Introduction to Management Accounting, Global Edition, 17th edition Charles Horngren Solution Manual by Ace Test Banks

Introduction to Management Accounting, Global Edition, 17th ed By Charles Horngre

Email: Richard@qwconsultancy.com

Chapter 1 Managerial Accounting, the Business Organization, and Professional Ethics LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7.

Explain why accounting is essential for decision makers and managers. Describe the major users and uses of accounting information. Explain the role of budgets and performance reports in planning and control. Describe the cost-benefit and behavioral issues involved in designing an accounting system. Discuss the role accountants play in the company’s value-chain functions. Identify current trends in management accounting. Explain why ethics and standards of ethical conduct are important to accountants.

CHAPTER 1:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 28. Finance and Management Accounting 29. Accounting’s Position in the Organization: Controller and Treasurer 30. Marketing and Management Accounting 31. Production and Management Accounting EXERCISES 32. Management Accounting and Financial Accounting 33. Planning and Control, Management by Exception 34. Line Versus Staff and Value Chain Responsibility 35. Microsoft’s Value Chain 36. Objectives of Management Accounting 37. Cost-Benefit of the Ethical Environment 38. Early Warning Signs of Ethical Conduct PROBLEMS 39. Management and Financial Accounting 40. Use of Accounting Information in Hospitals 41. Costs and Benefits 42. Importance of Accounting 43. Changes in Accounting Systems 44. Value Chain 45. Role of Controller 46. The Accountant’s Role in an Organization 47. Ethics and Accounting Personnel 48. Ethical Issues 49. Hundred Best Corporate Citizens CASES 50. 51. 52.

Line and Staff Authority Professional Ethics and Toxic Waste Information in Nike’s 10k Report

EXCEL APPLICATON EXERCISE 53. Budgets and Performance Evaluation COLLABORATIVE LEARNING EXERCISE 54. The Future Management Accountant INTERNET EXERCISE 55. Institute of Management Accountants (www.ifac.org)

CHAPTER 1: I.

OUTLINE

Management Accounting and Your Career A.

{L. O. 1}

Certified Management Accountant Financial accounting has long provided auditing positions that are typically staffed by Certified Public Accountants (CPAs) in the United States and chartered accountants (CAs) in many other nations. The certified management accountant (CMA) designation is the management accountant’s counterpart to the CPA. There are three key professional qualifications providing routes into accounting: ACA (Institute of Chartered Accountants), ACCA (Association of Chartered Certified Accountants), and CIMA (Chartered Institute of Management Accountants). Each of these qualifications is globally recognized. Each course can take 3 to 5 years.

Training for Top Management Positions In addition to preparing you for a position in an accounting department, studying accounting, and working as a management accountant, can prepare you for the very highest levels of management, such as CEO. Users of Accounting Information In general, users of accounting information fall into two general categories. 1. Internal managers who use information for day-to-day operating decisions and for long-range strategic decisions, and 2. External parties, such as investors and government authorities, who use the information for making decisions about the company. The internal managers make use of Management Accounting information whereas the external parties make use of Financial Accounting information. See EXHIBIT 1-1 for the major distinctions between these two types of accounting information.

II.

Roles of Accounting Information A.

{L. O. 2}

Accounting System—a formal mechanism for gathering, organizing, and communicating information about an organization’s activities. A good accounting system helps an organization achieve its goals and objectives by helping to answer three types of questions. 1. 2.

Scorecard Questions (Am I doing well or poorly?)—accumulation and classification of data, Attention-Directing Questions (Which problems should I look into?)— focuses on operating problems and opportunities, and

III.

Problem-Solving Questions (Of the several ways of doing the job, which one is best?)—quantifies the likely results of possible courses of action for long-range planning.

Management by Exception A.

{L. O. 3}

The Nature of Planning and Controlling The management process is a series of activities in a cycle of planning and control with Decision Making—the purposeful choice from among a set of alternative courses of action designed to achieve some objective, as the core. Planning—the setting of objectives and outlining how they will be attained. Controlling—the implementation of plans and using feedback to attain objectives. Planning determines action, action generates feedback, and feedback influences further planning and possible corrective actions. EXHIBIT 1-2 shows that the accounting system formalizes plans by expressing them as budgets. A budget is a quantitative expression of a plan of action. Budgets are the chief devices for compelling and disciplining management planning. Performance Reports—provide feedback by comparing results with plans and by highlighting Variances (i.e., deviations from plans). The accounting system records, measures, and classifies actions in order to produce performance reports. See EXHIBIT 1-3 for an example of a performance report for a hypothetical store, the Mayfair Starbucks. Management by Exception—concentrating on areas that need attention and ignoring areas that appear to be running smoothly. Managers use performance reports to investigate exceptions (i.e., items for which actual amounts differ significantly from budgeted amounts). Operations are then brought into conformity with plans, or the plans are revised.

Influences on Accounting Systems An accounting system is a formal mechanism for gathering, organizing, and communicating information about an organization’s activities. In the European Union and more than 100 countries worldwide, companies must comply with International Financial Reporting Standards (IFRS). In the United States (and select other countries), reports for external users are bound by generally accepted accounting principles (GAAP) and legal requirements. The auditor must make a judgment as to whether the financial statements of the company comply with the approved accounting standard and that they are a true and fair view of the situation. The auditor’s role is to express an opinion on the financial statements; it is the responsibility of the company directors to prepare and present the financial statements and to set in place any internal controls, policies to protect

and make the most efficient use of an organization’s assets. Because government agencies have legal power to order into evidence any internal document that they deem necessary, internal accounting systems may be affected by government regulation. An example is the way universities and defense contractors must allocate their costs to government contracts. As of January 2021, all U.K. companies are required to use U.K.-adopted international accounting standards (IAS) as opposed to those adopted by the EU. Management Audit—a review performed by internal auditors of profit-seeking organizations and governmental agencies to determine whether the policies and procedures specified by top management have been implemented. Under the Companies Act 2016 in Malaysia, it is a requirement of all public listed companies, private limited companies, and branch offices in Malaysia to appoint an approved auditor to audit the accounts of the company. IV.

Cost-Benefit and Behavioral Considerations

{L. O. 4}

Cost-Benefit Balance—weighing estimated costs against probable benefits. This is the primary consideration in choosing among accounting systems and methods. The value of a system must be seen as exceeding its cost. Behavioral Implications—the accounting system’s effects on the behavior (decisions) of managers. A system that managers believe in and trust will be used more in making decisions than one they distrust.

Planning and Control for Product Life Cycles and the Value Chain

{L. O. 5}

Product Life Cycle—the various stages through which a product passes: from conception and development; introduction into the market; maturation; and, finally, withdrawal from the market. In the planning process, managers must determine revenues and costs over the entire life cycle. Accounting also needs to track actual costs and revenues throughout the life cycle. Periodic comparisons between planned costs and revenues and actual costs and revenues allow managers to assess the current profitability of a product, determine its current life-cycle stage, and make any needed changes in strategy. See EXHIBIT 1-4 for a typical product life cycle. The Value Chain—set of business functions that add value to the products or services of an organization. These functions, not of equal importance, include research and development, design of products or services, production, marketing, distribution, and customer service. See EXHIBIT 1-5 for a depiction of business functions’ value chain. VI.

Accounting’s Position in the Organization

Line and Staff Authority Line Authority—authority extended downward over subordinates. Staff Authority—authority to advise but not command. It may be exerted downward, laterally, or upward. See EXHIBIT 1-6 for how a traditional manufacturing company divides responsibilities between line and staff managers. Line Departments are those that are central to the mission of the organization, whereas Staff Departments lend support and service to the line department. See EXHIBIT 1-6 for a partial organizational chart of a manufacturing company. Although controllers have a staff role, they are generally empowered by the firm’s president to approve, install, and oversee the organization’s accounting system to assure uniform accounting and reporting methods.

Controller and Treasurer Functions The chief financial officer (CFO), the top executive who deals with all finance and accounting issues in an organization, oversees the accounting function in most organizations. The controller (or comptroller in a government organization) is the top accounting officer in an organization. This executive, like virtually everyone in an accounting function, fills a staff role, whereas sales and production executives and their subordinates fill line roles. The duties of Treasurer include provision of capital, investor relations, short-term financing, banking and custody, credits and collections, investments, and risk management (insurance).

VI.

Adaptation to Change {L. O. 6} As decisions change, demands for information change. Accountants must adapt their systems to the changes in management practices and technology. Four major trends are influencing management accounting today: 1. 2. 3. 4. A.

Shift from a manufacturing to a service-based economy Increased global competition Advances in technology Changes in business process management

Service Sector The characteristics of service organizations include the following: 1. Labor is a major component of costs 2. Output is usually difficult to measure 3. Service organizations cannot store their major inputs and outputs

Global Competition

There has been a shift in the balance of economic power in the world due to countries lowering tariffs and duties, and a trend toward deregulation. C.

Advances in Technology The dominant influence on management accounting over the past two decades has been technological change, affecting both the production and the use of accounting information. One of the more rapidly growing uses of technology is electronic commerce or e-commerce. A major effect of technology on accounting systems has been the growing use of enterprise resource planning systems (ERP), which refers to conducting business online.

Changes in Business Process Management Some companies implement sweeping changes in operations through business process reengineering, the fundamental rethinking and radical redesign of business processes to improve performance in areas such as cost, quality, service, and speed. Companies can use computer-aided design (CAD) to design products that can be manufactured efficiently and computer-aided manufacturing (CAM) to produce a smoother, more efficient flow of production with fewer delays. The impact of both of these is to reduce processing time. Computer-Integrated Manufacturing (CIM) Systems—systems that use CAD and CAM together with robots and computer-controlled machines. Just-in-time (JIT) philosophy—the elimination of waste by (1) reducing the time that a product spends in the production process and (2) eliminating the time that products spend on activities that do not add value (e.g., inspection and waiting time). While it was a dominant mode of inventory keeping for manufacturers, it was crucial for suppliers to be totally reliable. The COVID-19 pandemic was probably the biggest factor in exposing the limitations of JIT. With businesses and consumers finding new ways to operate and interact in the post-pandemic era, suppliers and transport networks that were used to JIT are unable to cope with the sudden demand. The digital transformation of supply chain management means that businesses can reduce risks and manage supply chains better. Another step in gaining efficiency is lean manufacturing, which applies continuous process improvements to eliminate waste from the entire enterprise. Total Quality Management (TQM) initiatives minimizes costs by maximizing quality. It focuses on continuous improvement in quality and has come to represent a focus on satisfying one’s customers. The focus on quality has shifted to Six Sigma, a disciplined, data-driven approach to

a continuous process improvement effort designed to reduce costs by improving quality and ensuring that internal processes are running as efficiently as possible. E.

Implications of Process Changes for the Study of Management Accounting To adapt to changes, the student must understand why techniques are being used, not just how they are used. Students should develop their understanding of underlying concepts and principles, not just memorize rules and techniques.

VII.

Ethical Conduct for Professional Accountants A.

{L. O. 7}

Standards of Ethical Conduct Ethical standards require CPAs and CMAs to adhere to codes of conduct regarding integrity, objectivity, professional competence and due care, confidentiality and professional behavior. See Exhibit 1-7 for the International Code of Ethics for Professional Accountants, a code of conduct developed by the International Ethics Standards Board for Accountants (IESBA) of the International Federation of Accountants (IFAC). Professional accounting organizations have procedures for reviewing alleged behavior that is not consistent with the standards. The standards are shown as responsibilities regarding competence, confidentiality, integrity, and objectivity. A code of conduct is a document specifying the ethical standards of an organization. It is the centerpiece of most ethics programs.

B. Ethical Dilemmas Ethical dilemmas exist when managers must choose an alternative and there are (1) significant value conflicts among differing interests, (2) several alternatives are justifiable, and (3) there are significant consequences for stakeholders in the situation. C.

Resolution of Ethical Conflicts When faced with ethical issues, you should follow your organization’s established policies on the resolution of such ethical conflict.

CHAPTER 1:

Quiz/Demonstration Exercises

Learning Objective 1 1.

The CMAs must pass an exam that includes _____. a. financial control b. financial decision making c. financial planning d. all of the above

Which designation is the internal accountant’s counterpart to the CPA? a. CA b. CMA c. CFP d. none of the above

Learning Objective 2 3.

The major internal users of accounting information are _____. a. managers who use information for day-to-day operating decisions b. investors for investment decisions c. government authorities d. none of the above

In the European Union external reporting must comply with _____. a. GAAP b. IFRS c. IRS d. FASB

Learning Objective 3 5.

Which of the following should be considered in the selection of an accounting system? a. b. c. d.

behavioral effects of the system on managers costs of buying and operating the system improved decision-making power resulting from the system all of the above

Learning Objective 4 6.

Concentrating on areas that need attention and ignoring areas that appear to be running smoothly is called _____. a. variance analysis b. management by exception

c. d.

management smoothing budget analysis

Which of the following is not an example of a special report? a. cash flow report b. customer survey c. competitor analysis d. advertising impact analysis

The various stages through which a product passes are called: a. planning cycle b. control period c. budget cycle d. product life cycle

Learning Objective 5 9.

The focus on customers occurs in which functions of the value chain? a. research and development b. production c. marketing d. distribution e. all of the above

10.

The value-chain is a set of business functions that _____. a. are of equal importance b. are non-value added functions c. are preferable functions d. are value-added functions e. are only related to distribution

11.

The functions of planning for control, evaluating and consulting, and governmental reporting are typically assumed within organizations by _____. a. the company treasurer b. the company controller c. the company vice president of marketing d. external auditors

12.

The treasurer function includes _____. a. tax administration b. evaluating and consulting c. investor relations d. economic appraisal

Learning Objective 6

13.

Trends that are causing changes in management accounting today include: a. advances in technology b. increased global competition c. a shift from a manufacturing to a service-based economy d. A and B e. A, B, and C

14.

A step in changes in business process management to gain efficiency by continuous process improvement to eliminate waste from the entire enterprise is called _____. a. just in time b. lean manufacturing c. waste management d. none of the above

Learning Objective 7 15.

Ethical obligations of management accountants are governed by the IMA Statement of Ethical Professional Practice, which outlines responsibilities regarding _____. a. incompetence, full disclosure of all information, moral decay, and partisanship b. assisting in maximizing profits regardless of the means necessary c. competence, confidentiality, integrity, and objectivity d. none of these

16.

In the IMA’s Statement of Ethical Professional Practice, which of the following is not an example of competence? a. provide decision support information and recommendations that are accurate b. avoid actual or apparent conflicts of interest c. maintain an appropriate level of professional expertise d. perform professional duties in accordance with relevant laws

CHAPTER 1: 1. 2. 3. 4. 3. 4. 5. 6. 7. 8. 9. 12. 13. 14. 15. 16.

Solutions to Quiz/Demonstration Exercises

[c] [d] [a] [b] [d] [b] [a] [d] [e] [d] [b] [b] [e] [b] [c] [b]

Chapter 2 Introduction to Cost Behavior and Cost-Volume Relationships LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 9.

Explain how cost drivers affect cost behavior. Show how changes in cost-driver levels affect variable and fixed costs. Explain step- and mixed-cost behavior. Create a cost-volume-profit (CVP) graph and understand the assumptions behind it. Calculate break-even sales volume expressed in terms of total sales revenue earned and total units produced at break-even. Calculate the sales volume needed to reach a target profit in terms of units produced and in sales revenues earned. Differentiate between contribution margin and gross margin. Explain the effects of sales mix on profits (Appendix 2A). Compute cost-volume-profit (CVP) relationships on an after-tax basis (Appendix 2B).

CHAPTER 2:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 24. Marketing Function of Value-Chain and Cost Behavior 25. Production Function of Value-Chain and Cost Behavior 26. Tenneco Automotive's Value Chain EXERCISES 27. Identifying Cost Drivers 28. Basic Review Exercises 29. Variable- and Fixed-Cost Behavior 30. Variable- and Fixed-Cost Behavior 31. Basic Review Exercises 32. Basic Cost-Volume Graph 33. Basic Cost-Volume Graph 34. Basic Cost-Volume Graphs 35. Basic Cost-Volume Graphs 36. Hospital Costs and Pricing 37. Cost-Volume-Profit at a Hospital 38. Motel Rentals 39. Variable Cost to Break Even 40. Sales-Mix Analysis 41. Income Taxes 42. Income Taxes and Cost-Volume-Profit Analysis PROBLEMS 43. Joe’s Pub, Cost-Volume-Profit Analysis in a Small Business 44. Kroger Grocery Chain, Variable and Fixed Costs 45. Fixed Costs and Relevant Range 46. Comparing Contribution Margin Percentages 47. Movie Manager 48. Promotion of Rock Concert 49. Cost Reduction Program at Boeing 50. Basic Relationships, Restaurant 51. Changing Fixed Costs to Variable Costs at Blockbuster Video 52. CVP and Financial Statements for a Mega-Brand Company 53. Bingo and Leverage 54. Leverage at eBay 55. Adding a Product 56. Government Organization 57. Gross Margin and Contribution Margin 58. Choosing Equipment for Different Volumes 59. Sales Compensation, Variable/Fixed Costs, and Ethics 60. Sales-Mix Analysis 61. Hospital Patient Mix 62. Income Taxes on Hotels

63. CASES 64. 65. 66. 67. 68.

Tax Effects, Multiple Choice

Hospital Costs CVP in a Modern Manufacturing Environment Multiproduct Break-Even in a Restaurant Effects of Changes in Costs, Including Tax Effects Operating Leverage

EXCEL APPLICATION EXERCISE 69. CVP and Break-Even COLLABORATIVE LEARNING EXERCISE 70. CVP for a Small Business INTERNET EXERCISE 71.

Cost Behavior at Southwest Airlines (http://www.southwest.com)

CHAPTER 2: I.

OUTLINE

Identifying Activities, Resources, Costs, and Cost Drivers {L. O. 1} Cost Drivers - Output measures of resources and activities. EXHIBIT 2-1 shows the traditional and activity-based views of cost behavior. To apply the activity-based view, we must identify the resources used by each activity and the cost driver for each resource. Organizations can have many cost drivers. In this chapter, volume-based cost drivers are used to examine cost behavior. See EXHIBIT 2-2 for examples of costs and potential cost drivers for value-chain functions.

II.

Variable-Cost and Fixed-Cost Behavior

{L. O. 2}

The terms variable and fixed are used to describe costs based on how a cost behaves with respect to changes in a particular cost driver. Variable Cost - a cost that changes in direct proportion to changes in the cost driver level (i.e., costs per unit do not change, total costs do change). Examples include the costs of materials, merchandise, parts, supplies, commissions, and many types of labor. Fixed Cost - a cost that is not immediately affected by changes in the cost driver level (i.e., costs per unit do change, total costs do not change within the relevant range). Examples include real estate taxes, real estate insurance, many executive salaries, and space rentals. EXHIBIT 2-3 summarizes the relationship between fixed and variable costs. See EXHIBIT 2-4 for the relationship between the receiving activity and the costs of the fuel and equipment resources. See EXHIBIT 2-5 for the total cost lines for total fuel and equipment lease costs. IIII.

Cost Behavior: Further Considerations A.

Complicating Factors for Fixed and Variable Costs Relevant Range - the limits (i.e., time period and/or activity) of cost-driver activity within which a specific relationship between costs and the cost driver is valid. See EXHIBIT 2-6 for a graph of fixed cost behavior within a relevant range.

Step- and Mixed-Cost Behavior Patterns

{L. O. 3}

Step Cost is a cost that changes abruptly at different intervals of activity because the resources and their costs come in indivisible chunks. See PANEL A of EXHIBIT 27 for an illustration of a decision where a step cost could be treated as a fixed cost. See PANEL B of EXHIBIT 2-7 for an illustration of a decision where a step cost could be treated as a variable cost. Mixed Cost is a cost that contains elements of both fixed- and variable-cost behavior.

Effect of Time Horizon and Magnitude on Cost Behavior Cost behavior often depends on the time frame affected by a decision and on the magnitude of the change in cost-driver activity. For long time spans or large changes in activity level, more costs behave as variable. For short time spans or small changes in activity level, more costs behave as fixed. The

IV.

Cost-Volume-Profit Analysis Cost-Volume-Profit (CVP) Analysis—the study of the effects of output volume on revenue (sales), expenses (costs), and net income (net profit). The major simplifying assumption is to classify costs as either variable or fixed with respect to the volume of output activity. A CVP scenario follows. A.

CVP Scenario

Graphing the CVP Relationship

{L. O. 4}

The BEP can also be found by graphing the cost and revenue relationships. The process takes the following steps. Step 1:

Step 2:

Step 3: Step 4:

Step 5:

Draw the axes. The horizontal axis = sales volume, and the vertical axis = cost and revenue amounts expressed in terms of currency units Plot revenue. Select a convenient value at the upper end of the relevant range for sales volume. Then draw a line between the origin and the point. Plot the fixed costs. It should be a horizontal line intersecting the vertical axis at the level of fixed costs. Plot fixed costs plus variable costs. Determine the variable portion of cost at the volume of a convenient level of activity. Add this amount to fixed costs and plot the point. Then draw a line from the intersection of the vertical axis to this point. This line represents total costs, and the difference between the fixed cost line and this new line represents the variable costs. Locate the break-even point. The break-even point is where the total cost line crosses the sales revenue line. See EXHIBIT 2-8 for an illustration of a CVP graph. Break-Even Point is the level of sales at which revenue equals total cost and net income is zero.

Almost all break-even graphs show revenue and cost lines extending back to the vertical axis. This approach misleads because the relationships depicted are only valid

within the relevant range. CVP analysis is based on a set of important assumptions, which include the following: 1. 2. 3. 4.

Costs can be classified into variable and fixed categories. Efficiency and productivity remain unchanged. The behavior of revenues and costs is accurate and is linear over the relevant range. Sales Mix (i.e., the relative proportions or combinations of quantities of products that constitute total sales) is constant. [See APPENDIX 2A for more on sales mixes.] The difference in inventory levels at the beginning and end of a period is insignificant.

Computing the Break-Even Point 1.

{L. O. 5}

General Equation Approach. The basic income statement equation used for CVP analysis is (unit sales price × number of units sold) − (unit variable cost × number of units sold) − fixed expenses = net income

Contribution-Margin Method. Contribution Margin (CM) Per Unit - the sales price per unit minus the variable cost per unit. The BEP is reached when total contribution margin equals total fixed costs. Dividing total fixed costs by the CM per unit gives the BEP in number of units. To compute the sales revenue needed to break even using the equation technique, the variable costs must be expressed as a percentage of sales revenue, which is called the Variable-Cost Ratio or Percentage. Then, letting S = the sales revenue to break even, solve for S in the equation: S - (variable-cost ratio x S) - fixed expenses = 0 CM Percentage or Ratio - the portion of every sales dollar/euro/pound etc. that contributes to covering fixed costs and, hopefully, provides for profit (divide total contribution margin by total sales). Dividing total fixed costs by the CM ratio (total contribution margin / total sales) yields the sales revenues required to break even. The use of the CM ratio is necessary when a firm produces more than one product.

Relationship Between the Two Techniques. Both approaches result in the following short-cut formulas: break-even volume (units) = (fixed cost)/(CM per unit) break-even volume (revenue) = (fixed cost)/(CM ratio)

Effects of Changes in Fixed Expenses or Contribution Margin 1.

Changes in Fixed costs Increases (decreases) in fixed costs increase (decrease) the BEP.

Changes in Unit Contribution Margin Increases (decreases) in the CM per unit decrease (increase) the BEP.

Target Net Profit and an Incremental Approach

{L. O. 6}

CVP analysis can be used to determine the target sales, in units and revenues, needed to earn a target profit. Using either the contribution margin or equation techniques results in the following shortcut equations. target sales volume in units = fixed cost + target net income CM per unit target sales volume in sales revenue= fixed cost + target net income CM ratio The Incremental Approach (i.e., the change in total results under a new condition in comparison with some given or known condition) can be used. Divide the target net income by the CM per unit and add the result to the unit BEP to get the target sales volume in units. Likewise, divide the target net income by the CM ratio and add the result to the BEP sales revenue to get the target sales volume in sales revenue. F.

Multiple Changes in Key Factors Multiple factor changes can be demonstrated by constructing income statements reflecting the changes and comparing before change and after change results. Also, an incremental approach can be used to isolate just the effects of the changes and eliminate irrelevant and potentially confusing data.

Nonprofit Application Nonprofit organizations, such as government agencies, can use the principles of CVP analysis to determine how many individuals they can serve with limited budgets and to assess the impact of changes in the level of funding and/or costs on their ability to provide services. See EXHIBIT 2-9 for a graphical presentation of the nonprofit analysis.

CVP Analysis and Computer-Based Spreadsheets Numerous combinations of fixed costs, selling prices, variable costs, and target income levels can be analyzed quickly using these computerized spreadsheets. See EXHIBIT 2-10 for an example of spreadsheet analysis.

IV.

Additional Uses of CVP Analysis A.

Margin of Safety The margin of safety shows how far sales can fall below the planned level of sales before losses occur. It compares the level of planned sales with the break-even point: margin of safety = planned unit sales – break-even unit sales A small margin of safety generally indicates greater risk exposure than a larger margin of safety.

Operating Leverage Operating Leverage - the firm’s ratio of fixed and variable costs. In highly leveraged firms, (i.e., those with high fixed costs and low variable costs) small changes in sales volume will result in large changes in net income. Less leveraged firms show smaller changes in net income with changes in sales volume. Above the BEP, net income increases faster for highly leveraged firms. However, below the BEP, losses mount more rapidly. See EXHIBIT 2-9 for a graph comparing high versus low operating leverage.

Best Cost Structure Companies try to find their most desirable combination of fixed- and variable-cost factors. Some choose to increase their CM ratios and fixed costs by automating, while others may choose to lower their fixed costs and lower their CM ratios by putting their sales force on commissions rather than paying salaries. When the CM percentage of sales is low, large increases in volume are necessary before significant improvements in net profits are possible. As sales exceed the BEP, a high CM percentage increases profits faster than a low CM percentage.

VI.

Contribution Margin and Gross Margin

{L. O. 7}

Gross Margin (or Gross Profit) - the excess of sales over the Cost of Goods Sold (i.e., cost of the acquired or manufactured merchandise to be sold). Contribution Margin is the excess of sales over all variable costs. See EXHIBIT 2-12 which shows costs divided on two different dimensions: gross margin and contribution margin. V.

Appendix 2A: Sales-Mix Analysis

{L. O. 8}

Sales Mix - the relative proportions or combinations of quantities of products that comprise total sales. If the proportions of the mix change, the CVP relationships may also change.

Generally, selling a higher (lower) proportion of high CM products than anticipated results in higher (lower) net income. Factors other than CM per unit of product (e.g., CM per unit of time) can be useful in making sales mix decisions (see Chapter 5 for further explanation). VI.

Appendix 2B: Impact of Income Taxes

{L. O. 9}

The target sales equation can be rewritten as target sales - variable expenses - fixed expenses = target after-tax income / (1 - tax rate) Letting N = the number of units of sales necessary to achieve the desired after-tax income and substituting values for the selling price per unit, variable expenses per unit, fixed expenses, target after-tax income, and the tax rate into the equation, N can be solved. Alternatively, the following shortcut formula may be used: change in net income = (change in volume in units) x (CM per unit) x (1 - tax rate) Each unit beyond the BEP adds to after-tax net profit at the unit CM multiplied by (1 - income tax rate). When incorporating income taxes in CVP analysis, the BEP does not change because the BEP is the point of zero profits. Therefore, there are no taxes on losses or zero profits.

CHAPTER 2:

Quiz/Demonstration Exercises

Learning Objective 1 1.

Cost drivers _____. a. b. c. d.

can be volume based affect the total level of costs incurred by companies are activities that cause costs to be incurred all of these

Production is one of the value-chain functions. Which one of the following is not an example of a cost driver for production costs? a. labor hours b. number of people supervised c. sales revenue d. machine hours

Learning Objective 2 3.

Which of the following will remain constant if the level of cost-driver activity increases within the relevant range? a. variable cost per unit b. total variable costs c. total fixed costs d. total costs e. A and C. f. B, C, and D

The limits of cost-driver activity within which a specific relationship between costs and the cost driver is valid is called _____. a. variable range b. total range c. relevant range d. valid range

Learning Objective 3 Items 5 and 6 are based on the following data: Sustainable Games produces and sells the high quality pool tables produced in accordance with environmentally and socially sustainable materials and processes. The company expects the following sales and expenses in 2021 for its tables: Sales (1,000 tables @ $400 per table)

$ 400,000

Variable expenses Fixed expenses

200,000 120,000

How many tables must be sold for Sustainable Games to break even? a. 200 b. 400 c. 600 d. 800

What is the breakeven level of sales revenue? a. $60,000 b. $120,000 c. $150,000 d. $240,000

Learning Objective 4 7.

Which of the following is not an assumption of cost-volume-profit analysis? a. The behavior of revenues and expenses is accurately portrayed and is linear over the relevant range. b. Costs can be classified into variable and fixed categories. c. Sales mix will be constant. d. Efficiency and productivity will both increase. e. The inventory level at the end of the period will be insignificantly different from that at the beginning.

Increase in contribution margin per unit _____. a. increases break-even point b. decreases break-even point c. does not change break-even point d. means there is a change in fixed cost per unit

Learning Objective 5 Items 9 and 10 are based on the following data (ignore income taxes): Bamboozle Ltd. manufactures and sells widgets. A projected income statement for the expected sales volume of 100,000 widgets is as follows: Sales Variable expenses Contribution margin Fixed expenses Before-tax profit

£7,500,000 3,000,000 £4,500,000 2,500,000 £2,000,000

How many widgets would need to be sold to earn a pre-tax profit of £2,900,000? a. 110,000 d. 140,000 b. 120,000 e. 100,000 c. 130,000 f. none of the above

10.

What amount of sales revenue would be required to achieve a pre-tax profit of £3,500,000? a. £7,000,000 b. £7,500,000 c. £9,500,000 d. £10,000,000

e. some other amount Learning Objective 6 11.

The difference between sales and cost of goods sold is commonly called _____. a. contribution margin b. operating income c. gross margin d. excess sales

12.

If variable selling costs increase, then contribution margin (assuming all else constant) must _____. a. stay the same b. increase c. decrease d. need more information

Learning Objective 7 13.

TwinCo produces and sells two products. Product A sells for $8 and has variable expenses of $3. Product B sells for $18 and has variable expenses of $10. It predicts sales of 20,000 units of A and 10,000 units of B. Fixed expenses are $100,000 per month. Assume that TwinCo hits its sales goal for February of $600,000, and exceeds its expected before-tax profit of $70,000. What has happened? a. TwinCo sold 40,000 units of product A and no product B. b. TwinCo sold more of both products A and B than expected. c. TwinCo sold more of product A and less of product B than expected. d. TwinCo sold more of product B and less of product A than expected.

14.

Breakeven in units for a multi-product firm is calculated as fixed costs divided by _____. a. the sum of the contribution margin percentages for each product b. the weighted average contribution margin of all the products c. the sum of the individual product contribution margins d. it is not possible to calculate breakeven in units for a multi-product firm

Learning Objective 8 15.

Refer to the data provided for Bamboozle Ltd. in problems 9 and 10. Now assume that the company is subject to a 40% tax rate. How many widgets must it sell to achieve an aftertax income of £1,500,000? a. 111,111 b. 333,333 c. 66,666 d. 142,857

16.

After-tax profit equals before-tax profit _____. a. multiplied by the tax rate b. multiplied by 1 minus the tax rate

c. d.

divided by the tax rate divided by 1 minus the tax rate

CHAPTER 2: 1. [d] 2. [c] 3. [e] 4. [c] 5. [c]

6. [d]

7. [d] 8. [b] 9. [b]

10. [d]

11. [c] 12. [c] 13. [c] 14. [b] 15. [a]

Solutions to Quiz/Demonstration Exercises

The CM per unit must be computed. In this case, it is $200 ($400,000 $200,000)/1000 tables. Dividing the $120,000 fixed expenses by the $200 per unit CM gives 600 sets. Either multiplying the unit BEP by the unit selling price or by dividing the fixed expenses by the CM ratio. Using the first method, 600 tables multiplied by a price of $400 per table gives $240,000 of sales to break even. With the second method, $120,000 of fixed expenses divided by .50 ($200,000 CM/$400,000 Sales) also yields $240,000 to break even.

Add the before-tax desired profit to the fixed expenses and divide the result by the CM per unit. In this case, $2,900,000 + $2,500,000 = $5,400,000 / ($4,500,000 / 100,000 cases) gives 120,000 cases. Divide the sum of the target before-tax income and the fixed expenses by the CM percentage. In this case that is $6,000,000 [$3,500,000 + $2,500,000] divided by .60 [$4,500,000/$7,500,000] = $10,000,000.

The CM ratios for the two products are 62.5% for A and 44.4% for B. When the sales mix shifts to products with higher CM ratios, profits increase. To solve this problem it is necessary to convert the after-tax income desired to the pretax income necessary. Dividing £1,500,000 by .60 (1 - tax rate) gives £2,500,000 in pre-tax income required. Adding this to the £2,500,000 in fixed costs yields a required contribution margin of £5,000,000. Using the data provided for 100,000 widgets, the selling price per widget is £75.00 and the variable costs per widget are £30.00. This gives a CM per unit of £45.00, which can be divided into the £5,000,000 total contribution margin to give 111,111 widgets needed to sell to get £1,500,000 after-tax profit.

16.[b]

Chapter 3 Measurement of Cost Behavior LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4.

Explain management influences on cost behavior. Measure and mathematically express cost functions and use them to predict costs. Describe the importance of activity analysis for measuring cost functions. Measure cost behavior using the engineering analysis, account analysis, high-low, visual-fit, and least-squares regression methods.

CHAPTER 3:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 26. Mixed Costs and the Sales Force 27. Committed and Discretionary Fixed Costs in Manufacturing 28. Cost Functions and Decision Making 29. Statistical Analysis and Cost Functions EXERCISES 30 Step Costs 31. Mixed Costs 32. Various Cost-Behavior Patterns 33. Plotting Data 34. Cost Function for Expedia 35. Predicting Costs 36. Identifying Discretionary and Committed Fixed Costs 37. Cost Effects of Technology 38. Mixed Cost, Choosing Cost Drivers, High-Low and Visual-Fit Methods 39. Account Analysis 40. Linear Cost Functions 41. High-Low Method 42. Economic Plausibility of Regression Analysis Results PROBLEMS 43. Controlling Risk, Capacity Decisions, Technology Decisions 44. Step Costs 45. Government Service Cost Analysis 46. Cost Analysis at US Airways 47. Separation of Drug Testing Laboratory Mixed Costs into Variable and Fixed Components 48. School Cost Behavior 49. Activity Analysis 50. High-Low, Regression Analysis 51. Interpretation of Regression Analysis 52. Regression Analysis 53. Choice of Cost Driver 54. Use of Cost Functions for Pricing 55. Review of Chapters 2 and 3 CASES 56. 57. 58. 59.

Government Health Cost Behavior Activity Analysis Identifying Relevant Data Nike 10-K Problem: Step- and Mixed Cost Drivers

60.

Fixed and Variable Cost Data

COLLABORATIVE LEARNING EXERCISE 61. Cost-Behavior Examples INTERNET EXERCISE 62. Cost Behavior at Southwest Airlines (http://www.southwest.com)

CHAPTER 3: I.

OUTLINE

Cost Drivers and Cost Behavior Accountants and managers assume that cost behavior is linear over some relevant range of activities or change in cost drivers. Linear-Cost Behavior - graphed with a straight line when a cost changes proportionately with changes in a single cost driver. Volume of a product produced or service provided is the primary driver for some costs. Other costs are more affected by activities not directly related to volume and often have multiple cost drivers. These costs are not easily identified with or traced to units of output. In practice, many organizations use a single cost driver to describe each cost even though many have multiple causes. Careful use of linear-cost behavior with a single cost driver often provides cost estimates that are accurate enough for most decisions, though each cost may have a different cost driver. The use of linear cost behavior may be justified on costbenefit grounds. See EXHIBIT 3-1 for a graph of linear-cost behavior, the relevant range, and an activity or resource cost driver level.

II.

Management Influence on Cost Behavior

{L. O. 1}

Managers can influence cost behavior through their decisions about such factors as product or service attributes, capacity, technology, and policies to create incentives to control costs. A.

Product and Service Decisions and the Value Chain - product mix, design, performance, quality, features, distribution, and so on influence costs (i.e., the value chain).

Capacity Decisions. Strategic decisions about the scale and scope of an organization's activities result in fixed levels of capacity costs. Capacity Costs are the fixed costs of being able to achieve a desired level of production or service. Companies, such as Volkswagen, must be careful in controlling the level of capacity costs when they have long-term variation in demand.

Committed Fixed Costs – usually associated with investments in non-current assets such as property, plant, and equipment. These are typically large, indivisible amounts that the organization is obligated to incur or usually would not consider avoiding (e.g., mortgage or lease payments, interest payments on long-term debt, property taxes, insurance, and salaries of key personnel).

Discretionary Fixed Costs - no obvious relationship to levels of output activity but are determined as part of the periodic planning process. Management decides that certain levels of these costs should be incurred to meet the organization's goals (e.g., advertising and promotion costs, public relations, research and development costs, charitable donations, employee training programs, and purchased management consulting services). Discretionary fixed costs can be easily altered but become fixed until the next planning period.

Technology Decisions (e.g., labor-intensive versus robotic manufacturing or traditional banking services versus online banking) position a company to meet current goals and to respond to changes in the environment and affect the costs of products and services.

Cost-Control Incentives - created by management to have employees control costs. Managers use their knowledge of cost behavior to set expectations, and employees may receive compensation or other rewards that are tied to meeting these expectations while maintaining quality and service.

III.

Cost Functions

{L. O. 2}

Cost Measurement (or measuring cost behavior) - the first step in estimating or predicting costs as a function of appropriate cost drivers. The second step is to use these cost measures to estimate future costs at expected levels of the cost-driver activity. Measuring costs without obvious links to cost drivers presents some difficulty. Assumed relationships between costs and cost drivers are often used. A.

Form of Cost Functions. Cost Function - Algebraic equations that describe the relationship between a cost and its cost driver(s). A typical cost function equation is: Y = F + VX

where:

Y = Total cost F = Fixed cost V = Variable cost X = Cost-driver activity

When this mixed cost function is graphed, F is the intercept of the vertical axis and V is the slope of the cost function. Sometimes two or more cost drivers are used. B.

Developing Cost Functions

Two principles should be applied to obtain accurate and useful cost functions: plausibility (i.e., believable) and reliability (conformity between a cost function’s estimate of costs at actual levels of activity and actually observed costs). Choice of Cost Drivers: Activity Analysis {L. O. 3} Activity Analysis - identifies appropriate cost drivers and their effects on the costs of making a product or providing a service. The final product or service may have a number of cost drivers because a number of separate activities may be involved. Cost Prediction - applies cost measures to expected future activity levels to forecast future costs. Activity analysis is especially important for measuring and predicting costs for which cost drivers are not obvious. For many years, most organizations used only one cost driver: the amount of direct labor. However, previously "hidden" activities greatly influence cost behavior. Activities related to the complexity of performing tasks affect costs more directly than labor usage or other volume-related activity measures.

IV.

Methods of Measuring Cost Functions A.

{L. O. 4}

Engineering Analysis - measures cost behavior according to what costs should be, not by what costs have been. It entails a systematic review of materials, supplies, labor, support services, and facilities needed for products and services. This can be used for existing products or for new products similar to what has been produced before. Disadvantages are that it is extremely costly and not timely. Copyright ©2023 Pearson Education, Ltd

Account Analysis - selects a volume-related cost driver and classifies each account from the accounting records as a variable or fixed cost. The cost analyst then looks at each cost account balance and estimates either the variable cost per unit of cost driver activity or the periodic fixed cost.

High-Low, Visual Fit, and Least-Squares Methods These methods rely on the use of past cost data to predict costs. These methods may not be particularly useful in predicting costs for changing organizations. If these methods are used, the cost analyst must be careful that the historical data that is from a past environment is not obsolete. Historical data may hide past inefficiencies that could be reduced if they are identified. 1.

High-Low Method - makes use of the costs and activity levels for the high and low activity levels in a set of data (unless one of these levels is viewed as an outlier). The difference in costs for the two activity levels is divided by the difference in activity levels to determine the variable cost per unit of activity. Then, either the high activity level and the cost at that activity level or the low activity level and the cost at that activity are used to solve for the fixed cost. Due to its reliance on just two data points, this method is rarely used in practice (see EXHIBIT 3-3).

Visual-Fit Method - more reliable than the high-low method because all the available data are used. In the visual fit method, the cost analyst visually fits a straight line through a plot of all of the available data. The line is extended back until it intersects the vertical axis of the graph. The analyst measures where the line intersects the cost axis to estimate the fixed cost. An activity level is selected and the total mixed cost at that activity level is used to determine the variable cost per unit of activity by subtracting fixed cost from the total mixed cost amount and dividing by the activity level. The subjectivity in placing the line and in estimating the fixed and variable costs are disadvantages of this method and is rarely used in practice (see EXHIBIT 3-).

Least-Squares Regression Method – (or simply regression analysis) uses statistics to fit a cost function to all the data. Using one cost driver requires simple regression, while using more than one cost driver requires the use of multiple regression. Regression analysis usually measures cost behavior more reliably than other cost measurement methods. In addition, regression analysis yields important statistical information about the reliability of cost estimates so analysts can assess confidence in the cost measures and select the best cost driver. Coefficient of Determination (R2) - measures how much of the fluctuation of a cost is explained by changes in the cost driver (see EXHIBIT 3-5).

Appendix 3: Use and Interpretation of Least-Squares Regression This appendix provides an example of the use of computer spreadsheet regression commands to perform simple linear regression. Plotting the data and the possible elimination of outliers are discussed. A data set with two possible cost drivers is presented (see EXHIBIT 3-6) and the output from the regression commands is presented. The R2 values of two regression equations are compared to see which regression equation best fits the data. Caution is required because the assumptions of regression analysis should be examined to ensure that the data comply so that useful results can be obtained. Regression Assumptions – (1) Linearity within the relevant range; (2) Constant variance of residuals; (3) Independence of residuals; and (4) Normality of residuals.

CHAPTER 3:

Quiz/Demonstration Exercises

Learning Objective 1 1.

Managers influence cost behavior through their _____. a. technology decisions b. product and service decisions c. capacity decisions d. all of these e. only A and B

One of the following costs is an example of a discretionary fixed cost. a. investment in production equipment b. investment in the factory c. electricity costs d. research and development costs e. raw material purchases

Learning Objective 2 3.

In the cost function equation Y = F + VX, V represents the _____. a. total cost at the X level of activity b. fixed cost at the Y level of activity c. variable cost per unit of activity X d. variable cost at the F level of activity

In the cost function equation Y = F + VX, F represents the _____. a. slope b. intercept c. dependent variable d. independent variable

Learning Objective 3 5.

Which of the following organizations may use activity analysis? a. Robert Bosch GmbH b. Booking.com c. PwC (an international auditing, tax, and consulting firm) d. only A and B e. only C f. A, B, and C

d. e. f. g.

have benefits that outweigh the costs A, B, C, and D only A and D only A, C, and D

Learning Objective 4 7.

A school cafeteria incurred the following costs for September 20x7: Monthly Cost September 20x7 Amount Manager's salary Hourly workers' wages and benefits Food Equipment depreciation Supplies Total cafeteria costs

$ 3,000 18,000 15,000 2,000 3,000 $41,000

The cafeteria served 12,500 meals to students and staff during the month. Using an account analysis to classify costs, the cost function for the cafeteria is _____ per meal. a. c.

$5,000 + $2.88 b.$8,000 + $1.62 $33,000 + $1.60 d.$20,000 + $3.52

Use the following information for questions 10 through 12. The restaurant and bar at Hirsch Hotel has recorded the following costs and number of meals served from January through September of 20x7: Month

Cafeteria Costs

January February March April May June July August September

€31.800 34.400 36.900 38.300 38.600 34.700 36.300 43.000 41.200

Meals Served 8.800 9.000 9.800 10.200 10.500 9.200 9.700 12.000 11.500

Using the high-low method of cost estimation, the variable cost per meal served is _____. a. €2,666 b. €2,76 c. €3,50 d. €3,54

10.

The cost function derived using the high-low method, which can be used to estimate the costs of running the cafeteria is _____. a. €630 + €3,54X b. €10,733 + €2,666X c. €1,000 + €3,50X d. €10,928 + €2,76X e. €10,733 + €2,76

11.

Hampton Plc. used regression analysis to predict the annual cost of indirect materials. The results were as follows: Regression Output: Constant Std Err of Y Est R Squared Number of Observations X Coefficient(s) Std Err of Coef.

a. b. c. d.

£21,890 4,560 0.7832 22 11.75 2.1876

What is the linear cost function? Y = £20,100 + £4.60X Y = £21300 + £2.1876X Y = £21,890 +11.75X Y = £ 4,560 + £5.15X

CHAPTER 3:

Solutions to Quiz/Demonstration Exercises

1. [d] 2. [d] 3. [c] 4. [b] 5. [f] 6. [e] 7. [a] In order to answer this problem, the costs must first be classified as fixed or variable in relation to the cost driver. In this case, the supervisor's salary ($3,000 per month) and the equipment depreciation ($2,000 per month) are fixed, while the remaining costs ($36,000) vary with the number of meals served. Dividing the variable costs by the number of meals served gives $2.88 per meal, and the department's cost function is $5,000 + $2.88 per meal. 8. [c] The data for January and August are used since 8,800 is the low level of activity for the data set and 12,000 is the high level of meals served. Subtracting the cost for the low activity level from the cost at the high activity level gives $11,200 ($43,000 - $31,800). Dividing this by the difference in the activity levels of 3,200 meals (12,000 - 8,800) gives a rate of $3.50 per meal. 9. [b] Using the variable cost per meal found above of $3.50 and the low level of activity of 8,800 meals, the variable cost at that activity level is $30,800. Since the total cost of operating the cafeteria when 8,800 meals were served is $31,800, $1,000 is the estimate of fixed costs ($31,800 - $30,800). The variable cost per meal could also be multiplied by the highactivity level 12,000 to get $42,000 which can be deducted from the total cost at that level of $43,000 to also arrive at the estimate of fixed costs of $1,000. 10. [c] This answer is constructed using the elements found in answering questions 10 and 11. 11. [c]

Chapter 4 Cost Management Systems and Activity-Based Costing LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 9.

Describe the purposes of cost management systems. Explain the relationship among cost, cost object, cost accumulation, and cost assignment. Distinguish between direct and indirect costs. Explain the major reasons for allocating costs. Identify the main types of manufacturing costs: direct materials, direct labor, and indirect production costs. Explain how the financial statements of merchandisers and manufacturers differ because of the types of goods they sell. Understand the main differences between traditional and activity-based costing (ABC) systems and why ABC systems provide value to managers. Use activity-based management (ABM) to make strategic and operational control decisions. Describe the steps in designing an activity-based costing system (APPENDIX 4).

CHAPTER 4:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 31. Marketing and Capacity Planning 32. ABC and ABM Compared 33. ABC for Product Costing and Operational Control 34. ABC and Cost Management Systems 35. ABC and Benchmarking EXERCISES 36. Classification of Manufacturing Costs 37. Confirm Your Understanding of the Classification of Manufacturing Costs 38. Variable Costs and Fixed Costs; Manufacturing and Other Costs 39. Direct, Indirect, and Unallocated Costs 40. Cost Allocation in ABC 41. Activity-Based Costing 42. Two-Stage Activity-Based Costing—Stage One 43. Two-Stage Activity-Based Costing, Banking, Benchmarking 44. Direct, Indirect, and Unallocated Costs PROBLEMS 45. Cost Accumulation and Allocation 46. Hospital Allocation Base 47. Traditional and ABC Cost Accounting, Activity-Based Management 48. Activity-Based Costing and Product Line Profitability 49. Activity-Based Costing and Activity-Based Management, Automotive Supplier 50. Research in Activity-Based Costing or Activity-Based Management 51. Review of Chapters 2, 3, and 4 52. Review of Chapters 2, 3, and 4 53. Review of Chapters 2, 3, and 4 CASES 54. 55. 56. 57. 58.

Multiple Allocation Bases Traditional Versus ABC Systems ABC and Customer Profitability in Financial Services Identifying Activities, Resources, and Cost Drivers in Manufacturing Nike 10k Problem: Nike’s Cost Accounting System

EXCEL APPLICATION EXERCISE 59. Traditional Costing Versus Activity-Based Costing COLLABORATIVE LEARNING EXERCISE 60. Internet Research, ABC, and ABM INTERNET EXERCISE

61.

Vermont Teddy Bear Factory (http://www.vermontteddybear.com)

CHAPTER 4: I.

OUTLINE

Cost Management Systems

{L. O. 1}

A collection of tools and techniques that identifies how management’s decisions affect costs. The primary purposes are 1) aggregate measures of inventory value and cost of goods manufactured for external reporting to investors, creditors, and other external stakeholders; 2) cost information for strategic management decisions; and 3) cost information for operational control. A.

Cost Accounting Systems

{L. O. 2}

All kinds of organizations need some form of cost accounting, that part of the cost management system that measures costs for the purposes of management decisionmaking and financial reporting. The cost accounting system typically involves two processes: (1) Cost Accumulation—collecting costs by some “natural” classification such as materials or labor, and (2) Cost Allocation/Assignment—attaching costs to one or more cost objectives. (See EXHIBIT 4-1) B.

Cost Objectives Cost—a sacrifice or giving up of resources for a particular purpose. Cost Object (or Cost Objective)—anything for which managers want a separate measurement of costs (e.g., a product, a department, a sales region, a program, or something else for which decisions are made).

II.

Cost Terms Used for Strategic Decision Making and Operational Control Purposes {L. O. 3} A.

Direct Costs, Indirect Costs, and Cost Allocation

Direct Costs—identified specifically and exclusively with a given cost objective in an economically feasible way (tracing). Indirect Costs—not identified specifically and exclusively with a given cost objective in an economically feasible way. Cost allocation—to assign indirect costs to cost objects. A cost-allocation base is some measure of input or output that determines the amount of cost to be allocated to a particular cost object. Managers prefer to classify many costs as direct whenever it is “economically feasible” because it gives them greater confidence in their costs of products and services (i.e., less subjectivity). A particular cost can be direct for one cost objective but indirect for others. B.

Purposes of Cost Allocation

{L. O. 4}

Four purposes of cost allocation: (1) To predict the economic effects of strategic and

operational control decisions; (2) To provide desired motivation and to give feedback for performance evaluation; (3) To compute income and asset valuations for financial reporting; and (4) To justify costs or obtain reimbursement. Allocating fixed costs usually creates the greatest problems. C.

Methods of Cost Allocation Allocating indirect costs is a 5-step process: 1.

2. 3. 4. 5.

Accumulate indirect costs for a period into one or more cost pools. A cost pool is a group of individual costs that a company allocates to cost objects using a single cost-allocation base. Select an allocation base for each cost pool, preferably a cost driver, that is, a measure that causes the costs in the cost pool. Measure the units of the cost-allocation base for each cost object (e.g., a product) and compute the total units for all cost objects (e.g., all products). Determine the percentage of total cost-allocation base units used for each cost object. Multiply the percentage in step 4 by the total costs in the cost pool to determine the cost allocated to each cost object.

Unallocated Costs Unallocated Costs are too difficult to establish a cause-and-effect relationship (see EXHIBIT 4-2). Unallocated costs are costs that an accounting system records but does not allocate to any cost object (e.g., research and development, process design, legal expenses, accounting, information services, and executive salaries). (See EXHIBIT 4-3.)

III.

Cost Terms Used for External Reporting Purposes

{L. O. 5}

Categories of Manufacturing Costs Direct-Materials Costs—the acquisition costs of all materials that are physically identified as a part of the manufactured goods and that may be traced to the manufactured goods in an economically feasible way. Direct-Labor Costs—the wages of all labor that can be traced specifically and exclusively to the manufactured goods in an economically feasible way. Indirect Production Costs (Indirect Manufacturing Costs, Factory Overhead, Factory Burden, or Manufacturing Overhead)—include all costs other than direct material or direct labor that are associated with the manufacturing process (e.g., power, supplies, indirect labor, supervisory salaries, property taxes, rent, insurance, and depreciation).

Product Costs and Period Costs Product Costs—costs (e.g., direct materials, direct labor, and factory overhead) initially identified with goods produced or purchased for resale (i.e., inventory) and become expenses (i.e., cost of goods sold) only when the inventory is sold. Period Costs—costs (e.g., selling and general administration expenses) that are deducted as expenses during the current period without going through the inventory stage. EXHIBIT 4-4 shows the flow of costs for both merchandising companies and manufacturing companies. Note that manufacturing companies have three categories of inventory whereas only one is present for merchandisers. Direct-Materials Inventory—materials on hand and awaiting use in the production process. Work-In-Process Inventory—goods undergoing the production process but not yet fully completed. Costs include appropriate amounts of the three major manufacturing costs (i.e., direct material, direct labor, and factory overhead). Finished-Goods Inventory—goods fully completed but not yet sold.

Balance Sheet and Income Statement Presentation of Costs

{L. O. 6}

Typically, manufacturing and merchandising companies treat selling and administrative expenses in the same manner, but the detail of COGS differs. Manufacturers show the manufacturing cost of goods produced and then sold, which is composed of the three major cost categories: direct materials, direct labor, and factory overhead (see EXHIBIT 4-4). Merchandisers simply show the purchased cost of items, including freight, rather than the cost of goods manufactured and sold. IV.

Traditional and Activity-Based Cost Accounting Systems

{L. O. 7}

In the past, almost all companies used traditional costing systems—those that do not accumulate or report costs of activities or processes. This works well for fairly simple production and operating systems. The business environment has become more complex. This has led to the most significant improvement in cost accounting system design—activitybased costing (ABC). Many ABC teams find it useful to develop a process map—a schematic diagram with symbols that captures the interrelationships between cost objects, activities, and resources (see EXHIBIT 4-5). A.

An Illustration of Traditional (see EXHIBIT 4-6) and ABC Systems Activity-Based Accounting (ABA) or Activity-Based Costing (ABC) systems first

accumulate overhead costs for each of the activities of an organization, and then assign the costs of activities to the products, services, or other cost objects that caused that activity. Cost Drivers are identified for each activity to establish a cause-effect relationship between an activity and a cost object. Traditional systems often use only one cost driver and do not attempt to identify, accumulate, or report costs by activities performed. There are many variations in the design of ABC systems. In a two-stage ABC system (see EXHIBIT 4-7), there are two stages of allocation to get from the original resource cost to the final product or service cost. The first stage allocates costs to activity-cost pools. A cost pool is a group of individual costs that is allocated to cost objectives using a single cost driver. The second stage allocates activity costs to the products or services. The first-stage cost drivers are usually percentages. V.

Activity-Based Management: A Cost Management System Tool

{L. O. 8}

Activity-based management (ABM) is using the output of an activity-based cost accounting system to aid strategic decision-making and to improve operational control of an organization. One of the most useful applications of ABM is distinguishing between value-added cost (the necessary cost of an activity that a company cannot eliminate without affecting a product’s value to the customer), and nonvalue-added cost (unnecessary costs that a company tries to minimize and eliminate without affecting a product’s value to the customer). Examples of non-value-added costs are handling and storing inventories, and changing the setup of production-line operations to produce a different model of the product. Another ABC-related technique that has gained popularity is benchmarking (the continuous process of comparing products, services, and activities to the best industry standards. A.

Benefits of Activity-Based Costing and Activity-Based Management Many organizations in the manufacturing industry and service sector are adopting ABC systems because: 1.

3. 4.

Fierce competitive pressure has resulted in shrinking profit margins. Companies often do not have confidence in the accuracy of the margins for individual products or services. Greater diversity in the types of products and services, as well as customer classes, results in greater business operating complexity. The consumption of a company’s shared resources also varies substantially across products and customers. New production techniques have increased the proportion of indirect costs. The rapid pace of technological change has shortened product life cycles. Companies do not have time to make price or cost adjustments once they discover costing errors. The costs associated with bad decisions that result from inaccurate cost determinations are substantial (e.g., lost bids and hidden losses from

VI.

undercosted products). Computer technology has reduced the costs of developing and operating ABC systems.

Appendix 4: Detailed Illustration of Traditional and Activity-Based Cost Accounting Systems The chapter presents an illustration of the use of activity-based costing to provide more accurate costing for the Billing Department of AT&T’s smaller customer care centers, with two major customer classes (i.e., account inquiry and bill-printing services). EXHIBIT 4-8 shows the traditional costing system that has been in use. All billing department costs are totaled and then divided by the total number of customer inquiries (residential + commercial) to arrive at a cost per inquiry. This amount is then multiplied by the number of inquiries from each type of customer and divided by the number of customers of each type to give the cost/customer. The amounts derived are $4.58 per residential customer and $6.88 per commercial customer. Not being satisfied with the accuracy of the amounts produced under their traditional costing system, AT&T developed an activity-based costing system. A.

Design of an Activity-Based Cost Accounting System 1. 2. 3. 4.

{L. O. 9}

Determine the key components (project scope, cost objectives, key activities, resources, and related cost drivers). Determine the relationships among cost objects, activities, and resources (see EXHIBIT 4-9). Collect relevant data concerning costs and the physical flow of cost-driver units among resources and activities (see EXHIBITS 4-10 and 4-11). Calculate/interpret the new activity-based cost information (see EXHIBITS 4-12 and 4-13).

The detailed application of these steps for AT&T is provided in the text. Of particular interest are the key results of the study—the actual determination of the activity-based costs. In the key results, the residential customer’s cost is $3.98 compared to $4.58 with the traditional costing system, and the commercial customer’s cost is $10.50 compared to $6.88 derived under the traditional system. This result is common when high-volume cost objects with simple processes are overcosted when only one volume-based cost driver is used. B.

Strategic Decisions, Operational Cost Control, and ABM The conclusion of the AT&T chapter problem is summarized.

CHAPTER 4:

Quiz/Demonstration Exercises

Learning Objective 1 1.

The primary purposes of a cost-management system do not include _____. a. operational control b. inventory valuation c. strategic management decisions d. cost allocation

The cost accounting system typically involves two processes—cost allocation/assignment and _____. a. cost accumulation b. optimal cost mix c. cost estimation d. cost identification

Learning Objective 2 3.

The tracing or reassigning of costs to one or more cost objectives is referred to as _____. a. mixed-up costing b. historical costing c. cost allocation d. cost making

A sacrifice or giving up of resources of particular purpose is called _____. a. cost objective b. allocation base c. objective d. cost

Learning Objective 3 Items 5 and 6 are based on the following data: Anton, Inc., incurred the following costs in 2010 in producing video games: Wages $350,000 20,000 50,000

Machine operators Factory janitors Factory supervisor

Computer chips Casings Labels Glue

Materials used $300,000 200,000 100,000 25,000

Anton’s 2010 product indirect labor was _____. a. $ 70,000 b. $ 20,000

c. d. 6.

$ 350,000 $ 370,000

Mario’s product direct materials costs for 2010 were _____. a. $ 625,000 b. $ 300,000 c. $ 600,000 d. $ 25,000

Learning Objective 6 7.

Which of the following can be inventory costs? a. raw materials b. indirect labor c. direct labor d. factory overhead e. A, B, C, and D f. only A, B, and C

Reed Company had the following partial balance sheet for the year ended 20x7. Cash Accounts receivable Merchandise inventories Plant and equipment

$ 400,000 50,000 5,773,420 1,000,000

Reed is an example of a _____. a. service company b. merchandise company c. wholesale organization d. none of these Learning Objective 7 9.

The cost accounting system that uses a single cost pool for all indirect production costs is called _____. a. activity-based costing b. single level costing c. traditional costing d. all of the above

10.

A cost pool is a group of costs that is allocated to cost objectives using _____. a. only on cost driver b. the number of products made c. the number of products sold d. at least two cost drivers

no more than five cost drivers

Learning Objective 9 11.

The fourth step in the design and implementation of an activity-based-costing system is _____. a. determine cost objective b. collect relevant data concerning costs c. calculate and interpret the new activity-based information d. develop a process-based map that represents the flow of activities

12.

Activity-based costing usually can _____. a. decrease the number of cost drivers b. decrease the amount of money spent on a system c. turn indirect costs into direct costs d. reduce the accuracy of the cost allocations

CHAPTER 4: 1. [d] 2. [a] 3. [c] 4. [d] 5. [a]

6. [c]

7. [e] 8. [b]

Solutions to Quiz/Demonstration Exercises

If the cost objective is the product, then direct labor costs are those traceable to the product. Under most accounting systems, only the machine operators costs would be traceable to the product and the janitors and supervisors wages would be classified as indirect. Whereas all of the materials costs would be direct to the plant, only the computer chip, casing, and label costs would be direct to the product. The glue would be an allocated cost to the product. Manufacturing companies typically have three categories of inventory whereas merchandisers have only one category listed in their balance sheets. The income statements also differ (e.g., a cost of goods manufactured and sold versus a cost of purchased goods sold).

9. [c] 10. [a] 11. [c] 12. [d]

Chapter 5 Relevant Information for Decision Making with a Focus on Pricing Decisions LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 8.

Discriminate between relevant and irrelevant information for making decisions. Apply the decision process to make business decisions. Construct absorption and contribution-margin income statements, and identify their relevance for decision making. Decide to accept or reject a special order using the contribution-margin approach. Explain why pricing decisions depend on the characteristics of the market. Identify the factors that influence pricing decisions in practice. Compute a sales price by various methods, and compare the advantages and disadvantages of these methods. Use target costing to decide whether to add a new product.

CHAPTER 5:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 23. Fixed Costs and the Sales Function 24. Income Statements and Sales Managers 25. The Economics of the Pricing Decision 26. Pricing Decisions, Ethics, and the Law 27. Target Costing and the Value Chain EXERCISES 28. Pinpointing Relevant Costs 29. Information and Decisions 30. Identification of Relevant Costs 31. Straightforward Absorption Statement 32. Straightforward Contribution Income Statement 33. Straightforward Absorption and Contribution Statement 34. Absorption Statement 35. Contribution Income Statement 36. Special-Order Decision 37. Unit Costs and Total Costs 38. Advertising Expenditure and Nonprofit Organizations 39. Variety of Costs Terms 40. Acceptance of Low Bid 41. Pricing by Auto Dealer 42. Pricing to Maximize Contribution 43. Target Selling Prices 44. Competitive Bids 45. Target Costing 46. Target Costing PROBLEMS 47. Pricing, Ethics, and the Law 48. Analysis with Contribution Income Statement 49. Pricing and Contribution-Margin Technique 50. Cost Analysis and Pricing 51. Pricing of Education 52. Profit from Direct Selling vs. Royalty from Pay per View 53. Use of Passenger Jets 54. Effects of Volume on Operating Income 55. Pricing for a Guided Tour in Darjeeling Himalayan Railway 56. Pricing of a Special Order 57. Pricing and Confusing Variable and Fixed Costs 58. Demand Analysis 59. Target Costing 60. Target Costing and ABM 61. Target Costing Over Product Life Cycle

CASES 62. 63.

Use of Capacity Nike 10k Problem – Special Order

EXCEL APPLICATION EXERCISE 64. Determining Whether to Accept a Special Order COLLABORATIVE LEARNING EXERCISE 65. Understanding Pricing Decisions INTERNET EXERCISE 66. Marketing Decisions at Colgate-Palmolive (www.colgatepalmolive.com)

CHAPTER 5: I.

OUTLINE

The Concept of Relevance

{L. O. 1}

Whether information is relevant depends on the decision to be made. Accountants assist managers in making decisions by collecting and reporting relevant information. A.

What is Relevance? Relevant Information—the predicted future costs and revenues that will differ among alternatives. Although past data may be helpful in predicting future costs and revenues, past data is irrelevant in making future decisions. The authors provide two examples of the need for deciding relevant costs (i.e., which gas station to select to fill your tank and get the car lubricated, and the choice of materials for making a line of food containers). The expected future costs that differ between alternatives are the relevant costs to be used in selecting from the competing alternatives.

A Decision Model

{L. O. 2}

See EXHIBIT 5-1 for an illustration of the decision process and the role of information in the process. Historical data from the accounting system is combined with other data from outside the accounting system to formulate predictions. The predictions are then input into a decision model (i.e., any method used for making a choice) in order for a decision to be made, implemented, and evaluated. C.

Accuracy and Relevance Accountants often are forced to choose between more relevance and more accuracy. Precise but irrelevant information is worthless for decision-making. Imprecise but relevant information can be quite useful. Qualitative (subjective) information can be as important, or more important, than quantitative (financial) information.

The Relevance of Alternative Income Statements

{L. O. 3}

EXHIBIT 5-2 and EXHIBIT 5-3 provide schedules of factory overhead, and selling and administrative expenses for Cordell Company. E.

Absorption Approach (see EXHIBIT 5-4 for Absorption Income Statement). Absorption Costing—all factory overhead (both variable and fixed) is treated as product cost that becomes an expense in the form of manufacturing cost of goods sold only as sales occur. GAAP accounting requires the use of absorption costing. Gross Profit or Gross Margin is the difference between sales and fully absorbed cost of goods sold. Selling and Administrative expenses are treated as period expenses and

are deducted from gross profit to arrive at operating income. Costs are classified according to the three major functions (i.e., manufacturing, selling, and administrative) of management under absorption costing. F.

Contribution Approach (see EXHIBIT 5-5 for contribution income statement). Contribution Approach—all variable costs (both manufacturing and selling and administrative) are deducted from sales to result in Contribution Margin. Fixed expenses are deducted from the contribution margin to arrive at Operating Income. Costs are classified according to behavior (i.e., variable or fixed) under the contribution approach to income determination.

Comparing Contribution and Absorption Approaches The contribution-margin approach separates costs based on the primary distinction of cost behavior pattern. It deducts variable costs from sales to compute a contribution margin and then deducts fixed costs to measure profit. The absorption approach separates costs based on the primary distinction of manufacturing versus nonmanufacturing costs to measure profit. It deducts manufacturing costs from sales to compute a gross margin and then deducts nonmanufacturing costs to measure profit.

II.

Pricing Special Sales Order A.

Illustrative Example See EXHIBIT 5-5 for the contribution income statement of the Cordell Company. They examine whether a special order offered at $26 per unit received near year-end from a mail-order house should be accepted. The order would (1) not affect regular business, (2) not raise antitrust issues regarding price discrimination, (3) not affect total fixed costs, (4) not require additional variable selling and administrative expenses, and (5) use some otherwise idle manufacturing capacity.

Correct Analysis—Focus on Relevant Information and Cost Behavior {L. O. 4} See EXHIBIT 5-6 for the correct analysis using the contribution format income statement. The only relevant items are the increased revenues ($2,600,000) and increased costs ($2,400,000) associated with the special order. Although they may be included in the analysis, fixed costs that do not differ between alternatives are irrelevant.

Incorrect Analysis—Misuse of Unit Cost Misinterpreting fixed unit costs may cause a manager to decide that a special order results in a bad decision due to a mistreatment of the fixed

manufacturing costs (i.e., treating them as variable). D.

Confusion of Variable and Fixed Costs The $6 of fixed manufacturing cost per unit included in the $30 per unit manufacturing cost used in the incorrect analysis creates the flaw in the analysis. Total fixed costs will remain at constant regardless of whether different amounts of units are produced as long as both levels of activity are within the relevant range (see EXHIBIT 5-6).

Activity-Based Costing, Special Orders, and Relevant Costs Businesses that have identified all their significant cost drivers can predict the effects of special orders more accurately. The Cordell Company example is extended to indicate that, of the $24,000,000 of variable manufacturing costs expected to produce 1,000 units of product, $21,000,000 varies directly with units produced and $3,000,000 varies with the number of setups. The profitability of the special order for 100,000 units would now depend on the number of setups necessary for its production. Two levels are examined with one showing that the order would be profitable and the other showing that it would decrease profits.

III.

Basic Principles for Pricing Decisions

{L. O. 5}

In addition to pricing special orders, managers make the following pricing decisions: (1) Setting the price of a new or refined product; (2) Setting the price of products sold under private labels; (3) Responding to a new price of a competitor; and (4) Pricing bids in both sealed and open bidding situations. A.

The Concept of Pricing In perfect competition, all competing firms sell the same type of product at the same price. A firm can sell as much of a product as it can produce. The marginal cost (see EXHIBIT 5-7) is the additional cost resulting from producing and selling one additional unit. With a fixed set of production facilities, the marginal cost often decreases as production increases up to a point because of efficiencies created by larger volumes. Marginal revenue is the additional revenue resulting from the sale of an additional unit. In perfect competition, the marginal revenue curve is a horizontal line equal to the price per unit at all volumes of sales. As long as the marginal cost is less than the marginal revenue (price), additional production and sales are profitable. The profit-maximizing volume is the quantity at which marginal cost equals price. In imperfect competition, the price a firm charges for a unit will influence the quantity of units it sells (see EXHIBIT 5-8). At some point, the firm must reduce prices to generate additional sales.

To estimate marginal revenue, managers must predict the price elasticity – the effect of price changes on sales volume (see EXHIBIT 5-9). If small price increases cause large volume declines, demand is highly elastic. If prices have little or no effect on volume, demand is highly inelastic. Marginal cost is essentially the variable cost. Accountants assume that variable cost is constant within a relevant range of volume, whereas marginal cost may change with each unit produced. Within large ranges of production volume, however, changes in marginal cost are often small. B.

Pricing and Accounting Accountants seldom compute marginal revenue curves and marginal cost curves. Instead, they use estimates based on judgment to predict effects of additional production and sales on profits. In addition, they examine selected volumes, not the whole range of possible volumes.

IV.

General Influences on Pricing in Practice A.

{L. O. 6}

Legal Requirements Predatory Pricing (illegal)—a company establishes prices so low that competitors are driven out of the market so that the predatory price has no significant competition and the company can then raise prices dramatically. Pricing below average variable cost has been viewed by U.S. courts as predatory pricing. Discriminatory Pricing—charging different prices to different customers for the same product or service. It is illegal unless it reflects a differential incurred in providing the good or service. Both predatory pricing and discriminatory pricing charges can be defended by a company that cites its costs as a basis for its prices.

Competitors’ Actions Competitors usually react to price changes of their rivals. Knowledge of their rival’s capacity, technology, and operating policies help managers predict competitors’ reactions to a company’s prices. Tinkering with prices is based on the price setter’s expectations of competitors’ reactions and of the overall effects on total industry demand for the good or service in question.

Customer Demands If customers believe a price is too high, they may turn to other resources for the product or service, substitute a different product, or decide to produce the item themselves.

Cost-Plus Pricing

What is Cost-Plus Pricing? In some industries, such as agricultural commodities, costs have little or no effect on the setting of prices. In others, such as the automobile industry, managers use costs as a base in cost-plus pricing. The markup (i.e., the amount by which price exceeds cost) is originally set to provide a target return on investment, but must be flexible in order to meet market demands (e.g., defense contracting). Ultimately, the market sets prices. In the short run, the minimum price to be quoted, subject to consideration of longrun effects, should be equal to the costs that may be avoided by not landing the order— often all variable costs of producing, selling, and distributing the good or service. In the long run, the price must be set high enough to cover all costs, including fixed costs.

Cost Bases for Cost-Plus Pricing

{L. O. 7}

Cost plus is often the basis for target prices. The size of the “plus” depends on target (desired) operating income. Target prices can be based on a host of different markups based on a host of different definitions of cost. These bases include variable manufacturing costs, total variable costs, full absorption manufacturing costs, and full costs. Thus, there are many ways to arrive at the same target price. See EXHIBIT 510 for an illustration. Note that full cost (or fully allocated cost) is the total of all manufacturing costs plus the total of all selling and administrative costs. Because managers’ performance evaluations and bonuses are frequently based on absorption costing income, markups based on full absorption costs are prevalent. C.

Advantages of Contribution Margin Approach in Cost-Plus Pricing Prices based on variable costs represent a contribution approach to pricing. Full absorption costing fails to highlight different cost behavior patterns. The contribution approach is sensitive to cost-volume-profit relationships which makes it easier for managers to prepare schedules at different volume levels. See EXHIBIT 5-11 for examples of using the contribution approach and full costing approach for analyzing the effects of volume changes on operating income. A normal or target-pricing formula can be developed as easily using variable costs as full absorption or full costs. The contribution approach offers insight into the shortrun versus long-run effects of cutting prices on special orders. The manager can consider whether the increase in operating income (contribution margin) generated from a special order outweighs potential reductions in long-run profitability due to expectations of lower prices by customers. If a company is using full absorption costing, a manager must conduct a special study in order to make the special order decision.

Advantages of Absorption-Cost Approaches in Cost-Plus Pricing Absorption or full costs are far more widely used in practice than is the contribution approach. The following are some of the reasons offered: 1.

5. 6. 7.

In the long run, all costs must be covered to stay in business. Sooner or later fixed costs do indeed fluctuate as volume changes. Therefore, it is wise to assume that all costs are variable (even if some are fixed in the short run). Computing target prices based on cost-plus may indicate what competitors might charge, especially if they have approximately the same level of efficiency as you and also aim at recovering all costs in the long run. Absorption-cost formula pricing meets the cost-benefit test. It is too expensive to conduct individual cost-volume tests for the many products (sometimes thousands) that a company offers. There is much uncertainty about the shape of the demand curves and the correct price-output decisions. Absorption-cost or full-cost pricing copes with this uncertainty by not encouraging managers to take too much marginal business. Absorption-cost pricing tends to promote price stability and planning is more dependable. Absorption-cost pricing provides the most defensible basis for justifying prices to all interested parties, including government antitrust investigators. Absorption-cost pricing provides convenient reference (target) points to simplify hundreds of thousands of pricing decisions.

Using Multiple Approaches No single method of pricing is always the best. Most companies have gathered costs using some form of full-manufacturing-cost system because this is what is required for financial reporting. Managers are reluctant to focus just on variable costs when their bonuses are based on income shown in published financial statements that must use absorption costing.

Formats for Pricing

See EXHIBIT 5-12 for an illustration of a quote sheet to be used in pricing. A minimum price based on variable costs and a maximum price based on what the company thinks it can obtain are shown. Construction and service industries (e.g., auto repair) compile separate categories of costs of (1) direct materials, parts, and supplies and (2) direct labor. Different markup rates are used for each category to assure the recovery of direct costs, overhead costs, and to provide for profits. For decision-making purposes, it may be more beneficial to pinpoint costs first, before adding markups, than to have a variety of markups already embedded in the “costs” used as guides for setting selling prices.

VI.

Target Costing

{L. O. 8}

The focus is on marketing and the revenue side of the profit equation. A.

Target Costing and New Product Development Target Costing—a tool for making cost a key focus throughout the life of a product (i.e., the desired profit margin is subtracted from the market price to determine the target cost). The emphasis is on proactive, up-front planning throughout every activity of the new product development process. It is most effective at reducing costs during the product design phase, when the vast majority of costs are committed. Market research guides the whole product development process by supplying information on customer-required product functions. There is a strong emphasis on understanding customer needs (see EXHIBIT 5-13). Value engineering is a cost-reduction technique, in primarily the design stage, which uses information about all value chain functions to satisfy customer needs while reducing costs. Kaizen costing is continuous improvement during manufacturing.

Illustration of Target Costing Consider the target-costing system used by ITT Automotives to set their pricing approach for customers such as Mercedes-Benz.

Target Costing and Cost-Plus Pricing Compared A comparison is shown in relation to an automotive part bid. As global competition has increased, companies are more limited in influencing market prices. Cost management is the key to profitability.

CHAPTER 5:

Quiz/Demonstration Exercises

Learning Objective 1 1.

In making managerial decisions, relevant information involves _____ costs that _____ between alternatives. a. future; differ b. future; do not differ c. past; do not differ d. past; differ

For a revenue to be irrelevant to a particular decision, the revenue must _____. a. differ between the alternatives being considered b. be a future revenue c. be a past revenue d. A and B e. A and C f. only C

Learning Objective 2 3.

The role of historical data from the accounting system in making managerial decisions is _____. a. to serve directly as inputs in decision models b. to assist in making predictions that are inputs to a decision model c. to assist in making predictions about other information needed for making decisions d. none of the above

What is the last portion of the decision process? a. Implementation and evaluation b. prediction method c. feedback d. decision model

Learning Objective 3 Items 5 and 6 are based on the following data: In 20x1, its first year of operations, Knot, Inc., manufactured 110,000 units of its single product, ties. Variable manufacturing costs were $6 per unit of product. Fixed manufacturing costs were $110,000 and are based on the production volume of 110,000 units. Knot sold 100,000 ties during the year at an average selling price of $10. Variable selling costs were 50¢ per tie and fixed selling and administrative costs were $80,000. 5.

Knot’s operating income using the absorption approach for 20x1 is _____.

a. b. c. d. 6.

$0 $ 300,000 $ 160,000 $ 170,000

Horn Gren’s operating income using the contribution approach for 20x1 is _____. a. $0 b. $ 160,000 c. $ 170,000 d. $ 300,000

Learning Objective 4 Use the following information for questions 7 and 8. Tire Ready Tire Co. sells tires. A partial income statement for a typical month is given below. Sales (10,000 tires) $ 100,000 Costs: Direct Materials $ 20,000 Direct Labor 16,000 Overhead (50% variable) 20,000 56,000 Gross Profit $ 44,000 A local car dealer has offered to buy 500 tires for an upcoming promotion to launch the new line of sports cars he will carry. Although the normal selling price is $10 per tire, the dealer has offered $8 each, citing the large volume of the order as the reason for cutting the price. There is no change in fixed costs. 7.

If Ready Tire Co. accepts this order, the effect on the company’s income, assuming regular sales are unaffected, is a _____. a. $1,000 decrease b. $2,200 increase c. $2,300 decrease d. $1,700 increase

The fixed overhead of $2 per tire _____. a. is irrelevant in making the decision because the fixed costs per unit are unaffected b. is irrelevant in making the decision because the total fixed costs are unaffected c. will increase to above $1 per tire if the order is accepted d. will increase to above $1 per tire if the order is not accepted

Learning Objective 5 9.

In _____ competition, all competing firms will sell the same type of product at the same price. a. perfect b. fair

c. d. 10.

imperfect unfair

In perfect competition, the _____ curve is a horizontal line equal to the price per unit at all volumes of sales. a. marginal revenue b. step revenue c. incremental cost d. marginal cost

Learning Objective 6 11.

_____ influence pricing decisions. a. Costs b. Customer demands c. Competitors’ actions d. All of the above

12.

Which of the following legal requirements influences pricing in practice? a. competitive pricing b. predatory pricing c. nondiscriminatory pricing d. markup pricing

Learning Objective 7 13.

Popular markup formulas for pricing do not include a percentage of _____. a. variable manufacturing costs b. total variable costs c. fixed costs d. full costs

Learning Objective 8 14.

The majority of costs are committed in which stage of the value chain? a. research and development b. design c. production d. customer service

15.

A factor not usually included in determining the feasibility of earning the desired target profit margin is _____. a. interest rates b. competitor pricing c. inflation rates d. depreciation

CHAPTER 5: 1. [a] 2. [c] 3. [b] 4. [c] 5. [d]

Solutions to Quiz/Demonstration Exercises

Income under Absorption Approach Sales (100,000 * $10) COGS ((100,000 * ($6 + $1.00))

$1,000,000 (700,000)

Gross Profit 300,000 Selling and Administrative Expenses (100,000 * 50¢) + $80,000 130,000 Operating income $170,000 6. [b]

Income under Contribution Approach Sales (100,000 * $10) Variable costs: Manufacturing (100,000 * $6) Selling (100,000 * 50¢) Contribution Margin Fixed Expenses: Manufacturing Selling and Administrative Operating Income

7. [d]

8. [b]

$1,000,000 $600,000 50,000

(650,000) $350,000

$110,000 80,000

(190,000) $160,000

The solution to this problem requires determining the variable cost per tire and comparing those to the offer price. In this case, the variable costs are $20,000 for direct materials, $16,000 for direct labor, and $10,000 for variable overhead (1/2 of $20,000) for a total of $46,000. For 10,000 tires, this is a variable cost per tire of $4.60 ($46,000/10,000). Because the offer is for $8 per tire and variable cost is $4.60, then contribution margin would be $3.40 per tire. The profits would increase $1,700 (500 tires times $3.40). Total fixed costs should be used in comparing the alternatives. If the totals do not differ, fixed costs are irrelevant for the decision at hand.

9. [a] 10. [d] 11. [d] 12. [b] 13. [c] 14. [b] 15. [d]

Chapter 6 Relevant Information and Decision Making with a Focus on Operational Decisions LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 8.

Use a differential analysis to examine income effects across alternatives and show that an opportunity-cost analysis yields identical results. Decide whether to make or buy certain parts or products. Choose whether to add or delete a product line using relevant information. Compute the optimal product mix when production is constrained by a scarce resource. Decide whether to process a joint product beyond the split-off point. Decide whether to keep or replace equipment. Identify irrelevant and misspecified costs. Discuss how performance measures can affect decision making.

CHAPTER 6:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 24. Measurement of Opportunity Cost 25. Outsourcing Decisions 26. Unitized Costs 27. Historical Costs and Inventory Decisions EXERCISES 28. Opportunity Costs 29. Opportunity Cost of Home Ownership 30. Opportunity Cost at Nantucket Nectars 31. Hospitality Opportunity Cost 32. Make or Buy 33. Make or Buy at Nantucket Nectars 34. Make or Buy and the Use of Idle Facilities at Nantucket Nectars 35. Profit per Unit of Space 36. Deletion of Product Line 37. Sell or Process Further 38. Joint Products, Multiple Choice 39. Obsolete Inventory 40. Replacement of Old Equipment 41. Unit Costs 42. Relevant Investment 43. Weak Division 44. Opportunity Cost PROBLEMS 45. Hotel Rooms and Opportunity Costs 46. Extension of Preceding Problem 47. Make or Buy 48. Relevant-Cost Analysis 49. Hotel Pricing and Use of Capacity 50. Special Air Fares 51. Choice of Products 52. Analysis of Unit Costs 53. Use of Available Facilities 54. Joint Costs and Incremental Analysis 55. Joint Products: Sell or Process Further 56. Relevant Cost 57. New Machine 58. Conceptual Approach 59. Book Value of Old Truck 60. Decision and Performance Models 61. Review of Relevant Costs 62. Make or Buy

63. 64. CASES 65. 66. 67. 68.

Make or Buy, Opportunity Costs, and Ethics Irrelevance of Past Costs at Starbucks

Make or Buy Make or Buy Make or Buy Nike 10k Problem: Make or Buy

EXCEL APPLICATION EXERCISE 69. Identifying Relevant Revenue, Costs, and Income Effects COLLABORATIVE LEARNING EXERCISE 70. Outsourcing INTERNET EXERCISE 71. Green Mountain Coffee Company (http://www.greenmountaincoffee.com)

CHAPTER 6: I.

OUTLINE

Analyzing Relevant Information: Focusing on Future and Differential Attributes O. 1} A.

{L.

Opportunity, Outlay, and Differential Costs and Analysis Opportunity Cost—maximum available contribution to profit forgone (i.e., rejected) by using limited resources for a particular purpose. Opportunity cost applies to a resource that a company already owns or that it has already committed to purchase. Outlay Cost—requires a future cash disbursement and is the typical cost recorded by accountants. Presenting revenues, costs, and income of two alternatives and the differences in those revenues, costs, and incomes is referred to as differential analysis. Differential Costs (Revenue) (or Incremental Costs)—the difference in costs (revenue) between two alternatives.

II.

Make-or-Buy Decisions A.

{L. O. 2}

Basic Make or Buy and Idle Facilities Manufacturers have to decide whether to make or buy parts and subassemblies that go into their final products. Some companies make all their own parts and subassemblies in order to assure product quality, whereas others buy most of theirs to protect mutually advantageous long-run relationships with suppliers. When idle facilities exist, quantitative factors bearing on the decision typically include the direct material, direct labor, variable overhead, fixed overhead that may be avoided if the part is purchased, and the purchase cost of buying the parts. A make-or-buy decision for Nantucket Nectars Company is presented. The key to make-or-buy decisions is identifying the additional costs for making (or the costs avoided by buying) a part or component. Using activity analysis can help in identifying these costs.

Make or Buy and the Use of Facilities The alternative uses for the facilities that would be occupied if the part were made should be considered. The previous example is expanded to include the possible renting out of the space used to make the parts and the possibility of producing other products in that space. In all cases, companies should relate these decisions to the long-run policies for the use of capacity.

III.

Deletion or Addition of Products, Services, or Departments

{L. O. 3}

Avoidable and Unavoidable Costs Avoidable Costs—will not continue if an ongoing operation is changed or deleted. These costs are relevant in making the decision. Unavoidable Costs—will continue even if an operation is halted. These are not relevant because they will not differ between alternatives. Unavoidable costs may include Common Costs—costs of facilities and services that are shared by users (e.g., building depreciation, heating, air conditioning, and general management expenses). The same principles regarding relevance applied to special orders apply to decisions concerning adding or deleting products or departments. The example provided in this section is whether to drop the grocery line from the offerings of a discount department store that has three major departments: groceries, general merchandise, and drugs. Fixed expenses are divided into two categories, avoidable and unavoidable. In the initial analysis, the grocery line is kept because it provides a contribution over its avoidable fixed costs of $50,000. After analyzing whether to keep or drop the grocery line, the analysis is extended to consider replacing groceries with expanded general merchandise. When this alternative is considered, however, the proper decision is to expand general merchandise because this option contributes $80,000 rather than $50,000 toward covering common and other unavoidable costs.

IV.

Optimal Use of Limited Resources: Product Mix Decisions

{L. O. 4}

If a plant that makes more than one product is being operated at capacity, the orders to accept are those that make the biggest total profit contribution per unit of the limiting factor. Limiting Factor or Scarce Resource—an item that restricts or constrains the production or sale of a product or service. For example, in retail sales, the limiting resource is often floor space. Thus, retail stores must either focus on products using less space or using the space for shorter periods of time (i.e., greater Inventory Turnover—number of times the average inventory is sold per year). Do not emphasize those products that give the largest contribution per sales dollar or per unit of product. See EXHIBIT 6-2 for the effect of turnover on profit. V.

Joint Product Costs: Sell or Process Further Decisions

{L. O. 5}

Joint Products—two manufactured products have relatively significant sales values, and are not separately identifiable as individual products until their split-off point (e.g., chemicals, lumber, flour, and the products of petroleum refining and meatpacking). Split-Off Point— time in manufacturing where the joint products become individually identifiable. Separable Costs—any costs beyond the split-off point due to not being part of the joint process and can be exclusively identified with individual products. Joint Costs—costs of manufacturing joint products before the split-off point. A.

Sell or Process Further

Decisions on whether to sell joint products at the split-off point or to process some or all products further are frequently made by managers. The essence of the decision whether or not to process further is to compare the difference between incremental revenues and costs with the opportunity cost of selling the product at the split-off point. See EXHIBIT 6-3 for an example of a sell or process further analysis. See EXHIBIT 6-4 for another presentation of the sell or process further for the entire firm. The joint costs are included in the analysis along with the revenues generated from the sale of the other joint product. These items are not differential revenues or costs, and thus they do not affect the decision. It is important to recognize that the joint costs do not play a role in determining whether or not to process a joint product further. VI.

Keeping or Replacing Equipment

{L. O. 6}

Depreciation—purchased equipment cost is spread over (or charged to) the future periods in which the equipment is expected to be used (i.e., a periodic cost). Book Value (or net book value)—the original cost less accumulated depreciation, which is the summation of depreciation charged to past periods. Sunk Cost (historical or past cost)—a cost that has already been incurred and is irrelevant in the decision-making process. In making equipment replacement decisions, the book value of old equipment is a sunk cost and should therefore not be considered. The only relevant costs in making this decision are the expected future costs (e.g., the disposal value of old equipment and the cost of new equipment). The gain or loss on disposal and the book value of the old equipment are irrelevant. However, tax consequences of these items should be included in a keep-or-replace decision. See EXHIBITS 6-5 and 6-6 for an analysis of a keep-or-replace decision. VII.

Identify Irrelevant or Misspecified Costs

{L. O. 7}

In addition to past costs, future costs (whether fixed or variable), that will be the same under all feasible solutions, are irrelevant in making managerial decisions. Salaries of top managers and obsolete inventories are given as examples of future costs that will not differ in most decisions and are, therefore, irrelevant for those decisions. There are pitfalls of using unit costs, not total costs, for decisions. The effect that the expected volume of activity may have on a decision to replace an existing piece of equipment. If the expected volume level is at the level used by an equipment sales representative in claiming that a cost reduction is possible, then no problem exists with the analysis. On the other hand, if the expected volume level is much lower than that used by the sales representative in making his claim, a different result may occur. VIII. Conflicts Between Decision Making and Performance Evaluation

{L. O. 8}

To motivate people to make optimal decisions, performance evaluation methods should be consistent with the decision analysis. The equipment replacement decision is an example of performance evaluation, based on annual income, resulting in a bad decision. Because income

in Year 1 would be less if the replacement were made, managers may choose to retain the existing equipment. The savings in Years 2, 3, and 4 are, therefore, not realized. Failing to replace the existing equipment also allows the manager to hide the potential “loss on disposal” as depreciation expense over the remaining useful life of the old equipment. Ideally, performance would be evaluated against predictions made when making decisions. However, with the complexity of modern organizations and the innumerable decisions being made, this is not possible.

CHAPTER 6:

Quiz/Demonstration Exercises

Learning Objective 1 1.

If you can work for the year and make $25,000, but you decide to go to college, then the $25,000 is a(n) _____. a. sunk cost b. outlay cost c. misplaced cost d. opportunity cost

A cost that requires a cash disbursement sooner or later is referred to as a(n) _____ cost. a. opportunity b. outlay c. immediate d. differential

A piece of equipment purchased last year is an example of a(n) _____. a. opportunity cost b. relevant cost c. sunk cost d. differential cost

Learning Objective 2 4.

Who Corporation produces a part that is used in the manufacture of one of its products. The costs associated with the production of 10,000 units of this part are as follows: Direct materials $45,000 Direct labor 65,000 Variable overhead 30,000 Fixed overhead 70,000 Total Cost $210,000 Of the fixed overhead costs, $30,000 is avoidable. When Company has offered to sell 10,000 units of the same part to Who Corporation for $18 per unit. Assuming there is no other use for the facilities, Who should _____. a. make the part, as this would save $3 per unit b. make the part, as this would save $1 per unit c. buy the part, as this would save the company $30,000 d. buy the part, as this would save the company $3 per unit

Qualitative factor(s) that should be considered when evaluating a make-or-buy decision is (are) _____. a. the quality of the outside supplier’s product

b. c. d.

can the outside supplier provide the needed quantities can the outside supplier provide the product when it is needed all of the above

Learning Objective 3 Use the following information in answering questions 6 and 7. Buy Best is an electronic store having three operating departments. An income statement for the most recent month of operations appears below. Computers TVs

Radios Total

Sales $55,000 $44,000 $11,000 $110,000 Variable Costs 33,000 17,600 5,500 56,100 Contribution Margin 22,000 26,400 5,500 53,900 Fixed Costs Direct, avoidable (5,000) (4,000) (4,000) (13,000) Common, allocated based on sales dollars (10,000) (8,000) (2,000) (20,000) Profit (Loss) $ 7,000 $14,400 ($ 500) $ 20,900 6.

If Buy Best were to drop the toy line and make no other changes to its operations, income for the month would be _____. a. $ 20,400 b. $ 18,400 c. $ 19,400 d. $ 21,400

The space currently being used by the radio department could be converted to a phone department. If this were done, sales of the phones are expected to be $22,000 with variable costs of $8,800 and avoidable direct fixed costs of $3,000. Assuming no effects on the computers and TV departments, income for the month would be _____. a. $ 28,200 b. $ 29,600 c. $ 28,700 d. some other amount

Learning Objective 4 8.

When a multiproduct plant is being operated at capacity, the products that should be emphasized are those that provide the highest contribution margin _____. a. ratio b. per sales dollar c. per unit of limited resource d. per unit of product

Which of the following is not a scarce resource of a company or firm? a. customers b. floor space c. time d. laborers

Learning Objective 5 10.

PB Company drills for oil, and delivers it to refining companies. Currently it is selling its crude oil at $20/barrel. PB has been asked to refine the oil for commercial use. For a standard of refined oil, PB will be paid $30/barrel. PB estimates that the additional labor and refining cost involved in further processing of a barrel of oil is$6/barrel. PB Company should _____. a. continue selling crude oil at $20/barrel b. sell the super crude oil to another company for $21/gallon c. sell refined oil for an increased profit of $4/barrel d. do none of these

11.

A joint product should be processed beyond split-off if additional _____ from further processing exceeds _____. a. revenue; joint costs b. revenue; allocated joint costs c. revenue; additional costs of further processing d. revenue; allocated joint costs and additional costs of further processing

Learning Objective 6 12.

The book value of old equipment is irrelevant in replacement decisions because _____. a. it is a sunk cost b. it will be capitalized if the equipment is kept c. it represents a future cost that will differ between the options of replacing or keeping the equipment d. it represents a future cost that will not differ between the options of replacing or keeping the equipment.

13.

In analyzing whether to replace or keep existing equipment, the cost of the new equipment _____. a. is irrelevant because it is a historical cost b. is relevant because equipment is always relevant c. represents a future cost that will differ between the options of replacing or keeping the equipment d. both A and B

Learning Objective 7 14.

In general, a decision maker should be wary of _____. a. unit variable costs

b. c. d.

unit fixed costs unit sales price none of the above

CHAPTER 6: 1. [d] 2. [b] 3. [c] 4. [b]

Solutions to Quiz/Demonstration Exercises

The difference is $1 per unit ($10,000/10,000 units) in favor of making. It is easiest to see the difference in a total cost analysis: Make Buy Cost of purchasing Direct materials cost Direct labor cost Variable overhead Fixed overhead Total cost

5. [d] 6. [c] 7. [b]

45,000 65,000 30,000 70,000 $ 210,000

$180,000 0 0 0 40,000 $220,000

Income statements for answering 6 and 7 appear below. Income statements for answering 6 and 7 appear below.

Sales Variable costs Contribution margin Fixed costs: Direct Common Profit (loss)

Keep Toys $11,000 5,500 5,500

Drop Toys $99,000 50,600 48,400

Add Jewelry $121,000 59,400 61,600

(4,000) (9,000) (12,000) ( 2,000) (20,000) (20,000) $ (500) $19,400 $ 29,600

The reduction in the contribution margin exceeds the reduction in the direct fixed costs and the produce line should be kept if not considering adding the jewelry. For #7, the jewelry department provides an $8,700 higher segment margin than the toy line so it should replace produce. 8. [c] 9. [a] 10. [c]

The additional revenues generated of $10/barrel are greater than the further processing costs of $6/barrel.

11. [c] 12. [a] 13. [c] 14. [b]

Chapter 7 Introduction to Budgets and the Master Budget LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 9.

Explain how budgets facilitate planning and coordination. Anticipate possible human relations problems caused by budgets. Explain potentially dysfunctional incentives in the budget process. Explain the difficulties of sales forecasting. Explain the major features and advantages of a master budget. Follow the principal steps in preparing a master budget. Prepare the operating budget and the supporting schedules. Prepare the financial budget. Use a spreadsheet to develop a budget (Appendix 7)

CHAPTER 7:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 22. Budgets as Limitations on Spending 23. Sales Personnel and Budgeting 24. Master Budgets for Research and Development 25. Production Budgets and Performance Evaluation EXERCISES 26. Fill In the Blanks 27. Cash Budgeting 28. Purchases and Cost of Goods Sold 29. Purchases and Sales Budgets 30. Sales Budget 31. Sales Budget 32. Cash Collection Budget 33. Purchases Budget 34. Purchases Budget 35. Cash Budget PROBLEMS 36. Cash Budget 37. Cash Budget 38. Budget at Indian Hotel Company 39. Activity-Based Budgeting 40. Budgeting, Behavior, and Ethics 41. Spreadsheets and Sensitivity Analysis of Income Statement 42. Spreadsheets and Sensitivity Analysis of Operating Expenses CASES 43. 44. 45. 46.

Comprehensive Cash Budgeting (EXHIBITS 7-14, 7-15, 7-16) Cash Budgeting for a Hospital Comprehensive Budgeting for a University Nike 10k Problem: Budgeting Assumptions at Nike

EXCEL APPLICATION EXERCISE 47. Preparing a Cash Budget to Assist Long-Range Planning COLLABORATIVE LEARNING EXERCISE 48. Personal Budgeting INTERNET EXERCISE 49. Carnival Corporation (http://www.carnivalcorp.com)

CHAPTER 7: I.

OUTLINE

Budgets and the Organization

{L. O. 1}

Budget—a condensed business plan for the forthcoming year (or less). A budget is used in attracting funds from investors and banks and by managers to guide them in allocating resources, maintaining control, and measuring and rewarding progress. The most important functions of budgets are for planning, performance evaluation, and communication. Budgets provide a comprehensive financial overview of planned company operations. Budgets highlight potential problems and opportunities early, allowing managers to take steps to avoid the problems or use the opportunities wisely. Budgets are used for performance evaluation. Managers use budgets as a benchmark – a measure of expected or desired performance—against which they compare actual performance. Finally, budgets provide an important two-way communication channel. A.

Advantages of Budgets 1. 2. 3. 4.

It provides an opportunity for managers to reevaluate existing activities and evaluate possible new activities. It compels managers to think ahead by formalizing their responsibilities for planning. It aids managers in communicating objectives to units and coordinating actions across the organization. It provides benchmarks to evaluate subsequent performance.

Formalization of Planning Forces managers to think ahead—to anticipate and prepare for changing conditions. Planning is an explicit management responsibility. Managers will set goals and objectives and establish policies to aid in their achievement. The objectives are the destination points, and budgets are the road maps guiding us to those destinations. Evaluation of Activities Budgeting typically uses the current activities of the organization as a starting point for planning, but how managers use this starting point varies. At one extreme, in some organizations the budget process automatically assumes the activities for the new budget period will be the same as the activities for the previous period. At the other extreme, some organizations use a zero-base budget, which starts with the assumption that current activities will not automatically be continued. Communication and Coordination Budgets tell employees what is expected of them. A good budget process communicates both from the top down and from the bottom up. Top management makes clear the goals and objectives of the organization in its budgetary directives. Employees and lower-level managers then inform higher-level managers how they plan to achieve the goals and objectives. Budgets also help managers coordinate objectives. The budgetary process forces

managers to visualize the relationship of their department’s activities to those of other departments and the company as a whole. Performance Evaluation Budgeted goals and performance are generally a better basis for judging actual results than is past performance. The major drawback of using historical results for judging current performance is that inefficiencies may be concealed in the past performance. Changes in economic conditions, technology, personnel, competition, etc., also limit the usefulness of comparisons with the past. B.

Potential Problems in Implementing Budgets

{L. O. 2}

Budget Participation and Acceptance of the Budget In order to benefit an organization, budgets need the support of all the firm’s employees. Top management’s support of the budget can influence that of lower-level managers. Because budgets are often used to compare with actual results in evaluating subordinates, subordinates may regard them as straightjackets that are unduly restrictive. Accountants and higher-level managers need to show how budgets can help each manager and employee achieve better results. In addition, problems may arise if the employees and managers are rewarded on dimensions other than meeting budgets. Participative Budgeting—because the effectiveness of any budget depends on whether the affected managers and employees understand and accept the budget, some companies involve the affected personnel. C.

Incentives to Lie and Cheat

{L. O. 3}

Lying can arise if the budget process creates incentives for managers to bias the information that goes into their budgets. Managers may want to increase the resources allocated to their department (e.g., space, equipment, and personnel) in order to reach output targets and receive higher rewards. If organizations use budgets as a target for performance evaluations, managers may create budgetary slack or budget padding—overstate their budgeted costs or understate their budgeted revenues to create a budgeted profit level that is easier to achieve (see EXHIBIT 71). Budgetary slack helps buffer managers from budget cuts imposed by higher-level management and provides protection against cost increases or revenue shortfalls due to unforeseen events. Lying and cheating create cynicism about the budget process and a culture of unethical behavior in the organization. D.

Difficulties of Obtaining Accurate Sales Forecasts

{L. O. 4}

The sales budget is the foundation of the entire master budget. The accuracy of the estimated purchases budgets, production schedules, and costs depends on the detail and accuracy (in dollars, units, and mix) of the budgeted sales. Sales Forecast (i.e., a prediction of sales under a given set of conditions) is used to prepare the Sales Budget (i.e., the result of decisions to create the conditions that will generate a desired level of sales). A firm may have sales forecasted for various levels of advertising. Once a decision has been made regarding the level of advertising

expenditures, the sales budget is determined. Sales forecasts are usually prepared under the direction of the top sales executive. Important factors considered by a forecaster include: 1. 2. 3. 4. 5. 6. 7. 8.

Past patterns of sales Estimates made by the sales force General economic conditions Competitors’ actions Changes in the firm’s prices Changes in product mix Market research studies Advertising and sales promotion plans

Sales forecasting usually combines various techniques. In addition to the opinions of sales staff, statistical analysis of correlations between sales and economic indicators (prepared by economists and members of the market research staff) and opinions of line management provide valuable help. Ultimately, the sales budget is the responsibility of line management. III.

Types of Budgets

{L. O. 5}

The planning horizon for budgeting may vary from one day to many years. Strategic Plan—the most forward-looking budget, which sets the overall goals and objectives of the organization. Long-Range Planning—forecasted financial statements for 5- or 10-year periods. Long-range planning includes decisions about the addition or deletion of product lines, design and location of new plants, acquisition of buildings and equipment, and other long-term commitments. Capital Budgets—detail the planned expenditures for facilities, equipment, new products, and other long-term investments in coordination with long-range plans. A budget is a formal, quantitative expression of management plans. Master Budget (Pro Forma Statements)—summarizes the planned activities of all subunits of an organization (e.g., sales, production, distribution, and finance). It quantifies targets for sales, cost-driver activity, purchases, production, net income, and cash position, and any other objective that management specifies. It is a periodic business plan that includes a coordinated set of detailed operating schedules and financial statements. It includes forecasts of sales, expenses, cash receipts and disbursements, and balance sheets. Managers may also prepare daily or weekly task-oriented budgets that help them carry out their particular functions and meet operating and financial goals. Continuous Budgets (Rolling Budgets)—common form of master budgets that add a month in the future as the month just ended is dropped. This type of budget forces managers to think specifically about the forthcoming 12 months and thus maintain a stable-planning horizon. While a new month is added to a continuous budget, the other 11 months can also be updated.

Components of a Master Budget The usual master budget for a nonmanufacturing company has the following components: 1. a. b. c. d. e. 2.

Operating Budget (profit plan) Sales budget (and other cost-driver budgets as necessary) Purchases budget Cost of goods sold budget Operating expenses budget Budgeted income statement

Financial budget a. Capital budget b. Cash budget c. Budgeted balance sheet

See EXHIBIT 7-2 for a condensed diagram of the relationships among the various parts of the master budget for a nonmanufacturing company. Manufacturing companies must prepare ending inventory budgets and budgets for labor, materials, and factory overhead in addition to the budgets indicated for nonmanufacturing organizations. The two major parts of the master budget are the operating budget and the financial budget. Operating Budget—focuses on the income statement and its supporting schedules. It is sometimes called a Profit Plan, although it may show a budgeted loss or may be used to simply budget expenses in an agency with no revenues. Financial Budget—focuses on the effects that the operating budget and other plans (e.g., capital budgets and repayments of debt) will have on cash. IV.

Preparing the Master Budget A.

The Cooking Hut Background information on the company used to illustrate the preparation of the master budget, Cooking Hut Company (CHC), is provided. The actual March Sales of $40,000 and expected sales for the next five months are provided. See EXHIBIT 7-3 for a balance sheet at the beginning of the budget period. The details regarding the composition of sales as to whether they are cash or credit is given, as is the collection pattern for the credit sales. The company’s inventory policy and the payment pattern for purchases, wages and commissions and various operating expenses are supplied. In addition, the desire of the company to maintain a minimum cash balance at the end of each month is expressed. Borrowings and repayments of loans are said to be in multiples of $1,000. Loans are made at the beginning of a month and repayments occur at the end of a month with interest computed using a 12% annual rate.

Steps in Preparing the Master Budget

{L. O. 6}

The principal steps in preparing the master budget are a. Supporting Budgets and Schedules 1. Using the data given, prepare the following budgets and schedules for each of the months of the planning horizon: Schedule a. Sales budget Schedule b. Cash collections from customers Schedule c. Purchases and cost-of-goods-sold budget Schedule d. Cash disbursements for purchases Schedule e. Operating expense budget Schedule f. Cash disbursements for operating expenses b. Operating Budget 2. Using the supporting budgets and schedules, prepare a budgeted income statement for the 3 months ending June 30, 20X1. c. Financial Budget 3. Prepare the following budgets and forecasted financial statements: a. Capital budget b. Cash budget, including details of borrowings, repayments, and interest for each month of the planning horizon c. Budgeted balance sheet as of June 30, 20X1 1.

Step 1: Preparing Basic Data {L. O. 7} Using the data given in the description of the problem, the following schedules are prepared: a. Sales Budget (Schedule a) This schedule shows, by month, the expected credit, cash, and total sales. Total sales for the budget period are shown on the budgeted income statement (EXHIBIT 74). b. Cash Collections from Customers (Schedule b) This schedule indicates the sources for the cash collections as the current month’s cash sales and the collection of the prior month’s credit sales. Total cash collections for each month are the sum of these two amounts. The total of these disbursements is used in helping to construct the cash budget (EXHIBIT 7-5). c. Purchases (Schedule c) The budgeted purchases are found using the following equation:

Budgeted purchases

desired ending + cost of goods sold – inventory

beginning inventory

The cost of goods sold is derived from the sales budget by multiplying an appropriate percentage by the budgeted sales. The total amount of this expense appears in the budgeted income

statement (EXHIBIT 7-4). d. Disbursements for Purchases (Schedule d) The monthly payment for purchases is based on the dollar purchases derived in Schedule c and the company’s payment pattern for its merchandise purchases. CHC pays for half of its purchases in the month of purchase and the other half in the month following purchase. Therefore, payments for purchases include half of the current month’s purchases and half of the prior month’s purchases. The total of these disbursements is used in helping to construct the cash budget (EXHIBIT 7-4). e. Operating Expense Budget (Schedule e) This schedule details the amounts of wages, commissions, miscellaneous, rent, insurance and depreciation expenses for each month. Some of these vary with activity, whereas others are usually fixed each period. Totals for the budget period for these items are included on the budgeted income statement (EXHIBIT 7-4) f. Disbursements for Operating Expenses (Schedule f) The payments for these expenses include half of last month’s wages and commissions, half of the current month’s wages and commissions, and the current period’s rent and miscellaneous expenses. The total of these disbursements is used in helping to construct the cash budget (EXHIBIT 7-5). 2.

Step 2: Preparing the Operating Budget Amounts from the sales, purchases, and operating expenses schedules are used in helping to construct the budgeted income statement (EXHIBIT 7-4). Interest expense, determined in the cash budget (EXHIBIT 7-5), also is needed to complete the budgeted income statement.

Step 3: Preparation of Financial Budget

{L. O. 8}

The second part of the master budget is the financial budget, which consists of the capital budget, cash budget, and ending balance sheet. This chapter focuses on the cash budget and the budgeted balance sheet. a.

The capital budget is discussed in Chapter 11.

Cash Budget (EXHIBIT 7-5) The cash budget is constructed using three major sections. First, expected cash receipts (Schedule b) are added to the beginning cash balance to get the total cash available before financing. Then, cash disbursements for purchases (Schedule d), operating expenses

(Schedule f), and capital acquisitions or other cash expenses are added to the minimum cash balance desired to get the total cash needed. An excess or deficiency of cash is computed as the difference between the cash available and the total cash needed in order to determine whether the company needs to borrow funds or if prior borrowings and interest may be paid off. The last section of the cash budget details the financing activity and indicates the ending cash balance. c.

Budgeted Balance Sheet (EXHIBIT 7-6) The final step in preparing the master budget is to construct the budgeted balance sheet that projects each balance sheet item in accordance with the business plan expressed in the previous schedules. The first draft is rarely the final draft. As it is reworked, the budgeting process becomes an integral part of the management process itself—budgeting is planning and communicating.

Activity-Based Master Budgets Functional Budgets—budgeting process that focuses on preparing budgets for various functions, such as production, selling, and administrative support. Activity-Based Budgets—budgets that focus on the budgeted cost of activities required to produce and sell products and services.

Budgets as Financial Planning Models Financial Planning Models—mathematical models, used by most companies, of the master budget that can react to any set of assumptions about sales, costs, product mix, etc. Dow Chemical’s model that uses 140 separate, constantly revised cost inputs that are based on several different cost drivers is used as an example. The models give managers answers to “what-if” questions concerning deviations from sales targets, changes in input prices, and others.

VI.

Appendix 7: Use of Spreadsheet Models for Sensitivity Analysis

{L. O. 9}

This appendix shows how budgets can be prepared using spreadsheet computer software (see EXHIBIT 7-9, EXHIBIT 7-10, EXHIBIT 7-11, and EXHIBIT 7-12 for spreadsheet examples). It is important to have a data section where input values are located and to use cell formulas to construct the budgets. Then, one can easily alter the input data to instantly see the impact on the budget. Sensitivity Analysis (or what-if analysis)—the systematic varying of budget data input to determine the effects of each change on the budget.

CHAPTER 7:

Quiz/Demonstration Exercises

Learning Objective 1 1.

Which of the following is not an advantage of budgets? a. provide one-way communication channel b. compel managers to think ahead by formalizing their responsibilities for planning c. aid managers in communicating objectives to units d. provide benchmarks to evaluate subsequent performance

Learning Objective 2 2.

In order for budgets to be accepted by all the affected employees, the following process should be used: _____ budgeting. a. autocratic b. participative c. authoritarian d. socialist

Learning Objective 3 3.

The term used when managers overstate their budgeted costs or understate their budget revenues to create a budgeted profit level that is easier to achieve is _____. a. budgetary slack b. hypothetical budgeting c. budgetary tightening d. adverse budgeting

Learning Objective 4 4.

Which of the following budgets is considered the foundation of the entire master budget? a. purchases budget b. operating expense budget c. capital budget d. sales budget

Learning Objective 5 5.

_____ sets the overall goals and objectives of the organization. a. capital budgeting b. long-range planning c. strategic planning d. master budgeting

The _____ summarizes the planned activities of all subunits of an organization – sales, production, distribution, and finance – and is the periodic business plan that includes a

coordinated set of detailed operating schedules and financial statements. a. sales budget b. master budget c. strategic plan d. long-range plan 7.

The _____ includes the sales budget, purchases budget, cost of goods sold budget, operating expenses budget, and budgeted income statement, whereas the _____ includes the capital budget, cash budget, and the budgeted balance sheet. a. operating budget; financial budget b. financial budget, operating budget c. strategic plan; financial budget d. strategic plan; operating budget

_____ financial statements are another term for forecasted financial statements. a. long-range b. estimated c. future-oriented d. pro forma

Learning Objective 6 9.

The second step in the budgeting process is the preparation of the _____ budget. a. production b. sales c. cash collection from customers d. operating expense

10.

Which of the following is usually prepared before the disbursements for operating expenses budget? a. operating expense budget b. cash budget c. production budget d. budgeted balance sheet

Learning Objective 7 11.

Dow Corporation sells a product for $50. Budgeted sales for the first quarter of 20x1 are as follows: January $1,000,000 February 1,200,000 March 1,300,000 The company collects 60% in the month of sale, 20% in the following month, and 10% two months after the sale. Ten percent of all sales are uncollectible and are written off.

Budgeted cash receipts for March are _____. a. $ 780,000 b. $ 1,020,000 c. $ 1,120,000 d. $ 1,220,000 12.

Projected sales for Peck, Inc., for next year and beginning and ending inventory data: Sales 100,000 units Beginning Inventory 120,000 units Targeted Ending. Inv. 300,000 units The selling price is $10 per unit. Each unit requires 5 pounds of material, which costs $2 per pound. The beginning inventory of raw materials is 10,000 pounds. The company wants to have 9,000 pounds of material in inventory at the end of the year. Budgeted sales would be _____. a. $ 1,100,000 b. $ 960,000 c. $ 1,200,000 d. $ 1,000,000

Use the following information for questions 13 through 15. Projected sales for Module Company for the next month and beginning and ending inventory data are as follows: Sales Beginning inventory Targeted ending inventory

80,000 units 6,000 units 14,000 units

The selling price is $40 per unit. Each unit requires 8 pounds of material, which costs $2 per pound. The beginning inventory of raw material is 30,000 pounds. The company wants to have 40,000 pounds of material in inventory at the end of the month. 13.

Budgeted sales would be _____. a. $ 2,880,000 b. $ 3,520,000 c. $ 1,600,000 d. $ 1,920,000

14.

According to the production budget, how many units should be produced? a. 90,000 units b. 70,000 units c. 88,000 units d. 80,000 units

15.

Pounds of material to be purchased would be _____. a. 352,000 lbs.

b. c. d.

362,000 lbs. 392,000 lbs. 342,000 lbs.

Learning Objective 8 16.

Which of the following is not a part of the financial budget? a. production budget b. capital budget c. budgeted balance sheet d. budgeted income statement

17.

In constructing the cash budget, the finance section does not include _____. a. borrowing b. collections from customers c. repayments d. interest payments

CHAPTER 7: Solutions to Quiz/Demonstration Exercises

1. [a] 2. [b] 3. [a] 4. [d] 5. [c] 6. [b] 7. [a] 8. [d] 9. [c] 10. [a] 11. [c] The $1,120,000 expected cash receipts include $780,000, which represents 60% of March’s sales and $240,000 that is 20% of February’s purchases and $100,000 that is 10% of January sales. 12. [d] 100,000 units x $10 sales price per unit 13. [c] Budgeted sales are 80,000 units x $20/unit selling price, which is $1,600,000 in sales. 14. [c] The units to be produced are found by adding the units expected to be sold to the targeted ending inventory and then deducting the beginning inventory as shown below: Sales 80,000 units + Targeted ending inventory 14,000 units = Total needed 94,000 units - Beginning inventory 6,000 units = Production needed 88,000 units 15. [b] The number of pounds of material to be purchased is based on the production needs, target ending inventory, and the inventory of material already on hand. The computation appears below. Materials needed for production

88,000 units x 4 lbs./unit 352,000 lbs. + Desired ending inventory 40,000 lbs. = Total material needs 392,000 lbs. - Beginning inventory of material on hand 30,000 lbs. = Pounds of material to be purchased 362,000 lbs. 16. [a] 17. [b]

Chapter 8 Flexible Budgets and Variance Analysis LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 8.

Identify variances and label them favorable or unfavorable. Distinguish between flexible budgets and static budgets. Use flexible-budget formulas to construct a flexible budget. Compute and interpret static-budget variances, flexible-budget variances, and sales activity budgets. Understand how the setting of standards affects the computation and interpretation of variances. Compute and interpret price and quantity variances for materials and labor. Compute variable overhead spending and efficiency variances. Compute the fixed-overhead spending variance.

CHAPTER 8:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 19. Interpretation of Favorable and Unfavorable Variances 20. Marketing Responsibility for Sales-Activity Variances 21. Production Responsibility for Flexible-Budget Variances 22. Responsibility of Purchasing Manager 23. Variable Overhead Efficiency Variance EXERCISES 24. Flexible Budget 25. Basic Flexible Budget 26. Flexible Budget 27. Basic Flexible Budget 28. Activity-Level Variances 29. Direct-Material Variances 30. Labor Variances 31. Quantity Variances 32. Labor and Material Variances 33. Material and Labor Variances PROBLEMS 34. Hotel Parking Service 35. Flexible and Static Budgets 36. Summary Explanation 37. Explanation of Variance in Income 38. Activity and Flexible-Budget Variances at KFC 39. Summary of App Based Taxi Aggregator’s Performance 40. Hospital Costs and Explanation of Variances 41. Flexible Budgeting 42. Activity-Based Flexible Budget 43. Straightforward Variance Analysis 44. Variance Analysis 45. Similarity of Direct-Labor and Variable-Overhead Variances 46. Material, Labor, and Overhead Variances 47. Automation and Direct Labor as Overhead 48. Standard Material Allowances 49. Role of Defective Units and Nonproductive Time in Setting Standards 50. Review Problem 51. Review Problem on Standards and Flexible Budgets; Answers Are Provided CASES 52. 53. 54.

Activity and Flexible-Budget Variances Activity-Based Costing and Flexible Budgeting Analyzing Performance

55. 56.

Complete Variance Analysis Nike 10k Problem: Performance Standards

EXCEL APPLICATION EXERCISE 57. Flexible-Budget and Sales-Activity Variances COLLABORATIVE LEARNING EXERCISE 58. Setting Standards INTERNET EXERCISE 59. Flexible Budgets at Hershey Food Corporation (www.hersheyland.com)

CHAPTER 8: I.

OUTLINE

Using Budgets and Variances to Evaluate Results A.

{L. O. 1}

Favorable and Unfavorable Variances Favorable profit variance occurs when actual profit exceeds budgeted profit. Unfavorable profit variance occurs when actual profit falls below budgeted profit. Favorable cost variance occurs when actual costs are less than budgeted costs. Favorable (F) versus Unfavorable (U) Variances Profits Actual > Expected F Actual < Expected U

Revenues F U

Costs U F

Unfavorable Cost Variance occurs when actual costs exceed budgeted costs. Static Budget Variances (i.e., variances from master budget amounts) may not be very useful in helping management assess whether costs are being controlled adequately when the actual activity level differs considerably from the static budget activity level. B.

Static Budgets Versus Flexible Budgets

{L. 0. 2}

A static budget is prepared for only one level of activity (for example, volume of sales activity). Differences between actual results and the static budget are staticbudget variances. Actual results could be compared with the original plan, even though a different activity level was reached than was used in constructing the static budget. See EXHIBIT 8-1 for an illustration of this in the performance report. A performance report is a generic term that usually means a comparison of actual results with some budget. Variances shown on the performance report direct management’s attention to significant deviations from expected results, allowing management by exception. Flexible Budget (or Variable Budget)—a budget that adjusts for changes in sales volume and other cost-driver activities. It is identical to the static budget in format, but it can be prepared for any levels of activity. For performance evaluation, the flexible budget would be prepared for the actual levels of activity achieved. Differences between actual results and a flexible budget are flexible-budget variances. In contrast, the static budget is kept fixed at only the originally planned levels of activity. C.

Flexible-Budget Formulas

{L. O. 3}

The cost functions or formulas that were discussed in Chapters 2 and 3 are used in constructing flexible budgets within the relevant range of activity. See EXHIBIT 82 for an illustration of the use of a budget formula for Beg Pakaian to create budgets for 7,000, 8,000, and 9,000 units of sales. The fixed costs/expenses are the same, in total, at each volume level. The variable costs/expenses increase by the budgeted amount for each unit increase in the activity level. Cost drivers other than units sold or produced must be considered in creating flexible budgets. See EXHIBIT 8-3 for a graph of flexible budget of costs. D.

Activity-Based Flexible Budgets Organizations are increasingly adopting activity-based costing (ABC) systems that have multiple cost drivers. Activity-Based Flexible Budget—based on budgeted costs for each activity center and related cost driver. ABC systems focus on activities as the primary cost objects. Costs of activity centers are then assigned to final cost objects such as products or customer classes using cost drivers. Companies that use ABC systems develop a flexible budget for each activity center. See EXHIBIT 8-4 for an illustration of Beg Pakaian’s activity-based flexible budget.

Static-Budget Variances and Flexible-budget Variances {L. O. 4} There are two types of reasons why actual performance might not have conformed to the master budget. First, sales and cost-driver activity may be different than that forecasted (Activity-Level Variances). Second, revenues or variable costs per unit of activity and fixed costs per period may not be as expected (Flexible-Budget Variances). See EXHIBIT 8-6 for an illustration of these two types of variances. The sum of the flexible-budget variances and the activity-level variances is the master budget variance.

Integrating Static-Budget, Flexible-Budget, and Sales-Activity Variances Managers use comparisons between actual results, master budgets, and flexible budgets to evaluate organizational performance. In evaluating performance, it is useful to distinguish Effectiveness (i.e., the degree to which a goal, objective, or target is met) and Efficiency (i.e., the degree to which inputs are used in relation to a given level of outputs). Effectiveness may be measured by determining whether the master budget goal has been met. Efficiency can be measured by comparing actual results to the flexible budget.

III.

Revenue and Cost Variances Sales-Activity Variances These variances measure how effective managers have been in meeting the planned level of sales. The final three columns in EXHIBIT 8-6 for Beg Pakaian show the sales-activity variances. All unit prices and variable costs are held constant in constructing the master budget and the flexible budget. The differences between the amounts are due to the level of sales activity.

The sales-activity variance indicates to managers the effect of not selling the budgeted sales level. Marketing managers are typically in the best position to explain why actual sales activities differed from plans. Flexible-Budget Variances Flexible-budget variances measure the efficiency of operations at the actual level of activity. The differences between columns 1 and 3 in EXHIBIT 8-6 for Beg Pakaian are flexible-budget variances. The total flexiblebudget variance is the difference between the actual income achieved and the flexible budget income for the achieved activity level. The total flexible-budget variance arises from sales prices received, and the variable and fixed costs incurred. Flexible-budget variances may serve as the basis for periodic performance evaluation. Operations managers are in the best position to explain these variances. The variances should not be used to fix blame. Managers being evaluated may resort to cheating to beat the system. See EXHIBIT 8-7 for an expanded, line-by-line computation of flexible-budget variances for Beg Pakaian. The variances should be interpreted as signals that actual operations have not occurred exactly as anticipated when the flexible-budget formulas were set, rather than as being good or bad. Any cost differing significantly (materially) from the flexible budget must be explained. IIIII. The Role of Standards in Determining Variances A.

{L. O. 5}

Setting Standards Expected Cost—the cost that is most likely to be attained. Standard Cost—a carefully developed cost per unit that should be obtained. Standard Cost Systems—value products according to only standard costs and are used for inventory valuation purposes. For planning and control purposes, expected future costs and expected future activity levels are used to set budgets and prepare performance reports. The standard costs from the standard cost system are not necessarily used because they may differ from the expected future costs. Companies use different cost systems for inventory valuation, product costing for decisionmaking, and for performance evaluation. What standard of expected performance should be used? Perfection Standards (or Ideal Standards)—expressions of the most efficient performance possible under the best conceivable conditions, using existing specifications and equipment. No provision is made for spoilage, waste, machine breakdowns, and so on. These standards are not frequently used because of the adverse effect on employee motivation resulting from their use. The unfavorable variances resulting from the use of these standards indicate the improvement that is possible through continuous improvement efforts. Currently Attainable Standards—levels of performance that can be achieved by realistic levels of effort. They are set just tightly enough so that employees regard

their attainment as highly probable if normal diligence and effort are exercised. These standards allow for normal defectives, waste, spoilage, and nonproductive time. Variances from these standards should be random and negligible. Another interpretation is that they are set tightly and employees regard their fulfillment as possible, though unlikely. They can only be achieved under very efficient operations. With this interpretation, variances tend to be unfavorable while employees view them as being tough but reasonable goals. Advantages are that they can be used for financial budgeting, inventory valuation, and departmental performance evaluation. They also have a desirable motivational impact on employees. IVV. Finding Explanations for Variances A.

Trade-offs Among Variances Because the operations of organizations are linked, the level of performance in one area of operations will affect performance in other areas. Paying higher than standard costs for materials results in an unfavorable materials price variance. However, if the higher price is due to a better-than-standard quality of material being purchased, less scrap and rework than normal may be possible, resulting in a favorable materials usage variance. The labels “favorable” and “unfavorable” are attention directors, not problem solvers. Faulty expectations may be the cause of variances rather than the execution of plans by managers. The validity of expectations must be questioned whenever variances exist.

When to Investigate Variances If the variance is a result of random fluctuations, investigation is not needed. Managers expect a range of “normal” variances: this range may be based on economic (how large a dollar amount) or statistical (number of standard deviations from the expected mean) criteria. A typical investigation rule of thumb is to investigate all variances exceeding a certain dollar amount or percentage of expected cost, whichever is lower. The goal is to investigate those variances for which corrective action creates savings larger than the cost of investigation (i.e., benefits are greater than the costs).

Comparisons with Prior Period’s Results Some organizations compare the most recent budget period’s actual results with last year’s results for the same period or last month’s results rather than use the flexible budget’s benchmarks. Unless the activities undertaken in the current period are nearly the same as those for the year ago period or prior month, this comparison does not reveal much meaningful information.

More Detailed Analysis of Flexible-Budget Variances

Materials, labor, and overhead variances may be subdivided into price, usage, and spending components. If direct-labor costs are small in relation to total costs, they may be treated as overhead. Therefore, separate labor variances are not computed. A.

Variances for Direct Material and Direct Labor Variances from material and labor standards are found by comparing the flexible budget at the actual output level with the actual costs for these items. The flexiblebudget amounts are those that would have been spent for the actual output with expected efficiency. They are computed as follows: Flexible budget = Units of actual output achieved × Standard input allowed per unit of output achieved × standard price per unit of input

Computing Price and Quantity Variances

{L. O. 6}

Flexible-budget variances measure the relative efficiency of achieving the actual output. The price and usage variances subdivide the flexible-budget variance. Price Variance—the difference between actual input prices and standard input prices multiplied by the actual quantity of inputs used. Quantity Variance—the difference between the quantity of inputs used and the quantity of inputs that should have been used to achieve the actual quantity of output. Rate Variance—the difference between actual labor rates and standard labor rates multiplied by the actual quantity of labor used. The variances should be separated into those that are subject to a manager’s direct influence and those that are not. Prices are typically less controllable than usage factors. The variances, once computed, should be used to raise questions, provide clues, and direct attention rather than to explain why budgeted operating income was not achieved. The effects of trade-offs between prices and usage should be analyzed. Was the purchase of substandard, lower-price materials a good idea? The objective is to hold either price or usage constant so that the effect of the other can be isolated (see EXHIBITS 8-9 and 8-10). Direct-Material Price Variance = (actual price – standard price) x actual quantity Direct-Labor Price (Rate) Variance = (actual price – standard price) x actual quantity Direct-Materials Quantity Variance = (actual quantity used – standard quantity) x standard price Direct-Labor Quantity (Efficiency or Usage) Variance = (actual quantity used – standard quantity) x standard price

Summary of Materials and Labor Variances Exhibit 8-10 presents the analysis of direct material and direct labor in a format that deserves close study.

Interpretation of Price and Quantity Variances If the actual price is less than standard or the actual quantity used is less than the standard quantity allowed, the variance is favorable. The opposite relationships imply unfavorable variances. See EXHIBIT 8-10 for a graphical representation of the variances. When production does not equal sales, the sales-activity variance is the difference between the static budget and the flexible budget for the number of units sold. In contrast, the flexible-budget cost variances compare actual costs with flexiblebudgeted costs for the number of units produced. Therefore, two flexible budgets must be prepared. When the number of units of raw materials differs from the amount used in production, the price variance should be computed based on the actual amount purchased. The usage variance should still be based on the actual usage of materials as compared to the quantity allowed for the production level achieved.

Overhead Variances A.

Variable Overhead Variances

{L. O. 7}

The flexible-budget variance for variable overhead is subdivided into the variableoverhead efficiency variance and the variable overhead spending variance, computed as follows: Variable-Overhead Efficiency Variance = (actual quantity of – standard quantity) x cost-driver unit of cost driver allowed

standard variable-overhead rate per cost-driver

Variable-Overhead Spending Variance = actual variable overhead – (standard variable overhead rate per unit of cost-driver

actual cost-driver) activity used

The efficiency variance is controlled by regulating the cost-driver activity and the spending variance through the price paid for variable-overhead items. See EXHIBIT 8-11 for illustrations of the general approach for subdividing the

flexible-budget variances into the direct-materials price and usage variances, directlabor price and usage variances, and variable-overhead spending and usage variances. Actual costs are in the left-most column (A). A flexible budget based on actual inputs with expected prices is the center column (B). Finally, the right-most column contains a flexible-budget amount based on expected inputs for the actual outputs achieved at the expected prices (C). Differences between (A) and (B) are due to prices and differences between (B) and (C) are due to usage. B.

Fixed Overhead Variances

{L. O. 8}

The flexible budget in Column B based on actual inputs and the flexible budget in Column C based on standard inputs allowed are always the same. Fixed overhead is not expected to vary with the level of output (nor with the level of inputs). The entire fixed overhead flexible-budget variance shown in Exhibit 8-11 arises due to the difference between columns A and B because there is, by definition, no difference between columns B and C. This difference between the actual fixed overhead cost in column A and the budgeted cost in column B is the fixed overhead spending variance.

CHAPTER 8:

Quiz/Demonstration Exercises

Learning Objective 1 1.

_____ budgets provide expected revenues and costs for several levels of activity. a. flexible b. continuous c. master d. static

_____ are budgets for a single activity level. a. flexible budgets b. master budgets c. both A and B d. static budget

Learning Objective 2 3.

The Tiger Company has the following budgeted costs for the production of its only product, exercise machines: Variable manufacturing costs $ 200.00 per unit Selling expenses $ 30.00 per unit Administrative $ 20.00 per unit Fixed manufacturing costs $ 300,000 per month Fixed selling and admin. costs $ 150,000 per month What are High Tech’s expected costs for 10,000 units of product to be produced and sold in March? a. $ 2,300,000 b. $ 2,950,000 c. $ 450,000 d. $ 2,500,000

The flexible budget is based on the same assumptions of revenue and cost behavior (within the relevant range), as is the _____. a. master budget b. static budget c. neither A nor B d. both A and B

Learning Objective 3 5.

Which of the following is descriptive of an activity-based flexible budget? a.

based on actual costs for each activity center and related cost driver

b. c. d. 6.

based on budgeted costs for each activity center and related cost driver is limited to no more than ten activity centers A and C

The key differences between the traditional flexible budget and the activity-based flexible budget are _____. a. b. c. d.

the traditional should be used when a significant portion of the costs vary with cost drivers other than units of production traditional flexible budgeting is dramatically increasing in popularity some manufacturing costs that are fixed with respect to unit are variable with respect to cost drivers, and other than units, used for an activity-based flexible budget the larger the company, the more likely the activity-based flexible budget will not be used

Learning Objective 4 7.

When revenues or variable costs per unit of activity and fixed costs per period may not be as expected, this is called _____. a. flexible-level variance b. activity-budget variance c. static-budget variance d. master-budget variance

The flexible budget is prepared using the _____. a. estimated levels of activity of the closest competitor b. historical levels of activity c. most conservative levels of activity d. actual levels of activity

Learning Objective 5 9.

_____variances measure how effective managers have been in meeting the planned level of sales. a. continuous-budget b. flexible-budget c. sales-activity d. master-budget

10.

_____ variances measure the efficiency of operations at the actual level of activity. a. b. c. d.

zero-based budget master-budget flexible-budget sales-activity

Learning Objective 6 Use the following information for questions 11 through 14. The Victor Company has developed the following standards for one of their products. Direct materials: 10 pounds x $4 per pound Direct labor: 5 hours x $10 per hour Variable overhead: 5 hours x $2 per hour The following activity occurred during the month of July: Materials purchased: 1,000,000 pounds at $4.10 per pound Material used: 800,000 pounds Units Produced: 20,000 units Direct labor: 110,000 hours at $7.50 per hour Actual variable OH: $250,000 The company records the materials price variance at the time of purchase. 11.

The materials price variance is _____. a. $80,000 favorable b. $80,000 unfavorable c. $100,000 unfavorable d. $100,000 favorable

12.

The labor usage variance is _____. a. $70,000 favorable b. $70,000 unfavorable c. $100,000 unfavorable d. $100,000 favorable

Learning Objective 7 13.

The variable overhead spending variance is _____. a. $50,000 unfavorable b. $50,000 favorable c. $100,000 favorable d. $100,000 unfavorable

14.

The variable overhead efficiency variance is _____. a. $20,000 unfavorable b. $20,000 favorable c. $10,000 favorable d. $10,000 unfavorable

CHAPTER 8:

Solutions to Quiz/Demonstration Exercises

1. [a] 2. [c] 3. [b]

From the information provided, Tiger’s flexible-budget cost formula is $450,000 + $250.00 X, where X is the number of units produced. Inserting 10,000 for X gives $450,000 + ($250.00 x 10,000) which equals $2,950,000.

4. [d] 5. [b] 6. [c] 7. [a] 8. [d] 9. [c] 10. [c] 11. [c] As stated, the company determines the price variance based on the material purchased. Therefore, the price variance is ($4.10 – $4.00) x 1,000,000 pounds, which is $100,000. The variance is unfavorable because the actual price paid ($4.10) exceeds the standard price ($4.00). 12. [c] The labor usage variance is found by multiplying the standard labor rate ($10) by the difference between the actual hours worked (110,000) and the number of hours that should have been taken to produce 20,000 units of 100,000 = 20,000 x 5 hrs./unit. The resulting variance is $100,000 ((110,000-100,000) x $10), which is unfavorable because more hours were worked than should have been for the production level achieved. 13. [a] The spending variance is the difference between the flexible-budget variance and the actual variable-overhead costs. In this case, the flexible budget for variable overhead would be $200,000 (20,000 x 5 hours) x unit x $2/hr. This yields a flexible budget variance of $50,000 unfavorable because actual variable-overhead costs are $250,000. 14. [a] The efficiency variance is the difference between the actual quantity of the cost-driver activity and the standard quantity allowed, which is then multiplied by the standard rate. The actual quantity of 110,000 hours is more than the standard allowed of 100,000 hours. The 10,000 hours difference is multiplied by the standard rate of $2 to arrive at a $20,000 unfavorable variance.

Chapter 9 Management Control Systems and Responsibility Accounting LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 1.

Describe the relationship of management control systems to organizational goals. Explain the importance of evaluating performance and describe how it impacts motivation, goal congruence, and employee effort. Develop performance measures and use them to monitor the achievements of an organization. Use responsibility accounting to define an organizational subunit as a cost center, a profit center, or an investment center. Prepare segment income statements for evaluating profit and investment centers using the contribution margin and controllable-cost concepts. Measure performance against nonfinancial performance measures such as quality, cycle time, and productivity. Use a balanced scorecard to integrate both financial and nonfinancial measures of performance. Describe the difficulties of management control in service and nonprofit organizations.

CHAPTER 9:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 28. 29. 30. 31. 32.

Management Control Systems and Innovation Municipal Responsibility Accounting Control Systems and Customer Service Function of the Value Chain Control Systems and the Production Function of the Value Chain Key Performance Indicators

EXERCISES 33. Responsibility for Stable Employment Policy 34. Salesclerk’s Compensation Plan 35. Common Measures on a Balanced Scorecard 36. Goals and Objectives at Bharti Net 37. Performance Evaluation 38. Simple Controllable Costs 39. Quality Theories Compared 40. Quality Control Chart (EXHIBIT 9-12) 41. Cycle-Time Reporting PROBLEMS 42. Multiple Goals and Profitability 43. Responsibility Accounting, Profit Centers, and Contribution Approach 44. Incentives in Planned Economies 45. Balanced Scorecard 46. Quality Cost Report 47. Six Sigma, Mean, and Variance (EXHIBIT 9-13) 48. Productivity 49. Productivity Measurement CASES 50. 51. 52. 53.

Trade-offs Among Objectives Six Sigma Review of Chapters 1–9 Nike 10k Problem: Strategy at Nike

EXCEL APPLICATION EXERCISE 54. Wages for New Salary-Plus-Bonus Plan COLLABORATIVE LEARNING EXERCISE 55. Goals, Objectives, and Performance Measures INTERNET EXERCISE 56. Management Control System at Procter & Gamble (http://www.pg.com)

CHAPTER 9: I.

OUTLINE

Management Control Systems and Organizational Goals

{L. O. 1}

The foundation for control is the planning process. The outcome of planning provides the basis for control. Management Control System (MCS)—a logical integration of management accounting tools to gather and report data and to evaluate performance. See EXHIBIT 9-1 for the components of an MCS. The purposes of an MCS are: 1. 2. 3. 4. A.

clearly define and communicate the organization’s goals. ensure that every manager and employee understands the specific actions required of him/her to achieve organizational goals. communicate results of actions across the organization. motivate managers and employees to achieve the organization’s goals.

Management Control Systems and Organizational Goals A well-designed MCS aids and coordinates the process of making decisions and motivates individuals throughout the organization to work toward the same goals. It also coordinates forecasting revenue- and cost-driver levels, budgeting, measuring and evaluating performance. See EXHIBIT 9-2 for a description of the process of setting goals, objectives, and performance measures. Overall company goals, objectives, and performance measures are set by top management, not changed often, and reviewed on a periodic basis (usually once a year). Goals answer the question, “What do we want to achieve?” However, goals without measures do not motivate managers. Targets for goals are specific quantified levels of the measures. Goals and measures are often too vague to provide guidance. Therefore, critical processes and critical success factors are used. Critical Processes—series of related activities that directly affect the achievement of organizational goals (e.g., the goal “exceed guest expectations” would have “produce and deliver services” as a critical process). Critical (Key) Success Factors—actions that must be done well to drive the organization toward its goals (e.g., timeliness is a critical success factor for the “produce and deliver services” process and is measured by check-in time, check-out time, and response time to guest requests). Managers often face trade-off decisions with measures.

II.

Designing Management Control Systems and Organizational Goals {L. O. 2} A.

Motivating Employees To achieve maximum benefits at minimum costs, an MCS must foster goal congruence and managerial effort. Goal Congruence—individuals and groups aiming at the same organizational goals. It occurs when employees, working in their

perceived best interest, make decisions that meet the overall goals of the organization. Managerial Effort—exertion toward a goal or objective. Effort means not only working faster, but also working better (i.e., more efficient and effective). Incentives must be incorporated in the MCS to encourage goal-congruent behavior and managerial and employee effort. Performance evaluation along with bonuses tied to the achievement of objectives may help in this area. Motivation—aiming for some selected goal together with the resulting drive (effort) that creates action toward that goal. B.

Developing Performance Measures

{L. O. 3}

Both financial and nonfinancial measures of performance are important in achieving an organization’s objectives. Common to good performance measures are that they will have the following characteristics: 1. Reflect key actions and activities that relate to the goals of the organization 2. Affected by actions of managers and employees 3. Readily understood by employees 4. Reasonably objective and easily measured 4. Used consistently and regularly in evaluating and rewarding managers and employees 5. Balance long-term and short-term concerns Consideration of nonfinancial measures of performance can improve operational control. These nonfinancial measures may be timelier, and more easily understood and closely affected by employees at lower levels of the organization, where the product is made or services are rendered. Activities are now stressed that drive revenues and costs, instead of explaining the financial measures after the activity has occurred. The effects of nonfinancial measures of performance typically are not seen in the financial measures until considerable ground is lost. Financial measures are lagging indicators that arrive too late to help prevent problems and ensure the organization’s health. C.

Monitoring and Reporting Results A key driver of enterprise performance is the culture within the company that fosters continual learning and growth at all levels of management. Improvement in business processes must take place across all parts of the value chain. The performancereporting system, if effective, aligns results with managers’ goals and objectives, provides guidance to managers, communicates goals and their level of attainment throughout the organization, and enables organizations to anticipate and respond to change in a timely manner (see EXHIBIT 9-3).

Weighing of Costs and Benefits Designers of an MCS must also weigh the costs and benefits of various alternatives. These are often difficult to measure, and both may become apparent only after

experimentation or use. III.

Controllability and Measurement of Financial Performance MCS often distinguish between controllable and uncontrollable events and between controllable and uncontrollable costs. Usually, responsibility center managers are in the best position to explain their center’s results even if the managers had little influence over them. Uncontrollable Cost—cannot be affected by the management of a responsibility center within a given time span. Controllable Costs—influenced by a manager’s decision and actions. Costs that are completely uncontrollable tell nothing about a manager’s decisions and actions because, by definition, nothing the manager does will affect the costs. Uncontrollable costs should be ignored in evaluating a manager’s performance, whereas controllable costs should be used. Activity-based costing is helping companies to identify controllable costs. A.

Identifying Responsibility Centers

{L. O. 4}

Responsibility Center—a set of activities assigned to a manager, a group of managers, or a group of employees. An effective MCS gives each lower-level manager responsibility for a group of activities and objectives and then reports on: 1. 2. 3.

the results of activities the manager's influence on those results effects of uncontrollable events

Responsibility Accounting—identifies what parts of the organization have primary responsibility for each objective, develops performance measures and targets to achieve, and designs reports of these measures by organization subunit, or responsibility center. Responsibility centers usually are classified according to their financial responsibility. 1.

Cost Centers, Profit, and Investment Centers Cost Center—a responsibility center in which a manager is accountable for costs only (e.g., accounting department). Its financial responsibilities are to control and report costs only. Profit Center—responsibility for controlling costs (or expenses) as well as revenues (e.g., marketing department). Nonprofit organizations whose goal is to break even are also considered profit centers because they have responsibilities for both revenues and costs. Investment Center—success is measured not only by its income but also by relating that income to its invested capital, as in a ratio of income to the value of the capital employed. This term is not widely used in practice. Instead, these

responsibility centers are typically referred to simply as profit centers. B.

Contribution Margin Many organizations combine the contribution approach to measuring income with responsibility accounting (i.e., report by cost behavior as well as by degrees of controllability). Line a of EXHIBIT 9-5 gives the contribution margin for each of the various segments of a retail grocery store. The relevant segments of the company’s organization chart are shown in EXHIBIT 9-4.

Contribution Controllable by Segment Managers

{L. O. 5}

Line b in EXHIBIT 9-5 gives the contribution controllable by segment managers. Managers of the various segments may have control over certain advertising, sales promotion, salespersons' salaries, management consulting, training and supervision costs that are deducted from the segment contribution margin to yield the contribution controllable by segment managers. When service department costs are allocated, charges are made for division headquarters, or store depreciation or lease costs are determined. No easy answers exist regarding if, and how much of, these costs are controllable by segment managers. D.

Contribution by Segments Fixed expenses (e.g., depreciation, property taxes, insurance, and perhaps the segment manager's salary) are not under the control of the segment manager. These costs are deducted from the contribution controllable by segment managers to give the contribution by segments. Line c in EXHIBIT 9-5 shows segment contributions for a retail grocery store, which approximate the financial performance of the segments, as distinguished from the financial performance of its manager, which is measured in line b.

Unallocated Costs Central corporate costs (e.g., top management and some corporate-level services, such as legal and taxation) are frequently not allocated to segments unless a persuasive cause and effect, or activity-based justification for allocation of these costs.

IV.

Measurement of Nonfinancial Performance A.

{L. O. 6}

Control of Quality Quality Control—the effort to ensure that products and services perform to customer requirements. In the traditional approach to maintaining the desired level of quality in the United States, companies inspected completed products, and rejected or reworked those that failed inspection. Due to the expense of inspection, only a sample of products was tested. The production process was judged to be in control as long as the

number of defective products did not exceed an acceptable quality level. This meant that some defective products could still make their way to customers. Due to competitive pressures, and seeing the success of Japanese products, U.S. companies have learned that the traditional approach is extremely costly. The resources consumed in making and detecting defective parts are a waste, and considerable rework may be necessary to correct the defects. It is also very costly to repair products in use by customers or to win back a dissatisfied customer. Quality Cost Report—displays the financial impact in quality. See EXHIBIT 9-7 for Eastside Manufacturing Company’s quality cost report. There are four categories of quality costs: 1.

2. 3. 4.

Prevention—costs incurred to prevent the production of defective products or deliver substandard services, including engineering analyses to improve product design for better manufacturing, improvements in production processes, increased quality of material inputs, and programs to train personnel Appraisal—costs incurred to identify defective products or services including inspection and testing Internal Failure—costs of defective components, and final products or services that are scrapped or reworked External Failure—costs caused by delivery of defective products or services to customers, such as field repairs, returns, and warranty expenses The costs stated in reports typically understate the true quality costs because lost sales are not included due to measurement difficulty.

In recent years, more companies are taking the total quality management (TQM) approach to quality control. Total Quality Management—concentrates on the prevention of defects and on customer satisfaction and is the application of quality principles to all the organization’s endeavors to satisfy customers. The TQM approach assumes that the cost of quality is minimized when a firm achieves high quality levels. TQM delegates the responsibilities for many management functions to employees. For it to be successful, employees must be very well trained in the process, the product or service, and the use of quality-control information. In TQM, employees are trained to prepare, interpret, and act on quality-control charts, like that shown in EXHIBIT 9-8. Quality-Control Chart—statistical plot of measures of various product dimensions or attributes. The plot helps to detect process deviations before the process generates defects and identifies excess variation in product dimensions or attributes that should be addressed by process or design engineers. The most recent trend in quality control is six sigma, an analytical method aimed at achieving near-perfect results on a production line. Literally, six sigma requires fewer

than 3.4 defects per million. The focus is on measuring how many defects a company has in its process because once it measures the defects; it can take steps to eliminate them. B.

Control of Cycle Time Cycle Time (or Throughput Time)—the time taken to complete a product or service, or any of the components of a product or service. It is a summary measure of manufacturing efficiency and effectiveness, and is an important cost driver. The longer a product or service is in process the more costs are consumed. Lowering cycle time requires smooth-running processes and high quality, and also creates increased flexibility and quicker reactions to customer needs. As cycle time is decreased, quality problems become apparent throughout the process and must be solved if quality is to improve. Decreasing cycle time also results in bringing products or services more quickly to customers, a service customers’ value. The use of bar coding can be used to measure cycle times. Reports for cycle times, such as that in EXHIBIT 9-10, can be prepared to alert managers' attentions to cycle-time problem areas.

Control of Productivity Productivity—a measure of outputs divided by inputs. The fewer inputs needed to produce a given output, the more productive the organization. Companies differ as to which measures of input are most important depending on whether they are laborintensive, machine-intensive, or material-intensive organizations. Examples of different types of productivity ratios are given in EXHIBIT 9-11.

Choice of Productivity Measures The productivity measures companies choose to manage depend on the behaviors desired. Sometimes myopic attention to one or a few measures comes at the expense of others, resulting in the endangerment of the long-run profitability of a firm. Rather than specify productivity goals, managers may concentrate their control on the more fundamental activities of quality and service. Then the productivity measures can be used to monitor the actual benefits of improvements in these activities.

Productivity Measures Over Time Be careful in comparing productivity measures over time because process changes or inflation can make them misleading.

The Balanced Scorecard

{L. O. 7}

Balanced Scorecard—performance measurement and reporting system that strikes a balance between financial and operating measures, links performance to rewards, and gives explicit recognition to the diversity of stakeholder interests. Line managers can understand the numbers presented due to the use of nonfinancial measures. The

balanced scorecard focuses on performance measures from across the spectrum of the organization. This enhances the learning process because managers are made aware of the results of actions and how these actions are linked to the organizational goals. The classic balanced scorecard includes key performance indicators—measures that drive the organization to meet its goals—grouped into four categories (see EXHIBIT 9-11): 1. 2. 3. 4. IV.

Financial Customers Internal Processes Employee Growth and Learning

Management Control Systems in Service, Government, and Nonprofit Organizations {L. O. 8} Service, government, and nonprofit organizations have more difficulty implementing management control systems than do manufacturing firms because their outputs are more difficult to measure. Nonprofit and governmental agencies have the additional problem of not having a financial “bottom line” as an objective. Also, many people in nonprofit organizations seek their positions for reasons other than monetary rewards (e.g., the desire to help improve conditions in underdeveloped countries). There are six reasons why control systems will probably not be as highly developed in nonprofit organizations as they are in profit-seeking firms. 1. 2. 3.

4. 5. 6. VI.

Organizational goals are less clear and multiple, which requires difficult tradeoffs. Professionals dominate and have been less receptive to the installation and improvement of a formal control system. Measurements are more difficult because there is no profit measure and there are many discretionary fixed costs, which makes the relationships of inputs to outputs difficult to specify and measure. There is less competitive pressure to improve management control systems. The role of budgeting is often more a matter of playing bargaining games with sources of funding than it is rigorous planning. Motivations and incentives of individuals differ from those in for-profit organizations.

Future of Management Control Systems Certain management control principles that can guide the redesign of systems to meet new management needs follow: 1. 2.

Always expect that individuals will be pulled in the direction of their own self-interest. Design incentives so those individuals who pursue their own self-interests are also achieving the organization's objectives. When multiple objectives are present, multiple incentives are appropriate. Evaluate actual performance based on expected or planned performance, revised, if possible, for actual output achieved.

4. 5. 6.

Consider nonfinancial performance to be an important determinant of long-term success. Array performance measures across the entire value chain of the company. Periodically review the success of the management control system. Are objectives being met? Does meeting the objectives mean that subgoals and goals are being met too? Do individuals have, understand, and use the management control information effectively? Learn from management control successes (and failures) of competitors around the world. Despite cultural differences, human behavior is remarkably similar. Successful applications of new technology and management controls may be observed in the performance of others.

CHAPTER 9:

Quiz/Demonstration Exercises

Learning Objective 1 1.

A management control system is distinguished from a purely accounting system by _____. a. its focus on motivation and evaluation of performance consistent with the organization's goals b. its focus on organizational goals and objectives c. its focus on internal management decision making d. all of the above

Which of the following affects all components of a management control system? a. progress measurement b. feedback c. learning d. A and C e. A, B, and C

Learning Objective 2 3.

In order to encourage goal-congruent behavior and to motivate managerial effort, a management control system must include _____. a. ultimatums from top management regarding the accomplishment of short-run profitability without regard to long-run consequences b. organizational goals that are not rewarded by the performance evaluation and incentive structure of the firm c. a performance evaluation and incentive structure inconsistent with the organization's goals d. none of these

A management control system must foster _____. a. goal congruence b. managerial effort c. individuality d. B and C e. A and B

Learning Objective 3 5.

Good performance measures will not be _____. a. concerned with only long-term goals b. easily measured c. used to evaluate managers d. readily understood

Which of the following is a financial measure? a. number of defects b. required return on investments c. amount of wasted materials by employee d. number of customer complaints

Learning Objective 4 7.

Which of the following responsibility centers does not have accountability for revenues? a. investment centers b. profit centers c. cost centers d. none of the above

Which of the following is an example of a cost center? a. a division b. an accounting department c. a plant d. a subsidiary

Learning Objective 5 9.

In a segment income statement prepared using the contribution margin format, the key measure that is used to evaluate managers of the segments is _____. a. contribution controllable by segment managers b. contribution by segments c. unallocated costs d. contribution margin

10.

An example of an uncontrollable cost to a raw materials supervisor is _____. a. quality costs b. information system support cost c. ordering errors d. shipping costs

Learning Objective 6 11.

A quality cost report details the various costs of maintaining and selling quality products to customers and includes which of the following four categories? a. promotion, detention, suspension, and retention b. recision, derision, provision, and sedition c. elevation, degradation, normalization, and interpretation d. prevention, appraisal, internal failure, and external failure

12.

An example of an external failure cost is _____. a. a decrease in the quality of material inputs

b. c. d. 13.

scrap costs warranty costs inspections costs

For a company to improve its productivity, it must _____. a. use more inputs to produce fewer outputs b. produce fewer outputs for the level of inputs used c. use more inputs to produce the same level of output d. produce more outputs for the level of inputs used

Learning Objective 7 14.

The classic balanced scorecard’s key performance indicators include _____. a. financial b. employee growth and learning c. external processes d. A, B, and C e. A and B

15.

Which of the following examples does not measure financial performance? a. inventory turnover b. working capital c. market share d. all of the above

Learning Objective 8 16.

Service and nonprofit organizations have more difficulty in implementing management control systems than do manufacturing firms because _____. a. their outputs are more difficult to measure b. they have no goals c. they are concerned with the satisfaction of their customers d. their managers are less sophisticated and do not understand the purpose and use of management control systems

17.

Service and nonprofit organizations differ from profit-seeking organizations because in service and nonprofit organizations, _____. a. organizational goals and objectives are more easily determined b. less competitive pressure is exerted from other nonprofit organizations c. discretionary costs are usually small d. budgeting is less of a bargaining game

CHAPTER 9:

Solutions to Quiz/Demonstration Exercises

1. [d] 2. [d] 3. [d] 4. [e] 5. [a] 6. [b] 7. [c] 8. [b] 9. [a] 10. [b] 11. [d] 12. [c] 13. [d] 14. [e] 15. [c] 16. [a] 17. [b]

Chapter 10 Management Control in Decentralized Organizations LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 9.

Define decentralization and identify its expected benefits and costs. Distinguish between responsibility centers and decentralization. Explain how the linking of rewards to responsibility-center performance metrics affects incentives and risk. Compute return on investment (ROI), economic profit, and economic value added (EVA). Compare the incentives created by income, ROI, and economic profit (or EVA) performance measures. Define transfer prices and identify their purpose. State the general rule for transfer pricing and use it to assess alternative transfer prices based on total costs, variable costs, or market prices. Identify the factors affecting multinational transfer prices. Explain how controllability and management by objectives (MBO) aid the implementation of management control systems.

CHAPTER 10:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 23. Decentralization 24. Comparing Financial Measures of Performance 25. Performance Metrics and Ethics 26. Transfer Pricing and Organizational Behavior EXERCISES 27. Simple ROI Calculations 28. Simple ROI Calculation 29. Simple ROI and Economic Profit Calculations 30. EVA 31. Comparison of Asset and Equity Bases 32. Finding Unknowns 33. Gross Versus Net Asset Value 34. Variable Cost as a Transfer Price 35. Maximum and Minimum Transfer Price 36. Multinational Transfer Prices PROBLEMS 37. Agency Theory 38. Margins and Turnover 39. ROI by Business Segment 40. EVA versus Economic Profit 41. EVA 42. EVA 43. Evaluation of Divisional Performance 44. Use of Gross or Net Book Value of Fixed Assets 45. Role of Economic Value and Replacement Value 46. Profit Centers and Transfer Pricing in an Automobile Dealership 47. Transfer Pricing 48. Transfer-Pricing Concession 49. Transfer Prices and Idle Capacity 50. Transfer-Pricing Principles 51. Negotiated Transfer Prices 52. Transfer Prices and Minority Interests 53. Multinational Transfer Prices 54. Review of Major Points in This Chapter CASES 55. 56. 57.

Profit Centers and Central Services Management by Objectives Nike 10k Problem: ROI and Economic Profit

EXCEL APPLICATION EXERCISE

58.

Return on Investment and Economic Profit

COLLABORATIVE LEARNING EXERCISE 59. ROI INTERNET EXERCISE 60. Decentralization at Marriott International (http://www.marriott.com)

CHAPTER 10: I.

OUTLINE

Centralization Versus Decentralization

{L. O. 1}

Decentralization—the delegation of decision-making authority to managers throughout an organization. The lower in the organization that this freedom exists, the greater the degree of decentralization. Decentralization is a matter of degree along a continuum. Decentralization is not right for every firm. Centralization is the process by which decision-making is concentrated with a particular location or group. A.

Costs and Benefits Benefits of decentralization include: 1. Better decisions made by lower-level managers due to their having the best information regarding local conditions, 2. the acquisition of decision-making ability and other management skills that help lower-level managers move up in an organization, and 3. better motivation and higher status of lower-level managers. Costs include: 1. Making decisions that are not in the organization’s best interests, 2. duplication of services, 3. higher costs of accumulating and processing information, and 4. the waste of time due to dickering with other organizational units about goods or services one unit provides to another.

Middle Ground Cost-benefit considerations usually require that some management decisions are highly decentralized and others centralized. Decentralization is most successful when an organization’s segments are relatively independent of one another (i.e., decisions of a manager in one segment will not affect the fortunes of another segment). If much internal buying and selling or buying and selling from the same suppliers and outside markets take place, segments are candidates for heavier centralization.

Responsibility Centers and Decentralization

{L. O. 2}

Do not confuse profit centers (accountability for revenue and expenses) with decentralization (freedom to make decisions). Some profit center managers have considerable freedom in making decisions, whereas others need top-management approval for most decisions. Deciding on whether to use a cost center or a profit center hinges on whether goal congruence and managerial effort are enhanced, not on the degree of decentralization present. II.

Performance Metrics and Management Control

{L. O. 3}

Agency Theory, Performance, and Rewards Managers tend to focus their efforts in areas where performance is measured and where their performance affects rewards. The more objective the measures of performance, the more likely the manager will provide effort. The choice of rewards clearly belongs within an overall system of management control. They may be monetary, as in pay raises and bonuses, or they can be nonmonetary, such as promotions, praise, self-satisfaction, elaborate offices, and private dining rooms. The design of a reward system is mainly the concern of top management.

III.

Measures of Segment Performance A.

{L. O. 4}

Income Measures Measures of income are readily available from the financial reporting system at any level of the organization for which a company can identify revenues and expenses, such as a subsidiary, a division, or a business unit.

Return on Investment Return on Investment (ROI)—income (or profit) divided by the investment required to obtain that income or profit. This is a better test of profitability than is examining the income generated by different business segments. Given the same risks, for any given amount of resources required, the investor wants the maximum income. ROI is a useful common denominator and can be compared with rates inside and outside the organization, and with opportunities in other projects and industries.

ROI as the Product of Return on Sales and Investment Turnover The calculation of ROI is as follows: ROI

= =

income/revenue × revenue/invested capital return on sales × capital turnover

An improvement in either the Income Percentage Of Revenue (or Return on Sales)—income divided by revenue, or Capital Turnover—revenue divided by invested capital, without changing the other will improve ROI. Increasing turnover is one of the advantages of implementing the JIT philosophy. D.

Measuring Investment

Definitions of Investment Possible definitions of investment in this example are as follows: 1. Stockholders’ equity: This definition considers only the investment by the

stockholders. 2. Stockholders’ equity and long-term liabilities. This definition encompasses not only the investment by stockholders but also the investment by debt investors. 3. Stockholders’ equity, long-term liabilities, and current liabilities: This definition encompasses all sources of financing for the firm. Because of the accounting identity, this is also equal to total assets. F.

Valuation of Assets When firms use ROA measures, two additional issues arise related to the valuation of total assets. First, companies could value assets contained in the investment base at either gross book value or at net book value. Second, they should value assets at either historical cost or some version of current cost. Some possible definitions of invested capital are: 1. Total assets 2. Total assets employed (excludes vacant land and construction in process) 3. Total assets less current liabilities 4. Stockholders’ equity Averages for the period are typically used. For divisional manager performance evaluation, any three of the asset bases are recommended rather than stockholders’ equity. Total assets are the best base if the manager’s mission is to put all assets to their best use regardless of their financing. If extra assets must be carried that are not currently productive upon the direction of top management, then total assets employed is the best measure. If the manager has direct control over short-term credit and bank loans, then total assets less current liabilities is best. Managers will focus attention on reducing those assets and increasing those liabilities that are included in their base in order for their ROI or residual income to look better. Most companies use all assets in invested capital when computing ROI and residual income, and about half deduct some portion of current liabilities. Assets can be valued using gross book value (original cost), net book value (original cost less accumulated depreciation), and historical cost, or some version of current value. Practice is overwhelmingly in favor of net book value based on historical cost. Historical cost is used due to cost-benefit, objectivity, predictive ability, and risk reasons. However, for non-routine decisions, special studies should be undertaken to gather any current values that are relevant. Plant and Equipment: Gross or Net? Net Book Value (or book value)—original cost less accumulated depreciation. Most companies use net book value when calculating their investment. Gross Book Value—original cost of an asset before deducting accumulated depreciation. Some companies use gross book value because it facilitates comparisons between years and between plants or divisions. An example showing the impact of using net book value or gross book value on ROI is presented that shows improving results in later years

using net book value and a steady ROI if gross book value is used. The effect on motivation should be considered when selecting between net and gross book value. Managers evaluated using gross book value will tend to replace assets sooner than those firms using net book value. G.

Incentives from ROI Although evaluation based on ROI causes manager to consider both income and investment in their decisions, it still may not align the incentives for the manager with the goals of the firm.

IV.

Economic Profit or Economic Value Added (EVA) Some companies favor emphasizing an absolute amount of income rather than a percentage return. Economic Profit (Residual Income)—net income less “imputed” interest. Cost of Capital (“Imputed” interest)—what the firm must pay to acquire more capital, whether or not it actually has to acquire more capital to take on this project. The cost of capital is the minimum acceptable rate of return for investments in a project or division. The “imputed” interest rate used should reflect the risk of the investment. Economic Value Added (EVA)—net operating income less the after-tax weighted-average cost of capital multiplied by the sum of long-term liabilities and stockholders’ equity. EVA is a variant of residual income. EVA may increase shareholder value due to better allocating, managing, and redeploying scarce capital resources. See EXHIBIT 10-2.

Incentives From Income, ROI, or Economic Profit

{L. O. 5}

The use of ROI may cause some divisions to forgo investments that are desirable from a company-wide viewpoint because the investments lower the division’s ROI. The use of economic profit alleviates this problem, because all investments returning more than the company’s cost of capital is acceptable by all divisions because residual income increases. Thus, the use of economic profit (EVA) promotes goal congruence and leads to better decisions than ROI. Yet, most companies use ROI because it is easier for managers to understand, it facilitates comparison across divisions of different sizes, and when combined with appropriate growth and profit targets, dysfunctional motivations can be minimized. See EXHIBIT 10-5. VII.

Transfer Pricing

{L. O. 6}

When segments interact greatly, there is an increased possibility that what is best for one segment hurts another segment badly enough to have a negative effect on the entire organization. Such a situation may occur when one segment provides products or services to another segment and charges that segment a transfer price. Transfer Prices—amounts charged by one segment of an organization for a product or service that it supplies to another segment of the same organization. It is revenue to the segment providing the product or

service, and it is a cost to the acquiring department. A.

Purposes of Transfer Pricing Transfer prices exist within organizations to communicate data that will lead to goalcongruent decisions. They should help guide managers to make the best possible decisions regarding whether to buy or sell products and services inside or outside the total organization. They are also used to help in evaluating segment performance and, thus, motivate both the selling manager and buying manager toward goal-congruent decisions. Finally, multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs.

A General Rule for Transfer Pricing

{L. O. 7}

The general rule for transfer pricing is: Transfer Price

Outlay Cost

Opportunity Cost

Outlay cost is the additional amount the selling segment must pay to produce and transfer a product or service to another segment. It is often a variable cost for producing the item transferred. Opportunity cost is the maximum contribution to profit that the selling segment forgoes by transferring the item internally. See EXHIBIT 104. C.

Market-Based Transfer Prices If a competitive market exists for the product or service being transferred internally, the use of market price as a transfer price will generally lead to the desired goal congruence and managerial effort. Some adjustments to market prices can be made for things like selling and delivery expenses that are not necessary if an internal transfer takes place. However, market prices are not always available for items transferred internally.

Transfers at Cost When market prices are not available, are inapplicable, or are impossible to determine, versions of “cost-plus-a-profit” are often used in order to provide a “fair” or “equitable” substitute for regular market prices. Approximately half of the major companies in the world transfer items at cost. However, there are several possible definitions of cost including actual variable cost, standard variable cost, actual full cost, and standard full cost. There may be a problem with the use of cost as a transfer price. A cost’s behavior pattern may be disguised because the cost drivers affecting the acquiring division are typically units and those for the producing division may be more complicated. Problems with the use of actual cost are that the buying division is hindered in planning because actual cost cannot be

known in advance, and the supplying division has no incentive to control its costs because any inefficiencies are simply passed on to the buying division. The use of budgeted or standard costs is preferred. Cost-based transfer prices lead to dysfunctional decisions—decisions in conflict with the company’s goals. E.

Negotiated Transfer Prices Companies committed to segment autonomy often allow their managers to negotiate transfer prices. Cost and market prices may be considered in the negotiations, but no policy requires this. Supporters claim that because these managers have the best knowledge of what a company will gain or lose by producing and transferring the product or service, negotiation allows managers to make optimal decisions. Critics focus on the time wasted in negotiations.

Multinational Transfer Pricing

{L. O. 8}

Whereas domestic companies focus on goal congruence and motivation in establishing their transfer-pricing policies, multinational companies use transfer prices to try to minimize worldwide income taxes, import duties, and tariffs. Divisions in relatively low-tax countries attempt to set high transfer prices for products being sold to divisions in relatively high-tax divisions, and vice versa. Recognizing this tendency to set transfer prices in an attempt to minimize taxes, tax authorities set restrictions on allowable transfer prices. U.S. multinationals must follow an Internal Revenue code rule specifying that transfers be priced at “arm’slength” market values, or at the values that would be used if the divisions were independent companies. Even with this rule, companies have some latitude in deciding an appropriate “arm’s-length” price. VIII. Keys to Successful Management Control Systems

{L. O. 9}

Focus on Controllability Managers should be evaluated based on their controllable performance (in many cases some controllable contribution in relation to controllable investment). Decisions such as increasing or decreasing investment in a division are based on the economic viability of the division, not the performance of its manager.

Management by Objectives and Setting Expectations Management by Objectives (MBO)—the joint formulation by a manager and his or her superior of a set of goals and of plans for achieving the goals for a forthcoming period. The plans often take the form of a responsibility accounting budget (along with supplementary goals such as levels of management training and safety that may not be incorporated into the accounting budget). The manager’s performance is then

evaluated in relation to these agreed-upon objectives. Use of MBO allows managers to accept assignments to less profitable segments with less reluctance because the manager will be evaluated on budgeted results that are negotiated with a superior and not on absolute profitability. C.

Budgets, Performance Targets, and Ethics Either an ROI or a residual income system can promote goal congruence and managerial effort if top management gets everybody to focus on what is currently attainable in the forthcoming budget period.

CHAPTER 10:

Quiz/Demonstration Exercises

Learning Objective 1 1.

Advantages of decentralization include all of the following except _____. a. reduced service duplication b. better motivation and higher status of lower-level managers c. lower manager motivation d. time taken to negotiate between units

Advantages of decentralization include all of the following except _____. a. divisional management is able to react to changing market conditions more rapidly than top management b. divisional management is a source of personnel for promotion to top management positions c. decentralization permits divisional management to concentrate on firm-wide problems and long range planning d. decentralization can motivate divisional managers

Learning Objective 2 3.

Profit centers can _____. a. be used in both centralized and decentralized operations b. never be used by organizations regardless of their degree of centralization in decision making c. only be used if an organization is decentralized in structure d. only be used if an organization is centralized in structure

The main criticism of profit centers is _____. a. a profit center is difficult to identify b. managers are given profit responsibility without authority c. a profit center is too costly to identify d. A and B e. A and C

Learning Objective 3 5.

According to agency theory, employment contracts will not trade off _____. a. incentive b. risk c. timeliness d. cost of measuring performance

An example of an item that is not a reward for managers is _____. a. a promotion

b. c. d.

praise a larger office staff reduction

Learning Objective 4 Use the following information for questions 7 and 8. Wilson Corporation has three divisions: A, B, and C. The expected earnings and amount of investment in these divisions for the coming year are: Division A B C

Investment $ 1,000,000 1,500,000 2,500,000

Earnings $ 100,000 400,000 500,000

A proposed investment that costs $500,000 and has projected earnings of $100,000 has been offered to each of the three divisions. All divisions can make this investment and the company’s cost of capital is 10%. 7.

If division managers are being evaluated based on return on investment, _____ will invest in the project. a. the manager of division B b. the manager of division A c. the manager of division C d. all three managers

If division managers are being evaluated based on residual income, _____ will invest in the project. a. the manager of division A b. the manager of division B c. the manager of division C d. all three managers

Learning Objective 5 9.

An investment base used in calculating ROI or economic profit that facilitates comparisons between years and between plants and facilities is _____ value. a. net current market b. gross current market c. net book d. gross book

10.

The possible reasons that historical cost may be preferred to current market value when valuing assets for measuring performance is _____. a. lower costs of accumulating data

b. c. d. e.

lower risk more objective A, B and C A and C

Learning Objective 6 11.

When one segment or division of a company provides goods or services to another segment or division within the same company, a _____ price is charged which assists the segment managers in deciding whether the transfer should take place. a. competitive b. transfer c. minimum d. segment

12.

The objective of a transfer pricing system should be to _____. a. maximize the transfer price b. maintain goal congruence between the divisions and the entire firm c. minimize the transfer price d. B and C e. none of the above

Learning Objective 7 13.

The use of cost-based transfer prices has the advantage of _____. a. disguising the true cost-behavior pattern of the good or service being transferred b. reducing inefficiency on the part of the supplying division c. being easy to determine using existing accounting records d. leading to goal congruence and managerial effort more than the use of marketbased prices

14.

Sometimes market prices cannot be used in a transfer-pricing situation. Which of the following is not a reason that market prices cannot be used? a. may be very costly to gather the information b. may be impossible to determine c. may be nonexistent d. may be inapplicable in the transfer pricing situation

Learning Objective 8 15.

Factors influencing transfer pricing in multinational companies include _____. a. complying with legal restrictions placed on the setting of transfer prices such as the use of “arm’s-length” values required in the U.S. b. restrictions on sales tax to foreign owners imposed by foreign governments c. maximizing worldwide taxes and duties

. 16.

all of the above

As compared with national companies, multinational companies are _____. a. more likely to use transfer prices b. less likely to use transfer prices c. equally likely to use transfer prices d. likely to only use transfer prices in times of economic crisis

CHAPTER 10: 1. [b] 2. [c] 3. [a] 4. [b] 5. [c] 6. [d] 7. [b]

Solutions to Quiz/Demonstration Exercises

Before considering investing in the proposed project, the ROIs of the three divisions are expected to be: A—10.00% = $100,000 expected earnings/$1,000,000 investment B—26.67% = $400,000 expected earnings/$1,500,000 investment C—20.00% = $500,000 expected earnings/$2,500,000 investment The resulting ROIs for each division were they to make the investment are: A—13.33% = $200,000 expected earnings / $1,500,000 investment B—23.81% = $500,000 expected earnings / $2,100,000 investment C—19.35% = $600,000 expected earnings / $3,100,000 investment Therefore, only division R’s manager would be compelled to make the investment because it would increase his division’s ROI.

8. [d]

Before considering the investment in the proposed project, the economic profit of each division is: A—$0 = $100,000 – (10% x $1,000,000) B—$250,000 = $400,000 – (10% x $1,500,000) C—$250,000 = $500,000 – (10% x $2,500,000) The residual incomes for each division were they to invest in the project: A—$50,000 = $200,000 – (10% x $1,500,000) B—$290,000 = $500,000 – (10% x $2,100,000) C—$290,000 = $600,000 – (10% x $3,100,000) Because the economic profit would increase for all three divisions, each would invest in the project, which is the desired action from a company-wide perspective.

9. [d] 10. [d] 11. [b] 12. [b] 13. [c] 14. [a] 15. [a] 16. [a]

Chapter 11 Capital Budgeting LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 9.

Describe capital-budgeting decisions and use the net-present-value (NPV) method to make such decisions. Use sensitivity analysis to evaluate the effect of changes in predictions on investment decisions. Calculate the NPV difference between two projects using both the total project and differential approaches. Identify relevant cash flows for NPV analyses. Compute the after-tax net present values of projects. Explain the after-tax effect on cash received from the disposal of assets. Use the payback model and the accounting rate-of-return model and compare them with the NPV model. Reconcile the conflict between using an NPV model for making decisions and using accounting income for evaluating the related performance. Compute the impact of inflation on a capital-budgeting project (Appendix 11).

160

CHAPTER 11:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 25. Investment in R&D 26. Business Valuation and NPV 27. Replacement of Production Facilities 28. Capital Budgeting, Taxes, and Ethics EXERCISES 29. Exercise in Compound Interest 30. Exercise in Compound Interest 31. Exercise in Compound Interest 32. Basic Relationships in Interest Tables 33. PV and Moratorium 34. Simple NPV 35. NPV Relationships 36. New Truck 37. Present Values of Cash Inflows 38. Effect on Required Rate 39. NPV and IRR 40. Sensitivity Analysis 41. NPV and Sensitivity Analysis 42. Depreciation, Income Taxes, Cash Flows 43. After-Tax Effect on Cash 44. MACRS Depreciation 45. Present Value of MACRS Depreciation 46. NPV, ARR, and Payback 47. Weakness of the Payback Model 48. Comparison of Capital-Budgeting Techniques 49. Inflation and Capital Budgeting 50. Sensitivity of Capital Budgeting to Inflation PROBLEMS 51. Replacement of Office Equipment 52. Installation of a Computerized Distribution System 53. Discounted Cash Flow, Uneven Revenue Stream, Relevant Costs 54. Investment in Machine 55. Replacement Decision 56. Minimization of Transportation Costs Without Income Taxes 57. Straight-Line Depreciation, MACRS Depreciation, and Immediate WriteOff 58. MACRS, Residual Value 59. Purchase of Equipment, MACRS 60. MACRS and Non-residential Real Estate 61. PV of After-Tax Cash Flows, Payback, and ARR 62. Investment Justification Analysis and Graphs

161

63. 64. 65. 66. 67. CASES 68. 69. 70. 71. 72.

Fixed and Current Assets; Evaluation of Performance Investment Before and After Taxes After-Tax NPV Minimization of Transportation Costs After Taxes, Inflation Inflation and Nonprofit Institution

Investment in CAD/CAM Investment in Technology Investment in Quality Make or Buy and Replacement of Equipment Nike 10k: Nike Capital Budgeting with NPV

EXCEL APPLICATION EXERCISE 73. Net Present Value and Payback Period for a Purchase Decision COLLABORATIVE LEARNING EXERCISE 74. Capital Budgeting, Sensitivity Analysis, and Ethics INTERNET EXERCISE 75. Capital Budgeting at Carnival Corporation (http://www.carnivalcorp.com)

162

CHAPTER 11: I.

OUTLINE

Capital Budgeting for Programs or Projects Capital Budgeting—long-term planning for making and financing investments that affect financial results over more than just the next year. This chapter concentrates on the planning and controlling of programs or projects that affect more than one year’s financial results. The investments required for programs or projects are often called capital outlays. Accountants are information specialists (i.e., gather and interpret information). Capital budgeting has three phases: 1. 2. 3.

II.

Identifying potential investments, choosing which investments to make, and follow-up monitoring of the investments.

Discounted-Cash-Flow Models Discounted-Cash-Flow (DCF) Models—focus on a project’s cash inflows and outflows while taking into account the time value of money. DCF models are used by the majority of the large industrial firms in the United States and are the best measures of the financial effects of an investment. A.

Major Aspects of DCF DCF models focus on expected cash inflows and outflows rather than on net income and are based on the theory of compound interest. A brief summary of the tables and formulas used is included in APPENDIX B at the end of the book.

Net Present Value (NPV) Net-Present-Value (NPV) Method—a DCF approach to capital budgeting that computes the present values of all expected future cash flows using a minimum desired rate of return. The Required Rate of Return, Hurdle Rate, Discount Rate, or Cost of Capital—the minimum desired rate of return. The manager selects it based upon the project’s risk level. If the sum of the present values of all the expected cash flows is positive, the project is desirable and vice versa. A zero NPV leaves the decision maker indifferent between accepting and rejecting the project (i.e., break even).

Applying the NPV Method

{L. O. 1}

See EXHIBIT 11-1 for an example of the three steps in applying the NPV method: 1. 2.

Prepare a diagram of relevant expected cash inflows and outflows (right-hand side of EXHIBIT 11-1). Find the present value of each expected cash inflow or outflow (see

163

3. D.

APPENDIX B). Sum the individual present values.

Choice of the Correct Table Students should be shown the relationship between and proper use of the tables appearing in APPENDIX B. TABLE 1 should be used in discounting single amounts, whereas TABLE 2 is used for a series (i.e., annuities) of equal amounts. The factors in TABLE 2 are simply summations of the factors from TABLE 1.

Effect of Required Rate The required rate of return can have a large effect on NPVs. The higher the required rate of return, the lower the present value of each future cash inflow and the lower the NPV of the project. Investments that are desirable at one rate of interest may be undesirable at a higher rate of interest.

Assumptions of the NPV Model First, we act as if the predicted cash inflows and outflows will occur at the times specified. Second, we assume perfect capital markets (i.e., borrow or lend money at the same interest rate—minimum desired rate of return for the NPV model). The use of DCF models also passes the cost-benefit test. Depreciation and NPV We are concerned with cash flows, not revenues and expenses. Depreciation is an expense that does not require a current cash outlay. The entire cost of an asset is typically a lump-sum outflow of cash at time zero. Deducting depreciation from operating cash flows would be a double counting of a cost that has already been considered a lump-sum outflow.

Review of Decision Rules Net-Present-Value (NPV) Model—Comparison by expressing all amounts in today’s monetary units at time zero. 1. 2.

Calculate the NPV using the minimum desired rate of return as the discount rate. If the NPV is positive, accept the project, and vice versa.

Internal Rate of Return (IRR) Model This model determines the interest rate at which the NPV equals zero. If IRR > minimum desired rate of return, then NVP > 0, accept project. If IRR < minimum desired rate of return, then NVP < 0, reject project.

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Real Options This model is a capital-budgeting model that recognized the value of contingent investments—that is, investments that a company can adjust as is learns more about their potential for success.

III.

Sensitivity Analysis and Risk Assessment in DCF Models

{L. O. 2}

Sensitivity Analysis—shows the financial consequences that would occur if actual cash inflows differed from those expected. This approach of incorporating risk in capital-budgeting decisions answers “what-if” questions concerning the values of NPV when the cash flows, useful life, or required rate of return are changed. The two major types of sensitivity analysis are: (1) comparing the optimistic, pessimistic, and most likely predictions and (2) determining the amount of deviation from expected values before a decision is changed. Sensitivity analysis shows how risky a project might be by showing how sensitive it is to change. IV.

The NPV Comparison of Two Projects A.

{L. O. 3}

Total Project Versus Differential Approach Total Project Approach—compares two or more alternatives by computing the total impact on cash flows of each alternative and then computing NPVs for each alternative. The project with the largest NPV of total cash flows is preferred. Differential Approach—two alternatives are compared by computing the differences in cash flows between two alternatives and then computing the NPV of those differences. The differential approach is limited to comparing two projects at a time, whereas the total project approach can be used for more than two alternatives. Cash inflows are positive and cash outflows are negative in an analysis. See EXHIBIT 112 for an illustration of the two methods for a keep or replace decision.

Relevant Cash Flows B.

{L. O. 4}

Predicting Relevant Cash Flows Typical items to be included in an NPV analysis are: 1. Initial cash inflows and outflows—Included here are outflows for the purchase and installation of equipment and other items required by the new project, and either inflows or outflows from disposal of any items that are replaced such as their salvage value or costs of dismantling and discarding. 2. Investments in Working Capital—These are typically included as an outlay at time zero and are assumed to be recouped at the end of the project’s life. The difference between the initial outlay for working capital (mostly receivables and inventories) and the present value of its recovery is the present value of the cost of using working capital in the project. 3. Cash inflows and outflows at termination—The disposal value at the date

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of termination of a project is an increase in the cash inflow in the year of disposal. Operating cash flows during the life of the project—The major purpose of most investments is to affect revenue or costs (or both). Only overhead costs that differ between alternatives should be included. Depreciation and book values should be ignored. A reduction in a cash outflow (cash savings) is treated the same as a cash inflow.

Cash Flows for Investments in Technology In comparing the cash flows predicted for a computer-integrated manufacturing system (CIM) with the status quo, the expected cash flows for the status quo manufacturing system should be adjusted for probable decreases in market share, and subsequently revenues, if others in the industry are making CIM investments. In addition, unanticipated cost savings such as the flexibility to make product mix changes easily and the ability to implement design changes quickly and cheaply should be considered. Finally, the difficult-to-predict revenue and cost effects of a CIM investment can be incorporated in the investment decision subjectively.

Income Tax Effects

{L. O. 5}

Income taxes require cash disbursements. They can affect the amount and timing of cash flows. One of their roles in capital budgeting is to narrow the cash differences between projects. Cash savings from operations (i.e., inflows) cause an increase in taxable income, which creates partially offsetting increases in tax outflows. For example, a 40% income tax rate would reduce a $1 million cash operating savings to $600,000 because $400,000 of the $1 million would be paid in taxes. Marginal Income Tax Rate—the tax rate paid on additional pretax income. In capital budgeting, the company’s relevant tax rate is applied to additional cash inflows generated by a proposed project. A.

Effects of Depreciation Deductions One item that often differs between tax reporting and public reporting is depreciation. For public reporting purposes, depreciation spreads the cost of an asset over its useful life. Accelerated Depreciation—which charges a larger proportion of an asset’s cost to the earlier years and less to later years for tax purposes. See EXHIBIT 11-3 for an illustration of the interrelationships of income before taxes, income taxes, depreciation, and cash flows. The total after-tax effect on cash from an investment can be determined several ways. In one calculation, expenses other than depreciation are added to income taxes, which are then deducted from sales to obtain the after-tax cash. In another calculation, depreciation is added back to net income to arrive at after-tax cash. In a third method of computation, after-tax income, excluding the depreciation effects, is computed. Then, the tax savings generated because of the presence of depreciation are added to arrive at the total after-tax effect on cash.

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Recovery Period—period over which an asset is depreciated for tax purposes. Depreciation of fixed assets creates future tax deductions. The present value (PV) of the deductions depends on their specific yearly effects on future income tax payments. Therefore, the PV is influenced by the recovery period, the depreciation method used, the tax rates, and the discount rate. EXHIBIT 11-4 shows a method of analyzing data for capital budgeting, assuming straight-line depreciation. This method separates the cash effects of operations with the cash effects of depreciation. B.

Timing of Depreciation Tax Deductions and Cash Flow Effects The after-tax cash flows from revenues and expenses other than depreciation are found by multiplying the pretax amounts by (1 – the tax rate). In contrast, the after-tax effects of noncash expenses (e.g., depreciation) are computed by multiplying the tax deduction by the tax rate itself. Note that this is treated as a cash inflow because it is a decrease in the tax payment. The total cash effect of a noncash expense is only the tax-savings effect. Two assumptions are that tax payments occur concurrently with related pretax cash flows and that the companies for which analysis is desired are profitable. The first assumption is realistic because companies pay estimated taxes throughout the year. The second assumption is necessary so that the tax benefits can be realized.

Modified Accelerated Cost Recovery System (MACRS) Accelerated Depreciation Income tax laws allow the use of accelerated depreciation methods. Accelerated depreciation is any pattern of depreciation that writes off depreciable assets more quickly than does ordinary straight-line depreciation. The effect of using an accelerated depreciation method on a capital budgeting analysis is to increase the project’s NPV. This is the result of the tax savings occurring earlier in the life of the project and the fact that early-period cash flows are discounted less than late-period ones. See EXHIBIT 11-5 for examples of assets in the eight MACRS classes. See EXHIBIT 11-6 for MACRS depreciation schedules for recovery periods of three, five, seven, and ten years.

Present Value of MACRS Depreciation Tax Deduction In capital-budgeting decisions, it is often useful to know the PV of the tax savings from depreciation. See EXHIBIT 11-7 for the PVs for $1 to be depreciated over MACRS schedules for 3-, 5-, 7-, and 10-year recovery periods. The PV of tax savings can be found in three steps: 1.

Find the factor from EXHIBIT 11-7 for the appropriate recovery period and

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the required return. 2. Multiply the factor by the tax rate to find the tax savings per dollar of investment. 3. Multiply the result by the amount of the investment to find the total tax savings. F.

Tax Effects of Gains or Losses on Disposal at Termination

{L. O. 6}

The disposal of equipment for cash can also affect income taxes. Gains are taxed, reducing the net cash inflow from the sale of assets by the amount of the tax on the gain. Losses create tax savings, which can be added to the cash proceeds from the sale to obtain the net cash inflow from disposing of an asset. Although losses do result in tax savings and gains result in additional taxes, a company still has more net cash inflow from disposing of their assets when gains are realized. Second tax effect occurs when a company disposes of assets before the end of it recovery period. In addition to taxable gains or losses, disposal eliminates future tax depreciation. The roles of depreciation and book value are widely misunderstood when performing an analysis of the replacement of equipment. The following points summarize the role of depreciation for this type of decision (see EXHIBIT 11-8). 1. Initial investment: The amount paid for (and hence the depreciation on) old equipment is irrelevant, except for its effect on tax cash flows. However, the amount paid for new equipment is relevant because it is an expected future cost that will not be incurred if replacement is rejected. 2. Do not double-count: The investment in equipment is a one-time outlay at time zero. It should not be double-counted as an outlay in the form of depreciation. 3. Relation to income tax cash flows: The relevant item is the income tax effect, not the book value or the depreciation. The book value and depreciation are useful in predicting future income tax disbursements. VII.

Other Models for Analyzing Long-Range Decisions A.

{L. O. 7}

Payback Model Payback Time (or Payback Period)—measure of time it will take to recoup, in the form of cash inflows from operations, the initial outlay. In formula form: payback time =

initial investment /

equal annual cash inflows from operations

A weakness is that it does not measure profitability (i.e., the cash flows beyond the payback period) and it ignores the time value of money. A strength is that it provides a rough estimate of risk, especially in decisions involving areas of rapid technological

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change. When uneven cash flows are present, the formula given above cannot be employed. Instead, a cumulative approach must be used. Cash flows are accumulated until an amount equaling the initial investment is obtained. Prorating cash flows in the last year of the payback is sometimes required. B.

Accounting Rate-of-Return Model Accounting Rate-of-Return (ARR) Model (or the accrual accounting rate-of-return model, the unadjusted rate-of-return model, the book-value model)—a non-DCF capital-budgeting model expressed as the increase in expected average annual operating income divided by the initial required investment. ARR =increase in expected average / initial required annual operating income investment It shows the effect of an investment on an organization’s financial statements. The ARR may also be computed using the average investment in the asset, in which case the rate doubles. Major weaknesses of the ARR model are that it ignores the time value of money and the timing of cash flows.

VIII. Performance Evaluation A.

{L. O. 8}

Potential Conflict Managers are frequently frustrated if they are instructed to use a DCF model for making decisions and are evaluated later by a non-DCF model, such as the typical accounting rate-of-return model, which is based on accounting income instead of cash flows. An illustration is provided which shows that the ARR can be low in the early years of an asset’s life (due to a high book value) and higher in later years. Unfortunately, managers expecting to move to new positions within the next few years will be reluctant to make equipment replacement decisions because they will not be around when the higher ARR figures occur. They are also reluctant to replace due to heavy book losses on replaced equipment (see discussion in CHAPTER 6).

Reconciliation of Conflict Resolving the conflict between the use of DCF models for decision-making and nonDCF measures of performance can be accomplished using non-DCF models for decision making. However, the DCF models are superior analytical models. Another approach would be to use DCF models for both decision making and performance evaluation. Post-audits—a follow-up evaluation of capital-budgeting decisions. The purposes of post-audits include: 1. 2.

Seeing that investment expenditures are proceeding on time and within budget. Comparing actual cash flows with those originally predicted in order to

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3. 4.

motivate careful and honest prediction. Providing information for improving future predictions of cash flows. Evaluating the continuation of the project.

Post-audits are costly to perform because financial information is usually collected, summarized, and reported for products, departments, divisions, and territories, not for projects. However, most large companies use post-audits to some degree. X.

APPENDIX 11: Capital Budgeting and Inflation

{L. O. 9}

In addition to taxes, capital-budgeting decision makers should consider the effects of inflation on their cash flow predictions. If significant inflation is expected over the life of a project, it should be specifically and consistently analyzed in a capital-budgeting model. A.

Watch for Consistency Adjustments for inflation in both the minimum desired rate of return and in the cashflow predictions should be included in an analysis. Nominal (or market) interest rates—quoted market interest rate that includes an inflation element. If used in a capital budgeting analysis, the cash flows should be adjusted for inflation. See EXHIBIT 11-9 for the correct and incorrect ways to analyze an investment when inflation is present. Note that the recommended course of action differs based on the two different NPVs that are calculated. If a real rate of interest were used, the cash flows would not need to be adjusted.

Role of Depreciation Note that the cash savings from depreciation shown in EXHIBIT 11-9 are not affected by inflation because the amount of depreciation allowed by tax laws is based on an initial outlay at time zero. Critics claim that not allowing inflation adjustments for capital assets in computing annual depreciation discourages investment, whereas defenders of the existing U.S. tax laws assert that capital investment is encouraged in many other ways, such as the use of accelerated depreciation method.

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CHAPTER 11:

Quiz/Demonstration Exercises

Learning Objective 1 1.

Accountants are usually involved in which phase(s) of capital budgeting? a. human resource decisions b. reviewing mechanical specifications c. identifying potential investments d. B and C e. A, B, and C

Use the following information for questions 2 and 3. Taylor Company is considering the purchase of some labor-saving equipment for its packaging department. The equipment is expected to result in labor cost savings of $40,000 per year for the expected five-year life of the equipment. The cost of the equipment is $110,000 and the desired rate of return is 6%. 2.

The NPV of the investment for Taylor Company is _____. a. $ 79,558 b. $ 27,434 c. $ 147,434 d. $ 45,000

Learning Objective 2 3.

By how much could the annual labor savings of the equipment described in the illustration above decrease for the project to be minimally acceptable? a. none at all, it is just barely acceptable now b. none at all, it is below the acceptable point already c. just over 18% of the present $30,000 per year labor savings d. just over 15% of the present $30,000 per year labor savings

Sensitivity analysis allows a manager to answer “what-if” questions about changes in _____. a. useful life b. cash flows c. risk d. B and C e. A, B, and C

Learning Objective 3 Use the following information for questions 5 and 6. Turner Corporation is considering the replacement of some equipment by a more efficient,

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technologically advanced model. The new equipment costs $100,000, but the vendor has agreed to provide a trade-in on the existing equipment of $25,000. The present equipment has a remaining useful life of four years and the new equipment would be retired at the end of its fourth year of service. Given the expected level of future operations, the existing generating equipment’s operating costs are predicted to run $40,000 per year. The new equipment is expected to result in operating costs of $20,000 per year. The current equipment would have a $10,000 salvage value at the end of its useful life, whereas the proposed equipment’s salvage value is estimated to be $20,000. Turner’s minimum desired rate of return on investments is 10%. 5.

In using the total project approach, the NPV of replacing the existing equipment is _____. a. ($163,398) b. ($158,345) c. ($151,665) d. ($149,788)

The NPV difference between the two projects using the differential approach is _____. a. $1,927 in favor of replacing the present equipment b. $5,035 in favor of keeping the generating equipment c. $11,733 in favor of replacing the generating equipment d. $6,680 in keeping the present equipment

Learning Objective 4 7.

When analyzing relevant cash flows for NPV, which of the following should be considered? a. initial cash inflows and outflows at time zero b. investments in receivables and inventories c. fixed overhead d. A and B e. None of above

Which of these cash flows happens over a period of time? a. disposal value b. operating cash flows c. initial cash inflows d. none of the above

Learning Objective 5 Use the following information for questions 9 through 13. National Manufacturing Company is considering buying some new equipment that would allow for increased sales of its product. The incremental impact of the proposed $400,000 investment is shown below using straight-line depreciation and an expected useful life of four years for the equipment. The company has a minimum desired rate of return of 14%.

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Revenues Nondepreciation expenses Depreciation Total expenses Taxable income Income tax (40%) Net Income

$500,000 $300,000 100,000 $400,000 $100,000 40,000 $ 60,000

The annual cash inflows expected from the project are _____. a. $ 100,000 b. $ 40,000 c. $ 120,000 d. $ 140,000

10.

The present value of the tax savings from straight-line depreciation is _____. a. $ 100,000 b. $ 116,548 c. $ 81,584 d. $ 174,822

11.

The NPV of the investment using straight-line depreciation is _____. a. ($ 280,000) b. $ 66,192 c. $ 349,644 d. $ 116,548

12.

If the investment was allowed to depreciate over a three-year recovery period and the doubledeclining-balance method of depreciation was used, the present value of the tax savings from depreciation would be _____. a. $ 58,274 b. $ 66,464 c. $ 132,928 d. $ 280,000

13.

Using the DDB depreciation and a three-year recovery period to compute the tax savings from depreciation results in _____. a. a higher NPV, and is still positive to make the investment desirable b. a lower NPV that would suggest that the investment should be made c. an even lower NPV of the investment than resulted using the straight-line method d. the same NPV as was computed when using straight-line depreciation

Learning Objective 6 Use the following information for questions 14 and 15.

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Ultra Corporation is considering the replacement of a piece of equipment that it bought three years ago for $150,000. At the time of purchase, the equipment was expected to have a useful life of five years. Ultra, whose tax rate is 40%, uses straight-line depreciation. 14.

If Ultra is able to sell the equipment for $70,000, the net cash flows from the sale are _____. a. $ 10,000 b. $ 60,000 c. $ 66,000 d. $ 56,000

15.

If Ultra is able to sell the equipment for $25,000, the net cash flows from the sale are _____. a. $ 35,000 b. $ 39,000 c. $ 60,000 d. $ 90,000

16.

Depreciation affects capital budgeting decisions by _____. a. creating tax savings in the amount of the annual depreciation b. reducing cash flows provided by projects c. increasing cash flows by a dollar for each dollar of depreciation claimed d. creating tax savings in the amount of the tax rate multiplied by the depreciation claimed

Learning Objective 7 17.

The payback model and the accounting rate-of-return model are _____. a. impossible to apply, and therefore are never used b. alternative models that may be used in making capital-budgeting decisions that ignore the time value of money c. two excellent DCF models d. never used because they are just too simple

18.

A possible solution to the problem of reconciling the conflict between making decisions using a DCF model and using accounting income for measuring the resulting performance is to _____. a. make decisions with accounting-based decision models such as the accounting rate-of-return in the first place b. conduct post audits to compare actual with predicted cash flows for the DCF models rather than basing evaluations of projects on accounting measures c. do either A or B d. neither A or B

Learning Objective 8

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19.

DCF models may influence managers to make decisions that only benefit the _____. a. short-run time period b. long-run time period c. neither A and B d. both A nor B

20.

The purposes of a post-audit do not include _____. a. seeing that investment decisions are proceeding on time b. providing information for improving prior predictions of cash flows c. comparing actual cash flows with predicted cash flows d. evaluating the continuation of the project

Learning Objective 9 21.

If a market interest rate, which includes an inflation component, is used by a company as its minimum required rate of return in a net present value analysis, the _____. a. expected cash flows from operations must be adjusted for inflation for the analysis to be consistent b. expected cash flows from operations must not be adjusted for inflation for the analysis to be consistent c. project will automatically be unacceptable d. expected tax savings from depreciation must be adjusted for inflation for the analysis to be consistent

22.

If a real interest rate, which does not include an inflation component, is used by a company as its minimum required rate of return in a net present value analysis, the _____. a. project will automatically be unacceptable b. expected cash flows from operations must be adjusted for inflation in order for the analysis to be consistent c. expected cash flows from depreciation must be adjusted for inflation in order for the analysis to be consistent d. expected tax savings from operations must not be adjusted for inflation in order for the analysis to be consistent

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CHAPTER 11: 1. [a] 2. [b]

3. [c]

4. [d] 5. [b]

Solutions to Quiz/Demonstration Exercises

The NPV is found by subtracting the initial investment required from the present value of the future cash inflows. In this case, $45,000 annual cash inflow x 4.2124 (the interest factor from Table 2 for 5 years at 6%) = $147,434. $189,558 – $110,000 = $79,558. The level of annual cash inflows that makes the packaging equipment investment minimally acceptable is $28,487.32. This can be found by dividing the required present value of the cash inflows to make the project minimally acceptable (NPV = $0) of $120,000 by the Table 2 annuity present-value factor of 4.2124. The reduction of $6,512.68 is just over 18% of the initial $35,000 annual savings. The computations for each alternative using the total project approach are:

Item KEEP Operating Costs Salvage Value NPV

PV factor

P Value Period 0 Period 1 Period 2 Period 3 Period 4

3.1699 ($158,495) .6830 $ 6,830 ($151,665)

($50,000) ($50,000) ($50,000) ($50,000) $10,000

Item PV factor P Value Period 0 Period 1 Period 2 Period 3 Period 4 REPLACE Net Initial Outlay 1.0000 ($100,000) ($100,000) Operating Costs 3.1699 ($ 63,398) ($20,000) ($20,000) ($20,000) ($20,000) Salvage Value .6830 $ 13,660 $20,000 NPV ($149,738) 6. [c]

Using the differential approach, from the KEEP perspective the NPV analysis is:

Item PV factor P Value Period 0 Period 1 Period 2 Period 3 Period 4 Net Initial Outlay 1.0000 $100,000 $100,000 Operating Costs 3.1699 ($ 95,097) ($30,000) ($30,000) ($30,000) ($30,000) Salvage Value .6830 ($ 6,830) ($10,000) NPV ($ 1,927) 7. [e] 8. [a] 9. [d]

10. [c]

The easiest way to compute the cash flows generated by the investment is to add the depreciation back to the net income. In this case, $100,000 + $60,000 = $160,000. Alternatively, one could add the after-tax cash flows from operations to the tax savings resulting from the depreciation expense. Here, $120,000 [($500,000-300,000) x (1.40)] + $40,000 [$100,000 x .40] also gives $160,000 in total after-tax cash flows. The annual tax savings from depreciation are $40,000 [$100,000 x .40]. The present value of the savings is computed by multiplying the $40,000 by the present value

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11. [d]

factor for an annuity for four years at 14% of 2.9137. The result is $116,548. The computations are shown below. The after-tax cash flows from operations are $120,000 per year [($500,000 – $300,000) x (1 – .40)], whereas the annual tax savings from depreciation are given above.

Item After-tax operating cash flow increase Depreciation tax savings Initial investment Net Present Value

PV factor

Period 0 Period 1 Period 2 Period 3 Period 4

2.9137 349,644 120,000 120,000 120,000 120,000 2.9137 116,548 40,000 40,000 40,000 40,000 1.0000 ($400,000) ($400,000) $ 66,192

12. [d]

The savings from depreciation using DDB and a three-year life can be found by multiplying the depreciation expense by the tax rate and then multiplying the resulting amount by present value factor: Year 1 $400,000 x 2/3 = 266,667 x .40 = $106,667 x .8772 = $ 93,568 Year 2 $133,333 x 2/3 = 88,889 x .40 = $ 35,556 x .7695 = $ 27,360 Year 3 $ 44,444 – 0 = 44,444 x .40 = $ 17,778 x .6750 = $ 12,000 Total $ 132,928

13. [b]

Using the data from questions 11 and 12 above, the NPV would be $82,572, which makes the investment even more acceptable. The $82,572 can be found by adding the difference in the tax savings from depreciation, $16,380 [$132,928 – $116,548], to the NPV found using straight-line depreciation, $66,192.

14. [d]

The $70,000 from the sale must be reduced by the $4,000 tax on the gain from selling the equipment. The book value was $60,000 [$150,000 – (3 x $30,000/yr.)] resulting in a gain of $10,000. $10,000 x .40 = $4,000 of tax on the gain. The $25,000 from the sale must be increased by the tax savings created by the loss from selling the equipment. The loss of $35,000 [$60,000 book value – $25,000 selling price] results in a $14,000 [$35,000 x .40] tax savings, creating total cash flows of $39,000.

15. [a]

16. [a] 17. [a] 18. [c] 19. [a] 20. [c] 21. [b] 22. [d]

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Chapter 12 Cost Allocation LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7.

Describe the general framework for cost allocation. Allocate the variable and fixed costs of service departments to other organizational units. Use the direct and step-down methods to allocate service department costs to user departments. Allocate costs from producing departments to products or services using the traditional and ABC approaches. Allocate costs associated with customer actions to customers. Allocate the central corporate costs of an organization. Allocate joint costs to products using the physical-units and relative-sales-value methods.

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CHAPTER 12:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 25. Allocation and Cost Behavior 26. Allocation and the Sales Function 27. Allocation and Marketing EXERCISES 28. Allocation of Computer Costs 29. Fixed- and Variable-Cost Pools 30. Sales-Based Allocations 31. Direct and Step-Down Allocations, Activity-Based Allocation 32. Direct and Step-Down Allocations 33. Customer Profitability: Strategy 34. Joint Costs 35. Joint Costs 36. By-Product Costing PROBLEMS 37. General Framework of Allocation, Service Departments, ABC, Customer Profitability, and Process Maps (EXHIBIT 12-21) 38. Allocation of Automobile Costs 39. Allocation of Costs 40. Service Department Allocation and ABC, Product Costing 41. Service Department Allocation and ABC; Customer Profitability 42. Customer Profitability at a Distributor (EXHIBIT 12-22) 43. Customer Profitability and Allocation of Costs to Service 44. Medical Equipment 45. Direct Method for Service Department Allocation 46. Step-Down Method for Service Department Allocation 47. ABC Allocations; Process Map; What-if Analysis (EXHIBIT 12-23) 48. Activity-Based Allocations 49. Allocation of Central Costs 50. Joint Costs and Decisions CASES 51. 52. 53.

Customer Profitability (EXHIBITs 12-24, -25, -26) Allocation of Data Processing Costs (EXHIBIT 12-27) Nike 10-K Problem: Allocation of Corporate Expenses

EXCEL APPLICATION EXERCISE 54 Allocating Costs Using Direct and Step-Down Methods COLLABORATIVE LEARNING EXERCISE 55. Library Research on ABC and Customer Profitability

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INTERNET EXERCISE 56. Cost Allocation at Transformco (https://transformco.com/)

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CHAPTER 12: I.

OUTLINE

A General Framework for Cost Allocation

{L. O. 1}

Cost allocation is fundamentally a problem of linking (1) some cost or groups of costs with (2) one or more cost objectives (e.g., products, departments, and divisions). Ideally, cost allocation should assign each cost to the cost objective that caused it. Linking of costs with cost objectives is accomplished by selecting cost drivers (i.e., activities that cause costs). CostAllocation Base—a cost driver when it is used for allocating costs. Cost Pool—a group of individual costs that is allocated to cost objectives using a single cost driver. Several terms are used to describe the process of assigning costs to cost objectives. Terms frequently used include allocate, apply, absorb, reallocate, trace, assign, distribute, redistribute, load, burden, apportion, and reapportion. See EXHIBIT 12-1. There are two types of departments: 1) producing departments, where employees work directly on the organization’s products or services, and 2) service departments (e.g., personnel department and facility management department), which exist only to support other departments or customers. Some service department activities (e.g., order processing and customer service) support customers rather than the production process. II.

Allocation of Service Department Costs A.

{L. O. 2}

General Guidelines The preferred guidelines for allocating service departments are:

Allocate variable- and fixed-cost pools separately (sometimes called the dual method of allocation). Note that one service department (e.g., a computer department) can contain multiple cost pools if more than one cost driver causes the department's cost. At a minimum, there should be a variable-cost pool and a fixed-cost pool.

Establish the details regarding cost allocation in advance of rendering the service rather than after the fact. This approach establishes the “rules of the game” so that all departments can plan appropriately.

Evaluate performance using budgets for each service (staff) department, just as they are used for each production or operating (line) department. The performance of a service department is evaluated by comparing actual costs with a budget, regardless of how the costs are later allocated. From the budget, variable-cost pools and fixed-cost pools can be identified for use in allocation.

Variable-Cost and Fixed-Cost Pools Variable costs should be allocated as follows: budgeted unit rate x actual hours of cost driver

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The use of budgeted cost rates rather than actual cost rates for allocating variable costs of service departments protects the using departments from intervening price fluctuations and inefficiencies in the service departments. When an organization allocates actual total service department costs, it holds user department managers responsible for costs beyond their control and provides less incentive for service departments to be efficient. Fixed-Cost Pool The cost driver for the fixed-cost pool is the amount of capacity required when the service department was instituted. Therefore, fixed costs should be allocated as follows: budgeted percent of capacity × total budgeted fixed costs available for use The predetermined lump-sum approach is based on the long-run capacity available to the user, regardless of actual usage from month to month. The level of fixed costs is affected by long-range planning regarding the overall level of service and the relative expected usage, not by short-run fluctuations in service levels and relative actual usage. A major strength is that a user department's allocation is not affected by the actual usage of other user departments. C.

Budgeted Cost-Allocation Rates If fixed costs are allocated based on long-range plans, there is a natural tendency on the part of consumers to underestimate their planned usage and thus obtain a smaller fraction of the cost allocation. Top management can counteract these tendencies by monitoring predictions, and by following up and using feedback to keep future predictions more honest. In addition, rewards may be given for accurate predictions and penalties set (e.g., through higher charges) for usage above that predicted. (see EXHIBIT 12-2)

Allocating Fixed Costs Based on Capacity Available Allocation will be based on the long-run capacity available to the user regardless of the actual usage.

Allocating Service Department Costs to Producing Departments

{L. O. 3}

Service departments often support other service departments in addition to producing departments. See EXHIBIT 12-3 for relevant data in regard to an example, which is used to demonstrate two popular methods for allocating service department costs: the direct method and the step-down method. 1.

Direct Method—ignores other service departments when any given service department’s costs are allocated to the revenue-producing (operating) departments. The costs of operating the service departments are allocated

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directly to operating departments with no intermediate allocations for the services provided to other service departments. 2.

Step-Down Method—recognizes that some service departments support the activities in other service departments as well as those in production departments. A sequence of allocations is chosen, usually by starting with the service department that renders the greatest service (as measured by costs) to the greatest number of other service departments. The last service department in the sequence is the one that renders the least service to the least number of other service departments. Once a department’s costs are allocated to other departments, no subsequent service department costs are allocated back to it. See EXHIBIT 12-4 for an illustration of the application of the step-down allocation method for the text example.

Comparison of the Methods See EXHIBIT 12-5 for a comparison of the costs ultimately allocated to the producing departments. The method of allocation can greatly affect the amounts distributed to different producing departments. If significant differences are not generated, companies typically use the direct method due to its simplicity. A third method, the Reciprocal Method, provides the most theoretical accuracy because it fully realizes reciprocal services by service departments to each other. With this method, simultaneous equations and linear algebra are used to solve for the impact of mutually interacting services. Due to the difficulty managers have in understanding the application of this method, it is rarely used in practice. This method is described in a footnote in the text.

Costs Not Related to Cost Drivers The examples used in the text thus far have assumed that the costs in a given service department were caused by a single cost driver. The costs were then allocated using this single cost driver. If some costs in the service department are not related to a single cost driver, three alternative methods of cost allocation should be considered. a.

Identify additional cost drivers. Divide the costs in the service department into two or more cost pools and use a different cost driver to allocate the costs in each pool. Divide the service department costs into two cost pools, one with costs that vary in proportion to the cost driver (variable costs), and one with costs not affected by the cost driver (fixed costs). Allocate the former using the direct or step-down method, but do not allocate the latter. Costs not allocated are period costs for the organization and are not regarded as a cost of a particular production department.

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Allocate all costs by the direct or step-down method using a single cost driver. This assumption implicitly assumes that, in the long run, the cost driver causes all of the service department’s costs, even if a short-term causal relationship is not easily identifiable.

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IV.

Allocation of Costs to Product or Service Cost Objects

{L. O. 4}

So far the chapter has discussed allocations of costs to departments or segments of an organization. Cost allocation is often carried one step further, to the outputs (e.g., products, parts, services) of these departments. Cost Application (or cost attribution)—the allocation of total departmental costs to the revenue-producing products or services. A.

A Traditional Approach (see EXHIBITs 12-6, 12-7, and 12-8) 1.

2. 3.

Divide the costs in each producing department, including both the direct department costs and all the costs allocated to it, into two categories: 1) the direct costs that you can physically trace to the final cost objectives, and 2) the remainder, the indirect costs. Assign the direct costs to the appropriate products, services, or customers. Select one or more cost pools and related cost drivers in each production department, and assign all the indirect departmental costs to the appropriate cost pool. Allocate (apply) the total costs accumulated in Step 1 to products or services that are the outputs of the operating departments, using the cost drivers specified in Step 3. If only one cost driver is used, two cost pools should be maintained: one for variable costs and one for fixed costs. Variable costs should be allocated based on actual cost-driver activity. Fixed costs should either remain unallocated or be allocated based on budgeted cost-driver activity.

An ABC Approach In the past, companies used direct-labor hours to apply the costs of departments to units of product. However, direct-labor hours are not a very good measure of the cause of costs in modern, highly automated departments. As a result, companies are implementing activitybased costing (ABC) to develop measures that better reflect the consumption of resources and related costs in their environment by accumulating costs into key activities. Both direct-labor hours and machine hours are volume measures. If many costs are caused by non-volume-based cost drivers, ABC should be considered. As Chapter 4 states, ABC is a system that first accumulates the costs of each activity of an organization and then applies the costs of activities to the products, services, or other cost objects using appropriate cost drivers. The ABC system takes one large overhead cost pool and breaks it down into several pools, each associated with a key activity. The goal of activity-based costing is to trace the costs to products or services instead of arbitrarily allocating them. Although it is relatively easy to trace direct material and labor to products using physical measures, advocates of ABC maintain that, by using appropriate cost drivers, many manufacturing overhead costs can also be physically traced to products or services.

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Illustration of Activity-Based Costing Approach in Manufacturing The text provides an illustration of an ABC system for a manufacturer using the four-step procedure that was introduced in Chapter 4. a. b.

c. d.

First, the costing objective is to determine the costs of custom and standard displays for H.L. Display Company. Next, the interrelationships among activities, cost objectives, and resources were determined based on interviews with key personnel, and a process-based map representing the flow of activities, resources, and their interrelationship was developed. See EXHIBIT 12-9 for the process-based map. Using the process map as a guide, the accountants then collected the required cost and operational data via further interviews. Finally, EXHIBITs 12-10 and 12-11 presents the key results of the activity-based costing study.

Allocation of Costs to Customer Cost Objects to Determine Customer Profitability {L. O. 5} Customer profitability depends on more than the gross margin on the products or services they buy. It also depends on the costs incurred to fulfill customer orders and then provide other customer services such as order changes, returns, and expedited scheduling or delivery (see EXHIBIT 12-12). The following list is a profile of low and high cost-to-serve customers. Low Cost To Serve Large order quantity Few order changes Little pre- and post-sales support Regular scheduling Standard delivery Few returns A.

High Cost To Serve Small order quantity Many order changes Large amounts of pre- and post-sales support Expedited scheduling Special delivery requirements Frequent returns

Measuring and Managing Customer Profitability If service-department costs are assigned to producing departments and then to products, the allocation to products would be based on production-related output measures that may have little relationship to the cause of customer-service costs. An example in the text (Cedar City Distributors) is given to demonstrate this important concept (see EXHIBITS 12-13, 12-14, 12-15, 12-16, 12-17, and 12-18).

VI.

Allocation of Central Corporate Support Costs

{L. O. 6}

Whenever possible, the preferred cost driver for central services is usage, either actual or estimated. For some central services (e.g., data processing, advertising, and operations research), usage appears to be a reasonable basis to allocate costs. For others (e.g., public relations, top corporate management overhead, a real estate department, and a corporate

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planning department), usage seems an inappropriate base. For these types of costs, companies frequently use revenues as the cost driver, which represents an “ability to bear” philosophy rather than portraying any cause-and-effect relationship. A.

Use of Budgeted Sales for Allocation If the costs of central services are to be allocated based on sales, even though the costs do not vary in proportion to sales, the use of budgeted sales is preferable to the use of actual sales. At least this method means that the short-run costs of a given consuming department will not be affected by the fortunes of other consuming departments.

VII.

Allocation of Joint Costs and By-Product Costs A.

{L. O. 7}

Joint Costs Sometimes inputs are added to the production process before individual products are separately identifiable (i.e., before the split-off point). The costs of these inputs (e.g., materials, labor, and overhead costs) are called joint costs. Although allocations of these costs to the products, which emerge from the joint process, should not affect decisions regarding whether to process the products further, allocations are routinely made for inventory valuation and income determination purposes. Two conventional ways of allocating joint costs to products are widely used: physical units and relative sales values. They allocate the joint costs to the joint products in proportion to their number of physical units or sales dollars generated by the joint products. A twist on the relative-sales-value method is necessary when a joint product cannot be sold at the split-off point. Therefore, the sales value is approximated using: sales value at split-off = final sales value - separable costs

By-Product Costs By-Product—a product that, like a joint product, is not individually identifiable until manufacturing reaches a split-off point. By-products differ from joint products because they have relatively insignificant total sales values in comparison with other products emerging at split-off (e.g., glycerin from soap making and mill ends of cloth and carpets). If an item is accounted for as a by-product, only separable costs are allocated to it. All joint costs are allocated to the main products. Any revenues from by-products, less their separable costs, are deducted from the cost of the main products.

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CHAPTER 12:

Quiz/Demonstration Exercises

Learning Objective 1 1.

Major purposes for allocating costs are _____. a. to predict the economic effects of planning and control decisions b. to obtain desired motivation c. to compute income and asset valuations d. to justify costs or obtain reimbursement e. all of these

Which of the following purposes of allocation relate to planning and control? a. obtain desired motivation and compute income and asset valuations b. predict economic consequences and justify costs c. obtain economic consequences and justify costs d. compute income valuations and obtain reimbursement

Learning Objective 2 Use the following information for questions 3 and 4. The city of Mars leases a photocopy machine, which it uses in its Copy Services Department for $2,500 per month plus 4¢ per copy made. In addition to the lease costs, operating costs for toner, paper, operator salaries, and so on are variable at 7¢/copy. All departments of the city combined estimated that they would make 70,000 copies per month. The Recreation Department estimated that they would make 10,000 copies per month on average. In May, the Recreation Department made 12,000 copies and the total number of copies made by Copy Services for the month was 58,000. 3.

Following the guidelines of allocating variable and fixed costs of service departments separately, the variable costs of the Copy Services Department that should be allocated to the Recreation Department in June are _____. a. $1,320 b. $840 c. $1,130 d. $480 e. some other amount

Following the guidelines of allocating variable and fixed costs of service departments separately, the fixed costs of the Copy Services Department that should be allocated to the Recreation Department in June are _____. a. $0 b. $200 c. $2,500 d. $357

Learning Objective 3 Use the following information for questions 5 and 6. The Francis Corporation operates two service and two producing departments in its production of go carts. The budgeted direct costs and other pertinent data for an upcoming month follow.

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Service Departments Maintenance Personnel

Production Departments Tooling Assembly

Direct costs $144,000 $80,000 Machine hours # of employees 20 16

$280,000 $320,000 30,000 20,000 60 100

Personnel costs are allocated based on the number of employees, and maintenance costs are allocated based on machine hours. 5.

The amount of maintenance costs allocated to the Assembly Department using the direct method of cost allocation would be _____. a. $32,000 b. $48,000 c. $86,400 d. $57,600

The amount of maintenance costs (to the nearest dollar) allocated to the Tooling Department using the step-down method would be _____. a. $91,733 b. $54,000 c. $86,400 d. $8,888

Learning Objective 4 7.

The traditional approach to allocation of costs to the final cost objects focuses on _____. a. accumulating costs within producing departments and then allocating producing departments costs; and finally to products, services, or customers b. accumulating costs within departments and then allocating departmental costs to departments, and finally to products, services, or customers c. accumulating costs by products, services, or customers and deriving a cost per unit d. none of the above

Learning Objective 5 8.

Which of the following is a profile of a high cost-to-serve customer? a. large order quantity b. standard delivery c. frequent returns d. regular scheduling e. none of the above Use the following information for questions 9 and 10. Bally Inc. has four categories of overhead. The four categories and expected overhead costs for each category for next year are: Inspection Maintenance Materials Handling

$ 30,000 60,000 9,000

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Setups

8,000

Currently, overhead is applied using a predetermined overhead rate based upon budgeted direct labor hours, and 20,000 direct labor hours are budgeted for next year. The company has been asked to submit a bid for a proposed job. The company bases its bids on full manufacturing costs. Estimates for the proposed job are as follows: Direct materials Direct labor (400 hours) Number of material moves Number of setups

10 5

$ 2,000 4,000

Number of inspections 2 Number of machine hours

In the past, full manufacturing cost has been calculated by allocating overhead using a volume-based cost driver, direct labor hours. Expected activity for the four activity-based cost drivers that would be used is: Machine hours Setups

5,000 200

Material moves Quality inspections

600 1,000

If direct labor hours were used as the cost driver, the total cost of the proposed job would be _____. a. $5,140 b. $6,000 c. $10,280 d. $8,140

10.

If the activity-based cost drivers were used to assign overhead, the total cost of the proposed job would be _____. a. $890 b. $8,140 c. $6,890 d. $10,280

Learning Objective 6 11.

A method of allocating central costs of an organization to divisions, which clearly fails to demonstrate a cause-and-effect relationship, is to _____. a. allocate based on the actual usage of the service b. allocate on the basis of sales dollars c. allocate based on the estimated usage of the service d. do none of these

12.

Which of the following is an example of a central service? a. public relations b. legal services c. accounting d. advertising e. all of the above

Learning Objective 7

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Use the following for questions 13 and 14. ABC Co., produces two products through a single manufacturing process. Each batch of product results in 400 pounds of product X and 600 pounds of product Y. The process requires materials, labor, and manufacturing overhead costing $50,000 per batch. X sells for $30 per pound, whereas Y sells for $20 per pound. 13.

Using the physical units method of allocating joint production costs would result in an allocation to product X of: _____. a. $0 b. $30,000 c. $20,000 d. $50,000

14.

Using the relative sales value approach of allocating joint production costs would result in an allocation to product X of _____. a. $10,000 b. $30,000 c. $25,000 d.$40,000

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CHAPTER 12: 1. [e] 2. [c] 3. [a]

4. [d] 5. [d] 6. [a]

7. [b] 8. [e] 9. [d]

10. [c]

Solutions to Quiz/Demonstration Exercises

The allocation of variable costs: the variable portion of the lease of 4¢ per copy and the Copying Services variable operating costs of 7¢ per copy. The actual number of copies made (12,000) is multiplied by the variable cost of 11¢ per copy to give $1,320 allocated.

The $144,000 of maintenance cost is allocated based on machine hours. Assembly uses 40% [20,000 of 50,000 total machine hours] resulting in a $57,600 allocation. With the step-down method, Personnel costs are allocated first with $8,888.88 [$80,000 x (20/(20 + 60 + 100))] allocated to the Maintenance department. Then, of the $152,888.88 now in Maintenance, $91,733.33 [$152,888.88 x (30,000 / (30,000 + 20,000))] would be allocated to the Fabrication Department.

The total cost consists of direct material ($2,000), direct labor ($4,000), and applied overhead. The overhead rate is $5.35 per labor hour [($30,000 + $60,000 + $9,000 + $8,000)/20,000 direct labor hours]. Applying the $5.35 rate to 400 direct labor hours for the job gives $2,140 of overhead applied to this job. Adding this to the $2,000 direct materials and $4,000 direct labor gives $8,140 total cost. Rates are $12/machine hour for maintenance [$60,000/5,000], $15/move for materials handling [$9,000/600], $40/setup [$8,000/200], and $30/inspection [$30,000/1,000]: Maintenance (40 machine hours @ $12) $480 Materials handling (10 moves @ $15) 150 Setups (5 setups @ $40) 200 Inspections (2 @ $30) 60 Total overhead costs applied $890 Adding this to the $6,000 of materials and labor costs gives $6,890.

11. [b] 12. [e] 13. [c] 14. [c]

Based on physical units, X would be allocated 40% [400 pounds / (400 pounds + 600 pounds)] of the $50,000 of joint processing costs, or $20,000. Each product can be sold for $12,000. Product X has 400 pounds at $30 per pound, and product Y has 600 pounds at $20 per pound. Thus, the total sales value of the two products is $12,000, and each product would be allocated $25,000 [50% x $50,000 joint production costs].

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Chapter 13 Accounting for Overhead Costs LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 9.

Compute budgeted factory-overhead rates and apply factory overhead to production. Determine and use appropriate cost-allocation bases for overhead application to products and services. Use normalized variable- and fixed-overhead application rates and explain the disposition of overhead variances. Compare variable- and absorption-costing systems. Construct an income statement using the variable-costing approach. Construct an income statement using the absorption-costing approach. Distinguish between product-costing and planning-and-control purposes in accounting for variable and fixed costs. Compute the production-volume variance and show how it should appear in the income statement. Reconcile variable- and absorption-costing operating income and explain why a company might prefer to use a variable-costing approach.

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CHAPTER 13:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 32. Relationship Between Cost-Allocation Bases and Factory Overhead 33. Cost Application in Service Firms 34. Accounting for Fixed Costs 35. Marketing Decisions and Absorption Costing 36. Evaluating Production Using the Production-Volume Variance 37. Absorption Costing and the Value Chain EXERCISES 38. Discovery of Unknowns 39. Discovery of Unknowns 40. Relationship Among Overhead Items 41. Underapplied and Overapplied Overhead 42. Disposition of Year-End Underapplied Overhead 43. Simple Comparison of Variable and Absorption Costing 44. Comparison Over Four Years 45. Variable and Absorption Costing 46. Comparison of Production-Volume Variance 47. Reconciliation of Variable-Costing and Absorption-Costing Operating Income 48. Overhead Variances 49. Variances PROBLEMS 50. Choice of Cost-Allocation Base at Enriquez Machine Parts Company 51. Choice of Cost-Allocation Base at Enriquez Machine Parts Company 52. Choice of Cost-Allocation Base in Accounting Firm 53. Allocated Costs and Public Services 54. Overhead Accounting for Control and for Product Costing 55. Comparison of Variable Costing and Absorption Costing 56. All-Fixed Costs 57. Semifixed Costs 58. Absorption and Variable Costing 59. Absorption and Variable Costing 60. Fundamentals of Overhead Variances 61. Production-Volume Variance at Mobility Furnitures 62. Fixed Overhead and Practical Capacity 63. Selection of Expected Volume 64. Analysis of Operating Results 65. Standard Absorption and Standard Variable Costing 66. Disposition of Variances 67. Straightforward Problem on Standard Cost System 68. Straightforward Problem on Standard Cost System

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CASES 69. 70. 71. 72. 73. 74.

Multiple Overhead Rates and Activity-Based Costing Inventory Measures, Production Scheduling, and Evaluating Divisional Performance Performance Evaluation Converting an Income Statement from Absorption Costing to Variable Costing Converting an Income Statement from Variable Costing to Absorption Costing Nike 10K Problem—Overhead Costs at Umbro

EXCEL APPLICATION EXERCISE 75. Computing Budgeted Factory Overhead COLLABORATIVE LEARNING EXERCISE 76. Accounting for Overhead INTERNET EXERCISE 77. Dell (http://www.dell.com)

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CHAPTER 13: I.

OUTLINE

Accounting for Factory Overhead A.

{L. O. 1}

How to Apply Factory Overhead to Products Few companies wait until the actual factory overhead is finally known before computing the costs of products. Instead, they compute a budgeted (predetermined) overhead rate at the beginning of a fiscal year and use it to apply overhead costs as products are manufactured. This allows managers to have a close approximation of the costs of producing products continuously, not just at the end of the year.

Budgeted Overhead Application Rates The following steps summarize how to account for factory overhead:

II.

Select one or more cost drivers to serve as a base for applying overhead costs (e.g., direct-labor hours, direct-labor costs, machine hours, and production setups). The cost driver should be an activity that is the common denominator for systematically relating a cost or group of costs, such as machinery cost, set-up, and energy with products. The cost driver(s) should be the best measure of the cause-and-effect relationships between overhead costs and production volume.

Prepare a factory-overhead budget for the planning period (ordinarily a year). The two key items are (1) budgeted overhead and (2) budgeted volume of the cost driver. There will be a set of budgeted OH costs and associated budgeted cost-driver level for each overhead. There may be just one set in businesses with simple production systems.

Compute Budgeted Factory-Overhead Rate(s)—divide the budgeted total overhead for each cost pool by the budgeted cost driver level.

Obtain actual cost-driver data (e.g., machine hours) as jobs are produced.

Apply the budgeted overhead to the jobs by multiplying the budgeted rate(s) times the actual cost-driver data.

At the end of the year, account for any differences between the amount of overhead actually incurred and overhead applied to products.

Illustration of Overhead Application Using the Enriquez illustration, the process of applying overhead to products is demonstrated. The budgeted overhead rate, which is used to apply the overhead, is computed as follows:

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budgeted overhead application rate = total budgeted factory overhead / total budgeted amount of cost driver The total overhead applied is the result of multiplying actual cost driver by the budgeted overhead rate. A.

Choice of Cost-Allocation Bases

{L. O. 2}

Factory overhead is a conglomeration of manufacturing costs that, unlike direct materials or direct labor, cannot conveniently be applied on an individual job basis. Overhead is an integral part of a product’s total cost. Therefore, it is applied indirectly to products using a cost driver that is common to all jobs worked on and is the best available index of the product’s relative use of, and benefits from, the overhead items (i.e., a strong cause-and-effect relationship). Direct-labor costs or direct-labor hours have been a commonly used base for allocating overhead. In many cases, 80% of total overhead cost can be accounted for with just a few drivers (20% of the drivers identified). III.

Problems of Overhead Application A.

{L. O. 3}

Normalized Overhead Rates The Enriquez illustration used in the chapter has demonstrated the normal costing approach because the annual average overhead rate is used consistently throughout the year for product costing, without altering it from day to day and from month to month. The resultant “normal” product costs include an average or normalized chunk of overhead. As actual overhead costs are incurred by department, they are charged to the departments. On a weekly or monthly basis, these actual costs are then compared with budgeted costs to obtain budget variances for performance evaluation. This control process is distinct from the product-costing process of applying overhead to specific jobs. During the year and at year-end, the actual overhead amount incurred will rarely equal the amount applied. The most common and important contributor to these variances is operating at a different volume level than that used as a denominator in calculating the budgeted overhead rate. Other causes include: poor forecasting, inefficient use of overhead items, price changes in individual overhead items, erratic behavior of individual overhead items (e.g., repairs made only during slack time), and calendar variations (e.g., 20 workdays in one month, 22 in the next). All these peculiarities are mingled in an annual overhead pool. An annual rate is budgeted and used regardless of the month-to-month peculiarities of specific overhead costs. Such an approach is more defensible than applying the actual overhead for each month. This is due to the normal product cost being more useful for decisions and inventory-costing purposes than an “actual” product cost that is distorted by month-to-month fluctuations in

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production volume and by the erratic behavior of many overhead costs. In an actual-costing system, overhead would not be applied as jobs are worked on. Only after all overhead costs for the year are known can actual costs be applied to the jobs worked on during the year in an actual costing system. However, increased accuracy would be obtained at the serious sacrifice of timeliness in using costs for measuring operating efficiency, determining selling prices, and producing interim financial statements. It is possible to use a normal-costing system plus year-end adjustments to produce final results that closely approximate the results under actual costing. The manufacturing costs applied to products under the two systems are:

Direct Materials Direct Labor Manufacturing overhead B.

ACTUAL COSTING

NORMAL COSTING

Actual Actual Actual

Actual Actual Budgeted rates

Disposition of Underapplied or Overapplied Overhead When budgeted rates are used, the difference between incurred and applied overhead is typically allowed to accumulate during the year. Overapplied Overhead—the difference of the amount applied to products exceeding the amount incurred by the departments. Underapplied Overhead—the difference of the amount applied to products being less than incurred. At year-end, the difference is disposed of either through a write-off or proration. 1.

Immediate Write-off. With this method (which is more commonly used), underapplied overhead is added to the cost of goods sold to reduce current income, and overapplied overhead is subtracted from cost of goods sold to increase current income. Most of the goods worked on have been sold, and a more elaborate method of disposition is not worth the extra trouble. Also, the extra overhead costs represented by underapplied overhead do not qualify as part of ending inventory costs because they do not represent assets. They should be written off because they largely represent inefficiency or the underutilization of available facilities in the current period.

Proration Among Inventories. Prorate—assign in proportion to the size of the ending account balance. This method prorates underapplied overhead among three accounts (i.e., WIP, FG, and COGS). If the objective is to obtain as accurate a cost allocation as possible, all the overhead costs of the individual jobs worked on should be recomputed using the actual, rather than the budgeted, rates. Prorating should be performed on the basis of the ending balances in each of three accounts. In practice, prorating is done only when

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inventory valuations would be materially affected. C.

The Use of Variable and Fixed Application Rates Some companies distinguish between variable overhead and fixed overhead for product costing, as well as for control purposes. When this is the case, two rates may be developed: 1. budgeted variable-overhead application rate = budgeted total variable overhead / budgeted machine hours 2. budgeted fixed-overhead application rate = budgeted total fixed overhead / budgeted machine hours

IV.

Variable Versus Absorption Costing

{L. O. 4}

Two major methods of product costing are compared in this chapter: variable costing (the contribution approach) and absorption costing (the functional, full-costing, or traditional approach). These methods differ in only one conceptual respect: the accounting for fixed manufacturing overhead costs. A.

Accounting for Fixed Manufacturing Overhead Variable costing (or direct costing) signifies that fixed factory overhead is not inventoried. In contrast, absorption costing indicates that inventory values include fixed factory overhead. Variable costing regards fixed manufacturing overhead (fixed factory overhead) as an expired cost to be immediately charged against sales—not as an unexpired cost to be held back as inventory and charged against sales later as a part of cost of goods sold. Absorption costing is more widely used than variable costing. However, the growing use of the contribution approach in performance measurement and cost analysis has led to increasing use of variable costing for internal reporting purposes. However, absorption costing must be used for reports to shareholders and tax authorities. See EXHIBIT 13-2 for the comparison of flow of costs.

Facts for Illustration An example using the following standard cost information is presented for Desk PC, a division of Dell Computer, which produces desktop computers: Direct material:

$205

206

Direct labor: Variable manufacturing overhead: Standard variable costs per ring

75 20 $300

Fixed manufacturing overhead is budgeted at $1,500,000 for the budgeted production of 15,000 units per year. The sales price is $500 per unit. For simplicity, it is assumed that computers produced is the cost driver for variable manufacturing overhead. Also assumed is that both budgeted and actual selling price and administrative expenses are a yearly $650,000 fixed cost plus a variable sales commission of 5% of dollar sales. Actual production quantities are: 20X7 In units (computers): Opening inventory Production Sales Ending inventory

-------17,000 14,000 3,000

20X8 3,000 14,000 16,000 1,000

There are no variances from the standard variable manufacturing costs, and fixed manufacturing overhead incurred is exactly $1,500,000 per year. Using this information, income statements for both years are created and a reconciliation of the incomes is made. C.

Variable-Costing (VC) Method

{L. O. 5}

See EXHIBIT 13-3 for income statements using the variable-costing approach that are prepared based on the facts above. D.

Absorption-Costing (AC) Method

{L. O. 6}

See EXHIBIT 13-4 for the income statements using the AC method. If the inventory level does not change, the two methods result in the same net income. Companies with little inventory (e.g., in a JIT environment) generally experience only insignificant changes in inventory. As can be seen when comparing these income statements with those prepared using variable costing, there are three main differences. 1.

The unit product cost differs.

Fixed factory overhead does not appear as a separate line in an AC income statement. Instead, it is included in two places. One place is as part of the cost of goods sold, and the other is as a production-volume variance. ProductionVolume Variance—actual production deviates from the expected volume of production used in computing the fixed overhead rate: production-volume variance =

207

(actual volume - expected volume) x fixed-overhead rate Where the fixed-overhead rate is: budgeted fixed manufacturing overhead / expected volume of production 3.

Finally, the format for an AC income statement separates costs into the major categories of manufacturing and nonmanufacturing. In contrast, a VC income statement separates costs into the major categories of fixed and variable. In the AC method, revenue less manufacturing cost (both fixed and variable) is gross profit or gross margin. In a VC statement, revenue less all variable costs (both manufacturing and nonmanufacturing) is the contribution margin.

Fixed Overhead and Absorption Costs of Product {L. O. 7} All three differences between variable- and absorption-costing formats arise solely because variable costing treats manufacturing overhead differently from absorption costing. In this and subsequent sections, the accounting for factory overhead in an absorption-costing system is explored. A.

Variable and Fixed Unit Costs Graphs of the budgeted and fixed overhead are provided in the text. For variableoverhead costs, the budgeted overhead is the same as what is applied. For fixedoverhead costs, the applied costs may differ from the lump-sum budgeted costs. This is due to a volume difference between what is actually produced and that which was used in setting the fixed-overhead rate. The applied cost depends on volume: fixed cost applied

actual volume x fixed-overhead rate

When the volume level actually achieved equals that used in setting the fixedoverhead rate, the applied cost equals the budgeted amount. When actual volume differs from expected volume, the costs used for budgeting and control differ from those used for product costing. For budgeting and control purposes, managers use the actual cost behavior pattern for fixed costs. In contrast, as the graphs indicate, the absorption product-costing approach treats these fixed costs as though they had a variable-cost behavior pattern. The difference between applied and budgeted fixed overhead is the production-volume variance. B.

Nature of Production-Volume Variance

{L. O. 8}

The Production-Volume (or Volume) Variance can be calculated as follows: production-volume = applied fixed - budgeted fixed variance overhead overhead

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A production-volume variance arises when the actual production volume achieved does not coincide with the expected volume of production used as a denominator for computing the fixed-overhead rate for product-costing purposes: 1.

When expected production volume and actual production volume are identical, there is no production-volume variance.

When actual volume is less than expected volume, the production-volume variance is unfavorable because the usage of facilities is less than expected and fixed overhead is underapplied. Unfavorable production-volume variances increase the manufacturing costs shown on the income statement. When less is applied to inventory, which is later expensed as part of cost of goods sold than is incurred, the extra amount incurred is expensed on the current period’s income statement.

When actual volume exceeds expected volume, the production-volume variance is favorable because use of facilities is better than expected, and fixed overhead is overapplied. When fixed overhead costs are overapplied, current period expenses must be reduced on the income statement to reflect the favorable variance.

Most companies consider production-volume variances beyond immediate control. Idleness (due to disappointing total sales, poor production scheduling, unusual machine breakdowns, shortages of skilled workers, strikes, storms, etc.) are all possible causes of an unfavorable production-volume variance. With variable overhead, there is no production-volume variance. The concept of production-volume variance arises for fixed overhead because of the conflict between accounting for control (by flexible budgets) and accounting for product costing (by application rates). Remember that fixed costs come in big chunks and are related to the provision of big chunks of production or sales capability, not to the production or sale of a single unit of product. C.

Reconciliation of Variable Costing and Absorption Costing {L. O. 9} See EXHIBIT 13-5 for a reconciliation of the difference in operating incomes under the VC and AC approaches. It can be quickly computed by multiplying the fixedoverhead product-costing rate by the change in the total units in the beginning and ending inventories. The difference also equals the difference in the total amount of fixed manufacturing overhead charged as an expense during a given year. Whenever production exceeds sales, inventory increases and AC income > VC income. Whenever sales exceed production, inventory decreases and VC income > AC

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income. D.

Why Use Variable Costing? Many companies use VC income for internal purposes because AC income is affected by production volume and VC income is not. If a manager’s operating performance is heavily based on AC operating income, s/he may be tempted to produce unneeded units to either reduce an unfavorable or increase a favorable production-volume variance. The effect of either of these is an increase in operating income. No such temptation exists under the VC method. Sales-oriented companies may prefer VC because the sales level primarily affects income. In contrast, a production-oriented company (a company that can easily sell all the units it produces) might prefer AC because additional production increases the operating income with AC but not VC.

VI.

Effect of Other Variances Variances, other than production-volume, may be present if a company is using a normal- or standard-costing system. These other variances affect income for both the AC and VC methods. A.

Flexible-Budget Variances See EXHIBIT 13-6 for the relationship between the fixed-overhead flexible-budget variance and the production-volume variance. The flexible budget variance is the difference between the actual fixed-overhead costs and the budgeted fixed-overhead costs. Other than the production-volume variances, several flexible-budget variances may be computed. They measure components of the differences between actual amounts and the flexible-budget amounts for the output achieved. Flexible budgets are primarily designed to assist planning and control rather than product costing. The production-volume variance is not a flexible-budget variance and is designed to aid product costing. See EXHIBIT 13-7 for an illustration of an unfavorable flexible-budget variance having a negative impact on income. When variances are favorable, they increase operating income.

VII.

Appendix 13: Comparisons of Production-Volume Variance with Other Variances The only new variance introduced in this chapter is the production-volume variance, which arises because fixed-overhead accounting must serve two masters: the control-budget purpose and the product-costing purpose. See EXHIBITS 13-11 and 13-12 for displays of a framework for both the flexible-budget variances and the production-volume variance explained in the current chapter. Underapplied or overapplied overhead is always the difference between the actual overhead incurred and the overhead applied.

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CHAPTER 13:

Quiz/Demonstration Exercises

Learning Objective 1 1.

Lion Corp. computes its budgeted factory-overhead rate in the machining department based on the number of machine hours estimated for the year. In 2011, 30,000 machine hours were expected for the production of the company’s products using $150,000 budgeted overhead. The budgeted overhead rate for machining was _____. a. $6.00/m.h. b. $5.00/m.h. c. $7.00/m.h. d. $3.00/m.h.

Determine the overhead application rate in the manufacturing department if the overhead is $90,000 and the total direct labor is $30,000, assuming that direct-labor cost is used as a base. If a particular job required $200 of direct-labor cost, the amount of assembly department overhead that would be applied would be _____. a. $375 b. $200 c. $600 d. $400

Learning Objective 2 3.

In regard to all of the identified cost drivers for overhead, 20% of the identified cost drivers cause what percentage of total overhead cost? a. 65% b. 50% c. 95% d. 80% e. none of the above

No matter what cost drivers are chosen, the applied overhead rates are usually changed _____. a. yearly b. monthly c. weekly d. quarterly e. daily

Learning Objective 3 5.

Normalized overhead rates are used in order to _____. a. indicate the actual cost of producing a unit of product each month b. provide an exact allocation of the actual overhead costs to products c. confuse and perplex students taking a course in management accounting d. assist managers in making decisions because they are more representative of the longrun costs of producing a product because they are not affected by volume fluctuations or the erratic behavior of many overhead costs.

The principal difficulty with normal costing is that _____. a. the unit cost information is not received on a timely basis

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b. c. d.

it can result in fluctuating per-unit overhead costs there is no difficulty associated with using normal costing estimated overhead and estimated activity are likely to differ from actual overhead and actual costs resulting in underapplied or overapplied overhead.

Learning Objective 4 7.

Variable costing can be used for _____. a. internal reporting b. external reporting c. neither A and B d. both A nor B

Use the following information for questions 8, 9, 11, and 12. Mouse Corp. began operations on January 1, 20X1. The company sells a single product for $60 per unit. During 20X1, 20,000 units were produced and 15,000 were sold. No work-inprocess inventories were present on December 31, 20X1. Costs during 20X1 were as follows:

Direct materials . . . . . Direct labor . . . . . . . Manufacturing overhead Selling and administrative expenses

FIXED COSTS

VARIABLE COSTS

-0-0$44,000

$ 5.00 per unit produced $12.00 per unit produced $ 4.00 per unit produced

$30,000

$ 2.00 per unit sold

The company computes their fixed manufacturing overhead rate for absorption-costing purposes using an expected production level of 22,000 units. The actual fixed overhead for the year was equal to the budgeted amount. Learning Objective 5 8.

The income under the variable-costing approach for Mouse Corp. for the year 20X1 would be _____. a. $491,000 b. $481,000 c. $477,000 d. $487,000

Learning Objective 6 9.

The income under the absorption-costing approach for Mouse Corp. for the year 20X1 would be _____. a. $491,000 b. $481,000 c. $487,000 d. $477,000

Learning Objective 7

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10.

The production-volume variance occurs when using _____. a. the variable-costing approach because sales exceed the production for the period b. the variable-costing approach because production exceeds the sales for the period d. the absorption-costing approach because the production level differs from that used in setting the fixed-overhead rate that is used in applying fixed overhead to production d. the absorption-costing approach because production exceeds sales

Learning Objective 8 11.

Mouse Corp. has a production-volume variance for 20X1 of _____. a. $ 4,000 unfavorable b. $14,000 favorable c. $14,000 unfavorable d. $ 4,000 favorable

12.

The production-volume variance computed using the absorption-costing approach should appear on the income statement _____. a. as a reduction in income regardless of where it appears on the statement b. as an adjustment to actual gross profit from standard gross profit c. as neither A nor B d. as either A or B

Learning Objective 9 13.

A company might choose to use a variable-costing approach when determining income _____. a. because changes in sales will not affect the income computed b. because changes in production will not affect the income computed c. because they can sell all they can produce and are a production company d. to satisfy external reporting requirements

14.

A sales-oriented company may prefer which of the following product costing methods in order to provide a better signal about performance? a. absorption costing b. variable costing c. both A and B d. neither A nor B

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CHAPTER 13:

Solutions to Quiz/Demonstration Exercises

1. [b]

The rate is found by dividing the budgeted overhead for the machining department by the budgeted level of machine hours. In this case, $150,000/30,000 machine hours = $5.00/m.h.

2. [c]

The rate is 300% = $90,000/$30,000. Applying the rate to $200 of direct-labor costs gives $600.

3. [d] 4. [a] 5. [d] 6. [d] 7. [a] 8. [a]

The variable-costing income statement appears below: Mouse Corp. Income Statement Variable Costing Format Sales Variable cost of sales Direct materials Direct labor Var. man. OH ($4) Selling and adm. Contribution margin Fixed costs Manufacturing overhead Selling and administrative Net income

($60) ($5) ($12) ($2)

$900,000 $75,000 180,000 60,000 30,000

$44,000 30,000

345,000 $555,000

74,000 $481,000

9. [a] The absorption-costing income statement appears below: Mouse Corp. Income Statement Absorption Costing Format Sales ($60) Standard cost of goods sold: Direct materials ($5) $75,000 Direct labor ($12) 180,000 Var. man. OH ($4) 60,000 Fixed man. OH ($2) 30,000 Standard gross profit Fixed OH production-volume variance (2,000 x $2) Actual gross profit

$900,000

345,000 $555,000 4,000 $551,000

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Selling and adm. expenses Fixed Variable Net income

($2)

$30,000 30,000

60,000 $491,000

The $10,000 difference in incomes is due to the 5,000-unit increase in inventory during the year [$2 of fixed OH x 5,000 units = $10,000]. 10. [c] 11. [a]

The applied fixed manufacturing overhead would be $40,000 [20,000 x $2.00/unit fixed-overhead rate]. The $2.00/unit rate is found by dividing the $44,000 budgeted fixed overhead by the estimated 22,000 units of production.

12. [c] 13. [b] 14. [b]

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Chapter 14 Job Costing and Process-Costing Systems LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Distinguish between job-order costing and process costing. Prepare summary journal entries for the typical transactions of a job-order costing system. Use an ABC system in a job-order environment. Show how service organizations use job-order costing. Explain the basic ideas underlying process costing and how they differ from job-order costing. Compute output in terms of equivalent units. Compute costs and prepare journal entries for the principal transactions in a process-costing system. Demonstrate how the presence of beginning inventories affects the computation of unit costs under the weighted-average method. Understand the concept of transferred-in costs in a process-costing system with sequential process. Use backflush costing with a JIT production system.

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CHAPTER 14:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 15. Purpose of Accumulating Job Costs 16. Job-Order Compared to Process Costing 17. Cost Allocation in Service Firms 18. Purpose of Product Costing in a Process Production Environment 19. Process Costing in a JIT Environment EXERCISES 20. Job Costing in Business Sectors 21. Direct Materials 22. Use of WIP Inventory Account 23. Job-Cost Record 24. Analysis of Job-Cost Data 25. Analysis of Job-Cost Data 26. Discovery of Unknowns 27. Discovery of Unknowns 28. Relationships Among Overhead Items 29. Processing Costing in Business Sectors 30. Process Map and Process Costing 31. Equivalent Units 32. Basic Process Costing 33. Uneven Flow 34. Journal Entries 35. Journal Entries 36. Compute Equivalent Units 37. Journal Entries 38. Journal Entries PROBLEMS 39. Job Costing at Dell Computer 40. Relationships of Manufacturing Costs 41. Relationship of Subsidiary and General Ledgers, Journal Entries 42. Job Costing in an Accounting Service Provider Firm 43. Weighted Average Process Costing at Nally & Gibson 44. Process and ABC 45. Nonprofit Basic Process Costing 46. Two Materials, Basic Process Costing 47. Materials and Cartons in Basic Process Costing 48. Weighted Average Process Costing with Transferred-in-Costs 49. Backflush Costing 50. Review of Chapters 13 and 14 51. Review of Chapters 13 and 14 52. Nike 10-K Problem: ABC and Distribution Centers

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EXCEL APPLICATION EXERCISE 53. Value of Units Produced COLLABORATIVE LEARNING EXERCISE 54. Job and Process Costing INTERNET EXERCISE 55. Process Costing at a Variety of Companies (http://www.landsend.com; http://www.lazboy.com; http://www.tastykake.com)

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CHAPTER 14: I.

OUTLINE

Distinction Between Job-Order Costing and Process Costing

{L. O. 1}

Two extremes of product costing are job-order costing and process costing. Job-Order Costing (or Job Costing)—allocates costs to products that are readily identified by individual units or batches (e.g., construction, printing, aircraft, furniture, special-purpose machinery, and any manufacture of tailor-made or unique goods). Each unit or batch receives varying degrees of attention and skill. Process costing—averages costs over large numbers of nearly identical products (e.g., chemicals, oil, textiles, plastics, paints, flour, canneries, rubber, lumber, food processing, glass, mining, cement, and meat packing). These industries involve mass production of like units, which usually pass in continuous fashion through a series of uniform production steps called operations or processes. Job-order costing applies costs to specific jobs, which may consist of either a single physical unit (such as a custom sofa) or a few like units (such as a dozen tables) in a distinct batch or job lot. In contrast, process costing deals with great masses of like units and broad averages of unit costs. Product costing involves an averaging process. For inventory purposes, the unit cost is the result of taking some accumulated cost that has been allocated to departments and dividing it by some measure of production. The difference between the two methods is in the size of the denominator. For job-order costing it is small, and for process costing the denominator is large. Many companies use hybrid-costing systems, which are blends of ideas from both job costing and process costing. II.

Illustration of Job Costing A.

Basic Records of Enriquez Machine Parts Company Job-Cost Record (also called Job-Cost Sheet or Job Order)—where all costs for a particular product, service, or batch of products are recorded on the job-cost record (see EXHIBIT 14-1). A file of job-cost records for partially completed jobs provides supporting details for the Work-in-Process (WIP) Inventory account. A file of completed job-cost records comprises the Finished-Goods (FG) Inventory account. The job-cost record summarizes information contained on source documents. Materials Requisitions—records of materials used in particular jobs. Labor Time Tickets (or Time Cards)—record the time a particular direct laborer spends on each job. With current technology (e.g., online data entry, bar coding, and optical scanning), job-cost records and source documents are likely to be computer files, not paper records. As each job begins, a job-cost record is prepared. As units are worked on, entries are made on the job-cost record. Three classes of costs are accumulated on the job-cost

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record as units pass through the departments: material requisitions are the source of direct-materials costs, time tickets provide direct-labor costs, and budgeted overhead rates (i.e., a separate rate for each overhead cost pool) are used to apply factory overhead to products. (The computation of these budgeted rates will be described later in this chapter.) Relevant information is provided for illustrating the use of a job-order costing system for Enriquez Machine Parts Company (see EXHIBIT 14-2). B.

Applying Direct Materials and Direct Labor Costs {L. O. 2}

Applying Factory Overhead Costs

Finished Goods, Sales, and Cost of Goods Sold See EXHIBIT 14-2 for explanations of the journal entries required to record the transactions of Enriquez. These transactions illustrate how the various manufacturing costs are being accumulated in WIP, transferred to FG, and eventually reflected in Cost of Goods Sold (COGS).

III.

Activity-Based Costing/Management in a Job-Costing Environment

{L. O. 3}

Activity-based costing usually increases costing accuracy because it focuses on the cause– effect relationship between work performed (activities) and the consumption of resources (costs). A.

Illustration of ABC in a Job Order Environment See EXHIBIT 14-3 for Dell Computer Corporation’s value chain and ABC system. Dell adopted activity-based costing because of the aggressive cost reduction targets set by top management, and the need to understand product-line profitability. By using the value chain perspective, Dell targeted the non-value-added costs for reduction (e.g., preparation activity in the production facility). Marketing, distribution, and customer service are estimated during the budgeting process and included in the markup used to price a job.

IV.

Job Costing In Service And Nonprofit Organizations

{L. O. 4}

In nonprofit organizations, the “product” is usually not called a “job order”. It may be called a program or class of service. A “program” is an identifiable group of activities that frequently produces outputs in the form of services rather than goods (e.g., a safety program, an education program, and a family counseling program). Costs or revenues may be traced to individual hospital patients, individual social welfare cases, and individual university research projects. However, departments often work simultaneously on many programs, so the “job-order” costing challenge is to “apply” the various department costs to the various programs. Only then can managers make wiser decisions regarding the allocation of limited resources among

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competing programs. In service industries (e.g., repairing, consulting, legal, and/or accounting services), each customer order is a different job with a special account or order number. A.

Budgets and Control of Engagements An example is provided illustrating the use of cost data for controlling an auditing engagement for an accounting firm. If a fixed audit fee has been quoted, the profitability of an engagement depends on whether the audit can be accomplished within the budgeted time.

Accuracy of Costs of Engagements Managers of service firms (e.g., auditing and consulting firms) frequently use either the budgeted or “actual” costs of engagements as guides to pricing, and allocate effort among particular services or customers. Hence, the accuracy of costs of various engagements may affect decisions.

Process Costing Basics All product costing uses averaging to determine costs per unit of production. Process-costing systems apply costs to like products that are usually mass-produced in continuous fashion through a series of production processes. These processes usually occur in separate departments, although a single department sometimes contains more than one process. A.

Process Costing Compared with Job Costing {L. O. 5} See EXHIBIT 14-5 for the major differences between job-order costing and process costing. Process costing requires several work-in-process (WIP) accounts, one for each process (or department). As goods move from process to process, their costs are transferred accordingly. See EXHIBIT 14-6 for process costing at Nally & Gibson (a limestone quarry company). Process manufacturing systems vary in design. The processes required for manufacture can be sequential as shown in PANEL B of EXHIBIT 14-5 and in EXHIBIT 14-6, or they can simultaneously produce subcomponents of a final product that are later assembled. Process costing does not distinguish among individual units of product. Instead, accumulated costs for a period are divided by quantities produced during that period to get broad, average unit costs. Process costing can also be applied to nonmanufacturing activities (e.g., the costs of a post office sorting department divided by the number of items sorted). The central product-costing problem is how each department should compute the cost of goods transferred out and the cost of goods remaining in each department. If an identical amount of work was done on each unit transferred and on each unit in ending

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inventory, total costs are simply divided by total units. However, if the units in the inventory are each partially completed, the product-costing system must distinguish between the fully completed units transferred out and the partially completed units not yet transferred. VI.

Application of Process Costing An illustration is provided of cost and production data for a company that makes wooden marionettes in two processes: forming and finishing. When all units of product are fully complete at the end of a period, calculation of unit costs is simple. The costs incurred are simply divided by the number of units produced to get the unit costs. However, when some units are only partially complete at the end of a period, a five-step procedure must be used. Step 1: Step 2: Step 3: Step 4: Step 5:

VII.

Summarize the flow of physical units. Calculate output in terms of equivalent units. Summarize the accounted-for total costs, which are the total debits in work in process (i.e., the costs applied to work in process). Calculate unit costs. Apply costs to units completed and to units in the ending work in process.

Physical Units and Equivalent Units (Steps 1 and 2)

{L. O. 6}

The first column in EXHIBIT 14-7 provides a summarization of the flow of physical units. Units started and completed are added to the units remaining in ending workin-process to give the units accounted for. The second column of EXHIBIT 14-7 provides the equivalent units of production for both materials and conversion costs (i.e., all manufacturing costs other than direct materials). Equivalent Units—the number of completed units that could have been produced from the inputs applied (e.g., four units, each one-half completed, represents two equivalent units). Computation of equivalent units requires estimates of how much of a given resource was applied to units in process. Estimating the degree of completion for materials is usually easier than estimating those for conversion costs. The degree of completion for conversion costs depends on what proportion of the total effort needed to complete one unit or one batch has been devoted to units still in process. In industries where no exact estimate is possible or vast quantities in process prohibit costly physical estimates (e.g., textiles), all work in process in every department is assumed to be onethird, one-half, or two-thirds complete. In other cases, continuous processing entails little change of work-in-process levels from month to month. Consequently, in such cases, work in process is safely ignored, and monthly production costs are assigned solely to units completed and transferred out. VIII. Calculation of Product Costs (Steps 3 to 5)

{L. O. 7}

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See EXHIBIT 14-8 for a production-cost report, which shows Steps 3 to 5 of process costing. Step 3 summarizes the total costs to account for (i.e., the total costs in, or debits to, Work in Process). Step 4 obtains unit costs by dividing the two categories of total costs by the appropriate measures of equivalent units. Step 5 then uses these unit costs to apply costs to finished and work-in-process (WIP) products. Journal entries to reflect the costs incurred in the process are recorded by debiting the WIP account for a particular department and crediting the appropriate source (i.e., Direct-materials inventory, Accrued payroll, and Factory overhead). When goods are transferred to a subsequent department, the receiving department is charged for the costs of the goods transferred, and the sending department’s WIP account is credited. IX.

Effects of Beginning Inventories: Weighted-Average Method

{L. O. 8}

The goods completed and transferred out come from two sources: units started during the period, and from the partially completed units in beginning inventory. Some decision is required regarding how to account for the costs in the beginning inventory. Two common approaches are used: the weighted-average method and the first-in, first-out method. Weighted-Average (WA) Process-Costing Method—adds the cost of (1) all work done in the current period to (2) the work done in the preceding period on the current period’s beginning inventory of WIP. This total is divided by the equivalent units of work done to date, whether that work was done in the current period or previously. The term weighted-average is used to describe this method primarily because the unit costs used for applying costs to products are affected by the total cost incurred to date, regardless of whether those costs were incurred during or before the current period. See EXHIBIT 14-9 for the production-cost report using the weighted-average method. The costs of the beginning inventory are combined with the current period’s costs to get the total costs to account for (Step 3) and to compute the unit costs for materials and conversion costs (Step 4). The unit costs (average costs) are then used to apply costs to units transferred out and the partially completed ones remaining in ending inventory (Step 5). X.

Transferred-In Costs

{L. O. 9}

Many companies that use process costing have sequential production processes. Processes, other than the first, have units of product transferred in. Accompanying the units are Transferred-In Costs—costs incurred in a previous department for items that have been received by a subsequent department. They are similar to additional direct-materials costs, but should not be called direct-material cost in a subsequent department. Accounting for transferred-in costs is similar to accounting for direct materials, with one exception: Transferred-in costs are kept separate from the direct materials added in the department. Production-cost reports in later departments include three columns of costs instead of two: transferred-in costs, direct-material costs, and conversion costs. The total unit cost is the sum of all three types of unit costs. See EXHIBIT 14-10.

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XI.

Process Costing in a JIT System: Backflush Costing

{L. O. 10}

Tracking costs through various stages of inventory (i.e., raw material, work-in-process for each process or department, and finished goods inventory) makes accounting systems complex. Without inventories, all costs would be simply charged directly to cost of goods sold (COGS). Backflush Costing—used by organizations using JIT production systems with very small inventories to avoid having to trace costs through all inventory accounts. With backflush costing, costs are applied to products only when production is complete. A.

Principles of Backflush Costing Only two categories of costs exist in backflush costing: materials and conversion costs. Actual costs are entered into a materials inventory account, and actual labor and overhead costs are entered into a conversion costs account. Costs are transferred from these two temporary accounts directly into finished-goods inventories (FG). Some backflush systems even eliminate the FG inventory accounts and transfer costs directly to COGS. Backflush systems rely on the assumption that, as completion of production follows so soon after the application of conversion activities, balances in the conversion costs accounts always should remain near zero. Costs are transferred out almost immediately after being initially recorded.

Example of Backflush Costing The three steps to apply backflush costing are: 1. 2.

3a.

3b.

Record actual materials and conversion costs. Apply costs to completed units. When production is complete, costs from materials inventory and conversion-costs accounts are transferred directly to FG based on the number of units completed and a standard cost of each unit. Record cost of goods sold during the period. The standard cost of the items sold is transferred from FG to COGS. If completed units are delivered immediately to customers, so that FG inventories are negligible, steps 2 and 3 can be combined. If actual costs do not equal the standard amounts transferred from directmaterials and conversion costs, any differences are written off to COGS.

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CHAPTER 14:

Quiz/Demonstration Exercises

Learning Objective 1 1.

_____ allocates costs to products that are readily identified by individual units or batches, each of which receives varying degrees of attention and skill. a. Process costing b. Job-order costing c. Integrated costing d. Nonspecific costing

_____ averages costs over large numbers of nearly identical products and is most often found in such industries as chemicals, oil, textiles, plastics, paints, flour, canneries, rubber, lumber, food processing, glass, mining, cement, and meatpacking. a. Nonspecific costing b. Integrated costing c. Job-order costing d. Process costing

Learning Objective 2 Use the following information for questions 3 and 4 A summary of pertinent transactions for the year 20X1 for Hogan Company appears below. No inventories of materials, work-in-process, or finished goods were present at the beginning of the year.

MACHINING 1. Direct materials purchased on account 2. Direct materials requisitioned for manufacturing 3. Direct-labor costs incurred 4a. Factory overhead incurred 4b. Factory overhead applied 5. Cost of goods completed and transferred to finished-goods inventory 6a. Sales on account 6b. Cost of goods sold

ASSEMBLY

TOTAL $1,200,000

$450,000 50,000 150,000 210,000

$500,000 30,000 75,000 90,000

950,000 80,000 225,000 300,000

800,000 1,450,000 600,000

The incidence of labor costs to manufacture the company’s products would be recorded as _____. a. Direct Labor Expense 80,000; Direct Labor Payable 80,000

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b. c. d. 4.

WIP Inventory 80,000; Accrued Labor Payable 80,000 Direct Labor Payable 80,000; WIP Inventory 80,000 Accrued Labor Payable 80,000; WIP Inventory 80,000

The entry to recognize the manufacturing overhead applied to the product would be _____. a. Finished-Goods Inventory 300,000; WIP Inventory 300,000 b. Cost of Goods Sold 300,000; Factory Dept Overhead Control 300,000 c. Finished-Goods Inventory 300,000; Overhead Applied 300,000 d. WIP Inventory 300,000; Factory Dept Overhead Control 300,000

Learning Objective 3 5.

Which of the following is a reason to adopt activity-based costing in a job-order environment? a. aggressive cost reduction targets set by top management b. understanding product-line profitability c. both A and B d. small amounts of overhead e. none of the above

Based on the value chain, which function costs are allocated? a. customer service b. product design c. distribution d. production e. all of the above

Learning Objective 4 7.

Price Waterhouse Deloitte is a national CPA firm. Using their typical method for budgeting costs, they have determined the following bidding budget for an audit engagement: Direct professional labor $30,000 Travel costs 4,000 Applied overhead @ 200% of direct professional labor 60,000 Total costs $94,000 In recent months, they have been losing many bids to another national firm, KPYE. The few bids that Price Waterhouse Deloitte has been getting have either barely broken even or created losses for the firm. One lost potential client indicated that KPYE’s bids were much more detailed and contained a much lower overhead assignment than the one submitted by Price Waterhouse Deloitte. It is likely that KPYE _____. a. has lower operating costs than the other firms in the industry and can therefore price all their jobs below the competition b. will be out of business in the near future because their prices for services are so low c. is using an activity-based costing approach to costing their jobs, which traces more direct costs to jobs and leaves fewer costs classified as overhead to be allocated

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is engaged in illegal practices because they are not costing jobs with the customary 200% of direct professional labor rate

Which of the following costs usually is not directly traceable to an audit engagement? a. travel to and from the client b. labor incurred at the client’s site c. meals and entertainment with the client d. office space rent for CPA firm Learning Objective 5 9.

Process-costing systems differ from job-order costing systems in that the former _____. a. are far more complex and expensive to maintain b. do not require equivalent unit calculations for computing unit costs c. typically divide accumulated costs by a larger number of units of product for product costing purposes d. require fewer work-in-process accounts

10.

All of the following statements are true with respect to process costing except _____. a. unit costs are determined by processing department and added together to determine total unit costs b. identical products are produced on a continuous basis c. costs are accumulated by individual jobs d. the cost of production report provides the detail for the work-in-process accounts

Learning Objective 6 11.

Mark Inc. manufactures a prescription drug using two processes: Blending and Encapsulating. During a month in which they had no beginning inventory, materials for 200,000 units were placed into production in the Blending Department. At the end of the month, 120,000 units had been transferred to the Encapsulating Department with the remaining 80,000 units 25% complete for conversion costs. The 80,000 units contained all of their material ingredients. The number of equivalent units for material and conversion costs for the month in a processcosting system would be Material:_____ ; Conversion Costs: _____. a. 200,000; 120,000 b. 200,000; 140,000 c. 120,000; 120,000 d. 120,000; 140,000

12.

Equivalent production expresses all activity of the period in terms of _____. a. direct-labor hours b. partially completed units c. units of output d. fully completed units

Learning Objective 7

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Use the following information for questions 13 through 17. The Mantle Company produces miniature baseballs that are used for promotions at professional baseball games. The balls are produced in two processes: Forming and Finishing. The following information represents the activity of the Forming department: Units started Units completed Units of ending inventory Cost of materials added Conversion costs incurred

25,000 15,000 10,000 (50% complete for conversion) $50,000 $40,000

All materials are placed into production at the beginning of the process in the forming department. For questions 13 through 16, assume that Mantle had no beginning inventories in the Forming Department. 13.

The entry to record the cost of materials placed in production is _____. a. WIP Forming $50,000 Raw-Materials Inventory $50,000 b.

Raw-Materials Inventory Accounts Payable or Cash

WIP—Finishing Raw-Materials Inventory

$50,000

WIP—Finishing WIP—Forming

$50,000

$50,000 $50,000

$50,000

14.

The unit costs in the Forming Department are _____ for materials and _____ for conversion costs. a. $2.50; $1.60 b. $2.50; $2.00 c. $2.00; $2.20 d. $2.00; $1.60

15.

The cost of the 10,000 units remaining in ending inventory would be _____. a. $40,000 b. $30,000 c. $20,000 d. $36,000

Learning Objective 9 16.

The entry to record the costs transferred from the Forming Department to the Finishing Department would be _____. a. WIP—Finishing: $30,000; WIP—Forming: $30,000 b. WIP—Finishing: $30,000; WIP—Forming: $30,000 c. WIP—Forming: $60,000; WIP—Finishing: $60,000

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WIP—Forming: $60,000; WIP—Finishing: $60,000

Learning Objective 8 For question 17, assume the Forming Department had the following information related to their beginning inventory: Units Materials costs Conversion costs

4,000 (60% complete for conversion costs) $ 3,400 $ 3,750

17.

In computing unit costs using the weighted-average method, the cost for materials that would be divided by equivalent units of materials would be _____. a. $ 32,900 b. $ 50,000 c. $ 53,750 d. $ 53,400

18.

The cost per equivalent unit using the weighted-average method is calculated as: a. costs added during the period / equivalent units b. total costs to account for / equivalent units c. total costs to account for / number of partially completed units d. costs added during the period / number of partially completed units

Learning Objective 10 19.

Stanford Inc., uses backflush costing. During a recent month, $50,000 of materials were purchased and $70,000 of conversion costs were incurred for production. Materials are acquired just in time for use in production orders. If goods are shipped to customers upon completion of production, _____. a. materials and work-in-process accounts must be used to record production costs b. a finished-goods inventory account must be used to record the costs of finished goods, which are then transferred to cost of goods sold c. cost of goods sold could be charged directly with all production costs d. inventories will be so large that several work-in-process accounts must be used

20.

Any remaining conversion-cost balance at the end of an accounting period (per a backflush system) is charged to _____. a. cost of goods sold b. the finished-goods account c. the work-in-process account d. the materials inventory account

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CHAPTER 14: 1. [b] 2. [d] 3. [b] 4. [d] 5. [c] 6. [e] 7. [c] 8. [d] 9. [c] 10. [c] 11. [b]

Solutions to Quiz/Demonstration Exercises

Because all of the ingredients are present, 200,000 equivalent units of materials were produced. Conversion-cost equivalent units are composed of 120,000 completed units and 80,000 partially completed ones. The 80,000 units, which are 25% complete, equal 20,000 equivalent units of production. 120,000 + 20,000 = 140,000 equivalent units of production.

12. [d] 13. [a] 14. [c] 15. [b] 16. [b] (The following production-cost report is used for questions 13–17) Mantle Company Production-Cost Report Forming Department

TOTAL COSTS Costs to account for Divided by equivalent units Unit costs

$90,000 $4.00

Details Direct Conversion Materials Costs $50,000 25,000 $2.00

$40,000 20,000 $2.00

Application of costs to units not completed and still in process: Direct materials Conversion costs Work in process To units transferred to the Finishing Department Total costs accounted for 17. [d]

$ 20,000 10,000 $ 30,000

10,000 * ($2.00) 5,000 * ($2.00)

$60,000 $90,000

15,000 * ($4.00)

With the weighted-average method, the current period’s costs are blended together with the prior period’s costs when computing unit costs. Here, $50,000 + $3,400 =

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$53,400. 18. [b] 19. [c] 20. [a]

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Chapter 15 Basic Accounting: Concepts, Techniques, and Conventions LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. Read and interpret basic financial statements. 2. Analyze typical business transactions using the balance sheet equation. 3. Distinguish between the accrual basis of accounting and the cash basis of accounting, 4. Make adjustments to the accounts under accrual accounting. 5. Explain the nature of dividends and retained earnings. 6. Select relevant items from a set of data and assemble them into a balance sheet and an income statement. 7. Distinguish between the reporting of corporate owners’ equity and the reporting of owners’ equity for partnerships and sole proprietorships. 8. Explain the role of auditors in financial reporting and how accounting standards are set. 9. Identify how the measurement principles of recognition, matching and cost recovery, and stable monetary unit affect financial reporting. 10. Define continuity, relevance, faithful representation, materiality, conservatism, and cost– benefit (Appendix 15A). 11. Use T-accounts, debits, and credits to record transactions (Appendix 15B).

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12. CHAPTER 15:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 24. Accounting Valuation of Fixed Assets 25. Marketing, the Income Statement, and the Balance Sheet 26. Revenue Recognition and Evaluation of Sales Staff 27. Relationship Between the Balance Sheet and the Income Statement 28. Concepts of Relevance and Faithful Representation GENERAL EXERCISES and PROBLEMS 29. True or False 30. Simple Balance Sheet 31. Nature of Retained Earnings 32. Income Statement 33. Income Statement, Balance Sheet, and Dividends 34. Customer and Hotel 35. Property Owner and Municipality 36. Adjustments 37. Find Unknowns 38. Balance Sheet Equation: Solving for Unknowns 39. Fundamental Transaction Analysis and Preparation of Statements 40. Measurement of Income for Tax and Other Purposes 41. Debits and Credits 42. True or False 43. Use of T-Accounts 44. Use of T-Accounts 45. Use of T-Accounts UNDERSTANDING PUBLISHED FINANCIAL REPORTS 46. Balance Sheet Effects 47. Preparation of Balance Sheet for Daimler AG 48. Net Income and Retained Earnings 49. Earnings Statement, Retained Earnings 50. Sole Proprietorship and Corporation 51. Nike 10-K Problem: Interpreting the Income Statement and Balance Sheet EXCEL APPLICATION EXERCISE 52. Monthly Transactions Using the Balance Sheet Equation COLLABORATIVE LEARNING EXERCISE 53. Implicit Transactions INTERNET EXERCISE 54. McDonald’s Financial Statements (https://corporate.mcdonalds.com)

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CHAPTER 15: I.

OUTLINE

The Need for Accounting Accounting is the language of business. Managers, investors, and other interested groups usually want the answers to two important questions about an organization: How well did the organization perform for a given period? Where does the organization stand at a given point? Accountants answer these two questions with two major financial statements: an income statement and a balance sheet. To obtain these statements, accountants record an organization’s transactions. Transaction—any event that affects the financial position of an organization and requires recording. Through the years, many concepts, conventions, and rules have been developed regarding what events are to be recorded as accounting transactions and how their financial impact is measured.

II.

Financial Statements: Balance Sheet and Income Statement {L. O. 1} Financial statements are summarized reports of accounting transactions. They can apply to any point in time and to any span of time. Balance Sheet (more accurately called Statement of Financial Position or Statement of Financial Condition)—a snapshot of financial status at an instant of time. The balance sheet equation is assets = equities The equities side of this equation is often divided into two parts: assets = liabilities + owners’ equity Liabilities—the entity’s economic obligations to nonowners. Owners’ Equity—the excess of the assets over the liabilities. For Corporations (i.e., a business organized as a separate legal entity and owned by its stockholders), owners’ equity is called Stockholders’ Equity. Stockholders’ equity is a result of Paid-in Capital (i.e., the ownership claim arising from funds paid-in by the owners) plus Retained Earnings or Retained Income (the ownership claim arising from the investment of previous profits). The balance sheet equation for corporations becomes: assets

= =

liabilities + stockholders’ equity liabilities + (paid-in capital + retained earnings)

{L. O. 2} See EXHIBIT 15-1 and EXHIBIT 15-2 for illustrations of the effects of transactions on the balance sheet equation. Accounts Receivable—amounts due from customers on open account. Accounts Payable—amounts owed on open accounts.

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Revenue and Expenses Revenues—increases in ownership claims arising from the delivery of goods or services. To be recognized (i.e., formally recorded in the accounting records as revenue during the current period), revenue (1) must be earned by fully rendering goods or services to customers, and (2) must be realized (i.e., the seller must be reasonably assured that the resources promised in exchange for the goods or services will be received). Expenses—decreases in ownership claims arising from delivery of goods or services, or using up assets. Profits (or Earnings of Income)—the excess of revenues over expenses. Account—each item in a financial statement. Increases in revenues are increases in stockholders’ equity and increases in expenses decrease stockholders’ equity.

Relationship Between Balance Sheet and Income Statement Income Statement—measures the operating performance of the corporation by matching its accomplishments (i.e., revenues or sales) with its efforts (i.e., expenses such as cost of goods sold). The balance sheet shows the financial position at an instant of time, but the income statement measures performance for a span of time, whether it be a month, a quarter, or longer. Thus, the income statement is the major link between balance sheets.

The Analytical Power of the Balance Sheet Equation The balance sheet equation can highlight the link between the income statement and the balance sheet. The relationships between income statement items and those for the balance sheet can be seen in transforming the balance sheet equation as shown below: 1. assets (A) = liabilities (L) + stockholders’ equity (SE) 2. A = L + paid-in capital + retained earnings 3. A = L + paid-in capital + revenue - expenses Revenue and expense accounts are subdivisions of stockholders’ equity (i.e., temporary stockholders’ equity accounts). For every transaction, the balance sheet equation is always kept in balance.

III.

Accrual Basis and Cash Basis

{L. O. 3}

Accrual Basis—recognizes the impact of transactions on the financial statements in the periods when revenues and expenses occur instead of when cash is received or disbursed.

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Revenues are recorded as they are earned and expenses recorded as they are incurred, not necessarily when cash changes hands. Cash Basis—revenue and expense recognition would depend solely on the timing of various cash receipts and disbursements. The major deficiency of the cash basis is that it is incomplete. It fails to match efforts with accomplishments (expenses and revenues) in a manner that properly measures economic performance and financial position. It omits key assets (such as accounts receivable and prepaid rent) and key liabilities (such as accounts payable) from the balance sheets. A.

Nonprofit Organizations The examples in this chapter focus on profit-seeking organizations (for-profit), but nonprofit organizations, such as government agencies and charitable organizations, also use balance sheets and income statements. For many years, most nonprofit organizations used cash-basis rather than accrual accounting, but as these organizations are increasingly using accrual accounting.

IV.

Adjustments to the Accounts Adjustments—recording of implicit transactions, in contrast to the explicit transactions that trigger nearly all day-to-day routine entries, at the end of each reporting period in order to measure income for accrual accounting. They refine the accountant’s accuracy and provide a more complete and significant measure of efforts, accomplishments, and financial position. The four categories of transactions (i.e., economic events that should be recorded by an accountant) for which adjustments are necessary are outlined below. Source Documents—explicit evidence of any transactions that occur in the entity’s operation (e.g., sales slips and purchase invoices).

Adjustment Type I: Expiration of Unexpired Costs

{L. O. 4}

Assets frequently expire because of the passage of time. Assets may be viewed as bundles of economic services awaiting future use or expiration. Assets, other than cash and receivables, may be thought of as prepaid or stored costs that are carried forward to future periods rather than immediately charged against revenue. Expenses are used-up assets. Unexpired Cost— any asset that ordinarily becomes an expense in future periods (e.g., inventory and prepaid rent). A.

Timing of Asset Expiration Some assets expire immediately (e.g., advertising services and miscellaneous supplies). When this is the case, the usual accounting for them is to expense them instantaneously rather than recording them first as assets and then expensing them. The time at which assets expire can be debatable. For example, research and development costs must be written off as an expense under current generally accepted accounting principles. However, they may have some future economic

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benefit. B.

Depreciation Long-lived assets (e.g., equipment and buildings) have their cost recognized as an expense through the periodic recording of depreciation. Accountants usually (1) predict the length of the useful life, (2) predict the ultimate residual value, and (3) allocate the cost of the equipment to the years of its useful life in some systematic way. Residual Value—the predicted sales value of a long-lived asset at the end of its useful life.

VI.

Adjustment Type II: Recognition (Earning) of Unearned Revenues Unearned Revenues (or Deferred Revenues)—liabilities that are present due to the collection of payment prior to the rendering of services or sending products. As the services are rendered or goods delivered, the revenue must be recognized.

VII.

Adjustment Type III: Accrual of Unrecorded Expenses Accrue—to accumulate a receivable or payable during a given period even though no explicit transaction occurs (e.g., the accruals of wages of employees for partial payroll periods and the interest on borrowed money before the interest payment date). Usually, adjusting entries are made to bring these expenses and the resulting liabilities up to date.

VIII. Adjustment Type IV: Accrual of Unrecorded Revenues The final type of adjustment, the realization of revenues that have been earned but not recorded as such in the accounts, is the mirror image of the accrual of unrecorded expenses (e.g., interest receivable and interest revenue may need to be recorded at the end of an accounting period). See EXHIBIT 15-3 for a summarization of the four major types of adjustments needed to implement the accrual basis of accounting. IX.

Dividends and Retained Income

{L. O. 5}

Dividends—distributions of assets to stockholders that reduce retained income. A.

Dividends Are Not Expenses They are not expenses like rent and wages. They should not be deducted from revenues because they are not directly related to the generation of sales or the conduct of operations. The ability to pay dividends is fundamentally caused by profitable operations. Retained income increases as profits accumulate, and decreases as dividends occur. Retained income is frequently the largest stockholders’ equity account.

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Nature of Retained Earnings Although retained income is a result of profitable operations, it is not a pot of cash awaiting distribution to stockholders. Its value is distributed among the many assets held by the firm, not just cash. Dividends are distributions of assets that reduce ownership claims. The cash assets that are disbursed typically arose from profitable operations. Thus, dividends or withdrawals are often spoken of as “distributions of profits” or “distributions of retained earnings.” Often, dividends are erroneously spoken of as being “paid out of retained income.” In reality, cash dividends are distributions of assets that liquidate a portion of the ownership claim, which is made possible by profitable operations.

Preparing Financial Statements

{L. O. 6}

Using Stora Exor’s information in EXHIBIT 15-2, financial statements are constructed. See EXHIBIT 15-4 for the balance sheet, EXHIBIT 15-5 for the income statement, and EXHIBIT 15-6 for the Statement of Retained Earnings. The income statement is a “multiple-step” statement because it includes a subtotal for gross profit. Gross profit (or gross margin) is the excess of sales over the cost of the inventory that was sold. A “singlestep” statement would list all the expenses, including cost of goods sold, and deduct the total from sales. XI.

Sole Proprietorships and Partnerships

{L. O. 7}

The basic accounting concepts that underlie the owners’ equity for the corporate form of business also apply to Sole Proprietorships and Partnerships. In proprietorships and partnerships, however, distinctions are rarely made between paid-in capital and retained income. In contrast to corporations, sole proprietorships and partnerships are not legally required to account separately for paid-in capital (i.e., proceeds from issuances of capital stock) and for retained income. Instead, they typically accumulate a single amount for each owner’s original investment, subsequent investments, share of net income, and withdrawals. XII.

Generally Accepted Accounting Principles

{L. O. 8}

Generally Accepted Accounting Principles (GAAP)—the conventions, rules, and procedures that together make up accepted accounting practice at any given time. They become generally accepted by agreement. Such agreement is not solely influenced by formal logical analysis. Experience, custom, usage, and practical necessity contribute to the set of principles. Accordingly, it might be better to call them conventions, because principles suggest that they are the product of airtight logic. A.

Auditor’s Independent Opinion The financial statements of publicly held corporations and many other corporations are subject to an independent audit that forms the basis for a professional accounting

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firm’s opinion. An accounting firm must conduct an audit before it can render the opinion. Audit— an “examination” or in-depth inspection that is made in accordance with generally accepted auditing standards. An audit has been developed primarily by the American Institute of Certified Public Accountants (AICPA), which is the leading organization of auditors. An audit includes tests of the accounting records, internal control systems, and other procedures as deemed necessary. After auditing a company, an accountant issues an independent opinion—the accountant’s testimony that management’s financial statements are in conformity with generally accepted accounting principles. B.

Accounting Standard Setters TEACHING TIP: Internet sites—SEC, IASB, and FASB: http://www.fasb.org http://www.sec.gov

http://www.iasb.org

American GAAP is largely the work of the Financial Accounting Standards Board (FASB). The rest of the world is governed by the International Accounting Standards Board (IASB). The FASB and IASB continue to work together to improve comparability and consistency in global financial reporting. Securities and Exchange Commission (SEC)—a government agency established by federal law, has the ultimate responsibility for specifying GAAP for U.S. companies whose stock is held by the public. However, the SEC has informally delegated much rule-making power to the FASB. Congress can overrule both the SEC and the FASB, and the SEC can overrule the FASB. Undermining of the FASB occurs rarely. However, corporations and other interested parties exert pressure on all three tiers, if they think an impending pronouncement is “wrong”. The setting of accounting principles is complex and involves heavy interactions among the affected parties: public regulators (Congress and SEC), private regulators (FASB), companies, the public accounting profession, representatives of investors, and other interested groups. The Sarbanes-Oxley Act of 2002 dictates more regulatory control of both accounting and auditing standards. XIII. Three Measurement Conventions A.

{L. O. 9}

Recognition In general, revenue is recognized when the goods or services in question are delivered to customers. This was discussed earlier in the section entitled Revenues and Expenses.

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Matching and Cost Recovery Matching—the relating of accomplishments or revenues (as measured by the selling prices of goods and services delivered) and efforts or expenses (as measured by the cost of goods and services used) to a particular period for which income measurement is desired. Matching is a short description of the accrual basis for measuring income. Cost Recovery Concept—assets (e.g., inventories, prepayments, and equipment) are carried forward as assets because their costs are expected to be recovered in the form of cash inflows (or reduced cash outflows) in future periods.

Stable Monetary Unit The dollar is the monetary unit used for measuring assets and equities. It is the common denominator for quantifying the effects of a variety of transactions. While companies in the United States, Canada, Australia, and New Zealand use the dollar as the monetary unit, other countries use the franc, pound, mark, yen, or some other monetary unit. The dollars used in recording transactions, which result in the financial statements, do not incorporate any changes in its purchasing power. Several countries, including Brazil and Argentina, routinely adjust their accounting numbers for the effects of inflation. The most troublesome aspect is how to interpret the results of these adjusted numbers.

XIV. Appendix 15A: Additional Accounting Concepts A.

{L. O. 10}

The Continuity or Going Concern Convention Continuity (or Going Concern Convention)—the assumption that an organization will continue to exist and operate. Existing resources (e.g., plant assets) will be used to fulfill the general purposes of a continuing entity rather than sold in tomorrow’s real estate or equipment markets. It also implies that existing liabilities will be paid at maturity in an orderly manner.

Relevance and Faithful Representation Relevance and faithful representation are the two main qualities to make accounting information useful. Relevance is whether the information makes a difference to the decision maker. Two characteristic of relevance are predictive value and confirmatory value. Accountants also want information to exhibit faithful representation which requires information to be complete, neutral, and free of material errors. There are four characteristics that enhance relevance and faithful representation. They are comparability which requires consistency, verifiability, timeliness, and

236

understandability. C.

Materiality Materiality—the accounting convention that justifies the omission of insignificant information if its omission or misstatement would not mislead a user of financial statements. Many outlays that should theoretically be recorded as assets are immediately written off as expenses because of their lack of significance (e.g., a rule that requires the immediate write-off to expense of all outlays under a specified minimum of, say $100, regardless of the useful life of the asset acquired).

The Conservatism Convention (or The Prudence Convention) Conservatism Convention—selecting the method of measurement that yields the gloomiest immediate results (e.g., lower-of-cost-or-market and historical cost).

Cost-Benefit Cost-Benefit Criterion—as an accounting system is changed, its potential benefits should exceed its additional costs. Often the benefits are difficult to measure.

XV.

Appendix 15B: Using Ledger Accounts A.

{L. O. 11}

The Account Ledger Accounts—must be used to keep track of how the multitudes of transactions affect each particular asset, liability, revenue, expense, and so forth. T-Accounts— simplified versions of ledger accounts that take the form of the capital letter T. Double-Entry System—a method of record keeping in which at least two accounts are affected by each transaction.

General Ledger General Ledger—a collection of the group of accounts that supports the items shown in the major financial statements. It is usually supported by various subsidiary ledgers, which provide details for accounts in the general ledger. See EXHIBIT 15-7 for the general ledger of King Hardware Co.

Debits and Credits Debit—the left side of an account. Credit—the right side of an account. Debits increase assets and expense accounts, and decrease liability, owners’ equity accounts, and revenues. Credits decrease asset and expense accounts and increase liability, owners’ equity, and revenue accounts.

237

CHAPTER 15:

Quiz/Demonstration Exercises

Learning Objective 1 1.

Which of the following is a form of the balance sheet equation? a. Assets = Liabilities + (Paid in Capital + Retained Income) b. Assets +Liabilities = Owner’s Equity c. Assets + Owners’ Equity = Liabilities d. Assets - Paid-in Capital = Liabilities - Retained Income

Which of the following financial statements is a “snapshot” of a company’s financial status at an instant of time? a. income statement b. balance sheet c. statement of retained earnings d. cash flow statement e. both B and D

Learning Objective 2 3.

The effect of purchasing inventory using trade credit on the balance sheet equation is to _____. a. decrease assets and increase liabilities b. increase owners’ equity and decrease liabilities c. increase assets and increase owners’ equity d. increase assets and increase liabilities

The effect of selling an item on credit on the balance sheet is to _____. a. decrease assets and increase liabilities b. increase owner’s equity and decrease liabilities c. increase assets and increase liabilities d. increase assets and increase owner’s equity

Learning Objective 3 5.

When revenues are recognized as earned and expenses are recognized as incurred, a company is using _____. a. the cash basis of accounting b. the accrual basis of accounting c. both of these d. neither of these

Which basis of accounting violates the matching principle? a. cash basis of accounting b. accrual basis of accounting c. both A and B

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neither A nor B

Learning Objective 4 7.

What is considered to be a bundle of economic services awaiting future use? a. liabilities b. owners’ equity c. assets d. expenses e. revenue

After the bundle of economic services is used, where does the expired cost appear? a. income statement b. statement of retained earnings c. balance sheet d. all the above correct

Learning Objective 5 9.

_____ are distributions of assets that reduce ownership claims. a. assets b. expenses c. dividends d. retained earnings

10.

Retained income is represented in the company’s balance sheet by _____. a. the balance in the inventory account b. the balance in the plant and equipment account c. all of the assets less the liabilities and paid-in capital d. the balance in the cash account

Learning Objective 6 11.

Cost of goods sold appears on which financial statement? a. balance sheet b. income statement c. retained earnings d. all of the above

12.

Unearned revenue appears on which financial statement? a. balance sheet b. income statement c. statement of retained earnings d. none of the above

Learning Objective 7

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13.

Owners’ equity in sole proprietorships and partnerships differs from that for corporations in that _____. a. they do not separate retained income from the owner’s paid-in capital accounts b. they separate retained income from paid-in capital whereas corporations have only one ownership equity account c. they reflect the sum of assets and liabilities rather than the difference d. none of these

14.

Which entity may have two or more owners? a. partnership b. sole proprietorship c. both A and B d. neither A nor B

Learning Objective 9 15.

The practice of accounting for revenue when goods or services are delivered to customers is referred to as _____. a. revenue recognition b. the conservatism convention c. cost recovery d. the stable monetary unit assumption

16.

The practice of relating of accomplishments or revenues and efforts or expenses to a particular period for which the measurement of income is desired is called _____. a. the going concern assumption b. the conservatism convention c. revenue recognition d. the matching principle

17.

The practice of carrying forward assets such as inventories, prepayments, and equipment to be recovered in cash inflows (or reduced cash outflows) in future periods is known as _____. a. the conservatism convention b. the matching principle c. cost recovery d. revenue recognition

18.

The principle that uses the dollar as an unchanging yardstick for measuring transactions is referred to as _____. a. the conservatism convention b. the stable monetary unit assumption c. the going concern assumption d. revenue recognition

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CHAPTER 15:

Solutions to Quiz/Demonstration Exercises

1. [c] 2. [b] 3. [d] 4. [c] 5. [b] 6. [a] 7. [c] 8. [d] 9. [c] 10. [c] 11. [b] 12. [a] 13. [a] 14. [a] 15. [c] 16. [d] 17. [c] 18. [b]

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Chapter 16 Understanding Corporate Annual Reports: Basic Financial Statements LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Recognize and define the main types of assets in the balance sheet of a corporation. Recognize and define the main types of liabilities in the balance sheet of a corporation. Recognize and define the main elements of the stockholders’ equity section of the balance sheet of a corporation. Recognize and define the principle elements in the income statement of a corporation. Recognize and define the elements that cause changes in stockholders’ equity accounts. Explain the purpose of the cash flow statement and identify activities that affect cash, and classify them as operating, investing, or financing activities. Assess financing and investing activities using the statement of cash flows. Use both the direct method and the indirect method to explain cash flows from operating activities. Explain the role of depreciation in the statement of cash flows. Describe and assess the effects of the four major methods of accounting for inventories (Appendix 16A).

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CHAPTER 16:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 37. Production Facilities and Depreciation 38. R&D and the Recognition of Intangible Assets 39. Using the Income Statement to Evaluate Sales Success 40. Capital Investment and the Statement of Cash Flows 41. Purchasing Operations and LIFO versus FIFO GENERAL EXERCISES and PROBLEMS 42. Meaning of Book Value 43. Balance Sheet and Income Statement 44. Simple Changes in Retained Earnings and Total Stockholders’ Equity 45. Cash Received from Customers 46. Cash Paid to Suppliers 47. Cash Paid to Employees 48. Simple Cash Flows from Operating Activities 49. Net Income and Cash Flow 50. Net Loss and Cash Flows from Operating Activities 51. Preparation of a Statement of Cash Flows 52. Reconciliation of Net Income and Net Cash Provided by Operating Activities 53. Depreciation and Cash Flows 54. Cash Flows, Indirect Method 55. Preparation of Statement of Cash Flows 56. LIFO and FIFO 57. Lower of Cost or Market—U.S. GAAP 58. Lower of Cost or Market—IFRS 59. LIFO, FIFO, and Cash Effects 60. LIFO, FIFO, Prices Rising and Falling UNDERSTANDING PUBLISHED FINANCIAL REPORTS 61. Various Intangible Assets 62. Various Liabilities 63. Exercises in Assets, Liabilities, and Stockholders’ Equity 64. Classified Income Statement and Balance Sheet 65. Classified Balance Sheet—Britain 66. Gain on a Ship That Sank 67. Identification of Operating, Investing, and Financing Activities 68. Interest Expense 69. Indirect and Direct Cash Flows from Operations 70. Statement of Cash Flows, Direct and Indirect Methods 71. Comparison of Inventory Methods 72. Effects of Late Purchases 73. LIFO and FIFO at Big Bazaar 74. Effect of LIFO

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75.

Nike 10-K Problem: Using Financial Statements

EXCEL APPLICATION EXERCISE 76. Analyzing Differences Between Inventory Valuation Methods COLLABORATIVE LEARNING EXERCISE 77. Income Statement and Balance Sheet Accounts INTERNET EXERCISE 78. Tata Steel Limited’s Financial Statements (https://tatasteel.com)

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CHAPTER 16: I.

OUTLINE

Classified Balance Sheet

{L. O. 1}

See EXHIBIT 16-1 for the classified balance sheets of Nike, Inc. Assets and liabilities are classified into five main sections: current assets, noncurrent assets, current liabilities, noncurrent liabilities, and shareholders’ equity. These classifications of balance sheet items are described below. A.

Current Assets Current assets include cash and all other assets that are reasonably expected to be converted to cash, sold, or consumed during a normal operating cycle. Operating Cycle—the time span during which cash is spent to acquire goods and services that are used to produce the organization’s output, and then sold to customers, and finally the customers pay for their purchases with cash. As shown in EXHIBIT 16-1, current assets fall into several broad categories (e.g., cash and cash equivalents, accounts receivable, inventories, prepaid expenses, and other assets). Cash consists of bank deposits in checking accounts plus money on hand. Cash Equivalents—short-term investments that can easily be converted into cash with little delay (e.g., money market funds and treasury bills are good examples of cash equivalents). These securities are usually shown at cost or market price, whichever is lower. Accounts receivable is the total amount owed to the company by its customers. Because some customers ultimately will not pay their bill, an allowance or provision for doubtful accounts reduces the total. Inventories consist of merchandise, finished products of manufacturers, goods in process of being manufactured, and raw materials. Inventories are stated at their cost or market price, whichever is lower. Cost of manufactured products normally is composed of raw materials plus the cost of converting it into a finished product (i.e., direct labor and manufacturing overhead). Prepaid expenses are short-term prepayments or advance payments to suppliers (e.g., prepayment of rent and insurance premiums for coverage over the coming operating cycle). They are usually unimportant in relation to other assets. Other current assets are miscellaneous current assets that do not fit into the listed categories (e.g., notes receivable and short-term investments that are not cash equivalents).

Noncurrent Assets: Property, Plant, and Equipment

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Property, plant, and equipment are sometimes called Fixed Assets or plant assets. Tangible Assets—physical items that a person can see and touch. Details about these items are frequently found in the footnotes to the financial statements (see EXHIBIT 16-2). Land usually is accounted for as a separate item and is carried at its historical cost. Buildings and machinery and equipment are initially recorded at cost: the invoice amount + freight and installation - cash discounts. The major difficulties of measurement center on the choice of depreciation method (i.e., the allocation of original cost over the periods or products that benefit from the use of the assets). The amount to be depreciated is the difference between the original cost and the asset’s estimated residual value (i.e., the residual value is the amount expected to be received when selling the asset at the end of its economic life). There are three general methods of depreciation typically used: straight-line (see EXHIBIT 16-3), accelerated, and units of production. Leasehold improvements are investments made by a lessee (tenant) in items (e.g., painting, decorating, fixtures, and air-conditioning equipment) that cannot be moved from the premises when the lease expires. The cost of leasehold improvements is written off in the same manner as depreciation; however, it is called amortization. Construction in process is shown separately from other assets because the assets are not yet ready for use. It represents assets that will be part of buildings and equipment when completed. Natural resources (e.g., mineral deposits) are typically grouped with plant assets. Their original cost is written off in the form of depletion as the resources are used. Long-term investments are also noncurrent assets (e.g., long-term holdings of securities of other firms). Accounting for intercorporate investments is discussed in detail in CHAPTER 17. C.

Operating Lease Right-of-Use Assets

Intangible Assets

Intangible Assets—a class of long-lived assets that are not physical in nature. They are rights to expected future benefits deriving from their acquisition and continued possession (e.g., goodwill, franchises, patents, and copyrights). Goodwill—the excess of the cost of an acquired company over the sum of the market values of its identifiable individual assets less the liabilities. Only the goodwill arising from an actual acquisition should be shown as an asset on the purchaser’s records. Goodwill must be amortized over its expected useful life or 40 years, whichever is less, in the United States. The shortest amortization period is not specified, but a lump-sum write-off on acquisition is forbidden for U.S. firms.

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Liabilities 1.

{L. O. 2}

Current Liabilities Current Liabilities—an organization’s debts that fall due within the coming year or within the normal operating cycle if longer than a year. Notes payable are short-term debt backed by formal promissory notes held by a bank or business creditors. Accounts payable are amounts owed to suppliers who extend credit for purchases on open account. Accrued liabilities or accrued expenses payable are recognized for wages, salaries, interest, and similar items. The accountant recognizes expenses as they are incurred, regardless of when they are paid for in cash. Income taxes payable is a special accrued expense of enough magnitude to warrant a separate classification. The current portion of long-term debt shows the payments due within the next year on bonds and other long-term debt. Unearned or deferred revenues are recorded when cash is received before the goods or a firm delivers services. Working Capital—current assets less current liabilities.

Noncurrent Liabilities Noncurrent or Long-Term Liabilities—an organization’s debts that fall due beyond 1 year (e.g., deferred income taxes and long-term debt). See EXHIBIT 16-4 for Long-Term Debt Footnote. Long-term debt may be secured or unsecured. Secured debt provides debt holders with first claim on specified assets (e.g., mortgage bonds). If the company is unable to meet its regular obligations on the bonds, the specified assets may be sold and the proceeds used to pay off the firm’s obligations to its bondholders. Secured debt holders have first claim. Unsecured debt consists of Debentures—formal certificates of indebtedness that are accompanied by a promise to pay interest at a specified rate (e.g., bonds, notes, or loans). Unsecured debt holders are general creditors who have a general claim against total assets rather than a specific claim against particular assets. Holders of Subordinated bonds or debentures are junior to the other creditors in exercising claims against assets. Liquidation—converting assets to cash and using the cash to pay off outside claims. To increase the appeal of their bonds, many corporations issue debt that is convertible into common stock.

Stockholders’ Equity

{L. O. 3}

The final element of the balance sheet is stockholders’ equity or owners’ equity or capital or net worth, the total residual interest in the business. The main elements of

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stockholders’ equity arise from two main sources: (1) contributed or paid-in capital, and (2) retained income. Paid-in capital typically comes from owners who invest in the business in exchange for stock certificates, which are issued as evidence of stockholder rights. Capital stock can be divided into two major classes: common stock and preferred stock. Common Stock—all companies have common stock. Common stock has no predetermined rate of dividends, and is the last to obtain a share in the assets when the corporation is dissolved. Common shares usually have voting power in the management of the corporation. It is the riskiest class of ownership because it pays no guaranteed return, but may provide the best overall return because there is no limit to the stockholder’s potential participation in earnings. Preferred Stock—issued by about 40% of major U.S. firms. It typically has some priority over other shares regarding dividends or the distribution of assets on liquidation. Preferred shareholders typically do not have voting privileges. Par Value (or Legal Value, Stated Value)—value that is printed on the face of the stock certificate. It is generally illegal for a corporation to sell an original issue of its common stock below par. Shareholders have limited liability. Limited Liability— creditors cannot seek payment from shareholders as individuals if the corporation itself cannot pay its debts. Capital in excess of stated value is the excess received over the stated, par, or legal value of the shares issued. Common shares are usually issued at a price above par. Retained earnings (or retained income) are the increase in stockholders’ equity caused by profitable operations. A foreign currency translation adjustment appears on the balance sheet for companies with foreign operations. It arises from changes in the exchange rate between the dollar and foreign currencies. Treasury Stock—a corporation’s own stock that has been issued and subsequently repurchased by the company, and is being held for a specific purpose. Repurchase is a decrease in ownership claims. It should appear on the balance sheet as a deduction from stockholders’ equity. II.

Income Statement A.

{L. O. 4}

Operating Performance An income statement can take one of two major forms: single step or multiple step. A single-step statement merely lists all expenses without drawing subtotals, whereas a multiple-step statement contains one or more subtotals. Subtotals highlight significant relationships such as when cost of goods sold is deducted from revenues to give gross

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margin. The two most common subtotals: gross profit and income from operations (also called operating income). Depreciation expense, selling expenses, and administrative expenses are often grouped as “operating expenses” and deducted from gross profit to obtain operating income, which is also called operating profit. B.

Financial Management Operating management focuses on the major day-to-day activities that generate sales revenue. Financial management focuses on where to get cash and how to use it. Because financial rather than operating decisions affect interest income and expense, they often appear as separate items after operating income. The terms income, earnings, and profits are often used as synonyms. Net Income—the popular “bottom line” (i.e., the residual after deducting all expenses including income taxes. The term net is seldom used for any subtotals that precede the calculation of net income. Net income typically appears after provision for income taxes. Income statements conclude with disclosure of Earnings Per Share (EPS). EPS—net income divided by the average number of common shares outstanding during the year (see EXHIBIT 16-5).

III.

Statement of Changes in Stockholder’s Equity

{L. O. 5}

Statement of Changes in Stockholder’s Equity (or Statement of Retained Earnings)—a financial statement that analyzes changes in the retained earnings over a period of time. Net income increases retained earnings, whereas losses and dividends reduce retained earnings (see EXHIBIT 16-6). IV.

Statement of Cash Flows The statement has the following purposes: 1.

It shows the relationship of net income to changes in cash balances. Cash balances can decline despite positive net income and vice versa.

It reports past cash flows as an aid to: a. b. c.

Predicting future cash flows Evaluating management’s generation and use of cash Determining a company’s ability to pay interest and dividends, and to pay debts when they are due

It reveals commitments to assets that may restrict or expand future courses of action.

Basic Concepts

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Statement of Cash Flows—reports the cash receipts and cash payments of an organization during a particular period. The statement of cash flows along with the income statement and statement of retained earnings show why balance sheet items have changed by providing information about operating, investing, and financing activities. The statement of cash flows usually explains where cash came from during a period and where it was spent. B.

Typical Activities Affecting Cash

{L. O. 6}

The fundamental approach to the statement of cash flows is: (1) list the activities that increased cash and those that decreased cash, and (2) place each cash inflow and outflow into one of three categories according to the type of activity that caused it: operating activities, investing activities, and financing activities. Cash flows from operating activities are generally the effects of transactions that affect the income statement (e.g., collections from customers and cash payments to suppliers). Investing activities include (1) lending and collecting on loans and (2) acquiring and selling long-term assets. Financing activities include obtaining resources from creditors and owners and providing creditors with returns of and owners a return on their investments (i.e., payment of dividends). The FASB has decided to include the receipt and payment of interest and the receipt of dividends as operating activities because they affect the computation of income. C.

Focus of a Statement of Cash Flows

{L. O. 7}

See EXHIBIT 16-7 for Balmer Company’s summary transactions for the year, and EXHIBIT 16-8, EXHIBIT 16-9, and EXHIBIT 16-10 for Balmer Company’s condensed income statement and balance sheets, and statement of cash flows. It shows the changes in cash resulting from operating, investing, and financing activities. The change is then added to the beginning cash balance to yield the ending cash balance. 1.

Cash Flows from Financing Activities This section shows cash flows to and from providers of capital (e.g., increase or decrease in long-term debt, issue stock, repurchase stock, and pay dividends).

Cash Flows from Investing Activities This section shows cash flows from the purchase or sale of property, plant, equipment, and other long-lived assets.

Noncash Investing and Financing Activities For example, purchased fixed assets by issuing common stock. Cash did not change hands.

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Cash Flow from Operating Activities Many accountants build the statement of cash flows from the changes in balance sheet items, a few additional facts, and their familiarity with the typical causes of changes in cash. For instance, cash collected from sales is usually found by taking sales computed under the accrual basis from the income statement and adjusting it for the changes in the accounts receivable balance. Examples of other operating activity effects on cash are also provided: the purchase of inventory, payments of accounts payable, payments to suppliers, payments to employees, and payments for interest and income taxes. See EXHIBIT 16-11 for the effects of transactions on cash flows from operating activities.

VI.

Interpreting the Cash Flow A.

{L. O. 8}

DIRECT METHOD The direct method consists of listing cash receipts (inflows) and cash disbursements (outflows). The easiest way to construct the statement of cash flows from operations using the direct method is to examine the Cash column of the balance sheet equation (see EXHIBIT 16-7).

INDIRECT METHOD Indirect Method—reconciles net income to the net cash provided by operating activities. It also shows the link between the income statement and the statement of cash flows. The reconciliation begins with net income. Then additions and deductions are made for items that affect net income and net cash flow differently (see EXHIBIT 16-12). The most common additions or deductions from net income on the reconciliation are: • • • • •

Add decreases (or deduct increases) in accounts receivable Add decreases (or deduct increases) in inventories Add decreases (or deduct increases) in accounts payable Add decreases (or deduct increases) in wages and salaries payable Add decreases (or deduct increases) in unearned revenue

The general rules for reconciling these items are: 1. 2. 3. 4.

Deduct increases in noncash current assets Add decreases in noncash current assets Add increases in current liabilities Deduct decreases in current liabilities

A final step is to reconcile for amounts that are included in net income but represent investing or financing activities (in contrast to operating activities).

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Examples include: • • C.

Add loss (or deduct gain) from sale of fixed assets Add loss (or deduct gain) on extinguishment of debt

Reconciliation Schedule under Direct and Indirect Methods The FASB requires all statements of cash flows to use either the direct or the indirect method. In addition, a reconciliation schedule must be included showing the reconciliation of cash flows and net income (see EXHIBIT 16-13).

Role of Depreciation

{L. O. 9}

Depreciation does not entail a current outlay of cash and is added back to net income in the indirect method in order to obtain cash provided by operations. However, it should not mistakenly be thought of as a source of cash. E.

Statement of Cash Flows for Nike, Inc. See EXHIBIT 16-14 for Nike, Inc.’s statement of cash flows. It uses the indirect method to report the cash flows from operating activities. The effects of deferred taxes, the issuance of shares in conjunction with an executive stock option compensation plan, and changes in the exchange rates on foreign currencies on cash flows are provided on this statement along with the other items mentioned earlier in the chapter.

VII.

Appendix 16A: Accounting for Inventory—Four Major Inventory Methods 10}

{L. O.

A company’s inventory method affects its income statement, as well as its balance sheet. Each period, accountants must divide the costs of merchandise acquired between cost of goods sold, an expense, and cost of items remaining in ending inventory, an asset. Various inventory methods accomplish this division. If unit prices and costs did not fluctuate, all inventory methods would show identical results (see EXHIBITS 16-18, 16-19, and 16-20). A.

Specific Identification Specific Identification recognizes the actual cost paid for the specific physical item sold. Gross profit depends on which can the company sells. Physical observation and/or the labeling of items in stock with codes are used.

First-In, First-Out (FIFO) Method FIFO assumes that a company sells or uses up first the stock acquired earliest. Assuming inflation, FIFO tends to provide inventory valuations that closely

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approximate the actual market value of the inventory at the balance sheet date. Additionally, FIFO leads to a higher gross profit because COGS consists of older, lower costs. C.

Last-In, First-Out (LIFO) Method LIFO assumes that a company sells or uses up first the stock acquired most recently, and treats the most recent costs as COGS. LIFO leads to lower ending inventory valuation, and lower gross profit (which helps lower its tax liability). Income can dramatically increase when a company reduces its inventories. Under LIFO, inventory consists of LIFO layers (or LIFO increments), which are separately identifiable additions to inventory. All units in a particular LIFO layer have the same cost. As a company grows, the LIFO layers tend to pile on one another. Therefore, many LIFO companies show inventories that have very old layers.

Weighted-Average Cost The weighted-average cost method assigns the same unit cost to each unit available for sale. The unit cost is the cost of all units available for sale divided by the number of units available. This method produces a gross profit between FIFO and LIFO.

Inventory Methods and Physical Flow of Inventories Some companies choose the inventory method based upon the physical flow of units. However, it is not required to use the physical flow. Companies can use any one of the four inventory methods, although companies reporting under IFRS cannot use LIFO.

Lower-of-Cost-or-Market (LCM) Method Regardless of the inventory method used, accountants MUST decrease the inventory value if the inventory’s market price (current replacement cost or its equivalent under GAAP and net realizable value under IFRS) drops below its acquisition cost. Companies CANNOT increase inventory values when prices rise (i.e., the conservatism principle).

VIII.

Appendix 16B: Shareholder Reporting, Income Tax Reporting, and Deferred Taxes There are major differences in how to account for transactions between U. S. GAAP and U. S. tax laws (e.g., amortization and depreciation). When revenues and expenses on the income statement differ from the statement to the tax authorities, deferred taxes can arise. Most often, deferred taxes arise when tax expenses exceed book expenses (see EXHIBIT 16-21).

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CHAPTER 16:

Quiz/Demonstration Exercises

Learning Objective 1 1.

Cash, accounts receivable, inventories, and prepaid expenses _____. a. b. c. d.

are liabilities on the balance sheet are current assets on the balance sheet are classifications of stockholders’ equity would be considered long-term liabilities

Goodwill, franchises, patents, trademarks, and copyrights are examples of _____. a. b. c. d.

current assets current liabilities intangible assets long-term liabilities

Learning Objective 2 3.

Accounts payable, accrued liabilities, and income taxes payable are examples of _____. a. b. c. d.

current liabilities fixed assets stockholders’ equity long-term liabilities

Bonds that are convertible may be converted into _____. a. b. c. d.

debt fixed assets other bonds stock

Learning Objective 3 5.

Accounts in the stockholders’ equity section of the balance sheet may include _____. a. b. c. d.

cash, accounts receivable, inventories, prepaid expenses, and other current assets accounts payable, accrued liabilities, and income taxes payable machinery, equipment, buildings, land, and leasehold improvements common stock, preferred stock, paid-in-capital in excess of par; treasury stock; and retained earnings

Treasury stock is not used for which of the following reasons?

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a. b. c. d.

employee stock purchase plan to reduce the stock’s market value executive’s bonus to acquire another company

Learning Objective 4 7.

The item on the income statement found by deducting cost of sales and other operating expenses from sales is _____. a. b. c. d.

income from operations gross profit net income earnings per share

The item, required at the very bottom of the income statement, is _____. a. b. c. d.

gross profit income from operations earnings per share net income

Learning Objective 5 9.

What reduces retained earnings? a. b. c. d.

10.

net loss net income capital contributions trading one asset for another

What increases retained earnings? a. b. c. d.

net loss net income capital contributions dividend payouts

Learning Objective 6 11.

In a statement of cash flows, the payment to suppliers would be classified as a(n) _____ activity. a. b. c.

investing financing liquid

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d. 12.

The purchase of property, plant, and equipment would appear as a(n) _____ activity on a statement of cash flows. a. b. c. d.

13.

operating

financing investing operating liquid

Issuing equity securities would appear as a(n) _____ activity on a statement of cash flows. a. b. c. d.

financing investing operating liquid

Learning Objective 7 14.

Cash collections from customers are computed by _____. a. b. c. d.

15.

sales revenue + increase in accounts receivable sales revenue - increase in accounts receivable sales revenue – decrease in accounts receivable sales revenue + decrease in accounts payable

Charizard Inc.’s cost of goods sold was $72,000. During the year, inventory increased by $7,000 and accounts payable decreased by $11,000. How much was paid to suppliers during the year? a. b. c. d.

$ 90,000 $ 11,000 $107,000 $ 68,000

Learning Objective 8 16.

Under the indirect method, losses on sales of noncurrent assets are _____. a. b. c. d.

17.

deducted from net income to compute cash provided by operating activities added to net income to compute cash provided by operating activities shown under financing activities as a deduction shown under financing activities as an addition

Which of the following items would be added to net income to compute cash provided by (used in) operations under the indirect method?

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a. b. c. d.

increase in merchandise inventory decrease in accounts payable increase in accrued liabilities increase in cash dividends payable

Learning Objective 9 18.

Depreciation is added back to net income under the indirect method of computing the changes in cash flows because _____. a. b. c. d.

19.

Which of the following is treated like depreciation under the indirect method of computing the changes in cash flows? a. b. c. d.

it is an expense that was deducted in computing net income that did not require a current outlay of cash it represents a source of cash to the firm the useful life and residual value are estimated none of the above

depletion amortization neither A nor B both A and B

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CHAPTER 16:

Solutions to Quiz/Demonstration Exercises

1. [b] 2. [c] 3. [a] 4. [d] 5. [d] 6. [b] 7. [a] 8. [c] 9. [a] 10. [b] 11. [d] 12. [b] 13. [a] 14. [b] 15. [a] 16. [b] 17. [c] 18. [a] 19. {d]

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Chapter 17 Understanding and Analyzing Consolidated Financial Statements LEARNING OBJECTIVES: When your students have finished studying this chapter, they should be able to: 1. 2. 3. 4. 5. 6.

Contrast accounting for investments using the equity method and the market–value method. Explain the basic ideas and methods used to prepare consolidated financial statements. Describe how goodwill arises and how to account for it. Use financial statements analysis to evaluate an organization’s performance Explain and use a variety of popular financial ratios. Identify the major implications that efficient stock markets have for accounting.

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CHAPTER 17:

ASSIGNMENTS

CRITICAL THINKING EXERCISES 25. Market Method, Equity Method, and Total Assets 26. Depreciation in Consolidated Financial Statements 27. Just-in-Time (JIT) Inventory and Current Ratio 28. Market Efficiency GENERAL EXERCISES and PROBLEMS 29. Equity Method 30 Consolidated Financial Statements 31. Determination of Goodwill 32. Purchased Goodwill 33. Amortization and Depreciation 34. Allocating Total Purchase Price to Assets 35. Preparation of Consolidated Financial Statements 36. Intercorporate Investments and Ethics 37. Profitability Ratios 38. Financial Ratio UNDERSTANDING PUBLISHED FINANCIAL REPORTS 39. Meaning of Account Descriptions 40. Classification on Balance Sheet 41. Effects of Transactions Under the Equity Method 42. Noncontrolling Interests 43. General Electric and GECS 44. Goodwill 45. Accounting for Goodwill 46. Income Ratios and Asset Turnover 47. Financial Ratios 48. Nike 10-K Problem: Using Consolidated Financial Statements EXCEL APPLICATION EXERCISE 49. Calculating Financial Ratios COLLABORATIVE LEARNING EXERCISE 50. Financial Ratios INTERNET EXERCISE 51. General Electric’s Annual Report (http://www.ge.com)

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CHAPTER 17:

OUTLINE

Part One: Intercorporate Investments Including Consolidations Firms often invest in the equity securities of other companies. The investor may be simply investing excess cash, or he may be seeking some degree of control over the investee. There are three methods of accounting for intercorporate investments: the equity and market methods and consolidation. An investor that holds less than 20% of another company is assumed to be a passive investor—it cannot significantly influence the decisions of the investee—and it uses the market method. Investors with between 20% and 50% interest use the equity method. At this level of ownership, the investor has the ability to exert significant influence on the investee. Firms with an interest in excess of 50% must use the consolidation approach. I.

II.

Market Value and Equity Methods

{L. O. 1}

Market-Value Method—records the initial investment on the balance sheet at fair market value (FMV). Such investments are often called marketable securities in the financial statements. Trading Securities—investments that the company buys only with the intent to resell them shortly. Available-forSale Securities—investments that the company does not intend to sell in the near future. Changes in market value of trading securities are reported as gains (increase in FMV) or losses (decrease in FMV), whereas available-for-sale securities have their unrealized gains or losses shown in a separate valuation allowance account in the stockholders’ equity section of the balance sheet. (See EXHIBIT 17-1)

Equity Method—accounts for the investment at the acquisition cost adjusted for the investor’s share of dividends and earnings or losses of the investee after the date of investment. Investors increase the carrying amount of the investment by their share of investee’s earnings and reduce the carrying amount by dividends received from the investee and by their share in investee’s losses.

Consolidated Financial Statements

{L. O. 2}

Parent Company—the company owning more than 50% of the other business’s stock. Subsidiary—the company whose stock is owned by the other business. Although parent and subsidiary companies typically are separate legal entities, in many regards they function as one unit. Consolidated Financial Statements—financial statements that combine the financial statements of the parent company with those of various subsidiaries. A.

The Acquisition

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When a parent acquires a subsidiary, the evidence of interest is recorded as Investment in Subsidiary. When the consolidated statements are prepared, they cannot show both the evidence of interest and the underlying assets and liabilities of the subsidiary. To avoid such double-counting, the reciprocal evidence of ownership present is eliminated in two places: (1) the Investment in Subsidiary on the parent company’s books and (2) the Stockholders’ Equity on the subsidiary company’s books. The entries necessary to accomplish this are called eliminating entries. III.

Recognizing Income After Acquisition Long-term investments in equity securities (e.g., the investments in a subsidiary) are carried in the investor’s balance sheet by the equity method. The income generated by a subsidiary is recognized by the parent company as an increase in an account titled Investment in Subsidiary. A.

Noncontrolling Interests When a parent holds less than 100% of the stock of a subsidiary, a consolidated balance sheet includes an account on the equities side called Noncontrolling Interests in Subsidiaries, or simply Noncontrolling Interests—the account that shows the outside stockholders’ interest, as opposed to the parent’s interest, in a subsidiary corporation.

Perspective on Consolidated Statements See EXHIBIT 17-2 and EXHIBIT 17-3 for an illustration of how investments in subsidiaries are presented in companies’ annual reports. The headings of the statements indicate that they are consolidated statements. On balance sheets, the minority interest typically appears just above the stockholders’ equity section. On income statements, the minority interest in the net income is deducted as if it were an expense of the consolidated entity after all the other expenses are listed. Investments in Affiliates (or Investments in Associates)—listed as an asset on the balance sheet and reflect the purchase cost and interests in income or loss of investees. The FASB requires all subsidiaries to be consolidated. The major reason for forcing consolidation is to provide a more complete picture of the economic entity. See EXHIBIT 17-4 for a summary of the accounting for different levels of investment in subsidiaries.

Accounting for Goodwill

{L. O. 3}

In CHAPTER 16, goodwill is defined as the excess of cost over fair value of net identifiable assets of businesses acquired. The purchase price of a subsidiary often exceeds its book value. In fact, it frequently exceeds the sum of the fair market values of the identifiable individual assets less the liabilities. When the amount paid exceeds the book values, the assets will be valued at their fair market values for the consolidated statements. Any amounts paid above the fair market values of the individual assets are carried as goodwill in the consolidated financial statements.

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A purchaser may be willing to pay more than the current values of the individual assets received because the acquired company is able to generate abnormally high earnings. The causes of this excess earnings power may be traced to personalities, skills, locations, operating methods, and so forth. “Goodwill” is originally generated internally. For example, a happy combination of advertising, research, management talent, and timing may give a particular company a dominant market position for which another company is willing to pay dearly. This ability to command a premium price for the total business is goodwill. The selling company will never record goodwill. Therefore, the only goodwill recognized as an asset is that identified when one company is purchased by another. Part Two: Analysis of Financial Statements {L. O. 4} Careful analysis of financial statements can help decision makers evaluate an organization’s past performance and predict its future performance. Financial statements of Microsoft Corporation in EXHIBIT 17-5 and EXHIBIT 17-6 are used to focus on financial statement analysis. Investors analyze financial statements in order to decide whether to buy, sell, or hold common stock. Managers and the financial community (e.g., bank officers and stockholders) use them as clues to help evaluate the operating and financial outlook for an organization. Budgets or pro forma statements, carefully formulated expressions of predicted results including a schedule of the amounts and timings of cash repayments, are helpful to creditors. They want assurances of being paid in full and on time. IV.

Component Percentages Component Percentages—analysis and presentation of financial statements in percentage form to aid comparability, and is frequently used when comparing companies that differ in size (see EXHIBIT 17-7). The resulting statements are called Common-Size Statements. Income statement percentages are usually based on sales = 100%. Comparing the gross margin rate or the net income percentage with those of other firms in the industry or with prior years may be useful. Better yet, a comparison of these percentages (along with those for other items on the income statement) with what was budgeted for the current year may help in diagnosing what changes created better or worse results. Balance sheet percentages are usually based on total assets = 100%. One can see the shifts in the composition of assets between current and long term. In addition, one can see shifts in the equities side of the balance sheet between current liabilities, noncurrent liabilities, and stockholders’ equity.

Use of Ratios

{L. O. 5}

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See EXHIBIT 17-8 for how typical ratios are computed from financial statements. Many more ratios could be computed. For example, Standard & Poor’s Corporation sells a COMPUSTAT service. Via computer, COMPUSTAT can provide financial and statistical information for thousands of companies. The information includes 175 financial statement items on an annual basis and 100 items on a quarterly basis, plus limited footnote information. The SEC makes annual financial statements available online in its Edgar database (http://www.sec.gov/edgar.shtml). The ratios shown in EXHIBIT 17-8 are as follows: TYPICAL NAME OF RATIO

NUMERATOR

DENOMINATOR

Short-Term Ratios: Current ratio

Current assets

Current liabilities

Avg. collection period in days

Avg. A/R x 365

Sales on account

Debt-to-Equity Ratios: Current debt to equity Current liabilities

Stockholders’ equity

Total debt to equity

Total liabilities

Stockholders’ equity

Gross profit rate or percentage

Gross profit or gross margin

Sales

Return on sales

Net income

Sales

Return on stockholders’ equity

Net income

Average stockholders’ equity

Earnings per share

Net income less dividends on P/S

Avg. common shares outstanding

Profitability Ratios:

Price earnings

Market price per Earnings per share share of common stock

Dividend Ratios: Dividend yield

Dividends per common share

Dividend payout

Dividends per

Market price per common share Earnings per share

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common share

Comparisons

{L. O. 5}

Evaluation of a financial ratio requires a comparison. There are three main types of comparisons: (1) Time Series Comparisons—with a company’s own historical ratios (e.g., for 5 to 10 years); (2) Benchmark Comparisons—general rules of thumb (e.g., there is trouble if a company’s current debt is at least 80% of its tangible net worth); and (3) Cross-Sectional Comparisons—ratios of other companies or with industry averages from Dun and Bradstreet. Comparisons for the Microsoft Company data across years, against benchmarks, and to the industry are presented. B.

Discussion of Specific Ratios The current ratio is a widely used statistic. Other things being equal, the higher the current ratio, the more assurance the creditor has about being paid in full and on time. The average collection period in days is another important short-term ratio. An increase in this ratio might indicate increasing acceptance of poor credit risks or less energetic collection efforts. Both creditors and shareholders watch the debt-to-equity ratios to judge the degree of risk of insolvency and stability of profits. Companies with heavy debt in relation to ownership capital are in greater danger of suffering net losses or even bankruptcy when business conditions sour, revenues and many expenses decline, but interest expenses and maturity dates do not change. Investors find profitability ratios especially helpful. The gross profit rate and return on sales are both measures of operating success. Shareholders view the return on their invested capital as more important. The return on equity provides a measure of overall accomplishment. The final four ratios in EXHIBIT 17-8 are based on earnings and dividends. The first, earnings per share of common stock (EPS), is the most popular of all ratios. This is the only ratio that is required as part of the body of the financial statements of publicly held companies in the United States. The EPS must be presented on the face of the income statement. The calculation of EPS can be more complicated than is indicated in EXHIBIT 17-8 depending on the capital structure of the firm and the presence of common-stock equivalents. The price earnings, dividend yield, and dividend payout ratios are especially useful to investors in the common stock of the company.

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Operating Performance Ratios Businesspeople often look at invested capital’s rate of return as an important measure of overall accomplishment: rate of return on investment = income / invested capital The measurement of operating performance (i.e., how profitably assets are employed) should not be influenced by the management’s financial decisions (i.e., how assets are obtained). Operating performance is best measured by pretax operating rate of return on average total assets: pretax operating rate = operating income of return on average total assets average total assets The right-hand side of the equation above consists of two important ratios: operating inc. = operating income avg. total assets sales

sales avg. tot. assets

The right-hand side terms in the equation above are often called the operating income percentage on sales and total asset turnover (i.e., the two basic factors in profit making). An improvement in either will, by itself, increase the rate of return on total assets. If ratios are used to evaluate operating performance, they should exclude extraordinary items. Such items are not expected to recur, and therefore they should not be included in measures of normal performance. VI.

Efficient Markets and Investor Decisions

{L. O. 6}

Much research in accounting and finance has concentrated on whether the stock markets are “efficient”. Efficient Capital Market—market prices “fully reflect” all information available to the public. Therefore, searching for “underpriced” securities in such a market would be fruitless, unless an investor has information that is not generally available. If the real-world markets are indeed efficient, a relatively inactive portfolio approach would be an appropriate investment strategy for most investors. The hallmarks of the approach are risk control, high diversification, and low turnover of securities. The role of accounting information would mainly be in identifying the different degrees of risk among various stocks so that investors can maintain desired levels of risk and diversification. Many ratios are used simultaneously rather than one at a time for such predictions. Research showed that accounting reports are only one source of information. In the aggregate, companies that choose the least-conservative accounting policies do not fool the market. In sum, the market as a whole generally sees through any attempts by companies to gain favor through the choice of accounting policies that tend to boost immediate income.

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Some alternative sources of financial information are the following: company press releases, trade association publications, brokerage house analyses, and government economic reports. If accounting reports are to be useful, they must have some advantage over alternative sources in disclosing new information. Financial statement information may be more directly related to the item of interest, more reliable, lower in cost, and/or more timely than alternative sources.

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CHAPTER 17:

Quiz/Demonstration Exercises

Learning Objective 1 1.

The Colts Corporation has acquired a 10% interest in the shares of Giants Corporation. Colts reported income for 20X1 of $25 million and issued dividends of $10 million during the year. Becaise Colts use the available for sale method of accounting for their investment in Giants, for 20X1 the value of their income will _____. a. increase by $25 million, the amount of Giants earnings b. increase by $1 million, the dividends paid by Giants to Colts c. decrease by $10 million, the amount Giants paid out in dividends d. increase by $1.5 million, Colts’ share in the earnings of Giants reduced by their share of the dividends paid out

The Raiders Corporation owns 40% of the outstanding shares of the Warriors Corporation. During 20X1, Warriors reported income of $25 million and paid dividends of $10 million to shareholders. Raiders use the equity method to account for their investment in Warriors. Accordingly, the value of their Warriors investment during 20X1 will increase by _____. a. $14 million, the sum of the dividends received by Raiders and their share in the earnings of Warriors b. $6 million, Raiders’ share in earnings of Warriors reduced by the dividends received c. $4 million, the dividends paid by Warriors to Raiders d. $10 million, Raiders’ share in the earnings of Warriors

Learning Objective 2 3.

When a company purchases more than 50% of the stock of another business, the two companies’ financial statements must be presented _____. a. separately in the same annual report with the nature of the ownership interest fully disclosed b. in two separate sets of financial statements that cannot appear in the same annual report c. in the form of consolidated financial statements after eliminating entries are recorded to avoid the double counting of assets and equity d. together regardless of whether the ownership interest continues

Taylor Company owns 90% of the outstanding shares of Turner Company. If Turner Company reports earnings for the year of $20 million, the consolidated financial statements will show a _____ million increase in the _____. a. $20; consolidated shareholders’ equity b. $2; noncontrolling interest in Turner c. $20; consolidated net assets d. $20; noncontrolling interest in Turner

Learning Objective 3

280

Goodwill is recognized for accounting purposes _____. a. when a business is purchased for a price that exceeds the fair market value of its assets less liabilities b. every year as long as the IRS does not object c. when the value of a business exceeds its historical cost book value d. when a business is purchased for a price that exceeds the book value of its assets less liabilities

Goodwill may be caused by _____. a. excellent general management skills b. potential efficiency by rearrangement c. dominant market position d. all of the above e. none of the above

Learning Objective 5 Use the comparative balance sheets and income statements below for the Louise Company in answering questions 7 through 10: Louise Company Comparative Balance Sheets December 31, 20X1 and 20X2 20X1

20X2

Assets Cash Accounts Receivable (net) Inventory Property, Plant, and Equipment (net) Total Assets

$ 61,100 $ 27,200 72,500 142,700 122,600 107,800 577,700 507,500 $833,900 $785,200

Liabilities and Stockholders’ Equity Accounts Payable $104,700 $ 72,300 Notes Payable within one year 50,000 50,000 Bonds Payable 200,000 210,000 Common Stock—$10 par value 300,000 300,000 Retained Earnings 179,200 152,900 Total Liabilities and Stockholders Equity $833,900 $785,200 Louise Company Comparative Income Statements For the Years Ended 12/31/X1 and 12/31/X2

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Sales Cost of Goods Sold Gross Profit Operating Expenses Selling Expenses Administrative Expenses Interest Expense Income Tax Expense Total Operating Expenses Net Income 7.

20X2

20X1

$ 800,400 454,100 $ 346,300

$ 900,000 396,200 $ 503,800

$ 130,100 $ 104,600 40,300 115,500 25,000 20,000 14,000 35,000 $ 209,400 $ 275,100 $ 136,900 $ 71,300

The Louise Company’s current ratio for 20X2 was _____. a. 1.66 b. 5.39 c. 1.23

1.00

Louise Company’s total debt to equity ratio has _____. a. decreased from 0.74 to 0.73 from 20X1 to 20X2 b. increase from 0.73 to 0.27 from 20X1 to 20X2 c. decrease from 0.32 to 0.74 from 20X1 to 20X2 d. increased from 0.27 to 0.32 from 20X1 to 20X2

Louise Company’s gross profit rate for 20X1 was _____. a. 20.58% b. 55.98% c. 46.65%

d. 61.92%

In 20X2, Louise Company’s return on sales was _____. a. 2.39% b. 4.61% c. 23,27%

d. 17.10%

10.

Learning Objective 6 11.

An efficient capital market _____. a. creates an opportunity for investors to spot “underpriced” securities using publicly available information b. is one in which market prices “fully reflect” all information to the public c. has no bearing on accounting statements and procedures d. explains why some individuals are able to “beat the market” through the use of publicly available information

12.

If markets are truly efficient, then the proper portfolio includes which of the following characteristics? a. high diversification b. risk control c. low turnover of securities d. all of the above e. none of the above

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CHAPTER 17: 1. [b] 2. [b] 3. [c] 4. [b] 5. [a]

6. [d] 7. [a]

8. [b]

9. [b] 10. [d]

Solutions to Quiz/Demonstration Exercises

The amount of dividends received will increase the dividend income account. With the equity method, the investor recognizes his share in earnings, but reduces the investment by the amount of dividends received. Consolidated financial statements must be issued when ownership exceeds 50%. The noncontrolling interest will be increased by its share in the earnings of the subsidiary. Goodwill is recorded for the amount by which the purchase cost exceeds the fair market value of the net assets obtained. First, the assets are written up to their fair market values. Then any excess is recorded as goodwill, which is amortized over a period not exceeding 40 years. The current ratio is found by dividing the current assets by the current liabilities. Here current assets are $256,200 [$61,100 + $72,500 + $122,600] and current liabilities are $154,700 [$104,700 + $50,000]. Therefore, the current ratio is 1.66 [$256,200/$154,700]. In 20X1 the total debt-to-equity ratio was 0.73, which was computed as [($72,300 + $50,000 + $210,000) / ($300,000 + $152,900)]. In 20X2, the total debt-to-equity ratio has increased to 0.74 [($104,700 + $50,000 + $200,000) / ($300,000 + $179,200)]. The gross profit rate is found by dividing the gross profit by sales. For 20X1, that would be $503,800 / $900,000 = 55.98%. The return on sales is found by dividing the net income by sales. For 20X2, that was $136,900 / $800,400 = 17.10%.

11. [b] 12. [d]

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