SOLUTIONS MANUAL for Managerial Accounting 6th Edition by James Jiambalvo

Chapter 1 Managerial Accounting in the Information Age QUESTIONS 1. The goal of managerial accounting is to provide information needed for planning, control, and decision making. 2. Budgeted performance is a useful benchmark for evaluating current period performance. 3. This question asks students to identify three differences between financial and managerial accounting. In the text, five differences are noted: a) Managerial accounting is directed at internal rather than external users of accounting information. b) Managerial accounting may deviate from generally accepted accounting principles (GAAP). c) Managerial accounting may present more detailed information. d) Managerial accounting may present more nonmonetary information. e) Managerial accounting places more emphasis on the future. 4. Examples of nonmonetary information that might appear in managerial accounting reports include: the quantity of material consumed in production, the number of hours worked by the office staff, and the number of product defects. 5. Total variable costs change in proportion to business activity while total fixed costs do not change. 6. Salaries of the home appliance sales force would be a controllable cost for the manager of the home appliance department at a Sears store. Depreciation related to the department store building would be a noncontrollable cost. 7. Incremental analysis involves a comparison of the revenues that change and the costs that change when a decision alternative is selected. If incremental revenue exceeds incremental cost, a decision alternative should be undertaken. 8.

“You get what you measure!” suggests that managers’ behaviors are affected by performance measures.

9. Information flows up and down the value chain—between a company and its suppliers and between a company and its customers. Information technology is helping companies track buying patterns of customers and send targeted selling messages to them via email. Information technology is also helping companies better manage their supply chains and gain internal efficiencies. 10. A legal action is not necessarily ethical. Ethical actions involve “what’s right” while legal actions involve operating within boundaries of the law.

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EXERCISES E1. [LO 3] Suppose the company selected is Microsoft. Measure 1: Favorable outcome: Unfavorable outcome:

Number of errors in a piece of software. Number of errors is reduced. Software products are not released on a timely basis.

Measure 2: Favorable outcome: Unfavorable outcome:

Sales to new customers as a percent of total sales. Sales staff works hard to develop new clients. Company loses existing customers who receive less attention from the sales staff.

Measure 3: Favorable outcome:

Average time spent handling customer service calls. Customer service representatives handle more calls per hour. Customer questions are not fully addressed and customer satisfaction decreases.

Unfavorable outcome:

E2. [LO 2] The only costs that are relevant to a decision are incremental costs—that is, costs that change when an action is taken. The cost of the old copier is a sunk cost and will not change. Therefore, it is irrelevant to Rachel’s decision. E3. [LO 4] The code suggests that Guthrie clarify the ethical issue by confidential discussion with an objective advisor (this might be the IMA Ethics Counseling service) to obtain a better understanding of possible courses of action. Guthrie should then discuss the problem with the manager to whom his boss reports (since his boss is involved in the ethical dilemma). Unless required by law, communication of the problem to authorities or individuals outside the organization is not appropriate. E4.

[LO 4] Possible answers include: The CRM system notes that a customer makes significant wine purchases at dinners. At her next stay, the hotel provides a complimentary bottle of a limited release high-end wine resulting in increased customer loyalty. The CRM system notes that a customer has had three bookings in the last year. When the customer checks in, the hotel offers a complimentary room upgrade which results in increased customer loyalty. The CRM system identifies the top 1,000 guests in terms of annual billings and does a direct mailing of certificates that can be redeemed for a free night's stay resulting in increased customer loyalty. The CRM system notes that a customer has traveled with a small dog and wants the staff to walk the dog in the park in the early morning. The reservationist asks if

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this service is needed when booking an upcoming stay and makes sure a staff person is available. E5. [LO 1] Megan can prepare a profit budget for each store (planning). At the end of the accounting period, she can compare actual profit to the budget for each store (control). Significant differences from the budget should be investigated to determine their causes. E6. [LO 1] “c” is false. There are many possible reasons, other than lack of effective management, why actual costs are greater than planned. Typically, performance reports only suggest areas that should be investigated. E7. [LO 1] Deidre should not be concerned that cost of sales has increased. Cost of sales is a variable cost and it is expected that it will increase when sales increase. In the budget, cost of sales ($400,000) is 67% of sales ($600,000). Actual cost of sales ($425,000) is 61% of actual sales ($700,000). Thus, while cost of sales has increased, it has not increased disproportionate to the increase in sales. E8. [LO 1]. Managerial accounting focuses on accounting information for internal decision-making. This focus differs from financial accounting in a number of ways. For example managerial accounting: 1) focuses on internal users, 2) can deviate from generally accepted accounting principles (GAAP), 3) presents more detailed information, 4) presents more nonmonetary information, and 5) places emphasis on the future. E9. [LO 1] For purposes of awarding bonuses, it may be advisable to record sales when orders are placed so that the sales force is rewarded on a timely basis. If the company waited until the order was delivered, the sales force might be rewarded more than a year after obtaining a customer order. The point is that for internal reporting purposes, companies need not follow GAAP. E10. [LO 2] a. variable b. fixed c. variable d. fixed E11. [LO 2] a. variable b. variable c. fixed d. fixed e. variable

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E12. [LO 2] A cost is controllable by a manager whose actions affect the cost. Thus, for example, advertising may be a controllable cost for a store manager (who decides how much to spend on advertising) but it would be a non-controllable cost for the manager of a department at the store (who is not consulted about the amount to spend on advertising). E13. [LO 2, 3] Takesha should not consider how much he paid for the old machine because that is a sunk cost. He should consider the value of the old machine in the used lab machine market—an incremental cash inflow equal to the market value of the old machine that will result if he buys a new lab machine. E14. [LO 2] Incremental revenue per day Less incremental costs: Labor Parts Transportation Office staff Incremental Profit per Day

$2,500 $700 500 100 200

1,500 $1,000

Opportunity cost = $1,000 per day x 52 days = $52,000 Rent and depreciation do not enter into the calculation of the opportunity cost since these costs are not incremental (they will be incurred whether or not Ken decides to stay open on Saturday). E15. [LO 2] If Zachary visits his friend, he will incur a $560 (16 hours x $35) opportunity cost. E16. [LO 2, 3] The incremental cost per gallon is likely to be less than $6 because part of the $6 amount relates to fixed costs such as depreciation of equipment. If the incremental cost per gallon is less than $6, then the incremental cost of 15,000 gallons is less than $90,000. E17. [LO 3] a. When a second shift is added, material costs, workers’ salaries, and benefits are likely to increase. b. Depreciation of the building will not increase when a second shift is added. E18. [LO 3] The owner of LA Porsche may link Hulmut’s annual bonus to the average customer satisfaction rating. Thus, there is a link between the measure and Hulmut’s financial welfare. Some actions that Hulmut can take that may help ratings would be to 1) provide a comfortable waiting area for customers, 2) provide free coffee and snacks in the waiting area, and 3) provide transportation service for customers while their cars are under repair.

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E19. [LO 5] The IMA’s Statement of Ethical Professional Practice does not directly address this issue so students may take either side of this issue. Shauna does have obligations: Students could argue that the practice of entertaining customers with lavish vacations is a type of bribe that would violate the Competence standard (perform duties in accordance with laws and regulations) or the Integrity standard (refrain from engaging in any conduct that would prejudice carrying out duties ethically). Shauna does not have obligations: Students could argue that the practice of entertaining customers is not against the law and does not reduce one’s ability to carry out duties ethically. E20. [LO 5]. Responses will vary. Examples of Controller duties are as follows: Cost accounting, preparation of financial statements in accordance with GAAP, budgeting, variance analysis, advisor to senior leadership. Examples of skills are as follows: BA in Accounting, CPA, 5-10 years accounting experience, 5 years management experience, excellent written and verbal communication skills. E21. Student answers will vary.

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PROBLEMS P1. [LO 1, 2] a.

Santiago’s Salsa Budgeted Production Costs May 2017 30,000 Production Jars of Salsa Ingredient cost* $24,000 Labor cost** 14,400 Rent 5,000 Depreciation 6,000 Other 1,000 Total $50,400

*($20,000 ÷ 25,000) x 30,000 **($12,000 ÷ 25,000) x 30,000

b. With a wage rate of $20, 720 hours ($14,400 ÷ $20) will be needed in May. In April, only 600 hours were needed ($12,000 ÷ $20). Thus, 120 additional hours will be needed in May. The company can plan on hiring a part-time worker in May (approximately 30 hours per week) or the additional hours can be addressed with overtime, which would make the hourly rate higher. In which case, the hourly rate would be higher. Unless management anticipates the need for the part-time worker (by preparing a budget), he or she may not be hired on a timely basis. c. The actual cost per unit in April was $1.76 ($44,000 ÷ 25,000 units). The cost per unit in May is anticipated to be only $1.68 ($50,400 ÷ 30,000 units). Unit cost declines because some costs are fixed and do not increase with increases in volume.

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P2. [LO 2, 3] a. The variable costs are $1.28 per jar of salsa as follows:

Production Ingredient cost Labor cost Total

25,000 Jars of Salsa $20,000 12,000 $32,000

$32,000 ÷ 25,000 jars of salsa = $1.28 per jar of salsa. Thus, the incremental cost of producing an extra 50,000 jars of salsa is $64,000 (i.e., $1.28 × 50,000). b. The incremental revenue associated with a price reduction of $0.40 is $100,000 as follows: Original Revenue (325,000 × $5.00) Revenue with price change (375,000 × $4.60) Incremental revenue associated with price change

$1,625,000 1,725,000 $ 100,000

c. Yes, the price should be lowered since the incremental cost of this action ($64,000 in part a) is less than the incremental revenue ($100,000 in part b). P3. [LO 1, 2] Sales Department Budgeted Costs, 2017 (Assuming Sales of $11,000,000) Salaries (fixed) Commissions (variable) Advertising (fixed) Charge for office space (fixed) Office supplies & forms (variable) Total

$400,000 165,000 100,000 3,000 2,200 $670,200

Commissions [($150/$10,000) x $11, 000,000] = $165,000 Office supplies & forms [($2,000/$10,000,000) x $11,000,000] = $2,200

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P4. [LO 1] a. Sales exceeded the budget by 10.7% ($75,000 ÷ $700,000), while cost of merchandise increased by 22.9% and salaries increased by only 11.4%. Thus, the investigation should focus on cost of merchandise since a 22.9% increase is disproportionate to the increase in sales. b. Electricity would not be a controllable cost for the manager of sporting goods, and it is doubtful that including it on a performance report for sporting goods would be useful. P5. [LO 1, 2] Cyril should expect some costs to be greater than budgeted. Variable production costs will increase with the number of units produced, while fixed production costs will not increase. In the example, it is reasonable to assume that materials, direct labor and utilities are variable costs while the remaining costs (supervisory salaries, machine maintenance, depreciation of building, depreciation of equipment and janitorial) are fixed. (Note that a case can be made for other classifications.) P6. [LO 1, 2, 3] a. The information on the income statement, balance sheet and statement of cash flow is highly summarized for the entity as a whole. Linda needs product level information which is much more detailed. b. Examples of nonfinancial measures might be: Web site visits, number of repeat customers, delivery time, and customer satisfaction. c. Linda could improve customer satisfaction ratings by offering discounts, improving delivery time, and improving quality. d. Examples of costs in Linda’s operation are cost of contact lenses (variable), depreciation of computing equipment (fixed), salaries of information technology staff (fixed), and shipping (variable). P7. [LO 3] a. Managers may focus (too much) on new customers and ignore current customers who account for most of the company’s sales. b. Managers could decrease cost of goods sold by overproducing (i.e., producing more than needed for current sales and reasonable inventory) in an effort to decrease unit cost and cost of sales. However, this would result in an inventory buildup and excess inventory holding costs.

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c. Managers may be able to decrease selling and administrative expense in the short-run by cutting the number of employees. However, this may hurt employee morale and customer service. If that is the case, it may, in the long run, hurt company profitability. P8. [LO 2, 3] a. Incremental revenue will be $640 ($160 x 4). b. Incremental costs would include, for example, the cost of soap and shampoo, the cost of cleaning the room, and the cost of cleaning towels and bedding. c. Most likely, the incremental revenue will exceed the incremental costs, which are relatively low (e.g., shampoo and soap are inexpensive and cleaning personnel are paid fairly low wages). P9. [LO 5] Answers based on Sears Holding Company Code of Conduct. a. “Associates may not share pricing data among competing vendors.” b. “Associates may not use Company time or resources to support personal political activities.” c. “An associate should never accept from a vendor any personal services, promise of employment, samples for personal use, or money or its equivalent.” d. “Associates must not disclose proprietary or confidential information … includes strategies.”

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Case 1-1. [LO 2, 5]

LOCAL 635 Summary Union is disputing “cost of meal” charges to hotel employees. •

Distinguishes among fixed, variable, sunk, and opportunity costs.

•

Makes the point that there is no generally accepted meaning of the term “cost.”

Questions to ask students: 1. What is the source of conflict between Local 635 and the Riverside Hotel? 2. What are some examples of variable, fixed, sunk, and opportunity costs in the context of the Local 635 case? 3. What do you think is the incremental cost of an employee meal? 4. I contend that it is possible that the incremental cost is more than $300. How is this possible? 5. How should the contract be worded to avoid similar problems in the future? Discussion I start this case by asking a student to explain the source of conflict between Local 635 and the Riverside Hotel. The student is likely to explain that while employees are focused on the incremental cost of a meal, management is focused on various fixed costs as well as the incremental costs. This leads to a major take away—there is no generally accepted meaning of the term cost. We know what’s meant by fixed cost, variable cost, opportunity cost, sunk cost, etc., but there is ambiguity as to what exactly cost means. To begin working on the vocabulary of managerial accounting, I ask students for examples of variable, fixed, sunk, and opportunity costs in the context of the Local 635 case. The primary variable cost is the cost of food items (e.g., the cost of meat and salad ingredients). A fixed cost would be the depreciation on the oven (which is also a sunk cost). An opportunity cost would arise if a worker ate the last prime rib and the hotel lost a sale. I then ask the class to estimate the incremental cost of an employee meal. Most students think it is less than $12. I then suggest that it is possible that the incremental cost is more than $300! When asked to explain how this is possible, students focus on opportunity costs. Suppose an employee eats the last prime rib just before a steady

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customer, who always eats prime rib, comes into the restaurant. If this customer becomes disgruntled and never returns to the restaurant, the hotel could easily be out $300 or more in the next few months. How should the contract be rewritten? Students generally recommend that meal subsidies be based on some percent of menu prices. For example, meals could be free as long as 70% of the total of menu prices is less than $12. To wrap up, it should be noted that to ensure quality and customer satisfaction, kitchen workers must be motivated to do a good job. Thus, the hotel should be motivated to settle this dispute quickly in a way that seems fair to workers.

1-12 Jiambalvo Managerial Accounting Case 1-2. [LO 3]

BOSWELL PLUMBING PRODUCTS Summary A senior manager is requesting information on the “cost” of a product. •

Makes the point that appropriate cost information depends on the manager.

Questions to ask students: 1. What did the senior manager ask Nick and how did he reply? 2. Why is Nick’s response “Why do you want to know?” appropriate from the standpoint of incremental analysis? 3. What cost information would be relevant to a decision to drop the product that would not be relevant to a decision to increase a production run by 100 units? Discussion A senior manager has asked Nick Somner to tell her the cost of the D45 valve. Nick replies, “Why do you want to know?” This response is appropriate from the standpoint of incremental analysis. The cost information that the senior manager needs to make a decision depends on the decision she is facing. Thus, “Why do you want to know?” is just Nick’s way of asking “What decision are you facing?” If the senior manager is thinking of dropping the product, Nick should provide information on the incremental costs that will be saved if the product is dropped. If she is thinking of increasing a production run, Nick should provide the incremental cost associated with this action. For example, if the product is dropped, the company may save the cost of setting up the production line, the cost of ordering materials, and the cost of supervision. None of these costs are relevant to a decision to increase a production run by 100 units since none of these costs will change with the addition of 100 units to a planned production run.

Chapter 2 Job-Order Costing for Manufacturing and Service Companies QUESTIONS 1. Manufacturing costs include all costs associated with the production of goods. Examples of manufacturing costs are: labor costs of workers directly involved with manufacturing goods, cost of all materials directly traced to products, indirect factory labor, indirect materials used in production, depreciation of production equipment, and depreciation of the manufacturing facility. Nonmanufacturing costs are all costs that are not associated with the production of goods. These typically include selling costs and general and administrative costs. 2. Product costs are assigned to goods produced. Product costs are assigned to inventory and become an expense when inventory is sold. Period costs are not assigned to goods produced. Period costs are identified with accounting periods and are expensed in the period incurred. 3. Two common types of product costing systems are (1) job-order costing systems and (2) process costing systems. Job-order costing systems are generally used by companies that produce individual products or batches of unique products. Companies that use job-order costing systems include custom home builders, airplane manufacturers, and shipbuilding companies. Process costing systems are used by companies that produce large numbers of identical items passing through uniform and continuous production operations. Process costing tends to be used by beverage companies and producers of chemicals, paints, and plastics. 4. A job cost sheet is a form that is used to accumulate the cost of producing a job. The job cost sheet contains information on direct materials, direct labor, and manufacturing overhead related to a particular job. 5. Actual overhead is not known until the end of the accounting period. If managers used actual overhead rates to apply overhead to jobs, they would have to wait until the end of the period to determine the cost of jobs. In order to make timely decisions, managers need to know the cost of jobs before the end of the accounting period.

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6. An important characteristic of a good overhead allocation base is that it should be strongly related to overhead cost. Assume that setup costs are classified as manufacturing overhead. The number of setups that a job requires would be a better allocation base for setup costs than would the number of direct labor hours worked on that job. Number of setups is more closely related to setup costs than is the number of direct labor hours and, therefore, number of setups is a better allocation base. 7. In highly automated companies where direct labor cost is a small part of total manufacturing costs, it is unlikely that overhead costs vary with direct labor. Further, in such companies, predetermined overhead rates based on direct labor may be quite large. Thus, even a small change in labor (the allocation base) could have a large effect on the overhead cost allocated to a job. Companies that are capital-intensive should consider using machine hours as an allocation base (or better still, they should consider the use of an activity-based costing system, which is discussed in more detail in Chapter 6). 8. It is necessary to apportion over- or underapplied overhead among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts if the amount in the Manufacturing Overhead account is material whether a debit or credit balance. This assumes that the balances in Work in Process and Finished Goods are relatively large. If a company used a just-in-time systems and these balances were quite small, then it would be reasonable to just close over- or underapplied overhead to Cost of Goods Sold. 9. An unexpected increase in production would typically result in overhead being overapplied. Overhead is applied using a predetermined rate which equals estimated total overhead cost (including variable and fixed overhead) divided by the estimated level of the allocation base. Overhead applied equals the predetermined rate times the actual use of the allocation base. An unexpected increase in production means that the fixed component of the predetermined overhead rate will be multiplied by a larger number than anticipated. Thus, more fixed overhead will be applied than the company is likely to incur. 10. As companies move to computer-controlled manufacturing systems and greater use of robotics, direct labor will likely decrease (due to decreased need for workers) and manufacturing overhead will likely increase (due to higher depreciation costs associated with the computer-controlled systems).

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EXERCISES E1. [LO 4] Managers at Company A will perceive that overhead cost allocated to jobs increases with the amount of direct labor used. If they are evaluated on how well they control the cost of jobs, they will try to cut back on labor, which not only reduces labor costs but also overhead allocated to jobs they supervise. Following similar logic, managers at Company B will cut back on machine time and managers at Company C will make a special effort to control material costs (by reducing waste, searching for lower prices, etc). Note that the measure of performance (reduction in job costs) combined with the approach to allocating overhead drives managers to focus on different factors—this is a good example of “You get what you measure!” E2. [LO 5, 7] If over- or underapplied overhead is large, we typically allocate it to Work in Process, Finished Goods and Cost of Goods Sold based on the relative balances in these accounts. However, if a company uses JIT, the balances in Work in Process and Finished Goods are likely to be quite small compared to the balance in Cost of Goods Sold. Thus, there will be only a small difference between assigning all of the over- or underapplied overhead to cost of goods sold versus apportioning it among the three accounts based on their relative balances. E3. [LO 4, 5] The predetermined overhead rate at Precision Custom Molds is $100 per direct labor hour ($20,000,000 ÷ 200,000). Given Job 525 has 25 direct labor hours, $2,500 of overhead would be applied to it ($100 x 25).

E4. [LO 3] a. P b. P c. J

d. J e. P f. J

E5. [LO 1, 2] a. Y b. N c. Y d. Y

e. N f. Y g. Y h. N

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E6. [LO 2, 4] Note that direct materials are charged to Work in Process Inventory while indirect materials are charged to Manufacturing Overhead. Work in Process Inventory 200,000 Raw Materials Inventory

200,000

Manufacturing Overhead Raw Materials Inventory

10,000

E7. [LO 2, 4] Note that direct materials are charged to Work in Process Inventory while indirect materials are charged to Manufacturing Overhead. Work in Process Inventory Raw Materials Inventory (250 + 350 + 400 + 500 = 1,500)

1,500

Manufacturing Overhead Raw Materials Inventory

100

1,500

100

E8. [LO 2, 4] Note that direct labor is charged to Work in Process Inventory while indirect labor is charged to Manufacturing Overhead. Work in Process Inventory Wages Payable

70,000

Manufacturing Overhead Wages Payable

50,000

70,000 50,000

Chapter 2 Job-Order Costing and Modern Manufacturing Practices E9. [LO 2, 4] a.

Job No. 201 110 hrs.  $10/hr 90 hrs.  $21/hr. 40 hrs.  $12/hr. Total

$1,100 1,890 480 $3,470

Job No. 202 50 hrs.  $20/hr.

$1,000

Job No. 203 70 hrs.  $18/hr.

$1,260

Labor Report for the month of February (by job):

Job 201 201 201

Time Ticket 2101 2102 2103

202 203

Hours 110 90 40 240

Rate 10.00 21.00 12.00

Cost $1,100 1,890 480 3,470

2104

20.00

1,000

2105

18.00

1,260

Total labor charges Work in Process Inventory Wages Payable

$5,730

5,730 5,730

E10. [LO 5] (1)

Predetermined overhead allocation rate based on direct labor hours: $900,000 ÷ 60,000 DLH = $15 per direct labor hour

(2)

Predetermined overhead allocation rate based on direct labor costs: $900,000 ÷ $1,800,000 = $0.50 per dollar of direct labor

(3)

Predetermined overhead allocation rate based on machine hours: $900,000 ÷ 30,000 machine hours = $30 per machine hour

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E11. [LO 4, 5, 6] a. The use of predetermined overhead rates makes it possible to cost jobs immediately after they are completed. If a company used an actual overhead rate, then job costs would not be available until the end of the accounting period. If Franklin Computer Repair charges customers based on actual job cost, it would be detrimental to customer service and company cash flows to have to wait until the end of the accounting period to bill customers. b. The overhead rate is: $500,000 ÷ $800,000 = $0.625 per dollar of technician wages. Total job cost = $200 + $100 + ($100 x $0.625) = $362.50 E12. [LO 4, 5] a. Predetermined overhead rates: Allocation base Direct labor hours

Predetermined Overhead Rate $1,000,000 ÷ 40,000 DLH = $25 per direct labor hour

Direct labor cost

$1,000,000 ÷ $625,000 = $1.60 per dollar of direct labor cost

Machine hours

$1,000,000 ÷ 20,000 MH = $50 per machine hour

Direct material cost

$1,000,000 ÷ $800,000 = $1.25 per dollar of direct material

b. Cost of Job No. 253 using different allocation bases: Cost Direct Materials Direct labor Manufacturing Overhead* Total

DLH $3,000 1,800 3,750 $8,550

*Overhead rates in “a” above x actual activity.

DL cost $3,000 1,800 2,880 $7,680

MH $ 3,000 1,800 7,500 $12,300

DM cost $3,000 1,800 3,750 $8,550

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E13. [LO 2, 4, 5] a. Overhead applied is equal to $3  $100,000 of direct labor = $300,000. Work in Process Inventory $300,000 Manufacturing Overhead

$300,000

b. Actual overhead is $260,000 Manufacturing Overhead 260,000 Raw Materials Inventory Wages Payable Utilities Payable Accumulated Depreciation Repairs Payable

40,000 80,000 25,000 60,000 55,000

E14. [LO 5, 7] a. Overhead applied is $300,000 while actual overhead is $260,000. Thus, Manufacturing Overhead has a $40,000 credit balance. The journal entry to close the account to Cost of Goods Sold is: Manufacturing Overhead Cost of Goods Sold

40,000 40,000

b. Closing the balance in Manufacturing Overhead leads to product costs that are consistent with actual overhead costs rather than estimated overhead costs. c. Because Star Plastics uses a just-in-time inventory system, the balances in Work in Process and Finished Goods are likely to be quite small compared to Cost of Goods Sold. Thus, there is not likely to be a significant difference between charging the entire amount of overapplied overhead to Cost of Goods Sold versus apportioning it among Work in Process, Finished Goods and Cost of Goods Sold. E15. [LO 4, 5] Cost Summary: Job 325 Direct Material Direct Labor (250 hours x $16/hour) Manufacturing Overhead: ($25 per direct labor hour x 250 hours) Total

$10,000 4,000 6,250 $20,250

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E16. [LO 4, 5, 6] Estimated overhead = $210,000 which is allocated based on cost of attorney and paraprofessional time. Budgeted salaries: (5  $100,000) + (9 x $50,000) = $950,000 Predetermined overhead rate = $210,000 ÷ $950,000 = $0.22 per dollar of attorney and paraprofessional time. If client services require $45,000 in salaries, then indirect costs assigned are: $45,000  $0.22 = $9,900. E17. [LO 5] Since the Manufacturing Overhead account has an ending credit balance (before adjustment), manufacturing overhead for the period is overapplied. The problem states that the balance is material—this suggests that we prorate the balance among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold.

Accounts

Balance Work in Process Inventory $ 500,000 Finished Goods Inventory 600,000 Cost of Goods Sold 900,000 Total $2,000,000 Manufacturing Overhead Work in Process Inventory Finished Goods Inventory Cost of Goods Sold

% of Total 25 30 45

Total Overapplied $90,000 90,000 90,000

Adjustment $22,500 27,000 40,500 $90,000

90,000 22,500 27,000 40,500

E18. [LO 7] Examples of negative events that would require a company holding inventory are as follows: 1. Strikes at a supplier would interrupt delivery of critical materials. 2. Unanticipated machine break-downs would interrupt production. 3. Natural disasters or terrorist attacks would interrupt the delivery of materials. E19. [LO 4] Estimated manufacturing overhead was $2,000,000 and eighty percent was fixed. When the sequence of material movements was changed and 30,000 of machine hours were saved, $1,600,000 (80% of $2,000,000) would remain unchanged. If variable manufacturing overhead is approximately $4 per hour ($400,000÷100,000) the new variable portion would be $280,000 ($4 x (100,000 – 30,000)) which would make the total overhead about $1,880,000. The savings is only $120,000 or $4 per hour, much less than $20 per hour.

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E20. Student answers will vary. See below for possible ideas. One concept is the calculation of cost of goods manufactured and cost of goods sold. This concept is very important to someone who is an accountant for a manufacturing company. Accountants will need accurate information about direct materials, direct labor, and manufacturing overhead in determining the cost of manufactured products. From there, accountants can calculate the company’s cost of goods sold. It is important for these numbers to be calculated correctly since an overstatement of cost of goods sold will lead to an understatement of net income and vice versa. Accountants have a responsibility to gather correct information and communicate this information to others who rely on it. Thus, accountants must make sure that accurate cost records are kept throughout each year.

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PROBLEMS P1. [LO 3] a.

Satterfield’s Custom Glass Schedule of Cost of Goods Manufactured For the Year Ended December 31, 2017

Beginning balance in work in process inventory Add current manufacturing costs: Direct material $2,500,000 Direct labor 3,000,000 Manufacturing overhead 1,700,000 Total Less ending balance in work in process inventory Cost of goods manufactured b.

$ 210,000

7,200,000 7,410,000 300,000 $7,110,000

Satterfield’s Custom Glass Income Statement For the Year Ended December 31, 2017

Sales Less cost of goods sold: Beginning finished goods inventory Add cost of goods manufactured Cost of goods available for sale Less ending finished goods inventory Gross profit Less nonmanufacturing expenses: Selling & admin. expenses Net income (loss)

$8,500,000 $ 500,000 7,110,000 7,610,000 400,000

7,210,000 1,290,000 1,350,000 ($ 60,000)

Chapter 2 Job-Order Costing and Modern Manufacturing Practices P2. [LO 3] a.

Terra Cotta Designs Schedule of Cost of Goods Manufactured For the Year Ended December 31, 2017

Beginning balance in work in process inventory Add current manufacturing costs: Direct material: Beginning balance $ 450,000 Purchases 1,500,000 Ending balance (200,000) $1,750,000 Direct labor 2,500,000 Manufacturing Overhead 650,000 Total Less ending balance in work in process inventory Cost of goods manufactured b.

$ 650,000

4,900,000 5,550,000 350,000 $5,200,000

Terra Cotta Designs Income Statement For the Year Ended December 31, 2017

$7,000,000 $ 750,000 5,200,000 5,950,000 350,000

500,000 850,000

5,600,000 1,400,000

1,350,000 $ 50,000

2-11

2-12 Jiambalvo Managerial Accounting P3. [LO 4] a. Cost of Jobs: Direct materials Direct labor Mfg. overhead Total

1005 $ 650 1,600 2,880* $5,130

1006 1007 $ 850 $ 1,550 2,000 3,300 3,600 5,940 $6,450 $10,790

1008 $ 650 1,400 2,520 $4,570

*$1,600 x 180%

b. Raw Material Inventory Accounts Payable (To record purchase of steel) Raw Material Inventory Cash (To record purchase of supplies)

5,500 5,500

2,400 2,400

Work in Process Inventory 4,500 Manufacturing Overhead 1,000 Raw Material Inventory (To record materials used in production) Work in Process Inventory Manufacturing Overhead Wages Payable (To record labor)

5,500

9,900 6,500 16,400

Work in Process Inventory 17,820 Manufacturing Overhead (To record overhead applied to production)

17,820

Finished Goods Inventory 26,940 Work in Process Inventory (To record cost of jobs completed)

26,940

Accounts Receivable 40,410 Cost of Goods Sold 26,940 Sales Finished Goods Inventory (To record the sale of finished goods)

40,410 26,940

1009 $ 450 900 1,620 $2,970

1010 $ 350 700 1,260 $2,310

Chapter 2 Job-Order Costing and Modern Manufacturing Practices P4. [LO 2, 3, 4] a. The beginning balance in Work in Process is $14,500: Job 258 $5,000 Job 259 6,000 Job 260 3,500 Total $14,500 The ending balance in Work in Process Inventory is $8,400: Job 345 $2,500 Job 346 5,900 Total $8,400 b. The beginning balance in Finished Goods Inventory is $9,000: Job 257 $9,000 The ending balance in Finished Goods Inventory is $11,700: Job 341 $ 1,500 Job 342 3,300 Job 343 2,400 Job 344 4,500 Total $11,700 c. Cost of goods sold is determined as follows: Beginning balance in work in process inventory Add current manufacturing costs: Direct material $ 750,000 Direct labor 1,650,000 Manufacturing overhead 2,150,000 Total Less ending balance in work in process inventory Cost of goods manufactured Beginning finished goods inventory Add cost of goods manufactured Cost of goods available for sale Less ending finished goods inventory Cost of goods sold

14,500

4,550,000 4,564,500 8,400 $4,556,100 $

9,000 4,556,100 4,565,100 11,700 $4,553,400

Job 257 through Job 340 likely relate to the balance of Cost of Goods Sold.

2-13

2-14 Jiambalvo Managerial Accounting P5. [LO 4, 5] a. Predetermined overhead rate based on labor hours: $12,000,000 ÷ 300,000 hours = $40 per labor hour Overhead assigned to the model K25 shoe based on labor hours: $40 x 11,000 hours = $440,000

Predetermined overhead rate based on labor cost: $12,000,000 ÷ $4,800,000 = $2.50 per labor dollar Overhead assigned to the model K25 shoe based on labor cost: $2.50 x $165,000 = $412,500 b. Direct labor cost is the preferred allocation base because workers paid a higher rate work on more complex jobs, and more complex jobs lead to more overhead cost. P6. [LO 4, 5] a. Predetermined overhead rate based on direct labor cost: $200,000 ÷ $300,000 labor cost = $0.67 per labor dollar Predetermined overhead rate based on direct labor hours: $200,000 ÷ 25,000 hours = $8.00 per labor hour Predetermined overhead rate based on machine hours: $200,000 ÷ 8,000 machine hours = $25 per machine hour

Overhead based on labor cost Job 9823 Job 9824 Direct material $ 1,000 $2,000 Direct labor 1,400 1,400 Mfg. overhead 938 938 Total $3,338 $4,338

Chapter 2 Job-Order Costing and Modern Manufacturing Practices

Material Labor Overhead* Total

2-15

Overhead based on labor hours Job 9823 Job 9824 $ 1,000 $ 2,000 1,400 1,400 1,200 1,040 $ 3,600 $ 4,440

*Actual direct labor hours x $8

Overhead based on machine hours Job 9823 Job 9824 Material $1,000 $ 2,000 Labor 1,400 1,400 Overhead* 3,250 6,750 Total $5,650 $10,150 *Actual machine hours x $25

c. Given that depreciation on equipment accounts for 75 percent of applied overhead costs, an allocation based on machine hours seems reasonable. However, users of the job cost information should keep in mind that the applied overhead portion of job cost is not an incremental cost. P7. [LO 5] a.

Net Income, if over-applied overhead is immaterial and assigned to Cost of Goods Sold.

OH applied = .75 x $700,000 = Actual OH =

$525,000 450,000 $ 75,000

Therefore, overhead was over-applied by $75,000 Sales CGS ($1,000,000 - $75,000) Gross Profit Selling & Admin. Expenses Net Income

$2,500,000 925,000 1,575,000 1,000,000 $ 575,000

2-16 Jiambalvo Managerial Accounting b.

Net Income, if over applied overhead is material and prorated among appropriate accounts.

Balance WIP Inventory $ 80,000 FG Inventory 48,000 COGS 1,000,000 Total $1,128,000

Proportion 0.071 0.043 0.886* 1.000

Adjusted Adjustment Balance $ 5,325 $ 74,675 3,225 44,775 66,450 933,550 $75,000 $1,053,000

*Rounded so total equals 1.000

Sales CGS Gross Profit Selling Expenses Admin Expenses Net Income c.

$2,500,000 933,550 1,566,450 400,000 600,000 $ 566,450

Charging the entire amount of overapplied overhead to Cost of Goods Sold results in higher net income than prorating overapplied overhead among Work in Process, Finished Goods, and Cost of Goods Sold.

P8. [LO 5] a. If overapplied overhead is assigned to Cost of Goods Sold, the adjusted balance will be: $440,000 - $50,000 = $390,000. b. If overapplied overhead is assigned to Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold, the adjusted balances will be:

WIP Inv. FG Inv. COGS Total

Balance $ 66,000 44,000 440,000 $550,000

Proportion 0.12 0.08 0.80 1.00

Adjustment $ 6,000 4,000 40,000 $50,000

P9. [LO 4, 5, 6] a. Indirect cost per hour of service is $65: 50 professionals  1,600 hours = 80,000 hours per year. $5,200,000 indirect cost ÷ 80,000 hours = $65 per hour.

Adjusted Balance $ 60,000 40,000 400,000 $500,000

Chapter 2 Job-Order Costing and Modern Manufacturing Practices

2-17

b. Estimated cost of services for a potential client: Average salary per billable hour = $120,000 per year ÷ 1,600 hours = $75 per hour. Professional service (100 hours  $75 per hour) Indirect costs (100 hours  $65 per hour) Total

$ 7,500 6,500 $14,000

P10. [LO 2, 4] a. $30,000 + $40,000 -$15,000 = $55,000 b. $80,000 + $55,000 +$45,000 + $63,000 - $82,000 = $161,000 c. $95,000 + $161,000 - $110,000 = $146,000 d. $70,000 - $60,000 = $10,000 P11. [LO 4, 5] a. The predetermined overhead rate is $2.57 per direct labor dollar ($9,000,000 ÷ 3,500,000 = $2.57). b. Work in Process Inventory 5,750,000 Raw Materials Inventory

5,750,000

c. Work in Process Inventory 4,000,000 Wages payable

4,000,000

d. Work in Process Inventory 10,280,000 Manufacturing Overhead ($4,000,000  $2.57 = $10,280,000)

10,280,000

e. Cost of Goods Sold 720,000 Manufacturing overhead ($11,000,000 - $10,280,000 = $720,000)

720,000

P12. [LO 4, 5] a.

Job 201 Job 202 Job 203

$17,000 × $3.25 = $20,500 × $3.25 = $9,000 × $3.25 =

55,250 66,625 29,250 $ 151,125

2-18 Jiambalvo Managerial Accounting b.

Job 201

$9,500 × $3.33 = $3,000 × $4.76 = $4,500 × $2.40 =

$ 31,635 14,280 10,800 56,715

Job 202

$5,000 × $3.33 = $6,500 × $4.76 = $9,000 × $2.40 =

16,650 30,940 21,600 69,190

Job 203

$2,000 × $3.33 = $5,000 × $4.76 = $2,000 × $2.40 =

6,660 23,800 4,800 35,260

Total

$161,165

c. It appears that the relation between overhead and labor cost is different in the three production departments. Thus, it is preferable to use separate overhead rates for each. P13. [LO 2, 4, 5] a. Confectioners’ sugar (2,100 lbs.  $0.80) Granulated sugar (2,300 lbs.  $0.90) Chocolate (900 lbs.  $4.00) Caramel (300 lbs.  $1.50) Eggs (60 doz.  $0.85) Paraffin (90 lbs.  $0.50)

$1,680 2,070 3,600 450 51 45 $7,896

Chapter 2 Job-Order Costing and Modern Manufacturing Practices Raw Materials Inventory Accounts payable (various) Cash (To record purchase of sugar, chocolate, caramel, eggs, & paraffin)

7,896

Work in Process Inventory Wages Payable (To record direct labor cost)

5,400

Manufacturing Overhead Wages Payable (To record indirect labor cost)

2,500

Manufacturing Overhead Utilities Payable Rent Payable Accounts Payable (To record overhead costs incurred)

6,150

7,800 96

5,400

2,500

400 750 5,000

Work in Process Inventory 6,896 Raw Materials Inventory 6,896 (To record raw materials used: $2,500 + 7,896 - $3,500 = $6,896) Work in Process Inventory 7,650 Manufacturing Overhead 7,650 (To record overhead cost applied to jobs = $17  450 hours) Finished Goods Inventory 21,446 Work in Process Inventory 21,446 (To record production of finished goods: $6,500 + $5,400 + $6,896 + $7,650 – $5,000 = $21,446) Accounts Receivable Sales Revenue (To record sales)

35,000

Selling & Admin. Expenses 9,000 Accounts Payable (To record nonmanufacturing expenses incurred)

35,000

9,000

2-19

2-20 Jiambalvo Managerial Accounting Cost of Goods Sold 24,446 Finished Goods Inventory 24,446 (To record cost of sales: $9,000 + $21,446 - $6,000) Cost of Goods Sold 1,000 Manufacturing Overhead 1,000 (To record allocation of underapplied overhead to CGS) (6,150 + 2,500 - 7,650 = 1,000) Lane Confectioners Income Statement for the Month of March

Revenue Cost of goods sold Gross margin Selling & Admin. Exp. Net income (loss)

$35,000 25,446 ($24,446 + $1,000) 9,554 9,000 $ 554

P14. [LO 4, 5] Approximately 66 percent of overhead costs ($160,000 + $135,000) ÷ $450,000 are related to machinery. Without additional information, it appears that machine hours would be an appropriate overhead allocation base. The predetermined overhead allocation rate = $450,000 ÷ 15,000 machine hours = $30 per machine hour.

P15. [LO 5, 6] Overhead is overapplied Applied overhead ($6 x 35,000) Actual overhead Overapplied overhead

$210,000 200,000 $ 10,000

P16. [LO 5, 6] a. The predetermined overhead rate is $17 per repair technician hour ($170,000 ÷ 10,000 = $17). b. Overhead applied = $17  7,000 = $119,000 Overhead applied is $119,000 while actual overhead is $140,000. Thus, overhead is underapplied by $21,000 ($119,000 – $140,000 = $21,000)

Chapter 2 Job-Order Costing and Modern Manufacturing Practices

2-21

c. The journal entry to close the account to Cost of Goods Sold is: Cost of Goods Sold Manufacturing Overhead

21,000 21,000

P17. [LO 4, 5, 6] a. The predetermined overhead rate is $2,750 per hour of operating room use. ($5,500,000 ÷ 2,000 hours = $2,750). The total overhead charge to Candice for 3 hours of operating room usage is $8,250 ($2,750 x 3 hours).

b. The total cost of the knee surgery is $24,250: Pharmacy Sterile supply Supplies other OR services Anesthesia Anesthesiologist OR overhead charges

450 1,500 4,500 4,500 1,500 3,500 8,250 $24,200

2-22 Jiambalvo Managerial Accounting Case 2-1. [LO General chapter concepts and ethics]

BRIXTON SURGICAL DEVICES Summary The COO and CFO of a public company are coming up with “schemes” to manage earnings up in an effort to beat an aggressive earnings target which determines their bonus compensation. •

Indicates how profit can be “boosted” by overproduction.

•

Indicates how channel stuffing can boost profit.

•

Raises the interesting question “Does compliance with GAAP equate to ethical behavior?”

Questions to ask students 1. What’s the situation at Brixton Surgical Devices? 2.

How do Ed and Robin plan to increase profit?

Are their planned methods ethical and how will they affect shareholder value?

Discussion Ed (the COO) and Robin (the CFO) realize that their company is not likely to meet their earnings target and, in consequence, they won’t receive bonuses. To increase profit, they plan to offer discounts to customers for orders in October and November that can be shipped in December. This strategy is sometimes referred to as “channel stuffing” since the sales channel is being “stuffed” with merchandise. In reality, the company is simply moving sales that would have taken place next year into the current year. Arguably, this does not violate GAAP, since the company has actual orders that are shipped before year-end. However, this would require complete footnote disclosure in the annual report or shareholders might be misled and think there is a permanent increase in revenue. And, they may react quite negatively when profit is down in the first quarter of the next year. The second strategy, increasing production to lower unit costs and bury fixed production costs in inventory, also, most likely, does not violate GAAP. But it certainly hurts shareholder value. The company is using shareholders’ money to make an investment in inventory that is not really needed. Are these two strategies ethical? The answer to this question is, of course, subjective. Based on the ethical framework presented in chapter 1, I believe the strategies are not ethical. Consider questions 3 and 5 from the 7 question framework: 3.

Will an individual or an organization be harmed by any of the alternatives?

Chapter 2 Job-Order Costing and Modern Manufacturing Practices 5.

2-23

Would someone I respect find any of the alternatives objectionable?

Shareholders are harmed by the buildup in inventory and they will be misled by channel stuffing unless there is full disclosure (which would not suit the aims of the COO and CFO). Also, it seems quite likely that someone the COO and CFO respect will find the strategies objectionable.

2-24 Jiambalvo Managerial Accounting Case 2-2. [LO 4. 5, 6]

YSL MARKETING RESEARCH Summary Marketing research firm is bidding on a job and is considering various costs. •

Requires calculation of full cost and consideration of incremental costs including opportunity costs.

•

Brings up the importance of factors that are difficult to quantify.

Questions to ask students 1. Summarize the situation facing YSL Marketing Research. 2. What is the expected full cost of the Surenex engagement? 3. What is the lowest amount that Connie Bachmann, a partner at YSL, can bill without hurting company profit? 4. What should Connie consider in addition to the amount just calculated? Discussion Begin the discussion by asking a student to summarize the situation facing YSL Marketing Research. The company has been asked to conduct a survey for Surenex—a firm that has the potential to be a valued long-run client. However, Surenex is not currently willing to pay YSL’s normal billing rates, due to its current cash-flow challenges. a. A student is then asked to calculate the full cost of the project. Full Cost Partner salary (40 hours  $120) Staff salary (100 hours  $40) Direct charges Overhead (.31  $8,800) Total

$4,800 4,000 3,000 2,728 $14,528

Overhead calculation Estimated overhead $ 496,000 ÷ Estimated professional compensation 1,600,000 Overhead rate $ 0.31 b. What is the lowest amount that Connie can bill on this engagement without hurting company profit? The point of this question is to show that the answer is neither the full cost ($14,528) nor the variable cost of the job (assuming the

Chapter 2 Job-Order Costing and Modern Manufacturing Practices

2-25

variable costs are salaries and direct charges). To answer the question, students must consider the fact that if the Surenex job is undertaken, YSL will need to turn down business for which it can bid 1.5 times compensation plus out-of-pocket costs. That is, students must consider opportunity cost. If the company takes on the Surenex job, it will miss out on billing $13,200 (1.5 x $8,800) of professional compensation on some other job. In addition, to avoid hurting profit, the company must cover out-of-pocket costs. Thus, the lowest amount that Connie can bill is $16,200. Professional compensation

$4,800 4,000 $8,800

Salaries ($8,800  billing at 1.5 times) $13,200 Plus: Direct out-of-pocket costs 3,000 Total $16,200 c. The discussion concludes with the question, “What should Connie consider in addition to the amount just calculated?” Hopefully, a student will recognize that our previous analysis was short sighted in that we did not consider the fact that Surenex may end up being a hot company with “premium billing opportunities.” Therefore, YSL may be better off in the long-run by setting a relatively low price on the current job. Even a price that does not cover salaries and direct charges could be warranted if the prospect for future profit, from working for Surenex, is very high.

2-26 Jiambalvo Managerial Accounting Case 2-3. [LO 4, 5]

DUPAGE POWDER COATING Summary A company has bought a computer-controlled, electrostatic powder coating system. The result is overhead has increased (due to depreciation of the system) and labor hours have decreased. Since labor hours is the overhead allocation base, the overhead rate has increased. It now appears that small jobs, which still use the old manual system, are more costly than they were in the prior year—even though they are processed using the same equipment and labor as in the prior year. •

Indicates how costs can be distorted by overhead allocation.

Questions to ask students 1. What’s the situation at DuPage Powder Coating? 2.

What would the job have cost in the prior year and what did it cost this year?

Why have the cost of small jobs increased?

4. Should the company increase the prices of small jobs since costs have increased? Discussion a. The cost of the job in the current year is: Direct material $500 Direct labor (7 hours x $20) 140 Manufacturing overhead (7 labor hours x $22.15) 155 Total cost $795 b. The cost of the job in the prior year was: Direct material Direct labor (7 hours x $20) Manufacturing overhead (7 labor hours x $12)) Total cost

$500 140 84 $724

Chapter 2 Job-Order Costing and Modern Manufacturing Practices

2-27

The new overhead rate is determined as follows: Expected total overhead ÷ Expected labor hours Overhead rate

$1,440,000 65,000 $22.15

c. The fact that the cost of this job has increased from $724 to $795 does not indicate that the company is less efficient at handling small jobs in the current year. The increase is due to the purchase of the new equipment (which this job does not even use), which increased overhead and reduced labor, resulting in a large increase in the overhead rate. d. The decision to raise the price of small jobs should not be affected by the apparent increase in the cost of small jobs—that increase is artificial in that small jobs don’t even use the equipment that led to the higher overhead rate. A price increase should be determined based on an analysis of capacity and opportunity costs.

Chapter 3 Process Costing QUESTIONS 1. Job-order costing is used when a company produces individual products or batches of products that are unique. Generally, each unique product or batch is a “job” for which the company needs cost information. Therefore, manufacturing costs must be traced to specific jobs. Process costing, on the other hand, is used when a company produces large quantities of identical items. It is basically a system of averaging. The production costs are divided by the number of units to arrive at an average unit cost. 2. Student answers will vary but here is one possible answer. Three types of manufacturing companies which might use process costing include pharmaceutical firms, paint manufacturers, and chemical manufacturers. In each of these companies, the products are relatively homogenous and produced in large batches. In many cases, a product suitable for process costing will be a low-cost product, but not necessarily (i.e., various drugs can be expensive, as can various chemicals). 3. Equivalent units is the quantity of partially completed units expressed in terms of whole units. To calculate equivalent units, the number of units is multiplied by the percentage of completion. 4. Direct labor and manufacturing overhead, together, are called conversion costs. 5. The costs associated with units received from a preceding department within the company for further processing are called transferred-in costs. 6. Material may enter at the start of a production process while labor and overhead are incurred throughout the process. 7. Cost to account for = Cost in beginning work in process + Cost incurred in current period. 8. Reconciliation helps to ensure that mistakes are not made in calculations and units are not “lost.” 9. Transferred-in costs are the costs associated with units received from a preceding department within the company received for further processing. Therefore, they occur in all production departments except the first. 10. The four steps involved in preparing a production cost report are as follows: a. Account for the number of physical units b. Calculate the cost per equivalent unit for material, labor, and overhead c. Assign costs to items completed and items in ending work in process d. Account for the amount of product cost

3-2

Jiambalvo Managerial Accounting

EXERCISES E1. [LO 2] In the production of chips, much of manufacturing overhead is a fixed cost. This cost is assigned to completed items and work in process. By starting a large number of items at year end, and given the simplifying assumption that items in process are 50% complete, a significant proportion of the fixed manufacturing overhead will end up in work in process, which reduces the cost of finished items and ultimately the cost of goods sold. The result is that profit will be artificially inflated in the current period. This approach to increasing profit may mislead investors and other stakeholders and cause them to make bad decisions. Thus, the behavior is not ethical. E2. [LO 2] Cost per equivalent unit is calculated for material, labor and overhead. For each of these items, we sum the cost in beginning work in process and the cost incurred during the period. This becomes the numerator of the calculation. Then, we determine the number of units completed and the equivalent units in ending work in process. This becomes the denominator of the calculation. It is important to note that the equivalent units in ending work in process may be different for material, labor, and overhead. This is because material, labor, and overhead enter the production process at different times. Materials often enter the process at the beginning of the process, and labor and overhead are added evenly throughout the process. E3. [LO 1] The four cost items that may enter a processing department are direct materials, direct labor, manufacturing overhead, and transferred-in costs. E4. [LO 3] Case 1 Units in ending work in process Plus: Units completed during October Less: Units in beginning work in process Units started during October

2,500 15,000 (5,000) 12,500

Case 2 Units in beginning work in process

16,000

Plus: Units started during March

4,000

Units to account for

20,000

Less: Units in completed during March

(14,400)

Units in ending work in process

5,600

Chapter 3 Process Costing Case 3 Units in beginning work in process

300,000

Plus: Units started during December

950,000

Units to account for

1,250,000

Less: Units in ending work in process

(350,000)

Units completed during December

900,000

E5. [LO 3] Units in beginning work in process Units started in August Units to account for

850 95,000 95,850 cans

Units completed Units in ending work in process Total units accounted for

90,000 ? 95,850 cans

Units in ending work in process = 95,850 - 90,000 = 5,850 cans. E6. [LO 3] Units in beginning work in process Units started in August Units to account for

4,500 ? 38,000 gallons

Units completed Units in ending work in process Total units accounted for

31,000 7,000 38,000 gallons

Units started in August = 38,000 − 4,500 = 33,500 gallons. E7. [LO 2] Direct Labor Beginning WIP Cost incurred in March Total cost Units Units completed Equivalent units, ending WIP (10,000 pounds  50%) Total

$140,000 800,000 $940,000

35,000 pounds 5,000 40,000 pounds

Cost per equivalent unit = $940,000 ÷ 40,000 pounds = $23.50 per pound

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Jiambalvo Managerial Accounting

E8. [LO 3] Let X = the cost in beginning work in process Material: ($260,000 + X) ÷ (40,000 + 10,000) = $6 X = $40,000 Labor: ($120,000 + X) ÷ (40,000 + 3,000) = $3 X = $9,000 Overhead: ($161,000 + X) ÷ (40,000 + 3,000) = $4 X = $11,000 E9. [LO 2] The denominator is equal to units completed plus equivalent units in ending work in process. Material Units completed Equivalent units in ending work in process (600  0.90) Total

2,000 540 2,540

Conversion Units completed Equivalent units in ending work in process (600  0.50) Total

2,000 300 2,300

Chapter 3 Process Costing

3-5

E10. [LO 2, 3] a. Cost per equivalent unit for material is $6.00. Material cost in items completed is $222,000. Therefore, the number of completed units is 37,000 (i.e., $222,000 ÷ $6.00). Units in beginning work in process Units started in July Units to account for

2,500 40,000 42,500 cans

Units completed Units in ending work in process Total units accounted for

37,000 ? 42,500

This implies that 5,500 units are in ending work in process (42,500 - 37,000 = 5,500). b. Cost of ending work in process is $9,625 as follows: Material (.25  5,500 units  $6.00) Labor and overhead (.1  5,500 units  $2.50) Ending work in process

$8,250 1,375 $9,625

E11. [LO 2] Ending Work in Process Material (950  1.0  $0.80) Labor and overhead (950  .75  $0.90) Total

$760 641 $1,401

Cost of Items Completed Material (4,500  $0.80) Labor and overhead (4,500  $0.90) Total

$3,600 4,050 $7,650

E12. [LO 2] Ending Work in Process Material (20 x .85 x $2,050) Labor (20 x .80 x $800) Overhead (20 x .80 x $1,500) Total

$ 34,850 12,800 24,000 $71,650

3-6

Jiambalvo Managerial Accounting Cost of Items Completed Material (95  $2,050) Labor (95  $800) Overhead (95  $1,500) Total

$194,750 76,000 142,500 $413,250

E13. [LO 2] a. Material: Cost in beginning work in process Cost incurred during the period Total

$ 30,000 421,990 $451,990

Conversion costs: Cost in beginning work in process Cost incurred during the period Total

$ 13,000 394,880 $407,880

Equivalent units in ending work in process: Material (3,000 units  .85) Conversion costs (3,000  .45)

2,550 1,350

Cost per equivalent unit for material: $451,990 ÷ (45,000 + 2,550) Cost per equivalent unit for conversion costs: $407,880 ÷ (45,000 + 1,350) Total cost per equivalent units b. Cost of items completed in November: 45,000 units  $18.31

$9.51 8.80 $18.31

$823,950

c. Cost of ending work in process: Material cost (2,550  $9.51) Conversion cost (1,350  $8.80) Total cost of ending work in process

$24,251 11,880 $36,131

E14. [LO 2,3] Units in beginning WIP Units started during June Units to account for Less: Units in ending WIP Units Completed

40,000 500,000 540,000 (30,000) 510,000

Chapter 3 Process Costing Equivalent Unit Calculation Units Units completed Equivalent units Ending WIP (100% material, 75% conversion costs) Total

Material 510,000

Labor 510,000

Overhead 510,000

30,000 540,000

22,500 532,500

E15. [LO 2, 3] Units in beg. WIP Units started during May Units to account for Less: Units in Ending WIP Units Completed

2,300,000 770,000 3,070,000 (235,000) 2,835,000

Equivalent Unit Calculation Units Units completed Equivalent units Ending WIP (100% material, 60% conversion costs) Total

Material 2,835,000

Conversion 2,835,000

235,000 3,070,000

141,000 2,976,000

E16. [LO 1, 2] Units in beg. WIP Units started during the year Units to account for Less: Units in Ending WIP Units Completed Equivalent Unit Calculation Units Units completed Equivalent units ending WIP (80% material, 45% conversion costs) Total

45,000 200,000 245,000 (60,000) 185,000

Material 185,000

Conversion 185,000

48,000 233,000

27,000 212,000

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Jiambalvo Managerial Accounting

E17. [LO 2] Cost per Equivalent Unit Calculation

Cost Beginning WIP Cost incurred during Sept. Total

Material

Conversion

Total

$ 50,000 200,000 $250,000

$ 45,000 280,000 $325,000

$ 95,000 480,000 $575,000

Equivalent units

18,000*

16,200**

Cost per equivalent unit

$13.89

$20.06

$33.95

*15,000 + 3,000 = 18,000 **15,000 + (3,000 × .40) = 16,200

E18. [LO Incremental Analysis. The sales price should be lowered because the total net income increases by $5,000 over the current level. Units sold

112,000

Direct material ($.25 × 112,000) $ 28,000 Direct labor 112,000 Manufacturing overhead 200,000 Total cost $340,000 Profit is $80,000 [(112,000 x $3.75) - $340,000] New profit Current profit Incremental profit

$ 80,000 75,000 $ 5,000

Chapter 3 Process Costing

3-9

PROBLEMS P1. [LO 2] a. The company started the month with 11,000 units and 105,000 units were entered into production. Thus, the company must account for 116,000 units. At the end of the month, the company had 5,100 units in ending work in process. This implies that 110,900 units were completed (116,000 - 5,100). The denominators for the calculations of cost per equivalent are:

Material Labor Overhead

Units Completed 110,900 110,900 110,900

Beginning WIP Material $4,000.00 Labor 200.00 Overhead 300.00 Total $4,500.00

Equivalent Units in Ending WIP 5,100 3,570 3,570

Total 116,000 114,470 114,470

Cost Added Total Denominator Cost per EU $76,040.00 $80,040.00 116,000 $0.69 8,957.60 9,157.60 114,470 0.08 10,002.30 10,302.30 114,470 0.09 $94,999.90 $99,499.90 $0.86

b. Cost of items completed in May is $95,374.00: 110,900 units x $0.86 = $95,374.00 Cost of items in ending work in process: Material (5,100 equivalent units  $0.69) Labor (3,570 equivalent units  $0.08) Overhead (3,570 equivalent units  $0.09) Total

$3,519.00 285.60 321.30 $4,125.90

c. Beginning work in process Cost added Total

$ 4,500.00 94,999.90 $99,499.90

Cost of items completed Cost of ending WIP Total

$95,374.00 4,125.90 $99,499.90

3-10 Jiambalvo Managerial Accounting P2. [LO 2] a. The company started the month with 600 units and 2,700 units were entered into production. Thus, the company must account for 3,300 units. At the end of the month, the company had 700 units in ending work in process. This implies that 2,600 units were completed (3,300 - 700). The denominators for the calculations of cost per equivalent are:

Material Labor Overhead

Units Completed 2,600 2,600 2,600

Equivalent Units in Ending WIP Total 490* 420** 420**

3,090 3,020 3,020

*(700×.70); **(700×.60)

Material Labor Overhead Total

Beginning WIP $ 45,000 11,000 80,000 $136,000

Cost Added $267,090 76,580 496,820 $840,490

Total Denominator $312,090 3,090 87,580 3,020 576,820 3,020 $976,490

b. Cost of items completed in August is $834,600: 2,600 units x $321.00 = $834,600 Cost of items in ending work in process: Material (490 equivalent units  $101.00) Labor (420 equivalent units  $29.00) Overhead (420 equivalent units  $191.00) Total

$ 49,490.00 12,180.00 80,220.00 $141,890.00

c. Beginning work in process Cost added Total

$136,000.00 840,490.00 $976,490.00

Cost of items completed Cost of ending WIP Total

$834,600.00 141,890.00 $976,490.00

Cost per EU $101.00 29.00 191.00 $321.00

Chapter 3 Process Costing

3-11

P3. [LO 2, 3] a. Kao Tiles, Inc—October Unit Reconciliation Units in beg. WIP (65% material, 35% conversion costs) Units started during Units to account for

5,000 6,000 11,000

Units completed Units in ending WIP (75% material, 50% conversion costs) Units accounted for

4,000* 7,000 11,000

*Computed as 11,000 - 7,000 = 4,000. Cost per Equivalent Unit Calculation

Cost Beginning WIP Cost incurred during Oct. Total Units Units completed Equivalent units Ending WIP (75% material, 50% conversion cost) Total Cost per equivalent unit

Material

Labor

Overhead

Total

$170,000 422,000 $592,000

$160,000 1,055,000 $1,215,000

$ 50,000 107,500 $157,500

$ 380,000 1,584,500 $1,964,500

4,000

5,250 9,250

3,500 7,500

$64

$162

$21

$247

Cost Reconciliation Total cost to account for

$1,964,500

Cost of completed units (4,000 units x $247) Cost of ending WIP Material (5,250 equivalent units x $64) Labor (3,500 equivalent units x $162) Overhead (3,500 equivalent units x $21) Total cost accounted for

$ 988,000

b. Finished Goods Inventory Work in Process Inventory

$336,000 567,000 73,500

976,500 $1,964,500

988,000 988,000

3-12 Jiambalvo Managerial Accounting P4. [LO 2, 3] Aussie Yarn Company—August Unit Reconciliation Units in beg. WIP ((100% material, 70% conversion costs) Units started during Units to account for

7,000 34,000 41,000

Units completed Units in ending WIP (100% material, 50% conversion costs) Units accounted for

33,000* 8,000 41,000

*Computed as 41,000 - 8,000 = 33,000. Cost per Equivalent Unit Calculation

Cost Beginning WIP Cost incurred during August Total Units Units completed Equivalent units, ending WIP Total Cost per equivalent unit

Material

Labor

Overhead

Total

$ 6,000 26,390 $32,390

$ 2,000 12,430 $14,430

$ 2,500 14,520 $17,020

$10,500 53,340 $63,840

33,000

8,000 41,000

4,000 37,000

$0.79

$0.39

$0.46

$1.64

Cost Reconciliation Total cost to account for

$63,840

Cost of completed units (33,000 units x $1.64) Cost of ending WIP Material (8,000 equivalent units x $0.79) Labor (4,000 equivalent units x $0.39) Overhead (4,000 equivalent units x $0.46) Total cost accounted for

$54,120 $6,320 1,560 1,840

9,720 $63,840

Chapter 3 Process Costing

3-13

P5. [LO 1] a.

Work in process, dept. 1 80,000 Material inventory To record material used in department 1

80,000

Work in process, dept. 2 15,000 Material inventory To record material used in department 2

15,000

Work in process, dept. 1 Wages payable To record labor in department 1

40,000 40,000

Work in process, dept. 2 Wages payable To record labor in department 2

70,000

Work in process, dept. 1

220,000

70,000

Manufacturing overhead To record overhead applied in department 1 Work in process, dept. 2 100,000 Manufacturing overhead To record overhead applied in department 2 d.

Work in process, dept. 2 Work in process, dept. 1

220,000

100,000

364,000 364,000

To record cost of units transferred from department 1 to department 2 Note: This includes all beginning costs and costs incurred, since there is no ending work in process in this department (24,000 + 80,000 + 40,000 + 220,000). Finished goods inventory 563,000 Work in process, dept. 2 563,000 To record cost units completed and transferred to finished goods. Note: 44,000 + 15,000 + 70,000 + 100,000 + 364,000 – 30,000 = 563,000.

3-14 Jiambalvo Managerial Accounting P6. [LO 1] a.

Work in process (125,000 × $0.90 ×.40) Material inventory To record material used in production

45,000

Work in process (125,000×$0.90×.15) Wages payable To record labor

16,875

Work in process (125,000×$0.90×.45) Manufacturing overhead To record overhead applied

50,625

45,000

16,875

50,625

Finished goods inventory 112,500 Work in process (16,875+50,625+45,000) To record cost of units completed Cost of goods sold Finished goods inventory To record cost of units sold

P7. [LO 2, 3] a. 1,100 = (3,400 – 2,300) b. 3,400 c. 1,100 d. 770 = (1,100 x .70) e. 770 f. 3,400 = (1,100 + 2,300) g. 3,070 = (2,300 + 770) h. 3,070 = (2,300 + 770) i. 1.35 = (4,600 ÷ 3,400) j. 4.17 = (12,810 ÷ 3,070) k. 8.54 = (26,230 ÷ 3,070) l. 14.06 = (1.35 + 4.17 + 8.54)

112,500

112,500 112,500

Chapter 3 Process Costing P8. [LO 2, 3] Step 1. Cost per equivalent unit = 1.80 + 1.40 + 2.64 = 5.84 Cost of completed items (given) = $3,007,600 Cost per equivalent unit = $5.84 Therefore, the number of completed units = $3,007,600 ÷ 5.84 = $515,000 Step 2. Units in ending WIP (given) Add number of completed units Units accounted for

5,000 515,000 520,000

Step 3. Units accounted for Less units in beginning WIP (given) Units started during December

520,000 8,000 512,000

Step 4. Equivalent units, ending WIP: Material (5,000 x 100%) Labor (5,000 x 20%) Overhead (5,000 x 20%) Step 5. Units completed (calculated above) Total units for cost per equivalent unit calculation: Material = 515,000 + 5,000 Labor and Overhead = 515,000 + 1,000

5,000 1,000 1,000

515,000 520,000 516,000

Step 6. Total cost in cost per equivalent unit calculation: Material = 520,000 x $1.80 Labor = 516,000 x $1.40 Overhead = 516,000 x $2.64

$936,000 $722,400 $1,362,240

Step 7. Cost incurred in December: Material = $936,000 – 45,200 Labor = $722,400 – 10,500 Overhead = $1,362,240 − 26,300

$890,800 $711,900 $1,335,940

3-15

3-16 Jiambalvo Managerial Accounting Step 8. Cost Reconciliation: Total cost to account for ($936,000 + $722,400 + $1,362,240)

$3,020,640

Cost of completed units (515,000 x $5.84) Cost of Ending WIP Materials (5,000 x $1.80) Labor (1,000 x $1.40) Overhead (1,000 x $2.64) Total cost accounted for:

$3,007,600 $9,000 1,400 2,640

13,040 $3,020,640

P9. [LO 2, 3] Mixing Department, Simply Shine Shampoo—March Unit Reconciliation Units in beg. WIP (100% material, 90% conversion costs) Units started during Units to account for

15,000 660,000 675,000

Units completed Units in ending WIP (100% material, 70% conversion costs) Units accounted for

635,000* 40,000 675,000

*Computed as 675,000 − 40,000 = 635,000. Cost per Equivalent Unit Calculation Material Cost Beginning WIP Cost incurred during March Total Units Units completed Equivalent units, ending WIP Total Cost per equivalent unit

Labor

8,500 $ 1,200 254,750 78,360 $263,250 $79,560

Overhead $

2,500 130,100 $132,600

635,000

40,000 675,000

28,000 663,000

$0.39

$0.12

$0.20

Total $ 12,200 463,210 $475,410

$0.71

Chapter 3 Process Costing

3-17

Cost Reconciliation Total cost to account for

$475,410

Cost of completed units (635,000 units  $0.71) Cost of ending WIP Material (40,000 equivalent units x $.39) Labor (28,000 equivalent units x $.12) Overhead (28,000 equivalent units x $.20) Total cost accounted for

$ 450,850 $15,600 3,360 5,600

24,560 $475,410

Packing Department, Simply Shine Shampoo—March Unit Reconciliation Units in Beg. WIP (60% material, 50% conversion costs) Units started during Units to account for

14,500 635,000 649,500

Units completed Units in ending WIP (80% material, 60% conversion costs) Units accounted for *Computed as 649,500 − 38,000 = 611,500.

611,500* 38,000 649,500

Cost per Equivalent Unit Calculation Material Cost Beginning WIP Cost incurred during Mar. Total Units Units completed Equivalent units, ending WIP Total Cost per equivalent unit

Labor Overhead Trans.In

$ 925 $ 60 $ 115 88,941 12,626 18,914 $89,866 $12,686 $19,029

3,805 450,850 $454,655

611,500 611,500 611,500

611,500

30,400 22,800 22,800 641,900 634,300 634,300

38,000 649,500

$0.14

$0.70

$0.02

$0.03

Total $

4,905 571,331 $576,236

$0.89

3-18 Jiambalvo Managerial Accounting Cost Reconciliation Total cost to account for

$576,236

Cost of completed units (611,500 units x $0.89) Cost of ending WIP Material (30,400 equivalent units x $.14) Labor (22,800 equivalent units x $.02) Overhead (22,800 equivalent units x $.03) Trans. in (38,000 equivalent units x $.70) Total cost accounted for

$544,235 $4,256 456 684 26,600

31,996 $576,231*

*The $5 difference between the total cost to account for of $576,236 and total cost accounted for of $576,231 is due to rounding.

P10. [LO 2, 3] Mixing Department, Carnival Caramel Company—March Unit Reconciliation Units in beg. WIP (100% material, 70% conversion costs) Units started during Units to account for

5,000 45,000 50,000

Units completed Units in ending WIP (100% material, 50% conversion costs) Units accounted for

47,000* 3,000 50,000

*Computed as 50,000 − 3,000 = 47,000. Cost per Equivalent Unit Calculation

Cost Beginning WIP Cost incurred during March Total Units Units completed Equivalent units, ending WIP Total Cost per equivalent unit

Material

Labor

Overhead

$ 4,000 45,500 $49,500

$ 1,600 23,135 $24,735

$ 1,900 25,745 $27,645

47,000

3,000 50,000

1,500 48,500

$0.99

$0.51

$0.57

Total $

7,500 94,380 $101,880

$2.07

Chapter 3 Process Costing

3-19

Cost Reconciliation Total cost to account for

$101,880

Cost of completed units (47,000 units x $2.07) Cost of ending WIP Material (3,000 equivalent units x $.99) Labor (1,500 equivalent units x $.51) Overhead (1,500 equivalent units x $.57) Total cost accounted for

$97,290 $2,970 765 855

4,590 $101,880

Shaping Department, Carnival Caramel Company—March Unit Reconciliation Units in beg. WIP (80% conversion costs) Units started during Units to account for Units completed Units in ending WIP (60% conversion costs) Units accounted for *Computed as 52,000 – 1,500 = 50,500.

5,000 47,000 52,000 50,500* 1,500 52,000

Cost per Equivalent Unit Calculation Labor

Overhead Trans.In

Cost Beginning WIP Cost incurred during March Total

$ 800 13,592 $14,392

$ 600 9,166 $9,766

Units Units completed Equivalent units, ending WIP Total

50,500 900 51,400

50,500 1,500 52,000

Cost per equivalent unit

$0.28

$0.19

$1.96

4,420 97,290 $101,710

Total $

5,820 120,048 $125,868

$2.43

3-20 Jiambalvo Managerial Accounting Cost Reconciliation Total cost to account for Cost of completed units (50,500 units  $2.43) Cost of ending WIP Material Labor (900 equivalent units  $.28) Overhead (900 equivalent units  $.19) Trans. in (1,500 equivalent units  $1.96) Total cost accounted for Difference due to rounding

$125,868 $ 122,715 $

0 252 171 2,940

3,363 $126,078 $ 210

Chapter 3 Process Costing P11. [LO 2, 3] Blending Department, Tropical Sun Ltd.—May Unit Reconciliation Units in beg. WIP (80% material, 55% conversion costs) Units started during Units to account for

7,500 97,000 104,500

Units completed and transferred to bottling Units in ending WIP (65% material, 20% conversion costs) Units accounted for

92,500 12,000 104,500

Cost per Equivalent Unit Calculation

Cost Beginning WIP Cost incurred during March Total

Material

Conversion

7,000 106,339 $113,339

Units Units completed and trans. out 92,500 Equivalent units, ending WIP 7,800 Total 100,300 Cost per equivalent unit

$1.13

8,000 143,840 $151,840

Total $ 15,000 250,179 $265,179

92,500 2,400 94,900 $1.60

$2.73

Cost Reconciliation Total cost to account for

$265,179

Cost of units trans. out (92,500 units x $2.73) Cost of ending WIP Material (7,800 equivalent units x $1.13) Conversion costs (2,400 equivalent units x $1.60) Total cost accounted for

$252,525 $8,814 3,840

12,654 $265,179

3-21

3-22 Jiambalvo Managerial Accounting P12. [LO 2, 3] a.

Cost incurred in January: Material = $295,000 + 750,000 + 490,170

$1,535,170

Labor = $162,500 Overhead = ($162,500 ÷ 25) x $70

$162,500 455,000

Total cost of material: Total cost of conversion (162,500 + 455,000): b.

$1,535,170 $617,500

Material

Conversion

Total

Cost Beginning WIP $ 260,000 Cost incurred during Jan. 1,535,170 Total $1,795,170

$ 70,055 617,500 $687,555

$ 330,055 2,152,670 $2,482,725

Units Units completed 29,500 Equivalent units (55% conversion costs) ending WIP 9,500 Total equivalent units 39,000 Cost per equivalent unit

$46.03

29,500 5,225 34,725 $19.80

$65.83

Cost of goods completed during Jan.= 29,500 x $65.83 = $1,941,985 c. Materials Conversion Total Ending work in process inventory: Equivalent units of production (materials: 9,500 units × 100% complete; conversion: 9,500 units × 55% complete) 9,500 5,225 Cost per equivalent unit $ 46.03 $ 19.80 Cost of ending work in process inventory $437,285 $103,455 $540,740

Chapter 3 Process Costing P13. [LO 2, 3] a.

Unit Reconciliation Units in beginning WIP (40% complete) Units started during Units to account for

600 1,000 1,600

Units completed Units in ending WIP (80% complete) Units accounted for

1,300* 300 1,600

*Computed as 1,600 - 300 = 1,300. b.

c. d.

Cost per Equivalent Unit Calculation Labor Cost Beginning WIP $ 36,000 Cost incurred during March 102,600 Total $138,600

Overhead

Total

$ 6,000 47,900 $53,900

$ 42,000 150,500 $192,500

Units Units completed Equivalent units ending WIP (80% complete) Total equivalent units

1,300

240 1,540

Cost per equivalent unit

$90.00

$35.00

1,300 × $125.00 240 × $125.00

$125.00

= $162,500 = 30,000 $192,500

P14. [LO 2, 3] Unit Reconciliation Units in beg. WIP (100% material, 40% conversion costs) Units started during Units to account for Units completed Units in ending WIP (100% material, 60% conversion costs) Units accounted for *Computed as 39,000 − 8,500 = 30,500.

8,000 31,000 39,000 30,500* 8,500 39,000

3-23

3-24 Jiambalvo Managerial Accounting Cost per Equivalent Unit Calculation

Cost Beginning WIP Cost incurred during July Total

Material

Labor

$ 7,500 33,060 $40,560

$ 3,400 10,484 $13,884

$ 2,200 17,024 $19,224

30,500

5,100 35,600

$0.39

$0.54

Units Units completed 30,500 Equivalent units (60% conversion cost), ending WIP 8,500 Total 39,000 Cost per equivalent unit

$1.04

Overhead

Total $13,100 60,568 $73,668

$1.97

Cost Reconciliation Total cost to account for

$73,668

Cost of completed units (30,500 units x $1.97) Cost of ending WIP Material (8,500 equivalent units x $1.04) Labor (5,100 equivalent units x $0.39) Overhead (5,100 equivalent units x $0.54) Total cost accounted for

$ 60,085 $8,840 1,989 2,754

13,583 $73,668

P15. [LO 2, 3] a.

Unit Reconciliation Units in beg. WIP (100% material, 70% conversion costs) Units started during Units to account for

8,000 83,000 91,000

Units completed Units in ending WIP (100% material, 80% conversion costs) Units accounted for

89,200* 1,800 91,000

*Computed as 91,000 – 1,800 = 89,200.

Chapter 3 Process Costing Cost per Equivalent Unit Calculation Material Cost Beginning WIP $ 3,000 Cost incurred during Sept. 71,620 Total $74,620 Units Units completed Equivalent units ending WIP (80% conversion cost) Total Cost per equivalent unit b.

3-25

Labor

Overhead

Total

$ 300 8,764 $9,064

$ 200 13,396 $13,596

$ 3,500 93,780 $97,280

89,200

1,800 91,000

1,440 90,640

$0.82

$0.10

$0.15

Cost of goods completed during May = 89,200  $1.07 = $95,444 Cost of WIP remaining on May 31: Material (1,800 x $0.82) Labor (1,440 x 0.10) Conversion (1,440 x $0.15) Total

$1,476 144 216 $1,836

Cost Reconciliation Total cost to account for

$97,280

Cost of completed units (89,200 units x $1.07) Cost of ending WIP Total cost accounted for

$95,444 1,836 $97,280

P16. [LO 2, 3] a. Compute Equivalent Units Material Units completed 110,000 Equivalent units (45% conversion cost), ending WIP 20,000 Total 130,000

Conversion 110,000 9,000 119,000

$1.07

3-26 Jiambalvo Managerial Accounting b. Cost per Equivalent Unit Calculation Material Cost Beginning WIP $ 43,000 Cost incurred during May 87,000 Total $130,000 Equivalent units

Conversion

Total

$ 340,300 733,080 $1,073,380

$ 383,300 820,080 $1,203,380

130,000

119,000

$1.00

$9.02

Cost per equivalent unit

$10.02

c. Cost of goods completed during May = 110,000 x $10.02 = $1,102,200 d. Cost of WIP remaining on May 31: Material (20,000 x $1.00) Conversion (9,000 x $9.02) Total e. Finished Goods Inventory 1,102,200 Work in Process Inventory

$ 20,000 81,180 $101,180

1,102,200

P17. [LO 1] a.

Work in process 144,375 Raw Materials ($1.75  55%  150,000 = $144,375) To record material used in production Work in process Wages payable ($1.75  25%  150,000 = $65,625) To record labor

65,625

Work in process Manufacturing overhead ($1.75  20%  150,000 = $52,500) To record overhead applied

52,500

144,375

65,625

52,500

Chapter 3 Process Costing d.

Finished goods inventory 262,500 Work in process (144,375 + 65,625 + 52,500 = 262,500) To record cost of units completed Cost of goods sold Finished goods inventory To record cost of units sold

3-27

262,500

262,500 262,500

P18. You get what you measure a. Equivalent cost per unit will be $0.45 if production is increased to 350,000 units. Units produced

350,000,000

Direct material Direct labor Manufacturing overhead Total cost

$ 17,500,000 (350,000,000 x $0.05) 35,000,000 (350,000,000 x $0.10) 105,000,000 $157,500,000

Cost per equivalent unit

$0.45 ($157,500,000 ÷ 350,000,000)

b. Increasing the level of production from 300,000,000 units to 350,000,00 units would reduce the cost per unit to $0.45. But, if sales stay at 300,000,000 units it would also increase inventory levels. The increase of 50,000,000 units would increase total costs by $7,500,000 (50,000,000 x $0.15). Overall costs would increase not decrease even though profit per unit would increase as would net operating profit which would increase Jim’s bonus. This is not a good idea for the company as a whole.

3-28 Jiambalvo Managerial Accounting Case 3-1 [LO2, 3]

TECH-TONIC SPORTS DRINK Summary Company is considering alternative accounting treatments for the cost of lost units. •

Introduces the topic of lost units without the need for complex calculations.

•

Brings up the idea that management may select a specific accounting treatment to manage earnings.

Questions to ask students 1. What is the situation facing the Western Beverage Company and their product TechTonic Sports Drink Syrup? 2. What is the difference in reported profit for the month of April between the two approaches? 3. Which approach is most appropriate from a conceptual standpoint? 4. Which method will be favored by senior managers at Western Beverage? Discussion I begin the discussion by asking a student to summarize the situation facing Western Beverage. In April, this company had 300,000 spoiled (lost) units, and the company is considering two ways to treat the cost of the spoiled units. One approach is to “bury” the cost in the cost of units completed and the cost of units in process. The second approach is to calculate the cost of the spoiled units and charge this cost to cost of goods sold in April. a. What is the difference in reported profit for the month of April between the two approaches? Recall that 80% of the units completed were sold. Thus, 80% of the cost of units completed will be charged to cost of goods sold. This holds for both methods 1 and 2. In addition, under method 2, cost of goods sold will be increased by the charge for lost units ($879,000). Thus, the difference is $255,000 higher cost of goods sold (lower income from operations) with method 2.

Chapter 3 Process Costing Method 1 (80% of cost of units completed (80% of $1,659,000)

$1,327,200

Method 2 (80% of cost of units completed (80% of $879,000) Plus cost of lost units Total

$ 703,200 879,000 $1,582,200

Excess cost of goods sold under method 2

$ 255,000

3-29

b. Which approach is most appropriate from a conceptual standpoint? The fact that the cost of the lost units does not benefit future periods suggests that the entire cost of the lost units should be expensed in April as per method 2. c. Which method will be favored by Senior managers at Western Beverage? This depends on the specifics of their bonus agreement. Suppose that with method 1, they will be below target earnings by $200,000. In this case they may strongly support method 2 which will let them “earn” their bonuses. However, suppose that they are already above target earnings even with method 1. In this case, they may favor method 2 since this method will make it easier to achieve the target next month (because ending Finished Goods Inventory is lower in April, Cost of Goods Sold will be lower in May with method 2).

3-30 Jiambalvo Managerial Accounting Case 3-2. [Decision Making/Incremental Analysis]

JENSEN PVC, INC. Summary Company is considering lowering its price below current cost per unit. •

Relates information produced by a process costing system to decision making.

•

Brings up the important concept of incremental analysis.

Questions to ask students 1. What is the situation facing Jensen PVC? 2.

Would decreasing the price be a good decision?

Discussion I begin the discussion by asking a student to summarize the situation facing Jensen PVC. The company produces PVC irrigation pipe and, due to weak crop prices, farmers are cutting back on irrigation projects. With the reduction in output, cost per unit ($0.40 per foot) has increased to the point where it exceeds the current selling price ($0.39 per foot). The next question to ask is “Does decreasing the price below current unit cost make sense?” Hopefully, a student will answer yes and take the class through the following incremental analysis. New revenue $0.35 × 15,000,000 feet

$5,250,000

Old revenue $0.39 × 6,000,000 feet

$2,340,000

Incremental revenue

$2,910,000

Less incremental cost 9,000,000 extra feet × $0.15 for material & labor*

1,350,000

Incremental profit associated with decreasing price

$1,560,000

* Material and labor = $0.30 − $0.15 = $0.15 in 2017 or $0.40 − $0.25 = $0.15 in 2018.

Chapter 3 Process Costing

3-31

Some students may argue that decreasing the price today may make future price increases more difficult. However, I’d argue that the company is having a very serious problem today and may not survive in the future unless the current price is re-calculated.

Chapter 4 Cost-Volume-Profit Analysis QUESTIONS 1. A mixed cost is a cost that has a fixed cost component and a variable cost component. For example, the amount paid for telecommunication services would be a mixed cost if there was a fixed monthly fee plus a charge for use. 2. Discretionary fixed costs are those fixed costs that management can easily change in the short-run (e.g., advertising). Committed fixed costs are those fixed costs that cannot be easily changed in the short-run (e.g., rent). 3. Commissions paid to salespersons and direct materials are examples of variable costs. 4. Rent and insurance expenses are examples of fixed costs. 5. Salespersons are paid a base salary plus commissions. The base amount is fixed and commissions are variable. Thus, total compensation paid to the sales force is mixed. 6. With account analysis, managers use judgment to classify costs as either fixed or variable. The total of the costs classified as variable can then be divided by a measure of activity to calculate the variable cost per unit of activity. The total of the costs classified as fixed provides the estimate of fixed cost. 7. The relevant range is the range of activity for which estimates of costs are likely to be accurate. 8. The contribution margin is equal to the sales minus variable costs. The contribution margin ratio is the contribution margin per dollar of sales (i.e., the contribution margin per unit divided by the sales price per unit). 9. It would not be appropriate to focus on weighted average contribution margin per unit if the units were dissimilar (e.g., pencils and computers at an office supply warehouse). 10. Companies that have relatively higher fixed costs are said to have higher operating leverage. Thus, a software company with a large investment in research and development (a fixed cost) would likely have higher operating leverage compared to a trucking company that doesn't own its own trucks (the trucks are owned by owner-operators hired by the trucking company).

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Jiambalvo Managerial Accounting

EXERCISES E1. [LO 3] a. As sales declines, variable costs will be reduced as well. Fixed costs, however, will remain constant. If a large portion of costs in the cost structure are fixed, the company is said to have high operating leverage. When sales decline, profit will decline even faster because a small portion of the cost declines with sales (variable costs) but the fixed costs remain unchanged. b. John can turn fixed costs into variable costs by outsourcing. As an example, he might outsource the production of some components such as compressors. This would turn the cost of the compressors into a variable cost. He might also change the compensation of workers and provide a lower fixed salary but a higher "piece rate." E2. [LO 2] Oakland Hills Golf Course is more likely to focus on contribution margin per unit in Cost Volume Profit (CVP) analysis since each unit sold (a round of golf) is the same. Brook’s Men’s Clothing, however, is more likely to focus on the contribution margin ratio in CVP analysis since each unit (an article of clothing) is very different (e.g., a shirt is quite different from a suit or tie) and, as a result, a per unit contribution margin would be relatively meaningless. E3.

[LO 2] Cost per pound = $4 Price per pound = $6 Contribution Margin per Pound = $6 - $4 = $2 Fixed Cost = $20,000 Profit = $10,000 Number of units to be sold to break even = $20,000 ÷ $2 = 10,000 pounds Number of units to be sold to earn a $10,000 profit = ($20,000+$10,000) ÷ $2 = 15,000 pounds

Chapter 4 Cost-Volume-Profit Analysis E4.

[LO 1] Depreciation appears to be a fixed cost.

Direct labor appears to be a variable cost.

4-3

4-4

Jiambalvo Managerial Accounting Telecommunications appears to be a mixed cost. Note that the intercept is $80,000.

E5. [LO 1] ($22,000 - $9,000) ÷ (950,000 - 300,000) = $0.02 per copy of variable repair cost $22,000 - ($0.02 × 950,000) = $3,000 per month of fixed repair cost. E6. [LO 1 and Appendix] a. The highest level of activity is sales of 35,000 tickets with cost of $240,000. The lowest level of activity is sales of 19,000 tickets with cost of $160,000. ($240,000 − $160,000) ÷ (35,000 − 19,000) = $5 of variable cost per ticket sold. $240,000 – ($5 × 35,000) = $65,000 per month of fixed cost. Thus, cost = $65,000 + ($5 × No. of tickets sold). b. For a sales increase of 15,000 tickets, profit will increase by $300,000 (i.e., ($25 × 15,000) − ($5 × 15,000) = $300,000). c. The regression indicates that variable cost per ticket sold is $4.35675 and fixed costs are $86,620.20 per month. Using the regression, for a sales increase of 15,000 tickets, profit will increase by $309,649 (i.e., ($25 × 15,000) − ($4.35675  15,000) = $309,648.75).

Chapter 4 Cost-Volume-Profit Analysis

4-5

E7. [LO 1] a.

Sales b. The relation appears to be approximately linear between sales of $210,000 and $275,000. The customer service cost for sales of $170,000 appears to be an outlier. E8. [LO 1] a. Arguably, the only variable costs in human resources are staff wages and office supplies (and a case could be made that even salaries are fixed). In this case, variable costs are $505 per hire [($30,000 + $300) ÷ 60 hires]. Fixed costs are $10,000. b. The estimated cost for June with 75 new hires is: $10,000 + ($505  75) = $47,875. c. The incremental cost associated with 15 more employees is $7,575 (i.e., $505  15).

4-6

Jiambalvo Managerial Accounting

E9. [LO 1, 2] a. The only variable cost is food and beverages. Thus, variable costs per ticket sold are: Total variable costs (wages) Divided by tickets sold Variable cost per ticket sold

$29,400 4,200 $ 7.00

Fixed costs per month are: Author royalties/fees Wages Rent Utilities Depreciation -- theater equipment Owner’s salary Fixed costs per month

$ 80,000 165,000 60,000 7,000 14,000 10,000 $336,000

b. The contribution margin per ticket holder = $25 + $10 − $7= $28. Thus, the contribution margin ratio = $28 ÷ ($25 + $10) = 0.8 . In other words, the company has approximately 80 cents of contribution margin per dollar of sales. E10. [LO 1] a. Variable costs are: Material Direct labor Other utilities (80% variable) Supervisory salaries (25% variable) Equipment repair (80% variable) Indirect materials Factory maintenance (20% variable) Total variable costs Divided by units produced Variable cost per unit

$ 63,000 24,000 3,600 6,300 5,200 600 800 $103,500 1,500 $ 69

Fixed costs per month are: Depreciation Phone Other utilities (20% fixed) Supervisory salaries (75% fixed) Equipment repair (20% fixed) Factory maintenance (80% fixed) Total fixed costs per month

$ 8,000 300 900 18,900 1,300 3,200 $32,600

b. The incremental cost of producing 500 units is $34,500 (i.e., $69 variable cost per unit  500 units).

Chapter 4 Cost-Volume-Profit Analysis

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E11. [LO 2] a. The break-even point equals fixed cost divided by the contribution margin per unit. Thus, the break-even point is 25 cakes [i.e., $8,750 ÷ ($600 - $250) = 25 cakes]. b. The company must sell 45 cakes to earn a profit of $7,000. ($8,750 + $7,000) ÷ ($600 − $250) = 45 cakes E12. [LO 2] a. Given that variable cost per dollar of sales is $0.30, the contribution margin per dollar of sales (i.e., the contribution margin ratio) is $0.70. The break-even point equals fixed cost divided by the contribution margin ratio. Thus, the break-even point is $500,000 [i.e., $350,000 ÷ 0.70 = $500,000]. b. ($350,000 + $70,000) ÷ 0.70 = $600,000 c. The expected level of profit is: ($1,000,000  0.70) − $350,000 = $350,000. E13. [LO 2] a. The contribution margin is $700 ($1,000 - $300). b. The effect on profit of selling 8 more pairs of speakers is an increase of $5,600 ($700  8). c. The contribution margin ratio is $700 ÷ $1,000 = .70 d. The increase in profits is $10,000 × .70 = $ 7,000 E14. [LO 2] a. Expected profit is $1,000 (125) − $300 (125) − $49,000 = $38,500. b. The contribution margin ratio is $700 ÷ $1,000 = 0.70 Breakeven sales are $49,000 ÷ 0.70 = $70,000 Expected sales are 125  $1,000 = $125,000. The margin of safety is equal to expected sales − break-even sales = $125,000 − $70,000 = $55,000.

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Jiambalvo Managerial Accounting

E15. [LO 2] Expected profit is $1,200 (125) − $300 (125) − $49,000 = $63,500. E16. [LO 2] a. The weighted average contribution margin ratio is $630,000 ÷ $1,800,000 = 0.35. b. ($440,000 - $370,000) ÷ .35 =$200,000. $1,800,000 + $200,000 = $2,000,000. c. The contribution margin ratios of the three departments are: Department A ($180,000 ÷ $450,000) =.40 Department B ($150,000 ÷ $600,000) = .25 Department C ($300,000 ÷ $750,000)= .40 All else equal, Departments A and C should be emphasized in the weekly advertisement because these departments earn $.40 on each incremental dollar of sales while department B earns only $.25 on each incremental dollar of sales. E17. [LO 2, 3] a. Currently, profit as a percent of sales is $370,000 ÷ $1,800,000 = 20.56% b. The weighted average contribution margin ratio is $630,000 ÷ $1,800,000 = 0.35. Thus, if sales increase by 15%, profit will increase by: Increase in sales ($1,800,000  15%) Times contribution margin ratio Increase in profit

$270,000 .35 $94,500

The new sales level will be ($1,800,000 + $270,000) = $2,070,000. The new profit level will be ($370,000 + $94,500) = $464,500. Thus, profit as a percent of sales will be 22.44% (i.e., $464,500 ÷ $2,070,000). When sales increase, variable costs increase, but fixed costs do not increase. Thus, when sales increase, profit as a percent of sales will increase by a greater amount.

Chapter 4 Cost-Volume-Profit Analysis E18. [LO 3] a. Selling price Variable costs Contribution margin ÷ Hours to produce 1 item Contribution margin per hour

Stand A $110 50 60 2 $30

4-9

Stand B $100 64 36 1 $36

The company should produce just stand B. With 350 hours available, this stand will generate $12,600 of contribution margin ($36  350 hours) while stand A will generate just $10,500 ($30  350). b. If the company obtains additional labor, it should produce more of stand B. The incremental benefit of 15 labor hours is $540 ($36 contribution margin per hour x 15 hours).

4-10 Jiambalvo Managerial Accounting PROBLEMS P1. [LO 1] a. Depreciation of the building—fixed b. Salaries of restaurant staff—mixed (a minimum number is required in slow months plus additional people are required from November through February) c. Salaries of administrative staff—fixed d. Soap, shampoo, and other toiletries in rooms - variable e. Laundry costs—mixed (part is variable and part is fixed, e.g., depreciation on laundry equipment) f. Food and beverage costs—variable g. Grounds maintenance—fixed

P2. [LO 1, 2] a. Variable costs Component costs Supplies Assembly labor Shipping Total

$71,000 2,500 25,000 2,000 $100,500

Variable cost per disc player ($100,500 ÷ 150) = $670 Fixed costs Rent Supervisor salary Electricity Telephone Gas Advertising Administrative costs Total

$2,300 5,600 350 280 300 2,600 15,000 $26,430

b. Expected cost in August = $670 (175) + $26,430 = $143,680 c. Contribution margin = Selling price less variable cost = $1,300 − $670 = $630. d. Estimated profit at 175 units = $1,300 (175) − $670 (175) − $26,430 = $83,820. e. The special order will increase profit by ($1,050 − 670)  120 = $45,600.

Chapter 4 Cost-Volume-Profit Analysis P3. [LO 1, 2] a. High Low

Production 170 130 40

4-11

Cost $143,910 116,990 $ 26,920

Variable cost per unit = $26,920 ÷ 40 = $673. Total cost at 170 units Less variable costs ($673 × 170) Fixed cost

$143,910 114,410 $ 29,500

b. Break-even sales in units = $29,500 ÷ ($1,300 − $673) = approximately 47 units. c. Margin of safety = 175 − 47 = 128 units × $1,300 = $166,400 d. Total profit = ($1,300 * 175) − ($673 * 175) − $29,500 = $80,225. e. A major limitation of the high-low method is that it estimates variable and fixed costs using extreme values. Also, the approach uses only two observations. A better approach would be to use regression analysis. P4. [LO 1, Appendix] Based on the regression, fixed costs are $28,968.56 and variable costs are $676.30 per unit. b. Comparison of estimates:

Account analysis High-low Regression

Variable cost $670 $673 $676

Fixed cost $26,430 $29,500 $28,969

The regression approach arguably provides the best estimates because it uses more data and is less subjective.

4-12 Jiambalvo Managerial Accounting P5. [LO 2] a. Number of trips (6 per week × 52 weeks)

312

Revenue per trip ($360 x 5 passengers) Total revenue ($1,800 per trip x 312 trips)

$1,800 $561,600

Variable costs: Fuel Maintenance Total variable costs

$147,977 127,920 $275,897

Variable costs per trip ($275,897 ÷ 312)

$884.29

Contribution margin per trip ($1,800 − $884.29)

$915.71

Fixed costs: Salary Depreciation of plane Depreciation of office equipment Rent expense Insurance Miscellaneous Total fixed costs

$ 70,000 25,000 2,800 40,000 20,000 7,500 $165,300

Breakeven number of trips is ($165,300 ÷ $915.71) = 181 trips. b. If Michael draws a salary of $110,000, fixed costs will increase by $40,000 to $205,300. In this case, the breakeven number of trips is ($205,300 ÷ $915.71) 224. c. The average before tax profit per round trip is $120,403 ÷ 312 = $385.91. d. The incremental profit associated with adding a round trip is the contribution margin per trip, which is $915.71.

Chapter 4 Cost-Volume-Profit Analysis

4-13

P6. [LO 1, 2] a. Account Analysis Fixed cost per month (April data) Day manager salary Night manager salary Depreciation

Variable costs per room (April data): Cleaning staff Complimentary continental breakfast Total variable costs Divided by number of rooms Variable costs per room

$ 4,500 3,900 12,500 $20,900

$15,960 5,050 21,010 1,700 $ 12.36

b. High-Low Method ($42,715 – $41,910) ÷ (1,950 – 1,700) rooms = $3.22 per occupied room of variable cost. $41,910 – $3.22 x (1,700 rooms) = $36,436 of fixed costs per month. c. $120.00 – $3.22 = $116.78 contribution margin per occupied room. P7. [LO 1, 2] a. Income will only be proportional to sales if all costs are variable. That assumption is wrong (for example, the registration fee and the pay to Mindy Orwell are fixed). b. Sales Less cost of sales (55% of sales in prior year) Gross margin Less other expenses: Registration fee Booth rental (6% of sales) Salary of Mindy Orwell Before tax profit

$25,200 13,860 11,340 1,800 1,512 450 $ 7,578

4-14 Jiambalvo Managerial Accounting P8. [LO 1, 2] Sales Less cost of components Gross margin Less: Staff salaries Rent Utilities Advertising Operating profit before bonuses Staff bonuses Profit before taxes and owner “draw”

$1,600,000

$1,700,000

$1,800,000

$1,900,000

$2,000,000

960,000 640,000

1,016,000 684,000

1,064,000 736,000

1,112,000 788,000

1,160,000 840,000

280,000 40,000 8,000 7,000

305,000 91,500

349,000 104,700

401,000 120,300

453,000 135,900

505,000 151,500

244,300

$ 280,700

$ 317,100

$ 353,500

$ 213,500

In the prior year, cost of components was 60% of sales. In the coming year, prices will be reduced by 20% on all purchases over $1,000,000. Purchases of $1,000,000 corresponds to sales of $1,666,667. ($1,000,000 ÷ 0.60). Thus, the calculation of cost of components when sales are $1,700,000 is: $1,000,000 + [($1,700,000 – $1,666,667) × 0.60 × 0.8] = $1,016,000. P9. [LO 1] a. Production costs: ($112,978 − $83,007) ÷ (138 – 97) = $731 variable cost per unit $112,978 – ($731 × 138) = $12,100 fixed cost per month. Selling and admin costs: ($28,030 − $22,495) ÷ (138 – 97) = $135 variable cost per unit $28,030 – ($135 × 138) = $9,400 fixed cost per month. b. Sales (1,650 units × $900) Less production costs ($12,100 × 12) + ($731 × 1,650) Less selling and admin. costs ($9,400 × 12) + ($135 × 1,650) Income (loss)

$1,485,000 1,351,350 335,550 ($201,900)

Chapter 4 Cost-Volume-Profit Analysis

4-15

P10. [LO 1, 2] a. The high point is July with 310 loans and $55,725 in costs; the low point is February with 170 loans and $48,550 in costs. To find the variable cost per loan processed: Variable cost per loan = Change in cost ÷ Change in loans processed Variable cost per loan = ($55,725 - $48,550) ÷ (310 – 170) Variable cost per loan = $51.25 To find the fixed cost, substitute in the line equation using the high point: Total cost = Fixed cost + (Variable cost × Number of loans) $55,725 = Fixed cost + ($51.25 × 310) Fixed cost = $39,837.50 Therefore, the cost function will be: Total cost = $39,837.50 + $51.25(X) where X = activity level

b. Contribution margin per loan = $500 - $51.25 = $448.75 Breakeven = Fixed costs ÷ Contribution margin per loan Breakeven = $39,837.50 ÷ $448.75 = 89 loans (round up to the nearest whole unit when calculating breakeven)

c. Total cost = $39,837.50 + $51.25(X) Substitute 275 for X, then: Total cost = $39,837.50 + $51.25(275) Total cost = $53,931 Sales (275 loans @ $500 each) Less costs (calculated above) Estimated profit

$137,500 53,931 $ 83,569

4-16 Jiambalvo Managerial Accounting d.

Number of loans processed e.

It appears that the high-low method will give a reasonable estimate of variable and fixed costs. The points generally have a linear relationship. If you were to draw a line between the high point and the low point, the line would be generally representative of the rest of the data, but it would not fit perfectly. A potential outlier is the level of cost associated with 240 loans processed in August ($54,420).

Chapter 4 Cost-Volume-Profit Analysis

4-17

P11. [LO 2] a. Total

Per unit

Percent

Sales ($1,200 x 1,600 apps)

$1,920,000

$1,200

100.00%

Less variable expenses

1,184,000

$740*

61.67%

Contribution margin

736,000

$460

38.33%

Less fixed expenses

300,000

Operating income $ 436,000 *($1,184,000 ÷ 1,600) Breakeven point (in number of apps) = $300,000 ÷ $460 = 652 units (rounded) Contribution margin ratio = $460 ÷ $1,200 = 38.33% Breakeven point (in sales dollars) = $300,000 ÷ 38.33% = $782,677 (rounded) b. Margin of safety in units = 1,600 – 652 = 948 units Margin of safety in dollars = $1,920,000 - $782,677 = $1,137,323 c. Target sales (in units) = ($300,000 + $500,000) ÷ $460 = 1,739 units (rounded) Target sales (in dollars) = ($300,000 + $500,000) ÷ 38.33% = $2,087,138 (rounded) d. New income statement: Total

Per unit

Percent

Sales ($1,920,000 + $300,000)

$2,220,000

$1,200

100%

Less variable expenses*

1,369,000

$740

61.67%

Contribution margin

851,000

$460

38.33%

Less fixed expenses ($300,000 + $75,000)

375,000

Operating income *[1,600 + ($300,000 ÷ $1,200)] × 740

$ 476,000

Yes, they should increase their advertising, since their operating income will rise to $476,000 from $436,000 in the original scenario.

4-18 Jiambalvo Managerial Accounting P12. [LO 2] a. Contribution margin Sales Contribution margin ratio (CM ÷ sales)

Audio $1,137,500 3,250,000

Video $ 468,000 1,950,000

Car $ 624,000 1,300,000

0.35

0.24

0.48

b. A $125,000 increase in Audio sales would increase profit by $43,750 ($125,000 × .35) while the effect for Video would be $30,000 and $60,000 for the Car product line. All else equal, it would be better to increase sales of Car products. c. The weighted average contribution margin ratio is $2,229,500 ÷ $6,500,000 = .343 The break-even level of sales is: (Direct fixed + common fixed) ÷ contribution margin ratio ($785,000 + 710,000) ÷ .343 = $4,358,601 d. Sales need to achieve a profit of $1,800,000 is ($1,800,000 + $785,000 + $710,000) ÷ .343 = $9,606,414. e. Audio sales = ($3,250,000 ÷ 6,500,000)  $9,606,414 = $4,803,207 Video sales = ($1,950,000 ÷ 6,500,000)  $9,606,414 = $2,881,924 Car sales

= ($1,300,000 ÷ 6,500,000)  $9,606,414 = $1,921,283

P13. [LO 2, 3] a. The weighted-average contribution margin ratio is $618,100 ÷ $1,500,000 = 0.412067. Thus, if sales increase by 15% ($1,500,000  .15 = 225,000), profit will increase by: Increase in sales $225,000 Times weighted-average contribution margin ratio .412067 Increase in profit $ 92,715 Thus, profit will increase by 28.26% ($92,715 ÷ $328,100) Profit increases at a faster rate than sales because some costs are fixed and do not increase with sales. b. If the owner of ComputerGuard wanted to focus on the contribution margin per unit, she would, most likely, treat hours worked (on consulting, training, or repair services) as the unit of service. For example, if in the past fiscal year the company worked 7,500 hours, the weighted-average contribution margin per hour would be $82.41 ($618,100 ÷ 7,500 hours).

Chapter 4 Cost-Volume-Profit Analysis

4-19

P14. [LO 2] a. Smasher

Basher

Dinker

Total

2,000

3,000

8,000

$150,000

$180,000

$120,000

$450,000

Less variable costs

80,000

75,000

35,000

190,000

Contribution margin

$ 70,000

$105,000

$ 85,000

260,000

Units sold Sales

Less common fixed costs

140,000

Profit

$120,000

The weighted average contribution margin per unit is $32.50 [($35 × 2) + ($35 × 3) + ($28.33 × 3)] ÷ (2 + 3 + 3) b. The breakeven point in total units will be: $140,000 ÷ $32.50 = 4,308 (rounded) c. To calculate each product’s share of the breakeven sales volume in units: Smasher

Basher

Dinker

Breakeven sales in units (total) Multiply by sales mix % (model/unit sales/total/unit sales)

4,308

25.00%

37.50%

Breakeven sales in units by product

1,077

1,616

Total

4,309

(Note: rounding error will be present.)

d. The weighted average contribution margin ratio is $260,000 ÷ $450,000 = 57.78%. e. The amount in total sales dollars need to achieve a profit of $125,000 will be: ($140,000 + $125,000) ÷ 57.78% = $458,636 (rounded) f. To calculate each product’s sales in order to earn a target profit of $125,000: Smasher

Basher

Dinker

Total

$150,000

$180,000

$120,000

$450,000

33.33%

40.00%

26.67%

100.00%

Multiply by target sales level

$458,636

Target sales by product

$152,863

$183,454

$122,318

Sales (original level) Relative weight (model sales/total sales)

(Note: rounding error will be present.)

$458,635

4-20 Jiambalvo Managerial Accounting P15. [LO 3] a. Equillion has the highest operating leverage (note that it has $90,000,000 of fixed costs versus only $37,500,000 for Storis). b. For a 20% change in sales, Equillion’s profit will change by 100% while Storis’ profit will change by only 53%.

Change in contribution margin Previous profit % change

Equillion $22,500,000 22,500,000 100%

Storis $12,000,000 22,500,000 53%

c. Equillion is more risky. Note that if sales decrease by only 20%, profit will decline by 100% (versus a 53% decline for Storis). P16. [LO 3] a. Jurgis is not approaching this problem in a proper manner. Instead of focusing on profit per assembly hour, he should focus on the contribution margin per assembly hour. For sales of 2,500 units, the contribution margin is $1,500,000. To earn this contribution margin required 12,500 assembly hours. Thus, the contribution margin per assembly hour is $120 per hour. If five hours were available, profit would increase by $120  5 = $600 (which is the contribution margin per unit). b. Jurgis is underestimating the benefit of more assembly time. By focusing on profit per hour, which includes fixed costs that will not change, he estimates an average benefit of $62.40 per hour. However, the real benefit is $120 per hour. Thus, with 5 more hours, Jurgis expects an increase in profit of $312 (i.e., $62.40 x 5 hours). The actual benefit is $600 (i.e., $120 x 5 hours). c. If Jurgis pays workers $20 per hour of overtime premium, he will still make an incremental $100 per hour ($120 − $20).

Chapter 4 Cost-Volume-Profit Analysis P17.

4-21

[LO 3] a. The Mx100 has the highest contribution per hour of assembly time. Therefore, only the minimum number of Nx100s should be produced and the remaining assembly time should be devoted to Mx100s. Production of 4,000 Nx100s requires 12,000 assembly hours. This leaves 188,000 hours for production of Mx100s indicating that 94,000 pairs of Mx100s can be produced (188,000 ÷ 2 hours = 94,000). The contribution margin for Nx100s is $115 ($2,300,000 ÷ 20,000) per unit and the contribution margin for Mx100s is $95 ($7,600,000 ÷ 80,000) per unit. Contribution margin of Nx100s ($115  4,000) Contribution margin of Mx100s ($95  94,000) Total

$ 460,000 8,930,000 $9,390,000

b. Production of 6,000 Nx100s requires 18,000 assembly hours. This leaves 182,000 hours for production of Mx100s indicating that 91,000 pairs of Mx100s can be produced (182,000 ÷ 2 hours = 91,000). Contribution margin of Nx100s ($115  6,000) Contribution margin of Mx100s ($95  91,000) Total

690,000

8,645,000 $ 9,335,000

Note that the total contribution margin has declined by $55,000. Thus, the opportunity cost of requiring that at least 6,000 pairs of the Nx100 be produced is $55,000. P18. [LO 1 and Appendix] Increase in sales at normal prices Less 20% discount Increase in sales after discount Less incremental costs . 0.53082433 x $3,000,000 Incremental profit

$3,000,000 600,000 2,400,000 1,592,473 $ 807,527

Note that since the regression was estimated using normal selling prices, the incremental costs must be calculated using normal selling prices.

4-22 Jiambalvo Managerial Accounting Case 4-1. [LO 1, 2]

ROTHMUELLER MUSEUM Summary A museum is trying to estimate the financial impact of a new exhibition. •

Links C-V-P analysis and decision making.

Questions to ask students 1. What’s the situation at Rothmueller Museum? 2. What is the financial impact of the Ansel Adams exhibition? Is offering the exhibition a good decision from a financial standpoint? 3. How many people must attend the exhibition to break-even? Discussion I begin by asking a student to summarize the situation. Rothmueller Museum is planning an Ansel Adams exhibit. Alice Morgan, the photographic curator, wants to estimate its financial impact. The financial impact is a positive $67,840 as follows: Incremental revenue: 10,000 × $15 8,000 × $6 .2 × 8,000 × $8 × .3

$ 150,000 48,000 3,840 201,840

Incremental costs: Lease of photos Packing Insurance Guard Installation Advertising Programs

Incremental profit

100,000 5,000 4,000 12,000 2,000 7,000 4,000 134,000 $

67,840

Chapter 4 Cost-Volume-Profit Analysis

4-23

a. 6,639 people must attend the exhibition in order for its financial impact to be profit neutral (i.e., the museum will not be better off nor worse off financially). Incremental costs Divided by average incremental revenue ($201,840 ÷ 10,000) Number who must attend

$134,000 20.184 6,639

Offering the exhibition appears to be a good decision in that it will more than cover its incremental costs. It may be, however, that a different exhibition would have contributed even more “profit.” That is, there may be some opportunity cost.

4-24 Jiambalvo Managerial Accounting Case 4-2. [LO 2]

MAYFIELD SOFTWARE, CUSTOMER TRAINING Summary An internal report shows that the customer training center is losing money. The manager wants to know how many classes must be offered to break-even. •

Shows how allocated costs can make a valuable operation appear unprofitable.

Questions to ask students 1. What’s the situation at the customer training center for Mayfield Software? 2. What will be the impact on company profit if the training center is closed? 3. How many classes must be offered to break-even given the current room configuration and approach to allocation? 4. What happens to break-even if the amount paid to instructors is reduced to $3,500 per class? 5. What will be the impact on group profit if version 4.0 of “CustomerTrack” is released? Discussion a. If the customer training operation is shut down, Mayfield Software will lose $1,179,250 per year (i.e., profit before central charges). Note that the central charges are not likely to change as a result of closing the customer training center. b. Given the current room configuration and approach to allocation of central charges (20 percent of revenue), Marie must offer approximately 889 classes to break-even on the Report of Operating Results.

Chapter 4 Cost-Volume-Profit Analysis

4-25

Contribution margin per class: Revenue per class ($360 x 20) Variable costs: Trainer cost Operating manuals

$ 7,200 $

4,000 600

($510,000 ÷ 850)

Postage ($12,750 ÷ 850) Central charges

15 1,440

6,055

($1,224,000 ÷ 850)

Contribution margin Fixed costs: Director salary Receptionist Office manager Utilities Lease expense Rent Advertising Total

$ 1,145

180,000 60,000 80,000 38,000 400,000 100,000 160,000 $1,018,000

Break-even point: $1,145.00 (X) − $1,018,000 = 0. X = 889.08. c. If the amount paid to instructors is reduced to $3,500 per class, the break-even point drops to 619. Marie should give serious consideration to this option since it will have a very significant impact on profitability and the break-even point. Break-even point: $1,645.00 (X) − $1,018,000 = 0. X = 618.84. d. Finally, the impact of 30 sessions related to “CustomerTrack” is $34,350. $1,145.00 (30) = $34,350

4-26 Jiambalvo Managerial Accounting

Case 4-3. [LO 1, 2]

KROG’S METALFAB, INC. Summary Company is trying to estimate lost profit, related to fire damage, so it can submit an insurance claim. •

Focuses on cost estimation.

•

Demonstrates the effect of operating leverage—why profit does not increase or decrease at the same rate as sales.

Questions to ask students 1. What is the situation facing Krog’s Metalfab? 2. What are your estimates of lost profit? 3. What is wrong with Peter Newell’s analysis?

Discussion I begin the discussion the same way I begin the discussion of almost all cases, by asking a student to summarize the situation. Krog had a fire at the beginning of 2016 that reduced capacity and profit during 2016. The company has insurance to cover lost profit, but what is the amount of lost profit during 2016? At this point, I generally ask 5-10 students to simply give me their lost profit estimates and I put them on the board. If students have large estimates (say greater than $700,000) I’ll play the role of the insurance company and argue that their estimates are highly inflated. After all, the company only had profit of approximately $110,000 in 2015 (the year before the fire). I may go so far as to argue that the company should have ceased operations during the period of reconstruction to avoid having such high losses. In response, a sharp student will bring up the idea that this would have been the end of the business. And the company is surely worth more than $700,000 since it generates more than $300,000 per year in income from operations. (Note that the calculations for expected profit in 2016, without the fire, show annual expected profit of $336,434 using the regression approach and $398,446 using the high-low method.) At this point, I may fall back on Peter Newell’s analysis, and argue that as long as the insurance company is willing to pay the excess operating costs ($250,000) plus the $34,184 estimated by Peter, Krog should be happy. This reimburses the company for the average profit per dollar of sales ($.02 per dollar of sales). This should lead to a discussion of the fundamental flaw in Peter’s analysis. When sales decline, profit will not decline by the average profit per dollar of sales. It will decline by a higher percent since

Chapter 4 Cost-Volume-Profit Analysis

4-27

when sales decline, fixed costs will not decline (and as we will see, Krog Metalfab has high fixed costs). This drives home the concept of operating leverage and its link to fluctuations in profit. Now it’s on to reviewing the calculation of lost profit. The answer depends on how the students estimate fixed and variable costs. Below, I’ll review calculations based on cost estimates using regression, the high-low method, and account analysis. Regression analysis suggests that fixed costs are $260,816 per month and variable costs are $.3637 per dollar of sales. Thus, the estimate of lost profit is $1,064,270. Regression Expense = $260,816 + .3637  Sales R squared = .60 Sales in 2015

$5,091,094

Predicted sales with 7% increase $5,447,471 Predicted expense ($260,816  12) + (.3637  $5,447,471) 5,111,037 Predicted profit 336,434 Less actual loss 727,836 Lost profit $1,064,270 A student who has carefully reviewed the problem will note that February of 2015 is an outlier (expenses are higher than sales in this month). Without February in the data set, the regression indicates that fixed costs are $221,548 and variable costs are $.4359 per dollar of sales. With these estimates, lost profit is $1,142,178. Regression Expense = $221,548 + .4359  Sales R squared = .99 Sales in 2015

$5,091,094

Predicted sales with 7% increase $5,447,471 Predicted expense ($221,548  12) + (.4359  $5,447,471) 5,033,129 Predicted profit 414,342 Less actual loss 727,836 Lost profit $1,142,178 This estimate clearly shows the flaw in Peter’s analysis. Cost increase by $0.4359 per dollar of sales. That means that profit increases by $0.5637 per dollar of sales (the contribution margin ratio). Sales are off by $1,589,972 compared to predicted sales and

4-28 Jiambalvo Managerial Accounting this means that profit is off by $896,267. In addition, the company had $246,984 of excess expenses. Thus, it is easy to see why profit is off by more than $1,100,000. High-Low Approach If students use the high-low method, they will estimate variable costs as $0.4381 per dollar of sales and fixed costs as $221,874 per month.

Sales

August High $603,210

April Low $303,685

Change $299,525

Expense

$486,140

$354,931

$131,209

Variable cost per dollar of sales ($131,209 ÷ $299,525) = $0.4381 Fixed cost per month ($486,140 – ($.4381  $603,210) = $221,874 In this case, lost profit is estimated as $1,126,282. Sales in 2015

$5,091,094

Predicted sales with 7% increase $5,447,471 Predicted expense ($221,874  12) + (.4381  $5,447,471) 5,049,025 Predicted profit 398,446 Less actual loss 727,836 Lost profit $1,126,282 Account Analysis If students use account analysis, they are asked to classify cost of goods sold and selling expense as variable and administrative costs as fixed. Using annual totals this suggests that variable costs are $.9302 per dollar of sales and fixed costs are $246,000. Cost of goods sold Selling expense Total Sales Total ÷ sales

$4,518,475 217,124 $4,735,599 $5,091,094 0.9302

Administrative expense

$ 246,000

Use of these values results in estimated lost profit of $862,069. Estimated lost profit is lower here because estimated fixed costs are lower and estimated variable costs are higher.

Chapter 4 Cost-Volume-Profit Analysis Sales in 2015

$5,091,094

Predicted sales with 7% increase Predicted expense $246,000 + $.9302 x $5,447,471 Predicted profit Less actual loss Lost profit

$5,447,471

4-29

5,313,238 134,233 727,836 $ 862,069

This estimate seriously underestimates lost profit. The assumption that cost of goods sold and selling expense are completely variable is at odds with the data (see the regression analysis) which indicates a large fixed cost component.

Chapter 5 Variable Costing QUESTIONS 1.

In full costing, fixed manufacturing overhead is treated as a product cost. In variable costing, fixed manufacturing overhead is treated as a period cost.

When production exceeds sales, part of fixed manufacturing overhead will remain in ending inventory. In variable costing, the entire amount of fixed manufacturing overhead will be expensed since it is treated as a period cost.) Thus, income computed under full costing will exceed income computed under variable costing (since some fixed production costs are not expensed) when production exceeds sales.

Variable costing facilitates C-V-P analysis since fixed and variable costs are separated and a contribution margin is calculated. Also, under variable costing, managers cannot artificially inflate profit by producing more units than they sell and bury fixed manufacturing overhead in inventory.

Companies using JIT generally have low levels of work in process and finished goods inventory. Thus, even when a company uses full costing, very little of fixed manufacturing overhead is in inventory at the end of a period. Rather, most of it is expensed just as in variable costing.

Under full costing, ending inventory includes direct material, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. Under variable costing, ending inventory includes each of these items except fixed manufacturing overhead. Thus, the inventory balance under variable costing is always less than the balance under full costing (assuming the balance is not zero).

The full costing method will result in higher income. In this method, part of fixed manufacturing overhead will remain in ending inventory. However, all of fixed manufacturing overhead is expensed under variable costing.

The variable costing method will result in higher income. In this method, the beginning inventory charged to cost of goods sold is less than under full costing which includes some fixed manufacturing overhead.

Under variable costing, fixed manufacturing overhead costs are expensed in the year they are incurred. Under full costing, fixed manufacturing overhead is allocated to units and is only expensed when the units are sold.

The resulting number represents the difference in net income under full costing and variable costing.

10. Fixed production costs per unit are calculated by dividing total fixed production costs by the number of units produced. Each unit in ending inventory then receives this amount per unit. A company can “bury” fixed costs in inventory by overproducing. The more the company overproduces, the more fixed cost remains in ending inventory relative to cost of goods sold.

5-2

Jiambalvo Managerial Accounting

EXERCISES E1. [LO 2] The income statement produced using variable costing provides a contribution margin. If we divide this by sales, we have the contribution margin ratio (the contribution margin per dollar of sales). Once we have this value, we can estimate the incremental effect on profit of an increase in sales. E2. [LO 2] Increasing production will increase profit since more fixed manufacturing overhead will be buried in ending inventory rather than expensed in cost of goods sold. For example, if the company produced and sold 50,000 items, the entire $24,000,000 of fixed manufacturing overhead would be in cost of goods sold. However, if the company produces 60,000 units, the fixed manufacturing overhead per unit will be $400. Then $20,000,000 will end up in cost of goods sold when the company sells only 50,000 units (i.e., $400 x 50,000) and $4,000,000 will be in ending inventory ($400 x 10,000). Unless management anticipates a significant increase in sales next year, the inventory buildup primarily benefits them and not the shareholders. E3. [LO 1] Full Costing Method: Direct Material Cost Direct Labor Cost Variable Mfg OH Add Fixed Mfg OH Divided by units produced Cost per unit

Variable Costing Method: Direct Material Cost Direct Labor Cost Variable Mfg OH Divided by units produced Cost per unit

$ 500,000 400,000 800,000 1,700,000 1,000,000 $2,700,000 5,000 $ 540

$ 500,000 400,000 800,000 $1,700,000 5,000 $ 340

Chapter 5 Variable Costing

5-3

E4. [LO 1] Variable cost per unit Fixed manufacturing overhead per unit ($600,000 ÷ 1,500 pairs) Full cost per pair

$450 400 $850

Ending inventory under full costing: $850 × 300 pairs = $255,000 E5. [LO 1] Ending inventory under variable costing: $450 × 300 = $135,000 E6. LO [1] Full cost per pair is $850 per Exercise 4. Therefore, cost of goods sold under full costing is $850 × 1,200 pairs sold = $1,020,000. E7. [LO 1] Variable cost per pair is $450. Therefore variable cost of goods sold is $450 × 1,200 pairs = $540,000. Under variable costing, the $600,000 of fixed manufacturing overhead is treated as a period expense. E8. [LO 1] Sales ($1,800 × 1,200 pairs) Less cost of goods sold ($850 × 1,200 pairs) Gross margin Less fixed selling expense Less fixed administrative expense Net income

E9. [LO 1] Sales ($1,800 × 1,200 pairs) Less variable cost of goods sold ($450 × 1,200 pairs) Contribution margin Less fixed manufacturing overhead Less fixed selling expense Less fixed administrative expense Net income

$2,160,000 1,020,000 1,140,000 210,000 110,000 $ 820,000

$2,160,000 540,000 1,620,000 600,000 210,000 110,000 $ 700,000

5-4

Jiambalvo Managerial Accounting

E10. [LO 1, 2] The difference in net income between full and variable costing is $820,000 - $700,000 = $120,000. This is equal to the amount of fixed manufacturing overhead in ending inventory under full costing ($400 × 300 pairs = $120,000). E11. [LO 1] Fixed Manufacturing Overhead Divided by units produced Fixed Manufacturing Overhead per unit Direct Material per unit Direct Labor per unit Variable Manufacturing Overhead per unit Cost per unit

$180,000 50,000 $3.60 5.00 4.00 3.00 $15.60

Shovels produced Shovels sold Shovels in ending inventory × Cost per unit Value of ending inventory

50,000 (45,000) 5,000 $15.60 $78,000

E12. [LO 1] Direct Material per unit Direct Labor per unit Variable Manufacturing Overhead per unit Cost per unit Shovels produced Shovels sold Shovels in ending inventory × Cost per unit Value of ending inventory

$ 5 4 3 $12 50,000 (45,000) 5,000 $ 12 $60,000

E13. [LO 1, 2] Shovels produced Shovels sold Shovels in ending inventory × Fixed Manufacturing Overhead per unit Difference in net income

50,000 (45,000) 5,000 $ 3.60 $18,000

Chapter 5 Variable Costing E14. [LO 1] Fixed Manufacturing Overhead Divided by units produced Fixed Manufacturing Overhead per unit Direct Material per unit Direct Labor per unit Variable Manufacturing Overhead per unit Cost per unit

$180,000 50,000 $ 3.60 5.00 4.00 3.00 $ 15.60

Shovels sold × Cost per unit Cost of goods sold

45,000 $ 15.60 $702,000

E15. [LO 1] Direct Material per unit Direct Labor per unit Variable Manufacturing Overhead per unit Cost per unit Shovels sold × Cost per unit Variable cost of goods sold

$ 5.00 4.00 3.00 $12.00 45,000 $ 12 $540,000

E16. [LO 1] Sales ($30 × 45,000 units) Less cost of goods sold ($15.60 × 45,000 units) Gross margin Less selling and administrative expense Net income

$1,350,000 702,000 648,000 160,000 $ 488,000

E17. [LO 1] Sales ($30 × 45,000 units) Less variable cost of goods sold ($12 × 45,000) Contribution margin Less fixed costs: Fixed manufacturing overhead Fixed selling and administrative costs Net income

$1,350,000 540,000 810,000 180,000 160,000 $ 470,000

5-5

5-6

Jiambalvo Managerial Accounting

E 18. [LO 1, 2] Fixed Manufacturing Overhead Divided by units produced Fixed Manufacturing Overhead per unit

$180,000 50,000 $ 3.60

Shovels produced Shovels sold Shovels in ending inventory × Fixed Manufacturing Overhead per unit Fixed Manufacturing Overhead in ending inventory

50,000 45,000 5,000 $ 3.60 $ 18,000

The amount of fixed manufacturing overhead in ending inventory under full costing is equal to the difference in net income between full costing and variable costing.

Chapter 5 Variable Costing

5-7

PROBLEMS P1. [LO 1, 2] a. 2017 $ 750,000 20,000

2018 $ 750,000 25,000

2019 $ 750,000 15,000

37.50 150.00 $ 187.50

30.00 150.00 $180.00

50.00 150.00 $200.00

Sales ($250 x 20,000 units) $5,000,000 Less cost of goods sold: ($187.50 x 20,000) 3,750,000 ($180 x 20,000) ($180 x 5,000) + ($200 x 15,000) Gross margin 1,250,000 Less selling and admin. expense 220,000 Net income $1,030,000

$5,000,000

Fixed production overhead Divided by units produced Fixed production overhead per unit Variable production costs per unit Full cost per unit

3,600,000 1,400,000 220,000 $1,180,000

3,900,000 1,100,000 220,000 $ 880,000

Ending inventory -0($180 x 5,000)

$ 900,000 -0-

Even though sales are the same in each period, profit fluctuates. That results because different quantities are produced each period which affects the fixed manufacturing overhead in cost of goods sold versus ending inventory.

c. Units sold Selling price per unit Sales Less variable cost of goods sold: ($150 x 20,000) Contribution margin Less fixed costs: Production Selling and administrative Net income

2017 20,000 $ 250 $5,000,000

2018 20,000 $ 250 $5,000,000

2019 20,000 $ 250 $5,000,000

3,000,000 2,000,000

750,000 220,000 $1,030,000

Ending inventory -0($150 x 5,000)

$ 750,000 -0-

5-8

Jiambalvo Managerial Accounting

Profit does not fluctuate each period because fixed manufacturing overhead is treated as a period cost and expensed each year even if more units are produced than sold. Note that income is the same under variable and full costing in 2017 since the quantity produced is equal to the quantity sold. Income under full costing is higher than variable costing income in 2018 since the quantity produced is greater than the quantity sold. Income under full costing is less than income under variable costing in 2019 since the quantity produced is less than the quantity sold.

P2. [LO 1, 2] a. 2017 $50,000 5,000 $10.00 75.00 $ 85.00

2018 $50,000 6,000 $ 8.33* 75.00 $83.33

2019 $50,000 4,000 $12.50 75.00 $87.50

Sales ($225 per unit × 5,000 units) $1,125,000

$1,125,000

Fixed production overhead Divided by units produced Fixed production overhead per unit Variable production costs per unit Full cost per unit *Rounded

Less cost of goods sold: ($85 x 5,000) ($83.33 x 5,000) [($83.33 x 1,000) + ($87.50 x 4,000)] Gross margin Less selling and admin expense Net income

425,000 416,650

700,000 5,000 $ 695,000

708,350 5,000 $ 703,350

433,330 691,670 5,000 $ 686,670

$2,085,020

Ending inventory -0($83.33 x 1,000)

$ 83,330 -0-

b. In 2018, the company produced more units than it sold. As a result, the fixed manufacturing overhead costs applied to those products not sold but produced during the year are part of ending inventory and not cost of goods sold. In 2019, the company sold more units than it produced. The fixed manufacturing overhead costs that were included in ending inventory in 2018 are included in cost of goods sold in 2019. This is why net income is lowest in 2019 of all three years.

Chapter 5 Variable Costing

5-9

c. Fixed production overhead Variable production costs per unit Units sold Selling price per unit Sales Less variable cost of goods sold: ($75 x 5,000) Contribution margin Less fixed costs: Production Selling and administrative Net income

2017 $50,000 75

2018 $50,000 75

2019 $50,000 75

5,000 $ 225 $1,125,000

375,000 750,000

50,000 5,000 $ 695,000

50,000 5,000 $ 695,000 $2,085,000

Ending inventory -0($75 x 1,000)

$ 75,000 -0-

(Note: The $20 difference in total income across the three years between part a and part c is due to rounding.) d. Variable costing calculates cost of goods sold by multiplying the variable production cost per unit by the number of units sold each year. It does not allocate fixed manufacturing overhead to product costs. Since the company sold the same number of units in all three years, cost of goods sold and, thus, net income are the same each year.

5-10 Jiambalvo Managerial Accounting P3. [LO 1, 2] a. Fixed manufacturing overhead Divided by units produced Fixed manufacturing overhead per unit Variable manufacturing costs per unit Full cost per unit

2017 $30,000,000 30,000

2018 $30,000,000 30,000

2019 $30,000,000 22,000

1,000

1,364

1,000 2,000

1,000 2,364

Sales ($2,500 × 30,000 units) ($2,500 × 27,000) ($2,500 × 25,000) Less cost of goods sold: ($2,000 × 30,000) ($2,000 × 27,000) ([$2,000 x 3,000] + [2,364 x 22,000])

$75,000,000

Gross margin Less selling and administrative expenses Net income

15,000,000

13,500,000

350,000 $14,650,000

350,000 $13,150,000

$67,500,000 $62,500,000 60,000,000 54,000,000 58,008,000 4,492,000 350,000 $ 4,142,000 $31,942,000

Ending inventory -0($2,000 x 3,000)

$ 6,000,000 -0-

Chapter 5 Variable Costing

5-11

b. Fixed manufac. overhead Variable manufac. costs per unit

2017 $30,000,000 $1,000

2018 $30,000,000 $1,000

2019 $30,000,000 $1,000

Sales ($2,500 × 30,000 units) ($2,500 × 27,000) ($2,500 × 25,000) Less variable cost of goods sold: ($1,000 × 30,000 units) ($1,000 × 27,000) ($1,000 × 25,000) Contribution margin Less fixed costs: Manufacturing Selling and administrative Net income

$75,000,000 $ 67,500,000 $62,500,000 30,000,000 27,000,000 45,000,000

40,500,000

25,000,000 37,500,000

30,000,000 350,000 $14,650,000

30,000,000 350,000 $10,150,000

30,000,000 350,000 $7,150,000

Ending inventory -0($1,000 × 3,000)

$ 3,000,000 -0-

Under full costing, management could manipulate profit in 2018 by overproducing (producing more units than really needed in 2018). This results in fixed manufacturing overhead being buried in ending inventory. Note that the difference in profit in 2018 between full and variable costing is equal to the difference in ending inventory under full and variable costing. This approach to manipulating earnings could not be repeated year after year— eventually the inventory build-up would be quite obvious.

5-12 Jiambalvo Managerial Accounting P4. [LO 1, 2]

a. Units sold Units produced Fixed production costs Variable production costs per unit Selling price per unit Fixed selling and admin. expenses

2017 10,000 10,000 $350,000 $100 $350 $300,000

2018 9,000 10,000 $350,000 $100 $350 $300,000

2019 8,000 7,000 $350,000 $100 $350 $300,000

Fixed Manufacturing Overhead Divided by units produced Fixed Manufacturing Overhead per unit Variable Manufacturing Costs Full cost per unit

350,000 10,000 $ 35 100 $135

350,000 7,000 $ 50 100 $150

Sales (10,000 x $350) (9,000 x $350) (8,000 x $350) Less Cost of goods sold (10,000 x $135) (9,000 x $135) ([1,000 x $135] + [7,000 x $150]) Less Selling and admin. expenses Net income

$3,500,000 $3,150,000 $2,800,000 1,350,000 1,215,000 1,185,000 300,000 300,000 300,000 $1,850,000 $1,635,000 $1,315,000

Ending inventory -0($135 x 1,000)

$135,000 -0-

Chapter 5 Variable Costing

5-13

b. Fixed manufacturing overhead Variable production cost per unit Sales Less variable cost of goods sold Contribution margin Less fixed costs Manufacturing Selling and administrative Net income

2017 $350,000

2018 $350,000

2019 $350,000

$100

$3,500,000 $3,150,000 $2,800,000 1,000,000 900,000 800,000 2,500,000 2,250,000 2,000,000 350,000 350,000 350,000 300,000 300,000 300,000 $1,850,000 $1,600,000 $1,350,000

Ending inventory -0(100 x 1,000)

$100,000 -0-

Sampson’s management increased net income in 2018 under full costing by producing more units than needed. This approach to earnings management could not be repeated year after year. After manipulating earnings by increasing production for several years, it will become obvious that the company has excess inventory.

P5. [LO 1, 2] a. Fixed manufacturing overhead Divided by units produced Fixed manufacturing overhead per unit Variable manufacturing costs per unit Full cost per unit Sales ($4,000 × 10,000 units) Less cost of goods sold: ($2,800 × 10,000) ($2,800 × 2,000) + ($2,900 × 8,000) Gross margin Less selling and admin. expense Net income Ending inventory ($2,800 × 2,000)

2017 $ 2,400,000 12,000 200 2,600 $ 2,800

2018 $ 2,400,000 8,000 300 2,600 $ 2,900

$40,000,000

28,000,000 12,000,000 1,500,000 $10,500,000

28,800,000 11,200,000 1,500,000 $ 9,700,000

$ 5,600,000 -0-

5-14 Jiambalvo Managerial Accounting b.

Company performance is really not worse in 2018—note that the company had the same cost structure and the same level of sales. The difference is due to greater production in 2017 which lowered unit cost and buried fixed manufacturing overhead in inventory.

c. Fixed manufacturing overhead Variable manufacturing costs per unit Sales ($4,000 × 10,000 units) Less variable cost of goods sold: ($2,600 × 10,000 units) Contribution margin Less fixed costs: Manufacturing Selling and administrative Net income Ending inventory ($2,600 × 2,000)

2017 $2,400,000 $2,600

2018 $2,400,000 $2,600

$40,000,000

26,000,000 14,000,000

2,400,000 1,500,000 $ 10,100,000

$ 5,200,000 -0-

Variable costing presents a more realistic view of firm performance in that income is the same in both years which is consistent with the firm having the same cost structure and level of sales in both years.

Chapter 5 Variable Costing

5-15

P6. [LO 1, 2] a. Units sold Units produced Fixed production costs Variable production costs per unit Selling price per unit Fixed selling and administrative expenses

2017 18,000 21,000 $630,000 $200 $500 $200,000

2018 18,000 15,000 $630,000 $200 $500 $200,000

Fixed Manufacturing Overhead Divided by units produced Fixed Manufacturing Overhead per unit Variable Manufacturing Costs Full cost per unit

$630,000 21,000 $ 30 200 $ 230

$630,000 15,000 $ 42 200 $ 242

Sales (18,000 x $500) Less Cost of goods sold ($230 x 18,000) ($230 x 3,000) + ($242 x 15,000) Less Selling and administrative expenses Net income

$9,000,000 $9,000,000

4,140,000 4,320,000 200,000 200,000 $4,660,000 $4,480,000

The company had higher profit in 2017 than in 2018, but its performance was not necessarily better in 2017. Its sales and costs were the same in both years. However, since the company produced more units than it sold in 2017 and produced less than it sold in 2018, net income was higher in 2017.

c. Fixed manufacturing overhead Variable production cost per unit

Sales Less variable cost of goods sold Contribution margin Less fixed costs Manufacturing Selling and administrative Net income d.

2017 $630,000 $200

2018 $630,000 $200

$9,000,000 $9,000,000 3,600,000 3,600,000 5,400,000 5,400,000 630,000 630,000 200,000 200,000 $4,570,000 $4,570,000

Variable costing presents a more realistic view of the firm’s performance in these two years. The firm had the same amount of sales and costs in both years. Accordingly, net income for both years is the same. Under variable costing, income cannot be managed by producing more than needed.

5-16 Jiambalvo Managerial Accounting P7.

[LO 1] Income computed under full costing is $10,000 higher than income computed under variable costing. Under variable costing, the entire amount of fixed manufacturing overhead ($50,000) was treated as a period cost. Under full costing, $10,000 remains in ending inventory. Fixed manufacturing overhead Divided by units produced Fixed manufacturing overhead per unit

$50,000 1,000 $ 50

Amount of fixed manufacturing overhead in ending inventory: $50 × 200 units = $10,000

P8. [LO 1] Fixed manufacturing overhead Divided by units produced Fixed manufacturing overhead per unit

$600,000 50,000 $ 12

Knives produced Knives sold Knives in ending inventory × Fixed manufacturing overhead per unit Ending inventory under full costing

50,000 (45,000) 5,000 $ 12 $60,000

Net income under full costing Net income under variable costing Difference

$660,000 600,000 $ 60,000

P9. [LO 1, 2] a. Contribution margin ÷ sales = contribution margin ratio $8,000,000 ÷ $20,000,000 = .40. (Incremental sales × contribution margin ratio) – incremental salaries = incremental profit ($1,800,000 x .40) - $160,000 = $560,000 profit increase Since profit increases, Wilner Glass Company should hire the two additional sales representatives. b.

The chief accountant is treating income per dollar of sales as the contribution margin ratio. Income only varies in proportion to sales if all costs are variable which is clearly not the case for Wilner Glass Company.

Chapter 5 Variable Costing

5-17

P10. [LO 1, 2] a. Trio Office Supplies Incremental Income

Contribution margin ratio: ($12,000,000 ÷ $30,000,000) Incremental sales (3 x $400,000) Incremental contribution margin (.40 x $1,200,000) Incremental cost of three sales reps (3 x $150,000) Incremental profit

.40

$1,200,000

$480,000 450,000 $ 30,000

Since there is an incremental profit (albeit small), Trio Office Supplies should hire the three sales representatives. b. The major flaw is the calculation of income per dollar of sales and using this number rather than the contribution margin ratio.

P11.

[LO 1, 2] a. Variable Costing 2015 2016 2017 Sales $14,400,000 $15,840,000 $17,760,000 Less variable cost of goods sold 6,000,000 6,600,000 7,400,000 Contribution margin 8,400,000 9,240,000 10,360,000 Less: Fixed production costs 6,400,000 6,400,000 6,400,000 Fixed selling and admin. expense 3,600,000 3,600,000 3,600,000 Net income ($1,600,000) ($ 760,000) $ 360,000

5-18 Jiambalvo Managerial Accounting b.

Under full costing, it appears that Ed did a good job since the company hit the breakeven point in its first year and then earned a profit of $360,000 in its second year. However, variable costing provides a better picture of the firm’s profitability under Ed’s guidance. Note that under variable costing, the company had a $760,000 loss in its second year. Ed was able to show a profit under full costing by producing more than needed for current period sales and burying a substantial amount of fixed manufacturing cost in ending inventory. That’s why Zac could not show a profit under full costing in 2017. He had to cut production in 2017 to avoid building up excess inventory. This increased per unit cost. Income statements prepared under variable costing indicate that Zac’s performance was quite good. Sales have increased and so has profit.

The company should not get out of the tractor business. As indicated in the variable costing income statement, the company is now profitable. If the company can continue performing improvements, it will be quite successful.

P12. [LO 1, 2] a. Fixed manufacturing overhead Variable production cost per unit Sales Less Variable Cost of Goods Sold Contribution margin Less fixed costs Manufacturing Selling and administrative Net income

2015 $2,100,000 $ 900

2016 $2,100,000 $ 900

2017 $2,100,000 $ 900

$7,650,000 4,050,000 3,600,000

$9,350,000 4,950,000 4,400,000

$11,050,000 5,850,000 5,200,000

2,100,000 2,250,000 ($ 750,000)

2,100,000 2,250,000 $ 50,000

2,100,000 2,250,000 $ 850,000

b. Daryl performed much better in 2017 than Milo did in 2015 and 2016. Under the variable costing method, the company was unprofitable in 2015 and only slightly profitable in 2016. However, in 2017, the firm generated a relatively high profit. c. No, the company should not get out of the golf club business. The company saw a significant increase in profits in 2017 under variable costing. The reason why the company incurred a net loss under full costing in the same year was because the company sold twice as many units as it produced, and therefore fixed costs from prior year’s production reduced net income.

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P13. [LO 1, 2] a.

Fixed manufacturing overhead ÷ Units produced = fixed manufacturing overhead per unit $900,000 ÷ 150,000 = $6 $6 × 120,000 units sold = $720,000.

With variable costing, the entire amount of fixed manufacturing overhead ($900,000) will be expensed.

The amount of fixed manufacturing overhead in ending inventory under full costing is $180,000: $6 × 30,000 units = $180,000. This accounts for the difference between income under full versus variable costing.

P14. [LO 1, 2] a. Fixed manufacturing overhead Divided by units produced Fixed manufacturing overhead per unit

$1,500,000 500,000 $ 3

Units sold × Fixed manufacturing overhead per unit Amount of fixed mfg. overhead expensed

450,000 $ 3 $1,350,000

b. All $1,500,000 of fixed manufacturing overhead would be expensed under variable costing. c. Fixed manufacturing overhead Divided by units produced Fixed manufacturing overhead per unit Units in ending inventory × fixed manufacturing overhead per unit Amount of fixed manufacturing overhead in ending inventory Fixed manufacturing overhead expensed under variable costing Fixed manufacturing overhead expensed under full costing Difference

$1,500,000 500,000 $ 3

50,000 3

$ 150,000 $1,500,000 1,350,000 $ 150,000

5-20 Jiambalvo Managerial Accounting P15. [LO 1, 2] a. Fixed manufacturing overhead Divided by units produced Fixed manufacturing overhead per unit Variable manufacturing costs per unit ($75 + $30 + $5) Full cost per unit Sales ($150 × 230,000 units) Less cost of goods sold: ($121 × 230,000) Gross margin Less selling expense ($1,500,000.00 + (.05 × $34,500,000) Less administrative expense Net income Ending inventory ($121 × 20,000)

2017 $2,750,000 250,000 11

110 121

$34,500,000 27,830,000 6,670,000 3,225,000 900,000 $2,545,000

$2,420,000

b. Sales ($150 × 230,000 units) Less variable cost of goods sold: ($110.00 × 230,000) Less variable selling expense ($.05 × $34,500,000) Contribution margin Less fixed costs: Manufacturing Selling expense Administrative expense Net income Ending inventory ($110 × 20,000) c.

2017 $34,500,000 25,300,000 1,725,000 7,475,000 2,750,000 1,500,000 900,000 $ 2,325,000

$2,200,000

The amount of fixed manufacturing overhead included in ending inventory under full costing is $220,000 ($11 × 20,000 units). This accounts for the difference in income under full versus variable costing.

Chapter 5 Variable Costing P16. [LO 1, 2] a. Dorian Industrial Income Statement For the Year Ended December 31, 2017

Sales ($50 × 400,000) Less Cost of goods sold ($25* × 400,000) Gross margin Less: Fixed selling expenses Variable selling expense ($0.20 × 400,000) Fixed administrative expenses Net income * Product cost per unit: Direct material Direct labor Variable manufacturing overhead Fixed manufacturing overhead ($1,260,000 ÷ 420,000)

$20,000,000 10,000,000 10,000,000 300,000 80,000 100,000 $ 9,520,000

$15 5 2 3 $25

b. Dorian Industrial Income Statement For the Year End December 31, 2017

Sales ($50 × 400,000) Less Variable Expenses Production costs ($22 × 400,000) Selling costs ($0.20 × 400,000) Contribution margin Less Fixed Expenses Manufacturing overhead Selling Administrative Net income

$20,000,000 8,800,000 80,000 11,120,000 1,260,000 300,000 100,000 $ 9,460,000

5-21

5-22 Jiambalvo Managerial Accounting c. Units produced Units sold Units in ending inventory × FMOH per unit FMOH in ending inventory Net income under full costing Net income under variable costing Difference

420,000 400,000 20,000 $ 3 $ 60,000 $9,520,000 9,460,000 $ 60,000

P17. [LO 1, 2] a. Jorgensen Manufacturing Income Statement For the Year Ended December 31, 2017 Sales ($4,500 × 7,000) Less cost of goods sold ($4,200* × 7,000) Gross margin Less: Fixed selling and administrative expenses Variable selling expense ($225 × 7,000) Net income * Product cost per unit: Direct material Direct labor Variable manufacturing overhead Fixed manufacturing overhead ($800,000 ÷ 8,000)

$31,500,000 29,400,000 2,100,000 400,000 1,575,000 $ 125,000

$2,000 1,200 900 100 $4,200

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b. Jorgensen Manufacturing Income Statement For the Year End December 31, 2017

Sales ($4,500 × 7,000) Less variable expenses Production costs ($4,100 × 7,000) Selling costs ($225 × 7,000) Contribution margin Less fixed expenses Manufacturing overhead Selling and administrative Net income

$31,500,000 28,700,000 1,575,000 1,225,000

800,000 400,000 25,000

c. Units produced Units sold Units in ending inventory × Fixed manufacturing overhead per unit Fixed manufacturing overhead in ending inventory

8,000 7,000 1,000 $ 100 $100,000

Net income under full costing Net income under variable costing Difference

$125,000 25,000 $100,000

d. Net income under both variable costing and full costing would have been $200,000. Net income would be equal under both methods because the number of units produced equals the number of units sold. A calculation of net income under variable costing follows: Jorgensen Manufacturing Income Statement For the Year End December 31, 2017 Sales ($4,500 × 8,000) Less Variable Expenses Production costs ($4,100 × 8,000) Selling costs ($225 × 8,000) Contribution margin Less Fixed Expenses Manufacturing overhead Selling and administrative Net income

$36,000,000 32,800,000 1,800,000 1,400,000

800,000 400,000 200,000

5-24 Jiambalvo Managerial Accounting P18. [LO 1, 2] a. Axar Products Income Statement For the Year Ended December 31, 2017 Sales ($30 × 18,000) Less Cost of goods sold ($20* × 18,000) Gross margin Less: Fixed selling and administrative expenses Variable selling expense ($3 × 18,000) Net income * Product cost per unit: Direct material Direct labor Variable manufacturing overhead Fixed manufacturing overhead ($160,000 ÷ 20,000)

$540,000 360,000 180,000 80,000 54,000 $ 46,000

$ 6 4 2 8 $20

b. Axar Industrial Income Statement For the Year Ended December 31, 2017 Sales ($30 × 18,000) Less Variable Expenses Production costs ($12 × 18,000) Selling costs ($3 × 18,000) Contribution margin Less Fixed Expenses Manufacturing overhead Selling and administrative Net income

$540,000 216,000 54,000 270,000 160,000 80,000 $ 30,000

c. Break-Even Point in Sales Dollars $240,000 ÷ ($270,000 ÷ $540,000) = $240,000 ÷ 0.50 = $480,000 Break-Even Point in Units $240,000 ÷ ($30 − $12 − $3) = 16,000 units The break-even point cannot be calculated using full costing because full costing does not provide a contribution margin and a breakout of all fixed costs, both of which are needed in break-even analysis.

Chapter 5 Variable Costing

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Case 5-1. [LO 1, 2]

MICROIMAGE TECHNOLOGY, INC. Summary A company using full costing is showing a loss. A major investor notes that “It looks like the more we sell, the more we’ll lose.” Actually, the company’s prospects are fairly good. •

Relates variable costing to planning and decision making.

Questions to ask students 1. What’s the situation at MicroImage Technology? 2. Is it true that the more the company sells, the more it will lose? 3. Is forecasted profit encouraging? Discussion MicroImage Technology has a negative gross margin of $1,160,000. This leads Sanjay Patel, a major stockholder, to wonder if the more the company sells, the more it loses. This isn’t the case, which we can see if we recast the full costing income statement into a variable costing format and then calculate the break-even level of sales.

5-26 Jiambalvo Managerial Accounting a. Variable manufacturing costs: Direct material Direct labor Variable overhead Total

$16.00 ($1,280,000 ÷ 80,000) 15.00 ($1,200,000 ÷ 80,000) 11.00 ($160,000 + 400,000 + 320,000) ÷ 80,000 $42.00

Variable selling expense: Shipping Commissions Travel Total

$ 3.50 ($280,000 ÷ 80,000) 10.00 ($800,000 ÷ 80,000) 1.50 ($120,000 ÷ 80,000) $15.00

Fixed manufacturing costs: Rent Depreciation Supervisory salaries Miscellaneous Total

$ 1,800,000 5,000,000 4,500,000 3,700,000 $15,000,000

Fixed selling expense: Salaries Miscellaneous Total

$1,900,000 650,000 $2,550,000

Sales ($215 × 80,000 units) Less variable cost of goods sold: ($42.00 × 80,000) Less variable selling expense ($15.00 × 80,000) Contribution margin Less fixed costs: Manufacturing Selling expense Administrative expense Net income

2017 $17,200,000 3,360,000 1,200,000 12,640,000 15,000,000 2,550,000 4,900,000 $(9,810,000)

b. Note that the contribution margin in 2017 was $12,640,000, implying a contribution margin ratio of .7349 ($12,640,000 ÷ $17,200,000). Thus, the company is earning an incremental $0.74 on each dollar of sales. This is quite different from Sanjay Patel’s contention that the company is losing money on each sale. Total fixed costs are $22,450,000. With a contribution margin ratio of .7349, the break-even point is $30,548,374 (i.e., $22,450,000 ÷ .7349). That’s quite a bit higher than the current level of sales. However, the budgeted income statement for 2019 indicates that this target will be exceeded in 2019.

Chapter 5 Variable Costing

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c. Here are the budgeted income statements for 2018 and 2019. Note that the company expects to earn a substantial profit by the end of 2019. Sales ($215 × 104,000 units) Less variable cost of goods sold: ($42.00 × 104,000) Less variable selling expense ($15.00 × 104,000) Contribution margin Less fixed costs: Manufacturing Selling expense Administrative expense Net income

Sales ($215 × 166,400 units) Less variable cost of goods sold: ($42.00 × 166,400) Less variable selling expense ($15.00 × 166,400) Contribution margin Less fixed costs: Manufacturing Selling expense Administrative expense Net income

2018 $22,360,000

Sales up by 30%

4,368,000 1,560,000 16,432,000 15,000,000 2,730,000 3,800,000 $(5,098,000)

2019 $35,776,000

$2,550,000 + $180,000 $4,900,000 - $1,100,000

Sales up by 60%

6,988,800 2,496,000 26,291,200 15,000,000 2,820,000 4,400,000 $ 4,071,200

$2,730,000 + $90,000 $3,800,000 + $600,000

5-28 Jiambalvo Managerial Accounting

Case 5-2. [LO 1, 2]

RAINRULER STAINS Summary RainRuler Stains is considering marketing its products to large construction companies. The company has an income statement prepared using full costing. To estimate the impact of the new business, a manager treats cost of goods sold as a variable cost and all other costs as fixed. Jennifer Jones, an intern, proposes to do a more accurate analysis. •

Relates variable costing to planning and decision making.

Questions to ask students 1. What’s the situation at RainRuler Stains? 2. What is the contribution margin ratio for sales in the new channel? 3. What is the annual impact of sales in the new channel on profit? Discussion Jennifer Jones, an intern at RainRuler, notes that Reggie Sherman’s (VP of marketing) analysis is more than a little rough. He assumes that cost of goods sold is the only variable cost and all other costs are fixed. Jennifer proposes to do a more thorough analysis. We begin by recasting results for 2017 into a variable costing format.

Chapter 5 Variable Costing Total manufacturing costs (equal to cost of goods sold since production equals sales) Less fixed manufacturing costs Variable manufacturing costs Number of gallons Variable manufacturing cost per gallon Total selling expense Variable portion related to shipping ($0.70 × 310,000) Fixed selling expense

Sales ($15 × 310,000 gallons) Less variable cost of goods sold: ($6.25 × 310,000) Less variable selling expense ($0.70 × 310,000) Contribution margin Less fixed costs: Manufacturing Selling expense Administrative expense Net income

$3,300,000 1,362,500 1,937,500 310,000 $6.25 $870,000 217,000 $653,000 2017 $4,650,000 1,937,500 217,000 2,495,500

1,362,500 653,000 360,000 $ 120,000

5-29

5-30 Jiambalvo Managerial Accounting Now, let’s use this as a basis for estimating the annual impact of selling to construction companies. The new variable costing income will be:

Sales (($15 × 310,000 gallons) + ($12 x 70,000 gallons)) Less variable cost of goods sold: ($6.25 × 380,000) Less variable selling expense ($0.70 × 380,000) Contribution margin Less fixed costs: Manufacturing Selling expense Administrative expense Net income Profit in 2017 Profit in 2018 with sales to construction companies Incremental profit

2018 $5,490,000 2,375,000 266,000 2,849,000 1,362,500 653,000 360,000 $473,500 $120,000 473,500 $353,500

As indicated, the incremental profit associated with selling to construction companies is $353,500 which is much higher than the estimate of $243,852 provided by Reggie.

Chapter 6 Cost Allocation and Activity-Based Costing QUESTIONS

1. The statement is false. Cost allocation refers to the process of assigning indirect costs. Direct costs are traced to cost objects. Costs are allocated for a variety of reasons. It is not economically feasible to directly trace some costs to cost objects—these costs are classified as indirect costs and are allocated to the cost object via the use of an allocation base. 2. A cost objective is a product, service, or department that receives an allocation of cost. For example, a production department that receives an allocation of janitorial cost is a cost objective. Likewise, a product in a department that receives an allocation of depreciation of equipment is a cost objective. 3. A concern in forming a cost pool is that the costs within the cost pool be similar or homogeneous. It is unlikely that variable and fixed costs are similar (i.e., that one allocation base is suitable for allocating both fixed and variable costs). Homogeneous cost pools provide more accurate information and this would be a benefit of having one pool for variable costs and one for fixed costs. 4. Number of employees in a department would, most likely, result in a cause-andeffect allocation (at least for the variable costs in the cafeteria). 5. If budgeted costs are allocated, then service departments cannot pass on inefficiencies and waste. 6. In a responsibility accounting system, revenues and costs are traced to departments/ divisions and individuals with related responsibility for generating revenues and controlling costs. This facilitates performance evaluation of managers and the operations under their control. 7. Sometimes managers are allocated costs beyond their control in order to make them aware that the costs exist and must be covered by revenues of the firm.

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Jiambalvo Managerial Accounting

8. Traditional allocation methods use a small number of cost pools and allocation bases related to production volume. However, some costly activities are not related to production volume. Consider the costs associated with setups—in a traditional costing system setup costs would be allocated based on production volume and high volume products would receive most of the allocated cost even though low volume products may require an equal number of setups. 9. The traditional costing approach typically uses allocation bases that are measures of production volume (e.g., direct labor hours, direct labor cost, or machine hours). Also, relatively few cost pools are used under the traditional approach (e.g., one or two cost pools). ABC focuses on major activities that cause overhead costs to be incurred. Many of these activities are not related to production volume. Cost pools are formed for each major activity and costs are assigned to products using an allocation base that is a cost driver. Many of the cost drivers are not related to production volume. ABC typically uses more cost pools and related cost drivers. 10. ABC will tend to give more relevant costs than a traditional cost system when: (1) the production process is complex and varied (high and low volume products), (2) products consume resources differently, and (3) there are activities that are not related to production volume (e.g., setups).

Chapter 6 Cost Allocation and Activity-Based Costing

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EXERCISES E1. [LO 2] Fixed costs (e.g., administrative costs) are sometimes allocated based on a measure of business activity (e.g., sales). This makes the costs appear to be variable (e.g., the higher sales, the higher the allocation of administrative cost). In turn, this may lead to poor decisions if managers treat the allocated costs as incremental. E2. [LO 2] This allocation is potentially harmful. A hotel manager will tend to overestimate the costs that increase with revenue. And this may lead to poor decisions that affect revenue. For example, suppose a hotel manager is considering a trade association’s request for a special convention rate of $70 per room during a slow season. The manager estimates that incremental costs per room are $75 including $10 of allocated costs for general administration which are actually allocations of fixed costs! In this case, the manager will turn down the request even though his or her company would really make $5 of incremental profit per room. Remember, $10 of allocated costs appears incremental but, in fact, they are fixed. Thus, actual incremental costs are only $65, which is $5 less than incremental revenue of $70. E3. [LO 1] Student answers will vary. However, deans with relatively costly operations (e.g., the dean of the College of Engineering) will argue against using expense as the allocation base. The dean of Arts and Science (the college that likely has the most students) will argue against using the number of majors in the college. Finally, deans of colleges that take up a lot of space (again Engineering is likely due to its use of lab space) will argue against use of square feet. E4. [LO 2] Warner might want to encourage department managers to evaluate security services. When security costs are allocated, departments have an incentive to voice concerns about the cost of security service. This may make the security department more efficient. In addition, allocation of security costs that relate to manufacturing are required under GAAP.

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Jiambalvo Managerial Accounting

E5. [LO 1] a. Service Department Human resources Duplicating Janitorial Accounting Graphic design Food services b.

Allocation Base Number of employees Number of pages copied Floor space Number of sales transactions Time spent on design work Number of employees

Under the direct method costs are not allocated between service departments. Thus, the Human Resource department would not receive a share of Food Services costs.

E6. [LO 1] Total fixed costs to be allocated = $100,000 + 12,500 + 10,000 + 5,000 = $127,500. Fixed costs allocated to Sales ($127,500 x .4) Variable costs allocated to Sales (2,500,000 copies x $.02) Total costs allocated to Sales

$ 51,000 50,000 $101,000

Fixed costs allocated to Admin. ($127,500 x .6) Variable costs allocated to Admin (2,300,000 copies x $.02) Total costs allocated to Sales Admin.

$ 76,500 46,000 $122,500

E7. [LO 1] Allocation Base

Prod. Dept.1

Prod. Dept.2

Square footage

$2,250,000

$3,000,000

($75* x 30,000)

($75 x 40,000)

$3,000,000

$2,250,000

($75 X 40,000)

($75 x 30,000)

Direct labor hrs. * $5,250,000 ÷ 70,000 = $75

As indicated, the choice of the allocation base greatly affects the allocations of cost. Use of square footage as the allocation base assigns 57% of the cost to department 2 and 43% to department 1. However, use of direct labor hours allocates 57% of the cost to department 1 and only 43% to department 2. Department 1 would prefer to be allocated cost based on square footage and department 2 would prefer direct labor hours as the base.

Chapter 6 Cost Allocation and Activity-Based Costing

6-5

An allocation base that results in a cause and effect allocation is preferred. If maintenance costs are mostly related to building maintenance, then square footage is more likely to result in a cause and effect allocation. However, if maintenance costs are mostly related to cleaning up waste related to operations, then labor hours might be a better allocation base. E8. [LO 1] P1 has 200 ÷ 500 = 40% of production department employees. P2 has 300 ÷ 500 = 60% of production department employees. Service Department S1 S2 S3 Total cost

Service dept. Costs $ 4,500,000 3,000,000 2,700,000 $10,200,000

Cost Allocated to P1 P2 $1,800,000 $2,700,000 1,200,000 1,800,000 1,080,000 1,620,000 $4,080,000 $6,120,000

E9. [LO 2] a. The manufacturing overhead allocation includes $56 of fixed cost which will not increase if the special order is accepted (i.e., it is not an incremental cost). The incremental revenue and incremental costs associated with the order suggests that the company will be better off by $93,000 if the order is accepted. Incremental revenue (3,000 x $220) Incremental costs Material (3,000 x $125) Labor (3,000 x $50) Variable overhead (3,000 x $14) Incremental profit

$660,000 $375,000 150,000 42,000

567,000 $ 93,000

b. Managers who focus on reported cost may (incorrectly) treat the $56 of fixed cost as an incremental cost. In this case they will (incorrectly) conclude that the order should not be accepted because the total cost ($245) is more than the offer ($220).

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Jiambalvo Managerial Accounting

E10. [LO 1, 2] a. The reason that allocated general and administrative costs are higher for the Services Department is that revenue in the Sales Department has decreased. Since general and administrative costs are allocated based on actual revenues, changes in one department’s revenue affect another department’s allocation of overhead costs (since service has a higher proportion of total revenue, it will have a higher amount of allocated overhead). b. If service department costs are affected by Vance Mason’s decisions, then he should be held responsible for those costs. However, it appears that his department is being allocated costs over which he has no control. Allocating cost beyond Mason’s control may cause him to feel that he has been treated unfairly, especially if his performance evaluation is based on the service department’s profits. E11. [LO 1, 2] a. The manager of Auburn Business Banking will perceive that allocated service department costs are variable costs (when business banking revenue increases, the allocated costs increase). b. In performing incremental analysis, the president of Auburn Business Banking will tend to overestimate incremental costs because she will treat allocated costs as incremental costs (when some of the costs are, in all likelihood, fixed). E12. [LO 2] The use of a single cost pool causes A1 to be undercosted and B1 to be overcosted. With a single cost pool, both products receive the same allocation of cost per labor hour. However, A1 uses relatively more time in P1 where overhead costs are high while B1 uses relatively more time in P2 where overhead costs are low. The one-cost pool overhead rate is: $5,000,000 ÷ 500,000 DLH = $10/DLH Each product requires 5 direct labor hours in total. Therefore, each will be allocated $50 in overhead costs ($10  5)

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Now let’s calculate the amount of overhead allocated to each product if Morton used a separate overhead cost pool for each production department. P1’s overhead rate will be $3,000,000 ÷ 200,000 DLH = $15 per direct labor hour. P2’s overhead rate will be $2,000,000 ÷ 300,000 DLH = $6.67 per direct labor hour. Overhead allocated to each unit of A1 will be: (2 labor hours  $15) + (3 labor hours  $6.67) Overhead allocated to each unit of B1 will be: (1 labor hour  $15) + (4 labor hours  $6.67)

$50.01 $41.68

Note that the overhead allocated to B1 is lower with two cost pools while the allocation to A1 is higher. E13. [LO 1] a. If the costs of the design department are fixed and the department is able to complete jobs on a timely basis, then the opportunity cost of using the department is approximately zero and equal to the allocation (which is also zero). b. Subsidiaries often have to go outside for design work because of time delays. Thus, there is an opportunity cost associated with use that is greater than the allocation (which is zero). c. The allocation of $60 per hour must be less than the opportunity cost (subsidiaries are willing to pay $80 per hour to avoid delays). Thus, they must have a benefit that exceeds $80. d. The opportunity cost of using design services may be less than $60 since no one is being turned away or delayed. Thus, there does not appear to be a benefit foregone because of use.

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Jiambalvo Managerial Accounting

E14. [LO 2] COST POOL Inspection of raw materials Production equipment repairs and maintenance Raw materials storage Plant heat, light, water, and power Finished product quality control Production line setups

COST DRIVER Number of receipts Machine hours Dollar value of raw materials Square footage Number of inspections Number of setups

E15. [LO 1, 2] Cost per setup = $4,200,000 ÷ 2,000 = $2,100 Cost of setups related to EP150 = 2  $2,100 = $4,200 Setup cost per unit of EP150 = $4,200 ÷ 800 = $5.25 E16. [LO 1, 2] Cost per setup = $105,000 ÷ 1,500 = $70 Cost of setups related to the A128 design = 3  $70 = $210 Setup cost per A128 dress = $210 ÷ 325 = $0.65 E17. [LO 2] If the cost to process an order is much higher at one plant than at the other and the orders are similar, then there is a good chance that the costs are out of control at the higher cost location and a manager should investigate the situation. Conceivably, the company can adopt “best practices” from the low cost plant. E18. [LO 2] a. The cost of filling orders at Hearthstone Appliances is: ($300,000 + $450,000) ÷ 125,000 = $6 per order. The cost of filling orders at the auto supply chain is only $4.50 per order. While this is lower, it may be that this is due to size efficiencies that cannot be replicated by Hearthstone. Also, the products are different and filling orders for an auto supply company may just be inherently easier. b. Possibly, order “pickers” can take multiple order sheets out to the warehouse when individual orders are small. This will save considerable time going back and forth to the warehouse and may lead to lower costs if the company is willing to fire or reassign one or more of the five workers who pick parts. PROBLEMS

Chapter 6 Cost Allocation and Activity-Based Costing

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P1. [LO 1] a. Employee benefits Proportion Amount allocated

Allocation Base Head count

Rent Proportion Amount allocated

Square feet

Telecommunications Proportion Amount allocated

Headcount

General and adm. costs Proportion Amount allocated Total

$2,500,000

$1,000,000

$500,000 Sales $3,000,000 $7,000,000

Software 375 .75 $1,875,000

Consulting 125 .25 $625,000

20,000 .5 $500,000

375 .75 $375,000

125 .25 $125,000

$15,000,000 .652174 $ 1,956,522 $ 4,706,522

$8,000,000 .347826 $1,043,478 $2,293,478

Profit Report: (using multiple cost pools/allocation bases)

Sales Less direct costs Less allocated costs Income before taxes

Software $15,000,000 6,000,000 4,706,522 $ 4,293,478

Consulting $8,000,000 4,000,000 2,293,478 $1,706,522

Using multiple cost pools and multiple allocation bases allocates $543,478 ($2,293,478 - $1,750,000) more overhead cost to consulting than a single allocation base method. b. Assuming the controller’s assumptions are correct (that benefits and telecommunications costs are driven by headcount while rent is driven by space occupied and general and administrative costs are driven by relative sales), then the multiple cost pools provide better information on the resources consumed and the profitability of the two divisions.

6-10 Jiambalvo Managerial Accounting P2. [LO 1] a.

Employee Benefits Proportion* Amount allocated

Allocation Base Head count

Stock Stuffed Custom Stuffed Animals Animals 240 80 0.75 0.25 $1,125,000 $375,000

Rent Proportion Amount allocated

Square feet

10,000 0.50 $750,000

Telecommunications Proportion Amount allocated

Head count

240 0.75 $375,000

80 0.25 $125,000

General and Adm. Costs Proportion* Amount allocated

Sales

$ 7,500,000 0.60 $600,000

$ 5,000,000 0.40 $400,000

$2,850,000

$1,650,000

Total *rounded to two decimal places

Profit Report (using multiple cost pools/allocation bases): Stock Custom Stuffed Stuffed Sales $7,500,000 $5,000,000 Less direct costs $2,500,000 $4,000,000 Less allocated costs $2,850,000 $1,650,000 Income (loss) before taxes $2,150,000 ($ 650,000) b.

Assuming the controller’s assumptions are correct (that benefits and telecommunications costs are driven by headcount while rent is driven by space occupied and general and administrative costs are driven by relative sales), then the multiple cost pools provide better information on the resources consumed and the profitability of the two divisions.

Chapter 6 Cost Allocation and Activity-Based Costing

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P3. [LO 1] a. The opportunity cost of producing a Model 350 motor is simply the incremental cost of production (given that Binder has excess capacity and sales to Dacon will not affect sales to other customers). Direct material $25 Direct labor 5 Variable overhead ($1.20* x $5) 6 Total $36 * Variable overhead rate is equal to $6,000,000 of variable overhead ÷ $5,000,000 of direct labor. b. Since 60 percent of the overhead is fixed ($9 per motor), the incremental cost to produce the motors is $36 per motor ($25 + 5 + 6). Any bid greater than $36 (that’s accepted) will generate incremental profit. If Binder can get the order with a bid of $39, the company should bid this amount. It will generate incremental profit of $18,000 [($39 − $36)  6,000 motors]. c. The opportunity cost related to overhead, in this case, is simply the variable overhead amount. An allocation based on the opportunity cost idea, helps managers focus on incremental costs—the information needed for decision making.

6-12 Jiambalvo Managerial Accounting P4. [LO 1] a. The opportunity cost of producing a case of syrup is simply the incremental cost of production (given that Brennen has excess capacity and sales to Quality Candy will not affect sales to other customers). Direct material $ 9.00 Direct labor 5.00 Variable overhead ($0.45* x $5) 2.25 Total $16.25 * Variable overhead rate is equal to $270,000 of variable overhead ÷ $600,000 of direct labor. b. Since fixed OH is 75% of total OH ($810,000 ÷ $1,080,000), the fixed OH rate is $6.75 per case (75% × $9), the incremental cost to produce the cases is $16.25 per case ($9 + 5 + 2.25). Any bid greater than $16.25 (that’s accepted) will generate incremental profit. If Quality Candy can get the order with a bid of $19, the company should bid this amount. It will generate incremental profit of $13,750 [($19 − $16.25) x 5,000 cases]. c. The opportunity cost related to overhead, in this case, is simply the variable overhead amount. An allocation based on the opportunity cost idea, helps managers focus on incremental costs—the information needed for decision making. P5. [LO 1] a. Overhead rate based on direct-labor dollars ($75,000,000 overhead ÷ $7,500,000 labor)

$10 per dollar of labor

Overhead rate based on machine hours ($75,000,000 overhead ÷ 750,000 machine hours)

$100 per machine hour

Direct material Direct labor Overhead Cost

Labor $ $3,000 900 9,000 $12,900

Civilian Mach.Hrs. $ 3,000 900 10,000 $13,900

Military Labor $ Mach.Hrs. $ 3,500 $ 3,500 1,200 1,200 12,000 10,000 $16,700 $14,700

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b. The price charged for the civilian version of the Model KV10 does not depend on allocated costs. However, the military version is sold for “cost” plus 10 percent of cost. Therefore, the company has an incentive to make cost appear higher rather than lower. This can be accomplished by allocating overhead cost using direct labor cost as the allocation base. This base results in a higher cost ($16,700) compared to an allocation based on machine hours which results in a cost of only $14,700. c. Many, if not most, managers believe that “it is well known that allocation is somewhat arbitrary and the government is not at all surprised that companies pick allocation bases to maximize their profit.” Since no one is being “fooled,” the behavior is not illegal, and the “right” allocation isn’t obvious, picking an allocation base to maximize profit does not appear to be unethical. P6. [LO 1] a. Twenty-five percent of air miles are by Domestic (7,500,000 miles ÷ 30,000,000 miles) and International flights accounts for 75 percent of the total air miles. Therefore, Domestic flights will be allocated 25 percent of the service departments’ costs and International will be allocated 75 percent.

Ticketing Baggage handling Maintenance Total

Costs $ 4,000,000 2,000,000 9,000,000 $15,000,000

Allocated to Domestic International $ 1,000,000 $3,000,000 500,000 1,500,000 2,250,000 6,750,000 $3,750,000 $11,250,000

b. The best cause-and-effect relation is probably between maintenance costs and air miles flown (the most suspect relation is between ticketing and air miles flown—more miles do not lead to higher ticketing costs). Given that international passengers have more baggage and have more transfers than domestic flyers, the relation between baggage handling costs and air miles flown is probably stronger than the relation between air miles and ticketing but weaker than the relation between air miles and maintenance. A better allocation base for ticketing might be number of tickets issued. A better allocation base for baggage handling might be number of bags handled.

6-14 Jiambalvo Managerial Accounting P7. [LO 1]

Service depts. Maintenance ($700,000) Computing ($900,000)

Production department use of service Assembly Testing 70% * 30% 30%** 70%

Service dept. costs allocated to Assembly: (.70  $700,000) + (.30  $900,000) = $490,000 + 270,000 = $760,000. Service dept. costs allocated to Testing: (.30  $700,000) + (.70  $900,000) = $210,000 + 630,000 = $840,000. *[84,000 ÷ (84,000+36,000)] **[6 ÷ (6+14)] P8. [LO 1] Service departments: Maintenance ($600,000) Computing ($1,000,000) Service department cost allocated to Assembly: 66.67% × $600,000 33.33% × $1,000,000 Total Service department cost allocated to Testing: 33.33% × $600,000 66.67% × $1,000,000 *(100,000 ÷ (100,000 + 50,000)) **(30 ÷ (30+60))

Assembly 66.67% * 33.33%**

Testing 33.33% 66.67%

$400,020 333,300 $733,320

$199,980 666,700 $866,680

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P9. [LO 1] a. Allocation Base Salaries Headcount

Financial Planning Proportion Amount .75* $1,125,000 .80** $1,200,000

Business Consulting Proportion Amount .25 $375,000 .20 $300,000

b. Both headcount and salary appear to be plausible allocation bases, but they result in very different allocations. This suggests that in many cases allocations are somewhat arbitrary. *[15,000,000÷($15,000,000+$5,000,000)] **[200÷(200+50)] P10. [LO 1] a. Old overhead rate $12 per labor hour Current overhead rate ($3,500,000* ÷ 175,000 direct labor hours) $20 per labor hour *($2,700,000 + $800,000) Current overhead cost allocated to a 10 labor-hour job: ($20  10 labor hours) $200 Prior year overhead allocated to a 10 labor-hour job ($12  10 labor hours) $120 The current overhead cost for a 10 labor-hour job is 67% [(20-12)÷12] more than the prior overhead cost. b. Small jobs in the current year appear to be less profitable compared to the prior year. This is because they are allocated overhead costs as if they required use of the new equipment. Therefore, small jobs will be overcosted. In all likelihood, the jobs do not really cost more than they did in the prior year. One way to avoid miscosting of small (labor-intensive) jobs would be to develop a separate overhead allocation rate for jobs that are labor intensive and do not make use of the new equipment.

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P11. [LO 2] a. The recreation kayaks are uniform and probably made in large batches. The competition kayaks are custom-made, likely one at a time. Several costs in the overhead cost pool are probably less expensive on a per unit basis for recreation versus competition kayaks. For example, each competition kayak probably requires (on average) more equipment time, quality control, and setup and drafting costs per boat compared to each recreation kayak. b. Summit needs to look at the costs of activities that each line of kayaks requires. Summit could get more accurate costs if each of the major overhead cost components were allocated to the kayak line using an appropriate cost driver. c. Cost Pool

Cost

Building $ 35,000 Equipment 35,000 Materials ordering 25,000 Quality control 20,000 Maintenance & security 20,000 Setup and drafting 35,000 Supervision 40,000 Total $210,000 Per kayak

Recreation use of base* allocation .800 $ 28,000 .850 29,750 .667 16,675 .667 13,340 .800 16,000 .333 11,655 .833 33,320 $148,740 $148.74a

Competition use of base allocation .200 $ 7,000 .150 5,250 .333 8,325 .333 6,660 .200 4,000 .667 23,345 .167 6,680 $61,260 $306.30b

*For example, building is .800 or [8,000 ÷ (8,000+2,000)] a$148,740 ÷ 1,000 kayaks b$61,260 ÷ 200 kayaks

Total unit costs for each model boat: Sales price Direct materials Direct labor Overhead Total unit cost

Recreation $650.00 175.00 125.00 148.74 448.74

Competition $800.00 225.00 125.00 306.30 656.30

Chapter 6 Cost Allocation and Activity-Based Costing Gross Profit

$201.26

$143.70

6-17

6-18 Jiambalvo Managerial Accounting d.

The traditional allocation method used by Summit is essentially a volume-based method. In this problem, each unit of the competition kayak used the same amount of direct labor as a recreation kayak, but required much more of some overhead resources. For example, total competition kayaks accounted for 17 percent of volume and required 17 percent of direct labor but needed 66.7 percent of set up and drafting resources. Using a single traditional allocation base assumes that each product uses all overhead resources in the same proportion that the allocation base is used. Except for equipment, competition kayaks use more than 17 percent of overhead resources. Better information will be provided by an ABC system. With an ABC system, cost pools will be formed for key activities and overhead drivers (allocation bases) need not be based on production volume.

P12. [LO 2] a. Cost Pool Materials ordering Materials inspection Equipment setup Quality control Other

Overhead rate $72,000 ÷ 8,000 = $9 per order $75,000 ÷ 375 = $200 per rec. report $105,000 ÷ 3,000 = $35 per setup $69,000 ÷ 3,000 = $23 per inspection $100,000 ÷ $2,000,000 = $0.05 / labor cost

b. Materials ordering $9 per order  100 orders = Materials inspection $200 per report  60 reports = Equipment setup $35 per setup  30 setups = Quality control $23 per inspection  150 inspections = Other $0.05 per labor dollar  $39,000 = Total overhead assigned to Strawberry Cheesecake

$ 900 12,000 1,050 3,450 1,950 $19,350

c. Overhead rate per unit of strawberry cheesecake = $19,350 ÷ 19,500 units = $0.992 d. Total unit costs per unit of Strawberry Cheesecake = $10 + $2 + $0.992 = $12.992 e. With a traditional system: The overhead rate per direct labor dollar is: ($421,000 ÷ $2,000,000 direct labor cost) $0.211 per dollar of direct labor The direct labor cost, per unit, for the Strawberry Cheesecake: ($39,000 ÷ 19,500 units) $2.000

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Overhead assigned to each unit of Strawberry Cheesecake ($0.211  $2.00 direct labor cost) $0.422 Under the traditional system, less overhead cost is assigned to each unit of Strawberry Cheesecake than under the activity-based costing system. The traditional system allocates overhead to each unit on the basis of one cost driver. In this case, the cost driver is direct labor. Meanwhile, the activity-based costing system uses several cost pools to allocating overhead costs to each unit. P13. [LO 2] a.

Cost Pool Returned check costs Checking account reconciliation costs New account setup Copies of cancelled checks Website maintenance (for online banking) Total checking account costs

Cost $3,000,000 60,000 780,000 300,000 225,000 $4,365,000

Total cost driver Cost activity pool rate 200,000 $15.00 3,000 $20.00 60,000 $13.00 80,000 $3.75 10 $22,500

b. Costs Returned check costs Checking account reconciliation costs New account setup Copies of cancelled checks Website maintenance (for online banking) Total money market account costs ABC Allocation: Total overhead Divide by number of money market checking accounts Overhead cost per account c.

Activity Cost Pool Usage Rate 18,000 $15 420 $20 20,000 $13 50,000 $3.75 1 $22,500

$748,400 70,000 $10.69

Total Cost Allocated $270,000 8,400 260,000 187,500 22,500 $748,400

6-20 Jiambalvo Managerial Accounting Traditional Allocation: Total overhead Divide by total # of checking accounts Overhead cost per checking account

$4,365,000 221,750 $ 19.68

The money market account would be overcosted under traditional costing (using the number of checking accounts as the allocation base) because it is a high-volume product (it is associated with many accounts). It would absorb more than its reasonable share of overhead, as seen by comparing the ABC cost to the cost calculated using the number of checking accounts as the allocation base.

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P14. [LO 1, 2] a. Calculate predetermined overhead rate based on DLH: Estimated MOH (a) $1,800,000 Estimated DLH (b) 120,000 Planned OH rate a÷b $15 per DLH Calculate how much is allocated to Standard and Elite: Standard Elite

Usage of Cost Driver 3,000 Usage of Cost Driver 300

× ×

Rate $15 Rate $15

= = = =

$45,000 $4,500

b. Calculate individual pool rates: Maintenance Costs $700,000 Setup Costs $500,000 Engineering Costs $600,000

Standard Elite

Maintenance Costs $17,490 1,749

Cost pool rate ÷ ÷

120,000 200

400

= =

$5.83/DLH $2,500/setup

= $1,500/design change

Setup Costs $2,500 35,000

Engineering $3,000 30,000

Total MOH $22,990 66,749

c. Using traditional costing, Standard Switches, the high-volume product, are overcosted, while the low-volume, specialty product, Elite Switches, are undercosted. ABC will provide more accurate product costs because it does not make the simplifying assumption that all overhead costs are proportional to labor hours. Rather, some vary with labor hours, some vary with setups, and some vary with design changes.

6-22 Jiambalvo Managerial Accounting P15. [LO 2] a. Cost Pool Materials ordering Materials inspection Equipment setup Quality control Other Total mfg. overhead

Total cost driver activity

Cost pools $

840,000 525,000 2,500,000 1,000,000 25,000,000 $29,865,000

Cost pool rate 120,000 $7 2,100 $250 125 $20,000 5,000 $200 $12,500,000 $2

b. Costs Materials ordering Materials inspection Equipment setup Quality control Other Total mfg. overhead

Activity usage 1,200 315 1 500 $320,000

Cost Total cost pool rate allocated $7 $8,400 $250 78,750 $20,000 20,000 $200 100,000 $2 640,000 $847,150

c. ABC overhead cost per unit: Total overhead Divide by number of units ABC overhead cost per unit

$847,150 40,000 $ 21.18

Cost per unit using ABC: Direct materials Direct labor Overhead (calculated above) Total cost per unit

$37.00 8.00 21.18 $66.18

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e. Traditional Allocation: Total overhead Divide by direct labor dollars Overhead allocation rate per DL $

$29,865,000 12,500,000 $ 2.39

Art of Design: Total direct labor dollars OH rate Overhead allocated to Art of Design

$ 320,000 2.39 $ 764,800

Traditional overhead cost per unit: Total overhead Divide by number of units Overhead cost per unit

$764,800 40,000 $ 19.12

Cost per unit using Traditional: Direct materials Direct labor Overhead (calculated above) Total cost per unit

$37.00 8.00 19.12 $64.12

Art of Design is undercosted using traditional costing. It is a “specialty” product with relatively low volume. A more useful product cost is calculated using ABC.

6-24 Jiambalvo Managerial Accounting P16. [LO 2] a. Cost to book travel (per completed trip): $1,500,000 ÷ 30,000 completed trips = $50 per completed trip The benchmark cost is $35 per completed trip. Thus, it appears that Talbot’s costs are relatively high (30% more than the benchmark), and process improvement is warranted. b. The wages paid to employees who book travel are $750,000 (15 employees  $50,000. Number of trips booked but not necessarily completed: (1.30  30,000) 39,000 trips Number of completed trips booked: (2,000 consultants  15 trips)

30,000 trips

Bookings not completed

9,000 trips

Wage cost per trip booked but not necessarily completed: ($750,000 ÷ 39,000)

$19.23

Wage cost of trips not completed: (9,000  $19.23)

$173,070

Savings if number can be reduced by 50 percent: ($173,070  .5)

$86,535

P17. [LO 2] a. A sophisticated Web site and call center can reduce demands placed on tellers to process deposits, process withdrawals, deal with requests for CDs, answer questions related to balances, and respond to requests for statements. A sophisticated Web site or call center will not impact teller time to provide access to safe deposit boxes or reconcile the cash drawer. b. A sophisticated Web site, automatic cash machines, and call center software that provides responses to common questions are examples of technology that can reduce the cost of services provided by tellers. P18. [LO 2]

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With 6,000 employees and turnover of 15%, 900 people leave the company and 900 are added to take their place each year (.15 × 6,000). With this in mind, having 6 employees to handle new employee training appears excessive. Suppose each new employee requires a half day of training. That implies 450 (900 × ½) training days are needed. Assume that each trainer works 5 days per week for 48 weeks per year. Then, each trainer covers 240 training days. Thus, only 2 trainers are needed (450 ÷ 240 = 1.875). Reducing trainers by 4 would save $23,333 in salary each month. Now, consider operations. It’s not clear that 5 clerks are needed. Suppose paperwork related to resignations and new hires is 2 hours per person. This implies a need for 3,600 hours (2 hours × 1,800 resignations or hires). Assuming each clerk works 8 hours per day, with a 5 day work week for 48 weeks, a clerk has 1,920 hours. Again, it appears that only 2 clerks are needed (3,600 ÷ 1,920 = 1.875). A reduction of 3 clerks would save $10,800 per month. Based on the above analysis, which admittedly required some “ballpark” assumptions, the low hanging fruit is in operations and training. Note that the total savings is estimated to be $34,133 per month or $409,596 per year. Assuming the ABM study reduced waste for 3 years, the company would save approximately $1,228,788. If similar savings could be found in other departments, ABM would create substantial shareholder value.

6-26 Jiambalvo Managerial Accounting Case 6-1 [LO 2]

EASTSIDE MEDICAL TESTING Summary Service company example of ABC. •

Demonstrates that ABC costing will generally lower the cost of high volume, simple procedures and increase the cost of low volume, complex procedures.

•

Provides details of overhead and makes the point that some costs are fixed with respect to their drivers.

•

Integrated into a pricing decision context. Makes the point that ABC costs are not all avoidable costs. Thus, a procedure that is not covering its full ABC cost may still be valuable.

Questions to ask students 1. What is the situation at Eastside Medical Testing? 2. What is the ABC cost of each test? 3. Should Emmet (the owner of Eastside Medical Testing) lower the price of T1 or keep the current price and risk losing the business of Nuclear Systems? 4. What will be the effect on profit, if the company loses the business of Nuclear Systems (i.e., T1 tests decrease by 1,750)? Discussion What is the situation at Eastside Medical Testing? Eastside Medical Testing conducts tests to detect drug use. A client is questioning the high price of a test and doubts that the price is justified by significantly higher costs to conduct the test.

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a. What is the ABC cost of each test? Note especially that the cost of T1 increases under ABC from $29.10 to $51.5562. Rather than being the most profitable test, ABC indicates that the test is being sold at a loss. Overhead Setup labor Equipment Rent Billing Clerical Other Total

Costs $ 925,760 1,476,000 390,000 235,000 160,000 200,000 $ 3,386,760

Driver 3,310 setups per year $325,650 direct labor cost per year 299,500 tests per year 299,500 tests per year 299,500 tests per year 299,500 tests per year

Rate 279.6858 4.5325 1.3022 0.7846 0.5342 0.6678

T1 $35.00

T2 $26.00

T3 $22.00

T4 $21.00

T5 $20.00

12.00 1.50

10.50 1.00

7.50 1.10

7.35 1.10

5.85 1.10

27.9686 6.7988 1.3022 0.7846 0.5342 0.6678 38.0562

2.7969 4.5325 1.3022 0.7846 0.5342 0.6678 10.6182

2.7969 4.9858 1.3022 0.7846 0.5342 0.6678 11.0715

Total cost Profit per test

51.5562 $(16.5562)

22.1182 $3.8818

19.6715 $2.3285

19.5215 $1.4785

18.0215 $1.9785

Total profit

$(57,946.70)

$201,853.60

$167,652.00

$118,280.00

$182,022.00

Price per test Less: Material cost Direct labor at $18 per hour Overhead Setups Equipment Rent Billing Clerical Other Total overhead

Setup for T1 (279.6858  350 ÷ 3,500) = 27.9686 Equipment for T1 (4.5325  1.50) = 6.7988 Rent for T1 (1.3022) Billing for T1 (.7846) Clerical for T1 (.5342) Other for T1 (.6678)

6-28 Jiambalvo Managerial Accounting b. Should Emmet (the owner of Eastside Medical Testing) lower the price of T1 or keep the current price and risk losing the business of Nuclear Systems? Students may be inclined to suggest that the price should be increased! After all, the test is generating a loss at the current price. However, a perceptive student will note that most of the allocated costs are fixed. Note especially that setup cost relates to the cost of three skilled technicians (one of whom is the owner). It seems unlikely that this cost will be reduced if the T1 business is reduced. Assuming that the only variable costs are material cost and direct labor, then variable costs are $13.50 ($12.00 material and $1.50 direct labor). Even at a price of say $23 (much lower than the current price of $35), this test would have a significant contribution margin. c. What will be the effect on profit if the company loses the business of Nuclear Systems (i.e., T1 tests decrease by 1,750)? Again, assuming that the only variable costs are material and direct labor, the contribution margin on T1 is $21.50 ($35 selling price less $13.50 variable cost = $21.50). Thus, profit will decline by $37,625 ($21.50 x 1,750).

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Case 6-2 [LO 2]

QuantumTM Summary A company finds that it is receiving fewer large orders for electronic testing instruments that are relatively simple to produce—customers are saying the company is not price competitive for such products. On the other hand, the company is receiving more small orders for complex instruments and customers seem happy with the prices they pay for them. •

Shows how a traditional costing system can systematically overcost or undercost certain products.

•

Links ABC to decision making.

Questions to ask students 1. What’s the situation facing QuantumTM? 2. What’s the ABC cost of the Monitor and the Analyzer? 3. What’s the ABC cost of the data logging device? 4. The customer for the data logging device has a bid from a competitor for $22,000. Should QuantumTM meet this price? Discussion I begin by asking a student to summarize the situation. As noted, QuantumTM finds that it is receiving fewer large orders for electronic testing instruments that are relatively simple to produce—customers are saying the company is not price competitive for such products. On the other hand, the company is receiving more small orders for complex instruments and customers seem happy with the prices they pay for them. Jason Norton, VP of Operations, suspects that the problem is related to the company’s antiquated accounting system and suggests that the company use ABC.

6-30 Jiambalvo Managerial Accounting a. What’s the ABC cost of the monitor and the analyzer? Temperature Monitor Component cost Labor Overhead Design ($50 × 47) ÷ 900 Mat.order ($80 × 17) ÷ 900 Inspect. ($6.25 × 225) ÷ 900 Set-up ($31.25 × 1) ÷ 900 Labor related ($0.80 × $25) Deprec. ($80 × 112) ÷ 900

$250.00 25.00 $2.6111 1.5111 1.5625 0.0347 20.0000 9.9556

Total Analyzer Component cost Labor Overhead Design ($50 × 110) Mat.order ($80 × 25) Inspect. ($6.25 × 20) Set-up ($31.25 × 1) Labor related ($0.80 × $500) Deprec. ($80 × 7) Total

35.67 $310.67

$2,500.00 500.00 $5,500.00 2,000.00 125.00 31.25 400.00 560.00

8,616.25 $11,616.25

With the traditional costing system, the cost of the monitor was $395—with ABC, it’s $310.67. With the traditional costing system, the cost of the analyzer was $5,500—with ABC, it’s $11,616.25. Thus, ABC has indicated a higher cost for the complex item and a lower cost for the simple item.

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b. What’s the ABC cost of the data-logging device? Data-Logging Device Component cost Labor Overhead Design ($50 × 27) Mat. order ($80 × 17) Inspect. ($6.25 × 12) Set-up ($31.25 × 1) Labor related ($0.80 × $3,000) Deprec. ($80 × 10) Total

$9,000.00 3,000.00 $1,350.00 1,360.00 75.00 31.25 2,400.00 800.00

6,016.25 $18,016.25

c. What will the price be if the company follows its normal policy and marks cost up by 30%? $18,016.25 × 1.30 = $23,421.13 Since a competitor is asking only $22,000, a question arises as to what is the incremental profit at $22,000. Data-Logging Device Component cost Labor Variable Overhead Design ($50 × 27 × .6) $ 810.00 Mat. order ($80 × 17 × .7) 952.00 Inspect. ($6.25 × 12 × .5) 37.50 Set-up ($31.25 × 1 × .2) 6.25 Labor related ($0.80 × $3,000 × .8) 1,920.00 Deprec. ($80 × 10 × 0) 0.00 Total incremental cost

$9,000.00 3,000.00

3,725.75 $15,725.75

The incremental cost of the job is only $15,725.75. Therefore, a price of $22,000 will make an incremental contribution to profit of $6,274.25 assuming no opportunity costs. Thus, meeting the competitor’s price appears to be a good decision.

6-32 Jiambalvo Managerial Accounting

To pursue this case further, an instructor might ask, “Suppose the competitor was willing to produce the product for $17,000. Would QuantumTM actually lose money by meeting this price, which is lower than the ABC cost?” Given the incremental cost is only $15,725.75, the company will still have an incremental profit greater than $1,000. This drives home the point that ABC, as typically used in practice, does not compute the incremental cost of a product—it computes the full cost. Still, incremental analysis is needed for decision making.

Chapter 7 The Use of Cost Information in Management Decision Making QUESTIONS 1. Differential costs and differential revenues are the costs and revenues that differ between decision alternatives. 2. Sunk costs are the costs that have been incurred in prior periods. They are not incremental costs and, hence, they are not relevant in making a decision. 3. Avoidable costs are the costs that can be avoided if a particular action is undertaken. 4. Opportunity costs are the values of benefits foregone by selecting one decision alternative over another. Since opportunity costs differ depending upon which decision alternative is selected, they are relevant in evaluating decision alternatives. Alternatively, since opportunity costs are incurred when a decision alternative is selected, they are incremental costs related to that decision. 5. The proper (quantitative) approach to analyzing the question of dropping a product line is to calculate the change in income that will result from dropping the product line. If income will increase when the line is eliminated, the product line should be dropped; otherwise not. 6. Common costs which are incurred for the benefit of two or more products, such as the company president's salary, are not sunk because they are incurred in current and future periods. But they are still irrelevant because they usually do not differ among the decision alternatives. 7. Qualitative advantages of making rather than buying a component usually include exercising more control over the production process, quality, delivery schedules, and costs. 8. The amount of joint cost allocated to a product under relative sales value method cannot exceed the product's sales value at the split-off point. Thus, products that make a positive contribution to covering joint cost will not look unprofitable. 9. The value of time in a bottleneck department is generally quite high and equal to the contribution margin of all throughput per hour. Therefore, you don’t want to “waste it” setting up equipment. Since more setups are required with small batch sizes, it is generally advisable to have larger batch sizes in bottleneck departments. 10. A bottleneck department is referred to as a drum because it “beats a rhythm” that coordinates the production in other departments.

7-2

Jiambalvo Managerial Accounting

EXERCISES E1. [LO 1] Consider a decision to close a production facility that operates 24 hours a day. In this case, heat and light, which were fixed costs at the plant, would drop to zero. Thus, heat and light would be incremental cost savings with respect to the decision. Depreciation of the facility, which is also a fixed cost, would not be an incremental cost saving. Depreciation represents a sunk cost and sunk costs are never incremental costs. E2. [LO 1] If Jordan drops accessories, she will lose the contribution margin (which in this case is also the gross margin) of $30,000. The fixed costs allocated to accessories, which total $41,000, are not likely to decline. (Keep in mind that Jordan has only two assistants. It is doubtful that she can do without either one of them simply by dropping accessories). With the $41,000 of common fixed costs now assigned to music devices, that product line will show a loss and the company will be broke. This is a good example of the “cost allocation death spiral” at work! In analyzing a decision, it is important to determine the costs that will change (i.e., the costs that are incremental). Allocated common costs are seldom a good measure of incremental costs. E3. [LO 1] According to this Web site, sunk costs are “Costs already incurred which cannot be recovered regardless of future events.” Since the costs are unaffected by the future, they are never incremental costs and are irrelevant for decision making. According to this Web site, opportunity costs are “The costs of passing up the next best choice when making a decision.” Thus, opportunity costs arise from making a decision. Because they are incremental costs (they exist because a decision was made), they are always relevant for decision making.

Chapter 7 The Use of Cost Information in Management Decision Making E4. [LO 1] In this solution, supplies and travel are assumed to vary with revenue. Supplies as a percent of revenue $18,000 ÷ $212,500 Travel as a percent of revenue $3,000 ÷ $212,500

0.0847 0.0141

Increase in revenue Less: Cost of exhibit space Increase in supplies (.0847 × $40,000) Increase in travel (.0141 × $40,000) Increase in profit

$40,000 15,000 3,388 564 $21,048

The company should exhibit at the show since the impact on profit is positive. E5. [LO 1] Cost of RBG Less cost savings: Mailing Printing Salary of Pat Fisher Incremental cost of RBG

$35,000 $17,500 6,000 2,080

25,580 $ 9,420

The incremental cost is less than $10,000, so Craig will accept the RBG offer. E6. [LO 1, 2] a. The incremental profit is $240 as follows: Revenue $72 × 175 Less cost of unprepared food and beverage $50 × 175 Gain Lost revenue $56 × 190 Cost savings for food and beverage $37 × 190 Loss Net gain

$ 12,600 8,750 3,850

(10,640) 7,030 ( 3,610) $

240

7-3

7-4

Jiambalvo Managerial Accounting

b. As indicated above, the opportunity cost of accepting the New England group is $3,610. c. The restaurant should consider the fact that it may hurt its business with “regulars” who are turned away due to the closure. This could have serious long-term effects. E7. [LO 1] b, c, d, f, g, and i. E8. [LO 1] Cost of Making 1,000 Valves

Cost of Buying 1,000 Valves

Incremental Cost (Savings)

$ 950,000 650,000 300,000 1,900,000

-0650,000 -0650,000

($ 950,000) -0(300,000) (1,250,000)

500,000 200,000 300,000 1,000,000

-0-0-0-0-

-0-0-0$2,900,000

(55,000) 2,100,000 2,045,000 $3,695,000

(55,000) 2,100,000 2,045,000 $ 795,000

Variable costs Direct material Direct labor* Variable OH Fixed costs Depr. equip. Depr. building Sup. salaries* Other Cost savings on leased space Cost of buying valves Total

The company should make the valves—the incremental cost of buying them is $795,000. * The production workers and supervisor will be reassigned to other areas where, unfortunately, they really are not needed.

Chapter 7 The Use of Cost Information in Management Decision Making E9.

7-5

[LO 1] a. False b. False c. True d. False e. True f. False

E10. [LO 1] d, f, g, and h.

E11. [LO 1] Incremental benefit (cost) of completing the organizer: Price $130 Material (14) Direct Labor (16) Variable overhead (10) Benefit $ 90 Incremental benefit of selling partially completed organizer: Price $107 The company will be better off by $17 per organizer if the company sells the partially completed units. E12. [LO 1, 2] Unit cost of manufacturing pumps Less: Allocated fixed overhead (irrelevant) Add: Warranty cost ($20  .40) (Only 40% pumps are returned for repair) Unit cost of manufacturing pumps Unit cost of purchasing pumps

$ 80 (18) 8 $ 70 $ 85

The company should make the pumps. The amount of cost savings expected by making pumps in 2017: 15,000 ($85 − $70) = $ 225,000. Qualitative factors that should be considered in the outsourcing decision include product quality of purchased pumps and its effect on whirlpool sales, likely improvement in the quality of the company's self-manufactured pumps and delivery schedule of purchased pumps, and strategic effects of outsourcing.

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Jiambalvo Managerial Accounting

E13. [LO 1] Income Without Home Office Furniture Sales ($1,400,000 × 1.13) Less cost of sales ($900,000 × 1.13) Contribution margin Less direct fixed costs: Salaries Other Less allocated fixed costs Rent Insurance Cleaning President’s salary Other Net income

$1,582,000 1,017,000 $ 565,000 175,000 60,000 24,000 6,000 7,000 130,000 12,000 $ 151,000

Based on given assumptions, net income will not change. Therefore, the company should be indifferent between dropping or not dropping the Home Office Furniture product line. However, strategic and other qualitative factors should also be considered. E14. [LO 2] a. What is the quality assurance program of the company that will do the bottling? Problems with quality could ruin the brand. b. The premium brand’s popularity may actually increase sales of the less costly wines. Thus, sales of the low cost wines may decline if the premium brand is dropped. c. Quality may decline. Also, the talented workers who produce videos may be a resource to software developers who have a variety of “quick questions” related to including video in their products (this resource will be lost if the facility is closed). E15. [LO 2] a. Allocation based on physical output: Product A Product B Total

30 pounds (1/5) 120 pounds (4/5) 150 pounds

This indicates that $1,200 of the $6,000 joint cost will be allocated to Product A and $4,800 will be allocated to Product B.

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b. Sales of Product A are $3,000 (30 pounds  $100) while sales of Product B are $4,200 (120 pounds  $35). Since product B is showing a loss ($4,200 selling price and $4,800 cost), a manager might think that it should not be sold. However, the joint cost is not avoidable (unless the company drops both joint products). And product B contributes $4,200 toward covering joint costs and earning a profit. E16. [LO 2] a. Allocation based on relative sales values: Product A (30 pounds  $100) Product B (120 pounds  $35)

$3,000 (.4167) 4,200 (.5833) $7,200

This indicates that $2,500 of the $6,000 joint cost will be allocated to Product A and $3,500 will be allocated to Product B. b. The only time the allocated cost of a joint product will be greater than its price will be if the total revenue of all joint products is less than the joint costs (in which case the company should drop all of the joint products). E17. [LO 2] Allocation using physical quantity method: Superior grade = $900  (3,200 ÷ 4,000) = $720 Economy grade = $900  (800 ÷ 4,000) = $180 Allocation using relative sales value method: Relative sales values: Superior grade = 3,200 lbs.  $ 0. 50 = $1,600 Economy grade = 800 lbs.  $ 0.20 = $160 Cost Allocation Superior grade = $900  (1,600 ÷ 1,760) = $818 Economy grade = $900  (160 ÷ 1,760) = $82

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Jiambalvo Managerial Accounting

E18. [LO 1] Selling price per unit Less variable costs per unit: Direct material Direct labor Variable overhead Contribution margin per unit

$ 14.00 $2.75 1.00 .25

Times number of incremental units Incremental profit before cost of additional worker Less cost of additional worker Financial impact of hiring additional worker

4.00 10.00 7,000 70,000 55,000 $15,000

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PROBLEMS P1. [LO 1], Ethics Extrapolating from the information provided, an $837,500 incremental profit will be generated even if sales are only $7,000,000: Incremental sales Less cost of goods sold

$7,000,000

($4,200,000 ÷ $9,600,000) × $7,000,000

Less cost of TV ads Incremental profit

3,062,500 3,100,000 $837,500

Still, it would be unethical for Joan to bias her estimate of incremental sales simply because she “knows” (or thinks she knows) that the president will not go for the ads unless the revenue estimate is biased upwards. Joan wasn’t hired to provide biased information to the president—she was hired to provide honest estimates that the president can use to make decisions. It may be that the president knows of some incremental costs (including opportunity costs) of which Joan is unaware, and that’s the reason the president wants a high revenue figure. In this case, Joan’s bias may actually lead to a decline in shareholder value. P2. [LO 1, 2] a. Cost savings Salary of gardeners Plant materials Fertilizer Fuel Proceeds from sale of equipment Less cost of Highline Net benefit of outsourcing in year 1

$195,000 80,000 10,000 12,000

$ 297,000 30,000 327,000 300,000 $ 27,000

b. In the second year, savings will decrease by $30,000 since the proceeds from the sale of equipment only pertain to the first year. There will be a net cost of $3,000 ($297,000 − $300,000). c. The College should consider the impact on employee morale related to firing 3 gardeners, especially if they are long time employees. Also, the current gardeners may be very familiar with the University’s plants and trees and the care by Highline may be inferior, even though they assert that it will be comparable to the past.

7-10 Jiambalvo Managerial Accounting P3. [LO 1, 2] a. Incremental Cost Analysis Cost of outsourcing payroll function Cost savings (avoidable if outsource payroll function): Payroll clerk salary Payroll processing software updates Payroll tax update seminar costs Excess cost of outsourcing payroll

$22,000

$12,000 1,000 1,500 (14,500) $ 7,500

The company will spend $22,000 a year outsourcing payroll. By outsourcing payroll, the company would pay $7,500 more per year than it costs to carry out this function in-house. b. The company should consider the impact on employee morale if the payroll function is outsourced. If payroll were outsourced, the payroll clerk would be laid off. Other employees in the company may begin to wonder if they will be laid off as well, so there could be a decrease in morale in the future. P4. [LO 1]

Materials Labor to form Labor to install Misc. variable costs Allocated fixed costs Penalty ($1,200 × 5) Total cost

Do not buy Prefabricated $35,000 4,000 10,000 1,500 3,000 6,000 $59,500

Buy Prefabricated $42,000 -0-* 10,000 1,500 3,000 -0$56,500

Difference $7,000 (4,000) -0-0-0(6,000) ($3,000)

Bradley should buy the prefabricated duct-work which will result in a net incremental benefit of $3,000. *When the workers are reassigned to the other project, they will still be paid $4,000. However, I assume that $4,000 of wages that would ultimately have been paid to other workers on that project will no longer need to be paid. Thus, there is a net $4,000 benefit. P5. [LO 1, 2] 1. The $17,450 is a sunk cost and has no bearing on future decisions. These costs have already been incurred and are not reversible. Thus, they do not differ among decision alternatives and are not relevant in making a decision. She should also consider whether the Civic will need any repairs soon.

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2. Susan should buy the Honda Civic. By doing so, she would sell the Ford Focus for $8,500 and buy the Civic for $10,500. This makes her total costs $2,000. Meanwhile, if Susan were to have the Focus repaired, she would pay $2,500. Thus, the cost of repairing the Focus is greater than the cost of selling the Focus and then purchasing the Civic. 3. Susan may be influenced by her friends or family in making a decision. Friends and family members can have a large impact on purchasing decisions, and it is possible for Susan to be persuaded by a few people she is close to. P6. [LO 1] Incremental cost of purchasing containers (100,000 packages  $1.90) Cost savings: Direct material (.10  $8.00  100,000) Direct labor (.2  $3.50  100,000) Variable overhead* (.15  $1.25  100,000) Leased space savings Supervisor salary

$190,000

$80,000 70,000 18,750 17,000 72,000

Net benefit

257,750 $ 67,750

The company should purchase the containers—there is an expected net benefit of $67,750. *Fixed overhead is $2.25 per package ($225,000 ÷ 100,000 packages). Therefore, variable overhead is $1.25 ($3.50 total overhead - $2.25 fixed overhead). P7. [LO 1, 2] a. Sales Less: Variable costs already incurred Fixed costs already incurred Variable reprocessing costs Total

Reprocess and Sell $18,000

Sell to Practical $10,800

Difference ($7,200)

8,400

-0-

7,200 2,400

7,200 -0-

-02,400

($4,800)

$ -0-

7-12 Jiambalvo Managerial Accounting The company should repeat the coloring process—the net incremental benefit of this action is $4,800 compared to selling the carpet to Practical Home Solutions for $9 per square yard. b. A payment by Practical of $14 per square yard (rather than $9), would result in $6,000 of additional income [($14 − $9)  1,200 square yards]. In this case, selling to Practical would result in a $1,200 net benefit. However, the company should consider an important qualitative factor. Selling “defective” carpeting, with the Mulan Exotic Carpet brand identified, may more than offset the relatively small incremental benefit of $1,200. P8. [LO 1] Selling price Less: Material Labor Variable overhead Contribution margin Time to produce in minutes Contribution margin per minute Incremental revenue ($17.00 − 11.00) Less: Incremental material cost Incremental labor cost Incremental variable overhead Incremental profit (loss) Incremental time to produce in minutes Incremental profit per minute

ZylexA $11.00 $2.00 2.50 2.25

6.75 $4.25 25 minutes $0.17 ZylexB $6.00

$1.75 .50 1.10

3.35 $2.65 10 minutes $.265

There is no question that ZylexA has to be produced, because the company cannot make ZylexB without starting with ZylexA. The question is, “If you have a unit of ZylexA, should you take up production time converting it into ZylexB or should you just make more ZylexA?” The analysis indicates that production of ZylexB increases profit at a rate of $.265 per minute. Thus, ZylexB should be produced.

Chapter 7 The Use of Cost Information in Management Decision Making P9. [LO 1, 2] a. Effect of dropping accelerators: Lost contribution margin Savings of direct salaries Net effect

7-13

$(310,000) 65,000 $(245,000)

The company will be worse off by $245,000 if it drops accelerators. b. Conceivably, dropping accelerators would decrease sales of other products. Most likely, some customers come into the store to buy accelerators and end up buying audio or video products. This adds further weight to the argument for keeping accelerators. P10. [LO 1] Contribution margin of fescue ($3.00 − $.85) Contribution margin of Bermuda ($3.85 – $1.57)

$2.15 per square yard

$2.28 per square yard

Dedicating an additional 65,000 square yards to Bermuda grass would lead to an additional $8,450 of profit [($2.28 − 2.15)  65,000]. Thus, the president’s decision to stick with an equal mix which has an $8,450 opportunity cost. P11. [LO 1] a. Effect of dropping Model 599 fan: Lost revenue ($15,200  560) Cost savings Material ($7,050  560) Direct labor ($4,900  560) Direct fixed costs Net effect

($8,512,000) $3,948,000 2,744,000 1,000,000

7,692,000 ($820,000)

The Model 599 fan should not be dropped—dropping would reduce profit by $820,000. b. The Model 599 fan has relatively high direct labor cost per unit. Since all overhead costs are in one cost pool allocated using direct labor costs, the relatively high direct overhead costs associated with other models will be transferred to the Model 599. Also, Model 599 will receive a relatively large share of common overhead costs.

7-14 Jiambalvo Managerial Accounting P12. [LO 1] a. Yards of carpet Sales Less variable costs Less fixed costs Profit (loss)

Standard 45,000

Deluxe 75,000

Total 120,000

$700,000 430,000 303,750* ($ 33,750)

$1,525,000 925,000 506,250** $ 93,750

$2,225,000 1,355,000 810,000 $ 60,000

* (45 ÷ 120) x $810,000 = $303,750 ** (75 ÷ 120) x $810,000 = $506,250

b. Yards of carpet Sales Less variable costs Less fixed costs Profit (loss)

Deluxe 75,000 $1,525,000 925,000 810,000 ($ 210,000)

c. In many if not most cases, common costs will not be reduced when a product or product line is dropped. The costs are simply “passed on” to the remaining products, which may in turn appear unprofitable. P13. [LO 2] a. Joint cost ($35 + $100) Allocation based on weight Veneer (10 lbs. ÷ 70 lbs.)  $135 Peeler (60 lbs. ÷ 70 lbs.)  $135

$135.00

$ 19.29 115.71 $135.00

Profit per sheet of veneer: Selling price Cost Profit per sheet

$150.00 19.29 $130.71

Profit per peeler: Selling price Cost Profit (loss) per sheet

$50.00 115.71 ($65.71)

Total profit for both joint products ($130.71 − $65.71)

$65.00

b. No. The product is making a contribution of $50 toward covering joint cost.

Chapter 7 The Use of Cost Information in Management Decision Making c. Allocation based on relative sales value: Veneer ($150 ÷ $200)  $135 Peeler ($50 ÷ $200)  $135

$ 101.25 33.75 $135.00

Profit per sheet of veneer: Selling price Cost Profit per sheet

$150.00 101.25 $ 48.75

Profit per peeler: Selling price Cost Profit (loss) per sheet

$50.00 33.75 $16.25

Total profit for both joint products ($48.75 + $16.25)

7-15

$65.00

d. The relative sales value is preferred because it will not make a joint product appear unprofitable (unless for all joint products, the sum of the sales values is less than the joint costs). P14. [LO 2] a. Allocation based on relative sales values at the split-off point: Sales value of 100 pounds of orange peels Sales value of 300 pints of juice (300  $.40) Total

$350

Joint cost ($500 + $50)

$550

Allocation to peels ($350 ÷ $470)  $550 Allocation to juice ($120 ÷ $470)  $550 Total

$410 140 $550

Profit per 100-pound box of candied peels: Selling price Less joint cost Less cost of sugar coating and packaging Profit

$600 410 60 $130

120 $470

7-16 Jiambalvo Managerial Accounting Profit per pint of juice: Selling price Less joint cost per pint ($140 ÷ 300) Less cost of pasteurizing and packaging ($250 ÷ 300) Profit

$1.75 .47 .83 $0.45

b. Incremental revenue of sugar coating ($600 − $350) Incremental cost Net incremental benefit of sugar coating c. c. Incremental revenue of packaged juice: ($1.75 x 300 pints) – ($0.40 x 300 pints) Incremental cost of packaging and pasteurizing Net incremental benefit of pasteurizing and packaging $155 ÷ 300 pints = $0.52 per pint

$250 60 $190

$405 (250) $ 155

Chapter 7 The Use of Cost Information in Management Decision Making P15. [LO 2] a. Allocation based on weight: Type Salmon Halibut Flounder

Weight (lbs.) 15,000 23,000 37,000 75,000

Percent 20% 31% 49% 100%

Salmon Revenue (15,000 lbs.  $9.00) Cost (.20  $96,000) Profit

$135,000 19,200 $115,800

Halibut Revenue (23,000 lbs.  $6.00) Cost (.31  $96,000) Profit

138,000 29,760 $108,240

Flounder Revenue (37,000 lbs.  $3.00) Cost (.49  $96,000) Profit

111,000 47,040 $63,960

Total profit ($115,800 + $108,240 + $63,960)

$288,000

b. Allocation based on relative sales value: Type Salmon Halibut Flounder

Sales Value $135,000 138,000 111,000 $384,000

Percent 35.156% 35.938% 28.906% 100.000% *

*Note that numbers are rounded to three decimal places.

Salmon Revenue (15,000 lbs.  $9.00) Cost (.35156  $96,000) Profit

$135,000 33,750 $101,250

7-17

7-18 Jiambalvo Managerial Accounting Halibut Revenue (23,000 lbs.  $6.00) Cost (.35938  $96,000) Profit

$138,000 34,500 $103,500

Flounder Revenue (37,000 lbs.  $3.00) Cost (.28906  $96,000) Profit

$111,000 27,750 $ 83,250

Total profit ($101,250 + $103,500 + $83,250)

$288,000

c. Incremental revenue Revenue of paste ((37,000 lbs. ÷ 2) × $6) Original revenue of flounder (37,000 lbs.  $3) Incremental revenue Incremental cost Net incremental cost

$111,000 111,000 0 10,000 ($10,000)

Given that there is a net incremental cost of $10,000, Gavin should not convert the flounder into fish paste. Note that the joint costs allocated to the fish are not relevant to the analysis. These costs are not incremental costs. They exist whether or not the flounder is converted into fish paste.

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P16. [LO 2] a. Allocation based on weight: Type Copper Gold

Weight (lbs.) 62,500 250 62,750

Percent 99.60% 00.40% 100.00%

Copper Revenue (62,500 lbs.  $2.50) Cost (.9960  $500,000) Profit (loss)

$ 156,250 498,000 ($341,750)

Gold Revenue (250 lbs.  16  $950) Cost (.0040  $500,000) Profit

$3,800,000 2,000 $3,798,000

Total profit (-$341,750 + $3,798,000)

$3,456,250

The drawback of this method is that it may make a product (like copper), that is making a positive contribution toward covering joint cost, show a loss suggesting that it should be dropped. b. Allocation based on relative sales value: Type Copper Gold

Sales Value $ 156,250 3,800,000 $3,956,250

Percent 3.95% 96.05% 100.00%

Copper Revenue (62,500 lbs.  $2.50) Cost (.0395  $500,000) Profit

$156,250 19,750 $ 136,500

Gold Revenue (250 lbs.  16  $950) Cost (.9605  $500,000) Profit

$3,800,000 480,250 $ 3,319,750

Total profit ($136,500 + $3,319,750)

$3,456,250

c. If the joint cost has any value greater than $3,456,250, then, with the relative sales value approach to allocation, both copper and gold will show a loss.

7-20 Jiambalvo Managerial Accounting P17. [LO A1] a. Additional units in 8 hour shift (2,300 – 2,000) 300 Times average contribution margin $ 60 Additional profit per 8 hour shift with larger batch sizes $18,000 b.

Larger batch sizes may reduce flexibility to respond quickly to new orders. Also, an error in the production process may result in a larger number of defects compared to a small batch size.

P18. [LO 1and A1] Based on the company president’s comment that the two workers will be sitting around for 30 hours per week, it appears that they will be working for 10 hours per week. The machine packages 2,500 bottles per hour but it is 20 percent faster than the workers. Thus, the workers will be packing 2,083 bottles per hour (2,500 ÷ 1.2 = 2,083). With a contribution margin of $0.60 per bottle, the workers will be generating an incremental profit of $12,498 per week. 2,083 bottles per hour × 10 hours per week × $0.60 = $12,498 per week With 52 weeks per year, this amounts to $649,896—much higher than the $120,000 salary of the two workers combined.

Chapter 7 The Use of Cost Information in Management Decision Making

7-21

Case 7-1 [LO 1, 2]

PRIMUS CONSULTING GROUP Summary A consulting firm is considering a client offer of a fee that is less than standard rates. •

Indicates that even direct labor costs can be irrelevant to a short run decision.

•

Introduces qualitative factors in decision analysis.

Questions to ask students 1. What is the situation facing Primus Consulting Group? 2. What will be the affect on company profit of accepting the Northwood job? 3. What qualitative factors should be considered in the decision as to whether or not to accept the job? Discussion What is the decision facing Primus Consulting Group? Primus is considering an offer to conduct a study aimed at improving on-time delivery for Northwood Industries. Northwood has offered a flat $75,000 for the job which is less than the $87,350 that Primus would charge at normal rates. However, Primus has excess capacity. What will be the affect on company profit of accepting the Northwood job? Profit will increase by $52,290. Note that labor costs are irrelevant because there is excess capacity and the company can accept the job without turning down other business. Incremental revenue Incremental costs: Travel costs $21,000 Variable overhead (285* non-partner hours  20%  $30** per hour) 1,710 Incremental profit

$75,000

22,710 $52,290

*(125+160) **($2,400,000 ÷ 80,000 hrs)

What qualitative factors should be considered in the decision as to whether or not to accept the job? Before accepting this job, Primus must consider a number of qualitative factors. On the positive side, this job may provide an opportunity for Primus to demonstrate its expertise—this may lead to future business at higher rates. On the negative side, if other clients find out about this deal, they may ask for similar treatment.

7-22 Jiambalvo Managerial Accounting Case 7-2 [LO A1]

FIVE STAR TOOLS Summary Tool manufacturer is faced with production constraints. •

Focuses on various ways to loosen constraints.

•

Demonstrates how to identify which products are winners and which products are losers when confronted with constraints.

•

Makes the point that large profits may be foregone if a company does not adequately deal with constraints.

Questions to ask students a. What is the situation facing Five Star Tools? b. What steps can be taken to loosen the constraint in coating and sharpening? c. Which product should be emphasized (C210 Chisel or D400 Chisel) given the constraint in coating and sharpening? d. Focusing only on the Model C210 and Model D400 chisels, what would be the benefit of gaining one more hour of production time in coating and sharpening? e. What would be the incremental profit associated with adding an inspection station before coating and sharpening? Discussion 1. What is the decision facing Five Star Tools? Five Star Tools has a bottleneck in its coating and sharpening operation leading to missed deadlines on orders from important customers. 2. What steps can be taken to loosen the constraint in coating and sharpening? Students are likely to suggest a number of alternatives, which I put up on the board. They may include: o Adding an inspection station before coating and sharpening so valuable time is not wasted working on defective units. o Cross training workers in other departments so they can help out in coating and sharpening. o Outsourcing some of the work that would normally be performed internally by coating and sharpening. o Putting buffer inventory before coating and sharpening to make sure the department doesn’t run out of items to work on.

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o Reengineering the coating and sharpening operation to make it more efficient o Make sure that coating and sharpening isn’t shutdown due to workers taking breaks at the same time. 3. Which product should be “emphasized” (C210 Chisel or D400 Chisel) given the constraint in coating and sharpening? The model C210 should be emphasized because it generates a higher contribution margin per unit of the constraint. Contribution margin per unit Time in coating and sharpening Contribution margin per hour

Model C210 $250.00 .2 hours $1,250.00

Model D400 $430.00 .8 hours $537.50

4. Focusing only on the Model C210 and Model D400 chisels, what would be the benefit of gaining one more hour of production time in coating and sharpening? The benefit would be $1,250 since the time would be spent working on the Model C210. 5. What would be the incremental profit associated with adding an inspection station before coating and sharpening? The average contribution margin per hour spent in coating and sharpening is $850. Given the inspection station will save 240 hours, this means the company can generate an additional $204,000 of profit ($850 contribution margin per hour  240 hours). Hopefully, this makes the point that companies can generate large incremental profits by loosening constraints.

Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing QUESTIONS 1.

The manager would estimate the quantity that could be sold at various prices. The quantities would then be multiplied by the contribution margin per unit and fixed costs would be subtracted from the total contribution margin, yielding an estimate of profit at each price. The price that yields the highest profit is the profit maximizing price.

The cost-plus price is based on full cost per unit. However, to determine full cost per unit, one must first estimate the quantity that can be sold. But the quantity that can be sold depends on the price!

The target cost depends on price, and marketing staff is needed to determine product features and price. Engineers are needed to determine efficient production methods given the product features. And cost accountants are needed to estimate costs given the production process. A cross functional team helps ensure good communication among these various parties, increasing the likelihood that a product will be put into production that can be produced for the target cost.

In customer profitability analysis, indirect costs are grouped into cost pools (e.g., the cost pool related to processing fax orders, the cost pool related to processing Internet orders, the cost pool related to shipping, etc.). The costs are then allocated to customers using various cost drivers (allocation bases) to determine customer profitability.

With activity-based pricing, customers are charged for various services. For example, there might be separate charges for delivery, for rush orders, and for returns. This way, customers that impose high costs on a supplier will pay for the services they demand.

The target costing process starts with specifying the desired features and price for a product. The next step is to determine the desired profit. The desired profit is subtracted from the anticipated price to arrive at the target cost. Finally, the product is designed to meet the target cost.

The quantity of products demanded at various prices should be estimated at each price level. The variable costs should be subtracted from the price to obtain the contribution margin. The contribution margin should then be multiplied by the quantity demanded. The fixed costs are then subtracted from the total contribution margin; profit can then be estimated.

8-2

Jiambalvo Managerial Accounting The profit-maximizing price is difficult in real life because the demand for a product at various price levels is not usually known.

A special order is an order that is not considered part of a company’s normal business. If a company is operating at full capacity, the opportunity cost from the lost sales if the special order is undertaken must be considered. If excess capacity exists, no existing sales will be lost and do not, therefore, need to be considered.

Deciding what markup percentage to use for cost-plus pricing is difficult; experimentation with various levels may be necessary. Cost-plus pricing is also inherently circular for manufacturing firms. You must estimate demand to determine fixed costs per unit to mark up. When fixed costs per unit go higher, demand falls and fixed costs per unit increase yet again.

10. The lowest special-order price should be the incremental cost of the order including opportunity cost.

Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

8-3

EXERCISES E1. [LO 2, 3] While the computers may be a commodity, the business processes used by Bell to produce and sell computers are a source of competitive advantage. Assuming Bell is better at these business processes than its competitors, it may make sense to lower prices and gain market share. While Bell may be able to generate significant profit even at lower prices, the lower prices may be ruinous for competitors. E2. [LO 5] The CFO wants to spend the $1,000,000 to determine the profitability of Brindle Corporation’s customers. He is worried that the company is losing money with customers who place a lot of small orders and lose billing information that causes them to delay payments. By dropping unprofitable customers, the company will see an increase to its profits despite a decrease in sales. The marketing vice-president may, in fact, be worried that some customers really will be dropped. This will reduce sales and may have a negative effect on his bonus (which is based on sales rather than profit). However, if no customers are going to be dropped and prices to less profitable customers are not going to be changed, then there is, indeed, no point in conducting the customer profitability study. E3. [LO 1] Price Less variable cost Contribution margin per unit Number of units Total contribution margin

$6.00 1.20 4.80 ×2,000 9,600

Less lost contribution: $4.80 × 600 Net profit

2,880 $6,720

Price Less variable cost Contribution margin per unit Number of units Total contribution margin

$7.00 1.20 5.80 ×1,000 5,800

Less lost contribution: $4.80 × 300 Net profit

1,440 $4,360

The company should produce the seasonal beer and charge $6 per six-pack.

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Jiambalvo Managerial Accounting

E4. [LO 1]

Quantity 25,000 31,000 37,000

Price $7.95 6.95 5.95

Variable Cost per Unit $2.20 2.20 2.20

Contribution Margin per Unit $5.75 4.75 3.75

Total Contribution Margin $143,750 147,250 138,750

Fixed Costs $95,000 95,000 95,000

Profit $48,750 52,250 43,750

A price of $6.95 yields the largest monthly profit. E5. [LO 1] Quantity Demanded

Price

Variable Cost per Unit

330 380 390 430

$12.50 11.50 10.50 9.50

$2.50 2.50 2.50 2.50

Contribution Total Margin per Contribution Unit Margin $10.00 9.00 8.00 7.00

$3,300 3,420 3,120 3,010

Fixed Costs

Profit

$1,750 1,750 1,750 1,750

$1,550 1,670 1,370 1,260

A price of $11.50 yields the largest monthly profit. E6. [LO 1] Accepting the order will result in $204,000 of incremental profit. Incremental revenue ($125 × 3,000) Incremental costs: Material ($29 × 3,000)a Labor ($19 × 3,000)b Variable overhead ($9 × 3,000)c Incremental profit a. $725,000 ÷ 25,000 = $29 b. $475,000 ÷ 25,000 = $19 c. $225,000 ÷ 25,000 = $9

$375,000 $87,000 57,000 27,000

171,000 $204,000

Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

E7. [LO 1] Incremental revenue ($900 × 150) Incremental costs: Labor ($450 × 150)a Variable overhead ($400 × 150)b Incremental profit

8-5

$135,000 $67,500 60,000

127,500 $7,500

a. $360,000 ÷ 800 = $450 b. $320,000 ÷ 800 =$400 Accepting the order will result in an additional profit of $7,500 per year. E8. [LO 1] Incremental revenue $57 × 130 $7,410 Incremental costs: Labor $18a × 130 $2,340 b Variable overhead $12 × 130 1,560 3,900 Incremental profit $3,510 a. $13,950 ÷ 775 b. $9,300 ÷ 775 Accepting the Rotary Club’s offer will result in an additional $3,510 of profit each year. E9. [LO 2] a. Variable cost per unit Fixed costs per unit ($240,000 ÷ 1,200) Markup (25% × $280) Price b. Variable cost per unit Fixed costs per unit ($240,000 ÷ 600) Markup (25% × $480) Price

$ 80 200 280 70 $350

$ 80 400 480 120 $600

c. The company will not be able to sell 600 units at a price of $600. After all, the company’s quantity demanded is 600 units at a price of $350.

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Jiambalvo Managerial Accounting

E10. [LO 2] a. Variable cost per unit Fixed costs per unit ($210,000 ÷ 60,000) Cost Markup of 30% Price

$15.00 3.50 18.50 5.55 $24.05

b. Variable cost per unit Fixed costs per unit ($210,000 ÷ 40,000) Cost Markup of 30% Price

$15.00 5.25 20.25 6.08 $26.33

c. When the fixed costs are spread over a smaller number of units, the cost will increase. With cost-plus pricing, an increase in costs will increase the price. Thus, when production decreases, costs increase and prices increase. E11. [LO 2] Student answers will vary. E12. [LO 2] a. The target cost per unit is $2,100 = ($2,800 – .25 ($2,800)). b. If the product cannot be manufactured for $2,100, the company should consider increasing the price or modifying features so that the target cost can be achieved. E13. [LO 4] a. The target cost per unit is $97.50 = ($150 – .35 ($150)). b. If the product cannot be manufactured for $97.50, rather than eliminating the product from consideration, the company should consider increasing the price or modifying features so that the target cost can be achieved. E14. [LO 2] a. The target cost per unit is $24.50 = ($35 – .30 ($35)). b. If the product cannot be manufactured for $24.50, the company should consider increasing the price or modifying features so that the target cost can be achieved.

Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

E15. [LO 3] Sales Less: Cost of good sold (.85 × $55,000) Order processing (250 × $6) Rush handling (.7 × 250 × $11) Customer service (160 × $12) Relationship management costs Profitability of Johnson Brands account E16. [LO 3] a. Revenue Sales Order processing fee (250 × $7) Rush order fee (.7 × 250 × $13) Customer service fee (160 × $17) Total revenue Less costs: Cost of good sold (.85 × $55,000) Order processing (250 × $6.00) Rush handling (.7 × 250 × $11.00) Customer service (160 × $12.00) Relationship management costs Profitability of Johnson Brands account

8-7

$55,000 $46,750 1,500 1,925 1,920 3,500 $

$55,000 1,750 2,275 2,720

$46,750 1,500 1,925 1,920 3,500

55,595 (595)

$61,745

55,595 $ 6,150

b. Johnson will probably reduce the number of rush orders and calls for customer service. They may also reduce the number of orders they place by increasing the size of each order. E17. [LO 3] Sales Less: Cost of goods sold (.80 × $22,000) Order processing ($9 × 170) Rush handling ($11 × 170 × .80) Technical support ($13 × 90) Relationship management costs ($1,800 × 1) Profitability of Julius Company account

$22,000 $17,600 1,530 1,496 1,170 1,800

23,596 $(1,596)

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Jiambalvo Managerial Accounting

E18. [3]LO 6 a. Sales Order processing fees ($11 x 170) Rush fees ($20 x .80 x 170) Customer support fees ($21 x 90) Total revenue Less: Cost of goods sold Order processing Rush handling Technical support Relationship management costs Total expenses Profitability of Julius Company account

$22,000 1,870 2,720 1,890 $28,480 $17,600 1,530 1,496 1,170 1,800 23,596 $ 4,884

No. Julius Company’s activity would probably be less when activity-based pricing is instituted. Julius Company, upon seeing the charges for rush orders and customer support calls, will probably reduce their use of these services. In addition, they may reduce the number of orders they place during the year by increasing the size of each order.

Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

8-9

PROBLEMS P1. [LO 1] a. Variable Quantity Price Cost* 15,000 $85 $50.00 20,000 75 48.00 30,000 65 46.00 45,000 55 44.00 65,000 45 42.00 * Equals 20% of price + $28 + $5

CM/Unit $35 27 19 11 3

Total CM $525,000 540,000 570,000 495,000 195,000

Fixed Costs $160,000 160,000 160,000 160,000 160,000

Profit $365,000 380,000 410,000 335,000 35,000

b. The profit maximizing price is $65, which yields a profit of $410,000.

P2. [LO 1] a. Contribution Price Margin per Unit 450 $65.99 $41.50 $24.49 725 55.99 39.00 16.99 800 45.99 36.50 9.49 1,000 35.99 34.00 1.99 1,300 25.99 31.50 (5.51) * Equals 25% of price + $15 + $10 ** Equals $7,000 + $1,500 Quantity Demanded

Variable Cost per Unit*

Total Fixed Contribution Costs** Margin $11,020.50 $8,500 12,317.75 8,500 7,592.00 8,500 1,990.00 8,500 (7,163.00) 8,500

b. The price of $55.99 will maximize the profit.

P3. [LO 1] This approach does seem unethical. It seems to be a violation of the RobinsonPatman Act, which prohibits price discrimination. Thus, companies cannot sell same product to competing customers at different prices. The act of charging different prices across area codes is an example of price discrimination.

Profit $2,520.50 3,817.75 (908.00) (6,510.00) (15,663.00)

8-10 Jiambalvo Managerial Accounting P4. [LO 1] a. Price Quantity of of Rover Rover $9.99 36,000 10.99 35,500 11.99 35,000 12.99 34,000 13.99 31,000 14.99 26,000 15.99 16,000 16.99 11,000 17.99 6,000 N/A –

Price of Royal $20.99 20.99 20.99 20.99 20.99 20.99 20.99 20.99 20.99 20.99

Quantity of Royal

Total Revenue1

Cost of Rover2

Cost of Royal3

Profit4

12,000 12,300 12,500 13,000 14,000 15,000 16,000 20,000 22,000 26,000

$611,520 648,322 682,025 714,530 727,550 704,590 591,680 606,690 569,720 545,740

$324,000 319,500 315,000 306,000 279,000 234,000 144,000 99,000 54,000 –

$144,000 147,600 150,000 156,000 168,000 180,000 192,000 240,000 264,000 312,000

$143,520 181,222 217,025 252,530 280,550 290,590 255,680 267,690 251,720 233,740

1. Revenue equals price of Rover times quantity of Rover plus price of Royal times quantity of Royal. 2. Cost of Rover equals $9 times quantity of Rover. 3. Cost of Royal equals $12 times quantity of Royal. 4. Profit equals total revenue minus cost of Rover minus cost of Royal. The profit maximizing price of RoverPlus is $14.99. b. At the profit maximizing price, profit is $290,590. Without the RoverPlus brand, profit was $233,740. Thus, profit is $56,850 higher with RoverPlus.

Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

8-11

P5. [LO 1] a. Price of Quantity Price of Quantity Total Cost of Cost of Profit (4) Elles CD Elles CD West CD West CD Revenue (1) Elles (2) West (3) $10 950 $16 200 $12,700 $5,700 $1,400 $5,600 11 900 16 275 14,300 5,400 1,925 6,975 12 825 16 350 15,500 4,950 2,450 8,100 13 725 16 395 15,745 4,350 2,765 8,630 14 550 16 475 15,300 3,300 3,325 8,675 15 460 16 525 15,300 2,760 3,675 8,865 16 300 16 575 14,000 1,800 4,025 8,175 17 200 16 625 13,400 1,200 4,375 7,825 18 125 16 675 13,050 750 4,725 7,575 N/A 16 800 12,800 5,600 7,200 1. Revenue equals price of Elles CD times quantity of Elles CD plus price of West CD times quantity of West CD. 2. Cost of Elles CD equals $6 times quantity of Elles CD. 3. Cost of West CD equals $7 times quantity of West CD. 4. Profit equals total revenue minus cost of Elles CD minus cost of West CD. The profit maximizing price of the Elles CD is $15. b. At the profit maximizing price, profit is $8,865. Without the Elles CD, profit was $7,200. Thus, profit is $1,665 higher with the Elles CD. P6. [LO 2] a. Variable cost per unit Fixed cost per unit ($12,600,000 ÷ 6,000) Total Markup (30% × $4,800) Price

$2,700 2,100 4,800 1,440 $6,240

b. Price influences the quantity demanded, but the estimated quantity demanded is being used to determine the price! c. Variable cost per unit Fixed cost per unit ($12,600,000 ÷ 5,000) Total Markup (30% × $5,220) Price

$2,700 2,520 5,220 1,566 $6,786

d. The number of units sold will decrease after the increase in the price to $6,786.

8-12 Jiambalvo Managerial Accounting e. To mark-up full cost, a manufacturing firm must first estimate the quantity that will be sold so that it can determine the fixed manufacturing cost per unit. But price influences the quantity that can be sold, so the process is inherently circular. P7. [LO 2] a. Variable cost per unit Fixed cost per unit ($850,000 ÷ 8,500) Total Markup (35% × $133) Price

$ 33.00 100.00 133.00 46.55 $179.55

b. Variable cost per unit Fixed cost per unit ($850,000 ÷ 6,250) Total Markup (35% × $169) Price

$ 33.00 136.00 169.00 59.15 $228.15

c. The price in the second scenario is higher because the fixed costs are being spread over fewer units. As the cost goes up, so does the markup and price. However, if price goes up, demand is likely to fall, so the company will not sell as many units as previously estimated. This situation can turn into a “death spiral,” in that as the cost goes higher, the company sets the price higher, reducing demand further, which in turn drives up cost. It is a vicious cycle in which the company is eventually forced out of the market. P8. [LO 2] a. Variable cost per unit Fixed cost per unit ($400,000 ÷ 1,600) Total Markup (50% × $650) Price

$ 400 250 650 325 $ 975

b. Variable cost per unit Fixed cost per unit ($400,000 ÷ 1,000) Total Markup (50% × $800) Price

$ 400 400 800 400 $1,200

Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

8-13

c. The price in the second scenario is higher because the fixed costs are being spread over fewer units. As the cost goes up, so does the markup and price. However, if price goes up, demand is likely to fall, so the company will not sell as many units as previously estimated. d. This situation can turn into a “death spiral,” in that as the cost goes higher, the company sets the price higher, reducing demand further, which in turn drives up cost. It is a vicious cycle in which the company is eventually forced out of the market. P9. [LO 2] a. Price Desired profit (30% × $5,000) Target cost b. $2,500 + ($2,500,000 ÷ x)

$5,000 (1,500) $3,500 = $3,500 x = 2,500 units

c. Price Desired profit (30% × $4,000) Target cost Variable cost per unit ($2,500 - $800) Fixed cost per unit ($2,500,000 ÷ 2,500) Total

$4,000 (1,200) $2,800 $1,700 1,000 $2,700

The revised target cost will be $2,800 and, after dropping the steam feature, the cost per unit will only be $2,700 (with sales of 2,500 units). Therefore, the company will be able to produce the item at less than the new target cost.

8-14 Jiambalvo Managerial Accounting P10. [LO 2] a. Price Desired profit (25% × $4,700) Target cost b.

$4,700 (1,175) $ 3,525

$2,900 + ($1,800,000 ÷ x) = $3,525 x = 2,880 units

c. Price Desired profit (25% × $4,000) Target cost

$4,000 (1,000) $3,000

Variable cost per unit ($2,900 - $650) Fixed cost per unit ($1,800,000 ÷ 2,600) Total

$2,250 692 $2,942

The revised target cost will be $3,000 and, after dropping the steam feature, the cost per unit will only be $2,942 (with sales of 2,600 units). Therefore, the company will be able to produce the item at less than the new target cost.

P11. [LO 3] a. Cost per change order ($212,500 ÷ 850) Cost per return ($70,000 ÷ 1,000) Cost per design meeting hour ($78,000 ÷ 1,300)

$250 $ 70 $ 60

Indirect cost related to Orvieto job Change orders (25 x $250) $ 6,250 Returns (33 x $70) 2,310 Design hours (40 x $60) Total

2,400 $10,960

b. Lauden should consider adopting activity-based pricing and charging companies like Orvieto for the indirect costs they impose.

Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

P12. [LO 3] a. Mark-up of product cost and installer salary Charges for indirect services Change orders (25 × $300) Charge for returns (33 × $90) Charge for design time (40 × $85) Total revenue and charges Less costs Product costs Installer salaries Change orders (25 × $250)

8-15

$270,000 7,500 2,970 3,400 283,870 175,000 25,000 6,250

Returns (33 × $70) 2,310 Design time (40 × $60) Total costs Profit

2,400 210,960 $ 72,910

b. Use of activity-based pricing will discourage customers from imposing indirect costs on the company. On the other hand, some customers may find the “pay for service” plan to be offensive (aren’t we paying for service in the bid price?) and take their business elsewhere.

8-16 Jiambalvo Managerial Accounting Case 8-1 [LO 1, 2]

PRESTON CONCRETE Summary A supplier of concrete uses full cost pricing, but a sharp increase in interest rates has reduced demand for concrete and the company is considering a lower price. •

Demonstrates that cost shouldn’t be the sole focus of pricing. Demand must also be considered.

Questions to ask students 1. What’s the situation facing Preston Concrete and what is the cost plus price of the Fairview Construction Company job? 2. Should Preston lower its price to $115 per cubic yard? Discussion a. Preston is a supplier of concrete and typically sets price at 25 percent over full cost (including an allowance for administrative costs). Following its normal pricing policy, the price of the Fairview Construction Company job will be $142.63 per cubic yard computed as follows:

Material costs Delivery costs ($500,000 ÷ 500,000 cubic yards)

Yard operation costs ($300,000 ÷ 500,000 cubic yards)

Administrative costs ($2,000,000 ÷ 500,000 cubic yards) Total per cubic yard ($75 + 1.00 + .60 + 17 + 4.00) Total per mile Total per hour

$75.00 per cubic yard

1.00 per cubic yard 10.00 per mile 50.00 per truck hour

0.60 per cubic yard 17.00 per cubic yard

4.00 per cubic yard $97.60 10.00 50.00

Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

Price for Fairview job Per yard (6,000 × $97.60) Miles (8,400 × $10.00) Hours (300 × $50.00) Total cost Markup (25 percent) Price

$585,600 84,000 15,000 684,600 171,150 $855,750

Price per cubic yard ($855,750 ÷ 6,000)

$142.63

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b. Now let’s consider whether Preston should lower its price to $115 per cubic yard to obtain Fairview’s business. As indicated below, the incremental cost per cubic yard is only $108.50, so the price will cover incremental costs. However, there may be opportunity costs related to this lower price. For example, other customers may hear of the “deal” and demand similar low prices. Or a ruinous price war may start among Preston and its competitors. Incremental cost of Fairview job Material ($75 × 6,000 cubic yards) Delivery $10 × 8,400 miles $50 × 300 truck hours Yard operation ($17 × 6,000 cubic yards) Total incremental cost

$450,000 84,000 15,000 102,000 $651,000

Incremental cost per cubic yard ($651,000 ÷ 6,000 cubic yards)

$108.50

8-18 Jiambalvo Managerial Accounting Case 8-2 [LO 1]

GALLOWAY UNIVERSITY MEDICAL CENTER PHARMACY Summary Galloway University Medical Center Pharmacy is considering offering either free delivery or 20 percent off to encourage prescription renewals. •

Focuses on incremental analysis in comparing alternative actions to increase revenue.

Questions to ask students 1. What is the situation at Galloway University Medical Center Pharmacy? 2. Which option should be selected: offer free delivery, or offer 20 percent off on prescription renewals? Discussion GUMC attracts patients from a three state area. While patients generally fill their prescriptions on the day they are released, they turn to a local pharmacy when it comes time to renew them. The GUMC pharmacy is considering offering either free delivery or 20 percent off to encourage prescription renewals. Here is a comparison of the two alternatives:

Chapter 8 Pricing Decisions, Analyzing Customer Profitability, and Activity-Based Pricing

Current revenue Number of orders Revenue per order Cost (75% of revenue) Profit margin (25% of revenue)

$54,990,000.00 ÷ 846,000.00 $ 65.00 (48.75) $ 16.25

Free overnight delivery Incremental revenue 125,000 renewals × $65.00 Incremental costs Cost of orders (125,000 × $48.75) Delivery cost (125,000 × $9.00) Salary of two pharmacists Salary of staff person

$8,125,000

$6,093,750 1,125,000 180,000 50,000

7,448,750

Incremental profit

$ 676,250

20 percent discount Incremental revenue (125,000 renewals × $65.00 × .80)

$6,500,000

Incremental costs Cost of orders (125,000 × $48.75) Salary of two pharmacists Incremental profit

8-19

$6,093,750 180,000

6,273,750 $ 226,250

As indicated, the incremental profit associated with a 20 percent discount is $226,250, while the incremental profit associated with free delivery is in fact $676,250. Therefore, the free overnight delivery is the preferred alternative.

Chapter 9 Capital Budgeting and Other Long-Run Decisions QUESTIONS 1. A capital expenditure decision is a decision involving the acquisition of a long-lived asset. 2. Time value of money must be considered because the value of money received in the future from an investment is not equivalent to the value of money expended to acquire the investment in the current period. 3. Two approaches that consider the time value of money are the net present value (NPV) approach and the internal rate of return (IRR) approach. 4. With the net present value approach, investments are accepted if the net present value is equal to or greater than zero. With the internal rate of return approach, investments are accepted if the internal rate of return is equal to or greater than the required rate of return. 5. The cost of equity is the return demanded by shareholders for the risk they bear in supplying capital to the firm. 6. Because depreciation reduces taxable income, it results in a tax savings equal to the tax rate times the amount of depreciation. As a result, cash inflows are increased. 7. The net present value and internal rate of return methods consider the total stream of cash flows as well as the time value of money. Meanwhile, the payback method does not consider the total stream of cash flows and it does not consider the time value of money. Also, the accounting rate of return method does not consider the time value of money. 8. Managers may concentrate on short-run profitability rather than net present value if their performance is evaluated and compensated based on current period profit. 9. With uneven cash flows, the internal rate of return is calculated using a trial and error approach. Managers “guess” at the IRR and calculate the present value. If the present value is greater than zero, the guess is increased. If the present value is negative, the guess is decreased. An Excel spreadsheet can also be used to calculate the IRR. 10. In many cases, the benefits of an investment are difficult to quantify (i.e., there are soft benefits). However, ignoring them is equivalent to ignoring cash inflows and tends to discourage investment.

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Jiambalvo Managerial Accounting

EXERCISES E1. [LO 1] Interest expense is not treated as a cash outflow because the “charge” for interest is included in the cost of capital (i.e., the hurdle or discount rate). E2. [LO 1, 3] The NPV is positive and Sally should make the investment. Time

Cash Flow

10% PV Factor

PV Amounts

$(40,000,000)

1.0000

$(40,000,000)

6,550,000

5.3349

34,943,595

NPV

$5,056,405

1-8

Year

Effect on income

End of year investment

ROI

$1,550,000

$35,000,000

4.43%

1,550,000

30,000,000

5.17%

1,550,000

25,000,000

6.20%

1,550,000

20,000,000

7.75%

1,550,000

15,000,000

10.33%

1,550,000

10,000,000

15.50%

1,550,000

5,000,000

31.00%

1,550,000

Division by zero not defined

Although the project has a positive NPV, if Sally is overly focused on short-term performance, she may hesitate to make the investment, which has a relatively low ROI in the first four years. Note that ROI increases dramatically as the book value of the investment decreases due to depreciation. E3. [LO 1] The cash flows of a food processing company are generally less risky than the cash flows of a casino. E4. [LO 1] Cash Flow $850

11% Present Value Factor 4.2305

Total $3,595.93

Chapter 9 Capital Budgeting Decisions

9-3

E5. [LO 1] The numbers decrease from left to right in a given row because cash received in the future is worth less the higher the required rate of return. The numbers decrease from top to bottom in a given column because cash received further in the future is less valuable than it is today. E6. [LO 1] Cash Flow $1,200 950

15% Present Value Factor Total 4.1604 $ 4,992.48 .3759 357.11 $5,349.59

E7. [LO 1] Plan A Total $350,000 Plan B Cash Flow $ 40,000 200,000

8% Present Value Factors Total 5.7466 $229,864 .5403 108,060 $337,924

Plan C Cash Flow $35,000

8% Present Value Factor Total 5.7466 $201,131

Plan A should be selected as it has the highest present value. E8. [LO 1] Cash Flow ($85,000) 35,000

12% Present Value Factors Total 1.0000 ($85,000) 3.6048 126,168 $ 41,168

The net present value is positive so the project should be undertaken.

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Jiambalvo Managerial Accounting

E9.

[LO 1] The investment should not be undertaken because the internal rate of return of 13.8% is less than the required rate of 18%. Initial outlay Annuity amount

$200,000 35,000

Outlay ÷ annuity amount = PV of annuity factor

5.7143

Internal rate of return

13.8%

E10. [LO 1] a. Initial outlay Annuity amount Outlay ÷ annuity amount = PV of annuity factor Internal rate of return

$195,000 55,000

3.5455 12.7%

b. Tanya should make the investment because its return of 12.7% is greater than the required return of 10%. E11. [LO 2] Annual depreciation $90,000 ÷ 5 years

$18,000

Annual tax savings $18,000  .40

$7,200

Present value of $7,200 per year for 5 years at 15% $7,200  3.3522

$24,136

Chapter 9 Capital Budgeting Decisions E12.

[LO 2] Year 1 2 3 4

9-5

Income (Loss) ($350,000) (270,000) 400,000 650,000

The $350,000 loss in year 1 will offset income in year 3 resulting in a tax savings of $122,500 (i.e., $350,000  35% tax rate) in year 3. With respect to the $270,000 loss in year 2, $50,000 of it can be used to offset income in year 3 (resulting in a tax savings of $17,500 in year 3) and $220,000 of it can be used to offset income in year 4 (resulting in a tax savings of $77,000 in year 4). Cash Flow $122,500 17,500 77,000

14% Present Value Factors Total .6750 $82,688 .6750 11,813 .5921 45,592 $140,093

E13. [LO 1, 2] The annual cash inflow is $17,200, calculated as follows: Revenue Less: Cost other than depreciation Depreciation ($60,000 ÷ 6) Income before taxes Less taxes at 40% Net income Plus depreciation Cash flow

$34,000 12,000 10,000 12,000 4,800 7,200 10,000 $17,200

The net present value is positive, so the smoker should be purchased. Cash Flow $17,200 (60,000)

14% Present Value Factors 3.8887 1.0000

Total $66,886 (60,000) $ 6,886

9-6

Jiambalvo Managerial Accounting

E14. [LO 3] The payback period is 6 years as follows: Cost Cash inflows

$126,000 21,000

Cost ÷ Cash inflows = Payback period

6 years

E15. [LO 3] The accounting rate of return is 18%: Average income Average investment ($355,000 ÷ 2) Average income ÷ Average investment = Accounting rate of return

$32,000 177,500 18%

E16. [LO 1] As indicated, the NPV is close to zero at a rate of 11%. Thus, the IRR is approximately 11%. Given that the required rate of return is 14%, the ecommerce business should not be developed.

Time 0 1 2 3 4 5

Discount rate Cash Flow (1,300,000) (750,000) 221,000 850,000 950,000 940,000

11.14% Present Value Factor 1.0000 0.8998 0.8096 0.7284 0.6554 0.5897 NPV

Total ($1,300,000) ($674,850) $178,922 $619,140 $622,630 $554,318 160

Time 0 1 2 3 4 5

Discount rate Cash Flow (1,300,000) (750,000) 221,000 850,000 950,000 940,000

11.15% Present Value Factor 1.0000 0.8997 0.8094 0.7282 0.6552 0.5895 NPV

Total ($1,300,000) ($674,775) $178,877 $618,970 $622,440 $554,130 (358)

Chapter 9 Capital Budgeting Decisions

9-7

E17. [LO 1] As indicated below, the NPV is close to zero when using a return of 8 percent. Thus, the IRR is approximately 8 percent.

Time 0 1 2 3 4 5

Discount rate Cash Flow (2,500,000) (250,000) 440,000 650,000 850,000 1,102,765

8.00% Present Value Factor 1.0000 0.9259 0.8573 0.7938 0.7350 0.6806 NPV

Total ($2,500,000) $231,475 $377,212 $515,970 $624,750 $750,542 (51)

E18. [LO 1] The online business may help the company manage a potentially stodgy image associated with its mall locations. Also, the online business may actually generate a number of large sales for the brick and mortar locations. Some customers will shop the web site to make price and quality comparisons, but they will be unwilling to make, for example, a $5,000 purchase of a diamond ring over the Internet. Thus, after seeing merchandise on the web site, they may visit one of Reece’s mall stores to make a purchase. These potential benefits would be difficult to quantify.

9-8

Jiambalvo Managerial Accounting

PROBLEMS P1. [LO 1, 2] The original contract was worth $15,880,500 in present value terms while the new offer is worth $13,184,230. When the time value of money is taken into account, it is obvious that the new offer is not better than the old one. Time 0 1-5

Cash Flow $7,500,000 2,500,000

15% PV Factors 1.0000 3.3522

Time 1 2 3 4 5 5

Cash Flow 2,500,000 2,600,000 2,700,000 2,800,000 2,900,000 8,500,000

15% PV Factors 0.8696 0.7561 0.6575 0.5718 0.4972 0.4972

Total $7,500,000 8,380,500 $15,880,500 Total 2,174,000 1,965,860 1,775,250 1,601,040 1,441,880 4,226,200 $13,184,230

P2. [LO 1]

Cost of new refrigeration unit Additional annual profit ($9,000 - $5,000) Annual electricity savings Additional annual maintenance costs Amount collected from disposal of unit Net present value

Cash Flow ($25,000)

14% PV Factors 1.0000

4,000 2,500 (4,000) 6,000

5.2161 5.2161 5.2161 0.2697

PV Amounts ($25,000) 20,864 13,040 (20,864) 1,618 ($10,342)

Since the net present value is less than zero, the investment should not be undertaken. P3. [LO 1] Machine A Cost of machine Annual savings Net present value Machine B Cost of machine Annual savings Net present value

Cash Flow ($70,000) 20,000

13% PV Factors 1.0000 3.9975

($95,000) 25,000

1.0000 3.9975

PV Amounts ($70,000) 79,950 $9,950

($95,000) 99,938 $4,938

Machine A should be purchased since it has the slightly higher net present value.

Chapter 9 Capital Budgeting Decisions

9-9

P4. [LO 1] a. Present value of annual cash flows in Caribbean/Alaska itinerary at 12% ($169,000,000  6.8109) $1,151,042,100 Present value of annual cash flows in Caribbean/Eastern Canada itinerary at 12% ($155,000,000  6.8109) $1,055,689,500 Present value of annual cash flows in Caribbean/Alaska itinerary at 16% ($169,000,000  5.5755) $942,259,500 Present value of annual cash flows in Caribbean/Eastern Canada itinerary at 16% ($155,000,000  5.5755) $864,202,500 The cost of the ship is only $200,000,000. Therefore, the NPV will be positive under all of the alternatives which provides strong evidence that the ship should be purchased at either of the two required rates of return. b. The NPV will be positive (suggesting that the ship should be purchased) whether the required return is 12 percent or 16 percent. c. The difference in present values is $95,352,600 ($1,151,042,100 $1,055,689,500). Thus, there is a high opportunity cost if the firm decides to operate the ship in a Caribbean/Eastern Canada itinerary. P5. [LO 1, 2] Revenue Less amortization Income before taxes Less taxes Net income Add amortization Cash flow

Time 0 1 2 3 4

Year 1 $16,500,000 12,000,000 4,500,000 1,575,000 2,925,000 12,000,000 $14,925,000

Cash Flow ($20,000,000) 14,925,000 9,300,000 1,625,000 650,000

Year 2 $10,000,000 8,000,000 2,000,000 700,000 1,300,000 8,000,000 $9,300,000 12% PV Factors 1.0000 .8929 .7972 .7118 .6355

Year 3 Year 4 $2,500,000 $1,000,000 0 0 2,500,000 1,000,000 875,000 350,000 1,625,000 650,000 0 0 $1,625,000 $650,000

PV Amounts ($20,000,000) 13,326,532 7,413,960 1,156,675 413,075 $ 2,310,242

Since the NPV is positive, the company should produce the film.

9-10 Jiambalvo Managerial Accounting P6. [LO 1, 2] Cash flow per year: Revenue ($22,000 x 5) Less: Costs other than depreciation ($2,000 x 5) Depreciation ($350,000 ÷ 6) Income before taxes Less taxes Net income Add depreciation Cash flow

$110,000 10,000 58,333 41,667 16,667 25,000 58,333 $83,333

Annuity factor equals cost divided by net annual cash flow: ($350,000 ÷ $83,333) = 4.20 This implies an internal rate of return of approximately 11% (present value factor is 4.2305) Given the internal rate of return is lower than the required rate of 12%, the company should not invest in the remodel. P7. [LO 1, 2, 3] a. The net present value is positive $804,663. Thus the company should invest in the paint and body shop. Net income Add depreciation ($800,000 ÷ 10) Annual cash flow Cash Flow $284,000 (800,000)

12% Present Value Factors 5.6502 1.0000

$ 204,000 80,000 $284,000

PV Amounts $1,604,657 (800,000) $ 804,657

b. A present value of an annuity factor of 2.8169 implies the IRR is greater than 30 percent. Initial outlay Annuity amount

$800,000 284,000

Cost ÷ annuity = PV of annuity factor Note—the annuity factor for 30% is 3.0915.

2.8169

Chapter 9 Capital Budgeting Decisions c. The payback period is approximately 2.8 years: Initial outlay Annual cash flow

$800,000 284,000

Cost ÷ annuity = number of years to recover initial investment

2.8169

d. The accounting rate of return is 51%: Average income

$204,000

Average investment ($800,000 ÷ 2)

400,000

Average income ÷ average investment = accounting rate of return

51%

P8. [LO 1] a. Present value of Machine A

Annual amounts: Labor saving Power saving Chemical saving Add. Main. Add. Misc. Net annual cost savings Cost Installation Residual value

Cash Flow $25,000 1,500 3,000 (1,200) (2,500)

14% PV Factors

25,800 (30,000) (6,500) 4,000

2.9137 1.0000 1.0000 .5921

PV Amounts

NPV

$ 75,173 (30,000) (6,500) 2,368 $41,041

9-11

9-12 Jiambalvo Managerial Accounting b. Present value of Machine B

Annual amounts: Labor saving Power saving Chemical saving Add. Main. Add. Misc. Net annual cost savings Cost Installation Residual value

Cash Flow $32,000 2,000 3,500 (1,500) (2,700)

14% PV Factors

33,300 (55,000) (7,000) 6,000

2.9137 1.0000 1.0000 .5921

PV Amounts

NPV

$ 97,026 (55,000) (7,000) 3,553 $38,579

c. Both NPVs are greater than zero, so both are acceptable investments. However, the company should purchase machine A since it has a higher NPV. P9. [LO 1, 2] Drake should invest in the new limousine since the NPV is positive. Net income Add depreciation Annual cash flow Cash Flow $48,320 45,000 (160,000)

$25,320 23,000 $48,320 14% Present Value Factors 3.4331 .5194 1.0000

PV Amounts $165,887 23,373 (160,000) $ 29,260

Chapter 9 Capital Budgeting Decisions

9-13

P10. [LO 1, 2] Island Ferry should not invest in the boat because the NPV is negative. Revenue Less: Labor cost Fuel cost Maintenance cost Miscellaneous expense Depreciation expense ($950,000 - $50,000) ÷ 7 Income before taxes Taxes Net income Depreciation Annual cash flow Cash Flow $171,428 50,000 (950,000)

10% Present Value Factors 4.8684 0.5132 1.0000

$325,000 90,000 16,000 15,000 4,000 128,571 71,429 28,572 42,857 128,571 $171,428

PV Amounts $834,580 25,660 (950,000) ($89,760)

P11. [LO 1] Value of benefits = Needed present value = $600,000 = $104,185 Discount factor 5.7590 The annual value of the soft benefits will need to be $104,185 or more to make the net present value of the investment zero. If there is general agreement that the annual value of the soft benefits is at least $120,000, then the investment should be undertaken because it will have a zero or positive net present value.

9-14 Jiambalvo Managerial Accounting P12. [LO 1, 3] a. Revenue (45,000  $30) Less: Component cost Direct labor Depreciation ($500,000 - $15,000) ÷ 6 Miscellaneous Advertising Income before taxes Taxes Net income Depreciation Annual cash flow Cash Flow $155,333 15,000 (500,000)

$1,350,000 370,000 425,000 80,833 200,000 150,000 124,167 49,667 74,500 80,833 $ 155,333

15% Present Value Factor 3.7845 0.4323 1.0000

PV Amounts $587,858 6,485 (500,000) $ 94,343

b. The payback period is approximately 3.22 years: Initial outlay Annual cash flow

$500,000 ÷ 155,333

Number of years to recover initial investment

3.22 years

c. The accounting rate of return is 30%: Average income Average investment ($500,000 ÷ 2)

$74,500 ÷ $250,000

Accounting rate of return

29.8%

d. Given the positive NPV, the company should invest in Digidial.

Chapter 9 Capital Budgeting Decisions

9-15

P13. [LO 1] Year 1 2 Income $88,000 149,000 Depre. 60,000 60,000 Cash flow $148,000 209,000 Year 1. 2. 3. 4. 5. 6. 7. 7. 0.

Cash flow $148,000 209,000 297,200 406,620 496,382 609,720 711,992 80,000 (500,000)

3 237,200 60,000 297,200

4 346,620 60,000 406,620

5 436,382 60,000 496,382

6 549,720 60,000 609,720

7 651,992 60,000 711,992

14% PV Factors PV Amounts .8772 $ 129,826 .7695 160,826 .6750 200,610 .5921 240,760 .5194 257,821 .4556 277,788 .3996 284,512 .3996 31,968 1.0000 (500,000) NPV $ 1,084,111

Given the positive NPV, the company should invest in the new business. P14. [LO 1, 2] a. The cost of capital includes an allowance for expected inflation. Thus, in periods where expected inflation is high, the cost of capital is high, and firms demand a high return on their investments. b. Note that cash flows increase by 4% per year (except for the cash flow related to the depreciation tax shield). Cost savings Taxes on cost savings Tax savings related to depre. Cash flow Year 1 2 3 4 5

Year 1 $710,000

Year 2 $738,400

Year 3 $767,936

Year 4 $798,653

Year 5 $830,600

(239,750) (249,340)

(259,314)

(269,687)

(280,474)

161,000 $631,250

161,000 $669,622

161,000 $689,966

161,000 $ 711,126

Cash flow $ 631,250 650,060 669,622 689,966 711,126

Less cost of machine Net present value

161,000 $650,060

10% PV Factors .9091 .8264 .7513 .6830 .6209

PV Amounts $ 573,869 537,210 503,087 471,247 441,538 2,526,951 (2,300,000) $ 226,951

Given the positive NPV, the company should invest in the manufacturing equipment.

9-16 Jiambalvo Managerial Accounting P15. [LO 1] Note that in problem 14, the NPV was only $226,951 using a 10% required rate of return. This suggests that to determine the IRR, we should start with a return larger than, but close to, 10 percent. Below, the cash flows are brought to present value using a 13.7% rate of return. Since the sum of the present values is approximately equal to the cost of the investment (a difference of $691), the internal rate of return is approximately 13.7%. Given that this is greater than the required return of 10%, the investment should be undertaken.

Year 1. 2. 3. 4. 5.

Cash flow $ 631,250 650,060 669,622 689,966 711,126

Less cost of machine Net present value

13.7% PV Factors 0.8795 0.7735 0.6803 0.5984 0.5263

PV Amounts 555,184 502,821 455,544 412,876 374,266 2,300,691 (2,300,000) $ 691

P16. [LO 1] Student answers will vary but should include the idea that a higher required rate of return should be used reflecting the increased risk of the investment. P17. [LO 3] a. Richards is evaluated and compensated based on ROI which has some measure of income in the numerator and a measure of investment in the denominator. Thus, he will be highly focused on income. Some investment opportunities facing his division may increase shareholder wealth (as indicated by positive NPVs) but have a negative effect on short-run accounting income. If that will cause Richards to miss a bonus target, he may pass on these valuable investments. b. It will mitigate the problem. If Richards owns a great deal of stock/and or options, he will have a strong incentive to work to increase the firm’s stock price. And stock prices are likely to be positively impacted when the firm takes on projects with positive NPVs.

Chapter 9 Capital Budgeting Decisions

9-17

P18. [LO 1] Year 1 $65,000

Year 2 $66,300

Year 3 $78,230

Year 4 $88,000

Year 5 $95,238

25,100 24,900 2,100 9,000 61,100 Inc. before taxes 3,900 Taxes 1,560 Net income 2,340 Depre.* 9,000 Cash flow $ 11,340 *($50,000 – $5,000) ÷ 5

27,600 26,900 2,300 9,000 65,800 500 200 300 9,000 $9,300

30,392 28,900 2,500 9,000 70,792 7,438 2,975 4,463 9,000 $13,463

33,441 30,900 2,700 9,000 76,041 11,959 4,784 7,175 9,000 $16,175

36,695 32,800 2,800 9,000 81,295 13,943 5,577 8,366 9,000 $17,366

Revenue Less: Ingredients Salary Misc. Depreciation

Year 1. 2. 3. 4. 5. 5. 0.

12% PV Factors .8929 .7972 .7118 .6355 .5674 .5674 1.0000

Cash flow $ 11,340 9,300 13,463 16,175 17,366 5,000 (50,000) NPV

PV Amounts $ 10,125 7,414 9,583 10,279 9,853 2,837 (50,000) $

Using a rate of return of 12%, the NPV is approximately zero. Therefore, the IRR is approximately 12%. Palermo should invest in the delivery business given that the company’s required rate of return is only 10%.

9-18 Jiambalvo Managerial Accounting Case 9-1 [LO 1 and Ethics]

JUNIPER PACKAGING SOLUTIONS, INC. Summary Spencer Williams, vice president of a production facility, and the plant controller are planning on purchasing equipment, although there is a freeze on capital expenditures greater than $500,000. •

Raises the important ethical issue “Is it OK to violate company policy if you think it’s in the best interest of the shareholders?”

Questions to ask students 1. What is the situation of Spencer Williams and Juniper Packaging Solutions? 2. Is it ethical for Spencer and the controller to violate the CEO’s capital expenditure freeze and cover up their actions by asking vendors to submit multiple invoices for less than the maximum of $500,000? Discussion What is the situation facing Spencer and the controller? They believe that it is imperative that their company buy new state of the art equipment costing $2 million. However, the CEO has mandated a freeze on capital expenditures after third-quarter earnings dropped due to a weakening of the Asian economy and a decreased demand for shipping containers. The equipment needed is actually a number of “systems,” and Spencer and the controller have asked the equipment manufacturer to bill them separately for each one separately so that no purchase will be greater than $500,000. It does not appear that Spencer and the controller are acting ethically. They are deliberately violating the CEO’s current policy and the CEO is the elected representative of the shareholders—not Spencer and the controller. And while they may have good intentions, they have an implicit (if not explicit) contract to follow company policies. Other points to consider: • Spencer and the controller are attempting to cover up their actions. •

Spencer and the controller may be wrong! It’s not unlikely that the CEO knows more than they do about what actions will improve shareholder value.

Chapter 9 Capital Budgeting Decisions

9-19

Case 9-2 [LO 1, 2]

SERGO GAMES Summary A game company is considering outsourcing manufacturing of CDs. •

The case extends the discussion in the text which focuses on present value analysis related to investment decisions. This case demonstrates present value analysis is potentially important in any decision where cash inflows and outflows occur in different time periods (since the values of dollars received in different periods are not equivalent).

•

The case also provides students with an opportunity to critique an analysis that appears (on the surface) to be reasonable.

Questions to ask students: 1. What is the situation facing Sergo Games? 2. What is your analysis of the situation? 3. What are flaws in Leslie Eastman’s analysis? Discussion What is the decision facing Sergo Games? Sergo Games is considering outsourcing the production of CDs. An analysis by an accounting manager supports outsourcing. What is your analysis of the situation? The approach we take is to compute the NPV of the current cash flows with the NPV of cash flows that will occur if the company outsources production of the CDs. As indicated, the NPV of the current situation is $(14,471,297) while the NPV of the cash flows that occur if the company outsources is $(15,040,100). The difference is $568,803 and this is the value of the incremental savings associated with the status quo versus outsourcing.

9-20 Jiambalvo Managerial Accounting If Sergo Games chooses not to outsource the production of their CDs, the NPV would be as follows: Year 0 Labor Material Supervisor salaries Heat, light, etc. Tax savings

Year 1

Year 2

Year 3

Year 4

Year 5

(900,000) (900,000) (900,000) (900,000) (900,000) (4,800,000) (4,800,000) (4,800,000) (4,800,000) (4,800,000)

(.35x$6,670,000)

Total cash flows

(350,000) (200,000)

2,334,500

(3,915,500) (3,915,500) (3,915,500) (3,915,500) (3,915,500)

P.V. factor

1.000

×0.9009

×0.8116

×0.7312

×0.6587

×0.5935

Net present value (14,471,297)

(3,527,474) (3,177,820) (2,863,014) (2,579,140) (2,323,849)

The NPV for outsourcing is as follows: Year Year 0 1 Cost of CDs outside ($2.52 × 2,600,000)

Year 2

Year 3

Year 4

Year 5

(6,552,000) (6,552,000) (6,552,000) (6,552,000) (6,552,000)

Tax savings ($6,552,000 × .35)

2,293,200

Tax savings on losses

700,000

Total cash flows

700,000

P.V. factor

×1.000

2,293,200

(4,258,800) (4,258,800) (4,258,800) (4,258,800) (4,258,800) ×0.9009

×0.8116

×0.7312

×0.6587

×0.5935

Net present value (15,040,100) 700,000

(3,836,751) (3,456,442) (3,114,035) (2,805,272) (2,527,598)

Incremental savings from staying inside equals $568,803 (i.e., (14,471,297) – (15,040,100)) What are the flaws in Leslie Eastman’s analysis? A primary error is that the savings per CD is not $.05 since part of the cost of current production is depreciation expense which is sunk. Further, Leslie needs to consider tax effects related to current production versus outsourcing.

Chapter 10 Budgetary Planning and Control QUESTIONS 1. Budgets are useful in the planning process because they increase communication and coordination. Also, they force managers to carefully consider their goals and means to achieve them. 2. Budgets are useful in the control process because they provide benchmarks for evaluating performance. 3. In a top-down approach, budgets are prepared by high level managers without much input from subordinates. In a bottom-up approach, budgets are set with substantial input from subordinates. 4. In a zero-based budget, expenses are justified afresh in each budgeting period. Thus, no continuing project or activity receives funding automatically. 5. A spreadsheet allows you to change assumptions quickly and easily, facilitating “what-if” analysis. You can set up the spreadsheet with formulas representing your assumptions. Then you can change the assumptions in one cell and the spreadsheet will update automatically. 6. Cash budgets are prepared so that necessary loans can be arranged to deal with cash shortages (or so that the company can plan to deal with cash surpluses). 7. A static budget is a budget for one anticipated level of business activity. A flexible budget is a set of budget relationships that can be used to prepare budgets for various activity levels. 8. The costs of spoilage, rework, warranty repairs, and returns are some of the financial measures that capture the effect of defects in a process. 9. In absence of budgets, performance in a period might be compared to performance in prior periods to evaluate positive or negative trends. 10. Effective planning requires that managers provide truthful information and estimates for setting budgets. However, because a manager’s performance may be evaluated in comparison to a budget, he or she has an incentive to provide biased information so that budget goals are easier to achieve. Thus, there is inherent conflict between the planning and control uses of budgets.

10-2 Jiambalvo Managerial Accounting EXERCISES E1. [LO 3] If a manager knows that income will exceed the upper bound, he/she may shift income to the next period to increase budget-based compensation in that period. If a manager knows that income will be below the lower bound, he/she may shift income from the next period to obtain the hurdle and variable bonus. E2. [LO 3] Budget slack makes it more likely that a manager will receive the hurdle bonus and the maximum variable bonus. Slack can be created by decreasing revenue estimates and increasing expense estimates. E3. [LO 2] b, d, a, and c. E4. [LO 2] Locksafe Company Sales Budget For the Year Ending December 31, 2018

Sales for 2017 in units Projected sales at 120% of prior year Sales price per unit Budgeted revenue for 2018

First Quarter

Second Quarter

Third Quarter

Fourth Quarter

Year

23,000

28,000

27,000

32,000

110,000

27,600 $ × 25

33,600 $ × 25

32,400 $ × 25

38,400 $ × 25

132,000 $ × 25

$690,000

$840,000

$810,000

$960,000 $ 3,300,000

E5. [LO 2] Oregon Adventures Sales Budget For the Year Ending December 31, 2018

Sales for 2017 in units Projected sales at 135% of prior year Sales price per unit Budgeted revenue for 2018

First Quarter

Second Quarter

Third Quarter

Fourth Quarter

Year

6,000

7,000

10,000

9,000

32,000

8,100 $ × 75

9,450 $ × 75

13,500 × 75

12,150 $ × 75

$607,500

$708,750 $1,012,500

$911,250

43,200 × 75

$3,240,000

Chapter 10 Budgetary Planning and Control

10-3

E6. [LO 2] VitaPup Production Budget For the months of January, February, and March

Unit sales Plus desired ending inventory of finished units Total needed Less beginning inventory of finished units Units to be produced

January 13,000

February 14,900

March 19,400

Quarter 47,300

2,235 15,235

2,910 17,810

3,300* 22,700

3,300 50,600

1,300 13,935

2,235 15,575

2,910 19,790

1,300 49,300

*Equals 15% of April sales of 22,000 units. E7. [LO 2] Roehler Industrial Direct Materials Purchases Budget For the Year Ending December 31, 2017 Units to be produced Cost of raw material per unit (6 x $7) Cost of raw material needed for production Add desired ending inventory of raw material a

Quarter 1 45,000 $ × 42 1,890,000 258,300 2,148,300 283,500

Quarter 2 Quarter 3 Quarter 4 41,000 49,000 38,000 $ × 42 $ × 42 $ × 42 1,722,000 2,058,000 1,596,000 308,700 239,400 296,100 2,030,700 2,297,400 1,892,100 258,300 308,700 239,400

Year 173,000 $ × 42 7,266,000 296,100 7,562,100 283,500

Total material needed Less beginning inventory of raw material Required raw material purchases $1,864,800 $1,772,400 $1,988,700 $1,652,700

$7,278,600

a Equals 15% of next quarter’s material requirements.

E8. [LO 2] Roehler Industrial Direct Labor Budget For the Year Ending December 31, 2017 Quarter 1 Labor hours per unit Labor rate per hour Labor cost per unit Units to be produced Labor cost Total hours Average hours per quarter Approximate number of employees needed

Quarter 2

Quarter 3

Quarter 4

Year

3 ×$20 $60 × 45,000 $2,700,000

3 ×$20 $60 × 41,000 $2,460,000

3 ×$20 $60 ×49,000 $2,940,000

3 ×$20 $60 × 38,000 $2,280,000

135,000 ÷ 470

123,000 ÷ 470

147,000 ÷ 470

114,000 ÷ 470

288

262

313

243

3 ×$20 $60 × 173,000 $10,380,000

10-4 Jiambalvo Managerial Accounting E9.

[LO 2] Roehler Industrial Manufacturing Overhead Budget For the Year Ending December 31, 2017

Units to be produced Variable costs: Indirect material ($3.25/unit) Indirect labor ($2.20/unit) Utilities ($0.50/unit) Total variable overhead Fixed Costs: Supervisory salaries Factory depreciation Other Total fixed overhead Total overhead

Quarter 1 45,000

Quarter 2 41,000

Quarter 3 49,000

Quarter 4 38,000

Year 173,000

$146,250 99,000 22,500 267,750

$133,250 90,200 20,500 243,950

$159,250 107,800 24,500 291,550

$123,500 83,600 19,000 226,100

562,250 380,600 86,500 1,029,350

70,000 37,000 6,000

280,000 148,000 24,000

113,000 $380,750

113,000 $356,950

113,000 $404,550

113,000 $339,100

452,000 $1,481,350

E10. [LO 2] January Collection of credit sales Collection of December sales* Collection of January sales** Collection of January sales Collection of February sales Collection of February sales Collection of March sales

February

March

$60,000 112,000 $48,000 119,000

$172,000

$167,000

$51,000 127,400 $178,400

January $46,000 47,500

February

March

*($200,000 × .30) **($160,000 × .70)

E11. [LO 2] Cash disbursements for purchases Payment of December purchases* Payment of January purchases** Payment of January purchases Payment of February purchases Payment of February purchases Payment of March purchases

$47,500 60,000

$93,500 *($92,000 × .50) **($95,000 × .50)

$107,500

$60,000 42,500 $102,500

Chapter 10 Budgetary Planning and Control

10-5

E12. [LO 2] April Collection of credit sales Collection of February sales* Collection of March sales** Collection of April sales*** Collection of March sales Collection of April sales Collection of May sales Collection of April sales Collection of May sales Collection of June sales

May

June

$9,000 20,000 56,000 $10,000 16,000 63,000

$85,000

$89,000

$8,000 18,000 79,100 $105,100

May

June

*($90,000 × .10) **($100,000 × .20) ***($80,000 × .70)

E13. [LO 2] Cash disbursements for purchases April Payment of March purchases* $16,500 Payment of April purchases** 42,000 Payment of April purchases Payment of May purchases Payment of May purchases Payment of June purchases $58,500

$18,000 49,000

$67,000

$21,000 66,500 $87,500

*($55,000 × .30) **($60,000 × .70)

E14. [LO 3] Variable costs: Direct material Direct labor Variable overhead Variable cost per unit

$ 8.00 3.50 1.80 $13.30

Fixed costs: Supervisory salaries Depreciation Other fixed costs Fixed costs per month

$17,000 10,500 3,100 $30,600

Manufacturing costs for 12,000 units = $13.30 (12,000) + $30,600 = $190,200. Manufacturing costs for 15,000 units = $13.30 (15,000) + $30,600 = $230,100. Manufacturing costs for 17,000 units = $13.30 (17,000) + $30,600 = $256,700.

10-6 Jiambalvo Managerial Accounting E15. [LO 3]

Number of units Variable costs: Direct material ($8) Direct labor ($3.50) Variable overhead ($1.80) Total variable costs

Flexible Budget 13,000

Actual 13,000

Variance 0

$ 104,000 45,500 23,400 172,900

$ 102,500 50,000 23,000 175,500

$1,500 (4,500) 400 (2,600)

Fixed costs: Supervisory salaries Depreciation Other fixed costs Total fixed costs Total overhead

17,000 10,500 3,100 30,600 $203,500

17,750 9,500 3,400 30,650 $206,150

(750) 1,000 (300) (50) ($2,650)

E16. [LO 2, 3] The following performance report assumes that material and labor are variable costs and the remaining costs are fixed. Flexible Budget $660,000

Actual $660,000

Difference $ 0

120,000a 264,000b 384,000

130,000 285,000 415,000

(10,000) (21,000) (31,000)

Fixed costs: Owner’s salary Rent Depreciation Utilities Total fixed costs

65,000 55,000 45,000 22,000 187,000

65,750 55,000 45,200 21,000 186,950

(

Total cost

$571,000

$601,950

$(30,950)

Sales Variable costs: Material Labor Total variable costs

750) 0 ( 200) 1,000 50

a($100,000 ÷ $550,000) × $660,000 b($220,000 ÷ $550,000) × $660,000

The only expenses that Roden should focus on are material and labor—they are $10,000 (8.33%) and $21,000 (7.95%) respectively higher than the flexible budget. E17. [LO 3] Walter has an incentive to understate revenue and overstate expense in his budget. With biased estimates, it will be easier to beat the budget and achieve a bonus.

Chapter 10 Budgetary Planning and Control

10-7

PROBLEMS P1.

[LO 2] Preston Manufacturing Company Budgeted Income Statement for the Quarter Ended March 31, 2018 a.

Sales Less variable cost of sales Contribution margin Less fixed production costs Less fixed selling and administrative expenses Income before taxes Less taxes on income Net income

$616,000 369,600 246,400 $123,330 55,960

12% increase over prior quarter 12% increase over prior quarter $9,000 + 1.03 ($120,000 - $9,000)

179,290 67,110 26,844 $ 40,266

$7,000 + 1.02 ($55,000 - $7,000) 40% of income before taxes

b. Preston Manufacturing Company Cash Budget For the Quarter Ended March 31, 2018 Cash collected from sales: (.4 x $550,000) + (.6 x $616,000) Cash payments: Payment of material (.4 x $330,000 x .5) + (.4 x $369,600 x .5) Payment for labor (.4 x $369,600) Payment for variable overhead (.2 x $369,600) Payment for fixed production costs ($123,330 - $9,000) Payment for fixed sell. and adm. expense ($55,960 - $7,000) Payment of income taxes Plus beginning cash balance Ending cash balance

$589,600

$139,920 147,840 73,920 114,330 48,960 26,844

551,814 $ 37,786 160,000 $197,786

10-8 Jiambalvo Managerial Accounting c. Preston Manufacturing Company Budgeted Balance Sheet March 31, 2018 Assets: Cash Accounts receivable Inventory Total current assets Property, plant, and equipment Less accumulated depreciation Total assets

$ 197,786 246,400 .4 x $616,000 385,000 No change 829,186 440,000 (126,000) $110,000 + $9,000 + $7,000 $1,143,186

Liabilities and stockholders’ equity Accounts payable $ 73,920 Common stock 540,000 Retained earnings 529,266 Total liabilities and stockholders’ equity $1,143,186

.4 x .5 x $369,600 $489,000 + $40,266

P2. [LO 2] a Garret Bug Spray Manufacturing Company Budgeted Income Statement For the First Quarter of 2018 Sales of bug spray ($500,000 × 1.07) Less variable cost of goods sold ($280,000 × 1.07) Contribution margin Less fixed bug removal costs [$5,000 + (1.015 ×($90,000 - $5,000))]

$535,000 299,600 235,400 $91,275

Less fixed selling and administrative expenses [$3,000 + (1.03 × (50,000 – 3,000))]

Income before taxes Less taxes on income Net income

51,410

142,685 92,715 37,086 $55,629

Chapter 10 Budgetary Planning and Control

b. Garret Bug Spray Manufacturing Company Cash Budget For the First Quarter, 2018 Cash collected from sales: In quarter 4, 2017 ($500,000 x .50) $250,000 In quarter 1, 2018 ($535,000 x .50) 267,500 $517,500 Cash payments: Payment of material In quarter 4, 2017 ($280,000 x .40 x .40) 44,800 In quarter 1, 2018 ($299,600 x .40 x .60) 71,904 Payment for labor ($299,600 x. 40) 119,840 Payment for variable overhead ($299,600 59,920 x .20) Payment for fixed bug removal costs 86,275 ($91,275 - $5,000) Payment for fixed sell. and admin. Expense ($51,410 - $3,000) 48,410 Payment of income taxes 37,086 468,235 Excess of receipts over disbursements 49,265 Plus beginning cash balance 30,000 Ending cash balance $79,265 c. Garret Bug Spray Manufacturing Company Budgeted Balance Sheet For the First Quarter, 2018 Assets: Cash Accounts receivable ($535,000 x .50)

Total current assets Property, plant, and equipment Less accumulated depreciation ($80,000 + $5,000 + $3,000)

Total assets

$79,265 267,500 346,765 130,000 88,000 $388,765

Liabilities and stockholders’ equity Accounts payable ($299,600 x .40 x .40)

Common stock Retained earnings ($175,000 +$55,629)

Total liabilities and stockholders’ equity

$ 47,936 110,200 230,629 $388,765

10-9

10-10 Jiambalvo Managerial Accounting

P3. [LO 2] Part A: TechLabs Cash Budget For January 2018 Cash receipts Collection of December 2017 tuition ($80,000 x .50) Collection of January 2018 tuition ($110,000 x .50) Total cash receipts

$ 40,000 55,000 95,000

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 ($60,000 x .15) ÷ 12 Payment of taxes Total cash disbursements Excess of disbursements over receipts Plus beginning cash balance Ending cash balance

60,000 4,000 2,000 800 40,000 750 12,058 118,608 (23,608) 60,000 $ 36,392

Part B. TechLabs Budgeted Income Statement For January 2018 Tuition revenue Less: Salaries Rent Utilities Other Expenses Depreciation Interest expense Total expense Income before taxes Taxes on income Net income

$110,000 $60,000 4,000 2,000 800 8,000 750 75,550 34,450 12,058 $22,392

Chapter 10 Budgetary Planning and Control 10-11 Part C. TechLabs Budgeted Balance Sheet As of January 31, 2018 Assets Cash Accounts receivable ($110,000 x .50) Equipment (net) ($120,000 + $50,000 - $8,000) Total assets Liabilities Accounts payable Note payable Total liabilities Stockholders’ equity Common stock Retained earnings ($90,000 + $22,392) Total stockholders’ equity Total liabilities and stockholders’ equity

$ 35,392 55,000 162,000 $252,392 $ 50,000 60,000 110,000

30,000 112,392 142,392 $252,392

P4. [LO 2] a. Schrödinger Science Store Budgeted Income Statement for the Quarter Ended March 31, 2018 Sales ($350,000 x 1.10) Less cost of sales ($205,000 x 1.12) Gross margin Less selling, general and administrative expenses ($8,000 increase) Income before taxes Less income taxes (40%) Net Income

$385,000 229,600 155,400 58,000 97,400 38,960 $ 58,440

10-12 Jiambalvo Managerial Accounting b.

Schrödinger Science Store Cash Budget for the Quarter Ended March 31, 2018

Cash Receipts Collections of sales: 25% of Quarter 4, 2017 sales 75% of Quarter 1, 2018 sales Total cash receipts Cash Disbursements Payment for inventory purchases 50% of Quarter 4, 2017 purchases 50% of Quarter 1, 2018 purchases* Selling, general and adm. expenses (excludes $2,500 of depreciation) Income taxes Total disbursements Excess of receipts over disbursements Plus beginning cash balance Ending Cash balance

$87,500 288,750 $376,250

100,000 123,374 55,500 38,960 317,834 58,416 40,000 $ 98,416

*Beginning inventory in 2018 is $150,000. Cost of sales in the first quarter is $229,600. Ending inventory is $167,149 [65% of $257,152 (cost of goods sold in second quarter of 2015)]. Thus, purchases in the first quarter of 2018 are $246,749 (cost of goods sold plus ending inventory minus beginning inventory). c. Schrödinger Science Store Budgeted Balance Sheet March 31, 2018 Assets: Cash (from cash receipts and disbursements budget) Accounts receivable (25% of first quarter, 2018 sales) Inventory (65% of cost of sales in second quarter of 2018—$257,152) Furniture and fixtures ($50,000 less $2,500 depreciation) Total assets

167,149 47,500 $409,315

Liabilities: Accounts payable (50% of purchases in first quarter of 2018—$246,749)

$123,375

Stockholder's equity: Common stock Retained earnings ($147,500 plus net income) Total stockholder's equity Total liabilities and stockholder's equity

80,000 205,940 285,940 $409,315

$98,416 96,250

Chapter 10 Budgetary Planning and Control 10-13 d. As the ending cash balance for the first quarter is $98,416, a minimum desired cash balance of $30,000 will leave $68,416 for opening the store. A store opening requires $50,000. After opening the store, the company should have $18,416 ($68,416 - $50,000 = $18,416), so a store opening is possible.

P5. [LO 2] a. The World Restaurant Budgeted Income Statement For the First Quarter, 2018 Sales ($500,000 x 1.13) Less cost of sales ($345,000 x 1.13) Gross margin Less selling, general and administrative expenses ($12,000 increase) Income before taxes Less income taxes (40%) Net Income

$565,000 389,850 175,150 72,000 103,150 41,260 $61,890

b. The World Restaurant Cash Budget for the First Quarter, 2018 Cash Receipts Collections of sales: 20% of Quarter 4, 2017 sales $100,000 80% of Quarter 1, 2018 sales 452,000 Total cash receipts $552,000 Cash Disbursements Payment for inventory purchases 25% of Quarter 4, 2017 purchases 86,744 75% of Quarter 1, 2018 purchases* 378,757 Selling and adm. expenses (excludes $5,000 of depreciation) 67,000 Income taxes 41,260 Total disbursements (573,761) Net decrease in cash (21,761) Plus beginning cash balance 40,000 Ending Cash balance $ 18,239 *Beginning inventory in 2018 is $17,000. Cost of sales in the first quarter is $389,850. Ending inventory is $132,159 [30% of $440,531 (cost of goods sold in second quarter of 2018)]. Thus, purchases in the first quarter of 2018 are $505,009 (cost of goods sold plus ending inventory minus beginning inventory).

10-14 Jiambalvo Managerial Accounting

c. The World Restaurant Budgeted Balance Sheet End of First Quarter, 2018 Assets: Cash (from cash receipts and disbursements budget) Accounts receivable (20% of first quarter, 2018 sales) Inventory (30% of cost of sales in second quarter Of 2018—$440,531) Furniture and fixtures ($60,000 less $5,000 depreciation) Total assets

$ 18,239 113,000 132,159 55,000 $318,398

Liabilities: Accounts payable (25% of purchases in first quarter of 2018—$505,009)

$ 126,252

Stockholders’ equity: Common stock Retained earnings ($105,256 plus net income) Total stockholders’ equity Total liabilities and stockholders’ equity

25,000 167,146 192,146 $318,398

d. Since the ending cash balance for the first quarter is $18,239, a minimum desired cash balance of $15,000 will leave $3,239 for opening the new section. Adding a new section requires $50,000. Thus, a new section cannot be added without obtaining additional funds.

Chapter 10 Budgetary Planning and Control 10-15

P6. [LO 2] Modern Healthcare Budgeted Income for the Year 2018 Revenue (decrease of 2 percent) Less operating expenses: Salaries Physicians (no change) Physician assistant (new position) Nurses (no change) Nursing aid (no change) Receptionist (no change) Accounting services (no change) Training (increase of $15,000) Supplies (10 percent of revenue) Phone and fax (no change) Insurance (no change) Depreciation on office and equipment (increase of $20,000) Utilities (increase of 5 percent) Miscellaneous (increase of 5 percent) Total operating expenses Income before taxes Less taxes on income (35 percent) Net income P7. [LO 2] Pinnacle Engineering Budgeted Income Statement For Fiscal Year 2018 Revenue (increase 12%) Less operating expenses: Salaries expense (increase $36,000) Accounting services Training (increase 50,000) Supplies (8% of revenue) Phone and fax Insurance Depreciation (increase 9,000) Utilities (increase by 10%) Miscellaneous (increase by 10%) Income before taxes Less taxes on income Net income

$3,976,000 2,436,000 63,000 232,000 318,080 3,850 303,000 229,000 38,500 7,810

3,631,240 344,760 137,904 $ 206,856

$3,185,000

1,300,000 50,000 152,000 68,500 50,000 45,000 135,000 318,500 3,750 275,000 262,000 20,790 69,300 2,749,840 435,160 152,306 $ 282,854

10-16 Jiambalvo Managerial Accounting P8. [LO 2] a. Super Clean, Inc. Production Budget for 2018

Unit sales

Quarter 1

Quarter 2

Quarter 3

Quarter 4

57,000

65,000

105,000

42,000

Year 269,000

Plus: Desired ending inventory of finished units (12% of next quarter's sales)

7,800

12,600

5,040

10,000

64,800

77,600

110,040

52,000

279,000

finished units

7,000

7,800

12,600

5,040

7,000

Units to be produced

57,800

69,800

97,440

46,960

272,000

Total needed Less: beginning inventory of

b. Super Clean, Inc. Material Purchases Budget for 2018 Chemical A Quarter 1

Quarter 2

Quarter 3

Quarter 4

57,800

69,800

97,440

46,960

272,000

346,800

418,800

584,640

281,760

1,632,000

62,820

87,696

42,264

35,000

409,620

506,496

626,904

316,760

1,667,000

25,000

62,820

87,696

42,264

25,000

Ounces to be purchased

384,620

443,676

539,208

274,496

1,642,000

Cost per ounce

×$0.13

Cost of purchases of Chemical A

$50,001

$57,678

$70,097

$35,684

$213,460

Units to be produced Ounces of Chemical A per unit

Year

Ounces of Chemical A required for production Plus desired ending inventory of Chemical A (15% of next quarter's production needs) Total needed Less: beginning inventory of Chemical A

Chapter 10 Budgetary Planning and Control 10-17 Super Clean Inc. Material Purchases Budget for 2018 Chemical B

Units to be produced

Quarter 1

Quarter 2

Quarter 3

Quarter 4

57,800

69,800

97,440

46,960

272,000

× 11

635,800

767,800

1,071,840

516,560

2,992,000

115,170

160,776

77,484

85,000

750,970

928,576

1,149,324

601,560

3,077,000

60,000

115,170

160,776

77,484

60,000

690,970

813,406

988,548

524,076

3,017,000

Ounces of Chemical B per unit

Year

Ounces of Chemical B required for production Plus desired ending inventory of Chemical B (15% of next quarter's production needs) Total needed Less: beginning inventory of Chemical B Ounces to be purchased Cost per ounce

×$0.08

Cost of purchases of Chemical B

$55,278

$65,072

$79,084

$41,926

$241,360

c. Super Clean Inc. Budgeted Income Statement for the Year 2018 Quarter 1

Quarter 2

Quarter 3

Quarter 4

Year

$598,500

$682,500

$1,102,500

$441,000

$2,824,500

Variable cost of goods sold

208,620

237,900

384,300

153,720

984,540

Variable selling and adm.

29,925

34,125

55,125

22,050

141,225

359,955

410,475

663,075

265,230

1,698,735

Fixed production costs

65,000

260,000

Fixed selling and adm.

42,000

168,000

$252,955

$303,475

$556,075

$158,230

$127,035

Sales Less variable costs:

Contribution margin Less fixed costs

Net income

Variable cost of sales per bottle: Chemical A (6 x $0.13) Chemical B (11 x $0.08) Direct labor Variable overhead Total

$ 0.78 0.88 0.80 1.20 $3.66

10-18 Jiambalvo Managerial Accounting P9. [LO 2] a. Fenzel Slide Oil Production Budget for 2018 Quarter 1

Quarter 2

Quarter 3

Quarter 4

7,000

6,000

10,000

8,000

31,000

480

800

640

1,000

7,480

6,800

10,640

9,000

32,000

finished units

1,600

480

800

640

1,600

Units to be produced

5,880

6,320

9,840

8,360

30,400

Unit sales

Year

Plus: Desired ending inventory of finished units (8% of next quarter's sales) Total needed Less: beginning inventory of

b. Fenzel Slide Oil Material Purchases Budget 2018 Chemical A

Units to be produced Ounces of Chemical A per unit

Quarter 1

Quarter 2

Quarter 3

Quarter 4

Year

5,880

6,320

9,840

8,360

30,400

35,280

37,920

59,040

50,160

182,400

4,550

7,085

6,019

8,000

39,830

45,005

65,059

58,160

190,400

Ounces of Chemical A required for production Plus desired ending inventory of Chemical A (12% of next quarter's production needs) Total needed Less: beginning inventory of 4,800

4,550

7,085

6,019

4,800

Ounces to be purchased

Chemical A

35,030

40,455

57,974

52,141

185,600

Cost per ounce

×$1.05

Cost of purchases of Chemical A

$36,782

$42,477

$60,873

$54,748

$194,880

Chapter 10 Budgetary Planning and Control 10-19 Fenzel Slide Oil Material Purchases Budget 2018 Chemical B Quarter 1 5,880

Quarter 2 6,320

Quarter 3 9,840

Quarter 4 8,360

Year 30,400

3.5

20,580

22,120

34,440

29,260

106,400

(12% of next quarter’s production needs)

2,654

4,133

3,511

4,000

Total needed

23,234

26,253

37,951

33,260

110,400

Units to be produced Ounces of Chemical B per unit Ounces of Chemical B required for production Plus desired ending inventory of Chemical B

Less: beginning inventory of Chemical B

2,400

2,654

4,133

3,511

2,400

Ounces to be purchased

20,834

23,599

33,828

29,749

108,000

Cost per ounce

×$0.15

Cost of purchases of Chemical B

$_3,125

$_3,540

$_5,073

$_4,462

$_16,200

c. Fenzel Slide Oil Budgeted Income Statement for the Year 2018

Sales Less variable costs: Variable cost of goods sold Variable selling and adm. Contribution margin Less fixed costs: Fixed production costs Fixed selling and adm. Net income

Quarter 1

Quarter 2

Quarter 3

Quarter 4

Year

$84,000

$72,000

$120,000

$96,000

$372,000

56,910

48,780

81,300

65,040

252,030

3,360

2,880

4,800

3,840

14,880

23,730

20,340

33,900

27,120

105,090

3,000

12,000

3,000

12,000

$17,730

$14,340

$27,900

$21,120

$81,090

Variable cost of sales per bottle: Chemical A Chemical B Direct labor Variable overhead Total

$6.30 0.53 0.55 0.75 $8.13

10-20 Jiambalvo Managerial Accounting P10. [LO 2] Casey Wholesalers Cash Budget for the Year 2018 Quarter 1

Quarter 2

Quarter 3

Quarter 4

Year

Collection of previous quarter’s sales (40%)

$260,000

$290,000

$322,000

$350,000

$1,222,000

Collection of current quarter’s sales (60%)

435,000

483,000

525,000

580,800

$2,023,800

Total cash receipts

695,000

773,000

847,000

930,800

3,245,800

Payment of previous quarter’s purchases (20%)

75,000

82,000

90,000

105,000

352,000

Payment of current quarter’s purchases (80%)

328,000

360,000

420,000

480,000

1,588,000

240,000

960,000

75,000

Payment of taxes*

43,750

47,250

43,750

48,300

183,050

Total cash disbursements

686,750

729,250

793,750

948,300

3,158,050

Cash receipts Collection of credit sales:

Cash disbursements Payment for purchases:

Payment for selling and adm. expenses: (excludes depreciation of $10,000) Payment for capital expenditure

Excess of receipts over disbursements $__8,250 $_43,750 $_53,250 $_(17,500) $__87,750 * Taxes equal 35 percent of pretax income. For quarter 1, pretax income equals $125,000 [Sales ($725,000) minus cost of sales ($350,000), minus selling and administrative expense ($250,000)].

Chapter 10 Budgetary Planning and Control 10-21 P11. [LO 2] Eurofit Cycling Cash Budget for the Year 2018 Quarter 1

Quarter 2

Quarter 3

Quarter 4

Year

Collection of previous quarter’s sales (50%)

$275,000

$200,000

$237,500

$275,000

$ 987,500

Collection of current quarter’s sales (50%)

200,000

237,500

275,000

300,000

1,012,500

Total cash receipts

475,000

437,500

512,500

575,000

2,000,000

Payment of previous quarter’s purchases (30%)

58,500

48,000

60,000

67,500

234,000

Payment of current quarter’s purchases (70%)

112,000

140,000

157,500

186,900

596,400

Payment for selling and adm. expenses: (excludes depreciation of $7,000)

60,000

62,000

64,000

66,000

252,000

75,000

20,000

Payment of taxes*

57,050

77,350

90,650

103,950

329,000

Total cash disbursements

287,550

327,350

372,150

444,350

1,431,500

__187,450

_110,150

_140,350)

_130,650)

_568,600)

Cash receipts Collection of credit sales:

Cash disbursements Payment for purchases:

Payment for capital expenditure

Excess of receipts over disbursements

*35% x (sales – cost of sales – selling and administration)

10-22 Jiambalvo Managerial Accounting P12. [LO 2] Step 1 Expected sales in 2018 = (1.25 x sales of the same quarter previous year) Step 2 Cost of sales = (.75 x Expected Sales) Step 3 Ending inventory = (.35 x cost of sales next quarter) Step 4 Beginning inventory = Previous quarter's ending inventory Step 5 Purchases = Cost of sales + ending inventory - beginning inventory Q2, 2018 $300,000

Q3, 2018 $290,000

Q4, 2018 $368,000

Year $1,208,000

Q1, 2019

Sales in 2017

Q1, 2018 $250,000

Expected sales in 2018

320,000

375,000

362,500

460,000

$1,517,500

$300,000

Cost of goods sold

240,000

281,250

271,875

345,000

$1,138,125

180,000

Plus Ending inventory

98,438

95,156

120,750

78,750

Less Beginning inventory

_69,500

_98,438

_95,156

_120,750

_69,500

$268,938

$277,969

$297,469

$303,000

$1,147,375

Equals Purchases

P13. [LO 2] Results for basic assumption: Q1, 2017 Sales $254,000 Sales growth Desired ending inventory Cost of sales

Sales Cost of sales Plus desired ending inventory Less beginning inventory Purchases

Q2, 2017 $275,000

Q3, 2017 $320,000

Q4, 2017 $205,000

8% 15% of next quarter requirements 35% of sales

Q1, 2018

Q2, 2018

Q3, 2018

Q4, 2018

Q1, 2019

$274,320

$297,000

$345,600

$221,400

$296,666

96,012

103,950

120,960

77,490

103,693

15,593

18,144

11,624

15,554

27,800

15,593

18,144

11,624

_$83,805

$106,501

$114,440

_$81,420

Chapter 10 Budgetary Planning and Control 10-23 Results for combination 1: Q1, 2017 Sales $254,000 Sales growth Desired ending inventory % Cost of sales %

Q2, 2017 $275,000

Q3, 2017 $320,000

Q4, 2017 $205,000

10% 22% 33% Q1, 2018

Q2, 2018

Q3, 2018

Q4, 2018

Q1, 2019

$279,400

$302,500

$352,000

$225,500

$307,340

Cost of sales

92,202

99,825

116,160

74,415

101,422

Plus desired ending inventory

21,962

25,555

16,371

22,313

Less beginning inventory

27,800

21,962

25,555

16,371

Purchases

$86,364

$103,419

$106,976

$80,357

Sales

Results for combination 2: Q1, 2017 Q2, 2017 Q3, 2017 Q4, 2017 Sales $254,000 $275,000 $320,000 $205,000 Sales growth Desired ending inventory Cost of sales

15% 24% 28%

Q1, 2018

Q2, 2018

Q3, 2018

Q4, 2018

Q1, 2019

$292,100

$316,250

$368,000

$235,750

$335,915

Cost of sales

81,788

88,550

103,040

66,010

94,056

Plus desired ending inventory

21,252

24,730

15,842

22,573

Sales

Less beginning inventory

27,800

21,252

24,730

15,842

Purchases

$75,240

$92,028

$94,152

$72,741

10-24 Jiambalvo Managerial Accounting Results for combination 3: Q1, 2017 Q2, 2017 Q3, 2017 Q4, 2017 Sales $254,000 $275,000 $320,000 $205,000 Sales growth Desired ending inventory Cost of sales

9% 34% 40% Q1, 2018

Q2, 2018

Q3, 2018

Q4, 2018

Q1, 2019

Sales

$276,860

$299,750

$348,800

$223,450

$301,777

Cost of sales

110,744

119,900

139,520

89,380

120,711

Plus desired ending inventory

40,766

47,437

30,389

41,042

Less beginning inventory Purchases

27,800

40,766

47,437

30,389

$123,710

$126,571

$122,472

$100,033

P14. [LO 3] a. Both individuals are fighting for their self-interests, which are in conflict. Debra wants budgeted revenue low and budgeted expenses high so that she can easily achieve income goals that affect her bonus. Barney is interested in the accuracy of budget numbers (i.e., he is interested in developing a realistic plan) and making sure that Debra does not receive bonus compensation that is not justified (at least, in his opinion). b. One option for the President is to ask Debra and Barney to bring all relevant information to the table and make sure they understand each other’s position. He should also ask for information on the factors—controllable and uncontrollable—that contributed to the exceptional performance in 2017, and whether or not they are likely to continue in 2018. Then, the president may let Debra and Barney reach an agreement or set a budget according to his/her own best judgment. P15. [LO 1, 2, 3] a. Assumptions: Salaries of customer consultants are variable costs. Salaries of supervisors, office space expense, and depreciation are fixed costs.

Salaries of customer consultants Salaries of supervisors Office space charge Depreciation of equipment Total

14,000 calls Flex. Budget $200,000 30,000 5,000 7,000 $242,000

14,000 calls Actual $182,000 30,250 5,000 8,000 $225,250

Variance $18,000 (250) 0 (1,000) $16,750

Chapter 10 Budgetary Planning and Control 10-25 b. It appears that variances for salaries of customer consultants and depreciation of equipment are significant variances at about 9 percent and 14 percent of the flexible budget amounts. Some possible explanations: Call volume increased by 25 percent, this may have resulted in hiring part-time consultants. Or, possibly, additional consultants were hired at lower salaries. Possibly, additional consultants required additional telecom equipment. That might explain most of the increase in depreciation expense. c. Relevant non-financial measures might include: number of calls answered, average customer waiting time for a response, average duration of call, number of repeat calls for the same problem, level of customer satisfaction, and the number of customer complaints related to customer service. P16. [LO 3] The variances are “favorable” because the budget has not been adjusted for the actual number of units produced (which is less than planned). A flexible budget may indicate that actual costs are higher than expected (once the budget is adjusted for the actual level of production). The president is not likely to be impressed by favorable cost variances that are simply due to producing less than planned—especially if the lower output is due to quality problems in manufacturing! P17. [LO 3] a. Budget padding involves biasing estimates of sales downward and expenses upward so that actual profit is more likely to exceed budgeted profit. Franz has an incentive to pad his budget because exceeding the budget increases his budget-based bonus compensation. Budget padding may hurt company performance if the budget is less useful in terms of coordinating internal activities. This would be the case if the purchasing department bought too little material because they purchased a quantity consistent with budgeted sales (which are biased downward). b. The budget was set at $45,000,000 and budget compensation is capped when actual profit is more than 120% of budget or $54,000,000. Thus, there is no “need” to have profit higher than this amount. By delaying shipments for the last two weeks, Franz can shift the “excess” profit to the next quarter helping to ensure that he will maximize his bonus that quarter. This action could hurt shareholder value if customers become upset that they do not receive orders on time. P18. [LO 1] Listed below are four possible measures. There are other possibilities as well. 1. Customer satisfaction rating based on market survey data 2. Percent of orders delivered at customers’ requested delivery date 3. Production defect rate 4. Percent of sales related to new products (a product innovation measure)

10-26 Jiambalvo Managerial Accounting Case 10-1 [LO 3, Ethics]

COLUMBUS PARK – WASTE TREATMENT FACILITY Summary A manager of a water treatment facility is submitting a budget for an amount higher than the expected cost because she expects the budget to be cut by the city controller. •

Focuses on ethical considerations related to budgeting

Questions to ask students 1. What is the situation facing Ann Paxton at the Columbus Park Waste Treatment Facility? 2. Is it ethical to submit a padded budget because you expect it to be cut? Discussion Ann Paxton is the manager of the Columbus Park Waste Treatment Facility. She expects costs to be $4,200,000 but is going to submit a budget of $4,900,000 because she expects the city controller to cut her budget by 10 percent. Whether or not this is ethical is very difficult to determine. My own opinion is that Ann’s behavior is ethical. Suppose the new labor contract increases costs by $300,000 and waste is 500,000 gallons higher than expected—outcomes that could very well occur. In this case, costs will increase by $400,000 [$300,000 + (.20 x 500,000 gallons)] to $4,600,000. If the controller cuts the budget she submits by 10%, her department will only receive $4,410,000 ($4,900,000 x .90), which leaves little room for error. And note that most of the costs in Ann’s operation are fixed and may be sunk costs (e.g., depreciation of equipment). Thus, it will be very difficult to cut costs without a significant decrease in service. And decreases in service may be unacceptable when it comes to waste processing. One could also argue that “two wrongs do not make a right” and that Ann should sit down with the controller and try to develop a reasonable budget.

Chapter 10 Budgetary Planning and Control 10-27 Case 10-2 [LO 2]

ABRUZZI OLIVE OIL COMPANY Summary A small producer of olive oil is preparing budgets to consider the impact of various sales levels. • •

Relatively straightforward spreadsheet case. Refocuses student attention on the contribution margin.

Questions to ask students: 1. What is the situation facing Abruzzi Olive Oil Company? 2. Present the six monthly budget schedules Cheryl suggested (budgets with and without Consolidated business on top of increases of 5%, 10%, and 15%). 3. What is the impact on profit of obtaining the Consolidated business (assuming there is not a capacity constraint)? Discussion What is the decision facing Abruzzi Olive Oil Company? The owner, Cheryl Sounders, is preparing a budget spreadsheet when she gets the news that the company may have a large order from Consolidated Restaurants.

10-28 Jiambalvo Managerial Accounting a. Present the six monthly budget schedules Cheryl suggested (budgets with and without Consolidated business on top of increases of 5%, 10%, and 15%).

The first step is to build sales budgets with and without the Consolidated business.

January February March April May June July August September October November December

2017 9,200 9,000 9,400 8,600 8,000 8,500 8,200 7,500 8,900 9,300 9,200 9,600

2018 5% increase 9,660 9,450 9,870 9,030 8,400 8,925 8,610 7,875 9,345 9,765 9,660 10,080

2018 10% increase 10,120 9,900 10,340 9,460 8,800 9,350 9,020 8,250 9,790 10,230 10,120 10,560

2018 15% increase 10,580 10,350 10,810 9,890 9,200 9,775 9,430 8,625 10,235 10,695 10,580 11,040

Add 1,250 to each month for Consolidated business

January February March April May June July August September October November December

10,910 10,700 11,120 10,280 9,650 10,175 9,860 9,125 10,595 11,015 10,910 11,330

11,370 11,150 11,590 10,710 10,050 10,600 10,270 9,500 11,040 11,480 11,370 11,810

11,830 11,600 12,060 11,140 10,450 11,025 10,680 9,875 11,485 11,945 11,830 12,290

Chapter 10 Budgetary Planning and Control 10-29 The second step is to build production budgets based on the sales budgets. First, we do this without the extra sales to Consolidated. Note the calculation of ending inventory in December with 5% growth in sales is 12 % of December sales (.12 x 10,080 = 1,210). 5% January February March April May June July August September October November December

Sales 9,660 9,450 9,870 9,030 8,400 8,925 8,610 7,875 9,345 9,765 9,660 10,080

EI 1,134 1,184 1,084 1,008 1,071 1,033 945 1,121 1,172 1,159 1,210 1,210

BI Production 1,500 9,294 1,134 9,500 1,184 9,769 1,084 8,954 1,008 8,463 1,071 8,887 1,033 8,522 945 8,051 1,121 9,395 1,172 9,752 1,159 9,710 1,210 10,080

10% January February March April May June July August September October November December

Sales 10,120 9,900 10,340 9,460 8,800 9,350 9,020 8,250 9,790 10,230 10,120 10,560

EI 1,188 1,241 1,135 1,056 1,122 1,082 990 1,175 1,228 1,214 1,267 1,267

BI Production 1,500 9,808 1,188 9,953 1,241 10,234 1,135 9,381 1,056 8,866 1,122 9,310 1,082 8,928 990 8,435 1,175 9,843 1,228 10,217 1,214 10,173 1,267 10,560

10-30 Jiambalvo Managerial Accounting 15% January February March April May June July August September October November December

Sales 10,580 10,350 10,810 9,890 9,200 9,775 9,430 8,625 10,235 10,695 10,580 11,040

EI 1,242 1,297 1,187 1,104 1,173 1,132 1,035 1,228 1,283 1,270 1,325 1,325

BI Production 1,500 10,322 1,242 10,405 1,297 10,700 1,187 9,807 1,104 9,269 1,173 9,734 1,132 9,333 1,035 8,818 1,228 10,290 1,283 10,681 1,270 10,635 1,325 11,040

Chapter 10 Budgetary Planning and Control 10-31 Then, we redo the analysis, with the extra sales to Consolidated. 5% January February March April May June July August September October November December

Sales 10,910 10,700 11,120 10,280 9,650 10,175 9,860 9,125 10,595 11,015 10,910 11,330

EI 1,284 1,334 1,234 1,158 1,221 1,183 1,095 1,271 1,322 1,309 1,360 1,360

BI Production 1,500 10,694 1,284 10,750 1,334 11,019 1,234 10,204 1,158 9,713 1,221 10,137 1,183 9,772 1,095 9,301 1,271 10,645 1,322 11,002 1,309 10,960 1,360 11,330

10% January February March April May June July August September October November December

Sales 11,370 11,150 11,590 10,710 10,050 10,600 10,270 9,500 11,040 11,480 11,370 11,810

EI 1,338 1,391 1,285 1,206 1,272 1,232 1,140 1,325 1,378 1,364 1,417 1,417

BI Production 1,500 11,208 1,338 11,203 1,391 11,484 1,285 10,631 1,206 10,116 1,272 10,560 1,232 10,178 1,140 9,685 1,325 11,093 1,378 11,467 1,364 11,423 1,417 11,810

15% January February March April May June July August September October November December

Sales 11,830 11,600 12,060 11,140 10,450 11,025 10,680 9,875 11,485 11,945 11,830 12,290

EI 1,392 1,447 1,337 1,254 1,323 1,282 1,185 1,378 1,433 1,420 1,475 1,475

BI Production 1,500 11,722 1,392 11,655 1,447 11,950 1,337 11,057 1,254 10,519 1,323 10,984 1,282 10,583 1,185 10,068 1,378 11,540 1,433 11,931 1,420 11,885 1,475 12,290

10-32 Jiambalvo Managerial Accounting b. Note that the company will bump up against its 12,000 gallon capacity in December if it sells to consolidated and other sales increase by 15 percent (production would need to be 12,290). c. What is the impact on profit of obtaining the consolidated business (assuming there is not a capacity constraint)? Consolidated will purchase 15,000 gallons per year. Given a contribution margin of $15 (selling price of $25 - variable cost of $10), this will impact profit by $225,000. Note that under the three scenarios, Abruzzi will have enough capacity except in one month where it is short by only 290 gallons. All in all, it does look like it can take on the large order.

Chapter 11 Standard Costs and Variance Analysis QUESTIONS 1. Actual costs are compared with standard costs to evaluate performance. If an investigation of differences between actual and standard costs indicates that operations are inefficient, corrective action can be taken. 2. Standard costs can be developed as follows: Material price Material quantity Direct labor rates

Price lists provided by suppliers Specified in engineering plans or recipes Wage rates as specified in labor contracts and/or estimated by the management for different categories of workers Direct labor quantity Time and motion studies, and analysis of past data Overhead rate Estimated by dividing the amount of anticipated overhead by an estimate of the allocation base 3. Ideal standards are based on a “perfect” environment and do not include an allowance for equipment breakdown or material defects. Attainable cost standards are those that take into account a variety of circumstances (e.g., equipment breakdown) that will lead to costs greater than ideal. 4. Managers trying to achieve favorable material price variances may buy inferior material or in quantities that are too large (i.e., they overinvest in inventory) to get lower prices. 5. A favorable material price variance may occur if lower quality material is purchased. Similarly, a favorable labor rate variance may occur if workers having less than desirable level of skills are hired at lower wage rates. Both factors are likely to cause material spoilage and waste resulting in an unfavorable material quantity variance. 6. Management should investigate all significant variances because even a favorable variance may be indicative of poor management decisions (e.g., a favorable material price variance may be related to the purchase of inferior materials). 7. Yes—if total output is less than the output expected at the time the overhead rate was determined, less fixed overhead will be applied to production compared to the budget (i.e., there will be an unfavorable overhead volume variance). This does not indicate that overhead costs are in or out of control—it simply indicates that production is less than planned.

11-2 Jiambalvo Managerial Accounting 8. Only those variances that are deemed exceptional (material in amount) should be investigated. The cost and likely benefits of variance investigation should be considered in this decision. 9. Management by exception means that special attention is paid to those occurrences (such as variances) which are deemed exceptional (i.e., out of the ordinary.) 10. It implies that managers should be held accountable for only those variances that they can control.

EXERCISES E1. [LO 3] Unless the Cutting Department reduces production to 600 units per hour, excess work in process Inventory will build up in front of the Chemical Bath Department. An investment in the excess work in process does not create shareholder value. However, if the Cutting Department reduces production but does not reduce its work force (hoping that the bottleneck will be eliminated in the near future), it will have an unfavorable labor efficiency variance. The variance formula is (AH – SH) SR. Actual hours will not change but standard hours will be for 600 units, not 700. E2. [LO 3] If the production process is improved, the standard hours for the quantity produced may be decreased (it takes less time to produce an item). Now, unless the workforce is reduced or the work force has more items to work on, an unfavorable labor efficiency variance will result (actual labor hours will be greater than standard hours). E3. [LO 1] Material Price Variance = (AP - SP) AQP = ($59.33 - $57.00) 150 = $350 unfavorable Actual price = $8,900 ÷ 150 = $59.33 Material Quantity Variance = (AQU - SQ) SP = (104 - 125) $57 = $1,197 favorable Standard quantity = 50  2.5 = 125

Chapter 11 Standard Costs and Variance Analysis 11-3 E4. [LO 1] Labor Rate Variance = (AR - SR) AH = ($32.86 - $35.00) 2,100 = $4,494 favorable Actual wage rate = $69,000 ÷ 2,100 = $32.86 Labor Efficiency Variance = (AH - SH) SR = (2,100 -1,650) $35 = $15,750 unfavorable Standard hours = 75  22 = 1,650 E5. [LO 2, 3] Stanton Supply Company Actual Units Produced (56,000) Variable Overhead

Actual $468,500

Flex Budget* $448,000

Variance $20,500

Utilities

95,000

112,000

(17,000)

Maintenance

170,000

168,000

2,000

Total variable overhead

733,500

728,000

5,500

Supervisor salaries

127,000

126,000

1,000

Depreciation

145,000

150,000

(5,000)

Other fixed overhead

26,700

25,000

1,700

Total fixed overhead

298,700

301,000

(2,300)

Total Overhead costs

$1,032,200

$1,029,000

$3,200

Indirect material

Fixed Overhead

* Indirect Material = 56,000 x $8 = $448,000 Utilities = 56,000 x $2 = $112,000 Maintenance = 56,000 x $3 = $168,000

A manager should focus on the largest variances which are indirect materials and utilities.

11-4 Jiambalvo Managerial Accounting E6. [LO 1] Material Price Variance = (AP - SP) AQP = ($1,024 - $1,000) 770 = $18,480 unfavorable Actual quantity purchased = $788,480 ÷ $1,024 = 770 ounces Material Quantity Variance = (AQU - SQ) SP = (770 - 750) $1,000 = $20,000 unfavorable Standard quantity = 1,500 x .5 ounces = 750 ounces E7. [LO 1] Material Price Variance = (AP - SP) AQP = ($2,350 - $2,300) 250 = $12,500 unfavorable Actual price = $587,500 ÷ 250 = $2,350 per valve Material Quantity Variance = (AQU - SQ) SP = (248 - 240) $2,300 = $18,400 unfavorable Standard quantity = 60 x 4 valves = 240 valves E8. [LO 1] Labor Rate Variance = (AR - SR) AH = ($13.62 - $13.00) 8,200 = $5,084 unfavorable Actual wage rate = $111,700 ÷ 8,200 hours = $13.62 per hour Labor Efficiency Variance = (AH - SH) SR = (8,200 - 10,000) $13.00 = $23,400 favorable Standard hours = 25,000 x 0.40 hours per pair = 10,000 hours

Chapter 11 Standard Costs and Variance Analysis 11-5 E9.

[LO 1] Material Price Variance = (AP - SP) AQP = ($10.50 - $12.00) 4,000 = $6,000 favorable Actual price = $42,000 ÷ 4,000 yards = $10.50 per yard

Material Quantity Variance = (AQU - SQ) SP = (3,100 – 3,195) $12 = $1,140 favorable Standard quantity = 3,550 x 0.90 yards = 3,195 yards Labor Rate Variance = (AR - SR) AH = ($13.93 - $14.00) 4,450 = $312 favorable Actual wage rate = $62,000 ÷ 4,450 hours = $13.93 per hour Labor Efficiency Variance = (AH - SH) SR = (4,450 - 4,260) $14 = $2,660 unfavorable Standard hours = 3,550  1.2 hour per pair = 4,260 hours E10. [LO 2] Controllable Overhead Variance = Actual overhead - Flex budget level of overhead for actual production = $176,000 - [$90,000 + ($3.00  19,000)] = $176,000 - $147,000 = $29,000 unfavorable

11-6 Jiambalvo Managerial Accounting E11. [LO 1, 3] Labor Rate Variance = (AR - SR) AH = ($14.25 - $12.00) 11,700 = $26,325 unfavorable Labor Efficiency Variance = (AH - SH) SR = (11,700 - 10,350) $12.00 = $16,200 unfavorable Standard hours = 4,600  2.25 hours per unit = 10,350 hours Controllable Overhead Variance = Actual overhead – Flex. budget level of overhead for actual production = $50,000 - [$15,000 + ($9  4,600)] = $50,000 - $56,400 = $6,400 favorable Overhead Volume Variance = Flexible budget level of overhead for actual prod - Overhead applied to production = [$15,000 + ($9  4,600)] - ($11.50  4,600) = $3,500 unfavorable Standard overhead rate per unit = Est. overhead ÷ Estimated production = [$15,000 + ($9  6,000)] ÷ 6,000 = $11.50 per unit E12. [LO 1, 2, 3] Actual production cost equals standard cost plus the unfavorable variance ($5,200 x 800) + $351,900 = $4,511,900. Percent of Actual Variance

Amount

Production Cost

Material price variance

$8,900 unfavorable

0.20%

Material quantity variance

34,000 unfavorable

0.75%

Labor rate variance

(4,600) favorable

-0.10%

Labor efficiency variance

9,600 unfavorable

0.21%

Controllable overhead variance

4,000 unfavorable

0.09%

300,000 unfavorable

6.65%

Overhead volume variance

The overhead volume variance does not need to be investigated. There is an obvious explanation—the company produced only 800 units instead of the planned 960 units. The only other variance that exceeds 1/2 percent is the material quantity variance, which should be investigated.

Chapter 11 Standard Costs and Variance Analysis 11-7 E13.

[LO 1] Material Price Variance = (AP - SP) AQP = ($20 - $22) 57,000 = $114,000 favorable Actual price = $1,140,000 ÷ 57,000 linear feet = $20 per foot Material Quantity Variance = (AQU - SQ) SP = (55,000 - 54,000) $22 = $22,000 unfavorable Standard quantity = 2,000 x 27 feet = 54,000 feet Journal Entries Raw Material Inventory ($22 × 57,000) Material Price Variance Accounts Payable ($20 × 57,000)

1,254,000 114,000 1,140,000

(To record material purchases) Work in Process Inventory ($22 × 54,000) Material Quantity Variance Raw Material Inventory ($22 × 55,000)

1,188,000 22,000 1,210,000

(To record material used in production) E14.

[LO 1] Labor Rate Variance = (AR - SR) AH = ($12.25 - $13.00) 5,450 = $4,088 favorable Labor Efficiency Variance = (AH - SH) SR = (5,450 - 5,270) $13 = $2,340 unfavorable Journal Entry Work in Process Inventory ($13 × 5,270) Labor Efficiency Variance Labor Rate Variance Wages Payable ($12.25 × 5,450) (To record labor cost)

68,510 2,340 4,088 66,762

11-8 Jiambalvo Managerial Accounting E15. [LO 2] Manufacturing Overhead Various accounts (To record actual overhead incurred) Work in Process Inventory ($4.25 × 130,000) Manufacturing Overhead (To record overhead applied at $4.25 per unit)

575,000 575,000

552,500 552,500

The total overhead variance is the difference between overhead applied to production and actual overhead ($575,000 - $552,500 = $22,500). One third of the total variance relates to the volume variance and two-thirds relates to the controllable overhead variance. Overhead Volume Variance Controllable Overhead Variance Manufacturing Overhead

7,500 15,000 22,500

(To close manufacturing overhead and record overhead variances) E16. [LO 1, 2] Cost of Goods Sold Material Price Variance Labor Rate Variance Material Quantity Variance Labor Efficiency Variance Controllable Overhead Variance Overhead Volume Variance (To close variances to cost of goods sold)

11,120 3,600 1,650 3,900 5,650 2,550 4,270

Chapter 11 Standard Costs and Variance Analysis 11-9 E17. [LO 1, 2] Finished Goods Work in Process Inventory Cost of Goods Sold Total Apportionment of Variances Finished Goods Work in Process Inventory Cost of Goods Sold Total

$117,000 54,000 437,500 $608,500

19% 9% 72% 100%

$2,113 1,001 8,006 $11,120

19% 9% 72% 100%

Finished Goods Work in Process Cost of Goods Sold Material Price Variance Labor Rate Variance Material Quantity Variance Labor Efficiency Variance Controllable Overhead Variance Overhead Volume Variance

2,113 1,001 8,006 3,600 1,650 3,900 5,650 2,550 4,270

(To close variances to finished goods, work in process, and cost of goods sold)

11-10 Jiambalvo Managerial Accounting PROBLEMS P1. [LO 1, 3] a. Material Price Variance = (AP - SP) AQP = ($15.30 - $15.00) 19,000 = $5,700 unfavorable Actual price = $290,700 ÷ 19,000 pounds = $15.30 per pound Material Quantity Variance = (AQU - SQ) SP = (16,800 - 15,234) $15 = $23,490 unfavorable Standard quantity = 325,000  .75 ounce ÷ 16 ounces = 15,234 pounds b. The amount paid per pound was 2% higher than the standard price ($15.00 compared to $15.30). It may be that the standard price reflects an estimate of the annual average price and seasonal fluctuations are expected. Coffee used was approximately 10% more than standard. This should be investigated for possible causes (e.g., pilferage, waste, or use of more coffee per cup than the company’s recipe requires). P2. [LO 1] a. Material Price Variance = (AP - SP) AQP = ($2.10 - $2.75) 6,200 = $4,030 favorable Actual price = $13,000 ÷ 6,200 yards = $2.10 per yard Material Quantity Variance = (AQU - SQ) SP = (5,000 - 4,140) $2.75 = $2,365 unfavorable Standard quantity = 1,800 x 2.3 yards = 4,140 yards b. The material price variance is favorable. This could have been caused by negotiating a favorable price per yard. It could also have been achieved by purchasing substandard goods. The material quantity variance is unfavorable. This could have been caused by inefficient use of the materials, by pilferage, or other factors. However, given that the material price variance was favorable, this may indicate that substandard goods were purchased, resulting in more scrap than normal.

Chapter 11 Standard Costs and Variance Analysis 11-11 P3. [LO 1] a.

Standard labor hours required per dog Standard rate (labor rate per hour)

October November December 1 1 1 15 15 15

Actual cost of labor Actual labor hours worked Actual Rate = (Actual cost ÷ Actual hours)

$4,890 350

$6,500 355

$6,980 360

$13.97

$18.31

$19.39

Actual number of dogs groomed

300

310

330

Standard hours = (Actual # of dogs × standard hours required per dog)

300

310

330

Labor Rate Variance (AR - SR) AH

$360 F

$1,175 U

$1,580 U

Labor Efficiency Variance (AH - SH) SR

$750 U

$675 U

$450 U

b. The labor rate is increasing; employees may be getting raises (or more highly paid employees are being hired). The labor efficiency variance is decreasing; employees perhaps are gaining more experienced and, as a result, are becoming more efficient that they were earlier in the quarter. P4. [LO 1] a. Labor Rate Variance = (AR - SR) AH = ($49.41 - $42.00) 850 = $6,299 unfavorable Actual rate = $42,000 ÷ 850 hours = $49.41 per hour Labor Efficiency Variance = (AH - SH) SR = (850 – 1,125) $42 = $11,550 favorable Standard hours = 150 web sites × 7.5 hours per site = 1,125 hours b. Sales price Variable direct labor cost (7.5 hours x $42) Contribution margin per website

$ $

750 315 435

11-12 Jiambalvo Managerial Accounting c. Sales (150 Web site x $750) Variable direct labor cost (given) Actual contribution margin Actual contribution margin per Web site

$ 112,500 42,000 $ 70,500 $ 470

P5. [LO 1, 2] a. Standard Cost per unit: Material (1.20 gallon  $6) Labor (1.5 hours  $9) Variable overhead Fixed overhead ($55,000 ÷ 20,000) Total unit cost

$ 7.20 13.50 5.00 2.75 $28.45

b. Material Price Variance = (AP - SP) AQP = ($7.14 - $6.00) 35,000 = $39,900 unfavorable Actual price = $250,000 ÷ 35,000 gallons = $7.14 per gallon Material Quantity Variance = (AQU - SQ) SP = (30,000 - 27,600) $6 = $14,400 unfavorable Standard quantity = 23,000  1.2 gallons = 27,600 gallons Labor Rate Variance = (AR - SR) AH = ($8.25 - $9.00) 35,152 = $26,364 favorable Actual hours = $290,000 ÷ $8.25 per hour = 35,152 hours Labor Efficiency Variance = (AH - SH) SR = (35,152 – 34,500) $9 = $5,868 unfavorable Standard hours = 23,000 cans  1.5 hours per can = 34,500 hours Controllable Overhead Variance = Actual overhead - Flexible budget level of overhead for actual production = ($220,000 - $170,000) = $50,000 unfavorable Flexible budget = (($5 × 23,000) + $55,000) = $170,000

Chapter 11 Standard Costs and Variance Analysis 11-13 Overhead Volume Variance = Flexible budget level of overhead for actual production - Overhead applied to production = $170,000 - $178,250 = $8,250 favorable Overhead applied = $7.75 × 23,000 = $178,250 c. Possible Causes of Variances Unfavorable Material Price Variance: Market prices of materials were higher than expected. Or, possibly, the company increased the quality of materials and paid a higher price (but standards were not revised). Unfavorable Material Quantity Variance: More material was used because of unskilled labor, mishandling, accidents or processing defects. Favorable Rate Variance: Additional workers were hired at a lower rate than current workers. Or, possibly, a new labor contract was negotiated for a lower rate (concessions by the union) and standards were not revised. Unfavorable Labor Efficiency Variance: Labor workers for the company performed less efficiently. Unfavorable Controllable Overhead Variance: Less control over overhead expenses. Favorable Overhead Volume Variance: Production volume was greater than expected so more overhead was applied than budgeted. P6. [LO 1, 2] a. Standard Cost per unit: Material (0.75 liters  $2.50) Labor (4 hours  $13) Variable overhead Fixed overhead ($15.375 – $11.00) Total unit cost

$ 1.88 52.00 11.00 4.37 $69.25

b. Material Price Variance = (AP - SP) AQP = ($4.62 - $2.50) 13,000 = $27,560 unfavorable Actual price = $60,000 ÷ 13,000 liters = $4.62 per liter Material Quantity Variance = (AQU - SQ) SP = (10,100 – 5,850) $2.5 = $10,625 unfavorable Standard quantity = 7,800  0.75 liters = 5,850 liters

11-14 Jiambalvo Managerial Accounting Labor Rate Variance = (AR - SR) AH = ($11 - $13) 34,205 = $68,419 favorable Actual hours = $376,250 ÷ $11 per hour = 34,205 hours Labor Efficiency Variance = (AH - SH) SR = (34,205 - 31,200) $13 = $39,065 unfavorable Standard hours = 7,800 units  4 hours per unit = 31,200 hours Controllable Overhead Variance = Actual overhead - Flexible budget level of overhead for actual production = $125,000 - $120,800 = $4,200 unfavorable Flexible budget = ((7,800 × $11) + $35,000) = $120,800 Overhead Volume Variance = Flexible budget level of overhead for actual production - Overhead applied to production = $120,800 - $119,925 = $875 unfavorable Overhead applied = 7,800 × $15.375 = $119,925 c. Possible Causes of Variances Unfavorable Material Price Variance: Market prices of materials were higher than expected. Or, possibly, the company increased the quality of materials and paid a higher price (but standards were not revised). Unfavorable Material Quantity Variance: More material was used because of unskilled labor, mishandling, accidents or processing defects. Favorable Rate Variance: Additional workers were hired at a lower rate. Unfavorable Labor Efficiency Variance: The lower-wage employees were inefficient. Unfavorable Controllable Overhead Variance: Less control over overhead expenses. Unfavorable Overhead Volume Variance: Production volume was lower than expected so less overhead was applied than budgeted.

Chapter 11 Standard Costs and Variance Analysis 11-15 P7. [LO 1, 2] a. Standard overhead rate per unit = (Budgeted fixed overhead per unit + standard variable overhead per unit) = ($90,000 ÷ 25,000 units) + $8 = $11.60 b. Material Price Variance = (AP - SP) AQP = ($2.13 - $2.50) 40,000 = $14,800 favorable Actual price = $85,000 ÷ 40,000 pounds = $2.13 per pound Material Quantity Variance = (AQU - SQ) SP = (38,750 - 37,500) $2.50 = $3,125 unfavorable Standard quantity = 30,000  1.25 pounds = 37,500 pounds Labor Rate Variance = (AR - SR) AH = ($10.62 - $10) 35,300 = $21,886 unfavorable Actual wage rate = $375,000 ÷ 35,300 hours = $10.62 per hour Labor Efficiency Variance = (AH - SH) SR = (35,300 – 36,000) $10 = $7,000 favorable Standard hours = 30,000 units  1.2 hours per unit = 36,000 hours Controllable Overhead Variance = Actual overhead - Flexible budget level of overhead for actual production = $327,000 - [$90,000 + ($8  30,000)] = $327,000 - $330,000 = $3,000 favorable Overhead Volume Variance = Flexible budget level of overhead for actual production - Overhead applied to production = [$90,000 + ($8  30,000)] - ($11.60  30,000) = $330,000 - $348,000 = $18,000 favorable

11-16 Jiambalvo Managerial Accounting c. Variance Summary Material price variance Material quantity variance Labor rate variance Labor efficiency variance Controllable overhead variance Overhead volume variance Total

($14,800) favorable 3,125 unfavorable 21,886 unfavorable (7,000) favorable (3,000) favorable (18,000) favorable ($17,789) favorable

The favorable material price variance, the unfavorable labor rate variance and the favorable labor efficiency variance should be investigated because they are relatively large. Although the overhead volume variance is relatively large, its cause is obvious (more units were produced than planned). P8. [LO 1] a. Attorneys – Business Incorporations Labor rate variance = AH × (AR - SR) Labor rate variance = 92 × ( Labor rate variance = $1,380 U

$140

$125

)

40 × $125 × ( $1,000 F

2.50 92

= -

100 100

)

38 × ( $190 U

$180

$175

)

Labor efficiency variance = SR × (AH - SH) Standard hours = Labor efficiency variance = Labor efficiency variance =

30 × $175 × ( $1,225 F

1.50 38

= -

45 45

)

c. Paralegals -- Business Incorporations Labor rate variance = AH × (AR - SR) Labor rate variance = Labor rate variance =

135 × ( $270 U

$40

$38

)

Labor efficiency variance = SR × (AH - SH) Standard hours = Labor efficiency variance = Labor efficiency variance = b. Attorneys--Will Preparation Labor rate variance = AH × (AR - SR) Labor rate variance = Labor rate variance =

Chapter 11 Standard Costs and Variance Analysis 11-17 Labor efficiency variance = SR × (AH - SH) Standard hours = Labor efficiency variance = Labor efficiency variance =

40 × $38.00 × ( $950 F

4.00 135

= -

160 160

)

d. Paralegals -- Will Preparation Labor rate variance = AH × (AR - SR) Labor rate variance = Labor rate variance =

95 × ( $475 U

$30

$25

)

Labor efficiency variance = SR × (AH - SH) Standard hours = Labor efficiency variance = Labor efficiency variance =

30 × $25 × ( $125 U

3.00 95

= -

90 90

)

P9. [ LO 1, 2] a. Material Price Variance (Material A) = (AP - SP) AQP = ($0.23 - $0.35) 37,500 = $4,500 favorable Actual price = $8,500 ÷ 37,500 pounds = $0.23 per pound Material Price Variance (Material B) = (AP - SP) AQP = ($0.47 - $0.55) 12,000 = $960 favorable Actual price = $5,600 ÷ 12,000 pounds = $0.47 per pound Material Quantity Variance (Material A) = (AQU - SQ) SP = (37,500 - 33,600) $0.35 = $1,365 unfavorable Standard quantity = 42 batches  800 pounds per batch = 33,600 pounds Material Quantity Variance (Material B) = (AQU - SQ) SP = (12,000 - 10,500) $0.55 = $825 unfavorable Standard quantity = 42 batches  250 pounds = 10,500 pounds

11-18 Jiambalvo Managerial Accounting Labor Rate Variance = (AR - SR) AH = ($16.96 - $15.00) 460 = $902 unfavorable Actual wage rate = $7,800 ÷ 460 hours = $16.96 per hour Labor Efficiency Variance = (AH - SH) SR = (460 - 420) $15 = $600 unfavorable Standard hours = 42 batches  10 hours per batch = 420 hours Controllable Overhead Variance = Actual overhead - Flex budget level of overhead for actual production = $23,000 - $25,000 = $2,000 favorable Overhead Volume Variance = Flex budget level of overhead for actual prod - Overhead applied to production = $25,000 - ($500 x 42 batches) = $25,000 - $21,000 = $4,000 unfavorable b. Variance Summary Material price variance (A)

$(4,500) favorable

Material price variance (B)

(960) favorable

Material quantity variance (A)

1,365

unfavorable

Material quantity variance (B)

825

unfavorable

Labor rate variance

902

unfavorable

Labor efficiency variance

600

unfavorable

Controllable overhead variance

(2,000) favorable

Overhead volume variance

4,000 unfavorable $ 232 unfavorable

Total

The overhead volume variance does not suggest that overhead costs are out of control. It simply indicates that production was less than the level used in setting the overhead rate.

Chapter 11 Standard Costs and Variance Analysis 11-19 P10.

[LO 1, 2, 3] a. Standard cost per unit Material (3 pounds  $2.50 per pound) Labor (1.5 hours  $15 per hour) Variable overhead Fixed overhead Total

$7.50 22.50 9.00 1.00 $40.00

Material Price Variance = (AP - SP) AQP = ($2.53 - $2.50) 455,000 = $13,650 unfavorable Actual price = $1,150,000 ÷ 455,000 pounds = $2.53 per pound Material Quantity Variance = (AQU - SQ) SP = (425,000 - 375,000) $2.50 = $125,000 unfavorable Standard quantity = 125,000 seals  3 pounds per seal = 375,000 pounds Labor Rate Variance = (AR - SR) AH = ($15.25 - $15.00) 190,164 = $47,541 unfavorable Actual hours = $2,900,000 ÷ $15.25 per hour = 190,164 hours Labor Efficiency Variance = (AH - SH) SR = (190,164 – 187,500) $15 = $39,960 unfavorable Standard hours = 125,000 seals  1.5 hours per seal = 187,500 hours Controllable Overhead Variance = Actual overhead - Flexible budget level of overhead for actual production = $900,000 - [$130,000 + ($9  125,000)] = $900,000 - $1,255,000 = $355,000 favorable

11-20 Jiambalvo Managerial Accounting Overhead Volume Variance = Flex budget level of overhead for actual prod - Overhead applied to production = [$130,000 + ($9  125,000)] - ($10  125,000) = $1,255,000 - $1,250,000 = $5,000 unfavorable b. Variance Summary Material price variance

$13,650

Material quantity variance

125,000 unfavorable

Labor rate variance

47,541

unfavorable

39,960

unfavorable

Labor efficiency variance Controllable overhead variance Overhead volume variance Total

unfavorable

(355,000) favorable 5,000

unfavorable

$(123,849) favorable

The overhead volume variance (which occurred because actual production was less than planned) does not need to be investigated. The remaining variances appear to warrant investigation. P11. [LO 1] Labor Rate Variance = (AR - SR) AH = ($52 - $40) 425 = $5,100 unfavorable Actual rate = $22,100 ÷ 425 hours = $52 per hour Labor Efficiency Variance = (AH - SH) SR = (425 - 417) $40 = $320 unfavorable Standard hours = (1,250 samples  (20 minutes per sample ÷ 60 minutes)) = 417 hours Although the labor rate variance is relatively large, its cause is fairly obvious. It is not surprising that the company would need to pay a relatively high wage rate to a temporary worker with the skills to draw and prepare blood samples. As only 425 hours of work were performed in the month, it appears that the lab had only two full-time employees. Based on $60 per hour for one of them and $40 per hour for the other, and assuming that each worked an equal number of hours, the expected total cost at an average rate of $50 [($60 + 40) ÷2] is $21,250. With this in mind, the actual cost of $22,100 does not seem to be out of line.

Chapter 11 Standard Costs and Variance Analysis 11-21 P12. [LO 1] 1. Students may have various answers. Some possible answers are: Department Grinding Department Extrusion Department

Fabrication Department

Sales Department Accounting Department Administration Department Purchasing Department

Possible Standards Pounds processed per hour; Rate standards for employees Pounds extruded per hour; Rate standards for employees; Raw material required per pound of extruded plastic Hours required per table built; Hours required per park bench built; Rate standards for employees; Standard linear of lumber per product Number of sales calls per sales person; Amount of sales per person Standard time required for processing transactions Standard time required per order; Standard hourly rate for employees Standard time required per purchase order; Standard price per pound of raw materials purchased

Standards may be set by examining past history and by consulting employees currently working on the job. Time and motion studies may be undertaken. Engineers may be consulted about the standard quantity of materials and the standard processing cost. At least one representative from each department should participate in setting the standards. 2. Standard costing systems offer many potential benefits. Tighter control can be exercised over operations. By giving employees a clearly defined goal, they may strive harder to achieve it than when they are just “doing their best.” Also, standard costing facilitates “management by exception.” It is a system for drawing managers’ attention to processes that are deviating from standard. Standard costing systems can also be problematic. They require resources (monetary and time) to maintain. Employees may be suspicious of employers when a system is implemented and may strongly resist. Standard costing also places an emphasis on cost and quantity; intrinsic characteristics of the work environment such as quality, morale, and teamwork are not encouraged under a standard costing system. P13. [LO 3] a. Will should not act according to his initial instinct—the causes of the variances should be determined before managers are rewarded/reprimanded. b. The favorable material price variance could be due to purchasing inferior materials at a price less than standard. This could lead to material waste,

11-22 Jiambalvo Managerial Accounting which would show up in an unfavorable material quantity variance. It could also lead to an unfavorable labor efficiency variance if workers need to spend more time (than standard) to produce defect free units. c. Will should investigate the causes for variances before determining rewards or punishments. P14. [LO 1, 2] a. Labor rate variance = (AR − SR) AH = ($29.22 − $30.00) 10,200 = $7,956 favorable Actual rate = $298,000 ÷ 10,200 = $29.22 Labor efficiency variance = (AH − SH) SR = (10,200− 10,000) $30 = $6,000 unfavorable Standard hours = 2 × 5,000 = 10,000 b. Controllable overhead variance = Actual overhead − Flexible budget level of overhead for actual production = $314,600 − $295,000 = $19,600 unfavorable Actual overhead = ($23 × 10,200) + $80,000 = $314,600 Flexible budget overhead = (2 hours × 5,000 clients × $22) + $75,000 = $295,000 Overhead volume variance = Flexible budget level of overhead for actual production − Overhead applied to production = $295,000 − $292,115 = $2,885 unfavorable Applied overhead = [(($75,000 ÷ 10,400) + $22) × 10,000] = $292,115 Flexible budget overhead = (2 hours × 5,000 clients × $22) + $75,000 = $295,000

Chapter 11 Standard Costs and Variance Analysis 11-23 c. Possible Causes of Variances Favorable Rate Variance: Additional workers were hired at a lower rate than current workers. Unfavorable Labor Efficiency Variance: Perhaps the new workers were not as efficient as the older workers and used more time to process clients. Unfavorable Controllable Overhead Variance: Less control over overhead expenses. Unfavorable Overhead Volume Variance: Production volume was less than expected so less overhead was applied than budgeted. P15. [LO 3] a. No. Fewer customer calls and less time per call could result from bad as well as good performance. b. Favorable variance could occur because of good performance if: (1) Software quality improved so that customers did not need to call customer support as often, and if they did call, problems were simpler and could be solved in less time. (2) Customer support quality improved so that customers did not need to call repeatedly for the same problem. And, when customers called, questions were answered correctly and quickly. Favorable variance could occur because of bad performance if: (1) Software quality deteriorated resulting in much lower sales and, consequently, fewer customers called (although the remaining customers made frequent calls). (2) Customer support quality deteriorated as employees tried to cut-off customer calls in order to reduce the “time per call” measure, and the customers were so dissatisfied that they were discouraged from calling. The scenario is more likely if the software magazine review is reliable. P16. [LO 3] a. The favorable material price variance is due to the purchase of inferior materials at a bargain price. This could lead to an unfavorable material quantity variance if extra material needed to be used because of material defects and the need to rework defective products. The favorable labor rate variance is due to use of temporary replacement workers who are paid lower wage rates. But the use of replacement workers

11-24 Jiambalvo Managerial Accounting will lead to an unfavorable labor efficiency variance if the replacement workers are not able to produce items as efficiently as permanent workers. b. I would not characterize the decision to purchase materials at a bargain price as a good decision. The materials are inferior and may compromise product quality, the reputation of the company, and shareholder value. P17.

[LO 2] Due to the strike, 700,000 Road Guardian batteries were not produced and sold. How did this affect profit? The batteries sell for $44 per unit and the variable cost (assuming that overhead is essentially fixed due to the high level of investment in automation) is $9 ($5 of material and $4 of labor). Thus the contribution margin is $35. The effect of not producing and selling 700,000 Road Guardians is $24,500,000 ($35 x 700,000). The controller recognizes that the strike reduced productive capacity. However, he measures the cost of reduced capacity in terms of the difference between the amount of overhead in the flexible budget (which equals the amount in a static budget because all overhead is fixed) and the amount applied to inventory (a difference of $6,400,000). This difference is the overhead volume variance. It indicates that $6,400,000 of overhead was not applied to production, but that is not a reasonable measure of the effect of the strike. Overhead is essentially fixed and overhead was actually less than budgeted (by a relatively small amount). The effect of reduced capacity on profit needs to be assessed in terms of the lost contribution margin related to reduced capacity. As we saw above, the effect of the strike was reduced production of the Road Guardian by 700,000 units. Since the Road Guardian has a contribution margin of $35, the impact of the strike was $24,500,000.

P18. [LO 1, 2] a. Material Price Variance = (AP - SP) AQP = ($57.29 - $55) 24,000 = $54,960 unfavorable Actual price = $1,375,000 ÷ 24,000 yards = $57.29 per yard Raw Material Inventory Material Price Variance Accounts Payable

1,320,000 54,960

(To record the purchase of raw material inventory)

1,375,000

Chapter 11 Standard Costs and Variance Analysis 11-25 b. Material Quantity Variance = (AQU - SQ) SP = (22,300 - 21,250) $55 = $57,750 unfavorable Standard quantity = 8,500 parkas × 2.5 yards per parka = 21,250 yards Work in Process Inventory Material Quantity Variance Raw Material Inventory (To record the use of raw material)

1,168,750 57,750 1,226,500

c. Labor Rate Variance = (AR - SR) AH = ($36.36 - $35.00) 27,500 = $37,400 unfavorable Actual rate = $1,000,000 ÷ 27,500 hours = $36.36/hour Labor Efficiency Variance = (AH - SH) SR = (27,500 – 29,750) $35 = $78,750 favorable Standard hours = 8,500 parkas × 3.5 hours per parka = $29,750 Work in Process Inventory Labor Rate Variance Labor Efficiency Variance Wages Payable (To record direct labor)

1,041,350 37,400 78,750 1,000,000

d. Controllable Overhead Variance = Actual overhead - Flexible budget level of overhead for actual production = $90,000 - [$60,000 + ($6.50  8,500)] = $90,000 - $115,250 = $25,250 favorable Overhead Volume Variance = Flexible budget level of overhead for actual production - Overhead applied to production = [$60,000 + ($6.50  8,500)] - ($14.00  8,500) = $115,250 - $119,000 = $3,750 favorable

11-26 Jiambalvo Managerial Accounting Work in Process Inventory

119,000

Manufacturing Overhead

119,000

(To record overhead applied to production) Manufacturing Overhead

90,000

Various Accounts

90,000

(To record actual overhead) Manufacturing Overhead

29,000

Controllable Overhead Variance

25,250

Overhead Volume Variance

3,750

(To close Manufacturing Overhead and record overhead variances)

e. Cost of Goods Sold

42,360

Labor Efficiency Variance

78,750

Controllable Overhead Variance

25,250

Overhead Volume Variance

3,750

Material Price Variance

54,960

Material Quantity Variance

57,750

Labor Rate Variance

37,400

(To close variance accounts to Cost of Goods Sold)

Chapter 11 Standard Costs and Variance Analysis 11-27

Case 11-1. [LO 3]

JACKSON SOUND Summary Work in process inventory is building up at Jackson Sound even though the company has a JIT system. The culprit is the standard cost system which is encouraging overproduction. •

Notes linkages among process improvement, JIT, and a standard costing system.

•

Shows how a standard costing system can encourage overproduction.

Questions to ask students 1. What is the situation facing Jackson Sound? 2. Why does the circuit department have an incentive to overproduce? Discussion What is the situation facing Jackson Sound? The chief financial officer has noted a large amount of in-process inventory even though the company is supposed to be using a JIT approach. His assistant believes the problem is related to process improvements in the circuit department and the fact that bonuses are tied to standard cost performance. Why does the circuit department have an incentive to overproduce? Perhaps the best way to explain this is to focus on the labor efficiency variance [(actual hours - standard hours)  standard wage rate]. At Jackson Sound, actual hours in the circuit department are a constant since labor is essentially fixed. Note that the standard amount of labor hours per unit has declined from 12.5 to 10.4. Thus, unless production increases, standard hours in the variance formula will be less than actual hours and the circuit department will have an unfavorable variance. To avoid this, the circuit department is producing more units than the case department can handle and in-process inventory is building up in front of the case department. A point I try to stress to students is that process improvements are not likely to result in cost savings (and in this case costs have actually increased due to a greater investment in in-process inventory!) unless companies reduce head-count or find a productive use of the capacity that is being generated by the process improvements.

11-28 Jiambalvo Managerial Accounting Case 11-2. [LO 1, 2, 3]

CHAMPION INDUSTRIES Summary A purchasing manager is considering a material that costs more, but has a number of desirable properties. Since standards are not adjusted on a timely basis, purchase of the material will generate an unfavorable material price variance. •

Notes possible linkages among the material price variance, the material quantity variance, and the labor efficiency variance.

•

Emphasizes, “You get what you measure!”

Questions to ask students 1. What is the situation facing Champion Industries? 2. What is the cost savings associated with the new material? 3. What are the expected material and labor variances if standards are not updated on a timely basis? 4. If the purchasing manager is evaluated in terms of price variances, will he be motivated to suggest use of the new material? Discussion What is the situation facing Champion Industries? Stan Holbert, the purchasing manager is considering a material that costs more per pound. However, it will result in reduced waste and result in labor efficiencies.

Chapter 11 Standard Costs and Variance Analysis 11-29

a. What is the cost savings associated with the new material? Material cost, old material (150,000 units  10 pounds  $23)

$34,500,000

Labor cost, old material (150,000 units  2.5 hours  $30)

11,250,000

Total Less: Material cost, new material (150,000 units  8 pounds  $25)

45,750,000

30,000,000

Labor cost, old material (150,000 units  0.75 hours  $30)

3,375,000

Total

33,375,000

Cost savings

$ 12,375,000

b. What are the expected material and labor variances if standards are not updated on a timely basis? Material Price Variance (assuming 1,200,000 pounds purchased) = (AP - SP) AQP = ($25 - $23) 1,200,000 = $2,400,000 unfavorable Material Quantity Variance (assuming 1,200,000 pounds used) = (AQU - SQ) SP = (1,200,000 – 1,500,000) $23 = $6,900,000 favorable Standard quantity = 10 × 150,000 = 1,500,000 Labor Rate Variance (assuming no difference between actual and standard rates) = 0 Labor Efficiency Variance = (AH - SH) SR = (112,500 - 375,000) $30 = $7,875,000 favorable Standard hours = 150,000 × 2.5 = 375,000

11-30 Jiambalvo Managerial Accounting

c. If the purchasing manager is evaluated in terms of price variances, will he be motivated to suggest use of the new material? As indicated above, there will be an unfavorable price variance (until standards are updated), so he is not likely to suggest use of the material. This holds even though there is a large overall cost savings associated with the new material.

Chapter 12 Decentralization and Performance Evaluation QUESTIONS 1. Four advantages are: (a) Subunit managers have better information than top management, (b) Subunit managers can respond to changing conditions faster than top management can, (c) Managers who are given significant decision making authority tend to work harder than others, and (d) Decentralization provides managers training for higher management positions. 2. Two disadvantages are: (a) Decentralization my result in costly duplication of activities and (b) Managers may take actions to achieve their own goals at the cost of the goals of the company as a whole. 3. Some managers prefer exercising control over a greater number of employees and larger facilities. They tend to maximize their subunit size even though it may not be in the company’s best interest. This phenomenon is referred to as “empire building.” 4. Because subunits operate as relatively independent entities, they often perform basic activities, such as purchasing, accounting, and data processing, separately from other subunits, resulting in costly duplication of these activities. 5. As subunit managers are given authority to make decisions, they tend to work toward achieving their own goals, which are sometimes incompatible with company goals. This problem is referred to as “lack of goal congruence.” 6. Cost centers, profit centers, and investment centers are responsibility centers. They are distinguished by whether their managers are given authority (and consequently are held accountable for), over costs (cost centers), costs and revenues (profit centers), or profit and investments (investment centers). 7. EVA (economic value added) is essentially residual income with some adjustments to correct “accounting distortions.” For example, research and development is reported as an expense according to GAAP, but capitalized as an intangible asset and subsequently amortized in calculating EVA.

12-2

Jiambalvo Managerial Accounting

8. Financial measures of performance are “backward looking” in the sense that they report the financial effect of past actions. They do not reveal management’s current performance which affects future profits. 9. Note that other measures may be appropriate. Financial—ROI, growth in sales Customer—Customer satisfaction, market share Internal Process—Defect rate, lead time Innovation—Number of patents, employee satisfaction 10. Using market price as a transfer price allows both buying and selling divisions to be treated as independent companies and is likely to be considered fair and reasonable by both divisions.

Chapter 12 Decentralization and Performance Evaluation

12-3

EXERCISES E1. [LO 2] Interest expense is a charge for capital (specifically, capital provided by debt holders). In calculating EVA, we multiply the investment by the weighted average cost of capital to calculate the cost of using capital provided by debt holders and stockholders, and this amount is subtracted from NOPAT. We add back interest (and the related tax effect) to net income to remove it from the calculation of NOPAT. If we deducted interest expense in calculating NOPAT, we would be double counting the cost of capital provided by debt holders. E2. [LO 2] Noninterest-bearing current liabilities are subtracted because they are a free source of capital. Suppose you purchased $1,000,000 of inventory but suppliers did not require payment until you sold the inventory and collected cash. In this case, you would have a $1,000,000 investment in inventory but $1,000,000 of free capital (noninterest-bearing accounts payable). Your investment would be zero. E3. [LO 1] Decentralizing Lyndstrom Glass Company into two divisions may provide the following advantages: (a) better decisions, (b) quicker response, (c) higher motivation of managers, and (d) training for higher management positions. E4. [LO 1] Two financial performance measures would be (a) growth in sales compared to the prior period and (b) department profit compared to budgeted profit. Other measures are possible. E5. [LO 1] Because the customer service centers are not charged with responsibility for revenue, they should be organized as cost centers. As cost centers, they should be evaluated by comparing actual costs to budgeted costs. Also, they should be evaluated using a number of nonfinancial measures such as customer satisfaction. E6. [LO 1] Because the director has the decision-making authority for operating the facility and marketing classes, it makes sense to treat the training facility as a profit center. However, it may be better to view the training center’s mission as a part of the company’s overall marketing strategy (i.e., training leads to brand loyalty and future purchases of the company’s software products). In this case, focusing on profit performance could be detrimental to overall company success.

12-4

Jiambalvo Managerial Accounting

E7. [LO 2] NOPAT

= Net income + Interest expense - Tax savings related to the interest expense = Net income + interest expense (1 - tax rate) = $20,000,000 + $1,400,000 (1 - .4) = $20,840,000

Invested capital = Total assets - noninterest-bearing current liabilities = $235,000,000 - $36,000,000 = $199,000,000 ROI

= NOPAT ÷ Invested capital = $20,840,000 ÷ $199,000,000 = 10.47%

E8.

[LO 2]

NOPAT

= Net income + Interest expense - Tax savings related to the interest expense = Net income + interest expense (1 - tax rate) = $6,435,000 + $1,000,000 (1 - .35)* = $7,085,000

*tax rate is $3,465,000/$9,900,000 Invested capital = Total assets - non interest-bearing current liabilities = $97,000,000 - $3,200,000 = $93,800,000 ROI

= NOPAT ÷ Invested capital = $7,085,000 ÷ $93,800,000 = 7.55%

The company is not performing well given that the required rate of return on invested capital is 10 percent.

Chapter 12 Decentralization and Performance Evaluation

E9. [LO 2] NOPAT

= Net income + Interest expense - Tax savings related to the interest expense = Net income + interest expense (1 - tax rate) = $6,000,000 + $2,250,000 (1 - .4) = $7,350,000

Invested capital = Total assets - non interest-bearing current liabilities = $80,000,000 - $6,700,000 = $73,300,000 Residual Income = NOPAT - (Cost of capital × Invested capital) = $7,350,000 - (.10 × $73,300,000) = $20,000

The company appears profitable as indicated by the positive level of residual income. E10. [LO 2] NOPAT

= Net income + Interest expense - Tax savings related to the

interest expense = Net income + interest expense (1 - tax rate) = $3,500,000 + $1,650,000 (1 - .35) = $4,572,500 Invested capital = Total assets - non interest-bearing current liabilities = $35,000,000 - $11,400,000 = $23,600,000 Residual Income = NOPAT - (Cost of capital x Invested capital) = $4,572,500 - (.18 × $23,600,000)

= $324,500

12-5

12-6

Jiambalvo Managerial Accounting

E11. [LO 2] Division 1 ROI

= NOPAT ÷ Invested capital = $12,000,000 ÷ ($69,000,000-$4,500,000) = 18.6%

Residual Income/EVA

= NOPAT - (Cost of capital x Invested capital) = $12,000,000 - (.11 × $64,500,000) = $4,905,000

Division 2 ROI

= $5,900,000 ÷ ($23,000,000 - $2,300,000) = 28.5%

Residual Income/EVA

= $5,900,000 – (.10 × $20,700,000) = $3,830,000

While Division 2 had the highest ROI, Division 1 created more wealth (measured in terms of residual income or EVA); $4,905,000 as compared to $3,830,000 for Division 2. E12. [LO 2] a. Senior managers at Quantum increased profit while ROI slipped from 17.7% to 12.6%. They increased profit by taking on investments that earned a low return. But since the returns were positive, income increased. Since they are evaluated in terms of profit increases, they have an incentive to overinvest (take on projects with a rate of return less than the required rate). b. Managers at Aquafin are evaluated in terms of ROI. Since their current ROI is high (15%), they are not interested in investing in projects with a rate of return less than 15% (since such projects will lower their current ROI) even if the return is greater than the cost of capital which is only 10%. In other words, the managers at Aquafin have an incentive to underinvest.

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E13. [LO 2] Income from operations Add current period R&D Less amortization of capitalized R&D (1/3 x $9,450,000 + 1/3 x $12,400,000 = 1/3 x $15,600,000) Less taxes at 30 percent Adjusted NOPAT Total assets Add capitalized R&D (1/3 x $12,400,000 + 2/3 x $15,600,000) Less NIBCL Adjusted investment Cost of capital Required NOPAT EVA

$ 126,900,000 15,600,000

(12,483,333) 130,016,667 39,005,000 $ 91,011,667 $715,000,000 14,533,333 (14,000,000) 715,533,333 .12 85,864,000 $ 5,147,667

E14. [LO 3] Financial measures report the effect of past management decisions, just as a rear view mirror reflects what a car has left behind. A car driver has to look ahead for changing road conditions and also at the car’s dashboard for the car’s current operating measures (speed, RPM, gas level, engine temperature, etc.). Similarly, a manager needs to look at changing customer and market conditions as well as internal processes and innovation factors to make sure that he or she is “driving” the company toward long-term value creation. We also need to learn from the past. “If we ignore history we are doomed to repeat it.” E15. [LO 3] Customer-focused measures (among other possibilities): Customer retention (i.e., percent of customers who renew memberships) Customer satisfaction rating Number of new customers Key success items using customer satisfaction as an example among other possibilities: Targets – create a target for customer satisfaction rating Initiatives – identify actions improve customer satisfaction Responsibility – identify the specific employee(s) responsible for the target Funding – fund the initiative to improve customer satisfaction

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Jiambalvo Managerial Accounting

E16. [LO A1] The lab is organized as a profit center. Therefore, it should be allowed to charge competitive market prices for tests. Charging cost-based prices may lead to inefficient use of lab tests by the outpatient clinics (since they can use the lab at a charge less than the opportunity cost associated with use) and lab managers may lose their incentive to perform effectively. E17. [LO A1] Under the proposed transfer pricing policy, the container plant will generate a guaranteed profit of ten percent over full cost and have no incentive to reduce costs or to improve capacity utilization. Therefore, the policy may not be optimal for the company as a whole.

Chapter 12 Decentralization and Performance Evaluation

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PROBLEMS P1. [LO 1, 3] a. Budgets provide benchmarks for evaluating different plant operations, and variances draw attention to areas where costs may be out of control. If operations are out of control, process improvements can be initiated. b. Rate of defects, on-time delivery, machine down time, and employee turnover are four possibilities. There are others. P2. [LO 1, 2] ROI, Residual Income, and EVA would be reasonable measures because they all take into account the level of investment—and the divisional managers have authority to make investment decisions. P3. [LO 2] a. Net income Plus interest Less taxes related to interest NOPAT

2017 $3,300,000 726,000 (254,100) $3,771,900

2018 $3,426,000 770,000 (269,500) $3,927,000

Total assets Less NIBCL Investment

$55,000,000 (1,100,000) $53,900,000

$62,000,000 (1,320,000 $60,680,000

ROI (NOPAT ÷ Investment)

7.00 percent

6.47 percent

b. While income has increased, ROI has decreased. Thus, it is far from clear that company performance has improved.

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P4. [LO 2] a. 2017 $ 770,000 2,310,000 (924,000) $2,156,000

2018 $ 880,000 330,000 (132,000) $1,078,000

Total assets Less noninterest-bearing current liabilities Investment

$12,650,000

$12,100,000

550,000 $12,100,000

572,000 $11,528,000

NOPAT

$2,156,000

$1,078,000

Less required return x Investment

(1,210,000)

(1,383,360)

Residual income

$ (305,360)

Net income Plus interest Less tax effect of interest NOPAT

946,000

b. While income has increased, residual income has decreased. Thus, it is not clear that performance has improved. c. Note that this part is optional and is included to link finance and managerial accounting. The fact that interest expense is down, suggests that the company is relying less on debt financing. Since debt financing is cheaper than equity financing, the weighted average cost of capital has increased. P5. [LO 2] a. Year 1

Year 2

Year 3

Year 4

Year 5

NOPAT

$35,000,000

Investment*

440,000,000 7.95%

413,600,000

388,784,000

365,456,960

343,529,542

8.46%

9.00%

9.58%

10.19%

ROI (%)

*each year’s investment amount is equal to 94% of the previous year. b. As shown by the calculations in part a, if no new investment is made, ROI automatically improves from 7.95% to 10.19%. Thus, managers have an incentive to avoid or delay investments that will increase the investment base and consequently reduce ROI.

Chapter 12 Decentralization and Performance Evaluation

P6. [LO 2] a. 2017

2018

Net income Plus interest Less tax effect of interest NOPAT

$3,650,000 2,420,000 (968,000) $5,102,000

$4,950,000 2,975,000 (1,190,000) $6,735,000

Total assets Less noninterest-bearing current liabilities Investment

$59,500,000

$56,430,000

4,400,000 $55,100,000

4,950,000 $51,480,000

9.26%

13.08%

2017 0.0773

2018 0.0700

Investment turnover (Sales ÷ investment)

1.1978

1.8697

Profit margin x turnover = ROI

9.26%

13.08%

ROI b. Profit margin (NOPAT ÷ Sales)

c. Between 2017 and 2018, ROI increased. This was due to an increase in investment turnover (1.1978 vs. 1.8697) which overcame a decline in profit margin (.0773 vs. .0700).

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Jiambalvo Managerial Accounting

P7. [LO 2, 3] a.

Net income Plus interest Less tax effect of interest NOPAT

Hazardous Waste $1,870,000 1,375,000 (550,000) $2,695,000

Residential Waste $6,600,000 8,030,000 (3,212,000) $11,418,000

Total assets Less NIBCL Investment

$15,300,000 (3,300,000) $12,000,000

$87,000,000 (13,200,000) $73,800,000

22.46%

15.47%

Hazardous Waste $2,695,000 1,200,000 $1,495,000

Residential Waste $11,418,000 9,594,000 $ 1,824,000

ROI (NOPAT ÷ investment)

NOPAT Less required return x investment Residual Income/EVA

c. As measured in terms of EVA, Residential Waste has created the most shareholder value. d. Based on the limited information, Hazardous Waste is the best candidate for expansion. Its current ROI is quite high suggesting it may be able to earn a higher rate of return on additional assets compared to Residential Waste. P8. [LO 2] a. Under GAAP, research and development is treated as an expense even though it creates future value. Managers may be tempted to cut back on research and development in order to increase reported earnings in the short run. With EVA, research and development is capitalized and amortized over the future periods that are benefited. Since it is not immediately expensed for purposes of calculating EVA (and because managers are rewarded based on their EVA performance), managers will have less incentive to cut research and development.

Chapter 12 Decentralization and Performance Evaluation

b. Year 2016 2017

Cost $1,200,000 2,100,000

2018

2,640,000

Amortization 2016 2017 $400,000 $400,000 700,000

2018 $400,000 700,000

Unamortized Amount 700,000

880,000 $1,980,000

1,760,000 $2,460,000

Amortization over three years

Net income Plus interest Less tax effect on interest Plus current period R&D Less amortization of capitalized R&D Less tax effect of difference due to amortization less than current period .35 (2,640,000 – 1,980,000) NOPAT (adjusted)

$6,050,000 1,320,000 (462,000) 2,640,000

Total assets Plus unamortized R&D Less NIBCL Investment (adjusted)

$60,500,000 2,460,000 (23,100,000) $39,860,000

NOPAT Less cost of capital x investment EVA

$7,337,000 5,979,000 $1,358,000

(1,980,000)

(231,000) $7,337,000

c. Given that EVA is positive (i.e., the company is showing an economic profit measured in terms of EVA), managers may very well support introduction of EVA. It shows that they are able to earn a return greater than the cost of capital supplied to the firm.

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P9. [LO 2] a. As indicated, EVA has actually decreased from 2014 to 2015.

Income from operations Less taxes at 40% NOPAT

2018 $ 990,000 396,000 $594,000

2017 $ 935,000 374,000 $ 561,000

Total assets Less NIBCL Investment Cost of capital Required NOPAT

$4,400,000 319,000 4,081,000 0.12 489,720

$3,850,000 308,000 3,542,000 0.12 425,040

EVA

$ 104,280

$ 135,960

b. Income does not include a charge for equity capital. The cost of equity capital is calculated in EVA by multiplying the cost of capital times investment. c. EVA will drive managers to carefully consider investment in assets since the performance measure includes a charge equal to the cost of capital times the level of investment. Unless a new investment will yield a return higher than the cost of capital, EVA will decline.

Chapter 12 Decentralization and Performance Evaluation

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P10. [LO 2, 3] a. Brick & Mortar Division

Internet Division

Net income

$27,810,000

Plus interest Less tax effect of interest NOPAT

1,260,000 (504,000) $28,566,000

$(1,125,000) 418,500 $ (706,500)

Total assets Less noninterest-bearing current liabilities Investment

$162,000,000

$15,480,000

7,020,000 $154,980,000

2,520,000 $12,960,000

NOPAT Less required return x investment

$28,566,000 15,498,000

$ (706,500) 1,555,200

Residual Income/ EVA

$13,068,000

$(2,261,700)

b. In its early years, the Internet Division needs to make substantial investments in infrastructure (software development, servers, etc.) and prices may be set at a low level to build a customer base. Thus, it is not surprising that EVA is negative. Managers of the Internet Division could take actions that are in the long-run interest of the company and still reduce EVA. Since current period EVA does not capture what the managers of the Internet division are doing to create future value, it might be better to turn to a balanced scorecard to measure what the division is doing in terms of its customers, internal processes, and innovation to create future value. c. Brick and Mortar Division Customer measures: Customer satisfaction, market share Internal process measures: Current titles out of stock, discount sales as a percentage of total sales Internet Division Customer measures: Time to deliver books to customers, percent of customers making repeat purchases Internal process measures: Percent of Web site visits that translate into sales, number of times per month that the Web site is down

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d. Brick and Mortar Division Current titles out of stock (internal process) could influence Customer satisfaction (customer) Internet Division Number of times the Web site is down could influence the percent of Web site visits that translate into sales P11. [LO 2] a. In 000s Net income Total assets ROI (Income ÷ assets)

2015 2016 2017 2018 $3,750 $4,313 $5,088$6,105 $37,500 $47,925 $63,750 $87,500 10.00%

9.00%

7.98% 6.98%

b. Managers can increase income by investing in projects that earn a positive return even if the return is less than the cost of capital. This is what has happened. The company has made investments (note the increase in total assets), and income has increased. However, ROI has decreased from 10% to only 7 percent. Shareholders want a return to reward them for the risk they are bearing as equity holders. Apparently, they are not happy with a return less than 10 percent. c. In 000s Net income Cost of capital x investment EVA

2015 $3,750 (3,563) $ 188

2016 2017 2018 $4,313 $5,088 $6,105 (4,553) (6,056) (8,313) ($ 240) ($ 968) ($2,208)

EVA is declining indicating that the company is not earning a return on investments consistent with its cost of capital. This may very well explain the decline in stock price.

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P12. [LO 3] a. Financial—Growth in sales Customer—Customer satisfaction Internal process— Percent of shipments delivered on time, inventory turnover Innovation— Employee retention b. Employee retention could influence improvement in on time delivery which could influence customer satisfaction which could influence growth in sales. P13. [LO 3] a. Customer—Customer satisfaction Internal process—Percent of shipments delivered on time b. If Maria continues to manage production to meet short-run profit goals, customer satisfaction may decrease (or fail to increase) and the percent of shipments delivered on time may decrease (or fail to increase). P14. [LO A1] a. The market price is the best transfer price in this situation. It’s not likely to be controversial because it places both internal operations in the position of “stand alone” companies. b. Since the coal can be sold in an external market, the market price is the opportunity cost of producing the coal and selling it internally. P15. [LO A1] It appears that there is frivolous use of the plumbing and electrical department. A charge for service would reduce this problem. But should the charge be the “cost” of the service or the “market price?” Most likely a charge for the variable cost of the service provided (i.e., the hourly wage paid to maintenance workers) would reduce frivolous use. A market price (of $50 - $65 per hour) doesn’t seem appropriate since that isn’t the incremental cost of providing the service internally, and the maintenance services cannot be sold (by the City) in the external market— thus it is not a measure of the opportunity cost of providing the service.

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Jiambalvo Managerial Accounting

P16. [LO A1] a. Because the Fabric division has substantial idle capacity, variable cost is a good approximation of the opportunity cost of providing fabric to the Clothing division and should be used as the transfer price. b. The Fabric division is operating at capacity. Thus, to produce material for the Clothing division, it must give up external sales. In light of this, the market price is a good measure of the opportunity cost of providing fabric to the Clothing division and should be used as the transfer price. c. See answers to a. and b. P17. [LO 2] a. 1. Division without embroidery machine Operating Income Total assets

$ 5,000,000 $33,000,000

Less NIBCL

1,500,000

Investment ROI

$31,500,000 15.87%

2. Division with embroidery machine Operating income of division Add: Net income of machine Total net income

$ 5,000,000 1,027,500 $ 6,027,500

Total assets of division Add: Investment of machine Less noninterest-bearing current liabilities Total investment

$33,000,000 5,250,000

ROI

1,500,000 $36,750,000 16.40%

Chapter 12 Decentralization and Performance Evaluation

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b. 1. Division without embroidery machine Operating income

$ 5,000,000

Total assets Less noninterest-bearing current liabilities Investment Cost of capital Required NOPAT

$33,000,000

Residual income

1,500,000 $31,500,000 0.14 4,410,000 590,000

2. Division with embroidery machine Total Operating Income Total Investment

$ 6,027,500

Cost of capital

$36,750,000 0.14

Required NOPAT Residual Income

5,145,000 $ 882,500

c. Sarah will decide to purchase the machine because the machine will increase the division’s ROI and residual income.

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P18. [LO 4] a. Division B has the highest net income, followed by Division C and then Division A. An advantage of rewarding managers based on net income is that managers are clearly motivated to increase profitability of the firm. But a disadvantage is that evaluation in terms of profit can lead managers to make investments that earn a return less than the cost of capital. Hence, they may overinvest in assets. b. Net income Plus interest Less tax effect of interest NOPAT Total assets Less noninterestcurrent liabilities Investment ROI

Division A Division B Division C $178,500 $1,820,000 $1,365,000 52,500 1,925,000 1,225,000 21,000 770,000 490,000 $210,000 $2,975,000 $2,100,000 $927,500

$18,725,000

$11,156,250

52,500 $875,000

2,187,500 $16,537,500

1,050,000 $10,106,250

24.00%

17.99%

20.78%

bearing

Division A has the highest ROI, followed by Division C and then Division B. An advantage of using ROI to reward managers is that managers would have an incentive to increase the profitability of their division. However, a disadvantage is that managers could delay the purchase of modern equipment needed to stay competitive. New equipment tends to significantly raise the level of investment and reduce ROI. Managers may fear that the decline in ROI will lead to low ratings of their job performance.

Chapter 12 Decentralization and Performance Evaluation

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c. Division A $178,500 52,500 21,000 210,000

Division B $1,820,000 1,925,000 770,000 2,975,000

Division C $1,365,000 1,225,000 490,000 2,100,000

Total assets Less noninterest-bearing current liabilities Investment Cost of capital Required NOPAT

927,500

18,725,000

11,156,250

52,500 875,000 0.10 87,500

2,187,500 16,537,500 0.12 1,984,500

1,050,000 10,106,250 0.14 1,414,875

Residual income

$122,500

$990,500

$685,125

Net income Plus interest Less tax effect of interest NOPAT

Division B has the highest residual income, followed by Division C and then Division A. An advantage of using residual income to evaluate managers is that it does not give them an incentive to underinvest if a project will earn a return greater than the cost of capital. On the other hand, managers will not have an incentive to overinvest if a project will earn a return less than the cost of capital. However, a disadvantage is that residual income rewards accomplishments of the past and does not consider future benefits.

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Jiambalvo Managerial Accounting

Case 12-1 [LO 2]

HOME VALUE STORES Summary A company that operates membership warehouse stores is evaluated using EVA. •

Takes students through the calculation of EVA.

•

Shows increasing profit that does not necessarily equate to increasing shareholder value.

•

Takes students back to the need for a balanced scorecard.

Questions to ask students 1. What is the situation facing Home Value Stores? 2. What is residual income in 2018 and 2017? 3. Why is it that earnings are up in 2018 by 6.4%, but residual income is decreasing indicating a decline in shareholder value? 4. Both Tanya Barrett, a board member, and the new CEO are concerned about what the company is doing today to create future firm value. Is there a performance measurement technique that the company can use to help warehouse managers understand how their actions are linked to the company’s strategy and how they can affect future firm value? Discussion What is the situation facing Home Value Stores? Tanya Barrett, a board member of Home Value Stores, has asked for an evaluation of financial performance that takes into account both the level of investment and the cost of capital. Specifically, she wants to know the level of profit (loss) earned in excess of the amount given the investment in the company. In other words, she is asking for a calculation of residual income. a. What is residual income in 2018 and 2017? As indicated, residual income has declined in 2018, which may explain why the stock price has not gone up with the increase in sales and profit.

Chapter 12 Decentralization and Performance Evaluation

12-23

There are alternative approaches to calculating NOPAT that lead to the same result. Immediately below is the approach illustrated in the book. Tax rate = $666,400 ÷ $1,904,000 = 35%

Calculation of NOPAT (in thousands) 2018 $1,237,600 110,000

2017 $1,163,175 90,000

38,500

31,500

$1,309,100

$1,221,675

$3,485,000

$2,375,000

540,000 98,000 $2,847,000

500,000 89,000 $1,786,000

Required return given level of investment (invested capital x cost of capital)

$427,050

$267,900

EVA/RI = NOPAT less required return

$882,050

$953,775

Net income Plus interest expense Less tax effect related to interest NOPAT

Calculation of investment Total assets Less noninterest-bearing current liabilities: Accounts payable Taxes payable Investment

Why is it that earnings are up in 2018 by 6.4% but residual income is decreasing indicating a decline (albeit, a small decline) in shareholder value? Answering this question helps students see that higher profit is not necessarily a good outcome. In the current case, profit is up but not enough given the increase in investment. In particular, the company has had a large increase in inventory and a substantial increase in buildings and equipment. At least in the current period, the company is not earning a satisfactory return on this increased investment.

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Jiambalvo Managerial Accounting

b. Both Tanya Barrett, a board member, and the new CEO are concerned about what the company is doing today to create future firm value. Is there a performance measurement technique that the company can use to help warehouse managers understand how their actions are linked to the company’s strategy and how they can affect future firm value? Hopefully, students will suggest that the company create a balanced scorecard with performance measures that assess the customer, internal process, and learning and growth perspectives as well as the financial performance perspective. If time permits, I ask students to suggest measures to include on a balanced scorecard for Home Value Stores. Examples include: Sales per customer Sales per square foot Average time to check out Number of shopping trips per month per member Customer satisfaction

New product sales Number of product returns Number of customer complaints Employee turnover Employee satisfaction

Chapter 12 Decentralization and Performance Evaluation

12-25

Case 12-2 [LO 2]

WinTechMotors Summary A company is showing increased sales and profit. However, the company is not earning a return consistent with its cost of capital and EVA is negative. •

Demonstrates the value of EVA.

•

Links a management action (reducing the investment in inventory) to an EVA improvement.

Questions to ask students 1. What is the situation at WinTechMotors? 2. What is EVA in 2017 and 2016? 3. How many cars must be cut from inventory to achieve a zero EVA (i.e., a position where the company is earning a return equal to its cost of capital)? Discussion What is the situation at WinTechMotors? The owners believe that their company is a success because sales and profit have increased. However, profit does not capture the cost of equity and the owners have a large investment in their company. (a)What is EVA in 2017 and 2016? As indicated, EVA is negative in both years. Tax rate = $176,050 ÷ $503,000 = 35% 2017 $ 326,950 63,000 22,050 $ 367,900

2016 $ 171,145 58,500 20,475 $ 209,170

Total assets Less NIBCL Accounts payable Taxes payable Invested capital Cost of capital Required return

$6,948,000

$6,300,000

276,300 103,500 6,568,200 0.12 $ 788,184

117,000 36,000 6,147,000 0.12 $ 737,640

EVA

$(420,284)

$(528,470)

Net income Add interest expense Less taxes related to interest NOPAT

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Jiambalvo Managerial Accounting

(b & c) As indicated below, the company must cut 47 cars from inventory to achieve a zero EVA. At the end of 2017, the company had 75 cars on hand, but only 28 cars can be in inventory at the end of 2017 if the company is to have a zero EVA.

Needed EVA improvement ÷ cost of capital Required inventory reduction ÷ by average cost per car Number of cars that must be cut Current inventory level Average cost per car

2017 $420,284 0.12 3,502,367 75,000

2016 $528,470 0.12 4,403,917 75,000

$5,625,000

$5,040,000 75,000

Number of cars on hand

75,000 75

Revised number of cars

28_

The solution is to start selling cars that are placed on consignment with the company. Consignment cars do not require an investment in inventory. Indeed, this is the approach that many high-end used car dealers take.

Chapter 13 Statement of Cash Flows QUESTIONS 1. The income statement is prepared using accrual accounting which reflects both cash and non-cash transactions. The statement of cash flows is prepared using the cash basis of accounting which reflects only cash transactions. 2. Investors use the statement to assess whether the company they are investing in can earn a reasonable return on their investment and possibly pay a dividend. Managers use the statement to determine whether their company can generate enough cash to pay wages, pay suppliers, make debt payments, pay dividends, make investments in fixed assets, etc. 3. a. Operating cash flows relate to the production and delivery of goods and services. That is, they are related to the day-to-day profit-oriented activities of a business. An example of an operating cash inflow would be cash receipts from customers. An example of an operating cash outflow would be a cash payment to a supplier. b. Investing cash flows are related to the buying and selling of long-term assets. An example of a related cash inflow would be the cash inflow related to the sale of a company building. An example of a related cash outflow would be a cash payment related to the purchase of a patent. c. Financing cash flows generally involve cash flows related to long-term debt and equity. An example of a financing cash inflow would be a cash receipt from issuing a bond. An example of a financing cash outflow would be a cash payment related to a stock buy-back. 4. Cash received from interest is shown in the section for operating cash flows. This is consistent with FASB requirements but is somewhat confusing since it might seem more appropriate to classify these cash inflows under investing activities. 5. The investing and financing sections are identical whether one uses the direct or the indirect method. 6. The indirect method is used much more frequently compared to the direct method. If the direct method is used, the FASB requires a separate schedule reconciling cash flows from operating activities and net income. However, if the indirect method is used, this reconciliation is performed right in the statement. 7. Under the indirect method, the starting point for determining operating cash flows is net income. This allows the reader to connect the statement of cash flows to the income statement as a basis for converting accrual net income to cash flows provided by operations.

13-2 Jiambalvo Managerial Accounting 8. Depreciation expense is deducted in arriving at net income. However, it does not involve a cash outflow and, thus, must be added back to net income to calculate cash flows from operating activities. 9. Comparing relationships from year to year allows users to identify trends. For example, a startup company would normally be expected to have negative operating cash flows, net cash outflows from investing activities and, most likely, net cash inflows from financing activities. As time passes, however, operating cash flows should become positive and a much larger percent of total cash flows. Otherwise, the company is likely to be in serious financial difficulty. 10. Such a company most likely has products that are successful and well established. Thus, they can be “milked” for cash without substantial additional investments that might require additional financing.

Chapter 13 Statement of Cash Flows

13-3

EXERCISES E1.

[LO 3] The equation for determining cost of goods sold is: Beginning inventory + Purchases – Ending inventory = Cost of goods sold. This can be rewritten as: Beginning inventory – Ending inventory = Cost of goods sold – Purchases or, Ending inventory – Beginning inventory = Purchases – Cost of goods sold This shows that the difference between purchases and cost of goods sold is equal to the difference between ending inventory and beginning inventory. If ending inventory is greater than beginning inventory, then purchases are greater than cost of goods sold. This, in turn, implies that net income must be reduced by this difference to convert it to net cash provided by operating activities.

E2.

[LO 3] The answer depends on the stage of the company. A startup company might be opening new stores and have relatively few customers. This, hopefully, will change as the company’s reputation grows. This type of company might have great prospects but, in the short-run, negative operating cash flows. On the other hand, an established company with negative operating cash flows is generally in trouble. Such a company is typically not experiencing large growth so the negative cash flow is likely due to reduced demand for products or mismanagement of inventory, collection of receivables, etc.

E3.

[LO 3] The company generated $554 million in cash from operating activities, but used $295 million in investing activities and $333 million in financing activities. This resulted in a net decrease in cash of $74 million.

E4.

[LO 1] All listed events affect only the statement of cash flows. The intent of this question is to demonstrate that many common transactions and events do not impact the income statement yet do involve cash. For this reason, looking only at the income statement does not give a complete picture of a company’s financial situation.

E5.

[LO 1] 1. Financing - outflow 2. Investing - inflow

13-4 Jiambalvo Managerial Accounting 3. 4. 5. 6. 7. 8. E6.

E7.

E8.

Financing - inflow Investing - outflow Investing - outflow Investing – inflow (sales price); Operating – positive adjustment (loss) Financing - inflow Financing - outflow

[LO 2, 3] Investing Activities Cash payments for investments Cash payments for equipment Proceeds from sale of equipment Net cash used in investing activities

($260,000) (60,000) 35,000 ($285,000)

[LO 2, 3] Financing Activities Issue preferred stock Purchase treasury stock Proceeds from borrowing Retirement of bonds Net cash provided by financing activities

($200,000 + 60,000)

$125,000 (70,000) 150,000 (45,000) $ 160,000

[LO 2] Note that 2017 sales are irrelevant to this question. Accounts Receivable – beginning of year $ 600,000 Plus sales in 2018 2,850,000 Less cash collections from customers ? Accounts Receivable – end of year $ 480,000 This implies cash collections of $2,970,000

E9.

[LO 2] Note that 2017 cost of goods sold is irrelevant to this question. Beginning inventory Plus purchases Less cost of goods sold in 2018 Ending inventory

650,000 ? 3,085,000 $ 519,000

This implies purchases of $2,954,000 Beginning accounts payable Plus purchases Less ending accounts payable Cash payments for inventory

104,000 2,954,000 65,000 $ 2,993,000

Chapter 13 Statement of Cash Flows E10. [LO 3] 1. Added 2. Added 3. Added 4. Added 5. Deducted 6. Added 7. Added 8. Added 9. Added E11. [LO 3] Net Income Add back non-cash expenses: Depreciation expense Amortization expense Change in current accounts: Decrease in receivables Increase in prepaid insurance Increase in accounts payable Increase in wages payable Net cash provided by operating activities E12. [LO 3] Current Asset and Liability Accounts Accounts receivable Inventories Other current assets Accounts payable Income taxes payable Other current liabilities E13. [LO 3] a. NR b. D c. D d. A e. D f. A g. A h. D i. A

$169,325 65,000 6,500 13,000 (7,500) 6,500 4,300 $257,125

Decreased Increased Decreased Increased Increased Increased

13-5

13-6 Jiambalvo Managerial Accounting E14. [LO 3] Operating Activities Net Income Adjustments of net income to the cash basis: Depreciation Expense ($23,000 – $20,000) Increase in receivables Decrease in inventory Increase in prepaid rent Decrease in accounts payable Increase in wages payable Net cash provided by operating activities

$15,000 3,000 (2,000) 1,000 (600) (1,000) 2,000 $17,400

E15. [LO 2, 3] a. The cost of the equipment sold was $25,000 and book value (cost less accumulated depreciation) was $9,000. Therefore accumulated depreciation removed when the items was sold must have been $16,000. Beginning accumulated depreciation Plus depreciation expense for the year Less accum. deprec .removed as a result of sale Ending accumulated depreciation

$30,000 ? (16,000) $ 22,000

This implies depreciation expense of $8,000. b. Now solve for purchases of equipment: Beginning equipment Plus purchases of equipment Less cost of equipment sold Ending equipment

$105,000 ? (25,000) $ 130,000

This implies that equipment costing $50,000 was purchased. c. Operating Activities Net Income Adjustments of net income to cash basis: Depreciation Gain on sale of equipment ($18,500 - $9,000) Net cash provided by operating activities Investing Activities Purchase of equipment Cash received from sale of equipment Net cash used in investing activities

$380,000 8,000 (9,500) $378,500

($50,000) 18,500 ($31,500)

Chapter 13 Statement of Cash Flows

13-7

E16. [LO 1, 3] a. Net income includes many large non-cash deductions such as depreciation and bad debt expense. Thus, net income is typically, but certainly not always, less than cash flow from operating activities. b. Cash flows from investing activities are associated with long-term assets. When a company is growing (or even remaining of relatively constant size), it usually acquires more long-term assets than it sells producing a net investing cash outflow. c. The largest source of funds appears to be from financing activities. To fund investments, firms can use either internally generated funds or funds provided by creditors or stockholders. It appears that the company is using the funds provided by these individuals to finance growth as indicated by the large investments in years 2 and 3. E17. [LO 1, 2, 3] 1. F 2. T 3. F 4. T 5. F 6. F 7. T 8. T 9. T E18. [LO 3] Beginning retained earnings Plus net income Less dividends Ending retained earnings This implies dividends of $3,050,000.

$5,100,000 2,050,000 ? $4,100,000

13-8 Jiambalvo Managerial Accounting PROBLEMS P1. [LO 1] As anyone who has studied accounting knows, there is a major difference between income and cash flow. Indeed, income can be decomposed into two parts—cash flows and accruals. Further, there is no disagreement that the current value of a company depends upon its future cash flows. But somewhat surprisingly, research suggests that on average past earnings may in fact do a better job predicting future cash flows than past cash flows (see L.G. Godfrey, M.R. Veall, P.M. Dechow, S.P. Kothari and R.Watts, “The relation Between Earnings and Cash Flows –An Accounting Revolution,” Journal of Accounting and Economics, (May 1998), 133-168). However, there is still good reason to focus on cash flows. As discussed in chapter 13, income is measured using GAAP and GAAP allows managers considerable discretion to manage earnings. It is much more difficult to manage cash flow. Also, the cash flow statement provides considerable insight into the sources of cash which can help assess a company’s ability to pay its bills and avoid bankruptcy. P2. [LO 1] While cash may have increased by $2.5 million, that, by itself, does not mean things are going well for the company. For example, the firm could have borrowed $3 million (a financing cash event) and lost $0.5 million from producing and selling goods (an operating activity). When combined, cash increased $2.5 million but the loss of cash from operations is definitely not good news. If operating cash losses continue and the firm has exhausted its borrowing capacity, the firm could actually be unable to pay off the $3 million loan and possibly enter bankruptcy. In general, it is wise to focus on operating, investing, and financing cash flows. P3. [LO 1] a. b. c. d. e. f. g. h. i. j.

2 4 1 3 2 4 1 6 5 6

Chapter 13 Statement of Cash Flows P4. [LO 1] 1. c 2. b 3. d 4. b 5. c 6. f 7. d 8. e 9. f 10. e P5. [LO 1] 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25.

f a a f b g d e b f g f f g g e g g b e d g c a g

13-9

13-10 Jiambalvo Managerial Accounting P6. [LO 2] Octel Corporation Statement of Cash Flows – Direct Method For the Year Ended June 30, 2017 Operating Cash Flows Cash received from customers ($8,600 + $267,000 - $8,300) $267,300 Prepaid expenses (1,200) Payments for purchase of merchandise (74,400)* Payments for wages ($3,100 + $95,900 - $3,300) (95,700) Other operating expenses (61,000) Net cash provided by operating activities

$35,000

Financing Cash Flows Issue common stock Payment of dividends Net cash used in financing activities Net change in cash Cash – Beginning of 2017 Cash – End of 2017

(26,600) 8,400 48,000 $56,400

1,600 (28,200)

*($14,100 + Purchase - $73,200) = $15,200; Purchases = $74,300 ($12,600 + $74,300 - $12,500) = $74,400 -7. [LO 2] a. Cash spent on new equipment = $0 b. Net amount of investing cash flow = $3,200 Cash from sale of land – BV of land = Loss on sale of land Cash - $5,600 = $2,400 Cash = $3,200 c. Cash received from issuing stock = $11,040 ($5,300 + $17,170) – ($4,800 + $6,630) = $11,040 d. Cash paid to suppliers of inventory = $37,300 Inventory purchases: $35,200 $16,100 + ? - $37,000 = $14,300 Cash paid for inventory: $37,300 $7,800 + $35,200 - ? = $5,700 e. Cash paid for selling and general expenses = $13,640 This affects both prepaid expense and accrued liabilities. ($14,700 + ($770 - $1,430) - ($4,000 - $3,600) = $13,640

Chapter 13 Statement of Cash Flows f. Cash received from sale of land = $3,200 g. Cash received from sale of equipment = $0 h. Cash received from customers = $91,700 $11,600 + $94,000 - ? = $13,900 i. Cash paid for dividends = $14,660 $64,500 + $20,160 - ? = $70,000 j. Net amount of operating cash flows = $27,320 $91,700 - $37,300 - $13,640 - $13,440 = $27,320 k. Net amount of financing cash flows = ($3,620) $11,040 - $14,660 = ($3,620) P8. [LO 3] 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25.

f i i f i g d e i f g f f h h e h j i e d j c i g

13-11

13-12 Jiambalvo Managerial Accounting P9. [LO 3] Goodly’s Clothing Company Partial Statement of Cash flows – Indirect method For the Year Ended December 31, 2017 Operating activities Net Income Adjustments of net income to the cash basis: Depreciation expense Loss on sale of land Increase in receivables Increase in inventory Decrease in prepaid expenses Increase in accounts payable Decrease in accrued liabilities Net cash provided by operating activities

$35,815 2,600 3,600 (1,000) (600) 450 670 (650) $40,885

P10. [LO 3] Goodly’s Clothing Company Partial Statement of Cash flows – Indirect method For the Year Ended December 31, 2017

Operating activities Net Income Adjustment of net income to cash basis: Depreciation expense Gain on disposal of long-term assets Increase in accounts receivable Increase in inventories Increase in accounts payable Increase in accrued salaries payable Increase in income taxes payable Net cash provided by operating activities

$17,000 5,500 (150) (1,500) (11,900) 13,200 4,300 2,200 $28,650

P11. [LO 1, 3] 1. a. Operating activities - Added 2. a. Operating activities - Added 3. a. Operating activities - Subtracted 4. c. Investing activities 5. d. Would not appear in the statement (Note to instructor-while the item would not appear in the statement, it might appear in a schedule.) 6. a. Operating activities -Added 7. b. Financing activities

Chapter 13 Statement of Cash Flows

13-13

8. a. Operating activities - Subtracted 9. b. Financing activities 10. b. Financing activities 11. a. Operating activities - Added 12. a. Operating activities - Subtracted 13. c. Investing activities 14. c. Investing activities 15. b. Financing activities 16. b. Financing activities P12. [LO 2, 3] (a) Patton Company Statement of Cash Flows – Indirect method For the Year Ended December 31, 2017

Operating activities Net income Depreciation expense Increase in accounts receivables Increase in inventory Increase in prepaid expenses Increase in accounts payable Increase in accrued wages payable Net cash provided by operating activities

$12,210 3,560 (600) (1,300) (1,160) 1,200 450 14,360

Investing Activities Payments to purchase equipment Cash from sale of equipment Net cash used in investing activities

(25,000) 12,140* (12,860)

Financing Activities Net increase in cash Beginning cash balance –2017 Ending cash balance – 2017 * ($42,200 + $25,000 - $52,500) – ($7,200 + $3,560 - $8,200)

-01,500 15,500 $17,000

13-14 Jiambalvo Managerial Accounting (b) Patton Company Partial Statement of Cash Flows – Direct method For the Year Ended December 31, 2014 Operating activities Increase in prepaid expenses Cash received from customers ($5,800 + $40,700 - $6,400) Payments for other operating expenses Payments for inventory Payment of wages ($1,200 + $10,600 - $1,650) Net cash provided by operating activities

($1,160) 40,100 (1,130) (13,300)* (10,150) $14,360

*($8,700 + Purchases - $13,200 = $10,000); Purchases = $14,500 ($5,100 + $14,500 - $6,300) = $13,300

P13. [LO 2, 3] (a) Claims Corporation Partial Statement of Cash Flows For the Year Ended December 31, 2017 Operating activities-indirect method Net income Adjustments of net income to cash basis: Depreciation expense Gain on sale of land Increase in accounts receivable Increase in inventory Decrease in prepaid selling/general expenses Increase in accounts payable Increase in accrued liabilities Net cash provided by operating activities

$17,400 2,000 (5,700) (5,500) (4,800) 2,750 2,800 1,230 $10,180

(b) Claims Corporation Partial Statement of Cash Flows For the Year Ended December 31, 2017 Operating activities-direct method Cash received from customers ($4,700 + $80,700 - $10,200) Cash paid to suppliers of inventory Cash paid for selling and general expenses Cash paid for taxes Net cash provided by operating activities *($7,000 + Purchases - $46,200 = $11,800); Purchases = $51,000 ($3,000 + $51,000 - $5,800) = $48,200 **[$9,200 + ($850 - $3,600) – ($2,900 -$1,670)]

$ 75,200 (48,200)* (5,220)** (11,600) $ 10,180

Chapter 13 Statement of Cash Flows P14. [LO 2, 3] (a) Sellmer's Pasta, Inc. Statement of Cash Flows—Direct Method For the Year Ended December 31, 2017 Operating activities Cash received from customers($118,000+$449,000 – $120,500)$446,500 Payments to suppliers of inventory (163,700)* Increase in prepaid expenses (15,280) Payments for wages ($29,200+$176,000-$32,800) (172,400) Payments for advertising (16,400) Payments for misc. operating expenses (12,200) Net cash provided by operating activities

$66,520

Investing activities Purchase of equipment

(24,625)

Financing activities Payments on long-term notes Payments of dividends Net cash used in financing activities

$(18,995) (5,000) (23,995)

Net increase in cash 17,900 Cash – Beginning of 2017 263,000 Cash – End of 2017 $280,900 *($94,200 + Purchases - $173,000 = $83,800); Purchases = $162,600 ($235,200 + $162,600 - $234,100) = $163,700 (b) Sellmer's Pasta, Inc. Partial Statement of Cash Flows—Indirect Method For the Year Ended December 31, 2017 Operating activities Net Income Adjustments of net income to cash basis Depreciation Expense $ 2,600 Increase in accounts receivable (2,500) Decrease in inventory 10,400 Increase in prepaid expenses (15,280) Decrease in accounts payable 1,100 Increase in accrued wages 3,600 Net cash provided by operating activities

$68,800

(2,280) $66,520

13-15

13-16 Jiambalvo Managerial Accounting P15. [LO 3] a. In general, when receivables are increasing, less revenue is being converted into cash. In this case, whatever the revenue amount is, $129 million of it has not been collected which explains the increase in receivables. (Note: The answer ignores the issue of bad debts.) b. No. Suppose General Cereals brought a new product to the market that was enthusiastically received by customers and it made purchasing that item easy by offering more attractive credit terms. In combination, these two actions should cause revenues to rise significantly. And, ultimately, the company will have more operating cash flows. However, receivables will increase because of the more attractive credit terms (a deliberate strategy by the company to increase sales and ultimately cash inflows).

Chapter 13 Statement of Cash Flows

13-17

Case 13-1. [LO 3]

WELLCOMP COMPUTERS Summary A marketing VP at a computer company proposes grabbing market share by dropping prices but the COO is worried that this will hurt cash flow. •

Demonstrates the potential value of accelerating collection of receivables and delaying payments for purchases.

Questions to ask students 1. What is the situation at Wellcomp? Discussion The company typically collects payments from customers within 5 days but doesn’t pay suppliers for 30 days. Thus, as sales accelerate due to lowering prices, cash inflows from collections from customers are likely to outpace payments to suppliers even at lower prices.

Chapter 14 Analyzing Financial Statements: A Managerial Perspective QUESTIONS 1.

By analyzing financial statements, managers decide what suppliers to use, what businesses to partner with, and how to pay off the firm’s debts.

Horizontal analysis consists of analyzing the dollar value and percentage changes in financial statement amounts across time (e.g., from year to year or from quarter to quarter). Vertical analysis consists of analyzing financial statement amounts in comparison to a base amount. The base for the balance sheet is total assets, while net sales is the base for the income statement.

The difference between net income and cash flow from operations is due to accruals which are impacted by earnings manipulation.

The management discussion and analysis section of the annual report, credit reports, and news articles can be used to gain insight into a company's current and future financial performance.

Three profitability ratios are the gross margin percentage, return on total assets, and return on common stockholders' equity. Gross margin percentage is used to assess how much incremental profit is generated by each dollar of sales. Return on assets is used to assess how much income is generated by a company’s total assets. Return on common stockholders’ equity is used to determine how much income is generated relative to a firm’s level of common stockholders’ equity. Students may also discuss earnings per share and the price-earnings ratio.

Three turnover ratios are asset turnover, accounts receivable turnover, and inventory turnover. Asset turnover is used to assess how efficiently a firm uses its assets to generate sales. Accounts receivable turnover assesses how often a firm collects its accounts receivable. Inventory turnover assesses how quickly a firm sells its inventory. Students may also discuss days’ sales in accounts receivable and days’ sales in inventory.

Three debt-related ratios are the current ratio, the debt-to-equity ratio, and times interest earned. The current ratio assesses how well a firm is able to meet its short-term obligations. The debt-to-equity ratio determines how much debt a firm has relative to its total stockholders’ equity. Times interest earned assesses a firm’s operating income level relative to its interest expense. Students may also discuss the acid-test ratio (also called the quick ratio).

14-2 Jiambalvo Managerial Accounting 8.

Davis Company’s current ratio is expected to be highest in October. In this month, the company has its sales peak for the year which most likely results in a high level of accounts receivable (which is in the numerator of the current ratio.) Also, the collection of receivables results in cash flow which may be used to reduce payables (which is in the denominator of the current ratio.)"

Many of the company’s assets may be inventory. The company may not be able to quickly convert its inventory into sales and then to cash to satisfy its current liabilities. If this were the case, then the company’s quick ratio would be much lower than its current ratio since the quick ratio does not consider inventory.

10.

The gross margin percentage is calculated by dividing gross margin by net sales and provides a rough estimate of the incremental profit generated by each dollar of sales. A drop in gross margin percentage like that seen in Souki Corporation indicates that a firm is generating a higher cost of sales like that seen in Souki Corporation indicates that cost of sales in increasing faster than sales. This may hurt the company’s overall profitability.

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-3 EXERCISES E1. [LO 1] Companies are concerned about the financial viability of suppliers because they need a ready and cost efficient source of goods. Also, they may make investments in integrating their supplier’s information system with their own and they want that investment to pay off in the long run. With respect to customers, companies want to be confident that customers will be able to pay for the goods or services they purchase. E2. [LO 2] Cash will not be collected from fictitious sales. Thus, fictitious sales make earnings higher than cash flow. Likewise, if expenses are not recorded but they are paid, earnings will be higher than cash flow. E3. [LO 3] Note to instructor: Students’ answer will vary according to date of data used. As of February 1, 2015, the gross profit margin for Home Depot was 7.76% while the gross profit margin for Lowe's was only 4.82%. Thus, Lowe’s is more profitable in terms of this measure. E4. [LO 2] The answer to this exercise depends on the company recommended by the instructor. E5. [LO 2] The answer to this exercise depends on the company recommended by the instructor. E6. [LO 1] Horizontal analysis of Great Oaks Furniture. Great Oaks Furniture Balance Sheets Assets Current assets Cash Accounts receivable Inventory Prepaid expenses Total current assets Building and equipment, net Total assets

December 31, December 31, 2018 2017

41,200 570,000 5,070,000 83,800 5,765,000 1,097,000 $ 6,862,000

53,000 443,000 4,841,000 78,000 5,415,000 1,095,000 $6,510,000

Percent Change Change

$ (11,800) 127,000 229,000 5,800 350,000 2,000 $ 352,000

-22.3% 28.7% 4.7% 7.4% 6.5% 0.2% 5.4%

14-4 Jiambalvo Managerial Accounting Liabilities and stockholders’ equity Current liabilities Accounts payable $ 604,000 Bank loan payable 679,000 Other accrued payables 213,000 Total current liabilities 1,496,000 Long-term debt 1,729,000 Total liabilities 3,225,000

$ 624,000 625,000 313,000 1,562,000 1,797,000 3,359,000

$ (20,000) 54,000 (100,000) (66,000) (68,000) (134,000)

-3.2% 8.6% -31.9% -4.2% -3.8% -4.0%

Stockholders’ equity Common stock Retained earnings Total stockholders’ equity

1,359,000 2,278,000 3,637,000

1,359,000 1,792,000 3,151,000

486,000 486,000

0.0% 27.1% 15.4%

$ 6,862,000

$6,510,000

$ 352,000

5.4%

Total liabilities and stockholders’ equity

For the balance sheet, changes greater than 10 percent include a decline in cash, an increase in accounts receivable, a decline in other accrued payables, an increase in retained earnings, and an increase in total stockholders’ equity. Also note that in terms of dollars, there has been a large increase in inventory although the percent increase is only 4.7 percent.

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-5

Great Oaks Furniture Statements of Earnings Net sales Cost of goods sold Gross margin Operating expenses: Selling expenses General and administrative expenses Total operating expenses Operating income Interest expense Income before taxes Income taxes Net income

Year Ended Year Ended December 31, December 31, 2018 2017

Change

Percent Change

$ 5,568,000 2,840,000 2,728,000

$ 5,253,000 2,627,000 2,626,000

315,000 213,000 102,000

6.0% 8.1% 3.9%

501,000

630,000

(129,000)

-20.5%

835,000 1,336,000 1,392,000 139,000 1,253,000 439,000 $ 814,000

788,000 1,418,000 1,208,000 158,000 1,050,000 368,000 $ 682,000

47,000 (82,000) 184,000 (19,000) 203,000 71,000 132,000

6.0% -5.8% 15.2% -12.0% 19.3% 19.3% 19.4%

For the income statement, changes greater than 10 percent include a decrease in selling expenses, an increase in operating income, a decrease in interest expense and increases in income before taxes, income taxes and net income.

14-6 Jiambalvo Managerial Accounting E7. [LO 1] Vertical Analysis of Great Oaks December 31, Furniture Balance Sheets 2018 Assets Current assets Cash Accounts receivable Inventory Prepaid expenses Total current assets Building and equipment, net Total assets

41,200 570,000 5,070,000 83,800 5,765,000 1,097,000 $ 6,862,000

0.6% 8.3% 73.9% 1.2% 84.0% 16.0% 100.0%

53,000 443,000 4,841,000 78,000 5,415,000 1,095,000 $ 6,510,000

0.8% 6.8% 74.4% 1.2% 83.2% 16.8% 100.0%

Liabilities and stockholders’ equity Current liabilities Accounts payable $ 604,000 Bank loan payable 679,000 Other accrued payables 213,000 Total current liabilities 1,496,000 Long-term debt 1,729,000 Total liabilities 3,225,000

8.8% 9.9% 3.1% 21.8% 25.2% 47.0%

624,000 625,000 313,000 1,562,000 1,797,000 3,359,000

9.6% 9.6% 4.8% 24.0% 27.6% 51.6%

Stockholders’ equity Common stock Retained earnings Total stockholders’ equity

1,359,000 2,278,000 3,637,000

19.8% 33.2% 53.0%

1,359,000 1,792,000 3,151,000

20.9% 27.5% 48.4%

$ 6,862,000

100.0%

$ 6,510,000

100.0%

Total liabilities and stockholders’ equity

December 31, 2017

There appears to be a significant increase in accounts receivable, a significant decrease in accounts payable, other accrued payables and long-term debt.

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-7

Great Oaks Furniture Statement of Earnings Net sales Cost of goods sold Gross margin Operating expenses: Selling expenses General and administrative expenses Total operating expenses Operating income Interest expense Income before taxes Income taxes Net income

Year Ended December 31, 2018

Year Ended December 31, 2017

$ 5,568,000 2,840,000 2,728,000

100.0% 51.0% 49.0%

$ 5,253,000 2,627,000 2,626,000

100.0% 50.0% 50.0%

501,000

9.0%

630,000

12.0%

835,000 1,336,000 1,392,000 139,000 1,253,000 439,000 $ 814,000

15.0% 24.0% 25.0% 2.5% 22.5% 7.9% 14.6%

788,000 1,418,000 1,208,000 158,000 1,050,000 368,000 $ 682,000

15.0% 27.0% 23.0% 3.0% 20.0% 7.0% 13.0%

Cost of goods sold as a percent of sales increased from 50 to 51 percent. Selling expenses declined from 12 to 9 percent. In total, net income increased from 13 to 14.6 percent of sales.

14-8 Jiambalvo Managerial Accounting E8. [LO 3] 2018 Earnings per share $814,000 ÷ 100,000 $682,000 ÷ 100,000

$8.14

Price-earnings ratio $134 ÷ $8.14 $110 ÷ $6.82

16.46

Gross margin percentage $2,728,000 ÷ $5,568,000 $2,626,000 ÷ $5,253,000

0.49

Return on total assets [$814,000 + ($139,000 x (1 – 0.35))] ÷ $6,862,000 [$682,000 + ($158,000 x (1 – 0.35))] ÷ $6,510,000

0.13

Return on common equity $814,000 ÷ $3,637,000 $682,000 ÷ $3,151,000

0.224

2017

$6.82

16.13

0.50

0.12

0.216

The only significant change between years is the EPS. As indicated on the income statements, Great Oaks experienced a significant increase in net income in 2018 as compared to 2017. The ratios computed are all measures of profitability. In order to make a more complete assessment of the company’s performance, turnover, and debtrelated ratios would also have to be assessed. Comparative information should be looked at in terms of the company’s main competitors and the industry as a whole.

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-9 E9. [LO 3] 2018 Asset turnover $5,568,000 ÷ $6,862,000 $5,253,000 ÷ $6,510,000

.81

Accounts receivable turnover $5,568,000 ÷ $570,000 $5,253,000 ÷ $443,000

9.77

Days’ sales in receivables 365 ÷ 9.77 365 ÷ 11.86

37.36

Inventory turnover $2,840,000 ÷ $5,070,000 $2,627,000 ÷ $4,841,000

.56

Days’ sales in inventory 365 ÷ .56 365 ÷ .54

651.78

2017

.81

11.86

30.77

.54

675.92

As indicated, there appears to be a very significant problem related to excess inventory. The company has approximately 1.8 years of inventory on hand! Quite possibly, return on assets could be improved by decreasing inventory.

14-10 Jiambalvo Managerial Accounting E10. [LO 3] 2018 Current ratio $5,765,000 ÷ $1,496,000 $5,415,000 ÷ $1,562,000

3.85

Acid-test ratio ($41,200 + $570,000) ÷ $1,496,000 ($53,000 + $443,000) ÷ $1,562,000

0.41

Debt-to-equity ratio $3,225,000 ÷ $3,637,000 $3,359,000 ÷ $3,151,000

.89

Times interest earned $1,392,000 ÷ $139,000 $1,208,000 ÷ $158,000

10.01

2017

3.47

0.32

1.07

7.65

As indicated, the acid-test ratio is low. If low inventory turnover is due to out of date or damaged inventory that is difficult to sell, meeting current liabilities may be quite challenging.

E11. [LO 2] Net income versus cash flow from operations Net income Cash flow from operations Difference

2018

2017

$814,000 863,000 ($49,000)

$682,000 700,000 ($18,000)

Net income is actually lower than cash flow from operations. Thus, there is not an indication that earnings have been manipulated upward. Summary of analyses related to exercises E6 – E11. It is surprising that the company has been able to increase sales and decrease selling and administrative expenses. A very troubling finding is that the company has a great deal of inventory considering its level of sales— inventory turnover for 2018 is only .56 and days’ sales in inventory is 652 days. If the low inventory turnover is due to dated or damaged goods, the company may have difficulty meeting current liabilities as indicated by the acid-test ratio of 0.41.

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-11 E12. [LO 3] 2018 Inventory turnover $30,133.1 ÷ $2,797.8 $28,604.0 ÷ $2,642.5

10.77

Days’ sales in inventory 365 ÷ 10.77 365 ÷ 10.82

33.89

2017

10.82

33.73

With respect to inventory, Choice Foods has approximately 34 days of inventory on hand, which seems reasonable considering the nature of the company.

E13. [LO 1] a. Cramer Carpets Comparative Income Statements For the Years Ended December 31, 2018 and 2017

Sales Less: cost of goods sold Gross margin Selling expenses Administrative expenses Total operating expenses Income from operations Interest expense Net income

2018 $6,600,000 4,300,000 2,300,000 1,220,000 960,000 2,180,000 120,000 99,000 $ 21,000

100.0% 65.2% 34.8% 18.5% 14.5% 33.0% 1.8% 1.5% 0.3%

2017 $5,050,000 3,030,000 2,020,000 884,000 732,000 1,616,000 404,000 50,000 $ 354,000

100.0% 60.0% 40.0% 17.5% 14.5% 32.0% 8.0% 1.0% 7.0%

b. Cramer Carpets saw an increase in its cost of goods sold in 2018, which led to a gross margin of $2,300,000 in that year. Also, total expenses increased slightly, leaving income from operations and net income to be significantly lower in 2018. The amount of administrative expenses relative to sales was constant in both years. c. The president of Cramer Carpets should try to cut the company’s cost of goods sold by asking suppliers for discounts or buying carpets from different suppliers. The president could also look into how to decrease the company’s selling expenses.

14-12 Jiambalvo Managerial Accounting E14. [LO 3] a. Current Liabilities ($100,000 + $620,000 + $955,000 + $24,000) ÷ (Current Liabilities) = 2.5 $1,699,000 ÷ Current Liabilities = 2.5 $1,699,000 = Current Liabilities x 2.5 Current Liabilities = $1,699,000 ÷ 2.5 = $679,600 b. Acid-Test Ratio ($100,000 + $620,000) ÷ $679,600 = 1.06 c. Current Ratio ($1,699,000 - $165,000) ÷ ($679,600 - $165,000) $1,534,000 ÷ $514,600 = 2.98 By paying the account payable, Simply Spa Collections’ current ratio increased from 2.5 to 2.98. E15. [LO 3] a.Gross Margin Percentage $27,600 ÷ $84,500 = 32.66% b. Earnings Per Share ($1,920,000 - $440,000) ÷ 500,000) = $2.96 per share c.

Price-Earnings Ratio $25 ÷ $2.96 = 8.45

Return on Total Assets [$1,920 + ($1,200 x (1 – ($1,280 ÷ $3,200))] ÷ $79,150 = $2,640 ÷ $79,150 = 0.033

Return on Common Stockholders’ Equity (1,920,000 - $440,000) ÷ (4,200 + $7,350 + $33,120) = 0.31 Rahul Corporation seems to have an appropriate level of net income relative to the number of common shares outstanding. However, the firm’s price-earnings ratio is rather high. Rahul does seem to be generating a sufficient gross profit and return on total assets.

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-13 E16. [LO 3] a. Asset Turnover 2018 $84,500 ÷ $79,150 = 1.068 2017 $83,000 ÷ $76,370 = 1.087 b. Accounts Receivable Turnover 2018 $84,500 ÷ $10,870 = 7.774 2017 $83,000 ÷ $7,725 = 10.744 c. Days’ Sales in Receivables 2018 365 ÷ 7.777 = 46.93 2017 365 ÷ 10.744 = 33.97 d. Inventory Turnover 2018 $56,900 ÷ $13,860 = 4.105 2017 $56,600 ÷ $12,155 = 4.657 e. Days’ Sales in Inventory 2018 365 ÷ 4.105 = 88.92 2017 365 ÷ 4.657 = 78.38 The company is fairly consistent in its ability to efficiently use its assets as its asset turnover was 1.068 in 2018 and 1.087 in 2017. However, the decrease in asset turnover in 2018 could be a cause for concern in the future. Accounts receivable in 2018 dropped from 10.744 in 2017 to 7.744 in 2018, indicating that the firm is experiencing some trouble collecting its receivables. Inventory turnover decreased slightly from 4.657 in 2017 to 4.105 in 2018. Thus, the company is taking a longer time to sell its inventory than in the past. This is also supported by days' sale in inventory which increased from 78.38 in 2017 to 88.92 in 2018.

14-14 Jiambalvo Managerial Accounting E17. a. 2018 2017

[LO 3] Current Ratio $27,750 ÷ $21,380 = 1.298 $22,970 ÷ $19,500 = 1.178

Acid-Test (Quick Ratio)

2018 ($2,200 + $10,870) ÷ $21,380 = 0.611 2017 ($2,470 + $7,725) ÷ $19,500 = 0.523 c. Debt-to-Equity Ratio 2018 $32,380 ÷ $46,770 = 0.692 2017 $$30,500 ÷ $45,870 = 0.665 d. Times Interest Earned 2018 $4,400 ÷ $1,200 = 3.670 2017 $4,500 ÷ $1,000 = 4.500 Rahul’s current ratio increased from 1.178 in 2017 to 1.298 in 2018. However, its quick ratio increased from 0.523 in 2017 to 0.611 in 2018. Thus, the firm’s ability to pay off short-term obligations has improved. Debt-to-equity ratio increased slightly in 2018 going from 0.665 to 0.692. Times interest earned decreased from 4.500 to 3.670. Therefore, Rahul has demonstrated a decline in its ability to pay interest on its debt. E18. [LO 1] Bayberry Office Plus Horizontal Analysis

Sales Gross profit Net Income Current Assets Cash Accounts receivable Inventory Total current assets Total assets Current liabilities Total liabilities Total shareholders' equity

2018 $7,480 3,520 650

2017 $6,820 1,540 220

80 680 1,020 $1,780 2,420 465 1,320 1,100

75 600 1,000 $1,675 $3,080 450 2,310 770

Change $ 660 1,980 430 $

5 80 20 $105 -$660 15 -990 330

Percent Change 9.7% 128.6% 195.5% 6.7% 13.3% 2.0% 6.3% -21.4% 3.3% -42.9% 42.9%

Bayberry Office Plus saw significant increases in gross profit, which led to a 195.5% increase in net income from 2017 to 2018. Total liabilities decreased by nearly 43%, and total stockholders’ equity increased by the same percentage. As a result, the firm’s debt-to-equity ratio greatly improved. However, accounts receivable increased by over ten percent, which indicates that the firm may be having trouble collecting receivables from customers. The significant decrease in total assets is worthy of investigation.

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-15 PROBLEMS P1. [LO 1, 3] a. HG Lang Designs Income Statements Net sales Cost of goods sold Gross margin Operating expenses: Selling expenses General and administrative expenses Total operating expenses Operating income Interest expense Income before taxes Income taxes Net income

Year Ended December 31, 2018

Year Ended December 31, 2017

$ 20,632,000 14,442,000 6,190,000

100.0% 70.0% 30.0%

$ 19,282,000 12,533,000 6,749,000

100.0% 65.0% 35.0%

640,000

3.1%

578,000

3.0%

2,682,000 3,322,000 2,868,000 29,000 2,839,000 994,000 $ 1,845,000

13.0% 16.1% 13.9% 0.1% 13.8% 4.8% 9.0%

2,314,000 2,892,000 3,857,000 38,000 3,819,000 1,337,000 $ 2,482,000

12.0% 15.0% 20.0% 0.2% 19.8% 6.9% 12.9%

Ms. Aiello is most likely to focus on the increase in cost of goods sold (from 65% of sales to 70%). b. The current gross margin is $6,190,000. If cost of goods sold had stayed at 65%, the gross margin would have been $7,221,200 (i.e., 35% of $20,632,000). P2. [LO 3] a. Inventory turnover $14,442,000 ÷ $1,795,000 $12,533,000 ÷ $1,764,000 Days’ sales in inventory 365 ÷ 8.05 365 ÷ 7.11

2018

2017

8.05 7.11

45.34 51.34

b. Considering the industry average turnover is around 7.00 and days’ sales in inventory is around 52, the performance at HG Lang in 2018 is quite good and better than in 2017.

14-16 Jiambalvo Managerial Accounting P3. [LO 3] a. Current ratio $2,274,000 ÷ $175,000 $2,250,200 ÷ $186,200

2018

2017

12.99 12.08

Acid-test ratio ($65,000 + $352,000) ÷ $175,000 ($88,000 + $333,200) ÷ $186,200

2.38

Debt-to-equity ratio $486,000 ÷ $3,399,000 $552,200 ÷ $3,309,000

.14

Times interest earned $2,868,000 ÷ $29,000 $3,857,000 ÷ $38,000

98.90

2.26

.17

101.50

b. The ratios indicate that HG Lang is not likely to have any difficulty paying its bill to Mode Milano. P4. [LO 1, 3] a. With a $1,500,000 loan, the debt to equity ratio would be 0.58: $1,986,000* ÷ $3,399,000 = .58 *($1,500,000 + $486,000) b. With $110,000 more of interest expense, times interest earned would be 20.63: $2,868,000 ÷ $139,000* = 20.63 *($29,000 + $110,000) c. The bank manager, most likely, would be favorably inclined to make the loan. Even with the loan, the company has more equity than debt and income from operations is more than 20 times interest expense. HG Lang should have no difficulty making loan payments.

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-17 P5. [LO 2] a. The three strategies do, indeed, appear to constitute manipulation of earnings. The first strategy (often referred to as a bill and hold strategy) is being undertaken purely to shift income from a future period to the current period. Note that the customers are not being offered a discount to encourage a sale— the discount is being offered just so the company can book the sale early. The second strategy involves setting up a so-called cookie jar reserve. This involves overestimation of a restructuring charge so that income can be taken out of the reserve (i.e., the cookie jar) when needed to meet an earnings target. The third strategy simply violates the principle of conservatism. b. Each of the strategies would affect income but not cash flow. Thus, a comparison of net income and cash flow from operations might detect the earnings manipulation. c. The strategies are not consistent with ethical behavior. The boost in current period earnings enriches senior management but at the cost of misleading investors. P6. [LO 3] Based on the limited information, Danny should be cautious. Inventory turnover at Venture has declined from 5.63 to 4.20. This may be due to obsolete inventory. And note that the quick ratio (also called the acid-test ratio) which excludes inventory is rather low and has declined significantly. Also, Venture has taken on $6,200,000 in debt, most likely to help finance the investment in technology needed to monitor inventory levels. On the positive side, however, Venture generated over $6,100,000 of cash flow from operations in 2018. All in all, Danny should probably focus on whether the deal will really save money due to lower prices and improved inventory turnover. If this is the case, entering into the deal is probably a good idea.

14-18 Jiambalvo Managerial Accounting P7. [LO 2,3] a. Gross margin percentage Sales Cost of merchandise sold Gross margin Gross margin percentage

2017 $4,900,000 3,550,000 $1,350,000

2016 $4,800,000 3,500,000 $1,300,000

27.6%

27.1%

b. It appears that the company has done a good job of managing its gross margin. Note that the gross margin has increased even though pharmacy sales have increased and they have lower (and declining) gross margin percents compared to sales of other products carried at Balmer. c. Inventory turnover $3,550,000 ÷ $460,000 $3,500,000 ÷ $500,000 Days’ sales in inventory 365 ÷ 7.72 365 ÷ 7.00

2017 7.72

2016 7.00

47.28 52.14

It appears that the company has done a good job of controlling its inventory. Days’ sales in inventory is down from 52 days to 47 days.

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-19 P8. [LO 3] a. Percentage change in sales Percentage change in gross margin

Bell 6.5% 22.6%

Gangway 5.5% 6.6%

Gross margin percent 2017 Gross margin percent 2016

Bell 19.1% 16.6%

Gangway 18.0% 17.8%

Inventory turnover 2017 Inventory turnover 2016

Bell 41.92 72.58

Gangway 18.29 19.80

Days’ sales in inventory 2017 Days’ sales in inventory 2016

8.71 5.03

19.96 18.43

It appears that Bell’s performance has been better than Gangway’s performance. It had a larger increase in sales and gross margin, and in the most recent year it had a higher gross margin percent. Also, its inventory turnover is much better than Gangway’s inventory turnover.

P9. LO 4, 5 The gross margin percentages are the same as those calculated in P8. According to the excerpt, Bell cut its prices, but it still had an increase in its gross margin percentage and sales. Bell has effectively passed cost savings onto its customers, allowing the firm to increase its gross margin and sales.

14-20 Jiambalvo Managerial Accounting P10. [LO 1, 3] a. Horizontal Analysis: Mandrake Motorcycles Balance Sheets

December 31, December 31, 2018 2017

Stockholders’ equity Common stock Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity

425,000 200,000 630,000 210,000 1,465,000 1,175,000 $ 2,640,000

Percentage Change

$ (185,000) (15,000) 220,000 (10,000) 10,000 (100,000) $ (90,000)

-43.5% -7.5% 34.9% -4.8% 0.7% -8.5% -3.4%

205,000 320,000 280,000 805,000 410,000 1,215,000

55,000 50,000 5,000 110,000 (215,000) (105,000)

26.8% 15.6% 1.8% 13.7% -52.4% -8.6%

1,325,000 115,000 1,440,000

1,325,000 100,000 1,425,000

-015,000 15,000

0.0% 15.0% 1.1%

$ 2,550,000

$ 2,640,000

(90,000)

-3.4%

Liabilities and stockholders’ equity Current liabilities Accounts payable $ 260,000 Short-term debt payable 370,000 Other current liabilities 285,000 Total current liabilities 915,000 Long-term debt 195,000 Total liabilities 1,110,000

Change

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-21

Mandrake Motorcycles Income Statements Net sales Cost of goods sold Gross margin Operating expenses: Selling expenses General and administrative expenses Total operating expenses Operating income Interest expense Income before taxes Income taxes Net income

Year Ended Year Ended December 31, December 31, 2018 2017 $ 1,590,000 980,000 610,000

$ 1,690,000 1,175,000 515,000

300,000 210,000 510,000 100,000 48,000 52,000 18,200 33,800

$ (100,000) $ (195,000) $ 95,000

-5.9% -16.6% 18.4%

210,000

90,000

42.9%

200,000 410,000 105,000 72,000 33,000 11,550 21,450

$ $ $ $ $ $ $

10,000 5.0% 100,000 24.4% (5,000) -4.8% (24,000) -33.3% 19,000 57.6% 6,650 57.6% 12,350 57.6%

14-22 Jiambalvo Managerial Accounting Vertical Analysis: Mandrake Motorcycles Balance Sheets

December 31, 2018

Assets Current assets Cash and cash equivalents $ 240,000 Accounts receivable 185,000 Inventory 850,000 Other current assets 200,000 Total current assets 1,475,000 Property, plant and equipment, net 1,075,000 Total assets $ 2,550,000 Liabilities and stockholders’ equity Current liabilities Accounts payable $ 260,000 Short-term debt payable 370,000 Other accrued payables 285,000 Total current liabilities 915,000 Long-term debt 195,000 Total liabilities 1,110,000 Stockholders’ equity Common stock 1,325,000 Retained earnings 115,000 Total stockholders’ equity 1,440,000 Total liabilities and stockholders’ equity

$ 2,550,000

December 31, 2017

9.4% 7.3% 33.3% 7.8% 57.8% 42.2% 100.0%

425,000 200,000 630,000 210,000 1,465,000 1,175,000 $ 2,640,000

16.1% 7.6% 23.9% 8.0% 55.5% 44.5% 100.0%

10.2% 14.5% 11.2% 35.9% 7.6% 43.5%

205,000 320,000 280,000 805,000 410,000 1,215,000

7.8% 12.1% 10.6% 30.5% 15.5% 46.0%

52.0% 4.5% 56.5%

1,325,000 100,000 1,425,000

50.2% 3.8% 54.0%

100.0%

$ 2,640,000

100.0%

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-23

Year Ended December 31, 2018 $ 1,590,000 980,000 610,000

100.0% 61.6% 38.4%

300,000

18.9%

210,000

12.4%

210,000 510,000 100,000 48,000 52,000 18,200 33,800

13.2% 32.1% 6.3% 3.0% 3.3% 1.1% 2.1%

200,000 410,000 105,000 72,000 33,000 11,550 21,450

11.8% 24.3% 6.2% 4.3% 2.0% 0.7% 1.3%

Year Ended December 31, 2017 $ 1,690,000 100.0% 1,175,000 69.5% 515,000 30.5%

b. 2018 Return on total assets [$33,800 + (48,000 x (1 – 0.35))] ÷ $2,550,000 [$21,450 + (72,000 x (1 – 0.35))] ÷ $2,640,000

0.025

Gross margin percentage $610,000 ÷ $1,590,000 $515,000 ÷ $1,690,000

0.384

Accounts receivable turnover $1,590,000 ÷ $185,000 $1,690,000 ÷ $200,000

8.59

Days’ sales in receivables 365 ÷ 8.59 365 ÷ 8.45

42.49

Inventory turnover $980,000 ÷ $850,000 $1,175,000 ÷ $630,000

1.15

Days’ sales in inventory 365 ÷ 1.15 365 ÷ 1.87

317.39

Debt-to-equity ratio $1,110,000 ÷ $1,440,000 $1,215,000 ÷ $1,425,000

0.77

2017

0.026

0.305

8.45

43.20

1.87

195.19

0.85

14-24 Jiambalvo Managerial Accounting Times interest earned $100,000 ÷ $48,000 $105,000 ÷ $72,000

2.08 1.46

c. The company has had an increase in inventory but it also has very poor inventory turnover (only 1.15 in the most recent year). Also, while sales are down, cost of goods sold as a percentage of sales has also declined. This may be due to “overproduction.” If the company produced more than it needed to meet current period sales, unit cost would decrease (the company would be able to “bury” fixed manufacturing overhead in ending inventory). d. Monk should not open a Mandrake showroom unless he gets solid answers to the “red flags” indicated in part c. It is particularly troubling that sales have decreased. P11. [LO 1, 3] This information is quite consistent with what we concluded in part c of P10. Inventory is building up while cost of goods sold as a percent of sales is declining. If the company overproduced, unit costs would decline and cost of goods sold as a percent of sales would decline. However, inventory would increase.

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-25 P12. [LO 3] 1. a. Current Ratio ($145,000 + $85,000 + $268,000 + $137,000 + $34,000) ÷ ($217,000 + $68,000 + $46,000) = 2.02 b. Acid-Test (Quick Ratio) ($145,000 + $85,000 + $268,000) ÷ ($217,000 + $68,000 + $46,000) = 1.505 2.

1. Paid a cash dividend previously declared 2. Issued additional shares of common stock for cash 3. Sold inventory costing $80,000 for $115,000, on account 4. Declared a cash dividend of $19,000 5. Paid accounts payable of $85,000 6. Borrowed cash on a short-term note with the bank, $57,000 7. Purchased inventory on account for $91,000 8. Paid off all short-term notes due $68,000 9. Purchased equipment for cash, $23,000 10. Sold marketable securities costing $29,000 for $25,000 11. Collected cash on accounts receivable, $137,000 12. Paid interest on a note payable, $3,500

The Effect on Current Acid-test Ratio (Quick Ratio) increase increase increase

increase

increase decrease increase

decrease decrease increase decrease

decrease

none increase

14-26 Jiambalvo Managerial Accounting P13. [LO 1] a. Bao Corporation Comparative Balance Sheet December 31, 2018 and 2017 2018 Assets Current Assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property and equipment: Land Building and equipment, net Total property and equipment Total assets

Liabilities and Stockholders' Equity Current liabilities: Accounts payable Accrued expenses Notes payable, short term Total current liabilities Long-term liabilities: Bonds payable Notes payable Total long-term liabilities Total liabilities Stockholders' equity: Common stock Additional paid-in capital Total paid-in capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

2017

$1,900 9,100 11,300 560 22,860

1.2% 5.8% 7.2% 0.4% 14.5%

$1,300 7,300 9,100 250 17,950

0.8% 4.7% 5.8% 0.2% 11.5%

86,000

54.6%

86,000

55.2%

48,600 134,600 $157,460

30.9% 85.5% 100.0%

52,000 138,000 $155,950

33.3% 88.5% 100.0%

$17,600 1,620 540 19,760

11.2% 1.0% 0.3% 12.5%

21,000 4,430 220 25,650

13.5% 2.8% 0.1% 16.4%

5,300 34,400 39,700

3.4% 21.9% 25.3% 37.8%

5,300 35,000 40,300 65,950

3.4% 22.4% 25.8% 42.3%

11,000 19,000 30,000 68,000 98,000

7.0% 12.1% 19.1% 43.2% 62.2%

11,000 19,000 30,000 60,000 90,000

7.1% 12.2% 19.2% 38.5% 57.7%

$157,460

100.0%

$155,950

100.0%

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-27 b. Bao Corporation Comparative Income Statement For the Years Ended December 31, 2018 and 2017

Sales Cost of goods sold Gross margin Operating expenses: Selling expenses Administrative expenses Total operating expenses Net operating income Interest expense Income before taxes Less income taxes Net Income

2018 $130,000 67,000 63,000

100.0% 51.5% 48.5%

2017 $111,000 61,000 50,000

100.0% 55.0% 45.0%

24,500

18.8%

20,000

18.0%

17,500 42,000 21,000 5,600 15,400 6,160 $ 9,240

13.5% 32.3% 16.2% 4.3% 11.8% 4.7% 7.1%

14,600 34,600 15,400 4,700 10,700 4,280 $ 6,420

13.2% 31.2% 13.9% 4.2% 9.6% 3.9% 5.8%

There have not been any radical changes between 2017 and 2018. Perhaps the most significant change is that liabilities are down as a percent of total assets.

A significant issue is that the company doesn’t appear to be growing or investing in the future. Note that the investment in building and equipment has declined (but not by much).

Develop a strategy for continuous growth and another strategy for “breakthrough” (i.e., very significant) growth. Then, prepare budgets that estimate the financial impact of these strategies.

14-28 Jiambalvo Managerial Accounting P14. [LO 1] a. Bao Corporation Horizontal Analysis December 31, 2018 and 2017 Assets Current Assets: Cash Accounts receivable net Inventory Prepaid expenses Total current assets Property and equipment: Land Building and equipment, net Total property and equipment Total Assets

2018 $ 1,900 9,100 11,300 560 22,860

2017 $ 1,300 7,300 9,100 250 17,950

Change $600 1,800 2,200 310 4,910

Percent Change 46.2% 24.7% 24.2% 124.0% 27.4%

86,000

0.0%

48,600 134,600 $157,460

52,000 138,000 $155,950

-3,400 -3,400 1,510

-6.5% -2.5% 1.0%

$17,600 1,620 540 19,760

21,000 4,430 220 25,650

-3,400 -2,810 320 -5,890

-16.2% -63.4% 145.5% -23.0%

5,300 34,400 39,700 59,460

5,300 35,000 40,300 65,950

0 -600 -600 -6,490

0.0% -1.7% -1.5% -9.8%

11,000 19,000 30,000 68,000 98,000

11,000 19,000 30,000 60,000 90,000

0 0 0 8,000 8,000

0.0% 0.0% 0.0% 13.3% 8.9%

$157,460

$155,950

1,510

1.0%

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-29 b. Bao Corporation Horizontal Analysis For the Year Ended December 31, 2018 and 2017

Sales Cost of Goods Sold Gross margin Operating expenses: Selling expenses Administrative expenses Total operating expenses Net operating income Interest expense Net income before taxes Less income taxes Net Income

2018 $130,000 67,000 63,000

2017 $111,000 61,000 50,000

Change $19,000 6,000 13,000

Percent Change 17.1% 9.8% 26.0%

24,500

20,000

4,500

22.5%

17,500

14,600

2,900

19.9%

42,000 21,000 5,600 15,400 6,160 $ 9,240

34,600 15,400 4,700 10,700 4,280 $ 6,420

7,400 5,600 900 4,700 1,880 2,820

21.4% 36.4% 19.2% 43.9% 43.9% 43.9%

Not much has changed—and that may be the company’s most significant problem! Sales are up 17% but the change is really only $19,000.

Lack of significant growth.

See answer to e in problem 14-13.

P15. [LO 3] a. Current Ratio = $22,860 ÷ 19,760 = 1.157 Acid-test (Quick) Ratio = ($1,900 + $9,100) ÷ $19,760 = 0.557 Accounts Receivable Turnover = $130,000 ÷ $9,100 = 14.29 times Inventory Turnover = $67,000 ÷ $11,300 = 5.93 times Return on Assets = [$9,240 + ($5,600 x (1 – ($6,160 ÷ $15,400)))] ÷ $157,460 = 0.08 = 8.0% Debt-to-Equity Ratio = $59,460 ÷ 98,000 = 0.607 Times Interest Earned = $21,000 ÷ $5,600 = 3.75 b.

Bao’s current ratio is greater than 1, demonstrating that it has an ability to meet short-term obligations. However, its quick ratio is significantly lower, indicating that much of the firm’s current assets are inventory. Bao does appear to be collecting its accounts receivable on a timely basis as its accounts receivable turnover is greater than the industry average. However, its inventory turnover is

14-30 Jiambalvo Managerial Accounting slightly less than the industry expectation. Also, Bao’s return on assets, debt-toequity ratio, and times interest earned are significantly less than what is expected for companies in its industry. c.

Based on the analysis in part b., the loan appears to be a bit risky. The company isn’t that profitable and a $30,000 loan is more than 3 times net income.

P16. [LO 3] 1. It is becoming easier for Mendella to pay its bills as they come due because its current ratio has increased in each of the past two years. 2.

No, customers are not paying their accounts as well as they did in Year 1. In Year 1, Mendella’s accounts receivable turnover was 11.5, but in Year 3, it was 9.2.

Mendella’s inventory level is likely increasing since its inventory turnover has decreased both in Year 2 and Year 3.

Mendella’s market price is likely going down because its price-earnings ratio decreased in Year 2 and Year 3.

Mendella is employing financial leverage to the advantage of the common stockholders because its return on common stockholders’ equity is greater than return on assets.

P17. [LO 3] 1. decrease 2. increase 3. decrease 4. increase 5. increase 6. decrease 7. decrease 8. increase 9. decrease 10. increase

Chapter 14 Analyzing Financial Statements: A Managerial Perspective 14-31 P18. [LO 3] a. 2018 Gross Margin Percentage ($2,725,100 - $1,962,000) ÷ $2,725,100 ($2,500,000 - $1,747,000) ÷ $2,500,000

2017

28.0% 30.1%

b. The company has not managed its gross margin well. It has seen an increase in nongrocery items that have lower margins than grocery items. The firm should look to increase its sales of grocery items, which have higher gross margins. c. 2018

Inventory Turnover $1,962,000 ÷ $307,000 $1,747,000 ÷ $320,000

6.39

Days’ Sales in Inventory 365 ÷ 6.39 365 ÷ 5.46

57.12

2017

5.46

66.85

The company has effectively controlled its investment in inventory. Its inventory turnover ratio improved from 5.46 in 2017 to 6.39 in 2018. Thus, its number of days’ sales in inventory decreased in 2018.

14-32 Jiambalvo Managerial Accounting Case 14-1 [LO 1, 3]

JORDAN-WILLIAMS, INCORPORATED Summary Jordan-Williams Incorporated (JWI) is considering a strategic partnership with NetKnowledge (NK) and senior management of JWI is evaluating the financial analysis in a report from its due diligence team. •

Links financial analysis to an important management decision.

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Case is unstructured in that rather than specifying specific calculations, students are requested to perform whatever analysis they deem appropriate.

Questions to ask students 1. What is the situation facing JWI? 2. What are your thoughts on the memo prepared by Ted Chapman? 3. Should JWI pursue an alliance with NK? Discussion What is the situation facing JWI? JWI is a publisher of college textbooks that wants to enter the market for manager training. Their plan is to partner with a company that has the technology to deliver JWI’s content via the Internet. The company they are considering is NK, and a due diligence team headed by Ted Chapman has just finished a review of the company. Ted argues that NK, while in a loss position, will be profitable in three years. And NK has the cash to sustain it until it reaches profitability. What are your thoughts on the memo prepared by Ted Chapman? Ted’s analysis suggesting that NK will be profitable in three years is overly optimistic. He assumes that revenue will grow by 20 percent per year, but costs will not increase at all. Indeed, he assumes that costs will stay at a level of 80% of the prior year (2017). This seems highly unlikely considering that NK is a technology company and the technology it needs is likely to change rather dramatically over the next three years, requiring increased investments. Also, Ted has made a serious error in interpreting NK’s cash flow statement. He estimates that NK is “burning” approximately $11,000,000 of cash per year. Actually, that amount is the decrease in cash during fiscal 2017 (specifically, $10,800,000). However, during the year the company issued $13,000,000 in long term debt. Focusing on cash used in operating activities, it is clear that the company burned over $23,000,000 in cash. Pursuing an alliance with NK does not appear to be a good idea. The company is in a severe cash crunch and will need an immediate infusion of cash to survive. And it seems unlikely that the company will be able to attract equity investors. Note especially that the company had a net loss of nearly $32 million in 2017.