TEST BANK for Criminal Investigation 12th Edition by Charles Swanson, Neil Chamelin and Leonard Terr by StudyGuide

CHAPTER 1 BASIC FINANCIAL ACCOUNTING REVIEW INTRODUCTION This chapter reviews basic accounting principles and procedures. It is a necessary chapter for those whose accounting background is poor. If students have recently completed an introductory accounting course, this chapter could be omitted, or assigned for self review. Chapters 1 and 2 lay the foundation for most of the remaining chapters in the textbook.

TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True answers and F for False answers)

1. Accounting principles and concepts are broad rules developed to create a common language used by accountants.

2. A business owner’s personal assets should be included with the assets of the business entity.

3. The cost principle of valuing assets may not indicate the true value of the assets as time goes by.

4. Accrual accounting is based on the principle of matching sales revenue with expenses.

5. Cash basis accounting is never used in business.

6. The full-disclosure principle states that all accounting records should be available at any time to anyone who wants to look at them.

7. Changing depreciation methods from one period to the next would not conform to the principle of consistency.

8. The materiality of a particular transaction may need to be considered in deciding whether or not to conform to other accounting principles.

9. Depreciation is a method of allocating the cost of a long-lived asset to an expense over the life of the asset.

10. Straight-line depreciation allocates the cost of a long-lived asset in equal units of time over the life of the asset.

11. Assets plus liabilities equal ownership equity.

12. Sales revenue − Cost of sales = Gross Margin.

13. The term operating income identifies operating income before income tax.

14. Assets − ownership equity equals liabilities.

15. Double-entry-accrual accounting ensures the balance sheet equation is always kept in balance, as long as no errors are made in recording and posting transactions.

16. The debit side of a ledger account is always the left column. It is used to post debit values of a transaction.

17. A debit entry to a debit balanced ledger account will decrease the balance of the account.

18. A credit entry to a credit balanced account will increase the account balance.

19. An expense account carries a normal debit balance.

20. A trial balance showing the total of the debit and credit balanced accounts are equal at the end of an accounting period indicates all entries have been correctly posted.

21. Adjusting entries are normally necessary at the end of an accounting period to conform to the matching principle.

22. Beginning inventory + Purchases − Ending inventory = Cost of goods sold.

23. A sales revenue account is debit balanced.

24. The portion of a prepaid account to be expensed will require a debit to the prepaid account and a credit to an expense account.

25. End of period adjusting entries is recorded in a journal before the adjustments are posted to the ledger accounts.

MULTIPLE CHOICE QUESTIONS (Correct answers indicated by asterisk)

1. A cocktail lounge owner who takes home liquor for private parties at home without reflecting this in the lounge’s accounting records is violating the: (a) Matching principle (b) Going concern concept * (c) Business entity concept (d) Cost principle 2. A restaurant that records all purchases of food and beverages as an expense at the time of purchase and does not consider the end of period inventories would be violating the: (a) Cost principle (b) Materiality concept (c) Full disclosure principle * (d) Matching principle 3. The cost principle is concerned with: * (a) Recording items in the accounting records at their actual cost (b) Matching the cost of items with the related sales revenue (c) Valuing long-lived assets at their current market value rather than at cost (d) Setting menu prices at a certain mark-up over cost

4. The balance sheet equation can be expressed as: (a) Assets = Liabilities + Owners’ equity (b) Assets − Liabilities = Owners’ equity (c) Assets − Ownership equity = Liabilities * (d) All of the above 5. A restaurant purchased a new point of sale terminal by paying one-half of its cost in cash and owing the balance on account. The journal entry requires a: (a) debit to an asset and a credit to two liability accounts * (b) debit to an asset, a credit to an asset, and a credit to a liability (c) debit to an asset, a debit to a liability, and a credit to a liability (d) debit to two assets and a credit to a liability account 6. The length of the period of an accounting cycle is: * (a) A length of time that the business deems desirable and appropriate (b) A week at least (c) Monthly for all hospitality enterprises (d) Quarterly for a resort hotel 7. If cash was paid for a two-year $3,600 insurance policy on July 1, the amount of the insurance expensed on December 31 is: (a) $1,800 * (b) $ 900 (c) $2,700 (d) $ 600 8. A five-year depreciable asset cost $10,000 and had a residual value of $1,000. What is the balance of its accumulated depreciation account at the end of two years using straight-line depreciation? (a) $6,000 (b) $4,000 (c) $5,400 * (d) $3,600 9. Which of the following is correct? (a) Debits decrease assets (b) Debits decrease assets; credits increase liabilities (c) Debits increase owners’ equity * (d) Debits increase assets 10. Cost of goods sold is calculated as: (a) Beginning inventory + Ending inventory − Purchases * (b) Beginning inventory + Purchases − Ending inventory (c) Beginning inventory − Ending inventory − Purchases (d) Beginning inventory + Ending inventory + Purchases

11. The normal balance of each of the five basic categories of balance sheet and income statement accounts are either debit or credit balanced. Which of the following is not correct? * (a) Ownership equity: A debit balanced account (b) Liability: A credit balanced account (c) Expense: A debit balanced account (d) Asset: Debit balanced account 12. The inflow of assets as a result of business operations occurs from: (a) A capital investment (b) Borrowing through long-term debt * (c) The sales of goods and services (d) Incurring expenses 13. The posting of a transaction refers to: (a) Recording the balances of all accounts in the ledger to an unadjusted trial balance * (b) Entering amounts in ledger accounts as directed by general journal entries (c) Comparing postings from the general journal to the ledger accounts (d) Recording transactions in a general journal 14. The outflow of assets as a result of business operations are called: * (a) Expenses (b) Sales revenue (c) Ownership equity (d) Receivables 15. A restaurant purchased an ice machine for $4,000 paying $1,000 in cash with the balance carried on account. The journal entry to record this transaction is which of the following? (a) Debit equipment $4,000, credit cash $1,000 * (b) Debit equipment $4,000, credit cash $1,000 and credit accounts payable $3,000 (c) Debit equipment $1,000, credit accounts payable $3,000 (d) Debit equipment $3,000, credit cash $4,000 16. A ledger shows: (a) A chronological record of all accounting transactions (b) A balance of all balance sheet accounts (c) A balance of all income statement accounts * (d) A balance of all accounts

EXERCISE SOLUTIONS E1.1

a. The Full Disclosure principle b. The Full Disclosure and the Consistency principles c. The Matching principle d. The Going Concern and the Cost principle e. The Business Entity principles f. The Conservatism principle g. The Materiality concept

E1.2

Write a short explanation of the following terms: a. Operating Income: Describes income before income taxes when sales revenue is greater than total costs. b. Sales revenue: Sales revenue produced from the sale of goods and services. c. Net Income: Describes income after income taxes are deducted from operating income. d. Gross margin: Sales revenue minus cost of sales. e. Net loss: Describes operating income when sales revenue is less than total costs. f. Breakeven: Describes operating income when sales revenue is equal to total costs.

E1.3

Identify the normal balance as Debit or Credit for each of each the following: Ownership Sales Operating Account: Assets Liabilities Equity Revenue Expenses Balance: Debit Credit Credit Credit Debit

E1.4

Write the abbreviated linear equation for the balance sheet and income statement. Balance Sheet: A = L + OE Income Statement: SR – CS = GM – E = OI – Income tax = NI (or NL)

E1.5 At the end of an accounting period, it was determined that wages of employees $858 and management salaries $1,400 have been earned. Journalize the entry to accrue the wages and salaries expense. Account Titles

Debit

Wages expense Salaries expense Payroll payable

Credit

858 1,400 $ 2,258

E1.6 A restaurant reported the following for the first quarter of year 0007: Sales revenue (SR) of $420,680, cost of sales (CS) $201,928, and total expenses (TE) of $175,170. Find the gross margin (GM) and net income (NI). SR – $420,680 –

CS $201,928

= =

GM $218,752

– –

E = $175,170 =

NI $43,582

E1.7 For the month of March, a restaurant reported a beginning food inventory (BI) of $18,662, ending food inventory (EI) of $16,882 and food purchases (P) for resale was $197,900. What was the cost of food sales (CS) for the month of March? BI $18,662

+ P + $197,900

= =

GA $216,562

– –

EI $16,882

= =

CS $199,680

E1.8 Restaurant had $8,480 supplies on hand at the beginning April. During the month $11,222 of supplies was purchased. At the end of the month a check of the supplies indicated that $8,104 of supplies was on hand. Determine the amount of supplies used and journalize the adjusting entry. Beginning $8,480

+ Purchases + $11,222

= Available = $19,702

Account Titles

Supplies expense Supplies

– –

Debit

Ending $8,104

= Used = $11,598

Credit

$ 11,598 $ 11,598

E1.9 Equipment was purchased for $70,468. The equipment is estimated to have a serviceable life of 8 years and a residual value of $2,500. Using straight-line depreciation, answer the following: a. (Cost – Residual) / Life (time) = Depreciation expense $70,468 $2,500 = $67,968 / 8 years = $8,496 $67,968 / 96 months = $708 per month b. Give the journal entry to record the depreciation expense for one year. Account Titles

Debit

Depreciation Expense Accumulated Depreciation: Equipment

Credit

$ 8,496 $ 8,496

E1.10 A new van was purchased for $40,000 and was estimated to have a life of 4 years or 110,000 miles; trade in (residual) value is estimated to be $4,800. In the first year, the van was driven for 27,500 miles. a. Use the units-of-production method to determine the depreciation per mile (unit) and, b. total depreciation expense for the first year. (Cost – Residual) / Life (units) = Depreciation per unit a. ($40,000 − $4,800) / 110,000 (miles) = $35,200 / 110,000 = $0.32 per mile c. Depreciation per unit × Units = Depreciation expense $0.32 × 27,500 miles = $8,800 depreciation expense, Year 1 E1.11 Equipment was purchased for $46,400 with an estimated life of 8 years and a residual value of $4,000. What is depreciation expense for the first year, a. Using Sum of the years’ digits and, b. Double declining balance depreciation methods and the book value as of first day of year 2. a. SYD Numerator: Max-years of life in the 1st year minus 1 each subsequent year. SYD Denominator: n (n + 1) / 2 = 8(8 + 1) / 2 = 72 / 2 = 36 SYD fraction × (Cost − Residual) = Depreciation expense 8/36 × ($46,400 − $4,000) = 8/36 × $42,400 = $9,422.22  $9,422 b. DDB%: SL Rate × 2 = 100% / 8 = 12.5% × 2 = 25% Or: 200% / 8 = 25% DDB%: Depreciation expense: 25% × $46,400 = $11,600

E1.12 A restaurant paid $9,120 cash in advance for liability and casualty insurance for two years of coverage: a. Journalize the transaction for the prepaid. Account Titles

Debit

Prepaid Insurance Cash

Credit

9,120 $ 9,120

b. What is the insurance expense for one year and for one month? Prepaid cost / Prepaid life (years) = Insurance expense per year $9,120 / 2 years = $4,560 per year Prepaid cost / Prepaid life (months) = Insurance expense per month $9,120 / 24 months = $380 per month c. Record journal entry for six months of insurance expense

E1.13

Account Titles

Debit

Insurance Expense (6 × $380) Prepaid Insurance

$ 2,280 $ 2,280

Referring to the journal entries you completed for E1.12 (a) and (c), name and post the journal entries using the modified T account format as shown below.

Name:

Cash

Debit

Credit

(Beginning Balance)

Credit

Name: Prepaid Insurance Balance

$24,400 $9,120 15,280

Debit (Beginning Balance)

$9,120

Credit

Balance

$ -09,120 $ 2,280 6,840

Name: Insurance Expense Debit

Credit

(Beginning Balance)

Balance

$ -0$2,280

$2,280

E1.14 A business using the cash basis of accounting cannot locate all of its records for one month of operations. Beginning cash $22,260, ending cash $18,388, and cash payments were $162,800. Determine the unknown cash sales revenue: Beginning Cash Cash$22,260

+ +

Cash Sales? Unknown?

− –

Cash Payments $162,800

= =

Ending Cash

$18,388

Reverse the functions of (+) and (−) beginning with Ending Cash Ending Cash + Cash Payments – Beginning Cash = Cash Sales? $18,388 + $162,800 – $22,260 = $158,928 Proof

Beginning Cash + $22,260 +

Cash Sales 158,928

− –

Cash Payments $162,800

= =

Ending Cash $18,388

E1.15 A restaurant pays $10,800 in advance for six months’ building rent in advance and recognizes rental expense every month. a. What is the monthly rental expense? $10,800 / 6 (months) = $1,800 per month b. Journalize the monthly adjusting entry. Account title

Debit

Rent Expense Prepaid Rent

Credit

$ 1,800 $ 1,800

PROBLEM SOLUTIONS P1.1

Part 1: Solution, analysis of transactions and creation of Journal Entries. a. Owner opened a business account and deposited $60,000 in the bank. Account Titles

Debit

Cash Capital (OE)

Credit

$ 60,000 $ 60,000

b. Owner borrowed and deposited $30,000 on a note payable to the bank. Account Titles

Debit

Cash Note Payable

Credit

$ 30,000 $ 30,000

c. Owner paid one year of rent in advance, $18,000 cash. Account Titles

Debit

Prepaid Rent Cash

Credit

$ 18,000 $ 18,000

d. Purchased equipment $46,000; $16,000 cash and the balance on account. Account Titles

Debit

Equipment Cash Accounts Payable

Credit

$ 46,000 $ 16,000 30,000

e. Furnishings were purchased for $30,400 cash. Account Titles

Debit

Furnishings Cash

Credit

$ 30,400 $ 30,400

f. Owner purchased $3,200 of food inventory on account and paid $3,800 cash for beverage inventory. Account Titles

Debit

Food Inventory Beverage Inventory Accounts Payable Cash

Credit

$ 3,200 3,800 $ 3,200 3,800

g. Owner purchased supplies for $2,650 cash. Account Titles

Debit

Supplies Cash

Credit

$ 2,650 $ 2,650

h. Owner purchased $3,800 of food inventory on account. Account Titles

Debit

Food Inventory Accounts Payable

Credit

$ 3,800 $ 3,800

i. Owner paid $2,700 for a one-year liability and casualty insurance policy. Account Titles

Debit

Prepaid Insurance Cash

Credit

$ 2,700 $ 2,700

j. Employees were paid wages $12,800 and salaries $2,400. Account Titles

Debit

Wages Expense Salaries Expense Cash

Credit

$ 12,800 2,400 $ 15,200

k. Sales revenue first month was $42,800: 90% cash, 8% on credit cards, and 2% on accounts receivable. Account Titles

Debit

Cash Credit Card Receivables Accounts Receivable Sales Revenue

Credit

$ 38,520 3,424 856 $ 42,800

l. Owner paid $16,600 on accounts payable. Account Titles

Debit

Accounts Payable Cash

Credit

$ 16,600 $ 16,600

m. Owner paid $8,000 on note payable, plus interest of $960. Account Titles

Debit

Notes Payable Interest Expense Cash

Credit

8,000 960 $ 8,960

P1.1, Part 2: Solution posting journal entries to the General Ledger. Debit (a) $ 60,000 (b) 30,000

Cash Credit

38,520 (l) 16,600 (m) 8,960

Balance $ 60,000 90,000 72,000 56,000 25,600 21,800 19,150 16,450 1,250 39,770 23,170 $ 14,210

Credit card Receivables Debit Credit Balance (k) $ 3,424 $ 3,424 Accounts Receivable Debit Credit Balance (k) $ 856 $ 856 Food Inventory Debit Credit Balance (f) $ 3,200 $ 3,200 (h) 3,800 $ 7,000 Beverage Inventory Debit Credit Balance (f) $ 3,800 $ 3,800

Debit (c) $ 18,000

Prepaid Rent Credit $

Balance 18,000

Prepaid Insurance Debit Credit Balance (i) $ 2,700 $ 2,700

Debit (g) $ 2,650

Debit (d) $ 46,000

Debit (e) $ 30,400

Supplies Credit $ Equipment Credit

Furnishings Credit

Balance 2,650

Balance $ 46,000

Balance $ 30,400

Accounts Payable Debit Credit Balance (d) $ 30,000 $ 30,000 (f) 3,200 33,200 (h) 3,800 37,000 (l) $ 16,600 $ 20,400 Notes Payable Debit Credit Balance (b) $ 30,000 $ 30,000 (m) $ 8,000 $ 22,000 Capital, (OE) Debit Credit Balance (a) $ 60,000 $ 60,000

Debit

Sales Revenue Credit Balance (k) $ 42,800 $ 42,800

Salaries Expense Debit Credit Balance (j) $ 2,400 $ 2,400 Interest Expense Debit Credit Balance (m) $ 960 $ 960

Debit (j) $ 12,800

Wages Expense Credit $

Balance 12,800

P1.1, Part 3: Solution: Unadjusted Trial Balance March 31, 0006 Debit Cash $ 14,210 Credit card receivables 3,424 Accounts receivable 856 Food inventory 7,000 Beverage inventory 3,800 Prepaid rent 18,000 Prepaid insurance 2,700 Supplies 2,650 Equipment 46,000 Furnishings 30,400 Accounts payable Note payable Capital (OE) Sales revenue Wages expense 12,800 Salaries expense 2,400 Interest expense 960 Unadjusted Trial Balance $145,200 P1.2

Credit

$ 20,400 22,000 60,000 42,800

$145,200

Solutions, Adjusting Journal Entries (single compound entry) Account Titles

Debit

(a) Wages expense Salaries expense Payroll payable (b) Rent Expense Prepaid Rent (c) Depreciation Expense Accumulated Depreciation: Equipment Accumulated Depreciation: Furnishings (d) Insurance expense Prepaid insurance (e) Supplies Expense Supplies Inventory (f) Interest Expense Interest Payable

Credit

$ 2,877 1,400 $ 4,277 $ 8,800 $ 8,800 $ 10,700 $ 4,900 5,800 $ 4,000 $ 4,000 $ 1,218 $ 1,218 $

436 $

436

P1.3

Part 1:

Solutions, Journal Entries.

a. Owner invested $250,000 cash deposited in the business bank account. Account Titles

Debit

Cash Capital

Credit

$ 250,000 $ 250,000

b. Owner paid $108,000 cash for land. Account Titles

Debit

Land Cash

Credit

$ 108,000 $108,000

c. Owner borrowed $300,000 on a mortgage payable. Account Titles

Debit

Cash Mortgage Payable

Credit

$ 300,000 $ 300,000

d. Owner paid cash for a building, $285,400. Account Titles

Debit

Building Cash

Credit

$ 285,400 $ 285,400

e. Equipment was purchased for $48,000, paying $12,000 cash, and the balance owed on a note payable. Account Titles

Debit

Equipment Cash Notes Payable

Credit

$ 48,000 $ 12,000 36,000

f. Furnishings were purchased for $120,000 cash. Account Titles

Debit

Furnishings Cash

Credit

$ 120,000 $ 120,000

g. Linen inventory was purchased for $7,894 cash. Account Titles

Debit

Linen Inventory Cash

Credit

7,894 $

7,894

h. Supplies were purchased $3,200 of supplies on account. Account Titles

Debit

Supplies Accounts Payable

Credit

3,200 $

3,200

i. Vending inventory was purchased for $540 cash. Account Titles

Debit

Vending Inventory Cash

Credit

540 $

540

j. Room sales revenue during the month was $58,740; 98% cash and 2% credit cards receivable. Account Titles

Debit

Cash Credit card receivables Room Sales Revenue

Credit

$ 57,565 1,175 $ 58,740

k. Vending sales revenue from vending machines was $880 cash. Account Titles

Debit

Cash Vending Sales Revenue

Credit

880 $

880

l. Wages of $3,120 cash were paid. Account Titles

Debit

Wages Expense Cash

Credit

$ 3,120 $

3,120

m. Owner paid $3,200 cash on accounts payable. Account Titles

Debit

Accounts Payable Cash

Credit

3,200 $

3,200

n. Owner paid $4,200 annual casualty and liability insurance policy. Account Titles

Debit

Prepaid Insurance Cash

Credit

4,200 $

4,200

o. Owner paid $1,600 on the mortgage payable and interest of $1,728. Account Titles

Debit

Mortgage Payable Interest Expense Cash

Credit

$ 1,600 1,728 $ 3,328

P1.3, Part 2: Debit (a) $250,000

Solution, posting journal entries to the general ledger. Cash Credit

Balance $250,000 (b) $ 108,000 142,000 (c) $300,000 442,000 (d) 285,400 156,600 (e) 12,000 144,600 (f) 120,000 24,600 (g) 7,894 16,706 (i) 540 16,166 (j) 57,565 73,731 (k) 880 74,611 (l) 3,120 71,491 (m) 3,200 68,291 (n) 4,200 64,091 (o) 3,328 60,763 Credit Card Receivables Debit Credit Balance (j) $ 1,175 $ 1,175

(i)

Debit $ 540

Debit (n) $ 4,200

Vending Inventory Credit

Prepaid Insurance Credit

Debit (e) $ 48,000

Debit (h) $ 3,200

Debit (g) $ 7,894

Debit (b) $ 108,000 Debit (d) $ 285,400

Linen Inventory Credit

Land Credit Building Credit

Furnishings Credit

Debit (f) $ 120,000

(m) $ 3,200

Debit

Notes Payable Credit (e) $ 36,000

Balance $ 36,000

Debit

Capital (OE) Credit (a) $ 250,000

Balance $ 250,000

Balance $ 4,200

Room Sales Revenue Credit Balance (j) $ 58,740 $ 58,740

Vending Sales Revenue Debit Credit Balance (k) $ 880 $ 880

Balance $ 7,894 Debit (l) $ 3,120 Balance $ 108,000 Balance $ 285,400 14

Balance $ 120,000

Mortgage Payable Debit Credit Balance (c) $ 300,000 $ 300,000 (o) $ 1,600 $ 298,400

Balance $ 540

Balance $ 3,200

Balance $ 48,000

Accounts Payable Credit Balance (h) 3,200 $ 3,200 $ -0-

Debit

Debit Supplies Credit

Equipment Credit

Debit (o) $ 1,728

Wages Expense Credit

Interest Expense Credit

Balance $ 3,120

Balance $ 1,728

P1.3

Part 3: Solutions, Adjusting Journal Entries (separate entries for clarity). 1. The linen account balance is $7,894. Linen inventory on hand is $7,220. $7,894 − $7,220 = $674 linen used. Account Titles

Debit

Linen Expense Linen Inventory 2.

Account Titles

Debit

350

Accrued interest is 1% of note payable ($36,000 × 0.01) = $360 Account Titles

Debit

Credit

360 $

360

Equipment depreciation: ($48,000 − $3,000) / 120 mo. = $375 Account Titles

Debit

Depreciation Expense Accumulated Depreciation: Equipment

Credit

375 $

375

Furnishings depreciation: ($120,000 − $7,000) / 96 mo. = $1,177 Account Titles

Debit

Depreciation Expense $ Accumulated Depreciation: Furnishings 7.

Credit

350 $

Interest Expense Interest Payable

416

One month of prepaid insurance consumed ($4,200 /12) = $350 Account Titles

Credit

416 $

Insurance Expense Prepaid Insurance 4.

674

Wages earned by employees but unpaid is $416. Wages Expense Wages Payable

Credit

674

Credit

1,177 $

1,177

Building depreciation: ($285,400 − $42,000) / 240 mo. = $1,014 Account Titles

Debit

Depreciation Expense Accumulated Depreciation: Building

Credit

1,014 $ 1,014

Note: A compound depreciation expense entry will be used in the future. Account Titles

Debit

Depreciation Expense $ Accumulated Depreciation: Equipment Accumulated Depreciation: Furnishings Accumulated Depreciation: Building 9.

Credit

2,566 $

375 1,177 1,014

Supplies used during the first month are $533. Account Titles

Debit

Supplies Expense Supplies

Credit

533 $

533

P1.4, Task 1: Find the total of cash payments, which are stated in the problem: Cash Payments Purchased truck $ 12,000 Purchased inventories 30,280 Truck operating costs 1,024 Truck loan interest 1,280 Owner cash withdrawals 19,500 Total cash payments $64,084 Task 2: Set up the known information in a linear statement Beginning Cash + $15,000 +

Cash Sales? Unknown

− −

Cash Payments $64,084

= Ending Cash = $28,829

Task 3: Find the missing cash sales by reversing the linear additive functions. Ending Cash + Cash Payments $28,829 + $64,084

− Beginning Cash = $15,000 = −

Cash Sales $77,913

Task 4: Complete an Accrual Income Statement. Fast Snacks Income Statement For the Year Ended 12-31-2006 Sales Revenue Cost of Sales: Beginning Inventory Purchases Goods Available for sale Less: Ending Inventory Cost of Sales Gross Margin Operating Expenses Truck operating expenses Add: Truck expense invoice Interest expense [8% × $12,000] Depreciation expense [20% × $24,000] Total Operating Expenses Operating Income (before tax)

$77,913 -0$30,280 $30,280 ( 624) ( 29,656) $48,257 $ 1,024 280 960 4,800 ( 7,064) $41,193

A proprietary form of business cannot consider assets withdrawn from the business entity by the owner for personal use as an operating expense. Such withdrawals will reduce owner’s equity and is shown in the balance sheet as a contra equity account.

P1.5, Task 1: Find total cash payments, which are stated in the problem. Cash Payments Marina rental [4 × $800] New boats [3 x $5,000] Purchased inventories Boat maintenance and fuel Casual labor Boat loan repayment Interest expense [$15,000 × 0.06] Owner withdrawals [4 × $1,800] Total cash payments

$ 3,200 3,200 15,000 8,754 1,822 2,400 15,000 900 7,200 $54,276

Task 2: Set up the known information in a linear statement Beginning Cash $25,000

+ +

− Cash Payments = $54,276 = −

Cash Sales Unknown?

Ending Cash $22,697

Task 3: Find the missing cash sales by reversing the additive functions. Ending Cash + Cash Payments − Beginning Cash = $22,697 + $54,276 $25,000 = −

Cash Sales $51,973

Task 4: Complete an Accrual Income Statement. Income Statement For the Period Ending 09-15-2006 Sales Revenue $ 51,973 Cost of Sales Purchases [$8,754 + $137 invoice] $ 8,891 Cost of Sales ( 8,891) Gross Margin $ 43,082 Operating Expenses Marina rental expense $ 3,200 Boat maintenance and fuel expense 1,822 Casual labor expense 2,400 Interest expense 900 Depreciation expense [10% × $23,250] 2,325 Total Operating Expenses ( 10,647) Operating Income (before tax) $32,435 • $10,000 − $2,250 = $7,750 × 3 (boats) = $23,250 / 10% = $2,325 • Or: $10,000 − $2,250 = $7,750 × 3 (boats) = $23,250 × 10% = $2,325 • 100% / 10 = 10% straight-line depreciation rate on cost – residual; or 100% of the amount to be depreciated divided by the life of the asset:

CASE 1 SOLUTION Task 1: The missing cash sales represent Sales Revenue. Cash Payments Purchased truck $ 29,000 Inventories purchased 48,222 Truck expenses 3,288 Owner withdraws 28,800 Total cash payments $109,310

Reconciliation Beginning Cash Balance $ 35,000 Unknown Add: Cash Sales Less: Cash Payments (109,310) Ending Cash Balance $ 28,318 ($28,110 + $208 = $28,318)

Task 2: Set up the known information in a linear statement. Beginning Cash + $35,000 +

Cash Sales Unknown

− Cash Payments = $109,310 = −

Ending Cash $28,318

Task 3: Find the missing cash sales by reversing the linear additive functions. Ending Cash $28,318

+ Cash Payments − Beginning Cash = + $109,310 $35,000 = −

Cash Sales $102,628

Task 4: Complete an Accrual Income Statement. 3C Company Income Statement For the Year Ended 12-31-2005 Sales revenue $102,628 Cost of Sales Beginning inventory -0Purchases $48,222 Goods available for sale 48,222 Less: Ending Inventory ( 280) Cost of Sales ( 47,942) Gross Margin $54,686 Operating Expenses Truck operating expenses $ 3,288 Add: Truck expense invoice 188 Depreciation expense [20% × $25,000] _ 5,000 Total Operating Expenses ( 8,476) Operating Income (before tax) $46,210 • Depreciation: ($29,000 – $4,000) / 5 = $25,000 / 5 = $5,000 • Or: 100% / 5 = 20% straight-line depreciation rate on cost – residual; or 100% of the amount to be depreciated divided by the life of the asset is another alternative: 100% / 5 years = 20% per year. ($29,000 – $4,000) x 20% = $25,000 x 20% = $5,000 • Accrual net income does not represent cash. Accrual accounting recognizes inflows of sales revenue when earned and expense outflows when incurred. Non-cash expenses include depreciation. Proprietary withdrawals are not expenses and will reduce owner’s equity.

CHAPTER 2 UNDERSTANDING FINANCIAL STATEMENTS INTRODUCTION For students who have recently completed an introductory accounting course most of this chapter will be review material. However, the chapter explains financial statements in the specific terms used by hospitality industry enterprises; terms that may not be learned in a general business accounting course. Departmental income statements are discussed with emphasis on the calculation of cost of sales for food and beverages as well as the sales revenue mix. Changes in sales revenue mix between departments may affect the overall net income of the business enterprise. If course time does not permit complete coverage of the material in this chapter, it should at least be assigned for self-study. This chapter, along with Chapter 1, provides the foundation for most of the remaining chapters in the textbook. TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True answers and F for False answers) 1. Financial statements provide information useful to management for decision-making.

2. The uniform system of accounts ensures that the financial statement figures of an individual establishment are the same as national average figures.

3. The income statement gives a picture of the financial position of a business at a point in time.

4. Departmental income statements are typical of the hotel industry.

5. Direct expenses are generally the responsibility of, and controllable by the department head concerned.

6. The term FIFO stands for first-in, first-ordered.

7. When a hotel practices responsibility accounting, departments can be identified as either cost centers or production centers.

8. Contributory income is the income for a department, after indirect expenses have been deducted.

9. Indirect expenses should be allocated to the various departments only on a ratio of departmental sales revenue to total sales revenue basis.

10. Indirect expenses are usually controllable by department managers.

11. A department with a high contributory income percent will, with an increase in sales revenue, yield more net income to the overall establishment, than would a department with a lower contributory income percentage having the same sales revenue increase.

12. The balance sheet shows the operating results of a business over a specific period.

13. Marketable and short-term securities are current assets.

14. A hotel’s inventory of china, glass, and silver is usually shown as a current asset.

15. The two common methods of balance sheet presentation are known as the account form and the T form.

16. Accumulated depreciation, like the allowance for uncollectible accounts, is a form of contra accounts shown on the balance sheet.

17. The unexpired portion of a long-term lease paid in advance should be shown as an asset.

18. Credit balances on guests’ accounts receivable should be shown on the balance sheet as a reduction of accounts receivable.

19. A mortgage is a type of long-term liability.

20. Paid in capital, excess of par is the amount by which the present value of a fixed asset exceeds its original purchase price.

21. The only type of stock issued by hotel companies is common stock.

22. Retained earnings represent the accumulation of net incomes, less losses, and dividends, since a company started.

23. Retained earnings are part of the income statement.

24. Retained earnings are the link between the income statement and the balance sheet.

25. The liability and equity sections of a balance sheet show how the company’s assets are currently financed.

26. Ownership withdraws and dividends to stockholders’ are contra accounts.

27. A trial balance that is not in balance always indicates an error exists.

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk) 1. A direct expense is: (a) controllable by the accountant employed by the business (b) deducted from a department’s contributory income *(c) the responsibility of, and controllable by, a department head (d) allocated to a department without a supporting invoice 2. Contributory incomes are: *(a) departmental incomes before deduction of indirect expenses (b) the same as gross margin (c) sales revenues less indirect expenses (d) income before income tax 20

3. Net cost of sales food is calculated by adjusting cost of sales food by: (a) adding opening inventory to purchases and deducting closing inventory *(b) adding transfers in, deducting transfers out, deducting employee meals (c) adding opening and closing inventory to purchases (d) adding transfers in, adding employee meals, and deducting transfers out 4. Gross margin is: (a) income before income tax (b) sales revenue less indirect expenses *(c) sales revenue less cost of sales (d) sales revenue less direct expenses 5. Which of the following is not an inventory valuation method? (a) Specific item cost (b) FIFO (c) LIFO *(d) Perpetual cost 6. A decentralized departmental operation where managers are made accountable for their performance and the performance of employees in their department is known as: *(a) responsibility accounting (b) decentralized accounting (c) performance accounting (d) accounting decentralization 7. indirect expenses: (a) should be allocated to the operating departments on a square foot basis (b) should be allocated to the operating departments based on sales revenue (c) must be allocated to the operating departments to determine true net income *(d) allocated to operating departments will not change overall company net income 8. departmental sales revenue mix refers to the: *(a) ratio of sales revenue of various departments to total company sales revenue (b) ratio of indirect expenses allocated to departments based on the basis of sales revenue (c) ratio of direct expenses allocated to departments based on sales revenue (d) deduction of indirect expenses from a department’s sales revenue to arrive at contributory income 9. Which of the following is not normally considered a current asset in a hotel? *(a) Linen inventory (b) Cash (c) Prepaid expense (d) Marketable securities 10. A deferred expense is one that is: (a) never deductible for income tax purposes * (b) similar to a prepaid expense but for a term in excess of one year (c) not shown as an expense if the company has a loss (d) not shown as an expense until the company is liquidated

11. Deposits sent in by hotel room guests to hold rooms for some future period are shown on the balance sheet as a (an): (a) asset (b) reduction of accounts receivable (c) contra account *(d) liability 12. paid in capital, excess of par or stated value (capital surplus) is: *(a) the amount paid by stockholders in excess of the par or stated value of stock (b) accumulated retained earnings since the business began (c) net income less net losses of the business since it began (d) the difference between current market value of fixed or capital assets and the original cost price 13. retained earnings are: * (a) accumulated net incomes, less accumulated losses, less stockholders’ dividends paid out or distributed since the business began operations (b) accumulated net incomes plus dividends earned, since the business began (c) reduced by any deficits before being recorded on the balance sheet (d) represented by an equivalent amount of cash in the bank 14. Beginning retained earnings were $86,300. During the year, the company had a net loss of $10,200 and paid dividends of $16,800. Ending retained earnings are: (a) $92,900 (b) $113,300 (c) $79,700 * (d) $59,300 15. The two basic formats of balance sheet presentation are the: (a) “T” account form and report form (b) “T” account form and regular account form *(c) Account form and the report form (d) Responsibility account form and report form 16. Catering equipment was purchased at a cost of $24,400 that has an estimated life of 10 years and a residual value of $1,400. Using double-declining balance, calculate the depreciation expense for its second full year of use. *(a) $3,904 (b) $4,880 (c) $3,680 (d) $4,600

EXERCISE SOLUTIONS E2.1

To be classified as a current asset account, inventories must be purchased for resale.

E2.2

The key word is Traceable. Direct costs are said to be directly traceable, and indirect costs are considered non-traceable to a specific operating department.

E2.3

Determine the value of the ending inventory and cost of sales for M & B for March using: a. FIFO, b. LIFO, and c. Weighted average methods. March 02: 12 units @ $12.50 = March 16: 24 units @ $13.50 = Inventory Available, 36 units = a.

$150.00 $324.00 $474.00

March sales were: 32 units sold

FIFO EI: 4 units @ $13.50 = $54.00 FIFO CS: (12 × $12.50) + (20 × $13.50) = $150.00 + $270.00 = $420.00

LIFO EI: 4 units @ $12.50 = $50.00 LIFO CS: (8 × $12.50) + (24 × $13.50) = $100.00 + $324.00 = $424.00

Weighted Average: $474.00 / 36 units = $13.17 per unit EI:

4 units × $13.17 = $52.68

CS: 32 units × $13.17 = $421.44 E2.4

Find the missing purchases in an additive sequence by reversing the additive function: Beginning Inventory + Purchases − Ending Inventory = Cost of Sales $38,000 + $88,000 − $24,000 = $102,000

E2.5

E2.6

Beginning retained earnings (BRE) were $146,000 and during the year, cash dividends of $100,000 were paid to the owners. NI for the year was $228,000. Determine the ending retained earnings (ERE) using NI and NL. a.

BRE $146,000

+ NI + $228,000

ERE − Dividends = $100,000 = $274,000 −

BRE $146,000

+ NL $12,200 −

ERE − Dividends = $100,000 = $33,800 −

Sales revenue reported is $128,800 and direct costs of $68,200. Determine: a. contributory income and b. contributory income percentage. a. SR − DC = CI

$128,800 − $68,200 = $60,600

b. CI / SR = CI%

$60,600 / $128,800 = 47.0%

E2.7 A department has two operating divisions: Food service with sales revenue of $880,000 and a bar-lounge with sales revenue of $440,840. Calculate the sales revenue of each division as a percentage of total departmental sales revenue. Total Departmental sales revenue: $880,000 + $440,840 = $1,320,840 Food Division percentage of total sales: $880,000 / $1,320,840 = 66.6% Beverage Division percentage of total sales: $440,840 / $1,320,840 = 33.4% E2.8

Match each of the terms to account categories. a. Total assets − Total liabilities 4. b. Sales revenue − Total expenses 5. c. Depreciable asset 1. d. Debts owed to creditors 2. e. Sales revenue − Direct costs 3.

Owners’ equity (Net assets) Operating Income Fixed asset Liabilities Contributory income

E2.9

Allocate Indirect undistributed cost on the basis of square footage to two departments. (Cost / Allocation % = the amount allocated) Department 1: Basis, Sq. footage: $14,000 × 54% = $7,560 Department 2: Basis, Sq. footage: $14,000 × 46% = $6,440

E2.10

Find the sales revenue percentage of four different divisions of a department based on total sales revenue. Total SR SR Percentages Departmental Sales Revenue Rooms: $1,555,632 / $2,880,800 = 54.0% Food service: 921,856 / $2,880,800 = 32.0% Beverage: 403,312 / $2,880,800 = 14.0% Total sales revenue $2,880,800 100.0%

E2.11 A food division had beginning inventory of $4,400, purchases of $8,400 and ending inventory of $2,880. Determine the cost of goods available and cost of sales (CS): BI + Purchases = Goods available − EI = CS $4,400 + $8,400 = $12,800 − $2,880 = $9,920 E2.12 Cost of sales (CS) is $198,680. Employee meals were $1,225 and complimentary meals $142. Transfers-in was $82. Determine net cost of sales. CS − Employee meals − Complimentary meals + Transfers-in = Net CS $198,680 − $1,225 − $142 + $82 = $197,395 E2.13 Sales revenue food division was $337,218 and the sales revenue for the bar lounge was $206,682. Allocate $52,400 of indirect to each division on the basis of sales revenue. [Food %: $337,218 / $543,900 = 62.0% Bar %: $206,682 / $543,900 = 38.0%] a. Food division: $52,400 × 62% = $32,488 b. Bar division: $52,400 × 38% = $19,912

E2.14 Assume the following: Beginning retained earnings (BRE) were $125,000, ending retained earnings (ERE) were $150,000, and cash dividends of $77,000 were paid during the year. What was net income for the year? BRE $125,000

+ +

NI ?

ERE $150,000

+ +

Dividends $77,000

BRE $125,000

+ +

− −

Dividends $77,000

= =

ERE $150,000

BRE − $125,000 − Proof: NI − Dividends $102,000 $77,000 −

= =

NI $102,000

= =

ERE $150,000

PROBLEM SOLUTIONS P2.1

Food Department Income Statement For the first Quarter ended March 31, 0007 Sales Revenue Grill Room $183,200 Coffee Garden 82,900 Banquets 294,400 Total Sales Revenue: $560,500 Cost of Sales Net food costs: Gross Margin Operating expenses Salaries, wages, and related expenses Employee meals expenses Supplies expense Glassware and tableware expenses Laundry/Linen expense Licenses expense Printing expense Miscellaneous expense Total operating expenses: Operating income Other income Departmental income

224,200) $336,300

$176,400 18,200 10,300 4,300 13,500 2,400 4,900 8,200 (238,200) $ 98,100 800 $ 98,900

P2.2

Calculate cost of sales food, and net cost of sales. Beginning inventory Purchases Goods available Less: Ending inventory Cost of sales (food) Less: Employee meals Less: Promotional meals Cost of sales (net)

P2.3

$2,782 9,807 $12,589 ( 2,612) $ 9,977 219 288

( 507) $ 9,470

Calculate cost of sales food and net cost of sales. Beginning inventory Purchases Goods available Less: Ending inventory Cost of sales Add: Transfers in Subtotal Less: Employee meals Less: Promotional meals Less: Complimentary meals Less: Transfers out Net Cost of Sales

$15,357 47,879 $63,236 (12,887) $50,349 68 $50,417 $1,828 219 140 128

( 2,315) $ 48,102

P2.4

FIFO perpetual inventory control record: Item Description: M & B Supreme June Purchase-Received Issued-Sales 01 Bal. Fwd. 04 2 @ $11.00 = $22.00 06 8 @ $11.50 = $92.00 09 12 15

1 @ $11.00 = $11.00 2 @ $11.50 = 23.00 2 @ $11.50 = $23.00 6 @ $ 12.00 =$72.00

2 @ $11.50 = $23.00

2 @ $11.50 = $23.00 1 @ $12.00 = 12.00

6 @ $12.50 = $75.00

2 @ $12.00 = $24.00

3 @ $12.00 = $36.00 CS = $197.00

E Purchases $239.00 n d BI + Purchases = Inv. Available $33.00 + $239.00 = $272.00

− −

Balance Available Units × Cost = Total Cost 3 @ $11.00 = $33.00 1 @ $11.00 = $11.00 1 @ $11.00 = $11.00 8 @ $11.50 = $92.00 6 @ $11.50 = $69.00 4 @ $11.50 = $46.00 4 @ $11.50 = $46.00 6 @ $12.00 = $72.00 2 @ $11.50 = $23.00 6 @ $12.00 = $72.00 5 @ $12.00 = $60.00 5 @ $12.00 = $60.00 6 @ $12.50 = $75.00 3 @ $12.00 = $36.00 6 @ $12.50 = $75.00 6 @ $12.50 = $75.00 EI = $75.00 EI $75.00

= =

CS $197.00

LIFO perpetual inventory control record: Item Description: M & B Supreme June Purchase-Received Issued-Sales 01 Bal. Fwd. 04 2 @ $11.00 = $22.00 06 8 @ $11.50 = $92.00 09

3 @ $11.50 = $34.50

2 @ $11.50 = $23.00

6 @ $12.00 = $72.00

2 @ $12.00 = $24.00

3 @ $12.00 = $36.00

Balance Available Units × Cost = Total 3 @ $11.00 = $33.00 1 @ $11.00 = $11.00 1 @ $11.00 = $11.00 8 @ $11.50 = $92.00

6 @ $12.50 = $75.00

2 @ $12.50 = $25.00

3 @ $12.50 = $37.50

E Purchases $239 n $239.00 BI d + Purchases = $33.00 + $239.00 =

CS = $202.00 Inv. Available $272.00

EI − − $70.00

1 @ $11.00 = $11.00 5 @ $11.50 = $57.50 1 @ $11.00 = $11.00 3 @ $11.50 = $34.50 1 @ $11.00 = $11.00 3 @ $11.50 = $34.50 6 @ $12.00 = $72.00 1 @ $11.00 = $11.00 3 @ $11.50 = $34.50 4 @ $12.00 = $48.00 1 @ $11.00 = $11.00 3 @ $11.50 = $34.50 1 @ $12.00 = $12.00 1 @ $11.00 = $11.00 3 @ $11.50 = $34.50 1 @ $12.00 = $12.00 6 @ $12.50 = $75.00 1 @ $11.00 = $11.00 3 @ $11.50 = $34.50 1 @ $12.00 = $12.00 4 @ $12.50 = $50.00 1 @ $11.00 = $11.00 3 @ $11.50 = $34.50 1 @ $12.00 = $12.00 1 @ $12.50 = $12.50 EI = $70.00 = Cost of Sales = $202.00

Weighted average perpetual inventory control record: Item Description: M & B Supreme June Purchase-Received Issued-Sales 01 Bal. Fwd.

Balance available Units × Cost = Total 3 @ $11.00 = $ 33.00

2 @ $11.00 = $22.00

1 @ $11.00 = $ 11.00

{$103.00 / 9 = 11.44}

9 @ $11.44 = $102.96

3 @ $11.44 = $34.32

6 @ $11.44 = $ 68.64

2 @ 11.44 = $22.88

4 @ $11.44 = $ 45.76

6 @ $12.00 = $72.00 {$117.76 / 10 = $11.78}

10 @ $11.78 = $117.80

2 @ 11.78 = $23.56

8 @ $11.78 = $ 94.24

3 @ 11.78 = $35.34

5 @ $11.78 = $ 58.90

6 @ $12.50 = $75.00 {$133.90 / 11 = $12.17}

11 @ $12.17 = $133.87

2 @ 12.17 = $24.34

9 @ $12.17 = $109.53

3 @ 12.17 = $36.51

6 @ $12.17 = $ 73.02

8 @ $11.50 = $92.00

EPurchases $239.00 CS = $198.98 n BI d + Purchases = Inv. Available − EI $33.00 + $239.00 = $272.00 − $73.02

EI = $73.02 = =

Cost of Sales $198.98

*Cost of sales per the control record is $198.95 or $0.03 short of the $198.98, which is the correct amount, and the amount to be reported. The cumulative error results from rounding to the nearest cent when each cost of sales item was calculated.

P2.5

Consolidated Departmental Contributory Income Statement. Department Sales revenue Cost of sales Gross margin Wages and salaries cost Other direct costs Contributory income

Dinning a. Room $204,000 ( 81,600) $122,400 ( 65,280) ( 18,360) $ 38,760

Banquets $110,000 ( 41,800) $ 68,200 ( 35,200) ( 8,800) $ 24,200

Beverages $92,000 ( 29,440) $62,560 ( 12,880) ( 1,840) $47,840

Totals $406,000 ($152,840) $253,160 ($113,360) ($ 29,000) $110,800

Indirect costs allocation percentages on the basis of SR and sq. footage. Divisions Dining Banquets Beverage

Basis: Sales Revenue % $204,000 / $406,000 = 50.2% $110,000 / $406,000 = 27.1% $ 92,000 / $406,000 = 22.7% Total % 100.0%

Divisions Dining Banquets Beverage

Based on Square Footage % 2,400 / 6,000 = 40.0% 3,000 / 6,000 = 50.0% 600 / 6,000 = 10.0% Total % 100.0%

(1) Indirect costs allocated based on sales revenue percentages and square footage. Indirect costs allocated to divisions **Administration & general expenses *Marketing expenses Utilities expense Property operation & maintenance Depreciation expense Insurance expense Totals

Dining $ 6,024 5,020 2,000 4,848 5,600 1,600 $25,092

Banquets $ 3,252 2,710 2,500 6,060 7,000 2,000 $23,522

Beverages Totals $2,724 $12,000 2,270 10,000 500 5,000 1,212 12,120 1,400 14,000 400 4,000 $8,506 $57,120

** Allocated to the divisions as a percentage of total sales revenue percentage. The remaining indirect expense items are allocated based each of the divisions percentage of total square footage percentage.

(2) Departmental Income Statement, Indirect Costs Allocated: Departmental Divisions Contributory Income Less: Indirect Costs Departmental operating income c.

Dining Banquets Beverage Totals $ 38,760 + $ 24,200 + $ 47,840 = $110,800 ( 25,092) + ( 23,522) + ( 8,506) = ( 57,120) $ 13,668 + $ 678 + $ 39,334 = $ 53,680

Based on contributory income all divisions are profitable and remain so after the allocation of indirect costs, no division should be closed. If a division was to show a loss, its contributory income percentage should be considered before deciding whether or not the division should be closed.

P2.6

a. Calculate each division and the department’s contributory income percentages. Departmental Divisions Sales revenue Contributory income Contributory Income %

Dining c. $204,000 $ 38,760 19.0%

Banquets $110,000 $ 24,200 22.0%

Beverages $ 92,000 $ 47,840 52.0%

Totals $406,000 $110,800 27.0%

b. Calculate the cost of sales, wages and salaries, and direct costs as a percentage on the basis of sales revenue for each division of the department. Departmental Divisions Sales revenue Cost of sales Wages & salaries cost Other direct costs

Dinning d. $204,000 40.0% 32.0% 9.0%

Banquet $110,000 38.0% 32.0% 8.0%

Beverages $92,000 32.0% 14.0% 2.0%

c. The overall operating income would decrease because the contributory income from the dining room as a percentage of sales revenue is lower than from banquets. d. Assume the shift of $8,000 does occur. There is no change in total sales revenue and total undistributed (indirect) costs. Assume that other direct costs are fixed with the exception cost of sales, and wages and salaries cost. Calculate the new total operating income for each department and the new total operating income. Department Sales revenue Cost of Sales Gross Margin Wages and Salaries expense Other direct expenses Contributory income

Dining $212,000 ( 84,800) $127,200 ( 67,840) ( 19,080) $ 40,280

Banquets $102,000 ( 38,760) $ 63,240 ( 32,640) ( 8,160) $ 22,440

Beverages $92,000 (29,440) $62,560 ( 12,880) ( 1,840) $47,840

Totals $406,000 ( 153,000) $253,000 ( 113,360) ( 29,080) $110,560

Percentage of sales revenue Departmental Square Footage Percentage of Square Footage

52.2% 2,400 40.0%

25.1% 3,000 50.0%

22.7% 600 10.0%

100.0% 6,000 100.0%

Indirect Expenses (allocated) *Admin. & General expenses *Marketing expenses Utilities expense Property operation & maint. Depreciation expense Insurance expense Total expenses Operating income [BT]

$ 6,264 5,220 2,000 4,848 5,600 1,600 $25,532 $14,748

$ 3,012 2,510 2,500 6,060 7,000 2,000 $23,082 ($ 642)

$ 2,724 2,270 500 1,212 1,400 400 $ 8,506 $39,334

$12,000 10,000 5,000 12,120 14,000 4,000 $57,120 $53,440

*Indirect expenses are calculated based on total sales revenue. **The remaining indirect expense items are allocated based each of the divisions percentage of total square footage percentage.

P2.7

Do not close any department. Each department is making positive contributory income. If you assume that you cannot reduce the undistributed costs by closing a department, you will reduce operating income by the amount of the contributory income of the department you close. Completed balance sheet. Balance Sheet For the First Quarter Ended March 31, 0007 ASSETS Current Assets Cash $ 10,109 Credit card receivables 1,554 Accounts receivable 1,882 Inventories 7,225 Prepaid expenses 2,800 Total Current Assets $ 23,570 Property Plant & Equipment Land Building Less: Accumulated Depreciation Equipment Less: Accumulated Depreciation Furnishings Less: Accumulated depreciation Net Property Plant & Equipment Other assets China and Tableware Glassware Total other assets Total assets Liabilities & Stockholders’ Equity Current Liabilities Accounts payable Accrued expenses payable Income taxes payable Current portion of mortgage payable Total Current Liabilities Long-term Liabilities Mortgage payable Total Liabilities Stockholders’ Equity Capital Stock Retained earnings Total Stockholders’ Equity Total Liabilities & Stockholders’ Equity

$ 80,000 $712,800 ( 186,400) $119,080 ( 35,625) $ 64,120 ( 11,875)

526,400 83,455 52,245 $742,100 $ 8,780 2,620 $ 11,400 $777,070

$ 5,070 2,900 8,770 13,030 $ 29,770 $406,800 $436,570 $152,000 188,500 $340,500 $777,070

P2.8

Prepare a quarterly income statement. Jarvis Trailer Park Income Statement For the First Quarter Ended March 31, 0007 Trailer rental revenue [$60,000 + $200 – $1,575]* Expenses Insurance expense [ $4,800 × 3/12 ] $ 1,200 Wages expense [(5 × $9.95 × 8) + $4,500] 4,898 Maintenance expense [$80 + $400] 480 Office supplies expense [$300 – $100] 200 Utilities expense [$900 + $400] 1,300 Property tax expense [($6,000 / 12) × 3] 1,500 Salary expense [ given ] 10,500 Mortgage interest expense [$4,667 + $2,333] 7,000 Depreciation expense: Building [($216,000 / 240) × 3] 2,700 Depreciation expense: Office Equip. [($7,500 / 60) × 3] 375 Total Operating Expenses Operating Income [BT] Income tax (25%) [$28,472 × 25%] Net Income

$58,625

( 30,153) 28,472 ( 7,118) $21,354

*Sales revenue adjustment: (a) Yearly rent of $2,100 (at $175 a month) was prepaid for the year. Nine months of the $2,100, or $1,575, remains unearned and must be deducted from the reported sales revenue. (b) One rental tenant owes $200 in rent and it is added to trailer rental revenue.

P2.8 (Continued)

Jarvis Trailer Park Balance Sheet For the Quarter Ending March 31, 0007 Assets Current Assets Cash [$510,000 – $426,667] $ 83,333 Accounts Receivable [ given ] 200 Office Supplies [$200 – $100 ] 100 Prepaid Insurance [$4,800 x 9/12] 3,600 Prepaid Property Tax [$6,000 x 9/12] 4,500 Total Current Assets

$ 91,733

Property Plant & Equipment Land Building [ given ] Less: Accumulated depreciation * Office equipment [ given ] Less: Accumulated depreciation ** Net Property Plant & Equipment Total Assets

$168,600 $216,000 ( 2,700) $ 8,000 ( 375)

$213,300 $

7,625 389,525 $481,258

Liabilities & Stockholders’ Equity Current Liabilities Accounts payable [ $80 + $400 ] Wages payable [ $9.95 x 8 hrs x 5 days ] Interest payable [ given ] Unearned rental revenue [ $175 x 9 ] Income tax payable [ $28,472 x 25%] Current portion mortgage payable [given ] Total Current Liabilities

480 398 2,333 1,575 7,118 12,000 $ 23,904

Long Term Liabilities Long Term Mortgage Payable Total Liabilities

$336,000

Stockholders’ Equity Capital stock Retained earnings Total Stockholders’ Equity Total Liabilities & Stockholders’ Equity

$100,000 21,354

$336,000 $359,904

121,354 $481,258

CASE 2 SOLUTION Part (1)

4C Company Income Statement For the year ended December 31, 2007 Sales Revenue *Food operations $458,602 *Beverage operations 180,509 Total sales revenue $639,111 Cost of Sales, Food *Beginning inventory *Purchases Less: Ending inventory Cost of sales food Cost of Sales, Beverages *Beginning inventory *Purchases Less: Ending inventory Cost of sales beverages Total Cost of Sales Gross Margin

$ 6,128 181,110 ( 5,915) $181,323 $ 3,207 38,307 ( 2,211) $ 39,303 (220,626) $418,485

Operating Expenses Salaries and wages expense [$221,328 + $2,215] $223,543 *Laundry expense 16,609 *Kitchen fuel expense 7,007 *China and tableware expenses 12,214 *Glassware expense 1,605 *Contract cleaning expense 5,906 *Licenses expense 3,205 *Other operating expenses 4,101 *Administrative and general expenses. 15,432 *Marketing expense 6,917 *Utilities expense 7,918 *Insurance expense 1,895 *Rent expense 24,000 *Interest expense 23,981 Depreciation expense [$13,752 + $6,372] 20,124 Total operating expenses Operating Income Income tax expense [$44,028 × 22%] Net Income

(374,457) $ 44,028 ( 9,686) $ 34,342

*Trial balance accounts not requiring adjustment and used as stated in the trial. Depreciation expense: Equipment ($171,524 – $6,500) / 12 = $165,024 / 12 = $13,752 Depreciation expense: Furnishings ($53,596 – $2,620) / 8 = $50,976 / 8 = $6,372 35

Part (2)

4C Company Balance Sheet For the Year Ended December 31, 2007 Assets Current Assets *Cash $ 36,218 *Credit Card Receivables 13,683 *Accounts Receivable 3,421 Inventories Food $ 5,915 Inventories, Beverages 2,211 Total Inventories 8,126 *Prepaid Expenses 2,136 Total Current Assets $ 63,584 Property Plant & Equipment *Equipment Less: Accumulated Depreciation Furnishings *Less Accumulated Depreciation Net Property Plant & Equipment Total Assets Liabilities & Stockholders’ Equity Current Liabilities *Accounts payable Accrued payroll payable Current portion Bank Loan Payable Income taxes payable Total Current Liabilities

$171,524 ( 13,752) 53,596 ( 6,372)

47,224 204,996 $268,580

$ 8,819 2,215 38,260 9,686 $ 58,980

Long Term Liabilities Bank Loan Payable Total Liabilities Stockholders’ Equity *Common Stock Retained Earnings Total Stockholders’ Equity Total Liabilities & Stockholders’ Equity

157,772

125,258 $184,238 $50,000 34,342 $ 84,342 $268,580

*Trial balance accounts not requiring adjustment and used as stated in the trial.

CHAPTER 3 ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS INTRODUCTION Before financial statements can be analyzed, the reader must have a good grasp of the way different statements are prepared. It is extremely beneficial to have a firm conceptual understanding of basic accounting and the accounting terminology used by hospitality industry firms. For this reason, Chapters 1 and 2 should be reviewed or studied, as a prerequisite to this chapter on analysis and interpretation of information presented by balance sheets and income statements.

TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True answers and F for False answers)

1. Various readers of financial statements will generally analyze them in different ways.

2. Comparative horizontal balance sheet analysis shows each individual account, subtotal and total balance changes from one balance sheet date to the next. Changes are described in both dollars and percentages.

3. Comparison of periodic balance sheets is useful for controlling the day-to-day operations of a business.

4. In doing comparative horizontal analysis, the two terms used to describe changes from one period to the next are absolute changes for percent differences, and relative changes for dollar differences.

5. Common-size vertical income statements show each expense item as a percent of total sales revenue.

6. The average check is calculated by dividing the number of customers served during a period by the sales revenue for that period.

7. All other things being equal, it would be preferable to serve 4,000 guests each spending $2.50, than 4,200 guests each spending $2.40.

8. If a net income of $825 was made at a banquet and 750 customers were served, average net income per guest would be $1.10.

9. An analysis of trend results over time is usually more useful than looking at the results for two consecutive periods only.

10. Trend results are often useful in forecasting future results.

11. A trend index for several periods usually assigns the current period figure the value of 100.

12. A trend index shows sales revenue has increased from Year 1 to Year 4 by 63%. During the same period the accounts receivable trend index shows an increase of 75%. This would normally be a desirable trend.

13. Comparison of operating results in times of inflation can be done quite easily without adjusting for the effects of inflation.

14. To convert historic dollars to current dollars one multiplies historic dollars by the trend index number for the historic period and then divides that result by the trend index number for the current period.

15. Year 1 sales revenue is $240,000, and its trend index number is 120. Year 5 sales revenue (current year) is $360,000 and its trend index number is 150. Year 1 sales revenue converted to current dollars is $300,000.

16. An establishment can use internally generated information to produce its own series of trend index numbers.

17. The calculation of percentage change figures for specific income statement items when viewed over multiple periods can identify the direction in which a business is going.

18. Vertical analysis and trends analysis are similar forms used to conduct financial statements analysis.

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk)

1. Financial statement analysis is carried out by: (a) Management for the use of its employees. * (b) Various readers of financial statements for their own particular purposes (c) Management for the use of the tax department. (d) Stockholders for the use of management. 2. Comparative horizontal balance sheets show the: (a) Change in individual account balances in dollars from one period to the next. (b) Change in individual account balances in percentage terms from one period to the next. * (c) Change in individual account balances in both dollar and percentage terms from one period to the next. (d) Various assets, liability, and owners’ equity account balances as a percentage of total sales revenue. 3. In doing comparative horizontal analysis: * (a) Absolute changes show dollar differences and relative changes show percent differences. (b) Net income is given a value of 100%, and all other figures are expressed relative to that. (c) Total assets are given the value of 100%, and all other assets are expressed relative to that. (d) Relative changes show dollar differences and absolute changes show percent differences. 4. Common-size vertical income statements: * (a) Express total sales revenue as 100% and show all other items as a percentage of that. (b) Show gross profit as 100% and express all other items as a percentage of that. (c) Show net income as 100% and express all other items as a percentage of that. (d) Show the change from last period’s income statement to this period’s in percentage terms.

5. Average check is calculated by dividing: (a) Sales revenue for a period into the number of guests served during that period. * (b) Sales revenue for a period by the number of guests served during that period. (c) Sales revenue for a period by the number of guests served during that period and multiplying by 100. (d) Annual sales revenue by 365 and multiplying by number of guests served. 6. Average guest check has increased from $12.50 to $14.00. Average operating income per guest has increased from $1.00 to $1.50. From this information it is obvious that: (a) Higher prices are driving away customers. (b) More total net income is being made by the restaurant. * (c) Total average cost per guest is greater now than before. (d) Menu prices have increased. 7. Sales revenue in Period 1 is $100,000 and food cost is 40%. Sales revenue in Period 2 is $104,000 and food cost is 44%. The percent change in food cost percentage from Period 1 to Period 2 is: (a) 4%. (b) $4,400 (c) 4% of $4,000 * (d) 10% 8. Sales revenue in Period 1 is $3,000 and in Period 2 it is $4,000. The trend index figure for Period 2 (assuming Period 1 is given the value of 100) will be: (a) 104.0 (b) 130.0 * (c) 133.3 (d) 140.0 9. Sales revenue in Year 1 is $120,000 with a trend index number of 110. Sales revenue in Year 2 is $140,000 with a 121 trend index number. Year 1 sales revenue converted to current dollars is: (a) $121,000 * (b) $132,000 (c) $151,000 (d) $110,000 10. A restaurant’s average check in Year 1 is $20.00, in Year 2 is $21.00, and in Year 3 is $22.00. Using this as a basis, calculate the trend index numbers. The trend index numbers for the three years respectively, would be: (a) 120, 121, 122. (b) 100, 121, 122. * (c) 100, 105, 110. (d) 100, 120, 121.

EXERCISE SOLUTIONS E3.1

Comparative horizontal analysis: Cash Credit card receivables Food inventories Beverage inventories Total Current Assets

E3.2

July August Change Change % $ 8,240 $ 6,592 $ − 1,648 − 20.0% 1,480 2,398 + 918 + 62.0% 4,680 6,506 + 1,826 + 39.0% 2,880 2,448 − 432 − 15.0% $17,280 $17,944 $ + 664 + 3.8%

Common-size vertical analysis: July $ 8,240 47.7% 1,480 8.6% 4,680 27.1% 2,880 16.7% $17,280 * 100.0%

Cash Credit card receivables Food inventories Beverage inventories Total Current Assets * Items do not add up due to rounding. E3.3

Common-size vertical analysis: Condensed Income Statement Sales revenue $482,000 Cost of sales ( 202,440) Gross margin $279,560 Operating expenses ( 207,400) Operating income $ 72,160

E3.4

Room Rates $50.00 $48.00 $54.00

[42.0% + 43.0% + 15.0%] = 100.0%

* Gross margin is a subtotal and cannot be included to verify 100.0% of sales revenue. But gross margin – operating costs = operating income.

Trend Index 100.0 96.0 108.0

Base year = 100 [$48.00 / $50.00] [$54.00 / $50.00]

Determine the average check per guest for two sales revenue divisions. Dining Room Bar-Lounge

E3.6

100% 42.0% 58.0% 43.0% 15.0%

Calculation of trend index numbers for two of three years. Year 1 2 3

E3.5

August $ 6,592 36.7% 2,398 13.4% 6,506 36.3% 2,448 13.6% $17,944 100%

SR / $150,080 / $ 68,050 /

Guests = Avg. Check 9,380 = $16.00 5,444 = $12.50

Determine the cost of sales per guest. Dining Room Bar–Lounge

CS $51,522 $38,642

/ Guests = / 9,040 = / 6,222 =

CS per guest $5.70 $6.21

E3.7 Complete a horizontal analysis for Years 0007 to 0008 and a common-sized vertical analysis for Year 0008. Current Assets Cash Credit card receivables Accounts receivable Food inventory Prepaid expenses Total Current Assets E3.8

Yr. 0007 $10,000 1,000 800 11,200 3,300 $26,300

Complete comparative horizontal statement analysis. Determine the missing dollar values and the missing percentages; show the plus (+) or negative (–) effects.

Year 0007 Sales Revenue $23,502 Cost of sales − 9,208 Gross Margin $14,294 Direct costs −10,202 Contributory Income $ 4,092 Indirect costs − 2,477 Operating Income $ 1,615 E3.9

Yr. 0008 $12,000 1,500 880 7,840 4,620 $26,840

Horizontal Analysis Vertical ▲ Dollars ▲ % Yr. 0008 + $2,000 + 20.0% 44.7% + 500 + 50.0% 5.6% + 80 + 10.0% 3.3% – 3,360 – 30.0% 29.2% + 1,320 + 40.0% 17.2% + $ 540 + 2.0% 100.0%

Changes Dollars Percentage + $1,110 + 4.7% + 230 + 2.5% + $ 880 + 6.2% + 1,420 + 13.9% − $ 540 − 13.2% − 74 − 3.0% − $ 466 − 28.9%

Year 0008 $24,612 − 9,438 $15,174 −11,622 $ 3,552 − 2,403 $ 1,149

Convert historic dollars to current dollars. Year 0007 Month March April May

Sales Revenue $48,000 50,000 52,000

Conversion × (115.0 / 110.0) × (115.0 / 112.0) × (115.0 / 115.0)

= = = =

Current Dollars $50,182 $51,339 $52,000

PROBLEM SOLUTIONS P3.1

Complete a comparative horizontal analysis of balance sheets for Years 0007 - 0008. Comparative horizontal Analysis Assets Current Assets Cash Credit card receivables Accounts Receivable Vending Inventories Prepaid Expenses Total Current Assets

Year 0007 Dollar ▲

Year 0008 Percent ▲

+ 4,100 + 1,800 + 7,800 + 900 – 100 + 14,500

+ 36.3 % + 40.0 % + 70.3 % + 12.0 % – 2.4 % + 37.6 %

Land Building Furnishings Equipment Accumulated Depreciation Glassware, linen inventories Net Total Property & Equipment Total Assets

-0+ 37,200 + 9,700 -0+(20,300) + 3,100 + 29,700 + 44,200

-0+ 4.9 % + 11.6 % -0+ (6.4 %) + 25.4 % + 4.2 % + 5.9 %

Liabilities & Stockholders’ Equity Current Liabilities Accounts Payable Accrued Expenses Payable Taxes Payable Current portion, mortgage payable Total Current Liabilities

+ + + − +

3,000 750 3,350 2,300 4,800

+ 32.6 % + 18.1 % + 27.6 % − 17.0 % + 12.3 %

Long Term Liabilities Mortgage payable Total Liabilities

− 11,500 − 6,700

− 2.7 % − 1.4 %

Stockholders’ Equity Capital stock Retained earnings Total Stockholders’ Equity Total Liabilities & Stockholders’ Equity

+ 20,000 + 30,900 + 50,900 + 44,200

+ 16.0 % + 19.2 % + 17.8% + 5.9 %

Property Plant & Equipment

Comments: Accounts receivable increased by 70.3% and total current assets increased by 37.6%. Credit issuing and collection policies need to be checked because they are risking an increase in bad debt expense. Inventories of glassware and linen has increased by 25.4%. Unless they recently received a shipment or had to purchase a large quantity because the pattern was being discontinued, the operation should check their inventory maintenance policies. Accounts payable increased 32.6% and they should check their payment procedures to make sure they are complying with the terms of their suppliers.

P3.2

Calculate a common-size vertical analysis of balance sheets for years 0007 - 0008 from P3.1. Common-Size Vertical Balance Sheet Analysis Assets Year 0007 Year 0008 Current Assets Cash 1.5% 1.9% Credit card receivables 0.6% 0.8% Accounts receivable 1.5% 2.4% Vending inventories 1.0% 1.1% Prepaid expenses 0.6% 0.5% Total Current Assets 5.2% 6.7% Property Plant and Equipment Land Building Furnishings Equipment Accumulated Depreciation Glassware, linen inventories Net Property Plant and Equipment Total Assets

10.8% 101.2% 11.2% 12.1% (42.1%) 1.6% 94.8% 100.0%

10.2% 100.3% 11.8% 11.4% (42.3%) 1.9% 93.3% 100.0%

Liabilities & Stockholders’ Equity Current Liabilities Accounts payable Accrued expenses payable Taxes payable Current portion, mortgage payable Total Current Liabilities

1.2% 0.6% 1.6% 1.8% 5.2%

1.5% 0.6% 2.0% 1.4 % 5.5%

Long Term Liabilities Mortgage payable Total Liabilities

56.6 % 61.8 %

52.0 % 57.5 %

Stockholders’ Equity Capital stock Retained earnings Total Stockholders’ Equity Total Liabilities & Stockholders’ Equity

16.7% 21.5% 38.2% 100.0%

18.3% 24.2% 42.5% 100.0%

Comments: The common-sized vertical analysis does not indicate as many dramatic changes in the accounts that the comparative horizontal analysis does. Total current assets increased 1.5% as a proportion of total assets to 5.2% to 6.7%. Since the liquidity in Year 0006 is limited (5.2% CA to 5.2% CL), this is an improvement in the firms financial position. The majority of the increase is in AR. Credit issuing and collection policies need to be checked since they are risking an increase in bad debt expense. Long-term debt increased from 61.8% of total assets to 57.5%. This is appropriate since they will reduce interest expense and ultimately increase operating income (bt).

P3.3

a. Calculate the average check per guest for each operating division for August and September.

Departmental Divisions Room Service Dining room Bar-Lounge Coffee shop Banquets Totals

Month of August Sales Avg. Revenues / Guests = Check $ 22,600 / 927 = $24.38 118,500 / 4,628 = 25.61 5,500 / 846 = 6.50 53,400 / 9,709 = 5.50 198,600 / 6,687 = 29.70 $398,600 / 22,797 = $17.48

Month of September Sales Avg. Revenues / Guests = Check $ 18,000 / 756 = $23.81 95,500 / 3,765 = 25.37 4,100 / 637 = 6.44 48,700 / 8,604 = 5.66 211,500 / 6,805 = 31.08 $377,800 / 20,567 = $18.37

b. Calculation of average cost per guest and total average per guest for the months of August and September.

Operating expenses Cost of sales Wages & salaries exp. Benefits expenses Linen expense China expense Supplies expense Other expenses Total expenses

Month of August Total Total Avg. Cost / Guests = Cost $136,200 / 22,797 = $ 5.97 107,900 / 22,797 = 4.73 14,000 / 22,797 = 0.61 6,400 / 22,797 = 0.28 10,600 / 22,797 = 0.46 9,800 / 22,797 = 0.43 19,200 / 22,797 = 0.84 $304,100 / 22,797 = $13.34

Month of September Total Total Avg. Cost / Guests = Cost $127,800 / 20,567 = $ 6.21 101,500 / 20,567 = 4.94 14,500 / 20,567 = 0.71 6,000 / 20,567 = 0.29 9,800 / 20,567 = 0.48 9,400 / 20,567 = 0.46 17,600 / 20,567 = 0.86 $286,600 / 20,567 = $13.93

* Items do not add up due to rounding in the average costs columns.

c. Determine the departmental income per guest for August and September. Departmental Totals Total sales revenue Total operating expenses Total operating income Operating Income per Guest

August $398,600 ( 304,100) $ 94,500 $94,500 / 22,797 = $4.15

* Items do not add up due to rounding in the average costs columns.

September $377,800 ( 286,600) $ 91,200 $91,200 / 20,567 = $4.43

P3.4

Common-size vertical analysis of two similar restaurants: Restaurant “A” Sales revenue 100.0% Cost of sales ( 39.0%) Gross Margin 61.0%

Restaurant “B” 100.0% (38.3%) 61.7%

Direct Expenses Wages & salaries expense Supplies expense Other expenses Total Direct Expenses Contributory Income

(* 45.3%) 16.4%

Indirect Expenses Rent expense Insurance expense Other indirect expenses Total Indirect Expenses Operating Income

29.6% 8.2% 2.9%

34.2% 8.2% 3.0% (40.7%) 20.3%

4.2% 1.3% 2.1%

4.4% 1.5% 1.7% ( 7.6%) 12.7%

( 7.6%) * 8.9%

* Items do not add up due to rounding

The operating income of “A” is 3.8% above “B” (12.7% − 8.9%). The difference in operating income appears to be the cost of wages. “B” has a 4.6% higher wage cost than A (34.2% − 29.6%). Since both “A” and “B” are in the same town, the cost of wages should be evaluated further. This situation can result from a difference in employee staffing, salaries and hourly wage rates, which have been lumped into combined wages and salaries expense. It is also possible the wage variance may be due to differences in the menu and the style of service used. The average wages are 28.5% and the average for salaries is 4.0%. If wage costs of “B” were reduced to the same level as “A”, the 4.6% reduction in wage costs could increase operating income by $9,481 (4.6 % × $206,100). This would increase “B”’s operating income to $27,781 ($18,300 + $9,481) or 13.5% ($27,781 / $206,100) of sales revenue. This is comparable “A”’s operating income (bt). Other than wages expense, no major differences are noted in the direct expenses. However, B does have a slightly lower cost of sales percentage that compensates somewhat for its higher costs of wages percentage, and B also has higher indirect cost percentages than A for rent and insurance. Since rent and insurance costs are normally considered fixed costs, the site manager should not be held responsible for the fixed costs.

P3.5

Calculate the average check and average cost of sales food per guest. Average Check per Guest Average CS Food per Guest Total Avg. Total CS per Month SR / Guests = Check CS / Guests = Guest 1 $258,200 / 10,200 = $25.31 $ 96,200 / 10,200 = $ 9.43 2 274,800 / 10,400 = 26.42 104,300 / 10,400 = 10.03 3 285,600 / 10,300 = 27.73 110,500 / 10,300 = 10.73 4 289,400 / 10,100 = 28.65 113,100 / 10,100 = 11.20 5 298,300 / 10,400 = 28.68 118,900 / 10,400 = 11.43 6 304,600 / 10,500 = 29.01 123,700 / 10,500 = 11.78

b. Calculate trend index numbers for average checks and cost of sales per guest. Trend Index Calculations, Average Checks Trend Index Calculations, CS per Guest Month Conversion Trend Index Conversion Trend Index 1 $25.31 / $25.31 = 100.0 $ 9.43 / $9.43 = 100.0 2 $26.42 / $25.31 = 104.4 $10.03 / $9.43 = 106.4 3 $27.73 / $25.31 = 109.6 $10.73 / $9.43 = 113.8 4 $28.65 / $25.31 = 113.2 $11.20 / $9.43 = 118.8 5 $28.68 / $25.31 = 113.3 $11.43 / $9.43 = 121.2 6 $29.01 / $25.31 = 114.6 $11.78 / $9.43 = 124.9 c. Convert historic sales revenue and cost of sales to current dollars. Conversion of Historic SR to Current Dollars Month Total SR × Trend Index Conversion = Current $ 1 $258,200 × (114.6 / 100.0) = $295,897 2 274,800 × (114.6 / 104.4) = 301,648 3 285,600 × (114.6 / 109.6) = 298,629 4 289,400 × (114.6 / 113.2) = 292,979 5 298,300 × (114.6 / 113.3) = 301,723 6 304,600 × (114.6 / 114.6) = 304,600 Conversion of Historic CS to Current Dollars Month Total CS × Index Conversion = Current $ 1 $ 96,200 × (124.9 / 100.0) = $120,154 2 104,300 × (124.9 / 106.4) = 122,435 3 110,500 × (124.9 / 113.8) = 121,278 4 113,100 × (124.9 / 118.8) = 118,907 5 118,900 × (124.9 / 121.2) = 122,530 6 123,700 × (124.9 / 124.9) = 123,700 The trend index shows the average cost of sales for food is increasing faster than the average check (average sales revenue) by 9.0% (10.3 / 114.6). However, when the trend index is used to convert historic sales revenue to current dollars, we can see sales revenue has increased over the six-month period from $295,897 to $304,600, which represents an increase of $8,703 or 2.9%. For the same 6 months, the CS-food has increased from $120,154 to $123,700, which represents an increase of $3,546 or 3.0%. Using current dollars and all other costs being equal, the gross margin (SR – CS) increased by 2.9% [($180,900 – $175,743) / $175,743], which indicates the operation is doing somewhat better now than six months ago. 46

P3.6

a. Prepare a room rate index trend based on average room rates. Year 1 2 3 4 5

Conversion of room rates to Trend Index numbers Room Rates / Rm. Rate Yr. 1 = Trend Index Numbers $75.00 / $75.00 = 100.0 76.30 / 75.00 = 101.7 77.60 / 75.00 = 103.5 78.50 / 75.00 = 104.7 79.90 / 75.00 = 106.5

b. Using room rate trend index numbers, convert annual SR to current dollars. Conversion of Historic Sales Revenue to Current Dollars Year Annual SR Conversion Equation Current $ 1 $1,401,429 × (106.5 / 100.0) = $1,492,522 2 1,429,367 × (106.5 / 101.7) = 1,496,830 3 1,480,552 × (106.5 / 103.5) = 1,523,467 4 1,520,700 × (106.5 / 104.7) = 1,546,844 5 1,553,091 × (106.5 / 106.5) = 1,553,091 Looking at the annual sales revenue figures, it appears that room SR has increased by $151,662 ($1,553,091 − $1,401,429). However, looking at the current dollars, the increase is only $60,569 (1,553,091 − $1,492,522). This type of analysis could be helpful in forecasting an operating budget based on the trend shown in the conversion to current dollars. Given this limited analysis, a review of cost of sales and operating costs should also be carried out. P3.7

Complete a balance sheet comparative horizontal analysis for August and September Sales Revenue August September Dollar ▲ %▲ Room service $ 11,300 $ 9,000 2,300 − − 20.4% Dining room 75,900 63,700 − 12,200 − 16.1% Bar-lounge 5,500 4,100 1,400 − − 25.5% Coffee shop 53,400 48,700 4,700 − − 8.8% Banquets 66,200 70,500 + 4,300 + 6.5% Total sales revenue $212,300 $196,000 − 16,300 − 7.7% Cost of Sales ( 68,100) ( 63,900) − ( 4,200) − ( 6.2%) Gross Margin $144,200 $132,100 − 12,100 − 8.4% Operating Expenses Wages and salaries $ 75,800 $71,100 4,700 − − 6.2% Employee benefits 11,400 10,700 700 − − 6.1% Linen and laundry 3,200 3,000 200 − − 6.3% China, glassware & tableware 5,300 4,900 400 − − 7.5% Miscellaneous operating costs 4,900 4,700 200 − − 4.1% Operating supplies 9,600 8.800 800 − − 8.3% Total operating expenses (110,200) (103,200) − (7,000) − ( 6.4%) Operating Income $ 34,000 $28,900 5,100 − − 15.0% Only Sept. banquets SR increased; SR, CS, GM, operating expenses, and operating income.

P3.8

Using P3.7 information, complete common-size vertical income statement analysis.

Sales Revenue Room service Dining room Bar-lounge Coffee shop Banquets Total Sales Revenue Cost of sales Gross Margin Operating Expenses Wages and salaries Employee benefits Linen and laundry China, glass & tableware Misc. operating costs Operating supplies Total operating expenses Operating Income

August $ 11,300 5.3% 75,900 35.8% 5,500 2.6% 53,400 25.2% 66,200 31.2% $212,300 *100.0% ( 68,100) ( 32.1%) $144,200 67.9% $ 75,800 11,400 3,200 5,300 4,900 9,600 (110,200) $ 34,000

35.7% 5.4% 1.5% 2.5% 2.3% 4.5% ( 51.9%) 16.0%

September $ 9,000 4.6% 63,700 32.5% 4,100 2.1% 48,700 24.8% 70,500 36.0% $196,000 100.0% ( 63,900) ( 32.6%) $132,100 67.4% $71,100 10,700 36.3% 3,000 5.5% 4,900 1.5% 4,700 2.5% 8.800 2.4% (103,200) 4.5% $28,900 (52.7%) $ 9,000 14.7%

* Item do not add up due to rounding All departments had reduced sales revenue except Banquets which increased by 4.8%. Total September CS increased by 0.5% of sales revenue as did total operating expenses at 0.8%. P3.9

Convert the consolidated income statements to common-size vertical analysis income statements and determine the average check for each month. Sales Revenue Cost of sales Wages expense Operating expenses Total expenses Operating income Average Check Sales revenue Cost of sales Wages expense Operating expenses Total expenses Operating income

April 100.0% 34.4% 28.4% 18.3% (81.1%) 18.9%

May 100.0% 36.4% 29.8% 17.8%

$5.97 $2.05 1.69 1.09

37.9% 31.3% 17.5% ( 84.0%) 16.0%

(86.7%) 13.3%

$5.79

$5.55

$2.11 1.73 1.03 *( 4.84) $1.13

* Items do not add up due to rounding

June 100.0%

$2.10 1.74 0.97 *( 4.86) $0.93

( 4.81) $0.74

The trend percentages for this operation need to be investigated. The number of guests has increased considerably from April (May was 4,200 and 5,500 in June) over the 3 months beginning in April. The sales revenue and operating income per guest have both declined in May and June; however, cost of sales and wages expense increased relative to sales produced. Operating expenses have steadily declined in May and June. However, costs per guests have decreased but not significantly. The cause of the decrease in the average check must be determined and if possible reversed. If a special was offered over the three months to attract customers and the increase in customers was achieved, however, the objective should be to keep the increase in customers and average check to increase operating income. Although an increase in selling prices may cause customer resistance and a decrease in the average number of customers, a solution should be found to balance the needs of the increasing sales revenue and profits. The increase in operating cost percentages may be acceptable dependent on the reason they occurred. However, employee scheduling, portion control, and waste control during production should be examined and corrective action taken when problems are noted. P3.10 Freddie’s Fried Chicken Restaurant: a. Prepare a common-size vertical analysis income statement for 2 months. April Percentages May Percentages Sales Revenue Sales revenue-food 73.4% 74.3% Sales revenue-beverages 26.6% 25.7% Total Sales Revenue 100.0% 100.0% Operating expenses Cost of sales-food 35.9% 38.4% Cost of sales-beverages 23.3% 26.9% Wages expense 28.0% 29.6% Other operating expenses 28.5% 28.5% Total operating expenses 89.1% 93.5% Operating Income (BT) 10.9% 6.5% b. Prepare a comparative horizontal analysis income statement. Sales Revenue Sales revenue-food Sales revenue-beverages Total Sales Revenue Operating Expenses Cost of sales-Food Cost of sales-beverage Wages expense Other operating expenses Total operating expenses Operating income (BT)

April

May

$199,000 72,000 $271,000

$213,500 74,000 $287,500

+ $14,500 + 2,000 + $16,500

+ 7.3% + 2.8% + 6.1%

$ 71,500 16,800 76,000 77,100 $241,400 $ 29,600

$ 82,000 19,900 85,000 82,000 $268,900 $ 18,600

+ $10,500 + 3,100 + 9,000 + 4,900 + $27,500 ($11,000)

+ 14.7% + 18.5% + 11.8% + 6.4% + 11.4% – 37.2%

$ Change % Change

c. Calculate the average check, cost and operating income per guest.

Sales revenue Sales revenue–food Sales revenue–beverages Total Sales Revenue Operating expenses Cost of sales–food Cost of sales–beverages Wages expense Other operating expenses Total operating expenses Operating Income [BT]

April [20,000 Guests]

May [22,000 Guests]

$9.95 3.60

$9.70 3.36 $13.55

$3.58 0.84 3.80 3.86

*$13.07 $3.73 0.90 3.86 3.73

*(12.07) $ 1.48

(12.22) $ 0.85

* Items do not add up due to rounding

d. Comments: In May the restaurant has 10% or 2,000 (22,000 − 20,000 / 20,000) more guests, May sales revenue increased slightly by 6.1% or $16,500 [($287,500 – $271,000) / $271,500]. However, total average check per guest decreased by $0.48 cents ($13.55 – $13.07) and the overall operating expenses increased by $0.15 cents ($12.22 – $12.07). This is not a desirable trend, particularly since operating income has decreased by $11,000 ($29,600 − $18,600) from April to May. Freddie needs to investigate why the average check per guest has decreased. Is there a product quality problem or poor service? Are the servers using suggestive selling to encourage guests to buy more or menu items with a higher gross margin percentage and therefore increase the average check? The average cost per guest has also increased except for other operating costs. Freddie needs to investigate why costs have increased. If there are control problems such as portion control, wasted food, poor quality products, or the employees are not being productive, then Freddie needs to take corrective action. If costs have increased and there is no waste, consideration must be given to raising the menu prices to offset the cost increases. However, raising menu prices could result in a decrease in sales revenue and an in-depth evaluation should be made to determine whether increasing menu prices is wise. Finally, the average operating income per guest is down by 42.6% [($0.85 − $1.48) / $1.48]. This 42.6% decrease results from the reduced average sales revenue per guest and the increased cost per guest. If the problems are corrected, average operating income per guest will correct itself.

P3.11 Calculate sales revenue average check, expenses and operating income on a per guest basis. Comment on the dinning room’s operating results. Sales Revenue Sales revenue-Food Sales revenue-Beverages Total sales revenue Operating Expenses Cost of sales-Food Cost of sales-Beverage Wages expense Other operating expenses Total operating expenses Department Operating Income (BT)

October $31.09 13.08 $22.43

November $30.90 15.37 $23.44

$11.84 3.93 6.12 4.00

$11.15 4.72 6.11 4.04 (18.15) $ 4.28

(18.21) $ 5.23

While the total sales revenue in November increased slightly by $592 ($119,273 – $118,681) the number of guests have decreased by 201 (5290 – 5089). In addition, the November departmental operating income has increased $3,958 ($26,608 – $22,650) and the operating income per guest was $0.95 ($5.23 – $4.28). A change in sales mix from October to November has occurred; they are selling more beverages and less food in both total dollars and average per guest. Since beverages have a higher gross margin percentage, this would partially explain the increase in department operating income in total dollars and per guest. The average cost of food per guest has decreased by $0.69 cents ($11.84 – $11.15) and at the same time the average food check per guest has decreased by $0.19 cents ($31.09 – $30.90). The average gross margin for food per guest in October was $19.25 ($31.09 − $11.84) while it was $19.75 ($30.90 – $11.15) in November. It appears that guests are buying lower cost, higher dollar gross margin items in November. This change contributes to the increased departmental operating income. The average beverage sale per guest and the average cost of beverages per guest has increased from October to November. The beverage gross margin has increased from $9.15 ($13.08 – $3.93) in October to $10.65 ($15.37 – $4.72) in November. This also increases departmental operating income. Both labor costs and other costs are the same per guest in both months. The manager of the dining room needs to determine why the number of guests has decreased. This decrease could be a normal seasonal decrease or it could also be the result of an economic slowdown. It could also be due to the change in menu that is increasing the gross margin per guest. The guests may think they are no longer receiving value for their money and may be eating and drinking elsewhere. If the number of guests in the dining room in November could be increased, it would be even more profitable than it is now.

P3.12 Calculation of trend percentages: Period SR Food Trend % CS Food 1 $210,200 $60,330 2 233,322 11.0% 72,275 3 243,821 4.5% 81,400 4 253,574 4.0% 84,200 5 267,521 5.5% 90,768 6 273,406 2.2% 93,128

Trend % 19.8% 12.6% 3.4% 7.8% 2.6%

A/R $20,020 24,200 25,800 27,400 31,400 33,600

Trend % 20.9% 6.6% 6.2% 14.6% 7.0%

Calculations of food sales revenue trend percentages Pd 1: $210,200 Pd 2: $233,322 – $210,200 = $23,122 / $210,200 = 11.0% Pd 3: $243,821 – $233,322 = $10,499 / $233,322 = 4.5% Pd 4: $253,574 – $243,821 = $ 9,753 / $243,821 = 4.0% Pd 5: $267,521 – $253,574 = $13,947 / $253,574 = 5.5% Pd 6: $273,406 – $267,521 = $ 5,885 / $267,521 = 2.2% Calculations of cost of sales trend percentages Pd 1: $60,330 Pd 2: $72,275 – $60,330 = $11,945 / $60,330 = 19.8% Pd 3: $81,400 – $72,275 = $ 9,125 / $72,275 = 12.6% Pd 4: $84,200 – $81,400 = $ 2,800 / $81,400 = 3.4% Pd 5: $90,768 – $84,200 = $ 6,568 / $84,200 = 7.8% Pd 6: $93,128 – $90,768 = $ 2,360 / $90,768 = 2.6% Calculations of accounts receivable percentages Pd 1: $20,020 Pd 2: $24,200 – $20,020 = $4,180 / $20,020 = 20.9% Pd 3: $25,800 – $24,200 = $1,600 / $24,200 = 6.6% Pd 4: $27,400 – $25,800 = $1,600 / $25,800 = 6.2% Pd 5: $31,400 – $27,400 = $4,000 / $27,400 = 14.6% Pd 6: $33,600 – $31,400 = $2,200 / $31,400 = 7.0% The rate at which sales is increasing has slowed down over time from period 2 which had a 11.0% increase and the sales revenue slowed down to 2.2% at the end of period 6; the average increase from period 3 to period 6 was 4.05%. Food cost is increasing more quickly than the food sales from 19.8% in period 2 to 2.6% in period 6; the average increase of 9.24% from period 2 to period 6. Accounts receivable are increasing at a faster rate than food cost. Accounts receivable increased from 20.9% period 2 to 7.0% at the end of period 6. These trends are not desirable. The need exists to investigate the reason for the slow down in the growth of sales and see if we can increase sales more in the future. We need to check on food control to find out if food is being wasted or if there is a problem with purchasing. If we find any problems, we need to correct them. The increasing accounts receivable increases the risk of bad debt expense. We need to check and make sure that accounts receivable collection procedures are being followed and correct any problems we find. 52

P3.13 Conversion of historic sales revenue and cost of sales to current dollars for the six periods referred to in P3.12.

Period

Historic SR Food

Conversion Equation

Current Dollars

1 2 3 4 5 6

$210,200 233,322 243,821 253,574 267,521 273,406

× × × × × ×

147.0 / 107.0 147.0 / 114.0 147.0 / 121.0 147.0 / 130.0 147.0 / 144.0 147.0 / 147.0

= = = = = =

$288,779 300,863 296,212 286,734 273,094 273,406

Period

Historic Food Cost

Conversion Equation

Current Dollars

1 2 3 4 5 6

$60,330 72,275 81,400 84,200 90,768 93,128

× × × × × ×

151.0 / 121.0 151.0 / 125.0 151.0 / 131.0 151.0 / 137.0 151.0 / 144.0 151.0 / 151.0

= = = = = =

$75,288 87,308 93,827 92,804 95,180 93,128

When we convert this information to current dollars using the trend index, we discover that current dollars of sales revenue increased for Periods 2 and 3 then remained about the same for Period 4 and then decreased in Periods 5 and 6. At the same time, food cost increased in all periods except period 6 which remained the same. This indicates that an investigation is needed to determine why sales revenue is decreasing and food costs are increasing. If this is a time of high inflation, we need to consider increasing menu prices to keep up with the increasing costs. However, increasing menu prices may upset customers who may stop coming to our restaurant. P3.14 a. Calculate index numbers from the average room rates using the first period as the base index number.

Year 1 2 3 4 5

Room Rate $85.00 88.60 89.70 91.40 93.80

/ / / / /

First Year $85.00 85.00 85.00 85.00 85.00

= = = = =

Index Numbers 100.0 104.2 105.5 107.5 110.4

Using the index numbers from part a., convert the annual sales revenue of year 1 through year 5 to current dollars, and comment on your analysis.

Year 1 2 3 4 5

Conversion of Annual Sales Revenue Historic Conversion Current Dollars × Equation = Dollars $2,205,952 × (110.4 / 100.0) = $2,435,371 2,254,695 × (110.4 / 104.2) = 2,388,851 2,299,526 × (110.4 / 105.5) = 2,406,328 2,334,484 × (110.4 / 107.5) = 2,397,461 2,380,856 × (110.4 / 110.4) = 2,380,856

While total room sales revenue appears to have increased over the years, a conversion of room sales revenue to current dollars indicates that room sales revenue has decreased over the years. The reason for the decrease of room sales revenue needs to be investigated. Did a competitor open up near by? Have the facilities been allowed to decline with the result of not attracting as many guests.

CASE 3 SOLUTIONS a.

4 C Company Common-Size (Vertical) Income Statement For the Year Ended December 31, 2007 Sales Revenue Food Operations [$458,602 / $639,111] 71.8% Beverage Operations [$180,509 / $639,111] 28.2% Total Sales Revenue

100.0%

Cost of Sales Cost of Sales Food [$181,323 / $458,602] Cost of Sales Beverages [$39,303 / $180,509] Total Cost of Sales [$220,626 / $639,111] Gross Margin [$418,485 / $639,111]

(34.5%) 65.5%

Operating Expenses Salaries and Wages expense [$223,543 / $639,111] Laundry expense [$16,609 / $639,111] Kitchen Fuel expense [$7,007 / $639,111] China and tableware expenses [$12,214 / $639,111] Glassware expense [$1,605 / $639,111] Contract Cleaning expense [$5,906 / $639,111] Licenses expense [$3,205 / $639,111] Other Operating expenses [$4,101 / $639,111] Administrative-General expenses [$15,432 / $639,111] Marketing expense [$6,917 / $639,111] Energy expense [$7,918 / $639,111] Insurance expense [$1,895 / $639,111] Rent expense [$24,000 / $639,111] Interest expense [$23,981 / $639,111] Depreciation expense [$20,124 / $639,111] Total Operating Expenses [$374,457 / $639,111] Operating Income [$44,028 / $639,111] Income tax expense [$9,686 / $639,111] Net Income [$34,342 / $639,111]

39.5% 21.8%

35.0% 2.6% 1.1% 1.9% 0.3% 0.9% 0.5% 0.6% 2.4% 1.1% 1.2% 0.3% 3.8% 3.8% 3.1% (58.6%) 6.9% ( 1.5%) 5.4%

For similar type restaurants, the range of operating income (income before tax) ranges from a low of 1.5% to a high of 12.0% of sales revenue. 4C Company’s operating income of 6.9% appears to be acceptable since it is slightly above the mid range of 6.75%. Since this is the first year of operations for 4C Company, there may be current costs that will not be repeated in future years. Therefore, one may expect operating income to increase next year. It will take time to see growth toward achieving full sales revenue potential.

b. The average check for food is $6.88 ($458,602 / 66,612) and average total sales revenue per guest check for beverages is $2.71 ($180,509 / 66,612). Total sales revenue per guest is calculated to be $9.59 ($639,111 / 66,612). This seems reasonable for a family-type table service restaurant with a combined lunch and dinner average check. Total sales revenue for 4C Company is split at 71.8% for food and 28.2% for beverages and the percentages are in line with industry averages for this type of restaurant. c. Cost of Sales Food is [Cost of sales food / Total sales revenue food]: $181,323 / $458,602 = 39.5% (The mid range is 35%) Cost of Sales Beverages is: [Cost of sales beverages / Sales revenue beverage]: $39,303 / $180,509 = 21.8%

(The mid range is 25%)

The overall cost of sales relative to total sales revenue shown in the common-size vertical income statement is 34.5%, which, in the first year of operations, compares favorably with the restaurant association’s figures that range from 30% to 40%. The cost of food sold is a little below the restaurant association’s standard of 35%. Cost of beverages is 3.2% below the restaurant association’s average standard of 25%. Charlie should check that he is giving his guests good value for their money for beverages and that the bartender is serving the correct portions. Charlie should consider adjusting the menu prices of beverages to give his guests better value. If the guests think they are getting good value for their money, they may buy more beverages and thus, increase total gross margin. Since beverages take very little labor to produce, he is unlikely to increase labor costs. If Charlie can increase average check, he will increase his gross margin and, therefore, his operating income. The sales revenue for 4C Company is split at 71.8% for food and 28.2% for beverages. The percentages are in line with the industry averages for this type of restaurant. d. It is generally preferred to have a higher percentage of beverage sales revenue to food sales revenue, since beverage cost of sales is lower per dollar of sales revenue generated. A lower cost of sales percentage will yield a higher gross margin. This is true if you are comparing a $4.00 beverage item and a $4.00 food item. However, if Charlie has a choice between selling a $4.00 beverage item and an $8.00 food item, he is better to sell the $8.00 food item because the dollar gross margin will be higher even if the percentage is lower.

CHAPTER 4

RATIO ANALYSIS

INTRODUCTION This chapter could be considered a continuation of Chapter 3, although Chapter 3 is not necessarily a prerequisite for ratio analysis. However, to have a good comprehension of the information provided by ratio analysis, the student should have a good understanding of basic accounting, and in particular its application to the hospitality industry. Therefore, Chapters 1 and 2 should be studied, or assigned for self study, as a prerequisite to this chapter. TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True answers and F for False answers)

1. A percentage is a type of ratio.

2. The best method of comparing a ratio is with a predetermined standard or base figure.

3. The three major users of ratios are management, creditors, and owners of the business.

4. Certain current liquidity ratios are indicative of effective working capital management.

5. Current liabilities divided by current assets gives the current ratio.

6. In a hotel, the current ratio is normally higher than 2 to 1.

7. One of the useful current liquidity ratios is known as window dressing.

8. The quick ratio is the same as the current ratio except that, in the quick ratio, the accounts receivable are not included in the current assets.

9. The accounts receivable turnover for a given period is calculated by dividing the total accounts receivable credit sales revenue by the average accounts receivable.

10. The accounts receivable average collection period is calculated by dividing 365 by the annual accounts receivable turnover ratio.

11. Net worth is total tangible assets less total liabilities.

12. The total liabilities to total equity ratio is one of several long-term solvency ratios.

13. Asset shrinkage occurs when the value of assets declines during bankruptcy.

14. Calculating long-term solvency ratios using assets at their book value, rather than fair market value, can be misleading.

15. Creditors of a company prefer to see a high, rather than a low, debt to equity ratio.

16. High financial leverage is indicated by a low debt to equity ratio.

17. A company may have a net income without being profitable.

18. The net return on assets is calculated by dividing income before interest and income tax by total average assets.

19. The number of times interest is earned ratio indicates a company’s ability to meet its interest payments as they fall due.

20. A company is presently earning 8% return on its assets. The company wishes to borrow funds from its stockholders for expansion, guaranteeing them a 10 percent dividend rate. The stockholders should be eager to lend the money to the company.

21. The net income to sales revenue ratio is also known as the gross margin.

22. Earnings per share is calculated by dividing the average number of shares outstanding into net income.

23. The price earnings ratio is calculated by dividing earnings per share by market price per share.

24. Food inventory turnover is calculated by dividing average food inventory during the period by cost of food sales for the period.

25. Beverage inventory turnover is usually between 6 and 12 times a year.

26. The fixed asset turnover ratio is usually higher for a hotel than for a restaurant.

27. Analysis tools, when used properly, can indicate that a problem exists and offer the solution to that problem.

28. Seat turnover in a restaurant is calculated by dividing the number of seats by the number of guests served during a meal period.

29. The lowering of dining room standards of service could be indicated by a declining seat turnover figure.

30. Annual sales revenue per restaurant seat is calculated by dividing total annual sales revenue by the number of seats in the restaurant.

31. The comparison of percentage of beverage sales revenue to food sales revenue in a restaurant has no value.

32. Daily average room rate is calculated by dividing monthly sales revenue by the number of days in the month, times the number of rooms available.

33. The average room rate is not affected by the rate of double occupancy.

34. The number of rooms cleaned per housekeeper per day is a type of productivity measure.

35. The manager’s daily report is primarily concerned with information from the balance sheet.

36. As long as an establishment carries out comprehensive internal analysis of its operations, external comparisons can be ignored.

37. Many of the ratios available and useful in ratio analysis can be affected by whether the assets are owned or leased.

38. A high debt to equity ratio usually reduces the risk to the stockholders.

MULTIPLE CHOICE QUESTIONS (correct answer indicated by asterisk)

1. One method of comparing a ratio is with an industry average. Three other methods are: (a) Percentages, turnovers, and results from previous periods (b) Percentages, results from previous periods, and a competitor’s figures (c) Turnovers, percentages, and results from previous periods * (d) A Competitor’s figures, results from previous periods, and a predetermined standard 2. A current ratio of 2 to 1 means that: (a) Current liabilities are twice as high as current assets * (b) The difference between current assets and current liabilities is the same amount as current liabilities (c) The odds are two to one that the company will not be able to pay off its short-term debts (d) The company will take twice as long as normal to pay what it owes 3. The three major users of ratios are: (a) Management, creditors, and department heads * (b) Management, creditors, and owners (c) Supervisors, department heads, and managers (d) Lenders, creditors, and investors 4. Window dressing means: (a) The reduction of current assets to bring them more into line with current liabilities (b) The use of current assets to pay off long-term liabilities * (c) A reduction of both current assets and current liabilities to improve the current ratio (d) The selling of fixed assets to pay off current liabilities 5. A company has cash $1,400, accounts receivable $2,100, marketable securities $4,000, inventory $1,200, accounts payable $4,700, accrued expenses $500, and common stock $1,000. Its quick ratio is: (a) 1.39:1 (b) 1.67:1 (c) 1.60:1 * (d) 1.44:1 6. Accounts receivable turnover is: * (a) Total sales revenue for a period divided by average accounts receivable during that period (b) Normally about two to four times a month in a hotel (c) Calculated by dividing total sales revenue for a year by 365 (d) The average number of days that accounts receivable is outstanding 7. The debt to equity ratio is: (a) Total assets divided by total liabilities (b) Total long-term liabilities divided by total fixed assets * (c) Total liabilities divided by total stockholders’ equity (d) Total stockholders’ equity divided by total long-term liabilities

8. A debt to equity ratio of 1.75 means there is: * (a) $1.75 of debt for each $1.00 of equity (b) $0.75 of debt for each $1.00 of equity (c) $1.75 of equity for each $1.00 of debt (d) $0.75 of equity for each $1.00 of debt 9. Net return on assets is calculated by dividing: (a) Income after interest but before income tax by total average assets (b) Net income into total average assets (c) Net income by sales revenue * (d) Net income by total average assets 10. A company’s sales revenue for the year is $1,000,000 and income before tax $100,000. Tax rate is 50%. Average total assets are $750,000. Average stockholders’ equity is $250,000. Return on stockholders’ equity is: (a) 10.0% * (b) 20.0% (c) 5.0% (d) 6.7 % 11. The net income to sales revenue ratio is also known as the: (a) Sales ratio (b) Profit turnover * (c) Profit margin (d) Margin ratio 12. The credit card receivables turnover ratio is: (a) The average collection period divided by 365 (b) The average credit card receivables divided by credit card sales revenue * (c) Credit card sales revenue divided by average credit card receivables (d) 365 divided by average collection period 13. The price earnings ratio is calculated by: * (a) Dividing a market price per share by it’s earnings per share (b) Multiplying the market price per share by earnings per share (c) Dividing earnings per share by the market price per share (d) Dividing prices by sales revenue 14. Inventory turnover is calculated by dividing: (a) Food cost for the year by 365 * (b) Cost of sales for the period divided by average inventory during the period (c) Average inventory during the period divided by cost of sales for the period (d) Beginning inventory plus ending inventory divided by two 15. A restaurant with a monthly food inventory turnover of 4.0 would find that its food inventory is turning over: (a) Four times a year * (b) Four times a month (c) Once every four weeks (d) Four times as fast as its beverage inventory

16. Ratio analysis is most favorable for an individual restaurant when: (a) The restaurant’s figures are higher than the industry averages (b) The figures are the same as the industry averages * (c) They compare favorably with standards set by the restaurant’s management (d) The trend of figures over time is upward 17. Restaurant seat turnover is calculated by dividing: (a) Customers served during the year by 365 (b) Sales revenue for a period by the average check for that period * (c) The number of guests served during a period by the number of seats in the restaurant (d) The sales revenue for a period by the number of seats in the restaurant 18. Double occupancy is: * (a) The percentage of rooms occupied by more than one person during a period (b) The number of hotel guest rooms occupied more than once in a 24-hour period (c) The result of a desk clerk reserving the same room for two different people on the same night (d) Only desirable if the hotel has a low general occupancy rate 19. Sales revenue per available room can be calculated by: (a) Dividing the occupancy percentage by average room rate (b) Dividing the average room rate by occupancy percentage (c) Multiplying the occupancy percentage by rooms occupied * (d) Multiplying the occupancy percentage by average room rate 20. Financial leverage is: (a) The use of equity rather than debt to improve return on owners’ equity (b) A method of decreasing the debt to equity ratio * (c) The use of debt rather than equity to improve return on owners’ equity (d) A safe method of obtaining long-term debt financing in times of declining net income

EXERCISE SOLUTIONS E4.1 Calculate the current and quick ratios. a. Current ratio: [CA / CL] CA = $11,200 + $808 + $260 + $4,482 + $1,220 = $17,970 Calculation: $17,970 / $6,912 = 2.6:1 b. Quick (acid test) ratio: [Quick assets / CL] Quick assets: $11,200 + $808 + $260 = $12,268 Or: Quick assets = Total CA – Inventories for resale and prepaid items = $17,970 − $4,482 − $1,220 = $12,268 Calculation: $12,268 / $6,912 = 1.8:1 E4.2

Calculate working capital using E4.1 Information. CA = $11,200 + $808 + $260 + $4,482 + $1,220 = $17,970 The calculation: [CA − CL] = $17,970 − $6,912 = $11,058 Working Capital defines the excess of CA over CL that is available to conduct current operations and to meet its current debt obligations.

E4.3

Calculate average credit card receivables and the percentage of credit card receivables of total credit sales revenue. a. Average credit card receivables: [Beginning credit card receivables + Ending credit card receivables] / 2 Calculation: ($1,444 + $ 1,220) / 2 = $2,664 / 2 = $1,332 b. Credit card receivables as a percentage of total credit sales revenue: Calculation: $1,332 / $48,560 = 2.7%

E4.4

Complete a common-size vertical analysis of quick assets for both months and comment on the changes to quick assets. Month 1 % $12,205 / $15,449 = 79.0% 2,781 / 15,449 = 18.0% 463 / 15,449 = 3.0% Accounts Cash Credit card receivables Accounts receivable Total Quick Assets

Month 2 % $14,695 / $17,921 = 82.0% 2,957 / $17,921 = 16.5% 269 / $17,921 = 1.5%

Month 1 % Month 2 % $12,205 79.0% $14,695 82.0% 2,781 18.0% 2,957 16.5% 463 3.0% 269 1.5% $15,449 100.0% $17,921 100.0%

Cash increased by $2,490 ($14,695 – $12,205) or 20.4% ($2,490 / $12,205) and credit card receivables increased by $176 ($2,957 – $2,781) or 6.3% ($176 / $2,781) as a proportion of quick assets. This means credit card receivables are being collected a little faster and providing additional cash that can be used for other purposes.

E4.5

Calculate working capital and define its structure and purpose. Working Capital = [CA – CL] = $87,200 – $64,400 = $22,800 Structure: Working capital indicates the excess of current assets to current liabilities that is available to conduct current daily operations. When current assets are less than current liabilities, a liquidity problem may exist regarding the ability of a business to pay its current liabilities. The current ratio, [CA / CL] = $87,200 / $64,400 = 1.35:1 or $1.35 is available to meet each $1.00 of current liabilities. Purpose: The ratio indicates a company’s ability to pay off its current liabilities.

E4.6

You are given the working capital at the end of two consecutive years: Year 1 was $20,800 and Year 2 is $30,520. Sales revenue for Year 2 is $1,078,444. Calculate the working capital turnover ratio. Sales revenue / Average working capital The calculation:

$1,078,444 ($20,800 + $30,520) / 2

$1,078,444 $51,320 / 2

$1,078,444 $25,660

42.0 times

E4.7

Calculate food inventory turnover ratio and the average food inventory holding period in days that it takes the food inventory to turnover. [Cost of Sales for the period / Average inventory for the period] Average inventory = ($7,312 + $5,628) / 2 = $12,940 / 2 = $6,470 Turnover ratio calculation: $38,820 / $6,470 = 6.0 times during the month Turnover holding period in days: Operating days / Inventory turnover: 27 / 6 = 4.5 days

E4.8

Calculate total assets to total liabilities ratio and comment on the changes. Do any additional analysis you need so you can comment on these figures. Year 0006:

$482,200 / $330,252 = 1.460  1.46:1

Year 0007: $506,320 / $347,290 = 1.458  1.46:1 The ratio would be reported at 1.46:1 for both years although the total assets to total liabilities ratio increased in Year 0006 by 0.002 (Yr. 6: 1.460 and Yr. 7: 1.458). Total assets increased 5.0% ($24,120 / $506,320) or $24,120 ($506,320 – $482,200), and total liabilities increased by 5.2% ($17,038 / $347,290), or $17,038 (347,290 –$330,252) in Year 0007. These figures indicate the changes are not significant and should not change the creditor’s evaluation of their ability to collect what is owed to them. E4.9

Can you determine the general condition of liquidity without calculating working capital? If the following ratios apply to a restaurant, would the ratio for Year 0008 be considered adequate? The current ratios for the 3 years indicate a steady decline in liquidity, and it’s not necessary to calculate working capital. While working capital has changed only slightly, current assets relative to current liabilities have declined from $1.46 per $1.00 of current liabilities to $1.30 per $1.00 of current liabilities over the three years. A rule of thumb suggests a current ratio of 2:1. However, a restaurant operation could generally operate with a 1:1 current ratio since the majority of its current assets such as inventories can be considered liquid. The Year 0008 ratio of 1.30:1 appears adequate.

E4.10

Complete a comparative horizontal analysis of the change in each current asset. Comment on the change if it exceeds 10%. What, if anything, would you do as a manager? Dollar Change Current Assets Yr. 0006 − Yr. 0007 = Change % Cash $12,892 − $14,580 = + $1,688 + 13.1% Credit card receivables 2,700 − 3,460 = + 760 + 28.1% Accounts receivable 530 − 150 = – 380 – 71.7% Food inventories 4,280 − 4,366 = + 86 + 2.0% Beverage inventories 1,850 − 1,702 = – 148 – 8.0% Prepaid expenses 1,400 − 1,610 = + 210 + 15.0% Total Current Assets $23,652 − $25,868 = + $2,216 + 9.4% Comments: 1. Cash may have changed due to an increase in cash sales revenue. It is also possible that payments of accounts payable have been deferred. If payments have been deferred and the payment terms of creditors are not being met, problems in attaining future credit may occur. 2. Credit card receivables may have increased due to an increase of credit card credit sales revenue, or credit card receivables collection period could have increased. If so, the timing of the collection of credit card receivables need to be assessed to ensure that the credit card companies are paying in a timely manner. 3. A decrease in accounts receivable may have resulted from a decrease in accounts receivable credit sales revenue or a marked increase in the average collection period. If the average collection period has increased, the collection procedures need to be assessed to insure accounts receivable are being received in a timely manner. 4. The cost of a prepaid expense could have increased or an additional prepaid item may have been added. This ties up money in assets that are difficult to convert to cash; make sure these assets are not being paid too far in advance.

PROBLEM SOLUTIONS P4.1 Complete a common-size vertical analysis of current assets and calculate a current and quick ratio. Total current liabilities are $3,426. Cash Credit card receivables Accounts receivable Food inventory Prepaid insurance Prepaid rent Total Current Assets

$2,440 1,402 440 2,680 1,200 1,500 $9,662

/ / / / / /

$9,662 $9,662 $9,662 $9,662 $9,662 $9,662

= = = = = = =

25.3% 14.5% 4.6% 27.7% 12.4% 15.5% 100.0%

Current ratio: [CA / CL] = $9,662 / $3,426 = 2.82:1 Quick ratio: [Quick assets / CL] $2,440 + $1,402 + $440 = $4,282 / $3,426 = 1.25:1 Or: [CA − Inventories and Prepaids] $9,662 − ($2,680 + $1,200 + $1,500) = $9,662 – $5,380 = $4,282 / $3,426 = 1.25:1 64

P4.2

a. Working Capital: [CA – CL] Calculation Year 0006: $36,300 − $32,670 = $3,630 Calculation Year 0007: $46,700 − $37,700 = $9,000 b. Current ratio: [CA / CL] Calculation Year 0006: $36,300 / $32,670 = 1.11:1 Calculation Year 0007: $46,700 / $37,700 = 1.24:1 c. Quick (acid test) ratio: [Quick assets / Current Liabilities] Quick assets Year 0006: $36,300 − $6,100 − $2,400 = $27,800 Or: $12,778 + $2,442 + $580 + $12,000 = $27,800 Calculation Year 0006: $27,800 / $32,670 = 0.85:1 Quick assets Year 0007: $46,700 − $7,100 − $2,600 = $37,000 Or: $17,765 + $2,815 + $420 + $16,000 = $37,000 Calculation Year 0007: $37,000 / $37,700 = 0.98:1 d. Credit card receivables as a percentage of credit card sales revenue: [Average credit card receivables / Credit card sales revenue] Calculation Year 0007: ($2,442 + $ 2,815) / 2 ($544,800 × 61.5%)

$5,257 / 2 $335,052

$2,629 0.08% $335,052

e. Credit card receivables turnover rate ratio: [Credit card sales revenue / Average credit card receivables] Calculation Year 0007: $544,800 × 61.5% ($2,442 + $2,815) / 2

$335,052 $5,257 / 2

$335,052 $2,629

127.4 times

f. Credit card receivables average collection period: [365 / Credit card turnover] Calculation: 365 / 127.4 = 2.9 days g. Accounts receivable as a percentage of accounts receivable credit sales revenue: [Average accounts receivable / Accounts receivable credit sales revenue] Calculation: ($580 + $420) / 2 $544,800 × 2.5%

$1,000 / 2 $13,620

$500 3.7% $13,620

h. Accounts receivable turnover ratio: [AR credit sales revenue / Average AR] Calculation: $13,620 / ($580 + $420) / 2 = $13,620 / $500 = 27.2 times i. Accounts receivable average collection period: 365 / Accounts receivable turnover Calculation: 365 / 27.2 = 13.4 days j. Cost of sales as a percentage of sales revenue: (Cost of sales / Total sales revenue) Calculation: $212,472 / $544,800 = 39.0% k. Comment on what these ratios tell you about the restaurant. For the Year 0007, the restaurant has cash sales revenue of 36% or $196,128 and credit sales revenue of $378,636. Credit card sales revenue was 61.5% or $335,052 and credit card receivables as a percentage of credit card sales revenue is 0.08% and credit card receivables are collected on the average of every 2.9 days which is acceptable. Accounts receivable credit sales revenue was 2.5% or $13,620 and accounts receivable as a percentage of accounts receivable credit sales revenue is 3.7% and credit sales accounts receivable are collected on the average of 13.4 days which is also considered acceptable since the payment period is unknown. The only circumstances under which this average collection period would be considered as unacceptable would be if the terms were 10 days or less. The current ratio increased from 1.11:1 in Year 0006 to 1.24:1 in Year 0007 and is just acceptable for a restaurant. However, the quick ratio changed from 0.85:1 in Year 0006 to 0.98:1 in Year 0007 and this is on the low side. Creditors may have some concern about the restaurant’s ability to pay its short-term debt. Depending on the type of operation, the cost of sales cost percentage is high or at the upper end of acceptable based on industry standards which currently ranges from 29% to 37%. P4.3

Complete a common-size vertical analysis of CA and CL from P4.2. Current Assets Cash Credit card receivables Accounts receivable Marketable securities Inventories Prepaid expenses Total Current Assets

Year 0006 $12,778 = 35.2% 2,442 = 6.7% 580 = 1.6% 12,000 = 33.1% 6,100 = 16.8% 2,400 = 6.6% $36,300 100.0%

Year 0007 $17,765 = 38.0% 2,815 = 6.0% 420 = 0.9% 16,000 = 34.3% 7,100 = 15.2% 2,600 = 5.6% $46,700 100.0%

Current Liabilities Accounts payable Accrued expenses payable Taxes payable Interest payable Current mortgage payable Total Current Liabilities

Year 0006 $ 10,410 = 31.9% 3,760 = 11.5% 6,800 = 20.8% 500 = 1.5% 11,200 = 34.3% $32,670 * 100.0%

Year 0007 $12,400 = 32.9% 6,200 = 16.4% 8,400 = 22.3% 800 = 2.1% 9,900 = 26.3% $37,700 * 100.0%

* Items that do not add due to rounding

Discussion: Current Assets: Cash increased as did marketable securities over the operating year from Years 0006 to 0007. The total of cash and marketable securities was 68.3% (35.2% + 33.1%) in Year 0006 and 72.3% (38.0% + 34.3%) in Year 0007. It appears that the additional cash on hand at the end of Year 0007 of $4,987 ($12,778 – $17,765) may be in excess of anticipated operating needs and the opportunity exists to increase the marketable securities by $4,000 in Year 0007. Since cash on hand does not earn a return, management should consider investing the excess cash in safe marketable securities to earn additional income. A review of the current liabilities indicates that cash payments on accounts and accrued payables may have been deferred. Compliance with the terms issued by suppliers should be reviewed and corrected if required. It appears more money is tied up in inventories; inventory management policies should be reviewed. Prepaid expenses have also increased slightly, indicating a possible increase of an existing prepaid or the acquisition of a new prepaid. Current Liabilities: In both absolute and percentage terms, all payables increased slightly and only the current mortgage payable decreased over the year. Overall, the payables increased $5,030 ($32,670 – $37,700) over the year. The increase in current payables in general is desirable if the increases result from effective cash management and generates a form of free money. However, if the increase results from becoming delinquent in paying the bills when due, it would not be a desirable trend and should be corrected. P4.4

Using limited information to reconstruct a balance sheet. a. Current assets: Reliance on the known current ratio and the relation of current assets to total assets is the key that will allow all unknown current assets, fixed assets and total assets to be identified. Not all current assets are identified, but current liabilities are identified. Since the current ratio of 1.25:1 is given, it allows total current assets to be found. (1) Current liabilities total: $6,864 (AP $3,444 + $3,420 current note payable) (2) The current ratio indicates CA are 125.0% of CL, thus total current assets are $6,864 × 1.25 = $8,580 b. Since current assets (CA) have been calculated as $8,580: Cash ($976 + $1,500) = $2,476 and ending inventory is $4,945, for a total of $7,421, credit card receivables are found by deducting identified CA of $7,421 from known total CA of $8,580 − $7,421 = $1,159. c. Knowing CA are 25% of total assets, total assets can be found by dividing the known CA value by the percentage it represents of total assets to find value of total assets: $8,580 / 25% = $34,320 total assets.

d. With CA and total assets identified, we can identify fixed assets by deducting CA from total assets: ($34,320 − $8,580) = Fixed assets of $25,740. With all information identified, a balance sheet can now be prepared. Balance Sheet December 31, Year 0007 Assets Liabilities & Owners Equity Cash [$976 + $1,500] $ 2,476 Accounts payable $ 3,420 Credit card receivables 1,159 Current note payable 3,444 Inventories 4,945 Total Current Liabilities $ 6,864 Total Current Assets $ 8,580 Note payable [$23,000 – $3,444] 19,556 Fixed Assets 25,740 Total Liabilities [$6,864 + $19,556] $26,420 Total Assets $34,320 Owners’ Equity [$34,320 – $26,420] 7,900 Total Liabilities & Owners’ Equity $34,320 Having identified total assets [TA] and total liabilities [TL], Owners’ Equity [OE] can now be identified: [TA $34,320 – TL $26,420] = OE $7,900 Total assets = Total liabilities + Owners equity $34,320 = $26,420 + $7,900 P4.5

Calculate the ratios from information provided. a. Total assets to Total liabilities ratio: [Total assets / Total liabilities] Calculations: Year 0006: $422,200 / $312,400 = 1.35:1 Year 0007: $406,700 / $325,500 = 1.25:1 b. Total liabilities to Total assets ratio: [Total liabilities / Total assets] Calculation: Year 0006: $312,400 / $422,200 = 0.74:1 Year 0007: $325,500 / $406,700 = 0.80:1 c. Total liabilities to Total equity ratio: [Total liabilities / Total Stockholders’ equity] Calculation: Year 0006: $312,400 / $109,800 = 2.85:1 Year 0007: $325,500 / $81,200 = 4.01:1 Discussion: These ratios show an undesirable trend from the stockholders’ and creditors’ point of view. Debit increased by 1.16 (4.01 − 2.85) in one year. A potential lender will be cautious because of the increase of debt equity to ownership equity. Creditors have claim to 80% of the present total assets or $325,500 of the $406,700 of total assets at the end of Year 0007. It appears that financial leverage has been used to the advantage of owners. However, this is very risky

P4.6

Use the information provided from P4.5 and the income statement for year 0007, calculate the following ratios. a. Return on Assets: [Income before interest and income tax / Total average assets] Average assets: ($422,200 + $406,700) / 2 = $828,900 / 2 = $414,450 Calculation: $54,900 / $414,450 = 13.2% b. Net return on assets: [Net income after income tax / Total average assets] Calculation: $21,600 / $414,450 = 5.2% c. Number of times interest is earned: [Income before interest and income tax / Interest expense] Calculation: $54,900 / $26,100 = 2.1 times d. Net income to sales revenue ratio: [Net income [AT] / Total sales revenue] Calculation: $21,600 / $851,800 = 2.5% e. Return on stockholders’ equity: [Net income [AT] / Average stockholders’ equity] Average stockholders’ equity: ($109,800 + $81,200) / 2 = $191,000 / 2 = $95,500 Calculation: $21,600 / $95,500 = 22.6% Discussion: Item c: The number of times interest is earned is marginally low but acceptable. The income after tax can drop by 50% before the operation cannot pay its interest expense. Item d: Although the net income to total sales revenue shows a return of 2.5% which means that for each $1.00 of sales revenue 2.5 cents would be net income. This is considered rather low. Item e: From the stockholders point of view, the return of 22.6% on stockholders’ equity appears to be very satisfactory.

P4.7

Calculation of liquidity, long-term solvency and profitability ratios: a. Working Capital: [Current Assets – Current Liabilities] Calculation: Year 0007: $37,700 − $51,600 = ($13,900) Year 0008: $45,000 − $48,300 = ($ 3,300) b. Current ratio: [Current Assets / Current Liabilities] Calculation: Year 0007: $37,700 / $51,600 = 0.73:1 Year 0008: $45,000 / $48,300 = 0.93:1

c. Quick ratio (Acid test ratio): [Total current assets − Inventories − Prepaid expenses / Total current liabilities] Calculation: Year 0007: $37,700 − $14,600 − $3,800 = $19,300 / $51,600 = 0.37:1 Year 0008: $45,000 − $13.900 − $4,500 = $26,600 / $48,300 = 0.55:1 d. Credit card receivables as percentage of credit card sales revenue for Year 0008. [Average credit card receivables / Credit card sales revenue] Calculation: Year 0008: ($4,920 + $6,240) / 2 $742,600 × 62%

$11,160 / 2 $460,412

$5,580 1.2% $460,412

e. Credit card receivables turnover ratio, based on credit card sales revenue. Calculation: Year 0008: $460,412 $5,580

82.5 times

f. Credit card receivables average collection period for Year 0008. [365 / Credit card turnover] Calculation: Year 0008: 365 / 82.5 = 4.4 days g. Accounts receivable as a percentage of accounts receivable credit sales revenue. [Average accounts receivable / Accounts receivable credit sales revenue] Calculation: Year 0008: ($5,280 + $6,160) / 2 $742,600 × 12%

$11,440 / 2 $89,112

$5,720 $89,112

6.4%

h. Accounts receivable turnover ratio for Year 0008. [Accounts receivable credit sales revenue / Average accounts receivable] Calculation: Year 0008: $89,112 $5,720

15.6 times

i. Accounts receivable average collection period for Year 0008. [Accounts receivable credit sales revenue / Average accounts receivable] Calculation: Year 0008: j.

365 / 15.6 = 23.4 days

Total assets to total liabilities ratio for years 0007 and 0008. [Total assets / Total liabilities] Calculations: Year 0007: $355,100 / $243,600 = 1.46:1 Year 0008: $367,200 / $229,200 = 1.60:1

k. Total liabilities to total assets ratio for years 0007 and 0008. [Total liabilities / Total assets] Calculations: Year 0007: $243,600 / $355,100 = 0.69:1 Year 0008: $229,200 / $367,200 = 0.62:1 l.

Total liabilities to Stockholders’ equity for years 0007 and 0008. [Total liabilities / Stockholders’ equity] Calculations: Year 0007: $243,600 / $111,500 = 2.18:1 Year 0008: $229,200 / $138,000 = 1.66:1

m. Net return on total assets ratio for Year 0008. [Net income after income tax / Total average assets] Calculation: Year 0008: $27,500 ($355,100 + $367,200) / 2

$27,500 $722,300 / 2

$27,500 $361,150

7.6%

n. Number of times interest earned for Year 0008. [Income before interest and income tax / Interest expense] Calculation: Year 0008: $59,500 / $19,400 = 3.07 times o. Net income to total sales revenue ratio for Year 0008. [Net income after tax / Total sales revenue] Calculation: Year 0008: $27,500 / $742,600 = 3.7% p. Return on Stockholders’ equity for Year 0008. [Net income after tax / Average stockholders’ equity] Calculation: Year 0008: $27,500 $27,500 $27,500 ($111,500 + $ 138,000) / 2 $249,500 /2 $124,750 q.

22.0%

Food inventory turnover ratio Year 0008: [Cost of sales / Average inventory] Calculation: Year 0008: $301,900 $301,900 $301,900 21.2 ($14,600 + $13,900) / 2 $28,500 / 2 $14,250

r. Fixed assets turnover ratio Year 0008: [Total sales revenue / Total average fixed assets] Calculation: Year 0008: $742,600 ($317,400 + $322,200) / 2

$742,600 $742,600 $639,600 / 2 $319,800 71

2.32

P4.8

Projected Incremental Income Statement: Sales Revenue [$210,000 x 10%] $21,000 Cost of Sales [$21,000 x 30%] $6,300 Payroll expense [$125 x 52 weeks] 6,500 Depreciation expense [$20,000 / 5 yrs.] 4,000 Other operating expenses 1,400 Total Cost of Sales and expenses ( 18,200) Operating Income before Taxes $ 2,800 Income Tax [$2,800 x 25%] ( 700) Net Income $ 2,100 From the incremental income statement the average investment first year is: [Beginning investment + (Beginning investment + NI)] / 2 = Average investment [$20,000 + ($20,000 + $2,100)] / 2 = $42,100 / 2 = $21,050 [NI / Average investment] = Rate of return % Return on Investment: $2,100 / $21,050 = 10.0% Investment should not be made! The return is not 15% or greater.

b. Return on investment using $10,000 of owner’s funds and $10,000 of debt at 10% interest: Income before Interest and Taxes $2,800 Interest expense [$10,000 × 10%] (1,000) Operating Income [BT] $1,800 Income Tax [$1,800 × 25%] ( 450) Net Income $1,350 Average investment first year: [Beginning investment + (Beginning investment + NI)] / 2 = Average investment [$10,000 + ($10,000 + $1,350)] / 2 = $21,350 / 2 = $10,675 [NI / Average investment] = Rate of return % Return on Investment: $1,350 / $10,675 = 12.6% Investment should not be made! The return is not 15% or greater.

P4.9

Ratio analysis and evaluation. a. Increasing: As the ratio increases, current assets increased in relation to current liabilities. Current assets increased $0.36 from $1.04 to $1.40 to each $1.00 of current liabilities. b. Less efficient: Turnover of credit card receivables decreased and the average collection period has increased from 5.2 days (365 / 70) to 6.0 days (365 / 61). c. More efficient: Turnover of accounts receivable increased, and the average collection period decreased from 20.3 days (365 / 18) to 11.8 days (365 / 31). d. More money: The holding period of inventory increased from 9.9 days (365 /37) to 16.6 days (365 / 22) to turn the inventory over. e. Not improving: The return on stockholders’ equity decreased from 9.7% to 8.7%. f. Easier now: The liabilities to equity ratio decreased from 2.75:1 to 1.95:1, and it may be easier to find a lender in Year 0009. g. No: As noted in Item e. and f. above, the debt to equity ratio decreased from 2.75:1 to 1.95:1, and the return on stockholders’ equity decreased from 9.7% to 8.7%.

P4.10 Ratio analysis and evaluation. a.

Decreasing: Current assets decreased in relation to current liabilities, from 1.24:1 to 1.05:1.

b. More efficient: Turnover of credit card receivables increased slightly and the average collection period decreased from 4.0 days (365 / 91) to 3.7 days (365 / 98). c. More efficient: Turnover of accounts receivables increased, and the average collection period decreased from 26.1 days (365 / 14) to 11.8 days (365 / 31). d. Less money: The inventory-holding period decreased from 9.6 days (365 / 38) to 7.6 days (365 / 48) to turn the inventory over. e. Improving: The return on stockholders’ equity increased by 2.2%, from 7.7% to 9.9%. f. Three years ago: The liabilities to equity ratio increased from 1.94:1 to 2.95:1, which means debt increased to $1.01 of debt to each $1.00 of stockholders’ equity. Therefore, it would be more efficient to obtain debt financing now instead of 3 years ago. g. Yes: The debt to equity increased from 1.94:1 to 2.95:1, and the return on stockholders’ equity has also increased from 7.7% to 9.9%. P4.11 Calculation of various ratios, percentages and values. 1. Average room rate per room occupied: [Rooms Sales Revenue / Rooms Occupied] Calculation: $91,108 / 1,798 = $50.67 2. Rooms occupancy %: [Rooms Occupied / Rooms Available] Rooms available: 75 × 31 days = 2,325 rooms

Calculation: 1,798 / 2,325 = 77.3% 3. Room double occupancy %: [Guests – Rooms Occupied / Rooms Occupied] Calculation: (3,417 – 1,798) = 1,619 / 1,798 = 90.0% double occupancy 4. Food cost %: [Cost of Sales / Food Sales Revenue] Calculation: $18,904 / $45,209 = 41.8% 5. Beverage cost %: [Cost of Sales / Beverage Sales Revenue] Calculation: $4,805 / $14,810 = 32.4% 6. Rooms labor cost %: [Rooms Labor Cost / Rooms Sales Revenue] Calculation: $21,867 / $91,108 = 24.0% 7. Dining room labor cost %: [Dining Labor Cost / Dining Sales Revenue] Calculation: $15,011 / ($45,209 + $14,810) = $15,011 / $60,019 = 25.0%

8. Total average check, Dining Room: [Food sales revenue + Beverage sales revenue = Dining room sales revenue] [Dining Room Sales Revenue / Dining Room Guests] Calculation: ($45,209 + $14,810) / $3,720 = $60,019 / 3,720 = $16.13 Avg. check 9. Dining room average daily seat turnover: [Dining Room Guests / Seats Available] Seats available = 40 seats × 31 days = 1,240 Calculation: 3,720 / 1,240 = 3.0 seat turnover 10. Average month sales revenue per dining room seat: [Dining Sales Revenue / Seats] Calculation: $60,019 / 40 = $1,500 11. Beverage sales revenue to food sales revenue %: [Beverage Sales Revenue / Food Sales Revenue] Calculation: $14,810 / $45,209 = 32.8% 12. Beverage sales revenue to Rooms sales revenue %: [Beverage Sales Revenue / Rooms Sales Revenue] Calculation: $14,810 / $91,108 = 16.3% 13. Total dining room to Rooms sales revenue %: [Dining Sales Revenue / Rooms Sales Revenue] Calculation: $60,019 / $91,108 = 65.9% P4.12 Incremental analysis of pre-tax return (operating income) on investment. 1. Projected Pre-tax Incremental Income Statement Sales Revenue [$370,000 x 20%] Cost of Sales [$74,000 x 38%] Payroll expense [$160 x 52 weeks] Lease expense [$97,000 x 1/10] Other expenses [$150 x 52 weeks] Depreciation expense [$20,000 / 10] Total cost of sales and expenses Operating Income [BT]

$74,000 $28,120 8,320 9,700 7,800 2,000 ( 55,940) $18,060

Investment required: $97,000 (lease) + $20,000 (equipment) + $1,500 (inventory) = $118,500 From the incremental income statement, the average investment first year is: [Beginning investment + (Beginning investment + OI)] / 2 = Average investment [$118,500 + ($118,500 + $18,060)] / 2 = $255,060 / 2 = $127,530 [NI / Average investment] = Rate of return % Return on investment: $18,060 / $127,530 = 14.2% Investment should not be made. The return is not 15% or greater. 2. Alternative: Borrow $60,000 at 10% interest. Interest expense of $6,000 will reduce operating income (before tax) to $12,060 ($18,060 − $6,000). The new average investment will be: $37,000 (lease) + $20,000 (equipment) + $1,500 (inventory) = $58,500 [Beginning investment + (Beginning investment + OI)] / 2 = Average investment [$58,500 + ($58,500 + $12,060)] / 2 = $129,060 / 2 = $64,530 [NI / Average investment] = Rate of return %: $12,060 / $64,530 = 18.7% The investment should be made since the return exceeds 15%.

CASE 4 SOLUTIONS a. Working Capital: [CA – CL] = $63,584 − $58,980 = $4,604 b. Current ratio: [CA / CL] = $63,584 / $58,980 = 1.08:1 c. Quick ratio: [Quick assets / CL] = $53,322 / $58,980 = 0.90:1 Quick Assets: $36,218 + $13,683 + $3,421 = $53,322 d. Credit card receivables average collection period: [365 / Credit card receivables turnover ratio] [365 / Credit card sales revenue / Average credit card receivables] Calculation:

365 365 ($639,111 × 60%) / $13,683 $383,467 / $13,683 = 365 / 28.0 = 13.0 days average collection period

365 28.0 times

e. Accounts receivable average collection period: [365 / Accounts receivable turnover ratio] [365 / Accounts receivable sales revenue / Average accounts receivable] Calculation:

365 365 365 ($639,111 × 10%) / $3,421 $63,911 / $3,421 18.7 times = 365 / 18.7 = 19.5 days average collection period

f. Net return on assets: [Net income after tax / Total average assets] Calculation: $34,342 / $268,580 = 12.8% g. Net income to sales revenue ratio: [NI after tax / Total sales revenue] Calculation: $34,342 / $639,111 = 5.4% h. Return on Stockholders’ equity: [NI after tax / Average stockholders’ equity] Average stockholders’ equity: $50,000 + ($50,000 + $34,342) / 2 = ($50,000 + $84,342) / 2 = $134,342 / 2 = $67,171 Calculation of return: $34,342 / $67,171 = 51.1% i. Food inventory turnover ratio: [Cost of sales food / Average food inventory] Calculation: $181,323 / [($6,128 + $5,915) / 2] = $181,323 / ($12,043 / 2) = $181,323 / $6,022 = 30.1 times per year j. Beverage inventory turnover ratio: [Cost of sales beverage / Average beverage inventory] Calculation: $39,303 / [($3,207 + $2,211) / 2] = $39,303 / ($5,418 / 2) = $39,303 / $2,709 = 14.5 times k. Cost of sales % Food: [Cost of sales food / Food sales revenue] Calculation: $181,323 / $458,602 = 39.5% l. Cost of sales % beverage: [Cost of sales beverage / Beverage sales revenue] Calculation: $39,303 / $180,509 = 21.8%

1. The 4C company is incorporated and any payments to Mr. Driver for services are deductible as a salary expense for income statement purposes. This was not the case when the company was a proprietary business. 2. Comments on specific ratios of the 4C Company that may be considered unsatisfactory are identified and discussed in the following comments: i. The quick ratio of 0.90:1 is unsatisfactory. Since inventories for resale that are excluded from the ratio are turning over 30.1 times per year or every 12.1 days, this ratio might be considered marginally satisfactory. ii. The credit card receivables turnover ratio is unsatisfactory at 28 times per year and the collection period is high at 13 days. This ratio should average around 120 times per year. The collection period should average from 1.5 to 3 days. This ratio should be investigated. iii. Assuming the terms allowed is 5 days, the accounts receivable turnover ratio is marginally unsatisfactory at 18.7 times per year and the collection period is high at 19.5 days. This ratio should be around 24 times per year with an average collection period of 15 days. Without information this ratio should be investigated. iv. The food turnover ratio of 30.1 times per year indicates on average the inventory is being held for 12.1 days (365 / 30.1). The food turnover and average inventoryholding period may be marginally unsatisfactory dependent on the type of operation and its geographical location. Increasing the turnover and lowering the inventory holding time will cut costs and, therefore, the inventory turnover ratio should be continually evaluated. v. The beverage turnover ratio of 14.5 times per year, or an average inventory-holding period of 25.2 days (365 / 14.5) is unsatisfactory without further information. Holding beverage inventory for a month is unsatisfactory unless local conditions prevent restocking weekly or semi-monthly. 3.

Assuming $20,000 of stock was purchased back by the 4C Company, the following are recalculated: Changes in working capital, net return on assets, and the return on stockholders’ equity. i. The use of $20,000 for the corporation to purchase back treasury stock will decrease CA to $43,584 ($63,584 − $20,000). This action will decrease working capital from a positive $4,604 to a negative $15,396 ($43,584 − $58,980). Negative working capital will affect the working capital ratio. The ratio would be inadequate, and would not be acceptable. ii. In addition to creating an unacceptable working capital position, the current ratio will decrease from 1.08:1 to 0.74:1 ($43,584 / $58,980) and the quick ratio will decrease from 0.90:1 to 0.56:1 ($33,322 / $58,980). Both of these ratios also become unacceptable.

iii. New net return on assets: [Net income after tax / Total average assets] Calculation: $34,342 / $248,580 = 13.8% iv. Return on Stockholders’ equity: [NI after tax / Average stockholders’ equity] Average shareholders’ equity: [$50,000 + ($30,000 + $34,342)] / 2 = ($50,000 +$64,342) / 2 = $114,342 / 2 = $57,171 Return on SHE: Calculation = $34,342 / $57,171 = 60.1% The repurchase of $20,000 of the 4C Company common stock should not be made. Creditors or potential creditors would be greatly concerned. Creditors might decide to demand immediate payment of their loan and Mr. Driver could be bankrupt.

CHAPTER 5 INTERNAL CONTROL INTRODUCTION This chapter can be studied relatively independently of other chapters in the textbook. However, the meaningful use of most of the tools, techniques, and methods explained and illustrated in other chapters in the text depends on the accuracy of the information provided by the accounting system. Accuracy, in turn, is dependent on the completeness and effectiveness of the establishment’s internal control system. In particular, the students’ attention should be drawn to the last part of the chapter where some of the many ways in which theft or fraud can occur are listed. This should alert the students to the necessity for good internal control in all areas.

TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True and F for False answers)

1. Accurate accounting information is aided by a good internal control system.

2. An objective of internal control is to safeguard the assets of a business.

3. A small, owner-operated business needs as much internal control as a large business.

4. The cost of an internal control system is irrelevant as long as there are some benefits.

5. Collusion occurs when one employee bumps into another.

6. An internal control system, once instituted, should not be changed.

7. Procedures outlining the jobs to be performed by employees should be put into writing.

8. Procedures for a specific type of job, for example a storekeeper, will not vary from one establishment to another.

9. In the control of the receipt of food, the receiver should make out a credit memorandum if goods are short-shipped or returned for some reason.

10. Record keeping and physical control of assets should be separated so both employees are kept busy.

11. Lapping is a method of fraud that can occur if the employee who looks after accounts receivable also handles cash received in payment of those accounts.

12. Wherever possible, the work of one employee should check on the work of another.

13. In the control of food sales, if the cash remittance agrees with the cash register total reading, no further control is necessary.

14. Explaining to employees the reasons why tasks have to be carried out is not necessary for good internal control.

15. A card used in storeroom control to record items coming into and going out of the storeroom is a perpetual inventory card.

16. A purchase requisition is sent to a supplier from whom goods are ordered for delivery.

17. Machines aid in internal control because they prevent any fraud or theft.

18. To reduce labor costs in a large hotel, the person handling cash receipts should also make the related entries in the accounting records.

19. Cash received each day should be deposited intact daily in the bank.

20. Bonding employees who handle cash may reduce losses.

21. Petty cash is cash that does not have to be accounted for.

22. Wherever possible, payments for purchases should be made by check.

23. A voucher system is a system of control over payments for purchases of goods and services.

24. In a bank reconciliation, an outstanding check should be added to the company’s bank balance.

25. In a bank reconciliation, if the company’s and the bank’s balance figures do not immediately agree, the company should put through an adjustment on its books for the difference.

26. Food standard cost can be affected from one period to the next by a change in the sales mix.

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk)

1. An objective of internal control is to: (a) Eliminate collusion (b) Prevent employees from having access to cash (c) Provide 24-hour policing of employees * (d) Safeguard the assets 2. Collusion is when: (a) One waiter accidentally running into another * (b) Two or more employees are working together fraudulently (c) An employee having control of both records and assets (d) One employee checking the work of another 3. Internal control should generally be instituted only if: (a) The benefits from the control are less than the cost * (b) The cost of control is less than the resultant savings (c) Employees can be rotated in their jobs to eliminate collusion (d) Forms can be designed so they never need changing

4. Responsibilities for specific tasks should be defined so: * (a) In the case of error, a designated person can be held accountable (b) Employee A knows that he/she does not have to understand how Employee B does his or her job (c) Employees know what the policies and procedures are (d) Management supervision can be eliminated 5. Written procedures for each set of tasks are required: (a) Only when job rotation is in effect (b) For employees using electronic control equipment * (c) So employees know what the policies and procedures are (d) So the procedures will be the same from one company to another 6. Record keeping and the control of assets should be separated: (a) So one employee does not have too much to do (b) To prevent collusion * (c) To better safeguard the assets (d) So one employee does not get to know too much about the business 7. A purchase requisition is: (a) The same as a purchase order (b) Sent by a supplier to the hotel’s purchaser (c) Used to verify the supplier’s invoice quantities and prices * (d) Used by a department head or manager to request the purchase of supplies from a supplier 8. A perpetual inventory card is used for each item in the storeroom to: (a) Avoid having to periodically take inventory * (b) Record quantities received and quantities issued and to provide a running balance of what should be in inventory (c) Show at the end of each month, the total quantities of all items received in the storeroom. This total is the month-end inventory (d) Show at the end of each month, the total quantities of all items issued from the storeroom. This total is the month-end inventory 9. Lapping is a method of fraud that can occur when: (a) A cashier does not have sales check entries on the register tape checked * (b) The same employee is in control of both accounts receivable records and cash received in payment of those accounts (c) Jobs are not properly rotated (d) Written procedures are not prepared for the person in control of receivables 10. Machines should be used wherever possible in internal control to: * (a) Reduce the possibility of fraud and/or theft (b) Prevent collusion by employees (c) Prevent lapping (d) Eliminate the need for written procedures

11. Each day’s cash receipts should be deposited intact in the bank daily: (a) So a receipt will not be required from the bank * (b) To prevent temporary borrowing of funds by employees handling cash (c) To prevent lapping (d) To avoid having to establish a petty cash system 12. A bank reconciliation is: * (a) A month-end procedure to ensure that a company’s records of its bank balance agrees with the bank’s record (b) A procedure for paying invoices involving the use of bank checks and vouchers (c) A system of ensuring that the general cashier does not practice lapping (d) A discussion with the bank manager by a company’s general manager to solve a dispute between them 13. In a bank reconciliation outstanding checks are: * (a) Deducted from the bank statement balance (b) Added to the company’s bank balance (c) Deducted from the company’s bank balance (d) Added to the bank statement balance 14. The main purpose of calculating a standard food cost percentage is to: (a) Know in advance what the actual food cost will be (b) Be able to calculate the food cost each day * (c) Have a figure against which actual food cost can be compared (d) Be able to calculate in advance what the gross profit will be 15. In using standard cost control, a change in the sales revenue mix may cause: (a) Actual cost to be above standard cost even though it was previously lower (b) Actual cost to be below standard cost even though it was previously higher (c) Both the standard and the actual cost to decrease from the previous period * (d) All of the above answers are correct

EXERCISE

SOLUTIONS

E5.1

Major objective of internal control is to safeguard the assets and provide information to evaluate the effectiveness of internal control.

E5.2

Petty cash is established to make payments for minor low cost items.

E5.3

A purchase order is used by a business operation for purchases of goods or services from an external wholesaler, distributor, or supplier. A purchase requisition is an internal document used by an operating department to request that the purchasing department purchase goods or services from a supplier.

E5.4

Petty cash accountability uses a simple linear statement based on having cash payment receipts or vouchers for all disbursements. If cash on hand and cash payment receipts do not equal the fund limit, a cash shortage or overage exists. Cash on hand + Petty cash receipts = Funds accounted for – Fund limit = Over or Short $43.00 + $152.00 = $195.00 – $200.00 = $5.00 Shortage 82

E5.5

The purpose of the bank reconciliation is to bring the reported bank statement balance into equality with the check register (checkbook). The bank will report transactions they handled that the business is not fully aware of until receipt of the bank statement. The business has completed transactions recorded in the check register that are not reported in the bank statement. Such items as deposits in transit and outstanding checks will be used to adjust the bank statement balance. Items shown in the bank statement, such as NSF (non-sufficient funds) checks, bank service charges, interest earned on the checking account balance, etc. are used to adjust the check register.

E5.6

Standards are developed in dollar values and percentages for costs such as cost of sales, labor, and other items of cost. Standards are developed for sales revenue items such as selling prices. A standard represents what a cost or sales revenue item is when the standard is developed. Standards represent what cost and sales revenue items are expected to be in the near future. Standards are compared to actual costs and sales revenues from operations to determine the effectiveness of cost and revenue controls.

E5.7

A standard food cost percentage is compared to the actual food cost percentage to indicate to management how close actual food cost is to the standard food cost. If the actual food costs exceed the standard, an evaluation may be called for to correct the problem dependent on the level of the variance.

E5.8

Standard cost is $18,282 and total standard sales revenue is $48,487. Determine the standard cost percentage. (Total standard Cost / Total standard sales revenue = Standard cost %) ($18,282 / $48,487) x 100 = 37.7%

E5.9

Assuming total actual cost is $18,480 and total actual sales revenue is $48,487. Determine the actual cost percentage. (Total actual cost / Total actual sales revenue = Actual cost %) ($18,480 / $48,487) x 100 = 38.1%

E5.10 The person receiving the $51.40 check removes the $51.40 in cash and does not record

the payment made on the Arnold account. The amount of cash lapped daily is: Customer Name Arnold Sayers Carter Tuney Lossie Martie Buddy Smithe Brown Totals

Amount of Check $ 51.40 62.11 101.10 110.90 141.20 162.75 172.83 185.22 202.90 $1,190.41

Date Payment Received in August 2 4 7 12 14 17 22 27 30

Cash Removed $ 51.40 10.71 38.99 9.80 30.30 21.55 10.08 12.39 17.68 $202.90

An effective control measure is to not allow any one person to handle cash receipts or the recording of such receipts in the accounting records.

Problem Solutions P5.1

Calculate the October and November reimbursement checks to the petty cash fund. October:

Reimbursement check is $80.96 in exchange for the October receipts is valid and was reimbursed. (Cash in the fund was $19.04 + $80.96 = $100).

November: The list of petty cash disbursements listed total $78.09; however, no receipt exists for the $11.50 of postage stamps purchased on November 13, which reduces acceptable receipts to $66.59. Thus, cash on hand $1.91 + $66.59 = $$68.50 for reimbursement. The fund limit is $100 – $68.50 = $31.50 short. The requested $86.09 reimbursement is questionable since no receipt exists for the $11.50 purchase of stamps and management must resolve the matter of the $12.00 IOU, and additional $8.00 missing cash must investigated, and resolved before reimbursement can be made. If the fund operator cannot replace the IOU and provide a suitable answer for the missing postage receipt, and the missing $8.00, the fund operator should not be allowed to manage the petty cash fund, be discharged, and perhaps charged with theft. P5.2

P5.3

Bank Statement Reconciliation Tavara’s Tavern June 30, 0006 Bank Statement Balance $4,810.00 Check Register Balance Add: Deposits in transit 554.00 Add: Interest credited Subtotal $5,364.00 Subtotal Deduct: Outstanding checks #306 @ $ 27.00 #309 @ 108.00 Deduct: #311 @ 87.00 ( 222.00) Service charges Reconciled Balance $5,142.00 Reconciled Balance

Bank Statement Reconciliation October 31, 0007 Bank Statement Balance $3,506.00 Check Register Balance Add: Deposits in transit 2,266.00 Add: Interest credited Add: Bank debit error 20.00 Subtotal Subtotal $5,792.00 Deduct: Outstanding checks #3581 @ $298 Deduct: #3650 @ $402 ( 700.00) Bank service charge Reconciled Balance $5,092.00 Reconciled Balance

$5,112.00 38.00 $5,150.00

( 8.00) $5,142.00

$4,740.00 356.00 $5,096.00

( 4.00) $5,092.00

P5.4

Bank Statement Reconciliation August 31, 0007 Bank Statement Balance $2,760.00 Check Register Balance Add: Deposit in transit 456.00 Add: Interest credited Deposit in transit 1,212.00 Deposit error Subtotal $4,428.00 Subtotal Deduct: Outstanding checks #167 @ $ 61.00 Deduct: #169 @ 30.00 NSF check #175 @ 172.00 ( 263.00) Bank service charge Reconciled Balance $4,165.00 Reconciled Balance

$4,112.00 61.00 9.00 $4,182.00

( 11.00) ( 6.00) $4,165.00

P5.5

The present responsibilities of the retiring bookkeeper violate the internal control principle of separating the control of assets from record keeping. The new person hired may be allowed to remove the machine tapes from the front office or the restaurant machines and enter the amounts in the accounting records. The owner should handle the cash, collect it, count it, and verify it against the tape’s totals. The owner should make the daily bank deposits and complete the month-end bank reconciliation. The new bookkeeper may continue approving the invoices for payment and preparing checks, but only for the owner’s signature. Under no circumstances should the bookkeeper be allowed to sign checks. Since the owner already places all orders and does the receiving of beverages, the new bookkeeper can be assigned the task of checking invoices against receiving records of all items.

P5.6

In the delivery receiving area, losses could occur from:  An individual passing by could simply pick up some or all of the goods left on the receiving dock by a delivery driver.  A delivery driver making a delivery could easily pick up goods left on the dock by an earlier driver. The driver can keep the goods for personal use or sell them for personal gain.  An employee of the restaurant could pick up goods left on the dock and keep the goods for personal use or sell them for personal gain.  A supplier insisting that goods ordered have been delivered, when in fact, they were not delivered.  A supplier insisting that higher quality goods was delivered and must be paid for than was actually the case.  Spoilage of the goods as they sit on the receiving dock and are not put in proper storage. A restaurant owner can solve many of these potential losses by:  Requiring the individual given the responsibility of ordering goods to prepare a purchase order even if no formal format exists. A simple hand written list showing the date, time, the company name and the identity of the person who received the purchase order. A purchase order should list each item ordered by name, quantity ordered, and the price quoted for each item.

 Coordinating the day and time that deliveries will be accepted and insisting that the receiver/storekeeper be available to receive the goods before the driver unloads the goods.  Insisting that the driver have a copy of the delivery invoice showing items, quantities, and prices. A copy of the detailed invoice is checked off and signed by the receiver/storekeeper before the driver leaves. A copy of the detailed invoice is used to verify goods received against the order list and the received items should be moved immediately into storage.  Advising suppliers that no invoices will be paid unless they have been checked, verified, and signed by the receiver/storekeeper to verify the authenticity of the invoice.  Advising all employees that no one but the designated employee or, in his or her absence, the manager on duty is allowed to receive deliveries of goods, and sign delivery invoices. In the dining area, major losses may occur if servers are tempted to destroy scratch pad records that do not have sequential numbers. Such potential losses in a manual system can be generally overcome by:  Purchasing and using order-pads that have pre-printed sequential page numbers. Having servers sign a form for each pad of blank order pads. Requiring each employee to account for each page (by number) at the end of each shift.  If sales checks are collected only at one point-of-sale register, the sales checks must be presented for payment at which time the sales check number and server are noted. Only one employee should have access to the cash drawer.  Verifying each day that cash in the cash drawer is the equivalent to the amount of sales revenue rung up at the register. The total sales checks rung up at the register must also agree with an adding machine listing of sales check totals.  Ensuring each day that no sales checks are missing by sorting them into numerical sequence and confirming there are no missing sales checks.  If servers are using banks, each employee bank must be reconciled by guest check and server numbers. The total sales revenue plus the bank of each server is accounted for by cash, personal checks (if allowed) and credit card receipts.  An electronic point-of-sale terminal for use of the servers, coupled to an electronic collection register will provide many of the requirements of an effective manual system.

P5.7

Set a columnar schedule for each year, record the credit sales revenue, cost of sales, and operating income. In addition, for each year, calculate bad debits as a percentage of charge or credit sales revenue. Comment on the results. Year 1 2 3 4 5

Credit Sales Revenue $160,000 180,000 240,000 300,000 360,000

– – – – – –

Cost of Sales $ 64,000 72,000 96,000 120,000 144,000

Gross = Margin = $ 96,000 = 108,000 = 144,000 = 180,000 = 216,000

– – – – – –

Operating Expenses $ 80,000 90,000 120,000 150,000 180,000

Operating = Income = $16,000 = 18,000 = 24,000 = 30,000 = 36,000

(Credit SR ─ CS = GM ─ Expenses = Income before bad debts) Income before Bad Operating Bad Debts Year Bad Debts – Debts = Income Percentage 1 $16,000 – $ 960 = $15,040 0.6% 2 18,000 – 900 = 17,100 0.5% 3 24,000 – 3,840 = 20,160 1.6% 4 30,000 – 4,500 = 25,500 1.5% 5 36,000 – 5,400 = 30,600 1.5% (Period bad debts / Income before bad debts = Bad debts %) Although in the third year when the extended credit was introduced, the bad debt percentage of the restaurant has increased by a full percentage point; it has stabilized at that level. Despite the increase in bad debts percentage, credit sales revenue has increased and has resulted in a vast increase in operating income from credit sales revenue. One can conclude that the extension of credit to local business people was fully justified, and that some bad debt losses from accounts receivable are expected. However, the credit policy should be reviewed as well as collection procedures, rather than reverting to the earlier policy. P5.8

It appears the new bookkeeper has been lapping payments on accounts. To resolve this problem, the bookkeeper should not be allowed to handle any cash or incoming mail. The owner should open all incoming mail and prepare the bank deposit, listing all checks or other payments on account received and make the bank deposits. The bookkeeper can be given a list each day of any payments received so the related accounts can be credited. All cash received at the front desk by the front office cashier should also be turned over to the owner for direct deposit in the bank. Cash included payments on previous accounts receivable, a written list of who made the payments and the amounts can be provided to the bookkeeper so appropriate accounts can be credited.

P5.9

In the present situation, collusion could exist. The bartender may not be tearing up tickets received for drinks and giving them back for resale to the cashier at the door. To compensate for liquor usage caused by the resale of some of the tickets, the bartender could short pour drinks. The final result is the cashier and the bartender would split their additional cash profits gained by the resale of the tickets. This problem can be controlled if management actively supervised and observed the bartender to ensure tickets are properly handled. However, under the new proposal, 87

eliminating the tickets and the cashier, it will be easier for the bartender to steal. He or she could still short pour drinks, pocket the extra cash but would not have to split the proceeds. The new proposal violates a key principle of internal control: separating tasks so an employee who is in charge of assets (drinks) cannot also receive cash generated by cash sales revenue. If theft resulting from this new procedure were to exceed the cost of a cashier, there would be no benefit to using the new method. P5.10 a.

Calculation of a food cost percentage. Item Cost SP CS % 1 $ 2.20 / $ 6.80 32.4% 2 3.25 / 8.80 37.0% 3 3.75 / 9.85 38.1% Total $9.20 / $25.45 36.1%

Item 1 2 3 Totals

Cost $2.20 x 3.25 x 3.75 x

SP $6.80 8.80 9.85

Table Alternative: Units Total SR 50 = $ 340.00 x 50 = 440.00 x 50 = 492.50 x $1,272.50

Total CS $110.00 162.50 187.50 $460.00

CS % 32.4% 37.0% 38.1% 36.1%

b. Total CS: (50 × $2.20) + (50 × $3.25) + (50 × $3.75) = $460.00 Total SR: (50 × $6.80) + (50 × $8.80) + (50 × $9.85) = $1,272.50 Standard food cost: $460.00 / $1,272.50 = 36.1% c. The standard cost percentage will increase when the sales revenue mix changes to show greater amounts of the items with the highest food cost percentage. Item Cost SP CS % Units Total SR Total CS 1 $2.20 / $6.80 = 32.4% 25 $ 170.00 $ 55.00 2 3.25 / 8.80 = 37.0% 100 880.00 325.00 3 3.75 / 9.85 = 38.1% 25 246.25 93.75 Totals $1,296.25 $473.75 The total dollar CM = $1,296.25 – $473.75 = $822.50 d. The total sales revenue and total cost of sales has increased, and the total dollar CM have both increased. The individual dollar CM on Item 2 is $5.55; The individual dollar CM on Item 3 is $6.10. Therefore, if you sell more of Item #2 with a lower individual CM and fewer of Item 3, the overall dollar CM increases. The cost of sales percentage on Item 2 is lower by 1.1% (38.1 – 37.0%) and is acceptable.

P5.11 a. Calculate a standard cost percentage for a given month.

Item 1 2 3 4 5 6 Totals

Item Cost $2.50 1.80 2.30 1.80 2.25 2.80

Total Total Selling Quantity Standard Standard Price Sold Cost Sales Revenue $6.00 654 $ 1,635 $ 3,924 4.60 2,195 3,951 10,097 7.00 1,110 2,553 7,770 5.30 990 1,782 5,247 5.00 295 664 1,475 8.00 259 725 2,072 $11,310 $30,585

Standard cost percentage: $11,310 / $30,585 = 37.0% Actual cost percentage: $11,855 / $30,880 = 38.4% b. The difference between standard and actual cost percentages is only 0.014%, or $545 dollars less in actual cost ($11,310 − $11,855). The difference should be investigated to determine the cause and correct it. P5.12 a. Calculate total standard cost, total standard sales revenue, and cost of sales

percentages. Menu Item Item Cost 1 $1.80 2 2.10 3 4.20 4 3.05 5 1.40

Selling Quantity Price Sold $3.95 260 4.95 411 8.95 174 6.95 319 3.95 522

Total Standard Cost $ 468.00 863.10 730.80 972.95 730.80 $3,765.65

Total Standard Sales Revenue $1,027.00 2,034.45 1,557.30 2,217.05 2,061.90 $8,897.70

Cost of Sales Percentage 45.6% 42.4% 46.9% 43.9% 35.4% 42.3%

Actual cost percent: $3,804.10 / $8,873.40 = 42.9% Standard cost percent: $3,765.65 / $8,897.70 = 42.3% Actual cost percentage is higher than the standard percentage by 0.6%, which is minor. Normally the actual percentage is expected to exceed the standard percentage. The difference is $38.45 ($3,804.10 − $3,765.65). However, actual sales revenue is lower than the standard sales revenue, which is unusual and should be checked. b. If the sales revenue mix changed as indicated, we would expect the food cost standard percentage to decrease. Item 4 has a 43.9% standard food cost while menu item 1 has a 45.6% standard food cost. Since more of menu Item 4 with the lower food cost percentage are sold, this will tend to decrease the overall standard food cost percentage.

CASE 5

SOLUTIONS

a. No solution is offered. Each student’s report will be based on three specific areas selected by the student for discussion, which will differ. b. For soups, entrées, and desserts a standard cost control system can be established by using the following steps as a minimum: 1. Establish proper purchase control procedures. 2. Ensure there is adequate control over the storeroom using perpetual inventory cards and requisitions. 3. Use standard recipes and portion sizes. 4. Calculate standard costs for each item, including the cost of coffee in entrée costs. 5. Supervisors should direct the serving staff to charge for coffee if an entrée is not ordered. Supervisors need to check the servers to make sure they follow this policy. 6. Determine the desired selling prices to yield an appropriate gross margin and/or food cost percentage. 7. Periodically evaluate actual food cost to standard food cost. All items not part of the main menu can use the same standard cost procedures. All that is then required for overall food cost control is to ensure that an accurate count of these other items (coffee, milk, soft drinks, etc.) is maintained. Electronic sale registers and point-of-sale systems can easily handle this problem and provide a periodic tally or count of every item sold. Apparently, no policy exists as to when free coffee is available. Charlie must set a policy, announce it to the wait staff and put a note in the menus.

CHAPTER 6

THE BOTTOM-UP APPROACH TO PRICING

INTRODUCTION The prime purpose of this chapter is to encourage the students to think about net income as a cost to be considered in setting selling prices, rather than being merely what is left for the owners after all other costs are deducted from sales revenue. Prices, in other words, should be established to help ensure that a specific desired amount of net income results. The concepts established in this chapter will also be particularly useful in budgeting which is covered in Chapter 9.

TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True and F for False)

1. Trial-and-error pricing is also known as intuitive pricing.

2. Mark-up pricing occurs when the cost of food sold is marked up by a fixed percentage to obtain the selling price.

3. Long-run pricing is also known as tactical pricing.

4. Net income cannot be considered a cost of running a business.

5. If a company is in a 50% tax bracket, its net income after tax will be the same as the amount of tax.

6. A restaurant’s anticipated overall average check can be calculated by dividing the forecast annual sales revenue by (seats × daily seat turnover × days open in the year).

7. If seat turnover increases and average check increases, total sales revenue will decrease.

8. The average check calculation gives us the price of all items on the menu.

9. The average check is usually the same for each meal period.

10. It is necessary to know the proportion of total sales revenue normally derived from each meal period to forecast the average check by meal period.

11. If a restaurant operator wanted a 30% food cost for a menu item, he or she would multiply the item cost by three to obtain the selling price.

12. The cost multiplication factor that yields a 20% food cost is five.

13. The dollar gross margin on a particular menu item is more important than that item’s food cost percent.

14. The quantity of each item that guests choose of each of the various menu items offered is known as the sales revenue mix.

15. If we take an item with a high gross profit off a menu and replace it with an item with a lower gross margin, all other things being equal, our net income will be higher.

16. A method of menu analysis that concerns itself with each menu item’s popularity, combined with its contribution margin (gross margin), is known as menu engineering.

17. Integrated pricing occurs when both food cost and beverage cost are marked up by the same percentage.

18. An analysis of restaurant seat turnovers by day of the week can be useful in preparing staffing schedules.

19. Loss of sales revenue from a hotel room not sold overnight is no more serious than loss of sales revenue from a restaurant seat not used during a meal period.

20. Hotel room inventory cannot be increased quickly in the short run.

21. The $1 per $1,000 method of establishing room rates means that if the forecast annual sales revenue from the average room per year is $40,000, average room rate should be $40.

22. The $1 per $1,000 method of establishing room rates should be used with caution.

23. An average room rate is the rate charged at all times for each room in the hotel.

24. Size of room, decor, and view may be some of the factors to consider in establishing individual room rates.

25. Total number of guests during a period, fewer rooms occupied during that period, equals the number of rooms double occupied.

26. Room rates, because of higher construction and financing costs, are generally higher in newer hotels compared to older ones.

27. Room rates cannot be calculated based on the square foot area of the various size rooms.

28. Analysis of the room’s occupancy by day of the week can be useful in staff scheduling and advertising.

29. A hotel room’s rack rate is the normal rate for that room discounted by a fixed percentage.

30. The potential average room rate is defined as the average rate that would result if all rooms occupied overnight were sold at the rack rate without any discount.

31. When there is a large change in demand with a small change in price, this is known as inelastic demand.

32. When there is a small change in demand following a large change in price, this is known as inelastic demand.

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk)

1. Which of the following would not call for a tactical pricing decision? (a) Reacting to a competitor’s short-run pricing changes * (b) Establishing prices with the firm’s long-term financial objectives in mind (c) Knowing what discount to offer to accept group business while still making a profit (d) Adjusting prices to reach a new market segment 2. If, in a restaurant, food cost, labor cost, and other operating costs total 60%, and indirect costs including net income are $42,000, then sales revenue required to provide the desired net income will be: (a) $ 70,000 (b) $252,000 * (c) $105,000 (d) $168,000 3. Sales sales revenue in a restaurant open every day for a week is $5,296. The restaurant has 60 seats. Seat turnover is 1.5 per day. Average check is: (a) $17.64 (b) $11.76 (c) $12.60 * (d) $ 8.41 4. All other things being equal, an increased seat turnover will: * (a) Increase total sales revenue (b) Decrease the average check (c) Increase the average check (d) Decrease total sales revenue 5. Total annual restaurant sales revenue is $754,000. Lunch turnover is 2.25 and there are 60 seats. Lunch is served 5 days a week and is 30% of total annual sales revenue. Lunch average check will be: (a) $4.55 * (b) $6.44 (c) $7.95 (d) $5.45 6. A menu item has a food cost of $5.00 and the selling price is based on a 40% cost. The selling price of the menu item is: (a) $ 8.00 * (b) $12.50 (c) $ 7.00 (d) $20.00 7. Menu Item 1’s selling price is $3.00 and food cost 20%. Menu Item 2’s selling price is $6.00 and food cost 50%. All other things being equal, it would be better to sell: (a) An equal quantity of each item (b) More of Item 1 because it has a lower cost percent * (c) More of Item 2 than Item 1 (d) Some other item on the menu with a lower food cost percentage than item 2

8. Menu item sales revenue mix is: (a) The way menus are compiled with a mix of items with different costs (b) The way menus are compiled with a mix of items with different selling prices (c) The way menus are compiled with a mix of items with different costs and selling prices * (d) The quantity of various menu items guests choose from a menu 9. A method of menu analysis that concerns itself with each menu item’s popularity combined with its contribution margin (gross margin) is known as: * (a) Menu engineering (b) Menu factoring (c) Gross margin analysis (d) Popularity analysis 10. Average room rate for a motel is $80.00. Occupancy is 60% percent. The motel has 80 rooms. Double occupancy rate is 50%. Spread between single and double rates is $5.00. Average single rate is: (a) $70.00 * (b) $77.50 (c) $93.32 (d) $73.32 11. When the selling prices of items sold in two or more departments are set so that prices complement or are compatible with each other, this is known as: (a) Competitive pricing (b) Multi-department pricing * (c) Integrated pricing (d) Intuitive pricing 12. The loss of sales revenue from a guest room on a given day is more serious than loss of sales revenue from a restaurant customer on a given day because: (a) Room rates are always higher than average checks in a restaurant * (b) The lost room sales revenue cannot be recovered at some future time (c) The labor cost is higher in the rooms department (d) Food cost is only a fraction of restaurant sales revenue 13. Forecast annual motel room sales revenue is $642,400. The motel has 40 rooms and an 80% occupancy rate. What is the average room rate? * (a) $55.00 (b) $44.00 (c) $55.76 (d) $50.00 14. In menu engineering, there are four names used to identify four classifications of menu items, they are: (a) Plowhorses, puzzles, stars and losers (b) Plowhorses, puzzles, stars and winners (c) Plowhorses, puzzles, dogs and winners * (d) Plowhorses, puzzles, stars and dogs

15. Total guests during the year are 38,460. Rooms sold during the year are 29,840. The double occupancy rate is: (a) 22.4% (b) 86.2% * (c) 28.9% (d) 77.6% 16. Analyzing guest-room occupancy by day of the week is useful because it may indicate: (a) Which rooms are the most popular day by day? * (b) Where advertising efforts should be directed? (c) Which desk clerk is doing the best job of selling rooms? (d) Room rates could be increased on certain days of the week? 17. The maximum rate established for each room in a hotel is its: (a) Integrated rate (b) Yield rate * (c) Rack rate (d) Potential rate 18. A hotel’s potential average room rate is the average rate that would result if: * (a) All rooms occupied were sold at the rack rate without any discount. (b) All rooms sold were double occupied. (c) There were no unoccupied rooms. (d) All rooms sold were discounted by only 10%.

EXERCISE SOLUTIONS E6.1

Find operating income for a NI after tax of $56,000 and a 30% tax rate. Equation:

NI after tax 1 − Tax Rate

Calculation: $56,000 1 – 30% E6.2

Operating Income $56,000 70%

$80,000

Using information from E6.1, find the income tax to be paid. Equation: NI after tax 1 − Tax Rate

Operating Income − NI after tax = Tax

Calculation: $56,000 1 − 30%

$56,000 70%

$80,000 − $56,000 = $24,000

Alternative Equation: NI after tax 1 − Tax Rate

Operating Income × Tax Rate = Tax

Calculation: $56,000 $56,000 1 − 30% 70%

$80,000 × 30% = $24,000

E6.3

E6.4

E6.5

Forecast sales revenue. Calculation: Known Costs 100% − VC%

$174,600 100 – 82%

$174,600 18%

Determine average monthly check. Equation: Sales Revenue Seats × Turnover × Operating Days Calculation: $64,760 $64,760 $10.25 90 × 2.7 × 26 6,318

$970,000

Average Check

Using information from E6.4, determine effect on average check if seat turnover decreases from 2.7 to a 2.0 Equation: [Sales Revenue / Seats × Turnover × Operating Days = Average Check] Calculation: $64,760 / (90 × 2.0 × 26) = $64,760 / 4,680 = $13.84 (The average check would have to increase by $3.59 ($13.84 – $10.25)

E6.6

Determine the average check for a meal period. Equation: Meal Period Sales Revenue Meal Period Average Check. Seats × Turnover × 6 × 52 Calculation: $998,000 × 68% $678,640 $12.43 100 × 1.75 × 6 × 52 54,600

E6.7

Determine a double occupancy rate. Equation: Guests − Rooms Occupied Room Occupied

Double Occupancy Rate

Calculation: 23,450 − 18,760 4,690 25.0% 18,760 18,760 Alternative: Guests / Rooms = 23,450 / 18,760 = 125% of which 100% of 18,760 rooms are occupied, and 25% of the rooms are double occupied. E6.8

Determine expected average room rate. Equation: Total rooms revenue Average Room Rate Room’s × Occupancy % × 365 Calculation: $842,712 $842,712 $62.40 50 × 74% × 365 13,505

E6.9

Determine the rate to charge for each square foot. Calculation: 45 Rms. × 220 sq. ft. = 9,900 25 Rms. × 160 sq. ft. = 4,000 Total Square Footage: 13,900 Occupancy Percentage: × 0.70 Total Square Feet occupied: 9,730 Total day rooms sales revenue $2,390 / 9,730 = $0.246 per sq. ft. 96

E6.10 Calculating single and double room rates with a $12.00 spread. Rooms sold per day 60 Double rooms per day (24) Single rooms per say 36 Calculation: 36x + 24 (x + $12.00) = $2,988 36x + 24x + $288 = $2,988 60x = $2,988 − $288 = $2,700 x = $2,700 / 60 = $45.00 Single rate Single rate $45.00 + $12.00 = $57.00 double rate Proof 36 singles × $45.00 = 24 doubles × $57.00 = Average daily rooms revenue =

$1,620 1,368 $2,988

PROBLEM SOLUTIONS P6.1

a. Calculate sales revenue needed to cover total operating costs and NI [AT] and tax. Net income (AT) [22% × $80,000] Income tax [$17,600 / 72% = $24,444 × 28%] Depreciation expense [$76,000 × 20%] Interest expense [$35,000 × 8%] Insurance expense* License expense* Utilities expense* Maintenance expense* Administration expense* Management salary expense* Total known costs

$17,600 6,844 15,200 2,800 3,000 2,500 8,400 3,600 9,800 41,600 $111,344

*Identifies accounts and amounts given in the problem information. If total sales revenue is 100% and variable costs of food, wages, and other variable costs total 84%, then sales revenue at 100% − (38% + 34% + 12%) = 100% − 84% = 16%, that represents the $109,122 of total estimated known costs. Thus, = $111,344 / 16% = $695,900 or 100% of sales revenue b. The average check to support the forecasted sales revenue is: $695,900 / (60 × 2.5 × 365) = $695,900 / 54,750 = $12.71

P6.2

a. Calculation of sales revenue to cover total operating costs, NI (after tax) and tax, which is required to find the average room rate. Return on investment [$402,800 × 15%] Income tax [$60,420 /75% = $80,560 – $60,420] Interest expense [$806,400 × 10%] Depreciation: Building [$700,200 × 10%] Depreciation: Furnishings & Equip. [$150,400 × 20%] *Other known fixed costs *Other expenses [wages, supplies, etc., at 80% occupancy] *Other income [vending machines] Total sales revenue to support NI [AT]

$ 60,420 20,140 80,640 70,020 30,080 141,800 55,400 ( 5,210) $453,290

*Indicates identity and amounts used as given in the problem information. Average room rate is: $453,290 / (25 × 80% × 365) = $453,290 / 7,300 = $62.09 b. 25 × 80% = 20 Total rooms occupied, of which 20 × 30% = 6 double rooms occupied, and 20 – 6 = 14 rooms’ single occupied 20 × $62.09 = $1,242 average day room sales revenue 14x + 6 (x + $8.00) = $1,242.00 14x + 6x + $48.00 = $1,242.00 20x = $1,242.00 – $48.00 20x = $1,194.00

x = $1,194 / 20 x = $59.70 single rate Single rate $59.70 + $8.00 = $67.70 double rate Single rate alternative: [$1,242 – (6 × $8)] 20

($1,242 – $48) $1,194 20 20

$59.70

Proof of Calculated Room Rates: 14 singles × $59.70 = $ 836.00 6 doubles × $67.70 = 406.00 20 rooms occupied = $1,242.00 P6.3

Calculating average checks by meal periods. Breakfast:

(20% × $975,000) / (1.20 × 90 × 6 × 52) = $195,000 / 33,696 = $5.79

Lunch:

(30% × $975,000) / (1.25 × 90 × 6 × 52) = $292,500 / 35,100 = $8.33

Dinner:

(50% × $975,000) / (1.20 × 90 × 7 × 52) = $487,500 / 39,312 = $12.40

P6.4

Calculating seat turnovers by meal period. a. Equation: [Guests per day by meal period / Seats available]

Meal Lunch Dinner

Sun. Mon. Tue. 0 + 1.14 + 1.21 1.29 + 0.79 + 0.80

Wed. + 1.25 + + 0.77 +

Thu. 1.14 0.86

Fri. + 1.29 + 1.50

Sat. + 0.36 + 1.79

Week = 6.39 = 7.80

Sat. + 50 + 250

Week = 895 = 1,090

b. Equation: [Guests per day by meal period for the week] Meal Lunch Dinner

Sun. Mon. Tue. -0- + 160 + 170 180 + 110 + 112 • •

Wed. Thu. + 175 + 160 + 108 + 120

Lunch: Average customers (covers) per day: 895 / 6 = 149.2 Lunch: Average seat turnover for week: 6.39 / 6 = 1.07 Or: Weekly average seat turnover 895 Total seats available [140 × 6] 840

• •

Fri. + 180 + 210

1.07

Dinner: Average customers (covers) per day: 1,090 / 7 = 155.7 Dinner: Average seat turnover for week: 7.80 / 7 = 1.11

c. Staff scheduling, advertising, how much to produce, and attempting to increase the average check on low-turnover days.

P6.5

Prepare a blank menu engineering worksheet following the example in the text using lined paper. Restaurant: Beech Tree Café (A) (B) (C) (D) Menu Number Menu Item Item Sold Mix % Food (MM) Cost 1 328 11.7% $1.35 2 288 10.2% 1.18 3 420 14.9% 1.36 4 192 6.8% 0.76 5 164 5.8% 1.05 6 236 8.4% 2.21 7 152 5.4% 0.84 8 536 19.1% 0.97 9 312 11.1% 1.12 10 185 6.6% 1.85 100% Unit N = 2,813 N = 10

(E) (F) Item Item Selling CM Price (E – D) $5.95 $4.60 5.50 4.32 5.95 4.59 4.95 4.19 6.95 5.90 8.95 6.74 4.50 3.66 6.50 5.53 6.95 5.83 6.95 5.10

(H) (L) Menu Sales Menu CM Revenue (F × B) (E × B) $1,951.60 $1,508.80 1,584.00 1,244.16 2,499.00 1,927.80 950.40 804.48 1,139.80 967.60 2,211.20 1,590.64 684.00 556.32 3,484.00 2,964.08 2,168.40 1,818.96 1,285.75 943.50

Date: August 0006 Meal Period: Lunch (P) (R) (S) (T) CM MM% M. Item (%) Cate- Cate- Classifi- Profit gory gory cation Factor L H Plow 1.05 L H Plow 0.87 L H Plow 1.35 L L Dog 0.56 H L Puzzle 0.68 H H Star 1.11 L L Dog 0.39 H H Star 2.07 H H Star 1.27 H L Puzzle 0.66

I = ∑G J = ∑H M = ∑L $ 3,532.81 $17,859.15 $14,326.34

Average CM = M / Menu Items: $14,326.34 / 10 = $1,432.63

K=I/J 19.8%

Q = (100 / items) × 70% (100 / 10) = 10 × 70% = 7.0%

(G) Menu Costs (D × B) $442.80 339.84 571.20 145.92 172.20 521.56 127.68 519.92 349.44 342.25

O=M/N $5.09

Discussion: Even though the egg and tomato sandwich is a dog, you would likely leave it on the menu because it is a vegetarian item. You could attempt to increase its price to increase its contribution margin or decrease its selling price to try to increase sales. The other dog item, hot dog and fries, you should remove it from the menu and replaced it with an item with higher popularity and contribution margin. The veggie burger and salad, a puzzle, you should leave it on the menu since it is the other vegetarian item and to attract groups that include a vegetarian. You could test the price elasticity of the veggie burger by increasing its selling price to see if sales decrease. However, it is unlikely to be very price sensitive. You could try decreasing the selling price of the roast beef sandwich, the other puzzle, to try and increase its sales. Since the profit factors for the corn beef on rye and salmon sandwich, two of the plowhorses, are in the ideal range of 0.9 to 1.1, you can leave them as they are. The third plowhorse, the club sandwich has a high profit factor so you need to be sure to control its quality and you could try increasing its selling price to further increase its contribution margin. Finally, you need to maintain the quality of the stars so they continue to be stars. You could test the price elasticity of these items to further increase contribution margin.

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P6.6

Calculate the average check per meal period to cover all costs including net income (after tax). Using the information provided, the food cost percentage must be determined. Setting a base cost of $1.00 will allow the 150% to be applied to find the selling price, that divided into the cost will find the cost percentage. $1.00 + ($1.00 × 1.5) = $1.00 + $1.50 = $2.50 selling price Food cost percent is found by: Equation: [Cost / Selling Price = Cost %] ($1.00 / $2.50) × 100 = 40% Food cost at 40% + variable wage cost at 28% + other variable costs at 7% = 75% of the sales revenue required. Thus, 100% − 75% = 25% that identifies known costs to be 25% of sales revenue required. Known costs are: Fixed wages expense* Rent expense* Insurance expense* Depreciation expense, Equip. [$160,000 × 20%] Return on investment [12% × $180,000] Income tax [$21,600 / 70% = $30,857 − $21,600]** Total sales revenue to support NI (AT)

$ 51,600 36,000 4,800 32,000 21,600 9,257 $155,257

*Indicates identity and amounts given in the problem information. **Equation: [NI (AT) / 1 – tax rate = Operating Income − NI (AT) = Tax] Calculation: $21,600 / 1 − 30% = $21,600 / 1 − 70% = $30,857 – $21,600 = $9,257 tax Alternative: $21,600 / 1 − 30% = $21,600 / 1 − 70% = $30,857 x 30% = $9,257 tax Total costs including NI (AT) at $155,257 = 25% of total required sales revenue, thus: $155,257 / 25% = $621,028 = Total sales revenue Lunch average check is: (40% × $621,028) / (60 × 2 × 5 × 52) = $248,411 / 31,200 = $7.96 Dinner average check is: (60% × $621,028) / (60 × 1.25 × 5 × 52) = $372,617 / 19,500 = $19.11

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P6.7

a. Calculate the hotel’s average room rate for the next year. Administrative and general expenses* Marketing expenses* Energy expense* Repairs and maintenance expense* Property taxes* Insurance expense* Telephone department loss* Less: Income from food and beverage* First mortgage interest expense [8% × $601,000] Second mortgage interest expense [12% × $402,000] Return on investment [15% × 280,000] Depreciation: Building [5% × $1,860,000] Depreciation: Furniture and equipment [20% × $382, 000] Income tax [$42,000 / (1 – 25%) = $42,000 / 75% = $56,000 − $42,000] Total identified known costs

$ 38,300 28,900 35,100 28,800 17,600 4,800 9,700 (103,200) 48,080 48,240 42,000 93,000 76,400 14,000 $381,720

If room’s sales revenue is 100% and rooms operating expenses are 27%, then 73% (100% − 27%) must represent the above total of $381,720. Therefore, sales revenue $381,720 / 73% = $522,904 Average room rate is: $522,904 / (40 × 70% × 365) = $522,904 / 10,220 = $51.16 b. Average rooms occupied are 28. Of these 30% or 8.4 rooms are double occupied and the balance of 20 rooms are single occupied. Rooms sold per day Less: Double rooms per day Single rooms per day

28.0 ( 8.4) 19.6

(40 × 70%) (28 × 30%)

Day revenue is: 28 × $51.16 = $1,432.48 19.6x + 8.4(x + $15) = $1,432.48 19.6x + 8.4x + $126.00 = $1,432.48 28x = $1,432.48 − $126 28x = $1,306.48

x = $1,306.48 / 28 x = $46.66 Single rate Single room rate is $46.66 + $15.00 spread = $61.66 double room rate

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P6.8

a. Calculate an investment return based on net income after tax and determine an average single and double room rate. Return on investment [$520,000 × 12%] Income tax [$62,400 / 76% = $82,105 × 24%] or [$82,105 – $62,400] First mortgage interest expense [$359,000 × 10%] Second mortgage interest expense [$140,000 × 14%] Depreciation expense: Building [$632,000 × 5%] Consolidate depr: Furniture and Equipment [$117,000 × 20%] Indirect expenses Direct expenses Less: Restaurant lease income Total known identified costs

$ 62,400 19,705 35,900 19,600 31,600 23,400 44,800 59,300 ( 12,000) $284,705

Average room rate is: $284,705 / (30 × 70% × 365) = $284,705 / 7,665 = $37.14 b. Calculate single and set double room rate with a $12.00 spread: Rooms sold per day Double rooms per day Single rooms per day

21.0 (12.6) 8.4

(30 × 70%) (21 × 60%)

Day rooms revenue: 21 × $37.14 = $779.94 8.4x + 12.6(x + $12) = $779.94 8.4x + 12.6x + $151.20 = $779.94 21x = $779.94 − $151.20 21x = $628.74 / 21 x = $29.94 single rate Single room rate is $29.94 + $12.00 spread = $41.94 double room rate P6.9

Finding the rate per square foot to set room rates to achieve $912,500 of projected total sales revenue in the next year. Room sales revenue per day equals $912,500 / 365 = $2,500 daily sales revenue required. 15 × 150 sq. ft. = 2,250 15 × 220 sq. ft. = 3,300 15 × 380 sq. ft. = 5,700 11,250 Total square feet available 11,250 × 80% occupancy = 9,000 sq. ft. expected to be occupied. Room rate per sq. ft. = $2,500 / 9,000 = $0.278 per sq. ft. Room rates are: Single: 150 sq. ft. × $0.278 = $ 41.70 Double: 220 sq. ft. × $0.278 = $ 61.16 Suites: 380 sq. ft. × $0.278 = $105.64

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P6.10 Setting discount rates: Discount 5%:

75% ×

$60 − $8 $60 × (1 – 5%) − $8

= 75% × [$52 / ($60 × 95%)] − $8 = 75% × [$52 / ($57 − $8)] = 75% × ($52 / $49) = 75% × 1.06 = 79.5% Discount 10%:

75% ×

$52 $60 × (1 − 10%) − $8

= 75% × [$52 / ($60 × 90%) − $8)] = 75% × [$52 / ($54 − $8)] = 75% × ($52 / $46) = 75% × 1.13 = 84.8%

Discount 15%:

75% ×

$52 $60 × (1 − 15%) − $8

= 75% × [$52 / ($60 × 85%) − $8)] = 75% × [$52 / ($51 − $8)] = 75% × ($52 / $43) = 75% × 1.21 = 90.8% Discount 20%:

75% ×

$52 $60 × (1 − 20%) − $8

= 75% × [$52 / ($60 × 80%) − $8)] = 75% × [$52 / ($48 − $8)] = 75% × ($52 / $40) = 75% × 1.3 = 97.5%

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P6.11 a.

Total potential sales revenue is $62 × 7,300 room nights =$452,600. The new rack rate will have to be: $62 (75% × 100%) + (15% × 90%) + (10% × 80%) = $62 / (75% + 13.5% + 8%) = $62 / 96.5% = $64.25 Business traveler rate will be: $64.25 × 90% = $57.83 Sport traveler rate will be:

Vacation traveler: Business traveler: Sport traveler:

$64.25 × 80% = $51.40

75% × 7,300 × $64.25 = $351,769 15% × 7,300 × $57.83 = 63,324 10% × 7,300 × $51.40 = 37,522 Total $452,615*

*Difference between $452,600 and $452,615 is from rounding rates.

P6.12 Calculating new groups sales revenue, accept group, Yes or No. Rooms available Expected transient demand Group sales revenue committed Rooms available

Mon. Tue. Wed. Thu. 500 500 500 500 200 200 200 200 200 200 300 300 100 100 -0-0-

Potential group sales revenue Transients displaced

100 -0-

a. Potential sales revenue gain is: Less: marginal costs:

400 rooms × $60 400 × $15

Displacement sales revenue lost: Less: marginal costs:

100 100

Fri. 500 100 100 300

Sat. 500 50 100 350

Sun. 500 50 100 350

100 -0-

= $24,000 = ( 6,000)

$18,000

200 rooms × $80 = $16,000 200 × $15 = ( 3,000) Net revenue gain:

( 13,000) $ 5,000

b. Other considerations: • The additional 100 rooms sold on each Thursday and Friday would likely increase sales revenue in the food and beverage departments. • Some transients arriving on Monday and Tuesday might extend their stay into Wednesday and Thursday, but will no longer be able to remain if the new group is booked. This will further add to the displacement loss. • Some transients displaced on Wednesday and Thursday might well have extended their stay into Friday, Saturday, or Sunday, which will add to the displacement loss. • Some displaced transients may be dissatisfied and not return to the Inn if they were unsatisfied with the alternative accommodations. • Some displaced transients may not return if they found the alternate accommodations acceptable.

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CASE 6 SOLUTIONS Calculating average checks for food and beverage operations for three meal periods. a.

Lunch food sales revenue: (45% × $458,602) / (84 × 1.5 × 6 × 52) = $206,371 / 39,312 = $5.25 Dinner food sales revenue: (55% × $458,602) / (84 × 1.25 × 5 × 52) = $252,231 / 27,300 = $9.24 Lunch beverage sales revenue: (20% × $180,509) / (84 × 1.5 × 6 × 52) = $36,102 / 39,312 = $0.92 Dinner beverage sales revenue: (80% × $180,509) / (84 × 1.25 × 5 × 52) = $144,407 / 27,300 = $5.29 Total Average Check: $458,602 + $180,509 $639,111 39,312 + 27,300 66,612

Suggestions on how to raise the average check: • • • • • • • •

$9.59 (average check per Case 3)

Use better selling techniques such as promoting wine with meals. However, you have to be careful with this because of the drinking and driving concerns. Raise menu (food and beverage) prices. Suggestive selling of appetizers and desserts. Increase seat turnovers. Charlie would need to advertise to attract more guests. Increase the number of seats, if possible. Open for Sunday brunch, and for Saturday and Sunday dinner or buffet. Open for breakfast. Substitute low-priced with high-priced menu items that yield a higher gross margin.

Raising menu prices will have a psychological impact on customers in general. This same effect can also occur when lower-priced menu items are substituted with higher-priced menu items. This restaurant is family oriented and removing low-priced menu items could easily discourage business. Higher-priced menu items may increase food cost and the food cost percentage combined with a higher gross margin and operating income. However, these advantages may be more than offset with declining sales revenue from reduced guest counts. It may be preferable to concentrate on the other alternatives listed in part b.

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CHAPTER 7 COST MANAGEMENT INTRODUCTION Chapter 6 discussed the concept of establishing prices to help achieve a particular desired return on investment. However, there is often a limit to how high prices can be pushed before customer resistance occurs and reduced demand for the product or service occurs. To avoid constantly raising prices, concentrating on controlling costs may be required without which costs could escalate out of proportion to sales revenue. In Chapter 5, we saw how the use of standard cost control can assist in controling the cost of food and beverages. This chapter continues the discussion on cost control and discusses the importance of cost management and decisionmaking.

TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True and F for False)

1. Knowledge of the identity and classification of a specific cost is essential when making business decisions.

2. An indirect cost is normally controllable by an operating department head.

3. A joint cost is one that is partly direct and partly indirect.

4. A sunk cost is one that is not normally relevant to future decisions.

5. A fixed cost is one that never changes, even in the long run.

6. A semivariable cost is one that is partly fixed and partly variable.

7. A variable cost is one that varies in linear fashion with sales revenue.

8. A standard cost is what the cost should be for a given level of sales revenue.

9. An opportunity cost is one that is recorded on the income statement.

10. A discretionary cost is one that can either be incurred or not incurred.

11. Allocation of indirect costs to operating departments should be done with caution.

12. One should never sell below total cost.

13. In making decisions about costs, no other factors need to be considered other than the relevant costs.

14. An operation is considering closing for a certain period during which it has been losing money. If by closing, the remaining fixed costs would be greater than the previous losses, then normally the decision will be to close.

107

15. If at an equivalent sales revenue level, Business A has higher fixed costs than Business B, then Business B will make more net income than Business A from each additional sales revenue dollar above the current level.

16. A business with high fixed costs relative to variable costs is said to have high operating leverage.

17. Given two comparable business situations, the one with the lower fixed costs will have a higher break-even sales revenue level.

18. The equation for calculating the indifference point when deciding to pay a fixed rent amount or rent based on a percent of sales revenue is: Fixed rent costs divided by the variable rate percent.

19. The high-low method of separating semivariable costs into their two elements is the most accurate method.

20. On a multipoint graph, the information about the independent variable is plotted on the vertical axis.

21. On a multipoint graph, only one “correct” straight line can be drawn.

22. On a multipoint graph, the point at which the sloped straight line intersects the vertical axis gives the amount of total variable costs.

23. Regression analysis is a mathematical technique for separating the two elements in semivariable costs.

24. In regression analysis, the information about the independent variable is given the symbol X.

25. Regression analysis gives the least exact results for fixed and variable costs.

26. Standard portion sizes are an integral part of food cost control.

27. A standard recipe for each menu item is essential for effective cost control.

28. The fixed cost of labor is not a factor in labor cost control.

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk)

1. A sunk cost is one that is: (a) Made when excavating for a new swimming pool * (b) Not relevant to the present decision (c) Controllable in the future (d) The same as an opportunity cost 2. Which of the following costs is primarily fixed? (a) Food cost * (b) Insurance (c) Labor cost (d) Operating supplies

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3. Variable costs: (a) Decrease 10% if sales revenue increases 10%. (b) Are generally fixed in the short run * (c) Vary in a linear fashion with sales revenue (d) Are the same as indirect costs 4. Standard costs: * (a) Are what the costs should be for a particular level of sales revenue (b) Are not relevant in decision-making (c) Are the same as variable costs (d) Must be broken down into their fixed and variable elements 5. Indirect costs should be allocated to operating departments: (a) Because otherwise the departmental income after deducting direct costs will be incorrect (b) To insure that each department has a net income after deducting both direct and indirect costs (c) Pro-rata according to sales revenue in each department. * (d) Only after careful analysis of each cost to ensure the allocation is correct. 6. One can sell below cost when the sales revenue: (a) Would otherwise go to a competitor * (b) Is below total cost but covers variable costs and contributes towards fixed costs (c) Covers fixed costs but not necessarily all variable costs (d) Covers all direct costs 7. An operation should close during the off season when: (a) Variable costs are higher than fixed costs (b) The lost sales revenue would be higher than total costs (c) A net loss would be eliminated * (d) The net loss to be eliminated is greater than the remaining fixed costs 8. A restaurant with high operating leverage has: (a) Low fixed costs relative to variable costs (b) A high net income in relation to sales revenue * (c) Low variable costs relative to fixed costs (d) High sales prices in relation to costs 9. A company with low operating leverage: (a) Is better off than one with high operating leverage (b) Is not going to be as successful as one with high operating leverage (c) Will produce a low return on the investment * (d) All other things being equal will have a lower breakeven point than one with high operating leverage 10. In times of rising sales revenue, it would be better to: * (a) Have a business with high fixed costs relative to variable costs (b) Have high variable costs relative to fixed costs (c) Try and convert some of the fixed costs into variable ones (d) Change direct costs into indirect costs

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11. The equation for calculating the indifference point when deciding to pay a fixed rent amount versus rent based on a percent of sales revenue is: (a) Sales revenue divided by the variable rent percentage (b) Fixed rent cost multiplied by the variable rent percentage * (c) Fixed rent cost divided by the variable rent percentage (d) Fixed rent cost divided by (1 – variable rent percentage) 12. Using the high-low method, what are the fixed and variable costs if the high sales revenue is $160,000 with total costs of $90,000, and the low sales revenue is $96,000 with total costs of $58,000. What is the fixed cost and the variable percentage per dollar of sales revenue? (a) $ 9,750 fixed and 32.5% per dollar of sales revenue * (b) $10,000 fixed and 50.0% per dollar of sales revenue (c) $ 6,750 fixed and 32.5% per dollar of sales revenue (d) $ 4,240 fixed and 56.0% per dollar of sales revenue 13. The intersect point of the vertical and sloped lines on a multi-point graph: (a) Shows how much the independent variable is * (b) Gives the total fixed cost (c) Gives the total cost (d) Gives the total units 14. In making a decision about which piece of equipment to buy, two types of costs are considered. They are relevant and: (a) Sunk (b) Fixed * (c) Irrelevant (d) Controllable 15. Which is the best concept for allocating indirect costs? (a) Based on total sales revenue * (b) On the method best suited to allocate the costs equitably (c) Based on contributory income (d) Based on square footage

EXERCISE SOLUTIONS E7.1

Find variable cost %. Variable Costs / Sales Revenue = $2,856 / $6,800 = 42.0%

E7.2

Find contribution margin: [SR – VC = CM] Variable cost = $48,840 × 43% = $21,001 $48,840 − $21,001 = $27,839

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E7.3

Find the contribution margin and operating income; accept or reject? Sales Revenue [70 × $18] Variable costs [$1,260 × 68%] Contribution Margin Fixed costs Operating Income

E7.4

$1,260 ( 857) $ 403 ( 100) $ 303

* Accept the proposal

Allocation of indirect costs based on square footage. (Café Sq. Ft. / Total Sq. Ft.) x Indirect costs = Amount Allocated) Total Sq. Ft. = 2,200 + 580 = 2,780 2,200 / 2,780 = 79.1% × $12,000 = $9,492

E7.5

Find variable cost per guest and total fixed costs. High data Low data

Guests Labor Cost 18,000 $25,500 (12,000) (18,000) ▲ 6,000 ▲ $ 7,500

▲ Cost / ▲ Guests = VC per guest = $7,500 / 6,000 = $1.25

E7.6

High labor cost High VC [18,000 × $1.25] Fixed cost

$25,500 (22,500) $ 3,000

Low labor cost Low VC [12,000 × $1.25] Fixed cost

$18,000 ( 15,000) $ 3,000

Find variable cost per dollar of sales revenue and total fixed costs. High data Low data

S.R. $28,000 ( 23,000) ▲ $ 5,000

Operating Cost $20,000 ( 17,000) ▲ $ 3,000

▲ Cost / ▲ Guests = VC per SR dollar = $3,000 / 5,000 = 60% High operating cost High VC [28,000 × 60%] Fixed cost

$20,000 (16,800) $ 3,200

Low operating cost Low VC [23,000 × 60%] Fixed cost

$17,000 ( 13,800) $ 3,200

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E7.7 Calculate the contribution margin and operating income. Justify your decision to accept or not accept the booking. Sales Revenue [40 × $10.50] Variable costs [$420 × 65%] Contribution Margin Fixed costs (per day) Operating loss

$420 ( 273) $147 ( 150) ($ 3)

* Accept the function. By selling below total cost of $423 ($273 + 150), we offset FC costs by $147 of $150 that is incurred with or without the function. * Accept the offer!

E7.8 Find the indifference point (the breakeven point of sales revenue at which the fixed rent and variable rent for a year are the same). Explain which option you recommend? Fixed lease cost / Variable lease % = Indifference point (or breakeven sales revenue) $42,000 / 10% = $420,000 Since the sales revenue is expected to be greater than the indifference point, you would recommend not to take the fixed cost lease. E7.9

Given the information, do you recommend they close or stay open for the last three months. Recommend the restaurant stay open. If the restaurant closes, the operating income for the first 9 months will be $49,500. If the restaurant remains open the last three months, the total operation income would be $40,000 ($49,500 – $9,500). If the restaurant closes there will likely be close-down and start-up costs that will impact on costs for the new year.

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PROBLEM SOLUTIONS P7.1

Objective evaluation made to determine the best investment considering only relevant costs of the alternatives. Identify which model would be the best investment. (Primary) Unique costs Year 1 New equipment cost Initial installation costs Initial training costs First year costs

Model 1 $5,000 80 350 $5,430

Model 2 $5,500 100 300 $5,900

Model 3 $5,300 100 325 $5,725

Recurring inclusive costs Years 1-5 Maintenance [$275 x 5 ] [$300 x 5] [$250 x 5] Cost of supplies [$175 x 5] [$225 x 5] [$200 x 5] Less: Equipment residual value Total recurring inclusive costs Years 1-5 Total first year costs Total first year & Recurring inclusive costs

$1,375 875 ( 1,000) $1,250 $5,430 $6,680

$1,500 1,125 ( 1,200) $1,425 $5,900 $7,325

$1,250 1,000 ( 800) $1,450 $5,725 $7,175

(Alternative) Unique costs Year 1 Initial installation costs Initial training costs First year costs

Model 1 $ 80 350 $ 430

Model 2 $ 100 300 $ 400

Model 3 $ 100 325 $ 425

Recurring inclusive costs Years 1-5 Depreciation [$800 x 5] [$860 x 5] [$900 x 5] Maintenance [$275 x 5 ] [$300 x 5] [$250 x 5] Cost of supplies [$175 x 5] [$225 x 5] [$200 x 5] Total recurring inclusive costs Years 1 to 5 Total first year costs Total first year & Recurring inclusive costs

$4,000 1,375 875 $6,250 $ 430 $6,680

$4,300 1,500 1,125 $6,925 $ 400 $7,325

$4,500 1,250 1,000 $6,750 $ 425 $7,175

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P7.2

Consideration of selling below cost can be made if an objective analysis indicates variable costs are covered and a contribution towards fixed costs. a. The total variable cost plus the allocated fixed cost per person determines the total cost on a per person basis: Cost per person evaluation Food cost of sales Wage cost Other costs Total variable cost per person Fixed cost per person [$350 / 100] Total cost per person

$ 6.50 2.75 1.25 $10.50 3.50 $14.00

b. If 100% is the unknown selling price, contributory income wanted is 20%. Then 100% − 20% = 80% represents the total cost. If total cost per person is $14.00 or 80% of the unknown, the selling price is found by dividing the total cost per person by the 80% that represents the selling price. Selling price = $14.00 / 80% = $17.50 c. With the per person selling price, variable cost, fixed cost, and contributory income known, evaluate the position of accepting or not accepting the offer. Accepted Yes No $1,375 -0(1,050) -0$ 325 -0( 350) ( 350) ($ 25) ($350)

Sales revenue [100 × $13.75] Variable costs [100 × $10.50] Function gross margin Fixed costs Operating loss

Accept the function if there is no chance of accepting another offer. Variable costs are covered and a contribution of $325 is made towards fixed costs, thus the loss is minimized to $25 instead of $350 if the function is not accepted.

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P7.3

Allocate indirect costs (IDC) to each division based on square footage. Division Dining Room Coffee Shop Lounge Total Sq. Ft.

IDC Allocated 2,200 sq. ft. / 4,000 = 55.0% × $52,000 = $28,600 840 sq. ft. / 4,000 = 21.0% × $52,000 = $10,920 960 sq. ft. / 4,000 = 24.0% × $52,000 = $12,480 4,000 sq. ft. 100.0% $52,000

Indirect costs allocated Contributory income Allocated indirect costs Operating income

Dining Room $40,400 ( 28,600) $11,800

Coffee Shop $ 7,800 ( 10,920) ($ 3,120)

Lounge Totals $28,200 $76,400 ( 12,480) ( 52,000) $15,720 $24,400

b. Overall operating income = $11,800 − $3,120 + $15,720 = $24,400 Without additional information, consideration may be given to renting the coffee shop, from a simplistic point of view, rental income of $9,600 a year is better than a loss of ($3,120). It should be noted that rental income is greater than the existing contributory income for the coffee shop. c. Changes to indirect costs if the coffee shop is rented. Sales revenue or rent Less: Direct costs Contributory income

Dining Room $194,800 (154,400) $ 40,400

Coffee Shop $9,600 -0$9,600

Lounge Totals $141,100 $345,500 (116,500) (270,900) $ 24,600 $ 74,600

• Lounge sales revenue and direct costs will decline by $11,700 and $8,100 respectively • New indirect costs if coffee shop is rented will be $45,700. ($13,200 + $9,000 + $4,100 +$3,800 + $3,100 + $5,400 + $7,100 = $45,700) Renting the Coffee Shop Combined contributory income (+ rent): Less: Indirect costs: Overall operating income:

$74,600 ( 45,700) $28,900

The coffee shop should be rented out since overall operating income will increase by $4,500 ($28,900 − $24,400).

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P7.4

Annual operating income: + 3rd qtr. − 4th qtr. = Operating Income $7,100 + $10,100 + $8,600 − ($2,650) = $23,150 1st qtr. + 2nd qtr.

Operating income for 9 months; closed Quarter 4: 1st qtr. + 2nd qtr. + 3rd qtr. = Operating Income $7,100 + $10,100 + $8,600 = $25,800 Less 4th quarter expenses to be paid if closed: Operating income for 3 quarters Wages Advertising [600 × 50%] Utilities [$100 × 3 mo.] Maintenance [stated] Insurance [$1,200 × 40%] Interest [stated @ $750 per qtr.] Depreciation [$700 × 25%] Rent [stated @ $6,000 per qtr.] Adjusted operating income; 3 qtrs.

$25,800 $3,000 300 300 200 480 750 175 6,000

( 11,205) $ 14,595

Do not close. Known costs to be incurred if 4th quarter operations are closed is $11,205 and adjusts operating income from $23,150 to $14,595, or an additional loss of $8,555 ($23,150 – $14,595). P7.5

If Motel A is closed, overall net loss will be: Motel A Fixed costs Motel B Operating income Motel C Operating income Net operating loss

($110,000) 8,000 30,000 ($ 72,000)

If Motel B is closed, overall net loss will be: Motel A Operating Loss Motel B Fixed costs Motel C Operating income Net operating loss

($ 5,000) ( 167,000) 30,000 ($142,000)

If Motel C is closed, overall net loss will be: Motel A Operating Loss Motel B Operating income Motel C Fixed costs Net operating loss

5,000) 8,000 ( 260,000) ($257,000)

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Thus, closing Motel A which will minimize the overall loss. Leaving Motel’s B and C open with operating income of $8,000 and $30,000 respectively, they will provide an offset to reduce the overall net loss to the company of $72,000 ($110,000 – $38,000). The reason of closing Motel A is not because it’s presently losing money and Motel’s B and C have operating income. However, you would only close Motel A if you could not find employees to run the operation. If Motel A can remain open you have an overall operating income of $33,000. It may be worth offering wage increases during the summer months to attract and keep employees. Wages could be increased by $100,000 before it would be better to close. b. If Motel A is closed overall net loss will be: Motel A Fixed costs Motel B Operating income Motel C Operating income Net operating loss

($110,000) 45,000 63,000 ($ 2,000)

If Motel B is closed overall net income will be: Motel A Operating income Motel B Fixed costs Motel C Operating income Net operating income

$ 55,000 (113,000) 63,000 $ 5,000

If Motel C is closed overall net loss will be: Motel A Operating income Motel B Operating income Motel C Fixed costs Net operating loss

$ 55,000 45,000 (112,000) ($ 12,000)

Thus, close Motel B because the company overall will have a net operating income rather than an operating loss. Motel’s A and C will provide a total net operating income of $5,000 after absorbing the fixed costs Motel B, ($55,000 + $63,000 – $113,000). Note: This time Motel B is closed despite the fact it has the highest fixed costs. The same discussion applies to this situation as it does to Part a. However, in Part b. there is little leeway with increasing additional labor costs.

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P7.6

Determine the present operating income of each motel and recommend which should be purchased. Sales revenue Variable costs Fixed costs Operating income

Jack’s $550,000 $302,500 212,500 (515,000) $ 35,000

Jock’s $550,000 $330,000 185,000 (515,000) $ 35,000

Stated assumptions: (1) Sales revenue can be increased by 25% in both of the motels. (2) A saving of $12,000 on interest expense (FC) is possible in Jack’s Motel. (3) A cost savings of 6% reducing variable wage costs to 54% (60% − 6%) for Jock’s Motel. If these assumptions were achieved, the operating income would be: Jack’s Sales revenue $687,500 Variable costs $378,125 Fixed costs 200,500 Total operating costs (578,625) Operating income $108,875

Jock’s $687,500 $371,250 185,000 (556,250) $131,250

Calculations of stated assumptions: Sales revenue: Jacks and Jocks = $550,000 x 125% = $687,500 Jack’s Jock’s VC: $687,500 x 55% = $378,125 VC: $687,500 x 54% = $371,250 FC: $212,500 – $12,000 = $200,500 FC: $185,000 no change Based on the assumptions being achieved, Jock’s Motel would be a better proposition since its operating income would be higher than Jack’s Motel. The entrepreneurs should be advised that this would only be true if all the assumptions are correct. For example: If Jock’s variable costs stay at 60%, Jock’s operating income would be reduced to $90,000 ($687,500 x 6% = $41,250 – $131,250). Jack’s is the better proposition even if the assumption that $12,000 per year of fixed interest costs are not achieved, and Jack’s operating income would be reduced to $96,875 ($108,875 – $12,000 = $96,875). Thus, a final view would be that for Jock’s to remain the better proposition is based on the reduction of variable cost from 60% to 55%. P7.7

a. Fixed lease cost / Variable lease % (or FC / VC%) $2,800 × 12 months = $33,600 Indifference point is: $33,600 / 8% = $420,000 b. Assuming the average sales revenue forecast for the coming year is correct at $525,000, the anticipated fixed and variable cost would be: (1) Fixed lease cost remains at $33,600 (2) Variable lease cost would be $42,000 ($525,000 × 8%) Stella should choose the fixed lease option because this will result next year in a lease cost of $33,600 rather than a 8% lease cost of $42,000. 118

P7.8

a. Calculate the variable cost per room, total variable cost and, using the High-Low method, find the fixed cost per month. VC per room unit (person): High Cost − Low Cost High Units − Low Units $4,080 − $3,240 2,800 − 1,400

▲ Cost ▲ Units

▲ $ 840 ▲ 1,400

VC per unit

$0.70 per unit

b. Using the highest month, total variable cost is: 2,800 rooms × $0.70 = $1,960 Using the lowest month, total variable cost is: 1,600 rooms × $0.70 = $1,120 c. Using the highest month Total high $4,080 cost variable High (1,960) cost Fixed cost $2,120

P7.9

Using the lowest month Total low cost $3,240 Low variable cost ( 1,120) Fixed cost $2,120

Use the High-Low method to calculate the variable cost and fixed costs. High Cost − Low Cost High SR − Low SR $10,100 − $5,300 $27,400 − $11,200

▲ Cost ▲ SR

VC%

▲ $ 4,800 ▲ $16,200

29.63%

Total wage cost for August (High) Variable cost (High) = [$27,400 × 29.63%] Fixed wage cost, per month

$10,100 (8,119) $1,981

Total wage cost for January (Low) Variable cost (Low) = [$11,200 × 29.63%] Fixed wage cost, per month

$5,300 (3,319) $1,981

Total annual wages Fixed wages [$1,981 × 12] Total variable wage cost

$94,000 (23,772) $70,228

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P7.10 Regression analysis:

1 2 3 4 5 6 7 8 9 10 11 12 Totals

SR X $ 11,200 13,000 14,900 19,100 22,000 24,200 26,300 27,400 23,500 20,100 18,200 16,000

Wage Cost Y $ 5,300 6,100 6,200 7,000 9,000 9,600 9,700 10,100 8,300 7,600 8,000 7,100

XY (X × Y) $ 59,360,000 79,300,000 92,380,000 133,700,000 198,000,000 232,320,000 255,110,000 276,740,000 195,050,000 152,760,000 145,600,000 113,606,000

$235,900 X

$94,000 Y

$1,933,920,000  XY

X² (X × Y) 125,440,000 169,000,000 222,010,000 364,810,000 484,000,000 585,640,000 691,690,000 750,760,000 552,250,000 404,010,000 331,240,000 256,000,000 $4,936,850,000  X²

Fixed costs = (Y)( X2) – (X)( XY) n(X2) – (X)2 (94,000)(4,936,850,000) – (235,900)(1,933,920,000) 12 (4,936,850,000) – (235,900) (235,900) 464,063,900,000,000 – 456,211,712,000,000 59,242,200,000 – 55,648,810,000 7,852,172,000,000 3,593,390,000

$2,185.17

Total annual wages Less: Fixed costs [$2,185.17 x 12] Variable wages

$94,000 ( 26,222) $67,642

This compares to $70,228 with a cost variance of $2,450 ($70,228 − $67,778 ) of variable wage costs between the High-Low method used in P7.9 and regression analysis.

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P7.11 Additional data will require adjustments to high July data and low December data. July Adjustments: (Wage costs) Retroactive wage increase of $1,800 must be deducted: $21,600 − $1,800 = $19,800 July wage cost. Dec. Adjustments: (Sales revenue) The special $3,400 sales revenue must be deducted: $27,000 − $3,400 = $23,600 adjusted sales revenue. Dec. Adjustments: (Wage costs) The $900 wage costs for special party and sales revenue $1,400 bonus is deducted: $13,000 − $900 − $1,400 = $10,700 adjusted cost. After making the sales revenue and wage adjustments we have the following: Total wage costs July [High] Total VC December [Low] Change [▲]

Sales revenue $53,300 ( 23,600) ▲ $29,700

Wage costs $19,800 ( 10,700) ▲ $ 9,100

Variable wage cost: ▲ $9,100 / ▲ $29,700 = 30.64% per $1.00 of sales revenue. Using the high July figures or the low December figures: Total wage costs July [High] Variable wage cost July [High] [$53,300 × 30.64%] Fixed wage costs

$19,800 ( 16,331) $ 3,469

Total wage cost Variable wages Fixed wages

$10,700 ( 7,231) $ 3,469

Dec. [Low] Dec. [Low] [$23,600 × 30.64%]

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CASE 7 SOLUTION Additional sales revenue Food Sales revenue: [15 × $5.25 × 6 ×52] Beverage Sales revenue: [15 × $0.92 × 6 ×52]Total sales revenue Cost of sales: Food [39.5% × $24,570] Beverages [21.8% × $4,306] Total cost of sales Gross Margin

$24,570 4,306 $28,876 $ 9,705 939 ( 10,644) $18,232

Increase in expenses Wages: [4 × $5.50 × 6 × 52] Laundry: 2.6% China and tableware: 1.9% Glassware: 0.3% Other operating costs: 0.6% 5.4%

$ 6,864

Total Variable Expenses [5.4% × $28,876] Total Increase in Expenses Operating Income Less: Cost of advertising Operating Income (Increase)

$ 1,559

The advertising should be carried out.

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( 8,423) $ 9,809 ( 3,000) $ 6,908

CHAPTER 8 THE CVP APPROACH TO DECISIONS INTRODUCTION In Chapter 5, we briefly discussed the use of a standard cost to compare to actual costs to control food and beverage costs. Chapter 7 identified various costs by type, knowledge of which is necessary to facilitate understanding and their use in making rational business decisions. In particular, Chapter 7 emphasized the importance of breaking costs into their fixed and variable elements. This chapter continues the discussion of fixed and variable costs, and shows how they interrelate with the volume of sales revenue and/or sales units, as well as operating income. The resulting use of such information is the basis of Cost, Volume, Profit or CVP analysis.

TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True and F for False answers)

1. CVP analysis assumes that costs have been fairly accurately broken down into their fixed and variable elements.

2. In making decisions using CVP analysis, the only information one ever needs is about sales revenue and fixed and variable costs.

3. CVP analysis should be limited to individual decisions, or situations wherever possible.

4. Sales revenue less fixed costs equals contribution margin.

5. On a graph of sales revenue and costs, the fixed cost line is drawn from the point of intersection of the horizontal and vertical axes upward and to the right.

6. On a graph of sales revenue and costs, the breakeven point is that point where the fixed cost and the sales revenue lines intersect.

7. In the CVP formula where the denominator is expressed in percentage terms, the answer will be in dollars.

8. The CVP formula will usually give an answer more accurate than an answer from a multi-point graph.

9. In a business with both fixed and variable costs, the amount by which sales revenue has to go up to cover an increased fixed cost will be the amount of that fixed cost increase if net income is to remain unchanged.

10. The CVP formula can only be used if just one item (sales revenue, fixed cost, or variable cost) is changed at a time.

11. The variable cost percentage can be calculated by dividing the variable cost per unit by the average sales revenue per unit, and multiplying by 100.

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12. If the variable cost per customer served in a coffee shop is $1.00 and the average check is $3.33, the variable cost is 33.1/3%.

13. The CVP formula can be used to convert sales levels directly into units rather than dollars.

14. In the CVP formula, the contribution margin can only be expressed in percentage terms.

15. In a business with both fixed and variable costs, a 10% decrease in prices can be offset by a 10% increase in number of units sold.

16. The CVP formula cannot be used to help make decisions if a business is currently in a loss position.

17. If a motel is losing $1,000 a month and rents its units for an average of $20 a night, it needs to sell 50 more units a month to break even.

18. A joint cost is one shared by more than one department.

19. CVP analysis cannot be used to make decisions about a specific department if it has joint costs.

20. If two departments have the same fixed costs but different contribution margins, an increase in sales revenue in one department will not give the same amount of additional contributory income as the same sales revenue increase in the other department.

21. If a department has a 30% contribution margin, each extra dollar of sales revenue will yield a contribution margin of $0.70.

22. In a CVP analysis concerning two or more departments, one needs to know the sales revenue mix, or ratio of sales revenue, for each department.

23. In a multi-department CVP analysis, the combined contribution margin percentage is a figure weighted by the sales revenue mix.

24. In multi-department decisions, the CVP formula cannot be used for compound changes.

25. Decisions made as a result of CVP analysis are not guaranteed to be the correct ones.

26. When a company incorporates its tax rate into the calculations for CVP analysis, the desired profit before tax is calculated by dividing the after-tax net income by (1 – Tax rate).

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk)

1. An assumption under CVP analysis is that: (a) Fixed costs will remain fixed in the long run * (b) All relevant costs can be broken down into their fixed and variable elements (c) Variable costs will change in inverse fashion with sales revenue (d) Total costs will not increase as sales revenue increases

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2. Sales revenue is $250,000, fixed costs are $90,000, profit is $50,000, and sales price per unit is $25.00. Variable cost per unit is: * (a) $11.00 (b) $15.00 (c) $20.00 (d) $25.00 3. On a breakeven graph, the breakeven point is the point where the: * (a) Sales revenue and total cost lines intersect (b) Sales revenue and fixed cost lines intersect (c) Sales revenue and variable cost lines intersect (d) Total cost line intersects the vertical axis 4. When dealing with a problem using the CVP equation for a motel that receives rent from leasing out its restaurant, the rent income in the equation is: (a) Added to the room sales revenue (b) Deducted from variable costs (c) Added to profit * (d) Deducted from fixed costs 5. Fixed costs are $90,000, profit required is $10,000, and variable costs are 40%. Sales revenue will have to be (to nearest $1,000): (a) $150,000 * (b) $167,000 (c) $225,000 (d) $329,000 6. Fixed costs are $85,000, operating income required is $25,000, rent income is $5,000, and the contribution margin is 35%. Sales revenue will have to be (to nearest $1,000): (a) $162,000 * (b) $300,000 (c) $177,000 (d) $329,000 7. In using the CVP equation, the sales level required in units to breakeven is determined by dividing: * (a) Fixed costs by contribution margin in dollars (b) Fixed costs plus operating income by 100% minus the variable cost percentage (c) Fixed costs plus net income by the contribution margin percent (d) The sales level in dollars by unit variable cost 8. A college’s food operation has an average meal price of $6.00. Variable costs are $3.75 per meal and fixed costs total $75,000. How many meals must be sold to provide an operating income of $30,000? (a) 13,333 (b) 33,333 (c) 28,000 * (d) 46,667

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9. Given the facts in the Question 8, how many meals would have to be sold if variable costs increased 20%? (a) 50,000 (b) 23,333 (c) 46,667 * (d) 70,000 10. Given the facts in Question 8, how many meals would have to be sold if fixed costs declined by 20%? * (a) 40,000 (b) 24,000 (c) 46,667 (d) 70,000 11. An establishment has three departments with variable costs as a percentage of sales revenue of 30%, 40%, and 50%, respectively. Each department has the same level of sales revenue. The weighted average contribution margin is: (a) 40.0% * (b) 60.0% (c) 67.0% (d) 33.0% 12. A restaurant has a food operation with a 30% variable cost and a bar operation with a 25% variable cost. The food operation produces 60% of total sales revenue and the bar 40%. If the restaurant wanted an extra $7,500 in operating income, by how much would bar sales revenue only have to increase to provide this added profit? (a) $30,000 (b) $18,750 (c) $25,000 * (d) $10,000 13. Using the data from the previous question, by how much would sales revenue have to increase if the added operating income had to be provided by a joint increase in sales revenue, keeping the sales revenue mix the same? (a) $26,786 (b) $23,810 * (c) $10,417 (d) $10,714 14. When a company incorporates its tax rate into the calculations for CVP analysis, the desired operating income (before tax) is calculated by: * (a) Dividing the net income after tax by (1 − Tax rate) (b) Multiplying the net income after tax by (1 − Tax rate) (c) Multiplying the operating income before tax by (1 − Tax rate) (d) Dividing the operating income before tax by (1 – Tax rate)

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15. A restaurant has sales revenue of $500,000, variable costs of $200,000, and fixed costs of $200,000. The owner wants net income after tax of $40,000. The tax rate is 30%. What is the operating income (before tax)? (a) $ 17,143 (b) $ 40,000 * (c) $ 57,143 (d) $133,333 16. A restaurant specializes in a seafood buffet serving dinner only, at a price of $15.75 per person. Its average variable cost is $6.30 per person. The fixed cost is $6,000 per month. How many buffet meals must be served monthly to break even if they are open 20 days per month? (a) 952 (b) 380 (c) 32 * (d) 635

EXERCISE SOLUTIONS E8.1

Find breakeven sales revenue. Fixed costs / [1 − (VC / SR)] = $108,000 / [1 − ($128,000 / $320,000)] = $108,000 / (1 − 40%) = $108,000 / 60% = $180,000

E8.2

Find breakeven sales revenue. Fixed costs / (1 − 45%) = $137,500 / 55% = $250,000

E8.3

Find breakeven sales revenue. Fixed costs / CM% = $135,000 / 45% = $300,000

E8.4

Find breakeven sales revenue in units. Fixed costs / SP[u] − VC[u] = $53,400 / ($12.95 − $7.38) = $53,400 / $5.57 = 9,587 units

E8.5

Find breakeven units. Fixed costs / CM[u] = $62,400 / $2.08 = 30,000 units

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E8.6

Find the unit contribution margin, breakeven units, variable cost percentage, contribution margin percentage, and breakeven sales revenue in dollars. a. CM[u] = SP[u] − VC[u] = $12.75 − $4.85 = $7.90 b. Fixed costs / CM[u] = $142,200 / $7.90 = 18,000 units c. VC % = VC[u] / SP[u] = $4.85 / $12.75 = 38.0% d. CM% = 1 − VC% = 1 − 38% = 62.0% e. Fixed costs / CM% = $142,200 / 62.0% = $229,355

E8.7

Find operating income (before tax) and income tax. Net income after tax is: $200,000 × 20% = $40,000 OI = NI [AT] / [1 − Tax Rate] = $40,000 / [1 − 28%] = $40,000 / 72% = $55,556 Income tax = OI – NI [AT] = $55,556 – $40,000 = $15,556 Or: Income tax = OI × Tax Rate = $55,556 × 28% = $15,556

E8.8

Find the additional sales revenue required to support the desired net income after tax. a. NI [AT] / [1 − Tax Rate] = Additional OI [BT] $50,400 / [1 − 28%] = $50,400 / 72% = $70,000 $70,000 / [1 – .56] = $70,000 / 44% = $125,000 b. [Fixed costs + OI [BT]] / [1 − VC%] [$188,000 + $70,000] / [1 − 44%] = $258,000 / 56% = $460,714

E8.9

Find additional sales revenue required. Additional OI / [1 − VC%] = Sales Revenue Increase $9,600 / [1 − 72%] = $9,600 / 28% = $34,286

E8.10 Calculate the amount of sales revenue each cost item requires. Fixed Cost:

$120,000 / 38% =

$315,789

Added Cost:

$ 22,000 / 38% =

$ 57,895

Increase for OI [BT]: $ 55,000 / 38% =

$144,737

Totals:

$518,421

$197,000 / 38% =

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PROBLEM SOLUTIONS P8.1 a.

Find breakeven sales revenue: Fixed costs / [1 − (VC / SR)] = Breakeven $168,000 / [1 − ($434,000 / $700,000)] $168,000 / (1 − 62%) = $168,000 / 38% = $442,105

Find operating income if the restaurant’s actual sales revenue were to be $640,000 rather than $700,000. Variable costs as a percentage of sales revenue will not change. Contribution Margin Income Statement Sales Revenue $640,000 Variable Costs [62% × $640,000] ( 396,800) Contribution Margin $243,200 Less: Fixed Costs ( 168,000) Operating Income [BT] $ 75,200

c. If sales revenue is $640,000 instead of $700,000, how many fewer customers would be served? Total Sales Revenue / Average Check = Customers $700,000 / $14.00 $640,000 / $14.00 Customer change P8.2

= 50,000 = 45,714 = ( 4,286)

Customers Customers Fewer customers

Calculate sales revenue to support net income (after tax) of $33,600. NI [AT] / [1 − Tax Rate] = OI [BT] $33,600 / [1 − 30%] = $33,600 / 70% = $48,000 [Fixed costs + OI] / [1 − VC%] = Sales Revenue ($88,000 + $48,000) / (1 – 68%) = $136,000 / 32% = $425,000 Sales revenue Variable costs [68% × $425,000] Contribution Margin Less: Fixed costs Operating income [BT] Tax [$48,000 × 30%] Net Income [AT]

$425,000 ( 289,000) $136,000 ( 88,000) $ 48,000 ( 14,400) $ 33,600

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P8.3

a. Find breakeven sales revenue. VC% = 38% + 27% + 10% = 75% Depreciation expense: $150,000 x 20% = $30,000 Estimated known costs are considered Fixed costs: $48,000 + $2,800 + $4,500 + $3,000 + $21,600 + 30,000 = $109,900 Breakeven Sales Revenue: Fixed costs / (1 – VC %) $109,900 / (1 − 75%) = $109,900 / 25% = $439,600 Proof: Sales revenue Food cost [38% × $439,600] Gross Margin

$439,600 (167,048) $272,552

Expenses Variable costs [(27% + 10%) × $439,600] Identified known fixed costs Total operating costs Operating income [BT]

$162,652 109,900 (272,552) -0-

b. Return on investment before tax: $150,000 × 18% = $27,000 [Fixed costs + Operating income] / [1 – 75%] = ($109,900 + $27,000) / 25% = $136,900 / 25% = $547,600 Proof: Sales revenue

$547,600 ( 208,088) $339,512

Food cost [38% × $547,600] Gross Margin Expenses Variable costs [(27% + 10%) × $547,600] Known fixed costs Total operating costs Operating income (before tax)

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$202,612 109,900 ( 312,512) $ 27,000

P8.4

a. Find the present annual operating income: Contribution Margin Income Statement Sales Revenue: $582,000 Variable Costs: Cost of Sales [38% × $582,000] ( 221,160) Contribution Margin $360,840 Expenses Other variable costs [28% × $582,000] Fixed costs Operating income [BT] b.

$162,960 150,000 ( 312,960) $ 47,880

Find increase to operating income with a new cost added: Liquor variable costs: [38% × $582,000] Other variable costs: [28% × $582,000] Total variable costs

= $221,160 = $162,960 = $384,120

Fixed costs + OI + Added Cost $150,000 + $47,880 + $12,000 1 – (VC / SR) 1 − ($384,120 / $582,000) = ($150,000 + $47,880 + $12,000) / (1 − 66%) = $209,880 / 34% = $617,294 − $582,000 = $35,294 increase Or: $12,000 / CM% = $12,000 / 34% = $35,294 increase c.

Find the new operating income if menu prices are raised by 6%. Contribution Margin Income Statement Sales revenue [$582,000 × 106%] $616,920 Variable costs (no change) (384,120) Contribution Margin $232,800 Fixed costs [$150,000 + $12,000] (162,000) Operating income $ 70,800

d. Determine how much sales revenue can decrease before operating income falls below $30,000 per year. ($150,000 + $30,000 + $12,000) / [1 – ($384,120 / $616,920)] = $192,000 / (1 − 62.3%) = $192,000 / 37.7% = $509,284 Decrease in sales revenue = $616,920 – $509,284 = $107,636

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P8.5

a. Calculate motel’s breakeven level of occupancy: Assuming 10 rooms 4.5 × $60 = $270 3.5 × $74 = $259 2 × $90 = $180 Total: $709 $709 / 10 = $70.90

Fixed costs SP[u] − VC[u]

Rms. × % × Rate = Tot. Rev. 70 × 45% × $60 = $1,890 70 × 35% × $74 = $1,813 70 × 20% × $90 = $1,260 Total: $4,963

$4,963 / 70 = $70.90 Average Room Rate $445,000 $70.90 − $14.00

$445,000 $56.90

Rooms sold = $445,000 / $56.9 = 7,821 Rooms available = 70 rooms × 365 = 25,550 Occupancy % = 7,821 / 25,550 = 30.6% b. Find the occupancy % to provide OI [BT] of $65,000 per year. Fixed costs + OI CM[u]

$445,000 + $65,000 $56.90

$510,000 $56.90

8,963 Rooms sold

Rooms available = 70 rooms × 365 = 25,550 Occupancy % = 8,963 / 25,550 = 35.1% c. Find the occupancy percentage to provide an operating income operating income (OI) before tax of $65,000 if the average room rate is decreased by 20%. New selling price = $70.90 – 20% = $70.90 – $14.18 = $56.72 Or: $70.90 × 80% = $56.72 FC + OI $445,000 + $65,000 SP[u] − VC[u] $56.72 − $14.00 Required room sales

$510,000 $42.72

Fixed costs + OI CM[u]

$510,000 $42.72

11,938

Occupancy % = 16,180 / (70 × 365) = 11,938 / 25,550 = 46.7% d. Find the occupancy percentage to provide $65,000 OI [BT], average room rate increase is 10%, VC per unit is $16.00 and $30,000 is wanted for advertising. New average rate 10% increase = $70.90 × 110% = $77.99 Fixed costs + OI + Advertising SP[u] − VC[u]

$445,000 + $65,000 + $30,000 $77.99 − $16.00

Rooms Sold: Fixed costs + OI + Advertising CM[u] Occupancy % = 8,711 / 25,550 = 34.1%

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$540,000 $61.99

8,711

P8.6

a. What is the motel’s occupancy breakeven level? VC VC per Room Sold Room’s × Occupancy % × 365 $476,000 90 × 70% × 365 Fixed costs SP − VC[u]

$476,000 22,995

$20.70 VC per room

$300,000 $300,000 $65.60 − $20.70 $44.90

6,682

Rooms available = 90 rooms × 365 = 32,850 rooms Occupancy % = 6,682 / 32,850 = 20.3% b. What level of sales revenue is required to provide operating income before tax? Fixed costs + OI $300,000 + $100,000 CM[u] $44.90

$400,000 $44.90

$8,909

= $8,909 × $65.60 = $584,430 Sales revenue c. Room rate is increased by $8.00 and $100,000 of OI is still wanted. How many fewer rooms per night need to be sold as compared to rooms to be sold in part b. above? New room rate = $65.60 + $8.00 = $73.60 $400,000 / ($73.60 − $20.70) = $400,000 / $52.90 = 7,561 rooms New level of rooms to be sold: 8,909 − 7,561 = 1,348 / 365 = 3.7 or 4 rooms per night d. Cost changes: (1) + $2.00 VC per room variable (housekeepers) (2) + $1.00 other variable costs (3) + $48,000 fixed cost increase ($4,000 × 12 months) (4) + $30,000 added for advertising costs (5) + $20,000 added for OI VC[u] SP[u]

$20.70 + $2.00 + $1.00 $73.60

$23.70 32.2% $73.60

CM% = 1 − VC% = 1 − 32.2% = 67.8% SR

$300,000 + $48,000 + $30,000 + $120,000 67.8%

Rooms Sold = $734,513 / $73.60 = 9,980 Rooms available = 90 rooms × 365 days = 32,850 Occupancy % = 9,980 / 32,850 = 30.4%

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$498,000 67.8%

$734,513

P8.7

a. Total sales revenue is provided jointly by both departments. Rooms: $600,000 / $800,000 = 75.0% Food: $200,000 / $800,000 = 25.0% Totals: $800,000 100.0% Rooms variable costs: $180,000 / $600,000 = 30.0% Rooms contribution margin: (1 − VC) = (1 − 30%) = 70.0% Food variable costs: $160,000 / $200,000 = 80.0% Food contribution margin: (1 − VC) = (1 − 80%) = 20.0% Breakeven sales revenue =

Fixed costs Rooms’ % Sales revenue + Food % of sales revenue × Rooms CM% × Food CM%

$220,000 (75% × 70%) + (25% × 20%)

$220,000 $220,000 52.5% + 5% 57.5%

$382,609 BESR

b. Cost / CM% = $1,000 / 20% = $5,000 c. Cost / CM% = $40,000 / 70% = $57,143

P8.8

a. Determine the contribution margin of the café. CM = 1 − VC% = 1 − 48% = 52.0% b. Determine the contribution margin of the bar. CM = 1 − VC% = 1 − 38% = 62.0% c. Determine the combined contribution margin of the café and bar. (Café SR% × CM Café) + (Bar SR% × CM% Bar) = Combined CM% (65% × 52%) + (35% × 62%) = 33.8% + 21.7% = 55.5% Combined CM% d. Determine the additional sales revenue necessary to cover the additional $50,000 operating income if provided by both the café and the bar. Additional Sales Revenue: Cost / Combined CM% = $50,000 / 55.5% = $90,090

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P8.9

Calculate changes to contributory income. Total FC is $335,000. Sales revenue Variable costs Contribution margin

Rooms $440,000 ( 132,000) $308,000

Food $110,000 ( 66,000) $ 44,000

Totals $550,000 ( 198,000) $352,000

a. Increase Rooms Contribution Margin (CM) by $20,000: Rooms CM = $440,000 − $132,000 = $308,000 CM% = CM / SR = $308,000 / $440,000 = 70.0% CM% × SR increase = CM increase = 70% × $20,000 = $14,000 b. Increase Food CM by $20,000 Food CM = $110,000 − $66,000 = $44,000 CM% = CM / SR = $44,000 / $110,000 = 40% CM% × SR increase = CM increase = 40% × $20,000 = $8,000 c. Doubling present OI [BT] with no change to direct VC costs. Combined CM – Fixed costs = OI [BT] $308,000 + $44,000 − $335,000 = $17,000 $17,000 / 70% = $24,286 d. Doubling present Food OI [BT] with no change to direct VC costs. Combined CM – Fixed costs = OI [BT] $308,000 + $44,000 − $335,000 = $17,000 / 40% = $42,500 e. Doubling present operating income [BT] jointly with no change to direct (VC) costs. CM Rooms + CM Food = Combined CM Percentage of sales revenue rooms = $440,000 / $550,000 = 80% Percentage of sales revenue food = $110,000 / $550,000 = 20% Combined CM = (80% × 70%) + (20% × 40%) = 56% + 8% = 64% $17,000 / 64% = $26,563 f. Calculate the required total sales revenue if provided jointly by both departments. • Doubling OI [BT] by both departments • Add an additional $5,000 on advertising. • Change the SR ratios: rooms from 80% to 75% and food from 20% to 25%. • Food VC is decreased to 55%. Fixed costs + Advertising cost + Double CM Combined CM% $335,000 + $5,000 + $34,000 (75% × 70%) + (25% × 45%)

$374,000 $374,000 52.5% + 11.3% 63.8% 135

$586,207

P8.10 a. Find the desired OI [BT]. Food Item 1 2 3 4 5

SP – VC = CM / SP = CM% × $15.00 – $7.75 = $7.25 / $15.00 = 48.3% × 12.95 – 7.50 = 5.45 / 12.95 = 42.1% × 11.00 – 5.50 = 5.50 / 11.00 = 50.0% × 8.95 – 2.85 = 6.10 / 8.95 = 68.2% × 9.95 – 6.50 = 3.45 / 9.95 = 34.7% × *Beverage CM% = 1 – VC% = 1 – 55% = 45.0% × Total combined CM%

Fixed costs + OI CM%

$546,000 + $25,000 48.4%

$571,000 48.4%

SR% = CCM% 16.0% = 7.7% 20.0% = 8.4% 22.0% = 11.0% 14.0% = 9.5% 8.0% = 2.8% 20.0% = 9.0% 100% 48.4%

$1,179,752 Sales revenue

b. Removal of Item 5 and its sales revenue are evenly split over the remaining items. Beverage VC% will decrease and its CM% will increase to 48% (1 − 52%). Item CM% × SR% 1 48.3% × 18.0% 2 42.1% × 22.0% 3 50.0% × 24.0% 4 68.2% × 16.0% *Beverage 48.0% × 20.0% Total combined CM%

= CCM% = 8.7% = 9.3% = 12.0% = 10.9% = 9.6% 50.5%

Sales revenue: (Fixed costs + OI) / CM% = $571,000 / 50.5% = $1,130,693 c. New Operating Income before tax: CM: 50.5% × SR: $1,200,000 = $606,000 – Fixed costs $546,000 = $60,000

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P8.11 Alternative (1): Analysis of the first alternative, using owner’s capital. Management & supervisory salaries expense Rent expense Insurance expense Depreciation expense [20% × $160,000] Total (Known) Fixed Costs Return on investment [18% × $200,000] Operating Income [BT]

$49,200 32,000 4,800 32,000 $118,000 36,000 $154,000

Total Variable Costs = 35% + 30% + 18% = 83% 100% of SR − Total VC % = 100% − 83% = 17% Known cost % OI [BT] / Known FC % = SR $154,000 / 1 – 83% = $154,000 / 17% = $905,882 Sales revenue Alternative (2): By borrowing $60,000 and renting equipment for $40,000 reduces the use of owner’s capital to $100,000. The operating income [BT] return on investment is $18,000 (18% × $100,000) compared to the 1st alternative, which was $40,000. Depreciation expense is reduced by $8,000 to $24,000 (20% × $120,000). However, there are two added annual fixed costs; the $60,000 borrowed will create interest expense of $4,800 (8% × $60,000) and $10,000 per year for equipment rental. The effect of using the alternative (2) of assuming debt is summarized: Management and supervisory salaries expense Rent expense Insurance expense Depreciation expense [20% × $120,000] Interest expense [8% x $60,000] Equipment rental expense Total Fixed Costs Return on investment [18% x $100,000] Operating Income [BT]

$49,200 32,000 4,800 24,000 4,800 10,000 $124,800 18,000 $142,800

Fixed costs / 1 − VC% = SR $142,800 / [1 – (35% + 30% + 18%)] = $142,800 / 17% = $840,000 SR The required sales revenue is $65,882 lower with the loan option alternative 2, than with alternative 1, using 100% of invested capital. Since the contribution margin percentage is the same for both options, the owner would be better to borrow $60,000 to lower the required sales. As well, the owner still has $100,000 to invest in another project.

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P8.12 a. Calculate the hotel’s breakeven point. Fixed costs 1 − (VC / SR)

$570,000 1 − ($350,000 / $1,000,000)

$570,000 1 − 35%

$570,000 65%

$876,923

b. Operating income [BT] of 15% on $1,200,000 is $180,000. (FC + OI) / (1 − VC%) = SR ($570,000 + $180,000) / (1 – 35%) = $750,000 / 65% = $1,153,846 c. Complete an analysis of the renegotiations of the hotel’s land lease. i. Acceptance of a variable lease will reduce fixed costs $80,000 ($570,000 − $490,000) and variable costs will increase by 6.5%. 35% + (10% × 65%) = 35% + 6.5% = 41.5% $490,000 / 1 − 41.5% = $490,000 / 58.5% = $837,607 Breakeven ii. The indifference point (or breakeven sales) at which fixed rental cost and variable rental cost for one year are identical is: Fixed Cost Lease / Change of VC $80,000 $80,000 (41.5% VC − 35% VC) 6.5% Or:

$1,230,769

Variable rent cost % = 41.5% of Sales = 35% of Sales + $80,000 = 41.5% of Sales − 35% of Sales = 6.5% of Sales = $80,000

Sales = $80,000 / 6.5% = $1,230,769 iii. Should management accept the variable lease if sales revenue is forecast to be $1,200,000 next year? Sales Revenue $1,200,000 Variable Costs at 35% ( 420,000) Contribution Margin $ 780,000 × 10% = $78,000 Sales revenue $1,200,000 less the 35% variable cost of $420,000 yields a contribution margin of $780,000, and variable rental cost would be $78,000. The proposal should be accepted. iv. Should management accept the variable lease if sales revenue is forecasted to be $1,400,000 next year? Sales Revenue $1,400,000 Variable Costs at 35% ( 490,000) Contribution Margin $ 910,000 × 10% = $91,000 Sales revenue of $1,400,000 less the 35% variable cost of $490,000 yields a contribution margin of $910,000, and variable rental cost would be $91,000. The proposal should not be accepted.

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CASE 8 SOLUTIONS Analysis of restaurant costs, Year 2007 Cost of Sales Food & Beverage [$220,626 / $639,111] Salaries and wages expense Fixed portion Variable portion [$67,143 / $639,111] Laundry [$16,609 / $639,111] Kitchen fuel Fixed portion Variable portion [$3,207 / $639,111] China & tableware expense [$12,214 / $639,111] Glassware expense [$1,605 / $639,111] Contract cleaning expense [$3,207 / $639,111] Licenses Other operating expenses [$4,101 / $639,111] Administrative and general expenses Marketing expense Utilities expenses Fixed portion Variable portion [$4,818 / $639,111] Insurance expense Rent expense Interest expense Depreciation expense [$13,752 + $6,372] Totals

$220,626 $223,543 (156,400) $ 67,143 16,609 7,007 ( 3,800) $ 3,207 12,214 1,605 5,906 3,205 4,101 15,432 6,917 7,918 ( 3,100) $ 4,818 1,895 24,000 23,981 20,124

Variable Cost % 34.5%

Fixed Costs

$156,400 10.5% 2.6% 3,800 0.5% 1.9% 0.3% 5,906 3,205 0.6% 15,432 6,917 3,100 0.8%

51.7%

1,895 24,000 23,981 20,124 $264,760

a. Total variable costs as a percentage of sales revenue is: 51.7% b. Total fixed costs are: $264,760 c. Breakeven Sales Revenue / Average check per guest (from Case 3) $264,760 / (1 − 51.7%) = $264,760 / 48.3% = $548,157 $548,157 / $9.59 = 57,159 guests d.

To increase operating income to 10% [10% – 6.9%] = 3.1% increase in sales revenue] (1) $639,111 × 3.1% = $19,812 (2) OI increase / (1 – VC%) $19,812 / (1 – 51.7%) = $19,812 / 48.3% = $41,019 additional sales revenue (3) $41,019 / $9.59 = 4,277 additional guests

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CHAPTER 9 OPERATIONS BUDGETING INTRODUCTION This chapter, although it covers most of the relevant theory of budgeting, concentrates on budgeted income statements. For this reason, the student should be very familiar with the content of Chapter 2 concerning income statements and their typical content and format. Also, familiarity with the information of Chapter 6 concerning menu prices and room rates will be useful. The material in Chapters 7 and 8 concerning fixed and variable costs and their relationship to sales revenue is essential. This chapter will discuss budgeting and create a base for the section on cash budgeting in Chapter 11 and for much of the material in Chapter 12 that discusses long-term investments.

TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True and F for False answers)

1. Budgets are always expressed in monetary terms.

2. A long-term budget is usually for a period from 1 to 5 years.

3. A cash budget is a type of capital budget.

4. A fixed budget is one based on a specific level of sales revenue.

5. A flexible budget is one based on various possible levels of sales revenue.

6. One purpose of budgeting is to provide management control over operations.

7. The general manager and the comptroller should be the only ones to prepare a budget.

8. One of the advantages of budgeting is that it permits subsequent comparison of actual with forecast figures.

9. Budgets should only be prepared when the future is perfectly predictable.

10. In establishing objectives in budgeting, limiting factors should be considered.

11. Because there is usually a difference between budgeted figures and actual results, there is little reason to spend time and money on budgeting.

12. The first step in the preparation of departmental budgets is the sales revenue forecast.

13. Past actual sales records, when available, are the foundation on which budgeted sales revenue is built.

14. Derived demand is sales revenue from customers who walk in off the street.

15. In preparing budgeted sales revenue figures from historic records, current competition can be ignored.

16. Current economic factors are considered in budgeting.

17. Preparing a staffing schedule for employees is one of the purposes of budgeting.

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18. To forecast restaurant sales revenue for a meal period, the only factors that must be taken into consideration are the number of seats, seat turnover rate, and average check.

19. In forecasting monthly room sales revenue in a hotel, the number of rooms in the hotel can be ignored.

20. In forecasting beverage sales revenue in a dining room, that sales revenue can usually be calculated as a percent of food sales revenue.

21. With incremental budgeting, budgets are automatically increased each year by the rate of inflation.

22. A restaurant plans to keep its advertising budget at the same amount as last year. This is a form of ZBB.

23. An advantage of ZBB is that it concentrates on the dollar cost of each department’s activities and budget and not on broad percentage increases.

24. Variance analysis is a method of analyzing the differences between budgeted figures and actual results.

25. A difference between budgeted sales revenue and actual sales revenue can be broken down into a price variance and a sales volume variance.

26. A restaurant budgeted 1,000 customers with an average check of $12.00. Actual customers were 900 with an average check of $12.50. The price variance will be $250 favorable.

27. A motel budgeted the sale of 3,000 rooms and a cleaning cost of $4.00 per room. Actual results showed 3,100 rooms occupied with a cleaning cost of $4.05 per room; there is a sales volume variance of $200 unfavorable.

28. Variance analysis is only useful for showing department heads how badly they are doing their job.

29. A moving-average forecast is a time-series method of analysis.

30. A regression analysis forecast is not a time-series method.

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk)

1. Short-term budgets differ from long-term budgets in that a short-term budget: (a) Is for a day, week, or month and a long-term one is for six months or a year (b) Is expressed in monetary terms where a long-term budget is generally expressed in the number of customers or some other measure * (c) Is usually for a year or less and long-term budgets are in excess of a year (d) Is prepared by an accountant and a long-term budget is prepared by a manager

141

2. A capital budget is one: (a) Prepared at the head office (b) That plans for current assets * (c) Related to balance sheet items (d) Compiled from all other budgets 3. A flexible budget is one: * (a) Prepared for several possible levels of sales revenue (b) That can be changed by a general manager after preparation by a department (c) That is not part of the master budget (d) That includes only variable costs 4. The budget preparation procedure: (a) Is the sole responsibility of the controller * (b) Depends on the size and nature of the establishment (c) Starts from the top down (d) Commences after the period concerned has started 5. An advantage of budgeting is that: * (a) Those involved in budgeting are obliged to look ahead and be flexible (b) The unpredictable future is an excuse for not having fairly accurate estimates (c) If budgeted expenses are overestimated, there will be extra money at the end of the period for staff bonuses (d) Staff involved in budgeting will learn about confidential management matters 6. One of the steps in the budget cycle is to: (a) Increase the forecast return on investment over the previous period (b) Establish goals that are 50% above last year (c) Use variance analysis to compare a manager’s budget to the department budget * (d) Improve the effectiveness of budgeting as a result of the budgeting process 7. Limiting factors in budgeting are factors that: (a) Limit the time that can be spent on budgeting * (b) Must be considered when establishing sales revenue goals and expense budgets (c) Prevent a department head from talking to his staff about budgeting (d) Ensure that sales revenue goals will always be established at the highest limits 8. If restaurant has budgeted 1,000 customers at an average check of $9.00 and actual customers were 800 with an actual average check of $9.50, then: (a) Actual sales revenue will be higher than budgeted (b) We can assume that the higher average check is keeping customers away * (c) The cause of a significant difference between actual and budgeted figures should be investigated (d) Because of slower service fewer customers could be served 9. Derived demand is demand: * (a) Generated by one department from activity in another department in the same operation (b) From returning customers (c) From customers who have given up going to competitive restaurants (d) As a result of additional advertising

142

10. A restaurant has 125 seats with an average check of $8.00 and a daily seat turnover of 2.5. It is open 5 days a week and the average check is forecast to increase by 10% in the next year. Next year’s budgeted sales revenue will be: (a) $286,000 (b) $650,000 * (c) $715,000 (d) $ 13,750 11. When departmental budgets are increased each year by a flat percentage rate, this is known as: (a) ZBB * (b) Incremental budgeting (c) Incidental budgeting (d) Inflationary budgeting 12. Which of the following is not true of ZBB? * (a) It takes less time, effort, and paperwork than incremental budgeting (b) It can reallocate funds to the departments providing greatest benefit to the organization (c) It obliges managers to identify inefficient or obsolete functions within their areas of responsibility (d) It can identify areas of overlap or duplication 13. Variance analysis is a: (a) Procedure for questioning department heads about differences between budgeted and actual results (b) Method of analyzing limiting factors (c) Method of studying variations in budgeting process * (d) Method of analyzing causes of differences between budgeted and actual figures 14. A banquet department’s annual budgeted sales revenue was based on 45,000 guests at an average check of $10.00. Actual figures were 47,500 guests at a $9.50 average check. The total budget, price, and sales volume variances respectively are: (a) $1,250 Unfavorable, $23,750 Unfavorable, and $22,500 Favorable (b) $1,250 Favorable, $2,750 Favorable, $1,500 Unfavorable * (c) $1,250 Favorable, $23,750 Unfavorable, $25,000 Favorable (d) $1,250 Favorable, $23,750 Favorable, and $25,000 Unfavorable 15. The general equation for a moving-average forecast that uses n for the number of periods is: (a) Average for each of the previous n periods divided by n * (b) Total of all of the previous n periods divided by n (c) Total of all of the previous n periods multiplied by n (d) Average for each of the previous n periods multiplied by n

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EXERCISE SOLUTIONS E9.1

Estimate sales revenue: [Seats × Turnover × Average check × Operating days] 100 × 2.5 × $14.75 × 260 = $958,750 Estimated sales revenue

E9.2

Estimate monthly sales revenue: [Rooms × Occupancy % × Average room rate × Operating days] 80 × 62% × $74.00 × 30 = $110,112 Estimated Sales Revenue

E9.3

Calculate housekeeping cost and quantity variance analysis. a. Budget: 8,000 × $4.40 = $35,200 Actual: 8,480 × $4.90 = $41,552 Budget cost variance = $ 6,352 Unfavorable b. Cost variance: 8,480 × $0.50 = $4,240 Unfavorable c. Quantity variance: 480 × $4.40 = $2,112 Unfavorable Budget variance = $6,352 Unfavorable Proof: Actual Actual Budget Quantity cost Totals Actual variance 8,480 × $4.90 = $41,552 $41,552 $4,240 Actual × Budgeted = cost Unfavorable quantity cost variance ($6,352) 8,480 × $4.40 = $37,312 Unfavorable $2,112 Budgeted × Budgeted = Quantity quantity cost volume Unfavorable Variance Budget 8,000 × $4.40 = $35,200 $35,200

144

E9.4

Calculate sales revenue variance analysis. a. Budget: 8,000 × $82 = $656,000 Actual: 8,480 × $77 = $652,960 Budget variance = $ 3,040 Unfavorable and 480 rooms Favorable b. Price variance: 8,480 × $ 5.00 c. Sales volume variance: 480 × $82.00 Budget variance

= $42,400 Unfavorable = $39,360 Favorable = $ 3,040 Unfavorable

Proof: Actual volume 8,480 Actual volume 8,480

× ×

Actual price $77.00

Totals = $652,960

× Budgeted = price × $82.00 = $695,360

E9.5

$82.00

($42,400) Price Unfavorable variance

($3,040) Unfavorable

$39,360 Sales volume variance

Budgeted Budgeted = volume × price 8,000

Actual $652,960

Favorable

= $656,000

Budget $656,000

Calculate the moving average guests count for three months. January: Guests 1,670 February: Guests 1,880 March: Guests 2,882 Total guests, 3 months 6,432 [ of guests /  of time periods] 6,432 / 3 months = 2,144 Average guests per month

E9.6

Forecast operating income. SR: [Rooms × Occupancy % × Average room rate × Operating days] 45 × $58 × 76% × 365 = $724,014 VC: $8.00 × 45 × 76% × 365 = $99,864 Sales revenue Variable costs Contribution margin Less: Fixed costs Operating Income

Budget variance

$724,014 ( 99,864) $624,150 ( 480,000) $ 144,150

145

E9.7

Forecast annual sales revenue by meal periods. SR: [Seats × Turnover × Average check × Operating days = Meal sales revenue] Breakfast: 80 × 2.50 × $ 7.80 × 365 = $ 569,400 Lunch: 80 × 1.75 × $ 8.75 × 365 = $ 447,125 Dinner: 80 × 2.75 × $11.25 × 365 = $ 903,375 Total sales revenue = $1,919,900

E9.8

Calculate room sales revenue for three months. SR: [Rooms × Occupancy % × Room rate × Operating days = Rooms sales revenue] January 50 × $78 × 65% × 31 = $ 78,585 February 50 × $87 × 72% × 28 = $ 87,696 March 50 × $94 × 75% × 31 = $109,275 Room sales revenue = $275,556

E9.9

Calculate sales revenue and operating income for a year. SR = [Rooms Available x Avg. Occupancy % x Avg. room rate x 365 days] Rooms sales revenue: 70 × $125 × 74% × 365 = $2,363,375 OI = [SR – VC – Fixed costs ] Operating income = $2,363,375 − VC $212,704 − Fixed costs $1,056,000 = $1,094,671

E9.10 Answer questions relative to VC, gross margin and operating income. a. VC = VC% × SR = 72% × $ 912,000 = $656,640 b. GM = SR − VC = $912,000 − $656,640 = $255,360 c. OI = GM − Fixed costs = $255,360 − $102,000 = $153,360

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PROBLEM SOLUTIONS P9.1

Determine monthly sales revenue considering room rate increases and occupancy. Room rate increase for July and August is: $80 × 110% = $88 SR = [Rooms × Average room rate × Occupancy × Operating days] June: 40 × $80 × 74% × 30 days = $ 71,040 July: 40 × $88 × 84% × 31 days = $916,608 August: 40 × $88 × 92% × 31 days = $100,390

P9.2

Prepare an annual budget for the coming year. Sales revenue [60 × 74% × $84 × 365] Variable costs [60 × 74% × $8 × 365] Contribution margin Fixed costs Operating income

P9.3

$1,361,304 ( 129,648) $1,231,656 ( 825,000) $ 406,656

Calculate budgeted food sales revenue and beverage sales revenues. Meal period SR = [Meal period × Seats × Turnover × Days Available] Lunch: [66 × 1.75 × $12.95 × 27] Beverage: [15% × $40,385] Total lunch sales revenue

= $ 40,385 = 6,058 = $ 46,443

Dinner: [66 × 2.75 × $16.95 × 27] Beverage: [32% × $83,063] Total dinner sales revenue Total budgeted sales revenue

= $ 83,063 = 26,580 = $109,643 = $156,086

Budgeted food sales revenue = $40,385 + $83,063 = $123,448 Budgeted beverage sales revenue = $6,050 + $26,580 = $32,638 P9.4

Calculate the budgeted sales revenue for the coffee shop for January. [Seats × Turnover ×Average check × Operating days] Breakfast: [120 × 1.50 × $ 7.50 × 31] = $ 41,850 Lunch: [120 × 2.00 × $ 9.50 × 31] = $ 70,680 Dinner: [120 × 1.50 × $12.50 × 31] = $ 69,750 Total budgeted sales revenue $182,280

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P9.5

Prepare a 3 level flexible budget. Comment on the affect of operating and net income. Sales Revenue Variable Costs: [38% + 28% + 10% = 76%] Contribution Margin Fixed Costs: [$52,000 + $102,000] Operating Income Tax rate [29%] Net income Breakeven: Fixed costs + OI 1 − VC%

$800,000 (608,000) $192,000 (154,000) $ 38,000 ( 11,020) $ 26,980

$154,000 + $0 1 − 76.0%

$900,000 (684,000) $216,000 (154,000) $ 62,000 ( 17,980) $ 44,020

$154,000 24.0%

$1,000,000 ( 760,000) $ 240,000 ( 154,000) $ 86,000 ( 24,940) $ 61,060

$641,667

All three sales revenue levels exceed breakeven. At $800,000, operating income and net income represents 4.8% and 3.4% of sales revenue respectively. At $900,000, operating income and net income increases considerably to 6.9% and 4.9% of sales respectively. At $1,000,000, operating income and net income almost doubles at 8.6% and 6.1% of sales revenue respectively. The increases to operating income and net income are due to an increase in sales revenue at each level and variable and fixed costs remaining stable. P9.6

Calculate the food sales revenue for the month of June. Average number of guests per day is: 150 × 80% × 3 = 360 guests Breakfast: 360 × 95% × $ 7.50 × 30 = $ 76,950 Lunch: 360 × 25% × $12.50 × 30 = $ 33,750 Dinner: 360 × 75% × $25.20 × 30 = $204,120 Total dining room sales revenue = $314,820

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P9.7

Complete a budgeted income statement. Budgeted Income Statement Food Sales Revenue Weekday lunch [120 × 1.5 × $8.50 × 305] $466,650 Weekday dinner [120 × 1.25 × $18.50 × 305] 846,375 Sundays-holidays etc. [120 × 2.0 × $21.00 × 60] 302,400 Private party room food sales revenue 144,000 Total budgeted food sales revenue

$1,759,425

Beverage Sales Revenue Lunch [12% × $466,650] Dinner [25% × $846,375] Private party room [40% × $144,000] Total budgeted beverage sales revenue Total budgeted sales revenue

$ 55,998 211,594 57,600 $ 325,192 $2,084,617

Cost of sales Food cost [37% × $1,759,425] Beverage cost [33% × 325,192] Total cost of sales Gross Margin

$650,987 107,313 ( 758,300) $1,326,317

Operating Expenses Salaries expense Variable wage expenses [15% × $2,084,617] Employee Benefits expense [12% × $596,693] Other operating expenses [11.7% × $2,084,617] Fixed overhead expenses Total Operating Expenses Net operating income

149

$284,000 312,693 71,603 243,900 226,400 (1,138,596) $ 187,721

P9.8

Two alternative income statements; explain which you recommend and why? Budgeted Average Monthly Income Statement Alternative 1 Alternative 2 Sales revenue food $40,000 $48,000 Sales revenue beverage 10,000 12,000 Total Sales Revenue $50,000 $60,000 Cost of sales, food [37%] $14,800 $17,760 Cost of sales, beverage [30%] 3,000 3,600 Total Cost of Sales (17,800) (21,360) Gross Margin $32,200 $38,640 Operating Expenses Wages expenses $13,600 $15,600 Operating Supplies expense 4,000 4,800 Admin. & general expenses 2,600 2,800 Advertising & promo. 1,800 3,800 Repairs & maintenance 900 1,200 Utilities expense 1,300 1,400 Depreciation 700 700 Interest expense 600 600 Total Operating Expenses (25,500) (30,900) Operating income $ 6,700 $ 7,740 Alternative 2 appears to be the best choice and provides a higher level of operating income of $1,040. Alternative 2 also provides a higher level of sales revenue that adequately provides the increases to operating expenses and yields more net income. However, either alternative is risky if customers object to decreased portion sizes.

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P9.9

Complete an analysis for budget, price and volume variances. a. Sales revenue volume and price variances: Budget [1,500 × $5.00] Actual [1,550 × $4.80] Budget sales volume variance

$7,500.00 7,440.00 $ 60.00 Unfavorable

Price variance [1,550 × $0.20] Sales volume variance [50 × $5.00] Budget variance

310.00 Unfavorable 250.00 Favorable $ 60.00 Unfavorable

Proof: Actual Volume 1,550

Actual Price $4.80

Totals

Actual

= $7,440.00

Budget variance

$7,440.00

($310) × Budgeted = Price Unfavorable Price Variance $60.00 × $5.00 = $7,750.00 Unfavorable $250.00 Budgeted × Budgeted = Sales Favorable Budget Volume Price Volume Variance 1,500 × $5.00 = $7,500.00 $7,500.00 Actual Volume 1,550

Sales revenue volume and price variances: Budgeted volume [20,000 × $14.00] $280,000 Actual volume [21,500 × $13.50] 290,250 Budget sales volume variance $ 10,250 Favorable Price variance [21,500 × $0.50] Sales volume variance [1,500 × $14.00] Budget variance

$ 10,750 Unfavorable 21,000 Favorable $ 10,250 Favorable

Proof: Actual Volume 21,500 Actual Volume 21,500

Actual Price $13.50

Totals

Actual

= $290,250

$290,250

× Budgeted = Price × $14.00 = $301,000

Budgeted × Budgeted = Volume Price 20,000

$14.00

($10,750) Price Unfavorable Variance $21,000 Sales Volume Variance

= $280,000

Favorable

$10,250 Favorable Budget

$280,000 151

Budget Variance

Cost and sales volume variances Budgeted standard cost [1,000 × $6.00] $6,000 Actual quantity [900 × $6.25] 5,625 Budget cost variance $ 375 Unfavorable Cost variance [900 × $0.25] Sales volume variance [100 × $6.00] Budget cost variance Proof:

Actual Quantity 900 Actual Quantity 900

Actual Cost $6.25

× Standard = Cost × $6.00 =

Totals

Actual

$5,625

$5,625 $225 Cost Unfavorable Variance $600 Sales Favorable Volume Variance

$6.00

$6,000

Budget variance

$375 Favorable

$5,400

Budgeted × Standard = Quantity Cost 1,000

$ 225 Unfavorable 600 Favorable $ 375 Unfavorable 375

Budget

$6,000

(1) Sales revenue volume and price variances:

Actual Volume 14,800

Budgeted Volume 14,000

Budgeted price [14,000 × $6.45] Actual volume [14,800 × $6.75] Budget sales revenue variance

$90,300 99,900 $ 9,600 Favorable

Price variance [14,800 × $0.30] Sales volume variance [800 × $6.45] Budget sales revenue variance

$ 4,440 Favorable 5,160 Favorable $ 9,600 Favorable

Actual Price $6.75

Budgeted Price $6.45

Budgeted Price

$6.45

Proof: Totals

Actual

$99,900

$99,900 $4,440 Price Variance

Favorable $9,600 Favorable

$95,460 $5,160 Sales Volume Variance $90,300

Favorable

Budget

$90,300

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Budget Variance

(2) Cost variances: Budgeted quantity [14,000 × $2.45] Actual quantity [14,800 × $2.25] Budget quantity cost variance

$34,300 33,300 $ 1,000 Unfavorable

Cost variance [14,800 × $0.20] Sales volume variance [800 × $2.45] Budget cost variance

$ 2,960 Favorable 1,960 Unfavorable $ 1,000 Unfavorable

Proof: Actual Quantity 14,800

Actual Cost $2.25

Totals

Actual

= $33,300

$33,300

Budget variance

$2,960 × Standard = Cost Unfavorable Cost Variance $1,000 × $2.45 = $36,260 Unfavorable $1,960 Budgeted × Standard = Sales Unfavorable Budget Quantity Cost Volume Variance 14,000 × $2.45 = $34,300 $34,300 Actual Quantity 14,800

Cost variances: Budgeted hours: 400 guests / 20 guests = 20 × 4 hrs = 80 hours Actual rate of pay: $714 / 84 hrs = $8.50 Budget [80 hrs. × $8.00] Actual [84 hrs. × $8.50] Budget cost variance

$640.00 714.00 $ 74.00 Unfavorable

Cost variance [84 hrs. × $0.50] Sales volume variance [4 × $8.00] Budget cost variance

$ 42.00 Unfavorable 32.00 Unfavorable $ 74.00 Unfavorable

Proof: Actual Quantity 84 hrs Actual Quantity 84 hrs

Actual Cost $8.50

Totals

Actual

= $714.00

$714.00

× Standard = Cost × $8.00 = $672.00

$42.00 Cost Unfavorable Variance

$32.00 Budgeted × Standard = Sales Unfavorable Budget Quantity Cost Volume Variance 80 hrs × $8.00 = $640.00 $640.00 153

Budget variance

$74.00 Unfavorable

P9.10 Budgeted rooms to be sold next year: 80 × 75% × 365 = 21,900 a. Budgeted Departmental Contributory Income Statement Rooms Department Sales Revenue: [21,900 × $68.00] Expenses Fixed wages expense Housekeeping expenses [21,900 × 0.5 × $9.00] Subtotal Fringe benefits: [18% × $284,550] Other costs: [21,900 × $2.75] Rooms Contributory income

$1,489,200 $ 186,000 98,550 $ 284,550 51,219 60,225

( 395,994) $1,093,206

Overnight guests: 80 rooms × 75% = 60 rooms occupied 40% × 60 = 24 rooms double occupied 84 overnight guests Average breakfast guests: 80% × 84 = 67.2 Guests Snack bar sales revenue Breakfast: [67.2 × $6.50 × 365] Lunch: [50 × 1.5 × $8.95 x 365] Dinner: [50 × 2.0 × $10.95 × 365] Total Sales Revenue Expenses [78% × $804,113] Snack Bar Contributory Income

$159,432 245,006 399,675 $804,113 ( 627,208) $176,905

Consolidated Motel Departmental Income Statement Rooms Contributory Income $1,093,206 Snack Bar Contributory Income 176,905 Total Contributory Income $1,270,111 Less: Indirect, Undistributed Costs ( 580,800) Budgeted Operating Income $ 639,311 b. Rooms budgeted sales revenue variance analysis Rooms sales revenue: Budget [21,900 × $68.00] Actual [21,700 × $68.40] Budget rooms sales revenue variance

$1,489,200 1,484,280 $ 4,920 Unfavorable

Price variance [21,700 × $0.40] Sales volume variance [200 × $68.00] Budget rooms sales revenue variance

$ 8,680 Favorable 13,600 Unfavorable $ 4,920 Unfavorable

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Proof: Actual Volume 21,700

Actual Price $68.40

Totals

Actual Volume 21,700

× Budgeted = Price × $68.00 = $1,475,600

= $1,484,280

$68.00

Budget Variance

$1,484,280 $8,680 Price Variance

Favorable

($4,920) Unfavorable

($13,600) Sales Unfavorable Volume Variance

Budgeted × Budgeted = Volume Price 21,900

Actual

= $1,489,200

Budget

$1,489,200

The wage variance needs to be determined using hours and cost per hour, not cost per room. By doing it this way, you can see the effect of the change in the labor rate per hour plus the change in the time used to clean and clear each room. Actual hours worked = 21,700 × 32 minutes per room = 694,400 minutes / 60 minutes = 11,573.3 hours Budgeted hours: 21,900 × 30 minutes = 657,000 / 60 = 10,950 hours Actual wage rate / hour = $108,208 / 11,573.3 hours = $9.35 per hour For 21,700 rooms, you need 21,700 × 30 minutes = 651,000 / 60 = 10,850 minutes Rooms wage costs variance analysis: Budget quantity [21,900 × 0.5 × $9.00] $ 98,550 Actual quantity [21,700 × (32/60) × $9.35] 108,211 Budget quantity variance $ 9 ,661 Unfavorable Hours quantity variance [(11,573.3 – 10,850) × $9.00] Quantity volume variance [200 × 0.5 × $9.00] Cost variance [11,573.3 × $0.35] Budget cost variance

$ 6,510 Unfavorable 900 Favorable 4,051 Unfavorable $ 9,661 Unfavorable

Proof: Actual Quantity 11,573.3 Actual Quantity 11,573.3

Actual Cost $9.35

Totals = $108,208

× Standard = Cost × $9.00 = $104,160

Budgeted × Standard = Quantity Cost 10,950

$9.00

Actual

$98,550

Budget variance

$108,208 ($4,051) Cost Unfavorable Variance ($5,610) Sales Unfavorable Budget Volume Variance $98,550 155

($9,661) Unfavorable

P9.11 Calculate individual department contributory income statements, then combine each department into a combined departmental operating budget. Determine total combined operating income before depreciation, interest and taxes. Combined Departmental Operating Budget (First Year) Rooms Department Rooms sales revenue: [100 × 64% × $72 × 365] $1,681,920 Operating Expenses Wages expense, fixed [given] $326,900 Wages expense, variable: [100 × 64% = 64] [64 / 16 = 4] [4 × 8 × $8.50 × 365] 99,280 Total estimated wages expense $426,180 Employee fringe benefits [12% × $426,180] 51,142 Other variable expenses: [6% + 3%] × $1,681,920] 151,373 Total departmental direct costs ( 628,695) Rooms Department Contributory Income $1,053,225 Food Department Dining room sales revenue: Lunch: [75 × 1.5 × $8.25 × 6 × 52] $289,575 Dinner (food only) [75 × 1.0 × $14.00 × 6 × 52] 327,600 Total Dining Room Sales Revenue $ 617,175 Coffee Shop Sales Revenue Breakfast: [65 × 1.0 × $5.75 × 365] $136,419 Lunch: [65 × 1.5 × $7.75 × 365] 275,803 Dinner: [65 × 1.0 × $9.95 × 365] 236,064 Coffee breaks: [65 × 6.0 × $1.75 × 365] 249,113 Total Coffee Shop Sales Revenue 897,399 Lounge sales revenue: [20 × $8.50 × 310] 57,200 Subtotal food department $1,571,744 Total variable expenses: [89% × $1,571,744] ( 1,398,879) Food Department Contributory Income $ 172,865 Beverage Department Sales Revenue Beverage sales revenue per seat [90 × $5,250] $472,500 Beverage sales revenue; from coffee shop, lunch and dinner [($275,803 + $236,064) = $511,867 × 15%] 76,780 Beverage sales revenue; from dining room, lunch and dinner [25% × $617,175] 154,294 Total Beverage Sales Revenue $ 703,574 Beverage variable operating expenses [32% + 25% + 5% = 62%] [62% × $703,574] ( 436,216) Beverage Department Contributory Income $ 267,358 Combined Departmental Operating Budget Contributory Income, Rooms $1,053,225 Contributory Income, Food 172,865 Contributory Income, Beverage 267,358 Total Contributory Income $1,493,448 Less: Total Undistributed Indirect Expenses: ( 513,100) Operating Income (before depreciation, interest and tax) $ 980,348 156

P9.12 Use regression analysis.

The equation: Y = a + bX

X

= 70,657 (average of X nights, 5,888.08  5,888)

Y

= 91,358 (average Y guests = 7,613.167  7,613)

XY

= 538,362,791

X2

= 416,383,999

12 (538,362,791) – (70,657) (91,358) 12 (416,383,999) – (70,657) (70,657)

6,460,353,492 – 6,455,082,206 4,996,607,988 – 4,992,411,649

7,613 – (1.26 × 5,888) = 7,613 – 7,419 = 194

5,271,286 1.26 4,196,339

Therefore Y = 194 + 1.26X P9.13 Regression analysis: Total guests in Nov. 100 × 70% × 140% × 30 = 2,940 Breakfast: Lunch: Dinner:

CASE 9

750 + (82% × 2,940) = 3,161 900 + (15% × 2,940) = 1,341 1,200 + (42% × 2,940) = 2,435

3,161 × $5.25 = $19,595.25 1,341 × $10.24 = $13,731.84 2,435 × $15.78 = $38,424.30

SOLUTION

a. 4C Company forecasted sales revenue for Year 2008 Food Sales Revenue Lunch [84 × 1.5 × $5.85 × 6 × 52] + [15 × $5.85 × 6 × 52] Dinner [84 × 1.25 × $9.79 × 5 × 52] Total food sales revenue

$257,353 267,267 $524,620

Beverage Sales Revenue Lunch [84 × 1.5 × $1.12 × 6 × 52] + [15 × $1.12 × 6 × 52] Dinner [84 × 1.25 × $5.69 × 5 × 52] Total beverage sales revenue Total Sales Revenue

157

$ 49,271 155,337 204,608 $729,228

4C Company, Budgeted Income Statement, For the Year 2008 Sales Revenue Sales revenue: Food Sales revenue: Beverage Total sales revenue

$524,620 204,608 $729,228

Cost of Sales Cost of sales: Food [39.5% × $524,620] Cost of sales: Beverage [21.8% × $204,608] Total Cost of Sales Gross Margin

207,225 44,605 ( 251,830) $477,398

Operating Expenses Salary and wages expense

$255,903

[($223,543 – $18,000 + $6,864) = ($212,407 × 104% + $35,000)]

Laundry expense [2.6% × $729,228] Kitchen fuel expense

18,960 7,846

[VC: 0.5% × $729,228] + [Fixed costs: $3,800 + $400]

China & tableware expense [1.9% × $729,228] Glassware expense [.03% × $729,228] Contract cleaning expense [$5,906 + $600] Licenses expense Other operating expense [0.6% × $729,228] Administrative & general expenses [$15,432 × 105%] Marketing expenses [$6,917 + $3,000] Utilities expense [ 0.8% × $729,228] + Fixed costs: $3,100 + $2,000] Insurance expense [$1,895 × 110%] Rent expense [$24,000 × 110%] Interest expense Depreciation expense Total Operating Expenses Operating Income Income tax [22% × $59,396] Net income

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13,855 2,188 6,506 3,205 4,375 16,204 9,917 10,934 2,085 26,400 19,500 20,124 ( 418,002) $ 59,396 ( 13,067) $ 46,329

c. A comparative horizontal analysis and common-size vertical analysis of the 4C Company Budgeted Income Statement for Year 2008 will be compared to Year 2007 income statement (Case 2) and the common-size income statement (Case 3). Comparative Horizontal Analysis

Common-size Vertical Analysis

Sales Revenue Sales revenue: Food Sales revenue: Beverage Total Sales Revenue

Yr. 2007 $458,602 180,509 $639,111

Yr. 2008 $524,620 204,608 $729,228

$ Change +$66,018 + 24,099 +$90,117

▲Change +14.4% +13.4% +14.1%

Yr. 2008 71.9% 28.1% 100.0%

Yr.2007 71.8% 28.2% 100.0%

Cost of Sales: Food Cost of Sales: Beverage Total Cost of Sales Gross Margin

$181,323 39,303 ( 220,626) $418,485

$207,225 44,605 ( 251,830) $477,398

+$25,902 + 5,302 + 31,204 + 58,913

+14.3% +13.5% +14.1% +14.1%

28.4% 6.1% (34.5%) 65.5%

35.5% 21.8% (34.5%) 65.5%

Operating Expenses Salaries & wages expense Laundry expense Kitchen fuel expense China–Tableware expense Glassware expense Contract cleaning expense Licenses expense Other operating expenses Admin–general expenses Marketing expense Utilities expense Insurance expense Rent expense Interest expense Depreciation expense Total Operating Expense Operating Income Income tax Net Income

$223,543 16,609 7,007 12,214 1,605 5,906 3,205 4,101 15,432 6,917 7,918 1,895 24,000 23,981 20,124 $374,457 $ 44,028 ( 9,686) $ 34,342

$255,903 18,960 7,846 13,855 2,188 6,506 3,205 4,375 16,204 9,917 10,934 2,085 26,400 19,500 20,124 $418,002 $ 59,396 ( 13,067) $ 46,329

+$32,360 + 2,351 + 839 + 1,641 + 583 + 600 –0– + 274 + 772 + 3,000 + 3,016 + 190 + 2,400 – 4,481 –0– + 43,545 + 15,368 + 3,381 + 11,987

+14.5% +14.2% +12.0% +13.4% +36.3% +10.2% –0– + 6.7% + 0.5% +43.4% +38.1% +10.0% +10.0% –18.7% –0– +11.6% +34.2% +34.9% +34.2%

35.1% 2.6% 1.1% 1.9% 0.3% 0.9% 0.4% 0.6% 2.2% 1.4% 1.5% 0.3% 3.6% 2.7% 2.8% (57.3%) 8.1% 1.8% 6.4%

35.0% 2.6% 1.2% 1.9% 0.3% 0.9% 0.5% 0.6% 2.4% 1.1% 1.2% 0.3% 3.8% 3.8% 3.1% 58.6% 6.9% 1.5% 5.4%

(1) A comparative horizontal analysis of the 4C Company budgeted income statement for Year 2008 shows the following: (a) Sales revenue–food increased $66,018 or 14.4% ($524,620 – $458,602) and Sales revenue– beverage increased $24,099 or 13.4% ($204,608 – $180,509). Total sales revenue increased $90,117 or 14.1% ($729,228 – $639,111). This appears optimistic.

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(b) Total operating expenses increased $43,545 or 11.6% ($418,002 – $374,457). Total operating income increased $15,368 or 34.2% ($59,396 – $44,028) and net income increased $11,987 or 34.2% ($46,329 – $34,342). (2) A common-size vertical analysis of 4C Company’s budgeted income statement for Year 2008 shows the following: (a) Sales revenue–food increased 0.1% (71.9% – 71.8%) relative to total sales revenue and sales revenue–beverage decreased 0.1% (28.1% – 28.2%). This change is insignificant. (b) Total operating expenses decreased slightly by 1.3% (58.6% –57.3%) in Year 2008. There were no other significant changes noted. However, this change is due to the higher sales revenue while many of the fixed costs did not increase as much as the total sales revenue increased. (c) Operating Income increased by 1.2% (8.1% – 6.9%) and Net Income increased by 0.9% (6.3% – 5.4%) in Year 2008. If Charlie achieves final budget figures, he will have a successful year and increase the operations net income.

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CHAPTER 10 STATEMENT OF CASH FLOWS AND WORKING CAPITAL ANALYSIS INTRODUCTION The statement of cash flows and working capital analysis are discussed in this chapter. As you will see, both statements have in common the analysis and evaluation of current assets and current liabilities. The statement of cash flows (indirect method) converts an accrual income statement to a cash basis statement. It adjusts net income (or net loss) by identifying cash inflows and outflows as positive or negative adjustments. Non-cash expenses and non-operating gains or losses from the disposal of non-current assets adjust the cash balance based on their effect on the cash account. Day-to-day management of working capital is an important aspect of managing any enterprise and such an analysis shares the same concept of identifying cash inflows and outflows that increase or decrease working capital (current assets minus current liabilities). This chapter demonstrates how a statement of cash flows and a statement of source inflows and use outflows of working capital are developed. A good grasp of Chapters 2 and 3 will serve as a solid foundation for this chapter. The discussion of working capital analysis in this chapter will be of great assistance in Chapter 11 that discusses cash management.

TRUE or FALSE QUESTIONS (Correct answer indicated by T for True answers and F for False answers)

1. Total current assets − total current liabilities = working capital.

2. The SCF is considered a major financial statement as is the balance sheet and the income statement.

3. The financing activities section of a SCF evaluates transactions between the company and its creditors and owners.

4. The operating activities section of a SCF, indirect method, evaluates only the disposal of depreciable assets.

5. If a current asset account balance increases over an accounting period, the increase is treated as a negative number in a SCF.

6. Depreciation and amortization for the period are treated as positive numbers and added back in the operating section of a SCF, indirect method.

7. Gains on the disposal of non-current assets are treated as a positive number and losses are treated as a negative number on a SCF.

8. The three sections of a SCF are: operating activities, investing activities and financing activities.

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9. The payment of cash dividends is treated as a positive number in the financing activities section of a SCF.

10. The operating activities section of a SCF, indirect method, generally evaluates current assets, and liabilities, non-cash expenses, and gains or losses on the disposal of noncurrent assets.

11. The increasing or decreasing of long-term debt is evaluated in the financing activity section of a SCF.

12. The difference between the direct and indirect methods of preparing a SCF only affects the operating section of the statement.

13. The statement of source inflows and use outflows of working capital shows certain transactions that occurred at a specific point in time.

14. One of the purposes of a statement of source inflows and use outflows of working capital is to provide prospective investors with information.

15. Depreciation expense is a use of working capital.

16. The purchase of a fixed asset is a source of working capital.

17. A loss from operations is a use of working capital.

18. Payment of dividends will decrease working capital.

19. A transaction affecting a current asset and a current liability account only will not affect working capital.

20. When compiling a statement of source inflows and use outflows of working capital, detailed information from the current asset and liability accounts on the balance sheet is required.

21. Information in addition to that provided by the income statement, the retained earnings statement, and the balance sheets is sometimes required to compile a statement of source inflows and use outflows of working capital.

22. The net change in working capital figure from the statement of source inflows and use outflows of working capital need not be reconciled with any other figures.

23. If an establishment sold a long-term asset for $3,000 and purchased a new one for $20,000, only the difference of $17,000 will appear as a use of funds in the statement of source inflows and use outflows of working capital.

24. The statement of changes in working capital accounts shows how individual current asset and liability accounts increased or decreased during the period.

25. If the statement of changes in individual working capital accounts shows an increase in current liabilities during the period, this will cause a decrease in total working capital.

26. A statement of changes in individual working capital accounts must be prepared before a statement of source inflows and use outflows of funds can be compiled.

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27. The actual amount of working capital is not as indicative of a company’s debt paying ability as is its current ratio.

28. The current ratio is total current liabilities divided by total current assets.

29. The current ratio in a hotel or restaurant should be higher than 2:1.

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk)

1. Working capital is: (a) The amount of cash one has in the bank (b) The amount of cash required for purchase of capital or fixed assets * (c) The difference between current assets and current liabilities (d) Cash plus accounts receivable plus marketable securities 2. The three major activities evaluated in a SCF are: (a) Operating, investing, and profiting * (b) Operating, investing, and financing (c) Operating, investing, and managing (d) Operating, profiting, and financing 3. If kitchen equipment were purchased for $24,400 during the current period, the cost of the purchase would be shown as a: * (a) Negative number in the investing section of the SCF (b) Negative number in the operating section of the SCF (c) Negative number in the financing section of the SCF (d) Positive number in the investing section of the SCF 4. Restaurant furnishings with an original cost of $38,000 and accumulated depreciation account of $32,000, was sold for $4,200 cash. How will the proceeds of the sale be reported in a SCF, indirect method? (a) In the financing section, cash inflow of $1,800 (b) In the investing section, cash inflow of $1,800 (c) In the operating section, cash outflow of $1,800 * (d) In the investing section, cash inflow of $4,200 5. A restaurant owner borrowed $150,000 from a bank on a long-tem note. This transaction would be shown on a SCF as $150,000 cash? (a) Inflow in the operations section (b) Inflow in the investing section * (c) Inflow in the financing section (d) Outflow in the investing section 6. Depreciation expense on the income statement was $8,000. Which of the following statements is correct? (a) Depreciation is deducted as a negative number in the operating activities section * (b) Depreciation is added as a positive number in the operating activities section (c) Depreciation is not reported in a SCF (d) Accumulated depreciation is debited for $8,000

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7. The source inflows and use outflows of a working capital statement shows: * (a) How the balances of current assets and current liabilities changed during the year (b) How current assets and liabilities were decreased during the year (c) How current assets and liabilities were increased during the year (d) The source inflows and use outflows of the cash account during the period 8. A small corporate restaurant repurchased 5,000 shares of its own stock for $50,000 cash during the current period. How is this shown in a SCF? (a) A positive cash flow in the investing section (b) A positive cash flow in the operating section * (c) A negative cash flow in the financing section (d) A positive cash flow in the financing section 9. One of the following is not a use of working capital: (a) Purchase of a fixed asset * (b) Depreciation expense (c) Payment of principal on a long-term liability (d) Loss from operations 10. Which of the following is not a source of working capital? (a) Sale of a fully depreciated asset for $1,000 (b) Issuance of new stock * (c) Sale of marketable securities (d) New long-term bank loan 11. If marketable securities owned by a company were sold for cash, this would be a/an: (a) Source of working capital (b) Increase in current assets (c) Increase in working capital * (d) Transaction not affecting working capital 12. If the furniture and equipment account balance was $50,000 at the beginning of the period and $40,000 at the end of the period, we could assume that: (a) $10,000 of fixed assets were sold for cash * (b) There has been a $10,000 reduction in the account that could have been caused by one or more purchases and sales of assets (c) More than $10,000 of assets were sold and some new assets were purchased (d) Working capital has been decreased by $10,000 13. The statement of changes in working capital is a: (a) Part of the statement of source inflows and use outflows of working capital (b) Statement showing increases in current asset accounts and decreases in current liability accounts (c) Statement showing decreases in current asset accounts and increases in current liability accounts * (d) Statement showing changes in each current asset and current liability account

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14. If the statement of changes in working capital showed that a bank loan had been decreased from the beginning to the end of the period, this would be a/an: (a) Increase in working capital on the statement * (b) Decrease in working capital on the statement (c) Source of working capital (d) Use of working capital 15. It is important to know the dollar amount of working capital at any time because it: (a) Shows a company’s apparent ability to pay off current liabilities (b) Is indicative of a company’s collection rate on accounts receivable (c) Shows whether or not new fixed assets can be purchased * (d) None of the above is necessarily true 16. If two different companies had the same dollar amounts of working capital: (a) They are in an equally liquid position * (b) Their current ratios might be quite different (c) They would be equally good short-term credit risks (d) They will have identical statements of source and use of working capital 17. A motel can operate with a relatively low current ratio because: (a) It is not in the restaurant business * (b) Most of its assets are fixed rather than current (c) It operates on cash rather than a charge basis (d) Its inventory turns over very rapidly 18. If current assets are $75,000 and current liabilities are $100,000, the current ratio is? (a) 1:0.75 (b) Too low to continue in business (c) No concern to the creditors * (d) 0.75:1

EXERCISE SOLUTIONS E10.1 Identify category of account and the effect of a balance change. Account Title Credit card receivables Accounts payable Inventory (for resale) Accounts receivable Prepaid expenses Accrued payroll payable Interest payable Marketable securities

Category CA or CL CA CL CA CA CA CL CL CA

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Account Balance Increased Decreased Use Source Source Use Use Source Use Source Use Source Source Use Source Use Use Source

E10.2 Net income was $180,000. Inventory (for resale) increased $12,000 and Accounts payable increased by $9,000. Determine the net cash flow from operations, indirect method. Net income Inventory (CA increased) Accounts payable (CL increased) Net cash flow from operations

$180,000 ( 12,000) 9,000 $177,000

E10.3 Net income $280,000, depreciation expense $38,000, accounts receivable decreased $2,400; credit card receivables decreased $2,600; prepaid insurance increased $2,880; inventory decreased $3,700; accounts payable increased $4,700; other accrued payables decreased $3,600. Complete net cash flow from operations, indirect method. Net Income Depreciation expense $38,000 Accounts receivable 2,400 Credit card receivables 2,600 Prepaid insurance ( 2,880) Inventory 3,700 Accounts payable 4,700 Other accrued payables ( 3,600) Net adjustments Net cash flow from operations

$280,000

44,920 $324,920

E10.4 Identify the inflows and outflows of working capital. Net income Net loss Depreciation Cash dividends Sales of equipment

Inflow Outflow Inflow Outflow Inflow

Sale of equity stock Inflow Purchase of equipment Outflow Repayment long-term debt Outflow Increasing long-term debt Inflow Redemption of stock Outflow

E10.5 Cash flow ratios: Cash flow from operating activities $178,200; average CL $58,800, average total liabilities $666,500; sales revenue $2,555,450; and interest $59,000. a. The cash flow from operating activities to current liabilities ratio $178,200 / $58,800 = 3.03 times or 303% b. The cash flow for operating activities to total liabilities ratio $178,200 / $666,500 = 26.7% c. The cash flow from operating activities margin ratio $178,200 / $2,555,450 = 7.0% d. The cash flow from operating activities to interest ratio ($178,200 + $59,000) / $59,000 = 4.0 times or 400% 166

E10.6 Identify whether the transaction belongs to investing or financing and its effect as an increase or decrease in a Statement of Cash Flows. Investing or Financing Investing Financing Investing Investing Financing Financing Financing

Increase (+) or Decrease (−) Decrease (−) Increase (+) Increase (+) Decrease (−) Decrease (−) Decrease (−) Increase (+)

Purchase equipment. Sold shares of equity stock. Sold office furniture. Purchased a long-term investment. Declared and paid a cash dividend. Repurchased equity stock. Increased long-term debt.

E10.7 Determine the cash from operations by adjusting specific items of working capital. Working capital $87,500; accounts receivable increased $4,600, inventory decreased $7,754, and accounts payable increased by $3,737. Working Capital $87,500 −

▲ A/R $4,600 +

▲ INV + $7,754

▲ A/P $3,737

= Cash = $94,391

E10.8 Current assets = $42,600 and Current liabilities = $18,640:

E10.9

CA − CL = WC: $42,600 − $18,640 = $23,960 =

CA / CL = Current ratio (or WC ratio) $42,600 / $18,640 = 2.3:1

No, working capital nor its ratio will change if a transaction involves an equal exchange of an asset for an asset and total current assets will not change.

Determine the working capital at the beginning and the end of the year and calculate the change in working capital. Current Current Working Assets Liabilities Capital $137,500 − $73,525 = $63,975 142,240 − 73,250 = 68,990 $ 4,740 $ 275 $5,015

January 1, 2008 December 31, 2008 Change, increase in current assets Change, decrease in current liabilities Change, increase in working capital E10.10

Book value of a depreciable item decreased by $10,600 ($60,000 − $49,400) due to asset depreciation expense charges. Book value is the product of the cost of a depreciable minus its accumulated depreciation. Depreciation expense charges are treated as a source inflow to working capital and an automatic add-back in the operating activities section of the Statement of Cash Flows.

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E10.11

Determine the net cash flows from investing and financing activities. Investing Activities a. Equipment purchased: ($44,480) Old equipment sold: $ 1,200 Long-term investment sold: $50,000 Net cash flow, investing: $ 6,720 Financing Activities b. Repurchase equity stock: Paid cash dividend: Increased long-term debt: Net cash flow, financing:

E10.12

($18,000) ($36,600) $60,000 $ 5,400

Analyze each transaction and comment on transactional effects on working capital. a. No effect to working capital (WC); Purchased inventory (CA) on account (CL). The addition of both a CA and a CL of the same value does not change WC. b. Working capital will increase since cash (CA) is increased and the offset account being increased is a long-term liability. c. Working capital will increase cash (CA) and the offset accounts are not CA or CL accounts. d. Working capital will increase since cash (CA) and marketable securities (CA) would be reduced by the cost of the securities. The resulting gain of $4,800 is charged to a non-current account. e. No effect to working capital; this is an exchange of an asset (CA) for an asset (CA) and does not change total current assets. Prepaid expenses (CA) are consumed over the life of the prepaid.

PROBLEM SOLUTIONS P10.1 Complete an evaluation of cash flows for operating activities only, using the indirect method. Net income Adjustments to reconcile Net Income: Operating Activities Accounts receivable, increased Inventory, increased Depreciation (Automatic add back) Accounts payable, decreased Other current liabilities, increased Tax payable, decreased Net adjustments Net cash flow, operating activities

$43,900

($10,420) ( 1,875) 8,000 ( 5,782) 3,500 ( 1,970) ( 8,547) $35,353

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P10.2 Complete a SCF using the indirect method. Statement of Cash Flows, Indirect Method Net income Adjustments to reconcile Net Income: Operating Activities Credit card receivables, increased Accounts receivable, increased Inventories, increased Prepaid expenses, decreased Accounts payable, decreased Accrued payroll payable, increased Taxes payable, decreased Depreciation expense Gain on disposal, furnishings Loss on disposal of equipment Net adjustments to reconcile Net Income Net cash flow, operating activities Investing Activities Sold furnishings Sold equipment Purchased new furnishings Purchased new equipment Net Cash Flow from Investing Activities Financing Activities Reduction to long-term debt Cash dividends declared and paid Net cash flow, financing activities Net cash flow, increase Cash balance, December 31, 0007 Cash balance, December 31, 0008

$112,400

($ 680) ( 1,500) ( 1,200) 800 ( 2,100) 2,400 ( 900) 120,000 ( 3,200) 800 114,420 $226,820 $ 8,600 2,000 (16,800) (24,200) ($ 30,400) ($ 54,800) ( 122,400) ($177,200) $ 19,220 $ 12,020 $ 31,240

P10.3 Calculate a statement of changes in working capital and prepare a statement of sourceinflows and uses-outflows for the year ended December 31, 0008. Change in Working Capital Year 0007 Year 0008 Current assets $31,000 $33,000 Current liabilities ( 7,000) ( 8,000) Working capital $24,000 $25,000 Increase in working capital 1,000 $25,000 $25,000

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P10.3 (Continued) Statement of Source Inflows and Use Outflows of Working Capital Source inflows of working capital Net income $7,000 Depreciation expense 1,000 New shares of equity stock 1,000 Increase in loan 2,000 Total source inflows of working capital $11,000 Use outflows of working capital Purchase of new equipment Payment of cash dividends Total use outflows of working capital Net increase in working capital P10.4

$4,000 6,000 ($10,000) $ 1,000

Using information from P10.3, complete a SCF using the indirect method. Statement of Cash Flows for the Year Ended December 31, 0008 Net income $ 7,000 Adjustments to reconcile Net Income: Operating Activities Credit card receivables, decreased $ 66 Accounts receivable, decreased 534 Food inventories, increased ( 1,350) Beverage inventories, increased ( 450) Depreciation expense 1,000 Accounts payable, increased 2,300 Accrued expenses payable, decreased ( 100) Income tax payable, decreased ( 1,200) 1,100) Net adjustments to reconcile Net Income 800 Net cash flow, operating activities $ 7,800 Investing Activities Purchased equipment ($4,000) Net cash flow, investing activities ($ 4,000) Financing Activities Cash dividend distributed ($6,000) Issued new shares of equity stock for cash 1,000 Loan-term loan increased 2,000 Net cash flow, financing activities ($ 3,000) Net cash flow increase $ 800 Cash balance, December 31, 0007 14,800 Cash balance, December 31, 0008 $15,600

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P10.5 Changes in Working Capital Effect on Working Capital 12-31-07

12-31-08

Increase (WC)

Current Assets Cash Credit card receivables Accounts receivable Inventory Marketable securities Prepaid expenses Totals

$ 4,100 4,700 1,200 3,000 8,000 1,200 $22,200

$ 5,200 5,500 700 3,600 7,000 1,500 $23,500

$1,100 800

Current Liabilities Accounts payable Accrued expenses payable Income tax payable Current mortgage payable Totals Net working capital Net change Totals

$ 6,900 1,400 2,000 11,500 $21,800 $ 400 2,500 $ 2,900

$ 7,000 1,700 1,500 10,400 $20,600 $ 2,900 _______ $ 2,900

Decrease (WC)

500 600 $1,000 300 $2,800

$1,500

100 300 500 1,100 $4,400

______ $1,900

$4,400

2,500 $4,400

P10.6 Prepare a statement of source-inflows and use-outflows of working capital for the year ending December 31, 0008. Statement of Source Inflows and Use Outflows of Working Capital Source inflows of working capital Net income $ 6,800 Depreciation [From P10.5: $8,300 + $3,700] 12,000 12,000 Total source inflows of working capital $18,800 Use outflows of working capital Cash dividends distributed Purchased new furniture [From P10.5: $25,400 – $22,700] Mortgage reduction Total use outflows of working capital Net change, increase to working capital

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$ 3,200 2,700 10,400 ($16,300) $ 2,500

P10.7 Prepare a SCF, indirect method. P10.5 and P10.6 are referred to for the necessary information. Statement of Cash Flows for the Year Ended December 31, 0008 Net income $ 6,800 Adjustments to reconcile Net Income Operating Activities Credit card receivables, increased Accounts receivable, decreased Inventory, increased Marketable securities, decreased Prepaid expenses, increased Depreciation, building Depreciation, furniture and equipment Accounts payable, increased Accrued expenses payable, increased Income taxes payable, decreased Current mortgage payable, decreased Net adjustments to reconcile Net Income Net cash flow, operating activities Investing Activities Purchased furniture and equipment Net cash flow, investing activities

(800) 500 (600) 1,000 (300) 8,300 3,700 100 300 (500) ( 1,100) 10,600 $17,400

($2,700) ( 2,700)

Financing Activities Reduced long-term mortgage Cash dividends paid Net cash flow, financing activities Net cash flow increase Cash balance, December 31, 0007 Cash balance, December 31, 0008

($11,500) ( 3,200) (14,700) $ 1,100 4,100 $ 5,200

P10.8 Determine the changes in working capital and prepare the catering company’s statement of source inflows and use outflows for the year ended December 31, 0008. Change in Working Capital Year 0007 Current assets $35,700 Current liabilities ( 28,700) $ 7,000 Decrease in working capital $ 7,000

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Year 0008 $38,800 ( 41,300) ($ 2,500) 9,500 $ 7,000

Statement of Source Inflows and Use Outflows of Working Capital Source inflows of working capital Net mortgage $140,000 New stock shares 10,000 Depreciation: Building 7,500 Depreciation: New equipment 4,500 Total source inflows of working capital $162,000 Use outflows of working capital Operating loss New equipment Purchase of building Reduction of mortgage Total use outflows of working capital Net change, decrease in working capital

P10.9

Change in Working Capital Year 0007 Current assets $28,100 Current liabilities ( 6,700) Working Capital $21,400 Decrease in working capital Totals $21,400

8,100 6,300 150,000 7,100 ($171,500) $ 9,500

Year 0008 $36,100 ( 20,700) $15,400 6,000 $21,400

Statement of Source Inflows and Use Outflows of Working Capital Source inflows of working capital Net income $16,800 Depreciation 10,000 New mortgage 30,000 Total source inflows of working capital $56,800 Use outflows of working capital Purchase of building Dividends Total use outflows of working capital Net change, decrease in working capital

$50,000 12,800 ($62,800) $ 6,000

The working capital was reduced by $6,000 during the year even though net income was earned. As well, liquidity was greatly reduced. Reduction of liquidity is due to more working capital tied up in accounts receivable and inventory. Perhaps dividends should have been reduced or not paid. Procedures and policies for the collection of receivables need to reviewed and improved. Inventory should be reduced to the lowest level to meet demands. 173

CASE 10

SOLUTION

Complete a SCF from the pro-forma balance sheet for Year 2008 (Case 2 balance sheet). 4C Company Statement of Cash Flows for Year Ending, December 31, 2008 Cash Flows from Operations Net income Adjustments to reconcile Net Income Operating Activities Depreciation Credit card receivables, increased Accounts receivable, increased Food inventory, increased Beverage inventory, decreased Prepaid expenses, increased Accounts payable, decreased Accrued payroll, increased Income tax payable, increased Net adjustments to reconciled net income Net cash flow, operating activities Financing Activities Common stock repurchased Repayment of long-term debt Net cash flows, financing activities Net cash flow increase Beginning cash, December 31, 2007 Ending cash, December 31, 2008

$46,410

$20,124 ( 3,819) ( 2,413) ( 437) 16 ( 40) ( 2) 702 3,404 17,535 $63,945

($20,000) ( 38,260) ($58,260) $ 5,685 $36,218 $41,903

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CHAPTER 11 CASH MANAGEMENT INTRODUCTION An understanding of the accrual concept of accounting makes one realize that the net income figure on the income statement is not necessarily the equivalent of cash. For this reason, it is important for a business to develop cash budgets from budgeted income statements. Chapter 9 on budgeting will set the foundation and should be reviewed and studied as a necessary prerequisite to this chapter. Chapter 10 should also provide insight into the techniques used in cash management.

TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True and F for False answers)

1. The amount of cash that a company has on hand at any time is constantly fluctuating.

2. Cash management implies not only control of the cash account, but also control of all other working capital accounts.

3. The amount of cash on hand at the end of an accounting period should agree with the amount of net income for that period.

4. A cash budget helps in proper cash management.

5. Forecast income statements are the usual starting point in cash budgeting.

6. If annual property taxes were prepaid in January, and if monthly cash budgets were being prepared, one twelfth of the taxes would show as a disbursement for each of the twelve monthly cash budgets.

7. To prepare monthly cash budgets, it is necessary to know the normal pattern for collection of accounts receivable.

8. Depreciation would show as a disbursement on a cash budget.

9. The main purpose of cash budgeting is to forecast cash surpluses and deficiencies.

10. A company preparing cash budgets that show certain months with cash shortages (negative cash flow) may have difficulty borrowing short-term money.

11. Repayment of principal amounts on loans will show as a disbursement on a cash budget.

12. A company should only have sufficient cash on hand on the premises to cover normal day-to-day operations.

13. The difference between a company’s record of cash in the bank and the bank’s record is known as a bank float.

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14. A method of accelerating the flow of funds from individual units in a chain operation to the company’s head office bank account is known as concentration banking.

15. In a hotel, accounts receivable comprises the city ledger accounts only.

16. The procedure of aging accounts receivable is carried out to indicate to management when to write off accounts as bad debts.

17. The use of a bank lockbox is designed to speed up the collection of a company’s accounts receivable.

18. The monthly food inventory turnover rate is calculated by dividing food cost for the month into average food inventory during the month.

19. Average inventory is calculated by adding beginning and ending inventory figures together and dividing by two.

20. Normal food inventory turnover is between two and four times a month.

21. A low inventory turnover rate indicates a low investment in inventory.

22. No restaurant could ever achieve a food inventory turnover rate as high as 20 or more times in a month.

23. To conserve cash in a business, it is wise to pay accounts payable only after their due date.

24. When converting required cash flow to an after-tax profit amount, loan payments are deducted from cash flow and depreciation is added to the required cash flow.

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk)

1. Cash management should be practiced: (a) To ensure that there is always a surplus of cash on hand (b) Only buy companies with large inflows of cash * (c) To anticipate both surpluses and deficiencies of cash (d) So that new fixed assets can be purchased when they are on sale 2. Cash management is: (a) Forecasting monthly net income to know how much cash the company will have from month to month * (b) Managing all working capital accounts (c) Asking stockholders how much they should be paid in cash dividends (d) Selling goods and services on a cash basis only 3. If a company has an income of $5,000 (after depreciation but before income tax) during a particular month, its bank account should have increased by: (a) $5,000, plus depreciation, plus tax (b) $5,000, plus depreciation (c) $5,000, less income tax * (d) Probably some amount other than any of the above

176

4. In cash budgeting, depreciation expense on the income statement is not shown as a cash disbursement on a cash budget because: (a) One has a choice of depreciation methods (b) Depreciation is not really a business expense * (c) The recording of depreciation expense does not require an outlay of cash (d) Depreciation is only shown as an expense to reduce cash outflow from tax 5. Sales revenue in Month 1 of a new restaurant is forecast to be $60,000 and in Month 2 $75,000. Cost of sales is estimated to be 30% of sales revenue, with half the cost paid for in the month of purchase, the other half in the following month. Month 2’s cash disbursement for purchases is: * (a) $20,250 (b) $18,000 (c) $22,500 (d) $11,250 6. If a cash budget for the next six months showed that in Months 4 and 5 the closing bank balance figure was negative, the company should: * (a) Arrange short-term borrowing to cover the temporary shortage (b) Close during those two months (c) Use positive closing balances from Months 1, 2, and 3 to offset the Month 4 and 5 figures (d) Not pay any invoices from Months 4 and 5 until the situation improves 7. Which of the following would not affect the annual cash budget, assuming there will be disbursements for income tax? (a) Changing the depreciation method from straight line to sum-of-the-years digits * (b) Paying a stock dividend (c) Purchasing new fixed assets (d) Repaying a stockholder loan 8. Cash conservation implies: * (a) Practicing good working capital management (b) Not paying accounts payable until more than thirty days after they are due (c) Not taking a discount for prompt payment of an account to conserve the cash for a longer period in the bank (d) Not allowing any customers to charge their accounts 9. The difference between a company’s record of cash in the bank and the bank’s record is known as: (a) The indifference point * (b) Bank float (c) Concentration banking (d) Deficit financing 10. A method of accelerating the flow of funds from individual units in a chain operation to the company’s head office is known as: * (a) Concentration banking (b) Using bank float (c) Using lockboxes (d) Centralized banking

177

11. A house account in a hotel is: (a) Another name for a city ledger account (b) A ledger account for the purchase of a house for employee accommodation (c) Unpaid accounts of guests who have left * (d) The unpaid account of a guest still in the hotel 12. A schedule of aging of accounts shows: (a) The individual balances of all accounts receivable (b) The ages of guests who have unpaid accounts * (c) The proportion of total accounts receivable outstanding for various lengths of time (d) A list of house accounts for guests in a hotel for more than a week 13. A bank lockbox is used to: (a) Avoid having to use bank float (b) Avoid having to use concentration banking (c) Speed up payment of accounts payable * (d) Speed up collection of accounts receivable 14. A bar inventory turnover of 1/2 to 1 a month in an establishment, means that the inventory turnover is: * (a) Six to twelve times a year (b) Half to one time a week (c) Twice a month (d) Once every six months 15. If inventory turnover is increasing over time, and all other things remain equal, this means that: (a) More money is being tied up in inventory (b) Purchases are being made less frequently (c) The cost of sales percent should decline * (d) There is now less dollar value in inventory than previously

EXERCISE SOLUTIONS E11.1 Determine if the discount on accounts payable should or should not be taken and discuss your decision. $7,500 x 3% = $225 if payment is made within 5 days discount period and should be taken. If borrowing for 25 days at a 12% interest is considered to pay the $7,275 within the discount period, the interest would be: $7,275 x 25 x 12% / 365 = $21,825 / 365 = $59.79 The $7,275 should be borrowed. A saving of $165.21 ($225.00 – $59.79) is generated. E11.2 Calculate sales revenue percentages by category. April $50,400 = 100.0% $14,112 / $50,400 = 28.0% 28.0% / $50,400 = 68.0% $34,272 $ 68.0% 2,016 / $50,400 = 4.0% 4.0% Cash sales revenue decreased and sales revenue on credit cards increased. Sales revenue Cash sales revenue Credit card sales revenue Accounts receivable sales

March $48,200 = 100.0% $14,460 / $48,200 = 30.0% $31,330 / $48,200 = 65.0% $ 2,410 / $48,200 = 5.9%

178

E11.3 Calculate food inventory turnover and days of inventory available for March. Beginning food inventories + Food purchases − Ending food inventories Beginning food inventories + Ending food inventories a. $14,800 + $74,200 − $12,700 ($ 14,800 + $ 12,700) / 2

$76,300 5.5 times $13,750

b. 31 days / 5.5 = 5.6 days E11.4

Accounts receivable collections.Calculations are shown for Janauary January 0-30 days $21,100 / $27,500 = 76.7% 31-60 days $ 4,900 / $27,500 = 17.8% 61-90 days $ 1,000 / $27,500 = 3.7% Over 90 days $ 500 / $27,500 = 1.8% * Item does not add due to rounding

February 71.0% * 4.8% 3.0% 1.3%

March 67.8% 26.1% 4.3% 1.8%

Over the 3 months, a greater amount of the accounts have become past due in excess of thirty days. Collection procedures must be improved to offset this trend. E11.5 Determine the transfer frequency for four motels. Motel A:

2 × $3,200 = 4 days $1,600

Motel B:

2 × $5,700 = 6 days $1,900

Motel C:

2 × $6,500 = 2 days $6,500

Motel D:

2 × $2,600 = less than 1, thus daily $5,800

E11.6 Determine the minimum accounts receivable payment to make a lockbox system profitable. Bank charge per item Opportunity cost percentage per day × Time savings in days a.

$0.20 (10.0% / 365) × 2

$0.20 0.000547945

$365

$0.18 (8.0% / 365) × 3

$0.18 0.000657534

$274

$0.25 (8.5% / 365) × 4

$0.25 0.000931506

$268

179

E11.7 Calculate the cash inflows for the months of April and May. Cash sales revenue receipts inflows Cash sales revenue [32%] Credit card sales revenue [64%  94%] Credit card sales revenue, previous month [6%] Accounts receivable, previous month [4%] Total Cash Inflows

April $15,744 29,599 1,770 1,844 $48,957

May $16,896 31,764 1,889 1,968 $52,517

E11.8 Calculate cash outflows for the months of September and October. Cash payment outflows Cost of sales, current [75%] Cost of sales previous month [25%] Operating expenses [98%] Operating expenses previous month [2%] Total cash outflows [1] $18,954 × 75% = $14,216 [2] $18,392 × 25% = $ 4,598 [3] $25,439 × 98% = $24,930 [4] $24,684 × 2% = $ 494

[1] [2] [3] [4]

September $14,216 4,598 24,930 494 $44,238

October $14,592 4,739 25,590 509 $45,430

[5] [6] [7] [8]

[5] $19,456 × 75% = $14,592 [6] $18,954 × 25% = $ 4,739 [7] $26,112 × 98% = $25,590 [8] $25,439 × 2% = $ 509

E11.9 Calculate the ending cash balance of the first month of operations. Beginning cash balance February Cash sales revenue, current [86% × $39,300] $33,798 Cash sales revenue, previous month [14% × $38,400] 5,376 Total cash receipts Total cash available Cash payments Cost of sales, current [75% × $14,541] Cost of sales previous month [25% × $14,208] Wages expense Operating expenses Total February cash payments Ending February cash balance

180

$ 4,448

39,174 $43,622

$10,906 3,552 13,362 5,895 ($ 33,715) $ 9,907

PROBLEM SOLUTIONS P11.1 Prepare a cash budget for the month of December 1, 0007 Cash Budget For December, Year 0007 Beginning cash

$ 4,800

Cash receipts, operations Sales revenue, cash [$75,000 × 40%] Credit card sales revenue [$75,000 × 60% × 96%] Previous month credit card sales revenue [$80,000 × 60% × 4%] Total cash receipts Total cash available, December 0007 Cash disbursements, operations December cost of sales [$29,000 × 20%] November cost of sales [$30,000 × 80%] Wages expense Operating expenses Total cash disbursements Ending cash balance

$30,000 43,200 1,920 75,120 $79,920

$ 5,800 24,000 21,000 14,000 (64,800) $15,120

* Rent was prepaid and noted as a cash disbursement in January 0007 for the entire year. Depreciation is a non-cash expense and reduces the book value of related depreciable assets.

P11.2 Calculate the motel’s cash balance at December 31, 0008. Cash collections for November and December November sales revenue: $34,500 November cash sales [42%] November credit card sales [$34,500 x 58% x 92% ] October credit card sales [$32,500 x 58% x 8%] December sales revenue: $36,000 December cash sales [42%] December credit card sales [$36,000 x 58% x 92%] November credit card sales [$34,500 x 58% x 8%] January to October sales Total cash collected in Year 0008

181

Year 0008 $ 14,490 18,409 1,508

15,120 19,210 1,601 $ 70,338 $367,900 $438,238

Cash Reconciliation Beginning bank balance

Cash receipts, operations Cash sales revenue Total cash available

438,238 $445,338

Cash disbursements, Operations Operating expenses Management salary expense Building rent expense Insurance expense Interest expense Income tax (paid for Yr. 0007) Total cash disbursements, operations Cash excess (deficiency)

7,100

$302,300 23,000 18,500 2,400 7,600 9,800 ( 363,600) $ 81,738

Cash disbursements, Financing New furniture Bank loan payment [$73,900 – $49,200] Total cash disbursements, financing Ending Cash Balance

15,600 24,700 ( 40,300) $ 41,438

182

P11.3 Prepare a cash budget for each of the months of October, November, and December. The beginning cash balance on October 1 is $2,410. Collections on credit sales revenue averages 90% in the month following credit sales, and 10% in the month following. Average cost of sales is 38% of total sales revenue. The cost of sales is 60% paid in the current month and 40% in paid in the following month. Cash Budget Opening cash balance Cash receipts, operations Sales revenue: Cash Credit sales revenue: Current month collections Credit sales revenue: Previous month collections Total cash receipts, operations Cash receipts, financing Sale of equipment Total cash receipts, financing Cash disbursements, operations Cost of sales: Current month [60%] Previous month [40%] Payroll expense Rent expense Utilities expense Other operating expenses Interest expense Total Cash disbursements, operations Cash excess, (deficiency) operations Cash disbursements, financing Equipment New equipment Employee Bonus Total cash disbursements, financing Total Cash Disbursements Ending Cash Balance

October November December $ 2,410 $ 9,973 $ 15,547 27,900 12,600 1,600 $44,510

25,100 11,700 1,400 $48,173

32,400 10,800 1,300 $60,047

$44,510

$48,173

1,500 $61,547

$9,325 6,612 13,100 2,500 500 1,100 400 $33,527 $10,973

$8,459 6,217 12,700 2,500 450 900 400 $31,626 $16,547

$10,990 5,639 12,200 2,500 550 1,300 400 $33,579 $27,978

$1,000

_______ $ 1,000 $34,527 $ 9,973

_______ $ 1,000 $32,626 $15,547

$1,000 5,400 3,600 $10,000 $43,579 $17,968

Credit sales receivables collections: 90% following the month of sales and 10% the next month: October:

From September $14,000: collected in October $14,000 × 90% = $12,600 From August $16,000: collected in October $16,000 × 10% = $1,600 November: From October $13,000: collected in November $13,000 × 90% = $11,700 From September $14,000: collected in November $14,000 × 10% = $1,400 December: From November $12,000: collected in December $12,000 × 90% = $10,800 From October $13,000: collected in November $13,000 × 10% = $1,300

Cost of sales cash disbursement calculations: September: $43,500 × 38% = $16,530 × 60% = $ 9,918 current month; $16,530 × 40% = $6,612 in Oct. October: $40,900 × 38% = $15,542 × 60% = $ 9,325 current month; $15,542 × 40% = $6,217 in Nov. November: $37,100 × 38% = $14,098 × 60% = $ 8,459 current month; $14,098 × 40% = $5,639 in Dec. December: $48,200 × 38% = $18,316 × 60% = $10,990 current month; $18,316 × 40% = $7,326 in Jan.

183

P11.4 Prepare a budgeted income statement and a cash budget, and comment. a. Budgeted Income Statement for the month of June, 2008 Sales revenue [30 days × $1,500] $45,000 Cost of sales [$45,000 × 38%] ( 17,100) Gross margin $27,900 Operating expenses Wages & salaries expense [$45,000 × 37%] Rent expense Interest expense Other operating expenses [$45,000 × 10%] Depreciation expense Total operating expenses Operating income

$16,650 2,000 300 4,500 1,800 ( 25,250) $ 2,650

b. Cash Budget for the Month of June, 2008 Beginning cash balance $ 1,000 Cash receipts, operations Cash sales revenue [$45,000 × 40%] 18,000 23,760 Credit card sales revenue [$45,000 x 60% x 88%] Total cash available $42,760 Cash disbursements, operations Cost of sales [$45,000 × 38%] $17,100 Wages & salaries expense [$45,000 × 37%] 16,650 Rent expense 2,000 Loan interest expense 300 Total cash disbursements, operations (36,050) Cash excess (deficiency) $ 6,710 Cash disbursements, Financing Loan repayment ( 3,000) Ending cash balance $ 3,710 c. The budgeted income statement shows a positive operating income of $2,650, and the ending cash is also positive at $3,710. However, the ending cash increased to $3,710 from the beginning cash of $1,000. It appears the first month based on the budget will be a marginal success that depends on the accuracy of the estimated sales revenue and estimated operating costs. However, there is the additional cost of $4,500 in the next month. Since the business most likely cannot borrow additional money, it appears the business has a good chance of failing.

184

P11.5

Prepare a budgeted income statement for Year 0007 and calculate cash flow. a.

Budgeted Income Statement Rooms Dining Room Sales revenue $350,000 $150,000 Wages expense $ 87,500 $ 60,000 Cost of sales: food 52,500 Other operating expenses $ 17,500 $ 15,000 Total direct expenses ($105,000) ($127,500) Contributory Income $245,000 $ 22,500 Other income (vending machines) Subtotal Total indirect expenses Operating Income b.

Cash Flow for Year 0007 Adjustments Operating income Add back: depreciation Subtotal New equipment (net) $24,600 Mortgage payments 30,300 Bank loan payments 25,300 Dividends 42,000 Total estimated payments Net cash flow

P11.6

Total $500,000 $147,500 52,500 32,500 ($232,500) $267,500 5,500 $273,000 ( 185,000) $ 88,000

$ 88,000 75,000 $163,000

(122,200) $ 40,800

Prepare a cash budget for six months. Cash Budget April May June July August September Beginning balance: $30,000 $35,000 $ 41,300 $ 45,900 $66,900 $ 79,900 Cash receipts, operations Food sales revenue 34,000 35,600 46,000 50,000 45,000 40,800 Bar sales revenue 10,800 12,600 13,800 16,200 14,200 13,000 Cash Available $74,800 $83,200 $101,100 $112,100 $126,100 $133,700 Cash disbursements, operations Cost of sales purchases: Cost of sales, Food $12,000 $12,500 $13,600 $14,000 $14,600 $16,600 Cost of sales, Bar 4,400 4,800 5,400 6,400 6,800 8,200 Wages expense 13,000 13,800 15,000 14,800 13,400 12,200 Other expenses 10,400 10,800 11,200 11,600 11,400 10,600 Total cash disbursements $39,800 $41,900 $45,200 $46,800 $46,200 $47,600 Cash excess (deficiency) $41,300 $55,900 $65,300 $79,900 $86,100 Financing Activities Equipment purchased (10,000) Interest income $ 1,600 Ending Cash Balance $35,000 $41,300 $45,900 $66,900 $79,900 $86,100 185

P11.7

Calculate beginning cash and prepare a cash budget. Prepare an income statement for three months and a balance sheet as of March 31, 0008. Beginning cash: Cash from stock shares sold [40,000 × $6.00] $240,000 Cost of building $120,000 Cost of equipment 90,000 Cost of china, etc. 18,000 Cost of inventory 7,000 Cash disbursements (235,000) Beginning cash balance $ 5,000 (1)

(2)

Budgeted Income Statement For the First Quarter Ending March 31, 0008 January February Sales revenue $30,200 $60,800 Cost of sales ( 11,476) ( 23,104) Gross Margin $18,724 $37,696 Operating Expenses Other operating expenses $ 3,800 $ 3,800 Salaries & Wages Expense: Fixed salaries & wages expense 5,200 5,200 Variable salaries & wages expense 1,560 10,740 Depreciation Expenses: Building 500 500 Furniture & Equipment 750 750 China, Silverware, etc. 300 300 Total operating expenses 12,110 21,290 Operating income $ 6,614 $16,406

March $90,400 (34,352) $56,048 $ 3,800 5,200 19,620 500 750 300 30,170 $25,878

Cash Budget Opening cash balance Cash sales receipts, operations Current month sales revenue Previous month sales revenue Total cash available Cash Disbursements Cost of sales: Current month Cost of sales: Previous month Salaries and Wages Expense Fixed salaries & wages expense Variable salaries & wages expense Other operating expenses Total cash disbursements Cash excess (deficiency) Financing Activities Increased inventory Closing cash 186

January $ 5,000

February $ 11,260

March $20,422

$16,610

$33,440 13,590 $58,290

$49,720 27,360 $97,502

$ 4,590

$ 9,242 6,886

$13,741 13,862

5,200 1,560 $11,350 $11,260

5,200 10,740 3,800 $35,868 $22,422

5,200 19,620 3,800 $56,223 $41,279

$ 11,260

(2,000) $20,422

(2,000) $39,279

$21,610

(3)

Balance Sheet, March 31, 0008 Assets Current Assets Cash $ 38,279 Accounts receivable 40,680 Inventory 11,000 Total current assets

$ 89,959

Property Plant & Equipment Building Less: Accumulated depreciation Furniture & Equipment Less: Accumulated depreciation China, Silverware, etc. Less: Accumulated depreciation Net Property Plant & Equipment Total Assets

$223,350 $313,309

$120,000 ( 1,500) 90,000 ( 2,250) 18,000 ( 900)

$118,500 87,750 17,100

Liabilities & Stockholders’ Equity Current Liabilities Accounts payable

$ 24,411

[($90,400 x 38% x 60%) + $3,800]

Stockholders’ Equity Common stock Retained earnings [$6,614 + $16,406 + $25,878] Total Liabilities & Stockholders’ Equity P11.8

$240,000 48,898

$288,898 $313,309

Budgeted Income statement For the First Three Months Month 1 Month 2 Month 3 Sales revenue $48,000 $66,000 $84,000 Cost of sales $14,400 $19,800 $25,200 Salaries & wages expense 15,000 16,200 19,800 Other expenses 4,800 6,600 8,400 Rent expense 3,000 3,000 3,000 Depreciation expenses: Furniture & Equipment 3,000 3,000 3,000 China, glass & silverware 2,100 42,300 2,100 50,700 2,100 61,500 Net income $ 5,700 $15,300 $22,500 Retained Earnings

$ 5,700

187

$21,000

$43,500

Cash Budget For the First Three Months Month 1 Month 2 Beginning cash balances: $10,800 $16,800 Operating Activities Cash sales revenue receipts 38,400 9,600 Credit card sales revenue ______ 52,800 Total cash available $49,200 $79,200 Cash Disbursements Cost of sales, Food Labor expenses Other expenses Rent expense Total cash disbursements Cash excess (deficiency) Financing Activities Partnership withdrawals Ending Cash Balance

$14,400 15,000

Month 3 $ 35,400 13,200 67,200 $115,800

3,000 $32,400 $16,800

$19,800 16,200 4,800 3,000 $43,800 $35,400

$25,200 19,800 6,600 3,000 $54,600 $61,200

_______ $16,800

_______ $35,400

$46,200 $15,000

Balance Sheet (Condensed) For the First Three Months Cash $ 15,000 Accounts payable Inventory 9,000 Accounts receivable 16,800 Beginning partnership Furniture & Equipment 180,000 capital Net income (First 3 months) Less Accumulated Depr. ( 9,000) Partnership withdrawals China, Silverware, etc. 18,900 Ending Partnership Capital Totals Assets $230,700 Total Liabilities & Capital

188

8,400

225,000 43,500 (46,200) $222,300 $230,700

P11.9

Determine the level of sales revenue after tax flow to achieve a cash flow of $27,000. a. After tax cash flow is: $27,000 + $42,000 fixed costs − $21,000 depreciation. Net income is $48,000. Net Income [AT] $48,000 $48,000 $64,000 1 − tax rate 1 − 25% 75% Required sales revenue level is: Fixed Costs + OI $55,000 + $64,000 $119,000 1 − VC% 1 − 30% 70% b.

$170,000

Confirmation of $170,000 sales revenue level will meet cash flow objective. Sales revenue Variable cost [30% × $170,000] Fixed costs Subtotal Operating income [BT] Tax 25% [$64,000 × 25%] Net Income (after tax) Add: Depreciation Deduct: Loan payments Cash flow

$170,000 $51,000 55,000 (106,000) $ 64,000 ( 16,000) $ 48,000 21,000 ( 42,000) $ 27,000

189

P11.10 For each of three months, prepare an income statement, determine the beginning cash

and complete a cash budget. Room sales revenue calculations: Month 1: 6 rooms × $65 × 30 = $11,700 Month 2: 7 rooms × $65 × 30 = $13,650 Month 3: 8 rooms × $65 × 30 = $15,600 Cece Saw’s Motel Income Statement for the First Quarter Ending March 31 Month 1 Month 2 Month 3 Occupancy rate 60% 65% 70% Rooms sales revenue $11,700 $12,675 $13,650 Operating Expenses Laundry expense Advertising expense Insurance expense Fixed labor expense Variable labor expense Utilities expense Office supplies expense Interest expense Depr: Building Depr: Furniture & Equip. Depr: Linen Total operating expenses Operating Income

$1,170 200 300 5,000 400 300 100 1,600 556 200 100 $9,926 $1,774

$1,268 200 300 5,000 400 325 100 1,600 556 200 100 $10,049 $ 2,626

$1,365 200 300 5,000 400 350 100 1,600 556 200 100 $10,171 $ 3,479

Beginning Cash Calculation Cash investment $ 50,000 Long-term mortgage 240,000 Total Cash Available

$290,000

Cash Disbursements Land Building Furnishings Linen Prepaid advertising Prepaid insurance Total cash disbursements Beginning cash balance

( 286,000) $ 4,000

$ 50,000 200,000 24,000 6,000 2,400 3,600

190

Cece Saw’s Motel Cash Budget for the First Quarter Ending March 31 January February March Beginning cash balances $ 4,000 $ 9,930 $15,897 Operating Activities Cash rooms sales revenue Cash available

$11,700 $15,700

$12,675 $22,065

$13,650 $29,547

Cash Disbursements Laundry expense Salaries expense, fixed Wages expense, variable Utilities expense Office supplies expense Interest expense

$ 1,170 1,500 400 -0100 1,600

$ 1,268 1,500 400 300 100 1,600

$ 1,365 1,500 400 325 100 1,600

Total cash disbursements Cash excess (deficiency)

$ 4,770 $10,930

$ 5,168 $16,897

$ 5,290 $24,257

Financing Activities Loan principal repayment Closing cash

($1,000) ($ 1,000) ( $1,000) $9,930 $15,897 $23,257

191

Cece Saw’s Motel Balance Sheet for the First Quarter Ending March 31 Assets Current Assets Cash $23,797 Prepaid advertising 1,800 Prepaid insurance 2,700 Total current assets

$ 28,297

Property Plant & Equipment Land Building Less: Accumulated depreciation Furnishings & Equipment Less: Accumulated depreciation Linen Less: Accumulated depreciation Net Property Plant & Equipment Total Assets

277,432 $305,729

$ 50,000 200,000 1,668) 24,000 ( 600) 6,000 ( 300) (

198,332 23,400 5,700

Liabilities and Stockholders’ Equity Current Liabilities Accounts payable Wages payable Short-term portion mortgage payable Total current liabilities

Long-Term Liabilities Stockholders’ loan payable Mortgage payable Total long-term liabilities

$ 40,000 225,000

Stockholders’ Equity Common stock Retained earnings Total stockholders’ equity Total Liabilities & Stockholders’ Equity

$ 10,000 7,879

350 10,500 12,000 $

22,850

$265,000

192

$ 17,879 $305,729

CASE 11

SOLUTIONS

4C Company Monthly Operating Budget for Months January Through June, Year 2008 Sales Revenue Monthly sales revenue percentage Food sales [71.9%] Beverage sales [28.1%] Total monthly sales revenue

January 6.0% $31,477 12,276 $43,753

February 6.0% $31,477 12,295 $43,754

March 7.0% $36,723 14,323 $51,046

April 8.0% $41,970 16,369 $58,338

May 9.0% $47,216 18,415 $65,631

Cost of Sales, Food Beginning Inventory Purchases Ending Inventory Cost of Sales, Food [28.4%]

$ 5,915 12,646 ( 6,128) $12,433

$ 6,128 12,657 ( 6,352) $12,433

$ 6,352 14,675 ( 6,521) $14,506

$ 6,521 16,842 ( 6,785) $16,578

$ 6,785 $ 6,985 18,850 21,062 ( 6,985) ( 7,325) $18,650 $20,722

Cost of Sales, Beverage Beginning Inventory Purchases Ending Inventory Cost of Sales, Beverages Total Monthly Cost of Sales Monthly Gross Margin

$ 2,211 2,843 (2,378) $ 2,676 $15,109 $28,644

$ 2,378 2,563 (2,265) $ 2,676 $15,109 $28,644

$2,265 3,012 (2,155) $ 3,122 $17,628 $33,418

$ 2,155 4,268 (2,855) $ 3,568 $20,146 $38,192

$ 2,855 3,804 (2,645) $ 4,014 $22,664 $42,967

$ 2,645 4,410 (2,595) $ 4,460 $25,182 $47,741

Operating Expenses Salaries,fixed [$35,000] Wages, variable [30.3%]* Laundry [2.6%] Kitchen fuel: Fixed [$4,200 / 12] Variable [0.5%] China, tableware [1.9%] Glassware [0.3%] Contract cleaning [$6,506] Licenses [$3,205] Other operating [$4,375] [.006 x SR] Administrative & General [$16,204] Marketing [$9,917] Utilities: Fixed [$5,100 / 12] Variable [0.8% x SR] Insurance expense [$2,085 / 12] Rent expense [$26,400 / 12] Interest expense [$19,500 /12] Depreciation expense [$20,124 / 12] Total Operating Expenses Operating income Income tax [22%] Net Income

$ 2,917 13,257 1,138 350 219 831 131 542 267 263 1,350 826 425 350 174 2,200 1,625 1,677 $28,542 $ 102 ( 22) $ 80

$ 2,917 15,467 1,327 350 255 970 153 542 267 306 1,350 826 425 408 174 2,200 1,625 1,677 $31,239 $ 2,137 ( 470) $ 1,667

$ 2,917 17,676 1,517 350 292 1,108 175 542 267 350 1,350 826 425 467 174 2,200 1,625 1,677 $33,939 $ 4,207 ( 934) $ 3,373

$ 2,917 19,886 1,706 350 328 1,247 197 542 267 394 1,350 826 425 525 174 2,200 1,625 1,677 $36,636 $ 6,382 ( 1,404) $ 4,978

$ 2,917 22,096 1,896 350 365 1,386 219 542 267 438 1,350 826 425 583 174 2,200 1,625 1,677 $39,336 $ 8,482 ( 1,832) $ 6,650

*Variable salaries & wages costs: $255,799 – $35,000 / $729,228 = $220, 779 / $729,228 = 30.3%

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June 10.0% $52,462 20,461 $72,923

4C Company Monthly Cash Budget for Months January Through June, Year 2008

Beginning Cash Balance Cash Receipts Cash sales revenue Cash credit cards receivable Previous credit cards receivable Accounts receivable Total Cash Available Cash Disbursements Cash food purchases Accounts payable, food Cash beverage purchases Accounts payable, beverage Fixed wages Payroll Laundry Kitchen fuel: Fixed Kitchen fuel: Variable China, tableware Glassware Contract cleaning Licenses Other operation Accrued expenses: Admin Accrued expenses: Marketing Utilities: Fixed Utilities: Variable Insurance Rent Interest Depreciation Income tax payable Total Cash Disbursements Cash Excess Loan repayment (Financing) Ending Cash Balance

January February March April May June $36,218 $24,233 $21,089 $20,751 $15,469 $18,936 26,252 26,252 30,628 35,003 39,379 43,754 14,176 14,176 16,539 18,902 21,264 23,627 3,421 1,575 1,575 1,838 2,100 2,363 1,750 1,750 1,750 2,042 2,334 2,625 $81,817 $67,986 $71,581 $78,536 $80,546 $91,305

$6,955 $6,961 $8,071 $9,263 $10,368 $11,584 8,819 5,691 5,696 6,604 7,579 8,483 1,564 1,410 1,657 2,347 2,092 2,426 -01,279 1,153 1,355 1,921 1,712 2,215 2,917 2,917 2,917 2,917 2,917 13,257 13,257 15,467 17,677 19,886 22,096 1,138 1,138 1,327 1,517 1,706 1,896 350 350 350 350 350 350 219 219 255 292 328 365 831 831 970 1,108 1,247 1,386 131 131 153 175 197 219 542 542 542 542 542 542 3,205 267 267 267 267 267 263 263 306 350 394 438 -01,350 1,350 1,350 1,350 1,350 -0826 826 826 826 826 425 425 425 425 425 425 350 350 408 467 525 583 2,085 -0-0-0-0-02,200 2,200 2,200 2,200 2,200 2,200 1,625 1,625 1,625 1,625 1,625 1,625 1,677 1,677 1,677 1,677 1,677 1,677 6,545 -0-06,545 -0-054,396 43,709 47,642 59,879 58,422 63,367 $27,421 $24,277 $23,939 $18,657 $22,124 $27,938 3,188 3,188 3,188 3,188 3,188 3,188 $24,233 $21,089 $20,751 $15,469 $18,936 $24,750

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CHAPTER 12 CAPITAL BUDGETING AND THE INVESTMENT DECISION INTRODUCTION Most of the matters discussed in the preceding eleven chapters concerned techniques, tools, and methods available to management for short-run (generally defined as less than one year) decision making. This chapter is concerned with long-run decision making for capital assets or fixed assets. For this reason, the chapter may be studied relatively independently of others in the book, as long as the student has a good basic knowledge of accounting and terminolgy.

TRUE OR FALSE QUESTIONS (Correct answers indicated by T for True and F for False answers)

1. Decisions concerning investment in long-life assets are no more complex than decisions concerning day-to-day matters.

2. The ARR formula is: net annual savings divided by average investment.

3. With the ARR method, if there is a trade-in value of the asset, that value is deducted from initial investment (before dividing by two) to arrive at average investment.

4. The payback period method formula is: initial investment divided by net annual cash savings.

5. Net annual cash saving in the payback period method is calculated by deducting depreciation from net annual savings.

6. The payback period method measures the speed of recovering the cash put into an investment.

7. Under the payback period method, the possible trade-in value of the asset at the end of its useful life is ignored.

8. Both the payback period and the ARR methods ignore the time value of cash flows.

9. $1,000 today at 10% interest is worth more than $1,090 a year from now.

10. Discounted cash flow expresses future cash flows in terms of today’s value.

11. Discounted cash flow factors cannot be used if future cash flows are negative.

12. The discount rate used with the NPV investment method will be the same as the current bank savings account interest rate.

13. The IRR investment method determines the interest (discount) rate that will equate total discounted cash inflows with the initial investment.

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14. A mutually exclusive alternative means that, if only one of a number of proposals is to be accepted, the others will be rejected.

15. Capital rationing means that there is sufficient money to handle only a limited number of investments in any budget period.

16. If both NPV and IRR are used to evaluate various alternative investments, their ranking of these investments will always be identical.

17. In investment decision-making, one should ignore non-quantifiable factors.

18. Renting an asset, from a cash flow point of view, may be more profitable than purchasing.

19. If a company leases an asset, it will have a cash flow advantage because depreciation can be deducted and produces savings on income tax.

20. If, for a particular company, a purchase versus rental decision shows that the asset should be purchased, then all future similar decisions should dictate purchase.

21. In deciding to purchase or lease an asset, any asset trade-in value under the ownership option can be ignored.

22. In considering the leasing of an asset using discounted cash flow, the depreciation method selected will affect the calculations.

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk)

1. Decisions about investing in fixed assets differ from day-to-day expense decisions because: (a) The investment decision is affected by the future (b) Only the general manager can be involved in the decision * (c) The expenditure for any one decision is usually larger (d) It doesn’t matter if food is purchased and not used 2. The payback period investment method shows: (a) The number of years that it will take to recover the initial investment less eventual tradein value * (b) The time it takes to recover the initial investment (c) The relationship between increased net income from the investment and the actual investment (d) Year by year the additional cash flows from the investment 3. If an equipment investment was $10,000 with a 5-year life using straight-line depreciation and provided additional annual sales revenue of $3,500 and expenses (excluding depreciation) of $300, and the company is in a 50% tax bracket, the payback period is: (a) 3.13 years * (b) 3.85 years (c) 1.67 years (d) 16.7 years

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4. Given the facts in the preceding question, the ARR is: * (a) 12.0% (b) 5.2% (c) 6.0% (d) 2.6% 5. A Company is trading in a fully depreciated old asset for a new one. Cost of the new asset is $5,000 with a 5-year life and straight-line depreciation will be used. The company receives a $500 allowance for the asset traded in. Additional sales revenue from the investment will be $2,100 and expenses of $400 (excluding depreciation). The company is in a 25% tax bracket. The payback period is: (a) 7.50 years (b) 8.33 years (c) 3.46 years * (d) 2.95 years 6. Given the facts in the preceding question, the ARR is: (a) 17.8% * (b) 23.3% (c) 8.9% (d) 8.0% 7. One of the criticisms of the ARR method is that it: * (a) ignores the timing of net income (b) Ignores the eventual trade-in value of the asset (c) Gives results that are not as satisfactory as the payback period method (d) Does not allow two comparable investments to be considered at the same time 8. Average investment for the ARR method is calculated by: (a) Subtracting closing investment from the opening and dividing by 2 * (b) Adding opening investment and trade-in value and dividing by 2 (c) Dividing opening investment by 2 and adding trade-in value (d) Dividing trade-in value by 2 and adding opening investment 9. The NPV method has an advantage over the payback period and ARR methods because: (a) The forecasts of sales revenue and expenses are more accurate (b) It uses discounted cash flow factors compiled by computer (c) It allows one to ignore any non-monetary factors * (d) It takes into account the timing of cash inflows and outflows 10. Two alternative $15,000 investments are being considered. A 10% discount rate is used because the company never invests at a lower rate than this. The NPV of Alternative A shows a total present value of $12,400 and Alternative B a total present value of $12,800. Given this information one should select: (a) Neither, until one has used the ARR method to obtain the true rate of return (b) B because it has a higher total present value (c) Neither, until the investment has been discussed with the employees involved * (d) Neither, NPV is negative in both cases

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11. If the total present value of a 5-year investment using NPV and a 15% rate is $82,300, and the initial investment is $100,000, one should: (a) Not invest because in times of inflation 15% is not a high enough interest rate * (b) Not invest because NPV is negative (c) Determine the IRR and decide if one would be satisfied with that rate under the circumstances (d) Use the payback period and ARR methods to help make the decision 12. Purchasing is always preferable to leasing an asset because: (a) The asset will have a trade-in value at the end of its useful life (b) By purchasing and owning the asset, one can claim depreciation expense in excess of rental expense and thus reduce income tax (c) Pride of ownership by purchasing and owning is more important than showing rental cost as an expense * (d) None of the above statements are necessarily correct

EXERCISE SOLUTIONS E12.1 Calculate an Accounting Rate of Return (ARR): Net Annual Saving / Average Investment = $1,400 / $5,620 = 24.9% E12.2 Payback period = Initial Investment / Net Annual Saving a. Machine X: $28,400 / $6,128 = 4.6 years Machine Y: $26,200 / $8,800 = 3.0 years *Select Machine Y b. Yes, Machine Y E12.3 Calculate the payback period. Net annual saving: $2,900 Add depreciation: 4,400 Net annual cash saving: $7,300 $22,000 / $7,300 = 3.0 years E12.4 Calculate the Net Present Value of a specific amount of cash flow. Year 1: $4,285 × 0.9009 = $3,860 Year 2: $4,285 × 0.8166 = $3,499 Total $7,359 E12.5 Repayment schedule with an item cost of $22,800 requiring a principle payment of $4,560 per year plus interest at 12%: Yr. 0 1 2 3 4 5

Interest

Principle

$2,736 2,189 1,642 1,094 547

$4,560 4,560 4,560 4,560 4,560

Balance $22,800 18,240 13,680 9,120 4,560 -0-

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E12.6 Determine payback periods for two alternatives. Cost of investment Cash recovery: Years 1, 2, & 3 Years 1, 2, 3, & 4 Balance

Alternative 1 $33,000

Alternative 2 $33,000

(25,400) $ 7,600

( 30,000) $ 3,000

Alternative 1’s payback: $7,600 / $8,200 = 0.93 + 3 = 3.93 years Alternative 2’s payback: $3,000 / $12,100 = 0.25 + 4 = 4.25 years E12.7 Using the information in E12.6, determine the net present values Year Factor 12% 1 0.8929 2 0.7972 3 0.7118 4 0.6355 5 0.5674 Total 5 year PV Initial Investment NPV

Alternative 1 Total PV $ 7,143 6,856 6,264 5,211 2,326 $27,800 ( 33,000) ($ 5,200)

Alternative 2 Total PV $ 3,750 4,624 6,050 7,308 6,866 $28,598 ( 33,000) ($ 4,402)

Neither alternative is a good investment because NPV is negative in both cases.

PROBLEM SOLUTIONS P12.1 a.

Determine the best purchase between three different registers using ARR.

Annual saving Annual operating costs Depreciation expense Total cost Income tax Net saving

Register A: [$308 / ($6,300 + $500 / 2)] = $308 / $3,400 = 9.1% Register B: [$350 / ($6,000 / 2)] = $350 / $3,000 = 11.7% Register C: [$294 / ($6,700 + $300 / 2)] = $294 / $3,500 = 8.4% *Register B has the highest ARR. b. Register B should be purchased because it exceeds the 10% limit.

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P12.2 Using information from P12.1, determine the best investment using the payback period. A B C Net annual saving $ 308 $ 350 $ 294 Depreciation 1,160 1,200 1,280 Annual cash savings $1,468 $1,550 $1,574 Register A: $6,300 / $1,468 = 4.3 years Register B: $6,000 / $1,550 = 3.9 years Register C: $6,700 / $1,574 = 4.3 years Select Register B because it has the lowest payback period and meets the 4-year limitation. P12.3 Calculate net cash flow. Year 1 2 3 4 5 6

Cash Flow $37,500 43,800 46,300 50,000 60,000 18,500

Factor 13% 0.8850 0.7831 0.6931 0.6133 0.5428 0.5428 Total PV

Total PV $ 33,188 34,300 32,091 30,665 32,568 10,042 $172,854

If a 13% return is wanted, it is not achieved since the total PV is considerably less than the initial investment of $205,000. By trial and error an IRR of 7% gives a total present value of $205,213. P12.4 a. Alternative 1 payback will be in Year 5, and Alternative 2 in Year 4. Cost of investment Cash recovery: Years 1, 2, 3 & 4 Years 1, 2, & 3 Balance

Alternative 1 $70,000

Alternative 2 $70,000

( 60,000) $ 10,000

(61,200) $ 8,800

Alternative 1: $10,000 / $24,000 = 0.42 + 4 = 4.42 years. Alternative 2: $8,800 / $10,800 = 0.81 + 3 = 3.81 years. b. Determine net present values. Alternative 1 Alternative 2 Year Factor 10% Total PV Total PV 1 0.9091 $ 7,636 $22,000 2 0.8264 9,586 16,362 3 0.7513 12,772 12,922 4 0.6830 15,709 7,376 5 0.6209 14,902 4,967 Total 5 year PV $60,605 $63,627 Initial Investment ( 70,000) ( 70,000) Alternatives NPV ($ 9,395) ($ 6,373) Neither alternative is a good investment because NPV is negative in both cases. 198

P 12.5

Determine net cash flow for Machine A and Machine B alternatives. Year 1

Year 2

Year 3

Year 4

Year 5

Machine A Wage saving

$9,600

Operating costs Depreciation Total expenses

$1,950 1,500 $3,450

$1,150 1,500 $2,650

$1,700 1,500 $3,200

$1,150 1,500 $2,650

Income (before tax) Income tax [30%] Net income Add: depreciation Trade-in Net cash flow

$6,150 (1,845) 4,305 1,500

$6,950 (2,085) 4,865 1,500

$6,400 (1,920) 4,480 1,500

$6,950 (2,085) 4,865 1,500

$5,805

$6,365

$5,980

$6,365

$6,950 (2,085) 4,865 1,500 1,500 $7,865

Year 1

Year 2

Year 3

Year 4

Year 5

Machine B Wage saving

$9600

Operating costs Depreciation Total expenses

$1,950 1,560 $3,510

$1,250 1,560 $2,810

$1,650 1,560 $3,210

$1,250 1,560 $2,810

Income (before tax) Income tax [30%] Net income Add: depreciation Trade-in Net cash flow

$6,090 (1,827) 4,263 1,560

$6,790 (2,037) 4,753 1,560

$6,390 (1,917) 4,473 1,560

$6,790 (2,037) 4,753 1,560

$5,823

$6,313

$6,033

$6,313

$6,790 (2,037) 4,753 1,560 700 $7,013

Net NPV Year 1 2 3 4 5

Machine A Machine B Cash Flow Cash Flow $5,805 $5,823 6,365 6,313 5,980 6,033 6,365 6,313 7,865 7,013 Total 5 year PV Initial investment Net Present Value

Factor @ 12% 0.8929 0.7972 0.7118 0.6355 0.5674

Machine A Total NPV $ 5,183 5,074 4,257 4,045 4,463 $23,022 ( 9,000) $ 14,022

Machine B Total NPV $ 5,199 5,033 4,294 4,012 3,979 $22,517 ( 8,500) $ 14,017

Machine B has a slightly higher NPV and, if all other considerations are essentially equal, should be the unit purchased.

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P12.6 Incremental average annual cash flow for years 1 through 4. Sales revenue Variable costs [80%] Depreciation Total costs Operating income Income tax [35%] Net income Add: Depreciation Net cash flow

$30,000 $24,000 3,200 (27,200) $ 2,800 ( 980) $ 1,820 3,200 $ 5,020

*In Year 5, net cash flow will be $9,020 due to the $4,000 trade in. IRR analysis at 12% is: Year Cash flow Factor 12% Total PV 1 $5,020 0.8929 $ 4,482 2 5,020 0.7972 4,002 3 5,020 0.7118 3,573 4 5,020 0.6355 3,190 5 9,020 0.5674 5,118 Total $20,365 The investment will earn just over 12%, so it exceeds or achieves the 12% desired, and. the investment could be made. However, if the estimates of costs and expenses are inaccurate, the project would not achieve the desired return. P12.7 a. Calculation of net cash flow:

Interest expense Depreciation Tax deductible Income tax savings [28%] Net expenses Add: loan principal Deduct depreciation Net cash outflow

Purchasing Alternative Year 1 Year 2 Year 3 $2,250 $1,800 $1,350 5,200 5,200 5,200 $7,450 $7,000 $6,550 ( 2,086) ( 1,960) ( 1,834) $5,364 $5,040 $4,716 4,500 4,500 4,500 ( 5,200) ( 5,200) ( 5,200) $4,664 $4,340 $4,016

Year 4 Year 5 $ 900 $ 450 5,200 5,200 $6,100 $5,650 ( 1,708) ( 1,582) $4,392 $4,068 4,500 4,500 ( 5,200) ( 5,200) $3,692 $3,368

Rental alternative: Net cash outflow = $5,040 [$7,000 – (28% x 7,000)] per year. Cash flow Cash flow Discount Total Total Year Purchase Rental Factor 11% Purchase NPV Rental NPV 0 $7,500 $ 7,500 1 4,664 $5,040 0.9009 4,202 $ 4,541 2 4,340 5,040 0.8116 3,522 4,090 3 4,016 5,040 0.7312 2,936 3,685 4 3,962 5,040 0.6587 2,432 3,320 5 3,368 5,040 0.5935 1,999 2,991 5 (4,000) Residual 0.5935 ( 2,374 ) $20,217 $18,627 200

Under these circumstances, leasing the equipment appears to be the best alternative because total NPV of cash outflows is $1,570 less ($20,217 – $18,627). b. 1. Use of an accelerated depreciation method rather than straight line: An accelerated method increases depreciation expense in the early years of the asset’s life. 2. Arrange different payment terms, such as an initial down payment less than $7,500, and offset the lower down payment by increased yearly loan repayments. 3. Negotiations of an interest rate lower than 11%. 4.

The information does not consider the cost of repairs and maintenance of the equipment. These costs should have been considered.

P12.8 Determine net cash flow and net present values for alternatives. Purchase Alternative: Income (before depreciation) Depreciation Operating Income [BT] Income tax [30%] Net income Add: Depreciation Residual value Net cash flow Lease Alternative: Income (before rent) Rent [$0.30 per mile] Net saving before tax Income tax [30%] Net cash flow

Year 1 $38,000 ( 2,200) $35,800 (10,740) $25,060 2,200

Year 2 $47,000 ( 2,200) $44,800 (13,440) $31,360 2,200

Year 3 Year 4 $55,000 $60,000 ( 2,200) ( 2,200) $52,800 $57,800 (15,840) (17,340) $36,960 $40,460 2,200 2,200

$27,260

$33,560

$39,160

$42,660

Year 5 $65,000 ( 2,200) $62,800 (18,840) $43,960 2,200 2,500 $48,660

$39,000 ( 9,000) $30,000 ( 9,000) $21,000

$49,500 (13,500) $36,000 (10,800) $25,200

$57,500 $64,000 (15,000) (16,500) $42,500 $47,500 (12,750) (14,250) $29,750 $33,250

$70,000 (18,000) $52,000 (15,600) $36,400

NPV evaluation: Year 0 1 2 3 4 5

Cash flow Purchase ($13,500) 27,260 33,560 39,160 42,660 48,660

Cash flow Rental

Discount Factor 11%

$21,000 25,200 29,750 33,250 36,400

0.9009 0.8116 0.7312 0.6587 0.5935

Total Purchase NPV ($ 13,500) $ 24,559 27,237 28,634 28,100 28,880 $123,910

Total Rental NPV $ 18,919 20,452 21,753 21,902 21,603 $104,629

a. The purchase alternative with the higher NPV is the most favorable. b. No, the $1,000 leasing cost increase will decrease cash flow and decrease total NPV under the rental option.

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P12.9 Calculate the payback period, ARR and NPV. Income will be from: Elimination of previous loss 10% of soft drink sales revenue of $25,550

$2,150 2,555 $4,705

Expenses will be: Depreciation [($7,000 − $1,000) / 5 years] Machine maintenance Savings before income tax Income tax [30%] Net annual saving Add back depreciation Net annual cash flow a.

$1,200 100 ( 1,300) $3,405 ( 1,022) $2,383 1,200 $3,583

Payback period: $7,000 / $3,583 = 1.95 or 2 years ARR: [$2,383 / ($7,000 + $1,000) / 2] × 100 = ($2,383 / $4,000) × 100 = 59.6%

b. NPV: Annual Discount Year Cash flows Factor 12% 1 $3,583 0.8929 2 3,583 0.7972 3 3,583 0.7118 4 3,583 0.6355 5 3,583 0.5674 5 1,000 0.5674 Total 5 year PV Less: Initial investment Net Present Value

Total NPV $3,199 2,856 2,550 2,277 2,033 567 $13,482 ( 7,000) $ 6,482

The investment should be made because the NPV is positive. P12.10 Calculate NPV and determine whether to operate or lease.

Year 1 2 3 4 5

Sales Revenue $24,000 24,000 24,000 30,000 30,000

Lease Option Tax rate Net Cash @ 25% Flow $6,000 $18,000 6,000 18,000 6,000 18,000 7,500 22,500 7,500 22,500

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Discount Factor 10% 0.9091 0.8264 0.7513 0.6830 0.6209 Total NPV:

Total PV $16,364 14,875 13,523 15,368 13,970 $74,100

Operate Option Sales revenue Operating Expenses Variable costs [90% of SR] Other expenses Depreciation Total expenses Operating Income [BT] Income tax [25%] Net Income Add: Depreciation Net cash inflows

Year 1 Year 2 Year 3 Year 4 $700,000 $750,000 $800,000 $850,000

Year 5 $900,000

$630,000 $675,000 $720,000 $765,000 32,000 34,000 36,000 38,000 8,000 8,000 8,000 8,000 $670,000 $717,000 $764,000 $811,000 $30,000 $33,000 $37,000 $39,000 ( 7,500) ( 8,250) ( 9,000) ( 9,750) $22,500 $24,750 $27,000 $29,250 8,000 8,000 8,000 8,000 $30,500 $32,750 $35,000 $37,250

$810,000 40,000 8,000 $858,000 $40,000 (10,500) $31,500 8,000 $39,500

Net Cash Flow Cash Discount Year Flows Factor 10% 1 $30,500 0.9091 2 32,750 0.8264 3 35,000 0.7513 4 37,250 0.6830 5 39,500 0.6209 Total 5 year PV Less: Initial investment: Net Present Value

Total PV $27,728 27,065 26,296 25,442 24,526 $131,057 ( 35,000) $ 96,057

The motel, on the basis of NPV, should operate the restaurant since there is a projected gain of $21,957 ($96,057 less $74,100).

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CASE 12

SOLUTION

Assuming Year 2009: Year 2009 2010 2011 2012

Keep present arrangement: Pay monthly rent Rent 22% Tax Net Amount Factor 12% Total PV $29,040 $6,389 $22,651 0.8929 $20,225 00 31,944 7,028 24,916 0.7972 19,861 35,138 7,730 27,408 0.7118 19,509 38,652 8,503 30,149 0.6355 19,160 $78,757

Prepay $80,000 rent: If the rent is prepaid for the next four years and $80,000 is borrowed from the bank, the interest expense at the end of the first year will be 12% × $80,000 = $9,600. The interest will decrease by $2,400 per year. Year 1 2 3 4

Interest Tax Net Expense Savings Expense $9,600 $2,112 $7,488 7,200 1,584 5,616 4,800 1,056 3,744 2,400 528 1,872

Principle Payment $20,000 20,000 20,000 20,000

Total Cash Outflow $27,488 25,616 23,744 21,872

Factor 12% 0.8929 0.7972 0.7118 0.6355

Total PV $24,544 20,421 16,901 13,900 $75,766

a. The offer should be accepted. The NPV of prepaying the rent is $2,997 less ($78,757 – $75,760) b. Probably not, although the difference would likely be more than it is now.

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CHAPTER 13 FEASIBILITY STUDIES — AN INTRODUCTION INTRODUCTION In many ways, this chapter can be considered a continuation of Chapter 12. While Chapter 12 covered various methods for evaluating investments in long-term assets for periods up to five or so years, this chapter takes a look at what is required for very long-term investments in land and buildings. The chapter describes what is included in a feasibility study for a proposed new hotel, and in particular discusses the financial aspects of such a study.

TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True and F for False answers)

1. A feasibility study is designed to guarantee to a lender that a new hotel project will be financially successful.

2. A feasibility study can have either a positive or a negative recommendation.

3. A feasibility study may reduce the risk of a particular investment but does not eliminate the risk.

4. Most feasibility studies begin with a financial analysis of the proposal and conclude with other matters such as site evaluation.

5. The general market characteristics section of a feasibility study covers matters such as the proposed advertising budget.

6. The general market characteristics section of a feasibility study covers both descriptive and statistical data where these are relevant.

7. Auto access routes are an important part of the site evaluation section of a feasibility study for a downtown restaurant.

8. A hotel feasibility study should include in its supply and demand section local hotel occupancy trends broken down by class of hotel.

9. The major source of demand for all downtown city hotels is the tourist.

10. Business travel growth can often be correlated to growth in local office space occupancies.

11. The business traveler component of demand for hotel rooms in an area is 80% and has been growing at 7% a year. Composite growth rate is 56%.

12. Business travel demand for hotel rooms in an area is 80% and vacation travel demand 20%. Annual compound business travel growth is 7% and vacation travel 10%. Total composite growth rate is 7.6%.

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13. Current average nightly demand for hotel rooms in an area is 1,796 and composite growth rate of demand is 5.5%. Next year’s (year 1) demand for rooms will be 1,895 (to the nearest whole number).

14. Current average nightly demand for hotel rooms in an area is 1,796 and composite growth rate of demand is 5.5%. Two years from now (year 2) demand for rooms will be 2,095.

15. Average nightly demand for hotel rooms is 1,796 in a particular area and hotels in that area are averaging 75% occupancy. Total number of rooms presently available in that area is 2,395.

16. Average nightly demand for rooms in an area is 3,598 and hotels are averaging 75% occupancy. Total number of rooms presently available in that area is 4,568.

17. Average nightly demand for rooms in an area is 3,598 and area hotels are averaging an occupancy rate of 75%. A new hotel is to be built that will cause all hotels (including the new one) to operate at a 70% occupancy in the first year. The new hotel will have 496 rooms.

18. Interim financing is temporary financing while a property is being built, whereas bridge financing is used for post-opening working capital.

19. A long-term mortgage on a building is also referred to as a permanent mortgage.

20. A permanent mortgage is one on which interest only has to be paid.

21. A chattel mortgage is a mortgage taken out to finance chattels such as food and beverage inventories.

22. A pro-forma income statement is an income statement calculated on a cash basis.

23. Feasibility study sales revenue projections are usually prepared for one possible level of sales revenue only.

24. The best way to evaluate feasibility study financial projections is to convert the projected cash flow figures using net present value (NPV) or internal rate of return (IRR).

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk)

1. One of the following statements is not correct. A feasibility study: (a) May reduce the risk of a particular investment but does not eliminate it * (b) Is designed to ensure the financial success of an investment (c) Can indicate either a positive or a negative outcome of an investment (d) Should be independently prepared by an impartial third party

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2. Which of the following items would not be included in the general market characteristics section of a feasibility study? (a) Industrial growth trends (b) Employment and economic trends * (c) Local population’s vacation patterns (d) Transportation available 3. Which of the following would not be part of the site evaluation section of a feasibility study? * (a) Building material (frame versus steel/concrete) to be used in construction (b) Detailed maps of location (c) Transportation routes to and from the site (d) Site dimensions 4. Which of the following would not be part of the supply and demand information section of a hotel feasibility study? (a) Hotel occupancy trends in the local area for the past five years (b) A list of competitive hotels currently serving that market * (c) Average daily spending of the local population when they are away on vacation (d) The principle likely sources of demand for the new hotel 5. Business travel demand is estimated to comprise 80% and convention delegate demand 20% for a proposed new hotel. The annual average growth rate in business travel is 4% and convention delegates 5%. Composite overall average growth rate of demand is: (a) 3.2% * (b) 4.2% (c) 1.0% (d) 4.8% 6. In a particular area, demand for hotel rooms is 60% from business travel, 30% from convention delegate travel, and 10% from vacation travel. These three markets have been growing at 8%, 6%, and 5%, respectively. Composite growth rate of demand is: * (a) 7.1% (b) 4.8% (c) 1.8% (d) 0.5% 7. Current average nightly demand for hotel rooms in an area is 898 and composite total growth rate of demand is 5.5%. Next year’s (Year 1) demand for rooms will be (to the nearest whole number): (a) 945 (b) 953 * (c) 947 (d) 999 8. Current average nightly demand for hotel rooms in an area is 1,260 and composite total growth rate of demand is 6%. The demand for rooms in each of the next 3 years (years 1, 2, and 3), respectively, will be: (a) 1,336 / 1,416 / 1,521 (b) 1,416 / 1,501 / 1,591 (c) 1,336 / 1,336 / 1,336 * (d) 1,336 / 1,416 / 1,501

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9. Average nightly demand for hotel rooms in an area is 2,635. The hotels in that area are presently averaging 72% occupancy. The total number of rooms available is: (a) 1,897 * (b) 3,660 (c) 3,416 (d) 3,201 10. Average nightly demand for rooms in an area is 2,635. The hotels in that area are presently averaging 72% percent occupancy. Assume a new hotel is to be built that will cause occupancy for all hotels (including the new one) to drop to 65% in the first year (Year 1). The number of rooms in that new hotel will be: * (a) 394 (b) 349 (c) 368 (d) 386 11. Interim financing is the same as: (a) A bank loan for working capital (b) A permanent mortgage (c) A type of bond * (d) Bridge financing 12. A chattel mortgage is a: (a) Type of interim financing (b) Type of bridge financing * (c) Short-term mortgage taken out to finance items such as furniture and equipment (d) Short-term mortgage to finance food and beverage inventories

PROBLEM SOLUTIONS P13.1

a. Calculate the current average occupancy of 5 motels: Total Rooms occupied / Total Rooms available = Composite occupancy % Motel A B C D E

Rooms Available 74 45 58 48 52 277

× × × ×

Occupancy % 82% 73% 85% 70% 75%

= = = = =

Rooms Occupied 61 33 49 34 39 216

Composite occupancy: (216 / 277) = 78.0%

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b. Composite growth rate: Sources of Sources of Growth Demand Demand % Rate % Business travel 10% × 5% Vacation travel 80% × 8% Other travel 10% × 1% Total composite growth rate percentage

Composite Percentage = 0.5% = 6.4% = 0.1% 7.0%

c. Composite growth rate and projected demand for the next 4 years Year 0 1 2 3 4

Rooms Demand 216 231 247 264

Composite Growth % × × × ×

107% 107% 107% 107%

Future Demand 216 231 247 264 282

= = = =

d. Assume a 70% occupancy and calculate the rooms that could be supplied for the next 4 years: Year Current 1 2 3 4 P13.2

Rooms Demand 216 231 247 264 282

Occupancy @ 70% 70% 70% 70% 70% 70%

/ / / / /

Supply Required 309 330 353 377 403

= = = = =

− − − − −

Current Supply 277 277 277 277 277

a. Determination of rooms demand: Motel #1 #2 #3 #4 #5 #6 Totals

Rooms Occupancy = Rooms Available × % Demand 150 140 90 110 66 120 676

× × × × × ×

80% 90% 70% 80% 75% 75%

= = = = = =

Total rooms available in 6 motels: 676 Composite occupancy: (537 / 676) = 79.4%

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120 126 63 88 50 90 537

(49.5  50)

= = = = =

New Rooms Required 32 53 76 100 126

b. Composite growth rate: Sources of Sources of Growth Demand Demand % Rate % Business travel 60% × 6% Vacation travel 30% × 5% Other travel 10% × 4% Total composite growth rate percentage

Composite Percentage = 3.6% = 1.5% = 0.4% 5.5%

c. Composite growth rate and projected demand for the next 4 years: Year 0 1 2 3 4

Rooms Demand 537 567 598 631

Composite Growth % × × × ×

105.5% 105.5% 105.5% 105.5%

= = = =

Future Demand 537 567 598 631 666

d. Assume a 75% occupancy and calculate the rooms that could be supplied for the next 4 years: Year Current 1 2 3 4

Rooms Demand 537 567 598 631 666

/ / / / /

Occupancy @ 75% 75% 75% 75% 75% 75%

= = = = =

Supply Required 716 756 797 841 888

− − − − −

Current Supply 676 676 *586 586 586

= = = = =

New Rooms Required 40 80 211 255 302

*Motel 3 to be closed in Year 2 and current supply adjusted to 586 (676 – 90).

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P13.3

P13.4

Pro-forma Income Statement Food sales revenue Monday through Saturday: Lunch [120 × 1.5 × 6 × 52 × $5.60] Dinner [120 × 1.25 × 6 × 52 × $10.50] Sunday Dinner [120 × 1.75 × 52 × $13.00] Banquets: [12 × $14,000] Total food sales revenue Beverage sales revenue Lunch [12% × $314,496] $ 37,740 Dinner [30% × ($491,400 + $141,960)] 190,008 Banquets [40% × $168,000] 67,200 Total Sales Revenue Operating expenses Food cost [38% × $1,115,856] $424,025 Beverage cost [28% × $294,948] 82,585 Wages [$300,000 + (15% × $1,410,804)] 511,621 Benefits [10% × $511,621] 51,162 Other expenses [12% × $1,410,804] 169,296 Overhead costs 130,000 Total expenses Operating income [BT] a. Land Building Furn. & Equip. Expenses b. Year 0 1 2 3 4 5 c.

Total $150,000 900,000 300,000 100,000 $1,450,000

Debt $630,000 225,000 ________ $855,000

Building Mortgage Repayment Total Interest $63,000 63,000 63,000 63,000 63,000

$50,000 49,000 48,000 47,000 46,000

$13,000 14,000 15,000 16,000 17,000

Chattel Mortgage Payment Total Interest

Year 0 1 $61,000 $25,000 $36,000 2 61,000 21,000 40,000 3 61,000 16,000 45,000 4 61,000 11,000 50,000 5 60,000 * 6,000 54,000 * The final year payment is reduced due to rounding. 211

$ 314,496 491,400 141,960 168,000 $1,115,856

294,948 $1,410,804

(1,368,689) $ 42,115 Equity $150,000 270,000 75,000 100,000 $595,000 Balance $630,000 617,000 603,000 588,000 572,000 555,000 Balance $225,000 189,000 149,000 104,000 54,000 -0-

P13.5

Building Depreciation Year Expense Balance 0 $900,000 1 $54,000 846,000 2 51,000 795,000 3 48,000 747,000 4 45,000 702,000 5 42,000 660,000 Furniture & Equipment Depreciation Year Expense Balance 0 $300,000 1 $75,000 225,000 2 56,000 169,000 3 42,000 127,000 4 32,000 95,000 5 24,000 71,000

P13.6

Sales revenue Op. Costs 60% Indirect exp. Prepaid exp. Depreciation Interest

Year 1 2 3 4 5

Sales Revenue Calculation 50 rooms × 70% × 365 × $30 = $383,000 50 rooms × 75% × 365 × $30 = $411,000 50 rooms × 75% × 365 × $33 = $452,000 50 rooms × 75% × 365 × $35 = $479,000 50 rooms × 80% × 365 × $35 = $511,000

Year 1 $383,000

Year 2 $411,000

Year 3 $452,000

Year 4 $479,000

Year 5 $511,000

$230,000 40,000 20,000 129,000 75,000 $494,000

$247,000 44,000 20,000 107,000 70,000 $488,000

$271,000 48,000 20,000 90,000 64,000 $493,000

$287,000 52,000 20,000 77,000 58,000 $494,000

$307,000 56,000 20,000 66,000 52,000 $501,000

Net Income (or loss) ($111,000) ($ 77,000) ($ 41,000) ($ 15,000) * The prior year’s loss eliminates income tax.

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$ 10,000 *

P13.7

Net income (or loss)

Year 1 ($111,000)

Year 2 ($ 77,000)

Year 3 ($ 41,000)

Year 4 ($15,000)

Year 5 $10,000

Add: Depreciation Prepaid expenses Total add-backs Subtotal Deduct: Principal Net cash flow

$129,000 20,000 $149,000 $ 38,000 ( 49,000) ($ 11,000)

$107,000 20,000 $127,000 $ 50,000 ( 54,000) ($ 4,000)

$ 90,000 20,000 $110,000 $ 69,000 ( 60,000) $ 9,000

$77,000 20,000 $97,000 $82,000 (66,000) $16,000

$66,000 20,000 $86,000 $96,000 ( 71,000) $25,000

The above financial projections show no net income until Year 5 and cash flow is negative until Year 3. The accumulated cash flow over the 5 years is positive $35,000 ($25,000 + $16,000 + $9,000 − $4,000 − $11,000). On this evidence, the project does not seem financially feasible without some additional financing, or using a different financing approach to make the project more appealing.

CASE 13 SOLUTION No solution is offered because each student’s report will differ depending on the location chosen.

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CHAPTER 14 FINANCIAL GOALS AND INFORMATION SYSTEMS INTRODUCTION This final chapter has two major sections. The first covers financial goals and the various types of financial goals that a firm may select from as well as other goals. The second part of the chapter covers information systems and decision making. In many ways, the information system section in this chapter pulls together many of the preceding chapters in the text and shows how the information flowing from the accounting system provides the foundation on which rational decisions can be made to help a business reach its financial goals.

TRUE OR FALSE QUESTIONS (Correct answer indicated by T for True and F for False answers)

1. Regardless of the type and size of a hospitality enterprise, financial management will be an ongoing aspect of the overall management of the business.

2. The concepts of financial management are basically the same for both profit and nonprofit organizations.

3. Another term for a company’s statement of business purpose is a mission statement.

4. An organization’s statement of business purpose and its objectives define what the organization wants to achieve. Its action plan shows how it is going to get there.

5. Funds raised through proper financial management should never be invested in assets such as food and beverage inventories.

6. A definition of financial management is that it is concerned with the mix of inflow sources and mix of outflow uses of funds.

7. Profit maximization, as a financial goal of a business, will always lead to maximization of stockholder wealth.

8. Profit maximization as a financial goal means making the most amount of money in the shortest possible time.

9. One of the advantages of profit maximization as a financial goal is that it takes into consideration every possible risk.

10. One of the advantages of profit maximization as a financial goal is that it emphasizes short-run over long-run profitability.

11. Maximization of percentage return on investment is a variation of the profit maximization financial goal.

12. With maximization of percentage return on investment, no investment is made if the return is less than the cost of financing.

13. Most successful larger companies try over time to maximize stockholder wealth.

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14. Maximization of stockholder wealth has as its objective, the combination of the highest dividend payments and increasing the market value of the company’s shares.

15. With maximization of stockholder wealth as a financial goal, net income is more important than earnings per share.

16. Maximizing earnings per share may not be the same as maximizing market price per share.

17. A company can maximize its earnings per share by never paying dividends.

18. With maximization of stockholder wealth as a financial goal, the company can control the market price of its stock, and that price cannot be influenced by external economic factors.

19. Market price of a company’s shares may not reflect a hotel’s true wealth if it has real estate holdings.

20. A company’s overall financial goal may be reflected in secondary goals set by the organization’s department heads.

21. Management by exception is the establishment of secondary goals set by the department heads of the business organization.

22. An alignment of an organization’s overall financial goals and the secondary goals of its department heads is known as goal congruence.

23. Management by objectives is contradictory to goal congruence.

24. The four levels in the decision making process are data production, data sorting, information production, and variance analysis.

25. Data are converted into information when they acquire meaning.

26. A manager’s task is to make decisions and not be involved in establishing the information gathering system.

MULTIPLE CHOICE QUESTIONS (Correct answer indicated by asterisk)

1. Another term for a company’s statement of business purpose is a: (a) Strategy statement (b) Tactical statement * (c) Mission statement (d) Operational statement 2. A company’s statement of business purpose can: (a) Provide guidelines for allocating resources (b) Indicate where future growth will occur (c) Serve as a basis for internal communication * (d) Achieve all of the above

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3. Which of the following is not an objective of financial management? (a) Establishing goals (b) Deciding on the sources of needed funds (c) Allocating available funds effectively * (d) Establishing employee wage rates 4. Which of the following is not true of having profit maximization as a financial goal? * (a) It is often used as a financial goal by larger, successful companies (b) It may ignore investment risks (c) A company may become too highly levered (d) It generally tends to emphasize short-run profits 5. The market price of a company’s shares is established by a number of factors. Which of the following is not one of those factors? (a) An assessment by purchasers of the risk of equity ownership (b) The company’s earnings per share (c) The company’s dividend payments policy * (d) The company’s ratio of net income to debt 6. One of the following is not a disadvantage of having the maximization of stockholder wealth as a financial goal: (a) The price of the company’s shares may be influenced by factors outside the control of its management. (b) The general manager may be tempted to maximize his own wealth rather than the stockholders’. * (c) If earnings per share increase and the share price goes up, stockholders may sell their shares. (d) Management may be unwilling to take reasonable risks even though such an investment would be to the stockholders advantage. 7. Which of the following is not a characteristic of management by objectives (MBO)? * (a) It ensures profit maximization (b) Department heads participate in establishing secondary goals (c) Department heads participate in determining how they will be measured in attaining secondary goals (d) The measurement of secondary goals is established in quantitative terms 8. Which of the following is not an example of a social goal? (a) Protecting the consumer who buys the establishment’s food and beverages * (b) Holding regular social functions with employees and guests together (c) Maintaining equitable hiring practices (d) Supporting further education and training of employees 9. In proper sequence, starting at the bottom of the pyramid, the four levels in the decision making process is: (a) Decision making, information production, data sorting, and data production (b) Information production, data sorting, data production, and decision making * (c) Data production, data sorting, information production, and decision making (d) Data sorting, data production, information production, and decision making

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10. Which of the following is not a true statement about the manager’s responsibility in the decision making process? (a) Interpretation of information * (b) Sorting data (c) Involvement in establishing the information gathering system (d) Deciding what information is relevant to a decision 11. Relevant information normally increases the decision maker’s knowledge, but: (a) Can quickly lead to a situation known as information overload (b) Consequently must result in a correct decision * (c) Reduces the risk of a wrong decision (d) Is of little value if it does not relate to all aspects of a specific problem 12. The decision making process normally involves the following sequence of steps: * (a) Defining the problem, identifying alternative solutions, gathering information, and making decisions (b) Accumulating information, defining alternatives, identifying problems, and making decisions (c) Selecting alternatives, defining variables, taking action, and evaluating results (d) Examining the problem, identifying relevant information and taking action 13. Which of the following is not true of information in the decision making process? (a) It must be relevant (b) It must be timely (c) It needs to be as accurate as possible * (d) It cannot be judgmental 14. Management by exception is: (a) Another name for management by objectives (b) Never part of the management by objectives process * (c) A method of bringing to management’s attention facts about which decisions and action may be required (d) Another name for goal congruence

Problem Solutions P14.1

No solution is offered because each student’s response will be different.

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P14.2

That this is not a fair method can be demonstrated in a variety of ways, but consider the following possibility: Motel 1 2 3

Sales revenue percent increases 10% 15% 30%

Net income percent increase 20% 15% 0%

Average percentage 15% 15% 15%

In this situation, Motel 1 did not achieve a 15% sales revenue increase and would not be eligible for the trophy, even though it contributed the highest proportion of increased net income (20%) to the chain’s overall profitability. Motel 2 would be eligible, but would share the award with Motel #3. Unfortunately, Motel 3 had the greatest sales revenue percentage increase, but contributed 0% additional net income to the chain. In other words, under the “best combination” measurement, a motel could win the award by increasing its sales revenue at the expense of net income. Also, if a motel were already at its peak of generating sales revenue, it can only increase net income by becoming more cost effective, but would never be eligible for the award, even though it contributed to overall company profitability. The performance and evaluation measures used by this motel chain should be reconsidered so that it is fair to the individual motels. Fairness in the evaluation measures should increase the incentive to produce the best operating results, and contribute to the chain’s overall financial objectives. P14.3

a. In this objective, the phrase “top-quality menu items” is subjective and difficult to define despite its importance. There is no quantitative measure and no time frame in this objective. A suggested alternative or objective might be: “Through documented customer surveys conducted over the next 90 days, achieve a customer satisfaction ratinge of 90% on a question asking if indicated by customers thought that they have received value for the money.” b. Again, in this objective no quantitative measure is included and no time frame is stated. A suggested alternative objective might be: “To create an awareness by December 31 among 75% of the resort’s guests, that the resort is an exclusive and rather unique resort by providing facilities in luxury surroundings.” c. This objective is less subjective than the previous two, but is still vague with phrases such as “considerably increase,” “within driving distance,” and again no time frame is included. This objective would also be difficult to measure. A suggested alternative might be: “To increase total visits to the night club by 20% by September 30, from visitors who live within a 50-mile radius of the hotel.”

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P14.4 a. The total budget for the 6 periods was $454,500 and total actual results were

$454,000, with a variance of only $500. In three of the months, the maintenance manager would receive a bonus as follows: Month 2 3 6 Total

Bonus $1,000 + (2% × $1,000) 1,000 + (2% × $4,000) 1,000 + (2% × $ 500)

= $1,020 = 1,080 = 1,010 $3,110

It is obvious from this information that the 2% portion of the bonus is not a great incentive to the maintenance department manager, whereas a $1,000 lump sum would be. Indeed, if the maintenance manager could rearrange the budget numbers (with total overall budget for the six periods remaining the same), the following could result: Period 1 2 3 4 5 6

Budget $80,000 $79,500 $74,500 $74,500 $73,500 $72,500

Actual $82,000 $79,000 $74,000 $74,000 $73,000 $72,000

Variance $2,000 Unfavorable $ 500 Favorable $ 500 Favorable $ 500 Favorable $ 500 Favorable $ 500 Favorable

For the six periods, the overall budget is still favorable at $500, but the maintenance manager has now added two more months where a $1,000 bonus would be awarded. b. From the perspective of the general manager, it would probably be preferable to eliminate the lump-sum bonus, and change to an increased bonus percentage since this would eliminate any advantage from the maintenance department manager manipulating the numbers to obtain the lump sum. However, the maintenance manager would still attempt to manipulate the budget and perhaps delay an expense to obtain the monthly bonus. Perhaps the general manager should have the pay the bonus at year’s end on the total amount saved. P14.5

The hotel has two uniquely different markets that it is trying to serve: the family trade and the group meeting segments. It has decided on a marketing strategy that has not tailored its product to complementary market segments. Further, it has only one converted conference room that must also cater to a potentially diverse number of meeting groups with different needs and wants. It should probably take a survey of potential meeting and conference groups to determine their needs and then decide if it can satisfy these needs and at the same time, also continue to accommodate the family trade. Alternatively, it may have to adopt a completely new strategy to achieve its desired increase in room occupancy.

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P14.6

P14.7

Defining the Problem a. X b. c. d. e. f. X g. h. i. j. k. l. m. n. o.

Identifying Alternatives

Accumulating Information

Making the Decision

X X X X X X X X X X X X X

a. Current ratio: $11,700 / $19,200 = 0.61:1 ($0.61 for each $1 of current debt) Quick ratio: $8,700 / $19,200 = 0.45:1 ($0.45 for each $1 of current debt) Debt to equity ratio: ($19,200 + $33,300) / $84,600 = 0.62:1 Times interest earned: ($25,800 + $2,800) / $2,800 = 10.2 times Net income to sales revenue ratio Year 0007: ($19,400 / $101,100) = 19.2% Return on owner’s equity Year 0007: ($19,400 / $84,600) = 22.9% The current ratio, quick ratio, and the debt to equity ratio would not be considered acceptable to creditors. However, the remaining ratios show a healthy financial position from the stockholders point of view. A complete feasibility study should be carried out. b. The following would be additional useful information: 1. Breakdown of present sales revenue between rooms and trailer pads. 2. Present average rates for rooms and for trailer pads. 3. Proposed rates for new rooms and trailer pads. 4. Forecast occupancy levels for new rooms and trailer pads. 5. Forecast additional sales revenue from new rooms and trailer pads. 6. Additional sales revenue that might be derived from the snack bar as a result of additional occupancies. 7. Effects of expansion on operating and overhead costs. 8. What any competitive resorts or motels might do as a result of expansion. 9. Proposed breakdown of financing required into debt and equity. 10. Possible terms and costs of debt financing.

CASE 14

SOLUTION

No solution is offered because each student’s report will be different. A class discussion as to student recommendations should provide an excellent participation and learning environment. 220