Management Accounting 4th Edition Leslie G Eldenburg Solution Manual by Ace Test Banks

Solutions manual Management accounting 4th edition by Eldenburg et al.

Contemporary Management Accounting, Chapter 2

Chapter 1: The role of accounting information in management decision making Questions 1.1

Explain the value chain and list ways that value chain analysis benefits organisations. (LO4)

A value chain can be described as the key activities engaged in by the organisation or industry. We can view the value chain on two levels: at the industry level, and at the (more common) organisational level. Refer to figure 1.5 for a sample industry value chain and to figure 1.6 for a sample internal value chain. Value chain analysis may benefit an organisation in a number of ways including: •

Focuses on activities. The central feature of the value chain is its focus on activities and processes rather than functions or departments. This makes identification of improvements across segments more likely.

•

Encourages a broader organisational view. This is particularly so for management accounting staff and business unit managers. Management accounting staff are more likely to take a broader perspective if using a value chain framework when considering the consequences of decisions.

•

Breaks down more traditional representations of organisational activity. A value chain framework encourages higher levels of cross-fertilisation and communication between business segments, so that decisions are not confined by the traditional boundaries of functional areas.

•

Externalises thinking by incorporating suppliers and customers. An organisation’s value chain encompasses not only customers and suppliers, but in some cases extends to the customers’ customers and the suppliers’ suppliers. Analysis of the value chain leads to improved relationships between the organisation and others in the value chain, creating an extended organisation that can respond flexibly to dynamic and competitive environments. In other words, value chains explicitly recognise that no organisation operates in isolation from suppliers and customers.

•

Reinforces other initiatives such as activity-based costing (ABC). With the focus on activities, a value chain framework provides a sound foundation for exploring activity-based costing (which is covered in chapter 4). ABC uses activities as the foundation of product and service costing. Moreover, a value chain framework complements other recent initiatives like strategic cost management, which refers to the simultaneous focus on reducing costs and strengthening an organisation’s strategic position. This commonly involves taking a longer-term view of cost management and decision-making.

•

Provides a foundation for outsourcing and strategic alliance decisions. A value chain framework serves as the foundation for considering decisions such as outsourcing of particular parts of the value chain and for considering the formation

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of strategic alliances with say a distributor. In this way, the value chain serves as a strategic tool. •

Supports initiatives like supply chain analysis. As organisations work to increase profitability, improving their relationships with suppliers becomes a priority. Improvements can be identified through supply chain analysis. The supply chain is the flow of resources from the initial suppliers through the delivery of goods and services to customers and clients. The initial suppliers may be inside or outside the organisation. Negotiating lower costs with suppliers is a straightforward way to reduce costs. Suppliers may be willing to reduce prices, particularly for organisations willing to sign long-term purchase commitments. Occasionally, organisations work with suppliers to help them reduce their costs so that the savings can be passed along.

•

Categorises activities as value-added and non-value-added. Value chain analysis involves studying each step in the business process to determine whether some activities can be eliminated because they do not add value. This analysis extends to suppliers and customers, and includes shared planning, inventory, human resources, information technology systems, and even corporate cultures. Eventually, the analysis leads to business decisions for improving value.

1.2

Why do managers need to measure, monitor, and motivate performance? (LO1, 2 and 3)

Once operating plans are in place, organisations need to know whether the plans are being met or need to be changed to take advantage of new opportunities. To do this, actual performance needs to be measured and compared to the plans (monitored). To help managers move toward the organisational goals, incentives such as performancebased bonuses are offered (motivating).

1.3

List three types of internal reports and explain how each is used. List three types of external reports and explain how each is used. (LO2)

See figure 1.2 for a list of possible internal and external reports. Students may have thought of other reports as well. Following are examples of internal reports. Capital budgets support organisational strategies, the master budget supports operating plans, and variance reports (actual versus planned performance) help organisations monitor and motivate performance if they are tied to compensation contracts. Financial statements are external reports that provide creditors and shareholders information about current and past operations. Tax returns are reports prepared for the government that also determine the amount of taxes due. Suppliers need reports about inventory levels to keep an organisation’s inventory levels up to date.

Contemporary Management Accounting, Chapter 2

1.4

What types of information in addition to cost accounting are needed for management decisions? (LO1)

The type of information needed depends on the type of decision. For product-related decisions, managers may need information about the market, including the size of the market, their potential share, competitors’ prices and quality of products. For employeerelated decisions, they may need to know the amount of experience employees have had or estimate costs to lay them off using information about length of service from human resources. If managers are developing a new good or service, they need information from suppliers about the cost of resources. Students may have thought of other types of decisions and information needed for them.

1.5

Explain relevant information in a decision-making context. (LO 1 and 3)

Relevant information is information that varies with the available alternatives for a decision; these are relevant because they relate directly to each separate decision that could be made.

1.6

What is a cost object? (LO2)

A cost object is a thing or activity for which we measure costs. Cost objects might include products, services, customer, processes, departments, of the entire organisation. 1.7

In your own words, explain the path to higher-quality decisions. (LO3)

Higher quality decisions are made by using higher quality information, that is, information that has few uncertainties and is relevant, complete, as certain as possible, and timely. This information needs to be prepared in reports that are easy to understand, readily available, and timely. Then a high quality decision-making process is used. This is a process that is thorough, as unbiased as possible, focused, creative, and visionary as it relates to strategies. 1.8

Outline the meaning of structural cost drivers. (LO4)

Structural cost drivers are those that relate to the underlying economic structure of the organisation and include such concepts as scale, scope, experience, technology and complexity.

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1.9

Identify two key influences on the nature of a management accounting system. (LO2)

The nature of the management accounting system might be influenced by a number of influences including: • organisational structure • availability of information technology • organisational strategies • how the management accounting role is viewed within the organisation, and • types of decisions managers are confronted with

Contemporary Management Accounting, Chapter 2

Exercises 1.10 Value-added and non-value-added activities Some activities add value to an organisation, while others do not. Required Determine whether each of the following activities is likely to be valueadded or non-value-added and explain your choice. (a) Inspection activities (b) Moving materials to work stations (c) Manufacturing extra inventory to keep employees busy (d) Packing to fill a customer order (e) Product design initiatives (LO4) (a)

Inspection activities are non-value-added. Some organisations have very low defect rates, making it unnecessary to inspect; that is, the product design and manufacturing process insures high quality production. The concept of high quality is to ‘do it right the first time’. Some firms may inspect incoming materials to guarantee high quality during their manufacturing processes, but these costs could be eliminated through contractual arrangements with suppliers that include high penalties for low quality material deliveries.

(b)

Moving materials to work stations could also be either value-added or non-valueadded, depending on the circumstance. In organisations that use JIT systems, the amount of materials handling is reduced to the minimum level necessary, which reduces costs.

(c)

Manufacturing extra inventory to keep employees busy is non-value added if there are no sales for the inventory.

(d)

Packing to fill a customer order is more likely to be value adding as it is specifically related to a customer order

(e)

Product design initiatives are likely to be value adding as they relate to better product outcomes for customers.

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1.11 Internal and external reports Classify the following reports as internal or external. (a) Operating budget (b) Credit reports (c) Financial statements (d) Capital budget (e) Tax returns (f) Analysis of product mix (LO1 and 2) (a) (b) (c) (d) (e) (f)

internal external external internal external internal

Contemporary Management Accounting, Chapter 2

1.12 Management accounting function Differentiate between the management accounting function and the management accountant. (LO2) Most organisations will have a management accounting function in one form or another. In some organisations, this function might be performed by a variety of differently qualified and trained staff such as accountants (financial or management), costing clerks, engineers, and other staff with management training or experience. In some cases, the label management accountant might not even be used, but the management accounting work is still performed as a function. More often, though, the label management accountant, or some similar label such as resource analyst or internal management consultant, would be used

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1.13 Types of manager decisions Suppose that the following are activities conducted by Microsoft Corporation. A. Comparing the timeliness of development steps of a new release of Windows with the timeline that was laid out to guide development. B. Developing a timeline for the release of new Windows and Microsoft Office products over the next year. C. Debugging the next version of Windows. D. Providing technical support to customers who are having problems with Microsoft Office. E. Estimating cash expenditures for the next year. F. Comparing budgeted costs to actual costs and discussing major differences with department managers. G. Deciding whether to construct a new building on the Microsoft site. Required Identify whether each activity is most likely part of: (a) organisational strategies (b) operating plans (c) actual operations (d) measuring, monitoring, and motivating. For each item, explain why. (LO1) A.

(d)

Measuring, monitoring & motivating (specifically monitoring) because it is comparing actual versus expectations

(b)

Operating plans because it involves looking at short-term plans

(c)

Actual operations because this is part of normal operations (developing new products)

(c)

Actual operations because this is part of normal operations (customer support for existing products)

(b)

Operating plans because it involves developing short-term plans

(d)

Measuring, monitoring & motivating because it involves comparing actual to expectations and discussing variances from budget with managers (and measuring their performance as managers). Presumably the managers know in advance that their performance is measured based (or at least partially based) on these variances from budget, which should motivate their performance.

(a)

Organisational strategies because it involves a long-term decision to expand facilities

Contemporary Management Accounting, Chapter 2

Problems 1. 14 Industry and organisational value chain With reference to Marino Designs in Self-study problem 2, at the start of this chapter, differentiate between an industry value chain and an organisational value chain. (LO4) An industry value chain relates to the broader industry in which an entity chooses to compete. A company may participate in parts of the industry or the entire industry. For example, Marino Designs is described as a “fully integrated company” which means it operates across the entire industry value chain. They farm the Marino sheep for the raw material, wool, which is then converted into yarn then machine-knitted fabric for garment manufacture. Marino Designs market and distribute their products. They more than likely retail garments through the internet as well as own their own retail shops. The internal value-chain focuses on the key internal value-creating activities, which an entity engages in. Marino Designs focus on research and development, design, manufacture, distribution and sales, and marketing as key functions.

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1.15

Structural cost drivers (a) With reference to Marino Designs in Self-study problem 2, demonstrate the meaning of the structural cost drivers: scope, technology and experience. (b) Classify Marino Designs’ likely strategy as low cost or product differentiation. Explain. (LO4)

(a) Scale refers to the levels of investment in such activities as research and development, manufacturing, marketing and customer support. Marino Designs would appear to devote significant resources to research and development with new product design for garments made of Marino wool. They would spend considerable time and resources to maximise the quality of th raw material, Marino wool, as well as have farms and production capabilities that facilitate flexibility and shorter lead times. The self-study problem also indicates that Marino Designs have their own global fashion outlets, also contributing to the scale of the retail segment. Scope refers to the degree of vertical integration (horizontal integration is more closely related to scale). Marino Designs holds a strong value-chain position by being vertically integrating. Nevertheless, they have the opportunity to outsource parts of the value chain. For example, they could outsource the retail segment. They may not outsource the Marino sheep farming, knitting-mills or clothing manufacture as these activities might be considered core to the Marino Designs strategy. Experience refers to the times in the past that Marino Designs has already done what it is doing again. We are not given explicit details, but it could be argued that they have a high quality product that is in demand around the world and given the scale of the operations, have probably been operating for quite some time and would have built up a strong area of expertise around sheep farming for high quality Marino garment manufacture. Technology refers to the process technologies in each step of the value chain. It is not easy to evaluate the internal mechanisms of an organisation without access to the company. At one end of the value chain, one would assume that Design would have strong reliance on the latest fashion industry research and wool garment manufacturing design technologies – which can impact quite rapidly on production (for example, a change in demand for certain jacket design, or weave can be made instantly with computer design technology which instigates changes directly from computer to manufacturing (knitting mills). Marino Design would also place a strong emphasis on technological excellence in their outbound logistics, marketing, retail and customer service value chain activities (as reflected in use of the internet). Complexity relates to the extent of the product/service line. Marino Design remains fairly focused on their Marino jacket, but it would be expected that they have seasonable fashion lines, given their global presence with stores around the world. In this sense the number of product offerings would add to the complexity. (b) Marino Designs would more than likely follow a product differentiation strategy for the following reasons: • they are aiming to create and market a ‘unique’ product (evident in their focus on their Marino wool jacket – this wool is very expensive and a high quality);

Contemporary Management Accounting, Chapter 2

• • • • •

Their aim would be to provide a product which offers superior features and innovative ideas to their garment designs that would not be provided by other competitors (value of the Marino wool fabric over others); customers seek out Marino Design products (as evidenced in the illustration). customer loyalty to the brand ‘Marino Design’ means the price elasticity of demand is very much reduced and a premium pricing strategy can be followed; and any associated costs with differentiation can be passed on to customers they would maintain this strategy by continually focusing on strong marketing skills and ways to remain creative.

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1.16

Relevant information Suppose you are responsible for ordering a replacement for your office photocopy machine. Part of your job is to decide whether to buy it or lease it. Required (a) Describe something that could be considered relevant information in this decision and explain why it is relevant. (b) Describe something that could be considered irrelevant information in this decision and explain why it is irrelevant. (c) Explain why it was important to distinguish between relevant and irrelevant information in this problem. (LO1, 2 and 3)

(a)

The annual lease payment is relevant since it will not be incurred if the photocopy machine is purchased. Similarly, the purchase price is relevant because it will not be incurred if the machine is leased. There are many other possible answers to this question.

(b)

Any cost that would be incurred under both options would be irrelevant. Examples include the cost of supplies such as copier paper and toner. There are many other possible answers to this question.

(c)

To choose between options, it is necessary to investigate how the two options would differ. By definition, relevant costs differ across options and help the decision maker choose between options. If irrelevant information is included, costs would be over-estimated for one or both options, which could lead to a poor quality decision.

Contemporary Management Accounting, Chapter 2

1.17

Uncertainties, degree of uncertainty Community Children’s Hospital can invest in one of two different projects. The first project is to purchase and operate a hotel that is located two blocks from the hospital. The CEO of the hospital has no experience operating a hotel, but the hospital does provide rooms for in-patients, and so she is familiar with cleaning requirements and managing housekeeping staff. However, the hospital does little advertising and does not have a large public relations staff. In addition, the hospital and hotel are located in a part of town that is deteriorating. The other investment opportunity is to replace the heart monitors in the neonatal intensive care unit (critical care for newborns and infants). The new monitors would provide a range of functions, including monitoring the body temperature and blood pressure of infants, as well as monitoring heart functions. Each monitor can be used for up to four infants with information about each infant forwarded to one computer that is monitored by a special technician. The current monitors are bedside monitors that need to be read every 10 minutes by nursing staff. Required (a) Prepare a list of uncertainties that the CEO faces if she buys the hotel. (b) Prepare a list of uncertainties the CEO faces if she replaces the heart monitors. (c) Which scenario appears to have a greater degree of uncertainty? Why? (LO3)

(a) There are more possibilities than are listed, but here are some of the uncertainties the CEO faces in the ‘buy hotel’ alternative: • Vacancy rates (i.e. demand for rooms) • Optimal pricing structure for the rooms • Hotel operating costs • Tax consequences of running a for-profit business as a sideline to a not-for-profit business (uncertainty alleviated if she purchases tax advice) • Ways that hotel maintenance may differ from hospital maintenance • Security in this neighbourhood in the future • Long-term future of a hotel in a declining neighbourhood (b) There are more possibilities than are listed, but here are some of the uncertainties for the ‘heart monitor’ decision: • Future demand for neo-natal equipment at the hospital • Expected wages for the special technician (although she can easily find this out) • Maintenance or operating costs for the monitors that are not disclosed by the medical supply vendor • Expected useful life of the monitors • Hospital’s ability to charge patients for the new equipment • Effect of the new equipment on how nurses spend their time (c) The ‘buy hotel’ alternative probably has a greater degree of uncertainty because it is outside the core competencies of the hospital and CEO.

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1.18

Cost reduction; value chain analysis Budget Cupboards produces kitchen and bathroom cupboards that incorporate unusual functions, such as specialty drawers for knives and kitchen tools, and kitchen appliance holders that pop up from under the counter top. Competition in this industry has recently increased. Budget’s management wants to cut costs for its basic cupboard models and then cut prices using the structure of the table as shown. Required (a) The following table lists potential areas for cost reduction. Two potential cost reductions are provided for the first area listed (design phase). For each of the remaining areas, identify two potential ways that Budget Cupboard’s management could reduce costs.

(b)

Budget does not currently use value chain analysis. Describe several advantages of using value chain analysis. (LO2 and 4) (a)

Here are possible answers to this question; students may think of others.

Potential Area for Cost Reduction Manufacturing process

Administration

Changes in quality or functionality

Potential Cost Reduction (1) (2) Reduce inventory by using a Reduce inspection by using JIT system cellular manufacturing (also increases flexibility so that specialty items can be manufactured to order more easily) Outsource functions such as Explore software that would payroll if it is cheaper to do increase efficiency and so reduce number of employees needed Identify specialty functions Identify lower cost materials with low volume sales and that would not reduce current consider discontinuing them quality

Contemporary Management Accounting, Chapter 2

(b)

To price more competitively, overall costs need to be reduced without affecting product quality or functionality. Value chain analysis and JIT are methods that are used to reduce costs. JIT manufacturing reduces inventory storage and insurance costs, and frees up extra space in the manufacturing plant. If there are alternative uses for the space, the overall contribution margin should increase. Value chain analysis enables managers to categorise activities into value-added and non-value added. Then the non-value added activities are eliminated or minimised to save costs. The supply chain can be analysed to determine whether vendors can reduce their costs or provide higher quality goods and services at the same price.

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1.19

Quality of decisions Maria and Tracey became good friends while working at the same entity. Two years ago, they both decided to increase their savings so that they could eventually purchase homes. Each began by putting a portion of each month's salary into a savings account. At the end of the first year, they had each accumulated $4000. Because their savings accounts paid a very small interest rate, they decided to invest the savings to earn a higher rate of return. Maria and Tracey both hoped to save enough money to buy homes within five years. Maria decided to take an investment course offered through the entity. The course taught her about different types of investments and strategies for investing. She then purchased and read an investment book to learn more. Maria learned that some investments are riskier than others, and that investors must balance risk against desired return. Higher risk leads to higher returns on average; but, higher risk could also lead to low returns or even loss. She also learned that investment advisers recommend diversifying risky investments. One way to diversify is to invest in mutual funds, which invest in many different organisations. Maria decided that she was willing to assume some risk, but was not comfortable with a high level. She decided to invest her $4,000 in a share market mutual fund. She read consumer reports to learn about different mutual funds, and selected a fund that invests conservatively in fairly stable companies. However, the share market did not do well in the first year. The value of her mutual fund at the end of a year was $4050. Tracey talked with her boyfriend and other friends about how they invest. Her boyfriend’s cousin recommended investing in a start-up company that sells video games. He told her that the games were very popular with teenagers and that the company would probably be acquired, resulting in big gains for investors. This opportunity sounded good to Tracey, so she decided to invest her entire $4000 in the company’s shares. After 10 months, she was excited to learn that the company was being acquired. She received shares in the acquiring company in exchange for her original shares. At the end of the year, the market value of her shares was $8200. Required Evaluate the quality of the investment decisions made by Maria and Tracey. Hint: Refer to figure 1.3 (on page 18). (a) List the information used by Maria in making her investment decision. (b) List the information used by Tracey in making her investment decision. (c) Did Maria appear to use high-quality information? Explain. (d) Did Tracey appear to use high-quality information? Explain. (e) Describe Maria’s decision-making process. What did she do to explore her options? Did she appear to be biased? What were her priorities? How did she reach a conclusion?

Contemporary Management Accounting, Chapter 2

Describe Tracey’s decision-making process. What did she do to explore her options? Did she appear to be biased? What were her priorities? How did she reach a conclusion? (g) Did Maria appear to use a high-quality decision-making process? Explain. (h) Did Tracey appear to use a high-quality decision-making process? Explain. (i) Given your analyses of the information and decision-making processes used by Maria and Tracey, which investor made a higherquality decision? Explain. (LO1 and 3) (f)

(a) Maria appeared to use the following information in making her investment decision: • Information learned during investment course, including different types of investments and strategies for investing • Information learned from an investment book • Risk/return trade-off for different types of investments • Need to balance risk against desired return • Higher risk leads to higher returns on average, but can also lead to low returns or even loss • Investment advisors recommend diversifying risky investments • One way to diversify is to invest in mutual funds • Maria’s willingness to assume some risk, but not a high level • Information about different mutual funds obtained from reading Consumer Reports (b) Tracey appeared to use the following information in making her investment decision: • Investment strategies used by her boyfriend and other friends • Her boyfriend’s cousin’s recommendation about a start-up video game company • The opinion that the video games were very popular with teenagers and that the company would probably be acquired, resulting in big gains for investors • Her desire for a big gain (c) Maria appeared to use reasonably high-quality information (see figure 1.3). The information was obtained from various relatively objective and knowledgeable sources. She made use of a fairly large amount of relevant information to select an investment strategy, and then she used an understandable and objective source of information to help her select a mutual fund. (d) Tracey appeared to use fairly low-quality information (see figure 1.3). Most of the information consisted of personal opinions from people who most likely were not knowledgeable about investing and might have been biased. (e) Maria appeared to use a logical decision-making process. She began by learning about investment strategies in a course, and then expanded her knowledge by reading a book. She then made an intermediate decision to invest in a mutual fund. That decision seemed to be based primarily on her willingness to assume some risk, the recommendation that she diversify her investment risk, and the fact that she did not have a large amount of money to spread across multiple investment

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opportunities. She then conducted additional research to identify a mutual fund that matched her personal willingness to assume risk. (f) Tracey appeared to base her decision on what ‘sounded good’ based on personal opinions from her boyfriend’s cousin. She appeared to be biased toward an opportunity that might earn a large gain. (g) Maria’s decision-making process was fairly high quality (see figure 1.3). She did not appear to be biased in her approach, and she used multiple sources of information to help her explore options. She identified some key factors that were important for her decision, identified her own values/priorities, and chose an investment option that was consistent with the information she had collected and with her values. (h) Tracey’s decision-making process was fairly low quality (see figure 1.3). She explored alternatives only by talking with her boyfriend and friends. As soon as she heard about an opportunity that might result in a big gain, she stopped exploring options and made her decision. In short, she ‘jumped to a conclusion’ without careful thought. (i) Maria’s decision-making approach was much higher in quality than Tracey’s, as demonstrated in the answers to Parts A-H above. Notice, however, that in this case Tracey earned a higher return than Maria. When people hear that someone like Tracey earned a big gain, they often use it as evidence to argue that a higher quality decision-making process is not needed. ‘If we can earn a big gain by finding a startup company with a great product,’ they ask, ‘then why should we invest in something like a mutual fund, which has a lower average return?’ In this investment decision, there is also a risk and return trade-off. Maria intentionally chose a lower level of risk, so she would not expect to earn an exceptionally high return. Tracey, on the other hand, was apparently willing to assume a higher level of risk (even though she might not have realised it), which on average might lead to a higher rate of return. However, Tracey did not carefully investigate her investment. If the company had not been acquired, she might have lost all or most of her investment. She now owns shares in only one company; her risk is not diversified. If the company does poorly in the future, then she may not be able to realise a large gain. Over time, people who use better decision-making processes are more likely to obtain good results.

Contemporary Management Accounting, Chapter 2

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Relevant information; uncertainties; information for decision-making Janet Baker is deciding where to live during her second year of university. During her first year, she lived in the university residence college. Recently her friend Rachel asked her to share an off-campus flat for the upcoming school year. Janet likes the idea of living in a flat, but she is concerned about how much it will cost. To help her decide what to do, Janet collected information about costs. She would pay $400 per month in rent. The minimum lease term on the apartment is six months. Janet estimates that her share of the utility bills will be $75 per month. She also estimates that groceries will cost $200 per month. Janet spent $350 on a new couch over the summer. If she lives in the university residence college, she will put the couch in storage at a cost of $35 per month. Janet expects to spend $7500 on university fees and $450 on books each semester. Room and board on campus would cost Janet $2,900 per semester (four months). This amount includes a food plan of 20 meals per week. This cost is non-refundable if the meals are not eaten. Required (a) Use only the cost information collected by Janet for the following tasks. (i) List all of the costs for each option. Note: Some costs may be listed under both options. (ii) Review your lists and cross out the costs that are irrelevant to Janet’s decision. Explain why these costs are irrelevant. (iii) Calculate and compare the total relevant costs of each option. (iv) Given the cost comparison, which living arrangement is the better choice for Janet? Explain. (b) Identify uncertainties in the cost information collected by Janet. (i) Determine whether each cost is likely to be (1) known for sure, (2) estimated with little uncertainty, or (3) estimated with moderate or high uncertainty. (ii) For each cost that is known for sure, explain where Janet would obtain the information. (iii) For each cost that must be estimated, explain why the cost cannot be known. (c) List additional information that might be relevant to Janet’s decision (list as many items as you can). (i) Costs not identified by Janet (ii) Factors other than costs (d) Explain why conducting a cost comparison is useful to Janet, even if factors other than costs are important to her decision. (e) Consider your own preferences for this problem. Do you expect Janet’s preferences to be the same as yours? How can you control for your biases as you give Janet advice? (f) Think about what Janet’s priorities might be for choosing a housing arrangement. How might different priorities lead to different choices? (g) Describe how information that Janet gains over this next year might affect her future housing arrangements.

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Suppose Janet asks for your advice. (h) Use the information you learned from the preceding analyses to write a memo to Janet with your recommendation and a discussion of its risks. Refer in your memo to the information that would be useful to Janet. (LO1, 2 and 3) (a) (i) and (ii) The costs of each option are listed below: ‘Residence college’ Alternative Couch $350 Couch storage University fees

$35/mo (4 mos) $7500 (4 mos)

Books

$450 (4 mos)

Room & board

$2900 (4 mos)

‘Flat’ Alternative Rent $400/mo (6 mos) Utilities $75/mo (6 mos) Groceries $200/mo (6 mos) Couch $350 University fees

$7500 (4 mos)

Books

$450 (4 mos)

Not relevant because the cost occurred in the past Relevant Not relevant because it is the same across the alternatives Not relevant because it is the same across the alternatives Relevant

Relevant Relevant Relevant Not relevant because the cost occurred in the past Not relevant because it is the same across the alternatives Not relevant because it is the same across the alternatives

(iii) Some assumptions need to be made here because of the different time spans for the data. The apartment is to be leased for a minimum of 6 months, but the residence hall alternative is only good for 4 months. What does Janet do for the 2-month period after she cannot live in the residence college any longer? Are the semesters contiguous so that she can choose two 6-month leases in an apartment versus three 4-month periods in the residence college? If the semesters are contiguous, then the cost per month can be computed after annualising the information. Relevant monthly costs for the ‘residence college’ alternative: Room & board ($2,900/4) $725 Couch storage 35 $760 Relevant monthly costs for the ‘flat’ alternative: Apartment rent $400 Utilities 75 Groceries 200 $675

Contemporary Management Accounting, Chapter 2

Given the assumption that semesters are contiguous (and that costs can be annualised), the apartment seems to be less expensive for Janet than the residence hall by $85 per month. (b)

Costs Janet would know for sure:

Residence college University fees Couch

Source of Information Information published by the university Information published by the university Already purchased; know purchase price

Costs Janet would estimate with little uncertainty:

Couch storage (Assume Janet investigated prices of storage units) Rent (Assume Janet has identified a potential apartment and was given a rent quote)

Why Not Known for Sure Until a rental agreement is signed, the cost could vary because the rental rate could change or the storage unit could be rented to someone else Until a rental agreement is signed, the cost could vary because the rental rate could change or the apartment could be rented to someone else. Also, the rent could change after the initial six months unless an agreement is signed for a longer period.

Costs Janet would estimate with moderate or high uncertainty:

Utilities (Assume friends or the apartment manager have given Janet an estimate)

Groceries (Assume Janet estimated her own grocery costs)

Why Not Known for Sure Janet cannot be sure how much the utilities will cost. For example, suppose Janet and her roommate need to heat their apartment during the winter. Janet does not know how warm she and her roommate will keep the apartment, and she does not know how cold the winter will be. Also, she cannot know whether the utility rates will change during the year. Unless Janet has purchased her own groceries in the past, she might not know how much food costs or how much and what types of food she would eat. In addition, she might share costs with her roommate, making it more difficult for Janet to anticipate the food costs. Also, there can be unanticipated changes in food prices.

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(c)

Additional information that might be relevant to Janet’s decision (i) Costs not identified by Janet: • Janet might need to purchase more furniture if she lives in an apartment. She might need a bed, dresser, desk, chair, dining room set, lamps, etc. • Janet might need to purchase a range of household equipment and supplies under the apartment alternative, such as a vacuum cleaner, microwave oven, dishes, cookware, etc. • If Janet purchases furniture and other household items, she will need to consider what to do with them at the end of the semester. Will she sell them? Will she move them to another living situation? Will she put them into storage? There may be additional costs after the end of the semester, especially if her lease is for a time period longer than the semester. • If Janet chooses the residence college alternative, she might incur living costs during the break between semesters. • If the apartment is not within walking distance of the university, she might incur additional transportation costs. • Janet needs to consider the possibility that her roommate might not pay for her full share of costs. Janet could be held responsible for more than one-half of the rent, utilities, and other apartment costs. • There are a number of other additional costs that would differ under the two alternatives that students may list. (ii) Factors other than costs: • Janet has uncertainties under both options about how she will get along with her roommate; however, there might be more opportunities for disagreement and conflict under the apartment alternative. Janet needs to consider the pros and cons of each roommate situation. • Janet’s personal preferences for living in an apartment versus living in the residence college are likely to be a major factor. Personal preferences might include a desire for greater personal freedom, security, physical space, ability to cook, and so on. • Janet needs to consider the difference in flexibility in the two options. For example, if she chooses the apartment, she is committed for a minimum of six months’ rent and possibly a wide range of other costs such as furniture purchases, etc. These commitments might make it difficult for her to change her mind.

(d)

The cost comparison will help Janet plan her finances and decide whether she can afford each alternative.

(e)

Students need to recognise their own preferences, which are a function of their own previous experiences and tastes. For example, they might not want to spend time commuting to and from school. However, Janet might consider this to be less important than living in an apartment in a part of town she enjoys more. Students might have had good or bad experiences with roommates in a residence college, which causes them to be biased toward or against that option. One way for students to control biases is to first recognise their own preferences. Then they can look for ways in which their preferences affect what they consider to be relevant or important. Another way is to talk about this problem with other people who are likely to have preferences different than theirs.

Contemporary Management Accounting, Chapter 2

(f)

This question was partially answered in Part E. Some people weigh some factors more than others and these weights affect the choices they make. It is possible to come up with many different ways for Janet to prioritise the various factors from Parts A and C in deciding which option is best for her.

(g)

Janet might learn something about her ability to manage her funds. She might learn more about whether she likes or dislikes various aspects of living in an apartment such as: • Cooking her own meals • Commuting from an apartment off campus • Her roommate Janet also might learn more about her ability to manage costs is a less structured situation.

(h)

There is no one answer to these parts. Instructors might also like to guide students on the format the memo should take.

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1.21

Relevant information; recommendation Frank owns a caravan and loves to visit national parks with his family. However, the family only takes two one-week trips in the caravan each year. Frank’s wife would rather stay in motels than the caravan. She presented him with the following itemisation of the cost per trip, hoping that he will sell the caravan and use motels instead.

Required (a) What are the relevant costs for deciding whether the family should go on one more camping trip this year? (b) What are the relevant costs for deciding whether Frank should sell the caravan? Assume the family will take the same vacations but stay in motels if the caravan is sold. (c) What factors other than costs might influence the decision to sell the caravan? List as many as you can. (d) Consider your own preferences for this problem. Do you expect Frank’s preferences to be the same as yours? How can you control for your biases and consider this problem from Frank’s point of view? (e) Frank asks you to help him decide what to do. Do you think he should sell the caravan? Why? (LO1, 2 and 3) (a)

Relevant costs for deciding whether to go camping or stay home this year: • $1000: this is not relevant because it represents the past cost of the caravan • $150 (1000 km × $0.15): the petrol and oil portion of this is relevant because it is incremental • $220: depreciation is not relevant because it is related to the past cost of the caravan and insurance is not relevant because Francisco will insure the caravan whether they take the trip or not. • $250: the cost of groceries is relevant only to the extent that it exceeds the cost of groceries while at home.

Contemporary Management Accounting, Chapter 2

• •

$100: the cost of beverages is relevant only if it exceeds the cost of beverages while at home. Entertainment costs (movies, etc.) that the family might incur if they stay at home during their vacation time that they would not incur if they go camping instead

(b)

The relevant costs for deciding whether to continue to use the caravan or to sell it and stay in motels in the future: • $1000: this is not relevant (but the estimated cash inflow from selling the caravan will be relevant) • $150: this is now relevant because it is an estimate for the future costs of using the caravan. The family will probably drive their car if they sell the caravan, so that option will incur some level of petrol, oil, tyres and maintenance cost. • $220: depreciation is not relevant, but insurance is now relevant because it differs across the alternatives • $250: the cost of groceries is relevant only to the extent that it exceeds the cost of groceries while at home, also may need to consider differences in patterns of eating in restaurants. • $100: the cost of beverages is relevant only if it exceeds the cost of beverages while at home. • Motel costs: If they sell the caravan, the family will incur costs to stay in motels. • Storage costs of the caravan (if any) would no longer be required if the caravan is sold.

(c)

Other factors that Francisco might consider include: • The enjoyment that his children receive from camping (if they do in fact enjoy it) and whether their preferences will change as they grow older • The enjoyment that Francisco receives from camping • Francisco’s wife’s displeasure with camping and enjoyment of the alternatives • Expected selling price of the caravan

(d)

Some students might recommend that Frank keep the caravan because they view it as better than staying in motels. Others might suggest that Frank should experience more things than just state and national parks. Still others might think that a caravan must be too small for a 5-person family, so Frank should sell it. Personal biases often sway the way that people look at information for a problem. They often ignore information that contradicts their preferences. Frank and his family do not necessarily have the same experiences and preferences as students when responding to this question. One way for students to control biases is to first recognise their own preferences. Then they can look for ways in which their preferences affect what they consider to be relevant or important. Another way is to talk about this problem with other people who are likely to have preferences different from theirs.

(e)

As outsiders, it is difficult for students to give advice because they cannot know which priorities should be used to solve this problem. Accordingly, the best

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advice students could give Frank might be to discuss it with the family and come up with the best solution/compromise for the family. They could also recommend that Frank remain open to his own biases.

Contemporary Management Accounting, Chapter 2

1.22

Cost drivers; value chain; strategy; organisational structure Australian fashion designer Sean Ashby commenced his men’s swimwear and clothing business aussieBum in 2001. A keen swimmer and surfer, he was unable to find a good pair of men’s cossies and used his life savings of $20 000 to make a series of prototypes, buy materials and commence manufacturing in Australia. Despite rejection from local retailers who did not see the potential for aussieBum to compete with international brands, Ashby has proven critics wrong. He had no choice but to take his business online, with instant exposure to the international market. It now takes thousands of orders a day. Since the company’s inception, Ashby says that aussieBum has ‘taken on its own little cult revolution’, with celebrities such as Ewan McGregor, Billy Connolly and David Beckham fans of the aussieBum brand. Even Kylie Minogue’s male dancers wore aussieBum cossies in the film clip for her song ‘Slow’. The marketing thrust behind Ashby’s aussieBum is to live the dream — ‘the dream to be independent and present our gear in a way that gets noticed. We don’t apologise for pushing the boundaries . . . We have a saying at aussieBum — If you doubt yourself, wear something else’. The company doubled in size every year in its first five years and continued to grow by 20 per cent every quarter. By 2005, aussieBum earned more than $5 million in sales and carried no debt. The aussieBum brand now takes pride of place in stores such as Selfridges in the UK; Brown Thomas in Ireland; La Maison Stores in Canada; Alpha Male in Melrose Drive, Los Angeles; KaDeWa in Germany; as well as others in Spain, The Netherlands, Sweden, Poland and Russia. As well as direct department store sales, aussieBum’s internet retail orders are booming, with aussieBum being distributed to more than 70 countries. It now has over 200 000 consumers ordering direct via its custom built e-commerce site. Most of the raw materials are sourced from Italy and China. By manufacturing in Australia, aussieBum hopes to promote Australia’s culture and relaxed lifestyle as well as eliminate restrictions that might come with outsourcing production to other countries. Moreover, producing locally (through independent manufacturers) provides flexibility and a reduced timeframe in getting new products to market. With a heavy emphasis on innovative product design, aussieBum pays close attention to the design phase of the product process. Two recent examples of aussieBum’s flexibility and innovative approach to product development and marketing are worthy of note. First, it was able to capitalise on the consumer backlash against competitor Bonds when that company transferred more of its manufacturing offshore. Ashby estimates that aussieBum’s sales grew by at least 40 per cent as a result. Second, aussieBum was able to achieve continued growth during the global financial crisis. The company continues to avoid debt and own all its assets outright.

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Required (a) With reference to the information provided, distinguish between structural and executional cost drivers. (b) Illustrate and describe the industry and organisational value chain in which aussieBum operates. (c) Classify aussieBum’s likely strategy as low cost or product differentiation. Explain. (d) Classify aussieBum’s organisational structure as centralised or decentralised. Explain. (e) With reference to disruptive innovation, do you consider aussieBum to be a disruptor to the traditional garment industry value chain? Discuss why or why not. (LO2 and 4) (a) Structural cost drivers relate to those factors that cause costs insofar as the underlying structure of the organisation is concerned. Commonly we talk of five structural cost drivers: scale, scope, experience, technology and complexity. For example, complexity is determined by the number of different product categories. aussieBum has a product range that includes underwear, swimwear and leisurewear. The differences between each of the product ranges appear relatively small, suggesting that complexity at least might be relatively low. (b) Scale refers to the levels of investment in such activities as research and development, manufacturing, marketing and customer support. From a scale perspective, aussieBum spends significant resources in the research/development and design phases of their value chain. By devoting significant resources to research and development with new product design and innovative materials, this allows the organisation to bring new products to market regularly. They also manufacture in Australia through contracting arrangements, presumably to facilitate flexibility and shorter lead times. The scene setter also makes it clear that aussieBum uses a targeted marketing campaign. Scope refers to the degree of vertical integration (horizontal integration is more closely related to scale). aussieBum does not appear to be altering its value-chain position by vertically integrating. It appears to continue to outsource (for example raw material production, fabric manufacture and clothing manufacture) the activities that they consider are not core to the aussieBum strategy. Experience refers to the times in the past that aussieBum has already done what it is doing again. Although aussieBum is relatively new to the industry, the experience being developed by aussieBum is one based on constant innovation and differentiation. It may be argued that for aussieBum experience is not as important, or may to a certain extent, stifle innovation and creativity in a focused men’s clothing market. Technology refers to the process technologies in each step of the value chain. It is not easy to evaluate the internal mechanisms of an organisation without access to the company. At one end of the value chain, one would assume that aussieBum would have strong reliance on the latest textile industry research and design technologies – which can impact quite rapidly on production (for example, a change in fabric or weave can be made instantly with online technology linking changes directly to manufacturing (weaving machines) in any country). aussieBum would also place a strong emphasis on technological excellence in their outbound logistics,

Contemporary Management Accounting, Chapter 2

marketing and customer service value chain activities (as reflected in use of the internet). Complexity relates to the extent of the product/service line. aussieBum remains fairly focused on men’s swimwear, underwear, leisure and sportswear. In this sense the product offerings remain fairly tight, although the options available, particularly within swimwear and underwear, are many. Executional cost drivers are those that influence organisational cost in terms of how the business does what it does. They include: workforce involvement, total quality management, capacity utilisation, plant/process layout and efficiency, product configuration, and linkages with suppliers and customers. So, for example, the stronger the links with suppliers and customers, the more likely that advantages of cost and waste elimination can occur within each entity. aussieBum appears to have established strong links with retail customers, particularly those overseas, and enjoys strong, loyal support from its many internet customers. (c) An industry value chain relates to the broader industry in which an entity chooses to compete. Often the entity may participate in parts of the industry and the entire industry. For example, aussieBum does not manufacture the raw material components (materials) but chooses to source the materials from outside entities. aussieBum does manufacture, market and distribute its products. It does operate in part, as a retailer through its internet service but does not own retail shops. The internal value-chain focuses on the key internal value-creating activities, that an entity engages in. aussieBum focuses on research and development, design, manufacture, distribution and sales, and marketing as key functions. (d) aussieBum’s organisation would be relatively centralised. Sean Ashby, as CEO, would have oversight of all the functions from research and design to customer service. Given the product range is relatively focused on men’s leisure and underwear, there is not a great need to decentralise because of diverse product offerings. Similarly, many of the functions, such as manufacturing and retail are outsourced, so there is no need to decentralise based on geographic location. The support functions would serve all core functions such as R&D, marketing, and logistics. (e) aussieBum would be classified as a disruptor to the traditional garment industry by relying on the internet and social media for leverage in the market place. Many companies are now following similar strategies, where they are designing and selling a brand, rather than operating in other parts of the value chain and direct manufacturing. This is occurring in the food as well as fashion industry, with many value chain activities, such as manufacturing outsourced to contract manufacturers who have the scale (and other structural cost drivers) to work in a low cost and high quality environment. These companies are the early movers in disrupting traditional value chains, especially where manufacturing was seen a core activity. Airbnb and Uber, similarly are leveraging their brand through social media by the use of globally recognised computer applications (Apps) and the operational activities are performed by contractors committed to upholding the brand image and reputation. Disruptive innovation is about redesigning value chains and Sean Ashby would have reviewed every activity to see how the digital

1-29

world could help with access to organisations with the necessary structural and executional cost drivers, rather than requiring the funds to invest himself. Airbnb and Uber have gone one step further by enabling a global crowd to emerge to provide the necessary structural and executional cost drivers for relatively shortrun success.

Contemporary Management Accounting, Chapter 2

1.23

Using Figure 1.5 as an example, develop an internal value chain for an airline such as Virgin Australia. (LO4)

Student responses may vary, and might include the following: • Research & Development and Design activities discussion including cost leadership processes undertaken to deliver a low cost, but highly value service to customers. For example, students may discuss the online ticketing and check-in processes; the use of low cost paper boarding passes; the streamlined in-flight catering. Discussion can also include the technology required for support processes where cost leadership strategies might be reflected in accounting and administration practices. •

Inbound logistics relates to the provision of supplies necessary for an airline industry. This is varied and covers a broad range from airline service, fuel to catering services. To maintain cost leadership, an airline such as virgin Blue might outsource certain activities (such as airplane service to contractors). Supplier relationships, such as airline fuel suppliers and rental arrangements for allied airport staff and services (i.e. baggage handlers, flight controllers, terminal facilities) are important for an airline’s reputation.

•

The activity relating to production or service supply is the delivery of a low cost flight service to customers. For example, a low cost strategy airline such as Virgin Blue might focus on production processes that reduce idle capacity (ticketing strategies to operate flights at full capacity). Virgin Blue would also include defining activities and designated roles and activities to their permanent staff (the ground staff, cabin crew and pilots). In a low cost strategy environment a focus on activities can crate savings on additional costs relating to identifying activities that their own staff could do whilst ‘on the job’ instead of paying for additional contracted cleaning or maintenance personnel.

•

Marketing and distribution activities for Virgin Blue are aimed at operating their airlines at full capacity. That is, filling seats on planes in order to cover costs and achieving the lowest cost per air kilometre travelled. Strategies here include the online ticketing sales or ‘happy hour’ where customers can purchase last minute seats at a reduced cost. As part of this value chain function, Virgin Blue also reward their regular travellers with points for future travel.

•

A customer focus is important for an airline such as Virgin Blue. Whilst they aim at achieving a low cost strategy, they also aim to provide a quality experience for customers. Students may refer to the website for other activities that Virgin Blue perform such as carbon credits for promotion of their suitability activities and environmental awareness and other activities to encourage return travellers.

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1.24

Value chain in the public sector Traditionally, government organisations have tended to operate in silos, focusing on their own objectives and managing and protecting their own budgets. Recently, however, faced with seemingly intractable economic, social and environmental problems, many government organisations have sought to develop new ways of working. In particular, they have sought to explore how their objectives overlap and depend on other organisations and how they might share information and resources. One example is provided by attempts to reduce crime and enhance public safety in the criminal justice sector. In New Zealand the Ministry of Justice is the lead agency in the justice sector. The sector includes the New Zealand Police, the Serious Fraud Office, Child Youth and Family, the Department of Corrections and the Crown Law Office. The organisations in the criminal justice system can be thought of as being involved in a ‘pipeline’ that begins with crime prevention and the investigation of crime and proceeds all the way through to rehabilitation (see the figure below). Looking at the sector as a pipeline, we can see that policies and actions in any part of the system will affect other parts of the system. By working as a coordinated ‘justice sector’, changes can be made that result in the best outcomes for the sector as a whole.

Within this pipeline, the operations within one agency, Public Prisons, can be further analysed to show the links between its key activities and between the department and other organisations in the sector. Key activities follow this path: • offenders are convicted in the courts • offenders are sentenced and sent to prison • prisoners undergo an initial assessment • the serving of the sentence is planned • the offender’s sentence is managed, including provision of relevant rehabilitation programs • the offender’s release is planned and managed. Required (a) With reference to the information provided, distinguish between the structural and executional cost drivers in this value chain.

Contemporary Management Accounting, Chapter 2

(b) Is there an ability for governments to outsource any of these value chain activities? (LO1, 2 and 4) (a) and (b)

In this example, the government has worked to combine disparate operations into one value chain industry, which impacts both structural and executional cost drivers. In analysing structural cost drivers, the government have brought together the key parts of the business to generate scale across each segment indicated in the justice system pipeline. This allows for standardised procedures to be followed for each activity, which can be performance measured and audited. The activity of creating a justice pipeline is actually creating the scope, or the vertical integration of a previously fragmented activity. The experience was already there but operating in silos. This new value chain design has created a single system, which encourages greater communication between the key expert areas. This of course, would require technology to help drive improved communication across the value chain activities. A technology platform will ensure the pipeline functions. Without this, the system could easily become fragmented and siloed again as each component prat is highly complex. Because of the structural cost drivers that have emerged through the consolidation of the justice system activities, it is necessary for the executional cost drivers to play a role in maintaining the pipeline. For example, there must be workforce involvement in all activities to commit to maintaining this environment where communication is essential. This will ensure TQM of the single pipeline processes, optimisation of capacity utilisation, efficiency of the layout of the pipeline activities, how a single person is processed through the new pipeline, along with linkages to key support functions. Executional cost drivers are essential for transparency and ease of navigating through this new justice system pipeline.

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1.25

Management decision makingLO1, 2

The Woolworths Group has a goal of having customers put the company first across all their brands. To achieve this the Group has identified five priorities.9 1. Building a customer and store-led culture and team. 2. Generating sustainable sales momentum in food. 3. Evolving the drinks business to provide even more value and convenience to customers. 4. Empowering the portfolio businesses to pursue strategies to deliver shareholder value. 5. Becoming a lean retailer through end-to-end process and systems excellence.

Required (a) Given the strategic priorities, what decisions could management take to influence the structural cost drivers and executional cost drivers? (b) What type of information would management need in making decisions you have identified in (a)? (a) In order to meet their goals associated with “having customers put the company first”, improved customer orientation and experience, improving processes and delivering shareholder value, it is critical that management understand the firm’s structural and executional costs drivers (see Figure 1.7). Management decisions directly influence the firm’s structural cost drivers given decisions, for instance, about the scale (i.e. how much is invested in marketing and customer support), scope (i.e. degree of vertical integration), and complexity (i.e. extent of the firm’s food and drinks lines). An understanding of executional cost drivers (i.e. the benefits of workforce involvement and TQM, how capacity can be better utilised, how the relationship with customers can be improved) can further inform management decisions regarding different options to better manage costs and improve customer value. (b) As the following table illustrates, various sources of information can be relevant in enabling management to understand the impact of their decisions on the firm’s structural and cost drivers. Cost Driver Structural cost drivers Scale Scope Experience

Example sources of relevant information Annual investment in R&D, marketing and customer support. Degree of vertical integration. Average employee qualification levels. Number of employees participating in professional development activities.

Contemporary Management Accounting, Chapter 2

Technology Complexity

Annual investment in IT systems. Online store reliability/functionality. Number of product lines. Number of stores.

Executional cost drivers Workforce involvement

Employee feedback on their commitment to the organisation and senior management. TQM Annual investment in service quality improvement. Average weekly product returns. Capacity utilisation Average revenue per square metre of floor space. Average revenue per store. Process efficiency Average delivery times. Average customer check-out times. Product configuration Customer feedback on product options. Linkages with suppliers and Average supplier delivery times. customers Customer satisfaction.

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Solutions manual to accompany

Management accounting 4th edition by Eldenburg et al. Prepared by Vijaya Murthy

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 2: Cost concepts, behaviour and estimation Questions 2.1

‘As volume increases, total cost increases and per-unit cost decreases.’ What type of linear cost function does this describe? Draw a simple graph of this type of cost function. (LO2)

This function has both fixed costs and variable costs. If at least part of the cost is variable; total cost increases as production volumes increase. If at least part of the cost is fixed, the average total per-unit cost decreases because the average fixed cost decreases as volume increases. Total Cost

2.2

A motor vehicle assembly plant closes every August to retool for the next year’s model. How should August’s cost data be used in estimating the overhead cost function? (LO4)

Several years’ worth of data for August would be helpful for estimating the overhead cost function for subsequent Augusts, but the August data should not be used for estimating the overhead cost function for other months during the year. It is highly unlikely that the August data would be representative of the data during normal operations. However, August’s costs are probably a good estimate of the fixed costs for other months. When zero production occurs, only fixed costs are incurred.

Chapter 4: Cost–volume–profit (CVP) analysis

2.3

You have been asked to provide the managing director with an approximate cost function for the entity’s activities, and it must be done by this afternoon. Some members of the board of directors want to understand why performance varies so much across store locations. They have asked for a quick analysis today and want a more detailed analysis next week. Which cost estimation technique(s) should you consider using? Explain. (LO3 and 4)

Since time appears to be of the essence, one of several cost estimation techniques might be employed. First, account analysis will provide a rough estimate. Second, the two most recent income statements could be used to approximate fixed and variable costs using the two-point method, but the president would need to understand that the quality of information could be low using this method. Third, if enough observations of cost data are readily available, regression analysis can be run. However, usually it takes more time to collect the data necessary to use regression analysis. 2.4

At two levels of activity within the relevant range, average costs are $192 and $188, respectively. Assuming the cost function is linear, what can be said about the existence of fixed and variable costs? (LO2)

The information leads to a conclusion that fixed costs exist because cost per unit changes between two levels of activity within the relevant range. The information is not sufficient to determine the amount of fixed costs or whether variable costs exist.

2.5

You are about to start a coffee shop business. What do you understand by ‘cost behaviour’? Explain how your accountants could help you in building an understanding of cost behaviour. Identify the likely key costs and classify each as fixed or variable. (LO1, 2)

In the context of running a coffee shop, cost behaviour refers to how costs will vary as the activity level (i.e. number of coffees sold) changes. Accountants can use various techniques to estimate and understand a coffee shop’s cost behaviour, for instance: •

• •

Analysis of costs at the account level to identify the pattern of costs through time and how they have varied with the level coffees sold. This can be supported through the preparation of scatter plots which help to visualise likely cost behaviour. An engineered approach could be used to carefully identify what is involved and what costs are required in producing each cup of coffee and how these costs are likely to change as more coffees are sold. Quantitative analysis techniques (i.e. two-point method, high-low method, regression analysis) can be used to precisely estimate the cost behaviour of key costs.

The likely key costs involved in running a coffee shop and their behaviour is summarised in the table below.

4.1

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Key cost Direct and indirect materials (i.e. coffee, milk, sugar, serviettes, disposable cups and spoons) Rent Depreciation of equipment and fixtures Staffing costs

Electricity and other utilities

2.6

Likely cost behaviour Variable Fixed Fixed Fixed (assuming a minimum number of staff are required at most times. The cost might increase in a stepwise linear fashion, however, if additional staff are needed above certain activity levels). Fixed

Explain how information from a scatter plot helps in categorising a cost as fixed, variable, or mixed. (LO3)

Analysis of a scatter plot provided general information about whether a cost appears to be variable, fixed, or mixed. If there is a linear pattern in the scatter plot and the trend appears to go to zero, the cost could be variable. If a scatter plot with a linear trend intersects the vertical axis at a nonzero value, it could be mixed. If the scatter plot has no discernible pattern, the cost could be fixed. And if the pattern is linear with little or no slope, the cost could be fixed.

2.7

Explain the analysis at the account level approach to developing a cost function. (LO3)

The pattern of a cost over time in the accounting system, together with knowledge of operations, is used to classify costs as variable, fixed, or mixed. Costs such as managers' salaries are usually fixed; they are often directly associated in the general ledger with a particular department or product. Costs for variable materials used in the production process are usually available in the general ledger or in production records. Costs such as manufacturing overhead are often mixed; they tend to include fixed costs such as insurance and property taxes for the plant and variable costs such as indirect supplies used in manufacturing. For costs identified as mixed, another cost estimation technique such as the two-point method or regression analysis must be used to determine the fixed and variable components.

4.2

Chapter 4: Cost–volume–profit (CVP) analysis

2.8

List two examples of non-linear cost functions and describe a method of developing a cost function for each one. (LO2)

Learning curves are nonlinear representations of direct labour cost. The cumulative average time approach can be used to determine an approximation of total cost when labour experiences a learning rate. Economies of scale are a non-linear function. Information about past experience with economies of scale can be used to help estimate future costs. For example, volume discounts are examples of economies of scale. The required volumes needed to reach discounted prices are generally known, so these can be estimated using several different ranges to reflect the changes in price.

2.9

Why might some have trouble classifying costs as fixed or variable? (LO1 and 2)

It can be difficult to classify some costs as fixed or variable as: • A particular cost may possess characteristics of both • It may be difficult to identify what the cost items actually varies with i.e. identifying the true cost driver

2.10 The trend line developed using regression analysis provides a more accurate representation of a mixed cost function than the two-point or high-low methods. Explain why. (LO5) The trend line developed using regression analysis incorporates all of the cost observations, while the two-point method uses only two observations. Because there is fluctuation in cost over time, better estimates are developed using more observations, because they better reflect the past fluctuations and therefore should better estimate future fluctuations.

4.3

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Exercises 2.11

Fixed, variable, and mixed costs Bridges and Roads is an entity engaged in road construction. Some selected items from its chart of accounts are listed below. Required For each account, indicate whether the account represents a fixed, variable, or mixed cost for the operation of road construction activity. If mixed, indicate whether it is predominantly fixed or variable. Explain your answers. (a) Staff wages (b) Clerical wages (c) Rent (d) Licences (e) Insurance (LO2)

(f) Office supplies (g) Professional dues (h) Professinal subscriptions (i) Property taxes (j) Advertising

Staff wages – Could be variable or mixed (salary + overtime) for regular staff. If there is part time help, that cost would be variable; however staff are often salaried, in which case the total cost would be primarily fixed. Clerical wages – Fixed unless overtime is regularly scheduled, and then mixed Rent - Fixed Licenses- Fixed Insurance- Fixed Office supplies - Mixed, mostly variable Professional dues- Mostly fixed and discretionary Professional subscriptions- Fixed and discretionary Property taxes- Fixed Advertising – Fixed and discretionary

4.4

Chapter 4: Cost–volume–profit (CVP) analysis

2.12

Linear, stepwise linear, and piecewise linear cost functions (a) Total fixed costs are $10 000 per week and the variable cost per unit is $8. Write the algebraic expression for the cost function and graph it. What are the assumptions of the cost function? (b) Total fixed costs are $25 000 per week up to 2000 units a week and then jump up to $35 000 per week. The variable cost per unit is $8. Write the algebraic expression for the cost function and graph it. (c) The average cost to produce 10,000 units is $45 and the average cost to produce 12 000 units is $44. Estimate the average cost to produce 15 000 units. (d) The total cost function for Hot Dog Days, a hot dog cart business in Centennial Park, is TC = $5000 + 45%  total revenues. Estimate the total cost for a month when total revenues are $10 000. (LO2)

(a) TC = $10 000 + $8.00×Q Graph of Cost Function $14,000

Total Cost

$13,000 $12,000 $11,000 $10,000 $9,000 $8,000 0

100

200

300

400

Number of Units

The cost function includes the following assumptions: • Operations are within a relevant range of activity • Within the relevant range of activity: o Fixed costs will remain fixed o Variable cost per unit will remain constant

4.5

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(b) TC = $25 000 + $8.00×Q, for Q  2000 TC = $35 000 + $8.00×Q, for Q > 2000 Graph of Cost Function $80,000 $70,000

Total Cost

$60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 0

1,000

2,000

3,000

4,000

Number of Units

(c)

To estimate the costs at another production level, it is first necessary to estimate the cost function. Convert the average costs to total costs for each production level: Total cost at 10 000 units = 10 000 × $45 = $450 000 Total cost at 12 000 units = 12 000 × $44 = $528 000 Calculate the variable cost per unit using the Two-Point method: Change in cost = ($528 000 – $450 000)/(12 000 – 10 000) Change in volume = $78 000/2 000 = $39 per unit

Use one data point in the total cost function and solve for F: Using the data for 10 000 units: $450 000 = F + $39×10 000 F = $450 000 – $390 000 = $60 000 Combining the fixed and variable costs to create the cost function: TC = $60 000 + $39×Q Estimated total cost at 15 000 units: TC = $60 000 + $39×15 000 = $60 000 + $585 000 = $645 000 Estimated cost per unit = $645 000/15 000 = $43 (d)

Inserting $10 000 in revenues into the cost function total cost is estimated as:

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Chapter 4: Cost–volume–profit (CVP) analysis

TC = $5000 + 45%×$10 000 = $9500

2.13

Cost function and assumptions Express Lunch is a small food van that sells a variety of sandwiches and beverages. Total fixed costs are $20 000 per month. Last month total variable costs were $8000 when total sales were $32 000. Required (a) Write out the algebraic expression for the cost function. (b) What assumptions do we make when we develop this cost function? (LO2)

(a)

If total variable costs were $8,000 on total sales of $32,000, then variable cost per dollar of revenue is calculated as follows: $8,000/$32,000 = 0.25, or 25% of sales Combining fixed and variable costs, the cost function is: TC = $20,000 + 25%×Total sales

(b)

Assumptions: Fixed costs remain fixed within the relevant range, and variable costs remain constant within the relevant range. In addition, this particular cost function assumes that variable costs are driven by sales. Chapter 3 will point out another assumption for this cost function: the sales mix (the proportion of sales of different products) remains constant within the relevant range.

4.7

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2.14

Piecewise linear cost function; regression measurement error The following is the description of a cost: Total fixed costs are $50 000 per month and the variable cost per unit is $10.00 when production is under 1000 units. The variable cost drops to $9.00 per unit after the first 1000 units are produced. Required (a) Write the algebraic expression of the cost function and graph it. (b) Assume that the cost function just described is a reasonable representation of total costs. If the accountant performed regression analysis on weekly observations of this cost and did not realise that there were two relevant ranges, what problems would arise in the cost function that was produced? In other words, how would the cost function be mismeasured? (LO3, LO5)

(a)

TC = $50 000 + $10.00×Q for Q < 1 000 For Q > 1 000: TC = $50 000 + (1000 × $10.00) + $9.00×(Q – 1000) TC = $50 000 + $10 000 + $9.00×Q – $9000 TC = $51 000 + $9.00×Q

(b)

If the accountant did not detect that there were two different relevant ranges, the cost function mismeasurement depends on the values of Q. There are three general situations: 1. If all of the data estimation points occurred when Q was  1000 units, then the cost function would appear to be: TC = $50 000 + $10.00×Q. This cost function would provide reasonable estimates for Q  1000 units but would overestimate total cost for Q > 1 000 units.

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Chapter 4: Cost–volume–profit (CVP) analysis

2. If all of the data estimation points occurred when Q was > 1000 units, then the cost function would appear to be: TC = $51 000 + $9.00×Q. This cost function would provide reasonable estimates for Q > 1000 units but would underestimate total cost for Q  1000 units. 3. If the data estimation points occurred across the two relevant ranges, then the cost function would be some mixture of the functions for the two relevant ranges. This cost function will either overestimate or underestimate costs for almost any level of Q (see figure 2.3)

4.9

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2.15

Cost function; opportunity cost; relevant costs Yummy Yoghurt sells yogurt cones in a variety of natural flavours. Data for a recent month follow:

Required (a) Categorise each cost as fixed or variable. (b) Create a cost function. (LO2) (a) Fixed Cost of ingredients Rent Store attendant (salaried) Total Costs at $9,000 in sales (b)

$1000 2300 $3300

Variable $4500 ____ $4500

In many organisations, costs vary with dollars of revenue. In this type of situation, total revenue (TR) instead of quantity (Q) can be used in the cost function: Total variable cost/Total revenue = $4500/$9000 = 0.50, or 50% of revenue Combining fixed and variable costs, the cost function is: TC = $3300 + 50%×Total revenue

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Chapter 4: Cost–volume–profit (CVP) analysis

2.16

Fixed, variable, and mixed costs Spencer and Church is a CPA entity engaged in local practice. Some selected items from its chart of accounts are listed here. Required For each account, indicate whether the account represents a fixed, variable, or mixed cost for the operations of the local practice office. If mixed, indicate whether it is predominantly fixed or variable. Explain your answers. (a) Staff wages (b) Clerical wages (c) Rent (d) Licences (e) Insurance (LO2)

(f) Office supplies (g) Professional dues (h) Professinal subscriptions (i) Property taxes (j) Advertising

[Note about problem complexity: These are difficult questions because students will need to first visualise the costs (with very little information) and then apply chapter concepts. The Step 2 questions (A, B, and F) are the ones requiring significant assumptions to generate an answer.] (a) Staff wages – Could be variable or mixed (salary + overtime) for regular staff. If there is part time help, that cost would be variable; however staff are often salaried, in which case the total cost would be primarily fixed. (b)Clerical wages – Fixed unless overtime is regularly scheduled, and then mixed (c) Rent - Fixed (d)Licenses- Fixed (e) Insurance- Fixed (f)Office supplies - Mixed, mostly variable (g)Professional dues- Mostly fixed and discretionary (h)Professional subscriptions- Fixed and discretionary (i)Property taxes- Fixed (j)Advertising – Fixed and discretionary

4.11

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2.17

Cost function using regression; other potential cost drivers The new cost analyst in your accounting department just received a computer-generated report that contains the results of a simple regression analysis. The analyst was estimating the costs of the marketing department using units sold as the cost driver. Summary results of the report are shown below.

Required (a) Write an equation for the cost function based on the regression analysis. (b) What does the adjusted R-square tell you? (c) What other cost drivers could potentially explain marketing costs? Explain. (LO5) (a)

TC = $222.35×units sold. (Notice that the T-statistics on the fixed costs indicate that it is not likely to be different from zero. Therefore, the fixed cost is set at zero.)

(b)

The adjusted R-Square indicates how much of the variation in the marketing department cost can be explained by variation in units sold. In this problem, the variation in units sold explains about 61% of the variation in marketing department cost.

(c)

Other possible cost drivers for marketing department costs could be revenue, number of advertisements placed, or profits. In addition, it is possible that marketing costs are discretionary. The cost analyst needs to gather information about how marketing costs are set each year. For example, the analyst could ask the CFO whether the marketing department budgets its costs through a negotiation process with top management. If this is the case, the cost is discretionary and will be set through the negotiating process.

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Chapter 4: Cost–volume–profit (CVP) analysis

Problems 2.18

Cost function using high-low and regression; quality of cost estimates Following are sales and administrative cost data for Big Jack Burgers for four months:

Administrative cost is a mixed cost, and sales is a potential cost driver. Required (a) Using the high-low method, create a cost function for administrative costs. (b) In your own words, explain why the high-low method might not be a good method for estimating the cost function. (c) Create a scatter plot and add a trend line. After examining the plot, use your judgement to determine whether the cost is fixed, variable, or mixed. (d) Perform regression analysis to create a cost function for administrative costs. (e) Can we know for certain that the cost function from part (d) provides a good estimate for next month’s administrative costs? Why or why not? (f) Discuss whether sales are an economically plausible driver for administration costs for Big Jack Burgers. (LO4, LO5) (a)

Total revenue (TR) instead of quantity (Q) in the cost function because sales is a potential cost driver. Under the high-low method, the cost function is calculated using the highest and lowest values of the cost driver. First, the variable cost is calculated: ($68 333 – $43 333)/($1 132 100 – $632 100) = $25 000/$500 000 = 0.05 or 5% of sales The fixed cost is determined by substituting the variable cost into one of the high-low data points: $68 333 = F + 5%×$1 132 100 F = $68 333 – $56 605 = $11 728 Thus, the total cost function is: TC = $11 728 + 5%×Sales

4.13

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(b)

The high-low method uses the most extreme cost driver values, which could be outliers, that is, not represent the cost most of the time. That means that the cost function might not represent the actual cost, on average. Therefore, this cost function might provide poor estimates of future costs. Scatter Plot With Trend Line

Administrative Costs

$80,000

$60,000

$40,000

$20,000

$0 $0

$300,000

$600,000

$900,000

$1,200,000

Sales

(c)

Chart of data with trend line added by Excel; trend line extended to Y-axis (dashed line) using Word:

It appears that the cost is most likely mixed. There is a general downward slope (variable cost) that appears to meet the intercept enough above zero to suggest a fixed cost. The upward slope of the line indicates that there are variable costs. (d)

Following is the regression output. A t-statistic greater than 2 is often interpreted as meaning that the coefficient is significantly different from zero. Notice that the t-statistic for the intercept coefficient is 2.172, but the p-value is greater than 10% at 0.162. Based on the p-value, there is a 16% probability that the intercept (fixed cost) is not different from zero. Because this regression has few observations, the p-value result for the t-statistic is atypical. Additional judgement is required to decide whether it is appropriate to include a fixed cost in the cost function. Analysis at the account level can be used to increase the understanding of this cost. If this cost pool includes items such as salaries and other fixed costs (insurance, etc.), the regression intercept can be used as an estimate of the fixed costs. Then, the cost function would be TC = $16 800 + 4.5% × sales. Alternatively, analysis at the account level might indicate that there are few fixed

4.14

Chapter 4: Cost–volume–profit (CVP) analysis

costs. In that case, fixed costs are likely to be zero and would be excluded from the cost function. Then, the cost function would be: TC = 4.5% × sales Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations

Intercept X Variable 1

0.9680477 0.93711636 0.90567454 3293.4038 4 Coefficients Standard Error 16800.2444 7734.73545 0.04466925 0.00818212

t Stat 2.17205158 5.45937486

P-value 0.16197623 0.0319523

(e)

Because of unforeseen changes in cost behaviour, a cost function may not provide a good estimate for the next month’s costs. The past costs used for estimation might not be representative, especially because so few observations were used in the estimation. Sales might not be the activity that drives administrative costs. There might be a change in business operations or in the economy that would cause future costs to be different than in the past. There might be a large discretionary component in administrative costs, causing fluctuations in cost that are unrelated to any cost driver.

(f)

The cons of the high-low method as an estimation technique were discussed in Part B above. If there are only two or three data points, however, the high-low method may be the best option available. This method can be used in cases where there is not enough data to perform regression, and it can be further improved by adopting more representative data points than the highest and lowest values of the cost driver. If there are more data points, regression analysis incorporates all of the observations into the analysis. Therefore, the results rely on more complete information and provide a better estimate, on average. Both methods assume that the cost function is linear and that all data points come from a single relevant range. If these assumptions do not hold, then both methods may be unsuitable for estimating future costs. In addition, both of these methods assume that the data points are representative of future costs. Unusual cost items are assumed to continue in the future, and possible changes in costs such as those described in Part E are ignored.

4.15

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2.19

Scatter plot; cost function using regression The following scatter plot and simple regression results used revenue as a potential cost driver for research and development costs.

Required (a) Discuss whether the scatter plot suggests that revenue is a cost driver for research and development costs. (b) Using the regression results, write the cost function for research and development costs. (c) Based on the regression results, discuss whether it would be appropriate to use total revenue as a cost driver for research and development costs. (d) If you use the cost function from part (b) to estimate next month’s research and development costs, what assumptions are you making? Identify at least three assumptions and discuss their reasonableness. (LO3, LO5) (a)

The plot shows costs that are widely scattered. However, there does appear to be a general upward trend. Sales does not appear to explain much of the variation in research and development costs.

(b)

Using the regression results, the cost function is: i. TC = $50 365 + 0.82%×Sales

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Chapter 4: Cost–volume–profit (CVP) analysis

(c)

The adjusted R-Square statistic is very low at 0.186. This means that variation in sales explains only about 18% of the variation in research and development cost. Future costs are not likely to be estimated accurately if the cost driver explains only a small part of the variation in the cost.

(d)

Several very general assumptions apply to a linear cost function. First, the cost is assumed to be linear within the relevant range. Therefore, fixed costs would remain fixed and variable costs would remain constant within that range. When regression analysis is used to specify a cost function, the underlying cost function is assumed to be linear and that the cost driver is assumed to be economically plausible as a cost driver, that is, the relation makes sense from an economic standpoint. In this problem, assuming that the cost function is linear may not be appropriate. The scatter plot shows little evidence of linearity. In addition, research and development cost is often discretionary. These costs are set by decision, usually annually. Managers set the costs depending on the organisation’s strategies and funds available for research and development. Better cost estimates for discretionary costs can be obtained by gathering information about planned expenditures from the department head or from the managers who are responsible for costs.

4.17

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2.20 Cost driver; cost categories; appropriateness of regression; relevant information Susan looked at her long-distance telephone bill with dismay. After leaving her job last year to become a self-employed consultant, her long-distance charges had grown considerably. She had not changed long-distance plans for years, partly because she hated taking the time to review the range of service providers and plans. However, the size of her long-distance bill made it clear that it was time to make a change. She had recently seen numerous advertisements by telephone companies offering much lower rates than she was currently paying, but she was sure that at least some of those plans offered low rates only for night and weekend calls. Susan called her current long-distance service provider and asked how she could obtain a lower rate. She mentioned hearing that a competitor was currently offering long distance at 5c per minute. In responding to the service representative’s questions, Susan verified that most of her longdistance calls are weekday and out of state. She also agreed that her activity over the past two months—approximately 500 minutes of long distance per month—was her best estimate for future calling activity. Given this information, the service representative suggested that Susan buy the following long-distance service plan: (i) Up to 500 minutes of long distance for a flat fee of $20 per month. (ii) No refunds would be provided for usage less than 500 minutes per month. (iii) Any minutes over 500 per month would be billed at 10c per minute. (iv) No service change fee or cancellation fee would apply. Required (a) What is the cost driver for Susan’s long-distance telephone costs, assuming that the cost object is her consulting business? (b) In the proposed service plan, which of the costs are fixed and which are variable? Explain. (c) Would regression analysis be an appropriate tool for Susan to use in deciding whether to buy the new service plan? Why? (d) Is the cost of Susan’s current long-distance service plan relevant to this decision? Why? (e) Explain why Susan cannot be certain whether the new service plan will reduce her long-distance costs. (f) List additional information that might be relevant to Susan in deciding whether to buy the new service plan. (g) Are Susan’s long-distance services most likely a discretionary cost? Explain. (h) Are Susan’s long-distance services most likely a direct or indirect cost, assuming that the cost object is an individual consulting job? Explain. (i) Describe the pros and cons of the new service plan. (LO2)

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Chapter 4: Cost–volume–profit (CVP) analysis

(a)

The cost driver for long distance calls is the number of minutes on the telephone.

(b)

The fixed cost is the $20 flat fee. The variable cost is 10 cents per minute for those minutes over 500 per month.

(c)

Regression is useful for estimating a cost function when fixed and variable costs are unknown. In this problem, Susan already knows the cost function, so she does not need to estimate the cost function using regression or any other estimation technique.

(d)

Yes, to make a decision she needs to compare her costs under the old plan to what costs would be under the new plan.

(e)

She cannot be certain that she will use the same amount of time, on average, as she has in the past. Since her consulting work varies, the number of calls and whether they are long distance or local calls will vary.

(f)

Additional information could include the location of Susan’s future consulting work, the amount of travelling she will be doing since she cannot call from home when she is travelling, the cost of alternatives such as cellular service or any other types of telephone or communication service.

(g)

It is likely that Susan has to call people to conduct business, although she could use email. Since she probably can cut back on calls when her consulting work is not providing enough income, a portion of the cost is likely to be discretionary. Since she has to have telephone service to stay in business, part of the cost is committed and cannot be reduced.

(h)

The classification as direct or indirect depends on whether Susan’s calls are directly related to specific projects she works on or are indirect activities such as business promotion. It also depends on whether she can trace telephone calls to individual consulting jobs. Many cellular telephone bills do not list the calls made, so Susan may need to maintain her own records if she wishes to trace telephone usage. In most businesses, telephone costs are viewed as an indirect cost.

(i)

Pros: • Susan might prefer the convenience of not switching telephone companies • If Susan is happy with her current quality of service she might prefer to stay with

the same company and not investigate other companies’ plans • Susan may be able to predict her cost better, especially if she usually calls less

than 500 minutes a month • Below is Susan’s average cost per minute at different levels of calls per month.

Minutes 300 400 500 600 700

Total Cost $20.00 $20.00 $20.00 $20.00 + (600-500)×$0.10 = $30.00 $20.00 + (700-500)×$0.10 = $40.00

Average Cost $0.067 $0.05 $0.04 $0.05 $0.057

4.19

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The average cost is lowest at exactly 500 minutes per month. If her calls are over 400 minutes or under 600 minutes, her phone bill will be less than it would be at a rate 5 cents per minute, which appears to be the other alternative (although the 5 cents per minute rate might not be available for daytime week day calls). Cons • If Susan has a number of projects in her local area or will be travelling a lot, she may be paying for 500 minutes of service that she does not use • If Susan’s calling volume exceeds 500 minutes per month, she will pay a very high rate of 10 cents per minute

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Chapter 4: Cost–volume–profit (CVP) analysis

2.21

Cost categories; cost function The Leyland Hospital Cafe has been reporting losses in past months. In July, for example, the loss was $5000.

The Cafe purchases prepared food directly from Hospital Food Services. This charge varies proportionately with the number and kind of meals served. Personnel who are paid by the Cafe serve the food, tend the cash register, waiting and clean tables, and wash dishes. The staffing levels in the cafe rarely change; the existing staff can usually handle daily fluctuations in volume. Administrative costs are primarily the salaries of the Cafe manager and her office staff. The hospital charges the Cafe a surcharge of 10 per cent of its revenue. Utility costs are the costs of cooling, heating, and lighting the Cafe during its normal operating hours. The hospital’s management is considering shutting the Cafe down because it has been operating at a loss. Required (a) List the fixed expenses of the Cafe. (b) List the variable expenses of the Cafe and the most likely cost driver for each expense. (c) Write out the cost function for running the Cafe. (d) Estimate the profit or loss for August if the revenues of the Cafe increase to $80 000. (e) Explain why the original data show a loss but part (d) shows a profit. Be specific. (LO2, LO4, LO5)

4.21

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(a) and (b) Leyland Hospital Cafe costs: Purchases of prepared food Serving personnel Cashier Administration Hospital surcharge Utilities Totals

Fixed

Variable $21 000

$30 000 5 500 10 000 1 500 $47 000

7 000 _____ $28 000

Total revenue is the most likely cost driver for both variable costs. Food costs are likely to vary proportionately with sales, and the Hospital surcharge is specifically based on sales. (c)

Because revenue is the cost driver for both variable costs, total revenue (TR) instead of quantity (Q) can be used in the cost function: Variable cost = $28 000/$70 000 = 0.40, or 40% or revenue Combining fixed and variable costs, the cost function is: TC = $47 000 + 40%×Total revenue

(d)

The estimate of total costs given revenues of $80 000 using the cost function is: TC = $47 000 + 40%×80 000 = $79 000 Profit = Revenues – Total costs = $80 000 – $79 000 = $1000

(e)

Café’s fixed costs are assumed to be unchanged with the $10,000 increase in revenues. Only total variable costs are expected to increase, and the increase is estimated to be 40% of the increase in revenues. So, total variable costs are expected to increase by $4000 ($10 000×40%). So, the additional profit from a $10 000 increase in revenues is expected to be $6000 ($10 000 – $4000). In July there was a loss of $5000, so the estimated profit in August is $1000 (–$5000 + $6000).

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Chapter 4: Cost–volume–profit (CVP) analysis

(f)

If the hospital were to close the Cafe, it would lose the revenues, less the fixed costs and the variable food costs. Because the hospital surcharge is an allocation within the hospital, this surcharge should be ignored when computing the hospital’s opportunity cost (assuming that the charge does not relate to any variable costs for the hospital that arise because of the Cafe). Thus, for July the opportunity cost would have been $2000 — the operating loss of $(5000) + the hospital surcharge of $7000. To estimate the opportunity cost for August, the variable cost part of the cost function can be adjusted. Variable food costs are estimated to be 30% ($21 000/$70 000) of revenues. (This is the same as the previous 40% variable cost rate less the hospital surcharge of 10% of revenues.) The adjusted cost function is: TC = $47 000 + 30%×Total revenue During August, the opportunity cost is estimated to be: Revenue Fixed costs Variable costs (30%×$80 000) Net

$80 000 (47 000) (24 000) $ 9 000

4.23

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2.22 Cost behaviour; scatter plot Polar Bear Ski Wear is a shop that sells skiwear at a ski resort. Its cost accountant developed the following scatter plot for the cost of electricity for lights, heating, and cooling against retail sales revenue.

Required (a) In a business such as retail sales, what usually causes the cost of electricity to vary? (b) In what time of year would most skiwear be sold at a ski resort? (c) In the scatter plot, the cost of electricity appears to be related to volume of retail sales. If this shop specialised in selling swimwear, would the scatter plot look different? Explain what would change. (d) Identify and explain another cost that is similar in nature to the cost of electricity. When you plot the cost against a cost driver, a relationship becomes apparent. However, the cost varies with something other than the cost driver. (Think of other situations where this type of relationship might occur.) (LO3) (a)

In a retail business, electricity usually varies with hours of operation and possibly with the season (because of heating and air conditioning). A shop located near a ski area is likely to incur high heating costs during the winter. Electricity costs also vary with changes in electricity rates, but this is not considered a cost driver (a business activity that causes variations in total variable cost).

(b)

The shop is most likely a seasonal business, generating most its sales around the ski season (fall and winter). During the spring and summer months, the shop might experience very little business activity; it might even close when the ski area shuts down.

(c)

Assuming the highest electricity cost is during the winter when fewest bathing suits are sold, costs would be higher when there were fewer sales, so the trend would be the opposite of this plot. However, if the bathing suit shop is located in a geographic region where the highest electricity costs occur during the summer

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Chapter 4: Cost–volume–profit (CVP) analysis

because of air conditioning, then the highest sales might coincide with the highest electricity costs. (d)

Many costs can be related to volume of activity. For example, higher profits generally occur during periods when activity is high. Higher profits, in turn, generally mean there is more money available to spend on administrative travel, special promotions, employee training, and new office furniture or equipment. Although these expenditures are made because more money is available, they are discretionary expenditures and not caused by the level of activity. A correlation may appear in a scatter plot or regression analysis. However, correlation does not necessarily mean causation.

4.25

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

2.23

Cost function using regression; scatter plots; three potential cost drivers Laura Mills is the controller of Peer Jets International, a manufacturer of small corporate jets. She has undertaken a project to study the behaviour of overhead cost. She has assembled factory overhead data for the last 30 months from the company’s manufacturing facility. Laura has asked you to develop a model to predict the level of manufacturing overhead. Required (a) Create a scatter plot of manufacturing overhead for each of the potential cost drivers. (b) Would you eliminate any of the potential cost drivers based on the scatter plots? Why? (c) Explain why you create a scatter plot of the data before you perform regression analysis. (d) To practice your regression analysis skills, perform a simple regression analysis of manufacturing overhead for each of the three potential cost drivers. Write the cost function from each regression. (e) Based on the simple regression results, which cost driver does the best job of explaining manufacturing overhead costs? Explain. (f) Do your regression results support your answer to part (b)? Explain. (LO3, LO5)

(a) Factory Overhead 137896 174342 168896 178059 166605 165320 157585 165667 155657 144605 157608 171700 140686 171982 155252 140793 154377 150886 159198 145379 152614

Labour Hours 2092 1617 2215 1584 1930 1717 2319 2312 1880 1723 1992 2476 2087 2256 2179 1806 1671 2019 1585 1747 1618

Machine Hours 959 1227 1351 1480 952 986 931 1439 945 869 1171 1228 928 950 1016 902 948 1130 1335 1052 860

Raw Materials 414 623 437 479 678 666 585 479 619 489 445 581 446 688 580 464 610 532 415 517 640

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Chapter 4: Cost–volume–profit (CVP) analysis

159450 160983 175393 153031 166110 150041 170419 169062 157149

2122 1697 2406 1917 1658 2042 1757 1952 1536

1188 1254 1187 948 1015 971 1111 1326 1017

548 425 695 468 660 478 652 619 513

137896 178059

1536 2476

860 1480

414 695

(b)

None of the plots show a definite trend, but the plot for labour hours appears to have the least trend. Based only on the cost plots, labour hours could be deleted as a potential cost driver.

(c)

Costs and potential cost driver data are plotted to determine whether further analysis is necessary. Analysis of the plots involves looking for a linear or football-shaped positive slope or trend. If the observations are widely scattered, the cost driver does not explain the variation in cost; either the driver is wrong or the cost is mostly fixed. Sometimes a cost that is mostly variable. The plots help determine whether regression analysis should be performed using any of the potential drivers.

4.27

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(d)

Labour Hours Regression: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations

0.11279932 0.01272369 -0.02253618 11114.8173 30

Coefficients

Standard Error

t Stat

P-value

150410.682 4.56597156

14812.50852 7.600936029

10.1543 0.600712

6.86E-11 0.552864

Intercept Labour Hours

Only the intercept term is significantly different from zero, so the cost function is estimated as: TC = $150 411 Machine Hours Regression: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations

Intercept Machine Hours

0.612063 0.3746211 0.3522862 8846.1555 30 Standard Coefficients Error

t Stat

P-value

117598.67 38.217192

11.4268 4.095468

4.68E-12 0.000325

10291.47803 9.331580777

Both the intercept and slope coefficients are significant, so the cost function is estimated as: TC = $117 599 + $38.22*Machine hours

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Chapter 4: Cost–volume–profit (CVP) analysis

Raw Materials Regression: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations

Intercept Raw Materials

0.5033241 0.2533351

0.2266685 9665.9786 30 Standard Coefficients Error t Stat P-value 126216.91 10853.56778 11.62907 3.11E-12 60.215128 19.53627459 3.082222 0.004579

Both the intercept and slope coefficients are significant, so the cost function is estimated as: TC = $126 217 + $60.22* Raw materials (e)

Labour hours can be eliminated as a potential driver because its coefficient is not significantly different from zero (see Part D). The coefficients for each of the other potential cost drivers are significantly different from zero, and the adjusted R-Squares from the regressions are: Machine Hours Raw Materials

0.352 0.226

Based on the simple regression results, machine hours appears to do the best job of explaining manufacturing overhead costs; however, this driver explains only 35% of the variation in cost. (f)

Yes, the direct labour hours was not significantly related to manufacturing overhead costs using simple regression.

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2.24 Cost function using multiple regression (appendix 2A) Refer to the data and requirements of Problem 2.23. Required (a) Perform multiple regression using all three cost drivers. Compare the adjusted R-squares and cost functions for the multiple regression with the results of simple regressions for each potential cost driver. (b) Which cost drivers do the best job of explaining manufacturing overhead costs? Explain. (c) Select only the cost drivers that do the best job of explaining manufacturing overhead costs. Perform multiple regression analysis for those cost drivers and write the cost function. (d) Explain why more than one cost driver is plausible for manufacturing overhead costs. (LO5) (a)

Multiple regression with all three potential cost drivers: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations

Intercept Labour Hours Machine Hours Raw Materials

0.9092294 0.8266982 0.8067018 4832.5558 30

Coefficients 60988.489 -0.1959303 48.778501 82.976635

Standard Error 10361.2349 3.333162437 5.291558412 10.10654585

t Stat 5.886218 -0.05878 9.218173 8.210187

P-value 3.3E-06 0.953575 1.12E-09 1.08E-08

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Chapter 4: Cost–volume–profit (CVP) analysis

Comparison of simple and multiple regression results:

Adj. R2 Simple Regressions: Labour Hours

0.022

Machine Hours

0.352

Raw Materials

0.226

Multiple Regression

0.806

Intercept t-stat (p-value) $150,411 (<0.001) $117,599 (<0.001) $126,217 (<0.001) $60,988 (<0,001)

Independent Variables t-stat (pvalue) Labour Machine Raw Hours Hours Materials $4.57 (0.55) $38.22 (<0.001) $-0.20 (0.954)

$48.78 (<0.001)

$60.22 (0.005) $82.98 (<0.001)

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(b)

Labour hours does not appear to be a cost driver when using either simple regression or multiple regression; its coefficient is not significantly different from zero in either regression. Also, its coefficient is negative rather than positive in the multiple regression. Thus, labour hours can be eliminated as a potential cost driver. Both machine hours and raw materials are positive and significantly different from zero when using simple regression and also when using multiple regression. The adjusted R-Square is far higher in the multiple regression (0.806) than in either of the simple regressions (0.352 and 0.226) for these two cost drivers. A combination of cost drivers does a much better job of explaining the variation in manufacturing overhead costs than either cost driver alone.

(c)

Multiple regression using machine hours and raw materials as cost drivers: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations

Intercept Machine Hours Raw Materials

0.90921678 0.82667515 0.81383627 4742.5348 30

Coefficients 60677.5902 48.7422519 82.925842

Standard Error 8743.664851 5.157604083 9.881964042

t Stat 6.939606 9.450561 8.391636

P-value 1.86E-07 4.71E-10 5.29E-09

The cost function is: TC = $60 678 + $48.74×Machine hours + $82.93×Raw materials (d)

Manufacturing can be a complex activity requiring a number of different tasks. Each task includes different activities. Costs for these activities are likely related to specific cost drivers. In this example, machine hours and raw materials explain different activity costs, such as machining work on units, and materials handling for the units. A better understanding of the manufacturing process improves the ability to determine the types and number of cost drivers that can be used in a more complete cost function.

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Chapter 4: Cost–volume–profit (CVP) analysis

2.25 Use of prior year costs; quality of information Software Solutions is a family-owned business that has been in operation for more than 15 years. The board of directors is comprised of mainly family members, plus a few professionals such as an accountant and lawyer. Regina is a staff accountant who has been working on the budget for the last several weeks. The chief financial officer (CFO) needs to present the budget at the next board meeting and wants a preliminary copy in two days. Regina is certain that she will not be able to finish the budget within two days. Several department heads have not turned in their preliminary figures, and two departments have budgeted large increases in fixed costs for replacing computer equipment. Regina knows she should have alerted the CFO about these budgeted increases, but she has not had time. One of her co-workers knows that Regina is behind and suggests that she use last year’s budgets for those departments that have not provided information and also for the departments that increased their budgets by large amounts. The co-worker says that the budget can be straightened out later because the board does not pay attention to the details. Required (a) Is this an ethical dilemma for Regina? Why? (b) Why might it be important for the board of directors to have as much updated information as possible about the budget? (c) What should Regina do, given that not enough time is available to gather high-quality information? Explain your thinking. (LO6) (a)

Regina has at least two choices in this situation. She can tell the CFO that she cannot produce a very accurate budget within two days or she can pull together something that may not be very accurate. She may believe that her reputation as a diligent employee would suffer if she cannot produce something. However, if she submits a budget based on last year’s budget and she knows that this is likely to be inaccurate, her reputation would also suffer. This is a potential ethical dilemma for Regina because the CFO believes that he can rely on Regina’s work when he presents the budget to the board. If Regina uses last period’s budget, the department amounts and total budget may be quite inaccurate, and the CFO will present the board with information that is unreliable. When the budget is complete the board will likely see it again and notice the discrepancies between the preliminary and actual budgets and wonder why the first budget was so inaccurate, and that could reflect negatively on the CFO. More importantly, the board may make inappropriate decisions based on faulty data.

(b)

The board of directors monitors the performance of the CEO and top management. If they have outdated information and inaccurate information, they will draw erroneous conclusions about the performance of the organisation and the top management. They may either praise or criticise top management when the situation may not warrant it. They may also use the inaccurate information to help them approve decisions, such as a business expansion.

(c)

Although the board is not directly involved in day-to-day operations, in their role of oversight, they need the most current information available and explanations for information that is not available. The relationship between the CEO and the

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

board should be one of trust and confidence. If Regina submits unrealistically low budgets this month and then more accurate budgets next month, but with large increases in department costs, the board may begin to lose trust in the CEO’s ability to manage operations. Regina should submit the most current information she has, and use last year’s budgets for departments that have not turned theirs in, with a flag indicating that the information quality is low for the budgets in those departments and an explanation that the budget is currently based on last year’s information.

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Chapter 4: Cost–volume–profit (CVP) analysis

2.26

Scatter plots, cost function using regression, two potential cost drivers Suppose we need to predict the cost of maintenance for Brush Valley High School for the upcoming school year. From the school district records we gather weekly data about costs and volumes for two potential cost drivers: labour hours used in the maintenance department and number of enrolled students.

Required (a)

Identify and explain two potential cost drivers for total maintenance cost, in addition to number of students and maintenance hours worked.

(b)

Create a scatter plot, first for maintenance cost against hours worked and then maintenance cost against students. (c) Would you eliminate either cost driver based on the plots? Explain. (d) Perform regression analysis using each cost driver. Use your judgement to determine the most appropriate cost driver and write out the cost function for maintenance cost. (e) Can we know for certain that the cost driver chosen in part (d) is the best cost driver? Why? (LO5)

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(a)

Other cost drivers for total maintenance cost could be number of rooms cleaned, square feet cleaned, number of hours students attend school, number of hours the building is open, or number of classes and activities per period. Students may have thought of other drivers that could be logically related to cleaning maintenance costs.

(b)

(c)

I would eliminate number of students because there does not seem to be a positive linear relationship between maintenance cost and number of students.

(d)

Regression results for maintenance cost and number of maintenance hours worked: Regression Statistics Multiple R 0.920565237 R Square 0.847440356 Adjusted R Square 0.832184392 Standard Error 1217.06772 Observations 12

Intercept X Variable 1

Standard Coefficients Error t Stat 9134.875134 965.5045837 9.461245 35.74733262 4.796328319 7.453062

P-value 2.63E-06 2.18E-05

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Chapter 4: Cost–volume–profit (CVP) analysis

Regression output for maintenance cost and number of students: Regression Statistics Multiple R 0.247329 R Square 0.061172 Adjusted R Square -0.03271 Standard Error 3019.173 Observations 12

Intercept X Variable 1

Standard Coefficients Error -89867 130954.9 197.0261 244.0857

t Stat -0.68624 0.807201

P-value 0.508157 0.438328

According to the R Square statistics, changes in maintenance hours worked explains more than 80% of the changes in maintenance cost while number of students explains none. Therefore, maintenance hours is a reasonable cost driver. The p-values on the T-statistics are very small, providing high confidence that both the intercept and slope are different from zero. The total cost function is: TC = $9135 + $35.74×maintenance hours worked. (e)

It cannot be known for certain whether the number of maintenance hours is the best cost driver because every single possible cost driver cannot be identified. An unidentified cost driver could have a higher R-Square. However, it is logical to expect a strong relation between hours worked and cost. From the analyses performed, it is rational to conclude that hours worked will provide a reasonable estimate of future costs.

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2.27 Cost function using account analysis and high-low method The Elder Clinic, a not-for-profit entity, provides limited medical services to low-income elderly patients. The manager’s summary report for the past four months of operations is reproduced here.

The clinic receives an operating subsidy from the city, but unfortunately, the operating loss that has been incurred through June $(79 392) is larger than anticipated. Part of the problem is the salary increase that went into effect in June, which had been overlooked when the budget was submitted to the city last year. To compound the problem, the cold winter months traditionally bring with them an increase in cold-related health problems. Thus, the clinic is likely to experience an increase in patient visits during July. The clinic’s managers are considering an increase in patient fees to reduce losses. However, they are reluctant to raise fees because the patients have low incomes. They will raise fees only if it is necessary. Required (a) Use your judgement to classify costs as fixed, variable, or mixed. Explain how you classified each item. (b) Create a cost function for the Elder Clinic. Use the high-low method to estimate the function for any mixed costs. (c) Use the cost function to estimate July expenses based on a projection of 940 patient visits. (d) List reasons why management of the Elder Clinic cannot know with certainty what the expenses will be during July. List as many reasons as you can. (e) Describe the pros and cons of using your cost estimate from part (C) to decide whether to raise patient fees. (f) The managers need your July cost estimate to decide whether to raise patient fees. Use the information you learned from parts (a) and (b) to write a memo to the director of the Elder Clinic presenting your estimate of July costs. Provide the director with appropriate

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Chapter 4: Cost–volume–profit (CVP) analysis

information for understanding your methodology and evaluating the reliability of your cost estimate. (LO3) (a) and (b) Salaries are always fixed, and rent for this type of facility is usually fixed. Utilities cost varies with season not visits, it is considered fixed. The most current value is used to predict next period’s utilities. Medical supplies vary with number of patient-visits; each patient requires a certain number of supplies, such as tongue depressors, gloves, and so on. These would be variable. Some supplies, such as snake anti-venom, must be kept on hand whether or not they are used. These would be fixed. Therefore, medical supplies is a mixed cost. Other expenses appear to increase and decrease with number of patient-visits, but not proportionately. This analysis suggests that there are some of the other expenses are variable costs and some fixed, so this cost is classified as a mixed cost. Category Medical staff salaries* Medical supplies used** Administrative salaries Rent Utilities Other expenses Total Expenses

Fixed $14 115 219 3 412 1 100 226 664 $19 736

Variable

Cost Driver

Mixed

$3.49

Patient-visits

2.58 $6.07

Patient-visits

* The value in June is used for fixed costs because the increase in salaries will hold into the future. **Using high-low, variable cost is $3.49 ($3182 – $2934)/(849 – 778). Use March, high point of medical supplies cost and patient data, to find fixed: $3182 = F + $3.49×849. Use the same method for other expenses. Given the preceding computations and cost summary, the cost function is: TC = $19 736 + $6.07×patient-visits (c)

At 940 patient-visits, July expenses are estimated to be: TC = $19 736 + $6.07×940 = $25 441.80

(d)

There are many possible reasons that could be listed. Here are some of the reasons: • The managers will not know how many visits they will receive, and costs go up as patient-visits increase. Visits are affected by season, weather, current illnesses that are circulating in the area, and so on. Also, other facilities may open or close, affecting the number of visits at this clinic. • Prices of all inputs could change (usually increase). • Treatments and related costs may change as new drugs are available, new equipment is acquired, or there are changes in treatment procedures for certain illnesses.

(e)

There is no one answer to this part.

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2.28 Cost function judgement and methodology Suppose you have the responsibility of creating a cost function for the costs of an Internet service provider’s help line. Required (a) What is the cost object? Identify where you might obtain information about past costs for the cost object. (b) Identify at least two potential cost drivers. Explain where you might obtain information about past volumes for each cost driver. (c) What other information would you like to obtain before estimating the cost function? How might you obtain that information? (d) Identify the techniques introduced in this chapter that you would be most likely to use in creating the cost function. Explain why. (LO2) (a)

The cost object is the help line. Accounting records could be accessed to determine the wage rates and time worked for help support staff and supervisors. Analysis of general ledger entries could be used to determine past costs for phone service, supplies, and other miscellaneous costs. If the help line is housed in its own building, depreciation schedules, prepaid insurance schedules, etc. could be used to identify costs for building and occupancy costs. If the service is housed in a common building, cost allocation records could be used to identify past costs. The choice of information sources depends on how the past cost information is to be used.

(b)

Possible cost drivers include number of calls handled, number of hours worked, number of work stations, number of employees, or total number of Internet customers. Information about number of employees and hours worked is found in the payroll accounting system. Number of calls might have to be tracked by employees or by the telephone system. Number of customers is part of the revenue accounting records. Number of work stations might come from the department head.

(c)

It would be useful to obtain several years of monthly data from which to prepare scatter plots and run regression analysis. This data could be found in the accounting system, or it might need to be estimated if it has not been tracked in the past. Vendors, department heads, and others could be interviewed to identify any potential cost increases or other expected changes in cost behaviour from prior periods.

(d)

If enough data points are available, regression analysis would probably be the best choice. Regression analysis makes use of all data points and is more accurate than two-point methods, assuming a linear cost function. If not, a two point method might be best, with representative points selected from a scatter plot. Alternatively, analysis at the account level could be used to develop a cost function using information from the general ledger.

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Chapter 4: Cost–volume–profit (CVP) analysis

2.29 Adjusting data for use with regression; outlier Smeyer Industries is a large entity with more than 40 departments, each employing 35 to 100 persons. Recent experience suggests that the cost function used to estimate overhead in Department IP-14 is no longer appropriate. The current function was developed three years ago. Since then, a number of changes occurred in the facilities and processes used in Department IP-14. The changes happened one at a time. Each time a change was made, the cost accountant felt the change was not major enough to justify calculating a new overhead cost function. Now it is clear that the cumulative effect of the changes has been large. You have been assigned the task to develop a new cost function for overhead in Department IP-14. Initial analysis suggests that the number of direct labour hours is an appropriate cost driver. Departmental records are available for nine months. The records reveal the following information.

An assistant has analysed the data for March through July and made the appropriate adjustments except for the following items (for which the assistant was unsure of the proper treatment). (i) The semi-annual property tax bill for Department IP-14 was paid on June 30. The entire amount of $3,000 was charged to overhead for June. (ii) The costs to install a new piece of equipment with a life of 10 years in the department were charged to overhead in April. The installation costs were $4,300. (iii) Factory depreciation is allocated to Department IP-14 every month. The department’s share, $8,000, is included in overhead. (iv) A strike closed the plant for three weeks in July. Several non-union employees were kept on payroll during the strike. Their duties were general housekeeping and 'busy work' These costs were charged to overhead. You also have the details for the overhead account for the months of August and September. They are presented in the following table. You were hired on October 1 and have been keeping the department accounts since then. Therefore, you know that the data for October and November are correct, except for any adjustments needed for the preceding items.

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Required (a) Using the information provided, adjust the monthly cost data to more accurately reflect the overhead costs incurred during each month. (b) Discuss whether the data for July should be included in the estimate of future costs. Use a scatter plot to help you answer this question. (c) Develop a cost function by regressing overhead costs in Department IP-14 on direct labour hours. Discuss whether your cost function would be reasonable for estimating future overhead costs. Ignore any items you will discuss in part (d). (d) Identify and discuss any additional adjustments that might be needed to more accurately measure overhead costs for the regression in part (c). (e) Explain why adjustments probably need to be made to information from accounting records when estimating a cost function. (LO5)

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Chapter 4: Cost–volume–profit (CVP) analysis

(a)

Adjustments to more accurately reflect overhead costs incurred: Unadjusted Overhead

Property Tax(a)

Depreciation(b)

Mar Apr

$68 200 71 250

+$500 + 500

May June

68 150 73 500

+$361 + 36 –4300 + 36 + 36

July Aug

38 310 70 790

+ 500 + 500 –3000 + 500 + 500

Sept Oct Nov

80 350 68 750 68 200

+ 500 + 500 + 500

Other

Adjusted Cost

$68 736 67 486 68 686

+ 36 + 36 + 36 + 36 + 36

Payroll3

–10 8502

+$2750 –2750 + 4800 –4800

71 036 41 596 73 376 65 236 69 286 68 736

To predict future overhead, the first month is adjusted even though it is not an actual cost: 4300/10 × 12 = 35.83/mo. (rounded to $36) 2 Note IB-4’s power added to Dept. IP-14 3 Payroll paid every two weeks; 1/2 of August 5 payroll goes to July: 5500 × 1/2 = 2750. Similarly, 80% of September 2 payroll to August: .8 × 6000 = 4800. No adjustments are needed for items (c) and (d); these are correctly handled. The miscellaneous supplies account also looks suspicious, but there is insufficient information to make an adjustment. (b)

Operations in the month of July are not typical of the rest of the time period, as shown in the scatter plot below. If these observations are included in the regression analysis, the trend line is likely to distort costs. Because of the large difference between these values and the values in other months, July’s result is an outlier and should be removed from the data.

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(c)

Here are the regression results: Regression Statistics Multiple R 0.641981 R Square 0.412139 Adjusted R Square Outlier 0.314163 Standard Error 1980.47 Observations 8

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Chapter 4: Cost–volume–profit (CVP) analysis

Intercept X Variable 1

Standard Coefficients Error t Stat P-value 8777.818 29406.26 0.298502 0.775388 6.789722 3.310484 2.050976 0.086126

Based on the t-statistic and p-value for the intercept, the fixed cost does not appear to be different from zero. Therefore, the cost function is estimated as: Overhead cost = $6.79 × direct labour hours This cost function might not provide a very accurate estimate for future costs because the direct labour hours explain only about 31% of the variation in overhead costs (based on the adjusted R-square). Thus, considerable future variation in overhead costs is likely to occur due to factors other than changes in direct labour hours. (d)

According to the details provided for August and September, supplies were a large proportion of overhead cost. Based on the variation in dates at which supplies are recorded, they are most likely recorded at the time of purchase rather than at the time of use. Monthly overhead costs for supplies may be significantly overstated or understated if the amount of supplies inventory varies significantly from month to month. Thus, adjustments could be made to adjust the balance in supplies inventory each month. In addition, there could be seasonal variation in costs such as overtime pay and utilities. If the cost function is for annual costs, this may not be a problem, but if the company would like information about predicted monthly costs, these variations would need to be considered. Additional adjustments include any expected changes in costs from prior periods. For example, power costs could be adjusted upward if utility rates in the future are expected to be higher than in the past.

(e)

Following are three reasons for making adjustments when estimating cost functions. First, the accounting records might not accurately reflect the costs incurred during each time period. The process of preparing financial statements often includes adjustments so that costs are recorded in the correct time period. However, financial statements may be prepared less frequently than data is collected for cost estimation. Second, small adjustments that may be material when estimating a cost might not be sufficiently material to the financial statements for adjustments in the accounting records. Third, sometimes known changes have occurred in prices or cost behaviour. Prior cost data should be adjusted for these changes before the data are used to estimate future costs.

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2.30 Cost function using high-low method Wentworth Ltd sold 100 000 1 litre bottles of mineral water last year at $4 per unit and made a profit of $50 000. This year the costs for Wentworth Ltd remained the same, it sold 120 000 units at the same price, and made a profit of $80 000. Required (a) Determine the total fixed costs per year and the total variable cost per unit for Wentworth Ltd using the high-low method. (b) Write an equation for the cost function based on your answer to (a)

(a) If the profit was $50 000 last year, total costs must have been $350 000: Profit = Sales Revenue – Costs $50 000 = (100 000 x $4) – Costs $50 000 = $400 000 – Costs Costs = $350 000 Given that the profit was $80 000 this year, total costs must have been $400 000: Profit = Sales Revenue – Costs $80 000 = (120 000 x $4) – Costs $80 000 = $480 000 – Costs Costs = $400 000 Variable cost: = Change in cost ÷ Change in the cost driver = ($400 000 - $350 000) ÷ (120 000 – 100 000) = $2.50 If the total costs (TC) in the current year was $400 000, quantity (Q) was 120 000 units, and the variable cost (V) is $2.50 per unit then, using the total cost formula (i.e. TC = F + V x Q), fixed costs (F) can be calculated as follows: $400 000 = F + ($2.50 x 120 000) F = $100 000 (b) TC = F + V x Q TC = $100 000 + $2.50Q

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Chapter 4: Cost–volume–profit (CVP) analysis

2.31 Cost function using high-low method Mernda Health Care Centre recently began to offer day surgery procedures. The Centre was not experienced in the costing of such services and, as a temporary measure, the subsidised patient-day charge was set at $100. This charge was similar to other providers in the region. Management decided to review the charge once cost data was available for the first two months of operations. The following data was collected by the accounting department, together with the number of patient days.

Required (a) Classify each cost as fixed, variable or mixed, using patient days as the cost driver. (b) Use the high-low method to separate mixed costs into their fixed and variable components. (c) The accounting department has estimated that the average patient days per month will be 2000. If the Centre is to be operated as a not-for-profit, how much will it need to charge per patient day? (d) Suppose the Centre averages 2500 patient days per month. How much would need to be charged per patient day for the Centre to cover costs? (e) Explain why the per-patient-day charge decreased in (d) above. (f) Briefly explain the benefit of the classification of costs in the planning for the Centre. (a) Cost category Salaries, nurses Aides Laboratory Pharmacy Depreciation Laundry

Classification Justification Fixed The total cost has not changed despite increase in the number of patient days. Fixed The total cost has not changed despite increase in the number of patient days. Mixed The total cost has increased by 106.82%. This increase does not correlated with the 107.14% increase in patient days. Mixed The total cost has increased by 104.84%. This increase does not correlated with the 107.17% increase in patient days. Fixed The total cost has not changed despite increase in the number of patient days. Variable The total cost has increased by 107.14% in direct proportion

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Administration Fixed Lease (equipment)

Fixed

with the 107.14% increase in the number of patient days. The total cost has not changed despite increase in the number of patient days. The total cost has not changed despite increase in the number of patient days.

(b) As above, the laboratory and pharmacy costs appear to have a mixed-cost behavior. We can combine these two costs and determine the variable and the fixed components as follows: Variable cost: = Change in cost ÷ Change in the cost driver = ($150 000 - $141 000) ÷ (2 250 – 2 100) = $60.00 If the variable cost (V) is $60.00 per unit then, using the total cost formula (i.e. TC = F + V x Q), fixed costs (F) can be calculated as follows: $150 000 = F + ($60.00 x 2 250) F = $15 000

(c) As above, total fixed costs are as follows: Salaries, nurses Aides Laundry and Pharmacy (fixed component) Depreciation Administration Lease (equipment) Total

$6 000 $1 200 $15 000 $11 800 $12 000 $30 000 $76 000

Total variable cost per patient day are as follows: Laboratory and Pharmacy (variable component – as $60.00 per patient day above) Laundry ($16 800 ÷ 2 100 or $18 000 ÷ 2 250) $8.00 per patient day Total $68.00 per patient day Using the basic profit formula (assuming zero profit, given the not-for-profit status of the organisation), if there are 2 000 patient days per month, the following price will need to be charged to cover the fixed and variable costs: Profit = Sales Revenue – Variable Costs – Fixed Costs $0 = (SP x 2 000) – ($68.00 x 2 000) - $76 000 $0 = 2 000 SP – 212 000

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Chapter 4: Cost–volume–profit (CVP) analysis

SP = $106.00 per day (d) Profit = Sales Revenue – Variable Costs – Fixed Costs $0 = (SP x 2 500) – ($68.00 x 2 500) - $76 000 $0 = 2 500 SP – 246 000 SP = $98.40 per day

(e) In requirement (c), there were 2 000 patient days available to cover the fixed costs. In requirement (d), the number of patient days increased by 500 to 2 500. This increases the number of patient days available to spread the fixed costs over. (f)

The classification of the Centre’s costs, distinguishing between the variable, fixed and mixed costs, offers a number of benefits from a planning perspective. A key aspect of planning includes the preparation of budgets which forecast the financial impacts of a Centre’s future plans. Once the costs have been classified and the projected volume is known, the management accountant will be able to forecast the costs with fixed costs remaining constant regardless of the volume, and the variable and mixed costs being adjusted accordingly. Knowledge of the Centre’s cost classification would also critical in the support of the preparation of flexible budgets which explore the sensitivity of the Centre’s costs and other financial results as the assumptions regarding volume are altered.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. Prepared by Rodney Dormer

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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Chapter 4: Cost–volume–profit (CVP) analysis

Chapter 3: A costing framework and cost allocation Questions 3.1

For what purposes do organisations need cost information? (LO1)

Cost information is relevant to organisations in a number of different ways, for example:

• • • •

•

Cost information enables organisations to measure their profitability and meet their financial and taxation reporting obligations. Knowledge of current costs enables organisations to understand their current performance and identify opportunities for improved cost management. Knowledge of the current/expected costs associated with different alternative courses of action supports management decision making. Budgeted costs enable firm’s to predict their future profitability and these predicted costs serve as a target and benchmark against which to compare actual costs. Cost information can inform product and service pricing decisions, with costplus pricing strategies often used. What is a cost object? Give 3 examples. (LO1)

3.2

A cost object is anything for which a separate measurement of cost is desired. Examples include products, services, geographic regions, departments, segments and customers. 3.3

How do organisations identify the costs of a cost object? (LO1) Identifying the cost of a cost object (product, service, customer, department, business unit, etc.) involves a two-step process in which:

• •

Firstly, the direct costs (i.e. those that can be directly linked to a cost object) are traced to the cost object. Secondly¸ the indirect costs or overheads (i.e. those that cannot be directly linked to a cost object and are associated with a number of different cost objects) are allocated to the cost object.

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3.4

Explain the difference between a direct cost and indirect cost. (LO2)

A direct cost can be directly traced to a cost object — a tracking system will enable the direct association. An indirect cost is incurred for the benefit of multiple cost objects and is not economically feasible to directly trace.

3.5 Discuss the importance of selecting an appropriate cost driver for cost allocation. (LO3) A cost driver provides the link between the indirect cost and the cost object. A cost driver should explain the use of resources by the cost object. The selection of an inappropriate cost driver will lead to an incorrect cost allocation and affect decision making which incorporates the allocated cost.

3.6

Explain the differences and similarities among the direct, step-down, and reciprocal methods. (LO4)

Differences: • Direct method ignores all interactions among support departments. • The step-down method takes into account some of the interactions among support departments. • The reciprocal method takes into account all of the interactions among support departments. Similarities: • All of the methods allocate support department costs to operating departments • All of the methods rely on allocation bases to assign costs of support departments to operating departments. • All of the methods result in a total allocated cost per unit • All of the methods use cost pools, and those are usually departments. 3.7

Explain the similarities and differences between support department costs and manufacturing overhead costs. (LO3)

Support department costs are direct costs of the department, but indirect costs when allocated to other departments. Manufacturing overhead is a direct cost of the production process but it becomes an indirect cost when it is allocated to units.

3.8

What should determine the choice of cost allocation method (direct, stepdown and reciprocal) discussed in this chapter?

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Chapter 4: Cost–volume–profit (CVP) analysis

(LO4) Management’s objectives should be the determining factor, tempered by the availability of the data and the cost of performing the allocation. For example, if the primary purpose is cost control, a method that recognises interdepartmental relationships is appropriate. If the firm has a computer and appropriate software, the reciprocal allocation method is preferred. If the primary purpose is product costing and the firm has a manual system, the direct method may be preferred. Following are other factors to consider in choosing an appropriate allocation method: • As the number of cost pools increase, calculations become more complex under the reciprocal method, • When there are four or more support cost pools, software is needed to perform the reciprocal method calculations • The degree of interaction among support departments; fewer interactions result in fewer differences in allocation amounts

3.9

Explain how cost data is sourced in a costing framework. (LO4)

A costing system can be structured based on either actual or budgeted cost data using a match cost driver. Actual Data • Costs would be sourced from general ledger • Cost driver would be based on actual usage and this would require a system to collect this information

Budgeted Data • Costs would be sourced from budgeted information • Cost driver would be based on expected usage

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3.10

Outline the key steps in a costing framework. (LO4)

Key steps in a costing framework: Step 1 Identify cost objects of interest, trace direct costs and determine indirect costs pools and cost drivers Step 2 Determine indirect cost rate for each cost pool Step 3 Allocate indirect costs to the cost objects Step 4 Allocate indirect cost to cost objects Step 5 Determine full costs by totalling indirect costs and direct costs

3.11 What factors should be considered when choosing allocation bases? (LO3) Following are factors to consider in choosing an allocation base: • Costs and benefits of the information gathered • Does one of the bases better reflect the use of the support department's resources? • Will the allocation base be easy to measure and apply? • Are data available for the allocation base? How accurate are the data?

3.12 A product is started in department 1 and completed in department 2. Is department 1 a support department or an operating department? Explain. (LO3) Department 1 is an operating department because it works directly on the firm’s final product.

3.13 Explain the difference between operating departments and support departments. (LO3) Operating departments manufacture goods or produce services that are sold to clients. Support departments interact primarily with operating departments and other support departments, and not with outside customers. Support departments provide operating departments with internal services such as accounting, research and development, and so on.

3.14 What are the advantages and disadvantages of using estimated support cost allocation rates? (LO7) Estimated (budgeted) cost rates provide information for managers to use in budgeting and some of their decision-making. Managers can predict charges as they use the service. In addition, each department’s charges are not affected by other departments’ use of service. A disadvantage of budgeted rates is that user departments have little incentive to use resources efficiently because their charge is already known, and will not change with usage, if it is based on a fixed rate.

3.15

List at least three possible allocation bases that could be used to allocate

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accounting department costs to other departments. Give one advantage and one disadvantage of using each allocation base. (LO7) Accounting department costs could be allocated using number of employees, departmental direct costs, or time spent on activities for individual departments. An advantage of number of employees is that it would be simple to use in calculations. A disadvantage is that it probably does not reflect the use of the department by other departments. An advantage of departmental direct costs is that accounting activities probably increase as direct costs increase, and direct costs are fairly easy to measure. A disadvantage is that there are some accounting activities that do not vary with direct costs. And advantage of time spent on accounting activities for every department is that it probably most accurately reflects the use of accounting by other departments, but it would be hard to track, and there is likely measurement error when time is not recorded as used, but estimated or recorded after the fact.

3.16

Refer to the Partridge Insurance Illustration in the chapter. Explain how the support departments can be classified as both cost objects and cost pools in the costing system. (LO4)

The support departments at Partridge Insurance include: finance, personnel and computer services. Each of these are in the first instance cost objects as they are items for which we wish to accumulate costs (a cost object is anything for which a separate measurement of cost is required). Second, each can be viewed as a cost pool (a group of individual costs accumulated for a particular purpose). In this case the cost pools for finance, personnel and computer services are useful in themselves but are also used to allocate to the three operating departments. 3.17

During a recent management meeting at Sunset Consulting Services, a team member questioned why the costing system had multiple indirect cost pools given it would be easier just to have one. Provide a brief response to explain why the business has adopted multiple indirect costs pools.

The use of a single cost pool would certainly be more straightforward with a single predetermined indirect cost rate being used for all indirect costs. From a reliability perspective, however, this is problematic. This is because different indirect costs are likely to be driven by different cost drivers. In a manufacturing setting, for instance, some costs might be driven by labour hours. Others by machine hours or other factors like the number of defective units or batches. If all of these indirect costs that are driven by different factors are grouped together into a single pool, it could lead to serious cost distortions and poor management decision making.

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Exercises 3.18

Direct and indirect costs Frida’s Tax Practice has two departments, tax and audit. The tax department has two product lines, business returns and individual returns. A list of costs and three cost objects from Frida’s Tax Practice follow.

Required For each cost, identify whether it is direct or indirect for each cost object. (LO2)

Frida’s Tax Practice Cost Object

Cost a. Subscription to personal tax law updates publication b. Ink supplies for tax department photocopy machine c. Portion of total rent for tax department office space d. Wages for tax department administrative assistant e. Tax partner’s salary f. Charges for long distance call to Mr Gruper about personal tax return questions g. Tax partner lunch with Mr Gruper; the tax partner has lunch with each client at least once per year

Tax Departme nt

Personal Returns

Mr Gruper’s Personal Tax Return

(d) & (e) Notice that the wages of the tax department's administrative assistant are considered a direct cost when the cost object is the entire tax department but are considered indirect for the other two cost objects. The benefits of tracking the cost at that level do not exceed the benefits of the information that would be obtained. For the firm to make this cost direct for the personal returns cost object, the administrative assistant would have to maintain detailed time records as to time spent working on personal returns versus corporate returns. Now notice that the tax partner’s salary is considered a direct cost for all three cost objects. CPAs do keep detailed time records. In a service business such as this, the CPA’s time is the product being sold. The time records that the tax partner maintains support this cost as a direct cost. Of course, the tax partner probably spends some time in non-billable activities, so a portion of his or her salary is direct only to the tax department and indirect to the two other cost objects.

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3.19 Direct and indirect costs; fixed, variable, and mixed costs Your sister turned her hobby into a small business called Glazed Over. She is a potter and manufactures and sells bowls that can be used for decoration or for birdbaths. She has one employee who works 40 hours a week no matter how many bowls are made. She has asked your advice in developing a cost function for the bowls so that she can estimate costs for the next period.

Required The following list of costs comes from your sister’s general ledger. Assume the cost object is an individual unit (i.e. bowl). Categorise each cost as direct or indirect (D or I), and as fixed, variable or mixed (F, V or M). (a) Employee wages (b) Clay used to make bowls (c) Depreciation on the kilns (d) Glaze (the finish painted on the bowls) (e) Brushes for the glaze (f) Electricity (g) Business licence (h) Advertising (i) Pottery studio maintenance (cost of weekly cleaning service) (j) Packing materials for the bowls (LO2) [Note about problem complexity: Items F and H are coded as ‘Extend’ because judgment is needed for categorisation.] a.

D or I, F

Assuming that employee time can be traced to each bowl, wages are a direct cost. However, if time is not traced to individual bowls (for example, if the employee performs different types of tasks and records are not kept of the types of work performed) or if the employee does not work directly in production, then wages would be an indirect cost. Wages are fixed because they remain constant (the employee always works 40 hours).

D, V

Assuming that the cost of clay can be traced to each bowl, it is a direct cost. Total clay cost will vary with the number of bowls made.

I, F

Depreciation on the kilns is indirect because it cannot be directly traced to individual bowls, that is, it is a common cost of production for all of the bowls that are heat-treated in the kiln. The cost probably does not depend on production volume (assuming depreciation is not based on units produced), making it a fixed cost. Note: Depreciation using a method such as declining balance is not constant over time, but would still be considered fixed because it does not vary with production volume.

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D or I, V

If the glaze is expensive and therefore a relatively large cost, it is most likely traced to individual bowls, making it a direct and variable cost. If the cost of glaze is very small, it might not be traced to individual bowls, making it an indirect cost. Also, if the cost is small it might be grouped with overhead costs (variable).

I, V or F

Brushes for the glaze are most likely used for multiple bowls, making them a common cost for multiple units and an indirect cost. They might be fixed or variable, depending on whether they are “used up” after a certain quantity of production.

I, F or M

Electricity is an indirect cost because it cannot be traced to individual bowls. It might be fixed or mixed, depending on what causes the cost to vary. If the kiln is electric, part of the cost might vary proportionately with volume.

I, F

The business license is not related to production, making it an indirect cost. It is mostly likely a flat fee or is calculated on a basis unrelated to production volume, making it a fixed cost.

I, F

Advertising is not directly related to production, making it an indirect cost. This cost is also discretionary, so it is treated as fixed.

I, F or M

Pottery studio is an indirect and fixed cost if it is the same payment every week. If it is an hourly charge, it is probably a mixed cost, because the production area may need more cleaning as volumes increase.

D or I, V

Assuming that the cost of packing materials is traced to each bowl, this is a direct cost. If the packing materials are not traced (for example, if the cost is too small to justify tracing them), then this cost could be indirect. Packing costs are most likely variable because they will increase as production increases.

3.20 Cost driver selection

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For each of the following activities undertaken to bake pastries and cakes, identify a suitable cost driver to allocate costs. (a) Mixing ingredients (b) Baking pastries and cakes (c) Decorating cakes (d) Packing pastries and cakes on trays (e) Sales (f) Dispatch to customers (LO3)

(a) (b) (c) (d) (e) (f)

Activity Mixing ingredients Baking pastries and cakes Decorating cakes Packing pastries and cakes on trays Sales Dispatch to customers

Possible cost driver Number of cakes Order size Number of cakes Number of cakes or number of trays Number of orders Order size

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3.21 Direct and indirect costs; and cost driver selection LO2,3 Venture Buses operates throughout the south-eastern suburbs of Melbourne, with its depot located in Cheltenham. Every day, fuel is delivered and stored in tanks located in the depot. This fuel is used by all the buses and administration vehicles. The accountant has been requested to develop a system to assign the cost to the different vehicles in the depot. He has asked your assistance in coming up with a way to identify the fuel costs. Required (a) From the perspective of the depot, is the cost of fuel a direct or indirect cost? (b) From the perspective of the vehicles attached to the depot, can the cost be classified as either direct or indirect? Briefly explain. (c) What system would be required to have the cost classified as direct? (d) If the accountant decided to go with an indirect cost classification, how could the cost be allocated? (e) Identify some factors that would determine which method would be the best for the assignment of fuel costs to the vehicles. (a) The cost of fuel would be classified as a direct cost of the depot. Based a record of how much fuel was delivered to the depot, the cost of fuel can be directly linked to the depot. (b) As above, the cost of fuel would be classified as a direct cost of the vehicles. Based on pump records, the cost of fuel can be directly linked to each bus or vehicle. (c) As above, to trace the cost of fuel to the depot and individual buses and vehicles, the firm would need to have precise records of how much fuel was delivered to the depot and how much was pumped to each bus and vehicle.

(d) If the fuel was treated as an indirect cost, it would need to be allocated to the cost objects (i.e. depot, buses and other vehicles) in the following way: -

The cost of fuel is accumulated in a cost pool. A cost allocation formula would be developed with a cost driver selected (i.e. KMs traveled). The indirect cost rate would be measured (i.e. $0.10 per KM traveled). The cost would be allocated to the cost object by multiplying the indirect cost rate by the cost object’s use of the cost driver.

(e) Identify some factors that would determine which method would be the best for the assignment of fuel costs to the vehicles.

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3.22 Calculation of indirect cost rates Wright Medical Centre has identified the following activities and cost drivers for the coming financial year.

Required Calculate the activity cost rate for each activity. (LO4) Activity

Cost

Patient admission

$600,000 Number of patients Time taken for $5,000,000

Medical Consultation X-Ray Prescriptions

Cost Driver

appointment

$1,500,000 Number of XRays Number of items $700,000 to be dispensed

Total Activity Expected use cost rate of cost driver 10,000 $60 per admission 33 000 hours $151.51 per hour 15,000 x rays $100 per hour 200,000 $3.50 per items item

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3.23 Allocation rates – update question (business name) DataShow’s IT support department budgets its costs at $40 000 per month plus $12 per hour. For November the following were the estimated and actual hours provided by the IT support department to three operating departments.

Required (a) What is the support department’s allocation rate if estimated activity is the allocation base? (b) What is the support department’s allocation rate if actual activity is the allocation base? (c) List one advantage and one disadvantage for each type of allocation rate. (LO6) Allocation Rates

(a) Estimated costs = $40 000 + $12(5 000) = $100 000 Estimated allocation rate = $100 000/5000 hours = $20/hour

(b) Estimated cost at actual output = $40 000 + $12(4 900) = $98 800 Actual rate = $98 800/4900 hours = $20.16/hour

(c) An advantage of using an estimated allocation rate is that managers know in advance what their costs will be. A disadvantage is that there is no incentive to use housekeeping hours wisely because the cost rate is known and will not change during the period. An advantage for using an actual allocation rate is that managers have a better idea about the effects of their use of IT services on costs. A disadvantage is that they do not know their costs ahead of time, and they may have little control over whether the rate is higher or lower than expected.

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3.24 Allocating support costs to units A local hospital is required to account for the total cost of patient care, including support costs. Patients are assigned all direct costs. Support costs are $240 000 per month plus $90 per patient day. This 120-bed hospital averages 80 per cent occupancy. Required (a) Calculate the average daily charge per patient for support costs, assuming 30 days in a month. (b) Briefly comment on potential problems in using only one indirect cost pool for support costs given that individual patients receive a range of different treatments while an inpatient. (a) Allocating Support Costs to Units Monthly occupancy = 120 beds × 0.8 × 30 days = 2880 patient days Monthly costs = $240 000 + $90 × 2880 = $499 200 Average daily charge = $499 200/2880 = $173.33

(b) The use of a single cost pool can be problematic given that there is likely to be a significant variation in the supporting resources required to care for and meet the needs of each patient. Some patients will require more or less supporting services than others.

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3.25 Direct method using estimated costs, benchmarking Devon Ltd allocates support department costs using the direct method and estimated costs. The support department costs are budgeted at $88 000 for department A, $63 000 for department B, and $40 000 for department C. These costs are allocated using the proportion of total cost the firm would pay to an outside service provider.

Required (a) Allocate budgeted support department costs using the direct method, first using labour hours and then with the outside cost proportions as the allocation bases. (b) Could Devon Ltd use the cost of purchasing outside as an efficiency benchmark for the cost of both the support departments and the user departments? List several advantages and disadvantages of this approach. (LO6)

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(a) Direct method allocation using direct labour hours: Support Departments Dept. A Dept. B Dept. C Total

Operating Departments Casting Machining

Allocation Base: Direct labour hours

6,000

4,000

60%

40%

10,000 100% Costs: Direct costs Department A Department B Department C 0 Total allocated cost

$88,000 $191,000 (88,000)

$63,000

$40,000

(40,000)

$ 52,800 37,800 24,000

$35,200 0 25,200 0 16,000

$ 0

$114,600

$76,400

(63,000)

$ 0 $191,000

$ 0

Direct method allocation using costs to purchase outside: Support Departments Dept. A Dept. B Dept. C Total Allocation Bases: Department A outside costs $110,000

Operating Departments Casting Machining

$50,000

$60,000

45.45%

54.55%

$40,000

$30,000

57.14%

42.86%

$20,000

$30,000

40.00%

60.00%

(40,000)

$40,000 36,000 16,000

$48,000 0 27,000 0 24,000

$ 0

$92,000

$99,000

100% Department B outside costs $70,000 100% Department C outside costs $50,000 100% Costs: Direct costs Department A Department B Department C 0 Total allocated cost

$88,000 $191,000 (88,000)

$63,000

$40,000

(63,000)

$ 0 $191,000

$ 0

(b) Devon could use the cost of purchasing outside as a benchmark for both departments, but there are some advantages and disadvantages. Using the direct method, no interactions of support department services are reflected. This might

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understate the cost of services. However, fixed costs are included, and many of these may be sunk costs, for example depreciation expense. These could overstate the support department costs. If the costs for internal and external support services are similar, the cost to purchase outside might provide a good benchmark if it is equal to or less than the cost of internally providing the support. However, if the outside cost is more, incentive exists for increasing both the cost and use of services, which may be inefficient for the company overall. Alternatively, if the outside cost is much less, departments may begin to outsource the services and this duplicates services and may be inefficient for the overall company as well.

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3.26

Costing for a hospital Mercy Hospital uses a costing system for all patients who have surgery. The hospital uses a budgeted overhead rate for allocating overhead to patient stays. In March, the operating room had a budgeted allocation base of 1000 operating hours. The budgeted operating room overhead costs were $66 000.

Patient Dwight Schuller was in the operating room four hours during March. Other costs related to Schuller’s four-hour surgery include:

Physician cost is not included because physicians bill patients separately from the hospital billing system. Required (a) Determine the budgeted (i.e., estimated) overhead rate for the operating room. (b) Determine the total costs of Schuller’s four-hour surgery. (LO5) Mercy Hospital

(a)

Assumption that different types of surgeries are performed therefore it would be necessary to keep the costs of resources consumed by each patient

Estimated Costs $66 000 Estimated allocation base 1000 operating hours Allocation rate = > $66 000/1000 operating hours = $66 per operating hour (b)

Direct Costs: (given in question) Patient medicine $250 Cost of nurses 3500 Cost of supplies 800 Overhead (to be applied based on use of allocation base) 4 hours × $66 264 Total Cost $4814

3.27 Reciprocal method The Brown and Brinkley Brokerage firm is organised into two major sales

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divisions: institutional clients and retail clients. The firm also has two support departments: research and administration. The research department’s costs are allocated to the other departments based on a log of hours spent on tasks for each user. The administration department’s costs are allocated based on the number of employees in each department. Records are available for last period as follows.

Required Using the reciprocal method, determine the total cost of operations for each sales division. Use either simultaneous equations or Excel Solver. (LO5) The Brown and Brinkley Brokerage Manual Calculations using Simultaneous Equations: Support Departments Operating Departments Research Administration Institutional Retail Total Allocation Bases: Research hours

200

500

300

20%

50%

30%

8 32%

10 25 40%

1,000 100% Number of employees 7 28% 100.00% Department costs: Payroll costs Other costs 740,000 Total department costs

$350,000 $1,600,000 230,000

$300,000

$400,000

$550,000

150,000

120,000

240,000

$580,000 $2,340,000

$450,000

$520,000

$790,000

Given the above calculations, create simultaneous equations for the support costs: Research = $580 000 + 28% × Administration Administration = $450 000 + 20% × Research

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Set the two equations equal to each other and solve for the fully allocated cost of one support department: Research = $580 000 + 28% × ($450 000 + 20% × Research) Research = $580 000 + $126 000 + 5.6% × Research 94.4% × Research = $706 000 Research = $706 000/94.4% = $747 881 Then solve for the fully allocated cost of the other support department: Administration = $450 000 + 20% × Research = $450 000 + 20% × $747 881 = $450 000 + $149 576 = $599 576 Finally, allocate the full cost of each support department to all departments: Support Departments Operating Departments Research Administration Institutional Retail Total Allocation Bases: Research hours

200

500

300

20%

50%

30%

8 32%

10 25 40%

1,000

Number of employees

Total department costs Cost allocations: Research Administration 0 Total allocated costs

100% 7 28% 100.00%

$580,000 $2,340,000

$450,000

$ 520,000

(747,881) 167,881

149,576 (599,576)

373,941 191,864

$ 0 $2,340,000

$ 0

$1,085,805

$ 790,000

224,364 0 239,831 $1,254,195

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3.28 Reciprocal method. Paul’s Valley Protection Service has three support departments (S1, S2 and S3) and three operating departments (P1, P2, and P3). The direct costs of each department are $30 000 for S1, $20 000 for S2, and $40 000 for S3. The proportions of service provided by each support department to the others are given in the following table.

Required Using the reciprocal method, allocate the support department costs to the operating departments. (LO6) Paul’s Valley Protection Service Manual Calculations using Simultaneous Equations: Let S1 S2 and S3 represent the full cost of providing each department’s service. The simultaneous equations for support department costs are: S1 = $30 000 + 0.1 × S2 + 0.2 × S3 S2 = $20 000 + 0.4 × S1 + 0.2 × S3 S3 = $40 000 + 0.1 × S1 + 0.2 × S2 Substitute S1 into the equation for S2 and solve for S2: S2 = $20 000 + 0.4($30 000 + 0.1 × S2 + 0.2 × S3) + 0.2 × S3 S2 = $20 000 + $12 000 + 0.04 × S2 + 0.08 × S3 + 0.2 × S3 0.96 × S2 = $32 000 + 0.28 × S3 S2 = $33 333.33 + 0.291667 × S3 Substitute S1 into the equation for S3: S3 = $40 000 + 0.1($30 000 + 0.1 × S2 + 0.2 × S3) + 0.2 × S2 S3 = $40 000 + $3 000 + 0.01 × S2 + 0.02 × S3 + 0.2 × S2 0.98 × S3 = $43 000 + .21 × S2 Substitute S2 into the equation for S3 and solve for S3: 0.98 × S3 = $43 000 + 0.21($33 333.33 + 0.291667 × S3) 0.91875 × S3 = $43 000 + $7 000 S3 = $54 422 Substitute S3 back into the equation for S2 and solve for S3: S2 = $33 333.33 + 0.291667($54 422) = $49 206

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Substitute S2 and S3 back into the equation for S1 and solve for S1: S1 = $30 000 + 0.1($49 206) + 0.2($54 422) = $45 805 Finally support costs are allocated to all of the departments:

S1 S2 S3

Department Costs Cost Allocations: S1 S2 S3 0 Total Allocated Cost

Support Departments S1 S2 S3 Total 40% 10% 100% 10% 20% 100% 20% 20% 100%

Operating Departments P1 P2 P3 20%

20%

10% 50%

10%

40%

10%

$30,000 $90,000

$20,000

$40,000

(45,805) $ 0 49,201 0 10,884

18,322

4,581

$ 9,161

$ 4,581

(49,206)

9,841

24,603

10,884

(54,422)

5,442

21,769

5,442

$ 0

$24,444

$30,930

$34,625

$ 0 $90,000

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3.29 Step-down, direct, and reciprocal methods; accuracy of allocation Software Plus Ltd produces flight and driving simulations and games for personal computers. The company's president has a complaint about the accounting for support department costs. He points to the following table describing the use of various support departments in the company and says, 'According to this table, every department receives services from all the support departments. But I understand that only some of the support departments are bearing costs from the other support departments. Why is that?'

Required (a) What method has Software Plus Ltd been using to allocate support costs? Explain how you know. (b) Which method would ignore all interactions among support departments? Explain. (c) Which method would consider all interactions among support departments? Explain. (d) Allocate the support department costs to Games and Simulations using the step-down method. Explain how you decided which department’s costs to allocate first. (e) Allocate the support department costs using the direct method. (f) Allocate the support department costs using the reciprocal method. (g) In your own words, explain how the step-down method improves upon the direct method. (h) In your own words, explain how the reciprocal method improves upon the step-down method. (LO 6 and 7) (a)

Software Plus has been using the step-down method that reflects half of the support department interactions. The costs of support departments are allocated one at a time. Once the costs of a particular support department are allocated, that department does not receive allocations from the remaining support departments.

(b)

The direct method ignores all of the support department interactions. The costs of all support departments are allocated directly to operating departments. No support department costs are allocated to other support departments.

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(c)

The reciprocal method uses all of the support department interactions. The costs of support departments are allocated simultaneously to each other, and then support department costs are allocated to operating departments.

(d)

The following solution for the step-down method allocates the costs of Information Systems first. This department was chosen because it is largest with respect to direct support department costs. The costs of Information Systems are allocated to the other departments based on the percentages given in the problem. Administration is the next largest support department, so it is allocated second. When reviewing the allocation for Administration, remember that Information Systems is now out of the allocation, so the allocation percentages need to be adjusted. The percentage of Administration service remaining is (100%-50%), or 50%. To allocate Administration’s cost to, divide 10% by 50%, so receives 1/5 or 20% of Administration cost. Also note that the total cost allocated for Administration is $57 500, which is equal to the direct cost of $40 000 plus the $17 500 allocated from Information Systems. Because costs for all other support departments have already been allocated, costs are allocated only to the operating departments. The total cost allocated is $34 000, which is the sum of direct costs ($20 000) plus the costs allocated from Information Systems ($2500) and Administration ($11 500). Support Departments Operating Departments Admin. Maint. Info. Sys. Games Simulation Total

Allocation Percentages: Step 1: Information Systems Step 2: Administration Step 3: Maintenance

Direct Support Costs

20% 100% — 100% — 100%

$40,000 $110,000

Allocations: Step 1: Information Systems 17,500 0 Step 2: Administration (57,500) 0 Step 3: Maintenance 0 0 Total Allocated Costs $ 0 $110,000 (e)

20%

—

40%

20%

10%/50%

—

10%/50%

30%/50%

—

40%/70%

30%/70%

$20,000

$50,000

2,500

(50,000)

20,000

10,000

11,500

34,500

(34,000)

19,429

14,571

$ 0

$50,929

$59,071

When Administration is allocated using the direct method, only the percentages from Games and Simulations departments are used. So, Games receives 10%/(10% + 30%) ,or 1/4 of Administration’s cost, and Simulations receives the remaining 3/4 of cost. For the allocation of 40%/(40% + 30%), or 57.143% goes to Games and the remaining 42.857% goes to Simulations. Information Systems costs are allocated in a similar manner.

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Support Departments Operating Departments Admin. Maint. Info. Sys. Games Simulation Total Allocation Percentages: Administration

10%.40%

30%/40%

40%/70%

30%/70%

40%/60%

20%/60%

100% Maintenance 100% Information Systems 100% Direct Support Costs Allocations: Administration Maintenance Information Systems 0 Total Allocated Costs

(f)

$40,000 $110,000

$20,000

$50,000

(40,000) 0 0 0 0

$10,000

$30,000

(20,000)

11,429

8,571

(50,000)

33,333

16,667

$ 0

$54,762

$55,238

$ 0 $110,000

Below is the solution under the reciprocal method. This solution was obtained using Solver with the following simultaneous equations: Admin = $40 000 + 10%Maint + 50%Info Maint = $20 000 + 20%Admin + 10%Info Info = $50 000 + 35%Admin + 5%Maint Support Departments Operating Departments Admin. Maint. Info. Sys. Games Simulation Total

Use of Services: Administration Maintenance Information Systems

Direct Support Costs Allocations: Administration Maintenance Information Systems 0

— 100% 20% 100% 35% 100%

10%

50%

10%

30%

—

10%

40%

30%

—

40%

20%

$40,000 $110,000

$20,000

$50,000

(78,964) 0 6,507 0 32,457

7,896

39,482

7,896

23,689

(32,533)

3,253

13,013

9,760

4,637

(92,735)

37,094

18,547

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Total Allocated Costs

$ 0 $110,000

$ 0

$58,004

$51,996

(g)

The direct method does not reflect any of the interactions among support departments. The step-down method improves upon this by allocating the costs of each support department to other support departments and operating departments, starting with the department that provides the most service (sometimes measured by the total direct costs assuming that larger departments provide more services to other departments). After each department’s cost is allocated, that department drops out of the allocation scheme, so that not all interactions are reflected, but at least some of them are.

(h)

The reciprocal method improves upon the step-down method by reflecting all of the support department interactions.

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3.30

Direct, step-down, and reciprocal methods; assign costs to departments. Cost information for Lake County Library is as follows.

In addition to directly traceable costs, the library incurred $24,000 for a building lease. Required (a) Allocate to departments any costs that have not been traced, and then calculate total costs assigned to each department.

(b)

Allocate the support department costs to the operating departments using the direct method. (c) Allocate the support department costs to the operating departments Problemusing 3.26: Lake Librarymethod. Allocate first the costs for the support the County step-down department having theSupport largest direct costs. Operating Direct Costs Maintenance Administration Books Other Media Total (d) Allocate the support department costs to the $50,000 operating departments Salaries $20,000 $40,000 $70,000 $180,000 using the reciprocal method. Use either equations or 50,000 Supplies 5,000 5,000 simultaneous 15,000 25,000 Excel Solver. Other Costs Building lease (LO6) Total Costs

(a)

24,000 $254,000

The only cost not already assigned is the building lease cost of $24 000. Either Allocation Base Volumes number of employees or square feet can be used as an allocation base. Square Square feet 500 500 1,200 300 2,500 feet is a more logical base, reflecting the amount of space2 each department Number of employees 1 1 1 5 occupies. For example, the Maintenance department occupies 500/2,500 square Problem 3.26: Lake County20% Library feet, so Lease it is Allocation: allocated of the lease cost. Total costs assigned to each Building department are computed by adding lease costs. Below 100% % square feet 20%direct costs 20%to allocated 48% 12% Support Departments Operating Departments Allocation $4,800 $4,800 $11,520 $2,880 $24,000 is an excerpt from the sample spreadsheet for this problem: Total Assigned Total Assigned Costs Costs

(b)

Maintenance Administration $29,800 $49,800 $29,800 $49,800

Books Other Media $76,520 $97,880 $76,520 $97,880

Total $254,000 $254,000

This problem is very similar to direct method problems illustrated in the chapter. Allocation Base Volumes However, students need to identify that provide services Square feet 500the departments 500 1,200 support300 (administration and support) and 1the operating1 departments Number of employees 2 (books and 1 other media). The solution shown below assumes that maintenance services are allocated using square feet and administration is allocated using number of DIRECT METHOD ALLOCATION employees. Here is an excerpt from the sample spreadsheet for this problem: Support Departments Maintenance Administration

Operating Departments Books Other Media

Total

(c) Under the step-down method, it is necessary to identify the support department that provides the most services. Because Administration is the largest department when comparing support department costs, it will be allocated first. Below is an excerpt from the sample spreadsheet for this problem.

2,500 5

4.76

Number of employees

Total Assigned Costs Allocations: Administration Janitorial Total Allocated Costs

1 25% $29,800 12,450 -42,250 $0

2 50%

1 25%

4 100%

Chapter (CVP) analysis $49,800 4: Cost–volume–profit $76,520 $97,880 $254,000

-49,800 0 $0

24,900 33,800 $135,220

12,450 8,450 $118,780

0 0 $254,000

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(d)

Under the reciprocal method, the simultaneous equations for the support department allocations are developed first. Simultaneous equations: Admin = $49 800 + (500/2 000 square feet) × = $29 800 + (1/4 employees) × Admin Here are calculations for solving the simultaneous equations manually. First substitute the equation into the Admin equation and solve for Admin: Support Departments Departments Admin = $49 800 + (500/2 000) × [$29 800 + Operating (1/4) × Admin] Maintenance Administration Books Other Media Admin = $49 800 + $7450 + 0.0625 Admin Allocation Bases: Admin = $57 250/0.9375 = $61 067 Square feet

500 25%

1,200 300 60% 15% Now substitute Admin into the Maintenance equation and solve Number of employees 1 2 for Janitor: 1 Maintenance = $29 800 + (1/4) × $61 067 = $45 067 25% 50% 25%

Total 2,000 100% 4 100%

Below is an excerpt sample spreadsheet problem. It$97,880 shows the $254,000 Total Assigned Costs from the $29,800 $49,800 for this $76,520 results using Excel Solver to solve the simultaneous equations and allocate the Allocations: Administration 15,267 -61,067 30,533 15,267 0 support department costs. Janitorial Total Allocated Costs

-45,067 $0

11,267 $0

27,040 $134,093

6,760 $119,907

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Chapter 4: Cost–volume–profit (CVP) analysis

3.31 Step-down and reciprocal methods; uncertainties; pricing Kovacik manufactures two types of piggy banks in two different departments: a kangaroo-shaped piggy bank and a platypus-shaped piggy bank. The plant is highly automated and contains only two other departments: (1) engineering and design, and (2) information systems. Kovacik allocates support department costs according to estimated service use. Estimated information for next year is as follows:

Total allocated costs are assigned to individual units using the production volume. Required (a) Determine the estimated total allocated costs for the operating departments using the stepdown method. (b) Determine the estimated total allocated cost per unit of the kangarooshaped piggy bank and the platypus-shaped piggy bank under the stepdown method. (c) Explain why actual total allocated costs will turn out to be different from the estimated total allocated costs. (d) Determine the estimated total allocated costs for the operating departments using the reciprocal method. Use either simultaneous equations or Excel Solver. (e) Determine the estimated total allocated cost per unit of the kangarooshaped piggy bank and the platypus-shaped piggy bank under the reciprocal method. (LO5) (a)

Under the step-down method, the direct costs of Information Systems are allocated first because they are larger than the direct costs for the other support department (Engineering). In the first step, Information Systems costs are allocated to all other departments using the percent of services used as given in the problem. In the second step, the percentages for Engineering and Design must be adjusted to remove the percent of services used by Information Systems. Thus, the percent allocated to the Kangaroo department is 40%/(100%-10%) or 44.444%. The percent allocated to the Platypus Bank department is 50%/(100%10%) or 55.5556%. The total cost allocated in step 2 of $4300 is equal to the Engineering and Design direct costs of $2700 plus $1600 in costs allocated from Information Systems.

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Support Departments Operating Departments Engineering Information and Design Systems Kangaroo Bank Platypus Bank Total

Allocation Bases: Information systems

20% 100%

30%

50%

44.4444%

55.5556%

$8,000

$10,000

$20,000

(8,000) 0

2,400 1,911

4,000 0 2,389

$ 0

$14,311

$26,389

Engineering and design 100% Direct Costs

$2,700 $40,700

Allocations: Step 1: Information systems 1,600 Step 2: Engineering and design (4,300) 0 Total Allocated Costs $ 0 $40,700 (b)

Calculation of estimated total allocated cost per unit using costs calculated under the step-down method: Allocated Cost/Production Volume Kangaroo bank Platypus bank

$14 311/8 000 units $26 389/4 000 units

Allocated Cost Per Unit $1.789 $6.597

(c)

Actual total allocated costs will be different than budgeted total allocated costs because budgets never exactly predict costs or production levels. Production levels change because of unanticipated changes in product demand, unexpected production stoppages, delays in receipt of materials, and so on. There are many reasons for actual costs differing from budgeted costs, such as: • There can be unexpected inflation or deflation in the costs of materials, labour, supplies, etc. • Employment levels fluctuate because employees leave unexpectedly, it takes longer than expected to hire new employees, or management decides to change the number or types of employees. • Unanticipated new types of materials, designs, or technologies can be adopted, altering production costs. • Capacity constraints occur if demand is higher than usual. As organisations near their capacity levels, costs of congestion increase and money may be spent to relax the constraint. • Changes in product design or the manufacturing process affect the amount and cost of materials and labour.

(d)

Under the reciprocal method, the simultaneous equations for the two support departments are: Engineer = $2700 + 20% Info Info = $8000 + 10% Engineer

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Substituting Engineer into the Info equation and solving for Info: Info = $8000 + 10% ($2,700 + 20% Info) 0.98 Info = $8000 + $270 Info = $8439 Substituting Info back into the equation for Engineer: Engineer = $2700 + 20% ($8439) = $4388 The cost allocations are performed as follows: Support Departments Operating Departments Engineering Information and Design Systems Kangaroo Platypus Bank

Bank

40%

50%

30%

50%

Total

Services used: Engineering and design Information systems

Direct Costs Allocations: Engineering and design Information systems 0 Total Allocated Costs

(e)

10% 100% 20% 100% $2,700 $40,700

$8,000

$10,000

$20,000

(4,388) 1,688

439 (8,439)

1,755 2,532

2,194 0 4,219

$ 0 $40,700

$ 0

$14,287

$26,413

Calculation of estimated total allocated cost per unit using costs calculated under the reciprocal method: Allocated Cost/Production Volume Allocated Cost Per Unit Kangaroo bank $14 287/8 000 units $1.786 Platypus bank $26 413/4 000 units $6.603

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Problems 3.32 Categorisation of support costs Suppose a charitable organisation called Food on Wheels provides meals for low-income individuals who are unable to leave their homes. To support its services, it solicits contributions from individuals and businesses. Food on Wheels needs to submit financial statements to its major sponsor. The sponsor requires expenses to be assigned to the following cost pools: administrative, fund-raising, and programs. The bookkeeper for Food on Wheels is a volunteer who is taking accounting classes at the local community college. He knows that all of the costs to prepare and deliver meals should be assigned to the program. However, he is not sure how to assign some of the costs. In particular, he is concerned about the following two items. Costs for printing and mailing a monthly newsletter The newsletter is sent out to donors and clients and asks for donations. It also describes the organisation’s activities, provides information for obtaining meal services, and provides recipes for some of the meals that are served. The director of the organisation wants the cost of the news-letter to be classified as a program cost. She maintains that the program information and recipes should be considered educational material. Not-for-profit organisations typically classify educational materials as program expenses. Director’s salary and benefits The director of Food on Wheels spends much of her time raising funds, meeting with the board of directors, and performing other administrative duties. She also manages the cooks and drivers, purchases food and delivery supplies, and schedules the food deliveries. The director has instructed the bookkeeper to allocate her salary and benefit costs as follows: 50 per cent to the program, 25 per cent to fund-raising, and 25 per cent to administration. Required (a) Identify and discuss uncertainties about how each of the following costs should be classified: (i) Costs to print and mail the newsletter (ii) Director’s salary and benefits (b) Does this situation involve an ethical dilemma for the bookkeeper? Why? (c) Explain why the director has a preference for costs to be assigned to program expenses. (d) Explain how you think sponsors would prefer for the costs in part (a) to be assigned. (e) Suppose you are reviewing cost information for another organisation. Would you expect the organisation’s program costs to be biased upward, biased downward, or to be unbiased? Explain. (f) How would you classify the costs in part (a) if you were the

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bookkeeper for Food on Wheels? Explain your reasoning. (a)

(LO2 and 7) Uncertainties in cost classification: (i) The newsletter costs have no clear classification because the function of the newsletter seems to be partly fundraising and partly educational. Perhaps the cost should be allocated between fundraising and program. However, it might not be possible to identify an appropriate allocation base to separate these activities. Also, it could be argued that providing recipes is not educational. However, the recipes are most likely designed to save costs and to be nutritious, which would support their classification as educational. In addition, classification as “educational” does not necessarily mean that the newsletter is a program activity. On the one hand, knowledge about the needs of lowincome individuals is probably conveyed through the newsletter. Educating the public and promoting greater awareness can be important program goals for a charitable organisation. It can also be important for the public to learn about the activities of charitable organisations. On the other hand, the newsletter probably provides little, if any, direct benefit to the target of its charitable mission—low-income individuals who are unable to leave their homes. (ii) Classification of the director’s salary and benefits is uncertain because the proportion of cost is unknown that relates to fundraising activities, to administration, or to program activities. Even if detailed information were available about the time the director spends on various activities, there would still be uncertainty about whether to use time spent to assign her salary and benefits. An alternative might be to identify the proportion of ‘value’ she devotes to various activities. In addition, some of the director’s activities probably relate to more than one cost category. For example, her time at a board of director’s meeting might be considered administrative. However, the board probably discusses program issues such as whether to hire a new cook or to purchase a new delivery vehicle. She might also persuade board members to donate money while at a meeting.

(b)

This situation involves an ethical dilemma for the bookkeeper, who must decide how to assign costs. It also involves an ethical dilemma for the director, who is responsible for the financial statements. Both of these individuals have a responsibility to the organisation, to individuals who receive the organisation’s services, and to donors and other parties who rely on its financial statements. This situation involves a possible conflict of interest among interested parties, and requires the bookkeeper and director to apply judgment, along with personal and organisational values, in deciding what to do.

(c)

The director probably prefers to classify costs as related to the program cost pool. A larger proportion of program costs makes the organisation look more efficient in its use of resources, and also gives the appearance of appropriate effort from management.

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(d)

Donors would prefer costs to be assigned in an unbiased way—program costs should include the resources used for program purposes, fundraising costs should include resources used for raising money, and administrative costs should include resources used for general management of the organisation. However, as discussed in Part A above, there are many uncertainties about classification. Therefore, it is also not clear how the donors would prefer to see these costs classified.

(e)

Because of the incentives discussed in C above, costs are likely to be classified in the program cost pool when (1) the classification is uncertain and (2) a reasonable argument can be made for classification as program. This creates a bias in favour of classifying costs as program. Accordingly, program costs on average are likely to be overstated.

(f)

This is an open-ended problem, so there is no single solution. It is possible to argue for different types of allocations. The best solutions: (1) take into account uncertainties about how the costs should be classified, and (2) are designed to create an unbiased classification of costs (i.e., to avoid misleading donors and others).

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3.33 Step-down and reciprocal methods; choosing methods; cost pools; uncertainties Your brother is a physician and has decided to start a home health care agency. The government will reimburse treatment costs for about half of the patients under a new government-sponsored health insurance program for low-income residents. Your brother has asked you to explain the cost report that the government requires. He tells you that he can use either the stepdown or the reciprocal allocation method. He has several choices in allocation bases, but has little choice in the type of cost pools that are allowed. Required (a) Explain to your brother the differences in the two allocation methods. Remember that your brother is not familiar with accounting, use language he will understand. (b) Your brother wants to know how to choose the best allocation method and bases for his business. List some of the factors your brother should consider as he makes these decisions. (c) One of the cost pools allowed by the government is a pool for transportation-related costs. Your brother asked colleagues at other home health care agencies to list the costs they include in this pool. Each organisation has some costs that are identical, such as depreciation on vehicles, gas, and repairs. However, other costs in the pool are different; some agencies include facilities-related costs, and others do not. Why would cost pools for the same activity include different types of cost? (LO3) (a)

Both methods are appropriate for allocating support department costs to health program departments. The step-down method ranks support departments in order of service provided and then allocates their costs to other departments according to a cascading method. The support department providing most services is allocated first to all other departments, and is then dropped from the allocation process. Next, the support department providing the second-most services is allocated to the remaining departments, and then it drops out, and so on until all support department costs are allocated. Therefore, this method partially takes into account the fact that the support departments provide services for each other. The reciprocal method uses simultaneous equations to reflect all of the services provided among the support departments. Therefore, the reciprocal method more accurately measures support department costs before those costs are allocated to the health program departments.

(b)

Here are some factors that the physician should consider to choose the best allocation method and best allocation bases. Choosing the allocation method: If you only have a few support activities, the two methods are likely to produce similar allocations. However, the step-down method is easier to calculate and understand, so you may prefer that method. Alternatively, if there are a number of support departments, you will want to use the reciprocal method because it more accurately measures the cost of support

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services. You can either purchase software for these allocations, or I can set up a spreadsheet and show you how to use it. Choosing an allocation base: An allocation base is some measure of activity that is used to determine the amount of a support department’s cost that is allocated to each of the other departments. Ideally, you would like to choose allocation bases that are also cost drivers, that is, they cause costs to vary. For example, the number of patients would be a good allocation base for the cost of medical records because costs such as supplies and employee time are likely to vary with the number of patients. Square footage might be a good allocation base for the cost of maintenance services because those costs might vary with the square feet of space that is cleaned. If you choose cost drivers for allocation bases, the resulting allocations do a better job of measuring the use of resources. Give some thought to what might cause costs to change when you choose allocation bases for each cost pool. (c)

The types of costs in a cost pool depend on the size and structure of the organisation and also the manner of service provision. Some organisations may own no vehicles and incur costs only for renting and operating vehicles. Other organisations may have a large motor pool that requires a manager and several employees to maintain the vehicles.

3.34 Cost pools and allocation bases. You are an accountant for the Department of Defence. The government is considering a change of rules for the allocation of research and development costs. The government is asking contractors to submit a list of potential cost pools and allocation bases for activities within research and development. The government wants contractors to separate their research and development activities into several smaller cost pools with separate allocation bases.

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Your research department performs a variety of different duties, including developing new designs for products, developing and testing new materials for use in these products, designing the manufacturing processes for new products, and redesigning old products and their manufacturing processes. In addition, the research and development department creates commercial uses for new technology that have been developed under government contracts. Required (a) List at least four potential research and development activities that could be used as the basis for separate cost pools within the research and development department. (b) List two or more potential cost allocation bases for each cost pool listed in part (a). (c) List factors that you might consider in making a choice about the cost pools and the allocation bases. (LO3) (a)

Examples include: new product design, design of the manufacturing process, product re-design, and product testing.

(b)

Possible allocation bases: • New product design: number of new products, labour hours • Design of manufacturing process: labour hours, number of designs • Product redesign: number of engineering change orders • Product testing: number of hours in testing, number of products tested

(c)

Factors to consider in choosing cost pools and allocation bases: • The cost and benefit tradeoffs for collecting information. • Whether cost can be measured accurately for each pool. • Whether the activity uses as an allocation base that can be measured accurately. • Whether the activity uses as an allocation base that reflects the flow of resources used, at least partially.

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3.35 Step-down method; choosing allocation order and bases Space Products manufactures commercial and military satellites. Under its government contracts, the company is permitted to allocate administrative and other costs to its military division. These costs are then reimbursed by the government department. Government guidelines allow administrative costs to be allocated using either the direct costs incurred in the operating divisions or the number of employees as an allocation base. Management information systems (MIS) costs can be allocated either on the basis of direct costs incurred in the operating divisions or on the basis of CPUs (a measure of computer resources used). Data concerning the company’s operations appear here.

The MIS department is responsible for computer equipment and systems, and it maintains databases for the entire organisation. Required (a) Suppose Space Products uses the step-down method for allocating support department costs. Administrative costs are allocated first on the basis of the number of employees, and then MIS costs are allocated on the basis of CPUs. How much support department cost will be allocated to the military division? (b) Space Products produced 100 military satellites in the period considered in this problem. Assuming the company uses the allocations calculated in part (a), what is the average cost per military satellite? (c) Is the average cost that you calculated in part (b) most likely an underestimate, overestimate, or unbiased estimate of the incremental cost of producing one more military satellite? Explain. (d) Suppose Space Products uses the direct method of allocating support department costs. What is the maximum amount of support department cost that can be allocated to the military division under the government rules? (e) Suppose the management of Space Products always calculates its support department cost allocations to maximise the amount of contribution received from the government. Management selects this policy because it allows the company to be more competitive in its commercial markets. (i)Discuss possible reasons why the government does not specify a single, unambiguous support cost allocation method. (ii)From a taxpayer’s point of view, discuss whether you would agree with Space Product’s policy. (iii)From a competitor’s point of view, discuss whether you would agree

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with Space Product’s policy. (a)

(LO6) Step-down method allocation: Administrative MIS Military $ 600,000 $ 200,000 $4,000,000

Direct costs

Allocation of Administrative Costs: Number of Employees Percent Cost (600,000) 300,000 Allocation of MIS Costs: CPUs Percent Cost 182,000 Total Allocated Cost

$ 0 $4,482,000

Commercial $2,000,000

10 10% 60,000

40 50 40% 50% 240,000

$(260,000)

30 70 30% 70% 78,000

$ 0

$2,318,000

Support dept costs allocated to Military: Total allocated cost less direct cost $4 482 000 – $4 000 000 = $482 000 (b)

Average Cost Per Military Satellite = Total allocated cost ÷ Number of satellites produced = $4 482 000 ÷ 100 = $44 820

(c)

The average cost is most likely an overstatement of incremental cost. The average cost includes fixed costs which do not vary with the level of production (in the short run).

(d)

Direct method allocation; Maximum support costs allocated to military DOD allocation bases for Administrative: Commercial Direct costs $2,000,000 (33%) (67%) Employees 40 (44%) (56%)

Military $4,000,000 50

More administrative costs would be allocated to Military if direct costs were used as the allocation base (because 67% is greater than 56%).

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DOD allocation bases for MIS: Direct costs CPUs

Commercial $2,000,000 (33%) (67%) 30 (30%) (70%)

Military $4,000,000 70

In this case, CPUs would maximise the cost allocated to the Military division. Allocations: Administrative (based on direct costs) MIS (based on CPUs) Total Allocated Support Costs (e)

Commercial Military $200,000 $400,000 $ 60,000 $ 140,000 $260,000 $540,000

Policy to Maximise DOD Contribution (i) The DOD does not mandate a single allocation method because different defence contractors are organised differently and have different types of costs. In addition, there is always discretion because there are uncertainties in defining cost pools, assigning costs to cost pools, and specifying allocation bases. It would be impossible to prescribe a single allocation method that would accurately measure support costs on defence contracts and that would be fair to all contractors.

(ii)

As a taxpayer, I would prefer that the cost be allocated in a manner that fairly represents the amount of overhead used by military projects. I would prefer not to subsidise the overhead costs of a private corporation.

(iii)

As a competitor, I would prefer that the cost be allocated in such a manner that the contractor did not have an unfair competitive advantage. The government should pay its fair share, but no more. I would like to see some benchmark information about the amount of internal support department cost per job for commercial versus government contracts.

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3.36 Direct, step-down and reciprocal methods using dual rate and three departments In comprehensive example 6 (Middletown Children’s Clinic), we did not perform direct or step-down methods for the dual-rate costs. Following are the allocation bases for these costs. The support cost data are in comprehensive example 6.

Required (a) Draw a diagram of the direct method for the Middletown Children’s Clinic allocations using three support departments. (b) Allocate the support department costs using dual rates and the direct method. (c) Draw a diagram of the step-down method using the three support departments. (d) Allocate the support department costs using dual rates and the stepdown method. (e) Write out the simultaneous equations for the reciprocal allocation. (f) Set up a spreadsheet that uses Excel Solver to solve the simultaneous equations and then allocates support costs using dual rates and the reciprocal method. Check to see that your solution matches the solution in the text. (LO4 and 6)

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(a)

Following is a diagram of the direct method allocation for Middletown Children’s Clinic.

Support Departments

Operating Departments

Units Medical Patient Visits

Administration Medical Department Cost Pool Accounting

Housekeeping

(b)

Dental Patient Visits

Dental Department Cost Pool

Following is the dual-rate, direct method allocation for Middletown Children’s Clinic. Support Departments Administration Accounting Housekeeping Total

Operating Departments Medical Dental

Allocation Bases: Variable and fixed administration costs: Number of employees

3 8

62.5000%

37.5000%

(50%/75%) 67%

(25%/75%) 33%

(55%/85%) 65%

(30%/85%) 35%

8,000

1,000

88.8889%

11.1111%

100% Variable and fixed accounting costs: Time spent accounting

100% Variable housekeeping costs: Time spent cleaning

100% Fixed housekeeping costs: Square feet

9,000 100%

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Cost Allocations: Direct support costs

$61,400 $158,600 Allocate administration: Variable (11,052) Fixed (50,348) Allocate accounting: Variable Fixed Allocate housekeeping: Variable Fixed 0 Total Support Allocations $ 0 $158,600

(c)

$36,840

$60,360

$ 6,908 31,468

$ 4,145 0 18,881 0

6,140 18,420

3,070 0 9,210 0

(30,180) (30,180)

19,528 26,827

10,652 0 3,353

$ 0

$109,290

(9,210) (27,630)

$ 0

$49,310

Following is a diagram of the step-down method allocation for Middletown Children’s Clinic.

Step 1 Allocation: Other Support Departments: Administration

Accounting Housekeepin g Operating Departments Medical Department Cost Pool Dental Department Cost Pool

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Step 2 Allocation: Other Support Department: Accounting Administration

Operating Departments: Medical Department Cost Pool Dental Department Cost Pool

Step 3 Allocation: Operating Departments:

Accounting

Medical Patient Visits

Medical Department Cost Pool

Dental Patient Visits

Dental Department Cost Pool

(d)

When performing dual-rate allocations under the step-down method, it is necessary to decide whether to rank supports based on their total services performed, or to rank them separately for fixed and variable support services. Solutions for both approaches are shown below. (Differences in addition are due to rounding.)

Approach #1: Rank support departments based on total services (fixed and variable costs) Under this approach, Administration costs are allocated first because its total direct costs are greater than the other two support departments. Housekeeping is allocated second, and Accounting is allocated third.

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Support Departments Administration Housekeeping Accounting Total

Operating Departments Medical Dental

Allocation Bases: Variable and fixed administration costs: Number of employees 2 18.1818% 100% Variable housekeeping costs: Time spent cleaning

1 9.0909%

5 45.4545%

3 11 27.2727%

(5%/90%) 5.5556%

(55%/90%) 61.1111%

(30%/90%) 33.3333%

300

8,000

1,000

3.2258%

86.0215%

10.7527%

50%/75% 66.6667%

25%/75% 33.3333%

100% Fixed housekeeping costs: Square feet 9,300 100% Variable and fixed accounting costs: Time spent accounting 100%

Cost Allocations: Direct support costs

$61,400 $158,600

Step 1: Administration Variable (11,052) Fixed (50,348) Step 2: Housekeeping Variable Fixed Step 3: Accounting Variable Fixed 0 Total Support Allocations $ 0 $158,600

$36,840

$60,360

2,009 9,154

1,005 4,577

$ 5,024 22,885

$ 3,014 0 13,731 0

(32,189) (39,334)

1,788 1,269

19,671 33,836

10,730 0 4,229 0

(12,003) (33,476)

8,002 22,317

4,001 0 11,159

$ 0

$111,736

$ 0

$46,864

Approach #2: Rank support departments separately for fixed and variable cost allocations For variable support costs under this approach, Housekeeping costs are allocated first because its direct variable costs are greater than the other two support departments.

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Administration is allocated second, and Accounting is allocated third. For fixed support costs, Administration is allocated first, Housekeeping second, and Accounting third. Support Departments Administration Housekeeping Accounting Total

Operating Departments Medical Dental

Variable Support Allocation Bases: Variable housekeeping costs: Time spent cleaning 10% 100% Variable administration costs: Number of employees

55%

30%

1 11.1111%

5 55.5556%

3 9 33.3333%

50%/75% 66.6667%

25%/75% 33.3333%

1 9.0909%

5 45.4545%

3 11 27.2727%

300

8,000

1,000

3.2258%

86.0215%

10.7527%

50%/75% 66.6667%

25%/75% 33.3333%

100% Variable accounting costs: Time spent accounting 100%

Fixed Support Allocation Bases: Fixed administration costs: Number of employees

2 18.1818% 100%

Fixed housekeeping costs: Square feet 9,300 100% Fixed accounting costs: Time spent accounting 100%

Variable Cost Allocations: Variable support costs $11,052 50,442 Step 1: Housekeeping 3,018 Step 2: Administration (14,070) Step 3: Accounting 0 Total Variable 0 50,442

$30,180

$ 9,210

(30,180)

1,509 1,563 (12,282)

$ 16,599 7,817 8,188

$ 9,054 0 4,690 0 4,094

32,604

17,838

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Fixed Cost Allocations: Fixed support costs Step 1: Administration Step 2: Housekeeping Step 3: Accounting 0 Total Fixed 108,158

$50,348 108,158 (50,348)

$30,180

$27,630

9,154 (39,334)

4,577 1,269 (33,476)

22,885 33,836 22,317

13,731 0 4,229 0 11,159

79,038

29,119

RECIPROCAL ALLOCATIONS FOR VARIABLE SUPPORT COSTS Support Departments Operating Departments Total Allocations $Administration 0 $ Accounting 0 $Housekeeping 0 $111,642 $46,958 Medical Dental $158,600 Allocation Bases: Variable and fixed administration costs: Number of employees 1 2 5for the 3 (e) The dual-rate method requires two sets of simultaneous equations 9.0909% 18.1818% 45.4545% 27.2727% reciprocal allocations. Variable and fixed accounting costs: RECIPROCAL ALLOCATIONS FOR FIXED Time spent accounting 15% SUPPORT COSTS 10% 50% 25% Support Departments(Note: These Operating Departments Variable support cost simultaneous equations equations were Accounting Housekeeping Medical Dental Variable housekeeping costs: Administration shown inBases: the textbook on page 313): Allocation Time spent cleaning 10% 5% 55% 30% Administration = $11costs: 052 + 15%*Accounting + 10%*Housekeeping Variable and fixed administration Number employees 1 2 5 3 Accounting = $9210 + (1/11)*Administration + 5%*Housekeeping Solver for of Variable Costs 9.0909% 18.1818% 45.4545% 27.2727% Account House Housekeeping = $30Admin 180 + (2/11)*Administration + 10%*Accounting Variable and for fixed accounting costs: $16,354 Change cells Solver $12,416 $34,395 Time spent accounting 15% 10% 50% 25% Fixed support cost simultaneous Simultaneous equations $16,354 equations: $12,416 $34,395 FixedAdministration housekeeping costs: = $50 348 + (600/9 900)*Housekeeping + 15% * Accounting Square feet 600 300 8,000 1,000 Target function: Accounting = $27 630 + (1/11)*Administration + 300/9 900)*Housekeeping 6.0606% 3.0303% 80.8081% 10.1010% $63,166

Housekeeping = $30 180 + (2/11)*Administration + 10%*Accounting

Solver for Fixed Costs

(f)

Support Departments

3,440 $0

1,720 $0

11 100% 100% Total 100% 11 100% 100%

9,900 100%

Operating Departments

Admin Account House Below is an excerpt from the sample spreadsheet for this problem, Administration Accounting Housekeeping Medical showing Dental the Change cellssupport for Costs Solver cost allocation $58,164 $34,256 Varible Support $11,052under the $9,210 $30,180 variable reciprocal$44,181 method. Except for minor Variable Support Allocations: rounding differences, these$58,164 allocations $34,256 agree with those shown$7,434 in Figure $4,460 3.12, Simultaneous equations $44,181 Administration (16,354) 1,487 2,973 textbook page 390. Accounting 1,862 (12,416) 1,242 6,208 3,104 Target function: Housekeeping $136,602 Total Variable Allocations

Total

(34,395) $0

Support Departments

18,917 $32,559

10,319 $17,883

Total $50,442 0 0 0 $50,442

Operating Departments

Below is an excerpt from the sample spreadsheet for this problem, Administration Accounting Housekeeping Medical showing Dental the Total Fixed Support Costs cost allocation $50,348 $27,630 fixed support under the reciprocal$30,180 method. Except for minor $108,158 Fixed Support Allocations: rounding differences, these(58,164) allocations agree with those shown in Figure15,863 3.12, Administration 5,288 10,575 26,438 0 textbook page 390. Accounting 5,138 (34,256) 3,426 17,128 8,564 0 Housekeeping Total Fixed Allocations

2,678 ($0)

1,339 $0

(44,181) $0

35,702 $79,268

4,463 $28,890

Here is a summary of the reciprocal method variable and fixed support cost allocations to the operating departments:

Variable support costs Fixed support costs Total allocation

Operating Departments Medical Dental $ 32 559 $17 883 79 268 28 890 $111 827 $46 773

Total $ 50 442 108 158 $158 600

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3.37 Total cost under alternative allocation bases; special order price Danish Hospital recently installed a RAP Scanner, which is a diagnostic tool used both in suspected cancer cases and for detecting certain birth defects while the foetus is still in the womb. The scanner is leased for $5000 per month, and a full-time operator is paid $3000 per month. Data concerning use of the scanner for a typical month follow.

The direct costs consist primarily of supplies that are consumed in the scanning process. Currently, less than 20 per cent of the machine’s capacity is used. Required The following questions will help you analyse the information for this problem. (a) If the lease cost and the operator salary are allocated on the basis of minutes on the scanner, what is the total cost of a cancer scan? (b) Suppose the cancer scans are experimental. Rather than charging $600 per scan, the hospital costs are reimbursed under a national contract. The contract will reimburse direct costs as well as an allocated share of the lease cost and operator’s salary. As an allocation base, the contract allows either the number of scans or total minutes on the machine. What is the maximum reimbursable cost per cancer scan? (c) The hospital is bidding on a government contract to supply birth defect scans to indigent pregnant women. The hospital would provide up to 14 scans a month for a fixed fee per scan. Assuming the hospital does not want to lose money on this contract, what is the minimum acceptable fee? Explain how you decided which costs are relevant. (d) Identify uncertainties about which costs should be included in bidding for the contract described in part (c). (e) Discuss the pros and cons of using total allocated costs, including administrative overhead, in bidding for the contract described in part (c). (f) Suppose the hospital is bidding on the contract described in part (c). You have been asked to prepare a report of the hospital’s expected costs for the contract. Write a memo to the chief accountant recommending the costs you think should be included in the expected costs. Attach to the memo a schedule showing your computations. As appropriate, refer

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Chapter 4: Cost–volume–profit (CVP) analysis

to the schedule in the memo. (LO5) (a) The fixed costs should be allocated based on total activity during the period, which in this case is a month. If minutes are used as an allocation base, this means that total minutes per month must first be estimated.

Minutes per scan Times number of scans per month Total minutes per month Percent of Combined Minutes

Cancer 30 min 20 scans 600 minutes 60%

Birth Defects 10 min 40 scans 400 minutes 40%

Using total minutes per month as the allocation base, the cost allocations and cost per scan are calculated as follows: Cancer Birth Defects Lease $3000 $2000 Operator salary 1800 1200 Total allocated cost $4800 $3200 Divided by number of scans Allocated cost per scan Add direct costs per scan Total assigned cost per scan

20 scans

40 scans

$240 100 $340

$ 80 50 $130

Note: Caution should be exercised in interpreting the $340 as ‘the cost of a cancer scan’. It is the average cost, including allocated fixed costs. This cost does not represent the incremental cost of a cancer scan. (b)

Following is a comparison of the percent of costs that would be allocated to each type of scan under each of the allowed allocation bases:

Number of scans Minutes

Cancer 20 (33%) 600 (60%)

Birth Defects 40 (67%) 400 (40%)

The percent of costs allocated to cancer scans would be higher using minutes as an allocation base (60% of allocated costs, compared to only 33% using number of scans). Thus, the maximum reimbursement would be achieved using minutes as the allocation base. As computed in part A, this means that the maximum reimbursement would be $340 per scan. (c)

Since there is ample idle capacity, the total amount of fixed costs would probably not be affected if the hospital receives the contract. The direct costs are primarily for supplies that are consumed with each scan, so these costs are probably variable. The relevant costs for this decision are the costs that Danish would charge under the contract. In this situation, incremental costs consist only of the direct costs. As long as the fee at least covers the direct cost per scan of $50, the hospital is not expected to lose money and more patients will be served.

(d)

The minimum acceptable fixed fee is the fee that would cover the hospital’s incremental costs, as discussed in Part C. The calculation in Part C assumed

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that no fixed costs would change based on the government contract. However, the hospital managers cannot be certain that fixed costs would be unaffected by the contract. For example, demand for the machine is uncertain. More paying patients might need the machine, leading to a capacity constraint. In that case, the contract would cause the hospital to forego providing services to other patients (an opportunity cost). Even if no capacity constraint occurs, the hospital managers might want the government contract to cover some of its fixed costs. In that case, the managers would need to decide which fixed costs to include in the bid calculations. They cannot be certain which fixed costs to include because the inclusion of more costs would increase the bid price and reduce the likelihood of obtaining the contract. (e)

Possible arguments to discuss in favour of using total allocated costs: • The organisation calculates them for other reports, so the information is readily available. • Because the information is available, the cost of providing reports for the state will be low if the hospital wins the contract. • By incorporating overhead costs into the bid, the hospital can recover some of those costs. • This cost measure approximates the complete cost of providing scan services, at the predicted volume levels • It is not fair to require other hospital services to pay for support that is necessary for the scan services. Possible arguments against using total allocated costs: • It is not necessary to cover all costs; support costs such as administration are covered by the hospital’s primary activities • Part of the hospital’s mission is to serve indigent individuals; it is unfair to use a cost measure that might reduce the availability of services to those in need. • The hospital might lose the contract if it uses total allocated costs; another hospital could submit a lower cost bid. • The total allocated cost changes as volumes change. If the number of indigent patients varies widely from period to period, this cost can underestimate or overestimate the hospital’s actual costs by large amounts. Factors such as economic changes and occasional flu epidemics that are worse than usual will affect volumes of indigent patients using services.

(f)

This is an open-ended problem, so there is no single solution. It is possible to reasonably argue for several different types of cost to be included or excluded. The best solutions to this question provide: (1) a clear recommendation for the cost report, (2) reasonable arguments for the recommendation, (3) evidence of having considered multiple cost measures, (4) evidence of having considered major issues, and (5) support for the hospital’s interests while also considering interests of other stakeholders, such as the state, taxpayers, and service recipients. In addition, the memo should follow proper formatting and conventions. It should be concise, but at the same time provide sufficient information for the reader to evaluate the quality of the recommendation and to draw his or her own conclusions. In this scenario, the memo can use technical accounting jargon because the hypothetical reader is the head of the accounting department. However, if the memo were written to a non-accountant, technical jargon should be avoided.

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3.38 Step-down method; multiple versus single pool allocations; manager incentives. The Gleason Company, a division of a large international company, has prepared estimated costs for next year that can be traced to each department as follows.

Management would like to know the estimated total allocated product cost per unit. These costs will be used as a benchmark for future period operations. The following information is available and can be used as possible allocation bases. The difference between direct labour hours and total labour hours represents hours of supervisory labour or labour hours that are used indirectly for manufacturing. The cost of these hours in machining and assembly is part of manufacturing overhead.

Required (a) Allocate the building and grounds costs to all other departments using square metres. Add the allocated costs to direct costs to arrive at the total costs assigned to each department. (b) Explain whether each remaining department is a support or operating department. (c) Select a reasonable allocation base for the costs of each support department. Justify your choices. (d) Compute allocated overhead costs for each operating department. Given the allocation bases you selected in part (b), allocate support department costs to each operating department using the step-down method. Then calculate an overhead rate per direct labour hour for each operating department. (e) Calculate overhead rates for the operating departments assuming that Gleason uses an average, plant-wide factory overhead allocation rate based on direct labour hours. That is, aggregate the support department overhead costs into one cost pool and use direct labour

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(f) (g)

(h)

(i)

hours as the allocation base to determine the overhead rate per direct labour hour. What causes the difference between the rates you calculated in parts (d) and (e)? Assume that factory administration costs are allocated based on total labour hours and that the total allocated cost is used to charge other departments for administrative services. List one advantage and one disadvantage of this charge system. Suppose that you are the manager of the machining department at Gleason. You can outsource some of your department’s work. Outsourcing would reduce direct labour hours and, therefore, reduce the amount of overhead allocated to your department. What factors should you consider in deciding whether to outsource? Now suppose that you are the director of finance for Gleason. The manager of the machining department has decided to outsource some tasks. When you analyse the current period results, you notice that while direct labour costs decreased in machining, outsourcing costs are slightly higher this period than the prior period’s direct labour costs. When you ask the manager about these costs, he replies that the outsourcing does cost more than using direct labour, but because the amount of overhead for the department decreases, it is more profitable. What happened to the overhead that is no longer allocated to machining? Is the manager’s decision beneficial to Gleason Company as a whole? Explain.

(LO6) (a)

Building and grounds costs are most often allocated based on square feet. None of the other potential allocation bases relate to the services provided by building and grounds. The proportion of square feet used by each department is as follows:

Square feet Percent

Direct Costs Allocation: Building and grounds 41,010 Total Assigned Costs

(b)

Administration Total

Cafeteria

Machining

Assembly

500 10,000 5% 100%

1,000

3,500

5,000

10%

35%

50%

$78,270 $333,990

$4,920

$104,100

$146,700

2,051

4,101

14,353

20,505

$80,321 $375,000

$9,021

$118,453

$167,205

Administration provides services to other departments, making it a support department. Cafeteria provides meals for the employees, so it is a support department. Products are machined and assembled in Machining and Assembly. Because these products are then sold, these departments are considered operating departments.

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(c)

The support departments consist of Factory Administration and the Cafeteria, so this question requires selection and justification of an allocation base for the costs of each of these departments. This is an open-ended question; there is no single answer. The best solutions would evaluate the likelihood that a given allocation base would adequately differentiate between the service resources used by the other departments. This means that reasonable judgment needs to be applied in evaluating how well the various allocation base options would correlate with the use of service resources. Following are examples of reasonable arguments for each of the support departments: Allocation Base for Factory Administration: The services of Factory Administration relate to running the factory operations. Square feet might be a reasonable choice if administrative services are driven by the physical space a department occupies. However, this is unlikely. The number of purchase orders might be a reasonable choice if administrative services are driven by responsibility for departmental costs, which may be related to the effort involved in purchasing and paying for supplies. Using this same line of reasoning, the dollar amount of direct or assigned costs in each department might be appropriate as an allocation base. Direct labour hours, total labour hours, or number of employees are reasonable choices if administrative services tend to be driven by the management of employees. For Gleason, insufficient information is available about the types of activities that are most closely related to administration services. However, the management of employees is often the primary administrative service in a factory, and number of employees is likely to be representative of this effort. Therefore, the solution in Part D uses number of employees as the allocation base. Allocation Base for Cafeteria: The services of the Cafeteria relate to providing meals for employees. Because of this, a measure of employees (number or hours) would be the best choice. Because each employee would probably eat one or two meals a day, regardless of hours worked, hours may not reflect the use of meals as well as number of employees. In the following computations, the number of employees is used as the allocation base.

(d)

In this part, students are NOT asked to calculate total allocated costs. Instead, they are asked to calculate the amount of overhead costs allocated to each operating department using the step-down method and then to compute an overhead rate per direct labour hour. For this reason, the calculations shown below do not include the operating department direct costs. Although the number of employees is used to allocate the costs for both support departments, the percentages are different because (1) the total volume of the allocation base does not include the volume of the support department being allocated, and (2) under the step-down method the total volume of the allocation base used in the second step excludes the volume of the support department that was allocated in the first step.

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Support Departments Administration Cafeteria Total

Number of employees: For administration allocation

Operating Departments Machining Assembly

11 18.1818% 36.3636% 45.4546% 100% For cafeteria allocation

4 59 10% 44.4444% 55.5556% 100%

Support Costs (Part A) Allocations: Step 1: Administration Step 2: Cafeteria 0 Allocated Overhead Costs

$ 80,321 $89,342

$ 9,021

(80,321)

14,604 (23,625)

$29,208 10,500

$36,509 0 13,125

$ 0 $89,342

$ 0

$39,708

$49,634

3,000

6,000

$13.236

$8.272

Divide by direct labour hours Overhead rate per hour (e)

Calculate the plant-wide overhead rate by dividing total overhead costs by total direct labour hours as follows: Total overhead costs (Part B) / Total operating department direct labour hours = $89 342 / (3000 + 6000) = $9.927

(f)

When the step-down method is used, half of the support department interactions are reflected. Because assembly uses more direct labour hours than machining, it receives more overhead cost when direct labour hours are used in a plant-wide, single cost pool. Therefore, it receives more cost than if the services of departments are allocated based on use of the services. The opposite is true for the machining department; it receives less cost under a plant-wide allocation rate than when support costs are allocated based on services used. The step-down method more accurately reflects the use of resources.

(g)

An advantage of this method is that it is easy to calculate and understand. A disadvantage is that the cost per labour hour is likely to be high because it includes fixed costs that do not change with the number of employees or hours worked. High charges could lead other departments to consider reducing the number of employees in the department by outsourcing some service or product when it may not be cost effective to outsource. Another disadvantage is that the allocation does not attempt to match the flow of resources to products, so some products will appear to be subsidising other products because overhead resources used by all products is aggregated into only one pool.

(h)

The machining department manager would consider the cost of outsourcing versus the cost of using direct labour. Quality could also be a factor. In addition,

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the manager would want to know how department performance would appear to change as a result of outsourcing. If the manager receives a bonus based on the department’s performance (including allocated costs) and is able to offload part of the overhead allocation by reducing use of labour hours, then he/she would have a greater incentive to outsource. (i)

The Director of Finance would be unhappy with the decision to outsource. The overhead that is not allocated to machining is spread among other departments, so the overhead allocations to other departments increase. Because the machining manager’s decision increases incremental costs and does not reduce any of the overhead costs, it increases total cost and is suboptimal for the company as a whole.

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3.39

Cost allocation; behavioural issues In recent years, slow response times and frequent repairs have plagued Jetson Engineering’s computer system. The cause was a substantial increase in computer-aided design work that pushed the system beyond its intended capacity. Bob Wilson, the production manager, decided that a new computer should be acquired to absorb some of the additional work. Surprisingly, six months after installing the new computer, he noticed that many of the engineers continued to use the old computer system, even though the new system had excess capacity and several features that simplified programming. Bob discussed the situation with the supervisors of the entity’s six design teams. They explained that the finance director’s office allocates the cost of each computer to their work, based on the number of hours they use the computer. One responded, ‘Look, the old computer didn’t cost much and it’s highly utilised — even the accounting department uses that machine. When the cost per hour of use is calculated, it’s very low. The new machine, on the other hand, cost a lot of money, and in the first couple of months we didn’t use it much because it takes time to learn a new system. I was shocked when I saw how high my charges were for using the new machine. Because the cost is high and use is low, the cost per hour charged to my work was incredible. I’ll tell you something: next month we’ll probably use the new computer even less. Our job performance doesn’t look very good when our jobs cost a fortune to complete because of huge allocations of computer cost.’ ‘What a mess,’ Bob sighed. ‘Even though the new computer is bought and paid for and has plenty of capacity, the engineers aren’t using it. Don’t they realise that most of the computer costs are fixed costs? Using the new computer for 200 hours a month doesn’t really cost the company much more than using it for 20 hours a month.’ Required Recommend a change in the allocation system at Jetson that will change the behaviour of the design teams. (LO7)

The new computer system was purchased to absorb extra computer-aided design work. This should lead to jobs being undertaken more efficiently, and not lead to a backlog of jobs due to the inability of the design team members to access the technology. However, we can see from the information in the question that the improved efficiency may not be realised as the new computer is underutilised. This lack of use is not due to the inability of the computer to assist the design team members, but rather due to the consequences of the current cost allocation system. The design team members consider that jobs are been over-costed with the current allocation system. Jetson Engineering have implemented an internal charging system, in that individual departments are allocated costs for the use of central resources in this instance the computer system. The cost driver chosen is the number of hours of use. This is a volume based driver which would lead to a higher allocation to those jobs which make more use of the new computer. This has led to a disincentive to use the machine as higher costs are allocated. One reason behind the higher cost would be due to the

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depreciation charge, which would obviously be higher for a newer rather than older asset. It is in the interests of Jetson Engineering to encourage the use of the new computer – this will lead to higher productivity and efficiency. Bob’s comment about the total cost of the computer being fixed is correct, however, from the design team’s perspective it is viewed as a variable cost as it is being allocated based on its use. Possible changes to the allocation system could be: 1. Consider the cost as a facility level cost and not allocate to individual design teams. 2. Allocate it to all design teams evenly so that no one team is being penalised.

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3.40 Comprehensive problem; dual versus single rates; purpose of allocation Vines Company is a manufacturer of women’s and men’s swimsuits. The company uses a dual-rate system to allocate support costs. Last year’s support departments’ fixed and variable costs are as follows.

Required (a) Use the following allocation bases for fixed support costs: direct costs for accounting, number of employees for human resources, and squares for maintenance. (i) Allocate fixed support costs using the direct method. (ii) Allocate fixed support costs using the step-down method. (iii) Allocate fixed support costs using the reciprocal method. (b) Use the following allocation bases for variable support costs: time spent for accounting, number of employees for human resources, and time spent for maintenance. (i) Allocate variable support costs using the direct method. (ii) Allocate variable support costs using the step-down method. (iii) Allocate variable support costs using the reciprocal method. (c) Suppose support costs were not broken down into fixed and variable cost pools. What allocation base would you use to allocate the costs for each support department? Explain. (d) Describe several possible reasons why the managers of Vines Company allocate support costs to operating departments. (e) Discuss whether a dual-rate support cost allocation system is likely to be better for Vines Company than a single-rate system. (LO6)

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Allocation bases for reciprocal method fixed support cost allocation: Direct costs $122,800 $120,720 $800,000 $500,000 $1,543,520 %for for Variable allocationCosts: 7.9558% 7.8211% 51.8296% 32.3935% 100% Solver Employees 10 6 22 AccountF2 HRF Maintenance4 F % cells for allocation 9.0909%accounting 45.4545% 100% SolutionsChange manual to Solver accompany: Management by Eldenburg et al.27.2727% Not for for $71,471 $113,723 4e18.1818% $86,627 Square 800 1,000 5,000 5,000 11,800 Solver forfeet Variable Costs: distribution in%full. Instructors may post selected solutions for questions assigned as homework for allocation 6.7797% 8.4746% 42.3729% 100% AccountF HRF Maintenance Simultaneous equations $71,471 $113,723 $86,627 F 42.3729% to their LMS. Change cells for Solver $71,471 $113,723 $86,627 Solver function: for Variable Costs: Target AccountF HRF MaintenanceF Simultaneous equations $71,471 $113,723 $86,627 $271,822 Change cells for Solver $71,471 $113,723 $86,627 Target function: Simultaneous equations $71,471 $113,723 $86,627 $271,822 Fixed support costs $55,260 $100,696 $60,360 $216,316 Allocations: Target function: Accounting -71,471 5,686 5,590 37,043 23,152 0 $271,822 Fixed support costs $55,260 $100,696 $60,360 $216,3160 Human resources 10,338 -113,723 20,677 51,692 31,015 Allocations: Janitorial 5,873 7,341 -86,627 36,706 36,706 0 Accounting -71,471 5,686 5,590 37,043 23,152 Total allocations ($0) ($0) $0 $125,442 $90,874 $216,3160 Fixed support costs $55,260 $100,696 $60,360 $216,3160 Human resources 10,338 -113,723 20,677 51,692 31,015 Allocations: Maintenance 5,873 7,341 -86,627 36,706 36,706 0 Accounting -71,471 5,686 5,590 37,043 23,152 Total allocations ($0) ($0) $0 $125,442 $90,874 $216,3160 Human resources 10,338 -113,723 20,677 51,692 31,015 0 Maintainenance 5,873 7,341 -86,627 36,706 36,706 0 Total allocations ($0) ($0) $0 $125,442 $90,874 $216,316

(a)

Below are excerpts from the sample spreadsheet for this problem, which show the direct, step-down, and reciprocal method allocations of fixed support costs. The reciprocal method allocations were performed using Excel Solver. 1. Direct method 2. Step down method

3. Reciprocal method

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(b)

Target Step function: 2: Employees $131,954 % for allocation Problem Vines Company Step 3: 8.33: Time spent accounting % for allocation Variable support costs Allocations: Variable support costs Accounting Allocations: Variable costs Human resources Step 1:support Janitorial Fixed costs Maintenance Stepsupport 2: Human resources Total allocations Step 3: Accounting Total allocations direct costs Total

2 11.1111%

10 6 18 55.5556% 33.3333% 100% 30% 25% 55% 54.5455% 45.4545% 100% Chapter 4: Cost–volume–profit (CVP) analysis Support Departments Operating Departments $18,420 $22,104 $60,360 $100,884 Human $18,420 $22,104 $60,360 $100,884 Accounting Men's Total 0 -25,748 Resources 3,029Maintenenance 6,058 Women's 9,087 7,573 $18,420 $22,104 $60,360 $100,884 3,061 -33,667 -60,360 6,121 21,304 15,303 28,405 9,182 0 3,551 7,101 0 $55,260 $100,696 $60,360 $216,316 4,267 -29,205 8,534 -72,540 25,602 9,735 34,136 0 3,245 0 16,225 0 $49,993 11,462 $50,891 25,216 $100,884 -25,216$0 0 $0 0 $0 13,754 $73,680 $122,800 $120,720 $800,000 $49,601 $500,000$100,884 $1,617,200 $0 $0 $0 $51,283

Below are excerpts from the sample spreadsheet for this problem, which show the direct, step-down, and reciprocal method allocations of variable support costs. The reciprocal Potential allocation bases: method allocations were performed using Excel Solver.

Employees METHOD ALLOCATION--VARIABLE SUPPORT 2 2 4 10 6 24 RECIPROCAL COSTS Time spent accounting 15% Departments 10% 20% 30% 25% 100% Support Operating Departments Time spent cleaning 5% Human 10% 15% 30% 40% 100% Square feet 1,200 5,000 13,000 Accounting 800Resources1,000 Maintenance Women's 5,000Men's Total Allocation bases for reciprocal method variable support cost allocation: Time spent accounting 10% 20% 30% 25% 85% DIRECT METHOD COSTS 23.5294% % for allocationALLOCATION--VARIABLE SUPPORT 11.7647% 35.2941% 29.4118% 100% Employees 2 4 10 6 22 % for allocation 9.0909% 18.1818% 45.4545% 27.2727% 100% Time spent cleaning 5% 10% 30% 40% 85%

1. Direct method

2. Step-down method 3. Reciprocal method (c)

For accounting I would use time spent because it probably reflects the use of accounting employees and their salaries would be a large part of the fixed costs. Number of employees is already used for both fixed and variable costs, so I would continue to use it. Time spent in maintenance services probably provides a more accurate reflection of the resources used by each department for maintenance staff, and it’s likely as they spend more time in an area they also use more supplies.

(d)

Managers may want to use this information for benchmarks to compare current performance to past performance. It’s possible that they use these calculations to develop a transfer price policy for the use of support services.

(e)

If Vines is using this information for transfer prices, the variable portion is probably a better reflection of the marginal costs to the company of providing support services. These categories also give more precise information for benchmarks. It would be easier to investigate variances if cost pools are smaller and reflect only fixed or variable costs.

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3.41

Costing, service sector Hawk and Eagle Co., a law firm, had the following costs last year:

The following costs were included in overhead:

The firm recently improved its ability to document and trace costs to individual cases. Revised bookkeeping procedures now allow the firm to trace fringe benefit costs for direct professional labour, paralegal costs, telephone charges, computer time, and photocopying costs to each case individually. The managing partner needs to decide whether more costs than just direct professional labour should be traced directly to jobs to allow the firm to better justify billings to clients. During the last year, more costs were traced to client engagements. Two of the case records showed the following.

Three methods are being considered for allocating overhead this year: • Method 1: Allocate overhead based on direct professional labour cost. Calculate the allocation rate using last year’s direct professional labour costs of $15 million and overhead costs of $21 million. • Method 2: Allocate overhead based on direct professional labour cost. Calculate the allocation rate using last year’s direct professional labour costs of $15 million and overhead costs of $10 million ($21 million less $11 million in direct costs that are traced

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•

this year). Method 3: Allocate the $10 million overhead based on total direct costs. Calculate the allocation rate using last year’s direct costs (professional labour of $15 million plus other direct costs of $11 million).

Required a. Calculate the overhead allocation rate for method 1. b. Calculate the overhead allocation rate for method 2. c. Calculate the overhead allocation rate for method 3. d. Using each of the three rates computed in parts (a), (b), and (c), calculate the total costs of cases 875 and 876. e. Explain why the total costs allocated to cases 875 and 876 are not the same under the three methods. f. Explain why method 1 would be inappropriate. g. Would method 2 or method 3 be better? Explain. h. Outline another way to reconfigure the costing system for Hawk and Eagle Co. Discuss your proposed changes i. Explain how job costing in a service business is different from job costing in a manufacturing business. (LO5) (a)

Last year’s costs: Direct professional labour$15 000 000 Overhead costs (all other costs) Total costs $36 000 000

21 000 000

Overhead rate ($21 000 000/$15 000 000) 140% of direct professional labour cost (b)

Last year’s costs: Direct costs: Direct professional labour Other direct costs 11 000 000 Total direct costs26 000 000 Overhead costs (remaining costs) Total costs $36 000 000

$15 000 000

10 000 000

Overhead rate ($10 000 000/$15 000 000) 67% of direct professional labour cost (c)

Last year’s costs: Direct costs: Direct professional labour $15 000 000 Other direct costs 11 000 000 Total direct costs26 000 000 Overhead costs (remaining costs) 10 000 000 Total costs $36 000 000 Overhead rate ($10 000 000/$26 000 000) 38.5% of total direct costs

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(d)

Calculation of overhead allocated under three methods: Case 875 Case 876 Method 1: Direct professional labour * 140% $20 000 * 140% $28 000 Method 2: Direct professional labour * 67% $20 000 * 67% Method 3: Total direct costs * 38.5% Case 875: $29 000 * 38.5% Case 876: $37 000 * 38.5%

$13 400

$28 000

$13 400

$11 165 $14 245

Total costs under alternative allocation methods: Method 1 Method 2 Method 3 Case # 875: Direct costs $20 000 $29 000 $29 000 Allocated overhead 28 000 13 400 11 165 Total job costs 48 000 42 400 40 165 Case # 876: Direct costs 20 000 37 000 37 000 Allocated overhead 28 000 13 400 14 245 Total job costs 48 000 50 400 51 245 Total costs assigned (e)

$96 000

$92 800

$91 410

The allocation base is different for all three methods. In Method 1, only direct professional labour costs are used as allocation base and no direct costs were traced to jobs, so $21 million had to be allocated. This method has the highest overhead rate (140% of direct professional labour cost). None of the specific costs are traced to jobs. Therefore, the use of actual resources is not reflected other than the use of direct professional labour. In Method 2, $11 million in cost was traced directly to jobs, so only $10 million had to be allocated. Direct professional labour is the allocation base, but because the amount of common costs is less than half, the allocation rate is less than half (67% of direct professional labour cost). In Method 3, labour is combined with the direct costs (professional labour and all other direct costs) and this sum is used as the allocation base ($26 million). Divide the common overhead costs ($10 million) by the total direct costs ($26 million) to develop the allocation rate which is the lowest of all three (38.5% of total direct costs).

(f)

Method 1 would allocate overhead based on last year’s overhead costs, which included $11 million in costs that this year are traced as direct costs. It would be inappropriate to use Method 1 for allocating overhead costs this year because the method would significantly overestimate overhead costs.

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(g)

Method 2 separated out these direct costs and then allocated the overhead based only on the direct labour costs. This method gives more accurate costs than not separating the other direct costs from overhead. This method is still not the best, however, because in cases with equal direct labour cost but different direct costs, the overhead allocated to each job would be the same amount. Method 3 solves this problem by separating costs into three pools: direct professional labour, other direct costs, and overhead. The overhead is then allocated based on total direct costs (direct labour plus other direct costs). This method is the best option for allocating overhead and should be used to give law firm managers and clients an accurate breakdown of costs per case.

(h) The firm could be even more precise in terms of the number of overhead cost pools used. This would involve further analysis of the $10 million in remaining overhead costs to identify relevant cost pools and their associated cost drivers. Whilst such a system would potentially be more reliable, doing so would be more costly in terms of accounting processing costs. (i)

Most service industry organisations do not have as many direct materials to trace, although supplies and other materials used might be traced to each job, depending on the service. Professional labour or some measure of direct costs is used as an allocation base. Service organisations or industries rarely use machines, so machine hours are not usually used as an allocation base. Direct professional labour is often traced to each job, and the overhead in a service industry can include most of the support service costs such as accounting, receptionists, and so on.

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3.42 Costing, service sector LO5 Refer to question 3.41 above. Required (a) Draw a diagram of the costing system currently used by Hawk and Eagle Co. (b)Draw a diagram to show the proposed changes to the costing system under each of the three methods outlined. (c) Briefly comment on how the costing system has changed in the systems identified in (b) above. (a) Direct Professional Labour

Overhead costs: -

Fringe benefits for direct professional labour Paralegal costs Telephone call time Computer time Photocopying Other

Traced to individual clients

Individual Cases

Allocated to individual cases based on cost driver

(b) Method 1: as above Method 2:

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Direct Professional Labour Fringe benefits for direct professional labour

Traced to individual cases

Paralegal costs Individual Cases

Telephone call time Computer time Photocopying

Allocated to individual cases based on direct professional labour costs

Overhead costs

Method 3: Direct Professional Labour Fringe benefits for direct professional labour

Traced to individual case

Paralegal costs Telephone call time

Individual Cases

Computer time Photocopying Allocated to individual cases based on total direct costs Overhead costs

(c) The methods vary in terms of the percentage of costs that are treated as direct costs and the method by which indirect costs are allocated to individual cases. The greater the percentage of costs that are directly traced to individual cases, the more precise the costing information will be. For any overheads costs that are allocated to individual cases, it is important to ensure that the cost driver (i.e. total direct costs or direct professioanl hours) reliably explains the use of these costs by individual cases.

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3.43 Allocating variable and fixed overhead in the service sector Prime Personal Trainers is a personal training service in Bankstown for people who want to work out at home. Prime offers two different types of services: Setup and Continuous Improvement. Setup services consist of several home visits by a personal trainer who specialises in determining the proper equipment for each client and helping the client set up a home gym. Continuous Improvement services provide daily, weekly, or biweekly home visits by trainers. Prime’s accountant wants to create a job costing system for Setup services. She decides to use direct labour cost as the allocation base for variable overhead costs, and direct labour hours for fixed overhead cost. To estimate normal capacity, she calculates the average direct labour cost over the last several years. She estimates overhead by updating last year’s overhead cost with expected increases in rent, supervisor’s salaries, and so on. Following are her estimates (given in euros) for the current period.

Inventories consist of exercise equipment and supplies that are used by Prime for new clients. The following information summarises operations during the month of October. A number of new jobs were begun in October, but only two jobs were completed: job 20 and job 22. Account balances on October 1:

Purchases of equipment and supplies:

Equipment and supplies requisitioned for clients:

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Direct labour hours and cost:

Labour costs:

Office costs:

Required (a) What are the estimated allocation rates for fixed and variable overhead for the current period? (b) What is the total overhead cost allocated to Job 20 in October? (c) What is the total cost of job 20? (d) Calculate the amounts of fixed and variable overhead allocated to jobs in October. (e) Why would the accountant choose to use two cost pools instead of one? Will this method make a difference in client bills when the job includes more equipment and less labour than other jobs?

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(LO5) (a)

Set-up overhead estimated allocation rates Variable rate = Variable overhead costs/Direct labour costs = €150 000/€75 000 = 200% of direct labour costs Fixed rate = Fixed overhead costs/Normal direct labour hours = €120 000/3000 hours = €40 per direct labour hour

(b) Overhead allocated to Job 20 during October: Variable overhead (€250 * 200%) Fixed overhead (10 hours * €40) Total €900 (c)

(d)

Total cost of Job 20: Costs during October: Equipment and supplies Direct labour cost Variable overhead allocated Fixed overhead allocated Subtotal Beginning work in process Total cost for Job 20

€500 400

€1000 250 500 400 2150 3500 €5650

Amount of fixed overhead allocated to jobs in October: 229 direct labour hours * €40 fixed overhead allocation rate per DL hour = €9160 Amount of variable overhead allocated to jobs in October: €5725 direct labour costs * 200% variable overhead allocation rate = €11 450

(e)

Because some of the overhead varies with labour hours used, separating costs into two pools will better reflect the flow of variable overhead resources. When variable and fixed overhead costs are lumped into one pool, jobs that include more equipment and less labour would receive more cost under the single pool method than under the dual rate method.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. © John Wiley and Sons Australia, Ltd 2020

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Prepared by Vijaya Murthy

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 4: Cost–volume–profit (CVP) analysis Questions 4.1

If an entity has a mixed cost function, a 10 per cent increase in sales volume should increase income by more than 10 per cent. Explain why. (LO6) A mixed cost function includes both fixed and variable costs. If there are fixed costs in the cost function, then total costs will increase at a smaller rate than the increase in total sales volume. If there are variable costs in the cost function, then total costs will increase with total sales volume. When there is a combination of fixed and variable costs, a 10% volume increase will increase total costs by less than 10% because only the increase in variable cost is proportionate to volume; the fixed cost does not change with volume.

4.2

Explain how to calculate a weighted average contribution margin per unit. (LO3) The weighted average contribution margin per unit is calculated only when performing CVP analysis for multiple products. There are two ways to calculate it: (1)

Calculate the total contribution of all products by subtracting total variable costs from total revenues. Then calculate the weighted average contribution margin per unit by dividing the total contribution margin by the total number of units (the sum of units for all products).

(2)

Calculate the sales mix for each product by dividing the number of units sold for that product by the total number of units sold for all products. Calculate the contribution margin per unit for each product by subtracting that product’s variable cost from its revenues and dividing the result by that product’s number of units sold. Then calculate the weighted average contribution margin per unit by summing the following computation for all products: Each product’s sales mix percentage times its contribution margin per unit.

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4.3

An organisation experiences a 20 per cent increase in pre-tax profits when revenues increase 20 per cent. Assuming linearity, what do you know about the organisation’s cost function? (LO6) The firm has only variable costs and no fixed costs. If there were fixed costs, income would increase by more than 20% when sales increase by 20%.

4.4

What is the effect on an entity’s breakeven point of a lower income tax rate? (LO3 and 4) None. The firm does not pay income taxes at the breakeven point.

4.5

To estimate revenues, costs and profits across a range of activity, we usually assume that the cost and revenue functions are linear. What are the specific underlying assumptions for linear cost and revenue functions, and how reasonable are these assumptions? (LO5) Assumptions: Fixed costs remain fixed, variable costs per unit or as a percentage of revenue remain constant, selling prices per unit remain constant, the sales mix remains constant, and operations are within a relevant range where all of these assumptions are met. These are very strong assumptions. There is always some variation in fixed costs because they include costs such as electricity that varies with weather. In addition, organisations often get or give volume discounts, so variable costs and prices per unit may change at high volumes. However, results using these assumptions are accurate enough for general planning and decision making purposes.

4.6

Explain the relationship between margin of safety percentage and degree of operating leverage. (LO6) The margin of safety percentage and degree of operating leverage are related as follows. 1

Margin of Safety Percentage = 1 Degreeof Operating Leverage =Degreeof Operating Leverage Margin of Safety Percentage

As the degree of operating leverage gets larger (a higher proportion of fixed costs), the margin of safety percentage gets smaller, and vice versa.

4.7

How do volume discounts from suppliers affect our assumption that the cost function is linear? Explain how we incorporate this type of cost into a CVP analysis. (LO5 and 6) The cost function is assumed to be linear over a relevant range. If there are volume discounts, the cost function becomes piece-wise linear and the range of

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operations within which the organisation is performing must be taken into account in CVP analysis. The level of operations must be matched with the appropriate part of the function. Each piece can be considered as a separate relevant range, and the estimated level of activity needs to be matched with the appropriate relevant range. Otherwise, the analysis will either understate or overstate variable costs.

4.8

Explain the term sales mix in your own words. How does sales mix affect the contribution margin? (LO4) Sales mix is the specific proportion of total sales of each type of good or service that is sold. A simple example was presented in the chapter for an ice-cream store. Usually about 15% of revenue was from beverages and the rest from icecream products. As the proportion of specific products sold changes, the contribution margin ratio changes because the contribution per unit is different for the different products in the sales mix.

4.9

How are CVP analysis and breakeven analysis related? (LO2) CVP refers to changes in income over the relevant range of activity; as such, it includes the notion of breakeven. Breakeven is more narrowly constructed; it focuses on only one outcome — the single point at which total revenue equals total cost.

4.10 Can the margin of safety ever be negative? Explain your answer. (LO6) By definition, the margin of safety is the difference between expected unit sales and breakeven unit sales. If expected unit sales are below breakeven unit sales, the margin of safety will be negative.

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4.11 Describe three uses for CVP analysis. (LO1) CVP analysis can be used for planning purposes such as budgets, product emphasis, setting prices, setting activity levels, setting work schedules, purchasing raw materials, setting levels for discretionary costs such as advertising and research and development. It can also help with monitoring operations, and analysing the operating leverage of an organisation.

4.12 Explain how CVP analysis can be used to make decisions about increases in advertising costs. (LO4) To make decisions about advertising costs, accountants predict the amount of cost to be incurred and predict the increase in sales. CVP analysis is then used to determine whether the increase in cost is equal to or greater than the increase in contribution margin from additional units sold.

4.13 Under what circumstances will managers want sensitivity analysis results relating to a CVP analysis? (LO7) Good managers are likely to always ask for sensitivity analysis because uncertainty about sales volumes and other factors always exists. However, when unanticipated changes in the business environment or consumer preferences arise, managers will be even more interested in sensitivity analysis. By analysing a variety of scenarios, managers can respond more quickly to unanticipated changes.

4.14 How do different cost structures affect the breakeven point and operating leverage? (LO3, 4, 6) The cost structure of a firm, or the balance between their variable and fixed costs, affects the break-even point in the following ways: Cost structure High variable costs, low fixed costs

Low variable costs, high fixed costs

Impact on break-even point High variable costs will reduce the contribution margin and increase the break-even point. This impact, however, will be offset by the impact of the lower fixed costs which will reduce the break-even point. Low variable costs will improve the contribution margin and reduce the

Impact of operating leverage The high variable costs will reduce the contribution margin and reduce the operating leverage – each additional sale contributes relatively less to covering fixed costs and generating a profit. The low variable costs will increase the contribution margin and increase the

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break-even point. This impact, however, will be offset by the impact of the higher fixed costs which increase the break-even point.

operating leverage – each additional sale contributes relatively more to covering fixed costs and generating a profit.

4.15 Give an example of how a business can reduce variable costs by increasing fixed costs. (LO6) Two examples of how a business might reduce their variable costs by increasing their fixed costs include: • A manufacturer moving away from manual based labour (where workers are paid on a per-unit or hour basis) towards automated production. The reduction to the labour costs will reduce the variable costs, whilst the costs associated with automated production will be largely fixed costs. • A service firm changing the way sales personnel are paid. A firm might, for instance, currently compensate sales personnel by paying them a relatively small annual salary plus a significant sales commission for each customer sale (i.e. $55,000 p.a. + $500 per sale). If the firm changed how sales personnel were compensated by increasing the base salary and reducing the commission for each customer sale (i.e. $70,000 p.a. $300 per sale), it would reduce variable costs (i.e. commission per unit) and increase the fixed costs (i.e. annual salary). 4.16 Identify an industry that would have a high level of operating leverage. Briefly comment on your selection. (LO6) Two industries with a high level of operating leverage (i.e. low variable costs, high fixed costs) would include the following: •

•

Utilities (i.e. telecommunications, electricity, water): The major costs associated with the operations of utilities (i.e. maintenance and depreciation of network infrastructure assets) are largely fixed, with there being relatively minor incremental costs from additional usage. Education (i.e. Schools, Universities): The major costs associated with the operations of educational providers (i.e. staff salaries, building depreciation and maintenance) are largely fixed, with there being relatively minor incremental costs from each additional student.

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1 Exercises 4.17 CVP Single product (LO3) SmallScale Publishing has just commenced business and will sell only one title, “New to Business”. Market analysis has indicated that sales for the next 6 months should be 5 000 copies. The accountant has provided information that shows variable costs are $100 per title with fixed costs expected to be $200 000. The book is expected to sell for $150. Required (a) Calculate the breakeven number of books to be sold. (b)Calculate the estimated profit for the first six months. (a) Break-even point

= Fixed Costs ÷ Contribution Margin = $200 000 ÷ ($150 - $100) = 4 000 units

(b) Profit

= Sales Revenue – Variable Costs – Fixed Costs = (5 000 x $150) – (5 000 x $100) - $200 000 = $50 000

4.18 CVP Multiple products (LO4) SmallScale Publishing has now been operating for a couple of years. Sales have been growing and management have been excited about business performance. Currently the business sells two very popular books that are gaining international recognition; “New to Business”, and “How to Make Yourself a Success”. Next year, the estimated total sales are 60 000 books and the breakdown per title together with financial information follows:

Total fixed costs are expected to be $500 000. Required (a) Calculate the total number of books to be sold to break even next year. Show the number of books for each title. (b)Calculate the estimated profit for next year.

(a)

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New Business

to How to Make Yourself a Success 45 000 15 000

Sales Sales price per book Less Variable cost per book = Contribution margin % sales mix Weighted average contribution margin per unit: ($50 x 0.75) + ($20 x 0.25) Total break-even point ($500 000 ÷ $42.50) Total “New to Business” sales (11 765 x 0.75) Total “How to Make Yourself a Success” (11 765 x 0.25)

$150 ($100) $50 75%

$100 ($80) $20 25% $42.50 11 765 units 8 824 units 2 941 units

(b) Sales revenue: “New to Business” (45 000 x $150) “How to Make Yourself a Success” (15 000 x $100) Total sales revenue Less Variable costs: “New to Business” (45 000 x $100) “How to Make Yourself a Success” (15 000 x $80) Total variable costs Total contribution margin Less Fixed costs Total profit

$6,750,000 $1,500,000 $8,250,000 -$4,500,000 -$1,200,000

-$5,700,000 $2,550,000 -$500,000 $2,050,000

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4.19 Operating Leverage (LO6) SmallScale Publishing are considering offering eBooks. Market analysis has been undertaken and the breakdown of sales together with financial information follows. Due to the change in business model, fixed costs are expected to increase to $1 000 000.

Required (a) Calculate the breakeven in total units. (b)Compared to your answer in 4.17 above, is the margin of safety higher or lower? (c) Comment on whether you would recommend the business change to eBooks. (a) New Business

to How to Make Yourself a Success 45 000 15 000

Sales Sales price per book Less Variable cost per book = Contribution margin % sales mix Weighted average contribution margin per unit: ($100 x 0.75) + ($60 x 0.25) Total break-even point ($1 000 000 ÷ $90.00) Total “New to Business” sales (11 112 x 0.75) Total “How to Make Yourself a Success” (11 112 x 0.25)

$150 ($50) $100 75%

$100 ($40) $60 25% $90.00 11 112 units 8 334 units 2 778 units

(b) As calculated below, there has been a slight increase of 653 units (i.e. 48 888 units – 48 235 units) in the margin of safety:

Estimated sales Less Units at breakeven point = Margin of safety

Original (4.17) New New to How to Make New to How to Make Business Yourself a Business Yourself a Success Success 45 000 units 15 000 units 45 000 units 15 000 units 2 941 units 8 334 units 2 778 units 8 824 units 36 176 units 12 059 units 36 666 units 12 222 units

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Total margin of safety

48 235 units

48 888 units

(c) Based on financial considerations, the changes appear to be appropriate given the reduction to the breakeven point, increase in the margin of safety and substantial increase to the project profit:

Total breakeven point Total margin of safety Total profit

Original (4.17) 11 765 units 48 235 units $2 050 000

Sales revenue: New to Business (45 000 x $150) How to Make Yourself a Success (15 000 x $100) Total sales revenue Less Variable costs: New to Business (45 000 x $50) How to Make Yourself a Success (15 000 x $40) Total variable costs Total contribution margin Less Fixed costs Total profit

New 11 112 units 48 888 units $4 400 000 (See below)

$6,750,000 $1,500,000 $8,250,000 -$2,250,000 -$600,000

-$2,850,000 $5,400,000 -$1,000,000 $4,400,000

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4.20

Cost function; selling price; profit; contribution margin Find the missing figures for each of the independent cases. (LO3)

Selling Price/unit

Variable Costs/unit

Units Contribution Profit Sold Margin (total) Costs

Fixed (loss)

$80

10 000

$200 000

$120 000

$80 000

$15

$10

5 000

$25 000

1 000

$2 000

$3 000

($1 000)

$100

$75

500

$12 500

$8 000

$4 500

$10

1 000

$4 000

$6000

($2 000)

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4.21Cost function; selling price; profit; contribution margin Find the missing figure for each of the following independent cases:

(LO3) Selling Price/unit

Variable Costs/unit

Units Sold

Contribution Margin (total)

Fixed Costs

Profit (loss)

$40

$20

60 000

$1 200 000

$900 000

$300 000

$18

$12

10 000

$60 000

$48 000

$12 000

$25

$20

50 000

$250 000

100 000

$200 000

$50 000

$150 000

500 000

$500 000

$460 000

$40 000

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Chapter 4: Cost–volume–profit (CVP) analysis

4.22 Target profit; not-for-profit breakeven

(a)

The variable cost per gift basket is $2, fixed costs are $5000 per month, and the selling price of a basket is $7. How many baskets must be produced and sold in a month to earn a pre-tax profit of $1000? (b) The Community Clinic (a not-for-profit medical clinic) received a lump-sum grant from the City of Sydney of $460 000 this year. The fixed costs of the clinic are expected to be $236 000. The average variable cost per patient visit is expected to be $7.64 and the average fee collected per patient visit is $4.64. What is the breakeven volume in patient visits? (LO3) (a)

Information is given on a per unit basis, so use the following equation: Profit = (p – v) q – F $1000 = ($7 per gift basket – $2 per gift basket) × Q – $5000 $6000 = ($5 per gift basket) × Q Q = $6000/$5 per gift basket = 1200 gift baskets

(b)

This problem is about a not-for-profit organisation. Many not-for-profit organisations provide services or sell products at a loss and use donations or grants to cover the losses. As students approach problems in this textbook, they should think briefly about the type of organisation in the problem to help them solve it. This problem is a breakeven problem with a unit cost of $7.64 and unit revenue of $4.64, or a unit contribution margin (loss) of $(3.00). In a for-profit organisation, these numbers would indicate that the company loses money on each unit it sells. In a not-for-profit, it may be appropriate to sell services at a loss, as long as another source of funds covers the loss. In this problem, the clinic receives a grant from the city, so there is “fixed” revenue in addition to the fees collected. Taking the grant into account, the breakeven is: 0 = ($4.64 – $7.64) × Q + $460 000 grant – $236 000 fixed cost 0 = –$3×Q + $224 000 Solving for Q: 3Q = $224 000 Q = 74 667 patients

4.135

Total Cost

4.23 CVP graph

Dollars

$15,000 Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for $12,000 distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS. $9,000 $6,000

(a)

Create a CVP graph using the information in exercise 4.16, part (a). $3,000 Explain the information in the graph. (b) Create a CVP graph using the information in exercise 4.16, part (b). $0 Explain the information in the graph. 0 500 1,000 1,500 2,000 (LO3) Number of Gift Baskets

(a)

The revenue line is $7 times number of baskets and represents total revenue from units sold. The cost line intersects the intercept at $5000 reflecting the fixed cost. The slope is 2, which represents the variable cost. The breakeven occurs at 1000 gift baskets. Total revenues exceed total costs by $1000 at 1200 gift baskets.

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$400,000 Chapter 4: Cost–volume–profit (CVP) analysis

$0 0

37,500

75,000 112,500 150,000

Number of Patient Visits

(b)

Total revenue is the sum of the grant plus patient fees. Unlike most CVP graphs, the breakeven point is the maximum volume before the clinic incurs a loss. The grant exceeds fixed costs, so the clinic has a surplus up the breakeven point. Because the clinic’s contribution margin is negative, the surplus decreases by $3 per patient visit. After the breakeven point of 74 667 patient visits, the clinic incurs losses.

4.24

Cost function; breakeven

(a)

(b)

(c)

The average cost per unit was $234 at a volume of 1200 units and $205 at a volume of 1400 units. The profit was $24 000 at the lower volume. Estimate the variable cost per unit. Sparkle Car Wash Supplier sells a hose washer for $0.25 that it buys from the manufacturer for $0.12. Variable selling costs are $0.02 per hose washer. Breakeven is currently at a sales volume of $10 600 per month. What are the monthly fixed costs associated with the washer? Monthly fixed costs are $24 000 when volume is at or below 200 units and $36 000 when monthly volume is above 200 units. The variable cost per unit is $200 and the selling price is $300 per unit. What is the breakeven quantity?

(LO2) (a)

This problem gives information in units, so use the formula TC = v×q + F to determine variable cost. The average cost must first be turned into total cost:

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Total cost for 1200 units is $234×1200 = $280 800 Total cost for 1400 units is $205×1400 = $287 000 Use the two-point method (change in cost divided by change in volume) to determine the variable cost: Variable cost = (287 000 – 280 800)/(1400 – 1200) V = $31 Notice that the information about profit is not used because it is irrelevant for this problem. Recognising and discarding irrelevant information is an important skill. (b)

Turn sales into units and use profit = (P – V)×Q – F. Calculate the number of units sold: Revenue / Selling price per unit = Number of units $10 600/$0.25 per unit =42 400 units Variable cost is $0.12 plus selling costs of $0.02 = $0.14 per unit. Use the breakeven equation, and then solve for the unknown amount of fixed costs: 0 = ($0.25 – $0.14)×42 400 – F 0 = $4664 – F F = $4664

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Chapter 4: Cost–volume–profit (CVP) analysis

(c)

There can only be one breakeven point within the relevant range, so the breakeven point is first calculated for the first range. If the result is within that range, no additional calculations are needed. However, if the breakeven point is not in the first range, then calculations must be made for the next range. In the relevant range 0 < Q < 200, the breakeven point is calculated as: 0 = ($300 – $200) × Q – $24 000 Q = 240 units This result is outside of the relevant range, so it is not a feasible solution. In the relevant range 200 < Q, the breakeven point is calculated as: 0 = $100 × Q – $36 000 Q = 360 units This result is in the relevant range, so it is the breakeven point.

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4.25

Cost function; breakeven; profit

Ryans Music provides individual music lessons in the homes of clients. The following data is provided with respect to the last 12 months of activity ending 30 June 2016:

Each unit is equal to one half-hour lesson. Required (a) Assuming selling prices and costs remain the same as for 2016 calculate the number of lessons that are required to be sold in 2017 to break even. (b) If 4000 lessons were ‘conducted’ in 2017, what profit would be achieved? (c) For 2017, Ryans expects the unit labour cost to increase by $2 but, because of local competitive forces, Ryans does not wish to increase the lesson selling price. With some careful management, Ryans hopes to reduce annual fixed costs to $15 000. Calculate the number of music lessons that would need to be performed in 2017 in order to match the 2016 profit. (LO2) (a)

Break even = $18 000/($45 – $33) = 1500 units

(b)

(4000 units × $12) – $18 000 = $30 000 profit Contribution margin = $45 - $33 = $12

(c)

($15 000 + $30 000)/ $10 = 4 500 units

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Chapter 4: Cost–volume–profit (CVP) analysis

4.26

Contribution margin; contribution margin ratio Pamcar Industries sell IT equipment, specialising in printers and faxes. The following statement reflects the contribution margin of each activity, and overall profit levels:

Required (a) Calculate the contribution margin ratios for each of the two areas of activity, and in total. (b) Using the total contribution margin ratio, calculate the level of sales required to break even. (LO3) (a)

Sales Variable costs Contribution Margin Contribution margin ratio Sales mix

(b)

Printers 3 500 000 2 300 000 1 200 000 .34 .68

Faxes 1 600 000 1 120 000 480 000 .3 .32

Total 5 100 000 3 420 000 1 680 000 .33

Break-even sales = $958 000/.33 = $2 903 030 For printers = $2 903 030 × .68 = $1 974 060 For faxes = $2 903 030 × .32 = $928 970

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4.27

Targeted profit Information for Melong Industries is provided below.

Required (a) Calculate the number of units that need to be sold in 2016 to reach the after-tax profit target.

(b)

If the sales units in 2016 should be 25 per cent less than required to meet the after-tax profit target, what will the after-tax profit actually be?

(LO3) (a)

First, it is necessary to calculate the pre-tax profit: Pre-tax profit = $126 000 / (1 – .3) = $180 000 Adapt the basic calculation to show that the contribution margin needs to cover both fixed costs and the required pre-tax profit. ($620 000* + $180 000) / ($10.00 – $6.40) = 222 222.2 units *($240 000 + $380 000) Proof: Sales Less Variable Costs Contribution Margin Less Fixed Costs Profit pre tax Tax @ 30% Profit after tax

(222 222.2 × $10) (222 222.2 × $6.40)

$2 222 220.00 $1 422 222.08 $ 799 997.92 $ 620 000.00 $ 179 997.92 $ 53 999.38 $ 125 998.54

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Chapter 4: Cost–volume–profit (CVP) analysis

(b)

Sales would reduce to (222 222.2 × .75) = 166 666.65 units Sales Less Variable Costs Contribution Margin Less Fixed Costs Pre tax

((222 222.2 x.75) × $10) ((222 222.2 × .75) × $6.40)

$1 666 66.50 $1 066 666.56 $ 599 999.94 $ 620 000.00 –$ 20 000.06

The firm’s breakeven point is ($620 000 / 3.60) = 172 222.22 units — the reduced sales of $166 666.65 are below the breakeven point – therefore no profit can be generated. Another way to determine this is to look at the change in contribution margin — if 25% less units are sold (equal to a 55 555.55 reduction in sales units) then the contribution margin will decrease by a $199 997.98 (55 555.55 x $3.60) which is also equal to the decrease in before tax profit ($179 997.92 + 20 000.06).

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4.28

Breakeven point; profit; cost function Chloe Enterprises operates a single-product entity. Data relating to the product for 2016 were as follows:

Required (a) Calculate the break-even units for 2016. (b) Calculate the profit achieved in 2016.

(c)

Changes in marketing strategy are planned for 2017. This would increase variable marketing and distribution costs by $4 per unit, and reduce fixed non-manufacturing costs by $80 000 per year. Calculate the units that would need to be sold in 2017 to achieve the same profit as in 2016. (d) Would you recommend the change? Explain. (LO2, 3) (a)

Contribution margin Selling price Less variable manufacturing Variable marketing etc. $12

$20 $60 $28 $40 = $20

Break-even = $480 000/ ($20) = 24 000 units (b)

Profit = (32 000 units ×$20) – $480 000 = $160 000

(c)

Contribution margin will increase due to increased variable costs Currently $20 less additional $4 variable marketing = $16 To achieve same profit as 2016 = ($400 000 + $160 000)/ ($16) = 35 000 units

(d)

Based on the increased number of units required to achieve the same profit, the change is not recommended in the short term.

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Chapter 4: Cost–volume–profit (CVP) analysis

4.29

Breakeven point; profit; cost function Annalise Industries has provided the following information with respect to its current year’s activities:

Required (a) Calculate the break-even point in total units and units per product based on the above data. (b) Calculate the profit (loss) achieved in the current year.

(c)

Management is concerned about increasing competition for some of its products, and wants to increase its sales of product D relative to product C. The initiative would increase annual fixed costs by $50 000 and alter the sales mix to 25 per cent (product A), 15 per cent (product B), 40 per cent (product C) and 20 per cent (product D). On the available data, would you recommend the initiative? (LO2 and 4) (a) A 50 000

B 30 000

C 100 000

D 20 000

Selling price Variable costs Contribution margin Sales mix**

10 6 4 .25

15 10 5 .15

8 6 2 .50

25 15 10 .10

Weighted average contribution margin

.75

Unit sales

** product a 50000 units/200000 units product b 30000 units /200000 units product c 100000units /200000 units product d 20000 units /200000 units Breakeven = $450 000/$3.75 = 120 000 units Number of units of each product to sell: Product

A= 30 000 units (120000 x .25) B=18 000 units (120000 x .15) C = 60 000units (120000 x .5) D= 12 000 units (120000 x .10)

4.145

= 200 000

$3.75

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(b)

Profit (loss) = (200 000 units × $3.75) – $450 000 = $300 000

(c)

Unit sales Selling price Variable costs Contribution margin Sales mix Weighted average contribution margin

10 6 4 .25 1

15 10 5 .15 .75

8 6 2 .40 .8

25 15 10 .20 2

$4.55

Breakeven = $500 000/ $4.55 = 109, 890 units This represents a lower breakeven number of units as there would be a higher proportion of sales of Product D which has a higher contribution margin than Product C. Therefore the initiative is recommended.

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Chapter 4: Cost–volume–profit (CVP) analysis

4.30

Profit; price for target profit The Martell Company has recently established operations in a competitive market. Management has been aggressive in its attempt to establish a market share. The price of the product was set at $5 per unit, well below that of the company’s major competitors. Variable costs were $4.50 per unit, and total fixed costs were $600 000 during the first year.

Required (a) Assume that the company was able to sell 1 million units in the first year. What was the pre-tax profit (loss) for the year? (b) Assume that the variable cost per unit and total fixed costs do not increase in the second year. Management has been successful in establishing its position in the market. What price must be set to achieve a pre-tax profit of $25 000? Assume that sales remain at 1 million units. (LO3) (a)

Profit (loss) before taxes is: $5(1 000 000) – $4.50(1 000 000) – $ 600 000 = $500 000 – $600 000 = $(100 000)

(b)

Solving for price at target profit of $25 000: 1 000 000×P – $4.50(1 000 000) – $600 000 = $25 000 1 000 000×P = $5,125 000 P = $5.125 The firm needs to have an average selling price of $5.125 to earn $25 000 on sales of 1 000 000 units. This problem can be used to raise the issue of predatory pricing versus aggressive competition.

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4.31

Cost function; breakeven Data for the most recent three months of operations for the RainBeau Salon are as follows.

A cost-of-living salary increase occurred at the beginning of May. Required (a) What is the total cost function for RainBeau Salon? (b) If the average fee per appointment is $25, estimate the appointments required in June to break even. (LO2) (a) Cost Hair dresser salaries Manicurist salaries Supplies Utilities Rent Miscellaneous Total

Fixed $18 000 16 000 0 400 1 000 2 963 $38 363

Variable

$0.500

0.325 $0.825

TC = $38 363 + $0.825 × appointments Explanations: Salaries: The amount of salaries in May is used to predict the next month because there was a cost-of-living increase. Supplies: An examination of the pattern in supplies costs reveals that for April and May supply cost was $0.50 per appointment. The cost was higher in March, but it is best to use the most current information. Students may have averaged the three months for $0.52 per month, or they could have used the high-low method which gives $0.50 with no fixed costs. Utilities: Because weather probably drives most of utilities cost for this business, this solution uses the prior month’s utilities to predict next month’s cost. Miscellaneous: An examination of miscellaneous costs reveals that while it increases as volumes increase, it does not do so proportionately (as did supplies). For this solution the high-low method is used. Variable cost = $0.325 [($3580 – $3450)/(1900 – 1500)] Using TC = F + VC × Q and solving for F gives a fixed cost of $2963

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[$3450 = F + ($0.325 × 1500)] (b)

0 = ($25.00 – $0.825) Q – $38 363 0 = $24.175 × Q – $38 363 Q = 1587 appointments

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4.32

Breakeven; target profit; ROI target profit Madden Company projected its income before taxes for next year as shown here. Madden is subject to a 40 per cent income tax rate.

Required (a) What is Madden’s breakeven point in units sold for the next year? (b) If Madden wants $4.5 million in pre-tax profit, what is the required level of sales in dollars? (LO2 and 3) (a)

Divide sales and variable costs by 160 000 to get the per-unit selling price of $50 and the variable cost per unit of $12.50. Then breakeven formula is: $50×Q – $12.50×Q – $3 000 000 = $0 $37.5×Q = $3 000 000 Q = 80 000 units

(b)

Variable costs are $12.50 per unit/$50.00 per unit = 25% of revenue Breakeven in sales, where TR = total revenue: TR – 0.25×TR – $3 000 000 = $4 500 000 0.75×TR= $7 500 000 TR = $10 000 000

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4.33

Breakeven; target profit; cost changes; selling price Laraby Company produces a single product. It sold 25 000 units last year with the following results.

In an attempt to improve its product, Laraby’s managers are considering replacing a component part that costs $2.50 with a new and better part costing $4.50 per unit during the coming year. A new machine would also be needed to increase plant capacity. The machine would cost $18 000 and have a useful life of six years with no salvage value. The company uses straight-line depreciation on all plant assets. Required

What was Laraby Company’s breakeven point in units last year? How many units of product would Laraby Company have had to sell in the past year to earn $77 000 in after-tax profit? (c) If Laraby Company holds the sales price constant and makes the suggested changes, how many units of product must be sold in the coming year to break even? (d) If Laraby Company holds the sales price constant and makes the suggested changes, how many units of product will the company have to sell to make the same after-tax profit as last year? (e) If Laraby Company wishes to maintain the same contribution margin ratio, what selling price per unit of product must it charge next year to cover the increased materials costs? (LO2 and 3) (a) (b)

(a)

Selling price per unit: = $625 000/25 000 units= $25/unit Variable cost per unit: = $375 000/25 000 units= $15/unit Breakeven point: $25×Q – $15×Q – $150 000 = $0 Q = 15 000 units

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(b)

Adjust the after-tax income target to a before-tax income target. Income before tax × (1 – .45) = $77 000 Income before tax × 0.55 = $77 000 Income before tax = $140 000 Then solve for units at target profit: $25Q – 15Q – 150 000 = $140 000 Q = 29 000 units

$15.00 (2.50) 4.50 $17.00

Current fixed cost Plus depreciation on new machine $18 000/6 New fixed cost

$150 000 3 000 $153 000

Solve for breakeven where: $25×Q – $17×Q – $153 000 = $0 Q = 19 125 units (d)

Solve for target profit where: $25×Q – $17×Q – $153 000 = $100 000 (before tax) Q = 31 625 units

(e)

Current contribution margin ratio = ($25 – $15)/$25 = 40% New price: P – $17 = 0.40×P Rearrange terms: 0.60×P = $17 P = $28.33

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4.34

Breakeven: single product; profit calculation Janna Processing is a single-product entity, and provides the summary data shown relating to its product for 2016.

Required (a) Calculate the breakeven in units and sales dollars for 2016. (b) Calculate the profit earned in 2016. (c) Janna Processing is considering changes in plant operations and the production process for 2017. The changes would result in a reduction of variable costs per unit of $6, and increase fixed manufacturing costs by $265 000. How many units would need to be sold to earn the same profit as in 2016? Would you recommend the changes? (LO2 and 3)

(a)

Contribution margin = $50 – (24 + 8) = $18 Breakeven units = $756 000/ $18 = 42 000 units Sales $ = 42 000 units x selling price of $50 = $2 100 000 Or using the contribution margin ratio method: Sales = $756,000 / (18/50) = $2,100,000

(b)

Profit in 2016 = (48 000 units × $18) - $756 000 = $108 000

(c)

Change: Existing Variable costs = $32 less $6 reduction = $24 Adjusting contribution margin to 50 – 26 = $24 Fixed costs : Currently $756,000 plus $265,000 additional = $1,021,000 To earn the same profit as 2016 = ($1 021 000 + $108 000)/$24 = 47 042 units. This is slightly less than the 48 000 units required to sold in 2016 to earn the equivalent profit. This move would also have some impact on the mix between fixed and variable costs (operating leverage).

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4.35

Profit calculation; price to achieve profit target The management of Kayla Industries has been aggressive in trying to build market share. The price was set at $5 per unit, well below the existing market price. Variable costs were $4.50 per unit, and annual fixed costs in the first year were $600 000. To encourage sales staff to push sales higher, the management of Kayla Industries is considering placing staff on a remuneration scheme paying a retainer plus 2.5 per cent commission on sales. This will reduce fixed costs by $200 000. Do you consider this to be a good strategy? (LO3) Break even under existing arrangements: $ 600 000/($5 - $4.50) = 1 200 000 units Breakeven under proposed arrangements: $400 000/ ($5 - $4.625) = 1 066 667 units The proposal has the effect of slightly lowering the breakeven units. Management would most likely need to consider a range of other factors before making a final decision.

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4.36

Breakeven, selling price, target profit with price and cost changes All-Day Lolly Company is a wholesale distributor of confectionery. The entity services grocery and convenience stores in the metropolitan area. Small but steady growth in sales has been achieved by the All-Day Lolly Company over the past few years, but confectionery prices also have been increasing. The entity is reformulating its plans for the coming fiscal year. The following data were used to project the current year’s after-tax income of $100 400.

Confectionery manufacturers have announced that they will increase prices of their products an average of 15 per cent in the coming year because of increases in raw material (sugar, cocoa, peanuts, etc.) and labour costs. All-Day Lolly Company expects that all other costs will remain the same as during the current year. Required

(a) (b)

(c)

What is All-Day Lolly Company’s breakeven point in boxes of lollies for the current year? What average selling price per box must All-Day Lolly Company charge to cover the 15 per cent increase in the variable cost of lollies and still maintain the current contribution margin ratio? What volume of sales in dollars must the All-Day Lolly Company achieve in the coming year to maintain the same after-tax income as projected for the current year if the average selling price of lollies remains at $4 per box and the cost of confectionery increases 15 per cent?

(LO3) (a)

$4×Q – $2.40×Q – $440 000 = $0 Q = 275 000 boxes to break even

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(b)

Current contribution margin ratio = ($4.00–$2.40)/$4.00 = 40% Confectionery costs increase = $2.00 × 1.15 + $0.40 = $2.70 Selling price needed to maintain 40% contribution margin ratio: P – $2.70 = 0.40×P 0.60×P = $2.70 P = $4.50

(c)

Current pre-tax income: = $4.00×390 000 units – $2.40×390 000 units – $440 000 = $184 000 Required sales in units to maintain $184 000 in pre-tax income: $4Q – 2.70Q – 440 000 = $184 000 $1.30 × Q= $624 000 Q= 480 000 boxes Dollar sales = 480 000 boxes @ $4 = $1 920 000

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4.37

Breakeven; operating leverage; cost function decision You are the advisor of a Junior Achievement group in a local high school. You need to help the group make a decision about fees that must be paid to sell gardening tools at the Home and Garden Show. The group sells a set of tools for $20. The manufacturing cost (all variable) is $6 per set. The Home and Garden Show coordinator allows the following three payment options for groups exhibiting and selling at the show:

A. B. C.

Pay a fixed booth fee of $5600. Pay a fee of $3800 plus 10 per cent of all revenue from tool sets sold at the show. Pay 15 per cent of all revenue from tool sets sold at the show.

Required

(a) (b) (c) (d) (e)

Calculate the breakeven number of tool sets for each option. Which payment plan has the highest degree of operating leverage? Which payment plan has the lowest risk of loss for the organisation? Explain. At what level of revenue should the group be indifferent to options A and B? Which option should Junior Achievement choose, assuming sales are expected to be 1000 sets of tools? Explain.

(LO6) (a)

Breakeven for option 1: $5600/($20 – $6) = 400 sets Breakeven for option 2: New variable cost = 0.10×$20 = $2 $5600/($20 – $6 – $2) = 317 sets Breakeven for option 3: There are no fixed costs, so the breakeven point = 0 sets; if no units are sold, no fee is paid.

(b)

The cost function for option 1 has the highest proportion of fixed cost, so it has the highest operating leverage.

(c)

Lowest operating risk is option 3 because no fees are paid unless there are sales.

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(d)

To find the indifference point, the two cost equations are set equal to each other as follows: $5600 = $3800 + 10%TR $1800 = 10%TR TR = $18 000 When total revenues are below $18 000, option 2 is more profitable. Above $18 000, option 1 is more profitable.

(e)

Option 1 profit = ($20 – $6)×1000 – $5600 = $8400 Option 2 profit = ($20 – $6 – $2)×1000 – $3800 = $8200 Option 3 profit = ($20 – $20×0.15)×1000 = $11 000 The highest profit at sales of 1000 sets is $11 000 for option 3, so this is probably the best choice. (This answer ignores possible other factors that might influence the decision.)

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4.38

Target profit; margin of safety; operating leverage The following budget data apply to Newberry’s Nutrition:

Direct labour workers are paid hourly wages and go home when there is no work. The marketing and administration costs include $50 000 that varies proportionately with production volume. Assume that sales and production volumes are equal. Required

(a) (b) (c) (LO6) (a)

Calculate the number of units that must be sold to achieve a target after-tax income of $120 000, assuming the tax rate is 40 per cent. Calculate the margin of safety in both revenues and units. Calculate the degree of operating leverage. Categorise costs: Cost Direct materials Direct labour Fixed factory overhead Variable factory overhead Marketing and Administration Totals

Fixed

Variable $300 000 200 000

$100 000 110 000 $210 000

150 000 50 000 $700 000

Variable cost per unit = $700 000/100 000 units = $7.00 per unit Price per unit = $1 000 000/100 000 units = $10.00 per unit Target pre-tax income = $120 000/(1-.40) = $200 000 CVP calculation: ($10.00 – $7.00)Q – $210 000 = $200 000 $410 000 = $3.00×Q Q = 136 667 units.

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(b)

Before calculating the margin of safety, it is necessary to calculate the breakeven point: ($10.00 – $7.00)Q – $210 000 = $0 Q = $210 000/$3 = 70 000 units In revenue: 70 000 units × $10 per unit = $700 000 Margin of safety in units: 100 000 units – 70 000 units = 30 000 units Margin of safety in revenues: 30 000 units × $10 = $300 000 Double-check computation: $1 000 000 – $700 000 = $300 000

(c)

Degree of operating leverage = 1/Margin of safety percentage = 1/(30 000 units/100 000 units) = 3.33 Double-check calculation: Degree of operating leverage = (FC/Expected pre-tax income) + 1 = ($210 000/$90 000) + 1 = 3.33

4.39

Breakeven, targeted profit, margin of safety, operating leverage

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Pike Street Fudge makes and sells fudge in a variety of flavours in a shop located in the local public market. Data for a recent week are as follows:

All employees work standard shifts, no matter how much fudge is produced or sold. Required

(a) (b) (c) (d) (LO6) (a)

Calculate the breakeven point in units and in revenue. Calculate the number of units and the amount of revenues that would be needed for after-tax income of $3000. Calculate the margin of safety in units and the margin of safety percentage. Calculate the degree of operating leverage. It is first necessary to determine the cost function. Assuming that the cost of ingredients varies with the amount of fudge produced, the variable cost per pound is: $3200/2000 kg = $1.60/kg The rent is assumed to be fixed. The wages are also fixed because employees work standard shifts. Total fixed costs are: $800 + $4800 = $5600 Breakeven point in pounds: $5600/($4.80 per kg – $1.60 per kg) = 1750 kg Breakeven point in revenues: 1750 kg × $4.80 per kg = $8400

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(b)

Calculate the pre-tax income needed for an after-tax income of $3000: $3000/(1-20%)=$3750 Units needed to earn a pre-tax income of $3750: ($5600 + $3750)/($4.80 per kg –$1.60 per kg) = 2922 kg Revenues needed to earn a pre-tax income of $3750: 2922 kg × $4.80 per kg = $14 026 Check calculation using contribution margin ratio formula: Contribution margin ratio = ($4.80–$1.60)/$4.80 = 66.6667% ($5600 + $3750)/66.6667% = $14 025* *Difference due to rounding.

(c)

The margin of safety is current total sales less total sales at breakeven: $9600 – $8400 = $1200 The margin of safety percentage = $1204/$9600 = 0.125 = 12.5% (Revenues are 12.5% above the breakeven point.)

(d)

Degree of operating leverage = contribution margin/pre-tax income: = ($9600 – $3200)/$800 = 8.0 An alternative calculation for degree of operating leverage is: 1/margin of safety percentage = 1/0.125 = 8.0

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4.40

Breakeven; target profit; margin of safety Vines and Daughter manufactures and sells swimsuits for $40 each. The estimated income statement for 2017 is as follows:

Required

(a) (b) (c) (d) (e) (f) (g)

Calculate the contribution margin per swimsuit and the number of swimsuits that must be sold to break even. What is the margin of safety in the number of swimsuits? Suppose the margin of safety was 5000 swimsuits in 2016. Are operations more or less risky in 2017 as compared to 2016? Explain. Calculate the contribution margin ratio and the breakeven point in revenues. What is the margin of safety in revenues? Suppose next year’s revenue estimate is $200 000 higher. What would be the estimated pre-tax profit? Assume a tax rate of 30 per cent. How many swimsuits must be sold to earn an after-tax profit of $180 000?

(LO6) (a)

Estimated sales in number of swimsuits = $2 000 000/$40 = 50 000 swimsuits Variable cost per unit = $1 100 000/50 000 swimsuits = $22 per swimsuit Contribution margin = $40 – $22 = $18 per swimsuit Breakeven in units: $765 000/$18 = 42 500 swimsuits

(b)

Margin of safety is 50 000 – 42 500 = 7500 swimsuits

(c)

If the margin of safety was 5000 swimsuits in 2016 and increases to 7500 swimsuits in 2017 (calculated in Part B), then operations will be less risky in 2017. A larger margin of safety means that the company is operating further beyond the breakeven point; swimsuit sales can drop by a larger amount before the company incurs a loss.

(d)

Contribution margin ratio = $18/$40 = 0.45 Breakeven in revenues: $765 000/0.45 = $1 700 000

(e)

Margin of safety in revenue = $2 000 000 – $1 700 000 = $300 000

(f)

An increase in revenues of $200 000 is expected to increase pre-tax profits by $90 000 in profits ($200 000 × 0.45 contribution margin ratio)

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because fixed costs have been covered at this point. Total pre-tax is estimated to be: $135 000 + $90 000 = $225 000 (g)

Pre-tax profit = $180 000/(1 – .30) = $257 143 CVP calculation: ($765 000+$257 143)/$18 = 56 786 swimsuits

3 Problems 4.41 Cost function; breakeven; quality of information; relevant range Oysters Away picks, shucks and packs oysters and then sells them wholesale to fine restaurants across the state. The income statement for last year follows:

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Chapter 4: Cost–volume–profit (CVP) analysis

Pickers, shuckers and packers are employed on an hourly basis and can be laid off whenever necessary. Salespeople mostly deliver the product and are paid on a salaried basis. Required

(a) (b) (c)

Estimate the cost function for Oysters Away. What is the breakeven point in cases for Oysters Away? The manager thinks that the entity will harvest and sell 3000 cases of oysters next year. Estimate the after-tax income. (d) Oysters Away harvested and sold 2000 cases in each of the last several years. What does this suggest about the quality of the income information you calculated in part (c)? (e) Describe reasons why the cost function developed for the relevant range up to 2000 cases might not hold for 2001 to 3000. (LO2 and 3) Note about problem complexity: Item A is coded as Extend instead of Step 2 because judgment is minimal and students can use chapter examples for help.

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(a) Cost Wages Packing materials Rent and Insurance Admin and selling Total costs

Fixed

$25 000 45 000 $70 000

Variable $100 000 20 000

$120 000

Wages are classified as variable because employees are paid an hourly wage and can be laid off when there is no work. Packing materials would vary with the number of cases of oysters packed. Rent and insurance are fixed. No information is given about whether administrative and selling is fixed or variable. It is categorised above as fixed, but it could be a mixed cost. In the absence of additional information, this solution assumes the cost is fixed. Variable cost per case: $120 000/2000 cases = $60 Cost function: TC = $70 000 + $60×Q (b)

Breakeven calculation: $0 = ($100 – $60) × Q – $70 000 Q = $70 000/$40 per case Q = 1750 cases

(c)

Pre-tax profit = ($100–$60) × 3 000 cases – $70 000 = $120 000 – $70 000 = $50 000 After-tax profit = $50 000 × (1 – 0.20) = $40 000

(d)

If only 2000 cases have been harvested and sold each of the past several years, it is unlikely that 3000 cases will be sold next year unless there is some change in operations. In the absence of information about a change, the quality of the income estimate in Part C is probably low. In addition, any change in operations major enough to increase sales by 50% might change the cost function (see Part E). So, even if the manager anticipates expanding the size of operations, the quality of the income estimate is low.

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(e)

It is possible that the costs for workers or packing materials would change above 2000 cases. If the company does not have enough space to handle all of the oysters, rent would need to increase. The company might have to pay workers overtime or hire additional workers at a higher or lower rate than current workers (depending on skill levels and supply of workers). With the additional volume, the company might get a discount on packing materials, so that cost might be smaller. Administrative costs might or might not increase with the volume of operations. A 50% increase in volume is very significant, which might require additional administrative costs such as staff, supplies, or fixed assets.

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4.42

Relevant information; breakeven; target profit; price; uncertainties Francesca would like to lease a coffee cart in Melbourne. The lease is $800 per month and a city license to sell food and beverages costs $20 per month. The lessor of the stand has shown Francesca records indicating that gross revenues average $32 per hour. The out-of-pocket costs for ingredients are generally about 40 per cent of gross revenues. Last year she paid 25 per cent of her income in government taxes. Francesca pays $1000 per month for her apartment. She could store the cart overnight in the apartment’s garage, which is currently unused. Real estate developers in Melbourne estimate that about 20 per cent of the cost of a residential building is for the garage. At present, Francesca is earning $2400 per month as a ski instructor for one of the big ski areas. In the summertime she earns about the same income as a kayaking instructor. Required

(a)

List each piece of quantitative information in this problem. For each item, indicate whether it is relevant to Francesca’s decision and explain why. (b) If Francesca leases the cart and works 30 days in a month, how many hours will she have to work each day, on average, to be at least as well off financially as she is in her current job? (c) If Francesca wants to work only 25 days per month, how much will revenues have to increase for her to work four hours per day and be as financially well off as she is in her current job? (d) Can Francesca be certain that her revenues will average $32 per hour? Why or why not? (e) What other information might help Francesca with this decision? (LO2 and 3)

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(a) Quantitative information Cart lease $800 per month: This is relevant because this is a cost that will be incurred if Francesca leases the cart, but will not be incurred otherwise. City license $20 per month: This is relevant for the same reason as the cart lease. Lessor records showing average gross revenues of $32 per hour: This information is relevant if Francesca thinks she will sell about the same amount as the lessor. However, the lessor’s records might not be reliable. Ingredients 40% of revenue: This is relevant because this cost will be incurred only if Francesca sells coffee. Last year’s income tax rate of 25%: Assuming that the income tax rate is not different for operating the coffee cart, the tax rate is irrelevant to Francesca’s decision. The income tax rate will reduce earnings for both options. Condo rent of $1000 per month and 20% of condo cost for garage: This cost is not relevant because it will be the same under both options; it is unavoidable. Current income $2400 per month: This is relevant as the opportunity cost if Francesca decides to operate the coffee cart instead of continuing her current work.

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(b)

This question calls for calculating the hours Francesca should work to earn a target profit equal to her current earnings of $2400 per month. Before this computation can be performed, the cost function for the coffee cart must be determined:

Cart lease City license Ingredients Total

Fixed $800 20 $820

Variable

0.40×Revenue 0.40×Revenue

The monthly cost function is estimated as: TC = $820 + 0.40 × Revenue Target profit calculation (assuming that revenue is $32 per hour): $2400 = ($32 – 0.40×$32) × Hours per month – $820 $3220 = $19.2 × Hours per month Hours per month = 168 Assuming that she is willing to work 30 days per month, total hours per month are 168. Then, the average hours that must be worked per day to earn a target profit of $2400 is: 168 hours per month/30 days per month = 5.6 hours per day (c)

This problem requires students to perform the same calculation as when determining the selling price needed to achieve a target profit. Total hours per month = 25 days × 4 hours per day = 100 hours per month Target profit calculation: $2400 = (Revenue per hour – 0.40×Revenue per hour) × 100 hours – $820 $3220 = 60×Revenue per hour Revenue per hour = $53.67

(d)

As mentioned in Part (a) above, Francesca cannot be certain that the information she received from the lessor is reliable. In addition, revenues are likely to fluctuate based on weather, the economy, competition and consumer preferences.

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(e)

There are many other types of information to consider. Some information might help Francesca evaluate the financial viability of the coffee cart, such as local population trends, competition and economic outlook. Additional information relates to Francesca’s own preferences, such as whether she wants to give up her other occupations and how much she would enjoy running a coffee cart in Vail.

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4.43 Sales mix; multiple product breakeven; uncertainties; quality of information Dreamtime produces two products: regular boomerangs and premium boomerangs. Last month 1200 units of regular and 2400 units of premium were produced and sold. Average prices and costs per unit for the month are displayed here.

Product line fixed costs can be avoided if the product line is dropped. Corporate fixed costs can be avoided only if the entity goes out of business entirely. You may want to use a spreadsheet to perform calculations. Required (a) Assuming the sales mix remains constant, how many units of premium will be sold each time a unit of regular boomerangs is sold? (b) What are the total fixed product line costs for each product? (c) What are the total corporate fixed costs? (d) What is the overall corporate breakeven in total revenue and for each product, assuming the sales mix is the same as last month’s? (e) What is the breakeven in revenues for regular boomerangs, ignoring corporate fixed costs? (f) Why is the breakeven for regular boomerangs different when we calculate the individual product breakeven versus the combined product breakeven? (g) When managers monitor the profitability of regular boomerangs, are corporate fixed costs relevant? Explain. (h) CVP analysis assumes that the sales mix will remain constant. Explain why managers generally cannot know for certain what their sales mix will be. (i) What is the effect of uncertainty about the sales mix on the quality of the information obtained from CVP analyses? (LO4) (a)

Last month 1200 regular and 2400 premium boomerangs were sold. Assuming the sales mix remains constant, two premium boomerangs are sold for each regular boomerang.

(b)

Total fixed product line costs: Regular: 1200 units × $8.17 = $9804 Premium: 2400 units × $24.92 = $59 808

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(c)

Total corporate fixed costs: $5.62 × (1200 + 2400) units = $20 232

(d)

To calculate the overall breakeven, it is easiest to first calculate the weighted average contribution margin ratio using an income statement approach:

Premium 2 400 $108 720 16 584 $ 92 136

Total 3 600 $135 300 21 756 $113 544

Weighted average contribution margin ratio ($113 544/$135 300)

83.92%

Units Revenue Variable cost Contribution margin

Regular 1 200 $26 580 5 172 $21 408

Overall corporate breakeven (recall that there are three fixed costs): Revenues = ($9804 + $59 808 + $20 232)/83.92% = $107 059 Breakeven for Regular based on sales mix in revenues: $107 059×($26 580/$135 300)

$ 21 032

Breakeven for Premium based on sales mix in revenues: $107 059×($108 720/$135 300) Total corporate sales at breakeven (e)

86 027 $107 059

Breakeven for regular boomerangs ignoring corporate fixed costs: Revenues = $9804/[($22.15 – $4.31)/$22.15] = $9804/0.8054 = $12 173

(f)

When regular boomerangs is required to cover only its own fixed costs, the company does not need to sell as many units to breakeven. The breakeven revenue for boomerangs is higher when it covers both its own and corporate fixed costs ($21 032) than when it only covers its own fixed costs ($12 173).

(g)

Corporate fixed costs are not usually under the control of the individual product managers. Therefore, corporate fixed costs generally are not considered when evaluating individual product profitability. However, the company as a whole needs to cover all of its fixed costs, so it is important to take corporate fixed costs into account when planning overall operations.

(h)

The actual sales mix can differ from plans for many reasons. For example, customer preferences can change, altering the number and prices of units. Competitor’s prices and products could affect the sales mix. Consumer buying patterns change when the economy changes.

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Sometimes an unforeseen event will greatly alter consumer behaviour. These changes cannot easily be predicted. (i)

When the sales mix is more uncertain, the quality of information from CVP analysis is lower because the CVP assumptions are more likely to be violated. Therefore, the likelihood that the sales mix will remain constant must be evaluated. Sensitivity analysis should also be performed to examine a larger range of operations that incorporate possible changes in sales mix. The quality of the CVP analysis is negatively affected by higher uncertainty about any of the variables used.

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4.44

Cost function; marginal cost; opportunity cost; usefulness of CVP A neighbour asked for your help preparing a grant for a not-for-profit after-school art program that would benefit primary school children in the neighbourhood. He wants to charge low fees for most children, but also offer some scholarships for low-income children. He needs to have one staff person for every six children to meet state regulations. He can use high school student volunteers for two of these positions, but is concerned about potential absences on their part if he relies on them to meet the state regulations. He would like the program to serve at least 30 children, and more, if possible. He wants you to help him decide on the fees to charge and also to determine how many students could receive scholarships. Required (a) Think about the costs involved in an after-school program. Assume that your neighbour can use the local primary school for free. (i) List costs that will be incurred for the program, and categorise them as fixed, variable, or mixed. (ii) For each variable cost, choose a potential cost driver. Explain your choice. (b) Do you think the cost structure would be primarily fixed or primarily variable? Explain. Remember, even though staff work only part time, they will have a regular schedule to meet the state regulations of six children per staff member. (c) Suppose one of the staff members has only one child to help. What is the marginal cost for three scholarships? (d) Suppose the program is fully subscribed by fee-paying children. What is the opportunity cost per scholarship? (e) Will CVP analysis help your neighbour choose a fee that would cover at least 10 scholarships? Explain how you would set up a spreadsheet so that your neighbour could perform sensitivity analysis to make more informed decisions. (LO7)

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(a) (i)

Here are several possible costs; students may think of others. Cost Staff people Art supplies High school help Snack food

(ii)

Category Fixed (fixed schedule according to number of children) Mixed, some that will be used up, and some (easels) that will be fixed Fixed (fixed schedule according to number of children) Variable

Snack food is the only completely variable cost and number of snacks served would be a good cost driver. Art supplies have a variable component, and number of children or number of hours of art would be reasonable cost drivers.

(b)

The cost structure likely has a larger proportion of fixed costs because salaries for staff and supervisors would be much higher per hour than the cost of supplies and snacks.

(c)

The marginal cost is the variable cost (supplies and snacks) per child for three children.

(d)

The opportunity cost is the revenue foregone from a fee-paying child.

(e)

CVP analysis offers the neighbour an opportunity to vary assumptions, such as price and volume of children served while he is considering various options such as scholarships. A spreadsheet can be set up with an input area for all of the assumptions such as fixed costs, variable costs, number of children, fees per child, number of fee-paying children, number of scholarships, and so on. Then the CVP calculations would be performed in a separate part of the spreadsheet, with cell references to the input cells. The neighbour could then modify data in the input cells to analyse the expected financial results under different sets of assumptions.

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4.45

Breakeven; CVP; potential cost structure change; employee reaction Ersatz manufactures a single product. The following income statement shows two different levels of activity, which are assumed to be within Ersatz’s relevant range. You may want to use a spreadsheet to perform calculations.

Required (a) What is Ersatz’s breakeven point in units? (b) Draw a CVP chart showing the two levels of activity and the breakeven point. (c) If Ersatz plans to sell 1300 units, what will pre-tax income be? (d) Your boss asked you to draft an e-mail response to Ersatz’s major shareholder, who wants to know why pre-tax income increases by more than 700 per cent when sales increase by just 50 per cent. Both your boss and the shareholder are busy people and expect short answers. (e) Management expects that variable costs and selling prices will rise by 3 per cent, but fixed costs will not change. What will the new breakeven point be? Explain the result. (f) Management wants to change the way that sales representatives are paid. At present, sales representatives are paid $11 000 + $10 per unit. Management will replace this formula with a payment of $20 per unit. At what level of sales will it make no difference in income which cost function is used? (g) Add the new cost function to the preceding CVP chart. (h) Which of the two cost functions will minimise selling expenses assuming that sales are above the indifference level calculated in part (f)? (i) How would sales representatives be likely to respond to the new payment system? (j) Discuss the pros and cons to the entity of changing the way sales representatives are paid. (LO2 and 6)

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(a)

The variable cost per unit is the same for 1000 units and for 1500 units. Therefore, it is reasonable to assume that these variable costs will also apply to a volume of 1300 units. Variable costs per unit are: $40 + $10 + $6 = $56 per unit Fixed costs are: $10 000 + $11 000 + $20 000 = $41 000 Breakeven is: $100×Q – $56×Q – $41 000 = $0 Q = 932 units to break even

(b) Total Revenue

CVP Graph 3.32(B)

Total Cost

$250,000

Dollars

$200,000 $150,000

$100,000 $50,000 $0 0

500

1,000

1,500

2,000

Number of Units

(c)

At 1300 units, pre-tax income is estimated as: ($100 – $56) per unit×1300 units – $41 000 = $16 200

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(d)

Following is a possible solution to this question. Notice that the message is as short as possible, yet fully answers the shareholder’s question. The message also avoids use of highly technical language, but it assumes that the shareholder is familiar with the terms used in the income statement.

Dear Major Shareholder You asked why our profits increased by 700% when sales increased by only 50%. When we sell 1000 units, we are very close to the breakeven point — the point at which our revenues exactly cover our costs. As volume increases above this level, our profit increases by $44 per unit (our selling price of $100 minus variable costs of $56). Hence, when sales increase by 500 units, pre-tax income goes up by $22 000. This will be true for any 500 unit change in sales. At 1000 units our pre-tax income was only $3000, so the percentage change when we move from 1000 units to 1500 units is very high.

Please let me know if I can answer any additional questions. Sincerely Accountant (e)

New breakeven: $100×(1.03)×Q – $56×(1.03)×Q – $41 000 = $0 $103×Q – $57.68×Q = $41 000 Q= 905 units The old contribution margin was $44, and the new contribution margin is $45.32, so the contribution margin per unit has been increased by 3%, causing breakeven unit sales to decrease.

(f)

The two approaches will yield the same cost (and, therefore, the same income) when: $11 000 + $10×Q = $20×Q Q = 1100 units

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(g) Total Revenue

CVP Graph 3.32(G)

Old Costs

Dollars

New Costs

$250,000 $200,000 $150,000 $100,000 $50,000 $0 0

500

1,000

1,500

2,000

Number of Units

(h)

If sales exceed 1100 units, paying $10 000 per period + $10 per unit (the old pay arrangement) will result in lower total selling costs.

(i)

Sales representatives with high selling volumes would probably like the new system because they would be likely to earn more. The opposite would be true for sales representatives with low selling volumes. Sales representatives who dislike risk might prefer the existing pay system, which guarantees a minimum payment. People often dislike any change, so there may be resistance regardless of whether sales representatives are better off. Overall, the new pay system might encourage sales representatives to achieve higher sales. It also might lead to higher employee turnover.

(j)

Pros of changing the system: • Reduces operating risk by reducing fixed costs • Reduces costs if sales are less than 1100 units • May encourage sales representatives to sell more

Cons of changing the system: • Increases costs if sales are greater than 1100 units • Could have adverse effects on sales representative morale

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4.46

Cost function; breakeven; targeted profit; uncertainties and bias; interpretation Joe Davies is thinking about starting a company to produce carved wooden clocks. He loves making the clocks. He sees it as an opportunity to be his own boss, making a living doing what he likes best. Joe paid $300 for the plans for the first clock, and he has already purchased new equipment costing $2000 to manufacture the clocks. He estimates that it will cost $30 in materials (wood, clock mechanism, etc.) to make each clock. If he decides to build clocks full time, he will need to rent office and manufacturing space, which he thinks would cost $2500 per month for rent plus another $300 per month for various utility bills. Joe would perform all of the manufacturing and run the office, and he would like to pay himself a salary of $3000 per month so that he would have enough money to live on. Because he does not want to take time away from manufacturing to sell the clocks, he plans to hire two salespeople at a base salary of $1000 each per month plus a commission of $7 per clock. Joe plans to sell each clock for $225. He believes that he can produce and sell 300 clocks in December for Christmas, but he is not sure what the sales will be during the rest of the year. However, he is fairly sure that the clocks will be popular because he has been selling similar items as a sideline for several years. Overall, he is confident that he can pay all of his business costs, pay himself the monthly salary of $3000, and earn at least $4000 more than that per month. (Ignore income taxes.) Required (a) Perform analyses to estimate the number of clocks Joe would need to manufacture and sell each year for his business to be financially successful: (i) List all of the costs described and indicate whether each cost is (1) a relevant fixed cost, (2) a relevant variable cost or (3) not relevant to Joe’s decision. (ii) Calculate the contribution margin per unit and the contribution margin ratio. (iii) Write down the total cost function for the clocks and calculate the annual breakeven point in units and in revenues. (iv) How many clocks would Joe need to sell annually to earn $4000 per month more than his salary? (b) Identify uncertainties about the CVP calculations: (i) Explain why Joe cannot know for sure whether his actual costs will be the same dollar amounts that he estimated. In your explanation, identify as many uncertainties as you can. (Hint: For each of the costs Joe identified, think about reasons why the actual cost might be different than the amount he estimated.) (ii) Identify possible costs for Joe’s business that he has not identified. List as many additional types of cost as you can.

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(iii)

Explain why Joe cannot know for sure how many clocks he will sell each year. In your explanation, identify as many uncertainties as you can. (c) Discuss whether Joe is likely to be biased in his revenue and cost estimates. (d) Explain how uncertainties and Joe’s potential biases might affect interpretation of the breakeven analysis results. (e) Use the information you learned from the preceding analyses to write a memo to Joe with your recommendations. Attach to the memo a schedule showing relevant information. As appropriate, refer to the schedule in the memo. (LO2 and 3) (a) (i)

First clock Equipment Materials Rent space Utilities Joe’s salary Sales staff Total (ii)

Relevant No; Sunk cost No; Sunk cost Yes Yes Yes Yes Yes

Fixed

Variable

$30 each $2,500 300 3 000 2 000 $7,800

7 each $37 each

Contribution margin = $225 – $37 = $188 per clock Contribution margin ratio = $188/$225 = 0.8356

(iii)

TC = $7800 + $37×Q Breakeven in number of clocks: $7800/$188 per clock = 42 clocks Breakeven in revenues: $7800/0.8356 = $9335 Or 42 clocks × $225 per clock = $9450 (difference due to rounding)

(iv)

Number of clocks to achieve target profit: ($7800 + $4000)/$188 per clock = 63 clocks

(b) (i)

Joe cannot be certain that the price of wood will remain the same for the next year. If petrol costs increase, wood

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transportation costs could increase. If demand greatly increases or decreases, the purchase cost will change in response. If there is a natural disaster, such as a fire or flood, supply may be limited and prices could increase. Rent prices increase periodically, and so his rent could change in the next year. Utility bills could increase or decrease, according to weather, potential shortages, or increased demand due to bad weather in other parts of the country. He could have to pay sales people more or less than he plans, depending on the local economy and the demand for clocks. If there is only small demand for the clocks initially, he may have to increase salary until demand builds. There are many other answers for this question, too. (ii)

It is likely that Joe may need to advertise. He also may need a receptionist in the office during business hours. He has not included regulatory costs such as business licenses, employment and property taxes, and any local fees for services. Joe has not considered insurance or employee benefit costs. Students may have identified other costs as well.

(iii)

Joe cannot be certain that his estimated sales volume is correct because he does not know what the local and regional competition might be, and he does not know whether most of his sales will happen during holiday seasons. Unanticipated fluctuations are also likely to occur for discretionary products such as clocks. Furthermore, he does not have experience selling the clocks full time, so he might be overestimating demand for the clocks.

(c)

Because Joe likes to make the clocks, he is biased toward starting this business. Therefore, he is likely to overestimate revenues and underestimate costs. Part (B)2 above already identified a number of costs that he has overlooked.

(d)

Uncertainties and potential biases reduce the quality of the information used as inputs for the CVP analysis, thus reducing the quality of the CVP information. As a result, an objective person would be sceptical of the CVP results and would potentially seek higher quality information. For example, market research might be used to increase the quality of revenue estimates.

(e)

There is no one answer to this part – suggestion select students in group to discuss their recommendations and use this as a basis for class discussion.

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4.47 CVP sensitivity analysis; bias; quality of information Jasmine Krishnan has been taking entrepreneurship courses as part of her business degree. She developed a plan to start a travel agency specialising in semester break trips for students. She learned how to develop CVP analysis in her cost accounting class. Now she is preparing pro forma (forecasted) statements of profit or loss for a brochure about her plans for the travel agency. She wants to use the information from the CVP as a basis for the statements. Her entrepreneurship professor criticised her business plan because Jasmine included too small an amount for liability insurance. However, when she included the amount suggested by her father’s insurance agent, she had to set prices quite high, cut back on the amount she planned as her salary, find lower quality hotels for the students, or take some combination of these actions. She thought that hotel quality and prices would affect sales volumes negatively and did not want to risk incurring losses from low revenues during her first few years. She also needed a base level of salary to at least pay for her living expenses. She decided to ask friends and relatives to invest in her travel agency to ensure she had enough capital for the first few years. Once her reputation was well established, she assumed that higher customer volumes would cover all of her expected costs. She was confident that her planned trips would attract enough students each year to cover most of her costs. From focus groups on campus, she learned which types of trips were most appealing to other students. Now she planned to use sensitivity analysis to solve for volumes that would make the pro forma statements look attractive to investors. Required (a) In general, what information do we hope to gain from performing sensitivity analyses? Explain. (b) Explain how bias might enter into Jasmine’s sensitivity analyses. (c) How might Jasmine’s bias affect the quality of the investment brochure information? (d) Identify a potential ethical problem for Jasmine. (e) When you consider the well-being of Jasmine’s family and friends, how would you recommend that Jasmine use sensitivity analysis for her brochure? Explain. (LO6 and 7) (a)

Usually, sensitivity analysis is performed to determine how sensitive profits are to changes in assumptions such as estimated prices, costs and volumes of sales. Sensitivity analysis helps decision makers understand the range of operations that could be expected, both under normal conditions and under best and worst case scenarios.

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(b)

Jasmine is excited about her idea She probably also believes that setting up these trips would be quite a lot of fun. Therefore, she may be over-optimistic in her beliefs about future operations. When people find an alternative in which they are highly interested, they become biased toward that alternative and choose assumptions that are likely to lead to a positive decision about that alternative. In addition, they may interpret results more positively than if they were not biased. Jasmine would need to underestimate insurance or other costs or overestimate sales for this business venture to be attractive to investors. If she does this, she is biasing the information.

(c)

If the brochure contains biased information, the quality of information is low. Potential investors who rely on the brochure would be given misleading information. Thus, the quality of potential investor decisions would be low unless they seek and obtain more objective sources of information.

(d)

The ethical problem is that the biased information misleads potential investors to believe that the new venture has a higher probability of success than it actually has. Some investors may rely on Jasmine to return their investments in the future, but she may not succeed and may not be able to return the investment or any return on it. Most investors have a range of choices and consider both the investment return and risk as they compare their choices. By biasing the information, Jasmine would also bias the decision making process for her potential investors; they may invest in a project that is more risky than their other investments without realising the potential consequences of this decision. This is unfair to them and unethical.

(e)

Jasmine needs to present the most objective set of assumptions possible in her calculations so that her investors can make the best decisions for their own welfare. Sensitivity analysis showing realistic best and worst case scenarios will help investors identify more accurately the risk they are undertaking by investing in this venture. The quality of their decision making will be greatly improved.

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Small business owners; CVP research on the internet The Internet provides many resources to help small business owners successfully manage their businesses. These resources include information about common techniques used for planning and managing operations. Required (a) Why are small business owners often unaware of common business techniques such as CVP analysis? (b) Why might CVP analysis be even more useful to small business owners than to managers of large entities? (Hint: Consider whether information about the margin of safety and size of potential losses might be especially important for people who own small businesses.) (c) Use an Internet search engine to locate websites that provide information about the terms breakeven analysis and cost–volume– profit analysis. Also search for these terms on websites designed explicitly to help small business owners. Summarise what your research tells you about the uses and usefulness of breakeven and CVP analysis. (d) Suppose you are trying to help a small business owner learn to use breakeven and CVP analysis. Write a memo to the owner explaining what you think the owner should do and include appropriate references to internet resources that would be useful to the owner. Assume that you have already had a brief conversation with the owner about breakeven and CVP analysis, and the owner expressed an interest in learning more. Focus on communicating effectively by avoiding unnecessarily technical language and concentrating on the most important points. (LO2 and 3) (a)

Many small business owners have no business experience or education. They do not know any of the techniques needed for high quality decisions.

(b)

Because risk of loss for small businesses is the risk of loss of their personal cash flows, owners need to fully understand the consequences of their choices on profits. In addition, a large proportion of new businesses fail. Therefore, CVP analysis is highly useful. CVP analysis can help owners more thoroughly consider the quality of information they use to estimate future results and recognise the risks of their decisions. They are also able to perform sensitivity analysis to reduce elements of surprise from changes in future plans and results. They can respond more quickly to changes in their operating environment, increasing their chances of success.

(c)

Student answers to this question will vary depending on the websites they locate and explore.

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(d)

Student memos will vary, but they should include the following in simple, clear language: • Developing CVP analysis forces decision makers to estimate

•

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future revenues, costs, and volumes, which is good for small businesses because of the uncertainty in their operating environments. Using sensitivity analysis increases the ability of owners to identify risk and respond to changes in their operating environment. CVP analysis also acts as a budget or plan for future operations. Small business owners may not believe they need a plan, but most businesses do need to plan. Provide an overview of the process of using CVP analysis, including identification of the estimates that must be developed, the formulas used, and the types of sensitivity analysis that could be performed. Recommendations for setting up a spreadsheet to perform CVP analysis.

Not-for-profit breakeven price; budget alternatives

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The Elder Clinic, a not-for-profit entity, provides limited medical services to low-income elderly patients. The manager’s summary report for the past four months of operations is reproduced here.

The clinic receives an operating subsidy from the state government, but unfortunately, the operating loss incurred through June ($79 392) is larger than anticipated. Part of the problem is the salary increase that went into effect in June, which had been overlooked when the budget was submitted to the state government last year. To compound the problem, the cold winter months traditionally bring with them an increase in cold weather related health problems. Thus, the clinic is likely to experience an increase in patient visits during July. The accountant made the following assumptions in developing the cost function: • Salaries are fixed, and June values are used. • Medical supplies vary with patient visits. • Rent and utilities are fixed, and last period’s costs are used. • Other expenses are mixed and using regression, fixed cost is $702 and variable cost is $2.53 per patient visit. Clinic management is considering an increase in patient fees to reduce losses. Required (a) Develop a cost function for this data (refer to chapter 2). Use the cost function you developed to solve for the average patient fee necessary to break even, assuming there are 940 patient visits. Compare this new fee with the average patient fee charged during March through June. (b) Suppose the clinic raises its patient fees to break even. What problems do you see from the elderly patients’ perspective if the fee is raised? (c) In this setting, would an increase in fees be likely to affect patient volume? What problems do you see from the clinic’s perspective if the fee is raised? (d) Other than raising the fee, what ideas might the clinic consider to balance the budget? (LO2 and 3)

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(a)

The cost function is: TC = $19 736 + $6.07 × patient-visits. Breakeven, solving for price: $0 = (P – $6.29) × 940 patient-visits – $19 285 940 × P = $25 197.6 P = $26.81 per patient-visit The average patient fee during March–July was: $16 545/3290 patient-visits = $5.03 per patient-visit The actual fees charged are far below the levels needed to break even.

(b)

Many patients may not be able to afford this fee. Since many of elderly patients are on fixed incomes, they may have to make trade-offs between other living expenses and their medical expenses. They may also forego needed medical services.

(c)

If the fee is raised, volumes are likely to go down. That means that fees may need to be raised again, causing further declines in volume. This is called the ‘Death Spiral’.

(d)

If possible, the clinic could try to substitute cheaper labour for expensive labour. If a physician’s assistant or specially trained nurse can see some portion of patients instead of a physician, this would reduce some of the fixed cost. Analysis of other costs that can be reduced is needed. There may be grants that would offset some fixed costs, or it is possible that donors can be found to offset some costs. An annual fund raising event might be held.

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4.50

Cost function; target profit; operating leverage; CVP graph; owner goals Trang Nguyen owns Trang’s Stained Glass in Sydney. The business produces and sells three different types of stained glass windows: small, medium, and large. Trang has two full-time employees who work regular schedules to cut glass and assemble the windows. She borrowed money from the bank to start the business and pay living expenses. She is concerned that her cash flows might not be high enough either to pay herself or to repay the bank loan. She would like to generate approximately $10 000 in pre-tax profit each month to cover her living expenses and repay the loan. The following revenue and cost information covers the past four months:

Required (a) Develop a cost function for Trang’s Stained Glass. (b) Determine the level of revenue Trang’s Stained Glass must generate to achieve the targeted profit of $10 000 per month. (c) Calculate Trang’s degree of operating leverage for September. (d) Interpret Trang’s degree of operating leverage. (e) Create a CVP graph showing the breakeven point, target profit, and margin of safety. (f) Write a memo to Trang with recommendations about ways she might achieve her goals. (LO3 and 6) (a)

Below is one solution for the cost function. This solution involves a number of judgments about cost classification and choice of estimation methods. Other reasonable solutions are possible, particularly for ‘raw materials and supplies’ and ‘miscellaneous’. Labour and rent costs are most likely fixed. Rent is usually a fixed cost, and labour appears to be fixed for this company because the employees work regular schedules. Both of these costs are estimated based on the most recent month’s information. This procedure will incorporate the apparent rent increase that took place in September and the most recent employee schedules and pay rates. Therefore, the rent cost is estimated at $2200, and the labour cost is estimated at $4282. Raw materials and supplies for a manufacturing organisation are most likely to be variable. No information is provided about alternative cost

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Scatter Plot 3.39(A)

Miscellaneous Costs

drivers, so this solution estimates raw materials and supplies as a $900of revenue. This treatment is reasonable because these percentage types of$800 costs and revenues both tend to vary with the size of window. If raw material $700 and supply costs change over time, then it is best to use the most$600 recent information available. Therefore, this variable cost is estimated using the most recent month’s data: $500 $400 $4029/$16 116 = 25% of revenue $300 No information $200 is provided about the nature of the miscellaneous cost. Miscellaneous $100 might include direct costs such as packing materials for the windows $0and indirect costs for supplies used in the office. Also, this cost appears to have increased along with the increases in revenues $0 $5,000 $10,000 $15,000 $20,000 over the four months presented. The scatter plot shown below is used to further analyse the relationship. Revenues

The scatter plot seems to confirm a positive relationship between miscellaneous costs and revenues. Therefore, regression analysis will be used to estimate the cost function for miscellaneous costs, with revenues as the independent variable. Portions of the regression output are shown below. Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations

Intercept X Variable 1

0.93615673 0.876389423 0.814584134 50.45858562 4

Coefficients 334.098272 2 0.03030240 6

Standard Error 98.2079210 6 0.00804713 7

t Stat 3.40194 8 3.76561 4

P-value 0.07660 9 0.06384 3

Based on the regression results, the miscellaneous cost function is estimated as: TC = $334 + 3% of revenues Given the following summary of individual cost functions, the total cost function for Trang’s is TC = $6816 + 28% of total revenue. Cost Category Raw materials and supplies Labour Rent Miscellaneous Total

Fixed $ 0 4282 2200 334 $6816

Variable 25% of total revenue

3% of total revenue 28% of total revenue

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$30,000

(b)

The$25,000 monthly amount of revenues needed to generate profit of $10 000 per month is:

(c)

Dollars

$20,000

Revenue = $15,000

F + Profit 6816 + 10 000 = = 23356 CMR 1 − 0.28

The degree of operating leverage for September was: $10,000

[$16 116×(1 – 0.28)]/$4813 = 2.41 $5,000

(d)

If sales decrease by 10%, profit decreases by about 24% (10% × 2.41). $0 Elina’s cost structure includes a large proportion of fixed costs. $0

(e)

(f)

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$5,372

$10,744

$16,116

$21,488

$26,860

Revenues

There are many different ways to write a memo to Trang. Following are points that should be covered in the memo.

•

The CVP analysis indicates that Trang must achieve a substantial increase in revenues to achieve targeted profit of $10 000 per month. Revenue over Breakevenwould Point have to increase by $7240 Target September’s level, or 45% ($23 356 – $16 116)/$16 116 = 0.45). Profit

•

The CVP graph and degree of operating leverage indicate that fixed costs are a large portion of total costs. If Trang believes that this is too much risk, she will Margin need tooffind a way to increase Safety revenue without increasing fixed costs.

•

Here are a few possible recommendations for increasing revenues, students may have thought of others. She could offer classes in the evening to develop a larger clientele for her work. She could sell stained glass pieces and supplies to people taking classes and to others who produce stained glass for hobby purposes. Both of these plans are unlikely to increase fixed costs by much since employees are currently idle part of the time. (However, she would need to invest in higher inventories.)

Building and using a CVP financial model Toddler Toy Company sells baby dolls, teddy bears, and toy cars. The managers established a preliminary budget using the following

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assumptions. They would now like to evaluate the sensitivity of budgeted results to different sets of assumptions.

Required (a) Create a spreadsheet that the managers can use for sensitivity analysis. Modify input data in the spreadsheet to answer the following parts of this problem. You may wish to add cell references for percentage changes in prices, volumes, and costs. (b) Assume that the volume of dolls sold increases to 225 000 units with no change in fixed or variable costs. What is the new pre-tax income? Does the number produced by your financial model appear to be reasonable? (Manually estimate the increase in pre-tax profit if volume increases and fixed costs remain constant. Compare this figure to your spreadsheet result.) (c) Based on the original assumptions, what is the effect on pre-tax income if variable costs increase by 5 per cent for each of the three product lines? Assume that nothing else changes. (d) Return to the original assumptions. Assume that a sales manager proposed a new advertising campaign to boost sales volume. The campaign would cost $30 000 and is estimated to increase the volume of each product as follows: • Baby doll sales increase by 20 000 units. • Teddy bear sales increase by 7500 units. • Toy car sales increase by 30 000 units. What would be the effect on pre-tax income if this plan were adopted? (e) Return to the original assumptions. Now assume that due to competition, Toddler Toys must cut prices on each of its three products by 20 per cent. In addition, a new advertising campaign costing $45 000 must be instituted to counteract bad publicity. Given these assumptions, what is the new breakeven point? (f) Return to the original assumptions. What would be the pre-tax profit if Toddler Toys increases the price of all three products by 10 per cent and the volume of each product line decreases by 5 per cent? (g) Given the same assumptions as in part (f), how many units must Toddler Toys sell to earn a target pre-tax income of $100 000? A target pre-tax income of $150 000? A pre-tax return on investment

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(h)

(ROI) of 10 per cent? (Hint: To determine the target pre-tax income, multiply 10% times amount invested.) Spreadsheets for financial modelling allow sensitivity analysis of revenues, costs, and quantities such as estimated product volumes. (i) Explain why it is not possible to perfectly estimate revenues, costs, and quantities. (ii) Explain how sensitivity analysis can help managers evaluate the pros and cons of alternatives. (iii) Explain how manager bias might influence estimates of revenues, costs, and quantities.

(LO7)

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(a)

See the sample spreadsheet below. B

Toddler Toy Company 2 Assumptions for Coming Year 3 Toy Cars Baby Dolls Teddy Bears 4 225,000 125,000 200,000 5 Volume $3.15 $2.75 $3.50 6 Selling price per unit $35,000 $125,000 $65,000 7 Fixed costs $2.45 $1.75 $2.05 8 Variable cost per unit 9 10 Target pretax profit 11 Investment 12 Change in values for all products: 13 Increase in volume 14 Increase in price per unit 15 Increase in variable cost per unit 16 Increase in total fixed cost 17 18 Profit Calculations: Product 19 20 Toy Cars Baby Dolls Teddy Bears 21 225,000 125,000 200,000 22 Actual Sales Volume (units) 40.91% 22.73% 36.36% 23 % Weight 24 $3.150 $2.750 $3.500 25 Unit Sales Price $2.450 $1.750 $2.050 26 Variable Cost Per Unit $0.700 $1.000 $1.450 27 Contrib. Margin/Unit 28 $708,750 $343,750 $700,000 29 Total Sales Revenue $551,250 $218,750 $410,000 30 Total Variable Costs $35,000 $125,000 $65,000 31 Fixed Costs $122,500 $0 $225,000 32 Operating Profit 33 17.28% 0.00% 32.14% 34 Profit % of Sales 35 36 37 Breakeven and Target Profit Analyses: Product 38 39 Toy Cars Baby Dolls Teddy Bears 40 41 88,428 49,127 78,603 42 Sales Volume (units) 43 $278,548 $135,098 $275,109 44 Total Sales Revenue $216,648 $85,972 $161,135 45 Total Variable Costs $61,900 $49,127 $113,974 46 Total Contribution Margin 47 Fixed Costs 48 Net Profit 49

Total

$0 $2,000,000 0% 0% 0% $0

Total 550,000 100.00% $3.186 $2.145 $1.041 $1,752,500 $1,180,000 $225,000 $347,500 19.83%

Total 216,157 $688,755 $463,755 $225,000 $225,000 $0

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(b)

When the volume of doll sales increases to 225 000, total company profit increases from $347 500 to $383 750. Manual check: The profit should have increased by the contribution margin for dolls times the increase in volume of doll sales: (225 000 dolls – 200 000 dolls) × ($3.50 price per doll – $2.05 variable cost per doll) = 25 000 dolls × $1.45 per doll = $36 250 The profit increase is added to the original profit and the revised profit agrees with the spreadsheet: Original profit Increase in profit (calculated above) Revised profit

$347 500 36 250 $383 750

(c)

The expected pre-tax profit decreases from $347 500 to $288 500.

(d)

The expected pre-tax profit would increase from $347 500 to $375 000. Note about rounding in the following solutions. Because CVP is an estimation technique involving uncertain future revenues and costs, the authors do not believe that it would be useful for the spreadsheet to round units to whole numbers or to round prices to 2 decimal places. Additional precision in the calculations would not improve decision making.

(e)

The new breakeven point is a total of 668 919 units (243 243 dolls, 152 027 bears and 273 649 cars) and revenue of $1 705 135.

(f)

The expected pre-tax profit is $485 363.

(g)

The spreadsheet shows total units as follows for different levels of target income: Target Income $100 000 $150 000 $2 000 000 × 10% = $200 000

Total Units 239 050 275 827 312 604

(h) (i)

All of these cash flows and quantities are subject to change depending on things like consumer preferences, the economic environment, capacity constraints, unusual situations like electricity disruptions due to weather, labour strikes, and other factors that are not predictable.

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(ii)

Sensitivity analysis provides managers a model best-case, worst-case, and average scenarios. This can help them reduce risk in operations as they make decisions. For example, if there is a down turn in the economy, sales are likely to be affected. Sensitivity analysis can help managers determine whether the organisation will profit even if sales decrease. In addition, each product can be analysed separately to determine which product is most profitable and should be emphasised.

(iii)

Managers are often biased toward an optimistic view of the future. They may believe that their decisions will always turn out well, or they may wish to report favourable expectations to superiors. They may support one particular product based on their own preferences. They may favour a product designed or manufactured by employees who are also good friends. These types of biases often cause them to overestimate sales volumes and prices and to underestimate costs. Alternatively, they may be biased against products because they do not like them or because someone they do not like developed or manufactures them. These types of biases cause managers to underestimate sales volumes and prices and to overestimate costs.

Building and using a CVP financial model The following information for Pet Palace, a large retail store that sells petrelated merchandise, was recorded for the first quarter. The store tracks

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merchandise according to product type. The category ‘Other’ includes accessories such as dog beds, leashes, kitty litter boxes, bird cages, and so on. The company is considering several different strategies to improve operations for the next quarter.

Required (a) Create a spreadsheet that Pet Palace managers can use for sensitivity analysis. Modify information in the data input section and answer the questions in the following parts. (b) What is Pet Palace’s breakeven point? What total revenue is necessary for a target after- tax income of $100 000? (c) Pet Palace managers are considering their advertising campaign for the next period. They believe they could spend an additional $10 000 on advertising for a product line and increase sales by 10 per cent. One manager wants to increase advertising on pets because that product line is currently the smallest. Another manager believes the ads should promote the most profitable products, but they are not sure which products those would be. What is the after-tax profit if pets are promoted? What is the most profitable product? What is the after-tax profit if that product is promoted? (d) What factors, other than the quantitative results, might influence managers’ decisions to increase advertising? (LO7) (a)

See the sample spreadsheet on the following page.

(b)

The breakeven point is revenue of $900 442. Revenue needed for an after-tax target income of $100 000 is $1 118 732.

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Income statement Revenue variable cost Contribution margin Fixed costs Pretax income Taxes After-tax income

Food $486,726 $194,690 $292,035

Toys $146,018 $48,673 $97,345

Pets $73,009 $58,407 $14,602

Other $194,690 $48,673 $146,018

Total $900,442 $350,442 $550,000 $550,000 $0 $0 $0

(c)

Expected after-tax profit under the original assumptions is $11,250. Below is a summary of the expected after-tax profit if each product were emphasised in an advertising campaign: Product Emphasised Pets Food Toys Other

After-Tax Profit $ 4,875 26,250 11,250 15 000

This answer contradicts the previous answer. Based on the expected after-tax profit, the company would benefit most from emphasising Food in an advertising campaign. Other products have the highest contribution margin; each additional dollar of revenue for Other products contributes more to profits than an additional dollar of revenue for Food, Toys, or Pets products. However, estimated revenues for Food are much higher than for the other products. Therefore, a 10% increase in revenue for Food has a much larger positive effect on profit than a 10% increase in revenue for any of the other products. (d)

There are many possible answers to this question. Managers may increase advertising to increase brand recognition. If some products are unique to a particular outlet, managers may want to promote them because there is no competition for those products. Managers may also choose to advertise products that are on sale to bring customers into the store.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. Prepared by Gillian Vesty

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 13: Job costing for financial reporting

Chapter 5: Planning – budgeting and behaviour Questions 5.1

Outline the meaning of the profit planning or strategic budgeting process. (LO1)

Profit planning or strategic budgeting process refers to the process of considering alternative courses of action on profit asset and cashflow management. Consideration will be given to both the financial and non-financial impacts of alternative decisions. The impacts must consider not only the organisation’s own production or service provision, but also strategically in relation to competitor and market based responses.

5.2

Explain why it is important that an organisation’s budget be linked to strategy. (LO1)

It is important that an organisation’s budget is linked to strategy because the budget provides information about the boundaries within which the entity will operate and how scarce resources are to be allocated for the coming period. The budget informs those in the organisation how the strategic plan will be operationalised in the coming period.

5.3

In the planning or strategic budgeting process, explain how a sales revenue budget can be determined. (LO1 and 2)

In strategic budgeting a sales budget can be determined by the following: • Existing and past history of sales/revenue and product/service mix • The nature of sales initiatives and impacts, for example, changed product/service offerings, changed mix emphasis, and the likely reaction of competitors • Consideration of external market through competitor analysis • Review of macroeconomic conditions.

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Contemporary Management Accounting Solution Manual

5.4

Distinguish between a discretionary cost centre and an engineered cost centre. (LO3)

The difference relates to the identification of the relationship between inputs and outputs. In a discretionary cost centre the relationship between inputs and outputs is more difficult to identify. For example, training costs for employees cannot be easily linked to improved performance. An organisation cannot say that for every $1 spent on training there will be an X% improvement in profits. In contrast an engineered cost centre is one where the relationship between inputs and outputs is readily measured as there is a standard against which actual performance can be measured. For example when an activity is repeated it is easier to identify the resources required to produce the output. 5.5

Explain the key concepts of program budgeting. (LO4)

Program budgeting • requires the organisational unit to plan its expenditure around the programs or projects its conducts • requires justification for the expenditure for each program, which can be linked to the objectives of the program

5.6

Explain the key concepts of zero-based budgeting. (LO4)

Zero-based budgeting • requirement for managers to justify proposed budgetary expenditure as if no information about budgets or costs from prior budget cycles was available • encourages managers to cut costs and focus on desired outcomes • approach often leads to reduced wastage, greater performance of value-adding activities and a focus on quality improvement. • If used for austerity purposes, can constrain innovation, creativity and strategic risk taking.

5.7

Briefly describe the attributes of activity-based and kaizen budgeting. (LO4)

Activity based budgeting – costs are budgeted at the activity level and relevant cost drivers identified to determine resource consumption. The selection of cost drivers enables management to focus on the key product/service cost drivers. Kaizen budgeting – introduces a continuous improvement approach to budgeting as it sets targeted cost reductions across time and anticipates market price reductions across the life of the product.

5.8

Explain why the budgeting process might not necessarily be successfully implemented in an organisation.

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Chapter 13: Job costing for financial reporting

(LO1, 2 and 5) The budgeting process can lead to irrational behaviour and resource allocation based on politics, game-playing and empire building. Some employees may treat budgets like fixed contracts which need to be achieved at any cost regardless of long-term goals or strategic uncertainty (which may call for a deviation from the strategic path). Dysfunctional behaviour may arise when an employee/manager focuses on cost constraints (inputs) rather than value creation (outcomes); and their individual business unit performance to the detriment of entire organisational performance. Budgets may also de-motivate performance acting as a ‘stick’ with hard to achieve targets rather than a ‘carrot’ to motivate performance.

5.9

Outline the key components of Beyond Budgeting. (LO6)

The proponents of Beyond Budgeting advocate that budgeting should take place in an open and collaboratively dynamic environment whereby employees are motivated towards continuous improvement and are readily equipped with the skills and resources to adapt to changing conditions. As such the process should demonstrate decentralisation of decision making and key performance management structured as a form of benchmarking referred to as “relative” performance evaluation. Annual planning is replaced with adaptive and evolved orientation using rolling forecasts.

5.10

Why do proponents of the Beyond Budgeting movement recommend abandoning traditional budgets? (LO6)

One of the most important underlying assumptions of beyond budgeting is that every day is different. Therefore, the use of fixed budgets is risky, even dangerous, as it is based on assumptions that have not been foreseen. Proponents of the ‘Beyond Budgeting’ movement point out that budget achievement does not necessarily mean goal achievement. Likewise they suggest traditional budgeting impedes performance and interferes with decentralisation and employee empowerment (see Section in 5.6).

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5.11

What distinguishes zero-based budgeting from other types of budgeting? (LO6)

Zero-based budgeting is different because it starts with a zero based as managers are required to justify proposed budgetary expenditure as if no information about budgets or costs from prior budget cycles was available.

5.12

Discuss the similarities and differences between annual budgets and rolling budgets. (LO4)

Annual budgets reflect planned revenues and expenditures for the next 12 month period. In contrast rolling budgets are prepared monthly or quarterly and reflect planning changes, often through the next 12 to 18 months and thereby incorporate more current information that then static annual budget.

5.13

Classify the following cost centres as more likely to be engineered cost centres or discretionary cost centres: • R&D department • HR department • Manufacturing plant (LO3)

R&D department – discretionary cost centre HR department – discretionary cost centre Manufacturing plant – engineered cost centre In engineered cost centres the input / output relations are well understood. The optimal amount of input required to produce one unit of output can be readily determined. Once desired output is known, input can then be determined. For example, direct labour / materials are engineered costs and product outputs can be measured in physical terms. Whereas in discretionary cost centres, such as HR and R&D, the outputs are qualitative rather than purely quantitative; or the relationship between $ input and value of output achieved is not easily measurable. Consider working in an R&D lab on a new drug innovation. This may require years of work and sometimes disappointing results. The activities tend to be labour intensive with few variable costs. It is often difficult to determine the ‘optimal’ level of funding/spending in discretionary cost centres

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5.14

Explain how program budgeting assists with planning in discretionary cost centres. (LO4)

In a discretionary cost centre program budgeting means that instead of budgeting by line item (i.e. salaries, supplies, telephone and computing costs etc.) we can group costs according to the project/program. In this way the project/program becomes the cost object allowing the goals and outcomes of the individual program to be more readily identified. In this way we can more easily see the benefit to the program if we spend more money in marketing or staff training.

5.15

Explain how zero-based budgeting assists with planning in discretionary cost centres. (LO4)

If zero-based budgeting is used in discretionary cost centres we start with a zero resource allocation base and work from there. Every dollar amount has to be justified from this zero base. The reason why it helps with planning is that decision packages must be costed and qualitative benefits also identified and argued for in the expenditure. Zero-based budgeting breaks down the ‘incremental’ budgeting mindset but is timely and costly when done on an annual basis

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Exercises 5.16

Budgeting and behavioural implications Jordy is the CEO of a scaffolding construction company. He is about to begin preparing the budget for the coming financial year for the entire organisation. Last year he was disappointed with the animosity he received from his divisional managers. They were not happy with their individual budgeted forecasts. He knew the targets were hard to achieve, but why make them too easy? ‘I am not giving away bonuses for nothing,’ he thought? Jordy had always prepared the budget himself. He believes that no one knows the company better that he does. The company was established by Jordy’s father more than 30 years ago and Jordy has worked for the company since he left high school. Required Advise Jordy on the key requirements for successful budgeting. What changes to the way budgets are currently set would you recommend? (LO5)

Key requirements for successful budgeting: Jordy needs to be aware of the following factors key to successful budgeting: • Employee participation in budget setting • Ability for targets to be achieved by his subordinates (no building in slack with easy to achieve targets or alternatively targets that are de-motivating as they are too hard to achieve) • Beware of budgets that encourages behaviour that compromises quality, customer service and organisational performance in the long-run (staff animosity may compromise their productivity) • Allow for some flexibility in budgeting (i.e. ensure that uncontrollable externalities can be accommodated in the budgeting process) • Consider alternative forms of rewards other than using budgets for employee performance measurement Changes to current budgeting practices: Jordy needs to be aware of the key requirements for successful budgeting and incorporate these into his current budgeting practices. For example he should encourage greater employee involvement in budget and target setting. He should consider using long-run as well as short-term (financial and non-financial operational) measures for performance rewards.

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5.17

Strategic budgeting Stevan Donald, the marketing manager for Organic Brewing Company, has projected a 20 per cent increase in sales of hop beers next year. Required Comment on how this increase in sales will impact on profit, assets and cash flow. (LO1 and 2)

In light of a projected 20 percent increase in sales next year, Stevan Donald will need to consider the following in relation to: 1. Profit – will the increased revenue lead to higher profit, consideration has to be given to the additional costs that will be incurred as a result of increased activity 2. Assets – are there sufficient staff to be able to satisfy the increased demand. 3. Cash flow – increased demand will most likely increase the need for working capital due to increased debtors levels and operating expenditure. Resources will need to be given to debtors' management to ensure the cash flow.

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5.18

Relationships between operational budgets and strategic plans At a recent management meeting looking at the entity’s achievements against its strategic objectives, an operational manager was heard making the following comment: ‘I look after operations on a day-to-day basis. I have the operational budget for the coming year. I don’t need to be concerned with the strategic plans. These plans have got nothing to do with my accountabilities.’ Required Comment on the statement made by the operational manager. (LO2)

Budgets should be prepared in light of organisational strategies and are a method to communicate strategies and objectives throughout the organisation. Operating plans are developed from organisational strategies, and these are communicated from top levels throughout the organisation. Sub-units then develop budgets considering organisational objectives and communicate their budget goals to top management. After the budgeting process is complete, actual operations are compared to budgets and any differences are investigated. This process leads to re-evaluation of the organisation’s vision and strategies.

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5.19

Principles of Beyond Budgeting Ange Pala, the chief financial officer of a national tourist company, has become increasingly dissatisfied with the current budget process in the organisation. Much of her dissatisfaction relates to the amount of time and resources consumed in the budget process; the relatively poor efforts at estimating costs; and deciding where to focus attention for control purposes. At a recent seminar, Ange was introduced to the concepts of Beyond Budgeting. Required Identify three key principles of Beyond Budgeting and outline how they differ from more traditional budgeting principles. (Hint: see Table 5.1.) (LO4)

Key problems identified when using traditional budgeting Time and resources consumed in developing budget Poor efforts at estimating costs

Difficulty in identifying what to focus on for control purposes

Contrast with beyond budgeting principles Resources should be made available as needed Planning should be a continuous and inclusive process with measurement made through relative performance indicators Rather than basing governance on detailed budgeting; decentralised, autonomous employees should be given clear goals, values and boundaries to work to that focus on customer outcomes

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5.20

Profit planning, adjusting strategic plans Trinity Records is a company that finds and signs a new artist, develops a marketing strategy, records the music, and distributes the music to retailers. Data for the CD division of Trinity Records, which distributes CDs to large retailers, are shown below.

The budget, set at the beginning of the year, was based upon estimates of sales and costs. Administrative expenses include charges by corporate headquarters for providing strategic guidance. These fixed costs are allocated to divisions using revenue as the allocation base. Required Due to a booming economy, the division’s unit sales were higher than anticipated, even though the division’s share of the CD market fell from 22 per cent to 20 per cent during the year. How will this impact on the future budgeting of the CD division and other divisions of Trinity Records? (LO2) Rather than allocation of expenses as a function of revenue, Trinity Records management should consider the relationship between inputs and outcomes desired. Given that some of these fixed costs and administrative expenses could be classified as discretionary, the key question relates to the discretionary cost budget being justified in relation to strategic outcomes, not just viewed in relation to revenue. Management may look to improve their understanding and management of these costs by considering alternative options. First we could try to engineer some of the more routine and predictable elements of these costs. We may use activity-based costing to assist engineer costs. But students need to be aware that true discretionary costs cannot be engineered. In this way other exercises such as program budgeting or zerobased budgeting might help.

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5.21 Activity-based budgeting (LO4) Discuss how a hospital could use activity-based budgeting to assist with planning for the coming year. In meeting the needs of patients, various activities must be performed within hospitals. Activity-based budgeting (ABB) could be used to estimate the costs and the associated cost drivers of the above activities. Such estimates can support hospital management planning decisions regarding staffing and other resource requirements. Following ABB, hospitals can structure their budgets around patient activities with the forecast costs being based on the estimated activity cost drivers.

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5.22

Zero-based budgeting The manager of the HR department of Nancy Accountants has been asked to prepare her annual budget on a zero-basis. Required Outline why this request for a zero-based budget may have been made. (LO4)

The request for the HR department to prepare its budgets based on zero-based budgeting principles could have been made for a number of reasons including: • As a discretionary cost centre it was difficult to measure the value of the input dollars to the output • Concern that the costs were too high in the department • Justification from scratch for expenditure would demonstrate its link with the organisation’s objectives.

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5.23

Activity-based budgeting Data Processors provides credit card services for the banking industry. It is preparing its budget for 2020, and, as it has been using activity-based costing, it intends to develop an activity-based budget for 2020. The table below provides the actual cost driver rate for 2019, and the expected activity levels for 2020.

Required (a) What is the budget for the activities for 2020? (b) Previously, Data Processors used a traditional line-item budget. What benefits will the organisation gain by converting to the activity-based budget? (c) How will the activity-based budget assist in reducing costs in the future? (LO4) (a) Data Processors – Activity-based Budget 2020 Activity Transaction processing Statements New credit cards Billing disputes

Non-business customers $2 000 000 8 000 000 500 000 1 500 000 $12 000 000

Business customers $8 000 000 3 000 000 2 500 000 3 000 000 $16 500 000

Total budgeted $ $10 000 000 11 000 000 3 000 000 4 500 000 $28 500 000

(b) A traditional line item budget will simply break the $28 500 000 down by cost items such as salaries, rent, electricity, transport etc. The activity based budget will highlight which activities are incurring the costs, and with the identification of the relevant cost driver it will provide a better means to manage the costs (c) The activity-based budget will allow for cost reduction opportunities in the future as the identification of the key drivers of cost will focus management’s attention on those attributes of the activities that cause costs.

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5.24

Kaizen budgets Continuing from exercise 5.23, the financial controller of Data Processors recently attended an accounting conference, which discussed the benefits of adopting kaizen budgeting within an activity-based budget. After meeting with operational managers at Data Processors it was decided to instil a continuous improvement approach to operations by reducing the cost driver rate by 5 per cent in 2020 and a further 5 per cent in 2021. Required (a) Prepare the revised activity-based budget for 2020 and 2021. (b) Is there potential behavioural consequences of adopting this kaizen approach to budgeting at Data Processors. (LO4)

(a) Data Processors – Budget 2020 – Kaizen Budget Activity Transaction processing Statements New credit cards Billing disputes

Non-business customers $1 900 000 7 600 000 475 000 1 425 000 $11 400 000

Business customers $7 600 000 2 850 000 2 375 000 2 850 000 $15 675 000

Total budgeted $ $9 500 000 10 450 000 2 850 000 4 275 000 $27 075 000

Data Processors – Budget 2021 – Kaizen Budget Activity Transaction processing Statements New credit cards Billing disputes

Non-business customers $1 805 000 7 220 000 451 250 1 353 750 $10 830 000

Business customers $7 220 000 2 707 500 2 256 250 2 707 500 $14 891 250

Total budgeted $ $9 025 000 9 927 500 2 707 500 4 061 250 $25 721 250

Budget summary: Activity based budget 2020 = $28 500 000 Kaizen budget 2020 $27 075 000 Kaizen budget 2021 $25 721 250 (b) Potential behavioural consequences of adopting a Kaizen approach to budgeting are: • employee motivation issues - employees may consider the budget “too tight” in that the target cannot be met. • employees may cut corners to ensure bonus payment which could lead to quality problems.

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5.25

Strategic budgeting, alternative actions The Organic Corn Company processes and distributes corn packed in 500-gram plastic bags that are sold to supermarkets for 50 cents each in boxes of 100 bags. The most recent income statement and key financial metrics of the Organic Corn Company are provided below.

Management at Organic Corn has been increasingly concerned about the plastic bags being used. It has explored a range of options and is thinking of switching to an alternate packaging option. This will require some significant changes with only a minimal impact on revenue, at least in the short term. The following estimates have been made with respect to the next twelve months.

• Price increase of 5 cents per 500 gram packet, with volume expected to remain the same in the short term. • Sales commission expenses are expected to remain the same proportion of sales dollars. • Administration expenses are expected to increase by 15 per cent. • Investment in packaging technology will be $125 000, $25 000 in cash, the rest in debt. • Gross margin expected to be 31 per cent. Required (a) Calculate the impact of the new packaging system on annual profit. (b) Comment on your analysis. (LO2)

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(a) Organic Corn Company – Income Statement:

Sales ($0.55 x 1 600 000 bags) Cost of goods sold* Gross margin Administrative salaries (80,000*1.15) Sales commission (69,000/800,000 = 8.625%;

$ 880 000 607,200

272,800 92 000 75,900

8.625% *880,000 = 75,900

Advertising* Bad debts* Operating income Gross margin Profit margin

75000 16000

258 900 ($13,900 31.00% (1.58%)

*31%*880,000 = 272,800; therefore COGS is 607,200(880,000-272,800) ** New equipment depreciation is included in the COGS (b) In the short term, at least, the impact on profit and key indicators (gross margin and profit margin) is negative. However, management at Organic Corn are trying to improve their longer-term sustainability performance and corporate reputation by introducing a new environmentally improved packaging system.

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Problems 5.26

Discretionary cost centres Cowmilka is a dairy products producer. Its logistics cost centre has 65 employees and a fleet of 25 milk tankers. It is a cross-functional cost centre with administrative staff (customer service and order processors), mechanics and tanker drivers. Tanker drivers collect milk daily from farmers and deliver it to the varying Cowmilka manufacturing plants. There is also a team of 10 human resource (HR) staff that oversee the health and safety training programs for all Cowmilka operations. For example, nearly all Cowmilka’s employees are required to possess up-todate food handling, health and safety qualifications, and pass a short computer-generated health and safety test before entry is allowed onto any of Cowmilka’s operational sites. The board has raised concerns about cost control within the logistics department. In spite of increasing the incremental rate of funding to the logistics cost centre every year, it appears it will, yet again, run into deficit before the end of this financial year. Required What advice can you give the board to better control the logistics cost centre’s costs. (LO3)

From the organisation’s viewpoint the logistics centre is probably viewed as a discretionary cost centre, although within the centre some of its costs will be purely discretionary and others will be more predictable and routine (i.e. inputs to HR and training less predictable and routine than tanker drivers and milk transport). From the board’s perspective there are a number of things that could done to better control the cost centre’s costs such as try to engineer those costs that are predictable and routine. For more discretionary costs zero-based budgeting, activity-based budgeting or program budgeting might be more suitable.

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5.27

Planning and budgeting in support centres ‘I’m really not sure our information systems are as well placed as they could be to help us drive our performance. The industry data and my own observations suggest we need to do better in this regard. I really want to be ready when the market and the economy recovers and make sure we are doing better than the industry with respect to revenue. Also, we need to improve our planning processes and I’m really not too sure how to best plan for our expenditures in areas like R&D.’ Noel McEwen (who has been CEO for three years) was reflecting on recently released industry information and his own experiences as CEO of Southern District Dairy (SDD). SDD, a privately-owned company, produces a variety of milk, cheese and yogurt products. Dairy ingredients for production are sourced largely from dairy farms owned by SDD. The company has a strategy of producing high-quality products targeted towards consumers prepared to pay a premium price. Seventy (70) per cent of the company’s output is exported to parts of Asia. SDD is structured around three investment centres (business units) supported by four support cost centres (R&D; accounting and finance; HR; and marketing and logistics). For the support cost centres, budgeted versus actual cost is the key performance metric. The three investment centre units are set the same ROI target of 12 per cent as Noel believes all should be contributing equally to the company’s performance. The budget targets for the support cost centres are usually set on the basis of negotiation with Noel, although the common starting point is always last year’s budget. For example, with the R&D cost centre, Noel has linked the annual budget estimate to sales targets. The manager of R&D is then held accountable for managing the department within the annual budget estimate. Required (a) What are the possible limitations of the current process for planning and budgeting in the support cost centres of SDD? (b) Suggest ways in which the planning and budgeting process in the support cost centres of SDD might be improved. (LO3)

(a) The current planning and control for cost centres like R&D focuses on a comparison of actual versus target expenditure. The problem appears to be in how the target expenditure is determined. For example, at present the R&D budget is linked to sales targets, which makes little sense. This is treating a discretionary cost centre as though it is an engineered cost centre. (b) Better planning tools might relate to the use of program budgeting, activity-based budgeting, or from time to time zero-based budgeting. This would allow Brad to seek justifications for the expenditures in these support cost centres, rather than creating links (such as to revenue) that bear no real relationship.

5.28

Strategic budgeting Green Building Group specialises in a range of construction services including design services, shop and office fiitouts, and recently

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developed environmental consulting services for architects and local government. Summarised statement of profit or loss and key performance metrics are provided below.

The CEO of Green Building Group, Sue Smith, is hoping to increase the resources devoted to the environmental consulting services. This is based on the increasing number of queries for this type of work as well as some industry data that suggests 25 per cent growth rates per year over the last few years. Industry experts predict these growth rates to continue. Moreover, the retail business has remained relatively constant over the last three years, while consulting has grown by about 10 per cent per year. Sue was hoping to use some of the resources currently assigned to retail to the environmental consulting. Moreover, she knew she would have to hire an additional environmental science expert and engage in some targeted marketing of the environmentalactivity. Sue is interested to find out the impact of this likely switch in strategic emphasis on the key statement of profit or loss items and metrics for next year. Required (a) Based on the information available, make an estimate of revenue across the three areas of activity. Outline your assumptions. (b) Complete an estimate of the other income statement items and key metrics. Outline your assumptions. (c) What recommendations would you make to Sue? (LO2)

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(a) Three areas of revenue: 1. Shop fitouts– current estimate $600 000 Market analysis suggests no change in this area so revenue estimate would not change 2. Design services – current estimate $400 000 Market analysis suggests a growth of 10% in market – therefore revenue estimate would be $400 000 x 1.10 = $440 000 3. Environmental Consulting – current estimate $60 000 Market analysis suggests a 25% growth rate to continue Estimated revenue next year = $60 000 x 1.25 = $75 000 (b)

Revenue Gross margin* Selling, general & admin expenses IT expert Advertising Operating income Profit margin Total assets Return on assets

Shop fitouts $600 000 150 000

Design services $440 000 198 000

Environmental consulting $75 000 37 500

90 000

110 000

$60 000

$88 000

25 000 20 000 5 000 ($12 500)

Total $1 150 000 385 500 225 000 20 000 5000 $130 500 11.3% $1 000 000 13.05%

*assume stays the same proportion – Design services 45%, Environmental consulting 50% other adjustments • 10% taken from shop fitouts, general and admin expenditure – assumed that given stagnant market no additional work will be necessary and that efficiencies can be gained – overall costs do not change but this will make the design consulting look less profitable and shop fitouts more profitable • Environmental science expert to be employed on a part-time basis initially until growth warrants fulltime – costs of a full-time employee too high at present • Modest advertising budget given for design services (c) Reflecting on the budget prepared in part (b) it would appear that increasing the revenue in environmental consulting actually leads to lower profits and performance indicators due to the increased expenditure. However, this is taking a short term rather than a strategic view. Given that the market analysis suggests environmental consulting services are in the growth stage, higher revenues will be possible in the future. Future growth opportunities are important as it would appear that the shop fitout segment, which currently provides the highest revenue, is a market that may not be strong in the future. It cannot be assured that this segment will continue to be a cash cow for the business. Therefore, any expenditure in promoting the environmental consulting services now will provide Green Building Group with a stronger hold on this market in the future. 5.29

The Dancing Goat – profit planning

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The Dancing Goat is a small coffee operation with ten cafés located around Melbourne. Each has a manager and up to five full-time employees to cover the 7.30 am to 4.30 pm, Monday to Saturday opening hours. Logan, the owner, employs a total of 60 full-time employees and three part-time employees (bookkeeper, roaster and delivery van driver). The company structure is outlined in figure 5.12.

The coffee beans are roasted at the main Sopital Lane café and transported daily to the other cafés. Logan makes all decisions in relation to coffee bean purchasing, roasting, retail pricing and product offerings. He also sets up regular coffee training sessions for all employees. Coffee prices are set at a premium ($4.00 per coffee). The cafés offer a deliberately small, but high-quality gourmet menu (five types of specialty sandwiches made on the premises and unique Dancing Goat-inspired hand-made cupcakes supplied by a local gourmet cupcake supplier). The 12 roasted coffee bean blends are also packaged in 250 gram bags, which retail at all the cafés for $12 per bag. Logan visits each of the cafés most days to chat with his managers and ensure operations are running smoothly.

Logan arranges a meeting with management accounting consultant to review the partially completed annual summary report (below). Logan wants advice on how he might improve cash flow. Specifically, Logan wants to know how to increase profit performance and improve working capital. Logan and the consultant discuss the following:

•

• •

Inventory: Logan has recently handed the coffee inventory management over to Max, his Sopital café manager. While Max had been earning bonuses for keeping coffee prices down, Logan is concerned about the comments he has received from customers about the quality of their brew. On investigation, Max has been approached by alternative suppliers offering coffee beans at significantly reduced cost. The new suppliers require larger order quantities and, as a result, inventory levels have increased. Accounts receivable: These are the accounts set up by local community businesses for business entertaining purposes. Accounts receivable are minimal as they are generally settled, in full, at the end of each month. Accounts payable: These are probably stretched out as far out as they can be. Nevertheless, Max’s new fresh coffee bean suppliers are not offering the payment terms of the previous suppliers set up by Logan. This certainly requires further revision.

Logan wants to emphasise sales of high-margin products rather than the efficiency of operations. He is concerned that an efficiency focus will impact his niche marketing strategy for The Dancing Goat cafés.

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Required (a) The management accounting consultant suggests they review the strategic budgeting or profit planning process at The Dancing Goat. Drawing on relevant aspects of the profit planning process and figure 5.2, describe the discussions they might have in planning for the success of The Dancing Goat. (b) Assume Logan decides to introduce the Beyond Budgeting model at The Dancing Goat. Outline how the Beyond Budgeting model might work at The Dancing Goat? (LO2 and 6) (a) Good responses would explain the importance of linking strategy with planning. Students should highlight the overall issues relating to the desire to increase net income and improve working capital. These would include: – How to forecast sales; what information is needed (from internal and external sources – including customer research and competitor activity) – Implications for the cash flows – particularly in relation to inventory. For example, what are the cash impacts from advance coffee bean orders? What is the difference on cash flows if a just-in-time approach is taken? What is the available operating cash and what is Logan’s borrowing capacity? Does he need access to credit and overdraft facilities? Students should mention that accounts receivable is not really an issue at The Dancing Goat and also that there is not much space to move with accounts payable. Students should also mention implications for ROE and issues associated with working capital? What level of funds are returned to the Dancing Goat business? How much does Logan (as shareholder) want from the business? Students should ensure they mention that all planning decisions at The Dancing Goat be based on specific corporate/business strategies – this means Logan should not reduce costs (coffee beans and staff training) to the detriment of quality. Logan should try to maintain pricing in line with the differentiation strategy he is pursuing (b) Dancing Goat could use Beyond Budgeting but Logan would have to ensure that the staff he employs understand and work to this philosophy. He would radically decentralise control to each of the cafes and ensure there are skilled autonomous staff that will be able to make responsible decisions and are capable of adapting to customer needs and requirements. Each cafe would have a small team that can work well together and make independent decisions without Logan’s interference. Beyond Budgeting believes that customers like customised service and not the generic one size fits all experience. This fits, in some way, with the current Dancing Goat differentiation strategy – however, Logan must ensure that a culture is developed so that when a customer enters one of his cafes – they know they are at “The” Dancing Goat. Logan needs to provide all his managers with as much information as possible so they can make informed decisions about the management of their individual cafes. The individual Dancing Goat managers are held strictly accountable for their decisions. Cafe planning is done with up-to-date rolling forecasts which help coordinate cash flows so liquidity and excess cash can be reinvested. Resources are provided to the cafes on demand. Logan needs to set up a relative performance evaluation system around KPIs to foster competition and single out poor performers. Examples of KPIs for the Dancing Goat Cafes would be based on measures such as customer satisfaction, profits per cafe and cost to income ratios.

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5.30

Strategic budgeting, alternative courses of action Refer to the Paige’s Fashion House case in self-study problem 1. Paige ensures that members of her staff regularly attend international fashion shows (for design ideas) as well as become involved in Australian fashion shows. While these are costly events to attend, Paige considers it a necessary function of her business as it is important to maintain a high profile as an up-and-coming design group. The design team always works in advance, designing garments for the following season. A considerable proportion of their time is spent working on the formal collection. The formal garments are recognised in the industry as the haute couture range, highly expensive and exotic garments. They bring the ‘wow’ factor to the fashion parades. Paige often dresses celebrities attending high-profile events, such as the Logies; the Brownlow, DallyM and Allan Border medal presentations, and other Australian sports awards’ nights, in her latest formal range. The formal range is the signature style on which the other regular streetwear designs (that is, the casual and denim ranges) are created from. The streetwear range is the main income earner for Paige’s Fashion House. Her design team also designs shoes and bags to match every season’s range. These are made for Paige’s Fashion House by a high-quality Chinese manufacturing company. The large expense items are the fashion show costs, advertising expenses and the costs of preparing sample garments for fashion parades and celebrity wear. Distribution is generally through a local transport company who deliver small and large orders. Paige’s Fashion House sells its range in about 20 fashion outlets around Australia. Two are very large national department stores and the other 18 are fashion boutiques of varying sizes. Credit terms vary depending on the size of the store. The large department stores manage to stretch payment terms to 120 days, which is tough on cash flows; however, Paige tries to make it up with large deposits on order and 30-day balance payment terms for the smaller boutiques. She tries to extend her own accounts payable as much as she can, but given it is not a large organisation, she has trouble securing credit terms beyond 30 days. The company has to pay a considerable proportion of costs up-front to the bag and shoe manufacturer. The company needs some inventories of raw materials (fabrics, threads, other) well ahead of time to ensure it can supply once the product range is launched. This is also necessary for the bags and shoes, which are ordered and shipped in advance. Otherwise, finished goods inventory levels are kept relatively small for two reasons. First, much of a new season’s range is shipped to stores. Second, unsold inventory is mostly donated or heavily discounted to outlets providing high-quality clothing labels to charities. The following spreadsheet provides an overview of the new spring collection product range and some key financial information.

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Required Paige has asked your assistance on a consulting basis. She is seeking advice as to the direction of her business (strategy) and best course of action in terms of product emphasis going forward. She is pleased with the success of the company to date, but is fully aware of the changing dynamics of the industry. What would you advise? In particular what would you advise with respect to: (a) a mechanism for assigning expenses to the different product ranges to better assess product profitability (b) strategic direction and possible courses of action going forward, including impact on key financials (strategic budgeting) (c) the capacity of the company to meet key financial targets into the future. (LO1, 2 and 5) (a) Paige could consider the operating expenses in terms of variable, non-variable and activity-based indirect costs. That is, how much do the costs vary with sales and whether they can be allocated, or not, to product line items based on their direct and indirect nature. Some of these costs would be relatively easy to trace. But care should be taken. Students might consider that the majority of operating expenses associated with fashion shows and celebrity dressing and give-aways would be best allocated as direct costs to the high-end formal haute couture range. This might not necessarily be the case and students need to consider the influence of R&D and marketing costs on Paige’s fashion house branding and the sales of her other casual, accessories and jeans range. These costs may be better analysed using an activity-based costing approach; although the link to branding might be quite hard to disentangle and allocate fairly to the product ranges. In this way the Haute Couture range would always appear unprofitable and bear the majority of overhead costs. Further analysis might help understand the impact of this formal range on the other product lines. If Paige was looking to improve cost control, she might be better analysing the R&D and Marketing Expenses (which would be classified as discretionary) on project-related or zero-based budgeting basis. (b) Paige needs to first determine what her expected profits might be. For this she needs to estimate sales (which will require both internal and external data sources including detailed market analysis, sensitivity analysis and judgement based on likelihood of matching or improving on previous prices, sales volume), expenses (which requires detailed analysis, as described in part (a) above. A percentage of the profits are to be re-invested into working capital. Paige will need to ensure there is enough cash flow circulating in the business to pay accounts payable and to purchase inventory. What if she receives a large order? Can she afford to purchase the materials? What is her access to additional funds or borrowings? Does she have an overdraft facility? These are the questions that Paige needs to consider. She may be able to stretch out her accounts payable, but does not want to destroy her reputation with suppliers. Likewise, keeping an eye on accounts receivable can assist with cash flow. Paige might need to adjust customer payment terms if she can – however this might be difficult given the competitive nature of the industry and the purchasing power of her large department store customers. Paige also needs to understand the implications of financing to fund growth and whether she needs to plan for further investment in assets (operating assets such as sewing machines) or long-term assets (such as further investment in other businesses or additional manufacturing capacity) to maintain a

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competitive advantage in the market. The ROE target is 8% but Paige is currently only achieving 6%. She may need to reconsider her strategies. Some students may suggest she focus on street-wear which is the main income earner –some may suggest she make reductions in the formal line. However, the flagship is this haute couture range. Will any cost reduction in this area compromise the entire strategy? All decisions are linked and must be made in light of the strategic direction.

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(c) The capacity for Paige’s Fashion House to meet the proposed targets depends on the interrelated set of decisions and actions as described in (b) above. The underlying assumptions made about future customer purchases; clothing lines to retain/extend/drop; cost of sales per line and target gross margins are all important and will not be known until tested in the market. The results of actions taken will determine whether the underlying assumptions are correct and the targets achieved or otherwise. At this stage, the key targets are not being achieved (i.e. Income margin 10% - currently at 4%; ROE 8% - currently at 6%) which would be of concern to Paige. This market uncertainty requires she adopts interactive controls which take into account the need to revisit strategies before taking further action.

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5.31

Strategic budgeting The Fairyland Children’s Centre is a community-based, not-for-profit childcare service. A committee of management oversees its operations, with the elected members being parents of children attending the centre. The centre is licensed to operate with 50 effective full-time places. Due to the preference for part-time care, there are only seven places filled on a full-time basis. On 1 July 2016, a wage increase has been granted to employees. This wage increase could significantly impact the continuing viability of the Fairyland Children’s Centre. The employees have won wage increases of up to $148 per week, to be phased in over 18 months as shown below.

The first round of increases is to be paid from 1 July 2016, with the remaining increases to be phased in over the next 18 months. The new wage rates are based on a 38-hour week; however, the Fairyland Children’s Centre’s Committee of Management varied its employees’ conditions of employment some years ago to a 35-hour week. The current wages bill is $600 000 per year. The wage cost for the Fairyland Children’s Centre is influenced by the minimum staffing requirements as set out in regulations issued by the government. The ratio of staff members to children is dependent upon the number of children in particular age groups. This has been one of the factors influencing how the centre has distributed its 50 registered places to each age group, coupled with the space requirements for each age group and the constraints due to the configuration of the rooms in the centre. The places have been divided into four age groups: 6 months to 2 years, 2 years to 3 years, 3 years to 4 years, and 4 years to 5 years. The following table gives a breakdown of the centre’s room structure, the number of places allocated to each age group and the minimum staffing requirements for each age group as set in the government’s regulations.

As the minimum staffing requirements must be maintained at all times, additional staff are employed to cover staff absences due to lunch breaks, educational planning sessions, rostered days off, sick leave, annual leave, long service leave, and to maintain ratios at the beginning and end of each day. As the centre is a not-for-profit concern, any surpluses that are accumulated fund future asset acquisitions or are applied in future years to absorb budget deficits. The centre’s financial year runs from 1 January to 31 December. When setting the 2016 budget, the committee was aware that a wage increase was likely to be approved from 1 July but they did not know the exact amount. Therefore, the committee factored an average

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$25 per week increase per full-time employee (pro-rated for part-time employees), and $6.50 per day for agency relief staff into the budget. As a result, the 2016 budget incorporated a weekly fee set at $220 and a daily fee at $55 until 30 June, and then $230 per week and $57 per day from 1 July. A higher daily fee is charged for part-time places due to the additional costs incurred in administration activities associated with health and safety regulations and the likelihood that any vacancies will take longer to fill. In recent years, the centre’s director, Tina West, has found it difficult to fill single-day vacancies. Tina West organised a special meeting of the committee to discuss the impact of the wage increase on the centre. Tina commenced the meeting by giving everyone the background to the wage increase and the details regarding the phasing of payments and the new classification structure. She explained that the management at local centres in the area are agreeing to pay the full increase immediately rather than in increments as given in the determination. The reason given to justify the full payment now is both to attract and retain staff. In recent years, the ability to recruit qualified staff has been problematic, as many potential employees have sought occupations outside the childcare industry due to the low remuneration. Coupled with this is the centre’s current employees pushing for the full wage increase to be paid now, or at a minimum to have more than just the first stage payment made from 1 July 2016. The committee is more than aware of the difficulties in recruiting suitable staff. Over the past two years, several positions have been advertised with few applicants. In fact, the director’s position took over three months to fill. In the end, the assistant director at the time was promoted to the director’s position, as no external applicants were deemed suitable. Although the committee is pleased that they anticipated the first stage of the wage increase and incorporated it into the 2016 budget, they are still concerned about the overall wage increase on the centre. Committee members expressed concern about paying the future wage increases in advance, and the reaction of parents to a fee hike, especially if this is greater than other childcare centres in the area. The financial viability of the centre could be jeopardised if parents withdraw their children and vacant places cannot be filled quickly Required (a) Draw on the circumstances relating to Fairyland Children’s Centre to outline the problems associated with estimating revenue in budget preparation. (b) Comment on how the estimation of revenue is likely to affect cost planning at Fairyland Children’s Centre. (LO1, 2 and 5) (a) Planning and estimating revenue is a difficult exercise in most organisations. The problem confronting the Fairyland Children’s Centre is that in a time of growing costs through the wage increases for staff, finding ways to increase revenue is more difficult. Either more volume (through more available places being filled) or an increase in prices needs to be adopted. The other constraint here for the management is the minimum staffing ratio. Unless additional capacity can be added, management is restricted to 50 places. Currently, management are unsure

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about the impact of any price increase on enrolments. It this uncertainty that makes revenue estimation difficult. (b) The estimation of revenue is commonly used to set the level of activity and provide some guidance on costs where there is a link between the activity levels driving revenue and the cost of resources used. The key estimates would be the number of places; the number of places per room (e.g. babies, toddlers etc.); and fees. The fees themselves have little direct impact on many of the costs which are in part driven by available places. Moreover, an increase in wage rates has little to do with the activities of the Centre. The number of staff required is driven by the number of places in each room. Resource-wise, having more places in the ‘big’ room is less staff intensive, but this may not be possible due to the room structures.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. Prepared by Vijaya Murthy

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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Chapter 6: Operational budgets Questions 6.1 How are budgets related to organisational strategies? (LO1) Budgets are prepared in light of organisational strategies and are a method to communicate strategies and objectives throughout the organisation. Operating plans are developed from organisational strategies, and these are communicated from top levels throughout the organisation. Sub-units then develop budgets considering organisational objectives and communicate their budget goals to top management. After the budgeting process is complete, actual operations are compared to budgets and any differences are investigated.

6.2

Describe the types of information that managers use to develop budgets. (LO1)

Managers use many different types of information to develop budgets. Often they use last year’s results to determine a base level of costs and revenues. They also estimate future sales volumes, prices, and costs. Information for these estimates can be obtained from very specific sources, such as trade journals that provide total market share information, to very general sources such as economic trends described in business publications such as Australian Financial Review. Information is also obtained from individuals throughout the organisation. For example, engineers might provide estimates of cost changes resulting from expected changes to production processes. Individual department managers submit plans and budget requests. In addition, information is obtained from suppliers, companies from whom they rent, and others who might know whether cost changes are expected during the period for which the budget is developed.

6.3

How are the master budget and flexible budget related? (LO2)

The master budget is a particular application of the flexible budget for the specific level of operations that management expects during the next period. The flexible budget can be readily adapted to any level of activity within the relevant range; the master budget is one particular level of activity.

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6.4

Explain how the following budgets relate to each other: the revenue budget, the production budget, and the direct materials budget. (LO2)

The revenue budget determines the volume of units sold. This amount, less beginning inventories plus desired ending inventories determines the amount of units for the production budget. The production budget determines the amount of direct materials needed. If there are any constraints in the production process or for direct materials, these relationships could change.

6.5

How can budgeting assist an entity to efficiently use its human resources? (LO4)

An organisation would like the right people to be available at the right place and at the right time. This includes having the necessary talent in marketing to produce sales, and in production to provide the product. The various staff functions should be able to perform their assigned tasks in an effective and efficient manner. The budget provides advance guidance about personnel requirements during specific time periods.

6.6

What are the objectives of participative budgeting? (LO5)

If individuals who are affected by some aspect of the budget participate in that budget’s construction, there should be greater acceptance of the stated goals and the means to their attainment. If a manager has not had input to setting goals or to the resources required to attain them, there is a possibility that the budget may not be taken seriously as the formal financial expression of that individual’s responsibility and authority.

6.7

What methods do organisations use to minimise budgetary slack? (LO5)

To minimise budgetary slack, organisations ask outside consultants or market specialists to make forecasts for the next period and compare their forecasts to those generated internally. In addition, bonuses are paid for accuracy in budgeting as well as for meeting or beating budgets.

6.8 What adjustments should be made to static budgets before they are used for management performance evaluation? (LO5) Static budgets need the following adjustments for performance evaluation: • Use flexible budget to adjust for actual volumes • Remove allocated costs • Update costs for anticipated price changes

6.9

What are some of the challenges that organisations face when allocating budget authority and responsibility? (LO5)

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Here are some of the challenges that organisations face when they allocate budget authority and responsibility; students might have thought of others. Sometimes managers feel that they are held responsible for costs over which they have little or no control, and they begin to feel resentful. When there is interdependency among divisions and departments, it is difficult to separate the effects of individual manager’s efforts. Sometimes a new manager replaces someone who leaves, and the new manager is held responsible for whatever budget decisions were made previously. Sometimes uncontrollable external or internal factors alter budgets unexpectedly. For example, a few key employees could leave for better jobs. Unanticipated changes could occur in the organisation’s prices and costs.

6.10 Blowervacs produces and sells leaf blowers. Production levels are high in the summer and beginning of autumn and then taper off through the winter. Sales are high in autumn and early winter and then taper off in the spring. Explain why preparing a cash budget might be particularly important for Blowervacs. (LO3) Cash budgets help managers plan their short term borrowing needs to meet payroll, accounts payable, and other cash obligations. In a seasonal business, there are times when cash levels are quite high, but also times when very little cash is flowing into the company. Managers need to plan ahead for times of reduced cash flow so that employees and vendors are unaffected by these cycles. 6.11 Discuss the sources of information used to prepare a cash budget for a manufacturing entity. (LO3) In order to estimate the budgeted cash receipts and cash disbursements for a manufacturing entity, various sources of information are required. This includes, for instance, information concerning:

-Management strategic objectives and their desired sales targets and cash flows. -The likely competitive market conditions and the impact on budgeted sales. -Capital investment requirements to meet operational and strategic priorities. - The typical customer cash collection make-up (i.e. Percentage of cash sales versus credit sales? Any discounts? Any bad-debts? Credit sales collection timeline?). -Forecast production levels together with information concerning the inventory, staffing and other cost requirements to support production. -Typical inventory cash payment make-up (i.e. Percentage of cash versus credit purchases? Any discounts? Credit purchase payment timeline?). -Current cash balance, desired minimum cash balance, and details concerning the lines of credit (i.e. interest, repayments). 6.12 Whilst preparing the cash budget for next year, the accountant at Mines Ltd. identified a $20 million shortfall. This shortfall was due to a capital expenditure item of the same value. The CEO has identified that the purchase must be made to ensure competitive advantage for the business.

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Identify several ways that the business could overcome this situation. (LO3) A key benefit of the preparation of budgets is the pre-identification of any potential cash shortfalls such as the one described here. There are a number of ways in which this situation might be overcome. The firm could, for example: -

Identify a line of credit to finance the purchase. Make use of flexible budgets and explore how sensitive this shortfall is to changes in estimate production levels. Scrutinize all cash payments and identify any opportunities: o For improved efficiency. o To avoid/defer any cash payments for other capital expenditures. Identify opportunities to improve cash receipts from customers by, for instance, increasing production levels.

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4 Exercises 6.13

Budgeting for next semester; assumptions; monitoring Suppose a friend asks you to help her prepare a budget for the next semester. Required (a) Assuming you followed a process similar to that presented in this chapter, which budgets would you help her prepare? Explain your choices. (b) Create a list of information needed to complete the various budgets. Identify which pieces of information need to be estimated. (c) Create a list of the assumptions your friend will need to make for estimating the necessary information. How should your friend monitor her budget performance throughout the semester? Write an explanation that your friend, who is not familiar with accounting, will understand. (LO 1 and 2) (d)

(a)

A friend would need to prepare budgets for revenues and for costs that vary per month such as rent, food, and entertainment. An additional budget should be prepared for things that vary per semester, like books and tuition. Because personal costs tend to vary by month, these budgets are prepared for monthly costs by category instead of direct cost budgets that are used in manufacturing. Finally, she needs to prepare a cash budget to estimate her cash needs throughout the semester so that she does not run short.

(b)

Monthly information that is known for certain includes rent, insurance (if monthly) and car payments. Tuition and fees are known for certain. Other costs that must be estimated include food, books, and entertainment.

(c)

Assumptions may need to be made about tuition and fees. Do they vary with credit hours? If so, how many credit hours are expected? Assumptions also need to be made about the frequency and cost of events such as eating in restaurants and entertainment. If a lease has not been signed, an assumption needs to be made about the cost of rent. She will make assumptions about the amount and cost of food she will eat, entertainment costs, car and travel related costs. She will not have to make assumptions about costs that she knows ahead, for example tuition (if fixed) and rent. However, she will have to make assumptions about other costs that are not known ahead. These assumptions include the amount that will be spent, the frequency and timing of the expenditures. She will need to make similar assumptions about cash inflows that she does not know ahead. If she works a variable schedule at a restaurant, she cannot know the amount of tips she will receive and will have to make assumptions about the amounts and timing of these cash inflows. Similarly, there may be uncertainties with regard to the money that she receives from her parents. She may know for certain the amounts and timing of scholarship funds.

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(d)

Here is a plan for monitoring your budget. Each month, compare actual costs to the budgeted costs by budget category. The differences between actual and budgeted costs are called variances. If you have spent more than budgeted, a variance is considered unfavourable. If you have spent less than budgeted, the variance is favourable. At the end of each month, calculate a variance for each budget category and then add all of the variances together to see if you are over or under budget that month. To calculate these variances, you need to track your costs using the same categories included in the budget. I recommend you use one category to track monthly fixed costs like rent, utilities, car payment, and utilities. Keep two separate categories for discretionary costs, one for food and one for entertainment. You can cut back on discretionary costs more easily than the fixed costs. For example, if utilities are high one month, you could cut back on entertainment the next month to avoid having an overall variance from the budget at the end of the semester. If you have unfavourable variances for several months, you will need to find additional sources of revenue or cut back on discretionary expenditures. If you have favourable variances for several months you may want to wait until the end of the semester to adjust the budget, to make certain you have not overlooked anything.

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6.14

Production, direct materials and direct labour budgets Seer Manufacturing has projected sales of its product for the next six months as follows:

The product sells for $100, variable expenses are $70 per unit, and fixed expenses are $1500 per month. The finished product requires 3 units of raw material and 10 hours of direct labour. The entity tries to maintain an ending inventory of finished goods equal to the next two months of sales and an ending inventory of raw materials equal to half of the current month’s usage. Required (a) Prepare a production budget for February, March and April. (b) Prepare a forecast of the units of direct materials required for February, March and April. (c) Prepare a direct labour hours budget for February, March and April. (LO2) (a)

Production Budget Desired ending inventory Planned sales Total units needed Planned beginning inventory Production requirements

(b)

February 180 90 270 190 80

March 110 100 210 180 30

April 100 80 180 110 70

February 120 240 360 150 210

March 45 90 135 120 15

April 105 210 315 45 270

Direct Materials Unit Forecast a

Desired ending inventory Planned usageb Total units needed Planned beginning inventoryc Materials acquisitions a

(c)

Current production × 3 units direct materials × 0.5 to reflect 3 direct materials units per product, and half of this month’s production for ending inventory balance. b Current production × 3 c Prior month’s production × 3 × .5; January production was change in finished goods inventory plus January sales, or (100 + 90) – (40 + 90) + 40 = 100 units. Labour Requirements Budget February March April Labour hours neededa 800 300 700 a Current production × 10

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6.15

Production, labour, materials and sales budgets Bullen & Company makes and sells upmarket carry bags for laptop computers. John Crane, controller, is responsible for preparing Bullen’s master budget and has assembled the following data for next year. The direct labour rate includes wages, all employee-related benefits and the employer’s share of payroll tax. Labour-saving machinery will be fully operational by March. Also, as of 1 March, the entity’s enterprise agreement calls for an increase in direct labour wages that is included in the direct labour rate. Bullen expects to have 10 000 bags in inventory at the beginning of the year, and has a policy of carrying 50 per cent of the following month’s projected sales in inventory.

Required (a) Prepare the following budgets for Bullen & Company for the first quarter of next year. Be sure to show supporting calculations: (i) production budget in units (ii) direct labour budget in hours (iii) direct materials budget (iv) sales budget. (b) Calculate the total budgeted contribution margin for Bullen & Company for the first quarter of next year. Be sure to show supporting calculations. (c) Discuss at least three behavioural considerations in the profitplanning and budgeting process. (LO2)

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Notice that the first quarter is the first three months. April’s information is needed for some of March’s budget calculations. (a)

(1)

Production budget (units) January Sales units (a) 20 000 Plus ending inventory (b) 12 000 Total Units needed 32 000 Less Beginning inventory 10 000 Total units to be produced 22 000

February 24 000 8 000 32 000 12 000 20 000

March Quarter 16 000 60 000 9 000 9 000 25 000 69 000 8 000 10 000 17 000 59 000

(a) Current month’s sales (b) 50% of following month’s sales (2)

Direct labour budget (hours)

Units to be produced Direct labour hours per unit Total labour budget (hours)

January 22 000 4.0 88 000

February 20 000 4.0 80 000

March 17 000 3.5 59 500

Total 59 000 227 500

(3)

Direct materials budget (dollars) January February March Total Units to be produced 22 000 20 000 17 000 59 000 Cost per unit $10 $10 $10 Total direct material cost $220 000 $200 000 $170 000 $590 000

(4)

Sales budget (dollars)

Sales units Sales price per unit Total sales revenue budget

(b)

January February March 20 000 24 000 16 000 $80 $80 $75 $1 600 000 $1 920 000 $1 200 000 $4 720 000

Total 60 000

BULLEN & COMPANY Budgeted Contribution Margin First Quarter January 4.0 $15 $60

February 4.0 $15 $60

March 3.5 $16 $56

Quarter

Direct labour hours per unit Direct labour hourly rate Direct labour cost per unit Sales units

20 000

24 000

16 000

60 000

$1 600 000 1 200 000 200 000 $ 200 000

$1 920 000 1 440 000 240 000 $ 240 000

$1 200 000 896 000 160 000 $ 144 000

$4 720 000 3 536 000 600 000 $ 584 000

Sales revenue Direct labour cost Direct materials cost Contribution margin

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(c)

At least three behavioural considerations in the profit-planning and budgeting process include the following. • Goal alignment is critical. The individual manager’s goals may conflict with the entity’s goals. Setting targets in a budget process helps focus and motivate managers to achieve the entity’s objectives. • Participation from lower-level managers and other employees has two benefits. It uses information from those closest to the process, and the mangers have a stronger commitment to the budget itself. • The entire budget process is a form of communication. Feedback and other forms of improving communication are essential throughout the process.

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6.16

Flexible budget variances; profit effect of market share decline Data for the Stove Division of Appliances Now, which produces and sells a complete line of kitchen stoves, are as follows.

(a)

Revenues

Static Budget $16 491

Flexible Budget $17 480(a)

Actual $17 480

Flexible Budget Variance $ 0)

Cost of Sales Fixed overhead Variable selling Fixed selling Administration Total costs

5 892 1 977 456 1 275 4 773 14 373

6 245(a) 1 977(a) 483 (b) 1 275(a) 4 773(a) 14 753(a)

6 451 2 032 550 1 268 5 550 15 851

(206) (55) (67) 7) (777) $(1 098)

Income

$ 2 118

$ 2 727(a)

$ 1 629

The following calculations are short-cuts that can be used to calculate variable costs under a flexible budget, with revenues as the cost driver.

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Flexible budget for variable costs = Static budget variable cost/Revenues in static budget × Actual Revenues: (a) $5892/$16491 × $17 480 (b) $456/$16491 × $17 480 (b)

If market share is 20% and revenues are $17 480, then the following equation estimates the total market: 20% × Market = $17 480 Market = $17 480/0.20 = $87 400 If market share of 22% had been obtained, revenues would have been: $87 400 × 22% = $19 228 Thus, foregone revenue is: Revenue at 22% Market Share – Actual Revenues = $19 228 – $17 480 = $1748 The foregone profit is equal to the marginal profit that would have been earned on foregone revenues. Thus, the marginal profit is equal to the contribution margin on foregone revenues. (Remember: Fixed costs would not be affected by higher revenues.) The contribution margin per dollar of revenue from the original (static) budget follows: Revenue $16 491) Less variable costs: Cost of sales (5 892) Variable selling (456) Contribution Margin$10 143) Contribution Margin Ratio61.51%

Foregone profit is equal to the contribution margin on foregone revenues: Foregone Revenues × Contribution Margin Ratio = $1748 × 61.51% = $1075

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6.17

Direct materials budgeted payments Organic Industries intends to start business on the first of January. Production plans for the first four months of operations are as follows:

Each unit requires 2 kilograms of material. The entity would like to end each month with enough raw material inventory on hand to cover 25 per cent of the following month’s production needs. The material costs $7 per kilogram. The managers anticipate being able to pay for 40 per cent of its purchases in the month of purchase. They will receive a 10 per cent discount for these early payments. They anticipate having to defer payment to the next month on 60 per cent of their purchases. No discount will be taken on these late payments. The business starts with no inventories on January 1. Required Determine the budgeted payments for purchases of materials for each of the first three months of operations. (LO2) New Ventures

First, determine the purchases budget for the 1st quarter: January February March Production (units) 20 000 50 000 70 000 Raw materials needed per unit ×2 ×2 ×2 Production requirement 40 000 100 000 140 000 Ending inventory requirement (25% of next month’s production requirement) 25 000 35 000 35 000 Total needed 65 000 135 000 175 000 Less: Beginning inventory (0) (25 000) (35 000) Raw materials purchases (units) 65 000 110 000 140 000 Raw material unit cost × $7 × $7 × $7 Raw materials purchases $455 000 $770 000 $980 000

April 70 000 ×2 140 000

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Next calculate cash disbursements for purchases of raw materials: January purchases (a) February purchases (b) March purchases (c) Total cash payments (a) (b) (c)

January $163 800

$163 800

February $273 000 277 200 $550 200

March $462 000 352 800 $814 800

January: ($455 000 × 0.4).9 = $163 800 February: ($455 000 × 0.6) = $273 000 February: ($770 000 × 0.4).9 = $277 200 March: ($770 000 × 0.6) = $462 000 March: ($980 000 × 0.4).9 = $352 800

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6.18

Preparation of receipts from debtors schedule and cash budget Ken Martin, manager of Lonnie Car Repairers, has requested that you prepare a cash budget for the months of December and January. He has provided the following information to assist in this task. • Projected cash balance at the end of November is $30 000. • Actual revenue for October and November and projected revenue for December and January are as follows.

•

Analysis of past records has shown that credit sales are collected over a three month period, with 50 per cent being collected in the month of the sale, 40 per cent in the next month, and the remainder in the following month. Projected expenditure during December and January is as follows: − Selling and administrative expenses are budgeted to be $58 000 each month. − A new car hoist will be purchased for $100 000, with a $20 000 cash payment in December and the balance to be paid in March. − Ken wants to maintain a minimum cash balance of $30 000. − As more customers will want their vehicles serviced prior to Christmas, the consumables store will need more supplies. Accordingly, an order has been placed for $45 000 of inventory. This will arrive in late November and be paid in December.

Required (a) Prepare a schedule showing receipts from customers for the credit sales. (b) Prepare a cash budget for December and January. (c) Prepare a report for Ken outlining his cash position over the Christmas period. Give advice regarding any financing requirements or investment opportunities. (LO3)

(a) Receipts from Debtors Schedule for two months ending 31 January October $60 000 November $80 000 December $100 000 January $50 000

December 6 000 32 000 50 000 88 000

January 8 000 40 000 25 000 73 000

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(b) Cash budget for 2 months ended 31 January Dec

Jan

Total

88 000 42 000

73 000 30 000

161,000 72 000

Total receipts ANTICIPATED PAYMENTS Selling and administration Car hoist Inventory consumables Total Payments Excess (Deficit) receipts over payments Bank balance at beginning of month

130 000

103 000

233 000

58 000 20 000 45 000 123 000 7 000 30 000

58 000

58 000 45 000 37 000

116 000 20 000 45 000 181 000 52 000 30 000

Bank Balance at End of Month

37 000

82 000

ANTICIPATED RECEIPTS Receipts from debtors Cash sales

(c) Ken likes to maintain a minimum cash balance of $30 000. He should be able to achieve this over the December/January period. In fact as his planned cash balance is $37 000 at the end of December, he could choose to transfer $7000 to a higher-interest earning account. During January, he may be able to add to this as the cash flow through January based on the estimates is very favourable.

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6.19

Purchase, cost of goods sold, and cash collection budgets

The Zel Company operates at local flea markets. It has budgeted the following sales for the indicated months.

Zel’s success in this specialty market is due in large part to the extension of credit terms and the budgeting techniques implemented by the entity’s owner, Barbara Zel. Ms Zel is a recycler; that is, she collects her merchandise daily at neighbourhood garage sales and sells the merchandise weekly at regional flea markets. All merchandise is marked up to sell at its invoice cost (as purchased at garage sales) plus 25 per cent. Stated differently, cost is 80 per cent of selling price. Merchandise inventories at the beginning of each month are 30 per cent of that month’s forecasted cost of goods sold. With respect to sales on account, 40 per cent of receivables are collected in the month of sale, 50 per cent are collected in the month following, and 10 per cent are never collected. Required (a) What is the anticipated cost of goods sold for June? (b) What is the beginning inventory for July expected to be? (c) What are the July purchases expected to be? (d) What are the forecasted July cash collections? (LO2) (a)

Cost of goods sold = (0.8 × sales) = (0.8 × $1 700 000) = $1 360 000

(b)

Beginning inventories are 30% of that month’s cost of goods sold. Therefore, July Beginning Inventory = (0.3 × cost of goods sold) = (0.3 × 0.8 × $1 810 000) = $434 400

(c)

Ending inventory for July is the beginning inventory for August. Ending inventory (0.3 × 0.8 × 1 920 000) + July cost of goods sold (0.8 × 1 810 000) – Beginning inventory (part B) = Purchases

$ 460 800 1 448 000 (434 400) $1 474 400

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(d)

40% of receivables are collected in the month sold and 50% are collected the next month. For July: Cash sales $ 210 000 Collections from July credit sales (0.4 × $1 600 000) 640 000 Collections from June credit sales (0.5 × $1 500 000) 750 000 July cash collections $1 600 000

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6.20

Cash budget for revenues and expenses Maryborough Manufacturing has projected sales in units for four months of operations as follows:

The product sells for $18 per unit. Twenty-five per cent of the customers are expected to pay in the month of sale and take a 3 per cent discount; 70 per cent are expected to pay in the month following sale. The remaining 5 per cent will never pay. It takes 2 kilograms of materials to produce a unit of product. The materials cost $0.75 per kilogram. In January, no raw materials are in beginning inventories, but managers want to end each month with enough materials for 20 per cent of the next month’s production. The entity pays for 60 per cent of its materials purchases in the month of purchase and 40 per cent in the following month. It takes 0.5 hour of labour to produce each unit. Labour is paid $15.00 per hour and is paid in the same month as worked. Overhead is estimated to be $2.00 per unit plus $25 000 per month (including depreciation of $12 000). Overhead costs are paid as incurred. Maryborough will begin January with no finished goods or work in process inventory. The managers wish to end each month with 25 per cent of the following month’s sales in finished goods inventory. They will end each month with no work in process. Required Prepare a cash budget listing cash receipts and disbursements for February. The entity will begin February with a cash balance of $80 000. (LO3)

Cash receipts for February are From January (25 000 × $18 × .70) From February (30 000 × $18 × .25 × .97) Total February cash receipts

$315 000 130 950 €445 950

Production requirements are Sales requirement (units) Plus: Ending inventory (units) Total needs Less: Beginning inventory (units) Production requirement (units)

January 25 000 7 500 32 500 0 32 500

February 30 000 8 000 38 000 (7 500) 30 500

March 32 000 8 750 40 750 (8 000) 32 750

Materials Purchases Budget

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To support production (units) Plus: Ending inventory (units) Total needs Less: Beginning inventory (units) Total purchases (units)

65 000 12 200 77 200 0 77 200

61 000 13 100 74 100 (12 200) 61 900

Raw materials cost per unit

$0.75

Total purchases

$57 900

$45 425

Cash disbursements in February for raw materials are From January (€57 900 × 0.40) From February (€46 425 × 0.60) Total raw materials disbursements

$23 160 27 855 $51 015

Labour costs in February are 30 500 units × .50 hour per unit Wage rate Total cash disbursement, labour

15 250 hours $15 $228 750

Overhead costs in February are Total costs = $2(30 500) + 25 000 Less: Depreciation Total cash overhead costs

$86 000 12 000 $74 000

The February cash budget is thus: Beginning balance, 1 February Plus: February receipts Subtotal Less: Disbursements Raw materials Labour Overhead Total disbursements Ending balance, 28 February

65 500

$ 80 000 445 950 525 950 51 015 228 750 74 000 353 765 $172 185

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6.21

Flexible budget and variances; performance measurement; reasons for variances Play Time Toys is organised into two major divisions: marketing and production. The production division is further divided into three departments: puzzles, dolls and video games. Each production department has its own manager. The entity’s management believes that all costs must be covered by sales of the three product lines. Therefore, a portion of headquarters, marketing, and the production division costs are allocated to each product line. The entity’s accountant prepared the following performance report for the manager of the dolls production department.

Required

(a) (b)

(c)

Is Play Time using a static budget or a flexible budget to calculate variances? Explain. Do you agree with this approach? Why? Develop an appropriate benchmark for evaluating the performance of the dolls production department. Decide whether to include or exclude each cost category, and explain your decisions. Use the benchmark you created in part (b) to calculate variances.

(d)

Review the variances from part (c). Briefly describe the types of operating or budgeting problems that might have caused these variances. (LO4) (a)

Play Time Toys is using a static budget. It does not reflect the activity levels, so it is not a good measure of performance. The variable costs need to be related to actual production volumes. It also includes division, marketing and headquarters overhead costs and managers are not responsible for those. They should be eliminated. Managers and their departments should be evaluated relative to costs they can control. Any costs they cannot control should be removed.

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(b) & (c)

(d)

The following schedule eliminates costs that are not under the dolls production department manager’s control. These include production division costs, headquarters costs and marketing costs. Revenues and volume are included only because provide information about activity levels. Variable costs are adjusted for actual volume.

Volume Revenue

Budget 1 000 $12 000

Direct Materials Direct Labour Variable Overhead Fixed Overhead Total Costs

$2 000 1 000 1 000 800 $4 800

Benchmark Actual Variance 1 100 1 100 $13 200 $12 400 $2 200 1 100 1 100 800 $5 200

$2 100 1 225 1 100 1 020 $5 445

$ 100 (125) 0 (220) $(245)

The direct material variance is favourable and about 5% of the benchmark. Perhaps materials of lower quality than usual were purchased, or perhaps there was a price decrease that should be reflected through a new standard. If lower quality materials were purchased, more labour time might have been needed to produce the dolls, resulting in a negative labour variance. If there was no change in the quality of materials, then other reasons need to be investigated for the negative labour variance (11% of the benchmark). Perhaps there was unusually high turnover or other factors, resulting in lower productivity. It is also possible that the standard labour cost is too low, particularly if there was an unanticipated labour rate increase. The unfavourable fixed overhead variance is very large (28% of benchmark). Perhaps there were large discretionary expenditures, such as painting the production facility. Or, perhaps there was an unexpected increase in one or more fixed overhead cost categories. It is also possible that the budgeted cost is too low.

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6.22

Prepare cash budget A college student, Brad Worth, plans to sell atomic alarm clocks with CD players over the internet and by mail order to help pay his expenses during the summer semester. He buys the clocks for $32 and sells them for $50. If payment by check accompanies the mail orders (estimated to be 40 per cent of sales), he gives a 10 per cent discount. If customers include a credit card number for either internet or mail order sales (30 per cent of sales), customers receive a 5 per cent discount. The remaining collections are estimated to be:

Sales forecasts are as follows:

Brad plans to pay his supplier 50 per cent in the month of purchase and 50 per cent in the month following. A 6 per cent discount is granted on payments made in the month of purchase; however, he will not be able to take any discounts on September purchases because of cash flow constraints. All September purchases will be paid for in October. He has 50 clocks on hand (purchased in August and to be paid for in September) and plans to maintain enough end-of-month inventory to meet 70 per cent of the next month’s sales.

(a)

Required (a) Prepare schedules for monthly budgeted cash receipts and cash disbursements for this venture. During which months will Brad need to finance purchases? (b) Brad planned simply to write off the uncollectibles. However, his accounting professor suggested he turn them over to a collection agency. How much could Brad let the collection agency keep so that he would be no worse off? (LO3) Cash Receipts

Units sold

Sept 120

Oct 220

Nov 320

Dec 400

Jan 0

Feb Mar 0 0

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Cash sales (a) Credit card sales (b) One month later (c) Two months later (d) Three months later (e) Total (a) (b) (c) (d) (e)

$2 160 1 710 0 0 0 $3 870

$3 960 3 135 900 0 0 $7 995

$ 5 760 $ 7 200 $ 0 $ 0 $ 0 4 560 5 700 0 0 0 1 650 2 400 3 000 0 0 360 660 960 1 200 0 0 240 440 640 800 $12 330 $16 200 $4 400 $1 840 $800

Cash sales: Unit sales × $50 × 40% × (1-10%) Credit card sales: Unit sales × $50 × 30% × (1-5%) Collected one month later: Unit sales last month × $50 × 15% Collected two months later: Unit sales two months ago × $50 × 6% Collected three months later: Unit sales three months ago × $50 × 4%

Cash Disbursements Unit sold

Sept 120

Oct 220

Nov 320

Dec 400

Purchases: Desired ending inventory (a) Units sold this month Less beginning inventory (b) Budgeted purchases

154 120 (50) 224

224 220 (154) 290

280 320 (224) 376

0 400 (280) 120

$ 0 1 600 $1 600

$ 4 362 7 168 $11 530

$ 5 655 4 640 $10 295

$1 805 6 016 $7 821

Cash Disbursements: Paid same month (c) Paid next month (d) Total (a) (b) (c) (d)

Jan 0

$ 0 1 920 $1 920

Next month’s unit sales × 70% Prior month’s ending inventory Zero for Sept; other months: units purchased × $32 × 50% × (1–6%) September: 50 units purchased during August × $32; October: units purchased during Sept × $32; other months: prior month units purchased × $32 × 50%

Summary of Budgeted Cash Receipts and Disbursements

Cash receipts Cash disbursements Net cash flow

Sept Oct Nov Dec Jan Feb Mar $3 870) $7 995) $12 330) $16 200) $4 400) $1 840) $ 800) (1 600) (11 530) (10 295) (7 821) (1 920) (0) (0) $2 270) $ (3 535) $ 2 035) $ 8 379) $2 480) $1 840) $ 800)

Cumulative cash flow $2 270) $ (1 265) $ 770)) $ 9 149))$11 629))$13 460)) $14 269)

(b)

Although the problem does not require this calculation, the total amount of uncollectible accounts can be estimated as follows: (120 + 220 + 320 + 400) × $50 × 5% = $2650

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Because the only option under consideration is to write off the accounts, Brad could allow the collection agency to keep 100% of collections and still be no worse off.

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5 Problems 6.23

Preparation of receipts from debtors schedule and cash budget Point Piper prepares monthly cash budgets. Provided below is a set of relevant data extracted from existing reports, and the sub-budgets for the two months of September and October.

All sales are on credit. Collections from debtors normally have the following pattern: 60 per cent in the month of sale, 30 per cent in the month following the sale, and 10 per cent in the second month following the sale. Fortunately, Point Piper does not have much trouble with bad debts. Sales in June, July and August were $295 000, $266 000 and $302 000 respectively. Direct material purchases are paid for in the month following the purchase. Purchases in August were $182 000. Manufacturing overhead includes $12 500 for depreciation expense, while the marketing and administration expenses include an amount off $5600 for depreciation expenses. Point Piper expects to be able to repay the principal on a $50 000 loan in October. Required (a) Prepare a schedule of receipts from debtors for the two months ending 31 October. (b) Prepare a cash budget for September and October. The cash balance at 31 August was $12 600. (c) As part of its longer term plans, Point Piper was hoping to commence a product reinvention program for one of its core products. The project would require an initial cash commitment of $30 000. Management was hoping to fund this from the cash flows of the business. Does this seem feasible? (LO3)

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(a) Receipts from Debtors Schedule for two months ending 31October September June $295 000 July $266 000 August $302 000 September $314 000 October $412 000

October

26 600 90 600 188 400

30 200 94 200

305 600

247 200 371 600

(b) Cash budget for 3 months ended 30 September Sep

Oct

Total

305 600

371 600 8 200

677 200 8 200

Total receipts ANTICIPATED PAYMENTS Direct materials purchases Direct labour Manufacturing overhead IT equipment Marketing and admin Loan

305 600

379 800

685 400

182 000 51 400 9 100 16 500 33 400

162 000 55 200 10 900

Total Payments Excess (Deficit) receipts over payments Bank balance at beginning of month

292 400 13 200 12 600

311 500 68 300 25 800

344 000 106 600 20 000 16 500 66 800 50 000 0 603 900 81 500 12 600

Bank Balance at End of Month

25 800

94 100

ANTICIPATED RECEIPTS Receipts from debtors Sale of old equipment

33 400 50 000

(c) A program requiring an initial cash commitment of $30 000 from the cash flows of the business seems feasible. Based on current estimates and conditions, the cash balance at the end of October is expected to be $94 100 even after repaying the $50 000 loan.

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6.24

Prepare cash budget from financial statements The Red Bean Company processes and distributes beans. The beans are packed in 500 gram-plastic bags and sold to grocery chains for $0.50 each in boxes of 100 bags. During March the entity anticipates selling 16 000 boxes (sales in February were 14 000 boxes). Typically, 80 per cent of the entity’s customers pay within the month of sale, 18 per cent of the customer pay the month after, and 2 per cent of sales are never collected. The entity buys beans from local farmers. The farmers are paid $0.20 per 500 grams, cash. Most of the processing is done automatically. Consequently, most ($80 000) of the entity’s factory overhead is depreciation expense. The entity advertises heavily. For March managers expect to publish $75 000 worth of advertisements in popular magazines. This amount is up from February’s $60 000. The entity pays for 10 per cent of its advertising in the month the advertisements are run and 90 per cent in the following month. March’s budgeted income statement and statement of cost of goods manufactured and sold follow. All costs and expenses are paid for as incurred unless specifically indicated otherwise. The entity will begin March with a cash balance of $25 000, and pays a monthly dividend of $15 000 to the owners.

Required From the information provided, prepare a cash budget for March. (LO3)

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Cash receipts

February sales (14 000 × $0.50 × 100) × 18% March sales (16 000 × $0.50 × 100) × 80% Total March receipts

$126 000 640 000 $766 000

Cash disbursements Advertising: February ($60 000 × 90%) March ($75 000 × 10%) Total cash disbursements for advertising Administrative salaries Sales commissions Direct materials purchases Labour costs Overhead costs ($115 000 less depreciation of $80 000) Total cash disbursements for operations Cash dividends Total cash disbursements

$ 54 000 7 500 61 500 80 000 69 000 330 000 90 000 35 000 665 500 15 000 $680 500

The cash budget for March is thus: Beginning balance at 1 March Plus: March receipts Subtotal Less: March disbursements Ending balance at 31 March

$ 25 000) 766 000) 791 000) (680 500) $110 500)

Note: Credit loss expense and depreciation are ignored because they do not directly affect cash flows.

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6.25

Time budget; uncertainties; performance evaluation; priorities Patricia sighed and briefly closed her eyes. She was frustrated with the reconciliation she was working on. She was sure that she was missing something, but she could not determine what it was. And she felt the clock ticking. Patricia knew that the time budget for this assignment was only three hours, and she had already worked on it for two hours. Patricia started with a CPA entity after graduation, three months ago. Her first few assignments had been stressful. She had been a good student in school, and she expected to do well at work, too. But she often felt inadequate here, as though she was supposed to know more than she did. Her supervisor, Ron, told her not to worry too much. He said that her job was to learn and that she would be performing well soon. ‘All new-hires are slow to begin with’, he told her, ‘Just let me know if you have questions’. However, Patricia felt that she had pestered him with enough questions. Most of the time, the answers to her questions seemed so obvious  after Ron had answered her. She looked at the reconciliation again. Required (a) Explain why it might be difficult to establish accurate time budgets for accounting tasks. (b) Provide possible reasons why Patricia’s time on this assignment could exceed the budget. (c) Explain why Patricia is reluctant to seek Ron’s help on this assignment. (d) Describe how Ron might evaluate Patricia’s performance assuming: (i) She seeks his help and completes the assignment in four hours. (ii) She does not seek his help and completes the assignment in eight hours. (e) Suppose Patricia does not seek Ron’s help and completes the assignment in eight hours. (i) What priorities has Patricia used in making this choice? (ii) Has Patricia behaved ethically? Why? (f) What could Patricia learn from this experience that will improve her performance in the future? (g) Suppose Patricia asked for your advice (i) Use the information you learned from the preceding analyses to write a memo to Patricia with your recommendation. Refer in your memo to the information that would be useful to Patricia. (ii) Write one or two paragraphs explaining how you decided what information to include in your memo. (LO5)

(a)

Many accounting tasks are non-routine and involve unpredictable activities. For example, a reconciliation could require investigation of unusual items or uncover problems with the mathematical accuracy of other accounting records. Unforeseen problems make it difficult to establish an accurate time budget.

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(b)

Patricia’s time might exceed the budget because of unforeseen items, as discussed in Part A. Alternatively, her time could exceed the budget because she is inexperienced or is distracted by other matters (such as worrying about her performance).

(c)

Patricia is probably concerned that asking for more help will lead Ron to believe that she is incompetent or lacks confidence, which could in turn lead to a poor performance evaluation. She also might want to avoid interrupting Ron from performing his work.

(d)

It is uncertain how Ron would respond to either situation. Although he has told Patricia that ‘All new-hires are slow to begin with’, he probably has some unspoken expectation for how long it should take her to complete the task. He probably also has some expectation about the number and types of questions that are appropriate for a newly-hired staff member.

(i)

If Ron thinks that Patricia’s questions are reasonable and she completes the assignment in 4 hours, he will probably consider her performance to be acceptable for a new-hire. However, he will probably expect her to perform more quickly on future tasks. On the other hand, he might view her performance as poor if he believes that her questions involved issues about which she should already know.

(ii)

Ron will probably give Patricia a poor performance review if she does not seek his help and completes the assignment in 8 hours. He will probably assume that she wasted time by failing to ask him questions. However, he might consider this amount of time reasonable if Patricia adequately explains to him legitimate reasons for the reconciliation taking twice as long as expected—such as unanticipated reconciliation problems.

(e)

(i) Assuming that there were no unusual problems causing the reconciliation to be significantly more complex than expected, Patricia has probably prioritised self-reliance and worry about her performance as more important than meeting the job’s time budget. In addition, she has placed a low priority on communicating her work status with her supervisor.

(ii) The ethics in this problem involve Patricia’s responsibilities to her supervisor, her entity, and her client. Her supervisor and entity are both responsible for Patricia’s professional development and the quality of her job performance. If failing to ask questions hindered her development or job performance, then Patricia has not acted ethically. Her supervisor is probably evaluated at least in part on Patricia’s performance, so her poor performance would also reflect poorly on Ron’s performance. In addition, the entity and client have a financial stake in this situation. Time is money to a CPA entity; either the entity absorbs the cost of the additional time, or the time will be billed to the client. A failure to ask questions might have increased the length of time to complete Patricia’s tasks, and a failure to provide timely communication about problems with the reconciliation might prevent the entity from billing the client for legitimate cost overruns. Ethical behaviour in this situation would require Patricia to focus on what is best overall — for herself, her supervisor, her entity and her client. In this case, her personal concerns

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appeared to override the interests of other stakeholders. Thus, Patricia did not appear to act ethically. (f)

Because of Patricia’s lack of experience, it was difficult for her to gauge the quality of her work and the appropriateness of questions she might ask her supervisor. Nevertheless, once the job is completed she has an opportunity to reflect upon what occurred and to consider things she might have done differently. For example, she might identify a different way to sequence the work she performed to reduce the overall time. Or, she might think about how the work was similar to what she had learned in school, how it was different, and why. She might also ask Ron for suggestions about ways to improve her work. By reflecting on her work and asking for suggestions, Patricia can more readily recognise problems and solutions in future assignments.

(g)

(i) and (ii) There is no one answer to these parts. Use individual student responses as a basis for class discussion.

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6.26

Performance benchmark; variances and analysis Central Coast Public Clinic is a free outpatient clinic for public assistance patients. Among other services, the clinic provides visiting nurses for elderly patients in their homes. A homemaker who cleans and performs other household tasks accompanies each nurse. When the nurses are not visiting clients, they work at the office preparing for visits. When the homemakers complete their visits, they go home. Each year, the clinic receives a budget allotment from the state government. The government does not allow the clinic to spend more than this allotment. The clinic, in turn, allocates its budget among its various programs. The visiting nurse program was authorised (and spent) $250 396 in 2018 and $279 476 in 2019 as follows.

The nursing staff received a 5 per cent increase in salary one-third of the way through 2019. The homemakers did not receive an increase in wages in 2018 or in 2019 The prices of medical supplies increased about 2 per cent during 2019 compared to 2018. The prices of cleaning supplies were relatively constant across the two years. Transportation is provided by the nurses, who are reimbursed $0.20 per kilometre. The clinic’s general overhead is allocated to programs on the basis of budgeted program salaries. Required (a) In this problem you are not given a budget for 2019. If you want to evaluate performance of the 2019 clinic, what can you use as the basis of a flexible budget to develop a benchmark? (b) Prepare a schedule to evaluate the performance of this program in 2019 using the benchmark suggested in part (a). (c) If you were the general manager of the clinic, what would you like to discuss with the head of the visiting nurse program concerning the 2019 results? Explain. How many patients should have been served in 2019 for $279 476 if costs had been under control? (LO5) (d)

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(a)

The prior year’s actual results can be used as a static budget for the next period. The 2018 results can be used as the basis for a benchmark for 2019, adjusting for activity levels and any price changes.

(b)

To convert the 2018 results to a benchmark for 2019, adjust 2018 variable costs to reflect activity levels in 2019. In addition, adjust 2015 amounts for any known price changes. The following costs are most likely variable. To create an estimate for 2019, divide each cost by the level of activity in 2018 and then multiply by the level of activity in 2019. Home visits can be used to measure activity levels. Adjust for known cost increases, using information given in the problem. Homemakers: ($60 046 / 4312 visits × 5101 visits) Medical supplies: ($18 197 / 4312 visits × 5101 visits) Cleaning supplies ($6894 / 4312 visits × 5101 visits) Transportation ($9068 / 4312 visits × 5101 visits)

$71 033 21 527 8 155 10 727

The following costs are most likely fixed. To create an estimate for 2019, these costs are adjusted for known cost increases, using information given in the problem. Nurses: One-third year’s salary ($135 378 / 3) Two-thirds year’s salary (($135 378 × 105%) / 3) × 2 Total

$ 45 126 94 765 $139 891

Clinic general overhead is not included in the flexible budget because it is an allocated cost and the clinic manager has no control over it. Given the preceding calculations, the 2019 benchmark and variances are as follows: 2018 2019 2019 Costs Actual Benchmark Actual Variance Nurses $135 378 $139 891 $145 019 $(5 128) Homemakers 60 046 71 033 71 500 (467) Medical supplies 18 197 21 527 21 402 125) Cleaning supplies 6 894 8 155 9 216 (1 061) Transportation 9 068 10 727 11 144 (417) Total $229 583 $251 333 $258 281 $(6 948) Home visits Average cost per visit (c)

4312

5101

$53.24

$49.27

$50.63

It seems there is a large variance in cleaning supplies. Are employees taking supplies home? The homemakers did not get a raise but the nurses did, are homemakers taking home cleaning supplies because they feel they are underpaid? Why are nurses’ salaries so high? Did you add hours, or are some nurses getting larger raises? Do patients live further away or are errands being run using clinic car expense?

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(d) If costs had been in control, there would have been no variances. Thus, this question calls for the number of home visits that could have been made for the extra $6948 in unfavourable variances. The benchmark average cost of $49.27 cannot be used in the calculations because average cost includes fixed costs that do not change with changes in volume. Therefore, a benchmark variable cost per unit is calculated: Variable costs per visit: Homemakers Medical supplies Cleaning supplies Transportation Total Variable Costs Divided by benchmark number of visits Benchmark Variable Cost Per Visit ($111 442/5101)

$ 71 033 21 527 8 155 10 727 $111 442 5101 $21.85

Now the additional number of visits that could have been made is calculated for the variance: $6948 / $21.85 variable cost per visit = 318 visits Total visits that could have been made if costs had been in control: 5101 actual visits + 318 additional visits = 5419 visits

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6.27

Comprehensive manufacturing master budget problem The accountant at Fighting Kites has always prepared a budget that is calculated using only one estimated volume of sales. He has asked you to help him set up a spreadsheet that can be used for sensitivity analysis in the budgeting process. This year it appears that the entity may not meet expectations, which could result in a loss. He is concerned that the entity will incur a loss again next year, and wants to develop a budget that will easily reflect changes in the assumptions. After gathering information about next year’s operations, he will provide information using a what-if sensitivity analysis. PART 1 Spreadsheet with input box, revenue and production budgets Following are the assumptions regarding revenues, direct materials and labour costs, and inventory levels.

Required (a) Create a spreadsheet with a data input box at the top. Into this box put all of the relevant assumption data. This box should be formatted with a border to separate the input data from the cell-referenced data. Set up each schedule with cell references to information in the data input box. Any changes made to information in this box should be reflected through all of the schedules that you set up. As you proceed through parts 2 and 3 of this problem, more information will be given that needs to be located in the assumptions box, such as next year’s estimated variable and fixed manufacturing overhead, and support department costs. You will need to leave space in the data input box for this information, or add more rows as you develop the spreadsheet. (b) Prepare a revenue budget. (c) Prepare a production budget in units.

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(d) (e)

Prepare the direct materials usage budget and a direct materials purchases budget. Prepare a direct labour budget (in hours and cost).

PART 2 Overhead, ending inventory and cost of sales budgets Refer to the information for part 1. Following are estimated manufacturing overhead costs. Both fixed and variable overhead will be allocated based on the number of kites produced.

Required (a) Prepare a manufacturing overhead budget and determine variable and fixed overhead allocation rates by dividing the budgeted overhead by budgeted labour hours for the fixed overhead and units for the variable overhead. (b) Prepare a schedule that calculates the unit costs of ending inventory in finished goods, and then prepare the ending inventories budget. (c) Prepare a cost of goods sold budget. PART 3 Budgeted statement of profit or loss Refer to the information for parts 1 and 2. Following is the information that the accountant collected about support department costs.

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Required (a) (b)

Prepare a support department costs budget. Prepare a budgeted income statement. Assume an income tax rate of 25%.

PART 4 Cash budget with bad debts and borrowing Refer to the information for parts 1, 2 and 3. The entity’s managers budget cash flows on a quarterly basis so that they can plan short-term investments and borrowings. Kite sales are highest during the spring and summer. Sales are fairly even within each quarter, but sales vary across quarters as follows:

Accounts receivable at the end of the prior year, consisting of sales made during December, totalled $90 000. Payments from customers are usually received as follows:

The managers plan to maintain beginning inventory quantities during January and February, but to increase inventories to the targeted levels by the end of March and maintain those levels throughout the rest of the year. The entity pays its vendors 10 days after raw materials are received, so approximately two-thirds of all purchases are paid in the month of production and one-third are paid the following month. Accounts payable at the end of the prior year totalled $13 000. Employee wages and other production costs are paid during the month incurred. Property taxes are paid in two equal instalments on 31 March and 30 September, and insurance is paid annually on 30 June. Support costs are paid evenly throughout the year. Estimated income tax payments are made at the end of each quarter based on 25 per cent of total estimated taxes for the year. In addition to customer receipts, the entity expects to receive $10 000 in proceeds from the sale of equipment during January. It also plans to purchase and pay for new equipment costing $50 000 during January.

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The entity finances its short-term operations with a line of credit from the bank, which had a balance of $150 000 at the end of the previous year. The line of credit agreement requires the entity to maintain a minimum cash balance of $100 000 (non-interest-bearing). The entity’s line of credit requires quarterly interest payments at an annual rate of 5.5 per cent. (For simplicity, assume that all borrowings and repayments occur on the last day of each quarter.) Data Input Required

(a) budgets for cash receipts, cashMATERIALS disbursements, DIRECTPrepare LABOUR: quarterly Assembly Packing DIRECT PER KITE: Hoursand short-term financing. 0.5 0.1 Nylon $10 Cost per hour $30.00 $15.00 Ribs $5 (LO2 and 3) Cost per kite

$15.00

$1.50

String

Part 1 (a)

(b)

(c)

(d)

Target INVENTORIES: Beginning Ending REVENUE ASSUMPTIONS: Direct materials: Selling price $75 Below is the input section of the sample$7,000 spreadsheet for Volume this problem. The data Nylon $5,000 of sales 80,000 $3,000 $3,200 inputRibs box shown here includes only the input for Part 1. The solution for later String $1,000 $1,200 parts will show additional input items. Finished goods: Units 2,000 2,200 Cost $97,850

The Revenues Budget reflects the value of estimated sales volume and expected DIRECT MATERIALS USAGE AND PURCHASES BUDGET REVENUE BUDGET Total price as follows. Materials used: Units Price Cost

Selling price Units $10 sold Revenues Nylon 80,200 $802,000 Sales $75 80,000 $6,000,000 Ribs 80,200 $5 401,000 PRODUCTION BUDGET (UNITS) String 80,200 $2 160,400 Sales 80,000 Materials Usedand anticipated 1,363,400 Estimated sales volumes are used to predict the Ending Total inventory 2,200 inventory levels Add ending Totaltarget 82,200 number of units toinventory: produce as follows. $7,000 LessNylon beginning inventory 2,000 Ribs 3,200 Production 80,200 String 1,200 11,400 Deduct beginning inventory: The above the direct materials usage and Nylon schedules are used to prepare$5,000 Ribs 3,000 purchases budgets. String 1,000 (9,000) Total Purchases $1,365,800 DIRECT LABOUR BUDGET Hours Per Total Rate Per Labor

Units

(e)

Unit

Assembly The direct labour budget can now 80,200 be prepared. 0.5 Packing Total

80,200

0.1

Hours 40,100 8,020 48,120

Hour Cost $30.00 $1,203,000 $15.00 120,300 $1,323,300

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Fixed manufacturing overhead costs Depreciation $211,728 Chapter 13: Job costing for financial reporting Property taxes 28,872 Insurance 67,368 VARIABLE OVERHEAD: Plant management 240,600 FIXED OVERHEAD: $160,250 Depreciation $211,728 PartSupplies 2 Fringe benefits 336,840 Indirect labor 200,650 Property taxes 28,872 Miscellaneous 76,992 Maintenance 80,200 Insurance 67,368 Total $962,400

Here is an excerpt from the spreadsheet40,100 showing the additional area for Part 2: Miscellaneous Plant input management 240,600

(a)

Total labour hours Fixed overhead rate per labour hour

48,120 $20.00

Direct labour hours per unit Fixed overhead rate per unit

0.6 $12.00

Fringe benefits Miscellaneous

336,840 76,992

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Total $17.00 DirectINVENTORIES Labor: ENDING BUDGET Assembly $15.00 Raw materials: Packaging 1.50 Manual$7,000 Contemporary Management Accounting Solution Nylon 16.50 Ribs Total 3,200 Manufacturing Overhead: String 1,200 $11,400 COST OF GOODS SOLD BUDGET $6.00 Variable Beginning finished above, goods determine $97,850 (b) Using information the cost of ending inventories. Fixed 12.00 Cost Per Manufacturing Total Costs Incurred: 18.00 Units Unit Direct materials $1,363,400 Total Unitgoods cost $51.50 Finished 2,200 $51.50 113,300 Direct labour 1,323,300 Variable overhead 481,200 Total ending inventory $124,700 Fixed overhead 962,400 Cost of goods manufactured 4,130,300 (c) Using information above, the cost of goods sold budget4,228,150 is prepared. Total available Less: Ending finished goods 113,300 Cost of Goods Sold $4,114,850

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Part 3 SUPPORT DEPARTMENT COSTS: INCOME TAX RATE 25% Administration $1,034,580 Here is an excerpt from the spreadsheet showing the additional input area for Part 3: Marketing 620,748 SUPPORT DEPARTMENT COSTS BUDGET Distribution 310,374 Department Fixed Costs Customer service 103,458

Administration

(a)

(b)

$1,034,580

The support department costs budget is a simple Marketing 620,748 summary of the information BUDGETED INCOME STATEMENT Distribution 310,374 provided in the problem: Revenues $6,000,000 Customer 103,458 Cost of goodsservice sold 4,114,850 Total Margin $2,069,160 Gross 1,885,150 Operating costs: Administration $1,034,580 The Marketing income statement uses information from the individual budgets prepared in 620,748 PartsDistribution 1 and Parts 2 of this problem. Because the pre-tax income is negative, it is 310,374 not clear howservice to calculate the income tax expense. Customer 103,458 2,069,160 The solution below assumes that noPretax loss carry income tax expense is set to $0. Profit back is available, and the (184,010) Income tax expense 0 Profit $(184,010)

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Sales 10% 50% Property tax payments 50% 0% Insurance 0% 100% Contemporary Management Accounting Solution Manual 25% Other fixed overhead costs 25% Support costs 25% 25% Income tax payments (% of total expense) 25% 25% Proceeds-Sale of equipment $10,000 Purchase $50,000 Part 4 of new equipment

30% 50% 0% 25% 25% 25%

10% 0% 0% 25% 25% 25%

BANK LINE OF CREDIT

Here is an excerpt from the spreadsheet showing the additional input area for Part 4: Beginning balance $150,000 Annual interest rate Minimum cash balance

5.50% $100,000

QUARTERLY CASH RECEIPTS BUDGET (a) The cash budget requires a series of steps. JanuaryMarch

AprilJune

JulySeptember

OctoberNovember

Total Receipts Preparation from customers:of the cash receipts budget requires calculating the sales for each Sales from priorwithin quarter each quarter because $84,600 $94,000 $470,000 sales $282,000 $930,600 month only 50% of customer are received Sales 1st monththe of quarter 194,000 194,000 1,940,000 during month of sale. Another 47% is970,000 collected 582,000 the following month, and Sales 2nd month of quarter 194,000 970,000 582,000 194,000 1,940,000 3% is uncollectible. Cash receipts also500,000 include 300,000 the anticipated sale of Sales 3rd month of quarter 100,000 100,000 1,000,000 equipment during January. Subtotal 572,600 2,534,000 1,934,000 770,000 5,810,600 Sale of equipment 10,000 0 0 0 10,000 Total Receipts $582,600 $2,534,000 $1,934,000 $770,000 $5,820,600

Here are details for some of the calculations: • Sales from prior quarter = (Sales during prior quarter/3 months) × (50%-3%). For Jan–Mar, however, this is calculated as beginning A/R × (100%-2*3%). The uncollectible per cent must be doubled because beginning A/R is only one-half the prior month’s sales. • Sales 1st and 2nd months of quarter = (Sales during quarter/3 months) × (100%-3%) • Sales 3rd month of quarter = (Sales during quarter/3 months) × 50% Although the problem does not require it, the sample spreadsheet shows a Reconciliation of Salesof to total Cash Received reconciliation sales tofrom totalCustomers cash receipts from customers. This type of Total sales $6,000,000 reconciliation is useful because it provides a check on the mathematical accuracy Add beginning accounts 90,000 RAW MATERIAL CASH receivable DISBURSEMENTS of theaccounts cash receipts Less ending receivableschedule. January(100,000) AprilJulyOctoberLess bad debts (179,400) March June September November Total Total cash collected from customers $5,810,600 Unit production: First month 2,667 13,333 8,000 2,667 Ending accounts receivable = (Sales during fourth quarter/3 months) × 50% 26,667 Second month 2,667 13,333 8,000 2,667 26,667 Third month 2,867 13,333 8,000 2,667 26,867 Because entity carries accounts payable for raw material purchases, it is Total quarterlythe production 8,200 40,000 24,000 8,000 80,200

helpful to begin the cash disbursement calculations by summarising the cash Raw material payments: payments for raw material purchases. First, calculate the raw material purchases Purchases prior quarter $13,000 $17,044 $75,556 $45,333 $150,933 by month. The entity’s policy is to pay approximately two-thirds of45,333 its purchases Purchases 1st month of qtr 45,333 226,667 136,000 453,333 during2nd the month remainder the following Purchases month of qtrof purchase and the 45,333 226,667 136,000 month. 45,333 453,333 Purchases 3rd month of qtr 34,089 151,111 90,667 30,222 306,089 Total $137,756 $621,489 $438,222 $166,222 $1,363,689

Here are details for some of the calculations: • Unit production by month = Quarterly unit sales ÷ 3 months, where quarterly unit sales are calculated by multiplying total annual unit sales by the per cent of sales expected to occur each quarter. The third month of first quarter, however, includes production of an additional 200 units to increase inventory from the prior year level to the new target level. • Purchases prior quarter = Units produced 3rd month prior quarter × ($10 + $5 + $2) × 33.3333%. For the 1st quarter, purchases prior quarter = beginning A/P. For the 2nd quarter, the payments also include 1/3 of the targeted increase in raw material inventories (from $9000 to $11 400) that takes place during the 3rd month of the 1st quarter. • Purchases 1st, 2nd and 3rd month of qtr = Units produced during month × ($10 + $5 + $2). For the 1st quarter, the payments also include 2/3 of the

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targeted increase in raw material inventories (from $9000 to $11 400) that takes place during the 3rd month. Although the problem does not require it, the sample spreadsheet shows a reconciliation of total raw material purchases to total cash disbursements for CASH DISBURSEMENTS BUDGET Reconciliation of Purchases to Cash Disbursements purchases. This type of reconciliation it provides a check on January-is useful April-because JulyOctoberTotal purchases $1,365,800 the mathematical accuracy of the cash disbursements schedule. March June September November Total Add beginning accounts payable 13,000 Raw material purchases $137,756 $621,489 $438,222 $166,222 $1,363,689 Less ending accounts payable (15,111) Direct 135,300 660,000 396,000 132,000 $1,363,689 1,323,300 Totallabour cash paid for purchases Variable overhead costs paid 49,200 240,000 144,000 48,000 481,200 The cash for raw material purchases are then combined with Fixed overhead costsdisbursements paid: other disbursements in the cash disbursements budget shown that Property taxes 14,436 0 14,436 below. Notice 0 28,872 Insurance 0 67,368 0 0 67,368 the input section of the spreadsheet (shown at the beginning of the solution for Other 163,608 163,608 163,608 163,608 budget; 654,432 Part 4) is designed to facilitate preparation of the cash disbursements Support costs 517,290 517,290 517,290 517,290 2,069,160 the per cent of fixed costs paid during each quarter is included in 0the input 0 Income taxes 0 0 0 section. Subtotal 1,017,590 2,269,755 1,673,556 1,027,120 5,988,021 QUARTERLY SHORT-TERM FINANCING BUDGET Purchase equipment 50,000 0 0 0 50,000 JanuaryJulyOctoberTotal Disbursements $1,067,590 $2,269,755 April$1,673,556 $1,027,120 $6,038,021

Beginning March June September November Herereceipts are details for some of the calculations: Total cash $582,600 $2,534,000 $1,934,000 $770,000 • Direct labour paid = Units produced during quarter * ($15 1,673,556 + $1.50) 1,027,120 Total cash disbursements 1,067,590 2,269,755 • Variable overhead costs paid = Units produced 264,245 during quarter × $6 (257,120) Subtotal (484,990) 260,444 • onPayments for property taxes, insurance, support costs, are Interest loan (2,063) (8,759) and income (5,247) taxes(1,738) Excesscalculated receipts (disb.) $255,197 by multiplying the total($487,052) cost by the$255,486 per cent paid in each ($258,858) quarter Loan borrowing $487,052 ($255,486) ($255,197) $258,858 shown(repayment) in the input section. Increase in cash $0 + Fringe$0benefits + $0 • (decrease) Other fixed overhead costs = (Plant $0 management

Miscellaneous) × 25%. Notice that depreciation is excluded because it is a

Line of Credit: non-cash expense. Beginning loan balance $150,000 $637,052 $381,566 $126,369 Borrowing (repayment) 487,052 (255,486) (255,197) 258,858 The short-term financing budget includes a summary of cash receipts and Ending loan balance $637,052 $381,566 $126,369 $385,227

disbursements, which includes interest on the bank loan. It then calculates the Cash estimated Account: amounts repaid or borrowed on the entity’s line of credit. The spreadsheet allows any extra cash to be deposited$100,000 in the cash$100,000 account (but there Beginning cash balance $100,000 $100,000 is no extra cash in this problem). Recall that the entity’s line of credit agreement Increase (decrease) in cash 0 0 0 0 requires a minimum balance of $100100,000 000 in the100,000 cash accounting, this Ending cash balance $100,000 100,000 and 100,000 account is non-interest-bearing. Less cash minimum balance Excess cash balance

100,000 $0

Here are details for some of the calculations: • Interest on loan = Beginning loan balance * 5.5% * 1/4 year • Although the problem does not explicitly provide the beginning cash balance, it is assumed to be $100 000 because of the minimum balance requirement and because the entity had an outstanding bank loan. It is reasonable to assume that the entity would have reduced its bank loan with any excess cash.

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Chapter 13: Job costing for financial reporting

6.28

Comprehensive restaurant master budget problem You are the accountant for Wok and Egg Roll Express. Following are assumptions about sales for the coming month. Wok offers three basic meals: noodle bowls, egg rolls, and rice bowls. Each meal can be prepared with several different meats or with vegetables only. Costs and prices are similar for all varieties of each meal. Prices for noodles bowls are $4 each, egg rolls are $3 each, and rice bowls are $3.50 each. Estimated sales for the next month are 200 noodle bowls, 100 egg roll meals, and 500 rice bowls per day. PART 1 Revenues budget; uncertainties; revenue strategies Required (a) Prepare a revenue budget for the next month assuming it is 30 days long. (b) Discuss factors that affect the budgeted volumes of meals. (c) Identify possible ways the owner could increase total revenues. Discuss the pros and cons for each of your ideas. PART 2 Direct materials budget; uncertainties; cost control strategies The owner of Wok and Egg Roll Express studied the cost of direct materials for each type of meal. He estimates that noodle bowls use about $1 in direct materials, egg rolls use about $0.75, and rice bowls use about $0.90. Food is purchased daily to ensure high quality. Beginning and ending inventory amounts are minimal. Required (a) Explain why you would not need to prepare a production budget for Wok and Egg Roll Express. (b) Prepare a direct materials usage budget and a direct materials purchases budget. (c) Discuss reasons why actual costs might be different from budgeted costs in part (e). (d) Suppose the prices of food ingredients increase. Identify possible ways the owner could keep food costs within the budget. Discuss drawbacks for each of your ideas. PART 3 Direct labour budget; uncertainties; cost control strategies The owner of Wok and Egg Roll Express employs cooks and cashiers. The cashiers take orders and collect payment, transfer food from the cooks to customers, and clean tables. Cooks are paid $10 per hour, and cashiers are paid $8 per hour. Wok operates four shifts: 10 to 2, 11 to 2, 2 to 10, and 5 to 8. Weekdays and weekends are staffed similarly. Following are the shifts and required workers.

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Contemporary Management Accounting Solution Manual

Required (a) Prepare a labour budget showing hours and costs for a month. (Assume 30 days per month.) (b) Discuss reasons why actual labour costs might turn out to be different from budgeted costs in part (a). (c) Identify possible ways the owner could reduce labour costs. Discuss possible drawbacks for each of your ideas. PART 4 Overhead budget; uncertainties; cost control strategies Wok and Egg Roll Express does not separately account for production versus general overhead. Fixed overhead includes production overhead as well as support services and general administration. Variable overhead includes labour-related costs such as payroll taxes and employee benefits. Wok has estimated variable overhead costs as $2.50 per direct labour hour. Following are the estimated fixed overhead costs for one month:

Required (a) Prepare an overhead costs budget for one month. (b) Discuss reasons why actual overhead costs might turn out to be different from budgeted costs in part (a). (c) Identify possible ways the owner could reduce overhead costs. Discuss possible drawbacks for each of your ideas. PART 5 Budgeted statement of profit or loss; uncertainties; profit strategies Refer to the information from the preceding budgets. The income statement for Wok and Egg Roll Express consists of revenues less direct costs (direct materials and direct labour) to determine the gross margin. Then the overhead costs are deducted to determine operating income.

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Chapter 13: Job costing for financial reporting

Required (a) Prepare a budgeted income statement ignoring income taxes. (b) What are the major uncertainties in Wok’s budget? Explain. Wok’s owner would like to increase profits from the store. Suggest several possible ways to accomplish this goal. Explain your reasoning. (LO2) (c)

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Contemporary Management Accounting Solution Manual

Part 1 Input Area

Below is the input section of a sample Dailyspreadsheet for this problem. The data input box shown here includesPrice only the input for Part 1. The solution for later parts will show Meals: Volume additional input items. Noodle bowl $4.00 200 Egg Roll $3.00 100 BUDGET (30-DAY Monthly RiceREVENUE bowl $3.50MONTH) 500 Meals: Price Volume Revenue Noodle bowl $4.00 6,000 $24,000 (a) The revenue budget is calculated per month: Egg Roll $3.00 assuming 3,000 30 days 9,000 Rice bowl $3.50 15,000 52,500 Total revenue $85,500

(b)

There can be unanticipated changes in demand. An eating establishment can be very popular and then become less popular. A new restaurant could open nearby and take some of Wok’s market share. Economic downturns can also affect volumes. If people are not using expensive restaurants, they may increase their use of Wok. However, if people do not eat out as often, demand could drop. If a new office building opens nearby, lunch traffic could increase.

(c)

Launch an advertising campaign. Pros: Increase volume, thus increasing revenues; potential increase in market share Cons: Cost might exceed the benefit Distribute coupons to attract new customers. Pros: Increase volume, thus increasing revenues; potential increase in market share Cons: Cost to distribute and price discounts might exceed benefit Increase prices. Pros: Increase price per meal Cons: Decrease in sales volume might exceed benefit

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Chapter 13: Job costing for financial reporting

Part 2 Input Area Daily

As shown below, the product isCost added as a new column in the input Meals: Price cost information Volume area of the spreadsheet. $4.00 Noodle bowl 200 $1.00 Egg Roll Rice bowl

(a)

(b)

$3.00 $3.50

100 500

$0.75 $0.90

Beginning and ending inventories are minimal or non-existent in a restaurant. Thus, an appropriate assumption is that production approximately equals sales, and there is no need to calculate production. DIRECT MATERIALS USAGE AND PURCHASES BUDGET Direct material costs: Cost Volume Total Cost Given the answer to Part$1.00 A and assuming no changes in direct material Noodle bowls 6,000 $6,000 inventories, usage is equal material purchases: Egg rolls direct materials$0.75 3,000 to direct 2,250 Rice bowls $0.90 15,000 13,500 Total usage and purchases $21,750

(c)

Food prices, such as rice, vegetables, and meat, change regularly. Weather conditions and government regulation can affect the amount of crops harvested. Import and export law changes might affect the price of vegetables and meat. Food preferences also might affect prices. For example, when people stopped eating as much beef, prices dropped.

(d)

If food costs increase, portion size could be reduced. Or, less expensive ingredients could be used. However, it is likely that customers would notice these changes and may go elsewhere if they feel quality or value has diminished. The owner could also seek ways to reduce food waste. However, there might be little waste that can be eliminated if operations are already efficient.

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Contemporary Management Accounting Solution Manual DIRECT labour BUDGET labour Hours: Cooks Number of Hours per Employee Number of labour3Shifts Cooks Employee CashiersHours/Day Employees Shift: Employees Part 10 am am to to 22pm pm 10 2 2 4 2 8 2 11 3 3 3 3 9 3 11 am am to to 22pm pm 2 pm to 2 2 8 2part of 16 Below the additional input section for this the problem.2 pm is to 10 10pm pm 5 pm 3 3 3 3 9 3 pm to to 88pm pm 42 Rate Total of pay $10.00 $8.00

labour Cost:

(a)

Hours

Rate Per

Cashiers Hours per Employee 4 3 8 3

Employee Hours/Day 8 9 16 9 42

Monthly

The direct labourPer budget isPer calculated assuming 30Cost days per month (same as Day Month Hour CooksPart 1): 42 1,260 $10.00 $12,600 Cashiers Total

1,260 2,520

$8.00

10,080 $22,680

(b)

Sometimes employees are sent home when business is slow, reducing labour hours. If volumes increase, workers may be asked to stay overtime, and costs would increase. There could be a change in minimum wage laws so that the cashiers would need to be paid more. If turnover is high, the owner may need to increase the hourly wage for cooks or cashiers to reduce turnover.

(c)

Labour costs can be reduced by monitoring the shifts carefully to determine whether there are days of the week when fewer people could be used. If weekends or certain nights are slow, Wok may not need the same number of workers scheduled for each day of the week. A problem arises if volumes are unexpectedly large and people have to wait. Long lines annoy customers and cause them to leave or prevent them from coming back. Not all of the kitchen employees need to be cooks. Some employees could be hired at a cheaper wage just to prepare the foods but not cook them. However, if these people are poorly trained, quality could suffer and customers could be lost.

OVERHEAD BUDGET Variable overhead cost per direct labour hour: Direct labour Rate Per Hours Hour Fixed overhead costs: Part 4Variable overhead 2,520 $2.50 Utilities $300 Manager

$2.50

Total $6,300

5,000

overhead: BelowFixed isLease the additional input section 2,000for this part of the problem.

(a)

Utilities Miscellaneous 3,500 Manager Total $10,800 Lease Miscellaneous Below is the Total fixedoverhead overhead budget: Total overhead

300 5,000 2,000 3,500 10,800

$17,100

(b)

Before answering this question, it is necessary to visualise the types of costs included in overhead. Fixed overhead is likely to include costs such as utilities, manager salary and fixed rent. Utilities vary according to weather (for heating and cooling), so uncertainties exist about the monthly cost. If the manager quits, a replacement might cost more or less than the previous manager. The lease costs might remain stable, but could be renegotiated at the end of the lease term. Variable overhead might include supplies (such as napkins, condiments and disposable dishes) as well as labour-related costs such as employment taxes and benefits. The costs of these items can vary. Also, there are likely to be fluctuations in the quantities of supplies used.

(c)

It could be difficult to reduce utilities, the lease cost, or employment taxes. If the manager’s salary is cut, the manager may not do as good a job, or may quit. If the salary is not competitive, a new manager may not be as effective as the old

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Chapter 13: Job costing for financial reporting

one. The entity could put supplies behind the counter and require customers to ask for the, potentially reducing usage. However, customers might complain and it may take more time to get people through the line during busy times.

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BUDGETED INCOME STATEMENT Revenue $85,500 Direct Costs: Contemporary Management Accounting Solution Manual Direct materials $21,750 Direct labour 22,680 44,430

Part 5 Contribution Margin (a)

41,070

Overhead:

Below is the budgeted income Variable $6,300statement, which incorporates the answers to PartsFixed 1–4 of this problem: 10,800 17,100 Operating Profit

$23,970

(b)

Volume of sales and cost of food are the two most important uncertain estimates. If sales are off, profit will be less, or a loss could be incurred. If food prices increase, some of the profit will be lost. Labour is probably fairly stable, although turnover could be costly and should be monitored.

(c)

The manager should keep track of advertising costs and volumes to see if advertising is beneficial. Also, the entity could sponsor sporting events as a way of advertising, or walk-a-thons for good causes. All fixed and variable costs could be analysed for possible reduction, keeping in mind that quality needs to be held constant, or improved if possible. A cost benefit analysis needs to be done. There are a wide variety of good answers to this question.

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Chapter 13: Job costing for financial reporting

6.29

Organisational resources, uncertainties, performance, government budget responsibility

Required (a) (i) Explain how the budgeting process helps top managers articulate decisions about the use of resources. (ii) Explain how a budget identifies the resources available to individual departments within an organisation. (b) (i) Explain why the cost of resources such as labour and direct materials is uncertain. Include the effects of market forces in your discussion. (ii) Explain how changes in the price of resources such as labour and direct materials might cause managers to change the way those resources are used. (iii) Explain how the issues you discussed in parts (i) and (ii) can result in budget variances. (c) (i) Explain how budgets can be used to measure organisational performance. (ii) Explain how each of the following budget adjustments improves measurement of variances when evaluating the performance for individual managers within an organisation: (I) Using flexible budgets to adjust for actual volumes (II) Removing allocated costs (III) Updating costs for anticipated price changes (iii) How can the analysis of budget variances lead to continuous improvement in an organisation?

(LO1 and 5) (a)

(b)

(i)

The budget includes anticipated spending on various activities within an organisation. Through the process of creating budgets, managers are forced to make decisions about the amount of resources to allocate to different activities. The budget communicates the results of those decisions.

(ii)

Budgets are typically prepared at the department level and proceed through a process of negotiations between the department managers and head office. Thus, the budget communicates the resources that can be used for individual departments.

(i)

Prices for most resources are uncertain because they may change and decisions about how to spend resources may change. Prices for resources are subject to economic supply and demand as well as entity-specific arrangements. For example, companies that pay lower than market wages are likely to lose employees. To become more competitive in hiring employees, a company may need to increase pay levels or benefits, modify work hours, or make other concessions that increase resource costs. Raw material prices also fluctuate with market prices and with alternative contractual arrangements that are available to suppliers.

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Contemporary Management Accounting Solution Manual

(c)

(ii)

Large increases in the cost of an individual resource are likely to cause managers to seek ways to reduce use of that resource. For example, as labour costs increase managers may reduce labour time by increasing the quality of raw materials or by modifying production processes to use greater automation. Managers may also outsource work to countries having lower labour costs. Decreases in resource costs have the opposite effect; managers are likely to seek ways to increase the use of the resource. For example, managers have increased their use of automated production equipment as the cost automation has declined.

(iii)

Fluctuations in the costs and use of resources are likely to lead to budget variances because specific fluctuations cannot be foreseen when the budget is created. Although managers know that prices will fluctuate, they cannot perfectly estimate future prices. They also cannot perfectly anticipate modifications in their use of resources until future market conditions occur.

(i)

One way to measure organisational performance is to compare actual results to budgeted results. This comparison provides information about how well the organisation met its goals.

(ii)

(I)

Using flexible budgets to adjust for actual volumes: When an individual manager is not responsible for differences between budgeted and actual volumes, a flexible budget does a better job of measuring the level of expected costs that are under the manager’s control. Thus, variances calculated using a flexible budget provide better measures of the manager’s performance. When a flexible budget is not used, the manager may be inappropriately rewarded when actual volume is less than budgeted, and inappropriately penalised when actual volume exceeds the budget.

(II)

Removing allocated costs: When allocated costs cannot be controlled by the manager, they provide no information about the manager’s performance. Therefore, variances related to these costs also provide no information about the manager’s performance. To avoid inappropriately rewarding or penalising managers for variances in allocated costs, these costs should be removed from the performance evaluation.

(III)

Updating costs for anticipated price changes: managers should be held responsible for their use of resources at the expected price. As discussed in Part B above, managers are likely to change their use of resources based on changes in price. To encourage managers to make the best use of resources, they should be held accountable for their decisions based on the expected prices.

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Chapter 13: Job costing for financial reporting

(iii)

Continuous improvement is the process of constantly making small changes to enhance organisational performance. The analysis of budget variances helps managers identify areas where organisational performance is different than expected, leading to recommendations for ways to improve future planning and operations. For example, a favourable variance can focus manager attention on ways to achieve similar favourable results in the future. An unfavourable cost variance can help managers identify and eliminate waste or inefficiencies.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. Prepared by Rodney Dormer

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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Chapter 7: Job costing systems

7 Questions 7.1

Describe the procedures used in job costing. (LO1)

In job costing, direct costs such as direct materials and direct labour are traced to each individual job. Then the indirect costs, usually overhead costs, are allocated to all of the jobs on which has been done during the period using either an actual or estimated allocation rate. This rate is developed by dividing an actual or estimated overhead cost by an actual or estimated volume of an allocation base. Typical allocation bases include labour cost, labour hours, and machine hours. If an estimated allocation rate is used, then end-of-period adjustments need to be made for any underapplied or overapplied overhead cost.

7.2

Describe an inventoriable product cost. (LO2)

Inventoriable product costs are those costs that are included as part of the cost of inventory (i.e. work-in-process and finished goods). These costs are subsequently expensed as cost of sales on the sale of the completed products. In accordance with financial accounting conventions, inventoriable product costs include direct materials, direct labour and overhead costs. 7.3

List three examples of job cost records you would receive if you were building a new home. (Hint: Itemised bills made out to you are usually job cost records.) (LO1 and 3)

Most itemised statements recorded for a particular individual (‘job’) constitute a job order cost sheet. Examples of job cost records when building a new home: • Progressive building bill • Materials bill • Builders labour bill 7.4 List several different sources of information used in job costing, and explain why this information is required. (LO1) For job costing, information is needed about the resources used by individual jobs. This includes information from the payroll system, such as the number of hours specific employees work on particular jobs so that direct labour costs can be traced to each job. Information from materials stores is needed about the amount of direct materials used per job to trace direct costs to each job. Information collected by employees or equipment may be needed, such as number of machine hours, to use as the allocation base for overhead in some departments. Both fixed and variable overhead costs are also needed; they are usually accumulated in control accounts in the accounting records and then allocated to specific jobs.

Chapter 8: Process costing systems

7.5

Compare actual and normal cost systems. Discuss the ways in which they are similar and the ways they differ. (LO3)

Both systems treat direct material and direct labour costs in the same manner; these costs are assigned to the jobs on which they were actually incurred using the actual amount of allocation base used per job. The difference deals with indirect costs. In an actual cost system, actual indirect costs are totalled at the end of the period and then, retroactively, allocated to the jobs worked on during the period. In a normal cost system, indirect costs and activity are estimated at the start of the period and an estimated allocation rate is used during the period to assign the costs to jobs as work takes place. 7.6

Will underapplied and overapplied overhead arise under both actual and normal costing? Explain your answer. (LO3)

Under actual costing there is no underapplied or overapplied overhead because actual costs and actual volumes of the allocation base are used to allocate overhead. Under normal costing, an estimated rate is used to allocate overhead that is based on estimates of cost and production. Because costs or volumes cannot be perfectly predicted, there will always be overapplied or underapplied overhead under normal costing.

7.7

Within the area where you live, work, or attend school, name three businesses that would likely use job costing. (LO1)

Examples of businesses that would use job costing: veterinary clinic, dentist, custom iron security doors, print shop, motor vehicle repair shop, solicitor. Examples of businesses that would use process costing: aluminium smelter or an oil refinery. 7.8

Part of a contract between a union and a company guarantees that all manufacturing employees earn five hours of overtime each week. In the company’s job costing system, should overtime be treated as a direct or indirect cost? (LO3)

Because overtime hours are more expensive than regular hours, the overtime premium should be treated as an indirect cost and assigned to overhead, while the regular cost of the hours is a direct cost that should be assigned to particular jobs. Assigning overhead to specific jobs just because the production schedule called for that job at that time unfairly treats those jobs. Overhead is guaranteed and will occur no matter what jobs are in process, so the overtime premium should be treated as an indirect cost and recorded as an overhead cost that is spread among all jobs. 7.9 Exquisite Furniture designs and manufactures custom furniture from exotic materials. Explain why spoilage is sometimes recorded as a cost for a specific job and other times as overhead for this entity. (LO7) If a customer requests a material that is known to increase defect rates more than other materials or requests a design that is more difficult to manufacture, any spoilage

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should be recorded as a cost of the specific job. Spoilage that is part of normal operations, such as fabric that is occasionally cut too small, should be recorded as overhead and spread across all jobs because this spoilage arises in a random manner. 7.10 Explain how manufacturing overhead cost pools and cost allocation are related. (LO3) Cost pools are groups of overhead costs, that is, common costs for resources used to manufacture products or provide services. These costs need to be distributed among the goods and services to match cost with revenue during an accounting period. Cost allocation is the method used to distribute costs across units of goods or services. 7.11 List the most common allocation bases used in job costing and explain under what circumstances each base would be most appropriate. (LO3) The three most common overhead allocation bases in job costing are labour hours, labour cost, and machine hours. Accountants try to identify overhead allocation bases that best reflect the flow of overhead resources to individual products. In a department that uses a lot of equipment and little labour, the overhead costs are more likely related to the machines. Therefore, machine hours would be an appropriate base. If overhead is more related to labour and includes fringe benefits and other labour costs, labour hours is used if direct labour employees are paid similar wages. If direct labour employees have a wide variety of skills, and therefore there is wide variation in the hourly wage amount, then direct labour cost may more accurately reflect the use of overhead resources.

Chapter 8: Process costing systems

7.12 To what extent do the costs used to value inventories for external financial reporting support internal management decisions on issues such as whether to accept a special, one-off order or whether to outsource part or all of the production process? (LO5) In accordance with external financial reporting guidelines, inventories are valued using absorption costing. That is, all manufacturing costs – direct materials, direct labour, variable overhead, fixed overhead – are included in the cost of inventories. The use of absorption costing information in regards to internal management decisions can be problematic as some of the included costs (i.e. fixed overhead) will be unlikely to change as a result of a one-off order or outsourcing decision. The only costs that are likely to be relevant for such decisions includes the variable costs (i.e. direct materials, direct labour, and variable overhead). Including fixed costs in the analysis can result in misleading results.

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8 Exercises 7.13

Job Costing, determination of manufacturing overhead rates One Glass Brewery estimates the following activity for the coming year:

At the end of the financial period the following information was collected:

Required (a) What was the predetermined manufacturing overhead rate calculated at the beginning of the year? (b) What was the actual manufacturing overhead rate for the year? (c) Explain the difference between the rates calculated in (a) and (b) above. (LO3)

(a)

Predetermined overhead rate for the year is: $100 000 / 10 000 hours = $10 per hour

(b)

Actual overhead rate for the year is: $120 000 / 9000 hours = $13.33 per hour

(c)

The rate difference is due to the underestimation of the costs ($20 000) and overestimation of the labour hours (1000 hours).

Chapter 8: Process costing systems

7.14

Job costing, over- and underapplied overhead, journal entries Shane’s Shovels produces small, custom earth-moving equipment for landscaping companies. Manufacturing overhead is allocated to work in process using an estimated overhead rate. During April, transactions for Shane’s Shovels included the following:

Beginning and ending work in process were both zero. Required (a) What was the cost of jobs completed in April? (b) Was manufacturing overhead underapplied or overapplied? By how much? (c) Write out the journal entries for these transactions, including the adjustment. (LO3) (a)

Notice that the company uses normal costing (overhead is allocated using an estimated rate). However, under normal costing the company is required to make an end-of-period adjustment for any overapplied or underapplied overhead. This means that the after-adjustment costs assigned to jobs completed will be actual cost: Direct materials issued to production Indirect materials issued to production Overhead incurred Direct labour costs Total Actual Costs Incurred

$180 000 30 000 250 000 75 000 $535 000

(b)

This month overhead was underapplied by $55 000. This is the difference between total overhead costs of $280 000 (indirect materials of $30 000 plus other manufacturing overhead incurred of $250 000) and manufacturing overhead allocated of $225 000.

(c)

Work in process $180 000 Raw materials inventory (direct materials used)

$180 000

Overhead cost control $30 000 Raw materials inventory (indirect materials used)

$30 000

Overhead cost control Various accounts

$250 000

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Work in process Overhead cost control (allocations)

$225 000

Work in process Wages payable

$75 000

Finished goods Work in process

$480 000

$225 000

$75 000

$480 000

The problem states that beginning and ending WIP inventories were both zero. Therefore, all jobs were completed. Total WIP costs = $180 000 + $225 000 + $75 000 = $480 000 Cost of sales Finished goods

$480 000 $480 000

The problem does not provide any information about the delivery of jobs to customers. However, jobs are usually transferred to customers upon completion, so the following entry assumes that all finished goods inventory is transferred to cost of sales. Cost of sales Overhead cost control (adjustment)

$55,000 $55 000

The amount of underapplied overhead was calculated in Part (b). Notice this is also equal to the balance of entries to the overhead control account: $30 000 + $250 000 – $225 000. The balance in the overhead control account will be zero after this entry is recorded. Notice that with the overhead cost adjustment the total costs recorded in cost of sales of $535 000 ($480 000 + $55 000) are equal to the total costs in part (a).

Chapter 8: Process costing systems

7.15 Normal and abnormal spoilage Franklin Fabrication produces custom-made security doors and gates. Currently two jobs are in process, 359 and 360. During production of Job 359, the supervisor was on holidays and the employees made several errors in cutting the metal pieces for the two doors in the order. The spoiled metal pieces cost $20 each and had zero scrap value. In addition, an order of five gates that had been manufactured for Job 360 required a fine wire mesh that sometimes tore as it was being mounted. Because a similar wire could be used that was much easier to install, the customer had been warned that costs could run over the bid if any difficulty was encountered in installing the wire. One of the gates was spoiled during the process of installing the wire. The cost of the materials and direct labour for the gate was $150. The gate and metal were hauled to the dump and discarded.

Required (a) Should the spoilage for Job 359 be categorised as normal or abnormal spoilage? Explain. (b) Should the spoilage for Job 360 be categorised as normal or abnormal spoilage? Explain. (c) Prepare spoilage journal entries for both jobs. (LO7) (a)

The spoilage for Job 359 should be categorised as abnormal spoilage because operations were out of control while the supervisor was on holidays. This cost is recorded as a separate loss.

(b)

The spoilage of wire mesh for the gate is normal spoilage; it arises as a regular part of operations because it is such fine wire. This spoilage would be assigned to the cost of the job because the customer understood that the fine wire is more difficult to work with.

(c)

The following entries assume that the costs were already recorded in WIP (the usual case). Therefore, the credit entry is to WIP inventory. Loss from abnormal spoilage $20 Work in process inventory (Job 359 – spoiled metal at cost)

$20

Overhead cost control $150 Work in process inventory (Job 350 – spoiled gate at cost)

$150

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7.16

Direct costs and overhead Job 87M had direct material costs of $400 and a total cost of $2100. Overhead is allocated at the rate of 75 per cent of prime cost (direct material and direct labour).

Required (a) How much direct labour was used? (b) How much overhead was allocated? (LO2) (a)

This question involves definitions and relationships. The problem provides the following information: Material = $400 Overhead = 0.75*(material + labour) Substituting the cost of material into overhead: Overhead = $400*0.75 + 0.75 labour = $300 + 0.75 labour

Further: Material + labour + overhead = $2,100 Substitution gives: $400 + labour + ($300 + 0.75 labour) = $2100 1.75 labour = $1400 Labour = $800 (b)

Overhead = 0.75*($400 + 800) = $900

Chapter 8: Process costing systems

7.17

Analysis of WIP T-account Jasper Company uses a job costing system. Overhead is allocated based on 120 per cent of direct labour cost. Last month’s transactions in the work in process account are shown here:

Only one job, number 850, was still in process at the end of the month. Job 850 was charged with $9000 in overhead for the month. Required (a) What is the ending balance in the WIP account? (b) How much direct labour cost was used for job 850? (c) What is the amount of direct materials used for job 850? (LO1 and 2) (a) Beginning Balance Direct materials Direct labour Factory overhead Ending Balance

Work-In-Process Inventory 48 000 160 000 120 000 150 000 To finished goods

442 000

36 000

(b)

Overhead = 120%*Direct labour $9000 = 1.2 * Direct labour Direct labour = $9000/1.2 Direct labour = $7500

(c)

$36 000 is total cost of Job 850 at the end of the month. Total cost = Direct materials + Direct labour + Factory overhead $36 000 = Direct materials + $7500 + $9000 Direct materials= $19 500

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7.18

Journal entries Langley uses a job costing system. At the beginning of the month of June, two orders were in process as follows:

There was no inventory in finished goods on 1 June. During June, orders numbered 106 to 120 were put into process. Direct materials requirements amounted to $13 000, direct labour costs for the month were $20 000, and actual manufacturing overhead recorded during the month amounted to $28 000. The only order in process at the end of June was order 120, and the costs incurred for this order were $1150 of direct materials and $1000 of direct labour. In addition, order 118, which was 100 per cent complete, was still on hand as of 30 June. Total costs for this order were $3300. The entity's overhead allocation rate in June was the same as that used in May and is based on labour cost. Required (a) Prepare journal entries (with supporting calculations) to record the cost of goods manufactured, the cost of sales, and the closing of the overapplied or underapplied overhead to cost of sales. (b) Describe the two different approaches to closing overapplied or underapplied overhead at the end of the period. How do you choose an appropriate method? (LO2 and 3) (a) Work-in-Process Raw Materials Inventory

$13 000 $13 000

Work-in-Process Wages Payable

$20 000

Work-in-Process ($20 000 × 1.5)a Overhead Cost Control

$30 000

Overhead Cost Control Various Accounts

$28 000

Finished Goodsb Work-in-Process

$64 750

$20 000

$30 000

$28 000

$64 750

Chapter 8: Process costing systems

Cost of salesc Finished Goods

$61 450

Overhead Cost Control Cost of sales

$2 000

$61 450

$ 2 000

The overhead rate can be determined from the data on beginning work-inprocess. For example, the data for order 88 implies that the rate is $1800/1200 = 150% of direct labour cost. The same rate can be determined from the data for order 105. b

Beginning work-in-process Direct materials Direct labour Overhead allocated Total manufacturing costs Ending work-in-process ($1150 + 1000 + 1500) Cost of goods manufactured

$ 5 400 13 000 20 000 30 000 68 400 (3 650) $64 750

$ 0 64 750 64 750 (3 300) $61 450

Beginning finished goods Cost of goods manufactured Goods available for sale Ending finished goods Cost of sales (b)

The overapplied or underapplied overhead can be closed to cost of sales as shown above. Alternatively, it can be prorated to work-in-process, finished goods, and cost of sales in proportion to the flow of costs in each account during the period. The criterion usually used is whether the overhead adjustment is material in size. Each organisation has different criteria for setting the lower limit for materiality, but it is often between 5% and 10% of the amount of actual overhead cost. In this textbook, 10% is generally considered to be material.

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7.19

Cost of sales schedule Rebecca Ltd is a manufacturer of machines made to customer specifications. All production costs are accumulated by means of a job order costing system. The following information is available at the beginning of the month of October.

A review of the job order cost sheets revealed the composition of the work in process inventory on October 1 as follows:

Activity during the month of October was as follows:

On 31 October, inventories consisted of the following:

Required Prepare a detailed schedule showing the cost of goods manufactured for October. (LO2) The chapter does not provide an example of a statement of cost of goods manufactured. This statement should provide a calculation of the cost of goods manufactured by adding current period production costs to beginning work in process inventory and then subtracting ending work in process inventory. One of the current

Chapter 8: Process costing systems

period production costs is the cost of raw materials placed into production. This cost must be calculated by adding raw material purchases to beginning raw material inventory and then subtracting ending raw material inventory. Statement of Cost of Goods Manufactured

Beginning work in process inventory Raw materials placed into production: Beginning raw materials Plus purchases Raw materials available for use Less ending raw materials Raw materials placed into production Direct labour costs (3300×$10) Overhead allocated (3300×$2.60) Total manufacturing costs to account for Less ending work-in-process ($4320 + $5000 + $1300) Cost of goods manufactured

$ 5 100 $16 200 20 000 36 200 (17 000) 19 200 33 000 8 580 65 880 (10 620) $55 260

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7.20 Job costing journal entries Vern’s Van Service customises light trucks according to customers’ orders. This month the entity worked on five jobs, numbered 207 to 211. Materials requisitions for the month were as follows:

An analysis of the payroll records revealed the following distribution for labour costs:

Other overhead costs (consisting of rent, depreciation, taxes, insurance, utilities, etc.) amounted to $3600. At the beginning of the period, management anticipated that overhead cost would be $6400 and total direct labour would amount to $5000. Overhead is allocated on the basis of direct labour dollars. Jobs 207 to 210 were finished during the month; Job 211 is still in process. Jobs 207 to 209 were picked up and paid for by customers. Job 210 is still on the lot waiting to be picked up. Required (a) Prepare the journal entries to reflect the incurrence of materials, labour, and overhead costs; the allocation of overhead; and the transfer of units to finished goods and cost of sales. (b) Close overapplied or underapplied overhead to cost of sales. (LO2 and 3)

Chapter 8: Process costing systems

The overhead allocation rate is $6,400/$5,000, or $1.28 per labour dollar. (a) Summary of jobs:

Materials 3480 Labour Overhead 7040 Total

207 $ 970

208 $ 650

209 $ 800

210 $ 950

211 Total $ 110 $

1400 1792

1200 1536

800 1024

1700 2176

400 5500 512

$4162 $16020

$3386

$2624

$4826

$1022

Journal entries: Work-in-Process Overhead Cost Control Raw Materials Inventory

$ 3 480 750

Work-in-Process Overhead Cost Control Wages Payable

$ 5 500 2 200

Work-in-Process Overhead Cost Control ($5500*$1.28)

$ 7 040

Overhead Cost Control Various Accounts

$ 3 600

Finished Goods Work-in-Process Jobs 207, 208, 209 and 210

$14 998

$ 4 230

$ 7 700

$ 7 040

$ 3 600

$14 998

Cost of sales $10 172 Finished Goods Jobs 207, 208 and 209 ($4162 + $3386 + $2624 = $10 172) (b)

$10 172

First compare the actual to the allocated overhead for the month. Actual overhead is $6550 ($750 + $2200 + $3600). Allocated overhead is $7040 from the summary above. The difference of $490 ($6550 – $7040) is overapplied and needs to be removed from cost of sales. Overhead Cost Control Cost of sales

$490 $490

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7.21

Allocating overhead; over- and underapplied overhead; spoilage The Futons for You Company sells batches of custom-made futons to customers and uses predetermined rates for fixed overhead, based on machine hours. The following data are available for last year:

Required (a) Calculate the estimated overhead allocation rate to be used for the year. (b) Determine the overhead to be allocated to job 21. (c) Determine total overapplied or underapplied overhead at the end of the year. (d) Should cost of sales be increased or decreased at the end of the year? Why? (e) If the amount of overapplied or underapplied overhead is material, how is it assigned? (f) Suppose Job 21 required a special fabric cover for the futon pads. This type of fabric dulls the blades of the cutting machine, and a number of fabric covers were unusable. Should this spoilage be recorded for Job 21 or for all jobs processed this period? Explain your answer. (LO3 and 7) (a)

Budgeted fixed factory overhead cost Budgeted machine hours

$160 000 100 000 hours

Overhead estimated allocation rate = $160 000/100 000 hours = $1.60 per machine hour (b)

Overhead allocated to Job No. 21: Machine-hours used on job × Budgeted overhead rate = 16 000 hours × $1.60 = $25 600

(c)

Actual overhead = $160 000 Allocated overhead = 110 000 × $1.60 = $176 000 Overapplied overhead = $176 000 – $160 000 = $16 000

(d)

Cost of sales should be reduced because too much overhead was allocated.

(e)

If the amount is material, it should be prorated among work-in-process, finished goods, and cost of sales.

Chapter 8: Process costing systems

(f)

Spoilage that was incurred during production of job 21 should be allocated to job 21 because it arose through the choice of a special fabric that is known to dull the blades.

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7.22

Journal entries for job costing At the beginning of the accounting period, the accountant for ABC Industries estimated that total overhead would be $80 000. Overhead is allocated to jobs on the basis of direct labour cost. Direct labour was budgeted to cost $200 000 this period. During the period only three jobs were worked on. The following summarises the direct materials and labour costs for each:

Job 1231 was finished and sold; job 1232 was finished but is waiting to be sold; and job 1233 is still in process. Actual overhead for the period was $82 000. Required Prepare the following journal entries. (a) Cost recorded during production (b) Cost of jobs completed (c) Cost of sales (d) Allocation of overapplied or underapplied overhead allocated on a pro rata basis to the ending balances in work in process, finished goods, and cost of sales (LO2) (a)

The overhead allocation rate is $80 000/$200 000 = $0.40 per dollar of labour cost. The total cost of each job is Job 1231 $ 45 000 70 000 28 000 $143 000

Materials Labour Overhead

Job 1232 $ 70 000 90 000 36 000 $196 000

Job 1233 $ 30 000 50 000 20 000 $100 000

Work-in-Process Raw Materials Inventory

$145 000

Work-in-Process Wages Payable

$210 000

Overhead Cost Control Various Accounts

$82 000

Work-in-Process Overhead Cost Control

Total $145 000 210 000 84 000 $439 000

$145 000

$210 000

$82 000 $84 000 $ 84 000

Chapter 8: Process costing systems

(b)

Finished Goods Work-in-Process (Job 1231 + 1232 = $143 000 + $196 000)

$339 000 $339 000

(c)

Cost of sales Finished Goods (Job 1231)

$143 000 $143 000

(d)

Overhead Cost Control Cost of sales $2000 × ($143 000/$439 000) Finished Goods $2000 × ($196 000/$439 000) Work-in-Process $2000 × ($100 000/$439 000)

$2000 $ 651 893 456

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7.23 Spoilage journal entries Jones Company manufactures custom doors. When job 186 (a batch of 14 custom doors) was being processed in the machining department, one of the wood panels on a door split. This problem occurs periodically and is considered normal spoilage. Direct materials and labour for the door, to the point of spoilage, were $35. In addition, a storm caused a surge in electricity, and a routing machine punctured the wood for job 238. This incident occurred at the beginning of production, so spoilage amounted to only the cost of wood, at $200.

Required (a) Prepare the journal entries for normal and abnormal spoilage. (b) Now suppose that the wood from abnormal spoilage can be sold for $25. Record the journal entries for the disposal value. (c) Jones Company is considering hiring someone to inspect all wood after it arrives at the plant, but prior to production. Discuss the pros and cons of hiring an inspector. (LO7) (a)

Overhead cost control Work in process (Job 186)

$35 $35

Loss from abnormal spoilage $200 Work in process (Job 238) $200 This entry assumes that damage caused by a power surge is not a common event. (b)

Raw material inventory (spoiled wood to be sold) Loss from abnormal spoilage

$25

Cash

$25

Raw material inventory Sale of the spoiled wood. (c)

$25

Pros for hiring inspector: • Quality should improve • If defective materials are removed before they begin processing, labour and other material costs are saved • Rework and spoilage should be reduced Cons for hiring inspector: • Cost may not be worth the benefit • Inspector may have idle time – increasing cost without adding value • Other workers may not continue to inspect as carefully, so overall quality might not improve

Chapter 8: Process costing systems

9 Problems 7.24 Collecting overhead cost information A family member asked you to review the accounting system used for Hanna’s, a custom stained glass manufacturing business. The owner currently uses a software package to keep track of her bank account, but she does not produce financial statements. The owner seeks your help in setting up a costing system so that financial statements can be produced on a monthly basis. Required (a) What kind of costing system is needed for this setting? (b) You plan to categorise the banking data for entry into the financial statement records. List the categories you might use for these entries. List only broad categories here [see parts (c), (d), and (e) for more details.] (c) List several costs that might be included in a fixed overhead category. (d) List several costs that might be included in a variable overhead category. (e) List several costs that might be included in direct materials. (f) Write a memo to the owner discussing the alternative choices for the costing system. Include an explanation of the type of information that would need to be captured to support the costing system. (LO8) (a)

Because Hanna’s custom manufactures stained glass, a job costing system is needed. This will allow costs to be traced and overhead to be allocated to each custom job.

(b)

Keep in mind that the categories in the chequebook should focus on payments. The following are examples of categories that might be used: Direct labour Direct materials Variable overhead Fixed overhead Selling and administration

(c)

Rent, indirect labour, equipment depreciation, utilities, factory insurance, and factory maintenance costs. (Note that indirect labour could be fixed or variable).

(d)

Supplies such as solder, glue, special colouring, and etching materials; and indirect labour. (Note that indirect labour could be fixed or variable).

(e)

Glass, lead, finishing or hanging materials.

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(f)

The memo should explain that job costing or process costing would be two alternative systems for this type of business. However, job costing is the best costing system for this business because each piece is custom made. While working on a piece, it should be relatively easy to keep track of the cost of the glass used in that piece, and perhaps even the lead used in the piece. A tag can be attached to each piece as it is being crafted, or the design paperwork could show exactly how much of each type of glass will be used. Similarly, because each piece is custom, it should be relatively easy to capture the costs of the labourers who worked on that piece. Most labour and materials are direct and can be easily traced to each piece. Overhead can be gathered into a single cost pool and allocated based on direct labour hours or direct labour cost. Students should avoid using accounting technical language in the memo. They should describe the accounting using words that a non-accountant business owner would be likely to understand. Students may wish to read the following article: Jim Cole, ‘Speak English Please! How to Communicate Financial Information to Non-Accountants’, SmartPros, October 2004, available at www.smartpros.com/x44566.xml.

Chapter 8: Process costing systems

7.25

Cost of rework; control of scrap; accounting for scrap Dapper Dan Draperies manufactures and installs custom-ordered draperies.

Required (a) For all drapes, occasionally the sewing equipment malfunctions and the drape must be reworked. Explain how to account for the cost of rework when it is needed. (b) Explain how to account for the cost of rework when customers choose a fabric that is known to require rework. (c) Explain why scrap will always arise in this business. (d) Dapper Dan can sell scraps to quilting groups or just throw them away. List several factors that could affect this decision. (e) If Dapper Dan decides to sell scraps, explain the accounting choices for recording the sales value. (LO7) (a)

When spoilage is part of normal operations and units must be reworked, the cost of rework is part of overhead because it happens randomly but frequently, and is not associated with the complexity of a particular job.

(b)

If the customer chooses a fabric that is known to require rework, the rework occurs because of the customer’s decision. Therefore, it is recorded as a cost of the job.

(c)

In a drapery business, 100% of every piece of fabric cannot be used because drapes and curtains need to be cut a variety of lengths to custom-fit a variety of windows. Because the material is cut to match the windows, there will always be pieces left over that are too small to use on other jobs.

(d)

Quantitative factors include the expected selling price and the cost of disposal. Qualitative factors include the potential environmental effects of disposal versus sale. Students may have thought of others.

(e)

Scrap can be traced to each individual job in this business. If the cost of scrap is material (unlikely) it should be recorded at the time of production or the time that it is sold and credited to the individual job. However, in this business it is likely that the scrap is immaterial, so it can be recorded as other income when sold.

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7.26

Accounting for scrap You are helping a friend, Jonah, set up a new accounting system for a small start-up construction company. He specialises in custom, energy efficient homes that are built on a cost-plus basis. Cost-plus means that his customers pay a fixed percentage above the sum of direct and overhead costs.

As he goes through the accounts, Jonah asks why you set up a separate account for scrap. He does not believe that scrap should be recorded anywhere in his accounting system because it is worth little, and theft is no problem. He makes weekly trips to a recycling plant where he receives a small sum for the scrap. Most of the time Jonah is working on only one house and the scrap is only for that house. However, once in a while he is working on several houses, and the scrap for all of the houses is recycled at once. Required (a) Explain the two ways that scrap can be recorded in a job costing system. (b) Choose the appropriate method for Jonah and explain your choice. (c) Suppose you are a prospective homeowner. Explain to Jonah why you believe the revenue from scrap associated with your home should be recorded as a reduction in your costs rather than his overall costs. (d) Write a brief (and diplomatic) paragraph to convince Jonah that he needs to account for the revenues from scrap. (LO7) (a)

Scrap can be recorded at the time of production or at the time it is sold. It can be recorded as other income (if it is immaterial), credited to an individual job if it can be traced to that job, or credited to overhead if it is common to many different jobs.

(b)

If Jonah is only working on one custom house, the sale of scrap should be credited to this job. If he is working on a number of houses, it should be credited to overhead or prorated among the relevant houses.

(c)

Jonah, the scrap from my house results from materials purchased specifically for this job. The architectural plans called for some special materials, and the sale of scrap for these materials would reduce costs on this job. Because I am paying you based on costs and because these materials should reduce the cost of the house, I should not have to pay you for scrap that you receive payment for. I am paying for the materials, and you are paid again for the same materials. This is not fair, and you should discontinue the practice.

Chapter 8: Process costing systems

(d)

There are many ways to write this paragraph. Below is a possible way to write it. Jonah, I would like to point out several issues related to your method of accounting for scrap and recommend some changes. Because you are paid for jobs on a cost-plus basis, you should trace all costs and revenue from sales of scrap to each job so that your clients are treated fairly. In addition, these transactions need to be recorded for tax records. If the taxation office discovers through an audit that you are not recording some revenues, you will suffer penalties, could experience many years of tax return audits, and may even be charged with tax fraud. To avoid problems with both clients and the taxation office you need to begin recording sales of your scrap immediately. If the value of the scrap is small, it should be recorded at the time it is sold and the value credited to the house from which it came. I realise this will mean a little more bookkeeping work, but I am happy to take care of that for you, so just bring your records to my office on a regular basis.

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7.27 Job costing; overhead rates The Eastern Seaboard Company uses an estimated rate for allocating factory overhead to job orders based on machine hours for the machining department and on a direct labour cost basis for the finishing department. The company budgeted the following for last year:

During December, the cost record for job 602 shows the following:

Required (a) What is the estimated overhead allocation rate that should be used in the machining department? In the finishing department? (b) What is the total overhead allocated to job 602? (c) Assuming that job 602 consisted of 200 units of product, what is the unit cost for this job? (d) What factors affect the volume of production in a period? Can we know all of the factors before the period begins? Why? (e) Explain why the company would use two different overhead allocation bases. (LO2 and 3) (a)

(b)

Calculation of overhead estimated allocation rates: Machining:

$5 000 000 overhead cost/250 000 machine hours = $20 per machine hour

Finishing:

$3 000 000 overhead cost/$2 400 000 DL cost = 125% of direct labour cost

Overhead costs for Job 602: Machining: 35 machine hours × $20 per hr Finishing: $6750 direct labour cost × 125% Total overhead allocated

(c)

Total cost for Job 602: © John Wiley and Sons Australia, Ltd 2008

$ 700 8438 $9138

Chapter 8: Process costing systems

Direct materials ($7000 + $2000) Direct labour ($300 + $6750) Overhead (from Part B) 9 138 Total $25 188 Per unit total cost ($25,188/200 units)

$ 9 000 7 050

$125.94

(d)

Volume is affected by demand. The company’s competition, the economy, and customer preferences all affect demand. In addition, quality of the product can influence customer preferences. Volume can also be affected by any problems the factory may face such as machine malfunction, power outages, or natural disasters.

(e)

Allocating overhead to reflect the flow of resources improves the quality of information in reporting. Machine overhead costs are likely related to machine hours, whereas overhead in a labour-intensive department is likely related to labour hours or labour cost. If different departments use labour or machines more intensively, the allocations should reflect these uses of resources in some manner.

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Contemporary Management Accounting Solution Manual

7.28 Plant-wide versus production cost pools Flexible Manufacturers produces small batches of customised products. The accounting system is set up to allocate plant overhead to each job using the following production cost pools and overhead allocation rates

Actual resources used for job 75:

The manufacturing accountant wants to simplify the cost accounting system and use a plant wide rate. If the preceding costs are grouped into a single cost pool and allocated based on labour hours, the rate would be $35 per direct labour hour. Required (a) What cost should be allocated to job 75 using the plant-wide overhead rate? (b) What cost should be allocated to job 75 using the production cost pool overhead rates? (c) Why do the allocated amounts in parts (a) and (b) differ? (d) Which method would you recommend? Explain your choice. (LO2 and 3) [Note about terminology in this problem: This problem uses the terms “labour-paced assembly” and “machine-paced assembly,” which are not defined in the textbook. However, the terms should be relatively easy for students to understand. This problem opens the door for a discussion with students about production processes using varying degrees of labour and machines.] (a)

Allocated overhead cost for Job 75 using plant-wide rate: 3 direct labour hours * $35 per direct labour hour = $105.00

(b)

Allocated overhead cost for Job 75 using production cost pools: Labour-paced assembly (3 direct labour hours × $25) Machine-paced assembly (1.25 hours × $18) Quality testing (36 units × $2) Total allocation

$ 75.00 22.50 72.00 $169.50

Chapter 8: Process costing systems

(c)

(d)

Using more cost pools with more cost drivers that more accurately reflect use of resources gives a more accurate reflection of resources used. Under the old system, costs are spread across units without regard to use of any resource other than direct labour. Under the new system, costs are more carefully mapped to the use of overhead resources. If the information is only used for inventory valuation on financial statements, the accountant may wish to use the simplest method (plant-wide rate). However, managers tend to use product cost information for making decisions, so it would be better to use the second method with more refined cost pools and allocation bases. Then if decisions are made using this information, at least it more accurately reflects resource use. However, if the underlying cost pools are not separated into fixed and variable categories, the information should not be used in decision making. Also, the accountant should weigh the costs against the benefits. The more complex method requires more recordkeeping (in particular, machine hours). If managers to do not plan to use the information for decision making, the cost might exceed the benefit.

14.29

Contemporary Management Accounting Solution Manual

7.29 Effects of robotic equipment on overhead rates 'Our costs are out of control, our accounting system is screwed up, or both!' screamed the sales manager. 'We are simply non-competitive on a great many of the jobs we bid on. Just last week we lost a customer when a competitor underbid us by 25 per cent! And I bid the job at cost because the customer has been with us for years but has been complaining about our prices.' This problem, raised at the weekly management meeting, has been getting worse over the years. The Johnson Tool Company produces parts for specific customer orders. When the entity first became successful, it employed nearly 500 skilled machinists. Over the years the entity has become increasingly automated and now uses a number of different robotic machines. It currently employs only 75 production workers but output has quadrupled. The problems raised by the sales manager can be seen in the portions of two bid sheets brought to the meeting (as reproduced). The bids are from the cutting department, but the relative size of these three types of manufacturing costs is similar for other departments. The cutting department charges overhead to products based on direct labour hours. For the current period, the department expects to use 4000 direct labour hours. Departmental overhead, consisting mostly of depreciation on the robotic equipment, is expected to be $1 480 000. An employee can typically set up any job on the appropriate equipment in about 15 minutes. Once machines are operating, an employee oversees five to eight machines simultaneously. All that is required is to load or unload materials and monitor calibrations. The department’s robotic machines will log a total of 25 000 hours of run time in the current period. For bid 74683 the entity was substantially underbid by a competitor. The entity did get the job for bid 74687, but the larger jobs are harder to find. Small jobs arise frequently, but the entity is rarely successful in obtaining them.

Chapter 8: Process costing systems

Required (a) Critique the cost allocation method used within the current cost accounting system. (b) Suggest a better approach for allocating overhead. Allocate costs using your approach and compare the costs of both jobs under the two systems. (c) Discuss the pros and cons of using job costs to determine the price for a job order. (LO2 and 3) (a)

While direct labour may have been an appropriate overhead allocation basis when production was labour intensive, it does not capture cause-and-effect relationships in a highly automated environment. Direct labour hours are likely to have little relationship to the indirect resources used in production. In this situation, a poor accounting method can have disastrous results for the entity. The labour-based overhead rates discriminate against smaller orders (see the computations in Part B below). If these orders are lost, capacity may be underutilised, causing overhead rates to rise further. This can lead to a spiralling effect in which the entity prices itself out of business.

(b)

For the Johnson Tool Company, it appears that charging overhead on the basis of machine run time per order would more accurately reflect the resources used for each job. In this case, the overhead rate would be $1 480 000/25 000 hours = $59.20 per machine hour Using this approach, following are the costs for the two jobs. Bid 74683 Materials—Steel sheeting Direct labour: Equipment setup (0.25 hour × $12.50 Equipment tending (1 hour × $12.50) Overhead (3 machine hours × $59.20) Total cost

$280.25 3.13 12.50 177.60 $473.48

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Contemporary Management Accounting Solution Manual

Bid 74687 Materials—Steel sheeting Direct labour: Equipment setup (0.25 hour × $12.50) Equipment tending (1.25 hours × $12.50) Overhead (11 machine hours × $59.20) Total cost (c)

$2,440.50 3.13 15.63 651.20 $3,110.46

Pros for using job cost information to price orders: • The information is readily available • If the company is operating at capacity, the job cost allocation represent an opportunity cost for the capacity • Customers probably understand this information Cons for using job cost information to price orders: • Allocated costs are largely fixed costs that are averaged across jobs, so if the number of jobs decreases, the allocated costs increase and the price would go up and the company could lose the job • Allocated costs rarely reflect the use of resources, so they are an inaccurate measure upon which to base price • Although Johnson needs to cover its fixed costs, the managers might want to analyse competitors’ prices for similar jobs because their prices might be too high (and they lose bids) or too low (and they lose potential contribution margin). Fixed costs would be irrelevant in this circumstance.

Chapter 8: Process costing systems

7.30 Classification of rework costs, uncertainties, critique of rework and scrap policy Fran Markus is in the cost accounting group at Boats Galore, a large manufacturing company that produces customised boats and yachts. The company sometimes experiences quality problems with its fibreglass raw material, causing flawed areas in boat hulls. The problem is often fixed by reworking the flawed areas. Other times the hull is scrapped because it is too flawed, and a new hull is fabricated. The spoilage policy at Boats Galore is to charge the cost of rework and spoilage to overhead unless it arises because a hull design is particularly complicated. In those cases, the cost is assigned to the job. Two boats currently under construction require triple the amount of materials and labour time to enhance boat security. The customer wants each hull to be able to withstand the explosion of a small bomb. It is the company’s first order with this hull construction. Because of the new design and fibreglass process, the customer has agreed to a cost-plus contract and will pay cost plus a fixed percentage of cost. This contract assures that Boats Galore does not incur a loss from developing the enhanced security hull. This week, the third layer on one of the boat hulls had a flaw in the fibreglass. The area was reworked, after which it met the security requirements. Fran receives weekly data on labour and materials for each boat under construction. For regular production, workers estimate the time and materials used to rework flawed fibreglass areas, and Fran adds those costs to overhead instead of recording them as a cost of the particular job. Now she needs to decide how to record the cost of rework for the enhanced security hulls. The production people are not sure whether the flaw was due to poor quality fibreglass or to the triple hull design. If Fran adds the cost to the job order, the customer will pay for the labour and supplies as part of the cost-plus price. If she adds the cost to overhead, the cost will be spread across all jobs and only part of it will be allocated to the job having the enhanced security hulls. Required (a) Critique the company’s accounting policy for rework and scrap. (b) Describe uncertainties about the accounting treatment for the rework costs on the enhanced security hull job. (c) Discuss the pros and cons of alternative accounting treatments for the rework costs on this job. (d) Suppose you are an accounting work-experience student at Boats Galore. Fran asks you to recommend an accounting treatment for the rework costs on the enhanced security hull job. i) Write a memo to Fran with your recommendation. As you write the memo, consider what information Fran will need from you to help her make a final decision. ii) Write one or two paragraphs explaining how you decided what information to include in your memo. (LO7)

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Contemporary Management Accounting Solution Manual

(a) The cost of rework relies on employee estimates. Because rework increases costs and would be considered poor practice, employees have incentives to bias downward the amount of rework that they report. Information about the actual costs of rework is probably of poor quality. In addition, the company’s policy is to charge all non-job-specific rework and spoilage cost—both normal and abnormal—to overhead. The company should record abnormal spoilage that is not related to the requirements of a specific job to a separate abnormal cost account. (b)

The accountants do not know for certain whether the rework costs were caused by the special hull design or would have been incurred for jobs that had no special design features. Because of this uncertainty, they cannot know for certain whether the cost should be charged to the job or included in overhead costs as normal rework.

(c)

Pros of assigning rework costs to the job • The contract is cost plus, so the cost of rework is paid by the customer • If the problem arose because of the special hull design, the accountants are more accurately recording costs Cons of assigning rework costs to the job • If costs for the contract escalate to a higher level than the client anticipates, managers may be forced to renegotiate the contract • Rework costs could increase costs so much that the client will not return again, and Boats Galore would lose future sales • The costs are not traced accurately, so total costs will be less accurate

(d)

There is no one answer to these parts. Suggestion is for students to present their answer and use these as a basis for class discussion.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. Prepared by Albie Brooks, Judy Oliver and Gillian Vesty

Chapter 8: Process costing systems

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

14.35

10 Chapter 8: Process costing systems 11 12

13 Questions 8.1

Describe the differences between mass production and custom production of goods and services. Explain how these differences influence the costing method. (LO 1, 2)

Goods that are mass-produced have uniform specifications and are made in large batches or on a continuous assembly line. Services that are mass-produced are performed using the same skills and time and each task is very similar. Goods that are custom produced come in many variations and are made to specifications that vary with each order. Many services are custom, such as accounting, health care, and law services because each customer requires different inputs to match their needs. While it is relatively easy to track costs for custom made goods by attaching tags or using individual records to log costs of materials and labour, it is impossible to trace costs to mass-produced units. Job order costing is used for custom products. Direct material and labour costs are traced to each product and overhead costs are allocated using some allocation base that is labour or machine related. For mass-production, process costing is used. Equivalent units are calculated to account for units that are partially complete. Direct materials costs are allocated separately. Direct labour and overhead are combined and called conversion costs. These are allocated to complete and partially completed units.

8.2

Explain the difference between the weighted average and FIFO methods for process costing. Explain why an entity might choose one method over the other. (LO3)

The weighted average method ignores the period in which the product is started. In addition, costs from beginning inventories are added to costs of this period. All products completed are then given an average cost, regardless of when they were started. The FIFO method, on the other hand, tracks work completed and costs from the prior period separately from work completed and costs incurred during the current period. Under FIFO, beginning WIP consists of last period’s costs and work valued separately. At the end of the accounting period, this period’s costs to complete these units are added. Then the total costs for beginning WIP from last period and this period are summed and attached to the beginning inventory units that were completed this period. Then the units started and completed this period are valued using this period’s costs. If an organisation’s costs fluctuate regularly, the FIFO method will reflect the most current costs so that managers can investigate changes in cost more quickly.

8.3

Under what conditions will weighted average and FIFO process costing consistently produce similar equivalent unit costs?

(LO3) Weighted average and FIFO process costing produce similar equivalent unit costs whenever the unit cost of production does not change or whenever there are no beginning or ending work-in-process inventories. In addition, the equivalent unit costs will be similar if the number of equivalent units produced during the period is large relative to inventories.

8.4

Under what conditions could a process complete more units during the period than it started?

(LO2) A process would complete more units during the period than it started when there are more units in beginning inventory than in ending inventory.

8.5

‘We treat spoiled units as fully completed regardless of when the spoiled units are detected. This method makes unit costing much simpler.’ What is wrong with this approach?

(LO6) This approach would overstate the cost of spoiled units because partially complete units would be treated as if they had received 100% of direct materials and conversion costs, regardless of the amount actually allocated to those units.

8.6

In a continuous processing situation (such as an oil refinery), the beginning and ending WIP inventories are frequently the same. How does this simplify determination of equivalent units completed?

(LO2, 6) If the beginning and ending inventories are the same from one period to the next, the number of units started is equal to the number of units completed and transferred out. This means that WIP inventory can be ignored when calculating equivalent units. However, if costs change from one period to the next, then the cost allocated to ending WIP will not be the same as the cost allocated to beginning WIP.

8.7

Although process costing appears to use precise measurements, it requires several estimates. Discuss where judgement is needed in collecting information for process costing.

(LO7) Judgement is needed to determine the percentage complete that is used in process costing calculations. Each unit or batch of units is complete to a different degree than other units or batches because the process is continuous. The percent complete is an average completion percentage that is estimated using judgement.

11.1

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

8.8

Suppose the percent completion of ending WIP is overestimated at the end of year 1. How does this measurement error affect the process costing results in year 1 and year 2? (LO7)

If the percent completion in year 1 is overestimated, then the equivalent units for those units will be too high in year 1. In turn, this will cause the cost per equivalent unit in year 1 to be understated. In year 2, this misstatement will cause the equivalent units for completion of beginning WIP to be too low. The understatement of equivalent units will cause the cost per equivalent unit to be overstated in year 2.

8.9

A department within a processing operation has some finished units physically on hand. Should they be counted as completed units or as ending inventory in the department? Explain. (LO3)

They should be counted as ending WIP inventory in the department. Completed units imply that the units have been transferred to the next department or to finished goods, which is not the case with these units.

8.10

In processes involving pipeline operations or assembly line operations, if the pipeline or assembly line is always full, then beginning and ending WIP inventories are always 50 per cent complete with regard to conversion costs. Explain.

(LO5) This is what is referred to as ‘continuous processing’. Units just entering the process have had little done to them, while units just about to leave the process have had all or most of the conversion done. On average, the units in process are 50% complete as to conversion.

8.11

When units are transferred from one department to another, how are normal spoilage costs recorded? (LO6)

The cost of spoiled units is added to the total cost of goods transferred and increases the cost per unit.

8.12

An entity has one machine through which is drawn a standard type of wire to make nails. With minor adjustments, different sized nails are produced with different sized wire. Would you recommend that the entity employ job or process costing methods?

(LO7) Job costing is often used when products are manufactured in batches. In this entity, a single batch would have a specific sized wire and specific length of nail. The cost of each type of nail will depend primarily on the cost of the type of wire used and the time required for each type. Therefore job costing is the most appropriate method. This information would be lost if process cost techniques were employed.

8.13

List two factors that could affect managers’ choices for the number of times and points in processing to inspect units.

11.2

(LO6) Here are three factors. (1) If inspection costs are high and the cost to produce a single unit is very low, managers may decide to reduce the number of time units are inspected. In this case, inspection might occur only when units are completed. (2) If production costs are high and units go through several different departments, inspection may take place earlier in the manufacturing process so that spoiled units are caught when they are relatively incomplete. (3) If a company is developing a strategy of high quality products, inspection may take place more often to insure that products are free of defects.

8.14

List three factors that managers might consider in deciding whether to expend resources to reduce spoilage.

(LO6) Advantages of reducing spoilage include saving the cost of the spoiled units and being able to sell those units and increasing the contribution margin. In addition, in some industries companies need to compete on quality, and increased spoilage may lead to increased defects in units sold, harming the reputation of the company resulting in a loss of market share. Disadvantages might be that the costs incurred do not guarantee that spoilage will be significantly reduced, or that the benefits in improved quality will be worth the costs.

11.3

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

14 Exercises 8.15 Equivalent units under weighted average and FIFO Francisco’s mass-produces folding chairs in Port Sorrell. All direct materials are added at the beginning of production, and conversion costs are incurred evenly throughout production. The following production information is for the month of May:

Required (a) Calculate the equivalent units used to calculate cost per unit under the weighted average method. (b) Calculate the equivalent units used to calculate cost per unit under the FIFO method. (LO 2, 3) (a) and (b) Assumptions: Work performed in May: Beginning WIP % complete direct materials % complete conversion costs Units started Units completed and transferred out Ending WIP % complete direct materials % complete conversion costs

(a)

9 000 100% 40% 50 000 47 000 12 000 100% 30%

Weighted average equivalent units for direct materials is 59 000 (total work this period) because the ending units get 100% credit for direct materials, since direct materials are added at the beginning of processing. Equivalent units for conversion costs are 50 600 (total work this period) because ending inventory units are only 30% complete and, hence, have only 30% of the conversion costs (since conversion costs are incurred evenly during production).

11.4

Summarise Physical and Equivalent Units Weighted Average Total Direct Materials Units to account for Beg. WIP (40%) 9,000 Started this month 50,000 59,000 Units accounted for End WIP (30%) 12,000 12,000 Completed 47,000 47,000 59,000 59,000

Conversion Costs

3,600* 47,000 50,600

*12000 units x .30 (b) FIFO equivalent units are found under Total Work Performed This Period. Therefore direct materials equivalent units are 50 000 (excludes beginning inventory because direct materials were added last period and includes ending inventory because materials were added this period), and equivalent units for conversion costs are 47 000 (excluding work done on beginning WIP but including this period’s work to complete those units and including the portion of work completed on ending WIP. Summarise Physical and Equivalent Units FIFO Total Direct Materials Conversion Costs Units to account for Beg. WIP (40%) 9,000 Started this month 50,000 59,000 Units accounted for End WIP (30%) 12,000 12,000 3,600 Completed (47,000) This month 38,000 38,000 38,000 Beg WIP 9,000 5,400* 59,000 50,000 47,000 *9000 x .60% of work to complete units undertaken in current financial period as materials were added last period there was no equivalent units for material relating to the Beg WIP this period

11.5

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

8.16 Equivalent unit cost under weighted average and FIFO Fine Fans mass-produces small electric fans in Hawley Beach for home use. All direct materials are added at the beginning of production, and conversion costs are incurred evenly throughout production. The following production information is for the month of October:

Required (a) Calculate the equivalent cost per unit using the weighted average method. (b) Calculate the equivalent cost per unit using the FIFO method. (LO 2, 3) (a) and (b) Assumptions for October: Work performed:

Costs:

Beginning WIP % complete direct materials % complete conversion costs Units started Units completed and transferred out Ending WIP % complete direct materials % complete conversion costs

9 000 100% 20% 100 000 94 000 15 000 100% 60%

Beginning WIP (FIFO and Average) Direct materials Conversion costs Total beginning WIP costs Costs added this month Direct materials Conversion costs Total costs added Total costs to account for

Summarise Physical and Equivalent Units Weighted Average Total Direct Materials Units to account for Beg. WIP (20%) 9,000 Started this month 100,000 109,000 Units accounted for

Weighted $ 18 000 36 000 54 000 100 000 200 000 300 000 $354 000

Conversion Costs

11.6

End WIP (60%) Completed

15,000 94,000 109,000

9,000* 94,000 103,000

*15000 units x .6) Summarise Physical and Equivalent Units FIFO Total Direct Materials Units to account for Beg. WIP (20%) Started this month

Conversion Costs

9,000 100,000 109,000

Units accounted for End WIP (60%) Completed (94,000) This month Beg WIP

15,000

9,000

85,000 9,000 109,000

85,000

85,000 5,400 101,200

100,000

Calculate Actual Cost Per Equivalent Unit Weighted Average: Direct materials:

Beginning WIP + Direct materials cost = $118 000 Equivalent units for total work 109 000

= $1.08

Conversion costs:

Beginning WIP + Direct materials cost = $236 000 Equivalent units for total work 103 000

= 2.29

Total cost per equivalent unit:

$3.37

First-in, First-out: Direct materials:_____________Direct materials cost_____________ = $100 000 = $1.00 Equivalent units for total work performed this period 100 000 Conversion costs:______________Conversion costs______________ = $200 000 = 1.98 Equivalent units for total work performed this period 101 200 Total cost per equivalent unit: $2.98

11.7

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

8.17 Cost per equivalent unit under weighted average Fox and Sons is a toy maker and produces Flying Flingbats, a soft foam rubber boomerang. All direct materials are added at the beginning of production, and conversion costs are incurred evenly throughout production. Conversion was 75 per cent complete for the 8000 units in WIP on December 1 and 50 per cent complete for the 6000 units in WIP on 31 December. During the month, 12 000 Flingbats were completed and transferred out as finished goods. Following is a summary of the costs for the period:

Required Using the weighted average method, prepare a schedule calculating the equivalent unit cost for each cost pool for December. (LO 2, 3) Assumptions for December: Work performed:

Costs:

Beginning WIP 8 000 % complete direct materials 100% % complete conversion costs 75% Units started (12 000 – 8000 + 6000) 10 000 Units completed and transferred out 12 000 Ending WIP 6 000 % complete direct materials 100% % complete conversion costs 50%

Beginning WIP (FIFO and Weighted Average) Direct materials $19 200 Conversion costs 7 200 Total beginning WIP costs 26 400 Costs added this month Direct materials 31 200 Conversion costs 21 600 Total costs added 52 800 Total costs to account for $79 200

11.8

8.18 Account for costs under weighted average Refer to the information presented in Exercise 8.17. Required Prepare a process cost report under the weighted average method for December. (LO 3)

Process Cost Report – 31st December - Weighted Average Equivalent Units Conversion Direct material Costs Costs to account for Beg WIP This month Units to account for Beg. WIP Started this month Units accounted for End WIP Completed

Cost per Equivalent Unit

$26,400 $52,800 $79,200

$19,200 $31,200 $50,400

$7,200 $21,600 $28,800

8,000 10,000 18,000 6,000 12,000 18,000

6 000 12,000 18,000

$4.72

$ 2.80

3000* 12,000 15,000

1.92

Assignment of costs to inventory Completed goods Ending WIP Costs assigned

56640 22560 $79200

33600 16800 50400

23040 5760 28800

*6000 units x 50% work done this period in relation to conversion costs

11.9

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

8.19 Cost per equivalent unit under FIFO Refer to the information presented in Exercise 8.17 Required Using the FIFO method, prepare a schedule calculating the cost per equivalent unit for April. (LO 3) Process Cost Report – 31st December - FIFO Equivalent Units Conversion Direct material Costs Costs to account for Beg WIP This month

Units to account for Beg. WIP Started this month Units accounted for End WIP (50%) Completed (12,000) This month Beg WIP

Cost per Equivalent Unit

$26,400 $52,800 $79,200

$31,200 $31200

$21,600 $21600

8,000 10,000 18,000 6,000

6 000

3,000

4,000 8,000 18,000

4000 10 000

4000 2000 9000

5.52

3.12

2.40

19200 0

7200 4800

12480

9600

18720 $50400

7200 $28800

Assignment of costs to inventory Completed goods Beg WIP last month 26400 Beg WIP this month 4800 Started & completed this month 22080 53280 Ending WIP 25920 Costs assigned $79200

11.10

8.20 Account for costs under FIFO Refer to the information presented in Exercise 8.17 Required Prepare a process cost report under the FIFO method for December. (LO 3) Calculate Actual Cost Per Equivalent Unit Weighted Average: Direct materials:

Beginning WIP + Direct materials cost = $50 400 Equivalent units for total work 18 000

= $2.80

Conversion costs:

Beginning WIP + Direct materials cost = $28 800 Equivalent units for total work 15 000

Total cost per equivalent unit:

1.92

$4.72

First-in First-out: Direct materials:_____________Direct materials cost_____________ = $31 200 = $3.12 Equivalent units for total work performed this period 10 000 Conversion costs:______________Conversion costs______________ = $21 600 = 2.40 Equivalent units for total work performed this period 9 000 Total cost per equivalent unit: $5.52

11.11

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

8.21 Costs and journal entries under weighted average and FIFO Humphrey Manufacturing produces car parts and batteries. All direct materials are added at the beginning of production, and conversion costs are incurred evenly throughout production. The following production information is for the month of April:

Required (a) Using the weighted average method, assign costs to production for this period. (b) Using the FIFO method, assign costs to production for this period. (c) Write out the journal entries for either the weighted average or FIFO methods. (LO 4) (a) and (b) Assumptions for April: Work performed:

Costs:

Beginning WIP % complete direct materials % complete conversion costs Units started (8000 + 40 000 – 6000) Units completed and transferred out Ending WIP % complete direct materials % complete conversion costs

6 000 100% 40% 42 000 40 000 8 000 100% 25%

Beginning WIP (FIFO and Weighted Average) Direct materials $ 7 500 Conversion costs 2 125 Total beginning WIP costs 9 625 Costs added this month Direct materials 70 000 Conversion costs 42 500 Total costs added 112 500 Total costs to account for $122 125

11.12

a) Process Cost Report – April - Weighted Average Equivalent Units Conversion Direct material Costs Costs to account for Beg WIP This month

7500 70000 $77500

2125 42500 $44625

8000 40000 48000

2000* 40000 42000

2.6771

1.6146

1.0625

Assignment of costs to inventory Completed goods 107084 Ending WIP 15042 Costs assigned $122126

64584 12917 $77501

42500 2125 $44625

Units to account for Beg. WIP Started this month Units accounted for End WIP Completed

Cost per Equivalent Unit***

9625 112500 $122125

6000 42000 48000

*8000 units x 20% of work completed this period in relation to conversion costs

11.13

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

b) Process Cost Report – April - FIFO Equivalent Units Conversion Direct material Costs Costs to account for Beg WIP This month

9625 112500 $122125

Units to account for Beg. WIP Started this month

70000 $70000

42500 $42500

8000

2000

34000 6000 48000

34000 0 42000

34000 3600* 39600

$1.6667

$1.0732

7500

2125 3864

56668

36489

6000 42000 48000

Units accounted for End WIP Completed (40000) This month Beg WIP

Cost per Equivalent Unit***

$2.7399

Assignment of costs to inventory Completed goods Beg WIP last month 9625 Beg WIP this month 3864 Started & completed this month 93157

Ending WIP 15482 13336 2146 Costs assigned $122128 $77504 $44624 *6000 units x 60% which represents work undertaken this period to complete units Differences in total costs are due to rounding errors. If a spreadsheet is used to make these calculations, the totals will have fewer rounding errors.

***Calculate Actual Cost Per Equivalent Unit Weighted Average: Direct materials:

Beginning WIP + Direct materials cost = $77 500 = $ 1.6146 Equivalent units for total work 48 000

Conversion costs:

Beginning WIP + Direct materials cost = $44 625 = Equivalent units for total work 42 000

Total cost per equivalent unit:

1.0625

$2.6771

11.14

First-in, First-out: Direct materials:_____________Direct materials cost_____________ = $70 000 = $1.6667 Equivalent units for total work performed this period 42 000 Conversion costs:______________Conversion costs______________ = $42 500 = 1.0732 Equivalent units for total work performed this period 39 600 Total cost per equivalent unit: $2.7399

(c)

Journal entries for weighted average method for April: Work in process inventory Raw materials inventory To record the cost of raw materials used in production during April.

$70 000

Work in process inventory Wages and accounts payable To record the conversion costs incurred in production during April.

$42 500

$70 000

$42 500

Finished goods $107 084 Work in process inventory To record the cost of 40 000 units transferred to finished goods during April (includes the cost of normal spoilage).

$107 084

Journal entries for FIFO method for April: Work in process inventory Raw materials inventory To record the cost of raw materials used in production during April.

$70 000

Work in process inventory Wages and accounts payable To record the conversion costs incurred in production during April.

$42 500

$70 000

Finished goods $106 646 Work in process inventory To record the cost of 40 000 units transferred to finished goods during April (includes the cost of normal spoilage).

$42 500

$106 646

11.15

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS. 15

Problems

8.22

FIFO process costing; transferred-in costs; direct materials added during process Benton Industries began the year with 15 000 units in department 3 beginning WIP. These units were one-third complete, with $40 470 transferred-in cost for prior departments’ work and $14 322 for department 3 conversion costs. During the year, 93 000 additional units were transferred into department 3 from department 2 at a cost of $224 130. Department 3 incurred materials costs of $166 840 and conversion costs of $315 28 during the year. Department 3 ended the year with 11 000 units in WIP ending. These units were 40 per cent complete. Required Determine the cost of goods completed and the cost of ending WIP in department 3 using FIFO process costing. Assume that conversion costs are incurred evenly and materials are added in department 3 when units are 60 per cent complete. (LO 4) Process Cost Report for year – Department 3– FIFO Process Costing Equivalent Units Direct material TransferredWhen Conversion in 60%* Costs Costs to account for Beg WIP This month Units to account for Beg. WIP (33%) Started this month Units accounted for End WIP Completed (97000) This month Beg WIP

Cost per Equivalent Unit***

54972 706198 $760990

40470 0 224130 166840 $264600 $166840

14322 315228 $329550

15000 93000 108000 11000

11000

4400

82000 15000 108000

82000 0 93000

82000 15000** 97000

82000 10000** 96400

$2.41

$1.72

$3.27

40470

0 25800

14322 32700

197620

141040

268140

$7.40

Assignment of costs to inventory Completed goods Beg WIP last month 54972 Beg WIP this month 58500 Started & completed this 606800 month

11.16

Ending WIP 40898 26510 0 14388 $760990 Costs assigned $264600 $166840 $329550 *Note in this example direct materials are not added to the process until goods are 60% complete. Therefore as ending WIP is only 40% it has not had any direct materials added**beginning WIP was 33% complete – therefore all direct materials were added during the period and the remaining conversion work was undertaken (15000units *.77)

***Calculate First-in, First-out Cost Per Equivalent Unit Transferred-in:

_____________Transferred-in costs_____________ $2.41 Equivalent units for total work performed this period

Direct materials: _____________Direct materials cost_____________ 1.72 Equivalent units for total work performed this period

Conversion costs: ______________Conversion costs______________ 3.27 Equivalent units for total work performed this period Total cost per equivalent unit: $7.40

$224 130 = 93 000 $166 840 = 97 000 $315 228 = 96 400

11.17

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

8.23 Process costing under weighted average; spoilage; journal entries Victoria’s Closet mass-produces luxurious sleepwear for women. Consider the following data for the flannel nightgown department for the month of January. All direct materials are added at the beginning of production in the department, and conversion costs are incurred evenly throughout production. Inspection occurs when production is 100 per cent completed. Normal spoilage is 6600 units for the month.

Required Prepare a process cost report using the weighted average method. (LO 5) Preparation of process cost report using the weighted average method. Summary of unit information given in the problem: WIP Units Beginning (25% complete) 11 000 Started 74 000 Ending (75% complete)

Summary of Spoilage 61 000 Good completed 8000 Spoiled

16 000

Normal spoilage Abnormal spoilage Total

When computing equivalent units, notice that the ending WIP inventory units are considered 100% complete with respect to direct materials, since direct materials are added at the beginning of processing. However, the ending WIP inventory units are only 75% complete and, hence, have only 75% of the conversion costs (incurred evenly throughout production). Both normal and abnormal spoilage are assigned 100% of all costs because spoilage occurs just before inspection, which is at the 100% stage of completion.

Process Cost Report – January - Weighted average method

11.18

6600 ??? 8000

Equivalent Units Direct material Conversion Costs Costs to account for Beg WIP Current costs Total costs to account for

220000 1480000 $1700000

30000 942000 $972000

61000

6600 1400 16000 85000

6600 1400 12000 81000

$32

$20

$12

Assignment of costs to inventory Completed

1952000

1220000

732000

Normal Spoilage Abnormal Spoilage Ending WIP Costs assigned

211200 44800 464000 $2672000

132000 28000 320000 $1700000

79200 16800 144000 $972000

Units to account for Beginning WIP Started this month Units to account for

250000 2422000 $2672000

11000 74000 85000

Finished Goods Completed Spoilage Normal Abnormal** Ending WIP Units accounted for Cost per Equivalent Unit

**calculated as the missing figure to reconcile back to 85000 units – note we were given the 6600 units of normal spoilage Journal entries: Work in process inventory Raw materials inventory To record the cost of raw materials used in production during January.

$1 480 000

Work in process inventory Wages and accounts payable To record the conversion costs incurred in production during January.

$942 000

Finished goods Work in process inventory To record the cost of 61 000 units transferred to finished goods during January (includes the cost of normal spoilage).

$2 163 200

$1 480 000

$942 000

Abnormal spoilage loss Work in process inventory

$2 163 200

$44 800 $44 800

11.19

11.20

8.24 Process costing under FIFO, spoilage, standard costing Refer to the information provided in Problem 8.23

Required (a) Prepare a process cost report using the FIFO method. (b) Explain how a standard cost report would differ from the FIFO report you just produced. (c) Under what circumstances would a standard cost report be preferable to a FIFO cost report? Explain your answer. (a)

This problem is identical to problem 8.23, except that the FIFO method is used instead of the weighted average method.. (LO 6) Process Cost Report – January – FIFO method Equivalent Units Direct material Conversion Costs Costs to account for Beg WIP Current costs Total costs to account for

250000 2422000 $2672000

1480000 $1480000

942000 $942000

11000 50000

0 50000

8250* 50000

6600 1400 16000 85000

6600 1400 16000 74000

6600 1400 12000 78250

$32.0383

$20

$12.0383

Beg WIP last month

250000

220000

30000

Beg WIP this month Started and completed this month

99316

1601915

1000000

601915

Normal Spoilage Abnormal Spoilage Ending WIP Costs assigned***

211453 44854 464460 $2671998

132000 28000 320000 $1700000

79453 16854 144460 $971998

Units to account for Beginning WIP Started this month Units to account for

11000 74000 85000

Finished Goods Completed (61000) Beg WIP This month Spoilage Normal Abnormal** Ending WIP Units accounted for Cost per Equivalent Unit Assignment of costs to inventory Completed

11.21

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

*8250 equivalent units is the work undertakin during the period to complete the beg WIP (11000 units x .75) **calculated as the missing figure to reconcile back to 85000 units – note we were given the 6600 of normal spoilage ***rounding error

(b)

A standard cost report would be the same as the FIFO cost report from a format standpoint. However, the standard costs would be used instead of equivalent unit costs. That is the only difference.

(c)

If Victoria’s Closet wants to set a benchmark for productivity, standard costs are appropriate. A standard cost is an estimate of cost under efficient operations and therefore acts as a benchmark or budget with which actual costs can be compared. The standards need to be updated regularly, though.

11.22

8.25 Abnormal spoilage; quality savings; opportunity costs Kim Mills produces material for knitwear. The knit cloth is sold by the bolt. November data for its milling process follow. Beginning WIP was 20 000 units. Good units completed and transferred out during current period totalled 90 000. Ending WIP was 17 000 units. Inspection occurs at the 100 per cent stage of completion regarding conversion costs, which are incurred evenly throughout the process. Total spoilage is 7000 units. Normal spoilage is 3600 units. Direct materials are added at the beginning of the process. Required (a) Calculate abnormal spoilage in units. (b) Assume that the manufacturing cost of a spoiled unit is $1000. Calculate the amount of potential savings if all spoilage were eliminated, assuming that all other costs would be unaffected. (c) Discuss the opportunity costs of spoilage and why it might be important to require low defect rates in a manufacturing process. (LO 6) Summary of information given in the problem:

Beginning Started Ending

WIP Units 20 000 ???? 90 000 7000 17 000

Summary of Spoilage Good completed Spoiled

Normal spoilage Abnormal spoilage Total

3600 ???? 7000

(a)

Abnormal spoilage = 7000 – 3600 = 3400 units

(b)

Spoilage costs = 7000 × $1000 = $7 000 000

(c)

The opportunity costs of spoilage can be measured in several ways. First, in addition to the cost of the spoiled units, there is also the contribution margin foregone because the products could not be sold. In addition, there are the opportunity costs of bad units that are sold because they pass through inspection without having been detected as spoiled. Through word of mouth or services such as Consumer Reports or Good Housekeeping, a company’s reputation may suffer and the organisation loses market share. These costs can be considerable, especially if competitors have reputations for high quality with similar prices.

11.23

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

8.26

Spoilage with inspection point other than 100 per cent Use the information for Kim Mills from Problem 8.25. Now, assume that inspection occurs when units are 40 per cent complete.

Required (a) Calculate total spoilage for conversion cost calculations. (b) If normal spoilage is 1800 units instead of 3600, what is abnormal spoilage this period for conversion costs? (c) List several costs and benefits from moving inspection to an earlier position in the manufacturing process. (LO 6) (a)

If inspection occurs when units are 40% complete, direct materials have already been added, but conversion costs will only be 40% added. Equivalent units for direct materials = 100% × 7000 units = 7000 units Equivalent units for conversion costs = 40% × 7000 units = 2800 units

(b)

Abnormal spoilage for conversion costs = 2800 (total spoilage per Part A) – 1800 (normal spoilage) = 1000 units.

(c)

Here are several benefits of inspecting units earlier in their manufacturing process: • Kim saves the rest of the conversion cost that would be added. • Units are removed from further handling (storage and control), except to dispose of them. • If the manufacturing process further down the line would tend to hide the defects, a larger number of defective units are identified, and Kim avoids selling defective units to customers.

11.24

8.27 Process costing under weighted average and FIFO; choice of method Red Dog Products manufactures toys for dogs and cats. The most popular toy is a small ball that dispenses tiny treats and is placed within a larger ball. To get the treats, dogs must roll the balls around until the treats fall out. These balls are mass produced from plastic. Direct materials are introduced at the beginning of the process, and conversion costs are incurred evenly throughout the manufacturing process. Once each unit is completed, it is transferred to finished goods. Data for the month of March are as follows:

Required (a) Prepare a process cost report using the weighted average method. (b) Prepare a process cost report using the FIFO method. (c) What factors might affect the cost accountant’s choice of process costing method? Explain. (LO 4) (a) and (b) Weighted average and FIFO process costing reports: Process Cost Report – March- Weighted Average Equivalent Units Direct material Conversion Costs Costs to account for Beg WIP This month

28000 294000 $322000

Units to account for Beg. WIP Started this month

25000 220000 $245000

3000 74000 $77000

12000 88000 100000

6000 88000 94000

$3.27

$2.45

$0.82

287760

215600

72160

20000* 80000 100000

Units accounted for End WIP Completed Units accounted for Cost per Equivalent Unit*** Assignment of costs to inventory Completed goods

11.25

34320 $322080***

29400 $245000

4920 $77080

*calculated as missing figure – assumes no spoilage *** The total costs to account for disagree with the total calculated in part 1 because of differences due to rounding the cost per equivalent unit. If students used a spreadsheet for these calculations they would have no error.

Process Cost Report – March - FIFO Equivalent Units Direct material Conversion Costs Costs to account for Beg WIP This month

28000 294000 $322000

Units to account for Beg. WIP Started this month

25000 220000 $245000

3000 74000 $77000

12000

6000

68000 20000 100000

68000 0 80000

68000 14000 88000

$3.59

$2.75

$0.84

25000

3000 11760

187000 33000 $245000

57120 5040 $76920

20000* 80000 100000

Units accounted for End WIP Completed (88000) This month Beg WIP Units accounted for Cost per Equivalent Unit***

Assignment of costs to inventory Completed goods Beg WIP last month 28000 Beg WIP this month 11760 Started & completed this month 244120 Ending WIP 38040 Costs assigned $321920**

**refer comments Process Cost report (weighted average) above re rounding Calculate Actual Cost Per Equivalent Unit First-in, First-out: Direct materials:_____________Direct materials cost_____________ = $220 000 = $2.75 Equivalent units for total work performed this period 80 000 Conversion costs:______________Conversion costs______________ = 0.84 Equivalent units for total work performed this period

$74 000

88 000

11.26

Total cost per equivalent unit: $3.59

Weighted Average: Direct materials:

Beginning WIP + Direct materials cost Equivalent units for total work

$245 000 100 000

= $2.45

Conversion costs:

Beginning WIP + Direct materials cost Equivalent units for total work

$77 000 94 000

= 0.82

Total cost per equivalent unit:

(c)

$3.27

Factors that would affect the choice of accounting method include: • the stability of input prices • the need for current price information • whether managers want to compare a standard cost to actual costs • whether beginning and ending inventory levels are large or small.

11.27

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

8.28 Normal and abnormal spoilage; quality improvements Empire Forging produces small plumbing valves. January data for its valvemaking process follow. Beginning WIP was 60 000 units. Good units completed and transferred out during the current period totalled 420 000. Ending WIP was 68 000 units. Inspection occurs at the 100 per cent stage of completion with respect to conversion costs, which are incurred evenly throughout the process. Total spoilage is 36 000 units. Normal spoilage is 12 600 units. Direct materials are added at the beginning of the process. Required (a) Calculate abnormal spoilage in units for January. (b) Calculate the number of units started in January. (c) Calculate the percentage of units produced that is considered normal spoilage, and calculate the total percentage of units spoiled this period. List several potential business risks when spoilage rates increase dramatically. (d) Provide arguments for the manager of the valve department about the tradeoffs between investing in quality improvements and incurring the costs of undetected spoiled units. (LO 6) Summary of information given in the problem:

Beginning Started

Ending

WIP Units 60 000 ???? 420 000 Good completed 36 000 Spoiled 68 000

Summary of Spoilage Normal spoilage

12 600

Abnormal spoilage Total

?? 36 000

(a)

Abnormal spoilage = Total spoilage – Normal spoilage = 36 000 – 12 600 = 23 400 units

(b)

Units started in May: Refer to the above T-Account, and solve for the unknown number of units started 60 000 + Started – 420 000 – 36 000 = 68 000 Started = 464 000

(c)

Percentage of good units allowed for spoilage is 3% (12 600/420 000). Total spoiled units as a percentage of good units is 8.6% (36 000/420 000). When spoilage rates increase dramatically, it is likely that more spoiled units are sold as good units because they have been overlooked in the inspection process. This leads to more returns and potential loss of market share. In addition, the cost of good units increases, and so the contribution margin on those units decreases. It is also possible that more units have been reworked, and these could be lower quality than first run units, and rework also increases the cost of good units.

(d)

Below are examples of arguments that could be made; students may think of additional arguments.

11.28

The costs of undetected spoiled units can be quite high. Customers are unhappy with defective units and may not purchase the goods again, so market share could be lost. In addition, if the defect causes any type of harm, the company could be subject to legal action and may have to pay a settlement or high legal fees. These costs are difficult to value. It is much easier to determine the cost of quality improvements, such as more frequent inspections, quality circles with employees to elicit suggestions for improvements, or redesigning the product or manufacturing process to reduce defects. Because of the uncertainty of the costs of spoiled units, the company should analyse costs for returned units and warranty work, develop better tracking systems so that all spoiled units are counted (whether they are reworked or not), and hire a marketing company to identify customers who have quit using its products to determine if quality was a factor in this decision. Once the managers have more information, they will better understand the costs and benefits of quality problems and quality initiatives.

11.29

3 Work Performed: 4 Work in Process: Beg. WIP End. WIP 5 Units 2,000 Ending WIP Units were not given, 6 % completemanual direct materials 100% accounting so they must4e be by calculated: Solutions to accompany: 100% Management Eldenburg et al. Not for 7 % complete conversion costs 80% 25% Beginning WIP 2,000 distribution in full. Instructors may post selected solutions for questions assigned as 8 Units started 18,000 Units started 18,000 9 Units completed transferred 14,800 Total to account for 20,000 homework toand their LMS. out 10 Spoiled Units: Transferred out* -14,800 8.29 average and FIFO; spoilage 11 Normal Process costing under weighted 1,000 Normal spoilage -1,000 12 Abnormal 1,000 Abnormal spoilage The Rally Company operates under a process cost system using the-1,000 weighted 13 Ending WIP 3,200 average method. All direct materials are added at the beginning of production in 14 Costs: 15 Beginning Work in Process: * Note: Only good units the department, and conversion costs are incurred evenly throughout production. 16 Direct materials $4,000 transferred out Inspection occurs when production is 100 per centarecompleted. 17 Conversion costs $3,200 18 Costs Added This Month: Following are data for July. All unfinished work at the end of July is 25 per cent 19 Direct materials $36,000 20 Conversion costs $32,000 completed. The beginning inventory is 80 per cent completed. 21 22 23 1. Summarize Total Costs to Account For 24 Direct Conversion Total 25 Materials Costs Costs 26 Beginning WIP $4,000 $3,200 $7,200 27 Current period costs $36,000 $32,000 $68,000 28 Total costs to account for $40,000 $35,200 $75,200 29 30 2. Summarize Physical and Equivalent Units 31 Work Performed This Period 32 Beginning Complete Start Start Total Work Total Spoiled 33 WIP Beg. WIP and End. WIP Performed Units to Units 34 80% 20% Complete 25% This Period Acct for 100% 35 Physical Units 2,000 0 14,800 3,200 18,000 20,000 -2,000 36 37 Equivalent Units: 38 Direct Materials 2,000 0 14,800 3,200 18,000 20,000 -2,000 39 Conversion Costs 1,600 400 14,800 800 16,000 17,600 -2,000 40 41 Total Spoilage 2,000 42 Less Normal Spoilage 1,000 43 Abnormal Spoilage 1,000 44 45 46 47 48 Required 49 (a) Prepare a spreadsheet that uses a data input box and calculates information 50 51 necessary for a weighted average process cost report and presents the cost 52 report in an easily understood format. 53 (b)CostCopy the spreadsheet into a new range or new worksheet. If you use a new 54 3. Calculate Per Equivalent Unit 55 worksheet, highlight the tab and rename the worksheet ‘FIFO.’ Now alter 56 Weighted Average: Total Total the weighted average calculations so that the spreadsheet uses data from the 57 Cost Units input box to calculate the information necessary for a FIFO process cost 58 Direct Materials: $40,000 20,000 $2.0000 59 report and presents the cost report in an easily understood format. 60 Conversion Costs: $35,200 17,600 $2.0000 (c) Describe factors that would affect an accountant’s choice of process costing 61 62 Total Cost Per Equivalent $4.0000 method, andUnit make a recommendation for a process costing method for Rally. 63 Explain your choice. 64 4. Weighted Average Process Cost Report for January (LO 3, 4) 65 Cost Per Equivalent Spoiled Good 66 Unit Units Units Units Total 67 Total units completed and transferred out: A sample spreadsheet showing the solution for this problem follows – also get students 68 Good units $4.0000 14,800 $59,200 toNormal prepare – which format do is more 69 spoilage the manual reports $4.0000 1,000 they consider $4,000 understandable? 70 Total transferred out $63,200 71

Input Area for Assumptions Work Performed: Work in Process: Units

Beg. WIP 2000

End. WIP Note: Ending WIP Units were not given

11.30

% complete direct materials 100% % complete conversion costs 80% Units started Units completed and transferred out

100% 25% 18 000 14 800

Spoiled Units: Normal Abnormal

1 000 1 000

Calculation of Ending WIP: Beginning WIP 2 000 Units started 18 000 Total to account for 20 000 Transferred out –14 800 Normal spoilage –1 000 Abnormal spoilage –1 000 Ending WIP 3 200

Costs: Beginning Work in Process: Direct materials Conversion costs Costs Added This Month: Direct materials Conversion costs

$4000 $3200 $36 000 $32 000

1. Summarise Total Costs to Account For

Beginning WIP Current period costs Total costs to account for

Direct Materials $4 000

Conversion Costs $3 200

Total Costs $7 200

$36 000 $40 000

$32 000 $35 200

$68 000 $75 200

Total Units to Acct for 20 000

Spoiled Units 100% -2 000

20 000 17 600

-2 000 -2 000

2. Summarise Physical and Equivalent Units Work Performed This Period

Physical Units Equivalent Units: Direct Materials Conversion Costs

Beginning WIP 80% 2 000

Complete Beg. WIP 20% 0

Start and Complete 14 800

Start End. WIP 25% 3 200

Total Work Performed This Period 18 000

2 000 1 600

0 400

14 800 14 800

3 200 800

18 000 16 000

Total Spoilage Less Normal Spoilage Abnormal Spoilage

2 000 1 000 1 000

3. Calculate Cost Per Equivalent Unit FIFO: Direct Materials:

Current Cost $36 000

Current Units 18 000

$2.0000

Conversion Costs:

$32 000

16 000

$2.0000

11.31

$4.0000

4. FIFO Process Cost Report for January Cost Per Unit Beginning WIP Costs to complete beginning WIP: Direct materials Conversion costs Total costs added this period

$2.0000 $2.0000

Equivalent Units

Spoiled Units

Good Units 2 000

Total $7 200

_____

$0 $800 $800

2 000

$8 000

12 800

$51 200

_____

$4 000

14 800 J

$63 200

0 400

Total cost of beginning WIP transferred out Good units started, completed and trans. out

$4.0000

Normal spoilage

$4.0000

Total units C completedD and transferred outF B E

1 000 G

Abnormal spoilage $4.0000 1 000 $4 000 2 Input Area for Assumptions 3 Work Performed: 4 Work in Process: Beg. WIP End. WIP Ending WIP: 3 200 5 Units 2,000 Direct materials $2.0000 3 Ending 200 WIP Units were not given, $6,400 6 % complete direct materials 100% 100% so they must be calculated: Conversion costs $2.000025% 800 $1,600 7 % complete conversion costs 80% Beginning WIP 2,000 Total 8 Units started ending WIP 18,000 Units started 18,000 A B C D E F G H I J 9 Units Total cost A Bcompleted and C transferred D out E F14,800 G H to account I for_____J 20,000$8 000 30 2. Summarise Physical and Equivalent Units 10 FIFO Process Spoiled Units: Transferred out* -14,800 4. Cost Report forCost January 55 4. Weighted Average Process Report for January 31 Work Performed This1,000 Period 11 Normal Normal spoilage -1,000 Cost Per Equivalent Spoiled Good Total Good Units Accounted 56 Per Equivalent Spoiled Good 32 Beginning Complete Cost Start Start Total Workspoilage Total Spoiled 12 Abnormal 1,000 Abnormal -1,000 Unit Units Units Units Total 57 Unit Units Units Units Total 33 WIP (Total Beg. to WIP and for –End. WIPspoiled) Performed Units to18 000 Units3,200 account Total 13 For Beginning WIP Ending WIP 2,000 $7,200 58 Total units completed and transferred out:20% 34 80% Complete 25% This Period Acct for 100% $75 200 Total Accounted For 14 Costs: to complete beginning WIP: A Costs B units C D2,000 E F G3,200 H I J -2,000 59 Good $4.0000 14,800 $59,200 35 Physical Units 0 14,800 18,000 20,000 15 Beginning Work in * Note: A B C Process: D E F G0 H Only good I units J $0 Direct materials $2.0000 60 Normal spoilage $4.0000 1,000 $4,000 45 CalculateDirect Costmaterials Per Equivalent Unit 36 16 3. $4,000 are transferred out 23 1. Summarise Total Costs to Account For Conversion costs $2.0000 400 $800 61 Total transferred out $63,200 37 Equivalent Units: 46 17 Conversion costs $3,200 24 Direct Conversion Total 62 Total costs added this2,000 period _____ $800 38 Direct Materials 0 14,800 3,200 18,000 20,000 -2,000 (a) Weighted average: Following are excerpts from the sample spreadsheet for this 47 Weighted Average: Total Total 18 Costs Added This Month: 25 Materials Costs Costs 63 Abnormal spoilage $4.0000 1,000 $4,000 39 Conversion Costs 1,600 400 14,800 800 16,000 17,600 -2,000 48 Cost Units problem. 19 Direct materials $36,000 26 Beginning WIP $4,000 $3,200 $7,200 64 TotalDirect cost of beginning WIP transferred out 2,000 $8,000 40 49 Materials: $40,000 20,000 $2.0000 20 Conversion costs $32,000 27 Current period costs $36,000 $32,000 $68,000 65 Ending WIP: 3,200 41 Total Spoilage 2,000 50 21 28 Total costs to account for out $40,000 $35,200 $75,200 66 Direct materials $2.0000 3,200 $6,400 Good units started, completed, and trans. $4.0000 12,800 $51,200 42 Less Normal Spoilage 1,000 51 Conversion Costs: $35,200 17,600 $2.0000 29 67 Conversion costs $2.0000 800 $1,600 43 Abnormal Spoilage 1,000 52 68 Total ending WIP cost _____ $8,000 44 Normal $4.0000 1,000 _____ $4,000 53 Totalspoilage Cost Per Equivalent Unit $4.0000 69 54 70 Total Good Units Accounted For (Total to account for - Total spoiled) 18,000 Total units completed and transferred out 14,800 $63,200 71 Total Accounted For $75,200 72 Calculate Cost Per Equivalent Unit 3. Abnormal spoilage $4.0000 1,000 $4,000

(b)

FIFO: Following are excerpts from the sample spreadsheet for this problem. FIFO:WIP: Current Current Ending 3,200 Cost

Units

Direct materials 3,2002 are identical to the $6,400 The Direct input section and the sections for $2.0000 steps 1 and Materials: $36,000 18,000 $2.0000 Conversion costs $2.0000 800 $1,600 spreadsheet shown in Part A above. Therefore, only the sections for steps 3 and $8,000 Total ending WIP cost _____ 4 areConversion shown Costs: below. $32,000 16,000 $2.0000 Total Good Units Accounted For Total Per Equivalent Unit Total Cost Accounted For

(Total to account for - Total spoiled)

18,000 $4.0000 $75,200

11.32

(c)

Several factors affect accountants’ choices of costing systems. For process costing, the two main factors are ease of calculations (although with spreadsheets and software programs that currently of little concern) and the usefulness of more current cost information. If costs do not change rapidly and there is no need for the most current cost information, then weighted average is easier to calculate and understand. However, if managers want to monitor current period costs more closely, then FIFO is a better method because it better reflects the most current costs. It appears that Rally’s costs did not change from last period to this period. If costs change slowly, the weighted average method would be the easiest report to prepare.

11.33

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

8.30

Choice of costing method; process cost report; transferred-in units; spoilage Toddler Toys produces toy construction vehicles for young children. Plastic pieces are moulded in the plastics department. These pieces are transferred to the assembly department, where direct materials are added after some assembly has been done. For example, plastic pieces of road graders are put together, then the blades and wheel assemblies are added, and finally some details are painted on the sides and back. The direct materials are added in the assembly department when the process is 75 per cent complete. Beginning inventory is 80 per cent complete and ending inventory is 25 per cent complete. Following are data for August.

Required (a) Choose a process costing method for the assembly department. Explain your choice and describe its pros and cons. (b) Prepare a cost report using the method you chose in part (a). (LO 3, 6) Solutions below are provided first for the weighted average method. Then solutions for the FIFO method are presented. WEIGHTED AVERAGE SOLUTION (a)

If a student chose the weighted average method, its main advantage is that it is a little less complex to calculate. The disadvantage is that the cost information is not as current as FIFO information.

11.34

(b)

Here is a cost report using the weighted average method.

Process Cost Report – Assembly Department – August - Weighted average method Equivalent Units Direct Transferred material Conversion in (75%) Costs Costs to account for Beg WIP Current costs Total costs to account for

7060 70000 $77060

Units to account for Beginning WIP Started this month Units to account for

2000 18000 20000

4000 36000 $40000

2000 18000 $20000

1600 16000 $17600

14800

1000 1000 3200 20000

1000 1000 0 16800

1000 1000 800 17600

$4.1905

$2.00

$1.1905

$1.00

Assignment of costs to inventory Completed 62020 4190 Normal Spoilage

29600

17620

14800

2000 2000 6400 $40000

1190 1190

1000 1000 800 $17600

Finished Goods Completed Spoilage Normal Abnormal** Ending WIP Units accounted for Cost per Equivalent Unit

Abnormal Spoilage Ending WIP Costs assigned

4190 7200 $77600

$20000

*missing figure

3. Calculate Cost Per Equivalent Unit (Weighted Average) Transferred-in:

Direct materials:

Conversion costs:

Beginning WIP + Transferred-in costs $2.0000 Equivalent units for total work

Beginning WIP + Direct materials cost 1.1905 Equivalent units for total work

Beginning WIP + Direct materials cost 1.0000 Equivalent units for total work

$40 000

20 000 $20 000

16 800 $17,600

17 600

11.35

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Total cost per equivalent unit: $4.1905

(c)

Journal entries: Work in process inventory-Assembly Dept. Work in process inventory-Plastics Dept. To record the cost of units transferred from the plastics department during August.

$36 000

Work in process inventory-Assembly Dept. Raw materials inventory To record the cost of raw materials used in production during August.

$18 000

Work in process inventory-Assembly Dept. Wages and accounts payable To record the conversion costs incurred in production during August.

$16 000

$36 000

$18 000

$16 000

Finished goods inventory $66 210 Work in process inventory-Assembly Dept. To record the cost of 14 800 units transferred to finished goods during August (includes the cost of normal spoilage). Abnormal spoilage loss Work in process inventory-Assembly Dept. To record the cost of abnormal spoilage during August.

$66 210

$4 190 $4 190

11.36

FIFO SOLUTION (a) If a student chose FIFO, its main advantage is that the costs are more current, the disadvantage is that it is a bit more complex to calculate. (b)

Here is a cost report using the FIFO method. Notice that the first two parts are identical to the report under the weighted average method.

Process Cost Report – Assesmbly Department - August – FIFO method Equivalent Units Direct Transferred material Conversion in (75%) Costs Costs to account for Beg WIP Current costs Total costs to account for

7060 70000 $77060

Units to account for Beginning WIP Started this month Units to account for

2000 18000 20000

36000 $40000

18000 $20000

16000 $17600

2000

400

12800

1000 1000 3200 20000

1000 1000 3200 18000

1000 1000 0 14800

1000 1000 800 16000

$4.2162

$2.00

$1.2162

$1.00

4000

2000

1600

Finished Goods Completed (14800) Beg WIP this month Started & completed this month Spoilage Normal Abnormal** Ending WIP Units accounted for Cost per Equivalent Unit

Assignment of costs to inventory Completed Beg WIP last month

7600

Beg WIP this month Started and completed this month

400

Normal Spoilage Abnormal Spoilage Ending WIP Costs assigned***

400

53968 4216 4216 7200 $77600

25600

15568

12800

2000 2000 6400 $40000

1216 1216 0 $20000

1000 1000 800 $17600

11.37

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Calculate Cost Per Equivalent Unit (FIFO) Transferred-in: _________Transferred-in costs__________ $2.0000 Equiv. units for work performed this period

Direct materials: __________Direct materials cost_________ 1.2162 Equiv. units for work performed this period

Conversion costs:___________Conversion costs__________ 1.0000 Equiv. units for work performed this period Total cost per equivalent unit: $4.2162

(c)

$36 000 = 18 000 $18 000 = 14 800 $16 000 = 16 000

Journal entries: Work in process inventory-Assembly Dept. Work in process inventory-Plastics Dept. To record the cost of units transferred from the plastics department during August.

$36 000

Work in process inventory-Assembly Dept. Raw materials inventory To record the cost of raw materials used in production during August.

$18 000

Work in process inventory-Assembly Dept. Wages and accounts payable To record the conversion costs incurred in production during August.

$16 000

$36 000

$18 000

$16 000

Finished goods inventory $66 184 Work in process inventory-Assembly Dept. To record the cost of 14 800 units transferred to finished goods during August (includes the cost of normal spoilage). Abnormal spoilage loss Work in process inventory-Assembly Dept. To record the cost of abnormal spoilage during August.

$66 184

$4 216 $4 216

8.31 Process costing under weighted average and FIFO, spoilage, rework The accountant at Cellular Advantage needs to close the books at the end of January using the following information. Direct materials are added at the start of production. Conversion costs are incurred evenly throughout production.

11.38

21 Conversion costs $1,884,000 Conversion costs $60,000 22 Costs Added This Month: 23 Direct materials $2,960,000 Conversion costs $1,884,000 24 1. Summarise Total Costs to Account For 25 Direct Conversion Total 26 Materials Costs Costs 1. Summarise Total Costs to Account For 27 Beginning WIP $440,000 Total $60,000 $500,000 Direct Conversion 28 Current period costs $2,960,000 Costs $1,884,000 $4,844,000 Materials Costs Inspection occurs when production is 75% completed. Normal $5,344,000 spoilage is 13 200 29 Total costs to account for $440,000 $3,400,000 $500,000 $1,944,000 Beginning WIP $60,000 Current period costs $2,960,000 $1,884,000 $4,844,000 30 units per month. Total costs to account for $3,400,000 $1,944,000 $5,344,000 31 2. Summarise Physical and Equivalent Units Work Performed This Period 2.32Summarise Physical and Equivalent Units 33 Beginning Start Start Total Work Total Spoiled Work PerformedComplete This Period 34 WIP Beg. End. WIP Units to Units Beginning Complete Start WIP Startand Total Work Total Performed Spoiled WIP Beg.30% WIP and End.Complete WIP Performed60%Units to This Period Units 35 70% Acct for 75% 70% This Period 32,000 Acct for 75% 36 Physical Units 30% 22,000 Complete 0 60% 116,000 148,000 170,000 -16,000 Physical Units 22,000 0 116,000 32,000 148,000 170,000 -16,000 37 38 Equivalent Units: Equivalent Units: 39 Direct Materials22,000 22,000 116,000 148,000 32,000 148,000 170,000 -16,000 Direct Materials 0 116,000 0 32,000 170,000 -16,000 40 Conversion Costs6,600 6,600 112,000 15,400 112,000 146,600 19,200 146,600 153,200 -12,000 Conversion Costs 15,400 19,200 153,200 -12,000 41 3.42Calculate Cost Per Equivalent Unit 3. Calculate Cost Per Equivalent Unit 43 FIFO: Total Total 44 Weighted Average: Total Total Cost Units Direct Materials: $2,960,000 148,000 Cost $20.0000 45 Units 46 Direct Materials: $3,400,000 170,000 $20.0000 Conversion Costs: $1,884,000 146,600 $12.8513 47 48 Conversion Costs: $1,944,000 153,200 $12.6893 Total Cost Per Equivalent Unit $32.8513 49 Per Equivalent Unit $32.6893 4.50FIFO ProcessTotal Cost Cost Report 51 Cost Per Equivalent Spoiled Good Total Unit Units Units Units Costs 52 4. Weighted Average Process Cost Report Beginning WIP 22,000 $500,000 53 Cost Per Equivalent Spoiled Good Costs to complete beginning WIP: 54 Unit0 Units Units $0 Units Total Direct materials $20.0000 55 Totalcosts units completed and transferred out: Conversion $12.8513 15,400 $197,910 Total costs _____ $197,910 56 Good unitsadded this period $32.6893 122,000 $3,988,094 57 Normal spoilage: Total cost of beginning WIP transferred out 22,000 $697,910 58 Direct materials $20.0000 13,200 $264,000 59 Conversion costs $12.6893 9,900 $125,624 Good units started, completed, and trans. out $32.8513 100,000 $3,285,130 Required 60 Total transferred out $4,377,718 (a) Prepare a process cost report using the weighted average method. Normal spoilage 61 DirectAbnormal materials $20.0000 the FIFO method. 13,200 264,000 62 spoilage: cost report using (b) Prepare acosts process Conversion $12.8513 9,900 _____ 127,228 63 Direct materials $20.0000 2,800 (c) Explain why an entity might specify limits for normal spoilage, after which $56,000 64 Conversion costs $12.6893 2,100 $26,648 units completed and transferred out 122,000 $4,374,267 spoilageTotal is considered abnormal. 65 Total abnormal spoilage $82,648 66 Abnormal spoilage the work in progress and finished goods ledger accounts for this (d) Reconstruct DirectEnding materialsWIP: $20.0000 2,800 $56,000 67 32,000 month. Conversion costs materials $12.8513 2,100 32,000 $26,988 68 Direct $20.0000 $640,000 Total abnormal spoilage $82,988 69 4, 6) Conversion costs $12.6893 19,200 $243,634 (LO 70 Total ending WIP cost _____ $883,634 Ending WIP: 32,000 71 Direct materials $20.0000 32,000 $640,000 A72sampleConversion spreadsheet forAccounted this problem is to available $12.8513 $246,745 Totalcosts Good Units For (Total account19,200 for -below Total spoiled) 154,000 Total ending WIPFor cost _____ $886,745 73 Total Accounted $5,344,000 74 Total Good Units Accounted For Total Accounted For

(a)

(Total to account for - Total spoiled)

154,000

$5,344,000

Weighted Average Method

1. Summarise Total Costs to Account For

Beginning WIP Current period costs Total costs to account for

Direct Materials $ 440 000 2 960 000 $3 400 000

Conversion Costs $ 60 000 1 884 000 $1 944 000

Total Cost $ 500 000 4 844 000 $5 344 000

2. Summarise Physical and Equivalent Units Work Performed This Period Spoiled Beginning

Complete

Start

Total Work

Total

Beginning

and

Ending

Performed

Units to Units

11.39

Physical Units

WIP (70%) Complete WIP (60%)

22 000 (16 000)

Total Work 22 000 (16 000) Conversion Costs 6 600 (12 000)

This PeriodAccount

116 000*

32 000 148 000

170 000

116 000*

32 000 148 000

170 000

15 400

112 000*

19 200 146 600

153 200

Equivalent Units: Direct Materials

Physical Units 16 000 13 200 2 800

Total Spoilage Less Normal Spoilage Abnormal Spoilage

for

Equivalent Units Direct Conversion Materials Costs (100%) (75%) 13 200 2 800

9 900 2 100

*Because inspection takes place when units are 75% complete, spoiled units are

removed when units are 100% complete with respect to direct materials and 75% complete with respect to conversion costs. This also means that 25% of the conversion cost work is never performed on spoiled units. Therefore, the number of equivalent units started and completed for conversion costs is calculated as: Total physical units started and completed Less spoiled units not completed [16 000 × (1-75%)] Equivalent units started and completed for conversion costs

116 000 (4 000) 112 000

3. Calculate Cost per Equivalent Unit: Weighted Average Direct materials:

Beginning WIP + Direct materials cost = $3 400 000 = $20.0000 Equivalent units for total work 170 000

Conversion costs:

Beginning WIP + Direct materials cost = $1 944 000 = 12.6893 Equivalent units for total work 153 200

Total cost per equivalent unit: $32.6893

11.40

4. Weighted Average Process Cost Report Calculation Units Costs Total units completed and transferred out: Good units (22 000+116 000–16 000) × $32.6893 122 000 $3 988 094 Normal spoilage: Direct materials 13 200 × $20 264 000 Conversion costs 9900 × $12.6893 _______ 125 624 Total transferred out 122 000 4 377 718 Abnormal spoilage Direct materials Conversion costs Total abnormal spoilage

2800 × $20 2100 × $12.6893

Ending WIP: Direct materials 32 000 × $20 Conversion costs 19 200 × $12.6893 Total ending WIP cost Total Good Units Accounted For Total Accounted For

(b)

56 000 26 648 82 648 32 000 640 000 243 634 _______ 883 634 170 000 – 16 000 154 000 $5 344 000

FIFO Method The summary of physical and equivalent units and the summary of costs to account for are the same as those shown above for the weighted average method. Thus, the solution below shows only steps 3 and 4.

3. Calculate Cost per Equivalent Unit: FIFO Direct materials:_____________Direct materials cost_____________ = $2,960 000 = $20.0000 Equivalent units for total work performed this period 148 000 Conversion costs:______________Conversion costs______________ = $1 884 000 = 12.8513 Equivalent units for total work performed this period 146 600 Total cost per equivalent unit: $32.8513

11.41

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

4. FIFO Process Cost Report Calculation Beginning WIP Costs to complete beginning WIP: Direct materials 0 × $20 Conversion costs 15 400 × $12.8513 Total costs added this period Total cost of beginning WIP transferred out 22 000 New units started completed and transferred out100 000 100 000 Normal spoilage Direct materials Conversion costs Units completed and transferred out Abnormal spoilage Direct materials Conversion costs Total abnormal spoilage Ending WIP: Direct materials Conversion costs Total ending WIP cost Total Good Units Accounted For Total Costs Accounted For

(c)

13 200 × $20 9 900 × $12.8513

Units 22 000

Costs $ 500 000

______

0 197 910 197 910

697 910 × 3 285 130

______ 122 000

2 800 × $20 2 100 × $12.8513

$32.8513

264 000 127 228 4 374 267

56 000 26 988 82 988 32 000

32 000 × $20 19 200 × $12.8513 170 000-16 000

______ 154 000

640 000 246 745 886 745 $5 344 000

Because spoilage increases the cost of good units, most organisations want to minimise the number of units spoiled. By setting limits on normal spoilage, incentive is provided for managers and operations employees to keep spoilage under the limit. The accounting system combines the cost of normal spoilage with good units, so the amount of cost incurred for normal spoilage is not obvious. Many organisations view spoilage as part of the cost of producing good units. However, when spoilage amounts become large, abnormal spoilage is recorded and these amounts are more obvious to managers, so that quality problems can be investigated.

(d) Finished Goods - weighted average Transferred from WIP 4 377 718

Transferred from WIP

Finished Goods - FIFO 4 374 267

11.42

OB DM CC

WIP (weighted average) 500 000 FG 2 960 000 Ab. Sp. 1 884 000 Balance 5 344 000

OB DM CC

WIP (FIFO) 500 000 FG 2 960 000 AS 1 884 000 Balance 5 344 000

4377 718 82 648 883 634 5 344 000

4377 718 82 988 886 745 5 344 000

11.43

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

8.32

Two departmentsl; two periods; FIFO and weighted average; estimate accuracy Rausher Industries began a new product line this year. Management wants a cost report for the current year and a budget for next year. The product requires processing in two departments. Materials are added at the beginning of the process in department 1. Department 2 finishes the product but adds no direct materials. During the year work was begun on 12 000 units in department 1, and 9000 of these units were transferred to department 2. The remaining 3000 units were 60 per cent complete with regard to conversion costs in department 1, which incurred $36 000 in material costs and $14 040 in conversion costs. Department 2 completed and sent 7 000 units to the finished goods warehouse. It ended the period with 2000 units 40 per cent complete with regard to department 2’s conversion costs, which were $32 760 for the period. The plan for next year is to begin an additional 15 000 units in department 1. Management expects to finish the year with 5000 units one-half converted in department 1. Department 2 is expected to complete 14 000 units, and its ending inventory is expected to be 70 per cent complete. Materials are expected to be $48 600, and conversion costs for departments 1 and 2 are expected to be $14 545 and $59 075, respectively. Required (a) Prepare cost reports for the current year and a budgeted cost report for next year assuming the entity uses the following: (i) FIFO process costing. (ii) Weighted average process costing. (b) The employee responsible for estimating the percentage completion had experience estimating completion percentages for one of Rausher’s other product lines. However, she is wondering whether she could improve the accuracy of her estimates. A colleague in another department suggested that she consider using techniques such as timing one unit through each department and identifying points in the production process where units appear to be 25 per cent complete, 50 per cent complete, and so on. (i) Comment on whether the suggested method is likely to provide an accurate estimate of work in process. (ii) List two advantages of improving the accuracy of the estimate. What might be a disadvantage? (LO 3, 7)

(a)

FIFO process costing report and calculations for the current year and the budget for next year:

11.44

Process Cost Report – Department 1 (Current Year) FIFO method Equivalent Units Direct Conversion material Costs Costs to account for Beg WIP Current costs Total costs to account for

0 50040 $50040

Units to account for Beginning WIP Started this month Units to account for

0 12000 12000

Units to account for Completed (9000) Beg WIP this year Started & completed this year Ending WIP Units accounted for Cost per Equivalent Unit

36000 $36000

14040 $14040

0 9000 3000 12000

9000 3000 12000

9000 1800 10800

$4.30

$3.00

$1.30

Assignment of costs to inventory Started and completed this 38700 year Ending WIP 11340 $50040 Costs assigned

27000 9000 $36000

11700 2340 $14040

11.45

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS. Process Cost Report – Department 2 – (Current Year) – FIFO method Equivalent Units Transferred Direct Conversion in material Costs Costs to account for Beg WIP Current costs Total costs to account for

0 71460 $71460

38700 $38700

32760 $32760

Units to account for Beginning WIP Transferred from Department 1 Units to account for

0 9000 9000

Finished Goods Started & completed this year Ending WIP Units accounted for

7000 2000 9000

7000 800 7800

Cost per Equivalent Unit

$8.50

$4.30

$4.20

Assignment of costs to inventory Started and completed this 59500 year Ending WIP 11960 $71460 Costs assigned

30100 8600 $38700

29400 3360 $32760

FIFO Cost Per Equivalent Unit (Current Year) Department 1: Direct materials: _____Current Period Direct materials cost_____ = Equivalent units for total work performed this period

$36 000 12 000

= $3.00

Conversion costs:______Current Period Conversion costs______ = Equivalent units for total work performed this period Total cost per equivalent unit:

$14 040 10 800

= 1.30 $4.30

Department 2: Transferred-in costs:_____Current Period Transferred-in cost_____ $4.30 Equivalent units for total work performed this period Conversion costs:______Current Period Conversion costs______ = Equivalent units for total work performed this period Total cost per equivalent unit:

$38 700 =

9 000 $32 760 7 800

= 4.20 $8.50

11.46

FIFO BUDGET FOR NEXT YEAR Process Cost Report – Department 1 (Budget next year) FIFO method Equivalent Units Direct Conversion material Costs Costs to account for Beg WIP Current costs Total costs to account for

11340 63145 $74485

Units to account for Beginning WIP Started this year Units to account for

3000 15000 18000

Finished Goods Completed (13000) Beg WIP this year Started & completed this year Ending WIP Units accounted for Cost per Equivalent Unit

48600 $57600

14545 $16885

3000 10000 5000 18000

0 10000 5000 15000

1200 10000 2500 13700

$4.3017

$3.24

$1.0617

Assignment of costs to inventory Completed: Beg WIP last year

11340

9000

2340

Beg WIP this year Started and completed this month Ending WIP Costs assigned

1274

32400 16200 $57600

10617 2654 $16885

43017 188547 $74485

11.47

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS. Process Cost Report – Department 2 – (budget next year) – FIFO method Equivalent Units Transferred Direct Conversion in material Costs Costs to account for Beg WIP Current costs Total costs to account for

11960 114706 $126666

Units to account for Beginning WIP Transferred from Department 1 Units to account for

55631 $55631

59075 $59075

2000 13000 15000

Units accounted for Completed (14000) Beg WIP Started & completed this month Ending WIP Units accounted for

2000 12000

1200

1000 15000

12000 1000 13000

12000 700 13900

$8.53

$4.28

$4.25

Beg WIP last year

11960

8600

3360

Beg WIP this year Started and completed this month Ending WIP Costs assigned

5100

Cost per Equivalent Unit Assignment of costs to inventory Completed

5100

102360 7255 $126675

51360 4280 $64240

51000 2975 $62435

FIFO Cost Per Equivalent Unit (Next Year) Department 1: Direct materials:

_____Current Period Direct materials cost_____ = $3.2400 Equivalent units for total work performed this period

$48 600 =

Conversion costs: ______Current Period Conversion costs______ = 1.0617 Equivalent units for total work performed this period

$14 545 =

15 000

13 700

Total cost per equivalent unit: $4.3017 Department 2:

11.48

Transferred-in costs:_____Current Period Transferred-in cost_____ = $55 631 = $4.28 Equivalent units for total work performed this period 13 000 Conversion costs: ______Current Period Conversion costs______ = $59 075 = Equivalent units for total work performed this period 13 900 Total cost per equivalent unit:

(b)

4.25

$8.53

Weighted average process costing report and calculations for the current year and the budget for next year WEIGHTED AVERAGE CURRENT YEAR

Because there are no beginning inventories in period one, the cost reports for FIFO and weighted-average are the same. See the preceding FIFO report. WEIGHTED AVERAGE BUDGET FOR NEXT YEAR Process Cost Report – Department 1 (Budget next year) Weighted Average method Equivalent Units Direct Conversion material Costs Costs to account for Beg WIP Current costs Total costs to account for

11340 63145 $74485

Units to account for Beginning WIP Started this year Units to account for

3000 15000 18000

Finished Goods Completed Ending WIP Units accounted for Cost per Equivalent Unit

9000 48600 $57600

2340 14545 $16885

13000 5000 18000

13000 2500 15500

$4.2894

$3.20

$1.0894

41600

14162 2723

Assignment of costs to inventory Completed:

55762 18273

Ending WIP Costs assigned

$74485

16000 $57600

$16885

11.49

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS. Process Cost Report – Department 2 – (budget next year) – Weighted Average method Equivalent Units Transferred Direct Conversion in material Costs Costs to account for Beg WIP Current costs Total costs to account for

11960 114837 $126797

8600 55762 $55631

3360 59075 $59075

Units to account for Beginning WIP Transferred from Department 1 Units to account for

2000 13000 15000

Units accounted for Completed Ending WIP Units accounted for

14000 1000 15000

14000 700 14700

$8.5381

$4.2908

$4.2473

60071 4291 $64362

59462 2973 $62438

Cost per Equivalent Unit

Assignment of costs to inventory 119533 Completed Ending WIP Costs assigned

7264 $126797

Weighted Average Cost Per Equivalent Unit (Next Year) Department 1: Direct materials:Beginning WIP + Current Period Direct materials cost = $57 600 = $3.2000 Equivalent units for total work performed this period 18 000 Conversion costs:Beginning WIP + Current Period Conversion costs = $16 885 = 1.0894 Equivalent units for total work performed this period 15 500 Total cost per equivalent unit:

$4.2894

Department 2: Transferred-in costs:Beginning WIP + Current Period Transferred-in cost = $64 362 = $4.2908 Equivalent units for total work performed this period 15 000 Conversion costs:Beginning WIP + Current Period Conversion costs = $62 435 = 4.2473 Equivalent units for total work performed this period 14 700

11.50

Total cost per equivalent unit:

$8.5381

11.51

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(c)

(i)

If she better understands the flow of resources, she can more accurately determine percentage completed. This seems like a way to improve accuracy.

(ii)

More accurately estimating percentage completed would mean that cost per unit would better reflect the use of resources. In addition, the costs for each period would be more accurately identified with the units of that period. If it takes a lot of time to develop a more accurate estimate and if ending work in process inventory is relatively immaterial, the cost could be greater than the benefit.

11.52

8.33 Comparison of actual to standard processing costs, use in bonus decisions Tiffany Campbell is the cost accountant in a small manufacturing company, Calculator Components (CC). CC produces components for one of the large calculator manufacturers. Its strategy is to provide highly reliable components at the lowest possible price. To help maintain cost competitiveness, Tiffany produces two process cost reports each month, one based on the FIFO method and the other based on the standard cost method. When the reports are complete, costs from the two systems are compared. If actual costs are under control (that is, within the standard costs) for a particular division, the manager receives a small bonus. If costs have been under control throughout the year, a larger bonus is given at the end of December. This month Tiffany investigates the results for Kevin Meledrez’s division. Actual direct material costs are higher than standard cost, so the equivalent unit cost is higher than the standard. When she speaks to Kevin about the direct material costs in his division, he argues that the standard cost needs to be changed because the current supplier has increased the cost of a particular part. Kevin believes that he should not be held responsible for costs that are not under his control; when prices change, the standard should also change. Tiffany asks Kevin whether he had investigated other vendors who sell the same part to see whether the price change was across the board for all vendors. Kevin says that he has used this vendor for a number of years and is satisfied with the quality and timeliness of delivery. He does not believe that another vendor would provide the same quality and service, so he does not want to consider changing suppliers at this time. Required (a) Identify a variety of reasons why actual costs are likely to be different from standard costs for Computer Components. (b) Discuss whether Kevin would be likely to make the same argument about changing the standard if the supplier’s price had decreased. (c) Describe the pros and cons of changing vendors. (d) Explain the benefit to the entity of giving managers bonuses based on comparisons of actual to standard costs. (e) Discuss the advantages and disadvantages of adopting a policy of adjusting the standard cost for changes in vendor prices. (f) Suppose Tiffany asks for your advice. Use the information you learned from the preceding analyses to write a memo to Tiffany with your recommendation. As you write the memo, consider information that Tiffany needs from you to help her make a final decision. (LO 7)

(a)

Here are several possible answers to this question; students may think of others. Actual costs can differ from standards because of changes in prices, as described in the problem. Differences can also result from deviations from standards in the efficiency with which raw materials or labour hours are used. For example, an equipment malfunction might slow production or spoil some units. Employees can work faster or slower than expected. The quality of materials can be better or worse than expected, causing deviations from the expected amount of spoilage or scrap. A new labour contract could be negotiated, increasing direct labour costs. Overhead costs can also be higher or

11.53

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

lower than expected. There could be an increase in electricity rates or insurance costs. Equipment maintenance could be higher or lower than expected. (b)

Kevin might or might not make the same argument if the supplier’s price had decreased. However, it appears that he might have been making his argument to avoid responsibility. From the information presented, Kevin has at least some control over the purchase price. He stated that he does not want to consider changing suppliers at this time, and a division manager often has control over the purchasing function for the division. If he was making his argument primarily to avoid responsibility, then he would probably make a different argument if the price had decreased. In that case, he would probably want to be rewarded for good performance.

(c)

Changing vendors could have many benefits, such as reducing costs, enhancing quality, improving delivery timeliness, etc. Changing vendors could also do the opposite — increase costs, decrease quality, and result in delivery delays. The relationship with the vendor may also be important. It may not be in the company’s best interests to drop a long-term and beneficial relationship. At the same time, it might be in the company’s interests to develop a relationship with a new supplier.

(d)

The practice of giving managers bonuses based on comparisons of actual to standard costs can motivate managers to achieve or exceed standards. In turn, achieving the standards can help the company meet profitability and other goals.

(e)

Employees are most likely to be motivated by a standard that is achievable. Vendor price increases or decreases should be reflected in the standard if they are not in the manager’s control. This improves the fairness and achievability of the standard. However, the standard should not be adjusted for vendor price changes that the manager can influence. In this case, the adjustment would reduce the manager’s motivation to control costs.

(f)

There is no one answer to this part. Use student responses as a basis for class discussion.

11.54

8.34

Techtra makes electronic components used by other firms in a wide variety of end products. Initially the Techtra entities bid for any type of electronic assembly work that became available (mostly subcontract work from other firms experiencing temporary capacity problems). But over the years the firm narrowed its focus. It now produces essentially three products, although minor variations within each product line yield a large number of different models. Each of the products goes through three separate operating departments: assembly, soldering, and testing. When an order is received, it goes to production scheduling. Personnel there schedule time in each of the three departments. The availability of parts usually determines when a job can be started in the assembly department. If parts are not in stock, they are usually received from suppliers within a week. On the appropriate day, the computerised scheduling program places the job on the assembly department’s job list. Simultaneously, an electronic materials requisition goes to the stores department. Materials handling people then deliver the parts to the assembly department. The assembly operation is semiautomatic. When the department is ready to begin a new job, a worker inserts the appropriate guides into the equipment and adjusts the various settings. Parts are then loaded into the machines, which do the actual assembly. Because a worker keeps several machines running simultaneously, each order is processed using several (sometimes all) of the machines available in the department. Once the units for an order are assembled, an assembly department worker enters its completion in the computerised production system. The system then adds the job to the soldering department’s job list. Materials handling personnel load assembled product onto racks and take them to the soldering department. Soldering processes the jobs on a first-in, first-out basis unless production scheduling asks for priority treatment for a particular job. For each job the soldering machines must be set up for the appropriate product, but thereafter the operation is totally automatic. Once a job is completed, an entry is made in the production system, which adds it to the testing department’s job list. The products are then reloaded onto racks and transported to the testing department. By the time the products get to the testing department, many of the jobs are near or past their promised delivery date. Thus, the production scheduling system directs the testing department to work on jobs in the order of promised delivery date. Normally the entity expects 3 per cent to 5 per cent of the products to be defective and plans its lot size for each order accordingly. However, from time to time an entire order must be scrapped due to faulty assembly or soldering on every unit. When an order is scrapped, it is noted in the production system, and a rush replacement order is sent to the assembly department. Completed jobs that pass testing are immediately shipped to customers. Workers in the assembly, soldering, and testing departments each enter information in the production system detailing the amount of time spent working on specific jobs. This information, plus the materials requisitions, are used by the cost accounting system to track the cost of each job. The cost accounting system allocates departmental overhead to each job using overhead allocation rates based on budgeted overhead costs and budgeted hours for each department. General factory overhead − which includes production scheduling, materials handling, property taxes and so on − is charged to each job based on total materials costs.

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Within each of the three product types, the average cost per unit varies primarily with the size of each job order because of set-up costs. The cost data are used to update the entity’s pricing sheets and to determine the efficiency with which each order was produced. Management is considering a change in the organisation of the plant. They propose that the plant floor, instead of being arranged in functional departments, could consist of manufacturing ‘cells’ for each product; that is, they would establish clusters of assembly machines, soldering machines, and test equipment. Each cluster would be dedicated to making only one type of product. Under this arrangement, when an order is processed, individual units would proceed one by one through the assembly, soldering and test equipment in the appropriate cell. Most jobs would be completed within a day, but large jobs would sometimes take up to a week. The managers are also considering a change in the way parts are ordered from suppliers. The entity would place orders for each job, requesting delivery of parts on the day production is scheduled to begin. Required (a) Describe how the proposed changes would likely affect each of the following: (i) Size of work in process and raw materials inventories (ii) Material handling and machine setup costs (iii) Cost of defective units (iv) Ratio of units produced to units ordered (v) Production scheduling costs and machine utilisation rates (vi) Average cost per unit of product (vii) Ability to fulfil a customer’s rush order (b) Assuming the managers adopt the proposed manufacturing changes: (i) What would be the advantages of adopting a process costing system? (ii) The company would no longer carry significant inventories. How would this change affect the cost accounting? (LO 5, 6, 7)

Note: This problem assumes knowledge of job costing. The problem does not assume knowledge of JIT or backflush accounting, but Part B.2 encourages students to think about how process costing might be less complex in the absence of significant work in process inventories. (a)

(i)

Work in process inventories should greatly decrease. Currently, whole jobs are waiting to be processed at each department. With continuous processing, these will disappear. The only in-process inventory will be jobs in process within a cell, most of which will be completed the next day. Because individual units are produced one by one, there will be very few individual units in process at any point in time. Raw material inventory should almost disappear. The company currently carries a parts inventory. Under the new system, it would carry parts only for jobs in process.

(ii)

Materials handling costs may decrease depending on the trade-off in increased time of delivering parts more frequently to cells and elimination

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of transfers between departments. Finished goods still need to be transported to shipping. Machine set ups should all but disappear. Since each cell will be dedicated to one product line, machines can be permanently set for the product. Nonetheless, some adjustments will likely need to be made for different models, but the adjustments are probably minor. (iii)

There should be a substantial decrease in the number of defects. Instead of testing units after an entire batch has been completed, the units will be tested continuously. A faulty assembly or soldering operation should be caught (and corrective action taken) after only one or two units have been affected, not the entire order. In addition, fewer setting changes will be made to the equipment in assembly and soldering, which should reduce the likelihood that defects are caused by erroneous settings.

(iv)

The ratio of units produced to units ordered should decrease. Under the current system the firm must estimate the number of units that will fail to pass inspection. They must produce enough units so that units produced minus defective units still yield enough units to satisfy the customer’s order. To be highly confident that enough units will be produced to fill an order, an excess number of units is probably produced, on average. Under the new system a cell keeps on producing for an order until enough good units are achieved. Thus, only the minimum number of units needed will be produced.

(v)

The firm should experience a decrease in the workload for production scheduling. Instead of scheduling jobs through several departments, jobs need only be assigned to a single cell. Also, the need to expedite replacements for spoiled jobs should disappear as entire jobs should no longer be spoiled. Machine utilisation rates are likely to fall. If there are no orders for a particular product for a period of time, the cells dedicated to that product would be idle. In fact, this is the major trade-off for adopting a job versus process orientation. If a firm makes many different products (requiring different kinds of processing on a variety of machines) but none of them in any significant quantity, then it cannot afford to dedicate equipment to each product line. However, as the breadth of the product line decreases or manufacturing processes become more similar, management should consider the benefits of switching to a process orientation.

(vi)

This depends on the trade-off between the various costs saved and the additional costs incurred to obtain separate equipment for each cell (if necessary) and the cost of idle equipment. However, total costs will probably decrease. Presumably, management will not make the change unless they study existing and expected future production patterns and expect the cost savings to be larger than the additional costs.

(vii) The change in system will probably make it more difficult to fill a customer’s rush order. No parts inventories are maintained, and it will take approximately one week to receive new parts.

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(b)

(i)

With a change from a job orientation to a process orientation, there does not appear to be a need to know the cost for any particular order. The company could use process costing to calculate the average materials and conversion cost for each type of product. For pricing or profitability analysis, the firm could add the cost of materials required for each model to the average conversion cost. This manufacturing situation is similar to a fastfood restaurant where managers may wish to track the relative profitability of food versus drinks, but there is no need to capture the cost of hamburgers versus cheeseburgers, nor is there a need to know the profitability of a particular customer’s order. Under process costing, costs could be measured and monitored to ensure that costs of each process are in control. This accounting system would cost less than the current job costing system because detailed data for each job would no longer be tracked.

(ii)

First, there would be no need to keep track of raw material inventory. The cost of raw material purchases could be added directly to production. Second, the absence of significant work in process inventory reduces the need to calculate and track equivalent units. Units started would be roughly equal to units completed, so the company could adopt an actual cost system for each product line and simply record all production costs directly in cost of goods sold. This would also eliminate the need to choose between the FIFO and weighted average methods. The average materials and conversion cost for each type of product could be periodically measured and monitored to ensure that costs are in control. But it does not appear necessary to capture this information for units on a continuous basis. If desired, the small amount of jobs in process at the end of an accounting period could be handled through end of period adjustments rather than through a system that continuously tracks work in process inventory.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. Prepared by Albie Brooks, Judy Oliver and Gillian Vesty

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Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

16 Chapter 9: Absorption and variable costing 17

18 Questions 9.1

Explain the similarities and differences among absorption and variable costing. (LO1)

Absorption and variable costing share a number of similarities and distinct differences particularly in regards to the treatment of variable manufacturing costs:

Absorption versus variable costing

Similarities • Both are methods of measuring and reporting on a firm’s financial performance. • Both are beneficial sources of management accounting information, revealing important insights about a firm’s performance. • Both measure revenues in the same way. • Both recognize nonproduction costs as period costs. • Both treat direct materials, direct labour and variable overhead in the same way. That is, these costs are treated as inventoriable product costs, initially recognised on the balance and subsequently expensed as cost of goods sold when the items are sold. • If the current level of production is equal to sales, the inventory on the balance sheet and the operating income will

Differences • Absorption costing is required for financial reporting purposes. Variable costing cannot be used for financial reporting purposes. • Variable costing income statements distinguish between fixed and variable costs and identify the contribution margin. Absorption costing income statements do not. • Fixed product costs (i.e. fixed overhead) are treated differently: o Under absorption costing, fixed product costs are recognised as inventoriable product costs, initially recognised on the balance and subsequently expensed as cost of goods sold when the items are sold. o Under variable costing, fixed product costs are treated as period

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

be the same under both methods. •

9.2

costs, being expensed in the period in which they are incurred. If the current level of production is not equal to sales, the inventory on the balance sheet and the operating income will be different under both methods.

Explain how variable costing income statements can be reconciled to absorption costing income statements. (LO3)

The allocated fixed manufacturing overhead that is added (if production is greater than sales) or subtracted (if production is less than sales) from finished goods is the reconciliation amount between variable versus absorption costing. 9.3

Explain how income could fall even though the unit sales level rises. (LO3)

Increased sales by itself do not lead to higher profits, as the level of costs will be a determining factor. Therefore, for income to fall it suggests that the entity’s production costs (either variable, fixed or both) have also increased. Alternatively, the unit sales volume may have increased but sales process may have fallen, meaning sales revenue may in fact be lower.

9.4

The volume of manufacturing in a period has an effect on income calculated using absorption costing but has no effect on income calculated using variable costing. Explain. (LO2, 3)

Under variable costing, all fixed manufacturing overhead is treated as an expense of the period, regardless of how many units were produced or sold; income will vary only with the number of units sold, the level of production has no effect. Under absorption costing, fixed manufacturing overhead is first assigned to product; the amount of fixed overhead that appears on the income statement depends on unit sales. Income depends upon both the level of production and the level of sales.

9.5

The basic issue in variable and absorption costing could be said to be one of timing rather than amount. Explain. (LO1)

Eventually all of the units are sold under either method, so eventually all of the fixed manufacturing cost will be expensed under either method. Under variable costing, it is expensed during the period it is incurred, whereas under absorption costing, a portion of fixed manufacturing cost is inventoried and expensed when the inventory is sold rather than during the period it was incurred.

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9.6

What is the difference between a cost that is variable and variable costing? (LO1)

A variable cost increases proportionately with volume. Variable costing is a method of calculating income.

9.7

Explain how breakeven point would be affected under both absorption and variable costing. (LO2, 3)

The breakeven point should not be affected by the use of absorption costing or variable costing. The breakeven point is affected by revenue and costs classified as fixed or variable. 9.8

If inventory physically increases during the period, income under absorption costing will be higher than income using variable costing. Explain. (LO3)

The fixed manufacturing overhead of the current period will be shown in its entirety as an expense if variable costing is used. If absorption costing is used, some of it will be assigned to the units added to inventory, so that the fixed manufacturing overhead included in cost of goods sold will be less than the total fixed manufacturing overhead that is expensed on the variable costing income statement. 9.9

Why do the accounting standards require absorption costing for financial reporting? (LO1)

Accounting standards require the use of absorption costing with all manufacturing costs (i.e. direct materials, direct labour, variable overhead and fixed overhead) treated inventoriable product costs (i.e. initially recognised on the balance and subsequently expensed as cost of goods sold when the items are sold). This practice is consistent with the basic financial accounting asset recognition criteria and accrual accounting principles. Any manufacturing costs have the basic features of an asset in that they will deliver future economic benefits to the firm. Under accrual accounting principles, these costs should only be expensed when the items are sold and the economic benefits associated with inventory are reduced/depleted. 9.10

An entity uses variable costing for internal reports. It must convert the variable costing results to absorption costing results for external reports. How can this conversion be accomplished? (LO1)

This can be accomplished through the use of an adjusting journal entry at the end of the period. The objective is to distribute or allocate the fixed manufacturing overhead of the period between inventories on hand (WIP and FG) and cost of goods sold.

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

9.11

How can the use of absorption costing lead managers to make dysfunctional decisions for the entity? (LO3)

The use of absorption costing may lead to dysfunctional decisions as it may include costs (such as some of the fixed costs) which are not likely to be relevant to short-term decision-making.

Exercises 9.12 Absorption and variable income Famous Desk Company manufactures desks for office use. The variable cost of 100 units in beginning inventory is $80 each. The absorption cost is $146.67 each. Following is information about this period’s manufacturing.

Required (a) Estimate operating income for a month in which 200 desks are manufactured and 220 are sold if the company uses variable costing. (b) Estimate operating income for a month in which 200 desks are manufactured and 220 are sold if the company uses absorption costing and allocates fixed manufacturing costs to inventory using a rate based on normal capacity of 150 desks per month. (LO1) (a) and (b) First list all pertinent information: Revenue = 220 desks × $300 = $66 000 Variable production costs = 220 desks × $80 = $17 600 Variable selling and administrative costs = 220 desks × $30 = $6600 Fixed selling and administrative = $6000 Fixed overhead absorbed into inventory under normal production = $10 000/150 desks = $66.67 per desk Fixed overhead volume variance = $10 000 – (200 desks × $66.67) = $3334 overapplied, which is closed to COGS Variable Costing Revenue Variable costs: Production

$66 000) (17 600)

Absorption Costing Revenue $66 000) Cost of goods sold 220 desks × ($80 + $66.67) (32 267)

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Selling Contribution Margin

(6 600) 41 800)

Fixed costs: Production Admin and Sales Operating income

(10 000) (6 000) $25 800)

Volume variance Gross Margin

3 334) 37 067)

Selling and administrative ($6600 + $6 000) Operating income

(12 600) $24 467)

Double-check calculations: Difference in operating income = 20 units × $66.67 Difference in operating income = $1333 (fixed overhead brought onto income statement from units produced in prior periods) Difference in income = $25 800 – $24 467 = $1333.

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Beginning inventory

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution full. Instructors may post selected solutions for questions assigned as VARIABLEinCOSTING homework to their LMS. A100 A300

VariableAbsorption cost per unit produced 9.13 and variable income;$5.00 reconcile$2.50 incomes Rock Crusher Ltd produces two grades of sand (A100 and A300) used in the manufacture of industrial abrasives. The results of operations last year were as Revenue $240,000 follows: Variable costs: Production: A100 A300 Selling Contribution margin Fixed costs: Production: Selling and administrive Operating income

$15,000 10,000

-25,000 -35,000 180,000 -100,000 -60,000 $20,000

Fixed manufacturing costs were $100 000 and fixed selling and administrative costs were $60 000. The company held no beginning inventories. ABSORPTION COSTING Fixed production cost per ton $10.00 Required Total production cost per ton: Prepare a spreadsheet that can be used to answer all of the following questions. $15.00was the operating (a)A100 If Rock Crusher uses a variable costing system, what A300 $12.50

income? VARIABLE If Rock COSTING Crusher uses absorption costing and allocates actual fixed A100 A300 manufacturing costs to inventory on the basis of actual tons produced, what Revenue Variable cost per unit produced $5.00 $2.50 $240,000 was the operating income? Cost of goods sold: (c)A100 Reconcile and explain the difference between your answers to parts (a) and $45,000 Revenue A300 50,000 $240,000 -95,000 (b). (b)

costs: Gross margin (LO1) Variable

145,000 Production: Selling and administrative: A100 $15,000 Variable spreadsheet $35,000 A sample showing the calculations for this problem follows: A300 10,000 (25,000) COSTING FixedABSORPTION 60,000 -95,000 Selling (35,000) Fixed production cost per ton $10.00 Operating income $50,000

(a)

(b)

Contribution 180,000 Total production costmargin per ton: Fixed costs: A100 $15.00 Variable costing income statement Production: (100,000) A300 $12.50 Selling and administrive (60,000) Operating income $20,000 Revenue $240,000 Cost of goods sold: Calculation details for variable production cost per unit: A100 $45,000 A100: $20 000/4 000 tons = $5 per ton 50,000 (95,000) A300 A300:margin $15 000/6 000 tons = $2.50 per ton Gross 145,000 Selling and administrative: Variable costing income statement: $35,000 Absorption Fixed 60,000 (95,000) Operating income $50,000

Calculation details for cost of goods sold: Fixed production cost per ton = $100 000/10 000 tons = $10 per ton Variable production cost per ton was calculated in Part A Cost of goods sold: A100 [($10 + $5) × 3000] $45 000 A300 [($10 + $2.50) × 4000] 50 000 Total $95 000 (c)

The difference in income resides in inventory. There was no beginning inventory, but there were 3000 tons (10 000 tons produced – 7000 tons sold) with $10 of

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fixed production cost per ton absorbed into inventory on the balance sheet under absorption costing. The difference in income = $50 000 – $20 000 = $30 000, and the fixed production cost in inventory is 3000 × $10 = $30 000.

9.14 Absorption and variable inventory and income Plains Irrigation uses absorption costing for its external reports and variable costing for its internal reports. Data concerning inventories appear here:

Required (a) Why is the value of inventory for Plains Irrigation higher when absorption costing is used than when variable costing is used? Is this result always the case? Why? (b) What is the relationship between absorption costing and variable costing operating income in October? (State which valuation basis will yield the higher operating income and by how much the two operating incomes will differ.) (LO1) (a)

The value of inventory is higher when absorption costing is used because some fixed manufacturing overhead is allocated to inventory to match revenue with expense at the time of sale. If there is fixed manufacturing overhead, the value of inventory under absorption costing will always be higher than under variable costing.

(b)

To identify the costing method that would result in higher income, first calculate the change in inventory during October under both methods: October inventory added under absorption costing ($2598 – $1346) October inventory added under variable costing ($1647 – 854) Difference

$1252 793 $ 459

Because $459 more cost was assigned to inventory under absorption costing, income during October would be higher by $459 under absorption than under variable costing.

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

9.15 Absorption, variable, and throughput inventory and income Asian Iron began last year with no inventories. During the year, 10 500 units were produced, of which 9400 were sold. Data concerning last year’s operations appear here:

Variable manufacturing costs reflect the variable cost to produce the number of units manufactured. However, variable selling costs are not incurred until the units are sold, so they reflect the cost for the number of units sold. Asian Iron allocates actual manufacturing overhead costs to inventory based on actual units produced. Required (a) Calculate the value of ending inventory on the balance sheet under the following: (i) Variable costing (ii) Absorption costing (iii) Throughput costing (b) Calculate operating income under each of the following methods: (i) Variable costing (ii) Absorption costing (iii) Throughput costing (c) Estimate the variable costing operating income if 12 110 units were produced and sold in a year. (LO1) (a)

Under variable costing: Total variable production cost = ($2300 + 3300 + 2800) = $8400 Variable cost per unit = $8400/10 500 = $0.80 per unit Units in ending inventory = 10 500 – 9400 = 1,100 units Ending inventory = $0.80 × 1100 units = $880

Under absorption costing: Fixed manufacturing overhead = $8250/10 500 units Fixed manufacturing overhead = $0.7857 per unit Total cost per unit = $0.80 + $0.7857 = $1.5857 Ending inventory = $1.5857 × 1100 units = $1744

Under throughput costing: Total direct materials cost per unit = $2300/10 500 units Total direct materials cost per unit = $0.21905

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Ending inventory = $0.21905 × 1100 units = $241 (b) 1, 2, 3 Variable Costing Revenue Variable costs: Production ($0.80 × 9400) Selling Contribution margin Fixed costs: Production Selling and admin. Operating income

$32 900)

(7 520) (940) 24 440)

Absorption Costing Revenue $32 900) Cost of goods sold ($1.5857 × 9400) (14 906) Gross margin 17 994) Selling and admin. ($940 + 14 560) (15 500) Operating income $ 2 494)

Throughput Costing Revenue $32 900) Direct materials ($0.21905 × 9400) (2 059) Throughput margin 30 841) Operating expenses (a) (29 850) Operating income $ 991)

(8 250) (14 560) $ 1 630)

$(3300 + 2800 + 940 + 8250 + 14 560) = $29 850 Double-check calculations for absorption versus variable costing: There were no beginning inventories. Therefore, the change in inventory is equal to the ending inventory (calculated in Part A). Inventory under absorption costing $1744 Inventory under variable costing 880 Difference in inventory $ 864 Difference in operating income –$2494 –$1630

$ 864

Double-check calculations for absorption versus throughput costing: Inventory under absorption costing Inventory under throughput costing Difference in inventory

$1744 241 $1503

Difference in operating income –$2494 –$991

(c)

$1503

It is first necessary to calculate the revenue and variable costs per unit: Revenue per unit = $32 900/9400 = $3.50 Variable production cost per unit = $0.80 Variable selling cost per unit = $940/9400 = $0.10 There are several ways to estimate variable costing operating income at 12,110 units. One way is to prepare an estimated income statement: Revenue (12 110 × $3.50) Variable costs: Production (12 110 × $0.80) Selling (12 110 × $0.10) Contribution margin Fixed costs: Production Selling and administrative Operating income

$42 385) (9 688) (1 211) 31 486) (8 250) (14 560) $ 8 676)

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Another way is to begin with operating income at 9400 units (calculated in Part B) and add the incremental contribution margin for the additional 2710 units (12 110 – 9400): Operating income at 9400 units Incremental contribution margin [2710 × (NT$3.50 – 0.80 – 0.10)] Operating income at 12 110 units

$1630 7046 $8676

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9.16 Absorption and variable inventory and income, reconcile incomes Wild Bird Feeders produces deluxe bird feeders for distribution to catalogue companies and wild bird stores. The company uses an absorption costing system for internal reporting purposes but is considering using variable costing. Data regarding Wild Bird’s planned and actual operations for last year are presented here.

The planned per-unit cost figures shown in the schedule were based on manufacturing and sale of 140 000 units last year. Wild Bird uses an estimated manufacturing overhead rate for allocating manufacturing overhead to its product. Thus, a combined manufacturing overhead rate of $9 per unit was employed for absorption costing purposes last year. Any overapplied or underapplied manufacturing overhead is closed to cost of goods sold at the end of the reporting year.

Last year’s beginning finished goods inventory for absorption costing purposes was valued at the previous year’s planned unit manufacturing cost, which was the same as last year’s planned unit manufacturing cost. No work in process inventories were recorded either at the beginning or end of the year. The planned and actual unit selling price was $99.00 per unit for last year. You may want to use a spreadsheet to perform calculations. Required (a) What was the value of Wild Bird’s actual ending finished goods inventory on the absorption costing basis? (b) What was last year’s actual ending finished goods inventory on the variable costing basis? (c) What were the manufacturing contribution margin and the total contribution margin under variable costing for Wild Bird’s actual results for last year?

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Cost of ending inventory--Assuming LIFO Beginning inventory Increase in inventory Total

$1,530,000 255,000 $1,785,000

$1,380,000 230,000 $1,610,000

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as OVERAPPLIED (UNDERAPPLIED) OVERHEAD Variable Fixed Total homework to their LMS. Overhead applied to production $520,000 $650,000 $1,170,000 Actual overhead

520,000

710,000

1,230,000

(d)Overapplied Under absorption costing, what were $0 the total fixed ($60,000) costs on the income (Underapplied) ($60,000) statement? (i)COSTING What were the fixed selling and administrative costs? VARIABLE Revenue(ii) $12,375,000 to COGS at standard? What was the amount of overhead allocated Variable production costs -5,750,000 (iii) Do we need to consider sales of units from last period? Manufacturing contribution margin 6,625,000 Other variable costs: (iv) What was the amount of underapplied or overapplied overhead Variable selling $1,750,000 closed to COGS? Variable administrative 125,000 -1,875,000 Total margin 4,750,000 (v)contribution Sum these amounts for the total fixed costs. Fixed costs: (e)Manufacturing What overhead was the total variable cost expensed last yearon the variable costing $710,000 Selling 980,000 income statement? Administrative 850,000 -2,540,000 (f) Operating Was income absorption costing income higher or lower than variable costing income $2,210,000 for the year? Why? (g) WhatCOSTING is the amount of difference in income using absorption costing versus ABSORPTION Revenuevariable costing? How did it arise? $12,375,000 Cost of goods sold:

(LO1, 3) cost per unit sold Production

-6,375,000 Overapplied (underapplied) overhead -60,000 Gross 5,940,000 COST OF margin ENDING INVENTORY Previous year A sample spreadsheet showing the calculations for this problem follows: Last year Selling costs -2,730,000 Absorption Variable Absorption Variable Administrative costs Production cost per unit: Costing -975,000 Costing Costing Costing Operating income $2,235,000

Direct materials (actual)

$24.00

18.00 18.00 18.00 18.00 (a)Direct and labour (b) (actual) Variable manufacturing overhead (allocated=actual) 4.00 4.00 4.00 4.00 Absorption and variable costing ending inventory Fixed manufacturing overhead (allocated) 5.00 5.00 The Total problem does not provide the company’s cost flow assumption (LIFO or FIFO). $51.00 $46.00 $51.00 $46.00 However, the problem states that the prior costs are the same as 2010 planned costs. Units:2010 actual costs for direct materials, direct labour, and variable manufacturing The Beginning are inventory 30,000 overhead the same as the planned costs (i.e. $3 120 000/130 000 units = $24.00 Production 130,000 forSales direct materials, $2 340 000/130 000 units = $18.00 for direct materials, and VARIABLE COSTING -125,000 5,000 $520Ending 000/130 000 = $4.00 for variable manufacturing overhead). The problem also Revenue $12,375,000 inventory 35,000 production costs (5,750,000) states Variable that all overor underapplied overhead is assigned directly to cost of goods sold. Cost of ending inventory--Assuming FIFO $1,785,000 $1,610,000 Manufacturing contribution margin 6,625,000 Therefore, the 2010 overhead costs assigned to inventory are the same as the planned Other variable costs: costs. Thus,inventory--Assuming the prior year inventory costs are the same as the current year inventory Cost of ending LIFO Variable selling costs, and it does not matter which cost flow assumption$1,750,000 the company$1,530,000 uses. Beginning inventory $1,380,000

Variable administrative

Increase in inventory Total contribution margin Total

(c)

(d)

Fixed costs: Manufacturing overhead Manufacturing and total contribution margin Selling Administrative Operating income

125,000

(1,875,000) 255,000 4,750,000 $1,785,000

$710,000 980,000 850,000

230,000 $1,610,000

(2,540,000) $2,210,000

This question asks for the total fixed costs on the income statement and then proceeds to develop that cost in steps as follows. (i) Fixed selling and administration = ($980 000 + $850 000) = $1 830 000 (ii)

Fixed manufacturing overhead allocated to COGS: Fixed overhead at given allocation rate (125 000 × $5)

$625 000

(iii) As noted in the answer to Parts A and B, the cost per unit during the previous year was the same as the cost per unit assigned to inventory during last year. Therefore, the cost per unit assigned to cost of goods sold and to inventory is not affected by whether the company’s inventory levels increased or decreased during last year. In other words, sales of units that were produced last year do not need to be considered.

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(iv) Calculation of overapplied (underapplied) overhead: Overhead allocated to production Actual overhead (Underapplied) overhead (v)

$650 000 710 000 $ (60 000)

Total fixed costs on income statement = $1 830 000 + $625 000 + $60 000 (because the underapplied overhead is closed to COGS) = $2 515 000.

(e)

Variable costs on variable costing income statement (see the solution to Part C): $5 750 000 + $1 875 000 = $7 625 000.

(f)

Absorption income would be higher than variable income because the company produced more units that it sold, and the units remaining in ending inventories include an allocation of fixed manufacturing overhead cost under absorption costing. Therefore, total overhead expense on the income statement is less under absorption than under variable costing, where the total fixed cost for the period is expensed.

(g)

There are two ways to answer this question. The first method is to calculate the amount of fixed overhead added to inventory under absorption costing. The fixed overhead allocation rate is $5 per unit, and 5 000 units were added to inventory. Therefore, absorption costing income should be $25 000 higher than variable costing income. The second method is to prepare the two income statements and compare the results. The difference in income is (income statements are available on the sample spreadsheet for this problem): Absorption costing operating income $2 235 000 Variable costing operating income 2 210 000 Difference $ 25 000

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

9.17 Absorption, variable, and throughput income, reconcile incomes The following price and operating cost information applies to Happy Bikers Motorcycle Company.

No beginning balance in finished goods is evident because the beginning inventory account on the balance sheet is zero. Average manufacturing is 10 motorcycles per month. Sales are seasonal, so in some months no motorcycles are produced, while in other months manufacturing is high. During the most recent month, the company produced 18 motorcycles and sold 15. Required (a) Prepare an income statement for the most recent month using the variable costing method. (b) Prepare an income statement for the most recent month using the absorption costing method and choose a denominator level that represents ‘normal’ capacity. (c)

Prepare a schedule that reconciles the incomes among the three income statements.

(LO1, 3) (a) and (b) Variable Costing Revenue (a) $150 000) Variable costs: Production (b) (45 000) Selling (c) (3 750) Contribution margin 101 250) Fixed costs: Production (40 000) Selling and admin. (40 000) Operating income $21 250)

Absorption Costing

Throughput Costing

Revenue (a) $150 000) Cost of goods sold (d) (105 000) Volume variance (e) 26 667) Gross margin 71 667) Selling and admin. (f) (43 750) Operating income $ 27 917)

Revenue (a) $150 000) Raw materials (g) (30 000) Throughput margin 120 000) Operating expenses (h) (101 750) Operating income $ 18 250)

Calculation details: (a) Revenue = 15 motorcycles × $10 000 (b)

Variable production costs = 15 motorcycles × ($2000 + $1000) = $45 000

(c)

Variable selling and administrative costs = 15 motorcycles × $250 = $3750

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(d)

Absorption cost of goods sold: Normal capacity = 10 motorcycles per month Estimated fixed overhead per motorcycle = $40 000/10 = $4000 Total fixed and variable production cost per unit = $4000 + $2000 + $1000 = $7000 Cost of goods sold = 15 motorcycles × $7 000 = $105 000

(e)

Volume variance: Fixed production overhead Allocated overhead (18 motorcycles × $4000) Overapplied overhead

$40 000) 72 000) $(32 000)

Because the volume variance is material relative to actual production costs, it will be prorated between cost of goods sold and ending inventory. The portion allocated to cost of goods sold is: $32 000 × (15/18 motorcycles) $(26 667) (f)

Total selling and administrative expense = $40 000 + 15 motorcycles × $250 = $43 750

(g) Total raw materials = 15 motorcycles × $2000 = $30 000 (h) Total operating expenses: Direct labour and variable overhead (18 motorcycles × $1000) Fixed production costs Variable selling and administrative (15 motorcycles × $250) Fixed selling and administrative Total (c)

$ 18 000 40 000 3 750 40 000 $101 750

Here is a schedule to reconcile the three income statements. Recall that inventory increased during the month by 3 units (18 motorcycles manufactured, 15 motorcycles sold). Throughput costing operating income $18 250 Direct labour and variable overhead costs added to ending variable costing inventory (3 motorcycles × $1000) 3 000 Variable costing operating income 21 250 Fixed overhead costs allocated to ending absorption costing income (after the volume variance adjustment, this is equal to actual fixed overhead cost per unit [3 motorcycles × ($40 000/18)] 6 667 Absorption costing operating income $27 917

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS. 19

Problems

9.18 Differences in income; choice of absorption and variable costing King Island Lobster Company is a privately held company that buys lobsters from local fishermen and then delivers them to restaurants in several of Australia’s larger cities. The owners use variable costing income statements, but one owner’s daughter, who just started taking accounting classes at the local university, suggested that absorption income statements meet GAAP and, therefore, should be used. Required (a) Explain the difference between absorption and variable income statements. (b) Provide possible reasons why the company uses variable costing income statements. (c) Provide possible benefits to the company from using an absorption costing income statement. (d) What type of statement would you recommend for King Island Lobster Company? Why? (e) What additional information about King Island Lobster Company would you like to have to improve your recommendation in part (d)? (LO1, 3) (a)

Absorption income statements assign all direct production costs and allocate all indirect production costs to inventory. At the time of sale, per unit revenue is matched with per unit expense on the income statement. Variable income statements categorise costs into fixed and variable, and production related and non-production related costs.

(b)

If the company has no shareholders, the company may have no need for GAAPbased income statements. The variable income statement would be more useful for internal management use.

(c)

If the company wishes to apply for external funds, such as a bank loan, the company may be required to prepare GAAP-basis financial statements.

(d)

It is easy to prepare both types of statements. However, for decision-making purposes the variable statements are better.

(e)

If King Island Lobster wants other family members to know how the business is doing, GAAP statements would be prepared in a manner that would allow comparison with other businesses.

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9.19

Absorption, variable, and throughput income; normal capacity; choice of denominator Giant Jets is a French company that produces jet airplanes for commercial cargo companies. The selling price per jet is €1 000 000. Currently the company uses actual volumes to allocate fixed manufacturing overhead to units. However, Giant Jets’ accountant is considering the use of standard costs to produce the absorption income statements. The company anticipates the following.

Required (a) Prepare income statements using the variable costing method. (b) Prepare income statements using the absorption costing method. Allocate fixed overhead using actual units produced in the denominator. (c) In your own words, define 'normal capacity'. (d) Prepare an income statement using the absorption cost method and choose a denominator level that represents normal capacity. Explain your choice for normal capacity. (e) Prepare a brief summary that reconciles the incomes among the three income statements for each year. (LO1, 3) (a)

Production and sales data: Year Production Sales

Year 1 10 10

Year 2 6 4

Year 3 8 10

Variable costing income statements: Revenues (jets sold × €1 000 000) Variable costs: Production (jets sold × €200 000 + €150 000 + €50 000) Selling (jets sold × €100 000) Contribution margin Fixed costs: Production Administrative and selling Operating income

Year 1 Year 2 Year 3 €10 000 000 €4 000 000 €10 000 000

(4 000 000) (1 600 000) (1 000 000) (400 000) 5 000 000) 2 000 000)

(4 000 000) (1 000 000) 5 000 000)

(600 000) (600 000) (100 000) (100 000) €4 300 000) € 1 300 000)

(600 000) (100 000) €4 300 000)

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) (b)

Cost per jet under absorption costing: Year 1 Direct materials €200 000 Direct labour 150 000 Variable production overhead 50 000 Fixed production overhead per unit: €600 000/units produced 60 000 Total cost per jet €460 000 Jets sold Jets produced

Year 2 €200 000 150 000 50 000

Year3 €200 000 150 000 50 000

100 000 €500 000

75 000 €475 000

4 6

10 8

10 10

Cost of goods sold: Units produced this year Units produced last year Total

€4 600 000 0 €4 600 000

€2 000 000€3 800 000 0 1 000 000 €2 000 000€4 800 000

Absorption costing income statements: Revenues (jets sold × €1 000 000) Cost of goods sold

Year 1

Year 2

€10 000 000) €10 000 00) (4 600 000) (4 800 000) 5 400 000)

€4 000 000)

Throughput margin Administrative and selling [€100 000 + (jets sold × €100 000)] (1 100 000) (1 100 000) Operating income €4 300 000) €4 100 000)

Year 3

(2 000 000) 2 000 000) 5 200 000) (500 000) €1 500 000)

(c)

Normal capacity is an average capacity over time. It represents the volume of production that is expected to occur in a typical year.

(d)

There are likely to be differences of opinion on the normal volume. One way to estimate the normal volume is to calculate the average over the three years presented, or 8 jets per year. The following income statement is calculated using 8 jets as the normal volume. Cost per jet under absorption costing: Direct materials Direct labour Variable production overhead Fixed production overhead per unit: €600 000/8 jets Total cost per jet

€200 000 150 000 50 000 75 000 €475 000

Volume variance: Jets produced Fixed production overhead allocated

Year 1 10 €750 000

Year 2 6 € 450 000

Year 3 8 €600 000

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Actual fixed production overhead Over (under)applied overhead

600 000 €150 000

600 000 €(150 000)

600 000 € 0

The volume variance does not appear to be material relative to total production costs in Year 1 or Year 2 Therefore, all of it is allocated to cost of goods sold. Absorption costing income statements: Year 1 €10 000 000) €10 000 000) Cost of goods sold (jets sold × €475 000) (4 750 000) Volume variance adjustment 150 000) Throughput margin 5 400 000) Administrative and selling [€100 000 + (jets sold × €100 000)] (1 100 000) Operating income €4 300 000) Revenues (jets sold × €1 000 000)

(e)

Year 2 €4 000 000)

Year 3

(1 900 000) (4 750 000) (150 000) 0) 1 950 000) 5 250 000) (500 000) (1 100 000) €1 450 000) €4 150 000)

The textbook is not clear about which absorption costing income (the one in Part B or the one in Part D) to use in the reconciliation. Therefore, reconciliations are shown for both income statements.

Jets produced Jets sold Increase (decrease) in inventory of jets

Year 1 10 10 0

Year 2 6 4 2

Year 3 8) 10) (2)

€4 300 000

€ 900 000 €4 700 000)

0 4 300 000

400 000 1 300 000

0 €4 300 000

200 000 (200 000) €1 500 000 €4 100 000)

Variable costing income (Part A) €4 300 000 Fixed overhead costs allocated to ending absorption costing income Change in inventory × €75 000* 0 Absorption costing income (Part D) €4 300 000

€1 300 000 €4 300 000)

Throughput costing income (Part B) Direct labour and variable production overhead added to (subtracted from) ending variable costing inventory [Change in inventory × (€150 000+€50 000)]

Variable costing income (Part A) Fixed overhead costs allocated to ending absorption costing income Change in inventory × €100 000 Absorption costing income (Part B)

(400 000) 4 300 000)

150 000 (150 000) €1 450 000 €4 150 000)

*Because the volume variance was allocated 100% to cost of goods sold during Year 1 and Year 2, it can be ignored in this reconciliation.

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

9.20

Absorption, variable, and throughput income and inventory; method for manager bonus Fighting Kites produces several different kite kits. Last year, the company produced 20 000 kits and sold all but 2000 kits. The kits sell for $30 each. Costs incurred are listed here.

Beginning inventory last year held 2000 kits. Assume that under variable costing, the value of this inventory would have been $10 000. Assume that under absorption costing, the value of this inventory would have been $15 000. Required (a) If Fighting Kites uses variable costing, what was its operating income? What was the ending balance in finished goods inventory? (b) If Fighting Kites uses absorption costing and a denominator level of 25 000, what was its operating income? (c) If you were asked to make a recommendation for the absorption costing denominator level for next period’s operations, what would you suggest? Explain your choice. (d) If the manager of Fighting Kites is given a bonus based on income, which type of income statement would you recommend to evaluate manager performance? Explain your choice. (LO1, 3) (a) and (b) Product costs: Direct materials Other variable production costs Fixed production costs * Total product costs

Variable $ 40 000 60 000

Absorption $ 40 000

$100 000

$180 000

60 000 80 000

*Absorption costing fixed production rate: $100 000/25 000 kits = $4 per kit Fixed production cost allocated to kits produced: $4 × 20 000 kits = $80 000 Cost per kit (20 000 produced) $5 $2 Cost for 18 000 kits sold (assuming LIFO) $ 90 000 Cost for 2000 kits added to inventory 10 000 Total product costs $100 000

$162 000 18 000 $180 000

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Variable Costing

Absorption Costing

Revenue (a) $540 000) Variable costs: Production (above) (90 000) Selling (18 000) Contribution margin 432 000) Fixed costs: Production (100 000) Selling and admin. (100 000) Operating income $232 000)

Revenue (a) $540 000) Cost of goods sold (above) (162 000) Volume variance (c) (18 000) Gross margin 360 000) Selling and admin. (d) (118 000) Operating income $242 000)

Calculation details: (a) Revenue = 18 000 kits × $30 = $540 000 (b) Volume variance: Fixed production cost allocated ($4 × 20 000 kits) Actual fixed production cost (Underallocated) fixed production costs

(c)

$ 80 000) 100 000) $(20 000)

Because the volume variance is material, it is prorated between cost of goods sold and ending inventory: Cost of goods sold ($20 000 × 18 000/20 000 kits) $(18 000) Ending inventory ($20 000 × 2 000/20 000 kits) (2 000) Total volume variance adjustment $(20 000) Selling and administrative: Variable selling costs $ 18 000 Fixed selling and administrative costs 100 000 Total $118 000 Although the problem does not ask for a reconciliation of income across the two methods, it is useful to prepare a reconciliation to double-check the preceding calculations: Direct labour and variable overhead costs added to ending variable costing inventory ($60 000 × 2000/20 000 kits) 6 000 Variable costing operating income 232 000 Fixed overhead costs allocated to ending absorption costing income (after the volume variance adjustment, this is equal to actual fixed overhead cost per unit $100 000 × 2000/20 000 kits 10 000 Absorption costing operating income $242 000

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(c)

Student answers to this question should demonstrate that they have considered how the managers might use the absorption costing information, and they should also clarify their assumptions. If the managers’ primary goal in using absorption costing is to assign actual costs to inventory as accurately as possible, then next year’s expected production volume should be used as the denominator value. If demand and production volumes are expected to remain at 20 000, then a volume of 20 000 would be appropriate. If production volumes are not stable, then next year’s volume could be estimated using sales forecasts for next year and/or production volumes over several past years. On the other hand, the managers may wish to monitor use of capacity, particularly if production volumes vary. In that case, a volume such as practical capacity might be best.

(d)

Student responses will vary. Following is an example of a good response. I recommend that Fighting Kites use variable income or throughput income because both of these methods provide less incentive to build up inventories and more incentive to control fixed and overhead costs. In addition, these statements provide information about current period costs to those individuals charged with evaluating managers’ performance. The variable income statement displays fixed and variable, production and non-production costs in such a manner that they are easily compared across time for meaningful performance evaluation. For example, if manufacturing fixed costs are considerably higher or lower in one period than in the prior periods, this information would be easy to identify and managers could be rewarded or encouraged to control costs better. In addition, the information from both variable and throughput costing income statements is broken down into categories that are useful for decision-making. When Fighting Kites needs to make a short or long term production decision, the variable costing income statement provides ample relevant information. When capacity constraints exist, throughput costing information may be better. If Fighting Kites guarantees its direct labour employees a 40-hour work week, then throughput costing information provides the best information for decision-making.

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9.21 Absorption and variable income and uses, reconcile incomes Security Vehicles converts Hummers into luxury, high-security vehicles by adding a computerised alarm and radar system and various luxury components. The finished vehicles are sold for $100 000 each. Variable manufacturing costs (including the cost of the basic Hummer) are about $60 000 per vehicle. Fixed manufacturing costs are $60 000 per month. The fixed costs for administrative and selling expenses are $20 000 per month plus $5000 per vehicle sold.

At the beginning of last year Security had no inventories of finished vehicles. In January it produced four vehicles and sold three. In February it produced five and sold six. Required (a) What is the operating income for January if Security uses a variable costing system? (b) What is the operating income for January if Security uses an absorption costing system? (c) Reconcile the difference between the absorption and variable costing operating incomes in February. (d) Explain why Security Vehicles might produce both variable and absorption income statements for the same time period. (LO1, 3) (a)

(b)

Variable costing income statement for January: Revenue (3 vehicles × $100 000) Variable costs: Production (3 vehicles × $60 000) Administrative and selling (3 vehicles × $5000) Contribution margin Fixed costs: Production Administrative and selling Operating income Absorption costing income statement for January: Revenue (3 vehicles × $100 000) Cost of goods sold* Gross margin Operating expenses: Administrative and selling ($20 000 + $5000 × 3 vehicles) Operating income

$300 000) (180 000) (15 000) 105 000) (60 000) (20 000) $ 25 000)

$300 000) (225 000) 75 000) (35 000) $ 40 000)

*Absorption cost per unit (assuming that fixed costs are allocated based on actual costs and actual production volume): Variable production costs Fixed production costs ($60 000/4 vehicles) Total absorption cost per unit Cost of goods sold (3 vehicles × $75 000)

$60 000) 15 000) $75 000) $225 000)

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

(c)

This question calls for a reconciliation of February incomes under variable and absorption costing. First calculate February income under these two methods:

Variable Costing Absorption Costing Revenue (6 × $100 000) $600 000) Revenue (6 × $100 000) $600 000) Variable costs: Cost of goods sold* (435 000) Production (6 × $60 000) (360 000) Gross margin 165 000) Selling (6 × $5000) (30 000) Administrative and selling Contribution margin 210 000) ($20 000 + $5000 × 6 vehicles) Fixed costs: (50 000) Production (60 000) Operating income $115 000) Administrative and selling (20 000) Operating income $130 000)

Calculation details: *Absorption cost per unit (assuming that fixed costs are allocated based on actual costs and actual production volume): Variable production costs $60 000 Fixed production costs ($60 000/5 vehicles) 12 000 Total absorption cost per unit during February $72 000 Cost of goods sold: Vehicles produced during February (5 vehicles × $72 000) Vehicle produced during January (1 vehicle × $75 000) Total

$360 000 75 000 $435 000

In February, under absorption cost income, one Hummer was sold from January’s production. In January, overhead allocated to production was $15 000, so February’s income under absorption costing is $15 000 less than variable costing. (d)

An organisation could produce absorption cost income statements for external users such as shareholders, creditors and suppliers. For internal decisionmaking information, variable cost income statements could be produced.

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9.22

Over/underapplied overhead; units versus machine hours as allocation base Northcoast Manufacturing Company, a small manufacturer of parts used in appliances, just completed its first year of operations. The company’s controller, Vic Trainor, has been reviewing the actual results for the year and is concerned about the allocation of manufacturing overhead. Trainor uses the following information to assess operations. • Northcoast’s equipment consists of several machines with a combined cost of

•

• •

•

$2 200 000 and no residual value. Each machine has an output of five units of product per hour and a useful life of 20 000 hours. Selected actual data of Northcoast’s operations for the year just ended is presented here.

Total manufacturing overhead is allocated to each unit using an estimated plant-wide rate. The budgeted activity for the year included 20 employees, each working 1800 productive hours per year to produce 540 000 units of product. The machines are highly automated, and each employee can operate two to four machines simultaneously. Normal activity is for each employee to operate three machines. Machine operators are paid $15 per hour. Budgeted manufacturing overhead costs for the past year for various levels of activity are shown here.

You may want to use a spreadsheet to perform calculations.

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Required (a) Choose the budgeted level of activity (in units) closest to actual activity for the period and determine the dollar amount of total over/ underapplied manufacturing overhead. Explain why this amount is material. (b) Vic Trainor believes that Northcoast Manufacturing Company should be using machine hours to allocate manufacturing overhead. Using the data given, determine the amount of total over/underapplied manufacturing overhead if machine hours had been used as the allocation base. (c) Explain why machine hours might be a more appropriate allocation base than number of units. (d) Explain why using units as denominator volume might cause managers to build up inventories under absorption costing in periods when sales were slumping. (LO1, 3) Note: Parts B and C require students to use and evaluate overhead allocation methods introduced in earlier chapters. (a)

Among the 3 budgeted levels of activity presented in the problem, the one closest to the actual production of 500 000 units is for 540 000 units of production. Based on this budgeted level of activity, the amount of over/ underapplied overhead is calculated as follows: Estimated overhead allocation rate = Total budgeted overhead/budgeted direct labour cost = $961 200/(36 000 × $15) = 178% of direct labour cost Allocated overhead [(35 000 × $15) × 178%] Actual incurred overhead Overapplied (Underapplied) Overhead

$ 934 500) 1 130 000) $ (195 500)

This amount is material because it is over 11% of COGS ($195 500/$1 720 960) (b)

If machine hours were used, the amount of over/underapplied overhead would have been: Overhead allocation rate $961 200/108 000 machine hours = $8.90 per machine hour Allocated overhead ($8.90 × 130 000 machine hours) Actual incurred overhead Overapplied (Underapplied) Overhead

$1 157 000 1 130 000 $ 27 000

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(c)

Machine hours would be a more appropriate allocation base for Northcoast Manufacturing’s fixed manufacturing overhead because the company appears to have a capital-intensive manufacturing process where each direct labourer operates two to four machines simultaneously. In this type of setting, the use of machines drives a large portion of overhead costs, such as depreciation, maintenance, and utilities. Consequently, using machine hours as the allocation base results in more reliable cost information and better decisions.

(d)

If units are used as the denominator volume, managers can shift costs from the income statement to the balance sheet by producing more inventory than is sold. Each unit of inventory carries with it a portion of fixed cost that is booked as an asset (inventory) on the balance sheet and so fixed overhead cost is not completely expensed for the accounting period.

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9.23 Recommend income format Your brother started a small business, GameZ, that produces a software game he developed. It is his first year in business, and he kept detailed records of the business. However, his business records consist primarily of entries in his chequebook plus information using a simple method of adding and subtracting cash on a spreadsheet. Your brother has asked your advice about the kind of financial statements that would be helpful to his business. He would like you to prepare information for two different uses. First, he needs a small bank loan to provide cash during the low season in August. Most of his sales are made in December. He has a steady, low volume of sales most of the rest of the year. He wants to approach his bank about a line of credit upon which he could draw in August and then pay off in January. In addition, he would like to be able to analyse information from his operations to make decisions about whether to develop a new game, what price to set, and how much he could devote to advertising. He also recently hired an assistant to whom he assigned a great deal of responsibility for general operations. He would like to be able to monitor and reward her performance in some way. Required Write a memo to your brother in response to his request. Include the following aspects in your memo. (a) Outline his possible choices for income statement formats. (b) List the advantages and disadvantages of each format. (c) Recommend and explain which type of statement should be used for each of his desired purposes. (LO1, 3) (a)

Three choices are available for income statement formats, absorption costing, variable costing, and throughput costing. Absorption costing meets GAAP standards and is used for income statements required by banks and creditors. Variable and throughput costing income statements produce detailed information that can be used in decision-making.

(b)

Absorption costing matches revenues with expenses under accrual accounting. Because this is required for GAAP, these statements are appropriate for external reports to creditors and shareholders. Variable costing separates costs into fixed and variable categories and expenses all fixed costs as period costs. Income levels are not affected by changes in inventory levels so managers have no incentive to manipulate inventory when income is reported using variable costing. The same advantages and disadvantages apply to absorption costing.

(c)

As mentioned above, the bank and other creditors will want the absorption income statement, but the brother will want information produced by either the variable cost or throughput income statements. Variable cost statements provide more detail than throughput costing so variable income statements would likely be preferred for developing information for decision-making. For compensation purposes, variable or throughput income statements are best because income is less subject to manipulation through inventory level adjustments.

9.24 Bonuses and manufacturing decisions; profit variances; income statement format

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Palm Producers (PP) is expecting sales growth, and so it built nearly identical automated plants in Sandy Beach, Queensland, and in Singapore to produce its new Palm Powerhouse. Each plant manager is responsible for producing adequate inventories to meet sales orders and for maintaining quality while producing the Palm Powerhouse at the lowest possible cost. Under PP’s decentralised organisation, each plant maintains its own accounting records. Quarterly reports are filed with the corporate controller’s office and are then reviewed by corporate management. The following reports were filed for the third and fourth quarter by the two plants.

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Required (a) Suppose each plant manager receives a bonus based on absorption costing operating income that is 5% of operating income. Calculate the bonus for each manager. Explain how this bonus plan might affect the managers’ manufacturing decisions. (b) Examine changes in sales relative to cost of goods sold between the two quarters. What are two possible explanations for the Sandy Beach plant’s profit increase during the fourth quarter? (c) Assume that variable costs in this industry are an immaterial part of cost of goods sold. Recast the financial statements using the variable costing approach. (d) What would you conclude about the relative performances of the two plant managers in the fourth quarter? (e) Suppose you are the cost accountant for Palm Producers. Write a memo to the CFO recommending the type of income statement that would be best for monitoring divisional performance. Attach to the memo a schedule showing any calculations that might be useful to the CFO. As appropriate, refer to the schedule in the memo. (LO1, 2) (a)

Sandy Beach plant manager’s bonus = 5% of $12 646 = $632.30 Singapore plant manager’s bonus = 5% of $5791 = $289.55 Each plant manager would prefer higher income to receiver higher bonus amounts

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(b)

For the Sandy Beach plant, sales increase but cost of goods sold decreases. Either cost reductions were instituted or there was a build-up of inventory over the period, which would reduce the amount of fixed overhead in cost of goods sold.

(c)

If variable costs are immaterial, the difference in inventory amounts between the last two quarters is assumed to be expense that is on the balance sheet instead of on the income statement.

Fourth quarter income Change in inventory Variable costing income

Sandy Beach Plant $12 646) (18 100) $ (5 454)

Singapore Plant $5 791) (2 508) $3 283)

(d)

I would conclude that the Sandy Beach plant manager’s performance was poor during the last quarter of the year, and certainly not as good as the performance of the Singapore plant manager.

(e)

There is no one answer to this part. Generate class discussion by students presenting their answers.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. Prepared by Judy Oliver

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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Chapter 10: Flexible budgets, standard costs and variance analysis

22 Questions 10.1

Which type of entities would be suited to the use of a standard cost system? (LO2)

An entity that has a repetitive type activity would be suited to a standard cost system. As the activity will be repeated over and over again then it should be possible to identify the resources necessary for the activity and then assign the cost of the resource to calculate the standard cost.

10.2

Explain the difference between an ideal standard and a currently attainable standard. (LO2)

Ideal Standard: this standard assumes perfect operating conditions which achieve maximum efficiency. No allowances are made for process errors. Such standards can either motivate employees as it encourages higher levels of performance or demotivate employees due to their frustration at not being able to meet the target set. Currently Attainable Standard: this standard assumes 'normal' operating conditions which allows employees to meet the targets set without a superhuman effort. Obviously this standard has “inefficiencies” built in as it assumes less than 100% efficiency in the process.

10.3

Discuss the different methods that an organisation can use to determine standard costs. (LO2)

There are two different types of standards: 1. Ideal standard – assumes perfect operating conditions 2. Currently attainable standard – assumes “normal” operating conditions Standard costs can be calculated by referring to information provided from the following:

• • •

historical costs and trends expected changes in costs or processes estimates from industrial engineers.

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10.4

Discuss the behavioural issues that need to be considered when establishing a standard cost. (LO2)

The standard cost developed will be used as a benchmark for performance evaluation and as such whenever people within the organisation are held accountable to this target, their decision making may be influenced. For example, the materials manager may be encouraged to buy lower quality resources, leading to a favourable price variance, which would give the manager a higher performance rating in his/her evaluation.

10.5

Explain the difference between a static budget and a flexible budget. (LO1 and 3)

The static budget is based on forecasts of specific volumes of production or services, together with expectations about employee productivity and other factors that affect revenues and costs. However, the information in a static budget is biased when compared to actual results for a different volume of operations. To overcome differences between budgeted volume and actual volume managers make use of flexible budget techniques to monitor actual operations to determine whether operating targets are met. A flexible budget is a set of cost relationships that can be used to estimate costs and cash flows for any level of operations, within the relevant range. As such, a flexible budget uses the variable cost information from the master budget but adjusts sales information and variable costs to reflect actual volumes. Because fixed costs are not expected to change, these values are carried over from the static budget.

10.6 Which item has the same value for both the static budget and the flexible budget? (LO1, 3) Under both static and flexible budgets, any fixed costs will have the same value. Regardless of the activity level within the relevant range, these costs will not change.

10.7

Discuss the different types of budget variances that can be calculated. (LO3)

The different types of variances that can be calculated are as follows: Static Budget compared to Actual Results = Budget Variance Static Budget compared to Flexible Budget = Volume Variance Flexible Budget compared to Actual Results = Price/Efficiency Variance Therefore the Volume Variance + Price/Efficiency Variance = Budget variance

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10.8

Explain how accountants and managers decide which cost variances to monitor. (LO3)

The cost categories that are measured and monitored in a given organisation depend on several factors, including the following: • Nature of goods or services: Manufacturers monitor input prices and efficiency of labour and materials, whereas service organisations monitor cost per service provided, which may not include materials. All organisations monitor fixed costs, although the type of fixed costs varies widely with the type of business. • Cost accounting system used: The cost categories will be more precise with more complex cost accounting systems. An organisation with an ABC system that separates costs into flexible and committed categories could develop standards and measure variances for every activity performed. Alternatively, only broad categories may be tracked, such as the traditional direct materials and direct labour categories. • Costs that managers consider important: Overhead costs are often aggregated together and include indirect costs such as oil for machine maintenance. While these costs may not be individually important, they are often monitored as part of the larger category of overhead costs. • Cost/benefit trade-off for monitoring individual costs: For those costs already reported by the accounting system, such as direct labour in a job costing system, the cost to develop standards and monitor variances is probably low, and the benefit could be relatively high if such monitoring encourages labour to be more efficient. However, other costs, indirect materials used during set-ups, may be expensive to track. The benefit from tracking these costs may be low if only very small amounts of materials are used per set-up. These costs are likely to be aggregated into overhead.

10.9

List several ways that variances can be used to improve future operations. (LO1, 2 and 3)

Recurring favourable variances may indicate that some process has improved. These should be investigated so that standard production practices reflect the process improvements. Variances may also reflect opportunities to examine the manufacturing process and quality of materials to determine improvements. Sometimes the standard is wrong, and the monitoring process is improved by changing the standard to reflect current operations.

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10.10 Suppose that utilities are considered a fixed cost for a retail clothing outlet. Why might we expect a variance to occur for the cost of utilities? (LO3) Utilities are considered fixed costs. These include phone service, natural gas and electricity. The use of natural gas and electricity is affected by weather patterns. Because weather patterns change, these costs cannot be perfectly predicted. There may be unanticipated price changes in the cost of utilities. In addition, employees could be careless in their use of electricity or telephones. Therefore, variances occur regularly.

10.11 Distinguish between a price variance and an efficiency variance. (LO2 and 3) A price variance is the difference between standard and actual prices paid for resources purchased and used in the production of goods or services. An efficiency variance provides information about how economically direct resources such as materials and labour were used.

10.12 Explain what a favourable variance and an unfavourable variance mean in relation to revenue and costs. (LO3)

Revenue

Cost

Favourable Variance Budgeted Revenue is less than actual revenue

Unfavourable Variance Budgeted Revenue is more than actual revenue

Budgeted Cost is greater than actual cost

Budgeted Cost is less than actual cost

10.13 Why might the role of the accountant be referred to as one of a ‘detective’ in relation to variance analysis? (LO3) The accountant can be referred to as a detective as it is necessary for them to investigate and discover the reasons behind the variances that have been identified when comparing budget to actual. Is the variance due to price, uses of resources or some other reasons. Until the reason behind the variances are discovered, the organization is not able to respond in a way to improve future operations.

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10.14 Should management be upset if all variances for the period are unfavourable? (LO1, 2 and 3) No – unfavourable variances can also indicate process improvements e.g. an unfavourable price variance for material could lead to production efficiencies due to the higher quality material. An unfavourable labour efficiency variance could indicate that workers identified a problem that was corrected prior to dispatch to customers.

10.15 Should management be excited if all variances for the period are favourable? (LO1, 2 and 3) Opposite to 8.13 – a favourable price variance could indicate: purchase of poor quality resources which could lead to production problems; and purchase of bulk items suggesting higher costs of storage.

10.16 Variance analysis is only useful for organisations using a standard costing system. Discuss. (LO3) The analysis of variance between budgeted activity to actual activity is important for any entity to identify the reasons behind the variances. This will lead management to implement plans/strategies to improve future profitability. 10.17 Software Galore sells gaming software that is downloaded to the customer’s device on purchase. The owner, Fred, was talking with a friend who sang the praises of flexible budgeting in his manufacturing business. Fred was wondering whether a flexible budget would benefit his business decision making. Comment. (LO1) The use of flexible budgeting could offer a number of benefits to Software Galore. This will be particularly true if game sales are difficult to predict or volatile. Through the use of flexible budgets, Fred will be able to perform sensitivity analysis with different assumptions about his firm’s sales performance to enable him to better understand how more or less optimistic sales forecast will impact revenues, cash flows and other projections. In this situation with games being downloaded and not physically manufactured, however, it will be important for Fred to appreciate that many of his firm’s costs will not change with changes to the sales activity level. Thus, flexible budgeting is unlikely to reveal too much new information in regards to his firm’s expenses.

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23 Exercises 10.18 Selection of appropriate standard Franklin Industries’ CEO was talking with the CFO about the appropriate standard to use for the new product being launched in the coming year. The CEO argued that standards based on ideal performance would enable profits to be maximised through improved efficiency. The CFO argued, however, that the standard should be based on attainable performance or recent average historical performance. Required Briefly comment on which standard is best for Franklin Industries to use in developing the standard cost for the new product. (LO2) The CEO is wanting to use the ideal standard based on maximium efficiency; whereas the CFO is wanting to use a currently attainable standard. The best standard may lie somewhere between these two. The ideal standard assumes no problems with the production process with workers and machines operating at full capacity and efficiency. It could be that the currently attainable standard is comfortable in that it can be easily achieved. To stretch the production process, and apply continuous improvement principles, the development of a standard between the two may encourage improved performance.

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10.19 Direct costs in flexible budget Paper Bright Industries uses flexible budgeting to assess budgeted expectations against actual performance. Last month Paper Bright produced 12 000 units and incurred direct materials cost of $150 000. Its static budget for the year has a direct materials cost of $200 000 for 150 000 units. Required (a) Calculate the direct materials cost in the flexible budget. (b) Calculate the direct materials flexible budget variance. (LO2 and 4) (a) The direct material cost in the flexible budget would be: 12 000 units x ($200 000/ 150 000 units) = $16 000 (b) Flexible Budget Variance is -$134 000 and not favourable ($16 000 (flexible budget) less $150 000 (actual)).

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10.20 Flexible budget and variances Black Industries has a static budget based on production and sales of 24 000 units. Sales revenue is expected to be $96 000, variable costs $36 000 and fixed costs $32 000. Actual production and sales were 30 000 units with a profit of $50 000. Required (a) Calculate the amount of profit in the flexible budget. (b) Calculate the overall variance between the flexible budget and actual results. (LO4) (a) and (b) Based on 30000 units Sales Less variable costs Contribution margin Less fixed costs

Flexible Budget $120 000 $ 45 000 $ 75 000 $ 32 000

Actual Results

Profit

$ 43 000

$50 000

$7 000 (F)

Note: budgeted sales per unit = $96000/24000 units = $4 budgeted variable costs per unit = $36000 / 24000 units = $1.508.22 Variances and flexible budgets

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10.21 Flexible budget Helium Industries manufactures glitter balloons used as party accessories. The balloons are bagged in packages of 100 and sold for $20 per pack. The company incurs fixed manufacturing overhead of $25 000 per year and the fixed overhead is applied based on packs produced. Standard costs are: material $8 per unit, direct labour $5 per unit and variable overhead $3 per unit. The marketing manager believes sales for the coming year will be somewhere between 10 000 and 15 000 packs. Required (a) Prepare a flexible budget for sales of 10 000, 12 000 and 15 000. (Allocate fixed overhead based on the sales volume.) (b) What advantages are there for Helium Industries in using a flexible budget? (LO1 and LO4)

(a) Flexible Budgets Flexible Budget Sales ($20 per pack) Less variable costs Material ($8 per pack) Labour ($5 per pack) Variable overhead ($3 per pack) Total variable costs Contribution margin Less fixed costs Profit

10 000 units 200 000

12 000 units 240 000

15 000 units 300 000

80 000 50 000 30 000

96 000 60 000 36 000

120 000 75 000 45 000

160 000 40 000 25 000 15 000

192 000 48 000 25 000 23 000

240 000 60 000 25 000 35 00

(b) Flexible budgets assist in profit planning by identifying profit levels at different levels of activity. For control purposes the ability to compare actual activity with expected costs for actual activity enables an improved analysis of variance. Flexible budgeting enables recasting the static budget to a budget based on the actual level of activity.

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10.22 Static and flexible budgets, variances, information quality The photocopying department in the local polytechnic college has budgeted monthly costs at $40 000 per month plus $7 per student. Normally 800 students are enrolled. During March there were 730 students (which is within the relevant range). At the end of the month, actual fixed costs were $42 000 and variable costs were $3650. Required (a) Develop a static budget for photocopying costs based on 800 students. (b) Calculate the March static budget variance for fixed and variable photocopying costs. (c) Develop a flexible budget for the actual volume of students in March. (d) Calculate the March flexible budget variance for fixed and variable photocopying costs. (e) Which variance information — part (b) or (c) — is of higher quality? Explain. (LO4) Parts a to d are covered in the table below: 800 students Static Budget Variable costs Fixed costs Total costs

5,600 40,000 45,600

730 students Varianc e

Actual 3,650 42,000 45,650

1,950 2,000 50

F U F

1460 2000 540

F U F

730 students Flexible Budget Actual Variable costs Fixed costs

5,110 40,000

3,650 42,000

Total costs

45,110

45,650

(e) The comparison of the flexible budget with the actual results will provide higher quality information as it is comparing the same level of activity.

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10.23 Calculation of budget variances The accountant for Moon Industries has taken unexpected leave and has not completed the end-ofperiod budget analysis. The following incomplete budget analysis was found on her desk.

Additional information:

Required (a) Complete the variance analysis report. (b) Provide a brief report to management of any issues highlighted from your analysis in (a). (LO3)

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(a) Sales Units Large Small Assumption no change in selling price

Budgeted Actual 150 192 333 490

Static Budget

Variance

Flexible Budget

Variance

Actual $

Sales (small)

1,000,000

470000

1470000

1,470,000

Sales (large)

1,500,000

420000

1920000

1,920,000

Total Sales

2,500,000

890000

3390000

3,390,000

Materials (small)

400,000

57,000

343000

-347,000

690,000

Labour (small)

200,000

4,000

196000

-134,000

330,000

Var. OH (small)

50,000

20,600

29400

-45,200

74,600

Materials (large)

350,000

-418,000

768000

258,000

510,000

Labour (large)

200,000

-184,000

384000

114,000

270,000

Var. OH (large)

30,000

-66,000

96000

60,600

35,400

Contribution Margin

1,270,000

-546,400

1816400

336,400

1,480,000

Manufacturing overhead

120,000

-60,000

180,000

Selling Expenses

50,000

-40,000

90,000

Admin Expenses

30,000

5,000

25,000

1,070,000

-546,400

1,616,400

431,400

1,185,000

Variable Costs

Fixed Costs

Net Profit

(b) The budget analysis indicates a more favourable profit. This has come about due to a number of factors. Firstly, the change in sales volume for both products. The orignal static budget assumed a lower level of sales volume for each product. It can also be seen from the flexible budget variance that the production department have a favourable variance ($336 400) in relation to production costs. Althought higher fixed costs were incurred overall the cost savings from production have more than offset this increase.

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10.24 Variances and flexible budgets Sherry North is the supply manager for West Industries, a manufacturer of garden furniture for the major department store in Australia. As part of her bonus plan, Sherry must meet the materials budget that was established at the beginning of the year. As West Industries manufactures three products in large volumes, standard costs are easily established for the factors of production. The reports for the first half of the year indicate that the materials variance is unfavourable. In an attempt to achieve her bonus target Sherry has been purchasing lower-grade materials at reduced costs for a new supplier. Management have been very pleased with the turnaround in the variance. Required What implications do Sherry’s actions have for West Industries as a whole (especially in relation to other variances that may be reported in the production area)? (LO3) Sherry has been able to turnaround the material variance by purchasing lower cost materials. Given the description of the materials as “lower-grade” the implication is that the production department may experience problems will using lower quality material. This could lead to inferior products with lower quality, more rejects during the production process, or more time taken by production workers due to the poor quality of material. Due to the potential for an inferior product, West Industries customers may react to receiving an inferior product by returning goods or going to other suppliers.

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10.25 Static and flexible budgets Plush pet toys are produced in a largely automated factory in standard lots of 100 toys each. A standard cost system is used to control costs and to assign cost to inventory.

Variable overhead, estimated at $5 per lot, consists of miscellaneous items such as thread, a variety of plastic squeakers, and paints that are applied to create features such as eyes and whiskers. Fixed overhead, estimated at $24 000 per month, consists largely of depreciation on the automated machinery and rent for the building. Variable overhead is allocated based on lots produced. The standard fixed overhead allocation rate is based on the estimated output of 1000 lots per month. Required (a) (b)

Prepare a production budget for the coming year based on planned production 12 000 lots. Compare the budget prepared in (a) with a flexible budget based on actual activity of 15 000 lots.

(LO4)

12000 lots Direct material (15 metres per lot x $2 per metre) Direct labour (2 hours per lot x $10 per hour) Variable Overhead ($5 per lot) Fixed Overhead

Static Budget $ 360,000.00 $ 240,000.00 $ 60,000.00 $ 288,000.00 $ 948,000.00

15000 lots Flexible Budget $

450,000.00

300,000.00

75,000.00

288,000.00

1,113,000.00

The above budgets highlight that the variable costs will change with changes in volume however the fixed costs will remain the same for any budgeted level of activity.

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Problems 10.26 Developing direct cost standards; cost variances; use of variance analysis The Mighty Morphs produces two popular games, Powerful Puffs and Mini-Mite Morphs. Following are standard costs:

The standards call for more than one disk and documentation book per unit because of normal waste due to faulty DVDs and poor binding. Actual costs for last week follow:

Management decided that it would require too much effort to keep track of how many DVDs and hours are used for each of the games separately. Accordingly, the DVD materials and labour variances are combined rather than computed separately for each game. Required

(a) What is the documentation price variance for Mini-Mite Morphs? (b) What is the efficiency variance for DVDs? (c) What is the sum of all variances for assembly labour for both games? (d) Discuss the pros and cons of building waste into the standards. (LO1, 2, 3 and 4) (a)

Documentation price variance for Mini-Mite Morphs: Actual quantity × (actual price per unit - standard price per unit ) = [1005 books × ($2.95 - $3 )] + [(825 books × ($4.75 - $5 –)] = $50.25 F + $206.25 F = $256.50 F

(b)

Efficiency variance for DVDs (actual quantity - Standard quantity ) × standard price

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= [1005 books - (1.03 books per unit × 1000 units) ] × $3 + [825 books (1.03 books per unit × 800 units) ] × $5 = (1005 - 1030 ) × $3 + (825 – 824) × $5 = $75 F + $5 U = $70 F (c)

Labour price variance for both games: (actual price - standard price ) × actual labour hours = ($795/55 - $15 –) × 55

$ 30 F

Labour efficiency variance for both games: (actual hours - Standard hours for actual output ) × standard price = [55 - (0.01 × 1000) + (0.03 × 800) ] × $15 = [55 - (10 + 24) ] × $15 315 U Total labour variance $285 U (d)

Pros: • It may be less costly to allow waste in the standard than to inspect incoming materials or to pay for higher quality materials. • The company has done it this way a long time and change might be difficult for employees. Cons: • Several waste-related opportunity costs arise from defective units. As waste increases, it is likely that the number of defective units sold increases. Greater defect rates reduce customer satisfaction and reduce sales. By eliminating waste altogether, this cost is avoided. • The company would have saved $218.75, although no information is given about the amount of investment required to save this amount.

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10.27 Cost variance analysis; use of variance information Baker Street Animal Clinic uses a particular serum routinely in its vaccination program. Veterinarian technicians give the injections. The standard dose is 10cc per injection, and the cost has been $100 per 1000cc. According to records, 2000 injections were administered last month at a serum cost of $2270. The veterinarian noted that the serum for the injections should have cost $2000 [($0.10 per cc) × (10cc per injection) × (2000 injections)]. Moreover, she noted some carelessness in handling the serum that could easily lead to unnecessary waste. When this issue was brought to the attention of the technicians, together with the $270 discrepancy in costs, they claimed that the $270 excess costs must be due to the inflated prices charged by the veterinarian supply company. Purchasing records reveal that the price for the serum used last month had indeed increased to $105 per 1000cc. Required (a) Provide variance calculations to help you evaluate the technicians’ argument. (b) Discuss whether a significant waste of serum occurred last month. Include quantitative and qualitative information in your discussion. (c) If you were the manager for the Baker Street Animal Clinic, how would you use the results of your analyses in parts (a) and (b)? Explain. (LO3) (a)

The technicians have argued that the cost variance was caused by the price increase. Thus, the total variance can be separated into a price variance and an efficiency variance. Normally, the price variance is calculated using the purchase quantity. However, no information is given about the quantity purchased. Also, the problem presents total cost for serum used of $2270, which results in a $(270) total variance. However, the serum for 2000 injections costs $105 per 1000cc. Following are calculations for the price variance. Price variance for serum: Standard quantity of serum for actual injections Times amount of price increase per cc: [($105/1000 cc) - ($100/1000 cc)] = ($.105 - $.10) per cc Serum Price Variance (20 000 cc × $.005)

20 000 cc (.005) per cc $(100) U

Efficiency variance for serum: The efficiency variance cannot be calculated using the usual method because the quantity of serum used is unknown. However, the efficiency variance can be calculated by subtracting the price variance from the total serum cost variance. Total variance (given in the problem) Price variance Serum Efficiency Variance

$(270) U (100) U $(170) U

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(b)

The unfavourable efficiency variance represents the cost of wasted serum. To see this, consider the formula for the efficiency variance: Efficiency Variance = Standard cost × (Standard quantity – Actual quantity) The difference between the standard quantity and the actual quantity is the amount of serum wasted. At a standard cost of $.10 per cc, the volume of wasted serum is estimated to be 1700 cc ($170 unfavourable efficiency variance/$.10 per cc). Is this a significant amount of waste? This is a matter of judgement. Below are several ways to quantity the significance. Waste, relative to standard quantity of serum: Standard quantity of serum = 2000 injections × 10 cc Percent serum waste (1700 cc/20 000 cc)

20 000 8.5%

Note: The waste could also have been calculated using percent of standard cost: $170 efficiency variance/$2000 standard cost = 8.5% Number of additional injections that could have been given: Waste of 1700 cc / 10 cc per injection

170 injections

Following are possible issues to discuss when answering this question: • The percent waste (8.5%) might or might not be considered a significant cost. • Given the nature of operations at the Baker Street Animal Clinic, it would be reasonable for waste to be very close to zero. • Had there been zero waste, 8.5% or 170 more injections could have been given. • Perhaps the waste is a sign that the technicians are wasteful in other areas, too. There could be a significant larger problem. (c)

The manager would probably be concerned about the unfavourable efficiency variance. The manager could ask the technicians to review their procedures and to identify how and where waste is occurring. Once the reasons for waste are identified, the manager could help the technicians establish new procedures to minimise or eliminate the waste. If the technicians are unable to provide reasonable explanations for the waste, the manager might become concerned that someone is stealing serum and then selling or using it elsewhere. If the manager considered the cost to be sufficiently large, he/she might institute new procedures for monitoring the physical use of serum. However, this type of approach might cost more than the benefit. Perhaps the easiest and most cost-effective solution would be to provide the technicians with incentives based on the efficiency variance. The efficiency variance could be used as part of the technicians’ performance evaluation. This would encourage them to seek efficiency improvements on their own.

10.28 Flexible budget and variances; reasons for variances

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Play Time Toys is organised into two major divisions: marketing and production. The production division is further divided into three departments: puzzles, dolls and video games. Each production department has its own manager. The company’s management believes that all costs must be covered by sales of the three product lines. Therefore, a portion of production division costs are allocated to each product line. The company’s accountant prepared the following variance report for the dolls production department.

Required (a) Is Play Time Toys using a static budget or a flexible budget to calculate variances? Explain. (b) Do you agree with this approach? Why or why not? (c) Develop a flexible budget for the actual sales of 1100 units. (d) Use the benchmark you created in part (c) to calculate variances. (e) Review the variances from part (d). Briefly describe what the variances are suggesting regarding performance. (LO3 and 4) (a) At present Play Time Toys is using the static budget to calculate variances – this can be seen in the question as the volume levels for both budgets are not the same. (b) This approach will not provide meaningful insights into variances due to the difference in volume levels. (c) and (d) Flexible Budget Sales Volume 1 100 Revenue $13 200 Direct materials 2 200 Direct labour 1 100 Variable factory overhead 1 100 Fixed factory overhead 800 Production division overhead 100 Operating income $7 900 $ 6,850 F=Favourable variance; U=Unfavourable variance

Actual

Variance 1,100

$12,400

0 $ 800 (U)

2,100 1,225 1,100 1,020

$100 (F) $125 (U) 0 $220 (U)

105 $1050 (U)

$5 (U)

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(e) The variance analysis highlights that management need to focus on why sales revenue was less than budgeted. Was this caused by a reduction in the selling price, heavy discounts offered to clients or a change in the mix of products sold compared to budget. Productions costs, other than material, have been higher than expected and will need investigation. It might be that the reduced material price (as seen with the favourable variance) may have been a factor in the higher costs incurred in other parts of production.

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10.29 Flexible budget variance analysis Cardinal Products hired a new marketing manager early this year. After an informal consumer survey, the marketing manager decided to lower the firm’s selling price by 10 per cent and increase television advertising. The operating results at year end were disappointing. The marketing manager prepared the following analysis for the president. He assumed that direct materials and direct labour were variable costs and that advertising was a fixed cost.

‘As you can see’, the marketing manager reported, ‘the major problem is due to inefficiencies in production. My plan would have worked if production had kept its costs in line.’ Required (a) Prepare a flexible budget report. (b) What is the real source of the disappointing results? Explain. (LO3 and 4) (a)

Flexible Budget

115 000 units Actual 115000 units

Variance

Sales

$690,000

$621,000

$69,000

Direct materials

230,000

227,700

$2,300

Direct labour

143,750

138,000

$5,750

Variable overhead

57,500

57,000

$500

Fixed overhead

75,000

75,200

$200

Advertising

20,000

40,000

$20,000

163,750

$83,100

$80 650

Operating Income

(b) The flexible budget highlights that the real problem lies with marketing, from both a loss in sales and an overspend in the advertising budget.

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10.30 Evaluate grading scheme; professional responsibilities Variance analysis reflects information about actual performance relative to a standard. Variance analysis reports provide managers with information about the performance of employees, from direct labour to supervisors and managers. Grades provide similar information for recruiters who want to hire graduating students. Following is information about Professor Grader’s performance measurement system.

Professor Grader is popular; almost all of his students receive As. This phenomenon is widely attributed to Professor Grader’s superior teaching skills. Grades for this professor’s courses are determined as follows:

A student needs 700 points for an A, 600 points for a B, 500 for a C, and 400 for a D. From the 200 points given for perfect attendance, a student loses 5 points for every class missed (out of 40 class meetings); however, attendance is seldom taken. If the major assignment paper is 20 pages or longer, 200 points are earned; 10 points are lost for each page less than 20 (thus, a 12-page paper is worth 120 points). Professor Grader has given the same mid-semester exam for the past 20 years. To reduce the number of exam copies in students’ files, Professor Grader does not return the exams; grades are simply reported to individual students. A student group obtained a copy of the exam 15 years ago. They have chosen not to share the exam with any person not a member of the group; thus Professor Grader usually observes that grades on this exam are nearly normally distributed. The final exam is a take-home exam that the students have two weeks to complete. Required (a) Is it possible to develop a perfect system for measuring student performance in a course? Why? (b) How much variation is likely in student performance for each of the four graded items? Explain. (c) Describe the weaknesses in Professor Grader’s grading system as a performance measurement system. (d) What are Professor Grader’s professional responsibilities to various stakeholders in this situation? (e) Discuss whether Professor Grader has acted ethically in this situation. Describe the ethical values you use to draw your conclusions.

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(f)

Is it ethical for students in this situation to access a copy of the prior mid-semester exam or to seek assistance in completing take-home assignments? Does Professor Grader’s system affect the students’ responsibilities? Describe the ethical values you use to draw your conclusions.

(LO2 and 3) (a)

It is not possible to develop a perfect system for measuring student performance in a course. To know for certain the amount of effort put forth, and the understanding that each student acquires, a professor would have to monitor all of their actions related to the course, no matter where the student was. This is impossible. Even if it were possible to perfectly observe all student actions, uncertainty would still exist about how best to measure individual course performance. Should students be graded based on the improvement in their knowledge and other competencies during the course? Should they be graded based on an absolute standard for the course? Should grades be measured relative to other students in the same section or several sections taught by the professor?

(b)

There is probably wider variation in exam results than any of the other measures, but because some students have access to the exam, variation is reduced. There is probably very little variation in attendance because it is rarely monitored. There is probably little variation in the term paper because it is graded on quantity, not quality, and the quantity standards are known by all students. There is probably little variation on the take-home exam because students have two weeks to work on it, and judging from other aspects of this professor’s performance evaluation systems, it is likely that all of the questions have single correct answers because they are easy to grade.

(c)

As a performance measurement system, the grading system is faulty for several reasons. • The performance standard appears to be very low. Students will not be

motivated to work hard to learn the subject matter of the course. • The performance measurement for the final exam paper does not seem to be

consistent with the goals of the course. Measuring length instead of content would normally not measure whether students understood the subject matter of the course. • There is no feedback on the mid-semester exam. Consequently, students are

not apprised of whether they are meeting the standards of the course. They have no basis for changing their actions to improve future performance. • The performance measure is unfair to the extent that some students have access

to the mid-semester exam and others do not. • It is questionable whether a student’s performance on the final exam provides

information about overall performance. The potential for manipulation (having someone else work the final) is high. The defects in the performance measure are so severe that one should not attempt to use grades earned in this course as a measure of students’ comprehension of the subject matter.

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(d)

Professor Grader has a responsibility to students and to others who directly finance students (such as parents and spouses) to grade in a manner that is consistent with university and program policies and also with the grading system set forth in the course syllabus. The professor is also responsible for establishing a grading system that is fair to students in the course and that measures student learning (although how to do this is uncertain, as described in Part A). This group of stakeholders often considers grades as signals about student effort and/or ability. If the grades do not measure student effort or ability, even with error, these stakeholders do not have adequate information about the student’s progress. Professor Grader has responsibilities toward the recruiters who hire the university’s graduates. Recruiters want to identify students who work hard and learn new things quickly. Grades measure these skills and abilities, although with error. Without appropriate measurement, recruiters cannot identify students that might best suit their needs, and they may no longer use the university for recruiting. Professor Grader is responsible to the university, which expects professors to ensure that graduating students have met outcomes specified by the university, such as the ability to think critically, communicate effectively, be an effective team member, and are knowledgeable within their respective majors. Universities rely on professors and their evaluation systems to maintain standards. Professor Grader is responsible to other professors at the university, who rely on their colleagues to grade fairly so that students develop a better understanding of expectations and do not become unhappy about discrepancies in grades across courses or sections of courses. Professor Grader is responsible to state and federal governments and their citizens, who financially support the university, for using resources efficiently. The professor is responsible to these stakeholders for ensuring that the grading system encourages greater student learning. The professor also has a responsibility to the general public for improving the education of its citizens.

(e)

There are a variety of ways to answer this question. In general, however, Professor Grader does not appear to have acted ethically in this situation because the professor does not appear to have adequately addressed the responsibilities described in Part D. The professor appears to have placed low priority on values such as integrity, fairness, and professional competence.

(f)

It is unethical for students to cooperate on the take-home exam if Professor Grader has specifically asked them not to do that. It is also unethical for students to have access to an exam that is not public information. Some students in the class will act ethically because they have high ethical standards. It is unfair to these students when other students do no behave ethically. Some students in this situation might rationalise unethical behaviour by saying that ‘Everyone is doing it’, or ‘The professor should expect us to get all the help we can’. These types of rationalisations are simply ways of avoiding ethical responsibility. Although the professor’s system might contribute to unethical behaviour, the system does not justify unethical behaviour.

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A variety of values could be used to reach the conclusions drawn above. For example, the values of fairness, honesty, and integrity would lead students to behave ethically in this situation.

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10.31 Evaluating a proposal for measuring performance Benerux Industries has been in business for 30 years. The entity’s major product is a control unit for elevators. The entity has a reputation for manufacturing products of exceptionally high quality, resulting in higher prices for its units than competitors charge. Higher prices, in turn, have meant that the entity has been comfortably profitable. A major reason for the high product quality is a loyal and conscientious workforce. Production employees have been with the entity for an average of 18 years. Recently the entity hired a cost accountant from the local university. After a few months at the entity, the new accountant proposed a performance measurement report consisting of two parts. The first part will report the actual number of units started during each month, the target number of units that should have been started, and a variance. The second part will calculate an actual cost per good unit completed during each month, the target cost per unit, and a variance. The new accountant provided the following additional information concerning the performance report: The first part of the report concentrates on units started because many units are scrapped in the manufacturing process (to maintain high quality). Therefore, the best measure of effort expended is the number of units on which work was begun. The target number of units to be begun in a month is the number of units started in the corresponding month last year plus 5 per cent. In the second part of the report, actual costs per unit will be calculated by dividing total production cost incurred during the month by the number of good units completed during the month. The target cost per unit is the average cost for manufacturing this kind of product as determined from industry newsletters. The proposal concluded with the following comments: ‘This report should be prepared and distributed quarterly. For maximum benefit I suggest that a bonus be awarded whenever units started exceeds target and costs are below target. This system will result in substantially improved profits for the entity. It should be implemented immediately.’ Required (a) Is it possible to develop a perfect system for monitoring and motivating worker performance? Why? (b) Explain what the managers might learn by monitoring each of the variances in the proposed performance measurement system. (c) Discuss possible reasons why the entity did not previously use a variance system to monitor and motivate worker performance. (d) Describe weaknesses in the proposed performance measurement system. (e) If you were the CFO of Benerux Industries, how would you respond to the new cost accountant’s proposal? Discuss whether you agree with the proposal and explain how you would communicate your response. (LO2 and 3)

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(a)

Managers cannot perfectly observe employee effort and abilities. Therefore, it is impossible to perfectly measure, monitor, and motivate employee performance.

(b)

The first part of the performance measurement system allows company managers to learn whether the company’s production levels this year are 5% higher than production levels during the same month of the prior year. The second part of the performance measurement system allows the managers to learn whether actual cost per unit is higher or lower than the average cost for manufacturing this kind of product as determined from industry newsletters.

(c)

In companies that value quality, price and efficiency variances may not be as important as information about quality. If the company’s strategy is to be the highest quality manufacturer, and the market is willing to pay more for higher quality, the company may emphasise quality and may not emphasise cost control and efficiency.

(d)

The proposed performance measurement report suffers from several major weaknesses. • It concentrates on the wrong goals — quantity and cost. The entity has

achieved its success through quality. • The volume measure is susceptible to easy manipulation. Production

employees could presumably start a large number of units with virtually no effort. This would increase the amount of WIP on hand and increase inventory carrying costs. • The performance standard on quantity is arbitrary (5% increase). It seems

unrelated to sales and may encourage the accumulation of excess inventory. • The performance standard for cost is incorrect. The entity is producing a higher

quality product than other entities in the industry. Consequently, the entity should expect higher costs than other entities. • Even if the reports were appropriate, a quarterly report is unlikely to provide

sufficiently timely feedback to allow workers to adjust their performance to achieve budgeted goals. • Workers are likely to resent the new system and could then leave the company,

requiring increased costs in training and reduced productivity. (e)

There is no single answer to this question. However, the answer should contain a synthesis of the issues discussed in the preceding sections, and it should also address concerns about responding in a productive way to the new accountant. The following major areas should be addressed: • A summary of what the proposed system would measure (Part B) and the weaknesses in the proposal (Part D), followed by a conclusion about whether the CFO would support the proposal. Most likely, the CFO would not be in favour of the proposal because it focuses on inappropriate measures. • A discussion of whether a new performance measurement system would be useful for this company. This discussion would address possible reasons why variances are not currently used (Part C), followed by a conclusion about whether some type of new performance measurement system should be considered. One possible conclusion would be that no apparent reason

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currently exists to make a change. The company’s current control system seems to be working fine, so there may be no reason to consider changing it. An alternative conclusion might be that it would be useful for the company to investigate possible alternative performance measures. Even if the company’s system is working fine, there may be ways to improve it or to prevent unforeseen future problems; a performance measurement system might be useful. • Identify ways to respond to the new accountant. The response should be positive so that it encourages the accountant to continue to think creatively and to share new ideas. The response is also a learning opportunity for the new accountant. The CFO could discuss the proposal with the cost accountant and ensure that the accountant understands the proposal’s flaws. They could then discuss ways to improve upon the ideas in the proposal.

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Management accounting th 4 edition

by Eldenburg et al. Prepared by Judy Oliver

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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23.1 Chapter 11: Variance analysis: revenue and cost 24

25 Questions 11.1

Discuss the three variances that help explain the sales volume variance. (LO2)

The sales quantity (volume )variance reflects the difference between the standard and actual quantity of units sold at the standard selling price. The sales volume variance can be further explained by: 1. The market size variance – provides an indication of the proportion of the sales volume variance that can be attributed to unexpected changes in market size 2. The market share variance – provides an indication of the proportion of the sales volume variance that can be attributed to changes in the market share. 3. The product mix variance - provides an indication of changes in contribution margin caused by selling in a different mix from the planned mix of products.

11.2

Identify four revenue drivers. (LO2)

Revenue drivers relate to attributes of either the organisation or its external environment that can influence the level of sales achieved. Four revenue drivers could be: 1. market share 2. brand Strength 3. competition 4. customer satisfaction. 11.3

Why is the efficiency variance more useful for control purposes than the

price variance? (LO4 and 6) The price variance is dependent on negotiations with outside parties. However, the efficiency variance relates to the use of the factors of production which would be in the control of those within the organisation.

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11.4 Explain how accountants and managers decide which cost variances to monitor. (LO1, 4 and 6) The cost categories that are measured and monitored in a given organisation depend on several factors, including the following: • Nature of goods or services: Manufacturers monitor input prices and efficiency of labour and materials, whereas service organisations monitor cost per service provided, which may not include materials. All organisations monitor fixed costs, although the type of fixed costs varies widely with the type of business. • Cost accounting system used: The cost categories will be more precise with more complex cost accounting systems. An organisation with an ABC system that separates costs into flexible and committed categories could develop standards and measure variances for every activity performed. Alternatively, only broad categories may be tracked, such as the traditional direct materials and direct labour categories. • Costs that managers consider important: Overhead costs are often aggregated together and include indirect costs such as oil for machine maintenance. While these costs may not be individually important, they are often monitored as part of the larger category of overhead costs. • Cost/benefit trade-off for monitoring individual costs: For those costs already reported by the accounting system, such as direct labour in a job costing system, the cost to develop standards and monitor variances is probably low, and the benefit could be relatively high if such monitoring encourages labour to be more efficient. However, other costs, indirect materials used during set-ups, may be expensive to track. The benefit from tracking these costs may be low if only very small amounts of materials are used per set-up. These costs are likely to be aggregated into overhead.

11.5

Discuss why the variable overhead spending variance does not just focus on price. (LO5 and 6)

The variable overhead spending variance relates to both the use of actual overhead resources and the price paid for these resources.

11.6

How might the production volume variance encourage excess production? (LO5 and 6)

In order to achieve a favourable production volume variance the production manager would need to produce more than the budgeted volume – this obviously would encourage excess production.

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11.7

Discuss the ‘bookkeeping’ role of standard costing and its performance role. (LO4 and 6)

Bookkeeping role – as all costs in WIP are recorded at standard the variances enable the debits to equal the credits. Performance role – comparison of the expected usage and costs (standard cost) against the achieved usage and costs (actual cost) – this allows the performance to be evaluated. 11.8

Explain why variances for direct material and direct labour are separated into price and efficiency variances. (LO4)

Managers need information about the costs of direct materials and direct labour as well as whether direct materials and labour have been used efficiently. If the price and efficiency variances are combined, it is impossible to separate the causes of the variance into potential changes in prices of direct materials (or the labour hourly wage) and changes in the amount of materials (or labour hours) used to manufacture the product. Managers need specific information to better monitor operations and investigate changes.

11.9

Suppose that utilities are considered a fixed cost for a retail clothing outlet. Why might we expect a variance to occur for the cost of utilities? (LO6)

Utilities are considered fixed costs. These include phone service, natural gas and electricity. The use of natural gas and electricity is affected by weather patterns. Because weather patterns change, these costs cannot be perfectly predicted. There may be unanticipated price changes in the cost of utilities. In addition, employees could be careless in their use of electricity or telephones. Therefore, variances occur regularly.

11.10 Explain why the variance accounts need to be closed at the end of the period. (LO7) GAAP requires that revenues and expenses be matched. Revenues from the sales of units must be matched to the costs of producing those same units. When a standard cost system is used, production costs are recorded at standard rather than at actual costs. At the end of the accounting period adjusting entries are made to close the variance accounts and to distribute the amounts to inventory and cost of goods sold. These entries simultaneously close the variance accounts and adjust inventory and cost of goods sold to reflect actual costs for the period.

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11.11 Fly-a-Kite Company manufactures a variety of kite kits. You have been asked by the production manager to prepare a simple but meaningful variance report for product costs so that she can identify areas in need of improved cost control. List all of the variances you would present in the variance report for production costs and explain why each is useful. (LO1) For a simple but meaningful variance report for costs, the following variances should be calculated. • Price and efficiency variances for direct materials and direct labour provide information about price changes, purchasing efficiencies and the use of materials. Managers can correct some of these problems to insure cost-effective production. • The variable overhead spending variance and the fixed overhead budget variance provide information about whether costs are being kept under control. • The efficiency variance for variable overhead and production volume variances do not provide any incremental information about whether inputs were purchased or used efficiently.

11.12 Identify the common variances that are needed to reconcile the accounting records at the end of the period for a manufacturing entity. How are these variances treated at the end of the period if the total variance is immaterial? How are they treated if the total variance is material? (LO1, 4, 5 and 7)

At the end of the accounting period, the following variances need to be recorded: direct materials and direct labour price and efficiency variances, variable overhead spending variance, fixed overhead budget variance, variable overhead efficiency variance, and production volume variance. If the sum of these is immaterial, it is closed to cost of goods sold. If the sum is material, it is prorated across inventory and COGS. However, note that AASB102 Inventories does not allow the variances relating to over/underapplied overhead to be prorated between the cost of sales and inventory for external reporting purposes. All such variances are recognised as an expense. However, a business has the choice to change this for internal reporting purposes particularly if the variances are significant.

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11.13 Discuss factors that affect accountants’ decisions to investigate the reasons for variances. (LO4 and 6) Managers monitor variances that are large and unexpected. Sometimes a minimum dollar amount is set as a criteria so that only variances greater than that amount are investigated. Managers make trade-offs between the costs of investigating and the benefit from improving the process or standard. Trends in variances also may affect whether a variance is investigated. If accountants know a variance is increasing over time, they may decide to investigate to identify ways to reverse a negative trend or to modify future standards for a positive trend.

11.14 Suppose the direct materials price variance is large and favourable, and the direct materials efficiency variance is large and unfavourable. What questions would you be likely to ask when investigating these variances further? (LO5) When the direct materials price variance is large and favourable while direct materials efficiency variance is large and unfavourable, it is possible that lower quality materials are being purchased. This could have a negative effect on the efficiency variance if defective materials are being discarded. Both purchasing and production personnel should be asked whether there has been a change in the quality of materials purchased. Production personnel should also be asked to explain the unfavourable efficiency variances.

11.15 Why are direct materials price variances usually recorded at the time of purchase? (LO3) If the direct material price variance is recorded at the time of purchase, direct materials are recorded in inventory at standard cost and do not need to be tracked by purchase date and purchase price. This reduces bookkeeping time and effort and simplifies inventory control. It also clarifies that the price variance occurs at the time of purchase rather than at the time direct materials are used. This also allows any action in relation to the variance to be taken sooner rather than later.

11.16 A favourable variance is always good news and an unfavourable variance is always bad news. Discuss. (LO1) Whether a variance is good news or bad news depends on the item being analysed. For example – a favourable material price variance may indicate poor quality material which could cause problems in the production process. This could lead to an unfavourable labour efficiency variance. However, this would be due to the employees having to take more time to deal with the inferior materials.

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11.17 Briefly explain why actions by the material purchasing manager can cause unfavourable labour efficiency variances for the production manager. (LO4) By the purchase of lower quality material – this may cause problems in the production process and lengthen the processing time.

11.18 What is the cause of an unfavourable volume variance? (LO5) 26 The difference between the standard amount of fixed overhead cost allocated to products and the estimated fixed overhead costs is called the production volume variance. When actual volumes of the allocation base are less than normal volumes, fixed overhead will be underapplied and the variance will be unfavourable. 27 11.19 Recently the Victorian Government introduced a solar rebate of $2500 for eligible home owners. How might such an initiative impact on the budget variances for a business that installs solar panels given the rebate was announced halfway through the financial year? (LO2)

The introduction of the solar rebate would likely have a significant positive impact on the demand for the services of businesses which install solar panels. As such, actual sales volumes would likely to be much higher than what might have been reasonably anticipated at the start of the year. This would create a positive sales quantity variance. This new initiative, however, would not likely impact the sales price variance. This is because the rebate would not impact the price charged by solar panel installers and this variance is calculated using the actual volume: Sale price variance = (Actual Price – Standard Price) x Actual Volume

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28 Exercises 11.20 Revenue Variances LO2 Sunset Solar installs solar panels throughout Australia. The accountants estimated the market size to be 2 million solar panels with Sunset Solar hoping to achieve 5% market share. The static budget shows that each panel is expected to provide a $2000 contribution margin. At the end of the financial period, the actual sales volume was 90 000 panels. Management were surprised by the low sales volume especially given that analysts had identified that the market size had grown by 2% due to government rebates on solar panel installation. Required (a) Calculate the actual market size. (b) Calculate the actual market share. (c) Calculate the market size variance. (d) Calculate the market share variance. (e) Identify several factors that could have caused the variance identified in (d). (LO2) (a) The actual market size has grown by 2% from 2 million to 2.04 million: Original market estimate Change in market Actual market size (2 million x 1.02)

2 000 000 panels 2% 2 040 000 panels

(b) Solar Panel’s sales of 90 000 panels represents an actual market share of 4.41%:: Sunset Solar sales volume Actual market size Sunset Solar actual market share (90 000 ÷ 2 040 000 panels)

90 000 panels 2 040 000 panels 4.41%

(c) Market size variance = Change in market size x Budgeted market share x Planned average contribution margin = 40 000 x 5% x $2 000 = $4 000 000 favourable Where: Change in market size = Actual market size – Budgeted market size = 2 040 000 – 2 00 000 = 40 000

(d) Market share variance = Actual market size x Change in market share x Planned average contribution margin = 2 040 000 x (0.0441 – 0.05) x $2 000 = $24 072 000 unfavourable

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(e) The unfavourable market share variance could have been impacted by a number of factors: • Sunset Solar may not have had sufficient additional capacity to take on any new customers resulting from the impact of government rebates. • New solar panel installers may have entered the market. • Sunset Solar may have lost market share to other existing solar panel installer competitors who may have had branding, price, quality or other competitive advantages relative to Sunset Solar.

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11.21 Direct labour variances Following is information about Pine Furniture’s direct labour hours and wages last period.

Required (a) Calculate the direct labour efficiency variance. (b) Calculate the direct labour price variance. (LO3) (a) Direct labour efficiency = $1680 - $1750 = $70 favourable (b) Direct labour price variance = $1752 - $1680 = $72 unfavourable

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11.22 Direct material variances The Neon Manufacturing Company is a joint venture between Australian and Chinese firms with an assembly plant located in Beijing. The company’s managers expected to produce 20 000 units of product in March. The standard cost for the materials used for 20 000 units is 173 600 yuan, and the standard cost per unit is 2.80 yuan per kilogram. Actual production in March was 19 100 units. The company purchased and used 57 300 kilograms of materials costing 163 305 yuan. Required (a) What was the standard quantity of kilograms per unit? (b) What was the direct materials efficiency variance for March? (c) What was the direct materials price variance for March? (LO3) (a) Standard quantity of kilograms per unit is calculated by dividing the total standard cost by the expected number of units to determine the cost per unit then divide by the 2.80 yuan to determine the number of kilograms. 173600 yuan / 20 000 units = 8.68 yuan per unit / 2.80 yuan per kg = 3.1 kg per unit (b) Direct material efficiency variance =

(actual quantity used for actual output – standard quantity allowed for actual output) x standard price. (57300 kgs – (19100 units x 3.1kgs)) x 2.80 yuan = 5348 yuan favourable The variance is favourable as less material was used than expected. (c) Direct material price variance = (Actual price – Standard price) x quantity purchased ((163 305 yuan / 57300 kgs) – 2.80) x 57300 kgs = 2865 yuan unfavourable Price paid of 2.85 yuan per kg is higher than expected price of 2.80 yuan

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11.23 Fixed overhead variances, solve for unknown South Clinic charges its patients on the basis of actual direct costs incurred plus fixed costs at the rate of $40 per hour. The fixed cost rate of $40 per hour is based on the assumption of 6000 patient hours monthly, assuming that each patient requires half an hour. During September, 12 400 patients were seen and the following costs were recorded.

Required (a) How many patient hours were recorded? (b) What was the budgeted fixed cost? (c) What was the production volume variance? (d) What was the actual fixed overhead? (LO5) (a) Given 12400 patients seen this would equal 6200 patient hours (12400 patients x 0.5). (b) The budgeted fixed costs was $240 000 ( 6000 patients hours x $40). (c) Volume variance is $8000 favourable = $240 000 budgeted - $248000 allocated. Reconciliation, due to 400 more patients being seen, as each patient is assumed to take half an hour this is 200 hours x $40 per patients hour . (d) the actual fixed overhead was $264000 = budgeted cost + unfavourable spending variance ($240 000 + $24 000).

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11.24 Fixed and variable overhead variances Glen’s Landscaping Supplies uses a standard costing system to allocate overhead costs. The accountant estimated 8500 hours as the volume to develop standard overhead rates. Budgeted costs were $19 125 for fixed overhead and $15 300 for variable overhead. The following results were reported.

Required (a) Calculate the spending variances for fixed and variable overhead. (b) Calculate the overhead allocation rates for fixed and variable overhead. (c) Calculate the production volume variance for fixed overhead. (d) Calculate the efficiency variance for variable overhead. (LO5) (a) Spending variance Variable overhead: $14000 – (8200 hours x ($15300 / 8500) = $760 favourable Fixed overhead $19000 - $19125 = $125 favourable b. Overhead allocation rates Variable: $15300 / 8500 hours = $1.80 Fixed: $19125 / 8500 hours = $2.25 c. Production volume variance 8300 hours x $2.25 = $18675 applied $19125 budgeted => volume variance = $450 unfavourable Reconcile: standard hours 200 less (8500 – 8300) x $2.25 = $450 d. Variable overhead efficiency variance 8200 hours x $1.80 = $14760 (actual hours x std overhead rate) 8300 hours x $1.80 = $14940 applied =>efficiency variance = $180 favourable

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11.25 Direct labour variances and overhead spending variance The following data for Kitchen Tile Company relates to the production of 18 000 tiles during the past month. The entity allocates fixed overhead costs at a standard rate of $19 per direct labour hour.

Required (a) How many actual labour hours were worked to produce the 18 000 tiles? (b) What is the price variance for direct labour? (c) What is the budget variance for fixed costs? (LO3 and 6) (a)

This question requires a missing piece of information: the actual number of hours worked. However, because the labour efficiency variance is given, the variance formula can be used to solve for actual labour hours as follows: Labour efficiency variance = (Standard hours – Actual hours) × Standard price The variance amount is given as $6720 Favourable, and the standard labour price is given as $24.00 per hour. The number of standard labour hours is calculated as follows: Actual production = 18 000 tiles Standard efficiency is 6 tiles per labour hour Standard number of labour hours for 18 000 tiles: = 18 000 tiles/6 tiles per hour = 3000 hours Now solve for actual labour hours using the variance formula: $6720 = $24.00 × (3000 hours – Actual hours) $6720/$24 = 3000 – Actual hours 280 = 3000 – Actual hours Actual hours = 3000 – 280 = 2720 Quicker approach: The efficiency variance represents the amount by which actual hours exceed standard hours, times the standard price. This means that the efficiency variance represents 280 hours ($6720/$24). Because the variance was favourable, 280 fewer hours were used than the standard required. For

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18 000 tiles, standard labour hours are 3000 (18 000/6). Therefore, actual hours are 3000 – 280 = 2720 hours. (b)

The direct labour price variance is calculated using the following formula: Actual labour hours × (Actual price – Standard price) = 2720 hours × ($24.50 – $24.00) = $(1360) Unfavourable

(c)

The fixed overhead budget (i.e. spending) variance is calculated by simply taking the difference between standard and actual fixed costs: Actual fixed costs –Standard fixed costs = $58720 - $60 000 = $1280 Favourable

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11.26 Direct materials and labour variances, variances to investigate The managers of Bathroom Cabinets established the following standards for Model 535:

Last month, 15 342 units of Model 535 were produced at a cost of $26 870 for direct materials and $47 000 for direct labour. A total of 13 252 kilograms of direct materials was used. Total direct labour hours amounted to 2730 hours. During the same period, 110 000 kilograms of direct material were purchased for $273 000. The entity’s policy is to record materials price variances at the time materials are purchased. Required (a) What is the total standard cost for direct materials and direct labour for the output this period? (b) What was the direct materials price variance? (c) What was the direct materials efficiency variance? (d) What was the direct labour price variance? (e) What was the direct labour efficiency variance? (f) Identify any variances that are material (greater than 10 per cent of total direct cost at standard). Discuss whether you would investigate these variances. (LO3, 4 and 7)

(a)

Standard costs for actual output of 15 342 units: Direct materials (15 342 units × 0.8 kg × $2.00/kg) Direct labour (15 342 units × 0.2 hr × $17.00/hour) Total Direct materials price variance Actual cost of purchases $273 000 Standard cost for actual purchases ($2.00/kg × 110 000 kg) Price variance

$24,547.20 52 162.80 $76 710.00

(b)

220 000 F 53000 U

(c)

Direct materials efficiency variance Actual quantity of materials used 13 252.0) kg Standard quantity of materials for actual output (15 342 × 0.8 kg) 12 273.6) kg Variance in kilograms (978.4) kg Times standard cost per kilogram $2 Efficiency variance $(1 956.80) U

(d)

Direct labour price variance Actual labour cost Standard cost for actual labour hours ($17 × 2730 hours) Price variance

47 000U $46,410 U $ (590) U

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(e)

(f)

Direct labour efficiency variance Actual labour hours Standard labour hours for actual output (15 342 × 0.2 hours) F Variance in hours Times standard cost per hour Efficiency variance

2 730.0 3 068.4 F 338.4 hours $17 F $5 752.80 F

If managers use 10% of total direct costs as the criteria for investigation, then the only variance requiring investigation is the direct material price variance of $53000 unfavourable.. In addition the direct labour efficiency variance is relatively large compared to total direct labour cost at 11% ($5752.80/$52 162.80). Some managers may want to investigate this variance, especially if this company is concerned about quality as a strategy. If quality has decreased as a result of this favourable variance, defective or low quality units could affect Nakatani’s reputation and future revenues if customers are disgruntled. If production processes have improved, and there is no adverse change in quality, so managers might want to change the labour quantity standard.

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11.27 Direct materials and direct labour variances, journal entries

The following information pertains to Nell Company’s production of one unit of its manufactured product during the month of June. The company recognises the materials price variance when materials are purchased.

Required (a) Calculate the price and efficiency (quantity) variances for materials and labour. (b) Record the journal entries for purchase and use of direct materials and the journal entries for direct labour. (LO3) (a)

Direct material price variance [($0.17 – $0.20) × 100 000] Direct material efficiency variance [(5 × 10 000 – 60 000) × $0.20] Direct labour price variance [($7.20 – $7.00) × 3,900] Direct labour efficiency variance [(0.4 × 3900 – 1000000) × $7.00]

$3000 F 2000 U 780 U 700 F

(b)

Journal entries: Raw materials inventory (100 000 kg at $0.20/kg) Direct materials price variance Accounts payable

$3 000 $17 000

$20 000

Work in process inventory (5×10 000×$0.20) Direct materials efficiency variance Raw materials inventory (60 000 × $0.20)

$10 000 $2 000

Work in process inventory (0.4×10 000×$7.00) Direct labour price variance Direct labour efficiency variance Wages payable (3900 × $7.20)

$28 000 $780

$12 000

$700 $28 080

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11.28 Variable and fixed overhead variances, journal entries

Derf Company allocates overhead on the basis of direct labour hours. Two direct labour hours are required for each unit of product. Planned production for the period was set at 9000 units. Manufacturing overhead is estimated at $135 000 for the period (20 per cent of this cost is fixed). The 17 200 hours worked during the period resulted in the production of 8500 units. Variable manufacturing overhead cost incurred was $108 500 and the fixed manufacturing overhead cost was $28 000. Required (a) Determine the variable overhead spending variance. (b) Determine the variable overhead efficiency (quantity) variance. (c) Determine the fixed overhead spending (budget) variance. (d) Determine the production volume (fixed overhead volume or denominator) variance. (e) Prepare journal entries to close these variances at the end of the period. (LO5, 7) Standard fixed overhead is $135 000 × 0.20 = $27 000 Standard variable overhead is $135 000 × 0.80 = $108 000 The standard fixed overhead allocation rate is $27 000/(9000 × 2) = $1.50 per hour The standard variable overhead allocation rate is $108 000/(9000 × 2) = $6.00 per hour (a)

The variable overhead spending variance is: [$6.00 – ($108 500/17 200)] × 17 200 = $5300 U

(b)

The variable overhead efficiency variance is: [8500 × 2 – 17 200] × $6 = $1200 U

(c)

The fixed overhead spending (budget) variance is: $28 000 – $27 000 = $1000 U

(d)

The fixed production volume variance is: $1.50 × [(9000 × 2) – (8500 × 2)] = $1500 U

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(e)

Journal entries Variable overhead cost control (actual cost) Accounts payable and other accounts

$108 500 $108 500

Work in Process inventory (8500 × 2 hr × $6/hr) Variable overhead cost control

102 000

Variable overhead spending variance Variable overhead efficiency variance Variable overhead cost control

$5 300 $1 200

Fixed overhead cost control Accounts payable and other accounts

$28 000

WIP inventory (8500 × 2 × $1.50) Fixed overhead cost control

$25 500

Fixed overhead spending (budget) variance Production volume variance Fixed overhead cost control

$1 000 $1 500

Ending WIP, finished goods and/or COGSa Variable overhead spending variance Variable overhead efficiency variance Fixed overhead spending (budget) variance Production volume variance

$9 000

102 000

$6 500

$28 000

$25 500

$2 500

$5 300 $1 200 $1 000 $1 500

The total variance of $9000 would be prorated based on the ending balances in work-in-process inventory, finished goods inventory, and cost of goods sold.

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11.29 Direct cost and overhead variances; decision to automate Plush pet toys are produced in a largely automated factory in standard lots of 100 toys each. A standard cost system is used to control costs and to assign cost to inventory.

The entity’s policy is to record materials price variances at the time materials are purchased. Required (a) Calculate the commonly used direct cost and overhead variances. (b) Management is considering further automation in the factory. Robotcontrolled forklifts could reduce the standard direct labour per lot to 1.5 hours. (i) Estimate the savings per lot that would be realised from this additional automation. (ii) Assume the company would be able to generate the savings as calculated. Considering only quantitative factors, calculate the maximum price the managers would be willing to pay for the robot-controlled forklifts. Assume the company’s management requires equipment costs to be recovered in five years, ignoring the time value of money. (LO3, 4, 5 and 6)

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(a)

Direct materials variances: Direct material price variance = $62 000 - ($2.00 per metre ×30 000 metres) = $62 000 – $60 000 = $2000 unfavourable because the company paid more than standard Direct material efficiency standard = 15 metres per lot × 2400 lots – 34 000 metres) × $2.00 per metre = (34 000 metres – 36000 metres) × $2.00 per metre = $4000 favourable because the company used fewer metres than at standard Direct labour variances: Direct labour price variance = $39 000 – ($10 per hours × 4200 hours) = $39 000 – $42 000 = $3000 favourable Direct labour efficiency variance = (4200 hours - 2 hr per lot × 2400 lots) × $10 per hour = (4200 hours – 4800 hours) × $10 = $6000 favourable because the company used fewer hours than at standard Variable overhead spending variance = ($12 000 - $5 per lot × 2400 lots –) = $12 000 – $12 000 = $0 There is no spending variance for variable overhead. Fixed overhead budget variance = $24 920 – $24 000 = $920 unfavourable because the company spent more than standard The preceding are the commonly used variances for cost control. Some organisations also calculate and monitor the following variances: Variable overhead efficiency variance = [(2400 lots – 1000 lots) × $2] = $2800 unfavourable because the company allocated more overhead than at standard

Production volume variance Given that fixed overhead is allocated using the following rate: $24 000/1000 = $24/lot = [(2400 lots – 10000 lots) * $24/lot] = $33 600 favourable because lots were produced than expected

(b)

Reduction in labour hours (2.0 hours – 1.5 hours)

0.5 hours per lot

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Times cost per hour Cost savings per lot 2.

$10 per hour $5.00 per lot

Cost savings per month = (1000 lots × $5.00 per lot) = $5000 Cost savings over 5 years = ($5000 per month × 60 months) = $300 000 The maximum price the company would be willing to pay for the new equipment is $300 000. This is equal to the expected labour cost savings over 5 years (ignoring the time value of money).

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11.30 Journal entries for closing variances Following are the variances for Fine Products Manufacturing Company for the month of March. Assume that the price variance for direct materials is calculated at the time of purchase and that the amount of direct materials purchased is equal to the amount of direct materials used, with no beginning or ending inventories for direct materials.

Fine Products considers anything greater than $5000 as a material variance. Following are end of period inventory balances.

Required (a) Determine whether the total variance amount is material. (b) Prepare a journal entry to close the variances at the end of March. (LO7) (a)

Total variances = $7900 unfavourable. Because anything greater than $5000 is considered material, the total variance amount is material.

(b)

Total WIP, FG and COGS = $32 000. Each inventory and COGS account gets a portion of the variance: Work in Process ($2000/$32 000 × $7900) $ 494 Finished goods ($6000/$32 000 × $7900) 1 481 Cost of goods sold ($24 000/$32 000 × $7900) 5 925 Total $7 900 Journal Entry: Work in process inventory Finished goods inventory Cost of goods sold Direct materials efficiency variance Variable overhead spending variance

494 1 481 5 925 1 500 1 000

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Direct materials price variance Labour price variance Labour efficiency variance Fixed overhead budget variance Variable overhead efficiency variance

2 000 5 000 2 000 200 1 200

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11.31 Revenue variances The following data represents the flexible budget for Mountain Mist Brewery, a boutique brewery that manufactures and sells boutique ales.

Note that, overall, the increase in the final price of beer has contributed to the flattening of the Australian beer market. The budgeted market for beer sales in Australia was 1736 megalitres, but the actual market was 1730 megalitres. Required (a) Briefly explain the meaning of the $3.03 million contribution margin variance. (b) Calculate the market share and market size variances for Mountain Mist Brewery. (LO2) (a) This has been calculated by deducing the profit plan contribution margin ($59.85M) from the flexible budget contribution margin ($62.88M). This is a favourable variance as the planned level of sales of the boutique ales (54.6 megalitres) is higher than the planned level of sales (52.0) megalitres. (b) Market size variance = Change in market size × budgeted market share × planned average contribution margin (1730 megalitres – 1736 megalitres) × (52.0 megalitres / 1736 megalitres) × ($59.85M/52.0 megalitres) = -6 x .0299 x $1.15096M = $0.2064M U Therefore tells us that as the market size dropped the proportionate drop in contribution margin is $.2064 million

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Market share variance = Actual market size x change in market share x planned average contribution margin 1730 megalitres × (.0299 - .0315) × $1.1501M =1730 × -.00166 × $1.15096M =$3.18 F This tells us that given the actual market, there was an increase in the market share achieved which gave rise to an additional $1.99 million contribution margin.

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Problems 11.32 Revenue variances Consider the following information for Morgan’s Cheese and Butter Division.

Additional information:

Required (a) Calculate the market size and market share variances. (b) Comment on the meaning of your calculations (for example, how these help Cowabunga management evaluate performance). (LO2) (a) Market size variance Change in market size × budgeted market share × planned average contribution margin (65 000 000 kgs – 60 000 000 kgs) × (5 750 000 kgs/65 000 000kgs) × ($8 300 000 / $5 750 000) = 5 000 000 × .0884 x $1.443 =$637 806 U Market share variance Actual market size x change in market share x planned average contribution margin =60 000 000kgs × (.0884 – (5 500 000/60 000 000) × $1.443

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=60 000 000 kgs × (.0884 - .092) × $1.443 =60 000 000kgs × .0036 × $1.443 =$311 688 F (b) Market size variance indicates that as the market was smaller, based on our budgeted market share we would expect to have lost $637806 in contribution margin. While it could be possible, in most circumstances this variance is less likely to reflect managerial performance. The way Morgan’s management could contribute to increasing market size is with new product innovation that is not seen as a substitute to the existing product range. Extensive Morgan’s marketing campaigns may also contribute to increasing the market size. Market share variance: although the actual market size decreased, our market share percentage increased by .0036% which had the effect of increasing the contribution margin by $311 688. This reflects good performance which most likely would be attributed to Morgan’s management.

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11.33 Cost-volume-profit pricing and standard cost variances Fasteners Company has several divisions, and just built a new plant with a capacity of 20 000 units of a new product. A standard costing system has been introduced to aid in evaluating managers’ performance and for establishing a selling price for the new product. Fasteners Company currently faces no competitors in this product market. Managers price the product at standard variable and fixed manufacturing cost, plus 60 per cent mark-up. Managers hope this price will be maintained for several years. During the first year of operations, 1000 units per month will be produced. During the second year of operations, production is estimated to be 1500 units per month. In the first month of operations, employees were learning the processes, so direct labour hours were estimated to be 20 per cent greater than the standard hours allowed per unit. In subsequent months, employees were expected to meet the direct labour hours standards. Experience in other plants and with similar products led managers to believe that variable manufacturing costs would vary in proportion to actual direct labour dollars. For the first several years, only one product will be manufactured in the new plant. Fixed overhead costs of the new plant per year are expected to be $1 920 000 incurred evenly throughout the year. The standard variable manufacturing cost (after the break-in period) per unit of product has been set as follows:

At the end of the first month of operations, the actual costs incurred to make 950 units of product were as follows:

Fasteners Company managers want to compare actual costs to standard to analyse and investigate variances and take any corrective action. Required (a) (b)

What selling price should Fasteners Company set for the new product according to the new pricing policy? Explain. Using long-term standard costs, calculate all direct labour and manufacturing overhead variances.

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(e)

(f)

(g)

Is it reasonable to use long-term standard costs to calculate variances for the first month of operations? Why? Revise the variance calculations in part (b), using the expected costs during the first month of operations as the standard costs. Provide at least two possible explanations for each of the following variances: (i) direct labour price variance (ii) direct labour efficiency variance (iii) variable overhead spending variance (iv) fixed overhead spending variance The reasons for variances must be identified before conclusions and actions are decided upon. For two of the variance explanations you provided in part (e), explain what action(s) managers would most likely take. Would it most likely be easier or more difficult to analyse the variances at the new plant compared to Fasterners Comanpy’s other plants? Explain.

(LO3, 4, 5 and 6)

(a)

The problem states that management wants to maintain the selling price for several years, so the assumption is made that long-run standard costs will be used for pricing, rather than the expected costs during start up. Standard cost per unit Direct materials Direct labour Variable overhead Fixed overhead (a) Total Markup Selling price

4 pieces @ $20 10 hours @ $25 50% × $250 42.666% × $250 60% × $562

$ 80 250 125 107 562 337 $899

After start up, the entity will produce 1500 units per month or 18 000 per year. The budgeted labour costs for 18 000 units is 18 000 × $250 = $4 500 000. Using the same basis to allocate fixed overhead as is used to allocate variable overhead yields a fixed overhead rate of $1 920 000/$4 500 000 = 42.666% of labour cost. (b)

The variances for product costing purposes using the long-term standards would be Labour price variance (actual price - standard price ) × actual hours = ($26 – $25) × 12 000 = $12 000 U Labour efficiency variance (actual quantity - standard quantity for actual output ) × standard price =[12 000 - (10 × 950) ] × $25 = $62 500 U For product costing purposes, the overhead variances would be as follows (note that overhead is based on labour cost, not hours):

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Variable overhead spending variance = actual variable overhead - actual allocation base (labour cost) at standard rate = [$160 250 - (50% × $312 000) = $4250 U Fixed overhead budget variance actual fixed overhead - Static budget for fixed costs (budgeted fixed overhead per month) = [$172 220 - ($1 920 000/12 –] = $172 220 - $160 000 = $12 220 U Variable overhead efficiency variance = actual allocation base at standard rate - standard allocation base at standard rate = (actual labour cost - standard labour cost ) × standard variable rate = [$312 000 - ($25 × 10 hours × 950 units) ] × 50% = $37 250 U Production volume variance = Standard allocation base at standard rate (allocated cost) – estimated allocation base at standard rate (static budget) = (Standard labour cost for actual output – standard labour cost for estimated output) × standard rate = [($25 × 10 hours) × (950 units – 1,500)] × 0.42666 = ($237 500 – $375 000) × 0.42666 = $58 666 U (c)

Here are some pros and cons for using the long-term standard for the first month’s operations. Pros: • The accounting department performs the calculations they will use for the next year, and personnel will gain experience with the new system • The variances will reflect the results of the long-term standard and give workers a more accurate picture of the gaps in their performance • Using the long-term standard may highlight areas with very large variances that are likely to have larger variances over the next few months Cons: • Workers may be discouraged when their performance is compared to such high standards • The standard will not be viewed as realistic, and so may be ignored causing poorer performance in the first few months than otherwise • Information about variances from these standards is of poor quality and cannot be used reliably for planning or monitoring

(d)

The short term standards do not affect the labour price variance. It remains the same as above: Labour price variance = (actual price - standard price –) × actual hours = ($26 – $25) × 12 000 = $12 000 U

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However, a substantial portion of the labour efficiency variance was anticipated. That is, management expected it to take 10 × 1.2 = 12 hours per unit during the first month of operations. The following variance better reflects performance. Labour efficiency variance = [12 000 - (12 × 950) ] × $25 = $15 000 U The overhead spending and budget variances are probably unaffected by the learning curve experienced by labour. Therefore, they are the same as in part B, as follows. Variable spending variance = Actual allocation base (labour cost) at standard rate – actual variable overhead = [$160,250 - (0.5 × $312 000) = $ 4 250 U Fixed overhead budget variance = actual fixed overhead = static budget fixed costs (budgeted fixed overhead per month) – = [$172 220 - ($1 920 000/12 ] = $172 220 - $160 000 = $12 220 U The following variances are used as adjusting entries in the accounting records. It may be more appropriate for these variances to reflect the expected short-term performance as well. Therefore they could be calculated as follows. Variable overhead efficiency variance = [$312 000 - ($25 × 12 × 950) ] × 0.5 = $13 500 U Production volume variance = [($25 × 12 × 950) – ($25 × 12 × 1000)] × 0.5333 = ($285 000 – $300 000) × 0.5333 = 8000 U Where the adjusted fixed overhead rate is calculated as: Monthly fixed overhead = $1 920 000/12 = $160 000 Anticipated labour costs = ($25 × 12 × 1000) = $300 000 Rate based on anticipated activity = $160 000/$300 000 = 53.33% (e)

Following are several possible reasons for the variances. Students may think of others. (i)

Direct labour price variance: Because labour used more hours, overtime may have been paid. In addition, it is possible that workers with higher skill levels were hired. It is also possible that the standard is too low, that labour rates increased during the month.

(ii) Direct labour efficiency variance: The standard may be wrong because workers have so little experience at this new plant, the company may still be experiencing a learning curve, or labour may be working inefficiently for some reason such as lack of training, high absenteeism, or just low productivity. (iii) Variable overhead spending variance: Because this was the first month, it is possible that some costs were higher than anticipated. For example, the company may expect to receive volume discounts on indirect materials, but

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does not earn them until order sizes become as large as anticipated. Indirect labour may have had to work extra hours and received overtime pay. There may have been more maintenance on machines than anticipated during the start-up period. (iv) Fixed overhead budget variance. It is possible that utilities were higher than anticipated due to season or weather-related factors. The standard may be too low because accountants did not anticipate all of the fixed costs. Some periodic costs such as taxes or insurance may have been paid this month. (f)

Managers respond to variances according to the results of their investigations. If they find the standard is wrong, they change the standard. For example, it is likely that some of the standards at Fasteners Company will need adjusting as the company obtains more experience with the new product. If managers find that operations are out of control, they will monitor operations more closely and ask employees for suggestions to improve performance. If managers realise that the variances for this month are based on long-term standards, they may do nothing because they believe that over the next few months the variances will disappear. If managers discover that labour variances are related to employee turnover or absence, they may use compensation incentives based on attendance or longevity to improve this aspect of operations. However, increasing compensation will also increase labour costs, so the costs and benefits of these types of alternatives need to be analysed. Students may have thought of a number of different ways that managers respond to the variance information.

(g)

Because uncertainties exist about the appropriate amount for standards, it would probably be more difficult to analyse the variances at the new plant. It will take a number of months before production at the new plant becomes stable. At that time it will be easier to set standards because accountants will know more about regular operations, and most of the learning will have taken place, so results are less likely to be affected by learning curves.

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11.34 Cost variances; variance analysis; employee motivation Raging Sage Coffee is a franchise that sells cups of coffee from a cart in shopping centres. A computerised standard costing system is provided as a part of the franchise package. A portion of the standard cost data follows.

In its first month of operation, the Launceston franchise recorded the following data:

The entity’s policy is to record materials price variances at the time materials are purchased. Required (a) Are direct labour hours for the cart most likely fixed or variable? Explain. (b) Given your answer to part (a), should a direct labour efficiency variance be calculated? Why? (c) Calculate the direct materials price and efficiency variances. (d) How many cups of coffee did the franchise owners expect to sell this period? Compare this estimate to the amount actually sold. (e) Provide possible explanations for the drop in sales. (f) Suppose the clerks/brewers currently receive a bonus based on their ability to control costs as measured using cost variances. Recommend a bonus system that might help the owners contain costs but also increase sales. (LO3 and 4) (a)

For a coffee cart business, workers are scheduled with more help available when the shop is busy, such as in the morning. Although each worker’s hours vary, the schedule remains fairly fixed, so the cost structure includes a high proportion of fixed cost.

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(b)

In this business, workers need to be at the cart regardless of the number of customers. Therefore, the direct labour efficiency variance is meaningless and should not be calculated because it would be measuring whether the clerks sold as many cups of coffee per labour hour as was expected. Labour costs are fixed, so the computation would reflect a revenue variance, rather than a labour efficiency variance.

(c)

Price variance for coffee beans: Actual cost of coffee beans purchased 1800 U Standard cost of actual coffee beans purchased (240 kg × $6.00 per kg) $1440 U Price variance $(360) U Efficiency variance for coffee beans: Actual beans Coffee beans at standard lbs. (0.04 kg per cup × 8260 cups) Variance in kilograms Standard cost per kilogram Efficiency variance

(d)

224.00 kg 330.40 kg 106.40 kg $6.00 U $638.40 F

The quantity standard for direct labour implies that 20 cups should be sold per hour of clerk/brewer time: 0.05 hours per cup × 60 minutes per hour = 3 minutes per cup In 60 minutes, 20 cups are expected to be made and sold Expected sales volume (600 clerk/brewer hours × 20 cups per hour) 12 000) cups Actual sales volume 8 260) cups Difference between expected volume and actual volume (3 740) cups

(e)

There is an unfavourable coffee bean price variance, a favourable coffee bean efficiency variance, and sales were off by about 32% (3740 cups/12 000 cups). These variances might be related. One possibility is that the higher cost of coffee beans caused the clerks/brewers to reduce the quantity of coffee beans used per cup. This would have resulted in weaker coffee, which might have caused customers to go elsewhere. The following are other possible explanations for the unfavourable sales volume variance: • A competing coffee business opened nearby. • A nearby employer went out of business or launched a major lay-off of employees. • There was employee turnover. A clerk/brewer who was well-liked by customers left and was replaced by a clerk/brewer who was often impolite to customers. • There was road construction nearby, disrupting traffic to the shopping centre. • Nearby competitors decreased their selling prices.

(f)

Instead of basing a bonus based on cost variance measures, give employees a bonus based on profitability. This provides them motivation to encourage customers to return, increasing revenue and also to contain costs.

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11.35 Cost standards; cost variances; improving cost variance information Sunglass Guys produces two types of wraparound sunglasses on one assembly line. The monthly fixed overhead is estimated at $235 707, and the variable overhead is estimated at $8.15 per Regular Wrap and $12.32 per Deluxe Wrap.

The company set up a standard costing system and follows the common practice of basing the overhead rate on the total standard direct labour hours required to produce the estimated volume. The company uses only one overhead rate for fixed and variable overhead costs. Data concerning these two products appear here:

Last month, actual production volume was 4500 units of the Regular Wraps and 1300 units of the Deluxe Wraps. Actual variable overhead was $54 238, and actual fixed overhead was $237 859. The nine full-time employees who are classified as direct labour worked regular schedules for a total of 1564 hours. Required (a) Calculate the standard overhead rate per direct labour hour. (b) Explain why the entity’s overhead cost variances would provide poor information for monitoring and controlling costs. (c) Using the information available to you in this problem, suggest a method of allocating overhead costs that would provide better variance information. Using this method, calculate relevant variances for monitoring and controlling overhead costs. (d) For bookkeeping purposes, Sunglass Guys needs to calculate a production volume variance and a variable overhead efficiency variance. Calculate these variances, assuming that overhead costs are allocated using the method in part (c). (e) Because employees work regular schedules, direct labour costs tend to be fixed. Also, variable overhead consists primarily of indirect materials and facility-level costs (such as building rent, assembly line equipment, and utilities). These costs do not differ between Regular Wraps and Deluxe Wraps. Given this information, recommend a better cost allocation base for variable overhead. Explain your choice. (LO5 and 6)

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(a)

Standard overhead rate per direct labour hour: Calculate total estimated overhead at normal production volume: Estimated overhead = (4300 × $8.15) + (1400 × $12.32) + $235 707 = $288 000 Calculate estimated labour hours at normal production volume: Estimated hours = 0.2 × 4300 + 0.3 × 1400 = 1280 hours Calculate standard rate by dividing estimated cost by estimated hours: Rate = $288 000/1280 = $225 per direct labour hour

(b)

This method would be useless for monitoring and control because the fixed and variable overhead costs are not separated. When the production volume variance is commingled with the fixed overhead budget variance and variable overhead spending variances, spending variances cannot be calculated, so no information is available about cost control.

(c)

The recommendation is to separate fixed and variable overhead costs into separate standards. Only the spending variances will be useful for monitoring and controlling overhead costs. Using normal monthly volume, the fixed overhead budget variance is: Actual fixed overhead - Estimated fixed overhead cost (i.e. static budget)cost = $237 859–$235 707 = $2 152 U The variable overhead spending variance (using units of production as the allocation base): Actual variable overhead cost - Standard variable overhead for actual production = $54 238 - ($8.15 × 4500 Regular units) + ($12.32 × 1300 Deluxe units) – = $54 238 - $36 675 + $16 016 = $1547 U

(d)

To calculate the production volume variance, first determine what the fixed overhead standard rate would have been if it had been calculated separately from the variable overhead standard rate: (See calculation of normal labour hours in the solution to Part A.) Standard fixed overhead costs/Normal number of direct labour hours = $235 707 / 1280 = $184.15 per labour hour Production volume variance: Normal labour hours Standard labour hours for actual production (0.2 × 4500 Regular + 0.3 × 1300 Deluxe) Volume variance in labour hours Times the standard overhead rate Production volume variance

1280 hours 1290 hours 10 hours $ 184.14 F $1841.00 F

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Double-check the fixed overhead variance calculations in Parts C and D as follows: Standard fixed overhead cost allocated to actual production: Regular sunglasses: [($184.15×0.2) × 4500] $165 735) U Deluxe sunglasses: [($184.15×0.3) × 1300] 71 819) U Total fixed overhead allocated 237 554) U Less actual fixed overhead costs 237 859) U Total fixed overhead variance $ (305) U Sum of individual variances: [$(2152) U + $1841 F] Difference due to rounding

(311) U

To calculate the variable overhead efficiency variance, the standard volume of allocation base for actual output is compared to the actual volume of allocation base. Because variable overhead is allocated using actual units, an efficiency variance never arises (actual volume of units always equals actual volume of units). Therefore, the efficiency variance will be $0. (e)

If labour hours and costs are fixed, they do not vary with production. Therefore, labour hours provide a poor allocation base for variable overhead cost. A better option would be to allocate variable overhead using units produced because the variable overhead costs are more related to units than to labour.

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11.36 ABC costing; single versus dual rate spending variances; performance evaluation Data Processors Ltd performs credit card services for banks. The entity uses an ABC system. Following is information for the past year:

Required

(a) Using standard values for costs and activity, calculate an ABC allocation rate for each activity. (b) Prepare an operating cost statement for Data Processors Ltd that compares the static budget, the flexible budget, and actual costs. (c) Calculate the spending variance for the cost of processing transactions. (Hint: Treat this activity the same way you would treat variable overhead costs.) (d) Suppose the costs for processing transactions include some fixed and some variable costs, as shown:

(e)

(f)

Given this new information, calculate spending variances for the cost of processing transactions. Discuss possible reasons for the variances calculated in part (d). The CEO and CFO of Data Processors want your opinion about whether and how ABC variance information should be used in departmental manager performance evaluations. Use the information you learned from the preceding analyses to write a memo to the CEO and CFO presenting your evaluation of (i) whether the use of ABC cost variances in departmental manager performance evaluations would likely improve organisational performance, and (ii) which spending variance — the one from part (c) or part (d) — would provide better information for evaluating the credit card transaction processing manager’s ability to control costs. As you write the memo, consider what information the CEO and CFO will need from you to help them make a final decision.

(LO5 and 6) Note: This problem assumes knowledge of ABC. (a)

Activity Processing transactions Issuing statements

Estimated Cost $2 000 000 1 000 000

Estimated Activity ABC Rate 5 000 000 $0.40 250 000 $4.00

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Issuing credit cards Resolving disputes (b)

500 000 90 000

100 000 3 000

$5.00 $30.00

The flexible budget in the following statement is calculated by multiplying the actual activity level times the ABC allocation rate (Part a).

Static Actual Activity Budget Activity Processing transactions$2 000 000 5 800 000 F Issuing statements 1 000 000 270 000 U Issuing credit cards 500 000 110 000 F Resolving disputes 90 000 3 500 $3 590 000 F

Flexible Budget $2 320 000

Actual Cost Variance $2 200 000 $120 000

1 080 000

1 300 000 –220 000

550 000

400 000 150 000

105 000 $4 055 000

100 000 5 000 F $4 000 000$ 55 000

(c)

The spending variance for processing transactions is calculated in Part B as $120 000 F.

(d)

Budget (i.e. spending) variance for fixed processing costs: Actual cost 1 300 000 At standard (estimated cost) $1 000 000 Fixed budget variance $300 000 U Spending variance for variable processing costs: Actual cost Actual activity × standard activity rate (5 800 000 × $1 000 000/5 000 000) Variable spending variance

900 000 $1 160 000

Total spending/budget variance for processing costs

260 000 F $ 40 000 U

(e)

Fixed costs might have increased if new equipment or software was purchased that has not been reflected in the standard. Costs could be out of control. Variable costs might have been reduced if new equipment resulted in more efficient operations. The processes might have been improved somehow. The variance could also reflect normal fluctuations of processing activities.

(f)

There is no one answer to this activity.

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11.37 Cost variance; use of variance information The Software Development Company produces computer programs on DVDs for home computers. This business is highly automated, causing fixed costs to be very high, but variable costs are minimal. The entity is organised along three product lines: games, business programs, and educational programs. The average standard selling prices for each are $16 for games, $55 for business programs, and $20 for educational programs. The standard variable cost consists solely of one DVD per program at $2.00 per DVD, without regard to the type of program. Fixed costs for the period were estimated at $535 000. For the current period, standard sales are 40 000 games, 2000 business programs, and 10 000 educational programs. Actual results are as follows.

Required (a) Calculate standard pre-tax income and then reconcile it to actual pretax income by calculating the contribution margin sales mix variance, revenue sales quantity variance, sales price variance, materials price and quantity variances, and the fixed cost spending variance. (b) A new marketing manager was hired during the period. The manager changed prices and redirected sales efforts. 1. Discuss whether one or more of the preceding variances are relevant to evaluating the performance of the new marketing manager. 2. What do the variances suggest about the new manager’s performance? Explain. (c) An analysis reveals that the company will have to pay $1.80 per DVD next period. Prepare next period’s master budget. Assume a standard of one disk per program, total unit sales of 55 000, and the actual sales mix and sales prices from this period. (d) Discuss possible reasons why the company might not meet its budget for next period. (LO7)

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Note: This problem assumes knowledge of budgeting (a)

Standard pre-tax income Standard sales Games 40 000 @ $16 Business 2000 @ $55 Educational 10 000 @ $20 Total sales Standard variable costs 52 000 @ $2 Standard fixed costs Standard pre-tax income

$640 000) 110 000) 200 000) 950 000) (104 000) (535 000) $311 000)

Average contribution margin per unit per master budget: 40 000 × $14 + 2000 × $53 + 10 000 × $18 = $16.269231 52 000 Average standard contribution margin per unit for actual sales: 35 000 × $14 + 4 000 × $53 + 11 000 × $18 = $18.00 50 000 Master budget pre-tax income Sales quantity variance Contrib. margin sales mix variance Flexible budget pre-tax income

$311 000.00 (52 000 – 50 000)×$16.269231 (32 538.46) ($16.269231 – $18)×50 000 86 538.46) 365 000.00

Sales price variance: Games Business Material price variance Material quantity variance Fixed cost budget variance Actual pre-tax income

($616 000/35 000-$16)×35 000 56 000.00) ($198 000/4 000 - $55)×4 000 (22 000.00) ($106 575/50 750 - $2 –)×50 750 (5 075.00) (50 750 - 50 000 )×$2 (1 500.00) ($533 500 - $535 000 ) 1 500.00) $393 925.00)

(b)

The sales manager should be held responsible for only those variances related to activities under his or her control. Therefore, the productionrelated variances (material price and material quantity) should be excluded. The fixed cost budget variance should be considered only to the extent that the fixed costs are under the sales manager’s control. The sales manager is mostly likely responsible for some fixed costs, so a budget variance for those costs should be separated from the budget variance for other costs. The group of sales-related variances, considered together, provides information to evaluate whether the sales managers’ changes to prices and sales effort are benefiting the company. Although individual variances such as sales quantity and sales price may be negative, the important question is whether the sales manager’s new strategies are increasing the company’s profits.

The manager should be praised. The net effect of the manager’s changes can be seen in the sales mix, quantity, and price variances. These variances total to an $88 000 favourable variance ($32 538.46 U + $86 538.46 F + $56 000.00 F + $22 000.00 U).

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(c)

(d)

Sales Games Business Educational Total sales Variable costs Fixed costs Pre-tax income

(55 000×35 000/50 000) @ $17.60 (55 000×4 000/50 000) @ $49.50 (55 000×11 000/50 000) @ $20.00 55 000 @ $1.80

677 600 217 800 242 000 1 137 400 99 000 535 000 $ 503 400

The managers cannot know for certain whether there will be changes in customer preferences that affect the demand estimates. They also cannot know for certain when prices of inputs will increase. Although they can build known price changes into the budget, even vendors may not anticipate their own price increases up to a year in the future. The managers cannot know their costs for services such as electricity and transportation because these prices are affected by weather and gas and oil costs. There are many uncertainties that cannot be perfectly predicted; these are just a few examples.

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

11.38 Direct and overhead cost variance analysis; closing accounts at end of period Jennifer has just been promoted to manager of the piston division of Car Parts Co. The division, which manufactures pistons for hydraulic drives, uses a standard cost system and calculates the standard cost of a completed piston as $85, as follows:

The fixed overhead rate is based on an estimated 1000 units per month. Direct labour is nearly a fixed cost in this division. Selling and administrative costs are $50 000 per month plus $10 per piston sold. The following information is for production during April:

The entity’s policy is to record materials price variances at the time materials are purchased. You may want to use a spreadsheet to perform calculations.

Required (a) Prepare a flexible cost budget for the month of April. (b) Calculate all of the common direct cost variances. (Note: There are no variances for shaft housings.) (c) Calculate all common factory overhead variances. (d) Calculate a total variance for the selling and administrative costs. (e) Prepare a complete, yet concise, report that would be useful in evaluating control of production costs for April. (f) Prepare a report that sums all the variances necessary to prepare the reconciling journal entry at the end of the period. Explain how you would close the total variance; that is, identify the account or accounts that would be affected, and whether expenses in the accounts will be increased or decreased to adjust the records for the total variance. (g) Suppose you are manager of the piston division and you are reviewing the report prepared in part (e). Use information in the report to identify questions you might have about April’s production costs. (LO7) A sample spreadsheet showing the calculations for this problem is below. (Double-click on spreadsheet to view entire solution.)

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Proof of calculations: Net amount of relevant production cost variances Variances not used in evaluating production cost performance: Direct labour volume variance Variable factory overhead efficiency variance Fixed factory overhead volume variance Net amount of all production cost variances

$1,758

Chapter 9: Variance analysis: revenue and cost (300) (170) (1,000) $288

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(a)

FLEXIBLE COST BUDGET Cost Variable costs: Volume Rate Total shaftfrom a sample spreadsheet950 $35 $33,250 Below is anPiston excerpt for this problem. For variable Shaft housing 950 $20 19,000 costs, the flexible cost budget should reflect the actual volume, or 950 pistons. Variable factory overhead 397 $10 3,970 Because fixed costs are not expected to vary with production volume, they are Variable selling & administration 950 $10 9,500 presentedFixed using the static budget amount. The problem information indicates that costs: direct labourDirect is alabour fixed cost. Also, notice that the allocation base 6,000 for variable factory overhead is direct labour hours. Fixed factory overhead 20,000 Fixed selling & administrative 50,000 DIRECT TotalCOST VARIANCES $141,720 Quantity Standard Total Piston shaft direct materials price variance: The problemActual doesquantity not give the total standard amount labour cost @ standard price 1,000 of fixed $35 direct $35,000 or fixed factory but they can be calculated from the standard cost Actualoverhead, purchase cost 1,000 $34.95 34,950 $50 information: Favorable (Unfavorable)

direct materials efficiency variance: Fixed Piston direct shaft labour (1000 pistons × $6 per piston) Standard quantity @ standard price 950 $35 Fixed factory overhead (1000 pistons × $20 per piston)$35 Actual quantity @ standard price 954

(b)

Favorable (Unfavorable)

$ 6 000

33,250 20 000 33,390 ($140)

The direct costs consist of: piston shafts, shaft housings, and direct labour. Because the information in the problem indicates that actual costs were identical Direct labour variance: there are no variances for shaft housings. to standard costs for budget shaft housings, Budget for direct labour $6 shafts $6,000 Therefore, direct cost variancescost are calculated 1,000 only for piston and direct Actual direct labour cost labour. Also note that direct labour in this problem is treated as a6,120 fixed cost. Favorable (Unfavorable) ($120) Accordingly, budget and volume variances are calculated for direct labour using the sameDirect method thatvolume is used for fixed factory overhead. Below is an excerpt labour variance: from a sample spreadsheet showing problem. Actual volume @ standard ratethe direct cost 950variances $6 for this $5,700 Standard volume @ standard rate Favorable (Unfavorable)

1,000

6,000 ($300)

Double-check calculations for total piston shaft variances: Standard cost for quantity of pistons produced (950×$35) Actual cost for piston shafts purchased Increase in cost of raw material inventory: Quantity purchased 1000 Quantity used 954 FACTORY OVERHEAD COST VARIANCES Increase in inventory quantity 46 Quantity Standard Standard cost per piston shaft $ 5 Variable overhead spending variance: Book value of raw inventory increase Actual DL hours @ material standard cost 397 $10 Actual cost of pistons used in production Actual variable overhead cost Total piston Favorable shaft variance (Unfavorable) efficiency variance: [$50 + $(140)] SumVariable of priceoverhead and efficiency variances

Standard variable overhead cost 380 Standard variable overhead based on Double-check calculations direct labour variances: actual direct labourfor hours 397 Favorable (Unfavorable)

$33 250) U $(34 950)

Total

1 610) $3,970 (33 340) U 3,677 $ (90) U $293

$10

$3,800

$10

3,970 ($170)

Standard cost for quantity of pistons produced (950*$6) Fixed overhead budget Actual direct labour cost variance: Budget for fixed overhead 1,000 $20 Total direct labour variance Actual fixed overhead Favorable (Unfavorable)

$20,000 18,325 $1,675

Sum of direct labour budget and volume variances [$(120) + $(300)] (c)

Fixed overhead volume variance: Actual volume @ standard rate Standard volume @ standard rate Favorable (Unfavorable)

950 1,000

$20 $20

$ (90) U

$ 5 700 U (6 120) U $(420) U $(420) U

$19,000 20,000 ($1,000)

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Chapter 16: The strategic management of cost and revenues

Double-check calculations for variable overhead variances: Standard cost for quantity of pistons produced (950×$4) Actual variable overhead cost Total variable overhead variance

$3800) F (3677) F $ 123) F

Sum of spending and efficiency variances [$293 + $(170)] Double-check calculations for fixed overhead variances:

$ 123) F

Standard cost for quantity of pistons produced (950×$20) Actual fixed overhead cost Total fixed overhead variance

$19 000) F (18 325) F $ 675 F)

(d)

(e)

SELLING AND ADMINISTRATIVE VARIANCE Quantity Sum of budget and volume variances [$1675Standard + $(1000)] Total $ 675 F) Standard selling and administrative costs: Fixed $50,000 Below is an excerpt from a sample spreadsheet showing the total selling and Variable 950 $10 9,500 administrative variance for this problem. Total standard cost 59,500 Actual cost 59,101 Favorable (Unfavorable) $399

Before preparing a report that would be useful in evaluating control of production costs, identify costs that are relevant to production: direct costs and factory overhead. The selling and administrative costs are not relevant. Next, identify the relevant variances for evaluating production costs: the price and efficiency variances for direct materials, the spending variance for direct labour (because it is a fixed cost) and variable overhead, and the budget variance for fixed overhead costs. variable overhead efficiency variance is not relevant PRODUCTION COST The VARIANCE REPORT Variance because its information is already provided by the direct labour efficiency Static Flexible Actual Price/ Efficiency/ variance. SUMMARY The directOFlabour and production volume variances are not relevant Budget Budget Cost Spending Volume PRODUCTION COST VARIANCES Piston shafts $35,000 $33,250 $33,340 $50 ($140) Standard Actual ratherTotal because total volume is assumed to be driven by sales than by the Shaft housings 20,000 19,000 19,000 0 0 Cost Cost Variance production department.

Direct labor Piston shafts 6,000 6,000 6,120 (120) $33,250 $33,340 ($90) Variable factory 4,000 3,970 3,677 293 0 Shaftoverhead housings 19,000 19,000 Below is an excerpt from a sample spreadsheet showing a production cost Fixed factory overhead 20,000 20,000 18,325 1,675 Direct labour 5,700 6,120 (420) variance report this overhead problem. $85,000 $82,220 Total production costs $1,898123 ($140) Variablefor factory 3,800 $80,462 3,677

Fixed factory overhead Net amount Total of relevant production production costscost variances

19,000 $80,750

18,325 $80,462

675 $288 $1,758

The actual cost for piston shafts was calculated in Part B. (f)

Proof of calculations: The production cost variances would be closed using the method shown on Net amount of relevant production cost variances $1,758 pages 437–8 in the The first step iscost to sum all of the production cost Variances nottextbook. used in evaluating production performance: variances and determine whether they are material. Below is an excerpt Direct labour volume variance (300) from a sample spreadsheet computing net amount variances. Variable factory overheadthe efficiency varianceof all production cost (170) Fixed factory overhead volume variance Net amount of all production cost variances

(1,000) $288

The second step is to compare the total net amount of production cost variances ($288 F) with total actual production costs ($80 462). In this case, the variances amount to only 0.4% of actual costs. Therefore, the variances would be considered immaterial, and the adjustment would be made entirely to cost of goods sold. The adjusting journal entry would be made as follows:

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Piston shafts direct materials price variance Variable overhead spending variance Fixed overhead budget variance Piston shafts direct materials efficiency variance Direct labour spending variance Direct labour volume variance Variable overhead efficiency variance Production volume variance Cost of goods sold (g)

50 293 1675 140 120 300 170 1000 288

As manager of the piston division, I would like to know if the quality of the pistons was the same as usual. Four more pistons were used than expected, so it is possible that quality has been compromised with a lower price. This could be a problem if defective shafts are not removed from production and customers receive more defective pistons than usual. Sales volumes could drop. I would also like to know why labour costs and hours were up. If workers had to work overtime because of a quality problem, cost and hours would be up. It appears that fixed and variable overhead costs were under control, and were even less than expected during the period. Because the fixed overhead budget variance is fairly large, I would want to know if something has changed and whether the use of overhead has improved. If so, the standard could be changed, although the efforts of workers to reduce fixed costs needs to be recognised and praised.

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Chapter 16: The strategic management of cost and revenues

11.39 Auditor evaluation of variances for error and fraud, accounting principles for variances Auditors must plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatements, which may be caused by either error or fraud. Errors are unintentional misstatements caused by factors such as mistakes in processing accounting data, misinterpretation of facts, and confusion about accounting principles. Fraudulent financial reporting and misappropriation of assets are the only two types of financial statement fraud. Fraudulent financial reporting consists of intentional misstatements caused by factors such as manipulation of accounting data, misrepresentation of facts, and intentional misapplication of accounting principles. Misappropriation of assets includes stealing assets such as inventory and causing an organisation to pay for goods or services that were not received.

Auditors perform a variety of procedures to gather and evaluate information that will help them identify possible material misstatement. One potential audit procedure is to analyse a company’s cost variances, which might be caused by error or fraud. Required (a) For each of the following variances, describe in detail a possible error that could cause a variance even when no variance actually exists: (i) Direct materials price (ii) Direct materials efficiency (iii) Direct labour price (iv) Direct labour efficiency (v) Variable overhead spending (vi) Variable overhead efficiency (vii) Fixed overhead budget (viii) Production volume (b) Suppose a material amount of raw materials inventory theft took place during the past year. Which of the variances in part (a) would most likely reflect this fraud? Explain. (c) Discuss possible reasons why variance analysis might not uncover the theft described in part (b). (d) Suppose a production manager fraudulently entered a fictitious employee into the payroll system during the past year. The fictitious employee’s salaries are deposited directly into a bank account that is then accessed by the production manager. Which of the variances in part (a) would most likely reflect this fraud? Explain. (e) During the current year, suppose an accountant accidentally records a large equipment repair as an addition to property, plant, and equipment. Assume that equipment repairs and equipment depreciation are both recorded in variable overhead costs. Which of the variances in part (a) would most likely reflect this accounting error? Discuss how this error would affect the variance during the current year. Discuss how this error would affect the variance during the next year. (f) Suppose an entity’s managers want to report higher earnings on the income statement. Describe in detail a possible way that the managers © John Wiley and Sons Australia, Ltd 2020

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Contemporary Management Accounting Solution Manual

could improve reported earnings by intentionally misapplying accounting principles for variances. (LO3, 4, 5 and 6) (a)

There are many possible errors that could cause a variance even when no variance actually exists. Below are possible answers to this question; students may think of others. Direct materials price: The company has a policy of using the net method for recording early payment discounts, but an accountant erroneously recorded the purchase transaction using the gross method. Then when payment was made, a credit was erroneously recorded to a miscellaneous income account instead of to the cost of direct material purchases. This combination of errors would cause the cost of direct materials purchased to be overstated. Direct materials efficiency: A mechanical error could have occurred in recording the quantity of direct materials used in production. For example, a clerk might have accidentally entered a quantity of ‘975’ instead of ‘957’, overstating the quantity of direct materials used. Direct labour price: A payroll department employee made an error when entering the pay rate for an individual production employee in the payroll system. This error would cause the employee to be overpaid or underpaid, which in turn would overstate or understate direct labour cost. Direct labour efficiency: A production employee accidentally miscoded her time, causing hours to be charged to direct labour instead of indirect labour. This error would overstate direct labour hours and understate indirect labour hours (in either variable or fixed overhead cost). Variable overhead spending: When making an entry to record the transfer of indirect materials from the warehouse to production, a clerk accidentally coded the materials as direct materials instead of indirect materials. This error would overstate direct material costs and understate variable overhead costs. Variable overhead efficiency: An error in the accuracy of the variable overhead cost allocation base would also cause an error in this variance. For example, if the cost allocation base is either direct labour hours or direct labour costs, then the errors described above for direct labour efficiency or direct labour spending would cause an error in the variable overhead efficiency variance. Fixed overhead budget: An accounting clerk might have accidentally coded a fixed overhead cost as a variable overhead cost. This error would cause fixed overhead costs to be overstated and variable overhead costs to be understated. Production volume: An error in the computation of units produced would cause an error in this variance. Suppose personnel forget to record the number of units spoiled during a particular production run. This error would cause the number of good units produced to be too high, overstating the production volume.

(b)

The theft of inventory is accounted for with any other errors in inventory quantities at the time physical inventory is counted. Because it is not possible to distinguish between theft and errors, the adjustment for missing raw materials inventory is

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usually recorded as either direct materials or indirect materials (most likely in variable overhead). If the adjustment is recorded to direct materials, then the theft would be reflected in the direct materials efficiency variance (the usage of raw materials would appear to be higher). If the adjustment is recorded to indirect materials, then the theft would overstate variable overhead costs, which would be reflected in the variable overhead spending variance. (c)

There are several reasons for failing to uncover theft through analysis of the affected variances. Variances include offsetting positive and negative items, and the theft might be offset by positive variances such as more efficient use of materials. In addition, cost standards are often set based on past experience. If the company has always experienced significant theft, then the cost would already be anticipated in the cost standards.

(d)

Assuming that the fictitious employee time is charged to direct labour, this fraud would be reflected in the direct labour efficiency variance. If the pay rate for the fictitious employee is not equal to the standard direct labour pay rate, then the fraud would also be reflected in the direct labour price variance. If time for the fictitious employee is charged to an overhead account, then this fraud would be reflected in the variable overhead spending variance or fixed overhead budget variance.

(e)

This error will cause variable overhead costs to be overstated this year by the difference between the total cost and the amount that should have been depreciated this year. Variable overhead costs will be understated in future years by the amount of depreciation that should have been recorded. This error would be reflected in the variable overhead spending variance. During the current year the variance would be less favourable (or more unfavourable), and in future years it would be more favourable (or less unfavourable).

(f)

The most obvious way to increase earnings by misapplying accounting principles for variances is to close material variance accounts incorrectly. For example, favourable variances could be closed to cost of goods sold instead of prorated to cost of goods sold and work in process.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. Prepared by Albie Brooks © John Wiley and Sons Australia, Ltd 2020

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Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Chapter 12: Activity analysis: costing and management Questions 12.1

Explain how conventional and ABC cost systems differ. (LO1)

Activity-based costing analyses the activities performed in manufacturing and service production. Once the activities are identified, costs for each activity are collected into separate cost pools. Next a cost driver is chosen that reflects changes in the costs of activities. The cost driver is used to allocate the costs of the activity to products, services, or some other cost object. There are multiple cost pools and drivers. Conventional costing uses only a few overhead cost pools and allocates the costs based on drivers such as direct labour hours, direct labour cost, or machine hours. In a conventional cost system, the cost pools are very large and so it is impossible to find an allocation base that reflects resource use. It is merely a logical system of assigning part of overhead costs to each product or service. ABC, on the other hand, selects cost pools around activities so that a cost driver can be chosen to better reflect a product or service’s use of resources. Therefore, ABC systems have more cost pools and drivers. Because an ABC system is more complex, more time, effort, and money are required to implement ABC systems than conventional costing systems.

12.2

Mannon Company’s accountant exclaimed, 'Our cost accounting system allocates overhead based on direct labour hours, but our overhead costs appear to be more related to set-up activities than to the use of direct labour. It seems as though our costing system allocates too much cost to large batches of product and not enough cost to small batches.' Explain what she means. (LO1 and 3)

If direct labour hours are used for tending machines and equipment, small batches take fewer direct labour hours and so are allocated less overhead. However, if overhead costs increase more with setup time than with direct labour costs, the cost to set up for a large batch is likely similar to the cost of setting up a small batch. The cost per unit is then probably much lower for the large batch than for the small batch.

12.3

Describe the six ABC cost hierarchies. (LO2)

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Chapter 16: The strategic management of cost and revenues

1. Organisation-sustaining activities are activities related to the overall organisation and unaffected by customers served or by quantities of products, batches, or units. 2. Facility-sustaining activities are activities related to the overall operations of a production facility and unaffected by customers served or by quantities of products, batches, or units. 3. Customer-sustaining activities are customer service activities that are independent of sales volumes and mix. 4. Product-sustaining activities occur to support a product line or a single product if it is not part of a product line. 5. Batch-level activities increase as the number of batches increase. These activities include setup and monitoring batches of product. 6. Unit-level activities increase proportionately with production volumes or sales volumes. 12.4 The results from allocations using ABC are usually different from the results using conventional cost systems. Explain why these differences arise. (LO1) Because ABC uses more cost pools and more cost drivers to reflect cause and effect relationships, ABC costs usually map the relation between cost and use of resources more accurately. Hence ABC costs reflect different proportions of the resource costs than do conventional costs. 12.5

Does it matter if the ABC-generated cost data is somewhat subjective?

All costing data involves some degree of subjectivity or professional judgement. Traditional product costing systems, for instance, which might be based on plant-wide overhead rates assume that all overhead costs for the plant can be grouped into a single cost pool with a single cost-driver (i.e. labour hours or machine hours) influencing all of these costs. More contemporary costing systems including ABC also involve a degree of subjectivity. Different managers are likely to view the costs and benefits of adopting such systems differently. Judgement is required in regards to the identification of cost pools and their associated drivers. Again, different managers may have different views in regards to the number of cost pools required and what the underlying driver of each pool is. Whilst still involving a degree of subjectivity, ABC-generated costing data is more precise than costing data generated through other means. The use of ABC helps to ensure that the cost of products and services better reflects the use of resources by different products and services. 12.6 Does increasing the number of cost pools always increase the accuracy of allocations under an ABC system? Explain your answer. (LO1 and 5) No, increasing the number of cost pools and cost drivers can increase measurement error because small measurement errors for each pool and each driver can distort total cost once costs are allocated, simply from the increase in calculations that take place. In addition, if the production process is very simple and products use the same amount of resources each, increasing the number of cost pools will not increase the accuracy of the allocations.

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Contemporary Management Accounting Solution Manual

12.7 Is an ABC system appropriate for every industry and every type or organisation? Explain your answer. (LO5) No, because it is expensive to implement, the costs outweigh the benefits for some firms. Firms that are already operating efficiently may not benefit from an ABC system, especially if they have available capacity. Research has shown that ABC is more successful within organisations that use flexible systems, have integrated information systems, and produce a variety of products. 12.8 Should ABC be used in service industries? Why? (LO5) Yes, ABC can be used in service industries. In service organisations, ABC may be especially helpful if there are capacity limits. Service industries often have a large proportion of fixed resources, and understanding the relationship between cost and the use of these resources can improve the efficiency of the organisation.

12.9 What makes organisations such as local governments and universities suitable for ABC use? LO5 Local government organisations and universities are particularly suitable for ABC use given that they have a significant percentage of indirect costs (i.e. central administration and IT costs, building and other infrastructure costs) that are driven by a range of other factors than a single cost driver (i.e. student numbers, number of local residents, labour hours). 12.10 What use might management make of ABC-cost data output in universities, local governments and other such organisations? LO4

As the following examples illustrate, ABC-cost data outputs could have a number of potential management uses: •

•

ABC-cost data can be used to obtain more reliable estimates of the costs required for universities and local government entities to deliver their services to students and local rate payers, respectfully. This can inform how universities set their prices for students studying different disciplines (i.e. business, medicine, law, engineering), different course levels (i.e. bachelor, masters, PhD) and in different modes (i.e. online, on-campus). Similarly, local government entities can use ABC-cost data to inform their charges for different services (i.e. annual rates, waste collection, water). Universities and local government entities have numerous departments. Universities, for instance, have different faculties (i.e. business, arts, science, medicine) and support departments (i.e. student services, marketing, library). ABC-cost data can enable universities and local government entities to more reliability measure the performance of these departments. Knowledge of the activities required to meet the needs of their students and local rate payers can enable universities and local government entities to better:

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Chapter 16: The strategic management of cost and revenues

o identify and plan for their staffing and other resource requirements. o manage their costs given an understanding of the drivers of any non-value adding activities. 12.11 Does measurement error increase or decrease when ABC systems are implemented? Explain your answer. (LO3 and 5) Measurement error could decrease because ABC can do a better job of allocating costs to the use of resources. Better allocation reduces problems such as product cross-subsidisation, in which costs are overallocated to some products and underallocated to others. However, measurement error could increase because increasing the number of cost pools and cost drivers results in small measurement errors for each pool and each driver. As the number of calculations increase, these small measurement errors interact as costs are allocated (rates are developed and used as multipliers), and so the size of measurement error is likely to increase.

12.12 List several costs and several benefits of implementing an ABC system. (LO5) Several costs that are incurred when implementing an ABC system include the time it takes employees or consultants to determine appropriate cost pools and cost drivers, the cost to track and measure the number of activities because these may not be recorded in the accounting system, and the cost to set up an information system to develop ABC reports. Several benefits include the ability to identify non-value added activities, and a better understanding of the use of overhead resources.

12.13 Suppose that you are part of a student consulting team working for your university. You need to analyse accounting department activities and set up cost pools for these activities. Explain how you would identify the activities and pools. (LO3) First, meet with accounting employees to learn about all of the different activities they perform. Identify activities that are homogeneous and can be pooled together. For example, budget preparation for each department is probably similar, but it may take different amounts of time according to the complexity of the department. Pool all of the various budgeting activities. Once a list of activities has been identified, employees’ opinions about appropriate cost drivers can be solicited. Activities that have the same cost drivers could probably be pooled.

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Contemporary Management Accounting Solution Manual

12.14 Is ABC appropriate for an organisation that sells a wide range of customised products manufactured using flexible manufacturing systems? Why? (LO3 and 5) Yes, research has shown that ABC is more successful within organisations that use flexible systems, have integrated information systems, and produce a variety of products. With ABC, a better mapping of the use of resources to each product line allows managers to choose the optimal product mix. In addition, if the processes are complex, ABC allows analysis of the activities underlying complex processes so improvements are easier to identify, as are non-value added activities. In these cases, the costs are likely less than the benefits achieved. 12.15 Explain the difference between activity-based costing and activity-based management.

(LO4 and 5) Activity-based costing is a method of allocating costs to products or other cost objects. Activity-based management is the process of using ABC information to improve operations and profitability by analysing the actual activities and processes to reduce non-value added activities, and improve the efficiency of activities. In addition, managers may be able to better understand different products’ uses of fixed resources, which could be important if there are capacity constraints. 12.16

Outline the benefits of time-driven ABC. (LO5)

More informed decision-making in relation to the availability and best use of practical capacity: • difference between time available and time required to perform activities is made more obvious; • idle time can be quantified as ‘input costs minus costs assigned to activities’; • allows for more informed decision relating to the allocation of staff to activities; and • elimination or improved management of excess capacity

Improved computer costing systems capability when using standard rates

Complexity of operations can be incorporated into the time-driven ABC model. For example standard rates can be: • applied in real time to assign individual costs; • used in quotations to estimate prices for new orders • adjusted when existing conditions change • input prices change (salaries, operating expenses); • efficiency of the activity changes (learning curves; training programs; reengineered processes) • time units change (new technology and processes)

12.17 Using examples distinguish between value-added and non-value-added activities. (LO4)

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Value-added and non-value added activities Value added activities: tasks or functions that increase the worth of an organisation’s goods or services to customers. Non-value added activities: tasks or functions that are unnecessary and waste resources because they do not increase the worth of an organisation’s goods or services to customers. Examples: • Inspection activities: Inspection activities are non-value-added. Some organisations have very low defect rates, making it unnecessary to inspect; that is, the product design and manufacturing process insures high quality production. The concept of high quality is to ‘do it right the first time’. Some firms may inspect incoming materials to guarantee high quality during their manufacturing processes, but these costs could be eliminated through contractual arrangements with suppliers that include high penalties for low quality material deliveries. • Moving materials to work stations: Moving materials to work stations could also be either value-added or non-valueadded, depending on the circumstance. In organisations that use JIT systems, the amount of materials handling is reduced to the minimum level necessary, which reduces costs • Manufacturing extra inventory: Manufacturing extra inventory to keep employees busy is non-value added if there are no sales for the inventory. • Change layout of operational area: This would be a value-added activity as an improved layout will reduce time taken to move around the operational area and improve time taken in the process which should reduce cycle time

Exercises 12.18 Mapping costs to the cost hierarchy Each of the costs below is incurred by Fairgood & Hernandez, a small CPA firm. Required Identify whether each of the following costs most likely relates to an (i) organisation- sustaining activity, (ii) customer-sustaining activity, (iii) product-sustaining activity, (iv) batch-level activity, or (v) unit-level activity. For each item, explain your choice.

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(a) (b) (c) (d) (e)

Receptionist salary Financial forecasting software Photocopy machine rental Cleaning service Audit manager salary

(f) Long-distance telephone charges (g) Meal costs for entertaining clients (h) Costs of annual employee golf party (i) Office supplies such as paperclips and paper (j) Annual subscription for income tax regulations (LO2 and 3) (a)

Receptionist salary is an organisation-level cost because the receptionist serves everyone who comes through the door and thus cannot be identified with one product or unit.

(b)

Financial forecasting software is an organisational-level cost if it is used to forecast sales for the entire company. However if it used only by one product line, it is a product-sustaining cost.

(c)

Photocopy machine rental is a facility-level cost when everyone uses the machine, but could be a product, batch or unit related cost if a password were used to keep track of copies made for each client or department.

(d)

Cleaning service is a facility-level cost because the entire facility uses this evenly.

(e)

Audit manager’s salary is a unit-level cost because the managers is in charge of a number of different audits and bills his or her time to each audit.

(f)

Long distance telephone charges are unit-level if the bill includes details of to whom the calls were made, and could be product-sustaining if the calls are marketing a particular product. It just depends upon the purpose of the calls. Some companies have Watts lines and pay a flat fee for all long distance calls. In this case the cost is an organisation-level cost.

(g)

Meal costs for entertaining clients could be a customer-sustaining cost if related only to that particular customer, or product related if the customer is associated with only one product.

(h)

Costs of annual employee golf party is an organisation-level because it benefits all departments.

(i)

Office supplies such as paperclips and tablets of paper are organisation-level costs unless they can be traced to a particular product or batch.

(j)

Annual subscription for income tax regulations is a product-sustaining cost if it pertains to one department of the firm. If it pertains to the entire firm, it is a facilitylevel cost.

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12.19 Identifying costs using the ABC cost hierarchies MicroBrew is a successful brewery engaged in the development and production of specialty micro brews. It uses an ABC system. During the past year, it has incurred $1 250 000 of product development costs, $850 000 of materials handling costs, $2 500 000 of production line labour costs, $700 000 for production setup costs, $500 000 in power costs for cooling beer and running equipment, and $1 500 000 for manufacturing facility management. Required In an ABC cost hierarchy, calculate the total cost that would be classified as: (a) Facility-sustaining. (c) Batch-level. (b) Product-sustaining. (d) Unit-level. (LO2 and 3) Following are the CMA answers to this question. However, one could argue that some of the unit-level costs could instead be categorised as batch-level. (a) Facility-level costs: Manufacturing facility

$1 500 000

(b) Product-sustaining costs: Product development

$1 250 000

(c) Batch-level costs: Production setup (d) Unit-level costs: Materials handling Production line labour Power (assuming most power is to cool beer and run machines, not for overhead) Total unit-level costs

$700 000

$ 850 000 2 500 000 500 000 $3 850 000

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12.20 ABC cost hierarchy In ABC systems, activities are often separated into a hierarchy of six categories. Required In your own words, define and give examples of the following types of activities and costs in an ABC system for a national car rental company such as Hertz or Euro car: (a) Unit-level activities and costs. (b) Batch-level activities and costs. (c) Product-sustaining activities and costs. (d) Customer-sustaining activities and costs. (e) Facility-sustaining activities and costs. (f) Organisation-sustaining activities and costs. (LO2) (a)

Unit-level activities and costs relate to each unit produced, in this case, each car rented. The cost of washing each car between rentals is an example of a unit level cost. Costs for the activities of making the reservation, turning the vehicle over to the renter, and completing the paperwork at the end of the rental are also unit-level.

(b)

Batch-level activities and costs relate to the number of batches produced. For a car rental fleet, cars at a number of outlets are probably sent for oil changes or other routine maintenance in batches. Car rental companies located off-site near an airport usually operate a shuttle service from the airport to the rental car location. Multiple passengers are usually picked up and dropped off on each run of shuttle. Batch-level costs for the shuttle would include vehicle depreciation, maintenance, and gasoline, plus the driver’s labour costs.

(c)

Product-sustaining activities and costs relate to entire product lines. For a car rental company, the different types of cars for rent could be considered product lines, for example economy cars, mid-sized cars, and so on. Or the company might see its product lines more broadly, such as a product line of cars and a separate line for trucks. Advertising and marketing costs are likely to be productline related if the company advertises either trucks or cars, but not both.

(d) Customer-sustaining activities and costs relate to the different clients. Sometimes businesses establish a relationship with car rental agencies if employees need to travel by car for business. These customers may require special attention, such as car delivery, or last minute rentals. The costs of these services are customer-sustaining. Rental companies also have programs such as the Hertz #1 Club, where members receive preferential treatment. Special costs for these programs include extra personnel to process the rental and park the vehicle in an easily accessible location. (e)

Facility-sustaining costs relate to the facility. For a car rental agency, these could include depreciation and maintenance of the building and parking lots for each outlet. Facility-sustaining costs would also include the facility manager’s salary, electricity and janitorial service, computer terminals, and property taxes.

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(f)

Organisation-sustaining costs relate to the entire organisation. The CEO’s salary, and building lease, rent or depreciation costs at the company’s headquarters are all organisation-sustaining costs. Companies such as Hertz also have large organisation-wide costs for computerised reservation and vehicle inventory systems.

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12.21 Cost pools and cost drivers Following are lists of potential cost pools and cost drivers.

Required Match each cost driver to the most appropriate cost pool. Use each cost driver only once. Explain your choice. (LO3) F D

G B A E

Machining (As machine hours increase, costs such as maintaining machines increase) Purchasing activities (As number of invoices increases, costs such as wages for employees filling out invoices and supplies used by these employees increase.) Inspection (As the number of units produced increases, the number of units inspected also increases.) Assembly (As the number of parts increases, it takes more overhead cost in material handling, etc. to assemble the product.) Payroll (As number of employees increases, more employee time and supplies are needed to produce pay cheques.) A special quick freezing process for food (Food is usually frozen in batches. As the number of batches increases, costs such as electricity and quick-freezing supplies increases.) Laundry in a hospital (As the number of laundry pounds increases, more labour and supplies costs are incurred because more batches of clothes are washed.

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12.22 ABC costing; ABM Taylors Cheesecakes supplies cheesecakes to three large supermarket chains. Management has become concerned about the rising costs associated with the processing and dispatch of orders. An activity analysis of the indirect costs identified the following customer-related costs:

Sales are marked up 50% on cost. Required (a) Calculate the activity cost rate for each activity (b) Assign the activity costs to each of the three customers. (c) Calculate the contribution for each customer if the sales pattern for each is as follows: Customer 1 — $300 000; Customer 2 — $150 000; Customer 3 — $200 000. (d) Advise the management of Taylors Cheesecakes as to whether any changes should be made in its relationships with customers. (LO3 and 5)

(a) Activity Orders Processing Returns Processing Delivery Rush Orders Sales Visits *total costs = $440 000

Allocation Formula $200 000 / 450 orders $50 000 / 100 returns $100 000 / 700 deliveries $70 000 / 50 orders $20 000 / 100 visits

Activity Cost Rate $444.44 per order $500 per return $142.85 per delivery $1400 per order $200 per visit

(b) Activity Orders Processing, $444.44 per order Returns Processing, $500 per return Delivery, $142.85 per delivery Rush Orders, $1 400 per order Sales Visits, $200 per visit Total costs assigned** Adds to $439 993 – rounding

Customer 1 $133 332 25 000 57 140 14 000 10 000 $239 472

Customer 2 $44 444 12 500 28 570 28 000 5.000 $ 118 514

Customer 3 $22 222 12 500 14 285 28 000 5 000 $82 007

(c)

Sales Less cost of sales Contribution

Customer 1

Customer 2

Customer 3

$300 000 $200 000 $100 000

$150 000 $100 000 $50 000

$200 000 $133 333 $66667

Ranking Customer 1; Customer 3; Customer 2

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Customer Profitability Analysis using ABC Sales Less allocated costs*** Contribution

Customer 1

Customer 2

Customer 3

$300 000 $439 472 ($139472)

$150 000 $218 514 ($68514)

$200 000 $215340 ($15340)

Ranking Customer 3; Customer 2; Customer 1 ***refer calculations below to find out how the figures were determined – equal to cost of sales plus activity based customer costs

Customer 1 – cost of sales = ($300 000 / 150 * 100) = $200 000 Customer 2 – cost of sales = ($150 000 / 150 * 100) = $100 000 Customer 3 – cost of sales = ($200 000 / 150 * 100) = $133 333 The above profitability analysis indicates that all customers are not profitable when taking into account the customer related costs. Customer 3 is the more ‘profitable;’ customer due to the lower costs. The activity analysis indicates that this customer has low costs as it orders in larger quantities has low returns, has less frequent deliveries, and less visits. Despite the rush orders being higher this cost is offset by the other savings. (d) The activity analysis provides insight into how the customers interact with the Company. From the analysis it can be seen that both Customers 1 and 2 require further attention on their relationship with Taylor Cheesecakes. For example, Customer 1 is generating the highest revenue but providing the lowest profit. This is due to Customer 1 placing many low volume orders, generating more sales returns, more deliveries and more sales visits. Customer 2 is in a similar position when you compare their activity for the given sales revenue with that of Customer 3. Remember that for every $1 saved in costs Taylors Cheesecakes will generate an additional $1 in profit. It will be important for the management of Taylors Cheesecakes to discuss with the Customers how they can develop a more beneficial relationship. 12.23 Cost system design – activity analysis Prahan Daycare (PD) offers childcare services to the local community. For many years it simply offered services for preschoolers. In this environment, managing the costs and services seemed relatively straightforward. In recent years, government subsidies and building programs have enabled PD to offer expanded services. For example, two years ago PD added an after-school care program for older children. It is also planning school holiday programs and a special tours activity. Until now, the cost system has been relatively simple, with little regard for accumulating costs for the individual services offered. However, the new manager of PD, Noah Day, knows he needs better cost data, both for reliable costing of services and to help him manage the growing costs of PD. Required (a) Advise Noah how activity analysis might help with improved cost data. (b) Advise Noah how he could use activity analysis to help manage the activities.

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(LO4) (a) Activity analysis will assist Noah Day to identify why and where the costs are being incurred in the day care centre. The current cost system only has the need to assign costs to the preschool activity. A revised system will now be required to capture the cost of the full range of activities proposed and therefore, will need to allocate costs to the following activities: preschoolers; after school care; school holiday program; and special tours. The new system will require an analysis of business activities to identify the appropriate cost (resource) drivers to assign costs to the activities. Changes to the costing system may enable more costs to be recorded as a direct cost rather than an indirect cost e.g. requesting employees to keep a record of the hours worked on each activity. (b) The activity analysis necessary to set up the new costing system will also allow for cost management of the daycare’s services. An analysis of the cost drivers will enable Noah to identify what is causing costs to be incurred for the different activities. If Noah is able to lower the cost or the activity’s use of the cost driver then total costs will be reduced leading to higher profits.

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12.24 Conventional versus ABC costing Calder Products manufactures two component parts: AJ40 and AJ60. AJ40 components are being introduced currently, and AJ60 parts have been in production for several years. For the upcoming period, 1000 units of each product are planned for manufacturing. Assume that the only relevant overhead cost is for engineering change orders (any requested changes in product design or the manufacturing process). AJ40 components are expected to require four change orders, and AJ60 only two. Each AJ40 requires 1 machine hour, and each AJ60 requires 1.5 machine hours. The cost of a change order is $300. Required (a) Estimate the cost of engineering change orders for AJ40 and AJ60 components if Calder uses a conventional costing method and machine hours as the allocation base. (b) Now suppose that Calder uses an ABC system and allocates the cost of change orders using the number of change orders as a cost driver. Estimate the cost for change orders for each unit of AJ40 and AJ60. (c) Calculate the difference in overhead allocated to each product. This figure represents an amount that one product cross-subsidises the other product. Explain what that means. (LO1, 3 and 5) (a) Total engineering change cost (6*$300) Total allocated cost for AJ40 (1*1000/(1*1000 + 1.5*1000)*(6*300) Remainder is allocated to AJ60 $1,080

$1800 720

(b) Total engineering change cost (6*$300) Total allocated cost for AJ40 (4*$300) Remainder is allocated to AJ60 $ 600

$1800 1200

Conventional costing ABC costing Product Cross Subsidisation Overcharge (Undercharge) Percent Overcharge (Undercharge)

AJ40 $ 720 1200

AJ60 $1080 600

Total $1800 1800

$(480) (40)%

$ 480 80%

Cross subsidisation means that one product is allocated more overhead cost relative to its use of overhead resources and, therefore, other products’ overhead cost is less than their use of resources.

12.25 Costing; ABM Applewood Electronics manufactures two large-screen television models, the Monarch, which has been produced since 20105 and sells for $900, and the Regal, a new model introduced in early 2016 that sells for $1,140. Applewood’s CEO, Harry Hazelwood, suggested that the company should

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concentrate its marketing resources on the Regal model and begin to phase out the Monarch model. Applewood currently uses a conventional costing system. The following cost information has been used as a basis for pricing decisions over the past year.

Direct labour cost is $12 per hour, and the machine usage cost is $18 per hour. Manufacturing overhead costs were estimated at $4,800,000 and were allocated on the basis of machine hours.

Martin Alecks, the new company controller, suggested that an activitybased costing analysis first be run to get a better picture of the true manufacturing cost. The following data were collected:

Selling, general, and administrative expenses per unit sold are $265.00 for Monarch and $244.50 for Regal. Required (a) Calculate the manufacturing cost per unit for Monarch and Regal under: (i) A conventional costing system (ii) The ABC system

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(b)

Explain the differences in manufacturing cost per unit calculated in part (a). (c) Calculate the operating profit per unit for Monarch and Regal under: (i) A conventional costing system (ii) The ABC system (d) Should Applewood concentrate its marketing efforts on Monarch or on Regal? Explain how the use of ABC affects your recommendation. (LO1, 3 and 5) (a) (i) Manufacturing cost per unit under conventional cost accounting In the conventional cost accounting system, overhead is allocated to products based on machine hours. The rate per hour is calculated as follows: Total estimated overhead Estimated machine hours: Monarch (8.0 hours × 22 000 units) Regal (4.0 hours × 4000 units) Total estimated machine hours

$4 800 000 176 000 16 000 192 000

Estimated allocation rate per machine hour ($4 800 000/192 000) $25.00 The total manufacturing cost per unit is the sum of per unit direct material, direct labour, machine usage and allocated overhead as follows:

Direct material Direct labour Machine usage Overhead 100.00 Total

1.5 DL hrs × $12 42.00 8 mach hrs × $18 72.00 8 mach hrs × $25

Monarch $208.00 18.00

Regal $584.00 3.5 DL hrs × $12

144.00

4 mach hrs × $18

200.00

4 mach hrs × $25

$570.00

$798.00

(ii) Manufacturing cost per unit under ABC First, calculate the allocation rate for each of the ABC pools: Soldering joint Shipments Quality control inspection Purchase orders purchase order Machine power hour Machine setups

($942 000/1 570 000 solder joints)$0.60

per

solder

($860 000/20 000 shipments) $43.00 per shipment ($1 240 000/77 500 units inspected)$16.00 per ($950 400/190 080 purchase orders)$5.00

per

($57 600/192 000 machine hours)$0.30 per machine ($750 000/30 000 setups)

$25.00 per setup

Next, calculate total manufacturing costs allocated to each product under the ABC system and then calculate the total manufacturing cost per unit:

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Monarch___________ 1,185,000 solder jts × $0.60 $ 231,000 16,200 shipments × $43 163,400 Quality control 56,200 inspections × $16 340,800 Purchase orders 80,100 POs × $5 549,900 Machine power 176,000 mach hrs × $0.30 4,800 Machine setups 16,000 × $25 Total Manufacturing Overhead Total Manufacturing Overhead Per Unit $3,160,100/22,000 units 409.98 Direct material Direct labour 1.5 DL hrs × $12 Machine usage 8 mach hrs × $18 72.00 Total Manufacturing Cost Per Unit Soldering $0.60 Shipments

Regal__________ $ 711,000 385,000

solder

jts

696,600

3,800 shipment × $43

899,200

21,300 inspections × $16

400,500

109,980

52,800

16,000 mach hrs × $0.30

400,000

14,000 × $25

$3,160,100

POs

350,000 $1,639,900

$143.64

$1,639,900/4,000

208.00 18.00 144.00

584.00 3.5 DL hrs × $12 42.00 4 mach hrs × $18

$513.64

$1,107.98

(b)

The conventional costing system allocates a lump sum of overhead based only on machine hours, while the ABC system uses six cost pools to allocate the overhead. Allocations using these cost pools and cost drivers more accurately reflect the flow of resources.

(c)

(i)

Operating profit per unit under conventional cost accounting: Monarch Selling Price $ 900.00 Manufacturing (570.00) Selling, General and Administrative (265.00) Conventional costing operating profit $ 65.00

Regal $1 140.00 (798.00) (244.50) $ 97.50

(ii) Operating profit per unit under ABC: Selling Price Manufacturing Selling, General and Administrative ABC costing operating profit (d)

Monarch $900.00 (513.64) (265.00) $121.36

Regal $1 140.00 (1 107.98) (244.50) $ (212.48)

Based on the profit information using ABC, Applewood should concentrate on the Monarch. Under ABC, it appears that the organisation incurs a loss for each unit sold of Regal. Using this ABC information would definitely affect the recommendation because one product appears to have a negative profit margin. Note: This problem is from an old CMA exam. The calculations shown in this problem probably include fixed costs. Remember organisations need to emphasise the product with the highest contribution margin to maximise profits; however, that product cannot be identified with the information given in this problem. Applewood would need to separate costs into flexible (those that vary

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with activity) and committed (those that do not vary with activity) to determine the ABC contribution margin for each product. Once this is done, the product with highest contribution margin can be identified and emphasised.

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12.26 ABC costing, ABM Palmer Company uses an activity-based costing system. It has the following manufacturing activity areas, related drivers used as allocation bases, and cost allocation rates:

During the month, 100 units were produced, requiring two setups. Each unit consisted of 19 parts, used 1.5 direct labour hours, and 1.25 machine hours. Direct materials cost $100 per finished unit. All other manufacturing costs are classified as conversion costs. ABC costs for research and marketing costs are $140. All other non-manufacturing ABC costs are $320 per unit. Required (a) Calculate the manufacturing cost per unit for the period. (b) Calculate the total cost (manufacturing and non-manufacturing costs) per unit for the period. (LO3) (a)

Manufacturing cost per unit: Machine setup Material handling Machining Assembly Inspection Direct materials Total Costs Cost Per Unit

(b)

2 setups × $50.00 19 parts × $0.50 × 100 units 1.25 machine hours × $26.00 × 100 units 1.5 direct labour hours × $22.00 × 100 units 100 units × $12.00 100 units × $100.00 $18 800/100 units

Full cost per unit Total manufacturing cost per unit Research and marketing costs per unit Other non-manufacturing costs per unit Total full cost per unit

$ 100 950 3 250 3 300 1 200 10 000 $18 800 $188 $188 140 320 $648

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12.27 ABC in job costing; ABM; non-value-added activities Kestral Manufacturing identified the following overhead costs and cost drivers for the current period. Kestral produces customised products that move through several different processes. Materials and intermediate products are moved among several different workstations. Custom features are designed by engineers.

Information for three of the jobs completed during the period follows.

Required (a) If the company uses ABC, how much overhead cost should be assigned to job 42? (b) If the company uses ABC, calculate the cost per unit for job 43. (c) Kestral would like to reduce the cost of its overhead activities. Describe non-value added activities and explain why reducing these specific activities might also reduce cost. (d) How might Kestral benefit from the use of time-driven ABC? (LO3 and 5) (a)

Following are the ABC allocation rates: Activity Cost Machine set-up $ 40,000 Material handling 160,000 Product design 100,000 Number of inspection 260,000 $560,000

Activity level Allocation rate 400 $100 16,000 $10 2,000 $50 13,000 $20

For job 42, overhead costs = (2 × $100) + (60 × $10) + (40 × $20) + (20 × $50) = $2600 (b)

For job 43, overhead costs = (4 × $100) + (20 × $10) + (20 × $20) + (100 × $50) = $6000

(c)

Non-value added activities are tasks or functions that are unnecessary and waste resources because they do not increase the worth of an organisation’s goods or services to customers. At Kestral, non-value-added activities include moving materials from place to place (such as from receiving dock to warehouse to one work area and then to another work area). The company could reduce costs by minimising the handling of materials. Another non-value-added activity is inspection. With sufficient quality improvements and continuous inspection by workers during production processes, the need for a separate inspection process can be reduced or eliminated. Set-up costs are also considered non-value added and the set-up activity could be analysed to reduce steps and materials if possible so that costs are reduced.

(d)

Kestral may benefit from time-driven ABC through more informed use of the

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practical capacity available, and facilitate the identification and quantification of idle capacity. This may then help with better management of excess capacity. This is possible through the focus on time units as the critical variable. However, the use of a 'standardised cost per time unit of activity' might over simplify the realities of the environment of Kestral.

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12.28 Design ABC system; calculate per-unit ABC costs; uncertainties Elite Daycare provides two different services, full-time childcare for preschoolers, and after-school care for older children. The director would like to estimate an annual cost per child in each of the daycare programs, ignoring any facility-sustaining costs. She is considering expanding the services and wants to know whether full-time or after-school care is more profitable. The following activities and annual costs apply to the daycare centre. Salaries and wages are $100 000. Full-time children arrive between 8 am and 9 am. Older children arrive about 3 pm. All of the children are gone by 6 pm. Employees estimate that they spend about 20 per cent of their time on meal-related activities, 20 per cent supervising naps or recreation, 10 per cent in greeting or sending children home, and the rest of the time presenting educational experiences to the children. Meals and snacks cost about $20 000. Preschoolers receive two snacks and one meal per day, and the older children receive one snack per day. On average, snacks and meals do not differ in cost. Supplies cost $10 000 for the full-time childcare program and $8000 for the after-school program. Currently, 30 children participate in full-time care and 10 children in afterschool care. Because Elite Daycare maintains a waiting list for openings in its programs, the number of children in each program remains steady. Required (a) Identify a cost object and then choose a set of activities and cost drivers for Elite Daycare’s ABC system. Explain your choices. (b) Using the activities you chose in part (a), estimate the annual cost per child in each program. (c) Do uncertainties exist about the proportion of salaries and wages that should be allocated to full-time care versus after-school care? Why? (LO2, 4 and 5) (a)

There are several cost objects that could be chosen for Elite Daycare, depending on the planned use of information. The director may want to develop a function for total costs of the daycare for budget or benchmarking purposes. In that case, the cost object is the daycare itself. Alternatively, she might choose the type of service (full-time or part-time) as the cost object. If she wanted to better understand the cost per child, she could choose a per-child cost object. This problem focuses on the daycare cost function, so the cost object is the daycare program. Next, cost pools need to be developed. For Elite Daycare, there appear to a number of different activities: greeting and leaving, preparing and serving food, supervising naps, supervising recreation, and activity time. The greeting and supervising activities can probably be combined into one cost pool. However, supplies are probably used during activity time, and the director may want to know an approximate cost per child for activity time. Therefore, a single pool can be used for greeting, supervising naps, and recreation; a pool for supervising activities; and another pool can be used for meal-related activities (preparing and serving food, monitoring behaviour).

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Next, cost drivers for each pool need to be chosen. Cost drivers for greeting and supervising activities could be number of children or time spent. Because supervising naps and recreation activities are similar to greeting, cost driver choices would be similar for these two pools. A number of different children can be supervised at one time, so time spent would probably be the easiest to track and provide an appropriate accounting of costs related to supervising activities. Cost drivers for preparing and serving food could be either the number of meals served or the number of children served. Tracking meals served is probably just as easy as tracking number of children, but meals are more closely related to food preparation, so number of meals served will be used as the cost driver. Cost drivers for supplies could be number of art activities or number of children, among others. It would be easiest to track number of children, and it is likely that each child uses similar amounts of supplies. (b)

Annual cost per child The percentage of time for the greeting and supervising pool is 30% (20% + 10%), 20% for meal-related activities, and 50% for supervising educational activities. These times can be further categorised into full-time and after-school by considering the percentage of total hours each program uses. There are 10 hours available per full-time child, and 3 hours per child after school. Therefore, there are 300 (10 hours × 30 children) full-time child hours available per day and 30 (3 hours × 10 children) after-school child hours available. Of the total 330 hours available, 91% (300/330) of the hours are full-time child hours, and 9% are after-school child hours. Now the calculation of the ABC meal related activities cost requires several steps, as follows: Estimated annual volume of snacks/meals: (Assume 5 days per week × 50 weeks = 250 days) Full-time (30 children × 3 snacks & meals × 250 days) After-school (10 children × 1 snack × 250 days) Number of meals served

22 500 2 500 25 000

Total food cost Time spent on meal preparation (20% × $100 000) Total snacks and meals per year Estimated cost per snack/meal ($40 000/25 000)

$20 000 20 000 $40 000 $1.60

The total annual ABC cost per child is calculated as follows: Full-Time After-School Snacks/meals: Full-time (3 snacks/meals × 250 days × $1.60) $1200 After-school (1 snack/meal × 250 days × $1.60) $ 400 Supplies: Full-time ($10 000/30 children) After-school ($8000/10 children)

333

Supervising educational activities: Full-time (50% × 91% × $100 000)/30 After-school (50% × 9% × $100 000)/10

1517

800

450

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Supervising naps recreation and greeting: Full-time (30% × 91% × $100 000)/30 After-school (30% × 9% × $100 000)/10 Total Annual Cost Per Child (c)

910 ____ $3960

270 $1920

The employees work with both full-time and after-school children, and there are uncertainties about how much time they spend with each type of student. If the two groups of children are combined for some activities, then any allocation of salaries or wages to each service is arbitrary and unlikely to reflect the two services’ use of employee time. If the two services are completely separate, the cost of salaries and wages can be traced directly to the service. However, for activities such as snacks, some employee time is probably spent preparing snacks for both groups at once, and allocating this cost would be an uncertain and arbitrary process. It is impossible for employees to track exact time spent per service for activities undertaken for both services, such as snacks and possibly meeting parents at the end of the day. There are uncertainties about whether allocation bases reflect the use of resources because these are fixed resources, and the cost does not vary proportionately with any type of volume measure. Therefore, any allocation is arbitrary and will not accurately reflect use of those fixed resources.

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12.29 ABM; customer profitability You are asked for suggestions about increasing profitability for a customer that purchases low-margin products and requires costly services. Required (a) In your own words, define activity-based management (ABM). (b) In your own words, describe high-cost and low-cost customers. (c) Prepare a brief paragraph suggesting methods to improve profitability for this customer. (LO4 and 5) (a)

Activity-based management involves the use of ABC cost information to develop a comparison of the costs and benefits of tasks and procedures undertaken within the organisation to identify improvements that can be made in quality and efficiency or cost reductions.

(b)

A high-cost customer is one for whom contribution margin is low, relative to other customers, but who requires costly services such as special customised products, special shipping procedures, small production and delivery quantities, specialised post-sales service, or customer services before purchasing, and so on. Low-cost customers would provide relatively more contribution from their orders with little special treatment. These customers may order large quantities of regular products and not require any special delivery or help before or after the sale.

(c)

There are many possible ways to write this paragraph, and the wording depends on the assumptions that are made about the particular audience for the paragraph, the customer, and the nature of the company’s business. Below is a sample paragraph. Several approaches can be taken to improve profitability for high-cost customers. Accountants can identify costs for these types of customers, and the company can negotiate with each customer to either charge for some of the specialised services or motivate the customers to reduce the amount of costly services required. Ways to reduce costs include improving the predictability of orders, reducing the amount of engineering changes or other product changes required, and finding standard products that might substitute for customised products. Customers requiring large amounts of technical support following a purchase might be willing to pay for this service.

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12.30 Introductory TDABC Chief accountant San Kean Indi at Lewinsky and Dikolli Architects has begun a pilot project exploring the use of time-driven-activity-based-costing (TDABC). Indi became aware of the attributes of TDABC at a recent professional development seminar. Indi has decided to use the administration support function for the pilot. Relevant information that Indi has managed to collect so far is provided in Table 1.

Required (a) Why do you think Indi believes TDABC might be applicable for Lewinsky and Dikolli Architects? (b) Calculate the level of theoretical capacity and practical capacity within the administration support function. (c) Calculate the cost per time unit of practical capacity. (LO5) (a) Compared to conventional ABC, TDABC can be less complex and timeconsuming to apply and the results may be more accurate. Knowledge of the cost per time unit of capacity will enable Lewinsky and Dikolli Architects to relatively easily determine the administration support costs involved in meeting the needs of their various clients. (b) Theoretical capacity = (4 staff x 8 hrs x 5 days x 46 weeks) + (1 staff x 5 hrs x 5 days x 46 weeks) = 8 510 hours or 510 600 minutes Practical capacity (80%) = 8 510 hours x 0.8 = 6 808 hours or 408 480 minutes (c) = $632 000 ÷ 6 808 hours = $92.83 per hour OR = $1.55 per minute

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Problems 12.31 Setting up an ABC system; uncertainties Following is a list of steps that must be performed in setting up an ABC system: • Identify and sum the costs into activity-based cost pools. • Choose a cost driver for each activity. • For each ABC cost pool, allocate overhead costs to the product or service. • Identify the relevant cost object. • Identify the activities necessary for production or service delivery. • For each ABC cost pool, calculate a cost allocation rate. Required (a) Number the steps from 1 through 6 to indicate the sequence in which they are performed. (b) For each step, explain whether uncertainties are likely. (c) Pick the step that you think would require the greatest use of judgement, that is, would include the most uncertainties. Explain your choice. (LO3 and 5) (a) 3 Identify and sum the costs into activity-based cost pools 4 Choose a cost driver for each activity 6 For each ABC cost pool, allocate overhead costs to the product or service 1 Identify the relevant cost object 2 Identify the activities necessary for production or service delivery 5 For each ABC cost pool, calculate a cost allocation rate (b)

All of these steps include uncertainties. After a cost object is chosen, uncertainty exists about whether all of the activities necessary to produce the good or service are identified. Some activities may be overlooked, or the set of activities may include ones that rarely occur and would be an immaterial part of the process. In addition, uncertainties exist about the optimal number of activities for a given cost pool. There is uncertainty about whether the costs for developing additional cost pools would exceed the benefits. Uncertainties also exist about whether the system would be more or less accurate when potentially separate activities are grouped together. When assigning costs to activities, there is uncertainty about whether all direct costs have been identified and traced to each activity. For example, supplies such as cloths used to wipe off excess oil during the set-up process may be overlooked. In addition, the assignment of a common resource cost, such as a supervisor salary, may not reflect the time the supervisor spends on different activities. For each cost pool, there is uncertainty about whether all of the potential cost drivers have been identified and whether the chosen cost driver most accurately reflects the use of resources within that cost pool. In addition, some activities are © John Wiley and Sons Australia, Ltd 2020

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interdependent, and the cost pools and cost drivers may not accurately reflect these interdependencies. Choosing a cost driver for each activity requires the use of judgement. Some activities may have an obvious cost driver, while others could have several different drivers. Assembling a box, for example, may only require direct labour and thus have a clear cost driver. Other activities could include adding materials, using machine hours, and using direct labour hours. For these types of activities, several different cost drivers could be chosen. The accountant implementing ABC must identify the driver that best relates changes in activities to changes in cost. Measuring the amount of cost driver used per product is sometimes uncertain. Suppose time spent cleaning is a cost driver for a housekeeping cost pool. When a new employee is hired, the actual time may be longer than the normal time for the employee’s first several months. Therefore, uncertainty exists about whether the allocation base volume is accurately set, or whether the activity has been correctly measured when allocating the cost. (c)

There are many correct choices for this answer. The key is to focus on uncertainties and to explain why the need for judgement might be greater in one step than in the others. Below are two sample answers. The choice of cost drivers might require the greatest use of judgement because of the large number of uncertainties involved. There are uncertainties about whether all possible cost driver choices have been identified, and whether the selected cost driver actually reflects the use of resources of the cost pool more accurately than other choices. In addition, some high quality cost drivers may not be measured very accurately, there are certainties about whether a particular cost driver provides the best information. The choice of activity cost pools might require the greatest use of judgement because it not only involves a large number of uncertainties (as discussed in Part B above), but it also affects all of the remaining steps. Choices that are made about the activities influence the cost and benefits achieved from the entire system.

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12.32 ABC cost hierarchy; uncertainties In ABC systems, activities are often separated into a hierarchy of categories. Required (a) In your own words, explain what is meant by a cost hierarchy in ABC. (b) Explain why uncertainty is possible in classifying costs within the cost hierarchy. (c) Explain how categorising costs into a hierarchy helps accountants determine how costs behave. (LO2) (a)

A cost hierarchy in ABC divides activities into six levels: unit, batch, product, customer, facility, and organisation. This allows accountants to more carefully identify activities and their associated costs at all levels within the company.

(b)

Following are several reasons for uncertainty in classifying costs into the cost hierarchy categories; students may think of others. As costs are categorised into cost hierarchy categories, accountants might not completely understand the interdependencies within a group of activities. For example, costs that appear to be batch-level costs could also be affected by the number of units or the weight of the batch. Managers cannot be certain that the chosen cost driver in a specific cost category independently reflects cost changes. Additionally, costs that appear to be organisation-level costs could be driven by changes in volumes. For example, the costs of billing and interacting with customers regarding their bills could increase step-wise as a fixed cost. Accountants are uncertain whether this cost increases as the number of customers increase, or whether it is an organisation-level cost that will not change regardless of volumes.

(c)

Dividing costs into six levels helps accountants better identify all aspects of costs in a company. Thinking about a particular level helps accountants focus on activities that occur at that level. In addition, once activities have been developed for a particular level, it becomes easier to know how costs change with volumes of activity. For example, property taxes are a facility-level cost and therefore would not increase based on the number of batches produced, but only on the value of the building itself. Using these six levels helps accountants better map resource usage to products and services.

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12.33 ABC versus conventional job costing; uncertainties; advantages and disadvantages Vines Ltd produces custom machine parts on a job order basis. The company has two direct product cost categories: direct materials and direct labour. In the past, indirect manufacturing costs were allocated to products using a single indirect cost pool, allocated based on direct labour hours. The indirect cost rate was $115 per direct labour hour. The managers of Vines Ltd decided to switch from a manual system to software programs that release materials and signal machines when to begin working. Simultaneously, the company adopted an activity-based costing system. The manufacturing process has been organised into six activities, each with its own supervisor who is responsible for controlling costs. The following list indicates the activities, cost drivers, and cost allocation rates.

The company’s information system automatically collects the necessary data for these six activity areas. The data for two recent jobs follow:

Required (a) Suppose the company had not adopted an ABC system. Compute the manufacturing cost per unit for job orders 410 and 411 under the old, conventional costing system. (b) Under the new ABC system, calculate the manufacturing cost per unit for job orders 410 and 411. (c) Compare the costs per unit for job orders 410 and 411 as calculated. Explain why the cost per unit under the conventional costing system is different from cost per unit under the ABC system.

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(d) (e)

Explain why uncertainties may arise about the choice of cost drivers for each activity. Identify and explain to Vine Ltd’s managers the possible advantages and disadvantages of adopting the ABC system.

(LO1 and 5) (a) Per unit cost using the old method:

Direct materials Direct labour Indirect 215.63 Total

Job Order 410________ $9,700/10 units $ 970.00 $750/10 units 75.00 $115x(25 hrs/10 units) 287.50

Job Order 411________ $59,900/200 units$299.50 $11,250/200 units 56.25 $115x(375 hrs/200 units)

$1,332.50

$571.38

Job Order 410_______ 500 parts × $0.40 $ 200.00

Job Order 411________ 2,000 parts × $0.40 $

150 mach hrs × $20 21,000.00 500 parts × $0.80 1,600.00 2 assembly hrs × $5 150.00 10 units × $25 1 order × $1,500

3,000.00

1,050 mach hrs × $20

400.00

2,000 parts × $0.80

10.00

30 assembly hrs × $5

(b) Cost per unit cost using ABC

Material handling 800.00 Milling Grinding Assembly Inspection Shipping Direct material Direct labour Total costs for order Total cost per unit

$15,810.00/10 units $506.00

250.00 1,500.00 9,700.00 750.00 $15,810.00

200 units × $25 5,000.00 1 order × $1,500 1,500.00 59,900.00 11,250.00 $101,200.00

$1,581.00

$101,200.00/200 units

(c)

In the conventional costing system, the indirect costs were combined into a single cost pool and then allocated based on direct labour hours used by each order. Direct labour hours may or may not be related to costs in the overhead pool. It’s unlikely that they are related to a very large portion of those costs. However, under ABC, the indirect costs are divided into six cost pools and allocated using cost drivers that are more likely to reflect the use of resources. Therefore, the cost allocations provide more accurate information about costs.

(d)

There are many uncertainties about the choice of cost driver for each activitybased cost pool. There may be several different drivers that could be used, and several of them could be similar in their ability to relate cost to the activity. For example, if a school has classrooms that are similar in physical size with similar numbers of students in each class, number of rooms may be an adequate cost driver. However, if younger students are messier and cleaning their rooms takes longer, then time spent might be a better cost driver. Sometimes time spent is not measured. In this case number of rooms could be used, or square feet if rooms are different sizes. And this is a fairly forthright activity with easy to identify cost drivers. Other activities can be much more complex, and finding cost drivers

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(e)

can be more difficult. Identifying the most appropriate cost driver requires effort, and the best driver may be expensive to measure. If the activity changes in any way, a new driver might be needed. An ABC system allocates costs using more cost pools and more appropriate cost drivers, so costs are likely to be less distorted. For example, if direct labour hours were abnormally high for one job, under the conventional costing system the indirect costs assigned to that job would be higher even if more costs were not incurred. Under ABC this possibility for error is minimised because there are more allocation bases than direct labour hours. The ABC system is more costly to implement because it takes time to develop and many employees need to be involved. ABC is more useful in analysing operations to improve quality and reduce costs. Non-value added activities can be identified and other activities can be simplified, once they have been identified. This doesn’t tend to happen with conventional costing.

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12.34 ABC and process costing Kim Mills produces three different types of fabric using two departments. In department 1, machines weave the cloth. In department 2, the cloth is dyed a variety of colours. Information for the combined use of resources in both departments for the three types of fabric follows. Bolts are 20 yards each. All fabric is inspected during production. Robotic equipment inspects the fabric for obvious flaws as the bolts are wound up. Each bolt spends about 5 minutes in the inspection process.

Combined overhead costs for the two departments follow:

Previously, Kim Mills used a costing system focused on processes. It allocated direct materials to each product separately, but allocated direct labour and conversion costs as if they were incurred equally across the units produced. Under this costing system, the overhead cost for department 1 is $19 332 and for department 2 it is $38 664. Direct labour hours and costs in department 1 are 55 hours at $1100, and the remaining are in department 2. Direct materials for department 1 are $6000 for denim, $16 000 for lightweight, and $15 000 for heavyweight. The remaining direct materials are added in department 2. No beginning or ending inventory or abnormal spoilage is recorded for Kim Mills this period. Required (a) Set up a spreadsheet to perform the following calculations. Use a data input section and cell referencing. (i) Use conventional process costing to allocate the direct materials and conversion costs per department to total bolts produced. Develop a cost per bolt for each type of fabric. (Hint: You will need to first calculate the equivalent cost per bolt for conversion costs for each department.) (ii) Using activity-based costing, develop a cost per bolt.

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Units 1,000 4,000 2,000 7,000 Direct Costs: Direct labor hours 33 66 46 145 Direct materials $8,000 $24,000 $20,000 $52,000 Machine hours 500 1,333 1,500 3,333 Direct labor cost $660 $1,320 $920 $2,900 Number of set-ups 10 Solution Manual 30 20 60 Contemporary Management Accounting Inspection hours 83.3 333.3 166.6 583.2 Overhead Costs: Machine $40,000 Setup $11,000 CONVENTIONAL PROCESS COSTING (b) Compare the process costing and ABC results. Identify the products Inspection $6,996 conversion costs are allocated costs in bothand departments to the number of costs. bolts produced. With no beginning or with overstated those with understated Explain Total Overhead $57,996why Note: Because the therecosts are no beginning or ending under inventories, equivalent units are equalcosting. to physical units. are misstated traditional process Also, there isVolumes: no need to calculation conversion cost per unit separately for the two departments because (c) How could managers use the ABC information to improve conversion costsUnits are allocated in both departments 1,000 to the number of bolts or 4,000produced. With 2,000no beginning7,000 operations? ending inventories, thelabor number of bolts produced is identical in the two 66 departments. Direct hours 33 46 145 (LO1 Machine and 3)hours 500 1,333 1,500 3,333 Number of set-ups 10 30 20 60 Equivalent Conversion Cost Per Unit hoursarefor: 83.3 a sample333.3 166.6 583.2 (a)Total Conversion 1&2 Inspection Following excerpts from spreadsheet for this problem. Costs to Account Total Direct labor Overhead Total

$2,900 $57,996 $60,896

(b) Light-Weight Heavy-

Process Costing Activity-Based Costing

Denim $16.70 17.49

Weight Cotton $14.70 12.70

Cotton $18.70 22.29

Cost Per Bolt Overstated (Understated by Conventional process Costing

$ (0.79)

$ 2.00

$ (3.59)

Under process costing, the cost per bolt of light-weight cotton was overstated; it absorbed costs incurred by denim and heavy-weight cotton because costs under process costing are allocated to the department and then to the product. The production volume of light-weight cotton (4000 bolts) is much larger than either denim (1000 bolts) or heavy weight cotton (2000 bolts). When conversion costs are allocated based on number of units rather than based on the flow of resources used, the product with the most units is allocated relatively more cost. The production of light-weight cotton requires proportionately fewer setups than the other two products, so it should be allocated less of the cost for set-up. Light-weight cotton also uses proportionately fewer machine hours, and so it should also be allocated less of the machine activity costs. In addition, light-weight cotton uses less direct labour per bolt than the other two products. Under conventional process costing, direct labour is combined with other conversion costs and is allocated to units without regard to the actual labour used. (c)

Managers may want to investigate machine set-up costs and reduce them, or reduce the number of set-ups required for all products. In addition, perhaps inspection activities could be analysed and costs reduced. The managers might also investigate reasons why light-weight cotton uses significantly less direct labour than the other two products. Perhaps direct labour could be used more efficiently, reducing the direct labour cost.

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12.35 ABC costs; uncertainties; ABM, non-value-added activities Water Feature Company manufactures kits for fish ponds. The managers recently set up an ABC system to identify and reduce non-value-added activities. The ABC system includes the following cost pools, cost drivers, and estimated costs for manufacturing activities:

The company manufactures 10 kits per batch. Each kit requires 20 parts and two hours in moulding, and weighs 30 kilograms. Required (a) Calculate the total ABC manufacturing cost per batch. (b) Calculate the total ABC cost per finished kit. (c) Suppose that Water Feature’s managers also want to allocate marketing costs and customer service to each product. Total marketing costs for the period were $15 000, and customer service costs were $25 000. Number of batches produced was 1000. Calculate the total ABC cost per unit and cost per kit, including the costs of marketing and customer services. (d) Are the activities listed likely to be the only possible set of activities for Water Feature Company? Why? (e) Describe how the managers and accountants of Water Feature Company might use this new ABC system to identify non-value-added activities. (LO2, 3 and 5) (a) Total Cost Per Batch: Material handling Forming Melding setup Packing and shipping Inspection Direct labour Direct materials Total costs

20 parts × $1 per part × 10 kits $ 200.00 2 melding hours × $40 per hour × 10 kits 800.00 1 batch × $50.00 50.00 30 pounds × $1.30 per pound × 10 kits 390.00 $10 per kit × 10 kits 100.00 $20 per kit × 10 kits 200.00 $100 per kit × 10 kits 1,000.00 $2,740.00

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(b) Total budgeted cost per kit = Total budgeted cost per batch / Number of kits per batch = $2740.00 / 10 kits = $274.00 per kit (c) Cost per Kit Cost Per Batch (10 kits per batch) Total Cost from Parts A and B $2740 $274.00 Marketing ($15 000/1000 batches) 15 1.50 Customer Service ($25 000/1,000 batches) 25 2.50 Total $2780 $278.00 (d)

There are other potential activities that could be chosen for this company. Some activities could be separated further into more pools. For example, packing and shipping could be separated into a packing activity and a shipping activity. Melding may consist of several different tasks that could be considered separate activities. Alternatively, some of these cost pools could possibly be combined, such as melding setup and forming. There are many different choices that could be made for these activities.

(e)

The new ABC system can lead to identification of non-value-added costs by focusing manager attention on the organisation’s activities and cost drivers. As activities are analysed, some tasks or procedures in these activities might be identified as non-value added, and then eliminated. For example, if the ponds could be redesigned to require fewer parts, material-handling costs would likely be reduced. If specific types of defects cause inspection time to increase, redesigning parts or processes to eliminate the defects would decrease inspection time and also decrease customer service costs for product failures. The packing and shipping activities could be analysed to determine whether steps could be combined or some tasks eliminated or outsourced at lower cost. There are many other non-value activities that students might have identified.

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12.36 Uncertainties, actual versus estimated costs, practical capacity Data Processors performs credit card services for banks. The company uses an ABC system. The following information applies to the past year:

Required (a) Are the activities listed likely to be the only possible set of activities for the ABC system? Why? (b) Using estimated values for costs and activity, calculate an ABC allocation rate for each activity. (c) Explain why actual costs and activity levels are likely to be different from estimated amounts. (d) Is practical capacity likely to be higher or lower than the estimated activity levels? Explain. (LO3 and 5) (a)

These activities are not the only possible set. Each of these activities could be separated into a number of other activities. For example, the activity of issuing new credit cards could be further separated into the following cost pools: • Verifying authorisation of new credit cards to be issued • Mailing new credit cards • Validating new credit cards (before first use of the card) Each cost pool could be disaggregated into more cost pools. Alternatively, some of these cost pools could be aggregated in some organisations.

(b) Activity Transaction processing Statements New credit cards Billing disputes (c)

Estimated Cost $2 000 000 1 000 000 500 000 90 000

Estimated Activity 5 000 000 250 000 100 000 3 000

Rate $ 0.40 4.00 5.00 30.00

The volume of activities cannot be predicted with certainty from one month to the next. For example, although the number of credit cards issued last period is known, economic changes affect the number of people who will apply, as will

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advertising campaigns and competition among financial institutions. Some activities, such as issuing monthly statements, are easier to estimate than other activities, such as resolving billing disputes. The number of customers holding credit card accounts probably remains somewhat constant, although each month some credit card customers are gained and lost. It is more difficult to predict the number of billing disputes, which fluctuate with the volume of transactions and also with the degree of problems such as fraudulent credit card use, retailer errors, and charges for unsatisfactory goods or services. Costs will be different than expected because it is not possible to perfectly predict future costs. There may be unanticipated changes in prices, such as electricity rates, telephone charges, or employee health care costs. If activity volumes are higher than expected, then employee overtime pay may exceed expectations. Information technology programming and operating costs may be higher or lower than expected. For example, there could be fewer problems than expected when making improvements to the transaction processing system. There are also likely to be random fluctuations in costs such as office supplies. (d)

Practical capacity is the maximum capacity under typical operating conditions, taking into account regularly scheduled holidays and other down time. This company has several different types of capacity. The discussions below address three types of capacity; students may think of others. One type of capacity for Data Processors is the capacity of the computerised technology to process transactions. Because transactions occur at anytime and anywhere in the world, this capacity must operate 24 hours per day, 365 days per year. The capacity limit would be measured in terms of the maximum volume of transactions that could be processed. The practical capacity of the computerised technology for transaction processing is almost certainly higher than the estimated activity level. The company’s contracts with its customers probably include guarantees that the system is capable of processing a higher volume of transactions than expected. In addition, the company probably has back-up ‘hot’ sites that are fully operational and can take over processing in the case of system failure due to technological problems, natural disasters, terrorist attacks, etc. Capacity for Data Processors also includes the employee capacity to handle services such as billing disputes. This type of practical capacity is likely to be higher than estimated activity levels during slow times, but it could be lower when activities are unexpectedly high. However, the company probably has contractual commitments to resolve billing disputes within a maximum number of days. Thus, the company must be capable of expanding its employee practical capacity, as needed, to meet actual activity levels. The company may be able to expand this capacity quickly by using employee overtime or temporary labour. Another type of capacity for Data Processors is the physical capacity for printing and mailing monthly statements. Once again, the company is probably contractually committed to performance of this service in a timely manner, so the company must have sufficient capacity to handle higher than expected volume. Because it may be difficult to quickly expand this type of physical capacity, the company’s practical capacity is probably higher than its expected activity level.

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12.37 Design ABC cost system; usefulness for ABM Shearwater Council owns and operates an animal shelter that performs three services: housing and finding homes for stray and unwanted animals, providing health care and neutering services for the animals, and pet training services. One facility is dedicated to housing animals waiting to be adopted. A second facility houses veterinarian services. A third facility houses the director, his staff, and several dog trainers. This facility also has several large meeting rooms that are frequently used for classes given by the animal trainers. The trainers work with all of the animals to ensure that they are relatively easy to manage. They also provide dog obedience classes for adopting families. Estimated annual costs for the animal shelter and its services are as follows:

On average, 75 animals per day are housed at the facility, or about 27 375 (75 × 365) animal days in total. The number of animals housed during the year totalled 4500. In addition, the trainers offer about 125 classes during about 30 weeks throughout the year. On average, 10 families attend each class. Last year the veterinarian clinic experienced 5000 animal visits. One of the director’s staff members just graduated from an accounting program and would like to set up an ABC system for the shelter so that the director can better understand the cost for each of the shelter’s services. He gathers the following information:

Required (a) Identify cost pools and assign costs to them, considering the three cost objects of interest.

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(b) (c)

Determine a cost driver for each cost pool and explain your choice. Calculate the allocation rates for each cost pool and cost driver. Interpret the allocation rate for each cost pool (that is explain what it means).

(LO3 and 5) (a)

The staff member identified the following three cost objects. Each cost object represents one of organisation’s three services. • Animal shelter • Obedience training • Veterinarian services One possibility for cost pools is to create one pool for each cost object. This approach assumes that all costs can be directly assigned to one of these three services. Based on the following summary, it appears that some of the costs can be directly traced to the cost objects. However, some of the costs are indirect. (Note: Judgement is involved in these classifications; students might have categorised costs differently. For example, students might have classified veterinarians and technicians as indirect if they assumed that these employees provide services for the animal shelter in addition to the veterinarian clinic.) Direct Costs___________ Animal Obedience Veterinarian Shelter Training Services Indirect Total Director and staff salaries $ 0 $ 0 $ 0 $ 60,000 $ 60,000 Animal shelter employees’ salaries100,000 0 0 0 100,000 Veterinarians and technicians 0 0 150,000 0 150,000 Animal trainers* 20,000 20,000 0 0 40,000 Food and supplies** 50,000 0 75,000 0 125,000 Building-related costs 0 0 0 200,000 200,000 Total $170,000 $20,000 $225,000 $260,000 $675,000 *

The problem indicates that animal trainers provide training classes and also train animals housed in the animal shelter. 50% of the animal trainer time is devoted to obedience classes. The remaining 50% is assumed to relate to training for animals housed in the animal shelter.

** The problem states that $75 000 of this cost is used by the veterinary clinic. The remainder ($50 000) is assumed to be used in the animal shelter. A decision must be made about whether to allocate the two indirect costs to the three services. ‘Director and staff salaries’ is most likely a facility-level cost for general administration, which would NOT normally be allocated to individual product lines. ‘Building-related costs’ is also a facility-level cost. Sometimes this type of cost is allocated to individual products, and sometimes it is not. The

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following solution assumes that the building-related costs are NOT allocated to the shelter’s individual services. (b)

There are three cost pools to consider—one for each of the organisation’s services. For the animal shelter, a cost driver could be the number of animal days. On a daily basis, each animal would require similar time from employees to clean their cages, feed, and groom, and similar supplies such as food and bedding. Another possible cost driver is the total number of animals housed. However, this cost driver would not capture differences in cost caused by lengthy animal stays. A cost driver for obedience training could be number of classes, number of families taking classes, or number of weeks in which classes are held. Because each class would require about the same amount of time regardless of the number of families per class, number of classes is probably a better cost driver. A cost driver for veterinary services could be the number of animal-visits. Similar amounts of time and resources would be used per animal, although this assumes that the product mix of (e.g. neutering and vaccinations) remains relatively constant.

(c)

Given the cost pools identified in part A and the cost drivers in part B, the allocation rates are as follows: Allocation Cost Pool Total Cost Cost Driver Volume Rate Animal shelter $170,000 Animal days 27,375 $ 6.21 Obedience training 20,000 # of classes 125 160.00 Veterinarian services 225,000 Animal visits 5,000 45.00 The allocation rate for the animal shelter indicates that the average cost of housing a pet for one day is $6.21. The allocation rate for obedience training indicates that it costs on average $160 to offer a training class. The allocation rate for veterinarian services indicates that it costs on average $45 to provide veterinarian care per animal-visit.

12.38 Usefulness of ABC With reference to Keener Doors in comprehensive example 2, provide answers to each of the following questions with regard to the use of ABC information for activity-based management. (a) Why did the managers ask for additional analysis of marketing and warranty costs?

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(b) (c) (d)

When managers use ABC information to improve operations, why is it impossible to be certain that the company will achieve benefits? What benefits of ABM were illustrated? What costs did the company incur to generate these benefits? In your own words, describe how various quantitative and qualitative factors were weighed in reaching a decision about the hinge problem.

(LO3 and 5) (a) Managers requested additional analysis of marking and warranty costs to gain a better understanding of such costs with a view to cost reduction. The costs were to be analysed using doors as a single product line and windows as the other product line. (b)

The use of ABC information to improve operations does not give certainty that the company will achieve benefits. Firstly it requires individuals within the organisation to respond to the information presented in the reports prepared by the accountant. Individuals can interpret information differently and therefore take different decision paths. Another problem is the response in the market place. For example in relation to the hinge problem the company’s reputation may have already been lost to many customers who may be unwilling to continue purchasing doors – they may have already found another supplier – so the recapture of market share may not happen.

(c)

Benefits of ABM illustrated in Keener Doors example: • Managers were made aware of the costs associated with warranty work – in that the cost was nearly as large as marketing costs • The analysis enabled the managers to identify that the warranty costs were high due to hinge problems which leads to a need to replace the entire door. • From the identification of the problem operational staff worked towards finding a solution with suggestions being to reinforce a door around the hinge or the replacement of the current hinge with a new improved product. • The final solution was to change the hinge to improve the quality of the product, and this should lead to an improvement in the firm’s reputation in the market place and an opportunity to eventually increase market share. The costs associated with achieving this outcome would have included the salary costs of staff investigating the problem and the increased cost of the hinge – however, all this should be offset with improved market share bought about by an improvement in customer satisfaction.

(d)

Answer requires students to identify the importance of the use of qualitative versus quantitative information in the decision process re the hinge problem.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. © John Wiley and Sons Australia, Ltd 2008

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Prepared by Judy Oliver

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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Chapter 13: Relevant costs for decision making Questions 13.1

When making a non-routine operating decision, are all future costs relevant? Explain. (LO1)

Future costs are relevant only if they differ between the decision alternatives.

13.2 Business publications frequently provide subscriptions to students at a substantial discount. Why do you suppose such offers are made? (LO1) The magazine companies would want to cover their variable costs, but beyond that they are assuming they can gain readership by letting students subscribe at a discount. Then when the students graduate, they will continue to subscribe at the full rate, increasing the organisation’s profits and readership. The magazines also earn higher advertising fees with higher readership, so they receive additional revenue from student subscriptions. In addition, it is unlikely that many students would subscribe without the discounts, so the companies are not replacing their regular business.

13.3 An organisation is currently operating at capacity. Should it accept a request for a special order based on variable cost plus 40%? Explain. (LO2) If variable cost plus 40% is greater than or equal to the contribution margin on products for which capacity is currently used, the organisation should take the special order. If the contribution margin on current products is higher, the organisation should not take the special order.

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13.4 Refer to the general decision rule for special orders. (a) Would this same general decision rule apply to a decision to sell afternoon theatre tickets at a discounted price? Explain. (b) Identify two other business pricing situations that are similar to the afternoon theatre tickets. (LO2) (a)

Yes, it applies. The decision rule is to accept a special order as long as it covers at least the variable costs if it does not replace regular business. It is usually presumed that the audience that is attracted to afternoon shows is different from the audience that is attracted to regular times.

(b)

The pricing decision has to do with the fact that most costs are fixed, rather than variable. Weekend internet specials for the airlines are similar. Hotels and restaurants in resort areas often reduce prices during the off-season.

13.5 Describe several methods that can be used to relax constrained resources. (LO5) Constraints can be relaxed in a number of ways. If capacity is constrained, it can be expanded by purchasing new equipment, space, and hiring more labour. If there is a bottleneck, it can be relaxed by using it during all hours of operation, inspecting units before they go through the bottleneck to be certain only good units are produced by it, and by offloading demand to other machines or processes if possible. Material constraints are relaxed by changing the product design or by purchasing more materials.

13.6 In your own words, distinguish between quantitative and qualitative information. (LO1, 6) Quantitative information is data that can be used in a mathematical analysis. Qualitative information is information that is not numerical, that is, it cannot be quantified easily.

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13.7 Grover Nursery is a large nursery in Sydney that has always raised the bedding plants it sells. The managers recently decided to buy bedding plants from a wholesale nursery in another state. (a) List several quantitative factors that might encourage the managers to buy from another grower. (b) List several qualitative factors that might encourage the managers to grow their own plants. (LO4) (a) (b)

Possible quantitative factors include the incremental cost of growing bedding plants and the cost to purchase the plants from someone else. Possible qualitative factors include: • Timeliness of delivery • Quality of bedding plants • Whether the bedding plants are appropriate for this climate • Whether Grover can get the quantities of plants needed • Whether there are other wholesale nurseries to purchase from if this relationship does not work well.

13.8 List two qualitative factors that often need to be considered when making a decision about whether to outsource a product or service. (LO4) Qualitative factors that affect the decision to outsource include quality and timeliness of delivery. If the supplier market is competitive, it may be easy to ensure high quality because the organisation can switch vendors when quality drops. If only one or two vendors supply the product or service, it may be difficult to ensure high quality. Similar issues arise with ensuring timely deliveries of products or services that are outsourced.

13.9 Explain how managers decide which products in a sales mix to emphasise. (LO5) Managers examine the contribution margin per product, or per constrained resource to determine the products that should be emphasised. If there are no constraints, then the product with the highest contribution margin should be emphasised. The products can be rank-ordered and emphasised in that order. If resources are limited, a linear program can be used to determine the optimal sales mix if more than one constraint exists. If only one resource is constrained, the product with the highest contribution margin under that constraint should be emphasised.

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13.10 What kind of constraints would arise in an accounting entity during tax season? How could any constraints be relaxed? (LO5) Labour hours are the constraint for an accounting firm during tax time, and especially professional labour. Labour constraints can be relaxed by hiring more people, or by using computerised tax software to increase efficiency. Some tasks, such as opening mail, filing, and entering data into programs, can be performed by temporary labour or relatively unskilled labour. But some tasks require professional labour, which may be the binding constraint at times. Many accounting professionals work very long hours during tax season to relax these types of constraints.

13.11 List at least three different types of non-routine operating decisions and give an example of each one for a retail clothing factory outlet. (LO1) A special order decision for a retail clothing factory might be uniforms for a football team. It’s likely that the order would not replace regular business, unless they routinely sell uniforms. Another short-term decision would be whether to keep or drop a particular line of clothing, such as a line of jeans with a special treatment to make them look worn after the popularity of this style of jeans wanes. Another short-term decision would be whether to outsource administrative functions, such as payroll, or factory functions, such as sewing certain garments. If resources are constrained, product emphasis decisions under constrained resources need to be made. If resources are not constrained, products need to be identified for emphasising through advertising or promotions.

13.12 List two qualitative factors that often need to be considered when making a decision about whether to accept a special order. (LO2, 6) Considerations for special orders are whether the order would replace regular business, whether there is ample capacity, whether other customers might learn about a special pricing arrangement and demand the same price, and whether the price is above the variable cost plus any relevant fixed costs.

13.13 Give an example of joint products in a service industry and describe the main products and by-products.

(LO7) Here are a few examples; students may think of others that are also appropriate. A professor may do some consulting work that simultaneously generates ideas for a journal article (main product), a case for a book (main product), and a problem for an exam (by-product). A CPA firm may work on client development that simultaneously produces prospective engagements for the auditing and tax services (all probably main products). A research scientist may have an individual project that results in twentytwo patentable items (some may be main products, some may be by-products, and some may be scrapped). 13.14 A decision about processing a product further should not be influenced by joint cost allocation, but should be based on incremental costs and qualitative factors. Explain. © John Wiley and Sons Australia, Ltd 2020

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(LO7) Once the joint product emerges, the joint cost should be viewed as a ‘sunk’ cost; it is a past cost that should not influence subsequent product decisions. Further processing decisions should be made based on the additional revenues obtained in relation to the additional separable costs needed to obtain those revenues. 13.15 The allocation of a joint cost among joint products is essentially an arbitrary process. If this statement is true, then why allocate?

(LO7) If all joint products were sold in the period produced, costs might not need to be allocated. But for financial reporting, all production costs must be assigned to cost of goods sold and ending inventories of the joint products to match revenues and expenses.

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29 Exercises 13.16 Special order with no spare capacity Crystal Lattice produces exercise mats for use in fitness centres. Production capacity is 20 000 mats per year. Due to a chain of fitness centres closing, Crystal Lattice now has spare capacity of 2000 mats per year. An international hotel chain, Resteasy, has recently contacted Crystal Lattice to place a one-off order for 3000 mats. The hotel chain has recently remodelled a number of its hotels to incorporate fitness centres for guests. Budgeted costs for 20 000 mats are: • variable manufacturing costs $800 000 • fixed manufacturing costs $900 000. Mats normally sell for $100 each, and Resteasy has offered to pay $90 per mat. Resteasy has also requested that each mat be embossed with its company logo. An embossing machine costing $20 000 would therefore need to be purchased by Crystal Lattice. The machine could not be used for other products. Required (a) From a financial perspective, should Crystal Lattice accept the special order? Show calculations. (b) What other factors should be considered before the order is accepted? (LO2 and 6)

(a) Analysis of special order Production capacity 20 000 mats per year Idle capacity 2000 mats Special Order for 3000 mats from Resteasy Hotel Chain. Variable Manufacturing Costs $800 000 / 20 000 mats = $40 per mat Contribution Margin Sales Price Variable Costs Contribution Margin

Normal Sales $100 40 $ 60

Benefit of Special Order 3000 units × $50 Less incremental fixed cost Less Opportunity Cost 1000 units × $60 Net benefit of special order

Special Order $90 40 $50

$150 000 (20 000) $130 000 60 000 $70 000

(b) Qualitative Factors • Reaction of other customers if they find out that Resteasy is paying a lower price

per mat © John Wiley and Sons Australia, Ltd 2020

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• Potential of Resteasy to be a long term customer paying normal sales price.

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13.17 Outsource computations, qualitative factors Diamond Light Company incurred the following costs to produce 25 000 light switches for floor lamps last year.

The Ignition Company has offered to supply the switches for $8 per unit. An analysis of the overhead costs has identified that if the switches are outsourced, Diamond Light Company would eliminate $10 000 of fixed costs, and could use the released production capacity to generate additional income of $28 000 from producing a different product. Required (a) From a financial perspective, should the light switches be outsourced? Show calculations. (b) What qualitative factors need to be considered in the outsourcing decision? (LO4 and 6) (a) Financial analysis of decision to outsource light switches. Costs Make Direct materials $50 000 Direct labour $75 000 Variable manufacturing overhead $40 000 Purchase Price Fixed Costs Additional income if outsourced Costs $165 000 Savings if switches purchased from Ignition Company

Buy

$200 000 ($10 000) ($28 000) $162 000 $3 000

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Alternative calculation using full costs Costs Make Direct materials $50 000 Direct labour $75 000 Variable manufacturing overhead $40 000 Purchase Price Fixed Costs $60 000 Additional income if outsourced Costs $225000 Savings if switches purchased from Ignition Company

Buy

$200 000 $50 000 ($28 000) $222 000 $3 000

(b) Qualitative issues: • Reliability of supply • Quality of switch • Potential for price increases in the future

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13.18 Make or buy The management of SouthPak Company has asked for your assistance in deciding whether to continue manufacturing a part or to buy it from an outside supplier. The part, called AlphaB, is a component of SouthPak’s fi nished product. An analysis of the accounting records and the production data revealed the following information for the last financial year 1. The production department produced 72000 units of AlphaB. 2. Each unit of AlphaB requires 20 minutes to produce. Six people in the production department work full-time (4000 hours each per year) producing AlphaB. Each person is paid $12 per hour. 3. The cost of materials per AlphaB unit is $4. 4. Manufacturing costs directly applicable to the production of AlphaB are:

All of the above costs will be eliminated if AlphaB is purchased. 5. The lowest price for AlphaB from an outside supplier is $8 per unit. Delivery costs will be $0.80 per unit, and a part-time dispatch employee at $17 000 per year will be required. 6. If AlphaB is purchased, the excess space will be used to store SouthPak’s fi nished product. Currently, SouthPak rents storage space at approximately $1.60 per unit stored per year. Approximately 9000 units per year are stored in the rented space. Required Should SouthPak make or buy the part? Show all calculations. (LO4) Costs Direct Labour (24 000 hrs × $12) Direct Material (72 000 units × $4) Purchase Costs (72 000 × $8) Delivery costs (72 000 × .8) Part-time dispatch employee Savings in storage space (9000 units × $1.60) Fixed Costs Costs Additional costs to outsource

Make $288 000 $288 000

Buy

$576 000 $57600 $17 000 ($14 400) $23 600 $599600

$636200 $36600

From a financial perspective SouthPak should continue to make AlphaB as the costs are higher to outsource. However, if the capacity used to produce AlphaB could be used for other purposes then any benefit would need to be offset against the cost.

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13.19 By-product further processing decision For a given by-product, 100 units can be sold at the split-off point for $8 each, or processed further at a cost of $12 each and sold for $19. Required Should the by-product be processed further? Provide calculations and explain your answer. (LO7) According to the following calculations, the contribution margin is higher if the byproduct is sold at the split-off point rather than processed further. Therefore, the byproduct should not be processed further. Sold at split-off: 100 × $8 = $800 Processed further: 100 × ($19 – $12) = $700

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13.20 Identifying joint products Required (a) Which of the following related products would be considered joint products? Explain your choices. i. Sand produced with three levels of fineness ii. Motor vehicles and trucks iii. Milk, yoghurt, butter, and cheese iv. Motorcycles and mopeds v. Various lines of clothing manufactured for a discount department store vi. An airline that provides 3 classes of service: first class, business class, and economy class (b) List two more additional product groups that could be considered joint products. (LO7) (a)

The following are joint products i. Sand produced with three levels of fineness. The sand is produced by processing raw dirt and includes a number of joint costs such as labour and equipment. Some of the products are processed further. ii. Milk products are joint products because they all come from one liquid that is processed further, depending on the product. iii. Airlines could be considered as incurring joint costs because a large proportion of cost is common to all of the products.

The following are not joint products iv. Automobiles and trucks because either one can be manufactured without producing the other. v. Motorcycles and mopeds because either one can be manufactured without producing the other. vi. Clothing can be manufactured in any style without producing other styles and is therefore not a joint product. (b)

Two other product groups would include tour services or cruise lines, products manufactured from crude oil such as gasoline, diesel, and heating oil, and many types of food products such as beverage manufacture, cereals, milling operations, and so on.

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13.21 Identifying joint and separable costs Outback Cattle Company raises cattle and sells beef products. Following is a list of costs for the operation. Required

Identify whether each cost is most likely a (J) joint cost or a (S) separable cost. For each item, explain why. i. Veterinary costs for the calves ii. The cost of grinding meet for mince iii. The cost of feed for the cattle iv. The cost of labour to manage the cattle while they grow v. The cost of labour to prepare the cowhide for sale as leather vi. The cost for packaging steaks and roasts vii. The depreciation on the sheds that provide shelter for the cattle (LO7) i.

Joint

ii.

Separable

iii. iv. v. vi.

Joint Joint Separable Separable

vii.

Joint

All cattle require veterinary work, and the cost per specific cow is incurred before the split-off point. The cost occurs after the split-off point and can be traced directly to hamburger. The cost is incurred before the split-off point. The cost is incurred before the split-off point. The cost is incurred after the split-off point, specifically for leather. The cost is incurred after the split-off point, specifically for steaks and roasts. Cost of production incurred before the split-off point.

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13.22 NRV method, contribution margin and further processing for a service Deluxe Tours, a tour organiser, leased a cruise liner for a special roundthe-world tour. The lease cost is $200 000. Two classes of passengers are booked on the tour: first class and economy class. The total revenue from the 100 first-class passengers is $200 000, and from the 200 economy-class passengers is $200 000. Other costs for the two classes of passengers amount to $30 000 for first class and $30 000 for economy class. Required (a) How much of the lease cost would be allocated to first-class passengers if the net realisable value method is used? (b) What is the contribution margin generated by first-class passengers? (c) When the cruise liner managers are deciding whether to increase the number of first-class rooms, which joint cost allocation method is best to use? Explain. (LO7) (a) Number of passengers Revenue Incremental costs Net realisable value Allocated lease cost Margin

First-Class 100 $200 000 30 000 170 000 100 000 a b $ 70 000

Tourist-Class 200 $200 000 30 000 170 000 100 000 $ 70 000

a $200 000 lease cost * [$170 000/($170 000 + $170 000] = $100 000 b $200 000 lease cost * [$170 000/($170 000+$170 000] = $100 000 (b)

The answer to this question depends upon what is meant by ‘the contribution margin generated by first-class passengers.’ An accountant could determine it is $70 000, the margin after deducting a share of the lease cost. However, a more accurate reflection would be $170 000, the revenue generated by first-class passengers, less the incremental costs of serving those passengers. An alternative answer is to consider the amount of margin generated by having a separate class of passengers rather than filling the entire cruise ship with tourist-class passengers. Assume that 25 tourist-class berths replaced 20 firstclass berths. (Students could make any reasonable assumption concerning how many tourist-class berths would replace first-class berths.) So, the trade-off is 25 tourist-classes versus 20 first-class berths. Incremental contribution margin if first-class cabins are sold to tourist-class passengers: Contribution per passenger for first-class: $200 – $30 = $170 Contribution per passenger for tourist-class: $100 – $15 = $85 Contribution for 20 first class passengers (20 × $170) Contribution for 25 tourist class passengers (25 × $85) Additional contribution for first class

$3400 2125 $1275

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(c)

In the example above, no allocated costs were considered because they are essentially sunk costs for the decision to use the space for first-class or tourist class. Those costs are incurred either way, so only incremental contribution is analysed.

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13.23 Four joint cost allocation methods with sales mix, further processing decision The Palm Oil Company buys crude coconut and palm nut oil. Refining this oil results in four products at the split-off point: soap grade, cooking grade, light moisturiser and heavy moisturiser. Light moisturiser is fully processed at the split-off point. Soap grade, cooking grade and heavy moisturiser can individually be refined into fine soap, cooking oil, and premium moisturiser. In the most recent month (June), the output at the split-off point was:

The joint costs of purchasing the crude coconut and palm nut oil and processing it were $100 000. There were no beginning or ending inventories. Sales of light moisturiser in June were $50 000. Total output of soap, cooking oil and heavy moisturiser was further refined and then sold. Data relating to June are as follows:

Palm Oil Company had the option of selling the soap grade, cooking grade, and heavy moisturiser at the split-off point. This alternative would have yielded the following sales for the June production:

Required (a) Allocate the joint cost using each of the following methods: (i) sales value at split-off point (ii) physical output (iii) net realisable value (iv) constant gross margin NRV.

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(b)

Could Palm Oil Company have increased its June operating income by making different decisions about further refining the soap grade, cooking grade, or heavy moisturiser palm nut oil? Show the effect on the contribution margin of any changes you recommend.

(LO7) (a) Calculation of $100 000 joint-cost allocation using four allocation methods: (i) Sales value at split-off point Sales Value at Product Split-Off Point Soap grade $ 50 000 Cooking grade 30 000 Light moisturiser 50 000 Heavy moisturiser 70 000 $200 000

Allocation Proportions 50/200 = 0.25 30/200 = 0.15 50/200 = 0.25 70/200 = 0.35

of $100 000 $ 25 000 15 000 25 000 35 000 $100 000

(ii) Physical volume

Soap grade Cooking grade Light moisturiser Heavy moisturiser

Allocation Physical volume 100 000 gallons 300 000 gallons 50 000 gallons 50 000 gallons 500 000 gallons

Proportion 100/500 = 0.20 300/500 = 0.60 50/500 = 0.10 50/500 = 0.10

of $100 000 $ 20 000 60 000 10 000 10 000 $100 000

(iii) Estimated Net Realisable Value Estimated Net Final Sales Separable Realisable Allocation Product Value Costs Value Proportion of $100 000 Fine Soap $300 000 $200 000 $100 000 100/200=0.50 $ 50 000 Superior Cooking Oil 100 000 80 000 20 000 20/200=0.10 10 000 Light moisturiser 50 000 0 50 000 50/200=0.25 25 000 Premium Moisturiser 120 000 90 000 30 000 30/200=0.15 15 000 $200 000 $100 000 (iv) Constant Gross Margin Method First calculate the gross profit margin ratio for all products: Product Fine Soap Superior Cooking Oil Light Moisturiser Premium Moisturiser Total Less joint costs Gross margin

Final Sales Value $300 000 100 000 50 000 120 000 $570 000

Separable Costs Contribution $200 000 $100 000 80 000 20 000 00 000 50 000 90 000 30 000 $370 000 200 000 100 000 $100 000

Gross profit margin ratio = $100 000/$570 000 = 0.175439

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Second, apply the gross profit margin ratio to each product to determine cost of goods sold. Then subtract separable costs from cost of goods sold to determine the joint cost allocation for each product. Gross Product Revenue Margin* Fine Soap $300 000 $ 52 632 Superior Cooking Oil 100 000 17 544 Light Moisturiser 50 000 8 772 Premium Moisturiser 120 000 21 052 $570 000 $100 000

COGS 247 368 82 456 1 228 948 948

Separable Costs $200 000 80 000 0 90 000

Allocation of $100 000 $ 47 368 2 456 41 228 8 948 $100 000

* Gross margin = Revenue × Gross profit margin ratio = Revenue × 0.175439 (b)

Contribution from Processing Soap Grade into Fine Soap: Incremental revenue = $300 000 – 50 000 Incremental costs Incremental operating income

$250 000) 200 000) $ 50 000)

Contribution from Processing Cooking grade oil into Superior Cooking Oil: Incremental revenue = $100 000 – 30 000 $ 70 000) Incremental costs 80 000) Incremental operating income $(10 000) Contribution from Processing Heavy Moisturiser into Premium Moisturiser: Incremental revenue = $120 000 – 70 000 $ 50 000) Incremental costs 90 000) Incremental operating income $(40 000) Operating income can be increased by $50 000 if both Cooking Grade Oil and Heavy Moisturisers are sold at the split-off point. Soap Grade should continue to be processed further.

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13.24

Make or buy; qualitative factors Yoklic Ltd currently manufactures a subassembly for its main product. The costs per unit are as follows:

Regina Ltd has contacted Yoklic with an offer to sell it 5000 subassemblies for $55.00 each. Required (a) Should Yoklic make or buy the subassemblies? Create a schedule that shows the total quantitative differences between the two alternatives. (b) The accountant decided to investigate the fixed costs to see whether any incremental changes would occur if the subassembly were no longer manufactured. The accountant believes that Yoklic will eliminate $50 000 of fixed overhead if it accepts the proposal. Does this new information change the decision? Show your calculations. (c) What qualitative factors are important for accountants and managers to consider for Yoklic’s make or buy decision? (LO4 and 6) (a)

The relevant information for this problem includes the variable costs to make and the purchase price to buy. Cost to make ($4.00 + $30.00 + $15.00) Cost to buy 55 Savings if decision is to make

(b)

$ 4

Yes, this new information changes the decision. The cost to make is increased by the amount of fixed costs that will be eliminated if the part is purchased, which is $10 ($50 000/5 000) per unit. Cost to make ($4.00 + $30.00 + $15.00 + $10) Cost to buy 55 Savings if decision is to buy$14

(c)

$49

$59

Two qualitative factors would be very important for Yoklic. First, delivery times need to be reliable. Delivery delays can disrupt Yoklic’s ability to deliver products to its customers on a timely basis. In addition, quality is important. Yoklic needs to be assured that the quality will meet its needs.

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13.25 Constrained resource; qualitative factors Johnson and Sons Ltd produces organic orange juice from oranges it grows. Unfortunately, it has been a bad year for oranges because of severe frosts. Johnson only has 10 000 litres of juice. It usually sells 15 000 litres at $3 per litre. The variable costs of raising the oranges are $0.50 per litre. Johnson has loyal customers, but its managers are worried the company will lose customers if it does not have juice available for sale when people stop by the farm. A neighbour is willing to sell 5000 litres of extra orange juice at $2.95 per litre.

Required (a) Which type of non-routine operating decision is involved here? What are the managers’ decision options? (b) Using the general decision rule, what is the most per litre Johnson’s managers would be willing to pay for additional juice? (c) Why would Johnson be willing to pay the amount calculated in part (b) for more juice? (d) Is the quality of the neighbour’s juice a concern to Johnson’s managers in making this decision? Why or why not? (e) List another qualitative factor that might affect the managers’ decision. (LO5 and 6) (a)

Constrained resource problem. The manager needs to decide whether or not to buy more juice from a neighbour.

(b)

The general rule is that managers can pay what they pay now plus up to the entire contribution margin per constrained resource to relax a constraint. Therefore, the manager is willing to pay up to $3.00 ($2.50 contribution margin plus $0.50 variable cost).

(c)

If the company can supply its total demand this year, it is likely to affect its demand next year. If it cannot fill orders this year, customers may find another supplier.

(d)

Yes, quality is a concern. If the neighbour’s juice is lower quality, customers will be disappointed and may not come back. If the neighbour’s juice is much higher quality, customers may be disappointed later, and not come back. Customers may even seek out the true supplier of this higher quality juice.

(e)

The timeliness of delivery could be a factor, and the reliability of the supplier is important.

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13.26 CVP, single constrained resource Snowbird Snowboards converts regular snowboards to enhance safety capabilities for children. The income statement for last year, in which 500 snowboards were produced and sold, appears here.

Required (a) What volume of snowboards must be sold to earn pre-tax profits of $30 000? (b) Snowbird’s supplier of snowboards is unable to ship more than 500 boards for the upcoming season. Snowbird has been paying the supplier $85 for each snowboard. (The cost of the snowboards is included in variable production costs.) More expensive snowboards are available from other manufacturers for conversion. If Snowbird’s managers expect to sell more than 500 converted snowboards in the upcoming season, what is the most they would be willing to pay outside suppliers for each additional snowboard? (c) Suppose Snowbird pays the price you calculated in part (B) and sells an additional 200 snowboards. What is the company’s incremental profit on the 200 snowboards? (LO5) Note: This problem requires application of knowledge from Chapter 3. (a) It is first necessary to categorise costs and create a cost function: Fixed Variable Variable production $60 000 Fixed production $25 000 Variable selling and administration 10 000 Fixed selling and administration 35 000 Total $60 000 $70 000/500 boards = $140 each Selling price per snowboard = $150 000/500 = $300 CVP calculation in units: $30 000 = ($300 – $140)*Q – $60 000 $160*Q = $90 000 Q = 563 snowboard (b)

Managers are willing to pay what they pay now ($85) plus up to the entire contribution margin ($160) or $245 to buy more snowboards.

(c)

The incremental profit for 200 snowboards would be zero because the company has paid its entire contribution margin to buy additional snowboards.

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13.27 Multiple products; multiple resource constraints, sensitivity Mrs Meadows sells two popular brands of biscuits, Chip Dip and Soft Chunk Chocolate Chip. Both biscuits go through the mixing and baking departments, but Chip Dip is also dipped in chocolate in the coating department.

Sales manager Frank Ronan believes that Mrs Meadows can sell all of its daily production of Chip Dip and Soft Chunk. Both biscuits are made in batches of 600 biscuits. The batch times for producing each type of biscuit and the minutes available per day are as follows.

Revenue per batch for Chip Dip is $150 and the variable costs per batch are $100. Fixed costs of $2350 are allocated to Chip Dip. Revenue per batch for Soft Chunk Chocolate Chips is $175 and the variable costs per batch are $135. Allocated fixed costs are $1500. Required Set up the target function (contribution margin function) and the constraints for this problem. Enter these constraints and the target function into Excel Solver or another linear programming package and print out a formula sheet and all of the reports. (a) What is the optimal product mix? (b) What is the total contribution margin for that product mix? (c) Following the general decision rule, what would the managers of Mrs Meadows be willing to pay to relax each constraint? (d) Which constraints are binding? (e) By how much could the contribution margin for Soft Chunk increase before the optimal product mix changes? (LO5) Target function: = $50*Chip Dip + $40*Soft Chunk Constraints: Mixing: Baking: Dipping:

20*Chip Dip + 30*Soft Chunk < 4000 minutes 40*Chip Dip + 20*Soft Chunk< 6000 minutes 15*Chip Dip < 2000 minutes

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The following reports are produced from Microsoft Excel Solver: Answer Report Target Cell (Max) Cell

Name

Original Value

$A$6

Target Function

Final Value

8250

Adjustable Cells Cell $A$3

Name Dip

Original Value 0

$B$3

Soft

Final Value 125 50

Constraints Cell Name $B$9 Mixing $B$10 Baking

Cell Value 4000 6000

Formula $B$9<=4000 $B$10<=6000

Status Binding Binding

Slack 0 0

$B$11 Dipping

1875

$B$11<=2000

Not Binding

125

Sensitivity Report Adjustable Cells Objective

Allowable

Cell $A$3

Name Dip

Final

Value Cost 125 0

Reduced

Coefficient 50

Increase 30

Decrease 23.33333333

$B$3

Soft

Final

Shadow

Constraint

Allowable

Constraints Cell $B$9 $B$10

Name Mixing Baking

Value Price 4000 0.75 6000 0.875

R.H. Side 4000 6000

Increase 5000 222.2222222

Decrease 333.3333333 3333.333333

$B$11

Dipping

1875

2000

1E+30

125

(a)

The optimal sales mix (from the answer report — final value under adjustable cells) is 125 batches of Dip and 50 batches of Soft.

(b)

Total contribution margin is $8250 (answer report target function final value).

(c)

From the sensitivity report, Mrs. Meadows would be willing to pay $0.75 per minute (the shadow price) for mixing and $0.875 per minute (the shadow price) for baking.

(d)

From the answer report, mixing and baking are binding (under constraints – status).

(e)

From the sensitivity report, the contribution margin for soft chunk could increase by $35 per batch to $75 ($40 + $35), and then the sales mix would change (see allowable increase of objective coefficient for soft).

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13.28 Keep or drop and constrained resource The income statement for King Salmon Sales, which produces smoked salmon, follows:

Assume that the administrative costs are fixed and that all of the other costs are variable. Required (a) Suppose the state government curtails fishing because of low fish counts. As a result, King Salmon Sales can buy only 50 000 kg of salmon this year. Assume that the selling price, the fixed costs, and the variable costs remain the same as last year. Using only quantitative information, should King Salmon operate this year? Explain your answer, using calculations. (Hint: Before you begin, identify the type of nonroutine operating decision, the decision options, and the relevant information for this decision.) (b) Assume King Salmon can buy up to 70 000 kg of fish at $2.00 per kilogram and that the remainder of the fixed and variable costs remain the same as last year. Also assume that the selling price remains the same as last year and that the market will purchase at least another 30 000 kg of fish. If the managers of King Salmon wish to sell more salmon, what should they be willing to pay to purchase more fish? (Hint: This type of decision is different from part (a). Before you begin, identify the type of nonroutine decision, the decision options and the relevant information.) (LO5) (a)

This is a keep or drop decision, where the options are whether or not to produce salmon this year. Price is $8 per kg ($800 000/100 000) and variable costs per kilogram are $5.60 [($200 000 + $20 000 + $30 000 + $300 000 + $10 000)/100 000] so contribution margin is $2.40 per kg. At sales of 50 000 kilograms, the contribution margin will be $2.4 × 50 000 = $120 000. Fixed costs consist of administration, or $150 000. If King Salmon can avoid the fixed costs by not producing, the company should not produce this year. However, if the fixed costs are unavoidable, then it should produce because the loss will be reduced from $150 000 to $30 000. © John Wiley and Sons Australia, Ltd 2020

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(b)

This is a constrained resource problem, and the general rule is that managers are willing to pay what they pay now, plus up to the entire contribution margin. Right now they are paying $2.00 per kilogram for fish and the contribution margin is $2.40, so they are willing to pay up to $4.40 per kilogram for more fish. This assumes that demand does not change and that future supply prices will not be affected by this decision.

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13.29 Product emphasis and constrained resource Emily developed an innovative computer game, called Home By Myself (HBM). It was so successful that she quickly followed up with two sequels: Home By Myself II (HBM2) and Home By Myself III (HBM3). The costs of developing the games were $95 000 for HBM, $10 000 for HBM2, and $15 000 for HBM3.

The production process consists of copying the games to blank DVDs using her computer and then packing them with printed instructions in a display box. It takes longer to copy the original game than the sequels. Emily can produce, ready for shipping, about 20 copies of HBM, 30 copies of HBM2, or 45 copies of HBM3 in an hour.

Required (a) What is the contribution margin per hour of Emily’s time for each game? (b) In what order should Emily produce the games? (c) Using the general decision rule for constrained capacity, what is the most Emily should be willing to pay per hour for a worker to duplicate and pack diskettes after her normal working hours? (Assume that the worker would work at the same pace as Emily.) (LO5) (a)

Contribution margins per hour HBM = ($49 – $5)*20 = $880 HBM2 = ($29 – $2.50)*30 = $795 HBM3 = ($29 – $2.50)*45 = $1192.50 The development costs are sunk costs and are not included in the analysis.

(b)

First sell HBM3, then HBM, and then HBM2.

(c)

(Assume an 8-hour work day) First produce and sell 90 games of HBM3, which takes 2 hours (90 demand/45 per hour), then produce and sell HBM, which takes 6 hours (120 demand/20). There are no more hours left. Since the contribution margin per hour for HBM2 is $795/hour, Emily could spend up to $795 per hour © John Wiley and Sons Australia, Ltd 2020

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for 4 more hours to fill the demand of HBM2. If Emily is unable to hire part-time help, she would still be able to pay $3180 (4 × $795) for an eight hour day and let the worker do other things for four hours.

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13.30 Multiple products and resource constraints, sensitivity analysis Wildlife Foods prepares wild birdseed mixes and sells them to local pet stores, grocery stores, and wild bird stores. Two types of mixes have been most successful: Flight Fancy and Multigrain. Flight Fancy generates a contribution margin of $12 per 100 kilogram bag and Multigrain contributes $9 per 100 kg. Because Wildlife Foods has been very thorough in its sterilisation process, the birdseed never germinates and grows. Therefore, it is a top seller and the company can sell all of the birdseed it produces.

The seed is processed in three stages: mixing, sterilisation, and packaging. The time requirements for each batch of 100 bags of Flight Fancy and 10 000 kg of Multigrain (which is sold in bulk rather than bags) follow.

Required (a) Using a spreadsheet program such as Excel Solver, find the optimal product mix given the current constraints and contribution margins. (b) Which constraints are binding? (c) What happens if minutes available for mixing are doubled? Does another constraint become binding? What is the optimal product mix now? (LO5) The following reports are produced from Microsoft Excel Solver: Answer report Target Cell (Max) Cell

Name

Original Value

Final Value

$A$5

Target function

45 000

Adjustable Cells Cell $A$3

Name FF

Original Value 0

Final Value 15

$B$3

Cell Value 1500 6000

Formula $B$10<=4500 $B$8<=6000

Status Not Binding Binding

12000

$B$9<=12000

Binding

Constraints Cell Name $B$10 Packaging $B$8 Mixing $B$9

Sterilisation

(a)

Produce 15 batches of Fancy Flight and 30 batches of Multigrain

Slack 3000 0 0

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(b)

Mixing and sterilisation are binding.

(c)

Packaging and sterilisation are binding. The optimal mix changes to 45 batches of Fancy Flight and 10 batches of Multigrain.

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13.31 Special order The Cone Head House sells ice cream cones in a variety of flavours. Data for a recent week are as follows:

The Cone Head’s manager received a call from a university student club requesting a bid on 100 cones to be picked up in three days. The cones could be produced in advance by the store attendant during slack periods and then stored in the freezer. Each cone requires a special plastic cover that costs $0.05. Required (a) What are the managers’ decision options? (b) What quantitative information is relevant for this decision? (c) Using the general decision rule, what is the minimum acceptable price per cone for this special order? (d) Explain why Cone Head’s managers might be willing to sell cones at the price you calculated in part (c). (LO2) (a)

This is a special order decision and the manager needs to set a price for the order.

(b)

The manager needs to know the variable cost and any relevant fixed costs. Specifically, the variable costs are $530 for 1000 cones and the special cover cost of $0.05 per cone. The rent and store attendant are fixed costs and will not change if the special order is accepted, so they are irrelevant costs.

(c)

The minimum acceptable price is ($530/1000) + $.05 = $0.58.

(d)

By selling cones at the breakeven price, new customers may eat the ice cream and come into the store to buy. Brand recognition is increased. The employees are not busy otherwise.

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13.32 Special order; qualitative factors Beautiful Biscuits (BB) sells biscuits, brownies, and beverages to small local shops. The selling price per brownie is $1.25, the variable cost is $0.75, and the average cost is $1.00. The principal of a primary school asked BB to provide 10 dozen brownies for its spring picnic. The principal wants to buy the brownies at BB’s cost. Unlike regular sales, each special order brownie must be delivered in a plastic container to protect it from dust. The containers cost $0.05 each. The brownies can be prepared ahead of time when workers are not busy.

Required (a) Under the general decision rule for special orders, what is the minimum price per brownie that BB’s management should accept? (b) If the principal can pay no more than $0.80 per brownie, should BB take the order? Why or why not? (c) List several qualitative factors that could affect BB’s decision if the special order price for brownies is $0.80. (LO2 and 6) (a)

The minimum price is the variable cost plus any additional fixed costs incurred to produce the special order. In this problem, variable cost is $0.75 + $0.05 per cover = $0.80 per brownie.

(b)

Yes, the special order should be accepted. The brownies can be made when workers are not busy, so capacity is not a problem. BB may receive other orders in the future from parents of children at the school. Good publicity may result for the company.

(c)

If other customers find that they are paying a lot more than the school, they may ask for price reductions. If another special order came in that would be more profitable, but workers cannot fill the order, BB may regret having set the price at breakeven.

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13.33 Outsourcing calculations; uncertainties Saguaro Systems produces and sells speakers and CD players. The following information has been collected about the costs related to the systems:

Saguaro normally produces 25 000 of these systems per year. The managers have recently received an offer from a Chinese entity to produce these systems for $48 each. The managers estimate that $260 000 of Saguaro’s fixed costs could be eliminated if they accept the offer. Required (a) Which type of non-routine operating decision is involved here? What are the managers’ decision options? What quantitative information is relevant to the decision? (b) Perform a quantitative analysis for the decision, and present your results in a schedule. (c) Under the general decision rule for this type of decision, what production level is required for Saguaro’s managers to be indifferent? (d) List as many uncertainties as you can for this decision. (LO4) (a)

This is an insource or outsource (make or buy) problem. The manager can choose to make the speakers or buy them from a Chinese company. The variable costs of making the system and any avoidable fixed costs are relevant, as is the outside purchase price.

(b)

Cost under each alternative is calculated below: Make Purchase price Variable costs: Direct materials $22.00 Direct labour 16.00 Variable overhead 2.00 Avoidable fixed cost ($260 000/25 000) 10.40 Total $50.40

Buy $48.00

____ $48.00

Saguaro should buy because the units are $50.40 – $48.00 = $2.40 less expensive. (c)

The managers will be indifferent at the volume where the cost in-house is the same as the cost of outsourcing: $40X + $260 000 = $48X 8X = $260 000 X = 32 500 systems

(d)

Will the vendor be reliable in timeliness of delivery and quality? Will the vendor increase the price for the next batch? Will Saguaro find an alternative use for the

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production that brings in a contribution margin? Will Saguaro be able to discontinue the contract if sales fall?

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13.34 Special order calculations, qualitative factors Feed Barn packages and distributes three grades of animal feed. The material cost per tonne and estimated annual sales for each of the products are listed.

The fixed cost of operating the machinery used to package all three products is $10 000 per year. In the past, prices have been set by allocating the fixed operating cost to products on the basis of estimated sales in tons. The resulting full costs (material costs plus allocated fixed operating cost) are then marked up 100 per cent. The Feed Barn has received an offer from a foreign firm for 1000 tonnes of the premium grade feed. Sales to the foreign firm would not affect domestic sales, but would require an increase in fixed production costs of $2000. Required (a) Which type of non-routine operating decision is involved here? What are the managers’ decision options? (b) What relevant quantitative information is required for this type of decision? (c) Using only quantitative information, what is the minimum price that the Feed Barn’s managers should be willing to accept from the foreign entity? (d) What types of qualitative factors would the Feed Barn’s managers typically consider before agreeing to the sale? Explain. (LO2 and 6) (a)

This is a special order decision. The manager needs to price the order. The manager’s options are to accept or reject the special order.

(b)

The variable cost of production and any incremental fixed costs associated with the order need to be determined.

(c)

Minimum price for Premium = $8 × 1000 + $2000 = $10 000 for the order.

(d)

Although the problem states that this sale will not affect domestic sales, it is uncertain whether that means sales volumes, prices, or both. Therefore, the manager needs to know whether domestic customers will know the price set for this sale. They may demand the same price. The manager needs to know whether there is enough capacity to produce this order without replacing regular business. The manager also needs to know whether this customer is part of Feed Barn’s regular business.

13.35

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Horton and Associates produces two products named the Big Winner and the Loser. Last month 1000 units of the Loser and 4000 units of the Big Winner were produced and sold. Average prices and costs for the two products for last month follow:

The production lines for both products are highly automated, so large changes in production cause very little change in total direct labour costs. Workers who are classified as direct labour monitor the production line and are permanent employees who regularly work 40 hours per week. All costs other than corporate fixed costs listed under each product line could be avoided if the product line were dropped. Corporate fixed costs totalled $125 000, and the total sales amounted to 5000 units, producing the average cost per unit of $25. About $10 000 of the corporate fixed costs could be avoided if the Loser were dropped, and about $15 000 of the corporate fixed costs could be avoided if the Big Winner were dropped. The remaining $100 000 could be avoided only by going out of business entirely. Required (a) What is the overall corporate breakeven in total sales revenue, assuming the sales mix is the same as last month’s? (b) What is the breakeven sales volume (in units produced and sold) for the Loser? (In other words, what is the sales volume at which Horton should be financially indifferent between dropping and retaining the Loser?) (c) List at least two qualitative factors that would affect the decision to keep or drop the Loser. (LO3 and 6)

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(a) The following solution assumes that labour is a fixed cost. The average contribution margin per unit is used below to solve for the breakeven, but the contribution margin ratio could also be used. Loser 1 000 $95

Winner 4 000 $225

Variable cost per unit: Direct materials Variable overhead Total per unit

$40 5 $45

$ 95 15 $110

Product line fixed cost per unit: Direct labour Product line fixed Total per unit

$5 10 $15

$25 40 $65

Multiply Per Unit Amounts × Volume: Total revenue $95 000 Total variable cost 45 000 Contribution margin $50 000

$900 000 440 000 $460 000

$995 000 485 000 $510 000

$260 000

$275 000 125 000 $400 000

Volume Price per unit

Total Fixed Costs: Product-line fixed costs Corporate fixed costs Total

$15 000

Total 5 000

The overall corporate breakeven in revenues is:

(b)

Total fixed costs/Contribution margin ratio = $400 000 /($510 000/$995 000) = $780 392 To calculate the breakeven in units for Loser, the first step is to calculate the avoidable fixed costs for the product line and the contribution margin per unit: Avoidable fixed costs: Product linea Corporate Total

$15 000 10 000 $25 000

Calculated by multiplying total volume times the per-unit product line fixed cost rate. Price per unit Total variable cost per unit (see Part A) Contribution margin per unit

$95 45 $50

The breakeven point in units for Loser is calculated by dividing its avoidable fixed costs by its contribution margin per unit: $25 000/$50 = 500 units

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(c)

One potentially important qualitative factor is whether dropping one product would affect the sales of the other product. Another factor is employee morale if the company lays off personnel. A third factor is whether prices of inputs on any other products could change because the company reduces its purchase quantities, and any other potential responses from vendors. Students may think of other qualitative factors.

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13.36 Product emphasis and keep or drop, product breakeven, relevant information The income statement information for Kallapur and Trombley Cotton Growers follows:

Required (a) Using the general decision rule, which product should the entity emphasise? Support your answer with calculations. (b) Using the general decision rule, should the entity drop Regular (assuming no changes in demand for other products)? Support your answer with calculations. Show how operating income would change if Regular were dropped. (c) At what point (in bales) would the managers be indifferent to dropping Regular? In other words, what is the breakeven point for Regular? (d) What other information would you want before you make a decision about whether to drop Regular? (LO3 and 6) (a)

The problem gives no information about resource constraints, so this solution assumes there are none. Therefore, managers should emphasise the product with the highest contribution margin: Emphasise Premium first (contribution margin = $800), then Fancy (contribution margin = $720), and then Regular (contribution margin = $600).

(b)

For Premium and Fancy, contribution margin minus avoidable fixed costs is positive. For Regular, contribution margin minus avoidable fixed costs is negative $125, indicating that operating income would increase by $125 per unit if this product were dropped. That is, operating income should increase to $85 if the Regular product line is dropped. If Regular is dropped, the following income statement results: Revenue $4000 Variable costs 2480 Contribution margin 1520 Product line fixed costs 1160 360 Corporate fixed costs 275 Operating income $ 85

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(c)

If the contribution margin from Regular would cover the avoidable fixed costs, they would be indifferent between keeping or dropping the Regular product line. The contribution margin is $6 ($600 CM/100 bales) per bale. Solve for Q = the number of bales at which the total contribution margin for the product equals avoidable fixed costs $6*Q = $725 Q = 121 bales

(d)

Will dropping Regular affect the sales of any other products? Has there been a trend in sales (either decreasing or increasing) for Regular over time? What kinds of products and prices are competitors offering? Can some of the avoidable fixed costs be reduced so that the company can still carry the product? Can the selling price be raised?

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Problems 13.37 Identifying joint costs; choice of allocation method Roses to Go is a flower farm that specialises in fragrant roses for florist shops. Required (a) List five joint costs that are likely to be incurred by Roses to Go in raising roses. (b) The roses are sold by the dozen, with no difference in price for any of the bouquets. Which joint cost allocation method would be most appropriate? Explain your choice. (c) Now assume that Roses to Go raises two different types of roses, fragrant roses and regular roses. The growing requirements for the two types of roses do not differ. However, fragrant roses sell for twice as much as regular roses. Which joint cost allocation method would be most appropriate? Explain your choice. (LO7) (a)

Roses to Go must pay someone to water and tend to the roses. The company must pay for labour to cut the roses. It pays for fertiliser and water and depreciation on any buildings used in the production and cutting process. If the roses are cooled after cutting, the cost of cooling must be paid. All of these are joint costs.

(b)

Use the physical volume method because it is the most simple and will not distort costs if there is little difference in the packaging and pricing of the products.

(c)

If there are different prices, the sales value at split-off point method would work best here because the separable costs would be very similar. This method is most simple and would be the best choice because it does not distort the costs.

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13.38 Separable and joint costs, NRV, operating income, by-product

Doe Ltd grows, processes, cans and sells three main pineapple products: sliced pineapple, crushed pineapple, and pineapple juice. The outside skin, which is removed in the cutting department and processed as animal feed, is treated as a by-product. Doe Ltd's production process is as follows: Pineapples are first processed in the cutting department. The pineapples are washed, and the outside skin is cut away. Then the pineapples are cored and trimmed for slicing. The three main products (sliced, crushed, juice) and the by-product (animal feed) are recognisable after processing in the cutting department. Each product is then transferred to a separate department for final processing. The trimmed pineapples are forwarded to the slicing department, where they are sliced and canned. Any juice generated during the slicing operation is packed in the cans with the slices. The pieces of pineapple trimmed from the fruit are diced and canned in the crushing department. Again, the juice generated during this operation is packed in the can with the crushed pineapple. The core and surplus pineapple generated from the cutting department are pulverised into a liquid in the juicing department. An evaporation loss equal to 8% of the weight of the good output produced in this department occurs as the juices are heated. The outside skin is chopped into animal feed in the feed department. Doe Ltd uses the net realisable value method to assign costs of the joint process to its main products. The by-product is inventoried at its net realisable value. The NRV of the by-product reduces the joint costs of the main products. A total of 270 000 kg entered the cutting department in May. The schedule shows the costs incurred in each department, the proportion by weight transferred to the four final processing departments, and the selling price of each product.

Required (a) How many kilograms of pineapple result as output for pineapple slices, crushed pineapple, pineapple juice, and animal feed? (b) What is the net realisable value of each of the main products?

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(c)

What is the amount of the cost of the cutting department (joint costs) assigned to each of the main products and the by-product using Doe’s allocation method? (d) What is the gross margin for each of the three main products? (e) How valuable is the gross margin information for evaluating the profitability of each main product? (f) If no market exists for the outside skin as animal feed and, instead, it must be disposed of at a cost of $800, what effect will this cost have on the costs allocated to the main products? (LO7) The following chart traces the physical flow of the products and summarises cost and sales information.

Slicing Crushing Juicing Animal Feed Total

(a)

Total Weight 94 500 kg (35%*270 000) 75 600 kg (28%*270 000) 72 900 kg (27%*270 000) 27 000 kg (10%*270 000) 270 000 kg

Weight After Evaporation Loss

Costs $ 4 700 10 580

67 500 kg (72 900/1.08)

3 250 700 $19 230

Total Revenue $ 56 700 ($0.60*94 500) 41 580 ($0.55*75 600) 20 250 ($0.30*67 500) 2 700 ($0.10*2 700) $121 230

The weights are obtained by multiplying the initial 270 000 kilograms by the proportion delivered to each department and in the case of juicing, dividing by 1.08 to account for evaporation. The resulting weights are 94 500 kg for slicing, 75 600 for crushing 67 500 for juicing and 27 000 for feed.

(b)

(c)

Product

Selling price

Slices Crushed Juice Total

$ 56 700 41 580 20 250 $118 530

Separable cost

$ 4 700 10 580 3 250 $18 530

NRV

$ 52 000 31 000 17 000 $100 000

None of the costs are assigned to the by-product. The allocation of the $60 000 of cutting department costs to the main products is reduced by $2000 ($2700 – $700) for the NRV of animal feed (the by-product), so $58 000 is allocated Product

NRV

Proportion

Allocation

Slices Crushed Juice Total

$ 52 000 31 000 17 000 $100 000

52/100 31/100 17/100

$30 160 17 980 9 860 $58 000

Sales

Slices $56 700

(d) Crushed $41 580

Juice $20 250

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Joint cost Separable cost Gross margin

30 160 4 700 $21 840

17 980 10 580 $13 020

9 860 3 250 $ 7 140

58 000 18 530 $ 42 000

(e)

The gross margin information is of little value to management. As long as the overall processing is profitable, the net realisable value approach will show each of the products as valuable. For product mix decisions (such as whether to produce more juice and less crushed pineapple), information is needed about incremental revenues and costs rather than gross margin data.

(f)

If there is no disposal revenue, the additional costs are $800 to dispose of the outside skin plus $2700 in lost revenue (assuming that $700 of chopping costs would not be increased). The $3500 would be added to each product in the same proportions as in part C. Thus the correct additional costs would be: Slices Crushed Juice Total

Additional Cost $1820 1085 595 $3500

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13.39 Special order capacity constraint; relevant information; qualitative factors Rightway Printers, a book printing shop, is operating at 95 per cent capacity. The entity has been offered a special order for book printing at $8.50 per book; the order requires 10 per cent of capacity. No other use for the remaining 5 per cent idle capacity can be found. The average cost per book is $8, and the contribution margin per book for regular sales is $1.50.

Required (a) Which type of non-routine operating decision is involved here? What are the managers’ decision options? (b) What information is relevant for this decision? Does the problem give you all of the information the managers need to make a decision? What other information is needed? (c) Using the general decision rule, what premium are the managers willing to pay (per book) to relax the constrained capacity, assuming no qualitative factors are relevant? (d) Explain how capacity affects the quantitative analysis for this decision. (e) What qualitative factors could affect this decision? (LO2 and 6) (a)

This is a special order problem with a capacity constraint. The manager chooses whether to take the special order or not, but capacity limits will be exceeded if the order is taken.

(b)

Relevant information for the decision includes the variable cost, the contribution margin, and the selling price for regular business. The problem does not provide the selling price per book for regular business. Additional information that would be needed includes relevant qualitative factors.

(c)

The manager can pay up to $1.50 per book, plus the amount of variable cost that is related to capacity, to relax the constraint.

(d)

Capacity makes a difference in the minimum price that can be set. If Riteway is close to capacity limits, it would replace regular business with the special order and need to price the order the same as regular business that it would forego to take the order. In this problem, 5% of capacity would be used for regular business, and 5% would be excess capacity. So, the special order would need to be priced high enough to replace the lost contribution margin of the 5% of regular business.

(e)

Usually when operations get close to capacity limits, costs go up. Bottlenecks are more common, there is congestion in the plant, and production slows down. These costs need to be considered when setting a price for a special order that will move an organisation out of its normal operating range (relevant range). In addition, managers need to think about whether the business will lose some customers because demand cannot be filled.

13.40 Make or buy; qualitative factors Vernom Ltd produces and sells to wholesalers a highly successful line of summer lotion and insect repellents. Vernom has decided to diversify to

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stabilise sales throughout the year. A natural area for the entity to consider is the production of winter lotions and creams to prevent dry and chapped skin. After considerable research, a winter products line has been developed. However, because of the conservative nature of entity's managers, Vernom’s CEO has decided to introduce only one of the new products for this coming winter. If the product is a success, further expansion in future years will be initiated. The product selected is a lip balm to be sold in a lipstick-type tube. The product will be sold to wholesalers in boxes of 24 tubes for $8 per box. Because of available capacity, no additional fixed charges will be incurred to produce the product. However, a $200 000 fixed charge will be assigned to allocate a fair share of the company’s fixed costs to the new product. The remaining overhead costs are variable. Using estimated sales and production of 100 000 boxes of lip balm as the standard volume, the accounting department has developed the following costs per box of 24 tubes.

Vernom approached a cosmetics manufacturer to discuss the possibility of purchasing the tubes for the new product. The purchase price of the empty tubes from the cosmetics manufacturer would be $1.80 per 24 tubes. If Vernom accepts the purchase proposal, it is estimated that direct labour and variable overhead costs would be reduced by 10 per cent and direct materials costs would be reduced by 20 per cent. Required (a) Should Vernom Ltd make or buy the tubes? Show calculations to support your answer. (b) What would be the maximum purchase price acceptable to Vernom for the tubes? Explain. (c) Instead of sales of 100 000 boxes, revised estimates show sales volume at 125 000 boxes. At this new volume, additional equipment at an annual rental of $20 000 must be acquired to manufacture the tubes. However, this incremental cost would be the only additional fixed cost required, even if sales increased to 300 000 boxes. (The 300 000 level is the goal for the third year of production.) Under these circumstances should Vernom make or buy the tubes? Show calculations to support your answer.

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(d)

(e)

The entity has the option of making and buying at the same time. What is your answer to part (c) if this alternative is considered? Show calculations to support your answer. What qualitative factors should Vernom managers consider in determining whether they should make or buy the lipstick tubes?

(LO4 and 6) (a)

The company should make the tubes because the estimated cost to manufacture the tubes is less than the cost to purchase them: Cost to purchase tubes ($1.80 * 100 000)

$180 000

Avoidable costs to manufacture tubes: Direct labour (10% * $4 * 100 000) Direct material (20% * $6 * 100 000) Variable overheada (10% * $1.00 * 100 000) Total avoidable cost

$ 40 000 120 000 10 000 $170 000

Total overhead is projected at $300 000 ($3 × 100 000 boxes), of which $200 000 is fixed. Therefore, variable overhead must be $100 000 or $1.00 per box. (b) (c)

(d)

(e)

$170 000/100 000 = $1.70 is the price at which the firm would be indifferent between making and buying the tubes. The company should purchase the tubes during the first year because the avoidable cost for that option is lower: Total cost to purchase ($1.80 * 125 000)

$225 000

Avoidable cost to manufacture: Variable manufacturing cost ($1.70 * 125 000) Equipment rental Total

$212 500 20 000 $232 500

The company should make 100 000 tubes and purchase 25 000, based on the following cost comparison: Cost to make 100 000 and purchase 25 000: Manufacture 100 000 tubes manufactured Purchase 25 000 tubes at $1.80 For a total cost of

$170 000 45 000 $215 000

Cost to purchase 125 000 (from part c)

$225 000

Control over quality of the tubes, convenient delivery schedules, and control over future price increases would be factors that favour insourcing.

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13.41 Special order, qualitative factors, uncertainties, sensitivity

Jazzy Cases manufactures several different styles of jewellery cases. Management estimates that during the first quarter of this year the company will operate at about 80 per cent of normal capacity. Two special orders have been received, and management is making a decision about whether to accept either or both orders. The first order is from Penny-Wise Department Stores. The manager would like to market a jewellery case similar to one of Jazzy’s current models. Penny-Wise wants its own label on the cases and is willing to pay $5.75 per case for 20 000 cases to be shipped by 1 April. The cost data for Jazzy’s case, which is similar to the requested case, follow:

According to the specifications supplied by Penny-Wise, the special order case requires less expensive raw materials. Therefore, the raw materials for the special order will cost $2.25 per case. Management believes that the rest of the costs, labour time, and machine time will remain the same as for Jazzy’s case. The second order is from the Star-Mart Company. Its managers want 8000 cases for $7.50 per case. These jewellery cases, to be marketed under the Star-Mart label, would also need to be shipped by 1 April. However, these cases are somewhat different from any cases currently manufactured by Jazzy. Following are the estimated unit costs:

In addition to these per-unit costs, Jazzy would incur $1500 in setup costs and would need to purchase $2500 in special equipment to manufacture these cases. Currently, Jazzy would have no other use for the equipment once this order was filled.

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Jazzy’s capacity constraint is total machine hours available. The plant capacity under normal operations is 90 000 machine hours per year, or 7500 hours per month. Fixed manufacturing overhead costs are allocated to production on the basis of machine hours at $4 per hour and are budgeted at $360 000 per year. Jazzy can work on the special orders throughout the entire first quarter, in addition to performing its normal production. Jazzy’s managers do not expect any repeat sales to be generated from either special order. Required (a) What is the excess capacity of machine hours available in the first quarter? Explain how machine hour capacity affects the special order decision. (b) Ignore the Star-Mart order. Using the general decision rule, what is the minimum acceptable price for the Penny-Wise order? (c) Ignore the Penny-Wise order. What is the contribution margin per case for the Star-Mart order? What would be the total expected profit (loss) incurred by accepting this order? (d) Using only quantitative information, decide which special orders Jazzy should accept. (e) What qualitative factors are likely to be important to this decision? (f) Identify and explain uncertainties that affect Jazzy’s decision. (g) What might happen to costs if Jazzy’s production exceeds 95% of its capacity? Discuss how increased use of capacity from a special order might affect the company’s costs. (Hint: Think about whether bottlenecks could arise and how they might affect costs.) (h) Suppose you are the cost accountant for Jazzy. (i) Write a memo to Jazzy’s management recommending whether the company should accept each of the special orders. Attach to the memo a schedule showing your calculations. As appropriate, refer to the schedule in the memo. (ii) Write one or two paragraphs explaining how you decided what information to include in your memo. (LO4 and 6) (a)

90 000 × 0.2 = 18 000 hours per year of idle capacity. For 3 months, there are 4500 hours available. If the number of machine hours needed for either order or the combined order exceeds current capacity, the price needs to be the same as the regular price for those units.

(b)

The company needs 5000 hours for this order (20 000 cases × 0.25 hours per case). For the first 4500 hours used, the Penny Wise order just needs to cover its variable costs, since these 18 000 cases (4500 hrs/0.25 hrs per case = 18 000 cases) are made with idle capacity. The variable costs per case are $2.25 for raw materials + $3.00 for direct labour = $5.25 per case. For the 500 hours used to fill the Penny Wise order (the remaining 2000 cases), the company needs to receive $9 per case (since these would replace regular sales), less the $0.25 per case savings on the raw material, or $8.75 per case.

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Therefore, the minimum acceptable price is computed as follows: First 18 000 cases (18 000 @ $5.25) Remaining 2000 cases (2000 @ $8.75) Total

$ 94 500 17 500 $112 000

Minimum acceptable price per case ($112 000/20 000 cases) $5.60

(c)

The special order price is $5.75 per case, so the order would yield an incremental contribution of $3 000 ($0.15 per case × 20 000 cases). The Star-Mart order for 8000 cases would use 4000 hours (8000 cases × 0.5 hours per case). Since this quantity is under the capacity limit, the company needs only to cover the incremental costs of this order. The contribution margin per case for the Star-Mart order is $7.50 – ($3.25 + $3.00) = $1.25 per case. However, there are additional fixed costs to be incurred for this order. Therefore, the accept/reject decision takes this form: Incremental revenue for 8000 cases (8000 × $7.50) Incremental costs for 8000 cases: Variable costs [8000 × ($3.25 + $3.00)] Set-up & equipment costs ($1500 + $2500) Advantage of accept over reject

(d)

$60 000 $50 000 4 000

54 000 $ 6 000

The following are alternatives: (1) reject both offers (2) accept only the Penny-Wise order (3) accept only the Star-Mart order (4) accept both the Penny-Wise and Star-Mart orders Option (1) is not the best alternative because results for part (b) show that the advantage of option (2) over option (1) is $3000, and results computed in (c) show that the advantage of option (3) over option (1) is $6000. To consider option (4), suppose Jazzy first uses 4000 hours of idle capacity to produce the Star-Mart order (since it has a higher contribution for the order than does the Penny-Wise order). This leaves 500 hours of idle capacity. Since the Penny-Wise order will use 5000 hours, 4500 hours would be taken from regular production. Would this be profitable?

Incremental revenue for 20 000 cases (20 000 × $5.75) Incremental costs: Variable costs (20 000 × $5.25) Opportunity cost: Loss of contribution margin on 17 000 regular cases [($9 – $5.50)*17 000] Disadvantage of accept both (option 4) over accept Star-Mart only (option 3)

$115 000 $105 000 59 500

164 500 $ 49 500

Therefore (ignoring qualitative concerns), Jazzy should accept only the Star-Mart order, which provides an incremental contribution of $6000. (e)

Qualitative factors include the following. Students may have thought of other qualitative factors. • Will other customers find out about the special prices and then demand lower prices?

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• Will there be enough capacity? • How will these sales affect customer relations and future sales?

(f)

The company cannot know whether it will obtain other orders that would be larger and more lucrative than these two orders. Managers do not know whether their current capacity levels will hold for regular business; capacity could increase or decrease. Demand for one product could increase greatly, for example around Valentine’s Day, because that product was a ‘hot’ consumer item. Also, there is more uncertainty in the cost estimates for the Star-Mart order than for the PennyWise order because these cases are somewhat different than any cases Jazzy currently manufactures. In addition, fixed costs could change as the manufacturing plant becomes more congested (see part g).

(g)

The managers need to know whether the fixed costs will change as operations get closer to capacity constraints. The company is likely to incur increasing costs of congestion as production quantities get closer to the capacity limits. For example, bottlenecks will increase, machines might break down more frequently, and workers may not be as efficient. Such problems increase the variable costs per unit. Inventory levels and wait times for product in process might increase.

(h) & (i)

There is no one answer to these parts. Solutions can consider the following: • Describe the four options and the quantitative results shown in parts (a) through (d). • Remind management that they must consider the qualitative information and provide some examples of qualitative information they should take into account, making sure that management knows this is only a partial list and they should try to think of more. • Be explicit about the uncertainties in the estimates and discuss how they could affect the quantitative analyses and interpretation of results.

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13.42 Special order calculations and decision George Jackson operates a small machine shop. He manufactures one standard product available from many other similar businesses, and he also manufactures custom-ordered products. His accountant prepared the following annual income statement.

The depreciation charges are for machines used in the respective product lines. The power charge is apportioned on an estimate of power consumed. The rent is for the building space, which has been leased for 10 years at $7000 per year. The rent and the heat and lights are apportioned to the product lines based on the amount of floor space occupied. All other costs are current expenses identified with the product line causing them. A valued custom-parts customer has asked Jackson if he would manufacture 5000 special units for her. Jackson is working at capacity and would have to give up some other business to take this order. He cannot renege on custom orders already agreed to, but he would have to reduce the output of his standard product by about one-half for a year while producing the specially requested customer part. The customer is willing to pay $7 for each part. The material cost will be about $2 per unit and the labour will be $3.60 per unit. Jackson will have to spend $2000 for a special device that will be discarded when the job is done. Required (a) Calculate and present the following costs related to the 5000-unit custom order. i. The incremental cost of the order ii. The full cost of the order (incremental plus allocated fixed costs such as depreciation, rent, etc.) iii. The opportunity cost of taking the order iv. The sunk costs related to the order (b) Should Jackson take the order? Explain your answer. (LO2 and 6)

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(a) i.

ii.

iii.

Incremental cost: Materials ($2.00 × 5000) Labour ($3.60 × 5000) Special device Total Full cost: Incremental costs, from above + 1/2 of standard unit's allocated costsa Rent Heat and Light Total

$10 000 18 000 2 000 $30 000 $30 000 $500 50

550 $30 550

Depreciation on the equipment used for standard sales is not included on the assumption that the equipment is used only to produce the standard sales product. There is insufficient information to estimate the amount of power and ‘other’ costs which would be required by the new units. Therefore full cost is inexact and could be misleading if used. Contribution margin on standard units: Sales Variable costs: Material Labour Power Other Contribution margin on standard sales

$25 000 $8 000 9 000 400 900

18 300 $ 6 700

Opportunity cost of the special order is $6700/2 = $3350 for the lost contribution margin from foregone standard unit sales. iv.

(b)

Relative to the order, depreciation on the equipment for the standard sales is a sunk cost. Rent and the fixed portion of heat and light would also be sunk costs.

Differential revenue ($7 × 5000) Differential costs (A.1) Opportunity costs (A.3) Differential income

$35 000) (30 000) (3 350) $ 1 650)

The firm will be approximately $1650 better off by accepting the order (this is somewhat overstated because variable power or ‘other’ costs have not been included in the total cost to produce the special order).

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13.43 Foreign versus domestic production and comparative advantage Scott Mills was originally a producer of fabrics, but several years ago intense foreign competition led management to restructure the entity as a vertically integrated cotton garment manufacturer. Scott purchased spinning entity that produce raw yarn and fabricators that produce the final garment. The entity has both domestic and international operations. The domestic spinning and knitting operations are highly automated and use the latest technology. The domestic operations are able to produce cotton fabric for $1.52 per kilogram. The domestic fabricating operations are located exclusively in rural areas. Their locations keep total average labour costs to $16.40 per hour (including fringe benefits). The cost to ship products to the firm’s distribution centre is $0.10 per kilogram. The entity’s foreign subsidiary is a fabricating operation located in the Maldives, a group of islands near India. The average wage rate there is $0.70 per hour. The subsidiary purchases cotton fabric locally for $1.60 per kilogram. The finished products are shipped to Scott Mills’ distribution centre in New South Wales at a cost of $1.80 per kilogram. Both the domestic and foreign subsidiary use the same amount of fabric per product. Scott Mills has been producing three products for the private label market: sweatshirts, dress shirts, and lightweight jackets. In the past the firm processed a new order at whichever fabricating plant had the next available capacity. However, projections for the next few years indicate that orders will far exceed capacity. Management wants each plant to specialise in one of the products. The plants are constrained by the amount of sewing time available in each. The domestic plant has 8000 hours of sewing machine time available per week, while the foreign subsidiary has 10 000 hours available per week. The domestic plant’s variable overhead is charged to products at $4 per machine hour, while the subsidiary’s variable overhead averages $1 per machine hour. The windcheaters require 1 kilogram of cotton fabric to produce, the dress shirts use 400 grams of fabric, and the jackets require 1 kilogram of fabric. The domestic plant has special-purpose equipment that allows workers to sew a sweatshirt in 6 minutes, a shirt in 15 minutes, and a jacket in one hour. The foreign plant’s equipment constrains production to five sweatshirts per hour, three dress shirts per hour, or two jackets per hour. The wholesale prices are $8.76 each for the sweatshirts, $7.50 for the dress shirts, and $37 for the jackets. Required (a) Using only quantitative information, should the firm close its domestic operations and expand the foreign subsidiary? (b) Assuming that wages in the domestic operations remain constant, at what level of wages in the foreign subsidiary would the managers be indifferent between producing sweatshirts at one location versus the other?

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(c)

Discuss qualitative factors, including ethical issues, that might influence the decision in part (a). (d) Discuss whether production quality is likely to be a bigger concern for products produced at the foreign subsidiary versus products produced in the domestic operation. (e) If demand for each product exceeds capacity, in which product should each plant specialise? (f) Management insists on manufacturing all three products to maintain good customer relations. If demand for each product exceeds capacity, management would prefer to specialise according to your answer to part (e). At which plant should management produce the third product? (LO6) (a)

This is a keep or drop problem. Based only on quantitative factors, the company should produce at the facility having the lowest cost. Because the company’s managers could choose to produce different products at different facilities, quantitative calculations are performed separately for each product. The variable costs to produce and deliver each of the products to the firm's distribution centre from each plant are as follows. Note: Because employees operate the machines, this solution assumes that machine hours = labour hours. Domestic Sweatshirts: Materials Labour Var. overhead Shipping Total Dress Shirts: Materials Labour Var. overhead Shipping Total Jackets: Materials Labour Var. overhead Shipping Total

($1.52 × 1 kg) ($16.40 × 6/60 min) ($4 × 6/60 min) ($0.10 × 1 kg)

Foreign $1.52 1.64 0.40 0.10 $3.66

($1.60 × 1 kg) ($0.70 × 1/5 hr) ($1 × 1/5 hr) ($1.80 × 1 kg)

$1.60 0.14 0.20 1.80 $3.74

($1.52 × 1/4 kg) $0.380 ($16.40 × 15/60 min) 4.100 ($4 × 15/60 min) 1.000 ($0.10 × 1/4 kg) 0.025 $5.505

($1.60 × 1/4 kg) $0.4000 ($0.70 × 1/3 hr) 0.2333 ($1 × 1/3 hr) 0.3333 ($1.80 × 1/4 kg) 0.4500 $1.4166

($1.52 × 1 kg) ($16.40 × 1 hr) ($4 × 1 hr) ($0.10 × 1 kg)

($1.60 × 1 kg) ($0.70 × 1/2 hr) ($1 × 1/2 hr) ($1.80 × 1 kg)

$1.52 16.40 4.00 0.10 $22.02

$1.60 0.35 0.50 1.80 $4.25

The domestic plant should not be closed. It produces the sweatshirts at a lower overall cost than the foreign subsidiary. As long as the domestic plant can be kept busy producing sweatshirts, the company’s profits will be higher if both plants remain open. Note, however, that if domestic labour costs go up by as little as $0.80 per hour, the domestic plant will no longer be competitive.

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(b)

The managers would be indifferent between plants if the total variable cost in the foreign plant were the same as in the domestic plant, or $3.66 per sweatshirt (see part a). The difference between plants in the variable cost per sweatshirt is currently $0.08 ($3.74 – $3.66). Thus, the labour cost in the foreign plant would need to decrease by $0.08 per sweatshirt for the managers to be indifferent. The foreign plant produces 5 sweatshirts per hour, so the hourly wage rate would need to decrease by 5 × $0.08 or $0.40 per hour. Wages are currently $0.70 in the foreign plant, so they would need to be $0.30 per hour ($0.70 – $0.40).

(c)

The ethical issues involved in outsourcing labour include the consequences of moving relatively high paying factory jobs overseas, which tends to lower income for blue collar US workers and the potential exploitation of foreign labour. In some countries, US corporations or their suppliers pay only minimum wage, and families relying only on this income are usually below government poverty levels in their respective countries. In addition, labour unions often publicise these problems when firms are considering whether to close plants. This negative publicity can affect market prices and consumer demand. Other qualitative factors might include the need to deliver products rapidly. One plant or the other might be able to deliver rush orders more quickly. The quality of output might also be a factor (see part d below). Students may think of other issues.

(d)

Production quality might be a bigger problem at the foreign subsidiary, particularly since it is located in a developing country. Because the wage rates are so low, employees are poorly trained and there may be high turnover. Therefore, defect rates tend to be higher than in western counterpart plants.

(e)

The contribution margin earned per unit for each plant is Sweatshirts Dress shirts Jackets

Domestic ($8.76 – $3.66) $ 5.10 ($7.50 – $5.505) 1.995 ($37.00 – $22.02) 14.98

Foreign ($8.76 – $3.74) ($7.50 – $1.417) ($37.00 – $4.25)

$ 5.02 6.083 32.75

Dividing by the hours required per unit yields the contribution margin per hour: Sweatshirts Dress shirts Jackets

Domestic $51.00 7.98 14.98

Foreign $25.10 18.249 65.50

If demand exceeds capacity, the domestic plant should produce sweatshirts, and the foreign plant should produce jackets. (f)

The question asks which plant should produce the dress shirts. At first glance, it appears that the shirts are more profitable if produced by the foreign subsidiary. But this ignores the opportunity cost of lost alternative production. The net cost per hour to produce shirts at each plant is (see calculations in Part E): Foregone contribution margin* Contribution margin from shirts

Domestic $51.00 7.98

Foreign $65.5000 18.2502

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Net cost per hour

$43.02

$47.2498

* This is the foregone contribution margin from the next highest use of plant. It is less costly to produce the shirts domestically, if the plants are operating at capacity.

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13.44 Outsource; relevant costs; qualitative factors; uncertainties; biases Falco Services processes mortgage loan applications. The cost of home appraisals is included in its service fee, but Falco uses an outside appraisal service. The cost of appraisals has been increasing rapidly over the last several years, reaching $180 per appraisal last year. Falco’s CFO asked one of the accountants to estimate the cost of doing the appraisals in-house. Several of Falco’s mortgage brokers worked previously as real estate agents and have performed informal appraisals; however, none have professional appraisal experience. The accountant’s son-in-law owns the firm that currently performs most of the appraisals. The accountant prepares a report for the CFO that includes the following estimates for 1000 appraisals. Appraisers would have to be hired, but no additional computer equipment, space, or supervision would be needed. The report states that the total costs for 1000 appraisals would be $195 000 or $195.00 per appraisal. The current appraisal price is $180, so the report recommends that Falco continue to outsource the appraisal services.

Professional labour is the cost to hire two appraisers. Overhead consists of fixed overhead, which is allocated at 50 per cent of the cost of professional labour, and variable overhead (mostly fringe benefits), which is 40 per cent of the cost of professional labour. Falco’s CFO has to decide whether to continue to use the appraisal service or to hire appraisers and provide the service in-house. Required (a) (b) (c) (d) (e)

(f)

Which type of non-routine operating decision is involved here? What are the managers’ decision options? What is the expected total incremental cost for 1000 appraisals? Which costs in the accountant’s report are not relevant? Prepare a revised report that includes only relevant costs. Using the general decision rule, should Falco outsource appraisal services or provide this service itself? List uncertainties about Falco’s ability to begin a new appraisal service at or below the cost calculated. List as many uncertainties as you can. List possible qualitative factors that Falco’s CFO should consider in making this decision. List as many as you can.

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(g) (h)

Explain why the accountant might have been biased, and explain what effects that might have on the cost report. What are the costs to Falco of relying on the accountant’s report for this decision? What are the costs to the accountant of admitting that he might be biased in preparing information for this decision?

(LO4 and 6) (a)

Insource or outsource (make or buy). They need to decide whether to hire appraisers and do the appraisal in-house or to continue to outsource the services.

(b)

Only supplies, professional labour, and variable overhead (fringe benefits) are relevant, so cost is $145 000 [$5000 + $100 000 + (40% × $100 000)]. Fixed overhead will be incurred no matter what decision is made and so is excluded as irrelevant. New report using incremental costs

(c)

Supplies and paper Professional labour Variable overhead Total

$ 5 000 100 000 40 000 $145 000

(d)

A comparison of the cost to insource ($145 000 or $145 each) to the cost to outsource ($180 000 or $180 each) indicates that the company should insource.

(e)

Can 1000 appraisals be done by the hired professional labour? Will Falco be able to hire appraisers who have high standards and do a high quality appraisal? Will the number of appraisals requested change in the next year or two? How much uncertainty is there in the cost estimates?

(f)

Can the company maintain the level of quality and timeliness needed if it insources? Can it handle variations in volume if it insources?

(g)

The accountant is related to the owner of the appraisal firm. He may be biased toward using that firm. He may have included irrelevant information in hopes of biasing the outcome of the decision.

(h)

If Falco relies on the accountant’s report, it is likely that managers will decide to continue outsourcing when it appears that it would be cost effective to insource. The cost is the savings foregone from relying on biased information. In addition, the appraisal service may increase prices because the owner may believe that he has an advantageous situation through his father-in-law’s connections. If the accountant admits that he might be biased, he may feel relieved to act in a more ethical manner. Falco’s owner could respond with thanks and trust the accountant more in the future. Alternatively, the owner could be disappointed and not trust the accountant and possibly let him go.

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13.45 Keep or drop uncertainties; relevant information; qualitative factors Gourmet Fast Foods produces and sells many products in each of its 35 different product lines. Occasionally a product or an entire product line is dropped because it ceases to be profitable. The entity does not have a formalised program for reviewing its products on a regular basis to identify products that should be eliminated. At a recent meeting of Gourmet’s top management, the head of operations stated that several products or possibly an entire product line were currently unprofitable. After considerable discussion, management decided that Gourmet should establish a formalised product discontinuance program. The purpose of the program would be to review the entity’s individual products and product lines on a regular and ongoing basis to identify problem areas. The CFO proposed that a person be assigned to the program on a fulltime basis. This person would work closely with the marketing and accounting departments to determine the factors that indicate when a product’s importance is declining, and to gather the information that would be required to evaluate whether a product or product line should be discontinued.

Required (a) Explain why the managers of Gourmet Fast Foods cannot know for sure when a product or product line should be discontinued. (b) What factors might indicate the diminishing importance of a product or product line? List as many factors as you can. (c) If you were assigned to this position, what information would you want from the accounting system? (d) If you were assigned to this position, would you want any information other than that produced by the accounting system? If so, what type of information would be useful, and where would you be likely to obtain it? (e) List several benefits of assigning an employee full-time responsibility for a product discontinuance program. (f) If you were assigned to this position, describe the steps you would take as you analyse a given product. (LO3 and 6) (a)

Identifying relevant information when a number of products are produced using the same facilities can be problematic. Accountants need to separate fixed and variable costs, and identify any avoidable fixed costs. This takes time and effort, especially if the accounting system is set up to produce financial statements and no other cost accounting information. In addition, identifying revenue consequences of dropping a product or product line can be difficult. Gourmet managers cannot know for certain whether consumers will substitute another one of their products for those dropped, or one of their competitors’ products. In addition, managers cannot know for certain whether dropping one product or product line could affect sales volumes of the remaining products. The food industry is plagued by changes in preferences because of fad diets.

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(b)

If Gourmet’s accountants can identify relevant revenues and costs, monitoring the contribution margin for each product provides information about its profitability. In addition, managers may want to monitor changes in market share for products or product lines. If market share is falling rapidly, further analysis would be appropriate. Market share could be evaluated using revenue and sales order trends as well as industry information. Another important factor might be correlations in revenues among products with which managers could evaluate the potential reliance of sales from one product on another. Students may have thought of other factors.

(c)

I would want information to evaluate the factors described in Part B that would be found in the accounting system—i.e. historical revenues, variable costs, and fixed costs for each product or product line, as well as sales order data.

(d)

Additional information would include market share and industry trend information. Decision makers could monitor current diet books and food fads. They would also want information about competitors’ prices and market share. Students may have thought of other non-accounting information.

(e)

Benefits for establishing this position include the following. Students may have thought of other benefits. • Gourmet would have more information about product profitability and may be able to emphasise more profitable products, increasing overall margin. • Product lines that were not covering their avoidable costs could be dropped. • New product development is likely to receive more focus as the review program identifies areas of increasing demand. • Gourmet is likely to benefit from better monitoring of competitors’ product development, prices and market share trends.

(f)

This is an open-ended question; the specific steps are likely to vary based on the circumstances and the information found. Analysis for a given product might include the following general steps: • Identify the product to be analysed by using a quantitative monitoring technique (e.g. size decline in contribution margin or sales) or some other method • Obtain and analyse detailed revenue and cost data prior periods; look for negative trends • Obtain and analyse the correlation of sales for this product with other products; look for potential relationships with other products that might influence a decision to drop the product • Obtain and analyse industry information about the product; look for information about trends in customer tastes, competition, etc. • Discuss the product and its potential with marketing and sales personnel • Review the information for ideas about threats and opportunities related to other products • Prepare a report for management describing the product and its potential, summarising its financial situation, presenting major pros and cons of dropping the product, and recommending a course of action

13.46 Outsource calculations; qualitative factors; cost of quality Mills and Vines just received a bid from a supplier for 6000 motors per year used in the manufacture of electric lawn mowers. The supplier offered

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to sell the motors for $88 each. Mills and Vines’ estimated costs of producing the motor are as follows.

Prior to making a decision, the company’s CEO commissioned a special study to see whether any decreases were possible in fixed overhead costs. The company would avoid two setups, which would reduce total spending by $10 000 per setup. One inspector would be laid off at a savings of $28 000. A person in materials handling could also be laid off at a savings of $20 000. Engineering work would be reduced by 500 hours at $15 per hour. Although the work decreases by 500 hours, the engineer assigned to the motor line also spends time on other products. Required (a) Ignore the information from the special study. Using the general decision rule, determine whether the motor should be produced internally or purchased from the supplier. (b) Repeat the analysis, using the information from the special study. (c) Identify and discuss any qualitative factors that would affect the decision, including strategic implications. (d) After reviewing the special study, the controller made the following remark: ‘This study ignores the additional activity demands that purchasing the motor would cause. For example, although the part would no longer be inspected on the production floor, we will need to inspect the incoming parts in the receiving area. Will we actually save any inspection costs?’ Discuss whether you agree with the controller. Identify and explain other costs that might increase if the part is outsourced. (LO4 and 6)

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(a)

It would be more cost effective for Mills to insource because the avoidable costs of insourcing are lower than outsourcing: Make Buy Purchase price $88.00 Variable costs: Direct materials $40.00 Direct labour 20.00 Variable overhead 20.00 Total $80.00 $88.00

(b)

When avoidable fixed costs are identified, it is more cost effective to outsource rather than insource because the avoidable costs from insourcing are higher than the purchase price for outsourcing: Make Buy Purchase price $88.00 Variable costs: Direct materials $40.00 Direct labour 20.00 Variable overhead 20.00 Plus avoidable costs: Reduced setup cost ($20 000/6000) 3.33 Inspector ($28 000/6 000) 4.66 Materials handling ($20 000/6000) 3.33 ____ Total $91.32 $88.00 This solution assumes that the decrease in engineering work is not relevant because the engineer will be assigned to other products (i.e. the engineer’s pay will be unchanged).

(c)

Product quality is a major factor. Sometimes managers can easily increase quality inside an organisation; however, if a number of vendors are available, quality might be more easily maintained by asking vendors to compete on both quality and price. Vendor reliability is another important factor. Vendors’ abilities to maintain a timely delivery schedule and continue in operations are important factors. If there are very few vendors available and the product is outsourced to one of them, the potential of price increases exists, and so a long-term contract may be needed. The managers should also consider how the decision relates to the company’s core competencies and long-term strategies. If production of the motors is viewed as one of the company’s core competencies, then the managers would be less willing to adopt the outsource option.

(d)

Yes, incoming parts will need to be inspected, unless there is some sort of guarantee from the supplier that they will be defect-free. Until the units have been received, the level of quality is unknown. However, the inspection may be minimal compared to inspecting the production of the units. More information is needed about the inspection process currently in place and about what would be needed to inspect incoming units. Another potential cost is that the company might not be able to accept rush orders if it relies on outsourcing. Also, the company could incur production delays and possible lost sales if the vendor is unable to deliver on time.

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11.47 Product emphasis with constrained resource, cost function, uncertainties Riteway currently produces and sells five different products. Total demand for the products exceeds the firm’s capacity to produce all of them. The constraint on production is the time available on a special machine. Data on the products and time required on the special machine are summarised in the following chart.

The entity has only 5500 hours of time available on the special machine per period. Fixed costs are $110 000 per period.

Required (a) How many units of each product should the entity produce and sell to maximise income? (b) On further analysis, it was determined that while fixed costs do not vary as production volumes change, they do vary based on the number of different product lines. If only two types of products are produced, these costs are $60 000, but if all five types of products are produced, these costs will be $135 000. Using the two-point method, determine a linear cost function for the cost of product lines. (c) Describe possible business reasons for the cost behaviour described in part (b). (d) Using the results from part (a) and the cost function you developed for part (b), prepare an income statement for the firm by product line and by total products. (e) Review the results in part (d). Prepare a new product line income statement that reflects any changes that should be made in the production plans to maximise income. (f) Identify reasons why the managers cannot be certain that they have accurately estimated the following for each product: selling price, variable costs, machine hours needed per unit, and maximum unit demand per period. (g) Discuss how the uncertainties in part (f) might affect the managers’ production decisions. (LO5 and 6)

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(a) Machine time is the constraint, so the first step is to compute the contribution margin per machine hour for each of the products.

Sales price per unit Variable mfg. costs per unit Variable mktg. costs per unit Contribution margin per unit Machine hours per unit Contribution margin per machine hour

A $12 (8) (1) $ 3

B $15 (9) (1) $ 5

Product C $18 (11) (3) $ 4

0.20

0.30

0.25

$15.00 $20.00

$16.6667 $16.00

D E $24 $32 (12) (18) (2) (6) $10 $ 8 0.50 0.40 $20.00

Products E and D have the highest contribution margin per machine hour so they should be produced first. Then produce B, C and A, respectively. Given a total constraint of 5500 machine hours, the production should be: Machine Hours Available Maximum machine hours 5500) Production of E (max. demand 2000 units × 0.40 hrs per unit) (800) Production of D (max. demand 1500 units × 0.50 hrs per unit) (750) Remaining machine hours 3950) Production of B (max. demand 7500 units × 0.30 hrs per unit) (2250) Remaining machine hours 1700) Production of C (remaining machine hours 1700/0.25 = 6800 units) (1700) Note: This is less than the maximum demand for Product C, which is 20 000 units × 0.25 hrs = 5000 hrs Remaining machine hours 0)

Units produced Machine time per unit (hrs.) Total machine hours Contribution margin per hour Total contribution margin

E 2 000 0.4 800 $20 $16 000

D 1 500 0.5 750 $20 $15 000

Product B C Total 7 500 6 800 0.3 0.25 2 250 1 700 5 500 $16.67 $16 $37 500 $27 200 $95 700

This production plan leads to a loss: Total contribution margin Fixed costs Net loss

$ 95 700) 110 000) $(14 300)

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(b)

Two points can be used to calculate the fixed and variable portions of this mixed cost. Here are the high-low method calculations: High Low Difference

Number of Products 5 2 3

Cost $135 000 60 000 $ 75 000

Fixed costs that vary per product = $75 000/3 = $25 000 Fixed costs that do not vary are calculated using one of the data points: $135 000 = F + $25 000 × 5 F = $10 000 Thus, the cost function is TC = $10 000 + $25 000*Q, where Q is the number of products produced. (c)

There are many different factors that could affect fixed costs. It is likely that additional product lines would need more supervisory time and might also require greater expertise (and a higher salary). Factory insurance and equipment costs probably increase as the number of product lines increase. Also, companies are likely to incur fixed administrative and marketing costs for each product line. Students may have thought of other costs.

(d) Sales Variable costs Contribution margin Product line fixed costs* Product line margin Additional company fixed costs* Pre-tax income

Total $334 900) $64 000) (239 200) 95 700) (100 000) (4 300)

A B 0 $112 500)*

Product C D $122 400) $ 36 000)

0 (75 000)) 0 37 500) 0 (25 000)* 0 $ 12 500 )

(95 200) (21 000) (48 000) 27 200) 15 000) 16 000) (25 000) (25 000) (25 000) $ 2 200) $(10 000) $(9 000)

10 000 $(14 300)

* Based on the cost function developed in Part C, the fixed costs attributable to each product line are $25 000. The additional company fixed costs are $10 000. (e)

Part D reveals that although products D and E have the highest contribution margin per hour, their small volume fails to cover the product-line fixed cost of $25 000 each. Thus, products D and E should be dropped. For the remaining products, notice that the average contribution margin per hour earned by each of the products can be calculated as:

A ($15 × H – $25 000)/H

Average Contribution Margin Per Hour _ B C ($16.6667 × H – $25 000)/H ($16.00 × H – $25 000)/H

where H represents the number of hours devoted to each of the products.

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Note: Without the product-line fixed cost, the average contribution margin per hour would be the same as in part A. Given the constraints on the maximum demand for each of the products, the maximum average contribution margin earned by each product will be: Product

A B C

Hours

Contribution Margin

10 000 × 0.20 = 2000 7500 × 0.30 = 2250 20 000 × 0.25 = 5000

Contrib. Margin Per Hour

($15 × 2000) – $25 000 ($16.6667 × 2250) – $25 000 ($16.00 × 5000) – $25 000

$2.50 $5.56 $11.00

Thus, the firm should first produce product C, using 5000 hours. There remains 500 hours of time left, but this is an insufficient amount of time for either products A or B to cover the product-line fixed costs. Thus, the income statement reflecting optimal production is: Sales (20 000 units of C) Variable costs Product line fixed costs Additional company fixed costs Pre-tax income

$360 000) (280 000) (25 000) (10 000) $ 45 000)

The addition of the product line costs complicated the analysis because it is a stepwise linear cost. Step costs are often relevant costs that do severe damage to simple, short-term decision rules. (f)

Selling prices change with changes in consumer preferences (demand), changes in competitors’ prices, and changes in available substitutes. These changes are difficult to predict. Variable costs change with changes in demand and supply, transportation costs, maintenance costs, and operating efficiency. These changes are also difficult to predict. Technological advances occur continually, changing machine hour requirements. In addition, unpredictable factors such as machine breakdowns, worker efficiency, and raw material supply delays can influence machine hours used.

(g)

Because of the uncertainties mentioned in Part F, managers’ estimates of revenues and costs are easily biased. If managers do not care for a particular product, they may assume that their tastes are similar to those of customers, and negatively bias information about that product. Even if managers are unbiased, some revenue and cost information will tend to be overstated or understated, leading managers to believe that products were more or less profitable than they really are.

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13.48 Comprehensive problem Elder Services is a not-for-profit entity that has three departments in three separate locations, in addition to the headquarters. The entity provides services for elderly clients who are still living at home. One department provides meals, one department provides cleaning services, and one department provides health care services. Elderly Services relies on client fees and a small grant from the state government to provide services. Following are the results from last year’s operations.

In the past, the government provided small grants each year to cover losses for Elder Services. However, due to an economic downturn and decreased tax funds in the current year, the county will not be able to provide any support next year. In light of these changes, the managers of Elder Services are trying to decide how to balance the budget. Required (a) What is the contribution margin per visit for each department? Consider the next three situations independently. (b) To eliminate losses, the director of Elder Services would like to close the department that provides health services for clients. Assume no alternative uses are planned for the health services building and no change would occur in headquarters costs. Estimate the surplus (deficit) if the health services department is closed. (c) What would the estimated total surplus (deficit) be if cleaning services increase by 2000 clients, assuming no changes in fixed costs? (d) What would the estimated total surplus (deficit) be if Elder closes the meals division and that space is leased to another organisation for $2000 per month? Suppose you are hired to help Elder’s managers decide what to do about the lack of funding from the county this year. Ignore parts (b), (c), and (d) and answer the following questions as part of your analysis. (e) Which type of nonroutine operating decision does Elder Services need to make? What are the managers’ decision options?

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(f)

Perform quantitative analyses to help you decide whether one or more of the options listed in parts (b), (c) and (d) would be beneficial to the finances of Elder Services. (g) Now assume that the options in parts (b), (c) and (d), above are available. List uncertainties about Elder Services’ ability to achieve the quantitative results for each option: (b), (c) and (d). List as many uncertainties as you can. (h) List qualitative factors that the managers of Elder Services need to consider in making this decision. List as many factors as you can. (i) As a consultant to Elder Services, how might you go about acquiring qualitative information? (j) Suppose you decide to interview Elder Services employees to help you gather qualitative information. Identify possible reasons that information you obtain from employees might be biased. List as many reasons as you can. (k) Describe possible trade-offs the managers of Elder Services might need to make in deciding what to do. (LO3 and 6) (a)

Meals contribution margin = $50 000 – $30 000 – $5000 = $15 000 per visit = $1.5 Cleaning department’s contribution margin = $100 000 – $50 000 – 2000 = $48 000 per visit = $4.80 ($48 000/10 000) Health department’s contribution margin = $150 000 – $120 000 – $5000 = $25 000 per visit = $2.50

(b)

Last year’s deficit Eliminate contribution from Health (Part A) Estimated (deficit)

$ (8 000) (25 000) $(33 000)

(c)

Last year’s deficit Extra contribution margin (2000 × $4.80) Estimated surplus

$(8 000) 9 600) $ 1 600)

(d)

Last year’s deficit Eliminate contribution from Meals (Part A) Space rental ($2000 × 12) Estimated surplus

$ (8 000) (15 000) 24 000) $ 1 000)

The problem does not provide information about whether the clinic still absorbs the same amount of headquarters cost. The calculation above assumes that the amount due headquarters continues to be $60 000. If rent is considered revenue, the clinic could be allocated more of headquarters’ costs.

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(e)

This decision is a keep or drop decision. The manager needs to determine whether to drop any of these services. The manager could drop any one of the three services.

(f)

Dropping health services results in a greater deficit ($33 000 instead of $8000). Increasing cleaning services eliminates the deficit and adds a surplus of $1600 ($9600 – $8000). Closing meals adds a surplus of $1000 ($9000 – $8000). The relevant costs are the variable costs, and the number of services provided. Any avoidable fixed costs would be relevant. It’s not clear that any of these fixed costs are avoidable. The best option is to increase cleaning services.

(g)

There are uncertainties about whether demand will continue, and whether there will be price changes for labour or supplies or food for meals. There are uncertainties about labour hours, quantities of supplies used, and the specific types and quantities of fixed costs incurred. There are also uncertainties about whether the county will be able to continue to provide grants and about the level of grant support available. There are also uncertainties about how fixed costs might change if one or more services are dropped.

(h)

Qualitative factors for this decision include evaluation of how well the decision matches the clinic’s mission and strategies. Another important factor is the mix of services needed by the organisation’s clients. If many clients need two or three of the services, then dropping a service might reduce the value to clients of the remaining services. Dropping a service might also cause employee morale problems. If the managers decide to expand Cleaning services, they may face shortages in available personnel.

(i)

As a consultant, I could survey current customers to determine their sensitivity to changes in fees and changes in services. In addition, I could identify other organisations providing similar services and identify their fees and types of services provided. Because many of these services are not-for-profit, managers of competing organisations are often willing to share information because they want as many people served as possible. Other sources of information include the total market share for these types of services, industry publications, and web sites of government and other organisations providing similar services. Students may have thought of other sources.

(j)

Employees usually want to keep their positions, so they may tend to bias information so that their department appears more valuable to the organisation. Alternatively, if they believe that funds to their department would increase for some reason, they may tend to understate revenues and overstate costs to increase their budgeted funds.

(k)

Managers will need to eliminate losses, so they will make trade-offs among a number of factors. They may trade-off between increasing fees and dropping or reducing a service. They may trade-off higher quality services for lower quality services to maintain current fees. Trade-offs could be made in wage increases or number of employees needed. Students may have thought of additional tradeoffs.

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Solutions manual to accompany

Management accounting 4thedition by Eldenburg et al. Prepared by Albie Brooks

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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Chapter 14: Strategy and Control Questions 14.1

Define strategy and differentiate between corporate-level strategy and business-unit level strategy. (LO2)

The strategy of an organisation is usually related to future direction and what the organisation wants to be. The corporate-level strategy relates to what kinds of businesses the organisation wants to be in; while the business-unit level strategy seeks out competitive advantage at the business-unit level.

14.2

Briefly explain the link(s) between strategy and managerial control systems. (LO1 and 2)

As the strategy provides a guide to the future direction of the organisation, it is imperative that the managerial control system supports this strategy. For example, for an organisation with a low cost strategy we would expect the focus of the control system tools to be around cost and efficiency aspects of the organisation; at least this would be its focus in those parts of the organisation’s value chain where this would be appropriate. It is also possible that control system tools themselves help inform an organisation’s strategy; so the link between the two can be two-way. 14.3 What role does management accounting and control information play in developing new strategic directions? LO3 Management accounting and control information plays a critical role in the formation of new strategic directions. For instance, management accounting and control information can: • Enable managers to better understand the firm’s past performance and the instances in which past strategic objectives have/haven’t been met and the potential reasons for these variances. • Provide feedback on the firm’s environmental and social performance and inform the identification of relevant sustainability strategic priorities. • Involve benchmarking activities which enable managers to better understand the performance gaps relative to competitors and identify where the strategic priorities should lie. • Involve the preparation of budgets which forecast the potential outcomes of any revised strategies.

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14.4 What role does management accounting and control information pay in monitoring the success of the new strategic direction taken by an entity? LO3 Management accounting and control information includes the use of various financial and non-financial performance measures and comparisons of budgeted and actual performance to track the extent to which strategic objectives have been met. Following up on any variances may result in an organisation revising its strategic direction. 14.5

Distinguish between diagnostic and interactive use of specific control system tools. (LO3)

Diagnostic controls suggest a cycle of measure, monitor and feedback with a focus of keeping organisational activity in line with the existing strategy. Deviations from expected performance are viewed as a performance problem. For example, not meeting cost and efficiency targets would be viewed as an operational and performance problem. Interactive controls are more about the need to continually assess strategy. In this way, deviations from expected performance might suggest a strategy problem and not necessarily a performance problem. Interactive controls suggest more dynamic use of performance data and controls through greater communication between senior and unitlevel managers.

14.6

Using examples, explain the meaning of informal controls. (LO2)

Informal controls are those often less obvious controls that might influence operational performance. These might include: informal social networks within organisations; organisational culture; employee engagement; and recruitment and hiring practices.

14.7

Differentiate between belief systems and boundary systems. (LO3)

Belief systems and boundary systems are two of the less ‘accounting-based’ levers of control in Simons' levers of control framework. Belief systems relate more to the values and mission of the organisation; ‘what we believe in’. These may be formalised in mission statements and value statements. Of course, they also need to be ‘lived’ not just in writing. Boundary systems help set the ‘boundaries’ for organisational design, management and employee behaviour and practices. They help guide managers about what they can and cannot do and sets guidelines about routines and practices. Boundary systems ‘stake out the territory’ for managers to operate within.

14.8

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(LO4) Responsibility accounting is the process of assigning authority and responsibility to managers of sub-units in the organisation and then measuring and evaluating their performance. Examples of sub-units are: Cost Centres: In cost centres, managers are held responsible only for the costs under their control. Some cost centres provide support services that are relatively easy to monitor because their outputs are measurable. Cost centres are also used for subunits that produce goods or services that eventually will be sold by others. Managers in these cost centres are responsible for producing their goods or services efficiently. In discretionary cost centres (marketing, research and development, for example), the output is not easily measurable in dollars or activities. Cost centres are found in forprofit, not-for-profit, and government organisations. Cost centre managers are expected either to minimise costs for a certain level of output or to maximise output for a certain level of cost. Revenue Centres: In revenue centres, managers are held responsible for the revenues under their control. Revenue centres frequently sell products from manufacturing subunits. Managers are expected to maximise revenues. Profit Centres: Managers in profit centres are held responsible for both revenues and costs under their control. Profits centres produce and sell goods or services, and may include one or several cost centres. Profit centre managers are responsible for decisions about inputs, product mix, pricing, and volume of goods or services produced. The objective of profit centres is to maximise profits. Investment Centres: Managers of investment centres are held responsible for the revenues, costs, and investments under their control. Investments include any assets related to the investment centre, such as fixed assets, inventory, intangible assets, and accounts receivable. Investment centres resemble profit centres, where profitability is related to the assets used to generate the profits. The objective of investment centres is to maximise the return on investments made by the organisation. This means the most profitable projects must be identified and selected for investment.

14.9

Explain the meaning of span of control, span of accountability and span of attention. (LO4)

A manager’s attention will be determined firstly by the work unit she/he belongs to or manages (it could be a division; a manufacturing plant; a R&D department each with quite different functions and needs that will drive the manager’s daily activities). Secondly, the manager’s attention is influenced by his/her subordinates (the employee activities that she/he must monitor and control) as well as the resources that help perform the work unit function (are they adequate; are they outdated and require upgrading etc.). Thirdly, the manager’s attention will be drawn to the performance measures that work unit performance is evaluated on. These may be quantitative measures (such as profit or return on investment) or they might be qualitative measures (such as quality, lead times, customer satisfaction).

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14.10 What factors would force an organisation such as an airline to review its strategic direction? LO4 The airline industry is a dynamic industry characterised by intense global competition, technological innovation/change, and changing customer expectations. The industry is further exposed to volatile fuel prices and various economic factors (i.e. population and economic growth/changes) that may impact customer travel behaviours. Given the significant C02 emissions involved in airline travel, Airlines must further identify and manage their climate change risks. As such, various factors might force an airline to review its strategic direction. For example: •

•

Technological change and the introduction of new aircraft models/features can enable airlines to offer new services (i.e. extended flights which elimate the need for refuelling, new inflight services or features). The entrance of new airlines to the industry or changes made by existing competitors could increase competition and force airlines to reconsider how they maintain any cost and/or product differentiation advantages.

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Exercises 14.11 Strategy and control In their 2014 annual report, airlineVirgin Australia commented on the strategic direction of the company. After completing the Game Change Program, the Group has commenced Virgin Vision 2017, a strategy to maximise the Group’s potential by extracting value from the business. Over the next three years, the Virgin Australia Group will focus on: • Capitalising on growth business opportunities; • Driving yield enhancement; • Implementing a new cost program; • Optimising the balance sheet; • Setting a new standard in customer experience; and • Developing our people to their full potential. Required (a) Using the four components of Simons’ levers of control framework, comment briefly on how the management accounting and control system could be used to monitor the performance in achieving the strategic objectives. (b) Draw on Porter’s five forces to explain the competitive issues for Virgin Australia management. (c) Access the most recent annual report of Virgin Australia. Identify some of the key performance measures used by the airline (and reported externally) to monitor its performance. (LO1 and 3)

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(a) Belief Systems

Boundary Systems

Diagnostic Controls

Interactive Controls

To achieve the areas of focus outlined above, senior management will need to foster a cultural climate with a balance around financial management and meeting customer expectations. These attributes will need to be ‘lived’ within the organisation and not just statements. This is less evident. Nonetheless, work-unit design will need to be such as to facilitate work flows and decision making that complement the objectives. For example, overly rigid rules that restrict manager and employee activity from dealing with customer-related issues promptly would be supportive of the strategy and objectives. Specific measures of performance will need to be in place to monitor performance against targets. Measures which reflect the stated objectives include: customer-related measures; people development measures and cost-related measures. The objective of ‘capitalising on growth opportunities’ might require a more interactive use of control information and generate a greater focus on the market and competitive landscape. This requires much external monitoring of the competitive landscape.

(b) Some of the key issues to emerge from Porters competitive forces model for Virgin Australia include: Risk from potential entrants to the market. While the barriers to entry into the airline industry would be considered reasonably high (e.g. cost of aircraft), new competitors often emerge in the Australian market. Moreover, price wars often occur in the Australian market as participants move to maintain or enhance their market share. Buyers and customers. In the airline business, switching costs for buyers (consumers) are relatively low. This of course, is why airlines use loyalty programs and why Virgin Australia has more recently sought to increase its business class customer base. (c) Student responses here will vary, partly depending on the annual report accessed. For measures used at the senior level, the remuneration report is often a good place to start.

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14.12 Managerial accountability; span of attention Maddy is the divisional manager of the internet technologies division of IT World Ltd. The following information is currently available with respect to her role. • The internet technologies division is classified as a profit centre. • Maddy reports to the CEO. • The internet technologies division is responsible for software development, webpage construction, and IT services and consulting. • Maddy has four unit-level managers within her division, each in charge of functional profit centres. • IT World Ltd uses a division-focused set of performance measures. Maddy’s primary performance measure relates to the operating profit of the internet technologies division. She is also evaluated on the basis of client-satisfaction ratings and employee satisfaction scores. Required (a) Comment on the key factors influencing Maddy’s span of attention. Consider the influence of work-unit design, span of control and span of accountability. (b) Assume that IT World Ltd’s senior management has decided to alter the performance measures to reflect organisational performance only. How might this influence Maddy’s span of attention? (LO4) (a) Work unit design: the internet technologies division is classified as profit centre; and the division has four sub-units which are also classified as profit centres. Span of control: relates to the people and functions for which the manager is responsible. Maddy is responsible for four profit centre managers which include the functions of software development, webpage construction and IT services and consulting. Span of accountability: relates to the performance measures for which the manager is held responsible. Here, Maddy is evaluated on operating profit of the whole division, as well as two key non-financial measures: client-satisfaction ratings and employee satisfaction scores. (b) If Maddy’s key performance measures were to be based solely on organisational performance (span of accountability), Maddy’s focus may switch more to organisational performance than just her own division. This may influence her decision making in the future as she will be conscious of the impact of decision on the firm as a whole and not just her division.

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14.13 Levers of control Marissa Nafsik commenced at Mana Consulting (MANA) in 2010. The company has grown from a one-person operation to a rather diverse consulting company specialising in management consulting, technology consulting, particularly with respect to internet technologies, and, more recently, a forensic accounting service. MANA now employs 45 professional staff and 10 administrative staff. In the early days, Marissa was able to manage the company by meeting with staff on a one-on-one basis, holding lots of social gatherings and developing a strong culture of friendliness and hard work. The work seemed to get done with minimal formal monitoring of staff. Marissa was also very careful about who she hired, as it was important to her that new employees would adapt quickly to the company’s culture. Of course, as the company has grown, Marissa has found it increasingly difficult to use her personal touch like in the early days. As the company grew, she thought it best to document the kind of culture she wanted to preserve. Each employee was provided a copy of the MANA WAY as she called it. Still, as the company continued to grow, Marissa felt she was losing control. She found it more difficult to spend time with her staff and found herself constantly in her office planning, tendering for new consulting work, speaking with clients about work programs and the like. Moreover, since the forensic accounting business has started to take off, she has restructured the company into three divisions with a consulting manager for each division. She thought her best option for influencing the managers’ performance was to set some key targets relating to revenue within each division as well as to costs. She also set some expectations about client and employee satisfaction. What was worrying her now was whether she needed to rethink her negative attitude towards incentives and bonuses. She sat back in her chair and reflected. She was proud of what she had created but in some ways longed for the early days. Required (a) Using Simons’s levers of control, analyse the case. That is, identify and provide evidence of the existence of each of Simons’s levers of control. (b) Do you have any suggestions for how Marissa should proceed? (LO3)

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(a) Belief Systems

Boundary Systems

Diagnostic Controls

Interactive Controls

Essentially developed in the early days when the company was small with a focus on informality and one-on-one communication. This has been formalised in the MAMA WAY document. These seem less evident. The change to the company’s structure into three divisions is a form of boundary control and influences the work-unit design. Marissa has really only recently put in place specific performance measures such as those relating to revenue and costs within each division. These seem to reflect the firm’s current plans. In the early days the significant communication between Marissa and her employees may have served as a part interactive control. Since then, there is not as lot of evidence of this activity which has become harder to do as the company has grown. But it does seem that this communication that did take place was partly intended to assess current work programs and the like.

(b) Student responses here will vary. However, one response might be: This is a difficult situation encountered by many founding managers, as an organisation grows. This is where the need for carefully crafted control system tools become important. Marissa seems to have been able to get the company to this point without having to directly link incentives to performance. The company has been built on a reasonably informal culture as articulated in the MANA WAY. Perhaps it is time to return to the culture evident in this document. Marissa needs to work with the key work-unit managers to foster this culture. In doing so she may need to think more about organisational-wide performance and rewards to match the culture she is trying to develop.

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Problems 14.14 Managerial control systems; levers of control Unilever is a large Dutch–British consumer product manufacturer with sites around the world including Australia and New Zealand. Currently, there are 2000 employees in the Australian and New Zealand operations with two factories in New South Wales and two in Victoria. Unilever’s product range comprises well-known consumer product brands including personal hygiene products — Dove, Pond’s, Vaseline, Sunsilk, Lynx, Rexona; laundry detergents — Radiant, Surf, Lux; food and nutrition products — Bertolli (olive oil), Amora (salad dressings), Lipton (tea), Streets (ice cream, with Magnum their number 1 brand) and Knorr (Unilever’s number 1 brand worldwide for flavourings and gravy). More recently, Unilever’s management has re-evaluated its strategic direction. It had made plans to sell its US laundry arm before 2010 and to cut about 11 per cent of the worldwide workforce of 179 000. It also launched six global strategic initiatives, one of them relating to ‘business simplification’. In response to the global strategic initiative, Jean-Lin Toulemonde (Unilever Australasia Chairman) launched a ‘radical business simplification program at Unilever, designed to eliminate unnecessary work, make people more effective, and lift the company’s business performance’. Jean-Lin has a strong belief in business that ‘simple is often best’ and has looked to simplify things wherever possible. If you ask yourself whether you can imagine an organisation that is successful, responsive, fun to work at, full of motivated people and that is also very bureaucratic, the answer is clear: you can’t. The good news is your people can’t either! Bureaucratic procedures develop slowly but inexorably. I use the analogy of the street signs you see on Sydney streets — no doubt each of those sign placements made sense at one time, but the aggregate effect now is often chaos. Businesses need a periodic spring-cleaning, if they are to keep working effectively. Jean-Lin considered that part of that complexity came from the nature of the business. Unilever operate in many markets, with many product categories and many brands. In that type of environment it’s easy to end up trying to do too many things, rather than doing fewer things better. It’s easy to become overstretched, from both a process and resources point of view, and end up wasting opportunities.

He explained how the senior management team called for a more focused approach to fit with Unilever’s overall strategy ‘which is essentially about fewer, but bigger brands, and fewer, but more important activities’. He

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explained how they also identified problems with the Unilever organisational structure. They looked hard at the value-chain processes within Unilever to see where they could simplify them. They also evaluated their performance measurement control systems (PMCS). Jean-Lin argued that ‘if you measure everything that moves in your business, you may simply be complicating your business. We had a concept of “loose versus tight” controls — let things happen in the business, don’t try to control everything, and trust our people to deliver the results. You don’t need a lot of additional measures and KPIs [key performance indicators] — you simply need to measure whether you are achieving your original objectives’. He thought the biggest concern for divisional managers related to the delegation of control. He explained the questions coming from this layer of senior management was ‘are you really prepared to give me responsibility and resources to simplify the way I operate, and will you punish me if I make mistakes? Once we convinced people we were serious, and that mistakes would not be treated unreasonably, then people became enthusiastic and prepared to take risks. Required (a) Jean-Lin has provided a brief insight of management control at Unilever. Drawing on this insight, evaluate the role of performance measurement and control at Unilever. Use the levers of control to help guide your response. (b) How can performance measurement and control systems help with the implementation of Unilever’s organisational strategy? (LO3) (a) Jean-Lin wanted to give managers autonomy in decision-making – that is, use ‘loose’ versus ‘tight’ controls. Following from the worldwide strategic initiative, he seems to strongly support the business simplification plan. For example, it appears he prefers the use of a few simple measures as diagnostic tools to evaluate performance against original objectives. This notion of ‘simplification’ seems evident in much of what Jean-Lin wants for Unilever Australia. In some ways this may act as a belief system as a key value system of the company. Boundary systems are evident in the considered changes to the organisational structure. Organisational structure influences work-unit design and hence the boundaries within which managers operate.

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(b) Performance measurement and control systems provide the tools with which JeanLin can successfully implement, monitor and review the strategies of Unilever Australia. For example, an integrated set of performance measures should reflect Unilevers objective of simplification. In the process of evaluating profit performance – Jean-Lin would probably not evaluate profit performance variance analysis in a tight controlling way – i.e. backward looking or as a punishing mechanism. Instead he would use performance evaluation proactively to encourage discussion and strategy setting – forward looking. He would use the information from profit performance to maintain or alter patterns in organisational activities; encourage desirable activities, discourage and alter undesirable activities. Results from profit performance would not be used in a way that would discourage autonomy. Instead the individual managers would have the responsibility to ensure they prove their operational and competitive effectiveness. In chapter 13 we explore profit planning and strategic budgeting. Jean-Lin could use these tools as a vehicle to formalise and communicate strategy throughout Unilever Australasia. Jean-Lin would ensure that the three wheels of profit planning fits with the entire Unilever Group (global strategic initiatives). He would more than likely sit down with the Australasian CEO and managers under his control and set a broad framework of desired results in place. They would define the resources they had available for the profit planning exercise and measurement criteria (these would more than likely be broad-level measures (i.e. ROA; ROCE; Profit) – given Jean-Lin’s comments. The goals would be structured according to the profit planning wheels. It would then be up to the individual managers to work within these broad controls.

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14.15 Strategy and control Informal networks (such as the use of idea brokers) are one way of overcoming a lack of collaboration and innovation. Required Drawing on any of the five strategy and control frameworks outlined in the chapter, explain how organisations could use managerial control systems to help overcome a lack of collaboration and innovation. (LO2 and 4) For this task students are likely to produce quite different responses depending on which of the strategy and control frameworks are selected. However, one example, might relate to Simons' levers of control. For example, the use of strong belief and interactive controls could be used to facilitate communication between business units both in a formal (routine and planed) and informal (non-routine) way. Also diagnostic controls such as organisation-wide measures and targets may be more likely to facilitate collaboration across business units and foster organisation-wide decision making.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. Prepared by Gillian Vesty

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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Chapter 15: Capital budgeting and strategic investment decisions 30

Questions 15.1

State the three categories of capital investments and briefly explain the best capital investment evaluation tools suitable for each. (LO1, LO6)

1. investment decisions to comply with regulatory, safety, health and environmental requirements. 2. operational capital investment decisions 3. strategic capital investment decisions Category 1 – generally evaluated on best price and fit for purposes Category 2 – evaluation tools would be traditional NPV, IRR, Payback, Accrual accounting rate of return. Category 3 – tools identified for categories 1 and 2 are often considered insufficient on their own to evaluate strategic investments. Other considerations should include: • Qualitative factors (may be categorised and ranked) • Moving baseline concept to determine relevant cashflows (impact of not investing in project – cannot assume continuation of cashflows in ‘not invest’ decisions) • Expertise of project champion • Cost of reversing the decision 15.2 Describe the pros and cons of each of the capital budgeting methods learned in this chapter: (a) net present value, (b) internal rate of return, (c) payback, and (d) accrual accounting rate of return. (LO5)

(a)

Net present value (NPV) Pros: • NPV is more accurate than the payback and accrual accounting rate of return methods because it reflects the time value of money. • Under NPV, discounted cash flows reflect today’s dollars, so several different projects can be easily compared to determine the one with the highest NPV. Cons: • It is sometimes more difficult to estimate cash flows and choose an appropriate discount rate for NPV than finding the internal rate of return or calculating payback or an accounting rate of return.

(b)

Internal Rate of Return (IRR) Pros: • Many managers find IRR intuitively easier to understand than NPV • IRR has the same advantage as NPV of including the time value of money.

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• IRR can be used to compare potential projects (choose the one with highest IRR).

Cons: • Assumes cash flows can be reinvested at the IRR • When comparing projects, IRR does not take into consideration size of investment and may be inappropriate when managers need to choose among competing projects because capital is constrained. • IRRs from several projects cannot be summed or averaged, while net present values can. • IRR is calculationally more difficult than NPV and the other methods, particularly with uneven cash flows. (c)

Payback Method Pros: • Used extensively, particularly outside of the US • Focuses on high risk of long payback period Cons: • Does not incorporate time value of money • Ignores cash flows received after the investment is recovered

(d)

Accrual Accounting Rate of Return Pros: • Use for division or department performance because data is readily available Cons • Cost of investment is double-counted (depreciation is included in the numerator, and the investment is the denominator) • Not appropriate for capital budget decisions because it does not include the time value of money

15.3

A community health clinic operates as a not-for-profit entity. Typical capital expenditure decisions involve acquiring equipment that will perform medical tests beyond those currently possible at the clinic (hence, adding revenues) and/or perform tests more efficiently than currently (hence, decreasing expenses). To evaluate such expenditures, the clinic uses a discount rate equal to the return on its investment trust portfolio. Briefly explain why it does this. (LO1, LO4)

The return on the investment portfolio represents the clinic’s opportunity cost for funds. They can earn at least that return; therefore, any other investment must yield a higher return.

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15.4 Suppose an entity has five different capital budgeting projects from which to choose, but has constrained funds and cannot implement all of the projects. Explain why comparing the projects’ NPVs is better than comparing their IRRs. (LO1, LO5)

If several projects are being analysed, their NPVs can be summed to determine the NPV for that group or portfolio of projects, whereas IRR can be neither summed nor averaged. In addition, NPV provides information about the value of the projects in terms of today’s dollars. If projects are of different sizes, requiring large and small investments, NPV reflects these differences. IRR provides only a rate of return, and comparing rates of return does not take into consideration the size of return. In addition, the net present value method is calculationally simpler than the internal rate of return method. Determining IRR can be time consuming, particularly for projects having uneven cash flows. However, the use of a spreadsheet reduces the effort considerably. An important difference between the two methods is that the IRR method assumes cash inflows can be reinvested to earn the same return that the project would generate. However, it may be difficult for an organisation to identify other opportunities that could achieve the same rate when IRR is high. In contrast, the NPV method assumes that cash inflows can be reinvested and earn the discount rate — a more realistic assumption. If the discount rate is set equal to the organisation’s cost of capital, then alternative uses of cash would include paying off creditors or buying back stock. Therefore, if the results of analyses using the two methods are not the same, the NPV method is preferable. Both methods are used widely in business. One reason for the continued use of IRR is that many people find it intuitively easier to understand than NPV. In addition, managers may want to compare the IRR on prior projects to current project return rates as they consider new investment. 15.5 Due to a newly released safety regulation, Red Rock Chocolates will have to replace the fire safety equipment throughout its production facilities. How should Red Rock management assess this asset replacement? (LO2)

Capital budgeting tools like net-present-value analysis could help Red Rock Chocolates to compare the cost-effectiveness of the various available fire safety equipment systems. Given the importance of the fire safety equipment for employee safety, however, it is critical that the management of the firm also consider non-financial information concerning the reliability, serviceability, performance, coverage/capacity and other relevant aspects of the available alternatives. A cheaper system is certainly not likely to be the best alternative if they are compromised in terms of their performance.

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15.6 At recent management meeting the following statement was made by the Chief Operating Officer – “ this project is strategic for the firm and therefore non-discretionary”. Briefly comment on this statement. (LO6)

Non-discretionary expenditures are those which need to be made regardless of the financial and other impacts. As such, they may go ahead despite having a negative net present value, long payback period and/or other negative projected financial results. This example also illustrates how capital investment decisions involve more than just financial considerations with qualitative factors such as the alignment of the investment with the strategic priorities, and/or the ability of a project champion to justify the significance of the investment also potentially coming into play. 15.7 Forecasting the terminal value of equipment 20 years from now is difficult to do accurately, but errors in estimation probably have a small effect on the NPV. Explain. (LO2, LO3, LO4) After a number of years, the present value factors for all discount rates become quite small, and the incremental effect of future cash flows is therefore small. According to the present value tables, after about 15 years, the incremental values at rates above 8 to 10% are small (less than 20% of the original value). If these cash flows are small, but include error, the size of error would also be small and likely have little effect on the overall analysis.

15.8 When projects have longer lives, it is more difficult to accurately estimate the cash flows and discount rates over the life of the project. Explain why this statement is true. (LO1, LO6) Estimating future cash flows becomes more difficult over longer periods of time because the uncertainties increase. Changes in economic, political, and consumer tastes that affect cash flows cannot be easily predicted. More information is usually available about near-term economic factors than long-term. 15.9 The present value of a given cash flow gets smaller as the number of periods gets larger, regardless of whether cash flow is discounted with a real rate or nominal rate. Explain why this relationship happens and what it means from an economic perspective. (LO8) Future cash flows are discounted with present value factors that become increasingly small across time to reflect the fact that investors forego interest on cash flows that are received in the future relative to cash flows that are received today and could be invested today. This discounting reflects the opportunity cost (interest foregone) when money is received in the future instead of today.

15.10 Two methods can be used to incorporate the effects of inflation or deflation into an NPV analysis. In your own words, explain how a nominal

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discount rate is different from a real discount rate. Why are analyses using the nominal approach potentially more accurate than those using the real approach? (LO8) A nominal discount rate includes a factor for inflation, and the real rate does not. Both rates include a risk-free rate and a risk premium. Using a nominal approach, different cash flows can be inflated differentially. For example, petrol prices might inflate at a different rate than wages. If different types of cash flows are differentially inflated to better reflect future expectations, the preciseness of the estimation and analysis process increases and information quality increases.

15.11 How might inflation influence a decision to acquire an asset now rather than later? (LO8) Real assets tend to increase in nominal value under inflation, while monetary assets tend to remain fixed. If a firm has cash in a bank earning interest, the after-tax return could be less than the inflation rate. Therefore, the firm’s cash would be losing purchasing power over time. In this case it would be better for the firm to invest in a real asset that increases at the inflation rate or greater. 15.12 If an entity has unlimited funds, what criterion should be used to determine which projects to invest in? (LO1, LO4, LO6) Financial criterion is usually net present value (NPV). All investments with a positive net present value would be accepted, assuming that the cost of capital is constant across investments. However, other non-financial criterion might impact the decision-making process. Depending on the rationale for investing, the entity might have other strategic factors that dominate the decision and override the decision that has the highest NPV. For example, a government might decide to invest in a project that has overall greater benefits to the community over one that has the higher NPV (e.g. a government contract for fleet of vehicles, a decision to build vehicles locally with local labour, rather than import cheaper vehicles). A for-profit organisation might select a project for its strategic benefits, rather than select the project with the higher NPV (e.g. flexible manufacturing equipment rather than replacement equipment). For these decisions, it is often challenging to calculate an economic value for certain qualitative factors or to ensure the values fit within the proposed time frame of the investment. Some values are not readily quantifiable. For example, what if the proposed investment means indigenous artefacts might be destroyed or an avenue of old trees must be removed to make way for the development. Even if the company might have to spend more money to avoid fines (which can be included in the NPV) other benefits such as impact on reputation is a lot harder to quantify and include in the cash flows.

15.13 An international firm requires a rate of return of 15 per cent domestically and in developed countries, but 25 per cent in less-developed countries. Does this requirement mean that the firm is exploiting the less developed countries?

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(LO1, LO4) Requiring a higher return rate for projects in developing countries may be the firm’s way of coping with increased problems of uncertainty and risk. Less developed countries usually have less stable political systems, economies, inflation rates and consumer markets. In addition, infrastructure such as roads and utilities is sometimes unreliable, so production and transportation problems could occur more frequently. These factors increase the risk of doing business in developing countries. From the host government’s point of view, if a higher rate of return is not permitted under such circumstances, the investment would probably never have been made at all, and the developing country would be worse off as a result. The firm, however, must be careful to avoid any perception of exploitation, as the long-term reputation effect could be devastating.

15.14 When we covered cost–volume–profit (CPV) analysis in chapter 4, we calculated the amount of pre-tax profit needed to achieve a given level of after-tax profit. We could calculate a pre-tax rate of return given an aftertax rate of return. Why would it be inappropriate to use a pre-tax discount rate in capital budgeting? (For example, if an entity requires an after-tax return of 10 per cent and has a marginal income tax rate of 50%, why not use a 20 per cent pre-tax rate of return and ignore the separate income tax calculations?) (LO7) There are two reasons to incorporate tax effects more formally into NPV analyses. From an accounting standpoint, tax regulations permit a shift of both the amount and the timing (sometimes permanently) of taxes; this will have an effect on present values. If tax savings based on current tax rules are not incorporated into the analysis, these effects are not captured and the analysis is less accurate. From a mathematical standpoint, the factors in the tables are not linearly related (all of the formulas have exponents); e.g. the present value factor for 20% is not one-half of the factor for 10%.

31 32

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33 Exercises 15.15 Capital budgeting process Put the following six steps for capital budgeting in the most likely order, numbering the first activity as number 1, the second as 2, and so on. • Perform sensitivity analysis. • Identify decision alternatives. • Analyse qualitative factors. • Identify relevant cash flows. • Apply the relevant quantitative analysis technique. • Consider quantitative and qualitative information to make a decision. (LO1) The proper sequence is: 4, 1, 5, 2, 3 and 6.

15.16 Time value of money (a) What is the present value of $8000 received in seven years at 8 per cent interest? (b) Bonnie Lee buys a savings bond for $125. The bond pays 6 per cent and matures in 10 years. What amount will Bonnie receive when she redeems the bond? (c) Erik Peterson needs to have $10 000 at the end of five years to purchase a second car. His investment returns 6 per cent. How much does he need to invest now? (d) Conan Bardwell will receive $1000 in six years from an investment that returns 12 per cent. How much did he invest? (LO2) (a)

Using tables, the answer is ($8000 × 0.583) = $4664. Using Excel, the answer is $4667.92.

(b)

Using the tables, the answer is ($125 × 1.791) = $223.88. Using Excel, the answer is $223.86.

(c)

Using tables, the answer is ($10 000 × 0.747) = $7470. Using Excel, the answer is $7472.58.

(d)

Using tables, the answer is ($1000 × 0.507) = $507. Using Excel, the answer is $506.63.

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15.17 Present value and future value calculations Diamond Ltd agreed to sell some used equipment to one of its employees. Alternative financing arrangements for the sale have been discussed, and the present and future values of each alternative have been determined. Required (a) Diamond offered to accept a $1000 down payment and set up a note receivable that calls for four $1000 payments at the end of each of the next four years. What is the NPV of this note if it is discounted at 6 per cent? (b) The employee agrees to the down payment but would like the note for $4000 to be payable in full at the end of the fourth year. Because of the increased risk associated with the terms of this note, Diamond would apply an 8 per cent discount rate. What is the true selling price of the equipment? (c) Suppose the employee borrows the $5000 at 8 per cent interest for four years from a bank so that he can pay Diamond the full price of the equipment immediately. Also, suppose that Crown could invest the $5000 for three years at 7 per cent. What is the selling price of the equipment? What would be the future value of Diamond’s investment? (LO2, LO3) (a)

The PVFA for four payments discounted at 6% is 3.465. Thus, the present value of the note is $1000 × 3.465 = $3465. With the down payment, the total is $4465.

(b)

Because this is a single payment the factor is a present value single amount of 0.735, so the total is $4000 × .735 = $2940. With the down payment it becomes a total present value selling price of $3940.

(c)

The selling price of the equipment is $5000 no matter how the employee gets the cash and what Diamond does with the $5000. The future value factor for three years hence is 1.225, yielding: $5000 × 1.225 = $6125.

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15.18 NPV analysis Government supervisors in a remote area of Queensland are considering the purchase of a small, used plane to save on travel costs. The plane will cost $400 000 and can be sold in five years for 20 per cent of the original cost. Required If 10 per cent is the required rate of return, what minimum annual savings in transportation costs are needed for this plane to be a good investment? Ignore income taxes. (LO3) This problem is most easily solved in steps. First determine the present value of the terminal cash flow: Terminal value = $400 000 × 20% = $80 000 Present value = $80 000 × (PVF, 10%, 5 years) = $80 000 × 0.621 = $49 680 Subtract the present value of the terminal value from the investment to determine the present value needed from annual savings to justify the purchase: Minimum PV of annual savings = $400 000 – $49 680 = $350 320 Finally, determine the annual savings needed to achieve the present value calculated above. The following calculation assumes that the annual savings would be identical during each of the 5 years. Savings × (PVFA, 10%, 5 years) = $350 320 Savings × 3.791 = $350 320 Savings = $350 320/3.791 = $92 408 The company must generate at least $92 408 per year in savings to justify purchasing the plane.

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15.19 NPV calculations with taxes Overnight Laundry is considering the purchase of a new pressing machine that would cost $96 000 and produce incremental operating cash flows of $25 000 annually for 10 years. The machine has a terminal value of $6000 and is depreciated for income tax purposes using straight-line depreciation over a 10-year life. Overnight Laundry’s marginal tax rate is 33.3%. The company uses a discount rate of 18 per cent. Required What is the NPV of the project? (LO3) Cash Flow Timeline:

Investment Incremental cash flows: Annual Savings Taxes Net cash flow Terminal value

Time 0 $(96 000)

Years1–10

Year 10

$25 000 (a) (5 328) (a) $19 672 (a) $6 000

(a) Tax depreciation is not a cash flow but the tax benefit is as the depreciation expense reduces taxable profits. The annual depreciation expense = $(96 000 – 6 000)/10 years = $9000 per year Taxes per year = ($25 000 – $9000) * 33.3% = $5328 NPV calculation: NPV = $(96 000) + $19 672 (PVFA 18%, 10 years) + $6000 (PVF 18%, 10 years) NPV = $(96 000) + ($19 672 × 4.494) + ($6000 × 0.191) NPV = $(96 000) + $88 406 + $1146 NPV = ($6 648)

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15.20 NPV and IRR calculations Axel Ltd is planning to buy a new machine with the expectation that this investment should earn a rate of return of at least 15 per cent. This machine, which costs $150 000, would yield an estimated net cash flow of $30 000 a year for 10 years. Required (a) What is the NPV for this proposal? (b) What is the IRR for this proposal? (LO3, LO5) The net present value is $30 000 (5.019) – 150 000 = $570. The internal rate of return is a little higher than 15%. Using Excel, the actual rate is 15.098%.

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15.21 Equipment replacement; NPV; IRR; payback Garfield Construction is considering replacing an old machine that is currently being used. The old machine is fully depreciated, but it can be used for another five years, at which time it would have no terminal value. Garfield can sell the old machine for $60 000 on the date that the new machine is purchased. If the purchase occurs, the new machine will be acquired for a cash payment of $1 million. Because of the increased efficiency of the new machine, estimated annual cash savings of $300 000 would be generated during its useful life of five years. The new machine is not expected to have any terminal value.

Required (a) Garfield requires investments to earn a 12 per cent return. What is the NPV for replacing the old machine with the new machine? (b) What is the IRR to replace the old machine? (c) What is the payback period for the new machine? (LO3, LO5) (a) Initial net investment (1 000 000 – 60 000) Annual savings 300 000 Net present value (b)

Present Value 1.000 3.605

Present Factor $(940 000) 1 081 500 $ 141 500

First calculate the present value factor for an annuity of 5 payments that equates the cash inflows and outflows: $300 000 × F = 940 000 F = 3.13333 A factor of 3.13333 represents an internal rate of return of slightly less than 18%. A spreadsheet could be used to determine the exact answer of 17.913%.

(c)

Assuming the cash flows take place evenly throughout the year: $940 000/$300 000 = 3.13 years

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15.22 NPV, IRR, ARR and payback methods Amaro Hospital, a not-for-profit entity not subject to income taxes, is considering the purchase of new equipment costing $20 000 to achieve cash savings of $5000 per year in operating costs. The estimated useful life is 10 years, with no salvage value. Amaro’s minimum expected return is 14 per cent. Required (a) What is the NPV of this investment? (b) What is the IRR? (c) What is the accrual accounting rate of return based on the initial investment? (d) What is the payback period? (LO3, LO5) (a)

The net present value is ($5000 × 5.216) – 20 000 = $6080

(b)

The factor for the internal rate of return must be 20 000 = $5000*Factor Factor = 4.0 From the PVFA tables for 10 years, it would be just over 20% (PVFA = 4.192) Using Excel’s IRR function, the rate is 21.4%

(c)

Assuming straight-line depreciation, the earnings will be $5000 – $20 000/10 = $3000 The accounting rate of return is $3000/20 000 = 15%

(d)

The payback period is $20 000/$5000 = 4

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15.23 Strategic investment decisions FreshTucker Limited allows divisional managers to make capital investment decisions up to $10 million. However, divisional managers are required to send to head office details of each decision taken, including their justifications. The manager of the hospitality and conference facilities division, Ceila Wang, has been trying to improve this process within her division. At present, department managers within the division are required to provide a detailed NPV analysis of their investment proposals. Because of the nature of her division, Ceila wonders whether the right long-term projects are treated fairly within this decision model. She feels that some of the investment opportunities proposed by department managers are more strategic and a lot of potential projects do not seem to be meeting the positive NPV requirement. Required

(a) Identify reasons why the projects are not meeting a positive NPV requirement. (b) What type of qualitative factors would be relevant to the projects (LO4, LO6)

(a) Projects might not meet the NPV requirement for a number of reasons: • The projects are simply not financial viable given the significant initial outlay, significant ongoing cash outflows and/or poor cash inflows. • • •

The firm’s required rate of return could be too high, making it difficult for projects to meet the requirements. The projects are long-term investments whose major cash flows are not realised until later years. The proposed projects have other benefits (i.e. alignment with corporate strategy, competitive advantage, impact on employees, environmental, brand and reputation) that are not fully captured by NPV analysis.

(b) Examples of relevant qualitative factors could include the:

• • • • • • •

Degree to which the proposed investment aligns with the firm’s current strategic priorities and/or enables them to obtain an advantage over competitors. Impact on service quality. Impact on employees. Impact on the community and other stakeholders. Details of any positive or negative environmental impacts. Impact on the firm’s brand and reputation. Sensitivity of financial projections to changes in assumption estimates.

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15.24 Strategic investment decisions Refer question 15.23 above. Outline how Ceila might improve the investment decision-making model within the hospitality and conference facilities division to cater for strategic investments. (LO4, 6) As part of any revisions to improve the investment decision-making model, Ceila must recognise that NPV-analysis is just one, and not always the best, method of assessing proposed capital investments. This is particularly true in regards to strategically focused capital investments with long-term and uncertain impacts. Some options for Ceila to improve the investment decisionmaking model in her division include: • •

Applying a lower discount rate on strategically orientated investments. Expanding the analysis of non-financial considerations (i.e. use of indices or rankings which compare relevant attributes for the alternatives; ensuring that staff provide a more thorough narrative justification of their proposals and the alignment with the division’s strategic priorities).

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15.25 Relevant cash flows, NPV analysis with taxes and inflation (appendix 14A) Clearwater Bottling Company sells bottled spring water for $12 per case, with variable costs of $7 per case. The company has been selling 200 000 cases per year and expects to continue at that rate unless it accepts a special order from Blue Danube Restaurant. Blue Danube has offered to buy 20 000 cases per year at $9 per case. Clearwater must agree to make the sales for a five-year period. Blue Danube will not take fewer than 20 000 cases, but is willing to take more. Clearwater’s current capacity is 210 000 cases per year. Capacity could be increased to 260 000 per year if new equipment costing $100 000 were purchased. The equipment would have a useful life of five years and no salvage value. Maintenance on the new equipment would increase fixed costs by $20 000 each year. Variable costs per unit would be unchanged. Clearwater has a marginal income tax rate of 25 per cent. Inflation is estimated to be 4 per cent over each of the next five years. The risk-free rate is estimated to be 5 per cent. Clearwater can earn a rate of 12 per cent if it invests in an alternative investment having similar risk. Required (a) Create a timeline showing the relevant cash flows for this problem. (b) Ignoring inflation, using straight-line depreciation over five years and using a 12 per cent discount rate, determine the NPV if 20 000 cases are sold. (c) Ignoring inflation, using straight-line depreciation over five years and using a 12 per cent discount rate, determine the number of cases Blue Danube would need to purchase to bring the NPV to zero. (LO3, LO7, LO8) (a)

Cash Flow Timeline:

Investment Incremental cash flows: Annual Savings Taxes Net cash flow Terminal value

Time 0 $(100 000)

Years1–5

Year 10

$20 000) (a) (0) (b) $20 000) $0

Savings = Additional contribution margin – Increase in fixed costs = ($9 – $7) × 20 000 cases – $20 000 = $20 000 Depreciation = $100 000/5 years = $20 000 per year Incremental Taxes = (Savings – Depreciation) × 25% = ($20 000 – $20 000) × 25% = $0 (b)

The NPV for this part can easily be calculated manually as shown below. The sample spreadsheet shows the NPV to be $(27 904). The difference is due to rounding. NPV = $(100 000) + $20 000 (PVFA 12%, 5 years)

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NPV = $(100 000) + $20 000 × 3.605 NPV = $(27 900) (c)

To determine the amount of sales needed to bring the NPV to zero, first rewrite the incremental cash flows substituting Q for the volume of cases sold.

Cash Flow Timeline:

Investment Incremental cash flows: Annual contribution margin Incremental fixed costs Incremental taxes Net cash flow Terminal value

Time 0 $(100 000)

Years1–5

Year 10

$2Q) (a) (20 000) ($0.5Q – $5 000) (b) $1.5Q – $15 000) $0

Annual contribution margin per case (Q) = ($9 – $7)Q = $2Q Depreciation = $100 000/5 years = $20 000 per year Incremental Taxes = ($2Q – $20 000) * 25% = $0.5Q – $5 000 Next, set the NPV equal to zero and solve for Q: 0 = $(100 000) + ($1.5Q – $15 000) × 3.605 0 = $(100 000) + 5.4075Q – $54 075 5.4075Q = $154 075 Q = 28 493 cases

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15.26 NPV and payback with taxes Equipment with a cost of $60 000 will, if acquired, generate annual savings of $30 000 for six years, at which time it will have no further use or value. The company has a marginal tax rate of 40 per cent and requires a 10 per cent rate of return. It uses straight-line depreciation. Ignore inflation.

Required (a) What is the after-tax cash flow for each year? (b) What is the NPV of this investment? (c) What is the payback period? (LO3, LO7) (a)

Time 0 investment = -$60 000 Years 1–6:

1 Annual saving $18 000 Depreciation 4 000 Total annual after-tax flows$22 000

2 $18 000 4 000 $22 000

Year 3 4 5 6 $18 000 $18 000 $18 000 $18 000 4 000 4 000 4 000 4 000 $22 000 $22 000 $22 000 $22 000

Calculation details: Annual after-tax savings = $30 000 × (1 – 0.40) = $18 000 Straight-line depreciation = $60 000/6 years = $10 000 per year Depreciation tax savings per year = $10 000 × 0.40 = $4000 (b)

NPV calculation: NPV = -$60 000 + $22 000 × (PVFA 10% 6 years) NPV = -$60 000 + $22 000 × 4.355 = $35 810

(c)

To determine the payback period, first summarise the cumulative cash flows from the project: Year 1 2 3

Cumulative Cash Inflows 22 000 44 000 66 000

The original investment is $60 000, which is expected to be paid back between 2 and 3 years. If the cash flows are assumed to occur evenly throughout each year, the payback period is 2.73 years [(2 + (60 000 – 44 000)/22 000)]. Because cash flows are identical across years, the payback can also be calculated as follows: $60 000/$22 000 = 2.73 years.

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15.27 IRR Ferris Industries has $50 000 available to invest in new equipment. Management is considering four different equipment investments, each of which requires $50 000. The expected after-tax cash flow for each project has been estimated as follows:

Required (a)

Rank-order the projects in terms of desirability using the internal rate of return for each project as the criterion. Use Excel or a similar spreadsheet to calculate the IRRs. (b) What other factors should be considered in making the decision of which investment to choose? (LO5)

(a)

Internal rates of return were calculated using the Excel function IRR. The rates of return are: Project IRR 1 15.67% 2 27.32% 3 26.59% 4 28.14% Based solely on the internal rate of return, the projects would be ranked 4, 2, 3 and 1.

(b)

There appear to be considerable differences in risk among the projects. Projects 2 and 3 expect negative incremental operating cash flows during some of the years, and project 4 expects zero incremental operating cash flows during 2 of the 6 years. Projects 2, 3 and 4 show more variation across years than project 1. If there is a high rate of technological change in this industry, management may prefer project 2, which pays back most of the investment quickly.

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15.28 Alternative technologies and capital budgeting with taxes Lymbo Company, must install safety devices throughout its plant or it will lose its insurance coverage. Two alternatives are acceptable to the insurer. The first costs $100 000 to install and $20 000 to maintain annually. The second costs $150 000 to install and $10 000 to maintain annually. Each has a five-year income tax life and a 15-year useful life. Lymbo’s discount rate is 12 per cent, its marginal tax rate is 30 per cent and it uses straight-line depreciation . Required (a) Which system should be installed? Why? (b)

If Lymbo were a not-for-profit organisation that does not pay income taxes on its operations, which system would be installed? (LO4, LO7)

(a)

Based on the NPV of the two alternatives, the company should choose Alternative 2 with a less negative NPV than Alternative 1. Calculations for each alternative are shown below. Cash Flow Timeline for Alternative 1:

Investment Incremental cash flows: Maintenance Cost Taxes Net cash flow

Time 0 $(100 000)

Years 1–5

Years 6–15

$(20 000) 12 000 (a) $ (8 000)

$(20 000) 6 000 (b) $(14 000)

Depreciation = $100 000/5 years = $20 000 per year Incremental taxes deductions during years 1–5 = (Maintenance cost + Depreciation) × 30% = ($20 000 + $20 000) × 30% = $12 000 Incremental taxes deductions during years 6–15 = Maintenance cost × 30% = $20 000 × 30% = $6000 NPV Calculation for Alternative 1: NPV = $(100 000) + [$(8000) × (PVFA 12%, 5 years)] + [$(14 000) × (PVFA 12% 15 years – PVFA 12% 5 years)] NPV = $(100 000) + [$(8000) × 3.605] + [$(14 000) × (6.811 – 3.605] NPV = $(100 000) + $(28 840) + $(44 884) = $(173 724) Following is a different way to perform the same calculations for Alternative 1:

NPV of installation cost NPV of annual maintenance cost $(20 000) × (1–30%) × 6.811 NPV of depreciation tax shield $20 000 × 30% × 3.605 Total NPV

$(100 000) (95 354) 21 630 $(173 724)

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Cash Flow Timeline for Alternative 2:

Investment Incremental cash flows: Maintenance Cost Taxes Net cash flow

Time 0 $(150 000)

Years 1–5

Years 6–15

$(10 000) 12 000 (a) $ 2 000)

$(10 000) 3 000 (b) $ (7 000)

Depreciation = $150 000/5 years = $30 000 per year Incremental taxes deductions during years 1–5 = (Maintenance cost + Depreciation) × 30% = ($10 000 + $30 000) × 30% = $12 000 Incremental taxes deductions during years 6–15 = Maintenance cost × 30% = $10 000 × 30% = $3000 NPV Calculation for Alternative 2: NPV = $(150 000) +[ $2000 × (PVFA 12%, 5 years)] + [$(7000) × (PVFA 12% 15 years – PVFA 12% 5 years)] NPV = $(150 000) + [$2000 × 3.605] + [$(7000) × (6.811 – 3.605)] NPV = $(150 000) + $7210 + $(22 442) = $(165 232) Following is a different way to perform the same calculations for Alternative 2:

NPV of installation cost NPV of annual maintenance cost $(10 000) × (1–30%) × 6.811 NPV of depreciation tax shield $30 000 × 30% × 3.605 Total NPV (b)

$(150 000) (47 677) 32 445) $(165 232)

Following are the NPV calculations without the depreciation tax shield: NPV without income taxes for Alternative 1:

NPV of installation cost NPV of annual maintenance cost $(20 000) × 6.811 Total NPV

$(100 000) (136 220) $(236 220)

NPV without income taxes for Alternative 2:

NPV of installation cost NPV of annual maintenance cost $(10 000) × 6.811 Total NPV

$(150 000) (68 110) $(218 110)

The answer depends on management’s time-frame used in the budget process. If the not-for-profit organisation intends to occupy the building for the next 15 years, alternative 2 is still the best choice. However, management may concern itself only with

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current year outlays (a focus of many governmental units). In that case, alternative 1 might be chosen because its initial cost is $50 000 less than alternative 2. Although this is a common approach, one might question whether it is ‘proper’.

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15.29 Business expansion; NPV, taxes MacArthur’s is a fast food company planning to invest in a restaurant expansion that entails the refurbishment and opening of four new stores across the country. The cost of this investment is $4 800 000. It is to be depreciated (straight-line basis) over a period of 10 years with no residual value. The discount rate is 8 per cent. The company tax rate is 30 per cent. The other relevant cash flow information relating to this project is presented in the following table.

Rather than building the new stores, the MacArthur’s management team have also considered expanding offshore. However, the management accountant is concerned about the riskiness of this business and that not all factors have been included in the calculation. There is difficulty in capturing some qualitative non-financial factors and estimating other longer-term cash flows. Required (a) Calculate the NPV for the proposed investment. (b) Following on from the calculations in part (a), should MacArthur’s make the investment in the four new stores? (c) What would you advise on preparing for the offshore decision? Discussion should include reference to the financial and non-financial factors that may influence this decision and suggestions to improve the decision model. (LO3, LO7) (a)

Note the following is calculated in Excel. Year 1 2 3 4 5 6 7 8 9 10

Net after-tax cash inflow $843 580* $1 263 580 $1 823 580 $2 943 580 $3 503 580 $4 343 580 $3 783 580 $3 503 580 $1 823 580 $703 580

Discounted cash flows $781 093** $1 083 316 $1 447 617 $2 163 619 $2 384 478 $2 737 192 $2 207 683 $1 892 875 $912 244 $325 894 $15 936 010 $11 136 010

Total NPV (DCF – Initial Outlay) * 999,400 – (999,400- 480,000)*.30 ** -PV(0.08,1,,843,580) as calculated in excel. Note, if table used there will be rounding errors

(b)

Given the NPV is positive, it would be expected that MacArthur’s should invest in the four new stores. Based on the numbers, the investment should return $11 136 010 to the organisation over the life of the project. However, students should © John Wiley and Sons Australia, Ltd 2020

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mention that this depends on the quality of the input data that goes into calculating the NPV. There might be alternative options that generate higher NPV or there might be qualitative information that would help make the decision. For example, the moving baseline concept suggests that current profitability might not continue if they do not invest and their competitor does. (c)

When considering more strategic investments, such as whether to expand offshore or not, other considerations need to be made. For example, financial analysis would be conducted (NPV; IRR, payback) along with other qualitative factors, as indicated in part (b). Other information such as the riskiness of the project might be considered. This could mean a higher discount rate associated with the perceived riskiness, or it could remain outside the NPV calculation with risk considered in qualitative ways that may or may not be quantified or ranked in order of importance: •

strategic risk o does the investment link to the corporate strategy at MacArthur’s • reputation risk o if investors consider the move a bad management decision o linked to the quality of the proposal and the credibility of the project champion o are there any environmental and/or social impacts associated with the decision • foreign exchange risk o how stable is the currency and the country where investment is going o what is the transaction complexity and velocity • regulatory risk o likelihood of government changing rules • operational risk o are there qualified people to manage the new business (with strategic capabilities). MacArthur’s management might decide to provide weightings to each of the factors to ensure some of the qualitative factors have a voice in the decision making process. For example, the financial outcomes might be weighted at 60% and the non-financial indicators at 40%, or vice versa.

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35 15.30 Business expansion; NPV, taxes 36 Diggers is a coal mining company. Diggers has planned to invest in replacement equipment. Its existing equipment has come to the end of its useful life and will be scrapped with no resale value. The cost of the new replacement investment is $2 500 000. It is to be depreciated (straight-line basis) over a period of 10 years with no residual value. The discount rate is 8 per cent. The company tax rate is 30 per cent. The other relevant cash flow information relating to this project is presented in the following table. 37 38 39 The management team have also considered moving to clean coal technology to help improve the image of the company around issues of sustainability and stakeholders’ environmental concerns. While the net present value (NPV) of the alternative clean coal technology option has been calculated as $2 million, the management accountant is concerned that not all factors have been included in the calculation. There is difficulty in capturing some qualitative non-financial factors and estimating other longer-term cash flows. 40 41 Required 42 (a) Calculate the NPV for the proposed investment. 43 (b) In your opinion, which investment should the coal mining company make (replacement or clean coal technology)? Discussion should include reference to the financial and nonfinancial factors that may influence this decision and suggestions to improve the decision model. 44 (LO2, LO3, LO4, LO7)

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(a) Year 1 2 3 4 5 6 7 8 9 10

Net after-tax cash inflow $425 000* $635 000 $915 000 $1 475 000 $1 755 000 $2 175 000 $1 895 000 $1 755 000 $915 000 $355 000

Discounted cash flows $393 519** $544 410 $726 357 $1 084 169 $1 194 424 $1 370 619 $1 105 714 $948 172 $457 728 $164 434 $7 989 544 $5 489 544

Total NPV (DCF – Initial Outlay) * 500,000 – (500,000- 250,000)*.30 ** -PV(0.08,1,,425,000) as calculated in excel. Note, if table used there will be rounding errors

(b)

Given the NPV of the replacement equipment is $3 489 544 higher than the clean coal technology, students might suggest that the replacement equipment option should be taken as the NPV is higher. However, the management accountant is correct to raise issues associated with other factors not being considered in the NPV. This would be classified as a strategic investment and other factors would need to be considered along with the NPV. For example, if competitors purchase the clean coal technology, the cash flows that have been calculated for the replacement equipment might not eventuate. Note that the management accountant might have factored the potential competitor impact, when calculating the NPV of the replacement equipment as peak cash flows occur at Year 6. That is, if customers prefer the clean coal option, they might take their business elsewhere and expected cash flows will be negatively impacted. It might come earlier than Year 6, depending on the competitor activity (as well as the life cycle of coal and the availability of other substitute products, such as solar or wind power). Other factors should be considered, such as quality/reliability of the input data and the credibility of the manager proposing the investment. Similarly, Diggers’ sustainability reputation might be enhanced/damaged if they decide to invest/not invest in the clean coal technology — but the impact on income is difficult to quantify. In addition, if the outlay is much greater than the replacement equipment and benefits come later in the life of the project, then NPV methodology will penalise strategic investments.

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Problems

15.31 Real interest rates; uncertainties; effects of time Managers often use the real interest rate to help them decide whether to take on a new project. Required (a) What two factors are included in the real interest rate? (b) What economic factors could affect the two aspects you identified in part (a)? List as many factors as you can. (c) Discuss how certain you can be that interest rates will remain constant over the life of a project. (d) Does the time length of a project affect your answer to part (c)? Why? (LO8) (a)

The real rate includes both a risk free rate and a risk premium.

(b)

The risk free rate is affected by decisions by the Federal Reserve about the prime rate, and economic growth rates. The level of uncertainty and potential volatility of the cash flows for the project affect the risk premium.

(c)

Interest rates vary a great deal across time. They are affected by government policy, inflation, stock market returns, and many other factors that are difficult to predict.

(d)

Yes, the length of the project can make a difference in the certainty of the chosen rate. Interest and inflation rates usually trend across time; they move slowly up or down. If the project has a short life (3–5 years) and rates are currently low (or high), managers would expect them to rise (or decrease), but slowly. The choice of discount rate is less certain for projects with long lives (15–20 years or more). Interest and inflation rates could vary a great deal over this length of time, and predicting the average rate for the entire time period involves more uncertainty.

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15.32 IRR; developing a discount rate; evaluating risk The local homeless shelter received a large donation from a wealthy benefactor and asked you to review its decision-making process for the proposed investment choice. The shelter’s financial advisor suggested using the IRR to evaluate three different projects: • a hotel that offers rooms based on the renter’s ability to pay • an apartment complex for elderly who receive rent subsidisation from a federal government agency • a small cardboard box manufacturing entity that will serve as a job training facility for homeless clients Required (a) In your own words, describe the advantages and disadvantages of IRR for this decision. (b) This not-for-profit entity uses an IRR hurdle rate of 15 per cent for most projects. Is it a good idea for an organisation to use the same hurdle rate for most projects? Why? (c) List information that might help you develop a hurdle rate for each project. (d) Which alternative do you believe is most financially risky for the homeless shelter? Explain your thinking. (LO5, LO6) Notes about problem complexity: Part C will be quite difficult for most students. (a)

Advantages of IRR • It is easy to explain • It can be calculated using a spreadsheet Disadvantages • Without spreadsheets, it is time consuming to calculate • It does not take into consideration the relative size of projects • It does not give information about the dollar value of the investment

(b)

The discount rate should be different for every project because the risk of every project is different. Part of the discount rate is the risk premium, and that should be higher for projects that are riskier.

(c)

For discount rates, the following information would be helpful: current and historical inflation rates and treasury bond rates. In addition, historical financial information about the three alternative projects or similar projects in similar would be important to develop the risk premium. Information about demand for rooms, apartments, and boxes would be needed. Information about the availability of management and employees for the three alternatives would be useful.

(d)

The answer to this question depends in part upon the assumptions made about the current operations of the homeless shelter. If the shelter’s current operations are similar to an apartment complex, the second alternative is probably least risky because of the rent subsidisation, the first alternative next most risky, and the manufacturing operation most risky. Information about demand and employee stability is likely to be more uncertain than information about occupancy rates, etc. However, if the homeless shelter is just a large space with

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cots for homeless people, the managers’ experience may be irrelevant when considering risk. The amount of financial risk also depends on the size of investment. The managers need to consider potential problems that could affect financial outcomes. A hotel that offers rooms based on ability to pay could attract people who are using the hotel for illegal activities and require a great deal of monitoring. Alternatively, the manufacturing operation requires managers who are trained to work with homeless people and skilled at managing manufacturing operations. To better understand the financial risks for the three different types of operations, the managers may want to find similar businesses in the local area and examine their revenues and expenses across time. Managers of not-for-profit organisations are often willing to share information with each other.

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15.33 Timeline; maximum payment for zero NPV; qualitative factors; uncertainties The Mavericks are a professional football team with a long tradition of winning. However, over the last three years the team has not won a major championship, and attendance at games has dropped considerably. A large football manufacturer is the team’s major corporate sponsor. Cliff Walker, president of the football company, is also the president of the Mavericks. Cliff proposes that the team purchase the services of a star player, Jackson Howard. Jackson would create great excitement for Maverick fans and sponsors.

Jackson’s agent notifies Cliff that terms for the superstar’s signing with the Mavericks are a signing bonus of $8 million payable now and a house in a Sydney beachside suburb at a cost of $5 million. The annual salary and cost of living adjustments are under negotiation. Cliff’s initial reaction is one of shock. However, he decides to examine the cash inflows expected if Jackson is signed for a four-year contract. Net gate receipts would most likely increase by $2 million a year, corporate sponsorships would increase $2.5 million per year, television royalties would increase $0.5 million per year, and merchandise income (net of costs) would increase $1 million per year. Cliff believes that a 12 per cent discount rate is appropriate for this investment. The Mavericks marginal tax rate is 20 per cent. The signing bonus can be amortised (depreciated) over the four-year period for income tax purposes, providing an annual tax deduction of $2 million. Required (a) Create a time line showing the relevant cash flows for this problem. (b) Assuming that he is not willing to lose money on the contract, what is the maximum amount per year that Cliff would be willing to pay Jackson? You will need to set up a spreadsheet for this calculation and through trial and error find an amount that brings the NPV to zero, or use an algebraic approach and annuity factors. (c) Identify possible additional factors that Cliff should consider when deciding whether to sign Jackson to the four-year contract. List as many factors as you can. (d) For each of the relevant cash flows in this problem, discuss why Cliff cannot be certain about the dollar amount of the cash flow. (LO3, LO4, LO7) (a)

Following is the time line incorporating the algebraic approach to the solution. Notice that S is used for salary because the problem gives no information about its value. Nor does the problem provide information about the tax consequences of buying the house. Following are two solutions using two different assumptions. The first solution assumes no tax consequences for the $5 million house. The second solution assumes that the house could be amortised as a business expense over 4 years (the length of the contract). Solution #1: Cash Flow Timeline

Investment Incremental cash flows:

Time 0 $(13 000 000)

Years1–4

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Incremental revenues Incremental salary Incremental taxes Net cash flow

$6 000 000 (a) (S) $(800 000) + 0.20S (b) $5 200 000 – 0.80S

Incremental revenues = $2 million + $2.5 million + $0.5 million + $1 million = $6 million Amortisation = $2 000 000 per year Incremental Taxes = ($6 000 000 – $2 000 000 – S) × 20% = $(800 000) + 0.20S Solution #2: Cash Flow Timeline

Investment Incremental cash flows: Incremental revenues Incremental salary Incremental taxes Net cash flow

Time 0 $(13 000 000)

Years1–4

$6 000 000 (a) (S) $(550 000) + 0.20S (b) $5 450 000 – 0.80S

Incremental revenues = $2 million + $2.5 million + $0.5 million + $1 million = $6 million Amortisation = $2 000 000 per year + $5 000 000/4 = $3 250 000 Incremental Taxes = ($6 000 000 – $3 250 000 – S) × 20% = $(550 000) + 0.20S (b)

The maximum salary is the salary that will bring the NPV to zero. Solve this problem algebraically by setting NPV equal to zero and solving for S: Solution #1: 0 = $(13 000 000) +[ (PVFA 4 years, 12%) × ($5 200 000 – 0.8S)] 0 = $(13 000 000) + [3.037 × ($5 200 000 – 0.8S)] $2 792 400 = 2.4296S S = $1 149 325 Based on these calculations, Cliff could afford to pay up to $1 149 325 in salary annually. Solution #2: 0 = $(13 000 000) + [(PVFA 4 years, 12%) × ($5 450 000 – 0.8S)] 0 = $(13 000 000) + [3.037 × ($5 450 000 – 0.8S)] $3 551 650 = 2.4296S S = $1 461 825 Based on these calculations, Cliff could afford to pay up to $1 461 825 in salary annually.

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(c)

Here are factors that could affect Cliff’s willingness to sign Bob; students will probably think of others: • Are there other competing sports in the area that are played at the same time,

for example college team sports?

• Does Bob have a dubious reputation that could lead to behaviour that would turn fans against him and the team? • Will other team mates resent having a highly paid team member when their salaries may not be nearly as high? • If the team does not have a winning season, even after Bob has been signed, will attendance fall off?

(d)

The signing bonus and the cost of housing for Bob would be certain once the contract is signed. However, there is uncertainty about the incremental revenue cash flows. For example, Cliff cannot know whether fans will react to Bob in the way these estimates predict. It is possible that bad publicity could arise about Bob’s behaviour, which could change the expected increases in revenues. Fans can be unpredictable, and this could change the revenues greatly. Bob could become injured, and fan support would decrease. It is possible that a competing sport will reduce the amount of expected revenues. There is also uncertainty about the income tax cash flows. Income tax regulations could change, altering the tax rate or the deductibility of costs.

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15.34 Qualitative factors in investment decisions Energy plays an important role in improving people’s lifestyles. In Australia, our energy consumption is growing and is forecasted to increase by 50 per cent over the next 15 years. The available power resources in Australia (currently 80 per cent coal-fuelled) will not cope with the increasing demands. Further investment opportunities are required for long-term power supply, and options are currently being investigated by governments. Due to Australia’s high greenhouse gas emissions from the current coal-fi red power plants, nuclear energy has been advocated as the optimal ‘clean’ power alternative. In 2008–09, Australia exported around 10 000 tonnes of uranium (enough to supply more than twice its annual electricity needs) but has not yet used uranium to fuel its own energy industry. Furthermore, greenhouse gases could be reduced by one fifth, and electricity could be supplied to a third of the country. Nevertheless, the decision to invest in nuclear power is deemed politically sensitive and requires adopting world’s best practice to prevent unsafe reactor designs and minimise environmental risks. An Australian study found that accurate capital budgeting and subsequent cost control is a major factor in determining the successful provision of environmentally clean and cheap electricity in Australia. The report detailed the history of costing issues faced by nuclear power plant investors around the world. The most significant implementation problems relate to design flaws and licensing delays (for example, the Shoreham plant in Long Island, New York State, cost $5 billion to build and was never allowed to operate). Subsequent operational costing issues highlighted in the report were as a result of inadequate operator training and non-uniform designs that prevented the achievement of economies of scale in output volume. The study provided a breakdown of the history of costs relating to nuclear power plant employment. In general, the costs consist of the: • construction costs of building a plant with 1 GW capacity (approximately $1000 per kW) • operating costs of running the plant and generating energy (approximately 1.3 cents per kW-hour) • cost of waste disposal from the plant (approximately 0.2 cents per kW-hour) • cost of decommissioning the plant (approximately 10 per cent of construction costs). According to the report, construction costs are difficult to quantify but estimates provided have been based on worldwide examples. Construction timeframes were estimated to be around three years to completion and commencement of operations. Part of the operating cost estimates includes the raw material (uranium ore) costs, which are approximately 0.05 cents per kW-hour. The costs provided were based on a 40-year plant lifetime with discount interest rates of around 5 per cent. If the proposed capital budgeting scenario lives up to its promises, the study concludes that nuclear power will provide cheaper electricity than any other fossil-fuel-based generating facility in Australia. While the investment analysis might suggest nuclear power is a financially worthwhile investment for Australia, it is important to note that the final decision to invest in a project such as this one will depend on many other qualitative factors, including stakeholder acceptance.2

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Required (a) Identify the key qualitative factors that would need to be considered in any investment decision relating to nuclear power. (b) How might these qualitative factors be incorporated into a decision model. (LO1, LO4, LO6) (a)

Detailed risk assessment that would include the following: • Stakeholder reaction given the political sensitive nature of such an investment • The ability to meet zero emissions targets • The knowledge, skills and capabilities of personnel who will be managing and operating the plant • The impacts on society and employment if this form of power is favoured to the dirty coal-fired power stations • The environmental impacts of locating and building the plant • The ability to derive and manage the life cycle costs associated with the nuclear power industry

(b) • • •

Use of qualitative factors in cost–benefit analysis Use of ratings and indices to quantify the qualitative factors. Be considered alongside the more formal quantitative analysis

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15.35 Capital budgeting methods; sensitivity analysis; spreadsheet development; uncertainties Your brother, Jack, was laid off from his job with a large and famous software company. He would like to sell his shares in the company and use the proceeds to start a restaurant. The stock is currently valued at $500 000. He received a job offer from a competitor that will pay $90 000 per year plus benefits. He asked you to help him decide the best course of action. Required (a) What are the alternatives that Jack faces? (b) Choose the most appropriate analysis technique and explain your choice. (c) If your brother chooses to open a restaurant, what are his opportunity costs? (d) List the steps you would take to develop a spreadsheet that your brother could manipulate to help with the quantitative aspects of this decision. Assume that you only have time to set up a template and that your brother will fill in the specific information. However, you need to tell him the general categories of information he will need to gather. (e) List uncertainties about whether taking the job offer would turn out well for your brother. List as many uncertainties as you can. (f) List uncertainties about whether opening a restaurant would turn out well for your brother. List as many uncertainties as you can. (g) Explain why it is possible for your brother to make a good decision even though he cannot know for sure how well his alternatives would work out. (LO6) (a)

The choices are (1) hold the stock and work for $90 000 per year or (2) sell the stock, do not take the job, and start the restaurant. This is a long-term decision.

(b)

Either IRR or NPV methods could be used for this analysis. The decision is a long-term decision and therefore needs to include the time value of money. Both of these methods do that. With the NPV method, inflation rates for different categories of costs could be used, so the results would be more precise. In addition, it may be easier to understand the differences in these two plans in today’s dollars, rather than in rates of returns.

(c)

His opportunity costs are $90 000 plus benefits from the job offer, plus the return on the stock.

(d)

The following categories would be set into an input box: Investment amount, risk free rate, risk premium for the restaurant, risk premium for the stock, inflation rate, tax rates, all of the cash flows from the restaurant (revenues and variable and fixed costs). Once these are in the input box, formulas for calculating the incremental cash flows over time need to be set up, and the real cash flows would need to be inflated and then discounted. If depreciation is relevant for the investment, a MACRS table would need to be added.

(e)

Uncertainties about a new job include lack of information about the people Jack would work with, and also about the nature of the work to be done. The future of

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the company is not guaranteed. Students may have thought of other uncertainties. (f)

Jack faces uncertainties about customer preferences, which will result in uncertainty about revenues. He has not operated a restaurant, so he faces uncertainties about current costs and cost trends over time. He also faces uncertainties about the quality and quantity of employees available to cook, wait tables, and perform other tasks that need to be done.

(g)

Jackson faces many uncertainties, no matter which alternative he chooses. If he performs sensitivity analyses around each alternative and formally incorporates qualitative factors, such as the amount of enjoyment he takes in his current position and his perceptions of this aspect of owning a restaurant, he will be able to make a high quality decision.

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15.36 Choice of method; uncertainties; addressing company policy Paradise Resorts, a Hong Kong company that owns and operates holiday resorts, has hired you to analyse its investment opportunities in Australia. The entity's managers have always used the payback method and have asked you to prepare an analysis comparing three different resorts, one on the Gold Coast; another on the Sunshine Coast; and a third holiday resort in the Northern Territory. Required (a) List four methods that could be used to analyse this long-term decision. Describe each method in your own words. (b) In your own words, describe the advantages and disadvantages of each method you identified in part (a). (c) Explain why it is not possible to perfectly predict a project’s cash flows. (d) In using quantitative results for decision making, would you place equal reliance on the results of all four analysis techniques? Explain. (e) Discuss how the managers of the Hong Kong company might respond to your advice if you recommend an analysis method other than the payback method. (f) Write a brief memo to the CEO of the company, recommending your choice of analysis method and explaining the most important issues for the CEO to consider when choosing an analysis method. (LO1, LO4, LO6) (a)

Net present value (NPV): The sum of today’s and future cash flows discounted to today’s dollars. Internal rate of return (IRR): Discount rate necessary for the present value of the discounted cash flows to be equal to the investment Payback method: Measures the amount of time required to recover the initial investment Accrual accounting rate of return: Expected increase in average annual operating income as a percent of the initial increase in required investment

(b)

Net Present Value (NPV) Pros • Incorporates the time value of money • Calculates the discounted cash flows discounted in today’s dollars • If multiple projects are being considered, it is easier to identify the most profitable projects Cons • Requires estimating cash flows and choosing an appropriate discount rate Internal Rate of Return (IRR) Pros • Intuitively easier to understand for many managers © John Wiley and Sons Australia, Ltd 2020

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• Can be used to compare potential projects to other ones

Cons • Calculationally more difficult, particularly with uneven cash flows • Cannot sum or average IRR for multiple projects • Assumes cash flows can be reinvested at the IRR Payback Method Pros • Focuses on high risk of long payback period • Used extensively, particularly outside of the US Cons • Does not incorporate time value of money • Ignores cash flows received after the investment is recovered Accrual Accounting Rate of Return Pros • Use for division or department performance because data is readily available Cons • Does not incorporate time value of money • Cost of investment is double-counted • Not appropriate for capital budget decisions (c)

Price changes and consumer preferences cannot be easily predicted across time. This type of business is greatly affected by changes in economic conditions. When the economy is strong, people have more money for vacation travel, but it is a discretionary cost that is cut during economic downturns. In addition, consumer preferences change over time, and are affected by competing resort availability. These factors decrease the accuracy of any predictions made.

(d)

The NPV method and NPV profitability index would be the best quantitative methods for this decision. Using these methods inflation rates can be altered to more accurately reflect differences in inflation rates in the three different locations. Further, it is difficult to compare rates of return under the IRR method and the payback and accounting rate of return methods do not incorporate the time value of money.

(e)

The managers may respond unfavourably to methods with which they are unfamiliar. Therefore, it is important to make an educational presentation that simply explains the recommended method and that emphasises its benefits.

(f)

There are many different types of memos that can be written. At a minimum, the memo should briefly describe the pros and cons of their current method (payback) and of a preferred alternative. The memo should be written in nontechnical language that managers can easily understand, and it should also address the managers’ concerns about changing methods.

15.37 Timeline; relevant costs; NPV; payback; uncertainties Irrigation Supply is negotiating with a major hardware chain to supply heavy-duty sprinkler heads at $18 000 each year for five years. Irrigation

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Supply would need to retool at a cost of $20 000 to fill this order. Incremental costs associated with the order (in addition to the retooling costs) would be $12 000 per year. In addition, existing fixed overhead costs would be reallocated among Irrigation Supply’s products, which would result in a $1000 overhead charge against the special order. For income taxes, the retooling costs would be depreciated using the straight-line method with no terminal value, ignoring the half-year convention. Irrigation Supply’s marginal income tax rate is 25 per cent. Assume that all cash flows (except the initial retooling costs) occur at year-end. The company’s discount rate is 16 per cent.

Required (a) Create a time line showing the relevant cash flows for this problem. (b) What is the net present value of the special order? (c) What is the payback period for this project? (d) For this problem, what do you learn from the NPV analysis, and what do you learn from the payback period? (e) The managers of the hardware store (the customers in this problem) believe that demand will ensure their ability to purchase sprinkler heads from Irrigation Supply. Explain why the hardware chain’s managers cannot be certain about the future demand for sprinkler heads. (f) Discuss how uncertainties for the hardware store could lead to uncertainties for Irrigation Supply. (LO3, LO3, LO5) (a)

Cash Flow Timeline:

Investment Incremental cash flows: Operating income Taxes Net cash flow Terminal value

Time 0 $(20 000)

Years1-5

Year 5

$6 000 (a) (500) (b) $5 500 $0

$18 000 – $12 000 Taxes = net savings less depreciation times tax rate = [$6000 – ($20 000/5)] × 25% NPV calculation: NPV = –$20 000 + $5500 × (PVFA 16%, 5 years) NPV = –$20 000 + $5500 × 3.274 NPV = –$1993 (c)

Payback = $20 000/$5500 = 3.64 years

(d)

The results of the NPV analysis indicate that, after 5 years, Irrigation Supply will have lost $1993 in today’s dollars. This means that the investment will not have paid for itself in 5 years. Results from the payback method indicate that the investment will be recovered in 3.33 years. The payback period is shorter than 5 years because the time value of money and income taxes are not taken into consideration. © John Wiley and Sons Australia, Ltd 2020

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(e)

A number of different factors affect prices and demand. If competitors’ prices decrease, the hardware store may not be able to pay the current price. New technology could make the sprinkler heads obsolete. Weather patterns could change and alter demand. Land use could change, altering demand. These are just a few examples, students may think of others.

(f)

If Irrigation Supply relies on the hardware store for a portion of the contribution margin, any changes experienced by the hardware store will have an affect on Irrigation Supply. If the portion is small, the effect will be small, and if it is large, the effect could be quite large.

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15.38 Government infrastructure investment As part of community town planning, an industrial estate was proposed for development on the outskirts of a growing township which was a twohour commute from the Melbourne CBD. The estate required water and sewerage facilities to be provided. At this stage the land featured native vegetation, including a few big old gum trees, an old cave with Indigenous Australian artefacts, an old building near the cave and a local waterhole frequented by native wildlife. As part of the estate development, the following factors were considered by the Council Water Board: 1. financial NPV 2. environmental impacts: • land clearing • discharges to the environment (liquid waste into sewerage drains; carbon dioxide emissions to air; noise pollution) • water requirements 3. social impacts: • Indigenous heritage • European heritage • community acceptance The following two developments were submitted to the Council’s Water Board.

Required (a) What project should be accepted? (b) Discuss the ramifications of each option. (LO4, LO6)

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46 (a)

(b)

While the numbers would indicate Project 2 (as it is $4 000 000 cheaper) the qualitative data suggests Project 1 is the right one to choose. Project 1 would be the favoured decision because of the reduced impact on the environment and society. In reality, if heritage assets (Indigenous and European) are impacted at all, the government would most likely suggest this is not negotiable and would not let this proposal be tabled. This question is designed to generate debate and highlight to students that calculations alone decide a project. In government infrastructure proposals comprehensive cost–benefit analysis is undertaken which takes into account, a number of other factors discussed in part (b). Decisions should be based on how well students argue their position and should be more a conversation started to talk about issues associated with NPV. This is a conversation question to draw out the student’s ability to rationalise with qualitative data. Discuss with the students the potential for quantifying the environmental and social impacts. Could they put dollar values on the other aspects? For example, what is the price for community willingness to pay for Project 1 versus Project 2? Would there be demonstrations, damaged reputations if Project 2 was accepted? This type of project would require extensive community consultation and costing of ways to mitigate damages. Offset costs might need to be paid if vegetation was removed. Some of these non-cash flow factors can be considered in cost– benefit analysis, where social and environmental impacts (positive and negative) are quantified to enable better comparison with the NPV and the traditionally accepted cash flows associated with the project.

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15.39 NPV with and without inflation; tax effects (appendix 14A) Xi Phan, CEO of the Fine Furniture Supply Group, is considering an investment to upgrade his current computer-aided design equipment. The new equipment would cost $110 000, have a five-year useful life, and have a zero terminal value. The new equipment would generate annual cash operating savings of $36 000. The company’s required rate of return is 18 per cent per year. Required (a) Calculate the NPV of the project. Assume a 25 per cent marginal tax rate and straight-line depreciation, ignoring the half-year convention. (b) Phan is wondering whether the method in part (a) provides a correct analysis of the effects of inflation. The 18 per cent required rate of return incorporates an element attributable to anticipated inflation. For purposes of his analysis, Phan assumes that the existing rate of inflation, 5 per cent annually, will persist over the next five years. Recalculate the NPV adjusting the cash flows as appropriate, for the 5 per cent inflation rate. (c) Compare the quantitative results for parts (a) and (b). In general, how does inflation affect capital budgeting quantitative results? (d) Explain why managers cannot predict future inflation rates with total accuracy. (e) In your own words, explain how failure to consider the effects of inflation might bias managers’ capital budgeting decisions. (LO7, LO8) (a)

Data for this problem is summarised as follows: Investment Annual annuity

$110 000 $36 000

Period

5 years

Discount rate Terminal value Annual depreciation Tax rate Taxes After tax CF

18% $0 $22 000 25% $3500 $32 500

NPV calculation: PV of CF ($32 500 × 3.127 – PVFA 5 yrs, 18%) $101 626 Investment NPV

$(110 000) $ (8 374)

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(b) Inflation rate Nominal rate Income tax rate Initial investment Terminal cash flow Incremental operating cash flow

$ $ $

5% 18.0% 25% 110,000 36,000

Period Incremental Operating Cash Flow s

1 $36,000

2 $36,000

3 $36,000

4 $36,000

5 $36,000

Inflated Less taxes

$37,800 -$9,450

$39,690 -$9,923

$41,675 -$10,419

$43,758 -$10,940

$45,946 -$11,487

Terminal Cash Flow (inflated) Income Taxes on Gain Total Relevant Cash Flow Calculation of depreciation tax shield MACRS Rate (5-year) Depreciation Deduction (nominal) Tax savings

Present value of annual cash flow s Incremental cash flow s Tax savings from depreciation Total

28,350

20.00% 22,000 $ $5,500

32.00% 35,200 $ $8,800

28,350 $5,500 33,850

29,768 $8,800 38,568

$ $

Present value Sum of annual cash flow s Less initial investment Net present value

$28,686 $ $ $

29,768

$ $

$27,699

$ $

31,256

32,819

34,460

19.20% 21,120 $ $5,280

11.52% 12,672 $ $3,168

11.52% 12,672 $3,168

31,256 $5,280 36,536

32,819 $3,168 35,987

34,460 $3,168 37,628

$22,237

$ $

$18,562

113,631 110,000 3,631

(c)

When the cash flows are inflated, the discount rate and cash flows are valued consistently in nominal terms. Therefore incorporating inflation increases the accuracy of the analysis. Using a nominal discount rate with real cash flows underestimated the cash flows and understated the net present value.

(d)

Inflation rates change over time. Although they have been quite low over a number of years, if petrol or labour costs inflate, general inflation will increase. If cash flows from developing countries are being valued, inflation rates could be quite high and quite volatile, and become difficult to predict.

(e)

If managers are using a nominal discount rate and real cash flows, they will consistently reject projects that could have a positive NPV under the nominal method.

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15.40 NPV with taxes and inflation, uncertainties, sensitivity analyses and interpretation (appendix14A) Kelly Black is manager of the customer service division of a retail calculator store, Quik Computers. Kelly would like to buy computer diagnostic equipment that costs $10 000. The equipment will last five years. Kelly estimates that the incremental operating cash savings from using the equipment will be $3000 annually, measured at current prices. For income tax purposes, she will depreciate the equipment using the straight-line method ignoring the half-year convention. Kelly requires a 10 per cent real rate of return. The annual inflation rate is 5 per cent and the marginal income tax rate is 30 per cent. Required (a) Create a spreadsheet schedule showing the NPV calculations for the equipment. (b) Identify factors in your calculations that are uncertain, and explain why. (c) Explain how changes in technology might influence the risk involved in Real rate of return 10% this project. Inflation(d) rate Decide which of the factors 5% you identified Nominal ratewould = 15.50% indiscount part (b) likely have Income tax rate 30% a significant impact on the NPV calculation. Use your spreadsheet to Initial investment $10,000 Straight-line depreciation life of these factors, 5 performing sensitivity analyses. vary each Incremental operating cash flow (e) Use the quantitative$3,000 results and your judgement to interpret your Real rate of return 10% factors seem to have the largest and Inflation rate sensitivity analyses. Which 5% Income 30% results? Period tax ratesmallest effects on the NPV 1 2 3 4 Initial investment $10,000 Incremental Operating Cash Flows: (f) depreciation Describe the pros and cons of investing in the equipment. Straight-line life Flows: 5 Incremental Operating Cash 3,000 3,000 3,000 3,000 (g) Suppose you are the cost accountant for Quik Use the Incremental $3,000 Less Incomeoperating Taxes cash flow (900) (900) Computers. (900) (900) Net incremental operating cash $2,100 $2,100 information youflows learned from the preceding analyses$2,100 to write a$2,100 memo to Kelly with your recommendation about whether to accept or reject Period 1 2 3 4 Nominal incremental operating cash flows $2,205 $2,315 $2,431 $2,553 this project. Refer in your memo to one or more attachments of Incremental Operating Cash Flows: Incremental Operating Cash Flows: $3,000 $3,000 $3,000 spreadsheet schedules that would be useful to Kelly. In your $3,000 memo, Less Incomeof Taxes (900) (900) (900) (900) Calculation depreciation tax shield address the most important factors that Kelly should consider in Net incremental operating cash flows $2,100 $2,100 $2,100 $2,100 Depreciation Deduction (nominal) $2,000 $2,000 $2,000 $2,000 the decision. Nominal tax making savings $600 $600 $600 $600 (LO6, LO7, LO8) Calculation of depreciation tax shield Depreciation Deduction (nominal) $2,000 $2,000 $2,000 $2,000 Present value of annual cash flows (a) The problem does not specify whether$1,905 the nominal or real $1,728 method should be Depreciation deduction (real) $1,814 $1,645 Incremental cash flows $2,205 $2,315 $2,431 $2,553 used. Because only a single inflation rate applies to all cash flows, Real tax savings $571 $544 $518 $494 Tax savings from depreciation 600 600 600 the NPV 600 is Totalidentical incrementalunder cash flows $2,805 $3,031 spreadsheet $3,153 both methods. Below are excerpts$2,915 from a sample

for each method.

Present value of annual cash flows Present value Incremental cash flows Nominal Method Tax from depreciation Sumsavings of PV of annual cash flows Total incremental cash flows Less initial investment Net present value Present value

Real Sum ofmethod PV of annual cash flows Less initial investment Net present value

(b)

$9,948 ($10,000) ($52)

5 3,000 (900) $2,100

5 $2,680 $3,000 (900) $2,100 $2,000 $600

$2,000 $1,567 $2,680 $470 600 $3,280

$2,429 $2,100 571 $2,671

$2,185 $2,100 544 $2,644

$1,967 $2,100 518 $2,618

$1,771 $2,100 494 $2,594

$1,596 $2,100 470 $2,570

$2,429

$2,185

$1,967

$1,771

$1,596

$9,948 ($10,000) ($52)

Any assumptions are uncertain. These include all of the variables in the analysis. They are all uncertain because they are all affected by changes in the economy, changes in consumer patterns, and changes in technology, among others.

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(c)

Technology changes could reduce the effectiveness of the diagnostic equipment over time. If there are rapid and unexpected changes in technology, the equipment could become obsolete relatively quickly. People will have older calculators that need work, but the service division may not be able to use the equipment on newer machines, and have to buy new equipment sooner than expected. This would lead to decreases in revenues prior to purchase of new equipment and increases in costs over time when newer equipment is purchased.

(d)

All of the variables in the input section can be varied. Students should use their judgement to determine the factors that are most likely to change rapidly, and the amounts by which they will change.

(e)

The answer will vary depending on the factors and range of values used. The purpose of this question is to encourage students to learn more about NPV and sensitivity analysis by exploring how fluctuations in different factors affect NPV results. Students may have difficulty deciding (1) which factors are likely to have a significant effect, and (2) how much to modify each factor in their sensitivity analyses. Students should use reasonable judgement in making these decisions and explain their reasoning.

(f)

Student answers to this question will vary. However, here are some examples of pros and cons. Pros • The diagnostic system may improve service quality, increasing customer satisfaction. • It may reduce the amount of time that machines are in the shop. Cons • Kelly does not know for certain whether the diagnostic machine will reduce costs as much as anticipated. • The equipment could break down more often than expected. • Employees may need special training and, if employee turnover is high, this could be a problem.

(g)

There is no one answer to this part. Ask students to present their recommendations and use this as a basis for class discussion.

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15.41 NPV with taxes and inflation, qualitative factors, sensitivity analysis 14A)

(appendix

Wildcat Welders manufactures new and repairs old irrigation sprinkler systems in Western Australia. The entity has been plagued with industrial accidents involving its old welding technology. A new (safer) welding robot has been developed that will reduce labour costs, worker's compensation costs, and direct materials costs. The investment would be $10 million. The annual cash savings would be $7 million, but it would cost $2 million a year to operate the machine. The robots have an eight-year useful life with a terminal value of $1 million. The robots qualify for a government depreciation schedule which allows for faster depreciation of some capital assets. The schedule is as follows:

Inflation is estimated to be 5 per cent per year. The risk-free rate is estimated to be 4 per cent, and the entity’s managers require a minimum risk premium of 6 per cent. Wildcat’s marginal income tax rate is 25 per cent. Required (a) Develop a spreadsheet to calculate the NPV of this project, using the nominal rate method. Be sure to include a data input box at the top of the spreadsheet to allow for sensitivity analysis. (b) Identify a qualitative factor that could potentially override a negative NPV in making the decision to buy this equipment. Explain. (c) Alter the risk premium to perform sensitivity analyses, and answer the following questions: (i) Explain how you decided which values of the risk premium were reasonable to investigate. (ii) Describe how changing the risk premium affects the NPV for this project. (iii) The new equipment would most likely lower Wildcat’s risk of future lawsuits because of the reduced accident rate. Explain how this factor affects your assessment of the appropriateness of the risk premium. (d) Because Wildcat is uncertain about whether the annual cash savings from the equipment would be $7 million, alter the cash savings to perform sensitivity analyses and answer the following questions: (i) Explain how you decided which values of the cash savings were reasonable to investigate. (ii) Describe how changing the cash savings affects the net present value for this project. (iii) Identify the level of cash savings that results in a NPV of zero. (e) Suppose that current inflation is 2 per cent. Given this information, how reasonable is the inflation rate used by Wildcat? Perform sensitivity analysis around the inflation rate by changing the rate and

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Incremental operating cash flow

5,000,000

Period Incremental Operating Cash Flows Less Income Taxes Total Relevant Cash Flow

1 2 3 4 5 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 (1,250,000) (1,250,000) (1,250,000) (1,250,000) (1,250,000) $ 3,750,000 $ 3,750,000 $ 3,750,000 $ 3,750,000 $ 3,750,000

7 $5,000,000 (1,250,000) $3,750,000

8 $5,000,000 (1,250,000) $3,750,000

Calculation of depreciation tax shield MACRS Rate (7-year) Depreciation Deduction (nominal) Tax savings

14.29% 24.49% 17.49% 12.49% 8.93% 8.92% 8.93% $ 1,429,000 $ 2,449,000 $ 1,749,000 $ 1,249,000 $ 893,000 $ 892,000 $ 893,000 $357,250 $612,250 $437,250 $312,250 $223,250 $223,000 $223,250

4.46% 446,000.00 $111,500

Tax savings from depreciation Total

357,250 $ 4,107,250

111,500 $ 3,861,500

Contemporary Management Accounting Solution Manual

6 $5,000,000 (1,250,000) $3,750,000

observing the effects of the change on NPV. Explain how you made your choices. Present value of annual cash flows (LO6, Incremental cash flows LO7) $ 3,750,000 $ 3,750,000 $ 3,750,000 $ 3,750,000 $ 3,750,000 $ 3,750,000 $ 3,750,000 $ 3,750,000

(a)

612,250 $ 4,362,250

437,250 $ 4,187,250

312,250 $ 4,062,250

223,250 $ 3,973,250

223,000 $ 3,973,000

223,250 $ 3,973,250

Below is an excerpt from a sample spreadsheet showing calculations under the Present value $3,556,061 $3,269,991 $2,717,584 $2,282,647 $1,933,018 $1,673,504 $1,449,012 nominal method. The NPV for the project is $8 101 087. Sum of annual cash flows Less initial investment Net present value

$ $ $

18,101,087 10,000,000 8,101,087

(b)

Worker safety could easily override a negative NPV value. In addition, sometimes insurance companies will no longer insure individuals or businesses if they do not manage their risk of liability claims well. For example, homeowners insurance is cancelled for people who own certain breeds of dogs that are known to bite people after the first claim.

(c)

(i)

Students will have a number of different responses to this question. However, their logic should include the fact that this is replacement of equipment, which tends to be less risky than offering new products or services because the company has experience with the original equipment.

(ii)

As the risk premium increases, the discount rate also increases. As the discount rate increases, the NPV values decrease. So an increase in the discount rate decreases the NPV.

(iii)

Because the new equipment lowers Wildcat’s risk of future cash outflows from liability suits, it decreases their risk and therefore the risk premium should be lower.

(i)

Students will have various responses, but they should consider potential changes in labour cost that would tend to increase, and insurance, which might tend to decrease if Wildcat’s safety record improves.

(ii)

If cash savings increase, NPV should also increase, and vice versa.

(iii)

This can be determined from the spreadsheet by reducing the incremental operating cash flow in the input box. Through trial and error, it can be determined that NPV is nearly zero when annual cash flows are $2 553 195.

(d)

(e)

If current inflation is 2% and the inflation in the analysis is 5%, the inflation rate may be too high if current trends persist. However, when inflation or risk free rates are unusually low, these rates will be expected to increase over time. The choice, then, is a matter of judgement. Students will have a variety of answers, but should consider current information about inflation trends.

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15.42 Strategic investment decisions The Nutrition Division of Regal Foods focuses on health-related products. Historically, the Nutrition Division has been an excellent contributor to group performance, with annual growth rates of up to 12 per cent for the period 2006 to 2012, and revenues exceeding $2 billion. However, divisional manager Bruce Buncle has found growth increasingly difficult to maintain. An increasingly crowded market for health and nutritional products seems to be the main driver of these difficulties. As a consequence, debt levels of the division seem to be rising. However, Buncle is conscious that he needs to develop new products and markets in line with company objectives. Regal currently uses a common capital investment evaluation process for all investment projects in excess of $10 million. A summary of key criteria includes the following. • Projects must generate a positive NPV over the life of the project. • A minimum annual return on investment (ROI) of 10 per cent must be achievable within two years of the project commencing. • Project proposals must be presented in standard format with supporting calculations. Buncle cites the following example to illustrate his frustrations with the current process. Buncle and his management team have been considering a range of investment opportunities and have been contemplating a major investment in the bottled water industry. While the industry has its challenges (for example, environmental opposition to the use of plastic bottles, tightening environmental regulations and the expectation of reduced carbon emissions), Buncle and his management team see a lot of potential with such a strategic move. However, where significant capital expenditure is required, Buncle finds the company investment decision-making processes frustrating. The management team within the Nutrition Division has identified a new spring water source in a regional area — Hepburn Shire. The division plans to build a new water bottling plant to take advantage of the springs. The local authorities are happy to support the project. In fact, the local authorities are willing to forgo local taxes and provide subsidies to ensure the plant is built. The region has experienced relatively high levels of unemployment in recent years and the new plant will generate some 100 local new jobs. While there is some local opposition to the new facility on environmental grounds, Buncle considers these to be manageable. While he knows the project’s financial benefit looks not all that favourable, he believes the investment is a good strategic move for his division (particularly with the synergies expected with other parts of the division) and aligns with the company’s growth strategy. A summary of the project’s details is provided in the table. Buncle has raised his frustrations with senior management, arguing that projects such as his bottled water project are never going to meet the strict and somewhat narrow criteria currently used by Regal. He has been asked to come up with an alternative model for evaluating these types of

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strategic investments. He hopes to use the bottled water project to demonstrate his suggested model. Buncle has come to you for some advice on the development of a new model. Required (a) Outline the key components of your proposed model for evaluating strategic investments at Regal Foods. (b) Use the bottled water project of the Nutrition Division to illustrate the benefits of your model. On the basis of your analysis, would you recommend the investment be undertaken? (LO6) (a) The nature of this model may well vary, but we would expect to see some combination of financial and non-financial factors. The model needs to be suitable across the whole company (not just for the Nutrition Division’s bottled water project). A likely model might be: NPV + index of non-financial factors, where the non-financial factors are: Component

Calculation

Weighting in the nonfinancial component of model

Likert scale 1 to 5

25%

Likert scale 1–5

25%

Likert scale 1–5

25%

Likert scale 1–5

25%

Non-financial: 1. Alignment with divisional and organisational strategy 2. Moving baseline: risk of not investing 3. Project uniqueness and market leadership 4. Sustainability impacts

How this model might actually work is reasonably subjective. The overriding issue here is that a number of other factors will form part of the investment decision rather than the NPV alone. (b) Applying the model to the bottled water project of the Nutrition Division The NPV is negative by a small margin.

Component

Calculation

Non-financial:

Likert scale 1–5

Weighting in Value the model

1. Alignment with Score of 5 based on 25% divisional and high-level alignment organisational strategy

1.25 (5 * 1.25)

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2. Moving baseline: risk of not investing 3, Project uniqueness and market leadership Sustainability impacts

Score of 3 based on 25% possible lost opportunity to diversify Score of 1 with low 25% market uniqueness and unlikely to be a market leader Score of 1 suggesting 25% high level sustainability effects…water, plastic…

.75

.25

The weighted index of non-financial factors = 2.5 The model: NPV = ($0.06m) + index of 2.5 The negative NPV is a bit of an issue, though this is not uncommon with strategic-type investments. The weighted index score is 2.5/5; so moderate only. While the project appears to align with strategy and moving baseline has some effect; the investment is not particularly unique and seems to have some sustainability issues especially around the plastic bottle component, although the project will add value to the local community through employment.

Solutions manual to accompany

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Prepared by Judy Oliver

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS

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Chapter 16: The strategic management of costs and revenues Questions 16.1 How might customer profitability analysis be used to improve organisational performance? (LO2) Customer profitability analysis will enable the organisation to identify areas where customers are incurring costs in addition to the cost of sales. Additional costs could relate to rush orders, return of goods, changes to orders, site visits and constant phone calls to sort out problems. Such costs are non-value adding and reduction of these costs would increase an organisation’s profit. By highlighting which customers are contributing to the additional costs the management can then either stop dealing with the customer or develop strategies to work with the customers to try and reduce the cost and improve customer service and satisfaction.

16.2 Explain the similarities and differences among target costing, kaizen costing and life cycle costing. (LO3, LO4, LO5) Similarities between target and kaizen costing: • Rely on goal setting to achieve cost reduction. • Focus on product design and the manufacturing process to find ways to reduce cost. • Encourage organisations to work with suppliers to reduce costs. • Use functional teams to determine where costs can be cut. • Encourage employees to take an active part in the cost cutting decision making process. • Take advantage of the trade-offs among price, functionality and quality. • Focus on continuous improvements in products and processes. Differences between target and kaizen costing: • Target costing occurs in the design and decision-making phase of product development. • Kaizen costing occurs after the product has been manufactured for the first time, and continues throughout the life of the product. Similarities and difference among life cycle, target, and kaizen costing: • Life cycle costing (LCC) is similar to kaizen costing in that cost reductions over time are expected. LCC is different because there is no goal setting for specific targeted costs and the product is unprofitable in the beginning of the life cycle. • In target costing, an unprofitable product is never manufactured, but under life cycle costing the product is expected to make a profit at some time, although not at the beginning of its life cycle.

Chapter 1: The role of accounting information in management decision making

16.3 Identify three products for which target costing and kaizen costing could be used. Identify three products for which target costing and kaizen costing would be inappropriate. (LO3, LO4) Target and kaizen costing are most appropriate in the following situations: • Product development and design phases are long and complex. • The production process is complex. • The market is willing to pay for differences in quality or function. • The manufacturer can push some cost reductions onto suppliers and subcontractors. • The manufacturer can influence the design of subparts. Students should draw from these characteristics in identifying products for which target and kaizen costing would and would not be appropriate. For example, these methods would be appropriate for automobile design and production, heavy equipment manufacture, camera manufacture, computers, and electronics. Some service industries use various forms of target costing practices. For example, hospitals are reimbursed by Medicare with a flat-fee per patient by the diagnosis the patient is given. Doctors agree on clinical pathways, that is, the steps taken to treat the average patient with that diagnosis. The clinical pathway is designed to cost less than the reimbursement amount. Similarly, a CPA firm may use these methods to evaluate whether services can be provided to achieve desired profits or whether the entity should continue offering services to a client. Target and kaizen costing are not generally useful for simple product manufacturing such as small toys or for food and beverages such as colas, cereals, or pasta products.

16.4 Explain the target costing cycle, and discuss the decision criteria used to determine whether a product will be manufactured using a target costing approach. (LO3) First determine the product’s target price, quality, and functionality, then determine the target cost. Design the product and manufacturing or delivery process to achieve the target cost. A pilot project is set up to evaluate the feasibility of the product and process design and operation. If the product meets the target criteria, it goes into full production. At each stage decisions are made about whether the product will be able to meet the price, quality, and functionality requirements. If these are not met, the product will not be produced or the requirements will change in response to customer input. 16.5 How can the principles of target costing assist with the decision to invest or continue to invest in the game console market? (LO3) The target cost could be identified by comparing the price of the game console with the required profit margin as reflected in the firm’s strategic goals: Target cost = Price – Required profit margin

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Having identified the game console target cost, the firm would then explore how to best design the game console and the production processes to meet the target cost. This would involve working closing with the design team, production managers and materials suppliers. Product design changes, supplier negotiations and other changes may be required to reduce costs. A pilot project might further be used to confirm the feasibility of producing the game consoles for the target cost or less. If it is deemed feasible, this will increase the likelihood that the firm will continue to invest in the game console market. If, however, the firm is not able to meet the target cost, the firm might consider its ongoing involvement in the game console market. 16.6 In competitive markets such as the game console industry, how might management respond to techniques such as life cycle costing? (LO5) In the context of a game console manufacturer, life cycle costing would enable managers to understand how the price and costs will change over the full life cycle of the product from its initial development and introduction and the remainder of its life through to maturity, subsequent decline and disposal/recycling. This information will enable managers to evaluate to feasibility of new products given their profitability over a number of years. Based on this information, managers might, for instance, determine that even though a new game console is sold at a loss in its early years, it is still worthwhile given the profits it will generate in later years and the profits generated from game sales. 16.7 Explain cost-based pricing and give an example that shows how prices would be determined using this method. (LO6) Cost-based pricing is performed by adding a mark-up to some measure of product cost, such as variable costs or a partially or fully allocated cost. For example, if a computer’s variables costs were $300 and the required mark-up 100%, the price would be $600 ($300 + 100%×$300).

16.8 Explain market-based pricing and explain where managers and accountants can find information that would help them set prices using this type of approach. (LO6) Market based prices are determined using some measure of customer demand. Managers identify the amount that customers are willing to pay for a good or service and set the price at that amount. With historical information about prices and quantities sold, the price elasticity of demand formula can be used to determine a profitmaximising price. Market research could be conducted and competitors’ prices could be analysed. The internet is also a source for pricing information.

16.9 Supply chain analysis focuses particularly on one aspect of value chain analysis. Explain how supply chain analysis is performed and how it relates to value chain analysis.

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Chapter 1: The role of accounting information in management decision making

(LO1) Supply chain analysis explores the flow of resources from the initial suppliers (inside or outside the organisation) to the delivery of products or services to customers or clients. Often, prices of inputs are reduced through negotiations with suppliers and may entail long-term contracts. To further reduce costs, the purchasing organisation may provide engineering or other kinds of assistance to the supplier. Recall from chapter 1 that the value chain cycle follows processes in an organisation, in a continuous manner: research and development, product or service design, manufacturing process or service delivery design, manufacture or service delivery, marketing, distribution, customer service. The benefits from value chain analysis might include: enhanced efficiency, cost reduction, improvements in supplier and customer relationships, the ability to identify and eliminate non-value-added activities, reductions in rework, scrap, and waste, production cycle time reductions, and an increased ability to negotiate lower prices with suppliers.

16.10 List some common advantages and disadvantages for target and kaizen costing. (LO3, LO4) Common advantages: • use of goal setting encourages better performance • team approach motivates employee cooperation • allows a competitive price advantage for a short period of time. Common disadvantages: • stress of cost reduction environment can impair employee wellbeing • encourages organisations to forego some products having long term profit potential that are not profitable in the beginning.

16.11 If fixed costs are included in the marked up costs used in setting cost-based prices, a problem may occur when demand declines. Describe this problem. (LO6) This problem is called the death spiral because as demand falls, average costs increase because fewer units are produced. This means that price will increase because it is based on average cost. When price increases, demand usually falls, so production will also fall, and average cost will increase, causing prices to increase, causing demand to fall, and finally the company goes out of business.

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16.12 Explain why not-for-profit entities do not always set prices so that their operating costs are recovered. (LO6) Not-for-profit entities often receive donations and grants to help off-set operating costs. Therefore they do not have to set prices so that their operating costs are recovered. They have other organisational objectives, such as providing services to low-income people. Hence, they may set prices using a sliding scale according to ability to pay. They may not charge for some products or services.

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Chapter 1: The role of accounting information in management decision making

Exercises 16.13 Customer profitability analysis Hector Gonzales runs the Floral Art Company, which supplies floral arrangements to three large supermarket chains throughout Australia. Management has become concerned about the rising costs associated with the processing and dispatch of orders. An activity analysis of the indirect costs identifi ed the following customer related costs.

Required (a) Calculate the activity cost rate for each activity (b) Assign the activity costs to each of the three customers. (c) Calculate the contribution for each customer if the sales pattern for each is as follows: Customer 1 — $350 000; Customer 2 — $160 000; Customer 3 — $210 000. (d) Advise the management of the Cheesecake Company as to whether any changes should be made in its relationships with customers. Advise Ange as to how she should go about executing these changes? (LO2) (a) Activity Orders processing Returns processing Delivery Rush orders Sales visits *total costs = $440 000

Allocation formula $200 000 / 450 orders $50 000 / 100 returns $100 000 / 700 deliveries $70 000 / 50 orders $20 000 / 100 visits

Activity cost rate $444.44 per order $500 per return $142.85 per delivery $1400 per order $200 per visit

(b) Activity Orders processing, $444.44 per order Returns processing, $500 per return Delivery, $142.85 per delivery Rush orders, $1 400 per order

Customer 1 $133 332 25 000 57 140 14 000

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Customer 2 $44 444 12 500 28 570 28 000

Customer 3 $22 222 12 500 14 285 28 000

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Sales visits, $200 per visit Total costs assigned** Adds to $439 993 – rounding

10 000 $239 472

5.000 $ 118 514

5 000 $82 007

Sales Less cost of sales** Gross profit

Customer 1

Customer 2

Customer 3

$350 000 233333 $116667

$160 000 106666 $53334

$210 000 140000 $70000

Customer 1

Customer 2

Customer 3

$350 000 233 333 $116 667 $239 472

$160 000 106 666 $53 334 $ 118 514

$210 000 140 000 $70 000 $82 007

($122 805)

($65 180)

($12 007)

Ranking Customer 1; Customer 3; Customer 2

Customer profitability analysis using ABC Sales Less cost of sales** Gross Profit Less activity costs allocated (refer part b) Contribution

Ranking Customer 3; Customer 2; Customer 1 ***refer calculations below to find out how the figures were determined Customer 1 – cost of

sales = ($350 000 / 150 * 100) = $233333 Customer 2 – cost of sales = ($160 000 / 150 * 100) = $106666 Customer 3 – cost of sales = ($210 000 / 150 * 100) = $140000 (d) The activity analysis provides insight into how the customers interact with the Company. From the analysis it can be seen that both Customers 1 and 2 require further attention. For example, Customer 1 is generating the highest revenue but providing the lowest profit. This is due to Customer 1 placing many low volume orders, generating more sales returns, more deliveries and more sales visits. Customer 2 is in a similar position when you compare their activity for the given sales revenue with that of Customer 3. Remember that for every $1 saved in costs the entity will generate an additional $1 in profit. It will be important for the management to discuss with the Customers how they can develop a more beneficial relationship.

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Chapter 1: The role of accounting information in management decision making

16.14 Market-based price (elasticity formula) Duncans sells doughnuts. Data for a recent week are as follows:

The manager estimates that if she were to increase the price of cones from $1.75 to $1.93 each, weekly volume would be cut to 850 cones due to competition from other nearby ice cream shops. Required Estimate the profit-maximising price per cone. (LO6) Per cent change in price = ($1.93 – $1.75)/$1.75 = +10% Per cent change in demand = (1000 – 850)/1000 = –15% The elasticity is ln (1 + per cent change in quantity sold)/ln(1 + per cent change in price) = ln(1 – 0.15)/ln(1 + 0.1) = –0.16252/0.09531 = –1.705 Variable cost = $640/1000 Profit-maximising price = [–1.705/(–1.705+1)]*$0.64 = $1.55 To maximise profits, the manager needs to lower the price rather than increase it.

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16.15 Customer profitability analysis; strategic considerations Cougar Toys is a toy wholesaler supplying to a range of different customers. With concerns about sources of profi tability from these different customers, Cougar has embarked on a relatively simple customer analysis exercise. In the fi rst instance, customers have been classifi ed as large, medium or small based essentially on sales volume. The results of this analysis are provided in the following table.

Required (a) Using the activity-analysis data, calculate the profitability of each of the customer groups. (b) Management is concerned about the consolidation taking place in the industry. They know that going forward, customer relations and the strategic management of customers will be critical. Identify a number of the critical strategic factors that management might want to monitor in addition to the financial profitability analysis. (LO2) (a) Activity Order filling costs Distribution related costs Marketing/promotion/sales Administration-related costs

Allocation formula $420 000 / 160 orders $835 000 / 223 deliveries $935 000 / $5501 200 sales dollars $460 600 / 223 deliveries

Activity cost rate $2625 per order $3744.40 per delivery $0.17 per dollar $2065.47 per delivery

*total costs = $2650600 Activity Order filling costs Distribution related costs Marketing/promotion/sales Administration-related costs

Large 91875 187220 425000 103273 $807368

Medium 118125 235897 272051 130125 $756198

Small 210000 411884 238153 227202 $1087239

Total costs assigned** Adds to $2650805 – rounding

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Chapter 1: The role of accounting information in management decision making

Customer profitability analysis using ABC Large

Medium

Small

Sales

$2 500 000

$1 600 300

$1 400 900

Less cost of sales Gross Profit Less Activity Costs Contribution

1 500 000 1 000 000

880 165 720 135

770 495 630 405

$807 368 $192 632

$756 198 ($36 063)

$1 087 239 ($456 834)

(b) The profitability analysis highlights that when additional costs are assigned to customers both the medium and small customers become unprofitable, in particular the small customers. Small customers tend to place more orders and have more frequent deliveries which accounts for the higher costs of doing business. Moving forward Cougar Toys may choose to focus on only the large customers as they provide a higher profit. Alternatively, more work could be done with the medium customers to reduce the cost of doing business with them. The business should look ways of reducing costs by implementing new customer practices to reduce costs. Other issues for consideration include: 1. nature of contractual arrangement 2. life cycle stage of customer 3. status of customer relationships. 4. bargaining power of customer.

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16.16 Target costing Search online for two organisations that have used target costing. Briefly comment on what you find in relation to this practice. (LO3) Students will identify many different organisations. Use these examples to provide a discussion on target costing.

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Chapter 1: The role of accounting information in management decision making

16.17 Life cycle costing Search online for two organisations that have used life cycle costing. Briefly comment on what you find in relation to this practice. (LO5) Students will identify many different organisations. Use these examples to provide a discussion on life cycle costing.

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16.18 Market-based prices (elasticity formula) Arnie’s Flowers is a small Mt Macedon florist shop. Arnie sells flowers for bouquets, and she also prepares and delivers flower arrangements.

(a)

(b)

(a)

Required Arnie is trying to decide how much to charge for a new type of rose that wholesales for $0.40 per bud. She ran a special on a similar rose last month and discovered that a 20 per cent discount on the usual price increased sales by about 35 per cent. What would you suggest as a starting price for the rose? Explain. Arnie has been wondering whether she has been charging the right prices on some of her specialty bouquets. She has been using a markup for all specialty items of 200 per cent (that is, she charges three times wholesale cost). Arnie estimates that a 10 per cent increase in price on such items would decrease her unit sales by about 12 per cent. Perform calculations to estimate a profitmaximising mark-up. Based on your calculation, do you think she should increase or decrease her markup? Explain. (LO6) The elasticity is ln(1 + 0.35)/ln(1 – 0.20) = 0.30010/–0.22314 = –1.345 Mark-up = [–1.345/(–1.345+1)] – 1 = 2.899 or 2.9 Variable cost = $0.40 Price = (2.9 × $0.40) + 0.40 = $1.56

(b)

The elasticity is ln(1 – 0.12)/ln(1 + 0.10 = –0.12783/0.09531 = –1.341 Mark-up = [–1.341/(–1.341 + 1)] – 1 = 2.93 The formulas indicate that she should increase her current mark-up, to nearly 300%. However, these formulas are very sensitive to errors in the estimates of price and quantity changes, so they should be used only as guidelines. She can slowly begin increasing the mark-up until she reaches the point where contribution margin times quantity sold maximises her profits.

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Chapter 1: The role of accounting information in management decision making

16.19 Target costing Suppose that Hyundai used target costing to decide whether to produce a new vehicle, such as a Hybrid SUV Vehicle. Required (a) Describe the steps Hyundai’s design team would have taken. (b) Explain why managers cannot easily predict demand for a new product such as the Hybrid SUV Vehicle. (LO3) (a)

If Hyundai had used target costing for the Hybrid SUV Vehicle, the first step would have been to determine a market price for the new model. Focus groups and customer surveys would have been conducted. Once the market price had been established, the required profit margin would be subtracted, leaving the target cost. At this point a team would be assembled of engineers, accountants, and marketing people to design the product and the manufacturing process. If the team is able to do this at the target cost, a pilot production line is implemented. If costs come in at the target cost, the Hybrid SUV Vehicle would go into full production. If the target cost cannot be met, at either the design or pilot stage, the whole process is reiterated several times. If the Hybrid SUV Vehicle never came in at the target cost, the marketing department could do more research to see if customers would respond to an increased price or decreased quality or function. If the target cost is never met, the product is dropped.

(b)

New products such as the Hybrid SUV Vehicle may be well received, or they may not be. Consumers’ preferences vary across age groups, across geographical locations, across income brackets, across gender lines, and many other characteristics. Because of this, the survey and focus group information may not represent the population of consumers needed. In addition, economic factors affect the success of a new product. None of these can be known for certain ahead of time.

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16.20 Customer profitability – qualitative factors Refer to Paisley Insurance in comprehensive example 1 in chapter 12. In this example, an ABC and non-ABC version of the costs of servicing each type of account customer — residential and commercial — was determined. Required State some important qualitative and/or strategic factors that would warrant consideration alongside the quantified cost data. (LO2) Paisley Insurance has two main customer categories – Residential and Commercial Under the traditional costing model both customers were allocated indirect costs based on the number of account enquiries. Under this model focus would have been on reducing the number of enquiries to reduce the cost of servicing customers. In contrast the ABC model breaks down the indirect costs into four activities: account enquiry, correspondence, account billing and bill verification. In addition to the financial data other qualitative/strategic factors to consider would be: 1. Potential market growth of both categories of customers 2. Reducing costs of correspondence by emailing where possible 3. Structural changes in the market (i.e. the extent to which billing services are being outsourced and market prices offered) 4. Are billing services a core activity for Paisley? 5. Could activity-based management help to reduce costs overtime?

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Chapter 1: The role of accounting information in management decision making

16.21 Market-based price (elasticity formula); uncertainties; other pricing factors Chocolate Creations is a shop located at Docklands in Melbourne. It makes and sells Specialty chocolates in a variety of flavours. Revenue and cost data for a recent week are as follows:

All employees work standard shifts, regardless of how many chocolates are produced or sold. Henrietta, the shop’s manager, estimates that, if she decreased the price of boiled lollies by $0.60 per kg to a new price of $5.40 per kg, weekly volume would increase by 20 per cent. Required (a) Calculate the price elasticity of demand. (b) Calculate the profit-maximising price (c) Based on the profit-maximising price, does it appear that Henrietta should drop the price of the chocolates? Why? (d) List possible relevant factors that could influence Henrietta’s price decision. List as many factors as you can. (LO6) (a)

Elasticity = ln(1 + 0.20)/ln(1 – 0.10) Elasticity = 0.18232/–0.10536 = –1.730

(b)

Variable cost = $2400/1500 = $1.60 Profit maximising price = [–1.730/(–1.730 + 1)] × $1.60 = $3.79

(c)

She should drop the price, but in slow increments to determine the point at which the contribution margin times quantity sold maximises profits.

(d)

The following factors could affect her price decision: • Any constraints in the resources and capacity she has available • Competitor’s actions • General economic factors, if the economy is down, she may need to lower her price • Weather affects the number of customers and she may need to run sales during slow times to move inventory and ingredients that have a short shelf life.

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16.22 Market-based (elasticity formula) and cost-based prices; special order decision Oysters Away shucks and packs oysters and sells them wholesale to fine restaurants across the country. The income statement for last year follows:

Pickers, shuckers and packers are employed on an hourly basis and can be laid off whenever necessary. Salespeople merely deliver the product, and so are paid on a salaried basis. Linda Hanson, manager of Oysters Away, believes that a price increase of 10 per cent would result in a 15 per cent decrease in sales. The King Krab Restaurant is providing dinner for a meeting of the Pickers, Shuckers and Packers Union in Melbourne. King Krab offered to pay Oysters Away $65 a case for 300 cases of oysters. This sale would not affect Oysters Away’s regular sales. Required (a) Ignoring the King Krab offer, estimate the profit-maximising price for Oysters Away. (b) Assuming Linda is not willing to lose money on the King Krab order, what is the minimum price that she should accept for the special order? (c) What other relevant factors might Linda consider before she makes a decision about the King Krab order? List as many factors as you can. (LO6) Note: This problem requires knowledge of special order decisions (Chapter 8). (a)

Elasticity = ln(1 – 0.15)/ln(1 + 0.10) Elasticity = –0.16252/0.09531 Elasticity = –1.705 Variable cost (vc) = $120 000/2000 = $60 Profit maximising price = [–1.705/(–1.705 + 1)]*vc Profit maximising price = 2.42 × $60 Profit maximising price = $145 per case

(b)

The minimum price for a special order decision is variable cost, so it is $60 for Oysters Away.

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Chapter 1: The role of accounting information in management decision making

(c)

Linda must be sure that there are no constraints on the amount of oysters available at this time. She also needs to know whether there would be any increase in wages or fixed costs if she adds more capacity. She needs to know whether other customers might find out about this price and demand lower prices. Students may think of other relevant factors.

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16.23 Kaizen costing Blade Runner produces regular scooters and motorised scooters. Blade Runner scooters are considered the most reliable in the marketplace. Demand has been volatile, with huge increases in demand during the holiday season. In the past, the entity filled demand by anticipating demand increases and manufacturing inventories ahead of time. Recently, competition in the motorised scooter line has escalated, and Blade Runner needs to reduce prices and, therefore, cut costs. The motorised scooter’s current cost is $150. To be competitive, the marketing department says the price should be 10 per cent lower than the current price. Management currently achieves a pre-tax return of 10 per cent on sales of the scooters and wants to continue this rate of return. The following per-unit costs for motorised scooters are based on production of 700 000 per year.

Required (a) Calculate the price recommended by the marketing department. (b) Given the price you calculated in part (a), calculate the new contribution margin and the target cost. (c) Calculate the planned cost reduction for each cost category, assuming proportional cost reduction across categories. (LO4) (a)

Current price is equal to the cost plus 10% of the cost = 110% × $150 = $165.

(b)

New price = $165 – (10% × $165) = $148.50 Because the company wants to achieve a 10% return on sales, the new contribution margin = $14.85 ($148.50 × 10%). The contribution margin takes

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Chapter 1: The role of accounting information in management decision making

into account both fixed and variable product costs, because none of the costs will be incurred unless the motor scooter is produced. Therefore the new target cost is cost = $148.50 – $14.85 = $133.65 (c)

Need to reduce each cost by ($150 – $133.65)/$150 = 10.9%: Original amount $ 45 15 10 10 20 25 25 $150

Target cost $ 40.095 13.365 8.91 8.91 17.82 22.275 22.275 $133.650

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16.24 Kaizen costing; proposed cost reductions, uncertainties Refer to the information in exercise 16.23. The following cost reduction suggestions were made by the kaizen costing team. Direct materials — Suppliers agreed to cost reductions of $4.50 for direct materials. Direct labour — An engineer suggested that the scooters could be manufactured more quickly if production batches were cut in half. The engineer believes that a labour savings of $1.50 per scooter could be attained. Machining costs — The team has been unable to identify ways to reduce machining costs in the manufacturing process, but suggests that some of the machining tasks could be outsourced to suppliers so that some parts are preassembled, reducing the need for machine hours. This outsourcing would increase the cost of direct materials by $0.50 per unit, but cut machining costs by $1.30 per unit. The supplier has been very reliable, but does not currently have the machining expertise and would have to purchase equipment and hire several workers to fill these orders. Marketing — Marketing has agreed to combine ad campaigns for both products and believes they will save $2.50 per unit without losing sales. Administration and Engineering — No cost containment appears possible in administration because a new enterprise resource program was recently acquired. However, the head of engineering believes that his costs can be cut by $4.00 per unit. He believes that some employees are no longer needed because part of the new program was designed especially to provide information for product and manufacturing process design that had been hand collected in the past. Required (a) Calculate the new cost per category. Compare the total cost with the kaizen cost. Determine whether further cost-containment efforts need to be made. (b) In your own words, describe the next step in the kaizen process. (c) List qualitative factors that might be relevant to Blade Runner’s managers as they decide on any product or process changes. List as many factors as you can. (d) For each of the planned cost reductions, discuss uncertainties about whether the entity will achieve the planned cost reduction. (a) Following are the new costs: Direct materials Direct labour Machining Inspection Engineering Marketing Administration

$ 40.50 13.50 9.20 10.00 16.00 22.50 25.00 $136.70

Costs need to be reduced further by $136.70 – $133.65 = $3.05

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Chapter 1: The role of accounting information in management decision making

(b)

The next step will be to look for more cost savings so that the target cost can be met. No savings were mentioned for inspection, so that is one area that could be explored. Other departments may have to cut back further to meet the target cost of $133.65. After the target cost has been met, a pilot project would be set up. If the scooter can be produced for $133.65 in the pilot project, the product would be manufactured. If costs still were too high, the target costing process would be reiterated.

(c)

Any changes in suppliers would need to be carefully considered. The reliability of the supplier, the timeliness of delivery and quality of products supplied, all need to be explored. If suppliers do not meet required standards, new vendors must be found, and/or the target cost may not be met. Productivity gains by labour could reduce quality. Any trade-offs in quality or functionality to meet the target cost need to be explored and discouraged. The new target cost assumes no reductions in quality or functionality. For each category: is the cost reduction actually attainable without affecting quality or functionality? For marketing, will the cost reduction affect sales volumes? Will cutting inspection costs mean that more defective units are sold? Will direct labour workers feel too much pressure to continually reduce costs and turnover increase? Will the machining department continue to be precise in their work while cutting costs? Questions (i.e. uncertainties) about whether the company will be able to achieve its planned cost reductions are listed below. Students may think of others. Direct materials — How certain can managers be that the price set by vendors now will continue over the next accounting period? How certain can they be that no changes in the price of raw materials will occur? Direct labour — How certain can managers be that labour productivity will continue to improve? Could labour demand a pay rate increase in the next year? Machining — How certain can managers be that no new technology will be developed, making their current machines obsolete? Inspection — How certain can managers be that inspectors will not demand an increase in salaries, or that they will continue to provide high quality inspections? Engineering — How certain can engineers be that any changes will either improve quality or reduce costs as they anticipate? Marketing — How certain can managers be that the popular media will not increase prices for advertising? How certain can they be that appropriate customers are targeted in the advertising campaigns? Administration — How certain can managers be that administrative costs do not increase, especially costs for computerised systems and software?

Problems

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16.25 Cost-based and market-based pricing; elasticity; uncertainties; economy effects John Gold has owned and operated Heritage Jewellery Store for a number of years. He uses the standard mark-up of 300 per cent (known as a triple key in this industry) and uses an average cost that includes an allocation of overhead as the cost base. Lately, jewellery sales at the store have faltered as the country faces a recession. John’s son is taking a cost accounting course and suggests that his father should use a pricing formula based on the price elasticity of demand. Required (a) In your own words, provide a plausible explanation for John’s current use of cost-based pricing. (b) Explain elasticity to John in simple terms. (c) In your own words, explain how price changes affect demand for products that are highly elastic. (d) Explain why John’s price elasticity of demand cannot be predicted with certainty. (e) List possible reasons why a product’s price elasticity of demand would change. List as many reasons as you can. (f) Explain how changes in the economy affect prices. Give examples from the current business environment. (LO6) (a)

John is probably influenced by traditional pricing methods in this industry. The mark-ups may be published in industry trade journals and John knows that his competitors are using similar methods and so feels comfortable using this method.

(b)

Elasticity is the sensitivity of demand to changes in price. The demand for some products is greatly affected by any change in price. For example, commodities prices are published daily. Demand for these products is considered very elastic (very responsive to price changes). For other products, changes in price lead to little change in demand. For example, demand for expensive cars such as a Rolls Royce or Lotus is inelastic; it is not very responsive to small changes in price.

(c)

When prices increase, consumers will not buy products for which demand is very elastic. For example, if frost has damaged this year’s asparagus crop and the price increases, consumers will substitute other vegetables for asparagus and demand will decrease. However, if the weather is perfect for asparagus and the crop is large, prices decrease and demand increases because consumers buy asparagus instead of other vegetables that are similarly priced.

(d)

If John has not tracked sales and prices over the years, he does not have accurate data with which to use in the elasticity formulas. Therefore he cannot be certain about the accuracy of his estimates. These formulas are very sensitive to error, and if they are based on inaccurate estimates, he may set a price that is profitminimising instead of maximising. In addition, response to changes in his prices may depend on whether his competitors match his new prices, and John cannot know for certain whether their prices will change.

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(e)

Elasticity of demand depends on the availability of substitutes. As more substitutes are developed, demand becomes more elastic. In addition, as competitors enter a market, prices may drop to levels at which demand is satisfied, and small decreases in prices will not affect demand. As new markets open through globalisation, prices may increase because demand is greater than supply for a period of time. Students may think of other possibilities.

(f)

Changes in the economy cause a shift in the demand function. If economic times are good, people may be more willing to buy higher priced goods and services. Alternatively if there is a downturn, people may forego some types of purchases. For example, during a recent recession (2001 to 2003) people continued to indulge in low-priced luxury products such as specialty coffee drinks, but cut back on large expenditures such as luxury cars or boats. These changes in consumer preferences affect the elasticity of demand for these products.

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16.26 Customer analysis, non-quantifiable factors Tania Wells owns and operates Gym Gear R Us, a growing internet business that specialises in the sale of gymwear for men, women and children. Tania designs her products but has them manufactured offshore. Since starting the business three years ago, she has been able to build the company to the point where it is now generating annual sales in excess of $1 million. Melina’s long-term plans include reaching a sales target of $3 million within the next three years. She is clear about a number of things that are critical to the business: • product quality and a variety of product offerings • quick order-turnaround times and speed of delivery to customers Even though there are many individual customer, Tania wants to develop a customer development model that will identify the key issues associated with building stronger customer relationships. Required Identify some of the key components suitable for inclusion in a customer development model for Gym Gear R Us. (LO2) Gym Gear R Us requires a customer development model which is a comprehensive model for evaluating and managing customers as well as developing customer relations. The key components of the customer development model for Seepwear by M might include: • An activity-based customer profitability analysis (to recognise both high-value and costly customers) • Measures of customer satisfaction • Status of customer relationship (differentiate between new and existing customer. For example, new customers might get a voucher on first purchase to entice them to return; existing customers might be invited to join a loyalty program) • Threats to the market, such as new entrants and potential (low) switching costs for Gym Gear R Us customers

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16.27 Cost reductionvalue chain analysis Budget Cupboards produces kitchen and bathroom cupboards that incorporate unusual functions, such as specialty drawers for knives and kitchen tools, and kitchen appliance holders that pop up from under the counter top. Competition in this industry has recently increased. Budget’s management wants to cut costs for its basic cupboard models and then cut prices. Required (a) The following table lists potential areas for cost reduction. Two potential cost reductions are provided for the first area listed (design phase). For each of the remaining areas, identify two potential ways that Budget Cupboard’s management could reduce costs.

(b) Budget Cupboards does not currently use value chain analysis. Describe several advantages of using these methods when price competition increases. (LO1) Note: An example is provided in the textbook for students to follow in answering Part A. (a)

Here are possible answers to this question; students may think of others.

Potential area for cost reduction Manufacturing process

Potential cost reduction (i) Reduce inventory

Administration

Outsource functions such as payroll if it is cheaper to do so

Changes in quality or functionality

Identify specialty functions with low volume sales and consider discontinuing them

(b)

(ii) Reduce inspection by using cellular manufacturing (also increases flexibility so that specialty items can be manufactured to order more easily) Explore software that would increase efficiency and reduce number of employees needed Identify lower cost materials that would not reduce current quality

To price more competitively, overall costs need to be reduced without affecting product quality or functionality. Value chain analysis is a method that can be used to reduce costs. Value chain analysis enables managers to categorise activities into value-added and non-value added. Then the non-value added activities are

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eliminated or minimised to save costs. The supply chain can be analysed to determine whether vendors can reduce their costs or provide higher quality goods and services at the same price.

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16.28 Target and kaizen costing; uncertainties, manager incentives Suppose you are having a conversation with Sandy, another student in this course. Sandy is confused about the differences and similarities between target costing and kaizen costing. Another student, Kevin, overhears your conversation with Sandy and insists that neither of these methods is beneficial. Kevin argues that some companies run into financial problems using these methods because their managers manipulated the cost estimates to appear however they wanted. If the managers wanted to launch a new product or keep an old one, they made sure their cost estimates supported their decision. Required (a) In your own words, explain how target costing and kaizen costing are the same and how they are different. (b) Compare the information needed to apply the target costing and kaizen costing methods: (i) List the types of relevant information needed for each method. (ii) List the uncertainties in the relevant information for each method. (c) Discuss ways in which managers might be able to create biased estimates under a target or kaizen costing system. (d) Kevin argues that the types of issues you described in part (C) mean that target and kaizen costing are not beneficial. Discuss the validity of this argument. (LO3, LO4) (a) Target and kaizen costing are both market-based pricing techniques. Once the market price is established, both methods set cost goals for production. However, target costing occurs at the decision-making phase of product development and kaizen costing occurs once the product has been manufactured and price reductions are anticipated. Target costing specifies a particular cost for the product and the product will not be manufactured unless the target cost is met. In contrast, kaizen specifies specific cost reduction goals for the product across its life cycle. (b) Target costing Information needed Estimated selling price for a given design and functionality Estimates for sales volume

Estimated product costs: • Direct materials • Direct labour • Overhead costs

Uncertainties How certain can managers be that customers will be willing to pay the estimated price? Will competition drive the price down? Will competitors’ advertising campaigns affect demand? How certain are managers that demand will not change if economic conditions change? • How certain are managers that prices and quality will hold over time? • How certain are they that labour productivity will meet their estimates? Will employees demand higher pay rates? • Will electricity rates or taxes or insurance rates change? Will salaries for supervisory

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

employees increase? Will other overhead costs increase or decrease? • If the design phase takes very long, how certain can managers be that estimated costs will hold until production begins?

Information needed Same information as above Estimates for cost reductions over time: • Direct materials • Direct labour • Overhead costs

Kaizen costing Uncertainties Same uncertainties as above • How certain are managers that vendors will reduce prices and maintain quality over time? • How certain are they that labour productivity will increase over the product’s life cycle so that estimated cost reduction goals can be met? Will employees be willing to continually strive for productivity gains without reducing quality or functionality? • Some costs will likely increase over time, such as property taxes and utilities. How certain are managers that other costs can be cut to override any cost increases and reduce costs further? Can they find activities to eliminate to reduce overhead costs, such as number of setups?

(c)

Managers are able to create biased estimates under any system, by underestimating or overestimating costs and revenues. If managers are biased toward producing particular goods or services, they may unintentionally be very optimistic in their estimates of prices and volumes, and overestimate them. They may also underestimate costs, not checking with vendors to be certain that quality remains high when direct material costs are reduced. In addition, they may ask direct labour employees to estimate time under the best circumstances, not average circumstances. Because these analyses rely on the target costing team’s estimates, any bias in the estimates affects the decision, and potentially the success of the product. Similarly if managers are biased against products or services, they will underestimate volumes and prices, and overestimate costs. In this case, a decision could be made to forego an otherwise profitable product or service.

(d)

Kevin needs to understand that biased estimates affect all types of analyses. An advantage of target costing is that a pilot project is implemented before full production begins. At this stage any optimistic biases in estimates are highly likely to be revealed. While this method uncovers positive biases, negative biases may not be as easily discovered. However, because target and kaizen costing use teams, individual biases are likely to be minimised with input from a number of different people. Both target and kaizen costing focus on market prices, and this information is relatively easy to obtain in many industries, so team members can monitor their own biases with concrete information from the market place or from

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customer surveys. All methods of decision-making are subject to bias, so managers must continually monitor their own and colleagues’ tendencies toward bias as plans are developed and decisions made.

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16.29 Cost-based and market-based pricing, collusion Burton Turner and Short Whittum live in a small town in northern Queensland. They both own petrol stations and provide fuel and engine repair services for the area. The town is somewhat isolated, and during the wet months it is sometimes difficult to travel to other towns across the often flooded river. While having coffee one morning, Turner and Whittum discuss the prices they charge for fuel and for repair services. They decide that it would be a good policy if they both set the same prices, because then customers would choose between the two businesses based on the quality of service and the brand name of the petrol. Required (a) What pricing alternatives are available to Turner and Whittum for setting prices? List as many alternatives as you can. (b) Is this an open-ended problem? Why or why not? (c) Explore this problem from different perspectives: (i) Turner and Whittum (ii)Customers (iii) Government officials (d) Compare and contrast the legal and ethical issues in this situation. How are they the same? How are they different? (e) Ignoring possible legal issues, is the proposed pricing policy of Turner and Whittum ethical? Why or why not? (f) Suppose you are a government official, and you receive an anonymous phone call telling you that Turner and Whittum are charging the same prices for fuel and repair services. How might you monitor the two businesses to determine whether their actions are illegal? (LO6) (a)

The following pricing policies are available: cost-based pricing and market-based pricing.

(b)

This is an open-ended problem and has no single, ‘correct’ solution. There are many different cost-based prices that could be developed, depending on the cost definition used. Because the cost of wholesale petrol varies widely, retail prices also vary widely. Information for setting market-based pricing could be competitors’ prices, or could be developed from the relationship between price and demand.

(c)

(i) Turner and Whittum may see nothing wrong with their desire to collude in setting prices. They may feel that they each have loyal customers who will continue to use their services even if small price differences arise. (ii) Regular customers may not care whether the prices are collusively set because they value their relationships with the owner more than responding to changes in prices. However, over time prices could become higher than in nearby communities and local and out of town customers might feel resentful at having to pay more in this town.

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(iii) Government officials would see Turner and Whittum’s behaviour as collusion in setting prices. Even if gas and service prices are similar to prices in nearby small towns, government officials believe that prices should be set independently by competitors to guarantee free market economies. (d)

Legally, Turner and Whittum are prohibited from colluding on prices. From an ethical point of view, price collusion is detrimental to the local business environment and should not occur. Therefore, both viewpoints would condemn collusion because it restricts free trade. Legal consequences are more stringent than ethical consequences.

(e)

Because the town is so small, local residents cannot know whether both owners are monitoring each other’s prices and pricing competitively or colluding on prices. However, if prices are set competitively, they would increase relatively slowly, and are likely to be affected only by increases in underlying costs. The Financial Review occasionally carries reports of large companies in the fast food or airlines industries that raise prices expecting others to follow suite, and finally reduce their prices because no one else increased prices. If prices are set collusively, they would increase because both parties agree to the increase, so it is likely that they would be higher under collusion than under competition. If prices are higher for services in this small town, local residents are paying more than they should. This could mean unnecessary hardship for some people on limited incomes. Because of these possibilities, price collusion is unethical.

(f)

Price changes can be monitored but it would be very difficult to determine that collusion was taking place without actually recording a conversation in which prices were set collusively, or the practice of collusive pricing was mentioned.

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16.30 Target costing; relevant information — The Dublin Shirt Company Consider the Dublin Shirt Company in comprehensive example 1 and the additional material provided below. Two recent developments that may have an impact on the company should be noted. First, in the present climate, The Dublin Shirt Company can only afford to reduce its prices if it can cut costs. The sales director suggests that the company can lower its quality inspection costs by reducing inspections, which will improve on-time delivery rates. This proposal is to be discussed at the next board meeting. Second, last week, the sales director proposed that the company should enter the American market for women’s sports shirts, where comparable shirts sell for the equivalent of €9.75. This is considered to be an excellent selling price, given the small size of the shirt. Overall production costs would be similar to medium-sized shirts and normal selling, distribution and administration costs would amount to €3 per unit. Each shirt would require dyeing and also normal embroidery. A marketing consultant has obtained information about specific features required for the female wearer. Working in conjunction with the firm’s cost accountant, he has presented information on these features and approximate cost as follows.

It is anticipated that The Dublin Shirt Company will sell these products through an agent, with whom they have never dealt but who would like to place an order for 100 000 shirts this year. The company recognises that this (new) market will require additional selling costs in the United States, equivalent to €1 per shirt. The Dublin Shirt Company requires a contribution of €2 per unit but the goods are to be invoiced in US dollars unlike current sales that are invoiced in euro. Required (a) What is the target manufacturing cost for these shirts? Indicate what features, if any, should be added to the shirts already produced, in keeping with your target cost calculations. (b) Identify the strategic and international business factors that the management of The Dublin Shirt Company should consider in making this decision. (LO3) (a) Target cost calculation; SP = $9.75 less profit margin of $2 = a target cost of $7.75 Current cost = .87 (basic man cost) + 1.40 (dyeing) + 1.30 (embroidery) + 3.00 (extra selling, distribution and admin) + 1.00 (additional selling) + .49 (extra features) = $ 8.06 which is presently above the target cost of $7.75 by .31

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Given that they need to reduce costs by .31 Dublin Shirt has three options: 1. They might elect to not include some of the offered features - but given that the feature we would need to remove is ranked highly by customers (Embroidery on single sleeve at .25) this might not be the best option 2. They may need to reconsider the possibility of cutting costs somewhere else in the production or selling, distribution and admin areas 3. They may need to take a reduced margin, until they establish a position in the US market. (b)

Factors might include currency exchange rates when being invoiced in US dollars rather than Euros; developing a relationship with the new agent involved in US selling and distribution; monitoring of payments and contract; capacity for the new orders as well as timely delivery internationally

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16.31 Cost-based pricing; death spiral; uncertainties; customer reaction Suppose the owner of Haywood Ceramics needs to raise prices to stay in business, but is concerned that raising prices would result in a death spiral. To avoid a decline in sales, the owner is considering sending letters to her customers explaining why the price increase is necessary. The letter would inform customers about the cost increases that necessitated the price increase, explain what the company is doing to keep costs as low as possible, and allow customers to place orders for a given time period at the current price. Required (a) Describe the death spiral in your own words. (b) Explain why the owner cannot be sure how customers will respond to a price increase. (c) Suppose the owner decides to send letters to her customers. From a customer’s point of view, discuss possible pros and cons of this strategy. (d) Would you recommend that the owner send letters to her customers? Why? (LO6) (a)

Under cost-based pricing, decreases in volumes result in increases in prices. Because demand is sensitive to price, as prices increase, volumes are likely to decrease. Over time the product is discontinued because sales do not cover costs. This is called the death spiral.

(b)

There are a number of different reasons that customers would continue to shop at Haywood or choose to shop elsewhere. If there are other ceramics studios nearby, price-sensitive customers will find another studio with better prices. Some customers may decide to change hobbies if they believe the price increases are unwarranted. Some customers may value their relationship with the studio and not be willing to change, even if prices increase.

(c)

Pros: Customers may enjoy their relationship with the owner and be willing to accept price increases to continue the relationship because they understand the reason for the price increase. Cons: Customers may not care about why prices increase, but be more concerned about their ability to pay higher prices. These customers could be annoyed by letters explaining the price increase and feel resentful that they cannot afford to buy at Haywood, or cannot participate in their hobby as often.

(d)

Following is the recommendation of Roberta Maynard in ‘Taking the Guesswork out of Pricing’ (Nation’s Business, December 1997). She recommends that small businesses fail to consider the many interrelated factors that should affect pricing decisions. She suggests that pricing decisions should consider the company’s costs, the expected costs of product updates and new equipment, objectives for each product, and competitors’ products. She quotes a business consultant from Arthur Andersen who says that business owners typically price products arbitrarily, or they base prices only on cost or on competitors’ prices. In addition, customer perceptions, involvement of distributors and suppliers, government

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regulations, ethical considerations, and economic conditions play roles. Maynard gives a coffee wholesales example of the role of communicating with customers. When the cost of green coffee rose dramatically, the small business owner sent a six-page letter to customers explaining how coffee prices were changing, what his firm was doing to control costs, suggested things customers could do to reduce their costs, and informed them of the new price and when the change would be made. He allowed customers to place orders at current prices. He believed that his approach gave him credibility. He didn’t lose a single customer. Students may have made a similar recommendation.

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16.32 Market-based pricing; relevant information Frosty Treats, a boutique ice cream shop, has asked your advice in setting pricing policies. Frosty Treats manager has collected information about prices and sales over the last four years. Required (a) Explain how you would use the prices and sales information to suggest a possible pricing strategy. (b) What other information would you gather before you complete your recommendation? List as many types of information as you can. (LO6) (a)

Java Alive can develop information about prices and demand and use the profitmaximising formula to guide their pricing decisions.

(b)

Other information needed includes the size of the local coffee shop market, Java Alive’s market share, competitors’ drinks and prices, economic predictions for the local and regional area, any seasonal variation in sales and differences in elasticity due to seasonal variation.

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16.33 Market-based pricing; customer preferences Transrapid is a new magnetically levitated train being developed to run between major cities in Germany at a speed of 500 kilometres per hour. Engineers developed a system with trains departing every 10 minutes. Suppose Transrapid asked you to research customer preferences and to recommend a pricing policy. It costs considerably more to have trains depart as frequently as 10 minutes apart, so a cost-based pricing schedule will result in ticket prices that are considerably higher than alternative modes of transportation. Required (a) In addition to customer preferences, what information would you like to gather before recommending a pricing policy? Explain why each item you list is relevant. (b) Explain why it is important to understand customer preferences before building the system. (c) Is the need to consider customer preferences different for this organisation than for another type of organisation? Why? (LO6) (a)

Here are examples of information that could be gathered before recommending a pricing policy; students may think of others. • Information about prices, number of train departures, and volumes from train systems in other similar sized cities because this would give me an indication about price and volume relationships. • Information about competing transportation systems, for example information

about prices, frequency and volume of riders for buses in the area, or in similar locations • Information on expected economic conditions, particular petrol and parking

prices because automobiles would be a competing form of transportation so as costs to drive a car increase, ridership on trains may increase. (b)

Before making a recommendation to Transrapid, it would be wise to conduct market research. Transrapid did this before building the system. As reported by the consultants who worked with Transrapid: ‘The engineers were thinking of a system to accommodate trains departing every 10 minutes. Research indicated, however, that the value-to-customer increased significantly when planned departure frequency went from every hour to every half-hour to every 20 minutes. The value was only slightly increased if the departure interval was further decreased to the planned 10 minutes. At the same time, costs increased dramatically due to more complex electronics in the track, more train units, more personnel, and so forth. The result: Transrapid has now been re-engineered for scheduled departures every 20 minutes. The resulting design simplifications and scheduling of fewer trains per hour result in savings of hundreds of millions of dollars.’1

Hermann Simon and Ulf Munack, ‘Setting the Right Price, at Internet Speed’, Brandweek, 21 August 2000, pp. 22–7. 1

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Considering its pricing policies, Transrapid could set the initial price to be competitive with other land-based transportation, such as buses and other trains. As information is logged into its information system, a price-based on product elasticity could be developed. (c)

Customer preferences may be different for this type of product than others because the product potentially reduces the amount of time that customers travel. It is difficult to know the value that people set on extra time. In addition, it is difficult to know whether increasing the scheduled departure times would affect the price people are willing to pay. Because these factors are uncertain, gathering information about their preferences could be an important part of the pricing process. If prices are set too high, people will not try the train service, even though they may benefit from having more time for other activities. If prices are set too low, and need to be increased later, people may complain and look for other modes of transportation at that point.

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16.34 Market-based price (elasticity formula), uncertainties Hanson & Daughters produces a premium label apple juice to wholesalers at a current price of $7 per 5-litre container. Costs for a recent month, in which 100 000 5-litre containers were produced and sold, appear on following page:

Hanson & Daughters’ customers are loyal. Recently, a 10% increase in wholesale price resulted in only a 10 per cent decrease in litres sold. Required (a) Calculate the price elasticity of demand. (b) Calculate the profit-maximising price. (c) Explain why the management of Hanson & Daughters cannot be certain that another 10 per cent price increase would cause only another 10 per cent decrease in litres sold. (d) Provide possible reasons why so many customers were willing to continue purchasing the apple juice when prices increased by 10 per cent. List as many reasons as you can. (e) Describe the assumptions underlying the profit-maximising price you calculated in part (b). How realistic are these assumptions for Hanson & Daughters? What might occur if these assumptions are not met for Hanson & Daughters? (f) What would you recommend to Hanson & Daughters concerning its price for apple juice? Explain your reasoning. (a)

Elasticity = ln (1 + per cent change in quantity sold)/ln(1 + per cent change in price) = ln(1 – 0.10)/ln(1 + 0.10) = –0.10536/0.09531 = –1.105

(b)

Variable cost (VC) = $50,000/100,000 = $0.50 Profit maximising price = [elasticity/(elasticity + 1)] × VC = (–1.105/(–1.105+1)] × $0.50 = 10.52 × $0.50 = $5.26 This solution assumes that Hanson has enough capacity to fill increasing volumes of demand. The profit-maximising price is that point where contribution margin is largest overall, so as contribution margin decreases, volume of sales has to increase to more than make up for the decrease in margin.

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If an organisation cannot increase volumes to this point, it may be better off with a higher contribution margin and sales within its relevant range of operations. (c)

Customers may find substitutes for the product such as a cheaper brand or another type of juice.

(d)

Quality is good, the price was perceived as being reasonable, in light of quality, customer loyalty.

(e)

The assumptions are that the variable cost remains constant, that elasticity is greater than 1 and constant, and that changes in the price of juice do not affect product costs or sales of other products. In addition, the calculations are very sensitive to error, so any measurement error could affect the price. These are strong assumptions. If they are not met, the calculated price may not maximise profits.

(f)

Here is a sample recommendation. Student responses will vary, but should include the following points. My best estimate is that a price of $5.26 will maximise your profits. However, you should reduce your price slowly and monitor demand and profits. Keep reducing the price slowly until profit plateaus, and then keep the price steady at that point. You want to identify the point at which lower prices and higher volumes maximise profits.

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16.35 Cost reduction and market-based prices at a university Bainbridge University offers an MBA degree that is widely respected around the world. The tuition for the program has always covered the costs of the program until a recent recession increased the sensitivity of students to the cost of tuition. The business school managers decided to freeze the tuition cost for the past few years. The director of the MBA program asked a cost accounting class to act as consultants for the program and to make recommendations on possible ways to reduce costs or to increase tuition. You are part of a student team assigned to this project. Required (a) Is this problem open-ended? Why? (b) List relevant types of analyses that your team might perform. (c) Describe the steps you will take as you analyse the program, including the types of information you would like to use. (d) Explain how you would decide on an appropriate level of tuition. (LO1, LO3, LO4, LO6) (a)

This problem is open ended because there are a variety of solutions to the university’s problem. These solutions could involve not increasing tuition but cutting costs, increasing tuition and not cutting costs, or a combination of tuition increases and cost cutting. In addition, the amount that tuition could be increased is an open-ended problem that does not have a single correct answer. The same is true of potential cost cuts, and the combination of tuition increases and cost cuts. There are likely a number of different optimal solutions to this problem.

(b)

Some class members may want to analyse competitors’ programs and tuition and financial aid policies. Some class members could gather information to determine the elasticity of demand for the MBA degree. Some class members may gather information about costs, and may choose to use activity-based-costing and activity-based management or target and kaizen costing to reduced costs. Alternatively, value-chain analysis could be performed to provide information about costs and value-added and non-value added activities.

(c)

For this problem, an assumption is made that students will perform target costing. They may have made a different assumption, so the steps they list will be different from these. For target costing, the students would need to follow the target costing cycle presented in figure 5.3. They would need to gather information about past volumes and tuition levels, and current information using surveys of current and prospective students’ price preferences. In addition, they would need information about the direct costs of the program, number of courses offered, and number of students enrolled in different courses. Further, information about revenues from all possible sources would need to be gathered, including all educational offerings such as executive education, CPE courses, donations, grants, and government support.

(d)

Student responses will vary. At a minimum, students should consider multiple sources of information, and they should describe some trade-offs in making the decision. Here is a sample response.

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When deciding upon an appropriate level of tuition, I would evaluate the results of marketing research, the ability of students or other providers to pay tuition, alternative sources of funds, and the ability of the university to reduce costs. For example, if market research suggests that students are price sensitive, then the rate of tuition charged by competitor universities and the extent of available financial support from employers or governmental agencies might weigh heavily in the decision. I would also consider the university’s values and priorities. For example, some universities establish a relatively high tuition rate, but then give scholarships to students meeting certain criteria, such as low income, race, gender, scholastic aptitude, and so on.

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16.36 Life cycle costing Fancy Fleece developed a new outdoor wear fleece fabric that is both wind and water resistant, but retains a soft and fuzzy feel. The research and development process was more expensive than Fancy’s managers anticipated, and the materials in the fabric are also more expensive than anticipated. The managers believe that if Fancy prices the fleece to cover total costs, no one will buy it. The marketing department held several focus groups with manufacturers who produce and sell winter jackets and pants to determine an appropriate price. The marketing department also surveyed customers who recently purchased fleece jackets to determine the amount of premium they would be willing to pay for a jacket that is both wind and water resistant. The marketing department concluded that the new fleece fabric would sell at a price that covers variable costs, but does not cover the total costs of production and development. You have been asked to help the managers decide whether to produce the fleece and how to price it if they do produce it. Required (a) What kind(s) of analysis would you perform for this decision? (b) Explain whether it would generally be better for Fancy Fleece to use cost-based or market-based pricing. (c) Identify uncertainties about how much it will cost to produce the fleece. List as many uncertainties as you can. (d) Explain why the managers of Fancy Fleece cannot be certain that they would be able to sell the polar fleece to cover variable costs. (LO5) (a)

Because this product involved large costs for research and development before the product could be manufactured, life cycle costing would be the best analysis method.

(b)

Market-based costing is the only real alternative for pricing. If cost-based pricing is used, the price is likely to be so high that demand would be very small.

(c)

This is a new product with a new manufacturing process, creating many uncertainties. For example, accountants cannot be certain that estimated costs for direct materials will hold. Changes in prices and quantities required could affect these costs. Similarly, they cannot be certain that direct labour will meet the productivity estimates. The direct labour rate could also increase. Accountants cannot be certain that fixed and variable overhead costs will remain constant. Price changes or productivity changes could affect these estimates. They cannot know whether new technology will reduce the cost of production.

(d)

Because this is a new product, variable costs cannot be estimated easily. If variable costs increase or are underestimated initially, the price based on these estimates will not cover variable costs.

16.37 Profit effect of price change

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

The accountants at French Perfumery decided to increase the price of a scent called Breezy by 10%, from $6 per bottle to $6.60. French’s accountants expect the 10 per cent price increase to reduce unit sales by 20 per cent. Current sales are 200 000 bottles, and total variable costs are $800 000. Required (a) Estimate the pre-tax profit effect of the price change, assuming no effect on the variable cost rate, on total fixed costs, or on sales of other products. (Hint: Calculate the contribution margin at the old and new prices and volumes.) (b) How certain can the accountant be that volume will decline 20 per cent if the selling price increases to $6.60? What effect does this uncertainty have on the managers’ decision to increase the selling price? (LO6) (a)

Breezy Sales volume Price Revenue Variable costs Contribution margin

(b)

Original data 200 000 $6.00

New price and demand 160 000 $6.60

$1 200 000 800 000 $ 400 000

$1 056 000 640 000 $ 416 000

The uncertainty depends on several factors. The problem does not indicate how accountants estimated these amounts. If optical character readers tracked changes in prices and volumes, the estimates might be relatively accurate. However, the profit-maximising formula is sensitive to small changes in estimates. Measurement error could reduce the ability to anticipate how changes in price will affect demand. Other factors that could affect demand are competitors’ prices, the availability of close substitutes, and economic downturns.

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16.38 For-profit versus not-for-profit pricing; setting a market price Suppose the Tasmanian government decided to preserve some beautiful caves in the southwestern part of the state. To defray the cost of preservation, the Tasmanian state tourism managers decided to open the caves to guided tours. To prepare the caves for visitors, vapour locks were built so that the moisture content of the caves would remain stable. The Tasmanian government spent $10 million on the facilities. Now the managers need to decide on a price for the tours.

(a)

Required (a) Describe how pricing policies in not-for-profit organisations are different from pricing policies in for-profit organisations. (b) Use the internet or other sources to identify current prices for other similar attractions. (c) What additional information would you gather to evaluate the price? (d) Do you believe that the volume of tours is likely to be sensitive to the price charged for tours? Why? (e) The managers of the park department need your price recommendation. Use the information you learned from the preceding analyses to write a memo to the park department recommending a price for the tour. Provide appropriate information for park department managers to understand your methodology and evaluate the risks associated with your price recommendation. (LO6) Not-for-profit organisations usually have other sources of funds than revenues from their products and services. This allows them to set prices based on different objectives than just contribution margin. Some not-for-profits charge based on customer ability to pay, and they may provide services for free to low-income customers. For-profit organisations usually set one price for all customers, and the price includes a profit margin.

(b)

Fees for caves in Australian national parks, such as Gunns Plains Caves, are $12.00 for adults and $6.00 for children. Crystal Caves in Cairns are priced at $15.00 for adults and $8.00 for children. The Jenolan Caves Tours in The Blue Mountains range from $27.50 to $155 depending on the guided tour selected.

(c)

Information about other attractions in the local area could be gathered, for example prices for mine tours, entrance fees for any other types of similar tourist activities that could substitute for the cave tours. Surveys of tourists at nearby natural attractions, such as the Leven Canyon would provide information about pricing. Focus groups could be held with local residents touring the facility and then providing information about acceptable prices.

(d)

Because tourists can substitute among activities, the price for tours is likely to affect volume. Because national park entrance fees are $7 to $10, prices set similarly would probably attract the highest volume of tourists, but this may not be the profit-maximising price. It is possible that prices up to $15 to $30 would result in lower volumes, but a larger contribution. If capacity limits are a problem, prices could be increased during times when demand exceeds capacity and lowered when demand is low.

(e)

There is no one answer to this part.

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16.39 Cost-based pricing in a not-for-profit entity Cairns Legal Services is part of a larger not-for-profit organisation (Capricorn Resource Centre) that provides free legal and job placement services and houses a food bank for qualified clients. Last year’s costs for 5000 visits to legal services are presented here.

Expected grants for the next year from the federal government and the Cairns Council have been reduced due to an economic downturn. The organisation’s executive director is considering dropping legal services. Eliminating the legal services program will result in a savings of about $4000 in administrative costs. The space vacated by legal services could be used by the food bank, which is presently renting quarters in another building for $8000 a year. The director decided that individuals receiving legal services from the resource centre are to pay for their services, with exceptions based upon need determined on a case-by-case basis. It is not clear what the director means when he says that clients are to pay for their services. Required (a) If the director means that each person using legal services should pay for his or her own avoidable costs, what minimum fee should be charged on average for a legal service visit? (b) If the director means that all of the people using legal services should collectively pay for the avoidable costs of the legal services program, what minimum fee should be charged on average for a visit? (c) If the executive director wants the fee to cover the total costs of the Cairns Legal Services including avoidable and allocated costs, what minimum fee should be charged for a visit? (d) Suppose the centre begins charging the price you calculated in part (b). What problems might arise if these fees are implemented? Consider

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whether the price change would affect the client’s behaviour, and then how that behaviour change might affect Cairns Legal Services. (e) Suppose the Centre begins charging the price you calculated in part (c). Considering that the price is based on allocated costs, explain why this price might be viewed as arbitrary. (f) Discuss why a Capricorn director might issue an edict about having clients pay for their services, but not provide guidance about what the edict means. (a)

Avoidable costs would be any variable costs. Supplies appear to be the only variable costs, so the average cost of supplies of $1.20 ($6000/5000) would be the minimum fee.

(b)

Avoidable costs for the whole department would be the cost of lawyers, secretary, supplies, and paralegal and the avoidable administrative cost, plus the $8000 savings in rent, or $38.00 [($178 000 + $4000+$8000)/5000]. These costs would be dropped if the program were dropped.

(c)

The minimum fee for all avoidable and allocated costs is $44.40 ($222 000/5000).

(d)

This fee may be higher than many of the clients can afford and so volumes would drop. Then the fee would have to be increased, and volumes would likely drop again.

(e)

This price would be considered arbitrary because the cost allocations are considered arbitrary. The current allocation bases are salary for administrative costs and space occupied for rent. The use of other allocation bases would result in different amounts of allocations, and a different pricing structure.

(f)

The Capricorn executive may rely on those closer to the clients to determine how to best carry out instructions. Alternatively, the executive may not have analysed the information and realise that there are a number of different ways to interpret the edict.

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Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Solutions manual to accompany

Management accounting 4th edition by Eldenburg et al. Prepared by Judy Oliver

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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Chapter 17: Strategic management control: a lean perspective Questions 17.1

What is the lean thinking philosophy? Outline the five steps in the lean thinking model. (LO1)

The lean thinking philosophy's aim is to eliminate all sources of organisational waste. It requires an understanding that customers define what is of value in an organisation’s service or product offerings, and a refocus on accounting practices, control and performance measurement that involves ‘cradle to grave’ analysis. The five steps of the lean thinking model are: 1. identify and define value in organisational offerings 2. identify the relevant value chain processes and activities 3. enable a continuous one-piece flow through all value chain activities 4. implement a pull system in sync with customer demand 5. strive for continual perfection. 17.2

Describe the behavioural and social controls in a lean manufacturing environment. How would they be different to in traditional (non-lean) organisations? (LO1)

Behavioural controls — to direct employees' work effort Lean environment Non-lean environment • Standard operating procedures • SOBs typically absent (SOB) • Technical process documents • SOBs visible through operational typically held by supervisors. areas and would include pictures of how to do tasks • A manufacturing setting may have marked lines to show the physical flow of material and finished goods Social controls — setting culture of workplace Lean environment • Empowerment of workforce • Focus on teamwork • Peer pressure within team encourages skills development • Visualisation of what’s is required for the task to be completed

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Non-lean environment • Empowerment of supervisors only • Individual rather than team contribution • Visualisation little – paper reports only to supervisors • Training – single process

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

• Focus on skills matrix 17.3 What is a just-in-time manufacturing system? Why would organisations choose to adopt it? (LO3) Just-in-time (JIT) is an inventory management and manufacturing system where products are manufactured as demanded and raw materials are delivered just when they are needed in the manufacturing cycle. Very little inventory is kept on hand since; suppliers deliver small amounts on a regular basis. Organisations adopt Just-In-Time systems to keep inventory costs down and also to better manage quality because defects are often monitored more closely with JIT systems. Systems such as JIT are known as demand-pull systems, because demand pulls inventory through the system to the point of sales.

17.4 Outline the five steps in the theory of constraints? In many examples of the TOC in practice, idle capacity is generated. Why? Can this be a good thing? (LO2) Five steps of TOC 1. identify constraint 2. decide how to exploit the constraint 3. subordinate everything else to the constraint 4. elevate the constraint 5. if in the previous steps a constraint has been broken got back to step 1. Idle capacity is found in examples of TOC as the constraint is the weakest link in the production process. For example if the constraint is on the demand side, whereby there is insufficient demand for the product/service then production will slow leading to unused capacity. Is idle capacity good – probably not due to the costs associated with it – every $1 incurred is a $1 lower profit.

17.5 Explain how the TOC fits within the lean thinking philosophy. (LO1, LO2) The lean thinking philosophy aims to have production in sync with customer demand and that production be a continual process. TOC is about trying to identify bottlenecks or other process constraints that may inhibit the ability to have a continual process. Therefore the lean production philosophy is dependent on eliminating the constraints.

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17.6

Describe the four types of quality-related activities. (LO4)

Prevention activities are activities performed to insure defect-free production. These activities could include: • inspecting incoming direct materials • designing and redesigning products and manufacturing processes to reduce defect rates • identifying areas where defects arise and solving the underlying cause of the defects. Appraisal activities are activities performed to identify defective units, and include the following activities: • inspection of products • inspection of manufacturing process • monitoring of service delivery process • testing. Production activities are activities undertaken in the production or rework of failed units. These include: • labour tasks and materials to produce spoiled units • reworking spoiled units. Post-sales activities are activities undertaken after the product has been sold to remedy problems caused by defects and failed units. These activities include: • accepting returned products and exchanging them for good products or refunding their cost • repairing defective units • preparing for and participating in legal actions that result from defective units.

17.7 Should the lean thinking firm be concerned about the costs of quality activities? Describe by drawing on Deming’s 14 principles of management. (LO1, LO4) A lean thinking firm will have a focus on waste reduction and eliminating all non-value adding activities. The identification of both internal and external quality costs gives focus to organisational management of where to target reduction programs. For example, external and internal failure costs should be eliminated in total and other prevention and appraisal costs should be investigated to eliminate non-value adding activities. Deming’s principles inform how a lean thinking firm should operate for example — focus on employee training, teamwork, and high quality processes.

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17.8 What is throughput costing? How is it linked to lean accounting? (LO2) Throughput costing is a modified form of variable costing that measures the impact of bottlenecks and constraints on an organisation’s goal achievement. It is linked to lean accounting as it not concerned with allocating costs to products.

17.9 Explain why a lean organisation would refuse to implement an absorption costing system? (LO2) A lean organisation would refuse to implement an absorption costing system as such organisations consider all costs (other than direct materials) to be relatively fixed in the short term and classified as operational costs rather than product costs. Other arguments against cost allocation are that the focus is on increasing the efficiency of the constraint and not the calculation of a product cost, and complicated accounting allocations based on erroneous assumptions only confuse decision making.

17.10 Proponents of TOC suggest that it is problematic to make decisions based entirely on resource consumption (this is, the ABC system) because there is no guarantee that the spending to supply resources will be fully aligned with the new levels of resources demanded in the near future. Explain this comment. (LO2) This statement is about the argument between ABC and TOC. Students should explain the differences between ABC and TOC but at the same time point out that the proponents of ABC and TOC both believed their method would promote increased profits and control of costs. For example, ABC recognises that different products absorb costs/resources based on complexity rather than volume. That is why Cooper and Kaplan proposed using non-volume drivers to allocate costs to products. ABC assumes that costs are predominantly variable over the long run and that variability should be recognised in all decision making. By drawing attention to fixed costs in the ABC analysis managers will limit the increase which has been dramatic over the last few years. Alternatively TOC looks to prioritise scheduling of products where limited/constrained resources exist to maximise profit. Non-volume costs are eliminated from the analysis. TOC takes the alternative view to ABC on cost variability and considers most manufacturing costs are predominantly fixed, with materials being the only consistent variable cost. In TOC-based companies fixed costs can be maintained or reduced by improving processes and reducing non-value-added activities. Students should think of TOC as a short-term production mix decision process where costs are predominantly fixed. And think of ABC as a process to determine any increases or decreases in capacity and products (as well as any other long-term decision) because, in the long-term, all costs tend toward being variable. We can use insights from both - ABC insights on product profitability from total valuechain variable and fixed costs data and insights to re-evaluate the ABC costs based on the factors that limit/constrain production.

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So the timeframe is an important element in this argument. TOC is useful for shortterm decisions, but may encourage too much attention on short-term results to the detriment of long-term strategic goals. For example, labour and overhead costs might be unnecessarily reduced because these costs are considered to be operating costs rather than product costs. However, there is no indication as to whether the level of expenditure for such costs is appropriate for the level of operations, and if too high TOC will not show how to bring them under control. So ABC complements TOC in the long run as it provides more information for long term cost planning.

17.11 Based on your understanding of the TOC explain why conventional standard costed work in process inventories might hide problems, obscure interdependences and make it difficult to identify the real constraint in a system. Why might this conventional method lead companies to build excessive work in process inventories? (LO2) The standard cost system will encourage overproduction due to the production volume variance. This variance is only favourable when actual production exceeds planned production. Also with the allocation of fixed costs to products in a conventional system, excess production will defer the fixed costs being expensed. 17.12 Briefly comment on how a lean approach will impact on accounting practices? (LO1) Lean thinking is focused on identifying and eliminating any waste and nonvalue adding activities, and working to ensure that the activities of a firm are focused on creating value for customers. The application of lean thinking requires timely and relevant accounting information in regards to the costs associated non-value adding activities. The drivers of these costs must also be understood. Similarly, to evaluate the degree to which an organisation is meeting customer expectations and delivering value, accountants must ensure that they clearly understand the drivers of customer value. Various financial (i.e. sales turnover) and non-financial performance measures (i.e. market share, customer satisfaction, defect rates, delivery times) are required to enable managers to understand the degree to which they have been successful in creating customer value.

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Exercises 17.13 Categorising quality activities Following is a list of quality-related activities. (a) (b) (c) (d) (e) (f)

(g)

Inspection of units when they are 100% complete to remove defective units Designing a process with as few parts as possible to reduce the chance of defects Warranty costs for defective products returned to the factory for rework Reworking spoiled units before they leave the factory Costs to defend the entity against lawsuits for damages caused by defective products Tracking number of defects for each manufacturing team and posting daily defect rates on a plant-wide bulletin board Redesigning a manufacturing process to lower the rate of defects

Required Mark each activity according to whether it pertains to the internal cost of prevention (P), appraisal (A), internal (I), or external (E) costs. (LO4)

Type A

Quality activity (a) Inspection of units when they are 100% complete to remove defective units P (b) Designing a process with as few parts as possible to reduce the chance of defects PS (c) Warranty costs for defective products returned to the factory for rework PR (d) Reworking spoiled units before they leave the factory PS (e) Costs to defend the entity against lawsuits for damages caused by defective products P or A (f) Tracking number of defects for each manufacturing team and posting daily defect rates on a plant-wide bulletin board (Used to motivate employees to improve quality, also requires appraisal) PR (g) Redesigning a manufacturing process to lower the rate of defects

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17.14 Lean approach Elimination of waste to maximise customer value is at the core of the lean approach. Required Search online to find two organisations that have adopted a lean approach to operations. Identify the objective that led to the adoption of lean thinking and any changes that have been made to business processes as a result of the lean approach. (LO1) Students will identify a number of different organisations. This will enable discussion around the lean approach to operations.

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17.15 Lean thinking in an internet-based sales organisation Paige Maddern owns and operates Paige Nightwear (PN), an internet-based company specialising in high-quality nightwear for men and women. From the outset, Paige has had a number of key principles in mind which guide most of the business decisions and operations of PN including: 1. All products are to be manufactured locally by small manufacturers which satisfy strict quality control procedures and a quality audit conducted by PN. 2. The use of high-level electronic intelligence systems which support: • real-time tracking of all orders throughout complete order-filling process • an objective of all orders shipped within 24 hours of receipt of an order • real-time reporting of orders, sales and cost data, including product profitability • electronic links to manufacturing suppliers, enabling production to be triggered by sales order data • customer follow-up procedures which ensure a constant flow of customer feedback regarding the products as well as delivery processes. Paige has always believed that as an internet-based company it is important to make use of a range of technologies to maintain customer loyalty and customer growth. It was not going to be enough to just have good quality products. Required (a) How does the use of electronic links to manufacturing suppliers, enabling production to be triggered by sales order data, help reduce waste? (b) Given PNs operating environment and the key principles Paige uses to guide her company, what kind of accounting practices would you expect and not expect to observe with respect to output controls (refer to figure 15.2). (LO1)

(a)

• • • • • •

Allows for a just-in-time inventory system as suppliers only despatch supplies when triggered by a sales order Quality audit of suppliers eliminates need for goods to be inspected on arrival Reduces need for warehousing Reduces potential for inventory losses Reduces administrative effort as paperwork eliminated Inventory tracking lessened

(b) Overall it would be expected that the accounting activities are developed to streamline transactional processing and remove all non-value-adding activities. • Use of actual rather than standard costs removing need for variance analysis • No cost allocations — therefore no aborption costing system • Refocus of performance measurement systems to emphasise social controls e.g. training • Use of an annual blank purchase order with suppliers

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• • •

Removal of need for invoices as suppliers paid from packing slip in line with annual order Inventory valued based on material cost only Use of throughput costing due to low inventory levels

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17.16 Lean accounting Synergy Clothing (Synergy) began operations as a clothing manufacturer in the 1940s. It has grown from a small firm into a multi-divisional diversified clothing company with three key divisions: Fashion, which focuses on shirts and jeans; Uniforms which focuses on corporate and uniform wear; and Sportswear, which focuses on sports clothing with a specialty in custom sports uniforms. Until recently, the company had been owned by the same family. The grandson of the founder, Tim Peseta, still occupies a senior management position, although significant changes have occurred since the company was listed on the stock exchange in 2003. Since becoming a public company, a number of key structural and control system changes have been made by the new management team lead by CEO Noel Oliver. One of the first actions Noel took was to bring in a consulting firm to make an assessment of the whole organisation with a particular emphasis on the Fashion division. Noel had concerns that there was signifi cant waste in the Fashion division but he needed real evidence that this was the case. The consultant’s report was comprehensive and addressed the issues of particular interest to Noel. Provided below is an excerpt from the report that relates to some of the thoughts of the consultant relating to the fashion division (FD): 1. Customers and market • The FD was trying to supply product to any customer (retail outlet), irrespective of size of order, with little consideration for the costs associated with doing so. The consultant described this as trying to ‘deliver a purple polka dot shirt on a Sunday afternoon’. • The tendency for the FD to have a product for every part of the market without much regard for the innovative product technologies that had made the FDs brand strong in the past. • The focus on producing 50 ranges per season, much of which it would seem was made to stock, and remained as finished goods inventory awaiting an order. 2. Operations and staffing • There appeared insufficient resources dedicated to the design activity with the entire activity staffed by the equivalent of two staff. • Excessive inventory levels both in terms of raw materials (cloth, where purchasing seemed to occur in an unplanned way predominantly by Tim Peseta on annual international buying trips) and finished goods (shirts, estimated at 290 000 items). • Production volumes were governed by an economic order quantity model, which appeared to contribute to the excessive inventory levels, while the production process utilised manual, semi-automated and fully-automated procedures. Notwithstanding Tim’s tight control over the FDs operations, morale on the shop floor appeared high, with many long-term employees (one machinist having been with the firm for 42 years). Required (a) Identify which of the above issues raised by the consultant could be addressed using the principles of lean accounting.

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(b) Using lean accounting principles, what solutions for those items you have identified in part (a) would you provide? (LO1) (a)

Some of the relevant issues might include: 1. Customers and market • Production should be demand driven – not manufactured for stock to satisfy a ‘just in case’ situation. • Customer focus groups to identify and rank desired product features 2. Operations and staffing • Design activity staff – understaffing which could lead to constraints in new product development • Inventory purchasing - should be driven by orders • Process improvement – underuse of technology in manufacturing process

(b) The following lean accounting principles might be considered at Synergy Evaluation of the value chain processes and activities to support a continuous flow combined with the following: • The principles of target costing • Performance measurement • Calculating lean financial benefits Transaction elimination

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17.17 The TOC at Paisley Insurance Company As introduced in chapter 10, Paisley Insurance Company provides a range of insurance products to residential and commercial customers. Figure 17.16 shows the process map of Paisley’s billing department activities.

The following four key activities and available hours are identified as key activities within the billing department.

A recent concern for Paisley’s managers relates to the growing number of customer complaints associated with poor quality billing activities. On further investigation, several sources of bottlenecks have been observed at all stages of the billing department’s processes. For example, account enquiries often require detailed individual advice from Paisley’s insurance sales department.

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Supervisors for the correspondence activity have specialised skills and sometimes holdups in supervisory activities have resulted in accounts not being processed correctly or sent out in time. Bottlenecks in account billing have also occurred with unanticipated breakdowns of their ageing printing machines. Likewise, the verification activity is also performed by specialised employees. Currently, there is a shortage of labour for this activity, particularly while the senior manager is on maternity leave. At varying times, these bottlenecks have contributed to delays in sending bills out (hence, delayed payment to Paisley), as well as billing errors and growing customer complaints. Required (a) Drawing on your knowledge of the TOC, explain how this system might be useful for Paisley Insurance Company. (b) As part of a wider concept of lean thinking, explain how a lean approach might help Paisley Insurance Company improve the quality of the billing department activities. (LO2) (a) TOC centres on identifying bottlenecks or other process constraints. TOC concentrates on the weakest link in the chain that limits the system from achieving higher performance. From the data given about the activities in the billing department there appears to be a number of possible constraints which could be affecting customer service. Potential constraints include: • Lack of staff in sales department • Lack of staff in supervisory roles in correspondence activity • Machine breakdown • Lack of staff in verification activity These constraints have led to delays in sending out bills as well as billing errors which have led to the customer complaints. Students may also discuss the five steps Goldratt propsed to manage the constraints. (b) The lean approach would prompt Paisley Insurance to relook at the activities in the organisation’s value chain with a focus on eliminating non-value adding activities. This would lead to sequencing the work activities so that the service moves smoothly towards the customer. This will be supported by well trained employees and a performance monitoring system to identify bottlenecks and unsatisfory work times. There could also be changes in the structure of organisational units with a move to flatter/team based structures where staff or multi-skilled in the activities that are needed to satisfy customer demand.

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17.18 Throughput costing During its second year of operations, Grilling Machines, an entity that manufactures and sells electric tabletop grills, produced 275 000 units and sold 250 000 units at $60 per unit. The beginning inventory balance was 5000 units. No changes in fixed or variable costs occurred in the second year. The managers expected to sell 220 000 units, the same volume of manufacturing as last year. They set that amount as the normal capacity for allocating fixed overhead costs during the second year. For simplicity, assume that the budgeted fixed manufacturing overhead cost equals the actual cost this period. Also assume that the entity uses the first-in, firstout (FIFO) cost flow assumption. The following costs were incurred during the year:

Required Prepare a statement of profit or loss using throughput costing. (LO2)

Throughput costing Income statement Revenue ($60  250 000)

$ 15 000 000 (3 750 000)

Cost of sales^

11 250 000

Throughput contribution Other costs: Manufacturing conversion costs **

(8 387 500

Selling and administrative#

(2 000 000

Operating income

^ material costs only – reconciliation Beginning inventory $75 000 Direct materials $4 125 000 Goods available for sale $4 200 000 Less ending inventory $450 000 Cost of sales $3 750 000

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**Direct labour and overhead costs Direct labour – 275 000 units x $10 = $2 750 000 Variable manufacturing overhead – 275 000 units x $12.50 = $3 437 500 Fixed manufacturing overhead - $2 200 000 # Selling and adinistrative – $1 375 000 + (250 000 units x $2.50)

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17.19 JIT production Big Bertram uses the just-in-time method to manufacture golf clubs. The manufacturing schedule for the clubs is developed as customers place orders. Each club is made within a cell where five workers have production stations. The raw materials are delivered to the cell as needed. Each worker in the cell performs one step in the manufacturing process and then inspects the club before giving it to the next person. When a club is finished, it is set on a finished goods rack, which is sent to the packaging department at regular intervals. Required (a) What do we call a manufacturing system such as the one used by Big Bertram? (b) Describe general advantages of this type of system. (c) The supplier that manufactures the weights that are inserted in each club head would like to monitor Big Bertram’s inventory levels through the internet so that its new software program could release deliveries at appropriate times. List qualitative factors that might affect Big Bertram’s decision about this proposal. (LO3) (d)

It is a cellular or kanban system. An employee work team manufactures each item in a small workstation using Just-In-Time inventory control methods.

(e)

Each employee inspects his own work, and so defects are caught very quickly. Inventory is delivered to each cell just as it is needed and products are made only when they are ordered so inventory costs are minimised. Usually there are space savings.

(f)

A cellular system succeeds when manufacturing is continuous and the defect rates are low. If the supplier has any problems with the software and deliveries are slow, the line cannot manufacture anything. If there are any problems with quality, it may take longer to get these adjusted because the software has already been released materials for delivery. In addition, Big Bertram would want to emphasise the security aspects of the supplier’s access to its inventory levels. Firewalls and strong security code systems would be needed to protect the integrity of Bertram’s database and specialised software programs. Organisations in competitive industries guard their production information to protect their private information regarding areas of their competitive strengths.

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17.20 Quality costs using ABC versus traditional costing New-Rage Cosmetics uses a traditional cost accounting system to allocate quality control costs uniformly to all products at a rate of 14.5 per cent of direct labour cost. Monthly direct labour cost for Satin Sheen makeup is $27 500. In an attempt to more equitably distribute quality control costs, New-Rage is considering activity-based costing. The following monthly data have been gathered for Satin Sheen makeup.

Required (a) Calculate the amount of quality control cost assigned to each order of Satin Sheen makeup using: (i) activity-based costing (Hint: Total all the ABC costs for one month and divide by the number of orders.) (ii) traditional cost accounting (b) Explain the difference in quality control costs assigned under the two methods. (LO4) (a) 1. Quality control cost per order using ABC Incoming material inspection In-process inspection Product certification Total quality control costs

12 types of material × $11.50 17,500 units × $0.14 25 orders × $77.00

$138.00 2450.00 1925.00 $4513.00

Quality control cost per order

$4513.00/25 orders

$180.52

2. Quality control cost per order using traditional cost accounting Total quality control costs assigned = Direct labour costs × 15.5% = $27 500 × 15.5% = $4262.50 Quality control cost per order = $4262.50/25 orders = $170.50

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(b)

Under the ABC system, the costs are more related to the resources used to insure quality control. These costs are primarily product inspection and certification costs, and the allocated costs change as the types of materials and number of units inspected change. Under traditional cost accounting, direct labour costs may be related to number of units inspected if it takes more labour to produce more units, but in automated manufacturing settings this is not always the case. In addition, direct labour costs are not related to types of materials. Therefore, using direct labour costs to assign quality costs provides poor quality information about the variation in quality control costs among different orders. Accordingly, the ABC system provides more accurate costs for quality control.

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17.21 Quality costs in a lost dogs’ home Suppose that the director of lost dogs’ home is concerned about an increase in number of adopted dogs returned to the home because of behaviour problems. When dogs are returned, the home incurs extra animal intake and adoption costs, in addition to extra costs for board, room and more training for the dogs. In addition, the director is concerned that adopting families may not want another dog because of their unhappy experience. The director views this as a quality problem and wants to improve quality in adoption services and reduce costs at the same time. Required (a) List the four types of quality activities presented in the chapter. What type of quality problem is the lost dogs’ home experiencing? Explain your answer. (b) Will an ABC system help managers determine costs for their quality activities? Explain. (c) List one new cost pool and cost driver that could be used to improve the director’s ability to analyse quality. (LO4) (a)

Quality activities include: • Prevention activities performed to insure defect-free production • Appraisal activities performed to identify defective units • Production activities undertaken in the production or rework of failed units • Post-sales activities undertaken after the product has been sold to remedy problems caused by defects and failed units The shelter is experiencing a post-sales activity when animals are returned because of behaviour problems.

(b)

An ABC system might help managers if it included cost pools related to any of the types of quality activities listed in part 1 above. For example, the system could track the cost of training dogs while they are housed in the animal shelter (prevention), the cost of evaluating dog readiness for adoption (appraisal), the cost of additional training for dogs with greater than normal behavioural problems (production), or the cost of dogs returned because of behaviour problems (postsales).

(c)

There are many possible answers to this question; students may think of other cost pools or drivers. A possible cost pool could be the cost per animal returned. Costs in this pool could include costs for further training activities, for admitting the animal to the facility and working with families to find other animals, and the cost to house the animals while waiting for a new family. The cost driver for this cost pool would be the number of animals returned. There are some costs that cannot be measured, such as the cost of potential adopters who decide not to adopt another animal because of a bad experience.

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17.22 JIT manufacturing Livermore Components is a supplier of drive shafts to the motor vehicle industry. Currently it supplies two of the large car manufacturers in Australia and is also highly ranked in a tender bid to supply drive shafts to a Malaysian car manufacturer. Much of the value chain in the Australian industry is structured on the basis of JIT principles. It has been this way for some time and most of the industry participants compete on this basis. Suppliers to the large car companies (including Livermore) understand they lack bargaining power but most of them find a way to successfully participate. The dilemma facing Livermore’s management is the off-shore contract in Malaysia. If Livermore was to become the successful tenderer, the Malaysian manufacturer would also require component delivery on a JIT basis. Required Using your understanding of JIT principles, outline the ramifications for Livermore if successful in the tender process. (LO3) Livermore has tendered to supply drive shafts to a Malaysian car manufacturer. It can be assumed that the car manufacturer has buyer power and as such can dictate the terms of sale. As a just-in-time supplier the customer will most likely expect the drive shafts when required for production. Given the geographic distance this will pose a problem due to the time taken to ship the goods to Malaysia. To overcome such problems it is likely that Livermore will need to have a warehouse located in Malaysia to enable the justin-time deliveries. However, to support this approach it would be advisable for Livermore to obtain a regular updated production schedule for the next several months from the Malaysian manufacturer so that planning can be done to identify the level of drive shafts that would need to be held offshore. Livermore will also have to analyse what the best method of transporting the drive shafts to Malaysia is – i.e. ship or air transport. Alternatively Livermore could investigate either opening a production facility in Malaysia or outsourcing the production to a Malaysian company.

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17.23 The TOC at a day surgery A senior nurse manager working in an endoscopy clinic in the northern suburbs of Melbourne is contemplating issues that have surfaced with the purchase of a new endoscope (colonoscope) used to investigate intestinal problems. This valuable medical equipment now enables the clinic to process its patients more quickly through the operating theatre; however, there now appears to be bottlenecks elsewhere. Typically, patients begin to arrive at the clinic at 7.30 am. The operating list commences at 8.00 am. There is one administration staff, one surgeon, one anaesthetist, one theatre nurse, one anaesthetic nurse, one recovery room nurse and one recovery lounge nurse. The surgical procedures undertaken are either gastroscopy or colonoscopy. On a typical morning, the patient is first checked in by the administration personnel (15 minutes). They are then required to change into a theatre gown before an anaesthetic nurse assessment to ensure they are prepared and physically ready for surgery (30 minutes). The surgeon and anaesthetist find time between procedures to check the patient has signed the operating consent form and understands the procedure about to be undertaken (2 × 5 minutes). The patient is taken to theatre from the waiting lounge area (by the anaesthetist and anaesthetic nurse) and operated on. The preparation and administration of initial anaesthetic takes 10–15 minutes. The endoscopy procedure takes anywhere between 10 minutes and 40 minutes depending on the procedure (colonoscopy or gastroscopy) and the complexity of the patient’s condition (total average theatre time 20–55 minutes). The endoscopes are prepared by the theatre nurse for the surgeon. The theatre nurse also assists the surgeon during the procedure. Cleaning, sterilisation and preparation takes 40 minutes for either type of endoscope. Once the procedure is complete, the patient is then taken to the recovery area by the anaesthetist and nurse where 30 minutes of recoveryroom nursing observation is administered: 1:1 (patient:nurse) care is provided (5–10 minutes), 3:1 (patient:nurse) care is provided (20–25 minutes). The patient is then moved to the recovery lounge where they are observed by the recovery lounge nurse as they rest on a recliner and provided with refreshments until they are ready to be dressed and discharged (approximately 60 minutes). The patient is generally discharged about 4.5 hours after arriving at the clinic. The surgeon and anaesthetist only operate morning or afternoon shifts (morning: 8.00 am to 12 midday; afternoon: 2.00 pm to 6.00 pm). Sometimes the lists run overtime, but by no more than one hour. Required The senior nurse manager needs to evaluate the maximum number of patient bookings for a typical day and the nursing staff requirements. How might the TOC help with this evaluation? (LO2)

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Important details: Patient arrival 7.30 – procedures commence 8am Staffing: one theatre nurse, one anaestehtic nurse, one recovery room nurse and one recover lounge nurse Activity

Time

Person involved

Time for first patient @ maxium

Administration 15 minutes

Administratio n officer

Pre-op assessment

30 minutes

Anaesthetic nurse

Paperwork check

5 minutes

Surgeon &anaesthetist

15 mins 7.30 am – 7.45 am 30 mins 7.45am to 8.15am 5 mins 8.00am to 8.05am

Op pre& anaesthetic

15 minutes

Anaesthetist & nurse

Time for second patient @ maxium 15 mins 7.45 am 8.00am 8.30 am to 9am

Time for Third patient @ maximum 8.00am to 8.15am

8.05am to 8.10am

8.10am to 8.15am or during cleaning 11.00am to 11.15am 11.40am to 12.35pm 12.35pm to 1.15pm 12.35pm to 12.45pm 12.45pm to 1.05am 1.05am to 2.00pm

9.15am to 9.45am

15 mins 9am to 8.15am to 9.15am 8.30am Average 20 – 55 Surgeon, 55 mins 10.05am theatre time minutes anaethetist & 8.30am to to theatre nurse 9.25am 11.00am Cleaning 40 Theatre nurse 40 mins 11.00am /steralisation minutes 9.25am to to 10.05am 11.40 am Recovery 5-10 General nurse 10 mins 11.40am room minutes 1 for each 10.05am to to patient 10.15am 11.50 am Recovery 20-25 1 for 3 20 mins 11.50 am room minutes patients 10.15am to to 10.35am 12.15pm Recovery 60 1 nurse for all 60 mins 12.15pm lounge minutes patients 10.35am to to 11.35am 1.15ppm Based on above analysis the clinic would only be able to book 3 patients in the 4 hour block. The major constraint appears to be the anaethetist as they cannot undertake the preop procedures for the next patient until the patient in surgery is finished. As the above times are calculated based on maximum surgery time, if the surgery is less than the maximum, then there will be idle capacity on the part of the theatre staff.

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Problems 17.24 Lean accounting and quality Lance Novak recently acquired Chiefs Loft, a restaurant in an inner city suburb of Brisbane. Past records show the restaurant has generally experienced quite good customer numbers. While conducting his due diligence and from the first few weeks in the restaurant, a number of issues/concerns have emerged which Lance believes warrants swift action. These concerns include: • While the customer numbers have been as expected, other than by observation, there is little data maintained on repeat customers. • The process for taking orders is still completed manually and there appears to be duplication and double-handling of paper and documentation. • A number of different suppliers are used, even for similar products. It seems the previous owners would play one supplier off against the other to get better prices. • The ‘production’ process in the kitchen from taking the order to delivering the meal to the customer seems cumbersome with unnecessary delays. • The accounting data seems too late to be of much use in managing the restaurant day to day. Lance has a brother (who works in the strategic consulting area) who has offered to have a look at the restaurant and make some recommendations to improve operations and performance at Chiefs Loft. Required Drawing on your understanding of lean accounting and TQM prepare a report on the recommendations you think Lance’s brother is likely to make. (LO1 and 4) General statement that given the nature of this business it does only produce to customer demand so lean principles would be applicable. Following is a list of points that students may include in their report: • • • •

Analysis of customers – customers per day, customers per sitting, number of repeat customers etc. Customer focus groups to determine menu features and service requirements – these could be identified and ranked in order of customer preference before being used in the target cost analysis Order taking – electronic ordering system whereby the order taken at the table is directly sent to the kitchen – will eliminate the duplication and double handing of the current system Focus on building supplier relationships – rather than playing suppliers off against each other – better to have a manageable number of high quality suppliers.

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• •

Relook at the “production” processes to streamline and eliminate cumbersome and unnecessary delays. Redevelop accounting system for real time information based on actual cost data – late information not useful. Focus on variable costs and avoid cost allocation for product costing.

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17.25 Cost reduction; JIT; value chain analysis Budget Cupboards produces kitchen and bathroom cupboards that incorporate unusual functions, such as specialty drawers for knives and kitchen tools, and kitchen appliance holders that pop up from under the counter top. Competition in this industry has recently increased. Budget’s management wants to cut costs for its basic cupboard models and then cut prices. Required (c) The following table lists potential areas for cost reduction. Two potential cost reductions are provided for the first area listed (design phase). For each of the remaining areas, identify two potential ways that Budget Cupboard’s management could reduce costs.

(b) Budget Cupboards does not currently use just-in-time production. Describe several advantages of using these methods when price competition increases. (LO3) (a)

Here are possible answers to this question; students may think of others.

Potential Area for Cost Reduction Manufacturing process

Potential Cost Reduction (i) (ii) Reduce inventory by using a Reduce inspection by using JIT system cellular manufacturing (also increases flexibility so that specialty items can be manufactured to order more easily) Administration Outsource functions such as Explore software that would payroll if it is cheaper to do increase efficiency and so reduce number of employees needed Changes in quality Identify specialty functions Identify lower cost materials or functionality with low volume sales and that would not reduce current consider discontinuing them quality (b) To price more competitively, overall costs need to be reduced without affecting product quality or functionality. Value chain analysis and JIT are methods that are used to reduce costs. JIT manufacturing reduces inventory storage and insurance costs, and frees up extra space in the manufacturing plant. If there are alternative uses for the space, the overall contribution margin should increase. Value chain analysis enables managers to categorise activities into value-added

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and non-value added. Then the non-value added activities are eliminated or minimised to save costs. The supply chain can be analysed to determine whether vendors can reduce their costs or provide higher quality goods and services at the same price.

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17.26 Inventory management system; data accuracy; internal controls; estimating benefits Automotive parts company Mopar implemented a new inventory management system costing $1.5 million. Mopar distributed parts from three central and 11 regional warehouses to hundreds of parts dealers. The entity filled orders for approximately 1 million line items per week from an inventory of 280 000 parts for Chrysler, Dodge and Jeep brand vehicles. Mopar implemented the new system to improve its management of inventory levels. The entity previously maintained inventories based on forecasted demand, but often ran out of some parts and carried inventory levels that were too high for other parts. When a customer ordered a part that was out of stock at a particular warehouse, the entity incurred extra costs to search for the part at other warehouses. If the part was not found, Mopar placed a rush order to have it shipped directly to the customer from one of its 3000 suppliers. When inventory of a part was too high, valuable warehouse space was wasted and the entity incurred unnecessary inventory carrying costs. To reduce these types of problems, the company had manually tracked data for 100 of the highest-cost and best-selling parts. The managers used measures such as how often a part was out of stock to adjust inventory purchases. The new inventory system included a database that would track parts at all warehouses as well as suppliers, customers, and forecast levels. The system helped managers identify $3.5 million in overstocked inventory. They expected an additional $10 million in annual savings from reduced backorders and rush orders. Required (a) Is Mopar’s new inventory system likely to completely eliminate out-ofstock occurrences? Why? (b) Discuss whether it would be beneficial for Mopar to institute a JIT inventory management system. (c) Benefits from Mopar’s new system depend on the accuracy of data in its inventory database. Identify possible reasons why the data may be inaccurate. (d) Describe possible internal controls that could prevent or detect and correct inaccuracies in Mopar’s inventory database. (e) Mopar’s managers expected to achieve $10 million in annual savings from reduced backorders and rush orders. Suppose you are asked to develop an estimate of these savings. How might you go about making the estimate? Why types of data would you use? What types of assumptions would you need to make? (LO3) (a)

No, the new system is not likely to completely eliminate out of stock occurrences. Although it will track inventory levels across the supply chain, out-of-stock occurrences could still occur when demand for a given part exceeds forecasts or when delays occur in manufacturing or delivery. However, the company should experience fewer out-of-stock occurrences under the new system than under the

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old one because the new system tracks activity for all parts, not just the 100 highest-cost and best-selling ones. (b)

Students do not know exactly how Mopar does business with its customers, so they need to speculate, which is a more difficult task. Most likely, Mopar’s customers are parts distributors and, perhaps, individual auto repair shops. Those companies’ customers are individual consumers who need a part to repair a vehicle. When an average consumer brings a vehicle to a repair shop, they expect most parts to be available that same day. This means that some company — the repair shop or a nearby distributor — must carry a large number of parts that can be delivered immediately. Accordingly, Mopar’s ability to institute a JIT inventory management system could depend on whether its customers demand fast delivery. If Mopar would lose significant amounts of sales if it is no longer to meet fluctuating demand for parts, then a JIT system might not be possible for its deliveries to customers. However, Mopar could still institute a JIT system for delivery of raw materials to its production systems. It could use forecasted deliveries to its customers, plus some amount of safety stock for its own warehouses, to plan its manufacturing operations.

(c)

Data can be inaccurate because of errors, such as entry of incorrect part numbers, when inventory is transferred. It can also be accurate because of errors in counting and compiling physical inventory counts. Mopar’s new system relies on the accuracy of inventories at each of its own warehouses as well as the accuracy of suppliers’ and customers’ inventories. Thus, errors in any of these systems will cause inaccuracies in the data used by Mopar to forecast production and shipment requirements.

(d)

The use of electronic systems for recording inventory movement, such as bar codes or RFID tags, can reduce errors caused by human transaction entry. Errors can also be reduced by frequently counting physical inventories and adjusting accounting records to the physical counts. These controls also reduce database inaccuracies caused by inventory theft, by providing managers with more timely information about inventory shrinkage problems. Additional controls to prevent inventory theft include security, such as warehouse access restrictions and computerised controls over the inventory database.

(e)

The estimate of annual savings from reduced backorders and rush orders was probably based on probability distributions of these events under the new and old systems. For example, think about a part that was not individually tracked under the old system. Mopar had information about prior period inventory levels, but it did not have records about the quantity and timing of individual sales or of inventory levels at its suppliers or customers. The new system allows the company to monitor these items. Over time, this monitoring will allow Mopar to better forecast its inventory needs. The estimated savings consist of two items: (1) a reduced probability of backorders for the part times an estimated cost of fulfilling a backorder, and (2) a reduced probability of rush orders for the part times an estimated cost of fulfilling a rush order. The probabilities would most likely be developed from the system software itself; the company would establish an acceptable probability of these events, and the system would build these probabilities into the production and distribution forecasts. The estimated costs

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of filling a backorder or a rush order could be based on an analysis of the incremental costs associated with these activities. The annual savings estimates depend on assumptions about the new system’s ability to achieve given probabilities of backorder and rush order events, and it also assumes that the company can accurately estimate the costs of these events. An assumption also exists that the new system does not alter manufacturing costs.

Solutions manual to accompany

Management accounting th 4 edition

by Eldenburg et al. Prepared by Albie Brooks

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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Chapter 18: Responsibility accounting, performance evaluation and transfer pricing 47 Questions 18.1

Explain the differences between general and specific knowledge. Give an example of an industry where knowledge is quite general and an example of an industry that requires specific knowledge. (LO1)

General knowledge is usually easy to transfer throughout an organisation. Specific knowledge is more detailed and is therefore more costly to transfer throughout an organisation. General knowledge is needed in the food and beverage manufacturing, in clothing manufacture, and in restaurants and bars, among others. Specific knowledge is important to software companies, bio-tech organisations and healthcare organisations, among others.

18.2

Explain why organisational form may vary if specific knowledge versus general knowledge is needed for decision making. (LO1)

If general knowledge is required for success within an organisation, a centralised form is usually best because knowledge can easily be transferred to headquarters where decision making can be done from the perspective of the overall organisation. If specific knowledge is required, it is costly to transfer to headquarters, so a decentralised form is usually best because the decision-making authority lies with the people with specific knowledge to make the best decision. 18.3

Identify the four different types of responsibility centres and explain the general objectives of each. (LO2)

The four responsibility centre descriptions and objectives follow. Cost Centres: In cost centres, managers are held responsible only for the costs under their control. Some cost centres provide support services that are relatively easy to monitor because their outputs are measurable. Cost centres are also used for subunits that produce goods or services that eventually will be sold by others. Managers in these cost centres are responsible for producing their goods or services efficiently. In discretionary cost centres (marketing, research and development, for example), the output is not easily measurable in dollars or activities. Cost centres are found in for-profit, not-for-profit, and government organisations. Cost centre managers are expected either to minimise costs for a certain level of output or to maximise output for a certain level of cost. Revenue Centres: In revenue centres, managers are held responsible for the revenues under their control. Revenue centres frequently sell products from manufacturing subunits. Managers are expected to maximise revenues. Profit Centres: Managers in profit centres are held responsible for both revenues and costs under their control. Profits centres produce and sell goods or services,

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and may include one or several cost centres. Profit centre managers are responsible for decisions about inputs, product mix, pricing, and volume of goods or services produced. The objective of profit centres is to maximise profits. Investment Centres: Managers of investment centres are held responsible for the revenues, costs, and investments under their control. Investments include any assets related to the investment centre, such as fixed assets, inventory, intangible assets, and accounts receivable. Investment centres resemble profit centres, where profitability is related to the assets used to generate the profits. The objective of investment centres is to maximise the return on investments made by the organisation. This means the most profitable projects must be identified and selected for investment. 18.4

A national company, Fast Print, decided to expand into several developing countries. The company has been managed under a centralised organisational form, but is considering changing to a decentralised form. List the advantages and disadvantages of making this change. (LO1)

Advantages: Because expansion is into other countries, decision making will be timelier and probably more appropriate because local managers understand the local markets. The need to communicate detailed information up and down the organisation will be reduced. The people making the decisions have the most knowledge and expertise. Disadvantages: The decision makers may have objectives that are different from the overall company’s objectives. Decisions need to be coordinated among all of the divisions to reduce non-optimal behaviour such as duplication of products or services. Investment in new projects may not reflect the best opportunities, but instead reflect the most persuasive decision maker. 18.5

Explain how return on investment (ROI) is calculated and how it can be decomposed into two financial measures. (LO3)

ROI is calculated by dividing operating income by average assets, or income/assets. It can be decomposed as follows: ROI = sales/assets × income/sales.

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18.6

Explain how and why the use of ROI for performance evaluation can cause managers to make decisions that could be harmful to an entity in the long run. (LO3)

ROI can be increased by cutting costs or reducing assets. Cost cutting can improve short-term results but harm long-term results if discretionary expenditures such as advertising and research and development are cut. Similarly, reducing investment in new projects could improve ROI in the short term, but harm the organisation in the long term.

18.7

Explain how residual income is calculated, and define required rate of return in your own words. (LO3)

Residual income = operating income – (required rate of return × average operating assets). Many organisations have a minimum return that is expected on operations and new investments, this is their required rate of return.

18.8

Explain why the use of residual income for performance evaluation provides better incentives, in some ways, than ROI, but still causes managers to make some decisions that could be harmful to an organisation in the long run. (LO3)

The size of investment affects residual income less than ROI because it is used only to value the dollar amount of expected return, not as a denominator. Residual income is therefore less influenced than ROI by changes in investment, but it is still subject to the same disadvantages as ROI that affect the operating income — such as cost cutting to discretionary expenditures.

18.9

Explain how EVA differs from residual income. (LO3)

EVA is very similar to residual income because both subtract from operating income some measure of interest times investment. EVA is different than residual income because many adjustments are made to all parts of the calculation. For example, after tax operating income is usually used in EVA, whereas before tax operating income is usually used in RI. The assets are also adjusted under EVA, for example long-term leases are usually capitalised. There are over 160 possible adjustments that can be made to RI under EVA.

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18.10 An organisation’s plant in Queensland manufactures a product that is shipped to a branch in Tasmania for sale. Does it make any difference which branch (each is a profit centre) is charged for the cost of transportation? Explain. (LO2 and 4) From the overall organisation’s point of view, it does not matter which branch pays for shipping. However, if each branch is held responsible for their own costs, each would prefer to have the other one pay for shipping charges because costs in the paying branch will be increased.

18.11 Suppose transfer prices are set at market prices and a manager who previously purchased internally begins to purchase externally. Explain what it means to say that the outsourcing decision might have been suboptimal. (LO4) A suboptimal decision is one in which the overall organisation does not receive as high a contribution as is possible. If it is cheaper to produce the product or service internally, but the transfer price is set so that the incentive is to purchase externally, more is being paid for the good or service than should be, and a suboptimal decision has been made.

18.12 Describe as many different methods for setting transfer prices as you can. (LO4) Transfer prices can be set based on cost (variable, variable plus some fixed costs, or variable and a fully allocated fixed cost), or based on market price for the good or service (and there may be a variety of ways to estimate the market price). Alternatively, transfer prices can be negotiated between two divisions. The seller could receive market price and the buyer could receive variable cost under a dual-rate method. Lastly, an organisation could decide not to charge for transfers.

18.13 Cost allocation has no impact on the transfer price set. Discuss. (LO4) If an entity has a transfer pricing policy of full cost plus mark-up, then cost allocation can become an issue at the divisional level. For example the selling division could be motivated to allocate more costs to those goods/services being transferred to gain a higher profit for the division overall.

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18.14 'Transfer pricing is a waste of an entity’s resources; it all gets eliminated on consolidation'. Discuss. (LO4) Yes this is correct at the entity level. However, transfer pricing enables an assessment of divisional performance. As noted in the scene setter about Westpac “..To assess the financial performance of the revenue generating divisions it is necessary to identify the revenue and costs incurred in the operations. If the full cost of operating the divisions is to be used then it is necessary to recognise the use of resources from the shared services divisions..:”

18.15 Why do you consider that taxation authorities require an international transfer price to be set based on an arm’s length transaction? (LO4) To ensure that the government receives its fair share of taxes for entity activities in its country. For example, without the rules put in place by the Australian Taxation Office an entity would be motivated to transfer the higher costs to a high taxing country, and lower costs to a low taxing country.

18.16 At a recent management meeting at Skyward Industries, the Transport Division manager was heard to say “this transfer pricing is a waste of time – at the end of the year all the internal transactions are eliminated on consolidation in the financial reports”. Comment on this statement. (LO4) The manager is correct in identifying that internal transactions are eliminated on consolidation as financial reports are prepared. From a financial accounting perspective, there is no revenue generated or cost involved in internal transfers. In simple terms, a firm cannot generate revenue by selling items to itself. From a management accounting perspective, however, transfer pricing is important for a number of reasons: •

• •

Internal transfer prices enable management accountants to more accurately evaluate the performance of internal departments. If the costs and revenues involved with internal transfers are ignored, it would be difficult to reliably measure the overall performance of internal departments. Ensure that any internally transferred products and services are used efficiently. If there is no transfer price, there is no consequence for inefficient use by the receiving department. Enable internal managers to evaluate the financial consequences associated with either: 1. receiving products and services from other internal departments, or 2. from external suppliers.

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48 Exercises 18.17 Residual income; ROI; EVA The following selected data pertain to Garfield Landscaping for last year.

Required (a) Calculate the residual income. (b) Calculate the return on investment. (c) Calculate the economic value added. (LO3) (a)

Residual income = operating income – (rate of return × average assets) = ($2 000 000 – $1 200 000 – $200 000) – (15% × $3 000 000) = $600 000 – $450 000 = $150 000

(b)

ROI = operating income / average investment = $600 000/$3 000 000 = 20%

(c)

EVA = adjusted after-tax income – [weighted average cost of capital × (adjusted total assets – current liabilities)] = [$600 000 × (1-0.36)] – [12% × ($3 000 000 – $200 000)] = $384 000 – $336 000 = $48 000

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18.18 ROI; residual income; breakeven point; contribution margin Mirror Industries laminating division, BrightShine, incurred the following costs and expenses in the last period.

During the period, BrightShine produced 300 000 units of industrial photo prints, which were sold for $2 each. Mirrors’s investment in BrightShine was $500 000 and $700 000 at the beginning and ending of the year, respectively. BrightShine’s weighted average cost of capital is 15 per cent.

Required (a) Determine BrightShine’s return on investment for the year. (b) Compute BrightShine’s residual income (loss) for the year. (c) How many industrial photo print units did BrightShine have to sell during the year to break even? (d) What was BrightShine’s contribution margin for the year? (LO3) Note: Part C of this problem requires knowledge of breakeven analysis from Chapter 4.

(a)

Before calculating ROI, it is first necessary to calculate income: Sales (300 000 @ $2) Variable costs Fixed costs Income

$600 000) (450 000) (90 000) $ 60 000)

ROI = $60 000/[($500 000 + $700 000)/2] = 10% (b)

Residual income:

Income Minimum return [($500 000 + $700 000)/2 × 0.15] Residual income (c)

$60 000) (90 000) $(30 000)

Variable cost per unit: $450 000/300 000 = $1.50

Breakeven number of units: $2Q – $1.50Q – $90 000 = 0 $0.50Q = 90 000 Q = 180 000 units (d)

Sales

$600 000

Variable costs Contribution margin

450 000 $150 000

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18.19 EVA for segments Following is information for the Fulcrum Company’s three business segments located in Europe.

Fulcrum’s applicable tax rate for the segments is 30 per cent, and its weighted average cost of capital for each segment is 10 per cent. Required Determine the segment with the highest EVA. (LO3) Segment C has the highest EVA: Segment A EVA = after-tax income – WACC × (assets – current liabilities) = [$8 000 000 × (1-0.30)] – [10% × ($32 000 000 + $8 000 000 – $4 000 000)] = $5 600 000 – $3 600 000 = $2 000 000 Segment B EVA = [$4 000 000 × (1-0.30)] – [10% × ($30 0000 000)] = $2 800 000 – $3 000 000 = ($200 000) Segment C EVA = [$6 000 000 × (1-0.30)] – [10% × $21 000 000] = $4 200 000 – $2 100 000 = $2 100 000

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18.20 ROI, EVA, residual income Senior management at Harriot Industries, an Italian-based fashion house and cosmetics company, have been engaged in a debate around the best key financial measure relevant to evaluate the performance of senior executives and divisional managers. Currently, the performance of senior managers and divisional managers is based on return on investment (ROI), which forms the basis of the bonus payments, provided ROI increases are achieved each year. The main source of tension seems to be that some of the accounting staff are pushing for the use of economic value added (EVA) or, at the very least, residual income (RI) to be used at both the senior executive and divisional levels. You have been asked to contribute some views. On a recent visit to the head office of Harriot Industries you were able to access details on a printout from a digital whiteboard that represented a discussion about performance measures and a potential investment project in the Logistics Division. Some of this material is provided below.

Required Using the information provided in the table, demonstrate (perhaps including calculations) the key arguments that might be put forward to support the view that the sole use of return on investment (ROI) may be inappropriate, particularly at the divisional level. (LO3) The criticism often levelled at the sole use of ROI at the divisional level is that it may encourage decisions that in the short-term may be benefit the division or divisional manager, but in the longer-term may not be in the best interests of the firm. Here at Harriot Industries it is important to note that bonus payments for divisional managers are based on ROI performance alone. The information about the investment project on the whiteboard helps with our understanding of this. First of all, the NPV is positive. Provided the project meets Harriot’s other benchmarks such as in line with corporate and divisional strategies, the project looks favourable. However, if the project is adopted the ROI of the division will, in the short-term, decrease: the current ROI of the division is 16%, while the average ROI of the project in the first two years is 10%. Note this average is still above the current hurdle rate of 9%. Any reduction in ROI for the division will result in no bonus payment to the divisional manager. By way of illustration, if residual income had been the key performance measure, a different decision may have been encouraged: the residual income on the project is positive (12% v’s 9%); so the incentive not to invest is removed. Note, there may be other reasons not to invest in the project. Our emphasis here is on the potential for the performance measure to influence decision making.

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18.21 ROI; residual income; explaining the better measure The following financial data are for the evaluation of performance for Sandy Point Construction:

Sandy Point Construction currently uses return on investment to evaluate investment centre managers. An accounting intern from the local university suggested to the controller that residual income may be a better performance measure. Required (a) Calculate ROI for Sandy Point Construction. (b) Calculate residual income for Sandy Point Construction. (c) Write a brief memo to the controller explaining why residual income is a better performance measure. (LO3) (a)

ROI = $65 000/$500 000 = 13%

(b)

Residual income = $65 000 – (0.10*$500 000) = $65 000 – $50 000 = $15 000

(c)

There are many different ways this memo could be written. However, the memo would need to explain the behavioural implications of ROI: (1) the tendency to forego profitable projects that are less than the current ROI, and (2) that cutting costs that lead to long-term benefit improves the measure. In addition, it does not incorporate any measure of risk.

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18.22 Lease versus buy decision; ROI; residual income; EVA; manager incentives Refer to the information in Problem 18.21. The manager of Sandy Point Construction is considering a new project. She can buy or lease equipment that will reprocess tailings from old mines to remove any traces of gold left behind by the original separating processes. The purchase price of the equipment is $150 000. The cost to lease is $2000 per month. She estimates the return (incremental revenues minus incremental expenses, including lease cost) to be $40 000 per year. She knows that purchasing the equipment will increase the value of average operating assets. If she leases the equipment, expenses will increase, but not assets. (In other words, the lease will be accounted for as an operating lease.) Although it is more cost effective to purchase the equipment, she has decided to lease it.

Required (a) Calculate the new ROI if the equipment is (i) purchased or (ii) leased. (b) Calculate the new residual income if the equipment is (i) purchased, or (ii) leased. (c) One of the adjustments that can be made using EVA is to treat all operating lease costs as if they were purchases — in other words, to capitalise the lease. If Sandy Point Construction used EVA with this adjustment, how might the manager’s incentives and behaviour change? Explain. (LO3) (a)

Lease ROI New operating income = $65 000 + $40 000 – (12 × $2000) = $93 000 ROI = $93 000/$500 000 = 18.6% Purchase ROI New operating income = $65 000 + $40 000 = $105 000 Total assets including new = $650 000 ROI = $105 000/$650 000 = 16.2%

(b)

Lease residual income RI = $93 000 – (0.10 × $500 000) = $93 000 – $50 000 = $43 000 Purchase residual income RI = $105 000 – (0.10 × $650 000) = $40 000

(c)

If the performance measure causes managers to be indifferent (from the perspective of their compensation) to leasing or purchasing, they are more likely to base the decision on factors that create more value for the firm.

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18.23 ROI; transfer prices; taxes; employee motivation Fowler Electronics produces colour plasma screens in its Bien Hoa plant in Vietnam. The screens are then shipped to the entity’s plant in Sturt, South Australia, where they are incorporated into finished televisions. Although the Bien Hoa plant never sells plasma screens to any other assembler, the market for them is competitive. The market price is $750 per screen.

Variable costs to manufacture the screens are $350. Fixed costs at the Windsor plant are $2 000 000 per period. The plant typically manufactures and ships 10 000 screens per period to the Sturt plant. Taxes in Vietnam amount to 30 per cent, of pre-tax income. The Windsor plant has total assets of $20 000 000. The Sturt plant incurs variable costs to complete the televisions of $110 per set (in addition to the cost of the screens). The Sturt plant’s fixed costs amount to $4 000 000 per period. The 10 000 sets produced each period are sold for an average of $2500 each. For Sturt, the tax rate is 45 per cent of pre-tax income. The Sturt plant has total assets of $30 000 000. Required (a) Determine the return on investment for each plant if the screens are (b) (c) (d) (e)

transferred at variable cost. Determine the return on investment for each plant if the screens are transferred at market price. To reduce taxes, will Fowler prefer a transfer price based on cost or market price? Explain. Will the top managers in each plant prefer to use cost or market price as the transfer price? Explain. How would you resolve potential conflict over the transfer price policy?

(LO3 and 5) (a)

ROI if the screens are transferred at variable cost: Windsor Revenue (10 000 × $2500) Variable production costs: (10 000 × $350) (10 000 × $110) Fixed production costs Transfer price (10 000 × $350) Pretax income (loss) Income taxes (a) Net income (loss) Total assets ROI (Net income / Investment)

Sturt $25 000 000)

$(3 500 000) (2 000 000) 3 500 000) (2 000 000) 0) $(2 000 000)

(1 100 000) (4 000 000) (3 500 000) 16 400 000) (7 380 000) $9 020 000)

$20 000 000)

$30 000 000)

(10)%

30%

Income tax calculations:

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The Bien Hoa plant has a loss. However, if the Bien Hoa plant does not sell to outside customers, then it might always incur a loss if variable cost is used as the transfer price. Therefore, the income tax effect is estimated as zero. Tax for Sturt plant = $16 400 000 × 45% = $7 380 000 (b)

ROI if the screens are transferred at market price: Windsor Revenue (10 000 × $2500) Variable production costs: (10 000 × $350) (10 000 × $110) Fixed production costs Transfer price (10 000 × $750) Pretax income (loss) Income taxes (a) Net income (loss)

Sturt $25 000 000)

$(3 500 000)

Total assets

(2 000 000) 7 500 000) 2 000 000) (600 000) $1 400 000)

(1 100 000) (4 000 000) (7 500 000) 12 400 000) (5 580 000) $6 820 000)

$20 000 000)

$30 000 000)

23%

ROI (Net income / Investment)

Income tax calculations: Tax for Windsor plant: $2 000 000 × 30% = $600 000 Tax for Sturt plant = $12 400 000 × 45% = $6 820 000 (c)

The firm will prefer the market transfer price because it maximises company income. Total income is increased through tax rate differences between Vietnam and Australia. The net tax advantage of using market value for the transfer price is: Taxes if transfer price is the variable cost: Biet Hoa Sturt Total Taxes if transfer price is the market value: Biet Hoa Sturt Total Difference

$ 0 7 380 000 $7 380 000 $ 600 000 5 580 000 6 180 000 $1 200 000

(d)

The Biet Hoa plant manager will prefer to transfer at the market price, and the Sturt plant manager will prefer variable cost because these transfer prices make their operations look best.

(e)

Use of either the dual rate or the negotiation method would give managers the information they need to make the best decisions for the overall corporation. A problem with the dual rate method is that both plants appear to be more profitable than they really are. A problem with negotiating is that manager time can be tied up on activities that do not necessarily add value to the overall firm.

18.24 Transfer price; sale to outside versus inside customer

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The Enviro division of Solar Sun produces electric motors, 20 per cent of which are sold to the Energy Plus division of Solar Sun and the remainder to outside customers. Solar Sun treats its divisions as profit centres and allows division managers to choose their sources of sale and supply. Corporate policy requires that all interdivisional sales and purchases be recorded at variable cost as transfer price. Enviro division’s estimated sales and standard cost data for 2017, based on its full capacity of 100 000 units are as follows:

Enviro has an opportunity to sell the 20 000 units to an outside customer at a price of $75 per unit on a continuing basis. Energy Plus can purchase its requirements from an outside supplier for $85 per unit. Required Assuming that Enviro division desires to maximise its gross margin, should Enviro accept the new customer and drop its sales to Energy Plus for 2019? Why? (LO4 and 5) There are several ways to solve this problem. Here is one approach: First, consider the per-unit differences in cost and revenue for the two options. Enviro’s variable cost per unit is $45. If Enviro sells to outsiders at $75 per unit, the contribution margin is $30 to Enviro, so its gross margin improves by $600 000 ($30 × 20 000 units). If Energy Plus replaces Enviro’s units with $85 units from an outside supplier, the total cost per unit is $55 ($85 cost from outside vendor less the $30 contribution margin from outside customer). The variable cost of these units is $45 each, so Solar Sun’s gross margin is maximised only by transferring the units internally at a savings of $10 per unit. Here is another approach: Notice that none of Enviro division’s costs will change if it accepts the new opportunity; the division will continue to operate at full capacity. The only change in its gross margin will be the difference in revenue: Revenue from new customer (20 000 × $75) Current revenue from Energy Plus division Increase in revenue

$1 500 000 900 000 $ 600 000

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Based on the preceding calculation, the Enviro division will be better off if it accepts the new order. However, the company as a whole will not be better off. The company will receive outside revenue of $75 per unit and it will pay an outside supplier $85 per unit, for a net decrease in gross margin of $10 per unit.

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18.25 Choice of transfer price The following information relates to a new computer chip that Hand Held has developed for its new mobile phone that contains a personal organiser:

The variable costs of the mobile phone division will be incurred whether it buys from the chip division or from an outside supplier. Required (a) What is the highest price that the managers of the mobile phone division would want to pay the chip division for the chip? Explain. (b) If the chip division is working at full capacity and cannot produce additional units, what transfer price for the chip would be best for the entity as a whole? Explain. (c) If the chip division is not operating at capacity and has no prospect of reaching capacity, what is the lowest price its managers would typically be willing to sell chips to the mobile phone division? (LO4 and 5) (a)

The contribution margin is $8 for the mobile phone division, so they will only be willing to pay what they pay now ($12) plus up to $8 more or $20, although they may not want to assemble the cell phones at break even.

(b)

Chips should be sold in the division that has a $12 contribution margin rather than $8 contribution margin. If market price is used for the transfer price, units will always be sold externally instead of internally.

(c)

If the chip division has plenty of excess capacity, the transfer price should be the variable cost because the chip division could not sell the chips otherwise.

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18.26 Transfer pricing Georgina Chan is the chief financial officer of Colorado Pty Ltd, which has three interdependent divisions where, on average, about 30 per cent of the output of one division is transferred to one of the other divisions. She is currently dealing with a dispute within the accounting office about the best way to treat transfer pricing within the company. The chief executive officer has advised that any change to the policy should not compromise what is best for the company overall. Senior accountant Andy Chan says ‘as we are a highly decentralised firm, the only way to go is to use market price as the key method and allow sourcing autonomy’. Meanwhile, graduate accountant Roger Singh says ‘I disagree. If we go with full cost plus a 15 per cent mark-up and no sourcing autonomy, that would be best’. Required State one advantage and one disadvantage of each proposed policy and advise which policy you think would serve the company best. Briefly explain. (LO4 and 5) Market-based transfer policy and sourcing autonomy Best suited in conditions where: a reliable market price is available, divisions are more independent, and the benefits of competition are deemed greater than co-operation. With sourcing autonomy, and the availability of a reliable market price, Full cost plus 15% mark-up and no sourcing autonomy May produce a price similar to market price but with no sourcing autonomy means divisions must transact internally. Use of full-cost provides little incentive for supplier divisions to reduce costs. Colorado has a reasonable amount of interdependency between each of the divisions so a highly competitive environment would seem less suitable. This may mean the market based price with sourcing autonomy is less suitable in this setting.

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Problems 18.27 Transfer price; incentives for internal services Avra Valley Services has two divisions, Computer Services and Management Advisory Services. Both divisions work for external customers and, in addition, work for each other. Fees earned by Computer Services from external customers were $400 000 in 2017. Fees earned by Management Advisory Services from external customers were $700 000 in 2017. Computer Services worked 3000 hours for Management Advisory Services last year, and Management Advisory Services worked 1200 hours for Computer Services. The total costs of external services performed by Computer Services were $220 000, and for Management Advisory Services costs were $480 000.

Required (a) Determine the operating income for each division and for the company as a whole if the transfer price from Computer Services to Management Advisory Services is $50 per hour and the transfer price from Management Advisory Services to Computer Services is $60 per hour. (b) The manager of Computer Services has found another company willing to provide the same services as Management Advisory Services at $50 per hour. All of the employees in both units are guaranteed 40-hour work weeks. Currently, Management Advisory Services has idle capacity because of an economic downturn. Calculate the change in operating income for the entity as a whole if Computer Services uses outsourced services instead of using Management Advisory Services. (c) Recommend a transfer price policy that would provide incentives to use the internal services. Explain your recommendation. (d) Discuss possible qualitative factors that might affect the attractiveness of the outsourcing option. (LO4 and 5) (a) External revenues Internal transfer: $50 × 3 000 hours $60 × 1 200 hours Total costs Operating Income

Computer Services $400 000 150 000 (72 000) (220 000) $258 000

Management Advisory $700 000 (150 000) 72 000 (480 000) $142 000

(b)

Net income for the company currently = $400 000 ($258 000 + $142 000). The new income would be $340 000 [$400 000 – ($50 × $1200)].

(c)

Avra Valley could use an opportunity cost for the transfer price. This could be the variable costs for services. Although labour is guaranteed a wage, the hourly labour rate and cost of any supplies used in these services would approximate an opportunity cost. This way, the department that provides services receives credit for its work, but the department purchasing services is not charged as much as outsourcing would cost.

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(d)

Qualitative factors would include quality of service or level of technical expertise. Managers need to determine whether better quality of service or expertise would be provided inside the organisation or by outsourcing. Another potential qualitative factor is the possible effect on employee moral if the outsourcing option is taken and the firm lays employees off.

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18.28 Choice of transfer price, fairness to managers Prem International has two large subsidiaries, Oil and Chemical. Oil is an oil-refining entity, and its main product is petrol. Chemical produces and sells a variety of chemical products. Chemical owns a polystyrene processing plant next to Oil’s refinery. The polystyrene plant was built at the same time that Oil built a benzene plant at the refinery. Benzene is the raw material needed by Chemical to produce polystyrene. Chemical’s managers believe they can sell 100 million units of measure of polystyrene per year, which is less than full capacity. Following are Chemical’s expected revenues and costs for the polystyrene plant (volume is measured using units of measure in weight is not affected by temperature):

Oil can operate at full capacity and sell all of the petrol it produces. Following are Oil’s expected revenues and costs for the production of petrol:

For every kilogram of benzene that Oil produces, it will forgo selling a litre of petrol. However, 100 million kilograms per year would be only a small portion of total volume at the refinery. Following are Oil’s expected revenues and costs for the production of benzene (these costs include the costs of refining the crude oil):

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Required (a) On (b)

(e) (f)

an entity-wide basis, should Prem International produce polystyrene this year? Why? Using the usual quantitative rules for short-term decisions what is the maximum price that Chemical’s managers would be willing to pay for benzene? Would Chemical’s managers be willing to pay the maximum transfer price calculated in part (b)? Why? Using the usual quantitative rules for short-term decisions, what is the minimum price that Oil’s managers would be willing to receive for benzene? Would Oil’s managers be willing to receive the minimum transfer price calculated in part (d)? Why? What transfer price might be fair to the managers of both subsidiaries? Explain.

(LO4 and 5) (a)

Fixed costs are not relevant because it is unlikely that they would change under the two options. Following is a calculation of the contribution margin under each option Contribution margin for each kilogram of petrol: Selling price Crude oil Variable production costs Net

$0.16 (0.06) (0.02) $0.08

Contribution margin for each kilogram of polystyrene: Selling price Chemical variable production costs Crude oil Oil variable production costs Net

$0.30 (0.03) (0.06) (0.04) $0.17

Additional contribution margin for each kilogram of polystyrene

$0.09

Times expected quantity of polystyrene sold

100 million kilograms

Expected increase in pre-tax profit from selling polystyrene (b)

$9 million

Using the usual quantitative rules for short term decisions, the maximum transfer price Chemical would be willing to pay is the price at which Chemical’s contribution margin for Benzene would be zero, calculated as follows: Per Kilogram Selling price $0.30 Chemical variable production costs (0.03) Contribution margin before cost of Benzene $0.27 Chemical’s managers would be willing to pay up to $0.27 per kilogram for the Benzene.

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(c)

At a price of $0.27, the subsidiary would earn zero contribution margin, and it would report a net loss equal to its fixed costs. Assuming that the fixed cost of $0.05 per kilogram was based on 100 million kilograms of production, this means that Chemical would report an operating loss on Benzene of $5 million. At the same time, Oil would report a sizeable profit on the Benzene: Per Kilogram Transfer price $ 0.27 Crude oil (0.06) Oil variable production costs (0.04) Additional contribution margin $ 0.17 In #1 above, the contribution margin of selling petrol was calculated to be $0.08 per kilogram. Thus, Oil would report an incremental contribution margin of $0.09 ($0.17 – $0.08) per kilogram of Benzene produced. In other words, Oil would receive all of the company-wide benefit of selling Benzene. Chemical’s managers would be unhappy with this arrangement, because they would be responsible for selling the product but would receive none of the company-wide incremental profit.

(d)

Using the usual quantitative rules for short-term decisions, the minimum transfer price Oil would be willing to receive is the price equal to the contribution margin that Oil gives up ($0.08 per kilogram) plus the additional variable cost that Oil will incur if it produces Benzene (incremental variable production cost of $0.02 per kilogram) or $0.10 per kilogram.

(e)

Oil’s managers probably would not be willing to accept the transfer price of $0.10 per kilogram, because in this case Chemical would receive all of the companywide incremental profit. Because Oil can sell all of the petrol it produces, its managers have no incentive to produce a product for which they receive no incremental profit.

(f)

The most fair transfer price would be somewhere between $0.10 and $0.27 per kilogram (i.e., between the prices calculated in #2 and #4 above). In negotiations, however, the managers of Oil could have the upper hand. Because Oil is operating at full capacity and can sell all of its production elsewhere, its managers might be able to require a transfer price of $0.27. In this case, Chemical’s managers may have no option but to accept a transfer price of $0.27 (and to report operating losses every year because of its fixed costs). Sometimes companies establish transfer prices that reflect the degree of risk assumed by each responsibility centre. In the Prem International problem, this might mean that Chemical would receive most of the benefit, because it is assuming the risk of selling polystyrene to outside customers. Oil might be given a transfer price sufficient to ensure that it does not report an operating loss from the sale of Benzene ($0.10 plus fixed costs of $0.04 per kilogram).

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18.29 Transfer price; entity versus division profit; idle capacity

The furniture division of International Woodworking purchases timber and makes tables, chairs, and other wood furniture. Most of the timber is purchased from the Port Angeles Mill, also a division of International Woodworking. The furniture division and the Port Angeles Mill are profit centres. The furniture division manager proposed a new Danish-designed chair that will sell for $150. The manager wants to purchase the timber from the Port Angeles Mill. Production of 800 chairs is planned, using capacity in the furniture division that is currently idle. The Furniture Division can purchase the timber for each chair from an outside supplier for $60. International Woodworkers has a policy that internal transfers are priced at variable cost plus allocated fixed costs. Assume the following costs for the production of one chair:

Required (a) Assume that the Port Angeles Mill has idle capacity and would incur no additional fixed costs to produce the required timber. Would the furniture division manager buy the timber for the chair from the Port Angeles Mill, given the existing transfer price policy? Why? (b) Calculate the contribution margin for the entity as a whole if the manager decides to buy from the Port Angeles Mill and is able to sell 800 chairs. (c) What transfer price policy would you recommend if the Port Angeles Mill always has idle (excess) capacity? Explain why this transfer price policy provides incentives for the managers to act in the best interests of the entity as a whole. (d) Explain how the idle capacity affects the recommendation in part (c). (LO4 and 5)

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(a)

No because at a price of $150, the variable cost to the furniture division under the current transfer price policy is $155 and the Furniture Division would lose $5 per chair.

(b)

If the Furniture Division buys from Port Angeles, the contribution margin is as follows: Price $155 Variable Costs Transfer (40) Manufacturing (75) Selling (10) Contribution margin $ 30 The total contribution margin is 800 × $30 = $24 000

(c)

(d)

If Port Angeles always has excess capacity, the transfer price should be variable cost because Port Angeles has no other opportunities to sell the lumber. This transfer price policy would motivate the Furniture Division to purchase internally. The mill would want to keep its workers busy and be satisfied to transfer at variable cost because there are no other alternative outlets for the lumber. If there is no idle capacity, Port Angeles Mill would forego revenue from outside sales when units were transferred internally. Therefore they would not transfer except at the market price.

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18.30 ROI, residual income, EVA, effect on investment decision, performance evaluation Strong Welding Equipment Company produces and sells welding equipment nationally and internationally. Following is information about two divisions in US dollars.

Required (a) Calculate each division’s ROI. (b) Calculate each division’s residual income. (c) Calculate each division’s EVA. (d) Suppose the Brazilian division had an opportunity to invest $3 500 000 in a project that would generate sales of $5 000 000 and return on sales of 10 per cent, or $500 000. Would the division manager be likely to undertake this project if he or she is evaluated using ROI? Explain. (e) Recommend a performance evaluation measure that would increase the managers’ incentives to make decisions that would be in the best interests of the owners. (LO3) (a)

ROI ROI Brazil = $1 000 000/$4 000 000 = 25% ROI US = $120 000/$400 000 = 30%

(b)

Residual income RI Brazil = $1 000 000 – (10%*4 000 000) = $600 000 RI US = $120 000 – (10%*400 000) = $80 000

(c)

EVA EVA Brazil = $600 000 – [9%*($4 000 000 – $80 000)] = $600 000- $352 800 = $247 200 EVA US = $80 000 – [9%*($400 000 – 10 000)] = $80 000 – $35 100 = $44 900

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(d)

Current ROI is 25% New ROI = ($1 000 000 + $500 000)/($4 000 000 + $3 500 000) = 20%, which is lower than the current ROI of 25%. Therefore, the division manager would probably forego the opportunity.

(e)

EVA with appropriate adjustments would be the best performance evaluation measure. EVA overcomes many of the disadvantages of ROI and residual income.

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18.31 Choosing type of responsibility centre, support cost allocation, ROI The ATCO Company purchased the Dexter Company three years ago. Prior to the acquisition, Dexter manufactured and sold plastic products to a wide variety of customers. Since becoming a division of ATCO, Dexter only manufactures plastic components for products made by ATCO’s Macon division. Macon sells its products to hardware wholesalers.

ATCO’s corporate management gives the Dexter division management a considerable amount of authority in running the division’s operation. However, corporate management retains the authority for decisions regarding capital investments, price setting of all products, and the quantity of each product to be produced by the Dexter division. ATCO has a formal performance evaluation program for the management of all of its divisions. The performance evaluation program relies heavily on each division’s return on investment. The accompanying income statement of Dexter division provides the basis for the evaluation of Dexter’s divisional management. The corporate accounting staff prepare all of the divisions’ financial statements. The corporate general services costs are allocated on the basis of sales dollars, and the computer department’s actual costs are apportioned among the divisions on the basis of use. The net division investment includes division fixed assets at net book value (cost less depreciation), division inventory, and corporate working capital apportioned to the division on the basis of sales dollars.

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Required (a) Discuss the financial reporting and performance evaluation program of ATCO Company as it relates to the responsibilities of the Dexter division. (b) Based upon your response to part (a), recommend appropriate revisions of the financial information and reports used to evaluate the performance of Dexter’s divisional management. If you conclude that revisions are not necessary, explain why they are not needed. (LO2 and 3)

(a)

Return on investment is not a good performance measure for the division because division management has very little control over either net income or investment. Sales revenue is totally controlled by central management (they control both prices and quantities). In addition, it appears that division management does not have authority to alter the level of investment in the firm. While one might also mention problems with the allocation of costs and working capital on the basis of sales, and the use of net book value, these problems are trivial relative to the division manager’s lack of authority and lack of control over factors in the performance measure.

(b)

The division should be treated as a cost centre (it is not a profit centre). Apparently, the division management has control only over providing products at an efficient cost, given timing and quality constraints. The division’s performance should thus be measured relative to a well prepared flexible budget. If quality is important, quality performance measures should be included.

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18.32

Transfer pricing

Sunshop Books is a multi-divisional book company that listed on the stock exchange about three years ago. Like many in the industry, Sunshop started out in the 1980s as a single-site suburban bookstore. Company CEO Lewis Negus has been in the role for three years, having joined the company around the time of its stock exchange listing. It was expected that the listing would provide much needed capital to enable the company to compete in what was becoming a rapidly changing and dynamic environment due to: • continual merger and acquisition activity • developments in technology such as e-readers and e-books as well as in the development of digital applications • the financial difficulties experienced by industry participants particularly in the retail sector. The company is currently structured around three main divisions as follows. • Publishing: This division publishes educational textbooks, adult fiction and non-fiction books, and children’s books. Sunshop has a strong reputation for producing educational texts for the school and university markets. • Retail: This division grew out of the original shop. Sunshop owns a number of specialist bookshops itself with a focus on developing close links with customers. Of course, the retail shops also served as an outlet for many of the books published by the Publishing division. As well as owning its own shops, Sunshop had also taken an ownership stake in a number of specialist retail bookstore chains. • Technologies-based division: This division focuses on technological applications and works closely with the Publishing division in particular. This includes developing technological content to support the hardcopy textbooks produced by the Publishing division. For example, a recent project included the development of smart-card technology containing interactive software that enables students to self-test on content in the specific chapters of an auditing text. Each divisional manager is evaluated on the basis of return on investment along with a mix of other measures. Bonuses are paid on the basis of ROI performance alone. Transfer pricing issues While senior management valued divisional manager autonomy and decision making, they felt the organisational interests should normally prevail. To this end, the key components of the company’s transfer pricing policy were: • all transfers would occur at full costs plus a mark-up of 10 per cent • there would be no sourcing autonomy; transacting internally would be the first priority • divisions would be permitted to use any spare capacity to meet external demand. The manager of the Technologies-based division — Carly Taylor — has raised concerns about the policy. Carly is proud of the innovation and creativity with the technological developments the division has been able to

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generate, particularly in the last two years. This has resulted in an increase in demand for their services from external customers including other book publishers and educational institutions. Carly argues that her divisional ROI would be higher if she had more autonomy to service outside customers. She says ‘full costs plus 10 per cent just does not give us enough of a return . . . we could be earning twice the profit on outside work’. Required (a) Evaluate the current transfer pricing system (including consideration of the strengths and limitations). (b) What changes would you make to help address the limitations you identified? How would these changes be an improvement on the current system? (LO4 and 5) (a) Strengths include:

• • •

Divisions are investment centres (evaluated on the basis of ROI). The TP policy includes a mark-up on full costs providing at least some profit component With no sourcing autonomy internal work is prioritized. Policy allows any spare capacity to be used for additional outside work.

Weaknesses include:

• •

Main issues seems to be the lack of sourcing autonomy. Particularly for divisions such as the Technology-based division, which has an increasing demand for outside (more profitable work). The use of full cost plus a mark-up of only 10% may also be restricting divisional profitability (although at the same time may be helping to keep prices down).

(b) Responses here can vary but might include:

• • •

Allowing sourcing autonomy. Change TP method to market-based transfer pricing. Consider structure (should all current divisions/work units be investment centres?).

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Chapter 19: The balanced scorecard and strategy maps 49 Questions 19.1

Explain the differences between financial and non-financial performance measures and give two examples of each. (LO1)

Financial measures provide information measured in dollars or ratios of dollars. Examples are ROI, operating margin, total sales, and so on. Non-financial measures provide performance information about activities that cannot be measured in dollars. Examples would be defect rates, market share and employee retention rates.

19.2 Differentiate between a lag indicator and a lead indicator. Provide two examples of each. LO1 (LO1) Lag indicators identify the outcomes of a firm’s past performance. Lead indicators, by comparison, are like early warning signs, identifying the drivers of performance and enabling a firm to anticipate how their future performance will look. The following table identifies examples of lag and lead indicators in regards to the following objective: “improve customer satisfaction”. Objective Improve customer satisfaction

Example Lag Indicators -

Average percentage of surveyed satisfied customers per month. Average weekly net-promoterscore. Average number of customer complaints per month.

Example Lead Indicators - Average weekly percentage of product returns. - Average quarterly delivery times. - Average weekly product defect rates.

19.3 What is strategic decision making? What role does it play in the balanced scorecard? (LO4) Strategic decision making relates to decisions about the types of goods and services that organisations produce and the long-term methods that are developed to better compete. Strategic decision making relies on developing strategic operating plans and budgets that take advantage of an organisation’s core competencies. The balanced scorecard provides a more formal method for managers to incorporate mission, vision, and core competencies into their strategic decision making.

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19.4 Outline the purpose of strategy maps. (LO2) Strategy Maps are the link between the strategy and the balanced scorecard — the maps link the organisational strategy to the measures developed for the balanced scorecard. The maps provide a visual representation of the strategy, and illustrate the cause-effect relationships that link desired outcomes in the customer and financial perspectives to outstanding performance in critical internal processes.

19.5

Identify the four generic perspectives for a balanced scorecard and explain how they are related. (LO3)

Four generic perspectives for a balanced scorecard are financial, customer-related, learning and growth, and internal business processes. These are related because success in learning and growth and internal business processes should increase customer satisfaction and finally financial performance.

19.6 Describe the implementation process for the balanced scorecard. (LO4) To implement a balanced scorecard, first clarify vision, core competencies, and strategies. Then these strategies are translated to the four perspectives of the balanced scorecard: financial, customer, internal business and learning and growth. The scorecard is refined as it is communicated throughout the organisation to link department and overall organisational strategies and objectives. At the department level, performance targets and action plans are established. Data is collected over time and performance is monitored using the performance measures selected by departments. Employees are rewarded after results are analysed. The scorecard is refined for the next period. 19.7

How might a balanced scorecard be used? (LO4)

A balanced scorecard is a strategic and performance measurement tool. Its aim is to translate organisational visions and strategies into performance objectives and related measures that can be monitored over time. It assists managers to more fully integrate strategies throughout the organisation, anticipate and prevent possible future problems, and identify and take advantage of opportunity. It allows a continuous, strategic analysis of the organisation from multiple perspectives – financial, customer, internal business process and learning and growth. It is possible to use a balanced scorecard diagnostically (with a focus on meeting preset targets for performance measures) to measure monitor and provide feedback on performance; or interactively (with a focus on having some measures act as early warning signals) to help address the strategic uncertainties the organisation might face.

19.8 What potential problems could arise if the balanced scorecard was

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developed without a strategy map being available? (LO2) If a balanced scorecard was developed without a strategy map being available, it would make it more difficult for managers to appreciate the relationships between: 1. The four perspectives, and 2. Strategies and the performance measures. 19.9

Allied Trucking moves produce from farms to markets. Its managers decided to implement a balanced scorecard around the entity’s vision statement: 'We aim to be the industry leader in cost-effective and timely delivery of produce’. Provide two potential performance measures for each of the four perspectives for the balanced scorecard for Allied Trucking. (LO3)

Financial perspective: Operating margin, Cost per mile per ton transported Customer perspective: Customer satisfaction surveys, market share, growth in return customers, growth in new customers Internal business perspective: Percent on-time deliveries, number of complaints about food damage from loading and unloading Learning and growth perspective: Driver safety records (number of tickets or accidents), driver training hours, number of process improvements annually.

19.10 Suppose that a travel agency decided it would no longer compensate employees with sales commissions, but instead pay a salary with a bonus for high customer satisfaction ratings. What problems would you foresee from the agency’s financial perspective? (LO5) The sales force may increase satisfaction by reducing travel prices, or directing potential customers to another agency with lower prices to keep satisfaction ratings high. This would hurt financial performance. In addition, sales representatives might not apply pressure to close a sale when it might be appropriate to do so, because they may worry about the customer satisfaction ratings.

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19.11 (a) Pick two public companies, go to their websites and identify their major strategies. (b) Pick one of the companies from part (a) and go to the website of a competitor in the same industry. (For example, if you chose Coles, you might go to the website of Woolworths.) Now compare the strategies of both companies and list any similarities and differences. (LO2) Student answers to this question will vary depending on the companies chosen.

19.12 Explain why demand might increase for relevant and useful information in the future. What professional skills will help you meet that need? (LO1 and 3) As the business environment becomes increasingly competitive and dynamic, demand will increase for relevant and useful information to help organisations succeed. Accountants will need to conduct research using many different sources of information from web sites, libraries, journals, other people and others. They will also need to develop new internal sources of information that managers can use for decision making.

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50 Exercises 19.13 Balanced scorecard measures for financial perspective Following is financial information for last period about Curry House, a regional company with a number of fast-food stores:

Required Describe and calculate several measures that could be used for the financial perspective. (LO3) From the data given, the following measures could be used for the financial perspective: Operating margin = $522 510 Return on investment = ($10 450 200 – $9 927 690)/$4 180 080 = 12.5% Residual income = $522 510 – (0.15×$4 180 080) Residual income = $522 510 - $627 012 = ($104 502) Economic value added = $391 883 – (0.12×$4 180 080) = $109 727

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19.14 Financial and non-financial measures Managers increasingly use a mixture of financial and non-financial measures for organisational performance. Required In the following list of performance measures, identify those that are financial (F) and those that are non-financial (N). (a) (b) (c) (d) (e) (f) (g) (h) (i) (j)

Customer satisfaction ratings Market share Operating margin Return on sales Annual average purchase amount per customer Defect rate Normal spoilage Labour efficiency variance Number of new products developed annually Revenues from new products introduced this year

(LO1) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j)

N N F F F N F (Could be N if measured in units) F N F

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19.15 Balanced scorecard measures for customer perspective Leyland College is in the process of developing a balanced scorecard. The administrators decided that their customers are parents and future employers of their students. They believe the students are their products. Required Discuss whether each of the following potential measures would be useful for the customer perspective in the balanced scorecard. (a) Parent ratings of satisfaction with the high school curriculum (b) Graduation rate (c) Percentage of students employed during the summer after graduation (d) Employer satisfaction ratings for Flowing Wells High School graduates (e) Monthly earnings of graduates (f) Number of graduates attending classes beyond high school (g) Cost per student per year (h) Number of classes per student per semester (i) Average number of college credit hours completed per teacher (LO3) (a)

Customer satisfaction because parents are considered the customers and school administrators are measuring how satisfied parents are with the high school’s performance.

(b)

This is an internal business related measure because it measures the performance of the high school.

(c)

Customer satisfaction related because the administrators could consider future employers as customers. Changes in employment rate after graduation measures (with noise) the satisfaction of employers with Flowing Wells students. Economic conditions and other factors affect this rate, so it is an imperfect measure.

(d)

The administrators could consider employers as customers, and their satisfaction surveys would then reflect a potential measure of the customer perspective.

(e)

This is not a customer perspective measure because it reflects many other factors in addition to satisfaction of employers with graduates.

(f)

This measure reflects the performance of the high school but not the customer perspective, even though customers are probably interested in this rate.

(g)

This measures internal performance.

(h)

This measures internal performance

(i)

This measures the learning and growth perspective

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19.16 Learning and growth perspective

Markman Ltd, a large pharmaceutical company, is concerned about the ability of its research and development department to develop profitable new prescription drugs. Once a drug has been developed and patented, it takes 9 to 12 years to meet all of the regulatory requirements. The company can then market the drug for about 11.5 years, on average, before the patent expires. Then competitors produce generic drugs. Employees currently participate in profit-sharing plans, but the company wants to give additional bonuses to improve performance. Markman decided to implement a balanced scorecard approach. Required (a) Explain why monitoring and rewarding non-financial performance might be particularly important for Markman. (b) List one objective for Markman’s learning and growth perspective. (c) List two performance measures for the objective you picked in part (B). (LO3) (a)

Because so many years are spent in drug development, the results of current research, development, and testing will affect future financial performance, not current performance. If non-financial measures are used to reward employees, progress toward blockbuster drugs will be better monitored and rewarded.

(b)

Following is an example of an objective. Students may have thought of others. Objective: To increase new drugs that have been developed, patented, tested and are known in the market compared to drugs in the first phase of research.

(c)

Two measures are: • The number of new drugs that are on the market divided by total number of drugs researched. • The trend (growth rate) in number of new drugs that are on the market.

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19.17 Balanced scorecard measures for four perspectives Part of the process for developing a balanced scorecard is to identify one or more measures for each perspective. Required Categorise each of the following potential balanced scorecard measures according to the following perspectives:

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p)

F Financial C Customer I Internal business process L Learning and growth Percentage of customer orders delivered on time Ratio of research and development cost to number of new products developed Economic value added (EVA) Number of hours of employee training Direct labour price variance Market share Percentage of customer orders delivered without error Days in accounts receivables Throughput time Direct materials efficiency variance Asset turnover Employee retention rate Percentage of bad debts collected Customer satisfaction ratings Number of degrees and certificates held per employee or department Percentage of purchase orders that are error free

(LO3) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p)

I L F L F C I I I F F L I C L I

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19.18 Strategic plans; balanced scorecard measures for not-for-profit entity You have been invited by a classmate to help found a new not-for-profit organisation named Students Care. The organisation’s purpose is to provide scholarship money for children in Africa who have become orphans because of the AIDS epidemic. The organisation will operate only on campus, and the target donors are students. Suppose a wealthy businesswoman has offered to coordinate distribution of the scholarship funds to needy students, but wants to see a business plan for the organisation that describes the organisational vision and lists the core competencies, strategies, and operating plans. Required (a) Explain what each item on businesswoman’s list means. For each item, provide a possible example for Students Care. (b) Consider the perspective of internal business processes. Your classmate wants to measure the number of hours per week that volunteers spend collecting donations, but you believe it should be dollars collected per volunteer hour spent in collection, measured on a weekly basis. Give one advantage and one disadvantage for each measure. (c) You have had difficulty determining a measure of learning and growth, but a campus association recently organised a series of short workshops on improving student fundraising activities, as well as other aspects of governing student entities. Discuss the advantages and disadvantages of using the number of Students Care volunteers attending workshops as a measure for this perspective. (d) Outline how the use of a strategy map might have been useful in the balanced scorecard process. (LO2 and 3) (a)

Vision is the purpose of the organisation. For Students Care, the purpose is to send scholarship money to orphans in Africa. Core competencies are the organisation’s strengths relative to competition. Students Care is a campus based organisation run by students to raise funds for students. This is likely an advantage for raising funds from students compared to organisations managed by non-students. Strategies are the student’s long-term goals and include choosing an organisational structure – the number, types, and duties of officers – and the nature of the events that the organisation will sponsor. Operating plans are the plans that students make for raising and disbursing funds over the next semester or year. These would include number and times of meetings, types of activities for each meeting, and fund raising events. Operating plans for this organisation might include targets for the amount of funds the students hope to raise.

(b)

Below are examples of advantages and disadvantages for each measure. Students may think of others. Tracking volunteer hours per week: • Advantages: This measure is easy to track. If students are putting in good effort, funds are likely to increase as hours increase. Volunteers have incentives to put in more hours if they know that measure is being tracked.

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• Disadvantages: Students could spend lots of hours raising funds, with little results. They may count activities that are only peripherally connected to fundraising as part of their hours spent. Does not provide incentives to increase the overall amount of funds raised.

Dollars collected per volunteer hour: • Advantages: This measure focuses on the amount of funds raised instead of the time spent in fund raising, so students have incentives to focus on projects that result in more funds being raised. Students would be less likely to count peripheral hours as time spent on fund-raising activities, so the measure might be more accurate. • Disadvantages: This measure does not track the amount of time students spend in fund raising activities, and so they may minimise time spent, but maximise dollars per hour, but spend very few hours fund raising. It does not provide incentives to increase the overall amount of funds raised. (c) Learning and growth measures should reflect both organisational and employee efforts to increase knowledge and develop skills. It is likely to be more difficult to find activities that might increase these within volunteer organisations because student time is limited and measuring changes in knowledge and skills are also difficult. Tracking hours students spend at workshops would be easy to measure and monitor and would not involve the organisation’s time to set up. A disadvantage is that the quality of the workshops and the effort of students attending the workshop affect the benefits that the organisation receives. It could be possible that some of the workshops address issues that are not relevant to Students Care. (d) The use of a strategy map would have been useful in the balanced scorecard process because it links the strategy and the balanced scorecard. It provides a visual representation of the strategy. A strategy map informs the development of performance measures for use in the scorecard. It is the starting point for all BSC projects. According to Kaplan and Norton (2008) ‘A strategy map describes the process of value creation through a series of cause-and-effect linkages among objectives in the four BSC perspectives’…The generic strategy map illustrates how the strategy can be sliced into themes, each with its own cause and effect relationships….The strategic themes provide a common structure that managers can use to develop their own maps within the big picture of Students Care and a governance structure that assigns accountability for actions’

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19.19 Balanced scorecard perspectives, performance objectives, and measures Perspectives, performance objectives and potential performance measures for the balanced scorecard at Holiday Resorts are as follows: Perspectives (i) Financial (ii) Customer (iii) Internal business (iv) Learning and growth Performance objectives A. Reduce housekeeping costs B. Improve the quality of and results from advertising campaigns C. Decrease vacancy rate during the off-season D. Increase number of return customers E. Increase overall profits F. Increase the use of Internet-based reservations G. Retain high-quality employees H. Increase the number of activities available to customers I. Improve the quality of stay for holiday makers J. Provide employee training in quality customer service K. Reduce error rate in reservations Potential performance measures 1. Operating margin 2. Customer complaint rate 3. Survey customers at check-in about how they first heard about the resorts 4. Housekeeping cost per room 5. Number of employee hours spent in training 6. Error rate in reservation process 7. Percentage of reservations made using the website 8. Customer surveys about satisfaction and quality 9. Employee turnover rates 10. Number of activities per resort that are available to customers 11. Percentage and number of return customers 12. Number of hours of employee training offered 13. Vacancy rates 14. Customer focus groups inquiring about quality and potential success of advertising 15. Number of suggestions that improve quality of service Required (a) For each perspective (i–iv), identify at least one appropriate performance objective (A–K). (b) For each performance objective (A–K), identify at least one appropriate performance measure (1–15).

(c)

Explain the links between the measures.

(LO1 and 3)

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(a)

(i) a, e, I(i) c, d, h, i, k II(i) b, f, i IV. g, j

(b)

a. b. c. d. e. f. g. h. i. j. k.

(c)

Student responses may vary. Provided here is one example of a series of possible links. Commencing with the learning and growth perspective an increase in employee hours spent in training should lead to improved quality of stay, as measured by customer responses in focus groups or surveys (internal business process perspective). This should lead to a reduction in vacancy rates and an increase in return customers (customer perspective) resulting in enhanced profit overtime (financial perspective).

4 3, 14 13 11 1 7 9 10 2, 8, 14, 15 12, 5 6

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19.20 Balanced scorecard at individual level; strategy map; boundary systems Required (a) Reflect on the management accounting case and the balanced scorecards used by Qantas and Virgin Australia as part of their incentive plans. How might they use a strategy map in the process of developing their scorecards? (b) With reference to the management accounting case, explain how the airlines might be able to use the balanced scorecard as a form of boundary system. (LO2 and 4) (a) Qantas and Virgin Australia would use a strategy map as a starting point for their BSC development. It informs the development of suitable performance measures by describing the process of value creation through a series of cause-and-effect linkages among key objectives in the four BSC perspectives. First of all the airlines will use the strategy map to slice their corporate strategy into themes. The strategic themes might include those along the lines of safety, quality and profitability. They provide an overall company-wide governance and accountability structure that can be then tailored to the specific requirements of the individual business units (b) The airlines may be able to use the balanced scorecard as a boundary system by specifying the type of measures used and targets set in the scorecard. By acting as a boundary control the performance measures and targets articulate the expected behaviour required from managers and employees. They provide the boundaries within which employees should operate in the coming period. It is anticipated that the individual scorecards developed for the airlines’ executives and managers would certainly influence their behaviour and decision making; particularly when their scorecard performance measures are linked to incentives.

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19.21 Balanced scorecard perspectives: internal business process, innovation and growth The Galaxy Hotel Group owns and operates a number of mid-level boutique hotels mostly in regional Australia. Galaxy is structured around regions with a regional general manager usually given the responsibility of working closely with the managers of the hotels within their region. Commonly, a regional general manager is responsible for around 6 to 8 hotels. Within Australia, Galaxy has six regional general managers who report to the CEO, Angelo Vellma. Galaxy’s strategy has focused on meeting the needs of business and holiday travellers seeking 3 to 3.5 star accommodation for relatively short stays that are affordable but comfortable. One thing Galaxy enforces is its objective of having the same high-level service at each hotel. The CFO of Galaxy, Caitlin Zhang, has raised the idea of introducing a balanced scorecard. At this stage it has only been discussed at board level, but most of the board members are in favour of its implementation. As Zhang points out, ‘it will focus the attention of employees on our key priorities as well as provide the opportunity to reinforce our strategy throughout the company’. Zhang’s first draft balanced scorecard developed for use at the individual hotel level is provided below. To date, Zhang has constructed the first draft alone, without consulting others.

Another board member, Patrick Ryan, wonders about using the balanced scorecard a little differently. ‘Perhaps we could use the scorecard to facilitate discussion with our regional managers and individual hotel managers. Not all are the same and they obviously face different challenges. The scorecard could be used by senior management to meet with regional managers and discuss the performance of hotels in the region, and perhaps re-work part of the scorecard and set different priorities as the regions work to meet local challenges.’ Required

(a)

(b)

Angelo Vellma is a little concerned about the draft scorecard. He had recently attended a seminar on balanced scorecards and is worried about the lack of measures relating to what he thinks are important issues at the individual hotel level. He is particularly concerned at the lack of an internal business process perspective and a learning and growth perspective in the scorecard. Identify two measures relevant at the individual hotel level at Galaxy for the internal business process perspective and the learning and growth perspective. Provide a brief justification for each measure. Comment on the implementation process of the balanced scorecard at Galaxy to date.

(LO3 and 4) (a)

The balanced scorecard that has been developed does not consider the important objective of Galaxy which is to have the same high-level of service at each hotel. The measures developed all focus on financials and ignore other important non-financial aspects of the business operations.

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Internal business process – potential measures at individual hotel level • Customer ratings on service and internal processes such as response times • Number of customer complaints • Time taken to perform key tasks e.g. check in, check out, clean room, answer guest requests • Mystery guest assessment ratings – rating of 1(poor) to 10 (excellent) Learning and growth – potential measures at individual hotel level Staff focus– to ensure service provision of a high standard • Training hours per employee • Employee engagement index • Training courses attended – skill development of employees • Staff turnover – high levels could lead to lower quality service

(b)

Implementation can be assessed from both a technical and behavioural perspective. Summary of the process of implementation –

Positives • Vision and strategies identified

Negatives • Lacks non-financial performance measures in relation to the internal processes and learning and growth • Hasn’t developed a strategy map linking measures • Scorecard developed by CFO without involvement of others in the organisation • No targets/weightings for performance measures • Hasn’t captured differences between regions

The comments made by Patrick Ryan reinforce the negatives above. 19.22 Future direction of accounting information Think about the type of work you will perform in your future career. Required (a) Give examples of the types of financial and non-financial information you will probably use in your work. (b) List several methods you could use to produce information that will help predict future operations for your employer or for clients. (c) What types of continuous learning do you foresee in your career?

(d)

Explain why you may need to use creative or innovative ideas in your career. (LO1) (a)

The answer to this exercise will depend on the student’s planned career path. The purpose is to encourage students to tie the concepts of financial and non-

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financial measures to their future careers. They should be able to list several financial and non-financial measures for any type of work. (b)

Again, the answer will depend on students’ planned career paths. Students should be able to list methods, such as flexible budgets and benchmark targets, which would be relevant for predicting future operations for their employer or clients.

(c)

All students should list continuing professional education such as increasing the technical knowledge and ability to manipulate data using databases and spreadsheets. Some students will consider annual education needs for FASB and tax updates. Others might identify learning related to skills that will become more important after the entry level, such as people management.

(d)

As technology enables organisations to quickly manipulate data, the need for innovative data collection and analysis becomes a more central part of work. Bookkeeping responsibilities are now maintained by information systems, but the integrity of the systems needs to be continually monitored and improvements continuously made.

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51 Problems 19.23 Balanced scorecard; strategy map and implementation Terence Smythe, a veterinariant, decided to join a small group of vets so that he no longer has to be on call every night. Practice members share the responsibility of emergencies with other members of the group. In the past, Terrence differentiated his practice by specialising in the treatment of large farm. None of the other vets specialise in large farm animals, but all of them treat some farm animals. Terrences’s son just finished an accounting degree and recommended that the vets group consider implementing a balanced scorecard as they develop the policies and practices for the new group. Required (a) Explain what each of the four perspectives of the balanced scorecard mean in the context of a vets group. (b) Recommend several methods the group could use to assess a performance objective of patient satisfaction. (c) Recommend two measures for each of the four perspectives for the vets group. Explain your recommendations. (d) Construct a strategy map to reflect the links between the measures selected. Briefly discuss the links. (LO2 and 5) (a)

The financial perspective is similar across organisations. Because this is a service industry, any financial measures relating to cost will likely measure the cost of clinical staff members. The customer perspective will relate to the dental patients and possibly also to insurance companies, who pay for vet services. The customer perspective is important to vets because return business is probably most of their business. Internal business processes would include the ease with which patient appointments are booked, effective scheduling of staff, and effecting accounting practices, especially for billing and managing accounts receivables. Learning and growth would pertain to the vets, who need to participate in continuing professional education to keep their licenses and vets procedures current, and staff members such as veterinary nurses who are an important part of the animal care team.

(b)

Animals could be surveyed either before they leave the practice or by mail after the appointment date. The performance measure could be average customer satisfaction. In addition, the clinic may want to use waiting time as an important measure of customer satisfaction. If customers have to wait extended amounts of time, they will feel frustrated and may find a new clinic. Other measures could include tracking the proportion of patients who return for additional services, the number of customer complaints, and the number of return visits for problems with the original work.

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(c)

Financial perspective: • Operating margin reflects the overall profitability of the vet clinic and reflects changes in both revenues and costs. Tracking operating margin will alert the vets to potential problems with revenues or costs before the problems become too large. • Bad debts or insurance adjustments. Some patients may not have the ability to pay and if the percentage of patients with these types of problems increases, operating margin will fall. Bad debts and insurance adjustments can also indicate problems with services or with billing processes. Customer perspective is addressed in Part B.

Internal business processes: • Days in accounts receivable. This measure is important because some customers may be very slow to pay, or unable to pay. The clinic needs to Financial Perspective Operating Margin know immediately if there is a problem with receivables because it affects cash flows. • Patient throughput, that is, the rate at which patients are treated. Throughput Customer Customer Loyalty couldPerspective be measured as an average number of patients treated per day, per week, or other time period. This measure reflects the use of fixed assets, such as the vet’s examination table and equipment. Also, staff members are likely paid by salary, so the more patients the vets can see, the more profits the Customer Satisfaction clinic receives. Learning and growth Improve Debtors’ Improve Patient • Number of continuing professional education hours would be a good measure Management Throughput for the vets, so that they can be reminded to increase hours if they fall behind. Retaining licensure in this industry is extremely important. • Training hours for staff members could be measured to keep staff up to date Learning & Growth [Develop] Employees’ Process Improvement with the latest technology for this field. Perspective

Internal Perspective

(d) Strategy Map

Skill Professional Education – Vets Staff Training – Admin Staff

Students may present a range of differently structured strategy maps. The one above focuses on demonstrating the links between the chosen measures, although the strategy map focuses more on the objectives surrounding the measures. As an example, by developing the skills and professional knowledge of our employees, patient throughput should be improved which will lead to improvements in customer satisfaction measures and ultimately financial performance.

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19.24 Balanced scorecard measures Curry House owns a number of stores that sell fast food. As part of its compensation packages, Curry House provides employees with bonuses based on customer satisfaction surveys. Recent analysis of the data shows a positive correlation between survey ratings and sales; that is, as customer satisfaction increases, sales increase. However, at a certain point in this trend, sales plateau even though the ratings continue to increase. In addition, increasing customer satisfaction causes costs to also increase because more time is spent with each customer and more employees are on hand to help with food preparation and cashiering to reduce the time that customers wait for their food to be prepared. Other factors that appear to affect customer satisfaction are the general cleanliness of the store and the attitudes of the cashiers as they provide customer service. A factor that strongly affects sales at each store is its health rating from the local council. These ratings are published in the local daily newspaper. When a store has a low rating, sales at that outlet drop off until publication of an improved rating occurs. The owner wants to add one or more financial performance measures to the bonus package so that employees will earn more money when customer satisfaction increases at the same time that financial performance is also increasing. Required (a) Describe advantages and disadvantages of using a combination of performance measures reflecting the customer and financial perspectives. (b) Management would like to add other customer-related measures and is considering replacing survey satisfaction with some other measure. List one potential measure and list at least one advantage and one disadvantage for it. List one additional performance measure that could be included in the compensation package. Explain what it is and what it would contribute. (d) Explain how the scorecard measures (particularly the customer perspective) are being used in part as a boundary system. (LO1, 3 and 4) (c)

(a)

The advantages of using a combination of measures for the finance and customer perspectives is that no one measure is likely to capture all important aspects of these perspectives. A combination of measures allows managers to track multiple attributes, which might also be associated with specific strategies or performance objectives for employees. Disadvantages are that more measures need to be tracked, and employees could feel confused about the specific measures to which they should pay most attention.

(b)

There are many possible answers to this question; here is an example. Because the health department ratings affect customer perceptions and volumes so strongly, some measure of cleanliness might influence customer satisfaction. For example, a manager might make a spot inspection daily, or weekly using standards similar to the health department’s, and give each outlet a rating. An

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advantage of this measure is that outlets will maintain a high degree of cleanliness and the health department should always find that the outlets meet its standards. A disadvantage is that employees may spend too much time cleaning when they could be doing other activities that affect customer satisfaction, such as filling salt and pepper shakers or giving customers more attention. (c)

There are many possible answers to this question; here are two examples. Another performance measure could be the number of return customers. Fast food businesses rely heavily on repeat customers and increasing the number of returning customers is likely to increase revenues and profitability. This measure may be difficult to track, though; cashiers might ask each customer if they had eaten at a Curry House outlet before, but customers might not respond honestly. Another performance measure might be the percent change in sales at the store where the employee works. This data is already tracked, and it would encourage employees to focus their efforts on encouraging customers to spend more money.

(d)

The scorecard measures (particularly the customer perspective) are being used in part as a boundary system. Curry House management has linked the bonus package to the customer satisfaction measures. Targets now exist as a boundary with set parameters to guide management behavior. If customer satisfaction increases in line with financial performance so will the pay packet of the Curry House employees. Curry House have identified that customer satisfaction will increase if: stores are clean, food preparation time is reduced; cashiers speed up process of payment; and employee attitude is positive. Therefore, if bonuses are attached to such practices then employees will be motivated to meet such targets.

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19.25 Balanced scorecard, financial and non-financial measures Dyggur Equipment manufactures and sells heavy equipment used in construction and mining. Customers are contractors who want reliable equipment at a low cost. The entity’s strategy is to provide reliable products at a price lower than its competitors. Management wants to emphasise quick delivery and quick turnaround when equipment needs repair or service so that contractors are not without their equipment often or for long. Dyggur is considering the following performance measures for use in its balanced scorecard. Required (a) Categorise each of the following potential balanced scorecard measures as follows:

F C I L

Financial Customer Internal business process Learning and growth

(a) Manufacturing cycle time per product (b) Market share (c) Average ratings on customer satisfaction surveys (d) Average cost per unit (e) Economic value added (f) Percentage of receivables collected (g) Dollar value of warranty work (h) Time between order and delivery (i) Time it takes to repair returned equipment (j) Number of focus groups for new products (k) Number of new uses for current products (l) Number of times new technology is applied to current products (m) Number of product change suggestions from sales (n) Number of engineering change orders to improve manufacturing cycle (o) Revenue growth (p) Employee training hours (q) Number of quality improvement suggestions from employees (r) Number of new customers (s) Number of repeat customers (t) Employee turnover rate (u) Defect rates for manufacturing production (v) Percentage of error free-rates in: (i) purchasing (ii) billing (iii) customer record keeping (b) Explain how Dyggur would use the scorecard solely as a diagnostic tool. (LO1, 3 and 4)

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(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p) (q) (r) (s) (t) (u) (v)

I C C F and I F F and I F and C C and I C and I L L L L I F L L C C L and I I and C (i) I (ii) I and C (iii) I and C

(b)

Dyggur Equipment could use the balanced scorecard diagnostically by focusing on the performance on the scorecard measures in a 'measure, monitor feedback' cycle (see p. 707 of text). In this way the focus is on evaluating performance against pre-set standards as a representation of the intended strategy. Focus is on significant differences between planned and actual performance across the metrics; and on trying to bring performance back in line with expectations.

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19.26 Strategy; balanced scorecard measures and process Refer to the information in problem 19.25. Dyggur Equipment wants to offer weekend servicing of heavy equipment. None of its competitors offer this service, and management believes this service will bring in new business and help retain current customers. Required (a) List several advantages and disadvantages of this strategy. (b) List one financial and two non-financial performance measures that could be used to monitor the success of this plan. (c) Suppose the managers decide to launch this new service. At the end of the first year of operating weekend service, performance is evaluated by gathering and analysing measures such as those identified in part (b). How can this information be used to improve performance for the next period? (d) Given that Dyggur management are now exploring new strategies, outline how senior management could use the balanced scorecard interactively. (LO1 and 4) (a)

Advantages of weekend service: Because heavy equipment is expensive to purchase, contractors probably prefer to use it as often as possible during the week. Therefore, having a weekend service would be an attractive alternative for them. It is possible that Dyggur will attract new customers with this strategy. Disadvantages: If Dyggur currently operates services during the week, customers may have all of their repairs and maintenance done on the weekend instead of during the week so that there will be excess capacity during the week, and service employees may need extra compensation to work weekends.

(b)

Contribution margin per day might be a good financial performance measure because it takes into consideration both sales and variable costs. Nonfinancial measures could include average service time per vehicle, or a measure of labour time used that should encourage speedy service. In addition, a measure that tracks the number of customers with problems or complaints related to service should provide incentive for employees to spend enough time on each vehicle to prevent problems.

(c)

After a year’s worth of data has been collected, operations can be analysed and correlations developed to determine an optimal average service time per vehicle, or operating practices that help insure high quality service. For example, if quality problems are higher than preferred, a service inspector could be hired that would review all of the procedures used to service the vehicle with the service employee before the vehicle is returned to the owner. Problems that are uncovered during the review could be remedied if the balanced scorecard measures provide enough appropriate information about operations.

(d) Dyggur management could use the balance scorecard interactively by reviewing the strategy to help deal with strategic uncertainties. So rather than use the feedback on the performance metrics to stay on track as intended, the feedback process may result in a review of the intended strategy.

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19.27 Mission statement, strategy, balanced scorecard implementation Squeezers Juice and Tea Company manufactures organic juices and chai teas that are sold at whole foods stores. Several of its products have been featured in movies because the company’s products are popular with celebrities. The owners and employees value organic products and innovative combinations of juices and teas with outstanding taste. Several employees have found sources of unusual ingredients from organic farmers around the world. The ingredients are more expensive than those used by other juice manufacturers. Although Squeezers cannot set unrealistically high prices, it focuses on high quality. Demand for the company’s products is stable, even though it sets the highest prices for juices in its market. Recently, the costs of several unusual ingredients increased because of weather conditions. The owner is concerned that increasing prices any more could reduce demand. She has taken a business workshop and learned about the balanced scorecard. She wants to incorporate a balanced scorecard at Squeezers. Required (a) Draft a potential mission statement for Squeezers. Explain how you decided what should be included in the statement and how it should be worded. (b) Explain the company’s business strategy and core competencies. (c) Identify several performance objectives for each of the four perspectives. (d) Select two performance objectives for each of the four perspectives, and identify a potential performance measure for each. Explain your choices. (e) Describe possible methods to collect the data needed for each of the performance measures in part (d). For example, what existing information might be available? What new record-keeping might be required? Would the company need to develop surveys? (LO1 and 2) (a)

Here is a possible mission statement: Squeezers Juice and Tea Company produces the highest quality organic juices. We strive to satisfy customers who want organic juices and teas with outstanding taste. The preceding statement attempts to capture the essence of the company in as few words as possible. It used information in the problem to determine the company’s core values.

(b)

The business’ strategies are to be the high quality, high priced juice and tea seller. The core competencies include knowledge of the specific exotic juice and tea drinks that sell well and knowledge of suppliers of unusual gourmet organic ingredients.

(c)

There are many possible performance objectives for each of the four balanced scorecard perspectives. Below are examples. Financial: • Maintain and improve operating margins.

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• Increase revenues.

Customer perspective: • Increase market share. • Decrease product returns and complaints. • Increase customer satisfaction. Internal business processes • Maintain high standards of cleanliness and quality. • Monitor and increase throughput of product while maintaining quality. • Continue to appeal to celebrities (could be considered internal business processes — advertising, or customer perspective) Learning and growth: • Locate new suppliers continually. • Reduce employee turnover to decrease threat of competitors getting information about the beverage recipes. (d)

There are many possible answers to this question. Below are examples. Financial perspective objective measures: To measure improvements in operating margin, operating margin is monitored. To measure increase in revenues, changes in revenues are reported. Customer perspective objective measures: To measure increases in market share, market share is monitored and reported. To measure decreases in product returns and complaints, number of product returned and number of complaints are tracked and reported. Internal business perspective objective measures: To monitor cleanliness and quality, indices would need to be developed. To measure changes in throughput, the throughput rate would need to be monitored. Learning and growth perspective objective measures: To measure efforts in adding suppliers, the number of suppliers or number of new suppliers should be tracked and monitored. To measure efforts at reducing employee turnover, the turnover rate can be tracked and monitored.

(e)

Operating margins and revenues are usually tracked by the accounting system, but change in revenue may need to be calculated. Market share may not be tracked. Squeezers may need to begin collecting such data by gathering information from industry publications or by hiring a consulting company to conduct surveys. Product returns and customer complaints are probably not tracked, so a new system will need to be put into place to measure this. Managers may need to explore different types of indices for cleanliness and quality, although the health department probably inspects on a regular basis. However, health department standards may be too low for Squeezers. There is probably no way to measure the number of celebrities using Squeezer products. However, the company could keep track of the number of times that Squeezer products appear in TV programs or movies. Employees may need to report such information so that it can be tracked. It is likely that some instances will be missed, so this measure may include considerable measurement error. Purchasing probably has information about suppliers and can track these numbers. Human resources can begin to track turnover rates if they do not already do so.

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19.28 Participative strategic planning process and benefits, manager behavior (This problem assumes knowledge from management classes) Quantum Computers produces and sells laptop computers. The entity is currently deciding whether to continue concentrating on the laptop computer market or to expand by entering the highly competitive computer desktop workstation market. Most of the management staff has been with Quantum for a long time. Michael Mitchem, Quantum’s president, wants his management staff to assist him in Quantum’s strategic planning process. Mitchem has scheduled a three-day offsite meeting for the management staff to join together for the entity’s strategic planning process. Required (a) What functional areas should be discussed during the strategic planning process? (b) Identify at least six factors to be considered in a thorough strategic planning process that will move a company such as Quantum to another level of product development. (c) Identify at least three benefits that Quantum can derive from a participatory strategic planning process. (d) Discuss the expected behavior of the managers at Quantum who participate in the three-day offsite strategic planning meeting. (LO1 and 2) (a)

Several different functional areas should be discussed during the strategic planning process. This would include product research and development, production, marketing, and administrative support areas.

(b)

Below are six factors that should be considered in a thorough strategic planning process to move a company such as Quantum Computers to another level of product development. Students may think of others. • Define the mission of the organisation. State the fundamental, unique purpose that sets the company apart from other firms of its type and identify the scope of its operation in product and market terms. • Develop organisational objectives. State the specific aims that management seeks to achieve for the organisation within a stated period of time. Objectives improve the effectiveness of the organisation by providing direction, serving as standards for evaluating performance, and motivating members of the organisation. Objectives can be short and long range, and internal and external. • Evaluate current and projected risks and opportunities in the firm’s environment and business culture, including trends in the competitive, economic, demographic, social, technological, and regulatory areas. • Assess the organisations’ strengths and weaknesses compared to those of other organisations. Identify the firm’s core competencies. Strengths, weaknesses, opportunities, threats (SWOT) analysis is a strategic planning tool that forces managers to identify internal strengths and weaknesses and assess them in relation to external opportunities and threats.

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• Determine the total company resource constraints, including human, physical, and financial. • Formulate strategy. Select an appropriate strategy to take advantage of existing and expected external environmental conditions and the entity’s internal strengths and weaknesses.

(c)

Quantum Computers can derive the following benefits from a participatory strategic planning process. Students may think of others. • Exchange of ideas between participating managers leads to greater creativity, resulting in a better plan. • Participation fosters increased teamwork, cohesiveness, communication, and cooperation among departments and managers. • Communication will be improved, leading to better understanding of the overall mission and strategy and the potential contributions of each area to the organisational mission. This should contribute to improved goal congruence between operating areas and the overall goals of the entity.

(d)

The managers who participate in the three-day offsite strategic planning meeting are more likely to do/feel the following. Students may think of others. • Feel that they have been part of the process and be positive about the plan • Be more motivated and committed to making the plan succeed because they had the opportunity to express their opinions and insights. • Be more enthusiastic in communicating the plan to their subordinates.

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19.29 Balanced scorecard; strengths and weaknesses Brewster House is a not-for-profit shelter for the homeless. Lately funding has decreased, but the demand for overnight shelter has increased. In cold weather, clients are turned away because the shelter is full. The director believes that the current capacity could be used more efficiently. No one has taken time to analyse the physical layout of the shelter and current use of space. Several rooms are used for storage that could probably be used for temporary housing. The stored boxes need to be sorted and moved. Volunteers currently assign beds and manage overnight housing, because the director is busy with fund-raising. Volunteers work just a few shifts each week, so no one has taken responsibility for coordinating improvements in the services offered. The director is considering whether to implement a balanced scorecard to focus the attention of all volunteers on areas that need improvement. Brewster receives funds from several sources including a set annual budget from the council and direct donations from supporters. The director develops a budget each year based on expected funding, but she cannot precisely predict donations. The budget is used primarily to justify funding requests submitted to the council. The director has asked a group of accounting students from the local university to evaluate operations and recommend whether the organisation should develop a balanced scorecard. She cannot give bonuses based on the measures, but she wonders whether developing and monitoring performance measures would encourage the volunteers to increase the use of capacity. She also wonders whether some information from the balanced scorecard could be used to show donors the effectiveness of operations. Required (a) Describe several potential costs and benefits of the balanced scorecard for this organisation. (b) Describe one potential measure for each scorecard perspective appropriate for Brewster House. Explain how information for each measure will be collected. (c) Prepare a memo to the director that recommends whether Brewster House should adopt a balanced scorecard. In writing the memo, consider what information the director needs from you to help her make a decision. (LO1, 3 and 5) (a)

The following are potential benefits and costs of the balanced scorecard for Brewster House. Students may think of others. Benefits: Balanced scorecard performance measures could help Brewster House improve the quality and efficiency of its operations, by helping managers, employees, and volunteers focus on key indicators. If the organisation operates more efficiently, donors are more confident that their donations are effective. In addition, a balanced scorecard could be used to help communicate the objectives and expectations of the organisation to volunteers and donors.

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(b)

Costs: Setting up a balanced scorecard could require the organisation to establish new records, which could take time away from the organisation’s primary activities. In addition, the measures chosen by the accounting students may not be the best set of measures. Some of them might result in unintended consequences, for example the shelter may lose some of its volunteers if they believe that they cannot meet the organisations’ performance measure targets, or if they do not agree with those objectives and targets. Volunteers may also object to having their performance evaluated. There are many potential answers to this question. Below are examples. Financial perspective: Total amount of cash available (government and private grants and subsidies, and donations) per month compared to cash costs per month. If the shelter is using a check book approach to financial operations, a spreadsheet or bookkeeping software could be set up to track this information. It is highly likely that it is already being tracked, though. Customer perspective: Several choices can be considered for this perspective. If the Brewster House director views homeless people as customers, she may want to ask a random sample of the people staying overnight to complete a survey or answer some simple interview questions. If she views donors as customers because Brewster House helps them provide a social good for the community, then the director might want to survey donors about their satisfaction with services. These surveys would require the director to write the survey instrument, run a pilot study to determine whether the instrument gathered all of the necessary information for evaluation, and then develop the final instrument, use it, and evaluate the results. Internal business perspective: The director may want to monitor the percentage of funds used for administration compared to the percentage of funds used for providing shelter. This ratio is monitored by external agencies, such as the Better Business Bureau, and donors pay attention to these types of ratios when making decisions about their donations. Learning and growth perspective: The director and the volunteer staff would probably all benefit from further training. The director may want to learn more about fund raising or the business of running an organisation. The volunteers may want to learn more about dealing with homeless people who are also mentally ill. Separate measures of training hours per employee/volunteer could be tracked.

(c)

Student answers will vary. The memo should be written in language that would be easily understood by a non-accountant manager, and it should include: • Overview of major issues and recommendation • Explanation of the purpose and use of a balanced scorecard • Examples of a few key measures that might be used by Brewster House and how those measures might help the organisation meet its objectives • Description of the costs and benefits of a balanced scorecard for Brewster House • Explanation of how factors were weighed in reaching a recommendation • Major limitations or risks of the recommendation • Identification of next steps

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19.30 Strategy, balanced scorecard for organisation and employee Mark Hopper owns Dane Champions, a dog kennel that raises champion Great Danes for showing and breeding. His vision is to be the best-known breeder of Great Danes globally. His strategy is to breed and sell dogs from outstanding lineage from the standpoint of both physical health and goodnatured temperaments. Following is information about operations over the last year.

Required (a) Is the entity’s strategy one of cost leadership or product differentiation? Explain. (b) (i) Prepare a simple balanced scorecard with one performance measure for each of the four perspectives for Dane Champions using only the data presented. Explain your choices (ii) Explain how these measures are linked. (c) Kennel operating costs include the cost of a local high school student who cleans out the kennels every afternoon after school. Mark is considering whether to set up an individual scorecard for the student. He only pays minimum wage, and although the student is fairly slow, the kennels are kept reasonably clean. Mark wonders whether the student would resent being monitored more closely. Describe one reason for using a scorecard with the student and one reason against using it. (LO3 and 4) (a)

Dane Champions’ strategy is product differentiation. The company wants to be known for dogs with outstanding lineage from both health and temperament perspectives.

(b)

(i) There are multiple answers to this question. Below are examples of answers that take advantage of the data given in the problem. Financial perspective: The operating margin could be used to reflect Champions’ abilities to show and sell dogs so that revenues are maximised while costs are controlled. The current operating margin is:

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Revenues ($24 000 + $110 000) Expenses ($35 000 + $55 000) Operating margin

$134 000 90 000 $ 44 000

Mark could also track the cost per dog for kennelling or cost per show when he is on the road. In addition, revenues could be tracked separately and monitored for growth. Customer perspective: Puppy owners’ average satisfaction indicates the level of satisfaction for current puppy owners. Satisfied owners will be repeat customers and may tell their friends about the kennels, so sales will likely increase. Number of puppies returned also gives an indication of customer satisfaction. Puppies are only returned when owners are not satisfied. Internal processes: Training time spent to prepare dogs for both homes and shows is a measure of internal processes. For this measure, likely an optimal range exists, whereby puppies are trained well enough to succeed at home and in shows, but excessive training has not been done. Mark may want to analyse correlation statistics for changes in training hours and show results or number of puppies returned to identify the optimal range for training time. Learning and growth perspective: Number of champions compared to number of dogs shown would provide information about the company’s ability to identify and train dogs that will succeed in the show ring. Trips to dog shows may need to be added to this group of measures and number of wins per trip could be monitored to insure that an adequate number of trips are being taken, but that most trips result in wins. (ii) From the scorecard measures selected for part (a) we would expect some correlation or link between ‘time spent preparing dogs’ (internal business process perspective) and customer satisfaction (customer perspective); or, customer satisfaction (customer perspective) and revenue (financial perspective). (c)

There are many possible answers to this question; here are examples. Arguments for: The student may respond favourably to a balanced scorecard because it focuses attention on his or her work, and Mark may give praise or a bonus when scorecard results are positive. If Mark is concerned about the number of hours spent in cleaning, he could develop a bonus measure that would encourage quick clean-up while retaining the current level of cleanliness. This may mean that he has to pay a little bit more, so the decision depends on whether the benefits from faster clean-up outweigh the costs. Arguments against: The student could feel that Mark is unfairly monitoring his or her work and either quit or slow down.

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19.31 Balanced scorecard variances A large supermarket has used a balanced scorecard for several years. The store’s vision is to provide customers with low-cost goods and a high-quality shopping experience. The entity’s strategy has been to focus on reducing wait time for help on the floor and at the checkout counter. Information for the last two years follows.

Required (a) Classify each performance measure according to one of the four balanced scorecard perspectives. (b) Analyse the change in each performance measure from 2019 to 2020. Give one possible reason for the change. (c) Which performance measures need further investigation? Explain. (d) What do the balanced scorecard results suggest about the success of the entity’s strategy to reduce wait time? Explain. (e) When an organisation focuses on one strategy, problems sometimes arise in other areas. Do the balanced scorecard results provide evidence of possible deterioration in any operational areas? Explain. (LO3 and 4)

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(a)

Average sale Financial Average variable cost per sale......................................... Financial Average customer wait time at register ............................ Customer Average customer wait time on the floor .......................... Customer Shipping cost per order.................................................... Financial or internal Total returns .................................................................... Customer or financial Total revenue .................................................................. Financial Total labour cost .............................................................. Financial or internal Utilities cost ..................................................................... Financial or internal Number of out-of-stock items ........................................... Customer Employee turnover .......................................................... Learning and growth

(b)

There are many possible reasons for the changes in performance. Below are examples of reasons; students may think of others. • Average sale decreased. This could occur due to a general decline in the economy. It could also occur if sales at the store emphasised low-priced items. • Average variable cost per sale remained the same. • Average customer wait time at the counter remained the same. • Average wait time for help on the floor decreased. This could have occurred because more employees were hired to work the floor, or because of a decline in the number of customers. • Shipping cost per order declined. This could occur if fewer items or less heavy items were shipped, or, the store might have found a shipping company that charged lower prices. • Total returns increased. This might not be significant if total sales had also increased, but sales decreased. The increase in returns could have occurred if floor employees were giving poor product advice. It could also occur if the store received an unusual amount of defective products from a particular supplier. • Total revenue decreased. This could occur because of a bad economy, increased competition, or a change in consumer preferences. • Total labour costs increased. The company hired more workers, increased its pay rates or incurred more overtime cost. • Utilities costs increased. This could be due to higher rates or to relatively more inclement weather that required more heating or cooling. • Items out of stock increased. This could occur because the stores do not carefully track inventory or have optical character readers that track inventories. Alternatively, maybe the store does have such capabilities but no one has time or takes responsibility for the task of keeping stock up to date and on the shelves. They might also have launched a plan to reduce total inventory levels, increasing the out-of-stock incidence. • Employee turnover increased. This could occur if the company had a number of employees close to retirement age or waiting to go to college. Turnover could also increase if the company fails to pay competitive rates or if employees are not properly screened prior to hiring.

(c)

There is no single answer to this question; here is an example of an appropriate answer. Because operating margins depend on revenues, managers may want

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to investigate the decline in average sale. They may want to know if advertising campaigns were related to this problem or if it was driven by factors external to the firm, such as a bad economy. If there have been changes in advertising, managers will want to determine how best to advertise. If the changes are economy related, there may be little that managers can do. Because the company has been focusing on reducing wait time, manager likely want to examine wait time on the floor to see if changes in wait time affect changes in profitability. Managers may want to investigate the reduction in shipping costs to reward responsible employees and also to check that quality of service has not deteriorated in any way. Managers may want to investigate the increase in labour cost. A labour rate change could explain the variance, and then no further action would be needed. However, it is possible that employees have been overscheduled to reduce waiting time. The turnover rate increase may or may not be important to investigate. If employees are retiring, no problems exist. However, if effective clerks are leaving for better opportunities, future sales could be affected. (d)

The results suggest that the company has been successful in reducing its wait time. However, these results do not support a belief that decreasing wait time should increase sales. In addition, the managers cannot know for sure the cause of the downturn in revenues. It is possible that revenues would have decreased even more if the average wait had remained at 3 minutes.

(e)

It appears that the hardware store emphasised the strategy of reducing customer wait times. However, labour costs and total returns are higher than last year. It is possible that these are related to increasing the number of employees on the floor to reduce wait time. Perhaps the floor people are not well trained and give poor advice when customers buy products, or the floor employees convince customers to buy products that they do not need and later return. By tracking the reasons for returns, these problems can be analysed and corrected.

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19.32 Evaluate balanced scorecard design Frieda’s Fizz brews specialty soft drinks, including root beer and other flavours. Its vision is 'To proudly produce and sell extraordinarily smooth, rich, and delicious soft drinks to satisfy kids of all ages.' The entity has a reputation for high quality and unique flavour, enabling it to sell soft drinks at a premium price to gourmet grocery stores in the local area. The entity’s managers plan to expand the business to other geographic regions, but they want to ensure that they maintain high quality as the entity grows. They have decided to implement a balanced scorecard, and they have chosen the following balanced scorecard measures: Financial Perspective 1. Breakdown of manufacturing cost per case: ingredients, direct labour, packaging materials, and overhead 2. Operating profit per case 3. Return on investment Customer Perspective 4. Number of customer complaints relating to taste, freshness, package integrity, appearance, and foreign objects 5. Quality index (an internal measure of manufacturing quality, including microbiology and chemistry) 6. Percentage sales growth Internal Business Process Perspective 7. Ratio of plant production hours to total available time 8. Throughput (number of cases packaged) 9. Waste and scrap as a percent of total production cost Learning and Growth Perspective 10. Number of work-related injuries 11. Number of training hours per employee 12. Number of community volunteer hours per employee Required (a) Explain why uncertainties exist about the best balanced scorecard measures for Frieda’s Fizz. (Do not discuss any of the measures already listed. Instead, focus on why any set of measures might not provide ideal information and on why the managers cannot know with certainty which set of measures is best.) (b) For the balanced scorecard perspective: (i) Describe the strengths and weaknesses of the measures chosen for that category. (ii) Reach a conclusion about the reasonableness of the set of balanced scorecard measures for that category. (c) What are the pros and cons of implementing a balanced scorecard? (d) How valuable do you think the balanced scorecard will be in helping the managers of Frieda’s Fizz meet its vision? Explain. (e) The managers of Frieda’s Fizz want your evaluation of their proposed balanced scorecard. Use the information you learned from the preceding analyses to write a memo to the managers presenting your evaluation of

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(i) whether they should adopt a balanced scorecard (ii) the proposed balanced scorecard design. (LO4 and 5) (a)

Frieda’s Fizz managers cannot be certain that the set of measures they have chosen is the best set because they cannot know for certain whether the measures accurately reflect the objectives that were developed. The managers do not know whether their ability to track performance measures leads to accurate measurement, and they do not know whether there would be a better performance measure that has not been considered. In addition, there may be measures that were considered that would be better but are expensive to track. Managers may not have chosen the best measures, but the most convenient measures, or biased measures that demonstrate their strengths rather than weaknesses. Students may have thought of other uncertainties that affect an organisation’s ability to select appropriate measures.

(b) 1 and 2. Financial perspective: • Strengths: All three measures reflect some aspect of financial performance. In addition, the level of monitoring goes from more micro (direct and overhead costs per case) to the more macro (return on investment). • Weaknesses: The cost measures may be inaccurate if the company’s accounting system fails to accurately assign costs to products. In addition, ROI can be manipulated and includes incentives that may not be good for the long-term prospects of the organisation. • Conclusion: The set of financial performance measures appears to be reasonable if the managers wish to focus primarily on cost control and are not concerned about possible suboptimal decisions or manipulations from use of ROI. However, economic value added may be a better measure than ROI because it can be adjusted to minimise incentives that promote suboptimal behavior. In addition, none of these measures analyse sales (except indirectly through operating income), which are also an important part of profitability. The managers might also consider adding a measure for some aspect of sales; however, this might not be needed because a sales growth measure is included in the customer perspective. Customer perspective: • Strengths: These measures reflect several aspects relating to customer satisfaction, an important perspective for this organisation. These measures also move from micro (customer complaints and a product quality index) to macro (percentage sales growth). As customer complaints fall, sales should increase, increasing profitability. Similarly as the quality index increases, customer complaints should be reduced, although only the complaints regarding freshness and possibly taste. Percentage sales growth should increase profitability and provide evidence that the company is producing a high quality product that meets consumer demands. • Weaknesses: Some customers complain in hopes of receiving free products. Some customers do not complain when a problem arises; they just stop buying the product. The quality index may not reflect the taste of the beverage or whether there are foreign objects in the products, both of which greatly affect customer satisfaction translating to sales volumes. Percentage sales growth may not increase profitability if product contribution margins are low.

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• Conclusion: This set of measures is reasonable if the managers wish to focus primarily on product quality and sales growth. However, the managers may wish to focus on additional aspects of the customer perspective, particularly as the company begins to expand. For example, the managers may wish to monitor customer satisfaction with the ordering system, delivery or customer service.

Internal business process perspective: • Strengths: These measures would be important in cost-efficient production, and also provide an indication of how effectively capacity is being utilised. • Weaknesses: The ratio of plant production hours to total available time is designed to measure the extent to which the plant is productive versus idle. However, this measure might encourage inefficient use of productive capacity (although this concern is at least partially offset by the second measure, which addresses volume of output). The throughput measure could encourage overproduction or lower-quality production. A focus on waste and scrap might draw manager and employee attention away from costs that are more significant, such as raw materials and direct labour. • Conclusion: This set of measures is reasonable if the managers wish to focus primarily on plant utilisation and control of waste and scrap costs. However, other internal process measures may be more important, such as the number of times beverages are back-ordered. In addition, some measures might relate to quality, such as the length of time beverage waits to be shipped or the amount of time spent in shipping.

Learning and growth perspective: • Strengths: Monitoring injuries would encourage managers and employees to improve workplace safety, which would improve employee well-being as well as reduce costs from health care and lost work time. Monitoring training hours would improve employee abilities to perform their jobs and provide greater opportunities for individual advancement. Monitoring community volunteer hours would encourage employees to participate more actively in projects that benefit the community, enhancing the quality of the community as well as the company’s reputation. • Weaknesses: Training hours does not measure the quality or training or results from increased training. Number of community volunteer hours really does not relate to the organisation’s vision. Either the vision or the measure needs to be changed. • Conclusion: This set of measures is reasonable assuming that the managers do not wish to develop new products or encourage other innovations.

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(c)

Pros: • By definition, a balanced scorecard is a set of financial and non-financial measures relating to the company’s mission, strategies, and critical success factors. When the scorecard is implemented correctly with information relevant to good decision making, measurement of company efficiency and success should be much improved. The company will have a better understanding of what its customers and investors need and want, the business practices at which it excels, and a better understanding of potential internal improvements. • When a balanced scorecard is implemented, monitoring will be increased and improved. Every part of the business needs to be examined to ensure that the actual current operating performance aligns properly with long-term strategies • The balanced scorecard helps in evaluating overall performance and can lead to corrective action when needed. If every part of the business is monitored more closely, employees are likely to exert more effort because they know that they are being observed.

Cons: • If the balanced scorecard is not implemented well, there will be little improvement of operations. • Sometimes it may take several years before the full benefits of the scorecard are realised. Because the financial returns are not immediate, people may become frustrated at the perceived lack of results. • If the system is not implemented well, then the activities of the company will not be monitored effectively. If performance measures do not relate to the vision, strategies, and objectives, even effective monitoring may not lead to improvements. • Employees may resent being more closely monitored. They may feel that managers do not trust them and that they are doing their jobs incorrectly. Some measures may result in unintended consequences, such as an emphasis on customer satisfaction that results in higher costs than benefits.

(d)

The current balanced scorecard is likely to help the managers meet the organisational vision, but a few of the measures do not relate well to the company vision, such as number of community volunteer hours per employee. Either the vision should be changed, or this item may not need to be measured and monitored. There may be other measures more related to maintaining high quality through the upcoming growth phase that would be better for Frieda’s Fizz. The success of the balanced scorecard also depends on the support it receives throughout the organisation.

(e)

There is no one answer to this part. Get students to present their answer and use the presentations as a basis for class discussion.

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19.33 Strategies and balanced scorecard measures for a country Brian Henshall, Foundation Emeritus Professor of Management at The University of Auckland, suggests a number of potential performance measures that could be used to monitor performance for the country of New Zealand. Henshall recommends that the measures be published monthly to gauge progress. He also argues that a discussion of potential performance measures would help citizens define what they want. Ultimately, the measures could be used to monitor the performance of elected officials. Following are some of Henshall’s suggestions. Tangible wealth:

• gross domestic product (GDP) percentage change as a measure of • • • •

growth the ratio of government wealth creation to business wealth creation as a measure of government economic performance GDP per person employed and per total number of people in New Zealand as efficiency measures New Zealand dollar exchange rate (percentage change for last quarter or last year) as a measure of economic stability number of bankrupt firms to all trading entities as a measure of business stability

Environmental intangible wealth: • a pollution index that measures degradation of the environment from • • • • • •

pollution a ratio of protected land relative to total government-owned land a ratio of alternative energy resources relative to total energy produced Physical and social infrastructure: educational expense as a percentage of GDP health care expense as a percentage of GDP accidents index serious crimes index

Demographics: • changes in population growth, year to year • growth in education levels • a demographic index that monitors innovations by diversity of peoples • unemployment rates SOURCE: Information from Henshall, BD 2002, ‘Kiwi Scorecard,’ New Zealand Management, July 2002, pp. 15 ff.

Required (a) Suppose government officials developed an objective to increase the number of college graduates because they believe increased education will lead to increased GDP. Brainstorm and identify several ideas for action plans to carry out this strategy. (b) Pick one of your ideas from part (a) and discuss its pros and cons. (c) Brainstorm ideas for action plans to increase the number of high school graduates.

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(d)

Pick one of your ideas from part (c) and discuss its pros and cons.

(LO1) (a)

There are many possible answers to this question. Here are several ideas for increasing the number of university graduates: • The government could offer scholarships to students who might not attend university because of financial need. • The government could pressure universities to reduce their admissions standards so that more students were accepted to their programs. • The government could launch an advertising campaign aimed at promoting university education. • The government could provide special income tax incentives to individuals and businesses that incur university education costs.

(b)

The answer to this part will depend on the idea chosen. Here is a possible answer for one of the ideas presented in Part A. Action plan: Increase scholarships to financially needy students. Pros: Scholarship money will mean that many needy students who are quite capable will be able to complete their education. This should increase the number of students getting university degrees. Cons: Scholarship money that is provided only to the neediest students might mean that some capable students who do not qualify for scholarships based on need are unhappy with the system and do not apply for admission. This proposal also costs the government the amount of money granted in scholarships, plus the cost of processing applications.

(c)

There are many possible answers to this question. Here are several ideas for increasing the number of high school graduates: • High school students may need incentives to stay in school. A program that combines educational information about the benefits of a university education and the offer of university scholarships to students who graduate from high school might increase the graduation rate. • Standards could be lowered so that students would stay in school and graduate. • Alternative schools could be organised to help students at risk succeed.

(d)

The answer to this part will depend on the idea chosen. Here is a possible answer for one of the ideas presented in Part C. Action plan: Provide information about the benefits of university and university scholarships to all students who graduate from high school Pros: Direct financial incentives might be successful in encouraging high school students to graduate, and the educational information might help high school students understand why more education is desirable. Cons: This program could be very expensive to the government, and it might not have a large effect on high school graduation rates.

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Solutions manual to accompany

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Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

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Chapter 20: Rewards, incentives and risk management Questions 20.1

Explain agency theory and how it relates to reward systems. (LO1)

Agency theory is a theory about the relationship between principals and agents e.g. owners and managers, and between managers and employees. The principal hires the agent to do work on their behalf. Agency costs arise when agents fail to act in the interest of the principals. Reward systems are used to try and align the interests of shareholders and managers, or managers and employees.

20.2

Explain the difference between shares and share options. (LO2)

Shares represent equity in an entity now. Share options are an instrument that gives the holder the right but not the obligation to convert the options to shares at some time in the future, at an agreed price.

20.3

What are the arguments for reward systems at the executive level to contain a longer-term component? (LO3)

A common criticism of executive incentives is that they tend to focus on short-term results at the expense of results over the longer term. Therefore, reward systems that contain longer term components will encourage employees to focus on improving the performance not just this year but also for several years to come. This will help avoid decisions that might produce results now but offer no longer-term benefits. To this end, reward systems need to contain a balance of short-term and long-term incentives. This will help ensure a focus on the development of shareholder value in the longer-term.

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20.4

Discuss why an incentive package might include individual, divisional and corporate-level performance targets. (LO4)

An incentive package looking at all three levels of targets would be stronger in aligning the goals of the employee and the shareholders. It focuses the employee not only what they do on a day to day basis but how it impacts on the division they work in and the organisation overall. It also allows for targets to have different time horizons. For example, individual targets may be more short term focused, whereas the divisional and corporate level targets can take a more long-term view. The proportions of the incentive linked to performance at each of the three levels will vary according to the level the manager operates at. For example, a divisional level manager may have a higher proportion of the incentive relate to divisional performance, while a corporate-level manager may have a higher weighting on organisational performance. 20.5

Describe the advantages and disadvantages of equity rewards. (LO3)

Advantages of Equity rewards Disadvantages of Equity rewards • Encourages a longer-term view of • Dilution of shareholder value as a performance by recipients on the result of an increase in the premise that improved company number of issued shares performance over time is likely to • Possible temptation for managers impact favourably on the share to engage in accounting price for the company and misstatement or fraud to meet therefore translate to higher expectations and maintain share incentive payments in the future prices • May help to overcome the agency • Some managers are risk averse problem by aligning the interests and may have a preference for of shareholders and managers cash incentives • Involves no cash outflow for the • May be difficult to relate company (unless loans are managerial effort and decision provided to executives to acquire making to changes in share price the equity)

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20.6

How can target measures be used to promote either short-term or longterm performance? (LO4)

Target measures are used to evaluate performance of individuals and are often linked with remuneration. Therefore, if targets are met then employees will receive higher remuneration. The targets direct the actions of the employee, and can be structured to direct employee action towards meeting either short-term or long-term goals. For example: the target may be to increase return on investment (ROI) in the coming year – this would represent a short-term time frame; or it could be to increase the share price by $X over the next five year period – this would represent a long-term time frame.

20.7

Describe agency costs and give several examples of them. (LO1)

Agency costs arise when agents do not act in the interest of principals because they do not put in the effort required, or do not have the same tolerance for risk that principals have. Examples of agency costs include the cost of forgoing appropriate projects because managers perceive them to be too risky, and poor decision making because of lack of effort to search for high quality information and high quality decision making processes. Specific examples are given in the text.

20.8

What is the role of rewards and incentives for executives in reducing agency costs? (LO1)

Rewards and incentives are costs incurred to align the goals of the shareholders and executives, thereby encouraging the executives to act in the best interests of the shareholders. 20.9 The use of RPE systems for the evaluation of individual managers has been abandoned by many organisations. Microsoft is one example. Given this can be conclude that RPE is no good? LO4 The fact that some firms have not continued with RPE systems is not necessarily evidence that the approach is not appropriate as there could be many factors that could contribute to their abandonment (i.e. difficulty of identifying a comparable peer group and obtaining reliable performance information). Other evidence suggests that RPE systems are in fact gaining popularity in some contexts. Such systems can be viewed as equitable given that an individual managers performance is evaluated with reference to how other managers from outside of the firm and exposed to similar conditions have performed (see Bettis et al. 2014) Bettis, J. C., Bizjak, J. M., Coles, J. L., & Young, B. (2014). The presence, value, and incentive properties of relative performance evaluation in executive compensation

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contracts. Value, and Incentive Properties of Relative Performance Evaluation in Executive Compensation Contracts (February 8, 2014). 20.10 Identify why RPE would be used t the company level. (LO4) RPE systems can help companies to identify any performance gaps relative to others in the market. RPE systems can further enable companies to understand how well they have handled the changing conditions in the market relative to other similar companies that are exposed to the same conditions. Performance evaluations based solely on a company’s own performance can be misleading if there are significant uncontrollable external factors at play (i.e. general economic down-turn).

20.11 ‘Executives should only be compensated based upon the achievement of targets. They should not receive a fixed salary component’. Discuss. (LO4 and 5) Some researchers such as Deming and Kohn would not agree with this statement. They argue that extrinsic rewards do little in the long term to foster superior performance. Deming argues that it is best to pay people well and then help them forget about pay. Other issues relate to the difficulty in linking pay to performance. In contrast support can be found in a recent article in the Economist in which the author argues that while incentives may be badly used by some organisations, if properly managed they can be powerful tools in attracting and retaining talented people and boosting productivity. 20.12 Describe two disclosures required by the Corporations Act with respect to executive remuneration. (LO4 and 5) Students will need to search the internet to discover the requirements of the Corporations Act in relation to executive remuneration. For example, two disclosures are as follows: The Corporations Act 2001 requires that the Annual Directors’ Report include an explanation of the Board’s policy for determining the “nature and amount” of pay to Directors and executives. In the annual report, the Board is also required to show the relationship between the remuneration policy and the company’s performance; and to provide details of pay for each Director and each of the named five highest paid executives.

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20.13 Should a remuneration plan include a cash bonus or share options? Under which circumstances would either be appropriate? (LO3 and 4) Cash bonus would be preferred when: • executive or manager is risk-adverse • When the company does not want to dilute its equity holdings. Share options would be preferred when: • the company wants the recipients to take a longer-term view of performance – as there is a time lag between when the options are granted and when they are able to be exercised • Better aligns the interests of the shareholders and employees • Company does not want to use cash now 20.14 What are the advantages and disadvantages of having an individual’s remuneration linked to performance outcomes? (LO4 and 5) Advantages of linked remuneration • Better aligns goals of employees and shareholders •

•

Directs employee effort and provides a signal about performance metrics and corporate goals Motivates employee performance particularly for those who are likely to be influenced by extrinsic rewards

Disadvantages of linked remuneration • Possible temptation by managers to engage in accounting misstatement or fraud to meet performance tasks • May promote excessive risk taking on the part of the employee • •

Issue of time-lag between the measurement of performance and the receipt of the reward Poor metric selection

20.15 What role does the ASX Corporate Governance Council’s Corporate government principles and recommendations, and the Corporations Act have in executive remuneration? (LO5) The Corporations Act sets the legislative requirements with respect to the disclosure of remuneration practices of public companies. At present, these are relatively broad but must be adhered to. These are sometimes referred to as the ‘black letter’ law requirements. The ASX Corporate Governance Guidelines are sometimes referred to as the ‘soft’ law requirements in that they are not legally enforceable. These usually operate on the basis that companies not complying need to explain why they are not complying.

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20.16 Why would a company restrict when a senior executive can exercise their share options? (LO2, 3 and 5) A company may restrict the date when a senior executive can exercise the share option in order to ensure that the incentive meets its original objective. For example, the company may have an objective of having the share price increase over the next five years to say $5 per share. It could be that after one year the share price reaches this amount – the company would not want the executive to exercise the option now as there would be no incentive for him/her to continue working towards this being maintained over the next few years. It is part of an important package of short and long-term incentives and other rewards focus on the short-term. Sometimes the options are offered in batches or tranches overtime, so that they are nor all granted at the same time. This will usually result in different exercise dates. 20.17 Explain why boards of directors will often employ independent remuneration consultants to assist in developing and assessing compensation plans. (LO5) The use of third parties to oversee assessment development and feedback procedures should preserve anonymity and the integrity of the process. It also brings professionalism to the process, and may assist if the internal process has become a bit mechanical overtime. Also due to the specialist nature of the external consultants they would have exposure to different boardroom practices and be able to benchmark the company.

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Exercises 20.18 Structuring a compensation plan Required Describe the factors that need to be considered when structuring a compensation plan for executives. (LO2 and 4) Factors to consider when structuring a compensation plan include: • The measures to be used (individual; group; corporate). • The time period to which performance will relate (annual or say three-year averages). • The targets to be met to receive the incentive (what has to be achieved in relation to each measure). • The form of incentives to be used (mix of short-term long term, cash and/or equity)).

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20.19 Balanced scorecard; incentives Many organisations use a balanced scorecard set of measures to determine the short-term incentive for senior managers and executives. Required Outline any potential difficulties associated with using a set of balanced scorecard measures to determine the short-term incentive. (LO2 and 3) One of the key difficulties when using a set of balanced scorecard measures linked to incentives is how to convert the different measures into some form of index of performance so as to set benchmarks and determine whether the incentive is payable. Also, the nature of some balanced scorecard measures may not lend themselves to being linked to short-term performance; particularly where the measure may have a longerterm perspective.

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20.20 Relative performance evaluation Relative performance evaluation at the company level often results in using a market index like the ASX100 as the peer group. Required Outline the potential advantages and disadvantages of this practice. (LO2, 3 and 5) The use of relative performance evaluation allows the board of directors to discharge its accountability as CEOs are rewarded based on performance relative to other companies. Also RPE provides insurance against external shocks and is likely to be a more informative measure of CEO actions.

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20.21 Behaviour effect of share options Assume you are a senior manager at a publicly listed company. Under the company’s longer-term incentive plan you have recently received a parcel of share options. These share options can only be exercised (converted to shares) after three years. Required How might this incentive affect your behaviour and decision making? (LO3) The incentive of having share options that can only be exercised after three years will ensure that decisions made today do not have a negative impact on future operating performance. The managers will be motivated to improve the organisation’s performance beyond the current accounting period and this will influence decisions taken.

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20.22 Assessing rewards based on accounting profit Stevan is the divisional manager with the Liberty Property Development Group. His performance report shows a positive divisional margin but a loss for the year. Stevan has complained to the CEO about the common costs that have been charged to his division, and questions the method of charging. If they were not charged or were allocated in a different way, he would have a favourable profit figure and would be awarded his bonus. Required Should Stevan’s bonus be awarded based on the profit or loss figure? Why? (LO2 and 4) The current bonus system used by Liberty Property Development Group does not recognise the span of control of its divisional managers. Stevan’s performance has been assessed on issues over which he has little direct control. Therefore the bonus system lacks the incentive for managers as it does not reward them on performance that they have ability to influence. As stated in the question Stevan’s direct revenues and costs associated with the divisional were favourable.

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20.23 Risk profiling You are required to offer advice to a small but growing community bank. Describe the steps you would take to prepare a risk profile for this organisation. (LO6) Advice to the small but growing community bank on preparing a risk profile would be to identify the following 1.

2. 3. 4.

Strategic risks – associated with market-related activity and competitive dynamics, including threats from competitors and changes in technology such as technological innovations. Might also include measures of brand risk and reputation risk. Financial risks – such as the level of exposure to creditors and potential for a shortfall in liquidity Legal and regulatory risks – the exposure to and ability to comply with applicable and impending laws, and regulations in Australia and overseas. Operational risk – anything that might damage the ability of an organisation to provide product or service offerings to customers.

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20.24 Developing a reward system and reward targets You are a remuneration consultant. The board of a large multi-national bank has asked you to draft a proposal for a new reward system for senior executives. Currently all senior executives are paid a fixed salary. Your investigations at the entity reveal its mission is to be ‘the number one provider of quality banking services in the southern hemisphere’. You note that the entity has planned for 10 per cent profit growth over the next five years with a corresponding growth in share price. The entity has identified customer satisfaction, product quality and product innovation as the key indicators of success. The directors are concerned as company profits have been declining. They consider a revised remuneration scheme may motivate senior executives to grow profits and the share price. Required Prepare a report to the board outlining a new remuneration plan for the executives of the entity. (LO2, 3 and 4) Student responses will vary here as to the specific structure of their remuneration plan. Some thoughts follow. When developing the remuneration plan the structure should ensure that the goals of the organisation (and hence shareholders) are aligned with the employees. The goals for this organisation are as follows: 1. 10% profit growth over the next five years 2. Corresponding growth in share price. 3. Key performance indicators: customer satisfaction; product quality; and product innovation. Therefore the plan should incorporate both short and long-term incentives and rewards. This could be achieved by the following: Component

Delivery

Fixed

Cash Superannuation Cash or mix of cash and shares

Short-term incentive

Long-term incentive

Share options

Performance measure(s) Market median

Time period

Balanced scorecard set of measures based on individual, divisional and group performance Total shareholder return

Short-term targets set for 12 months, based on a BSC index

Focus on shareholder value creation over three-year period.

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20.25 Reward systems for different levels of employees Freshwater is an entity that processes and distributes bottled water throughout Australia and New Zealand. You have been employed as a remuneration consultant to develop a new reward system for the entity. Required Explain how you would develop an incentive plan for the CEO, the divisional manager of the process division, and the sales manager who arranges customer sales. How are the reward systems similar? How are the reward systems different? (LO2 and 4) Employee Level CEO

Features of reward system • Focus should be on overall organisational performance • Targets should cover several years • Share based incentives will encourage long-term focus • Focus should be on divisional performance • Cash incentive for this years performance a share based incentive to encourage continued performance • Cash incentive for meeting targets set which would include both financial and non-financial measures Cash based incentive to encourage increased sales levels for current financial period – a short-term focused measure to encourage increased performance now.

Divisional manager

Sales manager

The rewards systems are similar, in that incentives are given to encourage improved performance. The focus should be on measures that reflect managerial accountability. The reward systems are different, in that the measure for the CEO and divisional managers include an organisational focus and longer-term targets. These employees are responsible for the strategic direction of the company and therefore should be held accountable for its long-term performance.

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20.26 Assessing reward systems You are a remuneration consultant employed by a listed company to assess the CEO’s reward plan. The board is concerned that the CEO is overpaid in absolute terms and also when compared to other CEOs of major corporations. Required How might you determine whether or not the reward plan is appropriate? (LO2, 3 and 5) As a remuneration consultant I would apply relative performance evaluation (RPE) to assess whether the current remuneration plan is suitable. The use of RPE would allow the CEO to be compared against the performance of a peer group. Given that this company is listed on the ASX, then a suitable peer group would be selected from its classifications e.g. ASX50, ASX100, ASX200, or, an industry classification. The size of the company would determine the appropriate peer group.

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20.27 Remuneration disclosure The ASX Corporate Governance Principles and Recommendations set out rules to deal with enhanced management performance and effectiveness and requires disclosure of the process for performance evaluation of the board, its committees and individual directors and key executives. However, the outcomes of individual evaluations are not required to be disclosed. Required Why do you think such a recommendation is included in the guidelines? (LO5) Given the separation of ownership and control, shareholders look to the Board of Directors to monitor the organisation on their behalf. Given the emphasis on corporate governance, shareholders are seeking greater accountability and professionalism of their directors, and want to know what they are getting for the high level of remuneration now paid to directors. Individual evaluation data would be excluded partly to protect the privacy of individuals and the competitive properties of the company.

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20.28 Actions to mitigate risk Ben, an employee of Joseph’s, appears to be extremely enthusiastic about his back-office accounting role. He has been with Joseph’s company for about four years and has performed well in his position. Ben is very keen to progress in the company and Joseph has recently decided to offer him a posting at a small international operation in Asia. While the role is to remain in the back office, the position will not require efforts on a full-time basis. Instead, Joseph decides to provide Ben with an opportunity to manage the currently vacant front-office trading role. While the operation is small and Ben has limited trading skills, Joseph is sure Ben will be able to manage both roles and hopefully learn about, and at the same time develop, the trading arm of this international operation. Joseph decides to award Ben an uncapped bonus on profits earned for the group on top of his negotiated annual base salary. Required Prepare a report advising Joseph on the risk management ramifications of his decisions. What actions should Joseph take to mitigate any perceived risk? (LO6) In this example, the employee Ben has been given both the front-office trading role and the back-office accounting role. This does appear to be in conflict as Ben would be controlling his own activities. There are a number of risk management issues here. The table below first identifies some of the risk management issues, and then suggests actions to mitigate or reduce these risks. Risk management issues Little evidence of supervision of Ben’s activities

Actions to mitigate risk Introduce supervision and frequent reporting of trades Set limits of trading activities

Back-office reporting and operation (trading) reporting not separated with Ben performing both roles

Separate the back-office and operations roles. Ben should be performing one of them, not both.

Uncapped incentive system based on a single measure

Ensure the back-office accounting controls are adequate Introduce other measures, not just ‘profit’ Could place some ‘caps’ in place on the size of the bonus

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20.29 Shared bonus pools Becky Tan is the CFO at Frosters Systems, a diversified company with eight different business units (divisions). Becky has been asked by the CEO to develop a shared bonus pool system. Required What key decisions will Becky have to make to set up the shared bonus system? (LO4) Becky’s key decisions will include: a. Determining the size of the bonus pool; b. Who will be eligible to participate in the bonus pool bonus scheme; and c. How will the bonus pool be distributed to the eligible members?

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20.30 Risk classification framework Harley–Davidson, Inc. has found itself having to confront a number of riskrelated issues. These have mainly related to: (a) the need to increase the number of recalls due to faults (b) surging costs of making the repairs to faulty motorbikes (c) increasing pressure on market share. Required Classify each of the three events above according to the risk classification framework (strategic, operational, legal and regulatory, and financial). (LO6) Risk-related issues a. the need to increase the number of recalls due to faults b. surging costs of making the repairs to faulty motorbikes c. increasing pressure on market share.

Type of risk Operational Operational and financial Strategic

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20.31 Shared bonus pool Sarah Tesar is the lead partner of a medium-sized accounting firm. The eight partners share in an annual bonus pool. The characteristics of the bonus pool system include: • The bonus pool size each year is calculated as 40 per cent of annual profit. • The bonus pool is allocated on the basis of bonus units awarded according to the partners’ performance against target fees generated from new clients. This is meant to reinforce the firm’s strategy of growth through new client acquisition. If the fees target is met, one bonus unit is awarded; if the fees target is exceeded by 10 per cent, two bonus units are awarded; if the fees target is exceeded by 20 per cent, four bonus units are awarded; and if the fees target is exceeded by more than 20 per cent, six bonus units are awarded. This year the annual profit was $2.2 million and the partner performance according to their fees from new client target was as follows: three partners achieved 10 per cent above target; three other partners achieved 20 per cent above target; and two partners exceeded the target by more than 20 per cent. Required (a) Calculate: (i) the value of the bonus pool to be shared (ii) the value of one bonus unit (iii) the value of the bonus each manager would receive for the year. One of the partners, Russell Morris, has sought a meeting with Sarah to discuss the shared bonus pool system. He wrote in an email to Sarah ‘I spend a lot of my time providing our in-house training programs . . . I can’t be out chasing new clients at the same time! Why do we only have one measure for the bonus system?’ (b) How important is the selection of the bonus allocation formula and the measure(s) to be used? (c) In the light of Russell’s email, would you advise Sarah to make any changes to the current system? Explain. (LO4) (a) i. Bonus pool = 40% * $2.2m = $880 000

ii.

and iii Value of one bonus unit and size of bonus

Partner Bonus units per Total bonus unit performance partner 3 partners at 10% 2 bonus units 6 above target

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Value of bonus for each partner $29333* x 2 bonus units = $58 666

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

3 partners at 20% 4 bonus units above target 2 partners at more 6 bonus units than 20%

12 12

$29333 x 4 = $117 332 $29333 x 6 = $175 998

30m bonus units in total *$880 000/30 bonus units = $29 333 per bonus unit

b. The selection of the performance measures in the bonus system is critical. The measures are signalling what is important in terms of achievement and will influence the behaviour and decision making of the managers (and other eligible members). In this case, a single measure of performance is used - fees generated from new clients -. This measure is also used to distribute the bonus pool. This further enhances the impact of the performance measure. c. In terms of changes, there a number of options available: i. do nothing and leave the performance measure and bonus distribution system in place as it is; ii. move from using just one performance measure to multiple measures or even a balanced scorecard set of measures. This of course, introduces the problem of then distributing the bonus using multiple measures. Some form of weighted index would normally be suitable. This would allow for the use of some measures which capture Russell’s concerns, iii. the bonus system could be left untouched, but other mechanisms used to cater for situations like Russell is experiencing. For example, additional fixed pay could be added for such additional duties.

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20.32 Executive remuneration: two-strikes policy Investigate which companies have experienced either one-strike or twostrikes on their remuneration reports in the last year or two. Summarise your results and collect the specifics of one example. (LO4 and 5) This is student dependent based on the research undertaken.

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Problems 20.33 Developing a reward system Synergy Ltd’s incentive plan is based on a shared bonus pool. Return on investment (ROI) is used as the main performance metric and is calculated as: Operating profit before tax ÷ Assets at gross book value Receipt of the incentive is dependent on the achievement of annual ROI targets. These targets were set in consultation with division managers. Moreover, the senior management team is rewarded on the basis of organisational ROI. The amount of bonus received by managers is determined as follows. The bonus pool is determined as: $100 000 + 10% of increases in annual combined ROI The bonus pool is shared 15 per cent to senior management (shared equally among 10 managers on the basis of organisational ROI), 50 per cent to divisional managers (shared among three managers according to divisional ROI) and 35 per cent to managers within the divisions (shared among 12 mangers according to divisional ROI). The bonus payment is in the form of cash. While some members of the management team have expressed concerns about the use of ROI as the key performance metric, the CEO is intent on keeping things simple and believes that ROI is a good summary measure on which to base senior management and divisional manager rewards. One of the senior managers, Sonia Lee, has become persistent in her objections to the current bonus scheme. She feels the scheme needs to reflect shareholder interests with suitable measures at each level of the company that reflect managers’ span of control and the right mix of incentives. Required You have been asked to advise the board of Synergy Ltd on a possible new incentive plan that addresses the concerns of Sonia Lee. Prepare a report outlining the detail of your incentive plan. Make sure you explain how your plan addresses Sonia’s concerns. (LO2 and 4) Advice to Synergy Ltd’s management: The current remuneration plan is based on a shared bonus pool. One benefit of such a structure is that all employees are treated essentially the same. The main performance metric is very short-term focused as it relates to operating profit before tax and is based on annual ROI targets. As the bonus payments are cash based this also focuses the employees on the short-term. Criticisms have been made that the current system does not align the goals of the employees with shareholder interests.

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Therefore, a new system should reflect both short-term and long-term measures, and also focus on the managers’ span of control. Possible measures for the managers could include: (note there is no right/wrong answer it will be up to student to justify their plan) Senior managers – the reward system should focus on overall organisational performance – therefore the incentive plan should include both short-term and longterm measures. Rewards should be share based with either share options given that can be exercised in say 5 years, or alternatively a small parcel of shares given each year to reward growth in the share price. This would encourage long-term performance. Shortterm incentives could be in the form of cash or shares and might be based on a balanced scorecard set of key measures. Divisional managers – the attention of these managers should be on improving the operating performance of their divisions, but also have incentives which are linked to overall company performance – this will reinforce to divisional managers the role they play in overall company performance. Rewards should be a mixture of cash and shares with a suggested breakdown. 1. Company ROI or shareholder return measure over a three-five year period – share based 2. Divisional ROI for this year – cash based 3. Achievement of balanced scorecard targets for division – cash based Managers within the business units – the attention should be focused on divisional performance. Rewards should be cash based and paid on attainment of targets set with the divisional manager at the beginning of each year. Assessment of suggested new reward system: • Isolates business unit and managerial performance, therefore more likely to match span of control with span of accountability – however at the divisional level using ROI may not reflect divisional manager’s span of control • Contains a mix of measures – both long-term and short-term

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20.34 Risk management The Dancing Goat is the name Logan Jones chose for his café. The origins of the name came from a 1600s fable of a young goat herder watching his goats dance after they ate red coffee beans. Logan wanted his customers to have the same pleasant ‘dancing’ experience when they drank his specialty coffee blends. In his Sopital Lane café in Melbourne, Logan has a central roasting room in which he roasts fresh coffee beans from around the world. He offers 12 blends of coffee and delights customers with the atmosphere of his classy, European-style café with couches and low tables. The Dancing Goat has become very successful and Logan began to expand his operations to several locations around Melbourne. He roasts the coffee at the main Sopital Lane café and transports it daily to the other cafés. Logan now has 10 cafés located around Melbourne. They offer a deliberately small, but high-quality gourmet menu. Logan is well liked by his staff and they all understand his requirement for friendly service, a pleasant atmosphere and excellent coffee. Every new staff member learns to make coffee to Logan’s strict specifications and wears The Dancing Goat uniform with pride. Logan is particularly pleased when returning customers at each of the cafés praise his friendly, well-trained staff. Nevertheless, after several years of successful operations, the profitability of the Dancing Goat has begun to decline. Logan has decided to revisit The Dancing Goat’s ‘branding’ strategy. He recently read the following article relating to the Starbucks decision to ‘unbrand’. The idea is that the [Starbucks] chain will turn some of its premises into individually branded neighbourhood coffee shops, to find out whether it will do better by adopting a facade that’s more like an old-fashioned neighbourhood coffee shop. In its home-town of Seattle, an outlet called 15th Avenue Coffee and Tea will be the test-bed for this new non-brand, selling beer and wine as well as high end brew.

Logan is particularly interested in Starbuck’s test-bed 15th Avenue Coffee and Tea store, which courted coffee connoisseurs with the same elaborate coffee brewing machines that Logan decided to purchase for The Dancing Goat cafés. Although Logan is a little dubious about the potential success of the Starbucks’ approach in his operations, he is aware that several café managers are dissatisfied and keen to make significant changes. Logan ponders. Why not let one of the cafés loose for a couple of years to trial a similar unbranding approach? Logan could set simple performance targets based on profitable growth and pay uncapped incentives. He will allow the manager to determine what would best suit the local clientele without too much interference from Logan. After all, Logan knows the manager of the trial café he has selected is not scared to take risks. Logan will be satisfied as long as the profitability of this café remains at an acceptable level. Required Given your understanding of risk management, briefly provide advice to Logan on:

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(a) The risk profile and level of risk exposure for The Dancing Goat of the new approach. (b) How Logan might reduce this level of risk exposure. (LO6) (a) and (b) Risk profile and risk exposure issues Actions to reduce level of risk exposure include: Logan could put in place one or two Uncapped incentives could promote boundaries/rules around the incentive internal competition and encourage plan. excessive risk taking in decision making Decentralised decision making with little supervision

Other than the use of store profits, there is a lack of diagnostic controls

High performance culture and pressure to perform by the newly appointed store manager

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While autonomy and decentralised decision making sounds reasonable, Logan needs to ensure that decisions are in line with his overall objectives and strategy. So, he needs to have these clearly communicated to all store managers. Logan could put in place some additional measures to allow him to monitor the store and manager’s performance a little more, rather than just relying on profits, which is an outcome measure With more measures in place, Logan should be able to reduce the pressure on profit performance of a single store

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

20.35 Reward plan structure Whistlestop Adventure has grown from a one-man operation into a large, soon to be listed, adventure clothing and equipment company. For much of its four-year history, Whistlestop has used one company-wide incentive plan that all employees and managers participated in. The plan is based on equal sharing of a bonus pool determined on the basis of 10 per cent of all profits earned over $2 million. As the company has grown, the benchmark profit figure has changed, but otherwise the plan has remained substantially the same. The company founder explained that the plan was structured this way to encourage an organisational and team view, an objective that has permeated the company’s activities since its beginning. With the impending stock exchange listing, the newly constituted remuneration committee has been working on the development of new incentive plan for executives and managers. The brief from the board includes the requirement to ‘develop an incentive plan in line with company’s strategy of revenue growth through high-quality products and customer service, and align the interests of the new executive team with shareholders’. Required (a) If you were a member of the remuneration committee of Whistlestop how would you suggest the incentive plan be structured to meet the requirements set by the board? (b) What are the dangers for Whistlestop in moving away from the current incentive plan to a new one? How could these dangers be overcome? (LO2 and 4) (a) The new plan would need to incorporate measures to align the goals of employees to shareholders. As shareholders will be interested in the share price it will be necessary for senior management to be encouraged to make decisions that will favourably influence the share price in the market. Senior managers incentives are likely to include share based (either shares or options) and be linked to long-term performance targets, relating to measures such as total shareholder return or EVA. Also the shares could be payable in a few years; released in portions over a number of years; or, share options could be used. This form of structure would be suitable for the longer-term incentive component. Senior managers may also have a shortterm incentive based on [perhaps] a balanced scorecard set of measures reflecting organisational objectives like revenue growth, high-quality products and customer satisfaction. Also given the importance placed on high quality products and customer service, employees involved in either producing the products or providing customer service should be given incentives to encourage superior performance. The incentives should be both short-term based with a cash reward, but also include an additional bonus if quality levels are maintained (or improved) and customer satisfaction levels increase over the years. This additional bonus could be in the form of a small parcel of company shares or a cash bonus.

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(b) The main danger will be a behavioural backlash from employees as the distribution of bonus payments will change, and for some employees they may not even get a bonus if performance targets are not met, or will be excluded from participation in the new incentive arrangements. This may impact the current culture at Whistlestop. Communication with employees will be critical during the process of changing the bonus structure.

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20.36 Evaluating a reward system You are on the board of a computer software company that has three distinct divisions: home networks, small business systems and ERP systems. In a bid to encourage higher performance, it has been proposed that the company would benefit from creating a reward system with a profit-sharing component for divisional managers. At present, divisional managers are paid a fixed salary. The proposal is for the company to pool 5 per cent of the company’s profits each month and pay this amount at the end of the year based on divisional managers’ performance against targets. The targets will be set in the preliminary performance review at the beginning of the year. Targets will cover both divisional and company-wide performance. It is thought that this approach will encourage a commitment to the organisation and encourage individuals to strive for better results. There will be a vote for the current proposal at the next board meeting. Required (a) Discuss the advantages and disadvantages of the proposal. (b) Outline an alternative reward system. (LO2 and 4) (a)

The main advantage of the system is that it encourages divisional managers to improve company performance. However, given that the incentive is short-term focused the divisional managers may make decisions that positively impact on this year’s profit but will have a detrimental impact for the organisation longterm. Examples of decisions that could be made by the divisional manager include: cutting back funding of research and development; limiting employee training and development; cutting back on equipment upgrades and refurbishment. The fact that there is some organisation-wide performance criterion may help to overcome this possible negative outcome.

(b) To overcome the potential problems identified in (a) above, a number of things could be tried including: • Move away from a sole focus on annual performance targets • Increase the focus on organisational-wide performance • Supplement cash rewards with equity-based rewards to help align managerial interests with those of shareholders, and to promote a longer-term view.

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20.37 Behavioural issues associated with reward systems Fitness Forever International sells personal exercise equipment both within Australia and internationally. One division of Fitness Forever produces a product called Absaway, which is a specialised piece of equipment that focuses on exercising the abdominal region. The Absaway is manufactured with both internally sourced and purchased-in components. The divisional performance report shows that the division made sales of 20 000 units at a price of $100 each. The variable costs were $60 per unit. Fixed costs were $200 000. Fitness Forever calculates mangers’ bonuses based on profit. The manager of the Absaway division wants to maximize his bonus. To ensure that the divisional margin is reported at its highest possible level, the manager has been producing more units of the Absaway than required based on sales forecasts. Producing more units has the effect of increasing the ending inventory, which, in the income statement, reduces the cost of goods sold (also called cost of sales). This, in turn increases the divisional margin. The extra production of Absaway units has to be stored, thus increasing the need for warehouse space. Required (a) Comment on the strategy of the manager to produce more units of product than are needed in order boost divisional profits. Is it in the best interest of Fitness Forever? (b) You have been asked to comment on the current reward system at the next board meeting and make recommendations about any changes you think are necessary. What will you say? (LO3, 4 and 5) (a)

By allowing excess production of the Absaway, the divisional manager is able to defer recognition of fixed costs as expenses. The fixed costs will be allocated to the products and recorded as an asset until such time as the products are sold. This has the effect of increasing divisional profits, however, for the organisation this is not a favourable outcome as working capital is tied up in inventory that may not sell quickly, coupled with the additional costs of storage etc. This behavioural effect is an unintended consequence of the performance measure put in place.

(b)

The bonus scheme for the divisional manager should not be solely focused on divisional profits. A number of changes could be considered: • Move away from sole use of profit as the performance measure. Could add relevant divisional metrics such as revenue growth; or, if classified as an investment centre, use ROI or residual income • Combine divisional performance with organisational performance and/or individual performance • Do not have all metrics focused only on annual performance. Include at least one longer-term measure and reward. This might relate more to organisational performance. The reward itself might be in the form of shares or share options.

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20.38 Assessing a remuneration plan Hailey’s Hair Products has two criteria upon which its reward system is based: (1) rewarding executives for performance and (2) adding to shareholder value. At present, the remuneration package for executives consists of a base salary, annual bonus and stock options. The base salary is considered critical to attract the ‘best’ people to positions with the bonus and stock options encouraging performance that leads to increases in the share price. Base salaries are set at competitive levels to attract and retain the ‘best’ people. The bonus is payable if executives meet the annual performance targets set by the board at the beginning of the year. The stock options are not able to be exercised until five years after being granted. A recent initiative has meant that executives are able to substitute the bonus payment for stock options (but still with the five year restriction). The board’s remuneration committee is made up entirely of independent directors and makes use of outside advisors to ensure that recommendations are fair to all shareholders. Required Evaluate the remuneration plan for executives. (LO2, 3 and 4) The organisation has two key criteria relating to the reward system: 1. rewarding executives for performance and 2. adding to shareholder value. The current plan is structured as: Base salary; annual cash bonus (can be taken as share options) based on performance targets set by the Board; and stock options (not exercisable for five years once granted). Comments might include: • Base salaries appear to be industry competitive • Mix of short-term and longer-term incentives. Although we are not told what the performance measures are that are linked to the share options, it looks likely to be share price or some similar measure. • Mix of use of financial and non-financial measures. While details are not provided it seems the annual bonus might include non-financial performance targets while the granting of the stock options is likely to be based on a share price measure. • The use of stock options would appear to be in line with the objective of adding to shareholder value. • Although we are not told specifically, it would seem the reward system is targeted at senior executive. There is no indication whether this plan (or some other plan) extends to other levels in the firm.

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20.39 Risk classification Regal Foods is a multi-divisional company operating in a range of locations around the globe. Its product-based divisions are: Ice Cream and Associated Dairy Products, Confectionery, Nutrition, and Prepared Food. Regal has total sales in excess of $10 billion. The CEO, Ruby Day, recently undertook a company review, which identified the following strategies and objectives: • optimising product performance through strong research and development, product innovation and market share growth • enhancing financial performance through financial discipline and targeted capital expenditure. Divisional managers have traditionally been allowed significant autonomy in line with the decentralised divisional structure. CFO Paul Falkenberg has recently introduced relative performance evaluation (RPE) at the divisional level to promote competitiveness, with the objective of growing the company. Ice Cream and Associated Dairy Products Division The Ice Cream and Associated Dairy Products Division focuses on such products as ice cream, yoghurt, milk and cheeses. The current divisional manager is Alette Rennie, who has been in the position for the past three years. In that time, Alette has achieved average annual divisional revenue growth of 6 per cent. However, there are concerns about some of the exposures the division has. For example in a recent email to the CFO and CEO, Alette expressed concerns about some of the division’s exposures to the agricultural industry, the increasing global competition in dairy products, and the lack of bargaining power of the company in the local milk price wars. Nutrition Division The Nutrition Division focuses on health-related products. Historically, the Nutrition Division has been an excellent contributor to group performance, with annual growth rates of up to 12 per cent for the period 2006 to 2012, and revenues exceeding $2 billion. However, divisional manager Bruce Buncle has found it increasingly difficult to maintain growth. An increasingly crowded market for health and nutritional products seems to be the main driver of these difficulties. As a consequence, debt levels of the division seem to be rising. However, Buncle is conscious that he needs to develop new products and markets in line with company objectives. Buncle and his management team have been considering a range of investment opportunities and have decided on a major investment in the bottled water industry. While the industry has its challenges (for example, environmental opposition to the use of plastic bottles, tightening environmental regulations and the expectation of reduced carbon emissions), Buncle and his management team see a lot of potential with such a strategic move. However, where significant capital expenditure is required, Buncle finds the company investment decision-making processes frustrating.

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The management team within the Nutrition Division has identified a new spring water source in a regional area. The local authorities are in favour of the springs being used to supply the Nutrition Division with spring water for a new water bottling plant to be built in the region. In fact, the local authorities are willing to forgo local taxes and provide subsidies to Regal to ensure the plant is built. The region has experienced relatively high levels of unemployment in recent years and the new plant will generate some 100 local new jobs. While there is some local opposition to the new facility on environmental grounds, Buncle considers these to be manageable. While he knows the project’s financial benefit is mainly after the third year, he knows that the investment is a good strategic move for his division. Required Using the risk classification framework (strategic, operational, legal and regulatory, and financial) identify the key risks to which Regal and its divisions are exposed. (LO6)

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Risk type Strategic

Operational

Sample of key risks for Regal • Moving into the bottled water industry where reputation may be affected • Crowded health and nutritional products market making it increasingly difficult to compete successfully; as well as threat of substitute products • Competitive pressures in dairy industry including threat of substitute products • •

Legal and regulatory

•

Financial

• • •

Impact of seasonal factors on milk quality Errors in production process producing faulty or contaminated products Changes in industry regulation such as has occurred in the dairy industry in Australia Impact of competitive pressures like milk-price wars on liquidity position Any likely negative impact generated by planned capital expenditures

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20.40 Incentives and risk management Part A In the early 1980s, Bernard Hancock built a small brewery on his 150-acre property in the Macedon Ranges. The brewery, named Mountain Mist Brewery, was designed with ales in mind and Bernard introduced a number of cutting edge and innovative technologies to make the wellknown, popular pale ale Misty Hop and others such as Hazy Heidi, Mountain Maid and Sunny Sherpa. The brewery’s highest selling pale ale (Misty Hop) is widely recognised as a high quality boutique beer and is sold, along with the brewery’s other ales, to clubs and restaurants around Australia. All Mountain Mist Brewery ales are distributed in kegs (large containers) and 12-bottle cartons through its Victorian and national wholesalers. The brewery has continued to expand capacity on its site to meet growing consumer demands. Bernard’s vision for Mountain Mist Brewery is to: • grow profitably with incremental investment into selected markets to become one of the top six breweries in Australia • continuously improve perceived consumer quality by improving taste, freshness, package integrity and package appearance • enhance distributor service with better lead times, accurate order fills and lower product damage • continuously lower company costs per litre of beer so Mountain Mist can maintain resources for long-term productivity and success • continuously improve business performance through engaging and developing employees. Given recent sound performance, Bernard is pleased he had made the decision to expand Mountain Mist’s production interstate. This decision was made in line with Bernard’s key objective to be one of the top six national competitors. Mountain Mist currently holds seventh position. With its nearest competitor, Little Creatures, expanding into the eastern market from its Western Australian base, Bernard wants to ensure Mountain Mist will not only maintain market share but grow in size to take Little Creatures’ sixth position. Bernard wants to improve Mountain Mist’s brand presence in the western region, as well as reduce the transportation costs of moving beer across Australia. A local presence in Western Australia would also help reduce reliance on national retail distribution channels. A production site has been selected. A production manager from the Macedon Ranges site has been given the role of overseeing the operational set-up and staying on to manage the new operation. Others, such as microbiologists from the Mountain Mist laboratory, have also been offered the opportunity to move interstate. Thus, Bernard is moving some expertise from the Macedon Ranges and employing more staff at both sites to meet the new staffing requirements. As well as wanting a smooth manufacturing set-up, Bernard argues that it is vital for the Mountain Mist beer to be 100 per cent comparable between manufacturing sites. For Bernard, there are many issues still to contend with in relation to sourcing raw materials.

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Bernard also needs to employ a manager to oversee the sales side of the Western Australia venture. He has offered the role of Western Australia Sales Manager to Matt Jerome. Matt is in his late 20s and had been working for Mountain Mist for about four years in the administration area as an accounts clerk. He has recently spent time on the administrative side of the new Western Australian operations. Bernard is pleased with Matt’s work and knows he is keen to move from administration and account keeping into managing sales at the new facility. While he has not had any previous sales experience, Bernard is keen to offer Matt this personal development opportunity. Matt’s salary comprised a base salary and an incentive based on sales performance. While Mountain Mist had the corporate balanced scorecard (described earlier), they did not link scorecard results to their sales managers’ incentive plans. Bernard was concerned that the balanced scorecard measures would not drive the innovation and risk he required of his sales team. For example, Bernard wanted his sales team to continue to have the flexibility to make last minute changes if their customers required. He thought if they were influenced by rigid balanced scorecard performance measures, they might, in fact, be demotivated. He was also worried that they would work to the measure rather than profit maximisation through meeting customers’ unique, changeable and often immediate needs. Thus, Matt was able to earn a bonus based on the sales generated in the Western Australian region. Matt was also given the autonomy to hire his own sales and administration staff to help manage this new sales division. In addition, Bernard left Matt responsible for overseeing both sales and bookkeeping roles. After all, Matt had excelled at his administrative role in the past. Bernard has contemplated varying remuneration options for Matt. Although Matt will have assets under his control, Bernard decides to reward Matt based on the following incentive structure: • base salary — $120 000 per annum • individual bonus — based on the Western Australian division’s EBIT (capped at $50 000 per annum) • corporate bonus — based on Mountain Mist’s corporate performance (2 per • cent share of ‘above budget’ corporate profit pool) • other — 50 per cent of private health insurance cost, relocation expenses for Matt’s family. Matt has moved his family from the Macedon Ranges to Western Australia and begun to promote Mountain Mist Brewery. The aim is to have manufacturing operations and sales in place for summer 2010–11. Required (a) Discuss the benefits and limitations of Matt’s incentive scheme proposed by Bernard.

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(b) It is mentioned in the case that Matt has assets under his control. What performance measurement alternatives could Bernard have used? How might they improve (or otherwise) on the scheme proposed by Bernard? (LO2, 3, 4 and 6) Part A (a) Benefits • includes individual and corporate level performance • including corporate-level performance has the advantage of encouraging a more goal-congruent environment • the cap on EBIT may limit excessive risk taking Limitations • No use of non-financial measures. There appears to be exclusive use of financial measures both at the individual (EBIT) and corporate performance. • Sole use of cash as the form of reward (b) First, Bernard may have assets under his control, though he may have little to say in the issues associated in the decision to acquire those assets. Nevertheless, if it was thought that the Western Australia division should be classified as an investment centre, then suitable measures might include return-on-investment (ROI); residual income (RI) or economic-value-added (EVA). These measures could be used at the divisional or corporate level, and may better reflect Matt’s span of control.

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20.40 Incentives and risk management Part B Once the Western Australian operation has settled and sales are going well, Bernard considers further expansion opportunities. Given the mature life cycle status of the brewery industry, declining consumption, strong competition from leading producers and competition from substitute products, Bernard wants to expand his business in other value-adding ways. He calls on his management team for ideas. One potential idea worth pursuing comes from Damien Poulsen, a long-term employee. Damien Poulsen has been Bernard’s one and only production manager in charge of Mountain Mist’s spring water. Bernard has great respect for Damien’s work ethic and long-standing commitment to Mountain Mist. Damien is also a qualified microbiologist and employs a team of experts to extract and process the Mountain Mist spring water for the brewing department. A large portion of the Spring Water department’s (SWD) activities relates to the quality control (QC) function for Mountain Mist Brewery. Their main requirement is to ensure the spring water continually meets Mountain Mist’s strict specifications. The mix of sulphates, calcium, phosphorous and magnesium must be correct as excessive amounts of any ingredient can result in poor tasting ales. It can also lead to residue forming on the ale containers. As the spring water from Mountain Mist’s Macedon Ranges spring provides beautifully tasting spring water (free of excessive mineral content) and more than enough spring water for the beer manufacture, Damien Poulsen suggested to Bernard that they expand production into bottled water sales. He points out that spring water is the fastest growing beverage type in Australia and Mountain Mist would be foolish not to take advantage of the opportunity to participate in this market. Australians spent more than $500 million on bottled water last year, a 1.6 per cent increase on the previous year. The current key competitors in the bottled water market include Coca-Cola Amatil Limited (42.0 per cent), P&N Beverages Australia Pty Ltd (22.0 per cent) and others (36.0 per cent). These key competitors own prominent brands including Mount Franklin, Peats Ridge and Cool Ridge. Damien suggest to Bernard that a niche marketing opportunity exists and that they should compete with the higher-priced sparkling and still water brands, which include European imports such as San Pellegrino and Perrier. Damien is also aware of exploiting the growing market sensitivities towards increased water consumption. For instance, climate change has increased demand for bottled water (because of the extended hot summers). However, the demand remains high throughout the cooler seasons of the year for other sports and health-related reasons. The factors that significantly contribute to increasing demand for bottled water include general health awareness and greater knowledge of the benefits of adequate water consumption, concerns about the microbiological condition and taste of tap water in some regions, and that fact that many consumers are

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beginning to acknowledge bottled water as a healthy alternative to highsugar soft drinks. In Damien’s proposal, he outlines the cost structure required for the bottled spring water proposal. He builds his figures from the 2009 industry data. He bases his figures on the average retail price for 1-litre of bottled water ($2.53). Damien outlines the purchases that are most significant to this industry. They include containers, labels and other packaging materials. He explains how the costs for water extraction, such as pumping equipment, have been included in the depreciation cost (but mentions that these costs are currently paid for in full by the brewery). Water costs are relatively minor. That is, they pay the Macedon Ranges Shire Council fees for ground water extraction; however, the fees are insignificant. In the proposal, Damien also mentions that he could draw on existing labour for the production processes, but will need a small number of additional staff to handle the clerical, sales and marketing functions. The total labour costs are equivalent to 14.7 per cent of revenue. In this machine-intensive industry, approximately 53 per cent of total labour is required for managerial, clerical, sales, marketing and other functions. The remaining 47 per cent of total labour is involved in the bottled water production. Damien includes asset acquisitions and associated depreciation costs in his proposal. To begin, he includes full depreciation costs on existing equipment required for the filtration, UV sterilisation and zonation processes that remove undesirable compounds and organic elements from the spring water. Damien also includes the purchase of new assets such as computers and automated bottle production lines in his depreciation costs. In addition, he includes the purchase and depreciation on two trucks required to transport the bottled water to distributors from the Mountain Mist source. In Damien’s list of acquisitions required, he makes mention of new legislative requirements associated with environmental emissions. With this impending legislation, Damien allocates funds to the newly implemented carbon pollution reduction scheme (CPRS) that will measure, monitor and report on the Mountain Mist carbon emissions. To meet the legislative requirements, Damien needs to allocate a percentage of staff resources (15 per cent of one full-time employee’s wages) and equipment to correctly measure their carbon emissions. He notes that this additional cost will be incurred regardless of the decision to invest in the bottled spring water project. Damien also includes accounting, auditing, repair, maintenance, market research and advertising as components of ‘other’ costs. Marketing is a significant cost to the bottled water industry given the need to differentiate a largely homogeneous product. He explains that, in Europe, for water to be designated ‘natural’ it must be bottled at the spring. This could be an important marketing feature for Mountain Mist bottled spring water, even though Australia does not have such a labelling requirement. He mentions how competitor water that has been transported in holding tanks to bottlers can risk contamination. As such, water that is not bottled on site

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may require chlorination which in turn affects the taste. Mountain Mist water, as it is bottled onsite, can truly offer the ‘natural’ European equivalent marketing feature. Damien explains how they would pitch this style of marketing in the up-market hospitality channel representing pubs, restaurants, cafes, cinemas and arenas. They will also focus on marketing to supermarkets and convenience stores as sales through these major outlets comprise 67 per cent of total bottled water sales, but, in this setting, they will not compete on price. He points out that while price is important (that is, they will compete with house brands and generics), the image, particularly from the large brands, remains the most important factor in establishing market share. The niche market could bear additional costs for perceived additional quality and image created by the brewery arm. The main thrust of Damien’s argument is for Mountain Mist to exploit its economies of scope by expanding its beverage offerings. He explains that while materials and packaging are the main cost pressures, he hopes to achieve up to 60 per cent gross profit margin on the Mountain Mist privatelabel bottle water sales. He argues that he can reduce many of the costs. For example, input costs will be reduced as Mountain Mist has the spring water onsite. Rent is not applicable as Mountain Mist owns the Macedon Ranges facilities. In addition, wages, much of the depreciation and other costs can be allocated to the brewing division as it is currently paying for them anyway. As Bernard evaluates Damien’s $30 million bottled water proposal, he also considers the key success factors in the bottled water manufacturing industry. • Control of distribution arrangements — arrangement of distribution ensures timely delivery, low costs and maximised product reach. • Economies of scope — economies of scope refers to the efficiencies in distribution, marketing and administration when a firm produces a wide range of beverage brands. • Having a good reputation — first movers have an advantage in this industry in that they can establish strong reputations, which new competitors need to spend heavily on marketing to match. • Market research and understanding — market research into consumer profiles, attitudes and preferences are important for informing both brand promotion and bottle and label design. • Marketing of differentiated products — product innovation and differentiation (including packaging) contributes significantly to selling the industry’s products. • Economies of scale — scale economies are very important to a low value product since high volumes must be produced and sold to achieve reasonable profits. • Establishment of brand names — strong brand names contribute to the appeal of bottled water as an accessory, as well as building a product’s reputation of quality. This allows bottlers to both win market

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• •

share within particular consumer segments, and to charge premium prices. Attractive product presentation — the design of the bottle is of importance in winning market share and justifying higher pricing in this competitive industry. Effective product promotion — use of in-store merchandising can have a strong influence on consumer choice.

This all sounds quite interesting to Bernard, but he does wonder at the affect of the carbon pollution reduction scheme and the more recent negative publicity bottled water is receiving. This negative publicity surrounds the view that bottled water is not environmentally friendly as it produces significant greenhouse gas emissions and plastic bottles commonly end up in landfill. Bernard wonders at the viability of Damien’s $30 million proposal. Required (a) Advise Bernard on the types of strategic risks you might associate with Mountain Mist. In your discussion, include the risks associated with the expansion of Mountain Mist’s brewing to Western Australia and into the spring water market. You may also wish to discuss the beverage industry in general. (b) What do you consider the level of risk exposure for Mountain Mist? Justify using the risk profile discussion in this chapter. (c) What suggestions do you have for Bernard to overcome these risks? (LO2, 3, 4 and 6) (a) Strategic risks are associated with market-related activity and competitive dynamics and might relate to brand risk and reputation risk. The strategic risks currently confronting Mountain Mist include: • The maturity of the brewing industry restricting future growth opportunities • The threat to the brand should the Western Australian operation fail, or if due to Matt’s actions results in value-destroying activities/decisions. • The threat to the reputation of Mountain Mist, should the negative elements of the bottled water project outweigh the benefits.

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(b) and (c) Sample risk profile and risk exposure issues include:

Possible actions to reduce level of risk exposure

The strategic risks have been briefly outlined above in part (a) and include threats to the brand and reputation risk.

In some ways, Bernard’s actions in Western Australia and with the bottled water project are reactions to the maturity of Mountain Mist’s core activity – brewing.

Operational risks associated with Bernard will need to ensure that structural meeting the more recently introduced safeguards exist to ensure compliance is not environmental emissions regulations. a problem. Structural safeguards can also be used to clarify lines of responsibility and accountability. Bernard needs to ensure that Mountain Mists codes of conduct and mission statements are communicated throughout the organisation, particularly in the new ventures, to ensure a thorough understanding by all management of the organisational view and expectations.

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20.41 Remuneration plan (LO2, 4, 5) Matahari Ltd manufactures and installs renewable energy systems. It has four divisions in Australia: Wind, Thermal Solar, Photo Voltaic (PV) and Installation. The company was listed on the Australian Stock Exchange in 2013. The CEO, William Smith, believes that divisional managers should be given a high degree of autonomy and held accountable for the performance of their divisions. He believes that if the divisions prosper then the company and its shareholders will prosper. Before the beginning of each financial year, William reviews performance and then sets a return-on-investment (ROI) target for each division for the coming year. ROI is defined as the operating profit as a percentage of the book-value of the assets employed. Targets are set in consultation with the respective divisional manager with due regard to the prevailing market conditions. William makes sure that the ROI target is challenging but achievable. Over the past 10 years, the ROI targets have tended to increase slightly each year. Key personnel within each division are awarded a performance bonus, if and only if, the ROI of that division exceeds the target. For the past 7 years, Matahari has been using a bonus and incentive scheme to motivate and reward key personnel. The scheme is based on the distribution of a bonus pool. The size of the bonus pool is 10% of Matahari’s residual income for the year and is capped at $1.5 million per year. The bonus pool is distributed to divisions on the basis of the ROI achieved by each division. If a division does not reach its target, it does not receive a bonus. If a division achieves its target, it receives a bonus score equal to the division’s actual ROI less the division's target ROI, up to a maximum of 5.00 points. The bonus pool is then distributed according to each division’s score relative to the total bonus score. The bonus awarded to a division is then distributed to key personnel as determined by the divisional manager. William is disappointed that Chloe Lee, the manager of the PV Division, has not taken the opportunity to increase her division’s production capacity. The shareholders are supportive and would be happy to finance the expansion. William recalls that divisional managers have been reluctant to submit investment proposals on several occasions in the past. William has also found himself starting to think more about the suitability of the bonus system and underlying performance measures. A member of William’s business network has suggested that Matahari would benefit from the adoption of a balanced scorecard. William gets nervous when people start talking about non-financial measures; he thinks his focus on a small number of key financial measures has worked well to date and aligns with shareholder interests. Required (a) For the year ended 30 June 2019, Matahari’s residual income was $13 939 000. The target and actual ROI’s for each division are given in the Table below. Calculate the bonus awarded to each division by completing the Table below.

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(b) State two key strengths of the existing bonus plan. (c) Identify one key weakness of the existing bonus plan and suggest a change that would alleviate the weakness. (a) Division

Target ROI

Actual ROI

Bonus Score

Bonus Awarded ($’000) (to the nearest thousand dollar)

Wind Division

11.3%

12.5%

1.2

$577 000 [(1.2 ÷ 2.9) x $1 393 900]

Thermal Solar Division

9.5%

10.0%

0.5

$240 000 [(0.5 ÷ 2.9) x $1 393 900]

PV Division

12.8%

14.0%

1.2

$577 000 [(1.2 ÷ 2.9) x $1 393 900]

Installations Division

12.0%

11.5%

Bonus pool

2.9

$1 393 900 (i.e. 10% x $13 939 000)

(b) - The use of ROI encourages managers to carefully scrutinize any new asset acquisitions and encourages managers to focus on ensuring that their divisions operations are efficient. - The divisional managers are involved in establishment of the targets. The targets are challenging but achievable. These features can help to promote the adoption of targets by divisional managers. - ROIs are relatively simple to calculate and are largely free from professional judgement. - The use of ROI percentages enables larger and smaller divisions to be compared reliably. - The use of a residual income bonus pool which is shared by all managers encourages all managers to work collectively to boost the overall residual income of the firm. (c) A key weakness of the existing bonus plan system is that it is largely influenced by a potentially problematic performance measure: ROI. A focus on ROI could encourage divisional managers to delay needed capital investments and costcutting behavior which improves the operating profit, but diminishes service quality or reliability. Such behavior might improve the ROI in the short-term, but result in a deterioration of the firm’s performance in the long-term. As such, one key change the firm could implement is in regards to how the bonus score is calculated. The score could be expanded to include a range of other financial and non-financial performance measures.

Solutions manual

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to accompany

Management accounting th 4 edition

by Eldenburg et al. Prepared by Gillian Vesty

Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS

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Chapter 21: Sustainability management accounting Questions 21.1 What is the link between sustainability strategies and management accounting?

LO1

As more and more organisations recognise the importance of managing their environmental and social performance and commit to sustainability strategies, management accounting practices have had to innovate accordingly. Management accounting practices are required to translate an organisation’s sustainability strategies into specific objectives, with relevant environmental and social performance measures reported on to evaluate progress. Various other sustainability management accounting tools are now available to support the attainment of organisational sustainability strategies, for instance: environmental cost classification and reporting, sustainability cost allocation and full cost accounting, sustainability life cycle costing, sustainability balanced scorecards. 21.2

Define the terms ‘sustainability’, ‘sustainability management’ and ‘sustainability management accounting’. (LO1)

Sustainability is the development that meets the need of the present without compromising the ability of future generations to meet their own needs. Sustainability management is the process of measuring, monitoring and simultaneous control of the economic, environmental and social dimensions of an entity. Sustainability management accounting is the tool that simultaneously integrates the economic, environmental and social dimensions of an entity with strategic management.

21.3

Is sustainability achievable in all organisations regardless of their operating activities? (LO1)

Sustainability is potentially achievable in all entities regardless of their operating activities. For example, as highlighted in this chapter BHP Billiton (Australia’s largest mining corporation) is actively involved in promoting their sustainability performance and have been awarded for their sustainability achievements. Nevertheless, whilst they are considered significant GRI organisational stakeholders their mining activities could potentially create significant externalities. Their operational activities (like many other mining and industrial companies) might be considered to be at odds with the achievement of sustainability. In the process towards sustainability, competitors and other companies in the supply chain (suppliers and customers) are all affected by a company’s sustainability activities. Sustainability issues experienced by one company are likely to be informative about sustainability issues for other companies within the same industry. Suitable suppliers might be identified or negotiated on the terms of supplying raw materials that have been produced or extracted in compliance with sustainability factors. Likewise, potential customers may only decide to purchase products from sustainability promoting companies.

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It is important that students are aware that there may be potential conflicts among the interests of managers, companies, shareholders, vendors, customers, competitors, governments, society in general and future generations. Managers, companies and shareholders are often interested in maximising profits, which often conflicts with management emphasis on sustainability considerations. When companies act on sustainability information, they may be forced by governmental regulation or by public opinion to reduce externalities. Consumers and public interest groups monitor companies and take actions against companies they see as degrading the environmental. Governments are often caught in the middle. While they want to protect public environmental interests, they also want to promote economic growth.

21.4

Why should the economic, environmental and cultural dimensions be managed in unison? (LO1 and 2)

Optimum sustainability operations cannot be achieved without the economic, environmental and cultural dimensions being management in unison. Sustainability success is only achieved when jointly the three factors are met. For example, a company can no longer continue to exist (is no longer viable) if it cannot meet its financial goals despite achieving optimal environmental and social performance. Economic success can fuel achievement in the other two dimensions. Likewise, an entity’s social and environmental concerns and capabilities might highlight to customers and investors the need to provide continued support by purchasing or investing.

21.5

Will organisational efforts towards sustainability result in reduced organisational profits? (LO1 and 2)

Organisational efforts towards sustainability may not necessarily result in reduced organisational profits. Some organisations, actually promote their sustainability efforts to generate revenues. Other companies may find certain approaches actually increase rather than reduce their profits. For example, companies may undertake certain value chain activities to minimise waste and eliminate non-value added activities. They may decide to utilise more efficient energy sources or to negotiate improved supplier relationships for sustainability promoting inputs. Furthermore, shareholders seeking ‘green or ethical’ investments may be more inclined to invest in companies that are working towards sustainability outcomes.

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21.6

Outline the relationship between the scope (levels) of costs and full cost accounting. (LO3)

The (scope) levels of costs identify the following:

• • • • •

Level 1 – Conventional Costs Level 2 – Hidden Costs Level 3 – Contingent Costs Level 4 - Image and Relationship Costs Level 5 – Societal Costs

These are aligned with the Full Cost Accounting (FCA) approaches which originated with the work of the Tellus Institute (1992) that was further extended and critiqued by Bebbington and Thompson (1996); Gray (1992) and Jones (1999; 2003). The degree of FCA depends on the levels that are included in the analysis. For example, an organisation might conduct analysis to the first 2 levels whereas others might extend to fuller cost accounting by considering further levels or tiers as described below. Tier 0: Conventional Costs Includes direct and indirect costs usually associated with the project of both a capital and revenue nature (e.g. annual operating cost, overhead cost share). Tier 1: Hidden Costs These are additional costs that are usually found in overheads/general accounts. They would include regulatory and environmental management systems, monitoring and safety costs – both capital and revenue in nature (e.g. upfront and regulatory costs, waste management system related cost, back-end cost, testing and monitoring costs). Tier 2: Contingent Costs These are ‘contingent liability costs’ that are not presently incurred in a conventional accounting sense. They may emerge depending on circumstances (for example, if the law changes) and their likelihood can be estimated. Such costs include fines, future clean-up costs and regulatory costs associated with a project (e.g. property damage, natural resource damage and/or future emissions, changes in legal liability, unforeseen expenses, remediation cost). Tier 3: Image and Relationship Costs Costs and benefits that may be assessable in financial terms are likely to arise from improved environmental management. These costs and benefits could include the loss/gain of goodwill arising from a project; changing attitudes of suppliers, customers, and employees; and advertising/image issues arising from environmental performance of projects (e.g. corporate image, community relations, and consumer responses). Tier 4: Environmental Focused Costs Costs that would be incurred if an environmentally focused approach were taken to a project can be estimated. Costs to ensure that a project had zero environmental effect could be estimated. It is unlikely that such costs would become real costs in the absence of a radical change in the regulatory and operating environment (e.g.

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through external ecological accounting, describes environmental - air, water, soil ‘externalities’, measures impacts and monetizes natural capital impact cost, remediation cost, clean-up cost of known releases and ecological impact-added information related to solid waste). Tier 4: Environmental Focus Cost (extended) 1) Through external ecological accounting, describes environmental ‘externalities’ that are monetised (e.g. contingent valuation, damage function approach, hedonic pricing model). 2) Natural capital accounting (Biodiversity + ecosystem impacts) Tier 5: Social cost (extended) Includes loss of beauty, agriculture land, odours and sound, and similar loss of amenity

Source: Bakshi (2016, pp.26-27)

21.7

What types of management decisions can benefit through using sustainability cost information? (LO3 and 4)

The potential benefits from sustainability decision making will be reflected in all three financial, environmental and social outcomes. They may relate to financial gains through by long-term investment strategies such as value chain reengineering for reduction in non-value added outputs such as waste, emissions and environmental degradation. Benefits often extend to the external environment such as improvements to societal factors and local infrastructure in which the company is situated. Long term decision benefits are reflected in the short-term actions taken that demonstrate concern and respect the local and global environment and society. Short term sustainability decision benefits can lead to input efficiencies, resource consumption and other sustainability cost related factors. Other benefits can be demonstrated in positive cultural, stakeholder and employee morale outcomes. In general, the potential benefits arising from sustainability decision-making depends on the organisational context in which the decision was made. Optimal decisions should reflect the entity’s strategies, which in turn should reflect its mission and core competencies. Therefore, the sustainability decision making process for any organisation should begin with clarification of the mission, core competencies, and strategies relating to sustainability.

21.8

Discuss the importance of ethical decision-making in a sustainability management accounting framework. (LO2)

An ethical decision is often considered to be an ethical dilemma because it is openended (i.e. has no single correct solution). Ethical decisions can be supported by the use of a sustainability management accounting framework. That is, stronger guidance is provided when managers have a carefully derived set of sustainability measures and goals structured in a formal sustainability management accounting framework. A sustainability management accounting framework is generally based on organisational

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values, strategies and goals that demonstrate achievement of sustainability planning. In this framework ethical decisions are made to support the best use of resources, minimise effects on the society and environment in comparison to following a standard or traditional management accounting framework that focuses on achievement of bottom line profit goals. If the sustainability management accounting framework is adhered to it will alleviate potential uncertainties for managers in regards to the most ethically appropriate approach to be taken. However, it should be noted by students that ethical decisions involve trade-offs among the well-being of the company, society and other stakeholders. Given the voluntary nature of much of sustainability accounting there will be different people who are likely to have different opinions about what is considered fair sustainability accounting practices and the extent companies can pass their business risks directly on to their employees, community and environment. Managers need to consider what it means to be ethical or fair in terms of sustainability practices and how core values might be translated to an organisational-wide view of the concept of fairness. Below are several possible values that could be argued by managers when making sustainability management accounting decisions. Students may think of others when considering the importance of ethical decision making in a sustainability management accounting framework. • Value: Managers may only take actions that maximise company profits. Under this value, they believe it is not relevant to address questions of ethics when deciding whether to use sustainability accounting. They might consider a sustainability approach should only be taken when profits can be maximised. • Value: Managers should take actions that are legal. This value is similar to the preceding one; it would not be necessary for managers to consider questions of sustainability practices beyond compliance with labour or other laws. • Value: Managers should take actions that maximise the social benefit and/or take actions that do no harm to others. Under these values, managers would need to assess the effects of their decisions on the company, its employees, the environment and society as a whole. This type of assessment could be difficult for managers to perform, given uncertainties about the effects of some sustainability decisions and whether it would be fair for businesses to pass their business risks directly on to the employees, community and or the environment. The decisions would only be considered fair if they improve overall societal benefits, as argued by economists and business analysts. However, not undertaking some sustainability practices would also be unfair if they harm society, as argued by environmental advocacy groups, and others.

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21.9

What are the potential benefits from developing an input-output chart of accounts? (LO4)

The potential benefits from developing an input-output chart of accounts allow managers to increase efficiency, monitor and reduce potential sustainability impacts. A core part of sustainability information systems is the materials flow balances within a defined system. Inputs might include physical units of material, water and energy flows with associated outputs including products, waste and emissions. Students should note that the definition of ‘waste’ may also include the cost of wasted capital and labour which in some cases may represent a sign of inefficient production. In general, the input–output chart of accounts can provide valuable insights for managing life cycles and evaluating the (in)efficiencies on the bottom line. These insights may not be revealed with traditional cost management tools.

21.10 What key measures should be included in a sustainability balanced scorecard? (LO4) The key measures to be included in a sustainability balanced scorecard will vary from organisation to organisation depending on their mission, core values and strategic position. Students should identify that the balanced scorecard measures must be tailored to individual organisational requirements to maximise outcomes. The sustainability measures may be included as part of the company’s formal balanced scorecard performance measurement system. They may be specified in a tailor made sustainability scorecard. Some companies may decide to have an individual perspective for sustainability. For sustainability measures to be suitable they must align with strategy, be able to be measured and linked to positive sustainability outcomes or value. This means that although measures must be quantitative values they may be financial or non-financial in nature. Generally, the non-financial indicators are generated from outside the standard or formal accounting system. The majority of sustainability measures will fall in this category and will emerge from the varying value chain activities performed by the organisation. For example, leading measures of sustainability success may be linked to input materials purchased or the reputation of suppliers or measures relating to organisational innovation and learning. In production, the weight of emissions can be measured numerically and will be calculated from the type of energy inputs. Lagging sustainability measures might include the financial returns from ethical investors. Students may draw on the GRI indicators (page 790 of the text) for guidance on sustainability measures that might form part of the sustainability balanced scorecard.

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21.11 What are some of the sustainability-related considerations that managers should acknowledge when evaluating their organisation’s value chain? (LO4) It is important that every aspect of the value chain should be considered for enhanced sustainability performance. To begin, the research and design function is useful to draw attention to and plan the operational processes in both service or manufacturing firms. Careful research and design will ensure that waste is minimised throughout each aspect of the value chain. The supply (inbound logistics) function is useful to help consider the sustainability of purchased inputs, not only from the supplier but the supplier’s supplier. The supply manager (and associated supply chain processes) can follow sustainability-related impacts through the supply chain by ensuring they are aware of carbon emissions, environmental degradation, use of child labour or unsafe worker environments (particularly when sourcing from third world countries or impoverished regions) when sourcing products. Within the production function, management can ensure equipment or practices are aligned with sustainable practices, both social (optimising occupational, health and safety) as well as environmental (minimising environmental waste). As well as industrial equipment, attention can also be given to the health and safety of workers. By law, directors are required to maintain a safe environment for their workers. Outbound logistics, marketing and customer service functions can similarly pay attention to ensure the sustainability-attributes of their products are advertised to consumers. Attention to the delivery mode of products is also an important part of managing sustainability. For example, the use of energy efficient delivery vehicles. Similarly, some food industries measure ‘food miles’ – that is the distance travelled from input to final product which can be equated with input energy and associated carbon emissions. Other companies’ measure air miles travelled by executives and might prefer to use Skype or video conference to save carbon emissions. Marketing is most important to ensure consumers are aware of the sustainable nature of products. Issues here relate to ‘greenwashing’ which mean that organisations must ensure the other internal value chain activities match the marketing campaign.

21.12 What are some of the factors that managers should consider when implementing sustainability practices in their organisations? (LO5) The factors that managers should consider when implementing sustainability practices in their organisations might relate to the provision of information for sustainability decision making. For example, as the business environment becomes increasingly competitive and dynamic, demand will increase for relevant and useful information to help organisations succeed. Accountants will need to provide input on qualitative as well as quantitative factors and may use many different sources of sustainability information from websites, libraries, journals, other people and others. They will also need to develop new internal sources of sustainability information that managers can use for decision making. Accounting techniques continuously evolve and the requirement for sustainability information requires new ways of thinking and new skills. Organisations will also need to consider the training and skills related requirements to enable sustainability opportunities to be identified and realised and for continual sustainability measuring, monitoring and evaluation. Sometimes new methods are developed, such as the

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Sustainability Balanced Scorecard for strategic management, and sometimes new accounting protocols are implemented, such as those issued by the Global Reporting Initiative (GRI). Other times technological developments facilitate sustainability accounting practices. Accountants and managers need to understand their industry and new technologies that help their organisations choose the most appropriate sustainability accounting and sustainability production methods.

21.13 Briefly comment on how legislation and societal expectations could influence the scope of sustainability management practice within organisations. (LO1, 5)

As a result of legislative requirements, organisations can be required to more actively make use of sustainability management accounting tools and information to ensure that they are in compliance with the requirements. An example illustrating this is the recent Modern Slavery Bill (2018) which requires large Australian organisations to prepare annual Modern Slavery Statements that outline the actions they have taken to eliminate modern slavery risks in their operations and supply chain. This change in regulation, will further promote the uptake of sustainability management accounting tools designed to evaluate the social performance of organisations and their suppliers. Changing societal expectations regarding the importance of organisations improving their sustainability and helping to address climate change risks place further pressure on firms to improve their social and environmental performance. Again, various sustainability management accounting tools can be deployed to enable managers to better understand their current environmental and social performance and how their overall sustainability performance can be better managed. Doing so will help to ensure that the firm is operating in accordance with social expectations and is able to maintain the support of their customers, employees, investors, banks, community and other stakeholders.

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52 Exercises 21.14 Sustainability threats and opportunities The World Coal Institute claims that coal provides over 26.5 per cent of global primary energy needs and generates over 41.5 per cent of the world’s electricity. Coal is one of the cheapest forms of fuel available on the planet. However, burning fuel produces carbon dioxide which contributes to excessive greenhouse gas emissions and global warming. Rather than change energy sources, Clean Coal Technologies (CCTs) have been promoted as a means of reducing emissions, reducing waste as well as increase the efficiency (or amount of energy) gained from coal.72 Required Referring to the information in this problem and drawing on comprehensive example 2, discuss some of the sustainability management threats and opportunities for the future of Australian coal producers. (LO1, 2, 3, 4 and 5) Students may discuss the opportunities for coal producers to benefit from investing in clean coal technologies in terms of customer responsiveness. That is, their actions may lead to their customers deciding to stay with coal rather than switching to alternative power suppliers. Customers may make this decision based on their own economic factors relating to carbon credits or image related factors — where it is not viewed negatively by their own stakeholders that they are using clean coal technologies. Governments may also encourage this technology as the coal industry contributes substantially towards employment growth in Australia. Clean coal may also contribute towards this country achieving its Kyoto emission targets. Thus, potential opportunities may arise through grants or tax incentives that governments might offer to make the investment option more viable for coal fired power stations. Furthermore, potential savings can be made from the reduction in carbon emission fines that heavy emitters such as coal producers might incur (if carbon trading is introduced in Australia). Threats such as competition from other energy suppliers (gas, nuclear solar, wind) will exist regardless of the investment decision. The decision not to invest might make other energy producers more powerful if coal production technology is not considered to be flexible and innovative. Consumer demand for energy may drop overtime as energy productivity is developed. That is, high-efficiency building shells, efficient heating systems or other initiatives to reduce consumption such as compact fluorescent lighting. Other threats may emerge if potential future technologies take off. For example, more recently scientists have proposed two schemes — space solar power (SSP) where giant arrays of solar panels orbit the Earth. The other is lunar solar power (LSP) where vast arrays could be set up on the moon. Both proposals aim to capture solar energy and beam the power back to earth in the form of powerful microwaves. These schemes, while requiring substantial investment, would provide enough energy to power the entire earth as long as the sun continues to shine! For further information see: http://www7.nationalgeographic.com/ngm/0508/feature1/learn.html 21.15 Carbon trading Required (a) Explain how carbon-trading might reduce greenhouse gas emissions.

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(b)

How might the existence of carbon trading schemes affect the management accounting system within organisations? (LO 1 and 4) (a)

Carbon trading schemes aim to reduce global greenhouse gas emissions by opening up a market in trading and investing in emissions allowances and credits. In some parts of the world (i.e. Europe) carbon trading is linked to the Kyoto protocol which has developed global emission targets, broken down by country. Some of the Kyoto member countries now impose emission caps on their constituent industries. At this stage, only selected industries (generally the heavy emitters, referred to as ‘installations’) have received emission allowances. Any installation whose emissions exceed its allocated cap is subject to a penalty or fine and must purchase emissions allowances on the open market to cover the excess. If they do not exceed their allowance (emit less) they can sell their allowances. Market factors of demand and supply will ultimately determine the allowance trade price. This scheme provides incentives for companies to manage their energy consumption (perhaps switching from coal or gas to wind, solar or nuclear where feasible). Likewise, there are potential financial rewards for companies who reduce emissions as the carbon allowances and credits is a financial instrument.

(b)

As the carbon allowances and credits become financial instruments for companies, accounting systems will be required to be structured in a way that they can adequately measure, monitor and control for the costs and benefits relating to greenhouse gas emissions.

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21.16 Balanced scorecard indicators Comment on how the inclusion of environmental and social indicators in a balanced scorecard might contribute to an organisation’s profitability. (LO4) Carefully measured, managed and ultimately disclosed environmental and social performance can provide users of reports with confidence that companies are managing sustainability impacts. Taking a proactive approach internally through formal control mechanisms, such as the balanced scorecard, will ensure any ‘shocks’ are avoided. Unplanned for social or environmental impacts could increase costs (through fines and activities to restore damage) and therefore reduce overall profitability of the company and returns to shareholders. In addition, corporate reputation could be tarnished which might lead to reduced sales and the demise of the company in the long-run.

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21.17 Contingent Costs List some costs that may be considered to be ‘contingent’ sustainabilityrelated costs for the mining industry. (LO4)

Contingent costs are costs that might or might not be incurred at some point in the future. Examples of contingent costs for the mining industry include the costs of the remediation of unknown or future damage to the environment from mining activities. They might be fines for breaching environmental requirements, clean-up costs. Contingent costs also include the liability costs of compensating for undiscovered or future damage to property or persons adversely affected by the mining industry. Analysis of the potential consequences of mining activities can be undertaken, but not very precisely. Contingent costs might include costs relating to soil contamination, landslides, floods or damage to ecosystems, spills, greenhouse effects, endangering or displacement of species, discomfort or damage to public property, health problems in the community.

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21.18 Externalities and sustainability Read the management accounting case at the beginning of this chapter. Using Bank Australia as an example, list some of the positive externalities that might be achieved as a result of its operations. What are some of the negative externalities that could result from the banking operational activities? (LO1 and 3) Positive externalities include the benefits to society through responsible banking. That is, on one hand, bad debts are minimised as loans are only given to those that are capable of repaying them. Loans are not given to polluting industries, such as coal mining, or where funds will be used for unsustainable purposes. Internally, the “we Mean Business’ commitment means that all internal activities will promote sustainability. In mutual organisations, such as Bank Australia, funds are returned to owners. In this case Bank Australia promises a percentage of profits are routinely used to promote socially responsible projects which further contribute to promoting a sustainable future. Negative externalities might be the result of promises that are not achieved or loans being used by recipients for unintended purposes.

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21.19 Sustainability and classification Using the following table, classify each sustainability cost according to their appropriate category (level 1–5).

(LO3 and 4) Category Contingent costs

Conventional costs

Image and relationship costs

Potentially hidden costs

Societal costs

Sustainability cost Cleanup costs from a chemical accident Personal injury Sustainability legal expenses* Disposal of waste* Goodwill/impairment related costs New capital equipment costs Petroleum Raw materials Staff training Site studies* Feasibility studies* Disposal of waste* Remediation costs* Sustainability legal expenses* Community relations program Environmental labelling Sustainability reports Costs associated with stricter monitoring Decommissioning of site Costs associated with prolonged licensing permits Future compliance costs Site studies* Feasibility studies* Remediation costs* Habitat and wetland protection Landscaping around site

*It could be argued by students that depending on the context (for example, a nuclear power plant) and the relevant or already existing sustainability management accounting control systems in place — that some costs that might be considered hidden or contingent) might actually be accounted for by astute managers or legislated management practices. Students might suggest that more information could be provided to determine the extent of management anticipation for these costs in original capital budget or project proposals. Student responses should be discussed in terms of the underlying assumptions made.

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21.20 Sustainability disclosures; management accounting tools Search the newspapers/web to find examples of Australian companies disclosing their sustainability practices using management accounting information or tools such as the balanced scorecard. Provide a report on your findings. (LO 1 and 4) Students will provide varying responses depending on the context of their individual sustainability reports and the scope required by the instructor.

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54 21.21 Carbon footprint accounting 55 Consider the carbon footprint of an airline such as Qantas. Could an airline ever become carbon neutral or positive? Explain. What about a botanical garden? Discuss. (LO1)

1. Qantas – it is unlikely that airlines can fly aircraft without emitting carbon. However, to offset the carbon emissions airlines have taken other initiatives. Qantas have given passengers the opportunity of to contribute monies for each flight they have taken. The monies collected are then used to fund projects. For flights before 30 June 2010, the carbon offset payment towards Australian based Greenhouse Friendly™ approved abatement projects. After June 2010, monies will go towards projects that comply with Australian Government's National Carbon Offset Standard and a small percentage of funds will go to an environmental research trust. Reference: http://www.qantas.com.au/travel/airlines/fly-carbon-neutral/global/en

2. Botanical garden – the botanical gardens could be carbon neutral or positive. For example, they are full of young and mature trees and shrubs at varying stages of development. The plants absorb carbon dioxide during growth and release it to the atmosphere when harvested or litter composted. Carbon is embodied in the trunks, stems, branches, bark, leaves, roots, as well as the water bodies such as lakes. Carbon accumulation occurs quickly during the first few years of woodland growth (even up to 20-30 years before accumulation begins to slow). To become carbon neutral or positive, the gardens would ensure they have a balance between new strong absorber forms of plantations and the weaker or lower absorber forms of plantations or maturing trees. One goal of the gardens would be to return as much carbon to the soil instead of allowing too much litter and mulch to be released to the atmosphere. They would also monitor their use of energy consumption (electricity and other fuel to pump water, run machinery and maintain hot houses etc.).

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56 Problems 21.22 Sustainable management practices In an Environmental Victoria audit, it was found that Australian supermarkets could save $41.6 million annually if ‘green bags’ were universally adopted. This audit was conducted at Leo’s Fine Foods in Kew, Victoria. It was conducted as a timed experiment; that is, clocking a checkout operator on the time taken to fill reusable green or single-use plastic shopping bags. The results are highlighted in the table below.

The results show that there was little difference in transaction times for single-use bags compared with reusable bags. As a result of this experiment, Henty strongly suggests governments introduce a levy on single-use plastic bags to encourage further use of green bags.38 Required (a) If you were designing/conducting this experimental process, what are some of the concerns might you have for results being considered representative of the true situation being investigated? (b) What other sustainable management practices might supermarkets employ to decrease waste? (LO4 and 5) (a)

The answer to this question will vary. Students might raise the concern that the checkout operator was operating under the same conditions for each of the 30time trial tests. For example, was she allowed to rest between time trials? Were the room/environmental conditions similar for each of the 30 time trials? Can results be generalised from only one operator in one supermarket? Are the items being packed a similar set of items (size and weight and degree of packing difficulty) that might be found in any supermarket packing situation? Was the time trial aimed at determining speed versus quality of packing and related customer satisfaction?

(b)

Again answers may vary. Waste has a double meaning. Waste is a material which has been purchased but has not been converted into a marketable product. It is indicative of production inefficiencies and should be evaluated in terms of the organisational context. In this case the supermarket environment. Students might consider waste in terms of physical units — the products (reducing excessive packaging; eliminating or reducing the potential for expired products; waste disposal, treatment, sanitation and cleaning expenditures); the energy waste (paper, power, lighting; water) and associated emissions. They

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might also consider waste in terms of internal and external factors. External factors might be the location of the supermarket and environmental impact it may have (noise pollution; hazards). Students may also consider waste to be labour idle time or even wasted capital such as machinery or equipment that is not utilised.

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21.23 Environmental decision making — Environment Aotearoa and ‘dirty dairying’ in New Zealand In October 2015, Statistics New Zealand published the first comprehensive and independent report on the state of the country’s environment. This provided information on five ‘domains’ — air, atmosphere and climate, fresh water, land, and marine. The report was the first in a three-yearly cycle that reports on one domain every six months and provides a combined, comprehensive picture once every three years. At the time of its release the Minister for Statistics, Craig Foss, stated: This is the first comprehensive report on New Zealand’s environment produced by Statistics New Zealand. It puts into practice the maxim that you manage what you measure. Robust, independent financial reporting has helped achieve significant improvements in New Zealand’s financial management and our ambition is to achieve the same for the environment. Similarly, the Minister for the Environment, Nick Smith, explained: New Zealand’s environment is so important to our quality of life, our successful exporting industries and our nation’s brand that we need robust, independent reporting. It enables us to know where we match up, what areas need more attention, and helps us figure out what we need to do about problem areas. As the country’s population increases, its economy develops and lifestyles change, pressures on its natural resources grow. For example, there have been longstanding issues associated with dairy farming polluting rivers, referred to as ‘dirty dairying’, with at least 151 prosecutions over a four-year period from July 2008 to June 2012 involving 300 charges for unlawful discharges of dairy effluent.70 Regular and independent monitoring of the state of those resources is a first and vital step towards stopping, and hopefully reversing, further degradation. (a) With the use of online data, search for evidence that the dairy industry in New Zealand is working to prevent ‘dirty dairying’. (b) Is it possible for you to know the conditions under which the products you purchase are produced? Why? (c) Is it possible for managers of a dairy cooperative, such as Fonterra, to know with certainty that their outsource partners comply with agreedupon working conditions? Why? (LO1 and 2)

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(a)

Students answers will vary but they should be able to source several different industry websites for evidence. They should look at industry as well as the government oversight bodies. It is also useful for students to review the International Standards Organization (ISO) for social and environmental sustainability practices and procedures that are entailed. Discussion on Environmental Management Systems (EMS) and the measurement of physical flow data are encouraged.

(b)

Consumers cannot know the conditions under which the products they purchase are manufactured, and it is generally impossible to personally investigate working conditions. Not only would personal investigation be expensive, but access to farms and production facilities may be limited and outsiders may not be able to observe everyday practices. Consumers could gain at least some information by clarifying where the products they purchase are manufactured, investigating companies’ outsource practices (from dairy farm to final production of products such as cheese, infant formula, ice-cream etc.), and learning about common workplace problems. They can also determine whether any third parties, including government agencies, monitor and report.

(c)

Responsible organisations will generally trace back through the supply chain to ensure sustainable practices are maintained by partner organisations. They will do this for the supplier, but not always the supplier’s supplier. This can be a problem when there are varying processes to produce a single input product. If there is regulation to meet by supplier organisations, such as International Standards Organisation (ISO) compliance, this helps to ensure practices are complied with as they are regularly audited.

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21.24 Performance evaluation and sustainability balanced scorecard Refer to comprehensive example 3 and search online for more details about these disasters. Could a performance measurement system be useful in mitigating disasters such as these? Is there any way management accounting could provide useful early warning signals for senior management operating in large decentralised organisations such as these? (LO4) Management accounting control systems using performance evaluation, could provide useful warning signals to prevent the strategic risk experienced by the companies in this illustration. The associated scandals have impacted the organisational strategies in a big way. Performance measurement capturing all input-process-output aspects of the value chain will certainly help to pick up any anomalies or deviations from normal practice. The measures should also be aligned to ensure legal or regulatory requirements are maintained. Carefully designed performance measurement systems can help to detect early warning signs of any overly risky activities being undertaken by employees. Systems might also be able to pick up fraudulent operational decisions or the potential for activities to be deliberately over-run by people in a position to sanction the level of operational risk (i.e. likelihood of an accident happening). If issues are evident in one part of operations, questions might be raised about the other operational decisions and potential shortcuts that might be made to jeopardise the quality and/or safety throughout the value chain. An unnecessary propensity for risky operational procedures can result in unexpected ‘shocks’ and a flow on effect to overall financial, strategic and reputational risk.

While performance measurement is important, control needs to be managed correctly. For example, in one of these cases (i.e. VW) there was evidence of too much pressure for performance by the CEO. The CEO was recognised for using performance measurement to manage people out of the business (i.e. sack people if they do not achieve targets). When there are strategic goals to be number 1 in the industry, increased organisational pressure as a result of performance measurement targets might cause unwanted effects, particularly if aggressive targets are set. Mistakes can be made if pressure is placed on inexperienced employees. Sometimes, even potential whistleblowers might not be aware of, or capable of, picking up errors through systematic checks if they do not have adequate training. To overcome some of these issues, performance measures around employee skills and training can be very important as knowledgeable employees help to pick up frauds, errors or lapses in important organisational processes. Another performance measurement problem relates to the extent to which the achievement of performance measurement targets is linked to corporate bonuses and other incentives. This can be an issue if rewards for entrepreneurial risk taking are high. If strict performance measurement and control systems are used and executives are resistant to bad news, then employees might be too scared to highlight mistakes. Any poor performers might likely be reprimanded or sacked. Strict performance measures, which are difficult to achieve might lead to demotivation and burnout. In general, performance measurement systems can be very useful for early detection of sustainability-related impacts but when performance measurement results seem to be too good to be true, there should be heathy scepticism and increased demand for evidence.

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21.25 Performance evaluation and sustainability balanced scorecard Brewster House is a not-for-profit shelter for the homeless. Lately funding has decreased, but the demand for overnight shelter has increased. In cold weather, clients are turned away because the shelter is full. The director believes that the current capacity could be used more efficiently. No one has taken time to analyse the physical layout of the shelter and current use of space. Several rooms are used for storage that could probably be used for temporary housing. The stored boxes need to be sorted and moved. Volunteers currently assign beds and manage overnight housing, because the director is busy with fundraising. Volunteers work just a few shifts each week, so no one has taken responsibility for coordinating improvements in the services offered. The director is considering whether to implement a balanced scorecard to focus the attention of all volunteers on areas that need improvement. Brewster receives funds from several sources, including a set annual budget from the local council and direct donations from supporters. The director develops a budget each year based on expected funding but she cannot precisely predict donations. The budget is used primarily to justify funding requests submitted to the council. The director has asked a group of accounting students from the local university to evaluate operations and recommend whether the entity should develop a balanced scorecard. She cannot give bonuses based on the measures, but she wonders whether developing and monitoring performance measures would encourage the volunteers to increase the use of capacity. She also wonders whether some information from the balanced scorecard could be used to show donors the effectiveness of the operations in achieving social goals. Required (a) Describe how the balanced scorecard could be developed to help demonstrate the social sustainability goals. (b) Provide details of sustainability-related measures for each scorecard perspective you have designed for Brewster House. (c) What issues would Brewster House management have to overcome to ensure a change in practice? (LO4 and 5) (a) The balanced scorecard would be useful to direct activities to ensure the strategic outcomes are met (maximise welfare for the homeless and ensure bed space is optimised). Regular operational measures such as bed space available, number of beds demanded and number of clients turned away (as well as percentage of storage space utilised for overflow bedspace) could help to understand the capacity management issues in more detail. By linking the measures to the volunteer activity, it would make visible the effectiveness of capacity utilisation and management by each of the volunteers. They might be intrinsically motivated to ensure they perform better than the other volunteers. This in turn, might help with budget management and further funds from council. (b) Sustainability-related measures are more social in orientation for this case. As indicated in (a) above, operational measures would relate to bed capacity management. Employee measures would relate to number of new volunteers; volunteer retention rate; volunteer training. Customer measures would relate to health

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and wellbeing of the homeless (number of hospital referrals); number of clients turned away; number of counselling support activities supplied. The financial measures would relate to the donations received; number of new donors; number of sponsoring agencies; council revenue; grants awarded. (c) Management would have to carefully link their budget to the performance measurement system and activities of all employees and volunteers, so they can better see the links between the financials and the activities performed. A clear understanding of the optimal space available for housing will provide them with accurate bed numbers and the capacity available every night. In better linking capacity management to the budget, this might also help with the generation of more funds from council as well as donors. They are more likely to improve donations when they can exhibit good management. The balanced scorecard can be a tool to demonstrate outcomes to financial providers as well as being used for internal management control purposes.

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21.26 Sustainability; outsourcing; monitoring measures

To reduce costs and focus on core competencies, many entities are increasingly outsourcing manufacturing activities to vendors in countries having low labour costs such as China, India, Thailand, Indonesia and Mexico. Certain activists claim that this practice is socially irresponsible. They claim that numerous factory problems in low-cost countries include excessive work hours, poverty wages, toxic gas releases and harassment of union organisers. The problems were exacerbated after the collapse of a garment factory in Bangladesh resulting in 1137 deaths and 2500 injuries. As a result, 41 people, including the building’s owner, were charged with murder or culpable homicide. Such conditions have prompted individuals and organisations to reconsider their purchasing habits and policies. However, some people argued that boycotts against certain companies cause more harm than good; workers who were already poor often lost their jobs, and unionisation efforts and other improvements were hindered.64 They suggest it is difficult for companies to adequately monitor working conditions at outsource locations. Workers were often afraid to talk to inspectors, and they sometimes provided inaccurate information. For example, they sometimes erroneously said that they were not paid overtime because they did not understand how their pay was calculated. In the Bangladesh case, it was found that the owner and managers of the garment factory had forced the workers to enterthe building on the day of the accident despite major cracks appearing on the building a day earlier. Required (a) Describe whether and how sustainability management practices (that is, business practices related to human rights, labour standards and the environment) affect your decisions as a consumer. (b) Is it possible for you to know the conditions under which the products you purchase are produced? Why? (c) Is it possible for managers of companies that retail the final products to know with certainty that their outsource partners comply with agreed-upon working conditions? Why? (d) Would the inclusion of compliance monitoring costs in its purchasing decision process help? (e) Identify and explain four measures that a company could use to monitor worker conditions in outsource factories. For each measure, describe how the company might collect reliable data. (f) How should entities weigh corporate social responsibility and profits when deciding whether or how to outsource manufacturing? Describe the values you use in drawing your conclusions. (LO5) (a)

The answer to this question will vary. For some students, social responsibility may not enter their consumer decisions. For others, social responsibility may guide their decisions. The purpose of this question is to encourage students to consider their own responsibility for economic support of company behaviour.

(b)

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access to production facilities may be limited and outsiders may not be able to observe everyday practices. Consumers could gain at least some information by clarifying where the products they purchase are manufactured, investigating companies’ outsource practices (such as those published by the garment company or retailer), and learning about common workplace problems in various parts of the world. They can also determine whether any third parties monitor and report on working conditions where products are manufactured. (c)

Even the companies that outsource cannot know for certain the conditions in the manufacturing plant. It is likely that when people from corporate headquarters visit, all managers and employees are on their best behaviour. False documentation might be provided for working hours, pay and injury rates. Employees may be reticent to divulge workplace problems because they fear getting fired.

(d)

Compliance monitoring costs are the costs to observe conditions in the manufacturing plants where garments are produced. When selecting manufacturers for outsourcing, garment retailing companies should consider the amount of monitoring needed and the costs for that monitoring in their purchasing decisions. In other words, the monitoring costs are added to other purchase costs in evaluating total costs for purchasing from each supplier. Potential outsource partners are likely to be rejected if they believe it would be particularly expensive to monitor their operations. Here are some measures the company could monitor. Students may have thought of others. • Average worker pay: This measure could be used to evaluate whether worker pay meets at least a minimum acceptable level.

(e)

• Average worker benefits: This measure could be used to evaluate whether workers receive at least a minimum acceptable level of benefits such as unemployment insurance, health care and compensation for time lost due to injury. • Average hours per employee per day worked: This measure would indicate whether workers’ hours are reasonable. • Average age of workers, and the range of ages (youngest to oldest): These measures would allow evaluation of whether young workers are exploited. • Number of injuries: This measure would allow monitoring of the safety of workplace operations.

(f)

There is no one answer to this part. Here are some of the issues that students might discuss: A garment retailer needs to weigh the costs of its social responsibility initiatives with benefits, such as increase consumer sales from customer who care about such factors, aligning corporate actions with corporate values, and so on. The weight placed on social responsibility versus increased profits will depend on the viewpoint of the stakeholder. Some shareholders may prefer increased profits and not value actions taken to protect workers. The manufacturing line employees may want conditions to be similar in all plants that produce all the garment retailer’s products out of a sense of fairness. The officers and board of director members may put more weight on profits, or they may put more weight on social responsibility, depending on their viewpoints. Some customers might place pressure on the garment retailer to achieve lower costs, which would encourage the company to purchase from suppliers with less

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favourable working conditions. Other customers are willing to pay a higher price to cover the costs of more socially acceptable suppliers. Students also need to consider whether it is possible to clearly define the ‘best’ choice from a socially responsibility standpoint. What level of wages, work hours, and benefits is acceptable? Should the level of working conditions vary from country to country? Does it matter whether a supplier provides better working conditions than other employers in a location, if its working conditions are inferior to those in other countries?

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21.27 Ethical Decision making — promoting inappropriate uses of ABC When activity-based costing was first developed, consultants sometimes promoted it for inappropriate uses. Many consulting services focused on using ABC information for short-term decisions such as pricing and product emphasis. Yet in the early stages of ABC and activity-based management development, both flexible and committed costs were included in ABC cost pools and were not tracked separately. As a result, ABC unit costs included both fixed and variable costs, even when the fixed costs were irrelevant for decision making. ABC promoters suggested that all costs were variable in the long run, and they ignored criticism of their methods.

If the ABC cost rates include fixed costs, their unquestioned use in setting prices is detrimental to operations. If demand falls, then production volumes might fall too, causing costs per unit to increase followed by increases in prices. This type of pricing policy can lead to a death spiral, in which prices increase inappropriately as volumes decline. After ABC was developed, it was quickly added to cost accounting curriculums at many different universities. However, a few academics were highly critical of ABC and eventually provided evidence that overhead costs included a large portion of fixed costs, even in the long run.80 As research evidence accumulated, ABC consultants advised entities not to allocate facility-level costs and to categorise costs within each activity cost pool as flexible and committed. Then total costs could be used to analyse processes and improve operations, but flexible cost information could be retrieved for decision making. Currently, ‘incremental ABC cost analysis’ services are being promoted. These services are sometimes called predictive accounting. Because consulting services can be expensive and judging the outcome of new ideas difficult, managers need to incorporate healthy scepticism when considering the potential costs and benefits of products and services promoted by consultants.81 Required

What ethical problems might arise for managers when considering the use of consultants to develop ABC techniques for sustainability opportunities? Your answers should relate to the promotion of ABC for pricing, other short-term decision, incremental ABC or predictive accounting relating to sustainability opportunities? Answers should also consider the potential for consultant bias and whether the technique will benefit their client particularly when the consulting service might have uncertain outcomes. (LO2 and 4) Students will provide varying responses depending on the context of their individual responses and any scope requirements set by the instructor.

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21.28 Sustainability and job costing in a service sector Green and Greener Co., a law firm specialising in environmental litigation, had the following costs last year:

The following costs were included in overhead:

The entity recently improved its ability to document and trace costs to individual cases. Revised bookkeeping procedures now allow it to trace fringe benefit costs for direct professional labour, paralegal costs, telephone charges, computer time, and photocopying costs to each case individually. The managing partner needs to decide whether more costs than just direct professional labour should be traced directly to jobs to allow the entity to better justify billings to clients. During the last year, more costs were traced to client engagements. Two of the case records showed the following:

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•

costs of $15 million and overhead costs of $10 million ($21 million less $11 million in direct costs that are traced this year). Method 3: Allocate the $10 million overhead based on total direct costs. Calculate the allocation rate using last year’s direct costs (professional labour of $15 million plus other direct costs of $11 million).

Required (a) Calculate the overhead allocation rate for method 1. (b) Calculate the overhead allocation rate for method 2. (c) Calculate the overhead allocation rate for method 3. (d) Using each of the three rates calculated in parts (a), (b) and (c), calculate the total costs of cases 875 and 876. (e) Explain why the total costs allocated to cases 875 and 876 are not the same under the three methods. (f) Explain why method 1 would be inappropriate. (g) Would method 2 or method 3 be better? Explain. (h) Explain how professional service firms, like law firms might engage in sustainability practices. (LO1 and 4) (a)

Last year’s costs: Direct professional labour $15 000 000 Overhead costs (all other costs)21 000 000 Total costs $36 000 000 Overhead rate ($21 000 000/$15 000 000)140% of direct professional labour cost

(b)

Last year’s costs: Direct costs: Direct professional labour$15 000 000 Other direct costs 11 000 000 Total direct costs 26 000 000 Overhead costs (remaining costs)10 000 000 Total costs $36 000 000 Overhead rate ($10 000 000/$15 000 000) 67% of direct professional labour cost

(c)

Last year’s costs: Direct costs: Direct professional labour$15 000 000 Other direct costs 11 000 000 Total direct costs 26 000 000 Overhead costs (remaining costs)10 000 000 Total costs $36 000 000 Overhead rate ($10 000 000/$26 000 000)

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(d)

Calculation of overhead allocated under three methods: Case 875 Case 876 Method 1: Direct professional labour × 140% $20 000 × 140% $28 000

$28 000

Method 2: Direct professional labour × 67% $20 000 × 67%

$13 400

Method 3: Total direct costs × 38.5% Case 875: $29 000 × 38.5% Case 876: $37 000 × 38.5% Total costs under alternative allocation methods: Method 1 Method 2 Case # 875: Direct costs $20 000 $29 000 Allocated overhead 28 000 13 400 Total job costs 48 000 42 400 Case # 876: Direct costs 20 000 37 000 Allocated overhead 28 000 13 400 Total job costs 48 000 50 400 Total costs assigned (e)

$96 000 $92 800

$13 400

$11 165 $14 245

Method 3 $29 000 11 165 40 165 37 000 14 245 51 245 $91 410

(f)

(g)

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Method 3 solves this problem by separating costs into three pools: direct professional labour, other direct costs, and overhead. The overhead is then allocated based on total direct costs (direct labour plus other direct costs). This method is the best option for allocating overhead and should be used to give law firm managers and clients an accurate breakdown of costs per case. (h)

Most service industry organisations (a)

Last year’s costs: Direct professional labour$15 000 000 Overhead costs (all other costs) Total costs $36 000 000

21 000 000

Overhead rate ($21 000 000/$15 000 000)140% of direct professional labour cost (b)

Last year’s costs: Direct costs: Direct professional labour Other direct costs 11 000 000 Total direct costs26 000 000 Overhead costs (remaining costs) Total costs $36 000 000

$15 000 000

10 000 000

Overhead rate ($10 000 000/$15 000 000) 67% of direct professional labour cost (c)

Last year’s costs: Direct costs: Direct professional labour Other direct costs 11 000 000 Total direct costs26 000 000 Overhead costs (remaining costs) Total costs $36 000 000

$15 000 000

10 000 000

Overhead rate ($10 000 000/$26 000 000) 38.5% of total direct costs (d)

Calculation of overhead allocated under three methods: Case 875 Case 876 Method 1: Direct professional labour × 140% $20 000 × 140% $28 000

$28 000

Method 2: Direct professional labour × 67% $20 000 × 67%

$13 400

Method 3: Total direct costs × 38.5% Case 875: $29 000 × 38.5% Case 876: $37 000 × 38.5%

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$13 400

$11 165 $14 245

Solutions manual to accompany: Management accounting 4e by Eldenburg et al. Not for distribution in full. Instructors may post selected solutions for questions assigned as homework to their LMS.

Total costs under alternative allocation methods: Method 1Method 2 Method 3 Case # 875: Direct costs $20 000$29 000 $29 000 Allocated overhead 28 000 13 400 11 165 Total job costs 48 000 42 400 40 165 Case # 876: Direct costs 20 000 37 000 37 000 Allocated overhead 28 000 13 400 14 245 Total job costs 48 000 50 400 51 245 Total costs assigned (e)

$96 000$92 800

$91 410

(f)

(g)

(h)

Most service industry organisations like law firms are likely to engage in some form of sustainability practice. For example, they may be influenced by the actions of other companies, particularly competitors, and public opinion. Senior partners also create and are influenced by the company’s

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mission and core competencies which can have a sustainability focus. Sustainability practices might remain in-house. For example, they might become proactive in building or leasing environmentally friendly, ecoefficient offices and environment. They might undertake processes to eliminate waste and non-value added activities such as reduction in paper use and recycling activities. In a broader sense, law firms might also become proactive in sustainability litigation.

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21.29 Ethical Decision making – inappropriate allocation of underapplied overhead82 The Australian government has contracted with alternative energy industry organisations to develop new energy technologies. These contracts are sometimes based on cost. Because these organisations are also developing technologies for non-government entities, incentives exist to shift overhead costs to the government, so that commercial operations become more competitive. Because cost allocations are private information, research provides only indirect evidence that this cost shifting occurs. The following vignette is fictional, but it illustrates potential ethical problems that arise when governments use cost-based contracts for product development.

Deep Water Hydro is an hydro-electricity energy company that focuses on innovative research and development solutions for alternative energy supply for both commercial and government agencies. Because one of its commercial contracts fell through last year, the company had fewer jobs than anticipated. Consequently, the company’s overhead costs were underapplied at the end of the year, so an adjustment was made to increase cost of goods sold (also called cost of sales). Deep Water’s policy is to allocate production overhead as a percentage of direct labour costs for each contract. One of the government contracts completed last year was to develop a hydroelectricity generator that would supply energy from sea water entering Port Philip Bay in Melbourne. The job contract was based on cost-plus-fixed-fee for a total cost of $245 million. The hydro-electricity project was Deep Water’s only government contract last year. Commercial business completed was $105 million, so cost of goods sold (COGS) totalled $350 million. Disagreement about underapplied overhead adjustment The government official in charge of the contract complained to the federal contract auditor that Deep Water’s underapplied overhead should not have been closed to COGS. Instead, he argued that it should have been allocated on a pro rata basis among the contracts in progress, finished goods, and COGS. The auditor asked to see the cost accounting records and financial statements for the period. Following is an analysis of the direct costs and cost allocations (in millions): The $350 million in COGS included $245 million for the government contract. When the underapplied overhead ($100 million) was closed to COGS, the government portion of underapplied overhead was $70 million [$100  ($245  $350)]. Because the contract specified that the government would pay costs plus a fixed amount, the overhead adjustment effectively increased the revenue under the contract by $70 million.

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Actual direct labour costs were $150 million, and the pre-adjustment allocated overhead was $300 million. Therefore, the original allocation rate was 200 per cent ($300  $150) of direct labour cost. Total actual overhead turned out to be $400 million (the $300 million plus the $100 million underapplied). If Deep Water accountants could have perfectly estimated overhead at $400 million and direct labour cost at $150 million, they would have used 267 per cent ($400  $150) as the allocation rate. The underapplied overhead amount was material ($100 million out of $400 million, or 25 per cent). Therefore, the government auditor decided that it should have been allocated on a pro rata basis among the three accounts that reflected work done this period: contracts in progress, finished goods, and cost of goods sold. Had this method been used, the adjustment would have been prorated as follows:

The government's share of the COGS adjustment would be ($245  $350)  $29.4 million = $20.6 million. When the auditor compared this to the original adjustment of $70 million, she knew the government had been overcharged. Alternative methods for allocating overapplied or underapplied overhead The auditor offered Deep Water three alternatives for allocating the overhead adjustment. Under governmental contracts, underapplied overhead could be allocated based on direct materials cost, direct labour cost, or total direct costs. If Deep Water uses direct materials, COGS is increased by $25 million, of which the government portion is $17.5 million. If direct labour cost is used, COGS is increased by $33.3 million, of which the government portion is $23.3 million. If total direct cost is used, COGS is increased by $27.3 million, of which the government portion is $20.1 million. The government and Deep Water must now negotiate to determine the most appropriate proration method. Required

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(a) (b)

(c)

(d)

(e)

Is allocating proportionately more cost to government contracts an ethical problem for Deep Water? Why? When the government pays more than commercial customers pay for work done, does this situation pose a business problem, a social problem or both? Explain. Discuss the preferences of various stakeholders for this problem, including: • Deep Water managers • Deep Water shareholders • Deep Water commercial customers • Deep Water governmental customers • Deep Water competitors • Australian taxpayers Is it fair for the government to pay more for products and services than commercial customers pay? Is it fair for taxes to subsidise the overhead costs for a private business? How can an organisation monitor whether its accounting practices are ethical?

(LO2, 3 and 4) Student responses to questions (a) to (e) will be varied and each should be evaluated on their own merits and rewarded according to arguments posed and associated discussion.

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21.30 Ethical decision-making timely reporting of sustainability budget problems A dilemma that individuals face is whether to be truthful when it appears that a project is over budget. Being over budget typically means that actual costs exceed budgeted costs or that a planned timeline will not be met. People often delay reporting an over-budget condition either because they believe they can catch up later or because they wish to delay negative repercussions. Unfortunately, information delays prevent managers from responding rapidly and decisively to delays in project timing and cost overruns, leading to additional dissatisfaction and inefficiencies. Suppose an energy company establishes a budget of professional hours for a particular sustainability audit job. The hours are broken down by audit area with one area being the valuation of ‘clean energy’ inventory and cost of goods sold. During the last year, the audit client adopted new procedures for assigning product costs to individual units. The audit budget includes extra hours for the estimated time needed to document and assess the reasonableness of the new method. Many factors could cause this part of the audit to be over budget. Consider the following two scenarios: 1. The client failed to establish appropriate records needed to easily audit the new method, and this part of the audit will require more than the budgeted time to complete. 2. The auditor assigned to this part of the audit is inexperienced and is unable to complete the work in the budgeted time. Regardless of the reason for the overage, managers in charge of the audit need to be notified as soon as possible so that they can consider possible ways to realign staff and complete the total job on time. In addition, in the first scenario the audit entity might be able to bill the client for the extra work involved if the audit contract includes a provision for such price adjustments. However, this scenario would most likely require the client to be notified promptly, while the work is still being performed. In the second scenario, the overage may result in a poor performance evaluation, especially if the auditor has similar problems in other audit areas. Yet the overage may be considered reasonable in light of the auditor’s inexperience. Even so, the auditor should be able to accomplish the following: • develop alternative estimates of time and resource requirements for a project • effectively facilitate and control the project process and take corrective action as needed Therefore, the auditor must quickly recognise an impending overage and formulate appropriate strategies for completing the task as efficiently as possible. The auditor also needs to keep her supervisor apprised of the situation and seek help, when needed.

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Required (a) Have you ever failed to meet a deadline on a group project? If so, what were the reasons for the delay? When and how did you report the delay to your team members? Has someone else ever failed to meet a deadline? Does a failure to meet an agreed-upon deadline create an ethical problem? Why? (b) Explore the responsibilities, expectations, assumptions, incentives, and consequences for this problem from different perspectives, including: ▪ the team member who is late ▪ other team members ▪ the team’s client. (c) Draft a policy statement that you could adopt with future team members to handle project delays. How might this policy lead to improved team performance? (d) Think about your future career. How can you work toward developing your professional responsibility as a member of a work team? (LO 2 and 5) Student responses to questions (a) to (d) will be varied and each should be evaluated on their own merits and rewarded according to arguments posed and associated discussion.

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21.31 Ethical Decision-Making — Wasted Soup83 While she was watching operations at a food processing plant, a consultant noticed a large amount of soup on the floor under a filling machine. An operator washed this soup away each day. When asked about the loss of soup, the production manager replied that no losses occurred. In this manager’s view, no problem existed because the production line operating costs were below budgeted costs. Later, a productivity team analysed the amount of soup wasted over a given time period. The team estimated the cost of the leak to be $750 000 a year. To correct the problem, the company installed a set of valves costing $50 000. The new valves eliminated the loss of soup. Instead of measuring performance against expected budget levels, managers could compare actual profits to ideal profits that could be earned if operations were to run at their true potential. By focusing on the gap between ideal and actual profits, managers are encouraged to identify lost profit potential and to reconsider critical processes. Once gaps are identified, managers rank them according to their value to the organisation and correct them in priority order. Required (a) Is it an ethical problem when employees observe inefficiencies in the workplace, such as the loss of soup in this case? Why? (b) Why is it common for employees to do nothing when they observe inefficiencies? Compare the responsibility of operation workers to the responsibility of the operating manager with respect to identifying and correcting inefficiencies. In what ways are the responsibilities the same? In what ways are they different? (c) Is it ethical for employees to ignore inefficiencies? Why? What values did you use to arrive at the conclusion? (d) People do not always seek to achieve their best performance. For example, students sometimes apply minimum effort to achieve a targeted grade. What does it mean for individuals to seek continuous improvement? (LO2) Student responses to questions (a) to (d) will be varied and each should be evaluated on their own merits and rewarded according to arguments posed and associated discussion.

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21.32 Environmental accounting reports; ABC and ABM for environmental costs Many countries provide motivation for entities to produce environmental accounting reports. For example, 17 countries - United Kingdom, Denmark, Netherlands, Belgium, France and Germany among others participate in the European Environmental Reporting Awards program. In Japan, the Global Sustainability Forum and the National Association for the Promotion of Environmental Conservation have given Environmental Report Awards since 1997. In addition, Toyo Keizai and the Green Reporting Forum have given a Green Reporting Award since 1998. These awards encourage organisations to take responsibility for environmental conditions that affect the wellbeing of society as a whole. Visy Industries in Australia (refer to self-study problem 1) has also been recognised by similar Australian sustainability awards programs. You are required to conduct research about corporate environmental disclosures. Choose one company located in Japan and a competitor located in Australia. Go to each company’s website and search for information about its environmental policies and procedures. Also conduct research to find governmental guidelines for environmental accounting. Go to the website of the Environmental Protection Authority in your state or territory (for example, www.epa.vic.gov.au; www.epa.sa.gov.au) and search for information about environmental or sustainability accounting. Now perform a similar search on the website of Japan’s Ministry of the Environment (www.env.go.jp/en/). Skim through the information that you find on each website. In its Environmental Accounting Guidelines, Japan’s Ministry of the Environment identified the following environmental conservation cost categories:

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Required (a) Is environmental accounting an ethical issue? Why? (b) Which company provides the easiest-to-find and most understandable information about environmental policies and procedures? Explain. (c) Discuss a company’s responsibilities for reporting environmental information to various stakeholders, including shareholders, managers, employees, other companies, government regulators, product customers and the general public. (d) If one company provides better reporting than a competitor of its environmental behaviour, policies, and procedures, does that mean the company is more environmentally responsible than its competitor? Why? (e) What factors are likely to affect an entity’s willingness to publish an environmental accounting report? (f) Discuss possible reasons why the governments of different countries place different degrees of emphasis on environmental accounting reports. (g) Discuss ways in which ABC systems could be used to capture information for environmental accounting reports. (h) Discuss ways in which the process of preparing and publishing an environmental accounting report is likely to help a company reduce its environmental costs. (i) Should all governments require companies to publish environmental accounting reports? What values did you use to arrive at your conclusion? (LO1, 2, 3 and 4) Traditionally, companies have not publicly disclosed sustainability management accounting information. However, some governments have begun requiring companies to publicly disclose this type of information, and the awards described in the problem are designed to encourage greater voluntary disclosure. The solutions provided below assume that ‘sustainability accounting’ means public disclosure and/or internal use of sustainability management accounting. (a)

Environmental accounting is an ethical problem because of potential conflicts among the interests of managers, companies, shareholders, vendors, customers, competitors, governments, society in general and future generations. Managers, companies, and shareholders are often interested in maximising profits, which often conflicts with management emphasis on environmental considerations or public disclosure of environmental information. When companies report more environmental information, they are more likely to be forced by governmental regulation or by public opinion to reduce negative environmental effects. Competitors and other companies in the supply chain (vendors and customers) are also affected by a company’s environmental reporting. Information about environmental issues related to one company is likely to be informative about environmental issues for other companies in an industry. Consumers and public interest groups generally prefer more information about environmental issues to improve their abilities to monitor companies and take actions against companies they see as degrading the environment. Governments are often caught in the middle. While they want to

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protect public environmental interests, they also want to promote economic growth. (b)

The answer to this question depends on the companies that students investigate. Students often have difficulty distinguishing between ‘pleasing’ presentations and informative presentations. The answer to this question should include specific reasons about information on one site being more understandable or easy to find than on another site.

(c)

Company responsibilities for reporting environmental information are partly a function of environmental regulation. In countries where greater disclosure is required, companies have a clear legal responsibility to provide it. Company responsibilities for voluntary disclosure are less clear. Because of the conflicts of interest mentioned in Part A above, managers have no clear-cut responsibility. If viewed from the perspective of shareholders, the company’s responsibility might be to minimise environmental disclosure. Employees have a stake in the company’s financial wellbeing and might also prefer less disclosure; however, employees and their families might be affected by environmental problems such as air quality degradation or hazardous waste. In this case, the company’s responsibility might be to provide greater disclosure. Companies generally do not assume responsibility for competitors. However, greater disclosure by one company in an industry might stimulate similar disclosures by competitors. The responsibility to suppliers and customers includes mixed incentives. Less disclosure might help all related companies achieve higher profits, but greater disclosure could lead to improved environmental performance across the supply chain. Company managers often view their responsibility toward government regulators and the general public as meeting minimum legal requirements. However, this view of responsibility assumes that companies have no social responsibility for environmental matters. An alternative view is that companies are responsible for the stewardship of resources they use today and for the resources available to future generations. Many people would argue that company responsibilities lie somewhere in between these two extremes — that managers have responsibilities to generate profits and also to find ways to minimise adverse environmental effects. From this viewpoint, managers have a responsibility to use environmental accounting to help them make better environmental decisions.

(d)

The answer to this question depends on the interpretation of ‘better reporting’ for environmental behaviour, policies, and procedures. In Chapter 1 higher quality reports were defined as more relevant, understandable, and available. Given this definition, a better environmental report would provide information that is more useful to constituents such as shareholders, regulators, customers, and the general public. It would be easier to understand and would be readily available in a timely manner. Outsiders who read an environmental report can determine whether the report is easy to understand and available. However, it is more difficult to determine whether a report provides the most useful information, particularly when disclosures are voluntary. When information is provided voluntarily, it may be biased. For example, an environmental report could provide considerable information about a single environmentally-friendly project, but be silent about environmental problems. Therefore, it may not be possible to determine whether one company provides better environmental reporting than another.

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However, suppose it can be determined that one company provides better environmental reporting than another. In that case, better reporting might occur because the company has better environmental policies and procedures, which in turn could lead to better environmental behaviour. However, the other company could have better environmental behaviour, policies, and procedures (for example, have environmental ISO compliance) but simply fail to provide better reporting. (e)

Obviously, governmental regulation is a factor affecting the publication of environmental accounting reports. In the absence of such regulation, companies are likely to be influenced by the actions of other companies — particularly competitors — and public opinion. Managers also create and are influenced by the company’s mission and core competencies. Companies that place high priority on environmental responsibility are more likely to present a public environmental accounting report.

(f)

Many factors influence governmental emphasis on matters such as environmental accounting. Governments in economically stable countries are likely to place a greater emphasis on the environment. Countries in which citizens are more concerned about the environment will also place greater emphasis on the environment. Governments are also influenced by the actions of other governments and by the requirements of international organisations such as the European Union.

(g)

Methods similar to the ones described in the chapter for measuring quality costs could be used to measure environmental costs. The first step would be to identify different types of environmental activities, costs and drivers. One example is the list of cost categories included in the problem, developed by Japan’s Ministry of the Environment.

(h)

There are two ways that preparing and publishing environmental accounting reports help companies reduce its environmental costs. First, the process of preparing these reports necessarily includes investigation of environmental accounting and reports released by other companies. This investigation can lead to new ideas for reducing environmental costs. Second, companies that publicly release environmental information might be encouraged to more actively engage in continuous environmental improvements.

(i)

This question is open-ended, so answers will vary. It is important to clarify the trade-offs made when arriving at conclusions for this type of problem. Some people have a tendency to adopt a ‘high road’ and fail to recognise the practicalities of governmental regulation. Other people tend to do the opposite — they dismiss what they perceive as idealistic solutions and fail to seek creative or new solutions. The best solutions are those which clarify trade-offs, recognise limitations, and yet still seek to achieve improvement.

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21.33 Ethical decision making: the right thing to do84 In the past, drug makers have been reluctant to invest in cures for diseases in developing countries such as Africa and South America. Most people in these countries cannot afford to pay for treatments, and managers have typically invested in other long-term projects having higher returns. However, a few pharmaceutical companies have chosen to invest in neglected diseases, including tuberculosis, malaria and other tropical diseases. As an example, GlaxoSmithKline formed a joint venture with the World Health Organization to develop a malaria drug that costs less than 50 cents for a three-day treatment. This type of investment has several goals. From a reputation perspective, managers accused of keeping drug prices artificially high may believe that providing low-cost cures will alleviate pressure from regulators and consumers to lower prices for drugs sold in the United States and other developed countries. Furthermore, people from some less-developed countries will eventually have the ability to pay for cures. Finally, ‘it is the right thing to do,’ according to journalist Robert Langreth. Novartis chairman Daniel Vasella says, ‘If you only look at maximizing short-term profit, you may not survive in the long term’. Required Using figure 19.7, address the following question for this ethical dilemma to improve your skills in making ethical decisions. Think about your answers to these questions and discuss them with others: Does an ethical problem arise if pharmaceutical companies charge lower prices for drugs in developing countries than in developed countries? Why? (LO2) There will be varying viewpoints emerging from the discussion of this problem. Students may talk of the company research and development costs that need to be accounted for and covered; as well as the requirements for GlaxoSmithKline (or other pharmaceutical companies) to maintain or increase shareholder returns. They may discuss the political state of developing countries where governments may, or may not, have the financial capabilities to subsidise treatment for their people. They may discuss about whether it is the role of a company to be charitable or are these types of opportunities worthwhile reputation building exercises? In using Figure 19.9 students may point out that: • The ethical problem is identified as being about the deliberate choice to subsidise treatment costs to patients that cannot afford treatment, such as those in developing countries. • In objectively considering the wellbeing of others and society, the alternatives might include the promotion of philanthropic pursuits (such as the GlaxoSmithKline project), lobbying governments, negotiating supply arrangements; promotional and advertising capabilities (i.e. if purchase another company product, $x will be given to supplying certain drugs to improve world health standards). • Students might calculate the cost to the company’s reputation if they choose to ignore these types of ethical dilemmas. When choosing a course of action, the management must look to their mission and strategies in order to clarify the position they take. • In working towards ongoing improvement of personal and organisational ethics, senior managers might want to know the views of their employees; and how do

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ethical decisions impact on the internal reputation of the company. For example, are good ethics rewarded with attracting and retaining the best employees in a competitive environment?

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