operating leverage.

Financial advisers often say, “the higher the risk, the higher the potential profit,” which can also
be stated as “the higher the risk, the higher the potential loss.” The same applies to operating
leverage. Higher operating leverage can lead to higher profit. However, high operating leverage
companies that encounter declining sales tend to feel the negative impact more than companies
with low operating leverage.

To prove this point, let’s assume both companies in experience a 30 percentdecrease in sales. HOLC’s
profit would decrease by $120,000 (= 30 percent × $400,000 contribution margin) and LOLC’s

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 profit would decrease by $45,000 (= 30 percent × $150,000 contribution margin). HOLC would
certainly feel the pain more than LOLC.

Now assume both companies in experience a 30 percent increase in sales. HOLC’s profit would
increase by $120,000 (= 30 percent × $400,000 contribution margin) and LOLC’s profit would
increase by $45,000 (= 30 percent × $150,000 contribution margin). HOLC benefits more from
increased sales than LOLC.

K E Y   T A K E A W A Y  

• The  cost  structure  of  a  firm  describes  the  proportion  of  fixed  and  variable  costs  to  total  costs.  Operating  leverage  refers  to  the  

level  of  fixed  costs  within  an  organization.  The  term  “high  operating  leverage”  is  used  to  describe  companies  with  relatively  

high  fixed  costs.  Firms  with  high  operating  leverage  tend  to  profit  more  from  increasing  sales,  and  lose  more  from  decreasing  

sales  than  a  similar  firm  with  low  operating  leverage.  

R E V I E W   P R O B L E M   6 . 5  

What  are  the  characteristics  of  a  company  with  high  operating  leverage,  and  how  do  these  characteristics  differ  from  those  of  

a  company  with  low  operating  leverage?  

Solution  to  Review  Problem  6.5  

Companies  with  high  operating  leverage  have  a  relatively  high  proportion  of  fixed  costs  to  total  costs,  and  their  profits  tend  to  

be  much  more  sensitive  to  changes  in  sales  than  their  low  operating  leverage  counterparts.  Companies  with  low  operating  

leverage  have  a  relatively  low  proportion  of  fixed  costs  to  total  costs,  and  their  profits  tend  to  be  much  less  sensitive  to  

changes  in  sales  than  their  high  operating  leverage  counterparts.  

6.5 Using a Contribution Margin When Faced with Resource Constraints

L E A R N I N G   O B J E C T I V E  

1. Use  an  alternative  form  of  contribution  margin  when  faced  with  a  resource  constraint.  

Question: Many companies have limited resources in such areas as labor hours, machine hours,
facilities, and materials. These constraints will likely affect a company’s ability to produce goods
or provide services. When a company that produces multiple products faces a constraint,
managers often calculate the contribution margin per unit of constraint in addition to the
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 contribution margin per unit. The contribution margin per unit of constraint is the contribution
margin per unit divided by the units of constrained resource required to produce one unit of
product. How is this measure used by managers to make decisions when faced with resource
constraints?

Answer: Let’s examine the Kayaks-For-Fun example introduced earlier in the chapter. The
company produces two kayak models, River and Sea. Based on the information shown, Kayaks-
For-Fun would prefer to sell more of the River model because it has the highest contribution
margin per unit.

 
Kayaks-For-Fun has a total of 320 labor hours available each month. The specialized skills
required to build the kayaks makes it difficult for management to find additional workers.
Assume the River model requires 4 labor hours per unit and the Sea model requires 1 labor hour
per unit (most of the variable cost for the Sea model is related to expensive materials required for
production). Kayaks-For-Fun sells everything it produces. Given its labor hours constraint, the
company would prefer to maximize the contribution margin per labor hour.

 
Based on this information, Kayaks-For-Fun would prefer to sell the Sea model because it
provides a contribution margin per labor hour of $150 versus $100 for the River model. The
company would prefer only to make the Sea model, which would yield a total contribution

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 margin of $48,000 (= $150 × 320 hours). If the River model were the only model produced, the
total contribution margin to the company would be $32,000 (= $100 × 320 hours).

Analysis such as this often leads to further investigation. It may be that Kayaks-For-Fun can find
additional labor to alleviate this resource constraint. Or perhaps the production process can be
modified in a way that reduces the labor required to build the River model (e.g., through
increased automation). Whatever the outcome, companies with limited resources are wise to
calculate the contribution margin per unit of constrained resource.

K E Y   T A K E A W A Y  

• Many  organizations  operate  with  limited  resources  in  areas  such  as  labor  hours,  machine  hours,  facilities,  or  materials.  The  

contribution  margin  per  unit  of  constraint  is  a  helpful  measure  in  determining  how  constrained  resources  should  be  utilized.  
R E V I E W   P R O B L E M   6 . 6  

This  review  problem  is  based  on  the  information  for  Kayaks-­‐For-­‐Fun  presented  previously.  Assume  Kayaks-­‐For-­‐Fun  found  

additional  labor,  thereby  eliminating  this  resource  constraint.  However,  the  company  now  faces  limited  available  machine  

hours.  It  has  a  total  of  3,000  machine  hours  available  each  month.  The  River  model  requires  16  machine  hours  per  unit,  and  

the  Sea  model  requires  10  machine  hours  per  unit.  

1. Calculate  the  contribution  margin  per  unit  of  constrained  resource  for  each  model.  

2. Which  model  would  Kayaks-­‐For-­‐Fun  prefer  to  sell  to  maximize  overall  company  profit?  

Solution  to  Review  Problem  6.6  

1.    

2. Kayaks-­‐For-­‐Fun  would  prefer  to  sell  the  River  model  because  it  provides  a  contribution  margin  per  machine  hour  of  $25  

compared  to  $15  for  the  Sea  model.  If  only  the  River  model  were  sold,  the  total  contribution  margin  would  be  $75,000  (=  $25  ×  

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 3,000  machine  hours).  If  only  the  Sea  model  were  sold,  the  total  contribution  margin  would  be  $45,000  (=  $15  ×  3,000  machine  

hours).  

6.6 Income Taxes and Cost-Volume-Profit Analysis

L E A R N I N G   O B J E C T I V E  

1. Understand  the  effect  of  income  taxes  on  cost-­‐volume-­‐profit  analysis.  

Question: Some organizations, such as not-for-profit entities and governmental agencies, are not
required to pay income taxes. However, most for-profit organizations must pay income taxes on
their profits. How do we find the target profit in units or sales dollars for organizations that pay
income taxes?

Answer: Three steps are required:

Step 1. Determine the desired target profit after taxes (i.e., after accounting for income
taxes).

Step 2. Convert the desired target profit after taxes to the target profit before taxes.

Step 3. Use the target profit before taxes in the appropriate formula to calculate the target
profit in units or sales dollars.

Using Snowboard Company as an example, the assumptions are as follows:

Sales price per unit $ 250

Variable cost per unit 150

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 Fixed costs per month 50,000

Target profit 30,000

Assume also that the $30,000 target profit is the monthly profit desiredafter taxes and that
Snowboard has a tax rate of 20 percent.

Step 1. Determine the desired target profit after taxes.

Snowboard’s management wants to know how many units must be sold to earn a profit of
$30,000 after taxes. Target profit before taxes will be higher than $30,000, and we calculate it in
the next step.

Step 2. Convert the desired target profit after taxes to the target profit before taxes.

The formula used to solve for target profit before taxes is as follows.

Key  Equation  

Target  profit  before  taxes  =  Target  profit  after  taxes  ÷  (1  −  tax  rate)  

Using Snowboard Company’s data, the formula would read as follows:

Target profit before taxesTarget profit before taxes=$30,000÷(1−0.20)=$37,500  

Step 3. Use the target profit before taxes in the appropriate formula to calculate the target
profit in units or sales dollars.

The formula used to solve for target profit in units is

Total fixed costs + Target profitSelling price per unit − Variable cost per unit  

For Snowboard Company, it would read as follows:

Target profit in units=($50,000+$37,500)÷($250−$150)=$87,500÷$100=875 units  

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 This answer is confirmed in the following contribution margin income statement.

 
K E Y   T A K E A W A Y  

• Companies  that  incur  income  taxes  must  follow  three  steps  to  find  the  break-­‐even  point  or  target  profit.  

   

Step  1.  Determine  the  desired  target  profit  after  taxes.  

   

Step  2.  Convert  the  desired  target  profit  after  taxes  to  target  profit  before  taxes  using  the  following  formula:  

Target  profit  before  taxes  =  Target  profit  after  taxes  ÷  (1  −  tax  rate)  

   

Step  3.  Use  the  target  profit  before  taxes  from  step  2  in  the  appropriate  target  profit  formula  to  calculate  the  target  profit  in  units  or  in  

sales  dollars.  
R E V I E W   P R O B L E M   6 . 7  

This  review  problem  is  based  on  the  information  for  Snowboard  Company.  Assume  Snowboard’s  tax  rate  remains  at  20  percent.  

1. Use  the  three  steps  described  in  this  section  to  determine  how  manyunits  Snowboard  Company  must  sell  to  earn  a  monthly  profit  of  $50,000  

after  taxes.  

2. Use  the  three  steps  to  determine  the  sales  dollars  Snowboard  needs  to  earn  a  monthly  profit  of  $60,000  after  taxes.  

Solution  to  Review  Problem  6.7  

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 1. The  three  steps  to  determine  how  many  units  must  be  sold  to  earn  a  target  profit  after  taxes  are  as  follows:  

   

Step  1.  Determine  the  desired  target  profit  after  taxes.  

Management  wants  a  profit  of  $50,000  after  taxes  and  needs  to  know  how  many  units  must  be  sold  to  earn  this  profit.  

   

Step  2.  Convert  the  desired  target  profit  after  taxes  to  the  target  profit  before  taxes.  

The  formula  used  to  solve  for  target  profit  before  taxes  is  

Target profit before taxesTarget profit before taxesTarget profit before taxes=Target profit after taxes÷(1−tax rate)=$50,000÷(1−0.20)=$62,500  

   

Step  3.  Use  the  target  profit  before  taxes  in  the  appropriate  formula  to  calculate  the  target  profit  in  units.  

The  formula  to  solve  for  target  profit  in  units  is  

Total fixed costs + Target profitSelling price per unit−Variable cost per unit  

For  Snowboard  Company,  it  would  read  as  follows:  

Target profit in units=($50,000+$62,500)÷($250−$150)=$112,500÷$100=1,125 units  

2. The  three  steps  to  determine  how  many  sales  dollars  are  required  to  achieve  a  target  profit  after  taxes  are  as  follows:  

   

Step  1.  Determine  the  desired  target  profit  after  taxes.  

Management  wants  a  profit  of  $60,000  after  taxes  and  needs  to  know  the  sales  dollars  required  to  earn  this  profit.  

   

Step  2.  Convert  the  desired  target  profit  after  taxes  to  target  profitbefore  taxes.  

The  formula  used  to  solve  for  target  profit  before  taxes  is  

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 Target profit before taxesTarget profit before taxesTarget profit before taxes=Target profit after taxes÷(1−tax rate)=$60,000÷(1−0.20)=$75,000  

   

Step  3.  Use  the  target  profit  before  taxes  in  the  appropriate  formula  to  calculate  the  target  profit  in  sales  dollars.  

The  formula  used  to  solve  for  target  profit  in  sales  dollars  is  

Total fixed costs + Target profitContribution margin ratio  

Target profit in sales dollars=($50,000+$75,000)÷($100÷$250)=$125,000÷0.40=$312,500 in sales  

6.7 Using Variable Costing to Make Decisions

L E A R N I N G   O B J E C T I V E  

1. Understand  how  managers  use  variable  costing  to  make  decisions.  

In , we discussed how to report manufacturing costs and nonmanufacturing costs following U.S.
Generally Accepted Accounting Principles (U.S. GAAP). Under U.S. GAAP, all
nonmanufacturing costs (selling and administrative costs) are treated as period costs because
they are expensed on the income statement in the period in which they are incurred. All costs
associated with production are treated as product costs, including direct materials, direct labor,
and fixed and variable manufacturing overhead. These costs are attached to inventory as an asset
on the balance sheet until the goods are sold, at which point the costs are transferred to cost of
goods sold on the income statement as an expense. This method of accounting is
calledabsorption costing because all manufacturing overhead costs (fixed and variable)
are absorbed into inventory until the goods are sold. (The term full costing is also used to
describe absorption costing.)

Question: Although absorption costing is used for external reporting, managers often prefer to
use an alternative costing approach for internal reporting purposes called variable
costing. What is variable costing, and how does it compare to absorption costing?

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 Answer: Variable costing requires that all variable production costs be included in inventory,
and all fixed production costs (fixed manufacturing overhead) be reported as period costs. Thus
all fixed production costs are expensed as incurred.

The only difference between absorption costing and variable costing is in the treatment of fixed
manufacturing overhead. Using absorption costing, fixed manufacturing overhead is reported as
a product cost. Using variable costing, fixed manufacturing overhead is reported as a period
cost.summarizes the similarities and differences between absorption costing and variable costing.

Figure 6.8 Absorption Costing Versus Variable Costing

 
Impact of Absorption Costing and Variable Costing on Profit

Question: If a company uses just-in-time inventory, and therefore has no beginning or ending
inventory, profit will be exactly the same regardless of the costing approach used. However,
most companies have units of product in inventory at the end of the reporting period. How does
the use of absorption costing affect the value of ending inventory?

Answer: Since absorption costing includes fixed manufacturing overhead as a product cost, all
products that remain in ending inventory (i.e., are unsold at the end of the period) include a
portion of fixed manufacturing overhead costs as an asset on the balance sheet. Since variable
costing treats fixed manufacturing overhead costs as period costs, all fixed manufacturing

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 overhead costs are expensed on the income statement when incurred. Thus if the quantity of units
produced exceeds the quantity of units sold, absorption costing will result in higher profit.

We illustrate this concept with an example. The following information is for Bullard Company, a
producer of clock radios:

Assume Bullard has no finished goods inventory at the beginning of month 1. We will look at
absorption costing versus variable costing for three different scenarios:

• Month 1 scenario: 10,000 units produced equals 10,000 units sold

• Month 2 scenario: 10,000 units produced is greater than 9,000 units sold
• Month 3 scenario: 10,000 units produced is less than 11,000 units sold

Month 1: Number of Units Produced Equals Number of Units Sold

Question: During month 1, Bullard Company sells all 10,000 units produced during the
month. How does operating profit compare using absorption costing and variable costing when
the number of units produced equals the number of units sold?

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 Answer: presents the results for each costing method. Notice that the absorption costing income
statement is called a traditional income statement, and the variable costing income statement is
called a contribution margin income statement.

As you review , notice that when the number of units produced equals the number sold, profit
totaling $90,000 is identical for both costing methods. With absorption costing, fixed
manufacturing overhead costs are fully expensed because all units produced are sold (there is no
ending inventory). With variable costing, fixed manufacturing overhead costs are treated as
period costs and therefore are always expensed in the period incurred. Because all other costs are
treated the same regardless of the costing method used, profit is identical when the number of
units produced and sold is the same.

Figure 6.9 Number of Units Produced Equals Number of Units Sold

a $250,000 = $25 × 10,000 units sold.

b $110,000 = ($4 per unit fixed production cost × 10,000 units sold) + ($7 per unit variable production cost × 10,000 units

sold).

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 c $70,000 = $7 per unit variable production cost × 10,000 units sold.

d $50,000 = $20,000 fixed selling and admin. cost + ($3 per unit variable selling and admin. cost × 10,000 units sold).

e $30,000 = $3 per unit variable selling and admin. cost × 10,000 units sold.

f Variable costing treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead costs are

expensed in the period incurred regardless of the level of sales.

g Given.

Month 2: Number of Units Produced Is Greater Than Number of Units Sold

Question: During month 2, Bullard Company produces 10,000 units but sells only 9,000
units. How does operating profit compare using absorption costing and variable costing when
the number of units produced is greater than the number of units sold?

Answer: presents the results for each costing method. Notice that absorption costing results in
higher profit. When absorption costing is used, a portion of fixed manufacturing overhead costs
remains in ending inventory as an asset on the balance sheet until the goods are sold. However,
variable costing requires that all fixed manufacturing overhead costs be expensed as incurred
regardless of the level of sales. Thus when more units are produced than are sold, variable
costing results in higher costs and lower profit.

The difference in profit between the two methods of $4,000 (= $79,000 − $75,000) is attributed
to the $4 per unit fixed manufacturing overhead cost assigned to the 1,000 units in ending
inventory using absorption costing ($4,000 = $4 × 1,000 units).

Figure 6.10 Number of Units Produced Is Greater Than Number of Units Sold

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a $225,000 = $25 × 9,000 units sold.

b $99,000 = ($4 per unit fixed production cost × 9,000 units sold) + ($7 per unit variable production cost × 9,000 units

sold).

c $63,000 = $7 per unit variable production cost × 9,000 units sold.

d $47,000 = $20,000 fixed selling and admin. cost + ($3 per unit variable selling and admin. cost × 9,000 units sold).

e $27,000 = $3 per unit variable selling and admin. cost × 9,000 units sold.

f Variable costing always treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead

costs are expensed in the period incurred regardless of the level of sales.

g Given.

Month 3: Number of Units Produced Is Less Than Number of Units Sold

Question: During month 3, Bullard Company produces 10,000 units but sells 11,000 units (1,000
units were left over from month 2 and therefore were in inventory at the beginning of month
3). How does operating profit compare using absorption costing and variable costing when the
number of units produced is less than the number of units sold?
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 Answer: presents the results for each costing method. Using variable costing, the $40,000 in
fixed manufacturing overhead costs continues to be expensed when incurred. However, using
absorption costing, the entire $40,000 is expensed because all 10,000 units produced were sold;
an additional $4,000 related to the 1,000 units produced last month and pulled from inventory
this month is also expensed. Thus when fewer units are produced than are sold, absorption
costing results in higher costs and lower profit.

The difference in profit between the two methods of $4,000 (= $105,000 − $101,000) is
attributed to the $4 per unit fixed manufacturing overhead cost assigned to the 1,000 units in
inventory on the balance sheet at the end of month 2 and recorded as cost of goods sold during
month 3 using absorption costing ($4,000 = $4 × 1,000 units).

Figure 6.11 Number of Units Produced Is Less Than Number of Units Sold

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 a $275,000 = $25 × 11,000 units sold.

b $121,000 = ($4 per unit fixed production cost × 11,000 units sold) + ($7 per unit variable production cost × 11,000 units

sold).

c $77,000 = $7 per unit variable production cost × 11,000 units sold.

d $53,000 = $20,000 fixed selling and admin. cost + ($3 per unit variable selling and admin. cost × 11,000 units sold).

e $33,000 = $3 per unit variable selling and admin. cost × 11,000 units sold.

f Variable costing always treats fixed manufacturing overhead as a period cost. Thus all fixed manufacturing overhead

costs are expensed in the period incurred regardless of the level of sales.

g Given.

Advantages of Using Variable Costing

Question: Why do organizations use variable costing?

Answer: Variable costing provides managers with the information necessary to prepare a
contribution margin income statement, which leads to more effective cost-volume-profit (CVP)
analysis. By separating variable and fixed costs, managers are able to determine contribution
margin ratios, break-even points, and target profit points, and to perform sensitivity analysis.
Conversely, absorption costing meets the requirements of U.S. GAAP, but is not as useful for
internal decision-making purposes.

Another advantage of using variable costing internally is that it prevents managers from
increasing production solely for the purpose of inflating profit. For example, assume the manager
at Bullard Company will receive a bonus for reaching a certain profit target but expects to be
$15,000 short of the target. The company uses absorption costing, and the manager realizes
increasing production (and therefore increasing inventory levels) will increase profit. The
manager decides to produce 20,000 units in month 4, even though only 10,000 units will be sold.
Half of the $40,000 in fixed production cost ($20,000) will be included in inventory at the end of
the period, thereby lowering expenses on the income statement and increasing profit by $20,000.
At some point, this will catch up to the manager because the company will have excess or
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 obsolete inventory in future months. However, in the short run, the manager will increase profit
by increasing production. This strategy does not work with variable costing because all fixed
manufacturing overhead costs are expensed as incurred, regardless of the level of sales.

K E Y   T A K E A W A Y  

• As  shown  in  ,  the  only  difference  between  absorption  costing  and  variable  costing  is  in  the  treatment  of  fixed  

manufacturing  overhead  costs.  Absorption  costing  treats  fixed  manufacturing  overhead  as  a  product  cost  (included  in  

inventory  on  the  balance  sheet  until  sold),  while  variable  costing  treats  fixed  manufacturing  overhead  as  a  period  cost  

(expensed  on  the  income  statement  as  incurred).  

When  comparing  absorption  costing  with  variable  costing,  the  following  three  rules  apply:  (1)  When  units  produced  

equals  units  sold,  profit  is  the  same  for  both  costing  approaches.  (2)  When  units  produced  is  greater  than  units  sold,  

absorption  costing  yields  the  highest  profit.  (3)  When  units  produced  is  less  than  units  sold,  variable  costing  yields  the  

highest  profit.  
R E V I E W   P R O B L E M   6 . 8  

Winter  Sports,  Inc.,  produces  snowboards.  The  company  has  no  finished  goods  inventory  at  the  beginning  of  year  1.  The  

following  information  pertains  to  Winter  Sports,  Inc.,:  

 
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 1. All  100,000  units  produced  during  year  1  are  sold  during  year  1.  

1. Prepare  a  traditional  income  statement  assuming  the  company  uses  absorption  costing.  

2. Prepare  a  contribution  margin  income  statement  assuming  the  company  uses  variable  costing.  

2. Although  100,000  units  are  produced  during  year  2,  only  80,000  are  sold  during  the  year.  The  remaining  20,000  units  

are  in  finished  goods  inventory  at  the  end  of  year  2.  

1. Prepare  a  traditional  income  statement  assuming  the  company  uses  absorption  costing.  

2. Prepare  a  contribution  margin  income  statement  assuming  the  company  uses  variable  costing.  

Solution  to  Review  Problem  6.8  

1.    

1. Traditional  income  statement  (absorption  costing),  year  1:  

a
 $20,000,000  =  $200  ×  100,000  units  sold.  

b
 $13,500,000  =  ($5  per  unit  fixed  production  cost  ×  100,000  units  sold)  +  ($130  per  unit  variable  production  cost  ×  100,000  

units  sold).  

c
 $1,800,000  =  $800,000  fixed  selling  and  admin.  cost  +  ($10  per  unit  variable  selling  and  admin.  cost  ×  100,000  units  sold).  

2. Contribution  margin  income  statement  (variable  costing),  year  1:  

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a
 $20,000,000  =  $200  ×  100,000  units  sold.  

b
 $13,000,000  =  $130  per  unit  variable  production  cost  ×  100,000  units  sold.  

c
 $1,000,000  =  $10  per  unit  variable  selling  and  admin.  cost  ×  100,000  units  sold.  

d
 Variable  costing  treats  fixed  manufacturing  overhead  as  a  period  cost.  Thus  all  fixed  manufacturing  overhead  costs  are  

expensed  in  the  period  incurred  regardless  of  the  level  of  sales.  

e
 Given.  

2.    

1. Traditional  income  statement  (absorption  costing),  year  2:  

a
 $16,000,000  =  $200  ×  80,000  units  sold.  

b
 $10,800,000  =  ($5  per  unit  fixed  production  cost  ×  80,000  units  sold)  +  ($130  per  unit  variable  production  cost  ×  80,000  units  

sold).  

2. Contribution  margin  income  statement  (variable  costing),  year  2:  

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a
 $16,000,000  =  $200  ×  80,000  units  sold.  

b
 $10,400,000  =  $130  per  unit  variable  production  cost  ×  80,000  units  sold.  

c
 $800,000  =  $10  per  unit  variable  selling  and  admin.  cost  ×  80,000  units  sold.  

d
 Variable  costing  treats  fixed  manufacturing  overhead  as  a  period  cost.  Thus  all  fixed  manufacturing  overhead  costs  are  

expensed  in  the  period  incurred  regardless  of  the  level  of  sales.  

e
 Given.  
E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  

1. Describe  the  components  of  the  profit  equation.  

2. What  is  the  difference  between  a  variable  cost  and  a  fixed  cost?  Provide  examples  of  each.  

3. You  are  asked  to  find  the  break-­‐even  point  in  units  and  in  sales  dollars.  What  does  this  mean?  

4. You  are  asked  to  find  the  target  profit  in  units  and  in  sales  dollars.  What  does  this  mean?  

5. For  a  company  with  one  product,  describe  the  equation  used  to  calculate  the  break-­‐even  point  or  target  profit  in  (a)  units,  and  

(b)  sales  dollars.  

6. Distinguish  between  contribution  margin  per  unit  and  contribution  margin  ratio.  

7. What  does  the  term  margin  of  safety  mean?  How  might  management  use  this  information?  

8. Review  How  do  airlines  measure  break-­‐even  points?  In  2001,  which  airline  had  the  lowest  break-­‐even  point?  

9. How  does  the  break-­‐even  point  equation  change  for  a  company  with  multiple  products  or  services  compared  to  a  single-­‐

product  company?  

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 10. Describe  the  assumptions  made  to  simplify  the  cost-­‐volume-­‐profit  analysis  described  in  the  chapter.  

11. What  is  sensitivity  analysis  and  how  might  it  help  those  performing  cost-­‐volume-­‐profit  analysis?  

12. Review  What  were  the  owners  concerned  about  with  regards  to  projected  profits?  What  were  the  results  of  the  calculations  

made  to  address  the  owners’  concerns?  

13. If  you  are  asked  to  review  the  cost  structure  of  an  organization,  what  are  you  being  asked  to  do?  

14. When  might  the  contribution  margin  per  unit  of  constraint  be  more  effective  than  the  contribution  margin  per  unit  for  making  

decisions?  

15. Describe  the  three  steps  used  to  calculate  the  target  profit  for  companies  that  incur  income  tax  costs.  

16. Describe  the  difference  between  absorption  costing  and  variable  costing.  

17. Why  do  some  organizations  use  variable  costing?  

Brief  Exercises  

18. Planning  at  Snowboard  Company.  Refer  to  the  dialogue  at  Snowboard  Company  presented  at  the  beginning  of  the  chapter.  

What  information  is  Recilia,  vice  president  of  sales,  requesting  from  Lisa,  the  company  accountant?  How  does  Recilia  plan  on  

using  this  information?  

19. Contribution  Margin  Calculations.  Ace  Company  sells  lawn  mowers  for  $200  per  unit.  Variable  cost  per  unit  is  $40,  and  fixed  

costs  total  $4,000.  Find  (a)  the  contribution  margin  per  unit,  and  (b)  the  contribution  margin  ratio.  

20. Weighted  Average  Contribution  Margin  Calculation.  Radio  Control,  Inc.,  sells  radio  controlled  cars  for  $300  per  unit  

representing  80  percent  of  total  sales,  and  radio  controlled  boats  for  $400  per  unit  representing  20  percent  of  total  sales.  

Variable  cost  per  unit  is  $150  for  cars  and  $300  for  boats.  Find  (a)  the  contribution  margin  per  unit  for  each  product,  and  (b)  

the  weighted  average  contribution  margin  per  unit.  

21. Sensitivity  Analysis,  Sales  Price.  Refer  to  the  base  case  for  Snowboard  Company  presented  in  the  first  column  of  .  Assume  the  

unit  sales  price  decreases  by  10  percent.  Calculate  (a)  the  new  projected  profit,  (b)  the  dollar  change  in  profit  from  the  base  

case,  and  (c)  the  percent  change  in  profit  from  the  base  case.  

22. Sensitivity  Analysis,  Unit  Sales.  Refer  to  the  base  case  for  Snowboard  Company  presented  in  the  first  column  of  .  Assume  the  

number  of  units  sold  increases  by  10  percent.  Calculate  (a)  the  new  projected  profit,  (b)  the  dollar  change  in  profit  from  the  

base  case,  and  (c)  the  percent  change  in  profit  from  the  base  case.  

23. Operating  Leverage.  High  operating  leverage  means:  

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 1. The  company  has  relatively  low  fixed  costs.  

2. The  company  has  relatively  high  fixed  costs.  

3. The  company  will  have  to  sell  more  units  than  a  comparable  company  with  low  operating  leverage  to  break  even.  

4. The  company  will  have  to  sell  fewer  units  than  a  comparable  company  with  low  operating  leverage  to  break  even.  

5. Both  (2)  and  (3)  are  correct.  

6. Both  (1)  and  (4)  are  correct.  

24. Contribution  Margin  per  Unit  of  Constraint.  Paint  Toys  Company  sells  paint  ball  guns  for  $100  per  unit.  Variable  cost  is  $60  per  

unit.  Each  paint  ball  gun  requires  1.25  machine  hours  and  2.00  direct  labor  hours  to  produce.  Calculate  the  contribution  margin  

(a)  per  unit,  (b)  per  machine  hour,  and  (c)  per  direct  labor  hour.  

25. Target  Profit  with  Taxes.  Management  of  Lakewood  Company  would  like  to  achieve  a  target  profit  after  taxes  of  $300,000.  The  

company’s  income  tax  rate  is  40  percent.  What  target  profit  before  taxes  is  required  to  achieve  the  $300,000  after-­‐tax  profit  

desired  by  management?  

26. Absorption  Costing  Versus  Variable  Costing.  Describe  the  difference  between  absorption  costing  and  variable  costing.  Which  

approach  yields  the  highest  profit  when  the  units  produced  are  greater  than  the  units  sold?  Explain.  

Exercises:  Set  A  

27. Break-­‐Even  Point  and  Target  Profit  Measured  in  Units  (Single  Product).  Nellie  Company  has  monthly  fixed  costs  

totaling  $100,000  and  variable  costs  of  $20  per  unit.  Each  unit  of  product  is  sold  for  $25.  

Required:  

a. Calculate  the  contribution  margin  per  unit.  

b. Find  the  break-­‐even  point  in  units.  

c. How  many  units  must  be  sold  to  earn  a  monthly  profit  of  $40,000?  

Break-­‐Even  Point  and  Target  Profit  Measured  in  Sales  Dollars  (Single  Product).  Nellie  Company  has  monthly  fixed  

costs  totaling  $100,000  and  variable  costs  of  $20  per  unit.  Each  unit  of  product  is  sold  for  $25  (these  data  are  the  same  

as  the  previous  exercise):  

Required:  

 . Calculate  the  contribution  margin  ratio.  

a. Find  the  break-­‐even  point  in  sales  dollars.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     406  
     
 
 b. What  amount  of  sales  dollars  is  required  to  earn  a  monthly  profit  of  $60,000?  

Margin  of  Safety  (Single  Product).  Nellie  Company  has  monthly  fixed  costs  totaling  $100,000  and  variable  costs  of  

$20  per  unit.  Each  unit  of  product  is  sold  for  $25  (these  data  are  the  same  as  the  previous  exercise).  Assume  Nellie  

Company  expects  to  sell  24,000  units  of  product  this  coming  month.  

Required:  

 . Find  the  margin  of  safety  in  units.  

a. Find  the  margin  of  safety  in  sales  dollars.  

Break-­‐Even  Point  and  Target  Profit  Measured  in  Units  (Multiple  Products).  Hi-­‐Tech  Incorporated  produces  two  

different  products  with  the  following  monthly  data.  

Cell GPS Total

Selling price per unit $100 $400

Variable cost per unit $ 40 $240

Expected unit sales 21,000 9,000 30,000

Sales mix 70 percent 30 percent 100 percent

Fixed costs $1,800,000

Assume  the  sales  mix  remains  the  same  at  all  levels  of  sales.  

Required:  

 . Calculate  the  weighted  average  contribution  margin  per  unit.  

a. How  many  units  in  total  must  be  sold  to  break  even?  

b. How  many  units  of  each  product  must  be  sold  to  break  even?  

c. How  many  units  in  total  must  be  sold  to  earn  a  monthly  profit  of  $180,000?  

d. How  many  units  of  each  product  must  be  sold  to  earn  a  monthly  profit  of  $180,000?  

Break-­‐Even  Point  and  Target  Profit  Measured  in  Sales  Dollars  (Multiple  Products).  Hi-­‐Tech  Incorporated  produces  

two  different  products  with  the  following  monthly  data  (these  data  are  the  same  as  the  previous  exercise).  
Cell GPS Total

Selling price per unit $100 $400

Variable cost per unit $ 40 $240

Expected unit sales 21,000 9,000 30,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     407  
     
 
 Sales mix 70 percent 30 percent 100 percent

Fixed costs $1,800,000

Assume  the  sales  mix  remains  the  same  at  all  levels  of  sales.  

Required:  

Round  your  answers  to  the  nearest  hundredth  of  a  percent  and  nearest  dollar  where  appropriate.  (An  example  for  

percentage  calculations  is  0.434532  =  0.4345  =  43.45  percent;  an  example  for  dollar  calculations  is  $378.9787  =  $379.)  

 . Using  the  information  provided,  prepare  a  contribution  margin  income  statement  for  the  month  similar  to  the  one  

in  .  

a. Calculate  the  weighted  average  contribution  margin  ratio.  

b. Find  the  break-­‐even  point  in  sales  dollars.  

c. What  amount  of  sales  dollars  is  required  to  earn  a  monthly  profit  of  $540,000?  

d. Assume  the  contribution  margin  income  statement  prepared  in  requirement  a  is  the  company’s  base  case.  What  is  the  

margin  of  safety  in  sales  dollars?  

Changes  in  Sales  Mix.  Hi-­‐Tech  Incorporated  produces  two  different  products  with  the  following  monthly  data  

(these  data  are  the  same  as  the  previous  exercise).  

Cell GPS Total

Selling price per unit $100 $400

Variable cost per unit $ 40 $240

Expected unit sales 21,000 9,000 30,000

Sales mix 70 percent 30 percent 100 percent

Fixed costs $1,800,000

Required:  

 . If  the  sales  mix  shifts  to  50  percent  Cell  and  50  percent  GPS,  would  the  break-­‐even  point  in  units  increase  or  

decrease?  Explain.  (Detailed  calculations  are  not  necessary  but  may  be  helpful  in  confirming  your  answer.)  

a. Go  back  to  the  original  projected  sales  mix.  If  the  sales  mix  shifts  to  80  percent  Cell  and  20  percent  GPS,  would  the  

break-­‐even  point  in  units  increase  or  decrease?  Explain.  (Detailed  calculations  are  not  necessary  but  may  be  helpful  in  

confirming  your  answer.)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     408  
     
 
 CVP  Sensitivity  Analysis  (Single  Product).  Bridgeport  Company  has  monthly  fixed  costs  totaling  $200,000  and  

variable  costs  of  $40  per  unit.  Each  unit  of  product  is  sold  for  $50.  Bridgeport  expects  to  sell  30,000  units  each  month  

(this  is  the  base  case).  

Required:  

For  each  of  the  independent  situations  in  requirements  bthrough  d,  assume  that  the  number  of  units  sold  remains  at  

30,000.  

 . Prepare  a  contribution  margin  income  statement  for  the  base  case.  

a. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  the  unit  sales  price  increases  10  percent?  

b. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  the  unit  variable  cost  decreases  20  percent?  

c. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  total  fixed  costs  decrease  20  percent?  

CVP  Sensitivity  Analysis  (Multiple  Products).  Gonzalez  Company  produces  two  different  products  that  have  the  

following  monthly  data  (this  is  the  base  case).  

Cruiser Racer Total

Selling price per unit $300 $1,200

Variable cost per unit $120 $ 720

Expected unit sales 1,400 600 2,000

Sales mix 70 percent 30 percent 100 percent

Fixed costs $180,000

Required:  

For  each  of  the  independent  situations  in  requirements  bthrough  d,  assume  that  total  sales  remains  at  2,000  units.  

 . Prepare  a  contribution  margin  income  statement.  

a. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  the  Cruiser  sales  price  (1)  increases  20  percent,  or  (2)  

decreases  20  percent?  

b. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  the  Cruiser  sales  volume  increases  400  units  with  a  

corresponding  decrease  of  400  units  in  Racer  sales?  

c. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  total  fixed  costs  increase  five  percent?  Does  this  increase  

in  fixed  costs  result  in  higher  operating  leverage  or  lower  operating  leverage?  Explain.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     409  
     
 
 Contribution  Margin  with  Resource  Constraints.  CyclePath  Company  produces  two  different  products  that  have  

the  following  price  and  cost  characteristics.  

Bicycle Tricycle

Selling price per unit $200 $100

Variable cost per unit $120 $ 50

Management  believes  that  pushing  sales  of  the  Bicycle  product  would  maximize  company  profits  because  of  the  

high  contribution  margin  per  unit  for  this  product.  However,  only  50,000  labor  hours  are  available  each  year,  and  the  

Bicycle  product  requires  4  labor  hours  per  unit  while  the  Tricycle  model  requires  2  labor  hours  per  unit.  The  company  

sells  everything  it  produces.  

Required:  

 . Calculate  the  contribution  margin  per  unit  of  constrained  resource  for  each  model.  

a. Which  model  would  CyclePath  prefer  to  sell  to  maximize  overall  company  profit?  Explain.  

Target  Profit  Measured  in  Units  (with  Taxes).  Optical  Incorporated  has  annual  fixed  costs  totaling  $6,000,000  and  

variable  costs  of  $350  per  unit.  Each  unit  of  product  is  sold  for  $500.  Assume  a  tax  rate  of  20  percent.  

Required:  

Use  the  three  steps  described  in  the  chapter  to  determine  how  many  units  must  be  sold  to  earn  an  annual  profit  of  

$100,000  after  taxes.  (Round  to  the  nearest  unit.)  

Target  Profit  Measured  in  Sales  Dollars  (with  Taxes).  Optical  Incorporated  has  annual  fixed  costs  totaling  

$6,000,000  and  variable  costs  of  $350  per  unit.  Each  unit  of  product  is  sold  for  $500.  Assume  a  tax  rate  of  20  percent  

(these  data  are  the  same  as  the  previous  exercise).  

Required:  

Use  the  three  steps  described  in  the  chapter  to  determine  the  sales  dollars  required  to  earn  an  annual  profit  of  

$150,000  after  taxes.  

Absorption  Costing  Versus  Variable  Costing.  Technic  Company  produces  portable  CD  players.  The  company  has  no  

finished  goods  inventory  at  the  beginning  of  year  1.  The  following  information  pertains  to  Technic  Company.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     410  
     
 
  

Required:  

 . All  50,000  units  produced  during  year  1  are  sold  during  year  1.  

1. Prepare  a  traditional  income  statement  assuming  the  company  uses  absorption  costing.  

2. Prepare  a  contribution  margin  income  statement  assuming  the  company  uses  variable  costing.  

a. Although  50,000  units  are  produced  during  year  2,  only  40,000  are  sold  during  the  year.  The  

remaining  10,000  units  are  in  finished  goods  inventory  at  the  end  of  year  2.  

1. Prepare  a  traditional  income  statement  assuming  the  company  uses  absorption  costing.  

2. Prepare  a  contribution  margin  income  statement  assuming  the  company  uses  variable  costing.  

Exercises:  Set  B  

39. Break-­‐Even  Point  and  Target  Profit  Measured  in  Units  (Single  Product).  Phan  Incorporated  has  annual  fixed  costs  

totaling  $6,000,000  and  variable  costs  of  $350  per  unit.  Each  unit  of  product  is  sold  for  $500.  

Required:  

a. Calculate  the  contribution  margin  per  unit.  

b. Find  the  break-­‐even  point  in  units.  

c. How  many  units  must  be  sold  to  earn  an  annual  profit  of  $750,000?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     411  
     
 
 Break-­‐Even  Point  and  Target  Profit  Measured  in  Sales  Dollars  (Single  Product).  Phan  Incorporated  has  annual  fixed  

costs  totaling  $6,000,000  and  variable  costs  of  $350  per  unit.  Each  unit  of  product  is  sold  for  $500  (these  data  are  the  

same  as  the  previous  exercise).  

Required:  

 . Calculate  the  contribution  margin  ratio.  

a. Find  the  break-­‐even  point  in  sales  dollars.  

b. What  amount  of  sales  dollars  is  required  to  earn  an  annual  profit  of  $300,000?  

Margin  of  Safety  (Single  Product).  Phan  Incorporated  has  annual  fixed  costs  totaling  $6,000,000  and  variable  costs  

of  $350  per  unit.  Each  unit  of  product  is  sold  for  $500  (these  data  are  the  same  as  the  previous  exercise).  Assume  Phan  

Incorporated  expects  to  sell  51,000  units  of  product  this  coming  year.  

Required:  

 . Find  the  margin  of  safety  in  units.  

a. Find  the  margin  of  safety  in  sales  dollars.  

Break-­‐Even  Point  and  Target  Profit  Measured  in  Units  (Multiple  Products).  Advanced  Products  Company  produces  

three  different  CDs  with  the  following  annual  data.  

Music Data DVD Total

Selling price per unit $10 $4 $12

Variable cost per unit $ 3 $1 $ 3

Expected unit sales 8,000 10,000 22,000 40,000

Sales mix 20 percent 25 percent 55 percent 100 percent

Fixed costs $205,900

Assume  the  sales  mix  remains  the  same  at  all  levels  of  sales.  

Required:  

(Round  all  answers  to  the  nearest  cent  and  nearest  unit  where  appropriate.)  

 . Calculate  the  weighted  average  contribution  margin  per  unit.  

a. How  many  units  in  total  must  be  sold  to  break  even?  

b. How  many  units  of  each  product  must  be  sold  to  break  even?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     412  
     
 
 c. How  many  units  in  total  must  be  sold  to  earn  an  annual  profit  of  $200,000?  

d. How  many  units  of  each  product  must  be  sold  to  earn  an  annual  profit  of  $200,000?  

Break-­‐Even  Point  and  Target  Profit  Measured  in  Sales  Dollars  (Multiple  Products).  Advanced  Products  Company  

produces  three  different  CDs  with  the  following  annual  data  (these  data  are  the  same  as  the  previous  exercise).  
Music Data DVD Total

Selling price per unit $10 $4 $12

Variable cost per unit $ 3 $1 $ 3

Expected unit sales 8,000 10,000 22,000 40,000

Sales mix 20 percent 25 percent 55 percent 100 percent

Fixed costs $205,900

Assume  the  sales  mix  remains  the  same  at  all  levels  of  sales.  

Required:  

Round  your  answers  to  the  nearest  hundredth  of  a  percent  and  nearest  dollar  where  appropriate.  (An  example  for  

percentage  calculations  is  0.434532  =  0.4345  =  43.45  percent;  an  example  for  dollar  calculations  is  $378.9787  =  $379.)  

 . Using  the  information  provided,  prepare  a  contribution  margin  income  statement  similar  to  the  one  in  .  

a. Calculate  the  weighted  average  contribution  margin  ratio.  

b. Find  the  break-­‐even  point  in  sales  dollars.  

c. What  amount  of  sales  dollars  is  required  to  earn  an  annual  profit  of  $200,000?  

d. Assume  the  contribution  margin  income  statement  prepared  in  requirement  a  is  the  company’s  base  case.  What  is  the  

margin  of  safety  in  sales  dollars?  

Changes  in  Sales  Mix.  Advanced  Products  Company  produces  three  different  CDs  with  the  following  annual  data  

(these  data  are  the  same  as  the  previous  exercise).  

Music Data DVD Total

Selling price per unit $10 $4 $12

Variable cost per unit $ 3 $1 $ 3

Expected unit sales 8,000 10,000 22,000 40,000

Sales mix 20 percent 25 percent 55 percent 100 percent

Fixed costs $205,900

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     413  
     
 
 Required:  

If  the  sales  mix  shifts  more  toward  the  Data  product  than  the  other  two  products,  would  the  break-­‐even  point  in  

units  increase  or  decrease?  Explain.  (Detail  calculations  are  not  necessary,  but  may  be  helpful  in  confirming  your  

answer.)  

CVP  Sensitivity  Analysis  (Single  Product).  Skyler  Incorporated  has  monthly  fixed  costs  of  $1,000,000  and  variable  

costs  of  $24  per  unit.  Each  unit  of  product  is  sold  for  $120.  Skyler  expects  to  sell  15,000  units  each  month  (this  is  the  

base  case).  

Required:  

For  each  of  the  independent  situations  in  requirements  bthrough  d,  assume  that  the  number  of  units  sold  remains  at  

15,000.  (Round  to  the  nearest  cent  where  appropriate.)  

 . Prepare  a  contribution  margin  income  statement  for  the  base  case.  

a. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  the  unit  sales  price  decreases  10  percent?  

b. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  the  unit  variable  cost  increases  10  percent?  

c. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  total  fixed  costs  decrease  20  percent?  

CVP  Sensitivity  Analysis  (Multiple  Products).  CyclePath  Company  produces  two  different  products  that  have  the  

following  annual  data  (this  is  the  base  case).  

Bicycle Tricycle Total

Selling price per unit $200 $100

Variable cost per unit $120 $ 50

Expected unit sales 5,000 20,000 25,000

Sales mix 20 percent 80 percent 100 percent

Fixed costs $1,000,000

Required:  

For  each  of  the  independent  situations  in  requirements  bthrough  d,  assume  that  total  sales  remains  at  25,000  units.  

 . Prepare  a  contribution  margin  income  statement  for  the  base  case.  

a. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  the  Tricycle  sales  price  (1)  increases  10  percent,  or  (2)  

decreases  10  percent?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     414  
     
 
 b. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  Bicycle  sales  volume  decreases  500  units  and  there  is  a  

corresponding  increase  of  500  units  in  Tricycle  sales?  

c. Refer  to  the  base  case.  What  would  the  operating  profit  be  if  total  fixed  costs  decrease  10  percent?  Does  this  decrease  

in  fixed  costs  result  in  higher  operating  leverage  or  lower  operating  leverage?  Explain.  

Contribution  Margin  with  Resource  Constraints.  CyclePath  Company  produces  two  different  products  that  have  

the  following  price  and  cost  characteristics.  

Bicycle Tricycle

Selling price per unit $200 $100

Variable cost per unit $120 $ 50

Management  believes  that  pushing  sales  of  the  Bicycle  product  would  maximize  company  profits  because  of  the  

high  contribution  margin  per  unit  for  this  product.  However,  only  23,000  machine  hours  are  available  each  year,  and  

the  Bicycle  product  requires  2  machine  hours  per  unit  while  the  Tricycle  model  requires  1  machine  hour  per  unit.  The  

company  sells  everything  it  produces.  

Required:  

 . Calculate  the  contribution  margin  per  unit  of  constrained  resource  for  each  model.  

a. Which  model  would  CyclePath  prefer  to  sell  to  maximize  overall  company  profit?  Explain.  

Target  Profit  Measured  in  Units  (with  Taxes).  Martis  Company  has  annual  fixed  costs  totaling  $4,000,000  and  

variable  costs  of  $300  per  unit.  Each  unit  of  product  is  sold  for  $400.  Assume  a  tax  rate  of  20  percent.  

Required:  

Use  the  three  steps  described  in  the  chapter  to  determine  how  many  units  must  be  sold  to  earn  an  annual  profit  of  

$500,000  after  taxes.  (Round  to  the  nearest  unit.)  

Target  Profit  Measured  in  Sales  Dollars  (with  Taxes).  Martis  Company  has  annual  fixed  costs  totaling  $4,000,000  

and  variable  costs  of  $300  per  unit.  Each  unit  of  product  is  sold  for  $400.  Assume  a  tax  rate  of  20  percent  (these  data  

are  the  same  as  the  previous  exercise).  

Required:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Use  the  three  steps  described  in  the  chapter  to  determine  the  sales  dollars  required  to  earn  an  annual  profit  of  

$1,000,000  after  taxes.  

Absorption  Costing  Versus  Variable  Costing.  Photo  Company  produces  digital  cameras.  The  company  has  no  

finished  goods  inventory  at  the  beginning  of  year  1.  The  following  information  pertains  to  Photo  Company.  

Required:  

 . All  60,000  units  produced  during  year  1  are  sold  during  year  1.  

1. Prepare  a  traditional  income  statement  assuming  the  company  uses  absorption  costing.  

2. Prepare  a  contribution  margin  income  statement  assuming  the  company  uses  variable  costing.  

a. Although  60,000  units  are  produced  during  year  2,  only  40,000  are  sold  during  the  year.  The  

remaining  20,000  units  are  in  finished  goods  inventory  at  the  end  of  year  2.  

1. Prepare  a  traditional  income  statement  assuming  the  company  uses  absorption  costing.  

2. Prepare  a  contribution  margin  income  statement  assuming  the  company  uses  variable  costing.  

Problems  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 51. CVP  and  Sensitivity  Analysis  (Single  Product).  Madera  Company  has  annual  fixed  costs  totaling  $120,000  and  variable  

costs  of  $3  per  unit.  Each  unit  of  product  is  sold  for  $15.  Madera  expects  to  sell  12,000  units  this  year  (this  is  the  base  

case).  

Required:  

a. Find  the  break-­‐even  point  in  units.  

b. How  many  units  must  be  sold  to  earn  an  annual  profit  of  $50,000?  (Round  to  the  nearest  unit.)  

c. Find  the  break-­‐even  point  in  sales  dollars.  

d. What  amount  of  sales  dollars  is  required  to  earn  an  annual  profit  of  $70,000?  

e. Find  the  margin  of  safety  in  units  and  in  sales  dollars.  

f. Prepare  a  contribution  margin  income  statement  for  the  base  case.  

g. What  will  the  operating  profit  (loss)  be  if  the  sales  price  decreases  30  percent?  (Assume  total  sales  remains  at  12,000  

units,  and  round  to  the  nearest  cent  where  appropriate.)  

h. Go  back  to  the  base  case.  What  will  the  operating  profit  (loss)  be  if  the  variable  cost  per  unit  increases  10  percent?  

(Assume  total  sales  remains  at  12,000  units,  and  round  to  the  nearest  cent  where  appropriate.)  

CVP  Analysis  and  Cost  Structure  (Single  Product).  Riviera  Incorporated  produces  flat  panel  televisions.  The  

company  has  annual  fixed  costs  totaling  $10,000,000  and  variable  costs  of  $600  per  unit.  Each  unit  of  product  is  sold  

for  $1,000.  Riviera  expects  to  sell  70,000  units  this  year.  

Required:  

 . Find  the  break-­‐even  point  in  units.  

a. How  many  units  must  be  sold  to  earn  an  annual  profit  of  $2,000,000?  

b. Find  the  break-­‐even  point  in  sales  dollars.  

c. What  amount  of  sales  dollars  is  required  to  earn  an  annual  profit  of  $500,000?  

d. Find  the  margin  of  safety  in  units.  

e. Find  the  margin  of  safety  in  sales  dollars.  

f. How  much  will  operating  profit  change  if  fixed  costs  are  15  percent  higher  than  anticipated?  Would  this  increase  in  

fixed  costs  result  in  higher  or  lower  operating  leverage?  Explain.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 CVP  Analysis  with  Taxes  (Single  Product).  Riviera  Incorporated  produces  flat  panel  televisions.  The  company  has  

annual  fixed  costs  totaling  $10,000,000  and  variable  costs  of  $600  per  unit.  Each  unit  of  product  is  sold  for  $1,000.  

Riviera  expects  to  sell  70,000  units  this  year  (this  is  the  same  data  as  the  previous  problem).  Assume  a  tax  rate  of  30  

percent.  

Required:  

Round  all  calculations  to  the  nearest  dollar  and  nearest  unit  where  appropriate.  

 . How  many  units  must  be  sold  to  earn  an  annual  profit  of  $2,000,000  after  taxes?  

a. What  amount  of  sales  dollars  is  required  to  earn  an  annual  profit  of  $500,000  after  taxes?  

b. Refer  to  requirement  a.  What  would  happen  to  the  number  of  units  required  to  earn  $2,000,000  in  operating  profit  if  

the  company  were  a  non-­‐profit  organization  that  did  not  incur  income  taxes?  Explain.  (Detailed  calculations  are  not  

necessary  but  may  be  helpful  in  confirming  your  answer.)  

CVP  Analysis  and  Sales  Mix  (Multiple  Products).  Sierra  Books  Incorporated  produces  two  different  products  with  

the  following  monthly  data  (this  is  the  base  case).  

Text Lecture Notes Total

Selling price per unit $100 $12

Variable cost per unit $ 60 $ 3

Expected unit sales 21,000 14,000 35,000

Sales mix 60 percent 40 percent 100 percent

Fixed costs $750,000

Assume  the  sales  mix  remains  the  same  at  all  levels  of  sales  except  for  requirement  i.  

Required:  

Round  to  the  nearest  unit  of  product,  hundredth  of  a  percent,  and  nearest  cent  where  appropriate.  (An  example  for  

unit  calculations  is  3,231.15  =  3,231;  an  example  for  percentage  calculations  is  0.434532  =  0.4345  =  43.45  percent;  an  

example  for  dollar  calculations  is  $378.9787  =  $378.98.)  

 . Calculate  the  weighted  average  contribution  margin  per  unit.  

a.    

1. How  many  units  in  total  must  be  sold  to  break  even?  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     418  
     
 
 2. How  many  units  of  each  product  must  be  sold  to  break  even?  

b.    

1. How  many  units  in  total  must  be  sold  to  earn  a  monthly  profit  of  $100,000?  

2. How  many  units  of  each  product  must  be  sold  to  earn  a  monthly  profit  of  $100,000?  

c. Using  the  base  case  information,  prepare  a  contribution  margin  income  statement  for  the  month  similar  to  the  one  in  .  

d. Calculate  the  weighted  average  contribution  margin  ratio.  

e. Find  the  break-­‐even  point  in  sales  dollars.  

f. What  amount  of  sales  dollars  is  required  to  earn  a  monthly  profit  of  $80,000?  

g. Assume  the  contribution  margin  income  statement  prepared  in  requirement  d  is  the  company’s  base  case.  What  is  the  

margin  of  safety  in  sales  dollars?  

h. If  the  sales  mix  shifts  more  toward  the  Text  product  than  the  Lecture  Notes  product,  would  the  break-­‐even  point  in  

units  increase  or  decrease?  Explain.  (Detail  calculations  are  not  necessary,  but  may  be  helpful  in  confirming  your  

answer.)  

CVP  Analysis  and  Cost  Structure  (Service  Company).  Conway  Electrical  Services  provides  services  to  two  types  of  

clients:  residential  and  commercial.  The  company’s  contribution  margin  income  statement  for  the  year  is  shown  (this  is  

the  base  case).  Fixed  costs  are  known  in  total,  but  Conway  does  not  allocate  fixed  costs  to  each  department.  

Required:  

 . Find  the  break-­‐even  point  in  sales  dollars.  

a. What  is  the  margin  of  safety  in  sales  dollars?  

b. What  amount  of  sales  dollars  is  required  to  earn  an  annual  profit  of  $750,000?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     419  
     
 
 c. Refer  to  the  base  case  shown  previously.  What  would  the  operating  profit  be  if  the  Commercial  variable  costs  are  20  

percent  higher  than  originally  anticipated?  How  does  this  increase  in  Commercial  variable  costs  impact  the  operating  

leverage  of  the  company?  

CVP  and  Sensitivity  Analysis,  Resource  Constraint  (Multiple  Products).  Hobby  Shop  Incorporated  produces  three  

different  models  with  the  following  annual  data  (this  is  the  base  case).  
Plane Car Boat Total

Selling price per unit $20 $14 $24

Variable cost per unit $ 5 $ 7 $ 8

Expected unit sales 30,000 50,000 20,000 100,000

Sales mix 30 percent 50 percent 20 percent 100 percent

Fixed costs $650,000

Assume  the  sales  mix  remains  the  same  at  all  levels  of  sales  except  for  requirements  i  and  j.  

Required:  

Round  to  the  nearest  unit  of  product,  hundredth  of  a  percent,  and  nearest  cent  where  appropriate.  (An  example  for  

unit  calculations  is  3,231.151  =  3,231;  an  example  for  percentage  calculations  is  0.434532  =  0.4345  =  43.45  percent;  an  

example  for  dollar  calculations  is  $378.9787  =  $378.98.)  

 . Calculate  the  weighted  average  contribution  margin  per  unit.  

a.    

1. How  many  units  in  total  must  be  sold  to  break  even?  

2. How  many  units  of  each  product  must  be  sold  to  break  even?  

b.    

1. How  many  units  in  total  must  be  sold  to  earn  an  annual  profit  of  $500,000?  

2. How  many  units  of  each  product  must  be  sold  to  earn  an  annual  profit  of  $500,000?  

c. Using  the  base  case  information,  prepare  a  contribution  margin  income  statement  for  the  year  similar  to  the  one  in  .  

d. Calculate  the  weighted  average  contribution  margin  ratio.  

e. Find  the  break-­‐even  point  in  sales  dollars.  

f. What  amount  of  sales  dollars  is  required  to  earn  an  annual  profit  of  $400,000?  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     420  
     
 
 g. Go  back  to  the  base  case  contribution  margin  income  statement  prepared  in  requirement  d.  What  would  the  operating  

profit  be  if  the  Plane  sales  price  (1)  increases  10  percent,  or  (2)  decreases  10  percent?  (Assume  total  sales  remains  at  

100,000  units.)  

h. Go  back  to  the  base  case  contribution  margin  income  statement  prepared  in  requirement  d.  If  the  sales  mix  shifts  

more  toward  the  Car  product  than  to  the  other  two  products,  would  the  break-­‐even  point  in  units  increase  or  

decrease?  (Detailed  calculations  are  not  necessary.)  Explain.  

i. Assume  the  company  has  a  limited  number  of  labor  hours  available  in  production,  and  management  would  like  to  

make  efficient  use  of  these  labor  hours.  The  Plane  product  requires  4  labor  hours  per  unit,  the  Car  product  requires  3  

labor  hours  per  unit,  and  the  Boat  product  requires  5  hours  per  unit.  The  company  sells  everything  it  produces.  Based  

on  this  information,  calculate  the  contribution  margin  per  labor  hour  for  each  model  (round  to  the  nearest  cent),  and  

determine  the  top  two  models  the  company  would  prefer  to  sell  to  maximize  overall  company  profit.  

Absorption  Costing  Versus  Variable  Costing.  Wall  Tech  Company  produces  wood  siding.  The  company  has  no  

finished  goods  inventory  at  the  beginning  of  year  1.  The  following  information  pertains  to  Wall  Tech  Company.  

Required:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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  . All  200,000  units  produced  during  year  1  are  sold  during  year  1.  

1. Prepare  a  traditional  income  statement  assuming  the  company  uses  absorption  costing.  

2. Prepare  a  contribution  margin  income  statement  assuming  the  company  uses  variable  costing.  

a. Although  200,000  units  are  produced  during  year  2,  only  170,000  units  are  sold  during  the  year.  The  

remaining  30,000  units  are  in  finished  goods  inventory  at  the  end  of  year  2.  

1. Prepare  a  traditional  income  statement  assuming  the  company  uses  absorption  costing.  

2. Prepare  a  contribution  margin  income  statement  assuming  the  company  uses  variable  costing.  

b. Although  200,000  units  are  produced  during  year  3,  a  total  of  230,000  units  are  sold  during  the  year.  

The  30,000  units  remaining  in  inventory  at  the  end  of  year  2  are  sold  during  year  3.  

1. Prepare  a  traditional  income  statement  assuming  the  company  uses  absorption  costing.  

2. Prepare  a  contribution  margin  income  statement  assuming  the  company  uses  variable  costing.  

c. Analyze  the  results  in  years  1  through  3  (requirements  athrough  c).  

One  Step  Further:  Skill-­‐Building  Cases  

58. Internet  Project:  CVP  Analysis.  Using  the  Internet,  go  to  the  Web  site  for  Nordstrom,  

Inc.  (http://www.nordstrom.com),  and  selectinvestor  relations.  Find  the  most  recent  annual  report  and  print  the  

income  statement  (called  the  consolidated  statements  of  earnings).  

Required:  

a. Calculate  the  gross  profit  percentage  (also  called  thegross  margin  percentage)  by  dividing  the  gross  profit  by  net  

sales.  

b. Explain  how  the  gross  profit  percentage  is  different  than  the  contribution  margin  ratio  (no  calculations  are  necessary)?  

Decision  Making:  Automated  Versus  Labor  Intensive  Production.Wood  Furniture,  Inc.,  builds  high-­‐quality  wood  

desks.  Management  of  the  company  is  considering  going  from  a  labor-­‐intensive  process  of  building  desks  to  an  

automated  process  that  requires  expensive  machinery  and  equipment.  If  the  company  moves  to  an  automated  

process,  variable  production  costs  will  decrease  (direct  materials,  direct  labor,  and  variable  manufacturing  overhead)  

due  to  improved  efficiency,  and  fixed  production  costs  will  increase  as  a  result  of  additional  depreciation  costs.  The  

costs  predicted  for  the  coming  year  are  shown.  The  selling  price  is  expected  to  be  $900  per  unit  for  both  processes.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     422  
     
 
 Labor-Intensive Process Automated Process

Variable cost of goods sold $490 per unit $290 per unit

Fixed cost of goods sold (annual) $1,000,000 $2,600,000

Variable selling and administrative $10 per unit $10 per unit

Fixed selling and admin. (annual) $400,000 $400,000

Required:  

 . Calculate  the  break-­‐even  point  in  units  assuming  that  (1)  the  labor-­‐intensive  process  is  used,  and  (2)  the  automated  

process  is  used.  

a. Explain  why  there  is  such  a  significant  difference  in  break-­‐even  points  between  the  labor-­‐intensive  process  and  the  

automated  process.  

b. Assume  Wood  Furniture,  Inc.,  expects  to  produce  and  sell  8,000  units  this  coming  year  and  is  certain  sales  will  grow  by  

at  least  10  percent  per  year  in  future  years.  Calculate  the  expected  operating  profit  assuming  that  (1)  the  labor  

intensive  process  is  used,  and  (2)  the  automated  process  is  used.  

c. Using  requirement  c  as  a  guide,  explain  whether  management  should  stay  with  the  labor-­‐intensive  process  or  switch  to  

an  automated  process.  

Group  Activity:  Sensitivity  Analysis  and  Decision  Making.Performance  Sports  produces  inflatable  rafts  used  for  

river  rafting.  Sales  have  grown  slowly  over  the  years,  and  cost  increases  are  causing  Performance  Sports  to  incur  

losses.  Financial  data  for  the  most  recent  year  are  shown.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     423  
     
 
 Members  of  the  management  group  at  Performance  Sports  arrived  at  these  three  possible  courses  of  action  to  return  

the  company  to  profitability  (each  scenario  is  independent  of  the  others):  

0. Increase  the  sales  price  for  each  raft  by  10  percent,  which  will  cause  a  5  percent  drop  in  sales  volume.  Although  

sales  volume  will  drop  5  percent,  the  group  believes  the  increased  sales  price  will  more  than  offset  the  drop  in  rafts  

sold.  

1. Decrease  the  sales  price  for  each  raft  by  10  percent,  which  will  cause  an  8  percent  increase  in  sales  volume.  Although  

the  sales  price  will  drop  by  10  percent,  the  group  believes  an  increase  in  rafts  sold  will  more  than  offset  the  sales  price  

reduction.  

2. Increase  advertising  costs  by  $200,000,  which  will  increase  sales  volume  by  15  percent.  Although  fixed  selling  and  

administrative  costs  will  increase  by  $200,000,  the  group  believes  the  increase  in  rafts  sold  will  more  than  offset  the  

increase  in  advertising  costs.  

Required:  

Form  groups  of  two  to  four  students  and  assign  one  of  the  three  options  listed  previously  to  each  group.  Each  group  

must  perform  the  following  requirements:  

c. Calculate  the  projected  operating  profit  (loss)  for  the  option  assigned,  and  determine  whether  the  option  is  

acceptable.  

d. Discuss  and  document  the  advantages  and  disadvantages  of  the  option  assigned.  

e. As  a  class,  discuss  each  option  based  on  the  findings  of  your  group.  

Sensitivity  Analysis  Using  Excel.  Refer  to  the  information  for  Performance  Sports  in  Skill-­‐Building  Case  60.  Prepare  an  

Excel  spreadsheet  to  calculate  the  operating  profit  (loss)  for  the  base  case  and  for  each  of  the  three  scenarios  presented  in  the  

case.  Using  the  spreadsheet  in  the  Computer  Application  box  in  this  chapter  as  a  guide,  include  “data  entry”  and  “sensitivity  

analysis  results”  sections,  and  combine  variable  cost  of  goods  sold  and  selling  and  administrative  costs  on  one  line  and  fixed  

cost  of  goods  sold  and  selling  and  administrative  costs  on  another  line.  

Ethics:  Increasing  Production  to  Boost  Profit.  Hauser  Company  produces  heavy  machinery  used  for  snow  removal.  

Over  half  of  the  production  costs  incurred  by  Hauser  are  related  to  fixed  manufacturing  overhead.  Although  the  

company  has  maximum  production  capacity  of  20,000  units  per  year,  only  2,000  units  were  produced  and  sold  during  

year  1,  yielding  $25  million  in  operating  losses.  As  required  by  U.S.  GAAP,  the  company  uses  absorption  costing.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     424  
     
 
 At  the  beginning  of  year  2,  the  board  of  directors  fired  the  president  of  the  company  and  began  searching  for  a  new  

president  who  was  willing  to  make  substantial  changes  to  get  the  company  turned  around.  One  candidate,  Paul  

Glezner,  indicated  he  could  turn  the  company  around  within  a  year.  He  felt  the  company  was  producing  too  few  

products,  and  could  benefit  from  increased  production.  The  members  of  the  board  of  directors  were  impressed  and  

considered  Paul’s  contract  demands:  $10,000  in  base  annual  salary,  plus  30  percent  of  operating  profit.  Paul  made  it  

clear  he  would  help  the  company  for  year  2,  but  intended  to  move  on  after  the  year  ended.  

Management  of  Hauser  Company  approached  you  with  Paul’s  offer  and  asked  you  to  determine  whether  the  offer  is  

reasonable.  

Required:  

 . Assume  the  company’s  sales  will  remain  close  to  2,000  units  in  year  2.  How  does  Paul  intend  to  “turn  the  company  

around”  during  year  2?  

a. Why  do  you  think  Paul  insists  on  leaving  the  company  after  year  2?  

b. What  type  of  costing  system  would  you  recommend  Hauser  Company  use  during  year  2?  Explain.  

Comprehensive  Case  

63. CVP  and  Sensitivity  Analysis  for  a  Brewpub.  As  described  in  ,  three  entrepreneurs  were  looking  for  private  investors  

and  financial  institutions  to  fund  a  new  brewpub  near  Sacramento,  California.  This  brewpub  was  to  be  called  Roseville  

Brewing  Company  (RBC).  

Brewpubs  provide  two  products  to  customers:  food  from  the  restaurant  segment,  and  freshly  brewed  beer  from  the  

beer  production  segment.  Both  segments  are  typically  in  the  same  building,  which  allows  customers  to  see  the  beer  

brewing  process.  

After  months  of  research,  the  three  entrepreneurs  created  a  financial  model  that  showed  the  following  projections  for  

the  first  year  of  operations:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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In  the  process  of  pursuing  capital  (cash)  through  private  investors  and  financial  institutions,  they  were  asked  several  

questions.  The  following  is  a  sample  of  the  questions  most  commonly  asked:  

o What  is  the  break-­‐even  point?  

o What  sales  dollars  will  be  required  to  make  $200,000?  To  make  $500,000?  

o Is  the  product  mix  reasonable?  (Beer  tends  to  have  a  higher  contribution  margin  ratio  than  food,  and  therefore  

product  mix  assumptions  are  critical  to  profit  projections.)  

o What  happens  to  operating  profit  if  the  product  mix  shifts?  

o How  will  changes  in  price  affect  operating  profit?  

o How  much  does  a  pint  of  beer  cost  to  produce?  

It  became  clear  that  the  initial  financial  model  was  not  adequate  for  answering  these  questions.  After  further  research,  

the  entrepreneurs  created  another  financial  model  that  provided  the  following  information  for  the  first  year  of  

operations.  (Notice  that  operating  profit  of  $302,212  is  the  same  as  in  the  first  model.)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Required:  

Round  your  answers  to  the  nearest  hundredth  of  a  percent  and  nearest  dollar  where  appropriate.  (An  example  for  

percentage  calculations  is  0.434532  =  0.4345  =  43.45  percent;  an  example  for  dollar  calculations  is  $378.9787  =  $379.)  

g. What  were  potential  investors  and  financial  institutions  concerned  about  when  asking  the  questions  listed  

previously?  

h. Why  was  the  first  financial  model  inappropriate  for  answering  most  of  the  questions  asked  by  investors  and  bankers?  

Be  specific.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 i. Suppose  you  are  deciding  whether  to  invest  in  RBC.  Which  financial  ratio  would  you  use  to  check  the  reasonableness  of  

RBC’s  projected  operating  profit  as  compared  with  that  of  similar  businesses?  

j. Why  is  it  difficult  to  answer  the  question  “How  much  does  a  pint  of  beer  cost  to  produce?”  Which  costs  would  you  

include  in  answering  this  question?  

k. Perform  CVP  analysis  by  answering  the  following  questions:  

1. What  is  the  break-­‐even  point  in  sales  dollars  for  RBC?  

2. What  is  the  margin  of  safety  in  sales  dollars  for  RBC?  

3. Why  is  it  not  possible  for  RBC  to  find  the  break-­‐even  point  in  units?  

4. What  sales  dollars  would  be  required  to  achieve  an  operating  profit  of  $200,000  and  of  $500,000?  What  

assumptions  are  made  in  these  calculations?  

l. Assume  total  revenue  remains  the  same,  but  the  product  mix  changes  so  that  each  of  the  three  revenue  categories  is  

weighted  as  follows:  food  70  percent,  beer  25  percent,  other  5  percent.  Prepare  a  contribution  margin  income  

statement  to  reflect  these  changes.  How  will  this  shift  in  product  mix  affect  operating  profit?  

m. Although  the  financial  model  is  important,  what  other  strategic  factors  should  RBC  and  its  investors  consider?  

   

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     428  
     
 
 Chapter  7  
How Are Relevant Revenues and Costs Used to Make Decisions?

Bob Lee is president of Best Boards, Inc., a manufacturer of wakeboards. In the face of stiff
competition, Best Boards’ profits have declined steadily over the past few years. Bob is
concerned about the decline in profits and has instructed Jim Muller, the vice president of
operations, to do whatever it takes to reduce costs. In fact, Bob offered to pay Jim a bonus equal
to 25 percent of any production cost savings the company achieves during the coming year.

Jim Muller thinks he has a way to cut costs and earn his bonus, and he approaches Bob Lee and
Amy Eckstrom, the company’s accountant, to discuss his plan:

Bob and Amy, I hope you’ve had a chance to review my proposal to outsource production. I think it could save the company
Jim: thousands of dollars this coming year.

Bob: I did review your proposal. Give me a quick summary of what you have in mind.

Our staff accountants tell me that the average unit product cost for our wakeboards is about $110, and we make 10,000
Jim: wakeboards each year.

Amy: Sounds about right.

My thought is that we could save substantial amounts of money by having an outside supplier make our wakeboards rather
Jim: than doing it ourselves. I contacted one reputable wakeboard manufacturer interested in producing the boards for us.

Bob: What did you find?

They told me the wakeboards could be purchased from them for $70 a board. This amounts to $40 in savings per unit, and
Jim: $400,000 in total savings! Even after my 25 percent bonus of $100,000, Best Boards would save $300,000.

Jim has an interesting idea, but there are some issues that should be considered. Jim, you are correct in stating the average
unit product cost for our wakeboards is $110 given production of 10,000 units per year. However, it is not accurate to assume
we will eliminate $1,100,000, which is $110 per unit cost times 10,000 units, in total production costs by outsourcing
production. The average unit cost includes factory equipment lease payments, along with supervisors’ salaries, and factory
rent. These costs don’t go away quickly if we stop production. The equipment lease is for several years, we are locked into a
Amy: long-term lease for the factory building, and we would have to look at our supervisors’ contracts before letting them go.

Bob: Can we get a better idea of which costs would be eliminated by outsourcing production, and which costs would remain?

Amy: Sure. I’ll get a team working on this right away.

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     429  
     
 
 Best Boards is facing a decision common to many organizations: whether to build its own
product or to have another company build the product. We will come back to this scenario after
describing how companies facing such decisions can use differential analysis to make wise business
decisions.

7.1 Using Differential Analysis to Make Decisions

L E A R N I N G   O B J E C T I V E  

1. Describe  the  format  used  for  differential  analysis.  

Differential revenues and costs (also called relevant revenues and costsor incremental revenues
and costs) represent the difference in revenues and costs among alternative courses of action.
Analyzing this difference is calleddifferential analysis (or incremental analysis). We begin with a
relatively simple example to establish the format used to perform differential analysis and
present more complicated examples later in the chapter. As you work through this example,
notice that we also use the contribution margin income statement format presented.

Question: Assume Phillips Accountancy provides bookkeeping, tax, and audit services to its
clients. Management believes Phillips Accountancy has several unprofitable customers and
would like to perform differential analysis to find out how profits would change if Phillips
dropped these customers. Alternative 1 includes the annual revenues, costs, and resulting profit
if the company keeps all existing customers. Alternative 2 includes the annual revenues, costs,
and resulting profit if the company drops what it believes are unprofitable customers. How
should management decide whether to keep all existing customers or drop certain customers?

Answer: presents the format used by management to perform differential analysis. In this case,
differential analysis is used to evaluate whether Phillips Accounting should keep all customers or
drop unprofitable customers. The information in confirms that Phillips Accountancy would be
better off dropping the unprofitable customers (Alternative 2), because company profits would
increase by $20,000. The general rule is to select the alternative with the highest differential
profit. Take a close look at before reading the description of this information that follows.
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 Figure 7.1 Differential Analysis for Phillips Accountancy

 
Notice that in the columns labeled Alternative 1 and Alternative 2 show revenues, costs, and
profit for each alternative. The third column, labeledDifferential Amount, presents the
differential revenues and costs and resulting differential profit. Positive amounts appearing in
this column indicate Alternative 1 is higher than Alternative 2. Negative amounts appearing in
the Differential Amount column indicate Alternative 1 is lower than Alternative 2. The fourth
column shows whether Alternative 1 is higher or lower than Alternative 2 for each line item.

For example, the differential amount of $1,000,000 for revenue indicates Alternative 1 produces
$1,000,000 more in revenue than Alternative 2. The differential amount of $750,000 for variable
costs indicates variable costs are $750,000 higher for Alternative 1 than for Alternative 2. Move
to the bottom of . Notice that the differential amount for profit is negative ($20,000). This
indicates that Alternative 1 results in profits that are $20,000 lower than Alternative 2. Thus
Alternative 2 (dropping unprofitable customers) is the desirable course of action.

Notice that the columns labeled Alternative 1 and Alternative 2 show information in summary
form (i.e., no detail is provided for revenues, variable costs, or fixed costs). Some managers may
want only this type of summary information, whereas others may prefer more detailed
information. It is important to be flexible with the format, to best meet the needs of managers.
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 We will build upon the differential analysis format shown in throughout this chapter, and show
how more detail can easily be provided using the same format.

Next, this chapter focuses on how we use differential analysis to assist in making the following
types of decisions:

• Make or buy products

• Keep or drop product lines
• Keep or drop customers
• Accept or reject special customer orders

K E Y   T A K E A W A Y  

• Differential  revenues  and  costs  represent  the  difference  in  revenues  and  costs  among  alternative  courses  of  action.  Analyzing  

this  difference  is  called  differential  analysis.  Differential  analysis  is  useful  in  making  managerial  decisions  related  to  making  or  

buying  products,  keeping  or  dropping  product  lines,  keeping  or  dropping  customers,  and  accepting  or  rejecting  special  

customer  orders.  
R E V I E W   P R O B L E M   7 . 1  

Coffee  Express  is  a  small  coffee  shop  looking  to  expand  its  product  offerings  beyond  coffee.  The  company  is  evaluating  two  

alternatives—sandwiches  and  cookies.  Annual  projections  for  sales  of  sandwiches  are  as  follows:  sales,  $18,000;  variable  costs,  

$13,000;  and  fixed  costs,  $500.  Annual  projections  for  sales  of  cookies  are  as  follows:  sales,  $10,000;  variable  costs,  $3,000;  

and  no  additional  fixed  costs.  

Using  the  format  in  ,  perform  differential  analysis  to  determine  which  alternative  is  more  profitable,  and  by  how  much.  Assume  

adding  sandwiches  is  Alternative  1  and  adding  cookies  is  Alternative  2.  

Solution  to  Review  Problem  7.1  

As  shown  in  the  differential  analysis  given,  selling  cookies  is  the  most  profitable  alternative.  Selling  cookies  results  in  profits  of  

$7,000  for  the  year,  which  is  $2,500  higher  than  the  sandwich  alternative.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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7.2 Make-or-Buy Decisions

L E A R N I N G   O B J E C T I V E  

1. Use  differential  analysis  for  make-­‐or-­‐buy  decisions.  

Question: With the differential analysis format in hand, we can now go back to Best Boards, Inc.,
introduced at the beginning of the chapter. Recall that Best Boards produces each wakeboard
for $110, and Jim Muller, vice president of operations, received a bid for $70 per board from an
outside manufacturer. Best Boards’ president asked the company’s accountant, Amy Eckstrom,
to investigate whether it makes sense for Best Boards to hire an outside company to produce the
wakeboards. What information should Amy provide that will help management make this
decision?

Answer: presents the costs that the vice president of operations at Best Boards must evaluate in
deciding whether to make the wakeboards or buy them from an outside company. This is called
a make-or-buy decision because the company must decide whether to make the product
internally or buy the product from an outside firm (often called outsourcing).

Table 7.1 Make-or-Buy Decision

Costs to Make Wakeboard Costs to Buy Wakeboard

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Costs to Make Wakeboard Costs to Buy Wakeboard

Direct materials Wakeboards from supplier

Direct labor

Variable production costs Manufacturing overhead

Factory equipment lease Factory equipment lease

Factory building rent Factory building rent

Fixed production costs Supervisor salaries Supervisor salaries

Determining Differential Product Costs

Question: What information did Amy find to help Best Boards with the decision whether to make
their own wakeboards or buy them from an outside supplier?

Answer: After further research, Amy identified the following product costs associated with
wakeboard production at Best Boards:

Since Best Boards produces 10,000 wakeboards each year, the product cost per unit is $110 (=
$1,100,000 ÷ 10,000 units). However, Amy must identify which of the costs listed previously
are differential costs if the company acquires the wakeboards from an outside producer. That is,

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Amy must determine which costs will change and which will remain the same. Here’s what she
found:

• All variable production costs will be eliminated if Best Boards buys the wakeboards
rather than making them. These are differential costs.
• The factory equipment lease will continue for several years whether Best Boards makes
or buys the wakeboards. This is not a differential cost.
• The factory building lease covers several years, so this cost will continue whether Best
Boards makes or buys the wakeboards. This is not a differential cost.
• One of Best Boards’ two production supervisors was hired recently, is paid $50,000 per
year, and can be let go if needed. This is a differential cost.
• The other of Best Boards’ two production supervisors has been with the company for
several years, is paid $90,000 per year, and has five years remaining on her contract. This
is not a differential cost.

Question: Amy must now prepare a differential analysis to determine which alternative is best
for the company. Her analysis appears in . Because the focus of make-or-buy decisions is on
product costs, and because sales revenue is not differential to this decision, it is not necessary to
include sales revenue in the analysis. This in turn eliminates the need to show the contribution
margin or net income. (Even if sales revenue were included, the outcome would remain the
same.) What does Amy’s analysis tell us?

Figure 7.2 Make-or-Buy Differential Analysis for Best Boards, Inc.

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a $700,000 = $70 per unit × 10,000 units.

b One supervisor must be paid $90,000 per year even if the company buys the product. The other supervisor, who is paid

$50,000 per year, can be let go if the company buys the product.

Answer: Realizing that the information shown in does not provide the savings initially hoped for, Amy presents the

unfavorable analysis to Jim Muller and the company’s president, Bob Lee. Refer to as you follow Amy’s comments to Bob

and Jim about her analysis.

Bob: Hi, Amy, what have you got for us?

Amy: As you can see from my analysis, outsourcing the production of our wakeboards does not reduce overall production costs.

How can that be? I got a bid from an outside supplier for $70 per board, and our cost to produce the very same board is
Jim: $110.

As I mentioned before, the $110 includes costs that do not go away if we outsource production. Let’s look at my analysis.
Alternative 1 represents the production costs we incur to make the board ourselves, and Alternative 2 represents the costs we
Amy: incur if we buy the board from an outside supplier using Jim’s quote of $70 each.

Well, this certainly explains where the $110 product cost per board comes from if we produce the boards ourselves. I see the
Jim: total cost of $1,100,000. Divide this by 10,000 units produced annually, and the resulting cost per unit is $110.

Exactly! Now let’s look at Alternative 2 more carefully. Although we eliminate all variable product costs such as direct
materials and direct labor by outsourcing production, several fixed product costs remain. We still must lease the factory
equipment at a rate of $110,000 per year, and the factory building lease of $290,000 per year is in effect for several more
years. Also, one of our factory supervisors has a long-term contract for $90,000 per year and cannot be let go any time soon.
Amy: None of these costs can be eliminated if we outsource production. Add these costs to the $700,000 cost incurred to purchase

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 the boards from a supplier, and the total cost of $1,190,000 is $90,000 higher than if we produce the boards ourselves.

Perhaps we should consider outsourcing in a few years as these long-term commitments expire. Jim, I commend you for your
creative approach to reducing costs, but the numbers don’t make it feasible for us to discontinue production and buy the
Bob: products elsewhere.

Using a Summary Format for Differential Analysis

Question: The Differential Amount column presented in indicates Best Boards would be better
off producing wakeboards internally. However, management may want a more concise
explanation of why production costs are $90,000 higher when outsourcing production. How can
we present this information in a more concise format?

Answer: We show a more concise presentation in , which includes theDifferential

Amount column shown in along with a brief description for each item. Look closely at to
confirm that the Differential Amount column matches, and review the explanation of the
difference for each line item. As you compare these two figures, notice that only differential
costs are presented in , and therefore costs for the factory equipment lease, factory building rent,
and a portion of supervisor salaries are excluded from . That is, costs that do not differ from one
alternative to another are excluded from the summary differential analysis since this information
is irrelevant to the decision. The amounts in parentheses in indicate a negative impact on profit,
and amounts without parentheses indicate a positive impact on profit.

Figure 7.3 Summary of Differential Analysis for Best Boards, Inc.

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Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without
parentheses indicate a positive impact on profit.

The analysis shown in is particularly useful if all costs are not easily identified, and differential
costs can be determined. After all, the goal of differential analysis is to analyze the costs that
differ from one alternative to the next.

We often use the term avoidable cost to describe a cost that can be avoided, or eliminated, if one
alternative is chosen over another. If Best Boards chooses to buy the product from an outside
producer, the company avoids such costs as direct materials, direct labor, manufacturing
overhead, and the salary of one supervisor. In this context, avoidable cost is the same
asdifferential cost.

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 Business  in  Action  7.1  

Source: Photo courtesy of C.G.P. Grey, http://www.cgpgrey.com/.

Outsourcing Construction

Salt Lake City, Utah, recently built a $65 million library. The library’s façade was assembled from precast concrete panels

that a company called Pretecsa produced in a plant near Mexico City. Trucks hauled 140 truckloads of these panels—each

truckload averaging 10 tons—2,350 miles from Mexico City to Salt Lake City. In all, four million pounds of concrete were

shipped. As the director of Pretecsa noted, “The idea of manufacturing a building a couple of thousand miles away and then

exporting it, well it was considered crazy.”

The manager in charge of the library construction had tried to obtain the concrete panels from sources in the United States.

He stated, “We contacted precast contractors in Phoenix, Denver, and Las Vegas, but they didn’t feel they could do it cheaply

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 enough, once you factored in their shipping costs. Pretecsa’s low-cost labor made up for the higher shipping costs, and they

came in the cheapest.”

Pretecsa disclosed that it took 163,000 labor hours to produce the concrete panels and charged $2.5 million for all its

services, including materials. Labor costs alone in the United States would have been $3 million.

Source: Joel Millman, “Blueprint for Outsourcing,” The Wall Street Journal, March 3, 2004.
K E Y   T A K E A W A Y  

• Differential  analysis  requires  the  identification  of  all  revenues  and  costs  that  differ  from  one  alternative  to  another.  In  general,  

managers  select  the  alternative  with  the  highest  profit.  If  the  only  differences  between  the  alternatives  are  with  costs  (as  in  the  

make-­‐or-­‐buy  decision  for  Best  Boards),  decision  makers  would  select  the  alternative  with  the  lowest  cost.  
R E V I E W   P R O B L E M   7 . 2  

Quality  Bikes,  Inc.,  currently  produces  racing  bikes.  Management  is  interested  in  outsourcing  production  of  these  bikes  to  a  

reputable  manufacturing  company  that  can  supply  the  bikes  for  $600  per  unit.  Quality  Bikes  incurs  the  following  annual  

production  costs  to  produce  2,000  racing  bikes  internally:  

Outsourcing  production  eliminates  all  variable  production  costs,  the  production  supervisor’s  salary,  and  factory  insurance  

costs.  Factory  building  and  equipment  lease  costs  will  remain  the  same  regardless  of  the  decision  to  outsource  or  to  produce  

internally.  

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 1. Perform  differential  analysis  using  the  format  presented  in  .  Assume  making  the  bike  internally  is  Alternative  1,  and  buying  the  

bike  from  an  outside  manufacturer  is  Alternative  2.  

2. Which  alternative  is  best?  Explain.  

3. Summarize  the  result  of  outsourcing  production  using  the  format  presented  in  .  

Solution  to  Review  Problem  7.2  

1.    

*$1,200,000  =  $600  per  unit  ×  2,000  units.  

2. Buying  the  bikes  from  an  outside  supplier  is  the  best  alternative.  This  alternative  results  in  total  costs  of  $1,380,000,  providing  

$30,000  in  savings  compared  to  the  $1,410,000  cost  of  producing  bikes  internally.  

3.    

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Note:  Amounts  shown  in  parentheses  indicate  a  negative  impact  on  profit,  and  amounts  without  parentheses  indicate  a  positive  impact  

on  profit.  

7.3 Product Line Decisions

L E A R N I N G   O B J E C T I V E  

1. Use  differential  analysis  for  product  line  decisions.  

Question: As competitors enter the market and as products go through life cycles, managers
often must decide whether to keep or drop product lines. Aproduct line is a group of related
products. The Home Depot, Inc., has many different product lines such as appliances, flooring,
and paint products. Ford Motor Co. produces a variety of products such as compact cars, trucks,
and tractors. Companies must continually assess whether they should add new product lines, and
whether they should discontinue current product lines. Differential analysis provides a format
for these types of decisions. How would differential analysis be used to make a product line
decision?

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 Answer: Let’s look at an example of a product line decision. Assume Barbeque Company has
three product lines: gas barbecues, charcoal barbecues, and barbecue accessories. Charcoal
barbecue sales have declined in recent years, leading management to question whether this
product line is worth keeping. Barbeque Company would like to consider two alternatives.
Alternative 1 is to retain all three product lines, and Alternative 2 is to eliminate the charcoal
barbecues product line. Figure 7.4 "Product Line Decision" shows the decision facing the
manager at Barbeque Company: whether to eliminate or keep the charcoal barbecue product line.

Figure 7.4 Product Line Decision

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Figure 7.5 "Income Statement for Barbeque Company" presents the income statement for the
past year, separated by product line (this is often referred to as a segmented income statement).

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 Carefully examine Figure 7.5 "Income Statement for Barbeque Company". Notice that the
charcoal barbecues product line shows a loss of $8,000 for the year. This is the reason
management would like to consider dropping this product line.

Figure 7.5 Income Statement for Barbeque Company

*Includes cost of goods sold and other variable costs.

The variable costs in Figure 7.5 "Income Statement for Barbeque Company"are related directly
to each product line, and thus are eliminated if the product line is eliminated. That is, all variable
costs are differential costs for the two alternatives facing Barbeque Company.

Question: Notice that two lines appear for fixed costs: direct fixed costs and allocated fixed
costs. What is the difference between direct fixed costs and allocated fixed costs?

Answer: Direct fixed costs are fixed costs that can be traced directly to a product line. Direct
fixed costs are often differential costs. For example, the salary of the manager responsible for
charcoal barbecues is easily traced to the charcoal barbecues product line. If this product line is
eliminated, the product line manager’s salary is also eliminated (unless the product line manager
has a long-term employment contract).

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 Allocated fixed costs (also called common fixed costs) are fixed costs thatcannot be traced
directly to a product line, and therefore are assigned to product lines using an allocation process.
Allocated fixed costs are typicallynot differential costs. For example, rent paid for Barbeque
Company’s retail store is allocated to all three product lines because it is not easily traced to each
product line. However, the retail store rent likely will not decrease if the charcoal barbecues
product line is eliminated (unless the company chooses to move to a smaller, less costly store).
The charcoal barbecues’ allocation for rent would simply be reallocated to the other two
products. Thus rent for the retail store is an example of an allocated fixed cost that isnot a
differential cost for the two alternatives facing Barbeque Company.

Question: How are Barbeque Company’s allocated fixed costs assigned to individual product
lines?

Answer: Barbeque Company’s total allocated fixed costs of $120,000 are allocated based on
sales. Sales revenue for gas barbecues totals $450,000, which is 75 percent of total company
sales (= $450,000 ÷ $600,000). Thus 75 percent of all allocated fixed costs are assigned to the
gas barbecues product line. This amounts to $90,000 (= $120,000 × 0.75).

Question: Will dropping the charcoal barbecues product line result in higher company profit?

Answer: The differential analysis presented in Figure 7.6 "Product Line Differential Analysis
for Barbeque Company" provides the answer. Panel A shows the income statement for
Alternative 1: keeping all three product lines. Panel B shows the income statement for
Alternative 2: dropping the charcoal barbecues product line. And panel C presents the
differential analysis for the two alternatives. The differential analysis in panel C shows that
overall profit will decrease by $10,000 if the charcoal barbecue product line is dropped.

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 Figure 7.6 Product Line Differential Analysis for Barbeque Company

 
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 a $105,882 = ($450,000 ÷ $510,000) × $120,000.
b $14,118 = ($60,000 ÷ $510,000) × $120,000.

The Differential Amount column in panel C of Figure 7.6 "Product Line Differential Analysis for
Barbeque Company" indicates the company would be better off continuing with all three product
lines. However, management may want a more concise explanation of why profit is $10,000
higher when all three product lines are maintained. We provide such an explanation inFigure 7.7
"Summary of Differential Analysis for Barbeque Company", which presents the Differential
Amount column shown in panel C of Figure 7.6 "Product Line Differential Analysis for
Barbeque Company" along with a brief description for each item. Take a close look at panel C
of Figure 7.6 "Product Line Differential Analysis for Barbeque Company", confirm that
the Differential Amount column matches Figure 7.7 "Summary of Differential Analysis for
Barbeque Company", and review the explanation of the difference.

Figure 7.7 Summary of Differential Analysis for Barbeque Company

Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts

without parentheses indicate a positive impact on profit.

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 Figure 7.7 "Summary of Differential Analysis for Barbeque Company" shows that Barbeque
Company will lose sales revenue of $90,000 if it drops the charcoal barbecues product line.
However, it saves variable costs of $40,000 and direct fixed costs of $40,000 if it drops the
charcoal barbecues product line. Because the $80,000 in cost savings is not enough to make up
for the $90,000 loss in sales revenue, profit will decline by $10,000 (= $80,000 − $90,000).

Misleading Allocation of Fixed Costs

Question: How can the charcoal barbecues product line show a loss of $8,000 in Figure 7.6
"Product Line Differential Analysis for Barbeque Company", while the company as a whole is
better off keeping this product line?

Answer: The answer lies within allocated fixed costs. Even though total allocated fixed costs of
$120,000 cannot easily be traced to each product line, company management wants each product
line manager to be aware of these costs. As a result, it uses an allocation process to assign the
costs to product lines. Thus the charcoal barbecues product line is assigned $18,000 in allocated
fixed costs even though these costs cannot be controlled by the product line. If the charcoal
barbecues product line is eliminated, $18,000 in allocated fixed costs is not eliminated. Instead,
$18,000 in costs is assigned to the other two product lines.

In many situations, this increased allocation to other product lines may cause other product lines
to appear unprofitable. The message here is to be careful when analyzing segmented information
containing cost allocations. Allocated costs are typically not differential costs, and therefore are
typically not relevant to the decision.

An alternative view of the decision facing Barbeque Company—whether to keep or drop the
charcoal barbecues product line—is simply to calculate profitability of this product
line before deducting allocated fixed costs. Figure 7.6 "Product Line Differential Analysis for
Barbeque Company" shows a contribution margin of $50,000 for charcoal barbecues. Deduct

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 direct fixed costs of $40,000 and this product line has a remaining profit of $10,000. This
explains why Barbeque Company’s overall profit would be $10,000 lower if the charcoal
barbecues product line were eliminated. (As discussed previously, the allocated fixed costs are
irrelevant to this decision.)

Including Opportunity Costs in Differential Analysis

Managers must often consider the impact of opportunity costs when making decisions.
An opportunity cost is the benefit foregone when one alternative is selected over another. For
example, assume you have the choice between going to school and working. The opportunity
cost of attending school is the lost wages from working.

Question: In the case of Barbeque Company, assume the company can lease the space currently
being used by the charcoal barbecues product line for $25,000 per year. Thus the opportunity
cost (benefit foregone) of keeping the charcoal barbecues is $25,000. How does this affect
Barbeque Company’s decision to keep or drop charcoal barbecues?

Answer: Figure 7.8 "Differential Analysis with Opportunity Cost for Barbeque
Company" provides the answer by simply adding one item toFigure 7.7 "Summary of
Differential Analysis for Barbeque Company". Barbeque Company would increase profits
$15,000 by dropping the charcoal barbecues.

Figure 7.8 Differential Analysis with Opportunity Cost for Barbeque Company

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Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a

positive impact on profit.

Opportunity costs can also be included in the differential analysis format presented in Figure 7.6
"Product Line Differential Analysis for Barbeque Company". Panel C of Figure 7.6 "Product
Line Differential Analysis for Barbeque Company" is simply modified to reflect the opportunity
cost, as shown.

Sunk Costs and Differential Analysis

Question: What is a sunk cost, and how do sunk costs affect differential analysis?

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 Answer: A sunk cost is a cost incurred in the past that cannot be changed by future decisions.
For example, suppose Barbeque Company must dispose of store equipment related to the
charcoal barbecues product line if charcoal barbecues are eliminated. The original cost of this
store equipment is a sunk cost and should have no bearing on the decision whether to eliminate
charcoal barbecues. As a general rule, sunk costs are not differential costs.

Business  in  Action  7.2  

Source: Photo courtesy of Paul Sableman,http://www.flickr.com/photos/pasa/5583935536/.

Kmart Sells Stores

The management of Kmart Corp., a mass merchandising company with more than 1,500 stores throughout the United

States, agreed to sell 24 stores to Home Depot for $365 million in cash. Julian Day,Kmart’s president and chief executive

officer, stated, “We will take advantage of opportunities to create value that include the sale of existing stores.”

In deciding whether to sell the stores, management likely considered the differential revenues and costs associated with

keeping the stores versus selling them. Perhaps the stores were not profitable enough to exceed the $365 million in cash

that Kmart received from the sale. Large retail companies with many widely dispersed stores commonly review their

unprofitable stores on a regular basis and consider closing or selling stores that cannot turn a profit in the near future.

Source: Kmart Corp. press release, June 4, 2004 (http://www.kmartcorp.com).

K E Y   T A K E A W A Y  

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 • Managers  often  use  differential  analysis  to  determine  whether  to  keep  or  drop  a  product  line.  Direct  fixed  costs  are  typically  

eliminated  if  a  product  line  is  eliminated,  and  are  considered  differential  costs.  Allocated  fixed  costs  are  typically  not  

eliminated  if  a  product  line  is  eliminated,  and  are  not  differential  costs.  Managers  compare  sales  revenue  and  costs  for  each  

alternative  (keep  or  drop),  and  select  the  alternative  with  the  highest  profit.  
R E V I E W   P R O B L E M   7 . 3  

The  following  annual  income  statement  is  for  Austin  Appliances,  Inc.,  a  maker  of  electrical  appliances:  

Austin  Appliances  is  concerned  about  the  losses  associated  with  the  blenders  product  line  and  is  considering  dropping  this  

product  line.  Allocated  fixed  costs  are  assigned  to  product  lines  based  on  sales.  For  example,  $56,250  in  allocated  fixed  costs  is  

allocated  to  the  blenders  product  line  based  on  the  blenders  product  line  sales  as  a  percent  of  total  sales  [$56,250  =  $150,000  

×  ($750,000  ÷  $2,000,000)].  If  Austin  Appliances  eliminates  a  product  line,  total  allocated  fixed  costs  are  assigned  to  the  

remaining  product  lines.  All  variable  costs  and  direct  fixed  costs  are  differential  costs.  

1. Using  the  differential  analysis  format  presented  in  Figure  7.6  "Product  Line  Differential  Analysis  for  Barbeque  Company",  

determine  whether  Austin  Appliances  would  be  better  off  dropping  the  blenders  product  line  or  keeping  the  product  line.  

Support  your  conclusion.  

2. Assume  Austin  Appliances  can  lease  the  warehouse  space  currently  being  used  by  the  blenders  product  line  for  $15,000  per  

year.  How  does  this  affect  the  company’s  decision  to  keep  or  drop  the  blenders  product  line?  

3. Summarize  the  result  of  dropping  the  blenders  product  line  and  leasing  the  warehouse  space  using  the  format  presented  

in  Figure  7.8  "Differential  Analysis  with  Opportunity  Cost  for  Barbeque  Company".  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Solution  to  Review  Problem  7.3  

1. As  shown  in  the  differential  analysis  given  here,  Austin  Appliances  would  be  better  off  keeping  the  blenders  product  

line.  Dropping  this  product  line  would  result  in  a  drop  in  total  profit  of  $40,000.  

a
 $120,000  =  ($1,000,000  ÷  $1,250,000)  ×  $150,000.  

b
 $30,000  =  ($250,000  ÷  $1,250,000)  ×  $150,000.  

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 2. The  $15,000  opportunity  cost  of  keeping  all  three  product  lines  would  not  affect  the  company’s  decision  to  keep  the  

blenders  product  line.  If  the  blenders  are  dropped,  total  profit  will  decrease  by  $40,000.  Lease  revenue  of  $15,000  is  

not  enough  to  offset  the  $40,000  decrease  in  profit.  In  this  scenario,  total  profit  would  decrease  by  $25,000  (=  $40,000  

−  $15,000).  This  result  is  presented  formally,  as  follows:  

3.    

Note:  Amounts  shown  in  parentheses  indicate  a  negative  impact  on  profit,  and  amounts  without  parentheses  indicate  a  positive  impact  

on  profit.  

7.4 Customer Decisions

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 L E A R N I N G   O B J E C T I V E  

1. Use  differential  analysis  to  decide  whether  to  keep  or  drop  customers.  

Question: Much like product line decisions, managers often use profitability as a determining
factor to decide whether to keep or drop customers. This is an issue for all types of
organizations, including manufacturers, retailers, and service companies. How does the
differential analysis format differ for customer decisions compared to product line decisions?

Answer: Instead of tracing revenues, variable costs, and fixed costs directly to product lines, we
track this information by customer. Fixed costs that cannot be traced directly to customers are
allocated to customers. Let’s look at an example for a company called Colony Landscape
Maintenance to identify the similarities and differences between the two formats.

Evaluating Customer Information

Question: Colony Landscape Maintenance provides services to three large customers:

Brumfield, Hodges, and Orth. The segmented income statement inFigure 7.9 "Income Statement
for Colony Landscape Maintenance" provides annual revenue and cost information by customer.
Notice that this information is formatted similarly to the product line information in Figure 7.8
"Differential Analysis with Opportunity Cost for Barbeque Company". However, instead of
tracking information by product line, here we track information by customer. Examine Figure 7.9
"Income Statement for Colony Landscape Maintenance"carefully and notice that the Brumfield
account shows a loss for the year of $15,000. Should Colony Landscape Maintenance drop the
Brumfield account?

Answer: To answer this question we must take a closer look at the information in Figure 7.9
"Income Statement for Colony Landscape Maintenance". The variable costs and direct fixed
costs are related directly to each customer, and thus are eliminated if Colony eliminates the
Brumfield account. That is, all variable costs and direct fixed costs are differential costs for the
two alternatives facing Colony. Colony assigns the allocated fixed costs of $20,000 to Brumfield

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 based on sales revenue, and those costs will continue regardless of Colony’s decision. Thus
allocated fixed costs are not differential costs.

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 Figure 7.9 Income Statement for Colony Landscape Maintenance

 
Management of Colony Landscape Maintenance would like to know if dropping the Brumfield
account would increase overall company profit. The differential analysis presented in Figure 7.10
"Customer Differential Analysis for Colony Landscape Maintenance" provides the answer. Panel
A shows the income statement for Alternative 1: keeping all three customers. Panel B shows the
income statement for Alternative 2: dropping the Brumfield account. And panel C presents the
differential analysis for both alternatives. The differential analysis presented in panel C shows
that overall profit will decrease by $5,000 if Colony drops the Brumfield account.

Figure 7.10 Customer Differential Analysis for Colony Landscape Maintenance

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a $62,500 = ($500,000 ÷ $800,000) × $100,000.

b $37,500 = ($300,000 ÷ $800,000) × $100,000.

Figure 7.11 "Keep or Drop Customer" provides a bar chart summarizing how total profit will
decrease if the Brumfield account is dropped. This information comes from the bottom of panels
A and B in Figure 7.10 "Customer Differential Analysis for Colony Landscape Maintenance".

Figure 7.11 Keep or Drop Customer

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We show a more concise explanation in Figure 7.12 "Summary of Differential Analysis for
Colony Landscape Maintenance", which presents the Differential Amount column shown in
panel C of Figure 7.10 "Customer Differential Analysis for Colony Landscape
Maintenance" along with a brief description of each item.

Figure 7.12 Summary of Differential Analysis for Colony Landscape Maintenance

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Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without
parentheses indicate a positive impact on profit.

An alternative way of handling the decision facing Colony Landscape Maintenance is simply to
calculate profitability of the Brumfield accountbefore deducting allocated fixed costs. Figure
7.12 "Summary of Differential Analysis for Colony Landscape Maintenance" shows a
contribution margin of $30,000 for the Brumfield account. Deduct direct fixed costs of $25,000
and the customer has a remaining profit of $5,000. This explains why Colony’s overall profit
would be $5,000 lower if it eliminated the Brumfield account.

Business  in  Action  7.3  

Engineering Firm Fires Its Biggest Customer
The president of ABCO Automation, Inc., a 120-person engineering firm in North
Carolina, decided it was time to fire the firm’s biggest client. Although the client
provided close to 60 percent of the firm’s annual revenue, ABCO decided that firing this
client was necessary. The president of ABCO stated, “We cannot be a great place to
work without employees, and this client was bullying my employees. Its demands for
turnaround were impossible to meet even with people working seven days a week. No
client is worth losing my valued employees.”

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 The initial impact on revenues was significant. However, ABCO was able to cut costs
and obtain new customers to fill the void. In addition, the fired client later
gave ABCO two new projects on more equitable terms.
The lesson from this is that dropping customers is not always a financial
decision. ABCO’s client was profitable, but in the long run, the firm was at risk of losing
valuable employees. This was a risk ABCO was not willing to take.
Source: Roger Herman and Joyce Gioia, “Herman Trend Alert,” Strategic Business
Futurists 2004 (http://www.hermangroup.com).

Using Activity-Based Costing to Assess Customer Profitability

Question: Activity-based costing, which we discussed in Chapter 3 "How Does an Organization

Use Activity-Based Costing to Allocate Overhead Costs?", is a refined approach to allocating
costs to products or customers. Activity-based costing first assigns costs to activities and then to
products or customers based on their use of the activities. The cost information provided by
activity-based costing is generally regarded as more accurate than most traditional costing
methods. How can using activity-based costing information with differential analysis lead to
better decisions in areas such as product lines and customer profitability?

Answer: Let’s look at a brief example of how activity-based costing can help with customer
profitability. When assessing customer profitability, costs can be assigned to customers based on
each customer’s use of activities. Consultants from PricewaterhouseCoopers suggest that
customer costs are measurable across four categories of activities: [1]

• Cost to acquire customers: Consists of activities such as advertising and promotional

materials.
• Cost to provide goods and services: Consists of activities such as processing customer
orders and delivering goods.
• Cost to serve customers: Consists of activities such as technical support and processing
customer payments.
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 • Cost to retain customers: Consists of activities such as offering discounts and building
relationships.
• With the help of activity-based costing, costs can be assigned to activities within each
category. These costs are then allocated to customers based on each customer’s use of
activities. A significant advantage of using activity-based costing is having accurate data
for decision-making purposes, particularly in the area of differential analysis.

K E Y   T A K E A W A Y  

• Managers  use  differential  analysis  to  determine  whether  to  keep  or  drop  a  customer.  
The  format  is  similar  to  the  differential  analysis  format  used  for  making  product  line  
decisions.  However,  sales  revenue,  variable  costs,  and  fixed  costs  are  traced  directly  
to  customers  rather  than  to  product  lines.  
R E V I E W   P R O B L E M   7 . 4  

The  following  annual  income  statement  is  for  Tatum  &  Associates,  a  firm  that  
provides  legal  services  to  its  customers.  

 
Tatum  &  Associates  is  concerned  about  the  losses  associated  with  the  Elko  
Corporation  account  and  is  considering  dropping  this  customer.  Allocated  fixed  costs  
are  assigned  to  customers  based  on  sales.  For  example,  $105,000  in  allocated  fixed  
costs  is  assigned  to  Elko  based  on  this  customer’s  sales  as  a  percent  of  total  sales  
[$105,000  =  $300,000  ×  ($1,050,000  ÷  $3,000,000)].  If  a  customer  is  dropped,  total  

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 allocated  fixed  costs  are  assigned  to  the  remaining  customers.  All  variable  costs  and  
direct  fixed  costs  are  differential  costs.  
1. Using  the  differential  analysis  format  presented  in  Figure  7.10  "Customer  Differential  
Analysis  for  Colony  Landscape  Maintenance",  determine  whether  Tatum  &  Associates  
would  be  better  off  dropping  the  Elko  Corporation  account  or  keeping  the  account.  
Explain  your  conclusion.  
2. Summarize  the  result  of  dropping  the  Elko  Corporation  account  using  the  differential  
analysis  format  presented  in  Figure  7.12  "Summary  of  Differential  Analysis  for  Colony  
Landscape  Maintenance".  

Solution  to  Review  Problem  7.4  

1. As  shown  in  the  differential  analysis  provided,  Tatum  &  Associates  would  be  
better  off  dropping  the  Elko  Corporation  account.  Profit  is  $5,000  lower  if  
the  Elko  account  is  retained.  

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a
 $184,615  rounded  =  ($1,200,000  ÷  $1,950,000)  ×  $300,000.  
b
 $115,385  rounded  =  ($750,000  ÷  $1,950,000)  ×  $300,000.  

2.    

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 Note:  Amounts  shown  in  parentheses  indicate  a  negative  impact  on  profit,  
and  amounts  without  parentheses  indicate  a  positive  impact  on  profit.  

[1]  Joseph  A.  Ness,  Michael  J.  Schroeck,  Rick  A.  Letendre,  and  Willmar  J.  Douglas,“The  Role  of  ABM  in  Measuring  Customer  Value—Part  2,”  Strategic  
Finance  (April  2001):  44–49.  

7.5 Review of Cost Terms Used in Differential Analysis

L E A R N I N G   O B J E C T I V E  

1. Understand  cost  terms  used  in  differential  analysis.  

Question: We’ve introduced many new terms in this chapter. What are these important terms,
and how do they relate to differential analysis?

Answer: The important terms introduced in this chapter are outlined here:

Differential analysis requires that we consider all differential revenues and costs—costs that
differ from one alternative to another—when deciding between alternative courses of
action. Avoidable costs—costs that can be avoided by selecting a particular course of action—
are always differential costs and must be considered when deciding between alternative courses
of action.

Opportunity costs—the benefits foregone when one alternative is selected over another—are
differential costs, and must be included when performing differential analysis. Sunk costs—costs
incurred in the past that cannot be changed by future decisions—are not differential costs
because they cannot be changed by future decisions.

Direct fixed costs—fixed costs that can be traced directly to a product line or customer—are
differential costs and therefore pertinent to making decisions. However, we must review these
costs on a case-by-case basis because some direct fixed costs may not be considered differential
in spite of being traced directly to a product line. For example, a five-year lease on a warehouse

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 used solely for one product line is a direct fixed cost but not a differential cost because the costs
will continue even if the product line is eliminated.

Allocated fixed costs—fixed costs that cannot be traced directly to a product—are

typically not differential costs. For example, if a product line is eliminated, these costs are simply
allocated to the remaining product lines.

K E Y   T A K E A W A Y  

• When  deciding  between  alternatives,  only  those  revenues  and  costs  that  differ  from  one  alternative  course  of  action  to  another  are  relevant.  

Avoidable  costs,  opportunity  costs,  and  direct  fixed  costs  typically  fall  into  this  category.  Revenues  and  costs  that  do  not  differ  from  one  

alternative  course  of  action  to  another  are  irrelevant  to  the  decision.  
R E V I E W   P R O B L E M   7 . 5  

Match  each  of  the  following  terms  with  the  appropriate  definition  in  the  list  given.  

1. Differential  analysis  

2. Differential  revenues  and  costs  

3. Avoidable  costs  

4. Sunk  costs  

5. Direct  fixed  costs  

6. Allocated  fixed  costs  

7. Opportunity  costs  

a. The  benefits  forgone  when  one  alternative  is  selected  over  another.  

b. Fixed  costs  that  can  be  traced  directly  to  a  product  line.  

c. Revenues  and  costs  that  differ  from  one  alternative  to  another.  

d. Costs  incurred  in  the  past  that  cannot  be  changed  by  future  decisions.  

e. Costs  that  can  be  avoided  by  selecting  a  particular  course  of  action.  

f. Fixed  costs  that  cannot  be  traced  directly  to  a  product  line.  

g. Analyzing  the  difference  in  revenues  and  costs  from  one  alternative  course  of  action  to  another.  

Solution  to  Review  Problem  7.5  

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 1. g  

2. c  

3. e  

4. d  

5. b  

6. f  

7. a  

7.6 Special Order Decisions

L E A R N I N G   O B J E C T I V E  

1. Use  differential  analysis  for  special  order  decisions.  

Question: We have already learned that managers use differential analysis for make-or-buy
decisions, product line decisions, and customer decisions. Differential analysis also provides a
format that helps managers decide whether to accept special orders made by customers. What is
a special order, and how can differential analysis be used to make a special order decision?

Answer: A special order is a unique one-time order made by a customer. Differential analysis
provides a format that helps managers decide whether to accept or reject special orders, as shown
in the example that follows.

Special Order Considerations

Assume Tony’s T-shirts makes shirts for local soccer, baseball, basketball, and other sports
teams. The owner, Tony, purchases the shirts and prints graphics on the shirts for each team. The
graphics were designed several years ago, so design costs are no longer incurred. On average,
Tony sells 1,000 shirts each month. Typical monthly financial data follow:

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The monthly information provided relates to the company’s routine monthly operations. A
representative of the local high school recently approached Tony to ask about a one-time special
order. The high school will be hosting a statewide track and field event and is willing to pay
Tony’s T-shirts $17 per shirt to make 200 custom T-shirts for the event. Because enough idle
capacity exists to handle this order, it will not affect other sales. That is, Tony has the factory
space and machinery available to produce more T-shirts.

Tony incurs the same variable costs of $13 per unit to produce the special order, and he will pay
a firm $600 to design the graphics that will be printed on the shirts. This special order will have
no other effect on Tony’s monthly fixed costs.

Question: Should Tony accept the special order?

Answer: Let’s use differential analysis to answer this question. As shown in , Alternative 1
assumes Tony rejects the special order, and Alternative 2 assumes he accepts the special order.
The differential analysis in shows that Tony’s would be better off accepting the special order, as
profit increases $200.

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 Figure 7.13 Special Order Differential Analysis for Tony’s T-Shirts

 
a $23,400 = $20,000 + ($17 per shirt × 200 shirts).

b $15,600 = $13,000 + ($13 × 200 shirts).

c $4,600 = $4,000 + $600 cost for special order design.

Provides an alternative presentation of differential analysis for Tony’s T-shirts. As discussed

earlier in the chapter, this presentation summarizes the differential revenues and costs.

Figure 7.14 Summary of Differential Analysis for Tony’s T-Shirts

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 Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without
parentheses indicate a positive impact on profit.

Shows the differential revenues and costs for the special order being considered. If Tony’s T-
shirts accepts the special order, sales revenue will increase $3,400 with a corresponding increase
in variable costs of $2,600. Fixed costs will increase by $600 because design work is required for
the special order. Thus profit will increase by $200 (= $3,400 − $2,600 − $600).

Special Order Assumptions

Question: What assumptions were made with the differential analysis performed for Tony’s T-
shirts?

Answer: We made two important assumptions in the Tony’s T-shirts special order example. The
first assumption is that Tony’s has enough idle capacity to handle the order without disrupting
regular customer orders. Suppose Tony’s T-shirts is operating at capacity and cannot produce
any more T-shirts. Tony must turn away regular customers to make room for the special order. In
this scenario, the opportunity cost of turning away existing customers must be considered in the
differential analysis.

The second assumption is that this is a one-time order, and therefore represents a short-run
pricing decision. If Tony’s T-shirts expects future orders from the high school at the $17 per shirt
price, the company must consider the impact this might have on long-run pricing with other
customers. That is, regular customers may hear of this special price and demand the same price,
particularly those customers who have been loyal to Tony’s T-shirts for many years. Tony’s
might be forced to lower prices for regular customers, thereby eroding the company’s profits
over time. The key point is that companies evaluating special orders can drop prices in the short
run to cover differential variable and fixed costs. But in the long run, prices must cover all
variable and fixed costs.

Computer  Application  

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 Using Excel to Perform Differential Analysis
Managers often perform differential analysis with the help of computer software for
several reasons:
• Once the format is established, the template can be used repeatedly for different
scenarios.
• Formulas underlie all calculations, thereby minimizing the potential for math errors and
speeding up the process.
• Changes can be made easily without having to redo the entire analysis.
An example of how to use Excel to perform differential analysis for the special order
scenario presented in is shown here. Although many accounting courses do not require
the use of computer spreadsheets, you are encouraged to use spreadsheet software like
Excel when preparing homework or working review problems.

K E Y   T A K E A W A Y  

• Managers  often  use  differential  analysis  to  decide  whether  to  accept  a  special  one-­‐
time  order  made  by  a  customer.  Managers  compare  sales  revenue  and  costs  for  each  
alternative  (accept  or  reject  the  special  order),  and  select  the  alternative  with  the  
highest  profit.  Organizations  must  be  careful  to  consider  the  long-­‐run  implications  of  
reducing  prices  for  special  orders.  
R E V I E W   P R O B L E M   7 . 6  

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 The  following  monthly  financial  data  are  for  Quicko’s,  a  company  that  makes  
photocopies  for  its  customers.  On  average,  Quicko’s  makes  100,000  copies  each  
month.  

 
Quicko’s  is  approached  by  a  local  restaurant  that  would  like  to  have  20,000  flyers  
copied.  The  restaurant  asks  Quicko’s  to  produce  the  flyers  for  7  cents  a  copy  rather  
than  the  standard  price  of  8  cents.  Quicko’s  can  produce  up  to  130,000  copies  a  
month,  so  the  special  order  will  not  affect  regular  customer  sales.  Variable  costs  per  
copy  will  remain  at  5  cents,  but  production  of  the  restaurant  flyers  will  require  a  
special  copy  machine  part  that  costs  $250.  This  special  order  will  have  no  other  effect  
on  monthly  fixed  costs.  
1. Using  the  differential  analysis  format  presented  in  ,  determine  whether  Quicko’s  
would  be  better  off  accepting  or  rejecting  the  special  order.  
2. Summarize  the  result  of  accepting  the  special  order  using  the  format  presented  in  .  
3. Assume  Quicko’s  can  only  produce  100,000  copies  per  month,  and  that  regular  
customer  sales  would  decrease  as  a  result  of  the  special  order.  Using  the  differential  
analysis  format  presented  in  ,  determine  whether  Quicko’s  would  be  better  off  
accepting  or  rejecting  the  special  order.  

Solution  to  Review  Problem  7.6  

1.    
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a
 $9,400  =  $8,000  +  ($0.07  per  copy  ×  20,000  copies);or  alternative  
approach:  ($0.08  per  copy  ×  100,000  copies)  +  ($0.07  per  copy  ×  20,000  
copies).  
b
 $6,000  =  $5,000  +  ($0.05  per  copy  ×  20,000  copies);  or  alternative  
approach:  $0.05  ×  120,000  copies.  
c
 $2,250  =  $2,000  +  $250  cost  for  copy  machine  part.  

This  analysis  shows  that  Quicko’s  would  be  better  off  accepting  the  special  
order  because  profit  is  $150  higher  for  Alternative  2.  

2.    

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 Note:  Amounts  shown  in  parentheses  indicate  a  negative  impact  on  profit,  
and  amounts  without  parentheses  indicate  a  positive  impact  on  profit.  

3. Assuming  Quicko’s  has  a  capacity  of  100,000  copies  per  month,  the  analysis  
shows  the  company  would  be  better  off  rejecting  the  special  order  because  
profit  is  $450  higher  for  this  alternative.  

 
a
 $7,800  =  ($0.08  ×  80,000  regular  customer  copies)  +  ($0.07  ×  20,000  
special  order  copies).  
b
 $2,250  =  $2,000  +  $250  cost  for  copy  machine  part.  

7.7 Cost-Plus Pricing and Target Costing

L E A R N I N G   O B J E C T I V E  

1. Understand  how  to  use  cost-­‐plus  pricing  and  target  costing  to  establish  prices.  

The previous section focuses on using differential analysis to assess pricing for special orders.
Organizations also use other approaches to establish prices, such as cost-plus pricing and target
costing. We cover these two approaches next.

Cost-Plus Pricing

Questions: Companies that produce custom products, such as homes or landscaping for
commercial buildings, often have a difficult time determining a reasonable market price. Prices

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 for these products can be determined using cost-plus pricing. How is cost-plus pricing used to
arrive at a reasonable price?

Answer: Cost-plus pricing starts with an estimate of the costs incurred to build a product or
provide a service, and a certain profit percentage is added to establish the price. For example, a
defense contractor working with the government assumes the cost to build a new fighter jet is
$60 million. As there is no open market price for this product, the contractor must come up with
an approach to establishing the price that does not rely on market pricing. Based on industry-
wide standards and negotiations with the government, the contractor requests a 10 percent
markup on cost. If the government accepts this proposal, the contractor will receive $66 million
for each plane delivered [$66 million = $60 million + ($60 million × 10 percent)].

The concept of cost-plus pricing sounds simple. However, the difficulty is in determining which
costs should be included. Are only variable product costs included? Should fixed manufacturing
overhead be included? What about selling costs? The answers to these questions depend on the
negotiations between buyer and seller, and should be clearly defined in the agreement. When
using cost-plus pricing, it is important to establish in advance which costs are to be included for
pricing purposes.

Target Costing

Question: Organizations are constantly trying to find ways to become more efficient and reduce
costs. However, once manufacturing firms design a product and begin production, it is difficult
to make significant changes that will reduce costs. How can target costing help with this issue?

Answer: Target costing is an approach that mitigates cost efficiency problems associated with
introducing new products by integrating the product design, desired price, desired profit, and
desired cost into one process beginning at the product development stage. Target costing has four
steps:

Step 1. Design a product that provides the features and price demanded by customers.

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 Step 2. Determine the company’s desired profit.

Step 3. Derive the target cost by subtracting the desired profit (from step 2) from the
desired price (from step 1).

Step 4. Engineer the product to achieve the target cost (from step 3). If the desired target
cost cannot be achieved, the company must go back to step 1 and reevaluate the features
and price.

For example, suppose Hewlett-Packard designs a laser printer with features that customers have
requested and wants to sell it for $240; this is Step 1. Management requires a profit equal to 40
percent of the selling price, or $96 (= $240 × 40 percent); this is Step 2. The target cost is $144
(= $240 − $96); this is Step 3. The product engineers must now design this product in detail to
achieve or beat the target cost of $144; this is Step 4.

K E Y   T A K E A W A Y  

• Cost-­‐plus  pricing  starts  with  an  estimate  of  the  costs  incurred  to  build  a  product,  and  
a  certain  profit  percentage  is  added  to  establish  the  price.  Companies  often  use  this  
method  when  it  is  difficult  to  determine  a  reasonable  market  price.  Target  costing  
integrates  the  product  design,  desired  price,  desired  profit,  and  desired  cost  into  one  
process  beginning  at  the  product  development  stage.  
R E V I E W   P R O B L E M   7 . 7  

Suppose  Nike,  Inc.,  has  developed  a  new  shoe  that  can  be  sold  for  $140  a  pair.  
Management  requires  a  profit  equal  to  60  percent  of  the  selling  price.  Determine  the  
target  cost  of  this  product.  

Solution  to  Review  Problem  7.7  

The  target  cost  of  $56  is  found  by  subtracting  the  target  profit  from  the  target  selling  
price.  This  calculation  is  as  follows.  
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7.8 Identifying and Managing Bottlenecks

L E A R N I N G   O B J E C T I V E  

1. Understand  the  theory  of  constraints.  

Question: As we noted in , many companies have limited resources in such areas as labor hours,
machine hours, facilities, and materials. These constraints will likely affect a company’s ability
to produce goods or provide services. Companies facing constraints often use a variation of
differential analysis to optimize the use of constrained resources called the theory of
constraints. What are constrained resources, and how does the theory of constraints help
managers make better use of these resources?

Answer: Constrained resources are often referred to as bottlenecks. Abottleneck is a process in

which the work to be performed exceeds available capacity. The theory of constraints is a
recently developed approach to managing bottlenecks.

We will look at an example to help explain how the theory of constraints works. Assume
Computers, Inc., produces desktop computers using six departments as shown in . Computers are
assembled in departments 1, 2, and 3 and are then sent to department 4 for quality testing. Once
testing is complete, products are packaged in department 5. Department 6 is responsible for
shipping the products.

Question: The theory of constraints provides five steps to help managers make efficient use of
constrained resources. What are these five steps, and how will they help Computers, Inc.?

Answer: The five steps are described here, with a narrative indicating how Computers, Inc.,
would utilize each step.

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 Step 1. Find the constrained resource (bottleneck).

In this step, the process that limits production is identified. The management at Computers, Inc.,
has identified department 4, quality testing, as the bottleneck because assembled computers are
backing up at department 4. Quality testing cannot be performed fast enough to keep up with the
inflow of computers coming from departments 1, 2, and 3. A limitation of labor hours available
to perform testing is causing this backlog.

Step 2. Optimize the use of the constrained resource.

The constrained resource has been identified as the number of labor hours available to perform
testing. At this point, Computers, Inc., would like to optimize the labor hours used for quality
testing. To assist in this goal, we will calculate the contribution margin per unit of constraint (the
unit of constraint is labor hour in this example). Production will then focus on products with the
highest contribution margin per labor hour. provides this information for each product. (We first
introduced the concept of calculating a contribution margin per unit of constraint in .)

Figure 7.16 Contribution Margin per Unit of Constrained Resource for Computers, Inc.

 
Based on the information presented in , and given that labor hours in department 4 is the
constraint, Computers, Inc., would optimize the use of labor hours by producing the S150 model
because it provides a contribution margin of $800 per labor hour versus $500 for the A100
model, and $625 for the P120 model.

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 Step 3. Subordinate all nonbottleneck resources to the bottleneck.

The goal in this step is to shift nonbottleneck resources to the bottleneck in department 4. At this
point, improving efficiencies in other departments does little to alleviate the bottleneck in
department 4. Thus Computers, Inc., must try to move resources from other areas to department
4 to reduce the backlog of computers to be tested.

Step 4. Increase bottleneck efficiency and capacity.

Management’s goal is to loosen the constraint by providing more labor hours to department 4.
For example, management may decide to move employees from departments 1, 2, and 3 to the
quality testing department. Another option is to authorize overtime for the workers in department
4. Perhaps management will consider hiring additional workers for department 4.

Step 5. Repeat steps 1 through 4 for the new bottleneck.

Once the bottleneck in department 4 is relieved, a new bottleneck will likely arise elsewhere.
Going back to step 1 requires management to identify the new bottleneck and follow steps 2
through 4 to alleviate the bottleneck.

K E Y   T A K E A W A Y  

• Most  companies  have  limited  resources  in  areas  such  as  labor  hours,  machine  hours,  
facilities,  and  materials.  The  theory  of  constraints  is  an  approach  that  enables  
companies  to  optimize  the  use  of  limited  resources.  Five  steps  are  involved.  First,  find  
the  constrained  resource  (or  bottleneck).  Second,  optimize  the  use  of  the  constrained  
resource.  Third,  subordinate  all  nonbottleneck  resources  to  the  bottleneck.  Fourth,  
increase  bottleneck  efficiency  and  capacity.  Fifth,  repeat  the  first  four  steps  for  the  
new  bottleneck.  
R E V I E W   P R O B L E M   7 . 8  

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 Southside  Company  produces  three  types  of  baseball  gloves:  child,  teen,  and  adult.  
The  gloves  are  produced  in  separate  departments  and  sent  to  the  quality  testing  
department  before  being  packaged  and  shipped.  A  machine-­‐hour  bottleneck  has  
been  identified  in  the  quality  testing  department.  Southside  would  like  to  optimize  its  
use  of  machine  hours  (step  2)  by  producing  the  two  most  profitable  gloves.  The  
machine  hours  required  for  each  glove  follow:  
Child glove 0.25 machine hours

Teen glove 0.40 machine hours

Adult glove 0.50 machine hours

Price  and  variable  cost  information  is  as  follows:  

Price Variable Cost

Child glove $15 $5

Teen glove 20 8

Adult glove 35 22

1. Calculate  the  contribution  margin  per  unit  of  constrained  resource  for  each  glove.  
2. Which  two  gloves  would  Southside  prefer  to  produce  and  sell  to  optimize  the  use  of  
machine  hours  in  the  quality  testing  department?  

Solution  to  Review  Problem  7.8  

1.    

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2. The  company  would  prefer  to  produce  and  sell  the  child  and  teen  gloves,  since  these  
products  have  the  highest  contribution  margin  per  machine  hour.  

7.9 Be Aware of Qualitative Factors

L E A R N I N G   O B J E C T I V E  

1. Evaluate  qualitative  factors  when  using  differential  analysis.  

Question: This chapter has focused on using relevant revenue and cost information to perform
differential analysis. Using these quantitative factors to make decisions allows managers to
support decisions with measurable data. For example, the idea of outsourcing production of
wakeboards at Best Boards, Inc., presented at the beginning of the chapter, was rejected because
it was more costly to outsource production of the boards than to produce them internally.
Although using quantitative factors for decision making is important, management must also
consider qualitative factors. How might the consideration of qualitative factors improve
decisions made by managers?

Answer: Qualitative factors may outweigh the quantitative factors in making a decision. For
example, assume management at Best Boards, Inc., believes there will be a decline in the market
for wakeboards after next year. Outsourcing production makes it easier to quickly reduce costs in
the face of a downturn by simply ordering fewer wakeboards from the supplier. Continuing to
build the boards internally takes away this flexibility. The significant fixed costs often associated
with manufacturing firms are difficult to reduce in the short run if production declines. Thus the
qualitative factor of being able to reduce manufacturing costs quickly by outsourcing production
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 may outweigh the quantitative factors shown inFigure 7.3 "Summary of Differential Analysis for
Best Boards, Inc." andFigure 7.4 "Product Line Decision".

Question: What if the quantitative differential analysis for Best Boards had a different result, in
that it showed the company should outsource? What qualitative factors should management
consider before implementing this decision?

Answer: Management must consider whether product quality would remain the same. Financial
stability of the producer must be considered as well. It does no good to outsource production and
eliminate production facilities and employees if the producer being used suddenly shuts down.
Also, employee morale tends to slide if employees in one segment of a company are fired. This
can lead to an unhappy and inefficient workforce in other areas of the company, causing costs to
rise. These are just a few of the qualitative factors that must be weighed against quantitative
factors when performing differential analysis.

K E Y   T A K E A W A Y  

• Although  accountants  are  responsible  for  providing  relevant  and  objective  financial  
information  to  help  managers  make  decisions,  qualitative  factors  also  play  a  
significant  role  in  the  decision-­‐making  process.  
R E V I E W   P R O B L E M   7 . 9  

What  qualitative  factors  should  management  consider  when  deciding  whether  to  
outsource  production  or  keep  production  within  the  company?  

Solution  to  Review  Problem  7.9  

The  qualitative  factors  that  management  should  consider  when  deciding  whether  to  
outsource  production  include  the  following:  
• Will  the  quality  of  the  products  remain  the  same?  

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 • Will  shutting  down  the  manufacturing  facility  have  a  negative  impact  on  the  morale  
of  remaining  employees?  
• Is  the  producer  that  will  be  making  the  product  financially  stable  and  reliable?  

7.10 Appendix: Making Decisions Involving Joint Costs

L E A R N I N G   O B J E C T I V E  

1. Analyze  the  impact  that  joint  costs  have  on  decision  making.  

Question: When two or more products are produced from a single input, these products are
called joint products. The cost of this single input and the related manufacturing process costs
are called joint costs. For example, lumber companies often must deal with joint products
(different types of lumber) resulting from one input (a log). How do the concepts of joint
products and joint costs help a lumber company establish a cost for each of its products?

Answer: Suppose Oregon Lumber Company takes a log (the single input) and mills it into two
types of products: high quality Grade A lumber, and lower quality Grade B lumber. Grade A
lumber and Grade B lumber are examples of joint products, and the cost of the logs and related
manufacturing process costs are examples of joint costs.

presents the information for Oregon Lumber for the month of June. Joint costs for the month
total $250,000. Notice that the split-off point is the point at which identifiable products emerge
from the production process. The issue is how to allocate joint costs—the $250,000 in production
costs incurred prior to the split-off point—to the resulting joint products.

Two methods are commonly used to allocate these joint costs to the joint products: the physical
quantities method and the sales value method. We discuss each of these methods next.

The Physical Quantities Method

Question: The physical quantities method allocates joint costs based on a physical measure of
output. Assume Oregon Lumber produces 600,000 board feet of Grade A lumber and 200,000
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 board feet of Grade B lumber during June.How would Oregon Lumber use this information to
allocate $250,000 in joint production costs to each grade of lumber?

Answer: Oregon Lumber would allocate 75 percent of the joint costs to Grade A lumber (75
percent = 600,000 Grade A board feet ÷ 800,000 total board feet), and 25 percent of the joint
costs to Grade B lumber.

Grade A allocation:

$187,500 allocation = $250,000 joint costs × (600,000 Grade A board feet ÷ 800,000 total board
feet)

Grade B allocation:

$62,500 allocation = $250,000 joint costs × (200,000 Grade B board feet ÷ 800,000 total board
feet)

presents the profitability of each joint product for the month using the physical quantities method
assuming Grade A lumber sells for $0.40 per board foot and Grade B lumber sells for $0.30 per
board foot.

Figure 7.18 Joint Product Profitability for Oregon Lumber Company: Physical Quantities
Method

 
a
$240,000 = $0.40 per board foot × 600,000 Grade A board feet.

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 b $60,000 = $0.30 per board foot × 200,000 Grade B board feet.

c $187,500 = $250,000 joint costs × (600,000 Grade A board feet ÷ 800,000 total board feet).

d $62,500 = $250,000 joint costs × (200,000 Grade B board feet ÷ 800,000 total board feet).

Although Grade B lumber appears to be unprofitable, elimination of Grade B lumber sales

would not increase overall profit for Oregon Lumber. Grade B lumber contributes $60,000 to
covering joint costs. Thus elimination of Grade B lumber sales would result in a decrease in
overall profit of $60,000. The $62,500 in joint cost allocated to Grade B lumber would simply be
reallocated to Grade A lumber.

The Sales Value Method

Question: A different approach to allocating joint costs to joint products is

thesales value method, which allocates joint costs based on the relative sales value of each
product at the split-off point. How would Oregon Lumber allocate joint production costs using
this method?

Answer: Because sales revenue totals $240,000 for Grade A lumber and $60,000 for Grade B
lumber, 80 percent of the joint costs are allocated to Grade A lumber (80 percent = $240,000
Grade A revenue ÷ $300,000 total revenue), and 20 percent of the joint costs are allocated to
Grade B lumber:

Grade A allocation:

$200,000 allocation = $250,000 joint costs × ($240,000 Grade A sales value ÷ $300,000 total
sales value)

Grade B allocation:

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 $50,000 allocation = $250,000 joint costs × ($60,000 Grade B sales value ÷ $300,000 total sales
value)

presents the profitability of each joint product for the month using the sales value method, again
assuming Grade A lumber sells for $0.40 per board foot, and Grade B lumber sells for $0.30 per
board foot.

Figure 7.19 Joint Product Profitability for Oregon Lumber Company: Sales

 
a
$240,000 = $0.40 per board foot × 600,000 Grade A board feet.

b $60,000 = $0.30 per board foot × 200,000 Grade B board feet.

c $200,000 = $250,000 joint costs × ($240,000 Grade A sales value ÷ $300,000 total sales
value).

d $50,000 = $250,000 joint costs × ($60,000 Grade B sales value ÷ $300,000 total sales value).

The sales value method assumes that profit as a percent of sales will remain the same across all
products. For example, shows that Grade A lumber has a profit margin ratio of 16.67 percent (=
$40,000 profit ÷ $240,000 sales), as does Grade B lumber (= $10,000 profit ÷ $60,000 sales).
This method also ensures that joint costs allocated to each product will not exceed sales revenue
for each product (unless total joint costs are higher than total revenue).

As you review and , notice that the total column for both methods of joint cost allocation is the
same. The issue is not with the overall results. The issue is how to allocate joint costs to each
joint product.

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 Deciding Whether to Process Further

Question: Assume Oregon Lumber Company has the option of processing Grade B lumber
further into a finished product by sanding the lumber and painting it with primer. This option is
presented in . The sanded and painted Grade B lumber sells for $0.45 per board foot rather than
$0.30 for the unfinished Grade B lumber. The additional cost to sand and paint the Grade B
lumber is $0.05 per board foot. Should Oregon Lumber process Grade B lumber further into
finished lumber?

Figure 7.20 Further Processing of Oregon Lumber Company’s Grade B Lumber

Answer: The answer depends on whether the additional revenue exceeds the additional cost of
processing Grade B lumber further. Since the additional revenue of $0.15 per board foot (= $0.45
finished price − $0.30 unfinished price) is greater than the additional $0.05 per board foot
processing cost, Oregon Lumber should process the Grade B lumber further into finished lumber.
Profit increases $0.10 per board foot as a result of processing further (= $0.15 additional revenue
− $0.05 additional cost).

Oregon Lumber will decide whether or not to process Grade B lumber further regardless of how
joint costs are allocated to Grade A and Grade B lumber. In a sense, joint costs are sunk costs
with respect to this decision, and will not influence future processing decisions. Thus joint costs
incurredprior to the split-off point are irrelevant to the decision whether to process

further after the split-off point.

K E Y   T A K E A W A Y  

• Two  or  more  products  made  from  a  single  input  are  called  joint  products.  The  costs  of  
the  single  input  and  related  manufacturing  process  costs  must  be  allocated  to  each  of  
the  joint  products.  The  physical  quantities  method  allocates  joint  costs  based  on  a  
physical  measure  of  output  (e.g.,  pounds  or  yards  of  material).  The  sales  value  
method  allocates  joint  costs  based  on  the  relative  sales  value  for  each  of  the  joint  
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 products.  Regardless  of  the  allocation  method  used,  total  joint  costs  and  total  profit  
remain  the  same.  Companies  must  often  decide  whether  to  process  a  joint  product  
further.  If  as  a  result  of  processing  the  product  further,  additional  sales  revenue  
exceeds  additional  costs,  the  wise  decision  is  to  process  further.  
R E V I E W   P R O B L E M   7 . 1 0 .  

Fresh  Veggies,  Inc.,  purchased  10,000  pounds  of  fresh  apples  from  a  local  grower  for  
$4,000.  The  apples  were  separated  into  high-­‐quality  Grade  A  apples  (3,000  pounds)  
and  lower-­‐quality  Grade  B  apples  (7,000  pounds).  Fresh  Veggies  sells  Grade  A  apples  
for  $0.80  per  pound  and  Grade  B  apples  for  $0.50  per  pound.  
1. Allocate  joint  costs  to  each  product  using  the  physical  quantities  method  (pounds),  
and  calculate  the  profit  or  loss  for  each  product.  
2. Allocate  joint  costs  to  each  product  using  the  relative  sales  value  method,  and  
calculate  the  profit  or  loss  for  each  product.  
3. Assume  Grade  B  apples  can  be  processed  further  into  dried  apple  slices  for  an  
additional  $0.20  per  pound.  Customers  are  willing  to  pay  $0.65  per  pound  for  dried  
apple  slices.  Should  Fresh  Veggies,  Inc.,  process  the  Grade  B  apples  further?  

Solution  to  Review  Problem  7.10.  

1.    

 
a
 $2,400  =  $0.80  per  pound  ×  3,000  pounds  of  Grade  A  apples.  
b
 $3,500  =  $0.50  per  pound  ×  7,000  pounds  of  Grade  B  apples.  

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 c
 $1,200  =  $4,000  joint  costs  ×  (3,000  pounds  of  Grade  A  apples  ÷  10,000  
total  pounds).  
d
 $2,800  =  $4,000  joint  costs  ×  (7,000  pounds  of  Grade  B  apples  ÷  10,000  
total  pounds).  

2.    

 
a
 $2,400  =  $0.80  per  pound  ×  3,000  pounds  of  Grade  A  apples.  
b
 $3,500  =  $0.50  per  pound  ×  7,000  pounds  of  Grade  B  apples.  
c
 $1,627  (rounded)  =  $4,000  joint  costs  ×  ($2,400  Grade  A  sales  value  ÷  
$5,900  total  sales  value).  
d
 $2,373  (rounded)  =  $4,000  joint  costs  ×  ($3,500  Grade  B  sales  value  ÷  
$5,900  total  sales  value).  
3. Because  the  additional  revenue  of  $0.15  per  pound  (=  $0.65  price  with  further  
processing  −  $0.50  without  further  processing)  is  less  than  the  additional  $0.20  per  
pound  processing  cost,  Fresh  Veggies  should  notprocess  the  Grade  B  apples  further  
into  dried  apples.  Profit  decreases  $0.05  per  pound  (=  $0.20  additional  cost  −  $0.15  
additional  revenue)  as  a  result  of  processing  further.  
E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  
1. What  are  differential  revenues  and  costs?  
2. What  is  differential  analysis?  
3. Define  what  is  meant  by  a  “make-­‐or-­‐buy”  decision.  Describe  how  differential  analysis  
can  be  used  to  assist  in  making  this  type  of  decision.  
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 4.  and  provide  two  different  formats  for  presenting  the  same  analysis.  Describe  the  
similarities  and  differences  in  these  two  formats.  
5. What  is  an  avoidable  cost?  
6. Review  Why  did  Salt  Lake  City  choose  to  outsource  the  concrete  panels  to  a  company  
in  Mexico  City  even  though  the  library  was  being  constructed  in  Salt  Lake  City?  
7. How  is  differential  analysis  used  in  deciding  whether  to  keep  or  drop  product  lines?  
8. Why  are  direct  fixed  costs  typically  differential  costs?  
9. Why  are  allocated  fixed  costs  typically  not  differential  costs?  
10. What  is  an  opportunity  cost?  Why  is  an  opportunity  cost  a  differential  cost?  
11. Review  What  did  Kmart  do  with  24  of  its  stores?  Why  might  Kmarthave  taken  this  
action?  
12. How  is  differential  analysis  similar  for  customer  decisions  and  product  line  decisions?  
13. Review  Why  did  ABCO  Automation,  Inc.,  fire  its  biggest  client  even  though  the  client  
provided  close  to  60  percent  of  ABCO’s  annual  revenue?  
14. What  two  important  assumptions  must  be  considered  when  evaluating  special  order  
scenarios?  
15. What  is  cost-­‐plus  pricing?  
16. Describe  the  four  steps  of  target  costing.  
17. Describe  the  five  steps  used  to  manage  constraints  according  to  the  theory  of  
constraints.  
18. What  is  a  qualitative  advantage  of  keeping  unprofitable  customers?  
19. What  are  joint  products  and  joint  costs?  
20. Describe  the  two  methods  of  allocating  joint  costs.  

Brief  Exercises  

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 21. Cutting  Costs  at  Best  Boards,  Inc.  Refer  to  the  dialogue  at  Best  Boards,  Inc.,  
presented  at  the  beginning  of  the  chapter.  How  does  the  vice  president  of  operations,  
Jim  Muller,  expect  to  reduce  costs  and  earn  his  bonus?  What  was  the  flaw  in  his  plan?  
22. Make-­‐or-­‐Buy  Decision.  Coffee  Mugs,  Inc.,  currently  manufactures  ceramic  
coffee  mugs.  Management  is  interested  in  outsourcing  production  to  a  
reputable  manufacturing  company  that  can  supply  the  cups  for  $2  per  unit.  
Coffee  Mugs  produces  100,000  mugs  each  year.  Variable  production  costs  
are  $0.80  and  annual  fixed  costs  are  $150,000.  If  production  is  outsourced,  
all  variable  costs  and  40  percent  of  annual  fixed  costs  will  be  eliminated.  
Perform  differential  analysis  using  the  format  presented  inand  explain  
which  alternative  is  best,  Alternative  1  (producing  internally)  or  Alternative  
2  (outsourcing).  
23. Product  Line  Decision.  The  following  segmented  annual  income  
statement  is  for  Flash  Drive,  Inc.:  

For  items  A,  B,  and  C,  assign  allocated  fixed  costs  to  each  product  line  based  
on  sales  revenue  for  each  product  line  as  a  proportion  of  total  sales  
revenue.  For  example,  the  1  Gig  product  will  be  assigned  10  percent  of  
allocated  fixed  costs  (=  $1,000,000  in  1  Gig  sales  revenue  ÷  $10,000,000  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 total  sales  revenue),  or  $110,000  (=$1,100,000  total  allocated  fixed  costs  ×  
10  percent).  For  items  D,  E,  and  F,  calculate  the  profit  or  loss  for  each  
product  line.  
24. Customer  Decision.  Consulting  Group  LLC  has  two  customers.  Customer  
One  generates  $150,000  in  income  after  direct  fixed  costs  are  deducted,  
and  Customer  Two  generates  $200,000  in  income  after  direct  fixed  costs  
are  deducted.  Allocated  fixed  costs  total  $300,000  and  are  assigned  30  
percent  to  Customer  One  and  70  percent  to  Customer  Two  based  on  
several  different  cost  drivers.  Total  allocated  fixed  costs  remain  the  same  
regardless  of  how  these  costs  are  assigned  to  customers.  

Calculate  the  amount  of  allocated  fixed  costs  to  be  assigned  to  each  
customer,  and  determine  the  profit  or  loss  for  each  customer.  Should  
Consulting  Group  drop  Customer  Two?  Explain.  
25. Special  Order  Decision:  Operating  with  Idle  Capacity.  Jerseys,  Inc.,  currently  
produces  10,000  jerseys  a  year  for  its  regular  customers  and  charges  $10  per  jersey.  
Jerseys,  Inc.,  has  capacity  to  produce  an  additional  5,000  jerseys  if  sales  grow  in  the  
future.  Variable  costs  total  $6  per  jersey  and  annual  fixed  costs  total  $15,000.  The  city  
of  Rockville  recently  approached  the  company  and  proposed  a  one-­‐time  purchase  of  
3,000  jerseys  for  $8  each.  Should  Jerseys,  Inc.,  accept  the  proposal?  Explain.  
26. Cost-­‐Plus  Pricing.  KJ  Home  Builders  is  bidding  on  a  custom  home  for  a  potential  
customer.  The  company  typically  charges  15  percent  above  cost  and  estimates  the  
home  will  cost  $500,000  to  build.  Calculate  the  price  bid  by  KJ  Home  Builders.  
27. Constrained  Resources.  Deal,  Inc.,  produces  two  types  of  computers:  
Vortex  and  Zoom.  The  computers  are  produced  in  separate  departments  
and  sent  to  the  quality  testing  department  before  being  packaged  and  
shipped.  A  labor-­‐hour  bottleneck  has  been  identified  in  the  quality  testing  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 department  due  to  the  high  skill  requirements  of  the  job.  Deal,  Inc.,  would  
like  to  optimize  its  use  of  labor  hours  by  producing  the  most  profitable  
computer.  Based  on  the  information  shown,  calculate  the  contribution  
margin  per  quality  testing  labor  hour  for  each  product:  
Quality Testing Labor Hours Contribution Margin

Vortex 0.50 $600

Zoom 0.40 500

28. Evaluating  Qualitative  Factors.  Assume  your  company  is  considering  whether  to  
outsource  production.  What  qualitative  factors  should  be  considered  before  making  
this  decision?  
29. Allocating  Joint  Costs  (Appendix).  Charlotte  Company  produces  two  joint  chemical  
products,  product  A  and  B.  Prior  to  the  split-­‐off  point,  the  company  incurred  $100,000  
in  joint  costs.  Production  totaled  12,000  gallons  for  product  A  and  8,000  gallons  for  
product  B.  Allocate  joint  costs  to  each  product  using  the  physical  quantities  method  
(gallons).  

Exercises:  Set  A  
30. Make-­‐or-­‐Buy  Decision.  Wheels,  Inc.,  currently  manufactures  its  own  
custom  rims  for  automobiles.  Management  is  interested  in  outsourcing  
production  of  these  rims  to  a  reputable  manufacturing  company  that  can  
supply  the  rims  for  $80  per  unit.  Wheels,  Inc.,  incurs  the  following  annual  
production  costs  to  produce  10,000  rims  internally.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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If  production  is  outsourced,  all  variable  production  costs,  factory  building  

and  equipment  lease  costs,  and  factory  insurance  costs  will  be  eliminated.  
The  production  supervisor’s  salary  cost  will  remain  regardless  of  the  
decision  to  outsource  or  to  produce  internally  because  the  supervisor  
recently  signed  a  long-­‐term  contract  with  Wheels,  Inc.  
Required:  
a. Perform  differential  analysis  using  the  format  presented  in  .  Assume  
making  the  rims  internally  is  Alternative  1,  and  buying  the  rims  from  an  
outside  manufacturer  is  Alternative  2.  
b. Which  alternative  is  best?  Explain.  
c. Summarize  the  result  of  outsourcing  production  using  the  format  presented  
in  .  
d. Compare  the  format  used  in  requirement  a  with  that  of  requirement  c.  
Product  Line  Decision.  The  following  monthly  segmented  income  
statement  is  for  Durango  Company.  

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Management  is  concerned  about  the  losses  associated  with  product  line  A  
and  is  considering  dropping  this  product  line.  Allocated  fixed  costs  are  
assigned  to  product  lines  based  on  sales.  If  product  line  A  is  eliminated,  
total  allocated  fixed  costs  are  assigned  to  the  remaining  product  lines,  and  
all  variable  and  direct  fixed  costs  for  product  line  A  will  be  eliminated.  
Required:  
 . Perform  differential  analysis  using  the  format  presented  in  .  Assume  
keeping  all  product  lines  is  Alternative  1,  and  dropping  product  line  A  is  
Alternative  2.  
a. Which  alternative  is  best?  Explain.  
b. Summarize  the  result  of  dropping  product  line  A  using  the  format  presented  
in  .  
c. Explain  why  the  loss  shown  for  product  line  A  in  the  segmented  income  
statement  might  be  misleading  to  management.  
Customer  Decision.  The  following  customer  segmented  quarterly  
income  statement  is  for  Accounting  Associates.  

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Management  is  concerned  about  the  significant  losses  associated  with  the  
Nguyen  account  and  would  like  to  drop  this  customer.  Allocated  fixed  costs  
are  assigned  to  customers  based  on  sales  revenue.  If  Nguyen  is  dropped,  
total  allocated  fixed  costs  are  assigned  to  the  remaining  customers,  and  all  
variable  and  direct  fixed  costs  for  the  Nguyen  account  will  be  eliminated.  
Required:  
 . Perform  differential  analysis  using  the  format  presented  in  .  Assume  
keeping  all  customers  is  Alternative  1,  and  dropping  the  Nguyen  account  is  
Alternative  2.  
a. Which  alternative  is  best?  Explain.  
b. Summarize  the  result  of  dropping  the  Nguyen  account  using  the  format  
presented  in  .  
c. Explain  what  happened  to  the  profitability  of  the  other  two  customers  as  a  
result  of  dropping  the  Nguyen  account.  
Special  Order  Decision:  Operating  with  Idle  Capacity.  The  following  
monthly  financial  data  are  for  RadioCom,  Inc.,  a  maker  of  handheld  VHF  
radios.  RadioCom  produces  and  sells  5,000  radios  each  month  to  regular  
customers.  

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RadioCom  received  an  offer  from  the  Coast  Guard  Auxiliary  to  purchase  
1,000  radios  next  month  for  $75  per  unit.  RadioCom  can  produce  up  to  
7,000  radios  a  month,  so  the  special  order  would  not  affect  regular  
customer  sales.  Variable  costs  per  radio  will  remain  at  $60.  This  special  
order  will  have  no  effect  on  monthly  fixed  costs.  
Required:  
 . Using  the  differential  analysis  format  presented  in  ,  determine  
whether  RadioCom  would  be  better  off  rejecting  the  special  order  
(Alternative  1)  or  accepting  the  special  order  (Alternative  2).  
a. Summarize  the  result  of  accepting  the  special  order  using  the  format  
presented  in  .  
Special  Order  Decision:  Operating  at  Full  Capacity.  The  following  
monthly  financial  data  are  for  RadioCom,  Inc.,  a  maker  of  handheld  VHF  
radios.  RadioCom  produces  and  sells  5,000  radios  each  month  to  regular  
customers.  

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RadioCom  received  an  offer  from  the  Coast  Guard  Auxiliary  to  purchase  
1,000  radios  next  month  for  $75  per  unit.  RadioCom  can  only  produce  up  to  
5,000  radios  a  month,  so  the  special  order  would  result  in  reduced  sales  to  
regular  customers.  Variable  costs  per  radio  will  remain  at  $60.  This  special  
order  will  have  no  effect  on  monthly  fixed  costs.  
Required:  
 . Using  the  differential  analysis  format  presented  in  ,  determine  
whether  RadioCom  would  be  better  off  rejecting  (Alternative  1)  or  
accepting  (Alternative  2)  the  offer  received  from  the  Coast  Guard  Auxiliary.  
a. Summarize  the  result  of  accepting  the  special  order  using  the  format  
presented  in  .  
Target  Costing.  Quality  Sounds,  Inc.,  makes  speakers  and  headphones  
for  high-­‐end  sound  systems.  The  marketing  department  has  identified  a  
market  for  a  specific  type  of  headphones  that  Quality  Sounds  does  not  
currently  produce,  and  expects  to  be  able  to  sell  each  pair  for  $150.  
Management  requires  a  profit  of  45  percent  of  the  selling  price.  
Required:  

Determine  the  highest  cost  (target  cost)  management  would  be  willing  to  
accept  to  produce  this  product.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     499  
     
 
 Constrained  Resources.  Cycle,  Inc.,  produces  three  types  of  bicycles:  
racer,  cruiser,  and  climber.  The  bikes  are  produced  in  separate  departments  
and  sent  to  the  quality  testing  department  before  being  packaged  and  
shipped.  A  labor-­‐hour  bottleneck  has  been  identified  in  the  quality  testing  
department  due  to  the  high  skill  requirements  of  the  job.  Cycle,  Inc.,  would  
like  to  optimize  its  use  of  labor  hours  by  producing  the  two  most  profitable  
bikes.  Information  for  each  bike  follows.  
Quality Testing Labor Hours Price Variable Cost

Racer 1.25 $1,000 $400

Cruiser 1.00 500 300

Climber 1.00 800 450

Required:  
 . Calculate  the  contribution  margin  per  unit  of  constrained  resource  for  
each  product.  
a. Which  two  products  would  Cycle,  Inc.,  prefer  to  produce  and  sell  to  
optimize  the  use  of  labor  hours  in  the  quality  testing  department?  
Qualitative  Factors.  For  each  of  the  following  independent  scenarios,  
identify  at  least  one  qualitative  factor  that  should  be  considered  before  
making  the  decision.  
 . A  company  sells  three  types  of  computers  (laptops,  desktops,  and  
palmtops),  all  of  which  are  profitable.  The  company  faces  a  machine-­‐hour  
bottleneck  and  plans  to  eliminate  the  palmtop  product  because  it  has  the  
lowest  contribution  margin  per  machine  hour.  
a. A  company  plans  to  drop  an  unprofitable  customer.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     500  
     
 
 b. A  maker  of  high-­‐end  stereo  equipment  would  like  to  shut  down  its  
manufacturing  facility  and  outsource  production.  
Allocating  Joint  Costs  (Appendix).  Clemson  Products  produces  two  
joint  products,  product  Y  and  Z.  Prior  to  the  split-­‐off  point,  the  company  
incurred  $60,000  in  joint  costs.  Clemson  Products  produced  10,000  yards  of  
product  Y  and  30,000  yards  of  product  Z  produced.  Product  Y  sells  for  $4  
per  yard  and  product  Z  sells  for  $2  per  yard.  
Required:  
 . Allocate  joint  costs  to  each  product  using  the  physical  quantities  
method  (yards),  and  calculate  the  profit  or  loss  for  each  product.  
a. Allocate  joint  costs  to  each  product  using  the  relative  sales  value  method,  
and  calculate  the  profit  or  loss  for  each  product.  

Exercises:  Set  B  
39. Make-­‐or-­‐Buy  Decision.  Quality  Glass  currently  manufactures  windshields  
for  automobiles.  Management  is  interested  in  outsourcing  production  of  
these  windshields  to  a  reputable  manufacturing  company  that  can  supply  
the  windshields  for  $45  per  unit.  Quality  Glass  incurs  the  following  annual  
production  costs  to  produce  15,000  windshields  internally.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     501  
     
 
 If  production  is  outsourced,  all  variable  production  costs  will  be  eliminated,  
and  80  percent  of  fixed  production  costs  will  be  eliminated.  Regardless  of  
the  decision  to  outsource  or  to  produce  internally,  20  percent  of  fixed  
production  costs  will  remain  .  
Required:  
a. Perform  differential  analysis  using  the  format  presented  in  .  Assume  
making  windshields  internally  is  Alternative  1,  and  buying  windshields  from  
an  outside  manufacturer  is  Alternative  2.  
b. Which  alternative  is  best?  Explain.  
c. Summarize  the  result  of  outsourcing  production  using  the  format  presented  
in  .  
d. Why  might  some  managers  prefer  the  format  presented  in  requirement  c?  
Product  Line  Decision.  The  following  segmented  annual  income  
statement  is  for  Office  Express.  

Management  is  concerned  about  the  significant  losses  associated  with  the  
computers  product  line  and  would  like  to  drop  this  product  line.  Allocated  
fixed  costs  are  assigned  to  product  lines  based  on  sales.  If  the  computers  
product  line  is  eliminated,  total  allocated  fixed  costs  are  assigned  to  the  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     502  
     
 
 remaining  product  lines,  and  all  variable  and  direct  fixed  costs  for  the  
computers  product  line  will  be  eliminated.  
Required:  
 . Perform  differential  analysis  using  the  format  presented  in  .  Assume  
keeping  all  product  lines  is  Alternative  1,  and  dropping  the  computers  
product  line  is  Alternative  2.  
a. Which  alternative  is  best?  Explain.  
b. Summarize  the  result  of  dropping  the  computer  product  line  using  the  
format  presented  in  .  
c. Explain  what  happened  to  the  profitability  of  the  furniture  product  line  as  a  
result  of  dropping  the  computers  product  line.  
Customer  Decision.  The  following  customer  segmented  annual  
income  statement  is  for  Management  Consulting,  Inc.  

Management  is  concerned  about  the  losses  associated  with  the  Apple  LLP  
account  and  would  like  to  drop  this  customer.  Allocated  fixed  costs  are  
assigned  to  customers  based  on  sales  revenue.  If  Apple  LLP  is  dropped,  total  
allocated  fixed  costs  are  assigned  to  the  remaining  customers,  and  all  
variable  and  direct  fixed  costs  for  the  Apple  LLP  account  will  be  eliminated.  
Required:  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     503  
     
 
  . Perform  differential  analysis  using  the  format  presented  in  .  Assume  
keeping  all  customers  is  Alternative  1,  and  dropping  the  Apple  LLP  account  
is  Alternative  2.  
a. Which  alternative  is  best?  Explain.  
b. Summarize  the  result  of  dropping  the  Apple  LLP  account  using  the  format  
presented  in  .  
c. Explain  why  the  loss  shown  for  the  Apple  LLP  account  in  the  segmented  
income  statement  might  be  misleading  to  management.  
Special  Order  Decision:  Operating  with  Idle  Capacity.  The  following  
monthly  financial  data  are  for  Sport  Socks,  Inc.,  a  maker  of  socks  for  
runners.  Sport  Socks  makes  and  sells  40,000  pairs  each  month  to  regular  
customers.  

Sport  Socks  received  an  offer  from  a  large  sporting  goods  store  to  purchase  
15,000  socks  next  month  for  $0.90  per  pair.  Sport  Socks  can  produce  up  to  
60,000  pairs  of  socks  a  month,  so  the  special  order  would  not  affect  regular  
customer  sales.  Variable  costs  per  pair  will  remain  at  $0.70.  This  special  
order  will  cause  fixed  costs  to  increase  by  $6,000  for  next  month.  
Required:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     504  
     
 
  . Using  the  differential  analysis  format  presented  in  ,  determine  
whether  Sport  Socks  would  be  better  off  rejecting  the  special  order  
(Alternative  1)  or  accepting  the  special  order  (Alternative  2).  
a. Summarize  the  result  of  accepting  the  special  order  using  the  format  
presented  in  .  
Special  Order  Decision:  Operating  at  Full  Capacity.  The  following  
monthly  financial  data  are  for  Sport  Socks,  Inc.,  a  maker  of  socks  for  
runners.  Sport  Socks  makes  and  sells  40,000  pairs  each  month  to  regular  
customers.  

Sport  Socks  received  an  offer  from  a  large  sporting  goods  store  to  purchase  
15,000  socks  next  month  for  $0.90  per  pair.  Assume  Sport  Socks  can  only  
produce  up  to  40,000  pairs  of  socks  each  month.  Thus  any  special  orders  
would  result  in  reduced  sales  to  regular  customers.  However,  fixed  costs  
willnot  change  as  a  result  of  the  special  order.  
Required:  
 . Using  the  differential  analysis  format  presented  in  ,  determine  
whether  Sport  Socks  would  be  better  off  rejecting  the  special  order  
(Alternative  1)  or  accepting  the  special  order  (Alternative  2).  
a. Summarize  the  result  of  accepting  the  special  order  using  the  format  
presented  in  .  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     505  
     
 
 Target  Costing.  Nature  Wood,  Inc.,  makes  wood  tables  for  
commercial  use.  The  marketing  department  has  identified  a  market  for  a  
specific  table  that  the  company  does  not  currently  produce,  and  it  expects  
that  each  table  could  be  sold  for  $1,000.  Management  requires  a  profit  of  
30  percent  of  the  selling  price.  
Required:  

Determine  the  highest  cost  (target  cost)  management  would  be  willing  to  
accept  to  produce  this  product.  
Constrained  Resources.  Ratcliff  Enterprises  produces  three  types  of  
computers;  laptop,  desktop,  and  palmtop.  A  machine-­‐hour  bottleneck  has  
been  identified  in  the  production  department.  Ratcliff  would  like  to  
optimize  its  use  of  machine  hours  by  producing  the  two  most  profitable  
computers.  Information  for  each  computer  follows.  
Production Machine Hours Price Variable Cost

Laptop 2.00 $1,200 $900

Desktop 1.00 800 700

Palmtop 1.25 300 180

Required:  
 . Calculate  the  contribution  margin  per  unit  of  constrained  resource  for  
each  product.  
a. Which  two  products  would  Ratcliff  Enterprises  prefer  to  produce  and  sell  to  
optimize  the  use  of  machine  hours  in  the  production  department?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     506  
     
 
 Qualitative  Factors.  For  each  of  the  following  independent  scenarios,  
identify  at  least  one  qualitative  factor  that  should  be  considered  before  
making  the  decision.  
 . A  company  sells  three  types  of  chainsaws  (light  duty,  medium  duty,  
and  heavy  duty),  all  of  which  are  profitable.  The  company  faces  a  labor-­‐
hour  bottleneck  and  plans  to  eliminate  the  light  duty  product  because  it  has  
the  lowest  contribution  margin  per  labor  hour.  
a. A  company  plans  to  drop  an  unprofitable  customer.  
b. A  maker  of  farm  equipment  would  like  to  shut  down  its  manufacturing  
facility  and  outsource  production.  
Allocating  Joint  Costs  and  Evaluating  Overall  Company  Profit  
(Appendix).  Elexor,  Inc.,  produces  two  joint  products,  product  A  and  
product  B.  Prior  to  the  split-­‐off  point,  the  company  incurred  $10,000  in  joint  
costs.  Production  of  product  A  totaled  400  pounds,  and  product  B  totaled  
600  pounds.  Product  A  sells  for  $60  per  pound  and  product  B  sells  for  $10  
per  pound.  
Required:  
 . Allocate  joint  costs  to  each  product  using  the  physical  quantities  
method  (pounds),  and  calculate  the  profit  or  loss  for  each  product.  
a. Allocate  joint  costs  to  each  product  using  the  relative  sales  value  method,  
and  calculate  the  profit  or  loss  for  each  product.  
b. Using  your  answer  to  requirement  a,  describe  what  will  happen  to  overall  
company  profit  if  the  least  profitable  product  is  eliminated.  

Problems  
48. Make-­‐or-­‐Buy  Decision.  Vail  Door  Company  currently  manufactures  doors  
used  in  the  production  of  custom  homes.  Management  is  interested  in  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     507  
     
 
 outsourcing  production  of  the  doors  to  a  reputable  manufacturing  company  
that  can  supply  the  doors  for  $90  per  unit.  Vail  incurs  the  following  annual  
production  costs  to  produce  3,000  doors  internally.  

If  production  is  outsourced,  all  variable  production  costs,  equipment  lease  

costs,  and  factory  insurance  costs  will  be  eliminated.  The  production  
supervisor’s  salary  cost  will  remain  regardless  of  the  decision  to  outsource  
or  to  produce  internally  because  the  supervisor  recently  signed  a  long-­‐term  
contract  with  the  company.  The  factory  lease  has  five  years  remaining  and  
cannot  be  terminated  before  then.  
Required:  
a. Perform  differential  analysis  using  the  format  presented  in  .  Assume  
making  the  product  internally  is  Alternative  1,  and  buying  the  product  from  
an  outside  manufacturer  is  Alternative  2.  
b. Which  alternative  is  best?  Explain.  
c. Summarize  the  result  of  outsourcing  production  using  the  format  presented  
in  .  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     508  
     
 
 d. Assume  Vail  Door  Company  can  lease  the  space  it  currently  uses  to  produce  
doors  for  $30,000  per  year  if  production  of  doors  is  outsourced.  Because  
the  company  subleasing  this  space  would  also  pay  for  insurance,  Vail  would  
not  be  required  to  pay  for  factory  insurance.  Use  the  format  presented  in  to  
determine  if  Vail  would  be  better  off  outsourcing  production.  (Hint:  $30,000  
will  appear  in  the  analysis  as  an  opportunity  cost  similar  to  .)  
Make-­‐or-­‐Buy  Decision  and  Qualitative  Factors.  Soda  Bottling,  Inc.,  
currently  bottles  its  own  soda  drinks.  Management  is  interested  in  
outsourcing  the  production  of  bottles  to  a  reputable  manufacturing  
company  that  can  supply  the  bottles  for  $0.04  each.  Soda  Bottling  incurs  
the  following  monthly  production  costs  to  produce  1,000,000  bottles  
internally.  

If  production  is  outsourced,  all  variable  production  costs  and  70  percent  of  
fixed  production  costs  will  be  eliminated.  
Required:  
 . Perform  differential  analysis  using  the  format  presented  in  .  Assume  
making  the  product  internally  is  Alternative  1,  and  buying  the  product  from  
an  outside  manufacturer  is  Alternative  2.  
a. Which  alternative  is  best?  Explain.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     509  
     
 
 b. Summarize  the  result  of  outsourcing  production  using  the  format  presented  
in  .  
c. Assume  all  the  facts  of  this  problem  remain  the  same.  However,  
management  of  Soda  Bottling  has  an  opportunity  to  lease  the  space  it  
currently  uses  to  produce  bottles  for  $6,000  per  month  if  production  of  
bottles  is  outsourced.  Use  the  format  presented  in  to  determine  if  Soda  
Bottling  would  be  better  off  outsourcing  production.  (Hint:  $6,000  will  
appear  in  the  analysis  as  an  opportunity  cost  similar  to  .)  
d. Identify  at  least  one  qualitative  factor  that  should  be  considered  before  
management  decides  to  outsource  production.  
Product  Line  Decision.  The  following  monthly  segmented  income  
statement  is  for  Hal’s  Hardware.  

Management  is  concerned  about  the  low  profit  associated  with  the  tools  
product  line  and  is  considering  dropping  this  product  line.  Allocated  fixed  
costs  are  assigned  to  product  lines  based  on  floor  space  used  by  each  
product  line  (measured  in  square  feet),  resulting  in  the  following  
percentages  for  garden  supplies,  tools,  and  paint,  respectively:  20  percent,  
50  percent,  and  30  percent.  If  the  tools  product  line  is  eliminated,  total  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     510  
     
 
 allocated  fixed  costs  will  be  assigned  as  follows:  62.5  percent  to  garden  
supplies,  and  37.5  percent  to  paint.  All  variable  and  direct  fixed  costs  for  the  
tools  product  line  will  be  eliminated.  
Required:  
 . Perform  differential  analysis  using  the  format  presented  in  .  Assume  
keeping  all  product  lines  is  Alternative  1,  and  dropping  the  tools  product  
line  is  Alternative  2.  
a. Which  alternative  is  best?  Explain.  
b. Summarize  the  result  of  dropping  the  tools  product  line  using  the  format  
presented  in  .  
c. Assume  the  space  available  from  dropping  the  tools  product  line  can  be  
used  by  the  paint  product  line,  resulting  in  increased  revenues  for  paint  of  
$12,000  and  increased  variable  costs  for  paint  of  $4,000.  No  additional  
direct  fixed  costs  would  be  incurred,  and  80  percent  of  allocated  fixed  costs  
would  be  assigned  to  paint  and  20  percent  assigned  to  garden  supplies.  
Should  Hal’s  Hardware  drop  the  tools  product  line  and  use  the  freed-­‐up  
space  to  expand  the  paint  product  line?  (Hint:  Prepare  a  differential  analysis  
using  the  format  presented  in  to  find  the  answer.  Alternative  1  assumes  all  
product  lines  are  kept,  and  Alternative  2  assumes  the  tools  product  line  is  
dropped  with  a  corresponding  expansion  of  the  paint  product  line.)  
Product  Line  Decision  and  Qualitative  Factors.  The  following  annual  
segmented  income  statement  is  for  Wax,  Inc.,  a  maker  of  wax  for  cars,  
boats,  and  floors.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Management  is  concerned  about  the  loss  associated  with  the  floors  product  
line  and  is  considering  dropping  this  product  line.  Allocated  fixed  costs  are  
assigned  to  product  lines  based  on  direct  labor  hours  associated  with  each  
product  line,  resulting  in  the  following  percentages  for  cars,  boats,  and  
floors,  respectively:  30  percent,  25  percent,  and  45  percent.  If  the  floors  
product  line  is  eliminated,  total  allocated  fixed  costs  will  be  assigned  to  the  
remaining  products  as  follows:  55  percent  to  cars,  and  45  percent  to  boats.  
All  variable  and  direct  fixed  costs  for  the  floors  product  line  will  be  
eliminated.  
Required:  
 . Perform  differential  analysis  using  the  format  presented  in  .  Assume  
keeping  all  product  lines  is  Alternative  1,  and  dropping  the  floors  product  
line  is  Alternative  2.  
a. Which  alternative  is  best?  Explain.  
b. Summarize  the  result  of  dropping  the  floors  product  line  using  the  format  
presented  in  .  
c. Assume  the  space  available  from  dropping  the  floors  product  line  can  be  
used  by  the  boats  product  line,  resulting  in  increased  revenues  for  boats  of  
$200,000  and  increased  variable  costs  for  boats  of  $110,000.  An  additional  
$10,000  in  direct  fixed  costs  would  be  incurred  for  the  boats  product  line.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     512  
     
 
 Allocated  fixed  costs  would  be  assigned  as  follows:  40  percent  to  cars,  and  
60  percent  to  boats.  Should  Wax,  Inc.,  drop  the  floors  product  line  and  use  
the  freed-­‐up  space  to  expand  the  boats  product  line?  (Hint:  Prepare  a  
differential  analysis  using  the  format  presented  in  to  find  the  answer.  
Alternative  1  assumes  all  product  lines  are  kept,  and  Alternative  2  assumes  
the  floors  product  line  is  dropped  with  a  corresponding  expansion  of  the  
boats  product  line.)  
d. Identify  at  least  one  qualitative  factor  that  should  be  considered  before  
management  decides  to  drop  a  product  line.  
Customer  Decision.  The  following  customer  segmented  quarterly  
income  statement  is  for  Ciena  and  Associates,  a  firm  that  performs  legal  
services.  

Management  is  concerned  about  the  significant  losses  associated  with  the  
Davis  account  and  would  like  to  drop  this  customer.  Allocated  fixed  costs  
are  assigned  to  customers  based  on  sales  revenue.  If  Davis  is  dropped,  total  
allocated  fixed  costs  are  assigned  to  the  remaining  customers,  and  all  
variable  and  direct  fixed  costs  for  the  Davis  account  will  be  eliminated.  
Required:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     513  
     
 
  . Perform  differential  analysis  using  the  format  presented  in  .  Assume  
keeping  all  customers  is  Alternative  1,  and  dropping  the  Davis  account  is  
Alternative  2.  
a. Which  alternative  is  best?  Explain.  
b. Summarize  the  result  of  dropping  the  Davis  account  using  the  format  
presented  in  .  
c. Explain  what  happened  to  the  profitability  of  the  other  two  customers  as  a  
result  of  dropping  the  Davis  account.  
d. Assume  all  the  facts  of  this  problem  remain  the  same  with  one  exception.  
As  a  result  of  dropping  the  Davis  account,  Ciena  and  Associates  is  only  able  
to  reduce  thedirect  fixed  costs  associated  with  the  Davis  account  by  90  
percent.  The  remaining  10  percent  will  not  be  eliminated  for  several  more  
years.  Does  this  change  Ciena’s  decision  as  to  whether  to  drop  the  Davis  
customer?  Explain.  (Hint:  Modify  one  line  item  in  your  answer  to  
requirement  c.)  
Customer  Decision  and  Qualitative  Factors.  The  following  customer  
segmented  monthly  income  statement  is  for  Quality  Web,  Inc.,  a  firm  that  
provides  Web  site  maintenance  services.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     514  
     
 
 Management  is  concerned  about  the  losses  associated  with  the  Murray  
account  and  would  like  to  drop  this  customer.  Allocated  fixed  costs  are  
assigned  to  customers  based  on  sales  revenue.  If  Murray  is  dropped,  total  
allocated  fixed  costs  are  assigned  to  the  remaining  customers,  and  all  
variable  and  direct  fixed  costs  for  the  Murray  account  will  be  eliminated.  
Required:  
 . Perform  differential  analysis  using  the  format  presented  in  .  Assume  
keeping  all  customers  is  Alternative  1,  and  dropping  the  Murray  account  is  
Alternative  2.  
a. Which  alternative  is  best?  Explain.  
b. Summarize  the  result  of  dropping  the  Murray  account  using  the  format  
presented  in  .  
c. Explain  what  happened  to  the  profitability  of  the  other  two  customers  as  a  
result  of  dropping  the  Murray  account.  
d. Assume  all  the  facts  of  this  problem  remain  the  same  with  one  exception.  
As  a  result  of  dropping  the  Murray  account,  Quality  Web,  Inc.,  is  able  to  
reduce  total  allocatedfixed  costs  by  20  percent.  The  remaining  80  percent  
will  be  allocated  to  the  other  two  products  based  on  sales  revenue.  Does  
this  change  Quality  Web’s  decision  as  to  whether  to  drop  the  Murray  
customer?  Explain.  (Hint:  Add  one  line  item  in  the  requirement  c  analysis  to  
reflect  allocated  fixed  cost  savings.)  
e. Identify  at  least  one  qualitative  factor  that  should  be  considered  before  
deciding  whether  to  drop  the  Murray  account.  
Special  Order  Decision  with  Idle  Capacity  and  at  Full  Capacity.  The  
following  quarterly  financial  data  are  for  Pneumatic,  Inc.,  a  maker  of  
compressors.  On  average,  Pneumatic  makes  20,000  compressors  each  
quarter.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     515  
     
 
  

Pneumatic  received  an  offer  from  a  one-­‐time  customer  to  purchase  5,000  
compressors  this  coming  quarter  for  $275  per  unit.  Pneumatic  can  produce  
up  to  30,000  units  a  quarter,  so  the  special  order  would  not  affect  regular  
customer  sales.  Variable  costs  per  unit  will  remain  at  $100.  This  special  
order  will  have  no  effect  on  fixed  costs.  
Required:  
 . Using  the  differential  analysis  format  presented  in  ,  determine  
whether  Pneumatic  would  be  better  off  rejecting  the  special  order  
(Alternative  1)  or  accepting  the  special  order  (Alternative  2).  
a. Summarize  the  result  of  accepting  the  special  order  using  the  format  
presented  in  .  
b. Assume  Pneumatic  is  approached  with  the  same  special  offer,  but  has  
limited  capacity,  and  can  only  produce  up  to  20,000  units  per  quarter.  Thus  
any  special  orders  will  result  in  reduced  sales  to  regular  customers.  Using  
the  differential  analysis  format  presented  in  ,  determine  whether  
Pneumatic  would  be  better  off  rejecting  (Alternative  1)  or  accepting  
(Alternative  2)  the  special  order.  
c. Summarize  the  result  of  accepting  the  special  order  in  requirement  c  using  
the  format  presented  in  .  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     516  
     
 
 Special  Order  Decision  at  Full  Capacity.  The  following  monthly  
financial  data  are  for  Green  Mowers,  Inc.,  a  maker  of  electric  lawn  mowers.  
On  average,  Green  Mowers  makes  5,000  mowers  each  month.  

Green  Mowers  received  an  offer  from  a  one-­‐time  customer  to  purchase  
1,000  mowers  this  coming  month  for  $180  per  unit.  Green  Mowers  can  
produce  up  to  5,000  units  a  month,  so  the  special  order  would  reduce  
regular  customer  sales.  Variable  costs  per  unit  will  remain  at  $150.  This  
special  order  will  have  no  effect  on  fixed  costs.  
Required:  
 . Using  the  differential  analysis  format  presented  in  ,  determine  
whether  Green  Mowers  would  be  better  off  rejecting  the  special  order  
(Alternative  1)  or  accepting  the  special  order  (Alternative  2).  
a. Summarize  the  result  of  accepting  the  special  order  using  the  format  
presented  in  .  
b. Assume  Green  Mowers  can  increase  capacity  to  accommodate  the  special  
order  by  paying  an  additional  $20  in  variable  costs  per  unit  (for  overtime  
pay)  for  the  additional  1,000  units.  With  this  increased  capacity,  the  special  
order  would  not  affect  regular  customer  sales.  Using  the  differential  
analysis  format  presented  in  ,  determine  whether  Green  Mowers  would  be  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     517  
     
 
 better  off  rejecting  (Alternative  1)  or  accepting  (Alternative  2)  the  special  
order.  
c. Summarize  the  result  of  accepting  the  special  order  in  requirement  c  using  
the  format  presented  in  .  
Target  Costing.  Toolmakers,  Inc.,  produces  table  saws.  The  marketing  
department  has  identified  a  market  for  a  specific  type  of  table  saw  that  
Toolmakers  does  not  currently  produce,  and  expects  to  be  able  to  sell  each  
saw  for  $800.  Management  requires  a  profit  of  60  percent  of  the  selling  
price.  
Required:  
 . Determine  the  highest  cost  (target  cost)  management  would  be  
willing  to  accept  to  produce  this  product.  
a. Describe  the  four  steps  of  target  costing,  and  identify  what  Toolmakers  
would  do  next  if  it  cannot  make  the  product  at  or  below  the  target  cost.  
Constrained  Resources.  Instrumental  Strings,  Inc.,  produces  three  
types  of  string  instruments:  violin,  cello,  and  bass.  The  instruments  are  
produced  in  separate  departments  and  sent  to  the  quality  testing  
department  before  being  packaged  and  shipped.  A  labor-­‐hour  bottleneck  
has  been  identified  in  the  quality  testing  department  due  to  the  high  skill  
requirements  of  the  job.  Instrumental  Strings  would  like  to  optimize  its  use  
of  labor  hours  by  producing  the  two  most  profitable  instruments.  
Information  for  each  product  follows.  

 
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     518  
     
 
 Required:  
 . Calculate  the  contribution  margin  per  unit  of  constrained  resource  for  
each  product.  
a. Which  two  products  would  Instrumental  Strings  prefer  to  produce  and  sell  
to  optimize  the  use  of  labor  hours  in  the  quality  testing  department?  

b. Assume  additional  employees  are  hired  and  trained  for  

the  quality  testing  department  thereby  alleviating  this  constraint.  
A  labor-­‐hour  bottleneck  has  now  been  identified  in  the  packaging  
department,  which  is  recognized  by  management  as  a  crucial  
department  given  the  fine  craftsmanship  of  each  instrument.  Of  
the  three  instruments  produced  by  the  company,  identify  which  
two  products  Instrumental  Strings  would  prefer  to  produce  and  
sell  to  optimize  the  use  of  labor  hours  in  the  packaging  
department.  Assume  the  following  labor  hours  are  required  to  
package  each  instrument:  
Violin: 4.00 hours

Cello: 4.00 hours

Bass: 6.00 hours

Allocating  Joint  Costs  and  Product  Profitability  (Appendix).  Fresh  

Catch,  Inc.,  has  a  fleet  of  fishing  boats.  The  most  recent  outing  cost  $90,000  
and  yielded  24,000  pounds  of  salmon  and  8,000  pounds  of  halibut.  Fresh  
Catch  can  sell  salmon  for  $3  per  pound  and  halibut  for  $6  per  pound.  
Required:  
 . Allocate  joint  costs  to  each  product  using  the  physical  quantities  
method,  and  calculate  the  profit  or  loss  for  each  product.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     519  
     
 
 a. Allocate  joint  costs  to  each  product  using  the  relative  sales  value  method,  
and  calculate  the  profit  or  loss  for  each  product.  
b. Explain  what  happened  to  the  profitability  of  each  product  as  the  allocation  
method  was  changed  from  requirement  a  to  requirement  b.  Why  might  
management  make  bad  decisions  using  the  information  from  
requirement  a?  
c. Assume  salmon  can  be  processed  further  into  smoked  salmon  for  an  
additional  $2.50  per  pound.  Customers  are  willing  to  pay  $7  per  pound  for  
smoked  salmon.  Should  Fresh  Catch  process  the  salmon  further?  Explain.  
Allocating  Joint  Costs  (Appendix).  Fruit  Tree  Nursery  (FTN)  grows  
peach  and  apple  trees  in  containers  for  its  customers.  This  past  year,  FTN  
grew  3,000  peach  trees  and  7,000  apple  trees  at  a  cost  of  $100,000.  FTN  
can  sell  peach  trees  for  $20  each  and  apple  trees  for  $11  each.  
Required:  
 . Allocate  joint  costs  to  each  product  using  the  physical  quantities  
method,  and  calculate  the  profit  or  loss  for  each  product.  
a. Allocate  joint  costs  to  each  product  using  the  relative  sales  value  method,  
and  calculate  the  profit  or  loss  for  each  product.  
b. Assume  peach  trees  can  be  processed  further  by  allowing  them  to  grow  for  
another  few  months.  The  additional  processing  cost  is  $4  per  tree,  and  
customers  are  willing  to  pay  $23  for  the  larger  trees.  Should  FTN  process  
the  peach  trees  further?  Explain.  

One  Step  Further:  Skill-­‐Building  Cases  

60. Outsourcing  Building  Materials.  Review  What  qualitative  factors  did  the  manager  of  
the  library’s  construction  likely  consider  in  deciding  to  have  Pretecsa  produce  the  
concrete  panels?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     520  
     
 
 61. Internet  Project:  Outsourcing.  Accenture  LLP  is  a  global  management  consulting,  
technology  services,  and  outsourcing  company  with  more  than  $17  billion  in  annual  
revenues.  Go  to  Accenture’s  Web  site  (http://www.accenture.com)  and  
select  outsourcing,  or  type  outsourcingin  Accenture’s  search  feature.  Review  the  
information  provided  about  outsourcing,  select  a  specific  outsourcing  topic,  and  write  
a  one-­‐page  report  summarizing  your  findings.  
62. Sale  of  Stores  at  Kmart.  Refer  to  What  qualitative  factors  were  likely  considered  by  
the  company’s  management  in  considering  whether  to  keep  the  stores?  
63. Group  Activity:  Qualitative  Factors.  Each  of  the  following  scenarios  is  being  
considered  at  three  separate  companies.  
1. A  company  sells  three  types  of  bicycles  (racers,  cruisers,  and  climbers),  all  of  
which  are  profitable.  The  company  faces  a  labor-­‐hour  bottleneck  and  plans  
to  eliminate  the  cruiser  product  because  it  has  the  lowest  contribution  
margin  per  labor  hour.  
2. A  company  plans  to  accept  a  special  order  at  a  reduced  price  from  a  one-­‐
time  customer.  
3. A  maker  of  car  batteries  plans  to  eliminate  one  of  its  unprofitable  product  
lines.  
Required:  

Form  groups  of  two  to  four  students  and  assign  one  of  the  three  
independent  scenarios  listed  previously  to  each  group.  Each  group  must  
perform  the  following  requirements:  
d. Identify  at  least  two  qualitative  factors  that  should  be  considered  
before  making  the  decision.  
e. Discuss  each  option,  based  on  the  findings  of  your  group,  with  the  class.  

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 Special  Order  Decision  Using  Excel.  The  following  monthly  financial  
data  are  for  Green  Mowers,  Inc.,  a  maker  of  electric  lawn  mowers.  Green  
Mowers  makes  and  sells  5,000  mowers  each  month.  

Green  Mowers  received  an  offer  from  a  one-­‐time  customer  to  purchase  
1,000  mowers  this  coming  month  for  $180  per  unit.  Green  Mowers  can  only  
produce  up  to  5,000  units  a  month,  so  the  special  order  would  reduce  
regular  customer  sales.  Variable  costs  per  unit  will  remain  at  $150.  This  
special  order  will  have  no  effect  on  fixed  costs.  
Required:  
Prepare  an  Excel  spreadsheet,  similar  to  the  one  shown  in  the  Computer  
Application  box,  to  determine  whether  Green  Mowers  would  be  better  off  
rejecting  the  special  order  (Alternative  1)  or  accepting  the  special  order  
(Alternative  2).  Make  a  recommendation  as  to  which  alternative  should  be  
accepted  and  explain  the  reasoning  for  your  recommendation.  
Ethics:  Cost-­‐Plus  Pricing.  JR  Engineering  recently  negotiated  a  cost-­‐
plus  contract  with  Pineville  City  to  provide  engineering  services  at  a  rate  
equal  to  direct  labor  costs  plus  30  percent.  On  a  separate  note,  the  partners  
at  JR  Engineering  discovered  that  one  of  its  customers  filed  for  bankruptcy  
last  month  and  will  not  be  able  to  pay  the  $200,000  owed  to  the  firm.  

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 The  two  partners  at  JR  Engineering,  Julie  and  Ron,  decided  to  include  some  
of  the  direct  labor  costs  incurred  working  on  the  bankrupt  company  with  
the  direct  labor  costs  associated  with  Pineville  City.  As  Ron  stated,  “After  
all,  customers  fail  from  time  to  time,  and  it’s  only  fair  that  our  other  
customers  shoulder  some  of  the  burden.  This  enables  us  to  provide  the  
high-­‐quality  service  we  know  is  so  important  to  our  customers.”  

Are  JR  Engineering’s  actions  ethical?  What  are  the  long-­‐term  implications  of  
JR’s  actions?  Explain.  

Comprehensive  Cases  
66. Make-­‐or-­‐Buy  Decision.  Keyboard,  Inc.,  a  manufacturer  of  pianos,  typically  
sells  each  of  its  pianos  for  $1,480.  The  cost  of  manufacturing  and  marketing  
one  piano  at  the  company’s  usual  monthly  volume  of  6,000  units  is  shown.  

Required:  

a. Keyboard,  Inc.,  received  a  proposal  from  an  independent  

piano  manufacturer  that  will  produce  and  ship  2,000  pianos  each  
month  directly  to  Keyboard’s  customers  as  requested  by  
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 Keyboard’s  salespeople,  at  a  cost  of  $900  each.  This  will  have  the  
effect  of  reducing  total  fixed  marketing  and  administrative  costs  
by  5  percent.  As  a  result  of  reducing  production  capacity,  
Keyboard’s  total  fixed  manufacturing  costs  will  decrease  30  
percent.  Total  variable  manufacturing  costs  will  decrease  since  
only  4,000  pianos  will  be  produced  rather  than  6,000.  Total  
variable  marketing  and  administrative  costs  will  remain  
unchanged.  
Perform  differential  analysis  using  the  format  presented  in  to  
determine  if  Keyboard  should  accept  the  proposal  from  the  
outside  supplier.  Assume  making  all  6,000  pianos  internally  is  
Alternative  1,  and  outsourcing  the  production  of  2,000  pianos  and  
producing  4,000  pianos  internally  is  Alternative  2.  Explain  which  
alternative  is  best.  
b. Assume  the  same  facts  as  in  requirement  a,  with  one  
additional  point.  If  production  of  2,000  pianos  is  outsourced  and  
4,000  pianos  are  produced  internally,  Keyboard  can  use  the  idle  
capacity  to  produce  an  additional  1,400  beginner  pianos  that  can  
be  sold  for  $1,100  each.  Fixed  marketing  and  administrative  costs  
would  be  unchanged  (the  5  percent  reduction  described  in  
requirement  a  no  longer  applies).  Fixed  manufacturing  costs  
would  decrease  by  10  percent  (rather  than  the  30  percent  
described  in  requirement  a).  Per  unit  variable  cost  information  for  
the  beginner  pianos  would  be  as  follows:  
Variable manufacturing costs $400

Variable marketing and administrative costs $ 80

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 c. Perform  differential  analysis  using  the  format  presented  
in  to  determine  if  Keyboard  should  accept  the  proposal  from  the  
independent  supplier.  Assume  making  all  6,000  pianos  internally  
is  Alternative  1.  Alternative  2  consists  of  outsourcing  the  
production  of  2,000  pianos  and  producing  5,400  pianos  internally  
(=  4,000  regular  pianos  +  1,400  beginner  pianos).  Explain  which  
alternative  is  best.  (Hint:  Include  a  line  item  forsales  revenue  in  
your  analysis  to  determine  the  best  alternative.)  
Product  Line  Decision.  The  following  monthly  segmented  income  
statement  is  for  Thirst  Quench,  a  maker  of  soda,  sports  drink,  and  
lemonade.  

Management  is  concerned  about  the  losses  associated  with  the  sports  drink  
and  lemonade  product  lines  and  is  considering  dropping  all  product  lines  
except  soda.  Allocated  fixed  costs  are  assigned  to  product  lines  based  on  
direct  labor  hours  associated  with  each  product  line  resulting  in  the  
following  percentages  for  soda,  sports  drink,  and  lemonade,  respectively:  
25  percent,  20  percent,  and  55  percent.  If  the  sports  drink  and  lemonade  
product  lines  are  eliminated,  total  allocated  fixed  costs  will  decrease  by  
$40,000,  and  variable  costs  and  direct  fixed  costs  for  these  two  product  
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 lines  will  be  eliminated.  (No  allocated  fixed  cost  savings  occur  if  only  one  
product  line  is  dropped.)  
Required:  
 . Perform  differential  analysis  using  the  format  presented  in  .  Assume  
keeping  all  product  lines  is  Alternative  1,  and  keeping  only  the  soda  product  
line  is  Alternative  2.  
a. Which  alternative  is  best?  Explain.  
b. Summarize  the  result  of  keeping  only  the  soda  product  line  using  the  
format  presented  in  .  
c. Management  has  asked  you  to  look  at  the  numbers  for  each  product  line  
and  make  a  recommendation  on  how  to  increase  overall  company  profit.  
What  course  of  action  would  you  recommend?  Based  on  your  
recommendation,  describe  the  qualitative  factors  that  should  be  
considered.  

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 Chapter  8  

How Is Capital Budgeting Used to Make Decisions?

Julie Jackson is the president and owner of Jackson’s Quality Copies, a store that makes
photocopies for its customers and that has several copy machines. Julie has the following
discussion with Mike Haley, the company’s accountant:

Mike, I think it’s time to buy a new copy machine. Our volume of copies has increased dramatically over the last year, and we need a copier
Julie: that does a better job of handling the big jobs.

Mike: Do you have any idea how much the new machine will cost?

We can purchase a new copier for $50,000, maintenance costs will total $1,000 a year, and the copier is expected to last 7 years. Since the new
Julie: machine is quicker and will require less attention by our employees, we should save about $11,000 a year in labor costs.

Mike: Will it have any salvage value at the end of seven years?

Julie: Yes. The salvage value should be about $5,000.

Mike: How soon do you want to do this?

As soon as possible. From what I can tell, this is a winning proposition. The cash inflows of $82,000 that we will get from the labor cost savings
and the salvage value exceed the cash outflows of $57,000 that we expect to spend on the machine and annual maintenance costs. What do you
Julie: think?

Let me take a look at the numbers before we jump into this. We have to consider more than just total cash inflows and outflows. I’ll get back to
Mike: you by the end of the week.

Julie: Okay, thanks for your help!

Jackson’s Quality Copies is facing a decision common to many organizations: whether to invest
in equipment that will last for many years or to continue with existing equipment. This type of
decision differs from the decisions covered in the previous chapter because long-term investment
decisions affect organizations for several years. We will return to Julie’s plan to purchase a new
copier after we provide background information on long-term investment decisions.

8.1 Capital Budgeting and Decision Making

L E A R N I N G   O B J E C T I V E  

1. Apply  the  concept  of  the  time  value  of  money  to  capital  budgeting  decisions.  

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 Question: What is the difference between management decisions made in and management
decisions made in this chapter?

Answer: The types of decisions covered in this chapter and are similar in that they require an
analysis of differential revenues and costs. However,involves short-run operating decisions (e.g.,
special orders from customers), while this chapter focuses on long-run capacity decisions (e.g.,
purchasing long-lived assets to increase capacity for many years).

Organizations make a variety of long-run investment decisions. The San Francisco

Symphony invests in stage risers for its orchestra members.McDonald’s invests in new
restaurants. Honda Motor Co. invests in new manufacturing facilities. Bank of America invests
in new branches. These examples have one common feature: all of these companies are investing
in assets that will affect the organization for several years.

Question: The process of analyzing and deciding which long-term investments to make is called
a capital budgeting decision, also known as a capital expenditure decision. Capital budgeting
decisions involve using company funds (capital) to invest in long-term assets. How does the
evaluation of these types of capital budgeting decisions differ from short-term operating
decisions discussed in ?

Answer: When looking at capital budgeting decisions that affect future years, we must consider
the time value of money. The time value of money concept is the premise that a dollar received
today is worth more than a dollar received in the future. To clarify this point, suppose a friend
owes you $100. Would you prefer to receive $100 today or 3 years from today? The money is
worth more to you if you receive it today because you can invest the $100 for 3 years.

For capital budgeting decisions, the issue is how to value future cash flows in today’s dollars.
The term cash flow refers to the amount of cash received or paid at a specific point in time. The
term present value describes the value of future cash flows (both in and out) in today’s dollars.

Business  in  Action  8.1  

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 Capital Budgeting Decisions at JCPenney and Kohl’s
JCPenney Company has over 1,000 department stores in the United States,
and Kohl’s Corporation has over 800. Both companies cater to a “middle market.” In
October 2006, Kohl’s announced plans to open 65 new stores. At about the same time,
JCPenney announced plans to open 20 new stores, 17 of which would be stand-alone
stores. This was a departure from JCPenney’s typical approach of serving as an anchor
store for regional shopping malls.
The decision to open new stores is an example of a capital budgeting decision because
management must analyze the cash flows associated with the new stores over the long
term.
Source: James Covert, “Chasing Mr. and Mrs. Middle Market: J.C. Penney, Kohl’s Open
85 New Stores,” The Wall Street Journal, October 6, 2006.

When managers evaluate investments in long-term assets, they want to know how much cash
would be spent on the investment and how much cash would be received as a result of the
investment. The investment proposal is likely rejected if cash inflows do not exceed cash
outflows. (Think about a personal investment. If you would receive only $700 in the future from
an investment of $1,000 today, you undoubtedly would not make the investment because you
would lose $300!) If cash inflows are expected to exceed cash outflows, managers must
consider when the cash inflows and outflows occur before taking on the investment. (Again,
consider an investment of $1,000 today. If you expect to receive $1,050 in 20 years rather than at
the end of 1 year, you would probably think twice before investing because it would take 20
years to make $50!)

Question: We use two methods to evaluate long-term investments, both of which consider the
time value of money. What are these two methods?

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 Answer: The first is called the net present value (NPV) method, and the second is called
the internal rate of return method. Before presenting these two methods, let’s discuss the time
value of money (present value) concepts.

The Present Value Formula

Question: Suppose you invest $1,000 for 1 year at an interest rate of 5 percent per year, as
shown in the following timeline. How much will you have at the end of 1 year (or what is
the future value of the investment)?

Answer: You will have $1,050:

$1,050 = $1,000 × (1 + .05)

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 Question: Let’s change course and find the present value of the same future cash flow. If you
receive $1,050 in 1 year, how much is that worth in today’s dollars assuming an annual interest
rate of 5 percent?

Answer: The present value is $1,000, calculated as follows:

$1,000=$1,050(1+.05)

Question: Let’s go back to finding a future value. Assume you invest $1,000 today at an annual
rate of 5 percent for 2 years. How much will you have at the end of 2 years?

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Answer: At the end of 1 year, you will have $1,050 (= $1,000 × [1 + .05]). At the end of the
second year, you will have $1,102.50, which is $1,050 × (1 + .05). The equation is

$1,102.50 = $1,000 × (1 + .05) × (1 + .05)or$1,102.50 = $1,000 × (1 + .05)2

Question: Again, let’s change course and find the present value of the same future cash flow. If
you receive $1,102.50 in 2 years, how much is that worth in today’s dollars assuming an annual
interest rate of 5 percent?

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Answer: The present value is $1,000, calculated as follows:

$1,000=$1,102.50(1+.05)2

These examples show that one equation can be used to find the present valueof a future cash
flow. The equation is

Key  Equation  

P=Fn(1+r)n  

where

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 P  =  Present  value  of  an  amountFn  =  Amount  received  n  years  in  the  futurer  =  Annual  interest  
raten  =  Number  of  years  

Question: Let’s use this formula to solve for the following: Assume $500 will be received 4 years
from today, and the annual interest rate is 10 percent. What is the present value of this cash
flow?

Answer: The present value is $341.51, calculated as follows:

P=Fn(1+r)n=$500(1+.10)4=$5001.4641=$341.51

Present Value Tables

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 Question: Although most managers use spreadsheets, such as Excel, to perform present value
calculations (discussed later in this chapter), you can also use the present value tables in the
appendix to this chapter, labeled and , for these calculations. simply provides the present value
of $1 (i.e., F = $1) given the number of years (n) and the interest rate (r). How are these tables
used to calculate present value amounts?

Answer: Let’s look at an example to see how these tables work. Assume $1 will be received 4
years from today (n = 4), and the interest rate is 10 percent (r = 10 percent). What is the present
value of this cash flow? Look atin the appendix. Find the column labeled 10 percent and the row
labeled 4. The present value is $0.6830, or $0.68 rounded. The table amount given is often called
a factor. The factor in this example is 0.6830 (note that the formula to find this factor is shown at
the top of ).

Now assume all the same facts, except that $500 rather than $1 will be received in 4 years. To
find the present value, simply multiply the factor found in by $500, as follows:

Present value=Amount received in the future × Present value factor=$500×0.6830=$341.50

Notice that this present value is the same as the one we calculated using the formula P = Fn ÷ (1
+ r)n, with the exception of a small difference due to rounding the factor in . Next, we use
present value concepts to evaluate projects with the NPV method.

K E Y   T A K E A W A Y  

• Present  value  calculations  tell  us  the  value  of  future  cash  flows  in  today’s  
dollars.  The  present  value  of  a  cash  flow  can  be  calculated  by  using  the  
formula  P  =  Fn  ÷  (1  +  r)n.  It  can  also  be  calculated  by  using  the  tables  in  the  
appendix  of  this  chapter.  Simply  find  the  factor  in  given  the  number  of  
years  (n)  and  annual  interest  rate  (r).  Then  multiply  the  factor  by  the  future  
cash  flow,  as  follows:  

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 Present  value  =  Amount  received  in  the  future  ×  Present  value  factor  

R E V I E W   P R O B L E M   8 . 1  

For  each  of  the  following  independent  scenarios,  calculate  the  present  value  of  the  
cash  flow  described.  Round  to  the  nearest  dollar.  
1. You  will  receive  $5,000,  5  years  from  today,  and  the  interest  rate  is  8  percent.  
2. You  will  receive  $80,000,  9  years  from  today,  and  the  interest  rate  is  10  percent.  
3. You  will  receive  $400,000,  20  years  from  today,  and  the  interest  rate  is  20  percent.  
4. You  will  receive  $250,000,  10  years  from  today,  and  the  interest  rate  is  15  percent.  

Solution  to  Review  Problem  8.1  

Two  approaches  can  be  used  to  find  the  present  value  of  a  cash  flow.  The  first  
requires  using  the  formula  P  =  Fn  ÷  (1  +  r)n.  The  second  requires  usingin  the  appendix  
to  find  the  present  value  factor  and  inserting  it  in  the  following  formula:  

Present  value  =  Amount  received  in  the  future  ×  Present  value  factor  (from  )  

We  show  both  approaches  in  the  following  solutions.  

1. Using  the  formula  P  =  Fn  ÷  (1  +  r)n,  we  get  

$3,403=$5,000÷(1+.08)5  

Using  ,  we  get  

Present value$3,403=Future value × Present value factor=$5,000×0.6806  

2. Using  the  formula  P  =  Fn  ÷  (1  +  r)n,  we  get  

$33,928=$80,000÷(1+.10)9  

Using  ,  we  get  

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 Present value$33,928=Future value × Present value factor=$80,000×0.4241  

3. The  small  difference  between  the  two  approaches  is  due  to  rounding  the  
factor  in  .  
Using  the  formula  P  =  Fn  ÷  (1  +  r)n,  we  get  

10,434=$400,000÷(1+.20)20  

Using  ,  we  get  

Present value$10,440=Future value × Present value factor=$400,000×0.0261  

4. The  small  difference  between  the  two  approaches  is  due  to  rounding  the  
factor  .  
Using  the  formula  P  =  Fn  ÷  (1  +  r)n,  we  get  

$61,796=$250,000÷(1+.15)10  

Using  ,  we  get  

Present value$61,800=Future value × Present value factor=$250,000×0.2472  

8.2 Net Present Value

L E A R N I N G   O B J E C T I V E  

1. Evaluate  investments  using  the  net  present  value  (NPV)  approach.  

Question: Now that we have the tools to calculate the present value of future cash flows, we can
use this information to make decisions about long-term investment opportunities. How does this
information help companies to evaluate long-term investments?

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 Answer: The net present value (NPV) method of evaluating investments adds the present value
of all cash inflows and subtracts the present value of all cash outflows. The term discounted cash
flows is also used to describe the NPV method. In the previous section, we described how to find
the present value of a cash flow. The term net in net present value means to combine the present
value of all cash flows related to an investment (both positive and negative).

Recall the problem facing Jackson’s Quality Copies at the beginning of the chapter. The
company’s president and owner, Julie Jackson, would like to purchase a new copy machine. Julie
feels the investment is worthwhile because the cash inflows over the copier’s life total $82,000,
and the cash outflows total $57,000, resulting in net cash inflows of $25,000 (= $82,000 –
$57,000). However, this approach ignores the timing of the cash flows. We know from the
previous section that the further into the future the cash flows occur, the lower the value in
today’s dollars.

Question: How do managers adjust for the timing differences related to future cash flows?

Answer: Most managers use the NPV approach. This approach requires three steps to evaluate
an investment:

Step 1. Identify the amount and timing of the cash flows required over the life of the
investment.

Step 2. Establish an appropriate interest rate to be used for evaluating the investment,
typically called therequired rate of return. (This rate is also called the discount rate or hurdle
rate.)

Step 3. Calculate and evaluate the NPV of the investment.

Let’s use Jackson’s Quality Copies as an example to see how this process works.

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 Step 1. Identify the amount and timing of the cash flows required over the life of the
investment.

Question: What are the cash flows associated with the copy machine that Jackson’s Quality
Copies would like to buy?

Answer: Jackson’s Quality Copies will pay $50,000 for the new copier, which is expected to last
7 years. Annual maintenance costs will total $1,000 a year, labor cost savings will total $11,000
a year, and the company will sell the copier for $5,000 at the end of 7 years. Figure 8.1 "Cash
Flows for Copy Machine Investment by Jackson’s Quality Copies"summarizes the cash flows
related to this investment. Amounts in parentheses are cash outflows. All other amounts are cash
inflows.

Figure 8.1 Cash Flows for Copy Machine Investment by Jackson’s Quality Copies

 
Step 2. Establish an appropriate interest rate to be used for evaluating the investment.

Question: How do managers establish the interest rate to be used for evaluating an investment?

Answer: Although managers often estimate the interest rate, this estimate is typically based on
the organization’s cost of capital. The cost of capital is the weighted average costs associated
with debt and equity used to fund long-term investments. The cost of debt is simply the interest
rate associated with the debt (e.g., interest for bank loans or bonds issued). The cost of equity is
more difficult to determine and represents the return required by owners of the organization. The

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 weighted average of these two sources of capital represents the cost of capital (finance textbooks
address the complexities of this calculation in more detail).

The general rule is the higher the risk of the investment, the higher the required rate of return
(assume required rate of return is synonymous withinterest rate for the purpose of calculating the
NPV). A firm evaluating a long-term investment with risk similar to the firm’s average risk will
typically use the cost of capital. However, if a long-term investment carries higher than average
risk for the firm, the firm will use a required rate of return higher than the cost of capital.

The accountant at Jackson’s Quality Copies, Mike Haley, has established the cost of capital for
the firm at 10 percent. Since the proposed purchase of a copy machine is of average risk to the
company, Mike will use 10 percent as the required rate of return.

Step 3. Calculate and evaluate the NPV of the investment.

Question: How do managers calculate the NPV of an investment?

Answer: Figure 8.2 "NPV Calculation for Copy Machine Investment by Jackson’s Quality
Copies" shows the NPV calculation for Jackson’s Quality Copies. Examine this table carefully.
The cash flows come from Figure 8.1 "Cash Flows for Copy Machine Investment by Jackson’s
Quality Copies". The present value factors come from Figure 8.9 "Present Value of $1 Received
at the End of " in the appendix (r = 10 percent; n = year). The bottom row, labeled present
value is calculated by multiplying the total cash in (out) × present value factor, and it represents
total cash flows for each time period in today’s dollars. The bottom right of Figure 8.2 "NPV
Calculation for Copy Machine Investment by Jackson’s Quality Copies" shows the NPV for the
investment, which is the sum of the bottom row labeled present value.

Figure 8.2 NPV Calculation for Copy Machine Investment by Jackson’s Quality Copies

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The NPV is $1,250. Because NPV is > 0, accept the investment. (The investment provides a
return greater than 10 percent.)

The NPV Rule

Question: Once the NPV is calculated, how do managers use this information to evaluate a long-
term investment?

Answer: Managers apply the following rule to decide whether to proceed with the investment:

NPV Rule: If the NPV is greater than or equal to zero, accept the investment; otherwise, reject
the investment.

As summarized in Figure 8.3 "The NPV Rule", if the NPV is greater than zero, the rate of return
from the investment is higher than the required rate of return. If the NPV is zero, the rate of
return from the investment equals the required rate of return. If the NPV is less than zero, the rate
of return from the investment is less than the required rate of return. Since the NPV is greater
than zero for Jackson’s Quality Copies, the investment is generating a return greater than the
company’s required rate of return of 10 percent.

Figure 8.3 The NPV Rule

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Note that the present value calculations in Figure 8.3 "The NPV Rule"assume that the
cash flows for years 1 through 7 occur at the end of each year. In reality, these cash flows
occur throughout each year. The impact of this assumption on the NPV calculation is
typically negligible.
Business  in  Action  8.2  
Cost of Capital by Industry
Cost of capital can be estimated for a single company or for entire industries. New
York University’s Stern School of Businessmaintains cost of capital figures by
industry. Almost 7,000 firms were included in accumulating this information. The
following sampling of industries compares the cost of capital across industries. Notice
that high-risk industries (e.g., computer, e-commerce, Internet, and semiconductor)
have relatively high costs of capital.
Air transportation 11.48 percent

Auto and truck 11.04 percent

Auto parts 9.56 percent

Beverage (soft drinks) 8.16 percent

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 Computer 14.49 percent

E-commerce 15.65 percent

Grocery 9.79 percent

Internet 15.98 percent

Retail store 9.30 percent

Semiconductor 19.03 percent

Source: New York University’s Stern Business School, “Home

Page,”http://pages.stern.nyu.edu.

Annuity Tables

Question: Notice in Figure 8.1 "Cash Flows for Copy Machine Investment by Jackson’s Quality
Copies" that the rows labeled maintenance cost and labor savings have identical cash flows from
one year to the next. Identical cash flows that occur in regular intervals, such as these at
Jackson’s Quality Copies, are called an annuity. How can we use annuities in an alternate
format to calculate the NPV?

Answer: In Figure 8.4 "Alternative NPV Calculation for Jackson’s Quality Copies", we
demonstrate an alternative approach to calculating the NPV.

Figure 8.4 Alternative NPV Calculation for Jackson’s Quality Copies

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*Because this is not an annuity, use Figure 8.9 "Present Value of $1 Received at the End of " in
the appendix.

**Because this is an annuity, use Figure 8.10 "Present Value of a $1 Annuity Received at the
End of Each Period for " in the appendix. The number of years (n) equals seven since identical
cash flows occur each year for seven years.

Note: the NPV of $1,250 is the same as the NPV in Figure 8.2 "NPV Calculation for Copy
Machine Investment by Jackson’s Quality Copies".

The purchase price and salvage value rows in Figure 8.4 "Alternative NPV Calculation for
Jackson’s Quality Copies" represent one-time cash flows, and thus we use Figure 8.9 "Present
Value of $1 Received at the End of " in the appendix to find the present value factor for these
items (these are notannuities). The annual maintenance costs and annual labor savings rows
represent cash flows that occur each year for seven years (these are annuities). We use Figure
8.10 "Present Value of a $1 Annuity Received at the End of Each Period for " in the appendix to
find the present value factor for these items (note that the number of years, n, equals seven since
the cash flows occur each year for seven years). Simply multiply the cash flow shown in
column (A) by the present value factor shown in column (B) to find the present value for each
line item. Then sum the present value column to find the NPV. This alternative approach results

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 in the same NPV shown inFigure 8.2 "NPV Calculation for Copy Machine Investment by
Jackson’s Quality Copies".

Business  in  Action  8.3  

Winning the Lottery
Like many other states, California pays out lottery winnings in installments over several
years. For example, a $1,000,000 lottery winner in California will receive $50,000 each
year for 20 years.
Does this mean that the State of California must have $1,000,000 on the day the winner
claims the prize? No. In fact, California has approximately $550,000 in cash to pay
$1,000,000 over 20 years. This $550,000 in cash represents the present value of a
$50,000 annuity lasting 20 years, and the state invests it so that it can provide
$1,000,000 to the winner over 20 years.
Source: California State Lottery, “California State Lottery Home
Page,”http://www.calottery.com.
K E Y   T A K E A W A Y  

• Present  value  calculations  tell  us  the  value  of  cash  flows  in  today’s  dollars.  The  NPV  
method  adds  the  present  value  of  all  cash  inflows  and  subtracts  the  present  value  of  
all  cash  outflows  related  to  a  long-­‐term  investment.  If  the  NPV  is  greater  than  or  
equal  to  zero,  accept  the  investment;  otherwise,  reject  the  investment.  
R E V I E W   P R O B L E M   8 . 2  

The  management  of  Chip  Manufacturing,  Inc.,  would  like  to  purchase  a  specialized  
production  machine  for  $700,000.  The  machine  is  expected  to  have  a  life  of  4  years,  
and  a  salvage  value  of  $100,000.  Annual  maintenance  costs  will  total  $30,000.  Annual  
labor  and  material  savings  are  predicted  to  be  $250,000.  The  company’s  required  rate  
of  return  is  15  percent.  

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 1. Ignoring  the  time  value  of  money,  calculate  the  net  cash  inflow  or  outflow  resulting  
from  this  investment  opportunity.  
2. Find  the  NPV  of  this  investment  using  the  format  presented  in  Figure  8.2  "NPV  
Calculation  for  Copy  Machine  Investment  by  Jackson’s  Quality  Copies".  
3. Find  the  NPV  of  this  investment  using  the  format  presented  in  Figure  8.4  "Alternative  
NPV  Calculation  for  Jackson’s  Quality  Copies".  
4. Should  Chip  Manufacturing,  Inc.,  purchase  the  specialized  production  machine?  
Explain.  

Solution  to  Review  Problem  8.2  

1. The  net  cash  inflow,  ignoring  the  time  value  of  money,  is  $280,000,  
calculated  as  follows:  

2. The  NPV  is  $(14,720),  calculated  as  follows:  

 
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 3. The  alternative  format  used  for  calculating  the  NPV  is  shown  as  follows.  Note  
that  the  NPV  here  is  identical  to  the  NPV  calculated  previously  in  part  2.  

*Because  this  is  not  an  annuity,  use  Figure  8.9  "Present  Value  of  $1  Received  
at  the  End  of  "  in  the  appendix.  
**Because  this  is  an  annuity,  use  Figure  8.10  "Present  Value  of  a  $1  Annuity  
Received  at  the  End  of  Each  Period  for  "  in  the  appendix.  The  number  of  
years  (n)  equals  four  since  identical  cash  flows  occur  each  year  for  four  
years.  
4. Because  the  NPV  is  less  than  0,  the  return  generated  by  this  investment  is  less  than  
the  company’s  required  rate  of  return  of  15  percent.  Thus  Chip  Manufacturing,  Inc.,  
should  not  purchase  the  specialized  production  machine.  

8.3 The Internal Rate of Return

L E A R N I N G   O B J E C T I V E  

1. Evaluate  investments  using  the  internal  rate  of  return  (IRR)  approach.  

Question: Using the internal rate of return (IRR) to evaluate investments is similar to using the
net present value (NPV) in that both methods consider the time value of money. However, the
IRR provides additional information that helps companies evaluate long-term investments. What
is the IRR, and how does it help managers make decisions related to long-term investments?
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 Answer: The internal rate of return (IRR) is the rate required (r) to get an NPV of zero for a
series of cash flows. The IRR represents the time-adjusted rate of return for the investment being
considered. The IRR decision rulestates that if the IRR is greater than or equal to the company’s
required rate of return (recall that this is often called the hurdle rate), the investment is accepted;
otherwise, the investment is rejected.

Most managers use a spreadsheet, such as Excel, to calculate the IRR for an investment (we
discuss this later in the chapter). However, we can also use trial and error to approximate the
IRR. The goal is simply to find the rate that generates an NPV of zero. Let’s go back to the
Jackson’s Quality Copies example. provides the projected cash flows for a new copy machine
and the NPV calculation using a rate of 10 percent. Recall that the NPV was $1,250, indicating
the investment generates a return greater than the company’s required rate of return of 10
percent.

Although it is useful to know that the investment’s return is greater than the company’s required
rate of return, managers often want to know the exact return generated by the investment. (It is
often not enough to state that the exact return is something higher than 10 percent!) Managers
also like to rank investment opportunities by the return each investment is expected to generate.
Our goal now is to determine the exact return—that is, to determine the IRR. We know from that
the copy machine investment generates a return greater than 10 percent. summarizes this
calculation with the 2 columns under the 10 percent heading.

The far right side of shows that the NPV is $(2,100) if the rate is increased to 12 percent (recall
our goal is to find the rate that yields an NPV of 0). Thus the IRR is between 10 and 12 percent.
Next, we try 11 percent. As shown in the middle of , 11 percent provides an NPV of $(469).
Thus the IRR is between 10 and 11 percent; it is closer to 11 percent because $(469) is closer to
0 than $1,250. (Note that as the rate increases, the NPV decreases, and as the rate decreases, the
NPV increases.)

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 Figure 8.5 Finding the IRR for Jackson’s Quality Copies

 
*Because this is not an annuity, use in the appendix.

**Because this is an annuity, use in the appendix. The number of years (n) equals seven since
identical cash flows occur each year for seven years.

Note: the NPV of $(469) is closest to 0. Thus the IRR is close to 11 percent.

This trial and error approach allows us to approximate the IRR. As stated earlier, if the IRR is
greater than or equal to the company’s required rate of return, the investment is accepted;
otherwise, the investment is rejected. For Jackson’s Quality Copies, the IRR of approximately 11
percent is greater than the company’s required rate of return of 10 percent. Thus the investment
should be accepted.

Computer  Application  
Using Excel to Calculate NPV and IRR
Let’s use the Jackson’s Quality Copies example presented at the beginning of the chapter
to illustrate how Excel can be used to calculate the NPV and IRR. Two steps are required
to calculate the NPV and IRR using Excel. All cell references are to the following
spreadsheet shown.

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Step 1. Enter the data in the spreadsheet.
Rows 1 through 7 in the spreadsheet show the cash flows associated with the proposal to
purchase a new copy machine at Jackson’s Quality Copies (first presented in ).
Step 2. Input the functions to calculate NPV and IRR.
We selected cell H16 to calculate the NPV, so this is where the NPV function is input.
Cell E16 shows the function in detail with dialogue boxes provided for clarification.
Notice that the resulting NPV of $1,250 shown in cell H16 is the same as the NPV
calculated in and .
We selected cell H28 to calculate the IRR, so this is where the IRR function is input. Cell
E28 shows the function in detail. Notice that the resulting IRR of 10.72 percent shown
in cell H28 is very close to our approximation of slightly less than 11 percent shown in .
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 As an alternative to entering a function directly into the spreadsheet, the NPV function
under the Formulas menu in Excel can be used. Simply select the cell in the spreadsheet
where you would like the answer to appear (H16 in this case), and go to
the Formulas menu. Click on the fxsymbol or Insert Function on the formula bar.
Search for the function by typing in NPV, select NPV where it appears in the box, then
select OK. When asked for the Rate, enter the cell where the rate appears (B10). Then
under Value 1 enter the cells containing the series of cash flows, starting with year 1
(shown as C7:I7, which means C7 through I7). Select OK. Now go back and add the cash
flow at time 0 (B7) to the end of the NPV function. The resulting formula will look like
the formula shown in E16, and the answer will appear in the cell where the function is
entered (H16).
The IRR function can be inserted into a cell using the same process presented
previously. Select the cell in the spreadsheet where you would like the answer to appear
(H28), and go to the Formulas menu. Click on the fx symbol or Insert Function on the
formula bar. Search for the function by typing in IRR, select IRR where it appears in the
box below, then select OK. When asked for Values, enter the cells containing the series
of cash flows, starting with time 0 (shown as B7:I7, which means B7 through I7). When
asked for a Guess, enter your best guess as to what the IRR might be (this provides the
system with a starting point), then select OK. The resulting formula will look like the
formula shown in E28, and the answer will appear in the cell where the function is
entered (H28).
K E Y   T A K E A W A Y  

• The  IRR  is  the  rate  required  (r)  to  get  an  NPV  of  zero  for  a  series  of  cash  flows  and  
represents  the  time-­‐adjusted  rate  of  return  for  an  investment.  If  the  IRR  is  greater  
than  or  equal  to  the  company’s  required  rate  of  return  (often  called  the  hurdle  rate),  
the  investment  is  accepted;  otherwise,  the  investment  is  rejected.  
R E V I E W   P R O B L E M   8 . 3  

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 This  review  problem  is  a  continuation  of  ,  and  uses  the  same  information.  The  
management  of  Chip  Manufacturing,  Inc.,  would  like  to  purchase  a  specialized  
production  machine  for  $700,000.  The  machine  is  expected  to  have  a  life  of  4  years,  
and  a  salvage  value  of  $100,000.  Annual  maintenance  costs  will  total  $30,000.  Annual  
labor  and  material  savings  are  predicted  to  be  $250,000.  The  company’s  required  rate  
of  return  is  15  percent.  
1. Based  on  your  answer  to  ,  use  trial  and  error  to  approximate  the  IRR  for  this  
investment  proposal.  
2. Should  Chip  Manufacturing,  Inc.,  purchase  the  specialized  production  machine?  
Explain.  

Solution  to  Review  Problem  8.3  

1. In  ,  the  NPV  was  calculated  using  15  percent  (the  company’s  required  rate  of  
return).  Knowing  that  15  percent  results  in  an  NPV  of  $(14,720),  and  
therefore  seeing  the  return  is  less  than  15  percent,  we  decreased  the  rate  
to  13  percent.  As  shown  in  the  following  figure,  this  resulted  in  an  NPV  of  
$15,720,  which  indicates  the  return  is  higher  than  13  percent.  Using  a  rate  
of  14  percent  results  in  an  NPV  very  close  to  0  at  $224.  Thus  the  IRR  is  close  
to  14  percent.  

*Because  this  is  not  an  annuity,  use  in  the  appendix.  

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 **Because  this  is  an  annuity,  use  in  the  appendix.  The  number  of  years  (n)  
equals  four  since  identical  cash  flows  occur  each  year  for  four  years.  
2. Because  the  IRR  of  14  percent  is  less  than  the  company’s  required  rate  of  return  of  15  
percent,  Chip  Manufacturing,  Inc.,  should  notpurchase  the  specialized  production  
machine.  

8.4 Other Factors Affecting NPV and IRR Analysis

L E A R N I N G   O B J E C T I V E  

1. Understand  the  impact  of  cash  flows,  qualitative  factors,  and  ethical  issues  on  long-­‐
term  investment  decisions.  

Question: We have described the net present value (NPV) and internal rate of return (IRR)
approaches to evaluating long-term investments. With both of these approaches, there are
several important issues that must be considered.What are these important issues?

Answer: These issues include focusing on cash flows, factoring in inflation, assessing
qualitative factors, and ethical considerations. All are described next.

Focusing on Cash Flows

Question: Which basis of accounting is used to calculate the NPV and IRR for long-term
investments, cash or accrual?

Answer: Both methods of evaluating long-term investments, NPV and IRR, focus on the amount
of cash flows and when the cash flows occur. Note that the timing of revenues and costs in
financial accounting using the accrual basis is often not the same as when the cash inflows and
outflows occur. A sale can be recorded in one period, and the cash be collected in a future
period. Costs can occur in one period, and the cash be paid in a future period. For the purpose of

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 making NPV and IRR calculations, managers typically use the time period when the cash flow
occurs.

When a company invests in a long-term asset, such as a production building, the cash outflow for
the asset is included in the NPV and IRR analyses. The depreciation taken on the asset in future
periods is not a cash flow and is not included in the NPV and IRR calculations. However, there is
a cash benefit related to depreciation (often called a depreciation tax shield) since income taxes
paid are reduced as a result of recording depreciation expense. We explore the impact of income
taxes on NPV and IRR calculations later in the chapter.

Factoring in Inflation

Question: Is inflation included in cash flow projections when calculating the NPV and IRR?

Answer: Most managers make cash flow projections that include an adjustment for inflation.
When this is done, a rate must be used that also factors in inflation over the life of the
investment. As discussed earlier in the chapter, the required rate of return used for NPV
calculations is based on the firm’s cost of capital, which is the weighted average cost of debt and
equity. Since the cost of debt and equity already includes the effect of inflation, no inflation
adjustment is necessary when establishing the required rate of return.

The important point here is that cash flow projections must include adjustments for inflation to
match the required rate of return, which already factors in inflation. If cash flows are not adjusted
for inflation, managers are likely underestimating future cash flows and therefore
underestimating the NPV of the investment opportunity. This is particularly pronounced for
economies that have relatively high rates of inflation.

For the purposes of this chapter, assume all cash flows and required rates of return are adjusted
for inflation.

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 Be Aware of Qualitative Factors

Question: So far, this chapter has focused on using cash flow projections and the time value of
money to evaluate long-term investments. Using these quantitative factors to make decisions
allows managers to support decisions with measurable data. For example, the investment
opportunity at Jackson’s Quality Copies presented at the beginning of the chapter was accepted
because the NPV of $1,250 was greater than 0, and the IRR of 11 percent was greater than the
company’s required rate of return of 10 percent. Why do most companies also consider
nonfinancial factors, often called qualitative factors, when making a long-term investment
decision?

Answer: Although using quantitative factors for decision making is important, qualitative factors
may outweigh the quantitative factors in making a decision. For example, a large manufacturer
of medical devices recently invested several million dollars in a small start-up medical device
firm. When asked about the NPV analysis, the manager responsible for the investment indicated,
“My staff did a quick and dirty NPV analysis, which indicated we should not invest in the
company. However, the technology they were using for their device was of such strategic
importance to us, we could not pass up the investment.” This is an example of qualitative factors
(strategic importance to the company) outweighing quantitative factors (negative NPV).

Similar situations often arise when companies must invest in long-term assets even though NPV
and IRR analyses indicate otherwise. Here are a few examples:

• Investing in new production facilities may be essential to maintaining a reputation as the

industry leader in innovation, even though the quantitative analysis (NPV and IRR)
points to rejecting the investment. (It is difficult to quantify the benefits of being the
“industry leader in innovation.”)
• Investing in pollution control devices for an oil refinery may provide social benefits even
though the quantitative analysis (NPV and IRR) points to rejecting the investment.
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 (Although a reduction in fines and legal costs may be quantifiable and included in the
analyses, it is difficult to quantify the social benefits.)
• Investing in a new product line of entry-level automobiles may increase foot traffic at the
showroom, resulting in increased sales of other products, even though the quantitative
analysis (NPV and IRR) points to rejecting the investment. (It is difficult to quantify the
impact of the new product line on sales of existing product lines.)
• Clearly, managers must look at the financial information and analysis when considering
whether to invest in long-term assets. However, the analysis does not stop with financial
information. Managers and decision makers must also consider qualitative factors.

Ethical Issues

Question: Our discussion of NPV and IRR methods implies that managers can easily make
capital budgeting decisions once NPV and IRR analyses are completed and qualitative factors
have been considered. However, managers sometimes make decisions that are not in the best
interest of the company. Why might managers make decisions that are not in the best interest of
the company?

Answer: Several examples are provided next.

Short-Term Incentives Affect Long-Term Decisions

Managers are often evaluated and compensated based on annual financial results. The financial
results are typically measured using financial accounting data prepared on an accrual basis.

Suppose you are a manager considering an investment opportunity to start a new product line
that has a positive NPV. Because the NPV is positive, you should accept the investment
proposal. However, revenues and related cash inflows are not significant until after the second
year. In the first two years, revenues are low and depreciation charges are high, resulting in
significantly lower overall company net income than if the project were rejected. Assuming you

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 are evaluated and compensated based on annual net income, you may be inclined to reject the
new product line regardless of the NPV analysis.

Many companies are aware of this conflict between the manager’s incentive to improve short-
term results and the company’s goal to improve long-term results. To mitigate this conflict, some
companies offer managers part ownership in the company (e.g., through stock options), creating
an incentive to increase the value of the company over the long run.

Modifying Cash Flow Estimates to Get Approval

Managers often have a vested interest in getting proposals approved regardless of NPV and IRR
results. For example, assume a manager spent several years developing a plan to construct a new
production facility. Because of the significant work involved, and the projected benefits of
building a new facility, the manager wants to see the proposal approved. However, the NPV
analysis indicates the production facility proposal does not meet the company’s minimum
required rate of return. As a result, the manager decides to inflate projected cash inflows to get a
positive NPV, and the project is approved.

Clearly, a conflict exists between the company’s desire to accept projects that meet or exceed the
required rate of return and the manager’s desire to get approval for a “pet” project regardless of
its profitability. Again, having part ownership in a company provides an incentive for managers
to reject proposals that will not increase the value of the company.

Another way to mitigate this conflict is to conduct a postaudit, which compares the original
capital budget with the actual results. Managers who provide misleading capital budget analyses
are identified through this process. Postaudits provide an incentive for managers to provide
accurate estimates.

K E Y   T A K E A W A Y  

• Although  accountants  are  responsible  for  providing  relevant  and  objective  

financial  information  to  help  managers  make  decisions,  several  important  
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 factors  play  a  significant  role  in  the  decision-­‐making  process  as  described  
here:  
o NPV  and  IRR  analyses  use  cash  flows  to  evaluate  long-­‐term  investments  
rather  than  the  accrual  basis  of  accounting.  
o Cash  flow  projections  must  include  adjustments  for  inflation  to  match  the  
required  rate  of  return,  which  already  factor  in  inflation.  
o Using  quantitative  factors  to  make  decisions  allows  managers  to  support  
decisions  with  measurable  data.  However,  nonfinancial  factors  (often  called  
qualitative  factors)  must  be  considered  as  well.  
o Circumstances  sometimes  exist  that  cause  managers  to  make  decisions  that  
are  not  in  the  best  interest  of  the  company.  For  example,  managers  may  be  
evaluated  on  short-­‐term  financial  results  even  though  it  is  in  the  best  
interest  of  the  company  to  invest  in  projects  that  are  profitable  in  the  long  
term.  Thus  projects  that  reduce  short-­‐term  profitability  in  lieu  of  significant  
long-­‐term  profits  may  be  rejected.  
R E V I E W   P R O B L E M   8 . 4  

1. Why  must  cash  flow  projections  include  adjustments  for  inflation?  

2. Why  is  it  important  for  organizations  to  consider  qualitative  factors  when  making  
capital  budgeting  decisions?  

3. Assume  the  manager  of  Best  Electronics  earns  an  annual  bonus  based  on  
meeting  a  certain  level  of  net  income.  The  company  is  currently  considering  
expanding  by  adding  a  second  retail  store.  The  second  store  is  expected  to  
become  profitable  three  years  after  opening.  The  manager  is  responsible  
for  making  the  final  decision  as  to  whether  the  second  store  should  be  
opened  and  would  be  in  charge  of  both  stores.  

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 1. Why  might  the  manager  refuse  to  invest  in  the  new  store  even  though  the  
investment  is  projected  to  achieve  a  return  greater  than  the  company’s  
required  rate  of  return?  
2. What  can  the  company  do  to  mitigate  the  conflict  between  the  manager’s  
interest  of  achieving  the  bonus  and  the  company’s  desire  to  accept  
investments  that  exceed  the  required  rate  of  return?  

Solution  to  Review  Problem  8.4  

1. Projected  cash  flows  must  include  an  adjustment  for  inflation  to  match  the  required  
rate  of  return.  The  required  rate  of  return  is  based  on  the  company’s  weighted  
average  cost  of  debt  and  equity.  The  cost  of  debt  and  equity  already  factors  in  
inflation.  Thus  the  cash  flows  must  also  factor  in  inflation  to  be  consistent  with  the  
required  rate  of  return.  
2. Although  managers  prefer  to  make  capital  budgeting  decisions  based  on  quantifiable  
data  (e.g.,  using  NPV  or  IRR),  nonfinancial  factors  may  outweigh  financial  factors.  For  
example,  maintaining  a  reputation  as  the  industry  leader  may  require  investing  in  
long-­‐term  assets,  even  though  the  investment  does  not  meet  the  minimum  required  
rate  of  return.  The  management  believes  the  qualitative  factor  of  being  the  industry  
leader  is  critical  to  the  company’s  future  success  and  decides  to  make  the  investment.  

3. Best  Electronics  is  considering  opening  a  second  store.  

1. The  manager’s  bonus  is  based  on  achieving  a  certain  level  of  net  income  
each  year,  and  the  new  store  will  likely  cause  net  income  to  decrease  in  the  
first  two  years.  Thus  the  manager  may  not  be  able  to  achieve  the  net  
income  necessary  to  qualify  for  the  bonus  if  the  company  invests  in  the  new  
store.  
2. To  mitigate  this  conflict,  Best  Electronics  can  offer  the  manager  part  
ownership  in  the  company  (perhaps  through  stock  options).  This  would  
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 provide  an  incentive  for  the  manager  to  increase  profit—and  therefore  
company  value—over  many  years.  The  company  may  also  adjust  the  net  
income  required  to  earn  a  bonus  to  account  for  the  losses  expected  in  the  
new  store  for  the  first  two  years.  

8.5 The Payback Method

L E A R N I N G   O B J E C T I V E  

1. Evaluate  investments  using  the  payback  method.  

Question: Although the net present value (NPV) and internal rate of return (IRR) methods are
the most commonly used approaches to evaluating investments, some managers also use the
payback method. What is the payback method, and how does it help managers make decisions
related to long-term investments?

Answer: The payback method evaluates how long it will take to “pay back” or recover the initial
investment. The payback period, typically stated in years, is the time it takes to generate enough
cash receipts from an investment to cover the cash outflows for the investment.

Managers who are concerned about cash flow want to know how long it will take to recover the
initial investment. The payback method provides this information. Managers may also require a
payback period equal to or less than some specified time period. For example, Julie Jackson, the
owner of Jackson’s Quality Copies, may require a payback period of no more than five years,
regardless of the NPV or IRR.

Note that the payback method has two significant weaknesses. First, it doesnot consider the time
value of money. Second, it only considers the cash inflows until the investment cash outflows are
recovered; cash inflows after the payback period are not part of the analysis. Both of these
weaknesses require that managers use care when applying the payback method.

Payback Method Example

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 Question: What is the payback period for the proposed purchase of a copy machine at Jackson’s
Quality Copies?

Answer: The payback period is five years. Here’s how we calculate it. Figure 8.6 "Summary of
Cash Flows for Copy Machine Investment by Jackson’s Quality Copies" repeats the cash flow
estimates for Julie Jackson’s planned purchase of a copy machine for Jackson’s Quality Copies,
the example presented at the beginning of the chapter.

Figure 8.6 Summary of Cash Flows for Copy Machine Investment by Jackson’s Quality Copies

 
The payback method answers the question “how long will it take to recover my initial $50,000
investment?” With annual cash inflows of $10,000 starting in year 1, the payback period for this
investment is 5 years (= $50,000 initial investment ÷ $10,000 annual cash receipts). This
calculation is relatively simple when one investment is made at the beginning, and annual cash
inflows are identical. However, some investments require cash outflows at different points
throughout the life of the asset, and cash inflows can vary from one year to the next. Table 8.1
"Calculating the Payback Period for Jackson’s Quality Copies" provides a format to help
calculate the payback period for these more complex investments. Note that the review problem
at the end of this segment provides an example of how to calculate the payback period to the
nearest month when uneven cash flows are expected.

Table 8.1 Calculating the Payback Period for Jackson’s Quality Copies

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 Investment (Cash Outflow) Cash Inflow Unrecovered Investment Balance

Year 0 $(50,000) - $(50,000)a

Year 1 - $10,000 (40,000)b

Year 2 - 10,000 (30,000)c

Year 3 - 10,000 (20,000)

Year 4 - 10,000 (10,000)

Year 5 - 10,000 0

Year 6 - 10,000 0

Year 7 - 15,000 0

a $(50,000) = $(50,000) initial investment.

b $(40,000) = $(50,000) unrecovered investment balance + $10,000 year 1 cash

inflow.

c $(30,000) = $(40,000) unrecovered investment balance at end of year 1 +

$10,000 year 2 cash inflow.

Weaknesses of the Payback Method

Question: Why is it a problem to ignore the time value of money when calculating the payback
period?

Answer: Suppose you have 2 investments of $10,000 to choose from. The first investment
generates cash inflows of $8,000 in year 1, $2,000 in year 2, and $1,000 in year 3. The second

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 investment generates cash inflows of $2,000 in year 1, $8,000 in year 2, and $1,000 in year 3.
The two investments are summarized here:

Investment I Investment II

Year 0 $(10,000) $(10,000)

Year 1 8,000 2,000

Year 2 2,000 8,000

Year 3 1,000 1,000

Both investments have a payback period of two years. Does this mean both investments are of
equal value? No because the first investment generates far more cash in year 1 than the second
investment. In fact, it would be preferable to calculate the IRR to compare these two
investments. The IRR for the first investment is 6 percent, and the IRR for the second investment
is 5 percent.

Question: Why is it a problem to ignore the cash flows after the payback period?

Answer: Suppose $50,000 can be invested in 2 separate investments with the following cash
flows:

Investment I Investment II

Year 0 $(50,000) $(50,000)

Year 1 25,000 2,000

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 Year 2 25,000 2,000

Year 3 3,000 46,000

Year 4 0 35,000

The first investment has a payback period of two years, and the second investment has a payback
period of three years. If the company requires a payback period of two years or less, the first
investment is preferable. However, the first investment generates only $3,000 in cash after its
payback period while the second investment generates $35,000 after its payback period. The
payback method ignores both of these amounts even though the second investment generates
significant cash inflows after year 3. Again, it would be preferable to calculate the IRR to
compare these two investments. The IRR for the first investment is 4 percent, and the IRR for the
second investment is 18 percent.

Although the payback method is useful in certain situations where companies are concerned
about recovering investments as quickly as possible (e.g., companies on the verge of
bankruptcy), it is not a measure of profitability. The NPV and IRR methods compare the
profitability of each investment by considering the time value of money for all cash flows related
to the investment.

Wrap-Up of Chapter Example

In the Jackson’s Quality Copies example featured throughout this chapter, the company is
considering whether to purchase a new copy machine for $50,000. A week has passed since
Mike Haley, accountant, discussed this investment with Julie Jackson, president and owner.
Refer to Figure 8.2 "NPV Calculation for Copy Machine Investment by Jackson’s Quality
Copies", Figure 8.4 "Alternative NPV Calculation for Jackson’s Quality Copies", and Figure 8.5
"Finding the IRR for Jackson’s Quality Copies", andTable 8.1 "Calculating the Payback Period
for Jackson’s Quality Copies" as you learn what Mike’s findings are.

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 Julie: Hi Mike, any news on the copy machine proposal?

I ran the numbers for the new copy machine, and I think you’ll like the results. It’s
not as simple as looking at the difference between cash outflows of $57,000 and
cash inflows of $82,000 over the life of the asset. We also have to see when the cash
Mike: flows occur and convert them into today’s dollars.

Julie: OK. What did you find?

The NPV is $1,250 using a required rate of return of 10 percent. This means the
investment will generate a return of more than 10 percent after converting the cash
Mike: flows into today’s dollars.

Great! I realize the return is expected to be above 10 percent. Do you have a sense
Julie: of how far above 10 percent?

Yes. The IRR is about 11 percent. I also calculated the payback period to give you
Mike: an idea of how long it will take to recover our initial $50,000 investment.

Good idea. My hope is that we won’t be waiting too long to recover the original
Julie: investment.

Mike: It will take 5 years to fully recover the $50,000 investment.

Julie: Wow! That seems like a long time.

It is. But realize we bring in an additional $25,000 after the payback period. Also,
the payback method does not measure the profitability of the investment, it simply
tells us how long before the initial investment is recovered. Unless we anticipate
cash flow problems, I wouldn’t place too much importance on the payback period.
Mike: The NPV and IRR calculations are the best for evaluating this investment.

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 Good point. We don’t expect to have cash flow problems. We have plenty of capital,
and the business has generated positive cash flow for the past 10 years. Let’s order
Julie: the new machine!

Business  in  Action  8.4  

Capital Budgeting at Fortune 1000 Companies
Studies completed over the past 40 years have indicated that managers prefer to use
IRR and payback methods over NPV when evaluating long-term investments. However,
a recent survey of Fortune 1000 chief financial officers indicates that NPV is now the
most preferred method. According to this survey, the percentage of firms
that always or oftenuse each method is as follows:
NPV 85 percent

IRR 77 percent

Payback 53 percent

This survey also shows that companies with capital budgets exceeding $500,000,000
are more likely to use these methods than are companies with smaller capital budgets.
This is probably because larger companies have more specialized personnel in their
finance and accounting departments, which enables them to use more sophisticated
approaches in evaluating long-term investments.
Source: Patricia A. Ryan and Glenn P. Ryan, “Capital Budgeting Practices of the Fortune
1000: How Have Things Changed?” Journal of Business and Management 8, no. 4
(2002).
K E Y   T A K E A W A Y  

• The  payback  method  evaluates  how  long  it  will  take  to  “pay  back”  or  recover  the  
initial  investment.  The  payback  period,  typically  stated  in  years,  is  the  time  it  takes  to  
generate  enough  cash  receipts  from  an  investment  to  cover  the  cash  outflow(s)  for  

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 the  investment.  Although  this  method  is  useful  for  managers  concerned  about  cash  
flow,  the  major  weaknesses  of  this  method  are  that  it  ignores  the  time  value  of  
money,  and  it  ignores  cash  flows  after  the  payback  period.  
R E V I E W   P R O B L E M   8 . 5  

This  review  problem  is  a  continuation  of  Note  8.22  "Review  Problem  8.3"and  Note  
8.26  "Review  Problem  8.4"  and  uses  the  same  information.  The  management  of  Chip  
Manufacturing,  Inc.,  would  like  to  purchase  a  specialized  production  machine  for  
$700,000.  The  machine  is  expected  to  have  a  life  of  4  years  and  a  salvage  value  of  
$100,000.  Annual  maintenance  costs  will  total  $30,000.  Annual  labor  and  material  
savings  are  predicted  to  be  $250,000.  
1. Use  the  format  in  Table  8.1  "Calculating  the  Payback  Period  for  Jackson’s  Quality  
Copies"  to  calculate  the  payback  period.  Clearly  state  your  conclusion.  
2. Describe  the  two  major  weaknesses  of  the  payback  method.  

Solution  to  Review  Problem  8.5  

1. The  payback  period  is  slightly  more  than  three  years  since  only  $40,000  is  left  
to  be  recovered  after  three  years,  as  shown  in  the  following  table.  
Investment (Cash Outflow) Cash Inflow Unrecovered Investment Balance

Year 0 $(700,000) - $(700,000)

Year 1 - $220,000a (480,000)

Year 2 - 220,000a (260,000)

Year 3 - 220,000a (40,000)

Year 4 - 320,000b 0

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 a
 $220,000  =  $250,000  annual  savings  –  $30,000  annual  costs.  
b
 $320,000  =  $250,000  annual  savings  –  $30,000  annual  costs  +  $100,000  salvage  
value.  

2. A  more  precise  calculation  can  be  performed  assuming  the  $220,000  cash  
inflow  for  year  4  occurs  evenly  throughout  the  year  and  the  $100,000  
salvage  value  cash  inflow  occurs  at  the  end  of  year  4.  With  these  
assumptions,  we  simply  need  to  calculate  how  many  months  are  required  in  
year  4  to  recover  the  remaining  $40,000.  $40,000  divided  by  $220,000  
equals  0.18  (rounded).  Thus  0.18  of  a  year,  or  approximately  2  months  (=  
0.18  ×  12  months),  is  required  to  recover  the  remaining  $40,000.  This  more  
precise  calculation  results  in  a  payback  period  of  three  years  and  two  
months.  Note  that  the  salvage  value  is  ignored  as  this  cash  inflow  occurs  at  
the  end  of  year  4  when  the  machine  is  sold.  
3. First,  the  payback  method  does  not  consider  the  time  value  of  money  (no  present  
value  or  IRR  calculations  are  performed).  Second,  it  only  considers  the  cash  inflows  
until  the  investment  cash  outflows  are  recovered;  cash  inflows  after  the  payback  
period  are  not  part  of  the  analysis.  For  Chip  Manufacturing,  Inc.,  the  payback  period  is  
three  years  and  two  months.  However,  significant  cash  inflows  totaling  $280,000  
occur  after  the  payback  period  and  therefore  are  ignored  ($280,000  =  $320,000  year  
4  cash  inflows  –  $40,000  remaining  investment  recovered  in  the  first  2  months  of  year  
4).  

8.6 Additional Complexities of Estimating Cash Flows

L E A R N I N G   O B J E C T I V E  

1. Evaluate  investments  with  multiple  investment  and  working  capital  cash  flows.  

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 Question: The examples in this chapter are intended to help you learn the basics of evaluating
investments using the net present value (NPV), internal rate of return (IRR), and payback
methods. However, there are two additional items related to estimating cash flows that must be
considered: investment cash outflows and working capital. How do these two items impact long-
term investment decisions?

Answer: These items impact the analysis of long-term investments as described next.

Investment Cash Outflows

The examples thus far have assumed that cash outflows for the investment occur only at the
beginning of the investment. However, some investments require cash outflows at varying points
throughout the life of the project. For example, suppose the JCPenney Company plans
to open a new store, which requires a $10,000,000 investment at the beginning of the project for
construction of the building. However, the building will be expanded at the end of year 4, at a
cost of $2,000,000, to meet an expected increase in demand. The $2,000,000 cash outflow must
be included in the cash flows of the project for year 4 when calculating the NPV, IRR, and
payback period.

Working Capital

Working capital is defined as current assets (cash, accounts receivable, inventory, and the like)
minus current liabilities (accounts payable, wages payable, and accrued liabilities, for instance).
Many long-term investments require working capital. For example, JCPenney will need cash in
its registers when it opens the new store. Working capital is also required to fund inventory and
accounts receivable. Working capital necessary for long-term investments should be included as
a cash outflow, typically at the beginning of the project.

Some long-term investments have an expected life, at the end of which working capital is
returned to the company for investment elsewhere. When this happens, the working capital is

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 included in the cash flow analysis as a cash outflow at the beginning of the project and a
cash inflow at the end of the project.

KEY  TAKEAWAY  
• Investment  proposals  often  include  investment  cash  outflows  at  
varying  points  throughout  the  life  of  the  project.  These  cash  flows  
must  be  included  when  evaluating  investment  proposals  using  NPV,  
IRR,  and  payback  period  methods.  Many  investments  include  working  
capital  cash  flows  required  to  fund  items  such  as  inventory  and  
accounts  receivable.  Working  capital  is  included  as  a  cash  outflow,  
typically  at  the  beginning  of  the  project,  and  is  often  returned  back  to  
the  company  as  a  cash  inflow  later  in  the  project.  
R E V I E W   P R O B L E M   8 . 6  

The  management  of  Environmental  Engineering,  Inc.  (EEI),  would  like  to  open  an  
office  for  6  years  in  a  high-­‐growth  area  of  Las  Vegas.  The  initial  investment  required  
to  purchase  an  office  building  is  $250,000,  and  EEI  needs  $50,000  in  working  capital  
for  the  new  office.  Working  capital  will  be  returned  to  EEI  at  the  end  of  6  years.  EEI  
expects  to  remodel  the  office  at  the  end  of  3  years  at  a  cost  of  $200,000.  
Annual  net  cash  receipts  from  daily  operations  (cash  receipts  minus  cash  payments)  
are  expected  to  be  as  follows:  
Year 1 $ 60,000

Year 2 $ 80,000

Year 3 $120,000

Year 4 $150,000

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 Year 5 $160,000

Year 6 $110,000

Although  the  company’s  cost  of  capital  is  8  percent,  management  set  a  required  rate  
of  return  of  12  percent  due  to  the  high  risk  associated  with  this  project.  
1. Find  the  NPV  of  this  investment  using  the  format  presented  in  .  
2. Use  trial  and  error  to  approximate  the  IRR  for  this  investment  proposal.  
3. Based  on  your  answers  to  1  and  2,  should  EEI  open  the  new  office?  Explain.  
4. Use  the  format  in  to  calculate  the  payback  period.  

Solution  to  Review  Problem  8.6  

1. The  NPV  is  $27,571,  as  shown  in  the  following  figure.  

Note:  The  NPV  is  $27,571.  Because  NPV  is  >  0,  accept  the  investment.  
(The  investment  provides  a  return  greater  than  12  percent.)  

2. The  IRR  is  between  14  and  15  percent  (approximately  14.5  
percent).  The  IRR  is  the  rate  that  generates  a  NPV  of  zero.  
Because  the  NPV  is  positive  at  12  percent,  the  return  is  higher  
than  12  percent.  The  NPV  is  calculated  as  follows  using  a  rate  

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 of  14  percent,  NPV  =  $5,007,  and  15  percent,  NPV  =  $(5,446).  
Thus  the  IRR  is  between  14  and  15  percent.  

   

NPV  at  14  percent  is  

   

NPV  at  15  percent  is  

3. Yes.  The  NPV  is  positive  at  $27,571,  and  the  IRR  of  14.5  percent  is  higher  than  the  
company’s  required  rate  of  return  of  12  percent.  Thus  EEI  should  open  the  office  in  
Las  Vegas.  

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 4. The  payback  period  is  approximately  4.5  years.  This  approximation  assumes  
the  $90,000  unrecovered  investment  at  the  end  of  year  4  will  be  recovered  
about  halfway  through  year  5.  
Investment (Cash Unrecovered Investment
Outflow) Cash Inflow Balance

Year 0 $(300,000) - $(300,000)

Year 1 - $ 60,000 (240,000)a

Year 2 - 80,000 (160,000)b

Year 3 (200,000) 120,000 (240,000)c

Year 4 - 150,000 (90,000)

Year 5 - 160,000 0

Year 6 - 160,000 0

   
a
 $(240,000)  =  $(300,000)  unrecovered  investment  +  $60,000  year  1  cash  inflow.  
b
 $(160,000)  =  $(240,000)  unrecovered  investment  at  end  of  year  1  +  $80,000  
year  2  cash  inflow.  
c
 $(240,000)  =  $(160,000)  unrecovered  investment  at  end  of  year  2  –  $200,000  
year  3  investment  +  $120,000  year  3  cash  inflow.  

5. A  more  precise  calculation  can  be  performed  assuming  the  $160,000  cash  
inflow  for  year  5  occurs  evenly  throughout  the  year.  Simply  calculate  how  
many  months  are  required  in  year  5  to  recover  the  remaining  $90,000.  
$90,000  divided  by  $160,000  equals  0.56  (rounded).  Thus  0.56  of  a  year,  or  
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 approximately  7  months  (=  0.56  ×  12  months),  is  required  to  recover  the  
remaining  $90,000.  This  more  precise  calculation  results  in  a  payback  
period  of  four  years  and  seven  months.  

8.7 The Effect of Income Taxes on Capital Budgeting Decisions

L E A R N I N G   O B J E C T I V E  

1. Understand  the  impact  that  income  taxes  have  on  capital  budgeting  decisions.  

Question: Throughout the chapter, we assumed no income taxes were involved. This is a
reasonable assumption for not-for-profit entities and governmental agencies. However, firms
that pay income taxes must consider the impact income taxes have on cash flows for long-term
investments. How do for-profit organizations include income taxes in their analysis when making
long-term investment decisions?

Answer: Let’s look at an example to help explain how this works. The management of Scientific
Products, Inc. (SPI), is considering a five-year contract to build scientific instruments for a large
school district. The initial investment required to purchase production equipment is $400,000 (to
be depreciated over 5 years using the straight-line method, with no salvage value). An additional
$50,000 in working capital is required for the contract. Working capital will be returned to SPI at
the end of five years. Annual net cash receipts from daily operations (cash receipts minus cash
payments) are shown as follows. Since depreciation expense is not a cash outflow, it
is not included in these amounts.

Year 1 $ 50,000

Year 2 $ 60,000

Year 3 $120,000

Year 4 $200,000

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 Year 5 $130,000

Management established a required rate of return of 10 percent for this proposal. The company’s
tax rate is 40 percent. (The complexities of government tax codes have a significant impact on
the tax rate used. For simplicity, we use a tax rate of 40 percent for this example.)

When taxes are involved, it is important to understand which cash flows are affected by the tax
rate and which are not. We look at this by addressing the following capital budgeting items:

• Investment cash outflows

• Working capital cash outflows and inflows
• Revenue cash inflows and expense cash outflows
• Depreciation

Provides a detailed example of how companies adjust for income taxes when evaluating long-
term investments. Examine carefully, including the footnotes, as we explain each of these items.

Figure 8.7 NPV Calculation with Income Taxes for Scientific Products, Inc.

 
Note: the NPV is $(56,146).

Since NPV is < 0, reject the investment. (The investment provides a return less than 10 percent.)

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 a Initial investment purchase price and working capital do not directly affect net income and
therefore are not adjusted for income taxes.

b Amount equals net cash receipts before taxes × (1 – tax rate). For year 1, $30,000 = $50,000 ×
(1 – 0.40); for year 2, $36,000 = $60,000 × (1 – 0.40); and so forth.

c Depreciation tax savings = Depreciation expense × Tax rate. Depreciation expense is $80,000
(= $400,000 cost ÷ 5 year useful life). Thus annual depreciation tax savings is $32,000 (=
$80,000 depreciation expense × 0.40 tax rate).

1. Investment Cash Outflows. The initial investment in production equipment of $400,000

is not adjusted for income taxes because it does not directly affect net income. Thus this
amount is included in full in .
2. Working Capital Cash Outflows and Inflows. Working capital of $50,000 is not adjusted
for income taxes since it does not affect net income. Thus this amount is included in full
as a cash outflow at the beginning of the project and again in full when returned to the
company at the end of the project, as shown in .
3. Revenues and Expenses. When a company must pay income taxes, all revenue cash
inflows and expense cash outflows affect net income and therefore affect income taxes
paid. The goal is to determine the after-taxcash flow. This is calculated in the equation
that follows.The tax rate for Scientific Products, Inc., is 40 percent. Thus net cash
receipts (revenue cash inflows minus expense cash outflows) are multiplied by 0.60 (= 1
– 0.40). This results in an after-tax cash flow, as shown in .

Key  Equation  

After-­‐tax  revenue  cash  inflow  =  Before-­‐tax  cash  inflow  ×  (1  –  tax  rate)After-­‐
tax  expense  cash  outflow  =  Before-­‐tax  cash  outflow  ×  (1  –  tax  rate)  

4. Depreciation. Although depreciation expense is not a cash outflow, it does reduce taxable
income and thereby reduces taxes that are paid (recall that the entry to record

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 depreciation for financial accounting purposes does not affect cash; debit depreciation
expense and credit accumulated depreciation). The term used to describe this tax savings
isdepreciation tax shield. The tax savings resulting from depreciation are calculated as
follows:

Key  Equation  

Depreciation  tax  savings  cash  inflow  =  Depreciation  expense  ×  Tax  rate  

The production equipment, which has a purchase price of $400,000, has a useful life of 5 years
and no salvage value. SPI uses the straight-line method, which depreciates the original cost
evenly over the useful life of the asset. Thus depreciation expense is $80,000 (= $400,000 ÷ 5
years). This is multiplied by the tax rate of 40 percent to get the annual tax savings of $32,000 (=
$80,000 × 0.40), as shown in .

Question: Based on the information presented in , should SPI accept the investment proposal?

Answer: As you can see in , the NPV is negative ($[56,146]), so SPI’s management should
reject the investment proposal. provides a summary of how income taxes influence cash flows
for long-term investments. (Note that this section is intended to give you a general overview of
how income taxes effect capital budgeting decisions. Finance textbooks provide more detail
regarding how to adjust cash flows for income taxes in more complex situations.)

Figure 8.8 How Income Taxes Affect Capital Budgeting Cash Flows

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K E Y   T A K E A W A Y  

• Companies  that  pay  income  taxes  must  consider  the  impact  income  taxes  have  on  
cash  flows  for  long-­‐term  investments,  and  make  the  necessary  adjustments.  
Investment  and  working  capital  cash  flows  are  not  adjusted  because  these  cash  flows  
do  not  affect  taxable  income.  Revenue  cash  inflows  and  expense  cash  outflows  are  
adjusted  by  multiplying  the  cash  flow  by  (1  –  tax  rate).  Although  depreciation  expense  
is  not  a  cash  outflow,  it  provides  tax  savings.  The  tax  savings  is  calculated  by  
multiplying  depreciation  expense  by  the  tax  rate.  Once  these  adjustments  are  made,  
we  can  calculate  the  NPV  and  IRR.  
R E V I E W   P R O B L E M   8 . 7  

Car  Repair,  Inc.,  would  like  to  purchase  a  new  machine  for  $400,000.  The  machine  will  
have  a  life  of  4  years  with  no  salvage  value,  and  is  expected  to  generate  annual  cash  
revenue  of  $180,000.  Annual  cash  expenses,  excluding  depreciation,  will  total  
$20,000.  The  company  uses  the  straight-­‐line  depreciation  method,  has  a  tax  rate  of  
30  percent,  and  requires  a  10  percent  rate  of  return.  
1. Find  the  NPV  of  this  investment  using  the  format  presented  in  .  
2. Should  the  company  purchase  the  machine?  Explain.  

Solution  to  Review  Problem  8.7  

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 1. The  NPV  is  $50,112  as  shown  in  the  following  figure.  

   
a
 Initial  investment  purchase  price  does  not  directly  affect  net  income  and  
therefore  is  not  adjusted  for  income  taxes.  
b
 Amount  equals  cash  revenue  before  taxes  ×  (1  –  tax  rate);  $126,000  =  
$180,000  ×  (1  –  0.30).  
c
 Amount  equals  cash  expense  before  taxes  ×  (1  –  tax  rate);  $14,000  =  
$20,000  ×  (1  –  0.30).  
d
 Depreciation  tax  savings  =  Depreciation  expense  ×  Tax  rate.  Depreciation  
expense  is  $100,000  (=  $400,000  cost  ÷  4  year  useful  life).  Thus  annual  
depreciation  tax  savings  is  $30,000  (=  $100,000  depreciation  expense  ×  0.30  
tax  rate).  
2. Yes,  the  company  should  purchase  the  machine.  The  positive  NPV  of  $50,112  shows  
the  return  of  this  proposal  is  above  the  company’s  required  rate  of  return  of  10  
percent.  

8.8 Appendix: Present Value Tables

Figure 8.9 Present Value of $1 Received at the End of n Periods

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Note: Factor=1(1+r)n
Figure 8.10 Present Value of a $1 Annuity Received at the End of Each Period
for n Periods

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Note: Factor=1−(1+r)−nr
E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  
1. What  is  the  difference  between  capital  budgeting  decisions  covered  in  this  chapter  
and  management  decisions  covered  in  ?  
2. What  concept  must  be  considered  when  looking  at  cash  flows  over  several  years  for  a  
long-­‐term  investment?  Explain.  

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 3. What  is  meant  by  the  term  present  value?  
4. What  is  the  formula  used  to  calculate  the  present  value  of  a  future  cash  flow?  
Describe  each  component.  
5. Describe  the  three  steps  required  to  evaluate  investments  using  the  net  present  value  
method.  
6. How  do  most  firms  establish  the  required  rate  of  return  used  to  calculate  the  net  
present  value?  
7. What  is  meant  by  the  term  internal  rate  of  return?  Explain  the  IRR  decision  rule?  
8. For  the  purpose  of  calculating  net  present  value  and  internal  rate  of  return,  do  
companies  use  the  accrual  basis  of  accounting?  Explain.  
9. Why  might  a  firm  choose  to  accept  a  long-­‐term  investment  even  if  the  net  present  
value  is  below  zero?  
10. What  might  cause  a  manager  to  reject  a  long-­‐term  investment  even  though  the  net  
present  value  is  positive?  
11. Describe  the  two  steps  required  to  calculate  net  present  value  and  internal  rate  of  
return  when  using  Excel.  
12. What  is  the  payback  method,  and  why  do  managers  use  this  method?  
13. What  are  the  two  weaknesses  associated  with  the  payback  method?  
14. Refer  to  What  method  of  evaluating  long-­‐term  investments  is  most  popular?  Why  do  
you  think  the  payback  method  is  the  least-­‐used  method?  
15. What  does  the  term  working  capital  refer  to,  and  how  does  working  capital  affect  the  
evaluation  of  long-­‐term  investments?  
16. Assume  a  company  pays  income  taxes.  How  are  revenue  and  expense  cash  flows  
adjusted  for  income  taxes  when  calculating  the  net  present  value?  
17. Assume  a  company  pays  income  taxes.  How  does  depreciation  expense  affect  cash  
flows  even  though  it  is  a  noncash  expense?  

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 Brief  Exercises  
18. Investment  Decision  at  Jackson’s  Quality  Copies.  Refer  to  the  dialogue  at  Jackson’s  
Quality  Copies  presented  at  the  beginning  of  the  chapter.  What  is  Julie  Jackson  
proposing?  What  information  did  Mike,  the  accountant,  get  from  Julie  to  evaluate  the  
proposal?  
19. Present  Value  Calculations.  For  each  of  the  following  independent  
scenarios,  use  in  the  appendix  to  calculate  the  present  value  of  the  cash  
flow  described.  
1. $10,000  will  be  received  4  years  from  today.  The  rate  is  10  percent.  
2. $10,000  will  be  received  4  years  from  today.  The  rate  is  20  percent.  
3. $50,000  will  be  received  15  years  from  today.  The  rate  is  12  percent.  
4. $50,000  will  be  received  15  years  from  today.  The  rate  is  6  percent.  
20. Present  Value  Calculations  (Annuities).  For  each  of  the  following  
independent  scenarios,  use  in  the  appendix  to  calculate  the  present  value  
of  the  cash  flow  described.  Round  to  the  nearest  dollar.  
1. $1,000  will  be  received  at  the  end  of  each  year  for  6  years.  The  rate  is  12  
percent.  
2. $1,000  will  be  received  at  the  end  of  each  year  for  6  years.  The  rate  is  15  
percent.  
3. $10,000  will  be  received  at  the  end  of  each  year  for  6  years.  The  rate  is  7  
percent.  
4. $250,000  will  be  received  at  the  end  of  each  year  for  4  years.  The  rate  is  10  
percent.  
21. Net  Present  Value  Calculations.  Freefall,  Inc.,  has  two  independent  
investment  opportunities,  each  requiring  an  initial  investment  of  $65,000.  
The  company’s  required  rate  of  return  is  8  percent.  The  cash  inflows  for  
each  investment  are  provided  as  follows.  
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Required:  
a. Without  resorting  to  calculations,  which  investment  will  have  the  
highest  net  present  value?  Explain.  
b. Calculate  the  net  present  value  for  each  investment  (remember  to  include  
the  initial  investment  cash  outflow  in  your  calculation).  Should  the  company  
invest  in  either  investment?  Round  to  the  nearest  dollar.  
Internal  Rate  of  Return  Calculation.  An  investment  costing  $50,000  today  will  
result  in  cash  savings  of  $5,000  per  year  for  15  years.  Use  trial  and  error  to  
approximate  the  internal  rate  of  return  for  this  investment  proposal.  
Evaluating  Qualitative  Factors.  Chem,  Inc.,  produces  chemical  products.  The  
company  recently  decided  to  invest  in  expensive  pollution  control  devices  even  
though  the  negative  net  present  value  pointed  toward  rejecting  this  investment.  
What  qualitative  factor  likely  led  the  company  to  make  the  investment  in  spite  of  the  
negative  net  present  value?  
Ethical  Issues  in  Making  a  Capital  Budgeting  Decision.  Assume  the  
manager  of  a  store  earns  an  annual  bonus  based  on  meeting  a  certain  level  
of  net  income,  which  has  been  achieved  consistently  over  the  past  five  
years.  The  company  is  currently  considering  the  addition  of  a  second  store,  
which  is  expected  to  become  profitable  after  two  years.  The  manager  is  
responsible  for  making  the  final  decision  whether  the  second  store  should  

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 be  opened  and  would  receive  an  annual  bonus  only  if  a  certain  level  of  net  
income  were  achieved  for  both  stores  combined.  

Why  might  the  manager  refuse  to  invest  in  the  new  store  even  though  the  
investment  is  projected  to  achieve  a  return  greater  than  the  company’s  
required  rate  of  return?  
Net  Present  Value  Calculation  Using  Excel.  An  investment  costing  $200,000  today  
will  result  in  cash  savings  of  $85,000  per  year  for  3  years.  The  company’s  required  
rate  of  return  is  11  percent.  Use  Excel  to  calculate  the  net  present  value  of  this  
investment  in  a  format  similar  to  the  one  in  the  Computer  Application  box  in  the  
chapter.  
Payback  Period  Calculation.  Textile  Services,  Inc.,  plans  to  invest  $80,000  in  a  new  
machine.  Annual  cash  inflows  from  this  investment  will  be  $25,000,  and  annual  cash  
outflows  will  be  $5,000.  Determine  the  payback  period  for  this  investment.  
Net  Present  Value  Analysis  with  Multiple  Investments.  A  project  requiring  an  
investment  of  $20,000  today  and  $10,000  one  year  from  today,  will  result  in  cash  
savings  of  $4,000  per  year  for  15  years.  Find  the  net  present  value  of  this  investment  
using  a  rate  of  10  percent.  Round  to  the  nearest  dollar.  
Net  Present  Value  Calculation  with  Taxes.  An  investment  costing  $200,000  today  
will  result  in  cash  savings  of  $85,000  per  year  for  3  years.  The  company  has  a  tax  rate  
of  40  percent,  and  requires  an  11  percent  rate  of  return.  Find  the  net  present  value  of  
this  investment  using  the  format  shown  in  .  Round  to  the  nearest  dollar.  

Exercises:  Set  A  
29. Net  Present  Value  Analysis.  Architect  Services,  Inc.,  would  like  to  purchase  
a  blueprint  machine  for  $50,000.  The  machine  is  expected  to  have  a  life  of  4  
years,  and  a  salvage  value  of  $10,000.  Annual  maintenance  costs  will  total  

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 $14,000.  Annual  savings  are  predicted  to  be  $30,000.  The  company’s  
required  rate  of  return  is  11  percent.  
Required:  
a. Ignoring  the  time  value  of  money,  calculate  the  net  cash  inflow  or  
outflow  resulting  from  this  investment  opportunity.  
b. Find  the  net  present  value  of  this  investment  using  the  format  presented  
in  .  
c. Should  the  company  purchase  the  blueprint  machine?  Explain.  
Internal  Rate  of  Return  Analysis.  Architect  Services,  Inc.,  would  like  
to  purchase  a  blueprint  machine  for  $50,000.  The  machine  is  expected  to  
have  a  life  of  4  years,  and  a  salvage  value  of  $10,000.  Annual  maintenance  
costs  will  total  $14,000.  Annual  savings  are  predicted  to  be  $30,000.  The  
company’s  required  rate  of  return  is  11  percent  (this  is  the  same  data  as  the  
previous  exercise).  
Required:  
 . Use  trial  and  error  to  approximate  the  internal  rate  of  return  for  this  
investment  proposal.  Round  to  the  nearest  dollar.  
a. Should  the  company  purchase  the  blueprint  machine?  Explain.  
Payback  Period  Calculation.  Architect  Services,  Inc.,  would  like  to  purchase  a  
blueprint  machine  for  $50,000.  The  machine  is  expected  to  have  a  life  of  4  years,  and  
a  salvage  value  of  $10,000.  Annual  maintenance  costs  will  total  $14,000.  Annual  
savings  are  predicted  to  be  $30,000  (this  is  the  same  data  as  the  previous  exercise).  
Determine  the  payback  period  for  this  investment  using  the  format  shown  in  .  
Net  Present  Value  Analysis  with  Multiple  Investments,  Alternative  
Format.  Conway  Construction  Corporation  would  like  to  purchase  a  fleet  of  
trucks  at  a  cost  of  $260,000.  Additional  equipment  needed  to  maintain  the  
fleet  of  trucks  will  be  purchased  at  the  end  of  year  2  for  $40,000.  The  trucks  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 are  expected  to  have  a  life  of  8  years,  and  a  salvage  value  of  $20,000.  
Annual  costs  for  maintenance,  insurance,  and  other  cash  expenses  will  total  
$42,000.  Annual  net  cash  receipts  resulting  from  this  purchase  are  
predicted  to  be  $135,000.  The  company’s  required  rate  of  return  is  14  
percent.  
Required:  
 . Find  the  net  present  value  of  this  investment  using  the  format  presented  in  .  
a. Should  the  company  purchase  the  new  fleet  of  trucks?  Explain.  
Calculating  NPV  and  IRR  Using  Excel.  Wood  Products  Company  would  
like  to  purchase  a  computerized  wood  lathe  for  $100,000.  The  machine  is  
expected  to  have  a  life  of  5  years,  and  a  salvage  value  of  $5,000.  Annual  
maintenance  costs  will  total  $20,000.  Annual  net  cash  receipts  resulting  
from  this  machine  are  predicted  to  be  $45,000.  The  company’s  required  
rate  of  return  is  15  percent.  
Required:  
 . Use  Excel  to  calculate  the  net  present  value  and  internal  rate  of  return  in  a  
format  similar  to  the  Computer  Application  spreadsheet  shown  in  the  chapter.  
a. Should  the  company  purchase  the  wood  lathe?  Explain.  
Net  Present  Value  Analysis  with  Taxes.  Timberline  Company  would  
like  to  purchase  a  new  machine  for  $100,000.  The  machine  will  have  a  life  
of  5  years  with  no  salvage  value,  and  is  expected  to  generate  annual  cash  
revenue  of  $50,000.  Annual  cash  expenses,  excluding  depreciation,  will  
total  $24,000.  The  company  uses  the  straight-­‐line  depreciation  method,  has  
a  tax  rate  of  40  percent,  and  requires  a  12  percent  rate  of  return.  
Required:  
 . Find  the  net  present  value  of  this  investment  using  the  format  presented  in  .  
Round  to  the  nearest  dollar.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 a. Should  the  company  purchase  the  machine?  Explain.  

Exercises:  Set  B  
35. Net  Present  Value  Analysis.  Wood  Products  Company  would  like  to  
purchase  a  computerized  wood  lathe  for  $100,000.  The  machine  is  
expected  to  have  a  life  of  5  years,  and  a  salvage  value  of  $5,000.  Annual  
maintenance  costs  will  total  $20,000.  Annual  net  cash  receipts  resulting  
from  this  machine  are  predicted  to  be  $45,000.  The  company’s  required  
rate  of  return  is  15  percent.  
Required:  
a. Ignoring  the  time  value  of  money,  calculate  the  net  cash  inflow  or  outflow  
resulting  from  this  investment  opportunity.  
b. Find  the  net  present  value  of  this  investment  using  the  format  presented  
in  .  Round  to  the  nearest  dollar.  
c. Should  the  company  purchase  the  wood  lathe?  Explain.  
Internal  Rate  of  Return  Analysis.  Wood  Products  Company  would  like  
to  purchase  a  computerized  wood  lathe  for  $100,000.  The  machine  is  
expected  to  have  a  life  of  5  years,  and  a  salvage  value  of  $5,000.  Annual  
maintenance  costs  will  total  $20,000.  Annual  net  cash  receipts  resulting  
from  this  machine  are  predicted  to  be  $45,000.  The  company’s  required  
rate  of  return  is  15  percent  (this  is  the  same  data  as  the  previous  exercise).  
Required:  
 . Use  trial  and  error  to  approximate  the  internal  rate  of  return  for  this  
investment  proposal.  
a. Should  the  company  purchase  the  wood  lathe?  Explain.  
Payback  Period  Calculation.  Wood  Products  Company  would  like  to  purchase  a  
computerized  wood  lathe  for  $100,000.  The  machine  is  expected  to  have  a  life  of  5  

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 years,  and  a  salvage  value  of  $5,000.  Annual  maintenance  costs  will  total  $20,000.  
Annual  net  cash  receipts  resulting  from  this  machine  are  predicted  to  be  $45,000.  The  
company’s  required  rate  of  return  is  15  percent  (this  is  the  same  data  as  the  previous  
exercise).  Determine  the  payback  period  for  this  investment  using  the  format  shown  
in  .  
Net  Present  Value  Analysis  and  Qualitative  Factors,  Alternative  
Format.  Pete’s  Plumbing  Supplies  would  like  to  expand  into  a  new  
warehouse  at  a  cost  of  $500,000.  The  warehouse  is  expected  to  have  a  life  
of  20  years,  and  a  salvage  value  of  $100,000.  Annual  costs  for  maintenance,  
insurance,  and  other  cash  expenses  will  total  $60,000.  Annual  net  cash  
receipts  resulting  from  this  expansion  are  predicted  to  be  $115,000.  The  
company’s  required  rate  of  return  is  12  percent.  
Required:  
 . Find  the  net  present  value  of  this  investment  using  the  format  presented  in  .  
Round  to  the  nearest  dollar.  
a. Should  the  company  purchase  the  new  warehouse?  Explain.  
b. Provide  one  qualitative  factor  that  might  cause  the  company  to  reach  a  
different  conclusion  than  the  one  reached  in  requirement  b.  
Calculating  NPV  and  IRR  Using  Excel.  Pete’s  Plumbing  Supplies  would  
like  to  expand  into  a  new  warehouse  at  a  cost  of  $500,000.  The  warehouse  
is  expected  to  have  a  life  of  20  years,  and  a  salvage  value  of  $100,000.  
Annual  costs  for  maintenance,  insurance,  and  other  cash  expenses  will  total  
$60,000.  Annual  net  cash  receipts  resulting  from  this  expansion  are  
predicted  to  be  $115,000.  The  company’s  required  rate  of  return  is  12  
percent.  
Required:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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  . Use  Excel  to  calculate  the  net  present  value  and  internal  rate  of  return  in  a  
format  similar  to  the  Computer  Application  spreadsheet  shown  in  the  chapter.  
a. Should  the  company  purchase  the  warehouse?  Explain.  
Net  Present  Value  Analysis  with  Taxes.  Quality  Chocolate,  Inc.,  would  
like  to  purchase  a  new  machine  for  $200,000.  The  machine  will  have  a  life  
of  4  years  with  no  salvage  value,  and  is  expected  to  generate  annual  cash  
revenue  of  $90,000.  Annual  cash  expenses,  excluding  depreciation,  will  
total  $10,000.  The  company  uses  the  straight-­‐line  depreciation  method,  has  
a  tax  rate  of  30  percent,  and  requires  a  14  percent  rate  of  return.  
Required:  
 . Find  the  net  present  value  of  this  investment  using  the  format  presented  in  .  
Round  to  the  nearest  dollar.  
a. Should  the  company  purchase  the  machine?  Explain.  

Problems  
41. Evaluating  Alternative  Investments.  Washington  Brewery  has  two  
independent  investment  opportunities  to  purchase  brewing  equipment  so  
the  company  can  meet  growing  customer  demand.  The  first  option  
(equipment  A)  requires  an  initial  investment  of  $230,000  for  equipment  
with  an  expected  life  of  5  years  and  a  salvage  value  of  $20,000.  The  second  
option  (equipment  B)  requires  an  initial  investment  of  $120,000  for  
equipment  with  an  expected  life  of  4  years  and  a  salvage  value  of  $15,000.  
The  company’s  required  rate  of  return  is  10  percent.  Additional  cash  flow  
information  for  each  investment  is  provided  as  follows.  
Year 1 Year 2 Year 3 Year 4 Year 5

Equipment A

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Year 1 Year 2 Year 3 Year 4 Year 5

Utility savings $ 12,000 $ 14,000 $ 15,000 $ 16,000 $ 17,000

Additional revenue 45,000 48,000 50,000 55,000 60,000

Maintenance costs (5,000) (8,000) (10,000) (13,000) (16,000)

Equipment B

Utility savings $ 8,000 $ 9,000 $ 10,000 $ 10,000 -

Additional revenue 35,000 36,000 38,000 42,000 -

Maintenance costs (6,000) (8,000) (9,000) (11,000) -

42. Required:  
a. Calculate  the  net  present  value  for  each  investment  using  the  format  
presented  in  .  (Remember  to  include  the  initial  investment  cash  outflow  and  salvage  
value  in  your  calculation.)  Round  to  the  nearest  dollar.  
b. Which,  if  any,  investment  is  preferable?  Explain.  
Net  Present  Value,  Internal  Rate  of  Return,  and  Payback  Period  
Analyses.  Sherwin  Moore  Paint  Company  would  like  to  further  automate  its  
production  process  by  purchasing  production  equipment  for  $660,000.  The  
equipment  is  expected  to  have  a  useful  life  of  8  years,  and  will  be  sold  at  
the  end  of  8  years  for  $40,000.  The  equipment  requires  significant  
maintenance  work  at  an  annual  cost  of  $75,000.  Labor  and  material  cost  
savings,  shown  in  the  table,  are  also  expected  to  be  significant.  
Year 1 $160,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Year 2 $190,000

Year 3 $200,000

Year 4 $240,000

Year 5 $280,000

Year 6 $220,000

Year 7 $180,000

Year 8 $155,000

The  company’s  required  rate  of  return  is  11  percent.  Assume  the  
company  requires  all  investments  to  be  recovered  within  five  years.  
Required:  
 . Find  the  net  present  value  of  this  investment  using  the  format  
presented  in  .  Round  to  the  nearest  dollar.  
a. Use  trial  and  error  to  approximate  the  internal  rate  of  return  for  this  
investment  proposal.  
b. Determine  the  payback  period  for  this  investment  using  the  format  shown  
in  .  
c. Based  on  your  findings  in  requirements  a,  b,  and  c,  should  the  company  
purchase  the  production  equipment?  Explain.  
Calculating  NPV  and  IRR  Using  Excel.  Sherwin  Moore  Paint  Company  
would  like  to  further  automate  its  production  process  by  purchasing  
production  equipment  for  $660,000.  The  equipment  is  expected  to  have  a  
useful  life  of  8  years,  and  will  be  sold  at  the  end  of  8  years  for  $40,000.  The  
equipment  requires  significant  maintenance  work  at  an  annual  cost  of  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     592  
     
 
 $75,000.  Labor  and  material  cost  savings,  shown  in  the  table,  are  also  
expected  to  be  significant.  
Year 1 $160,000

Year 2 $190,000

Year 3 $200,000

Year 4 $240,000

Year 5 $280,000

Year 6 $220,000

Year 7 $180,000

Year 8 $155,000

The  company’s  required  rate  of  return  is  11  percent.  

Required:  
 . Use  Excel  to  calculate  the  net  present  value  and  internal  rate  of  return  in  a  
format  similar  to  the  Computer  Application  spreadsheet  shown  in  the  chapter.  
a. Should  the  company  purchase  the  production  equipment?  Explain.  
Net  Present  Value  Analysis,  Multiple  Investments,  and  Qualitative  
Factors.  Oil  Production,  Inc.,  would  like  to  drill  oil  from  land  the  company  
already  owns.  The  equipment  is  expected  to  cost  $4,000,000,  has  a  useful  
life  of  5  years,  and  will  be  sold  at  the  end  of  5  years  for  $400,000.  Annual  
costs  for  maintenance  and  other  cash  expenses  will  total  $550,000.  Annual  
net  cash  receipts  resulting  from  the  sale  of  oil  are  predicted  to  be  
$1,900,000.  Working  capital  of  $270,000  is  required  at  the  beginning  of  the  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     593  
     
 
 project  and  will  be  returned  at  the  end  of  5  years.  The  equipment  will  
require  refurbishing  at  the  end  of  year  3  at  a  cost  of  $300,000.  Although  the  
company’s  cost  of  capital  is  15  percent,  management  established  a  required  
rate  of  return  of  20  percent  due  to  the  high  risk  associated  with  this  project.  
Required:  
 . Find  the  net  present  value  of  this  investment  using  the  format  presented  in  .  
Round  to  the  nearest  dollar.  
a. Use  trial  and  error  to  approximate  the  internal  rate  of  return  for  this  
investment  proposal.  
b. Should  the  company  accept  the  proposal?  Explain.  
c. What  qualitative  factors  might  improve  management’s  view  of  this  
proposal?  
Calculating  NPV  and  IRR  Using  Excel.  Oil  Production,  Inc.,  would  like  
to  drill  oil  from  land  the  company  already  owns.  The  equipment  is  expected  
to  cost  $4,000,000,  has  a  useful  life  of  5  years,  and  will  be  sold  at  the  end  of  
5  years  for  $400,000.  Annual  costs  for  maintenance  and  other  cash  
expenses  will  total  $550,000.  Annual  net  cash  receipts  resulting  from  the  
sale  of  oil  are  predicted  to  be  $1,900,000.  Working  capital  of  $270,000  is  
required  at  the  beginning  of  the  project  and  will  be  returned  at  the  end  of  5  
years.  The  equipment  will  require  refurbishing  at  the  end  of  year  3  at  a  cost  
of  $300,000.  Although  the  company’s  cost  of  capital  is  15  percent,  
management  established  a  required  rate  of  return  of  20  percent  due  to  the  
high  risk  associated  with  this  project.  
Required:  
 . Use  Excel  to  calculate  the  net  present  value  and  internal  rate  of  return  in  a  
format  similar  to  the  Computer  Application  spreadsheet  shown  in  the  chapter.  
a. Should  the  company  accept  the  proposal?  Explain.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     594  
     
 
 Net  Present  Value,  Internal  Rate  of  Return,  and  Payback  Period  
Analyses;  Ethical  Issues.  Tower  CD  Stores  would  like  to  open  a  retail  store  
in  Houston.  The  initial  investment  to  purchase  the  building  is  $420,000,  and  
an  additional  $50,000  in  working  capital  is  required.  Since  this  store  will  be  
operating  for  many  years,  the  working  capital  will  not  be  returned  in  the  
near  future.  Tower  expects  to  remodel  the  store  at  the  end  of  3  years  at  a  
cost  of  $100,000.  Annual  net  cash  receipts  from  daily  operations  (cash  
receipts  minus  cash  payments)  are  expected  to  be  as  follows.  
Year 1 $ 80,000

Year 2 $115,000

Year 3 $118,000

Year 4 $140,000

Year 5 $155,000

Year 6 $167,000

Year 7 $175,000

The  company’s  required  rate  of  return  is  13  percent.  Assume  
management  decided  to  limit  the  analysis  to  7  years.  
Required:  
 . Find  the  net  present  value  of  this  investment  using  the  format  presented  in  .  
Round  to  the  nearest  dollar.  
a. Use  trial  and  error  to  approximate  the  internal  rate  of  return  for  this  
investment  proposal.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     595  
     
 
 b. Based  on  your  answer  to  requirements  a  and  b,  should  Tower  open  the  new  
store?  Explain.  
c. Use  the  format  presented  in  to  calculate  the  payback  period  (include  
working  capital  in  the  initial  investment).  Assuming  management  requires  
all  investments  to  be  recovered  within  three  years,  should  Tower  CD  Store  
open  the  new  store?  
d. What  is  the  weakness  of  using  the  payback  period  method  to  evaluate  long-­‐
term  investments?  
e. Assume  the  manager  of  the  company  wanted  to  live  in  Houston  and  
intentionally  inflated  the  projected  annual  cash  receipts  so  that  the  
proposal  would  be  accepted.  The  proposal  would  otherwise  have  been  
rejected.  Explain  how  the  company’s  use  of  a  postaudit  would  help  to  
prevent  this  type  of  unethical  behavior.  
Net  Present  Value  with  Taxes.  Refer  to  the  Tower  CD  Stores  
information  presented  in  the  previous  problem.  Assume  the  costs  
associated  with  the  purchase  of  the  building  are  depreciated  over  20  years  
using  the  straight-­‐line  method,  with  no  salvage  value.  Costs  associated  with  
the  building  remodel  are  depreciated  over  10  years  with  no  salvage  value,  
starting  with  year  4.  The  company’s  tax  rate  is  40  percent.  Again,  
management  will  limit  the  analysis  to  seven  years.  
Required:  
 . Find  the  net  present  value  of  this  investment  using  the  format  presented  in  .  
Round  to  the  nearest  dollar.  
a. Should  Tower  open  the  new  store?  Explain.  
b. How  did  income  taxes  affect  the  decision  being  made  by  Tower  CD  Stores?  

One  Step  Further:  Skill-­‐Building  Cases  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     596  
     
 
 48. Opening  New  Retail  Stores.  Refer  to  Provide  two  examples  of  cash  outflows  and  one  
example  of  cash  inflows  resulting  from  the  decision  to  open  a  new  store.  
49. Determining  the  Cost  of  Capital  by  Industry.  Refer  to  the  Why  do  you  think  the  cost  
of  capital  in  the  beverage  industry  is  low  relative  to  the  cost  of  capital  in  other  
industries?  
50. The  California  Lottery  and  Present  Value  Concepts.  Refer  to  the  Why  does  the  State  
of  California  need  only  $550,000  to  pay  a  $1,000,000  lottery  winner?  
51. Internet  Project:  Capital  Expenditures  at  Intel.  Go  to  Intel’s  Web  site  
(http://www.intel.com)  and  enter  “annual  report”  or  “10K  report”  in  the  
search  feature.  Find  the  most  recent  annual  report  or  10K  report  and  
review  the  Consolidated  Statements  of  Cash  Flows  portion  of  the  company’s  
financial  statements.  Find  the  Additions  to  property,  plant  and  
equipment  line  item  in  the  Investing  Activities  section  of  the  statement,  and  
answer  the  following  questions.  Be  sure  to  submit  a  printed  copy  of  the  
consolidated  statements  of  cash  flows  with  your  answers.  
a. How  much  cash  did  Intel  spend  on  additions  to  property,  plant,  and  
equipment  in  the  most  current  year?  How  does  this  amount  compare  with  amounts  
spent  in  the  previous  two  years?  
b. Describe  two  capital  budgeting  decision  techniques  that  were  likely  used  
by  Intel  to  make  long-­‐term  investment  decisions.  
Group  Activity:  Qualitative  Factors.  Each  of  the  following  scenarios  is  
being  considered  at  three  separate  companies.  
0. A  large  regional  energy  company  uses  coal  to  produce  electricity  that  is  sold  
to  local  power  companies.  Although  government  regulations  will  not  require  a  
cleaner  process  for  at  least  five  years,  the  company  is  considering  spending  millions  
of  dollars  on  equipment  that  will  reduce  pollutants  from  its  production  process.  
However,  the  net  present  value  analysis  indicates  this  proposal  should  be  rejected.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     597  
     
 
 1. A  producer  of  mountain  bikes  known  for  its  expensive,  high-­‐quality  bikes  
would  like  to  introduce  a  less  expensive  entry-­‐level  line  of  mountain  bikes.  
However,  the  projected  internal  rate  of  return  for  this  proposal  is  lower  
than  the  company’s  minimum  required  rate  of  return.  

2. A  maker  of  computer  chips  with  a  reputation  of  staying  on  the  cutting  
edge  of  technology  would  like  to  invest  in  a  new  production  facility.  However,  
the  net  present  value  analysis  indicates  this  proposal  should  be  rejected.  
Required:  

Your  instructor  will  divide  the  class  into  groups  of  two  to  four  
students,  and  assign  one  of  the  three  independent  scenarios  
listed  previously  to  each  group.  Each  group  must  perform  the  
requirements  listed  here:  
1. Identify  at  least  two  qualitative  factors  that  may  lead  to  accepting  
the  proposal.  
2. Discuss  each  option,  based  on  the  findings  of  your  group,  with  the  
class.  

Comprehensive  Cases  
53. Ethical  Issues  in  Capital  Budgeting.  Loomis  Nursery  grows  a  variety  of  
plants  for  wholesale  distribution.  The  company  would  like  to  expand  its  
operations  and  is  considering  a  move  to  one  of  two  locations.  The  first  
location,  Wyatville,  is  one  hour  from  the  ocean  and  therefore  attractive  for  
employees  who  like  to  travel  on  weekends.  The  second  location,  Kenton,  is  
not  as  close  to  the  ocean,  and  much  further  from  desirable  vacation  
destinations.  

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 The  company’s  controller,  Lisa  Lennox,  created  a  net  present  value  analysis  
for  each  location.  The  Kenton  location  had  a  positive  net  present  value,  and  
the  Wyatville  location  had  a  negative  net  present  value.  Upon  providing  this  
information  to  the  chief  financial  officer  of  the  company,  Max  Madden,  Lisa  
was  asked  to  “review  the  numbers  carefully  and  make  sure  all  the  benefits  
of  moving  to  Wyatville  were  included  in  the  analysis.”  Lisa  knew  that  Max  
preferred  vacationing  near  the  ocean  and  had  a  strong  desire  to  move  
operations  to  Wyatville.  However,  she  was  unable  to  find  any  errors  in  her  
analysis  and  could  not  identify  any  additional  benefits.  

Lisa  approached  Max  with  this  information.  Max  responded,  “There  is  no  
way  Kenton  should  have  a  higher  net  present  value  than  Wyatville.  Redo  
your  analysis  to  show  that  Wyatville  has  the  highest  net  present  value,  and  
have  it  on  my  desk  by  the  end  of  the  week.”  
Required:  
a. Is  Max  Madden’s  request  ethical?  Explain.  
b. How  should  Lisa  handle  this  situation?  (It  may  be  helpful  to  review  the  
presentation  of  ethics  in  .)  
Ethical  Issues  in  Capital  Budgeting.  Toyonda  Motor  Company  
produces  a  variety  of  products  including  motorcycles,  all-­‐terrain  vehicles,  
marine  engines,  automobiles,  light  trucks,  and  heavy-­‐duty  trucks.  Each  
division  manager  at  Toyonda  Motor  Company  is  paid  a  base  salary  and  is  
given  an  annual  cash  bonus  if  the  division  achieves  profits  of  at  least  10  
percent  of  the  value  of  assets  invested  in  the  division  (this  is  called  return  
on  investment).  

Peggy  Parkins,  manager  of  the  Light  Truck  Division,  is  considering  investing  
in  new  production  equipment.  The  net  present  value  of  the  proposal  is  
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 positive,  and  Peggy  is  convinced  the  new  equipment  will  provide  a  
competitive  edge  in  future  years.  However,  because  of  the  significant  up-­‐
front  cost  and  related  depreciation,  short-­‐term  profits  will  be  negatively  
affected  by  this  investment.  In  fact,  the  new  equipment  will  reduce  return  
on  investment  below  the  10  percent  threshold  for  at  least  3  years,  which  
will  prevent  Peggy  from  receiving  her  annual  bonuses  for  at  least  3  years.  
However,  profits  are  expected  to  increase  significantly  after  the  three-­‐year  
period.  Peggy  is  planning  to  retire  in  two  years  and  therefore  would  prefer  
to  reject  the  proposal  to  invest  in  new  production  equipment.  
Required:  
 . Describe  the  ethical  conflict  facing  Peggy  Parkins.  
a. What  type  of  employee  compensation  system  might  prevent  this  type  of  
conflict?  

   

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 Chapter  9  
How Are Operating Budgets Created?

Jerry Feltz is the president and owner of Jerry’s Ice Cream, a producer of high-quality ice cream
sold to specialty grocery stores. Jerry is holding a meeting with the company’s managers to
discuss plans for this coming year. Managers at the meeting are Tom Benson, the sales manager;
Lynn Young, the production manager; and Michelle Hopkins, the treasurer and controller.

It looks as if we are having another great year. Customers love our ice cream,
and sales are up. It’s time to begin the budgeting process for next year. Tom,
Jerry: do you have any thoughts on what our sales will look like for next year?

I think we will continue to see significant sales growth. But it’s difficult to
predict exactly how much growth. On the low end, I would expect about 10
Tom: percent; on the high end, perhaps 25 percent.

Wow! I knew sales were going well, but I had no idea we were expecting to
grow 10 percent to 25 percent next year. It will take some serious planning to
Lynn: produce enough ice cream to handle this growth.

I agree. We need to make sure production has enough capacity to handle the
growth, and cash flow planning will be critical to ensure we don’t run out of
Michelle: cash in the process of ramping up production.

Tom, talk with our salespeople and industry contacts so we can get a solid
estimate of quarterly sales for next year. If sales really are expected to grow
Jerry: as you say, we will face a huge challenge!

Tom: I’ll have something for you by the end of next week.

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 Michelle: I’ll start the budgeting process once we have the sales information from Tom.

The sooner we start the budgeting process, the better, particularly if I have to
Lynn: hire more employees and find more production space.

Let’s meet in two weeks to discuss the results of Tom’s research and to set up
Jerry: a plan to handle the growth. Thanks for your help!

Many companies encounter the same issue of growing sales that is facing Jerry’s Ice Cream. Those

that plan for growth have a better chance of succeeding than those that sit idle and hope it all

works out. Operating budgets are used to (1) plan operations and (2) control operations. We describe

both of these objectives next and then devote the remainder of this chapter to the planning phase by

creating an operating budget for Jerry’s Ice Cream. We cover the control phase in Chapter 10 "How

Do Managers Evaluate Performance Using Cost Variance Analysis?".

9.1 Planning and Controlling Operations

L E A R N I N G   O B J E C T I V E  

1. Understand  how  operating  budgets  are  used  for  planning  and  control.  

Question: If you have established a personal budget, you know the importance of planning to
achieve your goals. Assume one of your goals is to purchase a new car. It is not enough to
simply state, “I want to buy a new car next year.” If you do not plan ahead for a big expense like
this, you may find that you don’t have enough money for a reasonable down payment or that you
have very large monthly payments. If you plan ahead, you may see that working some additional
hours, cutting back on entertainment, or a combination of both, allows you to buy the car and
avoid these problems. Organizations are no different, except their needs tend to be more
involved. How do organizations formally plan for the future?

Answer: Let’s look at Jerry’s Ice Cream to answer this question. The company wants to increase
sales next year, but will have difficulty doing this without some type of plan, often called
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 a budget. A budget is a plan of the resources needed to achieve the organization’s goals.
Anoperating budget is a short-term budget (typically one year) that focuses on the daily
operations of the organization. Before presenting the detailed schedules of an operating budget,
we first discuss how organizations use budgets to plan and control their activities.

The Planning Phase

Question: How are budgets used to help organizations plan future activities?

Answer: Budgets are established in advance to help organizations communicate their plans to
employees and to help employees coordinate activities across the entire organization. Imagine
Jerry’s Ice Cream operating without a budget. If production has no forewarning of an increase in
customer demand, Lynn Young, production manager, has no opportunity to plan for an increase
in production. Inefficiencies will occur as Lynn struggles to keep pace with demand (e.g.,
employees working overtime or materials purchased at the last minute at a premium). Cash flow
may suffer as spending initially outpaces cash receipts, which would force the company to
borrow money quickly at a high interest rate. In the worst case, the company would run out of
product, miss out on sales, and perhaps run out of cash.

Turn the example around and assume Jerry’s Ice Cream does have a budget in place for the
coming year. The budget communicates the organization’s plans to Lynn, production manager,
and Michelle, treasurer and controller, showing that sales are expected to increase. Lynn can then
plan accordingly by hiring additional employees, arranging for the purchase of additional
materials, and finding more space for production. Michelle can also plan accordingly by
arranging for a short-term loan at a reasonable interest rate to meet short-term cash needs. As
described here, the planning phase uses the budget to communicate plans to employees and to
help employees coordinate activities across the organization.

The Control Phase

Question: How do organizations use budgets to control operations?

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 Answer: Organizations use budgets to evaluate performance. By comparing the budget with
actual results, companies can determine whether employees, and the company as a whole, have
performed as expected.

For example, assume Jerry’s Ice Cream estimates sales for the first quarter of next year will be
40,000 units at $6 per unit. Actual sales turn out to be 38,000 units at $6.20 per unit. The
company can evaluate sales manager Tom Benson’s performance by comparing the budget to
actual results. For unit sales, Tom did not perform as well as expected (38,000 units actually sold
versus 40,000 in budgeted unit sales). However, Tom exceeded expectations for sales price
($6.20 per unit actual sales price versus budgeted sales price of $6).

The next chapter covers the control phase of budgeting in depth. We now turn to the process of
creating an operating budget to plan a company’s operations for the coming year. Creating an
operating budget is an essential part of business. Depending on the type of product offered and
the size of the company, operating budgets vary widely in complexity. International companies
in particular face difficult hurdles when it comes to budgeting, as described in .

Business  in  Action  9.1  

Challenges of Budgeting for International Operations
Companies with operations in several different countries, calledmultinational
companies, face numerous challenges in establishing operating budgets. Most experts
agree that foreign exchange rates have the biggest impact on budgeting for
multinationals. Specific exchange rates are used when the budget is established.
However, these rates can fluctuate significantly and are likely to differ when companies
compare actual results with the initial budget. This makes the budget control process
difficult because exchange rate variations might cause the differences between actual
results and the budget.

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 Exchange rate fluctuations, along with other market characteristics—such as economic
uncertainty and unpredictable government activities—make budgeting for multinational
companies a challenging task.
Source: Ken Milani and Juan Rivera, “The Rigorous Business of Budgeting for
International Operations,” Management Accounting Quarterly 5, no. 2 (2004): 38–50.
K E Y   T A K E A W A Y  

• Organizations  establish  budgets  to  communicate  their  plans  to  employees  and  to  
coordinate  the  activities  of  employees  across  the  entire  organization.  Budgets  are  
often  compared  with  actual  results  to  evaluate  employee  and  organizational  
performance.  
R E V I E W   P R O B L E M   9 . 1  

Why  do  most  organizations  prepare  an  operating  budget?  

Solution  to  Review  Problem  9.1  

Most  organizations  prepare  an  operating  budget  for  two  reasons.  First,  budgets  help  
managers  communicate  plans  to  employees,  which  in  turn  helps  employees  
coordinate  activities  across  the  entire  organization.  Second,  budgets  are  often  
compared  to  actual  results  to  evaluate  employee  and  organizational  performance.  

9.2 The Budgeting Process

L E A R N I N G   O B J E C T I V E  

1. Understand  the  process  used  to  establish  budgets.  

Question: Some companies prefer to take a “top-down” approach to budgeting, in which upper
management establishes the budget with little input from other employees. These budgets are
imposed on the organization and do little to motivate employees or to gain acceptance by
employees. What method of budgeting is more effective than the top-down approach?

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 Answer: Successful companies approach budgeting from the bottom up. This requires the
involvement of various employees within the organization, not just upper management. Lower-
level employees often know more about their functional areas than upper management, and they
can be an excellent source of information for budgeting purposes. Although getting input from
employees throughout the organization can be time consuming, this approach tends to increase
employee motivation and acceptance of the budget.

Most organizations have a budget committee that supervises the budgeting process.
A budget committee is a group within the organization responsible for overseeing and approving
the master budget. Amaster budget is a series of budget schedules outlining the organization’s
plans for the upcoming period (typically for a year and presented in monthly or quarterly time
periods). The master budget can take many different forms but often includes schedules that
provide planning for sales, production, selling and administrative expenses, and capital
expenditures. These schedules lead to the budgeted income statement, cash flows, and balance
sheet (also part of the master budget).

shows the components of the master budget with references to the figure in which we present
each component for Jerry’s Ice Cream.

Figure 9.1 Master Budget Schedules

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a See for the sales budget.

b See for the selling and administrative budget.
c See for the production budget.
d See for the direct materials purchases budget.
e See for the direct labor budget.
f See for the manufacturing overhead budget.
g See for the capital expenditures budget.
h See for the budgeted income statement.
i See for the cash budget.
j See for the budgeted balance sheet.
K E Y   T A K E A W A Y  

• Some  companies  take  a  top-­‐down  approach  to  budgeting  (upper  management  

establishes  the  budget  with  little  input  from  others),  while  other  companies  take  a  

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 bottom-­‐up  approach  (lower  level  employees  are  involved  in  the  budgeting  process).  
The  bottom-­‐up  approach  tends  to  be  more  effective  as  employees  are  more  inclined  
to  accept  the  budget.  Regardless  of  the  approach  used,  the  budget  committee  (made  
up  of  a  group  within  the  organization)  is  responsible  for  overseeing  and  approving  the  
master  budget.  
R E V I E W   P R O B L E M   9 . 2  

1. What  is  a  master  budget?  

2. Why  do  successful  companies  tend  to  use  the  bottom-­‐up  approach  to  establish  a  
master  budget?  

Solution  to  Review  Problem  9.2  

1. A  master  budget  is  a  series  of  budget  schedules  outlining  the  organization’s  plans  for  
the  upcoming  period,  typically  prepared  monthly,  quarterly,  or  annually.  The  master  
budget  includes  budgets  for  sales,  production,  operating  expenses,  and  capital  
expenditures.  Managers  use  this  information  to  create  budgeted  financial  statements  
(income  statement,  cash  flows,  and  balance  sheet).  
2. The  bottom-­‐up  approach  requires  involvement  of  employees  throughout  the  
organization,  not  just  upper  management,  to  create  the  operating  budget.  Successful  
companies  use  this  approach  because  lower-­‐level  employees  tend  to  know  more  
about  their  functional  areas  than  upper  management,  providing  for  more  accurate  
budget  information.  Also,  employee  involvement  in  the  budget  process  increases  the  
likelihood  employees  will  accept  the  budget.  

9.3 The Master Budget

L E A R N I N G   O B J E C T I V E  

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 1. Develop  the  components  of  a  master  budget.  

Question: Developing a master budget is a lengthy process. Where do companies start when
preparing a master budget?

Answer: Study Figure 9.1 "Master Budget Schedules" carefully, as it serves as the road map for
the master budget presented throughout this chapter for Jerry’s Ice Cream. Notice that the
budgeting process starts with the sales budget. Also, note that the budgets described next are for
a manufacturing company. Manufacturing companies tend to have more budget schedules than
other types of organizations because their operations are more complex. Once you understand
budgeting in a manufacturing environment, you can easily modify the process to perform
budgeting in other organizations, as discussed later in the chapter. As we work through the
master budget for Jerry’s Ice Cream, assume the company prepares quarterly budgets.

Sales Budget

Question: The sales budget is the starting point for the master budget, as shown in Figure 9.1
"Master Budget Schedules". What is a sales budget, and how is it prepared?

Answer: The sales budget is an estimate of units of product the organization expects to sell
times the expected sales price per unit. This is perhaps the most important budget as it drives
most of the other budgets. For example, the production budget and related materials, labor, and
overhead budgets are based on expected sales.

Forecasting sales often involves extensive research and numerous sources. Companies, such as
Jerry’s Ice Cream, typically start with their sales staff since salespeople have daily contact with
customers and direct information about customer demand. Some companies pay for market trend
data to learn about industry and product trends. Many organizations hire market research
consultants to obtain and review industry data and ultimately to predict customer demand. Larger
companies sometimes employ economists to develop sophisticated models used to project sales.
Smaller, less sophisticated organizations simply base their estimates on past trends.Figure 9.2

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 "Estimating Sales" shows how companies obtain sales information from sales people, market
research consultants, and economists.

Figure 9.2 Estimating Sales

Tom Benson, sales manager at Jerry’s Ice Cream, talked with his salespeople and reviewed
market trends for ice cream using data obtained from a market research firm. His estimate,
shown in Figure 9.3 "Sales Budget for Jerry’s Ice Cream", assumes the company will increase
sales 15 percent this coming year. Thus, to get projected sales for quarter 1, Tom simply
multiplied last year’s first quarter sales by 1.15. The average price per unit last year was $6 (1
unit = 1 gallon), and Tom does not expect any change in this price. The sales budget is presented
in Figure 9.3 "Sales Budget for Jerry’s Ice Cream".

Figure 9.3 Sales Budget for Jerry’s Ice Cream

 
Production Budget

Question: The production budget is developed next and is based on sales budget
projections. What is a production budget, and how is it prepared?

Answer: If the organization uses a just-in-time production system, where production occurs just
in time to ship the products to the customer, units produced each quarter would be exactly the
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 same as projected sales. However, most companies, including Jerry’s Ice Cream, maintain a
certain level of finished goods inventory. Thus production is typically not the same as projected
sales. The production budget is an estimate of units to be produced and is based on sales
projections plus an estimate of desired ending finished goods inventory less beginning finished
goods inventory, as summarized in the following:

Key  Equation  

Units to beproduced=Expected salesin units+Desired unitsof ending inventory−Units inbeginnin

g inventory  

Jerry’s Ice Cream plans to sell 40,000 units in the first quarter, as shown inFigure 9.3 "Sales
Budget for Jerry’s Ice Cream". For the sake of simplicity, assume work-in-process inventory is
insignificant, and therefore beginning and ending work-in-process inventory is zero. (We assume
beginning and ending work-in-process inventory is zero throughout this chapter.) The
management prefers to maintain 10 percent of next quarter’s sales in ending inventory. Thus
4,800 units will be in inventory at the end of the first quarter (= 48,000 unit sales in second
quarter × 10 percent). Units needed for the first quarter total 44,800 (= 40,000 unit sales + 4,800
units desired ending inventory). However, Jerry’s will not produce 44,800 units because
inventory will be left over from the fourth quarter of last year. This beginning inventory will be
4,000 units (= 40,000 unit sales in first quarter × 10 percent). Thus actual production will total
40,800 units:

40,800Units to beproduced==40,000Expected salesin units++4,800Desired units ofending invent

ory−−4,000Units inbeginning inventory

Figure 9.4 "Production Budget for Jerry’s Ice Cream" presents the production budget for each of
the 4 quarters of the coming year. Examine this figure carefully, particularly the last line
labeled units to be produced. Lynn Young, the production manager, will be concerned about the
spike in production during the third quarter of 59,200 units. The third quarter, from July 1
through September 30, is the peak sales season for ice cream. It will be difficult for Lynn to plan
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 for this increase in production from the first and second quarters to the third quarter. However,
this is exactly why companies prepare budgets—to plan for the future!

Figure 9.4 Production Budget for Jerry’s Ice Cream

 
*Information from Figure 9.3 "Sales Budget for Jerry’s Ice Cream".

**Desired ending inventory = 10 percent × Next quarter sales; for the first quarter, 4,800 = 0.10
× 48,000. Fourth quarter desired ending inventory of 4,400 units is based on an estimate of sales
in the first quarter of next year.

***Beginning inventory = Inventory at end of previous quarter; for example, second quarter
beginning inventory = First quarter ending inventory.

Once Jerry’s Ice Cream knows how many units it must produce each quarter, budgets are
established for the individual components of production: direct materials, direct labor, and
manufacturing overhead. We present these budgets next.

R E V I E W   P R O B L E M   9 . 3  

Carol’s  Cookies  produces  cookies  for  resale  at  grocery  stores  throughout  North  
America.  The  company  is  currently  in  the  process  of  establishing  a  master  budget  on  a  

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 quarterly  basis  for  this  coming  fiscal  year,  which  ends  December  31.  Prior  
year  quarterly  sales  were  as  follows  (1  unit  =  1  batch):  
First quarter 64,000 units

Second quarter 76,800 units

Third quarter 96,000 units

Fourth quarter 83,200 units

Unit  sales  are  expected  to  increase  25  percent,  and  each  unit  is  expected  to  sell  for  
$8.  The  management  prefers  to  maintain  ending  finished  goods  inventory  equal  to  10  
percent  of  next  quarter’s  sales.  Assume  finished  goods  inventory  at  the  end  of  the  
fourth  quarter  budget  period  is  estimated  to  be  9,000  units.  
1. Prepare  a  sales  budget  for  Carol’s  Cookies  using  a  format  similar  toFigure  9.3  "Sales  
Budget  for  Jerry’s  Ice  Cream".  (Hint:  be  sure  to  increase  last  year’s  unit  sales  by  25  
percent.)  
2. Prepare  a  production  budget  for  Carol’s  Cookies  using  the  format  shown  in  Figure  9.4  
"Production  Budget  for  Jerry’s  Ice  Cream".  

Solution  to  Review  Problem  9.3  

1. The  following  is  a  sales  budget:  

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2. The  following  is  a  production  budget:  

*Desired  ending  inventory  =  10  percent  ×  Next  quarter  sales;  for  the  first  
quarter,  9,600  =  0.10  ×  96,000.  Fourth  quarter  desired  ending  inventory  of  
9,000  units  is  given.  

**Beginning  inventory  =  Inventory  at  end  of  previous  quarter;  for  example,  
Second  quarter  beginning  inventory  =  First  quarter  ending  inventory.  

Direct Materials Purchases Budget

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 Question: The number of units of finished goods to be produced each quarter from the
production budget is the starting point for the direct materials purchases budget. What is a
direct materials purchases budget, and how is it prepared?

Answer: The direct materials purchases budget is an estimate of raw materials needed to achieve
a desired level of production. Figure 9.4 "Production Budget for Jerry’s Ice Cream", the
production budget, shows that 40,800 finished units will be produced in the first quarter. We will
now establish a direct materials purchases budget that answers the questions: how many pounds
of material must be purchased during the first quarter to achieve this production, and what is the
cost of these materials?

Assume two pounds of material are required to produce one unit of product. Thus the amount of
materials required to produce 40,800 units of ice cream is 81,600 pounds (= 40,800 units × 2
pounds per unit). This amount is labeled as materials needed in production in the direct materials
purchases budget shown in Figure 9.5 "Direct Materials Purchases Budget for Jerry’s Ice
Cream". (To simplify this example, assume sugar is the only material used. However, other
materials, such as cream and vanilla, are typically required to produce ice cream.)

Figure 9.5 Direct Materials Purchases Budget for Jerry’s Ice Cream

 
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 *Information from Figure 9.4 "Production Budget for Jerry’s Ice Cream".

**Desired ending inventory = 20 percent × Next quarter production needs; for the first quarter,
19,680 = 0.20 × 98,400. Fourth quarter desired ending inventory of 20,000 pounds is based on an
estimate of materials needed in production first quarter of next year.

***Beginning inventory = Inventory at end of previous quarter; for example, Second quarter
beginning inventory = First quarter ending inventory.

****$2 direct materials cost per unit = 2 pounds of materials required per unit × $1 per pound.

Will the company buy 81,600 pounds of material in the first quarter? Probably not. Jerry’s will
have materials in beginning raw materials inventory and prefers to maintain a certain level
of ending raw materials inventory. Thus direct materials purchased is based on materials needed
in production plus an estimate of desired ending raw materials inventory less beginning raw
materials inventory. We summarize this in the following equation. Notice the similarity of this
equation to the inventory equation presented earlier for the production budget.

Key Equation

Materials tobe purchased=Materials neededin production+Desired materialsin ending inventory−

Materials inbeginning inventory

Assume the management prefers to maintain raw materials ending inventory equal to 20 percent
of next quarter’s materials needed in production. Thus 19,680 pounds of material will be in
inventory at the end of the first quarter (= 98,400 pounds of materials needed in production in
second quarter × 20 percent). Materials needed in inventory total 101,280 pounds (= 81,600
pounds of materials needed in production + 19,680 pounds of material in desired ending
inventory). However, Jerry’s will not purchase 101,280 pounds of materials because inventory
will be left over from the fourth quarter of last year. This beginning inventory will be 16,320

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 pounds (= 81,600 pounds of material needed in production in first quarter × 20 percent). Thus
direct materials purchased in the first quarter will total 84,960 pounds:

84,960Materials==81,600Materials neededin production++19,680Desired materialsin ending inv

entory−−16,320Materials inbeginning inventory

To estimate the cost of purchasing 84,960 pounds of material, multiply the number of pounds to
be purchased by the cost per pound. Assume the cost per pound of material for Jerry’s is $1. This
results in a cost of $84,960 for materials to be purchased during the first quarter, as shown at the
bottom ofFigure 9.5 "Direct Materials Purchases Budget for Jerry’s Ice Cream" (= 84,960
pounds to be purchased × $1 per pound).

Review the direct materials purchases budget shown in Figure 9.5 "Direct Materials Purchases
Budget for Jerry’s Ice Cream" carefully, particularly the line labeled direct materials to be
purchased. The purchasing manager at Jerry’s Ice Cream uses this information, along with the
price per pound, to negotiate the purchase of materials with suppliers.

Direct Labor Budget

Question: The direct materials purchases budget is the first of three supporting budgets for
production. The second is the direct labor budget. What is the direct labor budget, and how is it
prepared?

Answer: The direct labor budget is an estimate of direct labor hours, and related costs, necessary
to achieve a desired level of production. Knowing Jerry’s Ice Cream plans to produce 40,800
units of ice cream during the first quarter, this budget answers the questions: how many direct
labor hours will be necessary to achieve this production, and what will this labor cost?

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 Assume it takes 0.10 direct labor hours (or 6 minutes) to produce 1 unit of product. Thus 4,080
hours of direct labor will be required to produce 40,800 units of product (= 40,800 finished units
produced × 0.10 direct labor hours per unit). Given an average hourly rate of $13, the direct labor
cost for the first quarter totals $53,040 (= 4,080 hours × $13 per hour). This information is
shown in the direct labor budget presented in Figure 9.6 "Direct Labor Budget for Jerry’s Ice
Cream".

Figure 9.6 Direct Labor Budget for Jerry’s Ice Cream

 
*From Figure 9.4 "Production Budget for Jerry’s Ice Cream".

**$1.30 direct labor cost per unit = 0.10 direct labor hours per unit × $13 per hour.

Carefully review the direct labor budget shown in Figure 9.6 "Direct Labor Budget for Jerry’s
Ice Cream". The production manager at Jerry’s Ice Cream, Lynn Young, uses this information to
ensure the appropriate number of employees is available to meet production goals. Notice that
the number of direct labor hours needed in production for the third quarter is significantly higher
than each of the two previous quarters. Again, this is why organizations prepare budgets: to plan
for these types of events. Lynn will have to start planning for this spike in direct labor hours,
either by asking employees to work overtime or by hiring additional employees.

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 Manufacturing Overhead Budget

Question: The manufacturing overhead budget is the third of three supporting production
budgets. What is a manufacturing overhead budget, and how is it prepared?

Answer: The manufacturing overhead budget is an estimate of all production costs, other than
direct materials and direct labor, necessary to achieve a desired level of production. This budget
is presented in Figure 9.7 "Manufacturing Overhead Budget for Jerry’s Ice Cream". Notice that
overhead costs are separated into variable and fixed components.

Figure 9.7 Manufacturing Overhead Budget for Jerry’s Ice Cream

 
*From Figure 9.4 "Production Budget for Jerry’s Ice Cream".

**$1.20 = $240,480 total overhead cost ÷ 200,400 units to be produced for the year.

^Deduct depreciation to get the actual cash payment for overhead. This information is needed for
the cash budget presented in Figure 9.11 "Cash Budget for Jerry’s Ice Cream".
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 By definition, total variable overhead costs change with changes in production and are calculated
by multiplying units to be produced by the cost per unit. For example, indirect materials cost for
the first quarter of $6,120 is calculated by taking 40,800 units to be produced × $0.15 cost per
unit. Fixed costs generally do not change with changes in production and therefore remain the
same each quarter. (Note: In some situations, fixed overhead costs can change from one quarter
to the next. For example, hiring additional salaried personnel during the year would increase
fixed overhead costs, and purchasing equipment during the year would increase depreciation
costs. In this example, we assume fixed overhead costs do not change during the year.)

Depreciation is deducted at the bottom of the manufacturing overhead budget to determine cash
payments for overhead because depreciation is not a cash transaction. We use this information
later in the chapter for the cash budget.

R E V I E W   P R O B L E M   9 . 4  

Carol’s  Cookies,  the  company  featured  in  the  last  review  problem  and  in  the  next  
three,  is  now  preparing  the  budget  for  direct  materials  purchases,  direct  labor,  and  
manufacturing  overhead.  
Direct  Materials  Purchases  Budget  Information  

Each  unit  of  product  requires  1.5  pounds  of  direct  materials  per  unit,  and  the  cost  of  
direct  materials  is  $2  per  pound.  Management  prefers  to  maintain  ending  raw  
materials  inventory  equal  to  30  percent  of  next  quarter’s  materials  needed  in  
production.  Assume  raw  materials  inventory  at  the  end  of  the  fourth  quarter  budget  
period  is  estimated  to  be  41,000  pounds.  
Direct  Labor  Budget  Information  

Each  unit  of  product  requires  0.20  direct  labor  hours  at  a  cost  of  $12  per  hour.  
Manufacturing  Overhead  Budget  Information  

Variable  overhead  costs  are:  

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 Indirect materials $0.20 per unit

Indirect labor $0.15 per unit

Other $0.35 per unit

Fixed  overhead  costs  each  quarter  are:  

Salaries $28,000

Rent $22,000

Depreciation $16,165

1. Prepare  a  direct  materials  purchases  budget  for  Carol’s  Cookies  using  the  format  
shown  in  Figure  9.5  "Direct  Materials  Purchases  Budget  for  Jerry’s  Ice  Cream".  
2. Prepare  a  direct  labor  budget  for  Carol’s  Cookies  using  the  format  shown  in  Figure  9.6  
"Direct  Labor  Budget  for  Jerry’s  Ice  Cream".  
3. Prepare  a  manufacturing  overhead  budget  for  Carol’s  Cookies  using  the  format  shown  
in  Figure  9.7  "Manufacturing  Overhead  Budget  for  Jerry’s  Ice  Cream".  

Solution  to  Review  Problem  9.4  

1.    

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*Desired  ending  inventory  =  30  percent  ×  Next  quarter  production  needs;  for  
the  first  quarter,  44,280  =  0.30  ×  147,600  pounds.  Fourth  quarter  desired  
ending  inventory  of  41,000  pounds  is  given.  

**Beginning  inventory  =  Inventory  at  end  of  previous  quarter;  for  example,  
Second  quarter  beginning  inventory  =  First  quarter  ending  inventory.  

***$3  direct  materials  cost  per  unit  =  1.5  pounds  of  materials  required  per  
unit  ×  $2  per  pound.  

2.    

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*$2.40  direct  labor  cost  per  unit  =  0.20  direct  labor  hours  per  unit  ×  $12  per  
hour.  

3.    

 
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 *$1.36  =  $545,360  total  overhead  cost  ÷  401,000  units  to  be  produced  for  
the  year.  

^Deduct  depreciation  to  get  the  actual  cash  payment  for  overhead.  This  
information  is  needed  for  the  cash  budget  prepared  later.  

Selling and Administrative Budget

Question: Now that the sales and production-related budgets are complete, it is time to estimate
selling and administrative costs. What is a selling and administrative budget, and how is it
prepared?

Answer: The selling and administrative budget is an estimate of all operating costs other than
production. This budget is presented in Figure 9.8 "Selling and Administrative Budget for Jerry’s
Ice Cream".

Although many organizations may have variable and fixed costs in this budget, Jerry’s Ice
Cream treats all selling and administrative costs as fixed costs. Once again, depreciation is
deducted at the bottom of this budget to determine cash payments for selling and administrative
costs, which we use later in the chapter for the cash budget.

Figure 9.8 Selling and Administrative Budget for Jerry’s Ice Cream

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*Deduct depreciation to get the actual cash payment for selling and administrative costs.

**This information is needed for the cash budget presented in Figure 9.11 "Cash Budget for
Jerry’s Ice Cream".

Budgeted Income Statement

Question: Budgets completed to this point include sales (Figure 9.3 "Sales Budget for Jerry’s Ice
Cream"), production (Figure 9.4 "Production Budget for Jerry’s Ice Cream"), direct materials
(Figure 9.5 "Direct Materials Purchases Budget for Jerry’s Ice Cream"), direct labor (Figure 9.6
"Direct Labor Budget for Jerry’s Ice Cream"), manufacturing overhead (Figure 9.7
"Manufacturing Overhead Budget for Jerry’s Ice Cream"), and selling and administrative
(Figure 9.8 "Selling and Administrative Budget for Jerry’s Ice Cream"). Jerry’s Ice Cream now
has enough information to prepare the budgeted income statement. What is a budgeted income
statement, and how is it prepared?

Answer: The budgeted income statement is an estimate of the organization’s profit for a given
budget period. Most organizations, including Jerry’s Ice Cream, prepare the budgeted income
statement using the accrual basis of accounting: revenues are recorded when earned and
expenses are recorded when incurred. The budgeted income statement for Jerry’s Ice Cream is

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 presented in Figure 9.9 "Budgeted Income Statement for Jerry’s Ice Cream". The cash budget we
prepare later in the chapter will show when cash is received and paid.

Figure 9.9 Budgeted Income Statement for Jerry’s Ice Cream

 
*Cost of goods sold = Per unit cost of $4.50 (see above) × Units sold (fromFigure 9.3 "Sales
Budget for Jerry’s Ice Cream"); for the first quarter, $180,000 cost of goods sold = $4.50 unit
cost × 40,000 units.

The first line in the budgeted income statement, sales, comes from the sales budget in Figure 9.3
"Sales Budget for Jerry’s Ice Cream". The next line, cost of goods sold, is calculated by
multiplying unit sales from Figure 9.3 "Sales Budget for Jerry’s Ice Cream" by the cost per unit.
The cost per unit calculation is shown at the bottom of Figure 9.9 "Budgeted Income Statement
for Jerry’s Ice Cream". Carefully review this calculation. Since Jerry’s Ice Cream uses full-
absorption costing, all manufacturing costs related to goods sold are included (or fully absorbed)
in cost of goods sold.Figure 9.5 "Direct Materials Purchases Budget for Jerry’s Ice
Cream", Figure 9.6 "Direct Labor Budget for Jerry’s Ice Cream", and Figure 9.7 "Manufacturing
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 Overhead Budget for Jerry’s Ice Cream" provide this information on a per unit basis for direct
materials, direct labor, and manufacturing overhead, respectively.

The third line, gross margin, is simply sales minus cost of goods sold. The fourth line, selling
and administrative costs, comes from the selling and administrative budget in Figure 9.8 "Selling
and Administrative Budget for Jerry’s Ice Cream". The bottom line of the budgeted income
statement, net income, is gross margin minus selling and administrative costs. Income tax
expense is not included in this example for the sake of simplicity. However, income taxes can
significantly reduce projected net income and cash flows.

Question: How do companies use the budgeted income statement to improve operations?

Answer: The budgeted income statement is perhaps the most carefully scrutinized component of
the master budget. The management and employees throughout the organization use this
information for planning purposes and to evaluate company performance. The board of directors
and budget committee are responsible for approving the budget and often review periodic reports
comparing actual net income to budgeted net income to determine if profit goals are being
achieved. Lenders and owners often review the budget to ensure the organization is on track to
meet its goals. The budgeted income statement answers the question: what profits does the
organization expect to achieve?

After completing the budgeted income statement, only three budgets remain: the capital
expenditures budget, the cash budget, and the budgeted balance sheet. We discuss the capital
expenditures budget next.

   

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 R E V I E W   P R O B L E M   9 . 5  

Carol’s  Cookies  estimates  that  all  selling  and  administrative  costs  are  fixed.  Quarterly  
selling  and  administrative  cost  estimates  for  the  coming  year  are  
Salaries $60,000

Rent $ 7,000

Advertising $10,000

Depreciation $ 8,000

Other $ 1,000

1. Prepare  a  selling  and  administrative  budget  for  Carol’s  Cookies  using  the  format  
shown  in  Figure  9.8  "Selling  and  Administrative  Budget  for  Jerry’s  Ice  Cream".  
2. Prepare  a  budgeted  income  statement  for  Carol’s  Cookies  using  the  format  shown  
in  Figure  9.9  "Budgeted  Income  Statement  for  Jerry’s  Ice  Cream".  

Solution  to  Review  Problem  9.5  

1.    

 
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 *Deduct  depreciation  to  get  the  actual  cash  payment  for  selling  and  
administrative  costs.  

**This  information  is  needed  for  the  cash  budget  prepared  later.  

2.    

*Cost  of  goods  sold  =  Per  unit  cost  of  $6.76  (see  above)  ×  Units  sold  (from  
sales  budget);  for  first  quarter,  $540,800  cost  of  goods  sold  =  $6.76  unit  cost  
×  80,000  units.  

**From  selling  and  administrative  budget.  

Capital Expenditures Budget

Question: What is a capital expenditures budget, and how is it prepared?

Answer: The capital expenditures budget is an estimate of the long-term assets to be purchased
during the budget period. This includes purchases of tangible long-term assets such as property,

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 plant, and equipment, and intangible assets, such as patents, copyrights, and trademarks. This
budget can have a significant impact on cash flow and requires careful planning and analysis
(Chapter 8 "How Is Capital Budgeting Used to Make Decisions?"presents a detailed discussion
of capital budgeting). As shown in Figure 9.10 "Capital Expenditures Budget for Jerry’s Ice
Cream", Jerry’s Ice Cream plans to purchase computers and production equipment at the end of
the fourth quarter.

Figure 9.10 Capital Expenditures Budget for Jerry’s Ice Cream

 
Note: These acquisitions will have no effect on depreciation expense in the fourth quarter. Items
will be purchased at the end of the year. Thus depreciation begins the following year.

Because long-term asset purchases occur at the end of the year, depreciation will begin the
following year. Thus depreciation shown in the manufacturing overhead and selling and
administrative budgets will not be affected until the following year. The cash outlay required to
make these purchases is reflected in the cash budget presented next.

Cash Budget

Question: What is a cash budget, and how is it prepared?

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 Answer: The cash budget is an estimate of the amount and timing of cash inflows and outflows
for the budget period. Although the budgeted income statement provides an estimate of
profitability, it stops short of providing cash flow information. For example, some of the
$240,000 in first quarter sales revenue will be collected during the first quarter and some will be
collected the following quarter. A section of the cash budget will show when cash from sales will
be received.

The cash budget has the following sections, each of which is described afterFigure 9.11 "Cash
Budget for Jerry’s Ice Cream":

• Cash collections from sales

• Cash payments for purchases of materials
• Other cash collections and payments

Figure 9.11 "Cash Budget for Jerry’s Ice Cream" shows the cash budget for Jerry’s Ice Cream.
Amounts shown in parentheses represent cash outflows; amounts without parentheses represent
cash inflows.

Figure 9.11 Cash Budget for Jerry’s Ice Cream

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*Based on sales budget shown in Figure 9.3 "Sales Budget for Jerry’s Ice Cream". All sales are
on credit: 60 percent collected in the quarter of sale and 40 percent collected the following
quarter.

**Based on purchases budget shown in Figure 9.5 "Direct Materials Purchases Budget for
Jerry’s Ice Cream". All purchases are on credit: 70 percent paid in the quarter of purchase and 30
percent paid the following quarter.

***Does not include depreciation since depreciation expense does not involve a cash payment.
See related figures for calculations.
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 ^Excess of collections over payments = Cash collections from sales – Cash payments for
materials purchases – Other cash payments.

^^ Beginning cash balance = Cash balance at end of previous period. Balance for first quarter is
given.

^^^ Ending cash balance = Excess of collections over payments for the quarter + Beginning cash
balance.

Cash Collections from Sales

Question: Assume all sales at Jerry’s Ice Cream are on credit. How long does it take, on
average, for Jerry’s to collect on credit sales?

Answer: On average, 60 percent of credit sales are collected in the quarter sold and the
remaining 40 percent is collected the following quarter. These percentage estimates are based on
previous experience and take into consideration credit terms offered to customers. Since Jerry’s
Ice Cream only sells to customers with an excellent credit record, it anticipates no bad debts.

As you examine the cash collections from sales section of Jerry’s cash budget, notice that
$180,000 in cash will be collected in the first quarter related to credit sales made in the previous
quarter (this amount is given). Next, you will see $144,000 in cash collected in the first quarter
related to first quarter sales (= 60 percent collected in quarter of sale × $240,000 first quarter
sales). The remaining $96,000 will be collected in the second quarter, as shown in Figure 9.11
"Cash Budget for Jerry’s Ice Cream" (= 40 percent × $240,000 first quarter sales).

Cash Payments for Purchases of Materials

Question: Assume all purchases at Jerry’s Ice Cream are on credit. How long does it take, on
average, for Jerry’s to pay for these credit purchases?

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 Answer: On average, 70 percent of purchases are paid in the quarter purchased and the
remaining 30 percent is paid the following quarter. These percentage estimates are based on
previous experience and take into account credit terms offered by suppliers.

As you look at the cash payments for purchases of materials section of Jerry’s cash budget,
notice that $30,000 in cash will be paid in the first quarter related to purchases made in the
previous quarter (this amount is given). Next, you will see $59,472 in cash paid in the first
quarter related to first quarter purchases (= 70 percent paid in quarter purchased × $84,960 first
quarter purchases). The remaining $25,488 will be paid in the second quarter, as shown in Figure
9.11 "Cash Budget for Jerry’s Ice Cream" (= 30 percent × $84,960 first quarter
purchases). Figure 9.5 "Direct Materials Purchases Budget for Jerry’s Ice Cream" shows how
cash flows into the company for customer sales and out of the company for purchases of
materials.

Other Cash Collections and Payments

Question: What other cash collections and cash payments must be considered at Jerry’s Ice
Cream?

Answer: Assume Jerry’s Ice Cream has other cash payments but no other cash collections.
Direct labor cash payments are from Figure 9.6 "Direct Labor Budget for Jerry’s Ice Cream".
Manufacturing overhead cash payments are from Figure 9.7 "Manufacturing Overhead Budget
for Jerry’s Ice Cream". Recall that depreciation was subtracted from total overhead costs
in Figure 9.7 "Manufacturing Overhead Budget for Jerry’s Ice Cream"to calculate the cash
payments for overhead. Selling and administrative cash payments are from Figure 9.8 "Selling
and Administrative Budget for Jerry’s Ice Cream", where a similar depreciation adjustment was
made. Capital expenditure cash payments are from Figure 9.10 "Capital Expenditures Budget for
Jerry’s Ice Cream".

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 The other cash collections and payments section is also where organizations include financing
activities such as cash collections from the sale of bonds or cash payments for the repayment of
bank loans. Jerry’s Ice Cream does not have any of these financing activities.

The bottom section of the cash budget is where the ending cash balance is calculated for each
budget period. The manager responsible for cash planning, typically the treasurer, scrutinizes this
section carefully. Some organizations must borrow cash to fund the timing difference between
when cash is used for production and when cash is received from sales. The cash budget will
signal when short-term borrowing is necessary and allows time for the treasurer to arrange for
financing. The cash budget presented inFigure 9.11 "Cash Budget for Jerry’s Ice Cream" shows
that Jerry’s will not need to borrow cash in any of the four quarters. In fact, Jerry’s Ice Cream
will have a hefty reserve of cash totaling $155,576 at the end of the fourth quarter.

R E V I E W   P R O B L E M   9 . 6  

Carol’s  Cookies  has  the  following  information  pertaining  to  the  capital  expenditures  
and  cash  budgets.  
Capital  Expenditures  

The  company  plans  to  purchase  selling  and  administrative  equipment  totaling  
$20,000  and  production  equipment  totaling  $28,000.  Both  will  be  purchased  at  the  
end  of  the  fourth  quarter  and  will  not  affect  depreciation  expense  for  the  coming  
year.  
Cash  Budget  

All  sales  are  on  credit.  The  company  expects  to  collect  70  percent  of  sales  in  the  
quarter  of  sale,  25  percent  of  sales  in  the  quarter  following  the  sale,  and  5  percent  
will  not  be  collected  (bad  debt).  Accounts  receivable  at  the  end  of  last  year  totaled  
$200,000,  all  of  which  will  be  collected  in  the  first  quarter  of  this  coming  year.  

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 All  direct  materials  purchases  are  on  credit.  The  company  expects  to  pay  80  percent  
of  purchases  in  the  quarter  of  purchase  and  20  percent  the  following  quarter.  
Accounts  payable  at  the  end  of  last  year  totaled  $50,000,  all  of  which  will  be  paid  in  
the  first  quarter  of  this  coming  year.  

The  cash  balance  at  the  end  of  last  year  totaled  $20,000.  
1. Prepare  a  capital  expenditures  budget  for  Carol’s  Cookies  using  the  format  shown  
in  Figure  9.10  "Capital  Expenditures  Budget  for  Jerry’s  Ice  Cream".  
2. Prepare  a  cash  budget  for  Carol’s  Cookies  using  the  format  shown  inFigure  9.11  "Cash  
Budget  for  Jerry’s  Ice  Cream".  

Solution  to  Review  Problem  9.6  

1.    

Note:  These  acquisitions  will  have  no  effect  on  depreciation  expense  in  the  
fourth  quarter.  Items  will  be  purchased  at  the  end  of  the  year.  Thus  
depreciation  begins  the  following  year.  

2.    

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*Based  on  sales  budget.  All  sales  are  on  credit:  70  percent  collected  in  the  
quarter  of  sale,  25  percent  collected  the  following  quarter,  and  5  percent  
bad  debt.  

**Based  on  purchases  budget.  All  purchases  are  on  credit:  80  percent  paid  
in  the  quarter  of  purchase  and  20  percent  paid  the  following  quarter.  

***From  manufacturing  overhead  budget.  Amount  does  not  include  

depreciation.  

****From  selling  and  administrative  budget.  Amount  does  not  include  

depreciation.  
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 *****From  capital  expenditures  budget.  

^Excess  of  collections  over  payments  =  Cash  collections  from  sales  –  Cash  
payments  for  materials  purchases  –  other  cash  payments.  

^^  Beginning  cash  balance  =  Cash  balance  at  end  of  previous  period.  
Balance  for  first  quarter  is  given.  

^^^  Ending  cash  balance  =  Excess  of  collections  over  payments  for  the  
quarter  +  Beginning  cash  balance.  

Budgeted Balance Sheet

Question: The budgeted balance sheet is the last piece of the budget process.What is the
budgeted balance sheet, and how is it prepared?

Answer: The budgeted balance sheet is an estimate of the ending balances for all balance sheet
accounts. Managers use this to assess the impact that budgeted sales and costs will have on the
financial condition of the organization. We present the budgeted balance sheet for Jerry’s Ice
Cream inFigure 9.12 "Budgeted Balance Sheet for Jerry’s Ice Cream".

Information needed to prepare the budgeted balance sheet for Jerry’s Ice Cream is shown
throughout the chapter and is referenced in Figure 9.12 "Budgeted Balance Sheet for Jerry’s Ice
Cream". Additional information is provided here:

Plant and equipment (net) expected at the end of the budget period (December 31) is $530,000.

Common stock issued and outstanding at the end of the budget period (December 31) is expected
to be $650,000.

Actual retained earnings at the end of last year totaled $101,600, and no cash dividends will be
paid during the current budget period ending December 31.

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 Figure 9.12 Budgeted Balance Sheet for Jerry’s Ice Cream

 
*$124,800 = $312,000 in fourth quarter sales (Figure 9.3 "Sales Budget for Jerry’s Ice
Cream") × 40 percent to be collected next quarter (Figure 9.11 "Cash Budget for Jerry’s
Ice Cream").
**$20,000 = 20,000 pounds (Figure 9.5 "Direct Materials Purchases Budget for
Jerry’s Ice Cream") × $1 per pound (Figure 9.5 "Direct Materials Purchases Budget for
Jerry’s Ice Cream").
***$19,800 = 4,400 units (Figure 9.4 "Production Budget for Jerry’s Ice Cream") ×
$4.50 (Figure 9.9 "Budgeted Income Statement for Jerry’s Ice Cream").
^Given.

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 ^^ $30,576 = $101,920 in fourth quarter purchases (Figure 9.5 "Direct Materials
Purchases Budget for Jerry’s Ice Cream") × 30 percent to be paid next quarter (Figure
9.11 "Cash Budget for Jerry’s Ice Cream").
^^^$169,600 = $101,600 in retained earnings at end of last year (given) + $68,000
budgeted net income for the year (Figure 9.9 "Budgeted Income Statement for Jerry’s
Ice Cream").
Computer  Application  
Using Excel to Develop an Operating Budget
Managers often use spreadsheets to develop operating budgets. Spreadsheets help
managers perform what-if analysis by linking the components of the master budget and
automatically making changes to budget schedules when certain estimates are revised.
For example, if managers at Jerry’s Ice Cream wanted to see what would happen if sales
in units were decreased by 10 percent from the initial projection shown in Figure 9.3
"Sales Budget for Jerry’s Ice Cream", they would simply reduce sales by 10 percent, and
all budget schedules affected by this change would automatically be updated in the
spreadsheet.
An example of how to use Excel to develop an operating budget for Jerry’s Ice Cream
follows. Notice the tabs at the bottom of the spreadsheet. The first tab is for the sales
budget worksheet, the second tab is for the production budget worksheet, the next tab is
for the direct materials purchases budget worksheet, and so on. All these worksheets are
linked so changes to certain estimates are reflected in the appropriate budget schedules.

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 Spreadsheet programs are not the only way managers use technology to facilitate the
budgeting process. As indicated in Note 9.30 "Business in Action 9.2" the Web is also a
useful tool when it comes to efficient budgeting.
Business  in  Action  9.2  
Moving from Spreadsheets to Intranet Budgeting
The Pacific Northwest National Laboratory (PNNL) is one of nine multiprogram
national laboratories of the U.S. Department of Energy.PNNL is operated by Battelle
Science and Technology International, a global science and technology enterprise
that conducts $3,000,000,000 worth of research and development annually.
The Facilities & Operations (F&O) Business Office at PNNL has over 130 budget
activities, each of which requires an annual budget. The total annual budget is
$70,000,000. Prior to 2000, activity managers were required to use Excel to process
budget information. The F&O Business Office then uploaded this information to
formulate the division’s budget.
As the F&O Business Office began the budget process for 2001, management decided to
build a Web-based, or intranet, budget and planning system. The new system allowed
managers to use the Web to input budget information directly, thus eliminating the
need to upload initial budgets and subsequent budget changes.
Moving to intranet budgeting benefited PNNL’s F&O Business Office in several ways.
Activity managers no longer had to use Excel to enter budget information, which saved
450 hours. The F&O Business Office saved 60 hours by no longer having to upload Excel
budget information. Budget reports are easy to create, and the system provides real-time
reports for analysis and project management.
Many organizations are adopting intranet budgeting as the primary source of planning
and control. As the financial specialist at PNNLstated, intranet budgeting provides “a
tool that is easy to use, accurate, and simple and will continue to save us time and
money.”

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 Sources: Mary F. Astley, “Intranet Budgeting,” Strategic Finance, May 2003; Pacific
Northwest National Laboratory, “Home Page,”http://www.pnl.gov.
R E V I E W   P R O B L E M   9 . 7  

Assume  Carol’s  Cookies  will  collect  25  percent  of  fourth  quarter  budgeted  sales  in  full  
next  year  (this  represents  accounts  receivable  at  the  end  of  the  fourth  quarter).  The  
following  account  balances  are  expected  at  the  end  of  the  fourth  quarter:  
• Property,  plant,  and  equipment  (net):  $320,000  
• Common  stock:  $450,000  

Retained  earnings  at  the  end  of  last  year  totaled  $56,180,  and  no  cash  dividends  are  
anticipated  for  the  budget  period  ending  December  31.  
Prepare  a  budgeted  balance  sheet  for  Carol’s  Cookies  using  the  format  shown  
in  Figure  9.12  "Budgeted  Balance  Sheet  for  Jerry’s  Ice  Cream".  

Solution  to  Review  Problem  9.7  

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*$208,000  =  $832,000  in  fourth  quarter  sales  (from  sales  budget)  ×  25  percent  to  be  
collected  next  quarter  (given).  

**$82,000  =  41,000  pounds  ×  $2  per  pound  (from  direct  materials  budget).  

***$60,840  =  9,000  units  (from  production  budget)  ×  $6.76  cost  per  unit  (from  
budgeted  income  statement).  

^Given.  

^^  $59,492  =  $297,460  in  fourth  quarter  purchases  (from  direct  materials  budget)  ×  
20  percent  to  be  paid  next  quarter  (given).  

^^^  $208,180  =  $56,180  in  retained  earnings  end  of  last  year  (given)  +  $152,000  
budgeted  net  income  (from  budgeted  income  statement).  
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 Wrap-Up of Chapter Example

The management group at Jerry’s Ice Cream is reconvening to discuss sales growth anticipated
for the next budget period.

Tom, I recall you saying we should expect growth between 10 percent and 25
Jerry: percent next year. Have you been able to narrow this down a bit?

Yes, I’ve talked with our salespeople and industry contacts. We also obtained
trend data from a market research firm. Based on this information, sales
should increase about 15 percent this coming year. Most agree this growth is
a result of our high-quality product and our ability to quickly adjust flavors to
Tom: accommodate consumer tastes.

Jerry: This is great news. It looks like our ice cream is really catching on!

I received Tom’s projection a few days ago and already have a preliminary
budget for next year. Lynn, you will have to do some serious planning to
guarantee we have enough materials and employees for the third quarter spike
Michelle: in sales.

Yes, I realize we have some work to do to ensure we have enough resources to

Lynn: meet budgeted production levels.

Can’t we just hire a few more employees and let our suppliers know we will
Jerry: need more materials?

The problem is that we have a spike in production during the third quarter.
Production goes from 49,200 units in the second quarter to 59,200 units in the
third quarter and back down to 51,200 units in the fourth quarter. I don’t think
Lynn: materials will be an issue—our supplier has already assured me this will not

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 be a problem. But I can’t just hire new employees in the third quarter and fire
them in the fourth quarter.

Perhaps our existing employees can work overtime, or we can hire temporary
Jerry: employees.

Hiring temporary employees would be my preference, particularly since

college students are looking for part-time work during the summer months.
Working overtime would really cause problems with our budgeted hourly rate
Lynn: of $13.

Jerry: Michelle, do we have any cash flow problems with the anticipated growth?

Fortunately not. If all goes as planned, we should have more than $90,000 in
Michelle: the bank at the end of each quarter.

Excellent! Let’s do our best to stay on track. Michelle, I’d like an update at the
Jerry: end of the first quarter to see if actual profit meets or exceeds budgeted profit.

No problem. I’ll have it for you as soon as the books are closed for the first
Michelle: quarter.

Now that we all have some idea of what to expect this coming year, we can
make sure the resources are in place to make it happen. This should be an
exciting and challenging year for us. Let’s meet again next month to discuss
Jerry: our progress in preparing for next year.

This narrative provides an example of how the master budget is used for planning purposes. It is
much more efficient to plan in advance for significant increases in sales and production than to
wait and deal with production issues as they occur. The master budget can also be used for
control purposes by evaluating company performance. We discuss the control phase of budgeting

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 further in Chapter 10 "How Do Managers Evaluate Performance Using Cost Variance
Analysis?".

K E Y   T A K E A W A Y  

• The  master  budget  for  a  manufacturing  company  includes  budget  schedules  for  sales,  
production,  direct  materials,  direct  labor,  manufacturing  overhead,  selling  and  
administrative,  the  income  statement,  capital  expenditures,  cash,  and  the  balance  
sheet.  The  sales  budget  is  most  important  because  sales  projections  drive  the  other  
budgets.  

9.4 Budgeting in Nonmanufacturing Organizations

L E A R N I N G   O B J E C T I V E  

1. Describe  operating  budgets  for  merchandising,  service,  and  not-­‐for-­‐profit  

organizations.  

The examples used thus far to describe a master budget have been limited to manufacturing
companies. Manufacturing companies tend to have comprehensive operating budgets and
therefore serve as a good starting point in learning how to develop a master budget. However, all
types of organizations use operating budgets.

Merchandising Organizations

Question: What do operating budgets look like for merchandising organizations?

Answer: Merchandising organizations typically purchase finished goods and sell them to retail
or wholesale customers. Because merchandisers do not produce goods, they do not use
production or production-related budgets.

provides an overview of the master budget schedules for a merchandising organization. If you
compare this diagram with (master budget schedules for a manufacturing company), you will

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 notice that production and production-related budgets are not applicable to merchandising
organizations. Direct materials are not needed, and all labor and overhead costs are included in
the selling and administrative budget.

Figure 9.13 Master Budget Schedules for a Merchandising Organization

 
The most important aspect of budgeting for merchandising organizations is the merchandise
purchases budget. The merchandise purchases budgetestimates the units of merchandise to be
purchased and the cost per unit. Much like the production budget for a manufacturing company,
the merchandise purchases budget estimates units to be purchased (instead of units to be
produced) and is based on sales projections, as well as an estimate of desired ending merchandise
inventory less beginning merchandise inventory.

Service Organizations

Question: What do operating budgets look like for service organizations?

Answer: Service organizations, such as architectural and accounting firms, provide services
rather than tangible goods. These organizations do not have raw materials, finished goods, or

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 merchandise inventories, and therefore they do not have production or merchandise purchases
budgets. Instead, the focus is on projected sales revenue from services provided and the labor
necessary to achieve sales revenue projections. Service organizations must constantly estimate
services to be provided and make sure labor force resources are available to meet customer
demand.

Not-for-Profit Organizations

Question: Not-for-profit organizations, such as school districts and charitable organizations,

also use budgets for planning and control purposes. The budgeting process in most not-for-profit
organizations is critical because the approved budget often serves as the legal authority for
expenditures. What do operating budgets look like for not-for-profit organizations?

Answer: Because not-for-profit organizations are very diverse in nature—for example, some
provide a service, while others collect money to help victims of natural disasters or to promote
medical research—it is difficult to generalize about which master budget components apply and
which do not. However, with an understanding of the budget components used by
manufacturing, merchandising, and service organizations, one can establish a budgeting process
for virtually any not-for-profit organization. For an example of how one not-for-profit
organization goes about the budgeting process, read .

Business  in  Action  9.3  

Budgeting at a Not-for-Profit Organization
Yearly, a small not-for-profit symphony in California establishes an operating budget
with revenues totaling $200,000. The symphony’s treasurer oversees the budget
committee, which is made up of three board members. The budget committee is
responsible for creating, approving, and monitoring the budget.
The budget committee begins the budgeting process by reviewing information from the
year before. All board members and office staff are given spreadsheets showing last
year’s results and are asked to provide input for the next budget period. For example,
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 the committee responsible for ticket sales estimates sales revenue based on expected
ticket sales times the average sales price. Anticipated increases in sales price are
considered in the sales budget.
Expenses are also budgeted based on last year’s actual results. Those requesting
increases in budgeted expenditures must justify them. Once revenues and expenses are
established for the next budget period, the bookkeeper enters the information using
QuickBooks software and prints a preliminary budget report, which the budget
committee reviews. Once the budget committee has balanced the budget, reviewed it for
reasonableness, and approved it, it goes to the board of directors for approval.
The control phase of the budgeting process requires that all expenditures be in
accordance with the budget. Any expenditure exceeding the budget by more than $25
must be approved by the board of directors. A financial report
comparing actual revenues and expenditures withbudgeted revenues and expenditures
(produced using QuickBooks software) is submitted to the board of directors monthly.
K E Y   T A K E A W A Y  

• Merchandising  organizations  do  not  produce  goods,  and  therefore  do  not  have  
production  or  production-­‐related  budgets.  Instead,  merchandisers  prepare  a  
merchandise  purchases  budget.  Service  companies  do  not  have  production  or  
merchandise  purchases  budgets.  Instead,  service  organizations  focus  on  projected  
sales  and  labor  costs.  Not-­‐for-­‐profit  organizations  also  use  budgets  for  planning  and  
control  purposes.  The  format  depends  on  the  service  being  provided.  
R E V I E W   P R O B L E M   9 . 8  

Patel  and  Company  performs  accounting  services  for  its  customers.  The  company  had  
the  following  net  income  for  the  most  recent  year:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     649  
     
 
  
The  following  information  was  gathered  to  help  prepare  next  year’s  budgeted  income  
statement:  
• Service  revenue  will  increase  10  percent  (e.g.,  first  quarter  service  revenue  for  next  
year  will  be  10  percent  higher  than  the  first  quarter  shown  previously).  
• Manager  and  staff  salaries  will  increase  5  percent,  and  a  new  staff  accountant  will  be  
hired  at  the  beginning  of  the  second  quarter  at  a  quarterly  salary  of  $12,000.  
• Administrative  staff  wages  will  increase  10  percent.  
• Supplies  and  rent  will  remain  the  same.  
• Utilities  will  increase  5  percent.  
• Insurance  will  increase  25  percent.  
• Miscellaneous  expenses  will  decrease  10  percent.  
Prepare  a  quarterly  budgeted  income  statement  for  Patel  and  Company;  include  a  
column  summarizing  the  year.  

Solution  to  Review  Problem  9.8  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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*First  quarter  budget  of  $148,500  =  $135,000  in  last  year’s  first  quarter  revenue  ×  (1  +  
.10).  

**Quarterly  budget  of  $63,000  =  $60,000  in  last  year’s  quarterly  salaries  ×  (1  +  .05).  

***First  quarter  budget  of  $26,250  =  $25,000  in  last  year’s  first  quarter  salaries  ×  (1  +  
.05).  Second,  third,  and  fourth  quarter  budgets  include  newly  hired  staff  at  $12,000  a  
quarter.  

^Quarterly  budget  of  $11,000  =  $10,000  in  last  year’s  quarterly  budget  ×  (1  +  .10).  

^^  No  change  from  last  year.  

^^^  Quarterly  budget  of  $2,100  =  $2,000  in  last  year’s  quarterly  budget  ×  (1  +  .05).  
@
 Quarterly  budget  of  $17,500  =  $14,000  in  last  year’s  quarterly  budget  ×  (1  +  .25).  
@@
 Quarterly  budget  of  $5,850  =  $6,500  in  last  year’s  quarterly  budget  ×  (1  –  .10).  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 9.5 Ethical Issues in Creating Operating Budgets

L E A R N I N G   O B J E C T I V E  

1. Understand  ethical  issues  associated  with  budgeting.  

Question: Although bottom-up budgeting, in which management elicits input from employees
throughout the company, is effective in actively engaging those who have to achieve the
budgeted goals, this type of budgeting is not free from problems. Ethical issues often arise in the
budgeting process, particularly when employees and managers are evaluated by comparing their
actual results to the budget. How might ethical issues arise in the budgeting process?

Answer: To demonstrate how ethical dilemmas might arise, assume you are a manager and you
help upper management establish the master budget (this is the planning phase). Furthermore,
you are evaluated based on achieving budgeted profit on a quarterly basis (this is the control
phase). In fact, you will receive a $10,000 quarterly bonus, in addition to your base salary, if you
meet or exceed budgeted profit. There is an inherent conflict between the planning and control
phases of this process. You are helping the company plan, but you also want to be sure budgeted
profit is as low as possible so you can get the $10,000 bonus.

Establishing a sales and profit budget that is considerably lower than what will likely happen
causes problems for the entire organization. Production may be short of materials and labor,
causing inefficiencies in the production process. Selling and administrative support may be
lacking due to underestimating sales. Customers will not be satisfied if they must wait for the
product. The dilemma you face as a manager in this situation is whether to do what is best for
you (set a low profit estimate to earn the bonus) or do what is best for the company (estimate
accurately so the budget reflects true sales and production needs).
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 Organizations must recognize this conflict and have processes in place to ensure both the
interests of individual employees and the interests of the organization as a whole are served. For
example, employees can be rewarded not just for meeting goals but also for providing accurate
estimates. Perhaps a long-term stock option incentive system would provide motivation to do
what is best for the organization, thereby increasing shareholder value. Whatever incentive
system is implemented, organizations must promote honest employee input and beware of
fraudulent reporting to achieve financial targets.

K E Y   T A K E A W A Y  

• An  inherent  conflict  often  exists  between  the  planning  and  control  phases  of  
budgeting.  During  the  planning  phase,  organizations  are  most  concerned  about  
getting  accurate  estimates  that  lead  to  positive  results.  The  control  phase  requires  
evaluating  performance  of  employees  by  comparing  actual  results  to  the  operating  
budget.  Employees  often  must  decide  between  doing  what  is  best  for  the  individual  
employee  and  what  is  best  for  the  organization.  
R E V I E W   P R O B L E M   9 . 9  

Assume  you  are  the  manager  of  the  computer  division  of  High  Tech  Retail,  Inc.  You  
are  asked  to  help  the  company  prepare  a  budgeted  income  statement  for  the  
computer  division  before  the  start  of  each  fiscal  year.  At  the  completion  of  each  fiscal  
year,  division  managers  receive  a  bonus  equal  to  10  percent  of  actual  net  income  in  
excess  of  budgeted  net  income.  

Describe  the  ethical  conflict  facing  you  as  division  manager  when  asked  to  help  create  
the  budgeted  income  statement  for  your  division.  

Solution  to  Review  Problem  9.9  

Employees  who  are  evaluated  in  the  control  phase  by  comparing  actual  results  to  
budgeted  information  have  an  incentive  to  create  a  budget  that  is  easy  to  achieve,  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 and  perhaps  unrealistic.  This  can  create  problems  for  the  organization  as  a  whole  
since  inventory  purchases  are  made  based  on  budgeted  sales.  If  each  of  the  division  
managers  submits  a  sales  budget  that  significantly  underestimates  sales,  the  
company  will  likely  have  a  shortage  of  inventory  and  lose  out  on  sales  as  customers  
go  elsewhere  to  find  the  product.  Although  the  managers  will  have  an  easier  time  
achieving  sales  and  profit  goals,  the  company  as  a  whole  will  suffer.  The  ethical  
dilemma  of  choosing  between  doing  what  is  best  for  the  division  manager  and  what  is  
best  for  the  organization  can  ultimately  lead  to  lower  sales  and  dissatisfied  
customers.  
E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  
1. Describe  the  planning  phase  of  budgeting.  
2. Describe  the  control  phase  of  budgeting.  
3. Refer  to  Describe  two  characteristics  that  make  budgeting  difficult  for  multinational  
companies.  
4. Why  do  successful  companies  tend  to  use  the  bottom-­‐up  approach  to  budgeting?  
5. Briefly  describe  the  components  of  a  master  budget  for  a  manufacturing  organization.  
6. Why  is  the  sales  budget  the  most  important  component  of  the  master  budget?  
7. Describe  the  information  used  by  companies  to  estimate  sales.  
8. Describe  how  units  to  be  produced  is  calculated  in  the  production  budget.  
9. How  does  a  production  budget  help  the  production  manager  plan  for  the  future?  
10. Why  is  depreciation  deducted  at  the  bottom  of  the  manufacturing  overhead  budget?  
11. Why  do  companies  that  prepare  a  budgeted  income  statement  also  prepare  a  cash  
budget?  
12. Refer  to  Business  in  Action  9.2  titled  “Moving  from  Spreadsheets  to  Intranet  
Budgeting.”  What  are  the  advantages  of  using  intranet  budgeting?  What  are  some  
possible  disadvantages?  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 13. How  does  the  master  budget  for  a  merchandising  organization  differ  from  the  master  
budget  for  a  manufacturing  organization?  
14. Describe  the  difference  between  service  organization  budgets  and  manufacturing  
organization  budgets.  
15. Refer  to  Describe  the  two  procedures  that  the  symphony  uses  in  the  control  phase  of  
budgeting.  
16. Describe  the  ethical  conflict  that  can  occur  between  the  planning  and  control  phases  
of  the  budgeting  process.  
17. Why  might  a  sales  budget  that  intentionally  underestimates  sales  have  a  negative  
impact  on  the  organization?  

Brief  Exercises  
18. Budgeting  at  Jerry’s  Ice  Cream.  Refer  to  the  dialogue  for  Jerry’s  Ice  Cream  
presented  at  the  beginning  of  the  chapter  and  the  follow-­‐up  dialogue  after  .  
Required:  
a. In  the  opening  dialogue,  why  is  Jerry  Feltz  concerned  about  the  sales  
growth  expected  for  the  coming  year?  
b. In  the  follow-­‐up  dialogue,  why  is  the  company’s  treasurer  and  controller  
concerned  about  the  third  quarter?  
Budget  Sequence.  Indicate  the  order  in  which  the  following  budget  
schedules  are  prepared.  
0. Direct  materials  purchases  
1. Manufacturing  overhead  
2. Income  statement  
3. Direct  labor  
4. Selling  and  administrative  
5. Cash  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 6. Production  
7. Balance  sheet  
8. Sales  
9. Capital  expenditures  
Sales  Budget.  Schwartz  and  Company  expects  to  sell  100  units  in  the  first  quarter,  
90  units  in  the  second  quarter,  150  units  in  the  third  quarter,  and  160  units  in  the  
fourth  quarter.  The  average  sales  price  per  unit  is  expected  to  be  $3,000.  Prepare  a  
sales  budget  for  each  quarter  and  include  a  column  for  the  year  ending  December  31.  
Production  Budget.  Schwartz  and  Company  expects  to  sell  100  units  in  the  first  
quarter  and  90  units  in  the  second  quarter.  Assuming  the  company  prefers  to  
maintain  finished  goods  inventory  equal  to  10  percent  of  the  next  quarter’s  sales,  
prepare  a  production  budget  for  the  first  quarter  using  as  a  guide.  (Hint:  you  are  
preparing  a  production  budget  for  the  first  quarter  only.)  
Direct  Materials  Purchases  Budget.  The  production  budget  for  Kaminski  Products  
shows  the  company  expects  to  produce  500  units  in  the  first  quarter  and  600  units  in  
the  second  quarter.  Each  unit  requires  10  pounds  of  direct  materials  at  a  cost  of  $2  
per  pound.  The  company  prefers  to  maintain  raw  materials  inventory  equal  to  20  
percent  of  next  quarter’s  materials  needed  in  production.  Prepare  a  direct  materials  
purchases  budget  using  as  a  guide.  (Hint:  you  are  preparing  a  direct  materials  
purchases  budget  for  the  first  quarter  only.)  
Direct  Labor  Budget.  The  production  budget  for  Kaminski  Products  shows  the  
company  expects  to  produce  500  units  in  the  first  quarter.  Assuming  each  unit  of  
product  requires  3  direct  labor  hours  at  a  cost  of  $13  per  hour,  prepare  a  direct  labor  
budget  for  the  first  quarter  using  as  a  guide.  (Hint:  you  are  preparing  a  direct  labor  
budget  for  the  first  quarter  only.)  
Manufacturing  Overhead  Budget.  The  production  budget  for  Kaminski  Products  
shows  the  company  expects  to  produce  500  units  in  the  first  quarter.  Assume  variable  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 overhead  cost  per  unit  is  $5  for  indirect  materials,  $8  for  indirect  labor,  and  $3  for  
other  items.  Fixed  overhead  cost  per  quarter  is  $30,000  for  salaries,  $20,000  for  rent,  
and  $8,000  for  depreciation.  Prepare  a  manufacturing  overhead  budget  for  the  first  
quarter  using  as  a  guide  (Hint:  you  are  preparing  a  manufacturing  overhead  budget  
for  the  first  quarter  only.)  
Sales  Cash  Collections  Budget.  All  sales  for  Malik  and  Associates  are  on  credit.  
Accounts  receivable  at  the  end  of  last  quarter  totaled  $100,000.  Credit  sales  for  the  
first  quarter  of  the  upcoming  period  are  expected  to  be  $300,000.  The  company  
expects  to  collect  70  percent  of  sales  in  the  quarter  of  the  sale,  and  30  percent  the  
quarter  following  the  sale.  Prepare  a  sales  cash  collections  budget  for  the  first  quarter  
of  the  upcoming  period  using  the  top  of  as  a  guide.  (Hint:  you  are  preparing  a  sales  
cash  collections  budget  for  the  first  quarter  only.)  
Purchases  Cash  Payments  Budget.  All  direct  material  purchases  made  by  Keen  and  
Company  are  on  credit.  Accounts  payable  at  the  end  of  last  quarter  totaled  $50,000.  
Purchases  for  the  first  quarter  of  the  upcoming  period  are  expected  to  be  $200,000.  
The  company  expects  to  pay  40  percent  of  purchases  in  the  quarter  of  purchase  and  
60  percent  the  quarter  following  the  purchase.  Prepare  a  purchases  cash  payments  
budget  for  the  first  quarter  of  the  upcoming  period  using  the  middle  of  as  a  guide.  
(Hint:  you  are  preparing  a  purchases  cash  payments  budget  for  the  first  quarter  only.)  
Sales  Budget  for  Service  Organization;  Ethical  Issues.  Rami  and  
Associates  is  an  accounting  firm  that  estimates  revenues  based  on  billable  
hours.  The  company  expects  to  charge  8,000  hours  to  clients  in  the  first  
quarter,  9,000  hours  in  the  second  quarter,  7,000  hours  in  the  third  quarter  
and  8,500  hours  in  the  fourth  quarter.  The  average  hourly  billing  rate  is  
expected  to  be  $100.  
Required:  

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  . Prepare  a  services  revenue  budget  for  each  quarter  and  include  a  
column  for  the  year  ending  December  31.  (Hint:  this  is  similar  to  a  sales  
budget  except  sales  are  measured  in  labor  hours  rather  than  in  units,  and  
revenue  is  measured  as  an  average  hourly  billing  rate  rather  than  a  sales  
price  per  unit.)  
a. Since  the  manager  of  the  company  is  given  a  bonus  if  actual  billable  hours  
exceed  budgeted  billable  hours,  the  manager  intentionally  underestimated  
the  number  of  expected  billable  hours  for  each  quarter.  How  might  this  
underestimate  affect  the  company?  

Exercises:  Set  A  
28. Sales  and  Production  Budgets.  Templeton  Corporation  produces  windows  
used  in  residential  construction.  Unit  sales  last  year,  ending  December  31,  
are  as  follow:  
First quarter 40,000

Second quarter 50,000

Third quarter 52,000

Fourth quarter 48,000

29. Unit  sales  are  expected  to  increase  10  percent  this  coming  year  over  the  
same  quarter  last  year.  Average  sales  price  per  window  will  remain  at  $200.  

30. Assume  finished  goods  inventory  is  maintained  at  a  level  equal  to  5  percent  
of  the  next  quarter’s  sales.  Finished  goods  inventory  at  the  end  of  the  
fourth  quarter  budget  period  is  estimated  to  be  2,300  units.  
31. Required:  

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 a. Prepare  a  sales  budget  for  Templeton  Corporation  using  a  format  
similar  to  .  (Hint:  be  sure  to  increase  last  year’s  unit  sales  by  10  percent.)  
b. Prepare  a  production  budget  for  Templeton  Corporation  using  a  format  
similar  to  .  
Direct  Materials  Purchases  and  Direct  Labor  Budgets.  Templeton  
Corporation  produces  windows  used  in  residential  construction.  The  
company  expects  to  produce  44,550  units  in  the  first  quarter,  55,110  units  
in  the  second  quarter,  56,980  units  in  the  third  quarter,  and  52,460  units  in  
the  fourth  quarter.  (This  information  is  derived  from  the  previous  exercise  
for  Templeton  Corporation.)  

With  regards  to  direct  materials,  each  unit  of  product  requires  12  square  
feet  of  glass  at  a  cost  of  $1.50  per  square  foot.  Management  prefers  to  
maintain  ending  raw  materials  inventory  equal  to  10  percent  of  next  
quarter’s  materials  needed  in  production.  Raw  materials  inventory  at  the  
end  of  the  fourth  quarter  budget  period  is  estimated  to  be  65,000  square  
feet.  

With  regards  to  direct  labor,  each  unit  of  product  requires  2  labor  hours  at  
a  cost  of  $15  per  hour.  
Required:  
 . Prepare  a  direct  materials  purchases  budget  for  Templeton  Corporation  using  
a  format  similar  to  .  
a. Prepare  a  direct  labor  budget  for  Templeton  Corporation  using  a  format  
similar  to  .  
Manufacturing  Overhead  Budget.  Templeton  Corporation  produces  
windows  used  in  residential  construction.  The  company  expects  to  produce  
44,550  units  in  the  first  quarter,  55,110  units  in  the  second  quarter,  56,980  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     659  
     
 
 units  in  the  third  quarter,  and  52,460  units  in  the  fourth  quarter.  (This  
information  is  the  same  as  in  the  previous  exercise  for  Templeton  
Corporation.)  The  following  information  relates  to  the  manufacturing  
overhead  budget.  
Variable Overhead Costs

Indirect materials $2.50 per unit

Indirect labor $3.20 per unit

Other $1.70 per unit

Fixed Overhead Costs per Quarter

Salaries $50,000

Rent $60,000

Depreciation $36,370

Required:  
Prepare  a  manufacturing  overhead  budget  for  Templeton  Corporation  
using  a  format  similar  to  .  
Budgets  for  Cash  Collections  from  Sales  and  Cash  Payments  for  
Purchases.  Templeton  Corporation  produces  windows  used  in  residential  
construction.  The  dollar  amount  of  the  company’s  quarterly  sales  and  direct  
materials  purchases  are  projected  to  be  as  follows  (this  information  is  
derived  from  the  previous  exercises  for  Templeton  Corporation):  
1st 2nd 3rd 4th

Sales $8,800,000 $11,000,000 $11,440,000 $10,560,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     660  
     
 
 Direct materials purchases $ 820,908 $ 995,346 $ 1,017,504 $ 947,352

Assume  all  sales  are  made  on  credit.  The  company  expects  to  collect  
60  percent  of  sales  in  the  quarter  of  sale  and  40  percent  the  quarter  
following  the  sale.  Accounts  receivable  at  the  end  of  last  year  totaled  
$3,000,000,  all  of  which  will  be  collected  in  the  first  quarter  of  the  coming  
year.  

Assume  all  direct  materials  purchases  are  on  credit.  The  company  
expects  to  pay  70  percent  of  purchases  in  the  quarter  of  purchase  and  30  
percent  the  following  quarter.  Accounts  payable  at  the  end  of  last  year  
totaled  $325,000,  all  of  which  will  be  paid  in  the  first  quarter  of  this  coming  
year.  
Required:  
 . Prepare  a  budget  for  cash  collections  from  sales.  Use  a  format  similar  
to  the  top  section  of  .  
a. Prepare  a  budget  for  cash  payments  for  purchases  of  materials.  Use  a  
format  similar  to  the  middle  section  of  .  Round  to  the  nearest  dollar.  
Service  Company  Budgeted  Income  Statement  and  Ethical  
Issues.Lawn  Care,  Inc.,  has  two  owners  who  maintain  lawns  for  residential  
customers.  The  company  had  the  following  net  income  for  the  most  current  
year.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     661  
     
 
  

The  following  information  was  gathered  from  the  owners  to  help  prepare  
this  coming  year’s  budgeted  income  statement:  
o Service  revenue  will  increase  15  percent  (e.g.,  first  quarter  service  revenue  
for  this  coming  year  will  be  15  percent  higher  than  the  first  quarter  shown  
previously).  
o Owner  salaries  will  increase  8  percent.  
o Crew  wages  will  increase  12  percent.  
o Administrative  staff  wages  will  increase  5  percent,  and  a  new  staff  member  
will  be  hired  at  the  beginning  of  the  third  quarter  at  a  quarterly  rate  of  
$7,000.  
o Supplies  will  increase  9  percent.  
o Office  rent,  utilities,  and  miscellaneous  expenses  will  remain  the  same.  
o Insurance  will  increase  18  percent.  
o The  tax  rate  will  remain  at  30  percent.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     662  
     
 
 Required:  
h. Prepare  a  quarterly  budgeted  income  statement  for  Lawn  Care,  Inc.,  and  
include  a  column  summarizing  the  year.  
i. The  owners  of  Lawn  Care,  Inc.,  have  decided  to  expand  and  are  in  need  of  
additional  cash  to  expand  operations.  Unknown  to  the  owners,  the  
company’s  accountant  intentionally  inflated  the  revenue  projections  for  this  
coming  year  to  make  the  company  look  better  when  applying  for  a  loan.  Is  
this  behavior  ethical?  Explain.  (It  may  be  helpful  to  review  the  presentation  
of  ethics  in  .)  

Exercises:  Set  B  
33. Sales  and  Production  Budgets.  Catalina,  Inc.,  produces  tents  used  for  
camping.  Unit  sales  last  year,  ending  December  31,  follow.  
First quarter 6,000

Second quarter 10,000

Third quarter 12,000

Fourth quarter 8,000

34. Unit  sales  are  expected  to  increase  30  percent  this  coming  year  over  the  
same  quarter  last  year.  Average  sales  price  per  tent  will  remain  at  $300.  

35. Assume  finished  goods  inventory  is  maintained  at  a  level  equal  to  10  
percent  of  the  next  quarter’s  sales.  Finished  goods  inventory  at  the  end  of  
the  fourth  quarter  budget  period  is  estimated  to  be  1,900  units.  
36. Required:  
a. Prepare  a  sales  budget  for  Catalina,  Inc.,  using  a  format  similar  to  .  
(Hint:  be  sure  to  increase  last  year’s  unit  sales  by  30  percent.)  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     663  
     
 
 b. Prepare  a  production  budget  for  Catalina,  Inc.,  using  a  format  similar  to  .  
Direct  Materials  Purchases  and  Direct  Labor  Budgets.  Catalina,  Inc.,  
produces  tents  used  for  camping.  The  company  expects  to  produce  8,320  
units  in  the  first  quarter,  13,260  units  in  the  second  quarter,  15,080  units  in  
the  third  quarter,  and  11,260  units  in  the  fourth  quarter  (this  information  is  
derived  from  the  previous  exercise  for  Catalina,  Inc.).  

With  regards  to  direct  materials,  each  unit  of  product  requires  8  yards  of  
material,  at  a  cost  of  $4  per  yard.  Management  prefers  to  maintain  ending  
raw  materials  inventory  equal  to  15  percent  of  next  quarter’s  materials  
needed  in  production.  Raw  materials  inventory  at  the  end  of  the  fourth  
quarter  budget  period  is  estimated  to  be  14,000  yards.  

With  regards  to  direct  labor,  each  unit  of  product  requires  3  labor  hours  at  
a  cost  of  $16  per  hour.  
Required:  
 . Prepare  a  direct  materials  purchases  budget  for  Catalina,  Inc.,  using  a  format  
similar  to  .  
a. Prepare  a  direct  labor  budget  for  Catalina,  Inc.,  using  a  format  similar  to  .  
Manufacturing  Overhead  Budget.  Catalina,  Inc.,  produces  tents  used  
for  camping.  The  company  expects  to  produce  8,320  units  in  the  first  
quarter,  13,260  units  in  the  second  quarter,  15,080  units  in  the  third  
quarter,  and  11,260  units  in  the  fourth  quarter.  (This  information  is  the  
same  as  in  the  previous  exercise  for  Catalina,  Inc.)  The  following  
information  relates  to  the  manufacturing  overhead  budget.  
Variable Overhead Costs

Indirect materials $0.20 per unit

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     664  
     
 
 Indirect labor $4.20 per unit

Other $2.70 per unit

Fixed Overhead Costs per Quarter

Salaries $100,000

Rent $ 30,000

Depreciation $ 44,908

Required:  
Prepare  a  manufacturing  overhead  budget  for  Catalina,  Inc.,  using  a  
format  similar  to  .  
Budgets  for  Cash  Collections  from  Sales  and  Cash  Payments  for  
Purchases.  Catalina,  Inc.,  produces  tents  used  for  camping.  The  dollar  
amount  of  the  company’s  quarterly  sales  and  direct  materials  purchases  are  
projected  to  be  as  follows  (this  information  is  derived  from  the  previous  
exercises  for  Catalina,  Inc.):  
1st 2nd 3rd 4th

Sales $2,340,000 $3,900,000 $4,680,000 $3,120,000

Direct materials purchases $ 289,952 $ 433,056 $ 464,224 $ 362,272

Assume  all  sales  are  made  on  credit.  The  company  expects  to  collect  
80  percent  of  sales  in  the  quarter  of  sale  and  20  percent  the  quarter  
following  the  sale.  Accounts  receivable  at  the  end  of  last  year  totaled  
$400,000,  all  of  which  will  be  collected  in  the  first  quarter  of  the  coming  
year.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     665  
     
 
 Assume  all  direct  materials  purchases  are  on  credit.  The  company  
expects  to  pay  90  percent  of  purchases  in  the  quarter  of  purchase  and  10  
percent  the  following  quarter.  Accounts  payable  at  the  end  of  last  year  
totaled  $30,000,  all  of  which  will  be  paid  in  the  first  quarter  of  this  coming  
year.  
Required:  
 . Prepare  a  budget  for  cash  collections  from  sales.  Use  a  format  similar  
to  the  top  section  of  .  
a. Prepare  a  budget  for  cash  payments  for  purchases  of  materials.  Use  a  
format  similar  to  the  middle  section  of  .  Round  to  the  nearest  dollar.  
Service  Company  Budgeted  Income  Statement.  Civil  Engineers,  LLC,  
has  five  engineers  who  design  and  maintain  wetlands.  The  company  had  
the  following  net  income  for  the  most  current  year.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     666  
     
 
 The  following  information  was  gathered  from  management  to  help  prepare  
this  coming  year’s  budgeted  income  statement:  
o Service  revenue  will  increase  3  percent  (e.g.,  first  quarter  service  revenue  
for  this  coming  year  will  be  3  percent  higher  than  the  first  quarter  shown  
previously).  
o Existing  engineer  and  biologist  salaries  will  increase  5  percent,  and  a  new  
biologist  will  be  hired  at  the  beginning  of  the  second  quarter  at  a  quarterly  
salary  of  $10,000.  
o Administrative  staff  wages  will  increase  15  percent.  
o Supplies  and  rent  will  remain  the  same.  
o Utilities  will  increase  8  percent.  
o Insurance  will  increase  20  percent.  
o Miscellaneous  expenses  will  decrease  5  percent.  
Required:  

Prepare  a  quarterly  budgeted  income  statement  for  Civil  Engineers,  LLC,  

and  include  a  column  summarizing  the  year.  

Problems  
38. Budgeting  for  Sales,  Production,  Direct  Materials,  Direct  Labor,  and  
Manufacturing  Overhead;  Ethical  Issues.  Sanders  Swimwear,  Inc.,  produces  
swimsuits.  The  following  information  is  to  be  used  for  the  operating  budget  
this  coming  year.  

o Average  sales  price  for  each  swimsuit  is  estimated  to  be  $50.  Unit  
sales  for  this  coming  year  ending  December  31  are  expected  to  be  
as  follows:  
First quarter 3,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     667  
     
 
 Second quarter 5,000

Third quarter 20,000

Fourth quarter 6,000

o Finished  goods  inventory  is  maintained  at  a  level  equal  to  10  percent  of  the  
next  quarter’s  sales.  Finished  goods  inventory  at  the  end  of  the  fourth  
quarter  budget  period  is  estimated  to  be  400  units.  
o Each  unit  of  product  requires  3  yards  of  direct  materials,  at  a  cost  of  $4  per  
yard.  Management  prefers  to  maintain  ending  raw  materials  inventory  
equal  to  20  percent  of  next  quarter’s  materials  needed  in  production.  Raw  
materials  inventory  at  the  end  of  the  fourth  quarter  budget  period  is  
estimated  to  be  9,500  yards.  
o Each  unit  of  product  requires  0.5  direct  labor  hours  at  a  cost  of  $12  per  
hour.  

o Variable  manufacturing  overhead  costs  are  

Indirect materials $0.60 per unit

Indirect labor $3.50 per unit

Other $2.80 per unit

o Fixed  manufacturing  overhead  costs  per  quarter  are  

Salaries $30,000

Other $ 5,000

Depreciation $ 9,330

39. Required:  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     668  
     
 
 a. Prepare  a  sales  budget  using  the  format  shown  in  .  
b. Prepare  a  production  budget  using  the  format  shown  in  .  
c. Prepare  a  direct  materials  purchases  budget  using  the  format  shown  in  .  
d. Prepare  a  direct  labor  budget  using  the  format  shown  in  .  
e. Prepare  a  manufacturing  overhead  budget  using  the  format  shown  in  .  
f. As  the  production  manager,  what  concerns,  if  any,  do  you  have  about  
production  requirements  for  each  of  the  four  quarters?  
g. Assume  the  sales  budget  was  developed  based  on  input  provided  by  the  
company’s  vice  president  of  sales.  The  vice  president  is  paid  a  base  salary  
plus  a  bonus  if  actual  sales  exceed  budgeted  sales.  How  might  this  influence  
the  vice  president’s  estimate  of  quarterly  sales?  What  effect  might  this  have  
on  the  company?  
Budgeting  for  Sales,  Production,  Direct  Materials,  Direct  Labor,  and  
Manufacturing  Overhead.  Hershel’s  Chocolate  produces  chocolate  bars  and  
sells  them  by  the  case  (1  unit  =  1  case).  Information  to  be  used  for  the  
operating  budget  this  coming  year  follows:  

o Average  sales  price  for  each  case  is  estimated  to  be  $25.  Unit  
sales  for  this  coming  year,  ending  December  31,  are  expected  to  
be  as  follows:  
First quarter 80,000

Second quarter 84,000

Third quarter 88,000

Fourth quarter 97,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     669  
     
 
 o Finished  goods  inventory  is  maintained  at  a  level  equal  to  15  percent  of  the  
next  quarter’s  sales.  Finished  goods  inventory  at  the  end  of  the  fourth  
quarter  budget  period  is  estimated  to  be  13,000  units.  
o Each  unit  of  product  requires  5  pounds  of  cocoa  beans  for  direct  materials,  
at  a  cost  of  $3  per  pound.  Management  prefers  to  maintain  ending  raw  
materials  inventory  equal  to  10  percent  of  next  quarter’s  materials  needed  
in  production.  Raw  materials  inventory  at  the  end  of  the  fourth  quarter  
budget  period  is  estimated  to  be  43,000  pounds.  
o Each  unit  of  product  requires  0.10  direct  labor  hours  at  a  cost  of  $14  per  
hour.  

o Variable  manufacturing  overhead  costs  are  

Indirect materials $0.20 per unit

Indirect labor $0.15 per unit

Other $0.10 per unit

o Fixed  manufacturing  overhead  costs  per  quarter  are  

Salaries $80,000

Other $70,000

Depreciation $55,625

Required:  
 . Prepare  a  sales  budget  using  the  format  shown  in  .  
a. Prepare  a  production  budget  using  the  format  shown  in  .  
b. Prepare  a  direct  materials  purchases  budget  using  the  format  shown  in  .  
c. Prepare  a  direct  labor  budget  using  the  format  shown  in  .  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     670  
     
 
 d. Prepare  a  manufacturing  overhead  budget  using  the  format  shown  in  .  
Round  to  the  nearest  dollar.  
e. As  the  production  manager,  what  concerns,  if  any,  do  you  have  about  
production  requirements  for  each  of  the  four  quarters?  
Selling  and  Administrative  Budget  and  Budgeted  Income  
Statement.(The  previous  problem  must  be  completed  before  working  this  
problem.)  Hershel’s  Chocolate  produces  chocolate  bars.  Management  
estimates  all  selling  and  administrative  costs  are  fixed.  Quarterly  selling  and  
administrative  cost  estimates  for  the  coming  year  follow.  
Salaries $170,000

Rent $ 65,000

Advertising $120,000

Depreciation $ 75,000

Other $ 36,000

Required:  
 . Use  the  information  presented  previously  to  prepare  a  selling  and  
administrative  budget.  Refer  to  the  format  shown  in  .  
a. Use  the  information  from  the  previous  problem  and  from  requirement  a  of  
this  problem  to  prepare  a  budgeted  income  statement.  Refer  to  the  format  
shown  in  .  
b. How  will  management  use  the  information  presented  in  the  budgeted  
income  statement?  
Budgeting  for  Cash  Collections  and  Cash  Payments.  Hershel’s  
Chocolate  produces  chocolate  bars.  The  treasurer  at  Hershel’s  Chocolate  is  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 preparing  the  cash  budget  and  would  like  to  know  when  cash  collections  
from  sales  and  cash  payments  for  materials  will  occur.  The  dollar  amount  of  
the  company’s  quarterly  sales  and  direct  materials  purchases  are  projected  
to  be  as  follows  (this  information  is  the  result  of  working  the  previous  
problems  for  Hershel’s  Chocolate):  
1st 2nd 3rd 4th

Sales $2,000,000 $2,100,000 $2,200,000 $2,425,000

Direct materials purchases $1,215,000 $1,276,125 $1,349,400 $1,417,575

o All  sales  are  made  on  credit.  The  company  expects  to  collect  60  percent  of  
sales  in  the  quarter  of  sale  and  40  percent  the  quarter  following  the  sale.  
Accounts  receivable  at  the  end  of  last  year  totaled  $770,000,  all  of  which  
will  be  collected  during  the  first  quarter  of  this  coming  year.  
o All  direct  materials  purchases  are  on  credit.  The  company  expects  to  pay  80  
percent  of  purchases  in  the  quarter  of  purchase  and  20  percent  the  
following  quarter.  Accounts  payable  at  the  end  of  last  year  totaled  
$257,000,  all  of  which  will  be  paid  during  the  first  quarter  of  this  coming  
year.  
Required:  
b. Prepare  a  budget  for  cash  collections  from  sales.  Refer  to  the  format  shown  
at  the  top  of  .  
c. Prepare  a  budget  for  cash  payments  for  purchases  of  materials.  Refer  to  the  
format  shown  in  the  middle  section  of  .  
d. How  will  the  treasurer  use  this  information?  
Services  Revenue  and  Direct  Labor  Budgets  for  Service  Organization;  
Ethical  Issues.  Engineering,  Inc.,  provides  structural  engineering  services  for  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 its  clients.  Billable  hours  for  each  month  of  the  first  quarter  of  this  coming  
budget  period  are  expected  to  be  as  follows:  
January 2,000

February 2,200

March 3,000

The  average  hourly  billing  rate  is  estimated  to  be  $150.  
Required:  
 . Prepare  a  services  revenue  budget  for  Engineering,  Inc.,  for  each  month  of  
the  first  quarter  and  include  a  total  column  for  the  quarter.  (Hint:  this  is  
similar  to  a  sales  budget  except  sales  are  measured  in  labor  hours  rather  
than  in  units,  and  revenue  is  measured  as  an  average  hourly  billing  rate  
rather  than  a  sales  price  per  unit.)  
a. The  average  cost  for  each  hour  of  direct  labor  is  expected  to  be  $50.  
Assume  total  direct  labor  hours  are  expected  to  be  20  percent  higher  than  
billable  direct  labor  hours  presented  previously.  This  is  caused  by  
employees  working  on  projects  that  are  not  billable  to  clients  (e.g.,  
recruiting  and  community  work).  Prepare  a  direct  labor  budget  for  each  
month  of  the  first  quarter  and  include  a  total  column  for  the  quarter.  (Hint:  
this  budget  will  have  three  lines:  projected  direct  labor  hours,  labor  rate  per  
hour,  and  total  direct  labor  cost.)  
b. Assume  the  manager  of  the  company  is  given  a  monthly  bonus  if  actual  
billable  hours  exceed  budgeted  billable  hours.  How  might  this  influence  the  
manager’s  estimate  of  monthly  billable  hours  for  budgeting  purposes?  
What  effect  might  this  have  on  the  company?  

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 Merchandising  Company  Master  Budget.  Big  Apple  Sporting  Goods  is  
a  retail  store  that  sells  a  variety  of  sports  equipment.  The  company’s  fiscal  
year  ends  on  December  31.  Information  to  be  used  for  the  operating  
budget  this  coming  year  follows.  
Sales  and  Merchandise  Purchases  Budget  Information  

o Sales  for  this  coming  year  ending  December  31  are  expected  to  be  
as  follows:  
First quarter $600,000

Second quarter $650,000

Third quarter $660,000

Fourth quarter $800,000

o Cost  of  goods  sold  is  40  percent  of  sales  (this  is  the  first  line  of  the  
merchandise  purchases  budget).  Merchandise  inventory  is  maintained  at  a  
level  equal  to  20  percent  of  the  next  quarter’s  cost  of  goods  sold.  
Merchandise  inventory  at  the  end  of  the  fourth  quarter  budget  period  is  
estimated  to  be  $55,000.  
Selling  and  Administrative  Budget  Information  
o Management  estimates  all  selling  and  administrative  costs  are  fixed.  

o Quarterly  selling  and  administrative  cost  estimates  for  the  coming  

year  are  
Salaries $150,000

Rent $ 25,000

Advertising $ 40,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Depreciation $ 18,000

Other $ 12,000

Capital  Expenditure  and  Cash  Budget  Information  

o The  company  plans  to  pay  cash  for  property,  plant,  and  equipment  totaling  
$35,000  at  the  end  of  the  fourth  quarter.  This  purchase  will  not  affect  
depreciation  expense  for  the  coming  year.  
o The  company  expects  to  collect  70  percent  of  sales  in  the  quarter  of  sale  
and  30  percent  the  quarter  following  the  sale.  Accounts  receivable  at  the  
end  of  last  year  totaled  $200,000,  all  of  which  will  be  collected  during  the  
first  quarter  of  this  coming  year.  
o All  inventory  purchases  are  on  credit.  The  company  expects  to  pay  80  
percent  of  inventory  purchases  in  the  quarter  of  purchase  and  20  percent  
the  following  quarter.  Accounts  payable  at  the  end  of  last  year  totaled  
$68,000,  all  of  which  will  be  paid  during  the  first  quarter  of  this  coming  
year.  
o The  cash  balance  at  the  beginning  of  this  coming  year  is  expected  to  be  
$90,000.  
Budgeted  Balance  Sheet  Information  
o Assume  30  percent  of  fourth  quarter  budgeted  sales  will  be  collected  in  full  
the  following  year  (this  represents  accounts  receivable  at  the  end  of  the  
fourth  quarter).  

o Expected  account  balances  at  the  end  of  the  fourth  quarter  are  
Property, plant, and equipment (net) $120,000

Common stock $175,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 o Actual  retained  earnings  at  the  end  of  the  last  year  totaled  $252,000,  and  
no  cash  dividends  will  be  paid  during  the  current  budget  period  ending  
December  31.  
Required:  
k. Prepare  a  quarterly  sales  budget.  (Hint:  this  budget  will  not  have  any  units  
of  product,  only  total  sales  revenue.)  

l. Prepare  a  quarterly  merchandise  purchases  budget  using  the  

following  format.  All  amounts  are  in  dollars.  

m. Prepare  a  quarterly  selling  and  administrative  budget  using  the  format  

shown  in  .  
n. Prepare  a  quarterly  budgeted  income  statement  using  the  format  shown  
in  .  (Hint:  cost  of  goods  sold  will  be  based  on  a  percent  of  sales  rather  than  
a  cost  per  unit.)  
o. Prepare  a  quarterly  capital  expenditure  budget  using  the  format  shown  in  .  
p. Prepare  a  quarterly  cash  budget  using  the  format  shown  in  .  (Hint:  
Merchandising  companies  have  merchandise  purchases  rather  than  direct  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 materials  purchases.  Merchandising  companies  do  not  have  direct  labor  or  
manufacturing  overhead.)  
q. Prepare  a  budgeted  balance  sheet  at  December  31  using  the  format  shown  
in  .  (Hint:  merchandising  companies  have  merchandise  inventory  rather  
than  raw  materials  inventory  or  finished  goods  inventory.)  

One  Step  Further:  Skill-­‐Building  Cases  

44. Ethics  in  Budgeting.  SportsMax  sells  sporting  goods  equipment  at  100  
stores  throughout  North  America.  Robert  Manning  is  the  manager  of  one  
SportsMax  retail  store  in  Chicago.  The  company  is  in  the  planning  phase  of  
establishing  its  operating  budget  for  this  coming  year  and  has  asked  that  all  
store  managers  submit  their  estimates  of  sales  revenue,  costs,  and  resulting  
profit.  During  the  control  phase,  each  store  manager  is  evaluated  by  
comparing  budgeted  profit  with  actual  profit.  Store  managers  who  exceed  
budgeted  profit  are  given  a  bonus  equal  to  10  percent  of  actual  profit  in  
excess  of  budgeted  profit.  
Required:  
a. Describe  the  ethical  conflict  that  Robert  Manning  is  facing.  
b. As  the  president  and  CEO  of  SportsMax,  how  might  you  motivate  Robert  
Manning  to  provide  an  accurate  operating  budget?  
Group  Activity:  Creating  a  Budget.  Form  groups  of  two  to  four  
students.  Each  group  is  to  complete  the  following  requirements.  
Required:  
 . Assume  you  are  a  full-­‐time  student  living  in  an  apartment  near  your  college  
campus.  Create  a  personal  budget  that  includes  the  typical  monthly  expenses  you  
would  expect  to  incur.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 a. Explain  how  the  control  phase  of  budgeting  would  be  implemented  for  the  
personal  budget  created  in  requirement  a.  
b. Discuss  the  findings  of  your  group  with  the  class.  (Optional:  your  instructor  
may  ask  you  to  submit  your  findings  in  writing.)  
Creating  a  Sales  Budget  and  Production  Budget  Using  Excel.  Review  the  
information  for  Templeton  Corporation  in  Exercise  28.  Prepare  an  Excel  spreadsheet  
similar  to  and  showing  Templeton’s  sales  budget  and  production  budget.  
Internet  Project:  Budgeting.  Go  to  The  New  York  Times’  Web  site  
(http://www.nytimes.com),  or  a  similar  reputable  Internet  source,  and  find  an  article  
about  budgeting.  Summarize  the  article  in  a  one-­‐page  report,  and  indicate  how  the  
budget  described  in  the  article  is  used  for  planning  purposes.  Submit  a  printed  copy  
of  the  article  with  your  report.  

Comprehensive  Cases  
48. Comprehensive  Master  Budget.  Creative  Shirts,  Inc.,  produces  T-­‐shirts.  The  
company’s  fiscal  year  ends  on  December  31.  Information  to  be  used  for  the  
operating  budget  this  coming  year  follows.  
Sales  and  Production-­‐Related  Budget  Information  

o Average  sales  price  for  each  T-­‐shirt  is  estimated  to  be  $15.  Unit  
sales  for  this  coming  year,  ending  December  31,  are  expected  to  
be  as  follows:  
First quarter 20,000

Second quarter 24,000

Third quarter 28,000

Fourth quarter 18,000

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 o Finished  goods  inventory  is  maintained  at  a  level  equal  to  10  percent  of  the  
next  quarter’s  sales.  Finished  goods  inventory  at  the  end  of  the  fourth  
quarter  budget  period  is  estimated  to  be  2,000  units.  
o Each  unit  of  product  requires  3  yards  of  direct  materials,  at  a  cost  of  $2  per  
yard.  Management  prefers  to  maintain  ending  raw  materials  inventory  
equal  to  20  percent  of  next  quarter’s  materials  needed  in  production.  Raw  
materials  inventory  at  the  end  of  the  fourth  quarter  budget  period  is  
estimated  to  be  12,200  yards.  
o Each  unit  of  product  requires  0.1  direct  labor  hours  at  a  cost  of  $14  per  
hour.  

o Variable  manufacturing  overhead  costs  are  

Indirect materials $0.70 per unit

Indirect labor $0.90 per unit

Other $0.50 per unit

o Fixed  manufacturing  overhead  costs  per  quarter  are  

Salaries $18,000

Other $20,000

Depreciation $11,950

Selling  and  Administrative  Budget  Information  

o Management  estimates  all  selling  and  administrative  costs  are  fixed.  

o Quarterly  selling  and  administrative  cost  estimates  for  the  coming  

year  are  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     679  
     
 
 Salaries $15,000

Rent $ 5,000

Advertising $ 4,000

Depreciation $ 9,000

Other $10,000

Capital  Expenditures  and  Cash  Budget  Information  

o The  company  plans  to  pay  cash  for  selling  and  administrative  equipment  
totaling  $15,000  and  production  equipment  totaling  $9,000.  Both  will  be  
purchased  at  the  end  of  the  fourth  quarter  and  will  not  affect  depreciation  
expense  for  the  coming  year.  
o All  sales  are  made  on  credit.  The  company  expects  to  collect  70  percent  of  
sales  in  the  quarter  of  sale  and  30  percent  the  quarter  following  the  sale.  
Accounts  receivable  at  the  end  of  last  year  totaled  $80,000,  all  of  which  will  
be  collected  during  the  first  quarter  of  this  coming  year.  
o All  direct  materials  purchases  are  on  credit.  The  company  expects  to  pay  80  
percent  of  purchases  in  the  quarter  of  purchase  and  20  percent  the  
following  quarter.  Accounts  payable  at  the  end  of  last  year  totaled  $25,000,  
all  of  which  will  be  paid  during  the  first  quarter  of  this  coming  year.  
o The  cash  balance  at  the  beginning  of  this  coming  year  is  expected  to  be  
$30,000.  
Budgeted  Balance  Sheet  Information  
o Assume  30  percent  of  fourth  quarter  budgeted  sales  will  be  collected  in  full  
the  following  year  (this  represents  accounts  receivable  at  the  end  of  the  
fourth  quarter).  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 o Expected  account  balances  at  the  end  of  the  fourth  quarter  are  
Property, plant, and equipment (net) $100,000

Common stock $250,000

o Actual  retained  earnings  at  the  end  of  last  year  totaled  $42,720,  and  no  
cash  dividends  will  be  paid  during  the  current  budget  period  ending  
December  31.  
Required:  

p. Prepare  the  quarterly  sales  and  production-­‐related  budgets  using  the  

figure  formats  referenced  here:  
a. Sales  budget  ()  
b. Production  budget  ()  
c. Direct  materials  purchases  budget  ()  
d. Direct  labor  budget  ()  
e. Manufacturing  overhead  budget  ()  
q. Prepare  a  quarterly  selling  and  administrative  budget  using  the  format  
shown  in  .  
r. Prepare  a  quarterly  budgeted  income  statement  using  the  format  shown  
in  .  
s. Prepare  a  quarterly  capital  expenditures  budget  using  the  format  shown  in  .  
t. Prepare  a  quarterly  cash  budget  using  the  format  shown  in  .  
u. Prepare  a  budgeted  balance  sheet  at  December  31  using  the  format  shown  
in  .  
v. Why  does  management  at  Creative  Shirts,  Inc.,  prepare  a  master  budget?  
Explain.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Comprehensive  Master  Budget  with  Cash  Flow  Issues.  Air  Boats,  Inc.,  
produces  small  inflatable  boats.  The  company’s  fiscal  year  ends  on  
December  31.  Information  to  be  used  for  the  operating  budget  this  coming  
year  follows.  
Sales  and  Production-­‐Related  Budget  Information  

o Average  sales  price  for  each  boat  is  estimated  to  be  $150.  Unit  
sales  for  this  coming  year,  ending  December  31,  are  expected  to  
be  as  follows:  
First quarter 100,000

Second quarter 110,000

Third quarter 125,000

Fourth quarter 90,000

o Finished  goods  inventory  is  maintained  at  a  level  equal  to  15  percent  of  the  
next  quarter’s  sales.  Finished  goods  inventory  at  the  end  of  the  fourth  
quarter  budget  period  is  estimated  to  be  13,000  units.  
o Each  unit  of  product  requires  4  pounds  of  direct  materials,  at  a  cost  of  $5  
per  pound.  The  management  prefers  to  maintain  ending  raw  materials  
inventory  equal  to  8  percent  of  next  quarter’s  materials  needed  in  
production.  Raw  materials  inventory  at  the  end  of  the  fourth  quarter  
budget  period  is  estimated  to  be  30,000  pounds.  
o Each  unit  of  product  requires  0.5  direct  labor  hours  at  a  cost  of  $15  per  
hour.  

o Variable  manufacturing  overhead  costs  are  

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 Indirect materials $2.10 per unit

Indirect labor $1.10 per unit

Other $1.70 per unit

o Fixed  manufacturing  overhead  costs  per  quarter  are  

Salaries $250,000

Other $300,000

Depreciation $613,250

Selling  and  Administrative  Budget  Information  

o Management  estimates  all  selling  and  administrative  costs  are  fixed.  

o Quarterly  selling  and  administrative  cost  estimates  for  the  coming  

year  are  
Salaries $3,000,000

Rent $1,000,000

Advertising $ 900,000

Depreciation $1,200,000

Other $1,600,000

Capital  Expenditures  and  Cash  Budget  Information  

o The  company  plans  to  pay  cash  for  selling  and  administrative  equipment  
totaling  $5,000,000  and  production  equipment  totaling  $20,000,000  
(management  plans  to  fully  automate  production  with  new  machinery).  

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 Both  will  be  purchased  at  the  end  of  the  fourth  quarter  and  will  not  affect  
depreciation  expense  for  the  coming  year.  
o All  sales  are  made  on  credit.  The  company  expects  to  collect  90  percent  of  
sales  in  the  quarter  of  sale  and  10  percent  the  quarter  following  the  sale.  
Accounts  receivable  at  the  end  of  last  year  totaled  $1,400,000,  all  of  which  
will  be  collected  during  the  first  quarter  of  this  coming  year.  
o All  direct  materials  purchases  are  on  credit.  The  company  expects  to  pay  80  
percent  of  purchases  in  the  quarter  of  purchase  and  20  percent  the  
following  quarter.  Accounts  payable  at  the  end  of  last  year  totaled  
$400,000,  all  of  which  will  be  paid  during  the  first  quarter  of  this  coming  
year.  
o The  cash  balance  at  the  beginning  of  this  coming  year  is  expected  to  be  
$75,000.  
Budgeted  Balance  Sheet  Information  
o Assume  10  percent  of  fourth  quarter  budgeted  sales  will  be  collected  in  full  
the  following  year  (this  represents  accounts  receivable  at  the  end  of  the  
fourth  quarter).  

o Expected  account  balances  at  the  end  of  the  fourth  quarter  are  
Property, plant, and equipment (net) $32,000,000

Common stock $13,500,000

o Actual  retained  earnings  at  the  end  of  last  year  totaled  $2,641,400,  and  no  
cash  dividends  will  be  paid  during  the  current  budget  period  ending  
December  31.  
Required:  

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 o. Prepare  the  quarterly  sales  and  production-­‐related  budgets  using  
the  figure  formats  referenced  here:  
 . Sales  budget  ()  
a. Production  budget  ()  
b. Direct  materials  purchases  budget  ()  
c. Direct  labor  budget  ()  
d. Manufacturing  overhead  budget  ()  
p. Prepare  a  quarterly  selling  and  administrative  budget  using  the  format  
shown  in  .  
q. Prepare  a  quarterly  budgeted  income  statement  using  the  format  shown  
in  .  
r. Prepare  a  quarterly  capital  expenditures  budget  using  the  format  shown  in  .  
s. Prepare  a  quarterly  cash  budget  using  the  format  shown  in  .  
t. Prepare  a  budgeted  balance  sheet  at  December  31  using  the  format  shown  
in  .  (Hint:  cash  will  have  a  negative  balance.)  
u. Review  the  cash  budget  for  Air  Boats,  Inc.  What  issue  is  facing  the  treasurer,  
and  how  might  this  issue  be  resolved?  
Ethics  in  Budgeting.  Carol  Chadwick  is  the  manager  of  the  toys  
division  at  Matteler,  Inc.  Carol  is  in  the  process  of  establishing  the  budgeted  
income  statement  for  this  coming  year,  which  will  be  submitted  to  the  
company  president  for  approval.  The  division’s  current  year  actual  results  
were  slightly  higher  than  the  5  percent  growth  Carol  had  anticipated.  These  
results  are  shown  as  follows.  

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Division  managers  receive  a  20  percent  bonus  for  actual  net  income  in  
excess  of  budgeted  net  income.  Carol  believes  growth  in  sales  this  year  will  
be  approximately  12  percent.  She  is  considering  submitting  a  budget  
showing  an  increase  of  5  percent,  which  will  increase  her  chances  of  
receiving  a  significant  bonus  at  the  end  of  this  coming  year.  Assume  cost  of  
goods  sold  are  variable  costs  and  will  increase  in  proportion  with  sales  
revenue.  That  is,  cost  of  goods  sold  will  always  be  60  percent  of  sales  
revenue.  Assume  selling  and  administrative  expenses  are  fixed  costs.  
Required:  
 . Prepare  a  budgeted  income  statement  for  the  toys  division  assuming  sales  
revenue  will  increase  5  percent.  
a. Prepare  a  budgeted  income  statement  for  the  toys  division  assuming  sales  
revenue  will  increase  12  percent.  
b. How  much  will  Carol  potentially  have  to  gain  in  bonus  compensation  by  
submitting  a  budget  showing  a  5  percent  increase  in  sales  revenue  if  actual  
growth  turns  out  to  be  12  percent?  
c. As  the  president  and  CEO  of  Matteler,  how  might  you  motivate  Carol  
Chadwick  to  provide  an  accurate  budgeted  income  statement?  

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Chapter 10

How Do Managers Evaluate Performance Using Cost Variance Analysis?

Jerry Feltz, president and owner of Jerry’s Ice Cream, is discussing the results of operations for
the year with the company’s management group: Tom, the sales manager; Lynn, the production
manager; and Michelle, the treasurer and controller.

Good work, everyone! It looks as if our sales this past year exceeded the budget!
We were expecting to sell 200,000 gallons of ice cream, but it turns out we sold
Jerry: 210,000 gallons. Credit goes to our sales staff for their hard work!

Tom: Thanks, Jerry. We have a great group of salespeople and a terrific product.

I agree. I am concerned, however, about our direct labor and direct materials
costs. We expected a 5 percent increase in these costs over the original budget
since sales were 5 percent higher than anticipated. However, our cost overruns
far exceeded the 5 percent increase. We’ve got to get a handle on both of these
Jerry: costs.

This doesn’t sound right. My production crew used fewer materials than was
budgeted, and the average time it took to make each unit was also less than
expected. This should cause materials and labor costs to be lower than expected,
Lynn: not higher.

Jerry: Michelle, are you sure we have the right information here?

Michelle: Absolutely. Total costs for direct labor and direct materials were higher than

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 budgeted, even after considering the increase in sales.

Can you give me more detail as to how this happened? I want to know what
caused the increase in costs and how to prevent this from taking place in the
Jerry: future.

Michelle: Can I have a week to pull the information together?

Jerry: You’ve got it.

Jerry is evaluating the performance of his company by comparing actual costs to

budgeted costs. This is the control phase of budgeting. We covered theplanning phase of
budgeting in Chapter 9 "How Are Operating Budgets Created?" by showing how Jerry’s
Ice Cream prepared a master budget. The focus of this chapter is on the control phase
and how to calculate and analyze cost variances.

10.1 Flexible Budgets

L E A R N I N G   O B J E C T I V E  

1. Understand  how  flexible  budgets  are  used  to  evaluate  performance.  

Question: The master budget in Chapter 9 "How Are Operating Budgets Created?" was prepared
for only one level of activity (activity was measured by the number of units sold, which was
budgeted at 200,000 units). Although this works well in the planning phase of budgeting, it is not
appropriate for the control phase. Actual sales rarely match budgeted sales. When actual sales
differ from budgeted sales, it is inappropriate and perhaps unfair to evaluate employee
performance by comparing actual results to the master budget. If actual sales volume is higher
than the master budget, variable costs should be higher than the master budget. The opposite is
true as well. How do organizations modify the master budget to adjust for actual sales?

Answer: Organizations use a modified budget called a flexible budget. Aflexible budget is
simply a revised master budget based on the actualactivity level. It represents what costs should
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 be given a certain level of activity. The master budget at Jerry’s Ice Cream was based on sales of
200,000 units and production of 200,400 units. Because actual sales totaled 210,000 units, the
flexible budget should be based on 210,000 units of activity. (It should be noted that in Chapter 9
"How Are Operating Budgets Created?", we presented an example with budgeted sales of
200,000 units and budgeted production of 200,400 units resulting from differing beginning and
ending finished goods inventory amounts. In this chapter, we assume beginning and ending
finished goods inventory are the same, and therefore units produced and sold will be the same.
Thus we assume actual sales and actual production total 210,000 units.)

Question: Imagine being the production manager at Jerry’s Ice Cream, and you are evaluated
based on the quantity of direct materials used in production.Would it be fair to compare the
materials used to produce 210,000 units with the master budget showing the materials that
should have been used to produce 200,400 units?

Answer: Probably not. The budget should be adjusted upward to reflect the actual number of
units produced before a comparison is made, thus the termflexible budget. As we develop the
process of cost variance analysis, we will use flexible budget information. That is, we will revise
the master budget for direct materials, direct labor, and variable manufacturing overhead to
reflect actual sales volume of 210,000 units. However, we must first describe the concept
of standard cost.

K E Y   T A K E A W A Y  

• A  flexible  budget  is  a  revised  master  budget  that  represents  expected  costs  given  
actual  sales.  Costs  in  the  flexible  budget  are  compared  to  actual  costs  to  evaluate  
performance.  
R E V I E W   P R O B L E M   1 0 . 1  

What  is  a  flexible  budget,  and  why  do  companies  use  a  flexible  budget  to  evaluate  
production  managers?  

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 Solution  to  Review  Problem  10.1  

A  flexible  budget  is  a  revised  master  budget  based  on  the  actual  activity  level  
achieved  for  a  period.  The  master  budget  is  established  before  the  period  begins  for  
planning  purposes,  and  the  flexible  budget  is  established  after  the  period  ends  for  
control  and  evaluation  purposes.  Production  managers  are  evaluated  using  the  
flexible  budget  because  the  usage  of  direct  materials,  direct  labor,  and  manufacturing  
overhead  will  depend  on  the  actual  number  of  units  produced.  

10.2  Standard Costs

L E A R N I N G   O B J E C T I V E  

1. Explain  how  standard  costs  are  established.  

Question: Companies often use standard costs for planning and control purposes. What are
standard costs?

Answer: Standard costs are costs that management expects to incur to provide a good or service.
They serve as the “standard” by which performance will be evaluated. For example, fast-food
restaurants have a standard for the length of time it should take to serve a drive-through-window
customer. Phone directory operators have a standard length of time it should take to provide a
phone number to a customer. Manufacturing companies have a standard quantity of direct
materials to be used to produce one unit of product.

The Difference between Standard Costs and Budgeted Costs

Question: What is the difference between standard costs and budgeted costs?

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 Answer: The term standard cost refers to a specific cost per unit. Budgeted cost refers to costs in
total given a certain level of activity. Standard variable production costs at Jerry’s Ice Cream are
shown in .

Figure 10.1 Standard Costs at Jerry’s Ice Cream

*Direct materials standards come from the direct materials purchases budget presented in .

**Direct labor standards come from the direct labor budget presented in .

† Variable overhead costs are applied to products based on direct labor hours. Variable overhead
cost per direct labor hour is calculated by dividing total variable overhead costs of $100,200
(from the manufacturing overhead budget in ) by 20,040 total direct labor hours (from the direct
labor budget in ), which results in a standard variable overhead rate of $5 per direct labor hour.

These standard costs can then be used to establish a flexible budget based on a given level of
activity. For example, let’s use Jerry’s actual sales of 210,000 units. The variable production
costs expected to produce these units are shown in the flexible budget in .

Figure 10.2 Flexible Budget for Variable Production Costs at Jerry’s Ice Cream

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The standard cost presented in shows the variable production costs expected to produce one unit.
The flexible budget in uses the standard cost information to show the variable production costs
expected in total given a certain level of activity (210,000 units in this example). Later in the
chapter, we compare the flexible budget presented in to actual results and analyze the difference.
The flexible budget graph presented in shows that direct materials have the highest variable
production cost at $420,000, followed by direct labor at $273,000 and variable overhead at
$105,000.

Figure 10.3 Flexible Budget

Establishing Standard Cost

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 Question: What are the components needed to establish a standard cost for direct materials,
direct labor, and variable manufacturing overhead?

Answer: Notice in that direct materials has two separate standards necessary to calculate the
standard cost: standard quantity to produce 1 unit of product (2 pounds) and standard price ($1
per pound). Direct labor has two separate standards as well: standard hours to produce 1 unit of
product (0.10 hours) and standard rate ($13 per hour). Variable manufacturing overhead also has
2 separate standards: standard hours to produce 1 unit of product (0.10 direct labor hours) and
standard rate ($5 per hour). Thus there are two separate standards necessary to establish each
standard cost or six standards in total to establish a standard cost for direct materials, direct labor,
and variable manufacturing overhead.

As we explain next, there are many approaches to establishing these six standards for direct
materials, direct labor, and variable manufacturing overhead (we discuss fixed manufacturing
overhead at the end of this chapter).

Direct Materials Standard Quantity and Standard Price

Question: How do organizations determine the standard quantity and standard price for direct
materials?

Answer: The standard quantity for direct materials represents the materials required to complete
one good unit of product (i.e., a product with no defects), and it includes an allowance for waste
and spoilage. For Jerry’s Ice Cream, the standard quantity of materials needed for each gallon of
product is given in the recipe. Jerry’s adds a certain amount to the recipe quantity for waste and
spoilage. Similar to this approach, companies might find the standard quantity in the product
specifications outlined by product engineers. Some companies review historical production
information to determine quantities used in the past and use this information to set standard
quantities for the future.

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 The standard price for direct materials represents the final delivered cost of the materials and
includes items such as shipping and insurance. The standard price for materials at Jerry’s comes
from the purchase contract negotiated with the company’s supplier. As an alternative to this
approach, companies might use historical data or look at price trends in the marketplace.

As shown in , for Jerry’s Ice Cream, the standard quantity of direct materials is 2 pounds per
unit, and the standard price is $1 per pound. Thus the standard cost per unit for direct materials is
$2, calculated as follows:

$2 standard cost per unit = 2 pounds per unit × $1 per pound

Direct Labor Standard Hours and Standard Rate

Question: How do organizations determine the standard hours and standard rate for direct
labor?

Answer: The standard hours for direct labor represents the direct labor time required to complete
one good unit of product and includes an allowance for breaks and production inefficiencies such
as machine downtime. Jerry’s Ice Cream established this standard using historical information.
In addition to this approach, companies might use time and motion studies performed by
engineers who observe production workers and analyze the time required to perform production
activities.

The standard rate for direct labor represents the average cost of wages and benefits for each hour
of direct labor work performed. Jerry’s Ice Cream looked at past payroll records to determine
this standard. Companies also review labor contracts to estimate the costs associated with direct
labor.

As shown in , for Jerry’s Ice Cream, the standard hours for direct labor is 0.10, and the standard
rate is $13 per hour. Thus the standard cost per unit for direct labor is $1.30, calculated as
follows:

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 $1.30 standard cost per unit = 0.10 direct labor hours per unit × $13 per hour

Variable Manufacturing Overhead Standard Quantity and Standard Rate

Question: How do organizations determine the standard quantity and standard rate for variable
manufacturing overhead?

Answer: Thestandard quantity for variable manufacturing overhead represents the time required
to complete one unit of product. This time is often measured in direct labor hours or machine
hours, depending on how the company chooses to allocate overhead (recall that we covered the
choice of allocation base at length in ). Jerry’s Ice Cream uses direct labor hours to allocate
variable manufacturing overhead, so we apply the same standard quantity used for direct labor.

The standard rate for variable manufacturing overhead represents the variable portion of the
predetermined overhead rate used to allocate overhead costs to products (see for further
discussion of predetermined overhead rates).

As shown in , for Jerry’s Ice Cream, the standard quantity of direct labor hours is 0.10, and the
standard rate (predetermined overhead rate) is $5 per direct labor hour. Thus the standard cost
per unit for variable manufacturing overhead is $0.50, calculated as follows:

$0.50 standard cost per unit = 0.10 direct labor hours per unit × $5 per hour

Ideal Standards and Attainable Standards

Question: In the process of establishing standards, managers must decide between

using ideal standards or attainable standards. What is the difference between these two
standards?

Answer: Ideal standards are set assuming production conditions are perfect. For example, ideal
standards assume machines never break down, employees are never ill, and materials are never
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 wasted. Although ideal standards may provide motivation for workers to strive for excellence,
these standards can also have a negative impact because they may be impossible to achieve.

As an alternative to ideal standards, most managers use attainable

standards. Attainable standards take into consideration the likelihood of encountering problems
in production such as machine downtime, electricity outages, materials waste, and employee
illnesses. Most managers feel attainable standards have a positive behavioral impact on workers
because the standards are reasonable and attainable under normal production conditions. We
assume the use of attainable standards throughout this chapter.

Controlling Operations through Standards

Question: How are standards used to control operations?

Answer: Companies typically use standards to analyze the difference between budgeted costs
and actual costs. The process of analyzing differences between standard costs and actual costs is
called variance analysis. Managerial accountants perform variance analysis for costs including
direct materials, direct labor, and manufacturing overhead.

Standard costs are also used to determine product costs. Companies using standard costing
systems are able to estimate product costs without having to wait for actual product cost data,
and they often record transactions using standard cost information. The appendix shows how this
process works using journal entries.

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 Business  in  Action  10.1  

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 Source: Photo courtesy of Keith
Allison,http://www.flickr.com/photos/keithallison/2310444991/.
Controlling Costs in the NBA
The National Basketball Association (NBA) imposes a “salary cap” that dictates a
maximum dollar amount each team can pay its players collectively in one season. The
salary cap is based on a percentage of basketball-related income and was set at
$57,700,000 per team for the 2009–10 season. This serves as the cost budget for player
payroll. However, “salary exceptions” allow many teams to exceed the salary cap.
Annual salaries for some of the highest paid players for the 2009–10 season are shown
as follows:
• Kevin Garnett, Boston: $24,800,000
• Jason Kidd, Dallas: $21,400,000
• Kobe Bryant, Los Angeles: $21,300,000
• Shaquille O’Neal, Phoenix: $21,000,000
• Tim Duncan, San Antonio: $20,600,000
• Ray Allen, Boston: $18,400,000
Imagine being the manager of the Boston Celtics and having to pay one player almost
half of your entire budget! Clearly, controlling costs in this type of business environment
is a challenge, and budgeting is a crucial element in achieving financial success.
Source: InsideHoops.com, “Home Page,” http://www.insidehoops.com.
K E Y   T A K E A W A Y  

• Standard  costs  are  costs  management  expects  to  incur  to  provide  a  good  or  service.  
Manufacturing  companies  often  establish  standard  costs  for  direct  labor,  direct  
materials,  and  manufacturing  overhead.  Standard  cost  information  comes  from  a  
number  of  sources  such  as  historical  data,  product  specifications  outlined  by  product  
engineers,  contracts  with  suppliers,  and  labor  union  contracts.  
R E V I E W   P R O B L E M   1 0 . 2  

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 Recall  from  the  review  problems  in  that  Carol’s  Cookies  produces  cookies  for  resale  at  
grocery  stores  throughout  North  America.  We  established  a  master  budget  indicating  
Carol  expects  to  use  1.5  pounds  of  direct  materials  for  each  unit  produced  at  a  cost  of  
$2  per  pound  (1  unit  =  1  batch  of  cookies).  Each  unit  produced  will  require  0.20  direct  
labor  hours  at  a  cost  of  $12  per  hour.  Variable  manufacturing  overhead  is  applied  
based  on  direct  labor  hours  at  a  rate  of  $3.50  per  hour.  Last  year’s  sales  were  
expected  to  total  400,000  units.  

Carol  just  received  last  year’s  actual  results  showing  sales  of  390,000  units.  
1. Calculate  the  standard  cost  per  unit  for  direct  materials,  direct  labor,  and  variable  
manufacturing  overhead  using  the  format  shown  in  .  
2. Prepare  a  flexible  budget  based  on  actual  sales  for  direct  materials,  direct  labor,  and  
variable  manufacturing  overhead  using  the  format  shown  in  .  

Solution  to  Review  Problem  10.2  

1.    

2.    

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10.3 Direct Materials Variance Analysis

L E A R N I N G   O B J E C T I V E  

1. Calculate  and  analyze  direct  materials  variances.  

Question: In the dialogue at the beginning of the chapter, the president of Jerry’s Ice Cream was
concerned about significant cost overruns for direct materials. We cannot simply explain these
costs by saying that “we paid too much for materials” or “too many materials were used in
production.” Variances must be calculated to identify the exact cause of the cost overrun. What
variances are used to analyze the difference between actual direct material costs and standard
direct material costs?

Answer: The difference between actual costs and standard (or budgeted) costs is typically
explained by two separate variances: the materials price variance and materials quantity
variance. The materials price variance is the difference between actual costs for
materials purchased and budgeted costs based on the standards.
The materials quantity variance is the difference between the actual quantity of materials used in
production and budgeted materials that should have been used in production based on the
standards.

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 To this point, we have provided the data for Jerry’s Ice Cream necessary to calculate standard
costs. However, you must also have the actual materials cost and materials quantity data to
calculate the variances described previously. The actual data for the year are as follows:

Sales volume 210,000 units

Direct materials purchased 440,000 pounds

Cost of direct materials purchased $1.20 per pound

Direct materials used in production 399,000 pounds

Recall from that the direct materials standard price for Jerry’s is $1 per pound, and the standard
quantity of direct materials is 2 pounds per unit.shows how to calculate the materials price and
quantity variances given the actual results and standards information. Review this figure
carefully before moving on to the next section where these calculations are explained in detail.

Figure 10.4 Direct Materials Variance Analysis for Jerry’s Ice Cream

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 Note: AQP = Actual quantity of materials purchased. AP = Actual price of materials. AQU =
Actual quantity of materials used in production. SP = Standard price of materials. SQ = Standard
quantity of materials for actual level of activity.

*Standard quantity of 420,000 pounds = Standard of 2 pounds per unit × 210,000 actual units
produced and sold.

**$420,000 standard direct materials cost matches the flexible budget presented in .

† $88,000 unfavorable materials price variance = $528,000 – $440,000. Variance is unfavorable

because the actual price of $1.20 is higher than the expected (budgeted) price of $1.

‡ $(21,000) favorable materials quantity variance = $399,000 – $420,000. Variance is favorable

because the actual quantity of materials used in production of 399,000 pounds is lower than the
expected (budgeted) quantity of 420,000 pounds.

Direct Materials Price Variance Calculation

Question: The materials price variance answers the question, did we spend more or less on
direct materials than expected? If the variance is unfavorable, we spent more than expected. If
the variance is favorable, we spent less than expected. How is the materials price variance
calculated?

Answer: As shown in , the materials price variance is the difference between the actual quantity
of materials purchased at the actual price and the actual quantity of materials purchased at the
standard price:

Key  Equation  

Materials  price  variance  =  (AQP  ×  AP)  –  (AQP  ×  SP)  

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 Materials price variance=(AQP×AP)−(AQP×SP)=(440,000×$1.20)−(440,000×$1.00)=$88,000 u
nfavorable

Alternative Calculation. Since we are holding the actual quantityconstant and evaluating the
difference between actual price and standard price, the materials price variance calculation can
be simplified as follows:

Key  Equation  

Materials  price  variance  =  (AP  –  SP)  ×  AQP  

Materials price variance=(AP−SP)×AQP=($1.20−$1.00)×440,000=$88,000 unfavorable  

Note that both approaches—the direct materials price variance calculation and the
alternative calculation—yield the same result.

When labeling the variances calculated in this chapter, notice that all positive variances
are unfavorable and all negative variances are favorable (i.e., unfavorable cost
variances increase expected costs and favorable cost variances decrease expected costs).
As you calculate variances, you should think through the variance to confirm whether it
is favorable or unfavorable. For example, the materials price variance calculation
presented previously shows the actual price paid for materials was $1.20 per pound and
the standard price was $1. Clearly, this is unfavorable because the actual price was
higher than the expected (budgeted) price.

Direct Materials Quantity Variance Calculation

Question: The materials quantity variance answers the question, did we use more or fewer direct
materials in production than expected? If the variance is unfavorable, we used more than
expected. If the variance is favorable, we used fewer than expected. How is the materials
quantity variance calculated?

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 Answer: As shown in , the materials quantity variance is the difference between the actual
quantity of materials used in production at the standard price and the standard quantity of
materials allowed at the standard price:

Key  Equation  

Materials  quantity  variance  =  (AQU  ×  SP)  –  (SQ  ×  SP)  

Materials quantity variance=(AQU×SP)−(SQ×SP)=(399,000×$1.00)−(420,000×$1.00)=($21,000

) favorable

The standard quantity of 420,000 pounds is the quantity of materials allowed given actual
production. For Jerry’s Ice Cream, the standard quantity of materials per unit of production is 2
pounds per unit. Thus the standard quantity (SQ) of 420,000 pounds is 2 pounds per unit ×
210,000 units produced and sold.

Alternative Calculation. Since we are holding the standard price constant and evaluating the
difference between actual quantity used and standard quantity, the materials quantity variance
calculation can be simplified as follows:

Key  Equation  

Materials  quantity  variance  =  (AQU  –  SQ)  ×  SP  

Materials quantity variance=(AQU−SQ)×SP=(399,000−420,000)×$1.00=($21,000) favorable  

Note that both approaches—the direct materials quantity variance calculation and the
alternative calculation—yield the same result.

The materials quantity variance calculation presented previously shows the actual
quantity used in production of 399,000 pounds is lower than the expected (budgeted)
quantity of 420,000 pounds. Clearly, this is favorablebecause the actual quantity used
was lower than the expected (budgeted) quantity.
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 Possible Causes of Direct Materials Variances

Question: The managerial accountant at Jerry’s Ice Cream will likely investigate the cause of
the unfavorable materials price variance of $88,000. This will lead to discussions with the
purchasing department. What might have caused the $88,000 unfavorable materials price
variance?

Answer: The left panel of contains some possible explanations for this variance.

Figure 10.5 Possible Causes of Direct Materials Variances for Jerry’s Ice Cream

Whatever the cause of this unfavorable variance, Jerry’s Ice Cream will likely take action to
improve the cost problem identified in the materials price variance analysis. This is why we use
the term control phase of budgeting to describe variance analysis. Through variance analysis,
companies are able to identify problem areas (material costs for Jerry’s) and consider alternatives
to controlling costs in the future.

Question: Jerry’s Ice Cream might also choose to investigate the $21,000 favorable materials
quantity variance. Although this could be viewed as good news for the company, management

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 may want to know why this favorable variance occurred. What might have caused the $21,000
favorable materials quantity variance?

Answer: The right panel of contains some possible explanations for this variance.

Notice how the cause of one variance might influence another variance. For example, the
unfavorable price variance at Jerry’s Ice Cream might have been a result of purchasing high-
quality materials, which in turn led to less waste in production and a favorable quantity variance.
This also might have a positive impact on direct labor, as less time will be spent dealing with
materials waste.

Illustrates just how important it is to track direct materials variances accurately.

Business  in  Action  10.2  

The Effect of Rising Materials Costs on Auto Suppliers
In the first six months of 2004, steel prices increased 76 percent, from $350 a ton to
$617 a ton. For auto suppliers that use hundreds of tons of steel each year, this had the
unexpected effect of increasing expenses and reducing profits. For example, a major
producer of automotive wheels had to reduce its annual earnings forecast by
$10,000,000 to $15,000,000 as a result of the increase in steel prices.
Most auto part suppliers operate with very small margins. GR Spring and Stamping,
Inc., a supplier of stampings to automotive companies, was generating pretax profit
margins of about 3 percent prior to the increase in steel prices. Profit margins have been
cut in half since steel prices began rising.
These thin margins are the reason auto suppliers examine direct materials variances so
carefully. Any unexpected increase in steel prices will likely cause significant
unfavorable materials price variances, which will lead to lower profits. Auto part
suppliers that rely on steel will continue to scrutinize materials price variances and

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 materials quantity variances to control costs, particularly in a period of rising steel
prices.
Source: Brett Clanton, “Steel Costs Slam Auto Suppliers,” The Detroit News, June 29,
2004, http://www.detnews.com.

Clarification of Favorable Versus Unfavorable

Question: Why are variances labeled favorable or unfavorable?

Answer: The terms favorable and unfavorable relate to the impact the variance has on budgeted
operating profit. A favorable variance has a positive impact on operating profit.
An unfavorable variance has a negative impact on operating profit. Companies using a standard
cost system ultimately credit favorable variances and debit unfavorable variances to income
statement accounts. The appendix to this chapter describes this process in further detail.

K E Y   T A K E A W A Y  

• Standard  costs  are  used  to  establish  the  flexible  budget  for  direct  materials.  The  
flexible  budget  is  compared  to  actual  costs,  and  the  difference  is  shown  in  the  form  of  
two  variances.  The  materials  price  variance  focuses  on  the  price  paid  for  materials,  
and  it  is  defined  as  the  difference  between  the  actual  quantity  of  materials  purchased  
at  the  actual  price  and  the  actual  quantity  of  materials  purchased  at  the  standard  
price.  The  materials  quantity  variance  focuses  on  the  quantity  of  materials  used  in  
production.  It  is  defined  as  the  difference  between  the  actual  quantity  of  materials  
used  in  production  and  budgeted  materials  that  should  have  been  used  in  production  
based  on  the  standards.  
R E V I E W   P R O B L E M   1 0 . 3  

Carol’s  Cookies  expected  to  use  1.5  pounds  of  direct  materials  to  produce  1  unit  
(batch)  of  product  at  a  cost  of  $2  per  pound.  Actual  results  are  in  for  last  year,  which  

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 indicates  390,000  batches  of  cookies  were  sold.  The  company  purchased  640,000  
pounds  of  materials  at  $1.80  per  pound  and  used  624,000  pounds  in  production.  
1. Calculate  the  materials  price  and  quantity  variances  using  the  format  shown  in  .  
2. Use  the  alternative  approach  to  calculating  the  materials  price  and  quantity  
variances,  and  compare  the  result  to  the  result  in  part  1.  (Hint:  the  variances  should  
match.)  
3. Suggest  several  possible  reasons  for  the  materials  price  and  quantity  variances.  

Solution  to  Review  Problem  10.3  

1. As  shown  in  the  following,  the  materials  price  variance  is  $(128,000)  
favorable,  and  the  materials  quantity  variance  is  $78,000  unfavorable.  

   
Note:  AQP  =  Actual  quantity  of  materials  purchased.  AP  =  Actual  price  of  
materials.  AQU  =  Actual  quantity  of  materials  used  in  production.  SP  =  
Standard  price  of  materials.  SQ  =  Standard  quantity  of  materials  for  actual  
level  of  activity.  

*Standard  quantity  of  585,000  pounds  =  Standard  of  1.5  pounds  per  unit  ×  
390,000  actual  units  produced  and  sold.  
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 **$1,170,000  standard  direct  materials  cost  matches  the  flexible  budget  
presented  in  ,  part  2.  
†
 $(128,000)  favorable  materials  price  variance  =  $1,152,000  –  $1,280,000.  
Variance  is  favorable  because  the  actual  price  of  $1.80  is  lower  than  the  
expected  (budgeted)  price  of  $2  
‡
 $78,000  unfavorable  materials  quantity  variance  =  $1,248,000  –  
$1,170,000.  Variance  is  unfavorable  because  the  actual  quantity  of  
materials  used  in  production  of  624,000  pounds  is  higher  than  the  expected  
(budgeted)  quantity  of  585,000  pounds.  

2. Alternative  direct  materials  variance  calculations:  

Materials price variance=(AP−SP)×AQP=($1.80−$2.00)×640,000=($128,000) favorab

le (same as part 1)  

Materials quantity variance=(AQU− SQ)×SP=(624,000− 585,000)×$2.00=$78,000 unf

avorable (same as part 1)  

3. Possible  causes  of  favorable  materials  price  variance  are  

1. The  supplier  had  excess  materials  on  hand  and  lowered  prices  to  sell  
off  inventory;  
2. New  suppliers  entered  the  market,  which  resulted  in  an  excess  supply  of  
materials  and  lower  prices;  
3. Carol’s  Cookies’  purchasing  agent  is  a  strong  negotiator  and  was  able  to  
negotiate  lower  prices  than  anticipated;  
4. Lower-­‐quality  materials  were  purchased  at  a  lower  price.  
Possible  causes  of  unfavorable  materials  quantity  variance  are  
1.  Lower-­‐quality  materials  resulted  in  more  waste  and  spoilage;  
2.  New,  inexperienced  employees  were  hired,  resulting  in  more  waste;  
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 3.  Old  equipment  breaking  down  caused  an  increased  amount  of  waste.  
 
 
 

10.4 Direct Labor Variance Analysis

L E A R N I N G   O B J E C T I V E  

1. Calculate  and  analyze  direct  labor  variances.  

Question: In addition to investigating the causes of cost overruns for direct materials, the
president of Jerry’s Ice Cream wants to know why there were cost overruns for direct
labor. What variances are used to analyze these types of direct labor cost overruns?

Answer: Similar to direct materials variances, direct labor variance analysis involves two
separate variances: the labor rate variance and labor efficiency variance.
The labor rate variance is the difference between actual costs for direct labor and budgeted costs
based on the standards. Thelabor efficiency variance is the difference between the actual number
of direct labor hours worked and budgeted direct labor hours that should have been worked
based on the standards.

At Jerry’s Ice Cream, the actual data for the year are as follows:

Sales volume 210,000 units

Direct labor hours worked 18,900 hours

Cost of direct labor $15 per hour

Recall from that the standard rate for Jerry’s is $13 per direct labor hour and the standard direct
labor hours is 0.10 per unit. shows how to calculate the labor rate and efficiency variances given

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 the actual results and standards information. Review this figure carefully before moving on to the
next section where these calculations are explained in detail.

Figure 10.6 Direct Labor Variance Analysis for Jerry’s Ice Cream

Note: AH = Actual hours of direct labor. AR = Actual rate incurred for direct labor. SR =
Standard rate for direct labor. SH = Standard hours of direct labor for actual level of activity.

*Standard hours of 21,000 = Standard of 0.10 hours per unit × 210,000 actual units produced and
sold.

**$273,000 standard direct labor cost matches the flexible budget presented in .

† $37,800 unfavorable labor rate variance = $283,500 – $245,700. Variance is unfavorable

because the actual rate of $15 is higher than the expected (budgeted) rate of $13.

‡ $(27,300) favorable labor efficiency variance = $245,700 – $273,000. Variance is favorable

because the actual hours of 18,900 are lower than the expected (budgeted) hours of 21,000.

Direct Labor Rate Variance Calculation

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 Question: The direct labor rate variance answers the question, did we spend more or less on
direct labor than expected? If the variance is unfavorable, we spent more than expected. If the
variance is favorable, we spent less than expected. How is the labor rate variance calculated?

Answer: As shown in , the labor rate variance is the difference between the actual hours worked
at the actual rate and the actual hours worked at the standard rate:

Key  Equation  

Labor  rate  variance  =  (AH  ×  AR)  −  (AH  ×  SR)  

Labor rate variance=(AH×AR)−(AH×SR)=(18,900×$15)−(18,900×$13)= $37,800 unfavorable

Alternative Calculation. Because we are holding the actual hoursconstant and evaluating the
difference between actual rate and standard rate, the labor rate variance calculation can be
simplified as follows:

Key  Equation  

Labor  rate  variance  =  (AR  −  SR)  ×  AH  

Labor rate variance=(AR−SR)×AH=($15−$13)×18,900= $37,800 unfavorable  

Note that both approaches—direct labor rate variance calculation and the alternative
calculation—yield the same result.

As with direct materials variances, all positive variances are unfavorable, and all negative
variances are favorable. The labor rate variance calculation presented previously shows the
actual rate paid for labor was $15 per hour and the standard rate was $13. This results in
an unfavorablevariance since the actual rate was higher than the expected (budgeted) rate.

Direct Labor Efficiency Variance Calculation

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 Question: The direct labor efficiency variance answers the question, did we use more or less
direct labor hours in production than expected? If the variance is unfavorable, we used more
than expected. If the variance is favorable, we used less than expected. How is the labor
efficiency variance calculated?

Answer: As shown in , the labor efficiency variance is the difference between the actual hours
worked at the standard rate and the standard hours at the standard rate:

Key  Equation  

Labor  efficiency  variance  =  (AH  ×  SR)  −  (SH  ×  SR)  

Labor efficiency variance=(AH×SR)−(SH×SR)=(18,900×$13)−(21,000×$13)=($27,300) favorab

le  

The 21,000 standard hours are the hours allowed given actual production. For Jerry’s Ice Cream,
the standard allows for 0.10 labor hours per unit of production. Thus the 21,000 standard hours
(SH) is 0.10 hours per unit × 210,000 units produced.

Alternative Calculation. Because we are holding the standard rateconstant and evaluating the
difference between actual hours worked and standard hours, the labor efficiency variance
calculation can be simplified as follows:

Key  Equation  

Labor  efficiency  variance  =  (AH  −  SH)  ×  SR  

Labor efficiency variance=(AH−SH)× SR=(18,900−21,000)×$13=($27,300) favorable  

Note that both approaches—the direct labor efficiency variance calculation and the alternative
calculation—yield the same result.

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 The labor efficiency variance calculation presented previously shows that 18,900 in actual hours
worked is lower than the 21,000 budgeted hours. Clearly, this is favorable since the actual hours
worked was lower than the expected (budgeted) hours.

Possible Causes of Direct Labor Variances

Question: The managerial accountant at Jerry’s Ice Cream is interested in finding the cause of
the unfavorable labor rate variance of $37,800. Jerry’s Ice Cream might also choose to
investigate the $27,300 favorable labor efficiencyvariance. Although this could be viewed as
good news for the company, management may want to know why this favorable variance
occurred. What might have caused the $37,800 unfavorable labor rate variance and $27,300
favorable labor efficiency variance?

Answer: contains some possible explanations for the labor rate variance (left panel) and labor
efficiency variance (right panel).

Figure 10.7 Possible Causes of Direct Labor Variances for Jerry’s Ice Cream

As mentioned earlier, the cause of one variance might influence another variance. For example,
many of the explanations shown in might also apply to the favorable materials quantity variance.
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 We have demonstrated how important it is for managers to be aware not only of the cost of labor,
but also of the differences between budgeted labor costs and actual labor costs. This awareness
helps managers make decisions that protect the financial health of their companies.

Business  in  Action  10.3  

Labor Costs in the Airline Industry
United Airlines asked a bankruptcy court to allow a one-time 4 percent pay cut for
pilots, flight attendants, mechanics, flight controllers, and ticket agents. The pay cut was
proposed to last as long as the company remained in bankruptcy and was expected to
provide savings of approximately $620,000,000. How would this unforeseen pay cut
affect United’s direct labor rate variance? The direct labor rate variance would likely be
favorable, perhaps totaling close to $620,000,000, depending on how much of these
savings management anticipated when the budget was first established.
After filing for Chapter 11 bankruptcy in December 2002, United cut close to
$5,000,000,000 in annual expenditures. As a result of these cost cuts, United was able
to emerge from bankruptcy in 2006.
Source: Associated Press, “United May Seek End to Union Contracts,”USA Today,
November 25, 2004.

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 Follow-Up Meeting at Jerry’s Ice Cream

Jerry (president and owner), Tom (sales manager), Lynn (production manager), and Michelle
(treasurer and controller) were at the meeting described at the opening of this chapter. Michelle
was asked to find out why direct labor and direct materials costs were higher than budgeted, even
after factoring in the 5 percent increase in sales over the initial budget. Lynn was surprised to
learn that direct labor and direct materials costs were so high, particularly since actual materials
used and actual direct labor hours worked were below budget.

The group met again a week later to discuss the issue.

Jerry: Michelle, what do you have for us?

My staff has been working hard to identify why direct materials and direct labor
costs were higher than expected. First, I would like to confirm that these costs
Michelle: were indeed higher than anticipated.

I still don’t see how this can be. My production crew was as efficient with their
Lynn: time and materials as they’ve ever been.

You’re right, Lynn. Our variance analysis shows a favorable direct materials
quantity variance, which relates directly to the amount of materials used, and a
favorable direct labor efficiency variance, which relates directly to the efficiency
Michelle: of our production workers. Both variances are good news.

Jerry: Then why are our direct labor and direct materials costs so high?

The answer relates directly to the price we paid for materials, and the hourly
rates we paid for labor. Both were higher than expected. We expected to pay $1
per pound for direct materials, but actually paid $1.20 per pound. In addition,
Michelle: we expected to pay $13 an hour for direct labor when in fact we actually paid

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 $15 an hour. This means we paid 20 percent more than expected for direct
materials, which is $0.20 divided by $1, and 15 percent more than expected for
direct labor, which is $2 divided by $13.

I do recall Tony over in purchasing telling me he obtained some premium

materials for our ice cream, and I know we hired some relatively experienced
Lynn: workers who were paid a bit more than the normal starting rate.

This might explain why our customers were thrilled about our product. The
Tom: materials were high quality and the production workers really knew their stuff!

While I like the end result of a higher-quality product and increased sales, we
must do a better job of controlling costs. Perhaps Tony can negotiate a better
price for materials. I don’t mind paying our employees a higher wage based on
their experience, but let’s make sure we get some efficiency savings in the
process to help offset the higher wages. Michelle, can we continue to monitor
Jerry: material and labor costs?

Yes. I’ll have my staff analyze material and labor variances monthly, and I’ll
Michelle: have a report ready at the end of each month for you and Lynn.

Excellent! Lynn, let our production crew know they are doing a fine job, and
continue to encourage them to find ways to improve the efficiency of production.
Jerry: I’ll talk with Tony about the possibility of getting a better deal on materials.

As stated earlier, variance analysis is the control phase of budgeting. Using variance analysis for
direct materials and direct labor, Jerry’s Ice Cream was able to identify strong points in its
operations (quantity of materials used and efficiency of direct labor workforce), and perhaps
more important, Jerry’s was able to identify problem areas (price paid for materials and wages
paid to employees). This information gives the management a way to monitor and control

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 production costs. Next, we calculate and analyze variable manufacturing overhead cost
variances.

K E Y   T A K E A W A Y  

• Standard  costs  are  used  to  establish  the  flexible  budget  for  direct  labor.  The  flexible  
budget  is  compared  to  actual  costs,  and  the  difference  is  shown  in  the  form  of  two  
variances.  The  labor  rate  variance  focuses  on  the  wages  paid  for  labor  and  is  defined  
as  the  difference  between  actual  costs  for  direct  labor  and  budgeted  costs  based  on  
the  standards.  The  labor  efficiency  variance  focuses  on  the  quantity  of  labor  hours  
used  in  production.  It  is  defined  as  the  difference  between  the  actual  number  of  
direct  labor  hours  worked  and  budgeted  direct  labor  hours  that  should  have  been  
worked  based  on  the  standards.  
R E V I E W   P R O B L E M   1 0 . 4  

Carol’s  Cookies  expected  to  use  0.20  direct  labor  hours  to  produce  1  unit  (batch)  of  
product  at  a  cost  of  $12  per  hour.  Actual  results  are  in  for  last  year,  which  indicates  
390,000  batches  of  cookies  were  sold.  The  company’s  direct  labor  workforce  worked  
97,500  hours  at  $11  per  hour.  
1. Calculate  the  labor  rate  and  efficiency  variances  using  the  format  shown  in  .  
2. Use  the  alternative  approach  to  calculating  the  labor  rate  and  efficiency  variances,  
and  compare  the  result  to  the  result  in  part  1.  (Hint:  the  variances  should  match.)  
3. Suggest  several  possible  reasons  for  the  labor  rate  and  efficiency  variances.  

Solution  to  Review  Problem  10.4  

1. As  shown  in  the  following,  the  labor  rate  variance  is  $(97,500)  favorable,  and  
the  labor  efficiency  variance  is  $234,000  unfavorable.  

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Note:  AH  =  Actual  hours  of  direct  labor.  AR  =  Actual  rate  incurred  for  direct  
labor.  SR  =  Standard  rate  for  direct  labor.  SH  =  Standard  hours  of  direct  
labor  for  actual  level  of  activity.  

*Standard  hours  of  78,000  =  Standard  of  0.20  hours  per  unit  ×  390,000  
actual  units  produced  and  sold.  
**$936,000  standard  direct  labor  cost  matches  the  flexible  budget  
presented  in  ,  part  2.  
†
 $(97,500)  favorable  labor  rate  variance  =  $1,072,500  –  $1,170,000.  
Variance  is  favorable  because  the  actual  rate  of  $11  is  lower  than  the  
expected  (budgeted)  rate  of  $12.  
‡
 $234,000  unfavorable  labor  efficiency  variance  =  $1,170,000  –  $936,000.  
Variance  is  unfavorable  because  the  actual  hours  of  97,500  are  higher  than  
the  expected  (budgeted)  hours  of  78,000.  

2. The  following  are  alternative  direct  labor  variance  calculations:  

Labor rate variance=(AR−SR)×AH=($11−$12)×97,500=($97,500) favorable (same as

part 1)  

Labor efficiency variance=(AH−SH)×SR=(97,500−78,000)×$12=$234,000 unfavorabl

e (same as part 1)  
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 3. Possible  causes  of  favorable  labor  rate  variance  are  
1. A  higher  mix  of  newly  hired  and  unskilled  workers  caused  hourly  rates  
to  be  lower  than  anticipated;  
2. Product  demand  was  lower  than  expected,  thereby  reducing  the  amount  of  
overtime  initially  anticipated;  
3. A  new  labor  contract  was  negotiated  at  lower  pay  rates  than  anticipated.  
Possible  causes  of  unfavorable  labor  efficiency  variance  are  
1.  A  higher  mix  of  unskilled  workers  than  anticipated  caused  inefficiencies;  
2.  Cutbacks  in  training  reduced  the  expected  efficiency  of  direct  labor  
workers;  
3.  Old  equipment  breaking  down  caused  workers  to  waste  time  waiting  for  
repairs.  

10.5 Variable Manufacturing Overhead Variance Analysis

L E A R N I N G   O B J E C T I V E  

1. Calculate  and  analyze  variable  manufacturing  overhead  variances.  

Question: Similar to direct materials and direct labor variances, variable manufacturing
overhead variance analysis involves two separate variances.What are the two variances used to
analyze the difference between actual variable overhead costs and standard variable overhead
costs?

Answer: The two variances used to analyze this difference are the spending
variance and efficiency variance. Thevariable overhead spending variance is the difference
between actual costs for variable overhead and budgeted costs based on the standards. For a
company that allocates variable manufacturing overhead to products based on direct labor hours,

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 the variable overhead efficiency variance is the difference between the number of direct labor
hours actually worked and what should have been worked based on the standards.

At Jerry’s Ice Cream, the actual data for the year are as follows:

Sales volume 210,000 units

Direct labor hours worked 18,900 hours

Total cost of variable overhead $100,000

Recall from that the variable overhead standard rate for Jerry’s is $5 per direct labor hour and the
standard direct labor hours is 0.10 per unit. shows how to calculate the variable overhead
spending and efficiency variances given the actual results and standards information. Review this
figure carefully before moving on to the next section where these calculations are explained in
detail.

Figure 10.8 Variable Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream

Note: AH = Actual hours of direct labor. (This measure will depend on the allocation base that
the company uses. Jerry’s uses direct labor hours to allocate variable manufacturing overhead, so
AH refers to actual direct labor hours.) SR = Standard variable manufacturing overhead rate per
direct labor hour. SH = Standard hours of direct labor for actual level of activity.

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 *Since variable overhead is not purchased per direct labor hour, the actual rate (AR) is not used
in this calculation. Simply use the total cost of variable manufacturing overhead instead.

**Standard hours of 21,000 = Standard of 0.10 hours per unit × 210,000 actual units produced
and sold.

† $105,000 standard variable overhead costs matches the flexible budget presented in .

‡ $5,500 unfavorable variable overhead spending variance = $100,000 – $94,500. Variance is

unfavorable because the actual variable overhead costs are higher than the expected costs given
actual hours of 18,900.

§ $(10,500) favorable variable overhead efficiency variance = $94,500 – $105,000. Variance is

favorable because the actual hours of 18,900 are lower than the expected (budgeted) hours of
21,000.

Variable Overhead Spending Variance Calculation

Question: How is the variable overhead spending variance calculated?

Answer: As shown in , the variable overhead spending variance is the difference between what
is actually paid for variable overhead and what should have been paid according to the standards:

Key  Equation  

Variable  overhead  spending  variance  =  Actual  costs  −  (AH  ×  SR)  

Variable overhead spending variance=Actual costs−(AH×SR)=$100,000−(18,900×$5)= $5,500 u

nfavorable  

As with direct materials and direct labor variances, all positive variances are unfavorable, and all
negative variances are favorable. Note that there is no alternative calculation for the variable

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 overhead spending variance because variable overhead costs are not purchased per direct labor
hour. Thus actual rate (AR) is not used for this variance.

This variance is unfavorable for Jerry’s Ice Cream because actual costs of $100,000 are higher
than expected costs of $94,500.

Variable Overhead Efficiency Variance Calculation

Question: How is the variable overhead efficiency variance calculated?

Answer: As shown in , the variable overhead efficiency variance is the difference between the
actual hours worked at the standard rate and the standard hours at the standard rate:

Key  Equation  

Variable  overhead  efficiency  variance  =  (AH  ×  SR)  −  (SH  ×  SR)  

Variable overhead efficiency variance=(AH×SR)−(SH×SR)=(18,900×$5)−(21,000×$5)=($10,50

0) favorable  

The 21,000 standard hours are the hours allowed given actual production (= 0.10 standard hours
allowed per unit × 210,000 units produced). Since actual direct labor hours worked total 18,900,
the variable manufacturing overhead costs should be lower than initially anticipated at 21,000
standard hours. (This assumes variable overhead costs are truly driven by direct labor hours!)
This results in a favorable variable overhead efficiency variance.

Alternative Calculation. Since we are holding the standard rate constant and evaluating the
difference between actual hours worked and standard hours, the variable overhead efficiency
variance calculation can be simplified as follows:

Key  Equation  

Variable  overhead  efficiency  variance  =  (AH  −  SH)  ×  SR  

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 Variable overhead efficiency variance=(AH−SH)×SR=(18,900−21,000)×$5=($10,500) favorable

Note that both approaches—the variable overhead efficiency variance calculation and the
alternative calculation—yield the same result.

The variable overhead efficiency variance calculation presented previously shows that 18,900 in
actual hours worked is lower than the 21,000 budgeted hours. Again, this variance
is favorable because working fewer hours than expected should result in lower variable
manufacturing overhead costs.

Possible Causes of Variable Manufacturing Overhead Variances

Question: The managerial accountant at Jerry’s Ice Cream is interested in finding the cause of
the unfavorable variable overhead spending variance of $5,500. The spending variance can
result from variances in the cost of variable overhead items and the usage of these items. What
might have caused the $5,500 unfavorable variable overhead spending variance?

Answer: The left panel of contains some possible explanations for Jerry’s unfavorable overhead
spending variance.

Figure 10.9 Possible Causes of Variable Manufacturing Overhead Variances for Jerry’s Ice
Cream

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Question: Jerry’s Ice Cream might also choose to investigate the $10,500 favorable variable
overhead efficiency variance. What might have caused the $10,500 favorable variable overhead
efficiency variance?

Answer: The focus here is on the activity base used to allocate overhead. Since Jerry’s uses
direct labor hours as the activity base, the possible explanations for this variance are linked to
efficiencies or inefficiencies in the use of direct labor. The right panel of contains some possible
explanations for this variance.

Again, this analysis is appropriate assuming direct labor hours truly drives the use of variable
overhead activities. That is, we assume that an increase in direct labor hours will increase
variable overhead costs and that a decrease in direct labor hours will decrease variable overhead
costs.

Business  in  Action  10.4  

Hiding Fraud in Overhead Accounts

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 The controller of a small, closely held manufacturing company embezzled close to
$1,000,000 over a 3-year period. With annual revenues of $30,000,000 and less than
100 employees, the company certainly felt the impact of losing $1,000,000.
The forensic accountant who investigated the fraud identified several suspicious
transactions, all of which were charged to the manufacturing overhead account. To
prevent this type of fraud in the future, the forensic accountant recommended that
“significant manufacturing overhead variances be analyzed both within and across time
periods to identify anomalies.” Apparently, the company was not closely monitoring
manufacturing overhead variances when the fraud occurred.
Source: John B. MacArthur, Bobby E. Waldrup, and Gary R. Fane, “Caution: Fraud
Overhead,” Strategic Finance, October 2004, 28–32.
K E Y   T A K E A W A Y  

• Standard  costs  are  used  to  establish  the  flexible  budget  for  variable  manufacturing  
overhead.  The  flexible  budget  is  compared  to  actual  costs,  and  the  difference  is  
shown  in  the  form  of  two  variances.  Thevariable  overhead  spending  
variance  represents  the  difference  between  actual  costs  for  variable  overhead  and  
budgeted  costs  based  on  the  standards.  The  variable  overhead  efficiency  variance  is  
the  difference  between  the  actual  activity  level  in  the  allocation  base  (often  direct  
labor  hours  or  machine  hours)  and  the  budgeted  activity  level  in  the  allocation  base  
according  to  the  standards.  
R E V I E W   P R O B L E M   1 0 . 5  

Carol’s  Cookies  expected  to  use  0.20  direct  labor  hours  to  produce  1  unit  (batch)  of  
product,  and  the  variable  overhead  rate  is  $3.50  per  hour.  Actual  results  are  in  for  last  
year,  which  indicates  390,000  batches  of  cookies  were  produced  and  sold.  The  
company’s  direct  labor  workforce  worked  97,500  hours,  and  variable  overhead  costs  
totaled  $360,000.  

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 1. Calculate  the  variable  overhead  spending  and  efficiency  variances  using  the  format  
shown  in  .  
2. Suggest  several  possible  reasons  for  the  variable  overhead  spending  and  efficiency  
variances.  

Solution  to  Review  Problem  10.5  

1. As  shown  in  the  following,  the  variable  overhead  spending  variance  is  
$18,750  unfavorable,  and  the  variable  overhead  efficiency  variance  is  
$68,250  unfavorable.  

AH  =  Actual  hours  of  direct  labor.  SR  =  Standard  variable  manufacturing  

overhead  rate  per  direct  labor  hour.  SH  =  Standard  hours  of  direct  labor  for  
actual  level  of  activity.  

*Since  variable  overhead  is  not  purchased  per  direct  labor  hour,  the  actual  
rate  (AR)  is  not  used  in  this  calculation.  Simply  use  the  total  cost  of  variable  
manufacturing  overhead  instead.  

**Standard  hours  of  78,000  =  Standard  of  0.20  hours  per  unit  ×  390,000  
actual  units  produced  and  sold.  
†
 $273,000  standard  variable  overhead  costs  match  the  flexible  budget  
presented  in  ,  part  2.  

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 ‡
 $18,750  unfavorable  variable  overhead  spending  variance  =  $360,000  –  
$341,250.  Variance  is  unfavorable  because  the  actual  variable  overhead  
costs  are  higher  than  the  expected  costs  given  actual  hours  of  97,500.  
§
 $68,250  unfavorable  variable  overhead  efficiency  variance  =  $341,250  –  
$273,000.  Variance  is  unfavorable  because  the  actual  hours  of  97,500  are  
higher  than  the  expected  (budgeted)  hours  of  78,000.  
2. Possible  causes  of  unfavorable  variable  overhead  spending  variance  are  
1. A  higher  mix  of  skilled  indirect  labor  workers  caused  hourly  rates  to  
be  higher  than  anticipated;  
2. Utility  costs  to  run  the  machines  were  higher  than  anticipated  due  to  a  
nationwide  increase  in  energy  costs;  
3. A  shortage  in  available  indirect  materials  caused  costs  to  increase  
unexpectedly.  
Possible  causes  of  unfavorable  variable  overhead  efficiency  variance  are  
1.  A  higher  mix  of  unskilled  workers  than  anticipated  caused  inefficiencies;  
2.  Cutbacks  in  training  reduced  the  expected  efficiency  of  direct  labor  
workers;  
3.  Old  equipment  breaking  down  caused  workers  to  waste  time  waiting  for  
repairs.  

10.6 Determining Which Cost Variances to Investigate

L E A R N I N G   O B J E C T I V E  

1. Determine  which  variances  to  investigate.  

Question: Companies rarely investigate all variances because there is a cost associated with
identifying the causes of variances. This cost involves employees who spend time talking with
personnel from areas including purchasing and production to determine why variances occurred

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 and how to control costs in the future. What can managers do to reduce the cost of investigating
variances?

Answer: Managers typically establish criteria to determine which variances to focus on rather
than simply investigating all variances. This is calledmanagement by
exception. Management by exception describes managers who focus solely on variances that are
significant.

Question: summarizes the cost variances calculated for Jerry’s Ice Cream. If you were in
charge of investigating variances at Jerry’s Ice Cream, how would you determine which
variances to focus on and which to ignore?

Figure 10.10 Summary of Cost Variances at Jerry’s Ice Cream

*From .

**From .

† From .

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 Answer: Some managers might review all unfavorable variances. However, the variable
overhead spending variance of $5,500 is not very significant relative to the other variances and
may not be worth investigating. Also, by focusing solely on unfavorable variances, managers
might overlook problems that may result from favorable variances.

Another approach might be to investigate all favorable and unfavorable variances above a certain
minimum level, calculated as a percent of the flexible budget amount. For example, management
could establish a policy to investigate all variances at or above 10 percent of the flexible budget
amount for each cost. At Jerry’s Ice Cream, this would mean investigating all variances at or
above $42,000 for direct materials (= 10 percent × $420,000), $27,300 for direct labor (= 10
percent × $273,000), and $10,500 for variable overhead (= 10 percent × $105,000). Based on this
policy, the following variances would be investigated:

• Unfavorable direct materials price variance of $88,000 (≥ $42,000 minimum)

• Unfavorable direct labor rate variance of $37,800 (≥ $27,300 minimum)
• Favorable direct labor efficiency variance of $(27,300) (≥ $27,300 minimum)
• Favorable variable overhead efficiency variance of $(10,500) (≥ $10,500 minimum)

Many companies calculate and investigate variances weekly, monthly, or quarterly and focus on
trends. In this case, they may only investigate variances that are unfavorable and increasing over
time.

Whatever the approach, managers understand that investigating variances requires resources.
Thus managers must establish an efficient and cost-effective approach to analyzing variances by
weighing the benefits derived from investigating variances against the costs incurred to perform
the analysis.

Business  in  Action  10.5  

Using Cost Variances to Detect Fraud

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 Variance analysis is not only an effective way to control costs; some companies,
including The Dow Chemical Company, have found that investigating variances can
also help them detect fraudulent activities.Dow, which provides chemical, plastic, and
agricultural products to customers in 180 countries, has annual sales of
$33,000,000,000 and approximately 46,000 employees. In 1998, the company created
a department called Fraud Investigative Services (FIS) whose mission is to “deter and
prevent incidents of fraud and financial abuse through detection, investigation, and
education.”
The most common types of fraud allegations reviewed by Dow’s FIS include expense
report fraud, kickback schemes, and embezzlement. Paul Zikmund, the director of FIS,
states that “unexplainable cost variances between budget and actual amounts” are
among the warning signs he looks for in identifying fraud.
For example, suppose the actual cost for direct materials is significantly higher than the
budgeted cost. The cost accountant at Dow would begin investigating the cause of the
variance by talking with the company’s purchasing agent. The purchasing agent might
be unable (or unwilling) to explain why actual costs are so high. Further investigation
might indicate that the purchasing agent was intentionally overbilling the vendor and
receiving a kickback from the vendor.
Zikmund states that for every $1 that Dow spends on investigating fraud, the company
recovers nearly $4. He also notes that Dow’s loss per employee is far below the industry
average of $9 per employee per day. For a company with 46,000 employees, every dollar
in savings per employee adds up to a significant amount.
Sources: Paul Zikmund, “Ferreting out Fraud,” Strategic Finance, April 2003, 1–4; Dow
Chemical Company, “Home Page,”http://www.dow.com.
K E Y   T A K E A W A Y  

• Companies  often  establish  criteria  to  use  in  determining  which  variances  to  
investigate.  Some  might  investigate  all  variances  above  a  certain  dollar  amount.  
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 Others  might  investigate  variances  that  are  above  a  certain  percentage  of  the  flexible  
budget.  Or  management  might  combine  the  two  and  investigate  variances  above  a  
certain  dollar  amount  and  above  a  certain  percentage  of  the  flexible  budget.  
R E V I E W   P R O B L E M   1 0 . 6  

Use  the  solutions  to  ,  ,  and  to  complete  the  following:  

1. Calculate  the  total  variable  production  cost  variance  for  Carol’s  Cookies  using  the  
format  shown  in  .  
2. Assume  management  investigates  all  variances  at  or  above  15  percent  of  the  flexible  
budget  amount  (e.g.,  all  direct  materials  variances  at  or  above  15  percent  of  the  
direct  materials  flexible  budget  are  investigated).  Identify  which  of  the  six  variances  
calculated  for  direct  materials,  direct  labor,  and  variable  manufacturing  overhead  
management  should  investigate.  

Solution  to  Review  Problem  10.6  

1. See  the  following  figure.  

*From  .  
**From  .  

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 †
 From  .  

2. Based  on  this  policy,  the  following  variances  would  be  investigated:  
1. Direct  Materials.  Neither  variance  would  be  investigated  as  both  
variances  fall  below  $175,500  (=  15  percent  of  $1,170,000  standard  cost).  
2. Direct  Labor.  The  unfavorable  direct  labor  efficiency  variance  of  $234,000  
would  be  investigated  because  it  falls  above  $140,400  (=  15  percent  of  
$936,000  standard  cost).  
3. Variable  Overhead.  The  unfavorable  variable  overhead  efficiency  variance  
of  $68,250  would  be  investigated  because  it  falls  above  $40,950  (=  15  
percent  of  $273,000  standard  cost).  
10.7  Using  Variance  Analysis  with  Activity-­‐Based  Costing  
L E A R N I N G   O B J E C T I V E  

1. Explain  how  to  use  cost  variance  analysis  with  activity-­‐based  costing.  

Question: As discussed in , activity-based costing focuses on identifying activities required to

make a product, forming cost pools for each activity, and allocating overhead costs to products
based on the products’ use of each activity. Rather than establishing one standard variable
overhead rate and standard quantity based on one cost driver, activity-based costing establishes
several standard variable overhead rates and quantities, each having its own cost driver. How
would variance analysis be implemented for a company that uses activity-based costing?

Answer: Regardless of whether a company uses the traditional costing approach or an activity-
based costing approach, the process of performing variance analysis is the same. Similar to the
traditional costing approach, the variable overhead spending variance for activity-based costing
is calculated for each activity as follows:

Key  Equation  

Variable  overhead  spending  variance  =  Actual  cost  −  (AQ  ×  SR)  

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 The variable overhead efficiency variance is calculated for each activity using activity-based
costing as follows:

Key  Equation  

Variable  overhead  efficiency  variance  =  (AQ  ×  SR)  −  (SQ  ×  SR)  

Instead of using AH and SH to represent actual hours and standard hours as we did earlier in the
chapter, we use AQ and SQ to represent actual quantity and standard quantity for various
activities used in activity-based costing.

Let’s work through an example of variance analysis using activity-based costing. Suppose
Jerry’s Ice Cream identified three significant activities and established three standard rates to
allocate variable manufacturing overhead instead of one rate based on direct labor hours.
Information for the three activities for last year is:

Standard Quantity Actual

Activity Standard Rate per Unit Produced Costs Actual Quantity

Purchase $25 per purchase 1,600 purchase

orders order 0.01 orders per unit $42,000 orders

Product $0.20 per test 180,000 test

testing minute 1 minute per unit $31,000 minutes

$0.05 per minute of 575,000 minutes of

Energy machine time 2 minutes per unit $27,000 machine time

Recall that Jerry’s produced 210,000 units for the year. shows the resulting variable overhead
variance analysis. Notice that the format for is the same as for . The variance calculations are
also the same except variances are calculated for three activities rather than one. Note that total
actual variable overhead costs remain at $100,000, but they are simply broken out into 3
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 activities ($100,000 = $42,000 for purchase orders + $31,000 for product testing + $27,000 for
energy costs). Also, the flexible budget presented in , totaling $115,500, differs from the flexible
budget presented earlier since Jerry’s is using a different cost system in this example, which
often results in different budgeted amounts ($115,500 = $52,500 purchase orders + $42,000
product testing + $21,000 energy).

Figure 10.11 Variable Overhead Variance Analysis for Jerry’s Ice Cream Using Activity-Based
Costing

Note: AQ = Actual quantity of activity. SR = Standard variable manufacturing overhead rate per
unit of activity. SQ = Standard quantity of activity given actual production of 210,000 units.

*Standard quantity of 2,100 purchase orders = Standard of 0.01 purchase orders per unit ×
210,000 actual units produced.

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 **$2,000 unfavorable variable overhead spending variance = $42,000 −$40,000. Variance is
unfavorable because the actual variable overhead cost is higher than the expected cost given
actual quantity of 1,600 purchase orders.

† $(12,500) favorable variable overhead efficiency variance = $40,000 – $52,500. Variance is

favorable because the 1,600 actual purchase orders are lower than the 2,100 expected (budgeted)
purchase orders.

This type of costing system and resulting variance analysis provides management with further
information regarding variable overhead costs and variances. As discussed earlier, management
often establishes criteria to decide which variances to investigate. Assume that management of
Jerry’s Ice Cream chooses to investigate the $7,750 unfavorable efficiency variance associated
with energy. The management would like to know why 575,000 minutes of actual machine time
were used instead of the expected 420,000 minutes. Perhaps the machines were operating poorly
due to cutbacks in maintenance, or maybe new employees were not as efficient using the
machines. Whatever the cause, Jerry’s has identified the issue by integrating its activity-based
costing system with the cost variance analysis concepts discussed in this chapter.

K E Y   T A K E A W A Y  

• Using  cost  variance  analysis  with  activity-­‐based  costing  is  much  like  using  cost  
variance  analysis  with  traditional  costing.  Both  utilize  a  spending  variance  and  an  
efficiency  variance.  However,  activity-­‐based  costing  requires  calculating  a  spending  
and  efficiency  variance  for  each  activity  rather  than  only  one  activity  base  typically  
used  in  traditional  costing.  
R E V I E W   P R O B L E M   1 0 . 7  

Assume  Carol’s  Cookies  uses  activity-­‐based  costing  to  allocate  variable  manufacturing  
overhead  costs  instead  of  one  rate  based  on  direct  labor  hours.  Carol  identified  three  
activities  with  the  following  information  for  last  year.  

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 Standard Quantity Actual
Activity Standard Rate per Unit Produced Costs Actual Quantity

Indirect
materials $0.60 per pound 0.5 pounds per unit $130,000 220,000 pounds

Product $0.10 per test

testing minute 2 minutes per unit $ 60,000 750,000 test minutes

$0.12 per minute of 1,400,000 minutes

Energy machine time 4 minutes per unit $170,000 of machine time

Recall  that  Carol’s  Cookies  produced  and  sold  390,000  units  for  the  year.  Prepare  a  
variance  analysis  for  Carol’s  Cookies  using  the  format  shown  in.  

Solution  to  Review  Problem  10.7  

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Note:  AQ  =  Actual  quantity  of  activity.  SR  =  Standard  variable  manufacturing  
overhead  rate  per  unit  of  activity.  SQ  =  Standard  quantity  of  activity  given  actual  
production  of  210,000  units.  

*Standard  quantity  of  195,000  pounds  =  Standard  of  0.5  pounds  per  unit  ×  390,000  
actual  units  produced.  

**$(2,000)  favorable  variable  overhead  spending  variance  =  $130,000  –  $132,000.  

Variance  is  favorable  because  the  actual  variable  overhead  cost  is  lower  than  the  
expected  cost  given  actual  quantity  of  220,000  pounds.  

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 †
 $15,000  unfavorable  variable  overhead  efficiency  variance  =  $132,000  –  $117,000.  
Variance  is  unfavorable  because  the  220,000  actual  pounds  is  higher  than  the  195,000  
expected  (budgeted)  pounds.  
 

10.8 Fixed Manufacturing Overhead Variance Analysis

L E A R N I N G   O B J E C T I V E  

1. Calculate  and  analyze  fixed  manufacturing  overhead  variances.  

Question: Many organizations also analyze fixed manufacturing overhead variances. Recall
from earlier chapters that manufacturing companies are required to assign fixed manufacturing
overhead costs to products for financial reporting purposes (this is called absorption costing). It
is common for companies such as Jerry’s Ice Cream to apply fixed manufacturing overhead
costs to products based on direct labor hours, machine hours, or some other activity. Companies
using a standard costing system apply fixed overhead based on a standard dollar amount per
unit produced (this calculation is shown in the footnote to ). Assume Jerry’s uses direct labor
hours to assign fixed overhead costs to products shown in . How is this information used to
perform fixed overhead cost variance analysis?

Answer: It is important to start by noting that fixed overhead in the master budget is the same as
fixed overhead in the flexible budget because, by definition, fixed costs do not change with
changes in units produced. Thus budgeted fixed overhead costs of $140,280 shown in will
remain the same even though Jerry’s actually produced 210,000 units instead of the master
budget expectation of 200,400 units.

Figure 10.12 Fixed Manufacturing Overhead Information for Jerry’s Ice Cream

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Fixed manufacturing overhead variance analysis involves two separate variances: the spending
variance and the production volume variance. We show both variances in , and provide further
detail following the figure.

Figure 10.13 Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream

*From , the direct labor budget is 20,040 budgeted direct labor hours = 200,400 units budgeted
to be produced × 0.10 direct labor hours per unit.

**Standard hours of 21,000 = 210,000 actual units produced and sold × Standard of 0.10 hours
per unit.

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 † $140,280 is the original budget presented in the manufacturing overhead budget shown in . The
flexible budget amount for fixed overhead does not change with changes in production, so this
amount remains the same regardless of actual production.

‡ $(4,280) favorable fixed overhead spending variance = $136,000 – $140,280. Variance is

favorable because the actual fixed overhead costs are lower than the budgeted costs.

§ $(6,720) favorable fixed overhead volume variance = $140,280 – $147,000. Variance is

favorable because the volume of goods produced and sold was higher than expected.

Fixed Overhead Spending Variance Calculation

Question: How is the fixed overhead spending variance calculated?

Answer: The fixed overhead spending variance is the difference between actual and budgeted
fixed overhead costs. As shown in , Jerry’s Ice Cream incurred $136,000 in fixed overhead costs
for the year. Budgeted fixed overhead costs totaled $140,280. Thus the spending variance is
calculated as follows:

Key  Equation  

Fixed  overhead  spending  variance  =  Actual  costs  −  Budgeted  costs  

Fixed overhead spending variance=Actual costs − Budgeted costs=$136,000−$140,280=($4,280)

favorable  

Because fixed overhead costs are not typically driven by activity, Jerry’s cannot attribute any
part of this variance to the efficient (or inefficient) use of labor. In fact, there is no efficiency
variance for fixed overhead. Instead, Jerry’s must review the detail of actual and budgeted costs
to determine why the favorable variance occurred. For example, factory rent, supervisor salaries,

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 or factory insurance may have been lower than anticipated. Further investigation of detailed costs
is necessary to determine the exact cause of the fixed overhead spending variance.

Fixed Overhead Production Volume Variance Calculation

Question: How is the fixed overhead production volume variance calculated?

Answer: Before discussing the production volume variance, a word of caution: do not equate the
fixed overhead production volume variance with the variable overhead efficiency
variance. There is no efficiency variance for fixed manufacturing overhead because, by
definition, fixed costs do not change with changes in the activity base. The fixed overhead
volume variance is solely a result of the difference in budgeted production and actual production.
The fixed overhead production volume variance is the difference between the budgeted and
applied fixed overhead costs. As shown in , Jerry’s Ice Cream budgeted $140,280 in fixed
overhead costs for the year. Fixed overhead costs applied totaled $147,000. Thus the production
volume variance is calculated as follows:

Key  Equation  

Fixed  overhead  production  volume  variance  =  Budgeted  costs  −  Applied  costs  

Fixed overhead production volume variance=Budgeted costs − Applied costs=$140,280−$147,00

0=($6,720) favorable  

The fixed overhead production volume variance is a direct result of the difference in volume
(units) between budgeted production and actual production. All other variables are held constant
including standard direct labor hours per unit (0.10) and standard rate per direct labor hour ($7).
Thus an alternative approach to this calculation can be used assuming the standard fixed
overhead cost per unit is $0.70 (= 0.10 direct labor hours per unit × $7 per direct labor hour):

Key  Equation  
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 Fixed overhead productionvolume variance=Standard fixed overheadcost per unit×(Budgeted uni
tsproduced−Actual unitsproduced)  

Fixed overhead productionvolume variance($6,720) favorable=Standard fixed overheadcost per

unit=$0.70××(Budgeted unitsproduced(200,400budgeted units−−Actual unitsproduced)210,000a
ctual units)  

The fixed overhead production volume variance is favorable because the company produced and
sold more units than anticipated.

Comparison of Fixed and Variable Overhead Variances

Question: What are the similarities and differences between the fixed and variable overhead
variances?

Answer: summarizes the similarities and differences between variable and fixed overhead
variances. Notice that the efficiency variance is not applicable to the fixed overhead variance
analysis.

Figure 10.14 Comparison of Variable and Fixed Manufacturing Overhead Variance Analysis for
Jerry’s Ice Cream

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*Information is from .

**For variable manufacturing overhead, the flexible budget is the same as variable overhead
applied to production.

†
Information is from .

K E Y   T A K E A W A Y  

• Two  variances  are  calculated  and  analyzed  when  evaluating  fixed  manufacturing  
overhead.  The  fixed  overhead  spending  variance  is  the  difference  between  actual  and  
budgeted  fixed  overhead  costs.  Thefixed  overhead  production  volume  variance  is  the  
difference  between  budgeted  and  applied  fixed  overhead  costs.  There  is  no  efficiency  
variance  for  fixed  manufacturing  overhead.  
R E V I E W   P R O B L E M   1 0 . 8  
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 This  review  problem  is  based  on  the  budget  information  presented  inreview  problems  
and  variance  analysis  information  presented  in  review  problems.  The  following  
information  is  for  Carol’s  Cookies:  

Calculate  the  fixed  overhead  spending  and  production  volume  variances  using  the  
format  shown  in  .  

Solution  to  Review  Problem  10.8  

*Standard  hours  of  78,000  =  390,000  actual  units  produced  and  sold  x  standard  of  
0.20  hours  per  unit.  

**$5,340  unfavorable  fixed  overhead  spending  variance  =  $270,000  –  $264,660.  

Variance  is  unfavorable  because  the  actual  fixed  overhead  costs  are  higher  than  the  
budgeted  costs.  
†
 $7,260  unfavorable  fixed  overhead  volume  variance  =  $264,660  –  $257,400.  
Variance  is  unfavorable  because  the  volume  of  goods  produced  and  sold  was  lower  
than  expected.  

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10.9 Appendix: Recording Standard Costs and Variances

L E A R N I N G   O B J E C T I V E  

1. Explain  how  to  record  standard  costs  and  variances  using  journal  entries.  

This chapter has focused on performing variance analysis to evaluate and control operations.
Standard costing systems assist in this process and often involve recording transactions using
standard cost information. When accountants use a standard costing system to record
transactions, companies are able to quickly identify variances. In addition, inventory and related
cost of goods sold are valued using standard cost information, which simplifies the bookkeeping
process.

Recording Direct Materials Transactions

Question: In Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream", we
calculated two variances for direct materials at Jerry’s Ice Cream: materials price variance and
materials quantity variance. How are these variances recorded for transactions related to direct
materials?

Answer: Two journal entries are needed to record direct materials transactions that include these
variances. An example of each is shown next. (Typically, many more journal entries would be
made throughout the year for direct materials. For the purposes of this example, we will make
one journal entry for each variance to summarize the activity for the year.)

Materials Price Variance

The entry to record the purchase of direct materials and related price variance shown
in Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream" is

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Notice that the raw materials inventory account contains the actual quantity of direct
materials purchased at the standard price. Accounts payable reflects the actual cost, and
the materials price variance account shows the unfavorable variance. Unfavorable
variances are recorded as debits and favorable variances are recorded as credits.
Variance accounts are temporary accounts that are closed out at the end of the financial
reporting period. We show the process of closing out variance accounts at the end of this
appendix.
Materials  Quantity  Variance  

The entry to record the use of direct materials in production and related quantity variance shown
in Figure 10.4 "Direct Materials Variance Analysis for Jerry’s Ice Cream" is

Work-in-process inventory reflects the standard quantity of direct materials allowed at the
standard price. The reduction in raw materials inventory reflects the actual quantity used at the
standard price, and the materials quantity variance account shows the favorable variance.

Recording Direct Labor Transactions

Question: In Figure 10.6 "Direct Labor Variance Analysis for Jerry’s Ice Cream", we calculated
two variances for direct labor at Jerry’s Ice Cream: labor rate variance and labor efficiency
variance. How are these variances recorded for transactions related to direct labor?
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 Answer: Because labor is not inventoried for later use like materials, only one journal entry is
needed to record direct labor transactions that include these variances. (Again, many more
journal entries would typically be made throughout the year for direct labor. For the purposes of
this example, we will make one journal entry to summarize the activity for the year.)

Labor Rate and Efficiency Variances

The entry to record the cost of direct labor and related variances shown inFigure 10.6 "Direct
Labor Variance Analysis for Jerry’s Ice Cream" is

Work-in-process inventory reflects the standard hours of direct labor allowed at the standard rate.
The labor rate and efficiency variances represent the difference between work-in-process
inventory (at the standard cost) and actual costs recorded in wages payable.

Recording Manufacturing Overhead Transactions

Question: As discussed in Chapter 2 "How Is Job Costing Used to Track Production Costs?", the
manufacturing overhead account is debited for all actual overhead expenditures and credited
when overhead is applied to products. At the end of the period, the balance in manufacturing
overhead, representing overapplied or underapplied overhead, is closed out to cost of goods
sold. This overapplied or underapplied balance can be explained by combining the four
overhead variances summarized in this chapter in Figure 10.14 "Comparison of Variable and
Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream". How are these
variances recorded for transactions related to manufacturing overhead?

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 Answer: Based on the information at the left side of Figure 10.14 "Comparison of Variable and
Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice Cream", the entry to record
actual overhead expenditures is

The credit goes to several different accounts depending on the nature of the expenditure. For
example, if the expenditure is for indirect materials, the credit goes to accounts payable. If the
expenditure is for indirect labor, the credit goes to wages payable.

The next entry reflects overhead applied to products. This information comes from the right side
of Figure 10.14 "Comparison of Variable and Fixed Manufacturing Overhead Variance Analysis
for Jerry’s Ice Cream".

At this point, manufacturing overhead has a $16,000 credit balance, which represents
overapplied overhead ($16,000 = $252,000 applied overhead – $236,000 actual overhead). The
following summary of fixed and variable overhead variances shown in Figure 10.14
"Comparison of Variable and Fixed Manufacturing Overhead Variance Analysis for Jerry’s Ice
Cream"explains the overapplied amount of $16,000:

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Recording Finished Goods Transactions

Question: Review all the debits to work-in-process inventory throughout this appendix and you
will see the following costs (all recorded at standard cost):

How are these costs transferred from work-in-process inventory to finished good inventory when
the goods are completed?

Answer: When the 210,000 units are completed, the following entry is made to transfer the costs
out of work-in-process inventory and into finished goods inventory.

Note that the standard cost per unit was established at $4.50, which includes variable
manufacturing costs of $3.80 (see Figure 10.1 "Standard Costs at Jerry’s Ice Cream") and fixed
manufacturing costs of $0.70 (see footnote to Figure 10.12 "Fixed Manufacturing Overhead
Information for Jerry’s Ice Cream"). Total production of 210,000 units × Standard cost of $4.50
per unit equals $945,000; the same amount you see in the entry presented previously.
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 Recording Cost of Goods Sold Transactions

Question: How do we record the costs associated with products that are sold?

Answer: When finished product is sold, the following entry is made:

Note that the entry shown previously uses standard costs, which means cost of goods sold is
stated at standard cost until the next entry is made.

 
 
 

Closing Manufacturing Overhead and Variance Accounts

Question: At the end of the period, Jerry’s Ice Cream has balances remaining in manufacturing
overhead along with all the variance accounts. These accounts must be closed out at the end of
the period. How is this accomplished?

Answer: These accounts are closed out to cost of goods sold, after which point cost of goods
sold will reflect actual manufacturing costs for the products sold during the period. The
following entry is made to accomplish this goal:

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*$61,500 = $88,000 + $37,800 – $21,000 – $27,300 – $16,000.

K E Y   T A K E A W A Y  

• In  a  standard  costing  system,  all  inventory  accounts  reflect  standard  cost  information.  
The  difference  between  standard  and  actual  data  are  recorded  in  the  variance  
accounts  and  the  manufacturing  overhead  account,  which  are  ultimately  closed  out  
to  cost  of  goods  sold  at  the  end  of  the  period.  
R E V I E W   P R O B L E M   1 0 . 9  

1. Using  the  solution  to  Note  10.30  "Review  Problem  10.3",  prepare  a  journal  entry  to  
record  the  purchase  of  raw  materials.  
2. Using  the  solution  to  Note  10.30  "Review  Problem  10.3",  prepare  a  journal  entry  to  
record  the  use  of  raw  materials.  
3. Using  the  solution  to  Note  10.40  "Review  Problem  10.4",  prepare  a  journal  entry  to  
record  direct  labor  costs.  
4. Using  the  solutions  to  Note  10.49  "Review  Problem  10.5"  and  Note  10.67  "Review  
Problem  10.8",  prepare  a  journal  entry  to  record  actual  variable  and  fixed  
manufacturing  overhead  expenditures.  
5. Using  the  solutions  to  Note  10.49  "Review  Problem  10.5"  and  Note  10.67  "Review  
Problem  10.8",  prepare  a  journal  entry  to  record  variable  and  fixed  manufacturing  
overhead  applied  to  products.  
6. Based  on  the  entries  shown  in  items  1  through  5,  prepare  a  journal  entry  to  transfer  
all  work-­‐in-­‐process  inventory  costs  to  finished  goods  inventory.  

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 7. Assume  all  finished  goods  are  sold  during  the  period.  Prepare  a  journal  entry  to  
transfer  all  finished  goods  inventory  costs  to  cost  of  goods  sold.  
8. Based  on  the  entries  shown  in  items  1  through  7,  close  manufacturing  overhead  and  
all  variance  accounts  to  cost  of  goods  sold.  

Solution  to  Review  Problem  10.9  

1. The  following  is  a  journal  entry  to  record  purchase  of  raw  materials:  

2. The  following  is  a  journal  entry  to  record  usage  of  raw  materials:  

3. The  following  is  a  journal  entry  to  record  direct  labor  costs:  

4. The  following  is  a  journal  entry  to  record  actual  overhead  expenditures:  

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5. The  following  is  a  journal  entry  to  record  overhead  applied  to  production:  

6. The  product  cost  data  recorded  in  work-­‐in-­‐process  inventory  for  the  period  is  
as  follows:  

Thus  the  journal  entry  to  transfer  these  production  costs  from  work  in  
process  to  finished  goods  is:  

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 7. The  following  is  a  journal  entry  to  record  transfer  of  finished  goods  to  cost  of  
goods  sold:  

8. The  following  is  a  journal  entry  to  close  out  manufacturing  overhead  and  all  
variance  accounts:  

*$186,100  =  $78,000  +  $234,000  +  $99,600  –  $128,000  –  $97,500.  

**$99,600  underapplied  overhead  =  $630,000  actual  overhead  costs  –  

$530,400  applied  overhead.  Because  this  represents  a  debit  balance  in  
manufacturing  overhead,  the  account  must  be  credited  to  close  it.  To  
further  prove  this  is  accurate,  the  sum  of  all  overhead  variances  must  equal  
$99,600  unfavorable  as  shown  in  the  following:  
$18,750 unfavorable (fromNote 10.49 "Review
Variable overhead spending variance Problem 10.5")

Variable overhead efficiency $68,250 unfavorable (fromNote 10.49 "Review

variance Problem 10.5")

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 $5,340 unfavorable (from Note 10.67 "Review
Fixed overhead spending variance Problem 10.8")

Fixed overhead production volume $7,260 unfavorable (from Note 10.67 "Review
variance Problem 10.8")

Total manufacturing overhead

variance $99,600 unfavorable

E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  
1. Explain  how  a  flexible  budget  differs  from  a  master  budget.  
2. Assume  you  are  the  production  manager  for  a  manufacturing  company  that  
anticipated  selling  40,000  units  of  product  for  the  master  budget  and  actually  sold  
50,000  units.  Why  would  you  prefer  to  be  evaluated  using  a  flexible  budget  for  direct  
labor  rather  than  the  master  budget?  
3. What  is  a  standard  cost,  and  how  does  it  differ  from  a  budgeted  cost?  
4. How  are  standards  established  for  direct  materials,  direct  labor,  and  variable  
manufacturing  overhead?  
5. Explain  what  management  is  trying  to  evaluate  in  reviewing  the  materials  price  
variance  and  materials  quantity  variance.  Be  sure  to  include  the  formula  for  each  
variance  in  your  explanation.  
6. Explain  what  management  is  trying  to  evaluate  in  reviewing  the  labor  rate  variance  
and  labor  efficiency  variance.  Be  sure  to  include  the  formula  for  each  variance  in  your  
explanation.  
7. Explain  how  an  unfavorable  labor  rate  variance  might  cause  a  favorable  labor  
efficiency  variance  and  favorable  materials  quantity  variance.  

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 8. The  production  manager  just  received  a  report  indicating  an  unfavorable  labor  rate  
variance.  Further  investigation  reveals  that  the  sales  department  accepted  a  large  
rush  order.  Who  should  be  held  responsible  for  the  unfavorable  variance?  Explain.  
9. Refer  to  Note  10.38  "Business  in  Action  10.3"  Why  is  direct  labor  variance  analysis  
particularly  important  for  United  Airlines?  
10. Are  favorable  variances  always  a  result  of  good  management  decisions?  Explain.  
11. Do  most  companies  investigate  all  variances?  Explain.  
12. How  is  variable  overhead  variance  analysis  similar  for  companies  using  activity-­‐based  
costing  and  companies  using  traditional  costing?  
13. What  causes  the  fixed  overhead  production  volume  variance?  
14. (Appendix).  Why  are  direct  materials  and  direct  labor  variance  accounts  needed  in  a  
standard  costing  system?  What  happens  to  these  accounts  at  the  end  of  the  period?  

Brief  Exercises  
15. Analyzing  Costs  at  Jerry’s  Ice  Cream.  Refer  to  the  dialogue  at  Jerry’s  Ice  Cream  
presented  at  the  beginning  of  the  chapter.  What  happened  with  direct  labor  and  
direct  materials  costs  at  Jerry’s  Ice  Cream?  What  did  Jerry,  the  owner,  ask  Michelle  to  
do?  
16. Direct  Materials  Standard  Cost  and  Flexible  Budget.  Manhattan  Company  produces  
high-­‐quality  chairs.  Each  chair  requires  a  standard  quantity  of  10  board  feet  of  wood  
at  $5  per  board  foot.  Production  for  July  totaled  3,000  units.  Calculate  (a)  standard  
cost  per  unit  for  direct  materials  and  (b)  flexible  budget  amount  for  direct  materials  
for  the  month  of  July.  
17. Direct  Labor  Standard  Cost  and  Flexible  Budget.  Manhattan  Company  produces  high-­‐
quality  chairs.  Each  chair  requires  a  standard  quantity  of  8  direct  labor  hours  at  $15  
per  hour.  Production  for  July  totaled  3,000  units.  Calculate  (a)  standard  cost  per  unit  
for  direct  labor  and  (b)  flexible  budget  amount  for  direct  labor  for  the  month  of  July.  

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 18. Variable  Overhead  Standard  Cost  and  Flexible  Budget.  Manhattan  Company  
produces  high-­‐quality  chairs.  Variable  manufacturing  overhead  is  applied  at  a  
standard  rate  of  $10  per  machine  hour.  Each  chair  requires  a  standard  quantity  of  
three  machine  hours.  Production  for  July  totaled  3,000  units.  Calculate  (a)  standard  
cost  per  unit  for  variable  overhead  and  (b)  flexible  budget  amount  for  variable  
overhead  for  the  month  of  July.  
19. Materials  Price  Variance.  Sweets  Company  produces  boxes  of  chocolate.  The  
company  expects  to  pay  $5  a  pound  for  chocolate.  Sweets  purchased  4,000  pounds  of  
chocolate  during  the  month  of  April  for  $4.80  per  pound.  Calculate  the  materials  price  
variance  for  the  month  of  April.  
20. Materials  Quantity  Variance.  Sweets  Company  produces  boxes  of  chocolate.  A  
standard  of  2  pounds  of  material  is  expected  to  be  used  for  each  box  produced,  at  a  
cost  of  $5  per  pound.  Sweets  produced  1,000  boxes  of  chocolate  during  the  month  of  
April  and  used  2,200  pounds  of  chocolate.  Calculate  the  materials  quantity  variance  
for  the  month  of  April.  
21. Labor  Rate  Variance.  Tech  Company  produces  computer  servers.  The  company’s  
standards  show  an  expected  direct  labor  rate  of  $20  per  hour.  Tech’s  direct  labor  
workforce  worked  3,200  hours  to  produce  300  units  during  the  month  of  August  and  
was  paid  $22  per  direct  labor  hour.  Calculate  the  labor  rate  variance  for  the  month  of  
August.  
22. Labor  Efficiency  Variance.  Tech  Company  produces  computer  servers.  The  company’s  
standards  show  that  each  server  will  require  10  hours  of  direct  labor  at  $20  per  hour.  
Tech  produced  300  units  during  the  month  of  August  and  direct  labor  hours  totaled  
3,200  for  the  month.  Calculate  the  labor  efficiency  variance  for  the  month  of  August.  
23. Variable  Overhead  Spending  Variance.  Tech  Company  produces  computer  servers.  
Variable  overhead  is  allocated  to  each  server  based  on  a  standard  of  $100  per  
machine  hour.  A  total  of  850  machine  hours  were  used  during  the  month  of  August  
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 and  variable  overhead  costs  totaled  $96,000.  Calculate  the  variable  overhead  
spending  variance  for  the  month  of  August.  
24. Variable  Overhead  Efficiency  Variance.  Tech  Company  produces  computer  servers.  
Variable  overhead  is  allocated  to  each  server  based  on  a  standard  of  $100  per  
machine  hour  and  3  machine  hours  per  server.  A  total  of  850  machine  hours  were  
used  during  the  month  of  August  to  produce  300  servers.  Calculate  the  variable  
overhead  efficiency  variance  for  the  month  of  August.  
25. Investigating  Variances.  Fiber  Optic,  Inc.,  investigates  all  variances  above  10  percent  
of  the  flexible  budget.  The  flexible  budget  for  direct  materials  is  $50,000.  The  direct  
materials  price  variance  is  $4,000  unfavorable  and  the  direct  materials  quantity  
variance  is  $(6,000)  favorable.  Which  variances  should  be  investigated  according  to  
company  policy?  Show  calculations  to  support  your  answer.  
26. Spending  Variance  Using  Activity-­‐Based  Costing.  Albany,  Inc.,  uses  activity-­‐based  
costing  to  allocate  variable  manufacturing  overhead  costs  to  products.  One  of  the  
activities  used  to  allocate  these  costs  is  product  testing.  The  standard  rate  is  $15  per  
test  hour.  The  cost  for  this  activity  during  June  totaled  $2,000,  and  actual  test  time  
during  June  totaled  120  hours.  Calculate  the  spending  variance  for  this  activity  for  the  
month  of  June,  and  clearly  label  whether  the  variance  is  favorable  or  unfavorable.  
27. Fixed  Overhead  Spending  Variance.  Sampson  Company  applies  fixed  manufacturing  
overhead  costs  to  products  based  on  direct  labor  hours.  Budgeted  direct  labor  hours  
for  the  month  of  January  totaled  30,000  hours,  with  a  standard  cost  per  direct  labor  
hour  of  $12.  Actual  fixed  overhead  costs  totaled  $350,000  for  January.  Calculate  the  
fixed  overhead  spending  variance  for  January,  and  clearly  label  whether  the  variance  
is  favorable  or  unfavorable.  
28. (Appendix)  Journalizing  the  Purchase  of  Raw  Materials.  Mill  Company  purchased  
40,000  pounds  of  raw  materials  on  account  for  $3.40  per  pound.  The  standard  price  is  

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 $3  per  pound.  Prepare  a  journal  entry  to  record  this  transaction  assuming  the  
company  uses  a  standard  costing  system.  

Exercises:  Set  A  
29. Standard  Cost  and  Flexible  Budget.  Hal’s  Heating  produces  furnaces  for  
commercial  buildings.  The  company’s  master  budget  shows  the  following  
standards  information.  
Expected production for January 300 furnaces

Direct materials 3 heating elements at $40 per element

Direct labor 35 hours per furnace at $18 per hour

Variable manufacturing overhead 35 direct labor hours per furnace at $15 per hour

30. Required:  
a. Calculate  the  standard  cost  per  unit  for  direct  materials,  direct  labor,  
and  variable  manufacturing  overhead  using  the  format  shown  in  Figure  10.1  
"Standard  Costs  at  Jerry’s  Ice  Cream".  
b. Assume  Hal’s  Heating  produced  320  furnaces  during  January.  Prepare  a  
flexible  budget  for  direct  materials,  direct  labor,  and  variable  manufacturing  
overhead  using  the  format  shown  in  Figure  10.2  "Flexible  Budget  for  
Variable  Production  Costs  at  Jerry’s  Ice  Cream".  
Materials  and  Labor  Variances.  Hal’s  Heating  produces  furnaces  for  
commercial  buildings.  (This  is  the  same  company  as  the  previous  exercise.  
This  exercise  can  be  assigned  independently.)  

For  direct  materials,  the  standard  price  for  a  heating  element  part  is  $40.  A  
standard  quantity  of  3  heating  elements  is  expected  to  be  used  in  each  
furnace  produced.  During  January,  Hal’s  Heating  purchased  1,000  heating  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 elements  for  $38,000  and  used  980  heating  elements  to  produce  320  
furnaces.  

For  direct  labor,  Hal’s  Heating  established  a  standard  number  of  direct  labor  
hours  at  35  hours  per  furnace.  The  standard  rate  is  $18  per  hour.  A  total  of  
10,000  direct  labor  hours  were  worked  during  January,  at  a  cost  of  
$190,000,  to  produce  320  furnaces.  
Required:  
 . Calculate  the  materials  price  variance  and  materials  quantity  variance  
using  the  format  shown  in  Figure  10.4  "Direct  Materials  Variance  Analysis  
for  Jerry’s  Ice  Cream".  Clearly  label  each  variance  as  favorable  or  
unfavorable.  
a. Calculate  the  labor  rate  variance  and  labor  efficiency  variance  using  the  
format  shown  in  Figure  10.6  "Direct  Labor  Variance  Analysis  for  Jerry’s  Ice  
Cream".  Clearly  label  each  variance  as  favorable  or  unfavorable.  
Variable  Overhead  Variances.  Hal’s  Heating  produces  furnaces  for  
commercial  buildings.  (This  is  the  same  company  as  the  previous  exercises.  
This  exercise  can  be  assigned  independently.)  The  company  applies  variable  
manufacturing  overhead  at  a  standard  rate  of  $15  per  direct  labor  hour.  
The  standard  quantity  of  direct  labor  is  35  hours  per  unit.  Variable  overhead  
costs  totaled  $190,000  for  the  month  of  January.  A  total  of  10,000  direct  
labor  hours  were  worked  during  January  to  produce  320  furnaces.  
Required:  
Calculate  the  variable  overhead  spending  variance  and  variable  overhead  
efficiency  variance  using  the  format  shown  in  Figure  10.8  "Variable  
Manufacturing  Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  
label  each  variance  as  favorable  or  unfavorable.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     761  
     
 
 Fixed  Overhead  Variance  Analysis.  Hal’s  Heating  produces  furnaces  
for  commercial  buildings.  (This  is  the  same  company  as  the  previous  
exercises.  This  exercise  can  be  assigned  independently.)  The  company  
applies  fixed  manufacturing  overhead  costs  to  products  based  on  direct  
labor  hours.  Information  for  the  month  of  January  appears  as  follows.  Hal’s  
expected  to  produce  and  sell  300  units  for  the  month.  

Required:  
Calculate  the  fixed  overhead  spending  variance  and  production  volume  
variance  using  the  format  shown  in  Figure  10.13  "Fixed  Manufacturing  
Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  label  each  
variance  as  favorable  or  unfavorable.  
Journalizing  Direct  Materials  and  Direct  Labor  Transactions  
(Appendix).  Hal’s  Heating  produces  furnaces  for  commercial  buildings.  (This  
is  the  same  company  as  the  previous  exercises.  This  exercise  can  be  
assigned  independently.)  

Direct  materials  and  direct  labor  variances  for  the  month  of  January  are  
shown  as  follows.  
Materials price variance $(2,000) favorable

Materials quantity variance $ 800 unfavorable

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Labor rate variance $ 10,000 unfavorable

Labor efficiency variance $(21,600) favorable

Required:  
 . The  company  purchased  1,000  elements  during  the  month  for  $38  
each.  Assuming  a  standard  price  of  $40  per  element,  prepare  a  journal  
entry  to  record  the  purchase  of  raw  materials  for  the  month.  
a. The  company  used  980  elements  in  production  for  the  month,  and  the  
flexible  budget  shows  the  company  expected  to  use  960  elements.  
Assuming  a  standard  price  of  $40  per  element,  prepare  a  journal  entry  to  
record  the  usage  of  raw  materials  in  production  for  the  month.  
b. The  company  used  10,000  direct  labor  hours  during  the  month  with  an  
actual  rate  of  $19  per  hour.  The  flexible  budget  shows  the  company  
expected  to  use  11,200  direct  labor  hours  at  a  standard  rate  of  $18  per  
hour.  Prepare  a  journal  entry  to  record  direct  labor  costs  for  the  month.  
Investigating  Variances.  Quality  Tables,  Inc.,  produces  high-­‐end  
coffee  tables.  Standard  cost  information  for  each  table  is  presented  as  
follows.  

Quality  Tables  produced  and  sold  2,000  tables  for  the  year  and  encountered  
the  following  production  variances:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     763  
     
 
  

Required:  

Company  policy  is  to  investigate  all  unfavorable  variances  above  10  percent  
of  the  flexible  budget  amount  for  direct  materials,  direct  labor,  and  variable  
overhead.  
 . Identify  the  variances  that  should  be  investigated  according  to  
company  policy.  Show  calculations  to  support  your  answer.  
a. What  potential  weakness  exists  in  the  company’s  current  policy?  
Variance  Analysis  with  Activity-­‐Based  Costing.  Assume  Mammoth  
Company  uses  activity-­‐based  costing  to  allocate  variable  manufacturing  
overhead  costs  to  products.  The  company  identified  three  activities  with  
the  following  information  for  last  quarter.  
Standard Quantity per Actual
Activity Standard Rate Unit Produced Costs Actual Quantity

Indirect
materials $2.40 per yard 7 yards per unit $691,650 265,000 yards

Product $1.50 per test 215,000 test

testing minute 5 minutes per unit $301,000 minutes

Indirect $4.50 per direct 4 hours per unit $930,000 180,000 direct

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     764  
     
 
 labor labor hour labor hours

Required:  
Assume  Mammoth  Company  produced  40,000  units  last  quarter.  
Prepare  a  variance  analysis  using  the  format  shown  in  Figure  10.11  
"Variable  Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream  Using  Activity-­‐
Based  Costing".  Clearly  label  each  variance  as  favorable  or  unfavorable.  
Closing  Variance  and  Overhead  Accounts  (Appendix).  Gonzaga  
Products  had  the  following  balances  at  the  end  of  its  fiscal  year.  
Debit Credit

Materials price variance $10,000

Materials quantity variance $8,000

Labor rate variance 6,000

Labor efficiency variance 5,000

Manufacturing overhead 14,000

Required:  
 . Prepare  a  journal  entry  to  close  the  variance  and  manufacturing  
overhead  accounts.  Assume  the  balances  are  not  significant  and  thus  are  
closed  to  cost  of  goods  sold.  
a. Assume  all  products  were  sold  and  the  company  has  no  ending  inventories.  
After  making  the  entry  in  requirementa,  does  the  balance  of  cost  of  goods  
sold  on  the  income  statement  reflect  standard  costs  or  actual  costs?  
Explain.  

Exercises:  Set  B  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 37. Standard  Cost  and  Flexible  Budget.  Outdoor  Products,  Inc.,  produces  
extreme-­‐weather  sleeping  bags.  The  company’s  master  budget  shows  the  
following  standards  information.  
Expected production for September 5,000 units

Direct materials 8 yards per unit at $5 per yard

Direct labor 3 hours per unit at $16 per hour

Variable manufacturing overhead 3 direct labor hours per unit at $2 per hour

38. Required:  
a. Calculate  the  standard  cost  per  unit  for  direct  materials,  direct  labor,  
and  variable  manufacturing  overhead  using  the  format  shown  in  Figure  10.1  
"Standard  Costs  at  Jerry’s  Ice  Cream".  
b. Assume  Outdoor  Products  produced  5,100  sleeping  bags  during  the  month  
of  September.  Prepare  a  flexible  budget  for  direct  materials,  direct  labor,  
and  variable  manufacturing  overhead  using  the  format  shown  in  Figure  10.2  
"Flexible  Budget  for  Variable  Production  Costs  at  Jerry’s  Ice  Cream".  
Materials  and  Labor  Variances.  Outdoor  Products,  Inc.,  produces  
extreme-­‐weather  sleeping  bags.  (This  is  the  same  company  as  the  previous  
exercise.  This  exercise  can  be  assigned  independently.)  

For  direct  materials,  the  standard  price  for  1  yard  of  material  is  $5  per  yard.  
A  standard  quantity  of  8  yards  of  material  is  expected  to  be  used  for  each  
sleeping  bag  produced.  During  September,  Outdoor  Products,  Inc.,  
purchased  45,000  yards  of  material  for  $238,500  and  used  39,000  yards  to  
produce  5,100  sleeping  bags.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     766  
     
 
 For  direct  labor,  Outdoor  Products,  Inc.,  established  a  standard  number  of  
direct  labor  hours  at  three  hours  per  sleeping  bag.  The  standard  rate  is  $16  
per  hour.  A  total  of  14,700  direct  labor  hours  were  worked  during  
September,  at  a  cost  of  $238,140,  to  produce  5,100  sleeping  bags.  
Required:  
 . Calculate  the  materials  price  variance  and  materials  quantity  variance  
using  the  format  shown  in  Figure  10.4  "Direct  Materials  Variance  Analysis  
for  Jerry’s  Ice  Cream".  Clearly  label  each  variance  as  favorable  or  
unfavorable.  
a. Calculate  the  labor  rate  variance  and  labor  efficiency  variance  using  the  
format  shown  in  Figure  10.6  "Direct  Labor  Variance  Analysis  for  Jerry’s  Ice  
Cream".  Clearly  label  each  variance  as  favorable  or  unfavorable.  
Variable  Overhead  Variances.  Outdoor  Products,  Inc.,  produces  
extreme-­‐weather  sleeping  bags.  (This  is  the  same  company  as  the  previous  
exercises.  This  exercise  can  be  assigned  independently.)  The  company  
applies  variable  manufacturing  overhead  at  a  standard  rate  of  $2  per  direct  
labor  hour.  The  standard  quantity  of  direct  labor  is  three  hours  per  unit.  
Variable  overhead  costs  totaled  $32,000  for  the  month  of  September.  A  
total  of  14,700  direct  labor  hours  were  worked  during  September  to  
produce  5,100  sleeping  bags.  
Required:  
Calculate  the  variable  overhead  spending  variance  and  variable  overhead  
efficiency  variance  using  the  format  shown  in  Figure  10.8  "Variable  
Manufacturing  Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  
label  each  variance  as  favorable  or  unfavorable.  
Fixed  Overhead  Variance  Analysis.  Outdoor  Products,  Inc.,  produces  
extreme-­‐weather  sleeping  bags.  (This  is  the  same  company  as  the  previous  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     767  
     
 
 exercises.  This  exercise  can  be  assigned  independently.)  The  company  
applies  fixed  manufacturing  overhead  costs  to  products  based  on  direct  
labor  hours.  Information  for  the  month  of  September  appears  as  follows.  
Outdoor  Products  expected  to  produce  and  sell  5,000  units  for  the  month.  

Required:  
Calculate  the  fixed  overhead  spending  variance  and  production  volume  
variance  using  the  format  shown  in  Figure  10.13  "Fixed  Manufacturing  
Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  label  each  
variance  as  favorable  or  unfavorable.  
Journalizing  Direct  Materials  and  Direct  Labor  Transactions  
(Appendix).  Outdoor  Products,  Inc.,  produces  extreme-­‐weather  sleeping  
bags.  (This  is  the  same  company  as  the  previous  exercises.  This  exercise  can  
be  assigned  independently.)  

Direct  materials  and  direct  labor  variances  for  the  month  of  September  are  
shown  as  follows.  
Materials price variance $13,500 unfavorable

Materials quantity variance $(9,000) favorable

Labor rate variance $ 2,940 unfavorable

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     768  
     
 
 Labor efficiency variance $(9,600) favorable

Required:  
 . The  company  purchased  45,000  yards  of  material  during  the  month  
for  $5.30  per  yard.  Assuming  a  standard  price  of  $5  per  yard,  prepare  a  
journal  entry  to  record  the  purchase  of  raw  materials  for  the  month.  
a. The  company  used  39,000  yards  of  material  in  production  for  the  month,  
and  the  flexible  budget  shows  the  company  expected  to  use  40,800  yards.  
Assuming  a  standard  price  of  $5  per  yard,  prepare  a  journal  entry  to  record  
the  usage  of  raw  materials  in  production  for  the  month.  
b. The  company  used  14,700  direct  labor  hours  during  the  month  with  an  
actual  rate  of  $16.20  per  hour.  The  flexible  budget  shows  the  company  
expected  to  use  15,300  direct  labor  hours  at  a  standard  rate  of  $16  per  
hour.  Prepare  a  journal  entry  to  record  direct  labor  costs  for  the  month.  
Investigating  Variances.  Tool  Box,  Inc.,  produces  tool  boxes  sold  at  a  
variety  of  retail  stores  throughout  the  world.  Standard  cost  information  for  
each  toolbox  is  presented  as  follows.  

Tool  Box  produced  and  sold  100,000  toolboxes  for  the  year  and  
encountered  the  following  production  variances:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     769  
     
 
  

Required:  

Company  policy  is  to  investigate  all  unfavorable  variances  above  5  percent  
of  the  flexible  budget  amount  for  direct  materials,  direct  labor,  and  variable  
overhead.  
 . Identify  the  variances  that  should  be  investigated  according  to  
company  policy.  Show  calculations  to  support  your  answer.  
a. What  recommendations  would  you  make  for  the  company’s  current  policy?  
Variance  Analysis  with  Activity-­‐Based  Costing.  Assume  Hillside  Hats,  
LLC,  uses  activity-­‐based  costing  to  allocate  variable  manufacturing  overhead  
costs  to  products.  The  company  identified  three  activities  with  the  following  
information  for  last  month.  
Standard Quantity per Actual
Activity Standard Rate Unit Produced Costs Actual Quantity

Purchase
orders $50 per order 0.10 order per unit $65,000 1,600 orders

Product $2 per test 8,000 test

testing minute 0.50 minutes per unit $17,000 minutes

Indirect $3 per direct 1 hour per unit $43,000 13,000 direct

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     770  
     
 
 labor labor hour labor hours

Required:  
Assume  Hillside  Hats  produced  15,000  units  last  month.  Prepare  a  
variance  analysis  using  the  format  shown  in  Figure  10.11  "Variable  
Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream  Using  Activity-­‐Based  
Costing".  Clearly  label  each  variance  as  favorable  or  unfavorable.  
Closing  Variance  and  Overhead  Accounts  (Appendix).  Shasta  
Company  had  the  following  balances  at  the  end  of  its  fiscal  year.  
Debit Credit

Materials price variance $8,000

Materials quantity variance 2,000

Labor rate variance $12,000

Labor efficiency variance 5,000

Manufacturing overhead 4,000

Required:  
 . Prepare  a  journal  entry  to  close  the  variance  and  manufacturing  
overhead  accounts.  Assume  the  balances  are  not  significant  and  thus  are  
closed  to  cost  of  goods  sold.  
a. Assume  all  products  were  sold  and  the  company  has  no  ending  inventories.  
After  making  the  entry  in  requirementa,  does  the  balance  of  cost  of  goods  
sold  on  the  income  statement  reflect  standard  costs  or  actual  costs?  
Explain.  

Problems  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 45. Variance  Analysis  for  Direct  Materials,  Direct  Labor,  and  Variable  
Overhead.  Rain  Gear,  Inc.,  produces  rain  jackets.  The  master  budget  shows  
the  following  standards  information  and  indicates  the  company  expected  to  
produce  and  sell  28,000  units  for  the  year.  
Direct materials 4 yards per unit at $3 per yard

Direct labor 2 hours per unit at $10 per hour

Variable manufacturing overhead 2 direct labor hours per unit at $4 per hour

46. Rain  Gear  actually  produced  and  sold  30,000  units  for  the  year.  During  the  
year,  the  company  purchased  130,000  yards  of  material  for  $429,000  and  
used  118,000  yards  in  production.  A  total  of  65,000  labor  hours  were  
worked  during  the  year  at  a  cost  of  $637,000.  Variable  overhead  costs  
totaled  $231,000  for  the  year.  
47. Required:  
a. Calculate  the  materials  price  variance  and  materials  quantity  variance  
using  the  format  shown  in  Figure  10.4  "Direct  Materials  Variance  Analysis  
for  Jerry’s  Ice  Cream".  Clearly  label  each  variance  as  favorable  or  
unfavorable.  
b. Calculate  the  labor  rate  variance  and  labor  efficiency  variance  using  the  
format  shown  in  Figure  10.6  "Direct  Labor  Variance  Analysis  for  Jerry’s  Ice  
Cream".  Clearly  label  each  variance  as  favorable  or  unfavorable.  
c. Calculate  the  variable  overhead  spending  variance  and  variable  overhead  
efficiency  variance  using  the  format  shown  in  Figure  10.8  "Variable  
Manufacturing  Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  
label  each  variance  as  favorable  or  unfavorable.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     772  
     
 
 d. Company  policy  is  to  investigate  all  variances  greater  than  10  percent  of  the  
flexible  budget  amount  for  each  of  the  three  variable  production  costs:  
direct  materials,  direct  labor,  and  variable  overhead.  Identify  which  of  the  
six  variances  calculated  in  requirements  a  through  cshould  be  investigated.  
e. Provide  two  possible  explanations  for  each  variance  identified  in  
requirement  d.  
Fixed  Overhead  Variance  Analysis.  (This  problem  is  a  continuation  of  
the  previous  problem  but  can  also  be  worked  independently.)  Rain  Gear,  
Inc.,  produces  rain  jackets  and  applies  fixed  manufacturing  overhead  costs  
to  products  based  on  direct  labor  hours.  Information  for  the  year  appears  
as  follows.  Rain  Gear  expected  to  produce  and  sell  28,000  units  for  the  year.  

Required:  
 . Calculate  the  fixed  overhead  spending  variance  and  production  
volume  variance  using  the  format  shown  inFigure  10.13  "Fixed  
Manufacturing  Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  
label  each  variance  as  favorable  or  unfavorable.  
a. Company  policy  is  to  investigate  all  variances  greater  than  5  percent  of  the  
flexible  budget  amount.  Identify  whether  either  of  the  two  fixed  overhead  
variances  calculated  in  requirement  a  should  be  investigated.  
b. Provide  one  possible  explanation  for  variance(s)  identified  in  
requirement  b.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     773  
     
 
 Journalizing  Direct  Materials,  Direct  Labor,  and  Overhead  
Transactions  (Appendix).  Complete  the  following  requirements  for  Rain  
Gear,  Inc.,  using  your  solutions  to  the  previous  two  problems.  
Required:  
 . Prepare  a  journal  entry  to  record  the  purchase  of  raw  materials.  
a. Prepare  a  journal  entry  to  record  the  use  of  raw  materials.  
b. Prepare  a  journal  entry  to  record  direct  labor  costs.  
c. Prepare  a  journal  entry  to  record  actual  variable  and  fixed  manufacturing  
overhead  expenditures.  
d. Prepare  a  journal  entry  to  record  variable  and  fixed  manufacturing  
overhead  applied  to  products.  
e. Based  on  the  entries  shown  in  requirements  a  through  e,  prepare  a  journal  
entry  to  transfer  all  work-­‐in-­‐process  inventory  costs  to  finished  goods  
inventory.  
f. Assume  all  finished  goods  are  sold  during  the  period.  Prepare  a  journal  
entry  to  transfer  all  finished  goods  inventory  costs  to  cost  of  goods  sold.  
g. Based  on  the  entries  shown  in  requirements  a  through  g,  close  
manufacturing  overhead  and  all  variance  accounts  to  cost  of  goods  sold.  
Variance  Analysis  for  Direct  Materials,  Direct  Labor,  and  Variable  
Overhead;  Journalizing  Direct  Materials  and  Direct  Labor  Transactions  
(Includes  Appendix).  Prefab  Pools  Company  produces  large  prefabricated  
in-­‐ground  swimming  pools  made  of  a  specialized  plastic  material.  The  
master  budget  shows  the  following  standards  information  and  indicates  the  
company  expected  to  produce  and  sell  600  units  for  the  month  of  April.  
Direct materials 500 pounds per unit at $7 per pound

Direct labor 46 hours per unit at $12 per hour

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     774  
     
 
 Variable manufacturing overhead 46 direct labor hours per unit at $30 per hour

Prefab  Pools  actually  produced  and  sold  580  units  for  the  month.  
During  the  month,  the  company  purchased  330,000  pounds  of  material  for  
$2,277,000  and  used  295,800  pounds  in  production.  A  total  of  25,520  labor  
hours  were  worked  during  the  month  at  a  cost  of  $313,896.  Variable  
overhead  costs  totaled  $790,000  for  the  month.  
Required:  
 . Calculate  the  materials  price  variance  and  materials  quantity  variance  
using  the  format  shown  in  Figure  10.4  "Direct  Materials  Variance  Analysis  
for  Jerry’s  Ice  Cream".  Clearly  label  each  variance  as  favorable  or  
unfavorable.  
a. Calculate  the  labor  rate  variance  and  labor  efficiency  variance  using  the  
format  shown  in  Figure  10.6  "Direct  Labor  Variance  Analysis  for  Jerry’s  Ice  
Cream".  Clearly  label  each  variance  as  favorable  or  unfavorable.  
b. Calculate  the  variable  overhead  spending  variance  and  variable  overhead  
efficiency  variance  using  the  format  shown  in  Figure  10.8  "Variable  
Manufacturing  Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  
label  each  variance  as  favorable  or  unfavorable.  
c. Company  policy  is  to  investigate  all  variances  at  or  above  2  percent  of  the  
flexible  budget  for  direct  materials  and  4  percent  for  direct  labor  and  
variable  overhead.  Identify  which  of  the  six  variances  calculated  in  
requirements  athrough  c  should  be  investigated.  
d. Provide  two  possible  explanations  for  each  variance  identified  in  
requirement  d.  
e. Based  on  your  answer  to  requirement  a,  prepare  a  journal  entry  to  record  
the  purchase  of  raw  materials.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     775  
     
 
 f. Based  on  your  answer  to  requirement  a,  prepare  a  journal  entry  to  record  
the  usage  of  raw  materials.  
g. Based  on  your  answer  to  requirement  b,  prepare  a  journal  entry  to  record  
direct  labor  costs.  
Fixed  Overhead  Variance  Analysis.  (This  problem  is  a  continuation  of  
the  previous  problem  but  can  be  worked  independently.)  Prefab  Pools  
Company  produces  prefabricated  in-­‐ground  swimming  pools  and  applies  
fixed  manufacturing  overhead  costs  to  products  based  on  direct  labor  
hours.  Information  for  the  month  of  April  appears  as  follows.  Prefab  Pools  
expected  to  produce  and  sell  600  units  for  the  month.  

Required:  
 . Calculate  the  fixed  overhead  spending  variance  and  production  
volume  variance  using  the  format  shown  inFigure  10.13  "Fixed  
Manufacturing  Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  
label  each  variance  as  favorable  or  unfavorable.  
a. Company  management  has  asked  you  to  investigate  the  cause  of  the  fixed  
overhead  spending  variance  calculated  in  requirement  a.  Provide  one  
possible  explanation  for  this  variance.  
Variance  Analysis  for  Direct  Materials,  Direct  Labor,  Variable  
Overhead,  and  Fixed  Overhead.  Equipment  Products,  Inc.,  produces  large  
ladders  made  of  a  specialized  metal  material.  The  master  budget  shows  the  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     776  
     
 
 following  standards  information  and  indicates  the  company  expected  to  
produce  and  sell  4,000  units  for  the  month  of  May.  
Direct materials 60 pounds per unit at $3 per pound

Direct labor 8 hours per unit at $14 per hour

Variable manufacturing overhead 8 direct labor hours per unit at $6 per hour

Equipment  Products  actually  produced  and  sold  4,400  units  for  the  
month.  During  the  month,  the  company  purchased  300,000  pounds  of  
material  for  $960,000  and  used  286,000  pounds  in  production.  A  total  of  
30,800  labor  hours  were  worked  during  the  month  at  a  cost  of  $462,000.  
Variable  overhead  costs  totaled  $195,000  for  the  month.  

With  regards  to  fixed  manufacturing  overhead,  the  company  also  

applies  these  overhead  costs  to  products  based  on  direct  labor  hours.  Fixed  
manufacturing  overhead  information  for  the  month  of  May  appears  as  
follows.  

 
Required:  
 . Calculate  the  materials  price  variance  and  materials  quantity  variance  
using  the  format  shown  in  Figure  10.4  "Direct  Materials  Variance  Analysis  
for  Jerry’s  Ice  Cream".  Clearly  label  each  variance  as  favorable  or  
unfavorable.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     777  
     
 
 a. Calculate  the  labor  rate  variance  and  labor  efficiency  variance  using  the  
format  shown  in  Figure  10.6  "Direct  Labor  Variance  Analysis  for  Jerry’s  Ice  
Cream".  Clearly  label  each  variance  as  favorable  or  unfavorable.  
b. Calculate  the  variable  overhead  spending  variance  and  variable  overhead  
efficiency  variance  using  the  format  shown  in  Figure  10.8  "Variable  
Manufacturing  Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  
label  each  variance  as  favorable  or  unfavorable.  
c. Company  policy  is  to  investigate  all  variances  greater  than  10  percent  of  the  
flexible  budget  amount  for  each  of  the  3  variable  production  costs:  direct  
materials,  direct  labor,  and  variable  overhead.  Identify  which  of  the  six  
variances  calculated  in  requirements  a  through  c  should  be  investigated.  
d. Provide  two  possible  explanations  for  each  variance  identified  in  
requirement  d.  
e. Calculate  the  fixed  overhead  spending  variance  and  production  volume  
variance  using  the  format  shown  inFigure  10.13  "Fixed  Manufacturing  
Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  label  each  
variance  as  favorable  or  unfavorable.  
Journalizing  Direct  Labor  and  Overhead  Transactions  
(Appendix).Complete  the  following  requirements  for  Equipment  Products,  
Inc.,  using  your  solutions  to  the  previous  problem.  
Required:  
 . Prepare  a  journal  entry  to  record  direct  labor  costs.  
a. Prepare  a  journal  entry  to  record  actual  variable  and  fixed  manufacturing  
overhead  expenditures.  
b. Prepare  a  journal  entry  to  record  variable  and  fixed  manufacturing  
overhead  applied  to  products.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     778  
     
 
 Variance  Analysis  with  Activity-­‐Based  Costing.  Assume  Spindle  
Company  uses  activity-­‐based  costing  to  allocate  variable  manufacturing  
overhead  costs  to  products.  The  company  identified  three  activities  with  
the  following  information  for  last  quarter.  
Standard Quantity per Actual
Activity Standard Rate Unit Produced Costs Actual Quantity

Indirect
materials $5 per yard 14 yards per unit $4,850,000 990,000 yards

Product $3 per test 650,000 test

testing minute 10 minutes per unit $2,000,000 minutes

Indirect $9 per direct 410,000 direct

labor labor hour 6 hours per unit $3,800,000 labor hours

Required:  
 . Assume  Spindle  Company  produced  70,000  units  last  quarter.  Prepare  
a  variance  analysis  using  the  format  shown  in  Figure  10.11  "Variable  
Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream  Using  Activity-­‐Based  
Costing".  Clearly  label  each  variance  as  favorable  or  unfavorable.  
a. Company  policy  is  to  investigate  all  variances  above  5  percent  of  the  flexible  
budget  amount  for  each  activity.  Identify  the  variances  that  should  be  
investigated  according  to  company  policy.  Show  calculations  to  support  
your  answer.  

One  Step  Further:  Skill-­‐Building  Cases  

53. Variance  Analysis  and  Fraud.  Refer  to  Note  10.47  "Business  in  Action  10.4"  and  
to  Note  10.52  "Business  in  Action  10.5"  Explain  how  cost  variance  analysis  might  help  
detect  fraud.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     779  
     
 
 54. Group  Activity:  Setting  Standards.  Form  groups  of  two  to  four  students.  
Each  group  is  to  complete  the  following  requirements.  
Required:  
a. Define  and  discuss  the  differences  between  ideal  standards  and  
attainable  standards.  
b. Assume  your  group  works  for  a  company  that  produces  wood  desks  and  
you  are  in  the  process  of  creating  attainable  direct  material  and  direct  labor  
standards.  Provide  specific  examples  of  the  items  that  might  be  included  in  
(1)  the  standard  quantity  and  standard  price  for  direct  materials  and  (2)  the  
standard  hours  and  standard  rate  for  direct  labor.  Explain  where  this  
information  might  be  obtained,  and  identify  specific  production  
inefficiencies  your  group  included  in  creating  these  standards  that  would  
not  be  included  in  ideal  standards.  
c. Discuss  the  findings  of  your  group  with  the  class.  (Optional:  your  instructor  
may  ask  you  to  submit  your  findings  in  writing.)  
Internet  Project:  Standard  Costs  and  Cost  Variances.  Systems  Applications  and  
Products  (SAP)  is  the  world’s  largest  business  software  company  with  38,000  
customers  worldwide.  Go  to  the  SAP  Web  site  athttp://www.sap.com  and  find  the  
search  feature.  Type  in  “standard  costing”  or  “cost  variance”  and  find  an  article  that  
discusses  standard  costs  and/or  cost  variances  (there  are  several  articles  to  choose  
from).  Summarize  the  article  in  a  one-­‐page  report,  and  submit  a  printed  copy  of  the  
article  with  your  report.  
Ethics  and  Setting  Standards.  Wilkes  Golf,  Inc.,  produces  golf  carts  
that  are  sold  throughout  the  world.  The  company’s  management  is  in  the  
process  of  establishing  the  standard  hours  of  direct  labor  required  to  
complete  one  golf  cart.  Assume  you  are  the  production  supervisor,  and  you  
receive  a  bonus  for  each  quarter  that  shows  a  favorable  labor  efficiency  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     780  
     
 
 variance.  That  is,  you  receive  a  bonus  for  each  quarter  showing  actual  direct  
labor  hours  that  are  fewer  than  budgeted  direct  labor  hours.  

The  management  has  asked  for  your  input  in  establishing  the  standard  
number  of  direct  labor  hours  required  to  complete  one  golf  cart.  
Required:  
 . As  the  production  supervisor,  describe  the  ethical  conflict  you  face  
when  asked  to  help  with  establishing  direct  labor  hour  standards.  
a. How  might  the  management  of  Wilkes  Golf,  Inc.,  avoid  this  conflict  and  still  
achieve  the  goal  of  obtaining  reliable  direct  labor  hour  information?  
Using  Excel  to  Perform  Budget  Versus  Actual  Analysis.  The  
management  of  Home  Products,  Inc.,  prepared  the  following  budgeted  
income  statement  for  the  year  ending  December  31,  2012.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     781  
     
 
 At  the  end  of  2012,  the  company  prepared  the  following  income  statement  
showing  actual  results:  

Required:  

Prepare  an  Excel  spreadsheet  comparing  the  actual  results  to  budgeted  
amounts  using  the  format  shown  as  follows,  and  comment  on  the  results.  

Comprehensive  Cases  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     782  
     
 
 58. Variable  Production  Cost  Variance  Analysis.  Iron  Products,  Inc.,  produces  
prefabricated  iron  fencing  used  in  commercial  construction.  Variable  
overhead  is  applied  to  products  based  on  direct  labor  hours.  The  company  
uses  a  just-­‐in-­‐time  production  system  and  thus  has  insignificant  inventory  
levels  at  the  end  of  each  month.  The  income  statement  for  the  month  of  
November  comparing  actual  results  with  the  flexible  budget  based  on  
actual  sales  of  2,000  units  is  shown  as  follows.  

Iron  Products  is  disappointed  with  the  actual  results  and  has  hired  you  as  a  
consultant  to  provide  further  information  as  to  why  the  company  has  been  
struggling  to  meet  budgeted  net  profit.  Your  review  of  the  previously  
presented  budget  versus  actual  analysis  identifies  variable  cost  of  goods  
sold  as  the  main  culprit.  The  unfavorable  variance  for  this  line  item  is  
$67,400.  

After  further  research,  you  are  able  to  track  down  the  following  standard  
cost  information  for  variable  production  costs:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Actual  production  information  related  to  variable  cost  of  goods  sold  for  the  
month  of  November  is  as  follows:  
o 2,000  units  were  produced  and  sold.  
o 110,000  pounds  of  material  were  purchased  and  used  at  a  total  cost  of  
$528,000.  
o 5,600  direct  labor  hours  were  used  during  the  month  at  a  total  cost  of  
$134,400.  
o Variable  overhead  costs  totaled  $205,000.  
Required:  
e. Calculate  the  materials  price  variance  and  materials  quantity  variance  
using  the  format  shown  in  Figure  10.4  "Direct  Materials  Variance  Analysis  
for  Jerry’s  Ice  Cream".  Clearly  label  each  variance  as  favorable  or  
unfavorable.  
f. Calculate  the  labor  rate  variance  and  labor  efficiency  variance  using  the  
format  shown  in  Figure  10.6  "Direct  Labor  Variance  Analysis  for  Jerry’s  Ice  
Cream".  Clearly  label  each  variance  as  favorable  or  unfavorable.  
g. Calculate  the  variable  overhead  spending  variance  and  variable  overhead  
efficiency  variance  using  the  format  shown  in  Figure  10.8  "Variable  
Manufacturing  Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  
label  each  variance  as  favorable  or  unfavorable.  

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 h. List  each  of  the  six  variances  calculated  in  requirementsa,  b,  and  c,  and  total  
the  variances  to  show  one  net  variance.  Clearly  label  the  net  variance  as  
favorable  or  unfavorable.  Explain  how  this  net  variance  relates  to  variable  
cost  of  goods  sold  on  the  income  statement.  
i. Identify  the  highest  favorable  variance  and  highest  unfavorable  variance  
from  the  six  listed  in  requirement  d,  and  provide  one  possible  cause  of  each  
variance.  
Variable  Production  Cost  Variance  Analysis  and  Performance  
Evaluation.  Fast  Sleds,  Inc.,  produces  snow  sleds  used  for  winter  recreation.  
Variable  overhead  is  applied  to  products  based  on  machine  hours.  The  
company  uses  a  just-­‐in-­‐time  production  system,  and  thus  has  insignificant  
inventory  levels  at  the  end  of  each  month.  The  income  statement  for  the  
month  of  January  comparing  actual  results  with  the  flexible  budget  is  
shown  in  the  following  based  on  actual  sales  of  10,000  units.  

Fast  Sleds  is  disappointed  with  the  actual  results  and  has  hired  you  as  a  
consultant  to  provide  further  information  as  to  why  the  company  has  been  
struggling  to  meet  budgeted  net  income.  Your  review  of  the  budget  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 presented  previously  versus  actual  analysis  identifies  variable  cost  of  goods  
sold  as  the  main  culprit.  The  unfavorable  variance  for  this  line  item  is  
$8,700.  

After  further  research,  you  are  able  to  track  down  the  standard  cost  
information  for  variable  production  costs:  

Actual  production  information  related  to  variable  cost  of  goods  sold  for  the  
month  of  January  is  as  follows:  
o 10,000  units  were  produced  and  sold.  
o 150,000  pounds  of  material  was  purchased  and  used  at  a  total  cost  of  
$67,500.  
o 1,900  direct  labor  hours  were  used  during  the  month  at  a  total  cost  of  
$30,400.  
o 1,200  machine  hours  were  used  during  the  month.  
o Variable  overhead  costs  totaled  $10,800.  
Required:  
e. Calculate  the  materials  price  variance  and  materials  quantity  variance  using  
the  format  shown  in  Figure  10.4  "Direct  Materials  Variance  Analysis  for  
Jerry’s  Ice  Cream".  Clearly  label  each  variance  as  favorable  or  unfavorable.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 f. Calculate  the  labor  rate  variance  and  labor  efficiency  variance  using  the  
format  shown  in  Figure  10.6  "Direct  Labor  Variance  Analysis  for  Jerry’s  Ice  
Cream".  Clearly  label  each  variance  as  favorable  or  unfavorable.  
g. Calculate  the  variable  overhead  spending  variance  and  variable  overhead  
efficiency  variance  using  the  format  shown  in  Figure  10.8  "Variable  
Manufacturing  Overhead  Variance  Analysis  for  Jerry’s  Ice  Cream".  Clearly  
label  each  variance  as  favorable  or  unfavorable.  
h. List  each  of  the  six  variances  calculated  in  requirementsa,  b,  and  c,  and  total  
the  variances  to  show  one  net  variance.  Clearly  label  the  net  variance  as  
favorable  or  unfavorable.  Explain  how  this  net  variance  relates  to  variable  
cost  of  goods  sold  on  the  income  statement.  
i. Identify  the  highest  favorable  variance  and  highest  unfavorable  variance  
from  the  six  listed  in  requirement  d,  and  provide  one  possible  cause  of  each  
variance.  
j. Sue  Mays,  the  manager  at  Fast  Sleds,  Inc.,  reviewed  the  company’s  variance  
analysis  report  for  the  month  of  January.  The  materials  price  variance  of  
$(7,500)  was  the  most  significant  favorable  variance  for  the  month,  and  the  
materials  quantity  variance  of  $15,000  was  the  most  significant  unfavorable  
variance.  Sue  would  like  to  reward  the  company’s  purchasing  agent  for  
achieving  such  substantial  savings  by  giving  him  a  $2,000  bonus  while  not  
providing  any  bonus  for  the  production  manager.  
11. Do  you  agree  with  Sue’s  approach  to  awarding  bonuses?  Explain.  
12. What  circumstances  might  lead  to  the  conclusion  that  the  purchasing  agent  
should  not  receive  a  bonus  for  the  month  of  January?  
   

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Chapter 11

How Do Managers Evaluate Performance in Decentralized Organizations?

Mandy Dwyer is the president and CEO of Game Products, Inc., a producer of games and
sporting goods sold to a variety of retail stores. Game Products, Inc., has three divisions:
Sporting Goods, Board Games, and Computer Games. Each division is relatively autonomous
with a separate manager, who independently oversees each division. Mandy Dwyer is reviewing
the results of the most recent fiscal year with Larry Meske, the company’s CFO:

In reviewing our segmented income statement, it looks like the Board Games
division had a terrific year. Profits increased substantially over last year, more
than either of the other two divisions, and overall profit for this division is well
above the other two. Carla Klesko, the Board Games division manager, is to be
commended for her fine work! We should consider revising her compensation plan
Mandy: to increase her annual bonus based on these results.

Not so quick, Mandy. I agree that the Board Games division has successfully
increased profits, but we must consider more than just the bottom line (profits) in
Larry: determining how substantial the increase is in comparison to the other divisions.

Mandy: What do you have in mind?

For starters, we should consider what resources were invested in the Board
Games division, and determine the return produced from these resources. As you
recall, Carla made a significant investment in her division, whereas the other
division managers did not. So naturally, we would expect Board Games division
Larry: profits to increase by more than the other divisions.

I’ve always focused on the bottom line for each division. What performance
Mandy: measures do you propose we use?

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 We have several options. Return on investment (ROI), residual income (RI), and
economic value added (EVA) are three commonly used measures. Perhaps we can
discuss this further next month once I’ve had a chance to pull some information
Larry: together.

Mandy: Excellent idea. I look forward to getting your ideas on this issue next month.

Mandy and Larry are looking for ways to evaluate the performance of the company’s
three division managers. Since each division is responsible for more than just the cost of
production, as was the case in Chapter 10 "How Do Managers Evaluate Performance
Using Cost Variance Analysis?", top management must evaluate how productively each
division manager is using assets to produce profits. The focus of this chapter is on how
to evaluate the performance of division managers within a decentralized organization.

11.1 Using Decentralized Organizations to Control Operations

L E A R N I N G   O B J E C T I V E  

1. Define  the  term  decentralized  organization  and  explain  advantages  and  

disadvantages  of  decentralizing.  

Question: Many types of organizations decentralize operations to better manage each segment of
the organization. What does it mean to decentralize operations?

Answer: The term used to describe this type of organizational structure isdecentralized
organizations. Decentralized organizations delegate decision-making and operational
responsibilities to the managers of each segment of the organization. (Segments are often called
divisions or subunits.) For example, universities are often segmented by discipline with one
manager, or dean, responsible for each discipline (physical education, social sciences, business,
etc.). Retail companies are often segmented by region, with one manager responsible for each
region. Service companies are often segmented by service category, with one manager
responsible for each category (e.g., an accounting firm divided into audit and tax).
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 Decentralization is not limited to a particular type of organization, and most organizations that
have grown in size and complexity decentralize to some extent.

Reasons to Decentralize

Question: Why do organizations decentralize operations?

Answer: Organizations often decentralize out of necessity as they expand. The responsibility of
one manager, or group of managers, to run the entire organization can become overwhelming as
the number of products offered increases.

For example, Game Products, Inc., began by selling two board games to several retail stores in
the northeast United States. The company did not need to decentralize at that point because it
offered only two products and the geographic region in which it sold those products was limited.

A few years later, Game Products expanded sales to Canada and the southeast Unites States,
while also venturing into the computer games industry by purchasing a small maker of computer
games. Although operations were not decentralized at this time—all decisions were still made at
headquarters—top management was beginning to feel the strain of trying to manage two
segments of the company. The decision-making process was cumbersome and slow, and the
company began to miss market opportunities that would have increased sales and profits.

Two years later, Game Products decided to enter the sporting goods market, and top management
and the board of directors agreed that decentralization was critical to the future success of the
company. As a result, they assigned a manager to run each division. This change allowed top
management to concentrate on high-level issues. such as long-range strategic planning, and it
placed the decision making in the hands of managers who were intimately familiar with the
operations of their individual divisions.

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Although Game Products ultimately decided to decentralize operations, there are advantages and
disadvantages to decentralizing. illustrates how operations would look at Game Products, Inc., if
operations were decentralized or if they remained centralized.

Figure 11.1 Decentralized Versus Centralized Organizations

Advantages  of  Decentralizing  Operations  

Question: What are the advantages of decentralizing operations for companies like Game
Products, Inc.?

Answer: Organizations like Game Products tend to decentralize as their operations grow and
become more complex. The advantages of decentralizing are as follows:

• Increased Expertise. Rather than having one manager, or a group of managers, trying to
make decisions for a wide range of products, decentralized organizations delegate
decision-making authority to local managers who have expertise in specific products.
• Quicker Decisions. By having increased expertise and decision-making authority, local
managers are able to make decisions quickly without having to wait for the approval of
the organization’s top management.
• Refocus of Top Management Responsibilities. With local managers focusing on issues
important to the specific segment, top management is able to delegate the day-to-day
decision-making responsibilities and focus on broader companywide issues, such as long-
range strategic planning.
• Motivation of Local Managers. Managers who are given more responsibility, and the
control necessary to manage their responsibility, tend to be more motivated than those
who simply follow the orders issued by top management. In addition, a decentralized
structure provides a means to train local managers for promotion to the next level of
management.
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 Provides a real-life example of an organization that benefitted from decentralizing.

Business  in  Action  11.1  

Advantages of Decentralizing at a Community College
Sierra College is located in one of the fastest growing counties in California. Student
enrollment has increased from 5 percent to 10 percent per year over the last decade.
Prior to this rapid growth, the college held each division dean responsible for most
administrative duties. For example, the dean of business and technology was
responsible for administrative duties, such as hiring faculty members and developing
the schedule of classes to be offered each semester.
As student enrollment increased, course offerings expanded, and faculty headcount
grew into the hundreds, the administrative duties became overwhelming for each
division dean. As a result, management decided to decentralize further by creating
department chair positions to help with the administrative duties related directly to
each department. This change gave each department (business, music, computer
science, etc.) more control over day-to-day activities, and it allowed the deans to focus
on larger college issues, such as strategic planning and community relations. It also
allowed for quicker responses to issues, such as faculty teaching assignments and
classroom space utilization.
Source: Based on the author’s experience.

Disadvantages of Decentralizing Operations

Question: What are the disadvantages of decentralizing operations for organizations,

such as Game Products?

Answer: The results of decentralizing operations are not always positive. Three disadvantages of
decentralizing are as follows:

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 • Duplication of Services. Organizations that decentralize often duplicate administrative
services, such as accounting and computer support. That is, each segment may have its
own accounting department and computer support department when these services might
be provided more efficiently through one companywide department.
• Conflict of Interest. Managers who are evaluated solely with respect to their divisions
have no incentive to make a decision that benefits the organization as a whole at the
expense of the manager’s division. For example, a local manager may decide to purchase
raw materials from an outside supplier even though another division within the company
can produce the same materials at a lower cost. (To make matters worse, the other
division’s manager may refuse to sell the materials at a reduced price because she is
evaluated based on her division’s profits!) The appendix to this chapter discusses this
issue in greater detail.
• Loss of Control. Perhaps one of the most difficult decisions facing small, fast-growing
organizations is whether to continue to expand and decentralize or to limit growth and
remain highly centralized. Decentralization will lead to a loss of control at top
management levels, which can have negative consequences for the organization’s
reputation if local managers struggle to maintain the level of quality that customers
expect. Decentralized organizations are only as good as the local managers who are given
decision-making authority.

Business  in  Action  11.2  

Disadvantage of Decentralizing an Accounting Firm
Arthur Andersen was a large, decentralized accounting firm with offices located
throughout the world. One or more partners operated each office independently. In
2002, Arthur Andersen had 85,000 employees worldwide. The firm was indicted in
March 2002, and later found guilty, for obstructing justice by shredding tons of
documents related to its audit work for Enron Corporation. As a result, Arthur
Andersen agreed to cease its accounting practice in the United States in August 2002.

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 By 2005, only 200 employees remained at Arthur Andersen to wrap up the
dissolution of the firm.
Although the entire firm was indicted and found guilty of obstruction of justice, the
decision to shred documents was made at the Houston office, where the bulk of the
shredding took place. This serves as an extreme example of the disadvantage of
decentralizing an organization. Decisions left to the division managers (“partners” in
this case) can have a negative effect on the entire organization.
Note that the U.S. Supreme Court overturned the guilty verdict of the U.S. District Court
in June 2005, but the damage was done and the firm did not survive.
Source: Charles Lane, “Justices Overturn Andersen Conviction,”Washington Post, June
1, 2005, http://www.washingtonpost.com.

K E Y   T A K E A W A Y  

• Decentralized  organizations  delegate  decision-­‐making  and  operational  responsibilities  

to  the  managers  of  each  segment,  or  division,  of  the  organization.  Advantages  of  
decentralized  organizations  include  increased  expertise  at  each  division,  quicker  
decisions,  better  use  of  time  at  top  management  levels,  and  increased  motivation  of  
division  managers.  Disadvantages  include  duplication  of  services,  such  as  accounting  
and  computer  support;  potential  increase  in  conflicts  between  division  manager  goals  
and  companywide  goals;  and  loss  of  control  at  the  top  management  level.  
R E V I E W   P R O B L E M   1 1 . 1  

Landscaping  Services,  Inc.,  founded  and  operated  by  Ed  Barnes,  has  seen  revenues  
double  each  year  for  the  past  three  years.  Although  Ed  has  hired  several  laborers  to  
ease  the  workload,  he  is  still  working  seven  days  a  week,  10  hours  a  day.  Ed  would  
like  to  hire  a  manager  to  assist  in  managing  landscaping  projects  and  has  asked  for  
your  advice.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 1. What  concerns  might  you  have  about  Ed’s  plan  to  decentralize  operations?  
2. How  might  decentralizing  operations  benefit  Landscaping  Services,  Inc.?  

Solution  to  Review  Problem  11.1  

1. There  are  several  potential  disadvantages  to  decentralizing.  Two  examples  

follow:  
1. For  a  relatively  small  company,  such  as  Landscaping  Services,  Inc.,  the  
biggest  concern  is  losing  control  over  quality.  Presumably  Ed  is  successful  
because  he  provides  excellent  service.  He  must  instill  the  importance  of  
maintaining  quality  to  the  new  manager.  
2. Ed  must  establish  a  compensation  system  that  encourages  the  new  
manager  to  make  decisions  in  the  best  interest  of  the  organization.  For  
example,  if  the  new  manager  encounters  an  opportunity  to  pick  up  a  new  
customer,  there  must  be  an  incentive  to  pursue  this  opportunity.  If  the  new  
manager  is  simply  given  a  monthly  salary,  there  is  no  incentive  to  increase  
the  workload!  One  approach  is  to  offer  part  ownership  in  the  company  and  
therefore  rights  to  a  percentage  of  the  company’s  profits.  

2. There  are  several  potential  advantages  to  decentralizing.  A  few  examples  

follow:  
1. Ed  can  hire  a  manager  with  expertise  in  an  area  outside  of  Ed’s  expertise,  
which  can  lead  to  additional  business  and  a  higher  level  of  quality.  
2. Clients  will  no  longer  have  to  wait  for  Ed  to  arrive  before  a  decision  is  made  
on  how  to  proceed  with  the  work.  
3. Ed  can  put  more  time  into  obtaining  new  customers.  
11.2  Maintaining  Control  over  Decentralized  Organizations  
L E A R N I N G   O B J E C T I V E  

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 1. Define  three  types  of  responsibility  centers.  

Question: To evaluate performance, organizations often divide operations into segments.

Segments responsible for revenues, costs, and investments in assets are
called responsibility centers. Responsibility centers can be based on such attributes as sales
regions, product lines, or services offered. Why do organizations establish responsibility
centers?

Answer: The purpose of establishing responsibility centers within organizations is to hold

managers responsible for only the assets, revenues, and costs they can control. For example, a
factory manager typically has control over production costs, but not sales. This manager’s
responsibility center would only include production costs. A retail store manager typically has
control over sales prices and costs. This manager’s responsibility center would only include
revenues and costs. The level of control a manager has over a segment’s assets, revenues, and
costs will help determine the type of responsibility center used for each manager.

Figure 11.2 "Three Types of Responsibility Centers" illustrates the three types of responsibility
centers commonly used to evaluate segments: cost centers, profit centers, and investment centers.
Each type is described in the following sections.

Figure 11.2 Three Types of Responsibility Centers

Cost Center

Question: What is a cost center, and what measures are used to evaluate this type of
responsibility center?

Answer: A cost center is an organizational segment that is responsible for costs, but not revenue
or investments in assets. Service departments, such as accounting, marketing, computer support,
and human resources, are cost centers. Managers of these departments are evaluated based on
providing a certain level of services for the company at a reasonable cost.

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 Production departments within a manufacturing firm are also treated as cost centers. Production
managers are evaluated based on meeting cost budgets for producing a certain level of
goods. Chapter 10 "How Do Managers Evaluate Performance Using Cost Variance
Analysis?" describes the use of cost variance analysis to evaluate cost centers within a
manufacturing firm.

Profit Center

Question: What is a profit center, and what measures are used to evaluate this type of
responsibility center?

Answer: A profit center is an organizational segment that is responsible for costs and revenues
(and therefore, profit), but not investments in assets. Retail stores for companies, such
as Macy’s or Kmart, are treated as profit centers. Individual fast food restaurants
for McDonald’s or Kentucky Fried Chicken are also examples of profit centers. Managers of
profit centers are responsible for revenues, costs, and resulting profits. (Some individual retail
stores and fast food restaurants may be considered investment centers if the store manager is also
responsible for large investment decisions, such as enlarging the building and purchasing more
equipment to accommodate additional customers. Profit center determination must be made on a
case-by-case basis, and it depends on the level of responsibility assigned to the store manager.)

Methods of performance evaluation for profit centers vary. Some organizations compare actual
profit to budgeted profit. Others compare one profit center to another. Also, some organizations
use segmented income statement ratios, such as gross margin or operating profit, to compare
current profit center performance to prior periods and to other profit centers. Chapter 13 "How
Do Managers Use Financial and Nonfinancial Performance Measures?" explains how companies
can use financial ratios to evaluate profit center performance.

Investment Center

Question: What is an investment center, and what measures are used to evaluate this type of
responsibility center?
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 Answer: An investment center is an organizational segment that is responsible for costs,
revenues, and investments in assets. Investment center managers have control over asset
investment decisions. In many cases, investment centers are treated as stand-alone businesses.
Examples of investment centers include the Chevrolet division of General Motors and the printer
division of Hewlett Packard.

Several measures can be used to evaluate the performance of investment center managers,
including segmented net income, ROI, RI, and economic value added (EVA). The remainder of
this chapter will focus on these measures using Game Products, Inc., as the example company.
Before turning to these topics, however, look at Note 11.12 "Business in Action 11.3"which
indicates the challenges that accountants and managers at Hewlett-Packard face when preparing
the company’s annual report.

Business  in  Action  11.3  

Segment Reporting at Hewlett-Packard Company
Hewlett-Packard Company provides financial information for seven segments in its
annual report. Examples of segments and related revenues (in millions) include HP
Services ($15,617), Personal Systems Group ($29,166), and Imaging and Printing Group
($26,786). These segments are likely treated as investment centers where segment
managers are responsible for costs, revenues, and investments in assets.
Source: Hewlett-Packard Company, “2006 Annual Report,”http://www.hp.com.
K E Y   T A K E A W A Y  

• Responsibility  centers  are  categorized  depending  on  the  level  of  control  over  
revenues,  costs,  or  investments.  A  segment  responsible  only  for  costs  is  called  a  cost  
center.  A  segment  responsible  for  costs  and  revenues  is  called  a  profit  center.  A  
segment  responsible  for  costs,  revenues,  and  investment  in  assets  is  called  an  
investment  center.  Performance  measures  used  to  evaluate  managers  depend  on  the  
type  of  responsibility  center  being  managed.  
R E V I E W   P R O B L E M   1 1 . 2  
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 For  each  of  the  organizational  segments  listed,  determine  whether  it  is  a  cost  center,  
profit  center,  or  investment  center.  Explain  your  answer.  
a. Individual  retail  store  at  Home  Depot  
b. Accounting  department  at  Ford  Motor  Company  
c. Saturn  division  of  General  Motors  
d. Human  resources  department  at  IBM  
e. Production  department  at  Sony  
f. Jet  engine  division  of  General  Electric  
g. Computer  support  department  at  Nike  

Solution  to  Review  Problem  11.2  

a. Profit  center.  The  manager  is  responsible  for  costs  and  revenues,  but  not  
investments  in  assets.  (A  case  might  be  made  that  if  the  manager  has  control  over  
significant  purchases  of  assets  for  the  store,  this  would  be  an  investment  center.)  
b. Cost  center.  The  manager  is  responsible  for  costs  only,  not  revenues  or  investments  
in  assets.  
c. Investment  center.  The  manager  is  responsible  for  costs,  revenues,  and  investment  
decisions.  
d. Cost  center.  The  manager  is  responsible  for  costs  only,  not  revenues  or  investments  
in  assets.  
e. Cost  center.  The  manager  is  responsible  for  costs  only,  not  revenues  or  investments  
in  assets.  
f. Investment  center.  The  manager  is  responsible  for  costs,  revenues,  and  investment  
decisions.  
g. Cost  center.  The  manager  is  responsible  for  costs  only,  not  revenues  or  investments  
in  assets.  

11.3 Comparing Segmented Income for Investment Centers

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 L E A R N I N G   O B J E C T I V E  

1. Calculate  and  interpret  segmented  net  income  to  evaluate  performance.  

Question: Now that we know an investment center is an organizational segment responsible for
costs, revenues, and investments in assets, where do we start in trying to evaluate the
performance of investment centers?

Answer: The starting point for evaluating investment centers is typically with reviewing
segmented income for each investment center (or division).Segmented income is segment
revenues minus segment expenses. Top management is interested in the level of profit that each
division generates, and segmented income gives them this information.

Revisiting Game Products, Inc.

Question: In the dialogue at the beginning of the chapter, Mandy Dwyer, president and CEO,
said she would like to increase the annual bonus for Carla Klesko, manager of the Board Games
division, based on the division’s level of profit relative to the other divisions. How does the
Board Games division profits compare with the other divisions?

Answer: Profit for the Board Games division is higher than either of the other two, as shown
in Figure 11.3 "Segmented Income Statements (Game Products, Inc.)".

Figure 11.3 Segmented Income Statements (Game Products, Inc.)

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Although this income statement looks much like a financial accounting income statement
prepared for outside users, it is for internal use and therefore, need not comply with U.S.
Generally Accepted Accounting Principles (U.S. GAAP). In fact, organizations can define
income or profit many different ways when evaluating performance. For example, some might
only look at operating income, others might exclude allocated overhead from operating income.
Another alternative is to focus on gross margin. The point is that managerial accountants must be
flexible in designing reports that best meet the needs of managers.

The president of Game Products, Inc., referred to net income when she indicated that the Board
Games division performed very well for the year. Solely based on this measure, Mandy’s
statement is accurate as the Board Games division has net income of $3,466,000 versus
$2,306,000 for the Sporting Goods division and $1,577,000 for the Computer Games division.

Limitations of Using Segmented Income to Measure Performance

Question: Although using net income for each division as a performance measure is relatively
simple, there are two significant weaknesses. What are these weaknesses?

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 Answer: First, not all divisions are of equal size. Naturally, larger divisions should produce
larger profits. It is unfair to compare net income for a smaller division with net income for a
larger division for the purpose of evaluating division manager performance. With $34,000,000 in
sales, the Board Games division should be expected to have higher net income than the other
divisions, each of which has sales of less than $30,000,000.

One solution is to compare profit margin ratios for each division (net income ÷ sales). As shown
at the bottom of Figure 11.3 "Segmented Income Statements (Game Products, Inc.)", the
Sporting Goods division has the highest profit margin ratio at 11.53 percent, compared to 10.19
percent for Board Games, and 5.44 percent for Computer Games. (Chapter 13 "How Do
Managers Use Financial and Nonfinancial Performance Measures?" presents several additional
financial ratios used to evaluate performance.)

Because each division manager has control over revenues, costs, and investments in assets, each
division is considered an investment center. Thus a second weakness in using segmented net
income information to evaluate division manager performance is that net income as the sole
measure of performance ignores the assets used to produce net income.

For example, suppose the Sporting Goods division only invested approximately $29,000,000 in
assets to produce $2,306,000 in income, while the Board Games division invested $55,000,000
in assets to produce $3,466,000 in income. Which division had the best performance? We need a
measure to evaluate how well each division performed relative to the investments made. We
discuss three such measures next.

K E Y   T A K E A W A Y  

• Investment  center  managers  are  often  evaluated  using  segment  net  income,  which  is  
segment  revenues  minus  segment  expenses.  However,  two  weaknesses  are  that  this  

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 measure  does  not  consider  the  revenues  required  to  produce  segment  net  income,  
and  this  measure  ignores  the  assets  used  to  produce  segment  net  income.  
 
 
 
R E V I E W   P R O B L E M   1 1 . 3  

Kitchen  Appliances  has  two  divisions—a  Southern  division  and  a  Northern  division.  
The  following  segmented  financial  information  is  for  the  most  recent  fiscal  year  
ended  December  31  (dollar  amounts  are  in  thousands).  
Southern Division Northern Division

Sales $5,000 $30,000

Cost of goods sold 1,500 13,000

Allocated overhead 286 1,714

Selling and administrative expenses 2,100 12,000

Assume  the  tax  rate  is  30  percent.  

1. Prepare  a  segmented  income  statement  using  the  format  presented  in  Figure  11.3  
"Segmented  Income  Statements  (Game  Products,  Inc.)".  
2. Using  net  income  as  the  measure,  which  division  is  most  profitable?  Explain  why  this  
conclusion  might  be  misleading.  
3. Calculate  the  profit  margin  ratio  and  explain  why  organizations  often  use  this  ratio  
rather  than  simply  using  net  income?  

Solution  to  Review  Problem  11.3  

1. The  segmented  income  statements  are  shown  as  follows.  

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2. The  Northern  division  is  most  profitable  with  net  income  of  $2,300,000  
versus  net  income  of  $780,000  in  the  Southern  division.  Using  net  income  
to  evaluate  which  division  is  most  profitable  can  be  misleading  because  it  
does  not  consider  the  amount  of  assets  needed  to  produce  income.  For  
example,  the  Northern  division  may  have  invested  considerably  less  in  
assets  to  produce  net  income  of  $780,000.  

Another  reason  this  may  be  misleading  is  no  consideration  is  given  to  the  
dollar  amount  of  sales  required  to  produce  the  net  income  for  each  
division.  Clearly  the  Northern  division  has  significantly  higher  sales  
($30,000,000  versus  $5,000,000  for  the  Southern  division)  and  therefore  
should  have  significantly  higher  net  income.  

3. The  profit  margin  ratio  for  the  Southern  division  is  15.60  percent  (=  $780,000  
net  income  ÷  $5,000,000  sales),  and  the  profit  margin  ratio  for  the  Northern  
division  is  7.67  percent  (=  $2,300,000  net  income  ÷  $30,000,000).  This  
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 shows  that  each  dollar  in  sales  at  the  Southern  division  generates  more  net  
income  (15.60  cents)  than  at  the  Northern  division  (7.67  cents).  

Organizations  prefer  to  use  the  profit  margin  ratio  when  comparing  
segments  because  it  serves  as  an  equalizer  in  comparing  divisions  with  
significantly  different  levels  of  sales  revenue.  

11.4 Using Return on Investment (ROI) to Evaluate Performance

L E A R N I N G   O B J E C T I V E  

1. Calculate  and  interpret  return  on  investment  (ROI)  to  evaluate  performance.  

Question: Perhaps the most common measure of performance for managers responsible for
investment centers is return on investment (ROI). What is ROI, and how is it used to evaluate
investment centers?

Answer: ROI is defined as operating income divided by average operating assets:

Key  Equation  

Return on investment=Operating incomeAverage operating assets  

Note that different organizations use different measures to calculate ROI. Our goal in this
discussion is to introduce one common approach, but keep in mind that organizations often make
adjustments to this formula to better suit their needs.

The advantage of ROI as a performance measure is that it includes the use of assets. For
example, assume 2 divisions have $10,000 in operating income. Both divisions appear to have
performed equally well based on operating income. However, further review shows that Division
1 invested $200,000 in average operating assets to produce this income while Division 2 invested
$400,000. Clearly, the division that invested half the amount in assets to produce the same

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 amount of income had the best performance of the two. Comparing the ROI for each division
proves this:

ROI for Division 1ROI for Division 2=$10,000$200,000=5%=$10,000$400,000=2.5%  

Let’s take a closer look at the components of the ROI calculation, operating income and average
operating assets.

Operating Income and Average Operating Assets

Question: What is operating income, and how does it differ from net income?

Answer: Operating income is the income produced by the division from its daily activities.
It excludes items used in the calculation of net income, such as income tax expense, interest
income, interest expense, and any unusual gains or losses. The focus is on how well the division
performed relative to its core business operations, which does not include one-time gains or
losses from the sale of property, plant, and equipment for example.

Question: What are average operating assets, and how is this amount calculated?

Answer: Average operating assets are the assets that the division has in place to run the daily
operations of the business, and this value is calculated by adding beginning period balances and
ending period balances and dividing by two. Examples of operating assets include cash, accounts
receivable, prepaid assets, buildings, and equipment. As long as the division uses the assets to
produce operating income, they are included in the operating assets category. Examples of
nonoperating assets—assets not included in this calculation—include land held for investment
purposes and office buildings leased to other companies.

An average of operating assets is taken over the period being evaluated for two reasons. First,
operating assets are often purchased and sold during an accounting period, and simply taking the
ending balance might produce distorted, if not inaccurate, results. Second, operating income
represents information for a period of time (income statements always present information for
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 a period of time), while operating assets are presented at a point in time (balance sheets always
present information for a point in time). If both of these items are to be included in one ratio
(ROI), it is best to use average balance information for balance sheet items. In fact, if the
information is readily available, it would be best to take an average of daily operating asset
balances for the period being evaluated.

Computing ROI at Game Products, Inc.

Question: Using ROI as the measure, how do the divisions at Game Products, Inc., compare with
each other?

Answer: Figure 11.3 "Segmented Income Statements (Game Products, Inc.)"shows segmented
income statement information for each of Game Products’ three divisions. The operating
income line of this income statement provides information needed for the numerator of the ROI
calculation. Figure 11.4 "Segmented Balance Sheets (Game Products, Inc.)" presents the
segmented balance sheets for each division needed to calculate average operating assets.

Figure 11.4 Segmented Balance Sheets (Game Products, Inc.)

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Let’s see how each division ranks using ROI. Assume all assets at Game Products, Inc., are
operating assets. We use the information in Figure 11.3 "Segmented Income Statements (Game
Products, Inc.)" and Figure 11.4 "Segmented Balance Sheets (Game Products, Inc.)" to calculate
the ROI for each division in Figure 11.5 "ROI Calculations (Game Products, Inc.)".

Figure 11.5 ROI Calculations (Game Products, Inc.)

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*Operating income amount is from segmented income statements presented inFigure 11.3
"Segmented Income Statements (Game Products, Inc.)".

**Average operating assets are calculated using the balance sheet information in Figure 11.4
"Segmented Balance Sheets (Game Products, Inc.)". Since all assets at Game Products, Inc., are
operating assets, total asset amounts are used in this calculation. The calculation of average
operating assets for each division is (Beginning balance of total assets + Ending balance of total
assets) ÷ 2. Average operating assets for the Sporting Goods division is $29,350 (= [$30,500 +
$28,200] ÷ 2).

^ROI = Operating income ÷ Average operating assets. For Sporting Goods division, 11.23
percent = $3,295 ÷ $29,350.

The ROI measures presented in Figure 11.5 "ROI Calculations (Game Products, Inc.)" show that
although the Board Games division has the highest operating income, its ROI ranks in the middle
of the three divisions. The Sporting Goods division has the highest ROI at 11.23 percent, Board
Games is second at 8.93 percent, and Computer Games is the lowest at 6.75 percent. Since
managers of each division are responsible for maximizing profit based on investments they make
in assets, ROI is a reasonable approach to evaluating each manager. The Sporting Goods division
manager appears to be outperforming the other two managers based on this measure.

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 Issues with ROI as a Performance Measure

Like most financial measures of performance, ROI can be calculated in several different ways.
The components of this calculation often vary from one organization to the next. These
variations are discussed next.

Operating Income Calculation—A Closer Look

Question: For the purposes of the Game Products, Inc., example, we use the same definition of
operating income that is used for financial reporting purposes in accordance with U.S. GAAP.
However, organizations often create their own unique calculation of operating income for
internal evaluation purposes. How might the internal calculation of operating income vary from
U.S. GAAP?

Answer: There are several variations that organizations use when calculating operating income.
Two of the more common variations are discussed next.

Excluding Allocated Overhead

The segmented income statements for Game Products, Inc., are presented again in Figure 11.6
"Segmented Income Statements (Game Products, Inc.)"(these are the same segmented income
statements as in Figure 11.3 "Segmented Income Statements (Game Products, Inc.)"). Notice the
expense line item labeled allocated overhead (from corporate). Although we include this expense
in calculating operating income, many organizations do not, particularly if division managers
have no control over allocated overhead. Excluding allocated overhead has the effect of
increasing ROI for each division manager and holds each division manager responsible only for
expense amounts that are controllable.

Figure 11.6 Segmented Income Statements (Game Products, Inc.)

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Including Income Tax Expense

Review Figure 11.6 "Segmented Income Statements (Game Products, Inc.)"and notice the line
item labeled income tax expense. Although we do not include income tax expense in the
operating income calculation, some organizations prefer to include this item. Including after-tax
expense reduces ROI for each division manager (assuming each division is profitable).

The point here is that the needs of management determine how to define operating income. We
will use the U.S. GAAP definition, presented as operating income in Figure 11.6 "Segmented
Income Statements (Game Products, Inc.)", throughout this chapter unless indicated otherwise.

Average Operating Assets Calculation—A Closer Look

Question: For Game Products, Inc., we assume all assets are operating assets. That is,
all assets are used in the daily operations of the business. As discussed earlier, assets
that are not used in the daily operations of the business, such as land held for
investment or buildings sublet to other companies, are not included in this calculation.
The average is found by taking the beginning balance plus ending balance and
dividing by two. The issue in this calculation focuses on long-term assets that are
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 depreciated over time. What options exist in valuing long-term assets for the purpose
of calculating ROI?

Answer: There are two common approaches to valuing long-term assets when calculating ROI.
Each approach is discussed next.

Using Net Book Value to Calculate ROI

In the Game Products, Inc., example, we use the net book value of long-term assets to calculate
operating assets. That is, accumulated depreciation is subtracted from the original cost on the
segmented balance sheet in accordance with U.S. GAAP. The balance sheet presented in Figure
11.4 "Segmented Balance Sheets (Game Products, Inc.)" shows this in the line item
labeled property, plant, and equipment, net. The advantage of using net book value is that the
information is easily obtained from the financial records.

The problem with this approach is division managers with older assets that have been
substantially depreciated have an advantage over division managers with newer assets that have
not been significantly depreciated. Older assets have a lower net book value (cost – accumulated
depreciation) than newer assets, which reduces average operating assets in the denominator and
increases ROI.

For example, assume two divisions have identical operating income for the year and identical
assets. However, Division 1 has been in operation for many more years than Division 2 and thus
has far more accumulated depreciation on long-term assets. This results in a lower net book
value on long-term assets for Division 1 as shown in the following:

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Assuming all other assets are identical, and both divisions have identical operating income,
Division 1 will have a higher ROI simply because long-term assets are older and have more
accumulated depreciation, thereby reducing average operating assets in the denominator.
(Reducing the denominator increases the ratio.)

An additional weakness in using net book value to calculate average operating assets is the
disincentive it creates for division managers to replace old and inefficient long-term assets, such
as equipment and machinery. Although new equipment purchases may be needed to improve
efficiency and to remain competitive, the short-term impact is to reduce ROI. (Older equipment
will have a lower net book value than identical newer equipment. Thus replacing old equipment
will decrease ROI.)

If division managers are evaluated based on ROI, using net book value tends to discourage
investments in long-term assets, often at the expense of the organization’s long-term
profitability.

Using Gross Book Value to Calculate ROI

An alternative approach in calculating ROI is to use gross book value in the average operating
assets calculation. Gross book value simply refers to the original cost of long-term assets and
ignores accumulated depreciation.

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 In our example of two divisions with identical assets and identical operating income, the same
original cost amount is used in calculating average operating assets. Division 2 is not penalized
in the denominator for having newer assets and less accumulated depreciation.

Although both net book value and gross book value are used in practice, we will use net book
value throughout this chapter unless indicated otherwise. “Key Equation: Variations of ROI
Calculation” summarizes the issues surrounding the calculation of ROI.

Key  Equation  
Variations of ROI Calculation

Return on investment=Operating income*Average operating assets**  

*The U.S. GAAP definition of operating income is used for the numerator. However,
organizations often calculate operating income differently. Some exclude allocated
overhead while others may include income tax expense to get after-tax operating
income.
**Average operating assets includes only those assets used in the daily operations of the
business. Long-term assets are valued at net book value. However, valuation of long-
term assets varies from one organization to the next. Some use gross book value rather
than net book value.
Business  in  Action  11.4  

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Source: Photo courtesy of Rod

Ramsey,http://www.flickr.com/photos/rdrcollection/2078536386/
Internal Performance Measures at General Electric
General Electric Company provides financial information for six segments in its
annual report. Segments include Infrastructure, Commercial Finance, GE Money,
Healthcare, NBC Universal, and Industrial. The company’s annual report indicates that
“segment profit is determined based on internal performance measures used by the
Chief Executive Officer to assess the performance of each business in a given period.
Segment profit excludes or includes interest and other financial charges and segment
income taxes according to how a particular segment’s management is measured.”
This statement reaffirms the point that companies tailor performance measures to meet
the needs of each individual segment. For example,General Electric excludes interest
and other financial charges in measuring segment net income for some segments, such

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 as Healthcare, NBC Universal, and Industrial, while including interest and financial
charges for other segments, such as Commercial Finance and GE Money.
Source: General Electric, “2006 Annual Report,” http://www.ge.com.
R E V I E W   P R O B L E M   1 1 . 4  

This  is  a  continuation  of  Note  11.18  "Review  Problem  11.3"  for  Kitchen  Appliances.  
Recall  that  Kitchen  Appliances  has  two  divisions  broken  out  by  region—a  Southern  
division  and  a  Northern  division.  The  following  segmented  income  statement  is  for  
the  most  recent  fiscal  year  ended  December  31  (you  were  asked  to  prepare  this  
income  statement  in  Note  11.18  "Review  Problem  11.3").  

Segmented  balance  sheets  for  Kitchen  Appliances  appear  as  follows.  

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1. Calculate  average  operating  assets  for  each  division.  (Hint:  land  held  for  sale  is  not  an  
operating  asset.)  
2. Calculate  ROI  for  each  division.  
3. What  does  the  ROI  tell  you  about  each  division  at  Kitchen  Appliances?  

Solution  to  Review  Problem  11.4  

(All  dollar  amounts  are  in  thousands.)  

1. Average  operating  assets  are  calculated  in  the  following.  Note  that  land  held  
for  sale  is  not  an  operating  asset  and  thus  must  be  deducted  from  total  
assets  to  find  operating  assets.  

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*$9,600  =  ($9,400  ending  balance  +  $9,800  beginning  balance)  ÷  2.  

**$41,600  =  ($40,600  ending  balance  +  $42,600  beginning  balance)  ÷  2.  

2. ROI  is  calculated  as  follows:  

*Operating  income  is  provided  in  the  segmented  income  statement.  

**Average  operating  assets  is  calculated  in  requirement  1.  

^ROI  =  Operating  income  ÷  Average  operating  assets.  For  Southern  division,  

11.60  percent  =  $1,114  ÷  $9,600.  
3. The  Southern  division  of  Kitchen  Appliances  has  the  highest  ROI  at  11.60  percent.  The  
Northern  division’s  ROI  is  7.90  percent.  This  measure  indicates  the  Southern  division  
is  making  more  profitable  use  of  its  assets  than  the  Northern  division.  

Further Analysis of ROI

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 Question: How does breaking ROI down into two separate measures help division managers
improve their division’s ROI?

Answer: Many companies break ROI down into two ratios; operating profit margin and asset
turnover. Each of these measures can be used to evaluate strengths and weaknesses of ROI
within each division.

Key  Equation  

Operating profit margin=Operating incomeSales  

Key  Equation  

Asset turnover=SalesAverage operating assets  

Operating profit margin is the ratio of operating income to sales. It provides information about
how much operating profit is being produced for each dollar of sales. Asset turnover is the ratio
of sales to average operating assets. It provides information about how much revenue each dollar
invested in average operating assets produces.

These two ratios can be multiplied by each other to find the ROI as follows:

Key  Equation  

Return onInvestment=ROIOperating incomeAverage operating assets==Operatingprofit margin

Operating incomeSales××AssetturnoverSalesAverage operating assets  

Breaking out ROI into these two ratios provides information that helps division managers
identify areas for improvement. ROI can be improved by increasing the operating profit margin,
which focuses solely on income statement information. ROI can also be improved by increasing
asset turnover, which focuses on the division’s use of operating assets to produce sales.

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 Question: How are these ratios used to evaluate the three divisions at Game Products, Inc.?

Answer: Operating profit margin, asset turnover, and ROI calculations for Game Products, Inc.,
are shown in Figure 11.7 "Operating Profit Margin, Asset Turnover, and ROI for Game
Products, Inc.". Notice the resulting ROI for each division is the same as the ROI shown
in Figure 11.5 "ROI Calculations (Game Products, Inc.)" except for slight differences attributed
to rounding.

Figure 11.7 Operating Profit Margin, Asset Turnover, and ROI for Game Products, Inc.

*From Figure 11.3 "Segmented Income Statements (Game Products, Inc.)".

**From Figure 11.5 "ROI Calculations (Game Products, Inc.)".

Figure 11.7 "Operating Profit Margin, Asset Turnover, and ROI for Game Products, Inc." shows
that Sporting Goods has the highest operating profit margin at 16.48 percent compared to Board
Games (14.56 percent) and Computer Games (7.77 percent). However, Computer Games has the
highest asset turnover at 0.87 compared to Sporting Goods (0.68) and Board Games (0.61).

This information helps each division manager identify strengths and weaknesses. For example,
the Computer Games division has excellent asset turnover relative to other divisions, but has a
very low profit margin. The manager of this division must look for ways to improve the profit
margin for its products (e.g., increase prices, reduce operating expenses, or both).
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 Another example is the Sporting Goods division, which has an excellent profit margin, but
relatively low asset turnover. The manager of this division must look at ways to improve the
utilization of assets to increase turnover.

K E Y   T A K E A W A Y  

• ROI  is  defined  as  operating  income  divided  by  average  operating  assets  as  
shown  in  the  following  equation:  

Return on investment=Operating incomeAverage operating assets  

This  measure  provides  an  assessment  of  how  effectively  each  division  is  
using  operating  assets  to  produce  operating  income.  ROI  can  also  be  broken  
into  two  separate  ratios,  operating  profit  margin  and  asset  turnover,  which  
are  multiplied  together  to  get  ROI  as  follows:  

Return onInvestment=Operating incomeAverage operating assets=Operatingprofit mar

ginOperating incomeSales××AssetturnoverSalesAverage operating assets  

Many  variations  of  the  ROI  calculation  are  used  in  practice  depending  on  
the  nature  of  the  organization.  
R E V I E W   P R O B L E M   1 1 . 5  

Use  the  information  in  Note  11.26  "Review  Problem  11.4"  for  Kitchen  Appliances  to  
complete  the  following  requirements.  
1. Calculate  the  operating  profit  margin,  asset  turnover,  and  ROI.  
2. Which  division  has  the  highest  ROI?  Explain  how  the  two  ratios—operating  profit  
margin  and  asset  turnover—influenced  the  ROI  for  each  division.  

Solution  to  Review  Problem  11.5  

(All  dollar  amounts  are  in  thousands.)  

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 1.    

*From  Note  11.26  "Review  Problem  11.4"  data.  

**From  Note  11.26  "Review  Problem  11.4"  solutions,  part  1.  
^Due  to  rounding,  ROI  percent  is  slightly  different  than  when  computed  
inNote  11.26  "Review  Problem  11.4".  
2. The  Southern  division  has  the  highest  ROI  (11.59  percent  versus  7.88  percent  at  the  
Northern  division),  largely  attributed  to  the  high  operating  profit  margin  (22.28  
percent  versus  10.95  percent  at  the  Northern  division).  However,  the  Southern  
division  has  the  lowest  asset  turnover  at  0.52  compared  to  0.72  at  the  Northern  
division.  The  manager  of  the  Northern  division  must  look  for  ways  to  improve  the  
profit  margin  for  its  products  (e.g.,  increasing  prices  and/or  reducing  operating  
expenses).  Conversely,  the  manager  of  the  Southern  division  must  look  at  ways  to  
improve  the  utilization  of  assets  to  increase  turnover.  
 
 
 
 
 

11.5 Using Residual Income (RI) to Evaluate Performance

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 L E A R N I N G   O B J E C T I V E  

1. Calculate  and  interpret  residual  income  (RI)  to  evaluate  performance.  

Question: Although ROI is commonly used as a divisional performance measure, some division
managers dislike this measure. Why do some division managers prefer not to use ROI as a
performance measure?

Answer: Some managers dislike ROI because it can lead to decisions that benefit the division
but hurt the organization as a whole. Division managers have an incentive to turn down
investments that exceed the company’s minimum required rate of return but are below the
division’s current ROI, mainly because ROI trends are often used to evaluate managers. For
example, assume the manager of a division is evaluated based on ROI, and the division currently
has an ROI of 20 percent:

ROI before new investment=Operating incomeAverage operating assets=$20,000$100,000=20%

The company’s minimum required rate of return is 10 percent, and the division manager is
presented with an investment opportunity expected to yield an ROI of 15 percent. This
investment totals $70,000 and annual operating profit will be $10,500 (15 percent ROI = $10,500
÷ $70,000). Although this investment is well above the company’s minimum required rate of
return, the division manager will likely not make the investment since the division’s overall ROI
will decline from 20 percent to 17.9 percent:

ROI after new investment= $20,000 + $10,500$100,000 + $70,000=$30,500$170,000=17.9%

If evaluated solely based on ROI, the division manager would prefer to invest only in projects
that increase the division’s ROI above 20 percent. In fact, the division manager has an incentive
to shed all investments yielding less than 20 percent, even if the investments are producing a
return above the company’s minimum requirement of 10 percent. An alternative measure to ROI,
called residual income (RI), helps to mitigate this apparent conflict.

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 Calculating RI

Question: What is RI, and how does it help to prevent the conflict associated with ROI?

Answer: RI is the dollar amount of division operating profit in excess of the division’s cost of
acquiring capital to purchase operating assets. The calculation is as follows:

Key  Equation  

Residualincome=Operatingincome−(Percent costof capital × Averageoperating assets)  

Rather than using a ratio to evaluate performance, RI uses a dollar amount. As long as an
investment yields operating profit higher than the division’s cost of acquiring capital, managers
evaluated with RI have an incentive to accept the investment. The manager’s goal is to increase
RI from one period to the next.

Notice that operating income and average operating assets used here to calculate RI are the same
measures used in the ROI calculation presented earlier. The one new
item, percent cost of capital, is the company’s percentage cost to obtain investment funds (often
called capital). For example, a company that raises funds by issuing bonds would use the interest
rate associated with the bonds in establishing its percent cost of capital. We will always provide
the percent cost of capital in this chapter, leaving detailed discussions of its calculation to more
advanced courses. Note that several sources provide cost of capital information by industry. One
source is the Leonard N. Stern School of Business at New York University
(http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.htm).

Let’s take another look at the division that rejected an investment yielding an ROI higher than
the company’s minimum required rate of return of 10 percent but lower than the division’s
current ROI of 20 percent. Assume the company’s percent cost of capital is the same as its
minimum required rate of return of 10 percent. Three RI calculations are provided as follows, (1)
RIbefore the new investment, (2) RI from the new investment, and (3) RI afterthe new
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 investment. (Note that some organizations make adjustments to the cost of capital to determine
the minimum required rate of return. Throughout this chapter, assume percent cost of capital is
the same asminimum required rate of return unless stated otherwise.)

Residual income before new investment=$20,000−(10%×$100,000)=$20,000−$10,000=$10,000

Residual income from new investment=$10,500−(10%×$70,000)=$10,500−$7,000= $3,500

Residual income after new investment=$30,500−(10%×$170,000)=$30,500−$17,000=$13,500

Since the manager’s goal is to continually increase RI, the proposed investment would be
accepted resulting in an increase of $3,500 in RI (= $13,500 − $10,000). As shown in this
example, using RI as a performance measure is an effective way to minimize the conflict
between company goals and division goals that arise using ROI. Rather than maximizing ROI,
division managers focus on increasing RI. Managers are more likely to accept investment
proposals that have a return greater than the company’s minimum required rate of return,
regardless of the impact on the division’s ROI.

Limitation of RI

Question: Although RI resolves some of the problems of using ROI as a performance measure, it
does not provide an efficient means for comparing divisions. What is the problem with using RI
to compare divisions?

Answer: Similar to the problem encountered with using segmented net income to compare
divisions, RI is stated in dollars (or some other currency) rather than as a ratio. One division may
have high RI simply because it has a larger asset base, which produces higher revenues. Thus
division managers should be evaluated based on how effectively they increase RI from one
period to the next, perhaps in percentage growth, and not on how their RI compares to other
divisions.
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 Most organizations that use RI also use ROI. Using both measures has the benefit of comparing
one division to another by using ROI and minimizes the conflict between company goals and
division goals by using RI.

Computing RI at Game Products, Inc.

Question: Let’s revisit Game Products, Inc., and calculate RI for each of the three
divisions. How did the three divisions perform using RI as the measure?

Answer: Figure 11.8 "RI Calculations (Game Products, Inc.)" shows the RI calculation for each
division at Game Products, Inc., assuming a cost of capital of 8 percent. Notice that Sporting
Goods and Board Games have positive RI, which indicates both divisions are producing
operating income above and beyond the minimum required rate of return. Since the Computer
Games division has negative RI, this division is not producing enough operating income to
achieve the minimum required rate of return.

Having positive RI is reasonable for Sporting Goods and Board Games since both divisions have
an ROI above the 8 percent minimum required rate of return (as shown back in Figure 11.7
"Operating Profit Margin, Asset Turnover, and ROI for Game Products, Inc."). It is also
reasonable that Computer Games has negative RI since the division’s ROI is less than 8 percent.

Figure 11.8 RI Calculations (Game Products, Inc.)

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*From Figure 11.3 "Segmented Income Statements (Game Products, Inc.)".

**From Figure 11.5 "ROI Calculations (Game Products, Inc.)".

K E Y   T A K E A W A Y  

• RI  is  the  dollar  amount  of  division  operating  profit  in  excess  of  the  division’s  
cost  of  acquiring  capital  to  purchase  its  operating  assets.  The  calculation  is  
as  follows:  

Residualincome=Operatingincome−(Percent costof capital × Averageoperating assets)  

Operating  income  and  average  operating  assets  used  to  calculate  ROI  are  
also  used  here  to  calculate  RI.  The  percent  cost  of  capital  is  new  and  
represents  the  company’s  percentage  cost  to  obtain  investment  funds.  The  
goal  is  for  each  division  manager  to  increase  RI  over  time.  
R E V I E W   P R O B L E M   1 1 . 6  

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 This  is  a  continuation  of  the  Kitchen  Appliances  example  presented  inNote  11.18  
"Review  Problem  11.3",  Note  11.26  "Review  Problem  11.4",  andNote  11.33  "Review  
Problem  11.5".  Financial  information  for  Kitchen  Appliances  is  provided  again  as  
follows.  Assume  the  cost  of  capital  rate  is  6  percent.  

 
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 1. Calculate  RI  for  each  division.  
2. How  should  this  information  be  used  to  evaluate  each  division  manager?  

Solution  to  Review  Problem  11.6  

1. All  dollar  amounts  are  in  thousands.  

*From  Note  11.26  "Review  Problem  11.4"  data.  

**From  Note  11.26  "Review  Problem  11.4"  solutions,  part  1.  
2. Although  the  Northern  division  has  higher  RI  ($790,000)  than  the  Southern  division  
($538,000),  it  is  not  enough  to  simply  conclude  that  the  Northern  division  manager  is  
performing  better  than  the  Southern  division  manager.  The  goal  for  each  manager  is  
to  continually  increase  RI  over  time.  Thus  Kitchen  Appliances  should  compare  RI  for  
each  division  to  prior  periods  and  reward  division  managers  for  significant  increases  
from  one  period  to  the  next.  

11.6 Using Economic Value Added (EVA) to Evaluate Performance

L E A R N I N G   O B J E C T I V E  

1. Calculate  and  interpret  economic  value  added  (EVA)  to  evaluate  performance.  
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 Question: Another measure of performance similar to residual income (RI) is called
economic value added. What is economic value added, and how is it used to evaluate
divisions?

Answer: Economic value added (EVA) was created and trademarked byStern Stewart
& Company, a management consulting firm, and is defined as follows (additional
information can be found at Stern Stewart & Company’s Web
site: http://www.sternstewart.com).
Key  Equation  

Economicvalue added=Net operating profitafter taxesadjusted−(Percent costof capital × Average

operatingassetsadjusted)  

Although the calculation is similar to RI, adjustments are made to the financial
information to better reflect the economic results of the division.Stern Stewart &
Company created EVA to provide financial information without the “anomalies” that
result from following U.S. GAAP. One example of an anomaly is the expensing of
research and development (R&D) costs even though R&D breakthroughs often benefit
companies in future years.
There are two distinct differences in calculating EVA compared to RI. First, operating
profit is calculated net of income taxes. Finding operating incomeafter taxes simply
requires deducting income taxes from operating income. Second, adjustments are made
to operating income and average operating assets. Although more than 150 possible
adjustments can be made, most firms limit adjustments to 15 or less.
Three examples of adjustments to be considered when using EVA are related to research
and development (R&D), advertising, and noninterest bearing current liabilities.
• Research and development. U.S. GAAP requires that R&D costs be expensed as
incurred. However, R&D work typically benefits the company in future periods. EVA

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 capitalizes R&D costs (that is, records these costs as a long-term asset) and amortizes
these costs over the estimated useful life of R&D activities.
• Advertising. U.S. GAAP also requires that advertising costs be expensed as incurred.
Since marketing efforts typically benefit the company in future periods, EVA capitalizes
these costs and amortizes them over a period of time.
• Noninterest bearing current liabilities. EVA requires deducting noninterest
bearing current liabilities from average operating assets. This is because current
liabilities that do not require an interest payment are a free source of capital. For
example, a company purchasing large amounts of inventory (an asset) on account has a
free source of capital, which is presented as a noninterest bearing current liability on the
balance sheet.
These three items are provided as examples of adjustments proposed by EVA advocates.
However, the adjustments made depend on the organization since EVA calculations are
modified to fit the needs of the organization.
Computing  EVA  for  Game  Products,  Inc.  
Question: How is EVA calculated for the divisions at Game Products, Inc.?

Answer: provides the segmented income statements and segmented balance sheet
information for each division. These amounts were used earlier in the chapter to
calculate segmented net income, ROI, and RI. Notice that research and development
costs are now shown as a separate line item on the income statement, and average
balances are shown on the balance sheet rather than beginning and ending balances.
(Average balances are simply beginning balances plus ending balances divided by two.)
To simplify our analysis, we make only two adjustments—one for research and
development and one for noninterest bearing current liabilities. The management
believes research and development activities benefit future periods and would like to
capitalize R&D costs and amortize these costs over several years. In addition, all current
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 liabilities are noninterest bearing liabilities and as such will be deducted from average
operating assets.
The impact of these two adjustments that must be made to the financial information
presented in , described as follows, is shown in .
• Adjustment 1. On the balance sheet, capitalized R&D costs will increase average
operating assets by the unamortized amount of $400,000 for Sporting Goods,
$1,200,000 for Board Games, and $2,400,000 for Computer Games. On the income
statement, R&D expense for the year shown in is added back to operating income; R&D
amortization expense for one year will be deducted as an expense. R&D amortization
expense for the year is $100,000 for Sporting Goods, $300,000 for Board Games, and
$600,000 for Computer Games. (Note for the purposes of this chapter, amortization
expense amounts will be given. Detailed calculations are left to more advanced cost
accounting textbooks.)
Since net operating profit after taxes (NOPAT) is used in the EVA calculation, we must
remember to calculate NOPAT after making the R&D adjustments. Also, assume this is
the first year calculating EVA. Thus Game Products has decided not to make any
adjustments related to previous years’ R&D expenditures.
• Adjustment 2. All current liabilities are noninterest bearing and thus are deducted
from average operating assets. (Recall that all assets are considered operating assets at
Game Products, Inc.)

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 Figure 11.9 Income Statement and Balance Sheet Information (Game Products, Inc.)

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 shows the adjustments, and the resulting EVA calculation for each division. Assume the
company’s cost of capital rate is 8 percent. This is the same rate that was used for
calculating RI.
Figure 11.10 EVA Calculations (Game Products, Inc.)

*From .

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 Question: How did each of the three divisions perform using EVA as the measure?

Answer: As shown at the bottom of , all three divisions have positive EVA amounts,
which indicates all three have NOPAT (adjusted) in excess of each division’s cost of
investment funds (adjusted).
Recall from the example in that Computer Games was the only division with negative
RI. This negative amount turns to a positive amount using EVA mainly because research
and development costs are capitalized and amortized over future years rather than
expensed as incurred. Because the Computer Games division had significant research
and development costs, and these costs were backed out and recorded as an asset using
EVA, NOPAT (adjusted) increased significantly. This caused the EVA amount for
Computer Games to become positive.
Weaknesses  with  EVA  
Question: While EVA is no doubt a popular method for evaluating investment centers,
and companies as a whole, there are weaknesses in its approach.What are these
weaknesses?

Answer: As stated earlier, EVA is similar to RI except adjustments are made to operating
income and average operating assets to offset accounting anomalies created by U.S.
GAAP. Critics of EVA argue that U.S. GAAP was established for a variety of reasons, one
of which was to provide a set of reasonable and objective accounting rules to be followed
when recording economic events. Modifying U.S. GAAP to calculate EVA strays from the
objectivity provided by U.S. GAAP.
For example, U.S. GAAP requires R&D and advertising costs to be expensed in the
period incurred because it is very difficult and subjective to estimate the future benefit
these activities may provide. EVA adjustments described earlier for R&D and
advertising costs depart from U.S. GAAP. EVA recommends that these costs be
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 capitalized and amortized over the useful life of the activity. This leads to different
interpretations of what the useful life should be. Managers now have an incentive to
stretch useful lives out as far as possible to minimize amortization expense taken each
period.
As with any performance measure, EVA has advantages and disadvantages. The key is to
develop a measure that promotes behavior desired by top management and to provide
consistency in evaluating managers.
K E Y   T A K E A W A Y  

• EVA  is  simply  an  extension  of  RI.  Adjustments  are  made  to  operating  income  
and  average  operating  assets.  EVA  is  calculated  as  follows:  

Economicvalue added=Net operating profitafter taxesadjusted−(Percent costof capital

× Average operatingassetsadjusted)  

R E V I E W   P R O B L E M   1 1 . 7  

This  is  a  continuation  of  the  Kitchen  Appliances  example  used  in  previous  review  
problems.  Top  management  of  Kitchen  Appliances  has  decided  to  use  EVA  as  a  
performance  measure  for  its  division  managers.  The  cost  of  capital  rate  is  6  percent.  

Assume  management  will  make  three  adjustments  to  calculate  EVA  as  follows:  
• Adjustment  1.  Marketing  costs  will  be  capitalized  and  amortized  over  several  years.  
On  the  balance  sheet,  average  operating  assets  will  increase  by  the  unamortized  
amount  of  $70,000  for  the  Southern  division  and  $2,800,000  for  the  Northern  
division.  On  the  income  statement,  marketing  expense  for  the  year  will  be  added  
back  to  operating  income;  marketing  amortization  expense  for  one  year  will  be  
deducted.  Assume  marketing  amortization  expense  for  the  year  is  $30,000  for  the  
Southern  division  and  $1,200,000  for  the  Northern  division.  No  adjustments  will  be  
made  for  previous  years’  marketing  expenditures.  
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 • Adjustment  2.  Land  held  for  sale  is  not  an  operating  asset  and  thus  is  deducted  from  
average  operating  assets.  
• Adjustment  3.  All  current  liabilities  are  noninterest  bearing  and  thus  are  deducted  
from  average  operating  assets.  

Segmented  income  statements  and  balance  sheet  average  amounts  are  presented  
next.  

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1. Calculate  EVA  for  each  division.  

2. What  does  the  EVA  show  for  each  division?  

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 Solution  to  Review  Problem  11.7  

1. The  EVA  calculation  is  as  follows:  

2. Both  divisions  have  positive  EVA  amounts,  indicating  both  have  NOPAT  (adjusted)  
above  and  beyond  the  cost  of  investment  funds  (adjusted).  It  is  interesting  to  note  
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 that  when  compared  to  RI  amounts  calculated  in  ,  EVA  results  in  a  significantly  higher  
amount  for  the  Northern  division.  This  can  be  attributed  to  the  large  amount  of  
marketing  expenditures  at  the  Northern  division  that  were  expensed  using  RI,  but  
capitalized  and  amortized  using  EVA.  Deferring  significant  amounts  of  marketing  
expenses  to  future  years  has  the  impact  of  increasing  NOPAT  in  the  year  of  the  
expenditure,  thereby  increasing  EVA.  

11.7 Wrap-Up of Game Products, Inc.

Question: At the meeting described at the beginning of the chapter between Mandy Dwyer
(president and CEO) and Larry Meske (CFO), Mandy wanted to revise the compensation plan
for the manager of the Board Games division to increase her bonus because profits had
increased significantly compared to prior years. Larry suggested using measures other than
segmented net income to evaluate each division and asked for time to gather additional
information.What information did Larry gather, and how does this additional information help
Mandy evaluate each division?

Answer: Larry assembled the information using the five methods of evaluating investment
centers presented in this chapter: (1) segmented net income, (2) profit margin ratio, (3) return on
investment (ROI), (4) residual income (RI), and (5) economic value added (EVA). These five
measures have been calculated for each division of Game Products, Inc., and are summarized
in Figure 11.11 "Five Performance Measures at Game Products, Inc.".

Figure 11.11 Five Performance Measures at Game Products, Inc.

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Figure 11.12 "Comparison of Income Performance Measures for Each Division at Game
Products, Inc." shows a comparison of the three divisions for segmented income, RI, and
economic value added. Figure 11.13 "Comparison of Profit Margin Ratio and Return Investment
for Each Division at Game Products, Inc." shows a comparison of the three divisions for the
profit margin ratio and ROI.

Figure 11.12 Comparison of Income Performance Measures for Each Division at Game Products,
Inc.

Figure 11.13 Comparison of Profit Margin Ratio and Return Investment for Each
Division at Game Products, Inc.
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When Mandy and Larry meet again a month later, Larry has the difficult task of explaining the
information to Mandy and recommending a course of action.

Mandy Larry, let’s begin where we left off at our last meeting. What do you have for
(president me with regard to performance evaluation measures we might use for our
and CEO): division managers?

Here is a summary of five measures I think can be useful if used correctly

(see Figure 11.11 "Five Performance Measures at Game Products, Inc.").
As you suggested, Mandy, the starting point is segmented net income, which
is shown on line one. The Board Games division has the highest net income
Larry (CFO): and looks to be a strong performer in this regard.

Mandy: What is the ratio shown on line two?

This is the profit margin ratio. It is a much better measure to evaluate the
Larry: profitability of each division relative to sales. This measure shows the

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 Sporting Goods division produced the highest profit for each dollar in sales
with a ratio of 11.53 percent. Board Games is second at 10.19 percent and
Computer Games is last at 5.44 percent.

I see. What about the use of assets? Each division is responsible for
investments in assets and we would like to know how effective each division
Mandy: is in producing income with these assets. Is this where ROI comes in?

Yes. As shown on line three, the Sporting Goods division is making the best
use of its operating assets with an ROI of 11.23 percent. Board Games is
Larry: second at 8.93 percent, and Computer Games is last at 6.75 percent.

So you’re telling me Sporting Goods is doing better than the other two
Mandy: divisions, even though Board Games has the highest net income?

Larry: Yes, Sporting Goods is the most effective at using assets to produce profit.

Mandy: What are the last two measures you show here?

Both of these last two measures also consider asset use in the calculation.
As shown on line four, Sporting Goods had the best performance by
producing $947,000 in RI compared to $516,000 at Board Games and
Larry: $(419,000) at Computer Games.

Mandy: Computer Games has negative RI?

Yes. However, you will notice that EVA shown on line five presents a
Larry: different picture.

Mandy: Why?

Larry: Computer Games has high research and development costs each year—it’s

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 the nature of the industry. U.S. GAAP requires these costs to be expensed
when incurred. EVA suggests recording R&D costs as an asset and
amortizing the costs over the useful life of R&D activities. Since Computer
Games has much higher R&D costs than the other divisions, the numbers
changed dramatically relative to the other divisions. Also, after-tax income
is used rather than operating income, and average assets are adjusted as
well.

Mandy: Seems as if there is an awful lot of subjectivity in using EVA.

Yes, there is. If we choose to use EVA as one of our measures, management
Larry: must meet to discuss and agree upon the adjustments to be made.

Larry, thanks for your analysis. I’m beginning to understand the importance
of including asset use in our performance measures. Where do we go from
Mandy: here?

I like the first three measures—net income, profit margin ratio, and ROI.
They are widely used in industry, and managers tend to understand the
nature of these measures. The last two measures are also useful and should
not be overlooked. My recommendation is to meet with the division
managers to develop a comprehensive incentive compensation plan. The key
Larry: is to develop a plan that motivates our managers to achieve company goals.

Mandy: I like the idea! Let’s meet next week.

11.8 Appendix: Transfer Prices between Divisions

L E A R N I N G   O B J E C T I V E  

1. Explain  how  transfer  pricing  can  affect  performance  evaluation  measures.  

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 Question: Many companies have independent divisions that transfer goods or services from one
division to another. If division managers are evaluated based only on division results using
measures, such as segmented net income, profit margin ratio, or return on investment (ROI),
conflicts can arise causing managers to take a course of action that benefits the division but
hurts the company as a whole. For example, a division manager may decide to purchase raw
materials from an outside supplier even though the same materials can be produced at a lower
cost by another division within the company (the other division’s manager refuses to sell the
materials at a reduced price because she is evaluated based on her division’s profits!). How
should a company establish transfer pricing to avoid this kind of conflict?

Answer: The price used to value the transfer of goods or services between divisions within the
same company is called a transfer price. Several different approaches can be used to establish
transfer prices between divisions. The goal is to establish a transfer pricing policy that
encourages managers to do what is in the best interest of the company while also doing what is in
the best interest of the division manager (this is called goal congruence). Several common
approaches are presented next.

Using the General Economic Transfer Pricing Rule

Question: How does the general economic transfer pricing rule help organizations to establish
an appropriate transfer price?

Answer: The general economic transfer pricing rule attempts to establish guidelines for
divisions to maximize overall company profit. This rule states the transfer price should be set at
differential cost to the selling division (normally variable cost), plus the opportunity cost of
making the sale internally (none if the seller has idle capacity or selling price minus differential
cost if the seller is at capacity). This rule is summarized in “Key Equation: Economic Transfer
Pricing Rule.”

Key  Equation  
Economic Transfer Pricing Rule
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 Transfer price=Differential costto selling division+Opportunity cost ofselling internally  

Let’s look at an example illustrating how to establish a reasonable transfer price using the
economic transfer pricing rule. Umbrellas, Inc., has two divisions—Assembly and Marketing. In
the past, all transfers of umbrellas from Assembly to Marketing were valued at the variable cost
of $6 each. However, the Assembly division manager would like to raise the price to $9 per unit.

Which transfer price should be used to maximize company profit, $6 or $9? The answer depends
on whether the selling division (Assembly) is below capacity or at capacity.

Transfer Pricing When Selling Division Is below Capacity

Question: Assume Assembly is below capacity. This means there is no opportunity cost of selling
internally since no outside sales are forgone as a result of the transaction. What is the
appropriate transfer price in this scenario?

Answer: Given this set of circumstances, the Assembly division should set the transfer price at
its variable cost of $6 per unit as shown in “Key Equation: Transfer Pricing When below
Capacity (Umbrellas, Inc.).” This ensures Marketing does not purchase the umbrellas from
another supplier at an amount greater than Umbrella, Inc.’s variable cost.

Key  Equation  
Transfer Pricing When below Capacity (Umbrellas, Inc.)

Transfer price$6==Differential costto selling division$6*++Opportunity cost ofselling internally

$0**  

*This is the variable cost for Assembly to produce each umbrella.

**Opportunity cost is zero since no outside sales are forgone as a result of making this
internal sale.

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 If Assembly sets the transfer price higher than $6 per unit ($9 for example), thereby violating the
economic transfer pricing rule, the risk is that Marketing might find another company willing to
provide the umbrellas for an amount less than $9 and higher than $6. If Marketing chooses to
buy umbrellas from an outside supplier for $7, for example, profit declines at Umbrella, Inc.,
because the company paid $1 more than necessary for each umbrella ($1 = $7 outside supplier
price − $6 Umbrella, Inc.’s variable cost). Although Marketing looks better as an investment
center buying from the outside for $7 because the cost is $2 less than the internal transfer price,
the overall company is worse off because the $7 cost is $1 higher than if the umbrellas were
produced internally.

Transfer Pricing When Selling Division Is at Capacity

Question: Now assume Assembly is at capacity. This creates an opportunity cost of selling
internally, since outside sales must be forgone as a result of the transaction. What is the
appropriate transfer price in this scenario?

Answer: Given this new set of circumstances for Umbrellas, Inc., the Assembly division should
set the transfer price at its variable cost of $6 per unit plus the opportunity cost of selling
internally. Assume the Assembly division sells the umbrellas to outside customers for $10 each.
The opportunity cost of selling internally is $4 (= $10 market price − $6 variable cost). Thus the
transfer price that maximizes company profit is $10 as shown in “Key Equation: Transfer Pricing
When at Capacity (Umbrellas, Inc.).” Assembly is indifferent whether it sells internally for $10
or to outside customers for $10.

Key  Equation  
Transfer Pricing When at Capacity (Umbrellas, Inc.)

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 Transfer price$10==Differential costto selling division$6*++Opportunity cost ofselling internall
y$4**  

*This is the variable cost for Assembly to produce each umbrella.

**Opportunity cost is the revenue forgone of $4 by selling internally. Revenue forgone of
$4 = $10 market price – $6 variable cost.

The economic transfer pricing rule works well when outside market prices are available (see ).
However, not all goods or services transferred from one division to another have a readily
available outside market price. Thus other methods of establishing transfer pricing must be
considered.

Business  in  Action  11.5  

Transfer Pricing at General Electric
A review of the notes to General Electric’s annual report reveals the amount of
“intersegment revenues” recorded for each of the company’s six segments. This is
referring to revenue derived from transferring goods and services between divisions.
The note also states that “sales from one component (segment) to another generally are
priced at equivalent commercial selling prices.” It appears from this note thatGeneral
Electric uses market price to establish transfer prices.
Source: General Electric, “2006 Annual Report,” http://www.ge.com.

Using Cost to Set Transfer Price

Question: Another approach to establishing a transfer price is to use the cost of the goods or
services being transferred. How are these costs determined?

Answer: Transfer prices can be based on variable cost, full absorption cost, or cost-plus. Each
approach is described next.

Variable Cost

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 Some companies simply use the selling division’s variable cost as the transfer price. However,
the weakness in this approach is the selling division will not be able to mark up its products or
services, and as a result, will not be able to generate a profit. This is not a problem for selling
divisions treated as cost centers, but profit center and investment center managers will not be
satisfied with such an approach.

Full Absorption Cost

Companies sometimes set the transfer price at the selling division’s full absorption cost. The
selling division manager prefers to cover all costs rather than only variable costs, and using full-
absorption cost accomplishes this goal. However, the company’s concern is the buying division
might choose to purchase from an outside provider at a higher price than the differential cost plus
opportunity cost but lower than the selling division’s full absorption cost. The result is a decision
that does not maximize company profit.

Cost-Plus

Companies often add a markup to the selling division’s variable cost or full absorption cost to set
the transfer price. This enables the selling division to earn a profit on internal transfers. Again,
the risk is that the buying division might buy from an outside supplier at a higher price than
differential cost plus opportunity cost, resulting in lower company profit.

Negotiating Transfer Prices

Question: If the general economic transfer pricing rule is not used, and the cost approach is not
used, another alternative is to simply negotiate the transfer price. What are the potential
weaknesses in negotiating a transfer price?

Answer: Investment center division managers are often expected to act independent of each
other. In fact, many companies treat investment centers as separate businesses. To promote the
autonomy of each division manager, companies often require the buying and selling divisions to
negotiate a transfer price. This sounds reasonable in concept, but the same weakness exists here

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 as with using costs to set a transfer price. The buying division may choose to purchase the goods
or services from an outside supplier if negotiations break down, which may lead to a suboptimal
decision for the company as a whole.

An additional weakness is the time required to negotiate a transfer price. Managers can spend
significant amounts of time in negotiations when the time might be better spent more
productively elsewhere in the division.

Choosing the Best Approach to Establish a Transfer Price

Question: Which transfer pricing approach is best?

Answer: There is no one “best” approach to establishing transfer prices. No two companies are
identical, and the choice of a transfer pricing policy depends largely on the nature of the
company. The most common approaches used in industry are presented in this appendix. The
goal is to establish a transfer pricing policy that encourages managers to do what is in the best
interest of the company while also serving the best interest of the division manager.

K E Y   T A K E A W A Y  

• The  price  used  to  value  the  transfer  of  goods  or  services  between  divisions  within  the  
same  company  is  called  a  transfer  price.  Although  there  are  different  approaches  for  
establishing  a  transfer  price,  the  general  economic  transfer  pricing  rule  states  the  
transfer  price  should  be  set  at  differential  cost  to  the  selling  division  (normally  
variable  cost)  plus  the  opportunity  cost  of  making  the  sale  internally  (none  if  the  
seller  has  idle  capacity  or  selling  price  minus  variable  cost  if  the  seller  is  at  capacity).  
The  goal  is  to  establish  a  transfer  pricing  policy  that  encourages  managers  to  do  what  
is  in  the  best  interest  of  the  company  while  also  doing  what  is  in  the  best  interest  of  
the  division  manager.  
R E V I E W   P R O B L E M   1 1 . 8  

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 Maine  Products,  LLP,  has  two  divisions—Chocolate  and  Mint.  The  Chocolate  division  
typically  sells  its  chocolate  to  the  Mint  division  for  $3  per  pound,  which  covers  
variable  costs.  The  Chocolate  division  sells  to  outside  customers  for  $5  per  pound.  
Use  the  general  economic  transfer  pricing  rule  to  address  the  following  requirements:  
1. Calculate  the  optimal  transfer  price  assuming  the  Chocolate  division  is  below  
capacity.  
2. Calculate  the  optimal  transfer  price  assuming  the  Chocolate  division  is  at  capacity.  

Solution  to  Review  Problem  11.8  

1. Because  the  Chocolate  division  is  below  capacity,  no  outside  customer  sales  
are  forgone  as  a  result  of  selling  internally.  Thus  the  opportunity  cost  of  
selling  internally  is  zero.  The  optimal  transfer  price  is  $3,  calculated  as  
follows:  

Transfer price$3==Differential costto selling division$3*++Opportunity cost ofselling

internally$0**  

   

*This  is  the  variable  cost  per  pound.  

**Opportunity  cost  is  zero  since  no  outside  sales  are  forgone  as  a  result  of  
selling  internally.  
2. Since  the  Chocolate  division  is  at  capacity,  outside  customer  sales  are  
forgone  as  a  result  of  selling  internally.  Thus  there  is  an  opportunity  cost  of  
selling  internally.  The  optimal  transfer  price  is  $5,  calculated  as  follows:  

Transfer price$5==Differential costto selling division$3*++Opportunity cost ofselling

internally$2**  

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*This  is  the  variable  cost  per  pound.  

**Opportunity  cost  is  the  revenue  forgone  of  $2  by  selling  internally  (=  $5  
market  price  −  $3  variable  cost).  
E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  
1. What  is  meant  by  the  term  decentralized  organization?  
2. What  are  the  advantages  and  disadvantages  of  decentralizing  operations?  
3. Refer  to  Why  would  a  growing  college,  such  as  Sierra  College,  decentralize  
operations?  
4. Refer  to  How  did  decentralization  at  Arthur  Andersen  contribute  to  the  company’s  
downfall?  
5. Describe  the  three  types  of  responsibility  centers  presented  in  the  chapter.  
6. Describe  at  least  three  measures  used  to  evaluate  performance  of  investment  center  
division  managers.  
7. What  are  the  two  weaknesses  of  using  segmented  net  income  to  evaluate  managers  
of  investment  centers?  What  performance  measures  would  you  use  to  overcome  
these  weaknesses?  
8. What  is  the  primary  advantage  of  using  ROI  rather  than  segmented  net  income  or  
profit  margin  ratio  to  evaluate  investment  center  managers?  
9. Describe  operating  profit  margin  and  asset  turnover,  and  explain  how  each  of  these  
ratios  can  be  used  to  help  division  managers  improve  ROI.  
10. Describe  the  potential  conflict  that  can  occur  between  division  manager  goals  and  
overall  company  goals  when  evaluating  divisions  using  ROI.  
11. Refer  to  How  did  General  Electric  modify  net  income  to  evaluate  each  segment?  

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 12. Describe  residual  income  (RI),  and  explain  how  RI  can  resolve  the  conflict  between  
division  manager  goals  and  company  goals  often  created  by  using  ROI.  
13. Explain  the  difference  between  RI  and  economic  value  added.  
14. Refer  to  the  Game  Products,  Inc.,  performance  measures  presented  in.  Identify  which  
measures  you  would  recommend  to  the  CEO  of  Game  Products,  and  explain  the  
reasoning  behind  your  recommendation.  
15. Appendix.  Describe  the  general  economic  transfer  pricing  rule.  

Brief  Exercises  
16. Evaluating  Division  Managers  at  Game  Products,  Inc.  Refer  to  the  dialogue  at  Game  
Products,  Inc.,  presented  at  the  beginning  of  the  chapter.  Why  does  the  president  
want  to  give  Carla  Klesko,  the  Board  Games  division  manager,  a  bonus?  Does  the  CFO  
agree  that  Carla  deserves  a  larger  bonus  than  the  other  division  managers?  What  
performance  measures  would  the  CFO  like  to  consider  before  awarding  Carla  a  larger  
bonus?  
17. Decentralizing  Operations.  Burton  Electronics  produces  radios,  computers,  
and  navigation  systems.  Although  all  high  level  decisions  are  made  at  
company  headquarters  by  top  management,  rapid  expansion  and  
increasingly  specialized  products  have  caused  the  company  to  consider  
decentralizing  into  three  divisions.  Each  division  manager  would  be  
responsible  for  costs,  revenues,  and  investments  in  assets.  
Required:  
a. How  should  the  company  classify  each  division,  as  a  cost  center,  profit  
center,  or  investment  center?  Explain.  
b. What  are  the  potential  advantages  of  decentralizing?  
c. What  are  the  potential  disadvantages  of  decentralizing?  

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 Responsibility  Centers.  Aviation  Products,  Inc.,  operates  primarily  in  
the  United  States  and  has  several  segments:  
0. Accounting  and  finance:  responsible  for  recording  financial  
information  and  preparing  financial  reports.  
1. Human  resources:  responsible  for  hiring  employees  and  maintaining  
personnel  records.  
2. Retail  stores:  responsible  for  sales  prices  and  all  costs  within  each  store.  
3. Advertising:  responsible  for  promotional  materials.  
4. Production:  responsible  for  manufacturing  company  products.  
5. International  operations:  acts  as  an  independent  segment  responsible  for  
all  facets  of  the  business  outside  of  the  United  States.  
Required:  

For  each  of  the  preceding  segments,  identify  whether  it  is  a  cost  center,  
profit  center,  or  investment  center.  Explain  your  answer.  
Segmented  Net  Income.  Franklin  Bikes  has  two  divisions—Road  Bikes  
and  Mountain  Bikes.  Using  the  segmented  income  statements  presented  in  
the  following,  determine  the  profit  margin  ratio  for  each  division.  

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Return  on  Investment  (ROI).  The  segmented  income  statements  

presented  as  follows  are  for  the  two  divisions  of  Franklin  Bikes.  (This  is  the  
same  company  as  the  previous  exercise.  This  exercise  can  be  assigned  
independently.)  Assume  the  Road  Bikes  division  had  average  operating  
assets  totaling  $4,500,000  for  the  year,  and  the  Mountain  Bikes  division  had  
average  operating  assets  of  $800,000.  Calculate  ROI  for  each  division.  

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Residual  Income  (RI).  The  segmented  income  statements  presented  

as  follows  are  for  the  two  divisions  of  Franklin  Bikes.  (This  is  the  same  
company  as  the  previous  exercises.  This  exercise  can  be  assigned  
independently.)  Assume  the  Road  Bikes  division  had  average  operating  
assets  totaling  $4,500,000  for  the  year,  and  the  Mountain  Bikes  division  had  
average  operating  assets  of  $800,000.  The  company’s  cost  of  capital  rate  is  
8  percent.  Calculate  RI  for  each  division.  

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Economic  Value  Added  (EVA).  Computer  Tech  Company  has  two  

divisions—Hardware  and  Software.  Adjustments  have  already  been  made  
to  net  operating  profit  after  taxes  (NOPAT)  andaverage  operating  assets  for  
the  purposes  of  calculating  EVA  for  each  division.  This  adjusted  information  
is  shown  as  follows.  Assume  the  company’s  cost  of  capital  is  12  percent.  
Calculate  EVA  for  each  division.  
Hardware Division Software Division

NOPAT—adjusted $ 810,000 $ 980,000

Average operating assets—adjusted 3,500,000 3,200,000

(Appendix).  What  is  the  primary  goal  for  an  organization  establishing  a  transfer  
pricing  policy?  

Exercises:  Set  A  

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 24. Segmented  Net  Income.  Pool  Accessories,  Inc.,  has  two  divisions—
Furniture  and  Supplies.  The  following  segmented  financial  information  is  for  
the  most  recent  fiscal  year  ended  December  31.  
Furniture Division Supplies Division

Sales $3,000,000 $1,000,000

Cost of goods sold 1,600,000 430,000

Allocated overhead 375,000 125,000

Selling and administrative expenses 250,000 200,000

25. Assume  the  tax  rate  is  30  percent.  

26. Required:  
a. Prepare  a  segmented  income  statement  using  the  format  presented  
in  .  Include  the  profit  margin  ratio  for  each  division  at  the  bottom  of  the  
segmented  income  statement.  
b. Using  net  income  as  the  measure,  which  division  is  most  profitable?  Explain  
why  this  conclusion  might  be  misleading.  
c. What  does  the  profit  margin  ratio  tell  us  about  each  division?  Why  do  
organizations  often  use  profit  margin  ratio  to  evaluate  division  performance  
rather  than  simply  using  net  income?  
ROI.  Pool  Accessories,  Inc.,  has  two  divisions—Furniture  and  Supplies.  
(This  is  the  same  company  as  the  previous  exercise.  This  exercise  can  be  
assigned  independently.)  Segmented  income  statement  information  for  the  
most  recent  fiscal  year  ended  December  31  is  shown  as  follows.  Assume  the  
Furniture  division  had  average  operating  assets  totaling  $6,500,000  for  the  
year,  and  the  Supplies  division  had  average  operating  assets  of  $1,750,000.  

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Required:  
 . Calculate  ROI  for  each  division.  
a. What  does  ROI  tell  us  about  each  division?  Indicate  why  this  measure  is  
useful  in  evaluating  investment  centers.  
ROI  Using  Operating  Profit  Margin  and  Asset  Turnover.  Pool  
Accessories,  Inc.,  has  two  divisions—Furniture  and  Supplies.  (This  is  the  
same  company  as  the  previous  exercises.  This  exercise  can  be  assigned  
independently.)  Segmented  income  statement  information  for  the  most  
recent  fiscal  year  ended  December  31  is  shown  as  follows.  Assume  the  
Furniture  division  had  average  operating  assets  totaling  $6,500,000  for  the  
year,  and  the  Supplies  division  had  average  operating  assets  of  $1,750,000.  

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Required:  
 . For  each  division,  calculate  operating  profit  margin,  asset  turnover,  
and  resulting  ROI.  
a. Which  division  has  the  highest  ROI?  For  the  division  that  has  the  lowest  ROI,  
what  can  be  done  to  improve  this  ratio?  
RI.  Pool  Accessories,  Inc.,  has  two  divisions—Furniture  and  Supplies.  
(This  is  the  same  company  as  the  previous  exercises.  This  exercise  can  be  
assigned  independently.)  Segmented  income  statement  information  for  the  
most  recent  fiscal  year  ended  December  31  is  shown  as  follows.  Assume  the  
Furniture  division  had  average  operating  assets  totaling  $6,500,000  for  the  
year,  and  the  Supplies  division  had  average  operating  assets  of  $1,750,000.  
Assume  the  cost  of  capital  rate  is  10  percent.  

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Required:  
 . Calculate  RI  for  each  division.  
a. What  does  RI  tell  us  about  each  division?  
Solving  Unknowns  for  ROI.  The  following  information  is  for  two  
divisions  at  Kayak  Company.  
Lake Division Ocean Division

Sales ? $900,000

Operating income ? $108,000

Operating profit margin 8.0 percent ?

Average operating assets $150,000 $600,000

Asset turnover 1.7 ?

ROI ? ?

Required:  

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 Find  the  missing  information  for  each  division.  
EVA.  Links  Company  produces  golf  clubs  and  other  sporting  goods  
accessories.  The  following  information  is  for  each  division  at  Links  for  the  
most  recent  fiscal  year.  

To  calculate  EVA,  the  management  requires  adjustments  for  R&D  and  

noninterest  bearing  current  liabilities  as  outlined  in  the  following.  
Research  and  development  will  be  capitalized  and  amortized  over  several  
years  resulting  in  an  increase  to  average  operating  assets  of  $400,000  for  
the  Golf  division  and  $650,000  for  the  Sporting  Goods  division.  On  the  
income  statement,  R&D  expense  for  the  year  will  be  added  back  to  
operating  income;  then  R&D  amortization  expense  for  one  year  will  be  
deducted.  The  current  year  amortization  expense  will  total  $100,000  for  the  
Golf  division  and  $150,000  for  the  Sporting  Goods  division.  
Noninterest  bearing  liabilities  will  be  deducted  from  average  operating  
assets.  
Required:  
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 Calculate  EVA  for  each  division  and  comment  on  your  results.  
(Appendix)  Transfer  Pricing.  Creative  Colors,  Inc.,  a  producer  of  paint,  
has  two  divisions—Paint  division  and  Can  division.  Each  division  manager  is  
evaluated  based  on  profit  produced  by  each  division.  

The  Can  division  sells  its  cans  to  the  Paint  division  for  $2  per  case  to  cover  
variable  costs.  The  Can  division  also  sells  to  outside  customers  for  $3  per  
case.  
Required:  
 . Using  the  general  economic  transfer  pricing  rule,  calculate  the  
optimal  transfer  price  assuming  the  Can  division  is  below  capacity.  
a. Using  the  general  economic  transfer  pricing  rule,  calculate  the  optimal  
transfer  price  assuming  the  Can  division  is  at  capacity.  

Exercises:  Set  B  
31. Segmented  Net  Income.  Photo  Products,  Inc.,  has  three  divisions—Digital,  
Film,  and  Video.  The  following  segmented  financial  information  is  for  the  
most  recent  fiscal  year  ended  December  31.  
Digital Division Film Division Video Division

Sales $22,000,000 $8,000,000 $18,000,000

Cost of goods sold 10,000,000 2,000,000 7,000,000

Allocated overhead 4,125,000 1,500,000 3,375,000

Selling and administrative expenses 5,000,000 3,200,000 5,000,000

32. Assume  the  tax  rate  is  35  percent.  

33. Required:  

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 a. Prepare  a  segmented  income  statement  using  the  format  presented  
in  .  Include  the  profit  margin  ratio  for  each  division  at  the  bottom  of  the  
segmented  income  statement.  
b. Using  net  income  as  the  measure,  which  division  is  most  profitable?  Explain  
why  this  conclusion  might  be  misleading.  
c. What  does  the  profit  margin  ratio  tell  us  about  each  division?  Why  do  
organizations  often  use  profit  margin  ratio  to  evaluate  division  performance  
rather  than  simply  using  net  income?  
ROI.  Photo  Products,  Inc.,  has  three  divisions—Digital,  Film,  and  
Video.  (This  is  the  same  company  as  the  previous  exercise.  This  exercise  can  
be  assigned  independently.)  Segmented  income  statement  information  for  
the  most  recent  fiscal  year  ended  December  31  is  shown  as  follows.  Assume  
average  operating  assets  totaled  $15,000,000  for  the  Digital  division,  
$6,500,000  for  the  Film  division,  and  $17,500,000  for  the  Video  division.  

Required:  
 . Calculate  ROI  for  each  division.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 a. What  does  ROI  tell  us  about  each  division?  Indicate  why  this  measure  is  
useful  in  evaluating  investment  centers.  
ROI  Using  Operating  Profit  Margin  and  Asset  Turnover.  Photo  
Products,  Inc.,  has  three  divisions—Digital,  Film,  and  Video.  (This  is  the  
same  company  as  the  previous  exercises.  This  exercise  can  be  assigned  
independently.)  Segmented  income  statement  information  for  the  most  
recent  fiscal  year  ended  December  31  is  shown  as  follows.  Assume  average  
operating  assets  totaled  $15,000,000  for  the  Digital  division,  $6,500,000  for  
the  Film  division,  and  $17,500,000  for  the  Video  division.  

Required:  
 . For  each  division,  calculate  operating  profit  margin,  asset  turnover,  
and  resulting  ROI.  
a. Which  division  has  the  highest  ROI?  For  the  division  that  has  the  lowest  ROI,  
what  can  be  done  to  improve  this  ratio?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 RI.  Photo  Products,  Inc.,  has  three  divisions—Digital,  Film,  and  Video.  
(This  is  the  same  company  as  the  previous  exercises.  This  exercise  can  be  
assigned  independently.)  Segmented  income  statement  information  for  the  
most  recent  fiscal  year  ended  December  31  is  shown  as  follows.  Assume  
average  operating  assets  totaled  $15,000,000  for  the  Digital  division,  
$6,500,000  for  the  Film  division,  and  $17,500,000  for  the  Video  division.  
Assume  the  cost  of  capital  rate  is  16  percent.  

Required:  
 . Calculate  RI  for  each  division.  
a. What  does  RI  tell  us  about  each  division?  
Solving  Unknowns  for  ROI.  The  following  information  is  for  two  
divisions  at  Arrowhead,  Inc.  
North Division South Division

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Sales $1,200,000 $400,000

Operating income $ 132,000 $ 40,000

Operating profit margin ? ?

Average operating assets $1,000,000 ?

Asset turnover ? ?

ROI ? 8.0 percent

Required:  

Find  the  missing  information  for  each  division.  

EVA.  Sailboats,  Inc.,  sells  sailboat  parts  and  accessories  and  provides  
rigging  services.  The  following  information  is  for  each  division  at  Sailboats,  
Inc.,  for  the  most  recent  fiscal  year.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     867  
     
 
 To  calculate  EVA,  management  requires  adjustments  for  marketing  and  
noninterest  bearing  current  liabilities  as  outlined  in  the  following.  
Marketing  will  be  capitalized  and  amortized  over  several  years  resulting  in  
an  increase  to  average  operating  assets  of  $100,000  for  the  Sales  division  
and  $65,000  for  the  Services  division.  On  the  income  statement,  marketing  
expense  for  the  year  will  be  added  back  to  operating  income;  marketing  
amortization  expense  for  one  year  will  be  deducted.  The  current  year  
amortization  expense  will  total  $30,000  for  the  Sales  division  and  $15,000  
for  the  Services  division.  
Noninterest  bearing  liabilities  will  be  deducted  from  average  operating  
assets.  
Required:  

Calculate  EVA  for  each  division  and  comment  on  your  results.  
(Appendix)  Transfer  Pricing.  Gail’s  Gardening  has  two  divisions—
Retail  and  Nursery.  The  Retail  division  sells  plants  and  supplies.  The  Nursery  
division  takes  tree  seedlings  and  grows  them  to  healthy  young  plants  before  
selling  the  trees  internally  to  the  Retail  division  and  to  outside  customers.  
Each  division  manager  is  evaluated  based  on  profit  produced  by  each  
division.  

The  Nursery  division  sells  its  trees  to  the  Retail  division  for  $4  per  tree  to  
cover  its  variable  costs.  The  Nursery  division  also  sells  to  outside  customers  
for  $6  per  tree.  
Required:  
 . Using  the  general  economic  transfer  pricing  rule,  calculate  the  
optimal  transfer  price  assuming  the  Nursery  division  is  below  capacity.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     868  
     
 
 a. Using  the  general  economic  transfer  pricing  rule,  calculate  the  optimal  
transfer  price  assuming  the  Nursery  division  is  at  capacity.  

Problems  
38. Segmented  Net  Income,  ROI,  and  RI.  Custom  Auto  Company  has  two  
divisions—East  and  West.  The  following  segmented  financial  information  is  
for  the  most  recent  fiscal  year:  
East Division West Division

Sales $2,000,000 $4,000,000

Cost of goods sold 800,000 2,040,000

Allocated overhead 600,000 1,200,000

Selling and administrative expenses 360,000 380,000

39. The  East  division  had  average  operating  assets  totaling  $1,800,000  for  the  
year,  and  the  West  division  had  average  operating  assets  of  $2,600,000.  
Assume  the  cost  of  capital  rate  is  8  percent,  and  the  company’s  tax  rate  is  
30  percent.  Division  managers  are  responsible  for  sales,  costs,  and  
investments  in  assets.  
40. Required:  
a. What  type  of  responsibility  center  is  each  division  at  Custom  Auto  
Company?  Explain.  
b. Prepare  a  segmented  income  statement  using  the  format  presented  in  .  
Include  the  profit  margin  ratio  for  each  division  at  the  bottom  of  the  
segmented  income  statement.  
c. Calculate  ROI  for  each  division.  
d. Calculate  RI  for  each  division.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 e. Summarize  the  answers  to  parts  a,  b,  and  c  using  the  format  presented  in  .  
What  does  this  information  tell  us  about  each  division?  
Investment  Decisions  Using  ROI  and  RI.  (Note:  the  previous  problem  
must  be  completed  before  working  this  problem.)  Assume  each  division  of  
Custom  Auto  Company  is  considering  separate  investment  opportunities  
expected  to  yield  a  return  of  10  percent,  well  above  the  company’s  
minimum  required  rate  of  return  of  8  percent.  Each  investment  opportunity  
will  require  $1,000,000  in  average  operating  assets  and  yield  operating  
income  of  $100,000.  
Required:  
 . Using  the  information  presented  in  the  previous  problem,  and  the  
new  investment  proposal  information  presented  previously,  calculate  each  
division’s  overall  ROI  assuming  the  new  investment  is  accepted.  
a. Compare  your  results  in  part  a  to  each  division’s  ROI  prior  to  the  new  
investment  (calculated  in  the  previous  problem).  Which  division(s)  will  likely  
accept  the  proposal  and  which  will  likely  reject  the  proposal  using  ROI  as  
the  measure?  Explain.  
b. Using  the  information  presented  in  the  previous  problem,  and  the  new  
investment  proposal  information  presented  previously,  calculate  each  
division’s  overall  RI  assuming  the  new  investment  is  accepted.  
c. Compare  your  results  in  part  c  to  each  division’s  RI  prior  to  the  new  
investment  (calculated  in  the  previous  problem).  Which  division(s)  will  likely  
accept  the  proposal  and  which  will  likely  reject  the  proposal  using  RI  as  the  
measure?  Explain.  
d. Assume  the  goal  is  to  maximize  company  profit.  Which  measure  do  you  
think  is  best  in  deciding  whether  to  accept  a  new  investment  proposal,  ROI  
or  RI?  Explain.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     870  
     
 
 Segmented  Net  Income,  ROI,  and  RI;  Making  Investment  
Decisions.Quality  Cycles,  Inc.,  has  two  divisions—Cruisers  and  Racers.  The  
following  segmented  financial  information  is  for  the  most  recent  fiscal  year:  
Cruisers Division Racers Division

Sales $6,000,000 $10,000,000

Cost of goods sold 2,500,000 4,000,000

Allocated overhead 375,000 625,000

Selling and administrative expenses 2,100,000 3,950,000

The  Cruisers  division  had  average  operating  assets  totaling  

$5,700,000  for  the  year,  and  the  Racers  division  had  average  operating  
assets  of  $9,600,000.  Assume  the  cost  of  capital  rate  is  10  percent,  and  the  
company’s  tax  rate  is  30  percent.  
Required:  
 . Prepare  a  segmented  income  statement  using  the  format  presented  
in  .  Include  the  profit  margin  ratio  for  each  division  at  the  bottom  of  the  
segmented  income  statement.  
a. Calculate  ROI  for  each  division.  
b. Calculate  RI  for  each  division.  
c. Summarize  the  answers  to  parts  a,  b,  and  c  using  the  format  presented  in  .  
What  does  this  information  tell  us  about  each  division?  
d. Assume  each  division  of  Quality  Cycles,  Inc.,  is  considering  separate  
investment  opportunities  expected  to  yield  a  return  of  16  percent,  well  
above  the  company’s  minimum  required  rate  of  return  of  10  percent.  Each  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     871  
     
 
 investment  opportunity  will  require  $4,000,000  in  average  operating  assets  
and  yield  operating  income  of  $640,000.  
5. Using  the  information  presented  at  the  beginning  of  this  problem,  and  the  
new  investment  proposal  information  presented  previously,  calculate  each  
division’s  overall  ROI  assuming  the  new  investment  is  accepted.  
6. Compare  your  results  in  requirement  e.1  to  each  division’s  ROI  prior  to  the  
new  investment  (calculated  in  requirement  b).  Which  division(s)  will  likely  
accept  the  proposal  and  which  will  likely  reject  the  proposal  using  ROI  as  
the  measure?  Explain.  
7. Using  the  information  presented  at  the  beginning  of  this  problem,  and  the  
new  investment  proposal  information  presented  previously,  calculate  each  
division’s  overall  RI  assuming  the  new  investment  is  accepted.  
8. Compare  your  results  in  requirement  e.3  to  each  division’s  RI  prior  to  the  
new  investment  (calculated  in  requirement  c).  Which  division(s)  will  likely  
accept  the  proposal  and  which  will  likely  reject  the  proposal  using  RI  as  the  
measure?  Explain.  
9. Assume  the  goal  is  to  maximize  company  profit.  Which  measure  do  you  
think  is  best  in  deciding  whether  to  accept  a  new  investment  proposal,  ROI  
or  RI?  Explain.  
Operating  Profit  Margin,  Asset  Turnover,  and  ROI.  Financial  
information  for  Computer  Systems,  Inc.,  for  the  most  recent  fiscal  year  
appears  as  follows.  All  dollar  amounts  are  in  thousands.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Required:  
 . Calculate  average  operating  assets  for  each  division.  (Hint:  land  held  
for  sale  is  not  an  operating  asset.)  
a. Calculate  operating  profit  margin,  asset  turnover,  and  ROI  for  each  division.  
b. What  does  this  information  tell  us  about  each  division?  
Operating  Profit  Margin,  Asset  Turnover,  ROI,  and  RI.  Financial  
information  for  Web  Design,  LLP,  for  the  most  recent  fiscal  year  appears  as  
follows.  All  dollar  amounts  are  in  thousands.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     873  
     
 
  

Required:  
 . Calculate  average  operating  assets  for  each  division.  (Hint:  land  held  
for  sale  and  investments  in  Global,  Inc.,  arenot  operating  assets.)  
a. Calculate  operating  profit  margin,  asset  turnover,  and  ROI  for  each  division.  
b. Calculate  RI  for  each  division  assuming  a  cost  of  capital  rate  of  12  percent.  
c. What  does  the  information  from  requirements  b  and  c  tell  us  about  each  
division?  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     874  
     
 
 EVA.  Conner,  Inc.,  produces  brass  and  woodwind  music  instruments.  
The  following  information  is  for  each  division  at  Conner  for  the  most  recent  
fiscal  year.  

To  calculate  EVA,  management  requires  adjustments  for  R&D  expenses,  

marketing  expenses,  and  noninterest  bearing  current  liabilities  as  outlined  
in  the  following.  
Research  and  development  will  be  capitalized  and  amortized  over  several  
years  resulting  in  an  increase  to  average  operating  assets  of  $40,000  for  the  
Brass  division  and  $80,000  for  the  Woodwind  division.  On  the  income  
statement,  R&D  expenses  for  the  year  will  be  added  back  to  operating  
income;  R&D  amortization  expense  for  one  year  will  be  deducted.  The  
current  year  amortization  expense  will  total  $20,000  for  the  Brass  division  
and  $30,000  for  the  Woodwind  division.  
Marketing  will  be  capitalized  and  amortized  over  several  years  resulting  in  
an  increase  to  average  operating  assets  of  $30,000  for  the  Brass  division  
and  $38,000  for  the  Woodwind  division.  On  the  income  statement,  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     875  
     
 
 marketing  expenses  for  the  year  will  be  added  back  to  operating  income;  
marketing  amortization  expense  for  one  year  will  be  deducted.  The  current  
year  amortization  expense  will  total  $10,000  for  the  Brass  division  and  
$12,000  for  the  Woodwind  division.  
Noninterest  bearing  current  liabilities  will  be  deducted  from  average  
operating  assets.  
Required:  
 . Calculate  EVA  for  each  division.  What  do  the  results  show  us  for  each  
division?  
a. Why  does  EVA  typically  require  adjustments  to  operating  income  and  
average  operating  assets?  
(Appendix)  Transfer  Pricing,  Service  Company.  Kathy  Kraven  is  the  
CEO  and  president  of  Legal  Solutions,  Inc.  She  oversees  the  company’s  two  
divisions—Human  Resources  and  Litigation.  The  Human  Resources  division  
provides  legal  services  to  personnel  departments  at  various  clients  who  
need  help  creating  personnel  policies  and  manuals.  The  Litigation  division  
provides  legal  services  to  support  clients  in  litigation.  Litigation  often  asks  
for  help  from  Human  Resources  when  faced  with  issues  surrounding  
personnel  policies  but  also  has  the  option  of  seeking  help  outside  the  firm.  
Currently,  Human  Resources  is  below  capacity  and  uses  variable  cost  as  its  
price  for  providing  services  to  Litigation.  
Since  each  division  is  evaluated  by  how  much  profit  it  generates,  Human  
Resources  would  like  to  increase  the  price  charged  to  Litigation.  Litigation  is  
steadfast  against  any  such  change.  Kathy  Kraven  has  stepped  in  and  
established  the  following  policy:  effective  immediately,  Human  Resources  
will  charge  Litigation  variable  costs  plus  20  percent  for  any  services  
rendered  internally.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     876  
     
 
 Required:  
 . Why  is  the  Human  Resources  division  manager  concerned  about  the  
price  it  charges  to  Litigation?  
a. Why  is  the  Litigation  division  manager  concerned  about  an  increase  in  price  
charged  by  the  Human  Resources  division?  
b. Do  you  think  Kathy’s  plan  is  effective?  Explain.  
c. What  other  options  are  available  for  establishing  transfer  pricing?  
(Appendix)  Transfer  Pricing,  Retail  Company.  Fred’s  Fishing  Supplies  
has  two  divisions,  Lake  and  Deep  Sea.  Each  division  manager  is  evaluated  
based  on  profit  produced  by  each  division.  The  Lake  division  often  sells  a  
certain  graphite  fishing  rod  internally  to  the  Deep  Sea  division  for  $50  per  
rod  to  cover  variable  costs.  The  Lake  division  also  sells  the  same  graphite  
rod  to  outside  customers  for  $60  per  rod.  The  Deep  Sea  division  manager  
has  the  option  of  purchasing  a  similar  rod  from  an  outside  supplier  for  $56.  
Required:  
 . Using  the  general  economic  transfer  pricing  rule,  calculate  the  
optimal  transfer  price  assuming  the  Lake  division  is  below  capacity.  
a. Using  the  general  economic  transfer  pricing  rule,  calculate  the  optimal  
transfer  price  assuming  the  Lake  division  is  at  capacity.  
b. The  company’s  CEO  recently  established  the  following  policy:  all  internal  
transfers  will  be  made  at  variable  cost  plus  20  percent.  Assume  the  Lake  
division  is  operating  below  capacity.  As  the  Deep  Sea  division  manager,  
what  would  you  do:  purchase  internally  or  purchase  from  an  outside  
supplier?  Why?  How  will  your  decision  impact  overall  company  profit?  

One  Step  Further:  Skill-­‐Building  Cases  

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 46. Segments  at  Hewlett-­‐Packard.  Refer  to  Why  do  you  think  Hewlett-­‐Packardseparates  
its  operations  into  seven  segments?  
47. Transfer  Pricing  at  General  Electric  (Appendix).  Refer  to  How  does  General  
Electric  establish  transfer  prices?  What  does  this  approach  imply  with  regards  to  the  
products  and  services  being  provided?  
48. Group  Activity—Decentralizing  Operations.  Each  of  the  following  scenarios  
is  being  considered  at  two  separate  companies.  
1. Walker  Wood  Products  manufactures  custom  garage  doors  and  custom  
furniture.  The  company  recently  experienced  significant  growth  and  top  
management  would  like  to  separate  the  company  into  two  divisions—
Garage  and  Furniture.  
2. Iron  Manufacturing  produces  iron  fencing  for  residential  and  commercial  
properties.  The  company  recently  experienced  significant  growth  and  top  
management  would  like  to  separate  the  company  into  two  divisions—
Residential  and  Commercial.  
Required:  

Form  groups  of  two  to  four  students.  Each  group  is  to  perform  the  following  
requirements  for  the  scenario  assigned:  
c. Identify  the  potential  advantages  and  disadvantages  of  decentralizing  
into  two  divisions  and  allowing  the  manager  of  each  division  to  have  
complete  control  over  operations.  
d. Discuss  the  findings  of  your  group  with  the  class.  
Internet  Project—Economic  Value  Added.  Stern  Stewart  &  Company  is  a  global  
consulting  firm  that  pioneered  the  development  of  the  EVA  concept.  Go  to  the  Stern  
Stewart  &  Company  Web  site  athttp://www.sternstewart.com.  Review  the  
information  provided  at  this  Web  site  and  write  a  one-­‐page  report  summarizing  the  

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 information  you  found  to  be  most  interesting.  Also  submit  a  printed  copy  of  the  
information  from  the  Web  site  with  your  report.  
Creating  a  Segmented  Income  Statement  Using  Excel.  Pool  
Accessories,  Inc.,  has  two  divisions—Furniture  and  Supplies.  The  following  
segmented  financial  information  is  for  the  most  recent  fiscal  year  ended  
December  31.  
Furniture Division Supplies Division

Sales $3,000,000 $1,000,000

Cost of goods sold 1,600,000 430,000

Allocated overhead 375,000 125,000

Selling and administrative expenses 250,000 200,000

Assume  the  tax  rate  is  30  percent.  

Required:  
 . Prepare  an  Excel  spreadsheet  similar  to  showing  Pool  Accessories’  
segmented  income  statement  and  profit  margin  ratio  for  each  division.  

Comprehensive  Case  
51. Ethics  and  ROI.  Computer  chip  makers  incur  significant  costs  for  research  
and  development.  Some  research  and  development  projects  result  in  
technologies  used  in  new  computer  chips.  Other  research  and  development  
projects  do  not  result  in  a  useable  technology.  Because  of  the  unpredictable  
nature  of  R&D  activities,  U.S.  GAAP  require  that  R&D  costs  be  expensed  in  
the  period  incurred.  

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 Integrated  Circuits,  Inc.  (ICI),  produces  computer  chips  and  invests  heavily  
in  R&D.  The  firm  has  been  struggling  in  recent  years,  and  as  a  result,  the  
board  of  directors  hired  a  new  top  management  group  with  the  clear  
purpose  of  improving  profitability.  The  board  proposed  a  compensation  
package  providing  top  managers  with  an  annual  bonus  if  the  company’s  
operating  income  this  coming  year  (year  2)  increases  10  percent  compared  
to  year  1  and  ROI  remains  above  the  11  percent  level  achieved  in  year  1.  
The  new  top  management  group  is  willing  to  accept  this  proposal,  but  only  
if  costs  related  to  successful  R&D  activities  are  capitalized  and  amortized  
over  five  years  for  internal  reporting  purposes.  Their  argument  is  most  R&D  
activities  benefit  future  years,  and  U.S.  GAAP  unfairly  requires  all  R&D  costs  
to  be  expensed  in  the  period  incurred,  regardless  of  whether  the  activities  
are  successful.  This  treatment  by  U.S.  GAAP  provides  a  disincentive  for  
managers  to  invest  in  R&D  projects  that  are  vital  to  the  company’s  future  
survival.  The  board  of  directors  agrees  with  this  assertion  and  grants  the  
new  management  group  their  request  to  capitalize  costs  for  successful  R&D  
activities  over  five  years.  
One  year  has  passed  with  the  new  management  group  in  place,  and  their  
financial  results  are  presented  as  follows  (for  year  two),  along  with  last  
year’s  information  (year  one).  The  entire  $10,000,000  spent  on  R&D  in  year  
2  was  for  unsuccessful  projects  since  management  decided  to  go  a  different  
direction  with  the  company’s  technology  at  the  end  of  year  2.  Nevertheless,  
top  management  capitalized  the  entire  $10,000,000  and  amortized  these  
costs  over  5  years  as  reflected  in  the  year  2  financial  results.  (Note:  of  this  
amount,  $2,000,000  is  included  in  depreciation  and  amortization  
expensefor  year  2,  and  $8,000,000  is  included  in  average  operating  
assetsfor  year  2.)  
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Required:  
a. Based  on  the  financial  data  presented,  calculate  ROI  for  each  year  and  
the  percent  change  in  operating  income  from  year  1  to  year  2.  Does  the  
new  management  group  qualify  for  the  bonus?  
b. Prepare  revised  financial  information  in  the  same  format  as  presented  
previously  assuming  none  of  the  $10,000,000  in  year  2  R&D  costs  are  
capitalized  and  amortized.  (Hint:  Amounts  for  year  1  will  remain  the  same.  
Income  statement  and  balance  sheet  amounts  for  year  2  will  change.)  
Calculate  the  revised  ROI  for  year  two,  and  the  revised  percent  change  in  
operating  income  from  year  one  to  year  two.  Based  on  your  results,  would  
the  new  management  group  qualify  for  the  bonus?  
c. Is  the  new  management  group’s  treatment  of  R&D  costs  for  year  2  ethical?  
d. How  should  the  board  of  directors  respond  to  the  new  management  
group’s  assertion  that  $10,000,000  in  R&D  costs  should  be  capitalized  in  
year  2?  
Performance  Evaluation  Methods.  Casey  Fashions,  Inc.,  sells  clothing  
throughout  North  America.  The  company’s  compensation  committee,  made  
up  of  five  members  from  the  board  of  directors,  is  meeting  to  discuss  the  
CEO’s  contract,  which  expires  next  month.  The  committee  is  currently  
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 reviewing  financial  information  for  the  three  most  recent  fiscal  years:  year  3  
(most  recent),  year  2,  and  year  1  (shown  as  follows).  

The  income  statement  indicates  sales  increased  30  percent  from  year  1  to  
year  2  and  35  percent  from  year  2  to  year  3.  Net  income  increased  14  
percent  from  year  1  to  year  2,  and  18  percent  from  year  2  to  year  3.  One  
member  on  the  committee,  Chris  Carson,  would  like  to  offer  the  CEO  a  
multiyear  extension  with  a  significant  bump  in  salary  and  thousands  of  
shares  of  stock  options.  When  questioned  why,  Chris  pointed  to  the  
positive  results  reflected  on  the  income  statement.  

Another  committee  member,  Mary  Nichols,  agrees  with  Chris  that  income  
statement  trends  look  great,  but  she  would  like  to  review  other  measures  
of  performance  as  well.  Mary  has  asked  you  to  come  up  with  two  measures  
of  performance  that  go  beyond  simply  looking  at  the  income  statement.  

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Required:  
 . Calculate  ROI  for  each  of  the  three  years.  Note  that  balance  sheet  
amounts  presented  for  each  year  are  already  average  balances  (i.e.,  no  
need  to  calculate  average  balances).  Assume  land  held  for  sale  is  not  an  
operating  asset.  

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 a. Calculate  RI  for  each  of  the  3  years  assuming  the  company’s  cost  of  capital  
rate  is  12  percent.  
b. Prepare  a  written  report  to  the  compensation  committee  summarizing  and  
explaining  your  findings  in  part  a  and  b.  
   

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 Chapter  12  

How Is the Statement of Cash Flows Prepared and Used?

John Huston, CEO and founder of Home Store, Inc., has reviewed the company’s income
statement and balance sheet for the most recent fiscal year ended December 31, 2012. Home
Store has grown rapidly this past year, with sales and net income showing significant gains
compared to 2011. Although John is satisfied with the increase in profitability, he notices a
significant decline in cash. John decides to pursue this with Linda Nash (CFO) and Steve Bauer
(treasurer) in their weekly meeting:

I just received the income statement and balance sheet for 2012. Profits look great,
but our cash position seems to have deteriorated. We had $130,000 in cash to start
the year and ended with only $32,000. I noticed cash was declining throughout the
year when I reviewed our monthly financial statements, but I’m concerned about
John: how far our cash balance has dropped.

You’re right, John. We encountered cash flow problems several times throughout
the year in spite of increased sales and profits. On several occasions, I had to delay
Steve: payments to creditors because of cash flow issues.

John: Seems to me we shouldn’t have this problem. Where is our cash going?

Good question. Let me round up our cash flow information for the year. I’ll have
Linda: something for you by next week.

Great! I’d like to start next week’s meeting by discussing how much cash we
generated in 2012 from our daily operations. I realize net income is shown on an
accrual basis, but I’d like to know how much net income was received in the form
John: of cash.

Linda: No problem. I’ll have it for you next week.

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 Home Store, Inc., has cash flow problems that are common to many fast growing companies.
Although the income statement and balance sheet provide important information concerning
financial performance and financial condition, neither statement provides information regarding
cash activity for a period of time. The focus of this chapter is on preparing a statement that
provides cash flow information. This statement is appropriately called the statement of cash
flows.

12.1 Purpose of the Statement of Cash Flows

L E A R N I N G   O B J E C T I V E  

1. Define  the  purpose  of  the  statement  of  cash  flows.  

Question: Most organizations prepare four financial statements for external reporting purposes:
income statement, balance sheet, statement of owners’ equity, and statement of cash flows.
Financial accounting courses cover the first three statements in detail and often provide an
overview of the statement of cash flows. This chapter will focus on preparing the statement of
cash flows and on using the resulting cash flow information for analytical purposes. What
information is provided in the statement of cash flows?

Answer: The statement of cash flows provides cash receipt and cash payment information and
reconciles the change in cash for a period of time. Cash receipts and cash payments are
summarized and categorized as operating, investing, or financing activities. Simply put, the
statement of cash flows indicates where cash came from and where cash went for a period of
time.

Assume you keep track of your individual cash transactions for an entire year in a check register
(e.g., checks written and paycheck deposits) and suppose you have hundreds of transactions for
the year. Rather than showing every single transaction in a formal report, the statement of cash
flows summarizes these transactions. For example, all cash receipts from paychecks are added
together and shown as one line item, all cash payments for rent are added together and shown as
one line item, all cash payments for food are added together and shown as one line item, and so
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 on. The goal is to start with the beginning of the year cash balance, add all cash receipts for the
year, subtract all cash payments for the year, and find the resulting end-of-year cash balance.
Although the formal statement of cash flows is not quite this simple, the concept is the same.

Question: Why did the Financial Accounting Standards Board (FASB) create the statement of
cash flows in 1987?

Answer: The statement of cash flows was created due to a lack of cash flow information on the
income statement, balance sheet, and statement of owners’ equity. The income statement shows
revenues and expenses using the accrual basis of accounting, but it does not indicate how much
cash was received for revenues or paid for expenses. The balance sheet shows assets, liabilities,
and owners’ equity at a point in time, but it does not show how much cash was received or paid
for these items. The only cash information provided on these statements is the change in cash
from the end of last period to the end of the current period derived from the cash line item on the
balance sheet (often called cash and cash equivalents).

Owners, creditors, and managers wanted more cash flow information. They often asked such
questions as: Why did cash go down? How much cash was received related to net income? How
much cash was paid for the purchase of equipment? How much cash was received from issuing
bonds? As a result of the demand for more cash flow information, the FASB formally created the
statement of cash flows in 1987 (Statement of Financial Accounting Standard No. 95, which can
be found at http://www.fasb.org). Most companies are now required to prepare the statement of
cash flows along with the other three statements. We begin the process of explaining how to
prepare this statement in the next section.

Business  in  Action  12.1  

Cash Flows at Southwest Airlines

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Southwest Airlines was in the enviable position of generating $1,600,000,000 in
cash from operating activities for the year ended December 31, 2010. However, cash on
the balance sheet only increased $147,000,000 for the same period. Why did total cash
go up by such a small amount compared to the $1,600,000,000 increase in cash from
operating activities? The statement of cash flows provides the information necessary to
answer this question. Southwest spent $493,000,000 on property and equipment
(planes, parts, etc.) and $155,000,000 to pay off long-term debt. Southwest also
purchased $772,000,000 in short-term investments.
Source: Southwest Airlines, “2010 Annual Report,”http://www.southwest.com.
K E Y   T A K E A W A Y  

• The  statement  of  cash  flows  provides  cash  receipt  and  cash  payment  information  and  
reconciles  the  change  in  cash  for  a  period  of  time.  The  primary  purpose  of  the  
statement  is  to  show  what  caused  the  change  in  cash  from  the  beginning  of  the  
period  to  the  end  of  the  period.  
R E V I E W   P R O B L E M   1 2 . 1  

1. Describe  the  purpose  of  the  statement  of  cash  flows.  

2. Why  did  the  FASB  create  the  statement  of  cash  flows?  

Solution  to  Review  Problem  12.1  

1. The  purpose  of  the  statement  of  cash  flows  is  to  provide  a  summary  of  cash  receipt  
and  cash  payment  information  for  a  period  of  time  and  to  reconcile  the  difference  
between  beginning  and  ending  cash  balances  shown  on  the  balance  sheet.  The  
statement  of  cash  flows  clarifies  how  cash  was  generated  and  how  cash  was  used  for  
a  period  of  time.  
2. The  FASB  created  the  statement  of  cash  flows  because  owners,  creditors,  managers,  
and  other  stakeholders  wanted  more  information  regarding  cash  receipts  and  cash  
expenditures.  Although  the  balance  sheet  shows  cash  balances  at  the  end  of  each  

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 period,  no  further  information  is  provided  on  the  balance  sheet,  income  statement,  
or  statement  of  owners’  equity  regarding  cash  flow  activities.  The  statement  of  cash  
flows  takes  care  of  this  problem.  
12.2  Three  Types  of  Cash  Flow  Activities  
L E A R N I N G   O B J E C T I V E  

1. Describe  the  three  categories  of  cash  flows.  

Question: What are the three types of cash flows presented on the statement of cash
flows?

Answer: Cash flows are classified as operating, investing, or financing activities on the statement
of cash flows, depending on the nature of the transaction. Each of these three classifications is
defined as follows.

• Operating activities include cash activities related to net income. For example, cash
generated from the sale of goods (revenue) and cash paid for merchandise (expense) are
operating activities because revenues and expenses are included in net income.
• Investing activities include cash activities related to noncurrent assets. Noncurrent assets
include (1) long-term investments; (2) property, plant, and equipment; and (3) the
principal amount of loans made to other entities. For example, cash generated from the
sale of land and cash paid for an investment in another company are included in this
category. (Note that interest received from loans is included in operating activities.)
• Financing activities include cash activities related to noncurrent liabilities and owners’
equity. Noncurrent liabilities and owners’ equity items include (1) the principal amount
of long-term debt, (2) stock sales and repurchases, and (3) dividend payments. (Note that
interest paid on long-term debt is included in operating activities.)

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 Shows examples of cash flow activities that generate cash or require cash outflows within a
period. presents a more comprehensive list of examples of items typically included in operating,
investing, and financing sections of the statement of cash flows.

Figure 12.2 Examples of Cash Flow Activity by Category

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*Receipts of cash for dividends from investments and for interest on loans made to other entities
are included in operating activities since both items relate to net income. Likewise, payments of
cash for interest on loans with a bank or on bonds issued are also included in operating activities
because these items also relate to net income.
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 Question: Which section of the statement of cash flows is regarded by most financial experts to
be most important?

Answer: The operating activities section of the statement of cash flows is generally regarded as
the most important section since it provides cash flow information related to the daily operations
of the business. This section answers the question, “how much cash did we generate from the
daily activities of our core business?” Owners, creditors, and managers are most interested in
cash flow generated from daily activities rather than from a one-time issuance of stock or a one-
time sale of land. The operating activities section allows stakeholders to assess the ongoing
viability of the company. We discuss how to use cash flow information to evaluate organizations
later in the chapter.

Business  in  Action  12.2  

Cash Activity at Home Depot and Lowe’s
The Home Depot. Inc., and Lowe’s Companies, Inc., are large home
improvement retail companies with stores throughout North America. A review of the
statements of cash flows for both companies reveals the following cash activity. Positive
amounts are cash inflows, and negative amounts are cash outflows.

Amounts are in millions.

This information shows both companies generated significant amounts of cash from
daily operating activities; $4,600,000,000 for The Home Depot and
$3,900,000,000 for Lowe’s. It is interesting to note both companies spent significant
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 amounts of cash to acquire property and equipment and long-term investments as
reflected in the negativeinvesting activities amounts. For both companies, a significant
amount of cash outflows from financing activities were for the repurchase of common
stock. Apparently, both companies chose to return cash to owners by repurchasing
stock.
Source: The Home Depot Inc., “2010 Annual Report,”http://www.homedepot.com;
Lowe’s Companies Inc., “2010 Annual Report,” http://www.lowes.com.
K E Y   T A K E A W A Y  

• The  three  categories  of  cash  flows  are  operating  activities,  investing  activities,  and  
financing  activities.  Operating  activities  include  cash  activities  related  to  net  income.  
Investing  activities  include  cash  activities  related  to  noncurrent  assets.  Financing  
activities  include  cash  activities  related  to  noncurrent  liabilities  and  owners’  equity.  
R E V I E W   P R O B L E M   1 2 . 2  

Identify  whether  each  of  the  following  items  would  appear  in  the  operating,  
investing,  or  financing  activities  section  of  the  statement  of  cash  flows.  Explain  your  
answer  for  each  item.  
a. Cash  payments  for  purchases  of  merchandise  
b. Cash  receipts  from  sale  of  common  stock  
c. Cash  payments  for  equipment  
d. Cash  receipts  from  sales  of  goods  
e. Cash  dividends  paid  to  shareholders  
f. Cash  payments  to  employees  
g. Cash  payments  to  lenders  for  interest  on  loans  
h. Cash  receipts  from  collection  of  principal  for  loans  made  to  other  entities  
i. Cash  receipts  from  issuance  of  bonds  
j. Cash  receipts  from  collection  of  interest  on  loans  made  to  other  entities  

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 Solution  to  Review  Problem  12.2  
a. It  would  appear  as  operating  activity  because  merchandise  activity  impacts  net  
income  as  an  expense  (merchandise  costs  ultimately  flow  through  cost  of  goods  sold  on  
the  income  statement).  
b. It  would  appear  as  financing  activity  because  sale  of  common  stock  impacts  owners’  
equity.  
c. It  would  appear  as  investing  activity  because  purchase  of  equipment  impacts  
noncurrent  assets.  
d. It  would  appear  as  operating  activity  because  sales  activity  impacts  net  income  as  
revenue.  
e. It  would  appear  as  financing  activity  because  dividend  payments  impact  owners’  
equity.  
f. It  would  appear  as  operating  activity  because  employee  payroll  activity  impacts  net  
income  as  an  expense.  
g. It  would  appear  as  operating  activity  because  interest  payments  impact  net  income  
as  an  expense.  
h. It  would  appear  as  investing  activity  because  principal  collections  impact  noncurrent  
assets.  
i. It  would  appear  as  financing  activity  because  bond  issuance  activity  impacts  
noncurrent  liabilities.  
j. It  would  appear  as  operating  activity  because  interest  received  impacts  net  income  
as  revenue.  

12.3 Four Key Steps to Preparing the Statement of Cash Flows

L E A R N I N G   O B J E C T I V E  

1. Describe  the  four  steps  used  to  prepare  the  statement  of  cash  flows.  

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 Question: Recall from your financial accounting course that the accrual basis of accounting
recognizes revenue when earned and expenses when incurred, regardless of when cash is
exchanged. Conversely, the cash basis of accounting recognizes revenue when cash is received
and expenses when cash is paid, regardless of when goods or services are exchanged. The
income statement, balance sheet, and statement of owners’ equity are all created using the
accrual basis of accounting. However, the statement of cash flows is based on cash flows only,
and thus adjustments must be made to convert accrual basis information to a cash basis. What
information is necessary to make these adjustments?

Answer: Several pieces of information are required to make these adjustments in preparing the
statement of cash flows:

• Balance sheets for the end of last year and end of the current year are needed to calculate
the amount of change in each balance sheet account. These changes in balance sheet
accounts are needed to prepare certain parts of the statement of cash flows.
• Income statement information for the current year is needed as the starting point for
converting net income from an accrual basis to a cash basis, which is shown in the
operating activities section of the statement of cash flows.
• Other information is needed to complete the statement of cash flows, such as cash
dividends paid and the original cost of long-term investments sold.

Question: With this information in hand, four steps are required to prepare the statement of cash
flows. What are these four steps?

Answer: The four steps required to prepare the statement of cash flows are described as follows:

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 Step 1. Prepare the operating activities section by converting net income from an accrual basis to
a cash basis.

This step can be done using one of two methods—the direct method or theindirect method.
Because more than 98 percent of companies surveyed use the indirect method (see ), we will use
the indirect method throughout this chapter. The appendix describes the direct method.

The indirect method begins with net income from the income statement and makes several
adjustments related to changes in current assets, current liabilities, and other items to arrive
at cash provided by operating activities(or used by operating activities if the result is a cash
outflow). Cash provided by operating activities represents net income on a cash basis. It tells the
reader how much cash was received from the daily operations of the business.

Step 2. Prepare the investing activities section by presenting cash activity for noncurrent assets.

This step focuses on the effect changes in noncurrent assets have on cash. Noncurrent asset
balances found on the balance sheet, coupled with other information (e.g., cash proceeds from
sale of equipment) are used to perform this step.

Step 3. Prepare the financing activities section by presenting cash activity for noncurrent
liabilities and owners’ equity.

This step focuses on the effect changes in noncurrent liabilities and owners’ equity have on cash.
Noncurrent liabilities and owners’ equity balances found on the balance sheet, coupled with
other information (e.g., cash dividends paid) are used to perform this step.

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 Step 4. Reconcile the change in cash.

Each section of the statement of cash flows described in steps 1, 2, and 3, will show the total
cash provided by (increase) or used by (decrease) the activity. Step 4 simply confirms that the
net of these changes equates to the change in cash on the balance sheet.

For example, assume the balance sheet shows cash totaled $100 at the end of last year and $140
at the end of the current year. Thus cash increased $40 over the course of the current year. Step 4
reconciles this change with the changes shown in the three sections of the statement of cash
flows. Suppose operating activities provided cash of $170, investing activities used cash of $160,
and financing activities provided cash of $30. These 3 amounts netted together reconcile to the
$40 increase in cash shown on the balance sheet (= $170 − $160 + $30).

Business  in  Action  12.3  

Indirect Method Is Most Popular
Most companies prefer to use the indirect method to prepare the operating activities
section of the statement of cash flows. A survey taken in 2001 showed more than 98
percent of the 600 companies surveyed used the indirect method. Reasons for this
preference vary, but several possibilities are as follows:
• The indirect method links net income to cash flows from operating activities by
reconciling the two amounts.
• Accounting systems do not easily generate information needed to use the direct method.
• Those using the direct method are also required to provide a supplemental schedule
using the indirect method. It is less costly to simply prepare the statement using the
indirect method.
Source: American Institute of Certified Accountants, Accounting Trends and
Techniques (Washington, D.C.: American Institute of Certified Public Accountants,
2001).
K E Y   T A K E A W A Y  

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 • The  four  steps  required  to  prepare  the  statement  of  cash  flows  are  described  
as  follows:  

   
Step  1.  Prepare  the  operating  activities  section  by  converting  net  income  
from  an  accrual  basis  to  a  cash  basis.  
Step  2.  Prepare  the  investing  activities  section  by  presenting  cash  activities  
for  noncurrent  assets.  
Step  3.  Prepare  the  financing  activities  section  by  presenting  cash  activities  
for  noncurrent  liabilities  and  owners’  equity.  
Step  4.  Reconcile  the  change  in  cash  from  the  beginning  of  the  period  to  
the  end  of  the  period.  
R E V I E W   P R O B L E M   1 2 . 3  

Describe  the  four  steps  necessary  to  prepare  the  statement  of  cash  flows.  

Solution  to  Review  Problem  12.3  

The  four  steps  required  to  prepare  the  statement  of  cash  flows  are  as  follows:  
Step  1.  Prepare  the  operating  activities  section  by  converting  net  income  from  an  
accrual  basis  to  a  cash  basis.  
This  step  starts  with  net  income  on  an  accrual  basis  (from  the  income  statement)  and  
makes  adjustments  related  to  changes  in  current  assets,  current  liabilities,  and  other  
items  to  find  net  income  on  a  cash  basis.  The  resulting  cash  basis  net  income  is  
called  cash  provided  by  operating  activities.  
Step  2.  Prepare  the  investing  activities  section  by  presenting  cash  activity  for  
noncurrent  assets.  

This  step  focuses  on  the  effect  changes  in  noncurrent  assets  have  on  cash.  

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 Step  3.  Prepare  the  financing  activities  section  by  presenting  cash  activity  for  
noncurrent  liabilities  and  owners’  equity.  

This  step  focuses  on  the  effect  changes  in  noncurrent  liabilities  and  owners’  equity  
have  on  cash.  
Step  4.  Reconcile  the  change  in  cash.  

Each  section  of  the  statement  of  cash  flows  described  in  steps  1,  2,  and  3  will  show  
the  total  cash  provided  by  or  used  by  each  activity.  Step  4  confirms  that  the  net  of  
these  changes  equates  to  the  change  in  cash  derived  from  the  balance  sheet.  

12.4 Using the Indirect Method to Prepare the Statement of Cash Flows

L E A R N I N G   O B J E C T I V E  

1. Prepare  a  statement  of  cash  flows  using  the  indirect  method.  

Question: Now that you are familiar with the four key steps, let’s take a look at the statement of
cash flows for Home Store, Inc. Where do we start in preparing Home Store, Inc.’s statement of
cash flows?

Answer: As stated earlier, the information needed to prepare the statement of cash flows includes
the balance sheet, income statement, and other selected data. This information is presented in .
Other pertinent data for 2012 are as follows:

• Sold equipment with a book value of $11,000 (= $21,000 cost − $10,000 accumulated
depreciation) for $5,000 cash
• Purchased equipment for $67,000 cash
• Long-term investments were purchased for $12,000 cash. There were no sales of long-
term investments

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 • Bonds were paid with a principal amount of $18,000
• Issued common stock for $4,000 cash
• Declared and paid $32,000 in cash dividends

With these data and the information provided in , we can start preparing the statement of cash
flows. It is important to note that all positive amounts shown in the statement of cash flows
denote an increase in cash, and all negative amounts denote a decrease in cash.

Figure 12.3 Balance Sheet and Income Statement for Home Store, Inc.

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Step 1: Prepare the Operating Activities Section

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 Question: We will be using the indirect method to prepare the operating activities section.
(The direct method is covered in the appendix.) The starting point using the indirect method is
net income. Home Store, Inc., had net income of $124,000 in 2012. This amount comes from the
income statement, which was prepared using the accrual basis of accounting. How do we
convert this amount to a cash basis?

Answer: Several adjustments are necessary to convert this amount to a cash basis and to provide
an amount related only to daily operating activities of the business. If the resulting adjusted
amount is a cash inflow, it is calledcash provided by operating activities; if it is a cash outflow, it
is called cash used by operating activities.

Three general types of adjustments are necessary to convert net income tocash provided by
operating activities. These three types of adjustments are shown in , which also displays the
format used for the operating activities section of the statement of cash flows. Examine this
figure carefully.

Figure 12.4 Operating Activities Format and Adjustments

Adjustment One: Adding Back Noncash Expenses

Question: What is the first type of adjustment necessary to convert net income to a cash basis?

Answer: The first adjustment to net income involves adding back expenses that do not affect
cash (often called noncash expenses). For example, the accrual basis of accounting deducts
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 depreciation expense in calculating net income, even though depreciation expense does not
involve cash. (Recall the financial accounting entry to record depreciation expense: debit
depreciation expense and credit accumulated depreciation. Notice cash is not involved.) Thus to
convert net income to a cash basis, depreciation expense is added back to net income. In effect,
we are reversing depreciation expense because it is not an expense using the cash basis of
accounting. The end result is as though depreciation expense was never deducted as an expense.

Next, we show how the first adjustment to net income appears in the operating activities section
of the statement of cash flows for Home Store, Inc. (net income and depreciation expense come
from the income statement shown in ):

The income statement for Home Store, Inc., shows $24,000 in depreciation expense for the year.
As shown previously, this amount is added back to the net income of $124,000.

Adjustment Two: Adding Back Losses and Deducting Gains Related to Investing
Activities

Question: What is the second type of adjustment necessary to convert net income to a cash
basis?

Answer: The second adjustment to net income involves adding back losses and deducting gains
related to investing activities. For example, Home Store, Inc., realized a $6,000 loss on the sale
of equipment. This loss is shown on the income statement as a deduction in calculating net
income (see ). However, this loss is not related to the daily operations of the business. That is,

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 Home Store, Inc., is not in the business of buying and selling equipment daily. Remember, we
are trying to find the cash provided by operating activities in this section of the statement of cash
flows.

Since equipment is a noncurrent asset, cash activity related to the disposal of equipment should
be included in the investment activities section of the statement of cash flows. Thus the $6,000
loss shown as a deduction on the income statement is added back to net income, and it will be
included later in the investing activities section as part of the proceeds from the sale of
equipment. In effect, we are reversing the $6,000 loss because it is not an operating expense.

Here’s how the second adjustment to net income appears in the operating activities section of the
statement of cash flows for Home Store, Inc.:

Adjustment Three: Adding and Subtracting Changes in Current Assets and

Current Liabilities  

Question: What is the third type of adjustment necessary to convert net income to a cash basis?

Answer: The third type of adjustment to net income involves analyzing the changes in all
current assets (except cash) and current liabilities from the beginning of the period to the end of
the period. These changes are already shown in the far right column of the balance sheet portion
of . Two important rules must be followed to determine how the change is reflected as an
adjustment to net income. Study these two rules carefully:

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 1. Current assets. Increases in current assets are deducted from net income; decreases in
current assets are added to net income. (There is aninverse relationship between the
change in a current asset account and how it is shown as an adjustment.)
2. Current liabilities. Increases in current liabilities are added to net income; decreases in
current liabilities are deducted from net income. (There is a direct relationship between
the change in a current liability account and how it is shown as an adjustment.)

Now let’s work through each current asset and current liability line item shown in the balance
sheet () and use these rules to determine how each item fits into the operating activities section as
an adjustment to net income.

The first current asset line item, cash, shows the change in cash from the beginning of the year to
the end of year. Cash decreased by $98,000. The goal of the statement of cash flows is to show
what caused this $98,000 decrease. This amount will appear in step 4 when we reconcile the
beginning cash balance to the ending cash balance. The next line item is accounts receivable.

Accounts receivable (current asset) increased by $60,000. The current asset rule states that
increases in current assets are deducted from net income. Thus $60,000 is deducted from net
income in the operating activities section of the statement of cash flows. Here’s why.

Assume all Home Store’s sales shown on the income statement are credit sales (each sale
required a debit to accounts receivable and a credit to sales). The beginning accounts receivable
balance of $25,000 is increased by $900,000 for credit sales made during the year, resulting in
$925,000 in total receivables to be collected. Since $85,000 in accounts receivable remains at the
end of the year, $840,000 in cash was collected (= $925,000 − $85,000). On a cash basis, Home
Store, Inc., should show $840,000 in revenue rather than $900,000. Thus net income must be
reduced by $60,000 (= $900,000 revenue using accrual basis − $840,000 revenue using cash
basis). The accounts receivable T-account shown in the following provides further clarification.

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Here’s how the accounts receivable adjustment to net income appears in the operating activities
section of the statement of cash flows for Home Store, Inc.:

We will continue analyzing each current asset and current liability item in the balance sheet
shown in and present the resulting adjustments and completed operating activities section at the
end of our analysis in .

Merchandise inventory (current asset) increased by $66,000.Because the current asset rule states
that increases in current assets are deducted from net income, $66,000 is deducted from net
income in the operating activities section of the statement of cash flows. To explain why, let’s
assume Home Store, Inc., pays cash for all purchases of merchandise inventory. If the
merchandise inventory account increases over time, more goods are purchased than are sold.
Because merchandise inventory at Home Store, Inc., increased $66,000 and cost of goods sold
totaled $546,000 (as shown in ), the company must have purchased inventory with a cost of
$612,000 during the period (= $66,000 + $546,000). Thus more cash was paid for merchandise
($612,000) than was reflected on the income statement as cost of goods sold ($546,000). If

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 expenses are higher using a cash basis, the adjustment must decrease net income. Therefore
$66,000 is deducted from net income in the operating activities section of the statement of cash
flows. This information is summarized in the merchandise inventory T-account in the following.

Prepaid expenses (current asset) decreased by $2,000. Because the current asset
rule states that decreases in current assets are added to net income, $2,000 is added to net
income in the operating activities section of the statement of cash flows. This is because cash
paid for these expenses was lower than the expenses recognized on the income statement using
the accrual basis. Since expenses are $2,000 lower using the cash basis, net income must be
increased by $2,000.

Key  Point  
Important Current Asset Rule
When preparing the operating activities section of the statement of cash flows, increases
in current assets are deducted from net income; decreases in current assets are added
to net income.

Question: Now that we know how to handle the change in current assets when preparing the
operating activities section of the statement of cash flows, what do we do with current liabilities?

Answer: The current liability rule is a bit different than the current asset rule as described next.

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 Accounts payable (current liability) increased by $1,000. Because the current liability rule states
that increases in current liabilities are added to net income, $1,000 is added to net income in the
operating activities section of the statement of cash flows. An increase in accounts payable
signifies that Home Store, Inc., recorded more as an expense on the income statement (accrual
basis) than the company paid in cash (cash basis). Since expenses are lower using the cash basis,
net income must beincreased by $1,000.

Income tax payable (current liability) decreased by $9,000. Because the current liability rule
states that decreases in current liabilities are deducted from net income, $9,000 is deducted from
net income in the operating activities section of the statement of cash flows. A decrease in
income tax payable signifies that Home Store, Inc., paid more for income taxes (cash basis) than
the company recorded as an expense on the income statement (accrual basis). Since expenses are
higher using the cash basis, net income must be decreased by $9,000.

Key  Point  
Important Current Liability Rule
When preparing the operating activities section of the statement of cash flows, increases
in current liabilities are added to net income; decreases in current liabilities are
deducted from net income.

Question: What does the operating activities section of the statement of cash flows look like for
Home Store, Inc.?

Answer: shows the completed operating activities section of the statement of cash flows for
Home Store. Inc. The most important line is at the bottom, which shows cash of $22,000 was
generated during the year from daily operations of the business. Notice this amount is
significantly lower than the net income amount of $124,000 reported on the income statement.
Studycarefully noting the three types of adjustments made to net income.

Figure 12.5 Operating Activities Section of Statement of Cash Flows (Home Store, Inc.)
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R E V I E W   P R O B L E M   1 2 . 4  

through  will  use  the  data  presented  as  follows  for  Phantom  Books.  Each  review  
problem  corresponds  to  the  four  steps  required  to  prepare  a  statement  of  cash  flows.  

Phantom  Books  is  a  retail  store  that  sells  new  and  used  books.  Phantom’s  most  recent  
balance  sheet,  income  statement,  and  other  important  information  for  2012  are  
presented  in  the  following.  

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Additional  data  for  2012  include  the  following:  

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 • Sold  equipment  with  a  book  value  of  $8,000  (=  $30,000  cost  −  $22,000  accumulated  
depreciation)  for  $12,000  cash  
• Purchased  equipment  for  $27,000  cash  
• Sold  long-­‐term  investments  with  an  original  cost  of  $11,000  for  $3,000  cash  
• Purchased  long-­‐term  investments  for  $25,000  cash  
• Signed  a  note  with  the  bank  for  $5,000  cash.  No  principal  amounts  were  paid  during  
the  year  
• Repurchased  common  stock  (treasury  stock)  for  $16,000  cash.  No  new  common  stock  
was  issued  
• Declared  and  paid  $13,000  in  cash  dividends  
1. Prepare  the  operating  activities  section  of  the  statement  of  cash  flows  for  Phantom  
Books  using  the  indirect  method.  Follow  the  format  presented  in  .  
2. How  much  cash  did  Phantom  Books  generate  from  operating  activities  for  the  year?  

Solution  to  Review  Problem  12.4  

1. Start  with  net  income  from  the  income  statement;  make  the  appropriate  
adjustments  for  (1)  noncash  expenses,  such  as  depreciation  and  
amortization;  (2)  gains  and  losses  related  to  investing  activities;  and  (3)  
changes  in  current  assets  other  than  cash  and  current  liabilities.  The  
operating  activities  section  of  the  statement  of  cash  flows  for  Phantom  
Books  appears  as  follows.  

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2. Cash  totaling  $82,000  was  generated  from  the  company’s  operating  activities  during  
the  year.  

Before moving on to step 2, note that investing and financing activities sections always use the
same format whether the operating activities section is presented using the direct method or
indirect method.

Step 2: Prepare the Investing Activities Section

Question: Now that we have completed the operating activities section for Home Store, Inc., the
next step is to prepare the investing activities section.What information is used for this section,
and how is it prepared?

Answer: The investing activities section of the statement of cash flows focuses on cash activities
related to noncurrent assets. Review the noncurrent asset section of Home Store, Inc.’s balance
sheet presented in . Three noncurrent asset line items must be analyzed to determine how to
present cash flow information in the investing activities section.

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 Property, plant, and equipment increased by $46,000. The additional information provided for
2012 indicates two types of transactions caused this increase. First, the company purchased
equipment for $67,000 cash. Home Store, Inc., made the following journal entry for this
transaction:

Second, the company sold equipment for $5,000 cash (often called a disposalof equipment). This
equipment was on the books at an original cost of $21,000 with accumulated depreciation of
$10,000. Home Store, Inc., made the following journal entry for this transaction:

Notice the two entries to property, plant, and equipment shown previously. The net effect of
these 2 entries is an increase of $46,000 (= $67,000 − $21,000). This is summarized in the
following T-account:

Question: How is this property, plant, and equipment information used in the investing activities
section of the statement of cash flows for Home Store, Inc.?
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 Answer: First, the purchase of equipment for $67,000 cash is shown as adecrease in cash.
Second, the sale of equipment for $5,000 is shown as anincrease in cash. It is not enough to
simply show a cash outflow of $62,000 in the investing activities section of the statement of cash
flows (= $67,000 − $5,000). Instead, Home Store, Inc., must show the components of this cash
outflow as separate line items in the statement of cash flows as required by U.S. GAAP. The
formal presentation of this information in the investing activities section is shown later in .

Accumulated depreciation decreased noncurrent assets by $14,000.This contra asset account is

not typical of the other asset accounts shown on Home Store, Inc.’s balance sheet since contra
asset accounts have the effect of reducing assets. Thus as this accumulated depreciation account
increases, it further reduces overall assets. Terminology can get confusing, so here is a simple
way to look at it. The higher the account goes; the more it reduces assets. This is why the change
column shows this account as decreasing assets.

Two items caused the change in the accumulated depreciation account. First, the sale of
equipment during the year caused the company to take $10,000 in accumulated depreciation off
the books. Second, $24,000 in depreciation expense was recorded during the year (with a
corresponding entry to accumulated depreciation). This information is summarized in the
following T-account:

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 Question: How is accumulated depreciation information used in the statement of cash flows for
Home Store, Inc.?

Answer: This information is already reflected in two places (the work has already been done!).
First, depreciation expense is a noncash expense and is added back to net income in the operating
activities section of the statement of cash flows (see ). Second, $10,000 of accumulated
depreciation related to disposals is included as part of the $5,000 proceeds from the sale of
equipment in the investing activities section of the statement of cash flows (see ). Here are the
components of the equipment sale that support the $5,000 in cash proceeds shown in the
investing activities section:

Long-term investments increased by $12,000. The additional information provided for 2012
indicates there were no sales of long-term investments during the year. The increase of $12,000
is solely from purchasing long-term investments with cash. Thus the purchase of long-term
investments for $12,000 is shown as a decrease in cash in the investing activities section.

Shows the three investing activities described previously: (1) a $67,000 decrease in cash from
the purchase of equipment, (2) a $5,000 increase in cash from the sale of equipment, and (3) a
$12,000 decrease in cash from the purchase of long-term investments. Examine carefully noting
the impact these three items have on cash and the resulting cash used by investing activities of
$74,000.

Figure 12.6 Investing Activities Section of Statement of Cash Flows (Home Store, Inc.)

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R E V I E W   P R O B L E M   1 2 . 5  

Using  the  information  presented  in  :  

1. Prepare  the  investing  activities  section  of  the  statement  of  cash  flows  for  Phantom  
Books.  Follow  the  format  presented  in  .  
2. How  much  cash  did  Phantom  Books  use  for  investing  activities  during  the  year?  

Solution  to  Review  Problem  12.5  

1. Start  by  analyzing  changes  in  noncurrent  assets  on  the  balance  sheet.  Then  
prepare  the  investing  activities  section  of  the  statement  of  cash  flows.  The  
cash  flows  related  to  each  noncurrent  asset  account  are  underlined  as  
follows.  
Property,  plant,  and  equipment  decreased  by  $3,000.  Additional  data  
provided  indicate  2  items  caused  this  change:  (1)  equipment  was  purchased  
for  $27,000  cash,  causing  a  $27,000  increase  in  the  account;  and  (2)  
equipment  with  an  original  cost  of  $30,000  was  sold  for  $12,000  cash,  
causing  a  $30,000  decrease  in  the  account.  The  net  effect  of  these  2  items  
on  the  property,  plant,  and  equipment  account  is  a  decrease  of  $3,000  (=  
$27,000  purchase  −  $30,000  original  cost  of  equipment  sold).  The  impact  
these  items  have  on  cash  is  reflected  in  the  investing  activities  section  of  
the  statement  of  cash  flows  by  showing  a  $27,000  cash  outflow  for  the  
purchase  of  equipment  and  a  $12,000  cash  inflow  from  the  sale  of  
equipment.  
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 Accumulated  depreciation  decreased  assets  by  $7,000.  Two  items  caused  
this  change:  (1)  the  sale  of  equipment  caused  the  company  to  take  $22,000  
in  accumulated  depreciation  off  the  books—this  was  the  accumulated  
depreciation  on  the  books  for  the  equipment  sold,  and  (2)  $29,000  in  
depreciation  expense  was  recorded  during  the  year,  with  a  corresponding  
entry  to  accumulated  depreciation.  Neither  of  these  entries  to  accumulated  
depreciation  impacts  the  investing  activities  section.  However,  $29,000  in  
depreciation  expense  is  a  noncash  expense  and  is  added  back  to  net  income  
in  the  operating  activities  section  (see  solution  to  ).  
Long-­‐term  investments  increased  by  $14,000.  Additional  data  provided  
indicate  2  items  caused  this  change:  (1)  long-­‐term  investments  with  an  
original  cost  of  $11,000  were  sold  for  $3,000  cash,  and  (2)  long-­‐term  
investments  were  purchased  for  $25,000  cash.  The  net  effect  of  these  2  
items  on  the  long-­‐term  investments  account  is  an  increase  of  $14,000  (=  
$25,000  purchase  −  $11,000  original  cost  of  investments  sold).  The  impact  
these  items  have  on  cash  is  reflected  in  the  investing  activities  section  of  
the  statement  of  cash  flows  by  showing  a$25,000  cash  outflow  for  the  
purchase  of  investments,  and  a$3,000  cash  inflow  from  the  sale  of  
investments.  

The  investing  activities  section  of  the  statement  of  cash  flows  for  Phantom  
Books  is  shown  as  follows:  

 
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 2. Cash  totaling  $37,000  was  used  for  investing  activities  during  the  year.  

Step 3: Prepare the Financing Activities Section

Question: Now that we have completed the operating and investing activities sections for Home
Store, Inc., the next step is to prepare the financing activities section. What information is used
for this section, and how is it prepared?

Answer: The financing activities section of the statement of cash flows focuses on cash
activities related to noncurrent liabilities and owners’ equity (i.e., cash activities related to long-
term company financing). Review the noncurrent liability and owners’ equity sections of Home
Store, Inc.’s balance sheet presented in . One noncurrent liability item (bonds payable) and two
owners’ equity items (common stock and retained earnings) must be analyzed to determine how
to present cash flow information in the financing activities section. The formal presentation of
this information in the financing activities section is shown later in .

Bonds payable decreased by $18,000. The additional information provided for 2012 indicates
Home Store, Inc., paid off bonds during the year with a principal amount of $18,000. This is
reflected in the financing activities section of the statement of cash flows as an
$18,000 decrease in cash.

Common stock increased by $4,000. The additional information provided for 2012 indicates the
company issued common stock for $4,000 cash. This is reflected in the financing activities
section of the statement of cash flows as $4,000 increase in cash.

Retained earnings increased by $92,000. Two items caused this increase: (1) net income of
$124,000 increased retained earnings, and (2) cash dividends paid totaling $32,000 decreased
retained earnings. The net effect of these two entries is an increase of $92,000 (= $124,000 net
income − $32,000 cash dividends).

Question: How is this information used in the statement of cash flows?

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 Answer: Net income is already included at the top of the operating activities section as shown
in . Cash dividends are included in the financing activities section as a $32,000 decrease in cash.

shows the three financing activities described previously: (1) an $18,000 decrease in cash from
paying off the principal amount of bonds, (2) a $4,000 increase in cash from the issuance of
common stock, and (3) a $32,000 decrease in cash from the payment of cash dividends.
Examine carefully noting the impact these three items have on cash and the resulting cash used
by financing activities of $46,000.

Figure 12.7 Financing Activities Section of Statement of Cash Flows (Home Store, Inc.)

 
 
 
 
 
 
 
Business  in  Action  12.4  

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Source: Photo courtesy of Rob

Enslin,http://www.flickr.com/photos/doos/6086236471/.
Dividend Payments at Microsoft Corporation
By fiscal year ended June 30, 2004, Microsoft was sitting on more than
$60,000,000,000 in cash and short-term investments. After reviewing its options, the
company chose to give much of this cash back to shareholders in the form of cash
dividends. A one-time increase in cash dividends resulted in $33,500,000,000 paid to
the owners of the company during the second quarter of fiscal year 2005 (three months
ended December 31, 2004). This information is found in the financing activities section
of Microsoft’s statement of cash flows.
Source: Microsoft Corporation, “2004 Annual
Report,”http://www.microsoft.com; Microsoft Corporation, “2005 Second Quarter
Statement of Cash Flows,” http://www.microsoft.com.

Significant Noncash Investing and Financing Activities

Question: Some organizations have noncash activities involving the exchange of one noncurrent
or owners’ equity balance sheet item for another (e.g., the issuance of common stock for a

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 building; or the issuance of common stock in exchange for bonds held by creditors). Do these
types of transactions appear in the statement of cash flows?

Answer: These exchanges do not involve cash and thus do not appear directly on the statement
of cash flows. However, if the amount is significant, this type of exchange must be disclosed as a
separate note below the statement of cash flows or in the notes to the financial statements.

R E V I E W   P R O B L E M   1 2 . 6  

Using  the  information  presented  in  do  the  following:  

1. Prepare  the  financing  activities  section  of  the  statement  of  cash  flows  for  Phantom  
Books.  Follow  the  format  presented  in  .  
2. How  much  cash  did  Phantom  Books  use  for  financing  activities  during  the  year?  

Solution  to  Review  Problem  12.6  

1. Start  by  analyzing  changes  in  noncurrent  liabilities  and  owners’  equity  on  the  
balance  sheet.  Then  prepare  the  financing  activities  section  of  the  
statement  of  cash  flows.  The  cash  flows  related  to  each  noncurrent  liability  
and  owners’  equity  account  are  underlined  as  follows.  
Note  payable  increased  by  $5,000.  Additional  data  provided  indicate  the  
company  signed  a  note  with  the  bank  and  received  $5,000  cash.  This  is  
reflected  in  the  financing  activities  section  as  a  $5,000  cash  inflow.  
Common  stock  decreased  by  $16,000.  Additional  data  provided  indicate  
the  company  repurchased  common  stock  for  $16,000  cash.  This  is  reflected  
in  the  financing  activities  section  as  a$16,000  cash  outflow.  
Retained  earnings  increased  by  $38,000.  Two  items  caused  this  increase:  
(1)  net  income  of  $51,000  increased  retained  earnings  and  (2)  cash  
dividends  paid  totaling  $13,000  (provided  as  additional  data)  decreased  
retained  earnings.  The  net  effect  of  these  2  items  is  an  increase  of  $38,000  
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 (=  $51,000  net  income  −  $13,000  cash  dividends).  Net  income  is  already  
included  at  the  top  of  the  operating  activities  section  as  shown  in  the  
solution  to  .  Cash  dividends  are  included  in  the  financing  activities  section  
as  a  $13,000  cash  outflow.  

The  financing  activities  section  of  the  statement  of  cash  flows  for  Phantom  
Books  is  shown  as  follows:  

2. Cash  totaling  $24,000  was  used  for  financing  activities  during  the  year.  

Step 4: Reconcile the Change in Cash

Question: We’re almost done with Home Store, Inc.’s statement of cash flows.What is the fourth
and final step needed to complete the statement of cash flows?

Answer: The final step is to show that the change in cash on the statement of cash flows agrees
with the change in cash on the balance sheet. As shown at the bottom of the completed statement
of cash flows for Home Store, Inc., in , the net decrease in cash of $98,000 shown on this
statement (= $22,000 increase from operating activities − $74,000 decrease from investing
activities − $46,000 decrease from financing activities) agrees with the change in cash shown on
the balance sheet (= $32,000 ending cash balance − $130,000 beginning balance).

Figure 12.8 Statement of Cash Flows (Home Store, Inc.)

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a From .

b From .

c From .

d From .

provides a summary of cash flows for operating activities, investing activities, and financing
activities for Home Store, Inc., along with the resulting total decrease in cash of $98,000.

Figure 12.9 Cash Flows at Home Store, Inc.

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R E V I E W   P R O B L E M   1 2 . 7  

Using  the  information  presented  in  and  the  solutions  to  ,  ,  and  ,  prepare  a  complete  
statement  of  cash  flows  for  Phantom  Books.  Follow  the  format  presented  in  .  

Solution  to  Review  Problem  12.7  

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a
 From  .  
b
 From  .  
c
 From  .  

Home Store, Inc., Update

Recall the dialogue at Home Store, Inc., between John (CEO), Steve (treasurer), and Linda
(CFO). John was concerned about the company’s drop in cash from $130,000 at the beginning of
the year to $32,000 at the end of the year. He asked Linda to investigate and wanted to know
how much cash was generated from daily operations during the year. The group reconvened the

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 following week. As you read the dialogue that follows, refer to ; it is the statement of cash flows
that Linda prepared for the meeting.

Welcome, everyone. Linda, what information do you have for us regarding

John (CEO): the company’s cash flow?

I’ve completed a statement of cash flows for the year—here are copies for
your review (see ). This statement tells us about the company’s cash
activities during the year and ultimately explains why cash decreased by
Linda (CFO): $98,000.

John: How much cash did we generate from ongoing operations for the year?

That can be found in the top portion of the statement under “cash flows
Linda: from operating activities.” We generated $22,000 from operating activities.

Steve You’re kidding! We had net income totaling $124,000 but only generated
(Treasurer): $22,000 in cash?

John: That does seem like a huge disparity. Linda, are you sure this is correct?

Yes! The reason cash from operating activities is so much lower than net
income is that accounts receivable and merchandise inventory increased
significantly from the beginning of the year to the end of the year. In fact,
Linda: both accounts more than doubled.

The cash tied up in these two areas is definitely hurting our cash flow. We
really struggled to meet our cash budgets for accounts receivable
Steve: collections and inventory purchases.

Clearly, we’ve got to get a handle on receivables and inventory. But even
John: with this huge difference between net income and cash flows from operating

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 activities, we generated $22,000 in cash. This does not explain why cash
decreased by $98,000.

You’re right, John. Operating activities produced positive cash flow in spite
of these receivables and inventory issues. Let’s look further down the
statement. Notice we spent $67,000 on equipment and purchased $12,000 in
Linda: long-term investments.

Yes, I recall purchasing a new forklift—the old one was a safety hazard—
and purchasing long-term investments at the beginning of the year when our
Steve: cash balance was on the high side.

Once we factor in the cash proceeds from the old equipment, you can see we
Linda: spent $74,000 in cash for equipment and investments.

Looking back, we probably should have financed the equipment rather than
John: having paid for it all at once. What else can you tell us, Linda?

Bonds totaling $18,000 came due during the year, as shown toward the
Linda: bottom of the statement, and we paid $32,000 in dividends.

I realize the board felt cash levels were high enough during 2011 to warrant
a large dividend payment in 2012, but we need to cut way back on these
Steve: dividends in the future.

I agree. To answer your question, John, the $98,000 decrease in cash came
primarily from the purchase of equipment and long-term investments and
Linda: payments for bonds and cash dividends.

Thank you, Linda. This provides the information we need to improve cash
John: flow going forward.

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 As you can see from this dialogue, the statement of cash flows is not only a reporting
requirement for most companies, it is also a useful tool for analytical and planning purposes.
Next, we will discuss how to use cash flow information to assess performance and help in
planning for the future.

K E Y   T A K E A W A Y  

• The  statement  of  cash  flows  is  prepared  using  the  four  steps  described  in  the  
previous  segment.  In  step  1,  the  indirect  method  starts  with  net  income  in  the  
operating  activities  section  and  makes  three  types  of  adjustments  to  convert  net  
income  to  a  cash  basis.  The  first  adjustment  is  adding  back  expenses  that  do  not  
affect  cash,  such  as  depreciation.  The  second  adjustment  is  adding  back  losses  and  
deducting  gains  related  to  investing  activities.  The  third  adjustment  is  adding  and  
subtracting  changes  in  current  assets  (except  cash)  and  current  liabilities  using  the  
adjustment  rules.  Steps  2  and  3  are  done  by  analyzing  and  presenting  cash  activities  
associated  with  noncurrent  assets  (investing  activities)  and  noncurrent  liabilities  and  
owners’  equity  (financing  activities).  Step  4  shows  that  the  change  in  cash  on  the  
statement  of  cash  flows  agrees  with  the  change  in  cash  on  the  balance  sheet.  

12.5 Analyzing Cash Flow Information

L E A R N I N G   O B J E C T I V E  

1. Analyze  cash  flow  information.  

Question: Companies and analysts tend to use income statement and balance sheet information
to evaluate financial performance. In fact, financial results presented to the investing public
typically focus on earnings per share (Chapter 13 "How Do Managers Use Financial and
Nonfinancial Performance Measures?" discusses earnings per share in detail). However,
analysis of cash flow information is becoming increasingly important to managers, auditors, and
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 outside analysts. What measures are commonly used to evaluate performance related to cash
flows?

Answer: Three common cash flow measures used to evaluate organizations are (1) operating
cash flow ratio, (2) capital expenditure ratio, and (3) free cash flow. (Further coverage of these
measures can be found in the following article: John R. Mills and Jeanne H. Yamamura, “The
Power of Cash Flow Ratios,” Journal of Accountancy, October 1998.) We will use two large
home improvement retail companies, The Home Depot, Inc., and Lowe’s Companies, Inc., to
illustrate these measures.

Operating Cash Flow Ratio

Question: The operating cash flow ratio is cash provided by operating activities divided
by current liabilities. What does this ratio tell us, and how is it calculated?

Answer: This ratio measures the company’s ability to generate enough cash from daily
operations over the course of a year to cover current obligations. Although similar to the
commonly used current ratio, this ratio replaces current assets in the numerator with cash
provided by operating activities. The operating cash flow ratio is as follows:

Key  Equation  

Operating cash flow ratio= Cash provided by operating activitiesCurrent liabilities  

The numerator, cash provided by operating activities, comes from the bottom of the operating
activities section of the statement of cash flows. The denominator, current liabilities, comes from
the liabilities section of the balance sheet. (Note that if current liabilities vary significantly from
one period to the next, some analysts prefer to use average current liabilities. We will use ending
current liabilities unless noted otherwise.)

As with most financial measures, the resulting ratio must be compared to similar companies in
the industry to determine whether the ratio is reasonable. Some industries have a large operating
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 cash flow relative to current liabilities (e.g., mature computer chip makers, such as Intel
Corporation), while others do not (e.g., startup medical device companies).

The operating cash flow ratio is calculated for Home Depot and Lowe’s in the following using
information from each company’s balance sheet and statement of cash flows.

Home Depot and Lowe’s are in the same industry and have comparable ratios, which is what we
would expect for similar companies.

Capital Expenditure Ratio

Question: The capital expenditure ratio is cash provided by operating activities divided by capital
expenditures. What does this ratio tell us, and how is it calculated?

Answer: This ratio measures the company’s ability to generate enough cash from daily
operations to cover capital expenditures. A ratio in excess of 1.0, for example, indicates the
company was able to generate enough operating cash to cover investments in property, plant, and
equipment. The capital expenditure ratio is as follows:

Key  Equation  

Capital expenditure ratio=Cash provided by operating activitiesCapital expenditures  

The numerator, cash provided by operating activities, comes from the bottom of the operating
activities section of the statement of cash flows. The denominator, capital expenditures, comes
from information within the investing activities section of the statement of cash flows.

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 The capital expenditure ratio is calculated for Home Depot and Lowe’s in the following using
information from each company’s statement of cash flows.

Since the capital expenditure ratio for each company is above 1.0, both companies were able to
generate enough cash from operating activities to cover investments in property, plant, and
equipment (also called fixed assets).

Free Cash Flow

Question: Another measure used to evaluate organizations, called free cash flow, is simply a
variation of the capital expenditure ratio described previously.What does this measure tell us,
and how is it calculated?

Answer: Rather than using a ratio to determine whether the company generates enough cash
from daily operations to cover capital expenditures, free cash flow is measured in
dollars. Free cash flow is cash provided by operating activities minus capital expenditures. The
idea is that companies must continue to invest in fixed assets to remain competitive. Free cash
flow provides information regarding how much cash generated from daily operations is left over
after investing in fixed assets. Many organizations, such as Amazon.com, consider this measure
to be one of the most important in evaluating financial performance (see Note 12.34 "Business in
Action 12.5"). The free cash flow formula is as follows:

Key  Equation  

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 Free  cash  flow  =  Cash  provided  by  operating  activities  −  Capital  expenditures  

The cash provided by operating activities comes from the bottom of the operating activities
section of the statement of cash flows. The capital expenditures amount comes from information
within the investing activities section of the statement of cash flows.

The free cash flow amount is calculated for Home Depot and Lowe’s as follows using
information from each company’s statement of cash flows.

Because free cash flow for each company is above zero, both companies were able to generate
enough cash from operating activities to cover investments in fixed assets and have some left
over to invest elsewhere. This conclusion is consistent with the capital expenditure ratio analysis,
which uses the same information to assess the company’s ability to cover fixed asset
expenditures.

Formulas for the cash flow performance measures presented in this chapter are summarized
in Table 12.1 "Summary of Cash Flow Performance Measures".

Table 12.1 Summary of Cash Flow Performance Measures

Operating cash flow ratio= Cash provided by operating activitiesCurrent liabilities

Capital expenditure ratio=Cash provided by operating activitiesCapital expenditures

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 Free cash flow=Cash provided by operating activities − Capital expenditures

Business  in  Action  12.5  

Source: Photo courtesy of James Duncan

Davidson,http://www.flickr.com/photos/oreilly/6629275/
Free Cash Flow at Amazon.com
Amazon.com is an online retailer that began selling books in 1996 and has since
expanded into other areas of retail sales. The founder and CEO (Jeff Bezos) believes free
cash flow is so important, the annual report included a letter from Mr. Bezos to the
shareholders, which began with this statement, “Our ultimate financial measure, and
the one we want to drive over the long-term, is free cash flow per share.”
The company justifies this focus on free cash flow by making the point that earnings
presented on the income statement do not translate into cash flows, and shares are
valued based on the present value of future cash flows. This implies shareholders should
be most interested in free cash flow per share rather than earnings per share. Mr.

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 Bezos goes on to state, “Cash flow statements often don’t receive as much attention as
they deserve. Discerning investors don’t stop with the income statement.”
Amazon.com’s free cash flow for 2010 totaled $2,164,000,000, compared to
$2,880,000,000 in 2009. Net income for 2010 totaled $1,152,000,000, compared to
$902,000,000 in 2009. It is interesting to note that free cash flow is significantly higher
than net income for 2010 and 2009.
Source: Amazon.com, Inc., “2010 Annual Report,”http://www.amazon.com.
K E Y   T A K E A W A Y  

• Three  measures  are  often  used  to  evaluate  cash  flow.  The  operating  cash  flow  
ratio  measures  the  company’s  ability  to  generate  enough  cash  from  daily  operations  
over  the  course  of  a  year  to  cover  current  obligations.  The  formula  is  as  follows:  

Operating cash flow ratio=Cash provided by operating activitiesCurrent liabilities  

The  capital  expenditure  ratio  measures  the  company’s  ability  to  generate  enough  
cash  from  daily  operations  to  cover  capital  expenditures.  The  formula  is  as  follows:  

Capital expenditure ratio=Cash provided by operating activitiesCapital expenditures  

Free  cash  flow  measures  the  company’s  ability  to  generate  enough  cash  from  daily  
operations  to  cover  capital  expenditures  and  determines  how  much  cash  is  remaining  
to  invest  elsewhere  in  the  company.  The  formula  is  as  follows:  

Free  cash  flow  =  Cash  provided  by  operating  activities  −  Capital  expenditures  

R E V I E W   P R O B L E M   1 2 . 8  

The  following  financial  information  is  for  PepsiCo  Inc.  and  Coca-­‐Cola  Company  for  
fiscal  year  2010.  

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For  PepsiCo  and  Coca-­‐Cola,  calculate  the  following  measures  and  comment  on  your  
results:  
1. Operating  cash  flow  ratio  
2. Capital  expenditure  ratio  (Hint:  fixed  asset  expenditures  are  the  same  as  capital  
expenditures.)  
3. Free  cash  flow  

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 Solution  to  Review  Problem  12.8  

All  dollar  amounts  are  in  millions.  

1. The  formula  for  calculating  the  operating  cash  flow  ratio  is  as  follows:  

Operating Cash Flow Ratio=Cash provided by operating activitiesCurrent liabilities  

PepsiCo operating cash flow ratio=$8,448÷$15,892=0.53  

Coca-Cola operating cash flow ratio=$9,532÷$18,508=0.52  

PepsiCo  generated  slightly  more  cash  from  operating  activities  to  cover  
current  liabilities  than  Coca-­‐Cola.  

2. The  formula  for  calculating  the  capital  expenditure  ratio  is  as  follows:  

Capital Expenditure Ratio=Cash provided by operating activitiesCapital expenditures  

PepsiCo capital expenditure ratio=$8,448÷$3,253=2.60  

Coca-Cola capital expenditure ratio=$9,532÷$2,215=4.30  

Both  companies  generated  more  than  enough  cash  from  operating  

activities  to  cover  capital  expenditures.  

3. The  formula  to  calculate  free  cash  flow  is  as  follows:  

Free  cash  flow  =  Cash  provided  by  operating  activities  −  Capital  expenditures

PepsiCo free cash flow=$8,448−$3,253=$5,195

Coca-Cola free cash flow=$9,532−$2,215=$7,317  

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 The  conclusion  reached  in  requirement  two  is  confirmed  here.  Both  
companies  generated  more  than  enough  cash  from  operating  activities  to  
cover  capital  expenditures.  In  fact,PepsiCo  had  $5,195,000,000  remaining  
from  operating  activities  after  investing  in  fixed  assets,  and  Coca-­‐Cola  had  
$7,317,000,000  remaining.  

12.6 Appendix: Using the Direct Method to Prepare the Statement of Cash Flows

L E A R N I N G   O B J E C T I V E  

1. Prepare  a  statement  of  cash  flows  using  the  direct  method.  

Question: The same four steps apply to preparing a statement of cash flows using the direct
method as with the indirect method. The only difference is how the operating activities section is
presented in step 1; all other steps are the same as presented in the chapter. Although
presentation of the operating activities section using the direct method differs from the indirect
method, the end result is exactly the same. How does step 1 differ using the direct method?

Answer: Rather than adjusting net income from an accrual basis to a cash basis using the
indirect method, the direct method simply presents the income statement on a cash basis. The
format of the operating activities section using the direct method is presented in .

Figure 12.10 Operating Activities Format Using the Direct Method

The first item shown in , cash receipts from customers, is revenue (or sales) on a cash basis. The
second item, cash payments to suppliers, is cost of goods sold on a cash basis. The third

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 item, cash payments for operating expenses(also called selling and administrative expenses), is
operating expenses on a cash basis. The fourth item, cash payments for interest expense, is
interest expense on a cash basis. And the fifth item, cash payments for income taxes, is income
tax expense on a cash basis. Cash receipts minus cash payments results in cash provided by
operating activities.

Adjustments must be made to each income statement item to convert income statement
information from an accrual basis to a cash basis. These adjustments will be described next using
the same information for Home Store, Inc., presented earlier in the chapter. The income
statement and balance sheet for Home Store, Inc., are presented again in . We will start at the top
of the income statement with sales and work our way down item-by-item making adjustments to
convert each item to a cash basis.

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 Figure 12.11 Income Statement and Balance Sheet (Home Store, Inc.)

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 Converting Sales to Cash Receipts

Question: How are sales on an accrual basis converted to sales on a cash basis?

Answer: Sales of $900,000 shown on the income statement do not represent cash collected from
sales. The adjustment rule used to convert sales to cash receipts from customers is as follows:
increases in accounts receivable arededucted from sales revenue, and conversely, decreases in
accounts receivable are added to sales revenue. Since accounts receivable for Home Store, Inc.,
increased $60,000, a deduction of $60,000 from sales revenue must be taken to find cash receipts
from customers. Thus cash receipts from customers totaled $840,000 (= $900,000 sales −
$60,000 increase in accounts receivable). The accounts receivable T-account shown in the
following further clarifies this concept.

Here’s how sales revenue on a cash basis appears in the operating activities section of
the statement of cash flows for Home Store, Inc.:

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Converting Cost of Goods Sold to a Cash Basis

Question: How is cost of goods sold on an accrual basis converted to cost of goods sold on a
cash basis?

Answer: Two adjustments must be made to cost of goods sold to calculate cash paid to
suppliers. First, increases in inventory are added to cost of goods sold, and conversely, decreases
in inventory are deducted from cost of goods sold. Since inventory for Home Store, Inc.,
increased $66,000, cost of goods sold is increased $66,000. Second, increases in accounts
payable arededucted from cost of goods sold, and conversely, decreases in accounts payable
are added to cost of goods sold. Since accounts payable increased $1,000, cost of goods sold is
decreased $1,000. These 2 adjustments result in cash paid to suppliers of $611,000 (= $546,000
cost of goods sold + $66,000 increase in inventory − $1,000 increase in accounts payable).

Here’s how cost of goods sold on a cash basis appears in the operating activities section of the
statement of cash flows for Home Store, Inc.:

Converting Operating Expenses to a Cash Basis

Question: How are operating expenses on an accrual basis converted to operating expenses on a
cash basis?

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 Answer: Two adjustments must be made to operating expenses (also calledselling and
administrative expenses) to calculate cash payments for operating expenses. First, increases in
prepaid expenses are added to operating expenses, and conversely, decreases in prepaid expenses
are deducted from operating expenses. Since prepaid expenses for Home Store, Inc., decreased
$2,000, operating expenses are decreased $2,000. Second, increases in accrued liabilities
are deducted from operating expenses, and conversely, decreases in accrued liabilities
are added to operating expenses. Home Store, Inc., does not have any accrued liabilities and,
therefore, no adjustment is necessary for accrued liabilities. The 1 adjustment to operating
expenses at Home Store, Inc., results in cash payments for operating expenses of $118,000 (=
$120,000 selling and administrative expenses − $2,000 decrease in prepaid expenses).

Here’s how operating expenses on a cash basis appears in the operating activities section of the
statement of cash flows for Home Store, Inc.:

Depreciation Expense

Question: How is depreciation expense handled when using the direct method?

Answer: Since depreciation is a noncash expense, it is not included in the statement of cash
flows using the direct method.

Converting Interest Expense to a Cash Basis

Question: How is interest expense on an accrual basis converted to interest expense on a cash
basis?

Answer: Interest expense of $15,000 shown on the income statement does not necessarily
represent cash paid for interest expense. The adjustment rule used to convert interest expense to
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 cash payments for interest expense is as follows: increases in interest payable are deducted from
interest expense, and conversely, decreases in interest payable are added to interest expense.
Since Home Store, Inc., had no interest payable this year or last year, no adjustment to interest
expense is necessary.

Here’s how interest expense on a cash basis appears in the operating activities section of the
statement of cash flows for Home Store, Inc.:

Loss on Sale of Equipment

Question: How is the loss on sale of equipment handled when using the direct method?

Answer: Because the loss on sale of equipment is included as part of the proceeds from the sale
of equipment in the investing activities section, this item is not included in the operating
activities section. This holds true for both the direct and indirect methods.

Converting Income Tax Expense to a Cash Basis

Question: How is income tax expense on an accrual basis converted to income tax
expense on a cash basis?

Answer: Income tax expense of $65,000 shown on the income statement does not represent cash
paid for income taxes. The adjustment rule used to convert income tax expense to cash payments
for income taxes is: Increases in income taxes payable are deducted from income tax expense,
and conversely, decreases in income taxes payable are added to income tax expense. (The same
rules apply to companies that have deferred income taxes.) Since income taxes payable

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 decreased $9,000, income tax expense is increased $9,000. Thus cash payments for income taxes
totaled $74,000 (= $65,000 income tax expense + $9,000 decrease in income taxes payable).

Here’s how income tax expense on a cash basis appears in the operating activities section of the
statement of cash flows for Home Store, Inc.:

Question: What does the completed operating activities section for Home Store, Inc., look like
using the direct method?

Answer: The operating activities section for Home Store, Inc., is shown in . Notice that cash
provided by operating activities of $22,000 in (using the direct method) matches cash provided
by operating activities in (using the indirect method). The direct and indirect methods of
presenting the operating activities section of the statement of cash flows yield the exact same
results. Also note that the investing and financing activities do not change using the direct
method.

Figure 12.12 Operating Activities Section Using the Direct Method (Home Store, Inc.)

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*As shown in .

Summarizes the rules used to convert income statement line items to a cash basis. Review these
rules carefully before working .

Figure 12.13 Adjustment Rules for the Direct Method

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K E Y   T A K E A W A Y  

• The  same  four  steps  apply  to  preparing  the  statement  of  cash  flows  using  the  direct  
method  as  with  the  indirect  method.  The  difference  is  in  the  operating  activities  
section  of  step  1.  In  step  1,  the  indirect  method  starts  with  net  income  and  makes  
adjustments  to  convert  net  income  to  a  cash  basis.  The  direct  method  makes  
adjustments  directly  to  each  income  statement  revenue  and  expense  line  item,  
thereby  converting  each  line  item  to  a  cash  basis.  The  resulting  cash  provided  by  
(used  by)  operating  activities  is  identical  in  both  approaches.  
R E V I E W   P R O B L E M   1 2 . 9  

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 Using  the  information  presented  for  Phantom  Books  in  ,  prepare  the  operating  
activities  section  of  the  statement  of  cash  flows  using  the  direct  method.  Follow  the  
format  presented  in  ,  and  refer  to  the  adjustment  rules  in  .  

Solution  to  Review  Problem  12.9  

The  operating  activities  section  of  the  statement  of  cash  flows  for  Phantom  Books  
using  the  direct  method  is  presented  as  follows.  Notice  that  cash  provided  by  
operating  activities  of  $82,000  shown  here  using  the  direct  method  is  identical  to  cash  
provided  by  operating  activities  using  the  indirect  method  (shown  in  the  solution  to  ).  

a
 $756,000  =  $750,000  sales  revenue  +  $6,000  decrease  in  accounts  receivable.  
b
 $560,000  =  $546,000  cost  of  goods  sold  +  $13,000  increase  in  inventory  +  $1,000  
decrease  in  accounts  payable.  
c
 $75,000  =  $79,000  operating  expenses  −  $4,000  decrease  in  prepaid  expenses.  
d
 Since  no  interest  payable  balances  exist  this  year  or  last  year,  the  interest  expense  of  
$11,000  is  the  same  as  cash  payments  for  interest  expense.  
e
 $28,000  =  $30,000  income  tax  expense  −  $2,000  increase  in  income  tax  payable.  
E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  
1. Why  was  the  statement  of  cash  flows  created  by  the  Financial  Accounting  Standards  
Board  (FASB)?  

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 2. Describe  the  three  classifications  of  cash  flows,  and  provide  examples  of  activities  
that  would  appear  in  each  classification.  
3. Which  section  of  the  statement  of  cash  flows  is  widely  regarded  as  the  most  
important?  Why?  
4. Briefly  describe  the  four  steps  required  to  prepare  the  statement  of  cash  flows  using  
the  indirect  method.  
5. Refer  to  the  Why  is  the  indirect  method  used  by  most  companies?  
6. Describe  the  three  adjustments  necessary  to  convert  net  income  to  a  cash  basis  using  
the  indirect  method.  Provide  an  example  for  each  adjustment.  
7. Why  is  depreciation  expense  added  back  to  net  income  using  the  indirect  method  of  
preparing  the  statement  of  cash  flows?  
8. Assume  you  are  using  the  indirect  method  to  prepare  the  operating  activities  section  
of  the  statement  of  cash  flows.  Describe  the  adjustment  rules  for  current  assets  and  
current  liabilities,  and  provide  one  example  for  each  rule.  
9. You  have  just  completed  the  statement  of  cash  flows  for  a  company,  and  the  bottom  
of  the  statement  shows  a  net  increase  in  cash  of  $250,000.  Describe  where  this  
increase  should  be  shown  elsewhere  in  the  financial  statements.  
10. Provide  an  example  of  a  noncash  investing  or  financing  activity.  Describe  how  these  
transactions  are  disclosed  in  the  financial  statements.  
11. How  is  the  operating  cash  flow  ratio  calculated,  and  what  does  it  tell  the  user?  
12. How  is  the  capital  expenditure  ratio  calculated,  and  what  does  it  tell  the  user?  
13. How  is  free  cash  flow  calculated,  and  what  does  it  tell  the  user?  
14. Appendix.  Describe  how  the  indirect  method  differs  from  the  direct  method.  
15. Appendix.  Assume  you  are  using  the  direct  method  to  prepare  the  operating  activities  
section  of  the  statement  of  cash  flows.  Describe  the  adjustment  rule  used  to  
convert  sales  revenue  to  cash  receipts  from  customers.  

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 16. Appendix.  Assume  you  are  using  the  direct  method  to  prepare  the  operating  activities  
section  of  the  statement  of  cash  flows.  Describe  the  adjustment  rules  used  to  
convert  cost  of  goods  sold  to  cash  payments  to  suppliers.  

Brief  Exercises  
17. Evaluating  Cash  Flows  at  Home  Store,  Inc.  Refer  to  the  dialogue  at  Home  
Store,  Inc.,  presented  at  the  beginning  of  the  chapter  and  the  follow-­‐up  
dialogue  after  .  
Required:  
a. Why  was  the  CEO  concerned  about  the  company’s  cash  flow?  
b. Why  did  the  CEO  state,  “We  probably  should  have  financed  the  equipment  
rather  than  having  paid  for  it  all  at  once”?  
Classifying  Cash  Flows.  Identify  whether  each  of  the  following  items  
would  appear  in  the  operating,  investing,  or  financing  activities  section  of  
the  statement  of  cash  flows.  Briefly  explain  your  answer  for  each  item.  
0. Cash  receipts  from  the  sale  of  common  stock  
1. Cash  receipts  from  the  sale  of  a  building  
2. Cash  payments  for  income  taxes  
3. Cash  receipts  from  issuance  of  bonds  
4. Cash  payments  for  the  purchase  of  equipment  
Operating  Activities  Section  Using  the  Indirect  Method.  The  
following  income  statement  and  current  sections  of  the  balance  sheet  are  
for  Donzi,  Inc.  

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Required:  
Using  the  indirect  method,  prepare  the  operating  activities  section  of  the  
statement  of  cash  flows  for  Donzi,  Inc.,  for  the  year  ended  December  31,  
2012.  Use  the  format  presented  in  .  
(Appendix)  Operating  Activities  Section  Using  the  Direct  
Method.The  following  income  statement  and  current  sections  of  the  

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 balance  sheet  are  for  Donzi,  Inc.  (this  is  the  same  information  as  the  
previous  brief  exercise).  

Required:  
Using  the  direct  method,  prepare  the  operating  activities  section  of  the  
statement  of  cash  flows  for  Donzi,  Inc.,  for  the  year  ended  December  31,  
2012.  Use  the  format  presented  in  .  

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 Investing  Activities  Section.  The  following  information  is  from  the  
noncurrent  asset  portion  of  Santana,  Inc.’s  balance  sheet.  

The  following  activities  occurred  during  2012:  

o Sold  equipment  with  a  book  value  of  $3,000  (=  $13,000  cost  −  $10,000  
accumulated  depreciation)  for  $4,000  cash  and  depreciation  expense  for  
the  year  totaled  $26,000  
o Purchased  property  for  $43,000  cash  
o Purchased  long-­‐term  investments  for  $15,000  cash  
Required:  
Prepare  the  investing  activities  section  of  the  statement  of  cash  flows  for  
Santana,  Inc.,  for  the  year  ended  December  31,  2012.  Use  the  format  
presented  in  .  
Financing  Activities  Section.  The  following  information  is  from  the  
noncurrent  liabilities  and  owners’  equity  portions  of  Canton  Company’s  
balance  sheet.  

 
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 The  following  activities  occurred  during  2012:  
o Issued  bonds  for  $80,000  cash  
o Issued  common  stock  for  $100,000  cash  
o Earned  net  income  totaling  $60,000  
o Paid  cash  dividends  totaling  $15,000  
Required:  
Prepare  the  financing  activities  section  of  the  statement  of  cash  flows  for  
Canton  Company  for  the  year  ended  December  31,  2012.  Use  the  format  
presented  in  .  
Cash  Flow  Measures.  The  selected  information  in  the  following  is  
from  Diaz  Company’s  financial  records  for  the  most  recent  fiscal  year.  
Current assets $600,000

Current liabilities $250,000

Cash provided by operating activities $700,000

Net income $300,000

Capital expenditures $550,000

Required:  

Calculate  Diaz  Company’s  

0. Operating  cash  flow  ratio;  
1. Capital  expenditure  ratio;  and  
2. Free  cash  flow.  

Exercises:  Set  A  

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 24. Classifying  Cash  Flows.  Identify  whether  each  of  the  following  items  would  
appear  in  the  operating,  investing,  or  financing  activities  section  of  the  
statement  of  cash  flows.  Briefly  explain  your  answer  for  each  item.  
1. Cash  payments  for  the  repurchase  of  common  stock  
2. Cash  payments  for  the  purchases  of  merchandise  
3. Cash  receipts  from  the  collection  of  interest  on  loans  made  to  other  entities  
4. Cash  receipts  from  the  collection  of  principal  on  loans  made  to  other  
entities  
5. Cash  payments  to  shareholders  for  dividends  
6. Cash  payments  for  the  purchase  of  equipment  
25. Operating  Activities  Section  Using  the  Indirect  Method.  The  following  
income  statement  and  current  sections  of  the  balance  sheet  are  for  
Capstone,  Inc.  

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Required:  
a. Using  the  indirect  method,  prepare  the  operating  activities  section  of  
the  statement  of  cash  flows  for  Capstone,  Inc.,  for  the  year  ended  
December  31,  2012.  Use  the  format  presented  in  .  
b. How  much  cash  was  provided  by  (used  by)  operating  activities?  Briefly  
describe  what  this  amount  tells  us  about  the  company.  
(Appendix)  Operating  Activities  Section  Using  the  Direct  
Method.The  following  income  statement  and  current  sections  of  the  
balance  sheet  are  for  Capstone,  Inc.  (this  is  the  same  information  as  the  
previous  exercise).  

 
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Required:  
 . Using  the  direct  method,  prepare  the  operating  activities  section  of  
the  statement  of  cash  flows  for  Capstone,  Inc.,  for  the  year  ended  
December  31,  2012.  Use  the  format  presented  in  .  
a. How  much  cash  was  provided  by  (used  by)  operating  activities?  Briefly  
describe  what  this  amount  tells  us  about  the  company.  
Investing  Activities  Section.  The  following  information  is  from  the  
noncurrent  asset  portion  of  Caldera,  Inc.’s  balance  sheet.  

The  following  activities  occurred  during  2012:  

o Sold  equipment  with  a  book  value  of  $46,000  (=  $170,000  cost  −  $124,000  
accumulated  depreciation)  for  $37,000  cash  and  depreciation  expense  for  
the  year  totaled  $159,000  

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 o Purchased  equipment  for  $310,000  cash  
o No  additional  loans  to  other  entities  were  made  during  the  year  (Hint:  Solve  
for  the  principal  amount  on  loans  collected  during  the  year.)  
o Sold  long-­‐term  investments  with  an  original  cost  of  $27,000  for  $33,000  
cash  
Required:  
d. Prepare  the  investing  activities  section  of  the  statement  of  cash  flows  for  
Caldera,  Inc.,  for  the  year  ended  December  31,  2012.  Use  the  format  
presented  in  .  
e. How  much  cash  was  provided  by  (used  by)  investing  activities?  Briefly  
describe  what  this  amount  tells  us  about  the  company.  
Financing  Activities  Section.  The  following  information  is  from  the  
noncurrent  liabilities  and  owners’  equity  portions  of  Flash,  Inc.’s  balance  
sheet.  

The  following  activities  occurred  during  2012:  

o Paid  principal  amount  of  $20,000  for  long-­‐term  notes  payable  
o Received  $110,000  for  long-­‐term  notes  payable  
o Paid  principal  amount  on  bonds  totaling  $33,000  
o Repurchased  common  stock  for  $60,000  cash  
o Earned  net  income  totaling  $200,000  

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 o Paid  cash  dividends  totaling  $40,000  
Required:  
f. Prepare  the  financing  activities  section  of  the  statement  of  cash  flows  for  
Flash,  Inc.,  for  the  year  ended  December  31,  2012.  Use  the  format  
presented  in  .  
g. How  much  cash  was  provided  by  (used  by)  financing  activities?  Briefly  
describe  what  this  amount  tells  us  about  the  company.  
Operating  Activities  Section  Using  the  Indirect  Method  and  Cash  
Ratios.  The  following  data  are  for  Cycle  Company.  

Required:  

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  . Using  the  indirect  method,  prepare  the  operating  activities  section  of  the  
statement  of  cash  flows  for  Cycle  Company  for  the  year  ended  December  
31,  2012.  Use  the  format  presented  in  .  

a. Calculate  the  following  cash  measures:  

1. Operating  cash  flow  ratio  
2. Capital  expenditure  ratio  
3. Free  cash  flow  

Exercises:  Set  B  
30. Classifying  Cash  Flows.  Identify  whether  each  of  the  following  items  would  
appear  in  the  operating,  investing,  or  financing  activities  section  of  the  
statement  of  cash  flows.  Briefly  explain  your  answer  for  each  item.  
1. Cash  receipts  from  the  sale  of  goods  
2. Cash  payments  for  the  purchases  of  merchandise  
3. Cash  receipts  from  the  issuance  of  bonds  
4. Cash  payments  to  shareholders  for  dividends  
5. Cash  payments  to  employees  
6. Cash  receipts  from  the  sale  of  equipment  
31. Operating  Activities  Section  Using  the  Indirect  Method.  The  following  
income  statement  and  current  sections  of  the  balance  sheet  are  for  Manor  
Company.  

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Required:  
a. Using  the  indirect  method,  prepare  the  operating  activities  section  of  
the  statement  of  cash  flows  for  Manor  Company  for  the  year  ended  
December  31,  2012.  Use  the  format  presented  in  .  
b. How  much  cash  was  provided  by  (used  by)  operating  activities?  Briefly  
describe  what  this  amount  tells  us  about  the  company.  
(Appendix)  Operating  Activities  Section  Using  the  Direct  
Method.The  following  income  statement  and  current  sections  of  the  
balance  sheet  are  for  Manor  Company  (this  is  the  same  information  as  the  
previous  exercise).  
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Required:  
 . Using  the  direct  method,  prepare  the  operating  activities  section  of  
the  statement  of  cash  flows  for  Manor  Company  for  the  year  ended  
December  31,  2012.  Use  the  format  presented  in  .  
a. How  much  cash  was  provided  by  (used  by)  operating  activities?  Briefly  
describe  what  this  amount  tells  us  about  the  company.  
Investing  Activities  Section.  The  following  information  is  from  the  
noncurrent  asset  portion  of  Gebhardt  Company’s  balance  sheet.  

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The  following  activities  occurred  during  2012:  

o Sold  equipment  with  a  book  value  of  $4,000  (=  $90,000  cost  −  $86,000  
accumulated  depreciation)  for  $9,000  cash  and  depreciation  expense  for  
the  year  totaled  $71,000  
o Purchased  equipment  for  $50,000  cash  
o Loans  totaling  $62,000  were  made  to  other  entities  during  the  year  (Hint:  
Solve  for  the  principal  amount  on  loans  collected  during  the  year.)  
o Purchased  long-­‐term  investments  for  $16,000  cash  
Required:  
d. Prepare  the  investing  activities  section  of  the  statement  of  cash  flows  for  
Gebhardt,  Inc.,  for  the  year  ended  December  31,  2012.  Use  the  format  
presented  in  .  
e. How  much  cash  was  provided  by  (used  by)  investing  activities?  Briefly  
describe  what  this  amount  tells  us  about  the  company.  
Financing  Activities  Section.  The  following  information  is  from  the  
noncurrent  liabilities  and  owners’  equity  portions  of  System,  Inc.’s  balance  
sheet.  

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The  following  activities  occurred  during  2012:  

o Paid  principal  amount  of  $70,000  for  long-­‐term  notes  payable  
o Received  $40,000  for  long-­‐term  notes  payable  
o Paid  principal  amount  on  bonds  totaling  $15,000  (Hint:  Solve  for  the  
proceeds  received  from  the  issuance  of  bonds.)  
o Issued  common  stock  for  $100,000  cash  (Hint:  Solve  for  the  amount  paid  
for  the  repurchase  of  stock.)  
o Earned  net  income  totaling  $170,000  
o Paid  cash  dividends  totaling  $20,000  
Required:  
f. Prepare  the  financing  activities  section  of  the  statement  of  cash  flows  for  
System,  Inc.,  for  the  year  ended  December  31,  2012.  Use  the  format  
presented  in  .  
g. How  much  cash  was  provided  by  (used  by)  financing  activities?  Briefly  
describe  what  this  amount  tells  us  about  the  company.  
Operating  Activities  Section  Using  the  Indirect  Method  and  Cash  
Ratios.  The  following  data  are  for  Mills  Company.  

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Required:  
 . Using  the  indirect  method,  prepare  the  operating  activities  section  of  the  
statement  of  cash  flows  for  Mills  Company  for  the  year  ended  December  
31,  2012.  Use  the  format  presented  in  .  

a. Calculate  the  following  cash  measures:  

1. Operating  cash  flow  ratio  
2. Capital  expenditure  ratio  
3. Free  cash  flow  

Problems  
36. Classifying  Cash  Flows.  Big  Sky,  Inc.,  had  the  following  transactions  during  
2012:  
1. Issued  common  stock  for  $150,000  cash  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 2. Paid  $25,000  in  principal  on  previously  issued  bonds  
3. Paid  $300,000  in  salaries  and  wages  to  employees  
4. Sold  property  for  $45,000  cash  
5. Paid  $3,000  in  cash  dividends  
6. Received  $600,000  from  customers  for  cash  sales  
7. Paid  $350,000  cash  for  merchandise  
8. Converted  bonds  into  common  stock  
9. Purchased  a  building  for  $850,000  cash  
10. Paid  $310,000  for  operating  expenses  
11. Received  $200,000  cash  for  the  sale  of  long-­‐term  investments  
12. Issued  bonds  for  $87,000  cash  
13. Repurchased  common  stock  for  $35,000  cash  
14. Issued  common  stock  to  purchase  land  valued  at  $450,000  
15. Paid  $10,000  cash  for  interest  on  notes  payable  
Required:  

Classify  each  transaction  as  one  of  the  following:  operating  activity,  
investing  activity,  financing  activity,  or  noncash  transaction.  Briefly  explain  
your  answer  for  each  item.  
37. Prepare  a  Statement  of  Cash  Flows,  Indirect  Method.  Glenbrook  
Company’s  most  recent  balance  sheet,  income  statement,  and  other  
important  information  for  2012  are  presented  as  follows.  

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Additional  data  for  2012  are  as  follows:  

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 o Sold  equipment  with  a  book  value  of  $30,000  (=  $40,000  cost  −  $10,000  
accumulated  depreciation)  for  $28,000  cash  
o Purchased  equipment  for  $96,000  cash  
o There  were  no  sales  of  long-­‐term  investments  (Hint:  Solve  for  the  purchase  
of  long-­‐term  investments.)  
o Issued  bonds  for  $16,000  cash  
o Repurchased  common  stock  (treasury  shares)  for  $45,000  cash  
o Declared  and  paid  $12,000  in  cash  dividends  
Required:  
g. Use  the  four  steps  described  in  the  chapter  to  prepare  a  statement  of  cash  
flows  for  the  year  ended  December  31,  2012,  using  the  indirect  method.  
Refer  to  the  format  presented  in  .  
h. Briefly  describe  the  major  changes  in  cash  identified  in  the  statement  of  
cash  flows.  
(Appendix)  Prepare  a  Statement  of  Cash  Flows,  Direct  Method.Refer  
to  the  information  for  Glenbrook  Company  presented  in  the  previous  
problem.  
Required:  
 . Use  the  four  steps  described  in  the  chapter,  including  the  appendix,  to  
prepare  a  statement  of  cash  flows  for  the  year  ended  December  31,  2012,  
using  the  direct  method.  Refer  to  the  operating  activities  section  format  
using  the  direct  method  presented  in  and  the  adjustment  rules  for  the  
direct  method  presented  in  .  
a. Briefly  describe  the  major  changes  in  cash  identified  in  the  statement  of  
cash  flows.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Prepare  and  Analyze  a  Statement  of  Cash  Flows,  Indirect  
Method.Travel  Supply,  Inc.’s  most  recent  balance  sheet,  income  statement,  
and  other  important  information  for  2012  are  presented  as  follows.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Additional  data  for  2012  are  as  follows:  

o Sold  equipment  with  a  book  value  of  $3,000  (=  $23,000  cost  −  $20,000  
accumulated  depreciation)  for  $8,000  cash  
o Purchased  equipment  for  $47,000  cash  
o Sold  long-­‐term  investments  for  $9,000  cash  and  these  investments  had  an  
original  cost  of  $13,000  
o Paid  $16,000  cash  for  principal  amount  on  notes  payable  
o Issued  common  stock  for  $8,000  cash  
o Declared  and  paid  $22,000  in  cash  dividends  
Required:  
f. Use  the  four  steps  described  in  the  chapter  to  prepare  a  statement  of  cash  
flows  for  the  year  ended  December  31,  2012,  using  the  indirect  method.  
Refer  to  the  format  presented  in  .  
g. The  owner  of  Travel  Supply,  Inc.,  wants  to  know  why  cash  only  increased  
$51,000  even  though  the  company  had  net  income  of  $103,000,  issued  
common  stock  for  $8,000,  and  sold  long-­‐term  investments  for  $9,000.  Use  

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 the  information  in  the  statement  of  cash  flows  to  briefly  explain  why  cash  
only  increased  $51,000.  
Prepare  a  Statement  of  Cash  Flows,  Indirect  Method;  Analyze  Using  
Cash  Ratios.  Nolan  Company’s  most  recent  balance  sheet,  income  
statement,  and  other  important  information  for  2012  are  presented  as  
follows.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Additional  data  for  2012  are  as  follows:  

o Sold  equipment  with  a  book  value  of  $13,000  (=  $27,000  cost  −  $14,000  
accumulated  depreciation)  for  $21,000  cash  
o Purchased  equipment  for  $10,000  cash  
o Sold  long-­‐term  investments  for  $6,000  cash  and  these  investments  had  an  
original  cost  of  $8,000  
o Received  $19,000  cash  related  to  notes  payable  
o Issued  common  stock  for  $35,000  cash  
o Declared  and  paid  $4,000  in  cash  dividends  
Required:  
f. Use  the  four  steps  described  in  the  chapter  to  prepare  a  statement  of  cash  
flows  for  the  year  ended  December  31,  2012,  using  the  indirect  method.  
Refer  to  the  format  presented  in  .  
g. The  owner  of  Nolan  Company  wants  to  know  how  cash  more  than  doubled,  
from  $82,000  to  $165,000,  given  the  company’s  modest  net  income  of  
$9,000.  Use  the  information  in  the  statement  of  cash  flows  to  briefly  
explain  why  cash  more  than  doubled.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 h. Calculate  the  following  cash  measures:  
1. Operating  cash  flow  ratio  
2. Capital  expenditure  ratio  (Hint:  Capital  expenditures  can  be  found  
in  the  investing  activities  section  of  the  statement  of  cash  flows  
prepared  in  part  a.)  
3. Free  cash  flow  
(Appendix)  Prepare  a  Statement  of  Cash  Flows  (Direct  Method);  
Analyze  Using  Cash  Ratios.  Refer  to  the  information  for  Nolan  Company  
presented  in  the  previous  problem.  
Required:  
 . Use  the  four  steps  described  in  the  chapter,  including  the  appendix,  to  
prepare  a  statement  of  cash  flows  for  the  year  ended  December  31,  2012,  
using  the  direct  method.  Refer  to  the  operating  activities  section  format  
using  the  direct  method  presented  in  ,  and  the  adjustment  rules  for  the  
direct  method  presented  in  .  
a. Briefly  describe  the  major  changes  in  cash  identified  in  the  statement  of  
cash  flows.  

b. Calculate  the  following  cash  measures:  

1. Operating  cash  flow  ratio  
2. Capital  expenditure  ratio  (Hint:  Capital  expenditures  can  be  found  
in  the  investing  activities  section  of  the  statement  of  cash  flows  
prepared  in  part  a.)  
3. Free  cash  flow  
Prepare  and  Analyze  a  Statement  of  Cash  Flows,  Indirect  Method  
and  Direct  Method.  Ritz  Company’s  most  recent  balance  sheet,  income  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 statement,  and  other  important  information  for  2012  are  presented  as  
follows.  

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Additional  data  for  2012  are  as  follows:  

o Sold  equipment  with  a  book  value  of  $15,000  (=  $100,000  cost  −  $85,000  
accumulated  depreciation)  for  $32,000  cash  
o Purchased  equipment  for  $140,000  cash  
o Sold  long-­‐term  investments  for  $23,000  cash  and  these  investments  had  an  
original  cost  of  $24,000  
o Purchased  long-­‐term  investments  for  $5,000  cash  
o Issued  bonds  for  $105,000  cash  
o Issued  common  stock  for  $7,000  cash  
o Declared  and  paid  $11,000  in  cash  dividends  
Required:  
g. Use  the  four  steps  described  in  the  chapter  to  prepare  a  statement  of  cash  
flows  for  the  year  ended  December  31,  2012,  using  the  indirect  method.  
Refer  to  the  format  presented  in  .  
h. The  owner  of  Ritz  Company  wants  to  know  why  cash  decreased  from  
$350,000  to  $278,000  given  the  company’s  net  income  of  $18,000.  Use  the  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 information  in  the  statement  of  cash  flows  to  briefly  explain  why  cash  
decreased.  
i. Use  the  four  steps  described  in  the  chapter,  as  well  as  in  the  appendix,  to  
prepare  a  statement  of  cash  flows  for  the  year  ended  December  31,  2012,  
using  the  directmethod.  Refer  to  the  operating  activities  section  format  
using  the  direct  method  presented  in  and  the  adjustment  rules  for  the  
direct  method  presented  in  .  

One  Step  Further:  Skill-­‐Building  Cases  

43. Southwest  Airlines  Statement  of  Cash  Flows.  Refer  to  the  How  
couldSouthwest’s  cash  balance  increase  by  $147,000,000  even  though  the  company  
generated  $1,600,000,000  in  cash  from  operating  activities?  
44. Home  Depot  and  Lowe’s  Statement  of  Cash  Flows.  Refer  to  the  How  much  cash  was  
generated  from  daily  activities  for  each  company?  Where  was  the  bulk  of  this  cash  
spent  for  each  company?  
45. Internet  Project:  Statement  of  Cash  Flows.  Using  the  Internet,  find  the  
most  recent  annual  report  for  a  company  of  your  choice.  Print  the  
statement  of  cash  flows  and  include  it  with  your  response  to  the  following  
requirements.  
Required:  
a. How  much  cash  was  provided  by  (used  by)  operatingactivities?  
Compare  this  amount  to  net  income  (often  called  net  earnings)  and  explain  
why  the  two  are  different.  
b. What  method  did  the  company  use  to  prepare  theoperating  activities  
section,  direct  or  indirect?  Explain.  
c. How  much  cash  was  provided  by  (used  by)  investingactivities?  Which  
activity  in  this  section  had  the  biggest  impact  on  investing  cash  flows?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 d. How  much  cash  was  provided  by  (used  by)  financingactivities?  Which  
activity  in  this  section  had  the  biggest  impact  on  financing  cash  flows?  
e. Calculate  free  cash  flow.  Did  the  company  generate  enough  cash  from  
operating  activities  to  cover  capital  expenditures?  Explain.  
Dividend  Cash  Flow  at  Microsoft.  Refer  to  the  How  much  did  Microsoftpay  in  
dividends  during  the  second  quarter  of  2005?  Why  did  Microsoftpay  such  a  large  
dividend  to  shareholders?  
Cash  Flows  at  Amazon.com.  Refer  to  the  Why  does  Amazon.com  prefer  to  use  free  
cash  flow  per  share  rather  than  earnings  per  share  to  evaluate  the  company?  
Group  Activity:  Analyzing  General  Motors  Statement  of  Cash  
Flows.The  following  information  is  from  the  consolidated  statement  of  cash  
flows  for  General  Motors  (GM)  for  the  year  ended  December  31,  2005  (in  
millions).  

Required:  
An  investment  advisor  recently  reviewed  GM’s  statement  of  cash  flows  and  
balance  sheet  and  stated:  “GM  is  doing  great!  They  are  sitting  on  cash  of  
more  than  $30,000,000,000.  There  is  no  cash  flow  problem  with  this  
company!”  In  groups  of  two  to  four  students,  decide  whether  you  agree  
with  this  statement.  Support  your  conclusion  with  an  analysis  of  GM’s  cash  
flows.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Comprehensive  Case  
49. Ethics:  Manipulating  Data  to  Reach  Target  Cash  Flow.  Country  Market,  
Inc.,  sells  food  and  beverage  products  at  its  five  retail  stores.  The  company’s  
fiscal  year  ends  on  December  31.  The  company’s  president  and  CEO,  Jean  
Williams,  just  received  a  draft  of  the  statement  of  cash  flows  from  the  
controller,  Stan  Walker.  Jean  is  very  interested  in  the  results  since  a  
significant  part  of  her  annual  bonus  depends  on  generating  at  least  
$400,000  in  cash  from  operating  activities.  A  summary  of  the  statement  is  
provided  in  the  following:  

Becky  Swanson,  the  chief  financial  officer  (CFO)  for  Country  Market,  is  
approached  by  Jean:  
Jean: Becky, have you seen the statement of cash flows?

Becky: No, not yet. Last I heard Stan was just about done with it.

Jean: He just dropped off a copy for my review.

Becky: Excellent. How does it look?

Overall it looks fine, but something must be wrong with the operating activities
number. I assumed it would be well above $400,000. Can you take a look at it
Jean: and make sure we exceed $400,000?

Becky: I’ll do what I can.

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 Jean: Great. I knew I could depend on you.

Shortly after this discussion, Becky returned with revised numbers:

Jean, here is the corrected statement of cash flows (see as follows). I was able
to reclassify a portion of cash received from the sale of long-term investments
Becky: to the operating activities section to get to $403,000.

Jean: Excellent! Thanks, Becky, I knew you could do it!

Required:  
a. What  impact  did  the  reclassification  of  cash  flows  have  on  the  total  net  
increase  in  cash?  Explain.  
b. Are  Becky’s  actions  ethical?  Explain.  
c. If  you  were  the  CFO,  how  would  you  handle  Jean’s  request?  (If  necessary,  
review  the  presentation  of  ethics  in  for  additional  information.)  
   

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 Chapter 13

How Do Managers Use Financial and Nonfinancial Performance Measures?

Source: Photo courtesy of Jon

Seidman,http://www.flickr.com/photos/jonseidman1988/4481833335/.

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 Sandy Masako is the CEO of a fast-food restaurant called Chicken Deluxe. The company
operates hundreds of restaurants throughout North America and is choosing between two
suppliers of soft drinks: Deep Fizz Company and Extreme Fizz, Inc. Consumer surveys indicate
no significant preference between the two. Sandy is meeting with Dave Roberts, the CFO, and
Karen Kraft, the purchasing manager, to discuss the company’s options.

We have a big decision to make. Our soft drink contract is up at the end of
Sandy (CEO): this year, and we need to decide on a supplier for next year.

Karen
(Purchasing I’ve had preliminary discussions with both Deep Fizz and Extreme Fizz,
Manager): and the costs of their products are about the same.

Based on extensive surveys with our customers, they are not particularly
concerned about which supplier we choose, as long as it’s either Deep
Dave (CFO): Fizz or Extreme Fizz.

Both companies would like our business. This is a big contract for either
Karen: of them!

OK, so we have two companies offering the same terms, and customers
who would be satisfied with either company’s products. Are there any
Sandy: other criteria we should consider?

We must have a supplier that is on solid financial ground. If our supplier

were to have financial difficulties that jeopardized product quality or
Dave: timing of deliveries, we would be in a bind.

I agree. We need to determine whether these companies are in good

Karen: financial shape.

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 I suggest we have our accounting staff evaluate their financial
Dave: information by analyzing and comparing certain key financial measures.

Sandy: What do you have in mind?

My staff can look at financial trends and calculate several different ratios
to evaluate the strength of each company’s income statement and balance
sheet. We can compare these ratios for both companies and also compare
them to industry standards. This analysis should give us a better idea
Dave: about the financial stability of each company.

Excellent! We have a few months to make our decision. How much time do
Sandy: you need?

Dave: We can have it ready within a few weeks.

Sandy: Great, let’s plan on reviewing your analysis next month.

Chicken Deluxe is facing a supplier decision common to many companies. Financial stability is
an important factor in deciding on a supplier, along with the quality of product and reliability of
service. Chicken Deluxe must analyze financial information for Deep Fizz and Extreme Fizz to
determine the financial condition of each company.

The analysis of a company’s financial information typically follows a three-pronged approach.

First, trends within a company’s own financial information are analyzed, such as sales and
earnings from one year to the next, using two methods—trend analysis and common-size
analysis. Second, financial measures are compared between competitors. Finally, financial ratios
are compared to industry averages. We discuss these three approaches next using Coca-Cola as
an example. We will revisit the decision facing Chicken Deluxe later in the chapter.

13.1 Trend Analysis of Financial Statements

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 L E A R N I N G   O B J E C T I V E  

1. Perform  trend  analysis  to  evaluate  financial  statement  information.  

Question: How is trend analysis used to evaluate the financial health of an organization?

Answer: Trend analysis evaluates an organization’s financial information over a period of time.
Periods may be measured in months, quarters, or years, depending on the circumstances. The
goal is to calculate and analyze the amount change and percent change from one period to the
next.

For example, in fiscal years 2010 and 2009, Coca-Cola had the operating income shown as
follows. (Amounts are in millions. To convert to the actual amount, simply multiply the amount
given times one million. For example, $8,449 × 1,000,000 = $8,449,000,000. Thus Coca-
Cola had operating income of $8,449,000,000 in 2010.)

Amount 2010 Amount 2009 Amount Change Percent Change

Operating income $8,449 $8,231 ? ?

Although readers of the financial information can see that operating income increased
from 2009 to 2010, the exact dollar amount of the change and the percent change is
more helpful in evaluating the company’s performance. The dollar amount of change is
calculated as follows:
Key  Equation  

Amount  of  change  =  Current  year  amount  –  Base  year  amount  

Amount of change$218==Current year amount$8,449−−Base year amount$8,231  

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 Question: As you can see, operating income increased by $218,000,000 from 2009 to 2010. Is
this a significant increase for Coca-Cola?

Answer: Most of us consider $218,000,000 to be a huge amount, but the only way to gauge the
true significance of this amount for Coca-Cola is to calculate the percent change from 2009 to
2010. The percent change is calculated as the current year amount minus the base year amount,
divided by the base year amount.

Key  Equation  

Percent  change  =  (Current  year  amount  –  Base  year  amount)  ÷  Base  year  amount  

The calculation that follows shows operating income increased 2.6 percent from 2009 to 2010.
Although not an extraordinarily significant increase, this does represent positive results for Coca-
Cola.

Percent change2.6%=(Current year amount−Base year amount)÷Base year amount=($8,449−$8,

231)÷$8,231

Trend Analysis for the Income Statement and Balance Sheet

Question: Trend analysis is often used to evaluate each line item on the income statement and
balance sheet. How is this analysis prepared?

Answer: Figure 13.1 "Income Statement Trend Analysis for " shows Coca-Cola’s income
statement trend analysis, and Figure 13.2 "Balance Sheet Trend Analysis for " shows Coca-
Cola’s balance sheet trend analysis. Carefully examine each of these figures, including the
comments.

Figure 13.1 Income Statement Trend Analysis for Coca-Cola

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Note: Percent change for each line item is found by dividing the increase (decrease) amount by
the 2009 amount. For example, net sales 13.3 percent increase equals $4,129 ÷ $30,990.

Figure 13.1 "Income Statement Trend Analysis for " shows that net sales increased by
$4,129,000,000, or 13.3 percent. Cost of goods sold had a corresponding increase of
$1,605,000,000, or 14.5 percent. The increase in net sales and related increase in cost of goods
sold resulted in an increase in gross margin of $2,524,000,000, or 12.7 percent. The increase in
selling and administrative expenses of $1,800,000,000, or 15.8 percent, outpaced the increase in
net sales, resulting in a relatively small increase in operating income of $218,000,000, or 2.6
percent. The significant increase in other income (expenses), net of 555.6 percent relates to a
one-time gain of $4,978,000,000 resulting from Coca-Cola’s acquisition of Coca-Cola
Enterprises, Inc., in 2010 (this information comes from the notes to the financial statements).
This one-time gain caused an unusually large increase in net income for 2010. This is important
as we continue our analysis of Coca-Cola Company throughout the chapter. Net income will
appear to have an unusually large increase as we cover various measures of performance, but
keep in mind that the one-time gain in 2010 of $4,978,000,000 caused most of the increase from
2009 to 2010.

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 Figure 13.2 Balance Sheet Trend Analysis for Coca-Cola

Note: Percent change for each line item is found by dividing the increase (decrease) amount by
the 2009 amount. For example, cash and cash equivalents 22.4 percent increase equals $2,048 ÷
$9,151.

Current Assets and Current Liabilities

Question: What does the balance sheet trend analysis in Figure 13.2 "Balance Sheet Trend
Analysis for " tell us about current assets and current liabilities forCoca-Cola?

Answer: Figure 13.2 "Balance Sheet Trend Analysis for " shows that cash and cash equivalents
increased by $2,048,000,000, or 22.4 percent. Coca-Cola’s statement of cash flows would
provide detailed information regarding this increase. (Chapter 12 "How Is the Statement of Cash
Flows Prepared and Used?" covers the statement of cash flows.) Marketable securities increased
122.6 percent, accounts receivable increased 17.9 percent, and merchandise inventory increased
12.6 percent. Other current assets increased 42.0 percent.

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 Moving to current liabilities, accounts payable and accrued liabilities increased by 33.1 percent,
loans and notes payable increased 20.0 percent, and other current liabilities decreased 391.7
percent (mostly attributable to a significant increase in the current portion of long-term debt).

Noncurrent Assets and Noncurrent Liabilities

Question: What does the balance sheet trend analysis in Figure 13.2 "Balance Sheet Trend
Analysis for " tell us about noncurrent assets and noncurrent liabilities for Coca-Cola?

Answer: Figure 13.2 "Balance Sheet Trend Analysis for " shows that long-term investments
increased 11.2 percent. Property, plant, and equipment increased 54.0 percent, and intangible
assets increased by a significant 109.8 percent. Both items appearing under noncurrent liabilities
increased, with a 177.5 percent increase in long-term debt and a 99.2 percent increase in other
liabilities and deferred taxes.

Shareholders’ Equity

Question: What does the balance sheet trend analysis in Figure 13.2 "Balance Sheet Trend
Analysis for " tell us about shareholders’ equity for Coca-Cola?

Answer: Common stock increased 16.1 percent, and retained earnings increased 17.8 percent.
Accumulated other income (loss) went further into negative territory by 91.5 percent, and
treasury stock increased 9.3 percent.

Big Picture Balance Sheet Trend Analysis

Question: What are some of the key big picture items identified in the balance sheet trend
analysis shown in Figure 13.2 "Balance Sheet Trend Analysis for "?

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 Answer: Overall, total assets increased by $24,250,000,000, or 49.8 percent. Of course, total
liabilities and shareholders’ equity also increased by the same amount. The increases identified
in almost every asset, liability, and shareholders’ equity line item are significant. From reading
the notes to the financial statements, the authors were able to identify the main source of these
increases. In 2010, Coca-Cola acquired the remaining 67 percent of Coca-Cola Enterprises,
Inc.’s (CCE) North America business thatCoca-Cola did not already own. This resulted in
significant increases in noncurrent assets and noncurrent liabilities, which were acquired as part
of this transaction. It also resulted in the reporting of a one-time gain on the income statement of
$4,978,000,000, which came from Coca-Colaremeasuring its equity interest in CCE to fair value
upon close of the transaction in 2010.

This analysis points to the reason we perform trend analysis—to identify the increases and
decreases in dollar amounts from one year to the next and to take a close look at unusual trends.

Trend Analysis over Several Years

Question: The trend analysis just described works well when comparing financial data for two
years. However, many prefer to review trends over more than two years. How might a trend
analysis for several years be prepared?

Answer: A common approach is to establish the oldest year as the base year and compute future
years as a percentage of the base year. For example,Coca-Cola had the following net sales and
operating income for each of the past five years (in millions):

2010 2009 2008 2007 2006

Net sales $35,119 $30,990 $31,944 $28,857 $24,088

Operating income $ 8,449 $ 8,231 $ 8,446 $ 7,252 $ 6,308

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 Assuming 2006 is the base year, the trend percentage is calculated for each year using the
following formula:

Key  Equation  

Trend  percentage  =  Current  year  ÷  Base  year  

Figure 13.3 "Percentage Trend Analysis for " shows Coca-Cola’s trend percentages for net sales
and operating income. Most analysts would expand this analysis to include most, if not all, of the
income statement line items.

Figure 13.3 Percentage Trend Analysis for Coca-Cola

Note: Trend percentages are calculated as the current year divided by the base year (2006). For
example, the net sales 2010 trend percentage of 146 percent equals $35,119 (net sales for 2010)
divided by $24,088 (net sales for the base year 2006).

All percentages shown in Figure 13.3 "Percentage Trend Analysis for " are relative to the base
year, which is fiscal year 2006. Notice that the increase in operating income of 34 percent (= 134
percent – 100 percent) from 2006 to 2010 was less than the increase in net sales of 46 percent for
the same period. This signals that the increase in Coca-Cola’s operating expenses outpaced the
increase in net sales during this period. Figure 13.4 "Five-Year Percentage Trend in Operating
Income for " shows the trend percentages inCoca-Cola’s operating income from 2006 to 2010.

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 Figure 13.4 Five-Year Percentage Trend in Operating Income for Coca-Cola

K E Y   T A K E A W A Y  

• Trend  analysis  provides  a  means  to  analyze  company  data  over  a  period  of  time  by  
focusing  on  the  change  in  specific  line  items  within  the  income  statement  and  
balance  sheet.  Changes  are  typically  measured  in  dollars  and  percentages.  Trends  
over  several  years  can  be  evaluated  by  calculating  the  trend  percentage  as  the  
current  year  divided  by  the  base  year.  
Business  in  Action  13.1  
Trends Presented in Annual Reports
Most public companies present trend information in their annual reports. For
example, Intel shows net revenues, gross margin, research and development costs,
operating income, and net income for the past five years. Nike and PepsiCo both show
the percent change in selected income statement line items for the past two
years. Costco Wholesale Corporation presents selected income statement
information for the past five years. The fact that these financial data are provided in the
annual report confirms the importance of presenting trend information to shareholders.
Sources: Intel, “Annual Report, 2010,” http://www.intel.com; Nike, “Annual Report,
2010,” http://www.nike.com; PepsiCo, “Annual Report,
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 2010,” http://www.pepsico.com; Costco Wholesale Corporation, “Annual Report,
2010,” http://www.costco.com.
R E V I E W   P R O B L E M   1 3 . 1  

The  following  income  statements  and  balance  sheets  are  for  PepsiCo,  Inc.We  use  this  
information  in  review  problems  throughout  the  chapter.  

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1. Prepare  a  trend  analysis  for  PepsiCo‘s  income  statement  using  the  format  shown  
in  Figure  13.1  "Income  Statement  Trend  Analysis  for  ".  
2. Prepare  a  trend  analysis  for  PepsiCo’s  balance  sheet  using  the  format  shown  in  Figure  
13.2  "Balance  Sheet  Trend  Analysis  for  ".  
3. Compare  PepsiCo’s  increase  in  net  income  from  2009  to  2010  to  Coca-­‐Cola’s  increase  
shown  in  Figure  13.1  "Income  Statement  Trend  Analysis  for  ".  Which  company  has  the  
highest  percentage  growth  in  net  income?  
4. Compare  PepsiCo’s  increase  in  total  assets  from  2009  to  2010  to  Coca-­‐Cola’s  increase  
shown  in  Figure  13.2  "Balance  Sheet  Trend  Analysis  for  ".  Which  company  has  the  
highest  percentage  growth  in  total  assets?  

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 Solution  to  Review  Problem  13.1  

1.    

Note:  Percent  change  for  each  line  item  is  found  by  dividing  the  increase  
(decrease)  amount  by  the  2009  amount.  For  example,  net  sales  33.8  percent  
increase  equals  $14,606  ÷  $43,232.  

2.    

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Note:  Percent  change  for  each  line  item  is  found  by  dividing  the  increase  
(decrease)  amount  by  the  2009  amount.  For  example,  cash  and  cash  
equivalents  50.7  percent  increase  equals  $2,000  ÷  $3,943.  
3. Net  income  at  PepsiCo  increased  $374,000,000,  or  6.3  percent,  while  net  income  
at  Coca-­‐Cola  increased  $4,985,000,000,  or  73.1  percent  (as  shown  in  Figure  13.1  
"Income  Statement  Trend  Analysis  for  ").  ThusCoca-­‐Cola’s  growth  in  net  income  far  
exceeded  that  of  PepsiCo.  As  mentioned  earlier,  this  huge  increase  in  Coca-­‐Cola’s  net  
income  is  largely  attributable  to  a  one-­‐time  gain  in  2010  of  $4,978,000,000.  
4. Total  assets  at  PepsiCo  increased  $28,305,000,000,  or  71.0  percent,  while  total  assets  
at  Coca-­‐Cola  increased  $24,250,000,000,  or  49.8  percent  (as  shown  in  Figure  13.2  
"Balance  Sheet  Trend  Analysis  for  ").  Thus  PepsiCo’s  growth  in  total  assets  far  
exceeded  that  of  Coca-­‐Cola.  

13.2 Common-Size Analysis of Financial Statements

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 L E A R N I N G   O B J E C T I V E  

1. Perform  common-­‐size  analysis  to  evaluate  financial  statement  information.  

Question: How is common-size analysis used to evaluate the financial health of an organization?

Answer: Common-size analysis (also called vertical analysis) converts each line of financial
statement data to an easily comparable, or common-size, amount measured as a percent. This is
done by stating income statement items as a percent of net sales and balance sheet items as a
percent of total assets (or total liabilities and shareholders’ equity). For example, Coca-Cola had
net income of $11,809,000,000 and net sales of $35,119,000,000 for 2010. The common-size
percent is simply net income divided by net sales, or 33.6 percent (= $11,809 ÷ $35,119).

There are two reasons to use common-size analysis: (1) to evaluate information from one period
to the next within a company and (2) to evaluate a company relative to its competitors. Common-
size analysis answers such questions as “how do our current assets as a percent of total assets
compare with last year?” and “how does our net income as a percent of net sales compare with
that of our competitors?”

Using Common-Size Analysis to Evaluate Trends within a Company

Question: How is a formal common-size analysis prepared, and what does it tell us for Coca-
Cola?

Answer: Figure 13.5 "Common-Size Income Statement Analysis for " presents the common-size
analysis for Coca-Cola’s income statement, and Figure 13.6 "Common-Size Balance Sheet
Analysis for " shows the common-size analysis for Coca-Cola’s balance sheet. As you look at
these figures, notice that net sales are used as the base for the income statement, and total assets
(or total liabilities and shareholders’ equity) are used as the base for the balance sheet. That is,
for the income statement, each item is measured as a percent of net sales, and for the balance
sheet, each item is measured as a percent of total assets (or total liabilities and shareholders’
equity).
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 Figure 13.5 Common-Size Income Statement Analysis for Coca-Cola

Note: All percentages use net sales as the base. For example, 2010 cost of goods sold percent of
36.1 percent equals $12,693 cost of goods sold ÷ $35,119 net sales. Note that rounding issues
sometimes cause subtotals in the percent column to be off by a small amount.

In general, managers prefer expenses as a percent of net sales to decreaseover time, and profit
figures as a percent of net sales to increase over time. As you can see in Figure 13.5 "Common-
Size Income Statement Analysis for ", Coca-Cola’s gross margin as a percent of net sales
decreased from 2009 to 2010 (64.2 percent versus 63.9 percent). Operating income declined as
well (26.6 percent versus 24.1 percent). Income before taxes increased significantly from 28.6
percent in 2009 to 40.4 percent in 2010, again mainly due to a one-time gain of $4,978,000,000
in 2010. This caused net income to increase as well, from 22.0 percent in 2009 to 33.6 percent in
2010. In the expense category, cost of goods sold as a percent of net sales increased, as did other
operating expenses, interest expense, and income tax expense. Selling and administrative
expenses increased from 36.7 percent in 2009 to 37.5 percent in 2010.

Figure 13.6 Common-Size Balance Sheet Analysis for Coca-Cola

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As you can see from Figure 13.6 "Common-Size Balance Sheet Analysis for ", the composition
of assets, liabilities, and shareholders’ equity accounts changed from 2009 to 2010. Notable
changes occurred for intangible assets (26.4 percent in 2009 versus 36.9 percent in 2010), long-
term debt (10.4 percent in 2009 versus 19.3 percent in 2010), retained earnings (86.5 percent in
2009 versus 68.0 percent in 2010), and treasury stock (52.2 percent in 2009 versus 38.1 percent
in 2010).

 
 

Using Common-Size Analysis to Evaluate Competitors

Question: To this point, we have used common-size analysis to evaluate just one company, Coca-
Cola. Common-size analysis is, however, also an effective way of comparing two companies with
different levels of revenues and assets. For example, suppose one company has operating income
of $100,000, and a competing company has operating income of $2,000,000. If both companies
have similar levels of net sales and total assets, it is reasonable to assume that the more
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 profitable company is the better performer. However, most companies are not the same
size. How do we compare companies of different sizes?

Answer: This is where common-size analysis can help. Figure 13.7 "Common-Size Income
Statement Analysis for " shows an income statement comparison for Coca-
Cola and PepsiCo using common-size analysis. (The information for Coca-Cola comes
from Figure 13.5 "Common-Size Income Statement Analysis for ", and the information
for PepsiCo comes from the solution to part 1 of Note 13.15 "Review Problem 13.2" at the end
of this segment.)

Figure 13.7 Common-Size Income Statement Analysis for Coca-Cola andPepsiCo

Note that rounding issues sometimes cause subtotals in the percent column to be off by a small
amount.

Notice that PepsiCo has the highest net sales at $57,838,000,000 versusCoca-Cola at
$35,119,000,000. Once converted to common-size percentages, however, we see that Coca-
Cola outperforms PepsiCo in virtually every income statement category. Coca-Cola’s cost of
goods sold is 36.1 percent of net sales compared to 45.9 percent at PepsiCo. Coca-Cola’sgross
margin is 63.9 percent of net sales compared to 54.1 percent atPepsiCo. Coca-Cola’s operating
income is 24.1 percent of sales compared to 14.4 percent at PepsiCo. Figure 13.8 "Comparison

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 of Common-Size Gross Margin and Operating Income for " compares common-size gross
margin and operating income for Coca-Cola and PepsiCo.

Figure 13.8 Comparison of Common-Size Gross Margin and Operating Income for Coca-
Cola and PepsiCo

Common-size analysis enables us to compare companies on equal ground, and as this analysis
shows, Coca-Cola is outperforming PepsiCo in terms of income statement information.
However, as you will learn in this chapter, there are many other measures to consider before
concluding that Coca-Cola is winning the financial performance battle.

Common-size analysis is obviously crucial to comparative analysis. In fact, some sources of

industry data present the information exclusively in a common-size format, and most of the
accounting software available today has been engineered to facilitate this type of analysis.

Business  in  Action  13.2  

Common-Size Analysis Using Accounting Software
Most accounting computer programs, including QuickBooks, Peachtree, and MAS 90,
provide common-size analysis reports. You simply select the appropriate report format
and financial statement date, and the system prints the report. Thus accountants using

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 this type of software can focus more on analyzing common-size information than on
preparing it.
K E Y   T A K E A W A Y  

• Common-­‐size  analysis  converts  each  line  of  financial  statement  data  to  an  easily  
comparable  amount  measured  as  a  percent.  Income  statement  items  are  stated  as  a  
percent  of  net  sales  and  balance  sheet  items  are  stated  as  a  percent  of  total  assets  (or  
total  liabilities  and  shareholders’  equity).  Common-­‐size  analysis  allows  for  the  
evaluation  of  information  from  one  period  to  the  next  within  a  company  and  between  
competing  companies.  
R E V I E W   P R O B L E M   1 3 . 2  

Refer  to  the  information  presented  in  Note  13.10  "Review  Problem  13.1"for  PepsiCo,  
and  perform  the  following:  
1. Prepare  a  common-­‐size  analysis  for  PepsiCo’s  income  statement  using  the  format  
shown  in  Figure  13.5  "Common-­‐Size  Income  Statement  Analysis  for  ".  
2. Prepare  a  common-­‐size  analysis  for  PepsiCo’s  balance  sheet  using  the  format  shown  
in  Figure  13.6  "Common-­‐Size  Balance  Sheet  Analysis  for  ".  
3. Briefly  describe  any  significant  changes  from  2009  to  2010  identified  in  parts  1  and  2.  

Solution  to  Review  Problem  13.2  

1.    

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Note:  All  percentages  use  net  sales  as  the  base.  For  example,  2010  cost  of  
goods  sold  percent  of  45.9  percent  equals  $26,575  cost  of  goods  sold  ÷  
$57,838  net  sales.  Note  that  rounding  issues  sometimes  cause  subtotals  in  
the  percent  column  to  be  off  by  a  small  amount.  

2.    

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Note:  All  percentages  use  total  assets  or  total  liabilities  and  shareholders’  
equity  as  the  base.  For  example,  2010  cash  and  cash  equivalents  percent  of  
8.7  percent  equals  $5,943  ÷  $68,153.  Note  that  rounding  issues  sometimes  
cause  subtotals  in  the  percent  column  to  be  off  by  a  small  amount.  
3. The  composition  of  PepsiCo’s  income  statement  remained  relatively  
consistent  from  2009  to  2010.  The  most  notable  change  occurred  with  
selling  and  administrative  expenses,  which  increased  from  34.8  percent  of  
sales  in  2009  to  39.4  percent  of  sales  in  2010.  This  in  turn  drove  down  
operating  income  from  18.6  percent  in  2009  to  14.4  percent  in  2010.  This  

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 also  likely  caused  the  decrease  in  income  before  taxes,  income  tax  expense,  
and  net  income.  
The  composition  of  PepsiCo’s  balance  sheet  had  some  significant  changes  
from  2009  to  2010.  The  most  notable  changes  occurred  with  intangible  
assets  (23.0  percent  in  2009  versus  41.8  percent  in  2010),  other  assets  (13.7  
percent  in  2009  versus  4.5  percent  in  2010),  short-­‐term  obligations  (1.2  
percent  in  2009  versus  7.2  percent  in  2010),  long-­‐term  debt  (18.6  percent  in  
2009  versus  29.3  percent  in  2010),  common  stock  (0.7  percent  in  2009  
versus  6.7  percent  in  2010),  and  retained  earnings  (86.4  percent  in  2009  
versus  54.9  percent  in  2010).  

13.3 Ratio Analysis of Financial Information

L E A R N I N G   O B J E C T I V E  

1. Use  ratio  analysis  to  measure  profitability,  short-­‐term  liquidity,  long-­‐term  solvency,  
and  market  valuation.  

Question: Although reviewing trends and using common-size analysis provides an excellent
starting point for analyzing financial information, managers, investors, and other stakeholders
also use various ratios to assess the financial performance and financial condition of
organizations. What are the four categories of ratios used to evaluate the financial health of an
organization?

Answer: The four categories of ratios presented in this chapter are as follows (in order of
presentation):

1. Ratios used to measure profitability (focus is on the income statement)

2. Ratios used to measure short-term liquidity (focus is on short-term liabilities)
3. Ratios used to measure long-term solvency (focus is on long-term liabilities)
4. Ratios used to measure market valuation (focus is on market value of the company)
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 For each ratio, we (1) explain the meaning, (2) provide the formula, (3) calculate the ratio
for Coca-Cola for two years, and (4) compare the ratio for Coca-Cola to PepsiCo’s ratio
and industry averages. (Note: All industry averages throughout this chapter were obtained
fromhttp://moneycentral.msn.com. Some averages are not available or not applicable and
will be noted as such.)

Table 13.1 "Financial Ratio Formulas" summarizes the formulas for all the ratios presented in
this section, and Table 13.2 "Summary of Financial Ratios for " shows the ratio results for Coca-
Cola, PepsiCo, and the industry averages that will be covered throughout this section.

Table 13.1 Financial Ratio Formulas

Profitability Measures

1.

Gross margin ratio=Gross marginNet sales

Indicates the gross margin generated for each dollar in net sales.
2.

Profit margin ratio=Net incomeNet sales

Indicates the profit generated for each dollar in net sales.

3.

Return on assets=Net incomeAverage total assets

Indicates how much net income was generated from each dollar in average assets
invested.
4.
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 Return on common shareholders’ equity=Net income − Preferred dividendsAverage common sha
reholders’ equity

Indicates how much net income was generated from each dollar of common
shareholders’ equity.
5.

Earnings per share=Net income − Preferred dividendsWeighted average common shares outstand
ing

Indicates how much net income was earned for each share of common stock
outstanding.

Short-Term Liquidity Measures

6.

Current ratio=Current assetsCurrent liabilities

Indicates whether a company has sufficient current assets to cover current liabilities.
7.

Quick ratio=Cash + Marketable securities + Short-term receivablesCurrent liabilities

Indicates whether a company has sufficient quick assets to cover current liabilities.
8.

Receivables turnover ratio=Credit salesAverage accounts receivable

Indicates how many times receivables are collected in a given period.

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 9.

Average collection period=365 daysReceivables turnover ratio

Indicates how many days it takes on average to collect on credit sales.

10.

Inventory turnover ratio=Cost of goods soldAverage inventory

Indicates how many times inventory is sold and restocked in a given period.
11.

Average sale period=365 daysInventory turnover ratio

Indicates how many days it takes on average to sell the company’s inventory.

Long-Term Solvency Measures

12.

Debt to assets=Total liabilitiesTotal assets

Indicates the percentage of assets funded by creditors.

13.

Debt to equity=Total liabilitiesTotal shareholders’ equity

Indicates the amount of debt incurred for each dollar that owners provide.
14.

Times interest earned=Net income + Income tax expense + Interest expenseInterest expense

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 Indicates the company’s ability to cover its interest expense related to long-term debt
with current period earnings.

Market Valuation Measures

15.

Market capitalization=Market price per share×Number of shares outstanding

Indicates the value of a company at a point in time.

16.

Price-earnings ratio=Market price per shareEarnings per share

Indicates the premium investors are willing to pay for shares of stock relative to the
company’s earnings.

Table 13.2 Summary of Financial Ratios for Coca-Cola, PepsiCo, and the Industry
Average
Industry Average
Coca-Cola 2010 PepsiCo 2010 2010

Profitability Measures

1. Gross margin ratio 63.9 percent 54.1 percent 56.1 percent

2. Profit margin ratio 33.6 percent 10.9 percent 19.2 percent

3. Return on assets 19.4 percent 11.7 percent 14.2 percent

Return on common
4. shareholders’ equity 41.7 percent 32.3 percent 34.7 percent

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 Industry Average
Coca-Cola 2010 PepsiCo 2010 2010

5. Earnings per share $5.12 $3.97 Not applicable

Short-Term Liquidity Measures

6. Current ratio 1.17 to 1 1.11 to 1 1.20 to 1

7. Quick ratio 0.85 to 1 0.80 to 1 1.10 to 1

8. Receivables turnover ratio 8.58 times 10.57 times 9.70 times

9. Average collection period 42.54 days 34.53 days 37.63 days

10. Inventory turnover ratio 5.07 times 8.87 times 7.50 times

11. Average sale period 71.99 days 41.15 days 48.67 days

Long-Term Solvency Measures

12. Debt to assets 0.57 to 1 0.68 to 1 0.48 to 1

13. Debt to equity 1.33 to 1 2.17 to 1 0.94 to 1

14. Times interest earned 20.36 times 10.10 times 10.70 times

Market Valuation Measures

15. Market capitalization $146,500,000,000 $100,700,000,000 $87,500,000,000

16. Price-earnings ratio 12.48 times 16.04 times 14.60 times

Before we discuss the various ratios, it is important to note that different terms are often used in
financial statements to describe the same item. For example, some companies use the term net

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 revenues instead of net sales, and the income statement is often called the statement of earnings,
orconsolidated statement of earnings. Also be sure to review the income statement and balance
sheet information for Coca-Cola shown in Figure 13.5 "Common-Size Income Statement
Analysis for " and Figure 13.6 "Common-Size Balance Sheet Analysis for ". We refer to these
figures throughout this section. (All the dollar amounts given for Coca-Cola are in millions
unless stated otherwise.)

Profitability Ratios

Question: Analysts, shareholders, suppliers, and other stakeholders often want to evaluate profit
trends within a company and compare a company’s profits with competitors’ profits. What are
the five common ratios used to evaluate company profitability?

Answer: The five ratios used to evaluate profitability are as follows:

1. Gross margin ratio

2. Profit margin ratio
3. Return on assets
4. Return on common shareholders’ equity
5. Earnings per share

Gross Margin Ratio

Question: How is the gross margin ratio calculated, and what does it tell us about Coca-
Cola relative to PepsiCo and the industry average?

Answer: The gross margin ratio indicates the gross margin generated for each dollar in net sales
and is calculated as gross margin (which is net sales minus cost of goods sold) divided by net
sales:

Key  Equation  

Gross margin ratio=Gross marginNet sales  

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 The gross margin ratio for Coca-Cola using 2010 information is calculated as follows,
with PepsiCo and industry average information following it:

Gross margin ratio=$22,426$35,119=63.9%

Coca-Cola Coca-Cola PepsiCo Industry Average

2010 2009 2010 2010

Gross margin
ratio 63.9 percent 64.2 percent 54.1 percent 56.1 percent

The gross margin ratio indicates Coca-Cola generated 63.9 cents in gross margin for every dollar
in net sales. This ratio decreased slightly from 2009 to 2010 and is substantially higher
than PepsiCo’s 54.1 percent. Coca-Cola is also higher than the industry average of 56.1 percent.
(Alternative terms: Gross margin is often called gross profit, net sales is often called net
revenues, and cost of goods sold is often called cost of sales.)

Profit Margin Ratio

Question: How is the profit margin ratio calculated, and what does it tell us about Coca-
Cola relative to PepsiCo and the industry average?

Answer: The profit margin ratio shows the profit generated for each dollar in net sales. It is
calculated as net income divided by net sales:

Key  Equation  

Profit margin ratio=Net incomeNet sales  

The profit margin ratio for Coca-Cola using 2010 information is calculated as follows,
with PepsiCo and industry average information following it:

Profit margin ratio=$11,809$35,119=33.6%

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 Coca-Cola Coca-Cola PepsiCo Industry Average
2010 2009 2010 2010

Profit margin
ratio 33.6 percent 22.0 percent 10.9 percent 19.2 percent

The profit margin ratio indicates Coca-Cola generated 33.6 cents in net income for every dollar
in net sales. This ratio increased significantly from 2009 to 2010 and is substantially higher
than PepsiCo’s 10.9 percent.Coca-Cola is also higher than the industry average of 19.2 percent.
(Alternative term: Net income is often called net earnings.)

Return on Assets

Question: The gross margin ratio and profit margin ratio focus solely on income statement
information. Analysts also want to know what size asset base generated the net income. For
example, a company with assets of $100,000 and net income of $15,000 is likely performing
better than a company with assets of $300,000 and identical net income of $15,000. A measure
that considers the assets required to generate net income is called return on assets. How is
return on assets calculated, and what does it tell us about Coca-Cola relative toPepsiCo and the
industry average?

Answer: The return on assets ratio is used to evaluate how much net income was generated from
each dollar in average assets invested. Return on assets is net income divided by average total
assets:

Key  Equation  

Return on assets=Net incomeAverage total assets  

The average total assets amount is found by adding together total assets at the end of the current
year and previous year (2010 and 2009 for this example) and dividing by two. The return on

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 assets ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average
information following it:

Return on assets=$11,809($72,921+$48,671)÷2=$11,809$60,796=19.4%  

Coca-Cola Coca-Cola PepsiCo Industry Average

2010 2009 2010 2010

Return on
assets 19.4 percent 15.3 percent 11.7 percent 14.2 percent

The return on assets ratio indicates Coca-Cola generated 19.4 cents in net income for every
dollar in average assets. This ratio increased from 2009 to 2010 and is higher
than PepsiCo’s 11.7 percent. Coca-Cola exceeded the industry average of 14.2 percent.

(Note: There are several variations on the return on assets calculation. Some prefer to
use average operating assets in the denominator. Others adjust net income in the numerator by
adding back interest expense net of the interest expense tax benefit. We leave these variations to
advanced cost and intermediate accounting textbooks.)

Return on Common Shareholders’ Equity

Question: How is the return on common shareholders’ equity ratio calculated, and what does it
tell us about Coca-Cola relative to PepsiCo and the industry average?

Answer: Common shareholders are interested in thereturn on common shareholders’ equity ratio
because this ratio tells them how much net income was generated from each dollar of common
shareholders’ equity. The return on common shareholders’ equity ratio is calculated as follows:

Key  Equation  

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 Return on common shareholders’ equity=Net income − Preferred dividendsAverage common sha
reholders’ equity  

Note that preferred dividends are deducted from net income in the numerator. If the company
does not have any outstanding preferred stock, as is the case with Coca-Cola, the preferred
dividends amount is zero.

Average common shareholders’ equity in the denominator is found by adding together all items
in the shareholders’ equity section of the balance sheet at the end of the current year and
previous year (2010 and 2009 for this example), except preferred stock items, and dividing by
two.

Because Coca-Cola does not have preferred stock, an average of all items in the shareholders’
equity section is in the denominator. The return on common shareholders’ equity ratio for Coca-
Cola for 2010 is calculated as follows, with PepsiCo and industry average information following
it:

Return on commonshareholders’ equity=$11,809−$0[($10,937+$49,592−$1,450−$27,762)+($9,

417+$42,084−$757−$25,398)]÷2=$11,809$28,332=41.7%  

Coca-Cola Coca-Cola PepsiCo Industry

2010 2009 2010 Average 2010

Return on common 32.3

shareholders’ equity 41.7 percent 29.5 percent percent 34.7 percent

The return on common shareholders’ equity ratio indicates Coca-Colagenerated 41.7 cents in net
income for every dollar in average common shareholders’ equity. This ratio increased
significantly from 2009 to 2010 and is higher than PepsiCo’s 32.3 percent. Coca-Cola exceeded
the industry average of 34.7 percent.

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 Coca-Cola’s return on common shareholders’ equity of 41.7 percent is higher than its return on
assets of 19.4 percent, indicating that the company has positive financial
leverage. Financial leverage describes a company’s ability to leverage common shareholders’
equity by taking on debt at an interest rate lower than the company’s return on assets. For
example, assume a company has equity of $10,000 earning 10 percent. The company can
leverage this equity by borrowing $8,000 with a 6 percent interest rate. Assuming the company
uses this $8,000 to purchase assets that earn 10 percent, the company has created positive
financial leverage since the cost of borrowing is lower than the return on assets. This results in a
return on equity that is higher than the return on assets. (Note: For a one-year period, the return
on assets is $1,800 [= $18,000 × 10 percent] less the cost of debt of $480 [= 6 percent × $8,000],
or $1,320. This results in a return on assets of 7.3 percent [= $1,320 ÷ $18,000]. Positive
financial leverage causes the return on equity to be much higher at 13.2 percent [= $1,320 ÷
$10,000 equity].)

Although some level of financial leverage is generally regarded as healthy, companies that are
highly leveraged tend to be riskier than similar companies with less leverage. Analysts and
shareholders should avoid drawing quick conclusions that increases in return on common
shareholders’ equity are always better than decreases without thoroughly reviewing the rest of
the data.

Figure 13.9 "Return on Assets and Return on Equity for " shows the return on assets and return
on equity for Coca-Cola, PepsiCo, and the industry average.

Figure 13.9 Return on Assets and Return on Equity for Coca-Cola,PepsiCo, and the Industry
Average

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Earnings per Share

Question: How is earnings per share calculated, and what does it tell us aboutCoca-
Cola relative to PepsiCo and the industry average?

Answer: Earnings per share indicates how much net income was earned for each share of
common stock outstanding. The earnings per share ratio states net income on a per share basis
and is calculated as the following:

Key  Equation  

Earnings per share=Net income−Preferred dividendsWeighted average common shares outstandi

ng  

Note that preferred dividends are deducted from net income in the numerator. If the company
does not have any outstanding preferred stock, as is the case with Coca-Cola, the preferred
dividends amount is zero. The weighted average common shares outstanding amount used in the
denominator is typically provided in the financial statements, either on the income statement or
in the notes to the financial statements. (More advanced intermediate accounting textbooks
discuss this calculation in detail. Throughout this chapter, we provide the number of weighted
average common shares outstanding.)

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 Earnings per share for Coca-Cola using 2010 information is calculated as follows,
with PepsiCo and industry average information following it (dollar amount and shares are in
millions, except per share amount):

Earnings per share=$11,809−$02,308 shares=$5.12 per share  

Coca-Cola Coca-Cola PepsiCo Industry Average

2010 2009 2010 2010

Earnings per
share $5.12 $2.95 $3.97 Not applicable

The earnings per share amount at Coca-Cola indicates the company earned $5.12 for each share
of common stock outstanding. This ratio increased from 2009 to 2010. Although earnings per
share is useful for looking at trends over time within a company, it cannot be compared in any
meaningful way from one company to another because different companies have different
numbers of shares outstanding.

For example, assume two identical companies earn $10,000 for the year. One company has one
share of common stock outstanding, and the other has two shares outstanding. Thus one
company has earnings per share of $10,000 (= $10,000 ÷ 1 share) and the other company has
earnings per share of $5,000 (= $10,000 ÷ 2 shares). The second company is not performing any
worse; it simply has more shares outstanding. This is why you should not compare earnings per
share across companies. (Alternative terms: Earnings per share are often called EPS or income
per share.)

Business  in  Action  13.3  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1015  
     
 
  

Source: Photo courtesy of

DangApricot,http://commons.wikimedia.org/wiki/File:AnnTaylorLoftSign.JPG.
The Importance of Earnings per Share
The business press often uses earnings per share to announce a company’s earnings. For
example, the Associated Press addressed earnings at AnnTaylor Stores
Corporation, a retailer of women’s clothing, as follows: “Quarterly income fell to
$7,100,000, or 10 cents per share, from $30,100,000, or 41 cents, the year before.

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1016  
     
 
 Setting aside relocation costs, adjusted earnings were 18 cents per share, a penny higher
than the average estimate from analysts polled by Thomson Financial.”
This quote demonstrates not only that earnings per share data are important when
announcing a company’s earnings but also that analysts use these data when making
predictions about a company’s performance. A quick perusal of any business
publication, such as The Wall Street Journal, or a review of online business press
releases at sites like http://finance.yahoo.com will confirm that earnings per share data
are commonly used to announce a company’s financial results.
Source: Associated Press, “AnnTaylor’s 2Q Profit Plummets on Charge,” August 19,
2005.
R E V I E W   P R O B L E M   1 3 . 3  

Refer  to  the  information  presented  in  Note  13.10  "Review  Problem  13.1"for  PepsiCo,  
and  perform  the  following  for  2010:  
1. Calculate  the  gross  margin  ratio,  and  briefly  describe  what  it  means  for  PepsiCo.  
2. Calculate  the  profit  margin  ratio,  and  briefly  describe  what  it  means  for  PepsiCo.  
3. Calculate  return  on  assets,  and  briefly  describe  what  it  means  forPepsiCo.  
4. Calculate  return  on  common  shareholders’  equity,  and  briefly  describe  what  it  means  
for  PepsiCo.  Assume  PepsiCo  recorded  preferred  dividends  of  $6,000,000  in  2010.  
5. Calculate  earnings  per  share,  and  briefly  describe  what  it  means  forPepsiCo.  Assume  
weighted  average  common  shares  outstanding  totaled  1,590,000,000  shares.  

Solutions  to  Review  Problem  13.3  

1.    

Gross margin ratio=Gross marginNet sales=$31,263$57,838=54.1%  

For  every  dollar  in  net  sales,  PepsiCo  generated  54.1  cents  in  gross  margin.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 2.    

Profit margin ratio=Net incomeNet sales=$6,320$57,838=10.9%  

For  every  dollar  in  net  sales,  PepsiCo  generated  10.9  cents  in  net  income.  

3.    

Return on assets=Net incomeAverage total assets=$6,320($68,153+$39,848)÷2=$6,32

0$54,001=11.7%  

For  every  dollar  in  average  assets,  PepsiCo  generated  11.7  cents  in  net  
income.  

4.    

Return on commonshareholders’ equity=Net income − Preferred dividendsAverage co

mmon shareholders’ equity=$6,320−$6[($4,558+$37,402−$3,630−$16,745)+($280+$
34,443−$3,794−$13,383)]÷2=$6,314$19,566=32.3%  

For  every  dollar  in  average  common  shareholders’  

equity,PepsiCo  generated  32.3  cents  in  net  income  (after  deducting  
preferred  dividends).  

5.    

Earnings per share=Net income − Preferred dividendsWeighted average common share

s outstanding=$6,320−$61,590 shares=$3.97 per share  

For  each  common  share  outstanding,  PepsiCo  generated  $3.97  in  net  
income  (after  deducting  preferred  dividends).  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Short-Term Liquidity Ratios

Question: Suppliers and other short-term lenders often want to evaluate whether companies can
meet short-term obligations. What are the four common ratios used to evaluate short-term
liquidity?

Answer: The four ratios used to evaluate short-term liquidity are as follows:

1. Current ratio
2. Quick ratio
3. Receivables turnover ratio (often converted to average collection period)
4. Inventory turnover ratio (often converted to average sale period)

Current Ratio

Question: How is the current ratio calculated, and what does it tell us aboutCoca-Cola relative
to PepsiCo and the industry average?

Answer: The current ratio indicates whether a company has sufficient current assets to cover
current liabilities. It is found by dividing current assets by current liabilities:

Key  Equation  

Current ratio=Current assetsCurrent liabilities  

The current ratio for Coca-Cola for 2010 is calculated as follows, withPepsiCo and industry
average information following it:

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Current ratio=$11,199+$138+$4,430+$2,650+$3,162$8,859+$8,100+$1,549=$21,579$18,508=1
.17 to 1  

Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010

Current ratio 1.17 to 1 1.28 to 1 1.11 to 1 1.20 to 1

The current ratio indicates Coca-Cola had $1.17 in current assets for every dollar in current
liabilities. This ratio decreased from 2009 to 2010 and is slightly higher than PepsiCo’s 1.11 to 1
ratio. Coca-Cola is close to the industry average of 1.20 to 1. In general, a current ratio above 1
to 1 is preferable, which indicates the company has sufficient current assets to cover current
liabilities. However, finding the ideal minimum current ratio is dependent on many factors, such
as the industry, the overall financial condition of the company, and the composition of the
company’s current assets and current liabilities. Because of variations in these factors from one
company to the next, a more stringent measure of short-term liquidity is often used. We present
this measure, called the quick ratio, next.

Quick Ratio

Question: How is the quick ratio calculated, and what does it tell us aboutCoca-Cola relative
to PepsiCo and the industry average?

Answer: The quick ratio (also called acid-test ratio) indicates whether a company has sufficient
quick, or highly liquid, assets to cover current liabilities. The quick ratio is quick assets divided
by current liabilities:

Key  Equation  

Quick ratio=Cash + Marketable securities+Short-term receivablesCurrent liabilities  

Notice the numerator excludes current assets that are not easily and quickly converted to cash.
Although inventory is typically excluded from the numerator, further analysis is needed to

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 evaluate whether inventory should be included. For example, grocery stores turn inventory over
very quickly, typically within a couple of weeks, and should consider including inventory in the
quick ratio. Producers of wine, on the other hand, turn inventory over very slowly, and should
consider excluding inventory in the numerator of the quick ratio. For the sake of consistency,
you should exclude inventory from the numerator in this chapter, unless told otherwise. (Note:
Many companies provide two quick ratio calculations, one that includes inventory in the
numerator and one that excludes inventory in the numerator. If two ratios are presented, it is
important to label each ratio to indicate whether inventory has been included or excluded.)

It is helpful when reviewing a company’s balance sheet to remember that current assets are
presented in order of liquidity, with the most liquid current asset appearing first and the least
liquid appearing last. This helps in determining whether a particular current asset should be
included or excluded in the numerator of the quick ratio. The quick ratio for Coca-Colafor 2010
is calculated as follows, with PepsiCo and industry average information following it:

Quick ratio=$11,199+$138+$4,430$8,859+$8,100+$1,549=$15,767$18,508=0.85 to 1  

Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010

Quick ratio 0.85 to 1 0.95 to 1 0.80 to 1 1.10 to 1

The quick ratio indicates Coca-Cola had $0.85 in quick assets for every dollar in current
liabilities. This ratio decreased from 2009 to 2010 and is slightly higher than PepsiCo’s 0.80 to 1
ratio. Coca-Cola is below the industry average of 1.10 to 1.

Receivables Turnover Ratio

Question: How is the receivables turnover ratio calculated, and what does it tell us about Coca-
Cola relative to PepsiCo and the industry average?

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Answer: The receivables turnover ratio indicates how many times receivables are collected in a
given period and is found by dividing credit sales by average accounts receivable:

Key  Equation  

Receivables turnover ratio=Credit salesAverage accounts receivable  

Assume all net sales presented on the income statement are on account, and therefore will be
used in the numerator. The average accounts receivable amount in the denominator is found by
adding together accounts receivable at the end of the current year and previous year (2010 and
2009 for this example) and dividing by two. The receivables turnover ratio for Coca-Cola for
2010 is calculated as follows, with PepsiCo and industry average information following it:

Receivables turnover ratio=$35,119($4,430+$3,758)÷2=$35,119$4,094=8.58 times  

Coca-Cola Coca-Cola PepsiCo Industry Average

2010 2009 2010 2010

Receivables turnover
ratio 8.58 times 9.05 times 10.57 times 9.70 times

The receivables turnover ratio indicates Coca-Cola collected receivables 8.58 times during 2010.
This ratio decreased from 2009 to 2010 and is lower than PepsiCo’s 10.57 times. Coca-Cola is
below the industry average of 9.70 times.

Question: How is the receivables turnover ratio converted to average collection period?

Answer: The receivables turnover ratio can be converted to theaverage collection period, which
indicates how many days it takes on average to collect on credit sales, as follows:

Key  Equation  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Average collection period=365 daysReceivables turnover ratio  

This ratio is typically compared to the company’s credit terms to evaluate how effectively
receivables are being collected. The average collection period for Coca-Cola for 2010 is
calculated as follows, with PepsiCo and industry average information following it:

Average collection period=365 days8.58 times=42.54 days  

Coca-Cola Coca-Cola PepsiCo Industry Average

2010 2009 2010 2010

Average collection
period 42.54 days 40.33 days 34.53 days 37.63 days

The average collection period indicates Coca-Cola collected credit sales in 42.54 days, on
average. The number of days increased slightly from 2009 to 2010 and is higher
than PepsiCo’s 34.53 days. Coca-Cola is also above the industry average of 37.63 days and
therefore is slower at collecting accounts receivable than the industry as a whole.

Inventory Turnover Ratio

Question: How is the inventory turnover ratio calculated, and what does it tell us about Coca-
Cola relative to PepsiCo and the industry average?

Answer: The inventory turnover ratio indicates how many times inventory is sold and restocked
in a given period. It is calculated as cost of goods sold divided by average inventory:

Key  Equation  

Inventory turnover ratio=Cost of goods soldAverage inventory  

The average inventory amount in the denominator is found by adding together inventory at the
end of the current year and previous year (2010 and 2009 for this example) and dividing by two.
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 The inventory turnover ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and
industry average information following it:

Inventory turnover ratio=$12,693($2,650+$2,354)÷2=$12,693$2,502=5.07 times  

Coca-Cola Coca-Cola PepsiCo Industry Average

2010 2009 2010 2010

Inventory turnover
ratio 5.07 times 4.88 times 8.87 times 7.50 times

The inventory turnover ratio indicates Coca-Cola sold and restocked inventory 5.07 times during
2010. This ratio increased slightly from 2009 to 2010 and is substantially lower
than PepsiCo’s 8.87 times. Coca-Cola is well below the industry average of 7.50 times.

Question: How is the inventory turnover ratio converted to average sale period?

Answer: The inventory turnover ratio can be converted to theaverage sale period, which indicates
how many days it takes on average to sell the company’s inventory, as follows:

Key  Equation  

Average sale period=365 daysInventory turnover ratio  

The average sale period for Coca-Cola for 2009 is calculated as follows, withPepsiCo and
industry average information following it:

Average sale period=365 days5.07 times=71.99 days  

Coca-Cola Coca-Cola PepsiCo Industry Average

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 2010 2009 2010 2010

Average sale
period 71.99 days 74.80 days 41.15 days 48.67 days

The average sale period indicates Coca-Cola sold its inventory in 71.99 days, on average. The
number of days decreased from 2009 to 2010 and is substantially higher than PepsiCo’s 41.15
days. Coca-Cola is also above the industry average of 48.67 days and therefore is slower at
selling inventory than the industry as a whole.

Business  in  Action  13.4  

Industry Variations in Inventory and Receivable Turnover
Retail grocery stores turn inventory over every 22 days, meaning that shelves are
emptied and restocked about every three weeks. In addition to extremely fast inventory
turnover, retail grocery stores collect credit sales in seven days. Thus it takes 29 days, on
average, to convert freshly stocked inventory to cash. Very few industries are able to
convert inventory to cash as quickly. Examples of inventory and receivable turnover for
several industries are shown in the following.

Receivables Turnover Inventory Turnover

Auto manufacturers 39 days 41 days

Chemical manufacturing 51 days 61 days

Forestry and wood products 46 days 53 days

Computer systems 78 days 18 days

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Source: Industry averages found at MSN Money, Home
Page,”http://moneycentral.msn.com.
R E V I E W   P R O B L E M   1 3 . 4  

Refer  to  the  information  presented  in  Note  13.10  "Review  Problem  13.1"for  PepsiCo,  
and  perform  the  following  requirements  for  2010:  
1. Calculate  the  current  ratio,  and  briefly  describe  what  it  means  forPepsiCo.  
2. Calculate  the  quick  ratio,  and  briefly  describe  what  it  means  forPepsiCo.  
3. Calculate  the  receivables  turnover  ratio  and  average  collection  period,  and  briefly  
describe  what  these  measures  mean  for  PepsiCo.  Assume  all  sales  are  on  account.  
4. Calculate  the  inventory  turnover  ratio  and  average  sale  period,  and  briefly  describe  
what  these  measures  mean  for  PepsiCo.  

Solution  to  Review  Problem  13.4  

1.    

Current ratio=Current assetsCurrent liabilities=$5,943+$426+$6,323+$3,372+1,505$4,

898+$10,923+$71=$17,569$15,892=1.11 to 1  

For  every  dollar  in  current  liabilities,  PepsiCo  had  $1.11  in  current  assets.  

2.    

Quick ratio=Cash + Marketable securities + Short-

term receivablesCurrent liabilities=$5,943+$426+$6,323$4,898+$10,923+$71=$12,69
2$15,892=0.80 to 1  

For  every  dollar  in  current  liabilities,  PepsiCo  had  $0.80  in  quick  assets.  

3.    

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Receivables turnover ratio=Credit salesAverage accounts receivable=$57,838($6,323+
$4,624)÷2=$57,838$5,474=10.57 times  

PepsiCo  collected  receivables  10.57  times  during  2010.  

Average collection period=365 daysReceivables turnover ratio=365 days10.57 times=3

4.53 days  

PepsiCo  collected  credit  sales  in  34.53  days,  on  average.  

4.    

Inventory turnover ratio=Cost of goods soldAverage inventory=$26,575($3,372+$2,61

8)÷2=$26,575$2,995=8.87 times  

PepsiCo  sold  and  restocked  inventory  8.87  times  during  2010.  

Average sale period=365 daysInventory turnover ratio=365 days8.87 times=41.15 days  

PepsiCo  sold  its  inventory  in  41.15  days,  on  average.  

Long-Term Solvency Ratios

Question: Banks, bondholders, and other long-term lenders often want to evaluate whether
companies can meet long-term obligations. What are the three common ratios used to evaluate
long-term solvency?

Answer: The three ratios used to evaluate long-term solvency are as follows:

1. Debt to assets
2. Debt to equity
3. Times interest earned

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Debt to Assets

Question: How is the debt to assets ratio calculated, and what does it tell us about Coca-
Cola relative to PepsiCo and the industry average?

Answer: The debt to assets ratio indicates the percentage of assets funded by creditors and is
used to evaluate the financial leverage of a company. Debt to assets is found by dividing total
liabilities by total assets:

Key  Equation  

Debt to assets=Total liabilitiesTotal assets  

The higher the percentage, the higher the financial leverage. The debt to assets ratio for Coca-
Cola for 2010 is calculated as follows, with PepsiCoand industry average information following
it:

Debt to assets=$8,859+$8,100+$1,549+$14,041+$9,055$72,921=$41,604$72,921=0.57 to 1  

Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010

Debt to assets 0.57 to 1 0.48 to 1 0.68 to 1 0.48 to 1

The debt to assets ratio indicates that creditors funded 57 percent of Coca-Cola’s assets at the
end of 2010. This ratio increased from 2009 to 2010 and is lower than PepsiCo’s 0.68 to 1. Coca-
Cola is higher than the industry average of 0.48 to 1.

A review of the basic balance sheet equation shows that the complement of the debt to assets
ratio provides the percentage of assets funded byshareholders. Thus for every dollar Coca-
Cola has in assets, creditors fund $0.57 and shareholders fund $0.43 (= $1 – $0.57):

Assets$1.00=Liabilities +Shareholders’ equity =$0.57+$0.43  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 The debt to assets ratio reveals Coca-Cola (0.57 to 1) and PepsiCo (0.68 to 1) are more highly
leveraged than the industry average of 0.48 to 1.

Debt to Equity

Question: How is the debt to assets ratio calculated, and what does it tell us about Coca-
Cola relative to PepsiCo and the industry average?

Answer: A variation of the debt to assets ratio is the debt to equity ratio, which measures the
balance of liabilities and shareholders’ equity used to fund assets. The debt to equity ratio is total
liabilities divided by total shareholders’ equity:

Key  Equation  

Debt to equity=Total liabilitiesTotal shareholders’ equity  

This ratio indicates the amount of debt incurred for each dollar that owners provide. The debt to
equity ratio for Coca-Cola for 2010 is calculated as follows, with PepsiCo and industry average
information following it:

Debt to equity=$8,859+$8,100+$1,549+$14,041+$9,055$10,937+$49,592−$1,450−$27,762=$4
1,604$31,317=1.33 to 1  

Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Industry Average 2010

Debt to equity 1.33 to 1 0.92 to 1 2.17 to 1 0.94 to 1

The debt to equity ratio indicates that Coca-Cola had $1.33 in liabilities for each dollar in
shareholders’ equity. This ratio increased from 2009 to 2010 and is substantially lower
than PepsiCo’s 2.17 to 1. However, Coca-Cola is higher than the industry average of 0.94 to 1.

Business  in  Action  13.5  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1029  
     
 
  

Source: Photo courtesy of

spechtenhauser,http://www.flickr.com/photos/usinside/2931437356/.
Financial Leverage at General Motors and Toyota

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Prior to the company’s bankruptcy filing in 2009, General Motors (GM) was the
largest manufacturer of automobiles and trucks in the world (ranked by revenues).
However, GM took on substantial amounts of debt over several years. With an average
debt to equity ratio of 2.5 to 1, the automobile industry is relatively highly leveraged,
but GM’sratio was substantially higher at 11.3 to 1. This means that GM had $11.30 in
debt for every $1 in shareholders’ equity.
Toyota Motor Corporation, on the other hand, was not highly leveraged; it had a
debt to equity ratio of 1 to 1. Thus Toyota had $1 in debt for every $1 in shareholders’
equity. It is important to review other financial ratios before concluding
that Toyota was in better financial shape than GM, but the fact that GM was much
more highly leveraged than Toyota likely played a big role in GM’s downfall!
Source: Industry averages found at MSN Money, Home
Page,”http://moneycentral.msn.com and Yahoo! Finance, “Home
Page,”http://biz.yahoo.com.

Times Interest Earned

Question: How is times interest earned calculated, and what does it tell us aboutCoca-
Cola relative to PepsiCo and the industry average?

Answer: The times interest earned ratio (also called interest coverage ratio) measures the
company’s ability to cover its interest expense related to long-term debt with current period
earnings. The times interest earned ratio is net income before income tax expense and interest
expense divided by interest expense:

Key  Equation  

Times interest earned=Net income + Income tax expense + Interest expenseInterest expense  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Notice that income tax expense and interest expense are added back in the numerator to
find net income available to cover interest expense. The times interest earned ratio
for Coca-Cola for 2010 is calculated as follows, withPepsiCo and industry average
information following it:

Times interest earned=$11,809+$2,384+$733$733=$14,926$733=20.36 times  

Coca-Cola Coca-Cola PepsiCo Industry Average

2010 2009 2010 2010

Times interest
earned 20.36 times 25.97 times 10.10 times 10.70 times

The times interest earned ratio indicates Coca-Cola had earnings to cover interest
expense 20.36 times. This ratio decreased from 2009 to 2010 and is much higher
than PepsiCo’s 10.10 times. Coca-Cola is also higher than the industry average of
10.70 times. It appears that Coca-Cola has plenty of earnings to cover interest expense.
R E V I E W   P R O B L E M   1 3 . 5  

Refer  to  the  information  presented  in  Note  13.10  "Review  Problem  13.1"for  PepsiCo,  
and  perform  the  following  requirements  for  2010:  
1. Calculate  the  debt  to  assets  ratio,  and  briefly  describe  what  it  means  for  PepsiCo.  
2. Calculate  the  debt  to  equity  ratio,  and  briefly  describe  what  it  means  for  PepsiCo.  
3. Calculate  the  times  interest  earned  ratio,  and  briefly  describe  what  it  means  
for  PepsiCo.  

Solution  to  Review  Problem  13.5  

1.    

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 Debt to assets=Total liabilitiesTotal assets=$4,898+$10,923+$71+$19,999+$10,786$6
8,153=$46,677$68,153=0.68 to 1  

Creditors  funded  68  percent  of  PepsiCo’s  assets.  Owners  funded  the  
remaining  32  percent.  

2.    

Debt to equity=Total liabilitiesTotal shareholders’ equity=$4,898+$10,923+$71+$19,9

99+$10,786($109)+$4,558+$37,402−$3,630−$16,745=$46,677$21,476=2.17 to 1  

For  every  dollar  in  shareholders’  equity,  PepsiCo  had  $2.17  in  liabilities.  

3.    

Times interest earned=Net income + Income tax expense +Interest expenseInterest exp
ense=$6,320+$1,894+$903$903=$9,117$903=10.10 times  

PepsiCo  had  earnings  to  cover  interest  expense  10.10  times.  

Market  Valuation  Measures  

Question: Existing and potential shareholders are often interested in a company’s market
value. What are the two common measures used to evaluate market value?

Answer: The two measures used to determine and evaluate the market valueof a company are as
follows:

1. Market capitalization
2. Price-earnings ratio

Market Capitalization

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 Question: How is market capitalization calculated, and what does it tell us about Coca-
Cola relative to PepsiCo and the industry average?

Answer: Market capitalization (also called market cap) measures the value of a company at a
point in time. It is determined by multiplying market price per share times the number of shares
outstanding:

Key  Equation  

Market  capitalization  =  Market  price  per  share  ×  Number  of  shares  outstanding  

Coca-Cola’s market capitalization for 2010 is calculated as follows, withPepsiCo information

following it. The number of shares outstanding atCoca-Cola’s fiscal year ended December 31,
2010, totaled 2,292,000,000 (= 3,520,000,000 shares issued – 1,228,000,000 treasury shares).
The market price per share at that time was $63.92.

Market  capitalization  =  $63.92  per  share  ×  2,292,000,000  shares  =  $146,500,000,000  

Industry
Coca-Cola 2010 Coca-Cola 2009 PepsiCo 2010 Average 2010

Market
capitalization $146,500,000,000 $123,200,000,000 $100,700,000,000 $87,500,000,000

Coca-Cola’s market capitalization indicates that the company’s shares outstanding had a market
value totaling $146,500,000,000 at the end of 2010. This amount increased significantly from
2009 to 2010 and is higher than PepsiCo’s $100,700,000,000. Both Coca-Cola and PepsiCo are
above the industry average of $87,500,000.

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 (Note that the number of shares outstanding is typically found in the shareholders’ equity section
of the balance sheet or in the notes to the financial statements. We provide the number of shares
outstanding throughout this chapter, unless noted otherwise. This number is different than the
weighted average shares outstanding used to calculate earnings per share earlier in the chapter.
Also note that the price per share amount is from Yahoo’s finance Web site
at http://finance.yahoo.com. We provide this information throughout the chapter, unless noted
otherwise.)

Looking at a company’s market capitalization is a quick way of gauging its aggregate value. But
what does a number like Coca-Cola’s$146,500,000,000 market capitalization really tell us about
how a company compares to others? Note 13.54 "Business in Action 13.6" has the answer.

Business  in  Action  13.6  

Three Categories of Market Capitalization
Most investors refer to market capitalization as market cap. Companies are typically
classified into one of three market cap categories: small-cap, midcap, and large-cap. In
general, small-cap companies have a market value of less than $1,000,000,000, midcap
companies have a market value between $1,000,000,000 and $12,000,000,000, and
large-cap companies have a market value greater than $12,000,000,000.
Thus small-cap mutual funds are stock funds that invest in companies with a market
value of less than $1,000,000,000. Midcap mutual funds are stock funds that invest in
companies with a market value between $1,000,000,000 and $12,000,000,000, and so
on. These categories are important to investors because the stocks of small-cap
companies tend to be more volatile than those of mid- or large-cap companies.
Source: Definitions are from the Web site of Vanguard, one of the world’s largest
investment management firms (http://www.vanguard.com).

Price-Earnings Ratio

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 Question: How is the price-earnings ratio calculated, and what does it tell us about Coca-
Cola relative to PepsiCo and the industry average?

Answer: The price-earnings ratio (also called P/E ratio) measures the premium investors are
willing to pay for shares of stock relative to the company’s earnings. The price-earnings ratio is
found by dividing market price per share by earnings per share:

Key  Equation  

Price-earnings ratio=Market price per shareEarnings per share  

In general, a relatively high price-earnings ratio indicates investors expect favorable future
earnings, whereas a relatively low price-earnings ratio indicates investors expect moderate future
earnings. The price-earnings ratio for Coca-Cola for 2010 is calculated as follows,
with PepsiCo and industry average information following it. The market price information was
given in the market capitalization example, and we calculated earnings per share earlier in the
chapter.

Price-earnings ratio=$63.92$5.12=12.48 times  

Coca-Cola Coca-Cola PepsiCo Industry Average

2010 2009 2010 2010

Price-earnings
ratio 12.48 times 18.21 times 16.04 times 14.60 times

The price-earnings ratio indicates investors were willing to pay 12.48 times the earnings
for Coca-Cola’s stock. This ratio decreased from 2009 to 2010 and is lower than PepsiCo’s 16.04
times. Coca-Cola is also lower than the industry average of 14.60 times.

K E Y   T A K E A W A Y  

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 • Shareholders,  creditors,  and  analysts  often  evaluate  a  company’s  profitability.  Five  
ratios  used  to  evaluate  profitability  are  the  gross  margin  ratio,  the  profit  margin  ratio,  
return  on  assets,  return  on  common  shareholders’  equity,  and  earnings  per  share.  
Suppliers  and  other  short-­‐term  creditors  often  evaluate  whether  a  company  can  meet  
short-­‐term  obligations.  Four  ratios  used  to  evaluate  short-­‐term  liquidity  are  the  
current  ratio,  the  quick  ratio,  the  receivables  turnover  ratio  (often  converted  to  
average  collection  period),  and  the  inventory  turnover  ratio  (often  converted  to  
average  sale  period).  Banks,  bondholders,  and  other  long-­‐term  lenders  often  evaluate  
whether  companies  can  meet  long-­‐term  obligations.  Three  ratios  used  to  
evaluate  long-­‐term  solvency  are  debt  to  assets,  debt  to  equity,  and  times  interest  
earned.  Shareholders  are  particularly  interested  in  a  company’s  market  value.  Two  
measures  used  to  determine  and  evaluate  the  market  value  of  a  company  are  market  
capitalization  and  the  price-­‐earnings  ratio.  
 
 
R E V I E W   P R O B L E M   1 3 . 6  

Perform  the  following  requirements  for  PepsiCo  for  2010:  

1. Calculate  the  market  capitalization,  and  briefly  describe  what  it  means  for  PepsiCo.  
Assume  PepsiCo  had  1,581,000,000  shares  outstanding  at  the  end  of  2010,  and  the  
market  price  per  share  was  $63.68.  
2. Calculate  the  price-­‐earnings  ratio,  and  briefly  describe  what  it  means  for  PepsiCo.  
(Hint:  Earnings  per  share  was  calculated  for  PepsiCo  inNote  13.29  "Review  Problem  
13.3".)  

Solution  to  Review  Problem  13.6  

1.    

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 Market capitalization=Market price per share×Number of shares outstanding=$63.68×
1,581,000,000=$100.7 billion (rounded)  

PepsiCo’s  shares  outstanding  had  a  market  value  of  $100,700,000,000  at  

the  end  of  2010.  

2.    

Price-
earnings ratio=Market price per shareEarnings per share=$63.68$3.97=16.04 times  

Investors  were  willing  to  pay  16.04  times  earnings  forPepsiCo’s  stock.  
13.4  Wrap-­‐Up  of  Chapter  Example  

Recall the dialogue at Chicken Deluxe between Sandy Masako, the CEO; Dave Roberts, the
CFO; and Karen Kraft, the purchasing manager. Chicken Deluxe must choose between Deep
Fizz Company and Extreme Fizz, Inc., as the supplier of the company’s beverages. Dave was
asked to evaluate the financial condition of each company and report back to the group. The
group reconvenes the following month, where Dave presents the financial measures for each
company. As you read the dialogue, refer to Table 13.3 "Summary of Financial Ratios for Deep
Fizz Company; Extreme Fizz, Inc.; and the Industry Average"; it is the summary of financial
measures that Dave provides to the group.

Table 13.3 Summary of Financial Ratios for Deep Fizz Company; Extreme Fizz, Inc.; and the
Industry Average

Deep Fizz Extreme Fizz Industry Average

Profitability Measures

1. Gross margin 63.1 percent 54.1 percent 53.1 percent

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 Deep Fizz Extreme Fizz Industry Average

ratio

Profit margin
2. ratio 22.1 percent 23.2 percent 19.2 percent

3. Return on assets 15.1 percent 17.3 percent 14.2 percent

Return on
common
shareholders’
4. equity 36.5 percent 34.9 percent 34.7 percent

Earnings per
5. share $2.01 $3.76 Not applicable

Short-Term Liquidity Measures

6. Current ratio 0.85 to 1 1.25 to 1 1.20 to 1

7. Quick ratio 0.62 to 1 0.87 to 1 1.10 to 1

Receivables
8. turnover ratio 9.10 times 10.18 times 9.70 times

Average
9. collection period 40.11 days 35.85 days 37.63 days

Inventory
10. turnover ratio 5.12 times 7.86 times 7.50 times

11. Average sale 72.29 days 46.44 days 48.67 days

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 Deep Fizz Extreme Fizz Industry Average

period

Long-Term Solvency Measures

12. Debt to assets 0.34 to 1 0.38 to 1 0.48 to 1

13. Debt to equity 0.67 to 1 0.86 to 1 0.94 to 1

Times interest
14. earned 31.60 times 38.93 times 10.70 times

Market Valuation Measures

Market
15. capitalization $91,800,000,000 $86,500,000,000 $87,500,000,000

Price-earnings
16. ratio 19.34 times 20.31 times 14.60 times

Sandy: Let’s get started! Dave, what do you have for us?

I used several different financial ratios to evaluate profitability, short-term

liquidity, long-term solvency, and market valuation for Deep Fizz Company and
Extreme Fizz, Inc., Here is a summary of the results. Items 1 through 4 show that
both companies are doing very well with regard to profitability, and exceed the
industry average in all four categories. Earnings per share are not relevant for
comparative purposes because different companies have different amounts of
Dave: shares outstanding.

The profitability measures look good for both companies. What about the balance
Sandy: sheet?

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 Deep Fizz Extreme Fizz Industry Average

For the most part, Extreme Fizz has the edge on short-term liquidity, with top
marks for all short-term liquidity measures. However, Deep Fizz is not far behind.
Based on items 6 through 11, I consider both companies to have strong short-term
liquidity. The only concern is with Deep Fizz’s slow inventory turnover, which is
Dave: well below Extreme Fizz and the industry average.

What about long-term solvency? Given both companies have strong profitability
and excellent short-term liquidity, my biggest concern is whether these companies
Sandy: are able to meet long-term obligations.

The short answer is both companies will be able to meet long-term obligations as
indicated in the debt to assets, debt to equity, and times interest earned ratios.
Also notice that both companies have large market capitalizations, and price-
Dave: earnings ratios are strong across the board!

Sandy: So what do we get from all this information?

Both companies are solid. We shouldn’t have to worry about either company
Dave: having financial difficulties in the near future.

Looks like we’ll have to review other factors in deciding which company to use as
Karen: our supplier.

I agree. Thanks, Dave, for your analysis. If nothing else, this puts my mind at ease
Sandy: about whichever company we ultimately select as our supplier.

As you can see from the Chicken Deluxe example, analysts use many different financial
measures to evaluate financial performance. In the case of Deep Fizz and Extreme Fizz, both
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 companies appear to be strong performers. Armed with this information, management can
confidently choose either company knowing the winner will be on solid financial ground for
years to come.

13.5 Nonfinancial Performance Measures: The Balanced Scorecard

L E A R N I N G   O B J E C T I V E  

1. Develop  and  analyze  nonfinancial  performance  measures  using  a  balanced  scorecard.  

Question: Although financial measures are important for evaluation purposes, many
organizations use a mix of financial and nonfinancial measures to evaluate performance. For
example, airlines track on-time arrival percentages carefully, and delivery companies
like Federal Express (FedEx) and United Parcel Service (UPS) monitor percentages of on-time
deliveries. The balanced scorecard uses several alternative measures to evaluate
performance. What is a balanced scorecard and how does it help companies to evaluate
performance?

Answer: The balanced scorecard is a balanced set of measures that organizations use to motivate
employees and evaluate performance. These measures are typically separated into four
perspectives outlined in the following. (Dr. Robert S. Kaplan and Dr. David P. Norton created
the balanced scorecard, and it is actively promoted through their company, Balanced Scorecard
Collaborative. More information can be found at the company’s Web site
at http://www.bscol.com.)

1. Financial. Measures that shareholders, creditors, and other stakeholders use to evaluate
financial performance.
2. Internal business process. Measures that management uses to evaluate efficiency of
existing business processes.
3. Learning and growth. Measures that management uses to evaluate effectiveness of
employee training.

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 4. Customer. Measures that management uses to evaluate whether the organization is
meeting customer expectations.

The goal is to link these four perspectives to the company’s strategies and goals. For example, a
high percentage of on-time arrivals is likely an important goal from the perspective of
the customer of an airline. A high percentage of defect-free computer chips is likely an important
goal from theinternal business process perspective of a computer chip maker. A high number of
continuing education hours is likely an important goal from thelearning and growth perspective
for tax personnel at an accounting firm. Measures from a financial perspective were covered
earlier in this chapter.

Companies that use the balanced scorecard typically establish several measures for each
perspective. lists several examples of these measures.

Table 13.4 Balanced Scorecard Measures

Internal Business
Financial Process Learning and Growth Customer

Gross margin Hours of employee Customer satisfaction

ratio Defect-free rate training (survey)

Employee satisfaction Number of customer

Return on assets Customer response time (survey) complaints

Receivables
turnover Capacity utilization Employee turnover Market share

Inventory New product Number of employee Number of returned

turnover development time accidents products

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 Measures established across the four perspectives of the balanced scorecard are linked in a way
that motivates employees to achieve company goals. For example, if the company wants to
increase the defect-free rate and reduce product returns, effective employee training and low
employee turnover will help in achieving this goal. The idea is to establish company goals first,
then create measures that motivate employees to reach company goals.

K E Y   T A K E A W A Y  

• Most  organizations  use  a  mix  of  financial  and  nonfinancial  measures  to  evaluate  
performance.  The  balanced  scorecard  approach  uses  a  balanced  set  of  measures  
separated  into  four  perspectives—financial,  internal  business  process,  learning  and  
growth,  and  customer.  The  last  three  perspectives  tend  to  include  nonfinancial  
measures,  such  as  hours  of  employee  training  or  number  of  customer  complaints,  to  
evaluate  performance.  The  goal  is  to  link  financial  and  nonfinancial  measures  to  the  
company’s  strategies  and  goals.  
R E V I E W   P R O B L E M   1 3 . 7  

Assume  Chicken  Deluxe,  the  fast-­‐food  restaurant  franchise  featured  in  this  chapter,  
uses  a  balanced  scorecard.  Provide  at  least  two  examples  of  measures  that  Chicken  
Deluxe  might  use  for  each  of  the  following  perspectives  of  the  balanced  scorecard:  
1. Financial  
2. Internal  business  process  
3. Learning  and  growth  
4. Customer  

Solution  to  Review  Problem  13.7  

1. Answers  will  vary.  Several  examples  of  financial  measures  are  as  follows:  
1. Gross  margin  ratio  
2. Profit  margin  ratio  

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 3. Return  on  assets  
4. Receivables  turnover  
5. Inventory  turnover  

Answers  will  vary.  Several  examples  of  internal  business  process  

measures  are  as  follows:  
0. Capacity  utilization  
1. Amount  of  food  spoilage  
2. Order  response  time  

Answers  will  vary.  Several  examples  of  learning  and  growth  measures  
are  as  follows:  
0. Hours  of  employee  training  
1. Employee  satisfaction  
2. Employee  turnover  
3. Number  of  employee  accidents  

Answers  will  vary.  Several  examples  of  customer  perspective  

measures  are  as  follows:  
0. Customer  satisfaction  
1. Number  of  customer  complaints  
2. Market  share  
3. Amount  of  food  returned  
E N D -­‐ O F -­‐ C H A P T E R   E X E R C I S E S  

Questions  
1. What  is  trend  analysis?  Explain  how  the  percent  change  from  one  period  to  the  next  
is  calculated.  
2. What  is  common-­‐size  analysis?  How  is  common-­‐size  analysis  information  used?  

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 3. Explain  the  difference  between  trend  analysis  and  common-­‐size  analysis.  
4. Name  the  ratios  used  to  evaluate  profitability.  Explain  what  the  statement  “evaluate  
profitability”  means.  
5. Coca-­‐Cola’s  return  on  assets  was  19.4  percent,  and  return  on  common  shareholders’  
equity  was  41.7  percent.  Briefly  explain  why  these  two  percentages  are  different.  
6. Coca-­‐Cola  had  earnings  per  share  of  $5.12,  and  PepsiCo  had  earnings  per  share  of  
$3.97.  Is  it  accurate  to  conclude  PepsiCo  was  more  profitable?  Explain  your  
reasoning.  
7. Name  the  ratios  used  to  evaluate  short-­‐term  liquidity.  Explain  what  the  statement  
“evaluate  short-­‐term  liquidity”  means.  
8. Explain  the  difference  between  the  current  ratio  and  the  quick  ratio.  
9. Coca-­‐Cola  had  an  inventory  turnover  ratio  of  5.07  times  (every  71.99  days),  
and  PepsiCo  had  an  inventory  turnover  ratio  of  8.87  times  (every  41.15  days).  Which  
company  had  the  best  inventory  turnover?  Explain  your  reasoning.  
10. Name  the  ratios  used  to  evaluate  long-­‐term  solvency.  Explain  what  the  term  “long-­‐
term  solvency”  means.  
11. Name  the  measures  used  to  determine  and  evaluate  the  market  value  of  a  company.  
Briefly  describe  the  meaning  of  each  measure.  
12. What  is  the  balanced  scorecard?  Briefly  describe  the  four  perspectives  of  the  
balanced  scorecard.  

Brief  Exercises  
13. Evaluating  Suppliers  at  Chicken  Deluxe.  Refer  to  the  dialogue  at  Chicken  
Deluxe  presented  at  the  beginning  of  the  chapter  and  the  follow-­‐up  
dialogue  immediately  following  .  
Required:  
a. What  is  the  big  decision  that  Chicken  Deluxe  is  facing?  

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 b. Briefly  describe  the  results  of  Dave’s  analysis  of  the  two  suppliers.  
Trend  Analysis.  The  following  condensed  income  statement  is  
for  Apple,  Inc.  

Required:  
Prepare  a  trend  analysis  of  the  income  statements  from  2010  to  2011.  Use  
the  format  shown  in  as  a  guide.  (Round  percent  computations  to  one  
decimal  place.)  
Common-­‐Size  Analysis.  Refer  to  the  condensed  income  statement  
for  Apple,  Inc.,  in  Brief  Exercise  14.  
Required:  
Prepare  a  common-­‐size  analysis  of  the  income  statements  for  2010  and  
2011.  Use  the  format  shown  in  as  a  guide.  (Round  percent  computations  to  
one  decimal  place.)  
Gross  Margin  and  Profit  Margin  Ratios.  Refer  to  the  condensed  
income  statement  for  Apple,  Inc.,  in  Brief  Exercise  14.  
Required:  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
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 Compute  the  following  profitability  ratios  for  2011,  and  provide  a  brief  
explanation  after  each  ratio  (round  computations  to  one  decimal  place):  
0. Gross  margin  ratio  
1. Profit  margin  ratio  
Current  and  Quick  Ratios.  A  condensed  balance  sheet  for  Apple,  
Inc.,  appears  in  the  following.  

Required:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Compute  the  following  short-­‐term  liquidity  ratios  for  2011,  and  provide  a  
brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  
0. Current  ratio  
1. Quick  ratio  
Long-­‐Term  Solvency  Ratios.  Refer  to  the  condensed  balance  sheet  
for  Apple,  Inc.,  in  Brief  Exercise  17.  
Required:  

Compute  the  following  long-­‐term  solvency  ratios  for  2011,  and  provide  a  
brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  
0. Debt  to  assets  
1. Debt  to  equity  
Market  Capitalization.  On  September  24,  2011,  Apple,  Inc.,  had  
929,277,000  shares  of  common  stock  issued  and  outstanding,  and  the  
market  price  per  share  on  that  date  was  $403.33.  
Required:  

Compute  Apple’s  market  capitalization  at  September  24,  2011,  and  provide  
a  brief  explanation  of  what  this  measures  represents  (state  the  answer  in  
billions).  
Balanced  Scorecard.  Provide  two  nonfinancial  measures  likely  used  by  delivery  
companies  like  FedEx  and  UPS.  

Exercises:  Set  A  
21. Trend  Analysis.  The  following  condensed  income  statement  is  for  CarMax,  
Inc.,  a  large  retailer  of  used  vehicles.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Required:  
a. Prepare  a  trend  analysis  of  the  income  statements  from  2010  to  2011.  Use  
the  format  shown  in  as  a  guide.  (Round  computations  to  one  decimal  place.)  
b. What  does  the  trend  analysis  prepared  in  requirement  atell  you  about  the  
company?  
Common-­‐Size  Analysis.  Refer  to  the  condensed  income  statement  
for  CarMax,  Inc.,  in  Exercise  21.  
Required:  
 . Prepare  a  common-­‐size  analysis  of  the  income  statements  for  2011  and  
2010.  Use  the  format  shown  in  as  a  guide.  (Round  computations  to  one  decimal  
place.)  
a. What  does  the  common-­‐size  analysis  in  requirement  atell  you  about  the  
company?  
Profitability  Ratios.  Refer  to  the  condensed  income  statement  
for  CarMax,  Inc.,  in  Exercise  21  and  to  the  company’s  balance  sheet  shown  
as  follows.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Required:  

Compute  the  following  profitability  ratios  for  2011,  and  provide  a  brief  
explanation  after  each  ratio  (round  percentage  computations  to  one  
decimal  place  and  earnings  per  share  to  two  decimal  places):  
0. Gross  margin  ratio  
1. Profit  margin  ratio  
2. Return  on  assets  
3. Return  on  common  shareholders’  equity  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 4. Earnings  per  share  (assume  weighted  average  shares  outstanding  totaled  
223,449,000  shares)  
Short-­‐Term  Liquidity  Ratios.  Refer  to  the  condensed  income  
statement  for  CarMax,  Inc.,  in  Exercise  21  and  to  the  company’s  balance  
sheet  in  Exercise  23.  
Required:  

Compute  the  following  short-­‐term  liquidity  ratios  for  2011,  and  provide  a  
brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  
0. Current  ratio  
1. Quick  ratio  
2. Receivables  turnover  ratio  and  average  collection  period  (assume  all  sales  
are  on  account)  
3. Inventory  turnover  ratio  and  average  sale  period  
Long-­‐Term  Solvency  Ratios.  Refer  to  the  condensed  income  
statement  for  CarMax,  Inc.,  in  Exercise  21  and  to  the  company’s  balance  
sheet  in  Exercise  23.  
Required:  

Compute  the  following  long-­‐term  solvency  ratios  for  2011,  and  provide  a  
brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  
0. Debt  to  assets  
1. Debt  to  equity  
2. Times  interest  earned  
Market  Valuation  Measures.  The  following  requirements  are  
forCarMax,  Inc.,  as  of  February  28,  2011.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     1052  
     
 
 Required:  

 . Compute  the  following  market  valuation  measures  for  2011,  and  

provide  a  brief  explanation  after  each  measure  (state  market  capitalization  in  
billions,  and  round  price-­‐earnings  ratio  to  two  decimal  places):  
1. Market  capitalization  (assume  225,885,693  shares  were  issued  
and  outstanding  at  February  28,  2011,  and  the  market  price  was  
$35.37  per  share)  
2. Price-­‐earnings  ratio  (assume  earnings  per  share  was  $1.71)  
a. Refer  to  In  which  category  does  CarMax  belong?  Explain.  
Balanced  Scorecard  Customer  Measures.  Tech  University  has  more  
than  10,000  students  enrolling  in  courses  each  term.  The  management  
would  like  to  develop  a  balanced  scorecard  to  assess  performance.  
Required:  

Provide  at  least  three  customer  measures  Tech  University  can  use  on  its  
balanced  scorecard.  Assume  students  are  the  customers.  

Exercises:  Set  B  
28. Trend  Analysis.  The  following  condensed  income  statement  is  for  Colgate-­‐
Palmolive  Company,  a  large  retailer  of  personal  and  home  care  products.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Required:  
a. Prepare  a  trend  analysis  of  the  income  statements  from  2009  to  2010.  
Use  the  format  shown  in  as  a  guide.  (Round  computations  to  one  decimal  
place.)  
b. What  does  the  trend  analysis  prepared  in  requirement  atell  you  about  the  
company?  
Common-­‐Size  Analysis.  Refer  to  the  condensed  income  statement  
for  Colgate-­‐Palmolive  Company  in  Exercise  28.  
Required:  
 . Prepare  a  common-­‐size  analysis  of  the  income  statements  for  2010  and  
2009.  Use  the  format  shown  in  as  a  guide.  (Round  computations  to  one  decimal  
place.)  
a. What  does  the  common-­‐size  analysis  in  requirement  atell  you  about  the  
company?  
Profitability  Ratios.  Refer  to  the  condensed  income  statement  
for  Colgate-­‐Palmolive  Company  in  Exercise  28.  Assume  the  company  paid  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 preferred  dividends  totaling  $34,000,000  during  2010.  (The  company  had  
preferred  stock  outstanding  during  2010,  but  eliminated  all  preferred  stock  
by  the  end  of  2010.  This  is  why  preferred  stock  has  a  zero  balance  as  of  
December  31,  2010.)  

Required:  

Compute  the  following  profitability  ratios  for  2010,  and  provide  a  brief  
explanation  after  each  ratio  (round  percentage  computations  to  one  
decimal  place  and  earnings  per  share  to  two  decimal  places):  
0. Gross  margin  ratio  
1. Profit  margin  ratio  
2. Return  on  assets  
3. Return  on  common  shareholders’  equity  
4. Earnings  per  share  (assume  weighted  average  shares  outstanding  totaled  
487,800,000  shares)  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     1055  
     
 
 Short-­‐Term  Liquidity  Ratios.  Refer  to  the  condensed  income  
statement  for  Colgate-­‐Palmolive  Company  in  Exercise  28  and  to  the  
company’s  balance  sheet  in  Exercise  30.  
Required:  

Compute  the  following  short-­‐term  liquidity  ratios  for  2010,  and  provide  a  
brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  
0. Current  ratio  
1. Quick  ratio  
2. Receivables  turnover  ratio  and  average  collection  period  (assume  all  sales  
are  on  account)  
3. Inventory  turnover  ratio  and  average  sale  period  
Long-­‐Term  Solvency  Ratios.  Refer  to  the  condensed  income  
statement  for  Colgate-­‐Palmolive  Company  in  Exercise  28  and  to  the  
company’s  balance  sheet  in  Exercise  30.  
Required:  

Compute  the  following  long-­‐term  solvency  ratios  for  2010,  and  provide  a  
brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  
0. Debt  to  assets  
1. Debt  to  equity  
2. Times  interest  earned  
Market  Valuation  Measures.  The  following  requirements  are  
forColgate-­‐Palmolive  Company  as  of  December  31,  2010.  
Required:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1056  
     
 
  . Compute  the  following  market  valuation  measures  for  2010,  and  
provide  a  brief  explanation  after  each  measure  (state  market  capitalization  in  
billions,  and  round  price-­‐earnings  ratio  to  two  decimal  places):  
1. Market  capitalization  (assume  494,850,467  shares  were  issued  
and  outstanding  at  December  31,  2010,  and  the  market  price  was  
$77.74  per  share)  
2. Price-­‐earnings  ratio  (assume  earnings  per  share  was  $4.45)  
a. Refer  to  In  which  category  does  Colgate-­‐Palmolive  belong?  Explain.  
Balanced  Scorecard  Internal  Business  Process  Measures.  Tony’s  
Pizzeria  serves  pizzas  at  its  restaurants  and  provides  delivery  services  to  
customers.  The  management  would  like  to  develop  a  balanced  scorecard  to  
assess  performance.  
Required:  

Provide  at  least  three  internal  business  process  measures  Tony’s  Pizzeria  
can  use  on  its  balanced  scorecard.  

Problems  
35. Trend  Analysis  and  Common-­‐Size  Analysis.  The  following  condensed  
income  statement  and  balance  sheet  are  forNordstrom,  Inc.,  a  large  retailer  
of  apparel.  (Note  thatNordstrom’s  2010  fiscal  year  ends  on  January  29,  
2011.  This  is  called  the  2010  fiscal  year  because  only  one  month  is  in  2011,  
the  other  11  months  of  the  fiscal  year  are  in  2010,  and  the  company  has  
chosen  to  refer  to  this  as  the  2010  fiscal  year.  This  same  concept  applies  to  
fiscal  year  2009.)  

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Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 Required:  
a. Prepare  a  trend  analysis  of  the  income  statements  from  2009  to  2010.  Use  
the  format  shown  in  as  a  guide.  (Round  computations  to  one  decimal  place.)  
b. Prepare  a  trend  analysis  of  the  balance  sheets  from  2009  to  2010.  Use  the  
format  shown  in  as  a  guide.  (Round  computations  to  one  decimal  place.)  
c. Identify  all  items  that  changed  by  more  than  20  percent  in  the  trend  
analyses  prepared  in  requirements  a  and  b,  and  briefly  comment  on  the  
results.  
d. Prepare  a  common-­‐size  analysis  of  the  income  statements  for  2010  and  
2009.  Use  the  format  shown  in  as  a  guide.  (Round  computations  to  one  
decimal  place.)  
e. Prepare  a  common-­‐size  analysis  of  the  balance  sheets  for  2010  and  2009.  
Use  the  format  shown  in  as  a  guide.  (Round  computations  to  one  decimal  
place.)  
f. What  does  the  common-­‐size  analysis  prepared  in  requirements  d  and  e  tell  
you  about  the  company?  
Profitability  and  Short-­‐Term  Liquidity  Ratios.  Refer  to  the  
information  presented  in  Problem  35  for  Nordstrom.  
Required:  

 . Compute  the  following  profitability  ratios  for  2010,  and  provide  a  brief  
explanation  after  each  ratio  (round  percentage  computations  to  one  decimal  
place  and  earnings  per  share  to  two  decimal  places):  
1. Gross  margin  ratio  
2. Profit  margin  ratio  
3. Return  on  assets  
4. Return  on  common  shareholders’  equity  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1059  
     
 
 5. Earnings  per  share  (weighted  average  shares  outstanding  totaled  
218,800,000  shares)  

a. Compute  the  following  short-­‐term  liquidity  ratios  for  2010,  and  provide  
a  brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  
1. Current  ratio  
2. Quick  ratio  
3. Receivables  turnover  ratio  and  average  collection  period  (assume  
all  sales  are  on  account)  
4. Inventory  turnover  ratio  and  average  sale  period  
Long-­‐Term  Solvency  Ratios  and  Market  Valuation  Measures.  Refer  
to  the  information  presented  in  Problem  35  for  Nordstrom.  
Required:  

 . Compute  the  following  long-­‐term  solvency  ratios  for  2010,  and  provide  
a  brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  
1. Debt  to  assets  
2. Debt  to  equity  
3. Times  interest  earned  

a. Compute  the  following  market  valuation  measures  for  2010,  and  

provide  a  brief  explanation  after  each  measure  (state  market  capitalization  in  
billions,  and  round  price-­‐earnings  ratio  to  two  decimal  places):  
1. Market  capitalization  (assume  218,000,000  shares  were  issued  
and  outstanding  at  January  29,  2011,  and  the  market  price  was  
$40.08  per  share)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 2. Price-­‐earnings  ratio  (assume  the  earnings  per  share  amount  was  
$2.80)  
Income  Statement  Trend,  Common-­‐Size,  and  Profitability  
Analysis.The  following  condensed  income  statement  and  balance  sheet  are  
for  Starbucks  Corporation,  a  large  retailer  of  specialty  coffee  with  stores  
throughout  the  world.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Required:  
 . Prepare  a  trend  analysis  of  the  income  statements  from  2010  to  2011.  Use  
the  format  shown  in  as  a  guide.  (Round  computations  to  one  decimal  place.)  
a. Identify  all  items  that  changed  by  more  than  20  percent  in  the  trend  
analysis  prepared  in  requirement  a,  and  briefly  comment  on  the  results.  
b. Prepare  a  common-­‐size  analysis  of  the  income  statements  for  2011  and  
2010.  Use  the  format  shown  in  as  a  guide.  (Round  computations  to  one  
decimal  place.)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 c. What  does  the  common-­‐size  analysis  prepared  in  requirement  c  tell  you  
about  the  company?  

d. Compute  the  following  profitability  ratios  for  2011,  and  provide  a  brief  
explanation  after  each  ratio  (round  percentage  computations  to  one  decimal  
place  and  earnings  per  share  to  two  decimal  places):  
1. Gross  margin  ratio  
2. Profit  margin  ratio  
3. Return  on  assets  
4. Return  on  common  shareholders’  equity  
5. Earnings  per  share  (assume  weighted  average  shares  outstanding  
totaled  748,300,000  shares)  
Short-­‐Term  Liquidity,  Long-­‐Term  Solvency,  and  Market  
Valuation.Refer  to  the  information  presented  in  Problem  38  forStarbucks.  
Required:  

 . Compute  the  following  short-­‐term  liquidity  ratios  for  2011,  and  provide  
a  brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  
1. Current  ratio  
2. Quick  ratio  
3. Receivables  turnover  ratio  and  average  collection  period  (assume  
all  sales  are  on  account)  
4. Inventory  turnover  ratio  and  average  sale  period  

a. Compute  the  following  long-­‐term  solvency  ratios  for  2011,  and  provide  
a  brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 1. Debt  to  assets  
2. Debt  to  equity  
3. Times  interest  earned  

b. Compute  the  following  market  valuation  measures  for  2011,  and  

provide  a  brief  explanation  after  each  measure  (state  market  capitalization  in  
billions,  and  round  price-­‐earnings  ratio  to  two  decimal  places):  
1. Market  capitalization  (assume  744,800,000  shares  were  issued  
and  outstanding  at  October  2,  2011,  and  the  market  price  was  
$37.14  per  share)  
2. Price-­‐earnings  ratio  (assume  the  earnings  per  share  amount  was  
$1.66)  
Balance  Sheet  Trend  and  Common-­‐Size  Analysis.  The  following  
condensed  income  statement  and  balance  sheet  are  for  Wal-­‐Mart  Stores,  
Inc.  (note  that  Wal-­‐Mart’s  2010  fiscal  year  ends  on  January  31,  2011.  This  is  
called  the  2010  fiscal  year  because  only  one  month  is  in  2011,  the  other  11  
months  of  the  fiscal  year  are  in  2010,  and  the  company  has  chosen  to  refer  
to  this  as  the  2010  fiscal  year.  This  same  concept  applies  to  fiscal  year  
2009.)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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Required:  
 . Prepare  a  trend  analysis  of  the  balance  sheets  from  2009  to  2010.  Use  
the  format  shown  in  as  a  guide.  (Round  computations  to  one  decimal  
place.)  
a. Prepare  a  common-­‐size  analysis  of  the  balance  sheets  for  2010  and  2009.  
Use  the  format  shown  in  as  a  guide.  (Round  computations  to  one  decimal  
place.)  
b. What  does  the  balance  sheet  common-­‐size  analysis  prepared  in  
requirement  b  tell  you  about  the  company?  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1066  
     
 
 Income  Statement  Trend  and  Common-­‐Size  Analysis;  Profitability  
Ratios.  Refer  to  the  information  presented  in  Problem  40  forWal-­‐Mart.  
Required:  
 . Prepare  a  trend  analysis  of  the  income  statements  from  2009  to  2010.  Use  
the  format  shown  in  as  a  guide.  (Round  computations  to  one  decimal  place.)  
a. Based  on  the  income  statement  trend  analysis  prepared  in  requirement  a,  
describe  what  caused  the  increase  in  operating  income  from  2009  to  2010.  
b. Prepare  a  common-­‐size  analysis  of  the  income  statements  for  2010  and  
2009.  Use  the  format  shown  in  as  a  guide.  (Round  computations  to  one  
decimal  place.)  
c. What  does  the  income  statement  common-­‐size  analysis  prepared  in  
requirement  c  tell  you  about  the  company?  

d. Compute  the  following  profitability  ratios  for  2010,  and  provide  a  brief  
explanation  after  each  ratio  (round  percentage  computations  to  one  decimal  
place  and  earnings  per  share  to  two  decimal  places):  
1. Gross  margin  ratio  
2. Profit  margin  ratio  
3. Return  on  assets  
4. Return  on  common  shareholders’  equity  
5. Earnings  per  share  (assume  weighted  average  shares  outstanding  
totaled  3,656,000,000  shares)  
Short-­‐Term  Liquidity,  Long-­‐Term  Solvency,  Market  Valuation,  and  
Balanced  Scorecard.  Refer  to  the  information  presented  in  Problem  40  
for  Wal-­‐Mart.  
Required:  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1067  
     
 
  . Compute  the  following  short-­‐term  liquidity  ratios  for  2010,  and  provide  
a  brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  
1. Current  ratio  
2. Quick  ratio  
3. Receivables  turnover  ratio  and  average  collection  period  (assume  
all  sales  are  on  account)  
4. Inventory  turnover  ratio  and  average  sale  period  

a. Compute  the  following  long-­‐term  solvency  ratios  for  2010,  and  provide  
a  brief  explanation  after  each  ratio  (round  computations  to  two  decimal  
places):  
1. Debt  to  assets  
2. Debt  to  equity  
3. Times  interest  earned  

b. Compute  the  following  market  valuation  measures  for  2010,  and  

provide  a  brief  explanation  after  each  measure  (state  market  capitalization  in  
billions,  and  round  price-­‐earnings  ratio  to  two  decimal  places):  
1. Market  capitalization  (assume  3,516,000,000  shares  were  issued  
and  outstanding  at  January  31,  2011,  and  the  market  price  was  
$54.58  per  share)  
2. Price-­‐earnings  ratio  (assume  the  earnings  per  share  amount  was  
$4.48)  
c. Assume  Wal-­‐Mart  uses  a  balanced  scorecard  to  assess  performance.  
Provide  at  least  two  learning  and  growth  measures  the  company  can  
use  on  its  balanced  scorecard.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1068  
     
 
 One  Step  Further:  Skill-­‐Building  Cases  
43. Trend  Information  in  Annual  Reports.  Refer  to  Why  is  trend  information  important  to  
shareholders?  
44. Earnings  per  Share.  Refer  to  Was  AnnTaylor  Stores’  earnings  per  share  higher  or  
lower  than  analysts  expected?  Explain  whether  you  would  expect  the  company’s  
stock  price  to  increase  or  decrease  as  a  result  of  the  press  release.  
45. Inventory  Turnover  in  the  Computer  Industry.  Refer  to  Why  do  you  think  inventory  
turnover  for  the  computer  hardware  industry  is  so  quick?  
46. Financial  Leverage  in  the  Auto  Industry.  Refer  to  Why  do  most  investors  
consider  GM  to  be  highly  leveraged?  
47. Market  Capitalization  Categories.  Refer  to  Define  what  is  meant  by  small-­‐cap,  
midcap,  and  large-­‐cap.  In  which  category  does  Coca-­‐Colabelong?  Explain.  
48. Internet  Project:  Financial  Statement  Analysis.  Using  the  Internet,  find  the  
most  recent  annual  report  (or  form  10K)  for  a  manufacturing  or  retail  
company  of  your  choice.  Most  companies  have  links  to  the  information  at  
their  Web  sites  under  titles,  such  as  investor  relations  or  financial  reports.  
Print  the  income  statement  and  balance  sheet  for  the  company  selected  
and  include  these  documents  with  your  response  to  the  following  
requirements.  
Required:  

a. Compute  the  following  profitability  ratios  for  the  most  current  year,  
and  provide  a  brief  explanation  after  each  ratio  (round  percentage  
computations  to  one  decimal  place):  
1. Gross  margin  ratio  
2. Profit  margin  ratio  
3. Return  on  assets  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1069  
     
 
 4. Return  on  common  shareholders’  equity  

b. Compute  the  following  short-­‐term  liquidity  ratios  for  the  most  current  
year,  and  provide  a  brief  explanation  after  each  ratio  (round  computations  to  
two  decimal  places):  
1. Current  ratio  
2. Quick  ratio  
3. Receivables  turnover  ratio  and  average  collection  period  (assume  
all  sales  are  on  account)  
4. Inventory  turnover  ratio  and  average  sale  period  

c. Compute  the  following  long-­‐term  solvency  ratios  for  the  most  current  
year,  and  provide  a  brief  explanation  after  each  ratio  (round  computations  to  
two  decimal  places):  
1. Debt  to  assets  
2. Debt  to  equity  
d. Provide  a  one-­‐page  written  report  summarizing  your  results  in  
requirements  a,  b,  and  c.  Identify  any  areas  of  concern  as  well  as  areas  
of  strength  for  the  company.  
Group  Activity:  Analyzing  Lowe’s  Companies,  Inc.  The  condensed  
income  statement  and  balance  sheet  information  provided  as  follows  is  
for  Lowe’s  Companies,  Inc.,  a  large  retail  company  that  sells  building  
materials  and  supplies.  Lowe’s  had  1,354,000,000  shares  issued  and  
outstanding  at  January  28,  2011,  and  the  market  price  per  share  on  that  
date  was  $24.83.  (Note  that  Lowe’s  2010  fiscal  year  ends  on  January  28,  
2011.  This  is  called  the  2010  fiscal  year  because  only  one  month  is  in  2011,  
the  other  11  months  of  the  fiscal  year  are  in  2010,  and  the  company  has  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1070  
     
 
 chosen  to  refer  to  this  as  the  2010  fiscal  year.  This  same  concept  applies  to  
fiscal  year  2009.)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1071  
     
 
  

Form  groups  of  two  to  four  students.  Each  group  is  to  be  assigned  one  of  
the  following  three  categories  of  financial  measures:  

0. Profitability  measures  
1. Gross  margin  ratio  
2. Profit  margin  ratio  
3. Return  on  assets  
4. Return  on  common  shareholders’  equity  

1. Short-­‐term  liquidity  measures  

0. Current  ratio  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1072  
     
 
 1. Quick  ratio  
2. Inventory  turnover  ratio  and  average  sales  period  

2. Long-­‐term  solvency  and  market  valuation  measures  

0. Debt  to  assets  
1. Debt  to  equity  
2. Market  capitalization  
Required:  
c. Calculate  the  financial  measures  assigned  to  your  group.  Round  all  
computations  to  two  decimal  places,  except  the  market  capitalization  measure,  
which  can  be  rounded  to  the  nearest  billion  dollars.  
d. Provide  a  brief  explanation  of  each  measure  your  group  calculated  in  
requirement  a.  
e. Discuss  the  results  of  your  group  with  the  class.  
Performing  Income  Statement  Trend  Analysis  Using  Excel.  Review  
the  information  for  Apple,  Inc.,  in  Brief  Exercise  14.  
Required:  
Perform  income  statement  trend  analysis  for  Apple,  Inc.,  using  an  Excel  
spreadsheet.  The  format  should  be  similar  to  the  one  in  .  Round  percent  
computations  to  one  decimal  place.  

Comprehensive  Cases  
51. Financial  Statement  Analysis  and  Industry  Standards;  Manufacturing  
Company.  Susan  Hartford  is  the  president  and  CEO  of  Computer  Makers,  
Inc.  The  company  is  in  the  process  of  looking  for  a  supplier  of  computer  
chips,  and  Susan  has  asked  her  staff  to  review  the  financial  stability  of  Intel  
Corporation,  the  world’s  largest  maker  of  computer  chips.  Susan’s  staff  
began  by  collecting  industry  average  information,  which  is  shown  as  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     1073  
     
 
 follows,  and  would  like  your  help  in  calculating  and  evaluating  these  
measures  for  Intel.  
Measure Industry Average Intel

Gross margin 57.7 percent ?

Profit margin 21.9 percent ?

Return on assets 17.7 percent ?

Return on common shareholders’ equity 21.5 percent ?

Current ratio 2.3 to 1 ?

Quick ratio 1.9 to 1 ?

Receivables turnover 12.8 times ?

Inventory turnover 4.8 times ?

Debt to assets 0.21 to 1 ?

Debt to equity 0.26 to 1 ?

Market capitalization $80,000,000,000 ?

52. Intel’s  income  statement  and  balance  sheet  are  provided  as  follows.  The  
price  for  1  share  of  common  stock  at  December  25,  2010,  the  end  
of  Intel’s  fiscal  year,  was  $20.13.  The  number  of  shares  issued  and  
outstanding  at  December  25,  2010,  totaled  5,581,000,000.  Assume  all  sales  
were  on  account.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1074  
     
 
 53.  

54.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

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 55. Required:  
a. Using  the  industry  average  measures  provided,  compute  the  same  measures  
for  Intel  for  its  fiscal  year  ended  December  25,  2010.  (State  your  results  in  the  same  
format  used  for  industry  averages.)  
b. Summarize  your  results  in  requirement  a  by  completing  a  table  using  
the  following  headings:  
Measure Industry Average Intel Corporation

c. Immediately  following  each  measure,  indicate  whether  Intel’s  financial  

condition  is  better  or  worse  than  the  industry  average.  
d. Using  your  answers  to  requirements  a  and  b  to  support  your  position,  
determine  whether  Intel  is  financially  stable.  
Ethics:  Manipulating  Data  to  Meet  Loan  Requirements.  Custom  
Tech,  Inc.,  designs  and  produces  computers  for  a  variety  of  customers.  The  
company  has  encountered  a  cash  shortage  resulting  from  collection  
problems  with  several  customers.  If  Custom  Tech  is  unable  to  collect  a  
significant  portion  of  its  receivables  relatively  soon,  the  company  will  not  be  
able  to  pay  suppliers  and  employees  next  quarter.  As  a  result,  Custom  
Tech’s  president,  Don  Lardner,  began  discussions  with  a  local  bank  about  
obtaining  a  short-­‐term  loan.  Don  did  not  mention  the  cause  of  the  cash  flow  
shortage  other  than  to  say,  “This  happens  the  same  time  every  year  due  to  
the  cyclical  nature  of  our  business.”  

In  a  meeting  with  the  bank’s  loan  officer,  Jan  Johnson,  Don  was  told  the  
loan  should  not  be  a  problem  as  long  as  Custom  Tech  maintains  a  profit  
margin  ratio  above  10  percent,  quick  ratio  above  1.0  to  1,  and  debt  to  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1076  
     
 
 equity  ratio  below  1.4  to  1.  Don  indicated  this  was  in  line  with  his  
company’s  performance  and  agreed  to  provide  financial  statements  for  the  
most  recent  year  at  their  next  meeting.  

The  financial  statements  shown  as  follows  are  for  Custom  Tech’s  most  
recent  year  ended  December  31.  This  information  has  not  yet  been  
provided  to  the  bank.  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1077  
     
 
  

Required:  
 . Calculate  the  ratios  required  by  the  bank  and  determine  whether  Custom  
Tech  will  qualify  for  the  loan.  
a. Assume  you  are  the  CFO  for  Custom  Tech.  Don  Lardner  asks  you  to  
reclassify  $30,000  in  current  liabilities  to  common  stock.  Don  states,  “We  
owe  it  to  our  shareholders  and  employees  to  do  whatever  it  takes  to  get  
this  loan!  Without  it,  we  may  have  to  file  for  bankruptcy  and  let  our  
employees  go.  Once  we  get  this  loan  and  collect  our  outstanding  
receivables  we’ll  be  in  good  shape.”  Prepare  a  revised  balance  sheet  after  
making  the  $30,000  reclassification,  recalculate  the  ratios  required  by  the  
bank,  and  determine  whether  Custom  Tech  will  qualify  for  the  loan  with  the  
revised  numbers.  
Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  
Saylor  URL:  http://www.saylor.org/books/     1078  
     
 
 b. Are  the  president’s  actions  ethical?  If  you  were  the  CFO,  how  would  you  
handle  the  president’s  request?  (To  answer  these  questions,  you  may  want  
to  review  the  presentation  of  ethics  in  .)  

Attributed  to  Kurt  Heisinger  and  Joe  Ben  Hoyle     Saylor.org  

Saylor  URL:  http://www.saylor.org/books/     1079