Langfieldsmith 6e SM Ch06

CHAPTER 6

SERVICE COSTING ANSWERS TO REVIEW QUESTIONS 6.1

The distinguishing features of services organisations relate to their outputs; service organisations deliver help, utility or care or provide an experience, information or other intellectual content; and the majority of the value that they create is intangible. According to Australian government industry classifications, the service sector spreads across twelve different industries. Examples of these are the provision of communication services, such as telephone and internet access, accommodation, food and beverages, and transport. In contrast to manufacturing most service outputs exhibit the following features: •

intangible

•

heterogeneous

•

cannot be stored

•

consumed as produced.

(a)

(b)

(c)

Wholesale trading is a service, even though it involves the provision of tangible goods that can be stored and consumed later. Wholesale traders facilitate the transfer of products to retail traders and typically deal in very large volumes of homogeneous products that can be stored. However, there are also wholesale traders of products that cannot be stored, such as holidays. The outputs of cultural and recreational services are intangible, cannot be stored, are consumed as produced and, depending on competitive strategy, may be more or less heterogeneous. The product being consumed is the experience, whether it is a concert, playing or watching sport, or viewing art in an art gallery. The arts (for example, painting, music, ballet, stage plays, sculpture) provide quite homogeneous experiences. However, sports experiences will be heterogeneous. Health and community services more clearly demonstrate all of the common features of service outputs.

6.2

Retail and wholesale businesses are included in the services sector although they do not conform exactly to the definition and distinguishing features of service organisations described in Question 6.1 above. They provide tangible goods for resale but many of them also provide services such as finance, delivery and after-sales service.

6.3

In a university, the salary of a tenured/permanent staff member is a fixed cost. The salary of a sessional or part-time staff member is a variable cost. The cost driver for the sessional staff member is the number of hours per week and the number of weeks per semester that they teach. The university management can use this information to compile a faculty or departmental budget for staffing costs.

6.4

If we assume that the hotel incorporates a bistro, where meals of medium quality are served to encourage patrons, two direct costs relating to the bistro are the cost of food served and the wages (including on-costs) of the waiters who work in the bistro. An indirect cost is that portion of the salary (plus on-costs) of the hotel manager that is allocated to the bistro based on the time the manager spends overseeing the bistro operation. As part of its community promotional activities, the hotel sponsors a local junior football club and the club includes reference to the bistro in its promotional material. This is another indirect cost relating to the bistro. Management may use this information to evaluate the financial performance of the bistro.

6.5

The value chains of manufacturing and service organisations are similar. Both include research and development activities to identify new products (both goods and services) that will satisfy customer needs; both include design of products to meet customer needs; both include marketing activities to attract suitable customers to the product and after-sales support to ensure that the customer is happy after the purchase has been completed. However there are two major differences. One major difference is that the value chain for manufacturers includes a separate delivery (or distribution) segment after the production segment, since there may be a time delay between the

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production and delivery of the product. In service industries, the production and delivery of the service are usually combined, since they occur simultaneously as the service is consumed (services are perishable and cannot be stored). A second difference is that whereas the manufacturer’s value chain includes a supply segment, this does not occur in the service organisation’s value chain. Any consumption of materials, parts or components in service industries is relatively insignificant, as labour is the main cost component. 6.6

In manufacturing, product costs comprise direct materials, direct labour and manufacturing overhead. Direct materials and direct labour, as direct costs, can be traced to the cost object. Manufacturing overhead, as an indirect cost, is allocated. In some service organisations, these cost categories exist in much the same manner. However, many service organisations have little or no direct materials, and their main cost element is direct labour. All other costs are treated as indirect or overhead costs, including minor materials and consumables used in delivering the service. In service organisations, upstream and downstream costs may also be included in overhead costs, as costing of services is not influenced by accounting standards.

6.7

Retailers can focus on their purchasing activities to create competitive advantage by: • cutting out ‘middle-men’, i.e. dealing direct with manufacturers. This enables them to reduce their costs and therefore offer their products to customers at a lower price (while maintaining their profit margins). •

using their direct relationship with manufacturers to − −

improve the quality of the goods that they buy obtain products that are a little different from those available elsewhere (different features or colours maybe) − negotiate lower prices with the manufacturer. (This may also have been possible through the ‘middle-men’, although the benefits of these quantity discounts would not necessarily have been passed on to retailers.) The ability of retailers to use their direct relationship in these ways is likely to depend on the size of the orders that they place. The ‘Real life’ on page 260 provides an interesting example not only of a businesses seeking to create competitive advantage in this way, but of a business using promotional material to leverage this competitive advantage! Retailers could also choose to deal with ethical firms, so publicity could focus on standards being set such as suppliers being environmentally responsible, not employing child labour, not using harmful materials and being good employers.

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6.8 & 6.9 Key features and examples, together with appropriate costing systems are shown below.

6.10

Organisation

Key features

Examples

Costing system

Professional service firm

Mostly professional staff (often in large numbers), but relatively few customers. Emphasis is on how service is delivered rather than what is delivered. High degree of customisation and staff discretion in the service production /delivery. More of a ‘front office’ situation, where staff interact directly with customers.

Accounting and legal practices. Management and other forms of professional consulting. Medical services and architects.

Job costing. Direct costs (mainly labour) can be easily traced to job. Indirect costs (overhead including minor raw materials) allocated, usually based on direct labour.

Service shop

Medium contact time between staff and customers, medium customisation of service and medium discretion in what service is offered. Move away from ‘front office’ towards ‘back office’ orientation.

Hotel chains, banks, insurance offices, cafes and restaurants.

Hybrid costing is appropriate. Job costing where services are different (eg. car repairs, printing) moving towards process costing (or more likely operation costing) where some parts of service are standardised.

Mass service entity

Many customers, with each one requiring limited staff time, little customisation and very little opportunity for staff discretion. Mainly non-professional staff. Back office orientation. Equipment often involved. Emphasis on what is delivered rather than how.

Major transport facilities such as trains, planes and bus services. Postal and telecommunication services. Electricity and gas providers.

In many mass services, similarities in service means that process costing can be used. Modifications needed, depending on the degree of discretion.

Examples of public services that may be suited to the following costing approaches: (a) Job costing is most likely to be appropriate for road building, bridge repairs, building an infant welfare centre and the development of plans for a new skate park. (b) Process costing would be appropriate for processing library loans, collecting cash from parking machines, monitoring parking meters and issuing fines. (c) Hybrid costing methods may be needed for servicing traffic lights, repairing roads and lopping roadside trees. Each job is performed regularly and will be similar but will often differ in terms of time, distance travelled, materials used or equipment required (but not all of these).

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6.11 The WIP report covers the period 30 September 2001 to 2 June 2004. The WIP total of $7235.27 has been calculated by accumulating the charges for services provided (only in April and May 2004) to a corporate client; the services are yet to be finalised and fees are yet to be charged. Time spent by various members of staff on work for the client has been billed, according to their chargeout rates, to the corporate client account. The units refer to five minutes of service which are charged to clients, so that 12 units amount to one hour of service. The hourly chargeout rate for John Irving, an Adelaide partner, was therefore $355 ($1420 ÷ 48 five-minute intervals x 12 five-minute intervals per hour). In contrast the hourly rate for Timothy Boast is $80 ($140 ÷ 21 × 12). Although the chargeout rates already include overheads, the charge of $6.10 for files and stationery may reflect an attempt to adjust the bill for direct costs while maintaining a competitive chargeout rate. In many firms the cost of filing and stationery would be considered trivial, and systems would not be set up to track and charge these resources to specific jobs. This would particularly be the case if jobs all tended to use similar amounts of these resources. In these situations these costs would be spread across all jobs within the chargeout rate. 6.12 When billing systems are used to measure employee performance there is a temptation for the managers to overstate the time spent working for each client. This helps the manager to meet billing targets and may lead to promotion due to exceeding targets. Unfortunately this builds on itself as the next target will be set above the false amount stated, placing even more pressure on the manager next year to overcharge clients by overstating time worked for them. 6.13 Process costing is used where products are homogeneous and tracing direct costs to the cost object is not economically feasible. Total costs for each process are divided by total output, so that the unit cost is essentially an average cost. ‘Mass services’ are produced in large quantities, usually using repetitive processes. On the surface, there would be a prima facie case for using process costing for mass services entities, but it is not always straightforward. While each unit of output requires the same production processes and consumes the same types of resources, each of the ‘experiences’ is not necessarily identical. Over-the-counter banking transactions may appear to be the same, but are not. The same applies to claims made at a Medibank health insurance office. Returning from overseas has often highlighted the ‘luck-of-the-draw’ when choosing a queue to be processed by immigration officials. While similar processes are involved in producing these services different customers may make very different use of them. The greater the degree of discretion in the provision of the service, the less accurate process costing will be in these situations, as each service will consume different amounts of resources, for example staff time. 6.14

Usually manufacturing firms include manufacturing overhead but exclude upstream and downstream costs in the product cost, as per the influence of the Australian accounting standard AASB 102 Inventories, which requires that only manufacturing costs may be included in the product cost for the inventory valuation. As many services are consumed immediately they are produced, there are no inventories. As a consequence, individual service costs are not disclosed separately for financial reporting purposes. Instead service costs are estimated for management purposes, such as pricing their services, and the overhead recovery rate used in service firms usually includes all upstream (and downstream) costs. A software developer would incur relatively large upstream costs in research and development and design. The production and delivery segment of software programs would consist largely of direct labour and support costs. It is highly likely that a software developer would include upstream and downstream costs in the overhead rate as it would wish to recover the upstream costs in particular as soon as possible, given the relatively short life cycle of many software products and services.

6.15 While the Australian accounting standards do not require disclosure of the cost of individual services, it is nonetheless essential in many businesses that managers know the cost of the services they provide. Knowing the cost of the services can help: •

as a basis for setting fees for interior design services offered

•

to assess the profitability of each service

•

to determine which services to promote, refine or withdraw

•

to control costs (although, given the heterogeneity of services in many industries, this may sometimes be of limited value).

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6.16 Many of the examples of service costing are public utilities and government departments. Industries and organisations may wish to estimate service costs to: •

use the estimates in performance evaluation

•

control costs

•

facilitate cost recovery

•

budget for future costs

•

budget the amount of future service provision, given a particular spending allowance (as in government funded service providers).

6.17 The factors which affect the costs and benefits associated with service costing are as follows. (a) The complexity of the costing system, which depends on the nature of the production process and the exact nature of the service. Professional services are most commonly suited to a job costing system, since each service is customised, the volume of services is low and direct labour costs (the major cost element) can easily be traced to the service. At the other end of the scale, mass service providers produce a large volume of services, often utilising equipment through ‘back office’ operations. These costs can be traced to the processes rather than the service itself; hence a process costing approach is appropriate. Service shops may use a hybrid approach depending on the degree of customisation of the service. (b) The accuracy of the cost information. This varies as we move from left to right along the service type continuum (shown in Exhibit 6.5 on page 242). Professional services (such as accounting or legal practices) have more direct labour costs, whereas mass service entities (such as services provide through automatic ticket dispensing machines) have more equipment-related indirect costs. Since the tracing of indirect costs is a problem in service industries, the greater the proportion of overhead cost, the less accurate the service cost is likely to be. (c) The relevance of service costs to the entity’s strategic and competitive environment. If managers know the cost of their service, they are able to assess service profitability, decide which services to promote, refine or withdraw, set service fees and plan and control costs. Where competition is intense and the fee level is important, service providers need cost information. Some service industries, such as medical practices, have their fees largely regulated by government legislation, so the costs are irrelevant for setting fees, although they may be useful for planning and control. 6.18 Generally there are no inventories relating to the production of services, therefore there is no need for costing systems designed to calculate inventory value. Australian accounting standards do not require services to be costed for financial reporting purposes so they do not exist in ledger accounts in this form, or for this purpose. Services costs may appear in the general ledger in the form of line item operating expenses and be attributed to individual services to meet the information needs of management, but not for financial reporting purposes. (There are some exceptions, however, where the service is provided over more than one accounting period, and therefore the costs of the service need to be accumulated from one period to the next. For example, legal cases may extend over several months or even years and where fees have not been charged for these services it is necessary to accumulate their costs as work in process inventory.) 6.19 Organisations such as law firms, software development companies, accounting practices, architects and consulting engineers often work on ongoing projects, which overlap the closing date for financial reporting. While this work-in-process is not inventory in a physical sense, Australian accounting standard AASB 102 Inventories requires that their costs be recorded as assets where fees have not been charged. Costs of work-in-process must only contain production costs, so upstream and downstream costs must be excluded. 6.20 According to AASB 102, for external reporting purposes inventories of goods purchased for resale should include: •

the purchase price of the merchandise

•

import duties and other taxes related to the purchase price

•

the cost of transportation into the business and handling costs

•

other costs directly attributable to acquiring the inventory less

•

the deductions for trade discounts, rebates and other similar items.

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SOLUTIONS TO EXERCISES EXERCISE 6.21 (10 minutes) Classifying costs; controllable costs: hospital (a) (b) (c)

May be controllable by the director to a certain extent, but could also be considered uncontrollable, as it may depend on the medical needs of the patients admitted. Controllable cost. Uncontrollable cost.

EXERCISE 6.22 (10 minutes) Classifying costs; direct costs: hotel restaurant (a) (b) (c) (d) (e) (f)

Direct cost—directly related to the operations of the restaurant, it is a cost incurred in the restaurant in the provision of its output. Direct cost—directly related to the operations of the restaurant, it is a cost incurred in the restaurant in the provision of its output. Indirect cost—cost not under the control of the restaurant and not directly related to its operations. Indirect cost—cost not under the control of the restaurant and not directly related to its operations. Direct cost—directly related to the operations of the restaurant, it is a cost incurred in the restaurant solely for the purpose of providing restaurant services. Direct cost—directly related to the operations of the restaurant, it is a cost incurred by the restaurant solely to increase demand in the restaurant.

EXERCISE 6.23 (10 minutes) Classifying costs; value chain: telecommunications organisation 1 2 3 4 5 6 7 8 9

c a or b c d e c d c or e c or e

EXERCISE 6.24 (5 minutes) Classifying costs; value chain: retailer 1 2 3 4 5 6 7

a b and e b b b Not confined to one segment of the value chain c

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EXERCISE 6.25 (20 minutes) Service firm types 1

2

3

4

5

Mass services. There is low contact time (perhaps none if this can be done by mail or online); little or no customisation or discretion; back office/product orientated and a large number of customers; staff are non-professional. Professional services. There is high contact time and the services are essentially people-focused. Each service is unique, that is, there is a high level of customisation and discretion and very front office orientated. Staff who deliver the service are professionally qualified, although there may be a number of less qualified support staff behind the scenes. Service shop – assuming that we are considering over-the-counter transactions or regular services. Contact time, customisation and discretion are less than for professional services, but more than for mass services. These are job-related insofar as each service is technically different although they may all use the same processes, for example, the approval of a housing loan application. There is a combination of front and back office operations and a combination of reliance on both people and equipment. If we are considering the use of automatic teller machines, the bank could be considered a mass services entity. In this case, there is more emphasis on back office operations and equipment. Service shop. Contact time, customisation and discretion are less than professional services but more than mass services. This is a job related environment as each repair service is technically different although they may all consist of different combinations of similar processes. Mass services. There is low contact time and little or no customisation or discretion; back office/product orientated and a large number of customers. Staff, excluding pilots and some of the other flight crew, is non-professional. The service is largely supported by various types of equipment, from aircraft to boarding pass scanning machines.

EXERCISE 6.26 (30 minutes) Job costing: feature film production Fox Studios is comprised of eight stages, production offices and workshops which are located together with over 60 independent businesses, providing production services including casting, travel and freight, equipment rental, postproduction (film editing, sound re-recording and mixing) and special effects. Recent studio credits include Wolverine (2008), Australia (2007), Superman Returns (2005), Stealth (2004), and Son of the Mask (2004) . The Federal government currently provides a 15% rebate on qualifying expenditure and various Statebased incentives are also available, but all productions filming in Australia must do so through an Australian company. Fox Studios offers advice to overseas companies wishing to film in Australia, provides and coordinates the services to do so and bases its fees on the level of service provided on a case by case basis. Accurate job-order service costing is critical both for Fox and for the film production company. Job-order costing is the appropriate product-costing system for feature film production, because a film is a unique production. The production process for each film would outsource various specialist activities and use labour, material and support activities (that is, overhead) in different ways. This would be true of or any type of film (for example, filming on location, filming in the studio, or using animation).

EXERCISE 6.27 (15 minutes) Job costing and pricing: interior decorating firm 1

Calculation of the total cost of the firm’s contract to redecorate the council offices Budgeted overhead rate

=

budgeted overhead budgeted direct professional labour

=

$400 000

=

160% of direct labour cost

$250 000 Direct material Direct professional labour Overhead (160% × $6000) Total contract cost

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$ 2 800 6 000 9 600 $18 400

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2

Calculation of the service fee: Total contract cost Required profit margin (40%) Service fee

$18 400 7 360 $25 760

EXERCISE 6.28 (15 minutes) Job billing: interior decorating firm (continuation of Exercise 6.27) 1

Calculation of the fee charged to redecorate the council offices: Direct material (at cost) Labour cost ($180 x120 hrs, includes profit margin) Fee charged

$2 800 21 600 $24 400

2

The key differences between this billing system for estimating service fees and the costing system used in Exercise 6.27 are that the billing system estimates fees based on a chargeout rate per billable hour and that the chargeout rate includes an allowance to cover overhead and profit. In a service costing system the overhead costs are applied to the service using a single predetermined overhead rate for the business based on the number of professional labour hours worked. The total cost then needs to be increased by a profit margin to determine the fee charged.

3

The billing system would be a preferred method for estimating client fees as it: •

• •

Estimates the client service fees based on chargeout rates per billable hour for the various categories of labour that have been consumed in providing the service (usually, the chargeout rate is set to cover the cost of labour and overheads and a profit margin) rather than using a single business-wide overhead rate. Provides an ongoing estimate of charges for each client. Enables a firm to monitor current earnings on partially completed jobs by accumulating the billable charges for all clients.

EXERCISE 6.29 (20 minutes) Job costing and billing: IT consulting firm 1

Predetermined overhead rate based on direct labour costs.

Budgeted overhead

$1 106 000 $442 400

=

Budgeted direct labour cost

= 250% of professional labour cost (rounded) 2

Cost of services Smith and Sons

Jones and Partners

The Business Centre

Hourly rate

Hours

Total

Hours

Total

Hours

Total

IT Trainee

$20

50

$1 000

20

$ 400

70

$1 400

IT Graduate

$ 50

100

5 000

140

7 000

80

4 000

Senior Consultant

$150

15

2 250

10

1 500

20

3 000

Labour type

Total labour cost

8 250

8 900

8 400

Overhead

20 625

22 250

21 000

Total cost

$28 875

$31 150

$29 400

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3

Management may use the cost information: (a) as a basis for setting fees (b) to assess the profitability of each service (c) to decide on promotion, refinement, or withdrawal of services (d) to control costs.

4

If Gotta Geek Ltd was using a billing system for estimating its service costs, it would estimate the cost of each consulting job by accumulating the amounts that the client is to be charged for the service rather than by accumulating the costs of each job. The billing system would estimate the fees to be charged based on chargeout rates per billable hour for each separate labour type, such as IT trainees, graduates and senior consultants, that has been consumed in providing the IT consulting services, rather than using one single predetermined overhead rate for the entire business to allocate overhead costs to services.

EXERCISE 6.30 (20 minutes) Process costing: airport check-ins 1

Cost per check-in:

Total cost No. of passengers processed Cost per check-in

International $63 000 5 250 $12

Domestic $148 500 16 500 $9

2

Although the domestic terminal has the higher cost level, it also has a higher throughput. Many of the costs are fixed, and they are also the most significant ones: managerial and staff salaries, depreciation on various types of equipment and allocated rent. As these fixed costs are spread over a larger number of passengers, their impact becomes less. Also, the check-in procedures for domestic passengers will be simpler than those for international passengers. They have no passports to check, they frequently have only cabin baggage (especially business passengers) and there are no complications of passengers who are disembarking at different locations along the way – most domestic flights are direct and one-stop.

3

Process costing is used (and is relatively accurate) when products or services are homogeneous. While mass service entities such as the one under consideration display some of the characteristics of homogeneity, it is almost certain that the check-in processes differ between passengers. The services described in (2) above, such as the number of locations and the amount of luggage, may vary from one passenger to the next. Anybody who has ever stood in an airport check-in queue has observed that some passengers have a highly-developed capacity for creating problems at check-in for a variety of reasons!

4

The cost per check-in calculated above has limited value for Airport Services Ltd management. It cannot be used for setting fees or determining profitability, since there are no fees charged. The service cannot be promoted or withdrawn as it is an essential component of the entire service of passenger transport. It may have some use in controlling costs by comparing actual costs with budgeted costs, or similar costs from previous periods, or for benchmarking with other airports around Australia.

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EXERCISE 6.31 (20 minutes) Process costing: book order agency 1&2

3

Receipt of order

Pack and despatch order

Receipt of order

Total

Process costs

$564 500

$520 000

$396 000

$1 480 500

Cost per order

$25.66

$23.64

$18.00

$67.30

The total cost per order is an average only and is not likely to be a reliable estimate of the cost of processing individual orders. The greatest variation is likely to occur in the content of each order, as not every student will require the same number and types of books. Presumably, students doing final year may use more books than first year students. Since final year students may be studying different elective subjects, there may be diversity between the books ordered by students within the final year group. The weight of each package of books despatched and the distance that they are freighted may also be a source of differentiation.

EXERCISE 6.32 (20 minutes) When to use service costing 1

False. Australian accounting standards do not require the cost of individual services to be determined for financial reporting purposes, but these costs may be estimated to support managers in their quest to manage resources and create value.

2

True. Professional services are a good example in which the cost of each service can be determined accurately enough to assist in the setting of fees. Professional services display a high degree of customisation and discretion, and the major cost item (professional labour) is a direct cost. Using a job costing approach, the cost per service can be determined with a reasonable degree of accuracy, and can therefore be useful in setting fees in many professions.

3

False. The usefulness of service costs depends on the accuracy of the estimated service costs, the complexity of the costing system and the importance of service cost information in the firm’s competitive environment. A high level of overheads is likely to imply low reliability in service cost estimates (especially if there is a diversity of services), unless complex systems such as ABC are used. Generally speaking service businesses with high indirect costs are unlikely to adjudge service costing to be worthwhile, unless their competitive environment demands it.

4

True. In professional services firms that are characterised by high levels of direct labour costs and relatively low levels of indirect costs a conventional job costing system may provide a reasonably accurate estimate of the cost of each service produced. However, if the professional service firm has a high level of indirect costs, the answer to (3) above indicates why it may not find costing the services worthwhile. In these circumstances, it may be worthwhile to consider implementing activity-based costing to accurately allocate overhead costs to cost objects.

5

False. Conventional product costing methods apply overhead costs to goods or services using one or more volume-based cost drivers. The reliability of the costs will depend on the extent to which the overhead costs exist and are volume driven, and the selection of appropriate cost drivers. It is difficult to generalise about the reliability of these methods in service and manufacturing businesses. However, many service businesses are characterised by high levels of non-volume driven overheads. In these businesses conventional product costing methods would result in inaccurate service costs.

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EXERCISE 6.33 (40 minutes) Flow of costs: travel agency and a retailer 1

The income statement of a travel agency, a service firm that does not carry inventory, would be similar in format to the income statement of the Adelaide Bank Ltd in Exhibit 6.13 on page 258. It would not include line items for cost of sales (product cost) or a gross profit figure. Instead line items for operating expenses would be included, totalled and deducted from revenues to arrive at operating profit before income taxes. The income statement of a retailer, like that of Smashes Electrical Stores Ltd in Exhibit 6.14 on page 259, would include sales, cost of sales and gross profit. Cost of sales would include all of the costs of acquiring merchandise for resale. The company’s other expenses (period costs) would be identified separately from cost of sales and deducted from gross profit to arrive at profit before income taxes.

2

Sales staff salaries in an income statement for a travel agent would be shown as an expense line item with a name such as ‘employee salaries, wages, and benefits’.

3

Depreciation of the travel agency’s computer equipment would be included in an expense line item, possibly separately named as ‘depreciation’.

4

The costs of newspaper advertising for both a retailer and travel agent would be included as selling expense line items. In the case of the retailer this line item would appear below the gross profit.

5

The cost of merchandise for a retailer would be shown as cost of sales in the income statement and as a current asset, inventory, in the balance sheet.

6

The costs of stationery, to print reservations and tickets, consumed in a period for a travel agent would be shown as an expense line item in the income statement. The cost of stationery on hand at the end of the period would appear as a current asset in the balance sheet.

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SOLUTIONS TO PROBLEMS PROBLEM 6.34 (15 minutes) Classifying costs; direct and indirect; controllable and uncontrollable: hotel Some of these classifications are open to interpretation. The real test is whether the student shows an understanding of the various classifications in making a case for each item.

1

a, c, e

2

b, d, e

3

d, e* * The hotel general manager may have some control over the total space allocated to the kitchen.

4

b, d, e

5

a, d, e

6

a, d, e

7

a, c, e

8

b, d, e

9

b, d, e

10

b, d**, e ** Unless the dishwasher has been used improperly.

PROBLEM 6.35 (20 minutes) Classifying costs according to value chain: accounting firm Some of these classifications are open to interpretation. The real test is whether the student shows an understanding of the various classifications in making a case for each item. 1 2 3 4 5 6 7 8 9 10

c. g (cost driver is the number of audit assignments and number of hours spent on each assignment). h c. f (only one consultant). h a or b or both. f (only one research assistant). h c. f. i d. g (cost drivers include the method of advertising, the number of times they are shown, when they are shown and where they are shown). i c and e. g (cost drivers are the number of calls made, the method used – landline or mobile, and the location of the client). i c. f or g (if based on number of copies made). i c. g (cost drivers are the number and different types of tax returns). i c. g (cost drivers are the number and different types of tax returns). h c. f. i

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PROBLEM 6.36 (20 minutes) Classifying costs; value chain; variable and fixed; controllable and uncontrollable; product cost: retailer 1

tasks unclear so difficult to know whether (b) applies. e. g (cost driver is labour hours). h

2

b. g (cost drivers are revenue and labour hours). h

3

a. g (cost driver is sales volume). h. j

4

a. g (cost driver is sales volume). h. j

5

c. f. i

6

c. f (allocation is fixed in each year, based on revenue in the previous year). i

7

a. b. c. d. e. f. i

8

a (is responsible for ordering). b. e. f. h

9

b. e. g (cost driver opening hours). h

10

d. g (cost driver distance travelled or number of deliveries). h

PROBLEM 6.37 (20 minutes) Job costing: medical practice 1

Healthaware’s overhead includes all costs apart from direct labour. This approach is quite common in service businesses, where direct labour is the major cost and direct materials are insignificant. The overhead includes upstream and downstream costs, as well as any indirect production costs (such as depreciation on equipment used during the medical consultation). These costs are not included in the overhead rate for manufactured products, as the Australian accounting standards exclude nonmanufacturing costs from inventory valuations. However, Healthaware—like most service businesses— has no work in process or finished goods inventories. Their services are consumed as they are produced.

2

As general practitioners provide a vast range of services, the service costing system is likely to be quite complex. The salaried doctors are likely to be frustrated by Cooke’s costing system which requires them to keep detailed records of the time they spend on each procedure. The estimates of cost will not affect the practice’s billing system. The practice’s charges for services are likely to be closely linked to the Federal government’s scheduled fees. Any increase in the charge for a standard consultation would cause a substantial gap between the charge and the Medicare rebate, and may cause patients to leave the practice. The estimates of service profitability will not influence the practice’s product mix. General practitioners must provide a general range of services. It is not feasible for the practice to specialise in one or a few services, such as pregnancy or blood tests. This appears to be a case where the costs of the improved management information will outweigh the benefits of improved management information.

3

The practice must offer a full range of services, so that it can make a profit from its services overall, but can tolerate losses on some. These are also complementary services; only by offering standard consultations and pregnancy tests will cases be identified where blood tests are needed. Cooke’s advice is, therefore, poor.

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PROBLEM 6.38 (25 minutes) Job costing: consulting firm 1 % directly traceable to clients 80% 60% 90% 90% 70%

Costs Professional staff salaries Administrative support staff Travel Photocopying Other operating costs Total

$2 400 000 400 000 250 000 50 000 100 000 $3 200 000

Total traceable costs ($) $1 920 000 240 000 225 000 45 000 70 000 $2 500 000

The total traceable costs for the coming year are $2 500 000. Total over head = total costs – traceable costs = $3 200 000 – 2 500 000 = $700 000 2

Predetermined overhead rate based on directly traceable costs: Budgeted overhead

=

Budgeted directly traceable costs

$2 500 000

=

3

$ 700 000

28% of directly traceable costs

The percentage of cost (directly traceable and overhead) that WACS will add to each job: Desired profit

=

Total costs

$ 640 000 $3 200 000

=

20% of total costs

4 Martin Manufacturing project Professional staff salaries Administrative support staff Travel Photocopying Other operating costs Total direct costs (given) Plus overhead at 28% of traceable costs Total costs 5

Costs ($) 41 000 2 600 4 500 500 1 400 50 000 14 000 64 000

Martin Manufacturing would be billed $64 000 plus 20% profit markup. This amounts to $76 800. This approach taken by WACS may be described as a service costing system that determines total cost by applying a single predetermined overhead rate for the business based on the difference between directly traceable costs and total costs. The total cost then needs to be increased by a profit margin to determine the fee charged. A client billing system would estimate the fee charged based on a chargeout rate per billable hour, which includes an allowance for overhead and for profit.

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6

Other operating costs are likely to include depreciation of IT equipment, office furniture and other fixtures; rent or depreciation of firm accommodation; advertising of services; utilities; general office consumables and possibly training and professional development costs of staff. Such costs would be difficult to trace directly to services performed for clients.

7

Reasons why 100% of professional staff costs are not directly traceable to projects undertaken for clients would include time spent by staff on: training and professional development; marketing; tendering for projects; general meetings; and unexpected leave.

PROBLEM 6.39 (25 minutes) Job costing; future versus current costs: engineering firm 1

Direct costs $14 000 10 000 6 000 500 2 000 250 $32 750

Civil engineers Environmental scientists Support labour Travel Computer time Photocopying etc.

x Mark up 1.75 1.75 1.5 1.5 1.5 1.5

Tender bid $24 500 17 500 9 000 750 3 000 375 $55 125

2

The profit should be $55 125 – $32 750 = $22 375.

3

Managers may break down the project into stages and compare the actual costs incurred to the planned costs for each stage. They will also be interested in whether the actual hours and cost, for each cost element, is in line with the estimated costs.

4

There is likely to be a connection, because there needs to be feedback from the performance of previous projects in terms of estimating the hours appropriately for each type of labour, and the cost per hour. Computer time and travel estimates could also be monitored to make sure they are reasonably accurately estimated for the project and this may inform the tender process for other projects.

PROBLEM 6.40 (30 minutes) Job costing and job billing: health resort 1

Total cost of each program A

B

C

$140

$140

Activity Health check

$140 per checkup

Bush walk

$80 per hour

Gym workout

$240 per hour

Yoga class

$140 per hour

70

Massage

$140 per hour

35

70

$405

$450

Total cost*

$140 160

240

D

160

$160

480

240

140

70

$920

$470

*Total cost = labour cost + overhead application rate 2

The resort managers may use the cost information: (a) as a basis for setting fees (b) to assess the profitability of each service (c) to decide on promotion, refinement or withdrawal of particular types of services (d) to control costs.

3

The different rate of overhead for each class of labour suggests that each rate has been calculated individually by identifying the budgeted overhead for that particular activity and dividing it by the

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budgeted labour costs for the activity. This approach enables the resort to recognise that more overhead resources are used per hour of professional labour in the gym and during the medical check up, possibly because of the expensive equipment associated with these services. In contrast relatively few overhead resources are consumed during the bush walk. If the resort had calculated a blanket rate for all activities, the ratio between overhead and labour cost would have been constant. As can be seen by the differential in overhead rates, using a blanket rate would have concealed the level of diversity in overhead costs. 4 The price of each program using the chargeout rates. Activity Health check

Total rate

A

B

$168 per checkup

Bush walk

$96 per hour

Gym workout

$288 per hour

Yoga class

$168 per hour

84

Massage

$168 per hour

42

84

$486

$540

$168

$168

192 288

C

D

$168 192

192

576

288

168

84

$1104

$564

PROBLEM 6.41 (50 minutes) Service costing: hospital; department cost allocation 1

(a) Total costs = $13 125 000/35 000 patient days = $375 per day (b) Surgical Ward ($) Medical staff ($37.50 per hr) Nursing staff ($20 per hr) Other costs ($125 per patient-day)

Patient days Billing rate per day

2

1 875 000

Maternity Ward ($) 375 000

2 400 000

General Ward ($)

Total ($)

1 500 000

3 750 000

200 000

2 400 000

5 000 000

1 250 000

625 000

2 500 000

4 375 000

5 525 000

1 200 000

6 400 000

13 125 000

10 000 $552.50

5 000 $240.00

20 000 $320.00

35 000

Looking at the above data, the maternity patient seems to have a case for arguing that the billing rate is too high. If separate billing rates are calculated for each ward then the rate for maternity is only $240 per patient day. With a single billing rate for all wards, both maternity and general ward patients appear to be cross-subsidising the surgical ward patients. However, the calculation of individual ward billing rates may not be accurate. More work needs to be done to consider the appropriateness of the cost drivers used to allocate ‘other costs’ to wards. For example, patient days is unlikely to be an accurate cost diver for ‘other costs’. Maternity patients do use much less medical and nursing care, and may use less radiology and special meals, but currently this may not be reflected in the calculations.

3

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Medical staff Nursing staff Overhead: Patient records

Radiology Kitchen Other overhead

Nursing staff

Overhead: Patient records

Radiology

Kitchen

Other overhead

Application rate ($) 37.50 20.00

Cost drivers Medical staff hours Nursing staff hours

Number of patients

625 000

5 000

125.00

Medical staff hours in Surgical and General

1 000 000

90 000

11.1111

Nursing staff hours

1 500 000

250 000

6.00

per nursing staff hour

Nursing staff hours

1 250 000

250 000

5.00

per nursing staff hour

Cost application Medical staff

Quantity of cost driver

Cost ($) 3 750 000 5 000 000

100 000 250 000

Surgical

50 000 hours x $37.50 10 000 hours x $37.50 40 000 hours x $37.50 120 000 hours x $20.00 10 000 hours x $20.00 120 000 hours x $20.00

$ 1 875 000

1 000 patients x $125 1 000 patients x $125 3 000 patients x $125 50 000 hours x $11.1111 no cost driver 40 000 hours x $11.1111 120 000 hours x $6.00 10 000 hours x $6.00 120 000 hours x $6.00 120 000 hours x $5.00 10 000 hours x $5.00 120 000 hours x $5.00

$

$

No. of patient days Rate per patient day

$ 1 500 000

$ 3 750 000

$ 2 400 000

$ 5 000 000

$

375 000

$ 625 000

$

444 444

$ 1 000 000

$

720 000

$ 1 500 000

$ 600 000 $ 6 039 444 20 000 $ 301.97

$ 1 250 000 $ 13 125 000

375 000

200 000

125 000

–

720 000 $

$

Totals

555 556 $

$

General

125 000 $

$

per medical staff hours in Surgical and General wards

2 400 000 $

$

per patient

Maternity

$

Cost driver per medical staff hour nursing staff hour

60 000

600 000

6 275 556 10 000 $ 627.56

$

50 000

$

810 000 5 000 $ 162.00

4

The more detailed costing system ought to provide better information. The only question is whether the drivers are realistic. The cost of the kitchen may be better connected to patient days than nursing time as there is a closer connection between meals received and patient days than intensity of nursing. Before recommending this approach we would need to make a much more thorough assessment of the costs and benefits of the information.

5

The system may be better if there was a bed charge which took into account all of the floor space costs and meals, with medical and nursing charging by the day on a ward basis. Radiology could be charged by use. An admissions charge per patient could cover the patient records etc.

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PROBLEM 6.42 (25 minutes) Process costing: university enrolments 1 Total costs Students processed Cost per student

Validation

Student records

Fees collection

$82 600

$128 800

$81 900

14 000

14 000

14 000

$5.90

$9.20

$5.85

2

Total cost per student is $5.90 + $9.20 + $5.85 = $20.95.

3

The total cost of $20.95 to process each student enrolment is not a reliable estimate since it is an average cost based on total costs divided by the number of students processed. It does not allow for differences in services provided to individual students, as obviously, some enrolments will be more complex than others. Two examples of where students’ enrolments may differ are (i) the validation of secondary school records and (ii) students may undertake different course structures, thus the time taken to enter data into the student records system will vary. Costs cannot be easily traced to individual students; hence the average is not representative of all students.

4

Whether the process is outsourced or not, knowledge of the cost to process each student may be useful for: (a) (b) (c)

5

Charging a fee for student enrolment, if the university decides to introduce fees for some services presently provided free. Cost control, if the university decided to continue processing enrolments internally. Setting an ‘overhead recovery’ fee for overseas partners if the university offers its courses outside of Australia (a current practice in Australia).

Estimating costs for all student services depends on: (a) (b) (c)

The benefits of having the cost information versus the costs of obtaining the information. The purposes for which it was going to be used, as outlined in (4) above. Whether the services are repetitive, as above, or whether they are non-recurrent services, in which case an activity-based approach may be necessary. As we describe in Chapter 8, some universities are currently going down this path, although it is not known how sophisticated their activity-based costing systems are.

PROBLEM 6.43 (25 minutes) Estimating service costs; ethical issues: accounting firm 1

2

(a)

The system does provide a reliable estimate of the professional labour costs used as logs are kept by staff on the time spent on various jobs.

(b)

The use of 150 per cent mark up is unlikely to provide a reliable estimate of the costs of the other resources used by individual jobs. For example, it assumes that a senior partner uses other resources at three times the rate that a supervisor does, as the mark-up for other costs is based on professional labour rates and the senior partner rate is three times the supervisor rate. In fact the other costs consist of a large number of different items, which are likely to have differing relationships with professional salaries.

The billing system probably works reasonably well. In circumstances where the staff mix is not right and more senior staff are handling work that would usually go to junior staff then some discounting of the fee should occur. Otherwise the firm will find itself over-pricing and losing business. Also it could find its fees going up and down dramatically. What if Watson was only charged $1300 next year and

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Holmes was charged $1863! The practice manager could review fees to ensure that they were reasonable for the work required. 3

The firm could look carefully to see whether there are other costs that could be billed directly to the client, to reduce the mark-up being charged. For example, computer costs, clerical support, direct lodgment fees, and other costs could be separately accumulated and costed to clients. They could look at a system that budgets the cost for the client (and accumulates the fee history for the client) and then compares this with the actual fee so that variations are picked up. When extra work is requested by the client this must be noted.

4

I would first check that the firm did not provide extra services to Watson or that Watson himself had asked that particular accountants handle the work. In the absence of other explanations I would acknowledge that the charge was too high and re-bill him using the same charge as billed to Holmes and assure him that the fee will be checked next year. (This may mean that both Holmes and Watson’s fees increase next year, as a shortage of resources may make it necessary to use senior partners on each job for some of the time.)

PROBLEM 6.44 (30 minutes) Estimating costs in a retail business 1

Cost of inventory purchased during the year: Purchase price of inventories Goods and services tax on purchases Inwards freight Less trade discount on purchases Total

$545 000 54 500 10 000

$609 500 45 000 $564 500

2 Auto Spares Pty Ltd Income Statement for year ended 31 December Sales b Less cost of goods sold a Gross profit Less expenses: Staff salaries Rent Equipment depreciation and insurance Telephone Computer software and hardware Data transfer system Stationery and other consumables Electricity Net profit a b

3

$914 490 508 050 406 440

$160 000 30 000 5 000 3 300 15 000 6 000 3 000 4 800

227 100 $179 340

$564 500 × 90% = $508 050 $508 050 × 1.8 = $914 490

In order to provide more useful information for managing resources and creating value, the costing system could include the following modifications. (a)

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Goods purchased for resale could be separated into product categories for pricing and profitability assessment purposes. Some products may be able to carry higher or lower mark-ups than the standard figure of 80 per cent presently used.

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(b)

Costs of operating major responsibility centres such as purchasing, sales and delivery should be identified. This has been done in part only, with the staff salaries categories already identified.

(c)

The firm should adopt a full value chain approach to cost categorisation. This would require costs traced to, or attributed to (using an activity-based approach) the major activities of purchasing, sales transactions, marketing and customer support.

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SOLUTIONS TO CASES CASE 6.45 (45 minutes) Job costing; department overhead cost allocation: tour operator

1

Profit for individual packages sold in the corporate department

Revenue per package Less direct costs: Tour leader Tour assistant Air travel Accommodation Equipment hire Meals Total direct costs Contribution margin Less allocated corporate departmental costs* Profit per individual package × packages sold Total profit CM % sales revenue Profit % sales revenue

Bali $90 000

Thailand $72 000

Malaysia $112 000

Total

5 000 2 000 28 000 15 000 4 000 18 000 72 000 18 000

12 000 3 000 30 000 26 000 0 15 000 86 000 (14 000)

9 000 6 000 32 000 24 000 9 000 8 000 88 000 24 000

5 980

4 787

7 445

12 020 10

(18 787) 20

16 555 10

40

$120 200

($375 740)

$165 550

($89 990)

20.0%

(19.44)%

21.43%

13.36%

(26.09)%

14.78%

* Allocation of direct costs of running the corporate department ($230 000) based on sales revenue:

Total revenue % of total Cost per location Cost per package

2

Bali $900 000 26.00% $59 800 $5 980

Thailand $1 440 000 41.63% $95 749 $4 787

Malaysia $1 120 000 32.37% $74 451 $7 445

Total $3 460 000 100.00% $230 000

The Bali and Malaysian packages are making a contribution margin of 20 per cent and 21.4 per cent respectively, while the Thailand Discovery tour is unprofitable. The direct costs of Thailand package are comparable with Malaysia, but since it sells twice the number of packages as each of the others there may be scope for increasing the price. Even after allocating the costs of the corporate department, the Bali and Malaysian packages show a return on sales of 13.35 per cent and 14.78 per cent respectively. Increasing the price of the Thailand package in order to bring it to a profitable level would redistribute the corporate department costs, with a consequent improvement in profitability for the Bali and Malaysian packages.

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3

The allocation of corporate department overheads should not be based on actual sales revenue since there is probably little relationship between the overhead items and package revenue. Efforts should be made to trace the corporate department costs to activities associated with the packages, as suggested below. Salaries Phone Deprecation on equipment Rent and property taxes Utilities and other departmental costs

% of time managers spend on each package Direct calls made in relation to each package Value of equipment dedicated to each package Area of floor space occupied if traceable to packages Probably a fairly arbitrary method related to the number of packages or staffing levels.

Some of these may be slightly arbitrary but would be an improvement on the method presently used, especially in relation to salaries. 4

Some suggested improvements are as follows: (a) Market research should be undertaken to see if the price of the Thailand tour can be increased in order to improve the contribution margin. Activities associated with each tour should be investigated to see if cost savings are possible. (b) Corporate department costs should be allocated using a method similar to that suggested in (3) above providing a more equitable method of charging running costs to each package. Another approach would be to discontinue the practice of allocating running costs altogether and evaluate the profitability of each package on a contribution margin basis.

CASE 6.46 (50 minutes) Job costing using client cost sheet; fraud investigation: accounting firm 1

Calculation of overhead recovery rate based on professional labour dollars. If professional labour costs amount to 75 per cent of the firm’s total operating costs, overhead must represent 25 per cent of the total. The recovery rate will therefore be $1 of overhead for every $3 of professional labour, or 33.33 per cent of professional labour cost.

2

If overhead represents only 25 per cent of total operating costs, the firm would be unwise to spend too much effort in calculating a different rate for each grade of professional labour. The costs of tracking overhead costs such as administrative and support labour, telephone calls and photocopying to individual grades of professional labour would not justify the more sophisticated cost information. The single rate based on professional labour dollars may also reflect reality in a sense. If partners and managers are paid more than investigators and clerical staff, their chargeout rate will also attract a higher allocation of overhead. Because they are busier people, they may have less time to spend on support tasks, and so will need to employ support staff to carry out these functions on their behalf, thereby justifying the higher level of overhead charged out.

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3 & 4 Client cost sheet: fraud investigation Client code 4506B Client details Mr Jackson McInnes Jazz Industries Client manager Christine Miller Service provided Fraud investigation Date commenced 1 May Date completed 11 May Professional labour Date

Details Initial meeting with client Briefing meeting with project team Preparation of investigation plan Review of investigation plan Review of investigation plan Initial interviews with warehouse staff Documentation of ordering procedures On-site review of inventory ordering systems Interviews with suppliers Review consultation Interview of key managers Character checks of key employees Checking of supplier history Checking of supplier history Random check of inventory and supplier transactions Preparation of draft report Meeting to review report Edit report Discussion of final report Presentation of final report to client Total hours Labour rate per hour Total cost of professional labour

May 1 2 3

6

May 7 8 9 10 11

J House 1 1

C Miller 1 1

G Smith 1 6 2

2 2

4 4 5 3 2 3

2

3

4 2 2 6 8 2 3 3

22 $100 $2200

49 $60 $2940

2 3 2 9 $150 $1350

Overhead Total professional labour Overhead at 33.33% of total professional labour cost Total cost of investigation

5

$6490 2163 $8653

(a)

Staff should keep detailed time sheets for all their work, not just this particular client, in order to account for how they spend their time. This will enable senior partners to plan staffing needs and evaluate the capacity of the practice to undertake additional work. With regard to this client, detailed time sheets will establish the actual cost of completing the investigation, in total, and by stage.

(b)

Detailed time sheets on this particular investigation will enable the firm to cost the job, evaluate overhead recovery, justify the cost to the client and enable management to more accurately estimate the costs of undertaking any future investigations of a similar nature.

(c)

Any figure below $8653 means that the practice will not recover all of its direct and support costs let alone earn an acceptable level of profit. In a competitive market, reasons why the practice may decide to undertake the case for less than this figure include: (i)

Chapter 6

it may have ‘idle capacity’ and be happy to keep the staff occupied while it waits for activity levels to increase

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(ii) (iii) (iv)

by undertaking this investigation, it may be able to secure the client for other accounting work if the practice does not undertake this case, the client will engage a competitor to do it, thereby losing the benefits of any future work the practice may develop a reputation for this type of work and become a recognised expert in the area of inventory-related fraud.

6

If Spicer and Rabbit introduced a client billing system for estimating its service costs, it would accumulate the amounts that the client is to be charged for the service rather than by accumulating the costs of each job. The billing system would estimate the fees to be charged based on chargeout rates per billable hour for the partner, manager and investigator and the hours of service that they have provided, to cover its professional labour costs, overhead costs and a required profit margin.

7

It would be recommended that Spicer and Rabbit use a client billing system that would provide the firm with an ongoing estimate of charges for each of its clients and enable the firm to monitor its current earnings on partially completed jobs though accumulating the billable charges for all clients. Chargeout rates can be based on the market or professional association rates and can be adjusted in the light of changing market conditions, allowing the firm to stay competitive within the industry. A billing system also would allow the firm to monitor its profitability by using realisation rates.

CASE 6.47 (75 minutes) Process costing and hybrid costing: backpacker lodges 1

Staff salaries Equipment depreciation and insurance Electricity Telephone Building lease Linen Consumables Total costs Units processed Cost per unit of activity base (a) (b) (c) (d)

Payment collection $60 000 4 000 2 500 2 000 900 0 2 000 $71 400 2 400 persons $29.75 per person

$28.00 per person for accommodation reception $27.90 per day of room maintenance $29.75 per accommodation payment processed Total cost per person-day, based on an average stay of five days: Reception ($28.00/5 days) Room maintenance Payment collection ($29.75/5 days) Total

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Reception $50 000 6 000 3 000 4 000 1 200 0 3 000 $67 200 2 400 persons $28.00 per person

Room Maintenance $105 000 155 000 5 000 0 30 000 4 800 35 000 $334 800 12 000 person-days $27.90 per person-day

$5.60 27.90 5.95 $39.45

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2

The profitability of accommodation is poor, whichever way it is calculated. In total (2400 x 5 nights x $40 per night)

Revenue Less expenses: Reception Room maintenance

$ 67 200 $ 334 800

Payment collection

$ 71 400

$480 000

$473 400

Profit (loss)

$ 6 600 Per person per day

Revenue Less cost to process:

$40.00

Reception Room maintenance Payment collection

$ 5.60 $ 27.90 $ 5.95

$

Margin (loss)

39.45 $ 0.55

Per 5 day booking (5 nights x $40 per night)

Revenue Less expenses

$200.00

(5 nights x $39.45)

$

Margin (loss)

197.25 $2.75

3 & 4 Using a hybrid approach, customised services will be charged separately, whereas standardised services will be applied on an average cost per service. Costs to prepare and serve one meal, based on a throughput of 8000: Kitchen service Restaurant/table service

$88 000/8000 meals $64 000/8000 meals

$1100 $800 $1900

Hybrid costing Meal type Roast Spaghetti bolognaise Vegetarian burgers Fish fillets

Process cost

Ingredients

Cost per meal

$19.00 $19.00 $19.00 $19.00

$4.20 $3.30 $3.78 $5.40

$23.20 $22.30 $22.78 $24.40

Clearly, the serving of evening meals is unprofitable. Based on a throughput of 8000 meals, the costs to prepare and serve the meals ($19) exceeds the selling price ($5 – $15 per meal). As shown, adding the cost of ingredients only makes the picture worse.

5

The correct approach to use when costing the tours is hybrid costing:

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6

(a)

some customised elements, such as equipment depreciation, are assigned directly to each tour

(b)

the costs of standardised processes, such as the cost per day of tour guides, are averaged across each type of tour which uses the same processes

(c)

the total cost per tour will be the sum of customised elements, plus the average cost per standard services used by each tour.

While it is not possible to answer this question completely without further information, an outline of the approach can be provided. Annual costs assumed to be fixed: Equipment depreciation Tour van depreciation Fuel and van maintenance* Public liability insurance Other Total assumed annual fixed costs

$20 000 $5 000 $10 000 $15 000 $6 000 $56 000

* Is likely to be a mixed cost Thus to approach profitability the tours would have to earn total revenue of more than $56 000 and cover variable costs. To ensure a reasonable profit the lodge should estimate the cost per tour and then price each tour at cost plus a reasonable profit margin. (Of course the lodge would have to keep an eye on competitors’ prices, as well.) Without further information about the annual costs, it must be assumed that these are used equally by the tours, and so can be averaged across each tour using process costing. In this case, 400 half-day tours have been converted to equal 200 one day tours (equivalent production approach). Thus, there is equivalent of a total of 500 tour days. The average fixed cost per tour day is $56 000/500 tours = $112 per tour day. The cost per tour would be calculated as follows: One day Tour Tour guide Standardised services Total

$200 112 $312 *

Half day Tour $100 112 $212

* Plus the cost of meals

The cost of meals will be specific to each tour; however, the average number of persons per tour would be useful information to estimate the variable costs of picnic lunches. The information suggests that only the full day tours require picnic lunches for each participant in the tour. The cost of the tour guide will differ, depending on whether the tour is for one day or half a day (the above costing assumes that the guides will only charge $100 for a half day). For profitability assessment, the selling price per person for each tour is required, plus the average number of persons per tour. 7

In advising management how to improve the profitability of the business, care should be taken in using the cost information calculated in 1–6 above. Much of the cost is influenced by the base rate used (2400 backpackers, an average stay of 5 days, 8000 meals served, 300 one-day tours and 400 half-day tours) as the cost of standardised services are averaged in a process costing approach. Clearly, as the throughput of these services increases, the cost per service will be lowered. Where possible, the direct costs of each service should be identified more closely, allowing a contribution margin approach to be used. The contribution margin approach is useful due to the high level of fixed costs associated with many of the services. The costs associated with serving evening meals are a good illustration. When dividing the costs of preparing and serving meals by 8000 meals, the cost to prepare and serve the meal ($19) exceeds the revenue, without including the cost of the ingredients. Only telephone and electricity costs amounting to $21 000 are likely to be at all variable with the number of meals (and this

Chapter 6

Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd

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is taking a very conservative approach), leaving $131 000 (i.e. $88 000 + $64 000 - $21 000) in fixed costs. There is no firm information on selling price per meal (the range is $5 to $15) or the product mix of the 8000 meals served. The data given below assumes a range of selling prices, ingredients cost as given, and equal consumption of the four menus.

Assumed selling price

Meal Roast

12.00

Spaghetti bolognaise Vegetarian burger Fish fillets

Direct cost $4.20

Contributio n per meal

Volume

Total contribution

7.80

2 000

15 600

5.00

$3.30

1.70

2 000

3 400

10.00

$3.78

6.22

2 000

12 440

$15.00

$5.40

$9.60

2 000

$19 200 $50 640

The weighted average contribution per meal without including the possibly variable telephone and electricity costs is $50 640/8000 meals = $6.33. Thus the break-even point excluding electricity and telephone costs is $157 200/$6.33 = 24 834 meals. The present throughput of 8000 meals is obviously a long way below this, so management needs to increase throughput, although there may well be limited scope for this. A better approach may be to examine the level of fixed costs to see where savings can be made. Similar investigations should be made for each of the other services. In each case, there appears to be a high level of fixed costs, some of which are allocated across the services. If these are totalled, they suggest a business with a high fixed-cost structure. Where a number of process costs are an average, reducing the fixed costs or improving throughput will improve the unit cost of each of the services. 8

Management can use the cost information prepared in 1 to 6 above: (a) (b) (c) (d)

Chapter 6

to evaluate the profitability of each of the services for setting prices for each service in deciding which services to promote, refine or withdraw to control costs.

Solutions Manual to accompany Management Accounting: Information for Creating and Managing Value 6e by Langfield-Smith, Thorne and Hilton. Copyright  2012 McGraw-Hill Australia Pty Ltd

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