Managerial Accounting Tools for Business Decision Making, 5th Edition solution manual by Ace Test Banks

Managerial Accounting Tools for Business Decision Making, 5th Edition BY Weygandt, Kimmel, Kieso

CHAPTER 1 Managerial Accounting ASSIGNMENT CLASSIFICATION TABLE

Study Objectives

Questions

Brief Exercises

Do It!

Exercises

*1.

Explain the distinguishing features of managerial accounting.

1, 2, 3

*2.

Identify the three broad functions of management.

4, 5, 6, 7, 8

2, 3

*3.

Define the three classes of manufacturing costs.

11, 12

4, 5, 7

*4.

Distinguish between product and period costs.

*5.

Explain the difference between a merchandising and a manufacturing income statement.

9, 14

*6.

Indicate how cost of goods manufactured is determined.

15, 16, 17, 18

8, 10, 11

*7.

Explain the difference between a merchandising and a manufacturing balance sheet.

10, 19, 20, 21

*8.

Identify trends in managerial accounting.

22, 23, 24 25, 26

*9.

Prepare a worksheet and closing entries for a manufacturing company.

27, 28, 29

A Problems

B Problems

2, 3, 4, 5, 6

1A, 2A

1B, 2B

3, 4, 5, 7, 13

1A, 2A

1B, 2B

8, 12, 13, 14, 15, 17

3A, 4A, 5A

3B, 4B, 5B

8, 9, 10, 11, 12, 13, 14, 15, 16, 17

3A, 4A, 5A

3B, 4B, 5B

14, 15, 16, 17

3A, 4A

3B, 4B

*Note: All asterisked Questions, Exercises, and Problems relate to material contained in the appendix to the chapter.

1-1

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

Description

Difficulty Level

Time Allotted (min.)

Classify manufacturing costs into different categories and compute the unit cost.

Simple

20–30

Classify manufacturing costs into different categories and compute the unit cost.

Simple

20–30

Indicate the missing amount of different cost items, and prepare a condensed cost of goods manufactured schedule, an income statement, and a partial balance sheet.

Moderate

30–40

Prepare a cost of goods manufactured schedule, a partial income statement, and a partial balance sheet.

Moderate

30–40

Prepare a cost of goods manufactured schedule and a correct income statement.

Moderate

30–40

*6A

Complete a worksheet; prepare a cost of goods manufactured schedule, an income statement, and a balance sheet; journalize and post the closing entries.

Complex

40–50

Classify manufacturing costs into different categories and compute the unit cost.

Simple

20–30

Classify manufacturing costs into different categories and compute the unit cost.

Simple

20–30

Indicate the missing amount of different cost items, and prepare a condensed cost of goods manufactured schedule, an income statement, and a partial balance sheet.

Moderate

30–40

Prepare a cost of goods manufactured schedule, a partial income statement, and a partial balance sheet.

Moderate

30–40

Prepare a cost of goods manufactured schedule and a correct income statement.

Moderate

30–40

1-2

1-3 Q1-11

Knowledge

Broadening Your Perspective

*9. Prepare a worksheet and closing entries for a manufacturing company Q1-28

* 7. Explain the difference between a Q1-19 merchandising and a manufacturing balance sheet. * 8. Identify trends in managerial accounting.

* 5. Explain the difference between a merchandising and a manufacturing income statement. * 6. Indicate how cost of goods manufactured is determined.

* 4. Distinguish between product and period costs.

* 3. Define the three classes of manufacturing costs.

* 2. Identify the three broad functions of management.

Study Objective * 1. Explain the distinguishing features of managerial accounting.

E1-4 E1-5 E1-7 E1-8 E1-12 E1-13 Q1-15 Q1-16 Q1-17 Q1-18 BE1-8 BE1-10 BE1-11 BE1-9 E1-14 E1-16

E1-4 E1-5 E1-6

Q1-10 E1-15 Q1-20 Q1-21 Q1-22 Q1-26 Q1-23 DI1-4 Q1-24 E1-18 Q1-25 Q1-27 E1-19 Q1-29 P1-6A BE1-12 Real-World Focus

E1-15

Comprehension Q1-1 BE1-1 Q1-2 DI1-1 Q1-3 E1-1 Q1-4 Q1-8 Q1-5 BE1-2 Q1-6 BE1-3 Q1-7 DI1-1 Q1-12 DI1-2 BE1-4 E1-2 BE1-5 E1-3 BE1-7 Q1-13 E1-3 BE1-6 DI1-2 Q1-9 Q1-14 E1-15 E1-13 P1-1A P1-2A E1-14 E1-17 P1-4A DI1-3 E1-8 E1-9 E1-10 E1-11 E1-12 E1-13

P1-1A P1-2A P1-1B

Application

P1-5B

Decision Making Across the Organization Managerial Analysis Exploring the Web Communication

E1-17 P1-3A P1-4A P1-3B P1-4B

P1-4B P1-3A P1-5A P1-3B E1-14 E1-10 E1-16 E1-11 E1-17 P1-3A P1-4A P1-5A P1-4B P1-3B P1-5B

P1-1B P1-2B

P1-2B

Analysis

Ethics Case All About You

Synthesis Evaluation

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. EXPLAIN THE DISTINGUISHING FEATURES OF MANAGERIAL ACCOUNTING. 2. IDENTIFY THE THREE BROAD FUNCTIONS OF MANAGEMENT. 3. DEFINE THE THREE CLASSES OF MANUFACTURING COSTS. 4. DISTINGUISH BETWEEN PRODUCT AND PERIOD COSTS. 5. EXPLAIN THE DIFFERENCE BETWEEN A MERCHANDISING AND A MANUFACTURING INCOME STATEMENT. 6. INDICATE HOW COST OF GOODS MANUFACTURED IS DETERMINED. 7. EXPLAIN THE DIFFERENCE BETWEEN A MERCHANDISING AND A MANUFACTURING BALANCE SHEET. 8. IDENTIFY TRENDS IN MANAGERIAL ACCOUNTING.

1-4

CHAPTER REVIEW Managerial Accounting Basics 1.

(S.O. 1) Managerial accounting is a field of accounting that provides economic and financial information for managers and other internal users. Managerial accounting applies to all types of businesses—service, merchandising, and manufacturing—and to all forms of business organizations—proprietorships, partnerships and corporations. Moreover, managerial accounting is needed in not-for-profit entities as well as in profit-oriented enterprises.

Comparing Managerial and Financial Accounting 2.

There are both similarities and differences between managerial and financial accounting. a. Both fields of accounting deal with the economic events of a business and require that the results of that company’s economic events be quantified and communicated to interested parties. b. The principal differences are the (1) primary users of reports, (2) types and frequency of reports, (3) purpose of reports, (4) content of reports, and (5) verification process.

The role of the managerial accountant has changed in recent years. Whereas in the past their primary concern used to be collecting and reporting costs to management, today they also evaluate how well the company is using its resources and providing information to crossfunctional teams comprised of personnel from production, operations, marketing, engineering, and quality control.

Management Functions 4.

(S.O. 2) Managers perform three broad functions within an organization: a. Planning requires managers to look ahead and to establish objectives. b. Directing involves coordinating a company’s diverse activities and human resources to produce a smooth-running operation. c. Controlling is the process of keeping the firm’s activities on track.

Organizational Structure 5.

In order to assist in carrying out management functions, most companies prepare organization charts to show the interrelationships of activities and the delegation of authority and responsibility with the company. Stockholders own the corporation but manage the company through a board of directors. The chief executive officer (CEO) has overall responsibility for managing the business. The chief financial officer (CFO) is responsible for all of the accounting and finance issues the company faces. The CFO is supported by the controller and the treasurer.

Business Ethics

All employees are expected to act ethically in their business activities and an increasing number of organizations provide their employees with a code of business ethics.

Due to many fraudulent activities in recent years, U.S. Congress passed the Sarbanes-Oxley Act of 2002 which resulted in many implications for managers and accountants. CEOs and CFOs must certify the fairness of financial statements, top management must certify they maintain an adequate system of internal controls, and other matters.

1-5

Manufacturing Costs 8.

(S.O. 3) Manufacturing consists of activities and processes that convert raw materials into finished goods.

Manufacturing costs are typically classified as either (a) direct materials, (b) direct labor or (c) manufacturing overhead.

10.

Direct materials are raw materials that can be physically and conveniently associated with the finished product during the manufacturing process. Indirect materials are materials that (a) do not physically become a part of the finished product or (b) cannot be traced because their physical association with the finished product is too small in terms of cost. Indirect materials are accounted for as part of manufacturing overhead.

11.

The work of factory employees that can be physically and conveniently associated with converting raw materials into finished goods is considered direct labor. In contrast, the wages of maintenance people, timekeepers, and supervisors are usually identified as indirect labor because their efforts have no physical association with the finished product, or it is impractical to trace the costs to the goods produced. Indirect labor is classified as manufacturing overhead.

12.

Manufacturing overhead consists of costs that are indirectly associated with the manufacture of the finished product. Manufacturing overhead includes items such as indirect materials, indirect labor, depreciation on factory buildings and machines, and insurance, taxes, and maintenance on factory facilities.

Product Versus Period Costs 13.

(S.O. 4) Product costs are costs that are a necessary and integral part of producing the finished product. Period costs are costs that are matched with the revenue of a specific time period rather than included as part of the cost of a salable product. These are nonmanufacturing costs. Period costs include selling and administrative expenses.

Manufacturing Income Statement 14.

(S.O. 5) The income statements of a merchandising company and a manufacturing company differ in the cost of goods sold section.

15.

The cost of goods sold section of the income statement for a manufacturing company shows: Beginning Finished Goods Inventory

Cost of Goods Manufactured

–

Ending Finished Goods Inventory

Cost of Goods Sold

Determining Cost of Goods Manufactured 16.

(S.O. 6) The determination of the cost of goods manufactured consists of the following: a.

1-6

Beginning Work in Process Inventory

Total Current Manufacturing Costs

Total Cost of Work in Process

Ending – Work in Process = Inventory

Total Cost of Work in Process Cost of Goods Manufactured

17.

The costs assigned to the beginning work in process inventory are the manufacturing costs incurred in the prior period.

18.

Total manufacturing costs is the sum of the direct materials costs, direct labor costs, and manufacturing overhead incurred in the current period.

19.

Because a number of accounts are involved, the determination of cost of goods manufactured is presented in a Cost of Goods Manufactured Schedule. The cost of goods manufactured schedule shows each of the cost factors above. The format for the schedule is: Beginning work in process .................................................................. Direct materials used............................................................................ Direct labor ............................................................................................. Manufacturing overhead ...................................................................... Total manufacturing costs ................................................................... Total cost of work in process .............................................................. Less: Ending work in process............................................................ Cost of goods manufactured...............................................................

$XXXX $XXXX XXXX XXXX XXXX XXXX XXXX $XXXX

Manufacturing Balance Sheet 20.

(S.O. 7) The balance sheet for a manufacturing company may have three inventory accounts: finished goods inventory, work in process inventory, and raw materials inventory.

21.

The manufacturing inventories are reported in the current assets section of the balance sheet. a. The inventories are generally listed in the order of their expected realization in cash. b. Thus, finished goods inventory is listed first.

22.

Each step in the accounting cycle for a merchandising company is applicable to a manufacturing company. a. For example, prior to preparing financial statements, adjusting entries are required. b. Adjusting entries are essentially the same as those of a merchandising company. c. The closing entries for a manufacturing company are also similar to those of a merchandising company.

Contemporary Developments 23.

(S.O. 8) Contemporary developments in managerial accounting involve: (a) a U.S. economy that has in general shifted toward an emphasis on providing services, rather than goods; and (b) efforts to manage the value chain and supply chain.

24.

Many companies have significantly lowered inventory levels and costs using just-in-time (JIT) inventory methods. Under a just-in-time method, goods are manufactured or purchased just in time for use. In addition, many companies have installed total quality management (TQM) systems to reduce defects in finished products.

25.

Activity-based costing (ABC) is a popular method for allocating overhead that obtains more accurate product costs. The theory of constraints is a specific approach used to identify and manage constraints in order to achieve the company goals. The balanced scorecard is a performance-measurement approach that uses both financial and nonfinancial measures to evaluate all aspects of a company’s operations in an integrated fashion.

1-7

*Worksheet *26. (S.O. 9) When a worksheet is used in preparing financial statements, two additional columns are needed for the cost of goods manufactured schedule. a. The columns are labeled Cost of Goods Manufactured. b. The columns are inserted before the income statement columns. *27. In the cost of goods manufactured columns, a. The beginning inventories of raw materials and work in process and all manufacturing costs are entered as debits. b. The ending inventories of raw materials and work in process are entered as credits. c. The balancing amount for these columns is the cost of goods manufactured and is entered as a credit. The same amount is also entered in the income statement debit column. *28. The income statement and balance sheet columns are basically the same as for a merchandising company. a. Beginning finished goods inventory is entered in the income statement debit column. b. Ending finished goods inventory is entered in the income statement credit column and the balance sheet debit column. *29. In preparing closing entries, a Manufacturing Summary account is used to close all accounts that appear in the cost of goods manufactured schedule. a. Ending inventories of raw materials and work in process are debited and Manufacturing Summary is credited. b. Beginning inventories of raw materials and work in process and all manufacturing cost accounts are credited and Manufacturing Summary is debited. c. The balance in Manufacturing Summary is closed by debiting Income Summary and crediting Manufacturing Summary. *30. As in the case of a merchandising company, all accounts shown in the income statement for a manufacturing company are closed to Income Summary.

1-8

LECTURE OUTLINE A.

Managerial Accounting Basics. 1. Managerial accounting, also called management accounting, is a field of accounting that provides economic and financial information for managers and other internal users. 2. Managerial accounting applies to all types of businesses: service, merchandising, and manufacturing. It also applies to all forms of business organizations: proprietorships, partnerships, and corporations.

Comparing Managerial and Financial Accounting.

TEACHING TIP

ILLUSTRATION 1-1 presents comparative differences between financial and managerial accounting. 1. The distinguishing features of managerial accounting are:

1-9

Primary users of reports—internal users: officers and managers.

Types and frequency of reports—internal reports issued as frequently as needed.

Purpose of reports: special-purpose information for a specific decision.

Content of reports—pertains to subunits of the business and may be very detailed; extends beyond double-entry accounting to any relevant data; the standard is relevance to decisions.

Verification process—no independent audits.

Management Functions. 1. Manager’s activities and responsibilities can be classified into three broad functions:

TEACHING TIP

ILLUSTRATION 1-2 depicts the major functions performed by managers. Emphasize that managers make decisions in carrying out these functions and need managerial accounting information as input into their decision making-process. a.

Planning requires managers to look ahead and to establish objectives.

Directing involves coordinating a company’s diverse activities and human resources to produce a smooth-running operation.

Controlling is the process of keeping the company’s activities on track.

MANAGEMENT INSIGHT Louis Vuitton is a French manufacturer of high-end handbags, wallets, and suitcases. Luxury-goods manufacturers used to consider stock-outs to be a good thing, but Louis Vuitton recently changed its attitude. What are some of the steps that Louis Vuitton has taken in order to ensure that production meets demand? Answer: The company has organized flexible teams, with jobs arranged by the amount of time a task takes. Employees now are multiskilled, so they can switch between tasks and products. Also, the stores now provide sales data more quickly to the manufacturing facility, so that production levels can be changed more quickly to respond to demand.

1-10

Organizational Structure. 1. Most companies prepare organization charts to show the interrelationships of activities and the delegation of authority and responsibility within the company. 2. Stockholders own the corporation, but they manage it indirectly through a board of directors they elect. 3. The chief executive officer (CEO) has overall responsibility for managing the business, but delegates responsibility to other officers. 4. Responsibilities within a company are classified as either: line positions— employees directly involved in the company’s primary revenue-generating operating activities, or staff positions—employees involved in activities that support line employees’ efforts. 5. The chief financial officer (CFO) is responsible for all of the company’s accounting and finance issues, and is supported by the controller and the treasurer. Also serving the CFO is the internal audit staff who review the reliability and integrity of financial information provided by the controller and treasurer.

Business Ethics. 1. Companies use complex systems to control and evaluate managers’ actions. Unfortunately these systems and controls unwittingly create incentives for managers to take unethical actions sometimes. 2. Ethical business scandals (Enron, Worldcom) involving fraudulent activities of managers caused the U.S. Congress to enact the SarbanesOxley Act of 2002. This act requires that CEOs and CFOs certify that the financial statements give a fair presentation of the company’s operating results and its financial condition. 3. Top managers must certify that the company maintains an adequate system of internal controls to safeguard the company’s assets and ensure accurate financial reports.

1-11

4. The Institute of Management Accountants (IMA) has developed a code of ethical standards to provide guidance for managerial accountants. This code states that management accountants should not commit acts or condone acts by others in violation of these standards. F.

Manufacturing Costs. TEACHING TIP

Use ILLUSTRATION 1-3 to define the three classes of manufacturing costs. Emphasize that these are product costs that become a part of the value of the product. They are not recognized as expenses until the product is sold. Distinguish between product costs and period costs. Manufacturing costs are classified as (1) direct materials, (2) direct labor, or (3) manufacturing overhead. 1. Direct materials are raw materials that can be physically and directly associated with the finished product during the manufacturing process. a.

Indirect materials: (1) Do not physically become part of the finished product or, (2) Cannot be traced because their physical association with the finished product is too small in terms of cost (i.e. lock washers).

Companies account for indirect materials as part of manufacturing overhead.

2. Direct labor is the work of factory employees that can be physically and directly associated with converting raw materials into finished goods.

1-12 .

Indirect labor has no physical association with the finished product, or it is impractical to trace the costs to the goods produced.

Companies classify indirect labor as manufacturing overhead.

MANAGEMENT INSIGHT Nissan and Toyota were number 1 and 2 in a recent annual study of labor productivity in the auto industry. Labor represents about 15% of the total cost to make a vehicle. Since Nissan required only about 28.5 labor hours per vehicle, it saves about $300 to $450 in labor costs to build a car relative to Ford. Why might Nissan production require significantly fewer labor hours? Answer:

Nissan’s U.S. factories are probably newer than those of Chrysler and Ford. Newer factories tend to be more highly automated with less reliance on production-line employees.

3. Manufacturing overhead consists of costs that are indirectly associated with the manufacture of the finished product. a.

Manufacturing overhead includes indirect materials, indirect labor, depreciation on factory buildings and machines, and insurance, taxes, and maintenance on factory facilities.

Product Versus Period Costs. 1. Product costs are costs that are a necessary and integral part of producing the finished product. 2. Product costs do not become expenses until the company sells the finished goods inventory. 3. Period costs are costs that are matched with the revenue of a specific time period rather than included as part of the cost of a salable product. 4. Period costs include selling and administrative expenses and companies deduct them from revenues in the period in which they are incurred.

1-13

Manufacturing Costs in Financial Statements. 1. The principal differences in a manufacturer’s financial statements occur in the cost of goods sold section in the income statement and the current assets section in the balance sheet. 2. Manufacturers compute cost of goods sold by adding the beginning finished goods inventory to the cost of goods manufactured and subtracting the ending finished goods inventory.

TEACHING TIP

ILLUSTRATION 1-4 contrasts the cost of goods sold sections on the income statements of a merchandiser and a manufacturer. 3. To determine the cost of goods manufactured, companies add the cost of the beginning work in process to the total manufacturing costs for the current year to find the total cost of work in process for the year. Companies then subtract the ending work in process from the total cost of work in process to find the cost of goods manufactured.

TEACHING TIP

ILLUSTRATION 1-5 presents a cost of goods manufactured schedule. Point out that this schedule must be prepared before the cost of goods sold section on the income statement. 4. The balance sheet for a manufacturing company may have three inventory accounts:

1-14 .

Finished Goods Inventory, which shows the cost of completed goods on hand.

Work in Process Inventory, which shows the cost applicable to units that have been started into production but are only partially completed.

Raw Materials Inventory, which shows the cost of raw materials on hand.

TEACHING TIP

Use ILLUSTRATION 1-6 to contrast the inventory accounts of a merchandiser and a manufacturer. Emphasize that except for inventories, all other current asset accounts are of the same type for both merchandisers and manufacturers. SERVICE COMPANY INSIGHT Allegiant Airlines must know something because while other airlines are losing money, it is generating profits. As a low-budget airline, it focuses on controlling costs. It flies out of small towns, so wages are low and competition is nonexistent. If a route isn’t filling up, it quits flying it as often or cancels it altogether. What are some of the line items that would appear in the cost of service schedule of an airline? Answer: Some of the cost items that would appear in the cost of service schedule of an airline would be fuel, flight crew salaries, maintenance wages, depreciation on equipment, airport gate fees, and food-service costs.

Managerial Accounting Today. 1. Managerial accounting has experienced many changes in recent years including a shift toward addressing the needs of service companies and improving practices to better meet the needs of managers. 2. In some instances the managerial accountant may need to develop new systems for measuring the cost of serving individual customers. Companies may need new operating controls to improve the quality and efficiency of specific services.

1-15

3. The value chain refers to all activities associated with providing a product or service (i.e. research and development, production, delivery, etc.). Analysis of the value chain has made companies far more responsive to customer needs and has improved profitability. 4. Many companies now employ enterprise resource planning (ERP) software systems to manage their value chain. ERP systems provide a comprehensive, centralized, integrated source of information that companies can use to manage all major business processes, from purchasing to manufacturing to recording human resources. 5. Using computer-integrated manufacturing (CIM), many companies can now manufacture products by the use of robotic equipment which significantly reduces direct labor costs in many cases. 6. Technology is also affecting the value chain through business-tobusiness (B2B) e-commerce on the Internet. Interorganizational information systems connected over the Internet enables suppliers to share information nearly instantaneously and has changed the marketplace, often having the effect of cutting out intermediaries—the “middle man.” 7. Many companies have significantly lowered inventory levels and costs using just-in-time (JIT) inventory methods. Under a just-in-time method, goods are manufactured or purchased just in time for use. 8. Many companies have installed total quality management (TQM) systems to reduce defects in finished products. These systems require timely data on defective products, rework costs, and the cost of honoring warranty contracts.

MANAGEMENT INSIGHT Few companies compare with Chiquita Brands International when it comes to total quality management. Chiquita goes to great lengths to protect their bananas. Why is it important to keep track of costs that are incurred to improve product quality?

1-16

Answer: Most companies are concerned about product quality, but managers need to consider the cost/benefit tradeoff. If you spend too much on improving product quality, your customers might not be willing to pay the price needed to recover costs. Therefore it is very important that Chiquita closely track all of the costs that it incurs to protect the bananas, to ensure that these costs are factored into the price that it ultimately charges for the bananas. 9. In order to obtain more accurate product costs, many companies now allocate overhead using activity-based costing (ABC). Under ABC, companies allocate overhead based on each product’s use of activities in making the product. 10. All companies have constraints that limit their potential profitability. The theory of constraints is a specific approach used to identify and manage constraints in order to achieve the company goals. 11. The balanced scorecard is now used by many companies in order to attain a more comprehensive view of the company’s operations. The balanced scorecard is a performance-measurement approach that uses both financial and nonfinancial measures to evaluate all aspects of a company’s operations in an integrated fashion.

*J. Accounting Cycle for a Manufacturing Company. 1. The accounting cycle for a manufacturing company is the same as for a merchandising company when companies use a periodic inventory system. Except for the additional manufacturing inventories and manufacturing cost accounts, the journalizing and posting of transactions is the same. 2. When a company uses a worksheet in preparing financial statements, it needs two additional columns for the cost of goods manufactured schedule. 3. Manufacturing companies use a Manufacturing Summary account to close all accounts that appear in the cost of goods manufactured schedule. The balance of the Manufacturing Summary account is the Cost of Goods Manufactured for the period. .

1-17

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Managerial accounting is a field of accounting that provides economic information for external users. True

The primary users of managerial accounting information are external users who are stockholders, creditors, and regulatory agencies. True

False

Finished goods inventory for a manufacturing company is the equivalent of merchandise inventory for a merchandising company. True

1-18

False

Cost of goods manufactured for a manufacturing company is the equivalent of cost of goods sold for a merchandising company. True

10.

False

The sum of the direct materials costs, direct labor costs, and manufacturing overhead incurred is the total manufacturing costs for the current period. True

False

Selling and administrative expenses are product costs. True

False

Indirect materials, indirect labor, and maintenance on factory facilities are all included in manufacturing overhead. True

False

Finished Goods Inventory plus Work in Process Inventory constitutes Cost of Goods Available for Sale. True

False

Manufacturing Inventory is one of the three inventory accounts a manufacturing company may have. True

False

The purpose of reports in managerial accounting is to provide special-purpose information for a particular user for a specific decision. True

False

Multiple Choice

Which of the following does not apply to the content of managerial reports? a. Reporting standard is relevance to the decision to be made. b. May extend beyond double-entry accounting system. c. Pertains to subunits of the entity and may be very detailed. d. Pertains to the entity as a whole and is highly aggregated.

Management functions include a. planning. b. directing. c. controlling. d. all of the above.

Which of the following inventory accounts is not applicable to a manufacturing company? a. Finished Goods Inventory. b. Merchandise Inventory. c. Raw Materials Inventory. d. Work in Process Inventory.

If direct materials for one unit of product are $9.00, direct labor for one hour is $15.00, manufacturing overhead costs are $5.00 per direct labor hour, and one-fourth hour of direct labor is required to produce one unit of product, how much are the labor and overhead costs for one unit of product? a. $5.00. b. $2.50. c. $20.00. d. $15.00.

Direct materials and direct labor are a. period costs. b. product costs. c. overhead costs. d. indirect costs.

1-19

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

False False True False False

Multiple Choice 1. 2. 3. 4. 5.

1-20

d. d. b. a. b.

6. 7. 8. 9. 10.

True False True False True

ILLUSTRATION 1-1 DIFFERENCES BETWEEN FINANCIAL AND MANAGERIAL ACCOUNTING

1-21

ILLUSTRATION 1-2 MANAGEMENT FUNCTIONS

1-22

ILLUSTRATION 1-3 PRODUCT VERSUS PERIOD COSTS

1-23

ILLUSTRATION 1-4 COST OF GOODS SOLD SECTIONS— MERCHANDISER VS. MANUFACTURER

1-24

ILLUSTRATION 1-5 COST OF GOODS MANUFACTURED SCHEDULE

1-25

ILLUSTRATION 1-6 CURRENT ASSETS SECTIONS— MERCHANDISER VS. MANUFACTURER

1-26

CHAPTER 2 Job Order Costing ASSIGNMENT CLASSIFICATION TABLE Do It!

Exercises

A Problems

B Problems

1, 2, 3, 4

1, 2, 3, 4, 6, 7, 8, 9, 11

1A, 2A, 3A, 5A

1B, 2B, 3B, 5B

9, 10, 11, 12

1, 2, 3, 6, 7, 8, 10, 12

1A, 2A, 3A, 5A

1B, 2B, 3B, 5B

Indicate how the predetermined overhead rate is determined and used.

13, 14, 15

6, 7

2, 3, 5, 6, 7, 8, 11, 12, 13

1A, 2A, 3A, 4A, 5A

1B, 2B, 3B, 4B, 5B

Prepare entries for jobs completed and sold.

2, 3, 4, 6, 7, 8, 9, 10, 11

1A, 2A, 3A, 5A

1B, 2B, 3B, 5B

Distinguish between under- and overapplied manufacturing overhead.

17, 18

5, 12, 13

1A, 2A, 4A, 5A

1B, 2B, 4B, 5B

2-1

Study Objectives

Questions

Explain the characteristics and purposes of cost accounting.

1, 2, 3, 4

Describe the flow of costs in a job order costing system.

5, 6, 7, 8

Explain the nature and importance of a job cost sheet.

Brief Exercises

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

2-2

Description

Difficulty Level

Time Allotted (min.)

Prepare entries in a job order cost system and job cost sheets.

Simple

30-40

Prepare entries in a job order cost system and partial income statement.

Moderate

30-40

Prepare entries in a job order cost system and cost of goods manufactured schedule.

Simple

30-40

Compute predetermined overhead rates, apply overhead, and calculate under- or overapplied overhead.

Simple

20-30

Analyze manufacturing accounts and determine missing amounts.

Complex

30-40

Prepare entries in a job order cost system and job cost sheets.

Simple

30-40

Prepare entries in a job order cost system and partial income statement.

Moderate

30-40

Prepare entries in a job order cost system and cost of goods manufactured schedule.

Simple

30-40

Compute predetermined overhead rates, apply overhead, and calculate under- or overapplied overhead.

Simple

20-30

Analyze manufacturing accounts and determine missing amounts.

Complex

30-40

BE2-6 BE2-7 DI2-2 E2-2 E2-3 E2-6 BE2-8 DI2-3 E2-2 E2-3 E2-6 E2-12 E2-13 P2-1A

Q2-13 Q2-14

Q2-16

Q2-17 Q2-18 BE2-9 Communication Real-World Focus Exploring the Web

Q2-15

4. Indicate how the predetermined overhead rate is determined and used.

5. Prepare entries for jobs completed and sold.

6. Distinguish between under- and overapplied manufacturing overhead.

Broadening Your Perspective

BE2-5 DI2-2 E2-1 E2-2 E2-3

Q2-9 Q2-10

Q2-11 Q2-12

3. Explain the nature and importance of a job cost sheet.

BE2-2 BE2-3 BE2-4 DI2-1 E2-1 E2-2

Q2-6 BE2-1

Q2-5 Q2-7 Q2-8

2. Describe the flow of costs in a job order costing system.

Q2-3 Q2-4

Comprehension Q2-1 Q2-2

Knowledge

1. Explain the characteristics and purposes of cost accounting.

Study Objective

E2-7 E2-8 E2-9 E2-10 E2-11

P2-5A P2-2B P2-5B DI2-4 E2-5 P2-2A P2-4A P2-1B P2-4B

Managerial Analysis

P2-5B E2-4 P2-2A P2-5A P2-2B

E2-5 P2-2A P2-5A P2-2B P2-5B P2-1A P2-3A P2-1B P2-3B

P2-3A P2-4A P2-1B P2-3B P2-4B

P2-2A P2-5A P2-2B P2-5B

P2-1A P2-3A P2-1B P2-3B

E2-6 E2-7 E2-8 E2-10 E2-12 E2-7 E2-8 E2-11 E2-12 E2-13 P2-1A

E2-4 P2-2A P2-5A P2-2B P2-5B

E2-11 P2-1A P2-3A P2-1B P2-3B

Analysis

E2-3 E2-6 E2-7 E2-8 E2-9

Application

Synthesis

All About You Decision Making Across the Organization Ethics Case

Evaluation

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. EXPLAIN THE CHARACTERISTICS AND PURPOSES OF COST ACCOUNTING. 2. DESCRIBE THE FLOW OF COSTS IN A JOB ORDER COST ACCOUNTING SYSTEM. 3. EXPLAIN THE NATURE AND IMPORTANCE OF A JOB COST SHEET. 4. INDICATE HOW THE PREDETERMINED OVERHEAD RATE IS DETERMINED AND USED. 5. PREPARE ENTRIES FOR JOBS COMPLETED AND SOLD. 6. DISTINGUISH BETWEEN UNDER- AND OVERAPPLIED MANUFACTURING OVERHEAD.

2-4

CHAPTER REVIEW Cost Accounting Systems 1.

(S.O. 1) Cost accounting involves the measuring, recording, and reporting of product costs. From the data accumulated, both the total cost and unit cost of each product is determined.

A cost accounting system consists of accounts for the various manufacturing costs. These accounts are fully integrated into the general ledger of a company. An important feature of a cost accounting system is the use of a perpetual inventory system. Such a system provides information immediately on the cost of a product. The two basic types of cost accounting systems are (a) a job order cost system and (b) a process cost system.

Under a job order cost system, costs are assigned to each job or to each batch of goods.

A process cost system is used when a large volume of similar products are manufactured. Process costing accumulates product-related costs for a period of time instead of assigning costs to specific products or job orders.

Job Order Cost Flow 5.

(S.O. 2) The flow of costs in job order cost accounting parallels the physical flow of the materials as they are converted into finished goods. There are two major steps in the flow of costs: (a) accumulating the manufacturing costs incurred and (b) assigning the accumulated costs to the work done.

No effort is made when costs are incurred to associate the costs with specific jobs.

The assignment of manufacturing costs involves entries to Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold.

The cost of raw materials purchased are debited to Raw Materials Inventory when materials are received.

Factory labor costs are debited to Factory Labor when they are incurred. The cost of factory labor consists of (1) gross earnings of factory workers, (2) employer payroll taxes on the earnings, and (3) fringe benefits incurred by the employer.

10.

Manufacturing overhead costs are recognized daily as incurred and periodically through adjusting entries. The costs are debited to Manufacturing Overhead.

Assigning Manufacturing Costs to Work in Process 11.

(S.O. 3) The assignment of manufacturing overhead costs to work in process involves debits to Work in Process Inventory and credits to Raw Materials Inventory, Factory Labor, and Manufacturing Overhead.

2-5

Job Cost Sheet 12.

A job cost sheet is a form used to record the costs chargeable to a specific job and to determine the total and unit cost of the completed job. A separate job cost sheet is kept for each job. A subsidiary ledger consists of individual records for each individual item. The Work in Process account is referred to as a control account because it summarizes the detailed data regarding specific jobs contained in the job cost sheets. Each entry to Work in Process Inventory must be accompanied by a corresponding posting to one or more job cost sheets.

13.

Raw materials costs are assigned when the materials are issued by the storeroom. Work in Process Inventory is debited for direct materials used, Manufacturing Overhead is debited for indirect materials used, and Raw Materials Inventory is credited.

14.

Factory labor costs are assigned to jobs on the basis of time tickets prepared when the work is performed. Work in Process Inventory is debited for direct labor costs, Manufacturing Overhead is debited for indirect labor costs, and Factory Labor is credited.

Manufacturing Overhead Costs 15.

(S.O. 4) Manufacturing overhead relates to production operations as a whole and therefore cannot be assigned to specific jobs on the basis of actual costs incurred. Instead, manufacturing overhead is assigned to work in process and to specific jobs on an estimated basis through the use of a predetermined overhead rate.

16.

The predetermined overhead rate is based on the relationship between estimated annual overhead costs and expected annual operating activity. This relationship is expressed in terms of a common activity base such as direct labor costs, direct labor hours, or machine hours. a. The formula for the predetermined overhead rate is: Estimated Expected Annual ÷ Annual Operating Overhead Costs Activity b. c.

17.

Predetermined Overhead Rate

The use of a predetermined overhead rate enables the company to determine the approximate total cost of each job when the job is completed. In recent years, more companies are using machine hours as the activity base due to increased reliance on automation in manufacturing operations.

At the end of each month, the balance in Work in Process Inventory should equal the sum of the costs shown on the job cost sheets for unfinished jobs.

Assigning Costs to Finished Goods 18.

(S.O. 5) When a job is completed, the total cost is debited to Finished Goods Inventory and credited to Work in Process Inventory. Finished Goods Inventory is a control account that controls individual finished goods records in a finished goods subsidiary ledger.

19.

Cost of goods sold is recognized when the sale occurs by a debit to Cost of Goods Sold and a credit to Finished Goods Inventory (along with a debit to Accounts Receivable or Cash and a credit to Sales).

2-6

20.

At the end of a period, financial statements are prepared that present aggregate data on all jobs manufactured and sold. a. The cost of goods manufactured schedule has one new feature: in determining total manufacturing costs, manufacturing overhead applied is used instead of actual overhead costs. b. The cost of goods manufactured schedule is prepared directly from the Work in Process Inventory account.

Under- or Overapplied Manufacturing Overhead 21.

(S.O. 6) Manufacturing overhead may be under- or overapplied. When Manufacturing Overhead has a debit balance, overhead is said to be underapplied. Underapplied overhead means that the overhead assigned to work in process is less than the overhead incurred. When manufacturing overhead has a credit balance, overhead is overapplied. Overapplied overhead means that the overhead assigned to work in process is greater than the overhead incurred.

22.

At the end of the year, any balance in Manufacturing Overhead is eliminated through an adjusting entry, usually to Cost of Goods Sold. a. Underapplied overhead is debited to Cost of Goods Sold. b. Overapplied overhead is credited to Cost of Goods Sold.

2-7

LECTURE OUTLINE A.

Cost Accounting Systems. 1. Cost accounting involves the measuring, recording, and reporting of product costs. From the data accumulated, companies determine both the total cost and the unit cost of each product. 2. A cost accounting system consists of accounts for the various manufacturing costs. These accounts are fully integrated into the general ledger of a company. An important feature of a cost accounting system is the use of a perpetual inventory system that provides immediate, up-to-date information on the cost of a product. 3. There are two basic types of cost accounting systems:

TEACHING TIP

ILLUSTRATION 2-1 identifies the two basic types of cost accounting systems and their characteristics. a.

A job order system, where the company assigns costs to each job or to each batch of goods, and

A process cost system, used when a company manufactures a large volume of similar products.

MANAGEMENT INSIGHT Many companies suffer from poor cost accounting and sometimes make products they should not be selling. The managers of a diversified company thought they were making money, but a consulting firm found that the company had seriously underestimated costs. What type of costs do you think the company had been underestimating?

2-8 .

Answer: It is most likely that the company failed to estimate and track overhead. In a highly diversified company, overhead associated with the diesel locomotive jobs may have been “lost” in the total overhead pool for the entire company.

Job Order Cost Flow. 1. The flow of costs (direct materials, direct labor, and manufacturing overhead) in job order cost accounting parallels the physical flow of the materials as they are converted into finished goods.

TEACHING TIP

ILLUSTRATION 2-2 provides an overview of the cost flows through the general ledger accounts in a job order cost system. Emphasize the two steps of (1) accumulating manufacturing costs incurred, and then (2) assigning accumulated costs to products. 2. There are two major steps in the flow of costs: a.

Accumulating the manufacturing costs incurred; these costs are accumulated in three accounts: Raw Materials Inventory, Factory Labor, and Manufacturing Overhead, and

Assigning the accumulated costs to Work in Process Inventory and eventually to Finished Goods Inventory and Cost of Goods Sold.

3. Three entries are made to accumulate the manufacturing costs incurred.

TEACHING TIP

ILLUSTRATION 2-3 provides an example of the journal entries required to accumulate the cost of raw materials, factory labor, and actual manufacturing overhead.

2-9

When the company receives the raw materials it has purchased, it debits the costs of the materials to Raw Materials Inventory. Raw Materials Inventory is a control account. The subsidiary ledger consists of individual records for each item of raw materials.

The cost of factory labor consists of gross earnings of factory workers, employer payroll taxes, and fringe benefits (sick pay, pensions, and vacation pay) incurred by the employer. Companies debit labor costs to Factory Labor as they incur those costs. Factory labor is assigned to work in process and manufacturing overhead at the end of the period.

A company may record overhead costs periodically through adjusting entries by debiting Manufacturing Overhead. Manufacturing Overhead is a control account and the subsidiary ledger consists of individual accounts for each type of cost (factory utilities, factory repairs, etc.).

Assigning Manufacturing Costs to Work in Process. 1. A job cost sheet is a form used to record the costs chargeable to a specific job and to determine the total and unit costs of the completed job. The job cost sheets constitute the subsidiary ledger for the Work in Process Inventory account. 2. Each entry to Work in Process Inventory must be accompanied by a corresponding posting to one or more job cost sheets. 3. Three entries are made in assigning the manufacturing costs to work in process.

TEACHING TIP

ILLUSTRATION 2-4 provides an example of the journal entries required to assign direct materials, direct labor, and manufacturing overhead to Work in Process Inventory. Emphasize that actual overhead costs are not assigned but rather overhead is applied using a predetermined overhead rate. 2-10

Materials requisition slips indicate the quantity and type of materials withdrawn and the account to be charged. Companies charge direct materials to Work in Process Inventory and indirect materials to Manufacturing Overhead.

Companies assign factory labor costs to jobs on the basis of time tickets prepared when the work is performed. The time ticket indicates the hours worked, the account and job to be charged, and the total labor cost. Companies debit the Work in Process Inventory account for direct labor, and Manufacturing Overhead for indirect labor.

Companies assign manufacturing overhead to work in process and to specific jobs on an estimated basis through the use of a predetermined overhead rate. Using a predetermined overhead rate enables a cost to be determined for a job immediately.

4. The predetermined overhead rate is based on the relationship between estimated annual overhead costs and expected annual operating activity, expressed in terms of a common activity base.

TEACHING TIP

Use ILLUSTRATION 2-4 again to discuss how a predetermined overhead rate is calculated. Emphasize the importance of choosing an appropriate activity as a base for assigning overhead. a.

The company may state the activity in terms of direct labor costs, direct labor hours, machine hours, or any other measure that will provide an equitable basis for applying overhead costs to jobs.

The predetermined overhead rate is established at the beginning of the year.

5. Using a predetermined overhead rate enables the company to determine the approximate total cost of each job when it completes the job.

2-11

Assigning Costs to Finished Goods and Cost of Goods Sold. 1. When a job is completed, the company summarizes the costs in the applicable job cost sheet and debits Finished Goods Inventory. Finished Goods Inventory is a control account that controls individual finished goods records in a finished goods subsidiary ledger. Postings to the finished goods records are made directly from completed job cost sheets. 2. Companies recognize cost of goods sold when each sale occurs. Each sale requires an entry debiting Cash or Accounts Receivable and crediting Sales for the selling price and a second entry debiting Cost of Goods Sold and crediting Finished Goods Inventory for the cost of the goods.

TEACHING TIP

ILLUSTRATION 2-5 provides an example of the journal entries required to assign manufacturing costs to finished goods and to record a sale and the cost of completed units sold. SERVICE COMPANY INSIGHT Jet engines are one of the many products made by the industrial operations division of General Electric. At prices as high as $30 million per engine GE does its best to keep track of costs. Because of the high product costs, both the engines themselves and the subsequent service are most likely accounted for using job order costing. GE needs good cost records for its service jobs in order to control its costs. Explain why GE would use job order costing to keep track of the cost of repairing a malfunctioning engine for a major airline. Answer: GE operates in competitive environment. Other companies offer competing bids to win service contracts on GE airplane engines. GE needs to know what it costs to repair engines, so that it can present competitive bids while still generating a reasonable profit.

2-12

Job Order Cost Flows and Reporting Job Cost Data. 1. A job order cost accounting system may be illustrated in a flow chart.

TEACHING TIP

ILLUSTRATION 2-6 provides a flow chart of the cost flows through the general ledger accounts for the examples used in Illustrations 2-3, 2-4, and 2-5. 2. Entries in the job cost system also provide a summary of the inventory control accounts and source documents for assigning costs to jobs.

TEACHING TIP

ILLUSTRATION 2-7 identifies the major source documents used to make entries in a job order cost system. 3. The cost of goods manufactured schedule is the same as for companies that do not use job order costing with one exception: manufacturing overhead applied, rather than actual overhead costs, is added to direct materials and direct labor to determine total manufacturing costs. F.

Under- or Overapplied Manufacturing Overhead. 1. Underapplied overhead means that the overhead assigned to work in process is less than the overhead incurred (when Manufacturing Overhead has a debit balance). 2. Overapplied overhead means that the overhead assigned to work in process is greater than the overhead incurred (when Manufacturing Overhead has a credit balance).

2-13

TEACHING TIP

ILLUSTRATION 2-8 contrasts actual Manufacturing Overhead with applied overhead and indicates whether overhead is under- or overapplied. 3. At the end of the year, the company eliminates any balance in Manufacturing Overhead by an adjusting entry. Under- or overapplied overhead is considered to be an adjustment to cost of goods sold. 4. The company debits underapplied overhead to cost of goods sold and it credits overapplied overhead to cost of goods sold.

ETHICS INSIGHT In some industries, companies bill jobs on a “cost plus profit” basis. This creates an incentive for companies to pad their bills—overstate the costs incurred on particular jobs so as to inflate their bills. Suppliers to the government have often been accused of overbilling by misstating their cost accounting records. What feature of these businesses creates an incentive to misstate cost accounting data on particular jobs? What can customers do to protect themselves from overbilling? Answer: In these business situations, the compensation to the supplier depends on the costs incurred by the supplier. This so-called “costplus” arrangement creates an incentive for the supplier to overstate costs. Customers should stipulate that they have the right to have the suppliers’ records audited.

2-14

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Under a job order system, the company assigns costs to each job, or each batch of goods, to fill a specific customer order or replenish inventory. True

Manufacturing costs incurred in a job order system are accumulated by debits to Purchases, Factory Labor, and Manufacturing Overhead. True

False

A job cost sheet is a form used to record the costs chargeable to a specific job and to determine the total and unit cost of the completed job. True

False

In preparing the costs of goods manufactured schedule in job order costing, manufacturing costs include direct materials used, direct labor used, and manufacturing overhead applied. True

10.

False

A debit balance in the Manufacturing Overhead Account at the end of the period indicates that overhead has been overapplied. True

False

The entry to record the cost of goods sold includes a debit to Finished Goods Inventory. True

False

Actual overhead costs are debited to the Manufacturing Overhead account. True

False

The requisition of factory supplies to production requires a debit to the Manufacturing Overhead account. True

False

Manufacturing overhead costs cannot be traced directly to a specific job. True

False

Each debit to Work in Process Inventory must be accompanied by a corresponding posting to one or more job cost sheets. True

False

2-15

False

Multiple Choice 1.

A job order cost sheet includes a. the selling price of the job. b. a total when a job is completed and transferred to cost of goods sold. c. all manufacturing costs for a job. d. all manufacturing overhead costs for the period.

In a job order cost system the following accounts are used as a control account except a. Raw Materials Inventory. b. Factory Labor. c. Manufacturing Overhead. d. all of the above.

In a job order cost system, debits to Work in Process Inventory originate from all of the following except a. applying the predetermined overhead rate. b. assigning direct labor from time tickets. c. assigning actual manufacturing overhead costs to jobs. d. assigning direct materials from requisition slips.

The predetermined overhead rate is computed by dividing estimated a. level of activity by estimated overhead costs. b. level of activity by expected overhead costs. c. overhead costs by estimated cost of jobs. d. overhead costs by expected activity base.

If annual overhead costs are expected to be $1,000,000 and 200,000 total labor hours are anticipated (80% direct, 20% indirect), the overhead rate based on direct labor hours is a. $6.25. b. $5.00. c. $25.00. d. $4.00.

2-16

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False True True True

Multiple Choice 1. 2. 3. 4. 5.

c. b. c. d. a.

2-17

6. 7. 8. 9. 10.

True False False True True

ILLUSTRATION 2-1 COST ACCOUNTING SYSTEMS

2-18

ILLUSTRATION 2-2 JOB ORDER COST SYSTEM

2-19

ILLUSTRATION 2-3 ACCUMULATING MANUFACTURING COST ENTRIES

2-20

ILLUSTRATION 2-4 ASSIGNING MANUFACTURING COST TO WORK IN PROCESS ENTRIES

2-21

ILLUSTRATION 2-5 ASSIGNING COSTS TO FINISHED GOODS AND COST OF GOODS SOLD ENTRIES

2-22

ILLUSTRATION 2-6 JOB ORDER COST SYSTEM

2-23

ILLUSTRATION 2-7 FLOW OF DOCUMENTS—JOB COST SYSTEM

2-24

ILLUSTRATION 2-8 UNDER-AND OVERAPPLIED MANUFACTURING OVERHEAD

2-25

CHAPTER 3 Process Costing ASSIGNMENT CLASSIFICATION TABLE Brief Exercises

A Problems

B Problems

2, 4

5, 10

3, 5, 6, 7, 8, 9, 10, 11, 13, 14, 15

2A, 3A, 4A, 5A, 6A

2B, 3B, 4B, 5B, 6B

8, 9, 14, 15, 18

4, 6, 7, 8, 9

3, 5, 6, 7, 8, 9, 2A, 3A, 10, 11, 13, 14, 4A, 5A 15, 16, 17, 18, 19

2B, 3B, 4B, 5B

Prepare a production cost report.

16, 17, 19, 20

7, 12, 13

2A, 3A, 4A, 5A, 6A

2B, 3B, 4B, 5B, 6B

Compute equivalent units using the FIFO method.

21, 22

11, 12, 13

16, 17, 18, 19, 20

Study Objectives

Questions

* 1.

Understand who uses process cost systems.

1, 2

* 2.

Explain the similarities and differences between job order cost and process cost systems.

2, 3, 4, 5

* 3.

Explain the flow of costs in a process cost system.

* 4.

Make the journal entries to assign manufacturing costs in a process cost system.

6, 7

1, 2, 3

* 5.

Compute equivalent units.

10, 11, 12, 13

* 6.

Explain the four steps necessary to prepare a production cost report.

* 7.

**8.

Do It!

Exercises 1

*Note: All asterisked Questions, Exercises, and Problems relate to material contained in the appendix*to the chapter.

3-1

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

Description

Difficulty Level

Time Allotted (min.)

Journalize transactions.

Moderate

20–30

Complete four steps necessary to prepare a production cost report.

Simple

30–40

Complete four steps necessary to prepare a production cost report.

Simple

30–40

Assign costs and prepare production cost report.

Moderate

20–30

Determine equivalent units and unit costs and assign costs.

Moderate

20–30

Compute equivalent units and complete production cost report.

Moderate

15–25

*7A*

Determine equivalent units and unit costs and assign costs for processes; prepare production cost report.

Moderate

30–40

Journalize transactions.

Moderate

20–30

Complete four steps necessary to prepare a production cost report.

Simple

30–40

Complete four steps necessary to prepare a production cost report.

Simple

30–40

Assign costs and prepare production cost report.

Moderate

20–30

Determine equivalent units and unit costs and assign costs.

Moderate

20–30

Compute equivalent units and complete production cost report.

Moderate

15–25

*7B

Determine equivalent units and unit costs and assign costs for processes; prepare production cost report.

Moderate

30–40

3-2

3-3 Q3-16 Q3-17 Q3-19

* 7. Prepare a production cost report.

Broadening Your Perspective

*8. Compute equivalent units using the FIFO method.

Q3-8

Q3-10 Q3-11

Q3-6

DI3-1

Real-World Focus Exploring the Web

Q3-16 Q3-20

Q3-9

Q3-4 Q3-5 E3-1

E3-1

Knowledge Comprehension Q3-1 Q3-2 Q3-2 Q3-3

* 6. Explain the four steps necessary to prepare a production cost report.

* 1. Understand who uses process cost systems. * 2. Explain the similarities and differences between job order cost and process cost systems. * 3. Explain the flow of costs in a process cost system. * 4. Make the journal entries to assign manufacturing costs in a process cost system. * 5. Compute equivalent units.

Study Objective

E3-3 P3-1A Q3-7 BE3-1 BE3-2 Q3-12 Q3-13 BE3-5 BE3-10 DI3-3 E3-3 E3-5 E3-6 E3-7 E3-8 Q3-14 Q3-15 Q3-18 BE3-4 BE3-6 BE3-7 BE3-8 BE3-9 DI3-4 E3-3 E3-5 BE3-12 DI3-4 E3-7 E3-12 E3-13 Q3-21 Q3-22 BE3-11 BE3-12 BE3-3 DI3-2 E3-2 E3-9 E3-10 E3-11 E3-13 E3-14 E3-15 E3-17 E3-18 E3-19 P3-2A E3-6 E3-7 E3-8 E3-9 E3-10 E3-11 E3-13 E3-14 E3-15 E3-16 E3-17 P3-2A P3-3A P3-4A P3-5A P3-6A BE3-13 E3-16 E3-17 E3-18

Application

P3-2B P3-3B P3-4B P3-5B P3-6B E3-19 E3-20 P3-7A P3-7B

E3-18 E3-19 P3-2A P3-3A P3-4A P3-5A P3-2B P3-3B P3-4B P3-5B

E3-4 P3-1A P3-1B P3-3A P3-4A P3-5A P3-6A P3-2B P3-3B P3-4B P3-5B P3-6B

P3-1B

Synthesis

Managerial Analysis Decision Making Across the Decision Making Organization Across the Real-World Focus Organization Communication

P3-2A P3-3A P3-2B P3-3B

P3-1A P3-1B P3-1A P3-1B

Analysis

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

Ethics Case

Evaluation

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1.

UNDERSTAND WHO USES PROCESS COST SYSTEMS.

EXPLAIN THE SIMILARITIES AND DIFFERENCES BETWEEN JOB ORDER COST AND PROCESS COST SYSTEMS.

EXPLAIN THE FLOW OF COSTS IN A PROCESS COST SYSTEM.

MAKE THE JOURNAL ENTRIES TO ASSIGN MANUFACTURING COSTS IN A PROCESS COST SYSTEM.

COMPUTE EQUIVALENT UNITS.

EXPLAIN THE FOUR STEPS NECESSARY TO PREPARE A PRODUCTION COST REPORT.

PREPARE A PRODUCTION COST REPORT.

*8.

COMPUTE EQUIVALENT UNITS USING THE FIFO METHOD.

3-4

CHAPTER REVIEW Process Manufacturing and Accounting 1.

(S.O. 1) Process cost systems are used to apply costs to similar products that are mass produced in a continuous fashion, such as the production of ice cream, steel or soft drinks. In comparison, costs in a job order cost system are assigned to a specific job, such as the construction of a customized home, the making of a motion picture, or the manufacturing of a specialized machine.

(S.O. 2) Job order cost and process cost systems are similar in that (a) both use the same three manufacturing cost elements of direct materials, direct labor, and manufacturing overhead; (b) both accumulate costs of raw materials by debiting Raw Materials Inventory, factory labor by debiting Factory Labor, and manufacturing overhead costs by debiting Manufacturing Overhead; and (c) both flow costs to the same accounts of Work in Process, Finished Goods Inventory, and Cost of Goods Sold.

The major differences between a job order cost system and a process cost system are as follows: Job Order Cost System One for each job

Process Cost System One for each process

Documents used

Job cost sheets

Production cost reports

Determination of total manufacturing costs

Each job

Each period

Unit-cost computations

Cost of each job ÷ Units produced for the job

Total manufacturing costs ÷ Units produced during the period

Feature Work in process accounts

Process Cost Flow

(S.O. 3) In the Tyler Company example in the text book, manufacturing consists of two processes: machining and assembly. In the Machining Department, the raw materials are shaped, honed, and drilled. In the Assembly Department, the parts are assembled and packaged.

Materials, labor, and manufacturing overhead can be added in both the Machining and Assembly Departments. When the Machining Department finishes its work, the partially completed units are transferred to the Assembly Department. In the Assembly Department, the goods are finished and are then transferred to the finished goods inventory. Upon sale, the goods are removed from the finished goods inventory.

3-5

Assignment of Manufacturing Costs 6.

(S.O. 4) All raw materials issued for production are a materials cost to the producing department. Materials requisition slips may be used in a process cost system, but fewer requisitions are generally required than in a job order cost system, because the materials are used for processes rather than for specific jobs. The entry to record the materials used is: Work in Process—Machining .................................................. Work in Process—Assembly ................................................... Raw Materials Inventory.................................................

XXXX XXXX XXXX

The basis for allocating the overhead costs to the production departments in an objective and equitable manner is the activity that “drives” or causes the costs. A primary driver of overhead costs in continuous manufacturing operations is machine time used, not direct labor. Thus, machine hours are widely used in allocating manufacturing overhead costs. The entry to allocate overhead is: Work in Process—Machining .................................................. Work in Process—Assembly ................................................... Manufacturing Overhead................................................

XXXX

Time tickets may be used in determining the cost of labor assignable to the production departments. The labor cost chargeable to a process can be obtained from the payroll register or departmental payroll summaries. All labor costs incurred within a producing department are a cost of processing the raw materials. The entry to assign the labor costs is: Work in Process—Machining .................................................. Work in Process—Assembly ................................................... Factory Labor....................................................................

XXXX XXXX

XXXX XXXX XXXX

At the end of the period, the following transfer entries are needed: Work in Process—Assembly ................................................... Work in Process—Machining ........................................

XXXX

Finished Goods Inventory ........................................................ Work in Process—Assembly .........................................

XXXX

Cost of Goods Sold.................................................................... Finished Goods Inventory ..............................................

XXXX

XXXX XXXX XXXX

Equivalent Units 10.

3-6

(S.O. 5) A major step in process cost accounting is the calculation of equivalent units. Equivalent units of production measure the work done during the period, expressed in fully completed units. This concept is used to determine the cost per unit of completed product.

11.

The formula to compute equivalent units of production under the weighted-average method is as follows: Units Completed and + Transferred Out

Equivalent Units of Ending Work in Process

Equivalent Units of Production

12.

The method of computing equivalent units here is referred to as the weighted-average method. It considers the degree of completion (weighting) of the units completed and transferred out and the ending work in process. A lesser used method, called the FIFO method, is discussed in the appendix to this chapter.

13.

To illustrate the computation of equivalent units using the weighted-average method, assume that materials are entered at the beginning of the process and the following information is provided for the Processing Department of Silva Company:

Work in process, Beg. Started into production Total units Units transferred out Work in process, End. Total units 14.

Percentage Complete Materials Conversion Costs 100% 80%

Physical Units 2,500 4,500 7,000 6,000 1,000 7,000

100%

60%

The two equivalent unit computations are as follows:

Units transferred out Work in process, End 1,000 X 100% 1,000 X 60% Total equivalent units

Equivalent Units Conversion Materials Costs 6,000 6,000 1,000 7,000

600 6,600

Production Cost Report 15.

(S.O. 6) A production cost report is the key document used by management to understand the activities in a department because it shows the production quantity and cost data related to that department. In order to be ready to complete a production cost report, the company must perform four steps: a. Compute the physical unit flow. b. Compute the equivalent units of production. c. Compute unit production costs. d. Prepare a cost reconciliation schedule.

3-7

16.

The computation of physical units involves: a. adding the units started (or transferred) into production during the period to the units in process at the beginning of the period to determine the total units to be accounted for; and b. accounting for these units by determining the output for the periodwhich consists of units transferred out during the period and units in process at the end of the period. In the example above, the total units to be accounted for and the units accounted for are both equal to 7,000 units for the Silva Company.

17.

18.

In computing unit costs, production costs are expressed in terms of equivalent units of production. When equivalent units are different for materials and conversion costs, the formulas for computing unit costs are as follows: Total Materials Cost

Equivalent Units of Materials

Unit Materials Cost

Total Conversion Costs

Equivalent Units of Conversion Costs

Unit Conversion Cost

Unit Materials Cost

Unit Conversion Cost

Total Manufacturing Cost per Unit

The cost reconciliation schedule shows that the total costs accounted for equal the total costs to be accounted for as follows: Costs to be accounted for Transferred out .................................................. Work in process, End Materials......................................................... Conversion costs.......................................... Total costs..............................................................

19.

3-8

$XXXX $XXXX XXXX

XXXX $XXXX

(S.O. 7) Assume the Processing Department of Silva Company has the following additional cost information: Work in process, Beg. Direct materials: 100% complete............................. Conversion costs: 80% complete ............................ Cost of work in process, Beg............................................

$ 24,000 19,620 $ 43,620

Costs incurred during production Direct materials ........................................................... Conversion costs ........................................................ Costs incurred......................................................................

$200,000 150,000 $350,000

20.

Silva Company’s Processing Department Production Cost Report at the end of the period is as follows: Processing Department Production Cost Report For the Period Ended Physical Units

QUANTITIES Units to be accounted for Work in process, Beg. Started into production Total units Units accounted for Transferred out Work in process, End. Total units

COSTS Unit costs Costs during the period Equivalent units Unit costs [(a) ÷ (b)]

Equivalent Units Conversion Materials Costs

2,500 4,500 7,000 6,000 1,000 7,000

6,000 1,000 7,000

6,000 600 (1,000 X 60%) 6,600

Materials

Conversion Costs

(a) $224,000 (b) 7,000 $32.00

$169,620 6,600 $25.70

Costs to be accounted for Work in process, Beg. Started into production Total costs Cost Reconciliation Schedule Costs accounted for Transferred out (6,000 X $57.70) Work in process, End. Materials (1,000 X $32.00) Conversion costs (600 X $25.70) Total costs

Total $393,620 $57.70 $ 43,620 350,000 $393,620

$346,200 $32,000 15,420

47,420 $393,620

Operations Costing 21.

Companies often use a combination of a process cost and a job order cost system, called operations costing. Operations costing is similar to process costing in that standardized methods are used to manufacture the product. At the same time, the product may have some customized, individual features that require the use of a job order cost system.

3-9

Equivalent Units Using the FIFO Method *22. (S.O. 8) To illustrate the computation of equivalent units using the FIFO method, assume that materials are entered at the beginning of the process and the following information is provided for the Processing Department of Silva Company:

Work in process, Beg. Started into production Total units Units transferred out Work in process, End. Total units

Physical Units 2,500 4,500 7,000 6,000 1,000 7,000

Percentage Complete Materials Conversion Costs 100% 80%

100%

60%

*23. The equivalent units for material costs of the Processing Department under the FIFO method are computed as follows:

Production Data Work in process, Beg. Started and finished Work in process, End. Total

Processing Department Work Added Physical Units This Period 2,500 0 3,500 100% 1,000 100% 7,000

Equivalent Units 3,500 1,000 4,500

*24. The equivalent units for conversion costs of the Processing Department under the FIFO method are computed as follows:

Production Data Work in process, Beg. Started and completed Work in process, End. Total

Processing Department Work Added Physical Units This Period 2,500 20% 3,500 100% 1,000 60% 7,000

Equivalent Units 500 3,500 600 4,600

Production Cost Report Using the FIFO Method *25. Assume the Processing Department of Silva Company has the following additional cost information:

3-10

Work in process, Beg. Direct materials: 100% complete................................................ Conversion costs: 80% complete ............................................... Cost of work in process, Beg.........................................................

$ 24,000 19,620 $ 43,620

Costs incurred during the production Direct materials .............................................................................. Conversion costs ........................................................................... Costs incurred...................................................................................

$200,000 150,000 $350,000

*26. Silva Company’s Processing Department Production Cost Report at the end of the period using the FIFO method is as follows: Processing Department Production Cost Report For the Period Ended Physical Units QUANTITIES Units to be accounted for Work in process, Beg. Started into production Total units Units accounted for Completed and transferred out Work in process, Beg. Started and completed Work in process, End. Total units

Equivalent Units Conversion Materials Costs

2,500 4,500 7,000 2,500 3,500 1,000 7,000

COSTS Unit costs Costs during the period Equivalent units Unit costs [(a)/(b)]

(a) (b)

0 3,500 1,000 4,500

500 3,500 600 4,600

Materials

Conversion Costs

$200,000 4,500 $44.444

$150,000 4,600 $ 32.609

Costs to be accounted for Work in process, Beg. Started into production Total costs

Total costs

3-11

$350,000 $77.053 $ 43,620 350,000 $393,620

Cost Reconciliation Schedule Costs accounted for Transferred out Work in process, Costs to complete beg. work in process Conversion costs (500 X $32.609) Total costs Units started and completed (3,500 X $77.053) Total costs transferred out Work in process, End Materials (1,000 X $44.444) Conversion costs (600 X $32.609)

Total

$ 43,620 16,305 59,925 269,686 329,611 $44,444 19,565

64,009 $393,620

LECTURE OUTLINE A.

Uses of Process Cost Systems. 1. Process cost systems are used to apply costs to similar products that are mass-produced in a continuous fashion. 2. Once production begins, it continues until the finished product emerges, and each unit of finished product is like every other unit.

Similarities and Differences Between Job Order Cost and Process Cost Systems. 1. In a process cost system, costs are tracked through a series of connected manufacturing processes or departments, rather than by individual jobs as in a job order cost system. 2. Companies use process cost systems when they produce a large volume of relatively homogeneous products. 3. Job order cost and process cost systems are similar in three ways: a.

Both systems track the same manufacturing cost elements—direct materials, direct labor, and manufacturing overhead.

Both accumulate costs in the same accounts—Raw Materials Inventory, Factory Labor, and Manufacturing Overhead.

Both assign accumulated costs to the same accounts—Work in Process, Finished Goods Inventory, and Cost of Goods Sold.

4. There are four main differences between the two cost systems: a.

3-12

In a job order cost system, only one work in process account is used while separate accounts are maintained for each department or manufacturing process in a process cost system.

In a job order cost system, costs are charged to individual jobs and summarized in a job cost sheet; in a process cost system, costs are summarized in a production cost report for each department.

Costs are totaled at the completion of a job in a job cost system but at the end of a time period (i.e. a month or year) in a process cost system.

In a job cost system, the unit cost is the total cost per job ÷ by the units produced. In a process cost system, the unit cost is total manufacturing costs for the period ÷ by the units produced during the period.

TEACHING TIP

ILLUSTRATION 3-1 contrasts the differences between a job order cost and a process cost system.

Process Cost Flow. 1. The company can add materials, labor, and manufacturing overhead in each production department. 2. The costs of units completed are transferred from one department to another as those units move through the manufacturing process. 3. The costs of completed work are transferred to Finished Goods Inventory. 4. When inventory is sold, costs are transferred to Cost of Goods Sold.

3-13

TEACHING TIP

ILLUSTRATION 3-2 provides an overview of the flow of costs in a process cost system. Point out that a work in process account is maintained for each department or process in a process cost system.

Assigning manufacturing costs. 1. The accumulation of the costs of materials, labor, and manufacturing overhead is the same in a process cost system as in a job order cost system. 2. Entries to assign the costs of raw materials, factory labor, and overhead consist of a debit to Work in Process for each department and a credit to Raw Materials Inventory, Factory Labor, and Manufacturing Overhead. 3. The assignment of the three manufacturing cost elements to Work in Process in a process cost system is different from a job order cost system.

3-14 .

All raw materials issued for production are a materials cost to the producing department. A process cost system may use materials requisition slips, but fewer requisitions are generally required than in a job order system, because the materials are used for processes rather than specific jobs.

Companies may use time tickets to determine the cost of factory labor assignable to production departments. Since labor costs are assigned to a process rather than a job, the labor cost chargeable to a process can be obtained from the payroll register or departmental payroll summaries.

The objective in assigning overhead in a process cost system is to allocate the overhead costs to the production departments on an objective and equitable basis. A primary driver of overhead costs in continuous manufacturing operations is machine time used, not direct labor. Companies widely use machine hours in allocating manufacturing overhead costs.

4. The entry to record units completed and transferred to the warehouse is a debit to Finished Goods Inventory and a credit to Work in Process. 5. The entry to record the sale of goods is a debit to Cost of Goods Sold and a credit to Finished Goods Inventory.

MANAGEMENT INSIGHT Some companies continue to assign manufacturing overhead on the basis of direct labor despite the fact that there is no cause-and-effect relationship between labor and overhead. In such cases, the overhead rates may be misleading. What is the result if a company uses the wrong “cost driver” to assign manufacturing overhead? Answer: Incorrect application of manufacturing overhead will result in some products receiving too much overhead and others receiving too little.

Equivalent Units. 1. Equivalent units of production measure the work done during the period, expressed in fully completed units. 2. Companies use this measure to determine the cost per unit of completed product. 3. Equivalent units of production are the sum of:

3-15

Units completed and transferred out.

Equivalent units of ending work in process.

4. The weighted-average method is used to compute equivalent units of production. 5. This method considers the degree of completion (weighting) of the units completed and transferred out and the ending work in process. 6. In computing equivalent units, the beginning work in process is not part of the equivalent-units-of-production formula. 7. Companies need to make two equivalent unit computations: one for materials, and the other for conversion costs. This is necessary because ending work in process is fully complete as to materials, but only partially complete as to conversion costs.

MANAGEMENT INSIGHT Microsoft has struggled to control the costs of both manufacturing and distribution of video-game hardware. It is predicted that Microsoft’s “snowballing” costs in the next period could exceed budget by $2.4 billion. In what ways has cost accounting probably become more critical for Microsoft in recent years? Answer: In the past, Microsoft enjoyed very high profit margins on its software sales. As a consequence, it could afford to be less cost-conscious than most companies. In addition, in producing software, manufacturing costs represented a very small part of its total product cost. But the videogame hardware market is very competitive. In order to achieve its profitability goals, Microsoft will have to manufacture its product efficiently to meet its cost targets and to ensure adequate margins. The information provided by process cost accounting will be critical to its efforts.

3-16

Production Cost Report.

TEACHING TIP

Use ILLUSTRATION 3-3 to identify the four-step procedure to be followed at the end of a period for each department or process. Illustrations 3-4 through 3-8 provide an integrated example of each of the four required steps, culminating in the preparation of a production cost report. 1. In order to complete a production cost report, the company must perform four steps: a.

Compute the physical unit flow.

Compute the equivalent units of production.

Compute unit production costs.

Prepare a cost reconciliation schedule.

2. The first step in completing a production cost report requires computing physical unit flow.

TEACHING TIP

ILLUSTRATION 3-4 provides an example of computing the physical units within a department. Point out that it is necessary to know how many units were worked on during the period and to know what happened to the units. a.

3-17

The physical units are computed by adding the units started (or transferred) into production during the period to the units in process at the beginning of the period. This amount is called the total units to be accounted for.

These units then are accounted for by the output of the period, which consists of units transferred out during the period and any units in process at the end of the period.

3. The second step in completing a production cost report requires computing equivalent units of production. a.

Each processing department adds materials at the beginning of the process, and incurs conversion costs uniformly during the process.

Two computations of equivalent units are required—one for materials and one for conversion costs.

TEACHING TIP

ILLUSTRATION 3-5 provides an example of the computation of equivalent units of production for materials and conversion costs. Emphasize that when manufacturing cost elements are not incurred at the same time, there must be a separate equivalent unit computation for each cost element. 4. The third step in completing a production cost report requires computing unit production costs.

TEACHING TIP

ILLUSTRATION 3-6 provides an example of calculating unit production costs. Individual calculations of unit cost for materials and conversion costs are made. Emphasize that both beginning inventory costs and the current period’s material and conversion costs are used in the unit cost calculations.

3-18 .

Unit production costs are costs expressed in terms of equivalent units of production.

When equivalent units of production are different for materials and conversion costs, companies compute three unit costs: (1) materials, (2) conversion, and (3) total manufacturing.

Total manufacturing cost per unit is computed as the sum of unit materials cost + unit conversion cost.

5. The fourth step in completing a production cost report requires preparing a cost reconciliation schedule. a.

The company then prepares a cost reconciliation schedule to assign total costs to (1) units transferred out to the next department and (2) ending work in process.

The total manufacturing cost per unit is used in costing the units completed and transferred out.

The cost reconciliation schedule shows that the total costs accounted for equal the total costs to be accounted for.

TEACHING TIP

ILLUSTRATION 3-7 provides an example of the preparation of a cost reconciliation schedule. Point out that the cost reconciliation schedule shows that the total costs accounted for equal the total costs to be accounted for.

Preparing the Production Cost Report. 1. The production cost report contains both quantity and cost data for a production department. a.

3-19

This report is an internal document for management that shows production quantity and cost data for a production department.

TEACHING TIP

ILLUSTRATION 3-8 provides an example of a production cost report. The calculations made in the examples used in Illustrations 3-4 through 3-7 are used to complete the production cost report. b.

There are four steps in preparing a production cost report: (1) Prepare a physical unit schedule. (2) Compute equivalent units. (3) Compute unit costs. (4) Prepare a cost reconciliation schedule.

Production cost reports provide a basis for evaluating the productivity of a department. Managers can use the cost data to assess whether unit costs and total costs are reasonable.

*H. Equivalent Units Under FIFO. 1. Under the FIFO method, companies compute equivalent units on a firstin, first-out basis. 2. Companies assume that the beginning work in process is completed before new work is started under the FIFO method. 3. Equivalent units are the sum of the work performed to:

3-20 .

Finish the units of beginning work in process inventory.

Complete the units started into production during the period (units started and completed).

Start, but only partially complete, the units in ending work in process inventory.

4. The units started and completed during the current period are the units transferred out minus the units in beginning work in process. 5. Companies often expand the physical units schedule to ensure reporting of the beginning work in process and the units started and completed. 6. As with the weighted-average method, once companies determine the physical flow of units, they need to compute the equivalent units of production. a.

Since companies add materials at the beginning of the process, no additional materials costs are required to complete the beginning work in process.

Equivalent units for materials are the sum of: (1) Units started and finished. (2) Equivalent units of ending work in process.

Equivalent units for conversion costs are the sum of: (1) Equivalent units of beginning work in process. (2) Units started and finished. (3) Equivalent units of ending work in process.

7. The unit production costs are based entirely on the production costs incurred during the month. The costs in the beginning work in process are ignored because they were incurred on work done in the preceding month. 8. In preparing a cost reconciliation schedule under the FIFO method:

3-21

The cost of the beginning work in process is always assigned to the goods transferred to the next department (or finished goods, if processing is complete).

The ending work in process also will be assigned only the production costs incurred in the current period.

9. The weighted-average method of computing equivalent units is simple to understand and apply. It will be very similar to the FIFO method when prices do not fluctuate significantly from period to period. 10. Conceptually, the FIFO method is superior to the weighted-average method because it measures current performance using only costs incurred in the current period. It provides current cost information, which the company can use to establish more accurate pricing strategies for goods manufactured and sold in the current period.

3-22

20 MINUTE QUIZ Circle the correct answer. True/False 1. Costs are assigned to each specific job in a process cost system. True

False

2. In a process cost system, total costs are determined at the end of a period of time, such as a month. True

False

3. In a process cost system, the unit cost is total manufacturing costs divided by the equivalent units produced during the period. True

False

4. The accumulation of the costs of materials, labor, and manufacturing overhead is the same in a process cost system as in a job order cost system. True

False

5. More materials requisitions are generally required in a process cost system than in a job order cost system. True

False

6. Equivalent units of production equals units completed and transferred out + units in beginning work in process. True

False

7. Two equivalent unit computations are necessary—one for materials and the other for conversion costs. True

False

8. The first step in preparing a production cost report is to compute the equivalent units of production. True

False

9. The cost reconciliation schedule shows that the total costs accounted for equal the total costs to be accounted for. True

False

*10. Units in work in process at the beginning of the period are included in units “started and completed” under the FIFO method. True

3-23

False

Multiple Choice 1.

Which of the following is not a step in preparing a production cost report? a. Prepare a cost reconciliation schedule. b. Compute equivalent units of production. c. Compute the physical unit flow. d. Assign costs to particular jobs.

A department has no beginning work in process, has started 80,000 units and completed 50,000 units. Its ending work in process is 30,000 units, 60% complete as to conversion costs and fully complete as to materials. Its equivalent units for conversion costs are a. 50,000. b. 80,000. c. 68,000. d. 44,000.

In process costing, the computation of unit production costs requires a. the accumulation of material and conversion costs in work in process for each department or process. b. the computation of equivalent units for material and conversion costs. c. both a and b. d. neither a nor b.

Which of the following is not included in a production cost report? a. Costs accounted for. b. Entries to assign cost. c. Units accounted for. d. Units to be accounted for.

Unit costs for materials and conversion costs amount to $4 and $5 respectively. The ending work in process costs for 8,000 units (100% complete as to material and 70% complete as to conversion costs) amount to a. $60,000. b. $72,000. c. $44,000. d. $40,000.

3-24

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

False True True True False

Multiple Choice 1. 2. 3. 4. 5.

d. c. c. b. a.

3-25

6. 7. 8. 9. *10.

False True False True False

ILLUSTRATION 3-1 DIFFERENCES BETWEEN JOB ORDER COST AND PROCESS COST SYSTEM

3-26

ILLUSTRATION 3-2 FLOW OF COSTS IN PROCESS COST SYSTEM

3-27

ILLUSTRATION 3-3 PRODUCTION COST REPORT (STEPS)

3-28

ILLUSTRATION 3-4 STEP 1: COMPUTE THE PHYSICAL UNIT FLOW

3-29

ILLUSTRATION 3-5 STEP 2: COMPUTE EQUIVALENT UNITS OF PRODUCTION

3-30

ILLUSTRATION 3-6 STEP 3: COMPUTE UNIT PRODUCTION COST

3-31

ILLUSTRATION 3-7 STEP 4: PREPARE A COST RECONCILIATION SCHEDULE

3-32

ILLUSTRATION 3-8 PREPARING THE PRODUCTION COST REPORT

3-33

CHAPTER 4 Activity-Based Costing ASSIGNMENT CLASSIFICATION TABLE Brief Exercises

Do It!

Exercises

A Problems

B Problems

1, 2

1, 2, 3, 4, 5, 6, 12, 13

1A, 3A, 4A, 5A

1B, 3B, 4B, 5B

1A, 2A, 3A, 4A, 5A

1B, 2B, 3B, 4B, 5B

1A, 5A

1B, 5B

Study Objectives

Questions

*1.

Recognize the difference between traditional costing and activity-based costing.

1, 2, 3, 4, 5

*2.

Identify the steps in the development of an activitybased costing system.

*3.

Know how companies identify the activity cost pools used in activity-based costing.

*4.

Know how companies identify and use cost drivers in activity-based costing.

6, 10, 11, 12

*5.

Understand the benefits and limitations of activity-based costing.

13, 14, 15

*6.

Differentiate between value-added and nonvalue-added activities.

8, 16, 17

8, 9

12, 13, 14, 15, 16

*7.

Understand the value of using activity levels in activity-based costing.

10, 11, 12

17, 18

*8.

Apply activity-based costing to service industries.

9, 10

*9.

Explain just-in-time (JIT) processing.

7, 8

3, 4, 5, 6, 7, 12

1, 3, 4, 5, 6, 8, 9, 10, 11, 12, 13

*Note: All asterisked Questions, Exercises, and Problems relate to material contained in the appendix to the chapter.

4-1

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

4-2

Description

Difficulty Level

Time Allotted (min.)

Assign overhead using traditional costing and ABC; compute unit costs; classify activities as value- or non-value-added.

Moderate

35–45

Assign overhead to products using ABC and evaluate decision.

Moderate

25–35

Assign overhead costs using traditional costing and ABC; compare results.

Moderate

35–45

Assign overhead costs using traditional costing and ABC; compare results.

Moderate

40–50

Assign overhead costs to services using traditional costing and ABC; compute overhead rates and unit costs; compare results.

Moderate

35–45

Assign overhead using traditional costing and ABC; compute unit costs; classify activities as value- or non-value-added.

Moderate

35–45

Assign overhead to products using ABC and evaluate decision.

Moderate

25–35

Assign overhead costs using traditional costing and ABC; compare results.

Moderate

35–45

Assign overhead costs using traditional costing and ABC; compare results.

Moderate

40–50

Assign overhead costs to services using traditional costing and ABC; compute overhead rates and unit costs; compare results.

Moderate

35–45

4-3 DI4-4

Q4-19

Q4-18 Q4-20

*7. Understand the value of using activity levels in activity-based costing.

*8. Apply activity-based costing to service industries.

*9. Explain just-in-time (JIT) processing.

Broadening Your Perspective

BE4-8 BE4-9 DI4-3

Q4-8 Q4-16 Q4-17

*6. Differentiate between valueadded and non-value-added activities.

Exploring the Web Managerial Analysis

P4-5B

E4-15 P4-5A P4-5B

E4-9 E4-10 E4-11 E4-12 E4-13 P4-3A P4-3B

P4-3A P4-4A P4-5A P4-3B P4-4B P4-5B

P4-5A P4-5B

E4-11

P4-1A P4-2A P4-3A P4-4A P4-1B P4-2B P4-3B

P4-4B

Synthesis

P4-5A P4-5B

P4-2A P4-3A P4-4A P4-2B P4-3B P4-4B

Evaluation

Decision Making Decision Making Managerial Anal. Real-World Focus Across the Across the Organization Organization Ethics Case Real-World Focus Communication Communication All About You

E4-16 P4-5A

BE4-10 E4-17 E4-18

E4-12 E4-15 P4-1B BE4-8 BE4-9 E4-13 E4-16 E4-14 E4-14 P4-1A

BE4-9 DI4-3 P4-5B BE4-10 P4-5A

BE4-10 BE4-11 BE4-12

E4-11

Q4-13 Q4-14 Q4-15

*5. Understand the benefits and limitations of activity-based costing.

BE4-3 E4-1 E4-12 P4-1B DI4-2 BE4-4 E4-4 E4-13 P4-2B E4-1 BE4-5 E4-5 P4-1A P4-3B E4-3 BE4-6 E4-8 P4-2A P4-4B E4-4 BE4-7 E4-9 P4-3A P4-5B E4-5 E4-6 BE4-12 E4-10 P4-4A E4-8 DI4-2 E4-11 P4-5A

E4-1 E4-2 E4-3 E4-4 E4-5 E4-6

*4. Know how companies identify Q4-6 and use cost drivers in Q4-10 Q4-11 activity-based costing. Q4-12

E4-5 P4-5A E4-6 P4-1B E4-12 P4-4B E4-13 P4-5B P4-1A P4-4A

Analysis

E4-7 E4-8

Q4-7 DI4-1

*2. Identify the steps in the development of an activitybased costing system.

BE4-1 BE4-2 E4-1 E4-2 E4-3 E4-4

Application

*3. Know how companies identify Q4-9 the activity cost pools used in activity-based costing.

Q4-1 Q4-2 Q4-3 Q4-4 Q4-5 DI4-1

Knowledge Comprehension

*1. Recognize the difference between traditional costing and activity-based costing.

Study Objective

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. RECOGNIZE THE DIFFERENCE BETWEEN TRADITIONAL COSTING AND ACTIVITY-BASED COSTING. 2. IDENTIFY THE STEPS IN THE DEVELOPMENT OF AN ACTIVITY-BASED COSTING SYSTEM. 3. KNOW HOW COMPANIES IDENTIFY THE ACTIVITY COST POOLS USED IN ACTIVITY-BASED COSTING. 4. KNOW HOW COMPANIES IDENTIFY AND USE COST DRIVERS IN ACTIVITY-BASED COSTING. 5. UNDERSTAND THE BENEFITS AND LIMITATIONS OF ACTIVITY-BASED COSTING. 6. DIFFERENTIATE BETWEEN VALUE-ADDED AND NONVALUE-ADDED ACTIVITIES. 7. UNDERSTAND THE VALUE OF USING ACTIVITY LEVELS IN ACTIVITY-BASED COSTING. 8. APPLY ACTIVITY-BASED COSTING TO SERVICE INDUSTRIES. *9. EXPLAIN JUST-IN-TIME (JIT) PROCESSING.

4-4

CHAPTER REVIEW Traditional Costing And Activity-Based Costing 1.

(S.O. 1) Often the most difficult part of computing accurate unit costs is determining the proper amount of overhead cost to assign each product, service or job. For job order costing we assumed the direct labor cost was the relevant activity base for assigning overhead costs to a job and for process costing we assumed that machine hours was the relevant activity base.

Activity-based costing (ABC) allocates overhead to multiple activity cost pools and assigns the activity cost pools to products and services by means of cost drivers. In ABC, an activity is any event, action, transaction, or work sequence that causes the incurrence of cost in producing a product or providing a service. A cost driver is any factor or activity that has a direct cause-effect relationship with the resources consumed.

ABC allocates overhead in a two-stage process: In the first stage, overhead costs are allocated to activity cost pools, rather than to departments. Each is a distinct type of activity. In the second stage, the overhead allocated to the activity cost pools is assigned to products using cost drivers which represent and measure the number of individual activities undertaken or performed to produce products or provide services.

(S.O. 2) Activity-based costing involves the following four steps: a. Identify and classify the major activities involved in the manufacture of specific products, and allocate manufacturing overhead costs to the appropriate cost pools. b. Identify the cost driver that has a strong correlation to the costs accumulated in the cost pool. c. Compute the overhead rate for each cost driver. d. Assign manufacturing overhead costs for each cost pool to products, using the overhead rates (cost per driver).

Unit Costs Under ABC 5.

(S.O. 3) A well designed activity-based costing system starts with an analysis of the activities performed to manufacture a product or provide a service. This analysis should identify all resource-consuming activities. It requires a detailed, step-by-step walk through of each operation, documenting every activity undertaken to accomplish a task.

(S.O. 4) After costs are allocated to the activity cost pools, the cost drivers for each cost pool must be identified. The cost driver must accurately measure the actual consumption of the activity by the various products. To achieve accurate costing, a high degree of correlation must exist between the cost driver and the actual consumption of the overhead costs in the cost pool.

An activity-based overhead rate per cost driver is computed by dividing the total estimated overhead per activity by the number of cost drivers expected to be used per activity. The formula for this computation is as follows: Estimated Overhead Per Activity Expected Use of Cost Drivers Per Activity

4-5

Activity-Based Overhead Rate

In assigning overhead costs, it is necessary to know the expected use of cost drivers for each product. To assign overhead costs to each product, the activity-based overhead rates are multiplied by the number of cost drivers expected to be used per product.

Benefits of ABC 9.

(S.O. 5) The primary benefit of ABC is more accurate product costing because: a. ABC leads to more cost pools. b. ABC leads to enhanced control over overhead costs. c. ABC leads to better management decisions.

Limitations of ABC 10.

Although ABC systems often provide better product cost data than traditional volume-based systems, there are the following limitations: a. ABC can be expensive to use. b. Some arbitrary allocations continue.

When to Use ABC 11.

The presence of one or more of the following factors would point to possibly using ABC: a. Product lines differ greatly in volume and manufacturing complexity. b. Product lines are numerous, diverse, and require differing degrees of support services. c. Overhead costs constitute a significant portion of total costs. d. The manufacturing process or the number of products has changed significantly. e. Production or marketing managers are ignoring data provided by the existing system and are instead using “bootleg” costing data or other alternative data when pricing or making other product decisions.

Value-Added Versus Non-Value-Added Activities 12.

(S.O. 6) Activity-based management (ABM) extends the use of ABC from product costing to a comprehensive management tool that focuses on reducing costs and improving processes and decision making. a. Value-added activities increase the worth of a product or service to customers. Examples include engineering design, machining, assembly, painting, and packaging. b. Non-value-added activities are product- or service-related activities that simply add cost to, or increase the time spent on, a product or service without increasing its market value. Examples include repair of machines, the storage of inventory, the moving of raw materials, assemblies, and finished product; building maintenance; inspections; and inventory control. Examples for service enterprises might include taking appointments, reception, bookkeeping, billing, traveling, ordering supplies, advertising, cleaning, and computer repair.

13.

The purpose of ABM is to reduce or eliminate the time and cost devoted to non-value-added activities.

4-6

Classification of Activity Levels 14. (S.O. 7) The recognition that some activity costs are not driven by output units has led to the development of a classification of ABC activities, consisting of four levels. The four levels are classified and defined as follows: a. Unit-level activities. Activities performed for each unit of production. b. Batch-level activities. Activities performed for each batch of products rather than each unit. c. Product-level activities. Activities performed in support of an entire product line, but are not always performed every time a new unit or batch of products is produced. d. Facility-level activities. Activities required to support or sustain an entire production process. Activity-Based Costing in Service Industries 15. (S.O. 8) The general approach to identifying activities, activity cost pools, and cost drivers is the same for service companies and for manufacturers. Also, the labeling of activities as value-added and non-value-added, and the attempt to reduce or eliminate non-value-added activities as much as possible is just as valid in service industries as in manufacturing operations. 16. Implementation of activity-based costing in service industries is sometimes more difficult because there is a larger proportion of overhead costs which are company-wide costs that cannot be directly traced to specific services provided by the company. Just-In-Time Processing *17. (S.O. 9) Just-in-time (JIT) manufacturing is dedicated to having the right amount of materials, products, or parts at the time they are needed. Under JIT processing, raw materials are received just in time for use in production, subassembly parts are completed just in time for use in finished goods, and finished goods are completed just in time to be sold. *18. A primary objective of JIT is to eliminate all manufacturing inventories. Inventories are considered to have an adverse effect on net income because they tie up funds and storage space that could be made available for more productive purposes. *19. There are three important elements in JIT processing: a. A company must have dependable suppliers who are willing to deliver on short notice exact quantities of raw materials according to precise quality specifications. This may even include multiple deliveries within the same day. b. A multiskilled work force must be developed. c. A total quality control system must be established throughout the manufacturing operations. *20. The major benefits of implementing JIT processing are: a. Manufacturing inventories are significantly reduced or eliminated. b. Product quality is enhanced. c. Rework costs and inventory storage costs are reduced or eliminated. d. Production cost savings are realized from the improved flow of goods through the processes.

4-7

LECTURE OUTLINE

Traditional Costing Systems 1. A traditional costing system allocates overhead to products on the basis of predetermined plantwide or departmentwide volume of unit-based output rates such as direct labor or machine hours. 2. Direct labor is sometimes the appropriate basis for assigning overhead cost to products when

It constitutes a significant part of total product cost, and

A high correlation exists between direct labor and changes in the amount of overhead costs.

Activity-Based Costing. 1. Activity-based costing (ABC) allocates overhead to multiple activity cost pools, and it then assigns the activity cost pools to products and services by means of cost drivers. 2. In ABC, an activity is any event, action, transaction, or work sequence that incurs cost when producing a product or providing a service. 3. ABC allocates overhead in a two-stage process. The first stage allocates overhead costs to activity cost pools. The second stage assigns the overhead allocated to the activity cost pools to products, using cost drivers. 4. Cost drivers measure the number of individual activities undertaken or performed to produce products or provide services.

4-8

TEACHING TIP

ILLUSTRATION 4-1 provides examples of activities and related cost drivers that measure each activity’s contribution to the finished product. C.

Unit Costs Under ABC. 1. Activity-based costing involves the following steps: a.

Identify and classify the major activities involved in the manufacture of specific products, and allocate manufacturing overhead costs to the appropriate cost pools.

Identify the cost driver that has a strong correlation to the costs accumulated in the cost pool.

Compute the overhead rate for each cost driver.

Assign manufacturing overhead costs for each cost pool to products, using the overhead rates (cost per driver).

TEACHING TIP

ILLUSTRATION 4-2 presents the steps involved in an activity-based costing system. 2. A well designed activity-based costing system starts with an analysis of the activities performed to manufacture a product or provide a service. 3. It requires a detailed, step-by-step review of each operation, documenting every activity undertaken to accomplish a task. 4. Next, the system assigns overhead costs directly to the appropriate activity cost pool.

4-9

Identify Cost Drivers, Compute Overhead Rates, and Assign Overhead Costs to Products. 1. After costs are allocated to the activity cost pools, the company must identify the cost drivers for each cost pool. 2. A high degree of correlation must exist between the cost driver and the actual consumption of the overhead costs in the cost pool to achieve accurate costing. 3. The company computes an activity-based overhead rate per cost driver by dividing the estimated overhead per activity by the number of cost drivers expected to be used per activity.

TEACHING TIP

ILLUSTRATION 4-3 provides formulas for the activity-based overhead rate, the overhead costs assigned to products, and the overhead cost per unit. 4. In assigning overhead costs, it is necessary to know the expected use of cost drivers for each product. 5. The company multiplies activity-based overhead rates per cost driver by the number of cost drivers expected to be used per product to assign overhead costs to each product. 6. Under ABC, overhead costs are usually shifted from a high-volume product to a low-volume product. This shift results in more accurate costing because:

4-10 .

Low-volume products often require more special handling, (i.e.more machine setups and inspections), than high-volume products.

Assigning overhead using ABC will usually increase the cost per unit for low-volume products (and decrease the cost per unit for high-volume products) as compared to traditional overhead allocation.

SERVICE COMPANY INSIGHT Have you flown since the $15 baggage fees have been implemented? Baggage handling is extremely labor intensive. The tagging, sorting, loading on carts, loading in planes, unloading, etc., adds up to about $9/bag. Then there’s equipment costs and storage facilities ($4/bag) and $2 fuel cost. Why do airlines charge even higher rates for heavier bags, bags that are odd shapes, and bags with hazardous materials in them? Answer: Each of these factors increases the costs to the airlines. Heavier baggage is more difficult to handle, thus increasing labor costs. It also uses up more fuel. Bags that are odd shapes complicate handling both for humans and machines. In addition, odd shapes take up more space in the cargo area. Finally, hazardous materials require special handling and storage procedures. All of these factors should be considered by an airline when it decides how much to charge for special baggage.

Benefits of ABC. 1. The primary benefit of ABC is more accurate product costing because a.

ABC leads to more cost pools being used to assign overhead costs to products.

ABC leads to enhanced control over overhead costs; companies can trace many overhead costs directly to activities under ABC.

ABC leads to better management decisions; more accurate product costing should contribute to desired product profitability levels.

TEACHING TIP

ILLUSTRATION 4-4 presents the benefits of activity-based costing. Point out that ABC allocates overhead costs in a more accurate manner than traditional costing.

4-11

2. The limitations of ABC are: a.

ABC can be expensive to use; identifying multiple activities and applying numerous cost drivers results in increased costs.

Some arbitrary allocations continue; certain overhead costs still have to be allocated by means of some arbitrary volume-based cost driver (i.e.-labor hours).

SERVICE COMPANY INSIGHT Although most ABC applications are in manufacturing companies, small service businesses can apply it also. Mahany Welding Supply used ABC to determine the cost of servicing customers and feasible cost reduction opportunities. Application of ABC at Mahany provided information about the five employees who were involved in different activities of revenue generation. Managers applied activity cost pools to the five revenue-producing employees using relevant cost drivers. What positive implications does application of ABC have for the employees of this company? Answer: ABC will make these employees more aware of which activities cost the company more money. They will be motivated to reduce their use of these activities in order to improve their individual performance. 3. The presence of one or more of the following factors would point to ABC’s possible use.

4-12

Product lines differ greatly in volume and manufacturing complexity.

Product lines are numerous and diverse, and they require differing degrees of support services.

Overhead costs constitute a significant portion of total costs.

The manufacturing process or the number of products has changed significantly.

Production or marketing managers are ignoring data provided by the existing system and are instead using other alternative data when pricing or making product decisions.

Value-Added Versus Non-Value-Added Activities. 1. A refinement of activity-based costing used in activity-based management (ABM) is the classification of activities as either value-added or nonvalue-added. 2. Value-added activities increase the worth of a product or service, for which the customer is willing to pay. 3. Value-added activities are the activities of actually manufacturing a product or performing a service (i.e., engineering design, assembly, packaging). 4. Non-value-added activities are production- or service-related activities that simply add cost to or increase the time spent on a product or service without increasing its market value (i.e. machine repair, building maintenance, inventory control).

TEACHING TIP

ILLUSTRATION 4-5 provides examples of activities that are classified as valueadded and non-value-added. Point out that not all non-value-added activities are totally wasteful or easily eliminated. 5. Companies often use activity flowcharts to help identify the ABC activities.

4-13

6. Not all non-value-added activities are totally wasteful, nor can they be totally eliminated, but managers are motivated to minimize them as much as possible.

MANAGEMENT INSIGHT Production line technicians from General Mills flew to North Carolina to observe first-hand how race-car pit crews operate. In a NASCAR race the value-added activity is driving toward the finish-line. General Mills technicians were able to reduce setup time from 5 hours to just 20 minutes from what they learned at the car race. What are the benefits of reducing setup time? Answer: Setup time is a non-value-added activity. Customers are not willing to pay extra for more setup time. By reducing the time spent on setups, the company can reduce non-value-added costs. Also, by reducing setup time the company can switch from producing one product to producing a different product more quickly. This enables it to respond to customers’ demands more quickly, thus avoiding stock-outs.

Classification of Activity Levels. 1. A classification of ABC activities consisting of four levels are defined as

4-14

Unit-level activities: activities performed for each unit of production.

Batch-level activities: activities performed for each batch of products rather than each unit.

Product-level activities: activities performed in support of an entire product line.

Facility-level activities: activities required to support an entire production process.

TEACHING TIP

ILLUSTRATION 4-7 provides the types of activities and examples of cost drivers for each of the four different levels of ABC activities. 2. Companies may achieve greater accuracy in overhead cost allocation by recognizing the different levels of activities and developing specific activity cost pools and their related cost drivers. 3. Nonrecognition of this classification of activities is one of the reasons that volume-based cost allocation causes distortions in product costing. 4. The resources consumed by batch-, product-, and facility-level supporting activities do not vary at the unit level, nor can managers control them at the unit level. 5. Companies can control batch-, product-, and facility-level costs only by modifying batch-, product-, and facility-level activities.

Activity-Based Costing in Service Industries. 1. The overall objective of ABC in service firms is no different than it is for a manufacturing company: The objective is to identify the key activities that generate costs and to keep track of how many activities are performed for each service provided. 2. The general approach to identifying activities, activity cost pools, and cost drivers is the same for service companies and for manufacturers. 3. A larger proportion of overhead costs are company-wide costs that cannot be directly traced to specific services provided by the company, which sometimes makes implementation of ABC difficult in service industries.

. 4-15

SERVICE COMPANY INSIGHT Many times good ideas for new businesses result from identifying nonvalue adding activities in everyday processes. Think about the last time you moved your belongings. You probably bought boxes and packaging tape, assembled and taped the boxes, then cut open and disposed of the boxes. Some creative entrepreneurs have started renting reusable plastic bins—they even deliver the bins and pick them up after customers move. What incremental costs would a moving company that historically sold boxes and tape consider in deciding whether to provide plastic bins instead of the boxes and tape? Answer: In deciding whether to provide reusable plastic bins, the moving company would consider the following relevant costs: the cost of the bins (and the number of expected uses), the incremental revenue from boxes versus plastic bins, the lost tape revenue, and the cost of driving out to pick up the bins (they don’t have to drive out and pick up the boxes). A potential intangible benefit would be the positive public relations benefit of saying that they were switching to a more environmentally friendly packaging option.

*I.

Just-in-Time Processing. 1. Traditionally, continuous process manufacturing has been based on a just-in-case philosophy: inventories of raw materials are maintained just in case some items are of poor quality or a key supplier is shut down by a strike. This philosophy results in a “push approach”, in which raw materials are pushed through each process and often results in the buildup of extensive manufacturing inventories. 2. Many U.S. firms have switched to just-in-time (JIT) processing. Under JIT processing, companies receive raw materials just in time for use in production, they complete subassembly parts just in time for use in finished goods, and they complete finished goods just in time to be sold.

4-16

3. JIT strives to eliminate inventories by using a pull approach in manufacturing. This approach begins with the customer placing an order with the company, which starts the process of pulling the product through the manufacturing process. 4. JIT processing consists of three important elements: a.

Suppliers must be dependable and willing to deliver on short notice exact quantities of materials, and to specified work stations. Online computer linkage between the company and its suppliers facilitates this arrangement.

Workers must be multiskilled in order to operate and maintain several different types of machines.

The company must establish total quality control throughout the manufacturing operations, which tolerates no defects. Continuous monitoring by both employees and supervisors at each work station is required.

TEACHING TIP

ILLUSTRATION 4-6 presents the elements in JIT processing. Point out that JIT’s primary objective is to eliminate all manufacturing inventories. 5. The major benefits of JIT processing include: a.

Significant reduction or elimination of manufacturing inventories.

Enhanced product quality.

Reduction or elimination of rework costs and inventory storage costs.

Production cost savings from the improved flow of goods through the processes.

6. One of the major accounting benefits of JIT is the elimination of separate raw materials and work-in-process inventory accounts.

. 4-17

20 MINUTE QUIZ Circle the correct answer. True/False 1. Even in today’s automated environment, direct labor is sometimes the appropriate basis for assigning overhead cost to products. True

False

2. In the first stage of activity-based costing, overhead is assigned to products using cost drivers. True

False

3. The first step in activity-based costing is to identify and classify the major activities involved in the manufacture of specific products, and allocate manufacturing overhead to the appropriate cost pools. True

False

4. Before costs are allocated to the cost pools, the cost drivers for each cost pool must be identified. True

False

5. Under ABC, overhead costs are shifted from the high-volume product to the low-volume product. True

False

6. Activity-based costing does not change the amount of overhead costs, but it does allocate those costs in a more accurate manner. True

False

7. Overhead costs are not allocated by means of arbitrary volume-based cost drivers under ABC. True

False

8. Value-added activities increase the worth of a product or service to customers and involve resource usage that customers are willing to pay for. True

False

9. Product-level activities in ABC are required to support or sustain an entire production process. True

False

*10. Just-in-time processing strives to eliminate inventories by using a “pull approach” in manufacturing. True

4-18

False

Multiple Choice 1.

The last step in activity-based costing is to a. identify the major activities involved in the manufacture of specific products. b. compute the overhead rate per cost driver. c. identify the cost driver that has a strong correlation to the costs accumulated in the cost pool. d. assign manufacturing overhead costs for each cost pool to products.

Machine hours would be an accurate cost driver for a. assembly costs. b. inspecting costs. c. machining costs. d. machine setup costs.

All of the following are benefits of ABC except it leads to a. less cost pools used to assign overhead. b. more accurate cost data. c. enhanced control over overhead costs. d. better management decisions.

The level of ABC activities performed in support of an entire product line are classified as a. batch-level activities. b. facility-level activities. c. product-level activities. d. unit-level activities.

*5.

Just-in-time processing strives to eliminate inventories by using a a. just in case approach. b. pull approach. c. push approach. d. process approach.

4-19

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False True False True

Multiple Choice 1. 2. 3. 4. *5.

d. c. a. c. b.

4-20

6. 7. 8. 9. *10.

True False True False True

ILLUSTRATION 4-1 ACTIVITIES AND COST DRIVERS

4-21

ILLUSTRATION 4-2 STEPS IN ACTIVITY-BASED COSTING SYSTEM

4-22

ILLUSTRATION 4-3 COMPUTING ACTIVITY-BASED OVERHEAD RATE

4-23

ILLUSTRATION 4-4 BENEFITS OF ABC

4-24

ILLUSTRATION 4-5 VALUE-ADDED AND NON-VALUE-ADDED ACTIVITIES

4-25

ILLUSTRATION 4-6 CLASSIFICATION OF ACTIVITY LEVELS

4-26

ILLUSTRATION 4-7 ELEMENTS OF JIT PROCESSING

4-27

CHAPTER 5 Cost-Volume-Profit ASSIGNMENT CLASSIFICATION TABLE Study Objectives

Questions

Brief Exercises

Do It!

Exercises

A Problems

B Problems

Distinguish between variable and fixed costs.

1, 2, 3, 6

1, 2, 3, 4, 5, 6

1A, 6A

1B, 6B

Explain the significance of the relevant range.

4, 5

Explain the concept of mixed costs.

6, 7, 8

1, 3, 4, 5

List the five components of cost-volume-profit analysis.

Indicate what contribution margin is and how it can be expressed.

10, 11, 17

6, 7

8, 9, 10, 11, 12, 13, 17

1A, 2A, 3A, 4A, 5A, 6A

1B, 2B, 3B, 4B, 5B, 6B

Identify the three ways to determine the break-even point.

12, 13, 14

8, 9

3, 4

8, 9, 10, 11, 12, 13, 14, 16, 17

1A, 2A, 3A, 4A, 5A

1B, 2B, 3B, 4B, 5B

Give the formulas for determining sales required to earn target net income.

10, 12

14, 15, 17

2A, 5A, 6A

2B, 5B, 6B

Define margin of safety, and give the formulas for computing it.

16, 17

2A, 4A, 5A, 6A

2B, 4B, 5B, 6B

5-1

1, 2

1, 3, 4, 5, 6 7

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

5-2

Description

Difficulty Level

Time Allotted (min.)

Determine variable and fixed costs, compute break-even point, prepare a CVP graph, and determine net income.

Simple

20–30

Prepare a CVP income statement, compute break-even point, contribution margin ratio, margin of safety ratio, and sales for target net income.

Moderate

30–40

Compute break-even point under alternative courses of action.

Simple

20–30

Compute break-even point and margin of safety ratio, and prepare a CVP income statement before and after changes in business environment.

Moderate

20–30

Compute contribution margin, fixed costs, break-even point, sales for target net income, and margin of safety ratio.

Moderate

20–30

Determine contribution margin ratio, break-even point, and margin of safety.

Moderate

20–30

Determine variable and fixed costs, compute break-even point, prepare a CVP graph, and determine net income.

Simple

20–30

Prepare a CVP income statement, compute break-even point, contribution margin ratio, margin of safety ratio, and sales for target net income.

Moderate

30–40

Compute break-even point under alternative courses of action.

Simple

20–30

Compute break-even point and margin of safety ratio, and prepare a CVP income statement before and after changes in business environment.

Moderate

20–30

Compute break-even point and margin of safety ratio, and prepare a CVP income statement before and after changes in business environment.

Moderate

20–30

Determine contribution margin ratio, break-even point, and margin of safety.

Moderate

20–30

5-3

List the five components of cost-volume-profit analysis.

Indicate what contribution margin is and how it can be expressed.

Identify the three ways to determine the break-even point.

Give the formulas for determining sales required to earn target net income.

Define margin of safety, and give the formulas for computing it.

* 2.

* 3.

* 4.

* 5.

* 6.

* 7.

* 8.

Broadening Your Perspective

Explain the significance of the relevant range.

Explain the concept of mixed costs. E5-4 E5-5 E5-7

Distinguish between variable and fixed costs.

E5-4

P5-5A P5-6A P5-5B P5-6B P5-4A P5-6A P5-4B

E5-12 P5-2A E5-14 P5-2B E5-15 E5-17 E5-17 E5-16 P5-2A P5-2B

Q5-16 BE5-10 BE5-12 DI5-4

P5-6B

P5-5B P5-6B

Managerial Analysis Ethics Case All About You

P5-3A P5-4A P5-3B P5-4B P5-5A P5-5B E5-16 P5-1A P5-2A P5-1B P5-2B E5-10 E5-11 E5-12 E5-13 E5-14 E5-17 Q5-13 BE5-8 BE5-9 DI5-3 DI5-4 E5-8 E5-9

Q5-15 BE5-11 DI5-4

P5-3A P5-3B P5-4A P5-5A P5-6A P5-4B

P5-6A P5-6B

Evaluation

BE5-6 P5-1A P5-2A P5-1B P5-2B

P5-5A P5-5B

P5-1B

Synthesis

E5-10 E5-11 E5-12 E5-13 E5-17

Q5-11 Q5-17 BE5-6 BE5-7 E5-8 E5-9

DI5-2 BE5-3 E5-5 E5-3 E5-6 P5-1A

BE5-2

E5-2 DI5-1 Q5-8 E5-1 BE5-4 BE5-5

E5-3 E5-6 P5-1A P5-1B

Analysis

BE5-1 E5-5 E5-1 E5-2 DI5-1

Application

Communication Real-World Focus Decision Making Exploring the Web Across the Organization

Q5-12 Q5-14

Q5-10

Q5-9

Q5-6 Q5-7 BE5-1

Q5-4 Q5-5

Q5-1 Q5-2 Q5-3 Q5-6

Knowledge Comprehension

* 1.

Study Objective

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1.

DISTINGUISH BETWEEN VARIABLE AND FIXED COSTS.

EXPLAIN THE SIGNIFICANCE OF THE RELEVANT RANGE.

EXPLAIN THE CONCEPT OF MIXED COSTS.

LIST THE FIVE COMPONENTS OF COST-VOLUMEPROFIT ANALYSIS.

INDICATE WHAT CONTRIBUTION MARGIN IS AND HOW IT CAN BE EXPRESSED.

IDENTIFY THE THREE WAYS TO DETERMINE THE BREAK-EVEN POINT.

GIVE THE FORMULAS FOR DETERMINING SALES REQUIRED TO EARN TARGET NET INCOME.

DEFINE MARGIN OF SAFETY, AND GIVE THE FORMULAS FOR COMPUTING IT.

5-4

CHAPTER REVIEW Cost Behavior Analysis 1.

Cost behavior analysis is the study of how specific costs respond to changes in the level of business activity. A knowledge of cost behavior helps management plan operations and decide between alternative courses of action.

The activity index identifies the activity that causes changes in the behavior of costs; examples include direct labor hours, sales dollars, and units of output. Once an appropriate activity index is chosen, costs can be classified as variable, fixed or mixed.

Variable and Fixed Costs 3.

(S.O. 1) Variable costs are costs that vary in total directly and proportionately with changes in the activity level. Examples of variable costs include direct materials and direct labor, cost of goods sold, sales commissions, and freight-out. A variable cost may also be defined as a cost that remains the same per unit at every level of activity.

Fixed costs are costs that remain the same in total regardless of changes in the activity level. Examples include property taxes, insurance, rent, supervisory salaries, and depreciation. Fixed costs per unit vary inversely with activity; as volume increases, unit cost declines and vice versa.

Relevant Range 5.

(S.O. 2) The range over which a company expects to operate during the year is called the relevant range. Within the relevant range a straight-line relationship exists for both variable and fixed costs.

Mixed Costs 6.

(S.O. 3) Mixed costs are costs that contain both a variable element and a fixed element; they increase in total as the activity level increases, but not proportionately. For purposes of CVP analysis, mixed costs must be classified into their fixed and variable elements.

The high-low method uses the total costs incurred at the high and low levels of activity. The difference in costs represents variable costs, since only the variable cost element can change as activity levels change.

The steps in computing fixed and variable costs under the high-low method are: a. Determine variable cost per unit from the following formula: Change in Total Costs b.

High minus Low Activity Level

Variable Cost per Unit

Determine the fixed cost by subtracting the total variable cost at either the high or the low activity level from the total cost at that activity level.

Cost-Volume-Profit Analysis 9.

(S.O. 4) Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and volume on a company’s profits. It is a critical factor in such management decisions as profit planning, setting selling prices, determining product mix, and maximizing use of production facilities.

5-5

10.

CVP analysis considers the interrelationships among the following components: (a) volume or level of activity, (b) unit selling prices, (c) variable cost per unit, (d) total fixed costs, and (e) sales mix.

Basic CVP Components 11.

The following assumptions underlie each CVP analysis: a. The behavior of both costs and revenues is linear throughout the relevant range of the activity index. b. All costs can be classified as either variable or fixed with reasonable accuracy. c. Changes in activity are the only factors that affect costs. d. All units produced are sold. e. When more than one type of product is sold, the sales mix will remain constant. That is, the percentage that each product represents of total sales will stay the same.

Contribution Margin 12.

(S.O. 5) Contribution margin is the amount of revenue remaining after deducting variable costs. The formula for contribution margin per unit is: Unit Selling Price

13.

–

Unit Variable Costs

Contribution Margin per Unit

Contribution margin per unit indicates the amount available to cover fixed costs and contribute to income. The formula for the contribution margin ratio is: Contribution Margin Per Unit

Unit Selling Price

Contribution Margin Ratio

The ratio indicates the portion of each sales dollar that is available to apply to fixed costs and to contribute to income. Break-Even Analysis 14.

(S.O. 6) The break-even point is the level of activity at which total revenue equals total costs (both fixed and variable). Knowledge of the break-even point is useful to management when it decides whether to introduce new product lines, change sales prices on established products, or enter new market areas.

15.

A common equation used for CVP analysis is as follows: Sales = Variable Costs + Fixed Costs + Net Income

16.

Under the contribution margin technique, the break-even point can be computed by using either the contribution margin per unit or the contribution margin ratio.

17.

The formula, using unit contribution margin, is: Fixed Costs

5-6

Contribution Margin per Unit

Break-even Point in Units

18.

The formula using the contribution margin is: Fixed Costs

19.

Contribution Margin Ratio

Break-even Point in Dollars

A chart (or graph) can also be used as an effective means to determine and illustrate the breakeven point. A cost-volume-profit (CVP) graph is as follows: Dollars (000)

Sales Line

900 Total Cost Line

800 700 600 Break-even Point

Variable Costs

500 400 300

Fixed Cost Line

200 100 0

Fixed Costs 200 400 600 800 1000 1200 1400 1600 1800 Units of Sales

Target Net Income 20.

(S.O. 7) Target net income is the income objective for individual product lines. The follow-ing equation is used to determine target net income sales: Required Sales = Variable Costs + Fixed Costs + Target Net Income

Margin of Safety 21.

(S.O. 8) Margin of safety is the difference between actual or expected sales and sales at the break-even point. a. The formula for stating the margin of safety in dollars is: Actual (Expected) – Sales

Break-even Sales

Margin of Safety in Dollars

The formula for determining the margin of safety ratio is: Margin of Safety in Dollars

–

Actual (Expected) = Sales

Margin of Safety Ratio

The higher the dollars or the percentage, the greater the margin of safety.

. 5-7

LECTURE OUTLINE A.

Cost Behavior Analysis. 1. Cost behavior analysis is the study of how specific costs respond to changes in the level of business activity. 2. The activity index identifies the activity that causes changes in the behavior of costs. With an appropriate activity index, companies can classify the behavior of costs into three categories: variable, fixed, or mixed.

TEACHING TIP

Use ILLUSTRATION 5-1 to define and graphically illustrate variable and fixed cost classifications. Emphasize total cost behavior with changes in activity levels, then demonstrate unit cost behavior with activity level changes. Point out that for internal analysis of operations by management, having costs classified into variable and fixed classifications facilitates CVP analysis. 3. Variable costs are costs that vary in total directly and proportionately with changes in the activity level. A variable cost remains the same per unit at every level of activity. 4. Fixed costs are costs that remain the same in total regardless of changes in the activity level.

5-8

Because total fixed costs remain constant as activity changes, it follows that fixed costs per unit vary inversely with activity.

Examples of fixed costs include property taxes, insurance, rent, supervisory salaries, and depreciation on buildings and equipment.

5. The relevant range is the range of activity over which a company expects to operate during a year. It is important in CVP analysis because the behavior of costs is assumed to be linear (straight-line) throughout the relevant range. Although the linear relationship may not be completely realistic, the linear assumption produces useful data for CVP analysis as long as the level of activity remains within the relevant range. 6. Mixed costs are costs that contain both a variable element and a fixed element. Mixed costs change in total but not proportionately with changes in the activity level. a.

For purposes of CVP analysis, mixed costs must be classified into their fixed and variable elements. One method that management may use to classify these costs is the high-low method.

TEACHING TIP

Use ILLUSTRATION 5-2 to define and graphically illustrate the mixed costs classification. Point out that for CVP analysis, the variable and fixed elements of a mixed cost should be separated using a method such as the high-low method. b.

The high-low method uses the total costs incurred at the high and low levels of activity. The difference in costs between the high and low levels represents variable costs, since only the variable cost element can change as activity levels change. Fixed costs are determined by subtracting the total variable cost at either the high or low activity level from the total cost at that activity level.

MANAGEMENT INSIGHT The recession that started in 2008 produced a surprise for some manufacturers— the number of jobs lost was actually lower than in previous recessions. Between 2000 and 2008 many factories adopted lean manufacturing practices that relied less on large numbers of low skilled workers, and more on machines and a few highly skilled workers. Because the employees are highly skilled, employers are reluctant to loss them. . 5-9

Would you characterize labor costs as being a fixed cost, a variable cost, or something else in this situation? Answer: Because these labor costs are essentially unchanged for most levels of production, they are primarily fixed. However, it could be described as being a “step function.” If production gets too far outside the normal range, workers’ hours will change. If production goes too low, hours are cut, and if it goes too high, overtime hours are needed.

Cost-Volume-Profit Analysis. 1. Cost-volume-profit (CVP) analysis is the study of the effects of changes in costs and volume on a company’s profits. CVP analysis is important in profit planning. It is useful in setting selling prices, determining product mix, and maximizing use of production facilities.

TEACHING TIP

ILLUSTRATION 5-3 lists the basic components and assumptions that underlie CVP analysis. 2. CVP analysis considers the interrelationships among the following components:

5-10

Volume or level of activity.

Unit selling prices.

Variable cost per unit.

Total fixed costs.

Sales mix.

3. The following assumptions underlie each CVP analysis: a.

The behavior of both costs and revenues is linear throughout the relevant range of the activity index.

Costs can be classified accurately as either variable or fixed.

Changes in activity are the only factors that affect costs.

All units produced are sold.

When more than one type of product is sold, the sales mix will remain constant (the percentage that each product represents of total sales will stay the same).

4. Contribution margin is the amount of revenue remaining after deducting variable costs. It can be expressed as a per unit amount or as a ratio.

TEACHING TIP

Use ILLUSTRATION 5-4 to demonstrate the calculation of the contribution margin on a unit basis and as a ratio. Emphasize the importance of the contribution margin in CVP analysis.

5-11

Contribution Margin per Unit = Unit Selling Price – Unit Variable Costs.

Contribution Margin Ratio = Contribution Margin per Unit ÷ Unit Selling Price.

Break-even Analysis. 1. At the break-even point, the company will realize no income but will suffer no loss. 2. Knowledge of the break-even point is useful to management when it decides whether to introduce new product lines, change sales prices on established products, or enter new market areas. 3. The break-even point can be: a.

Computed from a mathematical equation: Break-even Point in Dollars = Total Variable Costs + Total Fixed Costs. The break-even point in units can be computed by using unit selling prices and unit variable costs.

TEACHING TIP

ILLUSTRATION 5-5 provides an example of break-even analysis calculated by the equation approach. The break-even point can be stated in terms of units or sales dollars. b.

Computed by using contribution margin: Break-even Point in Units = Fixed Costs ÷ Contribution Margin per Unit. Break-even Point in Dollars = Fixed Costs ÷ Contribution Margin Ratio.

TEACHING TIP

ILLUSTRATION 5-6 provides an example of computing the break-even point in dollars and units using the contribution margin approach.

5-12

Derived from a CVP graph at the intersection of the total-cost line and the total-sales line.

TEACHING TIP

ILLUSTRATION 5-7 provides an example of determining the break-even point in dollars and units by using a CVP graph. Point out that the equation approach (Illustration 5-5), the contribution margin technique (Illustration 5-6), and the CVP graph all provide the same answer and are alternative approaches to CVP analysis. 4. The income objective set by management is called target net income. To meet target net income, required sales must be determined. a.

Mathematical equation: Required Sales = Variable Costs + Fixed Costs + Target Net Income. Required sales may be expressed in either sales units or sales dollars.

Contribution margin technique: Fixed Costs + Target Net Income ÷ Contribution Margin Ratio = Required Sales in Dollars.

Graphic presentation: In the profit area of the CVP graph, the distance between the sales line and the total cost line at any point equals net income. A company can find required sales by analyzing the differences between the two lines until the desired net income is found.

SERVICE COMPANY INSIGHT FlightServe, a chartered aircraft company, decided to match up executives with charter flights in small “private jets”. The company noted that the average charter jet had eight seats, but it would break even at an average of 3.3 seats per flight. How did FlightServe determine that it would break even with 3.3 seats full per flight?

5-13

Answer: FlightServe determined its break-even point with the following formula: Fixed costs ÷ Contribution margin per seat occupied = Break-even point in seats.

TEACHING TIP

ILLUSTRATION 5-8 provides an example of calculating target net income using the mathematical equation approach, contribution margin technique, and the CVP graph (see Illustration 5-7 at 14,000 units of activity). 5. Margin of safety is the difference between actual or expected sales and sales at the break-even point. The margin of safety can be expressed in dollars or as a ratio. a.

Margin of Safety in Dollars = Actual (Expected) Sales – Break-even Sales.

Margin of Safety Ratio = Margin of Safety in Dollars ÷ Actual (Expected) Sales.

MANAGEMENT INSIGHT The promoter for the Rolling Stones’ tour guaranteed $1.2 million to the group. In addition, 20% of the gross goes to the stadium where the performance is staged and another $400,000 for other expenses such as ticket takers and advertising. What amount of sales dollars are required for the promoter to break even? Answer: Fixed costs = $1,200,000 + $400,000 = $1,600,000 Contribution margin ratio = 80%. Break-even sales = $1,600,000 ÷ .80 = $2,000,000.

5-14

20 MINUTE QUIZ Circle the correct answer. True/False 1.

The range over which a company is expected to operate is called the relevant range of the activity index. True

A mixed cost contains both selling and administrative cost elements. True

False

Margin of safety is the difference between actual sales and contribution margin. True

False

In a CVP income statement, contribution margin is reported in the body of the statement. True

10.

False

If the unit contribution margin is $300 and fixed costs are $240,000 then the break-even point in units would be 800 units. True

False

Sales mix is the percentage that each product represents of total sales. True

False

The contribution margin is the amount of revenue remaining after deducting fixed costs. True

False

If revenue = $80 and variable cost = 40% of revenue, then contribution margin = $48. True

False

If a salesperson incurs $2,000 of expenses in servicing two customers and $4,000 of expenses in servicing four customers, the fixed costs are $1,000. True

False

Variable costs are costs that remain the same per unit at every level of activity. True

False

5-15

False

Multiple Choice 1.

Which of the following is a false statement regarding assumptions of CVP analysis? a. Total fixed costs remain constant over the relevant range. b. Unit selling prices are constant. c. Changes in volume or level of activity increase variable costs per unit. d. All units produced are sold.

Mixed costs may be separated into fixed costs and variable costs by using a. the relevant range method. b. the high-low method. c. the contribution margin method. d. all of the above.

If the unit selling price is $500, the unit variable cost is $300, and the total monthly fixed costs are $300,000, then the contribution margin ratio is a. 30%. b. 40%. c. 50%. d. 60%.

If activity level increases 25% and a specific cost increases from $40,000 to $50,000, this cost would be classified as a a. variable cost. b. mixed cost. c. fixed cost. d. none of the above.

If total fixed costs are $900,000 and variable costs as a percentage of unit selling price are 40%, then the break-even point in dollars is a. $1,500,000. b. $360,000. c. $2,250,000. d. not determinable with the information given.

5-16

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False True False True

Multiple Choice 1. 2. 3. 4. 5.

c. b. b. a. a.

5-17

6. 7. 8. 9. 10.

False True True True False

ILLUSTRATION 5-1 COST CLASSIFICATIONS—VARIABLE AND FIXED COSTS

5-18

ILLUSTRATION 5-2 COST CLASSIFICATION—MIXED COSTS

5-19

ILLUSTRATION 5-3 BASIC COMPONENTS AND ASSUMPTIONS THAT UNDERLIE CVP ANALYSIS

5-20

ILLUSTRATION 5-4 CONTRIBUTION MARGIN

5-21

ILLUSTRATION 5-5 BREAK-EVEN ANALYSIS—EQUATION APPROACH

5-22

ILLUSTRATION 5-6 BREAK-EVEN ANALYSIS—CONTRIBUTION MARGIN TECHNIQUE

5-23

ILLUSTRATION 5-7 CVP GRAPH

5-24

ILLUSTRATION 5-8 TARGET NET INCOME

5-25

CHAPTER 6 Cost-Volume-Profit Analysis: Additional Issues ASSIGNMENT CLASSIFICATION TABLE Brief Exercises

A Problems

B Problems

1A, 2A

1B, 2B

1, 2, 3, 4, 5

1A, 2A, 4A, 6A

1B, 2B, 4B, 6B

6, 7, 8, 9, 10

11, 12, 13

12, 13, 14

14, 15, 16

5A, 6A

5B, 6B

16, 17, 18

17, 18, 19

7A, 8A

7B, 8B

Discuss net income effects under absorption costing versus variable costing.

19, 20, 21, 22

7A, 8A

7B, 8B

*8.

Discuss the merits of absorption versus variable costing for management decision making.

6-1

Study Objectives

Questions

Do It!

Describe the essential features of a cost-volume-profit income statement.

1, 2, 3, 4

1, 2, 3, 4, 5, 6

Apply basic CVP concepts.

2, 4, 5, 6

1, 2, 3, 4, 5, 6

Explain the term sales mix and its effects on break-even sales.

7, 8, 9

7, 8, 9, 10

Determine sales mix when a company has limited resources.

10, 11

11, 15

Understand how operating leverage affects profitability.

12, 13, 14, 15, 16

*6.

Explain the difference between absorption costing and variable costing.

*7.

Exercises

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

Description

Difficulty Level

Time Allotted (min.)

Compute break-even point under alternative courses of action.

Moderate

20–30

Compute break-even point and margin of safety ratio, and prepare a CVP income statement before and after changes in business environment.

Moderate

20–30

Determine sales mix with limited resources.

Simple

10–15

Determine break-even sales under alternative sales strategies and evaluate results.

Moderate

20–30

Compute degree of operating leverage and evaluate impact of operating leverage on financial results.

Moderate

20–30

Determine contribution margin, break-even point, target sales, and degree of operating leverage.

Moderate

20–30

*7A

Prepare income statements under absorption costing and variable costing for a company with beginning inventory, and reconcile differences.

Moderate

20–30

*8A

Prepare absorption and variable costing income statements and reconcile differences between absorption and variable costing income statements when sales level and production level change. Discuss relative usefulness of absorption costing versus variable costing.

Moderate

20–30

Compute break-even point under alternative courses of action.

Moderate

20–30

Compute break-even point and margin of safety ratio, and prepare a CVP income statement before and after changes in business environment.

Moderate

20–30

Determine sales mix with limited resources.

Simple

10–15

Determine break-even sales under alternative sales strategies and evaluate results.

Moderate

20–30

Compute degree of operating leverage and evaluate impact of operating leverage on financial results.

Moderate

20–30

Determine contribution margin, break-even point, target sales, and degree of operating leverage.

Moderate

20–30

*7B

Prepare income statements under absorption costing and variable costing for a company with beginning inventory, and reconcile differences.

Moderate

20–30

*8B

Moderate

20–30

6-2

6-3

Determine sales mix when a Q6-11 company has limited resources.

Understand how operating leverage affects profitability.

Explain the difference between absorption costing and variable costing.

Discuss net income effects under absorption costing versus variable costing.

Discuss the merits of absorption versus variable costing for management decision making.

*4.

*5.

**6.

*7.

**8.

Broadening Your Perspective

Explain the term sales mix and its effects on break-even sales.

*3.

Q6-12 Q6-13 Q6-15

Q6-7 Q6-8

Apply basic CVP concepts.

*2.

Q6-1 Q6-3

Describe the essential features of a cost-volume-profit income statement.

P6-8B

P6-7B P6-8B

P6-6A P6-5B P6-6B

Synthesis

Evaluation

Decision Making All About Managerial Analysis Across the You Ethics Case Organization

P6-8A P6-8B

Q6-19 P6-7A P6-8B P6-7A BE6-19 P6-8A P6-8A E6-18 P6-7B P6-7B

BE6-16 E6-18 P6-7B E6-18 BE6-17 E6-19 P6-8B E6-19 BE6-18 P6-7A P6-7A E6-17 P6-8A P6-8A

Q6-16 E6-14 P6-6A E6-14 BE6-12 E6-15 P6-5B E6-15 BE6-13 E6-16 E6-16 BE6-14 P6-5A P6-5A

P6-3A P6-3B P6-3A E6-11 P6-3B E6-12 E6-13

BE6-11 E6-11 BE6-15 E6-12 DI6-4 E6-13

P6-4B P6-6B

P6-4B

P6-6A BE6-1 P6-1B P6-1A P6-2B P6-2A P6-4B P6-4A P6-6B P6-6A P6-1B P6-2B E6-9 E6-6 E6-10 E6-7 P6-4A E6-8 P6-4B P6-4A

E6-2 E6-3 E6-4 E6-5 P6-1A P6-2A P6-4A

DI6-1 BE6-1 P6-1A P6-1A P6-2A P6-2A P6-1B P6-1B P6-2B P6-2B

Analysis

BE6-7 DI6-3 BE6-8 E6-6 BE6-9 E6-7 BE6-10 E6-8

BE6-2 BE6-3 BE6-4 BE6-5 BE6-6 DI6-2 E6-1

BE6-2 BE6-3 BE6-4 BE6-5 BE6-6

Application

Communication Real-World Focus Exploring the Web

Q6-18

Q6-19 Q6-22 Q6-20 Q6-21

Q6-17

Q6-14

Q6-10

Q6-8 Q6-9

Q6-2 Q6-4 Q6-5 Q6-6

Q6-2 Q6-4

Knowledge Comprehension

*1.

Study Objective

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. DESCRIBE THE ESSENTIAL FEATURES OF A COSTVOLUME-PROFIT INCOME STATEMENT. 2. APPLY BASIC CVP CONCEPTS. 3. EXPLAIN THE TERM SALES MIX AND ITS EFFECTS ON BREAK-EVEN SALES. 4. DETERMINE SALES MIX WHEN A COMPANY HAS LIMITED RESOURCES. 5. UNDERSTAND HOW OPERATING LEVERAGE AFFECTS PROFITABILITY. *6. EXPLAIN THE DIFFERENCE BETWEEN ABSORPTION COSTING AND VARIABLE COSTING. *7. DISCUSS NET INCOME EFFECTS UNDER ABSORPTION COSTING VERSUS VARIABLE COSTING. *8. DISCUSS THE MERITS OF ABSORPTION VERSUS VARIABLE COSTING FOR MANAGEMENT DECISION MAKING.

6-4

CHAPTER REVIEW Cost-Volume-Profit Income Statement 1.

(S.O. 1) The Cost-Volume-Profit (CVP) income statement classifies costs as variable or fixed and computes a contribution margin. Contribution margin is the amount of revenue remaining after deducting variable costs. It is often stated both as a total amount and on a per unit basis. Desossa Music Player Company CVP Income Statement For the Month Ended June 30, 2011 Sales Variable expenses Cost of goods sold Selling expenses Administrative expenses Total variable expenses Contribution margin Fixed expenses Cost of goods sold Selling expenses Administrative expenses Total fixed expenses Net income

Total $420,000

Per Unit $120

245,000 175,000

70 $ 50

$200,000 35,000 10,000

50,000 25,000 19,500 94,500 $ 80,500

Basic Computations 2.

(S.O. 2) Desossa Music Player’s CVP income statement shows that total contribution margin (sales minus variable expenses) is $175,000, and the company’s contribution margin per unit is $50. The contribution margin ratio (contribution margin divided by sales) is 41.67% ($50 ÷ $120). Desossa’s break-even point in units (using contribution margin per unit) or in dollars (using contribution margin ratio) are calculated as follows: Fixed cost $94,500

÷ ÷

Contribution margin per unit $50

= =

Break-even point in units 1,890 units

Fixed cost $94,500

÷ ÷

Contribution margin ratio .4167

= =

Break-even point in dollars $226,800

Assuming Desossa’s management has a target net income of $100,000, the required sales in units and dollars to achieve its target net income are calculated as follows: (Fixed cost + Target net income) ($94,500 + $100,000)

÷ Contribution margin per unit ÷ $50

(Fixed cost + Target net income) ÷ ($94,500 + $100,000) ÷

6-5

Contribution margin ratio .4167

= =

Required sales in units 3,890 units

= =

Required sales in dollars $466,762

Desossa’s margin of safety in dollars or as a ratio are calculated as follows: Actual (expected) sales $420,000

– –

Break-even sales $226,800

= Margin of safety in dollars = $193,200

Margin of safety in dollars ÷ Actual (expected) sales = $193,200 ÷ $420,000 =

Margin of safety ratio 46%

CVP and Changes in the Business Environment 5.

To better understand how CVP analysis works, let’s assume that shipping costs have increased significantly causing the unit variable cost to increase by 10%, what effect will this have on Desossa’s break-even point? Answer: A 10% increase in variable costs increases the per unit variable cost to $77 [$70 + ($70 X 10%)]. The new contribution margin per unit is therefore $43 ($120 – $77). Thus the new breakeven point in units is calculated as follows: Fixed cost $94,500

÷ ÷

Contribution margin per unit $43

= =

Break-even point in units 2,198 units

Sales Mix 6.

(S.O. 3) Sales mix is the relative percentage in which a company sells its multiple products. For example, if 60% of product A is sold for every 40% of product B, the sales mix of the product is 60% to 40%.

Break-even sales can be computed for a mix of two or more products by determining the weighted-average unit contribution margin of all the products. Assume that Seth Inc. sells tables and chairs in a ratio of four chairs for every one table. The sales mix in percentages is 20% (1/5) for tables and 80% (4/5) for chairs. The following is the per unit data for Seth Inc.: Unit Data Selling price Variable costs Contribution margin Sales mix-units Fixed costs = $192,000

Tables $100 60 $ 40 20%

Chairs $20 10 $10 80%

To compute break-even for Seth Inc., we use the weighted-average contribution margin as follows: Tables

Chairs

Sales Sales  Unit   Unit   Contribution X Mix  +  Contribution X Mix =      Margin Percentage  Margiin Percentage ($40

6-6

.20)

($10

.80)

Weighted – Average Unit Contribution Margin $16

Fixed Costs

$192,000

Weighted – Average Unit Contribution Margin $16 =

12,000 units

To break even, Seth must sell 2,400 (12,000 X 20%) tables and 9.600 (12,000 X 80%) chairs. 8.

At any level of units sold, net income will be greater if more high contribution margin units are sold than low contribution margin units. An analysis of these relationships generally shows that a shift from low-margin sales to high-margin sales may increase net income, even though there is a decline in total units sold.

The formula for computing the break-even point in dollars is fixed costs divided by the weightedaverage contribution margin ratio. To compute a company’s weighted-average contribution ratio, multiply each division’s contribution margin ratio by its percentage of total sales and then sum these amounts. Seth Inc’s contribution margin ratio for sales of tables is .40 ($40/$100) and for chairs is .50 ($10/$20). The weighted-average contribution margin ratio is calculated as follows: Tables

Chairs

 Contribution Sales Mix   Margin Ratio X Percentage (.40

.20)

Weighted - Average  Contribution Sales Mix  +  = X   MarginRatio Percentage Contribution Margin Ratiio +

(.50

.80)

.48

The break-even point in dollars is calculated as follows:

Fixed Costs

$192,000

Weighted - Average Contribution Margin Ratio o .48

= =

Break - even Point inDollars $400,000

Sales Mix with Limited Resources 10.

(S.O. 4) When a company has limited resources (e.g., floor space, raw materials, direct labor hours), management must decide which products to make and sell in order to maximize net income. Assume that Seth Inc. has limited machine capacity which is 2,600 hours per month. Relevant data consist of the following: Contribution margin per unit Machine hours required per unit

Tables $40 .8

Chairs $10 .16

The contribution margin per unit of limited resource is calculated as follows: Contribution margin per unit (a) Machine hours required (b) Contribution margin per unit of limited resource [(a) ÷ (b)]

6-7

Tables $40 .8

Chairs $10 .16

$50

$62.50

If Seth Inc. increases machine capacity hours by 400 hours per month, it would be better to use the hours to produce more chairs. Machine hours (a) Contribution margin per unit of limited resource (b) Contribution margin [(a) X (b)]

Tables 400

Chairs 400

$ 50 $20,000

$ 62.50 $25,000

Cost Structure and Operating Leverage 11. (S.O. 5) Cost structure refers to the relative proportion of fixed versus variable costs that a company incurs. In most cases, increased reliance on fixed costs increases a company’s risk. When sales are increasing, profits can increase at a high rate, but when sales decline, losses can also increase at a high rate. Companies can change their cost structure by using more sophisticated robotic equipment and reducing it later, or vice versa. The equipment would increase the fixed costs whereas labor increases variable costs. Variable Costing vs. Absorption Costing *12. (S.O. 6) There are two approaches to product costing. a. Under full or absorption costing all manufacturing costs are charged to the product. This is also the approach required under generally accepted accounting principles. b. Under variable costing only direct materials, direct labor, and variable manufacturing overhead costs are treated as product costs; fixed manufacturing overhead costs are recognized as period costs (expenses) when incurred. *13. The primary difference between variable and absorption costing is that under variable costing the fixed manufacturing overhead is charged as an expense in the current period. The result is that absorption costing will show a higher net income number than variable costing whenever units produced exceed units sold. The reason: the cost of the ending inventory is higher under absorption costing than under variable costing. *14. Assume Thibodeau Company manufactures candy bars and has the following information: Volume Information Candy bars in beginning inventory Candy bars produced Candy bars sold

2011 20,000 40,000 30,000

Financial Information Selling price per candy bar .................................................................................... Variable manufacturing cost per candy bar........................................................ Fixed manufacturing cost per year....................................................................... Fixed manufacturing cost per candy bar............................................................. Variable selling and administrative expense per candy bar............................ Fixed selling and administrative expense...........................................................

6-8

$1.00 $ .40 $12,000 $ .30 $ .05 $ 4,000

The absorption costing income statement and variable costing income statement are shown below: THIBODEAU COMPANY Income Statement For the Year Ended 2011 Absorption Costing Sales (30,000 X $1.00) ........................................................................... Cost of goods sold [30,000 X ($.40 + $.30)] ....................................... Gross profit ................................................................................................ Variable selling and administrative expenses (30,000 X $.05) ....... Fixed selling and administrative expenses ......................................... Net income ................................................................................................

$30,000 21,000 9,000 $1,500 4,000

5,500 $ 3,500

THIBODEAU COMPANY Income Statement For the Year Ended 2011 Variable Costing Sales (30,000 X $1.00) ........................................................................... Variable costs of good sold (30,000 X $.40)....................................... Variable selling and administrative expenses (30,000 X $.05) ....... Contribution margin ................................................................................. Fixed manufacturing overhead.............................................................. Fixed selling and administrative expense............................................ Net income ...............................................................................................

$30,000 $12,000 1,500 12,000 4,000

13,500 16,500 16,000 $ 500

*15. (S.O. 7) The effects of the alternative costing methods on income from operations are: Circumstance Units produced exceed units sold

Effects on Income From Operations Income under absorption costing is higher than under variable costing

Units produced are less than units sold

Income under absorption costing Is lower than under variable costing

Units produced equal units sold

Income will be equal under both approaches

*16. (S.O. 8) One of the problems with absorption costing is that management may be tempted to overproduce in a given period in order to increase net income. Therefore, to avoid this overproduction, variable costing is often used internally to evaluate management decision-making.

6-9

*17. The following are potential advantages of variable costing: a. Net income computed under variable costing is unaffected by changes in production levels. b. The use of variable costing is consistent with cost-volume-profit analysis. c. Net income computed under variable costing is closely tied to changes in sales levels giving a more realistic assessment of a company’s success or failure. d. The presentation of fixed and variable cost components on the face of the variable costing income statement makes it easier to identify these costs and understand their effect on the business.

6-10

LECTURE OUTLINE A.

Cost-Volume-Profit (CVP) Review. 1. Because CVP analysis is important for decision making, management often wants this information reported in a CVP income statement format for internal use. 2. The CVP income statement classifies costs and expenses as variable or fixed. It also reports contribution margin in the body of the statement.

TEACHING TIP

ILLUSTRATION 6-1 presents the basic format for a CVP income statement. Point out to students that this format is frequently used internally by management because it facilitates CVP analysis. 3. Contribution margin is the amount of revenue remaining after deducting variable costs, and is stated as both a total amount and on a per unit basis.

MANAGEMENT INSIGHT Analysts closely watch the “conversion rate” when analyzing an Internet business. This rate is computed by dividing the number of people who buy something at an Internet site by the number of people who visit the site. Conversion rates have an obvious effect on the break-even point. Studies show that conversion rates increase if the site has an easy-to-use interface, fast-performing screens, a convenient ordering process, and advertising that is clear. Besides increasing their conversion rates, what steps can online merchants use to lower their break-even points?

6-11

Answer:

In theory, one of the principal advantages of online retailers is that they can minimize their investment in “bricks and mortar” and thus minimize their fixed costs. Some online merchants never even handle the merchandise they sell. Instead, they simply provide a centralized location for customers to view merchandise and to place orders. The online retailer then forwards the order to the supplier, and the supplier ships it directly to the customer. However, some online merchants who originally planned on employing this model have since found it necessary to build their own warehouses and distribution centers to ensure timely and dependable product delivery. This increases their fixed costs, and consequently increases their break-even point.

Sales Mix 1. When a company sells many products, it is important that it understands its sales mix. 2. Sales mix is the relative proportion in which each product is sold when a company sells more than one product. It is important to managers because different products often have substantially different contribution margins and break-even points. 3. Break-even sales in units can be computed for a mix of two or more products by determining the weighted-average unit contribution margin of all the products.

6-12

The break-even point in units is computed by dividing fixed costs by the weighted-average unit contribution margin.

The weighted-average unit contribution margin is computed by adding the products of Product A’s unit contribution margin X its percentage of sales and Product B’s unit contribution margin X its percentage of sales.

TEACHING TIP

ILLUSTRATION 6-2 provides formulas for computing the break-even point in units and dollars, and for the weighted-average unit contribution margin and contribution margin ratio. c.

At any level of units sold, net income will be greater if higher contribution margin units are sold than lower contribution margin units.

A shift from low-margin sales to high-margin sales may increase net income even though there may be a decline in total units sold. Conversely, a shift from high- to low-margin sales may result in a decrease in net income, even though there may be an increase in total units sold.

4. The calculation of the break-even point in units works well if a company has only a small number of products. In a company with many products, break-even sales in dollars is calculated using the weighted-average contribution margin ratio.

6-13

The break-even point in dollars is computed by dividing fixed costs by the weighted-average contribution margin ratio.

The weighted-average contribution margin ratio is computed by adding the products of Division A’s contribution margin ratio X its sales mix percentage and Division B’s contribution margin ratio X its sales mix percentage.

If a higher percentage of a company’s sales come from the division with a higher contribution margin ratio, the weighted-average contribution margin ratio would increase, which would lower the break-even point in dollars.

SERVICE COMPANY INSIGHT Zoom kitchen, a chain of four restaurants in the Chicago area, is known for serving sizable portions of meat and potatoes. During the past four years salad sales have increased from 18% of its sales mix to 40%. This has pleased company management because the contribution margin on salads is much higher than on meat. Why do you suppose restaurants are so eager to sell beverages and desserts? Answer:

There is a reason why servers at restaurants keep your beverage glass full, and why they wave the dessert tray in your face at the end of the meal. Both of these items traditionally have very high contribution margins and require very minimal investments in fixed costs. As a consequence they are a great mechanism by which a company can hit its break-even point.

Limited Resources. 1. When a company has limited resources (i.e., machine hours), it is necessary to find the contribution margin per unit of limited resource. 2. Contribution margin per unit of limited resource is computed by dividing the contribution margin/unit of each product by the number of units of limited resource required for each product. 3. The contribution margin per unit of limited resource is then multiplied by the units of limited resource to determine total contribution margin and which product maximizes net income. 4. As discussed in Chapter 1, evaluating constraints is called the theory of constraints. According to this theory, companies must continually identify their constraints and find ways to reduce or eliminate them.

6-14

MANAGEMENT INSIGHT When fragrance sales recently went flat, retailers turned up the heat on fragrance manufacturers. They reduced the amount of floor space devoted to fragrances, and chose the fragrance with the highest contribution margin per square foot for a given period of time. What is the limited resource for a retailer, and what implication does this have for sales mix? Answer:

For retailers, the limited resource is not just shelf space, but shelf space per day. At first you might think that a product that is small and has a high contribution margin would be the product of choice. But you also have to factor in the amount of time that a product sits on the shelf. For example, suppose the following; Product A and B are the same size; product A has twice the contribution margin as product B, but A sits on the shelf five times as long as product B. In this case, once time spent on the shelf is taken into account, B’s superior turnover more than makes up for its lower contribution margin.

Cost Structure and Operating Leverage. 1. Cost structure is the relative proportion of fixed versus variable costs that a company incurs. 2. Cost structure can have a significant effect on profitability. 3. Operating leverage is the degree to which a company’s net income reacts to a change in sales. 4. Operating leverage is determined by a company’s relative use of fixed versus variable costs. a.

6-15

Companies with high fixed costs relative to variable costs have high operating leverage.

When a company’s sales revenue is increasing, high operating leverage is good because it means that profits will increase rapidly. However, when sales are declining, too much operating leverage can have devastating consequences.

5. The degree of operating leverage provides a measure of a company’s earnings volatility and can be used to compare companies. Degree of operating leverage is computed by dividing total contribution margin by net income.

TEACHING TIP

ILLUSTRATION 6-3 provides the formula for computing the degree of operating leverage. Emphasize that companies with high fixed costs have high operating leverage. 6. A cost structure that relies on higher fixed costs, and consequently has higher operating leverage, is not necessarily bad. Operating leverage can add considerably to a company’s profitability when used carefully.

SERVICE COMPANY INSIGHT Cost structures vary considerably across industries, but they also vary considerably across companies within industries. The airline industry has two types of companies–low-cost low-fare airlines and the high-cost high-fare airlines. The high-cost airlines use the hub-and-spoke approach which results in high-fixed costs and high operating leverage. The high-cost airlines also must pay very large retirement payments since they have been in business so long. What impact do these payments have on the break-even equation?

6-16

Answer:

The ongoing costs of retirement and health-care packages for retired employees represent a type of fixed cost. These so-called “legacy” costs can dramatically change the break-even equation. To cover these costs on old-line airline must fly many more passengers than a newer airline.

*E. Absorption Costing Versus Variable Costing. 1. Under absorption costing, all manufacturing costs are charged to, or absorbed by, the product. This approach is used for external reporting under generally accepted accounting principles. 2. Under variable costing, only variable manufacturing costs (direct materials, direct labor, and variable manufacturing overhead costs) are considered product costs. 3. Companies recognize fixed manufacturing overhead costs as period costs (expenses) when incurred under variable costing. 4. Selling and administrative expenses are period costs under both absorption and variable costing. 5. Companies use the cost-volume-profit format in preparing a variable costing income statement. 6. The one primary difference between variable and absorption costing is that under variable costing companies charge fixed manufacturing overhead as an expense in the current period, instead of being deferred to a future period through the ending inventory as under absorption costing. 7. Absorption costing will show a higher net income than variable costing whenever units produced exceed units sold since fixed overhead costs are deferred to a future period as part of the ending inventory cost.

6-17

8. When units produced and sold are the same, net income will be equal under the two costing approaches because there is no increase in ending inventory, and therefore no deferral of fixed overhead costs to future periods through the ending inventory. 9. When units produced are less than units sold, net income under absorption costing is less than net income under variable costing because fixed manufacturing overhead cost in beginning inventory is charged to the current year income under absorption costing.

TEACHING TIP

ILLUSTRATION 6-4 shows the relationship between production and sales and its effect on net income under absorption costing and variable costing. *F. Decision-Making Concerns. 1. For external reporting purposes, companies must report financial information using GAAP, which requires that absorption costing be used for the costing of inventory. 2. Some companies have recognized that net income calculated using GAAP does not highlight differences between variable and fixed costs and may lead to poor business decisions. Therefore, some companies use variable costing for internal reporting purposes. 3. When production exceeds sales, absorption costing reports a higher net income than variable costing because some fixed manufacturing costs are not expensed in the current period, but are deferred to future periods as part of inventory. 4. Management may be tempted to overproduce in a given period in order to increase net income, but this decision may not be in the company’s best interest since the buildup of inventories will lead to additional costs to the company in the long run.

6-18 .

5. Variable costing avoids the temptation to overproduce because net income under this approach is not affected by changes in production levels. *G. Potential Advantages of Variable Costing. 1. Variable costing has several potential advantages relative to absorption costing: a.

Net income computed under variable costing is unaffected by changes in production levels.

The use of variable costing is consistent with cost-volume-profit analysis.

Net income computed under variable costing is closely tied to changes in sales, and provides a more realistic assessment of the company’s success or failure.

The presentation of fixed and variable cost components on the variable costing income statement makes it easier to identify these costs and understand their effect on the company’s results.

TEACHING TIP

ILLUSTRATION 6-5 provides a listing of the potential advantages of variable costing.

6-19

20 MINUTE QUIZ Circle the correct answer. True/False 1. The CVP income statement classifies costs as variable or fixed and computes a contribution margin. True

False

2. The margin of safety indicates how much sales must increase before a company will be operating at a profit. True

False

3. Sales mix is the relative percentage in which each product is sold when a company sells more than one product. True

False

4. The break-even point in dollars is computed by dividing fixed costs by the weightedaverage contribution margin. True

False

5. When a company has limited resources, management must decide which product to make and sell in order to maximize contribution margin ratio. True

False

6. Contribution margin per unit of limited resource is obtained by dividing the contribution margin per unit of each product by the number of units of the limited resource required for each product. True

False

7. Operating leverage refers to the extent to which a company’s net income reacts to a given change in production. True

False

8. Companies that have higher fixed costs relative to variable costs have higher operating leverage. True

False

*9. Under variable costing, all variable costs are considered product costs. True

False

*10. Fixed manufacturing costs are a product cost under absorption costing but are a period cost under variable costing. True 6-20

False

Multiple Choice 1.

For a company selling multiple products, the break-even point in dollars is computed by dividing fixed costs by the a. contribution margin per unit. b. contribution margin ratio. c. weighted-average contribution margin per unit. d. weighted-average contribution margin ratio.

In order to maximize net income a company should produce and sell the product with the highest. a. contribution margin ratio. b. contribution margin per unit. c. contribution margin per unit of limited resource. d. weighted-average unit contribution margin.

Operating leverage refers to the extent to which a company’s net income reacts to a given change in a. fixed costs. b. production. c. sales. d. variable costs

*4.

Under variable costing, all of the following are considered product costs except a. direct materials. b. direct labor. c. variable manufacturing overhead. d. variable selling and administrative expenses.

*5.

All of the following are potential advantages of variable costing except that a. its use is consistent with cost-volume-profit and incremental analysis. b. variable costing net income is affected by changes in production levels. c. variable costing net income is closely tied to changes in sales levels. d. the presentation of fixed and variable cost components makes it easier to identify these costs.

6-21

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False True False False

Multiple Choice 1. 2. 3. *4. *5.

d. c. c. d. b.

6-22

6. 7. 8. *9. *10.

True False True False True

ILLUSTRATION 6-1 CVP INCOME STATEMENT

6-23

ILLUSTRATION 6-2 BREAK-EVEN POINT IN UNITS AND DOLLARS

6-24

ILLUSTRATION 6-3 DEGREE OF OPERATING LEVERAGE

6-25

ILLUSTRATION 6-4 EFFECT OF PRODUCTION AND SALES ON ABSORPTION AND VARIABLE INCOME

6-26

ILLUSTRATION 6-5 POTENTIAL VARIABLE COSTING ADVANTAGES

6-27

CHAPTER 7 Incremental Analysis ASSIGNMENT CLASSIFICATION TABLE Study Objectives

Questions

Brief Exercises

A Problems

B Problems

Identify the steps in management’s decisionmaking process.

1, 2

Describe the concept of incremental analysis.

3, 4

1, 17

Identify the relevant costs in accepting an order at a special price.

2, 3, 4, 18

Identify the relevant costs in a make-or-buy decision.

6, 7

5, 6, 7, 8, 18

Identify the relevant costs in determining whether to sell or process materials further.

8, 9, 10

5, 6

9, 10, 11, 12, 18

Identify the relevant costs to be considered in retaining or replacing equipment.

13, 14, 18

Identify the relevant costs in deciding whether to eliminate an unprofitable segment.

15, 16, 17, 18

7-1

Do It!

Exercises

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

7-2

Description

Difficulty Level

Time Allotted (min.)

Use incremental analysis for special order and identify nonfinancial factors in the decision.

Simple

20–30

Use incremental analysis related to make or buy, consider opportunity cost, and identify nonfinancial factors.

Moderate

30–40

Determine if product should be sold or processed further.

Moderate

30–40

Compute gain or loss, and determine if equipment should be replaced.

Moderate

30–40

Prepare incremental analysis concerning elimination of divisions.

Moderate

30–40

Use incremental analysis for special order and identify nonfinancial factors in the decision.

Simple

20–30

Use incremental analysis related to make or buy, consider opportunity cost, and identify nonfinancial factors.

Moderate

30–40

Determine if product should be sold or processed further.

Moderate

30–40

Compute gain or loss, and determine if equipment should be replaced.

Moderate

30–40

Prepare incremental analysis concerning elimination of divisions.

Moderate

20–30

7-3

Describe the concept of incremental analysis.

Identify the relevant costs in accepting an order at a special price.

Identify the relevant costs in a make-or-buy decision.

Identify the relevant costs in determining whether to sell or process materials further.

Identify the relevant costs to be considered in retaining or replacing equipment.

Identify the relevant costs in deciding whether to eliminate an unprofitable segment.

*2.

*3.

*4.

*5.

*6.

*7.

Broadening Your Perspective

Identify the steps in management’s decision-making process.

*1.

Study Objective

Q7-8 Q7-9 Q7-10

BE7-1

Real-World Focus Decision Making All About Across the You Exploring the Web Decision Making Organization Activity Across the Organization

BE7-8 DI7-4

Q7-12

E7-18 P7-5A P7-5B

P7-4A P7-4B

Decision Making Across the Organization Managerial Analysis Communication Ethics Case

E7-15 E7-16 E7-17

E7-13 E7-14 E7-18

E7-18 P7-3A P7-3B E7-9 E7-10 E7-11 E7-12 BE7-5 BE7-6 DI7-3

E7-18 P7-1A P7-1B E7-18 P7-2A P7-2B

E7-2 E7-3 E7-4

E7-17

Evaluation

E7-5 E7-6 E7-7 E7-8

Synthesis

BE7-4 DI7-2

BE7-3 DI7-1

BE7-2

Analysis

BE7-7

E7-1

Application

Q7-11

Q7-6 Q7-7

Q7-5

Q7-3 Q7-4

Q7-1 Q7-2

Knowledge Comprehension

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. IDENTIFY THE STEPS IN MANAGEMENT’S DECISIONMAKING PROCESS. 2. DESCRIBE THE CONCEPT OF INCREMENTAL ANALYSIS. 3. IDENTIFY THE RELEVANT COSTS IN ACCEPTING AN ORDER AT A SPECIAL PRICE. 4. IDENTIFY THE RELEVANT COSTS IN A MAKE OR BUY DECISION. 5. IDENTIFY THE RELEVANT COSTS IN DETERMINING WHETHER TO SELL OR PROCESS MATERIALS FURTHER. 6. IDENTIFY THE RELEVANT COSTS TO BE CONSIDERED IN RETAINING OR REPLACING EQUIPMENT. 7. IDENTIFY THE RELEVANT COSTS IN DECIDING WHETHER TO ELIMINATE AN UNPROFITABLE SEGMENT.

7-4

CHAPTER REVIEW

Incremental Analysis 1.

(S.O. 1) Management’s decision-making process frequently involves the following steps: a. Identify the problem and assign responsibility. b. Determine and evaluate possible courses of action. c. Make a decision. d. Review the results of the decision. Accounting’s contribution to the decision-making process occurs primarily in steps (b) and (d).

(S.O. 2) Business decisions involve a choice among alternative courses of action. In making such decisions, management ordinarily considers both financial and nonfinancial information. The process used to identify the financial data that change under alternative courses of action is called incremental analysis. a. Incremental analysis involves not only identifying relevant revenues and costs, but also determining the probable effects of the decision on future earnings. b. Data for incremental analysis involves estimates and uncertainty. c. Gathering data may involve market analysts, engineers, and accountants.

In incremental analysis, both costs and revenues may change. However, in some cases (1) variable costs may not change under the alternative courses of action, and (2) fixed costs may change.

Accept an Order at a Special Price 4.

(S.O. 3) An order at a special price should be accepted when the incremental revenue from the order exceeds the incremental costs. a. It is assumed that sales in other markets will not be affected by the special order. b. If the units can be produced within existing plant capacity, generally only variable costs will be affected.

Make or Buy 5.

(S.O. 4) In a make or buy decision, management must determine the costs which are different under the two alternatives. If there is an opportunity to use the productive capacity for another purpose, opportunity cost should be considered. Opportunity cost is the potential benefit that may be obtained by following an alternative course of action. This cost is an additional cost of making the component.

Sell or Process Further 6.

(S.O. 5) The basic decision rule in a sell or process further decision is: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs. Incremental revenue is the increase in sales which results from processing the product further.

7-5

Retain or Replace Equipment 7.

(S.O. 6) In a decision to retain or replace equipment, management compares the costs which are affected by the two alternatives. Generally, these are variable manufacturing costs and the cost of the new equipment. a. The book value of the old machine is a sunk cost which does not affect the decision. A sunk cost is a cost that cannot be changed by any present or future decision. b. However, any trade-in allowance or cash disposal value of the existing asset must be considered.

Eliminate an Unprofitable Segment 8.

(S.O. 7) In deciding whether to eliminate an unprofitable segment, management should choose the alternative which results in the highest net income. Often fixed costs allocated to the unprofitable segment must be absorbed by the other segments. It is possible, therefore, for net income to decrease when what appears to be an unprofitable segment is eliminated.

Many of the decisions involving incremental analysis also have important qualitative features.

7-6

LECTURE OUTLINE A.

Management’s Decision-Making Process.

TEACHING TIP

Use ILLUSTRATION 7-1 to discuss the management decision-making process. Emphasize that accountants are mainly involved in developing quantitative data that is relevant for alternative courses of action and preparing reports that review the results of decisions. 1. The steps are: a.

Identify the problem and assign responsibility.

Determine and evaluate possible courses of action.

Make a decision.

Review the results of the decision.

2. Accounting’s contribution to the decision-making process occurs primarily in steps (b) and (d)—evaluating possible courses of action, and reviewing results.

Incremental Analysis. 1. The process used to identify the financial data that change under alternative courses of action is called incremental analysis. TEACHING TIP

ILLUSTRATION 7-2 presents a list of the most common types of decision situations that utilize incremental analysis.

7-7

2. These data are relevant to the decision because they will vary in the future among the possible alternatives. 3. Incremental analysis sometimes involves changes that might seem contrary to your intuition. For example, sometimes: a.

Variable costs do not change under the alternative courses of action.

Fixed costs do change.

SERVICE COMPANY INSIGHT American Express decided to offer some of its customers $300 if they would give back their credit card. Customers could receive the $300 even if they hadn’t paid off their balance yet, as long as they agreed to give up their credit card. What are the relevant costs and other information that American Express would need to know in order to determine to whom to make this offer? Answer:

Clearly American Express would make this offer to those customers that are most likely to default on their bills. The most important relevant cost would be the “expected loss” that an at risk customer posed. If a customer has a high probability of defaulting, and if the expected loss exceeds the $300 cost, then American Express can probably save money by paying that customer to quit using their card so that the customer doesn’t ring up an even bigger bill.

4. Accept an order at a special price.

TEACHING TIP

ILLUSTRATION 7-3 provides an in-class example of a decision situation involving an order at a special price. Emphasize that if fixed costs do not change, the special price must be greater than the unit variable cost of the product in order for the proposal to be profitable.

7-8

The relevant information is the difference between the variable manufacturing costs to produce the special order and expected revenues.

If other sales are affected, then the company would have to consider the lost sales in making the decision.

If the company is operating at full capacity, it is likely that the special order would be rejected.

5. Make or buy.

TEACHING TIP

ILLUSTRATION 7-4 provides an in-class example of a make or buy decision. Point out that if resources have alternative uses, there is an opportunity cost that must be included in the analysis. a.

In a make or buy decision, the relevant costs are: (1) The variable manufacturing costs that will be saved. (2) The fixed manufacturing costs that can be eliminated. (3) The purchase price. (4) Opportunity costs: The potential benefit that may be obtained by following an alternative course of action.

INTERNATIONAL INSIGHT Manufacturers in various industries have engaged in overseas off-shoring (outsourcing) in recent years. Incremental analysis, comparing the relative labor costs in various nations, often leads to outsourcing production to countries like China. What are the disadvantages of outsourcing to a foreign country?

. 7-9

Answer:

Possible disadvantages of outsourcing are that the supplier loses control over the quality of the product, as well as the timing of production. Also, the company exposes itself to price changes caused by changes in the value of the foreign currency. In addition, shipping large, heavy products such as tires is costly, and disruptions in shipping (due to strikes, weather, etc.) can cause delays in final assembly of vehicles. As a result of the outsourcing, the company will have to reassign, or even lay off, many skilled workers. Not only is this very disruptive to the lives of those employees, it also hurts morale of the remaining employees. As more U.S. employers begin to use robotic automation in their facilities, they are able to reduce the amount of labor required, and thus are beginning to be able to compete more favorably with foreign suppliers.

6. Sell or process further.

7-10

Many manufacturers have the option of selling products at a given point in the production cycle or continuing to process with the expectation of selling them at a later point at a higher price.

The basic decision rule is: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs.

In many industries, a number of end-products are produced from a single raw material and a common production process. These multiple end-products are referred to as joint products.

All costs incurred prior to the point at which the two products are separately identifiable (the split-off point) are called joint costs.

Joint product costs must be allocated to individual products, frequently done based on the relative sales value of the joint products.

The allocation of joint product costs is important for the determination of product cost but is irrelevant for any sell-or-process-further decisions since these joint costs are sunk costs. They have already been incurred and cannot be avoided by any subsequent decision.

7. Retain or replace equipment. a.

Management often has to decide whether to continue using an asset or replace it.

The relevant items to be considered are: (1) The effects on variable costs. (2) The cost of the new equipment.

Any disposal value of the existing asset must also be considered.

The book value of the old asset does not affect the decision. Book value is a sunk cost, which is a cost that cannot be changed by any present or future decision.

8. Eliminate an unprofitable segment. a.

In deciding whether to eliminate an unprofitable segment, the relevant information is the contribution margin produced by the segment and the disposition of the segment’s fixed expenses.

In deciding on the future status of an unprofitable segment, management should consider the effect of elimination on related segments.

Management should also consider the effect of eliminating the segment on employees who may have to be discharged or retrained.

MANAGEMENT INSIGHT Buck Knives, a company with 260 employees and a 170,000-square foot facility, moved from Southern California to Idaho to save itself from financial ruin. Moving the factory would cost about $8.5 million, plus $4 million to move key employees. The company received only $7.5 million (instead of an estimated $11 million) for its California property, only 58 of 75 key employees were willing to move, the new plant price increased by $1.5 million, and wages surged in Idaho due to low unemployment. .

7-11

What were some of the factors that complicated the company’s decision to move? How should the company have incorporated such factors into its incremental analysis? Answer:

7-12

The company received only $7.5 million for its California property, only 58 of 75 key employees were wiling to move, construction was delayed by a year which caused the new plant to increase in price by $1.5 million, and wages surged in Idaho due to low unemployment. In performing incremental analysis of the decision to move, a company should perform sensitivity analysis. This would include evaluating the impact on the decision if all costs were, for example, 10% higher than expected or if cost savings were 10% lower than expected.

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Determining and evaluating possible courses of action is a step in management’s decision-making process. True

In incremental analysis fixed costs may not change under alternative courses of action, while variable costs may change. True

False

Any trade-in allowance or cash disposal value of the old asset is relevant in a retain or replace equipment decision. True

False

Joint product costs are relevant for any sell-or-process further decisions. True

10.

False

In deciding on the future status of an unprofitable segment, management should consider the effect of elimination on related product lines. True

False

Opportunity costs are costs that have already been incurred and will not be avoided by any future decision. True

False

Fixed manufacturing costs will never be relevant in a make or buy decision. True

False

Book value is a sunk cost and is therefore relevant in incremental analysis of retain or replace equipment. True

False

The basic decision rule to sell or process further is: process further as long as the incremental revenue from such processing exceeds the incremental processing costs. True

False

The relevant information to consider in accepting an order at a special price are the additional manufacturing costs incurred and expected revenues. True

False

7-13

False

Multiple Choice 1.

Which of the following is not a step in management’s decision-making process? a. Identify the problem and assign responsibility. b. Determine and evaluate possible courses of action. c. Make a decision. d. Prepare financial statements.

If revenues are $315,000 under alternative A and $324,000 under alternative B, and costs are $285,000 for A and $306,000 for B, then using the basic approach in incremental analysis, incremental revenues, costs, and net income, in comparing B to A are respectively a. $9,000, $(21,000), $(12,000). b. $(9,000), $21,000, $12,000. c. $9,000, $21,000, $12,000. d. $(9,000), $(21,000), $(12,000).

The cost to manufacture an unfinished unit is $120 ($90 variable, $30 fixed). The selling price per unit is $150. The company has unused productive capacity and has determined that units could be finished and sold for $195 with an increase in variable costs of 40%. What is the additional net income per unit to be gained by finishing the unit? a. $9. b. $30. c. $45. d. $36.

The potential benefit that may be obtained from following an alternative course of action is called a. opportunity benefit. b. opportunity cost. c. relevant cost. d. sunk cost.

In a make or buy decision, the relevant costs include each of the following except the a. variable manufacturing costs that will be saved. b. fixed manufacturing costs that can be eliminated. c. opportunity costs. d. each of the above is a relevant cost.

7-14

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True True True False

Multiple Choice 1. 2. 3. 4. 5.

d. a. a. b. d.

7-15

6. 7. 8. 9. 10.

False False True False True

ILLUSTRATION 7-1 MANAGEMENT’S DECISION-MAKING PROCESS

7-16

ILLUSTRATION 7-2 TYPES OF INCREMENTAL ANALYSIS

7-17

ILLUSTRATION 7-3 INCREMENTAL ANALYSIS—SPECIAL ORDER PROPOSAL

7-18

ILLUSTRATION 7-4 INCREMENTAL ANALYSIS—MAKE OR BUY

7-19

ILLUSTRATION 7-4 (Continued) INCREMENTAL ANALYSIS—MAKE OR BUY

7-20

CHAPTER 8 Pricing ASSIGNMENT CLASSIFICATION TABLE Study Objectives

Questions

Brief Exercises

Do It!

Exercises

1. Compute a target cost when the market determines a product price.

1, 2

1, 2, 3

2. Compute a target selling price using cost-plus pricing.

3, 4, 5, 6, 7, 8

2, 3, 4, 5

3. Use time-and-material pricing to determine the cost of services provided.

9, 10

4. Determine a transfer price using the negotiated, costbased, and market-based approaches.

11, 12, 13, 14, 15, 16, 17

7, 8, 9

5. Explain issues involved in transferring goods between divisions in different countries.

*6. Determine prices using absorption-cost pricing and variable-cost pricing.

19, 20

10, 11

A Problems

B Problems

3, 4, 5, 6, 7

1A, 2A

1B, 2B

8, 9, 10

11, 12, 13, 14, 15, 16, 17

4A, 5A, 6A

4B, 5B, 6B

18, 19, 20

7A, 8A

7B, 8B

*Note: All asterisked Questions, Exercises, and Problems relate to material contained in the appendix to the chapter.

8-1

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

Description

Difficulty Level

Time Allotted (min.)

Use cost-plus pricing to determine various amounts.

Simple

20–30

Use cost-plus pricing to determine various amounts.

Simple

20–30

Use time-and-material pricing to determine bill.

Simple

20–30

Determine minimum transfer price with no excess capacity and with excess capacity.

Moderate

20–30

Determine minimum transfer price with no excess capacity.

Moderate

20–30

Determine minimum transfer price under different situations.

Moderate

20–30

*7A*

Compute the target price using absorption-cost pricing and variable-cost pricing.

Moderate

30–40

*8A*

Compute various amounts using absorption-cost pricing and variable-cost pricing.

Complex

40–50

Use cost-plus pricing to determine various amounts.

Simple

20–30

Use cost-plus pricing to determine various amounts.

Simple

20–30

Use time-and-material pricing to determine bill.

Simple

20–30

Determine minimum transfer price with no excess capacity and with excess capacity.

Moderate

20–30

Determine minimum transfer price with no excess capacity.

Moderate

20–30

Determine minimum transfer price under different situations.

Moderate

20–30

*7B*

Compute the target price using absorption-cost pricing and variable-cost pricing.

Moderate

30–40

*8B*

Compute various amounts using absorption-cost pricing and variable-cost pricing.

Complex

40–50

8-2

8-3 Q8-10

*3. Use time-and-material pricing to determine the cost of services provided.

Broadening Your Perspective

Q8-19

Q8-20 BE8-10 BE8-11 E8-18 E8-19

BE8-6 DI8-3 E8-8 E8-9

Q8-4 Q8-7 Q8-8 BE8-2 BE8-3 BE8-4 BE8-5 DI8-2 E8-3

E8-20 P8-7A P8-8A P8-7B P8-8B

E8-10 P8-3A P8-3B

E8-4 E8-5 E8-6 E8-7 P8-1A P8-2A P8-1B P8-2B

E8-3

Application DI8-1 E8-1 E8-2

Exploring the Web Real-World Ethics Case Focus

Q8-18

*5. Explain issues involved in transferring goods between divisions in different countries.

*6. Determine prices using absorption-cost pricing and variable-cost pricing.

Q8-11 Q8-12 Q8-14 Q8-17

*4. Determine a transfer price using Q8-13 the negotiated, cost-based, and Q8-15 market-based approaches. Q8-16

Q8-9

Q8-6

Q8-3 Q8-5

*2. Compute a target selling price using cost-plus pricing.

Comprehension Q8-2 BE8-1

Knowledge

*1. Compute a target cost when the Q8-1 market determines a product price.

Study Objective

E8-16 E8-17 P8-4A P8-5A P8-6A P8-4B P8-5B P8-6B

Synthesis

Evaluation

Manag. Analysis Decision Making Decision Making Communication Across the Across the Ethics Case Organization Organization Manag. Analysis Real-World Focus Real-World Communication Focus Ethics Case

BE8-7 BE8-8 BE8-9 DI8-4 E8-11 E8-12 E8-13 E8-14 E8-15

Analysis

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. COMPUTE A TARGET COST WHEN THE MARKET DETERMINES A PRODUCT PRICE. 2. COMPUTE A TARGET SELLING PRICE USING COSTPLUS PRICING. 3. USE TIME-AND-MATERIAL PRICING TO DETERMINE THE COST OF SERVICES PROVIDED. 4. DETERMINE A TRANSFER PRICE USING THE NEGOTIATED, COST-BASED, AND MARKET-BASED APPROACHES. 5. EXPLAIN ISSUES INVOLVED IN TRANSFERRING GOODS BETWEEN DIVISIONS IN DIFFERENT COUNTRIES. *6. DETERMINE PRICES USING ABSORPTION-COST PRICING AND VARIABLE-COST PRICING.

8-4

CHAPTER REVIEW External Sales 1.

(S.O. 1) Some of the many factors that can affect pricing decisions include: a. Pricing Objectives • Gain market share • Achieve a target rate of return b. Environment • Political reaction to prices • Patent or copyright protection c. Demand • Price sensitivity • Demographics d. Cost Considerations • Fixed and variable costs • Short-run or long-run

In most cases, a company does not set prices. Instead the price is set by the competitive market (laws of supply and demand). These companies are called price takers and price taking often happens when the product is not easily differentiated from competing products, such as farm products (corn or wheat) or minerals (coal or sand).

Companies can set prices (1) where the product is specially made for a customer, (2) when there are few or no other producers capable of manufacturing a similar item, or (3) when a company can effectively differentiate its product or service from others.

Pricing in a Competitive Market 4.

Once a company has identified its segment of the market, it does market research to determine the target price. The target price is the price that the company believes would place it in the optimal position for its target audience. Once the company has determined the target price, it can determine its target cost by setting a desired profit. The difference between the target price and the desired profit is the target cost of the product. The target cost includes all product and period costs necessary to make and market the product.

Cost-Plus Pricing 5.

(S.O. 2) When the price is set by the company, price is commonly a function of the product or service. Cost-plus pricing involves establishing a cost base and adding to this cost base a markup to determine a target selling price. The size of the markup (the “plus”) depends on the desired return on investment (ROI) for the product line, product, or service. The cost-plus pricing formula is expressed as follows: Target Selling Price = Cost + (Markup Percentage X Cost)

The cost-plus approach has a major advantage: it is simple to compute. However, the cost model does not give consideration to the demand side—that is, will the customers pay the price. In addition, sales volume plays a large role in determining per unit costs. The lower the sales volume, the higher the price a company must charge to meet its desired ROI (because fixed costs are spread over fewer units and therefore the fixed costs per unit increases).

8-5

Instead of using both fixed and variable costs to set prices, some companies simply add a markup to their variable costs. Using variable costing as the basis avoids the problem of using poor cost information related to fixed cost per unit computations.

Time-and-Material Pricing 8.

(S.O. 3) Under time-and-material pricing, the company sets two pricing rates—one for the labor used on a job and another for the material. The labor rate includes direct labor time and other employee costs. The material charge is based on the cost of direct parts and materials used and a material loading charge for related overhead costs.

Using time-and-material pricing involves three steps: (1) calculate the per-hour labor charge, (2) calculate the charge for obtaining and holding materials, and (3) calculate the charges for a particular job. The per-hour labor charge typically includes the direct labor cost of an employee, selling, administrative, and similar overhead costs, and an allowance for a desired profit of employee time. The charge for materials typically includes the invoice price of any materials used on the job plus a material loading charge. The charges for any particular job are then a result of (1) the labor charge, (2) the direct charge for materials, and (3) the material loading charge.

10.

To illustrate a time-and-material pricing situation, assume the following data for Rancho Park Golf Club Repair Service: Rancho Park Golf Club Repair Service Budgeted Costs for the Year 2011

Repair service employee wages Administrative assistant salary Other overhead (supplies, depreciation, advertising, utilities) Total budgeted costs

Time Charges $26,000 1,950

Material Charges $ 5,000 1,000

4,940 $32,890

3,000 $ 9,000

Step 1: During 2011 Rancho Park budgets 1,300 of hours for repair time, and it desires a profit margin of $6 per hour of labor. Computation of the hourly charges are as follows: Per Hour Hourly labor rate for repairs Repair service employee Overhead costs Administrative assistant Other overhead Profit margin Rate charged per hour of labor

8-6

Total Cost

Total Hours

Per Hour Charge

$26,000

1,300

$20.00

1,950 4,940 $32,890

÷ ÷ ÷

1,300 1,300 1,300

= = =

1.50 3.80 $25.30 6.00 $31.30

Step 2: Rancho Park estimates that the total invoice cost of parts and materials used in 2011 will be $30,000 and it desires a 10 percent profit margin markup on the invoice cost of parts and materials. The computation of the material loading charge used by Rancho Park during 2011 is as follows: Material Loading Charge Overhead costs Parts manager’s salary Administrative assistant Other overhead

Total Invoice Cost, Parts and Materials

Material Loading Percentage

$5,000 1,000 6,000

$30,000

20.00%

3,000 $9,000

÷ ÷

30,000 30,000

= =

10.00% 30.00% 10.00% 40.00%

Profit margin Material loading percentage

Step 3: Rancho Park prepares a price quotation to estimate the cost to fix a set of woods for a patron. Rancho Park estimates the job will require a half hour of labor and $150 in parts and materials. Rancho Park’s price quotation is as follows: Rancho Park Golf Club Repair Service Time-and-Material Price Quotation Job: Arnold Palmer, repair of set of woods Labor charges: half hour @ $31.30....................... Material charges Cost of parts and materials................................... Material loading charge (40% X $150) ............... Total price of labor and materials ..........................

$ 15.65 $150.00 60.00

210.00 $225.65

Internal Sales 11.

(S.O. 4) Divisions within vertically integrated companies normally transfer goods or services to other divisions within the same company, as well as to customers outside the company. When goods are transferred internally, the price used to record the transfer between the two divisions is called the transfer price. Three possible approaches for determining a transfer price are (1) negotiated transfer prices, (2) cost-based transfer prices, and (3) market-based transfer prices.

Negotiated Transfer Prices 12.

The negotiated transfer price is determined through agreement of division managers. Using the negotiated transfer pricing approach, a minimum transfer price is established by the selling division, and a maximum transfer price is established by the purchasing division. Calculating the minimum transfer price depends on whether the selling division has excess capacity or not. If the selling division has no excess capacity, then the minimum transfer price is the variable cost plus its lost contribution margin (also known as opportunity cost). If the selling division has excess capacity, then the minimum transfer price is the variable cost.

8-7

Cost-Based Transfer Prices 13.

Another method of determining transfer prices is to base the transfer price on the costs incurred by the division providing the goods. If a transfer price is used, the transfer price may be based on variable costs alone, or on variable costs plus fixed costs. A markup may be added to these cost numbers. This method, however, may lead to a loss of profitability for the company and unfair evaluations of division performance.

Market-Based Transfer Prices 14.

The market-based transfer price is based on existing market prices of competing goods or services. A market-based system is often considered the best approach because it is objective and generally provides the proper economic incentives. Unfortunately, however, there is often not a well-defined market for the good or service being transferred and thus companies resort to a cost-based system.

Transfers Between Divisions in Different Countries 15.

(S.O. 5) As more companies “globalize” their operations, an increasing number of transfers are between divisions that are located in different countries. Companies must pay income tax in the country where income is generated. In order to maximize income, and minimize income tax, many companies prefer to report more income in countries with low tax rates, and less income in countries with high tax rates. This is accomplished by adjusting the transfer prices they use on internal transfers between divisions located in different countries. The division in the low-tax-rate country is allocated more contribution margin, and the division in the high-tax-rate country is allocated less.

*Absorption Cost Pricing *16. (S.O. 6) Absorption-cost pricing is consistent with generally accepted accounting principles (GAAP) because it defines the cost base as the manufacturing cost. Both variable and fixed selling and administrative costs are excluded from this cost base. Thus, selling and administrative costs plus the target ROI must be provided through the markup. The steps in using absorption-cost pricing are as follows: a. Compute the unit manufacturing cost. b. Compute the markup percentage using the formula:

Desired ROIper unit c.

Selling and Adminstrative Expenses Perr Unit

Markup Percentage

X Manufacturing Cost Per Unit

Set the target selling price using the formula:

Manufacturing Cost Per Unit

8-8

Markup Manufacturing Target X = Selling Price ( Percentage Cost Per Unit )

*Variable-Cost Pricing *17. Under variable-cost pricing, the cost base consists of all of the variable costs associated with a product, including variable selling and administrative costs. Because fixed costs are not included in the base, the markup must provide for fixed costs (manufacturing and selling and administrative) and the target ROI. Variable-cost pricing is more useful for making short-run decisions because it displays variable cost and fixed cost behavior patterns separately. The steps in using variable-cost pricing are as follows: a. b.

Compute the unit variable cost. Compute the markup percentage using the formula:

Desired ROI Per Unit + Fix xed Costs Per Unit c.

8-9

Variable Costs Per Unit

Set the target selling price using the formula:

Variable Cost Per Unit

= Markup Percentage X

Markup Target Variable X Cost Per Unit ) = Selling Price ( Percentage

LECTURE OUTLINE A.

External Sales. 1. Establishing the price for any good or service is affected by the following factors: pricing objectives, environment, demand, and cost considerations.

TEACHING TIP

ILLUSTRATION 8-1 identifies the factors that can affect pricing decisions. Emphasize that few management decisions are more important than setting prices. 2. In the long run a company must price its product to cover its costs and earn a reasonable profit. In most cases, a company does not set the price—it is set by the competitive market (laws of supply and demand). In this situation, companies are called price takers because the price of the product is set by market forces. 3. In some situations the company does set the price. This occurs where the product is specially made for a customer or when there are few or no other producers capable of manufacturing a similar item. It also occurs when a company can effectively differentiate its product from others.

Target Costing. 1. In a competitive market, the price of a product is greatly affected by supply and demand. No company in the market can affect the price to a significant degree. 2. A company chooses the segment of the market it wants to compete in (its market niche) in a competitive market.

8-10

3. Once the company has identified its market segment, it conducts market research to determine the target price. The target price is the price the company believes would place it in the best position for its target audience. 4. Once the company determines the target selling price it determines its target cost by setting a desired profit. 5. The difference between the target price and the desired profit is the target cost of the product. The target cost includes all product and period costs necessary to make and market the product.

MANAGEMENT INSIGHT Wal-Mart told jean maker Levi Strauss “the price should be $19 per pair of jeans instead of $23.” Wal-Mart often sets the price, and the manufacturer has to find out how to make a profit at that price. Levi Strauss revamped its distribution and production to improve its overall record of timely deliveries. The chief executive of Levi Strauss stated “we had to change people and practice.” What are some issues that Levi should consider in deciding whether it should agree to meet Wal-Mart’s target price? Answer: Levi may be tempted to reduce the quality of its product, or it may be forced to move more of its operations to low-wage suppliers. A big concern is that other retailers may complain that Levi is selling its jeans to Wal-Mart at a price that is lower than they receive. Also, customers may no longer be willing to pay for Levi’s other models of higher-priced jeans that it sells in other stores because they can get the low-price jeans (those with the lower gross margin) at Wal-Mart. All of these are issues that a manufacturer must consider in deciding whether to be a supplier to Wal-Mart.

8-11

Cost-Plus Pricing. 1. In a noncompetitive environment, the company is faced with the task of setting its own price, which is commonly a function of the cost of the product. 2. The typical approach is to use cost-plus pricing which involves establishing a cost base and adding to this cost base a markup to determine a target selling price. 3. The size of the markup depends on the desired return on investment (ROI) for the product line or product. 4. The cost-plus pricing formula is expressed as follows: Target Selling Price = Cost + (Markup Percentage X Cost). Markup Percentage is computed by dividing Desired ROI Per Unit by Total Unit Cost.

TEACHING TIP

Use ILLUSTRATION 8-2 to explain the computation of the markup percentage and target selling price using the cost-plus pricing approach. 5. The cost-plus pricing approach’s major advantage is that it is simple to compute. However, it does not give consideration to the demand side. In addition, sales volume plays a large role in determining per unit costs which in turn affect selling price. 6. The lower the sales volume, the higher the selling price the company must charge to meet its desired ROI. This occurs because fixed costs are spread over fewer units and the fixed cost per unit increase.

8-12

MANAGEMENT INSIGHT For nearly 90 years Parker Hannifin calculated the production cost, then added on a percentage of the cost to arrive at the price. If Parker reduced its production costs, it also cut the price for the product. This approach made it difficult for the company to ever substantially increase its profit margins. So the company’s CEO decided to implement strategic pricing schemes similar to other retailers. It decided to charge a higher markup for about a third of its products because it had a competitive advantage. What kind of help might the sales staff need in implementing this new approach? Answer: Many customers might object to the price increase, and some might even threaten to buy a competing product. The company needed to provide the sales staff with justifications for the product. For example, salespeople needed evidence to demonstrate that the superior quality of the product justified the higher price.

Time-and-Material Pricing. 1. Under time-and-material pricing, the company sets two pricing rates— one for the labor used on a job and another for the material. 2. The labor rate includes direct labor time and other employee costs. The material charge is based on the cost of direct parts and materials used and a material loading charge for related overhead costs. 3. Using time-and-material pricing involves three steps:

8-13

Calculate the per hour labor charge.

Calculate the charge for obtaining and holding materials.

Calculate the charges for a particular job.

TEACHING TIP

ILLUSTRATION 8-3 lists the steps involved in time-and-material pricing. Emphasize that both the labor charge and the material loading charge contain a desired profit margin. 4. The charge for labor time is expressed as a rate per labor hour which includes: a.

The direct labor cost of the employee (hourly rate or salary and fringe benefits).

Selling, administrative, and similar overhead costs.

An allowance for a desired profit or ROI per hour of employee time.

5. The charge for materials typically includes a material loading charge which covers the costs of purchasing, receiving, handling, and storing materials, plus any desired profit margin on the materials themselves. 6. The material loading charge is expressed as a percentage of the total estimated costs of parts and materials for the year. The company determines this percentage by doing the following:

8-14

Estimating the total annual costs for purchasing, receiving, handling, and storing materials.

Dividing the amount in a. by the total estimated cost of parts and materials.

Adding a desired profit margin on the materials themselves.

7. The charges for any particular job are the sum of the a.

Labor charge,

Charge for materials, and

Material loading charge.

SERVICE COMPANY INSIGHT For many decades, professionals in most service industries have used some form of hourly based price, regardless of the outcome. Many customers are now demanding that the bill be tied to actual performance instead of the amount of hours of work provided. What implications does this have for a service company’s need for managerial accounting? Answer: When service companies billed by the hour, they were better able to ensure their profitability because labor hours is their primary cost. But when billing schemes become performance-based, the company cannot be assured that the bill will cover its hourly costs. As a consequence, companies will need to be far more accurate in their estimates of the likelihood of achieving desired outcomes, or their costs may well exceed their revenues.

Internal Sales. 1. The transfer of goods between divisions of the same company is called internal sales. Divisions within vertically integrated companies normally sell goods to other company divisions as well as to outside customers. 2. When companies transfer goods internally, the price used to record the transfer between the divisions is the transfer price.

8-15

3. Setting a transfer price is often complicated because of competing interests among divisions within the company. A transfer price that is too high will benefit the selling division, but hurt the purchasing division. 4. There are three possible approaches for determining a transfer price:

Negotiated transfer prices.

Cost-based transfer prices.

Market-based transfer prices.

Negotiated Transfer Prices. 1. The negotiated transfer price is determined through agreement of division managers. It will range between the external purchase price per unit and the sum of the unit variable cost plus unit opportunity cost. 2. Opportunity cost is the contribution margin per unit of goods sold externally. 3. The minimum transfer price equals variable cost plus opportunity cost whether the seller is at full capacity or has excess capacity. However, opportunity cost will vary depending on whether a division is at full capacity or has excess capacity. 4. Given excess capacity (zero opportunity cost) to the selling division, it would be in the company’s best interest for the buying division to purchase goods internally as long as the selling division’s variable cost is less than the outside price. 5. When the selling division has excess capacity, it will receive a positive contribution margin from any transfer price above its variable cost while the buying division will benefit from any price below the outside price.

8-16

6. In the minimum transfer price formula, variable cost is defined as the variable cost of units sold internally which will differ from the variable cost of units sold externally in some instances (i.e. reduced variable selling expenses for internal sales). 7. Under negotiated transfer pricing, the selling division establishes a minimum transfer price and the purchasing division establishes a maximum transfer price. 8. Companies often do not use negotiated transfer pricing because:

Market price information is sometimes not easily obtainable.

A lack of trust between the two negotiating divisions may lead to a breakdown in negotiations.

Negotiations often lead to different pricing strategies from division to division which is sometimes costly to implement.

Cost-Based Transfer Prices. 1. One method of determining transfer prices is to base the transfer price on the costs incurred by the division producing the goods. 2. A cost-based transfer price may be based on full cost, variable cost, or some modification including a markup. 3. The cost-based approach often leads to poor performance evaluations and purchasing decisions. Under this approach, divisions sometimes use improper transfer prices which leads to a loss of profitability and unfair evaluations of division performance. 4. The cost-based approach does not provide the selling division with proper incentive. In addition, this approach does not reflect the selling division’s true profitability, and doesn’t even provide adequate incentive for the selling division to control costs since the division’s costs are passed on to the buying division.

8-17

Market-Based Transfer Prices. 1. The market-based transfer price is based on existing market prices of competing goods. This system is often considered the best approach because it is objective and generally provides the proper economic incentives. 2. When the selling division has no excess capacity, it receives market price and the purchasing division pays market price. 3. If the selling division has excess capacity, the market-based system can lead to actions that are not in the best interest of the company. 4. In many cases, there is not a well-defined market for the good being transferred. As a result, a reasonable market value cannot be developed, and companies must resort to a cost-based system.

TEACHING TIP

Use ILLUSTRATION 8-4 to explain the different transfer price approaches. Emphasize that the total contribution margin to the company is the same under all three approaches. I.

Transfers Between Divisions in Different Countries. 1. An increasing number of transfers are between divisions that are located in different countries. Differences in tax rates across countries can complicate the determination of the appropriate transfer price. 2. Companies must pay income tax in the country where they generate the income. Many companies prefer to report more income in countries with low tax rates in order to maximize income, and minimize income tax. 3. Companies maximize income by adjusting the transfer prices they use on internal transfers between divisions located in different countries. They allocate more contribution margin to the division in the low-tax-rate country while they allocate less to the division in the high-tax-rate country.

8-18 .

4. Adjusting the transfer prices to maximize income can result in inappropriate purchasing decisions and unfair evaluations. In addition, a company must consider whether it is legal and ethical to use a lower transfer price when the market price is clearly higher. ETHICS INSIGHT International transfer pricing issues create a huge headache for the Internal Revenue Service. It is estimated that the United States loses over $25 billion in underpaid taxes due to transfer price abuses. U.S. companies have also been accused of transfer pricing abuse. What are the implications for other taxpayers if companies reduce their taxes by using improper transfer prices to shift profits to lower-tax countries? Answer: If companies reduce their taxes by using improper transfer prices, then more of the tax burden will fall on law-abiding companies or on individual taxpayers. As countries such as Ireland, for example, have drawn increased foreign investment by non-Irish companies, many other European countries have complained that Ireland is using unfair tax incentives. Many countries are beginning to scrutinize the transferpricing practices of multinational companies more closely in order to reduce cheating and increase tax revenues. *J. Absorption-Cost Pricing. 1. Absorption-cost pricing uses total manufacturing cost as the cost base and provides for selling/administrative costs plus the target ROI through the markup. 2. Absorption-cost pricing involves three steps:

8-19

Compute the unit manufacturing cost.

Compute the markup percentage (the percentage must cover both the desired ROI and selling and administrative expenses).

Set the target selling price.

3. The markup percentage is computed by dividing the sum of the desired ROI per unit and selling and administrative expenses per unit by the manufacturing cost per unit. 4. The target selling price is computed as: Manufacturing cost per unit + (Markup percentage X Manufacturing cost per unit). 5. Most companies that use cost-plus pricing use either absorption cost or full cost as the basis because: a.

Absorption-cost information is most readily provided by a company’s cost accounting system.

Basing the cost-plus formula on only variable costs could encourage managers to set too low a price to boost sales.

Absorption-cost or full-cost pricing provides the most defensible base for justifying prices to managers, customers, and government.

TEACHING TIP

ILLUSTRATION 8-5 compares absorption-cost pricing and variable-cost pricing. Emphasize that the markup percentage provides for selling and administrative costs plus target ROI under absorption pricing while it covers fixed costs plus target ROI under variable-cost pricing. *K. Variable-Cost Pricing. 1. Variable-cost pricing uses all of the variable costs, including selling and administrative costs, as the cost base and provides for fixed costs and target ROI through the markup. 2. Variable-cost pricing is more useful for making short-run decisions because it considers variable cost and fixed cost behavior patterns separately.

8-20

3. Variable-cost pricing involves the following steps: a.

Compute the unit variable cost.

Compute the markup percentage.

Set the target selling price.

4. The markup percentage is computed by dividing the sum of the desired ROI per unit and fixed costs per unit by the variable cost per unit. 5. The target selling price is computed as: Variable cost per unit + (Markup percentage X Variable cost per unit). 6. The specific reasons for using variable-cost pricing are:

8-21

It is more consistent with cost-volume-profit analysis used to measure the profit implications of changes in price and volume.

This approach provides the type of data managers need for pricing special orders.

It avoids arbitrary allocation of common fixed costs to individual product lines.

20 MINUTE QUIZ Circle the correct answer. True/False 1. Once a company has determined the target price, it can determine its target cost by setting a desired profit. True

False

2. In a competitive, common-product environment the company must set a target selling price using cost-plus pricing. True

False

3. Under cost-plus pricing, the markup percentage is computed by dividing desired ROI per unit by variable cost per unit. True

False

4. The labor charge includes the direct labor cost of employees, selling, administrative, and similar overhead costs; and an allowance for a desired profit per hour. True

False

5. The charges for any particular job are the sum of the labor charge, the materials charge, and the material loading charge. True

False

6. An appropriate transfer price should assist the company in making proper purchasing decisions. True

False

7. An advantage of the cost-based transfer price approach is that it can increase a division manager’s control over the division’s performance. True

False

8. The market-based transfer price approach provides a fairer allocation of the company’s contribution margin to each division than the cost-based approach. True

False

9. In order to maximize income, and minimize income tax, companies can adjust the transfer prices they use on transfers between divisions located in different countries. True

False

*10. Absorption cost pricing is more consistent with cost-volume-profit analysis used to measure the profit implications of changes in price and volume. True 8-22

False

Multiple Choice 1.

The target cost of a product a. includes product costs but not period costs. b. is determined before the target price is established. c. is the difference between the target price and the desired profit. d. is determined by the target audience.

In the cost-plus pricing approach, the markup percentage is computed by dividing the a. desired ROI/unit by variable cost/unit. b. desired ROI/unit by total unit cost. c. total unit cost by desired ROI/unit. d. selling price/unit by desired ROI/unit.

All of the following are steps in the time-and-material pricing approach except calculating the a. labor charge. b. material loading charge. c. manufacturing overhead charge. d. charges for a particular job.

The total contribution margin to a company in the market-based transfer price approach is a. greater than in the cost-based approach. b. less than in the cost-based approach. c. the same as in the cost-based approach. d. either greater than or less than in the cost-based approach.

*5.

Absorption-cost pricing a. includes all variable costs in the cost base. b. excludes fixed manufacturing overhead from the cost base. c. provides the data needed for pricing special orders. d. uses a markup percentage that covers the desired ROI and the selling and administrative expenses.

8-23

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False False True True

Multiple Choice 1. 2. 3. 4. *5.

c. b. c. c. d.

8-24

6. 7. 8. 9. *10.

True False True True False

ILLUSTRATION 8-1 PRICING FACTORS

8-25

ILLUSTRATION 8-2 COMPUTATION OF MARKUP PERCENTAGE AND TARGET SELLING PRICE

8-26

ILLUSTRATION 8-3 TIME-AND-MATERIAL PRICING STEPS

8-27

ILLUSTRATION 8-4 TRANSFER PRICING APPROACHES

8-28

ILLUSTRATION 8-5 ABSORPTION-COST PRICING VS. VARIABLE-COST PRICING

8-29

CHAPTER 9 Budgetary Planning ASSIGNMENT CLASSIFICATION TABLE Study Objectives

Questions

Indicate the benefits of budgeting.

1, 2, 4

State the essentials of effective budgeting.

3, 5, 6, 7, 8

Identify the budgets that comprise the master budget.

9, 10, 11, 12, 13, 14, 15, 16

Describe the sources for preparing the budgeted income statement.

Brief Exercises

Do It!

Exercises

A Problems

B Problems

1, 2, 3, 4, 5, 6, 7

1, 2, 3

1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, 13

1A, 2A, 3A

1B, 2B, 3B

17, 18

1A, 2A, 3A, 6A

1B, 2B, 3B

Explain the principal sections of a cash budget.

19, 20

14, 15, 16, 17, 18, 19

4A, 6A

Indicate the applicability of budgeting in nonmanufacturing companies.

21, 22

3,18, 19, 20

9-1

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

9-2

Description

Difficulty Level

Time Allotted (min.)

Prepare budgeted income statement and supporting budgets.

Simple

30–40

Prepare sales, production, direct materials, direct labor, and income statement budgets.

Simple

40–50

Prepare sales and production budgets and compute cost per unit under two plans.

Moderate

30–40

Prepare cash budget for two months.

Moderate

30–40

Prepare purchases and income statement budgets for a merchandiser.

Simple

30–40

Prepare budgeted income statement and balance sheet.

Complex

40–50

Prepare budgeted income statement and supporting budgets.

Simple

30–40

Prepare sales, production, direct materials, direct labor, and income statement budgets.

Simple

40–50

Prepare sales and production budgets and compute cost per unit under two plans.

Moderate

30–40

Prepare cash budget for two months.

Moderate

30–40

Prepare purchases and income statement budgets for a merchandiser.

Simple

30–40

9-3 Q9-21 Q9-22

Broadening Your Perspective

Indicate the applicability of budgeting in nonmanufacturing companies.

Q9-19 Explain the principal sections of a cash budget.

E9-15 E9-16 E9-17 E9-18

E9-13 P9-1A P9-2A

BE9-7 DI9-2 DI9-3 E9-2 E9-3 E9-4 E9-5 E9-6 E9-7 E9-8

Application

Real-World Focus All About You

BE9-10 E9-3 E9-18 E9-19

Q9-20 BE9-9 DI9-5 E9-14

Q9-17 BE9-8 DI9-4

Q9-18

Describe the sources for preparing the budgeted income statement.

Q9-12 Q9-13 Q9-14 Q9-15 Q9-16 BE9-2 BE9-3 BE9-4 BE9-5 BE9-6

Q9-9 Q9-10 Q9-11 E9-1

DI9-1

Identify the budgets that comprise the master budget.

Q9-7 Q9-8 E9-1

Q9-4 E9-1

Q9-3 Q9-5 Q9-6

State the essentials of effective budgeting.

Q9-1 Q9-2 DI9-1

Indicate the benefits of budgeting.

Knowledge Comprehension

Study Objective

E9-20 P9-5A P9-5B

E9-19 P9-4A P9-6A P9-4B

P9-6A P9-1B P9-2B

Synthesis

P9-3A P9-3B

Evaluation

Manag. Analysis Decision Making Ethics Case Decision Making Across the Communication Across the Real-World Focus Organization Manag. Analysis Organization Exploring the Communication All About You web

E9-9 BE9-1 E9-10 E9-11 E9-12 E9-13 P9-1A P9-2A P9-1B P9-2B

Analysis

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. INDICATE THE BENEFITS OF BUDGETING. 2. STATE THE ESSENTIALS OF EFFECTIVE BUDGETING. 3. IDENTIFY THE BUDGETS THAT COMPRISE THE MASTER BUDGET. 4. DESCRIBE THE SOURCES FOR PREPARING THE BUDGETED INCOME STATEMENT. 5. EXPLAIN THE PRINCIPAL SECTIONS OF A CASH BUDGET. 6. INDICATE THE APPLICABILITY OF BUDGETING IN NONMANUFACTURING COMPANIES.

9-4

CHAPTER REVIEW Budgeting Basics 1.

(S.O. 1) A budget is a formal written statement of management’s plans for a specified time period, expressed in financial terms.

The role of accounting during the budgeting process is to (a) provide historical data on revenues, costs, and expenses, (b) express management’s plans in financial terms, and (c) prepare periodic budget reports.

Benefits of Budgeting 3.

The primary benefits of budgeting are as follows: a. It requires all levels of management to plan ahead. b. It provides definite objectives for evaluating performance. c. It creates an early warning system for potential problems. d. It facilitates the coordination of activities within the business. e. It results in greater management awareness of the entity’s overall operations. f. It motivates personnel throughout the organization.

Essentials of Effective Budgeting 4.

(S.O. 2) In order to be effective management tools, budgets must be based upon a. A sound organizational structure in which authority and responsibility are clearly defined. b. Research and analysis to determine the feasibility of new products, services, and operating techniques. c. Management acceptance which is enhanced when all levels of management participate in the preparation of the budget, and the budget has the support of top management.

The most common budget period is one year. A continuous twelve-month budget results from dropping the month just ended and adding a future month. The annual budget is often supplemented by monthly and quarterly budgets.

The responsibility for coordinating the preparation of the budget is assigned to a budget committee. The budget committee usually includes the president, treasurer, chief accountant (controller), and management personnel from each major area of the company.

A budget can have a significant impact on human behavior. A budget may have a strong positive influence on a manager when a. Each level of management is invited and encouraged to participate in developing the budget. b. Criticism of a manager’s performance is tempered with advice and assistance.

Long-range planning involves the selection of strategies to achieve long-term goals and the development of policies and plans to implement the strategies. Long-range plans contain considerably less detail than budgets.

The Master Budget 9.

(S.O. 3) The master budget is a set of interrelated budgets that constitutes a plan of action for a specified time period. It is developed within the framework of a sales forecast which shows potential sales for the industry and the company’s expected share of such sales.

9-5

10.

There are two classes of budgets in the master budget. a. Operating budgets are the individual budgets that result in the preparation of the budgeted income statement. b. Financial budgets focus primarily on the cash resources needed to fund expected operations and planned capital expenditures.

11.

The sales budget is the first budget prepared. It is derived from the sales forecast, and it represents management’s best estimate of sales revenue for the budget period. It is prepared by multiplying the expected unit sales volume for each product by its anticipated unit selling price.

12.

The production budget shows the units to produce to meet anticipated sales. It is derived from the budgeted sales units plus the desired ending finished goods units less the beginning finished goods units.

13.

The direct materials budget shows both the quantity and cost of direct materials to be purchased. It is derived from the direct materials units required for production plus the desired ending direct materials units less the beginning direct materials units.

14.

The direct labor budget shows the quantity (hours) and cost of direct labor necessary to meet production requirements. The direct labor budget is critical in maintaining a labor force that can meet expected levels of production.

15.

The manufacturing overhead budget shows the expected manufacturing overhead costs. The selling and administrative expense budget is a projection of anticipated operating expenses. Both budgets distinguish between fixed and variable costs.

Budgeted Income Statement 16.

(S.O. 4) The budgeted income statement is the important end-product in preparing operating budgets. This budget indicates the expected profitability of operations and it provides a basis for evaluating company performance. a. The budget is prepared from the budgets described in review points 11-15. b. For example, to find cost of goods sold, it is necessary to determine the total unit cost of a finished product using the direct materials, direct labor, and manufacturing overhead budgets.

Cash Budget 17.

(S.O. 5) The cash budget shows anticipated cash flows. It contains three sections (cash receipts, cash disbursements, and financing) and the beginning and ending cash balances. Data for preparing this budget are obtained from the other budgets.

18.

The budgeted balance sheet is a projection of financial position at the end of the budget period. It is developed from the budgeted balance sheet for the preceding year and the budgets for the current year.

Budgeting in Nonmanufacturing Companies 19.

9-6

(S.O. 6) The major differences in the master budget of a merchandiser and a manufacturer are that a merchandiser (a) uses a merchandise purchases budget instead of a production budget and (b) does not use the manufacturing budgets (direct materials, direct labor, and manufacturing overhead).

20.

In service enterprises, the critical factor in budgeting is coordinating professional staff needs with anticipated services. Budget data for service revenue may be obtained from expected output or expected input.

21.

In the budget process for not-for-profit organizations, the emphasis is on cash flows rather than on a revenue and expense basis. For governmental units, the budget must be strictly followed and overspending is often illegal.

9-7

LECTURE OUTLINE A.

Budgeting Basics. 1. Planning is the process of establishing enterprise-wide objectives. 2. A budget is a formal written statement of management’s plans for a specified future time period, expressed in financial terms. 3. Accounting information makes major contributions to the budgeting process.

The Benefits of Budgeting.

TEACHING TIP

Use ILLUSTRATION 9-1 to discuss the benefits of budgeting. Point out that even though the budget process is procedural, it has behavioral implications that could have a positive or negative effect on the accomplishment of company goals. 1. It requires all levels of management to plan ahead and to formalize goals on a recurring basis. 2. It provides definite objectives for evaluating performance at each level of responsibility. 3. It creates an early warning system for potential problems so that management can make changes before things get out of hand. 4. It facilitates the coordination of activities within the business by correlating the goals of each segment with overall company objectives.

9-8

5. It results in greater management awareness of the entity’s overall operations and the impact on operations of external factors, such as economic trends. 6. It motivates personnel throughout the organization to meet planned objectives.

Essentials of Effective Budgeting. 1. The essentials of effective budgeting are (a) sound organizational structure, (b) research and analysis, and (c) acceptance by all levels of management.

Effective budgeting depends on a sound organizational structure. In such a structure, authority and responsibility for all phases of operations are clearly defined.

Budgets based on research and analysis should result in realistic goals that will contribute to the growth and profitability of a company.

The effectiveness of a budget program is directly related to its acceptance by all levels of management.

Length of the Budget Period. 1. A budget may be prepared for any period of time. Various factors influence the length of the budget period.

9-9

The type of budget.

The nature of the organization.

The need for periodic appraisal.

Prevailing business conditions.

2. The budget period should be long enough to provide an attainable goal under normal business conditions and should minimize the impact of seasonal or cyclical fluctuations. 3. The most common budget period is one year.

TEACHING TIP

Use ILLUSTRATION 9-2 to give an overview of the budgeting process and identify those who are responsible for coordinating its preparation.

MANAGEMENT INSIGHT A recent study found that fewer than 14% of businesses with fewer than 500 employees do an annual budget or have a written business plan. For many small businesses the basic assumption is that, “As long as I sell as much as I can, and keep my employees paid, I’m doing OK”. Describe a situation in which a business “sells as much as it can” but cannot “keep its employees paid.” Answer: If sales are made to customers on credit and collection is slow, the company may find that it does not have enough cash to pay employees or suppliers. Without these resources the company will fail to survive.

The Budgeting Process/Budgeting and Human Behavior. 1. The budget is developed within the framework of a sales forecast that shows potential sales for the industry and the company’s expected share of such sales. Sales forecasting involves a consideration of various factors:

9-10

General economic conditions.

Industry trends.

Market research studies.

Anticipated advertising and promotion.

Previous market share.

Changes in prices.

Technological developments.

2. The input of sales personnel and top management is essential to the sales forecast. 3. In larger companies, a budget committee has responsibility for coordinating the preparation of the budget. 4. A budget can have a significant impact on human behavior. a.

A budget may inspire a manager to higher levels of performance.

A budget may discourage additional effort and pull down the morale of a manager.

In developing the budget, each level of management should be invited to participate. The overall goal is to reach agreement on a budget that the managers consider fair and achievable, but which also meets the corporate goals set by top management.

MANAGEMENT INSIGHT In an effort to revive its plummeting stock, Time Warner’s top management determined and publicly announced bold new financial goals for the next year. These goals were unfortunately not reached. The company got a new CEO and new budgets were developed with each operating unit setting what it considered optimistic but attainable goals.

9-11

What approach did Time Warner use to prepare the old budget? What approach did it use to prepare the new budget? Answer: Time Warner used a “top-down” approach to prepare the old budget since its goals were determined by top management. It used a participative approach to prepare the new budget since each operating unit set goals.

Budgeting and Long-Range Planning. 1. Budgeting and long-range planning are not the same. a.

One important difference is the time period involved; long-range planning usually encompasses a period of at least five years.

A second significant difference is in emphasis; long-range planning identifies long-term goals, selects strategies to achieve those goals, and develops policies and plans to implement the strategies. Management also considers anticipated trends in the economic and political environment and how the company should cope with them.

The final difference pertains to the amount of detail presented. Long-range plans contain considerably less detail than budgets because the data in long-range plans are intended more for a review of progress toward long-term goals than as a basis of control for achieving specific results.

2. The primary objective of long-range planning is to develop the best strategy to maximize the company’s performance over an extended future period.

9-12

The Master Budget. 1. The master budget is a set of interrelated budgets that constitutes a plan of action for a specified time period.

TEACHING TIP

Use ILLUSTRATION 9-3 to describe the components of the master budget. Point out that the individual budgets making up the master budget are prepared in an ordered sequence. The information developed in one individual budget serves as input in preparing other budgets. Budgeting is an interrelated process. 2. Sales Budget: The sales budget is the starting point in preparing the master budget. a.

Each of the other budgets depends on the sales budget.

The sales budget is derived from the sales forecast and it represents management’s best estimate of sales revenue for the budget period.

3. Production Budget: The production budget shows the units to produce to meet anticipated sales. a.

Production requirements are determined from the following formula: Budgeted Sales Units + Desired Ending Finished Goods Units – Beginning Finished Goods Units = Required Production Units.

TEACHING TIP

ILLUSTRATION 9-4 provides a production requirements formula and illustrates the preparation of a production budget. b.

. 9-13

The production budget provides the basis for the budgeted costs for each manufacturing cost element.

4. Direct Materials: The direct materials budget shows both the quantity and cost of direct materials to be purchased. a.

The quantities of direct materials are derived from the following formula: Direct Materials Units Required for Production + Desired Ending Direct Materials Units – Beginning Direct Materials Units = Required Direct Materials Units to be Purchased.

TEACHING TIP

ILLUSTRATION 9-5 provides a formula for direct materials quantities and illustrates the preparation of a direct materials budget. b.

The desired ending inventory is a key component in the budgeting process; inadequate inventories could result in temporary shutdowns of production.

5. Direct Labor: The direct labor budget contains the quantity (hours) and cost of direct labor necessary to meet production requirements. a.

The direct labor budget is critical in maintaining a labor force that can meet the expected levels of production.

The direct labor budget is also used in preparing the budgeted cost of goods sold and the cash budget.

6. Manufacturing Overhead: The manufacturing overhead budget shows the expected variable and fixed manufacturing overhead costs for the budget period. 7. Selling and Administrative Expense: The selling and administrative expense budget projects anticipated selling and administrative expenses for the budget period. This budget classifies expenses as either variable or fixed. This budget is also used in preparing the budgeted income statement and the cash budget.

9-14 .

8. Budgeted Income Statement: The budgeted income statement is the important end-product of the operating budgets. a.

This budget indicates the expected profitability of operations for the budget period.

The budgeted income statement provides the basis for evaluating company performance.

9. Cash Budget: The cash budget shows anticipated cash flows. a.

Because cash is so vital, this budget is often considered to be the most important financial budget.

The cash budget contains three sections: (1) Cash receipts. (2) Cash disbursements. (3) Financing.

TEACHING TIP

ILLUSTRATION 9-6 provides a format for preparing a cash budget. Point out that a cash budget is prepared for a period of time, such as a month, a quarter, a year.

9-15

Companies obtain data for preparing the cash budget from other budgets and from information provided by management.

A cash budget contributes to more effective cash management. It shows managers when additional financing is necessary well before the actual need arises and it indicates when excess cash is available for investments or other purposes.

MANAGEMENT INSIGHT Behind the grandeur of the Olympic Games lies a huge financial challenge—how to keep budgeted costs in line with revenues. The 2006 Winter Olympics in Italy narrowly avoided going into bankruptcy before the Games even started; organizers shifted promotional responsibilities to an Italian state-run agency. Why does it matter whether the Olympic Games exceed their budget? Answer: If the Olympic Games exceed their budget, taxpayers of the sponsoring community and country will end up footing the bill. Depending on the size of the losses, and the resources of the community, this could produce a substantial burden. As a result, other communities might be reluctant to host the Olympics in the future. 10. Budgeted Balance Sheet: The budgeted balance sheet is developed from the budgeted balance sheet for the preceding year and the budgets for the current year.

Budgeting in Nonmanufacturing Companies. 1. Budgets are also used by: a.

Merchandisers.

Service enterprises.

Not-for-profit organizations.

2. The major differences between the master budgets of a merchandiser and a manufacturer are that a merchandiser:

9-16

Uses a merchandise purchases budget instead of a production budget.

Does not use the manufacturing budgets (direct materials, direct labor, and manufacturing overhead).

3. In service enterprises, such as a public accounting firm, a law office, or a medical practice, the critical factor in budgeting is coordinating professional staff needs with anticipated services. a.

If a firm is overstaffed, several problems may result: (1) Labor costs are disproportionately high. (2) Profits are lower because of the additional salaries. (3) Staff turnover may increase because of lack of challenging work.

If a service enterprise is understaffed, it may lose revenue because existing and prospective client needs for service cannot be met. Also, professional staff may seek other jobs because of excessive work loads.

4. Budgeting is just as important for not-for-profit organizations as for profitoriented enterprises. a.

In most cases, not-for-profit entities budget on the basis of cash flows (expenditures and receipts), rather than on a revenue and expense basis.

The starting point in budgeting is usually expenditures, not receipts.

SERVICE COMPANY INSIGHT All organizations need to stick to budgets. The most recent recession has created budgeting challenges for nearly all governmental agencies. Even Princeton University experienced a 25% drop in the value of its endowment when the financial markets plunged. When the endowment fell the university had to make cuts because the endowment supports 45% of the university’s budget. Why would a university’s budgeted scholarships fall when the stock market suffers a serious drop?

9-17

Answer: Scholarships typically cannot be paid out of the “principal” portion of donations made to scholarship endowment funds. Instead, scholarship are usually funded through earnings generated by endowment investments. Any excess earnings above current year scholarship needs can be used for scholarships in subsequent years. But a serious drop in the value of endowment investments can wipe out previous earnings, in some cases completely eliminating funds available for scholarships.

9-18

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Budgeting is the process of establishing enterprise-wide objectives that serve as a deterrent to waste and inefficiency. True

The effectiveness of the budget program is directly related to its acceptance by all levels of management. True

False

Budgeting is not used in not-for-profit organizations because it is not necessary for these organizations to engage in profit planning. True

False

Long-range planning differs from budgeting in the time period involved, emphasis, and the amount of detail presented. True

10.

False

The budgeted income statement indicates the expected profitability of operations for the next year and provides the basis for evaluating company performance. True

False

The manufacturing overhead budget shows only the expected indirect labor costs for the year. True

False

The quantities of direct materials in the direct materials budget are derived from the formula: Desired Ending Direct Materials Units + Direct Materials Units Required for Production – Beginning Direct Materials Units = Required Direct Materials Units to be Purchased. True

False

The sales budget is the first budget prepared and each of the other budgets depends on it. True

False

One disadvantage of budgeting is that it does not facilitate the coordination of activities within a business. True

False

Budgeting always has the effect on human behavior of inspiring managers to higher levels of performance. True

False

9-19

False

Multiple Choice 1.

A formal written statement of management’s plans for a specified future time period, expressed in financial terms is a(n) a. accounting plan. b. budget. c. research analysis. d. sales budget.

Which of the following is not a benefit of budgeting? a. It reveals the prevailing business conditions. b. It results in greater management awareness of the entity’s overall operations. c. It creates an early warning system of potential problems. d. It provides definite objectives for evaluating performance at each level of responsibility.

All of the following are financial budgets except the a. budgeted balance sheet. b. budgeted income statement. c. capital expenditure budget. d. cash budget.

The master budget includes all of the following except a. Budgeted Income Statement. b. Capital Expenditure Budget. c. Cash Budget. d. Indirect Labor Budget.

If required production units are 75,000, budgeted sales units are 65,000, required direct materials purchases units are 3,000, and beginning finished goods units are 5,000, then desired ending finished goods units would be a. 2,000. b. 5,000. c. 12,000. d. 15,000.

9-20

ANSWERS TO QUIZ True/ False 1. 2. 3. 4. 5.

False True False False True

Multiple Choice 1. 2. 3. 4. 5.

b. a. b. d. d.

9-21

6. 7. 8. 9. 10.

True False True True False

ILLUSTRATION 9-1 BENEFITS OF BUDGETING

9-22

ILLUSTRATION 9-2 BUDGETING PROCESS

9-23

ILLUSTRATION 9-3 COMPONENTS OF THE MASTER BUDGET

9-24

ILLUSTRATION 9-4 PRODUCTION BUDGET

9-25

ILLUSTRATION 9-5 DIRECT MATERIALS BUDGET

9-26

ILLUSTRATION 9-6 CASH BUDGET

9-27

CHAPTER 10 Budgetary Control and Responsibility Accounting ASSIGNMENT CLASSIFICATION TABLE Brief Exercises

Study Objectives

Questions

Do It!

Describe the concept of budgetary control.

1, 2

Evaluate the usefulness of static budget reports.

3, 4, 5

1, 2

Explain the development of flexible budgets and the usefulness of flexible budget reports.

6, 7, 8, 9, 10, 11, 12

3, 4, 5

Describe the concept of responsibility accounting.

13, 14, 15, 16, 17, 18, 24

Indicate the features of responsibility reports for cost centers.

Identify the content of responsibility reports for profit centers.

20, 21

Explain the basis and formula used in evaluating performance in investment centers.

22, 23, 24

8, 9, 10

*8.

Explain the difference between ROI and residual income.

25, 26

11, 12

A Problems

B Problems

1, 2, 8, 10

1, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12

1A, 2A, 3A

1B, 2B, 3B

15, 16

16, 17, 18, 19

20, 21

Exercises 1

1, 2

9, 11, 14

*Note: All asterisked Questions, Exercises, and Problems relate to material contained in the appendix to the chapter.

10-1

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

Description

Difficulty Level

Time Allotted (min.)

Prepare flexible budget and budget report for manufacturing overhead.

Simple

20–30

Prepare flexible budget, budget report, and graph for manufacturing overhead.

Moderate

30–40

State total budgeted cost formula, and prepare flexible budget reports for two time periods.

Simple

20–30

Prepare responsibility report for a profit center.

Moderate

20–30

Prepare responsibility report for an investment center, and compute ROI.

Moderate

40–50

Prepare reports for cost centers under responsibility accounting, and comment on performance of managers.

Moderate

40–50

*7A

Compare ROI and residual income.

Moderate

25–35

Prepare flexible budget and budget report for manufacturing overhead.

Simple

20–30

Prepare flexible budget, budget report, and graph for manufacturing overhead.

Moderate

30–40

State total budgeted cost formula, and prepare flexible budget reports for two time periods.

Simple

20–30

Prepare responsibility report for a profit center.

Moderate

20–30

Prepare responsibility report for an investment center, and compute ROI.

Moderate

40–50

Prepare reports for cost centers under responsibility accounting, and comment on performance of managers.

Moderate

40–50

*7B

Compare ROI and residual income.

Moderate

25–35

10-2

10-3 P10-6A P10-6B

Q10-17 E10-13 Q10-18 Q10-24

Broadening Your Perspective

Q10-25 Q10-26

E10-20 E10-21 P10-7A

E10-16 E10-19 E10-17 E10-18

E10-15 P10-4A P10-4B

P10-7B

P10-3B

Synthesis

P10-5A P10-5B

BE10-3 E10-8 P10-2A P10-2B

E10-8

Evaluation

Exploring the Web Real-World Focus Communication All About You Manag. Analysis Decision Making Ethics Case Decision Making Across the Communication Organization Across the Ethics Case Organization Manag. Analysis Real-World Focus

BE10-11 BE10-12

BE10-8 BE10-9 BE10-10 DI10-4

Q10-22 Q10-23 Q10-24

7. Explain the basis and formula used in evaluating performance in investment centers.

*8. Explain the difference between ROI and residual income.

BE10-7 DI10-3 E10-16

Q10-20 Q10-21

E10-14

E10-7 BE10-5 E10-9 E10-4 E10-10 E10-6 E10-11 P10-1A E10-12 P10-3A P10-1B

Q10-11 BE10-4 DI10-1 DI10-2 E10-3 E10-5

BE10-6 E10-9 E10-11

E10-2 P10-3A E10-10 P10-3B

Analysis

Q10-5 BE10-1 BE10-2

Application

6. Identify the content of responsibility reports for profit centers.

5. Indicate the features of responsibility reports for cost centers.

Q10-19

Q10-6 Q10-7 Q10-8 Q10-10

Q10-9 Q10-12 E10-1

3. Explain the development of flexible budgets and the usefulness of flexible budget reports.

Q10-13 Q10-14 Q10-15 Q10-16

Q10-3 Q10-4

E10-1

2. Evaluate the usefulness of static budget reports.

4. Describe the concept of responsibility accounting.

Q10-1 Q10-2

E10-1

Knowledge Comprehension

1. Describe the concept of budgetary control.

Study Objective

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. DESCRIBE THE CONCEPT OF BUDGETARY CONTROL. 2. EVALUATE THE USEFULNESS OF STATIC BUDGET REPORTS. 3. EXPLAIN THE DEVELOPMENT OF FLEXIBLE BUDGETS AND THE USEFULNESS OF FLEXIBLE BUDGET REPORTS. 4. DESCRIBE THE CONCEPT OF RESPONSIBILITY ACCOUNTING. 5. INDICATE THE FEATURES OF RESPONSIBILITY REPORTS FOR COST CENTERS. 6. IDENTIFY THE CONTENT OF RESPONSIBILITY REPORTS FOR PROFIT CENTERS. 7. EXPLAIN THE BASIS AND FORMULA USED IN EVALUATING PERFORMANCE IN INVESTMENT CENTERS. *8. EXPLAIN THE DIFFERENCE BETWEEN ROI AND RESIDUAL INCOME.

10-4

CHAPTER REVIEW Budgetary Control 1.

(S.O. 1) The use of budgets in controlling operations is known as budgetary control. Such control takes place by means of budget reports that compare actual results with planned objectives. The budget reports provide management with feedback on operations.

Budgetary control involves: a. Developing budgets. b. Analyzing the differences between actual and budgeted results. c. Taking corrective action. d. Modifying future plans, if necessary.

Budgetary control works best when a company has a formalized reporting system. The system should a. Identify the name of the budget report such as the sales budget or the manufacturing overhead budget. b. State the frequency of the report such as weekly, or monthly. c. Specify the purpose of the report. d. Indicate the primary recipient(s) of the report.

Static Budget Reports 4.

(S.O. 2) A static budget does not modify or adjust data regardless of changes in activity during the year. As a result, actual results are always compared with the budget data at the activity level used in developing the master budget.

A static budget is appropriate in evaluating a manager’s effectiveness in controlling costs when (a) the actual level of activity closely approximates the master budget activity level, and/or (b) the behavior of the costs in response to changes in activity is fixed.

Flexible Budgets

(S.O. 3) A flexible budget projects budget data for various levels of activity. The flexible budget recognizes that the budgetary process is more useful if it is adaptable to changed operating conditions. This type of budget permits a comparison of actual and planned results at the level of activity actually achieved.

To develop the flexible budget, the following steps are taken: a. Identify the activity index and the relevant range of activity. b. Identify the variable costs, and determine the budgeted variable cost per unit of activity for each cost. c. Identify the fixed costs, and determine the budgeted amount for each cost. d. Prepare the budget for selected increments of activity within the relevant range.

For manufacturing overhead costs, the activity index is usually the same as the index used in developing the predetermined overhead rate; that is, direct labor hours or machine hours. For selling and administrative expenses, the activity index usually is sales or net sales.

10-5

The following formula may be used to determine total budgeted costs at any level of activity: Total budgeted costs = Fixed costs + (Total variable cost per unit X Activity level)

10.

Total budgeted costs at each level of activity can be shown graphically. a. In a graph, the activity index is shown on the horizontal axis and costs are shown on the vertical axis. b. The total budgeted costs for each level of activity are then identified from the total budgeted cost line.

11.

Flexible budget reports are another type of internal report produced by managerial accounting. The flexible budget report consists of two sections: (a) production data such as direct labor hours and (b) cost data for variable and fixed costs. It also shows differences between budget and actual results.

12.

Management by exception means that top management’s review of a budget report is focused either entirely or primarily to differences between actual results and planned objectives. The guidelines for identifying an exception are based on materiality and controllability.

Responsibility Accounting 13.

(S.O. 4) Responsibility accounting involves accumulating and reporting costs (and revenues, where relevant) on the basis of the manager who has the authority to make the day-to-day decisions about the items. A manager’s performance is evaluated on matters directly under that manager’s control.

14.

Responsibility accounting can be used at every level of management in which the following conditions exist: a. Costs and revenues can be directly associated with the specific level of management responsibility. b. The costs and revenues are controllable at the level of responsibility with which they are associated. c. Budget data can be developed for evaluating the manager’s effectiveness in controlling the costs and revenues.

15.

Responsibility accounting is especially valuable in a decentralized company. Decentralization means that the control of operations is delegated to many managers throughout the organization. A segment is an identified area of responsibility in decentralized operations.

16.

Responsibility accounting is an essential part of any effective system of budgetary control. It differs from budgeting in two respects: a. A distinction is made between controllable and noncontrollable items. b. Performance reports either emphasize or include only items controllable by the individual manager.

17.

A cost is considered controllable at a given level of managerial responsibility if that manager has the power to incur it within a given period of time. Costs incurred indirectly and allocated to a responsibility level are considered to be noncontrollable at that level.

18.

A responsibility reporting system involves the preparation of a report for each level of responsibility shown in the company’s organization chart. A responsibility reporting system permits management by exception at each level of responsibility within the organization.

10-6

19.

Responsibility centers may be classified into one of three types. A cost center incurs costs (and expenses) but does not directly generate revenues. A profit center incurs costs (and expenses) but also generates revenues. An investment center incurs costs (and expenses), generates revenues, and has control over investment funds available for use.

Cost Centers 20.

(S.O. 5) A responsibility report for cost centers compares actual controllable costs with flexible budget data. Only controllable costs are included in the report, and no distinction is made between variable and fixed costs.

21.

Direct fixed costs or traceable costs are costs that relate specifically to a responsibility center and are incurred for the sole benefit of the center. Indirect fixed costs or common costs pertain to a company’s overall operating activities and are incurred for the benefit of more than one profit center.

Profit Centers 22.

(S.O. 6) A responsibility report for a profit center shows budgeted and actual controllable revenues and costs. The report is prepared using the cost-volume-profit income statement format.

23.

In the responsibility report for a profit center: a. Controllable fixed costs are deducted from contribution margin. b. The excess of contribution margin over controllable fixed costs is identified as controllable margin. c. Noncontrollable fixed costs are not reported.

24.

Controllable margin is considered to be the best measure of the manager’s performance in controlling revenues and costs.

Investment Centers 25.

(S.O. 7) The primary basis for evaluating the performance of a manger of an investment center is return on investment (ROI). The formula for computing return on investment is: Investment Center Controllable Margin (in dollars) ÷ Average Investment Center Operating Assets = Return on Investment. a. Operating assets consist of current assets and plant assets used in operations by the center. Nonoperating assets such as idle plant assets and land held for future use are excluded. b. Average operating assets are usually based on the beginning and ending cost or book values of the assets.

26.

A manager can improve ROI by (a) increasing controllable margin or (b) reducing average operating assets.

27.

The return on investment approach includes two judgmental factors: a. Valuation of operating assets—cost, book value, appraised value, or market value. b Margin (income) measure—controllable margin, income from operations, or net income.

28.

Performance evaluation is a management function that compares actual results with budget goals. Performance evaluation includes both behavioral and reporting principles.

10-7

*Residual Income *29. (S.O. 8) To evaluate performance using the minimum rate of return, companies use the residual income approach. Residual income is the income that remains after subtracting from the controllable margin the minimum rate of return on a company’s average operating assets. The residual income would be computed as follows: Controllable Margin

10-8

–

Minimum Rate of Return X Average Operating Assets

Residual Income

LECTURE OUTLINE A.

The Concept of Budgetary Control. 1. The use of budgets in controlling operations is known as budgetary control. Such control takes place by means of budget reports that compare actual results with planned objectives. 2. Budgetary control consists of: a.

Preparing periodic budget reports that compare actual results with planned objectives.

Analyzing the differences to determine their causes.

Taking appropriate corrective action.

Modifying future plans, if necessary.

3. Budgetary control works best when a company has a formalized reporting system. This system does the following:

TEACHING TIP

Use ILLUSTRATION 10-1 to emphasize the importance of a formalized reporting system for effective budgetary control. Point out that different activities need to be monitored at different times by those who are responsible for the activities.

. 10-9

Identifies the name of the budget report (i.e. sales budget).

States the frequency of the report, such as weekly or monthly.

Specifies the purpose of the report.

Indicates the primary recipient(s) of the report.

4. A static budget is a projection of budget data at one level of activity. These budgets do not consider data for different levels of activity. As a result, companies always compare actual results with budget data at the activity level that was used in developing the master budget. 5. A static budget is appropriate in evaluating a manager’s effectiveness in controlling costs when: a.

The actual level of activity closely approximates the master budget activity level, and/or

The behavior of the costs in response to changes in activity is fixed.

6. A static budget report is appropriate for fixed manufacturing costs and for fixed selling and administrative expenses.

The Flexible Budget. 1. A flexible budget projects budget data for various levels of activity. In essence, the flexible budget is a series of static budgets at different levels of activity.

TEACHING TIP

Use ILLUSTRATION 10-2 to demonstrate the preparation of a flexible budget. Point out that once a flexible budget formula is developed, a flexible budget can be prepared for any level of activity. Emphasize that fixed costs are not calculated on a per unit basis because they are not expected to change in total with changes in activity within the relevant range. 2. To develop the flexible budget, management should: a.

10-10

Identify the activity index and the relevant range of activity.

Identify the variable costs, and determine the budgeted variable cost per unit of activity for each cost.

Identify the fixed costs, and determine the budgeted amount for each cost.

Prepare the budget for selected increments of activity within the relevant range.

3. Flexible budget reports are another type of internal report. The flexible budget report consists of two sections: a.

Production data for a selected activity index, such as direct labor hours.

Cost data for variable and fixed costs.

TEACHING TIP

ILLUSTRATION 10-3 provides an example of a flexible budget report. Emphasize that the actual costs are reported as incurred at the actual activity level achieved, and the flexible budget is developed at the same actual level of activity. 4. The flexible budget report provides a basis for evaluating a manager’s performance in two areas: a.

Production control.

Cost control.

5. Flexible budget reports are appropriate for evaluating performance since both actual and budgeted costs are based on the actual activity level achieved.

10-11

SERVICE COMPANY INSIGHT When the Exotic Newcastle Disease (an infectious bird disease) broke out in Southern California in 2003, it could have spelled disaster for the San Diego Zoo. The zoo spent almost half a million dollars on quarantine measures in 2003. It worked: no birds got sick and the damage to the zoo’s budget was minimized by a monthly budget reforecast. The new planning process, introduced a year earlier, allowed the zoo to redirect resources to ward off the disease. The San Diego Zoo’s annual static budget was behind the times before Paula Brock took over as CFO in 2001. Brock’s first efforts were to link strategy to the process. Consultants believe it’s a key way to improve people’s improvement in budgeting. What is the major benefit of tying a budget to the overall goals of the company? Answer: People working on a budgeting process that is clearly guided and focused by strategic goals spend less time arguing about irrelevant details and more time focusing on the items that matter.

Management by Exception. 1. Management by exception means that top management’s review of a budget report is focused either entirely or primarily on differences between actual results and planned objectives. 2. For management by exception to be effective, there must be guidelines for identifying an exception. The usual criteria are:

10-12

Materiality—usually expressed as a percentage difference from budget.

Controllability of the item—exception guidelines are more restrictive for controllable items than for items the manager cannot control.

The Concept of Responsibility Accounting. 1. Responsibility accounting involves accumulating and reporting costs (and revenues) on the basis of the manager who has the authority to make the day-to-day decisions about the items. 2. Under responsibility accounting, a manager’s performance is evaluated on matters directly under that manager’s control. 3. Responsibility accounting can be used at every level of management in which the following conditions exist: a.

Costs and revenues can be directly associated with the specific level of management responsibility.

The costs and revenues can be controlled by employees at the level of responsibility with which they are associated.

Budget data can be developed for evaluating the manager’s effectiveness in controlling the costs and revenues.

4. The reporting of costs and revenues under responsibility accounting differs from budgeting in two respects: a.

A distinction is made between controllable and noncontrollable items.

Performance reports either emphasize or include only items controllable by the individual manager.

MANAGEMENT INSIGHT While many compensation and promotion programs encourage competition and hard work, it does not foster collaboration, and can lead to distrust and disloyalty. As a consequence, many companies now explicitly include measures of collaboration in their performance measures.

10-13

How might managers of separate divisions be able to reduce division costs through collaboration? Answer: Division managers might reduce costs by sharing design and marketing resources or by jointly negotiating with suppliers. In addition, they can reduce the need to hire and lay off employees by sharing staff across divisions as human resource needs change. 5. A cost over which a manager has control is called a controllable cost. It follows that: a.

All costs are controllable by top management because of the broad range of its activity.

Fewer costs are controllable as one moves down to each lower level of managerial responsibility because of the manager’s decreasing authority.

6. Noncontrollable costs are costs incurred indirectly and allocated to a responsibility level. 7. A responsibility reporting system involves the preparation of a report for each level of responsibility in the company’s organization chart. 8. Responsibility reports for cost centers compare actual costs with flexible budget data. The reports show only controllable costs, and no distinction is made between variable and fixed costs. 9. There are three basic types of responsibility centers: cost centers, profit centers, and investment centers.

TEACHING TIP

ILLUSTRATION 10-4 identifies the three types of responsibility centers, the bases for evaluating the managers’ performance in the centers, and the type of performance report prepared for each center.

10-14

A cost center incurs costs (and expenses) but does not directly generate revenues.

A profit center incurs costs (and expenses) and also generates revenues.

Like a profit center, an investment center incurs costs (and expenses) and generates revenues. In addition, an investment center has control over decisions regarding the assets available for use.

10. Responsibility Reports. a.

The evaluation of a manager’s performance for cost centers is based on his or her ability to meet budgeted goals for controllable costs.

To evaluate the performance of a profit center manager, upper management needs detailed information about both controllable revenues and controllable costs. The report is prepared using the cost-volume-profit income statement. In the report: (1) Controllable fixed costs are deducted from contribution margin. (2) The excess of contribution margin over controllable fixed costs is identified as controllable margin. (3) Noncontrollable fixed costs are not reported.

The primary basis for evaluating the performance of a manager of an investment center is return on investment (ROI).

TEACHING TIP

ILLUSTRATION 10-5 provides the formula for calculating return on investment (ROI). Since the performance of managers of investment centers are evaluated by ROI, suggest ways that a manager might increase ROI.

10-15

Return on investment is computed by dividing controllable margin by average operating assets.

Judgmental factors in ROI are (1) valuation of operating assets and (2) margin (income) measure.

ACCOUNTING ACROSS THE ORGANIZATION No matter how you slice the movie business, by far the best return on investment comes from the not-so-glamorous world of G-rated films. However, these movies represent only 3% of the total films made in a typical year. What might be the reason that movie studios do not produce G-rated movies as often as R-rated ones? Answer: Perhaps Hollywood believes that big-name stars or large budgets, both of which are typical of R-rated movies, sell movies. However, one study recently concluded, “We can’t find evidence that stars help movies, and we can’t find evidence that bigger budgets increase return on investment.” Some film companies are going out of their way to achieve at least a PG rating.

Principles of Performance Evaluation. 1. The human factor is critical in evaluating performance. Behavioral principles include:

10-16

Managers of responsibility centers should have direct input into the process of establishing budget goals of their area of responsibility.

The evaluation of performance should be based entirely on matters that are controllable by the manager being evaluated.

Top management should support the evaluation process.

The evaluation process must allow managers to respond to their evaluations.

The evaluation should identify both good and poor performance.

2. Performance evaluation under responsibility accounting should be based on certain reporting principles. Performance reports should: a.

Contain only data that are controllable by the manager of the responsibility center.

Provide accurate and reliable budget data to measure performance.

Highlight significant differences between actual results and budget goals.

Be tailor-made for the intended evaluation.

Be prepared at reasonable intervals.

MANAGEMENT INSIGHT Among automobile manufacturing facilities in the U.S., nobody has more flexible plants than Honda. At the Honda plant, the switch from the production of one type of vehicle to a different type of vehicle takes only minutes instead of months like for most plants. This ability to adjust quickly to changing demand gave Honda a huge advantage when demand for more fuel-efficient cars increased quickly. What implications do these improvement in production capabilities have for management accounting within the organization? Answer: In order to maximize the potential of flexible manufacturing facilities managers need to be supplied with information on a more frequent basis. In turn, the tools used to evaluate performance need to take into account what information management had at its disposal, and what decisions were made in response to this information.

10-17

*F. Residual Income Compared To ROI. 1. Residual income is the income that remains after subtracting from the controllable margin the minimum rate of return on a company’s average operating assets. 2. Residual income is computed as follows: Controllable Margin – (Minimum Rate of Return X Average Operating Assets). 3. ROI sometimes provides misleading results because profitable investments are often rejected when the investment reduces ROI but increases overall profitability.

10-18

20 MINUTE QUIZ Circle the correct answer. True/False 1.

In a static budget, the data may be modified or adjusted if activity changes more than a specified amount during the year. True

Flexible budgets can be prepared for each of the types of budgets included in the master budget. True

False

The primary basis for evaluating the performance of a manager of an investment center is return on investment. True

False

There are three types of responsibility centers: cost, segment, and investment. True

10.

False

A responsibility reporting system begins with the lowest level of responsibility in an organization and moves upward to each higher level. True

False

Only controllable costs are included in a responsibility performance report, and there is no distinction made between variable and fixed costs. True

False

The terms “controllable costs” and “noncontrollable costs” are synonymous with variable costs and fixed costs, respectively. True

False

Under responsibility accounting, the evaluation of a manager’s performance is based on the matters directly under that manager’s control. True

False

Flexible budget reports consist of two sections: production data and cost data. True

False

With a flexible budget, if production increases, budget allowances for variable costs should increase both directly and proportionately. True

False

10-19

False

Multiple Choice 1.

A static budget report is appropriate for a. evaluating a manager’s performance in controlling variable costs. b. fixed manufacturing costs and fixed selling and administrative expenses. c. variable costs and fixed costs. d. none of the above.

The manufacturing overhead budget (1) provides the basis for computing the predetermined overhead rate for the year, and (2) is used in costing work in process and finished goods inventories. Is the above statement true for a. (1) only. b. (2) only. c. both (1) and (2). d. neither (1) nor (2).

At 40,000 direct labor hours, the flexible budget for indirect labor is $160,000. If $172,000 of indirect labor costs are incurred at 44,000 direct labor hours, the flexible budget report should show the following difference for indirect labor. a. $12,000 favorable. b. $4,000 unfavorable. c. $4,000 favorable. d. $12,000 unfavorable.

Controllable fixed costs are deducted from the contribution margin to arrive at a. income from operations. b. net income. c. controllable margin. d. realized income.

The numerator in computing return on investment is a. controllable margin. b. average operating assets. c. contribution margin. d. net assets.

10-20

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

False True True True True

Multiple Choice 1. 2. 3. 4. 5.

b. c. c. c. a.

10-21

6. 7. 8. 9. 10.

False True True False True

ILLUSTRATION 10-1 BUDGETARY CONTROL REPORTING SYSTEM

10-22

ILLUSTRATION 10-2 THE FLEXIBLE BUDGET

10-23

ILLUSTRATION 10-3 FLEXIBLE BUDGET REPORT

10-24

ILLUSTRATION 10-4 RESPONSIBILITY CENTERS

10-25

ILLUSTRATION 10-5 RETURN ON INVESTMENT

10-26

CHAPTER 11 Standard Costs and Balanced Scorecard ASSIGNMENT CLASSIFICATION TABLE Study Objectives

Questions

Brief Exercises 1

Do It!

Exercises

A Problems

B Problems

Distinguish between a standard and a budget.

1, 2

Identify the advantages of standard costs.

Describe how companies set standards.

4, 5, 6, 7, 8, 9

2, 3

1, 2, 3, 4, 17

State the formulas for determining direct materials and direct labor variances.

10, 11

4, 5

2, 3

4, 5, 6, 7, 8, 9, 10, 13, 14, 19

1A, 2A, 3A, 4A, 5A, 6A

1B, 2B, 3B, 4B, 5B, 6B

State the formula for determining the total manufacturing overhead variance.

11, 12, 19

1A, 2A, 3A, 4A, 5A, 6A

1B, 2B, 3B, 4B, 5B, 6B

Discuss the reporting of variances.

13, 14

10, 14, 15

Prepare an income statement for management under a standard costing system.

2A, 5A, 6A

2B, 5B, 6B

Describe the balanced scorecard approach to performance evaluation.

15, 16, 17

*9.

Identify the features of a standard cost accounting system.

8, 9

18, 19, 20

*10.

Compute overhead controllable and volume variances.

20, 21, 22, 23

10, 11

21, 22, 23

7A, 8A, 9A, 10A

7B, 8B, 9B, 10B

11-1

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

Description

Difficulty Level

Time Allotted (min.)

Compute variances.

Simple

20–30

Compute variances, and prepare income statement.

Simple

30–40

Compute and identify significant variances.

Moderate

20–30

Answer questions about variances.

Complex

30–40

Compute variances, prepare an income statement, and explain unfavorable variances.

Moderate

30–40

*6A

Journalize and post standard cost entries, and prepare income statement.

Moderate

40–50

*7A

Compute overhead controllable and volume variances.

Simple

10–15

*8A

Compute overhead controllable and volume variances.

Simple

10–15

*9A

Compute overhead controllable and volume variances.

Moderate

10–15

*10A

Compute overhead controllable and volume variances.

Moderate

10–15

Compute variances.

Simple

20–30

Compute variances, and prepare income statement.

Simple

30–40

Compute and identify significant variances.

Moderate

30–40

Answer questions about variances.

Complex

30–40

Compute variances, prepare an income statement, and explain unfavorable variances.

Moderate

30–40

*6B

Journalize and post standard cost entries, and prepare income statement.

Moderate

40–50

*7B

Compute overhead controllable and volume variances.

Simple

10–15

*8B

Compute overhead controllable and volume variances.

Simple

10–15

*9B

Compute overhead controllable and volume variances.

Moderate

10–15

*10B

Compute overhead controllable and volume variances.

Moderate

10–15

11-2

11-3

State the formula for determining the total manufacturing overhead variance.

Discuss the reporting of variances. Prepare an income statement for management under a standard costing system. Describe the balanced scorecard approach to performance evaluation. Identify the features of a standard cost accounting system. Compute overhead controllable and volume variances.

Broadening Your Perspective

*10.

*9.

State the formulas for determining direct materials and direct labor variances.

Study Objective Distinguish between a standard and a budget. Identify the advantages of standard costs. Describe how companies set standards.

Q11-10 Q11-11

Q11-8

Q11-3

Knowledge

DI11-4

Q11-7 Q11-9

P11-6A P11-2B P11-5B

E11-1 E11-2 E11-3 E11-7 E11-9 E11-10 E11-13 E11-14 P11-1A P11-2A P11-1A P11-2A P11-5A P11-6A P11-1B

P11-6B

P11-2B E11-11 P11-3B P11-5B E11-12 P11-4B P11-6B E11-19 P11-3A P11-4A E11-15 P11-3A P11-3B

P11-5A E11-8 P11-6A E11-19 P11-1B P11-3A P11-2B P11-4A P11-5B P11-3B P11-6B P11-4B

E11-4 E11-17

Analysis

BE11-8 E11-20 E11-19 BE11-9 P11-6A E11-18 P11-6B BE11-10 P11-7A P11-8B E11-20 BE11-11 P11-8A P11-9B E11-21 E11-21 P11-9A P11-10B E11-22 E11-22 P11-10A E11-23 P11-7B

BE11-2 BE11-3 DI11-1 BE11-4 BE11-5 DI11-2 DI11-3 E11-4 E11-5 E11-6 BE11-6 DI11-3 E11-11 E11-12 E11-19 E11-10 E11-14 E11-16 P11-2A P11-5A BE11-7 E11-17

Communication Managerial Analysis Exploring the Web

Q11-20 Q11-21 Q11-22 Q11-23

Q11-19

Q11-15 Q11-16 Q11-17

Q11-18

Q11-13 Q11-14

Q11-12

Q11-4 Q11-5 Q11-6

E11-1

Comprehension Application Q11-1 BE11-1 Q11-2 E11-1

Synthesis

Decision Making Across the Organization Ethics Case Real-World Focus All About You

Evaluation

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. DISTINGUISH BETWEEN A STANDARD AND A BUDGET. 2. IDENTIFY THE ADVANTAGES OF STANDARD COSTS. 3. DESCRIBE HOW COMPANIES SET STANDARDS. 4. STATE THE FORMULAS FOR DETERMINING DIRECT MATERIALS AND DIRECT LABOR VARIANCES. 5. STATE THE FORMULA FOR DETERMINING THE TOTAL MANUFACTURING OVERHEAD VARIANCE. 6. DISCUSS THE REPORTING OF VARIANCES. 7. PREPARE AN INCOME STATEMENT FOR MANAGEMENT UNDER A STANDARD COSTING SYSTEM. 8. DESCRIBE THE BALANCED SCORECARD APPROACH TO PERFORMANCE EVALUATION. *9. IDENTIFY THE FEATURES OF A STANDARD COST ACCOUNTING SYSTEM. *10. COMPUTE OVERHEAD CONTROLLABLE AND VOLUME VARIANCES.

11-4

CHAPTER REVIEW Standards and Budgets 1.

(S.O. 1) In concept, standards and budgets are essentially the same. Both are predetermined costs and both contribute significantly to management planning and control. a. A standard is a unit amount, whereas a budget is a total amount. b. Standard costs may be incorporated into a cost accounting system.

Why Standard Costs? 2.

(S.O. 2) Standard costs offer the following advantages to an organization: a. They facilitate management planning. b. They promote greater economy by making employees more “cost conscious.” c. They are useful in setting selling prices. d. They contribute to management control by providing a basis for the evaluation of cost control. e. They are useful in highlighting variances in management by exception. f. They simplify the costing of inventories and reduce clerical costs.

Setting Standard Costs 3.

(S.O. 3) Setting standards requires input from all persons who have responsibility for costs and quantities. Standards may be set at one of two levels. Ideal standards represent optimum levels of performance under perfect operating conditions. Normal standards represent efficient levels of performance that are attainable under expected operating conditions.

To establish the standard cost of producing a product, it is necessary to establish standards for each manufacturing cost element—direct materials, direct labor, and manufacturing overhead. The standard for each element is derived from the standard price to be paid and the standard quantity to be used.

Direct Materials

The direct materials price standard is the cost per unit of direct materials that should be incurred. a. This standard is based on the purchasing department’s best estimate of the cost of raw materials. b. This standard should include an amount for related costs such as receiving, storing, and handling.

The direct materials quantity standard is the quantity of direct materials that should be used per unit of finished goods. a. This standard is expressed as a physical measure, such as pounds, barrels, or board feet. b. This standard should include allowances of unavoidable waste and normal storage.

The standard direct materials cost per unit is the standard direct materials price times the standard direct materials quantity.

11-5

Direct Labor 8.

The direct labor price standard is the rate per hour that should be incurred for direct labor. a. This standard is based on current wage rates adjusted for anticipated changes, such as cost of living adjustments included in many union contracts. b. This standard generally includes employer payroll taxes and fringe benefits.

The direct labor quantity standard is the time that should be required to make one unit of the product. a. This standard is especially critical in labor-intensive companies. b. In setting this standard, allowances should be made for rest periods, cleanup, machine setup and machine downtime.

10.

The standard direct labor cost per unit is the standard direct labor rate times the standard direct labor hours.

Manufacturing Overhead 11.

The manufacturing overhead standard is based on a standard predetermined overhead rate. a. This overhead rate is determined by dividing budgeted overhead costs by an expected standard activity index. b. The standard manufacturing overhead rate per unit is the predetermined overhead rate times the activity index quantity standard.

Variances 12.

A variance is the difference between total actual costs and total standard costs. An unfavorable variance suggests that too much was paid for materials, labor, and manufacturing overhead or that there were inefficiencies in using materials, labor, and manufacturing overhead. Favorable variances indicate efficiencies in incurring costs and in using materials, labor, and manufacturing overhead.

13.

Analyzing variances begins with a determination of the cost elements that comprise the variance. For each manufacturing cost element, a total dollar variance is computed. Then this variance is analyzed into a price variance and a quantity variance.

Direct Materials Variances 14.

11-6

(S.O. 4) The formulas for the direct materials variances are:

Actual Quantity X Actual Price (AQ) X (AP)

–

Standard Quantity X Standard Price (SQ) X (SP)

Total Materials Variance (TMV)

Actual Quantity X Actual Price (AQ) X (AP)

–

Actual Quantity X Standard Price (AQ) X (SP)

Materials Price Variance (MPV)

Actual Quantity X Standard Price (AQ) X (SP)

–

Standard Quantity X Standard Price (SQ) X (SP)

Materials Quantity Variance (MQV)

15.

A variance matrix can be used in analyzing variances. In such cases, the formulas for each cost element are computed first and then the variances.

16.

Materials price variances are usually the responsibility of the purchasing department, whereas materials quantity variances are usually attributable to the production department.

Direct Labor Variances 17.

18.

The formulas for the direct labor variances are: Actual Hours X Actual Rate (AH) X (AR)

–

Standard Hours X Standard Rate (SH) X (SR)

Total Labor Variance (TLV)

Actual Hours X Actual Rate (AH) X (AR)

–

Actual Hours X Standard Rate (AH) X (SR)

Labor Price Variance (LPV)

Actual Hours X Standard Rate (AH) X (SR)

–

Standard Hours X Standard Rate (SH) X (SR)

Labor Quantity Variance (LQV)

Labor price variances usually result from paying workers higher wages than expected and/or misallocation of workers. Labor quantity variances relate to the efficiency of the workers and are the responsibility of the production department.

Manufacturing Overhead Variances 19.

(S.O. 5) The total overhead variance is the difference between the actual overhead costs and overhead costs applied based on standard hours allowed.

20.

To find the total overhead variance in a standard costing system, we determine the overhead costs applied based on standard hours allowed. Standard hours allowed are the hours that should have been worked for the units produced. The total overhead variance formula is as follows: Actual Overhead

21.

–

Overhead Applied

Total Overhead Variance

One reason for an overhead variance relates to over- or under-spending on overhead items. Generally the responsibility for these variances rests with the production department. The overhead variance can also result from inefficient use of overhead. The responsibility for these variances rests on either the production or sales departments.

Reporting of Variances 22.

(S.O. 6) All variances should be reported to appropriate levels of management as soon as possible. Variance reports facilitate the principle of “management by exception.” Rather than analyze every variance, top management will normally look for significant variances.

11-7

Statement Presentation of Variances 23. (S.O. 7) In income statements prepared for management under a standard cost accounting system, cost of goods sold is stated at standard cost and the variances are separately disclosed. In financial statements prepared for stockholders and other external users, standard costs may be used. 24. Standard costs may be used in costing inventories in financial statements prepared for stockholders when there are no significant differences between actual and standard costs. However, if the difference is material, the inventories and cost of goods sold must be reported at actual costs. Balanced Scorecard 25. (S.O. 8) Many companies use both financial and nonfinancial measures to evaluate performance. This approach is known as the balanced scorecard. The four most commonly employed perspectives are as follows: a. The financial perspective employs financial measures of performance used by most firms. b. The customer perspective evaluates how well the company is performing from the viewpoint of those people who buy and use its products or services. c. The internal process perspective evaluates the internal operating processes critical to success. d. The learning and growth perspective evaluates how well the company develops and retains its employees. The different perspectives are linked together so a company can better understand how to achieve its goals and what measures to use to evaluate performance. Standard Cost Accounting System *26. (S.O. 9) A standard cost accounting system is a double-entry system of accounting in which standard costs are used in making entries and variances are formally recognized in the accounts. A standard cost system may be used with either job order or process costing. *27. As an example, the purchase of raw materials inventory for $5,000 when the standard cost is $6,000 would be recorded as follows: Raw Materials Inventory....................................................................... Materials Price Variance.............................................................. Accounts Payable.......................................................................... a. b.

11-8

6,000

A debit balance in a variance account indicates an unfavorable variance. A credit balance in a variance account indicates a favorable variance.

1,000 5,000

Overhead Variances *28. (S.O. 10) The computation of the manufacturing overhead variances is conceptually the same as the computation of the materials and labor variances. For manufacturing overhead, however, both variable and fixed overhead must be considered. The formulas are: Actual Overhead

–

Overhead Applied*

Actual Overhead

–

Overhead Budgeted*

Fixed Overhead Rate

(

Normal Standard Capacity – Hours Hours Allowed

)

Total Overhead Variance Overhead Controllable Variance =

Overhead Volume Variance

*29. The overhead controllable variance shows whether overhead costs were effectively controlled. a. Budgeted costs are determined from the flexible manufacturing overhead budget for standard hours allowed. b. Most controllable variances are associated with variable costs, which are controllable costs. *30. The overhead volume variance indicates whether plant facilities were efficiently used during the period. a. This variance relates solely to fixed costs. b. It measures the amount that fixed overhead costs are under- or overapplied. *31. In computing the overhead variances, a. Standard hours allowed are used in each of the variances. b. Budgeted costs are derived from the flexible budget. c. The controllable variance generally pertains to variable costs. d. The volume variance pertains solely to fixed costs.

11-9

LECTURE OUTLINE A.

The Need for Standards. 1. Standards are common in business; those imposed by government agencies are often called regulations. 2. Both standards and budgets are predetermined costs, and both contribute to management planning and control. a.

A standard is a unit amount.

A budget is a total amount.

3. A standard is the budgeted cost per unit of product. 4. Standard costs offer a number of advantages to an organization:

They facilitate management planning.

They promote greater economy by making employees more “cost-conscious.”

They are useful in setting selling prices.

They contribute to management control by providing a basis for evaluation of cost control.

They are useful in highlighting variances in management by exception.

They simplify costing of inventories and reduce clerical costs.

Setting Standard Costs. 1. Companies set standards at one of two levels:

11-10

Ideal, or

Normal.

2. Ideal standards represent optimum levels of performance under perfect operating conditions. 3. Normal standards represent efficient levels of performance that are attainable under expected operating conditions. 4. Most companies that use standards set them at a normal level. Properly set, normal standards should be rigorous but attainable. ACCOUNTING ACROSS THE ORGANIZATION Recently a number of organizations, including corporations, consultants, and governmental agencies, agreed to share information regarding performance standards in an effort to create a standard set of measures for thousands of business processes. Companies that are interested in participating can go to the group’s Website and enter their information. How will the creation of such standards help a business or organization? Answer: A business or organization may use the data to compare its performance relative to others with regard to common practices such as processing a purchase order or filling a sales order. Armed with this information, an organization can determine which areas to focus on with improvement campaigns.

TEACHING TIP

Use ILLUSTRATION 11-1 to discuss the development of standard cost per unit of product. Emphasize that the standard cost for each product cost element consists of a quantity factor and a price factor. 5. The direct materials price standard should be based on the delivered cost of raw materials plus an allowance for receiving and handling.

11-11

6. The direct materials quantity standard should establish the required quantity plus an allowance for unavoidable waste and normal spoilage. 7. The direct labor price standard should be based on current wage rates and anticipated adjustments such as cost of living adjustments (COLAs). 8. The direct labor quantity standard should be based on required production time plus an allowance for rest periods, cleanup, machine setup, and machine downtime. a.

This standard, also called the direct labor efficiency standard, is especially critical in labor-intensive companies.

9. For manufacturing overhead, a standard predetermined overhead rate is used. It is based on an expected standard activity index such as standard direct labor hours or standard machine hours. 10. The total standard cost per unit is the sum of the standard costs of direct materials, direct labor, and manufacturing overhead.

MANAGEMENT INSIGHT The cost of manufacturing Susan’s Chili Factory chili consists of the costs of raw materials, labor to convert the basic ingredients to chili, and overhead. Susan’s managers need to determine the mix of ingredients for one gallon of chili and to develop the standard cost for the individual ingredients that go into the chili. How might management use this raw material cost information? Answer: Management might decide to increase the price of its chili. Or it might revise its recipes to use cheaper ingredients. Or it might eliminate some products until ingredients are available at costs closer to standard.

11-12

Analyzing and Reporting Variances from Standards. 1. One of the major management uses of standard costs is to identify variances from standards. Variances are the differences between total actual costs and total standard costs. a.

Variances are expressed in total dollars and not on a per unit basis.

When actual costs exceed standard costs, the variance is unfavorable.

If actual costs are less than standard costs, the variance is favorable.

2. Direct materials variances.

TEACHING TIP

ILLUSTRATION 11-2 provides formulas for computing total materials variance, materials price variance, and materials quantity variance.

11-13

(Actual Quantity X Actual Price) – (Standard Quantity X Standard Price) = Total Materials Variance (TMV).

(Actual Quantity X Actual Price) – (Actual Quantity X Standard Price) = Materials Price Variance (MPV).

(Actual Quantity X Standard Price) – (Standard Quantity X Standard Price) = Materials Quantity Variance (MQV).

3. Causes of materials variances. The investigation of a materials price variance usually begins in the purchasing department. The starting point for determining the cause(s) of an unfavorable materials quantity variance is in the production department.

TEACHING TIP

Use ILLUSTRATION 11-3 to demonstrate the calculation of the materials variances by means of a matrix. Journal entries are illustrated that incorporate standard costs into the accounts in the general ledger. 4. Direct labor variances.

TEACHING TIP

ILLUSTRATION 11-4 provides formulas for computing total direct labor variance, labor price variance, and labor quantity variance. a.

(Actual Hours X Actual Rate) – (Standard Hours X Standard Rate) = Total Labor Variance (TLV).

(Actual Hours X Actual Rate) – (Actual Hours X Standard Rate) = Labor Price Variance (LPV).

(Actual Hours X Standard Rate) – (Standard Hours X Standard Rate) = Labor Quantity Variance (LQV).

5. Causes of labor variances. a.

Labor price variances usually result from two factors: (1) Paying workers higher wages than expected, (2) Misallocation of workers.

11-14 .

Labor quantity variances relate to the efficiency of workers and generally can be traced to the production department.

TEACHING TIP

Use ILLUSTRATION 11-5 to demonstrate the calculation of the direct labor variances by means of a matrix. Journal entries are illustrated that incorporate standard costs into the accounts in the general ledger. 6. Manufacturing overhead variance. a.

Actual Overhead – Overhead Applied = Total Overhead Variance. (Overhead applied is based on standard hours allowed).

7. Causes of manufacturing overhead variance. Responsibility for the overhead variance rests with the production department. The cause of the variance may be: a.

Higher than expected use of indirect materials, indirect labor, and electricity, or

Inefficient use of overhead (i.e. reduced production due to machine breakdowns because of poor maintenance).

8. The overhead variance is the responsibility of the production department if the cause is lack of skilled labor or machine breakdowns. When the cause is a lack of sales orders, the responsibility rests outside the production department.

11-15

Reporting Variances. 1. All variances should be reported to appropriate levels of management as soon as possible. 2. Variance reports facilitate the principle of “management by exception” by highlighting significant differences. 3. Top management normally looks for significant variances. These may be judged on the basis of some quantitative measure, such as more than 10% of the standard or more than $1,000.

Statement Presentation of Variances. 1. In income statements prepared for management under a standard cost accounting system, cost of goods sold is stated at standard cost and the variances are disclosed separately. 2. When there are no significant differences between actual costs and standard costs, companies report their inventories at standard costs. 3. If there are significant differences between actual and standard costs, the financial statements must report inventories and cost of goods sold at actual costs.

Balanced Scorecard. 1. The balanced scorecard incorporates financial and nonfinancial measures in an integrated system that links performance measurement and a companys strategic goals.

11-16

2. The balanced scorecard evaluates company performance from four perspectives: a.

Financial perspective—employs financial measures of performance used by most firms.

Customer perspective—evaluates how well the company is performing from the viewpoint of those people who buy and use its products or services.

Internal process perspective—evaluates the internal operating processes critical to success.

Learning and growth perspective—evaluates how well the company develops and retains its employees.

3. Within each perspective, the balanced scorecard identifies objectives that will contribute to attainment of strategic goals. The objectives are linked across perspectives in order to tie performance measurement to company goals. 4. The balanced scorecard provides measurable objectives for nonfinancial measures such as product quality. 5. It integrates all of the companys goals into a single performance measurement system.

ACCOUNTING ACROSS THE ORGANIZATION Many of the benefits of a balanced scorecard approach are evident in the improved operations at United Airlines. When Glenn Tilton took over as United’s Chief Executive Officer he implemented an incentive program that allowed all employees to earn a bonus if the company “exceeded its goals for on-time flight departures and for customer intent to fly United again.” Which of the perspectives of a balanced scorecard were the focus of United’s CEO?

11-17

Answer: Improving on-time flight departures is an objective within the internal process perspective. Customer intent to fly United again is an objective within the customer perspective.

*G. Standard Cost Accounting System. 1. A standard cost accounting system is a double-entry system of accounting. In this system, companies use standard costs in making entries, and they formally recognize variances in the accounts. 2. The system is based on two important assumptions: a.

Variances from standards are recognized at the earliest opportunity, and

The Work in Process account is maintained exclusively on the basis of standard costs.

*H. Overhead Controllable and Volume Variances. 1. The total overhead variance is generally analyzed through a price variance (controllable variance) and a quantity variance (volume variance). 2. The overhead controllable variance shows whether overhead costs are effectively controlled. 3. The overhead volume variance relates to whether fixed costs were under-or over-applied during the year.

TEACHING TIP

ILLUSTRATION 11-6 provides formulas for computing total overhead variance, controllable variance, and volume variance.

11-18

Actual Overhead – Overhead Budgeted = Overhead Controllable Variance. (Overhead budgeted is based on standard hours allowed).

Fixed Overhead Rate X [Normal Capacity Hours – Standard Hours Allowed] = Overhead Volume Variance.

TEACHING TIP

Use ILLUSTRATION 11-7 to demonstrate the calculation of the overhead variances. Journal entries are illustrated that incorporate standard costs into the accounts in the general ledger. See Illustration 11-1 in which predetermined variable and fixed overhead rates per unit are computed as shown on the job cost sheet.

11-19

20 MINUTE QUIZ Circle the correct answer. True/False 1. The primary difference between standards and budgets is that a standard is a unit amount, whereas a budget is a total amount. True

False

2. An advantage of standard costs is that standard costs facilitate management planning by establishing expected future costs. True

False

3. Ideal standards represent an efficient level of performance that is attainable under expected operating conditions. True

False

4. The direct labor price standard generally includes employer payroll taxes and fringe benefits, such as paid holidays and vacations. True

False

5. (Actual Quantity X Standard Price) – (Standard Quantity X Actual Price) = Materials Price Variance. True

False

6. (Actual Hours X Actual Rate) – (Actual Hours X Standard Rate) = Labor Price Variance. True

False

7. Standard hours allowed are the hours that should have been worked for the units produced. True

False

8. Variance reports facilitate the principle of “management by exception.” True

False

9. In income statements prepared under a standard cost accounting system, cost of goods sold is stated at standard cost. True

False

*10. The overhead controllable variance is the difference between the actual overhead costs incurred and the overhead applied. True

11-20

False

Multiple Choice 1.

Which of the following is an advantage of standard costs? a. Contribution to management control. b. Promotion of greater economy and efficiency. c. Simplification of the costing of inventories and reduction of clerical costs. d. All of the above.

If the predetermined overhead rate per hour is $6 for variable and $2 for fixed overhead, standard direct labor hours per unit is 2 hours and actual direct labor hours per unit was 1.5 hours, then the overhead standard per unit is a. $4 per unit. b. $8 per unit. c. $16 per unit. d. $12 per unit.

The formula for the labor quantity (or efficiency) variance is a. (Actual Hours X Actual Rate) – (Actual Hours X Standard Rate). b. (Actual Hours X Standard Rate) – (Standard Hours X Standard Rate). c. (Standard Hours X Actual Rate) – (Standard Hours X Standard Rate). d. none of the above.

*4.

If actual overhead is $70,000, overhead applied is $67,000 and overhead budgeted for the standard hours allowed is $78,000, then the overhead controllable variance is a. $3,000 F. b. $11,000 U. c. $8,000 F. d. $8,000 U.

*5.

In a standard cost accounting system, a company purchased raw materials on account for $46,500 when the standard cost was $44,000. The journal entry would not include a a. debit to Raw Materials Inventory for $44,000. b. debit to Materials Price Variance for $2,500. c. credit to Materials Price Variance for $2,500. d. credit to Accounts Payable for $46,500.

11-21

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True True False True False

Multiple Choice 1. 2. 3. *4. *5.

d. c. b. c. c.

11-22

6. 7. 8. 9. *10.

True True True True False

ILLUSTRATION 11-1 STANDARD COSTS

11-23

ILLUSTRATION 11-2 FORMULAS FOR MATERIALS VARIANCES

11-24

ILLUSTRATION 11-3 VARIANCE ANALYSIS—DIRECT MATERIALS

11-25

ILLUSTRATION 11-4 FORMULAS FOR DIRECT LABOR VARIANCES

11-26

ILLUSTRATION 11-5 VARIANCE ANALYSIS—DIRECT LABOR

11-27

ILLUSTRATION 11-6 FORMULAS FOR OVERHEAD VARIANCES

11-28

ILLUSTRATION 11-7 VARIANCE ANALYSIS—OVERHEAD

11-29

CHAPTER 12 Planning for Capital Investments ASSIGNMENT CLASSIFICATION TABLE Brief Exercises

Do It!

Exercises

2, 3

Explain the net present value method.

4, 5, 6, 7

2, 3, 4, 5

Identify the challenges presented by intangible benefits in capital budgeting.

8, 9

Describe the profitability index.

Indicate the benefits of performing a post-audit.

Explain the internal rate of return method.

12, 13, 16

7, 8

Describe the annual rate of return method.

3, 14, 15

Study Objectives

Questions

Discuss capital budgeting evaluation, and explain inputs used in capital budgeting.

Describe the cash payback technique.

12-1

A Problems

B Problems

1, 2, 6, 9, 10, 11

1A, 2A

1B, 2B

1, 2, 3, 4 10, 11

1A, 2A, 3A, 4A, 5A

1B, 2B, 3B, 4B, 5B

5, 6, 7

3A, 5A

3B, 5B

8, 9, 10, 11

1A, 2A

1B, 2B

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

Description

Difficulty Level

Time Allotted (min.)

Compute annual rate of return, cash payback, and net present value.

Moderate

30–40

Compute annual rate of return, cash payback, and net present value.

Complex

30–40

Compute net present value, profitability index, and internal rate of return.

Moderate

20–30

Compute net present value considering intangible benefits.

Moderate

20–30

Compute net present value and internal rate of return with sensitivity analysis.

Moderate

30–40

Compute annual rate of return, cash payback, and net present value.

Moderate

30–40

Compute annual rate of return, cash payback, and net present value.

Complex

30–40

Compute net present value, profitability index, and internal rate of return.

Moderate

20–30

Compute net present value considering intangible benefits.

Moderate

30–40

Compute net present value and internal rate of return with sensitivity analysis.

Moderate

30–40

12-2

12-3

Describe the cash payback technique.

Explain the net present value method.

Identify the challenges presented by intangible benefits in capital budgeting.

Describe the profitability index.

Indicate the benefits of performing a post-audit.

Explain the internal rate of return method.

Describe the annual rate of return method.

Broadening Your Perspective

Discuss capital budgeting evaluation, and explain inputs used in capital budgeting.

Study Objective

Q12-14 Q12-15

Q12-12 Q12-13

Q12-11

Q12-8

Q12-9

BE12-9 E12-8 E12-9

Q12-3

E12-10 E12-11

E12-11

Real-World Focus Exploring the Web Decision Making Across the Organization

BE12-7 E12-7

BE12-3 E12-8 E12-10 E12-11

BE12-1 DI12-1 E12-9 E12-10

Application

Q12-16

Q12-10

Q12-4 Q12-7

Q12-5 Q12-6

Q12-2 Q12-3

Q12-1

Knowledge Comprehension

P12-5A P12-5B

BE12-4

BE12-4 P12-5A P12-5B

DI12-4 P12-1A P12-2A

BE12-8 DI12-3 E12-6

BE12-6

BE12-5 E12-4

P12-4A P12-4B

BE12-2 BE12-5 DI12-2 E12-1 E12-2 E12-3 E12-4 P12-1A

E12-1 E12-2 E12-6 P12-1A

P12-1B P12-2B

E12-5 P12-3A P12-3B

P12-3A P12-3B

P12-2A P12-3A P12-4A P12-1B P12-2B P12-3B P12-4B

P12-2A P12-1B P12-2B

Evaluation

All About Decision Making You Across the Organization Managerial Analysis Communication Ethics Case

Analysis Synthesis

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. DISCUSS CAPITAL BUDGETING EVALUATION, AND EXPLAIN INPUTS USED IN CAPITAL BUDGETING. 2. DESCRIBE THE CASH PAYBACK TECHNIQUE. 3. EXPLAIN THE NET PRESENT VALUE METHOD. 4. IDENTIFY THE CHALLENGES PRESENTED BY INTANGIBLE BENEFITS IN CAPITAL BUDGETING. 5. DESCRIBE THE PROFITABILITY INDEX. 6. INDICATE THE BENEFITS OF PERFORMING A POSTAUDIT. 7. EXPLAIN THE INTERNAL RATE OF RETURN METHOD. 8. DESCRIBE THE ANNUAL RATE OF RETURN METHOD.

12-4

CHAPTER REVIEW The Capital Budgeting Evaluation Process 1.

(S.O. 1) The capital budgeting evaluation process generally has the following steps: a. Project proposals are requested from departments, plants, and authorized personnel. b. Proposals are screened by a capital budget committee. c. Officers determine which projects are worthy of funding; and d. Board of directors approves capital budget.

Cash Flow Information 2.

While accrual accounting has advantages over cash accounting in many contexts, for purposes of capital budgeting, estimated cash inflows and outflows are preferred for inputs into the capital budgeting decision tools.

Sometimes cash flow information is not available, in which case adjustments can be made to accrual accounting numbers to estimate cash flows.

The capital budgeting decision, under any technique, depends in part on a variety of considerations: a. The availability of funds; b. Relationships among proposed projects; c. The company’s basic decision-making approach; and d. The risk associated with a particular project.

Cash Payback 5.

(S.O. 2) The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash inflow produced by the investment. The formula for computing the cash payback period is: Cost of Capital Investment ÷ Net Annual Cash Flow = Cash Payback Period Net annual cash flow can be approximated by adding depreciation expense to net income.

The evaluation of the payback period is often related to the expected useful life of the asset. a. With this technique, the shorter the payback period, the more attractive the investment. b. This technique is useful as an initial screening tool. c. This technique ignores both the expected profitability of the investment and the time value of money.

Net Present Value Method 7.

(S.O. 3) Under the net present value (NPV) method, cash flows are discounted to their present value and then compared with the capital outlay required by the investment. The difference between these two amounts is the net present value (NPV). a. The interest rate used in discounting the future net cash flows is the required minimum rate of return. b. A proposal is acceptable when NPV is zero or positive. c. The higher the positive NPV, the more attractive the investment.

12-5

When there are equal annual cash inflows, the table showing the present value of an annuity of 1 can be used in determining present value. When there are unequal annual cash inflows, the table showing the present value of a single future amount must be used in determining present value.

The discount rate used by most companies is its cost of capital—that is, the rate that the company must pay to obtain funds from creditors and stockholders.

10.

The net present value method demonstrated in the text requires the following assumptions: a. All cash flows come at the end of each year; b. All cash flows are immediately reinvested in another project that has a similar return; and c. All cash flows can be predicted with certainty.

Intangible Benefits 11.

(S.O. 4) By ignoring intangible benefits, such as increased quality or improved safety, capital budgeting techniques might incorrectly eliminate projects that could be financially beneficial to the company. To avoid rejecting projects that actually should be accepted, two possible approaches are suggested; a. Calculate net present value ignoring intangible benefits, and then, if the NPV is negative, ask whether the intangible benefits are worth at least the amount of the negative NPV. b. Project rough, conservative estimates of the value of the intangible benefits, and incorporate these values into the NPV calculation.

Mutually Exclusive Projects 12.

(S.O. 5) In theory, all projects with positive NPVs should be accepted. However, companies rarely are able to adopt all positive-NPV proposals because (1) the proposals are mutually exclusive (if the company adopts one proposal, it would be impossible to also adopt the other proposal), and (2) companies have limited resources.

13.

In choosing between two projects, one method that takes into account both the size of the original investment and the discounted cash flows is the profitability index. The profitability index formula is as follows:

Present Value of Net Cash Flows

Initial Investment

Profitability Index

The project with the greater profitability index should be the one chosen. 14.

Another consideration made by financial analysts is uncertainty or risk. One approach for dealing with uncertainty is sensitivity analysis. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential returns. In general, a higher risk project should be evaluated using a higher discount rate.

Post-Audit of Investment Projects 15.

12-6

(S.O. 6) A post-audit is a thorough evaluation of how well a project’s actual performance matches the projections made when the project was proposed. Performing a post-audit is beneficial for the following reasons: a. Management will be encouraged to submit reasonable and accurate data when they make investment proposals; b. A formal mechanism is used for determining whether existing projects should be supported or terminated; c. Management improves their estimation techniques by evaluating their past successes and failures.

16.

A post-audit involves the same evaluation techniques that were used in making the original capital budgeting decision—for example, use of the net present value method. The difference is that, in the post-audit, actual figures are inserted where known, and estimation of future amounts is revised based on new information.

Internal Rate of Return Method 17.

(S.O. 7) The internal rate of return method finds the interest yield of the potential investment. This is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows. Determining the internal rate of return can be done with a financial (business) calculator, computerized spreadsheet, or by employing a trial-and-error procedure.

18.

The decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return, and reject the project when the internal rate of return is less than the required rate.

Annual Rate of Return Method 19.

(S.O. 8) The annual rate of return method indicates the profitability of a capital expenditure and its formula is: Expected Annual Net Income ÷ Average Investment = Annual Rate of Return Average investment is based on the following:

Original investment + Value at end of usefull life = Average Investment 2 20.

The annual rate of return is compared with management’s required minimum rate of return for investments of similar risk. The minimum rate of return (the hurdle rate or cutoff rate) is generally based on the company’s cost of capital. The decision rule is: A project is acceptable if its rate of return is greater than management’s minimum rate of return; it is unacceptable when the reverse is true.

21.

When the rate of return technique is used in deciding among several acceptable projects, the higher the rate of return for a given risk, the more attractive the investment.

12-7

LECTURE OUTLINE A.

Capital Budgeting Evaluation Process 1. The process of making capital expenditure decisions in business is referred to as capital budgeting. 2. Capital budgeting involves choosing among various projects to find the one(s) that will maximize a company’s return on its financial investment.

TEACHING TIP

ILLUSTRATION 12-1 presents the steps involved in the capital budgeting evaluation process. 3. Top management requests proposals for projects from each department and a capital budgeting committee screens the proposals and recommends worthy projects to company officers. 4. Company officers decide which projects to fund and submit this list of projects to the board of directors for approval. 5. For purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs.

MANAGEMENT INSIGHT Monitoring capital expenditure amounts is one way to learn about a company’s growth potential. Few companies can grow if they don’t make significant capital investments. Why is it important for top management to constantly monitor the nature, amount, and success of a company’s capital expenditures?

12-8

Answer: In order to remain competitive, and to grow, companies must continually invest in new opportunities. However, not all projects will be successful, so management must continually monitor projects to ensure that continuation of the investment is in the company’s best interest.

Cash Payback. 1. The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash flow produced by the investment. 2. Net annual cash flow is computed by adding back depreciation expense to net income. Depreciation expense is added back because it is an expense that does not require an outflow of cash.

TEACHING TIP

ILLUSTRATION 12-2 provides an example of calculating the cash payback period on an investment project. Point out that cash payback is easy to compute and is often used to screen projects for risk, but it does not consider the profitability of the project. a.

The formula when net annual cash flows are equal is: Cost of Capital Investment ÷ Net Annual Cash FIow = Cash Payback Period.

The shorter the payback period, the more attractive the investment.

The cash payback technique recognizes that: (1) The earlier the investment is recovered, the sooner the company can use the cash funds for other purposes. (2) The risk of loss from obsolescence and changed economic conditions is less in a shorter payback period.

12-9

In the case of uneven net annual cash flows, the company determines the cash payback period when the cumulative net cash flows from the investment equal the cost of the investment.

The cash payback technique is relatively easy to compute and understand.

It should not ordinarily be the only basis for the capital budgeting decision because it ignores the expected profitability of the project.

Net Present Value Method. 1. Discounted cash flow techniques are generally recognized as the most informative and best conceptual approaches to making capital budgeting decisions. 2. These techniques consider both the time value of money and the estimated net cash flow from the investment. 3. The primary discounted cash flow technique is the net present value method. 4. The net present value method involves discounting net cash flows to their present value and then comparing that present value with the capital outlay required by the investment. The difference between these two amounts is referred to as net present value (NPV).

TEACHING TIP

ILLUSTRATION 12-3 presents a diagram of the decision criteria for the net present value method. a.

12-10 .

Company management determines what interest rate to use in discounting the future net cash flows. This rate is often referred to as the discount rate or required rate of return.

A proposal is acceptable when net present value is zero or positive, because this means the rate of return on the investment equals or exceeds the required rate of return.

The higher the positive net present value, the more attractive the investment.

TEACHING TIP

ILLUSTRATION 12-4 provides a short example of applying the net present value method. D.

Intangible Benefits. 1. Intangible benefits, such as increased quality, improved safety, or enhanced employee loyalty, are difficult to quantify, and thus often are ignored in capital budgeting decisions. 2. To avoid rejecting projects that should actually be accepted, managers can either a.

Calculate net present value (NPV) ignoring intangible benefits, and if the resulting NPV is negative, evaluate whether the intangible benefits are worth at least the amount of the negative NPV.

Incorporate intangible benefits into the NPV calculation by projecting rough, conservative estimates of their value. If, after using conservative estimates, the net present value is positive, the project should be accepted.

ETHICS INSIGHT Most manufacturers say that employee safety matters above everything else, but “safety doesn’t sell.” Recently a woodworking hobbyist with a Ph.D. in physics invented a device that automatically stops a power saw if the blade comes in contact with human flesh. The inventor eventually started his own company to build the devices and sell then directly to businesses that use power saws since existing saw manufacturers were unwilling to include the device into their saws. . 12-11

In addition to the obvious humanitarian benefit of reducing serious injuries, how else might the manufacturer of this product convince potential customers of its worth? Answer: Serious injuries cost employers huge sums, which can sometimes force small companies out of business. In addition to the obvious humanitarian benefit, the manufacturer can demonstrate that this device is a sound financial investment in terms of reduced health-care and workers’ compensation costs and fewer hours missed due to injury. Also, as the device gains wider acceptance, employers that do not have the device may ultimately be found negligent with regard to worker safety.

Mutually Exclusive Projects. 1. Proposals are often mutually exclusive—if the company adopts one proposal, it would be impossible to also adopt the other proposal. 2. The profitability index is a method that compares the relative merits of alternative capital investment projects. 3. This method takes into account both the size of the original investment and its discounted cash flows. 4. It is computed by dividing the present value of net cash flows by the initial investment. TEACHING TIP

ILLUSTRATION 12-5 provides an example of calculating the profitability index. Point out that any project with a positive NPV will have a profitability index greater than 1. 5. The higher the profitability index, the more desirable the project.

12-12

MANAGEMENT INSIGHT Building a new factory to produce 50-inch-plus TV screens can cost billions of dollars and manufacturers are wondering whether such investments are worth the gamble. If LCD makers decide to hold off on building new factories, price declines for wide-screen TVs could slow in two or three years as production falls behind added consumer demand. In building factories to manufacture 50-inch TV screens, how might companies build risk factors into their financial analysis? Answer: One approach is to use sensitivity analysis. Sensitivity analysis uses a number of outcome estimates to get a sense of the variability among potential returns. In addition, more distant cash flows can be discarded or given a low weighting because of their high uncertainty.

Post-Audit of Investment Projects. 1. A post-audit is a thorough evaluation of how well a project’s actual performance matches the original projections. 2. Performing a post-audit is important for several reasons. a.

Since managers know that their results will be evaluated, there is an incentive for them to make accurate estimates rather than presenting overly optimistic estimates in an effort to get projects approved.

A post-audit provides a formal mechanism for determining whether existing projects should be continued, expanded, or terminated.

Post-audits improve future investment proposals because managers improve their estimation techniques by evaluating past successes and failures.

3. A post-audit involves the same evaluation techniques used in making the original capital budgeting decision. In the post-audit, managers use actual figures where known, and they revise estimates of future amounts based on new information.

12-13

MANAGEMENT INSIGHT Inaccurate trend forecasting and market positioning are more detrimental to capital investment decisions than using the wrong discount rate. Companies often adopt projects or businesses only to discontinue then in response to market changes. Texas Instruments has dropped out of 12 business lines in recent years. How important is the choice of discount rate in making capital budgeting decisions? Answer: The point of this discussion is that errors in implementation, as well as the accuracy of the estimated future benefits and costs as measured by cash inflows and outflows, is what matters the most when making capital expenditure decisions. While the choice of discount rates will result in incremental differences in present value calculations. “missing the big picture” has the potential to cause much bigger decision errors. Underestimating potential future cash inflows can result in missed opportunities. Underestimating future costs can result in failed investments.

Internal Rate of Return. 1. The internal rate of return method differs from the net present value method in that it finds the interest yield of the potential investment. a.

The internal rate of return is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows.

TEACHING TIP

Use ILLUSTRATION 12-4 to calculate the internal rate of return on an investment project. Compare the net present value method and the internal rate of return method for the same investment proposal.

12-14

The determination of the internal rate of return involves the use of a financial calculator or computerized spreadsheet to solve for the rate (if the cash flows are uneven).

If the net annual cash flows are equal, an easier approach to solving for the internal rate of return can be used. This approach involves two steps: (1) Compute the internal rate of return factor. (2) Use the factor and the present value of an annuity of 1 table to find the internal rate of return.

The formula for determining the internal rate of return factor is: Capital Investment ÷ Net Annual Cash Flows = Internal Rate of Return Factor.

Once managers know the internal rate, of return, they compare it to the company’s required rate of return (the discount rate).

The IRR decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate.

TEACHING TIP

ILLUSTRATION 12-6 provides a diagram of the decision criteria for the internal rate of return method. 2. The two discounted cash flow methods differ as follows: a.

Objective: (1) Net present value: compute net present value (a dollar amount). (2) Internal rate of return: compute internal rate of return (a percentage).

. 12-15

Decision rule: (1) Net present value (NPV): If NPV is zero or positive, accept the proposal. If NPV is negative, reject the proposal. (2) Internal rate of return (IRR): If IRR is equal to or greater than the required rate of return, accept the proposal. If IRR is less than the required rate of return, reject the proposal.

Annual Rate of Return Method. 1. The annual rate of return method is based directly on accounting data rather than on cash flows.

TEACHING TIP

ILLUSTRATION 12-7 provides an example of calculating the annual rate of return on an investment project. Point out that this is the only approach that uses accrual accounting data, and it ignores the time value of money.

12-16

Annual rate of return is obtained from the following formula: Expected Annual Net Income ÷ Average Investment.

Management compares the annual rate of return with its required rate of return for investments of similar risk.

The required rate of return is generally based on the company’s cost of capital.

The decision rule is: A project is acceptable if its rate of return is greater than management’s required rate of return. It is unacceptable when the reverse is true.

The higher the rate of return for a given risk, the more attractive the investment.

12-17

The principal advantages of this method are the simplicity of its calculation and management’s familiarity with the accounting terms used in the computation.

A major limitation of this method is that it does not consider the time value of money.

20 MINUTE QUIZ Circle the correct answer. True/False 1.

For purposes of capital budgeting, estimated cash inflows and outflows are the preferred inputs. True

The cash payback technique is relatively easy to compute and considers the expected profitability of the project. True

False

The annual rate of return is computed by dividing net annual cash flow by the average investment. True

12-18

False

The internal rate of return is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows. True

10.

False

The internal rate of return method does not recognize the time value of money. True

False

Performing a post-audit is important because if managers know their estimates will be compared to actual results they will be more likely to submit reasonable and accurate data when they make investment proposals. True

False

The profitability index takes into account both the size of the original investment and the discounted cash flows. True

False

Intangible benefits, such as increased quality or improved safety, should be ignored in capital budgeting decisions. True

False

A company’s cost of capital is the rate that it must pay to obtain funds from creditors and stockholders. True

False

The primary discounted cash flow technique is the net present value method. True

False

Multiple Choice

All of the capital budgeting methods use cash flow except the a. cash payback method. b. annual rate of return method. c. internal rate of return method. d. profitability index method.

The cash payback period is computed by dividing the a. cost of the capital investment by the annual net income. b. cost of the capital investment by the present value of the cash flows. c. cost of the capital investment by the net annual cash flow. d. present value of the cash flows by the cost of the capital investment.

The primary discounted cash flow technique is the a. Annual rate of return method. b. Cash payback method. c. Net present value method. d. None of the above.

A company is considering investing in a project that costs $780,000 and is expected to generate net annual cash flows of $315,000 each year for 3 years. The company has a required rate of return of 9%. The present value of an annuity of 1 for 3 periods at 9% is 2.531. The net present value of this project is a. $797,265. b. $465,000. c. $797,725. d. $17,265.

If capital investment is $800,000 and equal annual cash inflows are $200,000, the internal rate of return factor is a. 25.0. b. 4.0. c. 5.0. d. .25.

12-19

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False True True False

Multiple Choice 1. 2. 3. 4. 5.

b. c. c. d. b.

12-20

6. 7. 8. 9. 10.

True True False True False

ILLUSTRATION 12-1 CAPITAL BUDGET AUTHORIZATION PROCESS

12-21

ILLUSTRATION 12-2 CASH PAYBACK PERIOD

12-22

ILLUSTRATION 12-3 NET PRESENT VALUE METHOD DECISION CRITERIA

12-23

ILLUSTRATION 12-4 DISCOUNTED CASH FLOWS

12-24

ILLUSTRATION 12-5 PROFITABILITY INDEX

12-25

ILLUSTRATION 12-6 INTERNAL RATE OF RETURN METHOD DECISION CRITERIA

12-26

ILLUSTRATION 12-7 ANNUAL RATE OF RETURN

12-27

CHAPTER 13 The Statement of Cash Flows ASSIGNMENT CLASSIFICATION TABLE Brief Exercises

Do It!

Exercises

A Problems

B Problems

3, 4, 5, 6, 7, 8, 9, 16, 22

1, 2, 3

10, 11, 12, 13, 14

4, 5, 6, 7

4, 5, 6, 7, 8, 9

2A, 3A, 5A, 7A, 9A, 11A

2B, 3B, 5B, 7B, 9B, 11B

8, 9, 10, 11

7, 9

7A, 8A

7B, 8B

12A

13, 14, 15

11, 12, 13, 14

4A, 6A, 8A, 10A

Study Objectives

Questions

*1.

Indicate the usefulness of the statement of cash flows.

1, 2, 15

*2.

Distinguish among operating, investing, and financing activities.

*3.

Prepare a statement of cash flows using the indirect method.

*4.

Analyze the statement of cash flows.

*5.

Explain how to use a worksheet to prepare the statement of cash flows using the indirect method.

*6.

Prepare a statement of cash flows using the direct method.

8, 18, 19, 20, 21

4B, 6B, 8B, 10B

*Note: All asterisked Questions, Exercises, and Problems relate to material contained in the appendix to the chapter.

13-1

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

Description

Difficulty Level

Time Allotted (min.)

Distinguish among operating, investing, and financing activities.

Simple

10–15

Determine cash flow effects of changes in equity accounts.

Simple

10–15

Prepare the operating activities section—indirect method.

Simple

20–30

*4A

Prepare the operating activities section—direct method.

Simple

20–30

Prepare the operating activities section—indirect method.

Simple

20–30

*6A

Prepare the operating activities section—direct method.

Simple

20–30

Prepare a statement of cash flows—indirect method, and compute free cash flow.

Moderate

40–50

*8A

Prepare a statement of cash flows—direct method, and compute free cash flow.

Moderate

40–50

Prepare a statement of cash flows—indirect method.

Moderate

40–50

*10A

Prepare a statement of cash flows—direct method.

Moderate

40–50

11A

Prepare a statement of cash flows—indirect method.

Moderate

40–50

*12A

Prepare a worksheet—indirect method.

Moderate

40–50

Distinguish among operating, investing, and financing activities.

Simple

10–15

Determine cash flow effects of changes in plant asset accounts.

Simple

10–15

Prepare the operating activities section—indirect method.

Simple

20–30

*4B

Prepare the operating activities section—direct method.

Simple

20–30

Prepare the operating activities section—indirect method.

Simple

20–30

*6B

Prepare the operating activities section—direct method.

Simple

20–30

Prepare a statement of cash flows—indirect method, and compute free cash flow.

Moderate

40–50

13-2

ASSIGNMENT CHARACTERISTICS TABLE (Continued) Problem Number

Description

Difficulty Level

Time Allotted (min.)

*8B

Prepare a statement of cash flows—direct method, and compute free cash flow.

Moderate

40–50

Prepare a statement of cash flows—indirect method.

Moderate

40–50

*10B

Prepare a statement of cash flows—direct method.

Moderate

40–50

11B

Prepare a statement of cash flows—indirect method.

Moderate

40–50

13-3

Distinguish among operating, investing, and financing activities.

Prepare a statement of cash flows using the indirect method.

Analyze the statement of cash flows.

Explain how to use a worksheet to prepare the statement of cash flows using the indirect method.

Prepare a statement of cash flows using the direct method.

*6.

Broadening Your Perspective

Indicate the usefulness of the statement of cash flows.

Study Objective

Q13-18

Q13-13

Q13-4 Q13-6 Q13-22 BE13-1

P13-8B BE13-8 BE13-9 BE13-10 BE13-11 DI13-3

P13-3B BE13-7 E13-8 E13-9 P13-5B E13-6 P13-3A P13-7B P13-2A P13-5A P13-9B P13-2B P13-7A P13-11B P13-7A P13-9A P13-7B P13-11A

Financial Reporting

P13-7A P13-8A P13-7B P13-8B

Analysis

Q13-19 E13-13 P13-4B P13-8A BE13-13 E13-14 P13-6B P13-8B BE13-14 P13-4A P13-8B BE13-15 P13-6A P13-10B E13-11 P13-8A E13-12 P13-10A

BE13-12 E13-10 P13-12A

E13-7 E13-9 P13-7A P13-8A P13-7B

BE13-4 BE13-5 BE13-6 DI13-2 E13-4 E13-5 E13-7

BE13-2 BE13-3 DI13-1 E13-2 E13-1 E13-3 E13-2 P13-1A P13-1B

Q13-15

Application

Exploring the Web Comparative Analysis Decision Making Across the Organization Communication

Q13-8 Q13-20 Q13-21

Q13-17

Q13-10 Q13-11 Q13-12 Q13-14

Q13-3 Q13-5 Q13-7 Q13-8 Q13-9 Q13-16

Q13-1 Q13-2

Knowledge Comprehension

Synthesis

Comp. Analysis Decision Making Across the Organization Ethics Case All About You

Evaluation

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. INDICATE THE USEFULNESS OF THE STATEMENT OF CASH FLOWS. 2. DISTINGUISH AMONG OPERATING, INVESTING, AND FINANCING ACTIVITIES. 3. PREPARE A STATEMENT OF CASH FLOWS USING THE INDIRECT METHOD. 4. ANALYZE THE STATEMENT OF CASH FLOWS. *5. EXPLAIN HOW TO USE A WORKSHEET TO PREPARE THE STATEMENT OF CASH FLOWS USING THE INDIRECT METHOD. *6. PREPARE A STATEMENT OF CASH FLOWS USING THE DIRECT METHOD.

13-5

CHAPTER REVIEW Usefulness of the Statement of Cash Flows 1.

(S.O. 1) The fourth basic financial statement is the statement of cash flows. The primary purpose of the statement is to provide information about an entity’s cash receipts and cash payments during a period.

The information in the statement of cash flows should help investors to assess the a. entity’s ability to generate future cash flows. b. entity’s ability to pay dividends and meet obligations. c. reasons for the difference between net income and net cash provided (used) by operating activities. d. cash investing and financing transactions during the period.

Classification of Cash Flows 3.

(S.O. 2) The statement of cash flows classifies cash receipts and cash payments by: a. Operating activities which include cash effects of transactions that create revenues and expenses and thus enter into the determination of net income. b. Investing activities which include (1) acquiring and disposing of investments and (2) lending money and collecting the loans. c. Financing activities which involve long-term liability and stockholders’ equity items and include (1) obtaining cash from issuing debt and repaying the amounts borrowed, and (2) obtaining cash from stockholders, repurchasing shares, and paying dividends.

Significant noncash transactions include the conversion of bonds into common stock and the acquisition of assets through the direct issuance of debt or common stock. These transactions are individually reported at the bottom of the statement of cash flows or they may appear in a separate note or supplementary schedule to the financial statements.

Format of the Statement of Cash Flows 5.

The three classes of activities constitute the general format of the statement with the operating activities section appearing first, followed by the investing activities and financing activities sections. a. The net cash provided or used by each activity is totaled to show the net increase (decrease) in cash for the period. b. The net change in cash for the period is then added to or subtracted from the beginning-ofthe-period cash balance. c. Finally, any significant noncash investing and financing activities are reported in a separate schedule at the bottom of the statement.

The statement of cash flows is not prepared from the adjusted trial balance. The information to prepare this statement usually comes from three sources: (a) comparative balance sheets, (b) the current income statement, and (c) additional information.

13-6

The Major Steps 7.

The major steps in preparing the statement are: Step 1: Determine net cash provided/used by operating activities. This step involves analyzing not only the current year’s income statement, but also comparative balance sheets and selected additional data. Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or disclose as noncash transactions. This step involves analyzing comparative balance sheet data and selected additional information for their effects on cash. Step 3: Compare the net change in cash on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree.

8. In performing step 1, the operating activities section must be converted from an accrual basis to a cash basis. This may be done by either the indirect method or the direct method. a. Both methods arrive at the same total amount for “net cash provided by operating activities” but they differ in disclosing the items that comprise the total amount. b. The indirect method is used extensively in practice. c. The FASB has expressed a preference for the direct method. The Indirect Method 9. (S.O. 3) The following points 10 through 15 explain and illustrate the indirect method. The First Step—Indirect 10. The first step is to determine net cash provided/used by operating activities. a. Under generally accepted accounting principles the accrual basis of accounting is used which results in recording revenues when earned and expenses when incurred. b. In order to determine net cash provided by operating activities it is necessary to report revenues and expenses on a cash basis. This is determined by adjusting net income for items that did not affect cash. 11. The operating activities section of the statement of cash flows should (a) begin with net income, (b) add (or deduct) items not affecting cash, and (c) show net cash provided by operating activities. 12. In determining net cash provided by operating activities, a. increases in specific current assets other than cash are deducted from net income, and decreases are added to net income. b. increases in specific current liabilities are added to net income, and decreases are deducted from net income. c. expenses for depreciation, amortization, and depletion and a loss on a sale of equipment are added to net income, and a gain on a sale of equipment is deducted from net income. The Second Step—Indirect 13. The second step, net cash provided/used by investing and financing activities is generally determined from changes in noncurrent accounts reported in the comparative balance sheets and selected additional data. a. If the account, Land, increases $50,000 and the transaction data indicates that land was purchased for cash, a cash outflow from an investing activity has occurred. b. If the account, Common Stock, increases $100,000 and the transaction data indicates that additional stock was issued for cash, a cash inflow from a financing activity has resulted. 14. The redemption of debt and the retirement or reacquisition of capital stock are cash outflows from financing activities.

13-7

The Third Step—Indirect 15. The third step is to compare the net change in cash on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree. Analysis of the Statement of Cash Flows 16. (S.O. 4) Free cash flow describes the cash remaining from operations after adjustment for capital expenditures and dividends. The formula for free cash flow is: Free Cash Flow = Cash Provided by Operating Activities – Capital Expenditures – Cash Dividends. Use of a Work Sheet *17. (S.O. 5) A worksheet may be used to assemble and classify the data that will appear on the statement of cash flows. The worksheet is divided into two parts: a. Balance sheet accounts with columns for (1) end of last year balances, (2) reconciling items (debit and credit), and end of current year balances. b. Statement of cash flows effects with debit and credit columns. This part of the worksheet consists of the operating, investing, and financing sections. *18. The following guidelines are important in using a worksheet. a. In the balance sheet accounts section, accounts with debit balances are listed separately from those with credit balances. b. In the cash flow effects section, inflows of cash are entered as debits in the reconciling columns and outflows of cash are entered as credits in the reconciling columns. c. The reconciling items shown in the worksheet are not entered in any journal or posted to any account. *19. The steps in preparing a worksheet are: a. Enter the balance sheet accounts and their beginning and ending balances in the balance sheet accounts section. b. Enter the data that explains the changes in the balance sheet accounts (other than cash) and their effects on the statement of cash flows in the reconciling columns of the worksheet. c. Enter the increase or decrease in cash on the cash line and at the bottom of the worksheet. This entry should enable the totals of the reconciling columns to be in agreement. *20. The statement of cash flows is prepared entirely from the data that appears in the worksheet under Statement of Cash Flows Effects. Preparing the Statement of Cash Flows— The Direct Method *21. (S.O. 6) The following points 22 through 29 explain and illustrate the direct method. The First Step—Direct *22. The first step is to determine net cash provided/used by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. a. If the income statement shows revenue of $120,000 and accounts receivable (net) increased $20,000 during the year, cash revenue is $100,000 ($120,000 – $20,000). b. If the income statement reports operating expenses of $60,000 but accounts payable have increased $12,000 during the year, cash operating expenses are $48,000 ($60,000 – $12,000).

13-8

*23. In the operating activities section, only major classes of cash receipts and cash payments are reported as follows: a. Cash receipts from (1) sales of goods and services to customers and (2) receipts of interest and dividends on loans and investments. b. Cash payments (1) to suppliers, (2) to employees, (3) for operating expenses, (4) for interest, and (5) for taxes. *24. The formula for computing cash receipts from customers is: Revenue from Sales

+ Decrease in Accounts Receivable or – Increase in Accounts Receivable

*25. The formula for computing cash payments to suppliers is: Cost of Goods Sold

+ Increase in Inventory or – Decrease in Inventory

+ Decrease in Accounts Payable or – Increase in Accounts Payable

*26. The formula for computing cash payments for operating expenses is: Operating + Increase in Prepaid Expenses + Decrease in Accrued Expenses Payable Expenses (exclusive of or or depreciation – Decrease in Prepaid Expenses – Increase in Accrued Expenses Payable expense) *27. The formula for computing cash payments for income taxes is: Income Tax Expense

+ Decrease in Income Taxes Payable or – Increase in Income Taxes Payable

The Second Step—Direct *28. The second step, net cash provided/used by investing and financing activities is generally determined from changes in noncurrent accounts reported in the comparative balance sheet and selected additional data. The Third Step—Direct *29. The third step is to determine the net increase or decrease in cash by determining the difference between cash at the beginning of the year and cash at the end of the year.

13-9

LECTURE OUTLINE A.

Usefulness of the Statement of Cash Flows. 1. The statement of cash flows provides information about the cash receipts cash payments, and net change in cash resulting from the operating, investing, and financing activities during a period. 2. The information in a statement of cash flows should help investors, creditors, and others assess:

The entity’s ability to generate future cash flows.

The entity’s ability to pay dividends and meet obligations.

The reasons for the difference between net income and net cash provided (used) by operating activities.

The cash investing and financing transactions during the period.

Classification of Cash Flows. 1. The statement of cash flows classifies cash receipts and cash payments as operating, investing, and financing activities.

TEACHING TIP

ILLUSTRATION 13-1 classifies the principal types of cash receipts and payments as operating, investing, and financing activities. a.

13-10 .

Operating activities include the cash effects of transactions that enter into the determination of net income, such as cash receipts from sales of goods or services and cash payments to suppliers and employees.

Investing activities include (1) acquiring and disposing of investments and property, plant, and equipment, and (2) lending money and collecting the loans.

Financing activities include (1) obtaining cash from issuing debt and repaying the amounts borrowed, and (2) obtaining cash from stockholders, repurchasing shares, and paying dividends.

2. Note that (1) operating activities involve income statement items, (2) investing activities involve cash flows resulting from changes in investments and long-term asset items, and (3) financing activities involve cash flows resulting from changes in long-term liability and stockholders’ equity items.

TEACHING TIP

ILLUSTRATION 13-2 identifies the information sources for analyzing the cash effects of operating, investing, and financing activities. C.

Significant Noncash Activities. 1. Companies do not report in the body of the statement of cash flows significant financing and investing activities that do not affect cash. 2. They report these activities in either a separate schedule at the bottom of the statement of cash flows or in a separate note or supplementary schedule to the financial statements. 3. Examples of significant noncash activities are:

. 13-11

Direct issuance of common stock to purchase assets.

Conversion of bonds into common stock.

Direct issuance of debt to purchase assets.

Exchanges of plant assets.

ACCOUNTING ACROSS THE ORGANIZATION Net income is not the same as net cash provided by operating activities. Net cash provided by operating activities is usually significantly larger than net income. In general, why do differences exist between net income and net cash provided by operating activities? Answer: The differences are explained by differences in the timing of the reporting of revenues and expenses under accrual accounting versus cash. Under accrual accounting, companies report revenues when earned, even if cash hasn’t been received, and they report expenses when incurred, even if cash hasn’t been paid.

Format of the Statement of Cash Flows. 1. The cash flows from operating activities section always appears first, followed by the investing activities and then the financing activities sections.

TEACHING TIP

ILLUSTRATION 13-3 presents a widely used format for the statement of cash flows. Point out that the noncash investing and financing activities appearing as a separate schedule at the bottom of the statement may, alternatively, be presented in a separate note or supplementary schedule to the financial statements. 2. Companies report the individual inflows and outflows from investing and financing activities separately. 3. The reported operating, investing, and financing activities result in either net cash provided or used by each activity. Companies total the amounts of net cash provided (used) by each activity, resulting in the net increase or decrease in cash for the period. This amount is then added to or subtracted from the beginning-of-period cash balance to obtain the end-of-period cash balance.

13-12 .

INVESTOR INSIGHT Some managers have taken actions that artificially increase cash flow from operating activities. WorldCom disclosed that it had improperly capitalized expenses which increased “Cash from operating activities.” Dynegy restated its cash flow statement because it had improperly included in operating activities $300 million from natural gas trading. For what reasons might managers at WorldCom and at Dynegy take these actions? Answer: Analysts increasingly use cash-flow-based measures of income, such as cash flow provided by operations, in addition to net income. More investors now focus on cash flow from operations and some compensation contracts now have bonuses tied to cash-flow numbers. Thus, some managers have taken actions that artificially increase cash flow from operations.

Preparing the Statement of Cash Flows. 1. Companies prepare the statement of cash flows differently from the three other basic financial statements. It is not prepared from an adjusted trial balance because the trial balance will not provide the necessary data. The information to prepare the statement of cash flows usually comes from three sources:

13-13

Comparative balance sheets.

Current income statement.

Additional information.

2. Preparing the statement of cash flows from these data sources involves three major steps: a.

Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. Determining net cash provided/used by operating activities involves analyzing not only the current year’s income statement but also comparative balance sheets and selected additional data.

Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or disclose as noncash transactions. This step involves analyzing comparative balance sheet data and selected additional information for their effects on cash.

Compare the net change in cash on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree.

3. A company must convert net income from an accrual basis to a cash basis to determine net cash provided/used by operating activities by using either (1) the indirect method or (2) the direct method.

TEACHING TIP

ILLUSTRATION 13-4 identifies the process of converting accrual basis net income to net cash provided/used by operating activities. Point out to students that either the indirect or direct method may be used to convert accrual basis net income to a cash basis. Using either method will yield the same result. F.

Preparing the Statement of Cash Flows—Indirect Method. 1. Step 1: Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. a.

13-14 .

Under the accrual basis of accounting, net income is not the same as net cash provided by operating activities.

Companies must adjust net income to convert certain items to the cash basis.

Noncash charges (depreciation expense, amortization, depletion) and losses in the income statement are added back to net income and gains are deducted which results in net cash provided by operating activities.

TEACHING TIP

ILLUSTRATION 13-5 lists some of the typical noncash items that are either added to or deducted from net income in calculating net cash provided /used by operating activities. d.

A final adjustment in reconciling net income to net cash provided by operating activities involves examining all changes in current asset and current liability accounts.

Deduct from net income increases in current asset accounts, and add to net income decreases in current asset accounts, to arrive at net cash provided by operating activities.

TEACHING TIP

ILLUSTRATION 13-6 identifies the noncash current assets and current liabilities that are used in adjusting net income to a cash basis. (1) When the Accounts Receivable balance increases, cash receipts are lower than revenue earned under the accrual basis. The company deducts from net income the amount of the increase in accounts receivable, to arrive at net cash provided by operating activities.

13-15

Increases in current liability accounts are added to net income, and decreases in current liability accounts are deducted from net income, to arrive at net cash provided by operating activities. (1) When the Accounts Payable balance increases, operating expenses on an accrual basis are higher than they are on a cash basis because expenses are incurred for which payment has not taken place. The company adds to net income the amount of the increase in accounts payable to arrive at net cash provided by operating activities.

TEACHING TIP

ILLUSTRATION 13-7 provides a short problem example of the calculation of net cash provided by operating activities using the indirect method. (The same problem data will be used in Illustration 13-8 to demonstrate the direct method calculation.) ACCOUNTING ACROSS THE ORGANIZATION In recent years, General Motors has seen its market share erode until the company reached the point where it actually consumed more cash than it generated. In the long term, GM must either increase its market share, or shrink its operations to fit its sales figures. Why does GM’s cash provided by operating activities drop so precipitously when the company’s sales figures decline. Answer: GM’s cash inflow is directly related to how many cars it sells. But many of its cash outflows are not tied to sales—they are “fixed.” For example, many of its employee payroll costs are very rigid due to labor contracts. Therefore, even though sales (and therefore cash inflows) fall, these cash outflows don’t decline.

13-16 .

2. Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or as noncash investing and financing activities. a.

Increases in any noncurrent asset (Land, Building, Equipment and Long-Term Investments) represent outflows of cash from investing activities. Decreases represent inflows of cash from investing activities.

Increases in long-term debt (Bonds Payable) or paid-in capital (Common Stock) accounts represent cash inflows from financing activities. Decreases in long-term debt or paid-in capital accounts represent cash outflows from financing activities as does the payment of dividends.

3. Step 3: Compare the net change in cash on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree. G.

Using Cash Flows to Evaluate a Company. 1. In the statement of cash flows, cash provided by operating activities is intended to indicate the cash-generating capability of the company. 2. Cash provided by operating activities fails to take into account that a company must invest in new fixed assets just to maintain its current level of operations. 3. Free cash flow is a measurement that provides additional insight regarding a company’s cash generating ability. 4. Free cash flow is calculated as cash provided by operations less capital expenditures and cash dividends.

*H. Preparing the Worksheet—Indirect Method. The steps in preparing a worksheet are: a.

13-17

Enter in the balance sheet accounts section the balance sheet accounts and their beginning and ending balances.

*I.

Enter in the reconciling columns of the worksheet the data that explain the changes in the balance sheet accounts other than cash and their effects on the statement of cash flows.

Enter on the cash line and at the bottom of the worksheet the increase or decrease in cash. This entry should enable the totals of the reconciling columns to be in agreement.

Statement of Cash Flows—Direct Method. 1. Step 1: Determine the net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. a.

Companies compute net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. (1) Increase in accounts receivable: when accounts receivable increase during the year, revenues on an accrual basis are higher than cash receipts from customers. (2) Increase in accounts payable: when accounts payable increase during the year, purchases on an accrual basis are higher than they are on a cash basis.

Companies report only major classes of operating cash receipts and cash payments; the difference between cash receipts and cash payments is the net cash provided by operating activities.

TEACHING TIP

ILLUSTRATION 13-8 provides a short in-class example of the calculation of net cash provided by operating activities using the direct method. It is based on the same problem data as Illustration 13-7 (indirect method). Point out to the students that either the direct or indirect method yields the same net cash from operating activities.

13-18 .

2. Step 2: Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or as significant noncash activities. a.

Increases in any noncurrent assets (Land, Building, Equipment and Long-Term Investments) represent outflows of cash from investing activities. Decreases represent inflows of cash from investing activities.

Increases in long-term debt (Bonds Payable) or paid-in capital accounts (Common Stock) represent cash inflows from financing activities. Decreases in long-term debt or paid-in capital accounts represent cash outflows from financing activities as does the payment of dividends.

3. Step 3: Compare the net change in cash on the statement of cash flows with the change in the cash account reported on the balance sheet to make sure the amounts agree.

13-19

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Inflows and outflows from investing and financing activities should be reported separately on the statement of cash flows. True

In addition to the adjusted trial balance, information for the statement of cash flows is taken from comparative balance sheets and the current income statement. True

False

The amortization of a patent is added back to net income to arrive at net cash provided by operating activities. True

10.

False

The only use of a statement of cash flows is to help investors, creditors, and others assess the reasons for the difference between net income and net cash provided by operating activities. True

False

A statement of cash flows starts with net income and adds (or deducts) items that did not affect cash to arrive at net cash provided by operating activities if the indirect method is used. True

False

Cash outflows to purchase property, plant, and equipment would be reported in the investing section of the statement of cash flows. True

False

When accounts receivable increases during the year, revenues on a cash basis are higher than revenues on an accrual basis. True

False

An increase in equipment will increase net cash provided by operating activities. True

False

The purchase of inventory and investments in property, plant, and equipment are considered cash outflows from operations. True

False

The issuance of shares of stock for plant assets is a significant noncash transaction. True

13-20 .

False

Multiple Choice

A company has credit sales of $900,000 and cash sales of $540,000 during the same year that the Accounts Receivable account decreased by $120,000. What was the total of cash receipts from sales? a. $1,320,000. b. $1,560,000. c. $1,020,000. d. $780,000.

Cash inflows from investing activities include a. sale of common stock. b. purchase of equipment. c. sale of land. d. issuance of long-term debt.

Operating activities do not include cash a. inflows from revenue. b. inflows from sale of equipment. c. outflows for income taxes. d. outflows for wages.

Which of the following would decrease net cash provided by operating activities? a. Decrease in short-term notes payable. b. Depreciation expense. c. Decrease in inventory. d. Loss on sale of equipment.

Noncash investing and financing activities a. may represent significant investing and financing activities. b. do not involve cash receipts or cash payments. c. are disclosed on a separate schedule. d. all of the above.

13-21

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False False False False

Multiple Choice 1. 2. 3. 4. 5.

b. c. b. a. d.

13-22 .

6. 7. 8. 9. 10.

True True False True True

ILLUSTRATION 13-1 TYPICAL RECEIPTS AND PAYMENTS CLASSIFIED BY ACTIVITY

13-23

ILLUSTRATION 13-2 INFORMATION SOURCES FOR ACTIVITIES

13-24 .

ILLUSTRATION 13-3 FORMAT OF THE STATEMENT OF CASH FLOWS

13-25

ILLUSTRATION 13-4 CONVERTING NET INCOME TO NET CASH PROVIDED (USED) BY OPERATING ACTIVITIES

13-26 .

ILLUSTRATION 13-5 OPERATING ACTIVITIES—INDIRECT METHOD ADJUSTMENTS FOR NONCASH ITEMS

13-27

ILLUSTRATION 13-6 OPERATING ACTIVITIES—INDIRECT METHOD ADJUSTMENTS FOR CURRENT ASSETS AND LIABILITIES

13-28 .

ILLUSTRATION 13-7 CASH FLOWS FROM OPERATING ACTIVITIES— INDIRECT METHOD

13-29

ILLUSTRATION 13-7 (Continued) CASH FLOWS FROM OPERATING ACTIVITIES— INDIRECT METHOD

13-30 .

ILLUSTRATION 13-8 CASH FLOWS FROM OPERATING ACTIVITIES— DIRECT METHOD

13-31

ILLUSTRATION 13-8 (Continued) CASH FLOWS FROM OPERATING ACTIVITIES— DIRECT METHOD

13-32 .

CHAPTER 14 Financial Statement Analysis ASSIGNMENT CLASSIFICATION TABLE Study Objectives

Questions

Brief Exercises

Discuss the need for comparative analysis.

1, 2, 3, 5

Identify the tools of financial statement analysis.

2, 3, 5, 6

Explain and apply horizontal analysis.

3, 4, 5, 25

Describe and apply vertical analysis.

Do It!

Exercises

2, 3, 5, 6, 7

1, 4

1, 3, 4

3, 4, 5, 25

2, 4, 8

2, 3, 4

Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

5, 6, 7, 8, 9, 10, 11,12, 13, 14, 15, 16, 17, 18, 19

2, 9, 10, 11, 12, 13

2, 4

5, 6, 7, 8, 9, 10, 11

1, 2, 3, 4, 5, 6, 7

Understand the concept of earning power, and how irregular items are presented.

20, 21, 22, 23

14, 15

3, 4

12, 13

8, 9

Understand the concept of quality of earnings.

14-1

Problems

ASSIGNMENT CHARACTERISTICS TABLE Problem Number

14-2

Description

Difficulty Level

Time Allotted (min.)

Prepare vertical analysis and comment on profitability.

Simple

20–30

Compute ratios from balance sheet and income statement.

Simple

20–30

Perform ratio analysis, and evaluate financial position and operating results.

Simple

20–30

Compute ratios, and comment on overall liquidity and profitability.

Moderate

30–40

Compute selected ratios, and compare liquidity, profitability, and solvency for two companies.

Moderate

50–60

Compute numerous ratios.

Simple

30–40

Compute missing information given a set of ratios.

Complex

30–40

Prepare income statement with discontinued operations and extraordinary loss.

Moderate

30–40

Prepare income statement with nontypical items.

Moderate

30–40

14-3 E14-13 P14-8 P14-9

DI14-4 BE14-14 BE14-15 DI14-3 E14-12

Q14-20 Q14-21 Q14-22 Q14-23 Q14-24 DI14-4

Decision Making Across the Organization Communication

6. Understand the concept of earning power, and how irregular items are presented.

7. Understand the concept of quality of earnings.

Broadening Your Perspective

P14-3 P14-4 P14-5 P14-7

Financial Reporting Comp. Analysis Exploring the Web

E14-8 BE14-11 E14-9 BE14-12 E14-10 BE14-13 P14-2 E14-5 P14-3 E14-11 P14-5 P14-1 P14-6

Q14-14 Q14-19 Q14-15 BE14-2 Q14-16 BE14-9 Q14-17 BE14-10 Q14-18 DI14-2 DI14-4 E14-6 E14-7

Q14-5 Q14-7 Q14-9 Q14-10 Q14-11 Q14-12 Q14-13

Q14-6 Q14-8 BE14-2

5. Identify and compute ratios used in analyzing a firm’s liquidity, profitability, and solvency.

E14-2 E14-3 E14-4

Q14-4 BE14-2 BE14-4 BE14-8

Q14-3 Q14-5 DI14-4

BE14-2 Q14-25

BE14-7 DI14-1 E14-1 E14-3 E14-4

Q14-4 BE14-2 BE14-3 BE14-5 BE14-6

4. Describe and apply vertical analysis.

Q14-3 Q14-5 DI14-4

BE14-2 Q14-25

3. Explain and apply horizontal analysis.

Q14-5

Q14-2 Q14-3

P14-1

Analysis

Q14-6 BE14-2

BE14-2

Application

2. Identify the tools of financial statement analysis.

Q14-5 BE14-1

Comprehension Q14-1 Q14-2 Q14-3

Knowledge

1. Discuss the need for comparative analysis.

Study Objective

Synthesis

Financial Reporting Comp. Analysis Decision Making Across the Organization Ethics Case All About You

Evaluation

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-Chapter Exercises and Problems

BLOOM’S TAXONOMY TABLE

STUDY OBJECTIVES 1. DISCUSS THE NEED FOR COMPARATIVE ANALYSIS. 2. IDENTIFY THE TOOLS OF FINANCIAL STATEMENT ANALYSIS. 3. EXPLAIN AND APPLY HORIZONTAL ANALYSIS. 4. DESCRIBE AND APPLY VERTICAL ANALYSIS. 5. IDENTIFY AND COMPUTE RATIOS USED IN ANALYZING A FIRM’S LIQUIDITY, PROFITABILITY, AND SOLVENCY. 6. UNDERSTAND THE CONCEPT OF EARNING POWER, AND INDICATE HOW IRREGULAR ITEMS ARE PRESENTED. 7. UNDERSTAND THE CONCEPT OF QUALITY OF EARNINGS.

14-4

CHAPTER REVIEW Characteristics 1.

Financial statement analysis enables the financial statement user to make informed decisions about a company.

When analyzing financial statements, three major characteristics of a company are generally evaluated: (a) liquidity, (b) profitability, and (c) solvency.

(S.O. 1) Comparative analysis may be made on a number of different bases. a. Intracompany basis—Compares an item or financial relationship within a company in the current year with the same item or relationship in one or more prior years. b. Industry averages—Compares an item or financial relationship of a company with industry averages. c. Intercompany basis—Compares an item or financial relationship of one company with the same item or relationship in one or more competing companies.

Tools of Analysis 4.

(S.O. 2) There are three basic tools of analysis: (a) horizontal, (b) vertical, and (c) ratio.

Horizontal Analysis 5.

(S.O. 3) Horizontal analysis, also called trend analysis, is a technique for evaluating a series of financial statement data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage. In horizontal analysis, a base year is selected and changes are expressed as percentages of the base year amount.

Vertical Analysis 6.

(S.O. 4) Vertical analysis, also called common size analysis, expresses each item within a financial statement as a percent of a base amount. Generally, the base amount is total assets for the balance sheet, and net sales for the income statement. For example, it may be determined that current assets are 22% of total assets, and selling expenses are 15% of net sales.

Ratio Analysis

(S.O. 5) A ratio expresses the mathematical relationship between one quantity and another as either a percentage, rate, or proportion. Ratios can be classified as: a. Liquidity ratios—measures of the short-term debt-paying ability. b. Profitability ratios—measures of the income or operating success of an enterprise for a given period of time. c. Solvency ratios—measures of the ability of the enterprise to survive over a long period of time.

There are four liquidity ratios: the current ratio, the acid test ratio, receivables turnover, and inventory turnover.

14-5

The current ratio expresses the relationship of current assets to current liabilities. It is a widely used measure for evaluating a company’s liquidity and short-term debt paying ability. The formula for this ratio is: Current Ratio =

10.

The acid-test or quick ratio relates cash, short-term investments, and net receivables to current liabilities. This ratio indicates a company’s immediate liquidity. It is an important complement to the current ratio. The formula for the acid-test ratio is: Acid-Test Ratio =

11.

Current Assets Current Liabilities

Cash + Short-Term Investments + Receivables (Net) Current Liabilities

The receivables turnover is used to assess the liquidity of the receivables. This ratio measures the number of times, on average, receivables are collected during the period. The formula for the ratio is: Receivables Turnover =

Net Credit Sales Average Net Receivables

Average net receivables can be computed from the beginning and ending balances of the net receivables. A popular variant of the receivables turnover is to convert it into an average collection period in terms of days. This is done by dividing the receivables turnover into 365 days. 12.

Inventory turnover measures the number of times, on average, the inventory is sold during the period. It indicates the liquidity of the inventory. The formula for the ratio is: Inventory Turnover =

Cost of Goods Sold Average Inventory

Average inventory can be computed from the beginning and ending inventory balances. A variant of inventory turnover is to compute the days in inventory. This is done by dividing the inventory turnover into 365 days. 13.

The profitability ratios are explained in review points 14 to 23.

14.

Profit margin is a measure of the percentage of each sales dollar that results in net income. The formula is: Profit Margin =

15.

Asset turnover measures how efficiently a company uses its assets to generate sales. The formula for this ratio is: Asset Turnover =

16.

Net Sales Average Assets

Return on assets is an overall measure of profitability. It measures the rate of return on each dollar invested in assets. The formula is: Return on Assets =

14-6

Net Income Net Sales

Net Income Average Assets

17.

Return on common stockholders’ equity measures profitability from the common stockholders’ viewpoint. The ratio shows the dollars of income earned for each dollar invested by the owners. The formula is: Net Income Return on Common = Stockholders’ Equity Average Common Stockholders’ Equity a.

18.

When preferred stock is present, preferred dividend requirements are deducted from net income to compute income available to common stockholders. Similarly, the par value of preferred stock (or call price, if applicable) must be deducted from total stockholders’ equity to arrive at the amount of common stockholders’ equity used in this ratio. Leveraging or trading on the equity at a gain means that the company has borrowed money at a lower rate of interest than it is able to earn by using the borrowed money. A comparison of the rate of return on total assets with the rate of interest paid for borrowed money indicates the profitability of trading on the equity.

Earnings per share measures the amount of net income earned on each share of common stock. The formula is:

Earnings per Share =

Net Income Weighted Average Common Shares Outstanding

Any preferred dividends declared for the period must be subtracted from net income. 19.

The price-earnings ratio measures the ratio of market price per share of common stock to earnings per share. It is an oft-quoted statistic that reflects investors’ assessments of a company’s future earnings. The formula for the ratio is: Price-Earnings Ratio =

20.

Market Price per Share of Stock Earnings per Share

The payout ratio measures the percentage of earnings distributed in the form of cash dividends. The formula is: Payout Ratio =

Cash Dividends Net Income

Companies with high growth rates generally have low payout ratios because they reinvest most of their income into the business. 21.

There are two solvency ratios: debt to total assets and times interest earned.

22.

The debt to total assets ratio measures the percentage of total assets provided by creditors. The formula for this ratio is: Total Debt Debt to Total = Assets Ratio Total Assets The adequacy of this ratio is often judged in the light of the company’s earnings. Companies with relatively stable earnings, such as public utilities, have higher debt to total assets ratios than cyclical companies with widely fluctuating earnings, such as many high-tech companies.

14-7

23.

Times interest earned measures a company’s ability to meet interest payments as they become due. The formula is: Times Interest Earned

Income before Income Taxes and Interest Expense = Interest Expense

Discontinued Operations 24.

(S.O. 6) Discontinued operations refers to the disposal of a significant component of a business, such as eliminating an entire activity or eliminating a major class of customers. a. When the disposal occurs, the income statement should report both income from continuing operations and income (loss) from discontinued operations. b. The income (loss) from discontinued operations consists of (1) income (loss) from operations and (2) gain (loss) on disposal of the segment. c. Both components are reported net of applicable taxes in a section entitled Discontinued operations, which follows Income from continuing operations.

Extraordinary Items 25.

Extraordinary items are events and transactions that meet two conditions: (a) unusual in nature and (b) infrequent in occurrence. a. To be “unusual,” the item should be abnormal and only incidentally related to customary activities of the entity. b. To be “infrequent,” the item should not be reasonably expected to recur in the foreseeable future. c. Extraordinary items are reported net of taxes in a separate section of the income statement immediately below Discontinued operations.

Changes in Accounting Principle 26.

A change in an accounting principle occurs when the principle used in the current year is different from the one used in the preceding year. Companies report most changes in accounting principle retroactively. That is, they report both the current period and previous periods using the new principle.

Income Statement with Irregular Items 27.

A partial income statement showing the additional sections and the material items not typical of regular operations is as follows: Income Statement (partial) Income before income taxes ............................................................................ Income tax expense ........................................................................................... Income from continuing operations ................................................................. Discontinued operations: Loss from operations of discontinued division, net of $XXX income tax savings ........................................................... Gain on disposal of division, net of $XXX income taxes...................... Income before extraordinary item.................................................................... Extraordinary item: Gain or loss, net of $XXX income taxes........................................... Net Income...........................................................................................................

14-8

$XXX XXX XXX $XXX XXX

XXX XXX XXX $XXX

28.

Comprehensive income includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.

Quality of Earnings 29.

(S.O. 7) In evaluating the financial performance of a company, the quality of a company’s earnings is of extreme importance to analysts. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of financial statements.

30.

Variations among companies in the application of generally accepted accounting principles— alternative accounting methods—may hamper comparability and reduce quality of earnings.

31.

In recent years, many companies have been also reporting a second measure of income called pro forma income—which excludes items that the company thinks are unusual or nonrecurring. Because many companies have abused the flexibility that pro forma numbers allow, it is an area that will probably result in new rule-making.

14-9

LECTURE OUTLINE A.

Basis of Financial Statement Analysis. 1. Analyzing financial statements involves evaluating three characteristics: a company’s liquidity, profitability, and solvency. a.

A short-term creditor (a bank) is primarily interested in liquidity—the ability of the borrower to pay obligations when they come due.

A long-term creditor (a bondholder) looks to profitability and solvency measures that indicate the company’s ability to survive over a long period of time.

Stockholders look at the profitability and solvency of the company. They want to assess the likelihood of dividends and the growth potential of the stock.

2. Comparison of financial information can be made on a number of different bases.

Intracompany basis: compares an item or financial relationship within a company in the current year with the same item or relationship in prior years.

Industry averages: compares an item or financial relationship of a company with industry averages (norms) published by Dun & Bradstreet, Moody’s, and Standard & Poor’s.

Intercompany basis: compares an item or financial relationship of one company with the same item or relationship in one or more competing companies.

Tools of Financial Statement Analysis. 1. Horizontal analysis (trend analysis) is a technique for evaluating a series of financial statement data over a period of time to determine the increase or decrease that has taken place, expressed as either an amount or a percentage.

14-10 .

TEACHING TIP

ILLUSTRATION 14-1 provides a horizontal analysis of sales over a three-year period. Emphasize that trends are observed by viewing the changes in an item over a number of years. 2. Vertical analysis (common-size analysis) is a technique that expresses each financial statement item as a percent of a base amount. A benefit of vertical analysis is that it enables one to compare companies of different sizes.

TEACHING TIP

ILLUSTRATION 14-2 provides an example of vertical analysis of an income statement. Point out to students that vertical analysis can be applied to a single company over a number of years to analyze changes in the composition of the statement items. Also it can be applied on a comparative (common size) basis to different companies regardless of company size. 3. Ratio analysis expresses the relationship among selected items of financial statement data. The relationship is expressed in terms of either a percentage, a rate, or a simple proportion. 4. Ratios can be classified as follows:

14-11

Liquidity ratios: measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash.

Profitability ratios: measure the income or operating success of a company for a given period of time.

Solvency ratios: measure the ability of a company to survive over a long period of time.

5. Liquidity ratios.

TEACHING TIP

ILLUSTRATION 14-3 provides a listing of the liquidity ratios; the formulas for calculation; and their major purpose or use. a.

The current ratio is a widely used measure for evaluating a company’s liquidity and short-term debt paying ability. It is computed by dividing current assets by current liabilities.

The acid-test (quick) ratio is a measure of a company’s immediate short-term liquidity. One computes this ratio by dividing the sum of cash, short-term investments, and net receivables by current liabilities.

Receivables turnover is used to assess the liquidity of receivables. Companies compute this ratio by dividing net credit sales by the average net receivables during the year. One computes the average collection period in days by dividing receivables turnover ratio into 365 days.

Inventory turnover measures the number of times, on average, the inventory was sold during the period. Companies compute the inventory turnover by dividing cost of goods sold by the average inventory during the year. One computes the average days in inventory by dividing inventory turnover into 365 days.

6. Profitability ratios.

TEACHING TIP

ILLUSTRATION 14-4 provides a listing of the profitability ratios; the formulas for calculation; and their major purpose or use. a.

14-12 .

Profit margin is a measure of the percentage of each dollar of sales that results in net income. Companies compute it by dividing net income by net sales.

Asset turnover measures how efficiently a company uses its assets to generate sales. It is computed by dividing net sales by average assets.

An overall measure of profitability is return on assets. One computes this ratio by dividing net income by average assets.

Return on common stockholders’ equity shows how many dollars of net income the company earned for each dollar invested by the owners. Companies compute it by dividing net income by average common stockholders’ equity. (1) When a company has preferred stock, it must deduct preferred dividend requirements from net income to compute income available to common stockholders. (2) Companies deduct the par value of preferred stock (or call price) from total stockholders’ equity to determine the amount of common stock equity used in the denominator. (3) Trading on the equity at a gain is borrowing money at a lower rate of interest than can be earned by using the borrowed money.

14-13

Earnings per share is a measure of the net income earned on each share of common stock. It is computed by dividing net income by the number of weighted average common shares outstanding during the year.

The price-earnings ratio is a measure of the ratio of the market price of each share of common stock to the earnings per share. One computes it by dividing the market price per share of the stock by earnings per share.

The payout ratio measures the percentage of earnings distributed in the form of cash dividends. Companies compute it by dividing cash dividends by net income.

7. Solvency ratios.

TEACHING TIP

ILLUSTRATION 14-5 provides a listing of the solvency ratios, the formulas for calculation, and their major purpose or use. a.

The debt to total assets ratio measures the percentage of the total assets that creditors provide. One computes it by dividing total debt (both current and long-term liabilities) by total assets.

Times interest earned (interest coverage ratio) provides an indication of the company’s ability to meet interest payments as they come due. Companies compute it by dividing income before interest expense and income taxes by interest expense.

INVESTOR INSIGHT Today, investors have access to information provided by corporate managers that used to be available only to professional analysts. Corporate managers have always made themselves available to security analysts for questions at the end of every quarter, but now the average investor can listen in on these discussions. If you want to keep current with the financial and operating developments of a company in which you own shares, what are some ways you can do so? Answer: You can obtain current information on your investments through a company’s Web site, financial magazines, and newspapers, CNBC television programs, investment letters, and a stockbroker.

14-14 .

Earning Power and Irregular Items. Earning power means the normal level of income to be obtained in the future. Irregular items include (a) discontinued operations, and (b) extraordinary items. 1. Discontinued operations refers to the disposal of a significant component of a business. Examples involve stopping an entire activity or eliminating a major class of customers. a.

The income (loss) from discontinued operations consists of the income (loss) from operations and the gain (loss) on disposal of the segment.

The discontinued operations section reports both the operating income (loss) and the gain (loss) on disposal net of applicable income taxes.

2. Extraordinary items are events and transactions that are: a.

Unusual in nature.

Infrequent in occurrence. (1) To be “unusual,” the item should be abnormal and only incidentally related to the company’s customary activities. (2) To be “infrequent,” the item should not be reasonably expected to recur in the foreseeable future.

TEACHING TIP

Use ILLUSTRATION 14-6 to distinguish between extraordinary and ordinary items. Emphasize the location of each item in the income statement and point out that extraordinary items should be reported net of taxes. c.

. 14-15

Companies report extraordinary items net of taxes in a separate section of the income statement, immediately below discontinued operations.

INVESTOR INSIGHT Many companies incur restructuring charges as they attempt to reduce costs. They often label these items in the income statement as “non-recurring” charges to suggest that they are isolated events which are unlikely to occur in future periods. If a company takes a large restructuring charge, what is the effect on the company’s current income statement versus future ones? Answer: The current period’s net income can be greatly diminished by a large restructuring charge, while the net income in future periods can be enhanced because they are relieved of costs (i.e., depreciation and labor expenses) that would have been charged to them. 3. A change in accounting principle occurs when the principle used in the current year is different from the one used in the preceding year. Accounting rules permit a change when management can show that the new principle is preferable to the old principle. 4. Companies report most changes in accounting principle retroactively. They report both the current period and previous periods using the new principle.

TEACHING TIP

ILLUSTRATION 14-7 presents a partial income statement that includes intraperiod tax allocation and separate sections for discontinued operations and extraordinary items. Emphasize that the items that are not typical of regular operations are reported net of taxes. 5. Comprehensive income includes all changes in stockholders’ equity during a period except those resulting from investments by stockholders and distributions to stockholders.

14-16 .

Quality of Earnings. 1. In evaluating the financial performance of a company, the quality of a company’s earnings is of extreme importance to analysts. A high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements. Issues related to quality of earnings are:

14-17

Alternative accounting methods. Variations among companies in the application of generally accepted accounting principles may hamper comparability and reduce quality of earnings.

Pro forma income. Pro forma income usually excludes items that the company thinks are unusual or nonrecurring. Many analysts are critical of using pro forma income because these numbers often make companies look better than they really are.

Improper recognition. Because some managers have felt pressure from investors to continually increase earnings, they have manipulated the earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue.

20 MINUTE QUIZ Circle the correct answer. True/False 1.

Intercompany comparison refers to comparison with other companies to provide insight into competitive position. True

Vertical analysis determines the percentage increase or decrease that has taken place over a period of time. True

False

Extraordinary gains and losses should be disclosed in the income statement immediately below discontinued operations net of taxes. True

10.

False

The debt to total assets ratio measures the percentage of total assets provided by longterm creditors. True

False

The formula for computing times interest earned is income before income taxes and interest expense divided by interest expense. True

False

Profit margin, return on assets, and return on common stockholders’ equity are profitability ratios. True

False

Receivables turnover, inventory turnover, and asset turnover are all common measures of liquidity. True

False

Liquidity ratios measure the ability of an enterprise to survive over a long period of time. True

False

A base year is determined when performing horizontal analysis. True

False

To compute pro forma income, companies generally can exclude any items they deem inappropriate for measuring their performance. True

14-18 .

False

Multiple Choice

Sales (in millions) for a three year period are: Year 1 $6, Year 2 $6.9, and Year 3 $7.5. Using Year 1 as the base year the percentage increase in sales in Years 2 and 3 are, respectively a. 115% and 125%. b. 115% and 109%. c. 115% and 130%. d. 87% and 80%.

An incorrect formula is a. current ratio = current assets ÷ current liabilities. b. receivables turnover = net credit sales ÷ average net receivables. c. asset turnover = net income ÷ average assets. d. payout ratio = cash dividends ÷ net income.

The acid-test ratio a. is a solvency ratio. b. measures immediate short-term liquidity. c. includes inventory in the numerator of the formula. d. includes total liabilities in the denominator of the formula.

The ratio that measures the overall profitability of assets is a. profit margin. b. asset turnover. c. return on common stockholders’ equity. d. return on assets.

Which of the following would least likely be considered an extraordinary item? a. Loss from fire destruction. b. Loss from meteorite destruction. c. Gain on sale of company vehicle. d. Gain on property taken over by a foreign government.

14-19

ANSWERS TO QUIZ True/False 1. 2. 3. 4. 5.

True False True False False

Multiple Choice 1. 2. 3. 4. 5.

a. c. b. d. c.

14-20 .

6. 7. 8. 9. 10.

True True False True True

ILLUSTRATION 14-1 HORIZONTAL ANALYSIS

14-21

ILLUSTRATION 14-2 VERTICAL ANALYSIS

14-22 .

ILLUSTRATION 14-3 LIQUIDITY RATIOS

14-23

ILLUSTRATION 14-4 PROFITABILITY RATIOS

14-24 .

ILLUSTRATION 14-5 SOLVENCY RATIOS

14-25

ILLUSTRATION 14-6 EXTRAORDINARY ITEMS

14-26 .

ILLUSTRATION 14-7 PARTIAL INCOME STATEMENT

14-27