R e v i e w P r o b l e m 1 25

you should follow your organization’s established policies on the resolution of such conflict.
If these policies do not resolve the ethical conflict, you should consider the following courses
of action:
1. Discuss the issue with your immediate supervisor except when it appears that the
supervisor is involved. In that case, present the issue to the next level. If you cannot
achieve a satisfactory resolution, submit the issue to the next management level. If your
immediate superior is the chief executive officer or equivalent, the acceptable reviewing
authority may be a group such as the audit committee, executive committee, board of
directors, board of trustees, or owners. Contact with levels above the immediate superior
should be initiated only with your superior’s knowledge, assuming he or she is not
involved. Communication of such problems to authorities or individuals not employed or
engaged by the organization is not considered appropriate, unless you believe there is a
clear violation of the law.
2. Clarify relevant ethical issues by initiating a confidential discussion with an IMA Ethics
Counselor or other impartial advisor to obtain a better understanding of possible courses
of action.
3. Consult your own attorney as to legal obligations and rights concerning the ethical
conflict.

Review Problem 1
Sterling Auto Detail is currently open Monday through Friday. In the past year, income before
taxes was as follows:

Numbers of cars detailed 2,080

Revenue $ 468,000
Less operating expenses:
Supplies (polish, wax, etc.) $ 5,824
Salaries of detailers 104,000
Water and other variable costs 12,480
Supervisor’s salary 65,000
Rent 36,000
Depreciation 5,000
Other fixed costs 1,050 229,354
Income before taxes $ 238,646

Quincy Davis, the owner of Sterling, is considering extending the workweek through Saturday. If
he takes this action, he’ll hire a part-time employee for $300 per day to act as the Saturday man-
ager so the supervisor still can have Saturday off. Quincy estimates that his company will detail
an additional 10 cars per Saturday, 52 weeks per year.

Req u ir ed
a. Calculate the annual incremental revenue associated with being open on Saturday.
b. Calculate the incremental cost associated with being open on Saturday.
c. Ignoring taxes, what is the incremental profit? Should Quincy open the business on
Saturdays?

A n s wer
a. The price of a detail is $225 ($468,000 ÷ 2,080). In total, 520 (10 × 52) additional cars will be
detailed. Thus, annual incremental revenue is $117,000 ($225 × 520).
26 c h a p te r 1 M a n a g e r i a l A c c o u n t i n g i n t h e I n f o r m a t i o n A g e

b. The incremental cost per detail job is as follows:

Supplies (polish, wax, etc.) ($5,824 ÷ 2,080) $ 2.80
Salaries of detailers 50.00
Water and other variable costs 6.00
$ 58.80
Thus, the incremental cost per year is:
520 details × $58.80 $30,576
Incremental cost of Saturday manager ($300 × 52 days) 15,600
Total incremental cost per year $46,176

c. The incremental profit is $70,824 ($117,000 − $46,176), suggesting that Quincy should stay
open on Saturdays.

Review Problem 2
Brennan Wealth Planning offers financial advice to high-net-worth individuals. Services include
tax advice, estate planning, and advice regarding the allocation of investments so that they are
consistent with customers’ risk profiles. Financial advisors at the firm also sell investments and
insurance products to customers. All advisors are paid a base salary plus a bonus based on the
total revenue they generate.
Hampton Financial Services is very similar to Brennan. However, at this firm, financial advi-
sors are paid a base salary plus a bonus based solely on customer satisfaction.

Req u i r ed
Discuss the concept of “You get what you measure!” and comment on how this may affect cus-
tomers at the two companies.

A n sw e r
The idea behind “You get what you measure!” is that performance measures drive the behavior
of managers. At Brennan, financial advisors have a clear incentive to sell as many services and
products as possible—even if customers don’t need the services. At Hampton, financial advisors
have a strong incentive to make customers happy with the advice and the services they receive.
Thus, it is quite possible that their customers will receive less biased recommendations and have
high levels of satisfaction.

Key Terms Budgets (4) Enterprise resource planning Noncontrollable cost (11)
Chief financial officer (CFO) (22) (ERP) systems (16) Opportunity cost (10)
Chief information officer (CIO) Fixed costs (9) Performance reports (5)
(22) Incremental analysis (12) Supply chain management
Controllable cost (11) Incremental cost (12) (SCM) systems (16)
Controller (21) Incremental revenue (12) Sunk costs (10)
Customer relationship manage- Indirect costs (10) Treasurer (22)
ment (CRM) systems (16) Management by exception (6) Value chain (15)
Direct costs (10) Managerial accounting (12) Variable costs (9)

Self-Assessment (Answers Below)

1. The primary goal of managerial accounting is to: c. Provide information to creditors, taxing authorities,
a. Provide information to current and potential inves- and current and prospective investors.
tors in the company. d. Provide information for planning, control, and deci-
b. Provide information to creditors as well as current sion making.
and prospective investors.
 Q u e s t i o n s 27

2. Match the following terms with the management activ- c. Rent.

ities described below: d. Advertising.
a. Planning 6. Which of the following is most likely to be a fixed
b. Control cost?
c. Decision making a. The cost of material used in production.
(1) This management activity involves changing b. Rent.
operations, revising plans, or rewarding/ c. Assembly labor cost.
punishing managers.
d. Commissions.
(2) This management activity compares actual
7. Costs incurred in the past are:
results with planned outcomes as a basis for
corrective action. a. Opportunity costs.
(3) This management activity formulates goals, b. Direct costs.
communicates them to employees, and specifies c. Sunk costs.
the resources needed to achieve them. d. Variable costs.
3. Which of the following statements about budgets is 8. ______________ costs are directly traceable to a prod-
false? uct, activity, or department, whereas _____________
a. Budgets may be expressed in dollars, quantities, or costs are not.
both. 9. The salary a student forgoes while in college is an exam-
b. Budgets may reflect projected revenues, projected ple of:
expenses, projected cash flows, or projected quanti- a. Opportunity cost.
ties of inputs or outputs. b. Direct cost.
c. Budgets must be prepared in accordance with c. Sunk cost.
GAAP.
d. Variable cost.
d. Budgets are useful both for planning and control.
10. Which of the following is not one of the seven
4. Which of the following statements is false? questions in the framework for ethical decision
­
a. Managerial accounting statements do not necessarily ­making?
comply with GAAP. a. Will an individual or an organization be harmed by
b. Financial accounting statements normally reflect any of the decision alternatives?
more detail than would be found in managerial b. Would someone I respect find any of the alterna-
accounting reports. tives objectionable?
c. Managerial accounting reports emphasize future c. At a gut level, am I comfortable with the decision I
activities and future costs. am about to make?
d. Financial accounting data are directed primarily at d. Are any of the alternatives illegal?
external users rather than internal users.
5. Which of the following is most likely to be a variable cost? Answers to Self-Assessment
a. Depreciation. 1. d 2. (1)-c, (2)-b, (3)-a 3. c 4. b 5. b
b. The cost of material used in production. 6. b 7. c 8. direct, indirect 9. a 10. d

Questions 1. What is the goal of managerial accounting?

2. In a performance report, current-period performance is compared with some benchmark.
What might be a useful benchmark?
3. List three differences between financial and managerial accounting.
4. List three examples of nonmonetary information that might appear in a managerial account-
ing report.
5. Explain the difference between fixed and variable costs.
6. Consider the manager of the home appliance department at a Sears store. For this manager,
list a cost that is controllable and a cost that is noncontrollable.
68 chapter 2 J o b - O r d e r C o s t i n g f o r M a n u f a c t u r i n g a n d S e r v i c e C o m p a n i e s

period, and companies cannot wait until the end of the period information system) for a specific client is a “job.” Using job-
before applying overhead to jobs. order costing, the salaries of consultants are charged to the job
If the amount of overhead applied to inventory does not as well as any materials provided to the client. Materials might
equal actual overhead, the difference must be apportioned include training manuals or software. Overhead, such as depre-
among Work in Process, Finished Goods, and Cost of Goods ciation of office equipment, utilities, and the salaries of office
Sold. This adjusts the accounts to reflect actual overhead costs. staff, is assigned to a job using a predetermined overhead rate.
If the amount of under- or overapplied overhead is small, the
balance can be closed to Cost of Goods Sold. Learning Objective 7 Discuss modern manufac-
turing practices and how they affect product costing.
Learning Objective 6 Explain how service
U.S. companies face stiff competition from companies abroad.
companies can use job-order costing to calculate In response, many have adopted manufacturing systems that
the cost of services provided to customers. minimize inventories of raw materials and work in process.
Much like manufacturing firms, service companies such as In addition, many companies have become highly automated
hospitals, law firms, accounting firms, consulting companies, and have instituted total quality management programs. JIT
and repair shops use job-order costing. Using job-order costing, production systems have reduced inventory levels, automa-
they assign wages, various material costs, and overhead to “jobs.” tion has increased levels of overhead and fixed costs, and total
Consider a consulting firm that provides services to various quality management programs have reduced product defects
clients. A specific engagement (e.g., installation of a computer and waste.

Review Problem 1
Ellie Richard’s Commercial Flooring installs stone, tile, and carpet flooring in office buildings, con-
dominiums, and restaurants. The company traces labor and materials to each job, but overhead is
assigned based on labor hours. At the start of the year, the company estimated overhead as follows:
Rent $ 35,000
Depreciation of trucks 25,000
Depreciation of equipment 5,000
Supervisor salaries 150,000
Other overhead 20,000
$235,000

Total labor hours were estimated to be 11,520.

During the first week in December, the company started and completed a job installing black granite
tiles in the remodeled lounge of Joey D’s Restaurant. In total, the job took 36 hours. The average
wage rate of installers is $35 per hour. Materials for the job including tiles and grouting cost $7,500.

Req u i red
a. What is the cost of the job?
b. Assuming that the company charges $80 per installer hour plus the cost of materials, with a
markup of 30 percent, what was the profit on the job?

An s w er
a. The overhead rate is $20.40 per labor hour ($235,000 ÷ 11,520 labor hours). Thus, the cost of
the job is:
Labor
36 hours × $35 per hour $1,260.00
Materials 7,500.00
Overhead
$20.40 × 36 hours 734.40
Total $9,494.40
 R e v i e w P r o b l e m 2 69

b. Charges are $12,630. Thus, the profit on the job is $3,136.60.

Labor $80 × 36 hours $ 2,880.00
Materials $7,500 × 1.3 9,750.00
Total charges 12,630.00
Less cost of job (9,494.40)
Profit $ 3,135.60

Review Problem 2
Herbert Plumbing Products produces a variety of valves, connectors, and fixtures used in commercial
and residential plumbing applications. The company has a just-in-time inventory and production
system, and it has relatively small amounts of material, work in process, and finished goods inventory.
At the end of October, the company had $20,000 of raw material inventory. In addition, jobs
281 and 282 were in process and job 279 was complete and awaiting shipment. The job cost sheets
for these jobs were as follows:

End of October

Direct Material Direct Labor Overhead Total Job Status

Job 279 $50,000 $15,000 $30,000 $ 95,000 Finished but not shipped
Job 281 20,000 5,000 10,000 35,000 In process
Job 282 60,000 20,000 40,000 120,000 In process

During November, the company began work on Jobs 283, 284, and 285. The status of the jobs at
the end of November is as follows:

End of November

Direct Material Direct Labor Overhead Total Job Status

Job 279 $50,000 $15,000 $30,000 $ 95,000 Shipped

Job 281 25,000 8,000 16,000 49,000 Shipped
Job 282 62,000 21,000 42,000 125,000 Shipped
Job 283 30,000 20,000 40,000 90,000 Shipped
Job 284 80,000 30,000 60,000 170,000 Shipped
Job 285 15,000 10,000 20,000 45,000 In process

Also during November, Herbert Plumbing Products purchased $120,000 of materials and incurred
$130,000 of actual overhead costs. The company charges over- or underapplied overhead to Cost
of Goods Sold.

Req u i red
Assume that all material used in November is direct.
a. What is the balance in Raw Materials Inventory at the end of November?
b. What is the balance in Work in Process Inventory at the end of November?
c. What is the balance in Finished Goods Inventory at the end of November?
d. What is the cost of goods manufactured for the month of November?
e. What is the cost of goods sold for the month of November?
70 chapter 2 J o b - O r d e r C o s t i n g f o r M a n u f a c t u r i n g a n d S e r v i c e C o m p a n i e s

An s w er
a. The beginning balance in raw materials inventory is $20,000.

Purchases are $120,000.

Inventory used in November:
Job 281 $ 5,000
Job 282 2,000
Job 283 30,000
Job 284 80,000
Job 285 15,000
Total  $132,000

Beginning balance + Purchases − Amount used = Ending balance

$20,000 + $120,000 − $132,000 = $8,000

b. The ending balance in Work in Process Inventory is the cost of jobs in process at the end of
November. This is the cost of job 285, which is $45,000.
c. The ending balance in Finished Goods Inventory is the cost of jobs that are completed but
not shipped. Since all completed jobs have been shipped, the balance is zero.
d. The beginning balance in Work in Process Inventory is:

Job 281 $ 35,000

Job 282 120,000
Total  $155,000

Additional costs added during November are:

Material cost $ 132,000 per part a
Direct labor cost
Job 281 $ 3,000
Job 282 1,000
Job 283 20,000
Job 284 30,000
Job 285 10,000 64,000
Overhead
Job 281 6,000
Job 282 2,000
Job 283 40,000
Job 284 60,000
Job 285 20,000 $ 128,000
Total $324,000

The ending balance in Work is Process Inventory is $45,000 per part b.

Beginning balance in WIP Inventory + Current manufacturing costs − Ending balance

in WIP Inventory = Cost of goods manufactured
$155,000 + $324,000 − $45,000 = $434,000

e. Beginning balance in Finished Goods Inventory is the cost of job 279, which is $95,000.
Cost of Goods Manufactured is $434,000, per part d.
Ending balance in Finished Goods Inventory is zero, per part c.

Beginning balance in Finished Goods Inventory + Cost of goods manufactured − Ending

balance in Finished Goods Inventory = Cost of goods sold

$95,000 + $434,000 − 0 = $529,000

 S e l f - A s s e s s m e n t 71

Alternatively, we could simply add up the cost of jobs shipped this period:
Job 279 $ 95,000
Job 281 49,000
Job 282 125,000
Job 283 90,000
Job 284 170,000
Total  $529,000

Note, however, that actual overhead is $130,000, while overhead applied to production at the
standard rate of $2 per dollar of direct labor is $128,000 per part d. Thus, cost of goods sold
must be increased by $2,000.
Cost of goods sold = $529,000 + $2,000 = $531,000

Key Terms Activity-based costing General and Administrative Overhead allocation rate (52)
(ABC) (57) Costs (39) Overhead applied (52)
Allocation base (52) Indirect labor costs (39) Period costs (40)
Computer-controlled manufac- Indirect materials (39) Predetermined overhead rates (58)
turing systems (64) Job (46) Process costing system (46)
Cost driver (57) Job cost sheet (48) Product costing system (36)
Cost of goods available for Job-order costing system (46) Product costs (40)
sale (45) Just-in-time (JIT) (63) Raw Materials Inventory (42)
Cost of goods manufactured (43) Manufacturing costs (38) Selling costs (39)
Cost pools (57) Manufacturing overhead (39) Time tickets (50)
Direct labor cost (39) Material requisition form (49) Total quality management
Direct material cost (38) Nonmanufacturing costs (39) (TQM) (65)
Finished Goods Inventory (43) Overapplied overhead (59) Underapplied overhead (59)
Full cost (41) Overhead allocation (56) Work in Process Inventory (42)

Self-Assessment (Answers Below)

1. Which of the following is a period cost? 4. The beginning balance in Finished Goods Inventory is
a. Raw materials costs. $50,000, the ending balance in Finished Goods Inven-
b. Manufacturing plant maintenance. tory is $100,000, and Cost of Goods Manufactured is
$200,000. What is Cost of Goods Sold?
c. Wages for production-line workers.
a. $100,000 c. $150,000
d. Salary for the vice president of finance.
b. $250,000 d. None of the above.
2. Full costing includes which of the following in deter- 5. Which entity would most likely use a job-order costing
mining product cost? system?
a. Only variable costs of production. a. Textile manufacturer.
b. Only fixed costs of production. b. Concrete block producer.
c. Administrative overhead. c. Petroleum refiner.
d. All fixed and variable costs of production. d. Antique automobile restorer.
3. Cost of Goods Sold is $200,000, the beginning balance 6. The predetermined overhead rate is determined as:
in Finished Goods Inventory is $50,000, the ending a. Estimated overhead costs divided by estimated
balance in Finished Goods Inventory is $100,000, and allocation base.
the ending balance in Work in Process Inventory is b. Actual overhead costs divided by estimated
$10,000. What is Cost of Goods Manufactured? allocation base.
a. $100,000 c. Estimated overhead costs divided by actual
b. $250,000 allocation base.
c. $50,000 d. Actual overhead costs divided by actual allocation
d. None of these answer choices is correct. base.
72 chapter 2 J o b - O r d e r C o s t i n g f o r M a n u f a c t u r i n g a n d S e r v i c e C o m p a n i e s

7. Overhead is overapplied if: c. Do not cost their services.

a. The actual overhead rate is greater than the d. Produce durable products.
budgeted overhead rate. 10. All of the following are true about just-in-time (JIT)
b. The Manufacturing Overhead account has a credit production except:
balance at the end of the period. a. JIT seeks to minimize inventories of raw materials
c. The actual overhead rate is greater than the rate and work in process.
used in prior periods. b. JIT is often referred to as “fat” production.
d. The overhead rate is material. c. JIT companies concentrate on improving quality.
8. Compared to traditional methods of allocating over- d. JIT companies need dependable suppliers.
head, activity-based costing (ABC) uses:
a. More allocation bases.
Answers to Self-Assessment
b. Only allocation bases related to direct labor.
c. Machine hours as an allocation base. 1. d 2. d 3. b 4. c 5. d 6. a
7. b 8. a 9. b 10. b
d. None of these answer choices is correct.
9. Service companies:
a. Do not use job-order costing.
b. Often use job-order costing.

Questions 1. What is the difference between manufacturing and nonmanufacturing costs?

2. What is the difference between product and period costs?
3. Identify the two most common types of product costing systems and discuss the manufacturing
environments associated with each system.
4. What is a job cost sheet? What information does it contain?
5. Why do companies apply overhead to jobs using a predetermined (budgeted) overhead rate
instead of applying actual overhead to jobs?
6. Discuss an important characteristic of a good overhead allocation base.
7. Some modern, capital-intensive production facilities have significantly reduced the propor-
tion of direct labor cost to total production cost. Discuss the effect this might have on the
selection of an allocation base for the application of overhead.
8. When might it be necessary to assign over- or underapplied overhead to Finished Goods,
Work in Process, and Cost of Goods Sold?
9. Would an unexpected increase in sales and production result in underapplied or overapplied
overhead? Explain.
10. As companies move to computer-controlled manufacturing systems, what happens to the mix
of product costs (direct material, direct labor, and manufacturing overhead)?

Exercises EXERCISE 2-1. You Get What You Measure! [LO 4] Consider three very similar companies.
Company A allocates manufacturing overhead to jobs using labor hours as the allocation base;
Company B allocates manufacturing overhead to jobs using machine hours as the allocation
base; and Company C allocates manufacturing overhead to jobs using material cost as the
­allocation base.

R equ i r ed
Explain why, in spite of the fact that the companies are very similar, supervisors at Company A
are very focused on controlling labor, whereas supervisors at Company B are very focused on
controlling machine run time, and supervisors at Company C are very focused on controlling
material costs. Use the concept of “You get what you measure!” in your answer.
152 c h apt e r 4 C o s t - V o l u m e - P r o f i t A n a l y s i s

Illustration A4-3
Viewing the output

while the coefficient on production (the slope of the regression line) is $90.83. Thus, the regression
line indicates that:

Cost = $93,618.78 + $90.83 (Production )

P-Value. The p-values corresponding to the intercept and the slope measure the probability of
observing values as large as the estimated coefficients when the true values are zero. In other words,
there is some probability that even when the true fixed cost is zero, we will observe an estimate
as large as $93,618.78. We would, of course, like this probability to be quite low (at least less than
.05). In the current case, the probability is very low (.00000579). Likewise, the probability that we
will observe an estimate as large as $90.83 when the true variable cost per unit is zero is also very
low (.0000000252). Thus, it seems highly unlikely that either the true fixed cost is zero or that the
true variable cost per unit is zero.

Review Problem 1
Potter Janitorial Services provides cleaning services to both homes and offices. In the past year,
income before taxes was $4,250, as follows:

Home Office Total

Revenue $250,000 $425,000 $675,000

Less variable costs:
Cleaning staff salaries 175,000 276,250 451,250
Supplies 30,000 42,500 72,500
Contribution margin $ 45,000 $106,250 151,250
Less common fixed costs:
Billing and accounting 25,000
Owner salary 90,000
Other miscellaneous
Common fixed costs 32,000
Income before taxes $ 4,250
 R e v i e w P r o b l e m 2 153

For the coming year, Janice Potter, the company owner, would like to perform CVP analysis. She
has asked you to help her address the following independent questions.

Req u i red
a. What are the contribution margin ratios of the Home and Office segments, and what is the
overall contribution margin ratio?
b. Assuming that the mix of home and office services does not change, what amount of rev-
enue will be needed for Janice to earn a salary of $125,000 and have income before taxes
of $4,000?
c. Suppose staff salaries increase by 20 percent. In this case, how will break-even sales in the
coming year compare to the prior year?

A n sw er
a. Contribution margin ratio for Home = $45,000 ÷ $250,000 = .18
Contribution margin ratio for Office = $106,250 ÷ $425,000 = .25
Overall contribution margin ratio = $151,250 ÷ $675,000 = .22407
b. ($25,000 + $125,000 + $32,000 + $4,000) ÷ .22407 = $830,097.73
c. Break-even in the prior year = ($25,000 + $90,000 + $32,000) ÷ .22407 = $656,045.
If staff salaries increase by 20 percent, then the contribution margin ratios will be as
follows:

Home Office Total

Revenue $250,000 $425,000 $675,000

Less variable costs:
Cleaning staff salaries 210,000 331,500 541,500
Supplies 30,000 42,500 72,500
Contribution margin 10,000 51,000 61,000
Contribution margin ratios 0.0400 0.1200 0.09037

In this case, the break-even level of sales will be = ($25,000 + $90,000 + $32,000) ÷ .09037 =
$1,626,646.01. Obviously, a 20 percent increase in staff salaries will have a very significant
impact on the break-even level of sales.

Review Problem 2
The Antibody Research Institute (ARI) is a biotechnology company that develops humanized
antibodies to treat various diseases. Antibodies are proteins that bind with a foreign substance,
such as a virus, and render it inactive. The company operates a research lab in Boston and currently
employs 23 scientists. Most of the company’s work involves development of humanized antibodies
for specific pharmaceutical companies. Revenue comes from this contract work and from royalties
on products that ultimately make use of ARI-developed antibodies.
In the coming year, the company expects to incur the following costs:

Expense Summary

Salaries of 23 research scientists $2,760,000

Administrative salaries 785,000
Depreciation of building and equipment 3,200,000
Laboratory supplies 765,000
Utilities and other miscellaneous (fixed) expenses 285,000
Total $7,795,000
154 c h apt e r 4 C o s t - V o l u m e - P r o f i t A n a l y s i s

Annual contract revenue is projected to be $4,000,000. The company also anticipates royalties
related to the sale of Oxacine, which is a product that will come to market next year. Oxacine
is marketed by Reach Pharmaceuticals and makes use of an antibody developed under contract
with ARI. The product is scheduled to sell for $120 per unit, and ARI will receive a royalty of
20 percent of sales. ARI, in turn, has a contractual commitment to pay 10 percent of royalties it
receives (i.e., 10 percent of the 20 percent) to the scientists who were on the team that developed
the antibody.

Req u i red
a. How many units of Oxacine must be sold for ARI to achieve its break-even point?
b. Reach Pharmaceuticals has projected annual sales of 180,000 units of Oxacine. Assuming
this level of sales, what will be the before-tax profit of ARI?
c. What if Reach Pharmaceuticals sells only 160,000 units of Oxacine? Assuming that the aver-
age salary of scientists is $120,000, how many scientists must be “downsized” to achieve the
break-even point?
d. Do you consider ARI to be high or low with respect to operating leverage? Explain.

An s w er
a. $4,000,000 + .20($120)(Q) − .10(.20)($120)(Q) − $7,795,000 = $–0–
$21.6(Q) = $3,795,000
Q = 175,694.44
b. $4,000,000 + .20($120)(180,000) − .10(.20)($120)(180,000) − $7,795,000 = $93,000
c. $4,000,000 + .20($120)(160,000) − .10(.20)($120)(160,000) − $7,795,000 = ($339,000)
Average salary = $2,760,000 ÷ 23 = $120,000
($339,000) ÷ $120,000 = (2.825)
This implies that approximately three scientists must be “downsized.”
d. ARI is extremely high with respect to operating leverage since costs other than royalty pay-
ments to scientists are generally fixed. The fact that the costs are fixed does not mean, how-
ever, that they cannot be cut. Some costs such as the salaries of the scientists are discretionary
fixed costs. Other costs such as depreciation are committed fixed costs.

Key Terms Account analysis (129) Fixed costs (125) Scattergraph (131)
Break-even point (137) High-low method (131) Semivariable costs (126)
Committed fixed costs (126) Margin of safety (138) Step costs (126)
Contribution margin (139) Mixed costs (126) Step fixed costs (127)
Contribution margin ratio (140) Operating leverage (148) Step variable costs (127)
Cost-volume-profit (CVP) Profit equation (137) Variable costs (124)
analysis (136) Regression analysis (134) “What if ” analysis (140)
Discretionary fixed costs (125) Relevant range (127)

Self-Assessment (Answers Below)

1. At Branson Corporation, the selling price per unit is 2. At Branson Corporation, the selling price per unit is
$800 and variable cost per unit is $500. Fixed costs are $800 and variable cost per unit is $500. Fixed costs
$1,000,000 per year. In this case, the contribution mar- are $1,000,000 per year. Assuming sales of $3,000,000,
gin per unit is: profit will be:
a. $300. a. $125,000.
b. $0.375. b. $680,000.
c. 2,500 units. c. $750,000.
d. None of the answer choices is correct. d. None of the answer choices is correct.
 Common Cost BehavioQ u east t ei or n s 155
r P

3. The contribution margin ratio measures: Drugs Cosmetics Housewares

a. Profit per unit. Sales $80,000 $40,000 $30,000
b. Contribution margin per dollar of sales. Variable cost 40,000 15,000 25,000
c. Profit per dollar of sales. Contribution
d. The ratio of variable to fixed costs. margin $40,000 $25,000 $ 5,000

4. In March, Octavius Company had the following costs Based on this information, estimate the increase in
related to producing 5,000 units: profit for a $10,000 increase in sales (assuming that the
sales mix stays the same).
Direct materials $60,000
a. $4,667.
Direct labor 20,000
Rent 5,000 b. $5,667.
Depreciation 4,000 c. $3,334.
Estimate variable cost per unit using account analysis. d. None of the answer choices is correct.
a. $17.80. 8. Consider the sales and variable cost information in
b. $4.00. Question 7. Assuming that total fixed costs at Fortesque
c. $5.80. Drug are $30,000 per month, what is the break-even
level of sales in dollars?
d. $16.00.
a. $86,326.
5. Using the following production/cost data, estimate
variable cost per unit using the high-low method: b. $45,876.
c. $72,284.
Month Production Cost d. $64,286.
January 2,000 $20,000 9. If a firm has relatively high operating leverage, it has:
February 2,500 $21,000 a. Relatively high variable costs.
March 3,000 $23,000 b. Relatively high fixed costs.
April 1,900 $18,500
c. Relatively low operating expenses.
a. $4.00. d. Relatively high operating expenses.
b. $3.70. 10. Product A has a contribution margin per unit of $500
c. $4.20. and requires 2 hours of machine time. Product B has
d. $4.09. a contribution margin per unit of $1,000 and requires
6. At Branson Corporation, the selling price per unit is 5 hours of machine time. How much of each product
$800 and variable cost per unit is $500. Fixed costs are should be produced, given there are 100 hours of available
$1,000,000 per year. In this case, the break-even point is machine time?
approximately: a. 50 units of A.
a. 3,333 units. b. 25 units of B.
b. 6,667 units. c. 50 units of A and 25 units of B.
c. 5,500 units. d. None of the answer choices is correct.
d. None of the answer choices is correct.
Answers to Self-Assessment
7. Consider the sales and variable cost information for the
1. a 2. a 3. b 4. d 5. d 6. a
three departments at Fortesque Drug in May:
7. a 8. d 9. b 10. a

QUESTIONS 1. Define the term mixed cost and provide an example of such a cost.
2. Distinguish between discretionary and committed fixed costs.
3. Provide two examples of costs that are likely to be variable costs.
4. Provide two examples of costs that are likely to be fixed costs.
5. Explain why total compensation paid to the sales force is likely to be a mixed cost.
6. Explain how to use account analysis to estimate fixed and variable costs.
7. Explain the concept of a relevant range.
 R e v i e w P r o b l e m 1 231

Illustration A6-1
• Ask the sales force to discuss the possibility of minor variations in stitching color with
Possible process
customers. If customers have a strong preference, confirm current colors with warehouse
­improvements for
before shipping. This should reduce returns.
­Mattress Warehouse
• Have a clerk call customers the day before a delivery to confirm that the customers will be
home. This should reduce the problem of customers not being home to accept deliveries.
• Reduce staffing in the wash operation from three full-time employees to two full-time
employees. This will save approximately $2,500 per month. Alternatively, consider outsourcing
the wash operation.

Step 4: Identify Ways to Improve the Efficiency and/or

­Effectiveness of the Activities
The most satisfying part of the ABM process is identifying ways to improve the efficiency and/
or effectiveness of activities, the fourth and last step of the ABM process. Pause for a minute and
consider the two activities analyzed. Can you suggest any process improvements?
To identify process improvements, the consultants at Solutions Analysis would think about
best practices they’ve identified at other clients, they would brainstorm with each other, and they
would solicit input from managers at Mattress Warehouse. Possible improvements are listed in
Illustration A6-1.

CONCLUSION
It is hoped that this brief treatment of ABM has provided you with insight into the nature
of an ABM study.5 Unlike ABC, which is focused on better costing of goods and services,
ABM is focused on process improvements. Still, ABM, like ABC, requires costing activities.
Once activities are costed, a manager conducting an ABM study can identify the so-called
low-hanging fruit. That is, the manager can identify activities whose costs are large and
apparently out of line. These are the activities that deserve immediate management attention.
One reason ABM studies have become so popular is that they often generate very
substantial financial returns. Consider the case of Mattress Warehouse. If it turns out
that eliminating one employee from the wash operation is appropriate, the company will
save $2,500 per month, or $30,000 per year. Over 5 years, that’s $150,000. To analyze the
wash operation, a consultant from Solutions Analysis likely spent less than eight hours
and billed Mattress Warehouse less than $4,000.

5
These books will provide you with additional information on activity-based management: Judith J. Baker, Activity-
Based Costing and Activity-Based Management for Health Care, Gaithersburg, MD: Aspen Publishers (1998); James
A. Brimson and John Antos, Activity-Based Management, New York: John Wiley and Sons (1994); and Robin
Cooper, Robert Kaplan, Lawrence Maisel, Eileen Morrissey, and Ronald Oehm, Implementing Activity-Based Cost
Management: Moving from Analysis to Action, Montvale, NJ: Institute of Management Accountants (1992).

Review Problem 1
Wilton International is a large conglomerate with divisions that produce chemicals, tires, specialty
metals, and pharmaceuticals. Two years ago, the chief financial officer noted that the company
paid consultants more than $6,000,000 per year to help solve problems related to manufactur-
ing efficiency, employee motivation, investment decisions, and a variety of other matters. The
$6,000,000 in charges reflect average fees of approximately $240 per hour. The CFO decided that
substantial funds could be saved by setting up an internal consulting group. Accordingly, five
senior consultants from a respected firm were hired to run an internal consulting group at an
average salary of $300,000 per year. These new managers hired 15 staff consultants at an average
232 c h a p t e r 6 C o s t A l l o c a t i o n a n d A c t i v i t y - B a s e d C o s t i n g

salary of $100,000 per year. Thus, the company had 20 full-time internal consultants at a yearly
cost of only $3,000,000. The 20 individuals can work approximately 37,974 hours per year in total.
In the first year of the consulting group, the CFO sent out a notice to all divisions that they would
no longer be allowed to hire outside consultants for work that could be performed by the internal
group. Further, each division was to be charged a flat annual fee for use of the consultants based
on their relative size (measured in sales dollars) over the past four years. With this approach, the
allocation was as follows:
Allocation

Chemicals $   300,000
Tires 600,000
Specialty metals 900,000
Pharmaceuticals 1,200,000
Total $3,000,000

With this allocation, the division managers made frequent demands for the services of the con-
sultants. Indeed, because of the demand for the services of the internal consultants, there were
frequent delays, often exceeding one month.
The following year, the CFO changed the method of allocation to a charge for hours worked.
Since costs were $3,000,000 and 38,000 hours were available, the charge was $79 per hour. With
this charge, demand for consulting services declined drastically. In fact, the average consultant was
only charging 70 percent of available hours. Further, all requests for service were easily answered
within a day or two.

Req u i r ed
a. Explain the difference in demand under the two allocation schemes.
b. Is the current charge of $79 per hour more or less than the opportunity cost of providing
consulting services?
c. Because, at a charge equal to the actual hourly wage paid to consultants, demand is less than
internal consulting capacity, the CFO is considering closing the internal consulting depart-
ment. Based on the limited information provided, what would you advise?

Answer
a. The initial allocation is a lump-sum allocation to each division based on average sales over the
past 4 years. This appears to be an ability to bear allocation. The result: excess demand and
delays resulting in an opportunity cost that exceeds the zero incremental charge for use. Excess
demand isn’t surprising when the incremental charge for service is zero. “Does your office
chair squeak? If so, call a consultant to fix it!” “Would you like to have someone do market
research for a product that you think has a low probability of market acceptance? Call in the
consultants—it won’t cost anything so you might as well get more information!”
b. The new allocation is $79 per hour, which was calculated as the $3,000,000 annual cost di-
vided by 37,974 hours. With this allocation, there is a drastic decline in requests and only
70 percent of available consulting time is used. This suggests that the opportunity cost of use
is less than $79. (If there was a need for consulting time with a benefit exceeding $79, then,
presumably, the manager with the need would call on the consultants.)
c. In the past, the company used only 25,000 hours of outside consultant time ($6,000,000 ÷
$240 per hour). Perhaps the company just hired too many internal consultants. In this case,
the company should downsize consulting to, say, 25,000 hours.
Alternatively, one could argue that the situation is just right. At many firms, consultants don’t
work more than 70 percent of their available time on billable projects because they need time for
training, and they need some slack or they won’t be able to respond on a timely basis when a new
project comes along.
Perhaps the company shouldn’t worry too much about the fact that only 70 percent of consultant
time is being used. After all, the company is saving $3,000,000 per year. The key question should be:
 B e vhiaevwi oPr rPoabtl teemr n 2s 233
Common Cost R

Is their service of high quality? The CFO should have a meeting with representatives from the
divisions and get their feedback on the quality of the services provided by the internal consultants.

Review Problem 2
Bender Electric Motors produces electric motors used by home appliance and other manufacturing
companies. Each motor is built to customer specifications although the number of units requested
may vary from 1 to as many as 2,000.
Bender has recently adopted an activity-based costing system with the following overhead costs
and drivers.

Cost Pool Annual Amount Annual Activity Cost Driver

Direct labor related $  400,000 $1,000,000 Direct labor cost

Material ordering    100,000      5,000 Purchase orders
Material inspection    600,000      4,000 Receiving reports
Equipment setup    200,000      1,000 Setups
Quality control    400,000      2,000 Inspections of motors
Machine related    800,000     40,000 Machine hours
Miscellaneous    400,000 $4,000,000 Product costs other
Total overhead $2,900,000 than miscellaneous
overhead

Recently the company received an order from Kromer’s Department Stores for 10 identical motors
for use in a holiday display. Bender estimates the following costs and activities related to the order:

Material cost $500

Labor cost $200
Purchase orders 2
Receiving reports 2
Setups 1
Inspections 1
Machine hours 10

Note that the costs indicated are for all 10 motors—they are not per motor.

Req u ir ed
a. Calculate the cost of the Kromer job using the new ABC system.
b. Calculate the cost of the Kromer job assuming the company used a traditional costing sys-
tem with labor cost as the only allocation base.
c. Briefly explain why costs are higher or lower using the ABC system in part a compared to the
traditional system in part b.

A n s we r
a.

Cost Pool Overhead Rate

Direct labor related $   0.40 per direct labor dollar

Material ordering $ 20.00 per purchase order
Material inspection $150.00 per receiving report
Equipment setup $200.00 per setup
Quality control $200.00 per inspection
Machine related $ 20.00 per machine hour
Miscellaneous $   0.10 per dollar of product costs other than misc.
234 chapte r 6 C o s t A l l o c a t i o n a n d A c t i v i t y - B a s e d C o s t i n g

ABC Cost of Kromer Job

Material $  500
Labor 200
Overhead:
Labor related ($0.40 × $200) $ 80
Material ordering ($20 × 2) 40 Cost other than
Material inspection ($150 × 2) 300 misc. = $1,720
Setup ($200 × 1) 200
Quality control ($200 × 1) 200
Machine related ($20 × 10) 200
Miscellaneous (.10 × cost other than misc.) 172
Total overhead 1,192
Total cost $1,892

b. Traditional Overhead Rate

Total overhead $2,900,000

Total labor cost $1,000,000
Rate $2.90 per labor dollar

Traditional Cost of Kromer Job

Material $   500
Labor $   200
Overhead ($2.90 × $200) $   580
Total cost $1,280
    
c. Costs are higher with ABC because the Kromer job is relatively small and makes use of a
number of activities whose costs are not proportionate to volume.

Key Terms Ability to bear costs (211) Cost allocation (204) Lump-sum allocations (216)
Activity-based costing (ABC) Cost driver (219) Product-level activities (221)
(218) Cost objective (209) Relative benefits approach to
Activity-based management Cost pool (209) allocation (211)
(ABM) (226) Direct method of allocating cost Responsibility accounting system
Batch-level activities (220) (212) (214)
Cause-and-effect relationship Equity approach to allocation Unitized (215)
(210) (211) Unit-level activities (220)
Controllable costs (214) Facility-level activities (221)

Self-Assessment (Answers Below)

1. Costs are allocated: 2. An important concern in forming a cost pool is to:
a. To provide information useful for decision making. a. Avoid placing similar costs in the same pool.
b. To reduce frivolous use of resources. b. Limit the number of costs that make up the
c. To encourage evaluation of internally provided pool.
services. c. Ensure that the costs in the pool are homogeneous,
d. To calculate the “full cost” of products/services for or similar.
GAAP reporting. d. None of these answer choices is correct.
e. All of these answer choices are correct.
 Q u e s t i o n s 235

3. In the cost allocation process, an allocation base: c. All costs related to Department A’s final product.
a. Must be some characteristic that is common to all d. All of these answer choices are correct.
of the cost objectives. 8. In allocating costs to products, more accurate costing is
b. Ideally should result in cost being allocated based generally obtained by:
on a cause-and-effect relationship. a. Allocating costs using labor hours as the allocation
c. Selection is not an easy matter. base.
d. All of these answer choices are correct. b. Having more than one cost pool.
4. The direct method of allocating costs: c. Always using allocation bases that are based on
a. Allocates service department costs to other service production volume.
departments. d. None of these answer choices is correct.
b. Allocates only direct costs. 9. Cost drivers in activity-based costing:
c. Allocates service department costs to producing a. Are always related to production volume.
departments only. b. Are workers who influence cost control.
d. None of these answer choices is correct. c. Often assign more costs to low-volume products
5. When fixed costs are stated on a per unit basis: than traditional allocation methods.
d. None of these answer choices is correct.
a. They are called “lump sum” allocations.
b. Fixed costs may appear to be variable to managers 10. Most companies that use an activity-based costing
receiving allocations. ­system use:
c. Decision making is greatly improved. a. No cost pools.
d. All of these answer choices are correct. b. One or two cost pools.
c. Two to five cost pools.
6. One way to avoid the problems associated with unitized
d. More than five cost pools.
fixed costs is to:
a. Not allocate fixed costs.
Answers to Self-Assessment
b. Use a lump-sum method of allocating fixed costs.
1. e 2. c 3. d 4. c 5. b 6. b 7. b 8. b 9. c 10. d
c. Combine fixed and variable costs in a single cost pool.
d. None of these answer choices is correct.
7. Controllable costs for the manager of Production
­Department A include:
a. Costs of the finance department.
b. Costs of material and labor used in Department A.

Questions 1. Is the following statement true: “Cost allocation refers to the process of assigning direct costs”?
Discuss.
2. Explain what a cost objective is and give two examples.
3. Explain one possible advantage to having two cost pools for each service department: one for
variable costs and one for fixed costs.
4. If a company is allocating cafeteria costs to all departments within the company, what alloca-
tion base might result in a cause-and-effect relationship?
5. Why is it generally a good idea to allocate budgeted, rather than actual, service department
costs?
6. What is a responsibility accounting system?
7. Why might noncontrollable costs be allocated to a department?
8. Briefly explain how traditional methods of allocating overhead to products might underallo-
cate costs to low-production-volume products.
9. How does activity-based costing differ from the traditional costing approach?
10. When would activity-based costing give more relevant costs than traditional costing systems?
276 c h a p t e r 7 T h e U s e o f C o s t I n f o r m a t i o n i n M a n a g e m e n t D e c i s i o n M a k i n g

You get what you You Get What You Measure and TOC
M e a s u r e
As you know, a major theme of this book is: “You get what you measure!” In other words, per-
formance measures drive the behavior of managers. TOC points out that performance measures
related to production volume (e.g., units produced per hour) can have a negative impact on share-
holder value when they are applied to nonbottleneck departments. Suppose at Dwyer Electronics, the
company measures and rewards Departments 1 and 2 for units produced per hour. In this case, the
departments have an incentive to produce more items than Department 3 can deal with since it is
a bottleneck. The result will be large levels of work-in-process inventory accumulating in front of
Department 3. That excess inventory is an investment of shareholder funds, but shareholders will
not receive a reasonable return on the investment since it serves no useful purpose. Remember: Be
careful of performance measures that encourage overproduction in nonbottleneck departments!

Review Problem 1
Bainbridge Harbor Service currently operates a walk-on ferry service between Bainbridge Island
and downtown Seattle. Five days per week, the schedule is as follows:

Morning
7 a.m. Ferry departs Bainbridge, arrives in Seattle at 7:30 a.m. Returns empty to
Bainbridge.
8:15 a.m. Ferry departs Bainbridge, arrives in Seattle at 8:45 a.m.

Evening
5:15 p.m. Ferry departs Seattle, arrives in Bainbridge at 5:45 p.m. Returns empty to Seattle.
6:30 p.m. Ferry departs Seattle, arrives in Bainbridge at 7:00 p.m.

The cost of a round-trip ticket is $30, and only round-trip tickets are sold.
Profit last year was as follows:

Revenue (40 round-trip fares per

day × $30 × 52 weeks × 5 days) $312,000
Depreciation 20,000
Dock rental 12,000
Fuel 62,400
Captain 90,000
Mate 55,000
Bookkeeping 15,000
Miscellaneous 10,400 264,800
Profit $ 47,200

The distance between Bainbridge and Seattle is 5 miles, the boat’s fuel efficiency is 1 mile per gallon,
and the cost of a gallon of fuel is estimated at $4. Bookkeeping costs are fixed, as is the annual
rental of dock space on both sides. Miscellaneous costs vary with miles.
The company is now considering offering a 10 a.m. trip to Seattle on Saturday morning with
a return trip at 3 p.m., on Saturday afternoon. The round-trip fare will remain at $30, and the
company estimates 15 fares per day. A captain will be paid $300 per day, and a mate will be paid
$150 per day.

Req u i r ed
What is the annual incremental profit (loss) associated with the Saturday trips?
 B e vhiaevwi oPr rPoabtl teemr n 2s 277
Common Cost R

A n sw er
Incremental revenue:
(15 round-trip fares per day × $30 × 52 weeks) $23,400
Incremental costs:
Fuel (5 miles per crossing × 2 × $4 per gallon × 52 weeks) 2,080
Captain ($300 × 52) 15,600
Mate ($150 × 52) 7,800
Miscellaneous (see below)     693
26,173
Incremental loss: ($ 2,773)
Given that there is an incremental loss, the Saturday
trips should not be ­undertaken.

Current miles per year:

6 crossings per day × 5 miles per crossing × 5 days per week × 52 weeks = 7,800 miles per year.
$10,400 annual miscellaneous ÷ 7,800 miles = $1.3333 per mile.
Miles for Saturday trips = 2 crossings per day × 5 miles per crossing × 52 weeks = 520 miles.
520 miles × $1.3333 = $693.

Review Problem 2
Mayfield Software has a 2,000-square-foot cafeteria located on the lower level of Building 3, the
company’s largest building. The vice president of operations for Mayfield insists that meal prices
be reasonable so workers will stay on campus and avoid wasting time driving to restaurants with
slow service. Employees at Mayfield are generally happy with the quality of food and the level of
service in the cafeteria. Still, Mayfield is considering outsourcing to Regal Food Service. Mayfield
is expanding and realizes that the future success of the company will require increased focus on
its core competencies (and food service is not a core competency!).
A cafeteria profit report for 2017 follows. In the report, the cafeteria is charged $20 per
year per square foot for space and 3 percent of sales for general overhead (to cover the centrally
administered costs of Mayfield Software, such as legal, brand advertising, salary of the CFO, etc.).
All business units receive the same 3 percent charge.

Cafeteria Profit Report for 2017

Sales $1,095,000
Less expenses:
Cost of food and supplies $657,000
Salaries 342,000
Space charge 40,000
Depreciation of equipment 6,000
General overhead charge 32,850 1,077,850
Cafeteria profit $      17,150

The terms of the agreement with Regal (which has not yet been signed) call for Regal to provide
similar-quality meals and service at the same prices that were charged in 2017. Regal will use
the current cafeteria space and existing equipment without cost. Regal will keep 96 percent of
sales revenue and remit 4 percent of sales revenue back to Mayfield. Regal will pay for all food
and supplies and hire and pay the salaries of all staff including the cafeteria manager, cooks,
and servers.

Req u ir ed
Evaluate the annual financial impact of the outsourcing decision assuming sales in the coming
year, under Regal, will be the same as in 2017.
278 chapter 7 T h e U s e o f C o s t I n f o r m a t i o n i n M a n a g e m e n t D e c i s i o n M a k i n g

An s w er

Incremental Revenue and Costs

Lost sales ($1,095,000)

4% payment from Regal 43,800
Food savings 657,000
Salary savings 342,000
Net effect ($   52,200)

Food services should not be outsourced since the effect is to reduce profit by $52,200. Note that
the general overhead charge is not included in the analysis because these costs will not actually
change due to the outsourcing decision. Thus, they are not incremental costs.

Key Terms Avoidable costs (263) Incremental cost (256) Opportunity cost (264)
Common costs (265) Incremental revenue (256) Relative sales value method (270)
Differential costs (256) Joint costs (269) Relevant costs (256)
Incremental analysis (256) Joint products (269) Split-off point (269)

Self-Assessment (Answers Below)

1. Differential costs are sometimes referred to as c. Should be allocated based on physical attributes only.
________________ costs. d. None of these answer choices is correct.
2. Which of the following costs should not be taken into 8. A joint product’s cost is $18, which includes $6 of allo-
consideration when making a decision? cated joint cost. Its sales price is $16. In this case:
a. Opportunity costs. c. Relevant costs. a. Profit will improve if the company discontinues
b. Sunk costs. d. Differential costs. production of the product.
b. The company should sell as few of the items as pos-
3. Which of the following is often not a differential cost?
sible to minimize the loss on sales.
a. Material.
c. The data are misleading because the $6 allocated
b. Labor.
joint cost will be incurred even if the product is
c. Variable overhead. discontinued.
d. Fixed overhead. d. All of these answer choices are correct.
4. True or false? Fixed costs are never incremental costs. 9. (Appendix) According to the Theory of Constraints,
5. Which of the following is not relevant when consider- optimizing use of a constraint requires:
ing whether or not to drop a product? a. Production of the product with the highest profit
a. The contribution margin. per unit.
b. Production of the product with the shortest produc-
b. Qualitative factors.
tion time.
c. The potential impact on demand for other products.
c. Production of the product with the highest contri-
d. Allocated common costs.
bution margin.
6. Opportunity costs are: d. Production of the product with the highest contri-
a. Never incremental costs. bution margin per unit of the constrained resource.
b. Always incremental costs. 10. (Appendix) True or false? Generally, parts should be
c. Sometimes sunk costs. inspected prior to being sent to a department that is a
d. None of these answer choices is correct. bottleneck.

7. The joint costs incurred in a joint product situation: Answers to Self-Assessment

a. Are incurred before the split-off point. 1. relevant 2. b 3. d 4. false 5. d
b. Are incurred after the split-off point. 6. b 7. a 8. c 9. d 10. true
308 c h apter 8 P r i c i n g D e c i s i o n s , C u s t o m e r P r o f i t a b i l i t y A n a l y s i s , a n d ­A c t i v i t y - B a s e d P r i c i n g

Learning Objective 2 Explain the cost-plus Learning Objective 3 Analyze customer profitabil-
­ pproach to pricing and why it is inherently circular
a ity, and explain the activity-based pricing approach.
for manufacturing firms. Also, explain the target The profitability of a customer depends not just on what is pur-
costing process for a new product. chased but also on the set of services provided to the customer
In cost-plus pricing, the full cost per unit is determined and (e.g., order processing, shipping, handling returns, etc.). To
price is set by adding a prespecified markup to the cost. This analyze the profitability of a customer, the cost of such services
process is circular for manufacturing firms in that the quantity must be subtracted from the customer’s gross margin. This
demanded, which is needed to estimate full cost per unit, is requires that service costs must be grouped into cost pools and
determined prior to setting the price, which has a major impact related cost drivers must be identified so that the cost per unit
on the quantity demanded. of service can be allocated to specific customers.
Using target costing, companies analyze the marketplace In activity-based pricing, customers are presented with a
and decide on a set of features and a price point for their menu of prices and are charged for services provided to them
product. They subtract a desired profit level from the price to (in addition to being charged for the goods they purchase). The
solve for the target cost. The product is then designed to meet charge for such services usually is determined based on an anal-
the target cost when it is produced. If the target cost cannot be ysis of their costs. Since they are charged for specific services,
achieved, the company may reconsider the set of features and customers will carefully consider the services they request and
the price or decide not to go ahead with the product. may end up imposing less cost on suppliers.

Review Problem 1
Heartland Tools is a large Midwest company that designs and manufactures dies, jigs, fixtures, roll-
form tooling, and special machines. Equipment used by the company includes milling machines,
HeliArc welders, drill presses, hydraulic presses, and heat treatment ovens. Due to intense compe-
tition from foreign companies, the firm currently has substantial excess capacity, and in the prior
year, the company laid off 545 employees.
To price its product, the company estimates design and product costs and marks the total
up by 40 percent to cover administrative and marketing costs and to earn a profit. Product costs
include material, labor, depreciation of equipment, and other overhead. The costs in the “other
overhead” cost pool are primarily fixed costs.
Costs are estimated as follows:
1. Design costs Based on estimated engineering hours times a rate of
$40 per hour.
2. Material Estimate of the actual cost of materials.
3. Labor Estimate of actual direct labor costs (estimate of actual
hours multiplied by the wage rate of employees likely
to be assigned to the job).
4. Depreciation of Based on predetermined overhead rates for each type of
manufacturing equipment. For each type of equipment, the company
equipment divides estimated annual depreciation by estimated
annual hours of use.

Equipment Type Annual Depreciation Annual Hours of Use

Milling $6,000,000 4,000

Welding $2,000,000 8,000
Drill press $1,000,000 5,000
Hydraulic press $4,000,000 4,000
Heat treatment $5,000,000 4,000
5. Other manufacturing Estimated as $50 per direct labor hour.
overhead (i.e., other
than depreciation)
 R e v i e w P r o b l e m 1 309

The company is currently pricing a job for Preston Manufacturing. A preliminary bid form indi-
cates the following:

Preliminary/Incomplete Cost Estimate and

Bid for Preston Manufacturing

Material $25,000
Direct labor 28 hours × $25 $    700
15 hours × $18 $    270
25 hours × $30 $    750
Design time 18 hours
Milling time 9.0 hours
Welding time 5.0 hours
Drill press time 7.0 hours
Hydraulic press time 6.5 hours
Heat treat time 2.0 hours
Other overhead ________
Estimated total cost ________
Markup at 40% ________
Bid ________

Req u ir ed
a. Estimate total cost and the bid price with the 40 percent markup.
b. Preston has told Heartland that it will use another supplier if Heartland’s bid is over $50,000.
Heartland’s CFO strongly objects to a $50,000 price since it will not even cover full costs.
Evaluate the CFO’s position. Should the company price the job at $50,000?

A n s we r
a. Cost-Plus Price for Preston Manufacturing

Material $25,000
Direct labor 28 hours × $25 $   700
15 hours × $18 270
25 hours × $30     750 1,720
Design time 18 hours × $40 720
Milling time 9.0 hours × $1,500 13,500
Welding time 5.0 hours × $250 1,250
Drill press time 7.0 hours × $200 1,400
Hydraulic press time 6.5 hours × $1,000 6,500
Heat treatment time 2.0 hours × $1,250   2,500 25,150
Other overhead 68 direct labor hours × $50 $ 3,400
Estimated total cost $55,990
Markup at 40% 22,396
Bid $78,386

Equipment Annual Annual Overhead

Type Depreciation House of Use Rate

Milling $6,000,000 4,000 $1,500

Welding $2,000,000 8,000 $   250
Drill press $1,000,000 5,000 $   200
Hydraulic press $4,000,000 4,000 $1,000
Heat treatment $5,000,000 4,000 $1,250
310 c h apter 8 P r i c i n g D e c i s i o n s , C u s t o m e r P r o f i t a b i l i t y A n a l y s i s , a n d ­A c t i v i t y - B a s e d P r i c i n g

b. It appears that the only costs that are likely to be incremental are those related to design,
material, and labor. Assuming this is the case, the company will generate an incremental
profit of $22,560 at a price of $50,000. Given that the company is operating below capacity
(and assuming this “low” price does not negatively impact future prices to Preston or other
customers), charging $50,000 for the job is a good decision.

Incremental revenue $50,000

Incremental costs
Design costs $   720
Material 25,000
Direct labor 1,720 27,440
Incremental profit $22,560

Review Problem 2
Automated Packaging Solutions is a distributor of high-speed packaging systems that include
conveyor belts, automated wrapping equipment, box loading systems, and other high-speed
equipment. The following steps are required for a “typical” order:
1. Meet with customer to determine requirements.
2. Design a preliminary system.
3. Meet with customer to discuss the preliminary system.
4. Revise design and fax to customer for final approval.
5. Pick components from stock or source from suppliers.
6. Ship to customer.
7. Supply installation service as required. Note that some customers perform the installation
with no help from Automated Packaging Solutions.
While this is a “typical” sequence, some customers simply place orders to replace broken
components or for specific components needed to upgrade their systems. In these cases, no design
work is needed.
Currently, the company prices most orders to achieve a 30 percent gross margin [(Sales -
Component costs) ÷ Sales = 30%]. Put another way, the company marks up component cost by
1.42857. However, the company vice president of marketing, Paxton Taylor, recently attended
a seminar on customer profitability measurement. She is concerned that the approach may be
severely limiting the company’s financial performance. According to the seminar presenter, the
cost-plus approach has a major flaw:

Cost-plus assumes that each customer imposes costs on your company in proportion to product costs.
That’s simply not true. Some customers are great—they buy a product, use it, and come back for more.
Others, well, you know the problem customers. They buy a product, return it, ask for a redesign, want
their order to be expedited and then they want a ton of customer service. You need to identify these
customers and then “fire them” or charge them for the value-added services they demand.

The seminar convinced Paxton that the time was right to implement an activity-based costing
approach to measure customer profitability. She got agreement from the company president and
the CFO and signed an agreement with Activity Analysis Consulting (AAC) to have Brian Hart, a
senior consultant, design a customer profitability measurement (CPM) system.
Paxton was amazed that Brian and his AAC staff were able to develop the CPM system in only
3 days. On the first day, Brian explained the idea of CPM and interviewed employees to determine
key activities and how much time they spend on them. On the second day, Brian finalized a set of
cost pools and drivers and allocated costs to the pools (see Exhibit 1). On the third day, the AAC
staff designed an Excel-based template that Automated Packaging Systems can use to calculate the
profitability of any customer. Later the next week, Brian presented an analysis of three customers
using the new tool (see Exhibit 2).
 B e vhiaevwi oPr rPoabtl teemr n 2s 311
Common Cost R

Exhibit 1
Cost pools and drivers

Driver Cost per

Activities Annual Cost Driver Quantity Driver Unit

Order processing $  637,859 No. of orders 16,258 $39.234

Pulling parts from stock 1,485,648 No. of parts picked 113,806 13.054
Shipping 1,405,793 No. of orders 16,258 86.468
Expediting 304,430 No. of expedited orders 4,177 72.882
Problem order activities 104,500 No. of problem orders 2,363 44.223
Engineering 482,351 No. of engineering hours 10,380 46.469
Installation activities 90,879 Hours of installation 1,985 45.783
Business sustaining activities 1,015,650 No. of orders 16,258 62.471
Total overhead $5,527,110

Order processing. Includes labor, depreciation of office equipment, depreciation of building, etc.
Pulling parts from stock. Includes labor, depreciation of equipment, depreciation of warehouse, etc.
Shipping. Includes labor related to packing orders and loading trucks, depreciation of forklift trucks, and payment to shipper.
Expediting. Includes premium for air and next day shipping.
Problem order activities. Estimate calculated as Total wages paid to customer service representatives × Percent of time they spend
on “problem orders”.
Engineering. Includes labor, drafting supplies, depreciation of computers, software, etc.
Installation activities. Includes labor used for installations and expenses related to small tools.
Business sustaining activities. Includes all costs other than cost of components and the seven other cost pools. Items include
executive salaries, accounting and legal expenses, depreciation of the office building and furniture and fixtures, etc.

Exhibit 2
Customer Profitability Analysis
Analysis of three customers
Customer A Customer B Customer C

Actual customer sales $25,000.00 $15,000.00 $2,000.00

Cost of goods sold 17,500.00 10,500.00 1,400.00
Gross margin   7,500.00   4,500.00    600.00
Gross margin percent 30% 30% 30%
Other Cost Drivers
Order processing 1 2 4
Pulling parts from stock 30 10 4
Shipping 1 2 4
Expediting — — 4
Problem order activities 1 — —
Engineering 102 6 —
Installation activities 20 10 —
Business sustaining activities 1 2 4
Other costs 6,279.51 1,243.53 1,096.44
ABC customer profitability $ 1,220.49 $ 3,256.47 ($  496.44)
Profit percent of sales 4.88% 21.71% -24.82%
Note:
Customer A purchased a single, relatively complex system.
Customer B purchased two relatively simple systems.
Customer C purchased single components on four occasions to replace broken parts. The customer requested
expediting to get their system up and running as quickly as possible.
312 c h apter 8 P r i c i n g D e c i s i o n s , C u s t o m e r P r o f i t a b i l i t y A n a l y s i s , a n d ­A c t i v i t y - B a s e d P r i c i n g

Req u i red
a. Show the details of the calculation of the “other costs” (amounting to $6,279.51) for C
­ ustomer A.
b. Paxton Taylor recently stated that she “now knows the true costs of serving each customer.”
Is this the case? What does the term true cost mean to Paxton? What should the term mean?
c. Paxton has now reviewed the profitability of each customer, and she finds that they generally
fit into one of three categories:
• Customers purchasing large, complex systems (like Customer A) whose profit as a percent
of sales ranges from 3 to 7 percent
• Customers purchasing relatively simple systems (like Customer B) whose profit as a per-
cent of sales ranges from 15 to 25 percent and
• Customers purchasing one or two components (like Customer C) who generate a negative
profit
   Next week, Paxton will have a meeting with Bill Ruben, CFO, to discuss the analysis. She
believes that Bill will recommend dropping sales to customers who purchase only one or two
components, and she believes that this action will increase company profit.
   Do you agree that profit will increase if the company drops Customer C types? Explain.
d. Suppose that at the meeting, Bill Ruben recommends not only dropping Customer C types
but also phasing out sales to Customer A types so that more attention can be paid to the
“sweet spot” (i.e., Customer B types).
Why might Bill’s recommendation hurt the profitability of Automated Packaging
1. 
­Solutions?
2. What type of analysis would you suggest be performed prior to adopting Bill’s recom-
mendation? Be specific as to what exactly the analysis will involve.

A n sw e r
a. Order processing $   39.23 (1 × $39.234)
Pulling 391.62 (30 × $13.054)
Shipping 86.47 (1 × $86.468)
Expediting —
Problem order 44.22 (1 × $44.223)
Engineering 4,739.84 (102 × $46.469)
Installation 915.66 (20 × $45.783)
Business sustaining 62.47 (1 × $62.471)
Total $6,279.51

b. True cost is a very nebulous term. There is no “true cost” applicable to all decisions. There
is, however, a true incremental cost applicable to each specific decision. Paxton most likely
means she has a better full cost number where “better” is still a bit vague.
c. The cost associated with Customer C is:
Order processing $   156.94
Pulling 52.22
Shipping 345.87
Expediting 291.53
Problem order —
Engineering —
Installation —
Business sustaining 249.88
Total $1,096.44

Some of these costs (especially business-sustaining and some order processing costs) will
not go away if the business is dropped. More importantly, if the company doesn’t supply
parts (that’s what C ordered), then they may lose type A and B sales. This suggests keeping C
customers—perhaps with increased prices for shipping and expediting.
 C o m m o n C o s t BSe eh laf v- A e sast tme er nnst 313
i osrs P

d. 1. The company may enter a cost allocation death spiral. Much of the costs allocated to A
and C don’t go away and are allocated to B. In other words, the company may lose more
revenue than it gains in cost savings.
2. Not surprisingly, an incremental analysis should be performed. The company needs to
calculate:
• Lost revenue from A and C
• Cost savings from dropping A and C
• Incremental effect on B sales
• Incremental effect on B costs

Key Terms Activity-based pricing (306) Customer profitability measure- Target costing (301)
Cost-plus pricing (299) ment (CPM) system (302)

Self-Assessment (Answers Below)

1. To determine the profit-maximizing price, a manager 6. The formula for target cost is:
must: a. Price - Desired profit.
a. Estimate the quantity demanded for various prices. b. Desired profit ÷ Price.
b. Estimate variable costs. c. Absorption cost × Profit percentage.
c. Estimate both the quantity demanded for various d. Desired profit - Absorption cost.
prices and variable costs.
7. Typically, which departments are involved in setting
d. None of these answer choices is correct. target costs?
2. Cost-plus pricing: a. Engineering.
a. Leads to profit maximization. b. Marketing.
b. Is inherently circular for manufacturing firms. c. Cost accounting.
c. Is difficult to perform. d. All of these answer choices are correct.
d. None of these answer choices is correct. 8. Which of the following is an advantage of cost-plus pricing?
3. Target costing: a. The selection of a markup percent is easily done.
a. Requires specification of desired level of profit. b. The method is simple to apply.
b. Targets specific costs for reduction. c. The cost-plus pricing method is inherently circular.
c. Is used primarily with products that are already in d. All of these are advantages to the cost-plus pricing
production. method.
d. Leads to profit maximization. 9. When is it beneficial for companies to accept an order
4. Customer profitability is measured as: that is priced at less than the product’s full cost?
a. Revenue - Cost of goods sold. a. When the company is operating at capacity.
b. Revenue - Indirect manufacturing costs. b. When incremental revenue exceeds incremental cost.
c. Revenue - Cost of goods sold - Indirect service c. It is always advantageous to have higher sales.
costs. d. It is never beneficial to accept an order that is priced
d. Revenue - Cost of goods sold - Indirect below full cost.
­manufacturing costs. 10. Cost-plus pricing includes which of the following costs?
5. With activity-based pricing: a. Manufacturing costs.
a. Customers face a menu of prices for various services. b. Selling costs.
b. Customers are encouraged to consider the costs c. Administrative costs.
they impose on a supplier. d. All of these costs are included in cost-plus pricing.
c. Customers may be charged less if they request less
product variety in their orders. Answers to Self-Assessment
d. All of these answer choices are correct. 1. c 2. b 3. a 4. c 5. d 6. a 7. d 8. b 9. b 10. a
 R e v i e w P r o b l e m 1 391

Review Problem 1
Boston Accounting Services provides accounting services to small businesses. The following data
relate to the preparation of a master budget for January 2017.
1. At the end of 2016, the company’s general ledger indicated the following balances:

Cash $ 62,000 Accounts payable $ 40,000

Accounts receivable 48,000 Note payable 10,000
Equipment (net) 80,000 Common stock 50,000
Retained earnings 90,000
Total $190,000 $190,000

2. Revenue in December 2016 was $80,000, and revenue budgeted for January 2017 is
$70,000.
3. Forty percent of revenue is collected in the month earned, and 60 percent is collected in
the subsequent month. The receivable balance at the end of 2016 reflects revenue earned in
December 2016.
4. Monthly expenses (excluding interest expense) are budgeted as follows: salaries,
$50,000; rent, $3,000; depreciation of equipment, $3,000; utilities, $1,000; other,
$2,000.
5. Expenses are paid in the month incurred. Purchases of equipment are paid in the month
after purchase. The $40,000 payable at the end of 2016 represents money owed for the
purchase of equipment in December 2016. No purchases of equipment are anticipated
for January.
6. The note is at 10 percent per annum and requires monthly interest payments of $83. The
entire principal must be paid in October 2017.
7. The tax rate is 35 percent. Taxes are paid as incurred.

Req u i red
Complete the following budgets:

a. Cash Budget
For January 2017

Cash Receipts
Collection of December 2016 revenue $
Collection of January 2017 revenue
Total cash receipts
Cash Disbursements
Payment of salaries
Payment of rent
Payment of utilities
Payment of other expenses
Payment for purchases of computer equipment
Payment of interest on note
Payment of taxes
Total cash disbursements
Plus beginning cash balance
Ending cash balance $
392 c h apter 1 0 B u d g e t a r y P l a n n i n g a n d C o n t r o l

b. Budgeted Income Statement

For January 2017

Revenue $
Less:
Salaries $
Rent
Utilities
Other expenses
Depreciation
Interest expense
Total expense
Income before taxes
Taxes on income at 35%
Net income $

c. Budgeted Balance Sheet

As of January 31, 2017

Assets
Cash $
Accounts receivable
Equipment (net)
Total assets $
Liabilities
Accounts payable $
Note payable
Total liabilities
Stockholders’ Equity
Common stock
Retained earnings
Total stockholders’ equity
Total liabilities and stockholders’ equity $

Answer
a. Cash Budget
For January 2017
Cash Receipts
Collection of December 2016 revenue (.6 × $80,000) $48,000
Collection of January 2017 revenue (.4 × $70,000) 28,000
Total cash receipts 76,000
Cash Disbursements
Payment of salaries 50,000
Payment of rent 3,000
Payment of utilities 1,000
Payment of other expenses 2,000
Payment for purchases of computer equipment 40,000
Payment of interest on note 83
Payment of taxes 3,821
Total cash disbursements (99,904)
Plus beginning cash balance 62,000
Ending cash balance $38,096
 R e v i e w P r o b l e m 2 393

b. Budgeted Income Statement

For January 2017

Revenue $70,000
Less:
Salaries $50,000
Rent 3,000
Utilities 1,000
Other expenses 2,000
Depreciation 3,000
Interest expense 83
Total expense 59,083
Income before taxes 10,917
Taxes on income at 35% 3,821
Net income $ 7,096

c. Budgeted Balance Sheet

As of January 31, 2017

Assets
Cash $ 38,096
Accounts receivable (.6 × $70,000) 42,000
Equipment (net) ($80,000 - $3,000) 77,000
Total assets $157,096
Liabilities
Accounts payable $     —
Note payable 10,000
Total liabilities 10,000
Stockholders’ Equity
Common stock $ 50,000
Retained earnings ($90,000 + 7,096) 97,096
Total stockholders’ equity 147,096
Total liabilities and stockholders’ equity $157,096

Review Problem 2
The results of operations for the Jackson Manufacturing Company for the fourth quarter of 2016
were as follows:
Sales $600,000
Less variable cost of sales 240,000
Contribution margin 360,000
Less fixed production costs $ 65,000
Less fixed selling and administrative expenses 105,000 170,000
Income before taxes 190,000
Less taxes on income 76,000
Net income $114,000
Note: Jackson Manufacturing uses the variable costing method. Thus, only variable production
costs are included in inventory and cost of goods sold. Fixed production costs are charged to
expense in the period incurred.
394 c h apter 1 0 B u d g e t a r y P l a n n i n g a n d C o n t r o l

The company’s balance sheet as of the end of the fourth quarter of 2016 was as follows:
Cash $200,000
Accounts receivable 120,000
Inventory 400,000
Total current assets 720,000
Property, plant, and equipment 200,000
Less accumulated depreciation 100,000
Total assets $820,000
Accounts payable $ 12,000
Common stock 600,000
Retained earnings 208,000
Total liabilities and stockholders’ equity $820,000

Additional information:
1. Sales and variable costs of sales are expected to increase by 10 percent in the next quarter.
2. All sales are on credit with 80 percent collected in the quarter of sale and 20 percent
­collected in the following quarter.
3. Variable cost of sales consists of 50 percent materials, 30 percent direct labor, and
20 percent variable overhead. Materials are purchased on credit: 90 percent are paid for
in the quarter of purchase, and the remaining amount is paid for in the quarter after
purchase. The inventory balance is not expected to change. Also, direct labor and variable
overhead are paid in the quarter the expenses are incurred.
4. Fixed production costs (other than $10,000 of depreciation) are expected to increase
by 5 percent. Fixed production costs requiring payment are paid in the quarter they are
­incurred.
5. Fixed selling and administrative costs (other than $5,000 of depreciation expense) are
expected to increase by 5 percent. Fixed selling and administrative costs requiring payment
are paid in the quarter they are incurred.
6. The tax rate is expected to be 40 percent. All taxes are paid in the quarter they are incurred.
7. No purchases of property, plant, or equipment are expected in the first quarter of 2017.

Req u i r ed
a. Prepare a budgeted income statement for the first quarter of 2017.
b. Prepare a budgeted statement of cash receipts and disbursements for the first quarter of 2017.
c. Prepare a budgeted balance sheet as of the end of the first quarter of 2017.

A n sw e r
a. Jackson Manufacturing Company
Budgeted Income Statement
For the Quarter Ended March 31, 2017

Sales $660,000 10% increase over prior quarter

Less variable cost of sales 264,000 10% increase over prior quarter
Contribution margin $396,000
Less fixed production costs $ 67,750 $10,000 + 1.05 ($65,000 - $10,000)
Less fixed selling and adm. 110,000 177,750 $5,000 + 1.05 ($105,000 - $5,000)
Income before taxes $218,250
Less taxes on income 87,300 40% of income before taxes
Net income $130,950
 S e l f - A s s e s s m e n t 395

b. Jackson Manufacturing Company

Cash Budget For the Quarter Ended March 31, 2017

Cash collected from sales:

$120,000 + .8 ($660,000)a $648,000
Cash payments:
Payment of material ($12,000 + 0.9 × $132,000)b 130,800
Payment for laborc 79,200
Payment for variable overheadd 52,800
Payment for fixed production costs
  ($67,750 - $10,000 depreciation) 57,750
Payment for fixed selling and administrative expenses
  ($110,000 - $5,000 depreciation) 105,000
Payment of income taxes 87,300
   Total cash payments 512,850
Excess of receipts over disbursements 135,150
Plus beginning cash balance 200,000
Ending cash balance $335,150
a
20% of prior quarter sales collected in next quarter (0.2 × $600,000) = $120,000
b
Material used in prior quarter (0.5 × $240,000) = $120,000
10% paid in next quarter $12,000
Material used in current quarter (0.5 × $264,000) = $132,000
c
Direct labor used (0.3 × $264,000) = $79,200
d
Variable overhead incurred (0.2 × $264,000) = $52,800

c. Jackson Manufacturing Company

Budgeted Balance Sheet As of March 31, 2017

Assets:
Cash $335,150
Accounts receivable 132,000 (0.2 × $660,000)
Inventory 400,000
   Total current assets 867,150
Property, plant, and equipment 200,000
Less accumulated depreciation (115,000) ($100,000 + $10,000 + $5,000)
Total assets $952,150
Liabilities and stockholders’ equity:
Accounts payable $ 13,200 (0.1 × $132,000)
Common stock 600,000
Retained earnings 338,950 ($208,000 + $130,950)
Total liabilities and stockholders’ $952,150
equity

Key Terms Budgets (368) Flexible budget (384) Slack (388)

Budget committee (370) Management by exception (386) Static budget (384)
Budget variances (384) Master budget (373) Zero-based budgeting (373)

Self-Assessment (Answers Below)

1. Which of the following statements about budgets is false? b. They enhance communication and coordination.
a. They are formal documents that quantify a c. They are useful in planning but not in control.
­company’s plans. d. They provide a basis for evaluating performance.
396 c h apter 1 0 B u d g e t a r y P l a n n i n g a n d C o n t r o l

2. Budgets are useful in the planning process because they 7. A ________________ budget is not adjusted for the
enhance ________________ and ________________. actual level of production whereas a _____________
3. Which of the following statements regarding a sales budget is adjusted for the actual level of production.
budget is false? 8. Which of the following is true about management by
a. Input from the sales force may be useful in predict- exception?
ing sales. a. Only large favorable variances are investigated.
b. Very large companies may hire economists to help b. Management by exception is an economical ap-
forecast sales. proach to cost control.
c. The sales budget is prepared before the cash receipts c. Management by exception can be used only with
and disbursements budget. computers.
d. The sales budget is developed after the production d. Large favorable variances should not be investigated.
budget. 9. True or false? There is never a conflict between the
4. Which of the following is the correct formula to deter- planning and control use of budgets.
mine required purchases of direct materials? 10. Which of the following is false?
a. Quantity required for production + Desired ending a. Including some nonmonetary measures of perfor-
quantity - Beginning quantity mance in a budget is not likely to be advantageous.
b. Quantity required for production - Desired ending b. If a key aspect of a company’s success is high-quality,
quantity + Beginning quantity defect-free products, it may be useful to budget
c. Quantity required for production + Desired ending the number of defects and the number of customer
quantity + Beginning quantity complaints at levels consistent with high quality.
d. Beginning quantity + Purchases - Desired ending c. The actual number of defects and complaints can be
quantity compared with the budgeted quantities to evaluate
5. Which of the following items do not require cash performance.
outflow? d. If a company is experiencing problems with em-
a. Salaries ployee absenteeism, it may be useful to budget an
b. Purchase of raw materials acceptable number of days missed and compare
actual days missed with the target.
c. Advertising
d. Depreciation Answers to Self-Assessment
6. Differences between budgeted and actual amounts are 1. c 2. communication, coordination 3. d 4. a 5. d
referred to as ________________. 6. budget variances 7. static, flexible 8. b 9. false 10. a

QUESTIONS 1. Why are budgets useful in the planning process?

2. Why are budgets useful in the control process?
3. What is the difference between the top-down and the bottom-up approach to developing a
budget?
4. What is meant by a zero-based budget?
5. How does use of a spreadsheet program facilitate “what if ” analysis in budgeting?
6. What are the main purposes of preparing a cash budget?
7. Explain the difference between a static and a flexible budget.
8. The number of defects in a manufacturing process is an example of a nonmonetary measure
of employee performance. Describe a financial measure that captures the effect of defects.
9. How would performance be evaluated if there were no budgets?
10. Why is there an inherent conflict between planning and control uses of budgets?
 A p p e n d i x 435

Recording Cost of Goods Sold

When units are sold, the cost of Finished Goods Inventory is reduced and Cost of Goods Sold is
increased by the standard cost of the units sold. Assume that all 1,000,000 gallons of ice cream
produced are sold. The standard cost is $4.25 per gallon. Therefore, the entry to record the Cost
of Goods Sold is:

(date) Cost of Goods Sold 4,250,000

Finished Goods Inventory 4,250,000
To record Cost of Goods Sold.

Closing Variance Accounts

At the end of the accounting period, the temporary variance accounts must be closed. As a prac-
tical matter, this is usually accomplished by debiting or crediting the variances to Cost of Goods
Sold. Before closing the variance accounts, Cost of Goods Sold is recorded at standard cost. Thus,
closing the variances results in the account being adjusted to approximate actual cost. It would
be more accurate to adjust Work in Process Inventory and Finished Goods Inventory (as well
as Cost of Goods Sold) to actual cost by allocating part of the total variance to these accounts.
However, unless the variances are significant and the balances in Work in Process Inventory and
Finished Goods Inventory are large relative to Cost of Goods Sold, closing the total variance to
Cost of Goods Sold is convenient and not misleading. In the case of Darrington Ice Cream, there
is no Work in Process or Finished Goods Inventory at the end of the year. (All of the ice cream
produced was sold.) Therefore, the variances are closed to Cost of Goods Sold.
The journal entry to close the variance accounts is as follows. Note that a favorable variance
reduces the amount of Cost of Goods Sold, whereas an unfavorable variance increases the account:

(date) Cost of Goods Sold 203,700

Overhead Volume Variance 50,000
Controllable Overhead Variance 20,000
Material Price Variance 178,200
Material Quantity Variance 22,500
Labor Rate Variance 13,000
Labor Efficiency Variance 60,000
To close variance accounts to
Cost of Goods Sold.

Review Problem 1
Sterling Steel Company produces steel billets that are sold to specialty steel fabricators. Fixed
overhead costs are budgeted at $20,000,000 per year, and variable overhead costs are budgeted at
$350 per ton. At the start of the year, the company planned to produce 70,000 tons.
During the year, the company actually produced 60,000 tons and incurred $42,000,000 of
overhead costs.

R equ ir ed
Calculate the controllable overhead variance and the overhead volume variance.

A n sw er
Controllable Flexible budget level of overhead
= Actual overhead -
overhead variance for actual level of production
= $42,000,000 - ($20,000,000 + ($350 × 60,000 tons))
= $42,000,000 - $41,000,000
= $1,000,000unfavorable
436 c h apte r 1 1 S t a n d a r d C o s t s a n d V a r i a n c e A n a l y s i s

Overhead volume Flexible budget level of overhead Overhead applied to production

= -
variance for actual level of production using standard overhead rate
= $41,000,000 - ($635.7143 × 60,000 tons)
= $41,000,000 - $38,142,858
= $2,857,142 unfavorable
Note: The standard overhead rate
= [$20,000,000 + ($350 × 70,000 tons)] ÷ 70,000 tons = $635.7143.

Review Problem 2
RampUp Storage Containers produces a 1,000-cubic-foot metal storage unit that is used by storage
companies and other businesses needing low-cost, mobile storage units. The units sell for $3,000
per unit.
The company uses a standard costing system. At the start of 2016, standard costs were set
as follows:

Standard cost per unit:

Material cost (6 prefabricated metal sheets × $200) $1,200

Direct labor (10 hours × $20) 200
Overhead ($500 per unit) 500
Total $1,900

The overhead rate was calculated as follows: At the start of 2016, the company estimated that it
would produce and sell 5,000 units and incur $500,000 of variable overhead costs and $2,000,000
of fixed overhead costs:

Variable overhead $ 500,000

Fixed overhead 2,000,000
Total 2,500,000
Divided by estimated production 5,000
Overhead cost per unit $     500

Based on estimated sales, standard costs, and other information, the following budget was pre-
pared:

2016 Budget (Expected Production and Sales of 5,000 Units)

Sales $15,000,000
Cost of sales 9,500,000
Gross profit 5,500,000
Selling, general, and administrative expense 3,900,000
Income from operations $ 1,600,000

During 2016, the company received an unexpected large order (1,000 units) from a national storage
company. The result was a substantial increase in the number of units produced and sold (6,000
units in total). Of the 6,000 units, 5,000 were sold at the standard price of $3,000 per unit. The
1,000 units sold to the national storage company were sold at $2,800 per unit.
 A p p e n d i x 437

To produce the 6,000 units, the company incurred the following production costs:
Material purchased and used
(36,200 metal sheets × $200) $ 7,240,000
Direct labor
(62,000 hours × $21) 1,302,000
Variable overhead 594,000
Fixed overhead 2,480,000
Total actual production costs $11,616,000

Req u i red
a. Calculate the production cost variances and indicate whether they are favorable or u
­ nfavorable.
b. Provide a brief interpretation of the overhead volume variance. In other words, answer the
question: What is the meaning of an overhead volume variance?
c. Calculate the financial impact of the 1,000 unit special order from the national storage c­ ompany.

A n sw er
a. Material price variance
(AP - SP) AQ
($200 - $200) 36,200 = –0–
Material quantity variance
(AQ - SQ) SP
(36,200 - 36,000) $200 = $40,000 unfavorable
Labor rate variance
(AR - SR) AH
($21 - $20) 62,000 = $62,000 unfavorable
Labor efficiency variance
(AH - SH) SR
(62,000 - 60,000) $20 = $40,000 unfavorable
Controllable overhead variance
Actual overhead - Flexible budget for actual production
$3,074,000 - [$2,000,000 + $100 (6,000)] = $474,000 unfavorable
Overhead volume variance
Flexible budget for actual production - Overhead applied
[$2,000,000 + $100 (6,000)] - ($500 × 6,000) = ($400,000) favorable
b. The overhead volume variance results from applying a predetermined fixed overhead rate to
more or fewer units than originally planned when the rate was determined. If more units are
produced than planned, more fixed overhead than anticipated will be applied at the standard
rate. If fewer units are produced than planned, less fixed overhead than anticipated will be
applied at the standard rate.
c. The selling price per unit for the 1,000 unit order is $2,800
Variable costs at standard are:
Material $1,200
Labor 200
Variable overhead 100 1,500
   Contribution margin $    1,300

1,000 extra units results in $1,300,000 of incremental profit.

   Contribution margin per unit $    1,300
   Number of units × 1,000
  Incremental profit $1,300,000
478 chapter 1 2 D e c e n t r a l i z a t i o n a n d ­P e r f o r m a n c e E v a l u a t i o n

NEGOTIATED TRANSFER PRICES

As discussed at the start of this chapter, one of the benefits of decentralization is that m
­ anagers who
are delegated significant decision-making responsibility tend to be highly motivated. To encourage
the sense of autonomy, some companies allow division managers to negotiate a transfer price. This
presents the subunit managers with the same situation faced by an ­independent business that
must negotiate a price for specialized items. However, the ­resulting transfer price may reflect the
relative negotiating skills of the subunit managers and fail to reflect the underlying opportunity
cost associated with producing goods and transferring them internally.

Link to PRACTICE
Transfer Pricing at Starbucks Switzerland, which has a low corporate tax rate, rather
than a country with a higher rate. European regulators
At Starbucks, the world’s largest coffee chain, all the
opened an investigation of Starbucks’ management of
coffee it uses worldwide is bought by a Starbucks’ sub-
international taxes in 2014.
sidiary in Switzerland. Although the coffee is never trans-
ported through Switzerland, the subsidiary then sells the
Source: Tom Fairless, “Huge Profit Stokes Concerns Over
coffee to Starbucks’ units operating in other countries at Starbucks’s Tax Practices in Europe,” The Wall Street Journal,
a transfer price including a 20 percent markup. That way, April 6, 2015. Available at: http://www.wsj.com/articles/
the profit related to the 20 percent markup gets taxed in starbuckss-tax-practices-draw-european-scrutiny-1428363189.

TRANSFER PRICING AND INCOME TAXES

IN AN INTERNATIONAL CONTEXT
When goods are transferred between profit centers in different countries, the income tax situa-
tions in the countries may create incentives for relatively high or relatively low transfer prices. For
example, suppose the tax rate in Country A is 10 percent, whereas the tax rate in Country B is
40 percent. Holding everything else constant, this creates an incentive to have high transfer prices
when goods are transferred from a profit center in Country A to a profit center in Country B. With
this approach, the profit center in Country A will have relatively high income (which is taxed at
a low rate), and the profit center in Country B will have ­relatively low income (which is taxed at
a high rate). Thus, overall taxes of company income for the two profit centers will be reduced. If
goods were to be transferred from a profit center in Country B to a profit center in Country A,
there would be an incentive for a relatively low transfer price. The Internal Revenue Service in the
United States and the taxing authorities in other countries are aware of these incentives and try
to make sure that transfer prices are not unreasonably high or low in response to the incentives
created by differences in income tax rates between countries.

Review Problem 1
Merlin Appliances, founded by Morgan D. Edwards in 1976, is a closely held company that
operates five stores in Michigan selling refrigerators, stoves, washers and dryers, and other
household appliances. The company’s stock is owned by various members of the Morgan D.
Edwards family, and five family members serve on the board of directors. The president and
CEO of Merlin is David Bell. David, who is not a family member, was hired in 2016 and is
responsible for all day-to-day company decisions. He reports to Brandon Edwards, who is
chairman of the board.
 R e v i e w P r o b l e m 1 479

At the end of fiscal 2017, David was asked to prepare a brief memo to the board reviewing
the company’s performance. A copy of the memo is presented below along with comparative
financial statements. A board meeting is scheduled for early February at which time the board
will review company performance and David’s compensation including his performance bonus
for 2017.

January 26, 2018

TO: Board of Directors of Merlin Appliances

FROM: David Bell, President and CEO
SUBJECT: Financial performance in fiscal 2017

At the start of 2017 we discussed the fact that the market for appliances was likely to be soft due to
economic conditions in the state of Michigan. Specifically, at the start of 2017, unemployment was
high and several major companies had made plans for substantial job cuts. In light of this, I am
very happy to report that we have had an outstanding year. Sales have increased by 7.68 percent,
and profit is up by 14.11 percent.
How was this accomplished? Here’s a brief outline of the three strategies we employed—I’ll
review them in detail at the February 7 board meeting.
1. Market research indicated that sales could be increased if we held the line on prices,
displayed a wider selection of items at each store, and had more items available in our
warehouse so that we could offer 1- or 2-day delivery. This strategy was implemented, with
obvious good results, in early 2017.
2. We adjusted our quarterly sales events. In addition to offering our normal discounts
at these events, we also offered terms with no payments (and no interest charges) for
6 months. This strategy was successful in attracting customers who might have delayed
purchases in the current year.
3. We retired all short-term and all long-term debt. As you know, we had cash reserves of
approximately $1.6 million at the end of 2016. (The money had been accumulated in
anticipation of expansion, but expansion plans have been put on hold.) Paying down debt
reduces company risk and appears to be a good use of the funds.
I also want to note that our exceptional performance in fiscal 2017 could not have been achieved
without the support of the 138 Merlin team members whose hard work and dedication to the
company’s success is evident in every sale and every delivery!
Finally, as you know, we paid out approximately $1,000,000 in dividends in fiscal 2017—no
dividends were paid in 2015, and dividends in 2016 were only $500,000.

See you on February 7.

480 chapter 1 2 D e c e n t r a l i z a t i o n a n d ­P e r f o r m a n c e E v a l u a t i o n

Comparative Income Statements 2017 2016 % Change

Sales $27,659,548 $25,687,240 7.68%

Less:
Cost of sales 19,361,684 17,981,068
Selling, general and administrative expense 5,531,910 5,137,448
Interest expense — 144,711
Income before income taxes $ 2,765,954 $ 2,424,013
Less income taxes 968,084 848,405
Net income $ 1,797,870 $ 1,575,608 14.11%

Comparative Balance Sheets 2017 2016

Assets
Cash and cash equivalents $    147,636 $ 1,586,250
Accounts receivable 2,990,221 2,568,724
Inventory 2,420,211 1,997,896
Prepaid expenses 47,399 45,265
Total current assets 5,605,467 6,198,135
Land 1,342,350 1,342,350
Building, furniture, fixtures (net) 8,438,088 8,523,321
Total noncurrent assets 9,780,438 9,865,671
Total assets $15,385,905 $16,063,806
Liabilities
Accounts payable $    210,240 $    199,790
Accrued liabilities 57,010 45,685
Taxes payable 60,690 49,321
Current portion of long-term debt — 188,754
Total current liabilities 327,940 483,550
Long-term debt — 1,258,360
Total liabilities 327,940 1,741,910
Stockholders’ Equity
Common stock 5,079,315 5,079,315
Retained earnings 9,978,650 9,242,581
Total stockholders’ equity 15,057,965 14,321,896
Total liabilities and stockholders’ equity $15,385,905 $16,063,806

Req u i red
a. Evaluate performance in fiscal 2017 and 2016 in terms of economic value added
(EVA). Assume a weighted average cost of capital of 15 percent in 2017 and 14 percent
in 2016. Briefly comment on whether this evaluation supports a significant bonus for
David Bell.
b. Suppose that the entire increase in net operating profit after taxes in 2017 is due to having
more inventory and “no payments or interest” for 6 months, which led to an increase in
accounts receivable. Evaluate the impact of these strategies in terms of their impact on EVA
using a 15 percent cost of capital.
 R e v i e w P r o b l e m 1 481

An s w er
a.

2017 2016

Net income $ 1,797,870 $ 1,575,608

Add interest 144,711
Less taxes related to interest — (50,649)
NOPAT $ 1,797,870 $ 1,669,670

2017 2016

Investment
Total assets $15,385,905 $16,063,806
Less NIBCL:
Accounts payable (210,240) (199,790)
Accrued liabilities (57,010) (45,685)
Taxes payable (60,690) (49,321)
Investment 15,057,965 15,769,010
Cost of capital 0.15 0.14
Required NOPAT 2,258,695 2,207,661
EVA (NOPAT - Required NOPAT) ($   460,825) ($   537,991)

Note that, alternatively, NOPAT could have been calculated as:

2017 2016

Income before taxes $ 2,765,954 $ 2,424,013

Add interest –0– 144,711
2,765,954 2,568,724
Less taxes 968,084 899,053
NOPAT $ 1,797,870 $ 1,669,671

The slight difference between the calculation here and above for 2016 is due to rounding.
It does not appear that a substantial bonus is warranted since EVA is negative in 2017
indicating that shareholder value has actually declined. This follows because net operating
profit is less than the level required given the investment in the company. Note that EVA was
also negative in 2016. Also note that EVA and residual income are identical in this problem
since there are no adjustments for “accounting distortions.”
b. The company increased inventory. And the policy of no payments or interest for 6 months
increased accounts receivable. Together, these two items increased investment by $843,812.
With a 15 percent cost of capital, NOPAT would need to increase by $126,572 to break even.
In actuality, NOPAT increased by $128,200 for a net benefit of $1,628. While positive, this
rather small amount is hardly in line with the financial gains claimed in David Bell’s memo:
Increase in inventory ($2,420,211 - $1,997,896) $422,315
Increase in receivables ($2,990,221 - $2,568,724) 421,497
Increase in investment 843,812
Cost of capital × .15
Required additional NOPAT 126,572
Less actual additional NOPAT ($1,797,870.00 - $1,669,670.15) 128,200
Net benefit $  1,628
482 chapter 1 2 D e c e n t r a l i z a t i o n a n d ­P e r f o r m a n c e E v a l u a t i o n

Review Problem 2
Ransom Apparel is a men’s casual clothing company. The company has set aggressive targets
in both sales growth and return on investment for the coming year. The company’s strategy for
achieving these goals includes a campaign aimed at building brand recognition. It is also seeking
improvements in product quality and on-time delivery from manufacturers in China and Vietnam
as well as expansion of the product line to include three styles of jeans, which will complement
the company’s line of silk shorts and slacks. A number of limited edition items is also part of the
company’s strategy.
To bolster its brand, the company plans to provide limited edition items to celebrities in
Los Angeles, San Diego, Chicago, and New York. The company hopes that the celebrities will be
seen around town and in fashion magazines such as GQ.

Req u i red
Based on this limited information, provide two objectives and two measures for each perspective
of the balanced scorecard. Using a strategy map, show how the objectives are related across the
four dimensions of a balanced scorecard. Note that a number of alternative measures could be
appropriate—the ones provided in the answer are simply examples of such alternatives.

An s w er
Measures for the various objectives are shown below in the strategy map. The logic behind the
strategy map is:
1. Development of limited edition items should improve the odds of celebrities wearing the
company’s products and being highlighted in trend-setting magazines such as GQ.
2. Development of a new line of jeans should lead to an increase in sales as the product line is
expanded.
3. Improved on-time delivery from suppliers should increase sales since the company is more
likely to meet its own delivery schedules to customers.
4. Improved product quality should improve ROI since the company will have lower costs
associated with returns.
5. If trend-setters wear the brand, brand recognition is expected to improve.

Strategic Objective Measure

Financial Increase sales Percent increase in sales

Improve ROI ROI

Customer Improve brand recognition Percent of target audience

who recognize brand
Brand worn by trend-setters Number of photos of celebrities
wearing brand in trendy
magazines

Internal Improve product quality Percent reduction in

Processes defect rate from plant
Improve on-time delivery Percent of supplier
by suppliers orders on time

Learning Develop new line of jeans New jeans developed

and Growth
Develop limited edition items Limited editions developed
 S e l f - A s s e s s m e n t 483

Key Terms Balanced scorecard (468) Noninterest-bearing current Residual income (RI) (463)
Cost center (455) ­liabilities (NIBCL) (459) Responsibility centers (455)
Decentralized organization (452) Net operating profit after taxes Return on investment
Economic value added (NOPAT) (458) (ROI) (457)
(EVA) (464) Profit center (456) Strategy map (471)
Investment center (456) Profit margin (458) Transfer price (Appendix, 474)
Investment turnover (458) Relative performance
Lack of goal congruence (453) evaluation (456)

Self-Assessment (Answers Below)

1. Which of the following is not a reason for having 7. Investment centers often are evaluated using:
­decentralized organizations? a. Time and motion studies.
a. Better information at the local level leads to superi- b. Return on investment.
or decisions. c. Residual income/EVA.
b. Goal congruence is enhanced. d. Both (b) and (c) are used.
c. Quicker response to changing circumstances.
8. Which of the following is a problem in using return on
d. Increased motivation of managers. investment to evaluate managers?
2. An investment center is responsible for: a. Managers of investment centers with high ROIs
a. Investing in long-term assets. may not invest in some projects with returns greater
b. Controlling costs. than the required rate of return.
c. Generating revenues. b. Managers may overinvest in high-ROI projects.
d. All of these answer choices are correct. c. Managers’ morale may suffer from being
evaluated.
3. A cost center is responsible for:
d. None of these answer choices is correct.
a. Investing in long-term assets.
b. Controlling costs. 9. Which of the following is a true statement regarding the
evaluation of an investment center?
c. Generating revenues.
a. Return on investment may be high because of old
d. All of these answer choices are correct.
equipment that is fully depreciated.
4. Use of profit as a performance measure: b. Residual income does not take into account the
a. May lead to overinvestment in assets. level of investment in fixed assets.
b. Is appropriate for an investment center. c. Return on investment does not take into account
c. Is appropriate as long as profit is calculated using the level of investment in fixed assets.
GAAP. d. None of these answer choices is correct.
d. Encourages managers to finance operations with 10. (Appendix) The transfer price that motivates the best
debt rather than equity. decisions is one that measures:
5. Cost centers are often evaluated using: a. The full cost of goods produced.
a. Variance analysis. b. The opportunity cost of producing and transferring
b. Operating margin. an item.
c. Return on investment. c. The selling division’s variable cost.
d. Residual income. d. None of these answer choices is correct.
6. Profit centers often are evaluated using:
a. Investment turnover. Answers to Self-Assessment
b. Income targets or profit budgets. 1. b 2. d 3. b 4. a 5. a 6. b
c. Return on investment. 7. d 8. a 9. a 10. b
d. Residual income.