Horngren's Cost Accounting A Managerial Emphasis, 17e by Datar Rajan Instructor Manual by Ace Test Banks

Horngren's Cost Accounting A Managerial Emphasis, 17e by Datar Rajan Instructor Manual

The Manager and Management Accounting

TRANSITION NOTES This chapter introduces the five-step decision-making process utilized by managers to make a variety of decisions. This process becomes an underlying theme of the text as it is applied to a number of types of decisions throughout the text. The steps of the five-step decision-making process are (1) identify the problem and uncertainties, (2) obtain information, (3) make predictions about the future, (4) make decisions by choosing among alternatives, and (5) implement the decision, evaluate performance, and learn. With the emphasis on the five-step decision process, material relating to the problem-solving, scorekeeping, and attention-directing roles of the management accountant are streamlined. There is also an increased emphasis on the linkage between the set of business functions in the value chain and customer expectations as key success factors.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 17 18 19 20 Revised 21 22 23 Revised 24 Revised 25 26 27

16th Edition 17 18 19 20 21 22 23 24 25 26 27

17th Edition 28 29 30 31 Revised 32 Revised 33 34 35 36 Revised 37

16th Edition 28 29 30 31 32 33 34 35 36 37

LEARNING OBJECTIVES 1. 2. 3.

Distinguish financial accounting from management accounting. Understand how management accountants help firms make strategic decisions. Describe the set of business functions in the value chain and identify the dimensions of performance that 2-2 Copyright © 2021 Pearson Education, Inc.

4. 5. 6. 7.

II.

customers are expecting of companies. Explain the five-step decision-making process and its role in management accounting. Describe three guidelines management accountants follow in supporting managers. Understand how management accounting fits into an organization’s structure. Understand what professional ethics mean to management accountants.

CHAPTER SYNOPSIS Chapter 1 is an important introductory chapter. The underlying premise of this text, Cost Accounting: A Managerial Emphasis (17th ed.), is the importance of cost accounting data in making managerial decisions. Distinction is made between financial accounting and managerial accounting. Financial accounting focuses on reporting financial information to external parties such as investors, government agencies, banks, and suppliers based on Generally Accepted Accounting Principles (GAAP). The most important way financial accounting information affects managers’ decisions and actions is through compensation, numbers in financial statements. Management accounting is the process of measuring, analyzing, and reporting financial and nonfinancial information that helps managers make decisions to fulfill the goals of an organization. Managers use management accounting information to: 1. develop, communicate, and implement strategy 2. coordinate design, operations, and a company’s performance. Cost accounting provides information for both management accounting and financial accounting professionals. Cost accounting is the process of measuring, analyzing and reporting financial and nonfinancial information related to the costs of acquiring or using resources in an organization. The distinction between management accounting and cost accounting is not so clear-cut, and we often use these terms interchangeably in the book. Successful management accounting systems capture and report information that helps managers make decisions to fulfill organizational goals in an effective and efficient manner. Management accounting also provides information critical to the planning and control decisions of managers. A five-step decision-making process is introduced to guide successful decision making: identify the problem, obtain information, make predictions about outcomes, make a decision, and implement the decision. 2-3 Copyright © 2021 Pearson Education, Inc.

Key guidelines for management accountants include: cost– benefit analysis, behavioral considerations, technical considerations, and different costs for different purposes. Understanding these guidelines is essential for the student to have a solid foundation for material that is presented later in the text. As those responsible for the integrity of the accounting information used by external and internal parties, accountants must maintain the highest of ethical standards. They must take special care to avoid the appearance of ethical improprieties—not only avoid unethical behavior, but avoid the appearance of such. The Sarbanes–Oxley Act of 2002, passed in response to several large accounting scandals, imposes strict ethical standards on accountants. Professional associations such as the AICPA and the IMA not only impose additional standards on their members but also provide resources that help members identify ethical issues and possible courses of action when ethical dilemmas confront them.

III.

IV.

POINTS OF EMPHASIS 1.

Make sure that the students understand the perspective of cost accounting and how it differs from that of financial accounting.

The cost–benefit ratio is pervasive throughout the text. The students should grasp this concept early or they will not fully understand cost accounting.

Another recurring theme throughout the text is the five-step decision model. Emphasize this concept and be certain the students are operationally familiar with it.

The guidelines to management accounting covered in Learning Objective 5 give the student a proper perspective in order to “do” management accounting.

It is helpful and sets an ethical tone for the class if you go over the points included in the IMA Code of Ethical Conduct. Discuss the definitions of the terms covered in the Code, making certain that the students have a grasp of what is involved in ethical conduct.

CHAPTER OUTLINE LEARNING OBJECTIVE

Distinguish financial accounting … reporting on past performance to external users from management accounting … helping managers make decisions

1.1

Accounting systems process economic events and transactions into information helpful to managers. This data is collected, categorized, summarized, and analyzed.

1.2

Accounting systems provide information found in the financial statements as well as in internal performance reports.

1.3

Managers use this information to administer the activities of their area of responsibility.

1.4

Information needs may vary depending on managerial needs. TEACHING POINT. It is good to stop here and evaluate the different needs of different users within the company. Sales managers are interested in sales data by region or sales person; distribution managers may be interested in orders by geographic location or requested due dates; manufacturing managers may be interested in quantities of products ordered so production scheduling can occur. All of these are interested in different aspects of the sales data.

1.5

Management accounting has a different focus than financial accounting. The management accountant reports financial and nonfinancial information that helps managers make decisions that will help the company achieve its goals or implement its strategy. It is forward-looking. TEACHING POINT. Students need to understand from the start the “decision-making” focus of management accounting.

1.6

Management accounting reports information in a manner that will help managers do their jobs better and are not restricted by Generally Accepted Accounting Principles (GAAP). TEACHING POINT. This is a good time to introduce an overriding element of management accounting—the cost–benefit ratio. Engage the students in a cost–benefit analysis from personal experience. For example, compare the cost of getting a college education (including lost wages) with the benefits. Link the discussion to the original decision to (1) attend college and (2) the choice of a college.

1.7

Financial accounting has a historical focus, as it reports the results of operations to external parties. These reports must adhere to GAAP.

1.8

Cost accounting and financial accounting do not operate independently. Cost accounting, in addition to providing information for management accounting decision-making needs, also provides data to meet financial accounting inventory-valuation needs. (Exhibit 1-1 summarizes the major differences between financial and managerial accounting.)

1.9

Cost management describes the activities managers undertake to use resources in a way that increases a product’s value to customers and achieves an organization’s goals. TEACHING POINT. Students are frequently confused by cost accounting terminology. Explain that different practices arise in different companies. Because cost accounting is not for external reporting purposes, there is frequently a lack of communication among companies, and no standard terminology developed. Many cost accounting terms lack a uniform definition, and many practices may go by different names.

Refer to Quiz Question 1

LEARNING OBJECTIVE

Understand how management accountants help firms make strategic decisions … they provide information about the sources of competitive advantage

2.1

Strategy describes how an organization will compete and the opportunities management should pursue. It involves matching its capabilities with the opportunities in the marketplace to accomplish its objective. TEACHING POINT. Emphasize here the difference in strategic and tactical decision making. Strategy focuses on the long term and is performed by upper management. Tactical decision making is short term and is in the realm of lower to middle management. For students a strategic decision is their choice of a college and a major. A tactical decision would be what class to study for tonight.

2.2

Two broad strategies include competing on the basis of price or on the basis of product differentiation. TEACHING POINT. Have the students brainstorm for names of

companies that have pursued either strategy. How have they implemented the strategy of price competition? How have they differentiated the product?

2.3

Strategic cost management describes cost management specifically focused on strategic issues. This seeks answers to questions such as: •

Who are our most important customers and how do we deliver value to them?

•

What substitute products exist in the market? How do they differ from ours?

•

What is our most critical capability? What do we do best?

•

Will adequate cash be available to fund the strategy or is outside financing needed?

Refer to Quiz Question 2 Problem 1-29

LEARNING OBJECTIVE

Describe the set of business functions in the value chain and identify the dimensions of performance that customers are expecting of companies … R&D, design, production, marketing, distribution, and customer service supported by administration to achieve cost and efficiency, quality, time, and innovation

3.1

The value chain is the sequence of business functions in which customer usefulness is added to products or services. (Exhibit 1-2 illustrates the six business functions in the value chain.)

3.2

Research and development (R&D) involves generating and experimenting with new ideas related to new products, services, or processes.

3.3

The design function undertakes detailed planning and engineering of products, services, or processes.

3.4

Production is procuring, transporting, and storing (inbound logistics) and coordinating and assembling (operations) resources to produce a product or deliver a service. 2-7 Copyright © 2021 Pearson Education, Inc.

3.5

Marketing involves promoting and selling products or services to customers.

3.6

Distribution is the process of delivering the products or services to customers.

3.7

Customer service provides after-sale service to customers. TEACHING POINT. All of these functions are important and interrelated. The failure of a company to deliver any one of these adequately will have a negative impact on the others. Ask the students about negative experiences they have had with a company and which element of the value chain was involved. Probe further, exploring how this failure impacted the student’s perception of the company in other areas.

3.8

Management accountants are involved in the value chain as they keep track of costs incurred in each category. This information helps managers evaluate cost–benefit tradeoffs.

3.9

Related to the value chain is the supply chain. Whereas the value chain is internal, the supply chain involves the flow of goods, services, and information from the initial source of materials and services to the delivery of products to consumers. The value chain can involve one or many different organizations. (Exhibit 1-3 illustrates an overview of the value chain.)

3.10 The value chain and supply chain should be used by the company to deliver improving levels of performance for the customer. Key success factors in accomplishing this delivery include the following: •

Cost and efficiency—Determine what customers are willing to pay for a product or service and set a target price. By subtracting the desired profit, the company can then work to accomplish its target cost.

•

Quality—Customers expect high levels of quality. Total Quality Management (TQM) is a philosophy that seeks to improve operations throughout the company and exceed customer expectations. TEACHING POINT. Emphasize that quality does not have to be the most expensive. A product or service can be a quality product or service if it conforms to its intent. This is quality of conformance. Quality of design relates to products being thought of as being top-notch. A Rolls Royce automobile has quality of design. There is a more thorough discussion of quality in Chapter 19.

•

today’s time-conscious society, the customer wants the product or service now. Any delay is unacceptable. A company that can compete on the basis of time, whether in development or delivery is one that has an edge in today’s market. TEACHING POINT. When Fred Smith founded Federal Express to deliver packages overnight, many thought he would not succeed. However, Smith realized an unmet demand for quick delivery.

•

Innovation—A constant flow of new products or services is the basis for ongoing company success.

•

Sustainability—Companies increasingly apply the key success factors of cost and efficiency, quality, time, and innovation to promote sustainability.

Refer to Quiz Questions 3 and 4 Exercise 1-18

LEARNING OBJECTIVE

Explain the five-step decision-making process … identify the problem and uncertainties, obtain information, make predictions about the future, make decisions by choosing among alternatives, and implement the decision, evaluate performance, and learn to do planning and control and its role in management accounting … planning and control of operations and activities

4.1

Managers should go through a routine process in order to make effective decisions. This five-step decisionmaking process can be utilized to make a variety of decisions. •

Identify the problems and uncertainties. What are the choices that are being faced and where do the uncertainties lie?

•

Obtain information. Gather information before making a decision helps the manager to make a more informed decision. TEACHING POINT. Guard against information overload, or

obtaining too much information. Narrow the choices so the volume of information is manageable. Too much information can lead to “paralysis of analysis,” or the inability to formulate a viable solution.

•

Make predictions about the future. On the basis of the information obtained attempt to predict the outcome of each course of action.

•

Make decisions by choosing among alternatives. The information has been gathered and projections made. Select an alternative. TEACHING POINT. Do not shy away from making a decision. Someone once asked the president of General Motors if he had ever made a bad decision. His response was that to reach the level of success he had achieved, you were doing good to bat .500. You are going to make bad decisions, learn from them.

Collectively, the four preceding steps are known as planning—the selection of organizational goals, predicting results under alternative ways of achieving these goals, deciding how to attain these goals, and communicating the goals to the entire organization. A budget has been described as the quantitative expression of a proposed plan of action. It is a planning tool. Control is the action taken to implement the planning decisions represented by the budget. •

Implement the decision, evaluate performance, and learn. All the effort expended in steps 1 through 4 is useless unless the decision is put into action. TEACHING POINT. Most people have been associated with organizations or individuals who would have great plans, and would go through steps 1 through 4 of the process, only to fail to implement the decision. A colleague once came into work one morning, announcing an intention to return to school for an advanced degree. Fifteen years later, that colleague is still in the same company, without the degree.

Once implemented, the decision must be monitored. This is performance evaluation. One way of doing this is by comparing the budget with the actual results. This makes budgeting a control tool in addition to a planning tool. Often this is accomplished by the use of a performance report. TEACHING POINT. Monitoring also helps keep the plan (or budget) realistic. If the person proposing the project knows the results will not be monitored, there is a tendency to overstate the

benefits so the project will receive approval.

Learn. If the results were not as planned, find out why. Use this information to improve the decision-making process for future decisions. Refer to Quiz Question 5 24, 25

LEARNING OBJECTIVE

Exercise 1-

Describe three guidelines management accountants follow in supporting managers … employing a cost–benefit approach, recognizing behavioral as well as technical considerations, and calculating different costs for different purposes

TEACHING POINT. These guidelines are the foundation for the rest of the text. Students must understand that everything that is to follow must be filtered through the lens of cost-benefit, behavioral and technical considerations, and different costs for different purposes.

5.1

Cost–benefit approach. Always ask if the benefits from undertaking the activity exceed the costs of doing so.

5.2

Behavioral and technical considerations. Consider the motivational aspect of the decision. Will the managers and employees be motivated to work toward the goals of the organization? Technical considerations provide managers with appropriate information at appropriate intervals to assist in decision making.

5.3

Different costs for different purposes. Much of this book is about alternative ways to compute costs. In determining the cost, the first question that should be asked is “What is the purpose of this cost number?” Performance evaluation, external reporting, and internal decision making are three different purposes that might require a different view of cost.

Refer to Quiz Question 6

LEARNING OBJECTIVE

Understand how management accounting fits into an organization’s structure

… for example, the responsibilities of the controller

6.1

Most organizations distinguish between line and staff relationships. Line management is directly responsible for attaining the goals of the organization. Production is a line function. Staff management supports line management with advice and assistance. Accounting and human resources are two examples of staff management functions.

6.2

The chief financial officer or CFO (also called the finance director) is the executive responsible for overseeing the financial operations of an organization. Included among the responsibilities of the CFO are several functions: •

Controller provides financial information to managers and shareholders and oversees the overall operations of the accounting system.

•

The treasury function includes banking, financing, investments, and cash management.

•

Risk management includes managing the financial risk of interest rate and exchange rate changes as well as derivatives management.

•

Taxation includes income taxes, sales taxes, and international tax planning.

•

Investor relations responds to and interacts with shareholders.

•

Strategic planning includes defining strategy and allocating resources to implement strategy. The scope and importance of an internal audit has increased in recent years and now includes reviewing and analyzing financial and other records to attest to the integrity of the organization’s financial reports and adherence to policies and procedures. (Exhibit 1-6 illustrates a typical organization chart for the CFO)

Refer to Quiz Questions 7 and 8 Problem 1-33

LEARNING OBJECTIVE

Understand what professional ethics means to management accountants … for example, management accountants must maintain integrity and credibility in every aspect of their job

7.1

Accountants have a special obligation regarding ethics, as they are responsible for the integrity of the financial information provided to external and internal users.

7.2

Sarbanes–Oxley focuses on improving internal control, corporate governance, monitoring of managers, and disclosure practices of public corporations. This legislation brought an increase in the ethical standards of managers and accountants.

7.3

The Institute of Management Accountants (IMA) is the largest association of management accountants in the United States.

7.4

The IMA offers professional certification in the form of the CMA designation—Certified Management Accountant. This certification represents a demonstration of technical competency in financial and managerial accounting and holds the CMA to high ethical standards.

7.5

The IMA Standards for Ethical Conduct for Practitioners of Management Accounting and Financial Management presents guidelines on issues relating to competence, confidentiality, integrity, and credibility. (Exhibit 1-7 is a copy of the IMA Ethical Conduct Statement.)

7.6

In addition to the Standards, the IMA has an ethics hotline to assist members in resolving their ethical dilemmas. TEACHING POINT. Students sometimes don’t realize the importance of proper ethical behavior. A sign on a church once read “Integrity—Gained over a lifetime, lost in an instant.” Emphasize that integrity, once lost, is difficult to regain. Also, it is important for the accountant to avoid even the appearance of unethical conduct.

Refer to Quiz Questions 9 and 10 Exercise 1-35

To download instructor resources, visit the Instructor’s Resource Center at www.pearsonhighered.com/irc. The following exhibits were mentioned in this chapter of the Instructor’s Manual, and have been included in the Image Library. Exhibit 1-1 summarizes the main differences between financial and managerial accounting. Exhibit 1-2 illustrates the six business functions in the value chain. Exhibit 1-3 illustrates an overview of the supply chain. Exhibit 1-4 illustrates an overview of a performance report. Exhibit 1-5 illustrates how accounting aids decision making. Exhibit 1-6 illustrates a typical organization chart for the CFO. Exhibit 1-7 is a copy of the IMA Ethical Conduct Statement. Exhibit 1-8 is a copy of the IMA Resolution of Ethical Conduct.

CHAPTER 1 QUIZ 1.

Why do most companies adhere to GAAP for their basic internal financial statements? a. GAAP is required by law for publicly held companies. b. To use GAAP and another system of reporting would be too costly for most companies. c. Accountants are required by their code of ethics to use GAAP accounting. d. Accrual accounting provides a uniform method to measure an organization’s financial performance.

Which of the following is not true about strategy? a. It involves matching its capabilities with the opportunities in the marketplace to accomplish its objective. b. It has a short-term focus. c. It can be implemented through price competition or product differentiation. d. It involves the use of strategic cost management.

c. d.

customer usefulness is added to products or services. applies only to manufacturing companies. is not relevant in today’s cost accounting environment.

Which of the following is not a key success factor in a company’s effort to deliver increased levels of performance to the customer? a. Time b. Innovation c. Quality d. Price reduction

The five-step decision-making process a. includes planning and control activities. b. is performed exclusively by management accountants. c. is not often used, as the costs exceed the benefits. d. must be performed following GAAP guidelines.

In supporting managers, management accountants have three guidelines. These guidelines are: a. Cost–benefit analysis, performance reporting, behavioral considerations, and technical considerations. b. Cost–benefit analysis, behavioral considerations and technical considerations, and different costs for different purposes. c. Financial statement preparation, technical considerations, strategic direction, and budgeting. d. Following functional lines of authority, cost–benefit analysis, behavioral considerations, and use of the value chain.

_____ management exists to provide advice and assistance to those responsible for attaining the objectives of the organization. a. Line b. Functional c. Staff d. Risk

The Treasurer a. is the executive responsible for overseeing the financial operations of an organization. b. undertakes banking, financing, investments, and cash management duties. c. provides financial information to managers and shareholders and oversees the overall operations of the accounting system. d. is a different title for the Controller. 2-15 Copyright © 2021 Pearson Education, Inc.

Which of the following is not one of the ethical responsibilities of a management accountant? a. Compliance b. Confidentiality c. Integrity d. Objectivity

10.

The Institute of Management Accountants issues which certification? a. CPA b. CIA c. CFE d. CMA

CHAPTER 1 QUIZ SOLUTIONS 1.

10.

An Introduction to Cost Terms and Purposes

TRANSITION NOTES This chapter has been rewritten to place more emphasis on the role of managerial decisions. Exhibits have been changed so the students can more easily follow the concepts. This chapter continues building on the framework begun in Chapter 1, emphasizing (1) calculating the cost of products or other cost objects, (2) obtaining information for planning and control as well as performance evaluation, and (3) identifying relevant 2-16 Copyright © 2021 Pearson Education, Inc.

information for decision making. It introduces concepts essential to topics covered in later chapters.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 22 Revised 23 24 Revised 25 26 27 28 new 29 Revised 30 Revised 31 Revised 32 Revised 33 Revised

III.

16th Edition 21 22 23 24 25 26 27 28 29 30 31 32

17th Edition 34 Revised 35 Revised 36 Revised 37 Revised 38 Revised 39 Revised 40 Revised 41 Revised 42 Revised 43 Revised 44 Revised 45 Revised 46 Revised 47 48 Revised

16th Edition 33 34 35 36 37 38 39 40 41 42 43 44 45 47 48

LEARNING OBJECTIVES 1.

Define and illustrate a cost object.

Distinguish between direct costs and indirect costs.

Explain variable costs and fixed costs.

Interpret unit costs cautiously.

Distinguish inventoriable costs from period costs.

Illustrate the flow of inventoriable and period costs.

Explain why product costs are computed in different ways for different purposes.

Describe a framework for cost accounting and cost management.

CHAPTER SYNOPSIS Chapter 2 defines and explains important cost accounting terms and concepts that will be discussed in the following chapters. Understanding the concepts and terms discussed in this chapter is a prerequisite to successfully completing the remaining chapters of the text. One guiding principle is that the term cost is a relative term, dependent both on the cost object chosen and the purpose for which cost is being calculated and reported. 2-17 Copyright © 2021 Pearson Education, Inc.

Costs are a critical element in most business decisions. Students also need to recognize that companies pay particular attention to costs because every dollar in cost reduction is one more dollar of operating income, whereas one more dollar of sales does not necessarily result in the same impact due to the additional costs that may be incurred in generating those sales. “Cost” is often actually “estimated cost” due to difficulties involved in cost tracing and allocation, relevant range issues, which cost method is used, and the cost–benefit approach to measuring costs. Although there are certain standard costing and reporting methods followed by all, companies calculate and report the same types of data differently depending on their industry and sector. Companies commonly operate in the merchandising, manufacturing, and service sectors.

III.

IV.

POINTS OF EMPHASIS 1.

Although terminology can be boring, it is important that the students grasp and understand the terms introduced in this chapter. They will have some familiarity with some of the terms; however, remind them that these words may have meanings that are different in a cost accounting context.

The distinction between inventoriable (or product) cost and period cost is an important one that students may have some trouble grasping, as they are accustomed to treating items such as wages, rent, utilities, and the like as expenses of the period. Likewise, the term conversion cost is one that should be mastered early on.

CHAPTER OUTLINE TEACHING POINT. Knowledge of the terminology in this chapter is important for the student to gain an understanding of the concepts covered in the course. In teaching the material in the chapter, it is very beneficial to repeatedly ask questions such as: (1) What is the cost object in the situation? (2) What costs can be traced? and (3) Which costs are allocated?

LEARNING OBJECTIVE

Define and illustrate a cost object … examples of cost objects are products, services,

activities, processes, and customers

1.1

Cost is a resource sacrificed or forgone to achieve a specific objective.

1.2

Actual cost is the historical amount, or cost incurred, as distinguished from budgeted cost, which is the predicted or forecasted (future) amount of cost.

1.3

Cost object is anything for which a measurement of cost is desired. Stated another way, the cost object is anything for which a measurement of costs is desired. For example, this can be a product, an assembly line, a product line, or a department. TEACHING POINT. Discuss with the students the concept of cost object. Use different examples of cost objects. Help them relate the concept to their own lives. The cost of taking a trip during spring break, the cost of a date, the cost of a college education, and the cost of a single class—all make good talking points. (Exhibit 2-1 illustrates examples of cost objects at BMW.)

1.4

Cost accumulation is the collection of cost data in some organized manner by means of an accounting system. Following accumulation, costs are assigned to the chosen cost object.

1.5

The process of cost assignment involves tracing and allocating costs, depending on the type of cost involved.

Refer to Quiz Question 1

LEARNING OBJECTIVE

Distinguish between direct costs … costs that are traced to the cost object and indirect costs … costs that are allocated to the cost object

2.1

Direct costs of a cost object are costs that are related to the cost object and can be traced to it in an economically feasible (cost effective) way. It is possible to trace costs to the cost object, but it is 2-19 Copyright © 2021 Pearson Education, Inc.

not always practical to do so from a cost–benefit perspective. Cost tracing is the process of assigning costs to a cost object. 2.2

Direct cost categories include direct materials and direct manufacturing labor. Direct materials are materials that go into the production of the product. Direct labor is the wages paid to workers who spend time working on the product.

2.3

Indirect costs of a cost object are related to the cost object but cannot be traced in an economically feasible way. These costs are frequently referred to as factory overhead, manufacturing overhead, or some similar term. These costs include supervisor salaries, supplies, or other costs incurred in the factory that are not direct materials or direct labor. Indirect costs are assigned to a cost object by allocation. TEACHING POINT. Make the observation that the same cost may be direct or indirect depending on the cost object. Use some illustrations. For example, a line supervisor in a factory could be a direct cost if the cost object were the particular assembly line, but would be indirect if the finished product is the cost object.

2.4

Cost assignment includes tracing direct costs and allocating indirect costs.

2.5

Accurate cost allocation can be a challenging task depending on the type of cost involved. For example, management may find it difficult to allocate administrative costs to cash product manufactured.

2.6

There are several factors that affect the classification of costs as direct or indirect. Three of these factors include: •

Materiality of the cost. The smaller the amount of the cost, the less likely that it is economically feasible to trace that cost to a particular cost object.

•

Available information-gathering technology. For example, bar-code technology has made it possible to trace just about any raw material used in the manufacturing process.

•

Design of operations. A cost used exclusively for a specific cost object can be readily traced. (Exhibit 2-2 illustrates the assignment of direct and indirect costs at BMW.) TEACHING POINT. Use an object in the classroom, such as a stool or chair. Place it on a desk or somewhere the students can easily see it. Ask: “What are the materials used in manufacturing

the object?” Once a list of materials is compiled, then have the students determine which are direct material costs and which are indirect costs.

Refer to Quiz Question 2 Direct or Indirect LEARNING OBJECTIVE

Exercise 2-22 only ID as

Explain variable costs and fixed costs … the two basic ways in which costs behave

3.1

Management must understand cost behavior in order to adequately predict costs. From a behavioral view, costs are classified as fixed or variable.

3.2

A variable cost changes in total in proportion to changes in the activity level. For example, if the number of units produced doubles, direct materials (a variable cost) would double in total. Note, however, that the variable cost per unit remains constant.

3.3

Total fixed costs do not change with changes in the activity level. If units produced doubles, total fixed costs remain the same. However, when expressed on a per-unit basis, fixed costs would with an increase in activity. (Exhibit 2-3 displays the cost behavior of variable and fixed costs in total.)

3.4

Costs are not inherently fixed or variable; cost behavior depends on the defined cost object. They may be variable with respect to level of activity and fixed for another.

3.5

A cost driver is a variable, such as the level or activity or volume that causally affects costs over a given span of time. Stated another way, there is a cause-and-effect relationship between the level of activity of the cost driver and the cost incurred. TEACHING POINT. Use several examples that will help the students grasp this concept. For example, their cost of gasoline is determined largely by the number of miles driven. This can also be used to illustrate that most costs, in reality, have multiple drivers. Gas cost is also affected by type of driving, the horsepower of the engine, and other factors.

3.6

concept that can be determined from a textbook; observation of the actual costs must be done in order to determine this range. (Exhibit 2-4 illustrates the relevant range of fixed costs at Thomas Transport Company.)

3.7

In dealing with costs, it is important to distinguish between behaviors of costs when expressed as unit costs and when dealing with total costs. Generally, decision makers should think in terms of total cost. However, in many decision analysis situations, calculating unit costs is essential.

Refer to Quiz Question 3 variable) and 2-28

LEARNING OBJECTIVE

Exercises 2-22 (fixed and

Interpret unit costs cautiously … for many decisions, managers should use total costs, not unit costs

4.1

Unit costs (also called average costs) are calculated by dividing total costs incurred by the number of units produced and are normally used in making decisions such as product mix and pricing. However, managers should usually think in terms of total costs for most decisions.

4.2

Fixed costs, when expressed on a unit basis can be misleading. For example, if fixed costs are $25,000 and you manufacture 5,000 units, fixed costs are $5 per unit. When production increases to 6,250 units, total fixed costs remain at $25,000, but the unit cost declines to $4. Avoid using the higher unit cost when production level changes.

Refer to Quiz Question 4 Exercise 2-32

LEARNING OBJECTIVE

Distinguish inventoriable costs … assets when incurred, then cost of goods sold

from period costs … expenses of the period when incurred

5.1

Manufacturing-sector companies purchase materials and components and convert them into finished goods.

5.2

Merchandising-sector companies purchase and sell tangible products without changing their basis form. These companies are known as retailers, wholesalers, and distributors.

5.3

Service-sector companies provide services (intangibles). However, there is frequently a tangible aspect to the service. TEACHING POINT. Have the students name companies that are representative of each sector. Likely, they will correctly identify the proper sector for each company. Point out, however, that a service company may have a tangible aspect, such as the tax return as the end product of a tax preparation service. Conversely, a merchandising company may emphasize the intangibles. As the saying goes, “sell the sizzle, not the steak.”

Refer to Quiz Question 5 5.4

The accounting system of a manufacturing company is more complex than for a merchandising or service company. The principal reason for this complexity is in the inventories held by a manufacturer. These companies will have three types of inventory. •

Direct materials inventory, or simply materials inventory, consists of materials being held by the company, ready to be used in the manufacturing process.

•

Work-in-process inventory represents product partially worked on but not yet completed. WIP is a representation of what is on the factory floor.

•

Finished-goods inventory is goods that have not yet been sold.

5.5

Merchandising companies purchase products in their completed form and do not make changes in their basic form. An inventory account for a merchandising company is called merchandise inventory, or simply inventory.

5.6

The work-in-process account will have three debits, representing the three types of manufacturing costs.

•

Direct material costs are the costs of materials that become part of the cost object and can be traced to the cost object in an economically feasible manner.

•

Direct manufacturing labor costs include compensation of manufacturing labor that can be traced to the cost object in an economically feasible manner. This includes labor of workers who work converting direct materials into finished goods.

•

Indirect manufacturing costs are all manufacturing costs that are related to the cost object but can’t be traced to that object in an economically feasible manner. These costs are allocated rather than traced. Other terms for this category include manufacturing overhead costs or factory overhead costs.

Refer to Quiz Question 6 5.7

Inventoriable costs are all costs of a product that are considered assets on the balance sheet when they are incurred and include direct materials, direct labor, and factory overhead. They become a part of the cost of the product and are assets until sold, when they become cost of goods sold. These are also known as product costs.

5.8

Period costs are all costs on the income statement other than cost of goods sold. Period costs are treated as expenses of the period in which they are incurred. (Exhibit 2-6 illustrates examples of period costs in a bank.)

LEARNING OBJECTIVE

Illustrate the flow of inventoriable and period costs . . . in manufacturing settings, inventoriable costs flow through work-in-process and finished goods accounts and are expensed when goods are sold; period costs are expensed as incurred

6.1

Manufacturing costs of completed products include direct material, direct labor and manufacturing overhead costs. These costs are recorded on the balance sheet as inventory until the product is sold. Exhibit 2-7 provides an illustration depicting how 2-24 Copyright © 2021 Pearson Education, Inc.

product costs in a manufacturing setting flow through the financial statements. TEACHING POINT. Point out to students that the inventoriable product costs are included on the balance sheet in direct material inventory, work-in-process inventory, and finished– goods inventory and that period costs are expensed on the income statement. Emphasize that product costs stay on the balance sheet until the product is sold. At the point of sale, product costs are expensed on the income statement as cost of goods sold. Exhibit 2-9 presents the product cost flow in a Taccount format.

6.2

Exhibit 2-8 provides an illustration of the cost of goods manufactured statement. TEACHING POINT. Walk students through the calculation of cost of goods manufactured, cost of goods sold and operating income using the information provided in Exhibit 2-7.

6.3

Prime cost is a term used to describe all direct costs or direct materials plus direct labor.

6.4

Conversion cost is direct labor plus factory overhead. It is the cost of converting the materials into a finished product. TEACHING POINT. Many companies with highly automated manufacturing operations have little or no direct labor. These companies often have only one prime cost (DM) and one conversion cost (Manufacturing Overhead).

Refer to Quiz Questions 7 and 8

LEARNING OBJECTIVE

Exercise 2-33

Explain why product costs are computed in different ways for different purposes … examples are pricing and product-mix decisions, government contracts, and financial statements

7.1

Costs can be measured in different ways. The management accountant should define and understand the ways costs are measured in a particular company or situation. TEACHING POINT. Labor costs can include only the wage paid to the workers or it can be broadened to include the cost of that labor to the employer—the wage rate plus the cost of benefits

the employee receives.

7.2

When measuring labor costs, two issues in cost measurement that require special attention are idle time and overtime premium. Idle time is wage paid for unproductive time caused by lack of orders, machine breakdowns, or other reasons. Overtime premium is the wage rate paid to workers in excess of their regular straight-time wage rate. Both of these are considered as overhead rather than direct labor costs.

7.3

Many cost terms have ambiguous meanings. Product cost is a term with an ambiguous meaning because there are different definitions of product cost depending on the purpose for measuring that cost.

7.4

Pricing and product-mix decisions require an emphasis on the total profitability of different products and would assign costs incurred in all business functions to the product.

7.5

Contracting with government agencies is frequently done on the “product cost” plus a prespecified margin of profit. This is known as cost plus pricing. Government agencies frequently have detailed specifications about what costs can be included in (or excluded from) the cost base.

7.6

Reporting product cost for financial statement purposes requires adherence to GAAP guidelines for costing. (Exhibit 2-11 illustrates how product costs can vary depending on the purpose for which product cost is being calculated.) (Exhibit 2-12 lists alternative classifications of costs.)

Refer to Quiz Question 9

LEARNING OBJECTIVE

Describe a framework for cost accounting and cost management … three features that help managers make decisions

8.1

This chapter deals with a number of cost terms and purposes. These concepts can be expressed in three features of cost accounting that have a wide range of 2-26 Copyright © 2021 Pearson Education, Inc.

uses in business applications. •

Calculating the cost of products, services, and other cost objects. Managers use this information in a variety of ways to formulate strategy and make various decisions, such as pricing, product mix, and cost management.

•

Obtaining information for planning and control and for performance evaluation. Budgeting is the most commonly used tool for planning and control and forces managers to:

•

Look ahead

Translate strategy into plans

Coordinate and communicate within the organization

Provide a benchmark for evaluating performance

Analyzing the relevant information for making decisions. Managers must understand which revenues and costs to consider and which to ignore in the decision-making process. Management accounting can assist managers in determining which information is relevant.

Refer to Quiz Question 10

different types of manufacturing inventory. Exhibit 2-8 uses a sample Cost of Goods Manufactured schedule and a sample Income Statement to illustrate the calculation and reporting of Cost of Goods Sold. Exhibit 2-9 shows related general ledger T-accounts for manufacturing cost flow for Cellular Products. Exhibit 2-10 shows the inventoriable costs and period costs for a retailer or wholesaler. Exhibit 2-11 illustrates how product costs can vary depending on the purpose for which product cost is being calculated. Exhibit 2-12 lists alternative classifications of costs.

CHAPTER 2 QUIZ 1.

Galway Co. management desires cost information regarding its Celtic brand. The Celtic brand is a(n) a. cost object. b. cost driver. c. cost assignment. d. actual cost.

The cost of printer paper on a college campus would be a direct cost to the college but would need to be allocated as an indirect cost to a. departments. b. buildings. c. schools. d. individual student instruction.

What is the total fixed cost of the shipping department of Elaine Co. if it has the following information for 2020? Salaries $800,000 75% of employees on guaranteed contracts Packaging $400,000 depending on size of item(s) shipped Postage $500,000 depending on weight of item(s) shipped Rent of warehouse space $250,000 annual lease a. b. c. d.

$850,000 $900,000 $1,050,000 $1,950,000

Rosland Graphics successfully bid on a job printing standard notebook covers during the year using last year’s price of $0.27 per cover. This amount was calculated from 2-28 Copyright © 2021 Pearson Education, Inc.

prior year costs, noting that no changes in any costs had occurred from the past year to the current year. At the end of the year, the company manager was shocked to discover that the company had suffered a loss. “How could this be?” she exclaimed. “We had no increases in cost and our price was the same as last year. Last year we had a healthy income.” What could explain the company’s loss in income this current year? a. Their costs were all variable costs and the amount produced and sold increased. b. Their costs were mostly fixed costs and the amount produced this year was less than last year. c. They used a different cost object this year than the previous year. d. Their costs last year were actual costs, but they used budgeted costs to make their bids. 5.

Which type of company converts raw materials into finished products? a. Not-for-profit b. Service c. Merchandising d. Manufacturing

The three categories of inventories commonly found in many manufacturing companies are: a. Direct materials, direct labor, and indirect manufacturing costs. b. Purchased goods, period costs, and cost of goods sold. c. Materials, work-in-process, and finished goods. d. LIFO, FIFO, and weighted average.

Inventoriable costs are a. only purchased goods for resale. b. a category of costs used only for manufacturing companies. c. recorded as expenses when incurred and later reclassified as assets. d. recorded as assets when incurred.

Period costs are a. all costs in the income statement other than cost of goods sold. b. defined as manufacturing costs incurred this period on the schedule of cost of goods manufactured. c. always recorded as assets when first incurred. d. those costs that benefit future periods.

a. b. c. d. 10.

gathered from all areas of the value chain. identified as period cost. designated as manufacturing cost only. explicitly defined by contract.

The primary focus of cost management is to a. help managers make different decisions. b. calculate product costs. c. aid managers in budgeting. d. distinguish between relevant and irrelevant information.

CHAPTER 2 QUIZ SOLUTIONS 1.

10.

Quiz Question Calculations 3.

Fixed costs = (800,000)  75% + 250,000 = $850,000

Cost-Volume-Profit Analysis

TRANSITION NOTES This chapter contains updated coverage of strategy and strategic uses of cost information. The five-step decision process is applied to Cost-Volume-Profit (CVP) decisions. There is a shift to the “essentials” of cost-volume-profit analysis with less focus on the assumptions of CVP analysis. This is in line with the increased focus on the managerial aspects of the text. Discussion of alternative fixed/variable cost structures, multiple product breakeven analysis, and contribution margin versus gross income have been revised and shortened. There are several significant revisions and additions to the problem material at the end of the chapter. EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 Revised 22 23 24 25 26 Revised 27 Revised 28 Revised 29 30 New 31 Revised 32 33 34 35 36 Revised 37 38 Revised

16th Edition 21 22 23 24 25 26 27 28 29 30 31 32 33 35 36 37 38

17th Edition 39 40 Revised 41 42 Revised 43 44 45 46 Revised 47 48 49 50 Revised 51 52 Revised 53 54

LEARNING OBJECTIVES 1.

16th Edition 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54

IV.

Determine the breakeven point and output level needed to achieve a target operating income.

Understand how income taxes affect CVP analysis.

Explain how managers use CVP analysis to make decisions.

Explain how sensitivity analysis helps managers cope with uncertainty.

Use CVP analysis to plan variable and fixed costs.

Apply CVP analysis to a company producing multiple products.

Apply CVP analysis in service and not-for-profit organizations.

Distinguish contribution margin from gross margin.

CHAPTER SYNOPSIS This chapter presents the cost-volume-profit (CVP) analysis model and illustrates how managers use that model to help answer important “what-if” business questions. CVP analysis also helps management accountants alert managers to the risks and rewards of decisions they are considering by illustrating how the “bottom-line” is affected by changes in activity levels or key pricing or cost components. CVP analysis is based on several assumptions, one of which is that fixed costs can be distinguished from variable costs. However, whether a cost is variable or fixed depends on the time period for the decision and also the range of activity (relevant range) being considered. Students are also presented with a method for applying CVP analysis to companies with multiple products and to situations where there is more than one cost driver. The applicability of CVP to manufacturers, service organizations, and nonprofits is discussed. Contribution margin is also defined and distinguished from gross margin.

III.

POINTS OF EMPHASIS 1.

The concepts of contribution margin, contribution margin income statement, breakeven, target operating income, along with other measures are introduced in this chapter. This is a “nuts and bolts” chapter that the student should understand if they are to grasp the material covered in future chapters. Spend time having the students work through problems that cover the concepts from this chapter.

IV.

Operating leverage is a concept that will help the students understand why operating income changes as it does. Help the students see the usefulness of DOL (Degree of Operating Leverage).

CHAPTER OUTLINE LEARNING OBJECTIVE

Explain the features of cost-volume-profit (CVP) analysis … how operating income changes with changes in output level, selling prices, variable costs, or fixed costs

1.1

Cost-volume-profit (CVP) analysis studies the behavior of total revenues, total costs, and operating income as changes occur in the units sold, the selling price, the variable cost per unit, or the fixed costs of a product.

1.2

The five-step decision-making process outlined in Chapter 1 can be utilized in doing CVP analysis. To review, the five steps are: a.

Identify the problems and uncertainties.

Obtain information.

Make predictions about the future.

Make decisions by choosing among alternatives.

Implement the decision, evaluate performance, and learn.

(The Emma Jones example in the text details each of these steps as faced by a GMAT test preparation salesperson.) 1.3

Contribution margin is the difference between total revenues and total variable costs. This is an indication of why operating income changes as the number of units sold changes.

1.4

Contribution margin per unit is the difference between selling price and variable cost per unit; that is, contribution margin per unit is the change in operating income for each additional unit sold.

1.5

components. Variable costs are subtracted from revenues to highlight contribution margin. Fixed costs are subtracted from contribution margin to arrive at operating income. (Exhibit 3-1 illustrates a contribution margin income statement.) TEACHING POINT. This is a good time to reinforce the definitions of fixed and variable costs and their behavior in total and per unit. Time spent here will help students grasp the differences in how these costs behave.

1.6

The contribution margin percentage or ratio equals contribution margin per unit divided by the selling price. This is an indication of the percent of each sales dollar that is available to pay fixed costs and return a profit.

1.7

CVP relationships and the calculation of operating income can be illustrated using three methods: Equation method. The equation method is based on the following formula: (Selling price × Quantity of units sold) – (Variable cost per unit × Quantity of units sold) – Fixed costs = Operating income Contribution margin method. Under this approach the equation is rearranged to calculate contribution margin per unit. This expresses the basic idea that each unit sold contributes that amount per unit to fixed costs or profit. [(Selling Price – Variable cost per unit) x Quantity of units sold] – Fixed Costs = Operating income (Selling Price – Variable cost per unit) = Contribution margin per unit Graph method. The graph method represents total costs and total revenues graphically. When costs and revenues are netted and graphed as one line, this is often referred to as a profit-volume or PV graph. (Exhibits 3-2 and 3-3 illustrate the graph method with a costvolume-profit graph and a profit-volume graph.) Go over these, and discuss each line on the graph and its significance.

1.8

Cost-Volume-Profit Assumptions. There are a number of assumptions that must be made in conducting CVP analysis. Although these assumptions do not always precisely hold, they can allow meaningful analysis. 3-4 Copyright © 2021 Pearson Education, Inc.

•

Changes in the levels of revenues and costs arise only because of changes in the number of units sold. Thus, number of units sold is the only revenue and cost driver.

•

Total costs can be separated into fixed and variable components. TEACHING POINT. Emphasize to the students that this is usually possible; the question is: “Do they have the ability to make this division, given the data available and their level of skill?”

•

Total revenues and total costs are linear; that is, when graphed they can be represented as a straight line.

•

Selling price, variable cost per unit, and total fixed costs (within a relevant range) are known and constant. TEACHING POINT. Obviously, these assumptions do not hold over time. Point out that any time one of the factors changes, it changes the dynamics and the analysis must be repeated.

Refer to Quiz Question 1

LEARNING OBJECTIVE

Determine the breakeven point and output level needed to achieve a target operating income … compare contribution margin and fixed costs

2.1

Breakeven Point (BEP). The breakeven point is that quantity of output sold at which total revenues equal total costs. Following is the formula for calculating BEP in units: Fixed costs Unit contribution margin

2.2

However, BEP, and therefore zero profit, is not what companies should strive for. Managers are concerned with how they can achieve their goals for operating profit. Target operating income is the level of sales needed to attain a specified dollar amount of operating income. In order to determine TOI, add the 3-5 Copyright © 2021 Pearson Education, Inc.

desired operating income to fixed cost in the breakeven calculation. Fixed costs + Target operating income = Quanity of units to be sold Unit contribution margin

TEACHING POINT. Work with the class in doing various exercises that illustrate the points covered in this learning objective. Contribution margin, CM ratio, and breakeven point are understood much more readily when students see how these are calculated, rather than simply learning a definition of them. Exercises 3-24 and 3-25 illustrate these concepts. (Exhibits 3-2 and 3-3 graphically illustrate the CVP analysis of breakeven point.) (Exhibit 3-4 displays the underlying spreadsheet data.)

Refer to Quiz Questions 2 and 3 Exercises 3-24 and 3-25

LEARNING OBJECTIVE

Understand how income taxes affect CVP analysis … focus on net income

3.1

Net income is operating income plus nonoperating revenues (such as interest revenues) minus nonoperating expenses (such as interest expense) minus income taxes.

3.2

To this point, we have ignored the effect of income taxes in our CVP analysis. To make net income evaluations, however, we must state results in terms of target net income rather than target operating income.

3.3

The TOI calculation can be easily adjusted to accommodate this change: Target NI = TOI – (TOI  Tax rate) or stated another way Target NI = TOI  (1 – Tax rate)

LEARNING OBJECTIVE

Explain how managers use CVP analysis in decision making … choose the alternative that maximizes operating income

4.1

CVP analysis is useful in numerous situations to evaluate anticipated results from strategic decisions. Decisions such as whether to increase advertising or reduce the selling price can be facilitated with CVP analysis. These types of problems are illustrated in the text.

Refer to Quiz Questions 7 and 8 28

LEARNING OBJECTIVE

Exercise 3-

Explain how sensitivity analysis helps managers cope with uncertainty … determine the effect on operating income of different assumptions

5.1

Sensitivity analysis is a technique that managers use to examine the effect of changes in the variables that will affect the outcome of the decision. This is also referred to as “what if” analysis; that is, asking: “What would happen if …?” TEACHING POINT. Sensitivity analysis is an excellent tool to illustrate the practical usefulness of Excel. By programming the decision data into an Excel spreadsheet, the effect of changes in variables can be instantly seen by changing the value on the spreadsheet.

5.2

The margin of safety is another aspect of sensitivity analysis. It may be expressed in units, dollars, or as a percentage. It is defined as the amount by which the current level of sales exceeds the breakeven point; that is, it is a measure of how much sales can decline 3-7 Copyright © 2021 Pearson Education, Inc.

and have the company remain profitable. Margin of safety in dollars = Revenues – Breakeven revenues Margin of safety units = Sales in units – Breakeven units Margin of safety percentage = Margin of safety in dollars / Revenues 5.3

Sensitivity analysis recognizes uncertainty, the possibility that actual amounts of revenue and costs will differ from expected amounts. Problem 3-29

LEARNING OBJECTIVE

Use CVP analysis to plan variable and fixed costs … compare risk of losses versus higher returns

6.1

Managers have the ability to choose the levels of fixed and variable costs in their cost structures. This is a strategic decision and can be as simple as choosing between automation and a labor-based manufacturing operation.

6.2

Sensitivity analysis can be utilized in making the decision to substitute fixed costs for variable costs in the cost structure. Exhibit 3-4 illustrates the effects of a choice of fixed over variable in the cost structure.

6.3

Operating leverage describes the effects of fixed costs on changes in operating income with changes in contribution margin or volume. It is defined as the percentage change in operating income from a given change in sales and is described as degree of operating leverage (DOL). For example, a company that has a DOL of 4 will experience a change in operating income four times the change in revenues. If revenues increase 5%, operating income would increase 4 × 5 or 20%.

6.4

Degree of operating leverage =

Contribution margin Operating income

TEACHING POINT. Note that DOL is a two-edged sword, with an increase in revenues. A high DOL accelerates the increase in operating income. However, a decrease in revenues accelerates the decrease in operating income. DOL also changes as revenues change; its value is dependent on the level of sales.

Refer to Quiz Questions 9 and 10 Problem 3-48 LEARNING OBJECTIVE

Apply CVP analysis to a company producing multiple products … assume sales mix of products remains constant as total units sold changes

7.1

Sales mix is the quantities or proportions of various products or services that constitute the total sales of a company. The CVP analysis discussed to this point assumes a single product. This is not reasonable, as most companies sell a large variety of products.

7.2

Recall that one of the assumptions of CVP analysis was that “selling price, variable cost per unit, and total fixed costs are known and constant.” With products having different selling prices and variable costs, how can the sale of multiple products be adapted to fit the CVP model?

7.3

CVP analysis with multiple products is performed by calculating a weighted average contribution margin based upon a constant sales mix percentage. This is illustrated in the text and in Exercise 3-33 and Problem 3-51.

Refer to Quiz Questions 11 Problem 3-51

LEARNING OBJECTIVE

Exercise 3-33;

Apply CVP analysis in service and not-for-profit organizations

…define appropriate output measures

8.1

CVP analysis for service and not-for-profit organizations differs from other organizations. CVP need to focus on measuring their output which is different from the tangible units sold by manufacturing and merchandising companies. Some examples of output that can be measured are passenger miles for airlines, patient days for hospitals and student credit-hours for universities.

LEARNING OBJECTIVE Distinguish contribution margin

…revenues minus all variable costs from gross margin …revenues minus cost of goods sold

9.1

Gross margin measures how much a company can charge for its products over and above the cost of acquiring or producing its products. Contribution margin indicates how much of a company’s revenues are available to cover fixed costs.

APPENDIX A.1

Business decisions are made in a world of uncertainty. A decision model helps managers deal with uncertainty through a five-step process.

A.2

Step one is to identify a choice criterion—an objective that can be quantified.

A.3 Step two identifies the set of alternative actions that can be taken. A.4

that can occur. An event is a possible relevant occurrence. These events should be mutually exclusive. TEACHING POINT. Rolling a die is an event with six possible outcomes, each of which is mutually exclusive.

A.5

Managers assign a probability to each event that can occur in step four. A probability distribution describes the likelihood that each of the mutually exclusive events will occur. These probabilities will equal 1.0.

A.6

Step five is to identify the set of possible outcomes— the predicted economic results of the possible combinations of actions and events. These outcomes are summarized in a decision table.

A.7

The expected value is the weighted average of the outcomes with the probability of each outcome serving as the weight. When measured in monetary terms, this is called the expected monetary value.

CHAPTER 3 QUIZ 1.

Which of the following is not a factor in cost-volumeprofit analysis? a. Units sold b. Selling price c. Total variable costs d. Fixed costs of a product

a. b. c. d. 3.

The time value of money is incorporated in the analysis. Costs can be classified into variable and fixed components. The behavior of revenues and expenses is accurately portrayed as linear over the relevant range. The number of output units is the only driver.

Contribution margin is calculated as a. total revenue – total fixed costs. b. total revenue – total manufacturing costs (CGS). c. total revenue – total variable costs. d. operating income + total variable costs.

Questions 4 through 6 are based on the following data. Tee Times, Inc. produces and sells the finest quality golf clubs in all of Clay County. The company expects the following revenues and costs in 2020 for its Elite Quality golf club sets: Revenues (400 sets sold @ $600 per set)$240,000 Variable costs 160,000 Fixed costs 50,000 4.

How many sets of clubs must be sold for Tee Times, Inc. to reach their breakeven point? a. 400 b. 250 c. 200 d. 150

How many sets of clubs must be sold to earn a target operating income of $90,000? a. 700 b. 500 c. 400 d. 300

What amount of sales must Tee Times, Inc. have to earn a target net income of $63,000 if they have a tax rate of 30%? a. $489,000 b. $429,000 c. $420,000 d. $300,000

b. c. d.

recommend management hire a futurist whose work is to predict business trends. wait to see what does happen and prepare a report based on actual amounts. use sensitivity analysis to explore various what-if scenarios in order to analyze changes in revenues or costs or quantities.

The Beta Mu Omega Chi (BMOC) fraternity is looking to contract with a local band to perform at its annual mixer. If BMOC expects to sell 250 tickets to the mixer at $10 each, which of the following arrangements with the band will be in the best interest of the fraternity? a. $2500 fixed fee b. $1000 fixed fee plus $5 per person attending c. $10 per person attending d. $25 per couple attending

Use the following information for questions 9 and 10. LSB Company has the following income statement: Revenues $100,000 Variable Costs 40,000 Contribution Margin 60,000 Fixed Costs 30,000 Operating Income 30,000 9.

What is LSB’s DOL? a. 3.33 b. 2.00 c. 0.50 d. 1.00

10. If LSB’s sales increase by $20,000, what will be the company’s operating profit? a. $42,000 b. $12,000 c. $50,000 d. $30,000 11.

Valley Company sells two products. Product M sells for $12 and has variable costs per unit of $7. Product Q’s selling price and variable costs are $15 and $10, respectively. If fixed costs are $60,000 and Valley sells twice as many units of Product M as Product Q, what is the BEP in units for Product M? a. 4,000 b. 6,000 c. 12,000 d. 8,000 3-13 Copyright © 2021 Pearson Education, Inc.

CHAPTER 3 QUIZ SOLUTIONS 1.

10.

11.

Quiz Question Calculations 4.

Variable costs per unit = $160,000/400 units sold = $400 Contribution Margin = $600 – 400 = $200 per unit Breakeven point = $50,000/$200 = 250 units

TOI = $50,000 + $90,000/$200 = 700 units

6. TNI = $50,000 + $63,000/(1 – 0.30)/$200 = 700 units × $600 = $420,000 8.

Cost of option a: $2,500 Profit = 0 Cost of option b: $1,000 + 5(250) = $2,250 Profit = $250 Cost of option c: $10 (250) = $2,500 Profit = 0 Cost of option d: $25 (125) = $3,125 Loss ($625)

DOL = $60,000/$30,000 = 2.0

10.

$20,000 / $100,000 = 20% 20% × 2 = 40% 40% × $30,000 = $12,000 increase

11.

Product M contribution margin (12 – 7) = 5 x sales mix of 2 = 10 Product Q contribution margin (10 – 5) = 5 x sales mix of 1 = 5 Total contribution margin of both products = 15 FC/CM = BEP – package $60,000/15 = 4,000 packages BEP – units of Product M = BEP – packages x sales mix of 2 = 8,000 units

Job Costing

TRANSITION NOTES The five-step decision-making process continues to be utilized in this chapter. This model is used in decision-making situations involving job costing, such as whether to bid on a job and the amount to bid. This process is illustrated by means of a decision-making example early in the chapter. The authors retain the seven-step approach to job costing, which is the process the company undergoes to develop the jobcosting system. In line with the increased managerial emphasis, the use of materials, direct labor, work-in-process, and other subsidiary records is given additional emphasis. Many new problems have been introduced at the end of the chapter, and others have been revised. Copyright © 2021

10-1 Pearson Education, Inc.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 22 23 24 25 Revised 26 Revised 27 28 Revised 29 30 Revised 31 Revised 32 Revised 33 Revised 34 Revised

16th Edition 21 22 23 24 25 26 27 28 29 30 31 32 33 34

17th Edition 35 Revised 36 Revised 37 Revised 38 Revised 39 Revised 40 Revised 41 Revised 42 New 43 Revised 44 Revised 45 Revised 46 Revised

16th Edition 35 36 37 38 39 40 42 43 44 45 46

LEARNING OBJECTIVES 1.

Describe the building-block concepts of costing systems.

Distinguish job costing from process costing.

Describe the approaches to evaluating and implementing job-costing systems.

Outline the seven-step approach to normal costing.

Distinguish actual costing from normal costing.

Track the flow of costs in a job-costing system.

Adjust for under- or overallocated manufacturing overhead costs at the end of the fiscal year using alternative methods.

Understand variations of normal costing.

CHAPTER SYNOPSIS Chapter 4 outlines the basics of costing systems by illustrating the accounting for costs in a typical jobcosting system. Two new key terms related to costing systems are introduced in this chapter; they are: cost pool and cost-allocation base. The chapter distinguishes job-costing systems from processCopyright © 2021

10-2 Pearson Education, Inc.

costing systems. Job-costing systems track costs to distinct jobs, whereas process-costing systems apply the average cost to each unit of a large batch of identical or similar products. The seven-step process to job costing is outlined, and normal-costing systems using standard costs are compared to actual-costing systems that use actual costs. The total of actual indirect costs often differs from the total of indirect costs applied in standardcosting systems and the chapter illustrates how to account for any underallocation or overallocation of indirect costs at the end of the fiscal period.

III.

IV.

POINTS OF EMPHASIS 1.

If students have not grasped the terminology of cost accounting before beginning this chapter, they are likely to remain in “catch-up” mode for the rest of the class. Make sure they understand the terminology before proceeding. This is essential.

Walking the students through the documents associated with job costing will help them understand the flow involved in a job-costing system. Relate these documents to the seven steps in a job-costing system. Then tie the seven steps to the journal entries and the flow of costs.

Be sure the students grasp the definitions of actual and normal costing.

Students should be able to calculate and understand the reasons for a predetermined overhead rate.

CHAPTER OUTLINE LEARNING OBJECTIVE

Describe the building-block concepts of costing systems … the building blocks are cost object, direct costs, indirect costs, cost pools, and cost-allocation bases

Because of the complexity of most manufacturing operations, companies need to establish a system to track costs so they can properly determine product costs. Before moving into the details of these systems, the student should have a Copyright © 2021

10-3 Pearson Education, Inc.

grasp of cost accounting terminology. From Chapter 2: 1.1

A cost object is anything for which a measurement of costs is desired.

1.2

The direct costs of a cost object are costs that are directly related to the cost object and can be traced to the cost object in an economically feasible manner.

1.3

The indirect costs of a cost object are costs that cannot be traced to the cost object in a costeffective manner and are allocated to the cost object.

1.4

Cost assignment is a general term for assigning costs, whether direct (cost tracing) or indirect (cost allocation), to a cost object. .

1.5

Two new terms related to costing systems are introduced in this chapter; they are cost pool and cost-allocation base. •

A cost pool is a grouping of individual indirect cost items.

•

A cost-allocation base is a systematic way to link indirect costs to a cost object. TEACHING POINT. These terms are the building blocks of costing systems. Take time at this point to reinforce the importance and meaning of these terms. Go beyond having the students know the definitions; use illustrations to help them understand the terms operationally.

Refer to Quiz Question 1

LEARNING OBJECTIVE

Distinguish job costing … job costing is used to cost a distinct product from process costing … process costing is used to cost masses of identical or similar units of products or services

2.1

Management uses two basic types of costing systems to assign costs to products or services. • A job-costing system, or a job-order system, is used by a company that makes a distinct product Copyright © 2021

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or service called a job. The product or service is often a single unit. The job is frequently the cost object. Costs are accumulated separately for each job or service. •

A process-costing system is used by a company that makes a large number of identical products. Costs are accumulated by department and divided by the number of units produced to determine the cost per unit. It is an average cost of all units produced during the period. The cost object is masses of similar units of a product or service. TEACHING POINT. Give examples of products or services that would be accounted for under each system. A mechanic’s invoice from a car repair shop is a good illustration of job-order costing, as it has direct materials, direct labor, and overhead sections. Point out that each repair job is different; the repair shop does not perform the same activities on each vehicle brought in for repairs, therefore, it is accounted for under a jobcosting system. As an example of a process system, you can use an inexpensive pen that some students will be using. Point out that the manufacturer makes millions of these. Although they differ in ink color and point size (medium, fine, etc.) the process is the same—the company just uses black instead of blue, fine instead of medium, and the pens are manufactured by the same process at the same cost for each pen. (Exhibit 4-1 offers examples of job costing and process costing in different sectors.)

Refer to Quiz Question 2 Exercise 4-21

LEARNING

OBJECTIVE Describe the approaches to evaluating and implementing job-costing systems … to determine costs of jobs in a timely manner

3.1

Managers use the five-step process introduced in Chapter 1 when deciding whether to take on a particular job and how much to bid for the job.

3.2

A very important element of any costing system is the addition of overhead to materials and labor costs. Management can use actual costing, tracing direct costs to a cost object by multiplying actual direct cost rates by actual quantities of Copyright © 2021

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the direct-cost inputs. 3.3

Although actual costing is an effective way to assign direct costs to jobs, it is very difficult to follow this practice for indirect costs. Managers prefer to calculate indirect costs over a longer period; thus making it impossible to complete the cost accumulation on individual jobs.

3.4

There are two reasons for using longer periods to calculate indirect cost rates. The numerator reason reduces the effect of seasonal patterns on the amount of costs. The denominator reason avoids spreading monthly fixed indirect costs over fluctuating levels of monthly output and fluctuating quantities of the cost-allocation base.

3.5

Normal costing is a costing system that (1) traces direct costs to a cost object by using the actual direct-cost rates times the actual quantities of the direct-cost inputs and (2) allocates indirect costs based on the budgeted indirect-cost rates times the actual quantities of the cost-allocation bases.

LEARNING OBJECTIVE

Outline the seven-step approach to normal costing … the seven-step approach is used to compute direct and indirect costs of a job

4.1

A seven-step approach is used to assign costs to an individual job. This approach is used by manufacturers, merchandisers, and companies in the service sector. Step 1:

Identify the Job that Is the Chosen Cost Object. The source documents (original records that support journal entries in an accounting system) such as the job-cost sheet, the material-requisition record, and the labor-time record assist managers in gathering information about the costs incurred on a job.

Step 2:

Identify the Direct Costs of the Job. Most manufacturing operations have two directcost categories—direct materials and direct manufacturing labor. Direct materials are ordered by means of a materials requisition. Quantities needed are based upon engineering specifications.

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As previously indicated, the labor-time record indicates the amount of time an employee spends on a particular job. Step 3:

Select the Cost-Allocation Bases to Use for Allocating Indirect Costs to the Job. Because these costs cannot be traced to the job, they must be allocated in a systematic manner. (Companies often use multiple costallocation bases to allocate indirect costs because different indirect costs have different cost drivers.)

Step 4:

Identify the Indirect Costs Associated with Each Cost-Allocation Base. Ideally, a cause-and-effect relationship can be established between the costs incurred and the cost-allocation base (or cost driver).

Step 5:

Compute the Rate per Unit of Each CostAllocation Base Used to Allocate Indirect Costs to the Job. Budgeted manufacturing overhead rate = Budgeted manufacturing overhead costs / Budgeted total quantity of cost allocation base.

Step 6:

Compute the Indirect Costs Allocated to the Job. Multiply the actual quantity of each different allocation base by the indirect cost rate for each allocation base.

Step 7:

Compute the Total Cost of the Job by Adding All Direct and Indirect Costs Assigned to the Job.

(Exhibits 4-2 and 4-3 display sample job-cost records, and Exhibit 4-4 provides an overview of the job-order cost system.)

4.2

With modern technology, managers have much more timely and accurate product cost information, making it easier to manage and control jobs. Electronic Data Interchange (EDI), bar coding, electronic materialsrequisition records, and electronic labor-time records are just a few of the innovations that have enhanced job-order cost systems.

Refer to Quiz Question 3

LEARNING OBJECTIVE

Distinguish actual costing

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… actual costing uses actual indirect-cost rates from normal costing … normal costing uses budgeted indirect-cost rates

5.1

Actual costing is a costing system that traces direct costs to a cost object by using actual direct-cost rates times the actual quantities of the direct-cost inputs. It allocates indirect costs based on the actual indirect-cost rate times the actual quantities of the cost-allocation bases. Normal costing, as described in the last section, allocates indirect costs based on budgeted indirect-cost rates.

5.2

Normal costing is frequently used to enable managers to overcome the problems associated with actual overhead rates encountered in actual costing. TEACHING POINT. Students frequently do not immediately grasp the difference in actual and normal costing. Emphasize that the only difference in the two is in overhead. Actual costing uses actual overhead whereas normal costing uses predetermined (or budgeted) overhead rates. (Exhibit 4-5 differentiates actual and normal costing.)

Refer to Quiz Question 4 Exercises 4-22 and 4-23

LEARNING OBJECTIVE

Track the flow of costs in a job-costing system … from purchase of materials to sale of finished goods

6.1

The flow of costs in a job-costing system can best be observed by tracing the journal entries associated with such a system.

6.2

Recall that manufacturing costs are product costs and that a manufacturer will have three inventory accounts—materials, work-in-process, and finished goods.

6.3

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TEACHING POINT. Get the students engaged in the flow of costs with journal entries, T-accounts, and flow charts drawn on the board. An understanding at this point will go a long way toward helping the student transition to a manufacturing mindset. Exercise 4-30 is a good one to walk through to illustrate this.

6.4

The manufacturing overhead accounts need some explanation here. Manufacturing overhead control represents actual manufacturing overhead incurred. These amounts would be an expense in a nonmanufacturing setting. Manufacturing overhead allocated (applied) represents the amount of overhead allocated to jobs. Some companies use only a single Manufacturing Overhead account.

6.5

Materials, Work-in-Process, Finished Goods, and Manufacturing Overhead Control all have subsidiary ledgers that provide details about the balance in the general ledger account.

6.6

Note the importance of the job-cost sheet. It is the subsidiary ledger for Work-in-Process and becomes the subsidiary ledger for Finished Goods. When the product is sold, it is the basis for the amount of the journal entry to record COGS. TEACHING POINT. Recalling that companies use different costs for different purposes, a company could include direct marketing costs and customer-service costs to jobs, as appropriate. (Exhibits 4-6 through 4-9 display the flow of costs in a jobcosting system.)

Refer to Quiz Questions 5-7 through 4-31

LEARNING OBJECTIVE

Exercises 4-29

Adjust for under- or overallocated manufacturing overhead costs at the end of the fiscal year using alternative methods … for example, writing the amount off to the Cost of Goods Sold account

7.1

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needs to be disposed of at the end of the year. 7.2

If the Control account balance exceeds the Applied account balance, overhead has been underapplied. (Actual spending exceeds the amount allocated.)

7.3

If the Applied account balance exceeds the Control account balance, overhead has been overapplied. (Actual spending is less than the amount allocated.) TEACHING POINT. An illustration of a glass of water helps the students visualize this concept. Actual overhead is the water poured into the glass until it is full. When overhead is applied, water is removed from the glass. If any water remains, actual overhead exceeds applied and overhead is underapplied. If there is not enough water, applied overhead exceeds actual and overhead is overapplied.

7.4

There are three approaches to dealing with the underor overapplied overhead—the adjusted allocation-rate approach, the proration approach, or the write-off to cost-of-goods-sold approach. •

The adjusted allocation-rate approach restates all overhead entries in the general and subsidiary ledgers using actual rates rather than budgeted rates. With computerized systems, this approach has become easier to implement. The approach gives the timeliness and convenience of normal costing during the year and the actual amounts at year end for planning purposes.

•

The proration approach spreads the underallocated or overallocated overhead to Work-in-Process, Finished Goods, and Cost of Goods sold in proportion to the ending balances in these accounts (or based on the total amount of manufacturing overhead allocated to these accounts). TEACHING POINT. Students will want to include the materials account in this proration. Point out that overhead is being prorated to those accounts that have overhead amounts in them so materials should not receive an allocation.

•

The write-off to cost-of-goods-sold approach is the simplest. Under this approach the underallocated or overallocated overhead is simply written off to cost of goods sold. This method is acceptable if the amount is immaterial.

TEACHING POINT. In a normal operating situation, the bulk of the adjustment would go to cost of goods sold under the

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proration approach. Therefore, the total amount of the adjustment must be very large before the amount becomes significant enough to avoid usage of the write-off approach. Illustrate the three methods.

Refer to Quiz Questions 8 and 9 Problem 4-39

LEARNING OBJECTIVE

Understand variations of normal costing … some variations of normal costing use budgeted direct-cost rates

8.1

Job costing can also be utilized in service industries with a great deal of success. However, it is most useful when a variation of normal costing is applied.

8.2

Under a variation from normal costing, direct labor costs are assigned to jobs based on predetermined direct labor rates. The approach facilitates costing of jobs as it is often difficult to determine the actual labor cost associated with a particular job as it is completed.

8.3

To implement this variation, calculate a budgeted direct labor rate by dividing budgeted total direct labor costs by the budgeted total direct labor hours. This rate is then applied to specific jobs based on the number of direct labor hours consumed by the job.

Refer to Quiz Question 10 Exercise 4-34

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Exhibits 4-2 and 4-3 display sample job-cost records. Exhibit 4-4 displays an overview of a typical job-costing system. Exhibit 4-5 differentiates actual and normal costing. Exhibits 4-6 through 4-9 display the flow of costs in a job-costing system.

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CHAPTER 4 QUIZ 1.

A cost-allocation base may be any of the following except a a. cost driver. b. cost pool. c. way to link indirect costs to a cost object. d. nonfinancial quantity.

A company that manufactures dentures for use by local dentists would use a. process costing. b. personal costing. c. operations costing. d. job costing.

The first step in the seven-step approach to job costing is to a. select the cost-allocation base to use in assigning indirect costs to the job. b. identify the direct costs of the job. c. identify the job that is the chosen cost object. d. identify the indirect-cost pools associated with the job.

Using normal costing rather than actual costing requires that the allocating of indirect manufacturing costs to work-in-process be a. done on a more timely basis, such as every two weeks rather than every month. b. journalized only at year end when adjusting entries are normally made. c. calculated by using the budgeted rate times actual quantity of allocation base. d. calculated by using the budgeted rate times the budgeted quantity of allocation base.

Manufacturing Overhead Control a. represents actual overhead costs incurred. b. has a normal debit balance. c. is a control account with a subsidiary ledger detailing the components of manufacturing overhead. d. All of the above

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b. c. d.

Materials Control Work-in-Process Control Finished Goods Control

The costs incurred on jobs that are currently in production but are not yet complete would appear in the a. Materials Control account. b. Finished Goods Control account. c. Manufacturing Overhead Control account. d. Work-in-Process Control account.

The Precision Widget Company had the following balances in their accounts at the end of the accounting period: Work-in-Process

$ 5,000

Finished Goods Cost of Goods Sold

20,000 200,000

If their manufacturing overhead was overallocated by $8,000 and Precision Widget adjusts their accounts using a proration based on total ending balances, the revised ending balance for Cost of Goods Sold would be

$192, 880.

$200, 000.

$207,120.

$208,000.

Liberty Box Company calculated an indirect-cost rate of $12.50 per labor hour for fringe benefits for use in their normal costing system. At the end of the year, the actual cost of fringe benefits was $980,000. The total of labor hours worked for the year was the same amount as budgeted, 70,000 hours. If Job #640 required the use of 15 labor hours and the company used the adjusted allocation rate approach, by what amount would the cost of Job #640 change? a. $560.00 Copyright © 2021

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b. c. d.

10.

$281.25 $22.50 $20.50

If each professional in a service company is paid on an annual salary basis, why might the firm want to use a predetermined or budgeted rate for direct or professional labor? a. A predetermined or budgeted rate is easier to justify to a client who might question a billing rate. b. Professional staff persons do not keep accurate records of the jobs on which they work. c. Professional staff incurs more client costs, such as travel, lodging, and out-of-town meals, while working on a job. d. Year-end bonuses paid to the professional staff are difficult to trace to individual jobs.

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CHAPTER 4 QUIZ SOLUTIONS 1.

10.

Quiz Question Calculations

Work-in-Process

$5,000 / 225,000

Finished Goods Cost of Goods Sold

2.2%  $8,000 = 176

$20,000 /225,000

8.9%  $8,000 = 712

$200,000 / 225,000 88.9%  $8,000 = 7,120

200,000 – 7,120 = $192,880

980.000/70,000 = $14.00 (actual rate) $14,000 – $12.50 = $1.50 excess of actual over budget 1.50  15 hours – $22.50 additional cost

Activity-Based Costing and Activity-Based Management

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TRANSITION NOTES In this chapter the five-step decision process is applied to a specific problem faced by management of a company. The decision process undertaken by the company is illustrated step-by-step. The text gives three reasons for refinement of a costing system. In a previous edition, a fourth reason— “advances in information technology” was included. This change reflects that, although information technology continues to change, the technology necessary for cost system refinement has been in place for a number of years and one does not need the latest technology to adopt an ABC system. There is an expanded discussion of the choice of cost-allocation bases.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 18 19 20 21 22 Revised 23 Revised 24 Revised 25 Revised 26 27 28 Revised 29 Revised

16th Edition 18 19 20 21 22 23 24 25 26 27 28 29

17th Edition 30 31 Revised 32 Revised 33 Revised 34 35 36 37 Revised 38 39 Revised 40 41 Revised 42 43 Revised

16th Edition 30 31 32 33 34 35 36 37 38 39 40 41 42 43

LEARNING OBJECTIVES 1.

Explain how broad averaging undercosts and overcosts products or services.

Present three guidelines for refining a costing system.

Distinguish between simple and activity-based costing systems.

Describe a four-part cost hierarchy.

Cost products or services using activity-based costing.

Evaluate the benefits and costs activity-based costing systems.

of implementing

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VI.

Explain how managers use activity-based costing systems in activity-based management.

CHAPTER SYNOPSIS Chapter 5 focuses on allocation of indirect costs by using an activity-based costing (ABC) system. Companies that produce a variety of products need a costing system that allocates costs based on the varying resource demands of each product. Activity-based costing systems can help companies make better decisions about pricing and product mix, and assist in decisions about product design, by providing more accurate information about how different products and services use resources. Activity-based costing systems identify activities as the cost objects. Inaccurate costing systems can provide misleading cost information and may result in product undercosting and product overcosting. Three guidelines for refining a costing system are: direct-cost tracing, indirect-cost pools, and cost-allocation bases. A cost hierarchy segregates costs into different cost pools. ABC systems typically use a cost hierarchy with four levels—output unit-level costs, batch-level costs, productsustaining costs, and facility-sustaining costs.

III.

POINTS OF EMPHASIS 1.

It is important that students understand the consequences of undercosting or overcosting a product. Help them relate this to the advantages of using an activity-based costing (ABC) system. Be certain they understand what is meant by refining a cost system.

Students will not be familiar with the concept of cost hierarchies. However, understanding how costs are incurred will go a long way toward understanding cost drivers and ABC systems.

Just like job costing has a seven-step procedure for implementation, ABC costing has a seven-step procedure. Help the students relate the two and understand differences in the seven steps in each system.

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IV.

CHAPTER OUTLINE LEARNING OBJECTIVE

Explain how broad averaging undercosts and overcosts products or services … it does not measure the different resources consumed by different products and services

1.1

The use of broad averages in allocating indirect costs can have a number of adverse consequences.

1.2

Traditional product-costing methods use a single indirect cost rate to allocate costs to all products. •

When a company has a variety of products, or an increasing proportion of indirect costs, this method may not give the best results.

1.3

Different products consume activities at different rates, traditional costing does not recognize these differences.

1.4

Peanut-butter costing uses broad averages to assign (or spread) costs uniformly to cost objects. TEACHING POINT. Use the term peanut-butter costing. It is one that students will relate to and remember.

1.5

The result can be undercosting or overcosting of products.

1.6

When a company has a situation in which undercosting or overcosting of products occurs due to broad averaging of costs, this is referred to as productcost cross-subsidization. Overcosting one product will undercost one or more other products. TEACHING POINT. Focus on the consequences of undercosting or overcosting products. Overcosting may set the selling price too high, having an adverse effect on sales volume. Undercosting may result in too low a sales price, where an increase in volume isn’t enough to generate an adequate profit. Managers sometimes do not realize that profits are maximized if products are priced properly. (Exhibits 5-1 and 5-2 illustrate the simple costing system at Plastim Corporation.)

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Part 1, Problem 5-30

LEARNING OBJECTIVE

Present three guidelines for refining a costing system … classify more costs as direct costs, expand the number of indirect-cost pools, and identify cost drivers

2.1

Refining a Costing System. A refined cost system reduces the use of broad averages for assigning costs of resources to cost objects. There are three principal reasons that have accelerated the demand for such refinements. •

Increase in product diversity. The growing demand for customized products has led to product diversity with the result that products and services demand differing quantities of resources. TEACHING POINT. Have students brainstorm the proliferation of products on the market. For example, point out the number of varieties and sizes of a product such as Coca-Cola, or the new ways that coffee is packaged for brewing (K cups or pods). A costing system needs to be able to handle such variety.

•

Increase in indirect costs with different cost drivers. With product and process technology, companies have experienced a decrease in direct costs (especially direct labor) with a resulting increase in indirect costs.

•

Increase in product market competition. Markets have become more competitive, forcing managers to obtain more accurate cost information to help them make strategic decisions, such as pricing and product mix.

2.2

The demand for refined cost systems precipitated by increases in product diversity, increased indirect costs, and competition is met by new technologies that facilitate implementation of these systems.

2.3

Three guidelines are presented for refining a costing system. •

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many direct costs as is economically feasible. •

Increase the number of indirect-cost pools. Expand the number of cost pools so that each pool is somewhat homogeneous. Each cost in the pool has a similar cause-and-effect relationship with a single cost driver.

•

Identify cost drivers. Whenever possible, managers should use the cost driver (the cause of indirect costs) as the cost-allocation base for each homogeneous indirect-cost pool (the effect).

Refer to Quiz Question 2 Exercise 5-21

LEARNING OBJECTIVE

Question 5-3,

Distinguish between simple and activity-based costing systems … unlike simple systems, ABC systems calculate costs of individual activities in order to cost products

3.1

A simple costing system has few indirect (often one) cost rates and allocates costs broadly. •

3.2

In today’s complex manufacturing environment, this can lead to inaccurate product costs.

An activity-based system (ABC) identifies activities as fundamental cost objects. •

Costs are then assigned to the activities and allocated to the individual products. (Exhibit 5-6 continues the Plastim example, comparing simple and activity-based costing systems.)

Refer to Quiz Question 3 5-23

LEARNING OBJECTIVE

Exercise

Describe a four-part cost hierarchy … a four-part cost hierarchy is used to categorize

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costs based on different types of cost drivers—for example, costs that vary with each unit of a product versus costs that vary with each batch of products

4.1

Cost Hierarchies. In an ABC system, costs are categorized on the basis of the different types of cost drivers utilized. ABC systems commonly use a four-level cost hierarchy. These cost drivers differ in their relationship between the indirect cost and the product or service. •

Output unit–level costs are the costs of activities performed that vary with each individual unit of the cost object, such as a product or service. These costs increase as the number of units produced increases.

•

Batch-level costs are the costs of activities that vary with a group of units of the cost object, rather than with each individual unit of the cost object. Set-up costs are an example of batch-level costs, as this cost is incurred once for each batch, regardless of the size of the batch.

•

Product-sustaining costs (service-sustaining costs) are the costs of activities undertaken to support individual products or services regardless of the number of units or batches produced. Design costs are an example of this type of cost.

•

Facility-sustaining costs are the costs of activities that managers cannot trace to individual cost objects, such as products or services, but that support the organization as a whole. Examples of this type of cost include general administration, rent, and building security. These costs usually lack a cause-andeffect relationship between the cost and the allocation base. TEACHING POINT. Students do not always grasp the significance of the cost hierarchy. Begin by talking generally about hierarchies (classifications) and then relate the general term to the cost hierarchy. Illustrate each and emphasize how the costs are incurred and how those costs are assigned to the product.

Refer to Quiz Question 4 Exercises 5-18 and 5-19

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LEARNING OBJECTIVE

Cost products or services using activity-based costing … use cost rates for different activities to compute indirect costs of a product

5.1

5.2

The chapter previously discussed the three guidelines for refining a cost system. Those guidelines, directcost tracing, homogeneous cost pools, and cost drivers with a cause-and-effect relationship lack specificity. In order to implement activity-based costing, a sevenstep procedure should be followed. Step 1:

Identify the products that are the chosen cost objects.

Step 2:

Identify the direct costs of the products.

Step 3:

Select the activities and cost-allocation bases to use for allocating indirect costs to the products.

Step 4:

Identify the indirect costs associated with each cost-allocation base (activity).

Step 5:

Compute the rate per unit of each costallocation base (activity) used to allocate indirect costs to the products.

Step 6:

Compute the indirect costs allocated to the individual products.

Step 7:

Compute the total costs of the products by adding all direct and indirect costs assigned to the products.

This process is not a strict step-by-step procedure. You may get to one step and realize you need to revise something you did in a previous step, so you will frequently find yourself going back to a previous step in implementing an activity-based costing system. (Exhibits 5-3, 5-4, and 5-5 continue the illustration of an activitybased costing system at Plastim.)

5.3 Compare alternative costing systems. The benefit of an ABC system is that it provides more accurate information that leads to better decisions. Managers must weigh this benefit against the measurement and implementation costs of an ABC system.

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Refer to Quiz Questions 6 and 7 Exercise 5-25 LEARNING OBJECTIVE

Evaluate the benefits and costs of implementing activity-based costing systems … more accurate costs that aid in decision making when products make diverse demands on indirect resources versus costs incurred for measurement and implementation

6.1

6.2

Managers choose the level of detail to use in a costing system by comparing the costs and benefits of each system. There are five signs that may indicate an ABC system will provide maximum benefit. They are: •

Significant amounts of indirect costs are allocated using only one or two cost pools.

•

All or most indirect costs are identified as output unit–level costs (few indirect costs are described as batch-level, product-sustaining, or facility-sustaining costs).

•

Products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity.

•

Products that a company is well suited to make and sell show small profits; whereas products that a company is less suited to produce and sell show large profits.

•

Operations staffs have substantial disagreement with the reported costs of manufacturing and marketing products and services.

When implementing ABC, a company must decide about the level of detail to use. Should it choose many finely specified activities, cost drivers, and cost pools, or would fewer suffice? The more activities utilized, the more complex the system. TEACHING POINT. When ABC was introduced, the prevailing thought was that it was only for very large companies and that the greater number of activities that were identified resulted in a better system. Typical ABC software was priced at $25,000 and up to the late 80’s, companies were identifying 100 to 150 activities. This took a great deal of effort to track and the classifications were not always accurate with so many cost pools. Today, software prices

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have declined, and companies realize they can get better results when identifying a limited number of activities.

Refer to Quiz Question 8 Problem 5-36

LEARNING OBJECTIVE

Explain how managers use activity-based costing systems in activity-based management … such as pricing decisions, product-mix decisions, and cost reduction

7.1

To this point, the emphasis in this chapter has been on the use of ABC to obtain better product costing. Better product costing is desirable because it leads managers to make better decisions, evaluate performance, and to learn. •

Activity-based management (ABM) is a method of management decision making that uses activitybased costing information to improve customer satisfaction and profitability.

•

ABM is defined broadly to include decisions about o

Pricing and product mix

Cost reduction

Process improvement

Product design

Refer to Quiz Question 9 Problem 5-38

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Plastim.

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CHAPTER 5 QUIZ 1.

Production-cost cross-subsidization results from a. allocating indirect costs to multiple products. b. assigning traced costs to each product. c. assigning costs to different products using varied costing systems within the same organization. d. assigning broadly averaged costs across multiple products without recognizing amounts of resources used by which products.

In refining a cost system a. total direct costs are unchanged because they can be traced in an economically feasible way to the product and traced costs are more accurate. b. the costs are grouped in homogeneous pools of the same or similar amounts. c. the criterion of cause-and-effect is used to relate indirect costs to a factor that systematically links to a cost object. d. the organization looks for cost-allocation bases that will provide a uniform spreading of indirect costs to each product.

Question 3 is based on the following data. The average cost data are for In-Sync Fixtures Company’s (a retailer) only two product lines, Marblette and Italian Marble. Marblette Italian Marble Purchase volume 20,000 1,000 Purchase cost per unit $50 $50 Shipments received 12 12 Hours used per shipment 5 3 * *These data were accumulated after a careful activity analysis. Currently, In-Sync Fixtures uses a traditional costing system with indirect costs allocated using purchased cost of goods as a basis. In-Sync Fixtures is considering refining the allocation of their receiving costs of $40,000. They realize that the Italian Marble is heavier and requires more care than the Marblette but that the Marblette comes in larger volume. 3.

Which statement can be made using the results of the activity analysis performed by In-Sync Fixtures? a. The use of this refined activity-based costing system will increase the accuracy of the resulting product costs because a more appropriate cost driver will be used as the allocation base.

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b. c. d.

The traditional allocation method currently being used is causing product-cost cross-subsidization with the product line Marblette being undercosted. The cost allocated to the Italian Marble product line under the current traditional system is more than the activity-based costing allocated cost. The use of this refined activity-based costing system will increase the accuracy of the resulting product costs because it probably will cost less to trace the costs to the product lines.

Advertising of a specific product is an example of a. unit-level costs. b. batch-level costs. c. product-sustaining costs. d. facility-sustaining costs.

The allocation of indirect costs in an activity-based costing system a. may require other costs to be allocated to activities before the costs of the activities can be allocated to the products. b. is simplified because more costs are identified as direct costs. c. requires the use of heterogeneous cost pools. d. is simplified because a limited number of activities are identified as cost objects.

Information for questions 6 and 7 is given below. Jackson Enterprises manufactures two products—a basic gizmo and an advanced model gizmo. The company is using an activity-based costing system. They have identified three activities for allocation of indirect costs. Activity Materials receiving Production setup Quality inspection

Cost Driver Number of parts Number of setups Inspection time

Cost-Allocation Rate $2.00 per part $500.00 per setup $90 per hour

A production run for the basic model is 250 units, for the advanced model, 100 units. Each unit of product consumes the following activities: Number of Parts Number of Setups Basic Gizmo 10 1 setup per production run Advanced Gizmo 15 1 setup per production run

Inspection Time 10 minutes 20 minutes

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Advanced Gizmo

$95.00

$125.00

The amount of overhead allocated to one unit of the basic model would be a. $592. b. $37. c. $162. d. $65.

The total cost of an advanced model would be a. $162. b. $65. c. $200. d. $285.

A significant limitation of activity-based costing is the a. attention given to indirect cost allocation. b. many necessary calculations. c. operations staff’s attitude toward the accounting staff. d. use it makes of technology.

Evaluating customer reaction of the tradeoff of giving up some features of a product for a lower price would best fit which category of management decisions under activity-based management? a. Pricing and product-mix decisions b. Cost reduction decisions c. Design decisions d. Discretionary decisions

CHAPTER 5 QUIZ SOLUTIONS 1.

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Quiz Question Calculations 6.

(2  10) + ($500/250) + ($90/60  10) = $37

$95 + $125 + ($2  15) + ($500/100) + ($90/60  20)

Master Budget and Responsibility Accounting

TRANSITION NOTES Much of this chapter has been rewritten to reflect the fivestep decision model and incorporate activity-based budgeting. The decision model is applied to the process of developing the budget given goals and objectives for the coming year. The illustrative budget preparation problem is updated and includes two cost drivers for the allocation of overhead, taking an ABC approach to budgeting. The assignment of overhead to the cost pools and then to the final cost object is illustrated. The advantages of budgeting are expanded to include facilitate learning as an advantage rather than just performance evaluation. This reflects the renewed managerial focus of this edition. There are a number of new or revised problems in the end-of-chapter material.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 Revised 22 23 Revised 24 25 26 27 28 Revised 29 30 31 32 Revised 33 Revised 34 35

16th Edition 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35

17th Edition 36 37 38 Revised 39 Revised 40 41 42 43 44 Revised 45 Revised 46 47 Revised 48

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16th Edition 36 37 38 39 40 41 42 43 44 45 46 47 48

VII.

LEARNING OBJECTIVES 1.

Describe the master budget and explain its benefits.

Describe the advantages of budgets.

Prepare the operating budget and its supporting schedules.

Use computer-based financial planning models for sensitivity analysis.

Describe responsibility centers and responsibility accounting.

Recognize the human aspects of budgeting.

Appreciate the special challenges of budgeting in multinational companies.

CHAPTER SYNOPSIS This chapter introduces the topic of budgets. Budgets are a primary financial planning tool used by businesses and other organizations. The chapter explains how businesses use and prepare budgets as part of the management process. The concept of responsibility centers and responsibility accounting is also discussed and are related to the concept of controllability. In addition, the human factor in budgeting is covered. The cash budget is presented in the Appendix.

III.

POINTS OF EMPHASIS 1.

Students need to understand the importance of budgeting, even if the budget targets are not achieved. Emphasize the concept that a budget is the financial expression of the goals for the upcoming period. An effective budget requires a well-thoughtout strategy.

Observe that budgets are more than just a planning tool, but help achieve coordination and communication, are useful as a framework for evaluating performance, and can be used to motivate employees.

Make sure students understand the meaning of such budgetary tools as activity-based budgeting, sensitivity analysis, and Kaizen budgeting.

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profit center and an investment center. Make sure they understand when each is used, and the differences in evaluation for each type. Emphasize the concept of controllability. 5.

IV.

Cover the cash budget as time allows. This is an important budget and it is one the students can relate to in their own lives.

CHAPTER OUTLINE LEARNING OBJECTIVE

Describe the master budget … the master budget is the initial budget prepared before the start of a period and explain its benefits … benefits include planning, coordination, and control

1.1

A budget is (1) the quantitative expression of a management’s proposed plan of action by management for a specified period, and (2) an aid to coordinate what needs to be done to implement that plan. TEACHING POINT. A quantitative expression of management’s plan for the future can best be seen in governmental budgeting. When the governor of a state, for example, presents his budget to the legislature, it includes what that governor wants to emphasize during his term. If he wants to be known as an education governor, there will be a large appropriation for education.

1.2

Effective budgeting integrates the company’s strategy into the budget process. Strategy specifies how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its objectives.

1.3

The path to effective strategies includes asking questions such as: •

What are our objectives?

•

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service design, operations and marketing) to create value for our customers while distinguishing ourselves from our competitors? What organizational and financial structures serve us best? •

1.4

1.5

What are the risks and opportunities of alternative strategies, and what are our contingency plans if our preferred plan fails?

Well-managed companies usually follow an annual budget cycle including the following steps: •

Before the start of the fiscal year, managers at all levels take into account the company’s past performance, market feedback, and anticipated future changes to initiate plans for the next period.

•

At the beginning of the fiscal year, senior managers give subordinate managers a frame of reference, a set of specific financial or nonfinancial expectations against which they will compare actual results.

•

During the course of the year, management accountants help managers investigate any deviations from the plans, such as an unexpected decline in sales. If necessary, corrective action follows.

The master budget expresses management’s operating and financial plans for a specified period (usually a fiscal year). The master budget includes a set of budgeted financial statements (sometimes called pro forma statements).

TEACHING POINT. Emphasize the components of the master budget, including the order that those components are prepared. For example, it would be fruitless to assign someone to prepare a production budget until that person knows the sales plans for the upcoming period. (Exhibit 6-1 illustrates the link among strategy, planning, and budgets.)

Refer to Quiz Questions 1 and 6-2

Questions 6-1

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Describe the advantages … coordination, communication, performance evaluation, and managerial motivation and challenges of implementing budgets ….time-consuming back and forth debates

2.1

Budgets are an integral part of management control systems. When administered thoughtfully by managers, budgets do the following: •

Promote coordination and communication among subunits within the company o

•

2.2

Budgets provide a framework for judging performance and facilitating learning. Budgeting can overcome two limitations of using past performance as a basis for judging actual results. o

Past results often incorporate past miscues and substandard performance.

Future conditions can be expected to differ from the past, budgets account for these changed conditions.

Budgets can be used to motivate managers and other employees. Studies have shown that challenging budgets improve employee performance.

Despite the fact that budgets are advantageous, there are a number of challenges in properly administering budgets. •

It is a time-consuming process that involves all levels of management. TEACHING POINT. Gone are the days (if they ever existed) when the accountant was sequestered in his office slaving over the development of a budget, only to emerge once it was complete. Budgets today involve employees throughout the company. The accountant is a budget coordinator, not a budget preparer—but this image still lives on.

•

Management at all levels should understand and support the budget. If top management support is lacking, the budget effort will be lackluster and halfhearted.

•

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Changing conditions may call for changes in plans. TEACHING POINT. The misuse of budgets has given budgeting a bad name. Budgeting is not a “four letter word,” nor is it a hammer to hold over the employee’s head as an excuse to deny funding requests. At one company the primary qualification the VP for finance seemed to have was his ability to say “No.” One manager of a department was often told to cut her budget, but she never saw her budget or knew what or how much she was budgeted.

Refer to Quiz Question 3

LEARNING OBJECTIVE Prepare the operating budget

… the budgeted income statement and its supporting schedules … such as cost of goods sold and nonmanufacturing costs

TEACHING POINT. As each budget is covered, it is useful to demonstrate the preparation of each budget. Problem 6-42 is a useful problem for this purpose. (Exhibit 6-2 provides an overview of the budgeting process.)

3.1

Budgets typically cover a set time period including a full business cycle. Normally an annual budget would be prepared, but broken down into subperiods such as a month or quarter.

3.2

Some companies utilize rolling budgets or continuous budgeting. This type of budget is created by continually adding a month or quarter to the existing budget, so that the company always has a 12-month budget in place.

3.3

The process of preparing the budget incorporates the five-step decision process that was introduced in Chapter 1. (If necessary, review these steps with the students.) The budgeting process includes both operating budgets and financial budgets.

3.4

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revenues, production, manufacturing costs, and other expenses for the period. It culminates in a budgeted income statement. 3.5

Financial budgets consist of a capital expenditures budget, a cash budget, a budgeted balance sheet, and a budgeted statement of cash flows.

3.6

Although details differ among companies, the following basic steps are common for developing the operating budget for a manufacturing company. Step 1:

The first step budget to be prepared is the revenues budget. Although this budget looks simple, the company should put a great amount of time into consideration of the projected sales numbers, as the remainder of the budget process relies on these projections.

TEACHING POINT. Cover the various approaches that can be utilized in arriving at the numbers for the revenues budget. Emphasize the economy, competitors, company plans for new or discontinuing products as relevant factors.

Step 2:

Based on the numbers included in the revenues budget, the company can then prepare the production budget. Included in this budget are projections about inventory levels. This budget is expressed only in units, not dollars.

Step 3:

From the production budget, the company can then move to the direct materials usage and direct materials purchases budgets. These are often prepared as one document. In addition to including projections about inventory levels for direct materials, management must also make predictions about direct material prices.

Step 4:

The direct manufacturing labor cost budget is prepared next. Labor standards—the time allowed per unit of output—are used to calculate direct labor costs. Because labor is not inventoried, the process for this budget is somewhat simpler than prior budgets.

Step 5:

The manufacturing overhead cost budget comes next. It includes a budget for each item of manufacturing overhead. Even though the budget looks simple, keep in mind that each line item in this budget is also its

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own budget. From this budget, managers can determine a predetermined overhead application rate. •

The use of activity-based cost drivers in preparing the manufacturing overhead cost budget gives rise to activity-based budgeting, or a focus on the activities necessary to produce and sell products and services.

Step 6:

The next budget to be prepared is the ending inventories budget. This is simply a listing of the budgeted ending inventories in materials and finished goods. Units and dollar amounts are included. Work-inprocess inventory is not budgeted.

Step 7:

The cost of goods sold budget is then prepared. Most of the information for this budget has already been generated. It is simply a matter of compiling the numbers already available into a cost of goods sold format for this budget.

Step 8:

The operating (nonmanufacturing) cost budget closely resembles the manufacturing overhead cost budget in form. It includes the budgeted amount for all operating costs the company expects to incur for the period (selling, general, and administrative). As with the overhead budget, each line item represents its own budget and follows a fixed/variable separation.

Step 9:

The budgeted, or pro forma, income statement follows the format of an income statement. As with the cost of goods sold budget, many of the items for this budget have already been generated during the budget process.

Refer to Quiz Questions 4 and 5 24, Problem 6-35

LEARNING OBJECTIVE

Exercises 6-21 through 6-

Use computer-based financial planning models for sensitivity analysis … for example, understand the effects of changes in selling prices and direct material prices on

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budgeted income

4.1

Financial planning models are mathematical representations of the relationships among operating activities, financing activities, and other factors that affect the master budget.

4.2

Companies can use computer-based systems, such as Enterprise Resource Planning (ERP) to perform calculations for these planning models.

4.3

Sensitivity analysis is a “what if” technique that examines how a result will change if the original predicted results are not achieved or if an underlying assumption changes. TEACHING POINT. To bring financial planning models down to a level that can be grasped more readily by the students, point out that an Excel spreadsheet that includes formulas can be a type of financial planning model. It is useful to demonstrate here how Excel can be used in sensitivity analysis in a simple spreadsheet. (Exhibits 6-4 and 6-9 display sensitivity analysis results.)

Refer to Quiz Question 6

LEARNING OBJECTIVE Describe responsibility centers

… a part of an organization that a manager is accountable for and responsibility accounting … measurement of plans and actual results that a manager is accountable for

5.1

Organization structure is an arrangement of lines of responsibility within an organization. Organizations can be structured by business function, by product line, or geographically.

5.2

A responsibility center is a part, segment, or subunit of an organization whose manager is accountable for a specified set of activities.

5.3

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center. There are our types of responsibility centers: •

Cost center – The manager is accountable for costs only. The accounting department would be accounted for as a cost center.

•

Revenue center – The manager is accountable for revenues only.

•

Profit center – The manager is accountable for revenues and costs. For example, the shoe department in a department store may be accounted for as a profit center.

•

Investment center – The manager is accountable for investments, revenues and costs. A single store or a division within the company may be accounted for as an investment center. TEACHING POINT. Emphasize that a key to successful responsibility accounting is to properly identify the costs a manager is responsible for. Any costs over which the manager lacks control should not be a part of his evaluation.

5.4

Budgets and responsibility accounting may be combined to provide feedback about performance relative to the budget of different responsibility centers.

5.5

These differences between budgeted and actual results are useful in at least three ways: •

Early warning. These variances may alert managers to events not immediately evident, thus allowing them to take early corrective action or exploit the available opportunities.

•

Performance evaluation. The variances allow managers to assess how well the company has performed in implementing its strategies.

•

Evaluating strategy. Variance may signal that the strategies being pursued by management are ineffective and need changing.

5.6

Controllability is the degree of influence that a specific manager has over costs, revenues, or related items for which he or she is responsible.

5.7

A controllable cost is any cost that is primarily subject to the influence of a given responsibility center manager for a given period.

5.8

This controllability can be difficult to pinpoint for two reasons: •

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•

With a long enough time span, all costs will come under someone’s control. Most performance reports cover a period of one year or less, so this does not normally present a problem.

Refer to Quiz Question 8

LEARNING OBJECTIVE

Recognize the human aspects of budgeting … to engage subordinate managers in the budgeting process

6.1

A budget is more effective when the lower-level managers actively engage in the budget process. This participation adds credibility to the budgeting process and creates greater commitment and accountability toward the budget.

6.2

Managers frequently play games with budgets and build in budgetary slack. This is the practice of underestimating revenues, overestimating costs, or overestimating time in order to make the budget targets more easily achievable. TEACHING POINT. Ask the students “If I gave you an assignment to report to the class on responsibility accounting, how soon could you have it ready for me?” Then probe their responses to bring out the fact that they have overestimated the time they really think they need to complete the task. This is an example of budgetary slack. Explore the reasons they built slack into their estimates.

6.3

Stretch targets are challenging but achievable levels of expected performance intended to create a little discomfort. Many of the best performing companies, such as General Electric, Microsoft and Novartis, set stretch targets.

6.4

Kaizen budgeting is a budgetary process that explicitly incorporates continuous improvement during the budget period. TEACHING POINT. Students will often question limits of improvements and cost reductions. Point out that Kaizen is about working smarter, not working harder. The idea is to find better ways, not just faster ways to produce the product or

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service.

6.5

A significant aspect of Kaizen budgeting is employee input. Companies that implement Kaizen budgeting believe that employees involved in the manufacturing, sales, or distribution process have the best information and knowledge on how the job can be done better.

6.6

Many companies proactively manage and report on environmental performance. Budgeting, using science-based targets, is a very effective tool to motivate managers to lessen carbon emissions. Refer to Quiz Questions 9 and 10 Exercise 6-31

LEARNING OBJECTIVE

Appreciate the special challenges of budgeting in multinational companies … exposure to currency fluctuations and to different legal, political, and economic environments

7.1 In budgeting in multinational companies three adjustments must be made: •

Operating results must be translated into a common currency for external financial reporting. Managers should anticipate fluctuations in exchange rates. Many managers use forward, future, and option contracts to minimize the exposure to foreign currency fluctuations.

•

A currency gain or loss must be budgeted and recognized when currencies are translated.

The political, legal, and economic environments must be understood.7.2 When conditions are volatile, budgeting is not useful for evaluating performance. Instead, managers use budgets to help them adapt their plans and coordinate their actions as circumstances change.

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A.1

The cash budget is an important component of the budgeting process. This chapter illustrates the operating budget, which is one part of the master budget.

A.2

The financial budget is the other part of the master budget, and includes the capital expenditures budget, the cash budget, the budgeted balance sheet, and the budgeted statement of cash flows.

A.3

The appendix focuses on the cash budget. It is best illustrated through example. Work through Problem 6-41 to illustrate this concept. If time is limited, use the chapter quiz, questions 11 and 12. Exhibit 6-6 presents a quarterly cash budget for Sylistic Furniture. Each section is explained in the text.

A.3

Refer to Quiz Questions 11 and 12 Exercise 6-34

CHAPTER 6 QUIZ 1.

Budgeting is the common accounting tool companies’ use for planning and controlling. Budgets a. provide a measure of planned financial results. b. are prepared independent of the company’s long-term strategies. c. do not usually reflect actual results, so they are a useless exercise. Copyright © 2021

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d. 2.

serve as the financial expression of management’s plans for the upcoming period.

[AICPA Adapted] Dewitt Co. budgeted its activity for October 2020 from the following information: • Sales are budgeted at $750,000. All sales are credit sales and a provision for doubtful accounts is made monthly at the rate of 2% of sales. • Merchandise inventory was $120,000 at September 30, 2004, and an increase of $10,000 is planned for the month. • Merchandise purchases are expected to be $497,500 during the month. • Estimated cash disbursements for selling and administrative expenses for the month are $105,000. • Depreciation for the month is projected at $25,000. Dewitt is projecting operating income for October 20204 in the amount of a. $105,000. b. $117,500. c. $129,000. d. $97,500.

Which of the following is not a major benefit of budgets? a. Compels planning b. Eliminates innovation c. Provides performance criteria d. Promotes coordination and communication

The following data apply to questions 4 and 5. Hester Company budgets on an annual basis for its fiscal year. The following beginning and ending inventory levels (in units) are planned for the fiscal year of July 1, 2020 through June 30, 2021. Raw material1 Work-in-process Finished goods

July 1, 2020 June 30, 2020 40,000 10,000 8,000 8,000 30,000 5,000

Three (3) units of raw material are needed to produce each unit of finished product.

[CMA Adapted] If Hester Company plans to sell 500,000 units during the 2020–2021 fiscal year, the number of units it would have to manufacture during the year would be a. 505,000 units. b. 500,000 units. c. 480,000 units. d. 475,000 units.

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[CMA Adapted] If 450,000 finished units were to be manufactured during the 2020–2021 fiscal year by Hester Company, the units of raw material needed to be purchased would be a. 1,395,000 units. b. 1,360,000 units. c. 1,320,000 units. d. 1,330,000 units.

Which of the following does not pertain to financial planning models in software form? a. Reduces computational burden and time required to prepare budgets b. Eliminates need to update budgets as uncertainty resolved c. Assists managers with sensitivity analysis d. Performs calculations that are mathematical representations of relationships in master budget

The major cost management concept used in Kaizen budgeting is that of a. eliminating inventories of every type but materials. b. refinements in the indirect-cost categories for costing systems. c. continuous improvement. d. sensitivity analysis using computer-based financial planning models.

Which of the following statements does not describe responsibility accounting? a. It measures the plans and actions of each responsibility center. b. It budgets to emphasize that for which each responsibility center is accountable. c. It calculates variances between budgeted and actual accountability for each responsibility center. d. It identifies managers at fault for operating problems by reports for each responsibility center.

Controllability a. is always clear cut as to who has responsibility for a cost. b. is another term for responsibility. c. is the responsibility of the corporate controller. d. is the degree of influence a specific manager has over costs, revenues, and other items.

10.

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c. d.

should be totally eliminated from the budget. is not found in governmental budgets.

The following data apply to questions 11 and 12 [Appendix]. Information pertaining to Brenton Corporation’s sales revenue is presented in the following table. February Cash sales Credit sales Total sales

March

April

$160,000 $150,000 $120,000 300,000 400,000 280,000 $460,000 $550,000 $400,000

Management estimates that 5% of credit sales are not collectible. Of the credit sales that are collectible, 60% are collected in the month of sale and the remainder in the month following the sale. Cost of purchases of inventory each month is 70% of the next month’s projected total sales. All purchases of inventory are on account; 25% are paid in the month of purchase, and the remainder is paid in the month following the purchase. 11.

[CMA Adapted] Brenton’s budgeted total cash receipts in April are a. $448,000. b. $437,000. c. $431,600. d. $328,000.

12.

[CMA Adapted] Brenton’s budgeted total cash payments in March for inventory purchases are a. $385,000. b. $358,750. c. $306,250. d. $280,000.

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CHAPTER 6 QUIZ SOLUTIONS 1.

10.

11.

12.

Quiz Question Calculations 2.

Sales $750.000 Cost of goods sold (487.500) (Beg Inv + Purchases – Ending inventory (Beg Inv + $10,000 OR $120,000 + $497,500 $130,000 = $487,500) Bad debt expense (15,000) S & A expense (105,000) Depreciation expense (25,000) Operating income

117,500

Sales 500,000 + Ending inventory 5,000 – Beginning inventory (30,000) Production

475,000

Required for production 3  450,000 = 1,350,000 + Ending inventory 10,000 – Beginning inventory (40,000) Purchases 1,320,000

11.

Cash receipts From April cash sales $120,000 From April credit sales 0.60(280,000  0.95) 159,600 From March credit sales 0.40(400,000  0.95) 152,000 Total collections $431,600

12.

75% paid in March

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March purchases 400,000  0.7 = 280,000 = 70,000 Total cash payments in March

25% paid in March $358,750

Flexible Budgets, Direct-Cost Variances, and Management Control

TRANSITION NOTES The discussion of the different levels of variance analysis has been streamlined, making for a more readable text. The links between the production variances and the sales-volume variances have been emphasized and tightened. Problem material in this chapter has been heavily revised, with a number of new problems and exercises introduced.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 Revised 22 23 24 Revised 25 26 27 28 29 30 31 32 Revised 33 34

16th Edition 21 22 23 24 25 26 27 28 29 30 31 32 33 34

17th Edition 35 36 Revised 37 Revised 38 39 40 41 Revised 42 Revised 43 Revised 44 45 New 46 Revised 47

16th Edition 35 36 37 38 39 40 41 42 43 44 46 47

LEARNING OBJECTIVES 1.

Understand static budgets and static-budget variances.

Examine the concept of a flexible budget and learn how to develop it.

Calculate flexible-budget variances and sales-volume variances.

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Explain why standard costs are often used in variance analysis.

Compute price variances and efficiency variances for direct-cost categories.

Understand how managers use variances.

Describe benchmarking and explain its role in cost management.

VIII. CHAPTER SYNOPSIS This chapter introduces the concept of flexible budgets and variances. Direct-cost variances—direct materials price and efficiency variances and direct labor price and efficiency variances are calculated and analyzed. In addition, managerial use of variances and benchmarking are discussed.

III.

IV.

POINTS OF EMPHASIS 1.

Students will find this material difficult. It is not enough to lecture on the material, variance analysis must be demonstrated and the students must be engaged to the point of calculating variances on their own. It is helpful to walk through the variance exhibits given in the chapter. Also, Exhibit 7–1 can be a useful template for the students in performing variance analysis. The comprehensive variance analysis problems at the end of the chapter are good to reinforce these concepts.

Be certain the students understand the interrelationships of efficiency and effectiveness and how easy it may become to emphasize one to the detriment of the other. In addition, emphasize the other uses of variance analysis—organizational learning and continuous improvement. Students can tolerate variance analysis much more readily if they perceive their usefulness.

CHAPTER OUTLINE LEARNING OBJECTIVE

Understand static budgets … the master budget based on output planned at

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start of period and static-budget variances … the difference between the actual result and the corresponding amount in the static budget

1.1

A variance is the difference between the actual results and the expected performance otherwise known as budgeted performance.

1.2

Variances enable managers to utilize management by exception as they highlight areas that are not operating as expected.

1.3

A static budget, or master budget, is based on the level of output planned at the start of the budget period.

1.4

A static-budget variance, then, is the difference between actual results and the corresponding budgeted amounts in the static budget.

1.5

A favorable variance, denoted F in this book, has the effect, when considered in isolation, of increasing operating income relative to the budgeted amount.

1.6

An unfavorable variance, denoted U in this book, has the effect, when viewed in isolation, of decreasing operating income relative to the budgeted amount. (Exhibit 7-1 illustrates the static-budget variance analysis for the Webb Company.) TEACHING POINT. At this point it is good to emphasize two points about variances. First, variance analysis is not simple. In order to fully understand variance analysis, one needs to understand the terminology. However, variance analysis is very valuable in that it can provide much useful information about how the company is operating. Second, the variances illustrated in this chapter (and others) are only the beginning of variance analysis. Anytime there are budgeted and actual amounts, a variance can be calculated.

Refer to Quiz Question 1 Quiz Question #1 is about Flexible Budgets LEARNING OBJECTIVE

Examine the concept of a flexible budget … the budget that is adjusted (flexed) to recognize the actual output level

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and learn how to develop one … proportionately increase variable costs; keep fixed costs the same

2.1

A flexible budget calculates budgeted revenues and budgeted costs based on the actual output in the budget period. This allows management to compare actual results with budgeted results for the actual activity level. The three-step process for developing the flexible budget is as follows: •

Identify the actual

•

Calculate flexible-budget for revenues based on budgeted selling price  actual quantity of output).

•

Calculate the flexible-budget for costs based on the budgeted variable cost per output unit, actual quantity of output and budgeted fixed costs.

quantity of output

(The flexible budget for Webb Company can be found in column 3 on Exhibit 7-2. The static budget is in column 5 on that Exhibit.)

LEARNING OBJECTIVE

Calculate flexible-budget variances … each flexible-budget variance is the difference between an actual result and a flexible-budget amount and sales-volume variances … each sales-volume variance is the difference between a flexible-budget amount and a staticbudget amount

3.1

The sales-volume variance is the difference between a flexible budget amount (calculated with actual output) and the corresponding static-budget amount.

3.2

The flexible-budget variance is the difference between an actual result and the corresponding flexible-budget amount.

3.3

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difference between the actual selling price and the budgeted selling price. (Exhibits 7-2 and 7-3 display flexible-budget variance analysis for the Webb Company.) (Exhibit 7-4 illustrates the relationship between static and flexible-budget variances.)

Refer to Quiz Questions 2 and 3 Exercises 7-21 through 7-25

LEARNING OBJECTIVE

Explain why standard costs are often used in variance analysis … standard costs exclude past inefficiencies and take into account expected future changes

4.1

A standard is a carefully determined price, cost, or quantity that is used as a benchmark for judging performance. It is usually expressed on a per-unit basis. •

A standard input is a quantity of input such as 2 pounds of raw material or one direct labor hour for each completed unit.

•

A standard price is the price a company expects to pay for a unit of input, such as $10 per direct labor hour.

•

A standard cost is the cost to the company of a unit of output, such as direct material cost of a completed unit. TEACHING POINT. Involve the students in a discussion of standards. A good example of a standard is the speed limits on the interstate highway. There is both a minimum and a maximum standard, expressed as minimum speed and the speed limit.

4.2

A standard can be thought of as a budget for one unit of product.

4.3

Standards, as used in variance analysis, have two advantages: •

They seek to exclude past efficiencies.

•

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4.4

Standards also simplify product costing, enabling the company to cost a product immediately upon its completion.

Refer to Quiz Question 4

LEARNING OBJECTIVE

Compute price variances … each price variance is the difference between an actual input price and a budgeted input price and efficiency variances … each efficiency variance is the difference between an actual input quantity and a budgeted input quantity for actual output for direct-cost categories

5.1

The total variance for direct materials and direct labor can be subdivided into two components—price and efficiency. These two variances help explain the two reasons that the actual cost differs from the budgeted numbers. TEACHING POINT. Sometimes these variances go by other names. The direct-material variances may be called price and usage variances. The direct-labor variances may be called rate and efficiency variances. This should be pointed out to the students. As the variance for both direct cost categories are calculated in a similar manner, it is less confusing to the student to use the consistent terminology of price and efficiency.

5.2

The price variance is the difference between actual price and budgeted price, multiplied by the actual input quantity such as direct materials (or When referring to direct labor, this is sometimes called the rate variance. Price Variance = (Actual Price of Input – Budgeted Price of Input)  Actual Quantity of Input (such as direct materials used)

5.3

The efficiency variance is the difference between an actual input quantity used (such as square yards of cloth) and the budgeted input quantity for actual output multiplied by budgeted price. For direct materials, this is sometimes referred to as the usage Copyright © 2021

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variance. Efficiency Variance = (Actual Qty of Input Used – Budgeted Qty of Input allowed for actual output)  Budgeted Price of Input TEACHING POINT. At this point it is important to demonstrate the calculation of the variances and get the students engaged in calculating them on their own.

5.4

In a standard cost system, inputs are recorded at standard. The impact of this is that the variances are isolated and recorded in the accounting system. In addition to simplifying product costing, this procedure draws attention to the variances. What becomes visible (variances) is more likely to receive management attention. TEACHING POINT. It is a good idea to walk the students through the journal entries for a standard costing system. This demonstrates the effects of recording inputs at standard cost. It also demonstrates drawing attention to the variances.

Refer to Quiz Questions 5 and 6 Exercises 7-26 and 7-28

LEARNING OBJECTIVE

Understand how managers use variances … managers use variances to improve future performance

6.1

6.2

Managers use variances in three ways: •

To evaluate performance after decisions are implemented

•

To trigger organizational learning

•

To make continuous improvements

Variances should not be interpreted in isolation. The cause of a variance in one part of the value chain may be related to decisions made in another.

TEACHING POINT. Discuss possible causes of variances and how one may affect another. For example, a favorable materials price variance may give rise to an unfavorable efficiency variance

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if the cheaper material is of lower quality. This may also result in an unfavorable labor efficiency variance as the workers find the lower-quality material more difficult to work with. Also, a favorable direct materials efficiency variance may be due to an experienced workforce. However, experienced workers are paid more and there may be an unfavorable direct labor price variance as a result. The opposite can be true with inexperienced workers.

6.3

Variances should be investigated when they are considered material. Frequently, this may be a subjective judgment or rule of thumb. It is equally important to investigate favorable variances as unfavorable. For example, all variances resulting from defective raw materials might be investigated, regardless of amount.

6.4

Managerial performance evaluation occurs on two dimensions—effectiveness and efficiency. • •

Effectiveness is the degree to which a predetermined objective or target is met. Efficiency is the relative amount of inputs used to achieve a given output level. TEACHING POINT. A manager of a restaurant once persuaded a group to have their annual banquet in his facility. However, in order to do so, he had to provide them with a degree of privacy. So he rented a portable partition to provide this privacy. Unfortunately, the cost of renting the partition almost equaled the revenue generated from the banquet (not even considering food and labor costs). The manager was effective in generating revenues, but he did not do it efficiently.

6.5

The second use of variances is organizational learning. Managers need to understand why variances arise, learn from them, and improve future performance.

6.6

Finally, variances are used to create a cycle of continuous improvement by identifying causes of the variances, initiating corrective actions, and evaluating the results of those actions.

6.7

Most companies utilize a combination of financial and nonfinancial measures for planning and control. Focusing on one or the other can result in an undue emphasis on that type of measure.

Refer to Quiz Question 7 Problem 7-40

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LEARNING OBJECTIVE

Describe benchmarking and explain its role in cost management … benchmarking compares actual performance against the best levels of performance

7.1

Benchmarking is the continuous process of comparing one company’s performance levels against the best levels of performance in competing companies or in companies having similar processes.

7.2

Managers will know the company will be competitive if it can attain the standards set by benchmarking. TEACHING POINT. It may be difficult for a company to attain sufficient information from competitors to set a valid benchmark. The company should not hesitate to look outside the industry. For example, if they want to benchmark their accounts receivable function, find a company who is not a competitor and benchmark against that company. Another approach would be to benchmark against the best within the company. One hotel chain selected its own properties as benchmark properties. The downtown Atlanta property may have been the benchmark for customer service, for example. (Exhibit 7-5 displays a benchmark comparison of airline costs/revenues per seat mile.)

Refer to Quiz Question 9 Problem 7-43

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Exhibit 7-4 illustrates the relationship between static and flexible-budget variances. Exhibit 7-5 displays a benchmark comparison of airline costs/revenues per seat mile.

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CHAPTER 7 QUIZ 1.

[CMA Adapted] Flexible budgets a. accommodate changes in the inflation rate. b. accommodate changes in activity levels. c. are used to evaluate capacity utilization. d. are static budgets that have been revised for changes in price(s).

[CMA Adapted] The following information is available for the Gabriel Products Company for the month of July: Static Budget Actual Units 5,000 5,100 Sales revenue $60,000 $58,650 Variable manufacturing costs $15,000 $16,320 Fixed manufacturing costs $18,000 $17,000 Variable marketing and administrative expense $10,000 $10,500 Fixed marketing and administrative expense $12,000 $11,000 The total sales-volume variance for operating income for the month of July would be a. $2,550 unfavorable. b. $1,350 unfavorable. c. $700 favorable. d. $100 favorable.

[CMA Adapted] Bartholomew Corporation’s master budget calls for the production of 6,000 units of product monthly. The master budget includes indirect labor of $396,000 annually; Bartholomew considers indirect labor to be a variable cost. During the month of September, 5,600 units of product were produced, and indirect labor costs of $30,970 were incurred. A performance report utilizing flexible budgeting would report a flexible-budget variance for indirect labor of a. $170 unfavorable. b. $170 favorable. c. $2,030 unfavorable. d. $2,030 favorable.

Which of the following is not an advantage for using standard costs for variance analysis? a. Standards simplify product costing. b. Standards are developed using past costs and are available at a relatively low cost. Copyright © 2021

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c. d. 5.

Standards are usually expressed on a per-unit basis. Standards can take into account expected changes planned to occur in the budgeted period.

Information on Pruitt Company’s direct-material costs for the month of July 2020 was as follows: Actual quantity purchased 30,000 units Actual unit purchase price $2.75 Materials purchase-price variance —unfavorable (based on purchases) $1,500 Standard quantity allowed for actual production 24,000 units Actual quantity used 22,000 units [CPA Adapted] For July 2020 there was a favorable directmaterials efficiency variance of a. $7,950. b. $5,500. c. $5,400. d. $5,600.

Information for Garner Company’s direct-labor costs for the month of September 2020 was as follows: Actual direct-labor hours 34,500 hours Standard direct-labor hours 35,000 hours Total direct-labor payroll $241,500 Direct-labor efficiency variance—favorable $3,200 [CPA Adapted] What is Garner’s direct-labor price (or rate) variance? a. $21,000 favorable b. $21,000 unfavorable c. $17,250 unfavorable d. $20,700 unfavorable

Performance evaluation using variance analysis should guard against a. emphasis on a single performance measure. b. emphasis on total company objectives. c. basing effect of a manager’s action on total costs of the company as a whole. d. highlighting individual aspects of performance.

The basic principles and concepts of variance analysis can be applied to activity-based costing a. by application as to the levels of cost hierarchy. b. through careful classification of costs as direct and indirect as applied to the product or job. c. with use of standard costing systems only. d. only through those activities related to individual units of product or service. Copyright © 2021

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Benchmarking is a. relatively easy to do with the amount of available financial information about companies. b. best done with the best in their field regardless of type of company. c. simply reporting the magnitude of differences in costs or revenues across companies. d. making comparisons to direct attention to why differences in costs exist across companies.

CHAPTER 7 QUIZ SOLUTIONS 1.

Quiz Question Calculations 2.

5,100 – 5,000 = 100 units  $7* = $700F Unit CM = (60,000 – 15,000 – 10,000) / 5,000 = $7

Actual DL $30,970 Flexible budget 5,600  $5.50 30,800 Flexible-budget variance 170 U

Actual price 30,000  2.75 82,500 Minus unfavorable price variance 1,500 Materials at standard 81,000 81,000/30,000 = $2.70 standard price per unit Actual quantity Standard quantity Efficiency variance

22,000 units 24,000 units 2,000  1.70 = $5,400 F $241,500 $220,800 10-59 Pearson Education, Inc.

Price variance

20,700 U

Standard rate = 3,200/(35,000 – 34,500) = $6.40

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FLEXIBLE-BUDGET AND SALES-VOLUME VARIANCE ANALYSIS Actual Results: Flexible Budget: Static Budget: Actual Units Sold Actual Units Sold Budgeted Units Sold X Actual Sales Mix X Actual Sales Mix X Budgeted Sales Mix X Actual CM/unit X Budgeted CM/unit X Budgeted CM/unit | - - - - Flexible-budget variance - - - - | - - - - Sales-volume variance - - - - | | - - - - - - - - - - - - - - - - - - - Static-budget variance - - - - -- - - - - - - - - - | SALES-MIX AND SALES-QUANTITY VARIANCE ANALYSIS Flexible Budget: Static Budget: Actual Units Sold Actual Units Sold Budgeted Units Sold X Actual Sales Mix X Budgeted Sales Mix X Budgeted Sales Mix X Budgeted CM/unit X Budgeted CM/unit X Budgeted CM/unit | - - - - - - Sales-mix variance - - - - - | - - - - Sales-quantity variance - - - - | | - - - - - - - - - - - - - - - - - - - Sales-volume variance - - - - - - - - - - - - - - | MARKET-SHARE AND MARKET-SIZE VARIANCE ANALYSIS Flexible Budget: Static Budget: Actual Market Size Actual Market Size Budgeted Market Size X Actual Market Share X Budgeted Market Share X Budgeted Market Share X Budgeted CM/unit X Budgeted CM/unit X Budgeted CM/unit | - - - - - - Market-share variance - - - - - | - - - - Market-size variance - - - - | | - - - - - - - - - - - - - - - - - - - Sales-quantity variance - - - - - - - - - - - - - - | INPUT PRICE AND EFFICIENCY VARIANCES Actual Costs: Flexible Budget: Actual Input Actual Input Budgeted Input (for actual output) X Actual Price X Budgeted Price X Budgeted Price | - - - - - - - Price variance - - - - - - - | - - - - - - Efficiency variance - - - - - - - | | - - - - - - - - - - - - - - - - - - - Flexible-budget variance - - - - -- - - - - - ----- - - - | INPUT YIELD AND MIX VARIANCES Actual Input/Actual Mix : Actual Inputs Used

(for actual output) X Actual Input Mix X Budgeted Input Mix X Budgeted Input Mix X Budgeted Price X Budgeted Price X Budgeted Price | - - - - - - - - Mix variance - - - - - - - - | - - - - - - - - Yield variance - - - - - - - | | - - - - - - - - - - - - - - - - - - - Efficiency variance - - - - - - - - - - - - - - - - - - - |

Flexible Budgets, Overhead Cost Variances, and Management Control

TRANSITION NOTES The five-step decision process is incorporated into this chapter as management faces decisions that must be made based upon the overhead variances. The discussion of overhead variances is streamlined making the discussion more readable. The end-of-chapter problem material has undergone significant revisions, with a number of new problems.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 22 23 24 25 Revised 26 Revised 27 Revised 28 29 Revised 30 Revised 31 32 Revised 33 34

16th Edition 21 22 23 24 25 26 27 28 29 30 31 32 33 34

17th Edition 35 36 37 38 39 Revised 40 41 Revised 42 Revised 43 44 45 46 Revised 47 Revised 48 Revised

16th Edition 35 36 37 38 39 40 41 42 43 44 45 46 47 48

LEARNING OBJECTIVES 1.

Explain the similarities and differences in planning variable overhead costs and fixed overhead costs.

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IX.

Develop budgeted variable overhead cost rates and budgeted fixed overhead cost rates.

Compute the variable overhead flexible-budget variance, the variable overhead efficiency variance, and the variable overhead spending variance.

Compute the fixed overhead flexible-budget variance, the fixed overhead spending variance, and the fixed overhead production-volume variance.

Show how the 4-variance analysis approach reconciles the actual overhead incurred with the overhead amounts allocated during the period.

Explain the relationship between the sales-volume variance and the production-volume variance.

Calculate overhead variances in activity-based costing.

Examine the use of overhead variances in nonmanufacturing settings.

CHAPTER SYNOPSIS The previous chapter focused on analysis of direct manufacturing costs. This chapter moves into planning and variance analysis of variable and fixed manufacturing overhead. Development of budgeted overhead cost rates is covered. Variable overhead spending and efficiency variance are presented, followed by fixed overhead spending and production-volume variances. A 4-way variance analysis is presented, along with the application of variance analysis in nonmanufacturing and service sectors. Finally, application of variance analysis in an ABC system is presented.

III.

POINTS OF EMPHASIS 1.

Developing budgeted variable overhead cost rates is critical to effectively managing overhead and conducting performance evaluation. Emphasize to the students that a “good” overhead rate using a valid cost driver is the foundation of effective overhead cost allocation.

Make sure the students understand the reasons and the potential problems associated with expressing fixed costs on a per-unit basis. Students often fall into the trap of using the same fixed cost per unit when volume changes. Copyright © 2021

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IV.

Presentation of the 4-way, 3-way, 2-way, and 1-way variance analysis can help the students see how these variances are related to one another. It is also an opportunity to demonstrate that different levels of management need different levels of detail in the reporting system.

CHAPTER OUTLINE LEARNING OBJECTIVE

Explain the similarities and differences in planning variable overhead costs and fixed overhead costs … for both, plan only essential activities and be efficient; fixed overhead costs are usually determined well before the budget period begins

1.1

Managing overhead costs is challenging. Managers must understand the behavior of overhead costs, plan for them, perform variance analysis, and act upon the results.

1.2

In planning variable overhead costs, managers must focus attention on activities that create a superior product or service and eliminate activities that do not add value.

1.3

Examining how each item of variable overhead relates to delivering a superior product or service is part of this process.

1.4

Effective planning for fixed overhead costs is similar to planning for variable overhead costs—focusing on eliminating the non-value-added costs.

1.5

An additional strategic issue for managers in fixed costs is choosing the appropriate level of capacity that will benefit the company in the long run.

1.6

Timing is an important issue in this planning. By the beginning of the budget period most decisions regarding fixed costs will have been made. With variable costs, day-to-day operating decisions affect the level of variable costs incurred in the period. TEACHING POINT. This is a good time to emphasize that fixed costs provide capacity. As such, the level of fixed costs must be determined well in advance of the budget period and those costs are frequently locked in for an extended time period. Thus this

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decision-making process can have a long-term effect on company profitability. Check recent business news articles for companies that have downsized, taking large losses while reducing capacity.

Refer to Quiz Question 1

LEARNING OBJECTIVE

Develop budgeted variable overhead cost rates … budgeted variable costs divided by quantity of cost-allocation base and budgeted fixed overhead cost rates … budgeted fixed costs divided by quantity of costallocation base

2.1

Standard costing is a costing system that (1) traces direct costs to output produced by multiplying the standard prices or rates produced by the standard quantities of inputs allowed for actual outputs produced, and (2) allocates overhead costs on the basis of the standard overhead cost rates times the standard quantities of the allocation bases allowed for the actual outputs produced

2.2

Developing budgeted variable overhead cost-allocation rates is a four-step process. TEACHING POINT. This process will become much clearer to the student if an example is used to work through the process of developing these cost rates. The Webb Company example in the text can be utilized.

Step 1:

Choose the Period to Be Used for the Budget. Normally companies will use a 12month period for budgeting, but a shorter time frame may be appropriate in given situations.

Step 2:

Select the Cost-Allocation Bases to Use in Allocating the Variable Overhead Costs to the Output Produced. In selecting the costallocation bases, management is seeking a cause-and-effect relationship between the cost and the base, or cost driver.

Step 3:

Identify the Variable Overhead Costs

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Associated with Each Cost-Allocation Base. TEACHING POINT. Identifying the cost-allocation bases and the costs associated with those bases are not necessarily sequential steps. The two frequently interact with each other as additional costs or drivers are identified and defined. The number of allocation bases and cost pools will vary depending on the system utilized by the company. With an activity-based system, there will be several drivers and cost pools.

Step 4:

Compute the Rate per Unit of Each CostAllocation Base Used to Allocate Variable Overhead Costs to Output Produced.

Budgeted variable overhead cost rate per output unit = Budgeted input allowed per output unit x Budgeted variable overhead cost rate per input unit 2.3

Fixed overhead costs are, by definition, a lump sum of costs that remain unchanged in total for a given period despite wide changes in the level of activity.

2.4

These costs are fixed in the sense that they do not automatically increase or decrease with the level of activity within the relevant range. TEACHING POINT. Discuss unitized fixed costs. Emphasize that fixed costs are expressed on a per-unit basis to facilitate assigning a unit cost to the product or service. Illustrate that a change in the level of activity changes the per-unit cost of the fixed amount, not the total fixed cost.

2.5

As with variable costs, there is a four-step procedure for developing the budgeted fixed overhead rate. Step 1:

Choose the Period to Use for the Budget. As with variable costs, this budget period is usually 12 months.

Step 2:

Select the Cost-Allocation Bases to Use in Allocating Fixed Overhead Costs to Output Produced. The cost driver, or allocation base, is also referred to as the denominator level as it is the denominator in the fixed overhead rate computation.

TEACHING POINT. Due to the nature of fixed costs it is not always feasible or possible to find a cause-and-effect relationship between the level of activity and the costs incurred. Therefore, even in a well-developed activity-based costing system, a company is likely to have an element of fixed overhead that is allocated under some “generic” allocation base such as machine hours or direct labor hours.

Step 3:

Identify the Fixed Overhead Costs

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Associated with Each Cost-Allocation Base. Step 4:

Compute the Rate per Unit of Each CostAllocation Base Used to Allocate Fixed Overhead Costs to Output Produced.

Budgeted fixed overhead cost per unit of costallocation base = Budgeted total costs in fixed overhead cost pool / Budgeted total quantity of cost-allocation base Refer to Quiz Question 2

LEARNING OBJECTIVE

Compute the variable overhead flexible-budget variance, … difference between actual variable overhead costs and flexible-budget variable overhead amounts the variable overhead efficiency variance, … difference between actual quantity of costallocation base and budgeted quantity of costallocation base and the variable overhead spending variance … difference between actual variable overhead cost rate and budgeted variable overhead cost rate

3.1

The variable overhead flexible-budget variance measures the difference between actual variable overhead costs incurred and the flexible-budget overhead amounts. Variable overhead Actual costs Flexible-budget flexible-budget variance = incurred amount

3.2

–

This variance reveals how much variable overhead costs differed from the flexible budget amount. However, it does little to explain why this difference occurred. To learn why the variance arose, it needs to be divided into two components—variable overhead efficiency variance and the variable overhead spending variance. TEACHING POINT. Demonstrating the variable overhead variances as you explain each one will help the students grasp the differences and meaning of each. It will also be helpful to explain what each variance represents using nonaccounting

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language.

3.3

The variable overhead efficiency variance measures the difference between actual quantities of the costallocation base used and budgeted quantities of the cost-allocation base that should have been used to produce actual output. Variable overhead efficiency variance = (Actual Qty of Cost-Allocation Base used for Actual Output – Standard (Budgeted) Qty of CostAllocation Base allowed for actual output)  Standard (Budgeted) variable overhead cost per unit of cost-allocation base (Price) TEACHING POINT. The variable overhead efficiency variance measures the efficiency with which the cost-allocation base is used. For example, if the allocation base is direct labor hours and there is an unfavorable direct labor efficiency variance, the variable overhead efficiency variance will also be unfavorable.

3.4

The variable overhead spending variance is the difference between the actual variable overhead cost per unit of the cost-allocation base and the budgeted variable overhead cost per unit of the cost-allocation base, multiplied by the actual quantity of variable overhead cost-allocation base used. This variance arises simply because the items that make up variable overhead cost more or less than was budgeted. Variable overhead spending variance = (Actual variable overhead cost per unit of costallocation base – Standard (Budgeted) variable overhead cost per unit of cost-Allocation Base)  Actual Qty of variable overhead cost-allocation base used (Exhibit 8-5 displays variable overhead efficiency and spending variance calculations.)

3.5

In recording the journal entries for variable overhead, the variances are included so that the costs of the products or services are recorded at standard. Note that an unfavorable variance will be recorded as a debit and a favorable variance as a credit. TEACHING POINT. In illustrating the computation of these variances it will reinforce the concept for the students if you conclude by illustrating the journal entries.

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LEARNING OBJECTIVE

Compute the fixed overhead flexible-budget variance, … difference between actual fixed overhead costs and flexible-budget fixed overhead amounts the fixed overhead spending variance, … same as the fixed overhead flexible-budget variance (no efficiency variance for fixed overhead costs.) and the fixed overhead production-volume variance … difference between budgeted fixed overhead and fixed overhead allocated on the basis of actual output produced

4.1

The flexible-budget amount for a fixed cost item is also the amount included in the static budget prepared at the start of the period because fixed costs are not affected by changes in output. TEACHING POINT. As with the variable overhead variances, demonstrating the fixed overhead variances as you explain each one will help the students grasp the differences and meaning of each. It will also be helpful to explain what each variance represents using nonaccounting language.

4.2

The fixed overhead flexible-budget variance is the difference between actual fixed overhead costs and fixed overhead costs in the flexible budget. Fixed overhead Actual costs Flexible-budget flexible-budget variance = incurred amount

–

4.3

Note that there is no fixed overhead efficiency variance because the amount of fixed overhead is unaffected by how efficiently the allocation basis is used to produce output.

4.4

Because there is no fixed overhead efficiency variance, the fixed overhead spending variance and the fixed overhead flexible-budget variance are the same. Fixed overhead Flexible-budget Copyright © 2021

Actual costs

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spending variance = – amount

incurred

4.5

This variance arises because the items making up the fixed overhead cost (such as insurance) were more or less than was budgeted.

4.6

The production-volume variance (also known as the denominator-level variance) arises only for fixed costs. This variance is the difference between budgeted fixed overhead and fixed overhead allocated based on the number of units actually produced. Production Budgeted Fixed overhead allocated volume variance = fixed overhead – for actual output units produced

4.7

The production-volume variance is an indicator of the use of capacity. If the company exceeded planned capacity, the variance is favorable, as fixed overhead is divided among a greater number of units. If the company fell short of planned capacity, the variance is unfavorable, as there was unused capacity. It should be noted that this variance is directly influenced by the production-denominator level, or definition of capacity for determining the application rate.

4.8

Another way to view the production-volume variance is that a favorable variance indicates that overhead was overallocated; if unfavorable, overhead is underallocated. (Exhibit 8-3 is a graphic presentation of the production-volume variance.)

4.9

As with variable overhead, the journal entries for fixed overhead incorporate the variances into the accounts. TEACHING POINT. As with variable overhead variances, the concept will be reinforced if you conclude by illustrating the journal entries.

4.10 At the end of the accounting period, any balance in the variable or fixed overhead variance accounts must be dealt with. If the amount is deemed to be immaterial, these balances may be written off directly to Cost of Goods Sold. If they are material, the balances should be allocated among Work-in-Process, Finished Goods, and Cost of Goods Sold. Refer to Quiz Questions 6, 7, and 8 Exercises 8-22 and 8-24 Copyright © 2021

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LEARNING OBJECTIVE

Show how the 4-variance analysis approach reconciles the actual overhead incurred with the overhead amounts allocated during the period … the 4-variance analysis approach identifies spending and efficiency variances for variable overhead costs and spending and productionvolume variances for fixed overhead costs

5.1

As we have seen, the calculation of variances for variable overhead and fixed overhead differ. •

Variable overhead has no production-volume variance.

•

Fixed overhead has no efficiency variance. (Exhibit 8-4 illustrates an integrated summary of the variable and fixed overhead variances.)

5.2

When all of the overhead variances are presented together, it is referred to as a 4-variance analysis. Although this presents the same information that the calculation of the individual variances gives, it does so in a unified presentation that also indicates that the fixed overhead efficiency and variable overhead production-volume variance never exist.

5.3

Not all managers need the detail found in the 4variance model. Managers of smaller businesses may understand their operations better from personal observation and nonfinancial measures. They may find that a 3-variance analysis provides an acceptable level of detail. This is obtained by combining the spending variances for variable and fixed overhead into a single overhead spending variance and presenting the variable overhead efficiency and fixed overhead productionvolume variances.

5.4

In other situations, it may be desirable to present even less detail. This can be accomplished through a 2variance analysis. This analysis combines the overhead spending variance and the variable overhead efficiency variance into a single flexible-budget variance along with the fixed overhead production-volume variance.

5.5

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into a 1-variance analysis reflecting a total overhead variance. This is the total underapplied or overapplied overhead costs. TEACHING POINT. Having the students work through the process of calculating variances and then presenting them in a 4-, 3-, 2-, and 1-variance analysis will reinforce the concepts covered in this chapter and help them to relate overhead variance analysis to the bigger picture.

5.6

All the variances discussed in this chapter are examples of financial performance measures. Managers will also find nonfinancial performance measures to be helpful.

5.7

Nonmanufacturing and service sector companies can benefit from the use of variance analysis. Many of these companies have a high level of fixed costs and the key to their profitability is the effective use of capacity.

Refer to Quiz Questions 9 and 10 Exercises 8-26 , 8-27 LEARNING OBJECTIVE

Explain the relationship between the sales-volume variance and the production-volume variance … the production-volume and operating income volume variances together comprise the salesvolume variance.

6.1

The sales-volume variance helps managers understand the lost contribution margin from selling fewer units than planned according to the static budget.

6.2

The sales-volume variance has two components: •

The operating income volume variance is measured as operating income (based on actual units sold) minus operating income per the static budget. If actual units sold are greater than static budget units sold, this variance will be favorable.

•

The production-volume variance is the difference between budgeted fixed overhead costs and allocated fixed overhead costs.

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LEARNING OBJECTIVE

Calculate variances in activity-based costing … compare budgeted and actual overhead costs of activities

7.1

As has already been mentioned, ABC systems classify costs of various activities into a cost hierarchy of output unit-level, batch-level, product-sustaining level, and facility-sustaining level costs.

7.2

The basic principles and concepts of variable and fixed overhead analysis can be applied to the cost hierarchy in an ABC system.

Refer to Quiz Question 11 40 and 8-42 LEARNING OBJECTIVE

Problem 8-

Examine the use of overhead variances in nonmanufacturing settings … analyze nonmanufacturing variable overhead costs for decision making and cost management; fixed overhead variances are especially important in service settings.

8.1

Managers consider variance analysis of all variable costs including distribution and other nonmanufacturing costs.

8.2

Costs incurred by service companies are not easily traced to outputs. Because the majority of costs are fixed overhead, effective utilization of capacity is a key element of profitability. Attention to fixed overhead variances can help managers utilize capacity effectively.

8.3

Nonfinancial measures such as variances between budgeted and actual amounts of materials used or machine hours worked may be reported earlier than financial variances. Both financial and nonfinancial performance measures are used to evaluate managers.

Refer to Quiz Question 12 Problem 8-46

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CHAPTER 8 QUIZ 1.

Which of the following pertains primarily to the planning of fixed overhead costs? a. A standard rate per output unit is developed. b. Only essential activities are to be undertaken. c. Activities are to be undertaken in the most efficient method. d. Key decisions are made at the start of the budget period determining the level of costs.

In selecting a cost-allocation base for variable overhead, what criteria for the base is preferred? a. Ease of acquiring reliable information for accurate allocations b. A cause-and-effect relationship between the cost and the activity level c. A single base that will simplify the allocation process d. One that has been used in the past

The following data apply to questions 3 through 10. Sebastian Company, which manufactures electrical switches, uses a standard cost system and carries all inventories at standard. The standard manufacturing overhead costs per switch are based on direct labor hours and are shown below: Variable overhead (5 hours @ $12 per direct manufacturing labor hour) $ 60 Fixed overhead (5 hours @ $15* per direct manufacturing labor hour) 75 Total overhead per switch $135 Copyright © 2021

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*Based on capacity of 200,000 direct manufacturing labor hours per month. The following information is available for the month of December: •

46,000 switches were produced although 40,000 switches were scheduled to be produced.

•

225,000 direct manufacturing labor hours were worked at a total cost of $5,625,000.

•

Variable manufacturing overhead costs were $2,750,000.

•

Fixed manufacturing overhead costs were $3,050,000.

[CMA Adapted] The variable overhead spending variance for December was a. $50,000 U. b. $350,000 U. c. $10,000 F. d. $60,000 F.

[CMA Adapted] The variable manufacturing overhead efficiency variance for December was a. $50,000 U. b. $350,000 U. c. $10,000 F. d. $60,000 F.

The total variable manufacturing overhead variance was a. $10,000 F. b. $10,000 U. c. $110,000 U. d. $110,000 F.

[CMA Adapted] The fixed manufacturing overhead spending variance for December was a. $450,000 F. b. $400,000 F. c. $50,000 U. d. $775,000 F.

The fixed overhead production-volume variance for December was a. $450,000 F. b. $400,000 F. c. $50,000 U. d. $775,000 F.

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What amount should be credited to the Allocated Manufacturing Overhead Control account for the month of December? a. $6,210,000 b. $5,800,000 c. $5,760,000 d. $5,700,000

Under the 2-variance method, the flexible-budget variance for December was a. $10,000 F. b. $40,000 U. c. $50,000 U. d. $100,000 U.

10.

Under the 3-variance method, the spending variance for December was a. $10,000 F. b. $40,000 U. c. $50,000 U. d. $100,000 U.

11.

Which of the following statements is true about overhead cost variance analysis using activity-based costing? a. Overhead cost variances are calculated only for output-unit level costs. b. Overhead cost variances are calculated only for variable manufacturing overhead costs. c. A 4-variance analysis can be conducted. d. Activity-based costing uses input measures for all activities, resulting in the inability to do flexible budgets needed for variance analysis.

12.

Which of the following is an example of a nonmanufacturing cost that may be analyzed using variances? a. Factory rent b. Product distribution costs c. Indirect labor d. Factory supplies

CHAPTER 8 QUIZ SOLUTIONS 1.

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10.

11.

12.

Quiz Question Calculations 3.

Standard 225,000 DLH  $12 Actual VOH Spending variance

Standard 46,000 switches  5 DLH/switch Actual DLH VOH Efficiency variance

Total variable overhead variance = $50,000 U + $60,000 F = $10,000 F

Budgeted fixed OH 200,000 DLH  $15/DLH = Actual fixed OH FOH Spending variance

Budgeted DLH Allocated 46,000  5

230,000  ($15 + $12) = $6,210,000

50,000 U – 60,000 F + 50,000 U = 40,000 U

10.

50,000 U + 50,000 U = 100,000 U

$2,700,000 2,750,000 $ 50,000 U =

230,000 225,000 5,000  $12 = $60,000 F

$3,000,000 3,050,000 50,000 U

200,000 230,000 30,000  15 = 450,000 F

Inventory Costing and Capacity Analysis

TRANSITION NOTES This chapter now has a single comprehensive example that integrates the two parts of the chapter. This helps relate inventory costing to the capacity level issues and should make 10-77 Copyright © 2021 Pearson Education, Inc.

it easier for the student to relate the two concepts. References to current economic conditions in various places have been updated. The section on regulatory requirements is now entitled “Tax Requirements.” In the section “DenominatorLevel Capacity Concepts and Fixed-Cost Capacity Analysis,” theoretical capacity was changed from 360 days to 365 days. Many end-of-chapter problems have been revised and some new ones introduced.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 22 23 24 25 26 Revised 27 28 Revised 29 30 31 Revised 32 Revised 33 Revised 34 Revised 35 Revised

16th Edition 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35

17th Edition 36 Revised 37 Revised 38 Revised 39 Revised 40 Revised 41 Revised 42 Revised 43 44 Revised 45 Revised 46 47 New 48 New

16th Edition 36 37 38 40 41 42 43 44 45 46 48

LEARNING OBJECTIVES 1. Identify what distinguishes variable costing from absorption costing. 2. Compute operating income under absorption costing and variable costing, and explain the difference in operating income. 3. Understand how absorption costing can provide undesirable incentives for managers to build up inventory. 4. Differentiate throughput costing from variable costing and absorption costing. 5. Describe the different capacity concepts that can be used in absorption costing. 6. Examine the key factors managers use to choose a capacity level to compute the budgeted fixed manufacturing cost rate. 7. Understand issues that play an important role in capacity planning and control.

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CHAPTER SYNOPSIS This chapter focuses on two types of choices: the inventory costing choice is an important application of how choices in the costing system impact the results reported in a firm’s financial statements. The three types of inventory costing methods are variable costing, which is introduced and compared with absorption costing; and throughput, or super-variable costing. The second choice is the denominator-level capacity choice which focuses on the capacity level used to calculate budgeted fixed manufacturing cost rates used in costing systems. There are four possible choices of capacity levels: —theoretical, practical, normal, and master budget utilization. The use of these capacity concepts affects the cost per unit that is calculated for fixed costs.

III.

POINTS OF EMPHASIS 1. Students may not have been introduced to the term absorption costing, even though they have used it in previous courses. Help them understand how absorption costing and variable costing differ and why variable costing is preferable for decision-making purposes. Observe that a variable costing income statement classifies costs by behavior; an absorption statement classifies costs by character. 2. Emphasize that, although all variable costs are listed on the top portion of the income statement, and are used to arrive at contribution margin, only variable manufacturing costs are included in variable cost of goods sold. 3. Students may react to the extreme nature of throughput costing. Emphasize that it does not have to be the only costing system employed, and is a useful short-term management tool. 4. Students may have trouble thinking “outside the box” on capacity concepts. The “teaching point” demonstration in the chapter outline will help them realize that capacity may have many definitions and meanings.

IV.

CHAPTER OUTLINE

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LEARNING OBJECTIVE

Identify what distinguishes variable costing … fixed manufacturing costs excluded from inventoriable costs from absorption costing … fixed manufacturing costs included in inventoriable costs

1.1

Variable costing (also known as direct costing) is a method of inventory costing in which all variable manufacturing costs are included as inventoriable costs. All fixed manufacturing costs are excluded from inventoriable costs and are treated as costs of the period in which they are incurred.

1.2

Absorption costing is a method of inventory costing in which all variable manufacturing costs and all fixed manufacturing costs are included as inventoriable costs. Thus, inventory “absorbs” all manufacturing costs. The concept of the inventory absorbing the fixed costs should help students grasp the concept. Those fixed costs are expensed when the item is sold. Absorption costing is the method required for Generally Accepted Accounting Principles for external financial reporting. TEACHING POINT. Two observations can be made about variable and absorption costing. First, a variable costing income statement classifies cost based on behavior. An absorption costing income statement classifies cost based on character (manufacturing, selling, administrative). Second, students frequently do not grasp the concept that not all variable costs are inventoriable—only variable manufacturing costs.

1.3

The main difference between the two is the treatment of fixed manufacturing costs. Exhibit 9-1 compares variable and absorption costing for the Stassen Company’s Telescope Product Line. TEACHING POINT. At this stage it is helpful to prepare income statements illustrating the two approaches. Before the students can understand why the differences arise between the two, they must have a concept of how an income statement is prepared under both methods. Exercise 9-16 can be used for this purpose, saving the second part to explain why the differences

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arise.

Refer to Quiz Question 1 9-21 Part 1

Exercise

LEARNING OBJECTIVE

Compute operating income under absorption costing … using the gross-margin format and variable costing, … using the contribution-margin format and explain the difference in income … income is affected by the unit level of production and the unit level of sales under absorption costing, but only by the unit level of sales under variable costing

(Exhibit 9-2 is an illustration comparing income statements prepared under variable costing and absorption costing for a two-year period.)

2.1

In 2020, production exceeded sales. Because all fixed costs are expensed under variable costing, absorption costing shows a higher operating income. The difference of $270,000 represents fixed costs that are included in ending inventory under absorption costing.

2.2

In 2021, sales exceed production, thus reducing inventory. Variable costing shows a higher operating income. The $202,500 difference represents the fixed costs in the change of inventory level ($135 fixed cost per unit  1,500 unit reduction in inventory). TEACHING POINT. This concept is best covered through illustration. The more students see these effects, the more likely they are to grasp the concept.

Refer to Quiz Questions 2, 3, and 4 Exercise 9-21 Part 2, 9-23

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Understand how absorption costing can provide undesirable incentives for mangers to build up inventory … producing more units for inventory absorbs fixed manufacturing costs and increases operating income

3.1

As has been observed, absorption costing is the required inventory method for external reporting in the United States and most other countries. Most companies also use absorption costing for internal accounting as well.

3.2

Companies use one method because it is seen as cost effective and less confusing for managers to deal with one common method for inventory reporting.

3.3

Using different inventory costing methods can lead to undesirable behavior on the part of managers seeking to enhance their performance evaluation, even to the detriment of the company.

3.4

Companies that use both methods for internal reporting—variable costing for short-run decisions and performance evaluation and absorption costing for long-run decisions—benefit from the advantages of both methods.

3.5

One motivation for an undesirable buildup of inventories could be due to the fact that a manager’s bonus is based on absorption-costing operating income (which increases as production increases). (Exhibit 9-4 illustrates the effect on absorption-costing operating income at different levels of production.) TEACHING POINT. An extreme example will illustrate how producing in order to build up inventory can result in higher profits under absorption costing and a better performance evaluation for the manager. By over-producing, the manager increases his income, with no increase in the level of sales. Production Equals Sales Sales $10/unit  1000 Cost of goods sold: VC (1000  4) FC Mfg costs Ending inventory Cost of goods sold Gross profit

10,000 4,000 3,000 7,000 -07,000 3,000 =====

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Production Exceeds Sales Sales $10/ units  1,000 Cost of goods sold: VC (2000  4) FC Mfg cost Ending inventory * Cost of goods sold Gross profit

10,000 8,000 3,000 11,000 5,500 5,500 5,500 =====

*1/2 of manufacturing costs

3.6

Top management can take several steps to reduce the undesirable effects of absorption costing. •

Focus on careful budgeting and inventory planning to reduce management’s freedom to build up excess inventory.

•

Incorporate a carrying charge for inventory in the internal accounting system.

•

Change the period to evaluate performance. Instead of quarterly or annual horizon, evaluate the manager over a three-to-five year period.

•

Include nonfinancial as well as financial variables in the measures of performance evaluation.

Refer to Quiz Question 5 Exercises 9-27

LEARNING OBJECTIVE Differentiate throughput costing

… direct material costs are inventoried from variable costing … variable manufacturing costs are inventoried and from absorption costing … variable and fixed manufacturing costs are inventoried

4.1

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promotes an excessive amount of costs being inventoried. They argue that only direct materials are truly variable. 4.2

This approach is known as throughput costing or supervariable costing. It is an inventory valuation method in which only direct material costs are included in inventoriable costs. All other costs are period costs and expensed in the period incurred. TEACHING POINT. Students will be slow to accept such a seemingly radical departure from traditional costing methods. Illustrate that, in the very short run, many variable costs do behave as though they were fixed. For example, consider a restaurant. When a server comes on duty, that server will likely work until the end of the shift. Even though business may fluctuate and the server may not stay busy the entire time, the employer is on the hook for 8 hours pay. The employer cannot (from a practical standpoint) tell the employee to take an hour off because business is slow. Thus, the server’s wages for the day are in a very real sense, fixed.

4.3

Throughput margin is defined as revenues minus direct material cost of goods sold. Exhibit 9-5 illustrates throughput costing for Telescope Product Line of Stassen Company.

4.4

Variable costing and absorption costing (as well as throughput costing) may be combined with actual, normal, or standard costing. (Exhibit 9-6 compares product costing under various inventory costing systems.) TEACHING POINT. This is a good place to revisit the definitions of actual, normal, and standard costing. Although these concepts are not difficult, they need to be brought into the discussion on occasion to reinforce the differences among the three.

4.5

Even though variable costing is not acceptable under GAAP, there are those who feel that it should be acceptable for external reporting purposes. Their argument is that fixed costs are more related to the capacity to produce rather than to actual production of specific units.

4.6

Those supporting absorption costing maintain that inventories should contain a fixed cost component because both fixed and variable manufacturing costs are necessary to produce goods.

4.7

A key issue in absorption costing is the capacity level used to compute fixed costs per unit produced.

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Refer to Quiz Question 6 Exercises 9-22 and 9-24

LEARNING OBJECTIVE

Describe the different capacity concepts that can be used in absorption costing … supply perspective: theoretical and practical capacity; demand perspective: normal and masterbudget capacity utilization

5.1

Determining the appropriate level of capacity is one of the most strategic and difficult decisions managers face. Too much capacity means incurring costs of unused capacity. Too little capacity means that demand may go unfilled.

5.2

Four different capacity levels are used to compute the budgeted fixed manufacturing cost rate. They are: • • • •

Theoretical capacity Practical capacity Normal capacity utilization Master-budget capacity utilization TEACHING POINT. To get students to “think outside the box” about capacity, perform the following demonstration. Get a small glass jar. Ask a student to fill the jar with marbles. When the student has done so, ask if the jar is full. Normally, you will get a “yes” for an answer. Then pull out a box of salt. Ask another student to pour as much salt into the jar with marbles. Then ask “Now is the jar full?” At this point, you will get some weak “yeses” but the students don’t quite trust their answers. Then pull out a glass of water. Have a student pour water into the marbles and salt. Emphasize that capacity is not a hard number, but depends on many factors.

5.3

Theoretical capacity is the level of capacity based on producing at full efficiency all the time. This measure of capacity does not allow for plant maintenance, shutdowns, interruptions, or any other factors. Theoretical capacity may be achieved for short periods of time, but it cannot be sustained. Theoretical capacity represents an ideal goal of capacity utilization.

5.4

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as scheduled maintenance time and shutdowns for holidays. 5.5

Normal capacity utilization is the level of capacity utilization that satisfies average customer demand over a period of time—often two to three years—that includes seasonal, cyclical, and trend factors.

5.6

Master-budget capacity utilization is the level of capacity utilization that managers expect for the current time period, which is typically one year.

5.7

Theoretical and practical capacity measure capacity in terms of what a plant can supply. Normal capacity and master-budget utilization measure capacity in terms of demand.

5.8

The capacity level chosen will affect the budgeted fixed overhead cost rate. As a lower capacity level is chosen, the fixed cost per unit increases. The Stassen Company illustration (page 338) demonstrates the effect of different capacity level choices on the fixed overhead rate.

Refer to Quiz Question 7 Exercise 9-29

LEARNING OBJECTIVE

Examine the key factors managers use to choose a capacity level to compute the budgeted fixed manufacturing cost rate … managers must consider the effect a capacity level has on product costing, pricing decisions, performance evaluation, and financial and tax statements

6.1

One of the principles of cost accounting covered in an earlier chapter was “different costs for different purposes.” That principle applies as we seek to choose a capacity level for different purposes, including: •

Product costing and capacity management

•

Pricing decisions

•

Performance evaluation

•

Financial reporting

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•

Tax requirements

6.2

Theoretical capacity is rarely used to calculate budgeted fixed manufacturing cost per unit because it departs significantly from the capacity that is effectively available to a company.

6.3

Practical capacity is frequently used to calculate budgeted fixed manufacturing cost per unit. This approach sets the cost of capacity at the cost of supplying the capacity regardless of demand. Practical capacity then highlights the cost of capacity acquired but not used and may serve to direct managers’ attention toward more effective capacity management.

6.4

The downward demand spiral is the continuing reduction in the demand for its products that occurs when competitor prices are not met. As demand drops further, Higher unit costs produced by costing systems based on normal and master-budget capacity utilization result in greater reluctance to meet competitors’ prices. TEACHING POINT. The downward demand spiral and its effect on profits is best illustrated through an example such as is included in the text.

6.5

As the company increases prices to cover fixed costs, demand drops due to the higher price, resulting in another price increase to cover still higher per-unit costs.

6.6

Note that capacity costs also arise in nonmanufacturing parts of the value chain and must be appropriately dealt with by management. Failure to consider these may create unexpected losses.

6.7

In performance evaluation, managers must guard against using a long-run measure such as normal capacity usage for a short-run purpose such as annual bonuses. Master-budget utilization would be more effective in this situation.

6.8

For external reporting purposes, the choice of capacity measure will affect the magnitude of the production-volume variance. How this variance is disposed of at the end of the year will impact the company’s operating income. •

The adjusted allocation-rate approach restates all amounts in the ledgers using actual rather than budgeted cost rates. This has the effect of switching to actual costing at the end of the year.

•

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the accounts containing overhead—Work-in-Process, Finished Goods, and Cost of Goods Sold—in proportion to the balances in these accounts. •

The write-off to cost-of-goods-sold approach simply writes the balance of the variance off to cost of goods sold. This can be utilized when the balance is immaterial. This method also is the simplest to utilize. TEACHING POINT. A number of cost accountants use the writeoff to cost-of-goods-sold approach with the belief that the balance to be written off must be very large before it becomes material. In a normal operating situation, a very large percentage of the balance will go to cost of goods sold, so it would take a huge balance to make a material difference between methods.

6.9

For tax reporting in the United States, the IRS requires companies to assign inventoriable indirect production costs by a method that fairly allocates costs among items produced. Practical capacity is permitted by the IRS as a method of calculating budgeted fixed manufacturing cost per month.

Refer to Quiz Questions 8, 9, and 10 Exercise 9-30

LEARNING OBJECTIVE

Understand issues that play an important role in capacity planning and control … uncertainty regarding the expected spending on capacity costs and the demand for installed capacity, the role of capacity-related issues in nonmanufacturing areas, and the possible use of ABC techniques in allocating capacity costs

7.1

Per-unit costs are based on a single level of output. The uncertainty attached to estimating demand and therefore production affects the cost per unit, and may negatively affect other decisions.

7.2

Fixed manufacturing costs, such as utilities, may be difficult to predict. This can also affect the determination of per-unit fixed cost amounts.

7.3

If capacity isn’t attained in the manufacturing process, there may be excess capacity later in the value chain, such as with distribution.

7.4

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capacity.

CHAPTER 9 QUIZ 1.

The main difference between variable costing and absorption costing is a. the treatment of nonmanufacturing costs. b. the accounting for variable manufacturing costs. c. the accounting for fixed manufacturing costs. d. their value for decision makers.

The following data apply to questions 2 and 3. Alvin Inc. planned and actually manufactured 200,000 units of its single product in 2020, its first year of operations. Variable manufacturing costs were $30 per unit of product. Planned and actual fixed manufacturing costs were $600,000, and marketing and administrative costs totaled $400,000 in 2020. Alvin sold 120,000 units of product in 2020 at a selling price of $40 per unit. 2.

[CMA Adapted] Alvin’s 2020 operating income using variable costing is a. $800,000. b. $600,000. c. $440,000. d. $200,000.

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[CMA Adapted] Alvin’s 2020 operating income using absorption costing is a. $840,000. b. $800,000. c. $440,000. d. $200,000.

[CPA Adapted] Operating income using variable costing as compared to absorption costing would be higher a. when the quantity of beginning inventory equals the quantity of ending inventory. b. when the quantity of beginning inventory is more than the quantity of ending inventory. c. when the quantity of beginning inventory is less than the quantity of ending inventory. d. under no circumstances.

Absorption costing enables managers to increase operating income in the short run by changing production schedules. Which statement is true regarding such action? a. The reason for increased operating income is the deferral of fixed manufacturing overhead contained in unsold inventory. b. A desirable effect of these changes in production is “cherry picking” the production line. c. This is done through decreases in the production schedule as customer demand for product falls. d. None of the above statements are true regarding the manager’s action to increase operating income through changes in the production schedule.

The proponents of throughput costing a. maintain that variable costing undervalues inventories. b. maintain that it provides more incentive to produce for inventory than do either variable or absorption costing. c. argue that only direct materials and direct labor are “truly variable” and all indirect manufacturing costs be written off in the period in which they are incurred. d. treat all costs except those related to variable direct materials as costs of the period in which they are incurred.

The absolute minimum absorption-inventory cost that would be reported under the best conceivable operating conditions is a description of which type of denominator-level concept cost? a. Master-budget utilization b. Practical capacity Copyright © 2021

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c. d.

Theoretical capacity Normal utilization

Use of capacity levels based on demand a. hides the amount of unused capacity. b. highlights the cost of capacity acquired but not used. c. yields a cost rate that does not include a charge for unused capacity. d. results in a price that covers the cost of capacity customers expect to pay.

A company may experience the downward demand spiral when a. the use of theoretical capacity as a denominator level has contributed to budgets that project sales to be higher than actually attainable. b. spreading capacity costs over a small number of units and setting selling prices even higher to recover those costs. c. engaged in a cyclical business and after experiencing an upturn. d. the production-volume variance is unfavorable each time period during a year.

10.

The manner in which a company deals with end-of-period variances will determine the effect production-volume variances have on the company’s end-of-period operating income. When the chosen capacity level exceeds the actual production level, which approach to end-of-period variances results in an unfavorable production-volume variance affect on that period’s operating income? a. Proration approach b. Adjusted allocation-rate approach c. Theoretical approach d. Write-off to cost-of-goods-sold approach

CHAPTER 9 QUIZ SOLUTIONS 1.

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10.

Quiz Question Calculations 2.

Sales 120,000  $40/unit $4,800,000 VC 120,000  $30/unit 3,600,000 Contribution margin $1,200,000 Fixed costs ($600,000 + $400,000) 1,000,000 Operating income 200,000 ======== Sales 120,000  $40 $4,800,000 COGS Variable 3,600,000 Fixed 360,000* 3,960,000 Gross profit 840,000 Fixed costs 400,000 Operating income 440,000 ======= Fixed manufacturing cost $600,000 / 200,000 units = $3 unit $3/unit  120,000 units sold = $360,000

Determining How Costs Behave

TRANSITION NOTES The five-step decision model is applied in this chapter to evaluate changes in costs and how these affect the chosen cost drivers. There is a greater discussion of managerial decision making using quantitative analysis and information that will lead to the new chapter 11 on data analytics Several new problems are introduced in the end-of-chapter material and many have been revised.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 Revised 22 Revised 23 24

16th Edition 21 22 23 24

17th Edition 35 36 37 Revised 38 Revised

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16th Edition 35 36 37 38

25 Revised 26 Revised 27 Revised 28 Revised 29 30 Revised 31 32 33 Revised 34 Revised

25 26 27 28 29 30 31 32 33 34

39 40 Revised 41 Revised 42 43 44 45 46 47 48

39 40 41 42 43 44 45 46 47 48

I. LEARNING OBJECTIVES

XI.

Describe linear cost functions and three common ways in which they behave.

Explain the importance of causality in estimating cost functions.

Understand various methods of cost estimation.

Outline six steps in estimating a cost function using quantitative analysis.

Describe three criteria used to evaluate and choose cost drivers.

Explain nonlinear cost functions, in particular, those arising from learning curve effects.

Be aware of data problems encountered in estimating cost functions.

CHAPTER SYNOPSIS Chapter 3 discussed cost-volume-profit analysis and the relationship among costs, profits, and activity levels. This chapter presents concepts and methods that can be utilized to analyze mixed costs and to break them into separate fixed and variable components. Managers use cost functions to gain a better understanding of cost behavior. Cost functions are mathematical descriptions of how a cost changes with changes in the level of an activity relating to that cost. Two key assumptions often made by managers using cost functions are: Variations in the level of a single activity (the cost driver) explain variations in the related total costs. Cost behavior is approximated by a linear cost function within the relevant range. The chapter also presents alternative cost functions that do not rely on these two assumptions. Regression analysis is discussed in greater detail in the Appendix. Copyright © 2021

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III.

POINTS OF EMPHASIS 1.

Make certain the students understand the assumptions in cost-behavior limitations. These are limiting assumptions and must be taken into account.

Emphasize that the equation for a cost function, y = a + bX is universal; it applies for all methods of cost estimation. Also make sure the students know the mathematical names, as well as the cost accounting names, for each element in the equation.

Make sure that the students understand that fixed, variable, and mixed are descriptions of cost behaviors and that they understand their behavior on a per-unit basis as well as total.

As accountants, we naturally have a preference for quantitative methods of estimating a cost function. Emphasize that high-low is simple, but that computers have made regression accessible to everyone. They do not need to understand how to compute a regression equation, but they should be able to interpret the results.

It is not so important to get into the mathematical details of the learning curve, but be sure the students understand the reality and application of learning curves.

Help the students realize that data does not always come to them in neat packages as shown in the text, but emphasize data collection problems.

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IV.

CHAPTER OUTLINE LEARNING OBJECTIVE

Describe linear cost functions … graph of cost function is a straight line and three common ways in which they behave … variable, fixed, and mixed

1.1

Understanding how costs behave is a valuable technical skill. A management accountant must be able to identify cost drivers, estimate cost relationships, and determine the fixed and variable components of costs. In order to effectively do this, the management accountant must have an understanding of the operations of the business, be a vital member of the management team, and be able to convey his or her findings.

1.2

A cost function is a mathematical description of how a cost changes with changes in the level of an activity relating to that cost.

1.3

Managers often estimate cost functions based on two assumptions: •

Variations in the level of a single activity (cost driver) explain the variations in the related total costs.

•

Costs behave in a linear manner within the relevant range of activity. A linear cost function is represented by a straight line. TEACHING POINT. These assumptions may not always be fulfilled. However, in many instances, they meet the criteria closely enough to allow for useful analysis.

1.4

The formula for a cost function is y = a + bX . These components will be discussed as we progress through the chapter.

1.5

Costs usually behave in one of three commonly encountered manners. They can be variable, fixed, or semi-variable.

1.6

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increases in total as the level of the cost driver increases. The amount by which the cost increases as the cost driver increases by one is the slope coefficient, represented by b in the equation for a cost function. 1.7

A fixed cost function is one in which the cost does not change in response to changes in the level of activity. It is referred to as the constant, and is represented by a in the equation.

1.8

A mixed cost function represents a cost that has both variable and fixed components. This is also known as a semi-variable cost. (Exhibit 10-1 displays examples of linear cost functions.) TEACHING POINT. It is good to illustrate the three concepts at this point. A good example may be the situation of renting a car. In theory, the car rental agency can present three options: (1) A flat rate per day, such as $50. The rental cost will be fixed at $50, regardless of miles driven. (2) A per mile rate, such as $1.00 for each mile driven. The rental cost will be variable based on the number of miles driven. (3) A mixed rate, such as $25 per day plus $0.50 per mile driven. The rental cost will be a fixed $25 a day plus an increasing amount for each mile driven.

1.9

From Chapter 2, there are three criteria for classifying a cost into its fixed and variable components. It will be helpful to review these three concepts at this point. •

Choice of cost object. Depending on the choice of the cost object, a given cost may be fixed or variable.

•

Time horizon. Whether a cost is fixed or variable for a particular activity may depend on the time horizon being considered in the decision. The longer the time frame, the more costs become variable.

•

Relevant range. Cost-behavior patterns are valid for linear cost functions only within the given relevant range. Outside this range, cost-behavior patterns change causing the costs to become nonlinear. (Exhibit 10-2 illustrates linearity within a relevant range.)

Refer to Quiz Question 1 Exercises 10-22, 10-23, and 10-24

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LEARNING OBJECTIVE

Explain the importance of causality in estimating cost functions . . . only a cause-and-effect relationship establishes an economically plausible relationship between an activity and its costs

2.1

Managers use cost estimation to measure a relationship based on data from past costs and the related level of an activity.

2.2

Estimating these past cost functions can help managers make more accurate cost predictions about future costs.

2.3

Critical to this process is correctly identifying the factors that affect costs. Managers are then looking for a cause-and-effect relationship between the costs incurred and the level of activity. We refer to this activity measure as a cost driver.

2.4

The cause-and-effect relationship may arise as a result of: •

A physical relationship between the level of activity and costs. As an example, there is a physical relationship between direct materials used and the number of units produced.

•

A contractual arrangement. For example, in a car rental contract that charges by the mile, miles driven is specified in the contract as the activity that affects the rental cost.

•

Knowledge of operations. A product with many parts will incur higher ordering costs than a product with few parts. If the company is measuring ordering costs, the activity driver could be number of parts.

2.5 Managers must be careful not to interpret a high correlation between two variables to mean that either variable causes the other. 2.6 Managers should always use a long run horizon to identify cost drivers because costs may be fixed in the short run (during which time they have no cost driver), but they are usually variable and have a cost driver in the long run. Focusing on the short run may inadvertently cause a manager to believe that a cost has no cost driver.

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LEARNING OBJECTIVE

Understand various methods of cost estimation … for example, the regression analysis (a quantitative analysis method) determines the line that best fits past data

. 3.1

There are several different methods for estimating costs. These methods include: •

The industrial engineering method, also called the work-measurement method, estimates cost functions by analyzing the relationship between inputs and outputs in physical terms. This is a thorough and detailed method, but can be very time consuming.

•

The conference method estimates cost functions based on analysis and opinions about costs and their drivers gathered from various departments of a company. Because it does not require detailed analysis of data, it can be used to develop cost functions very quickly. However, the emphasis on opinions rather than systematic estimation can make this a less accurate method.

•

The account analysis method estimates cost functions by classifying various cost accounts as variable, fixed, or mixed with respect to the identified level of activity. Although this method relies more on qualitative analysis, it is reasonably accurate, cost effective, and easy to use.

•

The quantitative analysis method uses a formal mathematical method to fit cost functions to past data observations. The most common quantitative analysis methods are the high-low method and regression analysis.

Refer to Quiz Question 2 Exercises 10-25 and 10-26

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LEARNING OBJECTIVE

Outline six steps in estimating a cost function using quantitative analysis … the end result (Step 6) is to evaluate the cost driver of the estimated cost function

4.1

Estimating a cost function using quantitative analysis involves a six-step procedure: Step 1:

Choose the dependent variable (cost being estimated or predicted). The dependent variable is the cost being estimated (y in the equation) and will depend on the specific cost function being estimated.

Step 2:

Identify the independent variable, or cost driver. The independent variable is the factor used to predict the cost function. This is the cost driver, otherwise referred to as X in the equation, or the slope. The cost driver, the level of activity, should be measurable and have an economically plausible relationship to the dependent variable.

TEACHING POINT. Beware of spurious relationships. Just because a relationship between the dependent and independent variable exists does not mean that there is a cause-and-effect relationship in place. Point out that you can prove (statistically) that drinking water is fatal; that is, 100% of people who drink water die. Obviously, there is no relationship between mortality and drinking water.

Step 3:

Collect data on the dependent variable and the cost driver. This is usually the most difficult step, as the data comes from a number of sources, and managers need to be concerned about the validity of the data.

Step 4:

Plot the data. The general relationship between the cost driver and costs can be readily seen by graphing a plot of the data. The plot provides insight into the relevant range of the cost function and reveals whether the relationship between the driver and costs is approximately linear.

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(Exhibit 10-4 is an example of this step, with data plotted on the graph.)

4.2

Step 5:

Estimate the cost function. As mentioned, there are two primary methods of estimating a cost function—the high-low method and regression analysis.

Step 6:

Evaluate the cost driver of the estimated cost function. Evaluation of the cost driver is discussed later in the chapter.

The high-low method is the simplest form of quantitative analysis. This method estimates the slope coefficient and the constant of the cost function using the high and low levels of activity and the costs incurred at each level. TEACHING POINT. At this juncture the high-low method should be illustrated by working through a problem. Exercise 10-28 is a good illustration of this method. Be certain the students understand that you select the high and low activity levels and not the high and low levels of cost. (Exhibit 10-5 illustrates an estimated cost function using the highlow method.)

4.3

Advantages of the high-low method are that it is simple to compute and understand, and it can give a quick insight into cost-activity relationships. However, it utilizes only two data points, thus ignoring a great deal of valid data.

4.4

Regression analysis is a statistical technique that measures the average amount of change in the dependent variable associated with a unit change in the independent variable. This method requires the use of statistical software but will usually give the most accurate results.

4.5

Multiple regression allows the manager to incorporate multiple cost drivers in the analysis to help explain the changes in costs as the activity level changes.

4.6

In a regression analysis, the residual term measures the distance between the actual and estimated costs for each observation. The r2 value is an indication of how good a predictor of costs the equation is. This is referred to as goodness of fit. (Exhibit 10-6 illustrates a least-squares regression line.)

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LEARNING OBJECTIVE

Describe three criteria used to evaluate and choose cost drivers … economically plausible relationships, goodness of fit, and significant effect of the cost driver on costs

5.1

One of the difficulties in applying a model to predict costs is determining how effective the model is in making those predictions. Under any of these models, the data can be entered, and a prediction equation derived. Is this the best cost driver to predict the behavior? How good is this driver at predicting cost behavior?

5.2

There are three criteria often used to evaluate cost drivers; they are: •

Economic plausibility. Do the cost driver and the level of costs seem to be related? Does it make sense that an increase in the independent variable will cause an increase in the costs?

•

Goodness of fit. Are the differences between the actual costs and predicted costs small? In a regression analysis, goodness of fit is measured by the r2 statistic.

•

Significance of independent variable. If the regression line (or total cost line) has a steep slope, this indicates a strong relationship between the cost driver and the costs incurred. (Exhibits 10-7 and 10-8 illustrate the use of alternative cost drivers for cost estimation purposes.)

5.3

As has been discussed in a previous chapter, activitybased costing focuses on individual activities. To implement ABC a cost driver must be identified for each activity. •

As a result, ABC systems have a large number of cost drivers and cost pools, requiring many cost relationships to be estimated. As a part of this process, the manager must pay careful attention to the cost hierarchy (unit, batch, product, or factory level).

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Refer to Quiz Question 6 Problem 10-39 and 10-47 LEARNING OBJECTIVE

Explain nonlinear cost functions, … graph of cost function is not a straight line, for example, because of quantity discounts or costs changing in steps in particular, those arising from learning curve effects … either cumulative average-time learning, where cumulative average time per unit declines by a constant percentage, as units produced double …or incremental unit-time learning, in which incremental time to produce the last unit declines by a constant percentage, as units produced double

6.1

Costs do not always behave in a neat, orderly, linear fashion. A nonlinear cost function for which the graph of the total costs, based on the level of a single activity, is not a straight line within the relevant range.

6.2

Economies of scale may prevent a cost from behaving in a linear fashion. When a larger number of items are ordered, the price per unit may decline.

6.3

Step cost functions are another example of nonlinear cost functions. A step cost function is a cost function in which the cost remains the same over various ranges of the level of activity but increases by discrete amounts at the level of activity increases from one range to the next.

6.4

A step variable-cost function has a narrow range in which the cost remains the same, whereas a step fixedcost function changes over a wider range of costs. TEACHING POINT. Illustrate step functions with examples. For example, the company requires one supervisor for every 20 workers. If they have 100 workers, there will be five supervisors. New supervisors would be hired only as 20 additional workers are employed. (Exhibit 10-9 displays the effect of quantity discounts and

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nonlinear cost functions.)

6.5

Nonlinear cost functions result from learning curves. A learning curve is a function that measures how labor-hours per unit decline as units of production increase because workers are learning and becoming better at their jobs. An experience curve is a broader application of the learning curve which measures the decline in costs per unit in other functions of the value chain.

6.6

In the cumulative average-time learning model, the cumulative average time per unit declines by a constant percentage each time the cumulative quantity produced doubles. With an 80% learning curve, if the quantity produced doubles, the average time for all units produced drops to 80% of the previous time. (Exhibit 10-11 illustrates the cumulative average-time learning model.)

6.7

In the incremental unit-time learning model, the incremental time needed to produce the last unit declines by a constant percentage each time the quantity of units produced doubles. An 80% learning curve under this model means that when unit production doubles, the time needed to produce the last unit is 80% of the time needed to produce the last unit before production doubled. (Exhibit 10-12 illustrates the incremental unit-time learning model.) (Exhibit 10-13 plots costs using learning curves at Rayburn Corporation.)

6.8

In setting prices, preparing budgets, and determining standards, a company needs to consider the learning curve effect. As production increases to meet demand, cost per unit decreases. These factors must be considered in the company’s planning process. (Exhibit 10-14 illustrates the learning effect on costs at Rayburn Corporation.) TEACHING POINT. Observe that this is one reason why custom products are more expensive—because they are unique, there is no learning curve effect.

Refer to Quiz Questions 7, 8, and 9 10-33 and 10-34 LEARNING OBJECTIVE

Be aware of data problems encountered in estimating cost functions … for example, unreliable data and poor recordkeeping, extreme observations, treating fixed costs as if they are variable, and a changing relationship between a cost driver and cost

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Exercise

7.1

7.2

The ideal database for estimating cost functions quantitatively has two characteristics: •

The database should contain numerous, reliably measured observations of the cost driver (the independent variable) and the related costs (the dependent variable).

•

The database should include many values spanning a wide range for the cost driver.

Because the ideal database does not usually present itself, the cost analyst should be aware of several frequently encountered problems and actions that can be taken to overcome the problems. •

The time period for measuring the dependent variable may not match the period for measuring the cost driver. Keeping records on the accrual basis will facilitate these comparisons.

•

Fixed costs are allocated as if they are variable. To avoid this problem, take care to distinguish between fixed and variable costs and do not treat unitized fixed cost as a variable cost.

•

Data are either not available for all observations or are not uniformly reliable. This is a collection issue; to overcome the problem, data should be obtained on a regular basis with follow up when data are missing.

•

Extreme values of observations occur from errors in recording costs. Adjust or eliminate unusual values before estimating a relationship.

•

There is no homogeneous relationship between the cost driver and the individual cost items in the dependent variable-cost pool. This can be overcome with additional cost pools or with multiple regression analysis.

•

The relationship between the cost driver and the cost is not stationary. This can occur when there is a change in operations. Splitting the data into “before and after” pools and estimating separate cost relationships may facilitate understanding.

•

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Refer to Quiz Question 10

OTHER RESOURCES To download instructor resources, visit the Instructor’s Resource Center at www.pearsonhighered.com/irc. The following exhibits were mentioned in this chapter of the Instructor’s Manual, and have been included in the Image Library. Exhibit 10-1 displays examples of linear cost functions. Exhibit 10-2 illustrates linearity within a relevant range. Exhibit 10-4 is an example of a step 4 scatter graph, with data plotted on the graph. Exhibit 10-5 illustrates an estimated cost function using the high-low method. Exhibit 10-6 illustrates a least-squares regression line. Exhibits 10-7 and 10-8 illustrate the use of alternative cost drivers for cost estimation purposes. Exhibit 10-9 displays the effect of quantity discounts and nonlinear cost functions. Exhibit 10-11 illustrates the cumulative average-time learning model. Exhibit 10-12 illustrates the incremental average-time learning model. Exhibit 10-13 plots costs using learning curves at Rayburn Corporation. Exhibit 10-14 illustrates the learning curve effect on costs at Rayburn Corporation.

CHAPTER 10 QUIZ 1.

A mixed cost function has a constant component of $20,000. If the total cost is $60,000 and the independent variable has the value 200, what is the value of the slope coefficient? a. $200 b. $400 c. $600 d. $40,000

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[CMA Adapted] Of the following methods, the one that would not be appropriate for analyzing how a specific cost behaves is a. the scatter graph method. b. the industrial engineering approach. c. linear programming. d. statistical regression analysis.

When the high-low method is used to estimate a cost function, the variable cost per unit is found by a. performing regression analysis on the associated cost and cost driver database. b. subtracting the fixed cost per unit from the total cost per unit based on either the highest or lowest observation of the cost driver. c. dividing the difference between the highest and lowest observations of the cost driver by the difference between costs associated with the highest and lowest observations of the cost driver. d. dividing the difference between costs associated with the highest and lowest observations of the cost driver by the difference between the highest and lowest observations of the cost driver.

The following data apply to questions 4 and 5. Tory Company derived the following cost relationship from a regression analysis of its monthly manufacturing overhead cost. y = $80,000 + $12X where: y = monthly manufacturing overhead cost X = machine-hours The standard error of estimate of the regression is $6,000. The standard time required to manufacture one six-unit case of Tory’s single product is four machine-hours. Tory applies manufacturing overhead to production on the basis of machinehours, and its normal annual production is 50,000 cases. 4.

[CMA Adapted] Tory’s estimated variable manufacturing overhead cost for a month in which scheduled production is 10,000 cases would be a. $80,000. b. $480,000. c. $160,000. d. $320,000.

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b. c. d.

$4.00/MH. $3.20/MH. $1.60/MH.

Three criteria to use in identifying cost drivers from the potentially large set of independent variables that can be included in a regression model are a. goodness of fit, size of the intercept term, and specification analysis. b. independence between independent variables, economic plausibility, and specification analysis. c. economic plausibility, goodness of fit, and significance of independent variable. d. spurious correlation, expense of gathering data, and multicollinearity.

Companies that take advantage of quantity discounts in purchasing their materials have a. decreasing cost functions. b. linear cost functions. c. nonlinear cost functions. d. stationary cost functions.

With the cumulative average-time learning model a. the cumulative time per unit declines by a constant percentage when production doubles. b. the time needed to produce the last unit declines by a constant percentage when production doubles. c. costs increase in total by a constant percentage as production increases. d. the total cumulative time increases in proportion to production increases.

When using the incremental unit-time learning model a. the cumulative time per unit declines by a constant percentage when production doubles. b. the time needed to produce the last unit declines by a constant percentage when production doubles. c. the time to produce one additional unit decreases by a constant percentage. d. costs increase incrementally in an undetermined pattern.

10.

Which of the following is not a common problem encountered in collecting data for cost estimation? a. Lack of observing extreme values b. Missing data c. Changes in technology d. Distortions resulting from inflation

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CHAPTER 10 QUIZ SOLUTIONS 1.

10.

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Quiz Question Calculations 1.

Total cost $60,000 - Fixed cost 20,000 (variable cost) Variable cost 40,000

y = 80,000 + 12X

40,000 200 units = $200/unit

Variable cost = (10,000 cases  4 machine hours/case  $12/machine hour) Variable cost = $480,000 5.

Fixed costs Machine hours

= $80,000

= $0.40/ machine hour 50,000  4

$0.40/ machine hour  4mh/unit = $1.60

Data Analytic Thinking and Prediction

TRANSITION NOTES This is a new chapter focusing on the vast amounts of data that are available regarding customer preferences, supplier behavior and marketing operations in the course of daily operations. Managers use data analytic techniques to make predictions based on these data. The business press refers to these trends as the age of big data, machine learning and artificial intelligence. Dataanalytic techniques used by management accountants help companies derive value from this data.

EXERCISES AND PROBLEMS CORRELATION CHART NOT AVAILABLE SINCE ALL MATERIAL IS NEW

II.

LEARNING OBJECTIVES 8.

Explain how management accountants can work with data scientists to create value.

XII.

10.

Explain the elements of a decision tree model.

11.

Describe how to refine a decision tree model to ensure the data represent the business context.

12.

Explain how to validate the predictions of full versus refined decision trees.

13.

Evaluate the predictions of different data science models to choose the best one for the business need and visualize and communicate model insights.

14.

Describe how to use and deploy data science models.

CHAPTER SYNOPSIS This chapter covers foundational concepts of data science for predictive modeling to aid decision making. Data science refers to the use of data analytics to draw conclusions from data. Predictive modeling is a data science technique used to make predictions based on past or current data.

III.

POINTS OF EMPHASIS 7.

Make certain the students understand the role of management accountants putting “big data” to work creating cost-saving and revenue-generating opportunities.

Recognize that once an understanding of the problem is achieved, data should be explored and evaluated for relevancy to that problem. Students should become familiar with the concept of functional versus flexible relationships and one specific predictive modeling technique: decision trees, including the refining techniques of overfitting and pruning. Choose among various predictive models using three techniques: cross-validation using prediction accuracy, cross-validation using maximum likelihood, and testing on holdout samples. Evaluate the predictions of different models to choose the best one for the situation.

IV.

CHAPTER OUTLINE LEARNING OBJECTIVE

Explain how management accountants can work with data scientists to create value

… use data to predict outcomes and impact decision making

2.1

Outcome prediction is different today with the increasing availability of inexpensive data storage and web-based computing power. We can now train sophisticated algorithmic models to predict a new record.

1.2

Management accountants need to understand some computer science and statistical tools used in data science so that they can effectively interact with other members of the data science team. Chapter 10 used linear regression and historic cost data to estimate costs and to understand cost drivers. This helps managers make better decisions. Chapter 11 focuses on predicting future revenues and costs. The methods of prediction help managers understand cost drivers, but the primary goal is to inform decisions and create value.

1.3

1.4

The data science framework is a seven-step decisionmaking process for applying machine learning techniques in business situations. Those steps are: 1. 2. 3. 4. 5. 6. 7.

Gain a business understanding of the problem Obtain and explore data Prepare data Build a model Evaluate the model Visualize and communicate insights Deploy the model

1.5

Each step will be discussed but students must keep the big picture in mind. Data Science relies on backtesting and feedback to choose among models.

1.6

In order to choose among models, data scientists subdivide their data into different samples: Training sample – used in step 4 to build a model Cross-validation sample – used in step 5 to evaluate and choose among models Holdout sample – used in step 5 to test how the model would perform on completely new data

Refer to Quiz Question 1 and 2 LEARNING OBJECTIVE

Identify the questions management wants to ask and the relevant data

. . . why is the question important, and what data should we use to address it

2.1

Once the problem is defined, management accountants play an important role in helping management decide which questions and what data have the potential to create value for the organization. This process covers the first three steps in the decision-making process.

2.2

Gain an understanding of the problem and form questions. This is a critical first step for the management accountant at the outset of any data science task.

2.3

The second step is to obtain and explore relevant data. Management accountants evaluate the data in terms of objectivity, whether the data is an estimate or is carefully measured, and its relevancy to the questions asked.

2.4

Exploratory data analysis refers to any activity that reveals deeper insight into a dataset. This may include a numeric analysis such as finding the mean, median, minimum and maximum, as well as gaining an understanding of its size and contents, and the features (fields) contained.

2.5

Step 3 is to prepare the data. In this step, management accountants determine how to organize and process the data. They determine whether additional data is needed, how different variables should be measured and what variables, if any, should be excluded.

2.6

Management accountants should avoid target leakage which occurs when data that are not available at the time of the analysis are included in the process. TEACHING POINT: The textbook has an example of target leakage where loan performance data which is collected after the loan is funded are included. These loans should be excluded from the dataset because it is data from the future.

Refer to Quiz Question 3 and 4 Problem 11-31 LEARNING OBJECTIVE

Explain the elements of a decision tree model

… using rules to segment the target variable into different classes

3.1

Step 4 is to build a model. The logistic regression model that was studied in chapter 10 assumes a functional form of the relationship between feature variables and the target variable to “fit” the curve.

3-2

Sometimes the use of a flexible model that does not assume a particular functional relationship between feature variables and the target variable are preferred. A very popular technique for this is called a decision tree.

3-3

A decision tree is a technique for segmenting the target variable into different regions based on a set of rules. These trees can be read as a series of “if-then-else” rules that ultimately generate a predicted value. The algorithm instructs us how to divide the data with a “cut” or line parallel to the x-axis or y-axis such that each of the two smaller rectangles contains a mix of dots (data points) that are more pure than the original rectangle. TEACHING POINT: The remaining pages of this section consist of the details used to create a decision tree. Using Exhibits 11-6, 11-9, 11-10, and 11-11, you can walk the students through the “cuts” that were made to develop an accurate model.

3-4

Between each cut, impurities are measured such that each subsequent cut will reduce the Gini impurity score. The “Gini impurity” measures the purity and then software determines where the cut should be to maximize reduction in the Gini impurity. This continues until all rectangles are pure. The technical term here is recursive partitioning.

Refer to Quiz Question 5 11-21 and 11-23

LEARNING OBJECTIVE

Exercises

Describe how to refine a decision tree model to ensure the data represent the business context … pruning the decision tree to prevent overfitting and improving predictions

4.1

There are two specific areas that management accountants address when refining a decision tree to better match the economics of the business: Overfitting occurs when a model matches the specific details of a dataset too closely, limiting its predictive powers, and, Pruning which is a technique used to sharpen the model’s powers.

4.2

Overfitting is a direct outcome of the flexibility and power of these models. In this case, it captures noise from random chance, making it less effective at accurately classifying observations from a new dataset. Overfitting limits a model’s ability to predict future outcomes.

4.3

One solution to overfitting is pruning. Pruning is a technique in which the tree is not grown to its full size, but instead only allowed to grow to a certain depth. TEACHING POINT: If you compare the fully grown decision tree from Exhibit 11-11 to the “pruned” tree from Exhibit 11-12, you’ll see that the tree in 11-12 stops at a depth of 3 where the tree in 11-11 goes to a depth of 4. The difference in depth creates different rules, one of which should predict more accurately.

Refer to Quiz Questions 6 Exercises 11-25 LEARNING OBJECTIVE

Explain how to validate the predictions of full versus refined decision trees … cross-validation using prediction accuracy and maximum likelihood and testing on holdout samples to balance the bias-variance tradeoff

5.1

In this chapter, we introduce three techniques used to choose among models such as the full and pruned decision tree. The three techniques are: 1. Cross-validation using prediction accuracy 16-6 Copyright © 2021 Pearson Education, Inc.

2. Cross-validation using maximum likelihood, 3. Testing on Holdout samples 5.2

Cross-validation using prediction accuracy is the process of comparing predictions of different models on a new set of data for which the actual outcomes are already known.

5.3

Cross-validation using maximum likelihood values is displayed on Exhibit 11-14. Choosing a model based on feedback from the validation sample means that the data scientist is using the validation sample to make decisions about which model performs better. The real test is how well the pruned decision tree model performs against data it has not seen.

5.4

Testing the model on the holdout sample provides an overall likelihood value. Comparing the value from the holdout sample to the validation sample, we are looking for similar results.

5.5

Two important principles guide the choice of models. They are 1) feedback loops are fundamental to data science, and 2) the choice of model is based on performance of the cross-validation data, not the training data.

Refer to Quiz Question 7 and 8 Exercise 11-26 LEARNING OBJECTIVE

Evaluate the predictions of different data science models to choose the best one for the business need and visualize and communicate model insights … use likelihood values, feature variables, confusion matrix, receiver operating characteristic curve, payoff matrix

6.1

Now that we’ve selected the model, we can proceed to step 5: evaluate the model.

6.2

There are several ways to evaluate the model: Evaluate the magnitude of the likelihood values – models with high likelihood give better predictions Evaluate feature variables – determine whether the 16-7 Copyright © 2021 Pearson Education, Inc.

feature variables used to make predictions about the target variable make economic sense Consider confusion matrix classifications – to use this technique, we must calculate the false positive rate (the fraction of negatives incorrectly identified as positives) and the true positive rate (the fraction of positives correctly identified as positive), at a given threshold value. A confusion matrix is a matrix that shows the predicted and actual classifications at a given threshold value. If confusion matrices are created with different cutoff default probabilities, they can indicate the nature of the tradeoff in choosing the cutoff default probability. Consider the receiver operating characteristic (ROC) curve – the more accurately a model predicts the target variable, the closer the ROC curve will go up along the y-axis on the left and then move horizontally across the top Quantify predictions using the payoff matrix – management accountants use their insights and knowledge of the business to estimate the payoffs. 6.3

Step 6 indicates that visualizing and communicating the insights of data science models is an important task for the management accountant because it helps managers understand the value and tradeoffs from using these models.

Refer to Quiz Questions 9 28 LEARNING OBJECTIVE

Exercise 11-27 and 11-

describe how to use and deploy data science models … understand critical inputs to exercise judgment to reach conclusions

7.1

Step 7 is to deploy the model. Here, the management accountant must understand critical model inputs and areas of significant judgment that normally pertain to data and cutoff values.

15.

16.

The choice of the cutoff depends heavily on the payoff matrix, so it is important to get good estimates of the payoffs. Where there is uncertainty, the management accountant evaluates the sensitivity of different payoffs on the cutoff decision.

Refer to Quiz Question 10

CHAPTER 11 QUIZ 1. Data science sits at the intersection of____ a. computer science and data skills b. math and statistics knowledge, inference and general accounting knowledge c. computer science and general accounting knowledge d. computer science and data skills, math and statistics knowledge, and substantive expertise in a particular area of interest or domain such as industry and management accounting knowledge 2. Which of the following is a true statement about the data science framework? a. The data science framework is the same as the five-step decision-making process b. The management accountants defer decisions and actions throughout the framework to the data scientists c. The data science framework is a seven-step decision-making process for applying machine learning techniques in business situations. d. None of these statements are true regarding the data science framework. 3. Any activity that reveals deeper insight into a dataset is known as ________. 16-9 Copyright © 2021 Pearson Education, Inc.

a. b. c. d.

Exploratory data analysis Evaluating the data Target feature selection Predictive model selection

4. Target leakage refers to data _______. a. that are included in the dataset but are duplicates b. that are private but are inadvertently included in the dataset c. that are not available at the time of the analysis that should be included. d. that are not available at the time of the analysis that should be excluded. 5. A decision tree is a technique for ______. a. modeling focusing on the functional form of the relationship between feature variables and the target variable. b. segmenting the target variable into different regions based on a set of rules c. segmenting the feature variables into different regions based on a set of rules d. segmenting the feature variables into different regions based on the information obtained from the management accountant. 6. Which of the following is false regarding the refining of the decision tree? a. Overfitting occurs when a model does not adhere closely to the specific details of a dataset such that it captures noise from random change, making it less effective at accurately classifying observations from a new dataset. b. Pruning is a technique in which the tree is not grown to its full size, but instead is only allowed to grow to a certain depth. c. Overfitting occurs when a model adheres too closely to the specific details of a dataset such that, in addition to signal, it captures noise from random chance, making it less effective at accurately classifying observations from a new dataset. d. Overfitting is an important concept for management accountants to recognize when using data analytic techniques. 7. Your full decision tree shows a likelihood value of .07 while the pruned tree shows a likelihood value of .11. Which tree is likely to predict most accurately? a. the full tree b. the pruned tree c. neither 8. Feedback loops and performance on cross-validation data are two important principles that guide ________. a. the decision of which management accountant to hire b. the determination of which dataset to use c. the decision about which should be the target variable d. the decision about which model to use 9. Which ROC curve suggests a higher level of accuracy? a. A curve that moves diagonally from bottom left to upper right b. A curve that moves horizontally near the bottom of the chart c. A curve that hugs the y-axis and then moves horizontally across the top of the chart d. A curve that hugs the x-axis and then moves vertically on the right of the chart

10. When we use data science models, as opposed to models that assume a functional relationship, qualitative assessments may safely be ignored. a. True b. False

CHAPTER 11 QUIZ SOLUTIONS 1.

10.

Decision Making and Relevant Information

TRANSITION NOTES This chapter continues the emphasis on the five-step decision process, applying it to relevant cost decisions relating to special order, outsourcing, capacity constraints, and equipment-replacement scenarios. The managerial emphasis is applied throughout the chapter with emphasis on problem solving for decision making through these example problems. There is expanded material on decisions and performance material. *This chapter was previously Chapter 11.

17th Edition 21 Revised 22 Revised 23 Revised 24 25 26 Revised 27 Revised 28 Revised 29 Revised 30 Revised 31 Revised 32 33 34

16th Edition 21 22 23 24 25 26 27 28 29 30 31 32 33 34

17th Edition 35 Revised 36 37 Revised 38 Revised 39 40 41 Revised 42 43 44 45 Revised 46 47 Revised 48 49 50

16th Edition 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50

LEARNING OBJECTIVES 1.

Use the five-step decision-making process.

Distinguish relevant from irrelevant information in decision situations.

Explain the concept of opportunity cost and why managers should consider it when making insourcingversus-outsourcing decisions

Know how to choose which products to produce when there are capacity constraints.

Explain how to manage bottlenecks.

Discuss the factors managers must consider when adding or dropping customers or business units.

Explain why book value of equipment is irrelevant in equipment-replacement decisions. Explain how conflicts can arise between the decision model a manager uses and the performance-evaluation model top management uses to evaluate managers.

XIII. CHAPTER SYNOPSIS Chapter 12 discusses the decision-making process and the concept of relevant information. Beginning with the fivestep decision model presented in Chapter 1, the concepts of relevant revenues and relevant costs are discussed. The terms sunk cost and opportunity cost are introduced. A number of types of relevant decision analysis problems are presented: one-time-only special orders, short-run pricing decisions, outsourcing, make-or-buy decisions, bottlenecks, dropping or adding a customer, product, 16-12 Copyright © 2021 Pearson Education, Inc.

segment, or branch office. Choice guidelines for operating with capacity constraints are covered. The irrelevance of book value is presented, along with a discussion of conflicts that arise between the decision model used by the manager and the performance evaluation model used to evaluate that manager.

III.

POINTS OF EMPHASIS Critical to student success in this chapter is their ability to correctly analyze the decision situation. It is helpful to take three approaches in this regard: 1.

Walk through a completed example in the text.

Work out a problem in class with students contributing their thoughts.

Assign an in-class problem for the students to work, either in groups or individually. Be available to assist when they hit a snag.

Be certain students have grasped the concept of relevance. Students who do not grasp this concept will have difficulty in analyzing data and making the correct decision. Students sometimes have difficulty shifting from contribution margin per unit of product to contribution margin per unit of the constrained resource. Although students grasp that products, individual stores, business segments, and so on, should be dropped when they are no longer profitable, they sometimes have trouble accepting that same logic when applied to customer segments.

IV.

CHAPTER OUTLINE LEARNING OBJECTIVE

Use the five-step decision-making process to make decisions … the five steps are identify the problem and uncertainties, obtain information, make predictions about the future, make decisions by choosing among alternatives, and implement the decision, evaluate performance, and learn

1.1

a formal method of making a choice and can include quantitative as well as qualitative analysis. 1.2

Regardless of the type of decision being considered, a good decision model will utilize the five-step decision process introduced in Chapter 1. (Exhibit 12-1 displays the five-step decision process for Precision Sporting Goods.)

LEARNING OBJECTIVE

Distinguish relevant from irrelevant information in decision situations … only costs and revenues that are expected to occur in the future and differ among alternative courses of action are relevant

13.1 The decision-making process will be facilitated if the relevant costs and revenues are distinguished from the irrelevant costs and revenues. This enables the decision maker to focus on what is relevant. 13.2 Relevant costs are expected future costs, relevant revenues are expected future revenues that differ among the alternative courses of action being considered. 13.3 Relevant costs and revenues must: •

Occur in the future

•

Differ among the alternative courses of action. TEACHING POINT. Be certain students have a grasp of the concept of relevance. Students who do not grasp this concept will have difficulty in analyzing data and making the correct decision. Use an example such as a night out. Give a couple of possible activities for the evening and ask what the costs of each are, making certain that the selections contain some common items. Then evaluate which costs are relevant and which are irrelevant. (Your great examples throughout this chapter make accounting concepts relevant to students!)

13.4 Sunk costs are costs that have been incurred. They are past costs and cannot be changed regardless of what action is taken. Sunk costs, then, are irrelevant. TEACHING POINT. Use several examples of sunk costs that students can relate to. For example, they have paid their tuition for the semester. At this point, none of it is refundable. The tuition cost is a sunk cost—even if they drop the course, or if

they fail the course. (Exhibit 12-2 illustrates relevant revenues and costs for Precision Sporting Goods.)

2.5 Any decision will involve quantitative as well as qualitative factors. 2.6

Quantitative factors are outcomes measured in numerical terms. Some are financial, in other words they can be expressed in monetary terms, like direct materials or marketing costs. Others are nonfinancial; they can be measured numerically, but are not expressed in monetary terms, like reduction in new product development time or the percentage of ontime flight arrivals for an airline.

2.7

Qualitative factors are outcomes that are difficult to measure in numerical terms. Employee morale and prestige are examples of two qualitative factors. TEACHING POINT. As accountants, we deal in numbers, so we have a high comfort level with the quantitative factors. We are less comfortable with the qualitative factors. However, the qualitative must not be ignored. They are often at least as important as the quantitative. A number of years ago, a family-run meat processor ran a series of ads in which the “bright young accountant” came to top management with suggestions for reducing the cost of the product. He was served a taste of one of the products, and found it good. The old man responded, “Yes, we know we could save some costs. But then our product wouldn’t be what you just tasted. We stand for quality here.” (Exhibit 12-3 lists key features of relevant information.)

2.8

The concept of relevance applies to any decision that a company (or individual) faces. This chapter presents some common types of problems that a business will often encounter.

2.9

A one-time-only special order decision is one faced by a company having excess capacity, along with a onetime opportunity to sell a number of units at less than full cost. TEACHING POINT. Work with the students in going over a special-order problem, such as Exercise 12-24. (Exhibit 12-4 displays a budgeted income statement for Surf Gear.) (Exhibit 12-5 displays a one-time-only special order decision for Surf Gear.)

encountered in relevant-cost analysis: •

Incorrect general assumptions, such as “all variable costs are relevant and all fixed costs are irrelevant.”

•

Unit cost data can be misleading if irrelevant costs are included in the analysis or if the same unit costs are used at different output levels.

2.11 Short-run pricing decisions are another type of onetime special order that companies may have to consider. Refer to Quiz Questions 1, 2, and 3 Exercises 12-22, 12-23, and 12-24

LEARNING OBJECTIVE

Explain the concept of opportunity cost and why managers should consider it when making insourcing-versusoutsourcing decisions. … in all decisions, it is important to consider the contribution to income forgone by choosing a particular alternative and rejecting others

3.1

A second type of frequently-encountered relevant analysis is an outsourcing decision, or a make-or-buy decision.

3.2

Outsourcing is purchasing goods or services from outside vendors rather than insourcing, or producing the same goods or services within the organization. TEACHING POINT. Illustrate an outsourcing problem. Example 2 in the text is a good problem to walk the students through.

3.3

An incremental cost is the additional total cost incurred for an activity (i.e., it is the additional cost incurred in producing one more unit). (Exhibit 12-6 displays incremental analysis of a make-or-buy decision for DVD Players at Soho Company.)

3.4

Incremental revenue is the additional total revenue from an activity. A project should not be undertaken if the incremental costs exceed the incremental revenues. 16-16 Copyright © 2021 Pearson Education, Inc.

3.5

The terms incremental costs and incremental revenues are sometimes used interchangeably with differential costs and differential revenues. This book makes a distinction between incremental and differential. When using these terms in practice, be sure of the intended meaning. An incremental cost is the additional total cost incurred for an activity. A differential cost is the difference in TOTAL relevant cost between two alternatives. Incremental revenue and differential revenue are defined similarly to incremental cost and differential cost.

3.6

Strategic and qualitative factors play an important role in relevant cost analysis. Some factors include: •

Control over design, quality, reliability, and delivery schedules

•

Becoming a leaner organization through outsourcing, focusing on core competencies

•

Dependence on suppliers

•

Price increases

•

Length of contracts TEACHING POINT. Outsourcing problems in particular present a good opportunity to discuss strategic and qualitative factors— long-term goals, quality, reliability of the supplier, future price increases, among others.

3.7

International outsourcing adds another factor to relevant cost analysis in the form of exchange rate risk. This risk can be reduced with the use of forward contracts.

3.8

Deciding to use a resource in a particular way means that a manager loses the opportunity to use the resource in alternative ways. This lost opportunity is a cost that the manager must consider in making decisions.

3.9

Opportunity cost is the contribution to operating income that is forgone by not using a limited resource in its next-best alternative use. TEACHING POINT. To illustrate opportunity costs, tell the students they have two potential job offers at salaries that vary by $5,000. Both jobs are equally attractive, and in the same city. The opportunity cost is the salary of the job not taken—in this case, the one with the lower salary. Change the scenario, where the lower-paying job is local and the other is in New York City (or some other high-cost area). Students will usually opt for the local job and the opportunity cost becomes the salary of the NYC job. As a final twist, add a third job at a lower salary than the others. This does not change the opportunity cost, as the

definition specifies that opportunity cost is the forgone revenue from the best alternative not taken.

3.10 In an outsourcing decision, there is often an opportunity cost associated with the use of the resources currently consumed by the operation being considered for outsourcing. These revenues must be considered. 3.11 Remind the students that opportunity costs are not incorporated into the formal accounting records as those records are historical records and only consider alternatives that were actually selected. (Exhibit 12-7 displays the total alternatives approach and the opportunity-cost approach to a make-or-buy decision for Soho Company.)

3.12 Carrying costs of inventory are another example of opportunity costs. The money that is invested in inventory could be put to some other purpose if a smaller amount of inventory were carried. Refer to Quiz Questions 4, 5, and 6 Problems 12-37, 12-38, and 12-39

LEARNING OBJECTIVE

Exercises

12-26, and

Know how to choose which products to produce when there are capacity constraints … select the product with the highest contribution margin per unit of the limiting resource

4.1

When a company is faced with more demand for its products and services than they can produce, they are faced with capacity constraints. These decisions are referred to as product-mix decisions, as management is faced with deciding how many of each product they should manufacture to maximize contribution margin.

4.2

As all products are not equally profitable, when faced with capacity constraints, the company must decide which products to sell and in what quantities in order to maximize profits. TEACHING POINT. This is a short-run decision as the level of capacity can be expanded in the long run. Additionally, demand may be shifting, so the decision is how to maximize revenues now. As the economic landscape changes, this decision can change.

4.3

contribution margin per unit of the constrained resource. TEACHING POINT. Students sometimes have difficulty shifting from contribution margin per unit of product to contribution margin per unit of the constrained resource. It should be helpful to walk through an example, such as Example 4 in the text.

4.4

Properly identifying the constrained resource, or bottleneck, is critical to maximizing profits (i.e., Theory of constraints).

Refer to Quiz Question 7 Exercises 12-27 and 12-28

LEARNING OBJECTIVE

Explain how to manage bottlenecks … keep bottlenecks busy and increase their efficiency and capacity by increasing throughput (contribution) margin

5.1

Properly identifying bottlenecks is critical to maximizing profits. The Theory of constraints describes methods to maximize operating income when faced with some bottleneck and nonbottleneck operations. The objective of TOC is to increase throughput margin while decreasing investments and operating costs.

5.2

TOC defines three measures; 1) Throughput margin equals revenues minus the direct material cost of goods sold; 2) Investments equal the sum of (a) material costs in direct material, work-in-process, and finished goods inventories; (b) R&D costs, and (c) capital costs of equipment and buildings; 3) Operating costs equal all costs of operations (other than direct materials) incurred to earn throughput margin. Operating costs include costs such as salaries and wages, rent, utilities, and depreciation.

5.3

TOC focuses on managing bottleneck operations by: 1.

Recognizing that the bottleneck determines the contribution margin of the entire system.

Identifying the bottleneck operation by identifying operations with large quantities of inventory waiting to be worked on.

operation. 4.

Take action to increase efficiency and capacity of all bottleneck operations.5.4 Action should be taken to increase the efficiency and capacity of the bottleneck operation as long as the incremental contribution margin exceeds the incremental costs of increasing efficiency and capacity. Desirable actions include the following: Eliminate idle time at the bottleneck operation. Shift products that do not have to be made on the bottleneck machine to nonbottleneck machines or to outside processing facilities. Reduce setup time and processing time at bottleneck operations. Improve the quality of parts or products manufactured at the bottleneck operation.

Exercises 12-29 and Problem 12-44

LEARNING OBJECTIVE

Discuss the factors managers must consider when adding or dropping customers or business units … managers should focus on how total revenues and costs differ among alternatives and ignore allocated overhead costs

6.1

Companies are often faced with the problem of adding or dropping product lines, business segments, branch offices, or customers. Relevant-revenue and relevantcost analysis can contribute to the decision-making process. (Exhibits 12-8 through 12-10 illustrate profitability analysis for Allied West.) TEACHING POINT. Students have very little difficulty accepting the fact that products, individual stores, business segments, and the like should be dropped when they are no longer profitable. However, they sometimes are reluctant to accept that same logic when applied to customer segments.

An example can illustrate this concept. Most are familiar with companies that have a minimum order requirement, such as $50 (i.e., below that amount, they will sell to you, but for an extra charge of $5 or some such amount). These companies have performed analyses that tell them that a customer who does not order $50 or more actually costs them money, so they take the stance that if you want to buy from them, you will have to pay for the privilege. Sometimes the answer may not be to totally drop the customer, but to give a reduced level of service. At a small college, for example, the number of books sold may not be as significant as at a large, state university. Some book publishers have made the decision to not have sales representatives make personal calls on faculty at small schools, but rely on phone calls and e-mail to keep in touch with faculty. These can be accomplished at a lower cost, but lack the element of personal service.

6.2

At times the decision to drop products or customers may be due to capacity constraints. If the company does not have the capacity to meet all demand, certain products may have to be discontinued or customers may have to be dropped.

6.3

The other side of this coin is adding product lines, customers, branch offices, or other items. This can occur when there is excess capacity or when the gains from the addition will also cover the added capacity costs. TEACHING POINT. Students will have an easier time grasping these concepts if they see them illustrated. Cover the Allied West example in the text or have the class work through the suggested exercises for this learning objective.

Refer to Quiz Question 8 and 12-31, Problem 12-46

LEARNING OBJECTIVE

Exercises 12-30

Explain why book value of equipment is irrelevant to managers making equipment-replacement decisions … it is a past cost

7.1

As discussed earlier in the chapter, sunk costs are irrelevant when making decisions about future actions.

7.2

TEACHING POINT. Students will sometimes observe that an asset can be sold so the book value should be relevant. Help the student distinguish between the book value of the asset (a sunk cost) and the revenue received if this asset is sold. These are two different issues that deal with the same object. Exercise 12-32 is an excellent problem to illustrate this point. However, this problem can be used to contrast the answer given by analyzing the numbers, and the path taken by the company. Due to short-term performance evaluations, political pressures within the company, and other factors, the manager would frequently opt to stay with the old equipment regardless of what the numbers say. (Exhibits 12-11 and 12-12 depict cost-comparison analysis of the equipment-replacement decision for Toledo Company.)

Refer to Quiz Question 9 Exercises 12-32 and 12-33

LEARNING OBJECTIVE

Explain how conflicts can arise between the decision model a manager uses and the performance-evaluation model top management uses to evaluate managers. … tell managers to take a multiple-year view in decision making but judge their performance only on the basis of the current year’s operating income

8.1

Managers may make decisions that are suboptimal when viewed from the company as a whole. One reason for this is that managers tend to act in their own selfinterest and the performance-evaluation system does not reward the behaviors indicated by the decision model the company employs.

8.2

Usually, these differences arise due to differences in the time frame under consideration. Managers are frequently evaluated on annual results, whereas the decision model looks at the entire life of the project under consideration. TEACHING POINT. This conflict is seen in Exercise 12-32. If the manager opts to buy the new machine, profits in the first year take a big hit, but future profits are greater. If the manager is evaluated on a one-year horizon, he will be reluctant to scrap

the existing machine. This conflict can also set up an ethical dilemma—should the manager act in the company’s interest, or is it ethical for personal interests to prevail as long as the manager does not violate company rules?

Refer to Quiz Question 10 Problem 12-50

APPENDIX A.1

Linear programming (LP) is a technique that can be utilized to determine which products to manufacture when multiple constraints exist. (Exhibit 12-13 summarizes the relevant data for the Power Recreation example.)

A.2

Solving an LP problem consists of three steps: • •

•

Determine the objective function. This is the objective, or goal, to be maximized or minimized. Specify the constraints. A constraint is a mathematical inequality or equality that must be satisfied by the variables in a mathematical model. Compute the optimal solution. There are two approaches to determine this—the trial and error approach and the graphic approach.

(Exhibit 12-14 illustrates the Power Recreation constraints in graphical form.)

A.3

The trial-and-error approach calculates the contribution margin at each corner with the optimal solution the corner producing the highest contribution margin.

A.4

The graphic approach draws an optimal line. That is the point farthest from the origin but passing through a point in the area of feasible solutions. This line represents the highest total contribution margin.

A.5

Sensitivity analysis can be utilized in this approach to deal with uncertainty in the constraints or variables.

Exhibit 12-1 displays the five-step decision process for Precision Sporting Goods. Exhibit 12-2 illustrates relevant revenues and costs for Precision Sporting Goods. Exhibit 12-3 lists key features of relevant information. Exhibit 12-4 displays a budgeted income statement for Surf Gear. Exhibit 12-5 displays a one-time-only special order decision for Surf Gear. Exhibit 12-6 displays incremental analysis of a make-or-buy decision for DVD players at Soho Company. Exhibit 12-7 displays total alternatives and opportunitycost analysis to a make-or-buy decision for Soho Company. Exhibits 12-8 through 12-10 illustrates a customer or segment profitability analysis for Allied Furniture. Exhibits 12-11 and 12-12 depict cost comparison analysis of the equipment-replacement decision for Toledo Company. Exhibit 12-13 (in the appendix) summarizes the relevant data for the Power Recreation example. Exhibit 12-14 (in the appendix) illustrates the Power Recreation constraints in graphical form.

CHAPTER 12 QUIZ 1.

Which of the following should not be considered for every option in the decision process? a. Relevant revenues b. Relevant costs c. Historical costs d. Opportunity costs

What is always the question to ask to determine if revenues or costs are relevant? a. What is the time frame for achieving results? b. What difference will a particular action make? c. Who will be responsible? d. How much will it cost?

[CPA Adapted] Mikaelabelle Products sells product A at a selling price of $40 per unit. Mikaelabelle’s cost per unit based on the full capacity of 500,000 units is as follows: Direct materials Direct labor

6 3

Indirect manufacturing (60% of which is fixed) $19

A one-time-only special order offering to buy 50,000 units was received from an overseas distributor. The only other costs that would be incurred on this order would be $4 per unit for shipping. Mikaelabelle has sufficient existing capacity to manufacture the additional units. In negotiating a price for the special order, Mikaelabelle should consider that the minimum selling price per unit should be a. $17 b. $19 c. $21 d. $23 4.

The concept of outsourcing services to countries with lower labor costs is known as a. opportunity cost. b. offshoring. c. insourcing. d. international outsourcing.

[CMA Adapted] Troy Instruments uses ten units of Part Number S1798 each month in the production of scientific equipment. The unit cost to manufacturing one unit of S1798 is presented below. Direct materials $ 4,000 Materials handling (10% of direct materials cost) 400 Direct manufacturing labor 6,000 Indirect manufacturing (200% of direct labor) 12,000 Total manufacturing cost $22,400 Materials handling represents the direct variable costs of the Receiving Department that are applied to all direct materials and purchased components on the basis of their cost. This is a separate charge in addition to indirect manufacturing cost. Troy’s annual indirect manufacturing cost budget is one-fourth variable and three-fourths fixed. Duncan Supply, one of Troy’s reliable vendors, has offered to supply Part Number S1798 at a unit price of $17,000. If Troy purchases the S1798 units from Duncan, the capacity Troy used to manufacture these parts would be idle. Should Troy decide to purchase the parts from Duncan, the unit cost of S1798 would a. decrease by $3,700. b. decrease by $5,600. c. increase by $3,600. d. increase by $5,300.

a. b. c. d.

Opportunity costs are considered period costs rather than inventoriable costs for accounting purposes. Opportunity costs must be considered by managers when making decisions. Opportunity cost plus the incremental future revenues and costs equal the relevant revenues and costs of any alternative when capacity is constrained. The opportunity cost of holding inventory is the income forgone by tying up money in inventory and not investing it elsewhere.

Nicholas, Inc. has provided the following unit data for review:

Selling price Variable cost

Simple Product Advanced Product $22.75 $55.00 10.00 34.50

Pounds of scarce raw material per unit

Which product, Simple or Advanced, is most profitable for Nicholas, Inc. to manufacture? a. Both in ratio of 3:5 b Both in ratio of 5:8 c. Simple d. Advanced 8.

RCG Services is investigating its profitability relationship with each of its customers. What is the one question RCG should ask in deciding whether to keep or drop a particular customer? a. Will the customer meet a specific designated gross margin percentage? b. Will the customer be willing to pay a higher price to insure RCG’s profitability? c. Will enough customers be found to replace any customers dropped for lack of profitability? d. Will expected total corporate office costs decrease if a decision is made to drop the customer?

[CPA Adapted] On December 31, 2020, Brown Co. had a machine with an original cost of $90,000, accumulated depreciation of $75,000, and an estimated salvage value of zero. On December 31, 2020, Brown was considering the purchase of a new machine having a five-year life, costing $150,000, and having an estimated salvage value of $30,000 at the end of five years. In its decision concerning the possible purchase of the machine, how much should Brown consider as sunk cost at December 31, 2020? a. $150,000 b. $120,000 c. $90,000 16-26 Copyright © 2021 Pearson Education, Inc.

d. 10.

$15,000

Which of the following is not a reason for the performance evaluation model to differ from the decision model? a. The use of different time frames: one being an annual basis, the other a period of several years. b. The accounting systems enable each decision to be tracked separately. c. The accrual accounting method incorporates irrelevant costs. d. Top management is rarely aware of particular desirable alternatives that were not chosen by subordinate managers.

CHAPTER 12 QUIZ SOLUTIONS 1.

10.

Quiz Question Calculations 3.

DM $ 6 DL 3 Variable OH 4 Add’l shipping $17

($10 x 40%) 4

Cost to Make Direct materials$4,000 Purchase of part Material handling 400 Direct labor 6,000 Indirect manufacturing 25% Total $13,400 Difference in favor of making

(given) Cost to Buy $17,000 1,700 3,000* $18,700 $5,300

*$12,000 

Simple 22.75 10.00 12.75

Selling price Variable cost Contribution margin

Pounds of material per unit Contribution margin per pound of material

Advanced 55.00 34.50 20.50 3

4.25 4.11

Simple provides a higher contribution margin per pound of scarce raw material.

Strategy, Balanced Scorecard, and Strategic Profitability Analysis

TRANSITION NOTES This chapter has a rewritten discussion on the choice of strategy, making the issues involved in that choice clearer. Rather than linking the balanced scorecard to quality improvement and reengineering, it is introduced after these topics are presented. A discussion of the use of strategy maps with the balanced scorecard is presented in order to create a linked or causal balanced scorecard. There is a renewed emphasis on effective implementation through employee communications. In addition, more discussion is included regarding the balanced scorecard and performance evaluation. The definition of unused capacity costs was updated. LO #2: What comprises reengineering has been deleted. *This chapter was previously Chapter 12.

EXERCISES AND PROBLEMS CORRELATION CHART 17h Edition 19 20 21 22 23 24 25 Revised 26 Revised 27 Revised 28 Revised 29 Revised 30 Revised 31 Revised

16th Edition 19 20 21 22 23 24 25 26 27 28 29 30 31

17th Edition 32 33 Revised 34 Revised 35 Revised 36 Revised 37 38 39 40 41 42 43 Revised 44 Revised

16th Edition 32 33 34 35 36 37 38 39 40 41 42 43 44

II.

LEARNING OBJECTIVES 1.

Recognize which of two generic strategies a company is using.

Understand

Analyze changes in operating income to evaluate strategy.

Identify unused capacity and learn how to manage it.

the four perspectives of the balanced scorecard.

CHAPTER SYNOPSIS Chapter 13 explores the role of strategy in long-range planning, focusing on the two generic strategies of product differentiation and cost leadership. The balanced scorecard is discussed as a method for implementing and evaluating strategies. The four perspectives of the balanced scorecard—financial, customer service, internal processes, and learning and growth are discussed. We use the balanced scorecard approach to implement strategy. We use methods to analyze operating income in order to evaluate the success of a strategy. Analysis of changes in operating income using the growth, price-recovery, and productivity components is explored. Engineered and discretionary costs are defined and distinguished. Capacity utilization is discussed, with a focus on managing unused capacity.

III.

POINTS OF EMPHASIS 1.

Spend substantial time on the balanced scorecard. This is not just the latest management fad; the balanced scorecard is a management tool that is likely to be around for a number of years. It has already been proven to be a valuable performance evaluation tool. However, to fully realize its potential, management must spend an adequate amount of time in preparation and implementation. Emphasize that the balanced scorecard is a versatile tool that can be utilized in any type of organization including not-for-profits. Merely substitute the 16-29 Copyright © 2021 Pearson Education, Inc.

organization’s ultimate objective for the financial perspective. 2.

IV.

Problems 13-33, 13-34, 13-35, and 13-36 provide a comprehensive overview of the chapter. You may find it preferable to work through these problems as a part of (or in place of) lecturing on the material.

CHAPTER OUTLINE LEARNING OBJECTIVE

Recognize which of two generic strategies a company is using … product differentiation or cost leadership

1.1

Strategy specifies how an organization matches its own capabilities with the opportunities in the marketplace to accomplish its objectives.

1.2

In other words, strategy describes how an organization can create value for its customers while differentiating itself from its competitors. TEACHING POINT. Brainstorm with the class ways in which an organization may differentiate itself from its competition. Probe further, considering if and how this differentiation creates value for the customer. Move from here to discuss if this will help the company accomplish its objectives. For example, a company may be a low-price leader. By charging the lowest price, it is differentiating itself from others. By giving the customer a lower price, it is creating value for the customer. However, can it do this and meet its profit goals?

1.3

In formulating its strategy, the organization must understand the industry in which it operates. Industry analysis focuses on five factors: •

Competitors. Who are your competitors? What are their characteristics?

•

Potential entrants into the market. Is your industry one in which there is easy entry or are there barriers to entry?

•

Equivalent products. Are there substitute products for yours? For example, if you manufacture paper cups, you are also competing with manufacturers of plastic and Styrofoam cups. 16-30 Copyright © 2021 Pearson Education, Inc.

•

Bargaining power of customers. Can your product be obtained elsewhere? Do you have a few customers who purchase large quantities?

•

Bargaining power of input suppliers. Are there limited sources for your raw materials? Are there only a few potential companies from which you may purchase supplies?

1.4

In setting its strategic direction, one choice available to organizations is product differentiation. This is the organization’s ability to offer products or services perceived by customers as superior and unique to those offered by competitors.

1.5

A second strategic choice for organizations is cost leadership. Under this approach an organization’s ability to achieve lower costs relative to competitors through productivity and efficiency improvements, elimination of waste, and tight cost control provide a competitive advantage.

1.6

To determine which strategy to follow, a company can create a customer preference map as is shown for Chipset, Inc. in Exhibit 13-1. TEACHING POINT. Have the students identify the strategy employed by a number of companies. Walmart will be one of the first mentioned as a cost leader. Probe how companies competing with Walmart can effectively compete.

Refer to Quiz Question 1

LEARNING OBJECTIVE

Understand the four perspectives of the balanced scorecard … financial, customer, internal business process, and learning and growth

2.1

The balanced scorecard translates an organization’s mission and strategy into a set of performance measures that serve as the framework for implementing its strategy.

2.2

balance financial and nonfinancial performance measures to evaluate short-run and long-run performance in a single report. 2.3

In any organization, managers will respond to the measure used to evaluate their performance. This often results in an overemphasis on this performance measure. The balanced scorecard can overcome this by utilizing a set of related performance measures.

2.4

The balanced scorecard measures the performance of an organization from four perspectives: •

Financial perspective. This perspective evaluates the profits and value created for shareholders.

•

Customer perspective. This perspective identifies targeted customer and market segments and measures success in these segments.

•

Internal-business-process perspective. This perspective focuses on internal operations that create value for customers. This perspective includes three subprocesses:

•

Post-sales-service process: Providing service and support to the customer after the sale of a product or service

Operations process: Producing and delivering existing products and services that will meet the needs of the customer

Innovation process: Creating products, services, and processes that will meet the needs of customers

Learning-and-growth perspective. This perspective identifies the capabilities at which the organization must excel in order to improve the internal processes that create value. (Exhibit 13-2 illustrates the interactions among the various perspectives for Chipset.) TEACHING POINT. Emphasize that the company will typically identify a limited number of objectives for each perspective, along with a method for measuring results for each initiative. Not all measures would be emphasized each year. Note that the perspectives build on one another. When the company successfully meets its learning and growth objectives, this should translate into improvements in the internal business perspective. This, in turn, will improve the customer perspective and finally result in improved financial performance. (Exhibit 13-3 illustrates The Balanced Scorecard for Chipset.)

2.5

2.6

2.7

Implementing a balanced scorecard is a companywide effort with commitment and leadership from top management an absolute requirement. Without such support, it will not succeed. A useful first step in designing a balanced scorecard is a strategy map. A strategy map is a diagram that describes how an organization intends to create value by connecting strategic objectives in each perspective in explicit cause-and-effect relationships. Companies use structural analysis to think carefully about the causal links in the strategy map. There are five types of items to consider in a structural analysis: strength of ties (causal links), orphan objectives (an orphan objective is a strategic objective with only weak ties (if any) leading out of it to other strategic objectives.), focal points (a strategic objective that has multiple links from other objectives funneling INTO it), trigger points (a strategic objective that has multiple ties to other objectives spurring OUT from it), and distinctive objectives (strategic objectives that distinguish an organization from its competitors and that are viewed as critical for achieving the organization’s strategy.) TEACHING POINT: Use the information provided and Chipset’s Strategy map (Exhibit 13-2) to walk students through this process.

2.8

Another important aspect of the balanced scorecard is that it must be aligned with strategy. The composition of any particular balanced scorecard will depend on the strategy adopted by the organization.

2.9

Managers interested in measuring environmental and social performance are incorporating these factors into their balanced scorecard.

2.10 There are several features that are characteristic of a good balanced scorecard. • •

It tells the story of a company’s strategy through a sequence of cause-and-effect relationships. It communicates the strategy to all members of the organization by translating strategy into a coherent and linked set of measurable operational targets. TEACHING POINT. The importance of this feature cannot be overemphasized. Numerous companies have failed because management did not adequately communicate its strategy to the rank-and-file.

•

TEACHING POINT. The balanced scorecard helps achieve goal congruence. It rewards managers for taking actions that will increase the value of the company, thus maximizing the managers’ personal wealth.

•

It focuses attention on only the most critical measures.

•

It highlights less-than-optimal tradeoffs that managers may make when they fail to consider operational and financial measures together.

2.11 Just as there are some features that are characteristic of a good balanced scorecard, there are some pitfalls that should be avoided. •

Do not assume the cause-and-effect linkages are precise. They are hypotheses about how they interact. With experience, the company should be able to refine these linkages.

•

Do not seek improvements over all measures all of the time. Keep an eye on the long-run profit maximization. Cost-benefit considerations are critical to a successful balanced scorecard.

•

Do not use only objective measures. Subjective measures such as customer and employee satisfaction ratings should be included. TEACHING POINT. Be careful in using such measures as customer satisfaction ratings. One company set a rather high goal for the percentage of positive comment cards returned. They fell far short of the goal, as they failed to realize that dissatisfied customers tended to turn in the cards. Unless a customer was extremely pleased, they would not normally complete a comment card.

•

Do not ignore nonfinancial measures when evaluating managers and other employees. Managers will focus on what measures their performance, so exclusion of these measures will mean that managers give them less importance.

2.12 Finally, the company must evaluate the success of its strategy and implementation of the balanced scorecard. This is done by comparing the target and actual performance columns on the scorecard. Refer to Quiz Questions 2, 3, 4 and 5 Exercise 13-19

LEARNING OBJECTIVE

Analyze changes in operating income to evaluate strategy … growth, price recovery, and productivity

3.1

Analyzing income statements for two years will reveal the change in operating income. However, in order to evaluate the success of management’s strategy, that change in operating income must be analyzed, asking “What caused the change?”

3.2

There are three factors that create changes in operating income: •

The growth component measures the change in operating income attributable solely to the change in the number of units sold. o

•

The growth component can be broken down into two categories:

➢

The revenue effect of growth measures the change in revenues due to a change in the number of units sold.

➢

The cost effect of growth measures how much costs would have changed based on current year output at prior year input costs. This is also broken down into fixed and variable components.

The price-recovery component measures the change in operating income attributable to change in the prices of inputs and outputs. •

The price-recovery component can also be broken down into the revenue and the cost effect categories. ➢

The revenue effect of price recovery measures the change in operating

income resulting from a change in the selling price from the prior year.

➢

•

The cost effect of price recovery measures the change in operating income due to changes in variable or fixed costs of inputs.

The productivity component measures the change in costs attributable to changes in the quantity of inputs. This measures the efficiency in the use of inputs. o

The productivity component uses current input prices to measure how costs have changed as a result of using more or fewer inputs, a change in the mix of inputs, or change in capacity utilized to produce current output compared with prior year inputs and capacity.

3.3

In addition to the growth, price-recovery, and productivity component, further analysis is needed. The company’s change in operating income may be the result of a change in market size or other favorable economic conditions.

3.4

If the growth came as a result of a price leadership strategy, the change in operating income from cost leadership should include the productivity gain, change in operating income from productivity-related 16-36 Copyright © 2021 Pearson Education, Inc.

growth, and any decrease in operating income from lowering prices. (Exhibit 13-6 illustrates a Strategic Analysis of Profitability.)

Refer to Quiz Questions 6 through 8 Exercises 13-20, 13-21, 13-22, and 13-23

LEARNING OBJECTIVE

Identify unused capacity … capacity available minus capacity used and how to manage it … downsize to reduce capacity

4.1

Fixed costs, as we have seen, are tied to capacity. In order to manage fixed costs, unused capacity must be measured and managed.

4.2

Unused capacity is the amount of productive capacity available over and above the productive capacity employed to meet customer demand in the current period.

4.3

Unused Capacity Costs = Cost of capacity committed to at the beginning of the year less manufacturing resources used during the year

4.4

When excess capacity is identified, it can be eliminated through downsizing (also called rightsizing). This is an integrated approach of configuring processes, products, and people to match costs to the activities that need to be performed to operate effectively and efficiently in the present and future.

Refer to Quiz Questions 9 and 10 Exercises 13-24

APPENDIX: PRODUCTIVITY MEASUREMENT A.1

outputs produced. The lower the inputs for a given quantity of outputs or the higher the outputs for a given quantity of inputs, the higher the productivity. A.2

The most frequently used productivity measure is referred to as partial productivity. It compares the quantity of output produced with the quantity of an individual input used and is commonly expressed as a ratio: Partial productivity = Quantity of output produced/Quantity of input used

A.3

Total factor productivity is the ratio of the quantity of output produced divided by the costs of all inputs used based upon current period prices: Total factor productivity = Quantity of output produced/costs of all inputs used (Exhibit 13-7 compares Chipset’s productivity in 2016 and 2017)

Refer to Quiz Question 11 Problems13-43 and 13-44

Exhibit 13-6 illustrates a Strategic Analysis of Profitability. Exhibit 13-7 compares Chipset’s productivity in 2019 and 2020.

Which of the following are two generic strategies described in the text that a company can use? a. Growth and product differentiation b. Price recovery and growth c. Product differentiation and cost leadership d. Cost leadership and price recovery

A trigger point is a ________. a. strategic objective that has multiple ties to other objectives spurring out from it b. strategic objective that has multiple links from another objective funneling into it c. strategic objective that distinguishes an organization from its competitors d. method by which we can differentiate products

A balanced scorecard for environmental and social performance is not viable. a. True b. False

The balanced scorecard gets its name from a. an attempt to provide short-run financial results with long-run financial strategies. b. an attempt to balance product quality and cost reduction. c. an attempt to match a company’s own capabilities with the opportunities in the marketplace to accomplish an overall objective. d. an attempt to balance financial and nonfinancial performance measures to evaluate both short-run and long-run performance in a single report.

Creating value for customers describes which one of the four perspectives of the balanced scorecard? a. Financial perspective b. Customer perspective c. Internal-business-process perspective d. Learning-and-growth perspective

The analysis used for evaluating the success of a strategy through changes in operating income components uses actual results of the current year compared to a. budgeted results for the current year. b. actual results for the previous year. c. target amounts for the current year. d. budgeted results for the previous year.

The growth in market share is used in calculating the net income effect of a. industry growth. b. product differentiation. c. cost leadership. d. either cost leadership or product differentiation, depending upon the strategy chosen.

Revenue and Revenue and Cost Effects Cost Effects of Cost Effect of Income Statement of Growth Price-Recovery Productivity Statement Amounts Component Component Amounts in 2019 in 2020 in 2020 in 2020 in 2020 (1) (2) (3) (4) (5) Income

Revenues $300,000 $40,000 F $85,000 F $425,000 Costs 240,000 24,000 U 34,000 U $8,000 U 306,000 Operating income $ 60,000 $ 16,000 F $51,000 F $ 8,000 U

$ 119,000 $59,000 F Change in operating income

The market growth rate in the industry was 9% in 2020. Sales in 2020 were 17,000 units at $25 each. Corum sold 15,000 units at a unit-selling price of $20 in 2019. The effect of the industry market size factor for Corum Company in 2020 was a. $5,200. b. $10,800. c. $12,240. d. $13,500. 9.

A discretionary cost can best be described by which of the following statements? a. The level of uncertainty of deviations of actual amounts from expected results is greater for discretionary costs than for engineered costs. b. Discretionary costs result from cause-and-effect relationships between outputs and inputs. c. Discretionary costs are added to or subtracted from in a step fashion. d. Discretionary costs are variable costs incurred in relation to capacity issues.

10.

Many companies have tried to downsize in an attempt to eliminate a. inefficiencies and waste associated with non-valueadded costs. b. their unused capacity. c. costs associated with both direct and indirect labor. d. costs through using information technology.

11.

[Appendix] Which of the following statements is true about productivity measures? a. A major disadvantage of total factor productivity is that it measures the combined productivity of all inputs to produce output. b. Partial productivity and total factor productivity measures work best together because the strengths of one are the weaknesses of the other. c. Total factor productivity is calculated by dividing the costs of all inputs used by the quantity of output produced. d. The higher the inputs for a given quantity of outputs or the lower the outputs for a given quantity of inputs, the higher the level of productivity.

CHAPTER 13 QUIZ SOLUTIONS 1.

10.

11.

Quiz Question Calculations 8.

15,000 units sold in 2019  9% growth = 1,350 unit increase due to market size growth 17,000 – 15,000 = 2,000 increase in unit sales $16,000  (1,350 / 2000) = $10,800

14 33 3

Pricing Decisions and Cost Management

TRANSITION NOTES Much of the presentation in this chapter has been streamlined, retaining certain material while rewriting and clarifying other essential coverage. The introductory material to alternative long-term pricing approaches has been shortened, placing an emphasis on the pricing approaches themselves. The five-step decision process is applied to target costing. The material discussing value engineering has been rewritten and updated. The discussion of value-chain analysis has been streamlined along with the life-cycle budgeting, which has undergone revisions. The section on customer life-cycle costing now contains more examples. Much of the problem material at the end of the chapter is new or revised. The section on antitrust laws was combined with pricing decisions and shortened and LO #8 eliminated. *This chapter was previously Chapter 13. 16-42 Copyright © 2021 Pearson Education, Inc.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 17 18 19 20 21 Revised 22 23 24 Revised 25 26 Revised 27 28

16th Edition 17 18 19 20 21 22 23 24 25 26 27 28

17th Edition 29 Revised 30 Revised 31 Revised 32 Revised 33 Revised 34 Revised 35 New 36 New 37

16th Edition 29 30 31 32 33 34

LEARNING OBJECTIVES 1. Discuss the three major factors that affect pricing decisions. 2. Understand how companies make long-run pricing decisions. 3. Price products using the target-costing approach. 4. Apply the concepts of cost incurrence and locked-in costs. 5. Price products using the cost-plus approach. 6. Use life-cycle budgeting and costing when making pricing decisions. 7. Describe pricing practices in which noncost factors are important.

XIV. CHAPTER SYNOPSIS This chapter describes the relationship between pricing decisions and product costing. Ultimately, how managers price a product or service depends on demand and supply. Three major influences on pricing decisions are customers, competitors, and costs. The time horizon of the pricing decision needs to be considered as there are different factors in play for short-term versus long-term pricing decisions. The target-costing approach is explained and distinguished from a traditional cost-plus approach. Target costing starts with a market-defined target price and then works 16-43 Copyright © 2021 Pearson Education, Inc.

back to a calculated target cost. Traditional cost-plus pricing approaches add required profit to product cost to determine product price. Life-cycle budgeting, price discrimination, peak-load pricing, and the impact of antitrust laws on pricing decisions are also discussed.

III.

IV.

POINTS OF EMPHASIS 1.

As students get involved in setting prices, they need a good understanding of the influences on pricing. Be certain they comprehend the interplay among customers, competitors, and costs in setting prices. Students also need to understand that different dynamics are at play in setting short-term prices versus long-term prices and that ultimately prices will depend on demand and supply

Students need to understand that target-costing pricing is a totally different approach from cost-plus pricing. Both methods have their place. Emphasize the target-costing approach.

Non-value-added costs are defined in terms of the customer. “Given a choice, would the customer pay for this cost?” Students frequently do not grasp the customer orientation in this definition.

As companies and customers become more environmentally aware, the issues of life-cycle budgeting and costing are becoming more important. There is a greater acknowledgement that the manufacturer may have some responsibility for the product at the end of its life cycle. This increases the importance of life-cycle budgeting. Students should be exposed to why this is becoming an important issue.

CHAPTER OUTLINE LEARNING OBJECTIVE

Discuss the three major factors that affect pricing decisions … customers, competitors, and costs

1.1

vacuum. They must take into account numerous factors if they are to succeed in the marketplace. Demand and supply for a product are factors that determine what a company can charge for a product or service. There are three influences on demand and supply: customers, competitors, and costs. 1.2

Customers influence price through their demand for a product based on features of the product and its quality.

1.3

Competitors have a significant influence on price. A company must always be aware of the actions of its competitors. These actions will influence the price at which a company can sell its product. It is beneficial to know competitors’ technology, plant capacity, and operating strategies. Exchange rate fluctuations can make prices of certain products more or less competitive in foreign markets.

1.4

The third influence on pricing is costs. A company cannot sell a product for less than its cost and hope to succeed. Knowledge of costs and cost behavior can enable a company to price its product to receive the maximum benefit.

1.5

A company must always keep in mind that the key factor is the customer’s willingness to pay. Pricing may not be restrained by competition, but there is a limit to what a customer is willing to pay for a product.

Refer to Quiz Question 1

LEARNING OBJECTIVE

Understand how companies make longrun pricing decisions … consider all future variable and fixed costs and earn a target return on investment

2.1

Long-run pricing is a strategic decision designed to build relationships with customers based on stable and predictable prices. TEACHING POINT. Companies value stability. By providing stable, predictable pricing, a company can plan more effectively. (Exhibit 14-2 illustrates the total cost of manufacturing Provalue

using activity-based costing.) (Exhibit 14-3 summarizes operating income for Provalue across the value chain using activity-based costing.)

2.2

Two approaches exist for long-run pricing decisions. The market-based pricing approach starts by asking, “Given what our customers want and how our competitors will react to what we do, what price should we charge?” The costbased approach computes price based on the costs to produce the product plus a target return on investment.

2.3

Companies operating in competitive markets use the market-based approach whereas companies operating in noncompetitive markets favor the cost-based approach.

LEARNING OBJECTIVE

Price products using the targetcosting approach … target costing identifies an estimated price customers are willing to pay and then computes a target cost to earn the desired profit

3.1

In setting long-range prices, companies can take a market-based approach, or they can take a cost-based approach. •

The market-based approach starts with a customer focus, asking what the customer wants, how competitors will react to our decisions, and what price should be charged. This approach is target pricing.

3.2

Market-based pricing starts with a target price. This is defined as the estimated price that potential customers will pay for a product. This price is based upon an understanding of the value placed on the product by the customer and how competitors will price their products.

3.3

Understanding the value a customer places on a product is a difficult assignment. However, the sales and marketing personnel have close contact with customers so they should be able to provide valuable insight.

3.4

Competitor analysis is also essential to setting viable market prices. When the company understands its competitors, it can more effectively evaluate how distinctive its own products and services will be in 16-46 Copyright © 2021 Pearson Education, Inc.

the market, and the price they might be able to charge as a result of being distinctive. Reverse engineering is another source of information that involves disassembling and analyzing competitors’ products to become familiar with competitors’ technology. 3.5

Implementing target pricing and target costing is a four-step process. Step 1:

Develop a product that satisfies the needs of potential customers. This is basically a restatement of the old marketing adage, “Find a need and fill it.” However, in today’s society, the company can play a part in creating that need.

Step 2:

Choose a target price. This price should be based on research of competitor’s products and what the customer is willing to pay.

Step 3:

Derive a target cost per unit by subtracting target operating income per unit from the target price. This is the estimated long-run cost per unit of a product or service that enables the company to achieve its target operating income per unit when selling at the target price.

Step 4:

Perform value engineering to achieve the target cost. Value engineering is a systematic evaluation of all aspects of the value chain with the objective of reducing costs and achieving a quality level that satisfies customers.

TEACHING POINT. Value engineering looks for better ways to accomplish an objective. This may mean a reduction in parts, using plastic that snaps together rather than metal that is attached by screws, using less packaging, redesigning the production process to reduce product movement, adopting a more efficient distribution network. It may include omitting features on the product that the customer does not value. For example, customers may indicate a desire for a certain feature to be included in the product. However, when told that the feature will add additional X dollars to the price, they would not want the feature. One Internet-based company studied their Web activity and discovered that many customers would place items in their cart and begin the checkout process. However, when they saw the amount of shipping charges, the sale was not completed. This forced the company to re-evaluate its shipping function, as customers were not willing to pay that level of shipping charges.

Refer to Quiz Question 2, 3, 4 14-20, 14-21

LEARNING OBJECTIVE

Exercises

Apply the concepts of cost incurrence … when resources are consumed and locked-in costs … when resources are committed to be incurred in the future

4.1

To implement value engineering, managers must distinguish between value-added and non-value-added costs. A value-added cost is a cost that, if eliminated, would reduce the actual or perceived value or utility (usefulness) customers experience from using the product or service. A non-value-added cost is a cost that, if eliminated, would not reduce the actual or perceived value or utility customers gain from using the product or service. TEACHING POINT. If ordering a fragile item, the customer is willing to pay for packaging materials—the customer does not want the item damaged in shipment. This is a value-added cost. On the other hand, the customer would not be willing to pay for rework of defective products, with the attitude that it should be done right the first time. This is a non-value-added cost. Emphasize that the distinction between the two is from the view of the customer.

4.2

In performing value engineering, a distinction must be made between cost incurrence and when costs are locked in.

4.3

Cost incurrence describes when a resource is consumed (or a benefit is forgone) to meet a specific objective. When direct materials are placed into production, the cost has been incurred.

4.4

Locked-in costs, or designed-in costs, are costs that have not yet been incurred, but will be incurred in the future based on decisions that have already been made. TEACHING POINT. In planning a trip, both types of these costs will be encountered. When the airline reservations are made, the cost of the airfare must be paid. That is an incurred cost. If a rental car is also booked, one locks-in rental price, but the cost

will not be incurred until the car is used. (Exhibit 14-4 is a graphical representation of the pattern of locked-in costs and cost incurrence.)

4.5

Design choices affect locked-in costs. Once the design of the product is finalized, the cost of the product is determined to a large degree. If the design of the product requires four screws, the cost of four screws is a locked-in cost. As the product is manufactured it becomes an incurred cost and can be avoided only by a redesign or by not manufacturing the product.

4.6

Because costs are incurred at all points in the value chain, but frequently locked in during the design phase, cost reductions can be most readily attained through value-chain analysis and the use of crossfunctional teams. By forming a team of representatives from all segments of the value chain the product can be designed to reduce costs while retaining features that customer’s value.

4.7

The key steps in value engineering are: •

Understanding customer requirements and valueadded and non-value-added costs

•

Anticipating how costs are locked in before they are incurred

•

Using cross-functional teams to redesign products and processes to reduce costs while meeting customer needs (Exhibit 14-5 illustrates calculation of cost-driver rates at Provalue.)

Refer to Quiz Question 5 14-27, 14-28

LEARNING OBJECTIVE

Problems

Price products using the cost-plus approach … cost-plus pricing is based on some measure of cost plus a markup

5.1

The cost-based approach starts with an evaluation of costs and where the selling price should be set in order to recoup costs and earn a desired return on 16-49 Copyright © 2021 Pearson Education, Inc.

investment. This is known as cost-plus pricing. TEACHING POINT. Depending on the competitive situation, companies would gravitate toward one approach or the other. For example, in a highly competitive market, the market approach would normally be utilized. These companies must accept the prices set by the market. If the market were less competitive, cost-plus pricing could be used. This approach is useful for companies offering products or services that differ from one another—legal services, income tax preparation, custom jewelry, to name a few. Have students identify various markets and determine which approach they are likely to utilize.

Companies selling distinctive products or services may be able to effectively utilize cost-plus pricing. The general approach to cost-plus pricing is to add a markup component to the cost base to arrive at the prospective selling price. 5.2

It should be noted that the cost-plus formula is only a starting point for pricing decisions. Costs, customers, and competitors still play a role in price setting. Unfortunately, managers will often rigidly stick to the cost-plus formula to the detriment of the company.

5.3

One approach to cost-plus pricing is to mark up the product to achieve a target rate of return on investment. This approach adds a markup based on the investment the company has in the equipment. The markup is added to the full cost of the product. TEACHING POINT. Illustrate an example of the approach to cost-plus pricing, as in Exercise 14-22. Emphasize that the desired return on investment and the markup percentage are two different numbers. If the students do not make this distinction, they will be confused about how to properly implement this approach to cost-plus pricing.

5.4

In many situations, it may be difficult to determine the specific amount of investment the company has to support a specific product, making application of the target return on investment difficult, if not meaningless. In these cases, the company simply determines the amount of desired profit and determines the appropriate markup percentage.

5.5

There are four different cost bases utilized for this purpose: •

Variable manufacturing cost, which includes only those manufacturing costs that are classified as variable.

•

Manufacturing cost, which includes all variable and fixed manufacturing costs.

•

Full cost of the product, which includes all costs incurred on behalf of the product. TEACHING POINT. Emphasize the importance of knowing the definition of cost in the application of the markup percentage. Using the wrong base with the wrong percentage markup will result in a product that is widely overpriced or underpriced—both undesirable results.

5.6

Surveys have shown that most managers use full cost of the product for their cost-based pricing decisions. Three advantages of this approach are cited. •

Full recovery of all costs of the product. The markup is designed to make a full recovery of all costs of the product.

•

Price stability. This approach leads to price stability, as it limits the ability and temptation of sales personnel to cut prices.

•

Simplicity. It does not require a detailed analysis of cost-behavior patterns.

5.7

As mentioned, the price as determined through the cost-plus formula is a prospective price. If the price under the cost-plus approach is deemed to be excessive, the markup percentage may need to be reduced. Reactions to customers and competitors may require a lower markup percentage.

5.8

Target pricing eliminates the need to go back-andforth among prospective cost-plus prices, customer reactions, and design modifications. Target pricing approaches the pricing problem by beginning with a target price and customer preferences and working back to the cost, unlike the cost-plus approach.

5.9

Suppliers providing unique products and services (such as accountants and attorneys) usually use cost-plus pricing.

5.10 Service companies such as home repair and automobile repair use a variation of cost-plus called the timeand-materials pricing method, in which job prices are based on materials used and labor time incurred. Quiz Questions 6 and 7 Exercises 14-22 and 14-23; Problems 1426, 1 4-29, 14-30, 14-31, 14-32

LEARNING OBJECTIVE

Use life-cycle budgeting and costing when making pricing decisions … accumulate all costs of a product from initial R&D to final customer service for each year of the product’s life

6.1

A normal budget cycle is a one-year period. However, companies sometimes need to consider target prices and costs over a multiple year product life cycle.

6.2

The product life cycle spans the time from initial R&D on a product to when customer service and support is no longer offered for that product.

6.3

Life-cycle budgeting is the process in which managers estimate revenues and business function costs of the entire value chain.

6.4

Life-cycle costing tracks and accumulates business function costs across the value chain from a product’s initial R&D to its final customer service and support. TEACHING POINT. In some instances, the manufacturer has a responsibility for the product beyond the sale. This can include the warranty period and the support period during which the company will make replacement parts available. In some cases, such as with a smoke detector, the manufacturer’s responsibility extends to disposal of the product. All of these post-purchase costs need to be considered in life-cycle budgeting and costing.

6.5

These factors make life-cycle budgeting important: •

The development period for R&D and design is long and costly. These costs must be recovered over the life span of the product.

•

Many costs are locked in at the R&D and design stages, even if R&D and design costs themselves are small. Poorly designed products require higher marketing and customer service costs. (Exhibit 14-7 illustrates the budgeting of life-cycle revenues and costs for a software package.)

6.6

A different approach to life-cycle costing is customer life-cycle costing. The approach considers the cost of ownership of the product for the customer from the initial purchase to ultimate disposal. TEACHING POINT. The purchase of a computer printer is an example of this concept. Companies may even sell printers at extremely low prices in order to make profits on the sale of replacement ink cartridges for the printer.

Exercise 14-24 and Problem 14-33

LEARNING OBJECTIVE

Explain the effects of legal restrictions on pricing … limit the ability to price below costs (predatory pricing), in coordination with competitors (collusive pricing), or to charge higher prices in the U.S. than in a home country (dumping) and the broader notion of price discrimination … charging different customers different prices for the same product, for example when orders arrive as demand approaches capacity limits (peak-load pricing)

7.1

The Sherman Act, the Clayton Act, the Federal Trade Commission Act, and the Robinson-Patman Act are the significant pieces of antitrust legislation in the United States. •

A principal component of these acts is the prohibition of predatory pricing; that is, deliberately setting prices below cost in an effort to drive competitors out of business and restrict supply. The company could then raise prices.

•

Another prohibited practice in the area of antitrust is dumping. This occurs when a non-U.S. company sells a product in the United States at a price below market value in the country where it is produced.

•

A third practice is collusive pricing. This occurs when companies in an industry conspire in their pricing and production decisions to achieve a price above a competitive price and therefore restrain trade.

•

Price discrimination is the practice of charging different prices to different customers for the same product or service. TEACHING POINT. A customer who buys an airline ticket a month in advance will pay a lower price than one who buys the ticket one day in advance. Ask the students to brainstorm for other examples of price discrimination. Some examples might include early bird dining prices, senior discounts, or quantity discounts. Discuss why companies use this type of price discrimination.

•

Another example of a pricing decision based on factors other than cost deals with capacity constraints. Peak-load pricing is the practice of charging a higher price for the same product or service when the demand approaches physical capacity to produce the product or service. TEACHING POINT. Motels are well known for peak-load pricing. During the first week in May, hotel prices in Louisville, Kentucky skyrocket, usually with a minimum stay of three nights. Why? The first Saturday in May is the Kentucky Derby. Three day packages start at $1,500 for a downtown Louisville hotel and go as high as $12,000. Engage the students in other examples of peak-load pricing.

7.2

Prices are also affected by factors other than cost when a product is sold internationally. Pricing differences occur due to differences in purchasing power of consumers in different countries and government restrictions that limit the prices that can be charged.

Refer to Quiz Questions 8, 9, 10

Exhibit 14-5 illustrates calculation of cost-driver rates at Provalue. Exhibit 14-7 illustrates the budgeting of life-cycle revenues and costs for a software package.

CHAPTER 14 QUIZ 1.

Major influences of competitors, costs, and customers on pricing decisions are factors of a. supply and demand. b. activity-based costing and activity-based management. c. key management themes that are important to managers attaining success in their planning and control decisions. d. the value-chain concept.

Short-run pricing decisions include a. pricing a main product in a major market. b. considering all costs in the value chain of business functions. c. adjusting product mix and volume in a competitive market while maintaining a stable price if demand fluctuates from strong to weak. d. pricing for a special order with no long-term implications.

Burkhart Company manufactures a product that has a variable cost of $25 per unit. Fixed costs total $1,000,000, allocated on the basis of the number of units produced. Selling price is computed by adding a 25% markup to full cost. How much should the selling price be per unit for 200,000 units? a. $31.25 b. $42.00 c. $37.50 d. $30.00

The first step in implementing target pricing and target costing is a. choosing a target price. b. determining a target cost. c. developing a product that satisfies needs of potential customers. d. performing value engineering.

The best opportunity for cost reduction is during the a. manufacturing phase of the value chain. b. product or process design phase of the value chain. c. marketing phase of the value chain. d. distribution phase of the value chain.

The following data apply to questions 6 and 7. Each month, Haddon Company has $275,000 total manufacturing costs (20% fixed) and $125,000 distribution and marketing costs (36% fixed). Haddon’s monthly sales are $500,000.

The markup percentage on full cost to arrive at the target (existing) selling price is a. 25%. b. 75%. c. 80%. d. 20%.

The markup percentage on variable costs to arrive at the existing (target) selling price is a. 20%. b. 40%. c. 80%. d. 66 2/3%.

The price of movie tickets for opening day and the few days following compared to the price six months later is an example of a. price gouging. b. peak-load pricing. c. dumping. d. demand elasticity.

Price discrimination is a. always illegal. b. a type of peak-load pricing. c. not regulated in the United States. d. the practice of charging different prices to different customers for the same product or service.

10.

Which of these do antitrust laws on pricing not cover? a. Collusive pricing b. Dumping c. Peak-load pricing d. Predatory pricing

CHAPTER 14 QUIZ SOLUTIONS 1.

10.

Variable cost Fixed cost Full cost

$25.00 5.00 ($1,000,000/200,000 units) $30.00

25% Markup Selling price

7.50 $37.50

Manufacturing costs Distribution & Marketing costs Total cost

$275,000 125,000 $400,000

Sales Full cost Profit

Markup Full cost

$500,000 $400,000 $100,000

Variable manufacturing Variable dist/marketing Total Variable cost Sales VC Markup

$500,000 300,000 $200,000

$100,000 $400,000

= 25%

$275.000  80% $125,000  64%

= =

$220,000 80,000 $300,000

$200,000 $300,000

66 2/3%

Cost Allocation, CustomerProfitability Analysis, and Sales-Variance Analysis

TRANSITION NOTES

In this chapter, the section on criteria to guide costallocation decisions and the section discussing allocating corporate costs to divisions and products have been rewritten and updated. A section on customer-revenue analysis has been added to accompany the section on “customer-cost analysis.” The discussion on customer-level costs has been streamlined. There is a significant expansion of the discussion of customer-profitability profiles with the five-step decision model applied to managing customer profitability. *This chapter was previously Chapter 14.

PROBLEMS CORRELATION CHART 17th Edition 18 Revised 19 20 21 Revised 22 Revised 23 Revised 24 Revised 25 26 27 28 29 Revised

16th Edition 18 19 20 21 22 23 24 25 26 27 28 29

17h Edition 30 31 32 33 Revised 34 35 Revised 36 Revised 37 Revised 38 39 40 41 New 42

16th Edition 30 31 32 33 34 35 36 37 38 39 40 41

LEARNING OBJECTIVES 1.

Discuss why a company’s revenues and costs differ across customers.

2. Identify the importance of customer-profitability profiles.

II.

Understand the cost-hierarchy-based operating income statement.

Understand criteria to guide cost-allocation decisions.

Discuss decisions faced when collecting and allocating indirect costs to customers.

Subdivide the sales-volume variance into the sales-mix variance and the sales-quantity variance. Subdivide the sales-quantity variance into the market-share variance and the market-size variance.

CHAPTER SYNOPSIS This chapter extends the discussion on allocation of indirect costs to products, identifying the reasons for such allocations and moving into the criteria and procedures for these allocations. The concept of allocating indirect costs to customers to determine customer profitability is introduced through a discussion of customer-level costs. The sales-volume variance, introduced in Chapter 7, is expanded to provide management more detailed information about why sales deviated from the budgeted amounts. This variance is subdivided into two components: the sales-mix 16-58 Copyright © 2021 Pearson Education, Inc.

and sales-quantity variances. The sales-quantity variance is further subdivided into the market-share and market-size variances.

III.

IV.

POINTS OF EMPHASIS 1.

It is important that students distinguish between purposes for cost allocation (Exhibit 14-1) and the criteria for doing so (Exhibit 15-8). As there are four of each, students sometimes confuse the two.

Customer-profitability profiles can best be grasped by the students through the use of examples. Going over the details contained in Exhibits 15-3 and 15-5 or by having the students’ work Problem 15-30 will help reinforce this section of the chapter.

Working a problem illustrating the sales-volume, sales-mix, sales-quantity, market-share, and marketsize variances will help students grasp these concepts. Also, be certain that this section is tied into the variances as presented in Chapter 7. Problems 15-38 and 15-39 help to illustrate these concepts.

CHAPTER OUTLINE LEARNING OBJECTIVE

Discuss why a company’s revenues and costs differ across customers … revenues differ because of differences in quantities purchased and price discounts, while costs differ because of different demands placed by customers on a company’s resources

1.1

Customer-profitability analysis is the reporting and assessment of revenues earned from customers and the costs incurred to earn those revenues. This will enable management to determine which customers are the most profitable and should be receiving a high level of attention from the company.

1.2

Two variables can be identified to explain revenue differences across customers: •

•

The magnitude of price discounting. A price discount is the reduction in selling price below list price to encourage customers to purchase more quantities.

1.3

Price discounts in practice occur for a number of reasons—volume, encouraging the customer to promote sales to others, poor negotiating by the salesperson.

1.4

Price discounts should be monitored in order to help improve customer profitability and also to be certain that the discounts are not illegal. Price discrimination, predatory pricing, and collusive pricing can all be illegal types of price discounts.

1.5

Revenues are only one aspect of customer profitability. A company must also look at the costs involved relating to various customers. The customercost hierarchy categorizes costs related to customers into different cost pools on the basis of different types of cost drivers, cost-allocation bases, or different degrees of difficulty in determining causeand-effect or benefits-received relationships.

1.6

Customer output unit-level costs are costs of activities to sell each unit to a customer. Product handling is one such cost.

1.7

Customer batch-level costs are costs of activities related to a group of units sold to a customer. Costs incurred to process or deliver an order are examples of these costs.

1.8

Customer-sustaining costs are costs of activities to support individual customers regardless of the number of units or batches of product delivered to the customer. Sales visits to customers or costs of a display at the customer site are examples of these costs.

1.9

Distribution-channel costs are costs of activities related to a particular distribution channel rather than to each unit of product, each batch of product, or specific customer. The salary of the manager for the wholesale distribution channel would be an example of this type of cost.

1.10 Division-sustaining costs are the costs of activities that cannot be traced to individual customers or distribution channels. The salary of the division manager is an example. Refer to Quiz Question 4

LEARNING OBJECTIVE

Identify the importance of customer-profitability profiles … expand relationships with profitable customers, change behavior patterns of unprofitable customers, and highlight that a small percentage of customers contributes a large percentage of operating income

2.1

Customer-profitability profiles provide a useful tool for managers, as these profiles can be used to rank customers based upon customer-level operating income. (Exhibits 15-3 and 15-4 illustrate customer cost and profitability analysis.)

2.2

The customer-profitability profile emphasizes shortterm customer profitability. Other factors to be considered in the decision regarding allocation of costs among individual customers include: •

Likelihood of customer retention. The more likely a customer will continue to do business with a company, the more valuable the customer. Customers differ in their loyalty and willingness to frequently “shop their business.”

•

Potential for sales growth. Is there a high likelihood that the customer’s industry and sales will continue to grow? If so, this may be a valuable customer.

•

Long-run customer profitability. What does management think the future holds for the company in its relationship with the customer including not just potential sales growth but also the cost of customer-support staff and special services required to support the customer.

•

Increases in overall demand from having wellknown (also known as reference) customers. Customers with established reputations help generate sales from other customers through product endorsements.

•

Ability to learn from customers. Customers who provide ideas about new products or ways to improve existing products are especially valuable. TEACHING POINT. This section contains a significant amount of marketing material. It is sometimes useful to move away from the “number crunching” and take the view from another business function. Have the students brainstorm positive or negative points relating to the factors above. For example, if an irate

customer bellows, “fix this situation, or I am taking my business elsewhere,” the customer is probably not one with a great deal of loyalty and is unlikely to be a long-term customer.

2.3

The five-step decision-making process can be utilized in managing customer profitability. This can help identify customers who deserve the highest service and priority and those less-profitable customers.

Refer to Quiz Question 5 15-20, 15-21

LEARNING OBJECTIVE

Exercises 15-19,

Understand the cost-hierarchy-based operating income statement … allocate only those costs that will be affected by actions at a particular hierarchical level

3.1

Exhibits 15-6 and 15-7 demonstrate the value of a hierarchical income statement format and the various degrees of objectivity when allocating other noncustomer level costs. Exercise 15-19

LEARNING OBJECTIVE

Understand criteria to guide cost-allocation decisions … such as identifying factors that cause resources to be consumed

4.1

Exhibit 15-8 presents four criteria to guide costallocation decisions. •

Cause-and-effect is the primary criterion used in activity-based costing. It is also one of the preferred methods of allocation, as it has a linkage between the amount of cost incurred and the reason for the cost.

•

object that received the benefit of the cost. •

Fairness as a cost-allocation guide is problematic. Although it sounds noble to cite fairness as a criterion, fairness lies in the eyes of the beholder and it would be difficult to obtain agreement about what allocation is fair. Often the result would be that the person who is most persuasive would get the most favorable allocation. This is more of an objective in allocation rather than a valid criterion.

•

Ability to bear is another problematic allocation criterion, as the costs are simply allocated based upon which cost object can best afford the allocation. This is, obviously, highly subjective and should be used only as a last resort. TEACHING POINT. A large, downtown hotel allocated all of its restaurant labor costs on the basis of revenue dollars. This hotel had seven restaurant outlets that were vastly different, including banquet, room service, a bar, a 24-hour restaurant, and a finedining facility. There are obvious differences in the way labor resources are consumed in these various outlets. However, the most glaring example was in the banquet operation. Because banquets were not regularly scheduled events, the banquet manager hired servers as contract laborers. These costs were not included in the restaurant labor pool. Therefore, the banquet manager got charged for his actual labor, plus an allocation for labor he was not utilizing. As it worked out, the more banquets that were hosted, the lower the income shown by the banquet operation. (Exhibit 15-8 lists the criteria for cost-allocation decisions.)

Refer to Quiz Question 2 Exercise 15-20

LEARNING OBJECTIVE

Discuss decisions faced when collecting and allocating indirect costs to customers … determining the number of cost pools and the costs to be included in each cost pool

5.1

In this section, we focus on the first purpose for cost allocation: to provide information for economic decisions, such as pricing, by measuring the full cost of delivering products. 16-63 Copyright © 2021 Pearson Education, Inc.

5.2

In an ABC system, indirect-cost pools are defined for different activities and cost drivers are used as allocation bases to assign these costs to products. The goal is to achieve homogeneity in each pool—costs that are caused by the same cost driver.

5.3

Note that there are two stages of allocation: the allocation to the cost pool, then the allocation to the product. This section focuses on the first stage of allocation. (Exhibit 15-9 diagrams indirect-cost pools and cost-allocation bases for two divisions.)

5.4

There are several options available to management in allocating corporate costs to divisions. As there is usually no direct cause-and-effect relationship for many of these costs, allocation of these costs presents difficulties.

5.5

Some companies allocate all corporate costs to divisions, because these costs are incurred to support division activities. This will motivate managers to examine how corporate costs are planned and controlled.

5.6

Other companies do not allocate any corporate costs to divisions because they are not controllable by the division managers.

5.7

Still other companies use a hybrid system, allocating corporate costs that are perceived to have a causal relationship to division activities or provide explicit benefits—human resources would be one example. This is generally the preferred method.

5.8

Once the decision is made regarding allocation of the corporate costs, management must then implement the decision. It is important that division managers are made aware of the allocation method. TEACHING POINT: Use Exhibit 15-10 to show a customer profitability analysis after all costs have been fully allocated.

Refer to Quiz Question 3 15-20 and 15-21

Exercises

LEARNING OBJECTIVE

Subdivide the sales-volume variance in the salesmix variance … this variance arises because actual sales mix differs from budgeted sales mix and the sales-quantity variance … this variance arises because actual total unit sales differ from budgeted total unit sales Subdivide the sales-quantity variance into the market-share variance …this variance arises because actual market share differs from budgeted market share and the market-size variance …this variance arises because actual market size differs from budgeted market size

6.1

Recall from Chapter 7 that the static-budget variance is the difference beween an actual result and the corresponding budgeted amount in the static budget. Another way to look at that is to say that the salesvolume variance is the difference between a flexiblebudget amount and the corresponding static-budget amount. The flexible-budget variance is the difference between an actual result and the corresponding flexible-budget amount based on the actual output level in the budget period. The sales-volume variance is the difference between a flexible-budget amount and the corresponding static-budget amount. It is calculated by subracting static-budget units sold from the actual number of units sold multiplied by the budgeted unit contribution margin.

6.2

A greater understanding of the sales-volume variance can be obtained when it is broken down into the salesmix variance and the sales-quantity variance.

6.3

The sales-mix variance is the difference between the budgeted contribution margin for the actual sales mix and the budgeted contribution margin for the budgeted sales mix. It arises because the actual sales mix varies from the budgeted mix. Sales-Mix Variance = (Actual Sales Mix – Budgeted Sales Mix) × Budgeted Contribution Margin per Unit

6.4

based on the mix of individual units. A favorable sales-mix variance arises when the actual sales mix shifts toward the products having the largest contribution margins. 6.5

The sales-quantity variance is the difference between the budgeted contribution margin based on actual units sold of all products at the budgeted sales mix and the contribution margin in the static budget. It arises because the number of units sold varies from the budget. A favorable sales-quantity variance indicates that the actual number of all products sold exceeds the budgeted units of all units sold. Sales-Quantity Variance = (Actual Units of All Products Sold – Budgeted Unit of all Products Sold) × Budgeted Sales Mix Percentage × Budgeted Contribution Margin per Unit

6.6

The sales-quantity variance can be further divided into the market-share and marketsize variances.

6.7

The market-share variance is the difference in budgeted contribution margin for actual market size in units caused solely by actual market share being different from budgeted market share. Market-Share Variance = actual market size in units x (actual market share – budgeted market share) x budgeted contribution margin per composite unit for budgeted mix

6.8

The market size variance is the difference in budgeted contribution margin at budgeted market share caused solely by actual market size in units being different from budgeted market size in units. Market-Size Variance = (Actual Market Size – Budgeted market size) x budgeted market share x budgeted contribution margin per composite unit for budgeted mix (Exhibit 15-11 displays calculation of the flexible-budget and sales-volume variances.) (Exhibit 15-12 illustrates calculation of the sales-mix and sales-quantity variances.) (Exhibit 15-13 illustrates calculation of the market-share and market-size variances.) (Exhibit 15-14 provides an overview of variances for the Provalue Division.)

Refer to Quiz Questions 6, 7, and 8 and 15-27; Problems 15-38, 15-39, 15-40, 15-41

Exercises 15-25

OTHER RESOURCES To download instructor resources, visit the Instructor’s Resource Center at www.pearsonhighered.com/irc. The following exhibits were mentioned in this chapter of the Instructor’s Manual, and have been included in the Image Library. Exhibit 15-3 displays customer profitability analysis for Provalue customers. Exhibit 15-4 displays a cumulative customer-profitability analysis for Provalue customers. Exhibits 15-5 illustrate customer cost and profitability analysis including the whale curve for cumulative profitability. Exhibit 15-6 illustrates the cost hierarchy income statement for Provalue Division. Exhibit 15-7 displays the income statement for Astel Computers using the cost hierarchy. Exhibit 15-8 displays the criteria for cost-allocation decisions. Exhibit 15-9 displays an overview diagram for allocation indirect costs to customers. Exhibit 15-10 displays the profitability of customers after fully allocation corporate costs. Exhibit 15-11 displays calculation of the flexible-budget and sales-volume variances. Exhibit 15-12 illustrates calculation of the sales-mix and sales-quantity variances. Exhibit 15-13 illustrates calculation of the market-share and market-size variances. Exhibit 15-14 diagrams the relationship between different sales variances.

CHAPTER 15 QUIZ 1.

b. c. d.

To motivate managers and other employees To measure income and assets for reporting to external parties To foster cost awareness among managers to improve decisions

Which of the following is considered more of a matter of judgment rather than an operational criterion? a. Cause-and-effect b. Benefits received c. Fairness or equity d. Ability to bear

Homogeneity is used to a. develop cost pools in which the costs have the same or similar cost-allocation base. b. develop cost pools of similar amounts for allocation purposes. c. develop cost pools based upon similarity of origination of costs to be allocated. d. develop cost pools only for activity-based costing.

Information about price discounting can be useful in analyzing revenues of customers if a. sales people are properly trained in sales forecasting. b. records in the information system are kept of reductions in selling price below list price. c. a strictly enforced company policy is in place regarding volume-based price discounts. d. sales people are on an incentive plan that is based on revenues.

Which of the factors that managers must consider in deciding the allocation of resources across customers might provide misleading signals about dropping a current customer? a. Potential for customer growth b. Likelihood of customer retention c. Long-run customer profitability d. Ability to learn from customer

Use the following information for questions 6 through 8. Natural Nutrients Bakery of Springfield produces three flavors of cat morsels that have budgeted and actual sales data for a bag of a dozen of their cat morsels as follows for December 2020: Budgeted Data

Bags CM per bag Cont. Margin

Actual Data

TunaFest

ChikBits

ChezNips

TunaFest

ChikBits

ChezNips

7,200 $2.50 $18,000

4,800 $4.00 $19,200

4,000 $5.00 $20,000

10,800 $2.00 $21,600

3,600 $3.00 $10,800

7,200 $7.50 $54,000

Total Contribution Margin

$57,200

$86,400

According to company forecasts, they were budgeting to earn a 25% market share in total units (bags) of specially prepared cat treats sold in December 2020 in Springfield. Reliable industry sources indicate that the total number of bags of cat treats sold for December 2020 in Springfield was 72,000. 6.

The amount of Natural Nutrients Bakery’s sales-volume variance for December 2020 is a. $3,600 F. b. $20,200 F. c. $20,020 F. d. $29,200 F.

The sales-quantity variance for December 2020 for Natural Nutrients Bakery is a. $3,600 F. b. $20,200 F. c. $20,020 F. d. $29,200 F.

The sales-mix variance for December 200 for Natural Nutrients Bakery is a. $8,600 F. b. $8,760 F. c. $160 F. d. $180 F.

CHAPTER 15 QUIZ SOLUTIONS 1.

Quiz Question Calculations 6.

Act Total Unit Sales 21,600  21,600  21,600 

Act Sales Mix** Bud CM 1/2  $ 2.50 = $27,000 1/6  $ 4.00 = 14,400 1/3  $ 5.00 = 36,000 $77,400 Budgeted CM 57,200 Sales-Volume Variance $20,200 F

TunaFest ChikBits ChezNips

** round to 5 decimal places to avoid rounding issues 7.

TunaFest ChikBits ChezNips

Unit Sales 21,600  21,600  21,600 

Bud Sales Mix 0.45  0.30  0.25 

Budgeted CM Sales-Quantity Variance 8.

Bud CM $ 2.50 = $24,300 $ 4.00 = 25,920 $ 5.00 = 27,000 $77,220 57,200 $20,020 F

From #7 $77,220 From #6 77,400 Sales-Mix Variance $ 180 F

Allocation of Support-Department Costs, Common Costs, and Revenues

TRANSITION NOTES This chapter include reorganized sections on the Overview of the direct, step-down and reciprocal methods of allocating costs and Calculating the Cost of Job WPP 298. 25% of end-of-chapter problem material is new or has been revised. *This chapter was previously Chapter 15.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 16 17 18 19 20 21 22 23 24 Revised 25 26

16th Edition 16 17 18 19 20 21 22 23 24 25 26

17th Edition 27 Revised 28 29 30 31 32 Revised 33 Revised 34 35 Revised 36

16th Edition 27 28 29 30 31 32 33 34 35 36

II.

Distinguish the single-rate method from the dual-rate method.

Understand how the choice between allocation based on budgeted and actual rates and between budgeted and actual usage can affect the incentives of division managers

Allocate multiple support-department costs using the direct method, the step-down method, and the reciprocal method.

Allocate common costs using the stand-alone method and the incremental method.

Explain the importance of explicit agreement between contracting parties when the reimbursement amount is based on costs incurred.

Understand how bundling of products causes revenueallocation issues and the methods managers use to allocate revenues.

CHAPTER SYNOPSIS Allocation of indirect costs is an area of constant discussion in many companies, with division, department, and product managers often questioning the amount of indirect costs allocated to their respective sections. This chapter discusses allocation of support department costs using the direct method, the step-down method, and the reciprocal method. The chapter presents the stand-alone method and the incremental method as techniques for allocation of common costs. The concept of bundled products and allocation of bundled product revenues is also introduced. Cost reimbursement based on contract provisions is also discussed.

III.

POINTS OF EMPHASIS 1.

It is important that the students grasp allocation issues including single- versus dual-rate allocation before moving into the methods for allocating costs to the service departments.

Likewise, students need to see the varying effects of actual versus budgeted cost allocations.

Work through each of the methods for allocating costs with multiple support departments—direct, step-down, and reciprocal. Illustrate the differences obtained under each method. If the differences are small, point out that the simplest method would work best in the 16-71 Copyright © 2021 Pearson Education, Inc.

particular case. 4.

IV.

Allocating common costs and allocating revenues of bundled products are really two sides of the same process. If the students grasp allocating common costs early, allocating bundled revenues should be fairly simple.

CHAPTER OUTLINE LEARNING OBJECTIVE

Distinguish the single-rate method … one rate for allocating costs in a cost pool from the dual-rate method … two rates for allocating costs in a cost pool—one for variable costs and one for fixed costs

1.1

Companies distinguish operating departments from support departments. An operating department, also called a production department, directly adds value to a product or service. Examples are manufacturing departments where products are made. A support department, also called a service department, provides support and assists operating departments and other service departments. TEACHING POINT. If students do not grasp the difference in operating departments and support departments early, they will not learn the material in this chapter. Identify several departments that might be found in a typical manufacturing organization, and have the students identify them as operating or support departments.

1.2

Costs incurred in the support departments must be allocated ultimately to the operating departments and eventually to the final cost object. A predetermined rate is normally utilized to make the allocations to the operating departments. A single-rate or a dualrate method may be utilized.

1.3

The single-rate method makes no distinction between fixed and variable costs. It allocates costs in each cost pool to cost objects using the same rate per unit of a single allocation base. 16-72 Copyright © 2021 Pearson Education, Inc.

1.4

The dual-rate method divides the costs of each support department into two pools—a variable-cost pool and a fixed-cost pool.

1.5

When using either the single-rate or dual-rate method, managers may allocate costs based upon: •

Budgeted rates and budgeted hours.

•

Budgeted rates and actual hours.

•

Actual rates and actual hours—this approach is not often used in practice. TEACHING POINT. It will be helpful if the students can visualize these concepts in action. Exercise 16-16 is a good illustration of different approaches to allocation.

1.6

Advantages of the single-rate method include that it is less costly to implement and it offers user departments some operational control over the charges they bear. A disadvantage of the single-rate method is that it may lead operating department managers to make suboptimal decisions that are in their own best interest but inefficient from the standpoint of the organization as a whole.

1.7

An advantage of the dual-rate method is that the dualrate method guides department managers to make decisions that benefit both the organization as a whole and each department. One disadvantage is that it requires managers to distinguish variable costs from fixed costs, which is often a challenging task. Another disadvantage is that it does not measure the cost of fixed support departments resources actually used by operating departments because fixed costs are allocated based on budgeted rather than actual usage.

Refer to Quiz Question 1 16 and 16-17

LEARNING OBJECTIVE

Exercise 16-

Understand how the choice between allocation based on budgeted and actual rates … budgeted rates provide certainty to users about charges and motivate the support division to control costs and between budgeted and actual usage can affect the incentives of division managers … budgeted usage helps in planning and efficient utilization of fixed resources, actual usage controls

consumption of variable resources

2.1

Once the decision has been made regarding single- or dual-rate allocation, the manager must next turn to the issue of choosing between allocating budgeted or actual costs.

2.2

When allocations are based on budgeted usage, user divisions know in advance their allocated costs. This can be of benefit in short-term and long-term planning.

2.3

A disadvantage of using budgeted costs is that there is an incentive for managers to underestimate their planned usage, thus being assigned a lower percentage of allocated costs. This can be overcome in part by assessing a higher charge for exceeding budgeted usage.

2.4

Allocating costs based on actual usage gives a more accurate allocation based on actual costs and usage.

2.5

Actual allocations have several disadvantages: a lack of timely information, reduced incentives for support to manage costs, and increased accounting costs.

2.6

A third approach is to allocate fixed costs on the basis of practical capacity supplied. This approach will charge each division with services actually used. In addition, variations in actual usage in one division will not affect allocations in other divisions. Finally, the costs of unused capacity are highlighted and not allocated to divisions. TEACHING POINT. This is an excellent time to discuss “game playing” with students to show how a department manager can lower the amount being allocated to the department by lowballing estimated usage (when budgeted capacity is used). Likewise, you can illustrate the lack of incentive on the part of supplying departments to control costs if actual costs are used for allocation. Enter into a discussion of how the problems presented by these two approaches might be resolved.

2.7

Generally, it is found to be preferable to allocate fixed costs based on capacity, under the approach that fixed costs provide capacity and variable costs should be allocated based on actual usage. (Exhibit 16-1 displays the impact of variations in actual usage on division cost allocations.)

Refer to Quiz Question 2 and Problem 16-27

Exercise 16-18

LEARNING OBJECTIVE

Allocate multiple support-department costs using the direct method, … allocates support-department costs directly to operating departments the step-down method, … partially allocates support-department costs to other support departments and the reciprocal method … fully allocates support-department costs to other support departments

3.1

When allocating costs from multiple support departments, a new set of problems arise. These problems arise because support departments utilize the services of other support departments and it must be decided how to handle these allocations. There are three approaches that may be utilized. •

The direct method allocates support department costs to operating departments only, ignoring usage of a support department by other support departments.

•

The step-down method or sequential allocation method allocates support-department costs to other support departments and to operating departments in a sequential manner that partially recognizes the mutual services provided among all support departments.

•

A common step-down sequence begins with the support department that renders the highest percentage of its total services to other support departments. Another approach is to begin with the department providing the highest dollar amount to other support departments.

Once costs are allocated out of a support department under the step-down method, no additional costs are allocated to that department.

repeated iterations of allocations or by formulating and solving linear equations expressing the relationships among the departments. o

There are three steps involved in the reciprocal method. Step 1: Express support-department costs and reciprocal relationships in the form of linear equations. Step 2: Solve the set of linear equations to obtain the complete reciprocated costs of each support department. Step 3: Allocate the complete reciprocated costs of each support department to all other departments based on the usage percentages.

TEACHING POINT. Work through exercises, such as 16-19 and 16-20 that illustrate each of these approaches. Do the stepdown method using one approach, and then have the students do it using the other approach. Discuss the differences obtained using the various methods.

3.2

The direct and step-down methods have the advantage of simplicity. The reciprocal method is theoretically the most precise, but is difficult to implement, especially with a large number of support departments. However, this difficulty is being lessened by the use of computers. In determining which method to utilize, the company should consider the amount of differences obtained under each of the approaches. (Exhibits 16-2 to 16-6 illustrate allocation of support-department costs.)

Refer to Quiz Questions 3, 4, and 5 16-19, 16-20, 16-21, and 16-22

Exercises

LEARNING OBJECTIVE

Allocate common costs using the stand-alone method … uses cost information of each user as a separate entity to allocate common costs and the incremental method … allocates common costs primarily to one user and the remainder to other users

4.1

Common costs are costs that are shared by two or more users. These can be the costs of operating a facility, an activity, or other cost objects.

4.2

These common costs must be allocated in some equitable fashion. Two methods that are frequently used for these allocations are the stand-alone cost-allocation method and the incremental cost-allocation method. TEACHING POINT. Brainstorm with the students for examples of common costs. For example, software that students buy for college is a common cost for all classes in which they use the computer. To get into the allocation issue, tell them they must purchase Excel for use in the Cost Accounting class. After purchasing it, however, they find use for it in three other classes. If they are trying to determine the cost of each class, how should the cost of the software be allocated? Pursue other similar situations.

4.3

The stand-alone cost-allocation method determines the weights for cost allocation by considering each user of the cost as a separate entity. The cost is allocated among the users based upon the total cost for each separately.

4.4

The incremental cost-allocation method ranks the individual users of the cost object in the order of users most responsible for the common cost and uses this ranking to allocate cost among those users. The first ranked user is the primary user and is assigned allocated costs up to the cost as a stand-alone user. The second ranked user is the first incremental user and is assigned cost equal to the additional cost that arises from having two users. This continues until costs have been assigned to all users. TEACHING POINT. Illustrate these two methods with a problem. Exercise 16-23 is a good example to walk through with the students.

Refer to Quiz Question 6 Exercises 16-23 and 16-24; Problem 16-32

LEARNING OBJECTIVE

Explain the importance of explicit agreement between contracting parties when the reimbursement amount is based on costs incurred … to avoid disputes regarding allowable cost items and how indirect costs should be allocated

5.1

Frequently, the price paid on a contract may be based on some definition of cost. In order to bill the price correctly, there must be explicit agreement about the definitions of cost, and what can be included and excluded.

5.2

Contract disputes often arise with respect to cost allocation. This highlights the importance of explicit definitions of the contract terms. TEACHING POINT. In addition to explicit contract terms, the buyer needs some oversight or control over costs incurred. In one case, the terms of the contract required that all checks to be charged to the contract be signed by the buyer. This proved to be an effective control in this case, as the builder of a hotel “gave” the company coffee mugs for the restaurant, but billed the hotel for them, plus a percentage. In the same contract, the builder fenced the backyard at his personal residence, and tried to include it as a cost of the contract.

5.3

5.4

In contracting with the U.S. Government, most contractors are reimbursed in one of two ways: •

The contractor is paid a set price without analysis of actual contract cost data. This method frequently accompanies competitive bidding, where there are established prices for the items sold in substantial quantities to the general public.

•

The contractor is paid after analysis of actual contract cost data. These are often contracts that state reimbursement will be based on allowable costs plus a fixed fee, otherwise known as a cost-plus contract.

uncertainty about the final cost to produce new equipment. This is especially true in defense department contracting. Due to the uncertainty involved, these contracts are rarely subjected to competitive bidding. 5.5

To be fair to all in the pricing of the merchandise, the government will assume a share of the risk of potentially high costs with a cost-plus contract.

5.6

An allowable cost is a cost that the contract parties agree to include in the costs to be reimbursed. TEACHING POINT. This is a good point for a discussion on professional ethics. Government contracts are known for cost overruns and outlandish pricing. What is the role of the cost accountant in these cases? Discuss this statement that blames the accounting system: “As for the $1,000 hammer. In many cases this is the fault of the accounting system. When a vendor delivers an airplane to the military, there is a fixed cost and a variable cost assigned to each part. The variable cost is the actual cost of the item as delivered from a vendor (the hardware store). In the case of the hammer this would be $10. The fixed cost is calculated by dividing all of the overhead by the number of parts. If the overhead is $990,000,000 and there are 1,000,000 parts, each is ascribed a fixed cost of $990. Thus the $1,000 hammer.”

Refer to Quiz Question 7 LEARNING OBJECTIVE

Understand how bundling of products … two or more products sold for a single price causes revenue-allocation issues … need to allocate revenues to each product in the bundle to evaluate managers of individual products and the methods managers use to allocate revenues …the stand-alone method, the incremental method, or the Shapley value method

. 6.1

When multiple products are bundled and sold at a single price, revenues must be allocated to the products included in the bundle.

6.3

in an economically feasible manner. 6.4

A revenue object is anything for which a separate measurement of revenues is desired.

6.5

A bundled product is a package of two or more products or services that is sold for a single price, but whose individual components may be sold as separate items at their own stand-alone prices. TEACHING POINT. Discuss examples of bundled products or services and why companies sell them in this manner. Examples would include a computer and printer; a DVD and a Blu-ray; a vacation package that includes air fare, hotel room, and rental car.

6.6

There are three methods frequently used to allocate revenue from bundled products: the stand-alone revenue-allocation method, the incremental revenueallocation method, and the Shapley value method.

6.7

Under the stand-alone revenue allocation method the individual prices of each product are used as weights to assign revenue to the product. Revenue as a stand alone product Total stand alone product revenues × selling price of bundle = Revenue assigned to product Under the incremental revenue-allocation method, ranks of the individual products are assigned by management. This ranking is used to allocate bundled revenues to individual products. The first ranked, or primary, product is assigned its full amount of revenues, followed by the second ranked, or first incremental product, and so on.

6.8

Under the Shapely value method, revenues are allocated to each product based on the average of the revenues allocated as the primary and first-incremental products as obtained by the incremental revenue allocation method.

6.9

Rankings of products can be based on stand-alone unit sales, importance of each of the individual products, or managerial intuition. TEACHING POINT. You can relate allocation of bundled revenues to the allocation of common costs covered earlier in the chapter. Exercise 16-25 is a good illustration of this concept and will help to reinforce this procedure.

Refer to Quiz Questions 8, 9, and 10 Exercise 16-25 and Problem 16-35

CHAPTER 16 QUIZ 1.

The use of a dual-rate cost-allocation method recognizes the a. improvements in technology allowing for use of multiple cost pools. b. need to use both budgeted and actual cost rates when allocating. c. need to use both budgeted and actual usage of quantities when allocating. d. behavior aspect of costs.

Managers are affected by risks they have to take and would prefer to use a. actual rates for cost allocation because the rates are calculated from real amounts. b. actual rates for cost allocation because actual rates are easier to justify to users. c. budgeted rates for cost allocation because the rates are known in advance. d. budgeted rates for cost allocation because any variances are transferred to users.

The following data apply to questions 3 through 5. Billy Stone, Inc. budgets the following amounts for its Buildings & Grounds and Computer Services Departments in servicing each other and the two manufacturing divisions of Signs and Mailers:

Used By Supplied By

Building & Grounds

Buildings & Grounds

—

Computer Services

Signs

0.20

Mailers 0.60

0.20 Computer Services 0.55

0.15

—

0.30

The actual results for the time period were as follows: Used By Supplied By

Building & Grounds

Buildings & Grounds 0.30 Computer Services 0.40

— 0.25

Computer Services

Signs

Mailers

0.10

0.60

—

0.35

Actual cost data for each department are: Fixed Buildings & Grounds $ 50,000 $90,000 Computer Services $100,000 $21,000

Variable

Total fixed costs allocated from Buildings & Grounds to the Signs Department, using the preferred allocation basis, by the direct allocation method are a. $37,500. b. $33,333. c. $30,000. d. $25,000.

Total variable costs allocated from Computer Services to Mailers Department, using the preferred allocation basis, by the step-down allocation method (begin with Building & Grounds) are a. $8,400. b. $12,000. c. $16,000. d. $25,235.

The equation to determine the total variable costs of Computer Services using the preferred allocation basis for the reciprocal allocation method is a. CS = $21,000 + 0.25 B&G. b. CS = $21,000 + 0.20 B&G. c. CS = $21,000 + 0.15 B&G. d. CS = $21,000 + 0.10 B&G.

Which of the following is often the most basic cause of contract disputes? a. Allowable costs b. Cost-allocation issues c. Use of common costs d. Writing into the contract “rules of the game”

Bundling of products creates the need for revenue allocation for each of the following except when a. selling prices for the bundle are set to recoup the stand-alone prices of each product in the bundle. b. the manager is responsible for profitability on a product-by-product basis. c. the manager’s bonus is based upon product profitability. d. persons involved with product development are compensated by percentage of revenues realized.

Use the following information for questions 9 and 10. Trio Company sells three products, Do, Ra, and Mi, for prices of $8, $7, and $5, respectively. They also offer combinations of the products for reduced overall prices. The following packages are available: (1) a package containing Do and Ra sells for $13.50, (2) a package of Do and Mi sells for $11.50, (3) a package containing Ra and Mi sells for $10.50, and (4) a package of all three products, Do, Ra, and Mi, sells for $17.00. 9.

If Trio Company uses the stand-alone method (based on selling prices) to allocate revenues to products, the amount of revenues to be allocated to Do from a package of all three products, as described in (4) above, sold would be a. $8.00. b. $6.80. c. $5.95. d. $4.25.

10.

If Trio Company uses the incremental-revenues allocation method and has designated Ra as the primary product, the amount of revenues from a bundled package of all three products to be allocated to Ra would be a. $7.00. b. $6.80. c. $5.95. d. $4.25.

CHAPTER 16 QUIZ SOLUTIONS 1.

10.

Quiz Question Calculations 3.

0.60/0.80  $50,000 = $37,500

Building & Grounds allocation to Computer Services 90,000  0.10 = $9,000, giving CS a total of $30,000 variable costs 0.40/0.75  $30,000 = $16,000

Although the question asks only for the equation, the calculations are shown here if you wish to complete the problem. CS = $21,000 + 0.10 B&G

B&G = $90,000 + 0.25 CS

B&G = $90,000 + 0.25($30,769)

CS = $21,000 + 0.10($90,000 + 0.25 CS)

B&G = $97,692

0.975 CS = $21,000 + $9,000 CS =$30,769 9.

Do: 8/20  $17 = $6.80

$8 + $7 + $5 = $20

Ra: 7/20  $17 = $5.95 Mi: 5/20  $17 = $4.25

Cost Allocation: Joint Products and Byproducts

TRANSITION NOTES

Reasons for allocating joint costs have been expanded to include litigation where joint costs are key inputs. Other sections of the chapter have undergone minor rewriting to enhance the clarity of the coverage. Virtually all of the end-of-chapter problems and exercises are new or revised. *This chapter was previously Chapter 16.

EXERCISES AND PROBLEMS CORRELATION CHART 17th

16th

17th

16th

Edition 21 22 23 24 25 26 27 28 29 30 31

II.

Edition 21 22 23 24 25 26 27 28 29 30 31

Edition 32 33 34 35 36 Revised 37 Revised 38 Revised 39 Revised 40 Revised 41 42 Revised 43 Revised

Edition 32 33 34 35 36 37 38 39 40 41 42 43

LEARNING OBJECTIVES 1.

Identify the splitoff point in a joint-cost situation and distinguish joint products from byproducts.

Explain why joint costs are allocated to individual products.

Allocate joint costs using four methods.

Identify situations when the sales value at splitoff method is preferred when allocating joint costs.

Explain why joint costs are irrelevant in a sell-orprocess-further decision.

Account for byproducts using two methods.

CHAPTER SYNOPSIS Chapter 16 continues the discussion of cost allocation but the focus in this chapter is on allocation of costs in situations where two or more products are produced using the same process. Several methods are presented for allocating the joint costs incurred before products are readily distinguishable from one another. The splitoff point is defined as that point in the production process where the products become identifiable and after which separable costs are tracked directly to each product. Four methods for allocation of joint costs are the sales value at splitoff method, the net realizable value (NRV) method, the constant gross-margin percentage method, and physical measures methods that use data such as weight or volume. Byproducts are defined as products that have low sales value compared to the other products resulting from the production process, and two methods of accounting for byproducts are introduced. The concept of different costs for different purposes is also revisited. The section on pricing decisions has been rewritten. 17-2 Copyright © 2021 Pearson Education, Inc.

III.

IV.

POINTS OF EMPHASIS 1.

Make sure the students understand the reasons for allocating joint costs.

Be sure to demonstrate each of the four methods for allocating joint costs. After illustrating the methodology for each, have the students calculate allocations for each method. Emphasize the strengths and weaknesses of each.

Emphasize the superiority of the sales value at splitoff method, and the reasons why it is preferred.

Accounting for byproducts is not a major issue, and it is not a complicated one, so it does not need a great deal of time devoted to it.

CHAPTER OUTLINE LEARNING OBJECTIVE

Identify the splitoff point in a joint-cost situation … the point at which two or more products become separately identifiable and distinguish joint products … products with high sales values from byproducts … products with low sales values

1.1

Joint costs are costs of a production process that yields multiple products simultaneously. For example, in processing of beef, the yield includes steaks, roasts, and hamburger in addition to cowhide and other products. Joint costs are incurred prior to the splitoff point.

1.2

The splitoff point is the juncture in a joint production process when two or more products become separately identifiable.

1.3

Separable costs are costs incurred beyond the splitoff point that are assignable to each of the specific products identified at the splitoff point. (Exhibit 17-1 lists examples of joint-cost situations.)

1.4

The outputs of a joint production process can be classified into two general categories: outputs with a positive sales value and outputs with a zero sales value. Only those outputs having positive sales value or that enable the company to avoid incurring costs are referred to as products.

1.5

A main product is the one product having a high total sales value compared with the total sales values of other products of the process.

1.6

If the process yields two or more products with high sales values, they are referred to as joint products.

1.7

An output of a joint production process having a low sales value is referred to as a byproduct. TEACHING POINT. Use some examples to illustrate each of these terms. In the processing of beef, main products would include various cuts of meat as well as the leather hide. Byproducts might include bone, which has only minimal value. Output that is discarded would not be considered a product.

1.8

In practice the distinction between main products, joint products, and byproducts may be difficult to determine.

LEARNING OBJECTIVE

Explain why joint costs are allocated to individual products … to calculate cost of goods sold and inventory, and for reimbursements under cost-plus contracts and other types of claims

2.1

Joint costs are allocated to individual products or services for several purposes: •

Computing inventoriable costs and the cost of goods sold for external and internal reporting purposes

•

Analyzing profitability of divisions and evaluating performance of division managers

•

Reimbursing companies that have some, but not all, of their products or services reimbursed under cost-plus contracts with, say, a government agency

•

jointly produced products or services, such as in extractive and energy industries, where output prices are regulated to yield a fixed return on a cost basis that includes joint-cost allocations. •

For any commercial litigation or insurance settlement situation in which the costs of joint products or services are key inputs.

LEARNING OBJECTIVE

Allocate joint costs using four methods … sales value at splitoff, physical measure, net realizable value (NRV), and constant gross-margin percentage NRV

3.1

Joint costs can be allocated using two approaches: market-based data (such as sales revenue) or by using physical measures (weight, quantity, or volume).

3.2

There are three methods that use the market-based data approach: •

Sales-value at splitoff method

•

Net realizable value (NRV) method

•

Constant gross-margin percentage NRV method (Exhibit 17-2 illustrates the basic relationships in the Farmland Dairy example.)

3.3

The sales value at splitoff method allocates joint costs to joint products on the basis of relative sales value at the splitoff point. Sales value of the quantity produced rather than quantity sold is used because the costs were incurred in all units produced, not just those sold. This method follows the benefitsreceived criterion discussed in an earlier chapter. (Exhibit 17-3 illustrates accounting for joint products under the sales value at splitoff method.)

3.4

The physical-measure method allocates joint costs on the basis of a comparable physical measure such as weight or volume at the splitoff point. This method is considered less desirable due to the fact that physical measures usually have no relationship to the revenue-generating abilities of a product. (Exhibit 17-4 illustrates accounting for joint products under the physical-measure method.)

3.5

The net realizable value (NRV) method allocates joint costs to joint products produced on the basis of final sales value minus separable costs. This method makes the assumption that products will be processed beyond the splitoff point. It is often used when selling prices for products at splitoff do not exist. (Exhibits 17-5 and 17-6 illustrate accounting for joint products under the net realizable value method.)

3.6

The constant-gross margin percentage NRV method allocates joint costs to joint products in such a manner that each individual product has the same gross-margin percentage. This method can result in negative allocations of joint costs. (Exhibit 17-7 illustrates accounting for joint products under the constant-gross margin NRV method.) TEACHING POINT. Illustrate each method, along with the strengths and weaknesses of each approach. Show how the physical measure and constant gross margin NRV methods can sometimes give less-than-optimal results.

LEARNING OBJECTIVE

Identify situations when the sales value at splitoff method is preferred when allocating joint costs … objectively measuring the benefits received by each product

4.1

The sales value at splitoff method is the preferred method when selling-price data exist at splitoff for a number of reasons: •

It measures the value of the product at the splitoff point. This is seen as the best measure of benefits received as a result of joint processing.

•

It does not anticipate subsequent management decisions. This method does not require information about any processing occurring after the splitoff point.

•

There is a common basis to allocate joint costs to products. All products can be measured by anticipated revenues from the product.

•

can become quite complex. 4.2

All of these approaches, however, are arbitrary, lacking any cause-and-effect relationship. Consequently, some companies choose not to allocate joint costs at all, carrying their inventories at NRV. Because this recognizes revenues before the sale is actually made, some companies choose to value inventories at NRV minus estimated operating income margin.

Refer to Quiz Questions 1 through 7 Exercises 17-21, 1723, and 17-25; Problem 17-32

LEARNING OBJECTIVE

Explain why joint costs are irrelevant in a sell-orprocess-further decision … because joint costs are the same whether or not further processing occurs

5.1

As mentioned, joint costs are irrelevant for decisionmaking purposes in a sell or process further situation.

5.2

The concept of relevant costs and revenues should be applied in the decision to sell or process further. If the additional revenues from further processing exceed the additional costs from this processing, the product should receive further processing.

5.3

Likewise, there can be the potential for conflict between cost concepts used for decision-making purposes and cost concepts used for performance evaluation. Using market-based methods of joint cost allocation tend to reduce these conflicts.

5.4

Joint costs allocated to joint products should not be used in making pricing decisions for joint products, as there is no cause-and-effect relationship that identifies resources demanded by each joint product that can be used as a basis for pricing.

Refer to Quiz Question 8 28; Problems 17-34 and 17-35

Exercises 17-26 and 17-

LEARNING OBJECTIVE

Account for byproducts using two methods … recognize in financial statements at time of production or at time of sale

6.1

Recall that a byproduct is a product emerging from a joint process that has relatively little sales value. Due to its inconsequential value, it is not beneficial to expend a large amount of resources accounting for byproducts.

6.2

Two methods are utilized to account for byproducts. •

The production method recognizes byproducts at the time production is completed. The NRV of the byproduct is offset against the costs of the main product.

•

The sales method recognizes the byproduct at the time of sale. No entries are made until the byproduct is sold. Revenues from the sale are reported as a revenue item in the period sold. These revenues can be grouped with sales, treated as other income, or deducted from cost of goods sold. TEACHING POINT. In keeping with the nature of byproducts, do not spend a great deal of time on this issue. However, the students should understand the different approaches to accounting for them. Illustration through journal entries is a good way to approach this topic.

(Exhibits 17-8 and 17-9 illustrate byproduct costing.) Refer to Quiz Questions 9 and 10 Exercises 17-22, 17-29, and 17-31

Exhibit 17-2 illustrates the basic relationships in the Farmland Dairy example. Exhibit 17-3 illustrates accounting for joint products under the sales value at splitoff method. Exhibit 17-4 illustrates accounting for joint products under the physical-measure method. Exhibits 17-5 and 17-6 illustrate accounting for joint products under the net realizable value method. Exhibit 17-7 illustrates accounting for joint products under the constant-gross margin NRV method. Exhibits 17-8 and 17-9 illustrate byproduct costing.

CHAPTER 17 QUIZ The following data apply to questions 1 through 5. Brant Corporation manufactures two products out of a joint process—Scout and Andro. The joint (common) costs incurred are $400,000 for a standard production run that generates 70,000 pounds of Scout and 30,000 pounds of Andro. Scout sells for $9.00 per pound whereas Andro sells for $7.00 per pound. 1.

[CMA Adapted] If there are no additional processing costs incurred after the splitoff point, the amount of joint cost of each production run allocated to Scout on a physicalquantity basis is a. $300,000. b. $280,000. c. $120,000. d. $100,000.

[CMA Adapted] If there are no additional processing costs incurred after the splitoff point, the amount of joint cost of each production run allocated to Andro on a sales value at splitoff basis is a. $300,000. b. $225,000. c. $175,000. d. $100,000.

[CMA Adapted] If additional processing costs beyond the splitoff point are $1.00 per pound for Scout and $2.333 per pound for Andro, the amount of joint cost of each production run allocated to Andro on a physical-quantity basis is a. $300,000. b. $280,000. c. $120,000. d. $100,000. 17-9 Copyright © 2021 Pearson Education, Inc.

[CMA Adapted] If additional processing costs beyond the splitoff point are $1.00 per pound for Scout and $2.333 per pound for Andro, the amount of joint cost of each production run allocated to Andro on an estimated net realizable value basis is a. $80,000. b. $147,350. c. $175,000. d. $320,000.

Assume the same cost information as in question 4. The amount of joint cost of each production run allocated to Scout using the constant gross-margin percentage NRV method is a. $224,910. b. $260,120. c. $335,090. d. $405,090.

[CPA Adapted] For purposes of allocating joint costs to joint products, the sales value at splitoff method could be used in which of the following situations? No costs Cost beyond beyond splitoff splitoff a. Yes No b. Yes Yes c. No Yes d. No No

Products G and H are joint products developed from the same process with each being processed further. Joint costs are incurred until splitoff, the separable costs are incurred in further refining each product. Sales values of G and H at splitoff are used to allocate joint costs. If the sales value of G at splitoff increases and all other costs and selling prices remain unchanged, joint costs allocated to: G H a. increases increases b. increases decreases c. decreases decreases d. decreases increases

[CPA Adapted] Tanner Company manufactures products Katran and Klare from a joint process. Product Katran has been allocated $7,500 of total joint costs of $30,000 for the 1,500 units produced. Katran can be sold at the splitoff point for $4 per unit, or it can be processed further with additional costs of $2,000 and sold for $7 per unit. If Katran is processed further and sold, the result would be a. a breakeven situation. b. an overall loss of $1,500. 17-10 Copyright © 2021 Pearson Education, Inc.

c. d.

a gain of $2,500 from further processing. a gain of $1,000 from further processing.

[CPA Adapted] In accounting for byproducts, the value of the byproduct may be recognized at the time of Production Sale a. Yes No b. Yes Yes c. No No d. No Yes

10.

[CPA Adapted] Mohler Corporation manufactures a product that yields the byproduct Jep. The only costs associated with Jep are selling costs of $0.10 for each unit sold. Mohler accounts for sales of Jep by deducting Jep’s separable costs from Jep’s sales and then deducting this net amount from the major product’s cost of goods sold. Jep’s sales were 200,000 units at $1.00 each. If Mohler changes its method of accounting for Jep’s sales by showing the net amount as additional sales revenue, the Mohler’s gross margin would a. increase by $180,000. b. increase by $200,000. c. increase by $220,000. d. be unaffected.

CHAPTER 17 QUIZ SOLUTIONS 1.

10.

Quiz Question Calculations 1.

Scout $400,000  70,000 lbs / 100,000 lbs = $280,000 Andro $400,000  30,000 lbs / 100,000 lbs = $120,000

Scout 70,000 lbs  $9 Andro 30,000 lbs  $7 =

= $630,000 210,000 $840,000

Scout 630,000/840,000  $400,000 = $300,000 Andro 210,000/840,000  $400,000 = $100,000 3.

See answer to #1

Scout Revenues Additional Proc $1  70,000

$630,000 (70,000) $560,000

Andro Revenues Additional Proc $2.33  30,000

$210,000 (70,000) Total NRV

140,000 $700,000

Scout 560,000/700,000  $400,000 = $320,000 Andro 140,000/700,000  $400,000 = $ 80,000 5. Sales Separable Costs Joint Costs Gross Profit *Adjusted for rounding 8.

Scout Andro $630,000 $210,000 (70,000) (70,000) $560,000 $140,000 (335,090) (65,010) 224,910 74,970*

Total $840,000 (140,000) $700,000 (400,000) 300,000

35.7%**

**300,000/840,000

Katran @ splitoff value $4 x 1500 = $6,000 Process further $7  1500 = $10,500 less separable costs of $2,000 = $8,500 $8,500 – $6,000 = $2,500 gain from further processing

10.

Sales of Jep Separable costs Jeb Gross Margin

200,000  $1 = $200,000 200,000  $0.10 = 20,000 $180,000

However, this amount is currently being deducted from the cost of the main product, so gross margin remains unchanged.

18 8

TRANSITION NOTES

The concept of equivalent units now precedes the introduction of the five-step process-costing sequence. This allows the students to more fully understand the steps in process costing, as equivalent units are an integral portion of these five steps. The discussion of the five steps has been rewritten to clarify the process. Added coverage of cryptocurrency and FIFO vs. LIFO Accounting. *This chapter was previously Chapter 17.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 Revised 22 Revised 23 Revised 24 25 26 27 28 29 30 31 32 33 34 Revised 35 Revised

16th Edition 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35

17th Edition 36 37 38 39 40 41 42 43 44 45 Revised 46 47 Revised

16th Edition 36 37 38 39 40 41 42 43 44 45 46 47

LEARNING OBJECTIVES 1.

Identify the situations in which process-costing systems are appropriate.

Understand the basic concepts of process costing and compute average unit costs.

Describe the five steps in process costing and calculate equivalent units.

Use the weighted-average method and the first-in, first-out (FIFO) method of process costing.

Apply process-costing methods to situations with transferred-in costs.

Understand the need for hybrid-costing systems such as operation costing.

II.

CHAPTER SYNOPSIS This chapter deals with the topic of process costing. Process costing is at the other end of the spectrum from job costing. Process-costing systems are used when companies produce a large quantity of identical or very similar goods or services. The main difference in jobcosting and process-costing systems is the extent of averaging—process systems use broad averaging to determine a unit cost for the period. The five-step process to process costing is presented: Step 1: Summarize the flow of physical units (of output). Step 2: Compute output in terms of equivalent units. Step 3: Summarize total costs to account for. Step 4: Compute cost per equivalent-unit. Step 5: Assign total costs to units completed and to ending work-in-process. The weighted-average method and the first-in, first-out (FIFO) method are two common process-costing methods. The primary difference between the two methods is that the FIFO method segregates current period production costs and units from the production costs and units that are part of beginning work-in-process. The use of standard costs and process costing with transferred-in costs are covered. Hybrid systems and operation costing are discussed.

III.

POINTS OF EMPHASIS 1.

This is a chapter that must use examples and problems. The students must be engaged in working the problems in order to learn the material. It will be beneficial if the students work through a cost of production report for weighted average and for FIFO (although the chapter no longer uses that title).

Don’t spend too little time on equivalent units. If the students cannot properly grasp this concept, the rest of what they are doing in this chapter will be incorrect. Make sure they understand how to calculate equivalent units when materials are added at the beginning and at the end of the process; and that they can calculate equivalent units for conversion cost when CC is added throughout the process.

As time allows, devote some attention to hybrid-cost systems such as operation costing as illustrated in the Appendix. As most systems fall on a continuum between pure job costing and pure process costing, this is a useful concept for the students to master. 19-4 Copyright © 2021 Pearson Education, Inc.

IV.

CHAPTER OUTLINE LEARNING OBJECTIVE

Identify the situations in which process-costing systems are appropriate … when masses of identical or similar units are produced

1.1

In Chapter 4 the need for cost-accounting systems was discussed and two approaches to cost-accounting systems were introduced—job costing and process costing. Job costing was covered in detail.

1.2

Recall that the two systems are described as the ends of a continuum. Most operations have characteristics of both job-costing and process-costing systems and management must make a determination about which type of system to use.

1.3

A job-costing system is best suited to operations that have distinct, identifiable units of a product, such as custom-made jewelry.

1.4

A process-costing system works best in an environment in which masses of identical or similar units are produced, such as food processing. TEACHING POINT. Have the students identify operations that would be appropriate for process costing and job costing. An auto repair shop is a good example of a job-costing system, as the invoice has materials, labor, and overhead charges on the bill. An inexpensive item such as a pen that students may be using is a good example of a process system. Point out that the pens are manufactured in the same way and in mass quantities. The only difference is in the color of the ink, the fineness of the point, and the color of the barrel. But these differences do not affect how the pens are manufactured—it is the same regardless of how these factors change.

1.5

In a process-costing system, the unit cost is determined by assigning total costs to many identical or similar units. Total costs are divided by the number of units produced to arrive at the unit cost.

1.6

The principal difference between the two systems is the extent of averaging used to compute unit costs of products or services. Process costing uses broad averages to determine an average production cost for all units produced. 19-5 Copyright © 2021 Pearson Education, Inc.

LEARNING OBJECTIVE

Understand the basic concepts of process costing and compute average unit costs … divide total costs by total units in a given accounting period

2.1

The simplest case of process costing occurs when there are no beginning or ending inventories of work-inprocess. This rare situation is the simplest as the total manufacturing costs incurred in the period can be divided by the number of units completed to determine unit cost. (Case 1 in the text illustrates this scenario.)

2.2

When there are beginning or ending work-in-process inventories, estimates must be made about the percentage of completion of the unfinished units. The accuracy of these estimates depends on the care, skill, and experience of the estimator and the nature of the conversion process.

2.3

These partially completed units must then be characterized into equivalent units of production. Partially assembled units are not the same as fully assembled units. In order to make comparisons between periods and accurately determine unit cost, the costs for the period must be divided by the equivalent units of production for the period. (Case 2 illustrates process costing with zero beginning but some ending work-in-process inventory, and introduces equivalent units of production.) TEACHING POINT. Although it is early in the chapter, it is good to perform some equivalent unit calculations at this point. Doing so will introduce the students to the most difficult aspect of process costing and will make the five-step procedure more readily understood. Exercise 18-21 is useful for this purpose. Exhibit 18-1 summarizes the flow of physical units and computes output in equivalent units. These are the first two steps in process costing.

2.4

There will be separate equivalent unit calculations for materials and for conversion cost due to the fact that material is typically introduced at the beginning of the process, whereas conversion costs are added uniformly throughout the process. 19-6 Copyright © 2021 Pearson Education, Inc.

TEACHING POINT. Make sure the students understand that when materials are added at the start of the process, the units are 100% complete for materials. Although this seems like a simple concept, students often get tripped up over it when they look at conversion cost equivalent unit calculations.

LEARNING OBJECTIVE

Describe the five steps in process costing … to assign total costs to units completed and to units in work-in-process and calculate equivalent units … output units adjusted for incomplete units

3.1

The five-step procedure to calculate the cost of fully assembled units during the month as well as the cost of partially completed units at the end of the period are: Step 1:

Summarize the flow of physical units of output.

Step 2:

Compute output in terms of equivalent units.

Step 3:

Summarize total costs to account for.

Step 4:

Compute cost per equivalent unit.

Step 5:

Assign total costs to units completed and to units in ending work-in-process.

Exhibit 18-2 illustrates steps 3 through 5 in process-costing in Case 2 Exhibit 18-3 diagrams the flow of costs in a process-costing system.

3.2

Journal entries in process-costing systems are similar to entries made in job-costing systems with respect to direct materials and conversion costs. The main difference is that in process costing, there is one Work in Process account for each process. Exercise 18-22 requires the preparation of journal entries pertaining to exercise 18-21 TEACHING POINT. The students will have less trouble remembering the five points if they relate them to the cost of

production report. These steps are the major sections of that report.

LEARNING OBJECTIVE

Use the weighted-average method … assign costs based on total costs and equivalent units completed to date and the first-in, first-out (FIFO) method … assign costs based on costs and equivalent units of work done in the current period of process costing

4.1

The most complex situation arises in process costing when the company has beginning and ending work-inprocess inventories.

4.2

There are two methods for process costing: the weighted-average process-costing method and the firstin, first-out (FIFO) process-costing method. The difference in the two methods deals with how equivalent units of production are calculated.

4.3

The weighted-average process-costing method calculates cost per equivalent unit of all work done to date regardless of when the work was performed and assigns this cost to finished goods and ending work-in-process inventory. (Case 3 illustrates process costing with some beginning and some ending work-in-process inventory.) (Exhibit 18-4 illustrates the first two steps in process costing in Case 3.) (Exhibit 18-5 illustrates steps 3 through 5 in process costing in Case 3.)

4.4

The journal entries associated with process costing are similar to those for a job-costing system. However, there will be separate work-in-process accounts for each production department, along with separate overhead accounts.

4.5

The first-in, first-out (FIFO) process-costing method assigns the cost of the previous accounting period’s equivalent units in beginning work-in-process inventory to the first units completed and transferred out and assigns the cost of equivalent units worked on during the current period first to finish the beginning inventory, then to units started and completed, and finally to units in ending work-inprocess. 19-8 Copyright © 2021 Pearson Education, Inc.

4.6

This method assumes that the earliest equivalent units in work-in-process are completed first—a logical assumption.

4.7

Unlike the weighted-average method, FIFO keeps work on beginning inventory before the current period separate from work done in the current period. (Exhibits 18-6 and 18-7 display use of the FIFO method for process costing.)

4.8

Each of the two methods, weighted-average and firstin, first-out, are widely used. If the company does not experience large fluctuations in price, there will be minimal differences between the two. With the trend to smaller inventory levels, the differences in costs between the two methods are also reduced.

4.9

FIFO has the advantage of providing information about changes in costs from one period to the next. This will allow them to adjust selling prices based on current conditions. It is, in theory, the method yielding the most precise unit prices.

4.10 Weighted-average has the advantage of simplicity and is more representative of average unit costs when prices fluctuate markedly from month-to-month. Refer to Quiz Questions 1 through 6 Exercises 18-24, 18-25, 18-26, and 18-27

LEARNING OBJECTIVE

Apply process-costing methods to situations with transferred-in costs … using weighted-average and FIFO methods

5.1

Many companies with process-costing systems have two or more departments or processes in the production cycle. Each department has its own unique work-inprocess account and factory overhead account.

5.2

Products completed by a department and carried forward to a subsequent production department are referred to as transferred-in costs by the subsequent production department.

5.3

and a credit to the Work-in-Process account for the transferring department. TEACHING POINT. Make certain the students understand that product transferred out to another production department is not finished goods. From the view of the transferring-out department, their work on the units is complete, but from the broader perspective of the entire organization, it remains workin-process.

5.4

Transferred-in costs can be accounted for under weighted-average or the FIFO methods. In essence, these costs are treated as direct materials in which all the materials are added at the beginning of the process for that department. (Exhibits 18-8 and 18-9 display use of the weighted-average method with transferred-in costs.) (Exhibits 18-10 and 18-11 display use of the FIFO method with transferred-in costs.)

5.5

Four points to remember when dealing with transferredin costs include: •

Be sure that transferred-in costs are included in your calculations.

•

Do not overlook transferred-in costs assigned to the beginning work-in-process inventory when using FIFO.

•

Costs fluctuate between periods. Therefore, transferred batches may contain batches accumulated at different costs.

•

Units may be measured by different denominations in different departments. One department may express its output in gallons, whereas a subsequent department may use quarts, for example.

5.6

As has been observed, product-costing systems do not fall neatly into either job-costing or process-costing categories. Oftentimes a company uses a hybrid-costing system that blends characteristics from both job-costing and processcosting systems.

5.7

In these situations, the product-costing system should be designed to fit the characteristics of the different production systems.

Refer to Quiz Question 7 and 18-32

Exercises 18-31

LEARNING OBJECTIVE

Understand the need for hybrid-costing systems such as operation costing … when product-costing does not fall into jobcosting or process-costing categories

6.1 6.2

A hybrid-costing system blends characteristics of jobcosting and process-costing systems. An operation, a common type of hybrid-costing system is a standardized method or technique that is performed repetitively, often on different materials, resulting in different finished goods.

6.3

For example, a furniture manufacturer may manufacture sofas. The sofa can have a basic design and the assembly of that sofa can be accounted for through a process-costing system. However, each sofa may use a different material—leather, vinyl, cloth, and so on. The only cost difference is in the materials used.

6.4

In situations such as these, the materials are accounted for under a job-costing system, and the conversion is handled through process costing. Exercises 18-28 and 18-33

APPENDIX: STANDARD-COSTING METHOD OF PROCESS COSTING A.1

Companies using process-costing systems find it fairly easy to set standards for quantities of inputs needed to produce output. Standard cost per unit can then be multiplied by input quantity standards to develop standard cost per output unit. (Exhibits 18-12 and 18-13 illustrate incorporation of standard costs into a process-costing system.) TEACHING POINT. As time allows, illustrate preparation of a Cost of Production Report using standard costs. Exercise 18-34 is a good example of this type of problem.

A.2

In using a standard-costing system, variances will arise because the standard quantity was not used or the standard price was not paid for the inputs.

A.3

entries for process costing. (Exhibit 18-14 displays the flow of standard costs in a processcosting system.)

Refer to Quiz Questions 8 through 10 Exercises 18-34; Problem 18-45

OTHER RESOURCES To download instructor resources, visit the Instructor’s Resource Center at www.pearsonhighered.com/irc. The following exhibits were mentioned in this chapter of the Instructor’s Manual, and have been included in the Image Library. Exhibit 18-1 illustrates the first two steps in process costing in Case 2. Exhibit 18-2 illustrates steps 3 through 5 in process costing in Case 2. Exhibit 18-3 diagrams the flow of costs in a processcosting system. Exhibit 18-4 illustrates the first two steps in process costing in Case 3. Exhibit 18-5 illustrates steps 3 through 5 in process costing in Case 3. Exhibits 18-6 and 18-7 display use of the FIFO method for process costing. Exhibits 18-8 and 18-9 display use of the weighted-average method with transferred-in costs. Exhibits 18-10 and 18-11 display use of the FIFO method with transferred-in costs. Exhibits 18-12 and 18-13 illustrate incorporation of standard costs into a process-costing system. Exhibit 18-14 displays the flow of standard costs in a process-costing system.

CHAPTER 18 QUIZ Use the following information for questions 1 through 10. Top That manufactures baseball-style hats. Material is introduced at the beginning of the process in the Cutting Department. Conversion costs are incurred (and allocated) uniformly throughout 19-12 Copyright © 2021 Pearson Education, Inc.

the process. As the cutting of material is completed, the pieces are immediately transferred to the Sewing Department. Data for the Cutting Department for the month of February 2020 follow: Work-in-process, January 31—50,000 units 100% complete for direct materials; 40% completed for conversion costs; actual costs of direct materials, $70,500; actual costs of conversion, $34,050 Units started during February, 225,000 Units completed during February 200,000 Work-in-process, February 28 75,000 units 100% complete for direct materials; 20% completed for conversion costs Direct materials added during February [actual costs] $342,000 Conversion costs added during February [actual costs] $352,950

Assuming Top That uses the weighted-average method to account for inventories, the equivalent units of work for the month of February are Direct Materials Conversion Costs a. 225,000 225,000 b. 200,000 200,000 c. 275,000 215,000 d. 225,000 200,000

Assuming Top That used the weighted-average method to account for inventories, the cost per equivalent whole unit produced during February is a. $3.30. b. $3.55. c. $3.77. d. $4.00.

Assuming Top That uses the weighted-average method to account for inventories, the assignment of costs to work-in-process at the end of February is a. $300,000. b. $266,250. c $166,525. d. $139,500.

If Top That uses the first-in, first-out (FIFO) method to account for inventories, the equivalent units of work for the month of February are Direct Materials Conversion Costs a. 225,000 225,000 b. 225,000 195,000 c. 275,000 200,000 d. 200,000 195,000

If Top That uses the FIFO method to account for inventories, the costs per equivalent unit for February are Direct Materials Conversion Costs a. $1.50 $1.76 b. $1.83 $1.72 c. $1.71 $1.81 d. $1.52 $1.81 19-13 Copyright © 2021 Pearson Education, Inc.

Assuming Top That uses the first-in, first-out (FIFO) method to account for inventories, the assignment of costs to units completed and transferred to the Sewing Department during February is a. $658,350. b. $636,450. c. $666,000. d. $652,000.

In the Sewing Department, additional direct materials are added to the product at the end of production. Without prejudice to your answer for questions 1 through 6, assume that 200,000 units were transferred from the Cutting Department and that the weightedaverage method is used. Data for February follow: Work-in-process, January 31—70,000 units (30% complete as to conversion) Units completed during February—240,000 units Work-in-process, February 28—30,000 units (80% complete as to conversion) For the Sewing Department, the equivalent units of work done in February is Transferred In Direct Materials Conversion Costs a. 200,000 200,000 200,000 b. 200,000 170,000 194,000 c. 240,000 240,000 245,000 d. 270,000 240,000 264,000

The following additional data apply to questions 8 through 10. Assuming the weighted-average method and the scenario from #1 above, the standard costs for the Cutting Department is —Direct materials: $1.50 per unit; Conversion costs $1.75 per unit 8.

The standard costs of units completed and transferred from the Cutting Department during February is a. $731,250. b. $650,000. c. $678,750. d. $600,000.

The conversion costs variance for the month of February is a. $40,800 favorable. b. $94,250 favorable. c. $11,700 unfavorable. d. $29,750 unfavorable.

10.

The journal entry to record inventory costs and direct-material variances for the month of February is a. Cutting Department Control 342,000 Direct Material Variances 4,500 Work-in-Process—Cutting Department 337,500 b.

Work-in-Process—Cutting Department Direct Material Variances

337,500 4,500

Cutting Department Control c.

342,000

Work-in-Process—Cutting Department Direct Material Variances Cutting Department Control

342,000 4,500

Work-in-Process—Cutting Department Direct Material Variances Cutting Department Control

341,250 750

337,500

CHAPTER 18 QUIZ SOLUTIONS 1.

10.

Quiz Question Calculations 1.

DM = 50,000 + 225,000 = 275,000 EU CC = 200,000 + 0.20(75,000) = 215,000 EU

($342,000 + $70,500)/275,000 = $1.50/unit for Materials ($352,950 + 34,050)/215,000 = $1.80/ unit for Conversion Cost $1.50 + $1.80 = $3.30

75,000  $1.50 75,000  0.2  $1.80

= $112,500 = 27,000 $139,500

Materials Conversion Cost BI 50,000  0.6 S&C EI 75,000  0.2

= 225,000 EU (number of units started) = 30,000 = 150,000 = 15,000 195,000

342,000

342,000/225,000 = $1.52/unit for Materials 352,950/195,000 = $1.81/unit for Conversion Cost

Beginning Work-in-Process To complete Beginning Work-in-Process 50,000  0.6  1.81 Started & Completed 150,000  3.33 Transferred to Sewing

Transferred in (240,000 x 100% + 30,000 x 100%) = 270,000 Direct Material (240,000 x 100%) + 30,000 x 0%) = 240,000 Conversion Costs (240,000 x 100% + 30,000 x 80%) = 264,000

Standard cost

Standard 225,000  $1.75 Actual Variance

10.

DM Standard cost 1.50 x 225,000 units started = $337,500 Actual cost = $342,000 Variance = $4,500 U

$104,550 54,300 $158,850 499,500 $658,350

(DM $1.50 + CC $1.75 = $3.25 x 200,000 transferred units = $650,000) $393,750 352,950 $ 40,800F

Spoilage, Rework, and Scrap

TRANSITION NOTES

In a sense, this chapter is an extension of previous chapters dealing with process costing and job costing. The presentation of this chapter has been streamlined by streamlining the presentation. *This chapter was previously Chapter 18.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 20 21 22 23

16th Edition 20 21 22 23

17th Edition 33 34 35 36

16th Edition 33 34 35 36

24 25 26 27 Revised 28 Revised 29 30 31 32

II.

24 25 26 27 28 29 30 31 32

37 38 39 Revised 40 Revised 41 Revised 42 Revised 43 44 45

37 38 39 40 41 42 43 44 45

LEARNING OBJECTIVES 1.

Understand the definitions of spoilage, rework, and scrap.

Identify the differences between normal and abnormal spoilage.

Account for spoilage in process costing using the weighted-average method and the first-in, first-out (FIFO) method.

Account for spoilage at various stages of completion in process costing.

Account for spoilage in job costing.

Account for rework in job costing.

Account for scrap.

CHAPTER SYNOPSIS Chapter 19 discusses the topic of accounting for manufacturing defects. Three categories of costs that result from defects in the manufacturing process are spoilage, rework, and scrap. Companies develop accounting techniques for identifying and quantifying the cost of manufacturing defects in order to properly record and report the value of inventory and cost of goods sold, and to develop and analyze proposed or implemented costreduction and quality-management strategies.

III.

POINTS OF EMPHASIS 1.

Students need to understand the distinction between scrap, rework, and spoilage. Their tendency will be to use these terms somewhat interchangeably.

This chapter presents a second opportunity for the students to deal with equivalent units of production. If you emphasize this aspect of the chapter, the remaining steps in process costing are generally grasped more easily, and are similar to the material 19-17 Copyright © 2021 Pearson Education, Inc.

covered in the previous chapter. 3.

IV.

Rework and spoilage are fairly simple concepts to grasp. Illustration of these topics through problem material will usually be sufficient for the students to comprehend the accounting.

CHAPTER OUTLINE LEARNING OBJECTIVE

Understand the definitions of spoilage, … unacceptable units of production rework, … unacceptable units of production subsequently repaired and scrap … leftover material

1.1

Spoilage, rework, and scrap have distinctive definitions in cost accounting that may not be the definition commonly used. It is important that these terms be used properly, as each receives a different accounting treatment.

1.2

Spoilage is units of production – whether fully or partially completed - that do not meet the specifications required by customers for good units and are discarded or sold at reduced prices.

1.3

Rework is units of production that do not meet the specifications required by customers but are repaired and sold as good finished units. TEACHING POINT. Note that rework is units that are repaired and sold as first quality units before they are shipped to customers. Do not confuse rework with remanufactured items. These are items that have been returned by customers for various reasons and cannot be sold as new items.

1.4

Scrap is residual material that results from manufacturing a product. It has low or zero sales value. TEACHING POINT. A simple demonstration will illustrate these three terms. Take a blank sheet of paper and make a pencil

mark on it. Tell the students the pencil mark is a defect. Then take an eraser and remove the mark. This illustrates rework. Then tear the sheet of paper. This cannot be made as new, so it is now spoilage. Finally, take another sheet of paper and cut circles out of it. There will be pieces too small to use to cut circles. These pieces are scrap.

LEARNING OBJECTIVE

Identify the differences between normal spoilage … spoilage inherent in an efficient production process and abnormal spoilage … spoilage that would not arise under efficient operation

2.1

Spoilage is divided into two types: normal spoilage and abnormal spoilage. •

Normal spoilage is spoilage inherent in the production process. It is viewed arising even in an efficient manufacturing process. Typically, normal spoilage is included as a part of the cost of good units manufactured.

•

Abnormal spoilage is spoilage that is not considered a part of the production process and does not arise under efficient operating conditions. Abnormal spoilage is regarded as avoidable and controllable.

2.2

To highlight the abnormal spoilage, companies calculate the units of abnormal spoilage and record the cost in a “Loss from Abnormal Spoilage” account, which appears as a separate line item in the income statement.

2.3

Some companies regard all spoilage as abnormal in order to make all spoilage visible.

Refer to Quiz Question 1 and 2 Exercise 19-20

LEARNING OBJECTIVE

Account for spoilage in process costing using the weighted-average method … spoilage cost based on total costs and equivalent units completed to date and the first-in, first-out (FIFO) method … spoilage cost based on costs of current period and equivalent units of work done in current period

2.1

Units considered normal spoilage in a process-costing system are counted in computing completed units.

2.2

The inspection point is the stage of completion at which products are examined to determine if they are acceptable units. Spoilage is typically assumed to occur at the stage of completion where inspection takes place. (Exhibit 19-1 illustrates the impact of including normal spoilage units.)

2.3

The five-step procedure for process costing (discussed in Chapter 18) needs only slight modification to accommodate accounting for spoilage. Step 1: Summarize the flow of physical units of output. Units of both normal and abnormal spoilage are identified. Step 2: Compute output in terms of equivalent units. Include a calculation for equivalent units for spoilage. Step 3: Summarize total costs to account for. This is all costs debited to the Work-in-Process account. Step 4: Compute cost per equivalent unit. Step 5: Assign total costs to units completed, to spoiled units, and to units in ending work-inprocess. (Exhibit 19-2 displays accounting for spoilage using the weighted-average method.)

2.4

2.5

Normal and abnormal units are treated as additional unit groups for which cost-per-equivalent-unit needs to be calculated and costs assigned.

2.6

Spoilage costs are always considered to have occurred in the current period and are not included in the cost of ending work-in-process inventory. (Exhibit 19-3 demonstrates accounting for spoilage using the FIFO method.)

Refer to Quiz Questions 3, 4, and 5 19-21, 19-22, 19-23, 19-24

LEARNING OBJECTIVE

Exercise

Account for spoilage at various stages of completion in process costing … spoilage costs vary based on the point at which inspection is carried out

4.1

When spoilage occurs at various stages of completion, an adjustment must be made in the accounting records.

4.2

The unit costs of normal and abnormal spoilage are the same when the two are detected at the same inspection point.

4.3

Normal spoilage is computed on the basis of the number of good completed units passing the inspection point during the current period.

4.4

Costs of abnormal spoilage are separately accounted for as losses of the accounting period in which they are detected. (Exhibit 19-4 illustrates the computation of equivalent units of production when inspection occurs at the 20% stage of completion.)

LEARNING OBJECTIVE

Account for spoilage in job costing … normal spoilage assigned directly or indirectly to job; abnormal spoilage written off as a loss of the period

5.1

The concepts of normal and abnormal spoilage also apply to job-costing systems.

5.2

Abnormal spoilage is a period cost and treated as an expense of the period in which it occurs.

5.3

Normal spoilage is inventoriable and included as a cost of the product.

5.4

Companies frequently distinguish between normal spoilage attributable to a specific job from normal spoilage common to all jobs.

5.5

When normal spoilage is considered attributable to a specific job, that job bears the cost of the spoilage.

5.6

When normal spoilage is considered attributable to all jobs, it is a characteristic of the production process and is allocated as a manufacturing overhead cost. TEACHING POINT. With more emphasis today on quality and reducing defects, companies are treating less spoilage as normal spoilage than in the past. Many companies now consider all spoilage to be abnormal. Although this may not be technically true, this treatment tends to highlight the total amount of spoilage.

Refer to Quiz Question 6 Problem 19-40

Exercise 19-32 and

LEARNING OBJECTIVE

Account for rework in job costing … normal rework assigned directly or indirectly to job; abnormal rework written off as a loss of the period

6.1

Units that are reworked are units that have been inspected and found to be unacceptable. However, these units are such that they can be repaired and sold as acceptable finished units.

6.2

Normal rework attributable to a specific job is charged to that job.

6.3

If it is normal rework common to all jobs, the costs are charged to manufacturing overhead and spread over all jobs.

6.4

If the rework is considered abnormal, the costs of the rework are charged to a “Loss from Abnormal Rework” account.

Refer to Quiz Questions 7, 8, and 9 Exercise 19-33 and Problem 19-41 LEARNING OBJECTIVE

Account for scrap … reduces cost of job either at time of sale or at time of production

7.1

Scrap is the leftover material resulting from manufacturing a product. It has a low (or zero) sales value. TEACHING POINT. An example of scrap is the sawdust that emerges when trees are sawed into lumber. Sawdust can be used for certain things, but it has a very low value. Planning can sometimes lower the amount of scrap, but some scrap is inevitable in certain manufacturing processes.

7.2

Two aspects of accounting for scrap are: •

•

Inventory costing, including when and how scrap affects operating income

7.3

One way of accounting for scrap is to recognize it at the time of sale. No inventory records are maintained for scrap. When sold, cash or accounts receivable is debited and scrap revenue is credited.

7.4

When scrap has more than an insignificant value, it is assigned an inventory valuation equal to its sales value and a materials account is debited with a credit to work-in-process or manufacturing overhead. When sold, cash or accounts receivable is debited with the inventory account being credited.

Refer to Quiz Question 10 Exercise 19-34

APPENDIX: STANDARD COSTING AND SPOILAGE NOTE: If standard costing was not covered in Chapter 18, you may skip this section and go to the section on Job Costing and Spoilage

A.1

Accounting for spoilage in process-costing systems using the standard-costing method is very similar to the standard-costing method discussed in the previous chapter. The only difference is that the normal and abnormal units are treated as additional unit groups for which cost-per-equivalent-unit needs to be calculated and costs assigned.

A.2

Costs are assigned to normal and abnormal spoilage units using standard costs.

A.3

As with the weighted-average and FIFO methods, the costs of normal spoilage are included in the total costs to account for and the costs assigned to units completed and transferred out. (Exhibit 19-5 illustrates accounting for spoilage using the standard-costing method.)

Refer to Exercise 19-31

Exhibit 19-1 illustrates the impact of including normal spoilage units. Exhibit 19-2 displays accounting for spoilage using the weighted-average method. Exhibit 19-3 demonstrates accounting for spoilage using the FIFO method. Exhibit 19-4 illustrates the computation of equivalent units of production when inspection occurs at the 20% stage. Exhibit 19-5 illustrates accounting for spoilage using the standard-costing method.

CHAPTER 19 QUIZ 1.

[CPA Adapted] In manufacturing its products for the month of September 2020, El Dorado Corporation incurred normal spoilage of $7,000 and abnormal spoilage of $3,000. How much spoilage cost should El Dorado charge as inventoriable for the month of September 2020? a. $0 b. $3,000 c. $7,000 d. $10,000

[CPA Adapted] Spoilage from a manufacturing process was discovered during an inspection of work-in-process. In a process-costing system, the cost of the spoilage would be added to the cost of the good units produced if the spoilage is Normal Abnormal a. Yes Yes b. Yes No c. No No d. No Yes

The following data apply to questions 3 through 5. Watkins Company had the following production for the month of June: Units Work-in-process, June 1 6,000 Started during June 24,000 Completed and transferred to finished goods 18,000 Abnormal spoilage incurred 3,000 Work-in-process, June 30 9,000 19-25 Copyright © 2021 Pearson Education, Inc.

Materials are added at the beginning of the process. As to conversion cost, work-in-process was 20% complete at the beginning and 70% complete at the end of the month. Spoilage is detected at the end of the process. 3.

[CPA Adapted] Using the weighted-average method, the equivalent units for June, with respect to conversion cost, were a. 30,000. b. 24,300. c. 23,700. d. 27,300.

Assume the manufacturing cost of the spoiled goods is $6,000. The journal entry to record the spoilage is a. Manufacturing Overhead Control 6,000 Work-in-Process 6,000 b.

Materials Control Work-in-Process

6,000 6,000

Loss from Abnormal Spoilage Work-in-Process

6,000 6,000

Finished Goods Work-in-Process

6,000 6,000

Using the first-in, first-out (FIFO) method, the equivalent units for June, with respect to conversion cost, were a. 26,100. b. 23,100. c. 22,500. d. 19,500.

Under process costing and job costing, the accounting treatment for the normal spoilage (assume related to normal factory operations) is Process costing Job costing a. Loss account is charged. charged.

Loss account is

b. Upon transfer, spoilage costs charged. are transferred along with other costs. c.

Loss account is

d. 7.

transferred along with other costs. charged.

control is

Manufacturing overhead control is charged.

No entry.

[CPA Adapted] During August 2020, Stirtz Company incurred the following costs on Job 924 for the manufacture of 600 scoreboard clocks: Original cost accumulation: Direct materials

$2,250 Direct manufacturing labor 1,800 Manufacturing overhead (150% of direct manufacturing labor) 2,700 $6,750 Direct costs of reworked 15 units: Direct materials $150 Direct manufacturing labor 240 $390 The rework costs were attributable to exacting specifications of Job 924, and the full rework costs were charged to the specific job. The cost per finished unit of Job 924 was a. $12.50. b. $11.25. c. $11.61 d. $11.90. The following data apply to questions 8 and 9. MedTech, Inc. manufactures surgical instruments to the exacting specifications of various customers. During April 2020, Job 911 for the production of 4,500 instruments was completed at the following costs per unit: Direct materials Direct manufacturing labor Allocated manufacturing overhead

60 20 80

$160 Final inspection of Job 911 disclosed 100 defective units and 50 spoiled units. The defective instruments were reworked at a total cost of $12,000, and the spoiled instruments were sold to a jobber for $3,000. 19-27 Copyright © 2021 Pearson Education, Inc.

[CPA Adapted] What would be the unit cost of the good units produced on Job 911? a. $160 b. $162 c. $164 d. $168

If the costs associated with spoilage and reworked units are considered as normal to manufacturing operations, the unit cost of the good units produced on Job 911 is a. $165. b. $164. c. $162. d. $160.

10.

[CPA Adapted] The sale of scrap from a manufacturing process usually would be recorded as a(n) a. increase in manufacturing overhead control. b. decrease in manufacturing overhead control. c. increase in finished goods control. d. decrease in finished goods control.

CHAPTER 19 QUIZ SOLUTIONS 1.

10.

Quiz Question Calculations 3.

Units Completed 18,000 Abnormal spoilage 3,000 Work-in-Process 6/30 (9,000  0.70) 6,300 Equivalent Units 27,300

Work-in-Process 6/1 (6,000  0.8) Started & Completed (18,000 – 6000) Abnormal Spoilage Work-in-Process 6/30 (9,000  0.70) Equivalent Units

4,800 12,000 3,000 6,300 26,100

Original Cost Accumulation Direct Costs of Rework Overhead Applied (240  150%) Total Cost

$ 6,750 390 360 $7,500

$7,500/600 clocks = $12.50 8.

Production costs Rework costs

$160  4,500 units

Revenue from sale of spoiled units Net Cost

$720,000 12,000 $732,000 (3,000) $729,000

739,000/4450 good units =

163.62 or $164

Production costs / Units

$720,000 / 4,500 = $160

20 99

Balanced Scorecard: Quality and Time

TRANSITION NOTES Part One of this chapter presents costs of quality through a balanced scorecard perspective. The discussion of the financial perspective places emphasis on opportunity costs resulting from poor quality. The discussion of cause-andeffect, or fishbone, diagrams has been expanded. In addition, the discussion of the learning-and-growth perspective has been expanded. Part Two, Time as a Competitive Tool, has undergone slight modifications in the written presentation to further explain the concepts. Part Three, discusses the balanced scorecard and time-related measures. *This chapter was previously Chapter 19. 20-1 Copyright © 2021 Pearson Education, Inc.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 17 18 Revised 19 20 21 22 Revised 23 24 Revised 25 Revised 26 27 28

II.

16th Edition 18 19 20 21 22 23 24 25 26 27 28 29

17th Edition 29 30 Revised 31 Revised 32 Revised 33 Revised 34 35 New 36 Revised 37

16th Edition 30 31 32 33 34 35 37 38

LEARNING OBJECTIVES 1.

Explain the four cost categories in a costs-of-quality program.

Develop nonfinancial measures and methods to improve quality.

Use cost-of-quality measures to make decisions

Use financial and nonfinancial measures to evaluate quality

Describe customer-response time and on-time performance and why delays occur.

Determine the cost of delays

Use financial and nonfinancial measures of time

CHAPTER SYNOPSIS This chapter looks at the balanced scorecard with particular reference to quality and time factors. Quality can be design quality or conformance quality. Quality costs are usually categorized as appraisal, inspection, internal failure, and external failure. A quality program will incur costs in the first two categories, with the expectation that failure costs will decrease. Several measures designed to detect quality problems are presented. The chapter also examines time as a competitive tool, 20-2 Copyright © 2021 Pearson Education, Inc.

focusing on customer-response time and on-time delivery as time-related factors.

III.

POINTS OF EMPHASIS 1.

This chapter covers a number of nontraditional topics that students may not readily see as relevant to the study of accounting. However, as society changes, the issues of quality and timeliness have become increasingly important. The cost accountant can assist management in these areas by providing relevant information.

Emphasize the two types of quality: quality of conformance and quality of design. Design quality refers to how closely the characteristics of a product or service meet the needs and wants of customers. Conformance quality is the performance of a product or service relative to its design and product specifications.

Emphasize the four categories of quality cost and the tradeoffs that occur. ▪

Prevention costs are those incurred to prevent the production of products that do not conform to specifications

▪

Appraisal costs are those incurred to detect which individual units of products do not conform to specifications

▪

Internal failure costs are those incurred on defective products BEFORE they are shipped to customers

▪

External failure costs are those incurred on defective products AFTER they have been shipped to customers

When prevention and appraisal costs increase, internal and external failure costs should decrease. 4.

Use the four perspectives, Financial, Customer, Internal-Business-Process and Learning and Growth, to measure and improve quality.

Customer-response time is how long it takes from the time a customer places an order for a product or service to the time the product or service is delivered to the customer. Coupled with on-time performance, these measures of time management can help a company improve its “time-based” performance. Link this improvement to increased profitability so the students understand the relationship. 20-3 Copyright © 2021 Pearson Education, Inc.

IV.

CHAPTER OUTLINE LEARNING OBJECTIVE

Explain the four cost categories in a costs-ofquality program … prevention, appraisal, internal failure, and external failure costs

1.1

Companies have found that quality can be used as a competitive tool. Quality is defined as the total features and characteristics of a product or service made or performed according to specifications to satisfy customers at the time of purchase and during use. TEACHING POINT. Don’t just recite this definition. Break it down, examining each aspect of the definition and its implications for organizations and customers.

1.2

International quality standards are becoming more prevalent. The International Organizations for Standardization has developed ISO 9000, a set of five international standards for quality management. Companies strive to receive ISO 9000 certification.

1.3

There are two aspects of quality. Design quality refers to how closely the characteristics of a product or service meet the needs and wants of customers. Design quality, then, involves giving customers what they desire in a product or service.

1.4

Conformance quality refers to the performance of a product or service relative to its design and product specifications. For example, if one buys an iPad and it breaks during the first week of use, there is a failure of conformance quality, as one anticipated it would last longer than one week. TEACHING POINT. Emphasize that quality does not have to be the most expensive. A product or service can be a quality product or service if it conforms to its design. This is quality of conformance. Ask the students to name their favorite restaurant. You will get a variety of responses usually including the more expensive ones. Ask why they like that particular restaurant. Then ask if they eat there every day. Of course, the response is that it would be too costly to do so. Then move to asking about where they would go to lunch today (if not the campus cafeteria). Responses are normally various fast food restaurants. Ask why those choices. Again, you will get responses such as good food at good prices. Then ask if

they would be upset if they got a Wendy’s hamburger if they ordered a $10 burger at Outback. This illustrates that both a Wendy’s and an Outback hamburger are quality products in terms of quality of conformance. Wendy’s is a good inexpensive burger. Outback is also a good burger, but one with a higher level of quality of design.

1.5

Costs of quality (COQ) fall into two broad categories— costs incurred as a result of producing products that do not meet quality standards and costs incurred to prevent the production of such products. •

Prevention costs are costs incurred to preclude the production of products that do not conform to specifications. Employee training is an example of such a cost.

•

Appraisal costs are costs incurred to detect units that do not meet specifications. Inspection, testing, and audits are examples.

•

Internal failure costs are costs incurred on defective products before they are shipped to customers. These costs include rework, scrap, and troubleshooting.

•

External failure costs are costs incurred on defective products after they are shipped to customers. These costs include recalls, warranty work, and returns. Additional costs that cannot be measured precisely are the lost sales from producing defective products. TEACHING POINT. When a company embarks on a quality improvement program, it will often discover that quality costs rise initially. This is due to the fact that the company invests in prevention and appraisal in an effort to reduce failure costs. However, there is a time lag between incurring prevention and appraisal costs and the resulting lower failure costs. The company should seek to reduce the failure costs, while investing in appraisal and prevention. Philip Crosby wrote a book entitled Quality Is Free. The premise of the text was that a company embarking on a quality enhancement program will find that the savings from reduced failure costs far exceed the costs of appraisal and prevention costs. Therefore, quality does not cost anything. (Exhibit 20-1 lists examples of items in each of the four cost categories.)

1.6

The seven-step activity costing approach introduced in Chapter 5 can be applied to determining quality costs. Step 1: Identify the chosen cost object. Step 2: Identify the direct costs of quality of the product. Step 3: Select the activities and cost-allocation bases to use for allocating indirect costs of quality to the product. Step 4: Identify the indirect costs of quality associated with each cost-allocation base. Step 5: Compute the rate per unit of each allocation cost base. Step 6: Compute the indirect costs of quality allocated to the product. Step 7: Compute the total costs of quality by adding all direct and indirect costs of quality assigned to the product. (Exhibit 20-2 illustrates analysis of the activity-based costs of quality.)

Refer to Quiz Question 1 Exercises 20-17, 20-18,20-19, and 20-20

LEARNING OBJECTIVE

Develop nonfinancial measures … customer satisfaction measures, such as number of customer complaints, internal-business-process measures, such as percentage of defective and reworked products, and learning-and-growth measures, such as employee empowerment and training and methods to improve quality … control charts, Pareto diagrams, and cause-and-effect diagrams

2.1

Managers would be wise to incorporate nonfinancial measures of customer satisfaction, which fall under the Customer Perspective, relating to quality.

2.2

Some potential measures would include: •

2.3

•

Market share

•

Percentage of customers that give high ratings for customer satisfaction

•

Number of customer complaints

•

Percentage of products that fail soon after they have been delivered to customers

•

Average delivery delays

•

On-time delivery rate

Management should carefully monitor whether these numbers improve or deteriorate over time. TEACHING POINT. Allow students to consider each measure and find more. Observe that some measures must be utilized with caution. One company was distressed with the percentage of comment cards that had negative comments. They failed to realize that dissatisfied customers are the ones motivated to complete these cards. Customers who don’t have complaints are not as likely to turn in a comment card.

2.4

Three techniques, falling under the Internal-BusinessProcess Perspective, exist to help management identify and analyze quality control problems: •

A control chart graphs successive observations of a particular step or operation. Observations outside the specified range are considered nonrandom and should be investigated. (Exhibit 20-3 displays statistical quality control representing defect rates at Formrob Corporation.)

•

charts

A Pareto diagram is a chart that indicates how frequently each type of defect occurs. (Exhibit 20-4 displays a Pareto diagram of defects at Formrob Corporation.)

•

A cause-and-effect diagram (otherwise known as a fishbone diagram) identifies potential causes of defects using a diagram that resembles the bone structure of a fish. (Exhibit 20-5 displays a cause-and-effect diagram of defects at Formrob Corporation.)

TEACHING POINT. Illustrate each of these in application. The students will grasp the concepts much more quickly if you show them each of these and how they are utilized in a quality control program. It is more important that the student understand how to use these methods than how to construct them. With understanding, the “how” will follow.

2.5

Companies strive to reach the ultimate achievement of quality known as Six Sigma quality. This designation signifies that the company’s process is so well understood and tightly controlled that the mean defect rate and standard deviation are both very small. Control charts, Pareto diagrams, and cause-and-effect diagrams are techniques that companies use to achieve this designation.

2.6

Nonfinancial measures of quality are at least as important as the costs of quality (COQ) measures.

2.7

Some possible nonfinancial measures of quality in the internal business process include: •

Percentage of defective products

•

Percentage of reworked products

•

Number of different types of defects analyzed using control charts, Pareto diagrams, and causeand-effect diagrams

•

Number of design and process changes made to improve design quality or reduce costs of quality

2.8

These are only illustrative; the actual measures used would depend on the characteristics of the particular company and its products.

2.9

Drivers of the internal business process are learningand-growth perspective of the balanced scorecard.

2.10 As these improve, the company should experience an improvement in the internal-business-process measures. Some measures of the learning-and-growth perspective include: •

Employee turnover (ratio of number of employees who leave the company to the average total number of employees)

•

Employee empowerment (ratio of number of processes in which employees have the right to make decisions without consulting supervisors to the total number of processes)

•

Employee training (percentage of employees trained in different quality-enhancing methods)

•

Experience and qualifications of design engineers

Refer to Quiz Questions 2 through 4 Problems 20-29 LEARNING OBJECTIVE

Use costs of quality measures to make decisions … identify relevant incremental costs and benefits and opportunity costs to evaluate tradeoffs.

3.1

In evaluating alternative solutions to dealing with quality problems, the company should utilize relevant cost analysis. This is done in a similar manner as covered in Chapter 12.

3.2

The key question is how total costs and total revenues will change under each alternative solution.

3.3

Some relevant costs and benefits when attempting to increase quality might include: •

Estimated incremental costs of each alternative

•

Cost savings from less rework, customer support, and repairs

•

Increased contribution margin from higher sales as a result of building a reputation for quality and performance. (Exhibit 20-6 analyzes the estimated effect of qualityimprovement actions at Formrob Corporation.)

Refer to Quiz Questions 5 and 6 Exercises 20-21 and 20-22

LEARNING OBJECTIVE

Use financial and nonfinancial measures to evaluate quality … nonfinancial measures are leading indicators of future costs of quality

4.1

4.2

Advantages of COQ measures include: •

COQ measures focus managerial attention on the effects of poor quality on operating income.

•

Total COQ help managers evaluate the costs and benefits of incurring prevention and appraisal costs to eliminate internal and external failure costs.

•

COQ measures assist in problem solving by comparing costs and benefits of different quality-improvement programs and by setting priorities for cost reductions.

Advantages of nonfinancial COQ measures include: •

They are often easy to quantify and understand.

•

They direct attention to physical processes and help managers identify the precise problem areas that need improvement.

•

Measures, such as number of defects, provide immediate short-run feedback on the success of quality-improvement efforts.

•

Measures, such as customer satisfaction, can be indicators of long-run future performance.

LEARNING OBJECTIVE

Describe customer-response time … time between receipt of customer order and product delivery Describe on-time performance …delivery of product at the time it is scheduled and why delays occur … uncertainty about the timing of customer orders and limited capacity

5.1

Time is an increasingly important strategic factor. Proper time management can increase revenues and decrease costs.

5.2

In order to manage time, it must be measured properly. Two operational measures of time are frequently utilized: customer-response time and on-time performance.

5.3

Customer-response time is the time it takes from the point when a customer places an order for a product or service to the point when the product or service is delivered to the customer. Components of customerresponse time include: • •

•

Receipt time is how long it takes marketing to specify to manufacturing the exact requirements of the customer order. Manufacturing cycle time (also called manufacturing lead time) is how long it takes from receipt of the order by manufacturing to the time the finished good is produced. Delivery time is how long it takes to deliver a completed order to a customer. (Exhibit 20-7 diagrams the components of customer-response time.) TEACHING POINT. One manufacturing company had a very complex product that traditionally took weeks just in testing. The company, after deciding to compete on the basis of time, installed a computer-integrated manufacturing system that reduced the testing to a matter of hours. The company found that customers were willing to pay premium prices to receive the order more quickly, and their sales increased dramatically.

5.4

Manufacturing cycle efficiency (MCE) is a measure of company response time efforts. It is calculated by dividing value-added manufacturing time by manufacturing cycle time.

5.5

On-time performance is the delivery of a product or service by the time it is scheduled to be delivered. On-time performance increases customer satisfaction, but there is a tradeoff between on-time performance and customer response time. TEACHING POINT. Airlines have their on-time performance published monthly. A company with poor on-time performance could simply extend the estimated flight time (customerresponse time). However, this would be missing the point of the on-time performance measure and customers would likely be quick to catch on to the games played by the airline.

5.5

Managing these two measures of time requires understanding the causes and costs of delays. A time driver is any factor that causes a change in the speed of an activity when the factor changes.

5.6

Uncertainty about when customers will order products or services is one time driver. As orders are received in a more random fashion, queues form and delays occur. TEACHING POINT. Even though a company may not know precisely when customers will demand the product, they can make predictions and attempt to minimize the wait time. For example, one supermarket chain pledges to have all registers open between 4:00 and 6:00 p.m. weekdays to minimize the checkout time. But even actions such as that will not eliminate wait times during high demand periods such as preparation for a snow storm or hurricane, as people flock to the stores to stock-up on items.

5.7

The second time driver is bottlenecks due to limited capacity. A bottleneck occurs when the work to be performed approaches or exceeds capacity available to do it. TEACHING POINT. Continuing the previous teaching point, when there is a back-up in the checkout lines, a bottleneck has occurred. Students will be more than familiar with bottlenecks— airports, concert events, and school cafeteria lines are three examples they have likely encountered. Have the students identify other bottlenecks. This will set the stage for the discussion on the Theory of Constraints later in this chapter.

5.8

Average waiting time is the average amount of time that an order waits in line before the machine is set up and the order is processed.

Refer to Quiz Question 7 20-25, Problem 20-32

LEARNING OBJECTIVE

Exercises 20-23, 20-24,

Determine the cost of delays … lower revenues and higher inventory carrying costs

6.1

In a relevant revenue and cost analysis, the time factor must be considered as manufacturing lead times and other time factors may be impacted by the decision. (Exhibit 20-8 lists the expected relevant costs and revenues of a decision to introduce a new product.)

Refer to Quiz Question 8

LEARNING OBJECTIVE

Use financial and nonfinancial measures of time …. nonfinancial measures are leading indicators of future financial effects of delays

7.1

Balanced scorecard measures can be utilized to illustrate how financial and nonfinancial measures of time relate to one another, reduce delays, and increase output of bottleneck operations. •

Financial measures—revenue gains or price increases from fewer delays; carrying cost of inventories

•

Customer measures—customer-response time; on-time performance

•

Internal-business-process measures—average manufacturing time for key products; manufacturing cycle efficiency for key processes; defective units produced at bottleneck; average reduction in setup time and processing time at 20-13 Copyright © 2021 Pearson Education, Inc.

bottleneck operationsLearning-and-growth measures—employee satisfaction; number of employees trained in managing bottleneck operations 7.2

Note the cause-and-effect linkages across the measures. For example, better training leads to better management of bottlenecks, which leads to better customer-response times and higher throughput contributions.

Problems 20-26 and 20-27

OTHER RESOURCES To download instructor resources, visit the Instructor’s Resource Center at www.pearsonhighered.com/irc. The following exhibits were mentioned in this chapter of the Instructor’s Manual, and have been included in the Image Library. Exhibit 20-1 lists examples of items in each of the four cost categories. Exhibit 20-2 illustrates analysis of the activity-based costs of quality. Exhibit 20-3 displays statistical quality control charts representing defect rates at Formrob Corporation. Exhibit 20-4 displays a Pareto diagram of defects at Formrob Corporation. Exhibit 20-5 displays a cause-and-effect diagram of defects at Formrob Corporation. Exhibit 20-6 analyzes the estimated effect of qualityimprovement actions at Formrob Corporation. Exhibit 20-7 diagrams the components of customer-response time. Exhibit 20-8 lists the expected relevant costs and revenues of a decision to add a new product.

CHAPTER 20 QUIZ 1.

b. c. d.

prevention, appraisal, internal failure, and external failure. design, conformance, control, and process. design, process specification, on-time delivery, and customer satisfaction.

Which of the following is not a nonfinancial performance measure for customer satisfaction? a. Number of defective units shipped to customers as a percentage of the total units of product shipped b. Number of customer complaints c. On-time delivery d. Number of defects for each product line

_____ is a formal means of distinguishing between random and nonrandom variation in an operating process. a. Statistical process control (SPC) b. A Pareto diagram c. A cause-and-effect diagram d. A fishbone diagram

Nonfinancial measures for internal business process quality performance include all but which of the following? a. Employee empowerment b. Process yields c. Feedback d. Product defect levels

A key question in relevant cost and relevant revenue analysis is: a. By how much can sales be increased and costs reduced? b. What purpose is best served for cost allocation and which criterion is most appropriate? c. How will total costs and total revenues change under each alternative? d. What are the amounts of incremental costs and incremental revenues under each alternative?

An advantage of financial cost of quality measures is that they a. are often easy to quantify and understand. b. provide immediate short-run feedback on whether quality improvement efforts have, in fact, succeeded in improving quality. c. direct attention to physical processes and therefore focus attentions on the precise problem areas needing improvement. d. provide a single, summary measure of quality performance. 20-15 Copyright © 2021 Pearson Education, Inc.

The amount of time between when a customer places an order for a product or requests a service to when the product or service is delivered to that customer is called a. customer-response time. b. order receipt time. c. order delivery time. d. manufacturing lead time.

Delays in customer-response time occur because of the a. uncertainty about when customers will order products. b. unused capacity that impedes average manufacturing time. c. customers’ response in paying invoices on time. d. overemphasis on measuring time drivers.

CHAPTER 20 QUIZ SOLUTIONS 1.

Inventory Management, Just-inTime, and Simplified Costing Methods

TRANSITION NOTES This chapter expands costs associated with goods for sale to include inventory shrinkage costs. The material covers just-in-time production , the effect of JIT on product costing, and material on JIT in service industries. A section on lean accounting, focusing on value streams, is included in the chapter. Several new and revised problems are presented at the end of the chapter. *This chapter was previously Chapter 20.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 22 23 Revised 24 25 26 27 Revised 28 Revised 29 Revised 30 Revised 31

16th Edition 21 22 23 24 25 26 27 28 29 30 31

17th Edition 32 Revised 33 34 35 36 37 Revised 38 Revised 39 Revised 40 Revised 41

16th Edition 32 33 34 35 36 37 38 39 40 41

LEARNING OBJECTIVES 1.

Identify six categories of costs associated with goods for sale.

Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision model.

Identify the effect of errors that can arise when using the EOQ decision model and ways to reduce conflicts between the EOQ model and models used for performance evaluation.

II.

Describe why companies are using just-in-time (JIT) purchasing.

Distinguish materials requirements planning (MRP) systems from just-in-time (JIT) systems for manufacturing.

Identify the features and benefits of a just-in-time production system.

Describe different ways backflush costing can simplify traditional inventory-costing systems.

Understand the principles of lean accounting.

CHAPTER SYNOPSIS This chapter presents inventory management and accounting for the costs of inventory. Materials or inventory costs typically represent one of the largest costs in both manufacturing and retail companies. Management accountants provide managers with the information necessary to effectively manage the costs of inventory. Six categories of costs associated with inventories are: purchasing costs, ordering costs, carrying costs, stockout costs, quality costs, and shrinkage. The economic-orderquantity (EOQ) decision model allows managers to determine an order quantity that balances ordering costs with carrying costs. Just-in-time inventory and production systems are discussed, as this approach to manufacturing and inventory management is moving more and more into the mainstream. With the reduction or elimination of many inventories, a simplified cost accounting system has become possible. Backflush costing and lean accounting are presented as two possible simplified systems.

III.

POINTS OF EMPHASIS 1.

In many respects, this is somewhat of a radical chapter. Just-in-time, backflush costing, and lean accounting present approaches that are far from traditional cost-accounting methods. Although it is important that the students understand the “nuts and bolts” of how these systems operate, it is probably more important that they understand the reasons for these systems and why they are able to closely replicate results obtained through traditional costing methods.

IV.

Emphasize the costs associated with goods for sale. As this involves inventory management, once the students realize the costs associated with inventory, they can more readily see the benefits of just-in-time systems.

Just-in-time is a system that has been around for a number of years with successful results. The students need to understand how just-in-time production and inventory systems operate and why they succeed.

Although backflush costing and lean accounting have not received the attention or acceptance of just-intime, they are likely to be a part of the cost accountant’s future. Students should have a general understanding of what is involved in these, and other, alternative costing systems.

CHAPTER OUTLINE LEARNING OBJECTIVE

Identify six categories of costs associated with goods for sale … purchasing, ordering, carrying, stockout, quality, and shrinkage

1.1

Inventory management includes planning, coordinating, and controlling activities related to the flow of inventory into, through, and out of an organization. Recall that activities consume costs, so much of inventory planning involves control of the six categories of cost associated with goods for sale. •

Purchasing costs are the costs of goods acquired from suppliers, including incoming freight costs. These are usually the largest cost category of goods for sale.

•

Ordering costs are the costs of preparing and issuing purchase orders, receiving and inspecting the items included in the orders, and matching invoices received, purchase orders, and delivery records to make payments.

•

Carrying costs are the costs that arise while goods are being held in inventory.

•

Stockout costs are the costs that arise when a company runs out of a particular item for which there is customer demand.

•

Costs of quality are the costs incurred to prevent and appraise, or that arise as a result of, quality issues. The four categories of quality cost are: prevention, appraisal, internal failure, and external failure. They were covered in chapter 20.

•

Shrinkage is the difference in the cost of inventory when physically counted and the amount shown on the books. It is the result of breakage, misclassification, theft, embezzlement, and clerical errors.

Refer to Quiz Question 1

LEARNING OBJECTIVE

Balance ordering costs with carrying costs using the economic-order-quantity (EOQ) decision model … choose the inventory quantity per order to minimize these costs

2.1

The first decision in managing goods for sale is to determine how much of a given product should be ordered. Order too much, inventory becomes obsolete and the company is saddled with large carrying costs. Order too little, and the company will be placing frequent orders and experiencing stockouts.

2.2

The economic-order-quantity (EOQ) decision model calculates the optimal quantity of inventory to order.

2.3

This model assumes there are only ordering and carrying costs associated with inventory. It also assumes: •

The same quantity is ordered at each reorder point.

•

Demand, ordering costs, and carrying costs are known with certainty. The purchase-order lead time—the time between placing an order and its delivery—is also known with certainty.

•

Purchasing cost per unit is unaffected by the quantity ordered.

•

No stockouts occur. The basis for this assumption is that the costs of stockouts are so high that managers maintain adequate inventory to prevent

them. •

When deciding on the size of a purchase order, managers consider costs of quality and shrinkage only to the extent that these costs affect ordering or carrying costs.

2.4

EOQ, then, ignores purchasing, stockout, quality, and shrinkage costs. However, it can be a useful tool as it represents the order quantity that minimizes the relevant ordering and carrying costs.

2.5

The EOQ model is expressed as follows:

EOQ =

2DP C

where D = Demand in units for a specified time period (usually one year) P = Relevant ordering costs per purchase order C = Relevant carrying costs per unit for the specified time period TEACHING POINT. Illustrate the EOQ model by calculating an order quantity. Exercise 21-21 is a good one to use here. Save the reorder point for later. Go beyond the problem requirements and calculate the carrying and order costs at EOQ. Then assign students the task of calculating the sum of these costs at varying order levels above and below the EOQ. They will see that EOQ does minimize these costs. (Exhibit 21-1 displays a graphical analysis of ordering and carrying costs.)

2.6

Once the decision of order quantity has been made, the second decision facing management is when to order a given product. This requires determination of the reorder point. This is the quantity level of inventory on hand that triggers a new purchase order. It can be calculated as follows: Reorder point = Number of units sold per unit of time  Purchase-order lead time TEACHING POINT. Finish Exercise 21-21, illustrating calculation of the reorder point. Demonstrate the consequences of ordering too soon or too late. (Exhibit 21-2 graphs inventory levels and reorder points.)

2.7

Orders do not always arrive on time. There may be shipping delays, strikes, weather-related delays, fluctuations in demand, or other factors that prevent the order from arriving before a stockout occurs. In order to protect against a stockout, the company

should provide for safety stock. Safety stock is inventory held at all times regardless of the quantity of inventory ordered using the EOQ model. This inventory serves as a buffer against unexpected events. 2.8

To calculate safety stock, multiply the average demand per day times the lead time. Lead time is the number of days from the time the order is placed until it is normally received. TEACHING POINT. Illustrate a computation of safety stock. (Exhibit 21-3 illustrates computation of safety stock.)

2.9

The EOQ model is only as effective as the numbers that go into the calculation; therefore, it is important to identify and estimate the relevant costs as accurately as possible.

Refer to Quiz Questions 2 through 6 21-24; Problems 21-30 and 21-31

LEARNING OBJECTIVE

Exercises 21-21 through

Identify the effect of errors that can arise when using the EOQ decision model … errors in predicting parameters have a small effect on costs and ways to reduce conflicts between the EOQ model and models used for performance evaluation … by making the two models congruent

3.1

3.2

Relevant inventory costs include the relevant incremental costs plus the relevant opportunity costs of capital. •

Relevant incremental costs of carrying inventory include costs such as warehouse rent, warehouse workers’ salaries, costs of obsolescence, costs of shrinkage, and costs of breakage.

•

Relevant opportunity cost of capital is the income forgone by investing capital in inventory rather than elsewhere.

The cost of a prediction error can be determined using a three-step approach.

Step 1: Compute the monetary outcome from the best actions that could be taken, given the actual amount of the cost input (cost per purchase order). Step 2: Compute the monetary outcome from the best action based on the incorrect predicted amount of the cost input. Step 3: Compute the difference between the two amounts. (Exhibit 21-4 illustrates the sensitivity of the EOQ to changes in ordering and carrying costs.)

3.3

Frequently, there will be conflict between the EOQ model and the models used for performance evaluation. When this is the case, managers may act in their own self-interest to the detriment of the company.

3.4

The primary issue is that there are no opportunity costs recorded in the financial accounting systems, and therefore this is not usually a part of the performance-evaluation model.

3.5

This can be overcome by charging managers responsible for managing inventory with carrying costs that include a required return on investment.

LEARNING OBJECTIVE

Describe why companies are using just-in-time (JIT) purchasing … high carrying costs, costs of quality, shrinkage, low ordering costs, high- quality suppliers, and reliable supply chains

4.1

Just-in-time purchasing is the purchase of materials or goods so that they are delivered just as needed for production or sales.

4.2

The EOQ model is compatible with JIT, as carrying costs are reduced. At the same time, the cost of placing an order is decreasing due to: •

Establishing long-term purchasing agreements so additional negotiation is not necessary with each purchase.

•

Placing purchase orders electronically, reducing the cost of placing an order.

•

4.3

Using purchase-order cards with pre-set dollar limits. These cards avoid traditional laborintensive procurement approval procedures.

JIT purchasing is not guided solely by the EOQ model, however. The EOQ model is designed to emphasize the tradeoff between relevant carrying and ordering costs. Inventory management also includes purchasing costs, stockout costs, and quality costs. (Exhibit 21-5 illustrates overall savings realized from utilizing JIT purchasing at Glare Shade.)

4.4

Companies implementing JIT must choose their suppliers carefully and develop long-term supplier relationships.

4.5

Relevant costs of purchasing need to be considered in this decision—costs such as insurance, materials handling, breakage. These can differ among suppliers. (Exhibit 21-6 illustrates relevant costs when choosing suppliers at Glare Shade.)

4.6

Levels of inventory held by retailers are influenced by the demand patterns of their customers and supply relationships with distributors and manufacturers.

4.7

The supply chain describes the flow of goods, services, and information from the initial sources of materials and services to the delivery of products to consumers regardless of whether these activities occur within the organization or in other organizations.

4.8

A company should utilize JIT purchasing only if activities throughout the supply chain are properly planned, coordinated, and controlled. TEACHING POINT. A truck assembly plant was attempting to implement a JIT inventory system, but one supplier of its engines was not able to produce and deliver on a just-in-time basis. In order to retain its customer, the supplier located a warehouse down the road from the assembly plant. Even though the supplier did not have a just-in-time production system, it was able to deliver to the assembly plant on a JIT basis and retain the customer.

4.9

An important point in supply-chain analysis is for each company in the supply-chain link to share information and plan and coordinate activities.

4.10 There are a number of benefits to this approach which can reduce uncertainty: •

Fewer stockouts at the retail level

•

Reduced manufacture of product not immediately needed by retailers

•

Fewer manufacturing orders that need to be

expedited •

Lower inventories held by each company in the supply chain Refer to Problems 21-34, 21-35, and 21-36

LEARNING OBJECTIVE

Distinguish materials requirements planning (MRP) systems … manufacturing products based on demand forecasts from just-in-time (JIT) systems for manufacturing … manufacturing products only upon receiving customer orders

5.1

Materials requirements planning (MRP) is a “push through” system that manufactures finished goods for inventory based on demand forecasts. An MRP system uses: •

Demand forecasts for final products

•

A bill of materials detailing the materials, components, and subassemblies for each final product

•

The available inventory of materials, components, and products

5.2

The master production schedule specifies the quantity and timing of each item to be produced.

5.3

Under an MRP system, inventory management can be a challenge as the system may not collect and update inventory records. The management accountant must maintain accurate records of inventory and its costs.

5.4

The management accountant must also estimate setup and downtime costs for production runs. Costs of setting up a production run are similar to ordering costs in the EOQ model.

5.5

In contrast to MRP’s “push through” approach, JIT is described as a “demand-pull” approach, meaning that demand, rather than forecasts, drive production.

Refer to Problem 21-32

LEARNING OBJECTIVE

Identify the features of a just-in-time production system … for example, organizing work in manufacturing cells, improving quality, and reducing manufacturing lead time to reduce costs and earn higher margins

6.1

JIT production, also known as lean production, is a “demand-pull” manufacturing system that manufactures each component in a production line as soon as, and only when, needed by the next step in the production line.

6.2

Thus, demand triggers each step of the production process as manufacturing activity is prompted by a need for that station’s output at the next step in the production process.

6.3

JIT seeks to: •

Meet customer demand in a timely way

•

With high-quality products

•

At the lowest possible cost TEACHING POINT. How a JIT system accomplishes these goals may not seem readily apparent to someone not familiar with JIT. As the following features of a JIT system are covered, be sure to point out how that feature helps meet these three objectives. One way to accomplish this is to have the students look for ways these objectives are met.

6.4

A JIT production system has these features: •

Production in a JIT system is organized in manufacturing cells, or work cells. These are groupings of the different types of equipment and tasks performed in the manufacturing operation. Materials move sequentially from one machine to another, minimizing material-handling costs.

•

Workers are hired and trained to be multiskilled and capable of performing a variety of operations and tasks.

•

Defects are aggressively eliminated. With low levels of inventory, workers can easily trace and

solve problems quickly and eliminate the cause of the defect. •

Setup time—the time required to get equipment, tools, and materials ready at the start of production—is reduced, along with a reduction in manufacturing cycle lead time. This makes production in smaller batches economical, reducing inventory levels, and enabling the company to respond faster to changes in demand.

•

Suppliers are selected on the basis of their ability to deliver quality materials in a timely measure. By entering into long-term relationships, the supplier delivers materials of a specified quality, eliminating the need for inspection. TEACHING POINT. Frequently, the window for delivery is very narrow. The company may indicate that the materials must be delivered between 9:00 A.M. and 9:30 A.M. If they arrive early, the manufacturing process is not ready. If late, the process is delayed.

6.5

Companies were initially attracted to JIT due to the lower carrying costs of inventory. However, they soon realized other benefits of lower inventories: emphasis on improving quality by eliminating the causes of rework, scrap, and waste along with lower manufacturing lead times.

6.6

JIT purchasing and production methods can be applied in industries other than retailing and manufacturing.

6.7

The success of a JIT production system hinges on the speed of information flows from customers to manufacturers to suppliers. Systems such as enterprise resource planning (ERP) are being utilized to improve these information flows.

6.8

An ERP system is an integrated set of software modules covering accounting, distribution, manufacturing, purchasing, human resources, and other functions. A single database is utilized, which collects data and feeds it into these software applications.

6.9

These systems give lower-level managers, workers, customers, and suppliers access to detailed and timely operating information.

6.10 JIT is a quantum change in how the company conducts its operations. Personal observation is enhanced as lack of inventory makes problems and performance more visible. Certain measures used by management in evaluation are also affected: •

Financial performance measures such as inventory

turnover ratios would increase. •

Nonfinancial performance measures of time, inventory, and quality would be affected in a positive manner.

6.11 Due to reductions in materials handling, warehousing, and inspection overhead costs are reduced. In addition, JIT assists in direct tracing of some costs usually classified as direct. TEACHING POINT. When JIT first emerged, a number of companies tried it and abandoned it as not working for them. The problem was that they attempted to reduce inventory levels without addressing problems in their manufacturing process. In essence, they attempted to adopt JIT inventory without JIT production and failed.

Quiz Questio #7

LEARNING OBJECTIVE

Describe different ways backflush costing can simplify traditional inventory-costing systems … for example, by not recording journal entries for work-in-process, purchase of materials, or production of finished goods

7.1

In adopting just-in-time production techniques the absence of inventories makes choices about cost-flow assumptions or inventory-costing methods unimportant. All manufacturing costs of the accounting period flow directly into cost of goods sold. This can permit a simplified costing system.

7.2

Traditional normal and standard costing systems use sequential tracking, which is a system of recording journal entries in the same order as purchases and progress in production.

7.3

Such sequential tracking system has four trigger points, or stages, in the cycle from purchase of direct materials to sale of finished goods at which journal entries are made into the accounting system.

7.4

An alternative approach to sequential tracking is backflush costing, a system that omits some of the journal entries relating to the four stages shown in a sequential tracking system.

7.5

Under backflush costing, journal entries for one or

more stages are omitted and the entries for a subsequent stage work backward to “flush out” the costs in the cycle for which entries were not made. 7.6

In a just-in-time system where inventories are minimal, backflush costing simplifies the costing system without a significant loss of information.

7.7

There are three approaches to backflush costing, with different placement of trigger points.

7.8

•

Three trigger points with entries at purchase of direct materials, completion of finished units of product, and sale of finished goods.

•

Two trigger points with entries at purchase of direct materials and sale of finished goods.

•

Two trigger points with entries at completion of finished units of product and sale of finished goods.

Note that none of the methods makes a provision for work-in-process as those inventory levels are minimal. TEACHING POINT. Backflush costing is radically different from the costing systems the students have been studying throughout the book. Cover examples of the journal entries in each approach to backflush costing. However, it is not enough just to go through the entries. Students need to understand why it is acceptable to omit these entries and that little or no information is lost by omitting the entries. Use of T-accounts in a sequential tracking system compared to the T-accounts in backflush costing will help the students see the reasoning behind backflush.

7.9

Accounting for variances is essentially the same for all standard-costing systems, including backflush costing. The direct materials efficiency variance is determined by physically comparing remaining direct materials with what should remain based on output of finished goods during the period.

7.10 Two justifications are given for using the sale, not completion, of finished goods as the trigger point: •

This removes incentive for managers to produce for inventory because conversion costs become period costs.

•

This approach gets managers focused on selling units rather than their production. (Exhibits 21-7 through 21-9 illustrate the journal entries under the various backflush approaches.)

7.11 Backflush costing, by one view, does not strictly adhere to generally accepted accounting principles.

For example, there is no recognition of work-inprocess in the financial statements. 7.12 Advocates of backflush, however, cite the accounting principle of materiality in their support of backflush costing. Work-in-process is immaterial, and the results from backflush closely approximate the costs under sequential tracking. 7.13 Backflush is not restricted to companies using JIT. A company with short manufacturing lead time or very stable inventory levels may use backflush with acceptable results. 7.14 Critics maintain that backflush costing leaves no audit trail. However, the absence of large inventories allows managers to keep track of operations through personal observation, computer monitoring, and nonfinancial measures. Refer to Quiz Questions 8, 9, and 10 28, 21-29, Problems 21-37, 21-38, and 21-39

LEARNING OBJECTIVE

Exercises 21-

Understand the principles of lean accounting … focus on costing value streams rather than products, and limit arbitrary allocations

8.1

Another simplified product costing approach is lean accounting, a costing method that creates value for customers by costing value streams, rather than individual products or departments.

8.2

Value streams are the value-added activities needed to design, manufacture, and deliver a given product to customers.

8.3

Lean accounting makes the entire value stream the cost object. As a result, product costs for individual products may not be computed. Standard costs and variances are not computed.

8.4

One result of lean accounting is that costs that are not directly traceable to the cost object are minimized.

8.5

Companies utilizing lean accounting have found the method much simpler (hence lean) than traditional product costing methods. Major factors in this

simplicity are the minimal amount of overhead allocations and the reduced recordkeeping to compute actual product costs. Refer to Problem 21-40

CHAPTER 21 QUIZ 1.

Which of the following categories of costs are important when managing inventories of goods for sale according to the authors of the text? a. Purchasing, ordering, supply, spoilage, and opportunity b. Purchasing, stockout, carrying, ordering, and quality c. Buying, holding, invoicing, opportunity, and investment d. Supply, obsolescence, holding, stockout, and transportation-in

The following data apply to questions 2 through 6. Liberty Celebrations, Inc. manufactures a line of flags. The annual demand for its flag display is estimated to be 100,000 units. The annual cost of carrying one unit in inventory is $1.60, and the cost to initiate a production run is $50. There are no flag displays on hand but Liberty had

scheduled 60 equal production runs of the display sets for the coming year, the first of which is to be run immediately. Liberty Celebrations has 250 business days per year. Assume that sales occur uniformly throughout the year and that production is instantaneous. 2.

[CMA Adapted] If Liberty Celebrations does not maintain a safety stock, the estimated total carrying cost for the flag displays for the coming year is a. $2,667. b. $2,000. c. $1,600. d. $1,333.

[CMA Adapted] The estimated total set-up cost for the flag displays for the coming year is a. $2,000. b. $3,000. c. $8,000. d. $12,500.

[CMA Adapted] If Liberty Celebrations were to schedule 30 equal production runs of the flag display for the coming year, instead of 60 equal runs, the sum of carrying costs and set-up costs for the coming year would increase (decrease) by a. $(166). b. $0. c. $166. d. $1,500.

[CMA Adapted] The number of production runs per year of the flag displays that would minimize the sum of carrying costs and set-up costs for the coming year is a. 50. b. 40. c. 30. d. 20.

[CMA Adapted] A safety stock of a 3-day supply of flag displays would increase Liberty Celebration’s planned average inventory in units by a. 1,200. b. 800. c. 400. d. 0.

Which of the following is not a major feature of a just-intime production system? a. Workers are trained to be multiskilled. b. Emphasis is placed on increasing set-up time and manufacturing lead time. c. Production is organized in manufacturing cells. d. Total quality management is aggressively pursued.

The following data apply to questions 8 through 10. Sit-On-It began operations in January 2020. Sit-On-It manufactures vehicular seat covers using a just-in-time production system supported by a backflush costing system. This system has two trigger points: (1) the purchase of raw materials, and (2) the sale of finished good units. Standard unit costs are $40 for raw materials and $25 for conversion costs. Sit-On-It writes off any underallocated or overallocated conversion costs immediately. The following data were available for January 2020: Production in good units 19,800 Sales of good units 19,750 Purchases of raw materials [20,000 units at $40] Conversion costs incurred

$800,000 $496,000

The journal entry to record the manufacture of finished good units is a. Finished goods control 1,287,000 Inventory: Raw and in-process control 792,000 Conversion costs allocated 495,000 b. Finished goods control 1,287,000 Conversion cost variance 1,000 Inventory: Raw and in-process control 792,000 Conversion costs control 496,000 c. Inventory: Raw and in-process control 800,000 Conversion costs allocated 495,000 Conversion cost variance 1,000 Various assets and liabilities 1,296,000 d. No entry

The January ending total for all inventory balances is a. $16,250. b. $12,250. c. $11,250. d. $10,000.

10.

The January cost of goods sold is a. $1,283,750. b. $1,284,750. c. $1,286,000. d. $1,296,000.

CHAPTER 21 QUIZ SOLUTIONS 1.

10.

Quiz Question Calculations 2.

Each production run is 100,000/60 = 1,666.67 Average inventory is 1,666.67/2 = 833.33 Carrying cost is 833.33  1.60 = $1,333

60 setups  $50 = $3,000

4. Carrying cost Set-up cost Total 30 runs is $166 less

Present $1,333 3,000 $4,333

30 Runs $2,666 1,500 $4,167

5. Square root of ((2 x 100,000 x 50) / 1.60) = square root of 6,250,000 = 2500 100,000 / 2500 = 40 6.

100,000/250 days = 400 demand per day 400  3 days = 1,200

250 (Purchases less Sales)  $40 = $10,000

10.

Material costs Conversion costs

19,750  $40 =

$790,000 496,000 $1,286,000

Capital Budgeting and Cost Analysis

TRANSITION NOTES The material on the multiyear focus of capital budgeting has been written to emphasize its life-cycle budgeting and costing characteristics. The stages of capital budgeting have been streamlined incorporating the prior six-stage process into five stages. These stages are detailed throughout the chapter. There is a great deal of revised problem material at the end of the chapter. *This chapter was previously Chapter 21.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 22 Revised 23 24 25 Revised 26 Revised 27 Revised 28 Revised 29 Revised 30 Revised 31 32

16th Edition 21 22 23 24 25 26 27 28 29 30 31 32

17th Edition 33 Revised 34 35 36 Revised 37 Revised 38 Revised 39 40 41 Revised 42 Revised

16th Edition 33 34 35 36 37 38 39 40 41 42

LEARNING OBJECTIVES 1.

Understand the five stages of capital budgeting for a project.

Use and evaluate the two main discounted cash flow (DCF) methods: the net present value (NPV) method and the internal rate-of-return (IRR) method.

Use and evaluate the payback and discounted payback methods.

II.

Use and evaluate the accrual accounting rate-of-return (AARR) method.

Identify relevant cash inflows and outflows for capital budgeting decisions.

Understand issues involved in implementing capital budgeting decisions and evaluating managerial performance.

Explain how managers can use capital budgeting to achieve their firms’ strategic goals.

CHAPTER SYNOPSIS This chapter introduces accounting for long-run investment decisions, those involving capital assets used by companies for multiyear periods to generate revenues. The chapter looks specifically at capital budgeting on a project-byproject basis. Management accountants play a key role in the planning and analysis of proposed and implemented capital expenditures, both by identifying those projects with the highest estimated return and by comparing actual and estimated returns. The five stages of capital budgeting for a project are: identify; obtain information; make predictions; choose an alternative; implement the decision, evaluate performance, and learn. Four methods for evaluating proposed capital projects are presented. Discounted cash flow (DCF) methods include the net present value (NPV) method and the internal rate-of-return (IRR) method. In addition, the payback and discounted payback methods, and the accrual accounting rate-of-return (AARR) method are covered. Determination of relevant cash inflows and cash outflows associated with capital projects is also reviewed. Income tax considerations in capital budgeting analysis are incorporated into the chapter.

III.

POINTS OF EMPHASIS 1.

Emphasize the five stages of capital budgeting. Students tend to get too caught up in the method used for selection of the project and do not grasp the importance of “implement the decision, evaluate performance, and learn” stages.

Students should have a basic comprehension of the four methods. It is important for them to be able to distinguish the characteristics that set each apart and why each method is used.

IV.

The discounted cash flow methods (NPV, IRR) and discounted payback are preferred as they take into account the time value of money, but payback has its adherents due to its simplicity. AARR does not consider cash flows, but looks at the accrual accounting numbers.

It is also important that students realize what is involved in determining relevant cash flows. The initial investment is more than the purchase price. Tax considerations must be taken into account in the operating cash flows as well as the terminal disposal flows.

CHAPTER OUTLINE

LEARNING OBJECTIVE

Understand the five stages of capital budgeting for a project … identify projects; obtain information; make predictions; make decisions; and implement the decision, evaluate performance, and learn

1.1

Capital budgeting is the process of making long-run planning decisions for investments in projects. Analogous to the five-stage decision sequence covered throughout this text, there are five stages to the capital budgeting process. Managers must choose from a group of projects, each of which may span several periods. This results in two dimensions of cost analysis: •

Horizontally across, as the project dimension

•

Vertically upward, as the accounting period dimension TEACHING POINT. When making an investment is mentioned, students tend to think of investments from a narrow perspective, as in investing in stocks. A simple example will help broaden their perspective. Ask the students why they might invest in a particular stock. You will get responses centered around, “to make a gain or profit.” Then ask, “Why would a company purchase a widget-making machine?” Some will say “To make widgets,” but eventually you should get a response that it is done to make a profit—the same reason for investing in stocks. Thus,

an investment can be anything in which the company anticipates making a profit. Use Exhibit 22-1 to illustrate the project and time dimensions of capital budgeting

•

Stage one of the capital budgeting process is to identify projects. At this stage the company seeks to identify potential capital investments that agree with the organization’s strategy.

•

Stage two of the capital budgeting process is to obtain information. At this stage the company seeks to gather information from all parts of the value chain to evaluate alternative projects.

•

Stage three involves making predictions, forecasting all potential cash flows attributable to the projects identified in stage 1.

•

Stage four is to choose an alternative. Determine which investment yields the greatest benefit and the least cost to the organization.

•

Stage five is to implement the decision, evaluate performance, and learn. Obtain funding and make the investments selected in stage 3. Track actual cash flows from the project and compare them against estimated numbers and revise plans if necessary. (Exhibit 22-1 graphically displays the project and time dimensions of capital budgeting.)

LEARNING OBJECTIVE

Use and evaluate the two main discounted cash flow (DCF) methods: the net present value (NPV) method and the internal rate-of-return (IRR) method … to explicitly consider all project cash flows and the time value of money

2.1

Discounted cash flow (DCF) methods measure all expected future cash inflows and outflows of a project and discount them back to the present period. This is done by considering the time value of money. Observe that the time value of money is the opportunity cost from not having the money today. TEACHING POINT. Explore the concept that money has a time

value. Ask the students if they would rather have $100 today or in a year. Obviously, most will select today. Then raise the amount promised in a year until someone will take the deferred amount. Explore reasons to take the money today—present need, uncertainty about getting the money, investing it, and earning more, and so on.

2.2

The two DCF methods, net present value (NPV) and the internal rate-of-return (IRR) use the required rate of return (RRR) which is the minimum acceptable annual return on the investment. RRR is also referred to as the discount rate, hurdle rate, cost of capital, or opportunity cost of capital.

2.3

The net present value method calculates expected monetary gain or loss from a project by discounting all expected future cash inflows and outflows back to the present point in time using the required rate of return. Projects with a zero or positive NPV will be acceptable as they meet the RRR. An NPV calculation involves a three-step process: Step 1: Draw a sketch of relevant inflows and outflows. Be certain to include only cash inflows and outflows. Avoid accrual-accounting concepts such as depreciation. Step 2: Discount the cash flows using the correct compound interest table from the Appendix and sum them. Step 3: Make the project decision on the basis of calculated NPV. (Exhibit 22-2 illustrates use of the net present value (NPV) method to analyze a project.) TEACHING POINT. Walk through at least one net present value problem with the class. This will enhance their understanding of the material. Get the students involved in the problem. Normally, this is something they have difficulty with. Hands-on learning will help them comprehend the material better. Point out the limitations of the tables—not every interest rate or period is on them. You may wish to demonstrate NPV using a business calculator or an Excel spreadsheet.

2.4

The internal rate-of-return (IRR) method calculates the discount rate at which an investment’s present value of all expected cash inflows equals the present value of its expected cash outflows (NPV = 0).

2.5

IRR is most easily determined with the use of a business calculator or computer software such as Excel. Lacking these, a trial-and-error approach must

be utilized. The steps to follow are: Step 1: Select a discount rate and calculate the project’s NPV. Step 2: If the calculated NPV is less than zero use a lower rate, if greater than zero, use a higher rate. Continue this process until the NPV approaches zero. If cash inflows are constant, the IRR can be determined by dividing the cost by the annual cash flows. This gives a factor. Using the number of periods use the Present Value of an Annuity table to find the number on the table closest to the calculated factor. The rate for that column will represent an approximation of the IRR. 2.6

A project is accepted only if the IRR equals or exceeds the required rate of return (RRR). TEACHING POINT. As with the NPV method, demonstrate the calculation of IRR. To save time, illustrate IRR in a project with uniform cash flows and one using Excel, thus avoiding the trialand-error approach. (Exhibit 22-3 illustrates use of the internal rate-of-return (IRR) method to analyze a project.)

2.7

The NPV method is generally regarded as the appropriate method for project selection decisions as choosing projects that meet NPV criteria leads to shareholder value maximization. Four advantages of the NPV method are cited: •

NPV expresses computations in dollars, so NPV’s of individual projects can be summed to calculate an NPV of a combination of projects.

•

The NPV of a project can always be computed and expressed as a unique number. In some cases, a project may yield multiple IRR’s.

•

NPV can be used when the RRR varies over the life of a project.

•

There are instances where the IRR will indicate erroneous decisions. The IRR method assumes that project cash flows can be reinvested at the project’s IRR. With a high IRR, this may not be a valid assumption. On the other hand, NPV assumes the project’s cash flows can be reinvested at the company’s required rate of return. This is a much more valid assumption.

2.8

To this point, we have assumed that the expected cash flows are certain. In reality, there is frequently a substantial amount of uncertainty associated with the prediction of future cash flows. To examine how a result will change if the predicted results are not obtained, managers can use sensitivity analysis (Chapter 3). (Exhibit 22-4 demonstrates the sensitivity of the NPV method to changes in assumptions.)

Refer to Quiz Questions 1, 2, 3, and 7 Exercise 22-26, and 22-28 parts 1 and 2

LEARNING OBJECTIVE

Use and evaluate the payback and discounted payback methods … to calculate the time it takes to recoup the investment

3.1

Another method for evaluating potential capital projects is the payback method. The payback method measures the time it takes to recoup the initial investment in a project.

3.2

If cash flows are uniform, payback is determined by dividing the initial investment by the annual expected cash flows. TEACHING POINT. Perceptive students may realize that this is the same calculation that is utilized in estimating IRR for a project with uniform cash flows.

3.3

If cash flows are not uniform, the calculation takes a cumulative form, subtracting the annual cash flow from the initial investment until the entire investment is recovered. For the year in which the payback is met, determine the fraction of the year by dividing the amount needed in that year by the amount expected to be realized in that year. TEACHING POINT. Illustrate computation of the payback period in projects having uniform and non-uniform cash flows. Exercise 22-23, part 1b and Exercise 22-25, part 1b work for this illustration

3.4

The payback method is easy to understand. It is seen as most useful as a preliminary screening tool when multiple projects are under consideration, when interest rates are high, or when the expected cash flows in later years are highly

uncertain. 3.5

The discounted payback method calculates the amount of time for the discounted expected future cash flows to recoup the initial investment in a project. Although discounted payback considers the time value of money, like the payback method, it ignores cash flows that occur after the payback period. Exercise 22-25, part 1c works for this illustration

Refer to Quiz Questions 4, 5, and 8 22-22 part 1b and 1c, Problem 22-38

LEARNING OBJECTIVE

Exercise

Use and evaluate the accrual accounting rate-ofreturn (AARR) method … after-tax operating income divided by investment

4.1

The accrual accounting rate-of-return (AARR) differs from the previous three methods in that it considers accrual accounting income rather than cash flows. It is calculated as follows: AARR = (Increase in expected average after-tax operating income)/Net initial investment.

4.2

The increase in expected average after-tax operating income is average increase in revenues (or decrease in expenses minus the additional depreciation expense deduction resulting from the new investment).

4.3

Many companies calculate AARR using average investment rather than initial investment, recognizing that the book value of the investment declines over time.

4.4

In using AARR, because companies calculate it differently, you should always understand how it is calculated in each individual situation.

Refer to Quiz Question 6

Exercises 22-22 part 1e and 22-28, parts 3 and 4

LEARNING OBJECTIVE

Identify relevant cash inflows and outflows for capital budgeting decisions … the differences in expected future cash flows resulting from the investment

5.1

In examining the four methods for evaluating long-term projects, the future cash flows were assumed to be certain. Unfortunately, this does not reflect reality in most situations.

5.2

One of the biggest challenges in capital budgeting, particularly DCF analysis, is determining which cash flows are relevant in making an investment selection. Additionally, determining the amount of these cash flows can be challenging.

5.3

Relevant cash flows are the differences in expected future cash flows as a result of making the investment. TEACHING POINT. Students often fail to realize the extent of the cash flows involved in a capital budgeting decision. Relating it to something they have experienced, such as the purchase of a vehicle, can help in understanding this concept. In addition to the purchase price of the vehicle, items such as insurance, gasoline, maintenance, and annual license fees must be taken into consideration. And there is the trade-in value when they decide to purchase a new vehicle. The purchase of a new vehicle can be compared to the costs associated with a used one as an extension of this concept.

5.4

Because most organizations are subject to income taxes, the relevant after-tax cash flows must be determined. (Exhibit 22-5 shows the effect on Cash Flow from Operations, Net of Income Taxes, in year 1 for Vector’s Investment in the New Hybrid Bus.)

5.5

It is important to understand how income taxes affect cash flows in each year. •

Additional revenues or reduced expenses both increase taxable income and therefore the additional revenues or savings will be reduced by an increase in taxes.

•

The depreciation effect must also be considered.

Depreciation, of course, is a noncash item. However, its treatment as an expense reduces taxable income, and also the amount of income tax. The tax savings from depreciation must be considered in the analysis of cash flows. •

5.6

Disposal of equipment at a gain or loss will create additional taxes or tax savings, respectively.

There are three categories of cash flows that must be considered: •

Net initial investment (see 5.7 below)

•

After-tax cash flow from operations

•

After-tax cash flows from terminal disposal of an asset and recovery of working capital. (Exhibit 22-6 illustrates the relevant cash inflows and outflows for Vector’s Hybrid Bus.)

5.7

5.8

5.9

The net-initial investment includes three components: Initial machine investment. Included in this category is the invoice price of the machinery plus transportation, handling, and other costs associated with the purchase and installation of the machine. •

Initial working-capital investment. This includes additional investments in working capital such as accounts receivable and inventories reduced by the additional accounts payable.

•

After-tax cash flow from current disposal of the old machine. Gain or loss on disposal would have an income tax effect that must be included.

Cash flow from operations includes the difference between each year’s cash flow from operations under the alternatives. This includes: •

Annual after-tax cash flow from operations (excluding the depreciation effect). The added cash flows may be additional revenues or reduced expenses. In either case, they must be reduced by the applicable tax rate.

•

Income tax savings from annual depreciation deductions. As depreciation is a noncash expense the depreciation deduction will decrease the tax liability and increase cash flows by the amount of tax savings.

The third category is cash flow from the terminal disposal of the investment. This includes:

•

After-tax cash flow from terminal disposal of machines. The tax effect of any gain or loss on disposal must be considered in addition to the expected salvage value of the equipment.

•

After-tax cash flow from terminal recovery of working-capital investment. When the project is completed, the additional cash flow required at the start of the project will be released.

Refer to Quiz Questions 9, 10 Problems 22-34 and 22-35

LEARNING OBJECTIVE

Exercises 22-29 and 22-30;

Understand issues involved in implementing capital budgeting decisions and evaluating managerial performance … the importance of post-investment audits and the correct choice of performance measures

6.1

Once an alternative has been selected, the fifth stage in capital budgeting is to implement the decision. In addition to setting the process in motion, this means managing the project—both management control of the investment activity and management control of the project as a whole.

6.2

This leads to the latter part of stage 5 in capital budgeting—evaluate performance and learn. Conducting a post-investment audit provides management with feedback about the performance of a project, so actual results can be compared to the costs and benefits expected when the project was selected. This can help the company determine why a project failed to meet expectations and assist them in improving their capital budgeting process in the future. TEACHING POINT. The post-investment audit can also serve to keep proponents of the project “honest.” Often someone will become the “champion” for the project, working hard to assure its selection and implementation. Knowing that the actual results will be compared with the predicted expectation will help keep the predictions realistic.

6.3

The entire capital budgeting process should be governed by the company’s strategic plan. Whatever decisions are made with regard to capital budgeting should advance the strategic goals of the company.

LEARNING OBJECTIVE

Explain how managers can use capital budgeting to achieve their firms’ strategic goals … make critical investments aligned with the firm’s objectives but whose benefits are uncertain or difficult to estimate

7.1

Strategic capital investment decisions require consideration of a broad range of factors that may be difficult to estimate.

7.2

As an example, the distant payoffs of research and development are more uncertain than investments in equipment. Companies may increase or decrease resources committed to R&D based on how successful they have been up to that point. This feature, called real options, is an important aspect of R&D investments.

73.

Capital budgeting techniques can be used to make decisions about investments in customers. NPVs of customers can be compared and resources allocated to show higher estimated customer value through higher NPV.

APPENDIX: CAPTIAL BUDGETING AND INFLATION A.1

It is important for capital budgeting techniques to also include the impact of inflation on cash flows. Declines in purchasing power of the monetary unit will inflate future cash flows.

A.2

When analyzing inflation, it is important to distinguish the real rate of return from the nominal rate of return. The real rate of return is the rate of return demanded to cover investment risk if there is no inflation. The real rate is made up of two elements: (1) a risk-free element, and (2) a businessrisk element. The nominal rate of return is the rate of return demanded to cover investment risk and the decline in general purchasing power of the monetary unit as a result of expected inflation. The nominal rate is made up of three elements: (1) a risk-free

element when there is no expected inflation, (2) a business-risk element, and (3) an inflation element. A.3

When incorporating inflation into the NPV it is important to maintain internal consistency. These include the nominal approach and the real approach. The nominal approach predicts cash flows and outflows in the nominal monetary units and uses the nominal rate as the required rate of return. The real approach predicts cash flows in real monetary units and uses the real rate as the required rate of return. (Exhibit 22-8 illustrates the NPV method using the nominal approach)

CHAPTER 22 QUIZ 1.

[CPA Adapted] If the algebraic sum of the present values of all cash flows related to a proposed capital expenditure discounted at the company’s required rate of return is positive, it indicates that the a. resultant amount is the maximum that should be paid for the asset. b. discount rate used is not the proper required rate of return for this company.

c. d.

investment is the best alternative. return on the investment exceeds the company’s required rate of return.

The following data apply to questions 2 through 6. The Hilltop Corporation is considering (as of 1/1/20) the replacement of an old machine that is currently being used. The old machine is fully depreciated but can be used by the Corporation through 2023. If Hilltop decides to replace the old machine, Baker Company has offered to purchase it for $50,000 on the replacement date. The disposal value of the old machine would be zero at the end of 2023. Hilltop uses the straight-line method of depreciation for all classes of machinery. If the replacement occurs, a new machine would be acquired from Busby Industries on January 2, 2020. The purchase price of $500,000 for the new machine would be paid in cash at the time of replacement. Due to the increased efficiency of the new machine, estimated annual cash savings of $150,000 would be generated through 2023, the end of its expected useful life. The new machine is expected to have a zero disposal price at the end of 2023. All operating cash receipts, operating cash expenditures, and applicable tax payments and credits are assumed to occur at the end of the year. Hilltop employs the calendar year for reporting purposes. Discount tables for several different interest (discount) rates that are to be used in any discounting calculations are given below. Assume for questions 2 through 6 that Hilltop is not subject to income taxes. Present Value of $1.00 Received at the End of Period Period 6% 8% 10% 12% 14% 1 0.94 0.93 0.91 0.89 0.88 2 0.89 0.86 0.83 0.80 0.77 3 0.84 0.79 0.75 0.71 0.68 4 0.79 0.74 0.68 0.64 0.59 5 0.75 0.68 0.62 0.57 0.52 Present Value of an Annuity of $1.00 Received at the End of Each Period Period 6% 8% 10% 12% 14% 1 0.94 0.93 0.91 0.89 0.88 2 1.83 1.78 1.73 1.69 1.65 3 2.67 2.58 2.49 2.40 2.32 4 3.47 3.31 3.17 3.04 2.91 5 4.21 3.99 3.79 3.61 3.43 2.

[CMA Adapted] If Hilltop requires investments to earn an 8% return, the net present value for replacing the old machine with the new machine is a. $100,000. b. $50,000. c. $63,000. d. $46,500.

[CMA Adapted] The internal rate-of-return, to the nearest percent, to replace the old machine is a. 12%. b. 10%. c. 8%. d. 6%.

[CMA Adapted] The payback period to replace the old machine with the new machine is a. 3.3 years. b. 3.0 years. c. 4.0 years. d. 2.5 years.

The discounted payback at a required rate of return of 8% is a. 4 years. b. 3 years. c. 3.57 years. d. 1.5 years.

The accrual accounting rate of return on the initial investment to the nearest percent is a. 0%. b. 11.0%. c. 5.6%. d. 30%.

[CPA Adapted] The assumption that cash flows are reinvested at the rate earned by the investment belongs to which of the following capital budgeting methods? Internal rate Net present of return value a. No No b. No Yes c. Yes Yes d. Yes No

[CPA Adapted] The payback capital budgeting technique considers: Time value Income over entire of money life of project a. Yes Yes b. Yes No c. No Yes d. No No

Refer to data for questions 2 through 6. If Hilltop is subject to an income tax rate of 30%, what amount of annual cash savings would be used in a discounted cash flow method or in the payback method?

a. b. c. d. 10.

$275,000 $150,000 $142,500 $105,000

Refer to data for questions 2 through 6. If Hilltop is subject to an income tax rate of 30% and a required rate of return of 8%, the net present value for replacing the old machine with the new machine is a. $46,500. b. $21,675. c $71,675. d. $334,425.

CHAPTER 22 QUIZ SOLUTIONS 1.

10.

Quiz Question Calculations 2.

PVA4 periods/8% ($150,000) 3.31 = $496,500 Cost $500,000 Less sale of old machine (50,000) 450,000 Net present value $ 46,500

450,000/150,000 = 3.0 IRR is approximately 12%

$450,000/$150,000 = 3.0 years

(450,000) + 139,500 + 129,000 +118,500 = (63,000) years) + (63,000 / 111,000) = .57 years = 3.57 years

($150,000 – 125,000 depr)/$450,000 = 5.6%

4 periods factor @ 12% = 3.04

150,000  0.7 = $105,000 after-tax cash flow from savings 125,000  0.3 = $37,500 tax savings from depreciation $105,000 + $37,500 = $142,500

10.

PVA4 periods/8% ($142,500) 3.31 = $471,675 Cost $500,000 Less sale of old machine (50,000) 450,000 Net present value $ 21,675

Management Control Systems, Transfer Pricing, and Multinational Considerations

TRANSITION NOTES The section on evaluating management control systems has been streamlined and as has the section comparing benefits and costs of decentralization. The material on distress prices in discussing market-based transfer pricing has been expanded. The chapter has been updated to reflect the changes to transfer pricing brought on by the 2017 Tax Cuts and Jobs Act. *This chapter was previously Chapter 22.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 16 17 Revised 18 New 19 New 20 Revised 21 Revised 22 23 24 Revised 25 Revised 26 Revised

16th Edition 17 19

20 21 22 23 24 25 26

17th Edition 27 Revised 28 Revised 29 Revised 30 Revised 31 32 33 Revised 34 35 36 37

16th Edition 27 28 29 30 31 32 33 34 35 36 37

II.

Describe a management control system and its three key properties.

Describe the benefits and costs of decentralization.

Explain transfer prices and the four criteria managers use to evaluate them.

Calculate transfer prices using three methods.

Illustrate how market-based transfer prices promote goal congruence in perfectly competitive markets.

Understand how to avoid making suboptimal decisions when transfer prices are based on full cost plus a markup.

Describe the range of feasible transfer prices when there is unused capacity and alternative methods for arriving at the eventual hybrid price.

Apply a general guideline for determining a minimum transfer price.

Incorporate income tax considerations in multinational transfer pricing.

CHAPTER SYNOPSIS Chapter 23 discusses the links among management control systems, strategy, organizational structure, and accounting information. The costs and benefits of centralized and decentralized organizational structures are compared. Pricing of products transferred between different company divisions or departments is reviewed and the impact of transfer price on subunit and corporate profits is examined.

III.

POINTS OF EMPHASIS 1.

Students frequently are aware of the term management control system, but may not have a grasp of what it really is. They should understand the definition and properties of such a system.

Decentralization is a central concept in businesses with diverse operations. Students should be aware of the advantages and disadvantages of a decentralized management structure.

With the prevalence of decentralization, transfer pricing is prevalent. Students should understand the need for transfer pricing in a decentralized operation, the criteria to be considered in setting

transfer prices, and the methods by which transfer pricing may be done. Be certain they understand that there is no final, correct way to do transfer pricing; as the environment changes, so will the transferpricing methods. 4.

IV.

In an increasingly global economy, international issues in transfer pricing related to income and other taxes should be taken under consideration. The effects of different tax rates should be understood, along with strategies that are available to exploit these differences.

CHAPTER OUTLINE LEARNING OBJECTIVE

Describe a management control system … gathers information for planning and control decisions and its three key properties … aligns with strategy, supports organizational responsibility of managers, and motivates employees

1.1

A management control system is a means of gathering and using information to aid and coordinate planning and control decisions throughout an organization and to guide the behavior of its managers and other employees.

1.2

Some companies design the management control system around the concept of the balanced scorecard, with financial and nonfinancial information in each of the four perspectives of the scorecard (see Chapter 13 for more details on the four perspectives).

1.3

Management control systems consist of formal and informal control systems. The formal management control system includes the explicit rules, procedures, performance measures, and incentive plans that guide the behavior of managers and employees. The formal control system is composed of several systems, such as the management accounting system, the human resources system, and the quality system.

1.4

The informal management system includes shared values, loyalties, and mutual commitments among members of the company, company culture, and unwritten norms about acceptable behavior. TEACHING POINT. As time allows, explore aspects of the informal management system—how it can work for the company, and how it can be a detriment. Have the students identify elements of the informal system they have encountered in organizations they have been a part of.

1.5

Effective management control systems should be closely aligned with the company’s strategies and goals and should fit the organizational structure and decisionmaking responsibility of individual managers.

1.6

Three key properties of an effective system are: •

Motivation—the desire on the part of managers and other employees to attain a selected goal (the goal-congruence aspect), combined with the pursuit of that goal (the effort aspect).

•

Goal congruence—Individuals and groups work toward achieving the organization’s goal while working in their own best interests that align with the overall goals of top management. TEACHING POINT. Observe that goal congruence is not the same as goal adoption. The employee has goals that are not the same as the company goals, but by working toward his or her goals the employee helps meet the company goals.

•

Effort—exertion toward achieving a goal. This goes beyond physical exertion to include physical and mental actions. Refer to Quiz Question 1

LEARNING OBJECTIVE

Describe the benefits of decentralization … responsiveness to customers, faster decision making, management development and the costs of decentralization … loss of control, duplication of activities

2.1

A management control system must fit the structure of

the organization. Although generally seen as beneficial, an organization with a decentralized system has additional issues to consider in the structure of its management control system. 2.2

Decentralization is an organizational structure that gives managers at lower levels the freedom to make decisions. Autonomy is the degree of freedom they have to make decisions.

2.3

There are a number of benefits to decentralization:

2.4

•

Creates greater responsiveness to the needs of a subunit’s customers, suppliers, and employees.

•

Leads to gains from faster decision making by subunit managers. Decentralization speeds decision making, creating a competitive advantage over centralized organizations.

•

Assists management development and learning. Subunit managers are more motivated and committed when they can exercise initiative.

•

Sharpens the focus of subunit managers and broadens the reach of top management.

For all its benefits, though, decentralization is not without its costs. •

Decentralization may lead to suboptimal decision making when a decision to benefit one subunit is more than offset by the costs to the organization as a whole. o

2.5

Suboptimal decision making—also called incongruent decision making or dysfunctional decision making—is most likely to occur when the subunits in the company are highly interdependent.

•

Leads to unhealthy competition. Manager’s attention is focused more on the subunit rather than the company as a whole, and loyalties may lie with the subunit first.

•

Duplication of output due to internal competition may exist.

•

There may be duplication of activities as several subunits may undertake the same action separately.

In choosing an organizational structure, top management must compare the costs and benefits of decentralization. •

Decentralization in multinational companies

presents a special challenge. Centralized control may be physically impractical due to languages, customs, cultures, business practices, rules, laws, and regulations that vary from country to country. •

2.6

In addition, when decentralizing with multinationals, there is a risk from the lack of control.

A decentralized organization must have a measure of the performance of the decentralized subunits. TEACHING POINT. In choosing the method to measure the performance of a decentralized unit, managers must remember that responsibility must be equal to control. Someone cannot be held responsible for what they cannot control. To use an example in class, you can select a student and say something to the effect that this student made a bad grade on the last test. But it wasn’t his fault, you are going to hold the poor test score against the student seated next to him. The students will immediately see how ridiculous this position is, and you can relate that to improperly holding someone in a company responsible for what is out of their control.

2.7

As previously discussed in Chapter 6, there are four types of responsibility centers: •

Cost center—the manager is accountable for costs only.

•

Revenue center—the manager is accountable for revenues only.

•

Profit center—the manager is accountable for revenues and costs.

•

Investment center—the manager is accountable for , revenues, costs and investments. Refer to Quiz Questions 2 and 3 Exercises 23-17, part 1, 2 and 3

LEARNING OBJECTIVE

Explain transfer prices … price one subunit charges another for product and four criteria managers use to evaluate them … goal congruence, management effort, subunit performance evaluation, and subunit autonomy

3.1

A transfer price is the price one subunit charges for a product or service supplied to another subunit of the same organization. The product or service transferred between subunits is called an intermediate product, which may be worked on further, or sold to an external customer. TEACHING POINT. A cost center can be treated as a profit center by charging users for the product or service rendered by the subunit. For example, the Maintenance Department may charge internal users of its services a predetermined transfer price, allowing it to be accounted for as a profit center.

3.2

There are four criteria used to evaluate transfer prices: •

The price should promote goal congruence so that division managers acting in their own interest will take actions that are aligned with the objectives of top management.

•

They should induce managers to exert a high level of management effort.

•

The price should help top management evaluate performance of individual subunits.

•

The transfer price should promote a high degree of subunit autonomy, if top management favors a high degree of decentralization.

LEARNING OBJECTIVE

Calculate transfer prices using three methods … (a) market-based, (b) cost-based, or (c) hybrid, each of which yields different operating incomes for the subunits.

4.1

Three methods for determining transfer prices are: market-based, cost-based, and hybrid. •

Market-based transfer prices can be used when there is an external market price for the product or service being provided. Frequently, this may be the price the unit charges outside customers.

•

Cost-based transfer prices can be used based on the cost of producing the product in question. Various cost bases, such as variable production cost, variable and fixed production cost, or full cost may be used (all product costs and costs from other business functions, such as R&D, marketing, and distribution).

•

Hybrid transfer prices take into account both cost and market information. Subunits are free to negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with external parties. Obviously, the subunits have the greatest amount of autonomy under this system. TEACHING POINT. Illustrate each of these three approaches by going through the Horizon Petroleum example in the text. Discuss which method each manager would prefer and why. (Exhibit 23-1 summarizes Horizon Petroleum’s costs and prices in the two divisions.) (Exhibit 23-2 presents division operating incomes for each transfer-pricing method at Horizon Petroleum.)

Refer to Quiz Questions 4 and 5 Exercises 23-16, part 4, 23-17

LEARNING OBJECTIVE

Illustrate how market-based transfer prices promote goal congruence in perfectly competitive

markets … division managers transacting internally are motivated to take the same actions as if they were transacting externally

5.1

5.2

Market-based transfer prices generally lead to optimal decisions when three conditions are satisfied: •

The market for the intermediate product is perfectly competitive.

•

Interdependencies of subunits are minimal.

•

There are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transferring internally.

A perfectly competitive market exists when there is a homogeneous product with buying prices equal to selling prices and no individual buyers or sellers can affect these prices by their own actions. Using market-based transfer prices in this environment will allow a company to meet the four criteria of evaluating transfer prices. If markets are not perfectly competitive, selling prices affect the quantity of product sold.

5.3

When supply outstrips demand, market prices may drop well below historical averages. If this is a temporary condition, these low market prices are called distress prices. The existence of distress prices creates a problem for management in judging performance. Should they use the distress price or the long-run average price? Problem 23-27

LEARNING OBJECTIVE

Understand how to avoid making suboptimal decisions when transfer prices are based on full cost plus a markup … buying divisions should not regard the fixed costs and the markup as variable costs

6.1

Cost-based transfer prices are helpful when market prices are unavailable, inappropriate, or too costly to obtain. In utilizing this method, managers must determine the appropriate definition of full cost. They also must determine how much, if any, markup should be applied.

6.2

This approach can lead to suboptimal decisions. If the price is based on actual costs, the selling division has no incentive to control costs.

6.3

Under the full cost approach, each subunit’s fixed costs must be allocated to products. This brings up a host of allocation questions—budgeted or actual cost rates? Have the correct activities, cost pools, and allocation bases been chosen?

6.4

Transferring the product at variable costs promotes goal congruence, but results in an operating loss for the supplying department. One approach to addressing this problem is for the purchasing department to make a fixed payment to the supplying department, in effect paying for using the capacity of the supplying department. Refer to Quiz Question 6 Problem 23-31

LEARNING OBJECTIVE

Describe the range of feasible transfer prices when there is unused capacity … from variable cost to market price of the product transferred and alternative methods for arriving at the eventual hybrid price . . . proration, negotiation between divisions, and

dual pricing

7.1

The proration approach is an alternative to full cost and variable cost transfer prices that splits the difference between the two approaches.

7.2

Negotiated price is the most common hybrid method and is the result of a bargaining process between selling and buying subunits. Each division manager is motivated to put forth effort to increase division

operating income. Disadvantages include the time and energy spent on the negotiations, and the fact that one of the negotiators may have a bargaining advantage. 7.3

Managers sometimes use a dual-pricing approach, one that uses two separate transfer prices to price each transfer between units. The selling division would get credit for full cost and the buying division pays market price. The difference is recorded into a corporate cost account.

7.4

Although dual pricing promotes goal congruence, it is not widely used due to the fact that it creates problems in computing taxable income in subunits located in different taxing jurisdictions.

Refer to Quiz Questions 7 and 8 Exercise 23-19 and Problems 23-28 and 23-29

LEARNING OBJECTIVE

Apply a general guideline for determining a minimum transfer price … incremental cost plus opportunity cost of supplying division

8.1

In setting transfer prices, managers frequently find that there is no transfer-pricing method that meets all criteria. Market conditions; the goal of the transfer-pricing system; the criteria of goal congruence, management effort, subunit performance, and subunit autonomy must all be considered. (Exhibit 23-3 summarizes the properties of the different transferpricing methods.)

8.2

The minimum transfer price should be the incremental cost of producing and transferring the product. The maximum transfer price would be the price available for external purchase.

8.3

Different situations call for variations in application of this general rule. •

With a perfectly competitive market and no unused capacity by the selling division, the transfer price should be the external market price, as the selling division has no incentive to sell it at a lower price.

•

When there is an intermediate market that is not perfectly competitive and there is unused capacity, capacity utilization can be increased only by decreasing prices. In this case, the incremental cost per unit would be an appropriate transfer price.

•

When there is no external market for the product, any price between the incremental cost and the external price for purchase would fulfill goal congruence.

Refer to Quiz Question 9 Exercises 23-21 and Problem 23-26

LEARNING OBJECTIVE

Incorporate income tax considerations in multinational transfer pricing … set transfer prices to minimize tax payments to the extent permitted by tax authorities

9.1

Transfer prices often have tax implications when the intermediate product is being sold or transferred between subunits operating under different tax rates. Income taxes are the major consideration, but payroll taxes, customs duties, tariffs, sales taxes, valueadded taxes, environmental-related taxes, and other government levies must be considered.

9.2

Income tax considerations dictate that total company income will be maximized when the transfer price results in the subunits with the lowest tax rate realizing the largest profit. However, managers need to be aware of financial accounting, tax, and other regulatory issues that restrict the prices that may be charged in these situations.

9.3

To meet these varying objectives, a company may choose to maintain one set of accounting records for tax reporting and another for internal management reporting. This often raises suspicions among the taxing authorities, so companies often resort to other management control techniques.

9.4

Tariffs are treated in a manner similar to income taxes—companies have incentives to lower transfer prices for products imported into a country to reduce tariffs on these products.

9.5

Another consideration in the international arena is that transfer prices are sometimes influenced by national restrictions on dividend- or other incomerelated payments to parties outside their national borders. By increasing the transfer price, the income can be reduced and more money removed from the host country without being subject to income-related restrictions.

Refer to Quiz Question 10 Exercises 23-20, 23-22, and 23-23

CHAPTER 23 QUIZ 1.

If management decides to pursue an unwise goal, the management control system for that company should a. reinforce this company goal. b. be scrapped because an unwise goal will harm the company and should not be reinforced with a systematic approach. c. not be changed from the previous wise goals to incorporate the current unwise goal. d. not tie the managers’ reward to the pursuit of an unwise goal.

Which of the following is not a benefit associated with decentralization? a. Quicker decision making b. Increased motivation of subunit managers c. Increased competition among managers d. Greater responsiveness to local needs

Which of the following is a cost associated with decentralization? a. Not enough time spent in gathering information about different subunits of the organization b. Decreased loyalty toward the organization as a whole c. More management development and learning d. Lack of day-to-day involvement by top management in operating decisions

[CPA Adapted] In a decentralized organization in which subunits may buy goods from one another, the transferpricing system should be designed primarily to a. allow subunit managers to buy from external parties. b. increase the consolidated value of inventory. c. minimize the degree of autonomy of subunit managers. d. evaluate performance of individual subunits and their managers.

[CPA Adapted] In order to motivate subunit managers to exert effort to maximize their own subunit’s operating income, interdivisional transfers of a product preferably should be made at prices a. equal to fully allocated costs to the producing subunit. b. equal to the market price of the product. c. equal to variable costs of the producing subunit. d. negotiated by top management.

The following data apply to questions 6 through 10. The Santa Fe Manufacturing Company has two divisions in Kansas, the Holton Division and the Derby Division. Currently, Derby buys a part (10,000 units) from Holton for $16 per unit. Holton has purchased new equipment and wants to increase the price to Derby to $18 per unit. The controller of Derby claims that she cannot afford to go that high, as it will decrease the division’s profit to near zero. Derby can buy the part from an outside supplier for $16 per unit. The incremental costs per unit that Santa Fe incurs to produce each unit are Holton’s variable costs of $12. Fixed costs per unit for Holton with the recent purchase of equipment are $5. 6.

Holton has no alternative uses for its facilities. Should Derby continue to buy from Holton or buy from the external supplier? Company as a whole Derby Division

only a. Buy from external supplier supplier b. Buy from external supplier c. Buy from Holton Division d. Buy from Holton Division supplier

Buy from external Buy from Holton Division Buy from Holton Division Buy from external

If Santa Fe would prefer to negotiate a transfer price between the divisions, what range of transfer prices would be used? a. $12 to $16 b. $12 to $17 c. $12 to $18 d. $16 to $18

If Holton could use its facilities for other manufacturing operations, that would result in monthly cash operating savings of $45,000. What would be the advantage (disadvantage) to Santa Fe? a. $(25,000) b. $5,000 c. $20,000 d. $25,000

If Holton has no alternative uses for its facilities and the external supplier drops the price to $11 per unit, what should be done from the point of view of Company as a whole Derby Division

only a. Buy from Holton Division supplier b. Buy from external supplier c. Buy from external supplier supplier d. Buy from Holton Division 10.

Buy from external Buy from Holton Division Buy from external Buy from Holton Division

Assume the Derby Division is located in England rather than Kansas. The income tax rate used in England is 45%, whereas the effective income tax rate is 30% in Kansas. Which cost would be the best transfer price for the company as a whole (based upon the original data)? a. Full cost of $17 b. Market price of $16 c. Variable cost of $12 d. The price that best promotes goal congruence

CHAPTER 23 QUIZ SOLUTIONS 1.

10.

Quiz Question Calculations 8.

External Price $16 Incremental cost to make Additional cost to buy

12 4

$4  1000 units $40,000 additional cost Income from alternative use 45,000 Advantage to buy $ 5,000 10.

$12 VC/Unit + $5 FC/Unit = $17

Performance Measurement, Compensation, and Multinational Considerations

TRANSITION NOTES Examples are updated, as are exchange rates, to make them more current. Some assignment materials have been changed. *This chapter was previously Chapter 23.

EXERCISES AND PROBLEMS CORRELATION CHART 17th Edition 21 22 Revised 23 Revised 24 New 25 Revised 26 27 New 28 Revised 29 Revised 30 31 Revised

16th Edition 21 22 23 24 25 26 27 28 29

17th Edition 32 Revised 33 Revised 34 Revised 35 Revised 36 New 37 38 39 40 Revised 41 42 Revised 43

16th Edition 30 31 32 33 35 36 37 38 39 41 42

II.

LEARNING OBJECTIVES 1.

Select financial and nonfinancial performance measures to use in a balanced scorecard.

Examine accounting-based measures for evaluating a business unit’s performance, including return on investment (ROI), residual income (RI), and economic value added (EVA®).

Analyze the key measurement choices in the design of each performance measure.

Study the choice of performance targets and design of feedback mechanisms.

Indicate the difficulties that occur when the performance of divisions operating in different countries is compared.

Understand the roles of salaries and incentives when rewarding managers.

Describe the four levers of control and why they are necessary.

CHAPTER SYNOPSIS This chapter moves the discussion of performance evaluation and the balanced scorecard from a company perspective to the subunit and to individual performance evaluation. In addition, the chapter presents three steps for designing an accounting-based performance measure. Four financial performance measures are: return on investment (ROI), residual income (RI), economic value added (EVA®), and return on sales (ROS). The link between compensation and management control systems is discussed, along with the role of management accountants in helping organizations design better incentive systems. The chapter also presents the four levers of control—diagnostic control systems, boundary systems, belief systems, and interactive control systems—and why they are necessary.

III.

POINTS OF EMPHASIS 1.

This chapter incorporates the balanced scorecard for subunits. Help the students realize that the balanced scorecard concept can be applied in a number of situations, from subunits to individuals.

Accounting-based performance measures can be good

indicators of the progress the company is making toward its goals and objectives. The students should understand each of these—ROI, RI, EVA®, and ROS—and what each measure shows. In addition, emphasize the usefulness of the DuPont approach to ROI.

IV.

Students do not have to fully comprehend how to deal with international issues such as those discussed in the text. However, they should be aware of them, along with the issues faced in performance evaluations when the results are expressed in a currency other than U.S. dollars.

The final section of this chapter (and book) covers levers of control. As the last section, it frequently gets overlooked. However, there are some important points that students need to be made aware of that are included in this section. Try to give adequate time to the discussion of these issues.

CHAPTER OUTLINE LEARNING OBJECTIVE

Select financial performance measures … such as return on investment, residual income and nonfinancial performance measures … such as customer satisfaction, number of defects to use in a balanced scorecard

1.1

This text has already discussed the balanced scorecard for the entire company, but today organizations are increasingly presenting financial and nonfinancial performance measures for subunits in this type of report.

1.2

The measures used to evaluate subunits are similar to those in a scorecard for the entire company. For example, a hotel chain might use the following measures: •

Financial perspective—stock price, net income, return on sales, return on investment, or economic value added

•

Customer perspective—market share in different geographic locations, customer satisfaction, and average number of repeat visits

•

Internal-business-process perspective—customerservice time for making reservations, for checkin; cleanliness of the hotel and rooms; quality of room service; time taken to clean rooms; quality of the restaurant experience; number of new services provided to customers; and time taken to plan and build new facilities

•

Learning-and-growth perspective—employee education and skill levels, employee satisfaction, employee turnover, employee training, and information systems availability TEACHING POINT. Brainstorm the balanced scorecard with the students. Have them identify how some of these measures can be quantified to demonstrate progress (or lack of it) toward an objective. Additionally, have them identify what measures might be appropriate for other businesses and how these measures can be adapted for subunits.

1.3

There are several steps involved in designing accounting-based performance measures: Step 1: Choose performance measures that align with top management’s financial goals. Ask: What is the best measure of a subunit’s financial performance (operating income, net income, return on assets, or revenues)? Step 2: Choose the details of each performance measure in Step 1. Ask: Should these measures be calculated annually or for a multiyear period? Should assets be defined as total assets or net assets, and should they be measured at historical or current cost? Step 3: Choose a target level of performance and feedback mechanism for each performance measure in Step 1. Ask: Should subunits have identical targets such as the same required rate of return on assets? How frequently should performance reports be sent to top management—daily, weekly, or monthly?

Refer to Quiz Questions 1 and 2 Exercise 24-28 LEARNING OBJECTIVE

Examine accounting-based measures for evaluating a business unit’s performance, including return on investment (ROI), … return on sales times investment turnover

residual income (RI), … income minus a dollar amount for required return on investment and economic value added (EVA®) … a variation of residual income

2.1

Four measures are commonly utilized to evaluate the economic performance of company subunits. Three of these are investment measures—return on investment, residual income, and economic value added. A fourth measure, return on sales, does not measure investment. These will be discussed in this chapter.

2.2

Investment refers to the resources or assets used to generate income. Comparison of operating income is an insufficient measure; managers must determine if the division generates sufficient operating income relative to the investment made to earn it. (Exhibit 24-1 displays 2020 financial data for Hospitality Inns.)

2.3

Return on investment (ROI) is an accounting measure of income divided by an accounting measure of investment: Return on Investment = Income/Investment

2.4

It should be noted that ROI is another name for the accrual accounting rate-of-return (AARR) discussed in Chapter 22.

2.5

ROI can provide more insight into performance when it is presented in its expanded view, also known as the DuPont method of profitability analysis.

Income Income Revenues =  Investment Revenues Investment

which is also written as ROI = Return on sales  Investment turnover 2.6

Note that the first measure in the expanded view is return on sales. The second measure is asset turnover. When combined, they equal the return on investment. TEACHING POINT. Illustrate the expanded view of ROI. Parts of Problem 24-38 lend itself to this illustration. Point out that this view helps the manager to see if the subunit’s greatest need is to improve the return on sales or if they need to work on the

efficiency with which they utilize their assets.

2.7

Residual income (RI) is an accounting measure of income minus a dollar amount for a required return on an accounting measure of investment; that is, residual income is net income for the subunit minus a charge for the use of assets (investments). Residual Income (RI) = Income – (Required rate of return × Investment)

2.8

The required rate of return is the minimum acceptable return the company seeks on its investment in the subunit. The required rate of return multiplied by the investment equals the imputed cost of the investment.

2.9

Some managers prefer RI as it allows them to focus on absolute dollars of return, as opposed to a percentage return. This approach is more likely to achieve goal congruence as a measure of the subunit manager’s performance. TEACHING POINT. As with ROI, illustrate the computation of RI. Again, parts of Problem 24-38 may be used for this illustration.

2.10 Economic value added is a specific type of residual income calculation that is used by many companies. Economic value added (EVA®) equals after-tax operating income minus the weighted-average cost of capital multiplied by total assets minus current liabilities. Economic value added (EVA) = After-tax Op. Inc. – [Weighted-average cost of capital  (Total assets – Current liabilities)] TEACHING POINT. Due to the number of items in the (EVA®) computation, students will tend to lose track of how this is calculated. They will comprehend it much quicker if they are presented with an illustration rather than just a formula. Now that ROI, RI, and EVA® have been discussed, their calculations can be presented by demonstrating an example such as Exercise 24-26.

2.11 Return on sales (ROS) is the fourth commonly used measure and has already been covered as a component of ROI in the DuPont method. ROS measures how effectively costs are managed. However, to evaluate overall performance ROI, RI, or EVA® are more appropriate as they consider both income and investment. Refer to Quiz Questions 3 - 7, 24-23, 24-24, 24-26; Problem 24-38 LEARNING OBJECTIVE

Exercises 24-21, 24-22,

Analyze the key measurement choices in the design of each performance measure … choice of time horizon, alternative definitions, and measurement of assets

3.1

Step 2 of designing an accounting-based performance measure includes choosing the time horizon, an element of the details of each performance measure. The measures covered represent the results for a single period, usually one year. Because managers may be inclined to take actions that favorably affect the short run but are detrimental to the long-run interests of the company, many companies evaluate subunits on these measures over multiple years.

3.2

Also in step 2, managers must define the terms being utilized. Four methods of defining investment are frequently used. •

Total assets available. All assets regardless of their intended purpose

•

Total assets employed. Total assets available minus idle assets and assets purchased for future expansion

•

Total assets employed minus current liabilities. Total assets excluding assets financed by shortterm creditors

•

Stockholders’ equity. This is calculated by assigning liabilities among subunits and deducting these amounts from the total assets of each subunit

3.3

For ROI or RI, companies frequently choose to define investment as total assets available. EVA® users would normally use total assets employed minus current liabilities.

3.4

To accurately design accounting-based performance measures, we must consider different ways to measure assets used in investment calculations. Current or historical costs are commonly used measures.

3.5

Current cost is the cost of purchasing an asset today identical to the one currently held or the cost of purchasing an asset that provides services similar to the one being held if an identical asset cannot be purchased. (Exhibit 24-2 illustrates the calculation of ROI using current cost estimates.)

3.6

Historical cost can include original cost or net book

value. Proponents of gross book value claim it enables comparisons on ROI across subunits. Using net book value masks a decline in earning power as the asset base is declining. Proponents of net book value maintain it is less confusing as it uses amounts consistent with balance sheet presentation and is consistent with income computations that include depreciation as an expense. Net book value is the measure most often used. Refer to Exercise 24-30; Problem 24-35, 24-36 LEARNING OBJECTIVE

Study the choice of performance targets and the design of feedback mechanisms … carefully crafted budgets and sufficient feedback for timely corrective action

4.1

Step 3 involves setting the target or budget for the measures previously chosen. This comparison of budgeted against actual results can be extremely useful. However, managers must be careful to tailor a budget to the particular subunit, accounting system, and performance measure in order to obtain useful results.

4.2

Continuous improvement is a popular way to establish targets with measures in each of the balanced scorecard perspectives.

4.3

A final, critical step involves the timing of feedback. Timing depends on three factors: •

How critical the information is for the success of the organization

•

The specific level of management receiving the feedback

•

The sophistication of the organization’s information technology TEACHING POINT. Timely feedback that is not useful is a waste of resources. A large downtown hotel had a sophisticated information technology system and was able to generate numerous reports, including a daily projected income statement for the month. It was not uncommon to visit the office of a member of top management and see a stack of these reports on a table in the corner of the office, untouched. Guard against giving too much information and seek to provide information that is both useful and timely.

Refer to Quiz Question 8 LEARNING OBJECTIVE

Indicate the difficulties that occur when the performance of divisions operating in different countries is compared … adjustments needed for differences in inflation rates and changes in exchange rates

5.1

Companies face additional difficulties when divisions are located in different countries. These difficulties will require adjustments in order to compare performance measures. Some of these issues are: •

The economic, legal, political, social, and cultural environments that differ significantly across countries.

•

Government controls on prices and products including customs, tariffs, import quotas and duties.

•

Availability of materials and skilled labor as well as costs of materials, labor, and infrastructure may differ significantly across countries.

•

Divisions operating in different countries account for their performance in different currencies. Inflation and changing foreigncurrency exchange rates affect performance measures.

5.2

In calculating ROI in a foreign country, decisions must be made regarding which currency to use, along with the appropriate exchange rate.

5.3

When one currency declines against the dollar, it may correspond to high inflation in the foreign currency. As a result, historical operating income and ROI’s will be higher. Inflation clouds the real return on assets and makes direct comparisons difficult.

5.4

If the exchange rate that prevailed at the time the assets were acquired is used, the inflation effect will be minimized, so this rate should be used to convert the assets to dollars.

5.5

The residual income calculation suffers from the same problem; adjusting it to dollars also makes these comparisons more meaningful.

Refer to Exercise 24-31, Problem 24-37 LEARNING OBJECTIVE

Understand the roles of salaries and incentives when rewarding managers … balancing risk and performance-based rewards

6.1

Up to this point, our focus has been on evaluating the performance of the subunit of a company (such as a division). However, performance of the subunit should not be considered the same as performance of the manager. A good manager may be placed in a difficult division in order to turn the division around, so his or her performance and that of the division may not be one and the same.

6.2

How performance of managers and employees is measured and evaluated affects their rewards. Compensation arrangements may range from a flat salary with no direct performance-based incentives to no salary and full commission. These varying arrangements need to consider the tradeoffs between creating incentives and imposing risk.

6.3

The owner of a company is an entrepreneur and expects to bear risk. A manager, on the other hand, does not like being subject to risk. However, the lack of risk on the part of the manager can create a moral hazard. This is a condition that occurs when the employee prefers to exert less effort compared with the effort desired by the owner because the employee’s efforts cannot be effectively monitored or enforced.

6.4

Intensity of incentives is a term that reflects the size of the incentive relative to the salary component. Preferred performance measures are those that are sensitive to or specifically change with the manager’s performance—but not with changes beyond the manager’s control. These motivate the managers and limit their risk exposure.

6.5

Financial and nonfinancial benchmarks may be used to evaluate performance. Benchmarks represent best practice and may be available within or outside an organization.

6.6

In evaluating performance at the individual-activity level, there are two issues that arise:

•

Designing performance measures for activities that require multiple tasks

•

Designing performance measures for activities done in teams

6.7

In performing multiple tasks, there is often a tradeoff between the quantity of work performed and the quality of that work. The reward system must be designed to balance these two objectives.

6.8

A team brings together individuals with expertise in a variety of activities. It can be expected that a team will achieve better results than individuals working alone.

6.9

Companies reward individuals on teams based on team performance. This creates two problems, however. Incentives for individual employees to excel are diminished, and other team members may not be productive members of the team.

6.10 These principles of performance evaluation also apply to executive compensation plans, although the magnitude and type of rewards may be significantly different. Refer to Quiz Question 9 and 10 Exercises 24-32 and 24-33 LEARNING OBJECTIVE

Describe the four levers of control and why they are necessary … boundary, belief, and interactive control systems counterbalance diagnostic control systems

7.1

Quantitative financial and nonfinancial measures have been the focus of this text in line with the management accounting focus. These diagnostic control systems, such as ROI, RI, and EVA® help managers track progress toward a company’s strategic goals.

7.2

There is, however, a tendency to cut corners in order to achieve the goals. One only needs to look at companies such as WorldCom, Enron, Tyco, and Health South to realize that other measures must be in place to balance the push for performance under diagnostic control systems.

7.3

Collectively, diagnostic control systems and the other

balancing systems are referred to as levers of control. The other three levers are boundary systems, belief systems, and interactive control systems. 7.4

Boundary systems describe standards of behavior and codes of conduct expected of all employees, especially actions that are off-limits. TEACHING POINT. Some standards of behavior are virtually universal in that they are normally expected of all employees in all companies. For example, all employees are expected to follow the law in the performance of their jobs. Other standards vary by company. For example, the dress code for male office workers at a large downtown hotel specified that they should not appear in the public areas of the hotel without a tie and jacket.

7.5

Belief systems articulate the mission, purpose, and core values of a company. They describe the accepted norms and patterns of behavior expected of all managers and employees with respect to one another, shareholders, customers, and communities. TEACHING POINT. These belief systems can manifest themselves in many ways. Many companies offer employees the opportunity to engage in public service as a part of their employment. One fast food chain offers college scholarships to its employees. Other companies contribute funds to build a Habitat for Humanity house, which will be built by their employees. These actions become part of the culture of the organization.

7.6

Interactive control systems are formal information systems that managers use to focus the company’s attention and learning on key strategic issues. This often involves face-to-face communications regarding critical issues facing the company. This may result in ongoing discussion and debate about ongoing plans. TEACHING POINT. One company was faced with an attempt by a labor union to unionize its employees. As a part of the effort, some false information was spread by the union organizers. The company president called a meeting of all the employees and discussed the situation with them face-to-face, answering their questions and dialoguing with the employees. This effort was seen as a critical factor in the defeat of the union effort.

Problems 24-39, 24-40, and 24-42

OTHER RESOURCES To download instructor resources, visit the Instructor’s Resource Center at www.pearsonhighered.com/irc.

The following exhibits were mentioned in this chapter of the Instructor’s Manual, and have been included in the Image Library. Exhibit 24-1 displays 2020 financial data for Hospitality Inns. Exhibit 24-2 illustrates the calculation of ROI using current cost estimates

CHAPTER 24 QUIZ 1.

An example of a performance measure based on external financial information would be a. market share. b. stock prices. c. innovation measures. d. defect rates.

Which of the following does not describe the three steps in designing an accounting-based performance measure? a. The issues in each step are interdependent. b. The decision maker will often proceed through the steps several times before deciding on one or more performance measure(s). c. The answers to the questions raised at each step depend on top management’s beliefs about the organization. d. The steps must be done in sequence.

The following data apply to questions 3 through 7. Information pertaining to Piney River Division of MO Corporation for 2020: Revenues $950,000 Variable costs 575,000 Traceable fixed costs 336,500 Average invested capital 350,000 Imputed interest rate 10% 3.

[CPA Adapted] The return on investment (ROI) was a. 4%. b. 10%. c. 11%. d. 37%.

The return on sales (ROS), a component of the DuPont method of profitability analysis, was (rounded to the nearest percent) a. 11%.

b. c. d.

40%. 1%. 4%.

[CPA Adapted] The residual income was a. $3,500. b. $35,000. c. $38,500. d. $0.

If top management at MO Corporation adopts a 15% target ROI for the Piney River Division, which combination (while holding other factors constant) will yield at least this targeted ROI? a. A 1% increase in sales volume b. A 5% decrease in average invested assets c. A 2% increase in sales prices d. A 3% decrease in fixed costs

Which of the following factors would not be needed to calculate EVA® from the given information for Piney River Division of MO Corporation? a. Income tax rate b. Weighted-average cost of capital c. Current liabilities d. Current assets

When calculating performance measures, it is best to use a. steady improvement against targets. b. gross book value asset measurement. c. historical cost asset measurement. d. current cost asset measurement.

James Jessmore is a manager at a local bank. James’s management style is best described as entrepreneurial—he is risk neutral. Wynetta George is a customer service representative who reports to James. Wynetta is risk averse. In designing a compensation package for James and Wynetta, which type of compensation arrangement should be emphasized more? James Jessmore Wynetta George a. Performance-based Performance-based b. Performance-based Straight salary c. Straight salary Performance-based d. Straight salary Straight salary

10.

Moral hazard is best described in contexts in which a. division managers cite enormous top management pressures “to make the budget” as excuses for not

b. c. d.

adhering to ethical accounting policies and procedures. the numbers that subunit managers report should be uncontaminated by “cooking the books.” an employee prefers to exert less effort than desired by the owner because the effort cannot be accurately monitored and enforced. socially responsible companies set aggressive environmental goals and measure and report their performance against them.

CHAPTER 24 QUIZ SOLUTIONS 1.

10.

Quiz Question Calculations 3.

Revenues $950,000 Variable costs (575,000) Traceable fixed costs (336,500) Operating income $ 38,500 38,500/350,000 = 11%

38,500/950,000 = 4.1% or rounded to 4%

Operating income 350,000  10% Residual income

$38,500 35,000 3,500

950,000  101% 575,000  101%

$959,500 (580,750) (336,500) Operating income 42,500 42,500/350,000 = 12.1%

350,000  0.95 = 332,500

950,000  102%

38,500/332,500 = 11.6%

$969,000 (575,000) (336,500) Operating income $ 57,500 57,500/350,000 = 16.4%

$950,000 (575,000) 336,500  0.97 = (326,405) Operating Income 48,595 48,595/350,000 = 13.9%

richard@qwconsultancy.com

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