Chapter 3 Solutions

Chapter 3 - Basic Cost Management Concepts

CHAPTER 3: BASIC COST MANAGEMENT CONCEPTS QUESTIONS 3-1

Cost assignment refers to the general case of assigning costs to cost pools or cost objects. When there is a direct and traceable link between the cost and the cost pool or cost object, then the management accountant traces that cost to the cost pool or cost object. When there is an indirect link between the cost and the cost pool or cost object, then the management accountant uses cost allocation. Cost allocation uses cost drivers to assign the cost.

3-2

Direct costs can be physically identified with and/or traced to the cost object because there is a direct causal link between them. Indirect costs cannot be traced to each cost object. Direct costs for a manufactured product include the materials (called direct materials) which are part of the product and the labor (called direct labor) which is used to assemble the product. Indirect costs include the machinery, plant and other labor necessary to manufacture the product, but which is not directly traceable to the product, such as labor for inspection and supervision.

3-3

All direct costs are variable by definition since they can be directly traced to the cost object, and thus must vary with the cost driver.

3-4

All fixed costs must be indirect, since the increase in the cost driver or volume of output does not affect the level of fixed cost.

3-5

A cost driver is any activity that has the effect of changing the level of total cost.

3-6

Variable costs are those for which total cost changes with each change in the cost driver. Fixed costs are the portion of total cost which remains constant as the cost driver changes.

3-7

A step-fixed cost varies with the cost driver, but in discrete steps. Costs remain fixed over narrow ranges of the cost driver. However, total costs increase by a constant amount at set intervals. Examples of step-fixed costs are the costs for certain clerical tasks, order filling, and other administrative tasks. At specific levels of the cost driver, an additional clerk must be added. Therefore, total costs increase by a constant amount at these points.

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Chapter 3 - Basic Cost Management Concepts

3-8

The relevant range is the range of the cost driver for which total cost is approximately linear. The relevant range is used to provide a useful range of activity for the cost driver in which it can be assumed that variable costs will be constant per unit of the cost driver. This is an assumption since the behavior of actual costs is likely to be non-linear (see Exhibit 3-6) over the range of the cost driver. The concept of the relevant range allows the management accountant to use the concept of constant unit variable cost for a defined range of operations, even though actual unit variable costs change over the entire range of the cost driver.

3-9

Conversion costs are the sum of direct labor and overhead costs. Prime costs are the sum of direct materials and direct labor.

3-10 Average cost can be misleading unless the activity level (denominator) is known. Because average cost includes a fixed cost component, it will be different at each possible activity level. The term average cost is meaningless if the denominator is unknown. An increase in volume does not increase total cost by the amount of the increase in volume multiplied by total unit cost; total cost increases by the increase in volume multiplied by the unit variable cost. 3-11

Total variable costs increase as the cost driver increases. Total fixed costs remain constant as the cost driver increases. Average variable costs remain constant as the cost driver increases. Average fixed costs decrease as the cost driver increases.

3-12 Unit cost is the additional cost that is incurred as the cost driver increases by one unit. 3-13 Product costs are costs which are capitalized as assets, or inventoried. They are referred to as manufacturing costs in manufacturing firms and merchandise inventory in merchandising firms. Period costs are expensed as they are incurred because there is no expectation that they will provide any future benefit to the firm. Since period costs are not directly or indirectly related to the production process, they are sometimes called non-manufacturing costs. 3-14 Cost of goods manufactured is the cost of the units produced this period and transferred into finished good inventory. Cost of goods sold is the cost of the units sold this period. Cost of goods sold will differ from cost of goods manufactured because of changes in finished goods inventory. If finished goods inventory is very nearly the same from the beginning to the end of the period, then cost of goods sold and cost of goods manufactured will be very nearly the same.

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Chapter 3 - Basic Cost Management Concepts

3-15 The types of inventory in manufacturing firms are: 1. materials inventory 2. work-in-process inventory 3. finished products inventory 3-16 Both accuracy and timeliness are important attributes of cost information. Accuracy is important because effective planning and decision making require accurate cost information. The same is true for effective decision making. 3-17 Executional cost drivers include employee empowerment, design of the production process or work place, and management of supplier relationships. 3-18 Structural cost drivers include scale, experience, technology, and complexity 3-19 Indirect materials include items used in the production process that are not included in the product itself; rags and small tools, lubricant for the machines, etc. 3-20

Indirect labor includes labor that is used in the manufacturing process but cannot be traced to each product as it is produced; indirect labor includes supervision, inspection (by batch, because inspection of each and every product would be a variable cost), training, etc.

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Chapter 3 - Basic Cost Management Concepts

BRIEF EXERCISES 3-21

The answer depends on what you consider the cost object. Suppose we consider the flight as the cost object, then the variable costs should include fuel and the flight team, and any meals or other products provided to passengers on the flight. If the object is the individual passenger, then the list of variable costs is shorter, since fewer costs are actually caused by the addition of another passenger – perhaps only beverages. While the cost of the aircraft and most airline staff would be clearly fixed costs for either type of cost object, some types of airline staff, such as baggage handlers and gate attendants might be variable with the flight.

3-22 We start with the cost object, which in this case could be the item of merchandise sold. Then the variable costs are the cost of merchandise and the selling costs for the cashiers and restocking. For a large discount retailer, most other costs will be driven by the number of hours open each week, and the variety of merchandise handled. For other types of retailers (not discounters), sales commissions might be an applicable variable cost. 3-23 The cost object for a movie theater could be the number of films being shown, or the number of screens. The cost of renting the movie from the film producer is the main cost. The key driver of revenue (not cost) is the number of ticket holders – for ticket revenue and also revenue from sales of food and beverages. Some costs will also be driven by the number of ticket holders, such as the cost of food and beverages. The cost of staff is likely to be a step cost, which depends on the expected number of ticket holders for each different day in the week, and time of day. Other facilities costs are likely to be fixed for the number of ticket holders, or number of films being shown. 3-24

The cost object here is more readily identified – the beer product, whether measured in individual bottles or larger quantities. The variable costs will be significant here, including the ingredients that go into the brewing of beer. Other costs for the brewery are likely to be fixed for this cost object, but there are important activity costs which will vary with, for example, the number of customers/distributors (delivery and account management costs), the number of different types of beer, or the complexity of the brewing process for the brewery (a brewery that specializes in the more expensive beers require more costly ingredients, processing time, and different packaging).

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Chapter 3 - Basic Cost Management Concepts

3-25 Here it is plausible to consider the individual lesson as the cost object. Variable costs would include that portion of the trainers’ pay which is based on each lesson (the salary portion of the trainers’ pay would be fixed for this cost object). Other variable costs could include any materials that are used for each lesson, and perhaps the travel cost to each client, if the company reimburses the trainers for miles traveled. 3-26 $200 + $13,400 -$400 = $13,200 3-27 $2.6 + $10 = $12.6 million 3-28 $66,000 + $98,000 +($22,000 - $1,000) - $2,000 = $183,000 3-29 $400,000 + $1,600,000 - $200,000 = $1,800,000 cost of goods sold 3-30 Period cost includes interest, advertising, and office expense: $4,000 + $2,500 + $14,000 = $20,500

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Chapter 3 - Basic Cost Management Concepts

EXERCISES 3-31 Fares and Fees in the Airline Industry (15 min) Very much like the consumer products industry (Procter & Gamble as an example) introduced at the start of the chapter, the airline industry is characterized by a high degree of complexity in pricing – both fares and fees. 1.

It is likely most will argue that the airline industry is a cost leadership industry. Most passengers look for the lowest price ticket and see very little difference between airlines in terms of quality, reliability, or service. On the other hand, airlines would very much like to build a “brand loyalty” by providing certain free services and customer service. Whether this will work is a good question for class discussion. One point that should arise in the discussion is to determine whether the airline business is a commodity business. Can a customer differentiate the different carriers? Another issue is the airlines’ desire for more control over the purchasing of tickets. Could this approach help them develop a brand, or simply add to the complexity and frustration of the consumer? On the other hand, some travel analysts have questioned the impartiality of the available Web sites passengers use to purchase tickets; arguments of this nature could drive the development of new search engines and away from airlines that did not participate in trusted, independent Web search sites. If the number of Web sites increases, as some in the travel industry expect, then it is likely to place more price pressure on the airlines and reinforce the commodity view of the industry.

2. The complexity of fees and fares presents a challenge for the consumer, and an opportunity for search sites such as Expedia to assist passengers in getting the flight they want at the lowest price. From the airlines’ point of view, the complexity presents an opportunity for revenue growth (fees for various services such as checked baggage, priority seating, etc.). Does the additional complexity increase the operating costs of the airline?

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Chapter 3 - Basic Cost Management Concepts

3-31 (continued -1) It is likely that the additional complexity in fares and fees will affect the airlines’ costs for the cost of additional time and materials in processing fee payments and in assisting customers. Of course, the additional fees are very likely to cover these additional costs. Source: Jad Mouawad and Claire Cain Miller, “Search for Low Airfares Gets More Competitive,” The New York Times, February 10, 2011; Gary Stoler, “Fee-fi-fo-fum, Airline Charges Leave Some Travelers Numb,” USA Today, September 20, 2011, p B1. For a contrasting view, see, Loizos Hereacleous and Jochen Wirtz, “Singapore Airlines Balancing Act,” Harvard Business Review, July-August 2010, pp. 145-149. The authors argue that Singapore Airlines simultaneously competes on cost leadership and differentiation. The authors further argue that this competition is common in Asian airlines. The authors call this a “dual strategy.”

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Chapter 3 - Basic Cost Management Concepts

3-32 Complexity of Operations and the Effect on Cost (15 min) The observations made by the consultant show that the manufacturer was incurring large costs in operations, distribution, and administration due to the high level of complexity in its products. Maintaining relationships with 10 vendors for a single item contributed to high purchasing and stocking costs. Similarly, most of the firm’s volume was made up of products with five color combinations, with the result that manufacturing, warehousing, shipping and selling costs were high relative to fewer color combinations. Also, the high product variety required smaller batch production and more frequent set-ups, which caused increased manufacturing costs. Also, the variety of different customers, prices, and promotional programs created increased manufacturing, shipping and customer service costs as well as increased costs in accounting for the customers’ invoices and account balances. The solution? Reduce complexity. This was done by reducing the number of customers; the low value customers were reviewed and some were not continued. Also, a process of review was developed for the introduction of new products or new variations on existing products, to ensure the likely profitability of the new product. Further, the complexity of equipment set-ups was reduced so that the firm could meet the customer’s demands for smaller batch sizes without increasing overall costs. The result of the program was that overall profit margins improved. The firm had found a way to deal with the cost consequences of its strategic initiative. Also, the firm adopted new cost management practices that included new non-financial measures such as set-up time and frequency, percent of orders shipped on time, percent of orders on just-in-time, and number of vendors for the top 20 commodity raw materials items. In addition, the firm began to calculate and regularly review customer profitability, by type of market and customer size.

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Chapter 3 - Basic Cost Management Concepts

Based on information in: Barry Berman, “Products, Products Everywhere,” The Wall Street Journal, August 23, 2010, p R8; “Managing Complexity Through Performance Measurement,” by Frank A. J. Gonsalves and Robert G. Eiler, Management Accounting, August 1996, pp 34-39. 3-33 Classification of Costs (10 min) Parts 1 and 2: 1. Print machine setup costs: activity; product 2. Cost of complexity; the number and variety of products: structural; product 3. Training costs for new staff: structural or executional; product 4. Ink: volume; product 5. Customer service costs: activity; period 6. Paper: volume; product 7. Redesign of the print process to improve efficiency: executional; product 8. Machine operation labor: volume; product 9. Order taking: activity; period 10. Purchasing and stocking paper and other supplies – activity; product

3. The ink could have a harmful environmental impact. The company could choose to use environmentally friendly ink, or dispose of the harmful ink in a proper manner. All waste paper should be properly recycled. 3-9 © 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-34 Classification of Costs (10 min) 1. period 2. product and indirect 3. product and indirect 4. product and direct 5. period (the answer is correct, but note that delivery of materials would be included in inventory cost of the materials if the purchaser paid for delivery) 6. period 7. product and direct 8. period 9. product and indirect (could be direct if electricity is metered and measured for each product) 10. period 11. period 12. product and indirect 13. period 14. period

3-35 Classification of Costs (10 min) 1. direct and variable 2. indirect and fixed 3. indirect and variable 4. indirect and fixed 5. direct and variable 6. indirect and fixed 7. indirect and variable 8. direct and variable 9. indirect and fixed 10. indirect and fixed

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Chapter 3 - Basic Cost Management Concepts

3-36 Classification of Costs (10 min) 1. direct 2. indirect 3. direct 4. indirect 5. direct 6. indirect 7. indirect 8. direct 9. indirect 10. indirect 3-37 Activity Levels and Cost Drivers (10 Min)

Cost Object 1 product line or customer 2 product line or customer 3 product line 4 product line 5 customer order 6 customer order 7 customer order 8 customer order 9 each customer 10 customer order 11 not allocated 12

not allocated

Cost Driver trace to product line, or each custom order requiring design trace to product line, or each custom order requiring testing product line number of purchase orders trace directly to customer trace directly to customer trace directly to customer trace directly to customer trace directly to customer trace directly to customer cannot be traced to product or customer; must be allocated using some reasonable method, for example, number of units produced cannot be traced to product or customer; must be allocated using some reasonable method, for example, the number of units produced 3-11

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Chapter 3 - Basic Cost Management Concepts

3-38 Application of the Direct Cost Concept in the Fashion Industry (15 min) It is always possible, by definition, to trace direct materials and direct labor costs to each unit produced. In some cases, as this one, the most practical approach is to trace the materials and labor costs directly to the batch. This is convenient both for cost management and pricing, since the batch is often for a single customer. This is a preview of job costing, which is the topic of the following chapter, chapter 4.

3-39 Direct Manufacturing Labor: Fixed or Variable? (10 min) The effect of the policy on cost is that labor expense, while fixed in total expenditure, is in reality a variable expense. Labor is flexible and can be moved from job to job or plant to plant as demand dictates; that is, labor cost at the plant level fluctuates with demand at each plant, while total labor cost at the firm stays fixed. Thus, instead of incurring a fixed cost for labor, the company’s total labor costs are flexible and vary with demand, as parttime labor is added when needed. Source: Clara Asbury, “In the Workplace, Jobs Morph to Suit Rapid Pace of Change,” The Wall Street Journal, March 22, 2002, p1.

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Chapter 3 - Basic Cost Management Concepts

3-40 Average and Total Costs (15 min) 1. Total cost: $ 1,500 (fixed cost of space rental) + 1,500 (variable cost of refreshments = $15 x 100) $ 3,000 Average cost: $3,000/100 people = $30.00 per person 2. Total cost: $ 1,500 (fixed cost of space rental) + 3,000 (variable cost of refreshments = $15 x 200) $ 4,500 Average cost: $4,500/200 people = $22.50 per person 3. Average costs decrease as attendance increases because the fixed cost component to total costs is now spread over 100 extra people. Fixed cost per person: $1,500/100 people = $15 $1,500/200 = $ 7.50 Decrease in fixed cost per person $ 7.50 Average cost for 100 people - Decrease per person in fixed costs Average cost for 200 people

$30.00 7.50 $ 22.50

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Chapter 3 - Basic Cost Management Concepts

3-41 Cost Classification for Dance Studio (15 min) 1. While a variety of possible cost objects are possible for the dance studio, the most reasonable choice is the studio since management’s goal is to analyze the profitability of the studios. 2. Studios as the cost object 1. a,c 2. a,c 3. a,c 4. a,c 5. a,c 6. b,c 7. a,c 8. a,d Or, Lessons as the cost object 1. a,d 2. b,d 3. b,d 4. b,d 5. b,d 6. b,d 7. b,d 8. b,d

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Chapter 3 - Basic Cost Management Concepts

3-42 Relevant Range (20 min) This exercise is intended to develop the student’s appreciation of the complexities in cost determination and the importance of considering foreign exchange effects when doing business abroad. 1. The volume-based costs include: a. Fixed costs: administrative costs of management in Austin and Paris and the 16 marketing and customer service locations b. Variable costs: the royalties paid for the images sold, the cost of computer operations personnel, the purchase of small servers as needed c. Step costs: purchase of larger computer servers as needed when demand increases, facilities costs including lease or depreciation expense, insurance, maintenance, security, etc.

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Chapter 3 - Basic Cost Management Concepts

2. The relevant range is applicable for PGI because PGI’s operations centers must grow as demand increases. This means higher variable costs due to the cost of adding small computer servers and the cost of hiring additional staff, etc. Note that the cost of the additional staff would be variable costs, but the cost of adding capacity – additional large servers and new administrative staff – would be a step cost, increasing unit costs. So PGI’s total costs increase in a non-linear, upward-sloping manner over wide ranges of demand. The relevant range is used to determine the level of unit variable cost and total fixed cost for a limited range of activity – a range in which there is no need for additional servers or hiring costs, etc. 3-42 (continued -1) 3. The growth of the company globally means that the company will be more exposed to the effects of foreign currency fluctuations. For example, a falling dollar relative to the Euro will lower the effective cost of PGI’s U.S.-based services to European customers, thereby potentially increasing demand in Europe. Also, the translation of the European earnings in Euros to PGI’s financial statement will mean foreign currency gains, as the Euro earnings are worth more with the falling dollar. The changes in the currency exchange rates can potentially and perhaps significantly affect the company’s earnings in two ways: increased sales and foreign currency exchange gains. The reverse would be true if the dollar were to appreciate relative to the Euro. The same currency issues apply should the company’s business continue to grow in China. In this case, the currency effect is likely to be smaller, since the Chinese currency has not changed much relative to the dollar in recent years.

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Chapter 3 - Basic Cost Management Concepts

3-43 Fixed, Variable and Mixed Costs (10 min) Department A Department B Department C Department D Department E

fixed variable mixed mixed variable

3-44 Fixed, Variable and Mixed Costs (10 min) Department A Department B Department C Department D Department E

mixed mixed fixed variable variable

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Chapter 3 - Basic Cost Management Concepts

3-45 Strategy; Variable and Fixed Costs (20 min) 1. The variable costs for Zipcar would be the same as for any car owner – gasoline (customers do not pay for gas, but instead a simple hourly rate) and upkeep. The fixed cost are the largest part of total cost, the cost of the car, insurance, and the parking spot, among others. 2. The key challenge facing Zipcar is the entrance of competitors such as Hertz and Enterprise car rental agencies. Zipcar has no “barrier to entry,” and is vulnerable to new competition. A good question for class discussion: “How will Zipcar be able to compete effectively against the larger companies?” Is the Zipcar concept a commodity which can be copied and used by the other companies, or are there some features and services that can make Zipcar unique and differentiated? One idea would be to stress that the company uses very small cars to achieve both convenience (in large cities) and a “green” advantage (by Zipcar’s estimate, each car it adds to its fleet keeps up to 20 cars off the road). Another approach might be to emphasize its initiative in the business and its environmental contribution over the last 10 years, ideas that might have traction with those customers who want to make a statement about their commitment to the environment. Since fixed costs are a key component of total costs for the company, the ability of the company to grow at a fast rate is critical. A larger company, with more members and more usage of its vehicles, would be able to more easily cover those fixed costs. As shown in Exhibit 3.11, average fixed costs fall as output increases. Another challenge for Zipcar is the rising cost of gasoline. Because of the short rental periods, it is not practical to have customers refuel the car, and the flat hourly rate is appropriate and convenient. But this also exposes Zipcar to fluctuations in gas prices which must be covered by that fixed hourly rate. Source: “The Business of Sharing,” The Economist, October 14, 2010; Adam Aston, “Growth Galore, but Profits are Zip,” Business Week, September 8, 2008, p 62. Also: Mark Clothier, ”In The Race for the Carless, Can Hertz Outrun Zipcar?” Bloomberg Businessweek, April 2, 2012, pp. 23-24. 3-18 © 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-46 Interpreting Average Cost (15 min) This question is based on a report by Paul Raeburn, “Hybrid Cars: Less Fuel but More Costs,” Business Week, April 15, 2002, p 107. See also information on the history of gas prices from January 2000 to the present at the U.S. Department of Energy website: http://tonto.eia.doe.gov/oog/info/gdu/gaspump.html CAFÉ standards have remained at 27.5 mpg since 2002 but have been increased by 2007 legislation which required 35 mpg by the year 2020. In May 2009, the Obama admiration pushed the 35MPG target back to 2012, and in August 2011 legislation was passed that required 54.5 mpg by 2025. The urgency of energy sustainability, oil independence from non-domestic supplies, and climate change have substantially increased the efforts to improve vehicle efficiency and reduce vehicle emissions. The rapid increase of gasoline prices in 2004-2011 should enhance the interest in the issue discussed. The costs shown for each gallon of gasoline saved look much better in 2011 than in 2002 when the article was written; in 2002 the price of gas averaged $1.30, about 30% of the 2011 price. The cost justification for higher fuel efficiency of the full hybrid would not pass in 2002 (cost of $1.80 per gallon when the price of gas was $1.30), but would surely pass the test in summer 2011, with the price of gas just short of $4.00 per gallon. The main point of this exercise is to have the students understand that the determination of an average cost, as in this report, requires a specification of the level of activity, or output, that drives costs. This is the reason the concept of average cost is often misunderstood and misused in practice. For example, since in this case total cost per gallon of gas depends on both variable costs (gasoline) and fixed costs (vehicle cost), the determination of an average cost requires an assumption of activity level. While variable costs (the price of gasoline) are constant per unit, for the number of gallons purchased, theaverage per-gallon fixed costof purchasing the vehicle will depend on the number of miles traveled. Car owners who travel relatively few miles will have large average fixed costs in contrast to “road warriors” with many miles traveled. 3-19 © 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

3-46 (continued -1) The Business Week report does a good job in this regard by reporting that the assumed activity was 12,000 miles per year for 12 years. This gives the reader a way to interpret the findings; those who drive more than this amount can expect lower “cost for each gallon of gas saved” from improvements in the vehicle, while those who drive fewer miles can expect higher costs than those reported. Instructors can start this exercise by asking the class how average cost is determined in this case. The key idea to bring out is that average fixed cost is determined by some pre-determined activity level. CAFÉ Standards links: http://www.nhtsa.gov/fuel-economy

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Chapter 3 - Basic Cost Management Concepts

3-47 Interpreting Average Cost (15 min) This question is based upon the following: Vincent Ryan, “Treasury: Bigger is Better,” CFO.com, November 9, 2010; “How Does Your Finance Department Measure Up?”Journal of Accountancy, January 1997, pp50-51. The main point of this exercise, as for 3-46 above, is to help the student understand the importance of taking activity levels into account when interpreting average cost information. The two articles show, as represented by the information presented in the exercise, that average fixed costs decline with higher levels of activity. Larger companies, with higher levels of transaction volume, will have higher total fixed costs, but average fixed costs should be lower due to economies of scale. Looked at another way, if a given firm were to grow, and its volume of transactions grew as well, then average fixed costs (or in this case the ratio of total accounting costs to total revenue) would have to fall. Average fixed cost would continue to fall with increasing numbers of transactions, until the firm felt it necessary to increase capacity in the accounting department, thereby increasing fixed costs. Thus, the data presented is as we would expect – larger firms will have lower average costs. We would not expect otherwise. Average fixed costs should be lower for the larger firms.

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Chapter 3 - Basic Cost Management Concepts

3-48 Average Cost (15 min) The percentage increase in total variable manufacturing cost, averaging both labor and fuel costs, is 7.5% for Company A and 6% for Company B. The increase is higher for Company A because it has a higher percent of fuel costs which have risen faster than labor costs. Calculations: 7.5% =(.5 x 5%) + (.5 x 10%) 6% = (.8 x 5%) + (.2 x 10%) The calculations for percentage change shown above hold irrespective of the underlying amounts, as long as the amounts are positive. The example below illustrates:

This example illustrates that two companies that may have the same total variable costs, and facing the same changes in materials or labor costs, will be affected differently if the mix of variable costs are not the same for the two companies. This example is sometimes called the “fallacy of averages.” The takeaway is that averages should be interpreted carefully, and in particular, the management accountant should always consider the components of cost which make up that average, as in the example above.

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Chapter 3 - Basic Cost Management Concepts

3-48 (continued -1) Here is another example. The recession in the early 1980s caused an increase in unemployment for workers at all educational levels. Also, in the great recession, during 2009, the unemployment rates were higher for all educational levels than in 1983. However, the overall unemployment rate in 2009 (10.2%) was lower than the overall unemployment rate in 1983(10.8%). Why? The reason for this apparently confusing result is that the group with the highest educational attainment and lowest unemployment rates in both recessions was a larger percentage of the total employed in 2009 relative to 1983. Since more 2009 workers were in the highly educated group than in 1983, and this group’s unemployment rate was lower (in both periods), the effect was to bring down the overall unemployment rate in 2009 relative to 1983. Source: Carl Bialik, “When Combined Data Reveal the Flaw of Averages,” The Wall Street Journal, December 9, 2009, p A21.

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Chapter 3 - Basic Cost Management Concepts

3-49 Classification of Costs; Customer Profitability Analysis (15 min) 1. Direct (D) or Indirect(I) 1. Staff salaries D 2. Rent on office and work space used I by the company 3. Licenses and fees I 4. Supplies; grooming supplies, and D related items 5. Medications D 6. Legal fees I* 7. Accounting services provided partI time by practicing accountant 8. Pet food D 9. Utilities for office and work space; I electricity and water 10. Fire insurance for office and work I space and its contents 11. Liability insurance for the company I business *It may be possible to trace some portions of legal fees to specific customers, so that the cost would be direct and not indirect

2. Pet Partner could use the information to identify costs that are traceable to each customer (the direct costs) and determine over a period of a month (or year) whether the direct costs traced to the customer are less than or greater than the revenues from the customer, that is, to determine if the customer is profitable or not. A much more thorough means of determining customer profitability analysis is covered in chapter 5, together with activity-based costing.

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Chapter 3 - Basic Cost Management Concepts

3-50 Classification of Costs (15 min) Parts 1 and 2 Fixed(F) or Variable (V)

Product (P) or Period (PD)

1. Food costs including pizza dough, olive oil, tomato sauce, etc. 2. Salaries for drivers 3. Salaries for telephone operators 4. Salaries for cooks 5. Insurance for drivers 6. Utilities; water and electricity

V

P

N* N* N* F V

7. Advertising 8. Discount coupons 9. Food handling licenses, inspections, and fees 10. Accounting and payroll services 11. Cooking supplies 12. Cleaning supplies 13. Mortgage payments 14. Insurance on facilities

F V F

PD PD P P P/PD (allocated to kitchen and other space) PD PD P

F V V F F

PD P P PD PD

*Note for Class Discussion: these costs are fixed unless Papa’s manager schedules drivers, operators, and cooks so as to eliminate slack time, in which case the cost of the drivers, operators, and cooks could be considered variable costs 3. There are a number of possible answers. Inefficiency and waste in the use of utilities or food products could be considered an environmental issue. Also, cleaning supplies should be environmentally-friendly and/or disposed of properly.

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Chapter 3 - Basic Cost Management Concepts

3-51 Classification of Costs (15 Min) Parts 1 and 2

1.Technicians 2.Parts 3.Purchase of oil and tires 4.Supplies 5.Tools 6.Rental of each location 7.Advertising 8. Utilities 9.Licenses and fees 10.Employee training* 11.Security service 12. Software for sales and reports 13. Disposal of waste oil and used tires

Fixed(F) or Variable (V)

Product (P) Period (PD)

F V V V F F F F F F F F V

P P P P P PD PD PD PD P PD PD PD

Employee training is considered a product cost because it is related to direct labor of the technicians. 3. The disposal of waste oil and used tires is the critical environmental issue for Speedy Auto Service. Both the waste oil and used tires, which would accumulate in significant quantities for this type of business, should be disposed of in an environmentally appropriate manner.

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Chapter 3 - Basic Cost Management Concepts

PROBLEMS 3-52 Executional Cost Drivers: Internet Retailer (20 min) The example of an internet retailer such as Bikes.com is a good example of the type of firm that must pay close attention to executional cost drivers. The reason is that its success depends on customer service – prompt response to customer requests, and prompt and accurate filling of customer orders. Customer loyalty is a key success factor for a firm such as this, and loyalty comes from superior customer service in all its dimensions. Amazon.com introduced the successful internet retailing business model, and has built a successful business on the basis of customer loyalty. This is the approach Bikes.com needs to follow – and this means execution, execution, execution. The fall off in sales growth could be an indication of problems in customer sales returns, that is customer satisfaction and loyalty. Bikes.com can review sales records to investigate. Specific executional steps that Bikes.com can take include looking for possible improvements in the purchase and stocking of merchandise and the shipping of customer orders – the upstream and downstream activities that must work smoothly to get the orders to the customers quickly and accurately. Also, Bikes.com should consider the work flow in the company. Can it be streamlined? Are there non-value-adding activities that can be eliminated? What are the bottlenecks, if any, that slow the process of accurately filling a customer’s order? Also, are employees aware of the importance of executional issues? Are the employees working together to achieve the required speed and accuracy necessary for the firm’s success? Executional cost drivers are important to Bikes.com in two ways. First, these are the executional issues which the firm must achieve in a superior way in order to compete effectively in internet retailing. And second, effective attention to the cost drivers and effective cost management can lower the costs of operation and speed the arrival of profits.

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Chapter 3 - Basic Cost Management Concepts

3-53 Structural Cost Drivers (25 min) Case A: A key structural issue for Food Fare is complexity. As the menu has changed, so will costs and service. More complexity means higher food purchasing costs, higher operating costs, and more complex operations. This will require new types of training for employees and perhaps additional employees. Moreover, it will be a challenge for Food Fare to continue to provide the speed of service that was possible with the shorter menu. The change will require careful attention to operations and to cost management issues for the firm to continue to be profitable. Employee training and new uses of technology to streamline the process of order taking and order filling are likely to be necessary. Scale might also be an important issue in this case – how large must each restaurant become, and how many restaurants must the chain have in order to justify the increased purchasing and stocking costs, and the new training and technology costs? Case B: A key issue in this case is the speed with which Gilman can provide customer service. The speed of service provides value to the customer and also increases profitability. In order to increase the speed of service, Gilman needs effective communication and coordination among the service teams. This is probably being accomplished now by cell phone. Gilman can research new and more effective ways to accomplish this, perhaps using hand-held internet access devices, iphones, or other modem-equipped devices. The advantage of computer-based access is that computer-based tools can be used in the scheduling and assignment of the service teams. Additionally, the computer can be used by each service team to quickly determine the availability of parts in the firm’s warehouse or in other service vehicles, thereby allowing faster service time. Also, the computer can be used to develop real-time analyses of customer demand and profitability – in order to better understand which services and which types of customers are most profitable.

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Chapter 3 - Basic Cost Management Concepts

3-53 (continued -1) Is it in installation or service, Brand X or Brand Y, residential or commercial, etc.? Scale is also an important cost driver for Gilman. To serve the large area it now serves, there should be a careful strategic analysis to get the right balance between order getting costs (advertising and promotion to obtain new customers) plus the costs of maintaining the truck fleet and service teams versus the opportunity to provide additional services to existing customers.

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Chapter 3 - Basic Cost Management Concepts

3-54 Cost of Goods Manufactured and Sold (30 min)

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Chapter 3 - Basic Cost Management Concepts

3-55 Cost of Goods Manufactured and Sold (30 min)

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Chapter 3 - Basic Cost Management Concepts

3-56 Cost of Goods Manufactured and Sold (30 min)

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Chapter 3 - Basic Cost Management Concepts

3-57 Cost of Goods Manufactured and Sold (30 min)

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Chapter 3 - Basic Cost Management Concepts

3-58 Cost of Good Manufactured and Income Statement (40 min) 3-34 © 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

Chapter 3 - Basic Cost Management Concepts

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Chapter 3 - Basic Cost Management Concepts

3-58(continued -1)

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